\nITEM 1. CONDENSED FINANCIAL STATEMENTS\nIGNYTE ACQUISITION CORP.\nCONDENSED BALANCE SHEETS\n| June 30, 2021 | December 31, 2020 |\n| (unaudited) |\n| Assets |\n| Cash | $ | 550,470 | $ | 25,425 |\n| Prepaid expense and other current assets | 181,923 | - |\n| Total current assets | 732,393 | 25,425 |\n| Deferred offering costs | - | 81,575 |\n| Cash and securities held in Trust Account | 57,504,345 | - |\n| Total Assets | $ | 58,236,738 | $ | 107,000 |\n| Liabilities and Stockholders' Equity |\n| Current liabilities: |\n| Accrued expenses | $ | 12,656 | $ | - |\n| Due to related party | 51,953 | 310 |\n| Promissory note - related party | - | 80,000 |\n| Total current liabilities | 64,609 | 80,310 |\n| Warrant liabilities | 1,875,000 | - |\n| Total liabilities | 1,939,609 | 80,310 |\n| Commitments and Contingencies(8) |\n| Common stock subject to possible redemption, 5,129,712 shares at redemption value | 51,297,120 | - |\n| Stockholders' Equity: |\n| Preferred stock, $ 0.0001 par value; 1,000,000 shares authorized; none issued and outstanding | - | - |\n| Common stock, $ 0.0001 par value; 50,000,000 shares authorized; 2,157,788 shares and 0 shares issued and outstanding (excluding 5,129,712 shares and 0 shares subject to possible redemption) at June 30, 2021 and December 31, 2020, respectively | 216 | 154 |\n| Additional paid-in capital | 4,730,179 | 26,846 |\n| Retained earnings (Accumulated deficit) | 269,614 | ( 310 | ) |\n| Total stockholders' equity | 5,000,009 | 26,690 |\n| Total Liabilities and Stockholders' Equity | $ | 58,236,738 | $ | 107,000 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n1\nIGNYTE ACQUISITION CORP.\nUNAUDITED CONDENSED STATEMENTS OF OPERATIONS\n| For the Three Months Ended | For the Six Months Ended |\n| June 30, 2021 | June 30, 2021 |\n| Formation and operating costs | $ | 110,980 | $ | 309,421 |\n| Loss from operations | ( 110,980 | ) | ( 309,421 | ) |\n| Other income |\n| Change in fair value of warrants | 725,000 | 575,000 |\n| Trust interest income | 2,087 | 4,345 |\n| Total other income | 727,087 | 579,345 |\n| Net income | $ | 616,107 | $ | 269,924 |\n| Basic and diluted weighted average shares outstanding, common stock subject to redemption | 5,068,102 | 4,183,046 |\n| Basic and diluted net loss per share | $ | 0.00 | $ | 0.00 |\n| Basic and diluted weighted average shares outstanding, common stock | 2,219,398 | 2,053,694 |\n| Basic and diluted net loss per share | $ | 0.28 | $ | 0.13 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n2\nIGNYTE ACQUISITION CORP.\nUNAUDITED CONDENSED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY\n| Common Stock | Additional Paid-in Capital | Retained Earnings(Accumulated Deficit) | Total Stockholders' Equity |\n| Shares | Amount |\n| Balance as of December 31, 2020 | 1,537,500 | $ | 154 | $ | 26,846 | $ | ( 310 | ) | $ | 26,690 |\n| Sale of 5,000,000 and 750,000 Units on February 1, 2021 and February 2, 2021 through IPO and over-allotment, respectively | 5,750,000 | 575 | 57,499,425 | - | 57,500,000 |\n| Sale of 2,350,000 and 150,000 Placement Warrants on February 1, 2021 and February 2, 2021, respectively, net of fair value of warrant liabilities | - | - | 50,000 | - | 50,000 |\n| Underwriting fee | - | - | ( 1,150,000 | ) | - | ( 1,150,000 | ) |\n| Other offering expenses | - | - | ( 399,485 | ) | - | ( 399,485 | ) |\n| Net loss | - | - | - | ( 346,183 | ) | ( 346,183 | ) |\n| Common stock subject to possible redemption | ( 5,068,201 | ) | ( 507 | ) | ( 50,680,513 | ) | - | ( 50,681,020 | ) |\n| Balance as of March 31, 2021 | 2,219,398 | 222 | 5,346,273 | ( 346,493 | ) | 5,000,002 |\n| Change in value of common stock subject to possible redemption | ( 61,610 | ) | ( 6 | ) | ( 616,094 | ) | ( 616,100 | ) |\n| Net income | 616,107 | 616,107 |\n| Balance as of June 30, 2021 (unaudited) | 2,157,788 | $ | 216 | $ | 4,730,179 | $ | 269,614 | $ | 5,000,009 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n3\nIGNYTE ACQUISITION CORP.\nUNAUDITED CONDENSED STATEMENT OF CASH FLOWS\n| For the Six Months Ended |\n| June 30, 2021 |\n| Cash flows from Operating Activities: |\n| Net income | $ | 269,924 |\n| Adjustments to reconcile net income to net cash used in operating activities: |\n| Increase in fair value of warrants | ( 575,000 | ) |\n| Interest earned on marketable securities held in Trust Account | ( 4,345 | ) |\n| Changes in current assets and current liabilities: |\n| Prepaid expenses | ( 181,923 | ) |\n| Accrued offering costs and expenses | 12,656 |\n| Due to related party | 51,643 |\n| Net cash used in operating activities | ( 427,045 | ) |\n| Cash Flows from Investing Activities: |\n| Purchase of investment held in Trust Account | ( 57,500,000 | ) |\n| Net cash used in investing activities | ( 57,500,000 | ) |\n| Cash flows from Financing Activities: |\n| Proceeds from Initial Public Offering, net of underwriters' fees | 56,350,000 |\n| Proceeds from private placement | 2,500,000 |\n| Repayment of promissory note to related party | ( 80,000 | ) |\n| Payments of offering costs | ( 317,910 | ) |\n| Net cash provided by financing activities | 58,452,090 |\n| Net change in cash | 525,045 |\n| Cash, beginning of the period | 25,425 |\n| Cash, end of the period | $ | 550,470 |\n| Supplemental disclosure of noncash investing and financing activities: |\n| Initial value of Common stock subject to possible redemption, as revised | $ | 51,023,118 |\n| Change in value of Common stock subject to possible redemption | $ | 274,002 |\n| Initial fair value of warrant liabilities | $ | 2,450,000 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n4\nIGNYTE ACQUISITION CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nNote 1 — Organization and Business Operations\nOrganization and General\nIgnyte Acquisition Corp. (the “Company”) is a newly organized blank check company incorporated as a Delaware corporation on August 6, 2020. The Company was incorporated for the purpose of effecting a merger, stock exchange, asset acquisition, stock purchase, reorganization or other similar business combination with one or more businesses (the “Business Combination”).\nThe Company has selected December 31 as its fiscal year end.\nThe Company is an early stage and emerging growth company and, as such, the Company is subject to all of the risks associated with early stage and emerging growth companies.\nAs of June 30, 2021, the Company had not commenced any operations. All activity for the period from August 6, 2020 (inception) through June 30, 2021 relates to the Company's formation and the initial public offering (“IPO”), which is described below. The Company will not generate any operating revenues until after the completion of its initial Business Combination, at the earliest. The Company will generate non-operating income in the form of interest income on cash and cash equivalents from the proceeds derived from the IPO.\nThe Company's sponsor is Ignyte Sponsor LLC (the “Sponsor”), a Delaware limited liability company (the “Sponsor”).\nFinancing\nThe registration statement for the Company's IPO was declared effective on January 27, 2021 (the “Effective Date”). On February 1, 2021, the Company consummated the IPO of 5,000,000 units (the “Units” and, with respect to the shares of common stock included in the Units being offered, the “Public Shares”), at $ 10.00 per Unit, generating gross proceeds of $ 50,000,000 , which is discussed in Note 4.\nSimultaneously with the closing of the IPO, the Company consummated the sale of 2,350,000 Private Placement Warrants (the “Private Placement Warrants”) at a price of $ 1.00 per Private Placement Warrant in a private placement to the Sponsor, generating total gross proceeds of $ 2,350,000 .\nOn February 2, 2021, the underwriters purchased an additional 750,000 Units to exercise its over-allotment option in full at a purchase price of $ 10.00 per Unit, generating gross proceeds of $ 7,500,000 . Simultaneously with the closing of the full exercise of the over-allotment option, the Company completed the private sale of an aggregate of 150,000 Private Placement Warrants to the Sponsor, at a purchase price of $ 1.00 per Private Placement Warrant, generating gross proceeds of $ 150,000 . A total of $ 7,500,000 was placed in the Trust Account after the payment of $ 150,000 underwriting discount.\nTransaction costs amounted to $ 1,549,485 consisting of $1,150,000 of underwriting discount and $ 399,485 of other offering costs. In addition, $ 975,465 of cash was held outside of the Trust Account (as defined below) and is available for working capital purposes.\nTrust Account\nFollowing the closing of the IPO, on February 1, 2021, $50,000,000 ($10.00 per Unit) from the net proceeds of the sale of the Units in the IPO and the sale of the Private Placement Warrants was held in a Trust Account (“Trust Account”), and will invest only in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, having a maturity of 185 days or less or in money market funds meeting certain conditions under Rule 2a-7 promulgated under the Investment Company Act which invest only in direct U.S. government treasury obligations. Except with respect to interest earned on the funds held in the Trust Account that may be released to the Company to pay income tax obligations, the proceeds from the IPO will not be released from the Trust Account until the earlier of the completion of a Business Combination or the Company's redemption of 100 % of the outstanding Public Shares if it has not completed a Business Combination in the required time period. The proceeds held in the Trust Account may be used as consideration to pay the sellers of a target business with which the Company completes a Business Combination. Any amounts not paid as consideration to the sellers of the target business may be used to finance operations of the target business.\n5\nInitial Business Combination\nIn connection with any proposed Business Combination, the Company will either (1) seek stockholders approval of the initial Business Combination at a meeting called for such purpose at which stockholders may seek to convert their shares, regardless of whether they vote for or against the proposed Business Combination or don't vote at all, into their pro rata share of the aggregate amount then on deposit in the Trust Account (net of taxes payable), or (2) provide its stockholders with the opportunity to sell their shares to the Company by means of a tender offer (and thereby avoid the need for a stockholder vote) for an amount equal to their pro rata share of the aggregate amount then on deposit in the Trust Account (net of taxes payable), in each case subject to the limitations described herein. The decision as to whether the Company will seek stockholders approval of a proposed Business Combination or will allow stockholders to sell their shares to the Company in a tender offer will be made by the Company, solely in its discretion,\nThe shares of Common Stock subject to redemption will be recorded at a redemption value and classified as temporary equity upon the completion of the IPO, in accordance with Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” In such case, the Company will proceed with a Business Combination if the Company has net tangible assets of at least $ 5,000,001 upon such consummation of a Business Combination and, if the Company seeks stockholder approval, a majority of the issued and outstanding shares voted are voted in favor of the Business Combination.\nThe Company will have 21 months from the closing of the IPO to complete the initial Business Combination (the “Combination Period”). However, if the Company is unable to complete the initial Business Combination within the Combination Period, the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem 100% of the outstanding public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including interest earned on the funds held in the Trust Account and not previously released to the Company but net of taxes payable ( and less up to $ 50,000 of interest to pay dissolution expenses), divided by the number of then outstanding public shares, which redemption will completely extinguish public stockholders' rights as stockholders (including the right to receive further liquidation distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the Company's remaining stockholders and the Company's board of directors, liquidate and dissolve, subject (in the case of (ii) and (iii) above) to the Company's obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law.\nThe Sponsor, officers and directors have agreed (i) to vote any shares owned by them in favor of any proposed Business Combination, (ii) not to convert any shares in connection with a stockholder vote to approve a proposed initial Business Combination or sell any shares to the Company in a tender offer in connection with a proposed initial Business Combination, (iii) that the founders' shares will not participate in any liquidating distributions from the Company's Trust Account upon winding up if a Business Combination is not consummated.\nThe Sponsor has agreed that it will be liable to ensure that the proceeds in the Trust Account are not reduced below $10.00 per share by the claims of target businesses or claims of vendors or other entities that are owed money by the Company for services rendered or contracted for or products sold to the Company. The agreement entered into by the Sponsor specifically provides for two exceptions to the indemnity it has given: it will have no liability (1) as to any claimed amounts owed to a target business or vendor or other entity who has executed an agreement with the Company waiving any right, title, interest or claim of any kind they may have in or to any monies held in the Trust Account, or (2) as to any claims for indemnification by the underwriters of the Proposed Public Offering against certain liabilities, including liabilities under the Securities Act. However, the Company has not asked its Sponsor to reserve for such indemnification obligations, nor has it independently verified whether the Sponsor has sufficient funds to satisfy its indemnity obligations and believe that the Sponsor's only assets are securities of the Company. Therefore, the Company believes it is unlikely that the Sponsor will be able to satisfy its indemnification obligations if it is required to do so.\nLiquidity and Capital Resources\nAs of June 30, 2021, the Company had $ 550,470 in its operating bank account, and working capital of $ 667,784 .\nPrior to the completion of the Initial Public Offering, the Company's liquidity needs had been satisfied through a payment from the Sponsor of $ 25,000 (see Note 6) for the Founder Shares to cover certain offering costs, the loan under an unsecured promissory note from the Sponsor of $ 80,000 (see Note 6), and the net proceeds from the consummation of the Private Placement not held in the Trust Account. In addition, in order to finance transaction costs in connection with a Business Combination, the Company's Sponsor or an affiliate of the Sponsor or the Company's officers and directors or their affiliates may, but are not obligated to, provide the Company Working Capital Loans (see Note 6). To date, there were no amounts outstanding under any Working Capital Loans.\nBased on the foregoing, management believes that the Company will have sufficient working capital and borrowing capacity to meet its needs through the earlier of the consummation of a Business Combination or one year from this filing. Over this time period, the Company will be using these funds for paying existing accounts payable, identifying and evaluating prospective initial Business Combination candidates, performing due diligence on prospective target businesses, paying for travel expenditures, selecting the target business to merge with or acquire, and structuring, negotiating and consummating the Business Combination.\n6\nNote 2 — Revision of Previously Issued Financial Statements\nOn April 12, 2021, the Staff of the Securities and Exchange Commission together issued a statement regarding the accounting and reporting considerations for warrants issued by special purpose acquisition companies entitled \"Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (\"SPACs\")\" (the \"SEC Statement\"). Specifically, the SEC Statement focused on certain settlement terms and provisions related to certain tender offers following a Business Combination, which terms are similar to those contained in the warrant agreement, dated as of January 27, 2021, between the Company and Continental Stock Transfer & Trust Company, a New York corporation, as warrant agent (the \"Warrant Agreement\").\nHistorically, the warrants were reflected as a component of equity as opposed to liabilities on the balance sheets and the statements of operations did not include the subsequent non-cash changes in estimated fair value of the Warrants, based on the application of FASB ASC Topic 815-40, Derivatives and Hedging, Contracts in Entity's Own Equity (“ASC 815-40). The views expressed in the SEC Staff Statement were not consistent with the Company's historical interpretation of the specific provisions within its warrant agreement and the Company's application of ASC 815-40 to the warrant agreement. the Company reevaluated the accounting treatment of (i) the 2,875,000 Public Warrants and (ii) the 2,500,000 Private Placement Warrants (See Note 4 and Note 5). Based on this reassessment, management determined that the private warrants should be classified as liabilities measured at fair value upon issuance, with subsequent changes in fair value reported in the Company Statement of Operations each reporting period.\nThe Company's management and the audit committee of the Company's Board of Directors concluded that it is appropriate to revise the Company's previously issued audited balance sheet as of February 1, 2021 as previously reported in its Form 8-K.\nThe following tables summarize the effect of the restatement on each balance sheet line item as of the date:\n| As Previously Reported | Adjustment | As Revised |\n| Balance Sheet at February 1, 2021 |\n| Warrant Liabilities | $ | - | $ | 2,303,000 | $ | 2,303,000 |\n| Total Liabilities | 426,200 | 2,303,000 | 2,729,200 |\n| Common stock subject to possible redemption | 45,973,118 | ( 2,303,000 ) | 43,670,118 |\n| Common stock | 194 | 23 | 217 |\n| Additional paid-in capital | 5,004,203 | ( 23 ) | 5,004,180 |\n| Accumulated deficit | $ | ( 4,396 ) | $ | - | $ | ( 4,396 ) |\n| Total Stockholders' Equity | 5,000,001 | - | 5,000,001 |\n| Number of shares subject to redemption | 4,597,312 | ( 230,300 ) | 4,367,012 |\n\nNote 3 — Summary of Significant Accounting Policies\nBasis of Presentation\nThe accompanying unaudited condensed financial statements are presented in U.S. dollars in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for financial information and pursuant to the rules and regulations of the SEC. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP. In the opinion of management, the unaudited condensed financial statements reflect all adjustments, which include only normal recurring adjustments necessary for the fair statement of the balances and results for the periods presented. Operating results for the period for the six months ended June 30, 2021 are not necessarily indicative of the results that may be expected through December 31, 2021.\nThe accompanying unaudited condensed financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Form 10-K filed by the Company with the SEC.\n7\nEmerging Growth Company\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act of 1933, as amended, (the “Securities Act”), as modified by the Jumpstart our Business Startups Act of 2012, (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statement with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\nUse of Estimates\nThe preparation of unaudited condensed financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited condensed financial statements and the reported amounts of expenses during the reporting period. Making estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the unaudited condensed financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. Actual results could differ from those estimates.\nCash and Cash Equivalents\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did not have any cash equivalents as of June 30, 2021 and December 31, 2020.\nMarketable Securities Held in Trust Account\nAt June 30, 2021, the assets held in the Trust Account were invested in money market funds.\nFair Value Measurements\nFASB ASC Topic 820 “Fair Value Measurements and Disclosures” (“ASC 820”) defines fair value, the methods used to measure fair value and the expanded disclosures about fair value measurements. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between the buyer and the seller at the measurement date. In determining fair value, the valuation techniques consistent with the market approach, income approach and cost approach shall be used to measure fair value. ASC 820 establishes a fair value hierarchy for inputs, which represent the assumptions used by the buyer and seller in pricing the asset or liability. These inputs are further defined as observable and unobservable inputs. Observable inputs are those that buyer and seller would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs reflect the Company’s assumptions about the inputs that the buyer and seller would use in pricing the asset or liability developed based on the best information available in the circumstances.\nThe fair value hierarchy is categorized into three levels based on the inputs as follows:\nLevel 1 — Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access. Valuation adjustments and block discounts are not being applied. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these securities does not entail a significant degree of judgment.\nLevel 2 — Valuations based on (i) quoted prices in active markets for similar assets and liabilities, (ii) quoted prices in markets that are not active for identical or similar assets, (iii) inputs other than quoted prices for the assets or liabilities, or (iv) inputs that are derived principally from or corroborated by market through correlation or other means.\nLevel 3 — Valuations based on inputs that are unobservable and significant to the overall fair value measurement.\nThe fair value of the Company’s certain assets and liabilities, which qualify as financial instruments under ASC 820, “Fair Value Measurements and Disclosures,” approximates the carrying amounts represented in the balance sheet. The fair values of cash, prepaid assets, and accounts payable are estimated to approximate the carrying values as of December 31, 2020 due to the short maturities of such instruments.\n8\nThe Company’s warrant liabilities are based on a valuation model utilizing management judgment and pricing inputs from observable and unobservable markets with less volume and transaction frequency than active markets. Significant deviations from these estimates and inputs could result in a material change in fair value. In some circumstances, the inputs used to measure fair value might be categorized within different levels of the fair value hierarchy. In those instances, the fair value measurement is categorized in its entirety in the fair value hierarchy based on the lowest level input that is significant to the fair value measurement. See Note 7 for additional information on assets and liabilities measured at fair value.\nConcentration of Credit Risk\nFinancial instruments that potentially subject the Company to concentrations of credit risk consist of a cash account in a financial institution, which, at times, may exceed the Federal Depository Insurance Coverage of $ 250,000 . At June 30, 2021 and December 31, 2020, the Company has not experienced losses on this account and management believes the Company is not exposed to significant risks on such account.\nCommon Stock Subject to Possible Redemption\nThe Company accounts for its common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption (if any) is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. The Company’s common stock feature certain redemption rights that is considered to be outside of the Company’s control and subject to the occurrence of uncertain future events. Accordingly, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders’ equity section of the Company’s balance sheet.\nNet Income Per Common Share\nNet income per common share is computed by dividing net income by the weighted average number of common stock outstanding for each of the periods. The calculation of diluted net income per common share does not include warrants since the inclusion of such warrants would be anti-dilutive.\nThe Company's statement of operations includes a presentation of income per share for common stock subject to possible redemption in a manner similar to the two-class method of income per common share. Net income per common share, basic and diluted, for redeemable common stock is calculated by dividing the interest income earned on the Trust Account, by the weighted average number of redeemable common stock outstanding since original issuance. Net income per common share, basic and diluted, for non-redeemable common stock is calculated by dividing the net income, adjusted for income attributable to redeemable common stock, by the weighted average number of non-redeemable common stock outstanding for the periods. Non-redeemable common stock includes the founder shares as these shares do not have any redemption features and do not participate in the income earned on the Trust Account.\n| For the Three Months Ended | For the Six Months Ended |\n| June 30, 2021 | June 30, 2021 |\n| Common stock subject to possible redemption |\n| Numerator: net income allocable to common stock subject to possible redemption |\n| Interest income on marketable securities held in trust | $ | 1,862 | $ | 3,876 |\n| Less: interest available to be withdrawn for payment of taxes | - | - |\n| Net income allocable to common stock subject to possible redemption | 1,862 | 3,876 |\n| Denominator: Weighted average redeemable common stock |\n| Redeemable common stock, basic and diluted | 5,068,102 | 4,183,046 |\n| Basic and diluted net income per share, redeemable common stock | $ | - | $ | - |\n| Non-redeemable common stock |\n| Numerator: net income minus redeemable net earnings |\n| Net income | $ | 616,107 | $ | 269,924 |\n| Redeemable net earnings | ( 1,862 ) | ( 3,876 ) |\n| Non-redeemable net income | 614,245 | 266,048 |\n| Denominator: Weighted average non-redeemable basic and diluted weighted average shares outstanding, common stock | 2,219,398 | 2,053,694 |\n| Basic and diluted net income per share, common stock | $ | 0.28 | $ | 0.13 |\n\n9\nOffering Costs associated with the Initial Public Offering\nThe Company complies with the requirements of the ASC 340-10-S99-1 and SEC Staff Accounting Bulletin (“SAB”) Topic 5A - “Expenses of Offering”. Offering costs consist principally of professional and registration fees incurred through the balance sheet date that are related to the IPO and were charged to stockholders' equity upon the completion of the IPO. Accordingly, as of February 1, 2021, offering costs in the aggregate of $ 1,549,485 have been charged to stockholders' equity (consisting of $1,150,000 of underwriting discount and $ 399,485 of other offering costs).\nWarrant Liabilities\nThe Company accounts for the Public Warrants and Private Warrants (as defined in Note 4 and 5) collectively (“Warrants”), as either equity or liability-classified instruments based on an assessment of the specific terms of the Warrants and the applicable authoritative guidance in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 815, Derivatives and Hedging (“ASC 815”). The assessment considers whether the Warrants meet all of the requirements for equity classification under ASC 815, including whether the Warrants are indexed to the Company’s own ordinary shares and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of the Company’s control, among other conditions for equity classification. This assessment, which requires the use of professional judgment, is conducted at the time of issuance of the Warrants and as of each subsequent quarterly period end date while the Warrants are outstanding.\nFor issued or modified warrants that meet all of the criteria for equity classification, such warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all the criteria for equity classification, such warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of liability-classified warrants are recognized as a non-cash gain or loss on the statements of operations.\nThe Company accounts for the Private Warrants in accordance with ASC 815-40 under which the Private Warrants do not meet the criteria for equity classification and must be recorded as liabilities. The fair value of the Private Warrants has been estimated using the Monte Carlo simulation model. See Note 7 for further discussion of the pertinent terms of the Warrants used to determine the value of the Private Warrants and Representative’s Warrants.\nThe Company evaluated the Public Warrants in accordance with ASC 815-40, “Derivatives and Hedging — Contracts in Entity’s Own Equity” and concluded that they met the criteria for equity classification and are required to be recorded as part a component of additional paid-in capital at the time of issuance.\nIncome Taxes\nThe Company follows the asset and liability method of accounting for income taxes under ASC 740, “Income Taxes.” Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statements carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that included the enactment date. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.\n10\nASC 740 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more likely than not to be sustained upon examination by taxing authorities. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of June 30, 2021. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position. The Company is subject to income tax examinations by major taxing authorities since inception.\nRisks and Uncertainties\nOn January 30, 2020, the World Health Organization (“WHO”) announced a global health emergency because of a new strain of coronavirus (the ”COVID-19 outbreak”). In March 2020, the WHO classified the COVID-19 outbreak as a pandemic, based on the rapid increase in exposure globally. The full impact of the COVID-19 outbreak continues to evolve. The impact of the COVID-19 outbreak on the Company’s financial position will depend on future developments, including the duration and spread of the outbreak and related advisories and restrictions. These developments and the impact of the COVID-19 outbreak on the financial markets and the overall economy are highly uncertain and cannot be predicted. If the financial markets and/or the overall economy are impacted for an extended period, the Company’s financial position may be materially adversely affected. Additionally, the Company’s ability to complete an initial Business Combination may be materially adversely affected due to significant governmental measures being implemented to contain the COVID-19 outbreak or treat its impact, including travel restrictions, the shutdown of businesses and quarantines, among others, which may limit the Company’s ability to have meetings with potential investors or affect the ability of a potential target company’s personnel, vendors and service providers to negotiate and consummate an initial Business Combination in a timely manner. The Company’s ability to consummate an initial Business Combination may also be dependent on the ability to raise additional equity and debt financing, which may be impacted by the COVID-19 outbreak and the resulting market downturn. The financial statement does not include any adjustments that might result from the outcome of this uncertainty.\nRecent Accounting Standards\nManagement does not believe that any recently issued, but not effective, accounting standards, if currently adopted, would have a material effect on the Company’s financial statement.\nNote 4 — Initial Public Offering\nOn February 1, 2021, the Company sold 5,000,000 Units, at a purchase price of $ 10.00 per Unit. Each Unit consists of one share of common stock and one-half of one warrant to purchase one share of common stock (“Public Warrant”). Each whole Public Warrant entitles the holder to purchase one share of common stock at a price of $ 11.50 per share, subject to adjustment.\nOn February 2, 2021, the Underwriters exercised the over-allotment option in full to purchase 750,000 Units (the “Over-Allotment Units”), generating an aggregate of gross proceeds of $ 7,500,000 , and incurred $ 150,000 in underwriting fees.\nPublic Warrants\nEach whole warrant entitles the holder to purchase one share of Common Stock at a price of $11.50 per share, subject to adjustment as discussed herein. The warrants will become exercisable 30 days after the completion of the Company's initial Business Combination. However, no warrants will be exercisable for cash unless the Company has an effective and current registration statement covering the shares of common stock issuable upon exercise of the warrants and a current prospectus relating to such shares of common stock. Notwithstanding the foregoing, if a registration statement covering the shares of common stock issuable upon exercise of the public warrants is not effective within a specified period following the consummation of the initial Business Combination, warrant holders may, until such time as there is an effective registration statement and during any period when the Company shall have failed to maintain an effective registration statement, exercise warrants on a cashless basis pursuant to the exemption provided by Section 3(a)(9) of the Securities Act, provided that such exemption is available. If that exemption, or another exemption, is not available, holders will not be able to exercise their warrants on a cashless basis. In the event of such cashless exercise, each holder would pay the exercise price by surrendering the warrants for that number of shares of common stock equal to the quotient obtained by dividing (x) the product of the number of shares of common stock underlying the warrants, multiplied by the difference between the exercise price of the warrants and the “fair market value” (defined below) by (y) the fair market value. The “fair market value” for this purpose will mean the average reported last sale price of the shares of common stock for the 5 trading days ending on the trading day prior to the date of exercise. The warrants will expire on the fifth anniversary of the completion of an initial Business Combination, at 5:00 p.m., New York City time, or earlier upon redemption or liquidation.\n11\nThe Company may call the warrants for redemption (excluding the Private Placement Warrants and any warrants underlying additional units issued to the Sponsor, initial stockholders, officers, directors or their affiliates in payment of Working Capital Loans made to the Company)\n•\nin whole and not in part;\n•\nat a price of $ 0.01 per warrant;\n•\nat any time after the warrants become exercisable,\n•\nupon not less than 30 days’ prior written notice of redemption to each warrant holder; and\n•\nif, and only if, the reported last sale price of the Common Stock equals or exceeds $ 18.00 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations) for any 20 trading days within a 30-trading day period commencing at any time after the warrants become exercisable and ending on the third business day prior to the notice of redemption to warrant holders; and\n•\nif, and only if, there is a current registration statement in effect with respect to the shares of common stock underlying such warrants.\nIf the Company calls the warrants for redemption as described above, the Company's management will have the option to require all holders that wish to exercise warrants to do so on a “cashless basis.” In such event, each holder would pay the exercise price by surrendering the warrants for that number of shares of common stock equal to the quotient obtained by dividing (x) the product of the number of shares of common stock underlying the warrants, multiplied by the difference between the exercise price of the warrants and the “fair market value” (defined below) by (y) the fair market value. The “fair market value” for this purpose shall mean the average reported last sale price of the shares of common stock for the 5 trading days ending on the third trading day prior to the date on which the notice of redemption is sent to the holders of warrants.\nIn addition, if (x) the Company issue additional shares of Common Stock or equity-linked securities for capital raising purposes in connection with the closing of the initial Business Combination at an issue price or effective issue price of less than $ 9.20 per share of common stock (with such issue price or effective issue price to be determined in good faith by the Company's board of directors, and in the case of any such issuance to the Sponsor, initial stockholders or their affiliates, without taking into account any founders' shares held by them prior to such issuance), (y) the aggregate gross proceeds from such issuances represent more than 60% of the total equity proceeds, and interest thereon, available for the funding of the initial Business Combination on the date of the consummation of the initial Business Combination (net of redemptions), and (z) the Market Value is below $9.20 per share, the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115% of the greater of (i) the Market Value or (ii) the price at which the Company issues the additional shares of common stock or equity-linked securities.\nNote 5 — Private Placement\nSimultaneously with the closing of the IPO, the Sponsor purchased an aggregate of 2,350,000 Private Placement Warrants at a price of $ 1.00 per Private Placement Warrant, for an aggregate purchase price of $ 2,350,000 , in a private placement (the “Private Placement”). Each Private Placement Warrant will entitle the holder to purchase one share of common stock at a price of $11.50 per share, subject to adjustment. The proceeds from the Private Placement Warrants was added to the proceeds from the IPO held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the proceeds from the sale of the Private Placement Warrants held in the Trust Account will be used to fund the redemption of the Public Shares (subject to the requirements of applicable law) and the Private Placement Warrants will expire worthless.\nThe Private Placement Warrants are identical to the Warrants underlying the Units sold in the IPO, except that the Private Placement Warrants are non-redeemable and may be exercised on a cashless basis, in each case so long as they continue to be held by the initial purchasers or their permitted transferees. Further, the Sponsor has agreed not to transfer, assign, or sell the Private Placement Warrants (including the shares of Common Stock issuable upon the exercise of the Private Placement Warrants), except to certain permitted transferees, until after the consummation of the Company's initial business combination.\nSimultaneously with the closing of the exercise of the over-allotment option, the Company completed the private sale (the “Private Placement”) of an aggregate of 150,000 private placement warrants (the “Private Placement Warrants”) to Ignyte Sponsor LLC, a Delaware limited liability company (the “Sponsor”), at a purchase price of $ 1.00 per Private Placement Warrant, generating gross proceeds of $ 150,000 .\n12\nNote 6 — Related Party Transactions\nFounder Shares\nOn August 12, 2020, the Sponsor paid $ 25,000 , or approximately $ 0.02 per share, to cover certain offering costs in consideration for 1,437,500 shares of Common Stock, par value $ 0.0001 (the “Founder Shares”). Up to 187,500 Founder Shares are subject to forfeiture by the Sponsor depending on the extent to which the underwriters' over-allotment option is exercised. On February 2, 2021, the underwriter exercised its over-allotment option in full, hence, the 187,500 Founder Shares are no longer subject to forfeiture since then.\nThe founders' shares were placed into an escrow account maintained in New York, New York by Continental Stock Transfer & Trust Company, acting as escrow agent. Subject to certain limited exceptions, these shares will not be transferred, assigned, sold or released from escrow (subject to certain limited exceptions set forth below) (i) with respect to 50% of such shares, for a period ending on the earlier of the one-year anniversary of the date of the consummation of the initial Business Combination and the date on which the closing price of the Company's common stock equals or exceeds $12.50 per share (as adjusted for share splits, share dividends, reorganizations and recapitalizations) for any 20 trading days within a 30-trading day period following the consummation of the initial Business Combination and (ii) with respect to the remaining 50% of such shares, for a period ending on the one-year anniversary of the date of the consummation of the initial Business Combination, or earlier, in either case, if, subsequent to the initial Business Combination, the Company consummates a liquidation, merger, stock exchange or other similar transaction which results in all of the Company's stockholders having the right to exchange their shares of common stock for cash, securities or other property.\nPromissory Note — Related Party\nOn November 20, 2020, the Company's executive officers loaned the Company $ 80,000 to be used for a portion of the expenses of the IPO. These loans are non-interest bearing, unsecured and are due at the earlier of June 30, 2021 or the closing of the IPO. As of February 1, 2021, the Company repaid the note in full.\nDue to Related Party\nAs of June 30, 2021, the amount due to related party is $ 51,953 which represent the accrual of administrative service fee $ 51,643 from January 26, 2021 to June 30, 2021 and formation cost $ 310 paid by the Officer.\nRelated Party Loans\nIn order to meet the Company’s working capital needs following the consummation of the IPO the Sponsor, officers, directors initial stockholders or their affiliates may, but are not obligated to, loan the Company funds (“Working Capital Loans”), from time to time or at any time, in whatever amount they deem reasonable in their sole discretion. Each loan would be evidenced by a promissory note. The notes would either be paid upon consummation of the initial Business Combination, without interest, or, at holder’s discretion, up to $ 1,500,000 of the notes may be converted into warrants at a price of $ 1.00 per warrant. The warrants would be identical to the Private Placement Warrants. In the event that the initial Business Combination does not close, the Company may use a portion of the working capital held outside the Trust Account to repay such loaned amounts, but no proceeds from the Trust Account would be used for such repayment. As of June 30, 2021 and December 31, 2020, no such Working Capital Loans were outstanding.\nAdministrative Service Fee\nThe Company has agreed, commencing on the date of the securities of the Company are first listed on The Nasdaq Capital Market (the “Listing Date”), to pay the Sponsor $ 10,000 per month for office space, utilities and secretarial support. Upon completion of the initial Business Combination or the Company's liquidation, the Company will cease paying these monthly fees. The Company accrued $ 51,643 and $ 30,000 for the administrative service fee for the period from the Listing Date to June 30, 2021and for the three months ended June 30, 2021.\nNote 7 — Recurring Fair Value Measurements\nThe following table presents information about the Company's assets and liabilities that were measured at fair value on a recurring basis as of June 30, 2021, and indicates the fair value hierarchy of the valuation techniques the Company utilized to determine such fair value.\n13\n| June 30, 2021 | Quoted Prices In Active Markets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Other Unobservable Inputs (Level 3) |\n| Assets: |\n| U.S. Money Market held in Trust Account | $ | 57,504,345 | $ | 57,504,345 | $ | - | $ | - |\n| $ | 57,504,345 | $ | 57,504,345 | $ | - | $ | - |\n| Liabilities: |\n| Warrant liabilities-Private Placement Warrants | $ | 1,875,000 | $ | - | $ | - | $ | 1,875,000 |\n| $ | 1,875,000 | $ | - | $ | - | $ | 1,875,000 |\n\nThe following table sets forth a summary of the changes in the fair value of the warrant liabilities for the period from August 6, 2020 (Inception) through June 30, 2021:\n| Warrant Liability |\n| Fair value as of February 1, 2021 | $ | 2,303,000 |\n| Issuance of private warrants in connection with over-allotment as of February 2, 2021 | 147,000 |\n| Change in fair value (1) | ( 575,000 ) |\n| Fair value as of June 30, 2021 | $ | 1,875,000 |\n\n(1) Represents the non-cash gain on the change in valuation of Private Warrants and is included in the change in fair value of warrant liability on the statement of operations.\nAt June 30, 2021, the Public Warrants were determined to contain none of the features requiring liability treatment; therefore, the Public warrants were not included in the fair value reporting.\nThe Private Warrants were valued using a Modified Black Scholes Model. The Private Warrants are considered to be a Level 3 fair value measurements due to the use of unobservable inputs. The Black Scholes Model can be modified to value SPAC Private Warrants by discounting the Acquisition Date warrant value to the Valuation Date and multiplying the present value by the probability of a future transaction occurring.\nTransfers to/from Levels 1, 2 and 3 are recognized at the end of the reporting period. There were no transfers between levels for the period from January 1, 2021 through June 30, 2021.\nThe following table provides quantitative information regarding Level 3 fair value measurements for Private Warrants as of June 30, 2021 and February 1, 2021.\n| June 30, 2021 | February 1, 2021 |\n| Exercise price | $ | 11.50 | $ | 11.50 |\n| Share price | $ | 9.68 | $ | 10.00 |\n| Volatility | 14.25 | % | 19.00 | % |\n| Expected life | 5 .00 | 5 .00 |\n| Risk-free rate | 0.87 | % | 0.42 | % |\n| Dividend yield | - | % | - | % |\n\nNote 8 — Commitments and Contingencies\nRegistration Rights\nThe holders of the founders’ shares issued and outstanding on the date of the IPO, as well as the holders of the representative shares, Private Placement Warrants and any warrants the Company’s Sponsor, officers, directors or their affiliates may be issued in payment of Working Capital Loans made to the Company (and all underlying securities), will be entitled to registration rights pursuant to an agreement signed on January 27, 2021. The holders of a majority of these securities are entitled to make up to two demands that the Company registers such securities. The holders of the majority of the founders’ shares can elect to exercise these registration rights at any time commencing three months prior to the date on which these shares of common stock are to be released from escrow. The holders of a majority of the representative shares, Private Placement Warrants and warrants issued to the Company’s Sponsor, officers, directors or their affiliates in payment of Working Capital Loans made to the Company (or underlying securities) can elect to exercise these registration rights at any time after the Company consummates a Business Combination. Notwithstanding anything to the contrary, EarlyBirdCapital may only make a demand on one occasion and only during the five-year period beginning on the Effective Date of the registration statement of which the IPO forms a part. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the Company’s consummation of a Business Combination; provided, however, that EarlyBirdCapital may participate in a “piggyback” registration only during the seven-year period beginning on the Effective Date of the registration statement of which the IPO forms a part. The Company will bear the expenses incurred in connection with the filing of any such registration statements.\n14\nUnderwriting Agreement\nThe underwriters have a 45-day option beginning February 1, 2021 to purchase up to an additional 750,000 units to cover over-allotments, if any, at the IPO price less the underwriting discounts.\nThe Company issued to the underwriter (and/or its designees) (the “Representative”) 100,000 shares of common stock for $ 0.0001 per share (the “Representative Shares”). The Company estimated the fair value of the stock to be $ 2,000 based upon the price of the founder shares issued to the Sponsor. The stock were treated as underwriters’ compensation and charged directly to shareholders’ equity. The underwriter (and/or its designees) agreed (i) to waive their conversion rights (or right to participate in any tender offer) with respect to such shares in connection with the completion of our initial business combination and (ii) to waive their rights to liquidating distributions from the trust account with respect to such shares if we fail to complete our initial business combination within 21 months from the closing of this offering.\nOn February 1, 2021, the Company paid a fixed underwriting fee of $ 1,000,000 .\nOn February 2, 2021, the underwriters purchased an additional 750,000 units to exercise its over-allotment option in full. The proceeds of $ 7,500,000 from the over-allotment was deposited in the Trust Account after deducting the underwriting discounts.\nBusiness Combination Marketing Agreement\nThe Company has engaged underwriters as advisors in connection with its Business Combination to assist it in holding meetings with the stockholders to discuss the potential Business Combination and the target business’s attributes, introduce the Company to potential investors that are interested in purchasing the Company’s securities in connection with the potential Business Combination, assist the Company in obtaining stockholder approval for the Business Combination and assist the Company with its press releases and public filings in connection with the Business Combination. The Company will pay the Marketing Fee for such services upon the consummation of the initial Business Combination in an amount equal to, in the aggregate, 3.5 % of the gross proceeds of the IPO, or $ 2,012,500 including the proceeds from the full exercise of the over-allotment option on February 2, 2021.\nRight of First Refusal\nIf the Company determines to pursue any equity, equity-linked, debt or mezzanine financing relating to or in connection with a Business Combination or after a Business Combination, then EarlyBirdCapital shall have the right, but not the obligation, to act as book running manager, placement agent and/or arranger, as the case may be, in any and all such financing or financings and to receive at least 25 % of the aggregate gross spread or fees from any and all such financings. This right of first refusal extends from the February 1, 2021 until the earlier of twelve (12) months after the consummation of an initial Business Combination or the liquidation of the Trust Account if the Company fails to consummate a Business Combination during the required time period.\nNote 9 — Stockholder’s Equity\nPreferred Stock — The Company is authorized to issue 1,000,000 shares of preferred stock with a par value of $ 0.0001 and with such designations, voting and other rights and preferences as may be determined from time to time by the Company's board of directors. At June 30, 2021 and December 31, 2021, there were no shares of preferred stock issued or outstanding.\nCommon Stock — The Company is authorized to issue 50,000,000 shares of common stock with a par value of $ 0.0001 per share. On August 12, 2020, the Sponsor paid $ 25,000 , or approximately $ 0.02 per share, to cover certain offering costs in consideration for 1,437,500 shares of Common Stock, par value $ 0.0001 . Of the 1,437,500 shares of common stock, an aggregate of up to 187,500 shares are subject to forfeiture to the Company for no consideration to the extent that the underwriters' over-allotment option is not exercised in full or in part, so that the initial stockholders will collectively own 20 % of the Company's issued and outstanding common stock after the IPO. On February 2, 2021, the underwriter exercised its over-allotment option in full, hence, the 187,500 Founder Shares are no longer subject to forfeiture since then. In August 2020, the Company also issued to designees of EarlyBirdCapital an aggregate of 100,000 shares of common stock (“representative shares”), at a price of $ 0.0001 per share. As of June 30, 2021 and December 31, 2020, there were 2,157,788 and 1,537,500 shares of common stock issued and outstanding, respectively.\n15\nCommon stockholders of record are entitled to one vote for each share held on all matters to be voted on by stockholders. In connection with any vote held to approve the initial Business Combination, the initial stockholders, as well as all of the Company’s officers and directors, have agreed to vote their respective shares of common stock owned by them immediately prior to the IPO and any shares purchased in the IPO or following the IPO in the open market in favor of the proposed Business Combination.\nNote 10 — Subsequent Events\nThe Company evaluated subsequent events and transactions that occurred after the balance sheet date up to the date that the unaudited condensed financial statements were issued.\n16\n\nITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nReferences to the “Company,” “us,” “our” or “we” refer to Ignyte Acquisition Corp.. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our unaudited condensed financial statements and related notes included herein.\nCautionary Note Regarding Forward-Looking Statements\nAll statements other than statements of historical fact included in this Report including, without limitation, statements under this “Management's Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company's financial position, business strategy and the plans and objectives of management for future operations, are forward- looking statements. When used in this Report, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or the Company's management, identify forward-looking statements. Such forward-looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company's management. Actual results could differ materially from those contemplated by the forward- looking statements as a result of certain factors detailed in our filings with the SEC. All subsequent written or oral forward-looking statements attributable to us or persons acting on the Company's behalf are qualified in their entirety by this paragraph.\nThe following discussion and analysis of our financial condition and results of operations should be read in conjunction with the unaudited condensed financial statements and the notes thereto contained elsewhere in this Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\nOverview\nWe are an early-stage blank check company incorporated as a Delaware corporation and formed for the purpose of effecting an initial business combination.\nWe leverage the more than nine decades of combined operational and financial experience of our management team and board of directors who are both established e-commerce entrepreneurs and sophisticated investors. We believe our extensive industry experience and proven ability to source, acquire, grow and revitalize companies will provide our management team with a robust and consistent flow of acquisition opportunities. Our management team and board's broad relationships across multiple networks, including leading consumer and technology company founders, executives of private and public companies, leading M&A investment banks and private equity firms, as well as their ability to engage early with founder-led businesses represents a differentiated advantage to successfully source transaction opportunities. Our team has been immersed in the same ecosystem as the current founders of private companies who are making decisions on how to build currency for future growth and monetization.\nWhile we may pursue an initial business combination target in any business, industry or geographical location, we are focusing our search primarily within the consumer-facing e-commerce sector. We are capitalizing on the ability of our management team to identify, acquire and operate a business or businesses that can benefit from our management team and board's established relationships and operating experience. Our management team has extensive experience in identifying and executing strategic investments and has done so successfully in several sectors, particularly in digital consumer-facing businesses. Over time, we believe that all companies will need to deploy an omni-commerce strategy to succeed, and we will leverage our management team and board's unique experience to successfully develop our business target's omni-commerce.\nResults of Operations\nOur entire activity since inception up to June 30, 2021 relates to our formation, the Initial Public Offering and, since the closing of the Initial Public Offering, a search for a Business Combination candidate. We will not be generating any operating revenues until the closing and completion of our initial Business Combination, at the earliest.\nFor the three months ended June 30, 2021, we had net income of $616,107, which consisted of $2,087 in interest earned on marketable securities held in the Trust Account, and $725,000 in unrealized gain on change in fair value of warrants, offset by $110,980 in formation and operating costs.\nFor the six months ended June 30, 2021, we had net income of $269,924, which consisted of $4,345 in interest earned on marketable securities held in the Trust Account, and $575,000 in unrealized gain on change in fair value of warrants, offset by $309,421 in formation and operating costs.\n17\nLiquidity and Capital Resources\nAs of June 30, 2021, we had $550,470 in its operating bank account, and working capital of $667,784.\nPrior to the completion of the Initial Public Offering, our liquidity needs had been satisfied through a payment from the Sponsor of $25,000 (see Note 6) for the Founder Shares to cover certain offering costs, the loan under an unsecured promissory note from the Sponsor of $80,000, and the net proceeds from the consummation of the Private Placement not held in the Trust Account. In addition, in order to finance transaction costs in connection with a Business Combination, our Sponsor or an affiliate of the Sponsor or our officers and directors or their affiliates may, but are not obligated to, provide us Working Capital Loans. To date, there were no amounts outstanding under any Working Capital Loans.\nWe anticipate that the $550,470 outside of the Trust Account as of June 30, 2021, will be sufficient to allow the Company to operate for at least the next 12 months from the issuance of the financial statements, assuming that a Business Combination is not consummated during that time.\nBased on the foregoing, management believes that we will have sufficient working capital and borrowing capacity to meet our needs through the earlier of the consummation of a Business Combination or one year from this filing. Over this time period, we will be using these funds for paying existing accounts payable, identifying and evaluating prospective initial Business Combination candidates, performing due diligence on prospective target businesses, paying for travel expenditures, selecting the target business to merge with or acquire, and structuring, negotiating and consummating the Business Combination.\nCritical Accounting Policies and Estimates\nThe preparation of the unaudited condensed financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited condensed financial statements and the reported amounts of expenses during the reporting period. Actual results could differ from those estimates. We have identified the following as our critical accounting policies:\nWarrant Liabilities\nWe account for the Warrants, as either equity or liability-classified instruments based on an assessment of the specific terms of the Warrants and the applicable authoritative guidance in FASB ASC 815, Derivatives and Hedging ASC 815. The assessment considers whether the Warrants meet all of the requirements for equity classification under ASC 815, including whether the Warrants are indexed to the Company's own ordinary shares and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of the Company's control, among other conditions for equity classification. This assessment, which requires the use of professional judgment, was conducted at the time of issuance of the Warrants and will continue as of each subsequent quarterly period end date while the Warrants are outstanding.\nFor issued or modified warrants that meet all of the criteria for equity classification, such warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all the criteria for equity classification, such warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of liability-classified warrants are recognized as a non-cash gain or loss on the statements of operations.\nCommon Stock Subject to Possible Redemption\nThe Company accounts for its common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption (if any) is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company's control) is classified as temporary equity. At all other times, common stock is classified as stockholders' equity. The Company's common stock feature certain redemption rights that is considered to be outside of the Company's control and subject to the occurrence of uncertain future events. Accordingly, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders' equity section of the Company's balance sheet.\nNet Income Per Common Share\nNet income per common share is computed by dividing net income by the weighted average number of common stock outstanding for each of the periods. The calculation of diluted net income per common share does not include warrants since the inclusion of such warrants would be anti-dilutive.\nThe Company's statement of operations includes a presentation of income per share for common stock subject to possible redemption in a manner similar to the two-class method of income per common share. Net income per common share, basic and diluted, for\n18\nredeemable common stock is calculated by dividing the interest income earned on the Trust Account, by the weighted average number of redeemable common stock outstanding since original issuance. Net income per common share, basic and diluted, for non-redeemable common stock is calculated by dividing the net income, adjusted for income attributable to redeemable common stock, by the weighted average number of non-redeemable common stock outstanding for the periods. Non-redeemable common stock includes the founder shares as these common stock do not have any redemption features and do not participate in the income earned on the Trust Account.\nOff-Balance Sheet Arrangements\nAs of June 30, 2021, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K.\n\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nAs of June 30, 2021, we were not subject to any market or interest rate risk. Following the consummation of our Initial Public Offering, the net proceeds received into the Trust Account, have been invested in U.S. government treasury bills, notes or bonds with a maturity of 180 days or less or in certain money market funds that invest solely in US treasuries. Due to the short-term nature of these investments, we believe there will be no associated material exposure to interest rate risk.\nITEM 4. CONTROLS AND PROCEDURES\nDisclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Co-Chief Executive Officers and Chief Financial Officer, to allow timely decisions regarding required disclosure.\nEvaluation of Disclosure Controls and Procedures\nAs required by Rules 13a-15 and 15d-15 under the Exchange Act, our Co-Chief Executive Officers and Chief Financial Officer carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2021. Based upon their evaluation, our Co-Chief Executive Officers and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15 (e) and 15d-15 (e) under the Exchange Act) continued to be ineffective with respect to the classification of the Company's Warrants as components of equity instead of as derivative liabilities and the re-classification of the Company's Class A ordinary shares between temporary and permanent equity. Any failure to maintain effective disclosure controls could adversely impact our ability to report our financial results on a timely and accurate basis, which could have adverse consequences, including with respect to the continued listing of our securities.\nDisclosure controls and procedures are designed to ensure that information required to be disclosed by us in our Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.\nChanges in Internal Control Over Financial Reporting\nDuring the fiscal quarter ended March 31, 2021, management identified a material weakness in internal controls related to the accounting for warrants issued in connection with our initial public offering, as described above, which material weakness continued to exist during the most recent fiscal quarter ended June 30, 2021. While we have processes to identify and appropriately apply applicable accounting requirements, we plan to enhance our system of evaluating and implementing the accounting standards that apply to our financial statements, including through enhanced analyses by our personnel and third-party professionals with whom we consult regarding complex accounting applications. The elements of our remediation plan can only be accomplished over time, and we can offer no assurance that these initiatives will ultimately have the intended effects.\n19\nPART II – OTHER INFORMATION\n\nITEM 1. LEGAL PROCEEDINGS.\nNone.\n\nITEM 1A. RISK FACTORS.\nFactors that could cause our actual results to differ materially from those in this report include the risk factors described in our Annual Report on Form 10-K for the year ended December 31, 2020 filed with the SEC on April 15, 2021, as amended on Form 10-K/A filed with the SEC on April 19, 2021. As of the date of this Report there have been no material changes to the risk factors disclosed in our Annual Report filed with the SEC.\n\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.\nNone.\n\nITEM 3. DEFAULTS UPON SENIOR SECURITIES.\nNone.\n\nITEM 4. MINE SAFETY DISCLOSURES.\nNot applicable.\n\nITEM 5. OTHER INFORMATION.\nOn May 28, 2021, we received a notice from Nasdaq Regulation, or Nasdaq, indicating that we were not in compliance with Nasdaq Listing Rule 5250(c)(1) as a result of our failure to timely file our Quarterly Report on Form 10-Q for the quarter ended March 31, 2021, which we refer to as the Form 10-Q, with the Securities and Exchange Commission, or SEC. The notice provided that we must submit a plan to regain compliance with Nasdaq Listing Rule 5250(c)(1) by July 26, 2021. Alternatively, we were permitted to regain compliance with the Nasdaq listing standards at any time prior to that date by filing the Form 10-Q with the SEC. We subsequently filed the Form 10-Q with the SEC on July 26, 2021.\nOn August 6, 2021, we received a notice from Nasdaq stating that, based on the Form 10-Q filing on July 26, 2021, we had regained compliance with the Nasdaq listing standards.\n\nITEM 6. EXHIBITS.\nThe following exhibits are filed as part of, or incorporated by reference into, this Quarterly Report on Form 10-Q.\n\n| No. | Description of Exhibit |\n| 31.1* | Certification of Principal Executive Officer Pursuant to Securities Exchange Act Rules 13a-14(a) and 15(d)-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2* | Certification of Principal Financial Officer Pursuant to Securities Exchange Act Rules 13a-14(a) and 15(d)-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1** | Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2** | Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS* | Inline XBRL Instance Document |\n| 101.CAL* | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.SCH* | Inline XBRL Taxonomy Extension Schema Document |\n| 101.DEF* | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB* | Inline XBRL Taxonomy Extension Labels Linkbase Document |\n| 101.PRE* | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\n\n\n| * | Filed herewith. |\n| ** | Furnished. |\n\n20\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| IGNYTE ACQUISITION CORP. |\n| Date: August 16, 2021 | By: | /s/David Rosenburg |\n| David Rosenberg |\n| Co-Chief Executive Officer (Principal Executive Officer) |\n\n\n| IGNYTE ACQUISITION CORP. |\n| Date: August 16, 2021 | By: | /s/ Steven Kaplan |\n| Steven Kaplan |\n| Chief Financial Officer (Principal Financial and Accounting Officer) |\n\n21\n\n\nWhat is the difference between the total net income for both redeemable and non-redeemable common stock and the total offering costs from the IPO in the first half of 2021 in dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nITEM 1. CONDENSED FINANCIAL STATEMENTS\\nIGNYTE ACQUISITION CORP.\\nCONDENSED BALANCE SHEETS\\n| June 30, 2021 | December 31, 2020 |\\n| (unaudited) |\\n| Assets |\\n| Cash | $ | 550,470 | $ | 25,425 |\\n| Prepaid expense and other current assets | 181,923 | - |\\n| Total current assets | 732,393 | 25,425 |\\n| Deferred offering costs | - | 81,575 |\\n| Cash and securities held in Trust Account | 57,504,345 | - |\\n| Total Assets | $ | 58,236,738 | $ | 107,000 |\\n| Liabilities and Stockholders' Equity |\\n| Current liabilities: |\\n| Accrued expenses | $ | 12,656 | $ | - |\\n| Due to related party | 51,953 | 310 |\\n| Promissory note - related party | - | 80,000 |\\n| Total current liabilities | 64,609 | 80,310 |\\n| Warrant liabilities | 1,875,000 | - |\\n| Total liabilities | 1,939,609 | 80,310 |\\n| Commitments and Contingencies(8) |\\n| Common stock subject to possible redemption, 5,129,712 shares at redemption value | 51,297,120 | - |\\n| Stockholders' Equity: |\\n| Preferred stock, $ 0.0001 par value; 1,000,000 shares authorized; none issued and outstanding | - | - |\\n| Common stock, $ 0.0001 par value; 50,000,000 shares authorized; 2,157,788 shares and 0 shares issued and outstanding (excluding 5,129,712 shares and 0 shares subject to possible redemption) at June 30, 2021 and December 31, 2020, respectively | 216 | 154 |\\n| Additional paid-in capital | 4,730,179 | 26,846 |\\n| Retained earnings (Accumulated deficit) | 269,614 | ( 310 | ) |\\n| Total stockholders' equity | 5,000,009 | 26,690 |\\n| Total Liabilities and Stockholders' Equity | $ | 58,236,738 | $ | 107,000 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\\n1\\nIGNYTE ACQUISITION CORP.\\nUNAUDITED CONDENSED STATEMENTS OF OPERATIONS\\n| For the Three Months Ended | For the Six Months Ended |\\n| June 30, 2021 | June 30, 2021 |\\n| Formation and operating costs | $ | 110,980 | $ | 309,421 |\\n| Loss from operations | ( 110,980 | ) | ( 309,421 | ) |\\n| Other income |\\n| Change in fair value of warrants | 725,000 | 575,000 |\\n| Trust interest income | 2,087 | 4,345 |\\n| Total other income | 727,087 | 579,345 |\\n| Net income | $ | 616,107 | $ | 269,924 |\\n| Basic and diluted weighted average shares outstanding, common stock subject to redemption | 5,068,102 | 4,183,046 |\\n| Basic and diluted net loss per share | $ | 0.00 | $ | 0.00 |\\n| Basic and diluted weighted average shares outstanding, common stock | 2,219,398 | 2,053,694 |\\n| Basic and diluted net loss per share | $ | 0.28 | $ | 0.13 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\\n2\\nIGNYTE ACQUISITION CORP.\\nUNAUDITED CONDENSED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY\\n| Common Stock | Additional Paid-in Capital | Retained Earnings(Accumulated Deficit) | Total Stockholders' Equity |\\n| Shares | Amount |\\n| Balance as of December 31, 2020 | 1,537,500 | $ | 154 | $ | 26,846 | $ | ( 310 | ) | $ | 26,690 |\\n| Sale of 5,000,000 and 750,000 Units on February 1, 2021 and February 2, 2021 through IPO and over-allotment, respectively | 5,750,000 | 575 | 57,499,425 | - | 57,500,000 |\\n| Sale of 2,350,000 and 150,000 Placement Warrants on February 1, 2021 and February 2, 2021, respectively, net of fair value of warrant liabilities | - | - | 50,000 | - | 50,000 |\\n| Underwriting fee | - | - | ( 1,150,000 | ) | - | ( 1,150,000 | ) |\\n| Other offering expenses | - | - | ( 399,485 | ) | - | ( 399,485 | ) |\\n| Net loss | - | - | - | ( 346,183 | ) | ( 346,183 | ) |\\n| Common stock subject to possible redemption | ( 5,068,201 | ) | ( 507 | ) | ( 50,680,513 | ) | - | ( 50,681,020 | ) |\\n| Balance as of March 31, 2021 | 2,219,398 | 222 | 5,346,273 | ( 346,493 | ) | 5,000,002 |\\n| Change in value of common stock subject to possible redemption | ( 61,610 | ) | ( 6 | ) | ( 616,094 | ) | ( 616,100 | ) |\\n| Net income | 616,107 | 616,107 |\\n| Balance as of June 30, 2021 (unaudited) | 2,157,788 | $ | 216 | $ | 4,730,179 | $ | 269,614 | $ | 5,000,009 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\\n3\\nIGNYTE ACQUISITION CORP.\\nUNAUDITED CONDENSED STATEMENT OF CASH FLOWS\\n| For the Six Months Ended |\\n| June 30, 2021 |\\n| Cash flows from Operating Activities: |\\n| Net income | $ | 269,924 |\\n| Adjustments to reconcile net income to net cash used in operating activities: |\\n| Increase in fair value of warrants | ( 575,000 | ) |\\n| Interest earned on marketable securities held in Trust Account | ( 4,345 | ) |\\n| Changes in current assets and current liabilities: |\\n| Prepaid expenses | ( 181,923 | ) |\\n| Accrued offering costs and expenses | 12,656 |\\n| Due to related party | 51,643 |\\n| Net cash used in operating activities | ( 427,045 | ) |\\n| Cash Flows from Investing Activities: |\\n| Purchase of investment held in Trust Account | ( 57,500,000 | ) |\\n| Net cash used in investing activities | ( 57,500,000 | ) |\\n| Cash flows from Financing Activities: |\\n| Proceeds from Initial Public Offering, net of underwriters' fees | 56,350,000 |\\n| Proceeds from private placement | 2,500,000 |\\n| Repayment of promissory note to related party | ( 80,000 | ) |\\n| Payments of offering costs | ( 317,910 | ) |\\n| Net cash provided by financing activities | 58,452,090 |\\n| Net change in cash | 525,045 |\\n| Cash, beginning of the period | 25,425 |\\n| Cash, end of the period | $ | 550,470 |\\n| Supplemental disclosure of noncash investing and financing activities: |\\n| Initial value of Common stock subject to possible redemption, as revised | $ | 51,023,118 |\\n| Change in value of Common stock subject to possible redemption | $ | 274,002 |\\n| Initial fair value of warrant liabilities | $ | 2,450,000 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\\n4\\nIGNYTE ACQUISITION CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nNote 1 — Organization and Business Operations\\nOrganization and General\\nIgnyte Acquisition Corp. (the “Company”) is a newly organized blank check company incorporated as a Delaware corporation on August 6, 2020. The Company was incorporated for the purpose of effecting a merger, stock exchange, asset acquisition, stock purchase, reorganization or other similar business combination with one or more businesses (the “Business Combination”).\\nThe Company has selected December 31 as its fiscal year end.\\nThe Company is an early stage and emerging growth company and, as such, the Company is subject to all of the risks associated with early stage and emerging growth companies.\\nAs of June 30, 2021, the Company had not commenced any operations. All activity for the period from August 6, 2020 (inception) through June 30, 2021 relates to the Company's formation and the initial public offering (“IPO”), which is described below. The Company will not generate any operating revenues until after the completion of its initial Business Combination, at the earliest. The Company will generate non-operating income in the form of interest income on cash and cash equivalents from the proceeds derived from the IPO.\\nThe Company's sponsor is Ignyte Sponsor LLC (the “Sponsor”), a Delaware limited liability company (the “Sponsor”).\\nFinancing\\nThe registration statement for the Company's IPO was declared effective on January 27, 2021 (the “Effective Date”). On February 1, 2021, the Company consummated the IPO of 5,000,000 units (the “Units” and, with respect to the shares of common stock included in the Units being offered, the “Public Shares”), at $ 10.00 per Unit, generating gross proceeds of $ 50,000,000 , which is discussed in Note 4.\\nSimultaneously with the closing of the IPO, the Company consummated the sale of 2,350,000 Private Placement Warrants (the “Private Placement Warrants”) at a price of $ 1.00 per Private Placement Warrant in a private placement to the Sponsor, generating total gross proceeds of $ 2,350,000 .\\nOn February 2, 2021, the underwriters purchased an additional 750,000 Units to exercise its over-allotment option in full at a purchase price of $ 10.00 per Unit, generating gross proceeds of $ 7,500,000 . Simultaneously with the closing of the full exercise of the over-allotment option, the Company completed the private sale of an aggregate of 150,000 Private Placement Warrants to the Sponsor, at a purchase price of $ 1.00 per Private Placement Warrant, generating gross proceeds of $ 150,000 . A total of $ 7,500,000 was placed in the Trust Account after the payment of $ 150,000 underwriting discount.\\nTransaction costs amounted to $ 1,549,485 consisting of $1,150,000 of underwriting discount and $ 399,485 of other offering costs. In addition, $ 975,465 of cash was held outside of the Trust Account (as defined below) and is available for working capital purposes.\\nTrust Account\\nFollowing the closing of the IPO, on February 1, 2021, $50,000,000 ($10.00 per Unit) from the net proceeds of the sale of the Units in the IPO and the sale of the Private Placement Warrants was held in a Trust Account (“Trust Account”), and will invest only in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, having a maturity of 185 days or less or in money market funds meeting certain conditions under Rule 2a-7 promulgated under the Investment Company Act which invest only in direct U.S. government treasury obligations. Except with respect to interest earned on the funds held in the Trust Account that may be released to the Company to pay income tax obligations, the proceeds from the IPO will not be released from the Trust Account until the earlier of the completion of a Business Combination or the Company's redemption of 100 % of the outstanding Public Shares if it has not completed a Business Combination in the required time period. The proceeds held in the Trust Account may be used as consideration to pay the sellers of a target business with which the Company completes a Business Combination. Any amounts not paid as consideration to the sellers of the target business may be used to finance operations of the target business.\\n5\\nInitial Business Combination\\nIn connection with any proposed Business Combination, the Company will either (1) seek stockholders approval of the initial Business Combination at a meeting called for such purpose at which stockholders may seek to convert their shares, regardless of whether they vote for or against the proposed Business Combination or don't vote at all, into their pro rata share of the aggregate amount then on deposit in the Trust Account (net of taxes payable), or (2) provide its stockholders with the opportunity to sell their shares to the Company by means of a tender offer (and thereby avoid the need for a stockholder vote) for an amount equal to their pro rata share of the aggregate amount then on deposit in the Trust Account (net of taxes payable), in each case subject to the limitations described herein. The decision as to whether the Company will seek stockholders approval of a proposed Business Combination or will allow stockholders to sell their shares to the Company in a tender offer will be made by the Company, solely in its discretion,\\nThe shares of Common Stock subject to redemption will be recorded at a redemption value and classified as temporary equity upon the completion of the IPO, in accordance with Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” In such case, the Company will proceed with a Business Combination if the Company has net tangible assets of at least $ 5,000,001 upon such consummation of a Business Combination and, if the Company seeks stockholder approval, a majority of the issued and outstanding shares voted are voted in favor of the Business Combination.\\nThe Company will have 21 months from the closing of the IPO to complete the initial Business Combination (the “Combination Period”). However, if the Company is unable to complete the initial Business Combination within the Combination Period, the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem 100% of the outstanding public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including interest earned on the funds held in the Trust Account and not previously released to the Company but net of taxes payable ( and less up to $ 50,000 of interest to pay dissolution expenses), divided by the number of then outstanding public shares, which redemption will completely extinguish public stockholders' rights as stockholders (including the right to receive further liquidation distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the Company's remaining stockholders and the Company's board of directors, liquidate and dissolve, subject (in the case of (ii) and (iii) above) to the Company's obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law.\\nThe Sponsor, officers and directors have agreed (i) to vote any shares owned by them in favor of any proposed Business Combination, (ii) not to convert any shares in connection with a stockholder vote to approve a proposed initial Business Combination or sell any shares to the Company in a tender offer in connection with a proposed initial Business Combination, (iii) that the founders' shares will not participate in any liquidating distributions from the Company's Trust Account upon winding up if a Business Combination is not consummated.\\nThe Sponsor has agreed that it will be liable to ensure that the proceeds in the Trust Account are not reduced below $10.00 per share by the claims of target businesses or claims of vendors or other entities that are owed money by the Company for services rendered or contracted for or products sold to the Company. The agreement entered into by the Sponsor specifically provides for two exceptions to the indemnity it has given: it will have no liability (1) as to any claimed amounts owed to a target business or vendor or other entity who has executed an agreement with the Company waiving any right, title, interest or claim of any kind they may have in or to any monies held in the Trust Account, or (2) as to any claims for indemnification by the underwriters of the Proposed Public Offering against certain liabilities, including liabilities under the Securities Act. However, the Company has not asked its Sponsor to reserve for such indemnification obligations, nor has it independently verified whether the Sponsor has sufficient funds to satisfy its indemnity obligations and believe that the Sponsor's only assets are securities of the Company. Therefore, the Company believes it is unlikely that the Sponsor will be able to satisfy its indemnification obligations if it is required to do so.\\nLiquidity and Capital Resources\\nAs of June 30, 2021, the Company had $ 550,470 in its operating bank account, and working capital of $ 667,784 .\\nPrior to the completion of the Initial Public Offering, the Company's liquidity needs had been satisfied through a payment from the Sponsor of $ 25,000 (see Note 6) for the Founder Shares to cover certain offering costs, the loan under an unsecured promissory note from the Sponsor of $ 80,000 (see Note 6), and the net proceeds from the consummation of the Private Placement not held in the Trust Account. In addition, in order to finance transaction costs in connection with a Business Combination, the Company's Sponsor or an affiliate of the Sponsor or the Company's officers and directors or their affiliates may, but are not obligated to, provide the Company Working Capital Loans (see Note 6). To date, there were no amounts outstanding under any Working Capital Loans.\\nBased on the foregoing, management believes that the Company will have sufficient working capital and borrowing capacity to meet its needs through the earlier of the consummation of a Business Combination or one year from this filing. Over this time period, the Company will be using these funds for paying existing accounts payable, identifying and evaluating prospective initial Business Combination candidates, performing due diligence on prospective target businesses, paying for travel expenditures, selecting the target business to merge with or acquire, and structuring, negotiating and consummating the Business Combination.\\n6\\nNote 2 — Revision of Previously Issued Financial Statements\\nOn April 12, 2021, the Staff of the Securities and Exchange Commission together issued a statement regarding the accounting and reporting considerations for warrants issued by special purpose acquisition companies entitled \\\"Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (\\\"SPACs\\\")\\\" (the \\\"SEC Statement\\\"). Specifically, the SEC Statement focused on certain settlement terms and provisions related to certain tender offers following a Business Combination, which terms are similar to those contained in the warrant agreement, dated as of January 27, 2021, between the Company and Continental Stock Transfer & Trust Company, a New York corporation, as warrant agent (the \\\"Warrant Agreement\\\").\\nHistorically, the warrants were reflected as a component of equity as opposed to liabilities on the balance sheets and the statements of operations did not include the subsequent non-cash changes in estimated fair value of the Warrants, based on the application of FASB ASC Topic 815-40, Derivatives and Hedging, Contracts in Entity's Own Equity (“ASC 815-40). The views expressed in the SEC Staff Statement were not consistent with the Company's historical interpretation of the specific provisions within its warrant agreement and the Company's application of ASC 815-40 to the warrant agreement. the Company reevaluated the accounting treatment of (i) the 2,875,000 Public Warrants and (ii) the 2,500,000 Private Placement Warrants (See Note 4 and Note 5). Based on this reassessment, management determined that the private warrants should be classified as liabilities measured at fair value upon issuance, with subsequent changes in fair value reported in the Company Statement of Operations each reporting period.\\nThe Company's management and the audit committee of the Company's Board of Directors concluded that it is appropriate to revise the Company's previously issued audited balance sheet as of February 1, 2021 as previously reported in its Form 8-K.\\nThe following tables summarize the effect of the restatement on each balance sheet line item as of the date:\\n| As Previously Reported | Adjustment | As Revised |\\n| Balance Sheet at February 1, 2021 |\\n| Warrant Liabilities | $ | - | $ | 2,303,000 | $ | 2,303,000 |\\n| Total Liabilities | 426,200 | 2,303,000 | 2,729,200 |\\n| Common stock subject to possible redemption | 45,973,118 | ( 2,303,000 ) | 43,670,118 |\\n| Common stock | 194 | 23 | 217 |\\n| Additional paid-in capital | 5,004,203 | ( 23 ) | 5,004,180 |\\n| Accumulated deficit | $ | ( 4,396 ) | $ | - | $ | ( 4,396 ) |\\n| Total Stockholders' Equity | 5,000,001 | - | 5,000,001 |\\n| Number of shares subject to redemption | 4,597,312 | ( 230,300 ) | 4,367,012 |\\n\\nNote 3 — Summary of Significant Accounting Policies\\nBasis of Presentation\\nThe accompanying unaudited condensed financial statements are presented in U.S. dollars in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for financial information and pursuant to the rules and regulations of the SEC. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP. In the opinion of management, the unaudited condensed financial statements reflect all adjustments, which include only normal recurring adjustments necessary for the fair statement of the balances and results for the periods presented. Operating results for the period for the six months ended June 30, 2021 are not necessarily indicative of the results that may be expected through December 31, 2021.\\nThe accompanying unaudited condensed financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Form 10-K filed by the Company with the SEC.\\n7\\nEmerging Growth Company\\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act of 1933, as amended, (the “Securities Act”), as modified by the Jumpstart our Business Startups Act of 2012, (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved.\\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statement with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\\nUse of Estimates\\nThe preparation of unaudited condensed financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited condensed financial statements and the reported amounts of expenses during the reporting period. Making estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the unaudited condensed financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. Actual results could differ from those estimates.\\nCash and Cash Equivalents\\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did not have any cash equivalents as of June 30, 2021 and December 31, 2020.\\nMarketable Securities Held in Trust Account\\nAt June 30, 2021, the assets held in the Trust Account were invested in money market funds.\\nFair Value Measurements\\nFASB ASC Topic 820 “Fair Value Measurements and Disclosures” (“ASC 820”) defines fair value, the methods used to measure fair value and the expanded disclosures about fair value measurements. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between the buyer and the seller at the measurement date. In determining fair value, the valuation techniques consistent with the market approach, income approach and cost approach shall be used to measure fair value. ASC 820 establishes a fair value hierarchy for inputs, which represent the assumptions used by the buyer and seller in pricing the asset or liability. These inputs are further defined as observable and unobservable inputs. Observable inputs are those that buyer and seller would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs reflect the Company’s assumptions about the inputs that the buyer and seller would use in pricing the asset or liability developed based on the best information available in the circumstances.\\nThe fair value hierarchy is categorized into three levels based on the inputs as follows:\\nLevel 1 — Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access. Valuation adjustments and block discounts are not being applied. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these securities does not entail a significant degree of judgment.\\nLevel 2 — Valuations based on (i) quoted prices in active markets for similar assets and liabilities, (ii) quoted prices in markets that are not active for identical or similar assets, (iii) inputs other than quoted prices for the assets or liabilities, or (iv) inputs that are derived principally from or corroborated by market through correlation or other means.\\nLevel 3 — Valuations based on inputs that are unobservable and significant to the overall fair value measurement.\\nThe fair value of the Company’s certain assets and liabilities, which qualify as financial instruments under ASC 820, “Fair Value Measurements and Disclosures,” approximates the carrying amounts represented in the balance sheet. The fair values of cash, prepaid assets, and accounts payable are estimated to approximate the carrying values as of December 31, 2020 due to the short maturities of such instruments.\\n8\\nThe Company’s warrant liabilities are based on a valuation model utilizing management judgment and pricing inputs from observable and unobservable markets with less volume and transaction frequency than active markets. Significant deviations from these estimates and inputs could result in a material change in fair value. In some circumstances, the inputs used to measure fair value might be categorized within different levels of the fair value hierarchy. In those instances, the fair value measurement is categorized in its entirety in the fair value hierarchy based on the lowest level input that is significant to the fair value measurement. See Note 7 for additional information on assets and liabilities measured at fair value.\\nConcentration of Credit Risk\\nFinancial instruments that potentially subject the Company to concentrations of credit risk consist of a cash account in a financial institution, which, at times, may exceed the Federal Depository Insurance Coverage of $ 250,000 . At June 30, 2021 and December 31, 2020, the Company has not experienced losses on this account and management believes the Company is not exposed to significant risks on such account.\\nCommon Stock Subject to Possible Redemption\\nThe Company accounts for its common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption (if any) is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. The Company’s common stock feature certain redemption rights that is considered to be outside of the Company’s control and subject to the occurrence of uncertain future events. Accordingly, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders’ equity section of the Company’s balance sheet.\\nNet Income Per Common Share\\nNet income per common share is computed by dividing net income by the weighted average number of common stock outstanding for each of the periods. The calculation of diluted net income per common share does not include warrants since the inclusion of such warrants would be anti-dilutive.\\nThe Company's statement of operations includes a presentation of income per share for common stock subject to possible redemption in a manner similar to the two-class method of income per common share. Net income per common share, basic and diluted, for redeemable common stock is calculated by dividing the interest income earned on the Trust Account, by the weighted average number of redeemable common stock outstanding since original issuance. Net income per common share, basic and diluted, for non-redeemable common stock is calculated by dividing the net income, adjusted for income attributable to redeemable common stock, by the weighted average number of non-redeemable common stock outstanding for the periods. Non-redeemable common stock includes the founder shares as these shares do not have any redemption features and do not participate in the income earned on the Trust Account.\\n| For the Three Months Ended | For the Six Months Ended |\\n| June 30, 2021 | June 30, 2021 |\\n| Common stock subject to possible redemption |\\n| Numerator: net income allocable to common stock subject to possible redemption |\\n| Interest income on marketable securities held in trust | $ | 1,862 | $ | 3,876 |\\n| Less: interest available to be withdrawn for payment of taxes | - | - |\\n| Net income allocable to common stock subject to possible redemption | 1,862 | 3,876 |\\n| Denominator: Weighted average redeemable common stock |\\n| Redeemable common stock, basic and diluted | 5,068,102 | 4,183,046 |\\n| Basic and diluted net income per share, redeemable common stock | $ | - | $ | - |\\n| Non-redeemable common stock |\\n| Numerator: net income minus redeemable net earnings |\\n| Net income | $ | 616,107 | $ | 269,924 |\\n| Redeemable net earnings | ( 1,862 ) | ( 3,876 ) |\\n| Non-redeemable net income | 614,245 | 266,048 |\\n| Denominator: Weighted average non-redeemable basic and diluted weighted average shares outstanding, common stock | 2,219,398 | 2,053,694 |\\n| Basic and diluted net income per share, common stock | $ | 0.28 | $ | 0.13 |\\n\\n9\\nOffering Costs associated with the Initial Public Offering\\nThe Company complies with the requirements of the ASC 340-10-S99-1 and SEC Staff Accounting Bulletin (“SAB”) Topic 5A - “Expenses of Offering”. Offering costs consist principally of professional and registration fees incurred through the balance sheet date that are related to the IPO and were charged to stockholders' equity upon the completion of the IPO. Accordingly, as of February 1, 2021, offering costs in the aggregate of $ 1,549,485 have been charged to stockholders' equity (consisting of $1,150,000 of underwriting discount and $ 399,485 of other offering costs).\\nWarrant Liabilities\\nThe Company accounts for the Public Warrants and Private Warrants (as defined in Note 4 and 5) collectively (“Warrants”), as either equity or liability-classified instruments based on an assessment of the specific terms of the Warrants and the applicable authoritative guidance in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 815, Derivatives and Hedging (“ASC 815”). The assessment considers whether the Warrants meet all of the requirements for equity classification under ASC 815, including whether the Warrants are indexed to the Company’s own ordinary shares and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of the Company’s control, among other conditions for equity classification. This assessment, which requires the use of professional judgment, is conducted at the time of issuance of the Warrants and as of each subsequent quarterly period end date while the Warrants are outstanding.\\nFor issued or modified warrants that meet all of the criteria for equity classification, such warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all the criteria for equity classification, such warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of liability-classified warrants are recognized as a non-cash gain or loss on the statements of operations.\\nThe Company accounts for the Private Warrants in accordance with ASC 815-40 under which the Private Warrants do not meet the criteria for equity classification and must be recorded as liabilities. The fair value of the Private Warrants has been estimated using the Monte Carlo simulation model. See Note 7 for further discussion of the pertinent terms of the Warrants used to determine the value of the Private Warrants and Representative’s Warrants.\\nThe Company evaluated the Public Warrants in accordance with ASC 815-40, “Derivatives and Hedging — Contracts in Entity’s Own Equity” and concluded that they met the criteria for equity classification and are required to be recorded as part a component of additional paid-in capital at the time of issuance.\\nIncome Taxes\\nThe Company follows the asset and liability method of accounting for income taxes under ASC 740, “Income Taxes.” Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statements carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that included the enactment date. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.\\n10\\nASC 740 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more likely than not to be sustained upon examination by taxing authorities. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of June 30, 2021. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position. The Company is subject to income tax examinations by major taxing authorities since inception.\\nRisks and Uncertainties\\nOn January 30, 2020, the World Health Organization (“WHO”) announced a global health emergency because of a new strain of coronavirus (the ”COVID-19 outbreak”). In March 2020, the WHO classified the COVID-19 outbreak as a pandemic, based on the rapid increase in exposure globally. The full impact of the COVID-19 outbreak continues to evolve. The impact of the COVID-19 outbreak on the Company’s financial position will depend on future developments, including the duration and spread of the outbreak and related advisories and restrictions. These developments and the impact of the COVID-19 outbreak on the financial markets and the overall economy are highly uncertain and cannot be predicted. If the financial markets and/or the overall economy are impacted for an extended period, the Company’s financial position may be materially adversely affected. Additionally, the Company’s ability to complete an initial Business Combination may be materially adversely affected due to significant governmental measures being implemented to contain the COVID-19 outbreak or treat its impact, including travel restrictions, the shutdown of businesses and quarantines, among others, which may limit the Company’s ability to have meetings with potential investors or affect the ability of a potential target company’s personnel, vendors and service providers to negotiate and consummate an initial Business Combination in a timely manner. The Company’s ability to consummate an initial Business Combination may also be dependent on the ability to raise additional equity and debt financing, which may be impacted by the COVID-19 outbreak and the resulting market downturn. The financial statement does not include any adjustments that might result from the outcome of this uncertainty.\\nRecent Accounting Standards\\nManagement does not believe that any recently issued, but not effective, accounting standards, if currently adopted, would have a material effect on the Company’s financial statement.\\nNote 4 — Initial Public Offering\\nOn February 1, 2021, the Company sold 5,000,000 Units, at a purchase price of $ 10.00 per Unit. Each Unit consists of one share of common stock and one-half of one warrant to purchase one share of common stock (“Public Warrant”). Each whole Public Warrant entitles the holder to purchase one share of common stock at a price of $ 11.50 per share, subject to adjustment.\\nOn February 2, 2021, the Underwriters exercised the over-allotment option in full to purchase 750,000 Units (the “Over-Allotment Units”), generating an aggregate of gross proceeds of $ 7,500,000 , and incurred $ 150,000 in underwriting fees.\\nPublic Warrants\\nEach whole warrant entitles the holder to purchase one share of Common Stock at a price of $11.50 per share, subject to adjustment as discussed herein. The warrants will become exercisable 30 days after the completion of the Company's initial Business Combination. However, no warrants will be exercisable for cash unless the Company has an effective and current registration statement covering the shares of common stock issuable upon exercise of the warrants and a current prospectus relating to such shares of common stock. Notwithstanding the foregoing, if a registration statement covering the shares of common stock issuable upon exercise of the public warrants is not effective within a specified period following the consummation of the initial Business Combination, warrant holders may, until such time as there is an effective registration statement and during any period when the Company shall have failed to maintain an effective registration statement, exercise warrants on a cashless basis pursuant to the exemption provided by Section 3(a)(9) of the Securities Act, provided that such exemption is available. If that exemption, or another exemption, is not available, holders will not be able to exercise their warrants on a cashless basis. In the event of such cashless exercise, each holder would pay the exercise price by surrendering the warrants for that number of shares of common stock equal to the quotient obtained by dividing (x) the product of the number of shares of common stock underlying the warrants, multiplied by the difference between the exercise price of the warrants and the “fair market value” (defined below) by (y) the fair market value. The “fair market value” for this purpose will mean the average reported last sale price of the shares of common stock for the 5 trading days ending on the trading day prior to the date of exercise. The warrants will expire on the fifth anniversary of the completion of an initial Business Combination, at 5:00 p.m., New York City time, or earlier upon redemption or liquidation.\\n11\\nThe Company may call the warrants for redemption (excluding the Private Placement Warrants and any warrants underlying additional units issued to the Sponsor, initial stockholders, officers, directors or their affiliates in payment of Working Capital Loans made to the Company)\\n•\\nin whole and not in part;\\n•\\nat a price of $ 0.01 per warrant;\\n•\\nat any time after the warrants become exercisable,\\n•\\nupon not less than 30 days’ prior written notice of redemption to each warrant holder; and\\n•\\nif, and only if, the reported last sale price of the Common Stock equals or exceeds $ 18.00 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations) for any 20 trading days within a 30-trading day period commencing at any time after the warrants become exercisable and ending on the third business day prior to the notice of redemption to warrant holders; and\\n•\\nif, and only if, there is a current registration statement in effect with respect to the shares of common stock underlying such warrants.\\nIf the Company calls the warrants for redemption as described above, the Company's management will have the option to require all holders that wish to exercise warrants to do so on a “cashless basis.” In such event, each holder would pay the exercise price by surrendering the warrants for that number of shares of common stock equal to the quotient obtained by dividing (x) the product of the number of shares of common stock underlying the warrants, multiplied by the difference between the exercise price of the warrants and the “fair market value” (defined below) by (y) the fair market value. The “fair market value” for this purpose shall mean the average reported last sale price of the shares of common stock for the 5 trading days ending on the third trading day prior to the date on which the notice of redemption is sent to the holders of warrants.\\nIn addition, if (x) the Company issue additional shares of Common Stock or equity-linked securities for capital raising purposes in connection with the closing of the initial Business Combination at an issue price or effective issue price of less than $ 9.20 per share of common stock (with such issue price or effective issue price to be determined in good faith by the Company's board of directors, and in the case of any such issuance to the Sponsor, initial stockholders or their affiliates, without taking into account any founders' shares held by them prior to such issuance), (y) the aggregate gross proceeds from such issuances represent more than 60% of the total equity proceeds, and interest thereon, available for the funding of the initial Business Combination on the date of the consummation of the initial Business Combination (net of redemptions), and (z) the Market Value is below $9.20 per share, the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115% of the greater of (i) the Market Value or (ii) the price at which the Company issues the additional shares of common stock or equity-linked securities.\\nNote 5 — Private Placement\\nSimultaneously with the closing of the IPO, the Sponsor purchased an aggregate of 2,350,000 Private Placement Warrants at a price of $ 1.00 per Private Placement Warrant, for an aggregate purchase price of $ 2,350,000 , in a private placement (the “Private Placement”). Each Private Placement Warrant will entitle the holder to purchase one share of common stock at a price of $11.50 per share, subject to adjustment. The proceeds from the Private Placement Warrants was added to the proceeds from the IPO held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the proceeds from the sale of the Private Placement Warrants held in the Trust Account will be used to fund the redemption of the Public Shares (subject to the requirements of applicable law) and the Private Placement Warrants will expire worthless.\\nThe Private Placement Warrants are identical to the Warrants underlying the Units sold in the IPO, except that the Private Placement Warrants are non-redeemable and may be exercised on a cashless basis, in each case so long as they continue to be held by the initial purchasers or their permitted transferees. Further, the Sponsor has agreed not to transfer, assign, or sell the Private Placement Warrants (including the shares of Common Stock issuable upon the exercise of the Private Placement Warrants), except to certain permitted transferees, until after the consummation of the Company's initial business combination.\\nSimultaneously with the closing of the exercise of the over-allotment option, the Company completed the private sale (the “Private Placement”) of an aggregate of 150,000 private placement warrants (the “Private Placement Warrants”) to Ignyte Sponsor LLC, a Delaware limited liability company (the “Sponsor”), at a purchase price of $ 1.00 per Private Placement Warrant, generating gross proceeds of $ 150,000 .\\n12\\nNote 6 — Related Party Transactions\\nFounder Shares\\nOn August 12, 2020, the Sponsor paid $ 25,000 , or approximately $ 0.02 per share, to cover certain offering costs in consideration for 1,437,500 shares of Common Stock, par value $ 0.0001 (the “Founder Shares”). Up to 187,500 Founder Shares are subject to forfeiture by the Sponsor depending on the extent to which the underwriters' over-allotment option is exercised. On February 2, 2021, the underwriter exercised its over-allotment option in full, hence, the 187,500 Founder Shares are no longer subject to forfeiture since then.\\nThe founders' shares were placed into an escrow account maintained in New York, New York by Continental Stock Transfer & Trust Company, acting as escrow agent. Subject to certain limited exceptions, these shares will not be transferred, assigned, sold or released from escrow (subject to certain limited exceptions set forth below) (i) with respect to 50% of such shares, for a period ending on the earlier of the one-year anniversary of the date of the consummation of the initial Business Combination and the date on which the closing price of the Company's common stock equals or exceeds $12.50 per share (as adjusted for share splits, share dividends, reorganizations and recapitalizations) for any 20 trading days within a 30-trading day period following the consummation of the initial Business Combination and (ii) with respect to the remaining 50% of such shares, for a period ending on the one-year anniversary of the date of the consummation of the initial Business Combination, or earlier, in either case, if, subsequent to the initial Business Combination, the Company consummates a liquidation, merger, stock exchange or other similar transaction which results in all of the Company's stockholders having the right to exchange their shares of common stock for cash, securities or other property.\\nPromissory Note — Related Party\\nOn November 20, 2020, the Company's executive officers loaned the Company $ 80,000 to be used for a portion of the expenses of the IPO. These loans are non-interest bearing, unsecured and are due at the earlier of June 30, 2021 or the closing of the IPO. As of February 1, 2021, the Company repaid the note in full.\\nDue to Related Party\\nAs of June 30, 2021, the amount due to related party is $ 51,953 which represent the accrual of administrative service fee $ 51,643 from January 26, 2021 to June 30, 2021 and formation cost $ 310 paid by the Officer.\\nRelated Party Loans\\nIn order to meet the Company’s working capital needs following the consummation of the IPO the Sponsor, officers, directors initial stockholders or their affiliates may, but are not obligated to, loan the Company funds (“Working Capital Loans”), from time to time or at any time, in whatever amount they deem reasonable in their sole discretion. Each loan would be evidenced by a promissory note. The notes would either be paid upon consummation of the initial Business Combination, without interest, or, at holder’s discretion, up to $ 1,500,000 of the notes may be converted into warrants at a price of $ 1.00 per warrant. The warrants would be identical to the Private Placement Warrants. In the event that the initial Business Combination does not close, the Company may use a portion of the working capital held outside the Trust Account to repay such loaned amounts, but no proceeds from the Trust Account would be used for such repayment. As of June 30, 2021 and December 31, 2020, no such Working Capital Loans were outstanding.\\nAdministrative Service Fee\\nThe Company has agreed, commencing on the date of the securities of the Company are first listed on The Nasdaq Capital Market (the “Listing Date”), to pay the Sponsor $ 10,000 per month for office space, utilities and secretarial support. Upon completion of the initial Business Combination or the Company's liquidation, the Company will cease paying these monthly fees. The Company accrued $ 51,643 and $ 30,000 for the administrative service fee for the period from the Listing Date to June 30, 2021and for the three months ended June 30, 2021.\\nNote 7 — Recurring Fair Value Measurements\\nThe following table presents information about the Company's assets and liabilities that were measured at fair value on a recurring basis as of June 30, 2021, and indicates the fair value hierarchy of the valuation techniques the Company utilized to determine such fair value.\\n13\\n| June 30, 2021 | Quoted Prices In Active Markets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Other Unobservable Inputs (Level 3) |\\n| Assets: |\\n| U.S. Money Market held in Trust Account | $ | 57,504,345 | $ | 57,504,345 | $ | - | $ | - |\\n| $ | 57,504,345 | $ | 57,504,345 | $ | - | $ | - |\\n| Liabilities: |\\n| Warrant liabilities-Private Placement Warrants | $ | 1,875,000 | $ | - | $ | - | $ | 1,875,000 |\\n| $ | 1,875,000 | $ | - | $ | - | $ | 1,875,000 |\\n\\nThe following table sets forth a summary of the changes in the fair value of the warrant liabilities for the period from August 6, 2020 (Inception) through June 30, 2021:\\n| Warrant Liability |\\n| Fair value as of February 1, 2021 | $ | 2,303,000 |\\n| Issuance of private warrants in connection with over-allotment as of February 2, 2021 | 147,000 |\\n| Change in fair value (1) | ( 575,000 ) |\\n| Fair value as of June 30, 2021 | $ | 1,875,000 |\\n\\n(1) Represents the non-cash gain on the change in valuation of Private Warrants and is included in the change in fair value of warrant liability on the statement of operations.\\nAt June 30, 2021, the Public Warrants were determined to contain none of the features requiring liability treatment; therefore, the Public warrants were not included in the fair value reporting.\\nThe Private Warrants were valued using a Modified Black Scholes Model. The Private Warrants are considered to be a Level 3 fair value measurements due to the use of unobservable inputs. The Black Scholes Model can be modified to value SPAC Private Warrants by discounting the Acquisition Date warrant value to the Valuation Date and multiplying the present value by the probability of a future transaction occurring.\\nTransfers to/from Levels 1, 2 and 3 are recognized at the end of the reporting period. There were no transfers between levels for the period from January 1, 2021 through June 30, 2021.\\nThe following table provides quantitative information regarding Level 3 fair value measurements for Private Warrants as of June 30, 2021 and February 1, 2021.\\n| June 30, 2021 | February 1, 2021 |\\n| Exercise price | $ | 11.50 | $ | 11.50 |\\n| Share price | $ | 9.68 | $ | 10.00 |\\n| Volatility | 14.25 | % | 19.00 | % |\\n| Expected life | 5 .00 | 5 .00 |\\n| Risk-free rate | 0.87 | % | 0.42 | % |\\n| Dividend yield | - | % | - | % |\\n\\nNote 8 — Commitments and Contingencies\\nRegistration Rights\\nThe holders of the founders’ shares issued and outstanding on the date of the IPO, as well as the holders of the representative shares, Private Placement Warrants and any warrants the Company’s Sponsor, officers, directors or their affiliates may be issued in payment of Working Capital Loans made to the Company (and all underlying securities), will be entitled to registration rights pursuant to an agreement signed on January 27, 2021. The holders of a majority of these securities are entitled to make up to two demands that the Company registers such securities. The holders of the majority of the founders’ shares can elect to exercise these registration rights at any time commencing three months prior to the date on which these shares of common stock are to be released from escrow. The holders of a majority of the representative shares, Private Placement Warrants and warrants issued to the Company’s Sponsor, officers, directors or their affiliates in payment of Working Capital Loans made to the Company (or underlying securities) can elect to exercise these registration rights at any time after the Company consummates a Business Combination. Notwithstanding anything to the contrary, EarlyBirdCapital may only make a demand on one occasion and only during the five-year period beginning on the Effective Date of the registration statement of which the IPO forms a part. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the Company’s consummation of a Business Combination; provided, however, that EarlyBirdCapital may participate in a “piggyback” registration only during the seven-year period beginning on the Effective Date of the registration statement of which the IPO forms a part. The Company will bear the expenses incurred in connection with the filing of any such registration statements.\\n14\\nUnderwriting Agreement\\nThe underwriters have a 45-day option beginning February 1, 2021 to purchase up to an additional 750,000 units to cover over-allotments, if any, at the IPO price less the underwriting discounts.\\nThe Company issued to the underwriter (and/or its designees) (the “Representative”) 100,000 shares of common stock for $ 0.0001 per share (the “Representative Shares”). The Company estimated the fair value of the stock to be $ 2,000 based upon the price of the founder shares issued to the Sponsor. The stock were treated as underwriters’ compensation and charged directly to shareholders’ equity. The underwriter (and/or its designees) agreed (i) to waive their conversion rights (or right to participate in any tender offer) with respect to such shares in connection with the completion of our initial business combination and (ii) to waive their rights to liquidating distributions from the trust account with respect to such shares if we fail to complete our initial business combination within 21 months from the closing of this offering.\\nOn February 1, 2021, the Company paid a fixed underwriting fee of $ 1,000,000 .\\nOn February 2, 2021, the underwriters purchased an additional 750,000 units to exercise its over-allotment option in full. The proceeds of $ 7,500,000 from the over-allotment was deposited in the Trust Account after deducting the underwriting discounts.\\nBusiness Combination Marketing Agreement\\nThe Company has engaged underwriters as advisors in connection with its Business Combination to assist it in holding meetings with the stockholders to discuss the potential Business Combination and the target business’s attributes, introduce the Company to potential investors that are interested in purchasing the Company’s securities in connection with the potential Business Combination, assist the Company in obtaining stockholder approval for the Business Combination and assist the Company with its press releases and public filings in connection with the Business Combination. The Company will pay the Marketing Fee for such services upon the consummation of the initial Business Combination in an amount equal to, in the aggregate, 3.5 % of the gross proceeds of the IPO, or $ 2,012,500 including the proceeds from the full exercise of the over-allotment option on February 2, 2021.\\nRight of First Refusal\\nIf the Company determines to pursue any equity, equity-linked, debt or mezzanine financing relating to or in connection with a Business Combination or after a Business Combination, then EarlyBirdCapital shall have the right, but not the obligation, to act as book running manager, placement agent and/or arranger, as the case may be, in any and all such financing or financings and to receive at least 25 % of the aggregate gross spread or fees from any and all such financings. This right of first refusal extends from the February 1, 2021 until the earlier of twelve (12) months after the consummation of an initial Business Combination or the liquidation of the Trust Account if the Company fails to consummate a Business Combination during the required time period.\\nNote 9 — Stockholder’s Equity\\nPreferred Stock — The Company is authorized to issue 1,000,000 shares of preferred stock with a par value of $ 0.0001 and with such designations, voting and other rights and preferences as may be determined from time to time by the Company's board of directors. At June 30, 2021 and December 31, 2021, there were no shares of preferred stock issued or outstanding.\\nCommon Stock — The Company is authorized to issue 50,000,000 shares of common stock with a par value of $ 0.0001 per share. On August 12, 2020, the Sponsor paid $ 25,000 , or approximately $ 0.02 per share, to cover certain offering costs in consideration for 1,437,500 shares of Common Stock, par value $ 0.0001 . Of the 1,437,500 shares of common stock, an aggregate of up to 187,500 shares are subject to forfeiture to the Company for no consideration to the extent that the underwriters' over-allotment option is not exercised in full or in part, so that the initial stockholders will collectively own 20 % of the Company's issued and outstanding common stock after the IPO. On February 2, 2021, the underwriter exercised its over-allotment option in full, hence, the 187,500 Founder Shares are no longer subject to forfeiture since then. In August 2020, the Company also issued to designees of EarlyBirdCapital an aggregate of 100,000 shares of common stock (“representative shares”), at a price of $ 0.0001 per share. As of June 30, 2021 and December 31, 2020, there were 2,157,788 and 1,537,500 shares of common stock issued and outstanding, respectively.\\n15\\nCommon stockholders of record are entitled to one vote for each share held on all matters to be voted on by stockholders. In connection with any vote held to approve the initial Business Combination, the initial stockholders, as well as all of the Company’s officers and directors, have agreed to vote their respective shares of common stock owned by them immediately prior to the IPO and any shares purchased in the IPO or following the IPO in the open market in favor of the proposed Business Combination.\\nNote 10 — Subsequent Events\\nThe Company evaluated subsequent events and transactions that occurred after the balance sheet date up to the date that the unaudited condensed financial statements were issued.\\n16\\n\\nITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\\nReferences to the “Company,” “us,” “our” or “we” refer to Ignyte Acquisition Corp.. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our unaudited condensed financial statements and related notes included herein.\\nCautionary Note Regarding Forward-Looking Statements\\nAll statements other than statements of historical fact included in this Report including, without limitation, statements under this “Management's Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company's financial position, business strategy and the plans and objectives of management for future operations, are forward- looking statements. When used in this Report, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or the Company's management, identify forward-looking statements. Such forward-looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company's management. Actual results could differ materially from those contemplated by the forward- looking statements as a result of certain factors detailed in our filings with the SEC. All subsequent written or oral forward-looking statements attributable to us or persons acting on the Company's behalf are qualified in their entirety by this paragraph.\\nThe following discussion and analysis of our financial condition and results of operations should be read in conjunction with the unaudited condensed financial statements and the notes thereto contained elsewhere in this Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\\nOverview\\nWe are an early-stage blank check company incorporated as a Delaware corporation and formed for the purpose of effecting an initial business combination.\\nWe leverage the more than nine decades of combined operational and financial experience of our management team and board of directors who are both established e-commerce entrepreneurs and sophisticated investors. We believe our extensive industry experience and proven ability to source, acquire, grow and revitalize companies will provide our management team with a robust and consistent flow of acquisition opportunities. Our management team and board's broad relationships across multiple networks, including leading consumer and technology company founders, executives of private and public companies, leading M&A investment banks and private equity firms, as well as their ability to engage early with founder-led businesses represents a differentiated advantage to successfully source transaction opportunities. Our team has been immersed in the same ecosystem as the current founders of private companies who are making decisions on how to build currency for future growth and monetization.\\nWhile we may pursue an initial business combination target in any business, industry or geographical location, we are focusing our search primarily within the consumer-facing e-commerce sector. We are capitalizing on the ability of our management team to identify, acquire and operate a business or businesses that can benefit from our management team and board's established relationships and operating experience. Our management team has extensive experience in identifying and executing strategic investments and has done so successfully in several sectors, particularly in digital consumer-facing businesses. Over time, we believe that all companies will need to deploy an omni-commerce strategy to succeed, and we will leverage our management team and board's unique experience to successfully develop our business target's omni-commerce.\\nResults of Operations\\nOur entire activity since inception up to June 30, 2021 relates to our formation, the Initial Public Offering and, since the closing of the Initial Public Offering, a search for a Business Combination candidate. We will not be generating any operating revenues until the closing and completion of our initial Business Combination, at the earliest.\\nFor the three months ended June 30, 2021, we had net income of $616,107, which consisted of $2,087 in interest earned on marketable securities held in the Trust Account, and $725,000 in unrealized gain on change in fair value of warrants, offset by $110,980 in formation and operating costs.\\nFor the six months ended June 30, 2021, we had net income of $269,924, which consisted of $4,345 in interest earned on marketable securities held in the Trust Account, and $575,000 in unrealized gain on change in fair value of warrants, offset by $309,421 in formation and operating costs.\\n17\\nLiquidity and Capital Resources\\nAs of June 30, 2021, we had $550,470 in its operating bank account, and working capital of $667,784.\\nPrior to the completion of the Initial Public Offering, our liquidity needs had been satisfied through a payment from the Sponsor of $25,000 (see Note 6) for the Founder Shares to cover certain offering costs, the loan under an unsecured promissory note from the Sponsor of $80,000, and the net proceeds from the consummation of the Private Placement not held in the Trust Account. In addition, in order to finance transaction costs in connection with a Business Combination, our Sponsor or an affiliate of the Sponsor or our officers and directors or their affiliates may, but are not obligated to, provide us Working Capital Loans. To date, there were no amounts outstanding under any Working Capital Loans.\\nWe anticipate that the $550,470 outside of the Trust Account as of June 30, 2021, will be sufficient to allow the Company to operate for at least the next 12 months from the issuance of the financial statements, assuming that a Business Combination is not consummated during that time.\\nBased on the foregoing, management believes that we will have sufficient working capital and borrowing capacity to meet our needs through the earlier of the consummation of a Business Combination or one year from this filing. Over this time period, we will be using these funds for paying existing accounts payable, identifying and evaluating prospective initial Business Combination candidates, performing due diligence on prospective target businesses, paying for travel expenditures, selecting the target business to merge with or acquire, and structuring, negotiating and consummating the Business Combination.\\nCritical Accounting Policies and Estimates\\nThe preparation of the unaudited condensed financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited condensed financial statements and the reported amounts of expenses during the reporting period. Actual results could differ from those estimates. We have identified the following as our critical accounting policies:\\nWarrant Liabilities\\nWe account for the Warrants, as either equity or liability-classified instruments based on an assessment of the specific terms of the Warrants and the applicable authoritative guidance in FASB ASC 815, Derivatives and Hedging ASC 815. The assessment considers whether the Warrants meet all of the requirements for equity classification under ASC 815, including whether the Warrants are indexed to the Company's own ordinary shares and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of the Company's control, among other conditions for equity classification. This assessment, which requires the use of professional judgment, was conducted at the time of issuance of the Warrants and will continue as of each subsequent quarterly period end date while the Warrants are outstanding.\\nFor issued or modified warrants that meet all of the criteria for equity classification, such warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all the criteria for equity classification, such warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of liability-classified warrants are recognized as a non-cash gain or loss on the statements of operations.\\nCommon Stock Subject to Possible Redemption\\nThe Company accounts for its common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption (if any) is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company's control) is classified as temporary equity. At all other times, common stock is classified as stockholders' equity. The Company's common stock feature certain redemption rights that is considered to be outside of the Company's control and subject to the occurrence of uncertain future events. Accordingly, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders' equity section of the Company's balance sheet.\\nNet Income Per Common Share\\nNet income per common share is computed by dividing net income by the weighted average number of common stock outstanding for each of the periods. The calculation of diluted net income per common share does not include warrants since the inclusion of such warrants would be anti-dilutive.\\nThe Company's statement of operations includes a presentation of income per share for common stock subject to possible redemption in a manner similar to the two-class method of income per common share. Net income per common share, basic and diluted, for\\n18\\nredeemable common stock is calculated by dividing the interest income earned on the Trust Account, by the weighted average number of redeemable common stock outstanding since original issuance. Net income per common share, basic and diluted, for non-redeemable common stock is calculated by dividing the net income, adjusted for income attributable to redeemable common stock, by the weighted average number of non-redeemable common stock outstanding for the periods. Non-redeemable common stock includes the founder shares as these common stock do not have any redemption features and do not participate in the income earned on the Trust Account.\\nOff-Balance Sheet Arrangements\\nAs of June 30, 2021, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K.\\n\\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nAs of June 30, 2021, we were not subject to any market or interest rate risk. Following the consummation of our Initial Public Offering, the net proceeds received into the Trust Account, have been invested in U.S. government treasury bills, notes or bonds with a maturity of 180 days or less or in certain money market funds that invest solely in US treasuries. Due to the short-term nature of these investments, we believe there will be no associated material exposure to interest rate risk.\\nITEM 4. CONTROLS AND PROCEDURES\\nDisclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Co-Chief Executive Officers and Chief Financial Officer, to allow timely decisions regarding required disclosure.\\nEvaluation of Disclosure Controls and Procedures\\nAs required by Rules 13a-15 and 15d-15 under the Exchange Act, our Co-Chief Executive Officers and Chief Financial Officer carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2021. Based upon their evaluation, our Co-Chief Executive Officers and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15 (e) and 15d-15 (e) under the Exchange Act) continued to be ineffective with respect to the classification of the Company's Warrants as components of equity instead of as derivative liabilities and the re-classification of the Company's Class A ordinary shares between temporary and permanent equity. Any failure to maintain effective disclosure controls could adversely impact our ability to report our financial results on a timely and accurate basis, which could have adverse consequences, including with respect to the continued listing of our securities.\\nDisclosure controls and procedures are designed to ensure that information required to be disclosed by us in our Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.\\nChanges in Internal Control Over Financial Reporting\\nDuring the fiscal quarter ended March 31, 2021, management identified a material weakness in internal controls related to the accounting for warrants issued in connection with our initial public offering, as described above, which material weakness continued to exist during the most recent fiscal quarter ended June 30, 2021. While we have processes to identify and appropriately apply applicable accounting requirements, we plan to enhance our system of evaluating and implementing the accounting standards that apply to our financial statements, including through enhanced analyses by our personnel and third-party professionals with whom we consult regarding complex accounting applications. The elements of our remediation plan can only be accomplished over time, and we can offer no assurance that these initiatives will ultimately have the intended effects.\\n19\\nPART II – OTHER INFORMATION\\n\\nITEM 1. LEGAL PROCEEDINGS.\\nNone.\\n\\nITEM 1A. RISK FACTORS.\\nFactors that could cause our actual results to differ materially from those in this report include the risk factors described in our Annual Report on Form 10-K for the year ended December 31, 2020 filed with the SEC on April 15, 2021, as amended on Form 10-K/A filed with the SEC on April 19, 2021. As of the date of this Report there have been no material changes to the risk factors disclosed in our Annual Report filed with the SEC.\\n\\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.\\nNone.\\n\\nITEM 3. DEFAULTS UPON SENIOR SECURITIES.\\nNone.\\n\\nITEM 4. MINE SAFETY DISCLOSURES.\\nNot applicable.\\n\\nITEM 5. OTHER INFORMATION.\\nOn May 28, 2021, we received a notice from Nasdaq Regulation, or Nasdaq, indicating that we were not in compliance with Nasdaq Listing Rule 5250(c)(1) as a result of our failure to timely file our Quarterly Report on Form 10-Q for the quarter ended March 31, 2021, which we refer to as the Form 10-Q, with the Securities and Exchange Commission, or SEC. The notice provided that we must submit a plan to regain compliance with Nasdaq Listing Rule 5250(c)(1) by July 26, 2021. Alternatively, we were permitted to regain compliance with the Nasdaq listing standards at any time prior to that date by filing the Form 10-Q with the SEC. We subsequently filed the Form 10-Q with the SEC on July 26, 2021.\\nOn August 6, 2021, we received a notice from Nasdaq stating that, based on the Form 10-Q filing on July 26, 2021, we had regained compliance with the Nasdaq listing standards.\\n\\nITEM 6. EXHIBITS.\\nThe following exhibits are filed as part of, or incorporated by reference into, this Quarterly Report on Form 10-Q.\\n\\n| No. | Description of Exhibit |\\n| 31.1* | Certification of Principal Executive Officer Pursuant to Securities Exchange Act Rules 13a-14(a) and 15(d)-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 31.2* | Certification of Principal Financial Officer Pursuant to Securities Exchange Act Rules 13a-14(a) and 15(d)-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 32.1** | Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 32.2** | Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 101.INS* | Inline XBRL Instance Document |\\n| 101.CAL* | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\\n| 101.SCH* | Inline XBRL Taxonomy Extension Schema Document |\\n| 101.DEF* | Inline XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101.LAB* | Inline XBRL Taxonomy Extension Labels Linkbase Document |\\n| 101.PRE* | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\\n\\n\\n| * | Filed herewith. |\\n| ** | Furnished. |\\n\\n20\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n\\n| IGNYTE ACQUISITION CORP. |\\n| Date: August 16, 2021 | By: | /s/David Rosenburg |\\n| David Rosenberg |\\n| Co-Chief Executive Officer (Principal Executive Officer) |\\n\\n\\n| IGNYTE ACQUISITION CORP. |\\n| Date: August 16, 2021 | By: | /s/ Steven Kaplan |\\n| Steven Kaplan |\\n| Chief Financial Officer (Principal Financial and Accounting Officer) |\\n\\n21\\n \\n\\nWhat is the difference between the total net income for both redeemable and non-redeemable common stock and the total offering costs from the IPO in the first half of 2021 in dollars?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is -1279561.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 31,\n \"input_length\": 18052\n}"}}},{"rowIdx":32,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nItem 1. Financial Statements (Unaudited)\nCONTEXTLOGIC INC.\nCONDENSED CONSOLIDATED BALANCE SHEETS\n(in millions, except par value)\n\n| As of March 31, | As of December 31, |\n| 2021 | 2020 |\n| (Unaudited) |\n| Assets |\n| Current assets: |\n| Cash and cash equivalents | $ | 1,620 | $ | 1,965 |\n| Marketable securities | 154 | 164 |\n| Funds receivable | 65 | 83 |\n| Prepaid expenses and other current assets | 88 | 102 |\n| Total current assets | 1,927 | 2,314 |\n| Property and equipment, net | 23 | 25 |\n| Right-of-use assets | 39 | 43 |\n| Marketable securities | — | 4 |\n| Other assets | 10 | 11 |\n| Total assets | $ | 1,999 | $ | 2,397 |\n| Liabilities and Stockholders’ Equity |\n| Current liabilities: |\n| Accounts payable | $ | 291 | $ | 434 |\n| Merchants payable | 381 | 454 |\n| Refunds liability | 54 | 77 |\n| Accrued liabilities | 309 | 367 |\n| Total current liabilities | 1,035 | 1,332 |\n| Lease liabilities, non-current | 34 | 38 |\n| Total liabilities | 1,069 | 1,370 |\n| Commitments and contingencies (Note 7) |\n| Stockholders’ equity: |\n| Preferred stock, $ 0.0001 par value: 100 shares authorized as of March 31, 2021 and December 31, 2020; No shares issued and outstanding as of March 31, 2021 and December 31, 2020 | — | — |\n| Common stock, $ 0.0001 par value: 3,500 ( 3,000 Class A, 500 Class B) shares authorized as of March 31, 2021 and December 31, 2020; 618 ( 501 Class A, 117 Class B) and 587 ( 478 Class A, 109 Class B) shares issued and outstanding as of March 31, 2021 and December 31, 2020 | — | — |\n| Additional paid-in capital | 3,243 | 3,210 |\n| Accumulated other comprehensive income (loss) | ( 1 | ) | 1 |\n| Accumulated deficit | ( 2,312 | ) | ( 2,184 | ) |\n| Total stockholders’ equity | 930 | 1,027 |\n| Total liabilities and stockholders’ equity | $ | 1,999 | $ | 2,397 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n1\nCONTEXTLOGIC INC.\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\n(in millions, except per share data)\n(Unaudited)\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| Revenue | $ | 772 | $ | 440 |\n| Cost of revenue | 335 | 156 |\n| Gross profit | 437 | 284 |\n| Operating expenses: |\n| Sales and marketing | 470 | 295 |\n| Product development | 51 | 25 |\n| General and administrative | 42 | 18 |\n| Total operating expenses | 563 | 338 |\n| Loss from operations | ( 126 | ) | ( 54 | ) |\n| Other income (expense), net: |\n| Interest and other income, net | — | 3 |\n| Remeasurement of redeemable convertible preferred stock warrant liability | — | ( 15 | ) |\n| Loss before provision for income taxes | ( 126 | ) | ( 66 | ) |\n| Provision for income taxes | 2 | — |\n| Net loss | ( 128 | ) | ( 66 | ) |\n| Net loss per share, basic and diluted | $ | ( 0.21 | ) | $ | ( 0.62 | ) |\n| Weighted-average shares used in computing net loss per share, basic and diluted | 619 | 106 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n2\nCONTEXTLOGIC INC.\nCONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS\n(in millions)\n(Unaudited)\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| Net loss | $ | ( 128 | ) | $ | ( 66 | ) |\n| Other comprehensive loss: |\n| Net unrealized holding losses on derivatives | ( 2 | ) | — |\n| Comprehensive loss | $ | ( 130 | ) | $ | ( 66 | ) |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n3\nCONTEXTLOGIC INC.\nCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\n(in millions)\n(Unaudited)\n\n| Three Months Ended March 31, 2021 |\n| Common Stock | Additional Paid-in | Accumulated Other | Accumulated | Total Stockholders’ |\n| Shares | Amount | Capital | Comprehensive Income | Deficit | Equity |\n| Balances as of December 31, 2020 | 587 | $ | — | $ | 3,210 | $ | 1 | $ | ( 2,184 | ) | $ | 1,027 |\n| Issuance of common stock upon exercise of options for cash | 2 | — | 1 | — | — | 1 |\n| Issuance of common stock upon settlement of restricted stock units, net of tax | 29 | — | ( 5 | ) | — | — | ( 5 | ) |\n| Stock-based compensation | — | — | 37 | — | — | 37 |\n| Other comprehensive loss, net | — | — | — | ( 2 | ) | — | ( 2 | ) |\n| Net loss | — | — | — | — | ( 128 | ) | ( 128 | ) |\n| Balances as of March 31, 2021 | 618 | $ | — | $ | 3,243 | $ | ( 1 | ) | $ | ( 2,312 | ) | $ | 930 |\n\n\n| Three Months Ended March 31, 2020 |\n| Redeemable Convertible Preferred Stock | Common Stock | Additional Paid-in | Accumulated | Total Stockholders’ |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Deficit |\n| Balances as of December 31, 2019 | 422 | $ | 1,536 | 103 | $ | — | $ | — | $ | ( 1,439 | ) | $ | ( 1,439 | ) |\n| Issuance of common stock upon exercise of options for cash | — | — | 3 | — | 1 | — | 1 |\n| Net loss and comprehensive loss | — | — | — | — | — | ( 66 | ) | ( 66 | ) |\n| Balances as of March 31, 2020 | 422 | $ | 1,536 | 106 | $ | — | $ | 1 | $ | ( 1,505 | ) | $ | ( 1,504 | ) |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n4\nCONTEXTLOGIC INC.\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(in millions)\n(Unaudited)\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| Cash flows from operating activities: |\n| Net loss | $ | ( 128 | ) | $ | ( 66 | ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: |\n| Depreciation and amortization | 2 | 2 |\n| Non-cash lease expense | 4 | 2 |\n| Stock-based compensation expense | 37 | — |\n| Remeasurement of redeemable convertible preferred stock warrant liability | — | 15 |\n| Other | ( 3 | ) | — |\n| Changes in operating assets and liabilities: |\n| Funds receivable | 18 | 8 |\n| Prepaid expenses, other current and noncurrent assets | 16 | 7 |\n| Accounts payable | ( 143 | ) | 31 |\n| Merchants payable | ( 73 | ) | ( 122 | ) |\n| Accrued and refund liabilities | ( 69 | ) | 3 |\n| Lease liabilities | ( 4 | ) | ( 2 | ) |\n| Other current and noncurrent liabilities | ( 11 | ) | ( 7 | ) |\n| Net cash used in operating activities | ( 354 | ) | ( 129 | ) |\n| Cash flows from investing activities: |\n| Purchases of marketable securities | ( 53 | ) | ( 73 | ) |\n| Maturities of marketable securities | 67 | 132 |\n| Net cash provided by investing activities | 14 | 59 |\n| Cash flows from financing activities: |\n| Payment of taxes related to RSU settlement and other financing activities, net | ( 5 | ) | 1 |\n| Net cash provided by (used in) financing activities | ( 5 | ) | 1 |\n| Net decrease in cash, cash equivalents and restricted cash | ( 345 | ) | ( 69 | ) |\n| Cash, cash equivalents and restricted cash at beginning of period | 1,965 | 754 |\n| Cash, cash equivalents and restricted cash at end of period | $ | 1,620 | $ | 685 |\n| Reconciliation of cash, cash equivalents, and restricted cash to the condensed consolidated balance sheets: |\n| Cash and cash equivalents | $ | 1,620 | $ | 675 |\n| Restricted cash included in other assets in the condensed consolidated balance sheets | — | 10 |\n| Total cash, cash equivalents and restricted cash | $ | 1,620 | $ | 685 |\n| Supplemental cash flow disclosures: |\n| Cash paid for income taxes, net of refunds | $ | 2 | $ | — |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n5\nCONTEXTLOGIC INC.\nNotes to Unaudited Condensed Consolidated Financial Statements\nNOTE 1. OVERVIEW, BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES\nContextLogic Inc. (“Wish” or the “Company”) is an ecommerce company that provides a shopping experience that is mobile-first and discovery-based, which connects merchants’ products to users based on user preferences. The Company generates revenue from marketplace and logistics services provided to merchants.\nThe Company was incorporated in the state of Delaware in June 2010 and is headquartered in San Francisco, California, with operations in Canada, China and the Netherlands.\nInitial Public Offering\nIn December 2020, the Company completed its initial public offering (“IPO”) of Class A common stock, in which it sold 46 million shares. The shares were sold at an IPO price of $ 24.00 per share for net proceeds of approximately $ 1.1 billion, after deducting underwriting discounts and commissions of approximately $ 52 million. Additionally, the Company incurred approximately $ 6 million of offering costs, net of reimbursements. Following the IPO, the Company has two classes of authorized common stock, Class A common stock, which entitles holders to one vote per share, and Class B common stock, which entitles holders to 20 votes per share.\nBasis of Presentation and Consolidation\nThe accompanying condensed consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles (“U.S. GAAP”). The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. The condensed consolidated financial statements are unaudited, but include all adjustments of a normal recurring nature necessary for a fair presentation of our quarterly results. The consolidated balance sheet as of December 31, 2020 is derived from audited financial statements, however, it does not include all of the information and footnotes required by U.S. GAAP for complete financial statements. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes in our Annual Report on Form 10-K for the year ended December 31, 2020, which was filed with the Securities and Exchange Commission (“SEC”) on March 25, 2021.\nUse of Estimates\nThe preparation of condensed consolidated financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the condensed consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. These estimates form the basis for judgments the Company makes about the carrying values of its assets and liabilities that are not readily available from other sources. These estimates include, but are not limited to, fair value of financial instruments, useful lives of long-lived assets, fair value of derivative instruments, incremental borrowing rate applied to lease accounting, contingent liabilities, redemption probabilities associated with Wish Cash, allowances for refunds and chargebacks and uncertain tax positions. As of March 31, 2021, the effects of the ongoing COVID-19 pandemic on the Company’s business, results of operations, and financial condition continue to evolve. As a result, many of the Company’s estimates and assumptions required increased judgment and these estimates may change materially in future periods.\nSegments\nThe Company manages its operations and allocates resources as a single operating segment. Further, the Company manages, monitors and reports its financials as a single reporting segment. The Company’s chief operating decision-maker is its Chief Executive Officer who makes operating decisions, assesses financial performance and allocates resources based on condensed consolidated financial information. As such, the Company has determined that it operates in one reportable segment.\n6\nConcentrations of Risk\nCredit Risk — Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents, funds receivable, marketable securities and derivative financial instruments. The Company’s cash and cash equivalents are held on deposit with creditworthy institutions. Although the Company’s deposits exceed federally insured limits, the Company has not experienced any losses in such accounts. The Company invests its excess cash in money market accounts, U.S. Treasury notes, U.S. Treasury bills, commercial paper and corporate bonds. The Company is exposed to credit risk in the event of a default by the financial institutions holding its cash, cash equivalents and marketable securities for the amounts reflected on the condensed consolidated balance sheets. The Company’s investment policy limits investments to certain types of debt securities issued by the U.S. government, its agencies and institutions with investment-grade credit ratings and places restrictions on maturities and concentration by type and issuer.\nThe Company's derivative financial instruments expose it to credit risk to the extent that the counterparties may be unable to meet the terms of the arrangement. The Company seeks to mitigate such risk by limiting its counterparties to, and by spreading the risk across, major financial institutions. In addition, the potential risk of loss with any one counterparty resulting from this type of credit risk is monitored on a monthly basis. The Company is not required to pledge, nor is it entitled to receive, collateral related to its foreign exchange derivative transactions.\nThe Company is exposed to credit risk in the event of a default by its Payment Service Providers (“PSPs”). The Company does not generate revenue from PSPs. Significant changes in the Company’s relationship with its PSPs could adversely affect users’ ability to process transactions on the Company’s marketplaces, thereby impacting the Company’s operating results.\nThe following PSPs each represented 10% or more of the Company’s funds receivable balance:\n\n| March 31, | December 31, |\n| 2021 | 2020 |\n| PSP 1 | 61 | % | 56 | % |\n| PSP 2 | 27 | % | 27 | % |\n\nServices Risk — The Company serves all of its users using third-party data center and hosting providers. The Company has disaster recovery protocols at the third-party service providers. Even with these procedures for disaster recovery in place, access to the Company’s service could be significantly interrupted, resulting in an adverse effect on its operating results and financial position. No significant interruptions of service were known to have occurred during the three months ended March 31, 2021 and 2020.\nSummary of Significant Accounting Policies\nThere have been no changes to the Company’s significant accounting policies described in its Annual Report on Form 10-K for the year ended December 31, 2020, filed with the SEC on March 25, 2021, that have had a material impact on its condensed consolidated financial statements.\nAccounting Pronouncements\nThe Company has reviewed recent accounting pronouncements and concluded they are either not applicable to the business or no material impact is expected on the condensed consolidated financial statements as a result of future adoption.\nNOTE 2. DISAGGREGATION OF REVENUE\nThe Company generates revenue from marketplace and logistics services provided to merchants. Revenue is recognized as the Company transfers control of promised goods or services to its users in an amount that reflects the consideration the Company expects to be entitled to in exchange for those goods or services. The Company considers both the merchant and the user to be customers. The Company evaluates whether it is appropriate to recognize revenue on a gross or net basis based upon its evaluation of whether the Company obtains control of the specified goods or services by considering if it is primarily responsible for fulfillment of the promise, has inventory risk, has latitude in establishing pricing and selecting suppliers, among other factors. Based on these factors, marketplace revenue is generally recognized on a net basis and logistics revenue is generally recognized on a gross basis. Revenue excludes any amounts collected on behalf of third parties, including indirect taxes.\nMarketplace revenue includes commission fees collected in connection with user purchases of the merchants’ products. The commission fees vary depending on factors such as user location, demand, product type, and dynamic\n7\npricing. The Company recognizes revenue when a user’s order is processed and the related order information has been made available to the merchant. Commission fees are recognized net of estimated refunds and chargebacks. Marketplace revenue also includes ProductBoost revenue for displaying a merchant’s selected products in preferential locations within the Company’s marketplace. The Company recognizes revenue when the merchants’ selected products are displayed. The Company refers to its marketplace revenue, excluding ProductBoost revenue, as its core marketplace revenue.\nThe Company’s logistics offering for merchants is designed for direct end-to-end single order shipment from a merchant’s location to the user. Logistics services include transportation and delivery of the merchant’s products to the user. Merchants are required to prepay for logistics services on a per order basis. The Company recognizes revenue over time as the merchant simultaneously receives and consumes the logistics services benefit as the services are performed. The Company uses an output method of progress based on days in transit as it best depicts the Company’s progress toward complete satisfaction of the performance obligation.\nThe following table shows the disaggregated revenue for the applicable periods:\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Core marketplace revenue | $ | 477 | $ | 340 |\n| ProductBoost revenue | 50 | 44 |\n| Marketplace revenue | 527 | 384 |\n| Logistics revenue | 245 | 56 |\n| Revenue | $ | 772 | $ | 440 |\n\nRefer to Note 11 – Geographical Information for the disaggregated revenue by geographical location.\nNote 3. FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENT\nThe Company’s financial instruments consist of cash equivalents, marketable securities, funds receivable, derivative instruments, accounts payable, accrued liabilities and merchants payable. Cash equivalents’ carrying value approximates fair value at the balance sheet dates, due to the short period of time to maturity. Marketable securities and derivative instruments are recognized at fair value. Funds receivable, accounts payable, accrued liabilities and merchants payable carrying values approximate fair value due to the short time to the expected receipt or payment date.\nAssets and liabilities recognized at fair value on a recurring basis in the condensed consolidated balance sheets consisting of cash equivalents, marketable securities and derivative instruments are categorized based upon the level of judgment associated with the inputs used to measure their fair values. Fair value is defined as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.\n8\nFinancial assets and liabilities subject to fair value measurements on a recurring basis and the level of inputs used in such measurements are as follows:\n\n| March 31, 2021 |\n| Total | Level 1 | Level 2 | Level 3 |\n| (in millions) |\n| Financial assets: |\n| Cash equivalents: |\n| Money market funds | $ | 97 | $ | 97 | $ | — | $ | — |\n| Marketable securities: |\n| U.S. Treasury bills | $ | 35 | $ | — | $ | 35 | $ | — |\n| Commercial paper | 62 | — | 62 | — |\n| Corporate bonds | 52 | — | 52 | — |\n| Non-US government | 5 | — | 5 | — |\n| Total marketable securities | $ | 154 | $ | — | $ | 154 | $ | — |\n| Total financial assets | $ | 251 | $ | 97 | $ | 154 | $ | — |\n| Financial liabilities: |\n| Accrued liabilities: |\n| Derivative liabilities | $ | 2 | $ | — | $ | 2 | $ | — |\n| Total financial liabilities | $ | 2 | $ | — | $ | 2 | $ | — |\n\n\n| December 31, 2020 |\n| Total | Level 1 | Level 2 | Level 3 |\n| (in millions) |\n| Financial assets: |\n| Cash equivalents: |\n| Money market funds | $ | 35 | $ | 35 | $ | — | $ | — |\n| U.S. Treasury bills | 30 | — | 30 | — |\n| Commercial paper | 9 | — | 9 | — |\n| Total cash equivalents | $ | 74 | $ | 35 | $ | 39 | $ | — |\n| Marketable securities: |\n| U.S. Treasury bills | $ | 38 | $ | — | $ | 38 | $ | — |\n| Commercial paper | 49 | — | 49 | — |\n| Corporate bonds | 81 | — | 81 | — |\n| Total marketable securities | $ | 168 | $ | — | $ | 168 | $ | — |\n| Prepaid and other current assets: |\n| Derivative assets | $ | 3 | $ | — | $ | 3 | $ | — |\n| Total financial assets | $ | 245 | $ | 35 | $ | 210 | $ | — |\n| Financial liabilities: |\n| Accrued liabilities: |\n| Derivative liabilities | $ | 4 | $ | — | $ | 4 | $ | — |\n| Total financial liabilities | $ | 4 | $ | — | $ | 4 | $ | — |\n\nThe Company classifies cash equivalents and marketable securities within Level 1 or Level 2 because the Company uses quoted market prices or alternative pricing sources and models utilizing market observable inputs to determine their fair value. The derivative asset and liability related to the Company’s foreign currency derivative contracts are classified within Level 2 of the fair value hierarchy as the valuation inputs are based on quoted prices and market observable data of similar instruments in active markets, including currency spot and forward rates.\n9\nThe following table summarizes the contractual maturities of the Company’s marketable securities:\n\n| March 31, | December 31, |\n| 2021 | 2020 |\n| Amortized Cost | Estimated Fair Value | Amortized Cost | Estimated Fair Value |\n| (in millions) |\n| Due within one year | $ | 154 | $ | 154 | $ | 164 | $ | 164 |\n| Due after one year through five years | — | — | 4 | 4 |\n| Total marketable securities | $ | 154 | $ | 154 | $ | 168 | $ | 168 |\n\nAll of the Company’s available-for-sale marketable securities are subject to a periodic evaluation for a credit loss allowance and impairment review. The Company did not identify any of its available-for-sale marketable securities requiring an allowance for credit loss or as other-than-temporarily impaired in any of the periods presented. Additionally, the unrealized net gain and net loss on available-for-sale marketable securities as of March 31, 2021 and December 31, 2020 were immaterial.\nNOTE 4. BALANCE SHEET COMPONENTS\nAccrued Liabilities\nAccrued liabilities consist of the following:\n\n| March 31, | December 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Vendor services | $ | 90 | $ | 121 |\n| Deferred revenue | 26 | 37 |\n| Wish Cash liability | 48 | 48 |\n| Other | 145 | 161 |\n| Total accrued liabilities | $ | 309 | $ | 367 |\n\nNOTE 5. DERIVATIVE FINANCIAL INSTRUMENTS\nThe Company conducts business in certain foreign currencies throughout its worldwide operations, and various entities hold monetary assets or liabilities, earn revenues, or incur costs in currencies other than the entity’s functional currency. As a result, the Company is exposed to foreign exchange gains or losses which impact the Company’s operating results. The Company bills its users based on their local currencies, primarily in U.S. dollars and Euros, and the Company makes payments to the merchants in China for products sold on the Wish platform in Renminbi, which creates exposure to currency rate fluctuations. The Company hedges these cash flow exposures to reduce the risk that its earnings and cash flows will be adversely affected by changes in exchange rates. As part of the Company’s foreign currency risk mitigation strategy, the Company enters into derivative contracts and foreign exchange forward contracts with up to twelve months in duration to hedge exposures for variability in U.S.-dollar equivalent of non-U.S.-dollar denominated cash flows associated with its forecasted revenue related transactions.\nThe Company’s derivatives transactions are not collateralized and do not include collateralization agreements with counterparties. The Company does not use derivative financial instruments for speculative or trading purposes.\n10\nVolume of Derivative Activity\nTotal gross notional amounts for outstanding derivatives (recognized at fair value) as of the end of period consist of the following:\n\n| March 31, 2021 | December 31, 2020 |\n| (in millions) |\n| Cash flow hedges | $ | 250 | $ | 600 |\n| Non-designated hedges | 219 | 422 |\n| Total | $ | 469 | $ | 1,022 |\n\nFair Value of Derivative Financial Instruments\n\n| March 31, 2021 | December 31, 2020 |\n| Assets(1) | Liabilities(2) | Assets(1) | Liabilities(2) |\n| (in millions) |\n| Derivative designated as hedging instruments |\n| Cash flow hedges | $ | — | $ | 2 | $ | 3 | $ | 2 |\n| Derivative not designated as hedging instruments |\n| Foreign currency forward contracts | $ | — | $ | — | $ | — | $ | 2 |\n| Total derivatives | $ | — | $ | 2 | $ | 3 | $ | 4 |\n\n(1) Derivative assets are included in prepaid and other current assets in the condensed consolidated balance sheets.\n(2) Derivative liabilities are included in accrued liabilities in the condensed consolidated balance sheets.\nDerivatives in Cash Flow Hedging Relationships\nThe changes in accumulated other comprehensive income resulting from cash flow hedging were as follows:\n\n| As of March 31, 2021 | As of December 31, 2020 |\n| (in millions) |\n| Balance beginning of the period | $ | 2 | $ | — |\n| Other comprehensive income before reclassifications | 7 | 9 |\n| Amounts recognized in core marketplace revenue and reclassified out of accumulated other comprehensive income | ( 9 | ) | ( 7 | ) |\n| Balance at the end of the period | $ | — | $ | 2 |\n\nThe Company recognizes changes in fair value of the cash flow hedges of foreign currency denominated merchants payable in accumulated other comprehensive loss in its consolidated balance sheets until the forecasted transaction occurs. When the forecasted transaction affects earnings, the Company reclassifies the related gain or loss on the cash flow hedge to core marketplace revenue. All amounts in other comprehensive income at period end are expected to be reclassified to earnings within 12 months. In the event the underlying forecasted transaction does not occur, or it becomes probable that it will not occur, the Company reclassifies the gain or loss on the related cash flow hedge from accumulated other comprehensive loss to core marketplace revenue. For the three months ended March 31, 2021, there were no net gains or losses recognized in core marketplace revenue relating to hedges of forecasted transactions that did not occur. The Company did not have a hedging program during the three months ended March 31, 2020.\nThe Company classifies cash flows related to its cash flow hedges as operating activities in its condensed consolidated statements of cash flows.\nDerivatives Not Designated as Hedging Instruments\nThe net gains on the change in fair value of the Company’s foreign exchange forward contracts not designated as hedging instruments were approximately $ 4 million for the three months ended March 31, 2021 and were recognized in other income (expense), net in the condensed consolidated statement of operations. The Company did not have a hedging program during the three months ended March 31, 2020.\n11\nThe Company classifies cash flows related to its non-designated hedging instruments as operating activities in its condensed consolidated statements of cash flows.\nNOTE 6. OPERATING LEASES\nThe Company leases its facilities and data center co-locations under operating leases with various expiration dates through 2025 .\nTotal operating lease cost was $ 4 million and $ 3 million for the three months ended March 31, 2021 and 2020, respectively. Short-term lease costs and variable lease costs and sublease income were not material.\nAs of March 31, 2021 and December 31, 2020, the Company’s condensed consolidated balance sheets included right-of-use assets in the amount of $ 39 million and $ 43 million, respectively, and lease liabilities in the amount of $ 14 million and $ 14 million in accrued liabilities, respectively, and $ 34 million and $ 38 million in lease liabilities, non-current, respectively.\nAs of March 31, 2021 and December 31, 2020, the weighted-average remaining lease term was 3.7 years and 3.9 years, respectively, and the weighted-average discount rate used to determine the net present value of the lease liabilities was 6 %.\nSupplemental cash flow information for the Company’s operating leases were as follows:\n\n| March 31, | March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Cash paid for amounts included in the measurement of lease liabilities: |\n| Operating cash flows from operating leases | $ | 4 | $ | 3 |\n\nThe maturities of the Company’s operating lease liabilities are as follows:\n\n| March 31, |\n| 2021 |\n| Year ending December 31, | (in millions) |\n| 2021 (remaining nine months) | $ | 12 |\n| 2022 | 15 |\n| 2023 | 11 |\n| 2024 | 10 |\n| 2025 | 5 |\n| Total lease payments | 53 |\n| Less: imputed interest | ( 5 | ) |\n| Present value of lease liabilities | $ | 48 |\n\nNOTE 7. COMMITMENTS AND CONTINGENCIES\nRevolving Credit Facility\nIn November 2020, the Company entered into a five-year $ 280 million senior secured revolving credit facility (the “Revolving Credit Facility”) to, among other things, permit the Company to increase its aggregate commitments by up to $ 100 million, if an accordion option is exercised and provided the Company is able to secure additional lender commitments and satisfy certain other conditions, and to enter into letters of credit from time to time, which reduces its borrowing capacity under the Revolving Credit Facility. Interest on any borrowings under the Revolving Credit Facility accrues at either adjusted LIBOR plus 1.50 % or at an alternative base rate plus 0.50 %, at the Company’s election, and the Company is required to pay a commitment fee that accrues at 0.25 % per annum on the unused portion of the aggregate commitments under the Revolving Credit Facility. The Company is required to pay a fee that accrues at 1.50 % per annum on the average daily amount available to be drawn under any letters of credit outstanding under the Revolving Credit Facility.\n12\nThe Revolving Credit Facility contains customary conditions to borrowing, events of default and covenants, including covenants that restrict the Company’s ability (and the ability of certain of the Company’s subsidiaries) to incur indebtedness, grant liens, make certain fundamental changes and asset sales, make distributions to stockholders, make investments or engage in transactions with affiliates. It also contains a minimum liquidity financial covenant of $ 350 million, which includes unrestricted cash and any available borrowing capacity under the Revolving Credit Facility. The obligations under the Revolving Credit Facility are secured by liens on substantially all of the Company’s domestic assets and are guaranteed by any material domestic subsidiaries, subject to customary exceptions. A standby letter of credit in the amount of approximately $ 10 million has been issued under the Revolving Credit Facility in conjunction with the lease of the Company’s headquarters in San Francisco, California. As of March 31, 2021, the Company had no t made any borrowings under the Revolving Credit Facility and it was in compliance with the related covenants.\nPurchase Obligations\nDuring 2019, the Company amended a marketing arrangement which increased the total commitment under the agreement and extended the arrangement to July 31, 2021. As of March 31, 2021, the remaining commitment under the amended agreement was $ 5 million, which is payable in 2021 .\nEffective September 1, 2019, the Company entered into an amendment to a colocation and cloud services arrangement committing the Company to make payments of $ 120 million for services over 3 years. As of March 31, 2021, the remaining commitment under this amended agreement was approximately $ 35 million and is payable within the next two years .\nLegal Contingencies\nAs of March 31, 2021 and December 31, 2020, there were no legal contingency matters that arose in the ordinary course of business, either individually or in aggregate, that would have a material adverse effect on the financial position, results of operations, or cash flows of the Company. Given the unpredictable nature of legal proceedings, the Company bases its estimate on the information available at the time of the assessment. As additional information becomes available, the Company reassesses the potential liability and may revise the estimate.\nNOTE 8. EQUITY Award activity and STOCK-based compensation\nEquity Award Activity\nA summary of activity under the equity plans and related information is as follows:\n\n| Options Outstanding | RSUs Outstanding |\n| Number of Options | Weighted- Average Exercise Price | Weighted- Average Remaining Contractual Term (In Years) | Number of RSUs |\n| (in millions) | (in millions) |\n| Balances at December 31, 2020 | 75 | $ | 0.234 | 3.2 | 30 |\n| Granted | — | $ | — | 1 |\n| Vested(1) | — | $ | — | ( 3 | ) |\n| Exercised | ( 2 | ) | $ | 0.154 | — |\n| Balances at March 31, 2021(2) | 73 | $ | 0.236 | 3.0 | 28 |\n\n\n| (1) | For the three months ended March 31, 2021, approximately 3 million RSUs vested upon satisfying both the service and liquidity vesting conditions. The shares remained unreleased as of March 31, 2021 due to the lock-up provisions related to the Company’s IPO. |\n\n| (2) | Outstanding RSUs as of March 31, 2021 include 10 million units of CEO Performance Award. |\n\nThe weighted-average grant date fair value of restricted stock units (“RSUs”) granted during the three months ended March 31, 2021 was $ 22.01 per share.\n13\nStock-Based Compensation Expense\nTotal stock-based compensation expense included in the condensed consolidated statements of operations is as follows:\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Cost of revenue | $ | 5 | $ | — |\n| Sales and marketing | 3 | — |\n| Product development | 15 | — |\n| General and administrative | 14 | — |\n| Total stock-based compensation | $ | 37 | $ | — |\n\nThe Company will recognize the remaining $ 134 million and $ 72 million of unrecognized stock-based compensation expense over a weighted-average period of approximately 1.32 years and 3.84 years related to RSUs and CEO Performance Award, respectively.\nEmployee Stock Purchase Plan\nThe Company’s Employee Stock Purchase Plan (“ESPP”) allows eligible employees to purchase shares of the Company’s Class A common stock at a discount through payroll deductions of up to 15 % of eligible compensation, subject to caps of $ 25,000 in any calendar year and 2,500 shares on any purchase date. The ESPP provides for 24 -month offering periods, generally beginning in November and May of each year, and each offering period consists of four six-month purchase periods. The initial offering period began on January 1, 2021 and will end in November 2022. The first purchase under the ESPP will be in May 2021 .\nOn each purchase date, participating employees will purchase Class A common stock at a price per share equal to 85 % of the lesser of the fair market value of the Company’s Class A common stock on (i) the first trading day of the applicable offering period and (2) the last trading day of each purchase period in the applicable offering period. If the stock price of the Company's Class A common stock on any purchase date in an offering period is lower than the stock price on the enrollment date of that offering period, the offering period will immediately reset after the purchase of shares on such purchase date and automatically roll into a new offering period.\nThe Company uses the Black-Scholes option pricing model to determine the fair value of shares to be purchased under the 2020 Employee Stock Purchase Plan (“ESPP”) with the following assumptions on the date of grant:\n\n| Three Months Ended |\n| March 31, 2021 |\n| Expected term (in years) | 0.38 to 1.88 |\n| Risk free interest rate | 0.09% to 0.13% |\n| Volatility | 46.45% to 62.28% |\n| Dividend yield | — |\n| Estimated fair value per ESPP share | $4.14 to $8.05 |\n\nNOTE 9. INCOME TAXES\nThe Company’s tax provision for the interim periods is determined using an estimate of the annual effective tax rate, adjusted for discrete items, if any, that arise during the period. Each quarter, the Company assesses its estimate of the annual effective tax rate, and if the estimated annual effective tax rate changes, the Company makes a cumulative adjustment in the period of change.\nThe Company’s quarterly tax provision and the estimate of the annual effective tax rate is subject to fluctuation due to several factors, including variability in pre-tax earnings, the geographic distribution of the pre-tax earnings, tax law\n14\nchanges, non-deductible expenses, such as stock-based compensation, and changes in the estimate of the valuation allowance.\nThe provision for income taxes was $ 2 million for the three months ended March 31, 2021 and was insignificant for the three months ended March 31, 2020. The year-over-year increase in provision for income taxes was primarily related to international operations. The Company continues to maintain a valuation allowance on its domestic net deferred tax assets which is excluded from the annual effective tax rate estimate.\nThe Company had immaterial unrecognized tax benefits as of March 31, 2021 and December 31, 2020, fully offset by a valuation allowance. These unrecognized tax benefits, if recognized, would no t affect the effective tax rate. No interest or penalties were incurred during the years ended March 31, 2021 and 2020.\nThe Company files income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions. The Company is not currently under examination by income tax authorities in federal, state or other jurisdictions. All tax returns will remain open for examination by the federal and state authorities for three and four years , respectively, from the date of utilization of any net operating loss or credits. Certain tax years are subject to foreign income tax examinations by tax authorities until the statute of limitations expire.\n15\nNOTE 10. Net loss per share\nBasic net income (loss) per share is computed using the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is computed by giving effect to potentially dilutive common stock equivalents outstanding during the period, as their effect would be dilutive. Potentially dilutive common shares include participating securities and shares issuable upon the exercise of stock options, the exercise of common stock warrants, the vesting of RSUs and each purchase under the 2020 ESPP, under the treasury stock method.\nIn loss periods, basic net loss per share and diluted net loss per share are the same, as the effect of potential common shares is anti-dilutive and therefore excluded.\nThe rights, including the liquidation and dividend rights, of the holders of Class A and Class B common stock are identical, except with respect to voting. As the liquidation and dividend rights are identical, the Company’s undistributed earnings or losses are allocated on a proportionate basis among the holders of both Class A and Class B common stock. As a result, the net income (loss) per share attributed to common stockholders will, therefore, be the same for both Class A and Class B common stock on an individual or combined basis.\nThe following table sets forth the computation of basic and diluted net loss per share:\n\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (in millions, except per share data) |\n| Numerator: |\n| Net loss | $ | ( 128 | ) | $ | ( 66 | ) |\n| Denominator: |\n| Weighted-average shares used in computing net loss per share, basic and diluted | 619 | 106 |\n| Net loss per share, basic and diluted | $ | ( 0.21 | ) | $ | ( 0.62 | ) |\n\nThe following outstanding shares of potentially dilutive securities were excluded from the computation of diluted net loss per share because including them would have had an anti-dilutive effect:\n\n| As of March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Redeemable convertible preferred stock, all series | — | 422 |\n| Series B warrant | — | 10 |\n| Warrant to purchase common stock | 1 | 1 |\n| Common stock options outstanding | 73 | 77 |\n| Unvested RSUs outstanding(1) | 28 | 44 |\n| Employee Stock Purchase Plan | 1 | — |\n| Total | 103 | 554 |\n\n\n| (1) | Unvested RSUs outstanding as of March 31, 2021 included 10 million units of CEO Performance Award. |\n\n16\nNOTE 11. GEOGRAPHICAL INFORMATION\nThe Company believes it is relevant to disclose geographical revenue information on both a demand basis, determined by the ship-to address of the user, and on a supply basis, determined by the location of the merchants’ operations.\nCore marketplace revenue by geographic area based on the ship-to address of the user is as follows:\n\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Europe | $ | 235 | 49 | % | $ | 159 | 47 | % |\n| North America(1) | 186 | 39 | % | 126 | 37 | % |\n| South America | 18 | 4 | % | 23 | 7 | % |\n| Other | 38 | 8 | % | 32 | 9 | % |\n| Core marketplace revenue | $ | 477 | 100 | % | $ | 340 | 100 | % |\n\n\n| (1) | United States accounted for $ 156 million and $ 103 million of core marketplace revenue for the three months ended March 31, 2021 and 2020, respectively. |\n\nChina accounted for substantially all of marketplace and logistics revenue during the three months ended March 31, 2021 and 2020 based on the location of the merchants’ operations.\nThe Company’s long-lived tangible assets, which consist of property and equipment, net and operating lease right-of-use assets, net, located in the United States were 87 % of the total long-lived tangible assets as of March 31, 2021 and December 31, 2020. The long-lived tangible assets outside the United States were located in China, Canada and the Netherlands.\n17\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nThe following discussion and analysis of our financial condition, results of operations and cash flows should be read in conjunction with (1) the unaudited condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q and (2) the audited condensed consolidated financial statements and notes thereto and management’s discussion and analysis of financial condition and results of operations for the year ended December 31, 2020 included in our Annual Report on Form 10-K filed on March 25, 2021. This discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under the heading \"Risk Factors\" in Part I, Item 1A of our Annual Report on Form 10-K for our year ended December 31, 2020. See also \"Special Note Regarding Forward-Looking Statements\" above.\nFinancial Results for the Three Months Ended March 31, 2021\n| • | Total revenue was $772 million, an increase of 75% year-over-year. |\n\n| • | Total cost of revenue and expenses were $898 million, including stock-based compensation expense of $37 million and $7 million of employer payroll taxes related to stock-based compensation. |\n\n| • | Loss from operations was $126 million. |\n\n| • | Net loss was $128 million. |\n\n| • | Adjusted EBITDA was a loss of $79 million or 10% of total revenue. |\n\n| • | Cash and cash equivalents and marketable securities were $1.8 billion. |\n\nAs of March 31, 2021, we had an accumulated deficit of $2.3 billion. We expect losses from operations to continue for the foreseeable future as we incur costs and expenses related to brand development, expansion of market share, continued development of our mobile shopping marketplace infrastructure and development of other businesses.\nCOVID-19\nThe outbreak of coronavirus disease 2019 (“COVID-19”) has affected businesses worldwide, as of the date of filing of this Quarterly Report, and continues to impact the major markets in which we operate. The COVID-19 pandemic has resulted in significant governmental measures being implemented to control the spread of the virus, and our operations as well as the operations of our third-party merchants and users have been and will continue to be disrupted by varying individual and governmental responses to COVID-19 around the world, such as business shutdowns, stay-at-home directives, travel restrictions, border closures, and other travel or health-related restrictions as well as by absenteeism, quarantines, self-isolations, office and factory closures, delays on deliveries, and disruptions to ports and other freight infrastructure. These restrictions may cause consumers and businesses to reduce their activities and their spending, have caused a slowdown in the global economy and have had, and may continue to have, a negative impact on our operations. If these conditions continue, sales volumes may decrease and we may, among other issues, experience or continue to experience delays in product development, a decreased ability to support our merchants, disruptions in sales, delivery and logistics, each of which could have a negative impact on our ability to meet shipment commitments and on our revenue and profitability.\nOur Financial Model\nOur business benefits from powerful network effects, fueled by our data advantage and massive scale. As more users join Wish, attracted by our affordable value proposition and shopping experience, we are able to increase revenue potential for our merchants. As more merchants succeed on Wish, more merchants join the platform and grow their businesses with Wish, broadening our product selection, which in turn improves user experience. By developing a strategy focused on users and merchants, we align user and merchant success with the success of our financial model. The growth in users and merchants generates more data, further strengthens our data advantage and creates an even better experience for everyone on our platform, in turn attracting more users and high-quality merchants.\nOur model relies on cost-effectively adding new users, converting those users into buyers and improving engagement and monetization of those buyers on Wish over time as well as adding new merchants, delivering economic success for those merchants, and having those merchants use more of our end-to-end platform.\n18\nKey Financial and Performance Metrics\nIn addition to the measures presented in our condensed consolidated financial statements, we monitor the following key metrics and other financial information to measure our performance, identify trends affecting our business, and make strategic decisions.\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| MAU | 101 | 109 |\n| LTM Active Buyers | 61 | 63 |\n| Adjusted EBITDA | $ | (79 | ) | $ | (51 | ) |\n| Adjusted EBITDA Margin | (10 | )% | (12 | )% |\n| Free Cash Flow | $ | (354 | ) | $ | (129 | ) |\n\nMonthly Active Users\nWe define MAUs as the number of unique users that visited the Wish platform, either on our mobile app, mobile web, or on a desktop, during the month. MAUs for a given reporting period equal the average of the MAUs for that period. An active user is identified by a unique email-address; a single person can have multiple user accounts via multiple email addresses. The change in MAUs in a reported period captures both the inflow of new users as well as the outflow of existing users who did not visit the platform in a given month. We view the number of MAUs as key driver of revenue growth as well as a key indicator of user engagement and awareness of our brand.\nMAUs decreased approximately 7% from the three months ended March 31, 2020 to the three months ended March 31, 2021, primarily driven by the decision to de-emphasize user acquisition in some emerging markets outside of Europe and North America where we faced logistical challenges due to the pandemic and to emphasize higher LTV users within the same value-conscious consumer category in many of the more developed markets.\nLTM Active Buyers\nAs of the last date of each reported period, we determine our number of unique active buyers by counting the total number of individual users who have placed at least one order on the Wish platform, either on our mobile app, mobile web, or on a desktop, during the preceding 12 months. We, however, exclude from the computation those buyers whose order is cancelled before the item is shipped and the purchase price is refunded. The number of Active Buyers is an indicator of our ability to attract and monetize a large user base to our platform and of our ability to convert visits into purchases. We believe that increasing our Active Buyers will be a significant driver to our future revenue growth.\nLTM Active Buyers decreased approximately 3% from the three months ended March 31, 2020 to the three months ended March 31, 2021, primarily due to our actions to de-emphasize low value items, which tend to have high conversion rates but unfavorable economics.\nA Note About Metrics\nThe numbers for some of our metrics, including MAUs, are calculated and tracked with internal tools, which are not independently verified by any third party. We use these metrics to assess the growth and health of our overall business. While these numbers are based on what we believe to be reasonable estimates of our user or merchant base for the applicable period of measurement, there are inherent challenges in measurement as the methodologies used require significant judgment and may be susceptible to algorithm or other technical errors. In addition, we regularly review and adjust our processes for calculating metrics to improve their accuracy, and our estimates may change due to improvements or changes in technology or our methodology.\n19\nNon-GAAP Financial Measures\nAdjusted EBITDA and Adjusted EBITDA Margin\nWe provide Adjusted EBITDA, a non-GAAP financial measure that represents our net income (loss) adjusted to exclude; interest and other income (expense), net (which includes foreign exchange gain or loss, foreign exchange forward contracts gain or loss and gain or loss on one-time non-operating transactions); provision or benefit for income taxes;, depreciation and amortization; stock-based compensation expense and related payroll taxes; remeasurement of redeemable convertible preferred stock warrant liability and other items. Additionally, we provide Adjusted EBITDA Margin, a non-GAAP financial measure that represents Adjusted EBITDA divided by revenue. Below is a reconciliation of Adjusted EBITDA to net loss, the most directly comparable GAAP financial measure.\nWe have included Adjusted EBITDA and Adjusted EBITDA Margin in this report because they are key measures used by our management and board of directors to understand and evaluate our operating performance and trends and how we are allocating internal resources, to prepare and approve our annual budget and to develop short- and long-term operating plans. We also believe that the exclusion of certain items in calculating Adjusted EBITDA can provide a useful measure for period-to-period comparisons of our business as it removes the impact of non-cash items and certain variable charges.\nAdjusted EBITDA has limitations as an analytical measure, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are:\n| • | although depreciation and amortization are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future, and Adjusted EBITDA does not reflect cash capital expenditure requirements for such replacements or for new capital expenditure requirements; |\n\n| • | Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs; |\n\n| • | Adjusted EBITDA does not consider the impact of stock-based compensation and related payroll taxes; |\n\n| • | Adjusted EBITDA does not reflect tax payments that may represent a reduction in cash available to us; and |\n\n| • | other companies, including companies in our industry, may calculate Adjusted EBITDA differently, which reduces its usefulness as a comparative measure. |\n\nBecause of these limitations, you should consider Adjusted EBITDA and Adjusted EBITDA Margin alongside other financial performance measures, including various cash flow metrics, net income (loss) and our other GAAP results.\nThe following table reflects the reconciliation of net loss to Adjusted EBITDA and net loss as a percentage of revenue to Adjusted EBITDA margin for each of the periods indicated:\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Revenue | $ | 772 | $ | 440 |\n| Net loss | (128 | ) | (66 | ) |\n| Net loss as a percentage of revenue | (17 | )% | (15 | )% |\n| Excluding: |\n| Interest and other expense (income), net | — | (3 | ) |\n| Provision for income taxes | 2 | — |\n| Depreciation and amortization | 2 | 2 |\n| Stock-based compensation expense | 37 | — |\n| Employer payroll taxes related to stock-based compensation expense | 7 | — |\n| Remeasurement of redeemable convertible preferred stock warrant liability | — | 15 |\n| Recurring other items | 1 | 1 |\n| Adjusted EBITDA | $ | (79 | ) | $ | (51 | ) |\n| Adjusted EBITDA margin | (10 | )% | (12 | )% |\n\n20\nFree Cash Flow\nWe also provide Free Cash Flow, a non-GAAP financial measure that represents net cash provided by (used in) operating activities less purchases of property and equipment. We believe that Free Cash Flow is an important measure since we use third parties to host our services and therefore we do not incur significant capital expenditures to support revenue generating activities.\nFree Cash Flow has limitations as an analytical measure, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are:\n| • | it is not a substitute for net cash provided by (used in) operating activities; |\n\n| • | other companies may calculate Free Cash Flow or similarly titled non-GAAP measures differently or may use other measures to evaluate their performance, all of which could reduce the usefulness of free cash flow as a tool for comparison; and |\n\n| • | the utility of free cash flow is further limited as it does not reflect our future contractual commitments and does not represent the total increase or decrease in our cash balance for any given period. |\n\nBecause of these limitations, you should consider Free Cash Flow alongside other financial performance measures, such as net cash provided by (used in) operating activities, net income (loss) and our other GAAP results.\nThe following table reflects the reconciliation of net cash provided by (used in) operating activities to Free Cash Flow for each of the periods indicated:\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Cash used in operating activities | $ | (354 | ) | $ | (129 | ) |\n| Less: |\n| Purchases of property and equipment | — | — |\n| Free Cash Flow | $ | (354 | ) | $ | (129 | ) |\n\nResults of Operations\nThe following table shows our results of operations for the periods presented and express the relationship of certain line items as a percentage of revenue for those periods. The period-to-period comparison of financial results is not necessarily indicative of future results.\n\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Revenue | $ | 772 | $ | 440 |\n| Cost of revenue(1) | 335 | 156 |\n| Gross profit | 437 | 284 |\n| Operating expenses: |\n| Sales and marketing(1) | 470 | 295 |\n| Product development(1) | 51 | 25 |\n| General and administrative(1) | 42 | 18 |\n| Total operating expenses | 563 | 338 |\n| Loss from operations | (126 | ) | (54 | ) |\n| Other income (expense), net |\n| Interest and other income, net | — | 3 |\n| Remeasurement of convertible preferred stock warrant liability | — | (15 | ) |\n| Loss before provision for income taxes | (126 | ) | (66 | ) |\n| Provision for income taxes | 2 | — |\n| Net loss | $ | (128 | ) | $ | (66 | ) |\n\n21\n\n| (1) | Includes stock-based compensation expense as follows: |\n\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Cost of revenue | $ | 5 | $ | — |\n| Sales and marketing | 3 | — |\n| Product development | 15 | — |\n| General and administrative | 14 | — |\n| Total stock-based compensation | $ | 37 | $ | — |\n\nThe following table presents the components of our condensed consolidated statements of operations as a percentage of revenue:\n\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| Revenue | 100 | % | 100 | % |\n| Cost of revenue | 43 | % | 35 | % |\n| Gross profit | 57 | % | 65 | % |\n| Operating expenses: |\n| Sales and marketing | 61 | % | 67 | % |\n| Product development | 7 | % | 6 | % |\n| General and administrative | 6 | % | 4 | % |\n| Total operating expenses | 74 | % | 77 | % |\n| Loss from operations | (17 | )% | (12 | )% |\n| Other income (expense), net: |\n| Interest and other income (expense), net | — | 1 | % |\n| Remeasurement of convertible preferred stock warrant liability | — | (3 | )% |\n| Loss before provision for income taxes | (17 | )% | (15 | )% |\n| Provision for income taxes | — | — |\n| Net loss | (17 | )% | (15 | )% |\n\nComparison of Three Months Ended March 31, 2021 and March 31, 2020\nRevenue\n\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | $ | % |\n| (in millions) |\n| Core marketplace revenue(1) | $ | 477 | $ | 340 | $ | 137 | 40 | % |\n| ProductBoost revenue | 50 | 44 | 6 | 14 | % |\n| Marketplace revenue | 527 | 384 | 143 | 37 | % |\n| Logistics revenue | 245 | 56 | 189 | 338 | % |\n| Revenue | $ | 772 | $ | 440 | $ | 332 | 75 | % |\n\n\n| (1) | Core marketplace revenue for the three months ended March 31, 2021 included approximately $9 million net gains from our cash flow hedging program. We did not have a hedging program during the three months ended March 31, 2020. |\n\nRevenue increased $332 million, or 75%, to $772 million for the three months ended March 31, 2021 as compared to $440 million for the three months ended March 31, 2020. This increase was attributable to both increased marketplace and logistics revenue.\n22\nMarketplace revenue increased $143 million, or 37% to $527 million for the three months ended March 31, 2021, as compared to $384 million for the three months ended March 31, 2020. This increase was primarily due to our efforts to improve buyer monetization and lower refunds. This increase was also partially driven by increased merchant utilization of our ProductBoost service.\nLogistics revenue increased $189 million, or 338% to $245 million for the three months ended March 31, 2021, as compared to $56 million for the three months ended March 31, 2020. This increase was primarily due to accelerated merchant adoption of our logistics offerings, as well as the expansion of our A+ program, in which Wish manages first mile collection from merchants to warehousing operations all the way to last mile delivery to the buyer.\nCost of Revenue and Gross Margin\n\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | $ | % |\n| (in millions) |\n| Cost of revenue | $ | 335 | $ | 156 | $ | 179 | 115 | % |\n| Percentage of revenue | 43 | % | 35 | % |\n| Gross Margin | 57 | % | 65 | % |\n\nCost of revenue increased $179 million, or 115%, to $335 million for the three months ended March 31, 2021, as compared to $156 million for the three months ended March 31, 2020, primarily due to costs related to the increased volume of logistics services provided and increased headcount. The increase was also driven by a $6 million stock-based compensation expense and related employer payroll taxes that we recognized in connection with the settlement of vested RSUs for our employees involved in infrastructure, merchant support, and logistics functions.\nThe gross margin decreased to 57% for the three months ended March 31, 2021 from 65% for the three months ended March 31, 2020, primarily due to increased volume of logistics services provided and the fact that logistics gross margin was at significantly lower rate than marketplace gross margin.\nSales and Marketing\n\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | $ | % |\n| (in millions) |\n| Sales and marketing | $ | 470 | $ | 295 | $ | 175 | 59 | % |\n| Percentage of revenue | 61 | % | 67 | % |\n\nSales and marketing expense increased $175 million, or 59%, to $470 million for the three months ended March 31, 2021, compared to $295 million for the three months ended March 31, 2020. The increase in sales and marketing expenses consisted primarily of incremental digital advertising spend associated with increased pricing from our largest vendors. To a lesser extent, the increase was also driven by a $4 million stock-based compensation expense and related employer payroll taxes that we recognized in connection with the settlement of vested RSUs, for our employees involved in marketing, user support, and business development functions. We anticipate that sales and marketing expenses will continue to be our most significant operating expense in the future and our overall profitability will depend on the success of our investments in sales and marketing.\nProduct Development\n\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | $ | % |\n| (in millions) |\n| Product development | $ | 51 | $ | 25 | $ | 26 | 104 | % |\n| Percentage of revenue | 7 | % | 6 | % |\n\nProduct development expense increased $26 million, or 104%, to $51 million for the three months ended March 31, 2021, as compared to $25 million for the three months ended March 31, 2020, primarily as a result of an increase in\n23\nemployee-related costs driven by increased headcount and an $18 million stock-based compensation expense and related employer payroll taxes that we recognized in connection with the settlement of vested RSUs, for our employees involved in product development activities. The increase was also, to a lesser extent, driven by expenses associated with data warehousing, processing and analytics.\nGeneral and Administrative\n\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | $ | % |\n| (in millions) |\n| General and administrative | $ | 42 | $ | 18 | $ | 24 | 133 | % |\n| Percentage of revenue | 6 | % | 4 | % |\n\nGeneral and administrative expense increased $24 million, or 133%, to $42 million for the three months ended March 31, 2021, as compared to $18 million for the three months ended March 31, 2020. The increase was primarily related to a $16 million stock-based compensation expense and related employer payroll taxes that we recognized in connection with the settlement of vested RSUs and increases in expenses associated with being a publicly listed company.\nRemeasurement of Redeemable Convertible Preferred Stock Warrant Liability\n\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | $ | % |\n| (in millions) |\n| Remeasurement of redeemable convertible preferred stock warrant liability | $ | — | $ | (15 | ) | $ | 15 | (100 | )% |\n| Percentage of revenue | — | (3 | )% |\n\nThe $15 million expense that we recognized during the three months ended March 31, 2020 was related to the change in fair value of the redeemable convertible preferred stock warrant liability. There was no remeasurement charge recognized during the three months ended March 31, 2021 because immediately prior to the completion of our IPO in December 2020, the outstanding redeemable convertible preferred stock warrant was net exercised. The fair value of the warrant at the time of exercise was reclassified into the Company’s Class A common stock and additional paid-in capital.\nProvision for Income Taxes\n\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | $ | % |\n| (in millions) |\n| Provision for income taxes | $ | 2 | $ | — | $ | 2 | — |\n| Percentage of revenue | — | — |\n\nProvision for income taxes increased $2 million for the three months ended March 31, 2021 compared to the three months ended March 31, 2020. The change in provision for income taxes was due primarily to an increase of taxes for our international operations.\nLiquidity and Capital Resources\nAs of March 31, 2021, we had cash, cash equivalents and marketable securities of $1.8 billion, a majority of which were held in cash deposits and money market funds, and were held for working capital purposes. We believe that our existing cash, cash equivalents and marketable securities will be sufficient to meet our anticipated cash needs for at least the next 12 months. Additional future financing may be necessary to fund our operations and there can be no assurance that, if needed, we will be able to secure additional debt or equity financing on terms acceptable to us or at all, especially in light of the market volatility and uncertainty as a result of the COVID-19 pandemic. Although we believe we have adequate sources of liquidity over the long term, the success of our operations, the global economic outlook, and the pace of\n24\nsustainable growth in our markets, in each case, in light of the market volatility and uncertainty as a result of the COVID-19 pandemic, among other factors, could impact our business and liquidity.\nNovember 2020 Credit Facility\nIn November 2020, we entered into the Revolving Credit Facility which enables us to borrow up to $280 million. The Revolving Credit Facility contains an accordion option which, if exercised and provided we are able to secure additional lender commitments and satisfy certain other conditions, would allow us to increase the aggregate commitments by up to $100 million. As of March 31, 2021, we had not made any borrowings under the Revolving Credit Facility. Refer to Note 7 to our condensed consolidated financial statements in Item 1 of Part I, “Financial Information” for additional details related to the Revolving Credit Facility.\nCash Flows\n\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Cash provided by (used in): |\n| Operating activities | $ | (354 | ) | $ | (129 | ) |\n| Investing activities | 14 | 59 |\n| Financing activities | (5 | ) | 1 |\n\nNet Cash Provided by (Used in) Operating Activities\nOur cash flows from operations are largely dependent on the amount of revenue we generate. Net cash provided by operating activities in each period presented has been influenced by changes in funds receivable, prepaid expenses, and other current and noncurrent assets, accounts payable, merchants payable, accrued and refund liabilities, lease liabilities, and other current and noncurrent liabilities.\nNet cash used in our operating activities for the three months ended March 31, 2021 was $354 million. This was primarily driven by our net loss of $128 million and $266 million unfavorable net working capital changes, which was partially offset by non-cash expenses, such as stock-based compensation expense of $37 million. Unfavorable working capital movement was mainly driven by accounts payable and merchants payable. Accounts payable decreased by $143 million primarily due to shorter vendor payment terms. Due to the COVID-19 pandemic, we were able to negotiate favorable payment terms with certain key digital advertising partners (45 days and 60 days). The payment terms with these key digital advertising partners reverted back to 30 days when the favorable terms expired on December 31, 2020. Merchants payable decreased by $73 million primarily driven by lower volumes in the first quarter of 2021 compared to the fourth quarter of 2020 due to seasonality and higher percentage of shipments through our A+ program which accelerated the payment of merchants payable due to higher delivery confirmation rates. Other decreases in unfavorable working capital movement were driven by refunds and accrued liabilities.\nNet cash used in our operating activities for the three months ended March 31, 2020 was $129 million. This was primarily driven by our net loss of $66 million and a $122 million decrease in merchants payable, which was partially offset by non-cash expenses, such as the remeasurement of redeemable convertible preferred stock warrant liability of $15 million, which was further offset by a $31 million increase in accounts payable.\nNet Cash Provided by (Used in) Investing Activities\nOur primary investing activities have consisted of investing excess cash balances in marketable securities.\nNet cash provided by investing activities was $14 million for the three months ended March 31, 2021. This was primarily due to $67 million of maturities of marketable securities, partially offset by $53 million purchases of marketable securities.\nNet cash generated from investing activities was $59 million for the three months ended March 31, 2020. This was primarily due to $132 million maturities of marketable securities, partially offset by $73 million purchases of marketable securities.\n25\nNet Cash Provided by (Used in) Financing Activities\nNet cash used in our financing activities was $5 million for the three months ended March 31, 2021 primarily due to tax payments related to RSU settlement.\nNet cash provided by financing activities was $1 million for the three months ended March 31, 2020 and was related to proceeds from stock option exercises.\nOff Balance Sheet Arrangements\nFor the three months ended March 31, 2021 and 2020, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.\nContingencies\nWe are involved in claims, lawsuits, government investigations, and proceedings arising from the ordinary course of our business. We record a provision for a liability when we believe that it is both probable that a liability has been incurred, and the amount can be reasonably estimated. Significant judgment is required to determine both probability and the estimated amount. Such legal proceedings are inherently unpredictable and subject to significant uncertainties, some of which are beyond our control. Should any of these estimates and assumptions change or prove to be incorrect, it could have a material impact on our results of operations, financial position, and cash flows.\nCritical Accounting Policies\nThe preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate our estimates, including those listed below. We base our estimates on historical facts and various other assumptions that we believe to be reasonable at the time the estimates are made. Actual results could differ from those estimates.\nOur critical accounting policies are as follows:\n| • | Revenue recognition; |\n\n| • | Operating lease obligations; |\n\n| • | Stock-based compensation; and |\n\n| • | Income taxes. |\n\nOur critical accounting policies are important to the portrayal of our financial condition and results of operations, and require us to make judgments and estimates about matters that are inherently uncertain.\nThere have been no material changes to our critical accounting policies and estimates as compared to those described in our Annual Report on Form 10-K for the year ended December 31, 2020, filed with the SEC on March 25, 2021.\nRecent Accounting Pronouncements\nSee Note 1 of Part I, Item 1 of this Quarterly Report on Form 10-Q for a full description of recent accounting pronouncements.\nItem 3. Quantitative and Qualitative Disclosures About Market Risk.\nWe have operations both within the U.S. and internationally, and we are exposed to market risks in the ordinary course of our business, including the effects of interest rate changes and foreign currency fluctuations. Information relating to quantitative and qualitative disclosures about these market risks is described below.\n26\nInterest Rate Sensitivity\nCash, cash equivalents and marketable securities as of March 31, 2021 were held primarily in cash deposits and money market funds. The fair value of our cash, cash equivalents, and investments would not be significantly affected by either an increase or decrease in interest rates due mainly to the short-term nature of these instruments. A 100 basis point increase or decrease in our current interest rates would have increased or decreased our interest income by $18 million for the three months ended March 31, 2021.\nForeign Currency Risk\nWe transact business in various foreign countries and are, therefore, subject to risk of foreign currency exchange rate fluctuations. We have established a foreign currency risk management policy to provide process and procedures for managing this risk. We use natural hedging techniques first to net off existing foreign currency exposures. For the remaining exposure, we may enter into short term foreign currency derivative contracts, including forward contracts to hedge exposures associated with monetary assets and liabilities, mainly merchants payable, and cash flows denominated in non-functional currencies.\nThe credit risk of our foreign currency derivative contracts is minimized since contracts are not concentrated with any one financial institution and all contracts are only placed with large financial institutions. The gains and losses on foreign currency derivative contracts generally offset the losses and gains on the assets, liabilities and transactions hedged. The fair value of currency derivative contracts is reported in the condensed consolidated balance sheets. The majority of these foreign exchange contracts expire in less than three months and all expire within one year. Refer to Note 5 to our condensed consolidated financial statements in Item 1 of Part I, “Financial Statements” for more information related to our derivative financial instruments.\nBased on our overall currency rate exposures as of March 31, 2021, including the derivative financial instruments intended to hedge the nonfunctional currency-denominated monetary assets, liabilities and cash flows, and other factors, a 10% appreciation or depreciation of the U.S. dollar from its cross-functional rates would not be expected, in the aggregate, to have a material effect on our financial position, results of operations and cash flows in the near-term.\nInflation Risk\nWe do not believe that inflation has had a material effect on our business, financial condition, or results of operations.\nItem 4. Controls and Procedures.\nEvaluation of Disclosure Controls and Procedures\nUnder the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, as of the end of the period covered by this report. Based on management’s evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective at a reasonable assurance level.\nIn designing and evaluating our disclosure controls and procedures, management recognizes that any disclosure controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting identified in connection with the evaluation required by Rules 13a-15(d) and 15d-15(d) of the Exchange Act that occurred during the three months ended March 31, 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n27\nPART II—OTHER INFORMATION\nItem 1. Legal Proceedings.\nInformation with respect to this item may be found in Note 7, Commitments and Contingencies, in our Notes to Unaudited Condensed Consolidated Financial Statements included in Part I, Item 1, of this Quarterly Report on Form 10-Q, which information is incorporated herein by reference.\nItem 1A. Risk Factors.\nYou should carefully consider the risks and uncertainties described under the heading \"Risk Factors\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2020 (the \"2020 Form 10-K\"), together with all of the other information contained in this Quarterly Report on Form 10-Q, including our condensed consolidated financial statements and related notes, before making a decision to invest in our Class A common stock. Additional risks and uncertainties that we are unaware of, or that we currently believe are not material, may also become important factors that affect our business. These risk factors could materially and adversely affect our business, financial condition and results of operations, and the market price of our ordinary shares could decline. These risk factors do not identify all risks that we face – our operations could also be affected by factors that are not presently known to us or that we currently consider to be immaterial to our operations. Due to risks and uncertainties, known and unknown, our past financial results may not be a reliable indicator of future performance and historical trends should not be used to anticipate results or trends in future periods. There have been no additional material changes from the risks and uncertainties previously disclosed under the \"Risk Factors\" section in our 2020 Form 10-K.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\n(a) Unregistered Sales of Equity Securities\nNone\n(b) Use of Proceeds\nOur IPO of Class A common stock was effected through a Registration Statement on Form S-1 (File Nos. 333-250531), which was declared or became effective on December 15, 2020. There has been no material change in the use of proceeds from our IPO as described in our final prospectus dated December 15, 2020 filed with the Securities and Exchange Commission, or SEC, pursuant to Rule 424(b) of the Securities Act of 1933, as amended, or the Securities Act.\nItem 6. Exhibits.\n\n| Exhibit Number | Description |\n| 31.1* | Certification of Principal Executive Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2* | Certification of Principal Financial Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32.1** | Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 32.2** | Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 101.INS* | Inline XBRL Instance Document – the instance document does not appear in the Interactive Data File because XBRL tags are embedded within the Inline XBRL document. |\n| 101.SCH* | Inline XBRL Taxonomy Extension Schema Document |\n| 101.CAL* | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF* | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB* | Inline XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE* | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104* | Cover Page Interactive Data File (embedded within the Inline XBRL document) |\n\n\n| * | Filed herewith. |\n\n| ** | Furnished herewith. |\n\n28\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| ContextLogic Inc. |\n| Date: May 12, 2021 | By: | /s/ Rajat Bahri |\n| Rajat Bahri |\n| Chief Financial Offer |\n| (Principal Financial Officer) |\n\n29\n \n\nWhat is the change in percentage of net loss from the three months ended March 31, 2020 to that ended March 31, 2021?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nItem 1. Financial Statements (Unaudited)\\nCONTEXTLOGIC INC.\\nCONDENSED CONSOLIDATED BALANCE SHEETS\\n(in millions, except par value)\\n\\n| As of March 31, | As of December 31, |\\n| 2021 | 2020 |\\n| (Unaudited) |\\n| Assets |\\n| Current assets: |\\n| Cash and cash equivalents | $ | 1,620 | $ | 1,965 |\\n| Marketable securities | 154 | 164 |\\n| Funds receivable | 65 | 83 |\\n| Prepaid expenses and other current assets | 88 | 102 |\\n| Total current assets | 1,927 | 2,314 |\\n| Property and equipment, net | 23 | 25 |\\n| Right-of-use assets | 39 | 43 |\\n| Marketable securities | — | 4 |\\n| Other assets | 10 | 11 |\\n| Total assets | $ | 1,999 | $ | 2,397 |\\n| Liabilities and Stockholders’ Equity |\\n| Current liabilities: |\\n| Accounts payable | $ | 291 | $ | 434 |\\n| Merchants payable | 381 | 454 |\\n| Refunds liability | 54 | 77 |\\n| Accrued liabilities | 309 | 367 |\\n| Total current liabilities | 1,035 | 1,332 |\\n| Lease liabilities, non-current | 34 | 38 |\\n| Total liabilities | 1,069 | 1,370 |\\n| Commitments and contingencies (Note 7) |\\n| Stockholders’ equity: |\\n| Preferred stock, $ 0.0001 par value: 100 shares authorized as of March 31, 2021 and December 31, 2020; No shares issued and outstanding as of March 31, 2021 and December 31, 2020 | — | — |\\n| Common stock, $ 0.0001 par value: 3,500 ( 3,000 Class A, 500 Class B) shares authorized as of March 31, 2021 and December 31, 2020; 618 ( 501 Class A, 117 Class B) and 587 ( 478 Class A, 109 Class B) shares issued and outstanding as of March 31, 2021 and December 31, 2020 | — | — |\\n| Additional paid-in capital | 3,243 | 3,210 |\\n| Accumulated other comprehensive income (loss) | ( 1 | ) | 1 |\\n| Accumulated deficit | ( 2,312 | ) | ( 2,184 | ) |\\n| Total stockholders’ equity | 930 | 1,027 |\\n| Total liabilities and stockholders’ equity | $ | 1,999 | $ | 2,397 |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n1\\nCONTEXTLOGIC INC.\\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\\n(in millions, except per share data)\\n(Unaudited)\\n\\n| Three Months Ended |\\n| March 31, |\\n| 2021 | 2020 |\\n| Revenue | $ | 772 | $ | 440 |\\n| Cost of revenue | 335 | 156 |\\n| Gross profit | 437 | 284 |\\n| Operating expenses: |\\n| Sales and marketing | 470 | 295 |\\n| Product development | 51 | 25 |\\n| General and administrative | 42 | 18 |\\n| Total operating expenses | 563 | 338 |\\n| Loss from operations | ( 126 | ) | ( 54 | ) |\\n| Other income (expense), net: |\\n| Interest and other income, net | — | 3 |\\n| Remeasurement of redeemable convertible preferred stock warrant liability | — | ( 15 | ) |\\n| Loss before provision for income taxes | ( 126 | ) | ( 66 | ) |\\n| Provision for income taxes | 2 | — |\\n| Net loss | ( 128 | ) | ( 66 | ) |\\n| Net loss per share, basic and diluted | $ | ( 0.21 | ) | $ | ( 0.62 | ) |\\n| Weighted-average shares used in computing net loss per share, basic and diluted | 619 | 106 |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n2\\nCONTEXTLOGIC INC.\\nCONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS\\n(in millions)\\n(Unaudited)\\n\\n| Three Months Ended |\\n| March 31, |\\n| 2021 | 2020 |\\n| Net loss | $ | ( 128 | ) | $ | ( 66 | ) |\\n| Other comprehensive loss: |\\n| Net unrealized holding losses on derivatives | ( 2 | ) | — |\\n| Comprehensive loss | $ | ( 130 | ) | $ | ( 66 | ) |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n3\\nCONTEXTLOGIC INC.\\nCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\\n(in millions)\\n(Unaudited)\\n\\n| Three Months Ended March 31, 2021 |\\n| Common Stock | Additional Paid-in | Accumulated Other | Accumulated | Total Stockholders’ |\\n| Shares | Amount | Capital | Comprehensive Income | Deficit | Equity |\\n| Balances as of December 31, 2020 | 587 | $ | — | $ | 3,210 | $ | 1 | $ | ( 2,184 | ) | $ | 1,027 |\\n| Issuance of common stock upon exercise of options for cash | 2 | — | 1 | — | — | 1 |\\n| Issuance of common stock upon settlement of restricted stock units, net of tax | 29 | — | ( 5 | ) | — | — | ( 5 | ) |\\n| Stock-based compensation | — | — | 37 | — | — | 37 |\\n| Other comprehensive loss, net | — | — | — | ( 2 | ) | — | ( 2 | ) |\\n| Net loss | — | — | — | — | ( 128 | ) | ( 128 | ) |\\n| Balances as of March 31, 2021 | 618 | $ | — | $ | 3,243 | $ | ( 1 | ) | $ | ( 2,312 | ) | $ | 930 |\\n\\n\\n| Three Months Ended March 31, 2020 |\\n| Redeemable Convertible Preferred Stock | Common Stock | Additional Paid-in | Accumulated | Total Stockholders’ |\\n| Shares | Amount | Shares | Amount | Capital | Deficit | Deficit |\\n| Balances as of December 31, 2019 | 422 | $ | 1,536 | 103 | $ | — | $ | — | $ | ( 1,439 | ) | $ | ( 1,439 | ) |\\n| Issuance of common stock upon exercise of options for cash | — | — | 3 | — | 1 | — | 1 |\\n| Net loss and comprehensive loss | — | — | — | — | — | ( 66 | ) | ( 66 | ) |\\n| Balances as of March 31, 2020 | 422 | $ | 1,536 | 106 | $ | — | $ | 1 | $ | ( 1,505 | ) | $ | ( 1,504 | ) |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n4\\nCONTEXTLOGIC INC.\\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\\n(in millions)\\n(Unaudited)\\n\\n| Three Months Ended |\\n| March 31, |\\n| 2021 | 2020 |\\n| Cash flows from operating activities: |\\n| Net loss | $ | ( 128 | ) | $ | ( 66 | ) |\\n| Adjustments to reconcile net loss to net cash used in operating activities: |\\n| Depreciation and amortization | 2 | 2 |\\n| Non-cash lease expense | 4 | 2 |\\n| Stock-based compensation expense | 37 | — |\\n| Remeasurement of redeemable convertible preferred stock warrant liability | — | 15 |\\n| Other | ( 3 | ) | — |\\n| Changes in operating assets and liabilities: |\\n| Funds receivable | 18 | 8 |\\n| Prepaid expenses, other current and noncurrent assets | 16 | 7 |\\n| Accounts payable | ( 143 | ) | 31 |\\n| Merchants payable | ( 73 | ) | ( 122 | ) |\\n| Accrued and refund liabilities | ( 69 | ) | 3 |\\n| Lease liabilities | ( 4 | ) | ( 2 | ) |\\n| Other current and noncurrent liabilities | ( 11 | ) | ( 7 | ) |\\n| Net cash used in operating activities | ( 354 | ) | ( 129 | ) |\\n| Cash flows from investing activities: |\\n| Purchases of marketable securities | ( 53 | ) | ( 73 | ) |\\n| Maturities of marketable securities | 67 | 132 |\\n| Net cash provided by investing activities | 14 | 59 |\\n| Cash flows from financing activities: |\\n| Payment of taxes related to RSU settlement and other financing activities, net | ( 5 | ) | 1 |\\n| Net cash provided by (used in) financing activities | ( 5 | ) | 1 |\\n| Net decrease in cash, cash equivalents and restricted cash | ( 345 | ) | ( 69 | ) |\\n| Cash, cash equivalents and restricted cash at beginning of period | 1,965 | 754 |\\n| Cash, cash equivalents and restricted cash at end of period | $ | 1,620 | $ | 685 |\\n| Reconciliation of cash, cash equivalents, and restricted cash to the condensed consolidated balance sheets: |\\n| Cash and cash equivalents | $ | 1,620 | $ | 675 |\\n| Restricted cash included in other assets in the condensed consolidated balance sheets | — | 10 |\\n| Total cash, cash equivalents and restricted cash | $ | 1,620 | $ | 685 |\\n| Supplemental cash flow disclosures: |\\n| Cash paid for income taxes, net of refunds | $ | 2 | $ | — |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n5\\nCONTEXTLOGIC INC.\\nNotes to Unaudited Condensed Consolidated Financial Statements\\nNOTE 1. OVERVIEW, BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES\\nContextLogic Inc. (“Wish” or the “Company”) is an ecommerce company that provides a shopping experience that is mobile-first and discovery-based, which connects merchants’ products to users based on user preferences. The Company generates revenue from marketplace and logistics services provided to merchants.\\nThe Company was incorporated in the state of Delaware in June 2010 and is headquartered in San Francisco, California, with operations in Canada, China and the Netherlands.\\nInitial Public Offering\\nIn December 2020, the Company completed its initial public offering (“IPO”) of Class A common stock, in which it sold 46 million shares. The shares were sold at an IPO price of $ 24.00 per share for net proceeds of approximately $ 1.1 billion, after deducting underwriting discounts and commissions of approximately $ 52 million. Additionally, the Company incurred approximately $ 6 million of offering costs, net of reimbursements. Following the IPO, the Company has two classes of authorized common stock, Class A common stock, which entitles holders to one vote per share, and Class B common stock, which entitles holders to 20 votes per share.\\nBasis of Presentation and Consolidation\\nThe accompanying condensed consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles (“U.S. GAAP”). The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. The condensed consolidated financial statements are unaudited, but include all adjustments of a normal recurring nature necessary for a fair presentation of our quarterly results. The consolidated balance sheet as of December 31, 2020 is derived from audited financial statements, however, it does not include all of the information and footnotes required by U.S. GAAP for complete financial statements. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes in our Annual Report on Form 10-K for the year ended December 31, 2020, which was filed with the Securities and Exchange Commission (“SEC”) on March 25, 2021.\\nUse of Estimates\\nThe preparation of condensed consolidated financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the condensed consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. These estimates form the basis for judgments the Company makes about the carrying values of its assets and liabilities that are not readily available from other sources. These estimates include, but are not limited to, fair value of financial instruments, useful lives of long-lived assets, fair value of derivative instruments, incremental borrowing rate applied to lease accounting, contingent liabilities, redemption probabilities associated with Wish Cash, allowances for refunds and chargebacks and uncertain tax positions. As of March 31, 2021, the effects of the ongoing COVID-19 pandemic on the Company’s business, results of operations, and financial condition continue to evolve. As a result, many of the Company’s estimates and assumptions required increased judgment and these estimates may change materially in future periods.\\nSegments\\nThe Company manages its operations and allocates resources as a single operating segment. Further, the Company manages, monitors and reports its financials as a single reporting segment. The Company’s chief operating decision-maker is its Chief Executive Officer who makes operating decisions, assesses financial performance and allocates resources based on condensed consolidated financial information. As such, the Company has determined that it operates in one reportable segment.\\n6\\nConcentrations of Risk\\nCredit Risk — Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents, funds receivable, marketable securities and derivative financial instruments. The Company’s cash and cash equivalents are held on deposit with creditworthy institutions. Although the Company’s deposits exceed federally insured limits, the Company has not experienced any losses in such accounts. The Company invests its excess cash in money market accounts, U.S. Treasury notes, U.S. Treasury bills, commercial paper and corporate bonds. The Company is exposed to credit risk in the event of a default by the financial institutions holding its cash, cash equivalents and marketable securities for the amounts reflected on the condensed consolidated balance sheets. The Company’s investment policy limits investments to certain types of debt securities issued by the U.S. government, its agencies and institutions with investment-grade credit ratings and places restrictions on maturities and concentration by type and issuer.\\nThe Company's derivative financial instruments expose it to credit risk to the extent that the counterparties may be unable to meet the terms of the arrangement. The Company seeks to mitigate such risk by limiting its counterparties to, and by spreading the risk across, major financial institutions. In addition, the potential risk of loss with any one counterparty resulting from this type of credit risk is monitored on a monthly basis. The Company is not required to pledge, nor is it entitled to receive, collateral related to its foreign exchange derivative transactions.\\nThe Company is exposed to credit risk in the event of a default by its Payment Service Providers (“PSPs”). The Company does not generate revenue from PSPs. Significant changes in the Company’s relationship with its PSPs could adversely affect users’ ability to process transactions on the Company’s marketplaces, thereby impacting the Company’s operating results.\\nThe following PSPs each represented 10% or more of the Company’s funds receivable balance:\\n\\n| March 31, | December 31, |\\n| 2021 | 2020 |\\n| PSP 1 | 61 | % | 56 | % |\\n| PSP 2 | 27 | % | 27 | % |\\n\\nServices Risk — The Company serves all of its users using third-party data center and hosting providers. The Company has disaster recovery protocols at the third-party service providers. Even with these procedures for disaster recovery in place, access to the Company’s service could be significantly interrupted, resulting in an adverse effect on its operating results and financial position. No significant interruptions of service were known to have occurred during the three months ended March 31, 2021 and 2020.\\nSummary of Significant Accounting Policies\\nThere have been no changes to the Company’s significant accounting policies described in its Annual Report on Form 10-K for the year ended December 31, 2020, filed with the SEC on March 25, 2021, that have had a material impact on its condensed consolidated financial statements.\\nAccounting Pronouncements\\nThe Company has reviewed recent accounting pronouncements and concluded they are either not applicable to the business or no material impact is expected on the condensed consolidated financial statements as a result of future adoption.\\nNOTE 2. DISAGGREGATION OF REVENUE\\nThe Company generates revenue from marketplace and logistics services provided to merchants. Revenue is recognized as the Company transfers control of promised goods or services to its users in an amount that reflects the consideration the Company expects to be entitled to in exchange for those goods or services. The Company considers both the merchant and the user to be customers. The Company evaluates whether it is appropriate to recognize revenue on a gross or net basis based upon its evaluation of whether the Company obtains control of the specified goods or services by considering if it is primarily responsible for fulfillment of the promise, has inventory risk, has latitude in establishing pricing and selecting suppliers, among other factors. Based on these factors, marketplace revenue is generally recognized on a net basis and logistics revenue is generally recognized on a gross basis. Revenue excludes any amounts collected on behalf of third parties, including indirect taxes.\\nMarketplace revenue includes commission fees collected in connection with user purchases of the merchants’ products. The commission fees vary depending on factors such as user location, demand, product type, and dynamic\\n7\\npricing. The Company recognizes revenue when a user’s order is processed and the related order information has been made available to the merchant. Commission fees are recognized net of estimated refunds and chargebacks. Marketplace revenue also includes ProductBoost revenue for displaying a merchant’s selected products in preferential locations within the Company’s marketplace. The Company recognizes revenue when the merchants’ selected products are displayed. The Company refers to its marketplace revenue, excluding ProductBoost revenue, as its core marketplace revenue.\\nThe Company’s logistics offering for merchants is designed for direct end-to-end single order shipment from a merchant’s location to the user. Logistics services include transportation and delivery of the merchant’s products to the user. Merchants are required to prepay for logistics services on a per order basis. The Company recognizes revenue over time as the merchant simultaneously receives and consumes the logistics services benefit as the services are performed. The Company uses an output method of progress based on days in transit as it best depicts the Company’s progress toward complete satisfaction of the performance obligation.\\nThe following table shows the disaggregated revenue for the applicable periods:\\n\\n| Three Months Ended |\\n| March 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| Core marketplace revenue | $ | 477 | $ | 340 |\\n| ProductBoost revenue | 50 | 44 |\\n| Marketplace revenue | 527 | 384 |\\n| Logistics revenue | 245 | 56 |\\n| Revenue | $ | 772 | $ | 440 |\\n\\nRefer to Note 11 – Geographical Information for the disaggregated revenue by geographical location.\\nNote 3. FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENT\\nThe Company’s financial instruments consist of cash equivalents, marketable securities, funds receivable, derivative instruments, accounts payable, accrued liabilities and merchants payable. Cash equivalents’ carrying value approximates fair value at the balance sheet dates, due to the short period of time to maturity. Marketable securities and derivative instruments are recognized at fair value. Funds receivable, accounts payable, accrued liabilities and merchants payable carrying values approximate fair value due to the short time to the expected receipt or payment date.\\nAssets and liabilities recognized at fair value on a recurring basis in the condensed consolidated balance sheets consisting of cash equivalents, marketable securities and derivative instruments are categorized based upon the level of judgment associated with the inputs used to measure their fair values. Fair value is defined as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.\\n8\\nFinancial assets and liabilities subject to fair value measurements on a recurring basis and the level of inputs used in such measurements are as follows:\\n\\n| March 31, 2021 |\\n| Total | Level 1 | Level 2 | Level 3 |\\n| (in millions) |\\n| Financial assets: |\\n| Cash equivalents: |\\n| Money market funds | $ | 97 | $ | 97 | $ | — | $ | — |\\n| Marketable securities: |\\n| U.S. Treasury bills | $ | 35 | $ | — | $ | 35 | $ | — |\\n| Commercial paper | 62 | — | 62 | — |\\n| Corporate bonds | 52 | — | 52 | — |\\n| Non-US government | 5 | — | 5 | — |\\n| Total marketable securities | $ | 154 | $ | — | $ | 154 | $ | — |\\n| Total financial assets | $ | 251 | $ | 97 | $ | 154 | $ | — |\\n| Financial liabilities: |\\n| Accrued liabilities: |\\n| Derivative liabilities | $ | 2 | $ | — | $ | 2 | $ | — |\\n| Total financial liabilities | $ | 2 | $ | — | $ | 2 | $ | — |\\n\\n\\n| December 31, 2020 |\\n| Total | Level 1 | Level 2 | Level 3 |\\n| (in millions) |\\n| Financial assets: |\\n| Cash equivalents: |\\n| Money market funds | $ | 35 | $ | 35 | $ | — | $ | — |\\n| U.S. Treasury bills | 30 | — | 30 | — |\\n| Commercial paper | 9 | — | 9 | — |\\n| Total cash equivalents | $ | 74 | $ | 35 | $ | 39 | $ | — |\\n| Marketable securities: |\\n| U.S. Treasury bills | $ | 38 | $ | — | $ | 38 | $ | — |\\n| Commercial paper | 49 | — | 49 | — |\\n| Corporate bonds | 81 | — | 81 | — |\\n| Total marketable securities | $ | 168 | $ | — | $ | 168 | $ | — |\\n| Prepaid and other current assets: |\\n| Derivative assets | $ | 3 | $ | — | $ | 3 | $ | — |\\n| Total financial assets | $ | 245 | $ | 35 | $ | 210 | $ | — |\\n| Financial liabilities: |\\n| Accrued liabilities: |\\n| Derivative liabilities | $ | 4 | $ | — | $ | 4 | $ | — |\\n| Total financial liabilities | $ | 4 | $ | — | $ | 4 | $ | — |\\n\\nThe Company classifies cash equivalents and marketable securities within Level 1 or Level 2 because the Company uses quoted market prices or alternative pricing sources and models utilizing market observable inputs to determine their fair value. The derivative asset and liability related to the Company’s foreign currency derivative contracts are classified within Level 2 of the fair value hierarchy as the valuation inputs are based on quoted prices and market observable data of similar instruments in active markets, including currency spot and forward rates.\\n9\\nThe following table summarizes the contractual maturities of the Company’s marketable securities:\\n\\n| March 31, | December 31, |\\n| 2021 | 2020 |\\n| Amortized Cost | Estimated Fair Value | Amortized Cost | Estimated Fair Value |\\n| (in millions) |\\n| Due within one year | $ | 154 | $ | 154 | $ | 164 | $ | 164 |\\n| Due after one year through five years | — | — | 4 | 4 |\\n| Total marketable securities | $ | 154 | $ | 154 | $ | 168 | $ | 168 |\\n\\nAll of the Company’s available-for-sale marketable securities are subject to a periodic evaluation for a credit loss allowance and impairment review. The Company did not identify any of its available-for-sale marketable securities requiring an allowance for credit loss or as other-than-temporarily impaired in any of the periods presented. Additionally, the unrealized net gain and net loss on available-for-sale marketable securities as of March 31, 2021 and December 31, 2020 were immaterial.\\nNOTE 4. BALANCE SHEET COMPONENTS\\nAccrued Liabilities\\nAccrued liabilities consist of the following:\\n\\n| March 31, | December 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| Vendor services | $ | 90 | $ | 121 |\\n| Deferred revenue | 26 | 37 |\\n| Wish Cash liability | 48 | 48 |\\n| Other | 145 | 161 |\\n| Total accrued liabilities | $ | 309 | $ | 367 |\\n\\nNOTE 5. DERIVATIVE FINANCIAL INSTRUMENTS\\nThe Company conducts business in certain foreign currencies throughout its worldwide operations, and various entities hold monetary assets or liabilities, earn revenues, or incur costs in currencies other than the entity’s functional currency. As a result, the Company is exposed to foreign exchange gains or losses which impact the Company’s operating results. The Company bills its users based on their local currencies, primarily in U.S. dollars and Euros, and the Company makes payments to the merchants in China for products sold on the Wish platform in Renminbi, which creates exposure to currency rate fluctuations. The Company hedges these cash flow exposures to reduce the risk that its earnings and cash flows will be adversely affected by changes in exchange rates. As part of the Company’s foreign currency risk mitigation strategy, the Company enters into derivative contracts and foreign exchange forward contracts with up to twelve months in duration to hedge exposures for variability in U.S.-dollar equivalent of non-U.S.-dollar denominated cash flows associated with its forecasted revenue related transactions.\\nThe Company’s derivatives transactions are not collateralized and do not include collateralization agreements with counterparties. The Company does not use derivative financial instruments for speculative or trading purposes.\\n10\\nVolume of Derivative Activity\\nTotal gross notional amounts for outstanding derivatives (recognized at fair value) as of the end of period consist of the following:\\n\\n| March 31, 2021 | December 31, 2020 |\\n| (in millions) |\\n| Cash flow hedges | $ | 250 | $ | 600 |\\n| Non-designated hedges | 219 | 422 |\\n| Total | $ | 469 | $ | 1,022 |\\n\\nFair Value of Derivative Financial Instruments\\n\\n| March 31, 2021 | December 31, 2020 |\\n| Assets(1) | Liabilities(2) | Assets(1) | Liabilities(2) |\\n| (in millions) |\\n| Derivative designated as hedging instruments |\\n| Cash flow hedges | $ | — | $ | 2 | $ | 3 | $ | 2 |\\n| Derivative not designated as hedging instruments |\\n| Foreign currency forward contracts | $ | — | $ | — | $ | — | $ | 2 |\\n| Total derivatives | $ | — | $ | 2 | $ | 3 | $ | 4 |\\n\\n(1) Derivative assets are included in prepaid and other current assets in the condensed consolidated balance sheets.\\n(2) Derivative liabilities are included in accrued liabilities in the condensed consolidated balance sheets.\\nDerivatives in Cash Flow Hedging Relationships\\nThe changes in accumulated other comprehensive income resulting from cash flow hedging were as follows:\\n\\n| As of March 31, 2021 | As of December 31, 2020 |\\n| (in millions) |\\n| Balance beginning of the period | $ | 2 | $ | — |\\n| Other comprehensive income before reclassifications | 7 | 9 |\\n| Amounts recognized in core marketplace revenue and reclassified out of accumulated other comprehensive income | ( 9 | ) | ( 7 | ) |\\n| Balance at the end of the period | $ | — | $ | 2 |\\n\\nThe Company recognizes changes in fair value of the cash flow hedges of foreign currency denominated merchants payable in accumulated other comprehensive loss in its consolidated balance sheets until the forecasted transaction occurs. When the forecasted transaction affects earnings, the Company reclassifies the related gain or loss on the cash flow hedge to core marketplace revenue. All amounts in other comprehensive income at period end are expected to be reclassified to earnings within 12 months. In the event the underlying forecasted transaction does not occur, or it becomes probable that it will not occur, the Company reclassifies the gain or loss on the related cash flow hedge from accumulated other comprehensive loss to core marketplace revenue. For the three months ended March 31, 2021, there were no net gains or losses recognized in core marketplace revenue relating to hedges of forecasted transactions that did not occur. The Company did not have a hedging program during the three months ended March 31, 2020.\\nThe Company classifies cash flows related to its cash flow hedges as operating activities in its condensed consolidated statements of cash flows.\\nDerivatives Not Designated as Hedging Instruments\\nThe net gains on the change in fair value of the Company’s foreign exchange forward contracts not designated as hedging instruments were approximately $ 4 million for the three months ended March 31, 2021 and were recognized in other income (expense), net in the condensed consolidated statement of operations. The Company did not have a hedging program during the three months ended March 31, 2020.\\n11\\nThe Company classifies cash flows related to its non-designated hedging instruments as operating activities in its condensed consolidated statements of cash flows.\\nNOTE 6. OPERATING LEASES\\nThe Company leases its facilities and data center co-locations under operating leases with various expiration dates through 2025 .\\nTotal operating lease cost was $ 4 million and $ 3 million for the three months ended March 31, 2021 and 2020, respectively. Short-term lease costs and variable lease costs and sublease income were not material.\\nAs of March 31, 2021 and December 31, 2020, the Company’s condensed consolidated balance sheets included right-of-use assets in the amount of $ 39 million and $ 43 million, respectively, and lease liabilities in the amount of $ 14 million and $ 14 million in accrued liabilities, respectively, and $ 34 million and $ 38 million in lease liabilities, non-current, respectively.\\nAs of March 31, 2021 and December 31, 2020, the weighted-average remaining lease term was 3.7 years and 3.9 years, respectively, and the weighted-average discount rate used to determine the net present value of the lease liabilities was 6 %.\\nSupplemental cash flow information for the Company’s operating leases were as follows:\\n\\n| March 31, | March 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| Cash paid for amounts included in the measurement of lease liabilities: |\\n| Operating cash flows from operating leases | $ | 4 | $ | 3 |\\n\\nThe maturities of the Company’s operating lease liabilities are as follows:\\n\\n| March 31, |\\n| 2021 |\\n| Year ending December 31, | (in millions) |\\n| 2021 (remaining nine months) | $ | 12 |\\n| 2022 | 15 |\\n| 2023 | 11 |\\n| 2024 | 10 |\\n| 2025 | 5 |\\n| Total lease payments | 53 |\\n| Less: imputed interest | ( 5 | ) |\\n| Present value of lease liabilities | $ | 48 |\\n\\nNOTE 7. COMMITMENTS AND CONTINGENCIES\\nRevolving Credit Facility\\nIn November 2020, the Company entered into a five-year $ 280 million senior secured revolving credit facility (the “Revolving Credit Facility”) to, among other things, permit the Company to increase its aggregate commitments by up to $ 100 million, if an accordion option is exercised and provided the Company is able to secure additional lender commitments and satisfy certain other conditions, and to enter into letters of credit from time to time, which reduces its borrowing capacity under the Revolving Credit Facility. Interest on any borrowings under the Revolving Credit Facility accrues at either adjusted LIBOR plus 1.50 % or at an alternative base rate plus 0.50 %, at the Company’s election, and the Company is required to pay a commitment fee that accrues at 0.25 % per annum on the unused portion of the aggregate commitments under the Revolving Credit Facility. The Company is required to pay a fee that accrues at 1.50 % per annum on the average daily amount available to be drawn under any letters of credit outstanding under the Revolving Credit Facility.\\n12\\nThe Revolving Credit Facility contains customary conditions to borrowing, events of default and covenants, including covenants that restrict the Company’s ability (and the ability of certain of the Company’s subsidiaries) to incur indebtedness, grant liens, make certain fundamental changes and asset sales, make distributions to stockholders, make investments or engage in transactions with affiliates. It also contains a minimum liquidity financial covenant of $ 350 million, which includes unrestricted cash and any available borrowing capacity under the Revolving Credit Facility. The obligations under the Revolving Credit Facility are secured by liens on substantially all of the Company’s domestic assets and are guaranteed by any material domestic subsidiaries, subject to customary exceptions. A standby letter of credit in the amount of approximately $ 10 million has been issued under the Revolving Credit Facility in conjunction with the lease of the Company’s headquarters in San Francisco, California. As of March 31, 2021, the Company had no t made any borrowings under the Revolving Credit Facility and it was in compliance with the related covenants.\\nPurchase Obligations\\nDuring 2019, the Company amended a marketing arrangement which increased the total commitment under the agreement and extended the arrangement to July 31, 2021. As of March 31, 2021, the remaining commitment under the amended agreement was $ 5 million, which is payable in 2021 .\\nEffective September 1, 2019, the Company entered into an amendment to a colocation and cloud services arrangement committing the Company to make payments of $ 120 million for services over 3 years. As of March 31, 2021, the remaining commitment under this amended agreement was approximately $ 35 million and is payable within the next two years .\\nLegal Contingencies\\nAs of March 31, 2021 and December 31, 2020, there were no legal contingency matters that arose in the ordinary course of business, either individually or in aggregate, that would have a material adverse effect on the financial position, results of operations, or cash flows of the Company. Given the unpredictable nature of legal proceedings, the Company bases its estimate on the information available at the time of the assessment. As additional information becomes available, the Company reassesses the potential liability and may revise the estimate.\\nNOTE 8. EQUITY Award activity and STOCK-based compensation\\nEquity Award Activity\\nA summary of activity under the equity plans and related information is as follows:\\n\\n| Options Outstanding | RSUs Outstanding |\\n| Number of Options | Weighted- Average Exercise Price | Weighted- Average Remaining Contractual Term (In Years) | Number of RSUs |\\n| (in millions) | (in millions) |\\n| Balances at December 31, 2020 | 75 | $ | 0.234 | 3.2 | 30 |\\n| Granted | — | $ | — | 1 |\\n| Vested(1) | — | $ | — | ( 3 | ) |\\n| Exercised | ( 2 | ) | $ | 0.154 | — |\\n| Balances at March 31, 2021(2) | 73 | $ | 0.236 | 3.0 | 28 |\\n\\n\\n| (1) | For the three months ended March 31, 2021, approximately 3 million RSUs vested upon satisfying both the service and liquidity vesting conditions. The shares remained unreleased as of March 31, 2021 due to the lock-up provisions related to the Company’s IPO. |\\n\\n| (2) | Outstanding RSUs as of March 31, 2021 include 10 million units of CEO Performance Award. |\\n\\nThe weighted-average grant date fair value of restricted stock units (“RSUs”) granted during the three months ended March 31, 2021 was $ 22.01 per share.\\n13\\nStock-Based Compensation Expense\\nTotal stock-based compensation expense included in the condensed consolidated statements of operations is as follows:\\n\\n| Three Months Ended |\\n| March 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| Cost of revenue | $ | 5 | $ | — |\\n| Sales and marketing | 3 | — |\\n| Product development | 15 | — |\\n| General and administrative | 14 | — |\\n| Total stock-based compensation | $ | 37 | $ | — |\\n\\nThe Company will recognize the remaining $ 134 million and $ 72 million of unrecognized stock-based compensation expense over a weighted-average period of approximately 1.32 years and 3.84 years related to RSUs and CEO Performance Award, respectively.\\nEmployee Stock Purchase Plan\\nThe Company’s Employee Stock Purchase Plan (“ESPP”) allows eligible employees to purchase shares of the Company’s Class A common stock at a discount through payroll deductions of up to 15 % of eligible compensation, subject to caps of $ 25,000 in any calendar year and 2,500 shares on any purchase date. The ESPP provides for 24 -month offering periods, generally beginning in November and May of each year, and each offering period consists of four six-month purchase periods. The initial offering period began on January 1, 2021 and will end in November 2022. The first purchase under the ESPP will be in May 2021 .\\nOn each purchase date, participating employees will purchase Class A common stock at a price per share equal to 85 % of the lesser of the fair market value of the Company’s Class A common stock on (i) the first trading day of the applicable offering period and (2) the last trading day of each purchase period in the applicable offering period. If the stock price of the Company's Class A common stock on any purchase date in an offering period is lower than the stock price on the enrollment date of that offering period, the offering period will immediately reset after the purchase of shares on such purchase date and automatically roll into a new offering period.\\nThe Company uses the Black-Scholes option pricing model to determine the fair value of shares to be purchased under the 2020 Employee Stock Purchase Plan (“ESPP”) with the following assumptions on the date of grant:\\n\\n| Three Months Ended |\\n| March 31, 2021 |\\n| Expected term (in years) | 0.38 to 1.88 |\\n| Risk free interest rate | 0.09% to 0.13% |\\n| Volatility | 46.45% to 62.28% |\\n| Dividend yield | — |\\n| Estimated fair value per ESPP share | $4.14 to $8.05 |\\n\\nNOTE 9. INCOME TAXES\\nThe Company’s tax provision for the interim periods is determined using an estimate of the annual effective tax rate, adjusted for discrete items, if any, that arise during the period. Each quarter, the Company assesses its estimate of the annual effective tax rate, and if the estimated annual effective tax rate changes, the Company makes a cumulative adjustment in the period of change.\\nThe Company’s quarterly tax provision and the estimate of the annual effective tax rate is subject to fluctuation due to several factors, including variability in pre-tax earnings, the geographic distribution of the pre-tax earnings, tax law\\n14\\nchanges, non-deductible expenses, such as stock-based compensation, and changes in the estimate of the valuation allowance.\\nThe provision for income taxes was $ 2 million for the three months ended March 31, 2021 and was insignificant for the three months ended March 31, 2020. The year-over-year increase in provision for income taxes was primarily related to international operations. The Company continues to maintain a valuation allowance on its domestic net deferred tax assets which is excluded from the annual effective tax rate estimate.\\nThe Company had immaterial unrecognized tax benefits as of March 31, 2021 and December 31, 2020, fully offset by a valuation allowance. These unrecognized tax benefits, if recognized, would no t affect the effective tax rate. No interest or penalties were incurred during the years ended March 31, 2021 and 2020.\\nThe Company files income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions. The Company is not currently under examination by income tax authorities in federal, state or other jurisdictions. All tax returns will remain open for examination by the federal and state authorities for three and four years , respectively, from the date of utilization of any net operating loss or credits. Certain tax years are subject to foreign income tax examinations by tax authorities until the statute of limitations expire.\\n15\\nNOTE 10. Net loss per share\\nBasic net income (loss) per share is computed using the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is computed by giving effect to potentially dilutive common stock equivalents outstanding during the period, as their effect would be dilutive. Potentially dilutive common shares include participating securities and shares issuable upon the exercise of stock options, the exercise of common stock warrants, the vesting of RSUs and each purchase under the 2020 ESPP, under the treasury stock method.\\nIn loss periods, basic net loss per share and diluted net loss per share are the same, as the effect of potential common shares is anti-dilutive and therefore excluded.\\nThe rights, including the liquidation and dividend rights, of the holders of Class A and Class B common stock are identical, except with respect to voting. As the liquidation and dividend rights are identical, the Company’s undistributed earnings or losses are allocated on a proportionate basis among the holders of both Class A and Class B common stock. As a result, the net income (loss) per share attributed to common stockholders will, therefore, be the same for both Class A and Class B common stock on an individual or combined basis.\\nThe following table sets forth the computation of basic and diluted net loss per share:\\n\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| (in millions, except per share data) |\\n| Numerator: |\\n| Net loss | $ | ( 128 | ) | $ | ( 66 | ) |\\n| Denominator: |\\n| Weighted-average shares used in computing net loss per share, basic and diluted | 619 | 106 |\\n| Net loss per share, basic and diluted | $ | ( 0.21 | ) | $ | ( 0.62 | ) |\\n\\nThe following outstanding shares of potentially dilutive securities were excluded from the computation of diluted net loss per share because including them would have had an anti-dilutive effect:\\n\\n| As of March 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| Redeemable convertible preferred stock, all series | — | 422 |\\n| Series B warrant | — | 10 |\\n| Warrant to purchase common stock | 1 | 1 |\\n| Common stock options outstanding | 73 | 77 |\\n| Unvested RSUs outstanding(1) | 28 | 44 |\\n| Employee Stock Purchase Plan | 1 | — |\\n| Total | 103 | 554 |\\n\\n\\n| (1) | Unvested RSUs outstanding as of March 31, 2021 included 10 million units of CEO Performance Award. |\\n\\n16\\nNOTE 11. GEOGRAPHICAL INFORMATION\\nThe Company believes it is relevant to disclose geographical revenue information on both a demand basis, determined by the ship-to address of the user, and on a supply basis, determined by the location of the merchants’ operations.\\nCore marketplace revenue by geographic area based on the ship-to address of the user is as follows:\\n\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| Europe | $ | 235 | 49 | % | $ | 159 | 47 | % |\\n| North America(1) | 186 | 39 | % | 126 | 37 | % |\\n| South America | 18 | 4 | % | 23 | 7 | % |\\n| Other | 38 | 8 | % | 32 | 9 | % |\\n| Core marketplace revenue | $ | 477 | 100 | % | $ | 340 | 100 | % |\\n\\n\\n| (1) | United States accounted for $ 156 million and $ 103 million of core marketplace revenue for the three months ended March 31, 2021 and 2020, respectively. |\\n\\nChina accounted for substantially all of marketplace and logistics revenue during the three months ended March 31, 2021 and 2020 based on the location of the merchants’ operations.\\nThe Company’s long-lived tangible assets, which consist of property and equipment, net and operating lease right-of-use assets, net, located in the United States were 87 % of the total long-lived tangible assets as of March 31, 2021 and December 31, 2020. The long-lived tangible assets outside the United States were located in China, Canada and the Netherlands.\\n17\\n\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\\nThe following discussion and analysis of our financial condition, results of operations and cash flows should be read in conjunction with (1) the unaudited condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q and (2) the audited condensed consolidated financial statements and notes thereto and management’s discussion and analysis of financial condition and results of operations for the year ended December 31, 2020 included in our Annual Report on Form 10-K filed on March 25, 2021. This discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under the heading \\\"Risk Factors\\\" in Part I, Item 1A of our Annual Report on Form 10-K for our year ended December 31, 2020. See also \\\"Special Note Regarding Forward-Looking Statements\\\" above.\\nFinancial Results for the Three Months Ended March 31, 2021\\n| • | Total revenue was $772 million, an increase of 75% year-over-year. |\\n\\n| • | Total cost of revenue and expenses were $898 million, including stock-based compensation expense of $37 million and $7 million of employer payroll taxes related to stock-based compensation. |\\n\\n| • | Loss from operations was $126 million. |\\n\\n| • | Net loss was $128 million. |\\n\\n| • | Adjusted EBITDA was a loss of $79 million or 10% of total revenue. |\\n\\n| • | Cash and cash equivalents and marketable securities were $1.8 billion. |\\n\\nAs of March 31, 2021, we had an accumulated deficit of $2.3 billion. We expect losses from operations to continue for the foreseeable future as we incur costs and expenses related to brand development, expansion of market share, continued development of our mobile shopping marketplace infrastructure and development of other businesses.\\nCOVID-19\\nThe outbreak of coronavirus disease 2019 (“COVID-19”) has affected businesses worldwide, as of the date of filing of this Quarterly Report, and continues to impact the major markets in which we operate. The COVID-19 pandemic has resulted in significant governmental measures being implemented to control the spread of the virus, and our operations as well as the operations of our third-party merchants and users have been and will continue to be disrupted by varying individual and governmental responses to COVID-19 around the world, such as business shutdowns, stay-at-home directives, travel restrictions, border closures, and other travel or health-related restrictions as well as by absenteeism, quarantines, self-isolations, office and factory closures, delays on deliveries, and disruptions to ports and other freight infrastructure. These restrictions may cause consumers and businesses to reduce their activities and their spending, have caused a slowdown in the global economy and have had, and may continue to have, a negative impact on our operations. If these conditions continue, sales volumes may decrease and we may, among other issues, experience or continue to experience delays in product development, a decreased ability to support our merchants, disruptions in sales, delivery and logistics, each of which could have a negative impact on our ability to meet shipment commitments and on our revenue and profitability.\\nOur Financial Model\\nOur business benefits from powerful network effects, fueled by our data advantage and massive scale. As more users join Wish, attracted by our affordable value proposition and shopping experience, we are able to increase revenue potential for our merchants. As more merchants succeed on Wish, more merchants join the platform and grow their businesses with Wish, broadening our product selection, which in turn improves user experience. By developing a strategy focused on users and merchants, we align user and merchant success with the success of our financial model. The growth in users and merchants generates more data, further strengthens our data advantage and creates an even better experience for everyone on our platform, in turn attracting more users and high-quality merchants.\\nOur model relies on cost-effectively adding new users, converting those users into buyers and improving engagement and monetization of those buyers on Wish over time as well as adding new merchants, delivering economic success for those merchants, and having those merchants use more of our end-to-end platform.\\n18\\nKey Financial and Performance Metrics\\nIn addition to the measures presented in our condensed consolidated financial statements, we monitor the following key metrics and other financial information to measure our performance, identify trends affecting our business, and make strategic decisions.\\n\\n| Three Months Ended |\\n| March 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| MAU | 101 | 109 |\\n| LTM Active Buyers | 61 | 63 |\\n| Adjusted EBITDA | $ | (79 | ) | $ | (51 | ) |\\n| Adjusted EBITDA Margin | (10 | )% | (12 | )% |\\n| Free Cash Flow | $ | (354 | ) | $ | (129 | ) |\\n\\nMonthly Active Users\\nWe define MAUs as the number of unique users that visited the Wish platform, either on our mobile app, mobile web, or on a desktop, during the month. MAUs for a given reporting period equal the average of the MAUs for that period. An active user is identified by a unique email-address; a single person can have multiple user accounts via multiple email addresses. The change in MAUs in a reported period captures both the inflow of new users as well as the outflow of existing users who did not visit the platform in a given month. We view the number of MAUs as key driver of revenue growth as well as a key indicator of user engagement and awareness of our brand.\\nMAUs decreased approximately 7% from the three months ended March 31, 2020 to the three months ended March 31, 2021, primarily driven by the decision to de-emphasize user acquisition in some emerging markets outside of Europe and North America where we faced logistical challenges due to the pandemic and to emphasize higher LTV users within the same value-conscious consumer category in many of the more developed markets.\\nLTM Active Buyers\\nAs of the last date of each reported period, we determine our number of unique active buyers by counting the total number of individual users who have placed at least one order on the Wish platform, either on our mobile app, mobile web, or on a desktop, during the preceding 12 months. We, however, exclude from the computation those buyers whose order is cancelled before the item is shipped and the purchase price is refunded. The number of Active Buyers is an indicator of our ability to attract and monetize a large user base to our platform and of our ability to convert visits into purchases. We believe that increasing our Active Buyers will be a significant driver to our future revenue growth.\\nLTM Active Buyers decreased approximately 3% from the three months ended March 31, 2020 to the three months ended March 31, 2021, primarily due to our actions to de-emphasize low value items, which tend to have high conversion rates but unfavorable economics.\\nA Note About Metrics\\nThe numbers for some of our metrics, including MAUs, are calculated and tracked with internal tools, which are not independently verified by any third party. We use these metrics to assess the growth and health of our overall business. While these numbers are based on what we believe to be reasonable estimates of our user or merchant base for the applicable period of measurement, there are inherent challenges in measurement as the methodologies used require significant judgment and may be susceptible to algorithm or other technical errors. In addition, we regularly review and adjust our processes for calculating metrics to improve their accuracy, and our estimates may change due to improvements or changes in technology or our methodology.\\n19\\nNon-GAAP Financial Measures\\nAdjusted EBITDA and Adjusted EBITDA Margin\\nWe provide Adjusted EBITDA, a non-GAAP financial measure that represents our net income (loss) adjusted to exclude; interest and other income (expense), net (which includes foreign exchange gain or loss, foreign exchange forward contracts gain or loss and gain or loss on one-time non-operating transactions); provision or benefit for income taxes;, depreciation and amortization; stock-based compensation expense and related payroll taxes; remeasurement of redeemable convertible preferred stock warrant liability and other items. Additionally, we provide Adjusted EBITDA Margin, a non-GAAP financial measure that represents Adjusted EBITDA divided by revenue. Below is a reconciliation of Adjusted EBITDA to net loss, the most directly comparable GAAP financial measure.\\nWe have included Adjusted EBITDA and Adjusted EBITDA Margin in this report because they are key measures used by our management and board of directors to understand and evaluate our operating performance and trends and how we are allocating internal resources, to prepare and approve our annual budget and to develop short- and long-term operating plans. We also believe that the exclusion of certain items in calculating Adjusted EBITDA can provide a useful measure for period-to-period comparisons of our business as it removes the impact of non-cash items and certain variable charges.\\nAdjusted EBITDA has limitations as an analytical measure, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are:\\n| • | although depreciation and amortization are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future, and Adjusted EBITDA does not reflect cash capital expenditure requirements for such replacements or for new capital expenditure requirements; |\\n\\n| • | Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs; |\\n\\n| • | Adjusted EBITDA does not consider the impact of stock-based compensation and related payroll taxes; |\\n\\n| • | Adjusted EBITDA does not reflect tax payments that may represent a reduction in cash available to us; and |\\n\\n| • | other companies, including companies in our industry, may calculate Adjusted EBITDA differently, which reduces its usefulness as a comparative measure. |\\n\\nBecause of these limitations, you should consider Adjusted EBITDA and Adjusted EBITDA Margin alongside other financial performance measures, including various cash flow metrics, net income (loss) and our other GAAP results.\\nThe following table reflects the reconciliation of net loss to Adjusted EBITDA and net loss as a percentage of revenue to Adjusted EBITDA margin for each of the periods indicated:\\n\\n| Three Months Ended |\\n| March 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| Revenue | $ | 772 | $ | 440 |\\n| Net loss | (128 | ) | (66 | ) |\\n| Net loss as a percentage of revenue | (17 | )% | (15 | )% |\\n| Excluding: |\\n| Interest and other expense (income), net | — | (3 | ) |\\n| Provision for income taxes | 2 | — |\\n| Depreciation and amortization | 2 | 2 |\\n| Stock-based compensation expense | 37 | — |\\n| Employer payroll taxes related to stock-based compensation expense | 7 | — |\\n| Remeasurement of redeemable convertible preferred stock warrant liability | — | 15 |\\n| Recurring other items | 1 | 1 |\\n| Adjusted EBITDA | $ | (79 | ) | $ | (51 | ) |\\n| Adjusted EBITDA margin | (10 | )% | (12 | )% |\\n\\n20\\nFree Cash Flow\\nWe also provide Free Cash Flow, a non-GAAP financial measure that represents net cash provided by (used in) operating activities less purchases of property and equipment. We believe that Free Cash Flow is an important measure since we use third parties to host our services and therefore we do not incur significant capital expenditures to support revenue generating activities.\\nFree Cash Flow has limitations as an analytical measure, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are:\\n| • | it is not a substitute for net cash provided by (used in) operating activities; |\\n\\n| • | other companies may calculate Free Cash Flow or similarly titled non-GAAP measures differently or may use other measures to evaluate their performance, all of which could reduce the usefulness of free cash flow as a tool for comparison; and |\\n\\n| • | the utility of free cash flow is further limited as it does not reflect our future contractual commitments and does not represent the total increase or decrease in our cash balance for any given period. |\\n\\nBecause of these limitations, you should consider Free Cash Flow alongside other financial performance measures, such as net cash provided by (used in) operating activities, net income (loss) and our other GAAP results.\\nThe following table reflects the reconciliation of net cash provided by (used in) operating activities to Free Cash Flow for each of the periods indicated:\\n\\n| Three Months Ended |\\n| March 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| Cash used in operating activities | $ | (354 | ) | $ | (129 | ) |\\n| Less: |\\n| Purchases of property and equipment | — | — |\\n| Free Cash Flow | $ | (354 | ) | $ | (129 | ) |\\n\\nResults of Operations\\nThe following table shows our results of operations for the periods presented and express the relationship of certain line items as a percentage of revenue for those periods. The period-to-period comparison of financial results is not necessarily indicative of future results.\\n\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| Revenue | $ | 772 | $ | 440 |\\n| Cost of revenue(1) | 335 | 156 |\\n| Gross profit | 437 | 284 |\\n| Operating expenses: |\\n| Sales and marketing(1) | 470 | 295 |\\n| Product development(1) | 51 | 25 |\\n| General and administrative(1) | 42 | 18 |\\n| Total operating expenses | 563 | 338 |\\n| Loss from operations | (126 | ) | (54 | ) |\\n| Other income (expense), net |\\n| Interest and other income, net | — | 3 |\\n| Remeasurement of convertible preferred stock warrant liability | — | (15 | ) |\\n| Loss before provision for income taxes | (126 | ) | (66 | ) |\\n| Provision for income taxes | 2 | — |\\n| Net loss | $ | (128 | ) | $ | (66 | ) |\\n\\n21\\n\\n| (1) | Includes stock-based compensation expense as follows: |\\n\\n\\n| Three Months Ended |\\n| March 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| Cost of revenue | $ | 5 | $ | — |\\n| Sales and marketing | 3 | — |\\n| Product development | 15 | — |\\n| General and administrative | 14 | — |\\n| Total stock-based compensation | $ | 37 | $ | — |\\n\\nThe following table presents the components of our condensed consolidated statements of operations as a percentage of revenue:\\n\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| Revenue | 100 | % | 100 | % |\\n| Cost of revenue | 43 | % | 35 | % |\\n| Gross profit | 57 | % | 65 | % |\\n| Operating expenses: |\\n| Sales and marketing | 61 | % | 67 | % |\\n| Product development | 7 | % | 6 | % |\\n| General and administrative | 6 | % | 4 | % |\\n| Total operating expenses | 74 | % | 77 | % |\\n| Loss from operations | (17 | )% | (12 | )% |\\n| Other income (expense), net: |\\n| Interest and other income (expense), net | — | 1 | % |\\n| Remeasurement of convertible preferred stock warrant liability | — | (3 | )% |\\n| Loss before provision for income taxes | (17 | )% | (15 | )% |\\n| Provision for income taxes | — | — |\\n| Net loss | (17 | )% | (15 | )% |\\n\\nComparison of Three Months Ended March 31, 2021 and March 31, 2020\\nRevenue\\n\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | $ | % |\\n| (in millions) |\\n| Core marketplace revenue(1) | $ | 477 | $ | 340 | $ | 137 | 40 | % |\\n| ProductBoost revenue | 50 | 44 | 6 | 14 | % |\\n| Marketplace revenue | 527 | 384 | 143 | 37 | % |\\n| Logistics revenue | 245 | 56 | 189 | 338 | % |\\n| Revenue | $ | 772 | $ | 440 | $ | 332 | 75 | % |\\n\\n\\n| (1) | Core marketplace revenue for the three months ended March 31, 2021 included approximately $9 million net gains from our cash flow hedging program. We did not have a hedging program during the three months ended March 31, 2020. |\\n\\nRevenue increased $332 million, or 75%, to $772 million for the three months ended March 31, 2021 as compared to $440 million for the three months ended March 31, 2020. This increase was attributable to both increased marketplace and logistics revenue.\\n22\\nMarketplace revenue increased $143 million, or 37% to $527 million for the three months ended March 31, 2021, as compared to $384 million for the three months ended March 31, 2020. This increase was primarily due to our efforts to improve buyer monetization and lower refunds. This increase was also partially driven by increased merchant utilization of our ProductBoost service.\\nLogistics revenue increased $189 million, or 338% to $245 million for the three months ended March 31, 2021, as compared to $56 million for the three months ended March 31, 2020. This increase was primarily due to accelerated merchant adoption of our logistics offerings, as well as the expansion of our A+ program, in which Wish manages first mile collection from merchants to warehousing operations all the way to last mile delivery to the buyer.\\nCost of Revenue and Gross Margin\\n\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | $ | % |\\n| (in millions) |\\n| Cost of revenue | $ | 335 | $ | 156 | $ | 179 | 115 | % |\\n| Percentage of revenue | 43 | % | 35 | % |\\n| Gross Margin | 57 | % | 65 | % |\\n\\nCost of revenue increased $179 million, or 115%, to $335 million for the three months ended March 31, 2021, as compared to $156 million for the three months ended March 31, 2020, primarily due to costs related to the increased volume of logistics services provided and increased headcount. The increase was also driven by a $6 million stock-based compensation expense and related employer payroll taxes that we recognized in connection with the settlement of vested RSUs for our employees involved in infrastructure, merchant support, and logistics functions.\\nThe gross margin decreased to 57% for the three months ended March 31, 2021 from 65% for the three months ended March 31, 2020, primarily due to increased volume of logistics services provided and the fact that logistics gross margin was at significantly lower rate than marketplace gross margin.\\nSales and Marketing\\n\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | $ | % |\\n| (in millions) |\\n| Sales and marketing | $ | 470 | $ | 295 | $ | 175 | 59 | % |\\n| Percentage of revenue | 61 | % | 67 | % |\\n\\nSales and marketing expense increased $175 million, or 59%, to $470 million for the three months ended March 31, 2021, compared to $295 million for the three months ended March 31, 2020. The increase in sales and marketing expenses consisted primarily of incremental digital advertising spend associated with increased pricing from our largest vendors. To a lesser extent, the increase was also driven by a $4 million stock-based compensation expense and related employer payroll taxes that we recognized in connection with the settlement of vested RSUs, for our employees involved in marketing, user support, and business development functions. We anticipate that sales and marketing expenses will continue to be our most significant operating expense in the future and our overall profitability will depend on the success of our investments in sales and marketing.\\nProduct Development\\n\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | $ | % |\\n| (in millions) |\\n| Product development | $ | 51 | $ | 25 | $ | 26 | 104 | % |\\n| Percentage of revenue | 7 | % | 6 | % |\\n\\nProduct development expense increased $26 million, or 104%, to $51 million for the three months ended March 31, 2021, as compared to $25 million for the three months ended March 31, 2020, primarily as a result of an increase in\\n23\\nemployee-related costs driven by increased headcount and an $18 million stock-based compensation expense and related employer payroll taxes that we recognized in connection with the settlement of vested RSUs, for our employees involved in product development activities. The increase was also, to a lesser extent, driven by expenses associated with data warehousing, processing and analytics.\\nGeneral and Administrative\\n\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | $ | % |\\n| (in millions) |\\n| General and administrative | $ | 42 | $ | 18 | $ | 24 | 133 | % |\\n| Percentage of revenue | 6 | % | 4 | % |\\n\\nGeneral and administrative expense increased $24 million, or 133%, to $42 million for the three months ended March 31, 2021, as compared to $18 million for the three months ended March 31, 2020. The increase was primarily related to a $16 million stock-based compensation expense and related employer payroll taxes that we recognized in connection with the settlement of vested RSUs and increases in expenses associated with being a publicly listed company.\\nRemeasurement of Redeemable Convertible Preferred Stock Warrant Liability\\n\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | $ | % |\\n| (in millions) |\\n| Remeasurement of redeemable convertible preferred stock warrant liability | $ | — | $ | (15 | ) | $ | 15 | (100 | )% |\\n| Percentage of revenue | — | (3 | )% |\\n\\nThe $15 million expense that we recognized during the three months ended March 31, 2020 was related to the change in fair value of the redeemable convertible preferred stock warrant liability. There was no remeasurement charge recognized during the three months ended March 31, 2021 because immediately prior to the completion of our IPO in December 2020, the outstanding redeemable convertible preferred stock warrant was net exercised. The fair value of the warrant at the time of exercise was reclassified into the Company’s Class A common stock and additional paid-in capital.\\nProvision for Income Taxes\\n\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | $ | % |\\n| (in millions) |\\n| Provision for income taxes | $ | 2 | $ | — | $ | 2 | — |\\n| Percentage of revenue | — | — |\\n\\nProvision for income taxes increased $2 million for the three months ended March 31, 2021 compared to the three months ended March 31, 2020. The change in provision for income taxes was due primarily to an increase of taxes for our international operations.\\nLiquidity and Capital Resources\\nAs of March 31, 2021, we had cash, cash equivalents and marketable securities of $1.8 billion, a majority of which were held in cash deposits and money market funds, and were held for working capital purposes. We believe that our existing cash, cash equivalents and marketable securities will be sufficient to meet our anticipated cash needs for at least the next 12 months. Additional future financing may be necessary to fund our operations and there can be no assurance that, if needed, we will be able to secure additional debt or equity financing on terms acceptable to us or at all, especially in light of the market volatility and uncertainty as a result of the COVID-19 pandemic. Although we believe we have adequate sources of liquidity over the long term, the success of our operations, the global economic outlook, and the pace of\\n24\\nsustainable growth in our markets, in each case, in light of the market volatility and uncertainty as a result of the COVID-19 pandemic, among other factors, could impact our business and liquidity.\\nNovember 2020 Credit Facility\\nIn November 2020, we entered into the Revolving Credit Facility which enables us to borrow up to $280 million. The Revolving Credit Facility contains an accordion option which, if exercised and provided we are able to secure additional lender commitments and satisfy certain other conditions, would allow us to increase the aggregate commitments by up to $100 million. As of March 31, 2021, we had not made any borrowings under the Revolving Credit Facility. Refer to Note 7 to our condensed consolidated financial statements in Item 1 of Part I, “Financial Information” for additional details related to the Revolving Credit Facility.\\nCash Flows\\n\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| Cash provided by (used in): |\\n| Operating activities | $ | (354 | ) | $ | (129 | ) |\\n| Investing activities | 14 | 59 |\\n| Financing activities | (5 | ) | 1 |\\n\\nNet Cash Provided by (Used in) Operating Activities\\nOur cash flows from operations are largely dependent on the amount of revenue we generate. Net cash provided by operating activities in each period presented has been influenced by changes in funds receivable, prepaid expenses, and other current and noncurrent assets, accounts payable, merchants payable, accrued and refund liabilities, lease liabilities, and other current and noncurrent liabilities.\\nNet cash used in our operating activities for the three months ended March 31, 2021 was $354 million. This was primarily driven by our net loss of $128 million and $266 million unfavorable net working capital changes, which was partially offset by non-cash expenses, such as stock-based compensation expense of $37 million. Unfavorable working capital movement was mainly driven by accounts payable and merchants payable. Accounts payable decreased by $143 million primarily due to shorter vendor payment terms. Due to the COVID-19 pandemic, we were able to negotiate favorable payment terms with certain key digital advertising partners (45 days and 60 days). The payment terms with these key digital advertising partners reverted back to 30 days when the favorable terms expired on December 31, 2020. Merchants payable decreased by $73 million primarily driven by lower volumes in the first quarter of 2021 compared to the fourth quarter of 2020 due to seasonality and higher percentage of shipments through our A+ program which accelerated the payment of merchants payable due to higher delivery confirmation rates. Other decreases in unfavorable working capital movement were driven by refunds and accrued liabilities.\\nNet cash used in our operating activities for the three months ended March 31, 2020 was $129 million. This was primarily driven by our net loss of $66 million and a $122 million decrease in merchants payable, which was partially offset by non-cash expenses, such as the remeasurement of redeemable convertible preferred stock warrant liability of $15 million, which was further offset by a $31 million increase in accounts payable.\\nNet Cash Provided by (Used in) Investing Activities\\nOur primary investing activities have consisted of investing excess cash balances in marketable securities.\\nNet cash provided by investing activities was $14 million for the three months ended March 31, 2021. This was primarily due to $67 million of maturities of marketable securities, partially offset by $53 million purchases of marketable securities.\\nNet cash generated from investing activities was $59 million for the three months ended March 31, 2020. This was primarily due to $132 million maturities of marketable securities, partially offset by $73 million purchases of marketable securities.\\n25\\nNet Cash Provided by (Used in) Financing Activities\\nNet cash used in our financing activities was $5 million for the three months ended March 31, 2021 primarily due to tax payments related to RSU settlement.\\nNet cash provided by financing activities was $1 million for the three months ended March 31, 2020 and was related to proceeds from stock option exercises.\\nOff Balance Sheet Arrangements\\nFor the three months ended March 31, 2021 and 2020, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.\\nContingencies\\nWe are involved in claims, lawsuits, government investigations, and proceedings arising from the ordinary course of our business. We record a provision for a liability when we believe that it is both probable that a liability has been incurred, and the amount can be reasonably estimated. Significant judgment is required to determine both probability and the estimated amount. Such legal proceedings are inherently unpredictable and subject to significant uncertainties, some of which are beyond our control. Should any of these estimates and assumptions change or prove to be incorrect, it could have a material impact on our results of operations, financial position, and cash flows.\\nCritical Accounting Policies\\nThe preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate our estimates, including those listed below. We base our estimates on historical facts and various other assumptions that we believe to be reasonable at the time the estimates are made. Actual results could differ from those estimates.\\nOur critical accounting policies are as follows:\\n| • | Revenue recognition; |\\n\\n| • | Operating lease obligations; |\\n\\n| • | Stock-based compensation; and |\\n\\n| • | Income taxes. |\\n\\nOur critical accounting policies are important to the portrayal of our financial condition and results of operations, and require us to make judgments and estimates about matters that are inherently uncertain.\\nThere have been no material changes to our critical accounting policies and estimates as compared to those described in our Annual Report on Form 10-K for the year ended December 31, 2020, filed with the SEC on March 25, 2021.\\nRecent Accounting Pronouncements\\nSee Note 1 of Part I, Item 1 of this Quarterly Report on Form 10-Q for a full description of recent accounting pronouncements.\\nItem 3. Quantitative and Qualitative Disclosures About Market Risk.\\nWe have operations both within the U.S. and internationally, and we are exposed to market risks in the ordinary course of our business, including the effects of interest rate changes and foreign currency fluctuations. Information relating to quantitative and qualitative disclosures about these market risks is described below.\\n26\\nInterest Rate Sensitivity\\nCash, cash equivalents and marketable securities as of March 31, 2021 were held primarily in cash deposits and money market funds. The fair value of our cash, cash equivalents, and investments would not be significantly affected by either an increase or decrease in interest rates due mainly to the short-term nature of these instruments. A 100 basis point increase or decrease in our current interest rates would have increased or decreased our interest income by $18 million for the three months ended March 31, 2021.\\nForeign Currency Risk\\nWe transact business in various foreign countries and are, therefore, subject to risk of foreign currency exchange rate fluctuations. We have established a foreign currency risk management policy to provide process and procedures for managing this risk. We use natural hedging techniques first to net off existing foreign currency exposures. For the remaining exposure, we may enter into short term foreign currency derivative contracts, including forward contracts to hedge exposures associated with monetary assets and liabilities, mainly merchants payable, and cash flows denominated in non-functional currencies.\\nThe credit risk of our foreign currency derivative contracts is minimized since contracts are not concentrated with any one financial institution and all contracts are only placed with large financial institutions. The gains and losses on foreign currency derivative contracts generally offset the losses and gains on the assets, liabilities and transactions hedged. The fair value of currency derivative contracts is reported in the condensed consolidated balance sheets. The majority of these foreign exchange contracts expire in less than three months and all expire within one year. Refer to Note 5 to our condensed consolidated financial statements in Item 1 of Part I, “Financial Statements” for more information related to our derivative financial instruments.\\nBased on our overall currency rate exposures as of March 31, 2021, including the derivative financial instruments intended to hedge the nonfunctional currency-denominated monetary assets, liabilities and cash flows, and other factors, a 10% appreciation or depreciation of the U.S. dollar from its cross-functional rates would not be expected, in the aggregate, to have a material effect on our financial position, results of operations and cash flows in the near-term.\\nInflation Risk\\nWe do not believe that inflation has had a material effect on our business, financial condition, or results of operations.\\nItem 4. Controls and Procedures.\\nEvaluation of Disclosure Controls and Procedures\\nUnder the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, as of the end of the period covered by this report. Based on management’s evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective at a reasonable assurance level.\\nIn designing and evaluating our disclosure controls and procedures, management recognizes that any disclosure controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.\\nChanges in Internal Control over Financial Reporting\\nThere were no changes in our internal control over financial reporting identified in connection with the evaluation required by Rules 13a-15(d) and 15d-15(d) of the Exchange Act that occurred during the three months ended March 31, 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\n27\\nPART II—OTHER INFORMATION\\nItem 1. Legal Proceedings.\\nInformation with respect to this item may be found in Note 7, Commitments and Contingencies, in our Notes to Unaudited Condensed Consolidated Financial Statements included in Part I, Item 1, of this Quarterly Report on Form 10-Q, which information is incorporated herein by reference.\\nItem 1A. Risk Factors.\\nYou should carefully consider the risks and uncertainties described under the heading \\\"Risk Factors\\\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2020 (the \\\"2020 Form 10-K\\\"), together with all of the other information contained in this Quarterly Report on Form 10-Q, including our condensed consolidated financial statements and related notes, before making a decision to invest in our Class A common stock. Additional risks and uncertainties that we are unaware of, or that we currently believe are not material, may also become important factors that affect our business. These risk factors could materially and adversely affect our business, financial condition and results of operations, and the market price of our ordinary shares could decline. These risk factors do not identify all risks that we face – our operations could also be affected by factors that are not presently known to us or that we currently consider to be immaterial to our operations. Due to risks and uncertainties, known and unknown, our past financial results may not be a reliable indicator of future performance and historical trends should not be used to anticipate results or trends in future periods. There have been no additional material changes from the risks and uncertainties previously disclosed under the \\\"Risk Factors\\\" section in our 2020 Form 10-K.\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\\n(a) Unregistered Sales of Equity Securities\\nNone\\n(b) Use of Proceeds\\nOur IPO of Class A common stock was effected through a Registration Statement on Form S-1 (File Nos. 333-250531), which was declared or became effective on December 15, 2020. There has been no material change in the use of proceeds from our IPO as described in our final prospectus dated December 15, 2020 filed with the Securities and Exchange Commission, or SEC, pursuant to Rule 424(b) of the Securities Act of 1933, as amended, or the Securities Act.\\nItem 6. Exhibits.\\n\\n| Exhibit Number | Description |\\n| 31.1* | Certification of Principal Executive Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| 31.2* | Certification of Principal Financial Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| 32.1** | Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\\n| 32.2** | Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\\n| 101.INS* | Inline XBRL Instance Document – the instance document does not appear in the Interactive Data File because XBRL tags are embedded within the Inline XBRL document. |\\n| 101.SCH* | Inline XBRL Taxonomy Extension Schema Document |\\n| 101.CAL* | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\\n| 101.DEF* | Inline XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101.LAB* | Inline XBRL Taxonomy Extension Label Linkbase Document |\\n| 101.PRE* | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\\n| 104* | Cover Page Interactive Data File (embedded within the Inline XBRL document) |\\n\\n\\n| * | Filed herewith. |\\n\\n| ** | Furnished herewith. |\\n\\n28\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n\\n| ContextLogic Inc. |\\n| Date: May 12, 2021 | By: | /s/ Rajat Bahri |\\n| Rajat Bahri |\\n| Chief Financial Offer |\\n| (Principal Financial Officer) |\\n\\n29\\n \\n\\nWhat is the change in percentage of net loss from the three months ended March 31, 2020 to that ended March 31, 2021?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is -93.93939393939394.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 32,\n \"input_length\": 19489\n}"}}},{"rowIdx":33,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nItem 1 - Condensed Consolidated Financial Statements (unaudited)\nAlbertsons Companies, Inc. and Subsidiaries\nCondensed Consolidated Balance Sheets\n(in millions, except share data)\n(unaudited)\n| September 11,2021 | February 27,2021 |\n| ASSETS |\n| Current assets |\n| Cash and cash equivalents | $ | 2,849.8 | $ | 1,717.0 |\n| Receivables, net | 544.7 | 550.9 |\n| Inventories, net | 4,179.1 | 4,301.3 |\n| Other current assets | 414.7 | 418.8 |\n| Total current assets | 7,988.3 | 6,988.0 |\n| Property and equipment, net | 9,201.1 | 9,412.7 |\n| Operating lease right-of-use assets | 5,861.3 | 6,015.6 |\n| Intangible assets, net | 2,181.3 | 2,108.8 |\n| Goodwill | 1,200.2 | 1,183.3 |\n| Other assets | 912.1 | 889.6 |\n| TOTAL ASSETS | $ | 27,344.3 | $ | 26,598.0 |\n| LIABILITIES |\n| Current liabilities |\n| Accounts payable | $ | 3,554.2 | $ | 3,487.3 |\n| Accrued salaries and wages | 1,492.3 | 1,474.7 |\n| Current maturities of long-term debt and finance lease obligations | 211.5 | 212.4 |\n| Current maturities of operating lease obligations | 621.7 | 605.3 |\n| Other current liabilities | 1,190.0 | 1,052.5 |\n| Total current liabilities | 7,069.7 | 6,832.2 |\n| Long-term debt and finance lease obligations | 8,129.1 | 8,101.2 |\n| Long-term operating lease obligations | 5,464.1 | 5,548.0 |\n| Deferred income taxes | 598.3 | 533.7 |\n| Other long-term liabilities | 2,524.1 | 2,659.5 |\n| Commitments and contingencies |\n| Series A convertible preferred stock, $ 0.01 par value; 1,750,000 shares authorized, 924,000 shares issued and outstanding as of September 11, 2021 and February 27, 2021 | 844.3 | 844.3 |\n| Series A-1 convertible preferred stock, $ 0.01 par value; 1,410,000 shares authorized, 826,000 shares issued and outstanding as of September 11, 2021 and February 27, 2021 | 754.8 | 754.8 |\n| STOCKHOLDERS' EQUITY |\n| Undesignated preferred stock, $ 0.01 par value; 96,840,000 shares authorized, no shares issued as of September 11, 2021 and February 27, 2021 | — | — |\n| Class A common stock, $ 0.01 par value; 1,000,000,000 shares authorized, 586,668,103 and 585,574,666 shares issued as of September 11, 2021 and February 27, 2021, respectively | 5.9 | 5.9 |\n| Class A-1 convertible common stock, $ 0.01 par value; 150,000,000 shares authorized, no shares issued as of September 11, 2021 and February 27, 2021 | — | — |\n| Additional paid-in capital | 1,936.1 | 1,898.9 |\n| Treasury stock, at cost, 120,009,647 shares held as of September 11, 2021 and February 27, 2021 | ( 1,907.0 ) | ( 1,907.0 ) |\n| Accumulated other comprehensive income | 78.7 | 63.5 |\n| Retained earnings | 1,846.2 | 1,263.0 |\n| Total stockholders' equity | 1,959.9 | 1,324.3 |\n| TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY | $ | 27,344.3 | $ | 26,598.0 |\n\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\n3\nAlbertsons Companies, Inc. and SubsidiariesCondensed Consolidated Statements of Operations and Comprehensive Income (in millions, except per share data)(unaudited)\n| 12 weeks ended | 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Net sales and other revenue | $ | 16,505.7 | $ | 15,757.6 | $ | 37,775.1 | $ | 38,509.2 |\n| Cost of sales | 11,788.7 | 11,182.7 | 26,867.1 | 27,162.8 |\n| Gross profit | 4,717.0 | 4,574.9 | 10,908.0 | 11,346.4 |\n| Selling and administrative expenses | 4,231.3 | 4,031.2 | 9,734.9 | 9,800.6 |\n| (Gain) loss on property dispositions and impairment losses, net | ( 0.2 ) | ( 18.3 ) | 0.1 | 12.0 |\n| Operating income | 485.9 | 562.0 | 1,173.0 | 1,533.8 |\n| Interest expense, net | 109.3 | 128.6 | 262.6 | 309.2 |\n| Loss on debt extinguishment | — | 49.1 | — | 49.1 |\n| Other income, net | ( 18.9 ) | ( 11.4 ) | ( 62.4 ) | ( 8.3 ) |\n| Income before income taxes | 395.5 | 395.7 | 972.8 | 1,183.8 |\n| Income tax expense | 100.3 | 111.2 | 232.8 | 313.1 |\n| Net income | $ | 295.2 | $ | 284.5 | $ | 740.0 | $ | 870.7 |\n| Other comprehensive income, net of tax |\n| Recognition of pension gain | 15.1 | 10.1 | 15.2 | 10.9 |\n| Other | — | 0.3 | — | 1.2 |\n| Other comprehensive income | $ | 15.1 | $ | 10.4 | $ | 15.2 | $ | 12.1 |\n| Comprehensive income | $ | 310.3 | $ | 294.9 | $ | 755.2 | $ | 882.8 |\n| Net income per Class A common share |\n| Basic net income per Class A common share | $ | 0.55 | $ | 0.52 | $ | 1.27 | $ | 1.57 |\n| Diluted net income per Class A common share | 0.52 | 0.49 | 1.26 | 1.49 |\n| Weighted average Class A common shares outstanding |\n| Basic | 465.3 | 477.3 | 465.2 | 529.2 |\n| Diluted | 573.0 | 582.9 | 470.6 | 583.3 |\n\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\n4\nAlbertsons Companies, Inc. and SubsidiariesCondensed Consolidated Statements of Cash Flows(in millions)(unaudited)\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 |\n| Cash flows from operating activities: |\n| Net income | $ | 740.0 | $ | 870.7 |\n| Adjustments to reconcile net income to net cash provided by operating activities: |\n| Loss on property dispositions and impairment losses, net | 0.1 | 12.0 |\n| Depreciation and amortization | 883.2 | 808.8 |\n| Operating lease right-of-use assets amortization | 333.0 | 309.3 |\n| LIFO expense | 29.1 | 23.2 |\n| Deferred income tax | 43.0 | 2.8 |\n| Contributions to pension and post-retirement benefit plans, net of (income) expense | ( 47.5 ) | ( 68.9 ) |\n| (Gain) loss on interest rate swaps and commodity hedges, net | ( 7.5 ) | 25.9 |\n| Amortization and write-off of deferred financing costs | 11.1 | 11.2 |\n| Loss on debt extinguishment | — | 49.1 |\n| Equity-based compensation expense | 49.0 | 28.3 |\n| Other | ( 21.2 ) | ( 28.7 ) |\n| Changes in operating assets and liabilities: |\n| Receivables, net | ( 6.4 ) | ( 21.7 ) |\n| Inventories, net | 93.0 | 62.2 |\n| Accounts payable, accrued salaries and wages and other accrued liabilities | 229.2 | 585.4 |\n| Operating lease liabilities | ( 249.3 ) | ( 228.4 ) |\n| Self-insurance assets and liabilities | 36.3 | 24.2 |\n| Other operating assets and liabilities | 22.6 | 255.4 |\n| Net cash provided by operating activities | 2,137.7 | 2,720.8 |\n| Cash flows from investing activities: |\n| Business acquisitions, net of cash acquired | ( 23.5 ) | — |\n| Payments for property, equipment and intangibles, including payments for lease buyouts | ( 822.5 ) | ( 702.9 ) |\n| Proceeds from sale of long-lived assets | 24.6 | 20.6 |\n| Other investing activities | 30.9 | ( 4.8 ) |\n| Net cash used in investing activities | ( 790.5 ) | ( 687.1 ) |\n| Cash flows from financing activities: |\n| Proceeds from issuance of long-term debt | — | 3,500.0 |\n| Payments on long-term borrowings | ( 0.5 ) | ( 3,388.5 ) |\n| Payments of obligations under finance leases | ( 32.2 ) | ( 32.9 ) |\n| Payment of redemption premium on debt extinguishment | — | ( 41.4 ) |\n| Payments for debt financing costs | — | ( 15.6 ) |\n| Dividends paid on common stock | ( 93.0 ) | — |\n| Dividends paid on convertible preferred stock | ( 59.1 ) | — |\n| Proceeds from convertible preferred stock | — | 1,680.0 |\n| Third party issuance costs on convertible preferred stock | — | ( 80.9 ) |\n| Treasury stock purchase, at cost | — | ( 1,680.0 ) |\n| Employee tax withholding on vesting of restricted stock units | ( 11.8 ) | ( 6.7 ) |\n| Other financing activities | ( 17.8 ) | ( 14.7 ) |\n| Net cash used in financing activities | ( 214.4 ) | ( 80.7 ) |\n| Net increase in cash and cash equivalents and restricted cash | 1,132.8 | 1,953.0 |\n| Cash and cash equivalents and restricted cash at beginning of period | 1,767.6 | 478.9 |\n| Cash and cash equivalents and restricted cash at end of period | $ | 2,900.4 | $ | 2,431.9 |\n\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\n5\nAlbertsons Companies, Inc. and SubsidiariesCondensed Consolidated Statements of Stockholders' Equity(in millions, except share data)(unaudited)\n| Class A Common Stock | Additional paid in capital | Treasury Stock | Accumulated other comprehensive income | Retained earnings | Total stockholders' equity |\n| Shares | Amount | Shares | Amount |\n| Balance as of February 27, 2021 | 585,574,666 | $ | 5.9 | $ | 1,898.9 | 120,009,647 | $ | ( 1,907.0 ) | $ | 63.5 | $ | 1,263.0 | $ | 1,324.3 |\n| Equity-based compensation | — | — | 22.2 | — | — | — | — | 22.2 |\n| Shares issued and employee tax withholding on vesting of restricted stock units | 945,942 | — | ( 10.0 ) | — | — | — | — | ( 10.0 ) |\n| Cash dividends declared on common stock | — | — | — | — | — | — | ( 46.5 ) | ( 46.5 ) |\n| Dividends accrued on convertible preferred stock | — | — | — | — | — | — | ( 36.4 ) | ( 36.4 ) |\n| Net income | — | — | — | — | — | — | 444.8 | 444.8 |\n| Other comprehensive income, net of tax | — | — | — | — | — | 0.1 | — | 0.1 |\n| Other activity | — | — | — | — | — | — | ( 0.1 ) | ( 0.1 ) |\n| Balance as of June 19, 2021 | 586,520,608 | $ | 5.9 | $ | 1,911.1 | 120,009,647 | $ | ( 1,907.0 ) | $ | 63.6 | $ | 1,624.8 | $ | 1,698.4 |\n| Equity-based compensation | — | — | 26.8 | — | — | — | — | 26.8 |\n| Shares issued and employee tax withholding on vesting of restricted stock units | 147,495 | — | ( 1.8 ) | — | — | — | — | ( 1.8 ) |\n| Cash dividends declared on common stock | — | — | — | — | — | — | ( 46.5 ) | ( 46.5 ) |\n| Dividends accrued on convertible preferred stock | — | — | — | — | — | — | ( 27.3 ) | ( 27.3 ) |\n| Net income | — | — | — | — | — | — | 295.2 | 295.2 |\n| Other comprehensive income, net of tax | — | — | — | — | — | 15.1 | — | 15.1 |\n| Balance as of September 11, 2021 | 586,668,103 | $ | 5.9 | $ | 1,936.1 | 120,009,647 | $ | ( 1,907.0 ) | $ | 78.7 | $ | 1,846.2 | $ | 1,959.9 |\n\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\n6\nAlbertsons Companies, Inc. and SubsidiariesCondensed Consolidated Statements of Stockholders' Equity(in millions, except share data)(unaudited)\n| Class A Common Stock | Additional paid in capital | Treasury Stock | Accumulated other comprehensive loss | Retained earnings | Total stockholders' equity |\n| Shares | Amount | Shares | Amount |\n| Balance as of February 29, 2020 | 582,997,251 | $ | 5.8 | $ | 1,824.3 | 3,671,621 | $ | ( 25.8 ) | $ | ( 118.5 ) | $ | 592.3 | $ | 2,278.1 |\n| Issuance of common stock to Company's parents | 1,312,859 | — | — | — | — | — | — | — |\n| Equity-based compensation | — | — | 19.0 | — | — | — | — | 19.0 |\n| Employee tax withholding on vesting of restricted stock units | — | — | ( 6.2 ) | — | — | — | — | ( 6.2 ) |\n| Repurchase of common stock | — | — | — | 101,611,736 | ( 1,680.0 ) | — | — | ( 1,680.0 ) |\n| Dividends accrued on convertible preferred stock | — | — | — | — | — | — | ( 3.9 ) | ( 3.9 ) |\n| Net income | — | — | — | — | — | — | 586.2 | 586.2 |\n| Other comprehensive income, net of tax | — | — | — | — | — | 1.7 | — | 1.7 |\n| Balance as of June 20, 2020 | 584,310,110 | $ | 5.8 | $ | 1,837.1 | 105,283,357 | $ | ( 1,705.8 ) | $ | ( 116.8 ) | $ | 1,174.6 | $ | 1,194.9 |\n| Equity-based compensation | — | — | 9.3 | — | — | — | — | 9.3 |\n| Shares issued and employee tax withholding on vesting of restricted stock units | 22,101 | — | ( 0.5 ) | — | — | — | — | ( 0.5 ) |\n| Equity reclassification | — | — | 30.0 | — | — | — | — | 30.0 |\n| Dividends accrued on convertible preferred stock | — | — | — | — | — | — | ( 26.9 ) | ( 26.9 ) |\n| Net income | — | — | — | — | — | — | 284.5 | 284.5 |\n| Other comprehensive loss, net of tax | — | — | — | — | — | 10.4 | — | 10.4 |\n| Other activity | — | — | ( 0.1 ) | — | — | — | — | ( 0.1 ) |\n| Balance as of September 12, 2020 | 584,332,211 | $ | 5.8 | $ | 1,875.8 | 105,283,357 | $ | ( 1,705.8 ) | $ | ( 106.4 ) | $ | 1,432.2 | $ | 1,501.6 |\n\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\n7\nAlbertsons Companies, Inc. and SubsidiariesNotes to Condensed Consolidated Financial Statements(unaudited)\nNOTE 1 - BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nBasis of Presentation\nThe accompanying interim Condensed Consolidated Financial Statements include the accounts of Albertsons Companies, Inc. and its subsidiaries (the \"Company\"). All significant intercompany balances and transactions were eliminated. The Condensed Consolidated Balance Sheet as of February 27, 2021 is derived from the Company's annual audited Consolidated Financial Statements, which should be read in conjunction with these Condensed Consolidated Financial Statements and which are included in the Company's Annual Report on Form 10-K for the fiscal year ended February 27, 2021, filed with the Securities and Exchange Commission (the \"SEC\") on April 28, 2021. Certain information in footnote disclosures normally included in annual financial statements was condensed or omitted for the interim periods presented in accordance with accounting principles generally accepted in the United States of America (\"GAAP\"). In the opinion of management, the interim data includes all adjustments, consisting of normal recurring adjustments, necessary for a fair statement of the results for the interim periods. The interim results of operations and cash flows are not necessarily indicative of those results and cash flows expected for the year. The Company' s results of operations are for the 12 and 28 weeks ended September 11, 2021 and September 12, 2020.\nSignificant Accounting Policies\nRestricted cash: Restricted cash is included in Other current assets or Other assets depending on the remaining term of the restriction and primarily relates to funds held in escrow. The Company had $ 50.6 million of restricted cash as of September 11, 2021 and February 27, 2021.\nInventories, net: Substantially all of the Company's inventories consist of finished goods valued at the lower of cost or market and net of vendor allowances. The Company uses either item-cost or the retail inventory method to value inventory before application of any last-in, first-out (\"LIFO\") reserve. Interim LIFO inventory costs are based on management's estimates of expected year-end inventory levels and inflation rates. The Company recorded LIFO expense of $ 14.6 million and $ 10.1 million for the 12 weeks ended September 11, 2021 and September 12, 2020, respectively, and $ 29.1 million and $ 23.2 million for the 28 weeks ended September 11, 2021 and September 12, 2020, respectively.\nEquity-based compensation: Equity-based compensation expense recognized in the Condensed Consolidated Statements of Operations (in millions):\n| 12 weeks ended | 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| RSUs | $ | 24.9 | $ | 8.0 | $ | 44.6 | $ | 25.8 |\n| RSAs | 1.9 | 1.3 | 4.4 | 2.5 |\n| Total equity-based compensation expense | $ | 26.8 | $ | 9.3 | $ | 49.0 | $ | 28.3 |\n| Total related tax benefit | $ | 6.4 | $ | 2.0 | $ | 11.5 | $ | 6.6 |\n\nAs of September 11, 2021, there was $ 126.2 million of unrecognized costs related to 11.5 million unvested granted restricted stock units (\"RSUs\"). That cost is expected to be recognized over a weighted average period of 1.8 years. As of September 11, 2021, there was $ 7.3 million of unrecognized costs related to 1.0 million unvested granted restricted common stock (\"RSAs\"). That cost is expected to be recognized over a weighted average period of 1.9 years.\nIncome taxes: Income tax expense was $ 100.3 million, representing a 25.4 % effective tax rate, for the 12 weeks ended September 11, 2021. Income tax expense was $ 111.2 million, representing a 28.1 % effective tax rate, for the\n8\n12 weeks ended September 12, 2020. The decrease in the effective tax rate was primarily driven by nondeductible transaction-related costs incurred during the 12 weeks ended September 12, 2020.\nIncome tax expense was $ 232.8 million, representing a 23.9 % effective tax rate, for the 28 weeks ended September 11, 2021. Income tax expense was $ 313.1 million, representing a 26.4 % effective tax rate, for the 28 weeks ended September 12, 2020. The decrease in the effective income tax rate was primarily driven by the recognition of discrete state income tax benefits during the 28 weeks ended September 11, 2021 and certain nondeductible transaction-related costs incurred during the 28 weeks ended September 12, 2020.\nSegments: The Company and its subsidiaries offer grocery products, general merchandise, health and beauty care products, pharmacy, fuel and other items and services in its stores or through digital channels. The Company's operating divisions are geographically based, have similar economic characteristics and similar expected long-term financial performance. The Company's operating segments and reporting units are its 12 operating divisions, which are reported in one reportable segment. Each reporting unit constitutes a business for which discrete financial information is available and for which management regularly reviews the operating results. Across all operating segments, the Company operates primarily one store format. Each division offers through its stores and digital channels the same general mix of products with similar pricing to similar categories of customers, has similar distribution methods, operates in similar regulatory environments and purchases merchandise from similar or the same vendors.\nRevenue Recognition: Revenues from the retail sale of products are recognized at the point of sale or delivery to the customer, net of returns and sales tax. Pharmacy sales are recorded upon the customer receiving the prescription. Third-party receivables from pharmacy sales were $ 236.0 million and $ 262.5 million as of September 11, 2021 and February 27, 2021, respectively, and are recorded in Receivables, net. For digital related sales, which primarily include home delivery and Drive Up & Go curbside pickup, revenues are recognized upon either pickup in store or delivery to the customer and may include revenue for separately charged delivery services. The Company records a contract liability when rewards are earned by customers in connection with the Company's loyalty programs. As rewards are redeemed or expire, the Company reduces the contract liability and recognizes revenue. The contract liability balance was immaterial as of September 11, 2021 and February 27, 2021.\nThe Company records a contract liability when it sells its own proprietary gift cards. The Company records a sale when the customer redeems the gift card. The Company's gift cards do not expire. The Company reduces the contract liability and records revenue for the unused portion of gift cards (\"breakage\") in proportion to its customers' pattern of redemption, which the Company determined to be the historical redemption rate. The Company's contract liability related to gift cards was $ 76.2 million as of September 11, 2021 and $ 98.1 million as of February 27, 2021. Breakage amounts were immaterial for the 12 and 28 weeks ended September 11, 2021 and September 12, 2020, respectively.\n9\nDisaggregated Revenues\nThe following table represents sales revenue by type of similar product (dollars in millions):\n| 12 weeks ended | 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Amount (1) | % of Total | Amount (1) | % of Total | Amount (1) | % of Total | Amount (1) | % of Total |\n| Non-perishables (2) | $ | 7,268.5 | 44.0 | % | $ | 7,126.6 | 45.2 | % | $ | 16,538.8 | 43.8 | % | $ | 17,910.4 | 46.5 | % |\n| Perishables (3) | 6,823.2 | 41.3 | 6,654.1 | 42.2 | 15,735.8 | 41.6 | 16,209.7 | 42.1 |\n| Pharmacy | 1,253.4 | 7.6 | 1,171.8 | 7.5 | 2,982.0 | 7.9 | 2,726.7 | 7.1 |\n| Fuel | 918.5 | 5.6 | 570.8 | 3.6 | 1,967.8 | 5.2 | 1,160.0 | 3.0 |\n| Other (4) | 242.1 | 1.5 | 234.3 | 1.5 | 550.7 | 1.5 | 502.4 | 1.3 |\n| Net sales and other revenue | $ | 16,505.7 | 100.0 | % | $ | 15,757.6 | 100.0 | % | $ | 37,775.1 | 100.0 | % | $ | 38,509.2 | 100.0 | % |\n\n(1) Digital related sales are included in the categories to which the revenue pertains.\n(2) Consists primarily of general merchandise, grocery and frozen foods.\n(3) Consists primarily of produce, dairy, meat, deli, floral and seafood.\n(4) Consists primarily of wholesale revenue to third parties, commissions and other miscellaneous revenue.\nRecently issued accounting standards: In June 2020, the FASB issued ASU 2020-06, \"Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity's Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity's Own Equity\" (\"ASU 2020-06\"). ASU 2020-06 simplifies the accounting for certain convertible instruments, amends guidance on derivative scope exceptions for contracts in an entity's own equity and modifies the guidance on diluted earnings per share calculations as a result of these changes. ASU 2020-06 will take effect for public entities for annual reporting periods beginning after December 15, 2021, and interim periods within those fiscal years. Early adoption is permitted. The Company is currently evaluating the effect of this standard on its Consolidated Financial Statements.\nNOTE 2 - FAIR VALUE MEASUREMENTS\nThe accounting guidance for fair value established a framework for measuring fair value and established a three-level valuation hierarchy for disclosure of fair value measurement. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability at the measurement date. The three levels are defined as follows:\nLevel 1 - Quoted prices in active markets for identical assets or liabilities;\nLevel 2 - Inputs other than quoted prices included within Level 1 that are either directly or indirectly observable; and\nLevel 3 - Unobservable inputs in which little or no market activity exists, requiring an entity to develop its own assumptions that market participants would use to value the asset or liability.\nFair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.\n10\nThe following table presents assets and liabilities which were measured at fair value on a recurring basis as of September 11, 2021 (in millions):\n| Fair Value Measurements |\n| Total | Quoted prices in active markets for identical assets(Level 1) | Significantobservableinputs(Level 2) | Significantunobservableinputs(Level 3) |\n| Assets: |\n| Short-term investments (1) | $ | 14.7 | $ | 5.0 | $ | 9.7 | $ | — |\n| Non-current investments (2) | 92.6 | 19.5 | 73.1 | — |\n| Derivative contracts (3) | 10.0 | — | 10.0 | — |\n| Total | $ | 117.3 | $ | 24.5 | $ | 92.8 | $ | — |\n| Liabilities: |\n| Derivative contracts (4) | $ | 26.3 | $ | — | $ | 26.3 | $ | — |\n| Total | $ | 26.3 | $ | — | $ | 26.3 | $ | — |\n\n(1) Primarily relates to Mutual Funds (Level 1) and Certificates of Deposit (Level 2). Included in Other current assets.\n(2) Primarily relates to investments in publicly traded stock (Level 1) and U.S. Treasury Notes and Corporate Bonds (Level 2). Included in Other assets.\n(3) Primarily relates to derivative contracts. Included in Other assets.\n(4) Primarily relates to interest rate swaps. Included in Other current liabilities.\nThe following table presents assets and liabilities which were measured at fair value on a recurring basis as of February 27, 2021 (in millions):\n| Fair Value Measurements |\n| Total | Quoted prices in active markets for identical assets(Level 1) | Significantobservableinputs(Level 2) | Significantunobservableinputs(Level 3) |\n| Assets: |\n| Short-term investments (1) | $ | 11.9 | $ | 4.4 | $ | 7.5 | $ | — |\n| Non-current investments (2) | 110.2 | 40.3 | 69.9 | — |\n| Total | $ | 122.1 | $ | 44.7 | $ | 77.4 | $ | — |\n| Liabilities: |\n| Derivative contracts (3) | $ | 40.0 | $ | — | $ | 40.0 | $ | — |\n| Total | $ | 40.0 | $ | — | $ | 40.0 | $ | — |\n\n(1) Primarily relates to Mutual Funds (Level 1) and Certificates of Deposit (Level 2). Included in Other current assets.\n(2) Primarily relates to investments in publicly traded stock (Level 1) and U.S. Treasury Notes and Corporate Bonds (Level 2). Included in Other assets.\n(3) Primarily relates to interest rate swaps. Included in Other current liabilities.\nThe estimated fair value of the Company's debt, including current maturities, was based on Level 2 inputs, being market quotes or values for similar instruments, and interest rates currently available to the Company for the issuance of debt with similar terms and remaining maturities as a discount rate for the remaining principal payments. As of September 11, 2021, the fair value of total debt was $ 8,325.6 million compared to the carrying value of $ 7,815.0 million, excluding debt discounts and deferred financing costs. As of February 27, 2021, the fair value of total debt was $ 8,150.7 million compared to the carrying value of $ 7,815.5 million, excluding debt discounts and deferred financing costs.\n11\nAssets Measured at Fair Value on a Non-Recurring Basis\nThe Company measures certain assets at fair value on a non-recurring basis, including long-lived assets and goodwill, which are evaluated for impairment. Long-lived assets include store-related assets such as property and equipment and certain intangible assets. The inputs used to determine the fair value of long-lived assets and a reporting unit are considered Level 3 measurements due to their subjective nature.\nNOTE 3 - DERIVATIVE FINANCIAL INSTRUMENTS\nThe aggregate notional amount of the Company's interest rate swaps as of September 11, 2021 and February 27, 2021, were $ 1,553.0 million and $ 1,653.0 million, respectively, of which none were designated as cash flow hedges as defined by GAAP.\nActivity related to interest rate swaps consisted of the following (in millions):\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | Location of loss recognized from derivatives |\n| Loss on undesignated portion of interest rate swaps | $ | — | $ | ( 0.4 ) | Other income, net |\n\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | Location of loss recognized from derivatives |\n| Loss on undesignated portion of interest rate swaps | $ | ( 0.3 ) | $ | ( 19.4 ) | Other income, net |\n\nNOTE 4 - LONG-TERM DEBT AND FINANCE LEASE OBLIGATIONS\nThe Company's long-term debt and finance lease obligations as of September 11, 2021 and February 27, 2021, net of unamortized debt discounts of $ 43.0 million and $ 44.8 million, respectively, and deferred financing costs of $ 63.6 million and $ 69.8 million, respectively, consisted of the following (in millions):\n| September 11,2021 | February 27,2021 |\n| Senior Unsecured Notes due 2023 to 2030, interest rate range of 3.25 % to 7.50 % | $ | 6,686.5 | $ | 6,680.5 |\n| Safeway Inc. Notes due 2021 to 2031, interest rate range of 4.75 % to 7.45 % | 504.4 | 504.3 |\n| New Albertsons L.P. Notes due 2026 to 2031, interest rate range of 6.52 % to 8.70 % | 470.9 | 469.1 |\n| Other financing obligations | 29.2 | 29.4 |\n| Mortgage notes payable, secured | 17.4 | 17.6 |\n| Finance lease obligations | 632.2 | 612.7 |\n| Total debt | 8,340.6 | 8,313.6 |\n| Less current maturities | ( 211.5 ) | ( 212.4 ) |\n| Long-term portion | $ | 8,129.1 | $ | 8,101.2 |\n\nSenior Unsecured Notes\nOn October 1, 2021, subsequent to the end of the 12 weeks ended September 11, 2021, the Company provided notice to the holders and trustee, of its election to redeem all of the $ 200.0 million aggregate principal amount currently outstanding of the Company's 5.750 % Senior Unsecured Notes due 2025 (the \"2025 Notes\"). The 2025 Notes will be redeemed on November 1, 2021 (the \"Redemption Date\"), using cash on hand, at a redemption price of 101.438 % of the principal amount thereof plus accrued and unpaid interest on the 2025 Notes to, but excluding, the Redemption Date.\n12\nABL Facility\nAs of September 11, 2021 and February 27, 2021, there were no amounts outstanding under the Company's asset-based loan facility (\"ABL Facility\"), and letters of credit (\"LOC\") issued under the LOC sub-facility were $ 323.8 million and $ 354.6 million, respectively.\nNOTE 5 - EMPLOYEE BENEFIT PLANS\nPension and Other Post-Retirement Benefits\nThe following tables provide the components of net pension and post-retirement (income) expense (in millions):\n| 12 weeks ended |\n| Pension | Other post-retirement benefits |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Estimated return on plan assets | $ | ( 24.5 ) | $ | ( 23.7 ) | $ | — | $ | — |\n| Service cost | 5.1 | 3.5 | — | — |\n| Interest cost | 9.7 | 12.6 | 0.1 | 0.1 |\n| Amortization of prior service cost | — | — | — | 0.4 |\n| Amortization of net actuarial loss (gain) | 0.2 | 0.5 | ( 0.1 ) | ( 0.1 ) |\n| Settlement (gain) loss | ( 14.3 ) | 3.0 | — | — |\n| (Income) expense, net | $ | ( 23.8 ) | $ | ( 4.1 ) | $ | — | $ | 0.4 |\n\n| 28 weeks ended |\n| Pension | Other post-retirement benefits |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Estimated return on plan assets | $ | ( 57.2 ) | $ | ( 55.2 ) | $ | — | $ | — |\n| Service cost | 12.0 | 8.3 | — | — |\n| Interest cost | 22.7 | 29.2 | 0.2 | 0.2 |\n| Amortization of prior service cost | 0.1 | 0.1 | — | 1.0 |\n| Amortization of net actuarial loss (gain) | 0.5 | 1.1 | ( 0.3 ) | ( 0.3 ) |\n| Settlement (gain) loss | ( 14.3 ) | 3.0 | — | — |\n| (Income) expense, net | $ | ( 36.2 ) | $ | ( 13.5 ) | $ | ( 0.1 ) | $ | 0.9 |\n\nThe Company contributed $ 9.2 million and $ 11.2 million to its defined pension plans and post-retirement benefit plans during the 12 and 28 weeks ended September 11, 2021, respectively. For the 12 and 28 weeks ended September 12, 2020, the Company contributed $ 1.7 million and $ 56.3 million, respectively. At the Company's discretion, additional funds may be contributed to the defined benefit pension plans that are determined to be beneficial to the Company. The Company currently anticipates contributing an additional $ 26.1 million to these plans for the remainder of fiscal 2021.\nDuring the 12 and 28 weeks ended September 11, 2021, the Company purchased a group annuity policy and transferred $ 203.5 million of pension plan assets to an insurance company, thereby reducing the Company's defined benefit pension obligations by $ 205.4 million. As a result of the annuity purchase, the Company recorded a settlement gain of $ 11.1 million during the 12 and 28 weeks ended September 11, 2021.\n13\nDefined Contribution Plans and Supplemental Retirement Plans\nTotal contributions expensed for defined contribution plans (401(k) plans) were $ 26.4 million and $ 16.3 million for the 12 weeks ended September 11, 2021 and September 12, 2020, respectively. For the 28 weeks ended September 11, 2021 and September 12, 2020, total contributions expensed were $ 42.6 million and $ 38.1 million, respectively.\nMultiemployer Pension Plans\nARP Act: The American Rescue Plan Act (\"ARP Act\") was signed into law on March 11, 2021. The ARP Act establishes a special financial assistance program for financially troubled multiemployer pension plans. Under the ARP Act, eligible multiemployer plans can apply to receive a one-time cash payment in the amount projected by the Pension Benefit Guaranty Corporation (\"PBGC\") to pay pension benefits through the plan year ending 2051. On July 9, 2021, the PBGC issued its interim final rule with respect to the special financial assistance program. The PBGC interim final rule provides direction on the application requirements, identifies which plans will have priority, eligibility requirements, the determination of the amount of financial assistance to be provided and establishes conditions and restrictions that apply to plans that receive the assistance. The Company is evaluating the interim final rule and has submitted comments during the 30-day comment period. The Company's evaluation includes any potential impact to the Company's Excess Plan as defined in and further described in \"Part II—Item 8. Financial Statements and Supplemental Data—Note 12\" of the Company's Annual Report on Form 10-K for the fiscal year ended February 27, 2021.\nNOTE 6 - COMMITMENTS AND CONTINGENCIES AND OFF BALANCE SHEET ARRANGEMENTS\nGuarantees\nCalifornia Department of Industrial Relations: On January 21, 2014, the Company entered into a Collateral Substitution Agreement with the California Self-Insurers' Security Fund to provide collateral related to certain California self-insured workers' compensation obligations pursuant to applicable regulations. The collateral not covered by the California Self-Insurers' Security Fund is covered by surety bonds for the benefit of the State of California Office of Self-Insurance Plans. A portion of the surety bonds is covered by irrevocable LOCs. The collateral requirements are adjusted annually based on semi-annual filings of an actuarial study reflecting liabilities as of December 31 of each year reduced by claim closures and settlements. The related LOC was $ 22.6 million as of September 11, 2021 and $ 40.1 million as of February 27, 2021, respectively.\nLease Guarantees: The Company may have liability under certain operating leases that were assigned to third parties. If any of these third parties fail to perform their obligations under the leases, the Company could be responsible for the lease obligation, including as a result of the economic dislocation caused by the response to the COVID-19 pandemic. Because of the wide dispersion among third parties and the variety of remedies available, the Company believes that if an assignee became insolvent, it would not have a material effect on the Company's financial condition, results of operations or cash flows.\nThe Company also provides guarantees, indemnifications and assurances pursuant to contractual obligations in the ordinary course of its business.\nLegal Proceedings\nThe Company is subject from time to time to various claims and lawsuits arising in the ordinary course of business, including lawsuits involving trade practices, lawsuits alleging violations of state and/or federal wage and hour laws (including alleged violations of meal and rest period laws and alleged misclassification issues), real estate disputes as well as other matters. Some of these claims or suits purport or may be determined to be class actions and/or seek substantial damages. It is the opinion of the Company's management that although the amount of liability with\n14\nrespect to certain of the matters described herein cannot be ascertained at this time, any resulting liability of these and other matters, including any punitive damages, will not have a material adverse effect on the Company's business or financial condition.\nThe Company continually evaluates its exposure to loss contingencies arising from pending or threatened litigation and believes it has made provisions where the loss contingency is probable and can be reasonably estimated. Nonetheless, assessing and predicting the outcomes of these matters involves substantial uncertainties. Management currently believes that the aggregate range of reasonably possible loss for the Company's exposure in excess of the amount accrued is expected to be immaterial to the Company. It remains possible that despite management's current belief, material differences in actual outcomes or changes in management's evaluation or predictions could arise that could have a material effect on the Company's financial condition, results of operations or cash flows.\nERISA Litigation: Two lawsuits were brought against Safeway Inc. (\"Safeway\") and the Safeway Benefits Plan Committee (the \"Benefit Plans Committee,\" and together with Safeway, the \"Safeway Benefits Plans Defendants\") and other third parties alleging breaches of fiduciary duty under the Employee Retirement Income Security Act of 1974, as amended (\"ERISA\") with respect to Safeway's 401(k) Plan (the \"Safeway 401(k) Plan\"). On July 14, 2016, a complaint was filed in the United States District Court for the Northern District of California by a participant in the Safeway 401(k) Plan individually and on behalf of the Safeway 401(k) Plan. An amended complaint was filed on November 18, 2016. On August 25, 2016, a second complaint was filed in the United States District Court for the Northern District of California by another participant in the Safeway 401(k) Plan individually and on behalf of all others similarly situated against the Safeway Benefits Plans Defendants and against the Safeway 401(k) Plan's former record-keepers. An amended complaint was filed on September 16, 2016, and a second amended complaint was filed on November 21, 2016. In general, both lawsuits alleged that the Safeway Benefits Plans Defendants breached their fiduciary duties under ERISA regarding the selection of investments offered under the Safeway 401(k) Plan and the fees and expenses related to those investments. All parties filed summary judgment motions which were heard and taken under submission on August 16, 2018. Plaintiffs' motions were denied, and defendants' motions were granted in part and denied in part. Bench trials for both matters were set for May 6, 2019. A settlement in principle was reached before trial. On September 13, 2019, settlement papers were filed with the Court along with a motion for preliminary approval of the settlement. A hearing for preliminary approval was set for November 20, 2019, but the Court vacated the hearing. The Court issued an order on March 30, 2020 requesting some minor changes to the notice procedures, and plaintiffs submitted an amended motion for preliminary approval. On September 8, 2020, the Court granted plaintiffs' amended motion, and a final approval hearing was held on April 26, 2021, at which time the Court took the matter under submission. On July 19, 2021, the Court issued a final order approving the settlement. In August 2021, a settlement fund was established with funds from insurers. A settlement administrator is now managing the calculation and payment of settlement provisions to class members.\nFalse Claims Act: The Company has received a civil investigative demand dated February 28, 2020 from the United States Attorney for the Southern District of New York in connection with a False Claims Act (\"FCA\") investigation relating to the Company's dispensing practices regarding insulin pen products. The investigation seeks documents regarding the Company's policies, practices and procedures, as well as dispensing data, among other things. The Company has cooperated with the U.S. Attorney in the investigation. The Company is currently unable to determine the probability of the outcome of this matter or the range of possible loss, if any.\nTwo qui tam actions alleging violations of the FCA have also been filed against the Company and its subsidiaries. Violations of the FCA are subject to treble damages and penalties of up to a specified dollar amount per false claim.\nIn United States ex rel. Proctor v. Safeway, filed in the United States District Court for the Central District of Illinois, the relator alleges that Safeway overcharged federal government healthcare programs by not providing the federal government, as part of its usual and customary prices, the benefit of discounts given to customers in pharmacy membership discount and price-matching programs. The relator filed his complaint under seal on November 11, 2011, and the complaint was unsealed on August 26, 2015. The relator amended the complaint on\n15\nMarch 31, 2016. On June 12, 2020, the Court granted Safeway's motion for summary judgment, holding that the relator could not prove that Safeway acted with the intent required under the FCA, and judgment was issued on June 15, 2020. On July 10, 2020, the relator filed a motion to alter or amend the judgment and to supplement the record, which Safeway opposed. On November 13, 2020, the Court denied relator's motion, and on December 11, 2020, relator filed a notice of appeal. The appeal is now pending in the Seventh Circuit Court of Appeals. Oral argument took place September 9, 2021.\nIn United States ex rel. Schutte and Yarberry v. SuperValu, New Albertson's, Inc., et al., also filed in the Central District of Illinois, the relators allege that defendants (including various subsidiaries of the Company) overcharged federal government healthcare programs by not providing the federal government, as a part of usual and customary prices, the benefit of discounts given to customers who requested that defendants match competitor prices. The complaint was originally filed under seal and amended on November 30, 2015. On August 5, 2019, the Court granted relators' motion for partial summary judgment, holding that price-matched prices are the usual and customary prices for those drugs. On July 1, 2020, the Court granted the defendants' motions for summary judgment and dismissed the case, holding that the relator could not prove that defendants acted with the intent required under the FCA. Judgment was issued on July 2, 2020. On July 9, 2020, the relators filed a notice of appeal. Oral argument was held on January 19, 2021. On August 12, 2021, the Court of Appeals for the Seventh Circuit affirmed the grant of summary judgment in the Company's favor. On September 23, 2021, the relators filed a petition for rehearing en banc with the Seventh Circuit. The Company's response to the petition for rehearing is due by November 9, 2021.\nIn both of the above cases, the federal government previously investigated the relators' allegations and declined to intervene. The relators elected to pursue their respective cases on their own and in each case have alleged FCA damages in excess of $ 100 million before trebling and excluding penalties. The Company is vigorously defending each of these matters and believes each of these cases is without merit. The Company has recorded an estimated liability for these matters.\nOpioid Litigation: The Company is one of dozens of companies that have been named in various lawsuits alleging that defendants contributed to the national opioid epidemic. At present, the Company is named in over 80 suits pending in various state courts as well as in the United States District Court for the Northern District of Ohio, where over 2,000 cases have been consolidated as Multi-District Litigation (\"MDL\") pursuant to 28 U.S.C. §1407. Most of these cases have been stayed pending bellwether trials. At present, the most active case is a matter in New Mexico state court where we have been in active discovery and where a September 2022 trial date has been set. The MDL Court and a state court in Utah are currently considering position statements from the parties in connection with scheduling bellwether trials and it is likely that the Company may be included in one or more of those anticipated bellwether trials. The Company is vigorously defending these matters and believes that these cases are without merit. At this stage in the proceedings, the Company is unable to determine the probability of the outcome of these matters or the range of reasonably possible loss, if any.\nCalifornia Air Resources Board: Upon the inspection by the California Air Resources Board (\"CARB\") of several of the Company's stores in California, it was determined that the Company failed certain paperwork and other administrative requirements. As a result of the inspections, the Company proactively undertook a broad evaluation of the record keeping and administrative practices at all of its stores in California. In connection with this evaluation, the Company retained a third party to conduct an audit and correct deficiencies identified across its California store base. The Company is working with CARB to resolve these compliance issues and comply with governing regulations, and that work is ongoing. CARB has made an opening demand regarding potential fines and penalties. On July 7, 2021, the parties entered into a settlement agreement for which the Company has recorded an estimated liability.\nFACTA: On May 31, 2019, a putative class action complaint entitled Martin v. Safeway was filed in the California Superior Court for the County of Alameda, alleging the Company failed to comply with the Fair and Accurate Credit Transactions Act (\"FACTA\") by printing receipts that failed to adequately mask payment card numbers as\n16\nrequired by FACTA. The plaintiff claims the violation was \"willful\" and exposes the Company to statutory damages provided for in FACTA. The Company has answered the complaint and is vigorously defending the matter. On January 8, 2020, the Company commenced mediation discussions with plaintiff's counsel and reached a settlement in principle on February 24, 2020. The parties will seek court approval of the settlement. The Company has recorded an estimated liability for this matter.\nOther Commitments\nIn the ordinary course of business, the Company enters into various supply contracts to purchase products for resale and purchase and service contracts for fixed asset and information technology commitments. These contracts typically include volume commitments or fixed expiration dates, termination provisions and other standard contractual considerations.\nNOTE 7 - OTHER COMPREHENSIVE INCOME OR LOSS\nTotal comprehensive earnings are defined as all changes in stockholders' equity during a period, other than those from investments by or distributions to the stockholders. Generally, for the Company, total comprehensive income or loss equals net income plus or minus adjustments for pension and other post-retirement liabilities. Total comprehensive earnings represent the activity for a period net of tax.\nWhile total comprehensive earnings are the activity in a period and are largely driven by net earnings in that period, accumulated other comprehensive income or loss (\"AOCI\") represents the cumulative balance of other comprehensive income, net of tax, as of the balance sheet date. Changes in the AOCI balance by component are shown below (in millions):\n| 28 weeks ended September 11, 2021 |\n| Total | Pension and Post-retirement benefit plans | Other |\n| Beginning balance | $ | 63.5 | $ | 61.3 | $ | 2.2 |\n| Other comprehensive income before reclassifications | 34.3 | 34.3 | — |\n| Amounts reclassified from accumulated other comprehensive income | ( 14.0 ) | ( 14.0 ) | — |\n| Tax expense | ( 5.1 ) | ( 5.1 ) | — |\n| Current-period other comprehensive income, net of tax | 15.2 | 15.2 | — |\n| Ending balance | $ | 78.7 | $ | 76.5 | $ | 2.2 |\n\n| 28 weeks ended September 12, 2020 |\n| Total | Pension and Post-retirement benefit plans | Other |\n| Beginning balance | $ | ( 118.5 ) | $ | ( 121.7 ) | $ | 3.2 |\n| Other comprehensive income before reclassifications | 11.1 | 9.6 | 1.5 |\n| Amounts reclassified from accumulated other comprehensive income | 4.9 | 4.9 | — |\n| Tax expense | ( 3.9 ) | ( 3.6 ) | ( 0.3 ) |\n| Current-period other comprehensive income, net of tax | 12.1 | 10.9 | 1.2 |\n| Ending balance | $ | ( 106.4 ) | $ | ( 110.8 ) | $ | 4.4 |\n\n17\nNOTE 8 - NET INCOME PER CLASS A COMMON SHARE\nThe Company calculates basic and diluted net income per Class A common share using the two-class method. The two-class method is an allocation formula that determines net income per Class A common share for each share of Class A common stock and the Company's Series A-1 convertible preferred stock (\"Series A-1 preferred stock\") and Series A convertible preferred stock (\"Series A preferred stock\" and together with the Series A-1 preferred stock, the \"Convertible Preferred Stock\"), a participating security, according to dividends declared and participation rights in undistributed earnings. Under this method, all earnings (distributed and undistributed) are allocated to Class A common shares and Convertible Preferred Stock based on their respective rights to receive dividends. The holders of Convertible Preferred Stock participate in cash dividends that the Company pays on its common stock to the extent that such cash dividends exceed $ 206.25 million per fiscal year. In applying the two-class method to interim periods, the Company allocates income to its quarterly periods independently and discretely from its year-to-date and annual periods. Basic net income per Class A common share is computed by dividing net income allocated to Class A common stockholders by the weighted average number of Class A common shares outstanding for the period, including Class A common shares to be issued with no prior remaining contingencies prior to issuance. Diluted net income per Class A common share is computed based on the weighted average number of shares of Class A common stock outstanding during each period, plus potential Class A common shares considered outstanding during the period, as long as the inclusion of such awards is not antidilutive. Potential Class A common shares consist of unvested RSUs and RSAs and Convertible Preferred Stock, using the more dilutive of either the two-class method or as-converted stock method. Performance-based RSUs are considered dilutive when the related performance criterion has been met.\n18\nThe components of basic and diluted net income per Class A common share were as follows (in millions, except per share data):\n| 12 weeks ended | 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Basic net income per Class A common share |\n| Net income | $ | 295.2 | $ | 284.5 | $ | 740.0 | $ | 870.7 |\n| Accrued dividends on Convertible Preferred Stock | ( 27.3 ) | ( 26.9 ) | ( 63.7 ) | ( 30.8 ) |\n| Earnings allocated to Convertible Preferred Stock | ( 11.0 ) | ( 9.0 ) | ( 84.2 ) | ( 9.0 ) |\n| Net income allocated to Class A common stockholders - Basic | $ | 256.9 | $ | 248.6 | $ | 592.1 | $ | 830.9 |\n| Weighted average Class A common shares outstanding - Basic (1) | 465.3 | 477.3 | 465.2 | 529.2 |\n| Basic net income per Class A common share | $ | 0.55 | $ | 0.52 | $ | 1.27 | $ | 1.57 |\n| Diluted net income per Class A common share |\n| Net income allocated to Class A common stockholders - Basic | $ | 256.9 | $ | 248.6 | $ | 592.1 | $ | 830.9 |\n| Accrued dividends on Convertible Preferred Stock | 27.3 | 26.9 | — | 30.8 |\n| Earnings allocated to Convertible Preferred Stock | 11.0 | 9.0 | — | 9.0 |\n| Net income allocated to Class A common stockholders - Diluted | $ | 295.2 | $ | 284.5 | $ | 592.1 | $ | 870.7 |\n| Weighted average Class A common shares outstanding - Basic (1) | 465.3 | 477.3 | 465.2 | 529.2 |\n| Dilutive effect of: |\n| Restricted stock units and awards | 6.1 | 4.0 | 5.4 | 4.3 |\n| Convertible Preferred Stock (2) | 101.6 | 101.6 | — | 49.8 |\n| Weighted average Class A common shares outstanding - Diluted (3) | 573.0 | 582.9 | 470.6 | 583.3 |\n| Diluted net income per Class A common share | $ | 0.52 | $ | 0.49 | $ | 1.26 | $ | 1.49 |\n\n(1) There were 0.3 million Class A common shares remaining to be issued for the 12 and 28 weeks ended September 11, 2021 compared to 0.4 million Class A common shares remaining to be issued for the 12 and 28 weeks ended September 12, 2020.\n(2) Reflects the number of shares of Convertible Preferred Stock issued, if converted into common stock for the period outstanding. For the 28 weeks ended September 11, 2021, 101.6 million potential common shares outstanding related to Convertible Preferred Stock were antidilutive.\n(3) There were no potential Class A common shares outstanding related to RSUs and RSAs that were antidilutive for the 12 and 28 weeks ended September 11, 2021. There were no potential Class A common shares outstanding related to RSUs and RSAs that were antidilutive for the 12 and 28 weeks ended September 12, 2020.\n19\nItem 2\n-\nManagement's Discussion and Analysis of Financial Condition and Results of Operations\nSPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS\nThis Form 10-Q contains \"forward-looking statements\" within the meaning of the federal securities laws. The \"forward-looking statements\" include our current expectations, assumptions, estimates and projections about our business and our industry. They include statements relating to our future operating or financial performance which the Company believes to be reasonable at this time. You can identify forward-looking statements by the use of words such as \"outlook,\" \"may,\" \"should,\" \"could,\" \"estimates,\" \"predicts,\" \"potential,\" \"continue,\" \"anticipates,\" \"believes,\" \"plans,\" \"expects,\" \"future\" and \"intends\" and similar expressions which are intended to identify forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors, some of which are beyond our control and difficult to predict, including, among others, changes in macroeconomic conditions, the retail consumer behavior and environment and the Company's industry, failure to achieve productivity initiatives, increased rates of food price inflation and factors related to the continued impact of the COVID-19 pandemic, about which there are still many unknowns, including its duration, recurrence, new virus strains, status and effectiveness of vaccinations, duration and scope of related government orders, financial assistance programs, mandates and regulations and the extent of the overall impact to our business and the communities we serve. Such risks and uncertainties could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements. In evaluating forward-looking statements, you should carefully consider the risks and uncertainties more fully described in the \"Risk Factors\" section or other sections in our reports filed with the SEC including the most recent annual report on Form 10-K and any subsequent periodic reports on Form 10-Q and current reports on Form 8-K. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements and risk factors. Forward-looking statements contained in this Form 10-Q reflect our view only as of the date of this Form 10-Q. We undertake no obligation, other than as required by law, to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.\nAs used in this Form 10-Q, unless the context otherwise requires, references to \"Albertsons,\" the \"Company,\" \"we,\" \"us\" and \"our\" refer to Albertsons Companies, Inc. and, where appropriate, its subsidiaries.\nNON-GAAP FINANCIAL MEASURES\nWe define EBITDA as generally accepted accounting principles (\"GAAP\") earnings (net loss) before interest, income taxes, depreciation and amortization. We define Adjusted EBITDA as earnings (net loss) before interest, income taxes, depreciation and amortization, further adjusted to eliminate the effects of items management does not consider in assessing our ongoing core performance. We define Adjusted net income as GAAP Net income adjusted to eliminate the effects of items management does not consider in assessing our ongoing core performance. We define Adjusted net income per Class A common share as Adjusted net income divided by the weighted average diluted Class A common shares outstanding, as adjusted to reflect all restricted stock units (\"RSUs\") and restricted common stock (\"RSAs\") outstanding at the end of the period. We define Net Debt as total debt (which includes finance lease obligations and is net of deferred financing costs and original issue discount) minus unrestricted cash and cash equivalents and we define Net Debt Ratio as the ratio of Net Debt to Adjusted EBITDA for the rolling 52 or 53 week period. See \"Results of Operations\" for further discussion and a reconciliation of Adjusted EBITDA, Adjusted net income and Adjusted net income per Class A common share.\nEBITDA, Adjusted EBITDA, Adjusted net income and Adjusted net income per Class A common share (collectively, the \"Non-GAAP Measures\") are performance measures that provide supplemental information we believe is useful to analysts and investors to evaluate our ongoing results of operations, when considered alongside other GAAP measures such as Net income, operating income and gross profit. These Non-GAAP Measures exclude\n20\nthe financial impact of items management does not consider in assessing our ongoing core operating performance, and thereby provide useful measures to analysts and investors of our operating performance on a period-to-period basis. Other companies may have different definitions of Non-GAAP Measures and provide for different adjustments, and comparability to our results of operations may be impacted by such differences. We also use Adjusted EBITDA and Net Debt Ratio for board of director and bank compliance reporting. Our presentation of Non-GAAP Measures should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items.\nNon-GAAP Measures should not be considered as measures of discretionary cash available to us to invest in the growth of our business. We compensate for these limitations by relying primarily on our GAAP results and using Non-GAAP Measures only for supplemental purposes.\n21\nSECOND QUARTER OF FISCAL 2021 OVERVIEW\nGiven the significant variations that occurred in our business during fiscal 2020 due to the COVID-19 pandemic, we provide a supplemental comparison of the 12 and 28 weeks ended September 11, 2021 (\"second quarter of fiscal 2021\" and \"first 28 weeks of fiscal 2021\") to the 12 and 28 weeks ended September 7, 2019 (\"second quarter of fiscal 2019\" and \"first 28 weeks of fiscal 2019\") for certain financial measures to demonstrate the two-year growth in our business in addition to comparisons to the 12 and 28 weeks ended September 12, 2020 (\"second quarter of fiscal 2020\" and \"first 28 weeks of fiscal 2020\").\nAs of September 11, 2021, we operated 2,278 retail food and drug stores with 1,725 pharmacies, 401 associated fuel centers, 22 dedicated distribution centers and 20 manufacturing facilities. With a strong consumer environment, we continue to make significant progress against all of our strategic priorities, including in-store excellence, accelerating our digital and omni-channel capabilities, increasing productivity and strengthening our talent and culture. Identical sales increased 1.5%, excluding fuel, during the second quarter of fiscal 2021, resulting in two-year stacked identical sales growth of 15.3%. We continue to gain market share in food market, and in Multi Outlet (\"MULO\") we are up on a two-year basis and down marginally on a one-year basis. Food market generally includes traditional supermarkets while MULO includes most food market, drug, mass merchants, club, dollar and military stores that sell food.\nUnderscoring our strong omni-channel capabilities that allow customers to complete their shopping with us in any way they want, our digital initiatives continue to resonate with our customers, as evidenced by our sustained sales levels in the second quarter of fiscal 2021, digital sales increasing 5% compared to the second quarter of fiscal 2020 and a two-year stacked growth of 248%. During the second quarter of fiscal 2021, we expanded our Drive Up & Go curbside pickup service to approximately 1,900 locations and offer delivery services across more than 2,000 of our stores. In our delivery service, we have expanded first party locations, and continue to work with third party services to engage with customers on the platform of their choice. In addition to our continuing partnership with Instacart, we have expanded our partnership with DoorDash to offer on-demand grocery delivery service where customers can receive a broad assortment in under one hour. We also recently launched a similar partnership with Uber, where customers can order a full assortment of groceries on the Uber platform.\nWith ongoing benefit enhancements, we continue to achieve significant success with our just for U loyalty program, which drives higher sales and customer retention, with membership growing 17% in the second quarter of fiscal 2021 compared to the second quarter of fiscal 2020, reaching 27.5 million members. Within the program, the number of actively engaged members, those that redeemed fuel or grocery rewards during the second quarter of fiscal 2021, increased by almost 9% compared to the second quarter of fiscal 2020, and our retention rate of actively engaged members was 93% in the second quarter of fiscal 2021.\nDuring the second quarter of fiscal 2021 we continued to roll out our Own Brands across all our banners, launching 85 new products and generating strong growth as our sales penetration increased by 60 basis points to 25.2% compared to the second quarter of fiscal 2020. We also continue to make significant progress on productivity initiatives, including promotional effectiveness, purchasing and procurement, labor efficiency and shrink.\nOur capital allocation strategy balances investing for the future, strengthening our balance sheet and returns to shareholders through a combination of dividends and opportunistic share repurchases. Capital expenditures were approximately $823 million during the first 28 weeks of fiscal 2021 as we opened seven new stores and completed 76 upgrades and remodels. Our balance sheet remains strong with a Net Debt Ratio of 1.3x as of the end of the second quarter of fiscal 2021. Capital returns to shareholders during the first 28 weeks of fiscal 2021 included our $0.10 per share quarterly dividend. On October 18, 2021, subsequent to the end of the second quarter of fiscal 2021, we announced a 20% increase to our quarterly dividend, which is now $0.12 per share of Class A common stock.\n22\nIn addition, we have continued to partner with the Department of Health and Human Services and local health authorities to administer COVID-19 vaccines to our local communities and, as of October 12, 2021, have administered approximately 7.5 million doses.\nSecond quarter of fiscal 2021 highlights\nIn summary, our financial and operating highlights for the second quarter of fiscal 2021 include:\n•Identical sales increase of 1.5%; two-year identical sales stacked growth was 15.3%\n•Digital sales increased 5%; on a two-year stacked basis digital sales growth was 248%\n•Net income of $295 million, or $0.52 per Class A common share\n•Adjusted net income of $370 million, or $0.64 per Class A common share\n•Adjusted EBITDA of $965 million\n•Opened one new store and completed 43 remodel projects\n•Launched 153 new Drive Up & Go locations\nStores\nThe following table shows stores operating, acquired, opened and closed during the periods presented:\n| 12 weeks ended | 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Stores, beginning of period | 2,278 | 2,252 | 2,277 | 2,252 |\n| Acquired (1) | — | — | 1 | — |\n| Opened | 1 | 2 | 6 | 2 |\n| Closed | (1) | (2) | (6) | (2) |\n| Stores, end of period | 2,278 | 2,252 | 2,278 | 2,252 |\n\n(1) The 28 weeks ended September 11, 2021 includes one store acquired from Kings and Balducci's that transferred to us subsequent to the end of the fourth quarter of fiscal 2020.\nThe following table summarizes our stores by size:\n| Number of stores | Percent of Total | Retail Square Feet (1) |\n| Square Footage | September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Less than 30,000 | 223 | 204 | 9.8 | % | 9.1 | % | 5.1 | 4.7 |\n| 30,000 to 50,000 | 786 | 781 | 34.5 | % | 34.6 | % | 32.9 | 32.8 |\n| More than 50,000 | 1,269 | 1,267 | 55.7 | % | 56.3 | % | 75.0 | 74.8 |\n| Total Stores | 2,278 | 2,252 | 100.0 | % | 100.0 | % | 113.0 | 112.3 |\n\n(1) In millions, reflects total square footage of retail stores operating at the end of the period.\n23\nRESULTS OF OPERATIONS\nComparison of Second Quarter of Fiscal 2021 and First 28 Weeks of Fiscal 2021 to Second Quarter of Fiscal 2020 and First 28 Weeks of Fiscal 2020:\nThe following tables and related discussion set forth certain information and comparisons regarding the components of our Condensed Consolidated Statements of Operations for the second quarter of fiscal 2021 and first 28 weeks of fiscal 2021 to the second quarter of fiscal 2020 and first 28 weeks of fiscal 2020 (in millions, except per share data).\n| 12 weeks ended |\n| September 11,2021 | % of Sales | September 12,2020 | % of Sales |\n| Net sales and other revenue | $ | 16,505.7 | 100.0 | % | $ | 15,757.6 | 100.0 | % |\n| Cost of sales | 11,788.7 | 71.4 | 11,182.7 | 71.0 |\n| Gross profit | 4,717.0 | 28.6 | 4,574.9 | 29.0 |\n| Selling and administrative expenses | 4,231.3 | 25.6 | 4,031.2 | 25.6 |\n| Gain on property dispositions and impairment losses, net | (0.2) | — | (18.3) | (0.1) |\n| Operating income | 485.9 | 3.0 | 562.0 | 3.5 |\n| Interest expense, net | 109.3 | 0.7 | 128.6 | 0.8 |\n| Loss on debt extinguishment | — | — | 49.1 | 0.3 |\n| Other income, net | (18.9) | (0.1) | (11.4) | (0.1) |\n| Income before income taxes | 395.5 | 2.4 | 395.7 | 2.5 |\n| Income tax expense | 100.3 | 0.6 | 111.2 | 0.7 |\n| Net income | $ | 295.2 | 1.8 | % | $ | 284.5 | 1.8 | % |\n| Basic net income per Class A common share | $ | 0.55 | $ | 0.52 |\n| Diluted net income per Class A common share | 0.52 | 0.49 |\n| 28 weeks ended |\n| September 11,2021 | % of Sales | September 12,2020 | % of Sales |\n| Net sales and other revenue | $ | 37,775.1 | 100.0 | % | $ | 38,509.2 | 100.0 | % |\n| Cost of sales | 26,867.1 | 71.1 | 27,162.8 | 70.5 |\n| Gross profit | 10,908.0 | 28.9 | 11,346.4 | 29.5 |\n| Selling and administrative expenses | 9,734.9 | 25.8 | 9,800.6 | 25.5 |\n| Loss on property dispositions and impairment losses, net | 0.1 | — | 12.0 | — |\n| Operating income | 1,173.0 | 3.1 | 1,533.8 | 4.0 |\n| Interest expense, net | 262.6 | 0.7 | 309.2 | 0.8 |\n| Loss on debt extinguishment | — | — | 49.1 | 0.1 |\n| Other income, net | (62.4) | (0.2) | (8.3) | — |\n| Income before income taxes | 972.8 | 2.6 | 1,183.8 | 3.1 |\n| Income tax expense | 232.8 | 0.6 | 313.1 | 0.8 |\n| Net income | $ | 740.0 | 2.0 | % | $ | 870.7 | 2.3 | % |\n| Basic net income per Class A common share | $ | 1.27 | $ | 1.57 |\n| Diluted net income per Class A common share | 1.26 | 1.49 |\n\nNet Sales and Other Revenue\nNet sales and other revenue increased 4.7% to $16,505.7 million for the second quarter of fiscal 2021 from $15,757.6 million for the second quarter of fiscal 2020. The increase in Net sales and other revenue was primarily driven by our 1.5% increase in identical sales, which includes an increase in pharmacy sales, partially from\n24\nadministering COVID-19 vaccines, an increase in sales related to the stores acquired and opened since the second quarter of fiscal 2020 and higher fuel sales.\nNet sales and other revenue decreased 1.9% to $37,775.1 million for the first 28 weeks of fiscal 2021 from $38,509.2 million for the first 28 weeks of fiscal 2020. The decrease in Net sales and other revenue was primarily driven by our 5.3% decrease in identical sales, which was partially offset by an increase in pharmacy sales, primarily from administering COVID-19 vaccines, and an increase in sales related to the stores opened since the first 28 weeks of fiscal 2020 and higher fuel sales.\nIdentical Sales, Excluding Fuel\nIdentical sales include stores operating during the same period in both the current year and the prior year, comparing sales on a daily basis. Direct to consumer digital sales are included in identical sales, and fuel sales are excluded from identical sales. Acquired stores become identical on the one-year anniversary date of the acquisition. Identical sales for the 12 and 28 weeks ended September 11, 2021 and the 12 and 28 weeks ended September 12, 2020, respectively, were:\n| 12 weeks ended | 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Identical sales, excluding fuel | 1.5% | 13.8% | (5.3)% | 21.0% |\n\nGross Profit\nGross profit represents the portion of Net sales and other revenue remaining after deducting Cost of sales during the period, including purchase and distribution costs. These costs include, among other things, purchasing and sourcing costs, inbound freight costs, product quality testing costs, warehouse and distribution costs, Own Brands program costs and digital-related delivery and handling costs. Advertising, promotional expenses and vendor allowances are also components of Cost of sales.\nGross profit margin decreased to 28.6% during the second quarter of fiscal 2021 compared to 29.0% during the second quarter of fiscal 2020. Excluding the impact of fuel, gross profit margin was flat compared to the second quarter of fiscal 2020, primarily due to higher product, supply chain and advertising costs, offset by benefits related to productivity initiatives, favorable product mix and improved pharmacy margins related to administering COVID-19 vaccines.\nGross profit margin decreased to 28.9% during the first 28 weeks of fiscal 2021 compared to 29.5% during the first 28 weeks of fiscal 2020. Excluding the impact of fuel, gross profit margin increased five basis points compared to the first 28 weeks of fiscal 2020. The increase in gross profit margin was primarily driven by productivity initiatives, favorable product mix and improved pharmacy margins related to administering COVID-19 vaccines, partially offset by sales deleverage and higher product and supply chain costs.\nSelling and Administrative Expenses\nSelling and administrative expenses consist primarily of store level costs, including wages, employee benefits, rent, depreciation and utilities, in addition to certain back-office expenses related to our corporate and division offices.\nSelling and administrative expenses were 25.6% of Net sales and other revenue during the second quarter of fiscal 2021 and the second quarter of fiscal 2020. Excluding the impact of fuel, Selling and administrative expenses as a percentage of Net sales and other revenue increased 55 basis points during the second quarter of fiscal 2021 compared to the second quarter of fiscal 2020. The increase in Selling and administrative expenses as a percentage\n25\nof Net sales and other revenue was primarily attributable to employee costs, depreciation and other expenses related to our investments in our digital and omni-channel capabilities and strategic priorities. The increase in employee costs was the result of additional labor related to reopening fresh departments, market-driven retail wage rate increases and higher equity-based compensation expense. These increases were partially offset by lower COVID-19 related costs and execution of productivity initiatives.\nSelling and administrative expenses increased to 25.8% of Net sales and other revenue during the first 28 weeks of fiscal 2021 compared to 25.5% of Net sales and other revenue for the first 28 weeks of fiscal 2020. Excluding the impact of fuel, Selling and administrative expenses as a percentage of Net sales and other revenue increased 90 basis points during the first 28 weeks of fiscal 2021 compared to the first 28 weeks of fiscal 2020. The increase in Selling and administrative expenses as a percentage of Net sales and other revenue was primarily attributable to sales deleverage, together with higher employee costs, depreciation and other expenses related to our investments in our digital and omni-channel capabilities and strategic priorities. The increase in employee costs was the result of additional labor related to reopening of fresh departments, market-driven retail wage rate increases and higher equity-based compensation expense. These increases were partially offset by lower COVID-19 related costs and execution of productivity initiatives.\n(Gain) Loss on Property Dispositions and Impairment Losses, Net\nFor the second quarter of fiscal 2021, net gain on property dispositions and impairment losses was $0.2 million, primarily driven by $6.2 million of gains from the sale of assets, partially offset by $6.0 million of intangible asset impairment. For the second quarter of fiscal 2020, net gain on property dispositions and impairment losses was $18.3 million, primarily driven by $20.0 million of gains from the sale of assets, partially offset by $1.7 million of asset impairments.\nFor the first 28 weeks of fiscal 2021, net loss on property dispositions and impairment losses was $0.1 million, primarily driven by $15.9 million of asset impairments, primarily related to right-of-use assets and intangible assets, partially offset by $15.8 million of gains from the sale of assets. For the first 28 weeks of fiscal 2020, net loss on property dispositions and impairment losses was $12.0 million, primarily driven by $22.8 million of asset impairments, primarily related to right-of-use assets, partially offset by $10.8 million of gains from the sale of assets.\nInterest Expense, Net\nInterest expense, net was $109.3 million during the second quarter of fiscal 2021 compared to $128.6 million during the second quarter of fiscal 2020. The decrease in interest expense was primarily attributable to lower average outstanding borrowings and lower average interest rates. The weighted average interest rate during the second quarter of fiscal 2021 was 5.4%, excluding deferred financing costs and original issue discount, compared to 6.0% during the second quarter of fiscal 2020.\nInterest expense, net was $262.6 million during the first 28 weeks of fiscal 2021 compared to $309.2 million during the first 28 weeks of fiscal 2020. The decrease in interest expense was primarily attributable to lower average outstanding borrowings and lower average interest rates. The weighted average interest rate during first 28 weeks of fiscal 2021 was 5.5%, excluding deferred financing costs and original issue discount, compared to 6.0% during the first 28 weeks of fiscal 2020.\n26\nLoss of Debt Extinguishment\nThere was no loss on debt extinguishment during both the second quarter of fiscal 2021 and first 28 weeks of fiscal 2021, compared to loss on debt extinguishment of $49.1 million during both the second quarter of fiscal 2020 and first 28 weeks of fiscal 2020. The loss on debt extinguishment during the second quarter and first 28 weeks of fiscal 2020 primarily consisted of a redemption premium payment and write-off of debt discounts associated with the redemption of the Company's 6.625% Senior Unsecured Notes due 2024 (the \"2024 Notes\").\nOther Income, Net\nFor the second quarter of fiscal 2021, Other income, net was $18.9 million compared to $11.4 million for the second quarter of fiscal 2020. Other income, net during the second quarter of fiscal 2021 was primarily driven by non-service cost components of net pension and post-retirement expense and income related to our equity investment, partially offset by unrealized losses from non-operating investments. Other income, net during the second quarter of fiscal 2020 was primarily driven by non-service cost components of net pension and post-retirement expense and income related to our equity investment.\nFor the first 28 weeks of fiscal 2021, Other income, net was $62.4 million compared to $8.3 million for the first 28 weeks of fiscal 2020. Other income, net during the first 28 weeks of fiscal 2021 was primarily driven by non-service cost components of net pension and post-retirement expense, realized gains from non-operating investments and income related to our equity investment, partially offset by unrealized losses from non-operating investments. Other income, net during the first 28 weeks of fiscal 2020 was primarily driven by non-service cost components of net pension and post-retirement expense and income related to our equity investment, partially offset by recognized losses on interest rate swaps and unrealized losses from non-operating investments.\nIncome Taxes\nIncome tax expense was $100.3 million, representing a 25.4% effective tax rate, for the second quarter of fiscal 2021. Income tax expense was $111.2 million, representing a 28.1% effective tax rate, for the second quarter of fiscal 2020. The decrease in the effective tax rate was primarily driven by nondeductible transaction-related costs incurred during the second quarter of fiscal 2020.\nIncome tax expense was $232.8 million, representing a 23.9% effective tax rate, for the first 28 weeks of fiscal 2021. Income tax expense was $313.1 million, representing a 26.4% effective tax rate, for the first 28 weeks of fiscal 2020. The decrease in the effective income tax rate was primarily driven by the recognition of discrete state income tax benefits during the first 28 weeks of fiscal 2021 and certain nondeductible transaction-related costs incurred during the first 28 weeks of fiscal 2020.\nWe currently expect our annual effective tax rate for fiscal 2021 to be in the range of approximately 23% to 24%.\nNet Income and Adjusted Net Income\nNet income was $295.2 million, or $0.52 per Class A common share, during the second quarter of fiscal 2021 compared to $284.5 million, or $0.49 per Class A common share, during the second quarter of fiscal 2020. Adjusted net income was $369.5 million, or $0.64 per Class A common share, during the second quarter of fiscal 2021 compared to $356.4 million, or $0.60 per Class A common share, during the second quarter of fiscal 2020.\nNet income was $740.0 million, or $1.26 per Class A common share, during the first 28 weeks of fiscal 2021 compared to $870.7, or $1.49 per Class A common share, during the first 28 weeks of fiscal 2020. Adjusted net income was $887.0 million, or $1.53 per Class A common share, during the first 28 weeks of fiscal 2021 compared to $1,157.6 million, or $1.95 per Class A common share, during the first 28 weeks of fiscal 2020.\n27\nAdjusted EBITDA\nFor the second quarter of fiscal 2021, Adjusted EBITDA was $965.4 million, or 5.8% of Net sales and other revenue, compared to $948.4 million, or 6.0% of Net sales and other revenue, for the second quarter of fiscal 2020. The increase in Adjusted EBITDA was primarily the result of an increase in Net sales and other revenue, partially offset by an increase in Selling and administrative expenses. For the first 28 weeks of fiscal 2021, Adjusted EBITDA was $2,273.5 million, or 6.0% of Net sales and other revenue, compared to $2,639.4 million, or 6.9% of Net sales and other revenue for the first 28 weeks of fiscal 2020. The decrease in Adjusted EBITDA was primarily the result of a decrease in Net sales and other revenue.\nSupplemental Two-Year Results - Comparison of Second Quarter of Fiscal 2021 to Second Quarter of Fiscal 2019\nThe following table provides a comparison of the second quarter of fiscal 2021 to the second quarter of fiscal 2019 for certain financial measures, including a compounded annual growth rate (\"CAGR\"), to demonstrate the two-year growth in our business. We believe these supplemental comparisons provide meaningful and useful information to investors about the trends in our business relative to pre-COVID-19 pandemic periods. These comparisons should not be reviewed in isolation or considered substitutes for our financial results included elsewhere in this Form 10-Q.\n| Second Quarter of Fiscal 2021 Supplemental Two-Year Results |\n| Identical sales two-year stacked (1) | 15.3 | % |\n| Net income per Class A common share two-year CAGR (2) | 1.0 | % |\n| Adjusted net income per Class A common share two-year CAGR | 94.0 | % |\n| Net income two-year CAGR (2) | 0.1 | % |\n| Adjusted net income two-year CAGR | 93.0 | % |\n| Adjusted EBITDA two-year CAGR | 30.4 | % |\n| Margins: |\n| Gross profit (1) | Increased 85 basis points |\n| Selling and administrative expenses (1) | Decreased 120 basis points |\n\n(1) Excluding fuel.\n(2) The net income per Class A common share two-year CAGR and net income two-year CAGR are impacted by gains related to sale leaseback transactions in the second quarter of fiscal 2019.\nNet sales and other revenue was $16.5 billion during the second quarter of fiscal 2021 compared to $14.2 billion during the second quarter of fiscal 2019. The increase in sales compared to the second quarter of fiscal 2019 was primarily due to the 15.3% increase in two-year stacked identical sales. Identical sales were driven in part by the 248% two-year stacked increase in digital sales.\nGross profit margin was 28.6% during the second quarter of fiscal 2021 compared to 27.8% during the second quarter of fiscal 2019. Excluding the impact of fuel, gross profit margin increased by approximately 85 basis points compared to the second quarter of fiscal 2019, primarily driven by sales leverage, improvements in shrink expense, productivity initiatives and improved pharmacy margins related to administering COVID-19 vaccines, partially offset by growth in digital sales and an increase in supply chain costs and COVID-19 expenses.\n28\nSelling and administrative expenses were 25.6% of sales during the second quarter of fiscal 2021 compared to 26.8% of sales for the second quarter of fiscal 2019. Excluding the impact of fuel, selling and administrative expenses as a percentage of sales decreased approximately 120 basis points primarily due to sales leverage and the execution of productivity initiatives, partially offset by increases in employee costs and other expenses related to our investments in our digital and omni-channel capabilities and strategic priorities and increased market driven retail wage rates, higher equity-based compensation expense as well as incremental COVID-19 expenses.\n29\nReconciliation of Non-GAAP Measures\nThe following tables reconcile Net income to Adjusted net income, and Net income per Class A common share to Adjusted net income per Class A common share (in millions, except per share data):\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Numerator: |\n| Net income | $ | 295.2 | $ | 284.5 | $ | 294.8 |\n| Adjustments: |\n| (Gain) loss on interest rate and commodity hedges, net (d) | (1.2) | 1.4 | — |\n| Facility closures and transformation (1)(b) | 14.8 | 6.1 | — |\n| Acquisition and integration costs (2)(b) | 3.4 | 2.2 | 7.5 |\n| Equity-based compensation expense (b) | 26.8 | 9.3 | 6.5 |\n| (Gain) loss on property dispositions and impairment losses, net (3) | (0.2) | (18.3) | (435.5) |\n| LIFO expense (a) | 14.6 | 10.1 | 5.8 |\n| Government-mandated incremental COVID-19 pandemic related pay (4)(b) | 18.3 | — | — |\n| Civil disruption related costs (5)(b) | — | (1.9) | — |\n| Transaction and reorganization costs related to Convertible Preferred Stock issuance and initial public offering (b) | — | 4.1 | — |\n| Amortization of debt discount and deferred financing costs (c) | 4.7 | 4.7 | 35.4 |\n| Loss on debt extinguishment | — | 49.1 | 23.1 |\n| Amortization of intangible assets resulting from acquisitions (b) | 11.5 | 13.1 | 68.9 |\n| Miscellaneous adjustments (6)(f) | 5.1 | 13.3 | 24.3 |\n| Tax impact of adjustments to Adjusted net income | (23.5) | (21.3) | 68.4 |\n| Adjusted net income | $ | 369.5 | $ | 356.4 | $ | 99.2 |\n| Denominator: |\n| Weighted average Class A common shares outstanding - diluted | 573.0 | 582.9 | 580.6 |\n| Adjustments: |\n| Restricted stock units and awards (7) | 8.1 | 9.6 | 7.6 |\n| Adjusted weighted average Class A common shares outstanding - diluted | 581.1 | 592.5 | 588.2 |\n| Adjusted net income per Class A common share - diluted | $ | 0.64 | $ | 0.60 | $ | 0.17 |\n| Supplemental Two-Year CAGR: |\n| Net income two-year CAGR | 0.1 | % |\n| Adjusted net income two-year CAGR | 93.0 | % |\n\n30\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Net income per Class A common share - diluted | $ | 0.52 | $ | 0.49 | $ | 0.51 |\n| Non-GAAP adjustments (8) | 0.13 | 0.12 | (0.33) |\n| Restricted stock units and awards (7) | (0.01) | (0.01) | (0.01) |\n| Adjusted net income per Class A common share - diluted | $ | 0.64 | $ | 0.60 | $ | 0.17 |\n| Supplemental Two-Year CAGR: |\n| Net income per Class A common share two-year CAGR | 1.0 | % |\n| Adjusted net income per Class A common share two-year CAGR | 94.0 | % |\n\nThe following table is a reconciliation of Adjusted net income to Adjusted EBITDA:\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Adjusted net income (9) | $ | 369.5 | $ | 356.4 | $ | 99.2 |\n| Tax impact of adjustments to Adjusted net income | 23.5 | 21.3 | (68.4) |\n| Income tax expense | 100.3 | 111.2 | 81.9 |\n| Amortization of debt discount and deferred financing costs (c) | (4.7) | (4.7) | (35.4) |\n| Interest expense, net | 109.3 | 128.6 | 177.5 |\n| Amortization of intangible assets resulting from acquisitions (b) | (11.5) | (13.1) | (68.9) |\n| Depreciation and amortization (e) | 379.0 | 348.7 | 381.7 |\n| Adjusted EBITDA | $ | 965.4 | $ | 948.4 | $ | 567.6 |\n| Supplemental Two-Year CAGR: |\n| Adjusted EBITDA two-year CAGR | 30.4 | % |\n\n(1) Includes costs related to closures of operating facilities and third-party consulting fees related to our strategic priorities and associated business transformation.\n(2) Related to conversion activities and related costs associated with integrating acquired businesses. Also includes expenses related to management fees in prior periods paid in connection with acquisition and financing activities.\n(3) Primarily due to gains related to sale leaseback transactions in the second quarter of fiscal 2019.\n(4) Represents incremental pay that is legislatively required in certain municipalities in which we operate.\n(5) Primarily includes costs related to store damage, inventory losses and community support as a result of the civil disruption during late May 2020 and early June 2020 in certain markets.\n31\n(6) Miscellaneous adjustments include the following (see table below):\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Non-cash lease-related adjustments | $ | 1.0 | $ | (0.1) | $ | 4.4 |\n| Lease and lease-related costs for surplus and closed stores | 6.5 | 10.8 | 5.2 |\n| Net realized and unrealized (gain) loss on non-operating investments | 12.8 | 0.2 | 10.8 |\n| Other (i) | (15.2) | 2.4 | 3.9 |\n| Total miscellaneous adjustments | $ | 5.1 | $ | 13.3 | $ | 24.3 |\n\n(i) Primarily includes adjustments for pension settlement gain, certain legal and regulatory accruals, unconsolidated equity investments and certain contract termination costs.\n(7) Represents incremental unvested RSUs and unvested RSAs to adjust the diluted weighted average Class A common shares outstanding during each respective period to the fully outstanding RSUs and RSAs as of the end of each respective period.\n(8) Reflects the per share impact of Non-GAAP adjustments for each period. See the reconciliation of Net income to Adjusted net income above for further details.\n(9) See the reconciliation of Net income to Adjusted net income above for further details.\nNon-GAAP adjustment classifications within the Consolidated Statement of Operations:\n(a) Cost of sales\n(b) Selling and administrative expenses\n(c) Interest expense, net\n(d) (Gain) loss on interest rate and commodity hedges, net:\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Cost of sales | $ | (1.2) | $ | 1.0 | $ | — |\n| Other income, net | — | 0.4 | — |\n| Total (Gain) loss on interest rate and commodity hedges, net | $ | (1.2) | $ | 1.4 | $ | — |\n\n(e) Depreciation and amortization:\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Cost of sales | $ | 36.0 | $ | 40.1 | $ | 38.0 |\n| Selling and administrative expenses | 343.0 | 308.6 | 343.7 |\n| Total Depreciation and amortization | $ | 379.0 | $ | 348.7 | $ | 381.7 |\n\n(f) Miscellaneous adjustments:\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Selling and administrative expenses | $ | 3.4 | $ | 9.9 | $ | 9.6 |\n| Other income, net | 1.7 | 3.4 | 14.7 |\n| Total Miscellaneous adjustments | $ | 5.1 | $ | 13.3 | $ | 24.3 |\n\n32\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Numerator: |\n| Net income | $ | 740.0 | $ | 870.7 | $ | 343.8 |\n| Adjustments: |\n| (Gain) loss on interest rate and commodity hedges, net (d) | (7.5) | 25.9 | 0.3 |\n| Facility closures and transformation (1)(b) | 35.6 | 15.9 | — |\n| Acquisition and integration costs (2)(b) | 6.9 | 8.5 | 33.6 |\n| Equity-based compensation expense (b) | 49.0 | 28.3 | 17.6 |\n| Loss (gain) on property dispositions and impairment losses, net (3) | 0.1 | 12.0 | (464.0) |\n| LIFO expense (a) | 29.1 | 23.2 | 16.3 |\n| Discretionary COVID-19 pandemic related costs (4)(b) | — | 89.9 | — |\n| Government-mandated incremental COVID-19 pandemic related pay (5)(b) | 47.4 | — | — |\n| Civil disruption related costs (6)(b) | — | 13.0 | — |\n| Transaction and reorganization costs related to Convertible Preferred Stock issuance and initial public offering (b) | — | 24.4 | — |\n| Amortization of debt discount and deferred financing costs (c) | 11.1 | 11.2 | 43.8 |\n| Loss on debt extinguishment | — | 49.1 | 65.8 |\n| Amortization of intangible assets resulting from acquisitions (b) | 27.6 | 30.6 | 161.7 |\n| Miscellaneous adjustments (7)(f) | (5.7) | 47.4 | 33.1 |\n| Tax impact of adjustments to Adjusted net income | (46.6) | (92.5) | 23.7 |\n| Adjusted net income | $ | 887.0 | $ | 1,157.6 | $ | 275.7 |\n| Denominator: |\n| Weighted average Class A common shares outstanding - diluted | 470.6 | 583.3 | 580.0 |\n| Adjustments: |\n| Convertible Preferred Stock (8) | 101.6 | — | — |\n| Restricted stock units and awards (9) | 8.8 | 9.2 | 8.2 |\n| Adjusted weighted average Class A common shares outstanding - diluted | 581.0 | 592.5 | 588.2 |\n| Adjusted net income per Class A common share - diluted | $ | 1.53 | $ | 1.95 | $ | 0.47 |\n| Supplemental Two-Year CAGR: |\n| Net income two-year CAGR | 46.7 | % |\n| Adjusted net income two-year CAGR | 79.4 | % |\n\n33\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Net income per Class A common share - diluted | $ | 1.26 | $ | 1.49 | $ | 0.59 |\n| Convertible Preferred Stock (8) | 0.03 | — | — |\n| Non-GAAP adjustments (10) | 0.26 | 0.49 | (0.11) |\n| Restricted stock units and awards (9) | (0.02) | (0.03) | (0.01) |\n| Adjusted net income per Class A common share - diluted | $ | 1.53 | $ | 1.95 | $ | 0.47 |\n| Supplemental Two-Year CAGR: |\n| Net income per Class A common share two-year CAGR | 46.1 | % |\n| Adjusted net income per Class A common share two-year CAGR | 80.4 | % |\n\nThe following table is a reconciliation of Adjusted net income to Adjusted EBITDA:\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Adjusted net income (11) | $ | 887.0 | $ | 1,157.6 | $ | 275.7 |\n| Tax impact of adjustments to Adjusted net income | 46.6 | 92.5 | (23.7) |\n| Income tax expense | 232.8 | 313.1 | 97.6 |\n| Amortization of debt discount and deferred financing costs (c) | (11.1) | (11.2) | (43.8) |\n| Interest expense, net | 262.6 | 309.2 | 402.7 |\n| Amortization of intangible assets resulting from acquisitions (b) | (27.6) | (30.6) | (161.7) |\n| Depreciation and amortization (e) | 883.2 | 808.8 | 897.6 |\n| Adjusted EBITDA | $ | 2,273.5 | $ | 2,639.4 | $ | 1,444.4 |\n| Supplemental Two-Year CAGR: |\n| Adjusted EBITDA two-year CAGR | 25.5 | % |\n\n(1) Includes costs related to closures of operating facilities and third-party consulting fees related to our strategic priorities and associated business transformation.\n(2) Related to conversion activities and related costs associated with integrating acquired businesses. Also includes expenses related to management fees in prior periods paid in connection with acquisition and financing activities.\n(3) Primarily due to gains related to sale leaseback transactions in the second quarter of fiscal 2019.\n(4) Includes $53 million of charitable contributions to our communities for hunger relief and $36.9 million in final reward payments to front-line associates at the end of the first quarter of fiscal 2020.\n(5) Represents incremental pay that is legislatively required in certain municipalities in which we operate.\n(6) Primarily includes costs related to store damage, inventory losses and community support as a result of the civil disruption during late May 2020 and early June 2020 in certain markets.\n34\n(7) Miscellaneous adjustments include the following (see table below):\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Non-cash lease-related adjustments | $ | 3.1 | $ | 1.9 | $ | 6.3 |\n| Lease and lease-related costs for surplus and closed stores | 16.7 | 29.5 | 12.0 |\n| Net realized and unrealized (gain) loss on non-operating investments | (9.7) | 4.7 | 7.5 |\n| Other (i) | (15.8) | 11.3 | 7.3 |\n| Total miscellaneous adjustments | $ | (5.7) | $ | 47.4 | $ | 33.1 |\n\n(i) Primarily includes adjustments for pension settlement gain, certain legal and regulatory accruals, unconsolidated equity investments and certain contract termination costs.\n(8) Represents the conversion of Convertible Preferred Stock to the fully outstanding as-converted Class A common shares as of the end of each respective period, for periods in which the Convertible Preferred Stock is antidilutive under GAAP.\n(9) Represents incremental unvested RSUs and unvested RSAs to adjust the diluted weighted average Class A common shares outstanding during each respective period to the fully outstanding RSUs and RSAs as of the end of each respective period.\n(10) Reflects the per share impact of Non-GAAP adjustments for each period. See the reconciliation of Net income to Adjusted net income above for further details.\n(11) See the reconciliation of Net income to Adjusted net income above for further details.\nNon-GAAP adjustment classifications within the Consolidated Statement of Operations:\n(a) Cost of sales\n(b) Selling and administrative expenses\n(c) Interest expense, net\n35\n(d) (Gain) loss on interest rate and commodity hedges, net:\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Cost of sales | $ | (7.8) | $ | 6.5 | $ | 0.3 |\n| Other income, net | 0.3 | 19.4 | — |\n| Total (Gain) loss on interest rate and commodity hedges, net | $ | (7.5) | $ | 25.9 | $ | 0.3 |\n\n(e) Depreciation and amortization:\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Cost of sales | $ | 86.8 | $ | 94.1 | $ | 90.0 |\n| Selling and administrative expenses | 796.4 | 714.7 | 807.6 |\n| Total Depreciation and amortization | $ | 883.2 | $ | 808.8 | $ | 897.6 |\n\n(f) Miscellaneous adjustments:\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Selling and administrative expenses | $ | 10.2 | $ | 34.7 | $ | 16.7 |\n| Other income, net | (15.9) | 12.7 | 16.4 |\n| Total Miscellaneous adjustments | $ | (5.7) | $ | 47.4 | $ | 33.1 |\n\nLIQUIDITY AND CAPITAL RESOURCES\nThe following table sets forth the major sources and uses of cash and cash equivalents and restricted cash for each period (in millions):\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 |\n| Cash and cash equivalents and restricted cash at end of period | $ | 2,900.4 | $ | 2,431.9 |\n| Cash flows provided by operating activities | 2,137.7 | 2,720.8 |\n| Cash flows used in investing activities | (790.5) | (687.1) |\n| Cash flows used in financing activities | (214.4) | (80.7) |\n\nNet Cash Provided by Operating Activities\nNet cash provided by operating activities was $2,137.7 million for the first 28 weeks of fiscal 2021 compared to $2,720.8 million for the first 28 weeks of fiscal 2020. The decrease in cash flow from operations compared to the first 28 weeks of fiscal 2020 was due to changes in working capital primarily related to accounts payable as our business experienced significantly elevated demand during the first 28 weeks of fiscal 2020 and a deferral of approximately $270 million of the employer-paid portion of social security taxes in the first 28 weeks of fiscal 2020 together with lower EBITDA during the first 28 weeks of fiscal 2021. These decreases were partially offset by less cash paid for interest and income taxes of $94 million and $72 million, respectively, $75 million payment for the UFCW & Employers Midwest Pension Fund settlement in the first 28 weeks of fiscal 2020 and a decrease of $45.1 million in contributions to our defined benefit pension plans and post-retirement benefit plans.\n36\nNet Cash Used by Investing Activities\nNet cash used in investing activities was $790.5 million for the first 28 weeks of fiscal 2021 compared to $687.1 million for the first 28 weeks of fiscal 2020.\nFor the first 28 weeks of fiscal 2021, cash used in investing activities consisted primarily of payments for property and equipment of $822.5 million and payments for business acquisitions of $23.5 million, partially offset by proceeds from the sale of long-lived assets of $24.6 million. Payments for property and equipment in the first 28 weeks of fiscal 2021 included the opening of six new stores, completion of 76 remodels and increased investment in our digital technology. For the first 28 weeks of fiscal 2020, cash used in investing activities consisted primarily of payments for property and equipment of $702.9 million. Payments for property and equipment in the first 28 weeks of fiscal 2020 included the completion of 132 remodels and continued investment in our digital technology. For the full fiscal year of 2021, we expect capital expenditures to be in the range of $1.9 billion to $2.0 billion.\nNet Cash Used in Financing Activities\nNet cash used in financing activities was $214.4 million during the first 28 weeks of fiscal 2021 compared to $80.7 million during the first 28 weeks of fiscal 2020.\nNet cash used in financing activities during the first 28 weeks of fiscal 2021 consisted primarily of dividends paid on our Class A common stock and Convertible Preferred Stock. Net cash used in financing activities during the first 28 weeks of fiscal 2020 consisted primarily of the $1.5 billion issuance of new Senior Unsecured Notes and $1.25 billion aggregate redemption of 2024 Notes and 2025 Notes, the $2.0 billion borrowing and subsequent repayment of the ABL Facility, the issuance of the Convertible Preferred Stock and the repurchase of outstanding Class A common stock.\nLiquidity and Factors Affecting Liquidity\nWe estimate our liquidity needs over the next 12 months to be in the range of $4.75 billion to $5.25 billion, which includes anticipated requirements for incremental working capital, capital expenditures, pension obligations, interest payments and scheduled principal payments of debt, dividends on Class A common stock and Convertible Preferred Stock, operating leases and finance leases. Based on current operating trends, we believe that cash flows from operating activities and other sources of liquidity, including borrowings under our ABL Facility, will be adequate to meet our liquidity needs for the next 12 months and for the foreseeable future. We believe we have adequate cash flow to continue to respond effectively to competitive conditions. In addition, we may enter into refinancing and sale leaseback transactions from time to time. There can be no assurance, however, that our business will continue to generate cash flow at or above current levels or that we will maintain our ability to borrow under our ABL Facility.\nThe holders of Convertible Preferred Stock are entitled to a quarterly dividend at a rate per annum of 6.75% of the liquidation preference per share of the Convertible Preferred Stock. On March 15, 2021, June 15, 2021 and September 15, 2021, we declared quarterly cash dividends of $29.5 million, respectively, to holders of the Convertible Preferred Stock, which was paid on March 31, 2021, June 30, 2021 and September 30, 2021, respectively. In addition, the holders of Convertible Preferred Stock will participate in cash dividends that we pay on our common stock to the extent that such cash dividends exceed $206.25 million per fiscal year.\n37\nWe have established a dividend policy pursuant to which we intend to pay a quarterly dividend on our Class A common stock. During the first 28 weeks of fiscal 2021, we paid quarterly cash dividends of $0.10 per share of Class A common stock on May 10, 2021 and August 10, 2021, to stockholders of record as of the close of business on April 26, 2021 and July 26, 2021, respectively. On October 18, 2021, subsequent to the end of the second quarter of fiscal 2021, we announced a 20% increase to our quarterly dividend, which is now $0.12 per share of Class A common stock, payable on November 12, 2021 to stockholders of record as of the close of business on October 29, 2021.\nAs of September 11, 2021, we had no borrowings outstanding under out ABL Facility and total availability of $3,483.1 million (net of letter of credit usage).\nMultiemployer Pension Plans\nThe American Rescue Plan Act (\"ARP Act\") establishes a special financial assistance program for financially troubled multiemployer pension plans. Under the ARP Act, eligible multiemployer plans can apply to receive a one-time cash payment in the amount projected by the Pension Benefit Guaranty Corporation (\"PBGC\") to pay pension benefits through the plan year ending 2051. The payment received by the multiemployer plan under this special financial assistance program would not be considered a loan and would not need to be paid back. Any financial assistance received by the multiemployer plan would need to be segregated from the other assets of the multiemployer plans and invested in investment grade bonds or other investments permitted by the PBGC.\nOf the 27 multiemployer plans to which we contribute, 16 plans are classified as \"Critical\" or \"Critical and Declining\" and are potentially eligible for special financial assistance under the ARP Act. Though the amount of financial assistance that each of these 16 plans could receive will vary by plan, we currently estimate that these 16 plans represent over 90% of the $4.7 billion we estimated as our share of the underfunding of the 27 plans. On July 9, 2021, the PBGC issued its interim final rule with respect to the special financial assistance program. The PBGC interim final rule provides direction on the application requirements, identifies which plans will have priority, eligibility requirements, the determination of the amount of financial assistance to be provided and establishes conditions and restrictions that apply to plans that receive assistance. We are evaluating the interim final rule and have submitted comments during the 30-day comment period, and we expect the special financial assistance program to provide funding for the multiemployer plans to which we contribute to remain solvent through the next 25 to 30 years.\nCRITICAL ACCOUNTING POLICIES\nThe preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. We have chosen accounting policies that we believe are appropriate to report accurately and fairly our operating results and financial position, and we apply those accounting policies in a fair and consistent manner. See the Critical Accounting Policies section included in our Annual Report on Form 10-K for the fiscal year ended February 27, 2021, filed with the SEC on April 28, 2021, for a discussion of our significant accounting policies.\nRECENTLY ISSUED AND RECENTLY ADOPTED ACCOUNTING STANDARDS\nSee Note 1 - Basis of presentation and summary of significant accounting policies of our unaudited interim Condensed Consolidated Financial Statements located elsewhere in this Form 10-Q.\n38\nItem 3\n-\nQuantitative and Qualitative Disclosures About Market Risk\nThere have been no material changes in our exposure to market risk from the information provided in our Annual Report on Form 10-K for the fiscal year ended February 27, 2021, filed with the SEC on April 28, 2021.\nItem 4 - Controls and Procedures\nBased on their evaluation of our disclosure controls and procedures (as defined in Rules 13a-15 and 15d-15 under the Securities Exchange Act of 1934 (the \"Exchange Act\")) as of the end of the period covered by this Form 10-Q, our Principal Executive Officer and Principal Financial Officer concluded our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms and is accumulated and communicated to management, including our Principal Executive Officer and Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting during the second quarter of fiscal 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n39\nPART II - OTHER INFORMATION\nItem 1 - Legal Proceedings\nThe Company is subject from time to time to various claims and lawsuits arising in the ordinary course of business, including lawsuits involving trade practices, lawsuits alleging violations of state and/or federal wage and hour laws (including alleged violations of meal and rest period laws and alleged misclassification issues), real estate disputes as well as other matters. Some of these claims or suits purport or may be determined to be class actions and/or seek substantial damages. It is the opinion of the Company's management that although the amount of liability with respect to certain of the matters described in this Form 10-Q cannot be ascertained at this time, any resulting liability of these and other matters, including any punitive damages, will not have a material adverse effect on the Company's business or financial condition. See the matters under the caption Legal Proceedings in Note 6 - Commitments and contingencies and off balance sheet arrangements in the unaudited interim Condensed Consolidated Financial Statements located elsewhere in this Form 10-Q.\nItem 1A - Risk Factors\nThere have been no material changes to the risk factors previously included in our Annual Report on Form 10-K for the fiscal year ended February 27, 2021, filed with the SEC on April 28, 2021, under the heading \"Risk Factors.\"\nItem 2 - Unregistered Sales of Equity Securities and Use of Proceeds\n(a) Unregistered Sales of Equity Securities\nNone.\n(b) Use of Proceeds\nNone.\n(c) Purchases of Equity Securities\nNone.\nItem 3 - Defaults Upon Senior Securities\nNone.\nItem 4 - Mine Safety Disclosures\nNot Applicable.\nItem 5 - Other Information\nNone.\n40\nItem 6 - Exhibits\n3.1 Certificate of Amendment to the Amended and Restated Certificate of Incorporation of Albertsons Companies, Inc.\n10.1 Employment Agreement, dated as of August 4, 2021, by and between Albertsons Companies, Inc. and Sharon McCollam (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on August 11, 2021)\n31.1 Certification of the Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002\n31.2 Certification of the Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002\n32.1 Certification of the Principal Executive Officer and of the Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002\nEXHIBIT 101.INS - Inline XBRL Instance Document\nEXHIBIT 101.SCH - Inline XBRL Taxonomy Extension Schema Document\nEXHIBIT 101.CAL - Inline XBRL Taxonomy Extension Calculation Linkbase Document\nEXHIBIT 101.DEF - Inline XBRL Taxonomy Extension Definition Linkbase Document\nEXHIBIT 101.LAB - Inline XBRL Taxonomy Extension Label Linkbase Document\nEXHIBIT 101.PRE - Inline XBRL Taxonomy Extension Presentation Linkbase Document\nEXHIBIT 104 - Cover Page Interactive Data File (embedded within the Inline XBRL document)\n41\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n| Albertsons Companies, Inc.(Registrant) |\n| Date: | October 20, 2021 | By: | /s/ Vivek Sankaran |\n| Vivek Sankaran |\n| Chief Executive Officer and Director(Principal Executive Officer) |\n\n| Date: | October 20, 2021 | By: | /s/ Sharon McCollam |\n| Sharon McCollam |\n| President and Chief Financial Officer(Principal Financial Officer) |\n\n42\n \n\nWhat is the rate of increase in total debt as a percentage of total assets from February 27, 2021 to September 11, 2021 in percent?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nItem 1 - Condensed Consolidated Financial Statements (unaudited)\\nAlbertsons Companies, Inc. and Subsidiaries\\nCondensed Consolidated Balance Sheets\\n(in millions, except share data)\\n(unaudited)\\n| September 11,2021 | February 27,2021 |\\n| ASSETS |\\n| Current assets |\\n| Cash and cash equivalents | $ | 2,849.8 | $ | 1,717.0 |\\n| Receivables, net | 544.7 | 550.9 |\\n| Inventories, net | 4,179.1 | 4,301.3 |\\n| Other current assets | 414.7 | 418.8 |\\n| Total current assets | 7,988.3 | 6,988.0 |\\n| Property and equipment, net | 9,201.1 | 9,412.7 |\\n| Operating lease right-of-use assets | 5,861.3 | 6,015.6 |\\n| Intangible assets, net | 2,181.3 | 2,108.8 |\\n| Goodwill | 1,200.2 | 1,183.3 |\\n| Other assets | 912.1 | 889.6 |\\n| TOTAL ASSETS | $ | 27,344.3 | $ | 26,598.0 |\\n| LIABILITIES |\\n| Current liabilities |\\n| Accounts payable | $ | 3,554.2 | $ | 3,487.3 |\\n| Accrued salaries and wages | 1,492.3 | 1,474.7 |\\n| Current maturities of long-term debt and finance lease obligations | 211.5 | 212.4 |\\n| Current maturities of operating lease obligations | 621.7 | 605.3 |\\n| Other current liabilities | 1,190.0 | 1,052.5 |\\n| Total current liabilities | 7,069.7 | 6,832.2 |\\n| Long-term debt and finance lease obligations | 8,129.1 | 8,101.2 |\\n| Long-term operating lease obligations | 5,464.1 | 5,548.0 |\\n| Deferred income taxes | 598.3 | 533.7 |\\n| Other long-term liabilities | 2,524.1 | 2,659.5 |\\n| Commitments and contingencies |\\n| Series A convertible preferred stock, $ 0.01 par value; 1,750,000 shares authorized, 924,000 shares issued and outstanding as of September 11, 2021 and February 27, 2021 | 844.3 | 844.3 |\\n| Series A-1 convertible preferred stock, $ 0.01 par value; 1,410,000 shares authorized, 826,000 shares issued and outstanding as of September 11, 2021 and February 27, 2021 | 754.8 | 754.8 |\\n| STOCKHOLDERS' EQUITY |\\n| Undesignated preferred stock, $ 0.01 par value; 96,840,000 shares authorized, no shares issued as of September 11, 2021 and February 27, 2021 | — | — |\\n| Class A common stock, $ 0.01 par value; 1,000,000,000 shares authorized, 586,668,103 and 585,574,666 shares issued as of September 11, 2021 and February 27, 2021, respectively | 5.9 | 5.9 |\\n| Class A-1 convertible common stock, $ 0.01 par value; 150,000,000 shares authorized, no shares issued as of September 11, 2021 and February 27, 2021 | — | — |\\n| Additional paid-in capital | 1,936.1 | 1,898.9 |\\n| Treasury stock, at cost, 120,009,647 shares held as of September 11, 2021 and February 27, 2021 | ( 1,907.0 ) | ( 1,907.0 ) |\\n| Accumulated other comprehensive income | 78.7 | 63.5 |\\n| Retained earnings | 1,846.2 | 1,263.0 |\\n| Total stockholders' equity | 1,959.9 | 1,324.3 |\\n| TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY | $ | 27,344.3 | $ | 26,598.0 |\\n\\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\\n3\\nAlbertsons Companies, Inc. and SubsidiariesCondensed Consolidated Statements of Operations and Comprehensive Income (in millions, except per share data)(unaudited)\\n| 12 weeks ended | 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\\n| Net sales and other revenue | $ | 16,505.7 | $ | 15,757.6 | $ | 37,775.1 | $ | 38,509.2 |\\n| Cost of sales | 11,788.7 | 11,182.7 | 26,867.1 | 27,162.8 |\\n| Gross profit | 4,717.0 | 4,574.9 | 10,908.0 | 11,346.4 |\\n| Selling and administrative expenses | 4,231.3 | 4,031.2 | 9,734.9 | 9,800.6 |\\n| (Gain) loss on property dispositions and impairment losses, net | ( 0.2 ) | ( 18.3 ) | 0.1 | 12.0 |\\n| Operating income | 485.9 | 562.0 | 1,173.0 | 1,533.8 |\\n| Interest expense, net | 109.3 | 128.6 | 262.6 | 309.2 |\\n| Loss on debt extinguishment | — | 49.1 | — | 49.1 |\\n| Other income, net | ( 18.9 ) | ( 11.4 ) | ( 62.4 ) | ( 8.3 ) |\\n| Income before income taxes | 395.5 | 395.7 | 972.8 | 1,183.8 |\\n| Income tax expense | 100.3 | 111.2 | 232.8 | 313.1 |\\n| Net income | $ | 295.2 | $ | 284.5 | $ | 740.0 | $ | 870.7 |\\n| Other comprehensive income, net of tax |\\n| Recognition of pension gain | 15.1 | 10.1 | 15.2 | 10.9 |\\n| Other | — | 0.3 | — | 1.2 |\\n| Other comprehensive income | $ | 15.1 | $ | 10.4 | $ | 15.2 | $ | 12.1 |\\n| Comprehensive income | $ | 310.3 | $ | 294.9 | $ | 755.2 | $ | 882.8 |\\n| Net income per Class A common share |\\n| Basic net income per Class A common share | $ | 0.55 | $ | 0.52 | $ | 1.27 | $ | 1.57 |\\n| Diluted net income per Class A common share | 0.52 | 0.49 | 1.26 | 1.49 |\\n| Weighted average Class A common shares outstanding |\\n| Basic | 465.3 | 477.3 | 465.2 | 529.2 |\\n| Diluted | 573.0 | 582.9 | 470.6 | 583.3 |\\n\\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\\n4\\nAlbertsons Companies, Inc. and SubsidiariesCondensed Consolidated Statements of Cash Flows(in millions)(unaudited)\\n| 28 weeks ended |\\n| September 11,2021 | September 12,2020 |\\n| Cash flows from operating activities: |\\n| Net income | $ | 740.0 | $ | 870.7 |\\n| Adjustments to reconcile net income to net cash provided by operating activities: |\\n| Loss on property dispositions and impairment losses, net | 0.1 | 12.0 |\\n| Depreciation and amortization | 883.2 | 808.8 |\\n| Operating lease right-of-use assets amortization | 333.0 | 309.3 |\\n| LIFO expense | 29.1 | 23.2 |\\n| Deferred income tax | 43.0 | 2.8 |\\n| Contributions to pension and post-retirement benefit plans, net of (income) expense | ( 47.5 ) | ( 68.9 ) |\\n| (Gain) loss on interest rate swaps and commodity hedges, net | ( 7.5 ) | 25.9 |\\n| Amortization and write-off of deferred financing costs | 11.1 | 11.2 |\\n| Loss on debt extinguishment | — | 49.1 |\\n| Equity-based compensation expense | 49.0 | 28.3 |\\n| Other | ( 21.2 ) | ( 28.7 ) |\\n| Changes in operating assets and liabilities: |\\n| Receivables, net | ( 6.4 ) | ( 21.7 ) |\\n| Inventories, net | 93.0 | 62.2 |\\n| Accounts payable, accrued salaries and wages and other accrued liabilities | 229.2 | 585.4 |\\n| Operating lease liabilities | ( 249.3 ) | ( 228.4 ) |\\n| Self-insurance assets and liabilities | 36.3 | 24.2 |\\n| Other operating assets and liabilities | 22.6 | 255.4 |\\n| Net cash provided by operating activities | 2,137.7 | 2,720.8 |\\n| Cash flows from investing activities: |\\n| Business acquisitions, net of cash acquired | ( 23.5 ) | — |\\n| Payments for property, equipment and intangibles, including payments for lease buyouts | ( 822.5 ) | ( 702.9 ) |\\n| Proceeds from sale of long-lived assets | 24.6 | 20.6 |\\n| Other investing activities | 30.9 | ( 4.8 ) |\\n| Net cash used in investing activities | ( 790.5 ) | ( 687.1 ) |\\n| Cash flows from financing activities: |\\n| Proceeds from issuance of long-term debt | — | 3,500.0 |\\n| Payments on long-term borrowings | ( 0.5 ) | ( 3,388.5 ) |\\n| Payments of obligations under finance leases | ( 32.2 ) | ( 32.9 ) |\\n| Payment of redemption premium on debt extinguishment | — | ( 41.4 ) |\\n| Payments for debt financing costs | — | ( 15.6 ) |\\n| Dividends paid on common stock | ( 93.0 ) | — |\\n| Dividends paid on convertible preferred stock | ( 59.1 ) | — |\\n| Proceeds from convertible preferred stock | — | 1,680.0 |\\n| Third party issuance costs on convertible preferred stock | — | ( 80.9 ) |\\n| Treasury stock purchase, at cost | — | ( 1,680.0 ) |\\n| Employee tax withholding on vesting of restricted stock units | ( 11.8 ) | ( 6.7 ) |\\n| Other financing activities | ( 17.8 ) | ( 14.7 ) |\\n| Net cash used in financing activities | ( 214.4 ) | ( 80.7 ) |\\n| Net increase in cash and cash equivalents and restricted cash | 1,132.8 | 1,953.0 |\\n| Cash and cash equivalents and restricted cash at beginning of period | 1,767.6 | 478.9 |\\n| Cash and cash equivalents and restricted cash at end of period | $ | 2,900.4 | $ | 2,431.9 |\\n\\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\\n5\\nAlbertsons Companies, Inc. and SubsidiariesCondensed Consolidated Statements of Stockholders' Equity(in millions, except share data)(unaudited)\\n| Class A Common Stock | Additional paid in capital | Treasury Stock | Accumulated other comprehensive income | Retained earnings | Total stockholders' equity |\\n| Shares | Amount | Shares | Amount |\\n| Balance as of February 27, 2021 | 585,574,666 | $ | 5.9 | $ | 1,898.9 | 120,009,647 | $ | ( 1,907.0 ) | $ | 63.5 | $ | 1,263.0 | $ | 1,324.3 |\\n| Equity-based compensation | — | — | 22.2 | — | — | — | — | 22.2 |\\n| Shares issued and employee tax withholding on vesting of restricted stock units | 945,942 | — | ( 10.0 ) | — | — | — | — | ( 10.0 ) |\\n| Cash dividends declared on common stock | — | — | — | — | — | — | ( 46.5 ) | ( 46.5 ) |\\n| Dividends accrued on convertible preferred stock | — | — | — | — | — | — | ( 36.4 ) | ( 36.4 ) |\\n| Net income | — | — | — | — | — | — | 444.8 | 444.8 |\\n| Other comprehensive income, net of tax | — | — | — | — | — | 0.1 | — | 0.1 |\\n| Other activity | — | — | — | — | — | — | ( 0.1 ) | ( 0.1 ) |\\n| Balance as of June 19, 2021 | 586,520,608 | $ | 5.9 | $ | 1,911.1 | 120,009,647 | $ | ( 1,907.0 ) | $ | 63.6 | $ | 1,624.8 | $ | 1,698.4 |\\n| Equity-based compensation | — | — | 26.8 | — | — | — | — | 26.8 |\\n| Shares issued and employee tax withholding on vesting of restricted stock units | 147,495 | — | ( 1.8 ) | — | — | — | — | ( 1.8 ) |\\n| Cash dividends declared on common stock | — | — | — | — | — | — | ( 46.5 ) | ( 46.5 ) |\\n| Dividends accrued on convertible preferred stock | — | — | — | — | — | — | ( 27.3 ) | ( 27.3 ) |\\n| Net income | — | — | — | — | — | — | 295.2 | 295.2 |\\n| Other comprehensive income, net of tax | — | — | — | — | — | 15.1 | — | 15.1 |\\n| Balance as of September 11, 2021 | 586,668,103 | $ | 5.9 | $ | 1,936.1 | 120,009,647 | $ | ( 1,907.0 ) | $ | 78.7 | $ | 1,846.2 | $ | 1,959.9 |\\n\\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\\n6\\nAlbertsons Companies, Inc. and SubsidiariesCondensed Consolidated Statements of Stockholders' Equity(in millions, except share data)(unaudited)\\n| Class A Common Stock | Additional paid in capital | Treasury Stock | Accumulated other comprehensive loss | Retained earnings | Total stockholders' equity |\\n| Shares | Amount | Shares | Amount |\\n| Balance as of February 29, 2020 | 582,997,251 | $ | 5.8 | $ | 1,824.3 | 3,671,621 | $ | ( 25.8 ) | $ | ( 118.5 ) | $ | 592.3 | $ | 2,278.1 |\\n| Issuance of common stock to Company's parents | 1,312,859 | — | — | — | — | — | — | — |\\n| Equity-based compensation | — | — | 19.0 | — | — | — | — | 19.0 |\\n| Employee tax withholding on vesting of restricted stock units | — | — | ( 6.2 ) | — | — | — | — | ( 6.2 ) |\\n| Repurchase of common stock | — | — | — | 101,611,736 | ( 1,680.0 ) | — | — | ( 1,680.0 ) |\\n| Dividends accrued on convertible preferred stock | — | — | — | — | — | — | ( 3.9 ) | ( 3.9 ) |\\n| Net income | — | — | — | — | — | — | 586.2 | 586.2 |\\n| Other comprehensive income, net of tax | — | — | — | — | — | 1.7 | — | 1.7 |\\n| Balance as of June 20, 2020 | 584,310,110 | $ | 5.8 | $ | 1,837.1 | 105,283,357 | $ | ( 1,705.8 ) | $ | ( 116.8 ) | $ | 1,174.6 | $ | 1,194.9 |\\n| Equity-based compensation | — | — | 9.3 | — | — | — | — | 9.3 |\\n| Shares issued and employee tax withholding on vesting of restricted stock units | 22,101 | — | ( 0.5 ) | — | — | — | — | ( 0.5 ) |\\n| Equity reclassification | — | — | 30.0 | — | — | — | — | 30.0 |\\n| Dividends accrued on convertible preferred stock | — | — | — | — | — | — | ( 26.9 ) | ( 26.9 ) |\\n| Net income | — | — | — | — | — | — | 284.5 | 284.5 |\\n| Other comprehensive loss, net of tax | — | — | — | — | — | 10.4 | — | 10.4 |\\n| Other activity | — | — | ( 0.1 ) | — | — | — | — | ( 0.1 ) |\\n| Balance as of September 12, 2020 | 584,332,211 | $ | 5.8 | $ | 1,875.8 | 105,283,357 | $ | ( 1,705.8 ) | $ | ( 106.4 ) | $ | 1,432.2 | $ | 1,501.6 |\\n\\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\\n7\\nAlbertsons Companies, Inc. and SubsidiariesNotes to Condensed Consolidated Financial Statements(unaudited)\\nNOTE 1 - BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\\nBasis of Presentation\\nThe accompanying interim Condensed Consolidated Financial Statements include the accounts of Albertsons Companies, Inc. and its subsidiaries (the \\\"Company\\\"). All significant intercompany balances and transactions were eliminated. The Condensed Consolidated Balance Sheet as of February 27, 2021 is derived from the Company's annual audited Consolidated Financial Statements, which should be read in conjunction with these Condensed Consolidated Financial Statements and which are included in the Company's Annual Report on Form 10-K for the fiscal year ended February 27, 2021, filed with the Securities and Exchange Commission (the \\\"SEC\\\") on April 28, 2021. Certain information in footnote disclosures normally included in annual financial statements was condensed or omitted for the interim periods presented in accordance with accounting principles generally accepted in the United States of America (\\\"GAAP\\\"). In the opinion of management, the interim data includes all adjustments, consisting of normal recurring adjustments, necessary for a fair statement of the results for the interim periods. The interim results of operations and cash flows are not necessarily indicative of those results and cash flows expected for the year. The Company' s results of operations are for the 12 and 28 weeks ended September 11, 2021 and September 12, 2020.\\nSignificant Accounting Policies\\nRestricted cash: Restricted cash is included in Other current assets or Other assets depending on the remaining term of the restriction and primarily relates to funds held in escrow. The Company had $ 50.6 million of restricted cash as of September 11, 2021 and February 27, 2021.\\nInventories, net: Substantially all of the Company's inventories consist of finished goods valued at the lower of cost or market and net of vendor allowances. The Company uses either item-cost or the retail inventory method to value inventory before application of any last-in, first-out (\\\"LIFO\\\") reserve. Interim LIFO inventory costs are based on management's estimates of expected year-end inventory levels and inflation rates. The Company recorded LIFO expense of $ 14.6 million and $ 10.1 million for the 12 weeks ended September 11, 2021 and September 12, 2020, respectively, and $ 29.1 million and $ 23.2 million for the 28 weeks ended September 11, 2021 and September 12, 2020, respectively.\\nEquity-based compensation: Equity-based compensation expense recognized in the Condensed Consolidated Statements of Operations (in millions):\\n| 12 weeks ended | 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\\n| RSUs | $ | 24.9 | $ | 8.0 | $ | 44.6 | $ | 25.8 |\\n| RSAs | 1.9 | 1.3 | 4.4 | 2.5 |\\n| Total equity-based compensation expense | $ | 26.8 | $ | 9.3 | $ | 49.0 | $ | 28.3 |\\n| Total related tax benefit | $ | 6.4 | $ | 2.0 | $ | 11.5 | $ | 6.6 |\\n\\nAs of September 11, 2021, there was $ 126.2 million of unrecognized costs related to 11.5 million unvested granted restricted stock units (\\\"RSUs\\\"). That cost is expected to be recognized over a weighted average period of 1.8 years. As of September 11, 2021, there was $ 7.3 million of unrecognized costs related to 1.0 million unvested granted restricted common stock (\\\"RSAs\\\"). That cost is expected to be recognized over a weighted average period of 1.9 years.\\nIncome taxes: Income tax expense was $ 100.3 million, representing a 25.4 % effective tax rate, for the 12 weeks ended September 11, 2021. Income tax expense was $ 111.2 million, representing a 28.1 % effective tax rate, for the\\n8\\n12 weeks ended September 12, 2020. The decrease in the effective tax rate was primarily driven by nondeductible transaction-related costs incurred during the 12 weeks ended September 12, 2020.\\nIncome tax expense was $ 232.8 million, representing a 23.9 % effective tax rate, for the 28 weeks ended September 11, 2021. Income tax expense was $ 313.1 million, representing a 26.4 % effective tax rate, for the 28 weeks ended September 12, 2020. The decrease in the effective income tax rate was primarily driven by the recognition of discrete state income tax benefits during the 28 weeks ended September 11, 2021 and certain nondeductible transaction-related costs incurred during the 28 weeks ended September 12, 2020.\\nSegments: The Company and its subsidiaries offer grocery products, general merchandise, health and beauty care products, pharmacy, fuel and other items and services in its stores or through digital channels. The Company's operating divisions are geographically based, have similar economic characteristics and similar expected long-term financial performance. The Company's operating segments and reporting units are its 12 operating divisions, which are reported in one reportable segment. Each reporting unit constitutes a business for which discrete financial information is available and for which management regularly reviews the operating results. Across all operating segments, the Company operates primarily one store format. Each division offers through its stores and digital channels the same general mix of products with similar pricing to similar categories of customers, has similar distribution methods, operates in similar regulatory environments and purchases merchandise from similar or the same vendors.\\nRevenue Recognition: Revenues from the retail sale of products are recognized at the point of sale or delivery to the customer, net of returns and sales tax. Pharmacy sales are recorded upon the customer receiving the prescription. Third-party receivables from pharmacy sales were $ 236.0 million and $ 262.5 million as of September 11, 2021 and February 27, 2021, respectively, and are recorded in Receivables, net. For digital related sales, which primarily include home delivery and Drive Up & Go curbside pickup, revenues are recognized upon either pickup in store or delivery to the customer and may include revenue for separately charged delivery services. The Company records a contract liability when rewards are earned by customers in connection with the Company's loyalty programs. As rewards are redeemed or expire, the Company reduces the contract liability and recognizes revenue. The contract liability balance was immaterial as of September 11, 2021 and February 27, 2021.\\nThe Company records a contract liability when it sells its own proprietary gift cards. The Company records a sale when the customer redeems the gift card. The Company's gift cards do not expire. The Company reduces the contract liability and records revenue for the unused portion of gift cards (\\\"breakage\\\") in proportion to its customers' pattern of redemption, which the Company determined to be the historical redemption rate. The Company's contract liability related to gift cards was $ 76.2 million as of September 11, 2021 and $ 98.1 million as of February 27, 2021. Breakage amounts were immaterial for the 12 and 28 weeks ended September 11, 2021 and September 12, 2020, respectively.\\n9\\nDisaggregated Revenues\\nThe following table represents sales revenue by type of similar product (dollars in millions):\\n| 12 weeks ended | 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\\n| Amount (1) | % of Total | Amount (1) | % of Total | Amount (1) | % of Total | Amount (1) | % of Total |\\n| Non-perishables (2) | $ | 7,268.5 | 44.0 | % | $ | 7,126.6 | 45.2 | % | $ | 16,538.8 | 43.8 | % | $ | 17,910.4 | 46.5 | % |\\n| Perishables (3) | 6,823.2 | 41.3 | 6,654.1 | 42.2 | 15,735.8 | 41.6 | 16,209.7 | 42.1 |\\n| Pharmacy | 1,253.4 | 7.6 | 1,171.8 | 7.5 | 2,982.0 | 7.9 | 2,726.7 | 7.1 |\\n| Fuel | 918.5 | 5.6 | 570.8 | 3.6 | 1,967.8 | 5.2 | 1,160.0 | 3.0 |\\n| Other (4) | 242.1 | 1.5 | 234.3 | 1.5 | 550.7 | 1.5 | 502.4 | 1.3 |\\n| Net sales and other revenue | $ | 16,505.7 | 100.0 | % | $ | 15,757.6 | 100.0 | % | $ | 37,775.1 | 100.0 | % | $ | 38,509.2 | 100.0 | % |\\n\\n(1) Digital related sales are included in the categories to which the revenue pertains.\\n(2) Consists primarily of general merchandise, grocery and frozen foods.\\n(3) Consists primarily of produce, dairy, meat, deli, floral and seafood.\\n(4) Consists primarily of wholesale revenue to third parties, commissions and other miscellaneous revenue.\\nRecently issued accounting standards: In June 2020, the FASB issued ASU 2020-06, \\\"Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity's Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity's Own Equity\\\" (\\\"ASU 2020-06\\\"). ASU 2020-06 simplifies the accounting for certain convertible instruments, amends guidance on derivative scope exceptions for contracts in an entity's own equity and modifies the guidance on diluted earnings per share calculations as a result of these changes. ASU 2020-06 will take effect for public entities for annual reporting periods beginning after December 15, 2021, and interim periods within those fiscal years. Early adoption is permitted. The Company is currently evaluating the effect of this standard on its Consolidated Financial Statements.\\nNOTE 2 - FAIR VALUE MEASUREMENTS\\nThe accounting guidance for fair value established a framework for measuring fair value and established a three-level valuation hierarchy for disclosure of fair value measurement. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability at the measurement date. The three levels are defined as follows:\\nLevel 1 - Quoted prices in active markets for identical assets or liabilities;\\nLevel 2 - Inputs other than quoted prices included within Level 1 that are either directly or indirectly observable; and\\nLevel 3 - Unobservable inputs in which little or no market activity exists, requiring an entity to develop its own assumptions that market participants would use to value the asset or liability.\\nFair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.\\n10\\nThe following table presents assets and liabilities which were measured at fair value on a recurring basis as of September 11, 2021 (in millions):\\n| Fair Value Measurements |\\n| Total | Quoted prices in active markets for identical assets(Level 1) | Significantobservableinputs(Level 2) | Significantunobservableinputs(Level 3) |\\n| Assets: |\\n| Short-term investments (1) | $ | 14.7 | $ | 5.0 | $ | 9.7 | $ | — |\\n| Non-current investments (2) | 92.6 | 19.5 | 73.1 | — |\\n| Derivative contracts (3) | 10.0 | — | 10.0 | — |\\n| Total | $ | 117.3 | $ | 24.5 | $ | 92.8 | $ | — |\\n| Liabilities: |\\n| Derivative contracts (4) | $ | 26.3 | $ | — | $ | 26.3 | $ | — |\\n| Total | $ | 26.3 | $ | — | $ | 26.3 | $ | — |\\n\\n(1) Primarily relates to Mutual Funds (Level 1) and Certificates of Deposit (Level 2). Included in Other current assets.\\n(2) Primarily relates to investments in publicly traded stock (Level 1) and U.S. Treasury Notes and Corporate Bonds (Level 2). Included in Other assets.\\n(3) Primarily relates to derivative contracts. Included in Other assets.\\n(4) Primarily relates to interest rate swaps. Included in Other current liabilities.\\nThe following table presents assets and liabilities which were measured at fair value on a recurring basis as of February 27, 2021 (in millions):\\n| Fair Value Measurements |\\n| Total | Quoted prices in active markets for identical assets(Level 1) | Significantobservableinputs(Level 2) | Significantunobservableinputs(Level 3) |\\n| Assets: |\\n| Short-term investments (1) | $ | 11.9 | $ | 4.4 | $ | 7.5 | $ | — |\\n| Non-current investments (2) | 110.2 | 40.3 | 69.9 | — |\\n| Total | $ | 122.1 | $ | 44.7 | $ | 77.4 | $ | — |\\n| Liabilities: |\\n| Derivative contracts (3) | $ | 40.0 | $ | — | $ | 40.0 | $ | — |\\n| Total | $ | 40.0 | $ | — | $ | 40.0 | $ | — |\\n\\n(1) Primarily relates to Mutual Funds (Level 1) and Certificates of Deposit (Level 2). Included in Other current assets.\\n(2) Primarily relates to investments in publicly traded stock (Level 1) and U.S. Treasury Notes and Corporate Bonds (Level 2). Included in Other assets.\\n(3) Primarily relates to interest rate swaps. Included in Other current liabilities.\\nThe estimated fair value of the Company's debt, including current maturities, was based on Level 2 inputs, being market quotes or values for similar instruments, and interest rates currently available to the Company for the issuance of debt with similar terms and remaining maturities as a discount rate for the remaining principal payments. As of September 11, 2021, the fair value of total debt was $ 8,325.6 million compared to the carrying value of $ 7,815.0 million, excluding debt discounts and deferred financing costs. As of February 27, 2021, the fair value of total debt was $ 8,150.7 million compared to the carrying value of $ 7,815.5 million, excluding debt discounts and deferred financing costs.\\n11\\nAssets Measured at Fair Value on a Non-Recurring Basis\\nThe Company measures certain assets at fair value on a non-recurring basis, including long-lived assets and goodwill, which are evaluated for impairment. Long-lived assets include store-related assets such as property and equipment and certain intangible assets. The inputs used to determine the fair value of long-lived assets and a reporting unit are considered Level 3 measurements due to their subjective nature.\\nNOTE 3 - DERIVATIVE FINANCIAL INSTRUMENTS\\nThe aggregate notional amount of the Company's interest rate swaps as of September 11, 2021 and February 27, 2021, were $ 1,553.0 million and $ 1,653.0 million, respectively, of which none were designated as cash flow hedges as defined by GAAP.\\nActivity related to interest rate swaps consisted of the following (in millions):\\n| 12 weeks ended |\\n| September 11,2021 | September 12,2020 | Location of loss recognized from derivatives |\\n| Loss on undesignated portion of interest rate swaps | $ | — | $ | ( 0.4 ) | Other income, net |\\n\\n| 28 weeks ended |\\n| September 11,2021 | September 12,2020 | Location of loss recognized from derivatives |\\n| Loss on undesignated portion of interest rate swaps | $ | ( 0.3 ) | $ | ( 19.4 ) | Other income, net |\\n\\nNOTE 4 - LONG-TERM DEBT AND FINANCE LEASE OBLIGATIONS\\nThe Company's long-term debt and finance lease obligations as of September 11, 2021 and February 27, 2021, net of unamortized debt discounts of $ 43.0 million and $ 44.8 million, respectively, and deferred financing costs of $ 63.6 million and $ 69.8 million, respectively, consisted of the following (in millions):\\n| September 11,2021 | February 27,2021 |\\n| Senior Unsecured Notes due 2023 to 2030, interest rate range of 3.25 % to 7.50 % | $ | 6,686.5 | $ | 6,680.5 |\\n| Safeway Inc. Notes due 2021 to 2031, interest rate range of 4.75 % to 7.45 % | 504.4 | 504.3 |\\n| New Albertsons L.P. Notes due 2026 to 2031, interest rate range of 6.52 % to 8.70 % | 470.9 | 469.1 |\\n| Other financing obligations | 29.2 | 29.4 |\\n| Mortgage notes payable, secured | 17.4 | 17.6 |\\n| Finance lease obligations | 632.2 | 612.7 |\\n| Total debt | 8,340.6 | 8,313.6 |\\n| Less current maturities | ( 211.5 ) | ( 212.4 ) |\\n| Long-term portion | $ | 8,129.1 | $ | 8,101.2 |\\n\\nSenior Unsecured Notes\\nOn October 1, 2021, subsequent to the end of the 12 weeks ended September 11, 2021, the Company provided notice to the holders and trustee, of its election to redeem all of the $ 200.0 million aggregate principal amount currently outstanding of the Company's 5.750 % Senior Unsecured Notes due 2025 (the \\\"2025 Notes\\\"). The 2025 Notes will be redeemed on November 1, 2021 (the \\\"Redemption Date\\\"), using cash on hand, at a redemption price of 101.438 % of the principal amount thereof plus accrued and unpaid interest on the 2025 Notes to, but excluding, the Redemption Date.\\n12\\nABL Facility\\nAs of September 11, 2021 and February 27, 2021, there were no amounts outstanding under the Company's asset-based loan facility (\\\"ABL Facility\\\"), and letters of credit (\\\"LOC\\\") issued under the LOC sub-facility were $ 323.8 million and $ 354.6 million, respectively.\\nNOTE 5 - EMPLOYEE BENEFIT PLANS\\nPension and Other Post-Retirement Benefits\\nThe following tables provide the components of net pension and post-retirement (income) expense (in millions):\\n| 12 weeks ended |\\n| Pension | Other post-retirement benefits |\\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\\n| Estimated return on plan assets | $ | ( 24.5 ) | $ | ( 23.7 ) | $ | — | $ | — |\\n| Service cost | 5.1 | 3.5 | — | — |\\n| Interest cost | 9.7 | 12.6 | 0.1 | 0.1 |\\n| Amortization of prior service cost | — | — | — | 0.4 |\\n| Amortization of net actuarial loss (gain) | 0.2 | 0.5 | ( 0.1 ) | ( 0.1 ) |\\n| Settlement (gain) loss | ( 14.3 ) | 3.0 | — | — |\\n| (Income) expense, net | $ | ( 23.8 ) | $ | ( 4.1 ) | $ | — | $ | 0.4 |\\n\\n| 28 weeks ended |\\n| Pension | Other post-retirement benefits |\\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\\n| Estimated return on plan assets | $ | ( 57.2 ) | $ | ( 55.2 ) | $ | — | $ | — |\\n| Service cost | 12.0 | 8.3 | — | — |\\n| Interest cost | 22.7 | 29.2 | 0.2 | 0.2 |\\n| Amortization of prior service cost | 0.1 | 0.1 | — | 1.0 |\\n| Amortization of net actuarial loss (gain) | 0.5 | 1.1 | ( 0.3 ) | ( 0.3 ) |\\n| Settlement (gain) loss | ( 14.3 ) | 3.0 | — | — |\\n| (Income) expense, net | $ | ( 36.2 ) | $ | ( 13.5 ) | $ | ( 0.1 ) | $ | 0.9 |\\n\\nThe Company contributed $ 9.2 million and $ 11.2 million to its defined pension plans and post-retirement benefit plans during the 12 and 28 weeks ended September 11, 2021, respectively. For the 12 and 28 weeks ended September 12, 2020, the Company contributed $ 1.7 million and $ 56.3 million, respectively. At the Company's discretion, additional funds may be contributed to the defined benefit pension plans that are determined to be beneficial to the Company. The Company currently anticipates contributing an additional $ 26.1 million to these plans for the remainder of fiscal 2021.\\nDuring the 12 and 28 weeks ended September 11, 2021, the Company purchased a group annuity policy and transferred $ 203.5 million of pension plan assets to an insurance company, thereby reducing the Company's defined benefit pension obligations by $ 205.4 million. As a result of the annuity purchase, the Company recorded a settlement gain of $ 11.1 million during the 12 and 28 weeks ended September 11, 2021.\\n13\\nDefined Contribution Plans and Supplemental Retirement Plans\\nTotal contributions expensed for defined contribution plans (401(k) plans) were $ 26.4 million and $ 16.3 million for the 12 weeks ended September 11, 2021 and September 12, 2020, respectively. For the 28 weeks ended September 11, 2021 and September 12, 2020, total contributions expensed were $ 42.6 million and $ 38.1 million, respectively.\\nMultiemployer Pension Plans\\nARP Act: The American Rescue Plan Act (\\\"ARP Act\\\") was signed into law on March 11, 2021. The ARP Act establishes a special financial assistance program for financially troubled multiemployer pension plans. Under the ARP Act, eligible multiemployer plans can apply to receive a one-time cash payment in the amount projected by the Pension Benefit Guaranty Corporation (\\\"PBGC\\\") to pay pension benefits through the plan year ending 2051. On July 9, 2021, the PBGC issued its interim final rule with respect to the special financial assistance program. The PBGC interim final rule provides direction on the application requirements, identifies which plans will have priority, eligibility requirements, the determination of the amount of financial assistance to be provided and establishes conditions and restrictions that apply to plans that receive the assistance. The Company is evaluating the interim final rule and has submitted comments during the 30-day comment period. The Company's evaluation includes any potential impact to the Company's Excess Plan as defined in and further described in \\\"Part II—Item 8. Financial Statements and Supplemental Data—Note 12\\\" of the Company's Annual Report on Form 10-K for the fiscal year ended February 27, 2021.\\nNOTE 6 - COMMITMENTS AND CONTINGENCIES AND OFF BALANCE SHEET ARRANGEMENTS\\nGuarantees\\nCalifornia Department of Industrial Relations: On January 21, 2014, the Company entered into a Collateral Substitution Agreement with the California Self-Insurers' Security Fund to provide collateral related to certain California self-insured workers' compensation obligations pursuant to applicable regulations. The collateral not covered by the California Self-Insurers' Security Fund is covered by surety bonds for the benefit of the State of California Office of Self-Insurance Plans. A portion of the surety bonds is covered by irrevocable LOCs. The collateral requirements are adjusted annually based on semi-annual filings of an actuarial study reflecting liabilities as of December 31 of each year reduced by claim closures and settlements. The related LOC was $ 22.6 million as of September 11, 2021 and $ 40.1 million as of February 27, 2021, respectively.\\nLease Guarantees: The Company may have liability under certain operating leases that were assigned to third parties. If any of these third parties fail to perform their obligations under the leases, the Company could be responsible for the lease obligation, including as a result of the economic dislocation caused by the response to the COVID-19 pandemic. Because of the wide dispersion among third parties and the variety of remedies available, the Company believes that if an assignee became insolvent, it would not have a material effect on the Company's financial condition, results of operations or cash flows.\\nThe Company also provides guarantees, indemnifications and assurances pursuant to contractual obligations in the ordinary course of its business.\\nLegal Proceedings\\nThe Company is subject from time to time to various claims and lawsuits arising in the ordinary course of business, including lawsuits involving trade practices, lawsuits alleging violations of state and/or federal wage and hour laws (including alleged violations of meal and rest period laws and alleged misclassification issues), real estate disputes as well as other matters. Some of these claims or suits purport or may be determined to be class actions and/or seek substantial damages. It is the opinion of the Company's management that although the amount of liability with\\n14\\nrespect to certain of the matters described herein cannot be ascertained at this time, any resulting liability of these and other matters, including any punitive damages, will not have a material adverse effect on the Company's business or financial condition.\\nThe Company continually evaluates its exposure to loss contingencies arising from pending or threatened litigation and believes it has made provisions where the loss contingency is probable and can be reasonably estimated. Nonetheless, assessing and predicting the outcomes of these matters involves substantial uncertainties. Management currently believes that the aggregate range of reasonably possible loss for the Company's exposure in excess of the amount accrued is expected to be immaterial to the Company. It remains possible that despite management's current belief, material differences in actual outcomes or changes in management's evaluation or predictions could arise that could have a material effect on the Company's financial condition, results of operations or cash flows.\\nERISA Litigation: Two lawsuits were brought against Safeway Inc. (\\\"Safeway\\\") and the Safeway Benefits Plan Committee (the \\\"Benefit Plans Committee,\\\" and together with Safeway, the \\\"Safeway Benefits Plans Defendants\\\") and other third parties alleging breaches of fiduciary duty under the Employee Retirement Income Security Act of 1974, as amended (\\\"ERISA\\\") with respect to Safeway's 401(k) Plan (the \\\"Safeway 401(k) Plan\\\"). On July 14, 2016, a complaint was filed in the United States District Court for the Northern District of California by a participant in the Safeway 401(k) Plan individually and on behalf of the Safeway 401(k) Plan. An amended complaint was filed on November 18, 2016. On August 25, 2016, a second complaint was filed in the United States District Court for the Northern District of California by another participant in the Safeway 401(k) Plan individually and on behalf of all others similarly situated against the Safeway Benefits Plans Defendants and against the Safeway 401(k) Plan's former record-keepers. An amended complaint was filed on September 16, 2016, and a second amended complaint was filed on November 21, 2016. In general, both lawsuits alleged that the Safeway Benefits Plans Defendants breached their fiduciary duties under ERISA regarding the selection of investments offered under the Safeway 401(k) Plan and the fees and expenses related to those investments. All parties filed summary judgment motions which were heard and taken under submission on August 16, 2018. Plaintiffs' motions were denied, and defendants' motions were granted in part and denied in part. Bench trials for both matters were set for May 6, 2019. A settlement in principle was reached before trial. On September 13, 2019, settlement papers were filed with the Court along with a motion for preliminary approval of the settlement. A hearing for preliminary approval was set for November 20, 2019, but the Court vacated the hearing. The Court issued an order on March 30, 2020 requesting some minor changes to the notice procedures, and plaintiffs submitted an amended motion for preliminary approval. On September 8, 2020, the Court granted plaintiffs' amended motion, and a final approval hearing was held on April 26, 2021, at which time the Court took the matter under submission. On July 19, 2021, the Court issued a final order approving the settlement. In August 2021, a settlement fund was established with funds from insurers. A settlement administrator is now managing the calculation and payment of settlement provisions to class members.\\nFalse Claims Act: The Company has received a civil investigative demand dated February 28, 2020 from the United States Attorney for the Southern District of New York in connection with a False Claims Act (\\\"FCA\\\") investigation relating to the Company's dispensing practices regarding insulin pen products. The investigation seeks documents regarding the Company's policies, practices and procedures, as well as dispensing data, among other things. The Company has cooperated with the U.S. Attorney in the investigation. The Company is currently unable to determine the probability of the outcome of this matter or the range of possible loss, if any.\\nTwo qui tam actions alleging violations of the FCA have also been filed against the Company and its subsidiaries. Violations of the FCA are subject to treble damages and penalties of up to a specified dollar amount per false claim.\\nIn United States ex rel. Proctor v. Safeway, filed in the United States District Court for the Central District of Illinois, the relator alleges that Safeway overcharged federal government healthcare programs by not providing the federal government, as part of its usual and customary prices, the benefit of discounts given to customers in pharmacy membership discount and price-matching programs. The relator filed his complaint under seal on November 11, 2011, and the complaint was unsealed on August 26, 2015. The relator amended the complaint on\\n15\\nMarch 31, 2016. On June 12, 2020, the Court granted Safeway's motion for summary judgment, holding that the relator could not prove that Safeway acted with the intent required under the FCA, and judgment was issued on June 15, 2020. On July 10, 2020, the relator filed a motion to alter or amend the judgment and to supplement the record, which Safeway opposed. On November 13, 2020, the Court denied relator's motion, and on December 11, 2020, relator filed a notice of appeal. The appeal is now pending in the Seventh Circuit Court of Appeals. Oral argument took place September 9, 2021.\\nIn United States ex rel. Schutte and Yarberry v. SuperValu, New Albertson's, Inc., et al., also filed in the Central District of Illinois, the relators allege that defendants (including various subsidiaries of the Company) overcharged federal government healthcare programs by not providing the federal government, as a part of usual and customary prices, the benefit of discounts given to customers who requested that defendants match competitor prices. The complaint was originally filed under seal and amended on November 30, 2015. On August 5, 2019, the Court granted relators' motion for partial summary judgment, holding that price-matched prices are the usual and customary prices for those drugs. On July 1, 2020, the Court granted the defendants' motions for summary judgment and dismissed the case, holding that the relator could not prove that defendants acted with the intent required under the FCA. Judgment was issued on July 2, 2020. On July 9, 2020, the relators filed a notice of appeal. Oral argument was held on January 19, 2021. On August 12, 2021, the Court of Appeals for the Seventh Circuit affirmed the grant of summary judgment in the Company's favor. On September 23, 2021, the relators filed a petition for rehearing en banc with the Seventh Circuit. The Company's response to the petition for rehearing is due by November 9, 2021.\\nIn both of the above cases, the federal government previously investigated the relators' allegations and declined to intervene. The relators elected to pursue their respective cases on their own and in each case have alleged FCA damages in excess of $ 100 million before trebling and excluding penalties. The Company is vigorously defending each of these matters and believes each of these cases is without merit. The Company has recorded an estimated liability for these matters.\\nOpioid Litigation: The Company is one of dozens of companies that have been named in various lawsuits alleging that defendants contributed to the national opioid epidemic. At present, the Company is named in over 80 suits pending in various state courts as well as in the United States District Court for the Northern District of Ohio, where over 2,000 cases have been consolidated as Multi-District Litigation (\\\"MDL\\\") pursuant to 28 U.S.C. §1407. Most of these cases have been stayed pending bellwether trials. At present, the most active case is a matter in New Mexico state court where we have been in active discovery and where a September 2022 trial date has been set. The MDL Court and a state court in Utah are currently considering position statements from the parties in connection with scheduling bellwether trials and it is likely that the Company may be included in one or more of those anticipated bellwether trials. The Company is vigorously defending these matters and believes that these cases are without merit. At this stage in the proceedings, the Company is unable to determine the probability of the outcome of these matters or the range of reasonably possible loss, if any.\\nCalifornia Air Resources Board: Upon the inspection by the California Air Resources Board (\\\"CARB\\\") of several of the Company's stores in California, it was determined that the Company failed certain paperwork and other administrative requirements. As a result of the inspections, the Company proactively undertook a broad evaluation of the record keeping and administrative practices at all of its stores in California. In connection with this evaluation, the Company retained a third party to conduct an audit and correct deficiencies identified across its California store base. The Company is working with CARB to resolve these compliance issues and comply with governing regulations, and that work is ongoing. CARB has made an opening demand regarding potential fines and penalties. On July 7, 2021, the parties entered into a settlement agreement for which the Company has recorded an estimated liability.\\nFACTA: On May 31, 2019, a putative class action complaint entitled Martin v. Safeway was filed in the California Superior Court for the County of Alameda, alleging the Company failed to comply with the Fair and Accurate Credit Transactions Act (\\\"FACTA\\\") by printing receipts that failed to adequately mask payment card numbers as\\n16\\nrequired by FACTA. The plaintiff claims the violation was \\\"willful\\\" and exposes the Company to statutory damages provided for in FACTA. The Company has answered the complaint and is vigorously defending the matter. On January 8, 2020, the Company commenced mediation discussions with plaintiff's counsel and reached a settlement in principle on February 24, 2020. The parties will seek court approval of the settlement. The Company has recorded an estimated liability for this matter.\\nOther Commitments\\nIn the ordinary course of business, the Company enters into various supply contracts to purchase products for resale and purchase and service contracts for fixed asset and information technology commitments. These contracts typically include volume commitments or fixed expiration dates, termination provisions and other standard contractual considerations.\\nNOTE 7 - OTHER COMPREHENSIVE INCOME OR LOSS\\nTotal comprehensive earnings are defined as all changes in stockholders' equity during a period, other than those from investments by or distributions to the stockholders. Generally, for the Company, total comprehensive income or loss equals net income plus or minus adjustments for pension and other post-retirement liabilities. Total comprehensive earnings represent the activity for a period net of tax.\\nWhile total comprehensive earnings are the activity in a period and are largely driven by net earnings in that period, accumulated other comprehensive income or loss (\\\"AOCI\\\") represents the cumulative balance of other comprehensive income, net of tax, as of the balance sheet date. Changes in the AOCI balance by component are shown below (in millions):\\n| 28 weeks ended September 11, 2021 |\\n| Total | Pension and Post-retirement benefit plans | Other |\\n| Beginning balance | $ | 63.5 | $ | 61.3 | $ | 2.2 |\\n| Other comprehensive income before reclassifications | 34.3 | 34.3 | — |\\n| Amounts reclassified from accumulated other comprehensive income | ( 14.0 ) | ( 14.0 ) | — |\\n| Tax expense | ( 5.1 ) | ( 5.1 ) | — |\\n| Current-period other comprehensive income, net of tax | 15.2 | 15.2 | — |\\n| Ending balance | $ | 78.7 | $ | 76.5 | $ | 2.2 |\\n\\n| 28 weeks ended September 12, 2020 |\\n| Total | Pension and Post-retirement benefit plans | Other |\\n| Beginning balance | $ | ( 118.5 ) | $ | ( 121.7 ) | $ | 3.2 |\\n| Other comprehensive income before reclassifications | 11.1 | 9.6 | 1.5 |\\n| Amounts reclassified from accumulated other comprehensive income | 4.9 | 4.9 | — |\\n| Tax expense | ( 3.9 ) | ( 3.6 ) | ( 0.3 ) |\\n| Current-period other comprehensive income, net of tax | 12.1 | 10.9 | 1.2 |\\n| Ending balance | $ | ( 106.4 ) | $ | ( 110.8 ) | $ | 4.4 |\\n\\n17\\nNOTE 8 - NET INCOME PER CLASS A COMMON SHARE\\nThe Company calculates basic and diluted net income per Class A common share using the two-class method. The two-class method is an allocation formula that determines net income per Class A common share for each share of Class A common stock and the Company's Series A-1 convertible preferred stock (\\\"Series A-1 preferred stock\\\") and Series A convertible preferred stock (\\\"Series A preferred stock\\\" and together with the Series A-1 preferred stock, the \\\"Convertible Preferred Stock\\\"), a participating security, according to dividends declared and participation rights in undistributed earnings. Under this method, all earnings (distributed and undistributed) are allocated to Class A common shares and Convertible Preferred Stock based on their respective rights to receive dividends. The holders of Convertible Preferred Stock participate in cash dividends that the Company pays on its common stock to the extent that such cash dividends exceed $ 206.25 million per fiscal year. In applying the two-class method to interim periods, the Company allocates income to its quarterly periods independently and discretely from its year-to-date and annual periods. Basic net income per Class A common share is computed by dividing net income allocated to Class A common stockholders by the weighted average number of Class A common shares outstanding for the period, including Class A common shares to be issued with no prior remaining contingencies prior to issuance. Diluted net income per Class A common share is computed based on the weighted average number of shares of Class A common stock outstanding during each period, plus potential Class A common shares considered outstanding during the period, as long as the inclusion of such awards is not antidilutive. Potential Class A common shares consist of unvested RSUs and RSAs and Convertible Preferred Stock, using the more dilutive of either the two-class method or as-converted stock method. Performance-based RSUs are considered dilutive when the related performance criterion has been met.\\n18\\nThe components of basic and diluted net income per Class A common share were as follows (in millions, except per share data):\\n| 12 weeks ended | 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\\n| Basic net income per Class A common share |\\n| Net income | $ | 295.2 | $ | 284.5 | $ | 740.0 | $ | 870.7 |\\n| Accrued dividends on Convertible Preferred Stock | ( 27.3 ) | ( 26.9 ) | ( 63.7 ) | ( 30.8 ) |\\n| Earnings allocated to Convertible Preferred Stock | ( 11.0 ) | ( 9.0 ) | ( 84.2 ) | ( 9.0 ) |\\n| Net income allocated to Class A common stockholders - Basic | $ | 256.9 | $ | 248.6 | $ | 592.1 | $ | 830.9 |\\n| Weighted average Class A common shares outstanding - Basic (1) | 465.3 | 477.3 | 465.2 | 529.2 |\\n| Basic net income per Class A common share | $ | 0.55 | $ | 0.52 | $ | 1.27 | $ | 1.57 |\\n| Diluted net income per Class A common share |\\n| Net income allocated to Class A common stockholders - Basic | $ | 256.9 | $ | 248.6 | $ | 592.1 | $ | 830.9 |\\n| Accrued dividends on Convertible Preferred Stock | 27.3 | 26.9 | — | 30.8 |\\n| Earnings allocated to Convertible Preferred Stock | 11.0 | 9.0 | — | 9.0 |\\n| Net income allocated to Class A common stockholders - Diluted | $ | 295.2 | $ | 284.5 | $ | 592.1 | $ | 870.7 |\\n| Weighted average Class A common shares outstanding - Basic (1) | 465.3 | 477.3 | 465.2 | 529.2 |\\n| Dilutive effect of: |\\n| Restricted stock units and awards | 6.1 | 4.0 | 5.4 | 4.3 |\\n| Convertible Preferred Stock (2) | 101.6 | 101.6 | — | 49.8 |\\n| Weighted average Class A common shares outstanding - Diluted (3) | 573.0 | 582.9 | 470.6 | 583.3 |\\n| Diluted net income per Class A common share | $ | 0.52 | $ | 0.49 | $ | 1.26 | $ | 1.49 |\\n\\n(1) There were 0.3 million Class A common shares remaining to be issued for the 12 and 28 weeks ended September 11, 2021 compared to 0.4 million Class A common shares remaining to be issued for the 12 and 28 weeks ended September 12, 2020.\\n(2) Reflects the number of shares of Convertible Preferred Stock issued, if converted into common stock for the period outstanding. For the 28 weeks ended September 11, 2021, 101.6 million potential common shares outstanding related to Convertible Preferred Stock were antidilutive.\\n(3) There were no potential Class A common shares outstanding related to RSUs and RSAs that were antidilutive for the 12 and 28 weeks ended September 11, 2021. There were no potential Class A common shares outstanding related to RSUs and RSAs that were antidilutive for the 12 and 28 weeks ended September 12, 2020.\\n19\\nItem 2\\n-\\nManagement's Discussion and Analysis of Financial Condition and Results of Operations\\nSPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS\\nThis Form 10-Q contains \\\"forward-looking statements\\\" within the meaning of the federal securities laws. The \\\"forward-looking statements\\\" include our current expectations, assumptions, estimates and projections about our business and our industry. They include statements relating to our future operating or financial performance which the Company believes to be reasonable at this time. You can identify forward-looking statements by the use of words such as \\\"outlook,\\\" \\\"may,\\\" \\\"should,\\\" \\\"could,\\\" \\\"estimates,\\\" \\\"predicts,\\\" \\\"potential,\\\" \\\"continue,\\\" \\\"anticipates,\\\" \\\"believes,\\\" \\\"plans,\\\" \\\"expects,\\\" \\\"future\\\" and \\\"intends\\\" and similar expressions which are intended to identify forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors, some of which are beyond our control and difficult to predict, including, among others, changes in macroeconomic conditions, the retail consumer behavior and environment and the Company's industry, failure to achieve productivity initiatives, increased rates of food price inflation and factors related to the continued impact of the COVID-19 pandemic, about which there are still many unknowns, including its duration, recurrence, new virus strains, status and effectiveness of vaccinations, duration and scope of related government orders, financial assistance programs, mandates and regulations and the extent of the overall impact to our business and the communities we serve. Such risks and uncertainties could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements. In evaluating forward-looking statements, you should carefully consider the risks and uncertainties more fully described in the \\\"Risk Factors\\\" section or other sections in our reports filed with the SEC including the most recent annual report on Form 10-K and any subsequent periodic reports on Form 10-Q and current reports on Form 8-K. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements and risk factors. Forward-looking statements contained in this Form 10-Q reflect our view only as of the date of this Form 10-Q. We undertake no obligation, other than as required by law, to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.\\nAs used in this Form 10-Q, unless the context otherwise requires, references to \\\"Albertsons,\\\" the \\\"Company,\\\" \\\"we,\\\" \\\"us\\\" and \\\"our\\\" refer to Albertsons Companies, Inc. and, where appropriate, its subsidiaries.\\nNON-GAAP FINANCIAL MEASURES\\nWe define EBITDA as generally accepted accounting principles (\\\"GAAP\\\") earnings (net loss) before interest, income taxes, depreciation and amortization. We define Adjusted EBITDA as earnings (net loss) before interest, income taxes, depreciation and amortization, further adjusted to eliminate the effects of items management does not consider in assessing our ongoing core performance. We define Adjusted net income as GAAP Net income adjusted to eliminate the effects of items management does not consider in assessing our ongoing core performance. We define Adjusted net income per Class A common share as Adjusted net income divided by the weighted average diluted Class A common shares outstanding, as adjusted to reflect all restricted stock units (\\\"RSUs\\\") and restricted common stock (\\\"RSAs\\\") outstanding at the end of the period. We define Net Debt as total debt (which includes finance lease obligations and is net of deferred financing costs and original issue discount) minus unrestricted cash and cash equivalents and we define Net Debt Ratio as the ratio of Net Debt to Adjusted EBITDA for the rolling 52 or 53 week period. See \\\"Results of Operations\\\" for further discussion and a reconciliation of Adjusted EBITDA, Adjusted net income and Adjusted net income per Class A common share.\\nEBITDA, Adjusted EBITDA, Adjusted net income and Adjusted net income per Class A common share (collectively, the \\\"Non-GAAP Measures\\\") are performance measures that provide supplemental information we believe is useful to analysts and investors to evaluate our ongoing results of operations, when considered alongside other GAAP measures such as Net income, operating income and gross profit. These Non-GAAP Measures exclude\\n20\\nthe financial impact of items management does not consider in assessing our ongoing core operating performance, and thereby provide useful measures to analysts and investors of our operating performance on a period-to-period basis. Other companies may have different definitions of Non-GAAP Measures and provide for different adjustments, and comparability to our results of operations may be impacted by such differences. We also use Adjusted EBITDA and Net Debt Ratio for board of director and bank compliance reporting. Our presentation of Non-GAAP Measures should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items.\\nNon-GAAP Measures should not be considered as measures of discretionary cash available to us to invest in the growth of our business. We compensate for these limitations by relying primarily on our GAAP results and using Non-GAAP Measures only for supplemental purposes.\\n21\\nSECOND QUARTER OF FISCAL 2021 OVERVIEW\\nGiven the significant variations that occurred in our business during fiscal 2020 due to the COVID-19 pandemic, we provide a supplemental comparison of the 12 and 28 weeks ended September 11, 2021 (\\\"second quarter of fiscal 2021\\\" and \\\"first 28 weeks of fiscal 2021\\\") to the 12 and 28 weeks ended September 7, 2019 (\\\"second quarter of fiscal 2019\\\" and \\\"first 28 weeks of fiscal 2019\\\") for certain financial measures to demonstrate the two-year growth in our business in addition to comparisons to the 12 and 28 weeks ended September 12, 2020 (\\\"second quarter of fiscal 2020\\\" and \\\"first 28 weeks of fiscal 2020\\\").\\nAs of September 11, 2021, we operated 2,278 retail food and drug stores with 1,725 pharmacies, 401 associated fuel centers, 22 dedicated distribution centers and 20 manufacturing facilities. With a strong consumer environment, we continue to make significant progress against all of our strategic priorities, including in-store excellence, accelerating our digital and omni-channel capabilities, increasing productivity and strengthening our talent and culture. Identical sales increased 1.5%, excluding fuel, during the second quarter of fiscal 2021, resulting in two-year stacked identical sales growth of 15.3%. We continue to gain market share in food market, and in Multi Outlet (\\\"MULO\\\") we are up on a two-year basis and down marginally on a one-year basis. Food market generally includes traditional supermarkets while MULO includes most food market, drug, mass merchants, club, dollar and military stores that sell food.\\nUnderscoring our strong omni-channel capabilities that allow customers to complete their shopping with us in any way they want, our digital initiatives continue to resonate with our customers, as evidenced by our sustained sales levels in the second quarter of fiscal 2021, digital sales increasing 5% compared to the second quarter of fiscal 2020 and a two-year stacked growth of 248%. During the second quarter of fiscal 2021, we expanded our Drive Up & Go curbside pickup service to approximately 1,900 locations and offer delivery services across more than 2,000 of our stores. In our delivery service, we have expanded first party locations, and continue to work with third party services to engage with customers on the platform of their choice. In addition to our continuing partnership with Instacart, we have expanded our partnership with DoorDash to offer on-demand grocery delivery service where customers can receive a broad assortment in under one hour. We also recently launched a similar partnership with Uber, where customers can order a full assortment of groceries on the Uber platform.\\nWith ongoing benefit enhancements, we continue to achieve significant success with our just for U loyalty program, which drives higher sales and customer retention, with membership growing 17% in the second quarter of fiscal 2021 compared to the second quarter of fiscal 2020, reaching 27.5 million members. Within the program, the number of actively engaged members, those that redeemed fuel or grocery rewards during the second quarter of fiscal 2021, increased by almost 9% compared to the second quarter of fiscal 2020, and our retention rate of actively engaged members was 93% in the second quarter of fiscal 2021.\\nDuring the second quarter of fiscal 2021 we continued to roll out our Own Brands across all our banners, launching 85 new products and generating strong growth as our sales penetration increased by 60 basis points to 25.2% compared to the second quarter of fiscal 2020. We also continue to make significant progress on productivity initiatives, including promotional effectiveness, purchasing and procurement, labor efficiency and shrink.\\nOur capital allocation strategy balances investing for the future, strengthening our balance sheet and returns to shareholders through a combination of dividends and opportunistic share repurchases. Capital expenditures were approximately $823 million during the first 28 weeks of fiscal 2021 as we opened seven new stores and completed 76 upgrades and remodels. Our balance sheet remains strong with a Net Debt Ratio of 1.3x as of the end of the second quarter of fiscal 2021. Capital returns to shareholders during the first 28 weeks of fiscal 2021 included our $0.10 per share quarterly dividend. On October 18, 2021, subsequent to the end of the second quarter of fiscal 2021, we announced a 20% increase to our quarterly dividend, which is now $0.12 per share of Class A common stock.\\n22\\nIn addition, we have continued to partner with the Department of Health and Human Services and local health authorities to administer COVID-19 vaccines to our local communities and, as of October 12, 2021, have administered approximately 7.5 million doses.\\nSecond quarter of fiscal 2021 highlights\\nIn summary, our financial and operating highlights for the second quarter of fiscal 2021 include:\\n•Identical sales increase of 1.5%; two-year identical sales stacked growth was 15.3%\\n•Digital sales increased 5%; on a two-year stacked basis digital sales growth was 248%\\n•Net income of $295 million, or $0.52 per Class A common share\\n•Adjusted net income of $370 million, or $0.64 per Class A common share\\n•Adjusted EBITDA of $965 million\\n•Opened one new store and completed 43 remodel projects\\n•Launched 153 new Drive Up & Go locations\\nStores\\nThe following table shows stores operating, acquired, opened and closed during the periods presented:\\n| 12 weeks ended | 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\\n| Stores, beginning of period | 2,278 | 2,252 | 2,277 | 2,252 |\\n| Acquired (1) | — | — | 1 | — |\\n| Opened | 1 | 2 | 6 | 2 |\\n| Closed | (1) | (2) | (6) | (2) |\\n| Stores, end of period | 2,278 | 2,252 | 2,278 | 2,252 |\\n\\n(1) The 28 weeks ended September 11, 2021 includes one store acquired from Kings and Balducci's that transferred to us subsequent to the end of the fourth quarter of fiscal 2020.\\nThe following table summarizes our stores by size:\\n| Number of stores | Percent of Total | Retail Square Feet (1) |\\n| Square Footage | September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\\n| Less than 30,000 | 223 | 204 | 9.8 | % | 9.1 | % | 5.1 | 4.7 |\\n| 30,000 to 50,000 | 786 | 781 | 34.5 | % | 34.6 | % | 32.9 | 32.8 |\\n| More than 50,000 | 1,269 | 1,267 | 55.7 | % | 56.3 | % | 75.0 | 74.8 |\\n| Total Stores | 2,278 | 2,252 | 100.0 | % | 100.0 | % | 113.0 | 112.3 |\\n\\n(1) In millions, reflects total square footage of retail stores operating at the end of the period.\\n23\\nRESULTS OF OPERATIONS\\nComparison of Second Quarter of Fiscal 2021 and First 28 Weeks of Fiscal 2021 to Second Quarter of Fiscal 2020 and First 28 Weeks of Fiscal 2020:\\nThe following tables and related discussion set forth certain information and comparisons regarding the components of our Condensed Consolidated Statements of Operations for the second quarter of fiscal 2021 and first 28 weeks of fiscal 2021 to the second quarter of fiscal 2020 and first 28 weeks of fiscal 2020 (in millions, except per share data).\\n| 12 weeks ended |\\n| September 11,2021 | % of Sales | September 12,2020 | % of Sales |\\n| Net sales and other revenue | $ | 16,505.7 | 100.0 | % | $ | 15,757.6 | 100.0 | % |\\n| Cost of sales | 11,788.7 | 71.4 | 11,182.7 | 71.0 |\\n| Gross profit | 4,717.0 | 28.6 | 4,574.9 | 29.0 |\\n| Selling and administrative expenses | 4,231.3 | 25.6 | 4,031.2 | 25.6 |\\n| Gain on property dispositions and impairment losses, net | (0.2) | — | (18.3) | (0.1) |\\n| Operating income | 485.9 | 3.0 | 562.0 | 3.5 |\\n| Interest expense, net | 109.3 | 0.7 | 128.6 | 0.8 |\\n| Loss on debt extinguishment | — | — | 49.1 | 0.3 |\\n| Other income, net | (18.9) | (0.1) | (11.4) | (0.1) |\\n| Income before income taxes | 395.5 | 2.4 | 395.7 | 2.5 |\\n| Income tax expense | 100.3 | 0.6 | 111.2 | 0.7 |\\n| Net income | $ | 295.2 | 1.8 | % | $ | 284.5 | 1.8 | % |\\n| Basic net income per Class A common share | $ | 0.55 | $ | 0.52 |\\n| Diluted net income per Class A common share | 0.52 | 0.49 |\\n| 28 weeks ended |\\n| September 11,2021 | % of Sales | September 12,2020 | % of Sales |\\n| Net sales and other revenue | $ | 37,775.1 | 100.0 | % | $ | 38,509.2 | 100.0 | % |\\n| Cost of sales | 26,867.1 | 71.1 | 27,162.8 | 70.5 |\\n| Gross profit | 10,908.0 | 28.9 | 11,346.4 | 29.5 |\\n| Selling and administrative expenses | 9,734.9 | 25.8 | 9,800.6 | 25.5 |\\n| Loss on property dispositions and impairment losses, net | 0.1 | — | 12.0 | — |\\n| Operating income | 1,173.0 | 3.1 | 1,533.8 | 4.0 |\\n| Interest expense, net | 262.6 | 0.7 | 309.2 | 0.8 |\\n| Loss on debt extinguishment | — | — | 49.1 | 0.1 |\\n| Other income, net | (62.4) | (0.2) | (8.3) | — |\\n| Income before income taxes | 972.8 | 2.6 | 1,183.8 | 3.1 |\\n| Income tax expense | 232.8 | 0.6 | 313.1 | 0.8 |\\n| Net income | $ | 740.0 | 2.0 | % | $ | 870.7 | 2.3 | % |\\n| Basic net income per Class A common share | $ | 1.27 | $ | 1.57 |\\n| Diluted net income per Class A common share | 1.26 | 1.49 |\\n\\nNet Sales and Other Revenue\\nNet sales and other revenue increased 4.7% to $16,505.7 million for the second quarter of fiscal 2021 from $15,757.6 million for the second quarter of fiscal 2020. The increase in Net sales and other revenue was primarily driven by our 1.5% increase in identical sales, which includes an increase in pharmacy sales, partially from\\n24\\nadministering COVID-19 vaccines, an increase in sales related to the stores acquired and opened since the second quarter of fiscal 2020 and higher fuel sales.\\nNet sales and other revenue decreased 1.9% to $37,775.1 million for the first 28 weeks of fiscal 2021 from $38,509.2 million for the first 28 weeks of fiscal 2020. The decrease in Net sales and other revenue was primarily driven by our 5.3% decrease in identical sales, which was partially offset by an increase in pharmacy sales, primarily from administering COVID-19 vaccines, and an increase in sales related to the stores opened since the first 28 weeks of fiscal 2020 and higher fuel sales.\\nIdentical Sales, Excluding Fuel\\nIdentical sales include stores operating during the same period in both the current year and the prior year, comparing sales on a daily basis. Direct to consumer digital sales are included in identical sales, and fuel sales are excluded from identical sales. Acquired stores become identical on the one-year anniversary date of the acquisition. Identical sales for the 12 and 28 weeks ended September 11, 2021 and the 12 and 28 weeks ended September 12, 2020, respectively, were:\\n| 12 weeks ended | 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\\n| Identical sales, excluding fuel | 1.5% | 13.8% | (5.3)% | 21.0% |\\n\\nGross Profit\\nGross profit represents the portion of Net sales and other revenue remaining after deducting Cost of sales during the period, including purchase and distribution costs. These costs include, among other things, purchasing and sourcing costs, inbound freight costs, product quality testing costs, warehouse and distribution costs, Own Brands program costs and digital-related delivery and handling costs. Advertising, promotional expenses and vendor allowances are also components of Cost of sales.\\nGross profit margin decreased to 28.6% during the second quarter of fiscal 2021 compared to 29.0% during the second quarter of fiscal 2020. Excluding the impact of fuel, gross profit margin was flat compared to the second quarter of fiscal 2020, primarily due to higher product, supply chain and advertising costs, offset by benefits related to productivity initiatives, favorable product mix and improved pharmacy margins related to administering COVID-19 vaccines.\\nGross profit margin decreased to 28.9% during the first 28 weeks of fiscal 2021 compared to 29.5% during the first 28 weeks of fiscal 2020. Excluding the impact of fuel, gross profit margin increased five basis points compared to the first 28 weeks of fiscal 2020. The increase in gross profit margin was primarily driven by productivity initiatives, favorable product mix and improved pharmacy margins related to administering COVID-19 vaccines, partially offset by sales deleverage and higher product and supply chain costs.\\nSelling and Administrative Expenses\\nSelling and administrative expenses consist primarily of store level costs, including wages, employee benefits, rent, depreciation and utilities, in addition to certain back-office expenses related to our corporate and division offices.\\nSelling and administrative expenses were 25.6% of Net sales and other revenue during the second quarter of fiscal 2021 and the second quarter of fiscal 2020. Excluding the impact of fuel, Selling and administrative expenses as a percentage of Net sales and other revenue increased 55 basis points during the second quarter of fiscal 2021 compared to the second quarter of fiscal 2020. The increase in Selling and administrative expenses as a percentage\\n25\\nof Net sales and other revenue was primarily attributable to employee costs, depreciation and other expenses related to our investments in our digital and omni-channel capabilities and strategic priorities. The increase in employee costs was the result of additional labor related to reopening fresh departments, market-driven retail wage rate increases and higher equity-based compensation expense. These increases were partially offset by lower COVID-19 related costs and execution of productivity initiatives.\\nSelling and administrative expenses increased to 25.8% of Net sales and other revenue during the first 28 weeks of fiscal 2021 compared to 25.5% of Net sales and other revenue for the first 28 weeks of fiscal 2020. Excluding the impact of fuel, Selling and administrative expenses as a percentage of Net sales and other revenue increased 90 basis points during the first 28 weeks of fiscal 2021 compared to the first 28 weeks of fiscal 2020. The increase in Selling and administrative expenses as a percentage of Net sales and other revenue was primarily attributable to sales deleverage, together with higher employee costs, depreciation and other expenses related to our investments in our digital and omni-channel capabilities and strategic priorities. The increase in employee costs was the result of additional labor related to reopening of fresh departments, market-driven retail wage rate increases and higher equity-based compensation expense. These increases were partially offset by lower COVID-19 related costs and execution of productivity initiatives.\\n(Gain) Loss on Property Dispositions and Impairment Losses, Net\\nFor the second quarter of fiscal 2021, net gain on property dispositions and impairment losses was $0.2 million, primarily driven by $6.2 million of gains from the sale of assets, partially offset by $6.0 million of intangible asset impairment. For the second quarter of fiscal 2020, net gain on property dispositions and impairment losses was $18.3 million, primarily driven by $20.0 million of gains from the sale of assets, partially offset by $1.7 million of asset impairments.\\nFor the first 28 weeks of fiscal 2021, net loss on property dispositions and impairment losses was $0.1 million, primarily driven by $15.9 million of asset impairments, primarily related to right-of-use assets and intangible assets, partially offset by $15.8 million of gains from the sale of assets. For the first 28 weeks of fiscal 2020, net loss on property dispositions and impairment losses was $12.0 million, primarily driven by $22.8 million of asset impairments, primarily related to right-of-use assets, partially offset by $10.8 million of gains from the sale of assets.\\nInterest Expense, Net\\nInterest expense, net was $109.3 million during the second quarter of fiscal 2021 compared to $128.6 million during the second quarter of fiscal 2020. The decrease in interest expense was primarily attributable to lower average outstanding borrowings and lower average interest rates. The weighted average interest rate during the second quarter of fiscal 2021 was 5.4%, excluding deferred financing costs and original issue discount, compared to 6.0% during the second quarter of fiscal 2020.\\nInterest expense, net was $262.6 million during the first 28 weeks of fiscal 2021 compared to $309.2 million during the first 28 weeks of fiscal 2020. The decrease in interest expense was primarily attributable to lower average outstanding borrowings and lower average interest rates. The weighted average interest rate during first 28 weeks of fiscal 2021 was 5.5%, excluding deferred financing costs and original issue discount, compared to 6.0% during the first 28 weeks of fiscal 2020.\\n26\\nLoss of Debt Extinguishment\\nThere was no loss on debt extinguishment during both the second quarter of fiscal 2021 and first 28 weeks of fiscal 2021, compared to loss on debt extinguishment of $49.1 million during both the second quarter of fiscal 2020 and first 28 weeks of fiscal 2020. The loss on debt extinguishment during the second quarter and first 28 weeks of fiscal 2020 primarily consisted of a redemption premium payment and write-off of debt discounts associated with the redemption of the Company's 6.625% Senior Unsecured Notes due 2024 (the \\\"2024 Notes\\\").\\nOther Income, Net\\nFor the second quarter of fiscal 2021, Other income, net was $18.9 million compared to $11.4 million for the second quarter of fiscal 2020. Other income, net during the second quarter of fiscal 2021 was primarily driven by non-service cost components of net pension and post-retirement expense and income related to our equity investment, partially offset by unrealized losses from non-operating investments. Other income, net during the second quarter of fiscal 2020 was primarily driven by non-service cost components of net pension and post-retirement expense and income related to our equity investment.\\nFor the first 28 weeks of fiscal 2021, Other income, net was $62.4 million compared to $8.3 million for the first 28 weeks of fiscal 2020. Other income, net during the first 28 weeks of fiscal 2021 was primarily driven by non-service cost components of net pension and post-retirement expense, realized gains from non-operating investments and income related to our equity investment, partially offset by unrealized losses from non-operating investments. Other income, net during the first 28 weeks of fiscal 2020 was primarily driven by non-service cost components of net pension and post-retirement expense and income related to our equity investment, partially offset by recognized losses on interest rate swaps and unrealized losses from non-operating investments.\\nIncome Taxes\\nIncome tax expense was $100.3 million, representing a 25.4% effective tax rate, for the second quarter of fiscal 2021. Income tax expense was $111.2 million, representing a 28.1% effective tax rate, for the second quarter of fiscal 2020. The decrease in the effective tax rate was primarily driven by nondeductible transaction-related costs incurred during the second quarter of fiscal 2020.\\nIncome tax expense was $232.8 million, representing a 23.9% effective tax rate, for the first 28 weeks of fiscal 2021. Income tax expense was $313.1 million, representing a 26.4% effective tax rate, for the first 28 weeks of fiscal 2020. The decrease in the effective income tax rate was primarily driven by the recognition of discrete state income tax benefits during the first 28 weeks of fiscal 2021 and certain nondeductible transaction-related costs incurred during the first 28 weeks of fiscal 2020.\\nWe currently expect our annual effective tax rate for fiscal 2021 to be in the range of approximately 23% to 24%.\\nNet Income and Adjusted Net Income\\nNet income was $295.2 million, or $0.52 per Class A common share, during the second quarter of fiscal 2021 compared to $284.5 million, or $0.49 per Class A common share, during the second quarter of fiscal 2020. Adjusted net income was $369.5 million, or $0.64 per Class A common share, during the second quarter of fiscal 2021 compared to $356.4 million, or $0.60 per Class A common share, during the second quarter of fiscal 2020.\\nNet income was $740.0 million, or $1.26 per Class A common share, during the first 28 weeks of fiscal 2021 compared to $870.7, or $1.49 per Class A common share, during the first 28 weeks of fiscal 2020. Adjusted net income was $887.0 million, or $1.53 per Class A common share, during the first 28 weeks of fiscal 2021 compared to $1,157.6 million, or $1.95 per Class A common share, during the first 28 weeks of fiscal 2020.\\n27\\nAdjusted EBITDA\\nFor the second quarter of fiscal 2021, Adjusted EBITDA was $965.4 million, or 5.8% of Net sales and other revenue, compared to $948.4 million, or 6.0% of Net sales and other revenue, for the second quarter of fiscal 2020. The increase in Adjusted EBITDA was primarily the result of an increase in Net sales and other revenue, partially offset by an increase in Selling and administrative expenses. For the first 28 weeks of fiscal 2021, Adjusted EBITDA was $2,273.5 million, or 6.0% of Net sales and other revenue, compared to $2,639.4 million, or 6.9% of Net sales and other revenue for the first 28 weeks of fiscal 2020. The decrease in Adjusted EBITDA was primarily the result of a decrease in Net sales and other revenue.\\nSupplemental Two-Year Results - Comparison of Second Quarter of Fiscal 2021 to Second Quarter of Fiscal 2019\\nThe following table provides a comparison of the second quarter of fiscal 2021 to the second quarter of fiscal 2019 for certain financial measures, including a compounded annual growth rate (\\\"CAGR\\\"), to demonstrate the two-year growth in our business. We believe these supplemental comparisons provide meaningful and useful information to investors about the trends in our business relative to pre-COVID-19 pandemic periods. These comparisons should not be reviewed in isolation or considered substitutes for our financial results included elsewhere in this Form 10-Q.\\n| Second Quarter of Fiscal 2021 Supplemental Two-Year Results |\\n| Identical sales two-year stacked (1) | 15.3 | % |\\n| Net income per Class A common share two-year CAGR (2) | 1.0 | % |\\n| Adjusted net income per Class A common share two-year CAGR | 94.0 | % |\\n| Net income two-year CAGR (2) | 0.1 | % |\\n| Adjusted net income two-year CAGR | 93.0 | % |\\n| Adjusted EBITDA two-year CAGR | 30.4 | % |\\n| Margins: |\\n| Gross profit (1) | Increased 85 basis points |\\n| Selling and administrative expenses (1) | Decreased 120 basis points |\\n\\n(1) Excluding fuel.\\n(2) The net income per Class A common share two-year CAGR and net income two-year CAGR are impacted by gains related to sale leaseback transactions in the second quarter of fiscal 2019.\\nNet sales and other revenue was $16.5 billion during the second quarter of fiscal 2021 compared to $14.2 billion during the second quarter of fiscal 2019. The increase in sales compared to the second quarter of fiscal 2019 was primarily due to the 15.3% increase in two-year stacked identical sales. Identical sales were driven in part by the 248% two-year stacked increase in digital sales.\\nGross profit margin was 28.6% during the second quarter of fiscal 2021 compared to 27.8% during the second quarter of fiscal 2019. Excluding the impact of fuel, gross profit margin increased by approximately 85 basis points compared to the second quarter of fiscal 2019, primarily driven by sales leverage, improvements in shrink expense, productivity initiatives and improved pharmacy margins related to administering COVID-19 vaccines, partially offset by growth in digital sales and an increase in supply chain costs and COVID-19 expenses.\\n28\\nSelling and administrative expenses were 25.6% of sales during the second quarter of fiscal 2021 compared to 26.8% of sales for the second quarter of fiscal 2019. Excluding the impact of fuel, selling and administrative expenses as a percentage of sales decreased approximately 120 basis points primarily due to sales leverage and the execution of productivity initiatives, partially offset by increases in employee costs and other expenses related to our investments in our digital and omni-channel capabilities and strategic priorities and increased market driven retail wage rates, higher equity-based compensation expense as well as incremental COVID-19 expenses.\\n29\\nReconciliation of Non-GAAP Measures\\nThe following tables reconcile Net income to Adjusted net income, and Net income per Class A common share to Adjusted net income per Class A common share (in millions, except per share data):\\n| 12 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Numerator: |\\n| Net income | $ | 295.2 | $ | 284.5 | $ | 294.8 |\\n| Adjustments: |\\n| (Gain) loss on interest rate and commodity hedges, net (d) | (1.2) | 1.4 | — |\\n| Facility closures and transformation (1)(b) | 14.8 | 6.1 | — |\\n| Acquisition and integration costs (2)(b) | 3.4 | 2.2 | 7.5 |\\n| Equity-based compensation expense (b) | 26.8 | 9.3 | 6.5 |\\n| (Gain) loss on property dispositions and impairment losses, net (3) | (0.2) | (18.3) | (435.5) |\\n| LIFO expense (a) | 14.6 | 10.1 | 5.8 |\\n| Government-mandated incremental COVID-19 pandemic related pay (4)(b) | 18.3 | — | — |\\n| Civil disruption related costs (5)(b) | — | (1.9) | — |\\n| Transaction and reorganization costs related to Convertible Preferred Stock issuance and initial public offering (b) | — | 4.1 | — |\\n| Amortization of debt discount and deferred financing costs (c) | 4.7 | 4.7 | 35.4 |\\n| Loss on debt extinguishment | — | 49.1 | 23.1 |\\n| Amortization of intangible assets resulting from acquisitions (b) | 11.5 | 13.1 | 68.9 |\\n| Miscellaneous adjustments (6)(f) | 5.1 | 13.3 | 24.3 |\\n| Tax impact of adjustments to Adjusted net income | (23.5) | (21.3) | 68.4 |\\n| Adjusted net income | $ | 369.5 | $ | 356.4 | $ | 99.2 |\\n| Denominator: |\\n| Weighted average Class A common shares outstanding - diluted | 573.0 | 582.9 | 580.6 |\\n| Adjustments: |\\n| Restricted stock units and awards (7) | 8.1 | 9.6 | 7.6 |\\n| Adjusted weighted average Class A common shares outstanding - diluted | 581.1 | 592.5 | 588.2 |\\n| Adjusted net income per Class A common share - diluted | $ | 0.64 | $ | 0.60 | $ | 0.17 |\\n| Supplemental Two-Year CAGR: |\\n| Net income two-year CAGR | 0.1 | % |\\n| Adjusted net income two-year CAGR | 93.0 | % |\\n\\n30\\n| 12 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Net income per Class A common share - diluted | $ | 0.52 | $ | 0.49 | $ | 0.51 |\\n| Non-GAAP adjustments (8) | 0.13 | 0.12 | (0.33) |\\n| Restricted stock units and awards (7) | (0.01) | (0.01) | (0.01) |\\n| Adjusted net income per Class A common share - diluted | $ | 0.64 | $ | 0.60 | $ | 0.17 |\\n| Supplemental Two-Year CAGR: |\\n| Net income per Class A common share two-year CAGR | 1.0 | % |\\n| Adjusted net income per Class A common share two-year CAGR | 94.0 | % |\\n\\nThe following table is a reconciliation of Adjusted net income to Adjusted EBITDA:\\n| 12 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Adjusted net income (9) | $ | 369.5 | $ | 356.4 | $ | 99.2 |\\n| Tax impact of adjustments to Adjusted net income | 23.5 | 21.3 | (68.4) |\\n| Income tax expense | 100.3 | 111.2 | 81.9 |\\n| Amortization of debt discount and deferred financing costs (c) | (4.7) | (4.7) | (35.4) |\\n| Interest expense, net | 109.3 | 128.6 | 177.5 |\\n| Amortization of intangible assets resulting from acquisitions (b) | (11.5) | (13.1) | (68.9) |\\n| Depreciation and amortization (e) | 379.0 | 348.7 | 381.7 |\\n| Adjusted EBITDA | $ | 965.4 | $ | 948.4 | $ | 567.6 |\\n| Supplemental Two-Year CAGR: |\\n| Adjusted EBITDA two-year CAGR | 30.4 | % |\\n\\n(1) Includes costs related to closures of operating facilities and third-party consulting fees related to our strategic priorities and associated business transformation.\\n(2) Related to conversion activities and related costs associated with integrating acquired businesses. Also includes expenses related to management fees in prior periods paid in connection with acquisition and financing activities.\\n(3) Primarily due to gains related to sale leaseback transactions in the second quarter of fiscal 2019.\\n(4) Represents incremental pay that is legislatively required in certain municipalities in which we operate.\\n(5) Primarily includes costs related to store damage, inventory losses and community support as a result of the civil disruption during late May 2020 and early June 2020 in certain markets.\\n31\\n(6) Miscellaneous adjustments include the following (see table below):\\n| 12 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Non-cash lease-related adjustments | $ | 1.0 | $ | (0.1) | $ | 4.4 |\\n| Lease and lease-related costs for surplus and closed stores | 6.5 | 10.8 | 5.2 |\\n| Net realized and unrealized (gain) loss on non-operating investments | 12.8 | 0.2 | 10.8 |\\n| Other (i) | (15.2) | 2.4 | 3.9 |\\n| Total miscellaneous adjustments | $ | 5.1 | $ | 13.3 | $ | 24.3 |\\n\\n(i) Primarily includes adjustments for pension settlement gain, certain legal and regulatory accruals, unconsolidated equity investments and certain contract termination costs.\\n(7) Represents incremental unvested RSUs and unvested RSAs to adjust the diluted weighted average Class A common shares outstanding during each respective period to the fully outstanding RSUs and RSAs as of the end of each respective period.\\n(8) Reflects the per share impact of Non-GAAP adjustments for each period. See the reconciliation of Net income to Adjusted net income above for further details.\\n(9) See the reconciliation of Net income to Adjusted net income above for further details.\\nNon-GAAP adjustment classifications within the Consolidated Statement of Operations:\\n(a) Cost of sales\\n(b) Selling and administrative expenses\\n(c) Interest expense, net\\n(d) (Gain) loss on interest rate and commodity hedges, net:\\n| 12 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Cost of sales | $ | (1.2) | $ | 1.0 | $ | — |\\n| Other income, net | — | 0.4 | — |\\n| Total (Gain) loss on interest rate and commodity hedges, net | $ | (1.2) | $ | 1.4 | $ | — |\\n\\n(e) Depreciation and amortization:\\n| 12 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Cost of sales | $ | 36.0 | $ | 40.1 | $ | 38.0 |\\n| Selling and administrative expenses | 343.0 | 308.6 | 343.7 |\\n| Total Depreciation and amortization | $ | 379.0 | $ | 348.7 | $ | 381.7 |\\n\\n(f) Miscellaneous adjustments:\\n| 12 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Selling and administrative expenses | $ | 3.4 | $ | 9.9 | $ | 9.6 |\\n| Other income, net | 1.7 | 3.4 | 14.7 |\\n| Total Miscellaneous adjustments | $ | 5.1 | $ | 13.3 | $ | 24.3 |\\n\\n32\\n| 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Numerator: |\\n| Net income | $ | 740.0 | $ | 870.7 | $ | 343.8 |\\n| Adjustments: |\\n| (Gain) loss on interest rate and commodity hedges, net (d) | (7.5) | 25.9 | 0.3 |\\n| Facility closures and transformation (1)(b) | 35.6 | 15.9 | — |\\n| Acquisition and integration costs (2)(b) | 6.9 | 8.5 | 33.6 |\\n| Equity-based compensation expense (b) | 49.0 | 28.3 | 17.6 |\\n| Loss (gain) on property dispositions and impairment losses, net (3) | 0.1 | 12.0 | (464.0) |\\n| LIFO expense (a) | 29.1 | 23.2 | 16.3 |\\n| Discretionary COVID-19 pandemic related costs (4)(b) | — | 89.9 | — |\\n| Government-mandated incremental COVID-19 pandemic related pay (5)(b) | 47.4 | — | — |\\n| Civil disruption related costs (6)(b) | — | 13.0 | — |\\n| Transaction and reorganization costs related to Convertible Preferred Stock issuance and initial public offering (b) | — | 24.4 | — |\\n| Amortization of debt discount and deferred financing costs (c) | 11.1 | 11.2 | 43.8 |\\n| Loss on debt extinguishment | — | 49.1 | 65.8 |\\n| Amortization of intangible assets resulting from acquisitions (b) | 27.6 | 30.6 | 161.7 |\\n| Miscellaneous adjustments (7)(f) | (5.7) | 47.4 | 33.1 |\\n| Tax impact of adjustments to Adjusted net income | (46.6) | (92.5) | 23.7 |\\n| Adjusted net income | $ | 887.0 | $ | 1,157.6 | $ | 275.7 |\\n| Denominator: |\\n| Weighted average Class A common shares outstanding - diluted | 470.6 | 583.3 | 580.0 |\\n| Adjustments: |\\n| Convertible Preferred Stock (8) | 101.6 | — | — |\\n| Restricted stock units and awards (9) | 8.8 | 9.2 | 8.2 |\\n| Adjusted weighted average Class A common shares outstanding - diluted | 581.0 | 592.5 | 588.2 |\\n| Adjusted net income per Class A common share - diluted | $ | 1.53 | $ | 1.95 | $ | 0.47 |\\n| Supplemental Two-Year CAGR: |\\n| Net income two-year CAGR | 46.7 | % |\\n| Adjusted net income two-year CAGR | 79.4 | % |\\n\\n33\\n| 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Net income per Class A common share - diluted | $ | 1.26 | $ | 1.49 | $ | 0.59 |\\n| Convertible Preferred Stock (8) | 0.03 | — | — |\\n| Non-GAAP adjustments (10) | 0.26 | 0.49 | (0.11) |\\n| Restricted stock units and awards (9) | (0.02) | (0.03) | (0.01) |\\n| Adjusted net income per Class A common share - diluted | $ | 1.53 | $ | 1.95 | $ | 0.47 |\\n| Supplemental Two-Year CAGR: |\\n| Net income per Class A common share two-year CAGR | 46.1 | % |\\n| Adjusted net income per Class A common share two-year CAGR | 80.4 | % |\\n\\nThe following table is a reconciliation of Adjusted net income to Adjusted EBITDA:\\n| 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Adjusted net income (11) | $ | 887.0 | $ | 1,157.6 | $ | 275.7 |\\n| Tax impact of adjustments to Adjusted net income | 46.6 | 92.5 | (23.7) |\\n| Income tax expense | 232.8 | 313.1 | 97.6 |\\n| Amortization of debt discount and deferred financing costs (c) | (11.1) | (11.2) | (43.8) |\\n| Interest expense, net | 262.6 | 309.2 | 402.7 |\\n| Amortization of intangible assets resulting from acquisitions (b) | (27.6) | (30.6) | (161.7) |\\n| Depreciation and amortization (e) | 883.2 | 808.8 | 897.6 |\\n| Adjusted EBITDA | $ | 2,273.5 | $ | 2,639.4 | $ | 1,444.4 |\\n| Supplemental Two-Year CAGR: |\\n| Adjusted EBITDA two-year CAGR | 25.5 | % |\\n\\n(1) Includes costs related to closures of operating facilities and third-party consulting fees related to our strategic priorities and associated business transformation.\\n(2) Related to conversion activities and related costs associated with integrating acquired businesses. Also includes expenses related to management fees in prior periods paid in connection with acquisition and financing activities.\\n(3) Primarily due to gains related to sale leaseback transactions in the second quarter of fiscal 2019.\\n(4) Includes $53 million of charitable contributions to our communities for hunger relief and $36.9 million in final reward payments to front-line associates at the end of the first quarter of fiscal 2020.\\n(5) Represents incremental pay that is legislatively required in certain municipalities in which we operate.\\n(6) Primarily includes costs related to store damage, inventory losses and community support as a result of the civil disruption during late May 2020 and early June 2020 in certain markets.\\n34\\n(7) Miscellaneous adjustments include the following (see table below):\\n| 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Non-cash lease-related adjustments | $ | 3.1 | $ | 1.9 | $ | 6.3 |\\n| Lease and lease-related costs for surplus and closed stores | 16.7 | 29.5 | 12.0 |\\n| Net realized and unrealized (gain) loss on non-operating investments | (9.7) | 4.7 | 7.5 |\\n| Other (i) | (15.8) | 11.3 | 7.3 |\\n| Total miscellaneous adjustments | $ | (5.7) | $ | 47.4 | $ | 33.1 |\\n\\n(i) Primarily includes adjustments for pension settlement gain, certain legal and regulatory accruals, unconsolidated equity investments and certain contract termination costs.\\n(8) Represents the conversion of Convertible Preferred Stock to the fully outstanding as-converted Class A common shares as of the end of each respective period, for periods in which the Convertible Preferred Stock is antidilutive under GAAP.\\n(9) Represents incremental unvested RSUs and unvested RSAs to adjust the diluted weighted average Class A common shares outstanding during each respective period to the fully outstanding RSUs and RSAs as of the end of each respective period.\\n(10) Reflects the per share impact of Non-GAAP adjustments for each period. See the reconciliation of Net income to Adjusted net income above for further details.\\n(11) See the reconciliation of Net income to Adjusted net income above for further details.\\nNon-GAAP adjustment classifications within the Consolidated Statement of Operations:\\n(a) Cost of sales\\n(b) Selling and administrative expenses\\n(c) Interest expense, net\\n35\\n(d) (Gain) loss on interest rate and commodity hedges, net:\\n| 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Cost of sales | $ | (7.8) | $ | 6.5 | $ | 0.3 |\\n| Other income, net | 0.3 | 19.4 | — |\\n| Total (Gain) loss on interest rate and commodity hedges, net | $ | (7.5) | $ | 25.9 | $ | 0.3 |\\n\\n(e) Depreciation and amortization:\\n| 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Cost of sales | $ | 86.8 | $ | 94.1 | $ | 90.0 |\\n| Selling and administrative expenses | 796.4 | 714.7 | 807.6 |\\n| Total Depreciation and amortization | $ | 883.2 | $ | 808.8 | $ | 897.6 |\\n\\n(f) Miscellaneous adjustments:\\n| 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Selling and administrative expenses | $ | 10.2 | $ | 34.7 | $ | 16.7 |\\n| Other income, net | (15.9) | 12.7 | 16.4 |\\n| Total Miscellaneous adjustments | $ | (5.7) | $ | 47.4 | $ | 33.1 |\\n\\nLIQUIDITY AND CAPITAL RESOURCES\\nThe following table sets forth the major sources and uses of cash and cash equivalents and restricted cash for each period (in millions):\\n| 28 weeks ended |\\n| September 11,2021 | September 12,2020 |\\n| Cash and cash equivalents and restricted cash at end of period | $ | 2,900.4 | $ | 2,431.9 |\\n| Cash flows provided by operating activities | 2,137.7 | 2,720.8 |\\n| Cash flows used in investing activities | (790.5) | (687.1) |\\n| Cash flows used in financing activities | (214.4) | (80.7) |\\n\\nNet Cash Provided by Operating Activities\\nNet cash provided by operating activities was $2,137.7 million for the first 28 weeks of fiscal 2021 compared to $2,720.8 million for the first 28 weeks of fiscal 2020. The decrease in cash flow from operations compared to the first 28 weeks of fiscal 2020 was due to changes in working capital primarily related to accounts payable as our business experienced significantly elevated demand during the first 28 weeks of fiscal 2020 and a deferral of approximately $270 million of the employer-paid portion of social security taxes in the first 28 weeks of fiscal 2020 together with lower EBITDA during the first 28 weeks of fiscal 2021. These decreases were partially offset by less cash paid for interest and income taxes of $94 million and $72 million, respectively, $75 million payment for the UFCW & Employers Midwest Pension Fund settlement in the first 28 weeks of fiscal 2020 and a decrease of $45.1 million in contributions to our defined benefit pension plans and post-retirement benefit plans.\\n36\\nNet Cash Used by Investing Activities\\nNet cash used in investing activities was $790.5 million for the first 28 weeks of fiscal 2021 compared to $687.1 million for the first 28 weeks of fiscal 2020.\\nFor the first 28 weeks of fiscal 2021, cash used in investing activities consisted primarily of payments for property and equipment of $822.5 million and payments for business acquisitions of $23.5 million, partially offset by proceeds from the sale of long-lived assets of $24.6 million. Payments for property and equipment in the first 28 weeks of fiscal 2021 included the opening of six new stores, completion of 76 remodels and increased investment in our digital technology. For the first 28 weeks of fiscal 2020, cash used in investing activities consisted primarily of payments for property and equipment of $702.9 million. Payments for property and equipment in the first 28 weeks of fiscal 2020 included the completion of 132 remodels and continued investment in our digital technology. For the full fiscal year of 2021, we expect capital expenditures to be in the range of $1.9 billion to $2.0 billion.\\nNet Cash Used in Financing Activities\\nNet cash used in financing activities was $214.4 million during the first 28 weeks of fiscal 2021 compared to $80.7 million during the first 28 weeks of fiscal 2020.\\nNet cash used in financing activities during the first 28 weeks of fiscal 2021 consisted primarily of dividends paid on our Class A common stock and Convertible Preferred Stock. Net cash used in financing activities during the first 28 weeks of fiscal 2020 consisted primarily of the $1.5 billion issuance of new Senior Unsecured Notes and $1.25 billion aggregate redemption of 2024 Notes and 2025 Notes, the $2.0 billion borrowing and subsequent repayment of the ABL Facility, the issuance of the Convertible Preferred Stock and the repurchase of outstanding Class A common stock.\\nLiquidity and Factors Affecting Liquidity\\nWe estimate our liquidity needs over the next 12 months to be in the range of $4.75 billion to $5.25 billion, which includes anticipated requirements for incremental working capital, capital expenditures, pension obligations, interest payments and scheduled principal payments of debt, dividends on Class A common stock and Convertible Preferred Stock, operating leases and finance leases. Based on current operating trends, we believe that cash flows from operating activities and other sources of liquidity, including borrowings under our ABL Facility, will be adequate to meet our liquidity needs for the next 12 months and for the foreseeable future. We believe we have adequate cash flow to continue to respond effectively to competitive conditions. In addition, we may enter into refinancing and sale leaseback transactions from time to time. There can be no assurance, however, that our business will continue to generate cash flow at or above current levels or that we will maintain our ability to borrow under our ABL Facility.\\nThe holders of Convertible Preferred Stock are entitled to a quarterly dividend at a rate per annum of 6.75% of the liquidation preference per share of the Convertible Preferred Stock. On March 15, 2021, June 15, 2021 and September 15, 2021, we declared quarterly cash dividends of $29.5 million, respectively, to holders of the Convertible Preferred Stock, which was paid on March 31, 2021, June 30, 2021 and September 30, 2021, respectively. In addition, the holders of Convertible Preferred Stock will participate in cash dividends that we pay on our common stock to the extent that such cash dividends exceed $206.25 million per fiscal year.\\n37\\nWe have established a dividend policy pursuant to which we intend to pay a quarterly dividend on our Class A common stock. During the first 28 weeks of fiscal 2021, we paid quarterly cash dividends of $0.10 per share of Class A common stock on May 10, 2021 and August 10, 2021, to stockholders of record as of the close of business on April 26, 2021 and July 26, 2021, respectively. On October 18, 2021, subsequent to the end of the second quarter of fiscal 2021, we announced a 20% increase to our quarterly dividend, which is now $0.12 per share of Class A common stock, payable on November 12, 2021 to stockholders of record as of the close of business on October 29, 2021.\\nAs of September 11, 2021, we had no borrowings outstanding under out ABL Facility and total availability of $3,483.1 million (net of letter of credit usage).\\nMultiemployer Pension Plans\\nThe American Rescue Plan Act (\\\"ARP Act\\\") establishes a special financial assistance program for financially troubled multiemployer pension plans. Under the ARP Act, eligible multiemployer plans can apply to receive a one-time cash payment in the amount projected by the Pension Benefit Guaranty Corporation (\\\"PBGC\\\") to pay pension benefits through the plan year ending 2051. The payment received by the multiemployer plan under this special financial assistance program would not be considered a loan and would not need to be paid back. Any financial assistance received by the multiemployer plan would need to be segregated from the other assets of the multiemployer plans and invested in investment grade bonds or other investments permitted by the PBGC.\\nOf the 27 multiemployer plans to which we contribute, 16 plans are classified as \\\"Critical\\\" or \\\"Critical and Declining\\\" and are potentially eligible for special financial assistance under the ARP Act. Though the amount of financial assistance that each of these 16 plans could receive will vary by plan, we currently estimate that these 16 plans represent over 90% of the $4.7 billion we estimated as our share of the underfunding of the 27 plans. On July 9, 2021, the PBGC issued its interim final rule with respect to the special financial assistance program. The PBGC interim final rule provides direction on the application requirements, identifies which plans will have priority, eligibility requirements, the determination of the amount of financial assistance to be provided and establishes conditions and restrictions that apply to plans that receive assistance. We are evaluating the interim final rule and have submitted comments during the 30-day comment period, and we expect the special financial assistance program to provide funding for the multiemployer plans to which we contribute to remain solvent through the next 25 to 30 years.\\nCRITICAL ACCOUNTING POLICIES\\nThe preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. We have chosen accounting policies that we believe are appropriate to report accurately and fairly our operating results and financial position, and we apply those accounting policies in a fair and consistent manner. See the Critical Accounting Policies section included in our Annual Report on Form 10-K for the fiscal year ended February 27, 2021, filed with the SEC on April 28, 2021, for a discussion of our significant accounting policies.\\nRECENTLY ISSUED AND RECENTLY ADOPTED ACCOUNTING STANDARDS\\nSee Note 1 - Basis of presentation and summary of significant accounting policies of our unaudited interim Condensed Consolidated Financial Statements located elsewhere in this Form 10-Q.\\n38\\nItem 3\\n-\\nQuantitative and Qualitative Disclosures About Market Risk\\nThere have been no material changes in our exposure to market risk from the information provided in our Annual Report on Form 10-K for the fiscal year ended February 27, 2021, filed with the SEC on April 28, 2021.\\nItem 4 - Controls and Procedures\\nBased on their evaluation of our disclosure controls and procedures (as defined in Rules 13a-15 and 15d-15 under the Securities Exchange Act of 1934 (the \\\"Exchange Act\\\")) as of the end of the period covered by this Form 10-Q, our Principal Executive Officer and Principal Financial Officer concluded our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms and is accumulated and communicated to management, including our Principal Executive Officer and Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.\\nChanges in Internal Control over Financial Reporting\\nThere were no changes in our internal control over financial reporting during the second quarter of fiscal 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\n39\\nPART II - OTHER INFORMATION\\nItem 1 - Legal Proceedings\\nThe Company is subject from time to time to various claims and lawsuits arising in the ordinary course of business, including lawsuits involving trade practices, lawsuits alleging violations of state and/or federal wage and hour laws (including alleged violations of meal and rest period laws and alleged misclassification issues), real estate disputes as well as other matters. Some of these claims or suits purport or may be determined to be class actions and/or seek substantial damages. It is the opinion of the Company's management that although the amount of liability with respect to certain of the matters described in this Form 10-Q cannot be ascertained at this time, any resulting liability of these and other matters, including any punitive damages, will not have a material adverse effect on the Company's business or financial condition. See the matters under the caption Legal Proceedings in Note 6 - Commitments and contingencies and off balance sheet arrangements in the unaudited interim Condensed Consolidated Financial Statements located elsewhere in this Form 10-Q.\\nItem 1A - Risk Factors\\nThere have been no material changes to the risk factors previously included in our Annual Report on Form 10-K for the fiscal year ended February 27, 2021, filed with the SEC on April 28, 2021, under the heading \\\"Risk Factors.\\\"\\nItem 2 - Unregistered Sales of Equity Securities and Use of Proceeds\\n(a) Unregistered Sales of Equity Securities\\nNone.\\n(b) Use of Proceeds\\nNone.\\n(c) Purchases of Equity Securities\\nNone.\\nItem 3 - Defaults Upon Senior Securities\\nNone.\\nItem 4 - Mine Safety Disclosures\\nNot Applicable.\\nItem 5 - Other Information\\nNone.\\n40\\nItem 6 - Exhibits\\n3.1 Certificate of Amendment to the Amended and Restated Certificate of Incorporation of Albertsons Companies, Inc.\\n10.1 Employment Agreement, dated as of August 4, 2021, by and between Albertsons Companies, Inc. and Sharon McCollam (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on August 11, 2021)\\n31.1 Certification of the Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002\\n31.2 Certification of the Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002\\n32.1 Certification of the Principal Executive Officer and of the Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002\\nEXHIBIT 101.INS - Inline XBRL Instance Document\\nEXHIBIT 101.SCH - Inline XBRL Taxonomy Extension Schema Document\\nEXHIBIT 101.CAL - Inline XBRL Taxonomy Extension Calculation Linkbase Document\\nEXHIBIT 101.DEF - Inline XBRL Taxonomy Extension Definition Linkbase Document\\nEXHIBIT 101.LAB - Inline XBRL Taxonomy Extension Label Linkbase Document\\nEXHIBIT 101.PRE - Inline XBRL Taxonomy Extension Presentation Linkbase Document\\nEXHIBIT 104 - Cover Page Interactive Data File (embedded within the Inline XBRL document)\\n41\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n| Albertsons Companies, Inc.(Registrant) |\\n| Date: | October 20, 2021 | By: | /s/ Vivek Sankaran |\\n| Vivek Sankaran |\\n| Chief Executive Officer and Director(Principal Executive Officer) |\\n\\n| Date: | October 20, 2021 | By: | /s/ Sharon McCollam |\\n| Sharon McCollam |\\n| President and Chief Financial Officer(Principal Financial Officer) |\\n\\n42\\n \\n\\nWhat is the rate of increase in total debt as a percentage of total assets from February 27, 2021 to September 11, 2021 in percent?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is -2.3942768229509377.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 33,\n \"input_length\": 30984\n}"}}},{"rowIdx":34,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nItem 1.\nFinancial Statements\nConsolidated Balance Sheets September 30, 2015 (unaudited)\nand December 31, 2014 1\nConsolidated Statements of Operations and Comprehensive Income (Loss) for the\nthree and nine months ended September 30, 2015 and 2014 (unaudited) 2\nConsolidated Statements of Changes in Shareholders' Equity for the three and\nnine months ended September 30, 2015 and 2014 (unaudited) 3\nConsolidated Statements of Cash Flows for the nine months ended\nSeptember 30, 2015 and 2014 (unaudited) 4\nNotes to Consolidated Interim Financial Statements (unaudited) 5\nItem 2. Management's Discussion and Analysis of Financial Condition and\nResults of Operation 30\nItem 3. Quantitative and Qualitative Disclosures About Market Risk 57\nItem 4. Controls and Procedures 58\nPART II\nOTHER INFORMATION\n\n| Item 1. | Legal Proceedings | 58 |\n| Item 1A. | Risk Factors | 58 |\n| Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 59 |\n| Item 3. | Defaults Upon Senior Securities | 59 |\n| Item 4. | Mine Safety Disclosures | 59 |\n| Item 5. | Other Information | 59 |\n| Item 6. | Exhibits | 60 |\n\nEVEREST RE GROUP, LTD.\nCONSOLIDATED BALANCE SHEETS\n\n| September 30, | December 31, |\n| (Dollars and share amounts in thousands, except par value per share) | 2015 | 2014 |\n| (unaudited) |\n| ASSETS: |\n| Fixed maturities - available for sale, at market value | $ | 13,490,960 | $ | 13,101,067 |\n| (amortized cost: 2015, $13,301,713; 2014, $12,831,159) |\n| Fixed maturities - available for sale, at fair value | - | 1,509 |\n| Equity securities - available for sale, at market value (cost: 2015, $127,411; 2014, $148,326) | 112,999 | 140,210 |\n| Equity securities - available for sale, at fair value | 1,357,311 | 1,447,820 |\n| Short-term investments | 1,615,045 | 1,705,932 |\n| Other invested assets (cost: 2015, $669,686; 2014, $601,925) | 669,686 | 601,925 |\n| Cash | 401,226 | 437,474 |\n| Total investments and cash | 17,647,227 | 17,435,937 |\n| Accrued investment income | 107,199 | 111,075 |\n| Premiums receivable | 1,663,425 | 1,397,983 |\n| Reinsurance receivables | 831,635 | 670,854 |\n| Funds held by reinsureds | 272,775 | 228,192 |\n| Deferred acquisition costs | 364,947 | 398,408 |\n| Prepaid reinsurance premiums | 193,122 | 154,177 |\n| Income taxes | 270,607 | 184,762 |\n| Other assets | 331,374 | 236,436 |\n| TOTAL ASSETS | $ | 21,682,311 | $ | 20,817,824 |\n| LIABILITIES: |\n| Reserve for losses and loss adjustment expenses | $ | 9,965,963 | $ | 9,720,813 |\n| Future policy benefit reserve | 59,580 | 59,820 |\n| Unearned premium reserve | 1,717,422 | 1,728,745 |\n| Funds held under reinsurance treaties | 83,137 | 3,932 |\n| Commission reserves | 79,904 | 87,990 |\n| Other net payable to reinsurers | 199,528 | 139,841 |\n| Losses in course of payment | 298,577 | 157,527 |\n| 4.868% Senior notes due 6/1/2044 | 400,000 | 400,000 |\n| 6.6% Long term notes due 5/1/2067 | 238,367 | 238,364 |\n| Accrued interest on debt and borrowings | 12,341 | 3,537 |\n| Equity index put option liability | 52,247 | 47,022 |\n| Unsettled securities payable | 65,147 | 41,092 |\n| Other liabilities | 271,086 | 316,469 |\n| Total liabilities | 13,443,299 | 12,945,152 |\n| NONCONTROLLING INTERESTS: |\n| Redeemable noncontrolling interests - Mt. Logan Re | 752,692 | 421,552 |\n| Commitments and contingencies (Note 9) |\n| SHAREHOLDERS' EQUITY: |\n| Preferred shares, par value: $0.01; 50,000 shares authorized; |\n| no shares issued and outstanding | - | - |\n| Common shares, par value: $0.01; 200,000 shares authorized; (2015) 68,585 |\n| and (2014) 68,336 outstanding before treasury shares | 686 | 683 |\n| Additional paid-in capital | 2,094,850 | 2,068,807 |\n| Accumulated other comprehensive income (loss), net of deferred income tax expense |\n| (benefit) of ($2,899) at 2015 and $20,715 at 2014 | (112,231 | ) | 48,317 |\n| Treasury shares, at cost; 25,500 shares (2015) and 23,650 shares (2014) | (2,810,878 | ) | (2,485,897 | ) |\n| Retained earnings | 8,313,893 | 7,819,210 |\n| Total shareholders' equity attributable to Everest Re Group | 7,486,320 | 7,451,120 |\n| TOTAL LIABILITIES, NONCONTROLLING INTERESTS AND SHAREHOLDERS' EQUITY | $ | 21,682,311 | $ | 20,817,824 |\n| The accompanying notes are an integral part of the consolidated financial statements. |\n\n1\nEVEREST RE GROUP, LTD.\nCONSOLIDATED STATEMENTS OF OPERATIONS\nAND COMPREHENSIVE INCOME (LOSS)\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands, except per share amounts) | 2015 | 2014 | 2015 | 2014 |\n| (unaudited) | (unaudited) |\n| REVENUES: |\n| Premiums earned | $ | 1,413,640 | $ | 1,389,998 | $ | 4,053,115 | $ | 3,806,805 |\n| Net investment income | 115,511 | 142,143 | 363,140 | 396,524 |\n| Net realized capital gains (losses): |\n| Other-than-temporary impairments on fixed maturity securities | (20,445 | ) | (106 | ) | (62,701 | ) | (495 | ) |\n| Other-than-temporary impairments on fixed maturity securities |\n| transferred to other comprehensive income (loss) | - | - | - | - |\n| Other net realized capital gains (losses) | (139,526 | ) | (9,342 | ) | (131,953 | ) | 71,189 |\n| Total net realized capital gains (losses) | (159,971 | ) | (9,448 | ) | (194,654 | ) | 70,694 |\n| Net derivative gain (loss) | (11,428 | ) | 1,855 | (5,225 | ) | 3,968 |\n| Other income (expense) | 17,413 | 11,332 | 59,561 | (5,835 | ) |\n| Total revenues | 1,375,165 | 1,535,880 | 4,275,937 | 4,272,156 |\n| CLAIMS AND EXPENSES: |\n| Incurred losses and loss adjustment expenses | 888,097 | 837,757 | 2,401,223 | 2,192,863 |\n| Commission, brokerage, taxes and fees | 300,048 | 290,519 | 882,132 | 820,208 |\n| Other underwriting expenses | 70,667 | 63,113 | 195,282 | 172,165 |\n| Corporate expenses | 5,924 | 9,958 | 17,312 | 18,802 |\n| Interest, fees and bond issue cost amortization expense | 8,990 | 12,424 | 27,006 | 28,970 |\n| Total claims and expenses | 1,273,726 | 1,213,771 | 3,522,955 | 3,233,008 |\n| INCOME (LOSS) BEFORE TAXES | 101,439 | 322,109 | 752,982 | 1,039,148 |\n| Income tax expense (benefit) | (6,133 | ) | 20,856 | 70,868 | 137,948 |\n| NET INCOME (LOSS) | $ | 107,572 | $ | 301,253 | $ | 682,114 | $ | 901,200 |\n| Net (income) loss attributable to noncontrolling interests | (19,019 | ) | (26,337 | ) | (61,526 | ) | (42,167 | ) |\n| NET INCOME (LOSS) ATTRIBUTABLE TO EVEREST RE GROUP | $ | 88,553 | $ | 274,916 | $ | 620,588 | $ | 859,033 |\n| Other comprehensive income (loss), net of tax: |\n| Unrealized appreciation (depreciation) (\"URA(D)\") on securities arising during the period | (91,059 | ) | (74,074 | ) | (144,335 | ) | 65,318 |\n| Reclassification adjustment for realized losses (gains) included in net income (loss) | 24,596 | (5,684 | ) | 59,526 | (1,641 | ) |\n| Total URA(D) on securities arising during the period | (66,463 | ) | (79,758 | ) | (84,809 | ) | 63,677 |\n| Foreign currency translation adjustments | (32,505 | ) | (34,974 | ) | (80,508 | ) | (38,374 | ) |\n| Benefit plan actuarial net gain (loss) for the period | - | - | - | - |\n| Reclassification adjustment for amortization of net (gain) loss included in net income (loss) | 1,556 | 825 | 4,769 | 2,366 |\n| Total benefit plan net gain (loss) for the period | 1,556 | 825 | 4,769 | 2,366 |\n| Total other comprehensive income (loss), net of tax | (97,412 | ) | (113,907 | ) | (160,548 | ) | 27,669 |\n| Other comprehensive (income) loss attributable to noncontrolling interests | - | - | - | - |\n| Total other comprehensive income (loss), net of tax attributable to Everest Re Group | (97,412 | ) | (113,907 | ) | (160,548 | ) | 27,669 |\n| COMPREHENSIVE INCOME (LOSS) | $ | (8,859 | ) | $ | 161,009 | $ | 460,040 | $ | 886,702 |\n| EARNINGS PER COMMON SHARE ATTRIBUTABLE TO EVEREST RE GROUP: |\n| Basic | $ | 2.02 | $ | 6.05 | $ | 14.04 | $ | 18.64 |\n| Diluted | 2.00 | 6.00 | 13.92 | 18.47 |\n| Dividends declared | 0.95 | 0.75 | 2.85 | 2.25 |\n| The accompanying notes are an integral part of the consolidated financial statements. |\n\n2\nEVEREST RE GROUP, LTD.\nCONSOLIDATED STATEMENTS OF\nCHANGES IN SHAREHOLDERS' EQUITY\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands, except share and dividends per share amounts) | 2015 | 2014 | 2015 | 2014 |\n| (unaudited) | (unaudited) |\n| COMMON SHARES (shares outstanding): |\n| Balance, beginning of period | 44,192,526 | 45,691,015 | 44,685,637 | 47,543,132 |\n| Issued during the period, net | 29,398 | 29,622 | 248,665 | 344,761 |\n| Treasury shares acquired | (1,137,473 | ) | (470,807 | ) | (1,849,851 | ) | (2,638,063 | ) |\n| Balance, end of period | 43,084,451 | 45,249,830 | 43,084,451 | 45,249,830 |\n| COMMON SHARES (par value): |\n| Balance, beginning of period | $ | 685 | $ | 683 | $ | 683 | $ | 680 |\n| Issued during the period, net | 1 | - | 3 | 3 |\n| Balance, end of period | 686 | 683 | 686 | 683 |\n| ADDITIONAL PAID-IN CAPITAL: |\n| Balance, beginning of period | 2,084,636 | 2,052,682 | 2,068,807 | 2,029,774 |\n| Share-based compensation plans | 10,214 | 7,274 | 26,043 | 30,182 |\n| Balance, end of period | 2,094,850 | 2,059,956 | 2,094,850 | 2,059,956 |\n| ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS), |\n| NET OF DEFERRED INCOME TAXES: |\n| Balance, beginning of period | (14,819 | ) | 299,304 | 48,317 | 157,728 |\n| Net increase (decrease) during the period | (97,412 | ) | (113,907 | ) | (160,548 | ) | 27,669 |\n| Balance, end of period | (112,231 | ) | 185,397 | (112,231 | ) | 185,397 |\n| RETAINED EARNINGS: |\n| Balance, beginning of period | 8,267,038 | 7,281,023 | 7,819,210 | 6,765,967 |\n| Net income (loss) attributable to Everest Re Group | 88,553 | 274,916 | 620,588 | 859,033 |\n| Dividends declared ($0.95 per share in third quarter 2015 and $2.85 year-to-date |\n| per share in 2015 and $0.75 per share in third quarter 2014 and $2.25 |\n| year-to-date per share in 2014) | (41,698 | ) | (33,973 | ) | (125,905 | ) | (103,034 | ) |\n| Balance, end of period | 8,313,893 | 7,521,966 | 8,313,893 | 7,521,966 |\n| TREASURY SHARES AT COST: |\n| Balance, beginning of period | (2,610,878 | ) | (2,310,824 | ) | (2,485,897 | ) | (1,985,873 | ) |\n| Purchase of treasury shares | (200,000 | ) | (74,991 | ) | (324,981 | ) | (399,942 | ) |\n| Balance, end of period | (2,810,878 | ) | (2,385,815 | ) | (2,810,878 | ) | (2,385,815 | ) |\n| TOTAL SHAREHOLDERS' EQUITY, END OF PERIOD | $ | 7,486,320 | $ | 7,382,187 | $ | 7,486,320 | $ | 7,382,187 |\n| The accompanying notes are an integral part of the consolidated financial statements. |\n\n3\nEVEREST RE GROUP, LTD.\nCONSOLIDATED STATEMENTS OF CASH FLOWS\n\n| Nine Months Ended |\n| September 30, |\n| (Dollars in thousands) | 2015 | 2014 |\n| (unaudited) |\n| CASH FLOWS FROM OPERATING ACTIVITIES: |\n| Net income (loss) | $ | 682,114 | $ | 901,200 |\n| Adjustments to reconcile net income to net cash provided by operating activities: |\n| Decrease (increase) in premiums receivable | (274,198 | ) | (255,645 | ) |\n| Decrease (increase) in funds held by reinsureds, net | 33,255 | (6,929 | ) |\n| Decrease (increase) in reinsurance receivables | (202,329 | ) | (256,458 | ) |\n| Decrease (increase) in income taxes | (61,627 | ) | (14,696 | ) |\n| Decrease (increase) in prepaid reinsurance premiums | (46,633 | ) | (101,478 | ) |\n| Increase (decrease) in reserve for losses and loss adjustment expenses | 347,729 | 172,511 |\n| Increase (decrease) in future policy benefit reserve | (240 | ) | (1,879 | ) |\n| Increase (decrease) in unearned premiums | 1,455 | 255,537 |\n| Increase (decrease) in other net payable to reinsurers | 67,550 | 101,984 |\n| Increase (decrease) in losses in course of payment | 142,418 | 165,105 |\n| Change in equity adjustments in limited partnerships | (12,725 | ) | (24,438 | ) |\n| Distribution of limited partnership income | 42,625 | 41,165 |\n| Change in other assets and liabilities, net | 18,573 | (32,114 | ) |\n| Non-cash compensation expense | 16,150 | 14,720 |\n| Amortization of bond premium (accrual of bond discount) | 38,770 | 38,010 |\n| Amortization of underwriting discount on senior notes | 3 | 43 |\n| Net realized capital (gains) losses | 194,654 | (70,694 | ) |\n| Net cash provided by (used in) operating activities | 987,544 | 925,944 |\n| CASH FLOWS FROM INVESTING ACTIVITIES: |\n| Proceeds from fixed maturities matured/called - available for sale, at market value | 1,687,589 | 1,638,278 |\n| Proceeds from fixed maturities matured/called - available for sale, at fair value | - | 875 |\n| Proceeds from fixed maturities sold - available for sale, at market value | 1,146,000 | 1,050,082 |\n| Proceeds from fixed maturities sold - available for sale, at fair value | 1,824 | 23,856 |\n| Proceeds from equity securities sold - available for sale, at market value | 22,120 | 11,174 |\n| Proceeds from equity securities sold - available for sale, at fair value | 439,692 | 452,514 |\n| Distributions from other invested assets | 41,782 | 59,264 |\n| Proceeds from sale of subsidiary (net of cash disposed) | 3,934 | - |\n| Cost of fixed maturities acquired - available for sale, at market value | (3,583,990 | ) | (3,729,423 | ) |\n| Cost of fixed maturities acquired - available for sale, at fair value | (234 | ) | (23,684 | ) |\n| Cost of equity securities acquired - available for sale, at market value | (6,581 | ) | (11,873 | ) |\n| Cost of equity securities acquired - available for sale, at fair value | (460,965 | ) | (262,871 | ) |\n| Cost of other invested assets acquired | (140,923 | ) | (120,911 | ) |\n| Net change in short-term investments | 83,584 | (284,822 | ) |\n| Net change in unsettled securities transactions | (18,242 | ) | 13,496 |\n| Net cash provided by (used in) investing activities | (784,410 | ) | (1,184,045 | ) |\n| CASH FLOWS FROM FINANCING ACTIVITIES: |\n| Common shares issued during the period, net | 9,896 | 15,465 |\n| Purchase of treasury shares | (324,981 | ) | (399,942 | ) |\n| Net proceeds from issuance of senior notes | - | 400,000 |\n| Third party investment in redeemable noncontrolling interest | 296,848 | 136,200 |\n| Dividends paid to shareholders | (125,905 | ) | (103,034 | ) |\n| Dividends paid on third party investment in redeemable noncontrolling interest | (67,233 | ) | (10,334 | ) |\n| Net cash provided by (used in) financing activities | (211,375 | ) | 38,355 |\n| EFFECT OF EXCHANGE RATE CHANGES ON CASH | (28,007 | ) | 10,167 |\n| Net increase (decrease) in cash | (36,248 | ) | (209,579 | ) |\n| Cash, beginning of period | 437,474 | 611,382 |\n| Cash, end of period | $ | 401,226 | $ | 401,803 |\n| SUPPLEMENTAL CASH FLOW INFORMATION: |\n| Income taxes paid (recovered) | $ | 123,234 | $ | 146,560 |\n| Interest paid | 18,039 | 15,150 |\n| The accompanying notes are an integral part of the consolidated financial statements. |\n\n4\nNOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)\nFor the Three and Nine Months Ended September 30, 2015 and 2014\n1. GENERAL\nEverest Re Group, Ltd. (\"Group\"), a Bermuda company, through its subsidiaries, principally provides reinsurance and insurance in the U.S., Bermuda and international markets. As used in this document, \"Company\" means Group and its subsidiaries.\nEffective February 27, 2013, the Company established a new subsidiary, Mt. Logan Re Ltd. (\"Mt. Logan Re\") and effective July 1, 2013, Mt. Logan Re established separate segregated accounts and issued non-voting redeemable preferred shares to capitalize the segregated accounts. Accordingly, the financial position and operating results for Mt. Logan Re are consolidated with the Company and the non-controlling interests in Mt. Logan Re's operating results and equity are presented as separate captions in the Company's financial statements.\nEffective July 13, 2015, the Company sold all of the outstanding shares of capital stock of a wholly-owned subsidiary entity, Mt. McKinley Insurance Company (\"Mt. McKinley\"), to Clearwater Insurance Company. The operating results of Mt. McKinley through July 13, 2015 are included within the Company's financial statements.\n2. BASIS OF PRESENTATION\nThe unaudited consolidated financial statements of the Company for the three and nine months ended September 30, 2015 and 2014 include all adjustments, consisting of normal recurring accruals, which, in the opinion of management, are necessary for a fair statement of the results on an interim basis. Certain financial information, which is normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America (\"GAAP\"), has been omitted since it is not required for interim reporting purposes. The December 31, 2014 consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by GAAP. The results for the three and nine months ended September 30, 2015 and 2014 are not necessarily indicative of the results for a full year. These financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto for the years ended December 31, 2014, 2013 and 2012 included in the Company's most recent Form 10-K filing.\nAll intercompany accounts and transactions have been eliminated.\nApplication of Recently Issued Accounting Standard Changes.\nNo accounting standards or guidance have been issued recently that would have a material impact on the Company's financial statements or financial reporting process.\n5\n3. INVESTMENTS\nThe amortized cost, market value and gross unrealized appreciation and depreciation of available for sale, fixed maturity, equity security investments, carried at market value and other-than-temporary impairments (\"OTTI\") in accumulated other comprehensive income (\"AOCI\") are as follows for the periods indicated:\n\n| At September 30, 2015 |\n| Amortized | Unrealized | Unrealized | Market | OTTI in AOCI |\n| (Dollars in thousands) | Cost | Appreciation | Depreciation | Value | (a) |\n| Fixed maturity securities |\n| U.S. Treasury securities and obligations of |\n| U.S. government agencies and corporations | $ | 337,271 | $ | 15,725 | $ | (70 | ) | $ | 352,926 | $ | - |\n| Obligations of U.S. states and political subdivisions | 683,715 | 32,087 | (1,523 | ) | 714,279 | - |\n| Corporate securities | 4,964,570 | 118,763 | (76,396 | ) | 5,006,937 | 2,006 |\n| Asset-backed securities | 437,376 | 2,575 | (1,554 | ) | 438,397 | - |\n| Mortgage-backed securities |\n| Commercial | 277,907 | 7,697 | (795 | ) | 284,809 | - |\n| Agency residential | 2,392,937 | 39,295 | (6,165 | ) | 2,426,067 | - |\n| Non-agency residential | 971 | 53 | (46 | ) | 978 | - |\n| Foreign government securities | 1,285,006 | 60,837 | (44,882 | ) | 1,300,961 | (2 | ) |\n| Foreign corporate securities | 2,921,960 | 115,881 | (72,235 | ) | 2,965,606 | 39 |\n| Total fixed maturity securities | $ | 13,301,713 | $ | 392,913 | $ | (203,666 | ) | $ | 13,490,960 | $ | 2,043 |\n| Equity securities | $ | 127,411 | $ | 3,509 | $ | (17,921 | ) | $ | 112,999 | $ | - |\n\n\n| At December 31, 2014 |\n| Amortized | Unrealized | Unrealized | Market | OTTI in AOCI |\n| (Dollars in thousands) | Cost | Appreciation | Depreciation | Value | (a) |\n| Fixed maturity securities |\n| U.S. Treasury securities and obligations of |\n| U.S. government agencies and corporations | $ | 221,052 | $ | 10,290 | $ | (304 | ) | $ | 231,038 | $ | - |\n| Obligations of U.S. states and political subdivisions | 783,129 | 41,969 | (626 | ) | 824,472 | - |\n| Corporate securities | 4,626,002 | 143,889 | (62,906 | ) | 4,706,985 | (6,910 | ) |\n| Asset-backed securities | 340,761 | 1,691 | (1,230 | ) | 341,222 | - |\n| Mortgage-backed securities |\n| Commercial | 231,439 | 10,675 | (429 | ) | 241,685 | - |\n| Agency residential | 2,157,182 | 37,555 | (11,573 | ) | 2,183,164 | - |\n| Non-agency residential | 2,734 | 54 | (57 | ) | 2,731 | - |\n| Foreign government securities | 1,488,144 | 71,177 | (26,866 | ) | 1,532,455 | - |\n| Foreign corporate securities | 2,980,716 | 109,673 | (53,074 | ) | 3,037,315 | - |\n| Total fixed maturity securities | $ | 12,831,159 | $ | 426,973 | $ | (157,065 | ) | $ | 13,101,067 | $ | (6,910 | ) |\n| Equity securities | $ | 148,326 | $ | 3,831 | $ | (11,947 | ) | $ | 140,210 | $ | - |\n\n(a) Represents the amount of OTTI recognized in AOCI. Amount includes unrealized gains and losses on impaired securities relating to changes in the value of such securities subsequent to the impairment measurement date.\n6\nThe amortized cost and market value of fixed maturity securities are shown in the following table by contractual maturity. Mortgage-backed securities are generally more likely to be prepaid than other fixed maturity securities. As the stated maturity of such securities may not be indicative of actual maturities, the totals for mortgage-backed and asset-backed securities are shown separately.\n\n| At September 30, 2015 | At December 31, 2014 |\n| Amortized | Market | Amortized | Market |\n| (Dollars in thousands) | Cost | Value | Cost | Value |\n| Fixed maturity securities – available for sale: |\n| Due in one year or less | $ | 1,080,129 | $ | 1,088,140 | $ | 1,183,247 | $ | 1,189,416 |\n| Due after one year through five years | 5,906,738 | 5,991,760 | 5,646,466 | 5,726,277 |\n| Due after five years through ten years | 2,377,276 | 2,382,188 | 2,270,073 | 2,313,672 |\n| Due after ten years | 828,380 | 878,621 | 999,257 | 1,102,900 |\n| Asset-backed securities | 437,376 | 438,397 | 340,761 | 341,222 |\n| Mortgage-backed securities: |\n| Commercial | 277,906 | 284,809 | 231,439 | 241,685 |\n| Agency residential | 2,392,937 | 2,426,067 | 2,157,182 | 2,183,164 |\n| Non-agency residential | 971 | 978 | 2,734 | 2,731 |\n| Total fixed maturity securities | $ | 13,301,713 | $ | 13,490,960 | $ | 12,831,159 | $ | 13,101,067 |\n\nThe changes in net unrealized appreciation (depreciation) for the Company's investments are derived from the following sources for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Increase (decrease) during the period between the market value and cost |\n| of investments carried at market value, and deferred taxes thereon: |\n| Fixed maturity securities | $ | (71,706 | ) | $ | (87,859 | ) | $ | (89,616 | ) | $ | 70,010 |\n| Fixed maturity securities, other-than-temporary impairment | (253 | ) | (261 | ) | 8,954 | (180 | ) |\n| Equity securities | (4,415 | ) | (3,287 | ) | (6,295 | ) | 3,327 |\n| Change in unrealized appreciation (depreciation), pre-tax | (76,374 | ) | (91,407 | ) | (86,957 | ) | 73,157 |\n| Deferred tax benefit (expense) | 9,919 | 11,649 | 5,563 | (9,480 | ) |\n| Deferred tax benefit (expense), other-than-temporary impairment | (8 | ) | - | (3,415 | ) | - |\n| Change in unrealized appreciation (depreciation), |\n| net of deferred taxes, included in shareholders' equity | $ | (66,463 | ) | $ | (79,758 | ) | $ | (84,809 | ) | $ | 63,677 |\n\nThe Company frequently reviews all of its fixed maturity, available for sale securities for declines in market value and focuses its attention on securities whose fair value has fallen below 80% of their amortized cost at the time of review. The Company then assesses whether the decline in value is temporary or other-than-temporary. In making its assessment, the Company evaluates the current market and interest rate environment as well as specific issuer information. Generally, a change in a security's value caused by a change in the market, interest rate or foreign exchange environment does not constitute an other-than-temporary impairment, but rather a temporary decline in market value. Temporary declines in market value are recorded as unrealized losses in accumulated other comprehensive income (loss). If the Company determines that the decline is other-than-temporary and the Company does not have the intent to sell the security; and it is more likely than not that the Company will not have to sell the security before recovery of its cost basis, the carrying value of the investment is written down to fair value. The fair value adjustment that is credit or foreign exchange related is recorded in net realized capital gains (losses) in the Company's consolidated statements of operations and comprehensive income (loss). The fair value adjustment that is non-credit related is recorded as a component of other comprehensive income (loss), net of tax, and is included in accumulated other comprehensive income (loss) in the Company's consolidated balance sheets.\n7\nThe Company's assessments are based on the issuers current and expected future financial position, timeliness with respect to interest and/or principal payments, speed of repayments and any applicable credit enhancements or breakeven constant default rates on mortgage-backed and asset-backed securities, as well as relevant information provided by rating agencies, investment advisors and analysts.\nThe majority of the Company's equity securities available for sale at market value are primarily comprised of mutual fund investments whose underlying securities consist of fixed maturity securities. When a fund's value reflects an unrealized loss, the Company assesses whether the decline in value is temporary or other-than-temporary. In making its assessment, the Company considers the composition of its portfolios and their related markets, reports received from the portfolio managers and discussions with portfolio managers. If the Company determines that the declines are temporary and it has the ability and intent to continue to hold the investments, then the declines are recorded as unrealized losses in accumulated other comprehensive income (loss). If declines are deemed to be other-than-temporary, then the carrying value of the investment is written down to fair value and recorded in net realized capital gains (losses) in the Company's consolidated statements of operations and comprehensive income (loss).\nRetrospective adjustments are employed to recalculate the values of asset-backed securities. All of the Company's asset-backed and mortgage-backed securities have a pass-through structure. Each acquisition lot is reviewed to recalculate the effective yield. The recalculated effective yield is used to derive a book value as if the new yield were applied at the time of acquisition. Outstanding principal factors from the time of acquisition to the adjustment date are used to calculate the prepayment history for all applicable securities. Conditional prepayment rates, computed with life to date factor histories and weighted average maturities, are used in the calculation of projected prepayments for pass-through security types.\nThe tables below display the aggregate market value and gross unrealized depreciation of fixed maturity and equity securities, by security type and contractual maturity, in each case subdivided according to length of time that individual securities had been in a continuous unrealized loss position for the periods indicated:\n\n| Duration of Unrealized Loss at September 30, 2015 By Security Type |\n| Less than 12 months | Greater than 12 months | Total |\n| Gross | Gross | Gross |\n| Unrealized | Unrealized | Unrealized |\n| (Dollars in thousands) | Market Value | Depreciation | Market Value | Depreciation | Market Value | Depreciation |\n| Fixed maturity securities - available for sale |\n| U.S. Treasury securities and obligations of |\n| U.S. government agencies and corporations | $ | 201 | $ | (1 | ) | $ | 1,844 | $ | (69 | ) | $ | 2,045 | $ | (70 | ) |\n| Obligations of U.S. states and political subdivisions | 20,162 | (316 | ) | 35,460 | (1,207 | ) | 55,622 | (1,523 | ) |\n| Corporate securities | 1,323,515 | (51,785 | ) | 425,091 | (24,611 | ) | 1,748,606 | (76,396 | ) |\n| Asset-backed securities | 89,526 | (674 | ) | 44,765 | (880 | ) | 134,291 | (1,554 | ) |\n| Mortgage-backed securities |\n| Commercial | 44,260 | (795 | ) | - | - | 44,260 | (795 | ) |\n| Agency residential | 343,504 | (2,182 | ) | 382,730 | (3,983 | ) | 726,234 | (6,165 | ) |\n| Non-agency residential | 176 | (2 | ) | 44 | (44 | ) | 220 | (46 | ) |\n| Foreign government securities | 299,055 | (22,177 | ) | 183,387 | (22,705 | ) | 482,442 | (44,882 | ) |\n| Foreign corporate securities | 699,077 | (40,165 | ) | 279,126 | (32,070 | ) | 978,203 | (72,235 | ) |\n| Total fixed maturity securities | $ | 2,819,476 | $ | (118,097 | ) | $ | 1,352,447 | $ | (85,569 | ) | $ | 4,171,923 | $ | (203,666 | ) |\n| Equity securities | - | - | 97,871 | (17,921 | ) | 97,871 | (17,921 | ) |\n| Total | $ | 2,819,476 | $ | (118,097 | ) | $ | 1,450,318 | $ | (103,490 | ) | $ | 4,269,794 | $ | (221,587 | ) |\n\n8\n\n| Duration of Unrealized Loss at September 30, 2015 By Maturity |\n| Less than 12 months | Greater than 12 months | Total |\n| Gross | Gross | Gross |\n| Unrealized | Unrealized | Unrealized |\n| (Dollars in thousands) | Market Value | Depreciation | Market Value | Depreciation | Market Value | Depreciation |\n| Fixed maturity securities |\n| Due in one year or less | $ | 85,547 | $ | (4,021 | ) | $ | 83,375 | $ | (12,950 | ) | $ | 168,922 | $ | (16,971 | ) |\n| Due in one year through five years | 1,220,223 | (50,689 | ) | 577,851 | (41,640 | ) | 1,798,074 | (92,329 | ) |\n| Due in five years through ten years | 924,605 | (51,295 | ) | 208,989 | (20,624 | ) | 1,133,594 | (71,919 | ) |\n| Due after ten years | 111,635 | (8,439 | ) | 54,693 | (5,448 | ) | 166,328 | (13,887 | ) |\n| Asset-backed securities | 89,526 | (674 | ) | 44,765 | (880 | ) | 134,291 | (1,554 | ) |\n| Mortgage-backed securities | 387,940 | (2,979 | ) | 382,774 | (4,027 | ) | 770,714 | (7,006 | ) |\n| Total fixed maturity securities | $ | 2,819,476 | $ | (118,097 | ) | $ | 1,352,447 | $ | (85,569 | ) | $ | 4,171,923 | $ | (203,666 | ) |\n\nThe aggregate market value and gross unrealized losses related to investments in an unrealized loss position at September 30, 2015 were $4,269,794 thousand and $221,587 thousand, respectively. The market value of securities for the single issuer whose securities comprised the largest unrealized loss position at September 30, 2015, did not exceed 0.2% of the overall market value of the Company's fixed maturity securities. In addition, as indicated on the above table, there was no significant concentration of unrealized losses in any one market sector. The $118,097 thousand of unrealized losses related to fixed maturity securities that have been in an unrealized loss position for less than one year were generally comprised of domestic and foreign corporate securities, as well as foreign government securities. The majority of these unrealized losses are attributable to net unrealized foreign exchange losses, $44,092 thousand, as the U.S. dollar has strengthened against other currencies and unrealized losses in the energy sector, $43,353 thousand, as falling oil prices have disrupted the market values for this sector, particularly for oil exploration, production and servicing companies. The $85,569 thousand of unrealized losses related to fixed maturity securities in an unrealized loss position for more than one year related primarily to foreign and domestic corporate securities, foreign government securities and agency residential mortgage-backed securities. Of these unrealized losses, $60,407 thousand related to securities that were rated investment grade by at least one nationally recognized statistical rating organization. There was no gross unrealized depreciation for mortgage-backed securities related to sub-prime and alt-A loans. In all instances, there were no projected cash flow shortfalls to recover the full book value of the investments and the related interest obligations. The mortgage-backed securities still have excess credit coverage and are current on interest and principal payments.\nThe Company, given the size of its investment portfolio and capital position, does not have the intent to sell these securities; and it is more likely than not that the Company will not have to sell the security before recovery of its cost basis. In addition, all securities currently in an unrealized loss position are current with respect to principal and interest payments.\n9\nThe tables below display the aggregate market value and gross unrealized depreciation of fixed maturity and equity securities, by security type and contractual maturity, in each case subdivided according to length of time that individual securities had been in a continuous unrealized loss position for the periods indicated:\n\n| Duration of Unrealized Loss at December 31, 2014 By Security Type |\n| Less than 12 months | Greater than 12 months | Total |\n| Gross | Gross | Gross |\n| Unrealized | Unrealized | Unrealized |\n| (Dollars in thousands) | Market Value | Depreciation | Market Value | Depreciation | Market Value | Depreciation |\n| Fixed maturity securities - available for sale |\n| U.S. Treasury securities and obligations of |\n| U.S. government agencies and corporations | $ | 13,187 | $ | (20 | ) | $ | 26,897 | $ | (284 | ) | $ | 40,084 | $ | (304 | ) |\n| Obligations of U.S. states and political subdivisions | 20,428 | (242 | ) | 18,199 | (384 | ) | 38,627 | (626 | ) |\n| Corporate securities | 1,245,830 | (55,388 | ) | 362,320 | (7,518 | ) | 1,608,150 | (62,906 | ) |\n| Asset-backed securities | 192,253 | (1,230 | ) | - | - | 192,253 | (1,230 | ) |\n| Mortgage-backed securities |\n| Commercial | 28,191 | (123 | ) | 9,777 | (306 | ) | 37,968 | (429 | ) |\n| Agency residential | 141,807 | (172 | ) | 678,972 | (11,401 | ) | 820,779 | (11,573 | ) |\n| Non-agency residential | - | - | 266 | (57 | ) | 266 | (57 | ) |\n| Foreign government securities | 235,725 | (15,415 | ) | 139,200 | (11,451 | ) | 374,925 | (26,866 | ) |\n| Foreign corporate securities | 567,905 | (36,926 | ) | 290,234 | (16,148 | ) | 858,139 | (53,074 | ) |\n| Total fixed maturity securities | $ | 2,445,326 | $ | (109,516 | ) | $ | 1,525,865 | $ | (47,549 | ) | $ | 3,971,191 | $ | (157,065 | ) |\n| Equity securities | 50,285 | (4,068 | ) | 73,994 | (7,879 | ) | 124,279 | (11,947 | ) |\n| Total | $ | 2,495,611 | $ | (113,584 | ) | $ | 1,599,859 | $ | (55,428 | ) | $ | 4,095,470 | $ | (169,012 | ) |\n\n\n| Duration of Unrealized Loss at December 31, 2014 By Maturity |\n| Less than 12 months | Greater than 12 months | Total |\n| Gross | Gross | Gross |\n| Unrealized | Unrealized | Unrealized |\n| (Dollars in thousands) | Market Value | Depreciation | Market Value | Depreciation | Market Value | Depreciation |\n| Fixed maturity securities |\n| Due in one year or less | $ | 98,021 | $ | (5,166 | ) | $ | 80,002 | $ | (8,174 | ) | $ | 178,023 | $ | (13,340 | ) |\n| Due in one year through five years | 1,233,244 | (68,124 | ) | 518,613 | (12,761 | ) | 1,751,857 | (80,885 | ) |\n| Due in five years through ten years | 679,374 | (28,529 | ) | 187,717 | (10,734 | ) | 867,091 | (39,263 | ) |\n| Due after ten years | 72,436 | (6,172 | ) | 50,518 | (4,116 | ) | 122,954 | (10,288 | ) |\n| Asset-backed securities | 192,253 | (1,230 | ) | - | - | 192,253 | (1,230 | ) |\n| Mortgage-backed securities | 169,998 | (295 | ) | 689,015 | (11,764 | ) | 859,013 | (12,059 | ) |\n| Total fixed maturity securities | $ | 2,445,326 | $ | (109,516 | ) | $ | 1,525,865 | $ | (47,549 | ) | $ | 3,971,191 | $ | (157,065 | ) |\n\nThe aggregate market value and gross unrealized losses related to investments in an unrealized loss position at December 31, 2014 were $4,095,470 thousand and $169,012 thousand, respectively. The market value of securities for the single issuer whose securities comprised the largest unrealized loss position at December 31, 2014, did not exceed 0.2% of the overall market value of the Company's fixed maturity securities. In addition, as indicated on the above table, there was no significant concentration of unrealized losses in any one market sector. The $109,516 thousand of unrealized losses related to fixed maturity securities that have been in an unrealized loss position for less than one year were generally comprised of domestic and foreign corporate securities, as well as foreign government securities. The majority of these unrealized losses are attributable to unrealized losses in the energy sector, $58,891 thousand, as falling oil prices disrupted the market values for this sector, particularly for oil exploration, production and servicing companies during the fourth quarter of 2014 and unrealized foreign exchange losses, $34,687 thousand, as the U.S. dollar has strengthened against other currencies. The $47,549 thousand of unrealized losses related to fixed maturity securities in an unrealized loss position for more than one year related primarily to foreign and domestic corporate securities, foreign government securities and agency residential mortgage-backed securities. Of these unrealized losses, $42,884 thousand related to securities that were rated investment grade by at least one nationally recognized statistical rating organization. The gross unrealized depreciation for mortgage-backed securities included $15 thousand related to sub-prime and alt-A loans. In all instances, there were no projected cash flow shortfalls to recover\n10\nthe full book value of the investments and the related interest obligations. The mortgage-backed securities still have excess credit coverage and are current on interest and principal payments.\nThe components of net investment income are presented in the table below for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Fixed maturities | $ | 108,134 | $ | 115,057 | $ | 326,970 | $ | 348,872 |\n| Equity securities | 11,090 | 11,086 | 35,783 | 36,111 |\n| Short-term investments and cash | 381 | 295 | 1,084 | 1,202 |\n| Other invested assets |\n| Limited partnerships | 370 | 21,690 | 13,993 | 25,658 |\n| Other | (242 | ) | 869 | 1,366 | 3,220 |\n| Gross investment income before adjustments | 119,733 | 148,997 | 379,196 | 415,063 |\n| Funds held interest income (expense) | 2,569 | 1,817 | 8,162 | 6,875 |\n| Future policy benefit reserve income (expense) | (300 | ) | (471 | ) | (1,402 | ) | (915 | ) |\n| Gross investment income | 122,002 | 150,343 | 385,956 | 421,023 |\n| Investment expenses | (6,491 | ) | (8,200 | ) | (22,816 | ) | (24,499 | ) |\n| Net investment income | $ | 115,511 | $ | 142,143 | $ | 363,140 | $ | 396,524 |\n\nThe Company records results from limited partnership investments on the equity method of accounting with changes in value reported through net investment income. Due to the timing of receiving financial information from these partnerships, the results are generally reported on a one month or quarter lag. If the Company determines there has been a significant decline in value of a limited partnership during this lag period, a loss will be recorded in the period in which the Company identifies the decline.\nThe Company had contractual commitments to invest up to an additional $469,064 thousand in limited partnerships at September 30, 2015. These commitments will be funded when called in accordance with the partnership agreements, which have investment periods that expire, unless extended, through 2020.\nThe components of net realized capital gains (losses) are presented in the table below for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Fixed maturity securities, market value: |\n| Other-than-temporary impairments | $ | (20,445 | ) | $ | (106 | ) | $ | (62,701 | ) | $ | (495 | ) |\n| Gains (losses) from sales | (5,218 | ) | 7,311 | (15,812 | ) | 3,668 |\n| Fixed maturity securities, fair value: |\n| Gains (losses) from sales | (17 | ) | 82 | 25 | 1,022 |\n| Gains (losses) from fair value adjustments | - | (938 | ) | 56 | (938 | ) |\n| Equity securities, market value: |\n| Gains (losses) from sales | (3,573 | ) | (181 | ) | (4,455 | ) | (1,235 | ) |\n| Equity securities, fair value: |\n| Gains (losses) from sales | (13,646 | ) | (1,823 | ) | (13,041 | ) | (1,873 | ) |\n| Gains (losses) from fair value adjustments | (117,087 | ) | (13,792 | ) | (98,741 | ) | 70,548 |\n| Short-term investments gains (losses) | 15 | (1 | ) | 15 | (3 | ) |\n| Total net realized capital gains (losses) | $ | (159,971 | ) | $ | (9,448 | ) | $ | (194,654 | ) | $ | 70,694 |\n\nThe Company recorded as net realized capital gains (losses) in the consolidated statements of operations and comprehensive income (loss) both fair value re-measurements and write-downs in the value of securities deemed to be impaired on an other-than-temporary basis as displayed in the table above. The Company had no other-than-temporary impaired securities where the impairment had both a credit and non-credit component.\n11\nThe proceeds and split between gross gains and losses, from sales of fixed maturity and equity securities, are presented in the table below for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Proceeds from sales of fixed maturity securities | $ | 414,538 | $ | 446,699 | $ | 1,147,824 | $ | 1,073,938 |\n| Gross gains from sales | 11,826 | 12,821 | 37,525 | 28,828 |\n| Gross losses from sales | (17,061 | ) | (5,428 | ) | (53,312 | ) | (24,138 | ) |\n| Proceeds from sales of equity securities | $ | 156,593 | $ | 150,124 | $ | 461,812 | $ | 463,688 |\n| Gross gains from sales | 5,250 | 2,545 | 18,890 | 13,047 |\n| Gross losses from sales | (22,469 | ) | (4,549 | ) | (36,386 | ) | (16,155 | ) |\n\n4. DERIVATIVES\nThe Company sold seven equity index put option contracts, based on two indices, in 2001 and 2005, which remain outstanding. The Company sold these equity index put options as insurance products with the intent of achieving a profit. These equity index put option contracts meet the definition of a derivative under FASB guidance and the Company's position in these equity index put option contracts is unhedged. Accordingly, these equity index put option contracts are carried at fair value in the consolidated balance sheets with changes in fair value recorded in the consolidated statements of operations and comprehensive income (loss).\nThe Company sold six equity index put option contracts, based on the Standard & Poor's 500 (\"S&P 500\") index, for total consideration, net of commissions, of $22,530 thousand. At September 30, 2015, fair value for these equity index put option contracts was $41,809 thousand. Based on historical index volatilities and trends and the September 30, 2015 S&P 500 index value, the Company estimates the probability that each equity index put option contract of the S&P 500 index falling below the strike price on the exercise date to be less than 23%. The theoretical maximum payouts under these six equity index put option contracts would occur if on each of the exercise dates the S&P 500 index value were zero. At September 30, 2015, the present value of these theoretical maximum payouts using a 3% discount factor was $429,402 thousand. Conversely, if the contracts had all expired on September 30, 2015, with the S&P index at $1,920.03, there would have been no settlement amount.\nThe Company sold one equity index put option contract based on the FTSE 100 index for total consideration, net of commissions, of $6,706 thousand. At September 30, 2015, fair value for this equity index put option contract was $10,438 thousand. Based on historical index volatilities and trends and the September 30, 2015 FTSE 100 index value, the Company estimates the probability that the equity index put option contract of the FTSE 100 index will fall below the strike price on the exercise date to be less than 51%. The theoretical maximum payout under the equity index put option contract would occur if on the exercise date the FTSE 100 index value was zero. At September 30, 2015, the present value of the theoretical maximum payout using a 3% discount factor and current exchange rate was $43,896 thousand. Conversely, if the contract had expired on September 30, 2015, with the FTSE index at ₤6,061.60, there would have been no settlement amount.\nThe fair value of the equity index put options can be found in the Company's consolidated balance sheets as follows:\n\n| (Dollars in thousands) |\n| Derivatives not designated as | Location of fair value | At | At |\n| hedging instruments | in balance sheets | September 30, 2015 | December 31, 2014 |\n| Equity index put option contracts | Equity index put option liability | $ | 52,247 | $ | 47,022 |\n| Total | $ | 52,247 | $ | 47,022 |\n\n12\nThe change in fair value of the equity index put option contracts can be found in the Company's statement of operations and comprehensive income (loss) as follows:\n\n| (Dollars in thousands) | Three Months Ended | Nine Months Ended |\n| Derivatives not designated as | Location of gain (loss) in statements of | September 30, | September 30, |\n| hedging instruments | operations and comprehensive income (loss) | 2015 | 2014 | 2015 | 2014 |\n| Equity index put option contracts | Net derivative gain (loss) | $ | (11,428 | ) | $ | 1,855 | $ | (5,225 | ) | $ | 3,968 |\n| Total | $ | (11,428 | ) | $ | 1,855 | $ | (5,225 | ) | $ | 3,968 |\n\n5. FAIR VALUE\nGAAP guidance regarding fair value measurements address how companies should measure fair value when they are required to use fair value measures for recognition or disclosure purposes under GAAP and provides a common definition of fair value to be used throughout GAAP. It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly fashion between market participants at the measurement date. In addition, it establishes a three-level valuation hierarchy for the disclosure of fair value measurements. The valuation hierarchy is based on the transparency of inputs to the valuation of an asset or liability. The level in the hierarchy within which a given fair value measurement falls is determined based on the lowest level input that is significant to the measurement, with Level 1 being the highest priority and Level 3 being the lowest priority.\nThe levels in the hierarchy are defined as follows:\n\n| Level 1: | Inputs to the valuation methodology are observable inputs that reflect unadjusted quoted prices for identical assets or liabilities in an active market; |\n\n\n| Level 2: | Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument; |\n\n\n| Level 3: | Inputs to the valuation methodology are unobservable and significant to the fair value measurement. |\n\nThe Company's fixed maturity and equity securities are primarily managed by third party investment asset managers. The investment asset managers obtain prices from nationally recognized pricing services. These services seek to utilize market data and observations in their evaluation process. They use pricing applications that vary by asset class and incorporate available market information and when fixed maturity securities do not trade on a daily basis the services will apply available information through processes such as benchmark curves, benchmarking of like securities, sector groupings and matrix pricing. In addition, they use model processes, such as the Option Adjusted Spread model to develop prepayment and interest rate scenarios for securities that have prepayment features.\nIn limited instances where prices are not provided by pricing services or in rare instances when a manager may not agree with the pricing service, price quotes on a non-binding basis are obtained from investment brokers. The investment asset managers do not make any changes to prices received from either the pricing services or the investment brokers. In addition, the investment asset managers have procedures in place to review the reasonableness of the prices from the service providers and may request verification of the prices. In addition, the Company continually performs analytical reviews of price changes and tests the prices on a random basis to an independent pricing source. No material variances were noted during these price validation procedures. In limited situations, where financial markets are inactive or illiquid, the Company may use its own assumptions about future cash flows and risk-adjusted discount rates to determine fair value. Due to the unavailability of prices for one private placement security, the Company valued the security at $6,125 thousand at September 30, 2015 and made no such adjustments at December 31, 2014.\n13\nThe Company internally manages a small public equity portfolio which had a fair value at September 30, 2015 and December 31, 2014 of $226,322 thousand and $196,980 thousand, respectively, and all prices were obtained from publically published sources.\nEquity securities denominated in U.S. currency with quoted prices in active markets for identical assets are categorized as level 1 since the quoted prices are directly observable. Equity securities traded on foreign exchanges are categorized as level 2 due to the added input of a foreign exchange conversion rate to determine fair or market value. The Company uses foreign currency exchange rates published by nationally recognized sources.\nAll categories of fixed maturity securities listed in the tables below are generally categorized as level 2, since a particular security may not have traded but the pricing services are able to use valuation models with observable market inputs such as interest rate yield curves and prices for similar fixed maturity securities in terms of issuer, maturity and seniority. For foreign government securities and foreign corporate securities, the fair values provided by the third party pricing services in local currencies, and where applicable, are converted to U.S. dollars using currency exchange rates from nationally recognized sources.\nThe fixed maturities with fair values categorized as level 3 result when prices are not available from the nationally recognized pricing services. The asset managers will then obtain non-binding price quotes for the securities from brokers. The single broker quotes are provided by market makers or broker-dealers who are recognized as market participants in the markets in which they are providing the quotes. The prices received from brokers are reviewed for reasonableness by the third party asset managers and the Company. If the broker quotes are for foreign denominated securities, the quotes are converted to U.S. dollars using currency exchange rates from nationally recognized sources. Historically, most of the level 3 fixed maturities have resulted from new issuances and the third party prices services have not yet included the issuance in their data base. Generally, in subsequent measurement periods, the issuances will be included in the data base and the fair value will transfer to level 2.\nThe composition and valuation inputs for the presented fixed maturities categories are as follows:\n\n| · | U.S. Treasury securities and obligations of U.S. government agencies and corporations are primarily comprised of U.S. Treasury bonds and the fair value is based on observable market inputs such as quoted prices, reported trades, quoted prices for similar issuances or benchmark yields; |\n\n\n| · | Obligations of U.S. states and political subdivisions are comprised of state and municipal bond issuances and the fair values are based on observable market inputs such as quoted market prices, quoted prices for similar securities, benchmark yields and credit spreads; |\n\n\n| · | Corporate securities are primarily comprised of U.S. corporate and public utility bond issuances and the fair values are based on observable market inputs such as quoted market prices, quoted prices for similar securities, benchmark yields and credit spreads; |\n\n\n| · | Asset-backed and mortgage-backed securities fair values are based on observable inputs such as quoted prices, reported trades, quoted prices for similar issuances or benchmark yields and cash flow models using observable inputs such as prepayment speeds, collateral performance and default spreads; |\n\n\n| · | Foreign government securities are comprised of global non-U.S. sovereign bond issuances and the fair values are based on observable market inputs such as quoted market prices, quoted prices for similar securities and models with observable inputs such as benchmark yields and credit spreads and then, where applicable, converted to U.S. dollars using an exchange rate from a nationally recognized source; |\n\n\n| · | Foreign corporate securities are comprised of global non-U.S. corporate bond issuances and the fair values are based on observable market inputs such as quoted market prices, quoted prices for similar securities and models with observable inputs such as benchmark yields and credit spreads and then, where applicable, converted to U.S. dollars using an exchange rate from a nationally recognized source. |\n\n14\nThe Company's liability for equity index put options is categorized as level 3 since there is no active market for these seven long dated equity put options. The fair values for these options are calculated by the Company using an industry accepted pricing model, Black-Scholes. The model inputs and assumptions are: risk free interest rates, equity market indexes values, volatilities and dividend yields and duration. The model results are then adjusted for the Company's credit default swap rate. All of these inputs and assumptions are updated quarterly. One of the option contacts is in British Pound Sterling so the fair value for this contract is converted to U.S. dollars using an exchange rate from a nationally recognized source.\nThe following table presents the fair value measurement levels for all assets and liabilities, which the Company has recorded at fair value (fair and market value) as of the periods indicated:\n\n| Fair Value Measurement Using: |\n| Quoted Prices |\n| in Active | Significant |\n| Markets for | Other | Significant |\n| Identical | Observable | Unobservable |\n| Assets | Inputs | Inputs |\n| (Dollars in thousands) | September 30, 2015 | (Level 1) | (Level 2) | (Level 3) |\n| Assets: |\n| Fixed maturities, market value |\n| U.S. Treasury securities and obligations of |\n| U.S. government agencies and corporations | $ | 352,926 | $ | - | $ | 352,926 | $ | - |\n| Obligations of U.S. States and political subdivisions | 714,279 | - | 714,279 | - |\n| Corporate securities | 5,006,937 | - | 4,999,371 | 7,566 |\n| Asset-backed securities | 438,397 | - | 438,397 | - |\n| Mortgage-backed securities |\n| Commercial | 284,809 | - | 284,809 | - |\n| Agency residential | 2,426,067 | - | 2,426,067 | - |\n| Non-agency residential | 978 | - | 978 | - |\n| Foreign government securities | 1,300,961 | - | 1,300,961 | - |\n| Foreign corporate securities | 2,965,606 | - | 2,959,481 | 6,125 |\n| Total fixed maturities, market value | 13,490,960 | - | 13,477,269 | 13,691 |\n| Fixed maturities, fair value | - | - | - | - |\n| Equity securities, market value | 112,999 | 97,871 | 15,128 | - |\n| Equity securities, fair value | 1,357,311 | 1,267,765 | 89,546 | - |\n| Liabilities: |\n| Equity index put option contracts | $ | 52,247 | $ | - | $ | - | $ | 52,247 |\n\nThere were no transfers between Level 1 and Level 2 for the nine months ended September 30, 2015.\n15\nThe following table presents the fair value measurement levels for all assets and liabilities, which the Company has recorded at fair value (fair and market value) as of the periods indicated:\n\n| Fair Value Measurement Using: |\n| Quoted Prices |\n| in Active | Significant |\n| Markets for | Other | Significant |\n| Identical | Observable | Unobservable |\n| Assets | Inputs | Inputs |\n| (Dollars in thousands) | December 31, 2014 | (Level 1) | (Level 2) | (Level 3) |\n| Assets: |\n| Fixed maturities, market value |\n| U.S. Treasury securities and obligations of |\n| U.S. government agencies and corporations | $ | 231,038 | $ | - | $ | 231,038 | $ | - |\n| Obligations of U.S. States and political subdivisions | 824,472 | - | 824,472 | - |\n| Corporate securities | 4,706,985 | - | 4,706,985 | - |\n| Asset-backed securities | 341,222 | - | 341,222 | - |\n| Mortgage-backed securities |\n| Commercial | 241,685 | - | 233,088 | 8,597 |\n| Agency residential | 2,183,164 | - | 2,183,164 | - |\n| Non-agency residential | 2,731 | - | 2,731 | - |\n| Foreign government securities | 1,532,455 | - | 1,532,455 | - |\n| Foreign corporate securities | 3,037,315 | - | 3,030,149 | 7,166 |\n| Total fixed maturities, market value | 13,101,067 | - | 13,085,304 | 15,763 |\n| Fixed maturities, fair value | 1,509 | - | 1,509 | - |\n| Equity securities, market value | 140,210 | 124,295 | 15,915 | - |\n| Equity securities, fair value | 1,447,820 | 1,337,396 | 110,424 | - |\n| Liabilities: |\n| Equity index put option contracts | $ | 47,022 | $ | - | $ | - | $ | 47,022 |\n\n16\nThe following tables present the activity under Level 3, fair value measurements using significant unobservable inputs by asset type, for the periods indicated:\n\n| Three Months Ended September 30, 2015 | Nine Months Ended September 30, 2015 |\n| Corporate | Foreign | Corporate | Foreign |\n| (Dollars in thousands) | Securities | Corporate | Total | Securities | CMBS | Corporate | Total |\n| Beginning balance | $ | 1,958 | $ | 7,837 | $ | 9,795 | $ | - | $ | 8,597 | $ | 7,166 | $ | 15,763 |\n| Total gains or (losses) (realized/unrealized) |\n| Included in earnings | (8 | ) | 62 | 54 | (4 | ) | - | 177 | 173 |\n| Included in other comprehensive income (loss) | (137 | ) | (1,287 | ) | (1,424 | ) | (139 | ) | - | (1,216 | ) | (1,355 | ) |\n| Purchases, issuances and settlements | 1,723 | - | 1,723 | 3,651 | - | - | 3,651 |\n| Transfers in and/or (out) of Level 3 | 4,030 | (487 | ) | 3,543 | 4,058 | (8,597 | ) | (2 | ) | (4,541 | ) |\n| Ending balance | $ | 7,566 | $ | 6,125 | $ | 13,691 | $ | 7,566 | $ | - | $ | 6,125 | $ | 13,691 |\n| The amount of total gains or losses for the period |\n| included in earnings (or changes in net assets) |\n| attributable to the change in unrealized gains |\n| or losses relating to assets still held |\n| at the reporting date | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - |\n| (Some amounts may not reconcile due to rounding.) |\n\n\n| Three Months Ended September 30, 2014 | Nine Months Ended September 30, 2014 |\n| Corporate | Asset-backed | Foreign | Non-agency | Agency | Corporate | Asset-backed | Foreign | Non-agency | Agency |\n| (Dollars in thousands) | Securities | Securities | Corporate | RMBS | RMBS | Total | Securities | Securities | Corporate | RMBS | RMBS | Total |\n| Beginning balance | $ | - | $ | 3,000 | $ | - | $ | 259 | $ | - | $ | 3,259 | $ | - | $ | 5,299 | $ | 481 | $ | 347 | $ | - | $ | 6,127 |\n| Total gains or (losses) (realized/unrealized) |\n| Included in earnings | - | 1,203 | - | 187 | - | 1,390 | - | 1,259 | 18 | 329 | - | 1,606 |\n| Included in other comprehensive income (loss) | 42 | (201 | ) | (62 | ) | (114 | ) | - | (335 | ) | 42 | (126 | ) | (82 | ) | (138 | ) | - | (304 | ) |\n| Purchases, issuances and settlements | 1,274 | 22,797 | 4,517 | (332 | ) | 29,845 | 58,101 | 1,274 | 21,303 | 4,038 | (538 | ) | 29,845 | 55,922 |\n| Transfers in and/or (out) of Level 3 | - | (1,431 | ) | - | - | - | (1,431 | ) | - | (2,367 | ) | - | - | - | (2,367 | ) |\n| Ending balance | $ | 1,316 | $ | 25,368 | $ | 4,455 | $ | - | $ | 29,845 | $ | 60,984 | $ | 1,316 | $ | 25,368 | $ | 4,455 | $ | - | $ | 29,845 | $ | 60,984 |\n| The amount of total gains or losses for the period |\n| included in earnings (or changes in net assets) |\n| attributable to the change in unrealized gains |\n| or losses relating to assets still held |\n| at the reporting date | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - |\n| (Some amounts may not reconcile due to rounding.) |\n\nThe net transfers to/(from) level 3, fair value measurements using significant unobservable inputs, of $4,541 thousand and $2,367 thousand of investments for the nine months ended September 30, 2015 and 2014, respectively, primarily relate to securities that were priced using single non-binding broker quotes as of December 31, 2014 and 2013, respectively. The securities were subsequently priced using a recognized pricing service as of September 30, 2015 and 2014, and were classified as level 2 as of those dates.\n17\nThe following table presents the activity under Level 3, fair value measurements using significant unobservable inputs for equity index put option contracts, for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Liabilities: |\n| Balance, beginning of period | $ | 40,819 | $ | 33,309 | $ | 47,022 | $ | 35,423 |\n| Total (gains) or losses (realized/unrealized) |\n| Included in earnings | 11,428 | (1,855 | ) | 5,225 | (3,968 | ) |\n| Included in other comprehensive income (loss) | - | - | - | - |\n| Purchases, issuances and settlements | - | - | - | - |\n| Transfers in and/or (out) of Level 3 | - | - | - | - |\n| Balance, end of period | $ | 52,247 | $ | 31,455 | $ | 52,247 | $ | 31,455 |\n| The amount of total gains or losses for the period included in earnings |\n| (or changes in net assets) attributable to the change in unrealized |\n| gains or losses relating to liabilities still held at the reporting date | $ | - | $ | - | $ | - | $ | - |\n| (Some amounts may not reconcile due to rounding.) |\n\n6. REDEEMABLE NONCONTROLLING INTERESTS – MT. LOGAN RE\nMt. Logan Re is a Class 3 insurer registered in Bermuda effective February 27, 2013 under The Segregated Accounts Companies Act 2000 and 100% of the voting common shares are owned by Group. Separate segregated accounts have been established effective July 1, 2013 and non-voting, redeemable preferred shares have been issued to capitalize the segregated accounts. Each segregated account will invest in a diversified set of catastrophe exposures, diversified by risk/peril and across different geographic regions globally. The financial statements for Mt. Logan Re are consolidated with the Company with adjustments reflected for the third party noncontrolling interests reflected as separate captions in the Company's financial statements.\nThe following table presents the activity for redeemable noncontrolling interests in the consolidated balance sheets for the periods indicated:\n\n| Nine Months Ended | Twelve Months Ended |\n| September 30, | December 31, |\n| (Dollars in thousands) | 2015 | 2014 |\n| Redeemable noncontrolling interests - Mt. Logan Re, beginning of period | $ | 421,552 | $ | 93,378 |\n| Unaffiliated third party investments during period, net | 336,848 | 279,200 |\n| Net income (loss) attributable to noncontrolling interests | 61,526 | 59,307 |\n| Dividends paid on third party investment in redeemable noncontrolling interest | (67,233 | ) | (10,334 | ) |\n| Redeemable noncontrolling interests - Mt. Logan Re, end of period | $ | 752,692 | $ | 421,552 |\n| (Some amounts may not reconcile due to rounding.) |\n\nIn addition, the Company has invested $50,000 thousand in the segregated accounts from inception to date.\nThe Company expects its participation level in the segregated funds to fluctuate over time.\n7. CAPITAL TRANSACTIONS\nOn July 9, 2014, the Company renewed its shelf registration statement on Form S-3ASR with the Securities and Exchange Commission (the \"SEC\"), as a Well Known Seasoned Issuer. This shelf registration statement can be used by Group to register common shares, preferred shares, debt securities, warrants, share purchase contracts and share purchase units; by Holdings to register debt securities and by Everest Re Capital Trust III (\"Capital Trust III\") to register trust preferred securities.\n18\n8. EARNINGS PER COMMON SHARE\nBasic earnings per share are calculated by dividing net income by the weighted average number of common shares outstanding. Diluted earnings per share reflect the potential dilution that would occur if options granted under various share-based compensation plans were exercised resulting in the issuance of common shares that would participate in the earnings of the entity.\nNet income (loss) attributable to Everest Re Group per common share has been computed as per below, based upon weighted average common basic and dilutive shares outstanding.\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands, except per share amounts) | 2015 | 2014 | 2015 | 2014 |\n| Net income (loss) attributable to Everest Re Group per share: |\n| Numerator |\n| Net income (loss) attributable to Everest Re Group | $ | 88,553 | $ | 274,916 | $ | 620,588 | $ | 859,033 |\n| Less: dividends declared-common shares and nonvested common shares | (41,698 | ) | (33,973 | ) | (125,905 | ) | (103,034 | ) |\n| Undistributed earnings | 46,855 | 240,943 | 494,683 | 755,999 |\n| Percentage allocated to common shareholders (1) | 99.0 | % | 98.9 | % | 98.9 | % | 99.0 | % |\n| 46,364 | 238,407 | 489,434 | 748,273 |\n| Add: dividends declared-common shareholders | 41,293 | 33,631 | 124,638 | 101,993 |\n| Numerator for basic and diluted earnings per common share | $ | 87,657 | $ | 272,038 | $ | 614,072 | $ | 850,266 |\n| Denominator |\n| Denominator for basic earnings per weighted-average common shares | 43,361 | 44,941 | 43,728 | 45,615 |\n| Effect of dilutive securities: |\n| Options | 367 | 415 | 392 | 426 |\n| Denominator for diluted earnings per adjusted weighted-average common shares | 43,728 | 45,356 | 44,120 | 46,041 |\n| Per common share net income (loss) |\n| Basic | $ | 2.02 | $ | 6.05 | $ | 14.04 | $ | 18.64 |\n| Diluted | $ | 2.00 | $ | 6.00 | $ | 13.92 | $ | 18.47 |\n| (1) | Basic weighted-average common shares outstanding | 43,361 | 44,941 | 43,728 | 45,615 |\n| Basic weighted-average common shares outstanding and nonvested common shares expected to vest | 43,820 | 45,419 | 44,197 | 46,086 |\n| Percentage allocated to common shareholders | 99.0 | % | 98.9 | % | 98.9 | % | 99.0 | % |\n| (Some amounts may not reconcile due to rounding.) |\n\nThere were no anti-diluted options outstanding for the three and nine months ended September 30, 2015 and 2014.\nAll outstanding options expire on or between February 21, 2017 and September 19, 2022.\n9. CONTINGENCIES\nIn the ordinary course of business, the Company is involved in lawsuits, arbitrations and other formal and informal dispute resolution procedures, the outcomes of which will determine the Company's rights and obligations under insurance and reinsurance agreements. In some disputes, the Company seeks to enforce its rights under an agreement or to collect funds owing to it. In other matters, the Company is resisting attempts by others to collect funds or enforce alleged rights. These disputes arise from time to time and are ultimately resolved through both informal and formal means, including negotiated resolution, arbitration and litigation. In all such matters, the Company believes that its positions are legally and commercially reasonable. The Company considers the statuses of these proceedings when determining its reserves for unpaid loss and loss adjustment expenses.\n19\nAside from litigation and arbitrations related to these insurance and reinsurance agreements, the Company is not a party to any other material litigation or arbitration.\nThe Company has entered into separate annuity agreements with The Prudential Insurance of America (\"The Prudential\") and an additional unaffiliated life insurance company in which the Company has either purchased annuity contracts or become the assignee of annuity proceeds that are meant to settle claim payment obligations in the future. In both instances, the Company would become contingently liable if either The Prudential or the unaffiliated life insurance company were unable to make payments related to the respective annuity contract.\nThe table below presents the estimated cost to replace all such annuities for which the Company was contingently liable for the periods indicated:\n\n| At September 30, | At December 31, |\n| (Dollars in thousands) | 2015 | 2014 |\n| The Prudential | $ | 142,661 | $ | 142,653 |\n| Unaffiliated life insurance company | 32,414 | 31,964 |\n\n10. OTHER COMPREHENSIVE INCOME (LOSS)\nThe following tables present the components of comprehensive income (loss) in the consolidated statements of operations for the periods indicated:\n\n| Three Months Ended September 30, 2015 | Nine Months Ended September 30, 2015 |\n| (Dollars in thousands) | Before Tax | Tax Effect | Net of Tax | Before Tax | Tax Effect | Net of Tax |\n| Unrealized appreciation (depreciation) (\"URA(D)\") on securities - temporary | $ | (105,356 | ) | $ | 14,558 | $ | (90,798 | ) | $ | (178,878 | ) | $ | 29,004 | $ | (149,874 | ) |\n| URA(D) on securities - OTTI | (253 | ) | (8 | ) | (261 | ) | 8,954 | (3,415 | ) | 5,539 |\n| Reclassification of net realized losses (gains) included in net income (loss) | 29,235 | (4,639 | ) | 24,596 | 82,967 | (23,441 | ) | 59,526 |\n| Foreign currency translation adjustments | (47,298 | ) | 14,793 | (32,505 | ) | (104,542 | ) | 24,034 | (80,508 | ) |\n| Benefit plan actuarial net gain (loss) | - | - | - | - | - | - |\n| Reclassification of benefit plan liability amortization included in net income (loss) | 2,393 | (837 | ) | 1,556 | 7,336 | (2,567 | ) | 4,769 |\n| Total other comprehensive income (loss) | $ | (121,279 | ) | $ | 23,867 | $ | (97,412 | ) | $ | (184,163 | ) | $ | 23,615 | $ | (160,548 | ) |\n\n\n| Three Months Ended September 30, 2014 | Nine Months Ended September 30, 2014 |\n| (Dollars in thousands) | Before Tax | Tax Effect | Net of Tax | Before Tax | Tax Effect | Net of Tax |\n| Unrealized appreciation (depreciation) (\"URA(D)\") on securities - temporary | $ | (84,122 | ) | $ | 10,309 | $ | (73,813 | ) | $ | 75,275 | $ | (9,777 | ) | $ | 65,498 |\n| URA(D) on securities - OTTI | (261 | ) | - | (261 | ) | (180 | ) | - | (180 | ) |\n| Reclassification of net realized losses (gains) included in net income (loss) | (7,024 | ) | 1,340 | (5,684 | ) | (1,938 | ) | 297 | (1,641 | ) |\n| Foreign currency translation adjustments | (38,998 | ) | 4,024 | (34,974 | ) | (42,998 | ) | 4,624 | (38,374 | ) |\n| Benefit plan actuarial net gain (loss) | - | - | - | - | - | - |\n| Reclassification of benefit plan liability amortization included in net income (loss) | 1,269 | (444 | ) | 825 | 3,640 | (1,274 | ) | 2,366 |\n| Total other comprehensive income (loss) | $ | (129,136 | ) | $ | 15,229 | $ | (113,907 | ) | $ | 33,799 | $ | (6,130 | ) | $ | 27,669 |\n\n20\nThe following table presents details of the amounts reclassified from AOCI for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, | Affected line item within the statements of |\n| AOCI component | 2015 | 2014 | 2015 | 2014 | operations and comprehensive income (loss) |\n| (Dollars in thousands) |\n| URA(D) on securities | $ | 29,235 | $ | (7,024 | ) | $ | 82,967 | $ | (1,938 | ) | Other net realized capital gains (losses) |\n| (4,639 | ) | 1,340 | (23,441 | ) | 297 | Income tax expense (benefit) |\n| $ | 24,596 | $ | (5,684 | ) | $ | 59,526 | $ | (1,641 | ) | Net income (loss) |\n| Benefit plan net gain (loss) | $ | 2,393 | $ | 1,269 | $ | 7,336 | $ | 3,640 | Other underwriting expenses |\n| (837 | ) | (444 | ) | (2,567 | ) | (1,274 | ) | Income tax expense (benefit) |\n| $ | 1,556 | $ | 825 | $ | 4,769 | $ | 2,366 | Net income (loss) |\n\nThe following table presents the components of accumulated other comprehensive income (loss), net of tax, in the consolidated balance sheets for the periods indicated:\n\n| Nine Months Ended | Twelve Months Ended |\n| September 30, | December 31, |\n| (Dollars in thousands) | 2015 | 2014 |\n| Beginning balance of URA (D) on securities | $ | 223,250 | $ | 201,154 |\n| Current period change in URA (D) of investments - temporary | (90,348 | ) | 28,767 |\n| Current period change in URA (D) of investments - non-credit OTTI | 5,539 | (6,671 | ) |\n| Ending balance of URA (D) on securities | 138,441 | 223,250 |\n| Beginning balance of foreign currency translation adjustments | (99,947 | ) | (4,530 | ) |\n| Current period change in foreign currency translation adjustments | (80,508 | ) | (95,417 | ) |\n| Ending balance of foreign currency translation adjustments | (180,455 | ) | (99,947 | ) |\n| Beginning balance of benefit plan net gain (loss) | (74,986 | ) | (38,896 | ) |\n| Current period change in benefit plan net gain (loss) | 4,769 | (36,090 | ) |\n| Ending balance of benefit plan net gain (loss) | (70,217 | ) | (74,986 | ) |\n| Ending balance of accumulated other comprehensive income (loss) | $ | (112,231 | ) | $ | 48,317 |\n\n11. CREDIT FACILITIES\nThe Company has two active credit facilities for a total commitment of up to $1,100,000 thousand, providing for the issuance of letters of credit and/or unsecured revolving credit lines. The following table presents the costs incurred in connection with the two credit facilities for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Credit facility fees incurred | $ | 132 | $ | 132 | $ | 431 | $ | 527 |\n\n21\nThe terms and outstanding amounts for each facility are discussed below:\nGroup Credit Facility\nEffective June 22, 2012, Group, Bermuda Re and Everest International entered into a four year, $800,000 thousand senior credit facility with a syndicate of lenders, which amended and restated in its entirety the July 27, 2007, five year, $850,000 thousand senior credit facility. Both the June 22, 2012 and July 27, 2007 senior credit facilities, which have similar terms, are referred to as the \"Group Credit Facility\". Wells Fargo Corporation (\"Wells Fargo Bank\") is the administrative agent for the Group Credit Facility, which consists of two tranches. Tranche one provides up to $200,000 thousand of unsecured revolving credit for liquidity and general corporate purposes, and for the issuance of unsecured standby letters of credit. The interest on the revolving loans shall, at the Company's option, be either (1) the Base Rate (as defined below) or (2) an adjusted London Interbank Offered Rate (\"LIBOR\") plus a margin. The Base Rate is the higher of (a) the prime commercial lending rate established by Wells Fargo Bank, (b) the Federal Funds Rate plus 0.5% per annum or (c) the one month LIBOR Rate plus 1.0% per annum. The amount of margin and the fees payable for the Group Credit Facility depends on Group's senior unsecured debt rating. Tranche two exclusively provides up to $600,000 thousand for the issuance of standby letters of credit on a collateralized basis.\nThe Group Credit Facility requires Group to maintain a debt to capital ratio of not greater than 0.35 to 1 and to maintain a minimum net worth. Minimum net worth is an amount equal to the sum of $4,249,963 thousand plus 25% of consolidated net income for each of Group's fiscal quarters, for which statements are available ending on or after January 1, 2012 and for which consolidated net income is positive, plus 25% of any increase in consolidated net worth during such period attributable to the issuance of ordinary and preferred shares, which at September 30, 2015, was $5,277,454 thousand. As of September 30, 2015, the Company was in compliance with all Group Credit Facility covenants.\nThe following table summarizes the outstanding letters of credit and/or borrowings for the periods indicated:\n\n| (Dollars in thousands) | At September 30, 2015 | At December 31, 2014 |\n| Bank | Commitment | In Use | Date of Expiry | Commitment | In Use | Date of Expiry |\n| Wells Fargo Bank Group Credit Facility | Tranche One | $ | 200,000 | $ | - | $ | 200,000 | $ | - |\n| Tranche Two | 600,000 | 456,379 | 12/31/2015 | 600,000 | 444,012 | 12/31/2015 |\n| Total Wells Fargo Bank Group Credit Facility | $ | 800,000 | $ | 456,379 | $ | 800,000 | $ | 444,012 |\n\nBermuda Re Letter of Credit Facility\nEffective December 31, 2014, Bermuda Re renewed its $300,000 thousand letter of credit issuance facility with Citibank N.A. referred to as the \"Bermuda Re Letter of Credit Facility\", which commitment is reconfirmed annually with updated fees. The Bermuda Re Letter of Credit Facility provides for the issuance of up to $300,000 thousand of secured letters of credit to collateralize reinsurance obligations as a non-admitted reinsurer. The interest on drawn letters of credit shall be (A) 0.35% per annum of the principal amount of issued standard letters of credit (expiry of 15 months or less) and (B) 0.45% per annum of the principal amount of issued extended tenor letters of credit (expiry maximum of up to 60 months). The commitment fee on undrawn credit shall be 0.15% per annum.\nThe following table summarizes the outstanding letters of credit for the periods indicated:\n\n| (Dollars in thousands) | At September 30, 2015 | At December 31, 2014 |\n| Bank | Commitment | In Use | Date of Expiry | Commitment | In Use | Date of Expiry |\n| Citibank Bilateral Letter of Credit Agreement | $ | 300,000 | $ | 3,672 | 11/24/2015 | $ | 300,000 | $ | 112 | 8/30/2015 |\n| 65,013 | 12/31/2015 | 3,672 | 11/24/2015 |\n| 2,681 | 12/31/2016 | 70,922 | 12/31/2015 |\n| 173 | 8/30/2017 | 2,014 | 12/31/2016 |\n| 119,002 | 9/30/2019 | 149,353 | 12/30/2018 |\n| Total Citibank Bilateral Agreement | $ | 300,000 | $ | 190,541 | $ | 300,000 | $ | 226,073 |\n\n22\nHoldings Credit Facility - Expired\nEffective August 15, 2011, the Company entered into a three year, $150,000 thousand unsecured revolving credit facility, referred to as the \"Holdings Credit Facility\", which expired on August 15, 2014. The Company decided not to renew the Holdings Credit Facility at expiration.\n12. REINSURANCE AND TRUST AGREEMENTS\nCertain subsidiaries of Group have established trust agreements, which effectively use the Company's investments as collateral, as security for assumed losses payable to certain non-affiliated ceding companies. At September 30, 2015, the total amount on deposit in trust accounts was $404,008 thousand.\nOn April 24, 2014, the Company entered into two collateralized reinsurance agreements with Kilimanjaro Re Limited (\"Kilimanjaro\"), a Bermuda based special purpose reinsurer, to provide the Company with catastrophe reinsurance coverage. These agreements are multi-year reinsurance contracts which cover specified named storm and earthquake events. The first agreement provides up to $250,000 thousand of reinsurance coverage from named storms in specified states of the Southeastern United States. The second agreement provides up to $200,000 thousand of reinsurance coverage from named storms in specified states of the Southeast, Mid-Atlantic and Northeast regions of the United States and Puerto Rico as well as reinsurance coverage from earthquakes in specified states of the Southeast, Mid-Atlantic, Northeast and West regions of the United States, Puerto Rico and British Columbia.\nOn November 18, 2014, the Company entered into a collateralized reinsurance agreement with Kilimanjaro Re to provide the Company with catastrophe reinsurance coverage. This agreement is a multi-year reinsurance contract which covers specified earthquake events. The agreement provides up to $500,000 thousand of reinsurance coverage from earthquakes in the United States, Puerto Rico and Canada.\nKilimanjaro has financed the various property catastrophe reinsurance coverage by issuing catastrophe bonds to unrelated, external investors. On April 24, 2014, Kilimanjaro issued $450,000 thousand of variable rate notes (\"Series 2014-1 Notes\"). On November 18, 2014, Kilimanjaro issued $500,000 thousand of variable rate notes (\"Series 2014-2 Notes\"). The proceeds from the issuance of the Series 2014-1 Notes and the Series 2014-2 Notes are held in reinsurance trust throughout the duration of the applicable reinsurance agreements and invested solely in US government money market funds with a rating of at least \"AAAm\" by Standard & Poor's.\n13. SENIOR NOTES\nThe table below displays Holdings' outstanding senior notes. Market value is based on quoted market prices, but due to limited trading activity, these senior notes are considered Level 2 in the fair value hierarchy.\n\n| September 30, 2015 | December 31, 2014 |\n| Consolidated Balance | Consolidated Balance |\n| (Dollars in thousands) | Date Issued | Date Due | Principal Amounts | Sheet Amount | Market Value | Sheet Amount | Market Value |\n| 4.868% Senior notes | 06/05/2014 | 06/01/2044 | $ | 400,000 | $ | 400,000 | $ | 388,768 | $ | 400,000 | $ | 404,892 |\n| 5.40% Senior notes | 10/12/2004 | 10/15/2014 | 250,000 | - | - | - | - |\n\nOn June 5, 2014, Holdings issued $400,000 thousand of 30 year senior notes at 4.868%, which will mature on June 1, 2044. Interest will be paid semi-annually on June 1 and December 1 of each year. The proceeds from the issuance have been used in part to pay off the $250,000 thousand of 5.40% senior notes which matured on October 15, 2014.\n23\nInterest expense incurred in connection with these senior notes is as follows for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Interest expense incurred | $ | 4,868 | $ | 8,256 | $ | 14,604 | $ | 16,385 |\n\n14. LONG TERM SUBORDINATED NOTES\nThe table below displays Holdings' outstanding fixed to floating rate long term subordinated notes. Market value is based on quoted market prices, but due to limited trading activity, these subordinated notes are considered Level 2 in the fair value hierarchy.\n\n| Maturity Date | September 30, 2015 | December 31, 2014 |\n| Original | Consolidated Balance | Consolidated Balance |\n| (Dollars in thousands) | Date Issued | Principal Amount | Scheduled | Final | Sheet Amount | Market Value | Sheet Amount | Market Value |\n| 6.6% Long term subordinated notes | 04/26/2007 | $ | 400,000 | 05/15/2037 | 05/01/2067 | $ | 238,367 | $ | 218,281 | $ | 238,364 | $ | 246,312 |\n\nDuring the fixed rate interest period from May 3, 2007 through May 14, 2017, interest will be at the annual rate of 6.6%, payable semi-annually in arrears on November 15 and May 15 of each year, commencing on November 15, 2007, subject to Holdings' right to defer interest on one or more occasions for up to ten consecutive years. During the floating rate interest period from May 15, 2017 through maturity, interest will be based on the 3 month LIBOR plus 238.5 basis points, reset quarterly, payable quarterly in arrears on February 15, May 15, August 15 and November 15 of each year, subject to Holdings' right to defer interest on one or more occasions for up to ten consecutive years. Deferred interest will accumulate interest at the applicable rate compounded semi-annually for periods prior to May 15, 2017, and compounded quarterly for periods from and including May 15, 2017.\nHoldings can redeem the long term subordinated notes prior to May 15, 2017, in whole but not in part at the applicable redemption price, which will equal the greater of (a) 100% of the principal amount being redeemed and (b) the present value of the principal payment on May 15, 2017 and scheduled payments of interest that would have accrued from the redemption date to May 15, 2017 on the long term subordinated notes being redeemed, discounted to the redemption date on a semi-annual basis at a discount rate equal to the treasury rate plus an applicable spread of either 0.25% or 0.50%, in each case plus accrued and unpaid interest. Holdings may redeem the long term subordinated notes on or after May 15, 2017, in whole or in part at 100% of the principal amount plus accrued and unpaid interest; however, redemption on or after the scheduled maturity date and prior to May 1, 2047 is subject to a replacement capital covenant. This covenant is for the benefit of certain senior note holders and it mandates that Holdings receive proceeds from the sale of another subordinated debt issue, of at least similar size, before it may redeem the subordinated notes. Effective upon the maturity of the Company's 5.40% senior notes on October 15, 2014, the Company's 4.868% senior notes, due on June 1, 2044, have become the Company's long term indebtedness that ranks senior to the long term subordinated notes.\nOn March 19, 2009, Group announced the commencement of a cash tender offer for any and all of the 6.60% fixed to floating rate long term subordinated notes. Upon expiration of the tender offer, the Company had reduced its outstanding debt by $161,441 thousand.\nInterest expense incurred in connection with these long term subordinated notes is as follows for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Interest expense incurred | $ | 3,937 | $ | 3,937 | $ | 11,811 | $ | 11,811 |\n\n24\n15. SEGMENT REPORTING\nThe U.S. Reinsurance operation writes property and casualty reinsurance and specialty lines of business, including Marine, Aviation, Surety and Accident and Health (\"A&H\") business, on both a treaty and facultative basis, through reinsurance brokers, as well as directly with ceding companies primarily within the U.S. The International operation writes non-U.S. property and casualty reinsurance through Everest Re's branches in Canada and Singapore and through offices in Brazil, Miami and New Jersey. The Bermuda operation provides reinsurance and insurance to worldwide property and casualty markets through brokers and directly with ceding companies from its Bermuda office and reinsurance to the United Kingdom and European markets through its UK branch and Ireland Re. The Insurance operation writes property and casualty insurance directly and through general agents, brokers and surplus lines brokers within the U.S. and Canada. The Mt. Logan Re segment represents business written for the segregated accounts of Mt. Logan Re, which were formed on July 1, 2013. The Mt. Logan Re business represents a diversified set of catastrophe exposures, diversified by risk/peril and across different geographical regions globally.\nThese segments, with the exception of Mt. Logan Re, are managed independently, but conform with corporate guidelines with respect to pricing, risk management, control of aggregate catastrophe exposures, capital, investments and support operations. Management generally monitors and evaluates the financial performance of these operating segments based upon their underwriting results. The Mt. Logan Re segment is managed independently and seeks to write a diverse portfolio of catastrophe risks for each segregated account to achieve desired risk and return criteria.\nUnderwriting results include earned premium less losses and loss adjustment expenses (\"LAE\") incurred, commission and brokerage expenses and other underwriting expenses. We measure our underwriting results using ratios, in particular loss, commission and brokerage and other underwriting expense ratios, which, respectively, divide incurred losses, commissions and brokerage and other underwriting expenses by premiums earned.\nMt. Logan Re's business is sourced through operating subsidiaries of the Company; however, the activity is only reflected in the Mt. Logan Re segment. For other inter-affiliate reinsurance, business is generally reported within the segment in which the business was first produced, consistent with how the business is managed.\nExcept for Mt. Logan Re, the Company does not maintain separate balance sheet data for its operating segments. Accordingly, the Company does not review and evaluate the financial results of its operating segments based upon balance sheet data.\n25\nThe following tables present the underwriting results for the operating segments for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| U.S. Reinsurance | September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Gross written premiums | $ | 537,483 | $ | 640,660 | $ | 1,464,840 | $ | 1,573,776 |\n| Net written premiums | 511,238 | 615,078 | 1,383,647 | 1,536,114 |\n| Premiums earned | $ | 488,485 | $ | 559,488 | $ | 1,480,427 | $ | 1,478,258 |\n| Incurred losses and LAE | 225,944 | 249,004 | 699,575 | 701,473 |\n| Commission and brokerage | 121,050 | 123,432 | 364,005 | 339,166 |\n| Other underwriting expenses | 13,718 | 12,118 | 37,054 | 33,054 |\n| Underwriting gain (loss) | $ | 127,773 | $ | 174,934 | $ | 379,793 | $ | 404,565 |\n\n\n| Three Months Ended | Nine Months Ended |\n| International | September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Gross written premiums | $ | 354,871 | $ | 406,254 | $ | 966,091 | $ | 1,181,513 |\n| Net written premiums | 318,478 | 352,608 | 896,872 | 977,235 |\n| Premiums earned | $ | 291,396 | $ | 320,020 | $ | 935,228 | $ | 958,399 |\n| Incurred losses and LAE | 229,013 | 236,559 | 630,752 | 604,166 |\n| Commission and brokerage | 70,894 | 73,143 | 226,321 | 215,716 |\n| Other underwriting expenses | 9,128 | 8,758 | 25,292 | 24,683 |\n| Underwriting gain (loss) | $ | (17,639 | ) | $ | 1,560 | $ | 52,863 | $ | 113,834 |\n\n\n| Three Months Ended | Nine Months Ended |\n| Bermuda | September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Gross written premiums | $ | 267,035 | $ | 205,342 | $ | 605,365 | $ | 573,793 |\n| Net written premiums | 251,678 | 189,447 | 557,453 | 548,210 |\n| Premiums earned | $ | 222,240 | $ | 181,754 | $ | 616,241 | $ | 546,699 |\n| Incurred losses and LAE | 154,327 | 108,961 | 372,572 | 310,602 |\n| Commission and brokerage | 52,980 | 48,421 | 151,356 | 140,968 |\n| Other underwriting expenses | 9,457 | 9,360 | 27,045 | 25,805 |\n| Underwriting gain (loss) | $ | 5,476 | $ | 15,012 | $ | 65,268 | $ | 69,324 |\n\n\n| Three Months Ended | Nine Months Ended |\n| Insurance | September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Gross written premiums | $ | 489,124 | $ | 364,111 | $ | 1,173,012 | $ | 911,242 |\n| Net written premiums | 418,960 | 310,690 | 1,022,389 | 802,431 |\n| Premiums earned | $ | 360,742 | $ | 290,518 | $ | 888,711 | $ | 742,038 |\n| Incurred losses and LAE | 262,328 | 239,823 | 662,052 | 557,047 |\n| Commission and brokerage | 50,268 | 40,418 | 127,125 | 114,535 |\n| Other underwriting expenses | 35,677 | 31,311 | 99,232 | 83,672 |\n| Underwriting gain (loss) | $ | 12,469 | $ | (21,034 | ) | $ | 302 | $ | (13,216 | ) |\n\n26\n\n| Three Months Ended | Nine Months Ended |\n| Mt. Logan Re | September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Gross written premiums | $ | 72,200 | $ | 50,334 | $ | 183,694 | $ | 109,163 |\n| Net written premiums | 60,903 | 49,757 | 153,281 | 98,666 |\n| Premiums earned | $ | 50,777 | $ | 38,218 | $ | 132,508 | $ | 81,411 |\n| Incurred losses and LAE | 16,485 | 3,410 | 36,272 | 19,575 |\n| Commission and brokerage | 4,856 | 5,105 | 13,325 | 9,823 |\n| Other underwriting expenses | 2,687 | 1,566 | 6,659 | 4,951 |\n| Underwriting gain (loss) | $ | 26,749 | $ | 28,137 | $ | 76,252 | $ | 47,062 |\n\nThe following table reconciles the underwriting results for the operating segments to income before taxes as reported in the consolidated statements of operations and comprehensive income (loss) for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Underwriting gain (loss) | $ | 154,828 | $ | 198,609 | $ | 574,478 | $ | 621,569 |\n| Net investment income | 115,511 | 142,143 | 363,140 | 396,524 |\n| Net realized capital gains (losses) | (159,971 | ) | (9,448 | ) | (194,654 | ) | 70,694 |\n| Net derivative gain (loss) | (11,428 | ) | 1,855 | (5,225 | ) | 3,968 |\n| Corporate expenses | (5,924 | ) | (9,958 | ) | (17,312 | ) | (18,802 | ) |\n| Interest, fee and bond issue cost amortization expense | (8,990 | ) | (12,424 | ) | (27,006 | ) | (28,970 | ) |\n| Other income (expense) | 17,413 | 11,332 | 59,561 | (5,835 | ) |\n| Income (loss) before taxes | $ | 101,439 | $ | 322,109 | $ | 752,982 | $ | 1,039,148 |\n\nThe Company produces business in the U.S., Bermuda and internationally. The net income deriving from and assets residing in the individual foreign countries in which the Company writes business are not identifiable in the Company's financial records. Based on gross written premium, the table below presents the largest country, other than the U.S., in which the Company writes business, for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| United Kingdom gross written premium | $ | 212,039 | $ | 199,052 | $ | 565,143 | $ | 536,928 |\n\nNo other country represented more than 5% of the Company's revenues.\n16. SHARE-BASED COMPENSATION PLANS\nFor the three months ended September 30, 2015, share-based compensation awards granted were 4,720 restricted shares, granted on September 9, 2015, with a fair value of $176.37 per share.\n27\n17. RETIREMENT BENEFITS\nThe Company maintains both qualified and non-qualified defined benefit pension plans and a retiree health plan for its U.S. employees employed prior to April 1, 2010.\nNet periodic benefit cost for U.S. employees included the following components for the periods indicated:\n\n| Pension Benefits | Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Service cost | $ | 3,203 | $ | 2,460 | $ | 9,398 | $ | 7,381 |\n| Interest cost | 2,758 | 2,542 | 7,926 | 7,625 |\n| Expected return on plan assets | (2,904 | ) | (2,822 | ) | (8,710 | ) | (8,468 | ) |\n| Amortization of prior service cost | 4 | 13 | 15 | 38 |\n| Amortization of net (income) loss | 2,312 | 1,173 | 6,824 | 3,356 |\n| FAS 88 settlement charge | - | 5,269 | - | 5,269 |\n| Net periodic benefit cost | $ | 5,373 | $ | 8,635 | $ | 15,453 | $ | 15,201 |\n\n\n| Other Benefits | Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Service cost | $ | 498 | $ | 407 | $ | 1,498 | $ | 1,221 |\n| Interest cost | 329 | 342 | 987 | 1,026 |\n| Amortization of net (income) loss | 76 | 82 | 497 | 246 |\n| Net periodic benefit cost | $ | 903 | $ | 831 | $ | 2,982 | $ | 2,493 |\n\nThe Company did not make any contributions to the qualified pension benefit plan for the three and nine months ended September 30, 2015 and 2014.\n18. INCOME TAXES\nThe Company is domiciled in Bermuda and has significant subsidiaries and/or branches in Canada, Ireland, Singapore, the United Kingdom, and the United States. The Company's Bermuda domiciled subsidiaries are exempt from income taxation under Bermuda law until 2035. Pre-tax income generated by Group's non-Bermuda subsidiaries and the UK branch of Bermuda is subject to applicable federal, foreign, state and local taxes on corporations. Company subsidiaries domiciled in the US as well as the Canadian and Singapore branches of Everest Re generate US pre-tax income (loss). Foreign domiciled subsidiaries, including the UK branch of Bermuda Re, generate non-US pre-tax income (loss). Fluctuations in US and non-US pre-tax income (loss) primarily result from the impact of catastrophe losses and realized investment gains (losses).\nFor interim reporting periods, the company is generally required to use the annualized effective tax rate (\"AETR\") method, as prescribed by ASC 740-270, Interim Reporting, to calculate its income tax provision. Under this method, the AETR is applied to the interim year-to-date pre-tax income to determine the income tax expense or benefit for the year-to-date period. The income tax expense or benefit for a quarter represents the difference between the year-to-date income tax expense or benefit for the current year-to-date period less such amount for the immediately preceding year-to-date period. Management considers the impact of all known events in its estimation of the Company's annual pre-tax income and AETR.\n19. DISPOSITIONS\nOn July 13, 2015, the Company closed its agreement to sell all of the outstanding shares of capital stock of Mt. McKinley, a Delaware domiciled insurance company and wholly-owned subsidiary of the Company to Clearwater Insurance Company, a Delaware domiciled insurance company. The Company received $20,156 thousand in cash for Mt. McKinley and did not recognize any realized gain or loss from the sale.\n28\nConcurrently with the closing, the Company entered into a retrocession treaty with an affiliate of Clearwater Insurance Company. Per the retrocession treaty, the Company retroceded 100% of the liabilities associated with certain Mt. McKinley policies, which had been reinsured by Everest Reinsurance (Bermuda), Ltd. (\"Everest Re Bermuda\"), a wholly-owned subsidiary of the Company. As consideration for entering into the retrocession treaty, Everest Re Bermuda transferred cash of $140,279 thousand, an amount equal to the net loss reserves as of the closing date. The maximum liability retroceded under the retrocession treaty will be $440,279 thousand, equal to the retrocession payment plus $300,000 thousand. The Company will retain liability for any amounts exceeding the maximum liability retroceded under the retrocession treaty.\n20. SUBSEQUENT EVENTS\nThe Company is currently negotiating two additional reinsurance agreements with Kilimanjaro to provide the Company with catastrophe reinsurance coverage. Kilimanjaro will fund the catastrophe reinsurance coverage through the issuance of two classes of catastrophe reinsurance bonds.\n29\n\nITEM 2.\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION\n| Three Months Ended | Percentage | Nine Months Ended | Percentage |\n| September 30, | Increase/ | September 30, | Increase/ |\n| (Dollars in millions) | 2015 | 2014 | (Decrease) | 2015 | 2014 | (Decrease) |\n| Gross written premiums | $ | 1,720.7 | $ | 1,666.7 | 3.2 | % | $ | 4,393.0 | $ | 4,349.5 | 1.0 | % |\n| Net written premiums | 1,561.3 | 1,517.6 | 2.9 | % | 4,013.6 | 3,962.7 | 1.3 | % |\n| REVENUES: |\n| Premiums earned | $ | 1,413.6 | $ | 1,390.0 | 1.7 | % | $ | 4,053.1 | $ | 3,806.8 | 6.5 | % |\n| Net investment income | 115.5 | 142.1 | -18.7 | % | 363.1 | 396.5 | -8.4 | % |\n| Net realized capital gains (losses) | (160.0 | ) | (9.4 | ) | NM | (194.7 | ) | 70.7 | NM |\n| Net derivative gain (loss) | (11.4 | ) | 1.9 | NM | (5.2 | ) | 4.0 | -231.7 | % |\n| Other income (expense) | 17.4 | 11.3 | 53.6 | % | 59.6 | (5.8 | ) | NM |\n| Total revenues | 1,375.2 | 1,535.9 | -10.5 | % | 4,275.9 | 4,272.2 | 0.1 | % |\n| CLAIMS AND EXPENSES: |\n| Incurred losses and loss adjustment expenses | 888.1 | 837.8 | 6.0 | % | 2,401.2 | 2,192.9 | 9.5 | % |\n| Commission, brokerage, taxes and fees | 300.0 | 290.5 | 3.3 | % | 882.1 | 820.2 | 7.5 | % |\n| Other underwriting expenses | 70.7 | 63.1 | 12.0 | % | 195.3 | 172.2 | 13.4 | % |\n| Corporate expenses | 5.9 | 10.0 | -40.5 | % | 17.3 | 18.8 | -7.9 | % |\n| Interest, fees and bond issue cost amortization expense | 9.0 | 12.4 | -27.6 | % | 27.0 | 29.0 | -6.8 | % |\n| Total claims and expenses | 1,273.7 | 1,213.8 | 4.9 | % | 3,523.0 | 3,233.0 | 9.0 | % |\n| INCOME (LOSS) BEFORE TAXES | 101.4 | 322.1 | -68.5 | % | 753.0 | 1,039.1 | -27.5 | % |\n| Income tax expense (benefit) | (6.1 | ) | 20.9 | -129.4 | % | 70.9 | 137.9 | -48.6 | % |\n| NET INCOME (LOSS) | $ | 107.6 | $ | 301.3 | -64.3 | % | $ | 682.1 | $ | 901.2 | -24.3 | % |\n| Net (income) loss attributable to noncontrolling interests | (19.0 | ) | (26.3 | ) | -27.8 | % | (61.5 | ) | (42.2 | ) | 45.9 | % |\n| NET INCOME (LOSS) ATTRIBUTABLE TO EVEREST RE GROUP | $ | 88.6 | $ | 274.9 | -67.8 | % | $ | 620.6 | $ | 859.0 | -27.8 | % |\n| RATIOS: | Point Change | Point Change |\n| Loss ratio | 62.8 | % | 60.3 | % | 2.5 | 59.2 | % | 57.6 | % | 1.6 |\n| Commission and brokerage ratio | 21.2 | % | 20.9 | % | 0.3 | 21.8 | % | 21.5 | % | 0.3 |\n| Other underwriting expense ratio | 5.0 | % | 4.5 | % | 0.5 | 4.8 | % | 4.6 | % | 0.2 |\n| Combined ratio | 89.0 | % | 85.7 | % | 3.3 | 85.8 | % | 83.7 | % | 2.1 |\n| At | At | Percentage |\n| September 30, | December 31, | Increase/ |\n| (Dollars in millions, except per share amounts) | 2015 | 2014 | (Decrease) |\n| Balance sheet data: |\n| Total investments and cash | $ | 17,647.2 | $ | 17,435.9 | 1.2 | % |\n| Total assets | 21,682.3 | 20,817.8 | 4.2 | % |\n| Loss and loss adjustment expense reserves | 9,966.0 | 9,720.8 | 2.5 | % |\n| Total debt | 638.4 | 638.4 | 0.0 | % |\n| Total liabilities | 13,443.3 | 12,945.2 | 3.8 | % |\n| Redeemable noncontrolling interests - Mt. Logan Re | 752.7 | 421.6 | 78.6 | % |\n| Shareholders' equity | 7,486.3 | 7,451.1 | 0.5 | % |\n| Book value per share | 173.76 | 166.75 | 4.2 | % |\n| (NM, not meaningful) |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional (a) | $ | 848.1 | 60.1 | % | $ | - | 0.0 | % | $ | 848.1 | 60.1 | % |\n| Catastrophes | 40.0 | 2.7 | % | - | 0.0 | % | 40.0 | 2.7 | % |\n| Total | $ | 888.1 | 62.8 | % | $ | - | 0.0 | % | $ | 888.1 | 62.8 | % |\n| 2014 |\n| Attritional (a) | $ | 807.3 | 58.1 | % | $ | 0.5 | 0.0 | % | $ | 807.8 | 58.1 | % |\n| Catastrophes | 30.0 | 2.2 | % | - | 0.0 | % | 30.0 | 2.2 | % |\n| Total | $ | 837.3 | 60.3 | % | $ | 0.5 | 0.0 | % | $ | 837.8 | 60.3 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 40.8 | 2.0 | pts | $ | (0.5 | ) | - | pts | $ | 40.3 | 2.0 | pts |\n| Catastrophes | 10.0 | 0.5 | pts | - | - | pts | 10.0 | 0.4 | pts |\n| Total segment | $ | 50.8 | 2.5 | pts | $ | (0.5 | ) | - | pts | $ | 50.3 | 2.5 | pts |\n| Nine Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional (a) | $ | 2,332.1 | 57.5 | % | $ | (0.8 | ) | 0.0 | % | $ | 2,331.3 | 57.5 | % |\n| Catastrophes | 80.0 | 2.0 | % | (10.0 | ) | -0.3 | % | 70.0 | 1.7 | % |\n| Total | $ | 2,412.1 | 59.5 | % | $ | (10.8 | ) | -0.3 | % | $ | 2,401.2 | 59.2 | % |\n| 2014 |\n| Attritional (a) | $ | 2,120.8 | 55.7 | % | $ | (2.9 | ) | -0.1 | % | $ | 2,117.9 | 55.6 | % |\n| Catastrophes | 75.0 | 2.0 | % | - | 0.0 | % | 75.0 | 2.0 | % |\n| Total | $ | 2,195.8 | 57.7 | % | $ | (2.9 | ) | -0.1 | % | $ | 2,192.9 | 57.6 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 211.3 | 1.8 | pts | $ | 2.1 | 0.1 | pts | $ | 213.4 | 1.9 | pts |\n| Catastrophes | 5.0 | - | pts | (10.0 | ) | (0.3 | ) | pts | (5.0 | ) | (0.3 | ) | pts |\n| Total segment | $ | 216.3 | 1.8 | pts | $ | (7.9 | ) | (0.2 | ) | pts | $ | 208.3 | 1.6 | pts |\n| (a) Attritional losses exclude catastrophe losses. |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in millions) | 2015 | 2014 | 2015 | 2014 |\n| Fixed maturities | $ | 108.1 | $ | 115.1 | $ | 327.0 | $ | 348.9 |\n| Equity securities | 11.1 | 11.1 | 35.8 | 36.1 |\n| Short-term investments and cash | 0.4 | 0.3 | 1.1 | 1.2 |\n| Other invested assets |\n| Limited partnerships | 0.4 | 21.7 | 14.0 | 25.7 |\n| Other | (0.2 | ) | 0.9 | 1.4 | 3.2 |\n| Gross investment income before adjustments | 119.7 | 149.0 | 379.2 | 415.1 |\n| Funds held interest income (expense) | 2.6 | 1.8 | 8.2 | 6.9 |\n| Future policy benefit reserve income (expense) | (0.3 | ) | (0.5 | ) | (1.4 | ) | (0.9 | ) |\n| Gross investment income | 122.0 | 150.3 | 386.0 | 421.0 |\n| Investment expenses | (6.5 | ) | (8.2 | ) | (22.8 | ) | (24.5 | ) |\n| Net investment income | $ | 115.5 | $ | 142.1 | $ | 363.1 | $ | 396.5 |\n| (Some amounts may not reconcile due to rounding.) |\n| At | At |\n| September 30, | December 31, |\n| 2015 | 2014 |\n| Imbedded pre-tax yield of cash and invested assets | 3.0% | 3.0% |\n| Imbedded after-tax yield of cash and invested assets | 2.5% | 2.6% |\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| 2015 | 2014 | 2015 | 2014 |\n| Annualized pre-tax yield on average cash and invested assets | 2.7% | 3.4% | 2.8% | 3.2% |\n| Annualized after-tax yield on average cash and invested assets | 2.2% | 2.7% | 2.3% | 2.7% |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (Dollars in millions) | 2015 | 2014 | Variance | 2015 | 2014 | Variance |\n| Gains (losses) from sales: |\n| Fixed maturity securities, market value: |\n| Gains | $ | 11.8 | $ | 12.7 | $ | (0.9 | ) | $ | 37.5 | $ | 27.5 | $ | 10.0 |\n| Losses | (17.0 | ) | (5.5 | ) | (11.5 | ) | (53.3 | ) | (23.9 | ) | (29.4 | ) |\n| Total | (5.2 | ) | 7.3 | (12.5 | ) | (15.8 | ) | 3.7 | (19.5 | ) |\n| Fixed maturity securities, fair value: |\n| Gains | - | 0.1 | (0.1 | ) | - | 1.3 | (1.3 | ) |\n| Losses | - | - | - | - | (0.3 | ) | 0.3 |\n| Total | - | 0.1 | (0.1 | ) | - | 1.0 | (1.0 | ) |\n| Equity securities, market value: |\n| Gains | - | - | - | - | - | - |\n| Losses | (3.6 | ) | (0.1 | ) | (3.5 | ) | (4.5 | ) | (1.2 | ) | (3.3 | ) |\n| Total | (3.6 | ) | (0.1 | ) | (3.5 | ) | (4.5 | ) | (1.2 | ) | (3.3 | ) |\n| Equity securities, fair value: |\n| Gains | 5.3 | 2.5 | 2.8 | 18.9 | 13.0 | 5.9 |\n| Losses | (18.9 | ) | (4.4 | ) | (14.5 | ) | (31.9 | ) | (14.9 | ) | (17.0 | ) |\n| Total | (13.6 | ) | (1.9 | ) | (11.7 | ) | (13.0 | ) | (1.9 | ) | (11.1 | ) |\n| Total net realized capital gains (losses) from sales: |\n| Gains | 17.1 | 15.4 | 1.7 | 56.4 | 41.9 | 14.5 |\n| Losses | (39.5 | ) | (10.0 | ) | (29.5 | ) | (89.7 | ) | (40.3 | ) | (49.4 | ) |\n| Total | (22.5 | ) | 5.4 | (27.9 | ) | (33.3 | ) | 1.6 | (34.9 | ) |\n| Other-than-temporary impairments: | (20.4 | ) | (0.1 | ) | (20.3 | ) | (62.7 | ) | (0.5 | ) | (62.2 | ) |\n| Gains (losses) from fair value adjustments: |\n| Fixed maturity securities, fair value | - | (0.9 | ) | 0.9 | 0.1 | (0.9 | ) | 1.0 |\n| Equity securities, fair value | (117.1 | ) | (13.8 | ) | (103.3 | ) | (98.7 | ) | 70.5 | (169.2 | ) |\n| Total | (117.1 | ) | (14.7 | ) | (102.4 | ) | (98.7 | ) | 69.6 | (168.3 | ) |\n| Total net realized capital gains (losses) | $ | (160.0 | ) | $ | (9.4 | ) | $ | (150.6 | ) | $ | (194.7 | ) | $ | 70.7 | $ | (265.4 | ) |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\n| Gross written premiums | $ | 537.5 | $ | 640.7 | $ | (103.2 | ) | -16.1 | % | $ | 1,464.8 | $ | 1,573.8 | $ | (108.9 | ) | -6.9 | % |\n| Net written premiums | 511.2 | 615.1 | (103.8 | ) | -16.9 | % | 1,383.6 | 1,536.1 | (152.5 | ) | -9.9 | % |\n| Premiums earned | $ | 488.5 | $ | 559.5 | $ | (71.0 | ) | -12.7 | % | $ | 1,480.4 | $ | 1,478.3 | $ | 2.2 | 0.1 | % |\n| Incurred losses and LAE | 225.9 | 249.0 | (23.1 | ) | -9.3 | % | 699.6 | 701.5 | (1.9 | ) | -0.3 | % |\n| Commission and brokerage | 121.1 | 123.4 | (2.4 | ) | -1.9 | % | 364.0 | 339.2 | 24.8 | 7.3 | % |\n| Other underwriting expenses | 13.7 | 12.1 | 1.6 | 13.2 | % | 37.1 | 33.1 | 4.0 | 12.1 | % |\n| Underwriting gain (loss) | $ | 127.8 | $ | 174.9 | $ | (47.2 | ) | -27.0 | % | $ | 379.8 | $ | 404.6 | $ | (24.8 | ) | -6.1 | % |\n| Point Chg | Point Chg |\n| Loss ratio | 46.3 | % | 44.5 | % | 1.8 | 47.3 | % | 47.5 | % | (0.2 | ) |\n| Commission and brokerage ratio | 24.8 | % | 22.1 | % | 2.7 | 24.6 | % | 22.9 | % | 1.7 |\n| Other underwriting expense ratio | 2.7 | % | 2.1 | % | 0.6 | 2.4 | % | 2.2 | % | 0.2 |\n| Combined ratio | 73.8 | % | 68.7 | % | 5.1 | 74.3 | % | 72.6 | % | 1.7 |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 225.5 | 46.2 | % | $ | 0.5 | 0.2 | % | $ | 226.0 | 46.4 | % |\n| Catastrophes | 0.2 | 0.0 | % | (0.3 | ) | -0.1 | % | (0.1 | ) | -0.1 | % |\n| Total segment | $ | 225.7 | 46.2 | % | $ | 0.2 | 0.1 | % | $ | 225.9 | 46.3 | % |\n| 2014 |\n| Attritional | $ | 246.7 | 44.1 | % | $ | 1.3 | 0.2 | % | $ | 248.1 | 44.3 | % |\n| Catastrophes | - | 0.0 | % | 0.9 | 0.2 | % | 0.9 | 0.2 | % |\n| Total segment | $ | 246.7 | 44.1 | % | $ | 2.3 | 0.4 | % | $ | 249.0 | 44.5 | % |\n| Variance 2015/2014 |\n| Attritional | $ | (21.2 | ) | 2.1 | pts | $ | (0.8 | ) | - | pts | $ | (22.1 | ) | 2.1 | pts |\n| Catastrophes | 0.2 | - | pts | (1.2 | ) | (0.3 | ) | pts | (1.0 | ) | (0.3 | ) | pts |\n| Total segment | $ | (21.0 | ) | 2.1 | pts | $ | (2.1 | ) | (0.3 | ) | pts | $ | (23.1 | ) | 1.8 | pts |\n| Nine Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 732.4 | 49.5 | % | $ | (24.3 | ) | -1.6 | % | $ | 708.1 | 47.9 | % |\n| Catastrophes | 0.2 | 0.0 | % | (8.8 | ) | -0.6 | % | (8.5 | ) | -0.6 | % |\n| Total segment | $ | 732.6 | 49.5 | % | $ | (33.1 | ) | -2.2 | % | $ | 699.6 | 47.3 | % |\n| 2014 |\n| Attritional | $ | 691.3 | 46.8 | % | $ | 2.3 | 0.2 | % | $ | 693.6 | 46.9 | % |\n| Catastrophes | 6.3 | 0.4 | % | 1.5 | 0.1 | % | 7.8 | 0.5 | % |\n| Total segment | $ | 697.7 | 47.2 | % | $ | 3.8 | 0.3 | % | $ | 701.5 | 47.5 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 41.1 | 2.7 | pts | $ | (26.6 | ) | (1.8 | ) | pts | $ | 14.5 | 1.0 | pts |\n| Catastrophes | (6.1 | ) | (0.4 | ) | pts | (10.3 | ) | (0.7 | ) | pts | (16.3 | ) | (1.1 | ) | pts |\n| Total segment | $ | 34.9 | 2.3 | pts | $ | (36.9 | ) | (2.5 | ) | pts | $ | (1.9 | ) | (0.2 | ) | pts |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\n| Gross written premiums | $ | 354.9 | $ | 406.3 | $ | (51.4 | ) | -12.6 | % | $ | 966.1 | $ | 1,181.5 | $ | (215.4 | ) | -18.2 | % |\n| Net written premiums | 318.5 | 352.6 | (34.1 | ) | -9.7 | % | 896.9 | 977.2 | (80.4 | ) | -8.2 | % |\n| Premiums earned | $ | 291.4 | $ | 320.0 | $ | (28.6 | ) | -8.9 | % | $ | 935.2 | $ | 958.4 | $ | (23.2 | ) | -2.4 | % |\n| Incurred losses and LAE | 229.0 | 236.6 | (7.5 | ) | -3.2 | % | 630.8 | 604.2 | 26.6 | 4.4 | % |\n| Commission and brokerage | 70.9 | 73.1 | (2.2 | ) | -3.1 | % | 226.3 | 215.7 | 10.6 | 4.9 | % |\n| Other underwriting expenses | 9.1 | 8.8 | 0.4 | 4.2 | % | 25.3 | 24.7 | 0.6 | 2.5 | % |\n| Underwriting gain (loss) | $ | (17.6 | ) | $ | 1.6 | $ | (19.2 | ) | NM | $ | 52.9 | $ | 113.8 | $ | (61.0 | ) | -53.6 | % |\n| Point Chg | Point Chg |\n| Loss ratio | 78.6 | % | 73.9 | % | 4.7 | 67.4 | % | 63.0 | % | 4.4 |\n| Commission and brokerage ratio | 24.3 | % | 22.9 | % | 1.4 | 24.2 | % | 22.5 | % | 1.7 |\n| Other underwriting expense ratio | 3.2 | % | 2.7 | % | 0.5 | 2.7 | % | 2.6 | % | 0.1 |\n| Combined ratio | 106.1 | % | 99.5 | % | 6.6 | 94.3 | % | 88.1 | % | 6.2 |\n| (NM, not meaningful) |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 195.5 | 67.1 | % | $ | 0.4 | 0.1 | % | $ | 195.9 | 67.2 | % |\n| Catastrophes | 34.4 | 11.8 | % | (1.3 | ) | -0.4 | % | 33.1 | 11.4 | % |\n| Total segment | $ | 229.9 | 78.9 | % | $ | (0.9 | ) | -0.3 | % | $ | 229.0 | 78.6 | % |\n| 2014 |\n| Attritional | $ | 213.0 | 66.5 | % | $ | (4.6 | ) | -1.4 | % | $ | 208.4 | 65.1 | % |\n| Catastrophes | 29.3 | 9.2 | % | (1.2 | ) | -0.4 | % | 28.1 | 8.8 | % |\n| Total segment | $ | 242.3 | 75.7 | % | $ | (5.8 | ) | -1.8 | % | $ | 236.6 | 73.9 | % |\n| Variance 2015/2014 |\n| Attritional | $ | (17.5 | ) | 0.6 | pts | $ | 5.0 | 1.5 | pts | $ | (12.5 | ) | 2.1 | pts |\n| Catastrophes | 5.1 | 2.6 | pts | (0.1 | ) | - | pts | 5.0 | 2.6 | pts |\n| Total segment | $ | (12.4 | ) | 3.2 | pts | $ | 4.9 | 1.5 | pts | $ | (7.5 | ) | 4.7 | pts |\n| Nine Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 565.2 | 60.4 | % | $ | (2.7 | ) | -0.3 | % | $ | 562.5 | 60.1 | % |\n| Catastrophes | 71.3 | 7.6 | % | (3.1 | ) | -0.3 | % | 68.2 | 7.3 | % |\n| Total segment | $ | 636.6 | 68.0 | % | $ | (5.8 | ) | -0.6 | % | $ | 630.8 | 67.4 | % |\n| 2014 |\n| Attritional | $ | 548.2 | 57.1 | % | $ | (4.7 | ) | -0.5 | % | $ | 543.5 | 56.6 | % |\n| Catastrophes | 63.9 | 6.7 | % | (3.3 | ) | -0.3 | % | 60.6 | 6.4 | % |\n| Total segment | $ | 612.1 | 63.8 | % | $ | (8.0 | ) | -0.8 | % | $ | 604.2 | 63.0 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 17.0 | 3.3 | pts | $ | 2.0 | 0.2 | pts | $ | 19.0 | 3.5 | pts |\n| Catastrophes | 7.4 | 0.9 | pts | 0.2 | - | pts | 7.6 | 0.9 | pts |\n| Total segment | $ | 24.5 | 4.2 | pts | $ | 2.2 | 0.2 | pts | $ | 26.6 | 4.4 | pts |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\n| Gross written premiums | $ | 267.0 | $ | 205.3 | $ | 61.7 | 30.0 | % | $ | 605.4 | $ | 573.8 | $ | 31.6 | 5.5 | % |\n| Net written premiums | 251.7 | 189.4 | 62.2 | 32.8 | % | 557.5 | 548.2 | 9.2 | 1.7 | % |\n| Premiums earned | $ | 222.2 | $ | 181.8 | $ | 40.5 | 22.3 | % | $ | 616.2 | $ | 546.7 | $ | 69.5 | 12.7 | % |\n| Incurred losses and LAE | 154.3 | 109.0 | 45.4 | 41.6 | % | 372.6 | 310.6 | 62.0 | 20.0 | % |\n| Commission and brokerage | 53.0 | 48.4 | 4.6 | 9.4 | % | 151.4 | 141.0 | 10.4 | 7.4 | % |\n| Other underwriting expenses | 9.5 | 9.4 | 0.1 | 1.0 | % | 27.0 | 25.8 | 1.2 | 4.8 | % |\n| Underwriting gain (loss) | $ | 5.5 | $ | 15.0 | $ | (9.5 | ) | -63.5 | % | $ | 65.3 | $ | 69.3 | $ | (4.1 | ) | -5.9 | % |\n| Point Chg | Point Chg |\n| Loss ratio | 69.4 | % | 59.9 | % | 9.5 | 60.5 | % | 56.8 | % | 3.7 |\n| Commission and brokerage ratio | 23.8 | % | 26.6 | % | (2.8 | ) | 24.6 | % | 25.8 | % | (1.2 | ) |\n| Other underwriting expense ratio | 4.3 | % | 5.2 | % | (0.9 | ) | 4.3 | % | 4.7 | % | (0.4 | ) |\n| Combined ratio | 97.5 | % | 91.7 | % | 5.8 | 89.4 | % | 87.3 | % | 2.1 |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 153.4 | 69.0 | % | $ | - | 0.0 | % | $ | 153.4 | 69.0 | % |\n| Catastrophes | - | 0.0 | % | 0.9 | 0.4 | % | 0.9 | 0.4 | % |\n| Total segment | $ | 153.4 | 69.0 | % | $ | 0.9 | 0.4 | % | $ | 154.3 | 69.4 | % |\n| 2014 |\n| Attritional | $ | 108.8 | 59.8 | % | $ | - | 0.0 | % | $ | 108.8 | 59.8 | % |\n| Catastrophes | - | 0.0 | % | 0.2 | 0.1 | % | 0.2 | 0.1 | % |\n| Total segment | $ | 108.8 | 59.8 | % | $ | 0.2 | 0.1 | % | $ | 109.0 | 59.9 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 44.6 | 9.2 | pts | $ | - | - | pts | $ | 44.6 | 9.2 | pts |\n| Catastrophes | - | - | pts | 0.7 | 0.3 | pts | 0.7 | 0.3 | pts |\n| Total segment | $ | 44.6 | 9.2 | pts | $ | 0.7 | 0.3 | pts | $ | 45.4 | 9.5 | pts |\n| Nine Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 376.5 | 61.1 | % | $ | (5.2 | ) | -0.8 | % | $ | 371.3 | 60.3 | % |\n| Catastrophes | - | 0.0 | % | 1.3 | 0.2 | % | 1.3 | 0.2 | % |\n| Total segment | $ | 376.5 | 61.1 | % | $ | (3.9 | ) | -0.6 | % | $ | 372.6 | 60.5 | % |\n| 2014 |\n| Attritional | $ | 313.7 | 57.4 | % | $ | (5.0 | ) | -0.9 | % | $ | 308.7 | 56.5 | % |\n| Catastrophes | - | 0.0 | % | 1.9 | 0.3 | % | 1.9 | 0.3 | % |\n| Total segment | $ | 313.7 | 57.4 | % | $ | (3.1 | ) | -0.6 | % | $ | 310.6 | 56.8 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 62.8 | 3.7 | pts | $ | (0.2 | ) | 0.1 | pts | $ | 62.6 | 3.8 | pts |\n| Catastrophes | - | - | pts | (0.6 | ) | (0.1 | ) | pts | (0.6 | ) | (0.1 | ) | pts |\n| Total segment | $ | 62.8 | 3.7 | pts | $ | (0.8 | ) | - | pts | $ | 62.0 | 3.7 | pts |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\n| Gross written premiums | $ | 489.1 | $ | 364.1 | $ | 125.0 | 34.3 | % | $ | 1,173.0 | $ | 911.2 | $ | 261.8 | 28.7 | % |\n| Net written premiums | 419.0 | 310.7 | 108.3 | 34.8 | % | 1,022.4 | 802.4 | 220.0 | 27.4 | % |\n| Premiums earned | $ | 360.7 | $ | 290.5 | $ | 70.2 | 24.2 | % | $ | 888.7 | $ | 742.0 | $ | 146.7 | 19.8 | % |\n| Incurred losses and LAE | 262.3 | 239.8 | 22.5 | 9.4 | % | 662.1 | 557.0 | 105.0 | 18.9 | % |\n| Commission and brokerage | 50.3 | 40.4 | 9.9 | 24.4 | % | 127.1 | 114.5 | 12.6 | 11.0 | % |\n| Other underwriting expenses | 35.7 | 31.3 | 4.4 | 13.9 | % | 99.2 | 83.7 | 15.6 | 18.6 | % |\n| Underwriting gain (loss) | $ | 12.5 | $ | (21.0 | ) | $ | 33.5 | -159.3 | % | $ | 0.3 | $ | (13.2 | ) | $ | 13.5 | -102.3 | % |\n| Point Chg | Point Chg |\n| Loss ratio | 72.7 | % | 82.5 | % | (9.8 | ) | 74.5 | % | 75.1 | % | (0.6 | ) |\n| Commission and brokerage ratio | 13.9 | % | 13.9 | % | - | 14.3 | % | 15.4 | % | (1.1 | ) |\n| Other underwriting expense ratio | 9.9 | % | 10.8 | % | (0.9 | ) | 11.2 | % | 11.3 | % | (0.1 | ) |\n| Combined ratio | 96.5 | % | 107.2 | % | (10.7 | ) | 100.0 | % | 101.8 | % | (1.8 | ) |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 262.9 | 72.9 | % | $ | (0.9 | ) | -0.3 | % | $ | 262.1 | 72.6 | % |\n| Catastrophes | - | 0.0 | % | 0.2 | 0.1 | % | 0.2 | 0.1 | % |\n| Total segment | $ | 262.9 | 72.9 | % | $ | (0.6 | ) | -0.2 | % | $ | 262.3 | 72.7 | % |\n| 2014 |\n| Attritional | $ | 236.1 | 81.2 | % | $ | 3.7 | 1.3 | % | $ | 239.8 | 82.5 | % |\n| Catastrophes | - | 0.0 | % | - | 0.0 | % | - | 0.0 | % |\n| Total segment | $ | 236.1 | 81.2 | % | $ | 3.7 | 1.3 | % | $ | 239.8 | 82.5 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 26.8 | (8.3 | ) | pts | $ | (4.6 | ) | (1.6 | ) | pts | $ | 22.3 | (9.9 | ) | pts |\n| Catastrophes | - | - | pts | 0.2 | 0.1 | pts | 0.2 | 0.1 | pts |\n| Total segment | $ | 26.8 | (8.3 | ) | pts | $ | (4.3 | ) | (1.5 | ) | pts | $ | 22.5 | (9.8 | ) | pts |\n| Nine Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 630.5 | 70.9 | % | $ | 31.5 | 3.6 | % | $ | 662.0 | 74.5 | % |\n| Catastrophes | - | 0.0 | % | 0.1 | 0.0 | % | 0.1 | 0.0 | % |\n| Total segment | $ | 630.5 | 70.9 | % | $ | 31.6 | 3.6 | % | $ | 662.1 | 74.5 | % |\n| 2014 |\n| Attritional | $ | 552.5 | 74.5 | % | $ | 4.5 | 0.6 | % | $ | 557.0 | 75.1 | % |\n| Catastrophes | - | 0.0 | % | 0.1 | 0.0 | % | 0.1 | 0.0 | % |\n| Total segment | $ | 552.5 | 74.5 | % | $ | 4.6 | 0.6 | % | $ | 557.0 | 75.1 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 78.0 | (3.6 | ) | pts | $ | 27.0 | 3.0 | pts | $ | 105.0 | (0.6 | ) | pts |\n| Catastrophes | - | - | pts | - | - | pts | - | - | pts |\n| Total segment | $ | 78.0 | (3.6 | ) | pts | $ | 27.0 | 3.0 | pts | $ | 105.0 | (0.6 | ) | pts |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\n| Gross written premiums | $ | 72.2 | $ | 50.3 | $ | 21.9 | 43.4 | % | $ | 183.7 | $ | 109.2 | $ | 74.5 | 68.3 | % |\n| Net written premiums | 60.9 | 49.8 | 11.1 | 22.4 | % | 153.3 | 98.7 | 54.6 | 55.4 | % |\n| Premiums earned | $ | 50.8 | $ | 38.2 | $ | 12.6 | 32.9 | % | $ | 132.5 | $ | 81.4 | $ | 51.1 | 62.8 | % |\n| Incurred losses and LAE | 16.5 | 3.4 | 13.1 | NM | 36.3 | 19.6 | 16.7 | 85.3 | % |\n| Commission and brokerage | 4.9 | 5.1 | (0.2 | ) | -4.9 | % | 13.3 | 9.8 | 3.5 | 35.7 | % |\n| Other underwriting expenses | 2.7 | 1.6 | 1.1 | 71.6 | % | 6.7 | 5.0 | 1.7 | 34.5 | % |\n| Underwriting gain (loss) | $ | 26.7 | $ | 28.1 | $ | (1.4 | ) | -4.9 | % | $ | 76.3 | $ | 47.1 | $ | 29.2 | 62.0 | % |\n| Point Chg | Point Chg |\n| Loss ratio | 32.5 | % | 8.9 | % | 23.6 | 27.4 | % | 24.0 | % | 3.4 |\n| Commission and brokerage ratio | 9.6 | % | 13.4 | % | (3.8 | ) | 10.1 | % | 12.1 | % | (2.0 | ) |\n| Other underwriting expense ratio | 5.2 | % | 4.1 | % | 1.1 | 5.0 | % | 6.1 | % | (1.1 | ) |\n| Combined ratio | 47.3 | % | 26.4 | % | 20.9 | 42.5 | % | 42.2 | % | 0.3 |\n| (NM, not meaningful) |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 10.7 | 21.1 | % | $ | - | 0.0 | % | $ | 10.7 | 21.1 | % |\n| Catastrophes | 5.4 | 10.5 | % | 0.4 | 0.9 | % | 5.8 | 11.4 | % |\n| Total segment | $ | 16.1 | 31.6 | % | $ | 0.4 | 0.9 | % | $ | 16.5 | 32.5 | % |\n| 2014 |\n| Attritional | $ | 2.7 | 7.2 | % | $ | - | 0.0 | % | $ | 2.7 | 7.2 | % |\n| Catastrophes | 0.7 | 1.7 | % | - | 0.0 | % | 0.7 | 1.7 | % |\n| Total segment | $ | 3.4 | 8.9 | % | $ | - | 0.0 | % | $ | 3.4 | 8.9 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 8.0 | 13.9 | pts | $ | - | - | pts | $ | 8.0 | 13.9 | pts |\n| Catastrophes | 4.7 | 8.8 | pts | 0.4 | 0.9 | pts | 5.1 | 9.7 | pts |\n| Total segment | $ | 12.7 | 22.7 | pts | $ | 0.4 | 0.9 | pts | $ | 13.1 | 23.6 | pts |\n| Nine Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 27.4 | 20.7 | % | $ | - | 0.0 | % | $ | 27.4 | 20.7 | % |\n| Catastrophes | 8.4 | 6.4 | % | 0.4 | 0.3 | % | 8.8 | 6.7 | % |\n| Total segment | $ | 35.8 | 27.1 | % | $ | 0.4 | 0.3 | % | $ | 36.3 | 27.4 | % |\n| 2014 |\n| Attritional | $ | 15.0 | 18.4 | % | $ | - | 0.0 | % | $ | 15.0 | 18.4 | % |\n| Catastrophes | 4.7 | 5.8 | % | (0.2 | ) | -0.2 | % | 4.5 | 5.6 | % |\n| Total segment | $ | 19.8 | 24.2 | % | $ | (0.2 | ) | -0.2 | % | $ | 19.6 | 24.0 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 12.4 | 2.3 | pts | $ | - | - | pts | $ | 12.4 | 2.3 | pts |\n| Catastrophes | 3.7 | 0.6 | pts | 0.6 | 0.5 | pts | 4.3 | 1.1 | pts |\n| Total segment | $ | 16.0 | 2.9 | pts | $ | 0.6 | 0.5 | pts | $ | 16.7 | 3.4 | pts |\n| (Some amounts may not reconcile due to rounding.) |\n| (Dollars in millions) | At September 30, 2015 | At December 31, 2014 |\n| Fixed maturities, market value | $ | 13,491.0 | 76.4 | % | $ | 13,101.1 | 75.1 | % |\n| Fixed maturities, fair value | - | 0.0 | % | 1.5 | 0.0 | % |\n| Equity securities, market value | 113.0 | 0.6 | % | 140.2 | 0.8 | % |\n| Equity securities, fair value | 1,357.3 | 7.7 | % | 1,447.8 | 8.3 | % |\n| Short-term investments | 1,615.0 | 9.2 | % | 1,705.9 | 9.8 | % |\n| Other invested assets | 669.7 | 3.8 | % | 601.9 | 3.5 | % |\n| Cash | 401.2 | 2.3 | % | 437.5 | 2.5 | % |\n| Total investments and cash | $ | 17,647.2 | 100.0 | % | $ | 17,435.9 | 100.0 | % |\n| (Some amounts may not reconcile due to rounding.) |\n| At | At |\n| September 30, 2015 | December 31, 2014 |\n| Fixed income portfolio duration (years) | 3.0 | 2.9 |\n| Fixed income composite credit quality | A1 | A1 |\n| Imbedded end of period yield, pre-tax | 3.0% | 3.0% |\n| Imbedded end of period yield, after-tax | 2.5% | 2.6% |\n| Nine Months Ended | Twelve Months Ended |\n| September 30, 2015 | December 31, 2014 |\n| Fixed income portfolio total return | 1.4% | 3.5% |\n| Barclay's Capital - U.S. aggregate index | 1.1% | 6.0% |\n| Common equity portfolio total return | -5.0% | 10.4% |\n| S&P 500 index | -5.3% | 13.7% |\n| Other invested asset portfolio total return | 4.1% | 11.8% |\n| At September 30, 2015 |\n| Case | IBNR | Total | % of |\n| (Dollars in millions) | Reserves | Reserves | Reserves | Total |\n| U.S. Reinsurance | $ | 1,290.2 | $ | 2,013.9 | $ | 3,304.1 | 33.2 | % |\n| International | 775.7 | 1,069.5 | 1,845.3 | 18.5 | % |\n| Bermuda | 862.4 | 1,225.5 | 2,087.8 | 20.9 | % |\n| Insurance | 1,001.0 | 1,249.8 | 2,250.8 | 22.6 | % |\n| Mt. Logan Re | 18.4 | 38.7 | 57.1 | 0.6 | % |\n| Total excluding A&E | 3,947.7 | 5,597.4 | 9,545.1 | 95.8 | % |\n| A&E | 236.1 | 184.8 | 420.9 | 4.2 | % |\n| Total including A&E | $ | 4,183.8 | $ | 5,782.2 | $ | 9,966.0 | 100.0 | % |\n| (Some amounts may not reconcile due to rounding.) |\n| At December 31, 2014 |\n| Case | IBNR | Total | % of |\n| (Dollars in millions) | Reserves | Reserves | Reserves | Total |\n| U.S. Reinsurance | $ | 1,409.5 | $ | 1,925.4 | $ | 3,334.9 | 34.3 | % |\n| International | 902.5 | 868.6 | 1,771.0 | 18.2 | % |\n| Bermuda | 783.9 | 1,108.2 | 1,892.0 | 19.5 | % |\n| Insurance | 968.3 | 1,250.4 | 2,218.6 | 22.8 | % |\n| Mt. Logan Re | 13.0 | 15.0 | 28.0 | 0.3 | % |\n| Total excluding A&E | 4,077.1 | 5,167.5 | 9,244.6 | 95.1 | % |\n| A&E | 251.1 | 225.1 | 476.2 | 4.9 | % |\n| Total including A&E | $ | 4,328.2 | $ | 5,392.6 | $ | 9,720.8 | 100.0 | % |\n| (Some amounts may not reconcile due to rounding.) |\n| At | At |\n| September 30, | December 31, |\n| (Dollars in millions) | 2015 | 2014 |\n| Gross reserves | $ | 420.9 | $ | 476.2 |\n| Reinsurance receivable | (113.2 | ) | (18.0 | ) |\n| Net reserves | $ | 307.6 | $ | 458.2 |\n| (Some amounts may not reconcile due to rounding.) |\n| Bermuda Re (1) | Everest Re (2) |\n| At December 31, | At December 31, |\n| (Dollars in millions) | 2014 | 2013 | 2014 | 2013 |\n| Regulatory targeted capital | $ | 2,050.0 | $ | 2,154.6 | $ | 1,209.6 | $ | 1,094.6 |\n| Actual capital | $ | 2,748.0 | $ | 2,712.2 | $ | 2,893.0 | $ | 2,814.3 |\n| Impact of Interest Rate Shift in Basis Points |\n| At September 30, 2015 |\n| -200 | -100 | 0 | 100 | 200 |\n| (Dollars in millions) |\n| Total Market/Fair Value | $ | 15,883.0 | $ | 15,507.1 | $ | 15,106.0 | $ | 14,677.4 | $ | 14,235.5 |\n| Market/Fair Value Change from Base (%) | 5.1 | % | 2.7 | % | 0.0 | % | -2.8 | % | -5.8 | % |\n| Change in Unrealized Appreciation |\n| After-tax from Base ($) | $ | 657.8 | $ | 340.0 | $ | - | $ | (364.4 | ) | $ | (740.2 | ) |\n| Impact of Percentage Change in Equity Fair/Market Values |\n| At September 30, 2015 |\n| (Dollars in millions) | -20% | -10% | 0% | 10% | 20% |\n| Fair/Market Value of the Equity Portfolio | $ | 1,176.2 | $ | 1,323.3 | $ | 1,470.3 | $ | 1,617.3 | $ | 1,764.4 |\n| After-tax Change in Fair/Market Value | $ | (201.7 | ) | $ | (100.9 | ) | $ | - | $ | 100.9 | $ | 201.7 |\n\nITEM 3.\nQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nMarket Risk Instruments. See \"Liquidity and Capital Resources - Market Sensitive Instruments\" in PART I – ITEM 2.\n57\nITEM 4.\nCONTROLS AND PROCEDURES\nAs of the end of the period covered by this report, our management carried out an evaluation, with the participation of the Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the \"Exchange Act\")). Based on their evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission's rules and forms. Our management, with the participation of the Chief Executive Officer and Chief Financial Officer, also conducted an evaluation of our internal control over financial reporting to determine whether any changes occurred during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Based on that evaluation, there has been no such change during the quarter covered by this report.\nPART II\n\nITEM 1.\nLEGAL PROCEEDINGS\nIn the ordinary course of business, the Company is involved in lawsuits, arbitrations and other formal and informal dispute resolution procedures, the outcomes of which will determine the Company's rights and obligations under insurance and reinsurance agreements. In some disputes, the Company seeks to enforce its rights under an agreement or to collect funds owing to it. In other matters, the Company is resisting attempts by others to collect funds or enforce alleged rights. These disputes arise from time to time and are ultimately resolved through both informal and formal means, including negotiated resolution, arbitration and litigation. In all such matters, the Company believes that its positions are legally and commercially reasonable. The Company considers the statuses of these proceedings when determining its reserves for unpaid loss and loss adjustment expenses.\nAside from litigation and arbitrations related to these insurance and reinsurance agreements, the Company is not a party to any other material litigation or arbitration.\n\nITEM 1A.\nRISK FACTORS\nNo material changes.\n58\nITEM 2.\nUNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nIssuer Purchases of Equity Securities.\n| Issuer Purchases of Equity Securities |\n| (a) | (b) | (c) | (d) |\n| Maximum Number (or |\n| Total Number of | Approximate Dollar |\n| Shares (or Units) | Value) of Shares (or |\n| Purchased as Part | Units) that May Yet |\n| Total Number of | of Publicly | Be Purchased Under |\n| Shares (or Units) | Average Price Paid | Announced Plans or | the Plans or |\n| Period | Purchased | per Share (or Unit) | Programs | Programs (1) |\n| July 1 - 31, 2015 | 1,756 | $ | 183.2850 | - | 5,631,185 |\n| August 1 - 31, 2015 | 514,629 | $ | 177.4608 | 514,629 | 5,116,556 |\n| September 1 - 30, 2015 | 626,078 | $ | 174.4833 | 622,844 | 4,493,712 |\n| Total | 1,142,463 | $ | - | 1,137,473 | 4,493,712 |\n\n(1) On September 21, 2004, the Company's board of directors approved an amended share repurchase program authorizing the Company and/or its subsidiary Holdings to purchase up to an aggregate of 5,000,000 of the Company's common shares through open market transactions, privately negotiated transactions or both. On July 21, 2008; February 24, 2010; February 22, 2012; May 15, 2013; and November 19, 2014, the Company's executive committee of the Board of Directors has approved subsequent amendments to the share repurchase program authorizing the Company and/or its subsidiary Holdings, to purchase up to a current aggregate of 30,000,000 of the Company's shares (recognizing that the number of shares authorized for repurchase has been reduced by those shares that have already been purchased) in open market transactions, privately negotiated transactions or both.\n\nITEM 3.\nDEFAULTS UPON SENIOR SECURITIES\nNone.\n\nITEM 4.\nMINE SAFETY DISCLOSURES\nNot applicable.\n\nITEM 5\n.\nOTHER INFORMATION\nNone.\n59\nITEM 6.\nEXHIBITS\n\n| Exhibit Index: |\n| Exhibit No. | Description |\n| 31.1 | Section 302 Certification of Dominic J. Addesso |\n| 31.2 | Section 302 Certification of Craig Howie |\n| 32.1 | Section 906 Certification of Dominic J. Addesso and Craig Howie |\n| 101.INS | XBRL Instance Document |\n| 101.SCH | XBRL Taxonomy Extension Schema |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase |\n| 101.LAB | XBRL Taxonomy Extension Labels Linkbase |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase |\n\n60\nEverest Re Group, Ltd.\nSignatures\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n| Everest Re Group, Ltd. |\n| (Registrant) |\n| /S/ CRAIG HOWIE |\n| Craig Howie |\n| Executive Vice President and |\n| Chief Financial Officer |\n| (Duly Authorized Officer and Principal Financial Officer) |\n\n\n \n\nWhat is the percent change in the total outstanding amount of the Citibank Bilateral Letter of Credit Agreement from September 30, 2015 to December 31, 2014?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nItem 1.\\nFinancial Statements\\nConsolidated Balance Sheets September 30, 2015 (unaudited)\\nand December 31, 2014 1\\nConsolidated Statements of Operations and Comprehensive Income (Loss) for the\\nthree and nine months ended September 30, 2015 and 2014 (unaudited) 2\\nConsolidated Statements of Changes in Shareholders' Equity for the three and\\nnine months ended September 30, 2015 and 2014 (unaudited) 3\\nConsolidated Statements of Cash Flows for the nine months ended\\nSeptember 30, 2015 and 2014 (unaudited) 4\\nNotes to Consolidated Interim Financial Statements (unaudited) 5\\nItem 2. Management's Discussion and Analysis of Financial Condition and\\nResults of Operation 30\\nItem 3. Quantitative and Qualitative Disclosures About Market Risk 57\\nItem 4. Controls and Procedures 58\\nPART II\\nOTHER INFORMATION\\n\\n| Item 1. | Legal Proceedings | 58 |\\n| Item 1A. | Risk Factors | 58 |\\n| Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 59 |\\n| Item 3. | Defaults Upon Senior Securities | 59 |\\n| Item 4. | Mine Safety Disclosures | 59 |\\n| Item 5. | Other Information | 59 |\\n| Item 6. | Exhibits | 60 |\\n\\nEVEREST RE GROUP, LTD.\\nCONSOLIDATED BALANCE SHEETS\\n\\n| September 30, | December 31, |\\n| (Dollars and share amounts in thousands, except par value per share) | 2015 | 2014 |\\n| (unaudited) |\\n| ASSETS: |\\n| Fixed maturities - available for sale, at market value | $ | 13,490,960 | $ | 13,101,067 |\\n| (amortized cost: 2015, $13,301,713; 2014, $12,831,159) |\\n| Fixed maturities - available for sale, at fair value | - | 1,509 |\\n| Equity securities - available for sale, at market value (cost: 2015, $127,411; 2014, $148,326) | 112,999 | 140,210 |\\n| Equity securities - available for sale, at fair value | 1,357,311 | 1,447,820 |\\n| Short-term investments | 1,615,045 | 1,705,932 |\\n| Other invested assets (cost: 2015, $669,686; 2014, $601,925) | 669,686 | 601,925 |\\n| Cash | 401,226 | 437,474 |\\n| Total investments and cash | 17,647,227 | 17,435,937 |\\n| Accrued investment income | 107,199 | 111,075 |\\n| Premiums receivable | 1,663,425 | 1,397,983 |\\n| Reinsurance receivables | 831,635 | 670,854 |\\n| Funds held by reinsureds | 272,775 | 228,192 |\\n| Deferred acquisition costs | 364,947 | 398,408 |\\n| Prepaid reinsurance premiums | 193,122 | 154,177 |\\n| Income taxes | 270,607 | 184,762 |\\n| Other assets | 331,374 | 236,436 |\\n| TOTAL ASSETS | $ | 21,682,311 | $ | 20,817,824 |\\n| LIABILITIES: |\\n| Reserve for losses and loss adjustment expenses | $ | 9,965,963 | $ | 9,720,813 |\\n| Future policy benefit reserve | 59,580 | 59,820 |\\n| Unearned premium reserve | 1,717,422 | 1,728,745 |\\n| Funds held under reinsurance treaties | 83,137 | 3,932 |\\n| Commission reserves | 79,904 | 87,990 |\\n| Other net payable to reinsurers | 199,528 | 139,841 |\\n| Losses in course of payment | 298,577 | 157,527 |\\n| 4.868% Senior notes due 6/1/2044 | 400,000 | 400,000 |\\n| 6.6% Long term notes due 5/1/2067 | 238,367 | 238,364 |\\n| Accrued interest on debt and borrowings | 12,341 | 3,537 |\\n| Equity index put option liability | 52,247 | 47,022 |\\n| Unsettled securities payable | 65,147 | 41,092 |\\n| Other liabilities | 271,086 | 316,469 |\\n| Total liabilities | 13,443,299 | 12,945,152 |\\n| NONCONTROLLING INTERESTS: |\\n| Redeemable noncontrolling interests - Mt. Logan Re | 752,692 | 421,552 |\\n| Commitments and contingencies (Note 9) |\\n| SHAREHOLDERS' EQUITY: |\\n| Preferred shares, par value: $0.01; 50,000 shares authorized; |\\n| no shares issued and outstanding | - | - |\\n| Common shares, par value: $0.01; 200,000 shares authorized; (2015) 68,585 |\\n| and (2014) 68,336 outstanding before treasury shares | 686 | 683 |\\n| Additional paid-in capital | 2,094,850 | 2,068,807 |\\n| Accumulated other comprehensive income (loss), net of deferred income tax expense |\\n| (benefit) of ($2,899) at 2015 and $20,715 at 2014 | (112,231 | ) | 48,317 |\\n| Treasury shares, at cost; 25,500 shares (2015) and 23,650 shares (2014) | (2,810,878 | ) | (2,485,897 | ) |\\n| Retained earnings | 8,313,893 | 7,819,210 |\\n| Total shareholders' equity attributable to Everest Re Group | 7,486,320 | 7,451,120 |\\n| TOTAL LIABILITIES, NONCONTROLLING INTERESTS AND SHAREHOLDERS' EQUITY | $ | 21,682,311 | $ | 20,817,824 |\\n| The accompanying notes are an integral part of the consolidated financial statements. |\\n\\n1\\nEVEREST RE GROUP, LTD.\\nCONSOLIDATED STATEMENTS OF OPERATIONS\\nAND COMPREHENSIVE INCOME (LOSS)\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands, except per share amounts) | 2015 | 2014 | 2015 | 2014 |\\n| (unaudited) | (unaudited) |\\n| REVENUES: |\\n| Premiums earned | $ | 1,413,640 | $ | 1,389,998 | $ | 4,053,115 | $ | 3,806,805 |\\n| Net investment income | 115,511 | 142,143 | 363,140 | 396,524 |\\n| Net realized capital gains (losses): |\\n| Other-than-temporary impairments on fixed maturity securities | (20,445 | ) | (106 | ) | (62,701 | ) | (495 | ) |\\n| Other-than-temporary impairments on fixed maturity securities |\\n| transferred to other comprehensive income (loss) | - | - | - | - |\\n| Other net realized capital gains (losses) | (139,526 | ) | (9,342 | ) | (131,953 | ) | 71,189 |\\n| Total net realized capital gains (losses) | (159,971 | ) | (9,448 | ) | (194,654 | ) | 70,694 |\\n| Net derivative gain (loss) | (11,428 | ) | 1,855 | (5,225 | ) | 3,968 |\\n| Other income (expense) | 17,413 | 11,332 | 59,561 | (5,835 | ) |\\n| Total revenues | 1,375,165 | 1,535,880 | 4,275,937 | 4,272,156 |\\n| CLAIMS AND EXPENSES: |\\n| Incurred losses and loss adjustment expenses | 888,097 | 837,757 | 2,401,223 | 2,192,863 |\\n| Commission, brokerage, taxes and fees | 300,048 | 290,519 | 882,132 | 820,208 |\\n| Other underwriting expenses | 70,667 | 63,113 | 195,282 | 172,165 |\\n| Corporate expenses | 5,924 | 9,958 | 17,312 | 18,802 |\\n| Interest, fees and bond issue cost amortization expense | 8,990 | 12,424 | 27,006 | 28,970 |\\n| Total claims and expenses | 1,273,726 | 1,213,771 | 3,522,955 | 3,233,008 |\\n| INCOME (LOSS) BEFORE TAXES | 101,439 | 322,109 | 752,982 | 1,039,148 |\\n| Income tax expense (benefit) | (6,133 | ) | 20,856 | 70,868 | 137,948 |\\n| NET INCOME (LOSS) | $ | 107,572 | $ | 301,253 | $ | 682,114 | $ | 901,200 |\\n| Net (income) loss attributable to noncontrolling interests | (19,019 | ) | (26,337 | ) | (61,526 | ) | (42,167 | ) |\\n| NET INCOME (LOSS) ATTRIBUTABLE TO EVEREST RE GROUP | $ | 88,553 | $ | 274,916 | $ | 620,588 | $ | 859,033 |\\n| Other comprehensive income (loss), net of tax: |\\n| Unrealized appreciation (depreciation) (\\\"URA(D)\\\") on securities arising during the period | (91,059 | ) | (74,074 | ) | (144,335 | ) | 65,318 |\\n| Reclassification adjustment for realized losses (gains) included in net income (loss) | 24,596 | (5,684 | ) | 59,526 | (1,641 | ) |\\n| Total URA(D) on securities arising during the period | (66,463 | ) | (79,758 | ) | (84,809 | ) | 63,677 |\\n| Foreign currency translation adjustments | (32,505 | ) | (34,974 | ) | (80,508 | ) | (38,374 | ) |\\n| Benefit plan actuarial net gain (loss) for the period | - | - | - | - |\\n| Reclassification adjustment for amortization of net (gain) loss included in net income (loss) | 1,556 | 825 | 4,769 | 2,366 |\\n| Total benefit plan net gain (loss) for the period | 1,556 | 825 | 4,769 | 2,366 |\\n| Total other comprehensive income (loss), net of tax | (97,412 | ) | (113,907 | ) | (160,548 | ) | 27,669 |\\n| Other comprehensive (income) loss attributable to noncontrolling interests | - | - | - | - |\\n| Total other comprehensive income (loss), net of tax attributable to Everest Re Group | (97,412 | ) | (113,907 | ) | (160,548 | ) | 27,669 |\\n| COMPREHENSIVE INCOME (LOSS) | $ | (8,859 | ) | $ | 161,009 | $ | 460,040 | $ | 886,702 |\\n| EARNINGS PER COMMON SHARE ATTRIBUTABLE TO EVEREST RE GROUP: |\\n| Basic | $ | 2.02 | $ | 6.05 | $ | 14.04 | $ | 18.64 |\\n| Diluted | 2.00 | 6.00 | 13.92 | 18.47 |\\n| Dividends declared | 0.95 | 0.75 | 2.85 | 2.25 |\\n| The accompanying notes are an integral part of the consolidated financial statements. |\\n\\n2\\nEVEREST RE GROUP, LTD.\\nCONSOLIDATED STATEMENTS OF\\nCHANGES IN SHAREHOLDERS' EQUITY\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands, except share and dividends per share amounts) | 2015 | 2014 | 2015 | 2014 |\\n| (unaudited) | (unaudited) |\\n| COMMON SHARES (shares outstanding): |\\n| Balance, beginning of period | 44,192,526 | 45,691,015 | 44,685,637 | 47,543,132 |\\n| Issued during the period, net | 29,398 | 29,622 | 248,665 | 344,761 |\\n| Treasury shares acquired | (1,137,473 | ) | (470,807 | ) | (1,849,851 | ) | (2,638,063 | ) |\\n| Balance, end of period | 43,084,451 | 45,249,830 | 43,084,451 | 45,249,830 |\\n| COMMON SHARES (par value): |\\n| Balance, beginning of period | $ | 685 | $ | 683 | $ | 683 | $ | 680 |\\n| Issued during the period, net | 1 | - | 3 | 3 |\\n| Balance, end of period | 686 | 683 | 686 | 683 |\\n| ADDITIONAL PAID-IN CAPITAL: |\\n| Balance, beginning of period | 2,084,636 | 2,052,682 | 2,068,807 | 2,029,774 |\\n| Share-based compensation plans | 10,214 | 7,274 | 26,043 | 30,182 |\\n| Balance, end of period | 2,094,850 | 2,059,956 | 2,094,850 | 2,059,956 |\\n| ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS), |\\n| NET OF DEFERRED INCOME TAXES: |\\n| Balance, beginning of period | (14,819 | ) | 299,304 | 48,317 | 157,728 |\\n| Net increase (decrease) during the period | (97,412 | ) | (113,907 | ) | (160,548 | ) | 27,669 |\\n| Balance, end of period | (112,231 | ) | 185,397 | (112,231 | ) | 185,397 |\\n| RETAINED EARNINGS: |\\n| Balance, beginning of period | 8,267,038 | 7,281,023 | 7,819,210 | 6,765,967 |\\n| Net income (loss) attributable to Everest Re Group | 88,553 | 274,916 | 620,588 | 859,033 |\\n| Dividends declared ($0.95 per share in third quarter 2015 and $2.85 year-to-date |\\n| per share in 2015 and $0.75 per share in third quarter 2014 and $2.25 |\\n| year-to-date per share in 2014) | (41,698 | ) | (33,973 | ) | (125,905 | ) | (103,034 | ) |\\n| Balance, end of period | 8,313,893 | 7,521,966 | 8,313,893 | 7,521,966 |\\n| TREASURY SHARES AT COST: |\\n| Balance, beginning of period | (2,610,878 | ) | (2,310,824 | ) | (2,485,897 | ) | (1,985,873 | ) |\\n| Purchase of treasury shares | (200,000 | ) | (74,991 | ) | (324,981 | ) | (399,942 | ) |\\n| Balance, end of period | (2,810,878 | ) | (2,385,815 | ) | (2,810,878 | ) | (2,385,815 | ) |\\n| TOTAL SHAREHOLDERS' EQUITY, END OF PERIOD | $ | 7,486,320 | $ | 7,382,187 | $ | 7,486,320 | $ | 7,382,187 |\\n| The accompanying notes are an integral part of the consolidated financial statements. |\\n\\n3\\nEVEREST RE GROUP, LTD.\\nCONSOLIDATED STATEMENTS OF CASH FLOWS\\n\\n| Nine Months Ended |\\n| September 30, |\\n| (Dollars in thousands) | 2015 | 2014 |\\n| (unaudited) |\\n| CASH FLOWS FROM OPERATING ACTIVITIES: |\\n| Net income (loss) | $ | 682,114 | $ | 901,200 |\\n| Adjustments to reconcile net income to net cash provided by operating activities: |\\n| Decrease (increase) in premiums receivable | (274,198 | ) | (255,645 | ) |\\n| Decrease (increase) in funds held by reinsureds, net | 33,255 | (6,929 | ) |\\n| Decrease (increase) in reinsurance receivables | (202,329 | ) | (256,458 | ) |\\n| Decrease (increase) in income taxes | (61,627 | ) | (14,696 | ) |\\n| Decrease (increase) in prepaid reinsurance premiums | (46,633 | ) | (101,478 | ) |\\n| Increase (decrease) in reserve for losses and loss adjustment expenses | 347,729 | 172,511 |\\n| Increase (decrease) in future policy benefit reserve | (240 | ) | (1,879 | ) |\\n| Increase (decrease) in unearned premiums | 1,455 | 255,537 |\\n| Increase (decrease) in other net payable to reinsurers | 67,550 | 101,984 |\\n| Increase (decrease) in losses in course of payment | 142,418 | 165,105 |\\n| Change in equity adjustments in limited partnerships | (12,725 | ) | (24,438 | ) |\\n| Distribution of limited partnership income | 42,625 | 41,165 |\\n| Change in other assets and liabilities, net | 18,573 | (32,114 | ) |\\n| Non-cash compensation expense | 16,150 | 14,720 |\\n| Amortization of bond premium (accrual of bond discount) | 38,770 | 38,010 |\\n| Amortization of underwriting discount on senior notes | 3 | 43 |\\n| Net realized capital (gains) losses | 194,654 | (70,694 | ) |\\n| Net cash provided by (used in) operating activities | 987,544 | 925,944 |\\n| CASH FLOWS FROM INVESTING ACTIVITIES: |\\n| Proceeds from fixed maturities matured/called - available for sale, at market value | 1,687,589 | 1,638,278 |\\n| Proceeds from fixed maturities matured/called - available for sale, at fair value | - | 875 |\\n| Proceeds from fixed maturities sold - available for sale, at market value | 1,146,000 | 1,050,082 |\\n| Proceeds from fixed maturities sold - available for sale, at fair value | 1,824 | 23,856 |\\n| Proceeds from equity securities sold - available for sale, at market value | 22,120 | 11,174 |\\n| Proceeds from equity securities sold - available for sale, at fair value | 439,692 | 452,514 |\\n| Distributions from other invested assets | 41,782 | 59,264 |\\n| Proceeds from sale of subsidiary (net of cash disposed) | 3,934 | - |\\n| Cost of fixed maturities acquired - available for sale, at market value | (3,583,990 | ) | (3,729,423 | ) |\\n| Cost of fixed maturities acquired - available for sale, at fair value | (234 | ) | (23,684 | ) |\\n| Cost of equity securities acquired - available for sale, at market value | (6,581 | ) | (11,873 | ) |\\n| Cost of equity securities acquired - available for sale, at fair value | (460,965 | ) | (262,871 | ) |\\n| Cost of other invested assets acquired | (140,923 | ) | (120,911 | ) |\\n| Net change in short-term investments | 83,584 | (284,822 | ) |\\n| Net change in unsettled securities transactions | (18,242 | ) | 13,496 |\\n| Net cash provided by (used in) investing activities | (784,410 | ) | (1,184,045 | ) |\\n| CASH FLOWS FROM FINANCING ACTIVITIES: |\\n| Common shares issued during the period, net | 9,896 | 15,465 |\\n| Purchase of treasury shares | (324,981 | ) | (399,942 | ) |\\n| Net proceeds from issuance of senior notes | - | 400,000 |\\n| Third party investment in redeemable noncontrolling interest | 296,848 | 136,200 |\\n| Dividends paid to shareholders | (125,905 | ) | (103,034 | ) |\\n| Dividends paid on third party investment in redeemable noncontrolling interest | (67,233 | ) | (10,334 | ) |\\n| Net cash provided by (used in) financing activities | (211,375 | ) | 38,355 |\\n| EFFECT OF EXCHANGE RATE CHANGES ON CASH | (28,007 | ) | 10,167 |\\n| Net increase (decrease) in cash | (36,248 | ) | (209,579 | ) |\\n| Cash, beginning of period | 437,474 | 611,382 |\\n| Cash, end of period | $ | 401,226 | $ | 401,803 |\\n| SUPPLEMENTAL CASH FLOW INFORMATION: |\\n| Income taxes paid (recovered) | $ | 123,234 | $ | 146,560 |\\n| Interest paid | 18,039 | 15,150 |\\n| The accompanying notes are an integral part of the consolidated financial statements. |\\n\\n4\\nNOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)\\nFor the Three and Nine Months Ended September 30, 2015 and 2014\\n1. GENERAL\\nEverest Re Group, Ltd. (\\\"Group\\\"), a Bermuda company, through its subsidiaries, principally provides reinsurance and insurance in the U.S., Bermuda and international markets. As used in this document, \\\"Company\\\" means Group and its subsidiaries.\\nEffective February 27, 2013, the Company established a new subsidiary, Mt. Logan Re Ltd. (\\\"Mt. Logan Re\\\") and effective July 1, 2013, Mt. Logan Re established separate segregated accounts and issued non-voting redeemable preferred shares to capitalize the segregated accounts. Accordingly, the financial position and operating results for Mt. Logan Re are consolidated with the Company and the non-controlling interests in Mt. Logan Re's operating results and equity are presented as separate captions in the Company's financial statements.\\nEffective July 13, 2015, the Company sold all of the outstanding shares of capital stock of a wholly-owned subsidiary entity, Mt. McKinley Insurance Company (\\\"Mt. McKinley\\\"), to Clearwater Insurance Company. The operating results of Mt. McKinley through July 13, 2015 are included within the Company's financial statements.\\n2. BASIS OF PRESENTATION\\nThe unaudited consolidated financial statements of the Company for the three and nine months ended September 30, 2015 and 2014 include all adjustments, consisting of normal recurring accruals, which, in the opinion of management, are necessary for a fair statement of the results on an interim basis. Certain financial information, which is normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America (\\\"GAAP\\\"), has been omitted since it is not required for interim reporting purposes. The December 31, 2014 consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by GAAP. The results for the three and nine months ended September 30, 2015 and 2014 are not necessarily indicative of the results for a full year. These financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto for the years ended December 31, 2014, 2013 and 2012 included in the Company's most recent Form 10-K filing.\\nAll intercompany accounts and transactions have been eliminated.\\nApplication of Recently Issued Accounting Standard Changes.\\nNo accounting standards or guidance have been issued recently that would have a material impact on the Company's financial statements or financial reporting process.\\n5\\n3. INVESTMENTS\\nThe amortized cost, market value and gross unrealized appreciation and depreciation of available for sale, fixed maturity, equity security investments, carried at market value and other-than-temporary impairments (\\\"OTTI\\\") in accumulated other comprehensive income (\\\"AOCI\\\") are as follows for the periods indicated:\\n\\n| At September 30, 2015 |\\n| Amortized | Unrealized | Unrealized | Market | OTTI in AOCI |\\n| (Dollars in thousands) | Cost | Appreciation | Depreciation | Value | (a) |\\n| Fixed maturity securities |\\n| U.S. Treasury securities and obligations of |\\n| U.S. government agencies and corporations | $ | 337,271 | $ | 15,725 | $ | (70 | ) | $ | 352,926 | $ | - |\\n| Obligations of U.S. states and political subdivisions | 683,715 | 32,087 | (1,523 | ) | 714,279 | - |\\n| Corporate securities | 4,964,570 | 118,763 | (76,396 | ) | 5,006,937 | 2,006 |\\n| Asset-backed securities | 437,376 | 2,575 | (1,554 | ) | 438,397 | - |\\n| Mortgage-backed securities |\\n| Commercial | 277,907 | 7,697 | (795 | ) | 284,809 | - |\\n| Agency residential | 2,392,937 | 39,295 | (6,165 | ) | 2,426,067 | - |\\n| Non-agency residential | 971 | 53 | (46 | ) | 978 | - |\\n| Foreign government securities | 1,285,006 | 60,837 | (44,882 | ) | 1,300,961 | (2 | ) |\\n| Foreign corporate securities | 2,921,960 | 115,881 | (72,235 | ) | 2,965,606 | 39 |\\n| Total fixed maturity securities | $ | 13,301,713 | $ | 392,913 | $ | (203,666 | ) | $ | 13,490,960 | $ | 2,043 |\\n| Equity securities | $ | 127,411 | $ | 3,509 | $ | (17,921 | ) | $ | 112,999 | $ | - |\\n\\n\\n| At December 31, 2014 |\\n| Amortized | Unrealized | Unrealized | Market | OTTI in AOCI |\\n| (Dollars in thousands) | Cost | Appreciation | Depreciation | Value | (a) |\\n| Fixed maturity securities |\\n| U.S. Treasury securities and obligations of |\\n| U.S. government agencies and corporations | $ | 221,052 | $ | 10,290 | $ | (304 | ) | $ | 231,038 | $ | - |\\n| Obligations of U.S. states and political subdivisions | 783,129 | 41,969 | (626 | ) | 824,472 | - |\\n| Corporate securities | 4,626,002 | 143,889 | (62,906 | ) | 4,706,985 | (6,910 | ) |\\n| Asset-backed securities | 340,761 | 1,691 | (1,230 | ) | 341,222 | - |\\n| Mortgage-backed securities |\\n| Commercial | 231,439 | 10,675 | (429 | ) | 241,685 | - |\\n| Agency residential | 2,157,182 | 37,555 | (11,573 | ) | 2,183,164 | - |\\n| Non-agency residential | 2,734 | 54 | (57 | ) | 2,731 | - |\\n| Foreign government securities | 1,488,144 | 71,177 | (26,866 | ) | 1,532,455 | - |\\n| Foreign corporate securities | 2,980,716 | 109,673 | (53,074 | ) | 3,037,315 | - |\\n| Total fixed maturity securities | $ | 12,831,159 | $ | 426,973 | $ | (157,065 | ) | $ | 13,101,067 | $ | (6,910 | ) |\\n| Equity securities | $ | 148,326 | $ | 3,831 | $ | (11,947 | ) | $ | 140,210 | $ | - |\\n\\n(a) Represents the amount of OTTI recognized in AOCI. Amount includes unrealized gains and losses on impaired securities relating to changes in the value of such securities subsequent to the impairment measurement date.\\n6\\nThe amortized cost and market value of fixed maturity securities are shown in the following table by contractual maturity. Mortgage-backed securities are generally more likely to be prepaid than other fixed maturity securities. As the stated maturity of such securities may not be indicative of actual maturities, the totals for mortgage-backed and asset-backed securities are shown separately.\\n\\n| At September 30, 2015 | At December 31, 2014 |\\n| Amortized | Market | Amortized | Market |\\n| (Dollars in thousands) | Cost | Value | Cost | Value |\\n| Fixed maturity securities – available for sale: |\\n| Due in one year or less | $ | 1,080,129 | $ | 1,088,140 | $ | 1,183,247 | $ | 1,189,416 |\\n| Due after one year through five years | 5,906,738 | 5,991,760 | 5,646,466 | 5,726,277 |\\n| Due after five years through ten years | 2,377,276 | 2,382,188 | 2,270,073 | 2,313,672 |\\n| Due after ten years | 828,380 | 878,621 | 999,257 | 1,102,900 |\\n| Asset-backed securities | 437,376 | 438,397 | 340,761 | 341,222 |\\n| Mortgage-backed securities: |\\n| Commercial | 277,906 | 284,809 | 231,439 | 241,685 |\\n| Agency residential | 2,392,937 | 2,426,067 | 2,157,182 | 2,183,164 |\\n| Non-agency residential | 971 | 978 | 2,734 | 2,731 |\\n| Total fixed maturity securities | $ | 13,301,713 | $ | 13,490,960 | $ | 12,831,159 | $ | 13,101,067 |\\n\\nThe changes in net unrealized appreciation (depreciation) for the Company's investments are derived from the following sources for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Increase (decrease) during the period between the market value and cost |\\n| of investments carried at market value, and deferred taxes thereon: |\\n| Fixed maturity securities | $ | (71,706 | ) | $ | (87,859 | ) | $ | (89,616 | ) | $ | 70,010 |\\n| Fixed maturity securities, other-than-temporary impairment | (253 | ) | (261 | ) | 8,954 | (180 | ) |\\n| Equity securities | (4,415 | ) | (3,287 | ) | (6,295 | ) | 3,327 |\\n| Change in unrealized appreciation (depreciation), pre-tax | (76,374 | ) | (91,407 | ) | (86,957 | ) | 73,157 |\\n| Deferred tax benefit (expense) | 9,919 | 11,649 | 5,563 | (9,480 | ) |\\n| Deferred tax benefit (expense), other-than-temporary impairment | (8 | ) | - | (3,415 | ) | - |\\n| Change in unrealized appreciation (depreciation), |\\n| net of deferred taxes, included in shareholders' equity | $ | (66,463 | ) | $ | (79,758 | ) | $ | (84,809 | ) | $ | 63,677 |\\n\\nThe Company frequently reviews all of its fixed maturity, available for sale securities for declines in market value and focuses its attention on securities whose fair value has fallen below 80% of their amortized cost at the time of review. The Company then assesses whether the decline in value is temporary or other-than-temporary. In making its assessment, the Company evaluates the current market and interest rate environment as well as specific issuer information. Generally, a change in a security's value caused by a change in the market, interest rate or foreign exchange environment does not constitute an other-than-temporary impairment, but rather a temporary decline in market value. Temporary declines in market value are recorded as unrealized losses in accumulated other comprehensive income (loss). If the Company determines that the decline is other-than-temporary and the Company does not have the intent to sell the security; and it is more likely than not that the Company will not have to sell the security before recovery of its cost basis, the carrying value of the investment is written down to fair value. The fair value adjustment that is credit or foreign exchange related is recorded in net realized capital gains (losses) in the Company's consolidated statements of operations and comprehensive income (loss). The fair value adjustment that is non-credit related is recorded as a component of other comprehensive income (loss), net of tax, and is included in accumulated other comprehensive income (loss) in the Company's consolidated balance sheets.\\n7\\nThe Company's assessments are based on the issuers current and expected future financial position, timeliness with respect to interest and/or principal payments, speed of repayments and any applicable credit enhancements or breakeven constant default rates on mortgage-backed and asset-backed securities, as well as relevant information provided by rating agencies, investment advisors and analysts.\\nThe majority of the Company's equity securities available for sale at market value are primarily comprised of mutual fund investments whose underlying securities consist of fixed maturity securities. When a fund's value reflects an unrealized loss, the Company assesses whether the decline in value is temporary or other-than-temporary. In making its assessment, the Company considers the composition of its portfolios and their related markets, reports received from the portfolio managers and discussions with portfolio managers. If the Company determines that the declines are temporary and it has the ability and intent to continue to hold the investments, then the declines are recorded as unrealized losses in accumulated other comprehensive income (loss). If declines are deemed to be other-than-temporary, then the carrying value of the investment is written down to fair value and recorded in net realized capital gains (losses) in the Company's consolidated statements of operations and comprehensive income (loss).\\nRetrospective adjustments are employed to recalculate the values of asset-backed securities. All of the Company's asset-backed and mortgage-backed securities have a pass-through structure. Each acquisition lot is reviewed to recalculate the effective yield. The recalculated effective yield is used to derive a book value as if the new yield were applied at the time of acquisition. Outstanding principal factors from the time of acquisition to the adjustment date are used to calculate the prepayment history for all applicable securities. Conditional prepayment rates, computed with life to date factor histories and weighted average maturities, are used in the calculation of projected prepayments for pass-through security types.\\nThe tables below display the aggregate market value and gross unrealized depreciation of fixed maturity and equity securities, by security type and contractual maturity, in each case subdivided according to length of time that individual securities had been in a continuous unrealized loss position for the periods indicated:\\n\\n| Duration of Unrealized Loss at September 30, 2015 By Security Type |\\n| Less than 12 months | Greater than 12 months | Total |\\n| Gross | Gross | Gross |\\n| Unrealized | Unrealized | Unrealized |\\n| (Dollars in thousands) | Market Value | Depreciation | Market Value | Depreciation | Market Value | Depreciation |\\n| Fixed maturity securities - available for sale |\\n| U.S. Treasury securities and obligations of |\\n| U.S. government agencies and corporations | $ | 201 | $ | (1 | ) | $ | 1,844 | $ | (69 | ) | $ | 2,045 | $ | (70 | ) |\\n| Obligations of U.S. states and political subdivisions | 20,162 | (316 | ) | 35,460 | (1,207 | ) | 55,622 | (1,523 | ) |\\n| Corporate securities | 1,323,515 | (51,785 | ) | 425,091 | (24,611 | ) | 1,748,606 | (76,396 | ) |\\n| Asset-backed securities | 89,526 | (674 | ) | 44,765 | (880 | ) | 134,291 | (1,554 | ) |\\n| Mortgage-backed securities |\\n| Commercial | 44,260 | (795 | ) | - | - | 44,260 | (795 | ) |\\n| Agency residential | 343,504 | (2,182 | ) | 382,730 | (3,983 | ) | 726,234 | (6,165 | ) |\\n| Non-agency residential | 176 | (2 | ) | 44 | (44 | ) | 220 | (46 | ) |\\n| Foreign government securities | 299,055 | (22,177 | ) | 183,387 | (22,705 | ) | 482,442 | (44,882 | ) |\\n| Foreign corporate securities | 699,077 | (40,165 | ) | 279,126 | (32,070 | ) | 978,203 | (72,235 | ) |\\n| Total fixed maturity securities | $ | 2,819,476 | $ | (118,097 | ) | $ | 1,352,447 | $ | (85,569 | ) | $ | 4,171,923 | $ | (203,666 | ) |\\n| Equity securities | - | - | 97,871 | (17,921 | ) | 97,871 | (17,921 | ) |\\n| Total | $ | 2,819,476 | $ | (118,097 | ) | $ | 1,450,318 | $ | (103,490 | ) | $ | 4,269,794 | $ | (221,587 | ) |\\n\\n8\\n\\n| Duration of Unrealized Loss at September 30, 2015 By Maturity |\\n| Less than 12 months | Greater than 12 months | Total |\\n| Gross | Gross | Gross |\\n| Unrealized | Unrealized | Unrealized |\\n| (Dollars in thousands) | Market Value | Depreciation | Market Value | Depreciation | Market Value | Depreciation |\\n| Fixed maturity securities |\\n| Due in one year or less | $ | 85,547 | $ | (4,021 | ) | $ | 83,375 | $ | (12,950 | ) | $ | 168,922 | $ | (16,971 | ) |\\n| Due in one year through five years | 1,220,223 | (50,689 | ) | 577,851 | (41,640 | ) | 1,798,074 | (92,329 | ) |\\n| Due in five years through ten years | 924,605 | (51,295 | ) | 208,989 | (20,624 | ) | 1,133,594 | (71,919 | ) |\\n| Due after ten years | 111,635 | (8,439 | ) | 54,693 | (5,448 | ) | 166,328 | (13,887 | ) |\\n| Asset-backed securities | 89,526 | (674 | ) | 44,765 | (880 | ) | 134,291 | (1,554 | ) |\\n| Mortgage-backed securities | 387,940 | (2,979 | ) | 382,774 | (4,027 | ) | 770,714 | (7,006 | ) |\\n| Total fixed maturity securities | $ | 2,819,476 | $ | (118,097 | ) | $ | 1,352,447 | $ | (85,569 | ) | $ | 4,171,923 | $ | (203,666 | ) |\\n\\nThe aggregate market value and gross unrealized losses related to investments in an unrealized loss position at September 30, 2015 were $4,269,794 thousand and $221,587 thousand, respectively. The market value of securities for the single issuer whose securities comprised the largest unrealized loss position at September 30, 2015, did not exceed 0.2% of the overall market value of the Company's fixed maturity securities. In addition, as indicated on the above table, there was no significant concentration of unrealized losses in any one market sector. The $118,097 thousand of unrealized losses related to fixed maturity securities that have been in an unrealized loss position for less than one year were generally comprised of domestic and foreign corporate securities, as well as foreign government securities. The majority of these unrealized losses are attributable to net unrealized foreign exchange losses, $44,092 thousand, as the U.S. dollar has strengthened against other currencies and unrealized losses in the energy sector, $43,353 thousand, as falling oil prices have disrupted the market values for this sector, particularly for oil exploration, production and servicing companies. The $85,569 thousand of unrealized losses related to fixed maturity securities in an unrealized loss position for more than one year related primarily to foreign and domestic corporate securities, foreign government securities and agency residential mortgage-backed securities. Of these unrealized losses, $60,407 thousand related to securities that were rated investment grade by at least one nationally recognized statistical rating organization. There was no gross unrealized depreciation for mortgage-backed securities related to sub-prime and alt-A loans. In all instances, there were no projected cash flow shortfalls to recover the full book value of the investments and the related interest obligations. The mortgage-backed securities still have excess credit coverage and are current on interest and principal payments.\\nThe Company, given the size of its investment portfolio and capital position, does not have the intent to sell these securities; and it is more likely than not that the Company will not have to sell the security before recovery of its cost basis. In addition, all securities currently in an unrealized loss position are current with respect to principal and interest payments.\\n9\\nThe tables below display the aggregate market value and gross unrealized depreciation of fixed maturity and equity securities, by security type and contractual maturity, in each case subdivided according to length of time that individual securities had been in a continuous unrealized loss position for the periods indicated:\\n\\n| Duration of Unrealized Loss at December 31, 2014 By Security Type |\\n| Less than 12 months | Greater than 12 months | Total |\\n| Gross | Gross | Gross |\\n| Unrealized | Unrealized | Unrealized |\\n| (Dollars in thousands) | Market Value | Depreciation | Market Value | Depreciation | Market Value | Depreciation |\\n| Fixed maturity securities - available for sale |\\n| U.S. Treasury securities and obligations of |\\n| U.S. government agencies and corporations | $ | 13,187 | $ | (20 | ) | $ | 26,897 | $ | (284 | ) | $ | 40,084 | $ | (304 | ) |\\n| Obligations of U.S. states and political subdivisions | 20,428 | (242 | ) | 18,199 | (384 | ) | 38,627 | (626 | ) |\\n| Corporate securities | 1,245,830 | (55,388 | ) | 362,320 | (7,518 | ) | 1,608,150 | (62,906 | ) |\\n| Asset-backed securities | 192,253 | (1,230 | ) | - | - | 192,253 | (1,230 | ) |\\n| Mortgage-backed securities |\\n| Commercial | 28,191 | (123 | ) | 9,777 | (306 | ) | 37,968 | (429 | ) |\\n| Agency residential | 141,807 | (172 | ) | 678,972 | (11,401 | ) | 820,779 | (11,573 | ) |\\n| Non-agency residential | - | - | 266 | (57 | ) | 266 | (57 | ) |\\n| Foreign government securities | 235,725 | (15,415 | ) | 139,200 | (11,451 | ) | 374,925 | (26,866 | ) |\\n| Foreign corporate securities | 567,905 | (36,926 | ) | 290,234 | (16,148 | ) | 858,139 | (53,074 | ) |\\n| Total fixed maturity securities | $ | 2,445,326 | $ | (109,516 | ) | $ | 1,525,865 | $ | (47,549 | ) | $ | 3,971,191 | $ | (157,065 | ) |\\n| Equity securities | 50,285 | (4,068 | ) | 73,994 | (7,879 | ) | 124,279 | (11,947 | ) |\\n| Total | $ | 2,495,611 | $ | (113,584 | ) | $ | 1,599,859 | $ | (55,428 | ) | $ | 4,095,470 | $ | (169,012 | ) |\\n\\n\\n| Duration of Unrealized Loss at December 31, 2014 By Maturity |\\n| Less than 12 months | Greater than 12 months | Total |\\n| Gross | Gross | Gross |\\n| Unrealized | Unrealized | Unrealized |\\n| (Dollars in thousands) | Market Value | Depreciation | Market Value | Depreciation | Market Value | Depreciation |\\n| Fixed maturity securities |\\n| Due in one year or less | $ | 98,021 | $ | (5,166 | ) | $ | 80,002 | $ | (8,174 | ) | $ | 178,023 | $ | (13,340 | ) |\\n| Due in one year through five years | 1,233,244 | (68,124 | ) | 518,613 | (12,761 | ) | 1,751,857 | (80,885 | ) |\\n| Due in five years through ten years | 679,374 | (28,529 | ) | 187,717 | (10,734 | ) | 867,091 | (39,263 | ) |\\n| Due after ten years | 72,436 | (6,172 | ) | 50,518 | (4,116 | ) | 122,954 | (10,288 | ) |\\n| Asset-backed securities | 192,253 | (1,230 | ) | - | - | 192,253 | (1,230 | ) |\\n| Mortgage-backed securities | 169,998 | (295 | ) | 689,015 | (11,764 | ) | 859,013 | (12,059 | ) |\\n| Total fixed maturity securities | $ | 2,445,326 | $ | (109,516 | ) | $ | 1,525,865 | $ | (47,549 | ) | $ | 3,971,191 | $ | (157,065 | ) |\\n\\nThe aggregate market value and gross unrealized losses related to investments in an unrealized loss position at December 31, 2014 were $4,095,470 thousand and $169,012 thousand, respectively. The market value of securities for the single issuer whose securities comprised the largest unrealized loss position at December 31, 2014, did not exceed 0.2% of the overall market value of the Company's fixed maturity securities. In addition, as indicated on the above table, there was no significant concentration of unrealized losses in any one market sector. The $109,516 thousand of unrealized losses related to fixed maturity securities that have been in an unrealized loss position for less than one year were generally comprised of domestic and foreign corporate securities, as well as foreign government securities. The majority of these unrealized losses are attributable to unrealized losses in the energy sector, $58,891 thousand, as falling oil prices disrupted the market values for this sector, particularly for oil exploration, production and servicing companies during the fourth quarter of 2014 and unrealized foreign exchange losses, $34,687 thousand, as the U.S. dollar has strengthened against other currencies. The $47,549 thousand of unrealized losses related to fixed maturity securities in an unrealized loss position for more than one year related primarily to foreign and domestic corporate securities, foreign government securities and agency residential mortgage-backed securities. Of these unrealized losses, $42,884 thousand related to securities that were rated investment grade by at least one nationally recognized statistical rating organization. The gross unrealized depreciation for mortgage-backed securities included $15 thousand related to sub-prime and alt-A loans. In all instances, there were no projected cash flow shortfalls to recover\\n10\\nthe full book value of the investments and the related interest obligations. The mortgage-backed securities still have excess credit coverage and are current on interest and principal payments.\\nThe components of net investment income are presented in the table below for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Fixed maturities | $ | 108,134 | $ | 115,057 | $ | 326,970 | $ | 348,872 |\\n| Equity securities | 11,090 | 11,086 | 35,783 | 36,111 |\\n| Short-term investments and cash | 381 | 295 | 1,084 | 1,202 |\\n| Other invested assets |\\n| Limited partnerships | 370 | 21,690 | 13,993 | 25,658 |\\n| Other | (242 | ) | 869 | 1,366 | 3,220 |\\n| Gross investment income before adjustments | 119,733 | 148,997 | 379,196 | 415,063 |\\n| Funds held interest income (expense) | 2,569 | 1,817 | 8,162 | 6,875 |\\n| Future policy benefit reserve income (expense) | (300 | ) | (471 | ) | (1,402 | ) | (915 | ) |\\n| Gross investment income | 122,002 | 150,343 | 385,956 | 421,023 |\\n| Investment expenses | (6,491 | ) | (8,200 | ) | (22,816 | ) | (24,499 | ) |\\n| Net investment income | $ | 115,511 | $ | 142,143 | $ | 363,140 | $ | 396,524 |\\n\\nThe Company records results from limited partnership investments on the equity method of accounting with changes in value reported through net investment income. Due to the timing of receiving financial information from these partnerships, the results are generally reported on a one month or quarter lag. If the Company determines there has been a significant decline in value of a limited partnership during this lag period, a loss will be recorded in the period in which the Company identifies the decline.\\nThe Company had contractual commitments to invest up to an additional $469,064 thousand in limited partnerships at September 30, 2015. These commitments will be funded when called in accordance with the partnership agreements, which have investment periods that expire, unless extended, through 2020.\\nThe components of net realized capital gains (losses) are presented in the table below for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Fixed maturity securities, market value: |\\n| Other-than-temporary impairments | $ | (20,445 | ) | $ | (106 | ) | $ | (62,701 | ) | $ | (495 | ) |\\n| Gains (losses) from sales | (5,218 | ) | 7,311 | (15,812 | ) | 3,668 |\\n| Fixed maturity securities, fair value: |\\n| Gains (losses) from sales | (17 | ) | 82 | 25 | 1,022 |\\n| Gains (losses) from fair value adjustments | - | (938 | ) | 56 | (938 | ) |\\n| Equity securities, market value: |\\n| Gains (losses) from sales | (3,573 | ) | (181 | ) | (4,455 | ) | (1,235 | ) |\\n| Equity securities, fair value: |\\n| Gains (losses) from sales | (13,646 | ) | (1,823 | ) | (13,041 | ) | (1,873 | ) |\\n| Gains (losses) from fair value adjustments | (117,087 | ) | (13,792 | ) | (98,741 | ) | 70,548 |\\n| Short-term investments gains (losses) | 15 | (1 | ) | 15 | (3 | ) |\\n| Total net realized capital gains (losses) | $ | (159,971 | ) | $ | (9,448 | ) | $ | (194,654 | ) | $ | 70,694 |\\n\\nThe Company recorded as net realized capital gains (losses) in the consolidated statements of operations and comprehensive income (loss) both fair value re-measurements and write-downs in the value of securities deemed to be impaired on an other-than-temporary basis as displayed in the table above. The Company had no other-than-temporary impaired securities where the impairment had both a credit and non-credit component.\\n11\\nThe proceeds and split between gross gains and losses, from sales of fixed maturity and equity securities, are presented in the table below for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Proceeds from sales of fixed maturity securities | $ | 414,538 | $ | 446,699 | $ | 1,147,824 | $ | 1,073,938 |\\n| Gross gains from sales | 11,826 | 12,821 | 37,525 | 28,828 |\\n| Gross losses from sales | (17,061 | ) | (5,428 | ) | (53,312 | ) | (24,138 | ) |\\n| Proceeds from sales of equity securities | $ | 156,593 | $ | 150,124 | $ | 461,812 | $ | 463,688 |\\n| Gross gains from sales | 5,250 | 2,545 | 18,890 | 13,047 |\\n| Gross losses from sales | (22,469 | ) | (4,549 | ) | (36,386 | ) | (16,155 | ) |\\n\\n4. DERIVATIVES\\nThe Company sold seven equity index put option contracts, based on two indices, in 2001 and 2005, which remain outstanding. The Company sold these equity index put options as insurance products with the intent of achieving a profit. These equity index put option contracts meet the definition of a derivative under FASB guidance and the Company's position in these equity index put option contracts is unhedged. Accordingly, these equity index put option contracts are carried at fair value in the consolidated balance sheets with changes in fair value recorded in the consolidated statements of operations and comprehensive income (loss).\\nThe Company sold six equity index put option contracts, based on the Standard & Poor's 500 (\\\"S&P 500\\\") index, for total consideration, net of commissions, of $22,530 thousand. At September 30, 2015, fair value for these equity index put option contracts was $41,809 thousand. Based on historical index volatilities and trends and the September 30, 2015 S&P 500 index value, the Company estimates the probability that each equity index put option contract of the S&P 500 index falling below the strike price on the exercise date to be less than 23%. The theoretical maximum payouts under these six equity index put option contracts would occur if on each of the exercise dates the S&P 500 index value were zero. At September 30, 2015, the present value of these theoretical maximum payouts using a 3% discount factor was $429,402 thousand. Conversely, if the contracts had all expired on September 30, 2015, with the S&P index at $1,920.03, there would have been no settlement amount.\\nThe Company sold one equity index put option contract based on the FTSE 100 index for total consideration, net of commissions, of $6,706 thousand. At September 30, 2015, fair value for this equity index put option contract was $10,438 thousand. Based on historical index volatilities and trends and the September 30, 2015 FTSE 100 index value, the Company estimates the probability that the equity index put option contract of the FTSE 100 index will fall below the strike price on the exercise date to be less than 51%. The theoretical maximum payout under the equity index put option contract would occur if on the exercise date the FTSE 100 index value was zero. At September 30, 2015, the present value of the theoretical maximum payout using a 3% discount factor and current exchange rate was $43,896 thousand. Conversely, if the contract had expired on September 30, 2015, with the FTSE index at ₤6,061.60, there would have been no settlement amount.\\nThe fair value of the equity index put options can be found in the Company's consolidated balance sheets as follows:\\n\\n| (Dollars in thousands) |\\n| Derivatives not designated as | Location of fair value | At | At |\\n| hedging instruments | in balance sheets | September 30, 2015 | December 31, 2014 |\\n| Equity index put option contracts | Equity index put option liability | $ | 52,247 | $ | 47,022 |\\n| Total | $ | 52,247 | $ | 47,022 |\\n\\n12\\nThe change in fair value of the equity index put option contracts can be found in the Company's statement of operations and comprehensive income (loss) as follows:\\n\\n| (Dollars in thousands) | Three Months Ended | Nine Months Ended |\\n| Derivatives not designated as | Location of gain (loss) in statements of | September 30, | September 30, |\\n| hedging instruments | operations and comprehensive income (loss) | 2015 | 2014 | 2015 | 2014 |\\n| Equity index put option contracts | Net derivative gain (loss) | $ | (11,428 | ) | $ | 1,855 | $ | (5,225 | ) | $ | 3,968 |\\n| Total | $ | (11,428 | ) | $ | 1,855 | $ | (5,225 | ) | $ | 3,968 |\\n\\n5. FAIR VALUE\\nGAAP guidance regarding fair value measurements address how companies should measure fair value when they are required to use fair value measures for recognition or disclosure purposes under GAAP and provides a common definition of fair value to be used throughout GAAP. It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly fashion between market participants at the measurement date. In addition, it establishes a three-level valuation hierarchy for the disclosure of fair value measurements. The valuation hierarchy is based on the transparency of inputs to the valuation of an asset or liability. The level in the hierarchy within which a given fair value measurement falls is determined based on the lowest level input that is significant to the measurement, with Level 1 being the highest priority and Level 3 being the lowest priority.\\nThe levels in the hierarchy are defined as follows:\\n\\n| Level 1: | Inputs to the valuation methodology are observable inputs that reflect unadjusted quoted prices for identical assets or liabilities in an active market; |\\n\\n\\n| Level 2: | Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument; |\\n\\n\\n| Level 3: | Inputs to the valuation methodology are unobservable and significant to the fair value measurement. |\\n\\nThe Company's fixed maturity and equity securities are primarily managed by third party investment asset managers. The investment asset managers obtain prices from nationally recognized pricing services. These services seek to utilize market data and observations in their evaluation process. They use pricing applications that vary by asset class and incorporate available market information and when fixed maturity securities do not trade on a daily basis the services will apply available information through processes such as benchmark curves, benchmarking of like securities, sector groupings and matrix pricing. In addition, they use model processes, such as the Option Adjusted Spread model to develop prepayment and interest rate scenarios for securities that have prepayment features.\\nIn limited instances where prices are not provided by pricing services or in rare instances when a manager may not agree with the pricing service, price quotes on a non-binding basis are obtained from investment brokers. The investment asset managers do not make any changes to prices received from either the pricing services or the investment brokers. In addition, the investment asset managers have procedures in place to review the reasonableness of the prices from the service providers and may request verification of the prices. In addition, the Company continually performs analytical reviews of price changes and tests the prices on a random basis to an independent pricing source. No material variances were noted during these price validation procedures. In limited situations, where financial markets are inactive or illiquid, the Company may use its own assumptions about future cash flows and risk-adjusted discount rates to determine fair value. Due to the unavailability of prices for one private placement security, the Company valued the security at $6,125 thousand at September 30, 2015 and made no such adjustments at December 31, 2014.\\n13\\nThe Company internally manages a small public equity portfolio which had a fair value at September 30, 2015 and December 31, 2014 of $226,322 thousand and $196,980 thousand, respectively, and all prices were obtained from publically published sources.\\nEquity securities denominated in U.S. currency with quoted prices in active markets for identical assets are categorized as level 1 since the quoted prices are directly observable. Equity securities traded on foreign exchanges are categorized as level 2 due to the added input of a foreign exchange conversion rate to determine fair or market value. The Company uses foreign currency exchange rates published by nationally recognized sources.\\nAll categories of fixed maturity securities listed in the tables below are generally categorized as level 2, since a particular security may not have traded but the pricing services are able to use valuation models with observable market inputs such as interest rate yield curves and prices for similar fixed maturity securities in terms of issuer, maturity and seniority. For foreign government securities and foreign corporate securities, the fair values provided by the third party pricing services in local currencies, and where applicable, are converted to U.S. dollars using currency exchange rates from nationally recognized sources.\\nThe fixed maturities with fair values categorized as level 3 result when prices are not available from the nationally recognized pricing services. The asset managers will then obtain non-binding price quotes for the securities from brokers. The single broker quotes are provided by market makers or broker-dealers who are recognized as market participants in the markets in which they are providing the quotes. The prices received from brokers are reviewed for reasonableness by the third party asset managers and the Company. If the broker quotes are for foreign denominated securities, the quotes are converted to U.S. dollars using currency exchange rates from nationally recognized sources. Historically, most of the level 3 fixed maturities have resulted from new issuances and the third party prices services have not yet included the issuance in their data base. Generally, in subsequent measurement periods, the issuances will be included in the data base and the fair value will transfer to level 2.\\nThe composition and valuation inputs for the presented fixed maturities categories are as follows:\\n\\n| · | U.S. Treasury securities and obligations of U.S. government agencies and corporations are primarily comprised of U.S. Treasury bonds and the fair value is based on observable market inputs such as quoted prices, reported trades, quoted prices for similar issuances or benchmark yields; |\\n\\n\\n| · | Obligations of U.S. states and political subdivisions are comprised of state and municipal bond issuances and the fair values are based on observable market inputs such as quoted market prices, quoted prices for similar securities, benchmark yields and credit spreads; |\\n\\n\\n| · | Corporate securities are primarily comprised of U.S. corporate and public utility bond issuances and the fair values are based on observable market inputs such as quoted market prices, quoted prices for similar securities, benchmark yields and credit spreads; |\\n\\n\\n| · | Asset-backed and mortgage-backed securities fair values are based on observable inputs such as quoted prices, reported trades, quoted prices for similar issuances or benchmark yields and cash flow models using observable inputs such as prepayment speeds, collateral performance and default spreads; |\\n\\n\\n| · | Foreign government securities are comprised of global non-U.S. sovereign bond issuances and the fair values are based on observable market inputs such as quoted market prices, quoted prices for similar securities and models with observable inputs such as benchmark yields and credit spreads and then, where applicable, converted to U.S. dollars using an exchange rate from a nationally recognized source; |\\n\\n\\n| · | Foreign corporate securities are comprised of global non-U.S. corporate bond issuances and the fair values are based on observable market inputs such as quoted market prices, quoted prices for similar securities and models with observable inputs such as benchmark yields and credit spreads and then, where applicable, converted to U.S. dollars using an exchange rate from a nationally recognized source. |\\n\\n14\\nThe Company's liability for equity index put options is categorized as level 3 since there is no active market for these seven long dated equity put options. The fair values for these options are calculated by the Company using an industry accepted pricing model, Black-Scholes. The model inputs and assumptions are: risk free interest rates, equity market indexes values, volatilities and dividend yields and duration. The model results are then adjusted for the Company's credit default swap rate. All of these inputs and assumptions are updated quarterly. One of the option contacts is in British Pound Sterling so the fair value for this contract is converted to U.S. dollars using an exchange rate from a nationally recognized source.\\nThe following table presents the fair value measurement levels for all assets and liabilities, which the Company has recorded at fair value (fair and market value) as of the periods indicated:\\n\\n| Fair Value Measurement Using: |\\n| Quoted Prices |\\n| in Active | Significant |\\n| Markets for | Other | Significant |\\n| Identical | Observable | Unobservable |\\n| Assets | Inputs | Inputs |\\n| (Dollars in thousands) | September 30, 2015 | (Level 1) | (Level 2) | (Level 3) |\\n| Assets: |\\n| Fixed maturities, market value |\\n| U.S. Treasury securities and obligations of |\\n| U.S. government agencies and corporations | $ | 352,926 | $ | - | $ | 352,926 | $ | - |\\n| Obligations of U.S. States and political subdivisions | 714,279 | - | 714,279 | - |\\n| Corporate securities | 5,006,937 | - | 4,999,371 | 7,566 |\\n| Asset-backed securities | 438,397 | - | 438,397 | - |\\n| Mortgage-backed securities |\\n| Commercial | 284,809 | - | 284,809 | - |\\n| Agency residential | 2,426,067 | - | 2,426,067 | - |\\n| Non-agency residential | 978 | - | 978 | - |\\n| Foreign government securities | 1,300,961 | - | 1,300,961 | - |\\n| Foreign corporate securities | 2,965,606 | - | 2,959,481 | 6,125 |\\n| Total fixed maturities, market value | 13,490,960 | - | 13,477,269 | 13,691 |\\n| Fixed maturities, fair value | - | - | - | - |\\n| Equity securities, market value | 112,999 | 97,871 | 15,128 | - |\\n| Equity securities, fair value | 1,357,311 | 1,267,765 | 89,546 | - |\\n| Liabilities: |\\n| Equity index put option contracts | $ | 52,247 | $ | - | $ | - | $ | 52,247 |\\n\\nThere were no transfers between Level 1 and Level 2 for the nine months ended September 30, 2015.\\n15\\nThe following table presents the fair value measurement levels for all assets and liabilities, which the Company has recorded at fair value (fair and market value) as of the periods indicated:\\n\\n| Fair Value Measurement Using: |\\n| Quoted Prices |\\n| in Active | Significant |\\n| Markets for | Other | Significant |\\n| Identical | Observable | Unobservable |\\n| Assets | Inputs | Inputs |\\n| (Dollars in thousands) | December 31, 2014 | (Level 1) | (Level 2) | (Level 3) |\\n| Assets: |\\n| Fixed maturities, market value |\\n| U.S. Treasury securities and obligations of |\\n| U.S. government agencies and corporations | $ | 231,038 | $ | - | $ | 231,038 | $ | - |\\n| Obligations of U.S. States and political subdivisions | 824,472 | - | 824,472 | - |\\n| Corporate securities | 4,706,985 | - | 4,706,985 | - |\\n| Asset-backed securities | 341,222 | - | 341,222 | - |\\n| Mortgage-backed securities |\\n| Commercial | 241,685 | - | 233,088 | 8,597 |\\n| Agency residential | 2,183,164 | - | 2,183,164 | - |\\n| Non-agency residential | 2,731 | - | 2,731 | - |\\n| Foreign government securities | 1,532,455 | - | 1,532,455 | - |\\n| Foreign corporate securities | 3,037,315 | - | 3,030,149 | 7,166 |\\n| Total fixed maturities, market value | 13,101,067 | - | 13,085,304 | 15,763 |\\n| Fixed maturities, fair value | 1,509 | - | 1,509 | - |\\n| Equity securities, market value | 140,210 | 124,295 | 15,915 | - |\\n| Equity securities, fair value | 1,447,820 | 1,337,396 | 110,424 | - |\\n| Liabilities: |\\n| Equity index put option contracts | $ | 47,022 | $ | - | $ | - | $ | 47,022 |\\n\\n16\\nThe following tables present the activity under Level 3, fair value measurements using significant unobservable inputs by asset type, for the periods indicated:\\n\\n| Three Months Ended September 30, 2015 | Nine Months Ended September 30, 2015 |\\n| Corporate | Foreign | Corporate | Foreign |\\n| (Dollars in thousands) | Securities | Corporate | Total | Securities | CMBS | Corporate | Total |\\n| Beginning balance | $ | 1,958 | $ | 7,837 | $ | 9,795 | $ | - | $ | 8,597 | $ | 7,166 | $ | 15,763 |\\n| Total gains or (losses) (realized/unrealized) |\\n| Included in earnings | (8 | ) | 62 | 54 | (4 | ) | - | 177 | 173 |\\n| Included in other comprehensive income (loss) | (137 | ) | (1,287 | ) | (1,424 | ) | (139 | ) | - | (1,216 | ) | (1,355 | ) |\\n| Purchases, issuances and settlements | 1,723 | - | 1,723 | 3,651 | - | - | 3,651 |\\n| Transfers in and/or (out) of Level 3 | 4,030 | (487 | ) | 3,543 | 4,058 | (8,597 | ) | (2 | ) | (4,541 | ) |\\n| Ending balance | $ | 7,566 | $ | 6,125 | $ | 13,691 | $ | 7,566 | $ | - | $ | 6,125 | $ | 13,691 |\\n| The amount of total gains or losses for the period |\\n| included in earnings (or changes in net assets) |\\n| attributable to the change in unrealized gains |\\n| or losses relating to assets still held |\\n| at the reporting date | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - |\\n| (Some amounts may not reconcile due to rounding.) |\\n\\n\\n| Three Months Ended September 30, 2014 | Nine Months Ended September 30, 2014 |\\n| Corporate | Asset-backed | Foreign | Non-agency | Agency | Corporate | Asset-backed | Foreign | Non-agency | Agency |\\n| (Dollars in thousands) | Securities | Securities | Corporate | RMBS | RMBS | Total | Securities | Securities | Corporate | RMBS | RMBS | Total |\\n| Beginning balance | $ | - | $ | 3,000 | $ | - | $ | 259 | $ | - | $ | 3,259 | $ | - | $ | 5,299 | $ | 481 | $ | 347 | $ | - | $ | 6,127 |\\n| Total gains or (losses) (realized/unrealized) |\\n| Included in earnings | - | 1,203 | - | 187 | - | 1,390 | - | 1,259 | 18 | 329 | - | 1,606 |\\n| Included in other comprehensive income (loss) | 42 | (201 | ) | (62 | ) | (114 | ) | - | (335 | ) | 42 | (126 | ) | (82 | ) | (138 | ) | - | (304 | ) |\\n| Purchases, issuances and settlements | 1,274 | 22,797 | 4,517 | (332 | ) | 29,845 | 58,101 | 1,274 | 21,303 | 4,038 | (538 | ) | 29,845 | 55,922 |\\n| Transfers in and/or (out) of Level 3 | - | (1,431 | ) | - | - | - | (1,431 | ) | - | (2,367 | ) | - | - | - | (2,367 | ) |\\n| Ending balance | $ | 1,316 | $ | 25,368 | $ | 4,455 | $ | - | $ | 29,845 | $ | 60,984 | $ | 1,316 | $ | 25,368 | $ | 4,455 | $ | - | $ | 29,845 | $ | 60,984 |\\n| The amount of total gains or losses for the period |\\n| included in earnings (or changes in net assets) |\\n| attributable to the change in unrealized gains |\\n| or losses relating to assets still held |\\n| at the reporting date | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - |\\n| (Some amounts may not reconcile due to rounding.) |\\n\\nThe net transfers to/(from) level 3, fair value measurements using significant unobservable inputs, of $4,541 thousand and $2,367 thousand of investments for the nine months ended September 30, 2015 and 2014, respectively, primarily relate to securities that were priced using single non-binding broker quotes as of December 31, 2014 and 2013, respectively. The securities were subsequently priced using a recognized pricing service as of September 30, 2015 and 2014, and were classified as level 2 as of those dates.\\n17\\nThe following table presents the activity under Level 3, fair value measurements using significant unobservable inputs for equity index put option contracts, for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Liabilities: |\\n| Balance, beginning of period | $ | 40,819 | $ | 33,309 | $ | 47,022 | $ | 35,423 |\\n| Total (gains) or losses (realized/unrealized) |\\n| Included in earnings | 11,428 | (1,855 | ) | 5,225 | (3,968 | ) |\\n| Included in other comprehensive income (loss) | - | - | - | - |\\n| Purchases, issuances and settlements | - | - | - | - |\\n| Transfers in and/or (out) of Level 3 | - | - | - | - |\\n| Balance, end of period | $ | 52,247 | $ | 31,455 | $ | 52,247 | $ | 31,455 |\\n| The amount of total gains or losses for the period included in earnings |\\n| (or changes in net assets) attributable to the change in unrealized |\\n| gains or losses relating to liabilities still held at the reporting date | $ | - | $ | - | $ | - | $ | - |\\n| (Some amounts may not reconcile due to rounding.) |\\n\\n6. REDEEMABLE NONCONTROLLING INTERESTS – MT. LOGAN RE\\nMt. Logan Re is a Class 3 insurer registered in Bermuda effective February 27, 2013 under The Segregated Accounts Companies Act 2000 and 100% of the voting common shares are owned by Group. Separate segregated accounts have been established effective July 1, 2013 and non-voting, redeemable preferred shares have been issued to capitalize the segregated accounts. Each segregated account will invest in a diversified set of catastrophe exposures, diversified by risk/peril and across different geographic regions globally. The financial statements for Mt. Logan Re are consolidated with the Company with adjustments reflected for the third party noncontrolling interests reflected as separate captions in the Company's financial statements.\\nThe following table presents the activity for redeemable noncontrolling interests in the consolidated balance sheets for the periods indicated:\\n\\n| Nine Months Ended | Twelve Months Ended |\\n| September 30, | December 31, |\\n| (Dollars in thousands) | 2015 | 2014 |\\n| Redeemable noncontrolling interests - Mt. Logan Re, beginning of period | $ | 421,552 | $ | 93,378 |\\n| Unaffiliated third party investments during period, net | 336,848 | 279,200 |\\n| Net income (loss) attributable to noncontrolling interests | 61,526 | 59,307 |\\n| Dividends paid on third party investment in redeemable noncontrolling interest | (67,233 | ) | (10,334 | ) |\\n| Redeemable noncontrolling interests - Mt. Logan Re, end of period | $ | 752,692 | $ | 421,552 |\\n| (Some amounts may not reconcile due to rounding.) |\\n\\nIn addition, the Company has invested $50,000 thousand in the segregated accounts from inception to date.\\nThe Company expects its participation level in the segregated funds to fluctuate over time.\\n7. CAPITAL TRANSACTIONS\\nOn July 9, 2014, the Company renewed its shelf registration statement on Form S-3ASR with the Securities and Exchange Commission (the \\\"SEC\\\"), as a Well Known Seasoned Issuer. This shelf registration statement can be used by Group to register common shares, preferred shares, debt securities, warrants, share purchase contracts and share purchase units; by Holdings to register debt securities and by Everest Re Capital Trust III (\\\"Capital Trust III\\\") to register trust preferred securities.\\n18\\n8. EARNINGS PER COMMON SHARE\\nBasic earnings per share are calculated by dividing net income by the weighted average number of common shares outstanding. Diluted earnings per share reflect the potential dilution that would occur if options granted under various share-based compensation plans were exercised resulting in the issuance of common shares that would participate in the earnings of the entity.\\nNet income (loss) attributable to Everest Re Group per common share has been computed as per below, based upon weighted average common basic and dilutive shares outstanding.\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands, except per share amounts) | 2015 | 2014 | 2015 | 2014 |\\n| Net income (loss) attributable to Everest Re Group per share: |\\n| Numerator |\\n| Net income (loss) attributable to Everest Re Group | $ | 88,553 | $ | 274,916 | $ | 620,588 | $ | 859,033 |\\n| Less: dividends declared-common shares and nonvested common shares | (41,698 | ) | (33,973 | ) | (125,905 | ) | (103,034 | ) |\\n| Undistributed earnings | 46,855 | 240,943 | 494,683 | 755,999 |\\n| Percentage allocated to common shareholders (1) | 99.0 | % | 98.9 | % | 98.9 | % | 99.0 | % |\\n| 46,364 | 238,407 | 489,434 | 748,273 |\\n| Add: dividends declared-common shareholders | 41,293 | 33,631 | 124,638 | 101,993 |\\n| Numerator for basic and diluted earnings per common share | $ | 87,657 | $ | 272,038 | $ | 614,072 | $ | 850,266 |\\n| Denominator |\\n| Denominator for basic earnings per weighted-average common shares | 43,361 | 44,941 | 43,728 | 45,615 |\\n| Effect of dilutive securities: |\\n| Options | 367 | 415 | 392 | 426 |\\n| Denominator for diluted earnings per adjusted weighted-average common shares | 43,728 | 45,356 | 44,120 | 46,041 |\\n| Per common share net income (loss) |\\n| Basic | $ | 2.02 | $ | 6.05 | $ | 14.04 | $ | 18.64 |\\n| Diluted | $ | 2.00 | $ | 6.00 | $ | 13.92 | $ | 18.47 |\\n| (1) | Basic weighted-average common shares outstanding | 43,361 | 44,941 | 43,728 | 45,615 |\\n| Basic weighted-average common shares outstanding and nonvested common shares expected to vest | 43,820 | 45,419 | 44,197 | 46,086 |\\n| Percentage allocated to common shareholders | 99.0 | % | 98.9 | % | 98.9 | % | 99.0 | % |\\n| (Some amounts may not reconcile due to rounding.) |\\n\\nThere were no anti-diluted options outstanding for the three and nine months ended September 30, 2015 and 2014.\\nAll outstanding options expire on or between February 21, 2017 and September 19, 2022.\\n9. CONTINGENCIES\\nIn the ordinary course of business, the Company is involved in lawsuits, arbitrations and other formal and informal dispute resolution procedures, the outcomes of which will determine the Company's rights and obligations under insurance and reinsurance agreements. In some disputes, the Company seeks to enforce its rights under an agreement or to collect funds owing to it. In other matters, the Company is resisting attempts by others to collect funds or enforce alleged rights. These disputes arise from time to time and are ultimately resolved through both informal and formal means, including negotiated resolution, arbitration and litigation. In all such matters, the Company believes that its positions are legally and commercially reasonable. The Company considers the statuses of these proceedings when determining its reserves for unpaid loss and loss adjustment expenses.\\n19\\nAside from litigation and arbitrations related to these insurance and reinsurance agreements, the Company is not a party to any other material litigation or arbitration.\\nThe Company has entered into separate annuity agreements with The Prudential Insurance of America (\\\"The Prudential\\\") and an additional unaffiliated life insurance company in which the Company has either purchased annuity contracts or become the assignee of annuity proceeds that are meant to settle claim payment obligations in the future. In both instances, the Company would become contingently liable if either The Prudential or the unaffiliated life insurance company were unable to make payments related to the respective annuity contract.\\nThe table below presents the estimated cost to replace all such annuities for which the Company was contingently liable for the periods indicated:\\n\\n| At September 30, | At December 31, |\\n| (Dollars in thousands) | 2015 | 2014 |\\n| The Prudential | $ | 142,661 | $ | 142,653 |\\n| Unaffiliated life insurance company | 32,414 | 31,964 |\\n\\n10. OTHER COMPREHENSIVE INCOME (LOSS)\\nThe following tables present the components of comprehensive income (loss) in the consolidated statements of operations for the periods indicated:\\n\\n| Three Months Ended September 30, 2015 | Nine Months Ended September 30, 2015 |\\n| (Dollars in thousands) | Before Tax | Tax Effect | Net of Tax | Before Tax | Tax Effect | Net of Tax |\\n| Unrealized appreciation (depreciation) (\\\"URA(D)\\\") on securities - temporary | $ | (105,356 | ) | $ | 14,558 | $ | (90,798 | ) | $ | (178,878 | ) | $ | 29,004 | $ | (149,874 | ) |\\n| URA(D) on securities - OTTI | (253 | ) | (8 | ) | (261 | ) | 8,954 | (3,415 | ) | 5,539 |\\n| Reclassification of net realized losses (gains) included in net income (loss) | 29,235 | (4,639 | ) | 24,596 | 82,967 | (23,441 | ) | 59,526 |\\n| Foreign currency translation adjustments | (47,298 | ) | 14,793 | (32,505 | ) | (104,542 | ) | 24,034 | (80,508 | ) |\\n| Benefit plan actuarial net gain (loss) | - | - | - | - | - | - |\\n| Reclassification of benefit plan liability amortization included in net income (loss) | 2,393 | (837 | ) | 1,556 | 7,336 | (2,567 | ) | 4,769 |\\n| Total other comprehensive income (loss) | $ | (121,279 | ) | $ | 23,867 | $ | (97,412 | ) | $ | (184,163 | ) | $ | 23,615 | $ | (160,548 | ) |\\n\\n\\n| Three Months Ended September 30, 2014 | Nine Months Ended September 30, 2014 |\\n| (Dollars in thousands) | Before Tax | Tax Effect | Net of Tax | Before Tax | Tax Effect | Net of Tax |\\n| Unrealized appreciation (depreciation) (\\\"URA(D)\\\") on securities - temporary | $ | (84,122 | ) | $ | 10,309 | $ | (73,813 | ) | $ | 75,275 | $ | (9,777 | ) | $ | 65,498 |\\n| URA(D) on securities - OTTI | (261 | ) | - | (261 | ) | (180 | ) | - | (180 | ) |\\n| Reclassification of net realized losses (gains) included in net income (loss) | (7,024 | ) | 1,340 | (5,684 | ) | (1,938 | ) | 297 | (1,641 | ) |\\n| Foreign currency translation adjustments | (38,998 | ) | 4,024 | (34,974 | ) | (42,998 | ) | 4,624 | (38,374 | ) |\\n| Benefit plan actuarial net gain (loss) | - | - | - | - | - | - |\\n| Reclassification of benefit plan liability amortization included in net income (loss) | 1,269 | (444 | ) | 825 | 3,640 | (1,274 | ) | 2,366 |\\n| Total other comprehensive income (loss) | $ | (129,136 | ) | $ | 15,229 | $ | (113,907 | ) | $ | 33,799 | $ | (6,130 | ) | $ | 27,669 |\\n\\n20\\nThe following table presents details of the amounts reclassified from AOCI for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, | Affected line item within the statements of |\\n| AOCI component | 2015 | 2014 | 2015 | 2014 | operations and comprehensive income (loss) |\\n| (Dollars in thousands) |\\n| URA(D) on securities | $ | 29,235 | $ | (7,024 | ) | $ | 82,967 | $ | (1,938 | ) | Other net realized capital gains (losses) |\\n| (4,639 | ) | 1,340 | (23,441 | ) | 297 | Income tax expense (benefit) |\\n| $ | 24,596 | $ | (5,684 | ) | $ | 59,526 | $ | (1,641 | ) | Net income (loss) |\\n| Benefit plan net gain (loss) | $ | 2,393 | $ | 1,269 | $ | 7,336 | $ | 3,640 | Other underwriting expenses |\\n| (837 | ) | (444 | ) | (2,567 | ) | (1,274 | ) | Income tax expense (benefit) |\\n| $ | 1,556 | $ | 825 | $ | 4,769 | $ | 2,366 | Net income (loss) |\\n\\nThe following table presents the components of accumulated other comprehensive income (loss), net of tax, in the consolidated balance sheets for the periods indicated:\\n\\n| Nine Months Ended | Twelve Months Ended |\\n| September 30, | December 31, |\\n| (Dollars in thousands) | 2015 | 2014 |\\n| Beginning balance of URA (D) on securities | $ | 223,250 | $ | 201,154 |\\n| Current period change in URA (D) of investments - temporary | (90,348 | ) | 28,767 |\\n| Current period change in URA (D) of investments - non-credit OTTI | 5,539 | (6,671 | ) |\\n| Ending balance of URA (D) on securities | 138,441 | 223,250 |\\n| Beginning balance of foreign currency translation adjustments | (99,947 | ) | (4,530 | ) |\\n| Current period change in foreign currency translation adjustments | (80,508 | ) | (95,417 | ) |\\n| Ending balance of foreign currency translation adjustments | (180,455 | ) | (99,947 | ) |\\n| Beginning balance of benefit plan net gain (loss) | (74,986 | ) | (38,896 | ) |\\n| Current period change in benefit plan net gain (loss) | 4,769 | (36,090 | ) |\\n| Ending balance of benefit plan net gain (loss) | (70,217 | ) | (74,986 | ) |\\n| Ending balance of accumulated other comprehensive income (loss) | $ | (112,231 | ) | $ | 48,317 |\\n\\n11. CREDIT FACILITIES\\nThe Company has two active credit facilities for a total commitment of up to $1,100,000 thousand, providing for the issuance of letters of credit and/or unsecured revolving credit lines. The following table presents the costs incurred in connection with the two credit facilities for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Credit facility fees incurred | $ | 132 | $ | 132 | $ | 431 | $ | 527 |\\n\\n21\\nThe terms and outstanding amounts for each facility are discussed below:\\nGroup Credit Facility\\nEffective June 22, 2012, Group, Bermuda Re and Everest International entered into a four year, $800,000 thousand senior credit facility with a syndicate of lenders, which amended and restated in its entirety the July 27, 2007, five year, $850,000 thousand senior credit facility. Both the June 22, 2012 and July 27, 2007 senior credit facilities, which have similar terms, are referred to as the \\\"Group Credit Facility\\\". Wells Fargo Corporation (\\\"Wells Fargo Bank\\\") is the administrative agent for the Group Credit Facility, which consists of two tranches. Tranche one provides up to $200,000 thousand of unsecured revolving credit for liquidity and general corporate purposes, and for the issuance of unsecured standby letters of credit. The interest on the revolving loans shall, at the Company's option, be either (1) the Base Rate (as defined below) or (2) an adjusted London Interbank Offered Rate (\\\"LIBOR\\\") plus a margin. The Base Rate is the higher of (a) the prime commercial lending rate established by Wells Fargo Bank, (b) the Federal Funds Rate plus 0.5% per annum or (c) the one month LIBOR Rate plus 1.0% per annum. The amount of margin and the fees payable for the Group Credit Facility depends on Group's senior unsecured debt rating. Tranche two exclusively provides up to $600,000 thousand for the issuance of standby letters of credit on a collateralized basis.\\nThe Group Credit Facility requires Group to maintain a debt to capital ratio of not greater than 0.35 to 1 and to maintain a minimum net worth. Minimum net worth is an amount equal to the sum of $4,249,963 thousand plus 25% of consolidated net income for each of Group's fiscal quarters, for which statements are available ending on or after January 1, 2012 and for which consolidated net income is positive, plus 25% of any increase in consolidated net worth during such period attributable to the issuance of ordinary and preferred shares, which at September 30, 2015, was $5,277,454 thousand. As of September 30, 2015, the Company was in compliance with all Group Credit Facility covenants.\\nThe following table summarizes the outstanding letters of credit and/or borrowings for the periods indicated:\\n\\n| (Dollars in thousands) | At September 30, 2015 | At December 31, 2014 |\\n| Bank | Commitment | In Use | Date of Expiry | Commitment | In Use | Date of Expiry |\\n| Wells Fargo Bank Group Credit Facility | Tranche One | $ | 200,000 | $ | - | $ | 200,000 | $ | - |\\n| Tranche Two | 600,000 | 456,379 | 12/31/2015 | 600,000 | 444,012 | 12/31/2015 |\\n| Total Wells Fargo Bank Group Credit Facility | $ | 800,000 | $ | 456,379 | $ | 800,000 | $ | 444,012 |\\n\\nBermuda Re Letter of Credit Facility\\nEffective December 31, 2014, Bermuda Re renewed its $300,000 thousand letter of credit issuance facility with Citibank N.A. referred to as the \\\"Bermuda Re Letter of Credit Facility\\\", which commitment is reconfirmed annually with updated fees. The Bermuda Re Letter of Credit Facility provides for the issuance of up to $300,000 thousand of secured letters of credit to collateralize reinsurance obligations as a non-admitted reinsurer. The interest on drawn letters of credit shall be (A) 0.35% per annum of the principal amount of issued standard letters of credit (expiry of 15 months or less) and (B) 0.45% per annum of the principal amount of issued extended tenor letters of credit (expiry maximum of up to 60 months). The commitment fee on undrawn credit shall be 0.15% per annum.\\nThe following table summarizes the outstanding letters of credit for the periods indicated:\\n\\n| (Dollars in thousands) | At September 30, 2015 | At December 31, 2014 |\\n| Bank | Commitment | In Use | Date of Expiry | Commitment | In Use | Date of Expiry |\\n| Citibank Bilateral Letter of Credit Agreement | $ | 300,000 | $ | 3,672 | 11/24/2015 | $ | 300,000 | $ | 112 | 8/30/2015 |\\n| 65,013 | 12/31/2015 | 3,672 | 11/24/2015 |\\n| 2,681 | 12/31/2016 | 70,922 | 12/31/2015 |\\n| 173 | 8/30/2017 | 2,014 | 12/31/2016 |\\n| 119,002 | 9/30/2019 | 149,353 | 12/30/2018 |\\n| Total Citibank Bilateral Agreement | $ | 300,000 | $ | 190,541 | $ | 300,000 | $ | 226,073 |\\n\\n22\\nHoldings Credit Facility - Expired\\nEffective August 15, 2011, the Company entered into a three year, $150,000 thousand unsecured revolving credit facility, referred to as the \\\"Holdings Credit Facility\\\", which expired on August 15, 2014. The Company decided not to renew the Holdings Credit Facility at expiration.\\n12. REINSURANCE AND TRUST AGREEMENTS\\nCertain subsidiaries of Group have established trust agreements, which effectively use the Company's investments as collateral, as security for assumed losses payable to certain non-affiliated ceding companies. At September 30, 2015, the total amount on deposit in trust accounts was $404,008 thousand.\\nOn April 24, 2014, the Company entered into two collateralized reinsurance agreements with Kilimanjaro Re Limited (\\\"Kilimanjaro\\\"), a Bermuda based special purpose reinsurer, to provide the Company with catastrophe reinsurance coverage. These agreements are multi-year reinsurance contracts which cover specified named storm and earthquake events. The first agreement provides up to $250,000 thousand of reinsurance coverage from named storms in specified states of the Southeastern United States. The second agreement provides up to $200,000 thousand of reinsurance coverage from named storms in specified states of the Southeast, Mid-Atlantic and Northeast regions of the United States and Puerto Rico as well as reinsurance coverage from earthquakes in specified states of the Southeast, Mid-Atlantic, Northeast and West regions of the United States, Puerto Rico and British Columbia.\\nOn November 18, 2014, the Company entered into a collateralized reinsurance agreement with Kilimanjaro Re to provide the Company with catastrophe reinsurance coverage. This agreement is a multi-year reinsurance contract which covers specified earthquake events. The agreement provides up to $500,000 thousand of reinsurance coverage from earthquakes in the United States, Puerto Rico and Canada.\\nKilimanjaro has financed the various property catastrophe reinsurance coverage by issuing catastrophe bonds to unrelated, external investors. On April 24, 2014, Kilimanjaro issued $450,000 thousand of variable rate notes (\\\"Series 2014-1 Notes\\\"). On November 18, 2014, Kilimanjaro issued $500,000 thousand of variable rate notes (\\\"Series 2014-2 Notes\\\"). The proceeds from the issuance of the Series 2014-1 Notes and the Series 2014-2 Notes are held in reinsurance trust throughout the duration of the applicable reinsurance agreements and invested solely in US government money market funds with a rating of at least \\\"AAAm\\\" by Standard & Poor's.\\n13. SENIOR NOTES\\nThe table below displays Holdings' outstanding senior notes. Market value is based on quoted market prices, but due to limited trading activity, these senior notes are considered Level 2 in the fair value hierarchy.\\n\\n| September 30, 2015 | December 31, 2014 |\\n| Consolidated Balance | Consolidated Balance |\\n| (Dollars in thousands) | Date Issued | Date Due | Principal Amounts | Sheet Amount | Market Value | Sheet Amount | Market Value |\\n| 4.868% Senior notes | 06/05/2014 | 06/01/2044 | $ | 400,000 | $ | 400,000 | $ | 388,768 | $ | 400,000 | $ | 404,892 |\\n| 5.40% Senior notes | 10/12/2004 | 10/15/2014 | 250,000 | - | - | - | - |\\n\\nOn June 5, 2014, Holdings issued $400,000 thousand of 30 year senior notes at 4.868%, which will mature on June 1, 2044. Interest will be paid semi-annually on June 1 and December 1 of each year. The proceeds from the issuance have been used in part to pay off the $250,000 thousand of 5.40% senior notes which matured on October 15, 2014.\\n23\\nInterest expense incurred in connection with these senior notes is as follows for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Interest expense incurred | $ | 4,868 | $ | 8,256 | $ | 14,604 | $ | 16,385 |\\n\\n14. LONG TERM SUBORDINATED NOTES\\nThe table below displays Holdings' outstanding fixed to floating rate long term subordinated notes. Market value is based on quoted market prices, but due to limited trading activity, these subordinated notes are considered Level 2 in the fair value hierarchy.\\n\\n| Maturity Date | September 30, 2015 | December 31, 2014 |\\n| Original | Consolidated Balance | Consolidated Balance |\\n| (Dollars in thousands) | Date Issued | Principal Amount | Scheduled | Final | Sheet Amount | Market Value | Sheet Amount | Market Value |\\n| 6.6% Long term subordinated notes | 04/26/2007 | $ | 400,000 | 05/15/2037 | 05/01/2067 | $ | 238,367 | $ | 218,281 | $ | 238,364 | $ | 246,312 |\\n\\nDuring the fixed rate interest period from May 3, 2007 through May 14, 2017, interest will be at the annual rate of 6.6%, payable semi-annually in arrears on November 15 and May 15 of each year, commencing on November 15, 2007, subject to Holdings' right to defer interest on one or more occasions for up to ten consecutive years. During the floating rate interest period from May 15, 2017 through maturity, interest will be based on the 3 month LIBOR plus 238.5 basis points, reset quarterly, payable quarterly in arrears on February 15, May 15, August 15 and November 15 of each year, subject to Holdings' right to defer interest on one or more occasions for up to ten consecutive years. Deferred interest will accumulate interest at the applicable rate compounded semi-annually for periods prior to May 15, 2017, and compounded quarterly for periods from and including May 15, 2017.\\nHoldings can redeem the long term subordinated notes prior to May 15, 2017, in whole but not in part at the applicable redemption price, which will equal the greater of (a) 100% of the principal amount being redeemed and (b) the present value of the principal payment on May 15, 2017 and scheduled payments of interest that would have accrued from the redemption date to May 15, 2017 on the long term subordinated notes being redeemed, discounted to the redemption date on a semi-annual basis at a discount rate equal to the treasury rate plus an applicable spread of either 0.25% or 0.50%, in each case plus accrued and unpaid interest. Holdings may redeem the long term subordinated notes on or after May 15, 2017, in whole or in part at 100% of the principal amount plus accrued and unpaid interest; however, redemption on or after the scheduled maturity date and prior to May 1, 2047 is subject to a replacement capital covenant. This covenant is for the benefit of certain senior note holders and it mandates that Holdings receive proceeds from the sale of another subordinated debt issue, of at least similar size, before it may redeem the subordinated notes. Effective upon the maturity of the Company's 5.40% senior notes on October 15, 2014, the Company's 4.868% senior notes, due on June 1, 2044, have become the Company's long term indebtedness that ranks senior to the long term subordinated notes.\\nOn March 19, 2009, Group announced the commencement of a cash tender offer for any and all of the 6.60% fixed to floating rate long term subordinated notes. Upon expiration of the tender offer, the Company had reduced its outstanding debt by $161,441 thousand.\\nInterest expense incurred in connection with these long term subordinated notes is as follows for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Interest expense incurred | $ | 3,937 | $ | 3,937 | $ | 11,811 | $ | 11,811 |\\n\\n24\\n15. SEGMENT REPORTING\\nThe U.S. Reinsurance operation writes property and casualty reinsurance and specialty lines of business, including Marine, Aviation, Surety and Accident and Health (\\\"A&H\\\") business, on both a treaty and facultative basis, through reinsurance brokers, as well as directly with ceding companies primarily within the U.S. The International operation writes non-U.S. property and casualty reinsurance through Everest Re's branches in Canada and Singapore and through offices in Brazil, Miami and New Jersey. The Bermuda operation provides reinsurance and insurance to worldwide property and casualty markets through brokers and directly with ceding companies from its Bermuda office and reinsurance to the United Kingdom and European markets through its UK branch and Ireland Re. The Insurance operation writes property and casualty insurance directly and through general agents, brokers and surplus lines brokers within the U.S. and Canada. The Mt. Logan Re segment represents business written for the segregated accounts of Mt. Logan Re, which were formed on July 1, 2013. The Mt. Logan Re business represents a diversified set of catastrophe exposures, diversified by risk/peril and across different geographical regions globally.\\nThese segments, with the exception of Mt. Logan Re, are managed independently, but conform with corporate guidelines with respect to pricing, risk management, control of aggregate catastrophe exposures, capital, investments and support operations. Management generally monitors and evaluates the financial performance of these operating segments based upon their underwriting results. The Mt. Logan Re segment is managed independently and seeks to write a diverse portfolio of catastrophe risks for each segregated account to achieve desired risk and return criteria.\\nUnderwriting results include earned premium less losses and loss adjustment expenses (\\\"LAE\\\") incurred, commission and brokerage expenses and other underwriting expenses. We measure our underwriting results using ratios, in particular loss, commission and brokerage and other underwriting expense ratios, which, respectively, divide incurred losses, commissions and brokerage and other underwriting expenses by premiums earned.\\nMt. Logan Re's business is sourced through operating subsidiaries of the Company; however, the activity is only reflected in the Mt. Logan Re segment. For other inter-affiliate reinsurance, business is generally reported within the segment in which the business was first produced, consistent with how the business is managed.\\nExcept for Mt. Logan Re, the Company does not maintain separate balance sheet data for its operating segments. Accordingly, the Company does not review and evaluate the financial results of its operating segments based upon balance sheet data.\\n25\\nThe following tables present the underwriting results for the operating segments for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| U.S. Reinsurance | September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Gross written premiums | $ | 537,483 | $ | 640,660 | $ | 1,464,840 | $ | 1,573,776 |\\n| Net written premiums | 511,238 | 615,078 | 1,383,647 | 1,536,114 |\\n| Premiums earned | $ | 488,485 | $ | 559,488 | $ | 1,480,427 | $ | 1,478,258 |\\n| Incurred losses and LAE | 225,944 | 249,004 | 699,575 | 701,473 |\\n| Commission and brokerage | 121,050 | 123,432 | 364,005 | 339,166 |\\n| Other underwriting expenses | 13,718 | 12,118 | 37,054 | 33,054 |\\n| Underwriting gain (loss) | $ | 127,773 | $ | 174,934 | $ | 379,793 | $ | 404,565 |\\n\\n\\n| Three Months Ended | Nine Months Ended |\\n| International | September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Gross written premiums | $ | 354,871 | $ | 406,254 | $ | 966,091 | $ | 1,181,513 |\\n| Net written premiums | 318,478 | 352,608 | 896,872 | 977,235 |\\n| Premiums earned | $ | 291,396 | $ | 320,020 | $ | 935,228 | $ | 958,399 |\\n| Incurred losses and LAE | 229,013 | 236,559 | 630,752 | 604,166 |\\n| Commission and brokerage | 70,894 | 73,143 | 226,321 | 215,716 |\\n| Other underwriting expenses | 9,128 | 8,758 | 25,292 | 24,683 |\\n| Underwriting gain (loss) | $ | (17,639 | ) | $ | 1,560 | $ | 52,863 | $ | 113,834 |\\n\\n\\n| Three Months Ended | Nine Months Ended |\\n| Bermuda | September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Gross written premiums | $ | 267,035 | $ | 205,342 | $ | 605,365 | $ | 573,793 |\\n| Net written premiums | 251,678 | 189,447 | 557,453 | 548,210 |\\n| Premiums earned | $ | 222,240 | $ | 181,754 | $ | 616,241 | $ | 546,699 |\\n| Incurred losses and LAE | 154,327 | 108,961 | 372,572 | 310,602 |\\n| Commission and brokerage | 52,980 | 48,421 | 151,356 | 140,968 |\\n| Other underwriting expenses | 9,457 | 9,360 | 27,045 | 25,805 |\\n| Underwriting gain (loss) | $ | 5,476 | $ | 15,012 | $ | 65,268 | $ | 69,324 |\\n\\n\\n| Three Months Ended | Nine Months Ended |\\n| Insurance | September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Gross written premiums | $ | 489,124 | $ | 364,111 | $ | 1,173,012 | $ | 911,242 |\\n| Net written premiums | 418,960 | 310,690 | 1,022,389 | 802,431 |\\n| Premiums earned | $ | 360,742 | $ | 290,518 | $ | 888,711 | $ | 742,038 |\\n| Incurred losses and LAE | 262,328 | 239,823 | 662,052 | 557,047 |\\n| Commission and brokerage | 50,268 | 40,418 | 127,125 | 114,535 |\\n| Other underwriting expenses | 35,677 | 31,311 | 99,232 | 83,672 |\\n| Underwriting gain (loss) | $ | 12,469 | $ | (21,034 | ) | $ | 302 | $ | (13,216 | ) |\\n\\n26\\n\\n| Three Months Ended | Nine Months Ended |\\n| Mt. Logan Re | September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Gross written premiums | $ | 72,200 | $ | 50,334 | $ | 183,694 | $ | 109,163 |\\n| Net written premiums | 60,903 | 49,757 | 153,281 | 98,666 |\\n| Premiums earned | $ | 50,777 | $ | 38,218 | $ | 132,508 | $ | 81,411 |\\n| Incurred losses and LAE | 16,485 | 3,410 | 36,272 | 19,575 |\\n| Commission and brokerage | 4,856 | 5,105 | 13,325 | 9,823 |\\n| Other underwriting expenses | 2,687 | 1,566 | 6,659 | 4,951 |\\n| Underwriting gain (loss) | $ | 26,749 | $ | 28,137 | $ | 76,252 | $ | 47,062 |\\n\\nThe following table reconciles the underwriting results for the operating segments to income before taxes as reported in the consolidated statements of operations and comprehensive income (loss) for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Underwriting gain (loss) | $ | 154,828 | $ | 198,609 | $ | 574,478 | $ | 621,569 |\\n| Net investment income | 115,511 | 142,143 | 363,140 | 396,524 |\\n| Net realized capital gains (losses) | (159,971 | ) | (9,448 | ) | (194,654 | ) | 70,694 |\\n| Net derivative gain (loss) | (11,428 | ) | 1,855 | (5,225 | ) | 3,968 |\\n| Corporate expenses | (5,924 | ) | (9,958 | ) | (17,312 | ) | (18,802 | ) |\\n| Interest, fee and bond issue cost amortization expense | (8,990 | ) | (12,424 | ) | (27,006 | ) | (28,970 | ) |\\n| Other income (expense) | 17,413 | 11,332 | 59,561 | (5,835 | ) |\\n| Income (loss) before taxes | $ | 101,439 | $ | 322,109 | $ | 752,982 | $ | 1,039,148 |\\n\\nThe Company produces business in the U.S., Bermuda and internationally. The net income deriving from and assets residing in the individual foreign countries in which the Company writes business are not identifiable in the Company's financial records. Based on gross written premium, the table below presents the largest country, other than the U.S., in which the Company writes business, for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| United Kingdom gross written premium | $ | 212,039 | $ | 199,052 | $ | 565,143 | $ | 536,928 |\\n\\nNo other country represented more than 5% of the Company's revenues.\\n16. SHARE-BASED COMPENSATION PLANS\\nFor the three months ended September 30, 2015, share-based compensation awards granted were 4,720 restricted shares, granted on September 9, 2015, with a fair value of $176.37 per share.\\n27\\n17. RETIREMENT BENEFITS\\nThe Company maintains both qualified and non-qualified defined benefit pension plans and a retiree health plan for its U.S. employees employed prior to April 1, 2010.\\nNet periodic benefit cost for U.S. employees included the following components for the periods indicated:\\n\\n| Pension Benefits | Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Service cost | $ | 3,203 | $ | 2,460 | $ | 9,398 | $ | 7,381 |\\n| Interest cost | 2,758 | 2,542 | 7,926 | 7,625 |\\n| Expected return on plan assets | (2,904 | ) | (2,822 | ) | (8,710 | ) | (8,468 | ) |\\n| Amortization of prior service cost | 4 | 13 | 15 | 38 |\\n| Amortization of net (income) loss | 2,312 | 1,173 | 6,824 | 3,356 |\\n| FAS 88 settlement charge | - | 5,269 | - | 5,269 |\\n| Net periodic benefit cost | $ | 5,373 | $ | 8,635 | $ | 15,453 | $ | 15,201 |\\n\\n\\n| Other Benefits | Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Service cost | $ | 498 | $ | 407 | $ | 1,498 | $ | 1,221 |\\n| Interest cost | 329 | 342 | 987 | 1,026 |\\n| Amortization of net (income) loss | 76 | 82 | 497 | 246 |\\n| Net periodic benefit cost | $ | 903 | $ | 831 | $ | 2,982 | $ | 2,493 |\\n\\nThe Company did not make any contributions to the qualified pension benefit plan for the three and nine months ended September 30, 2015 and 2014.\\n18. INCOME TAXES\\nThe Company is domiciled in Bermuda and has significant subsidiaries and/or branches in Canada, Ireland, Singapore, the United Kingdom, and the United States. The Company's Bermuda domiciled subsidiaries are exempt from income taxation under Bermuda law until 2035. Pre-tax income generated by Group's non-Bermuda subsidiaries and the UK branch of Bermuda is subject to applicable federal, foreign, state and local taxes on corporations. Company subsidiaries domiciled in the US as well as the Canadian and Singapore branches of Everest Re generate US pre-tax income (loss). Foreign domiciled subsidiaries, including the UK branch of Bermuda Re, generate non-US pre-tax income (loss). Fluctuations in US and non-US pre-tax income (loss) primarily result from the impact of catastrophe losses and realized investment gains (losses).\\nFor interim reporting periods, the company is generally required to use the annualized effective tax rate (\\\"AETR\\\") method, as prescribed by ASC 740-270, Interim Reporting, to calculate its income tax provision. Under this method, the AETR is applied to the interim year-to-date pre-tax income to determine the income tax expense or benefit for the year-to-date period. The income tax expense or benefit for a quarter represents the difference between the year-to-date income tax expense or benefit for the current year-to-date period less such amount for the immediately preceding year-to-date period. Management considers the impact of all known events in its estimation of the Company's annual pre-tax income and AETR.\\n19. DISPOSITIONS\\nOn July 13, 2015, the Company closed its agreement to sell all of the outstanding shares of capital stock of Mt. McKinley, a Delaware domiciled insurance company and wholly-owned subsidiary of the Company to Clearwater Insurance Company, a Delaware domiciled insurance company. The Company received $20,156 thousand in cash for Mt. McKinley and did not recognize any realized gain or loss from the sale.\\n28\\nConcurrently with the closing, the Company entered into a retrocession treaty with an affiliate of Clearwater Insurance Company. Per the retrocession treaty, the Company retroceded 100% of the liabilities associated with certain Mt. McKinley policies, which had been reinsured by Everest Reinsurance (Bermuda), Ltd. (\\\"Everest Re Bermuda\\\"), a wholly-owned subsidiary of the Company. As consideration for entering into the retrocession treaty, Everest Re Bermuda transferred cash of $140,279 thousand, an amount equal to the net loss reserves as of the closing date. The maximum liability retroceded under the retrocession treaty will be $440,279 thousand, equal to the retrocession payment plus $300,000 thousand. The Company will retain liability for any amounts exceeding the maximum liability retroceded under the retrocession treaty.\\n20. SUBSEQUENT EVENTS\\nThe Company is currently negotiating two additional reinsurance agreements with Kilimanjaro to provide the Company with catastrophe reinsurance coverage. Kilimanjaro will fund the catastrophe reinsurance coverage through the issuance of two classes of catastrophe reinsurance bonds.\\n29\\n\\nITEM 2.\\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION\\n| Three Months Ended | Percentage | Nine Months Ended | Percentage |\\n| September 30, | Increase/ | September 30, | Increase/ |\\n| (Dollars in millions) | 2015 | 2014 | (Decrease) | 2015 | 2014 | (Decrease) |\\n| Gross written premiums | $ | 1,720.7 | $ | 1,666.7 | 3.2 | % | $ | 4,393.0 | $ | 4,349.5 | 1.0 | % |\\n| Net written premiums | 1,561.3 | 1,517.6 | 2.9 | % | 4,013.6 | 3,962.7 | 1.3 | % |\\n| REVENUES: |\\n| Premiums earned | $ | 1,413.6 | $ | 1,390.0 | 1.7 | % | $ | 4,053.1 | $ | 3,806.8 | 6.5 | % |\\n| Net investment income | 115.5 | 142.1 | -18.7 | % | 363.1 | 396.5 | -8.4 | % |\\n| Net realized capital gains (losses) | (160.0 | ) | (9.4 | ) | NM | (194.7 | ) | 70.7 | NM |\\n| Net derivative gain (loss) | (11.4 | ) | 1.9 | NM | (5.2 | ) | 4.0 | -231.7 | % |\\n| Other income (expense) | 17.4 | 11.3 | 53.6 | % | 59.6 | (5.8 | ) | NM |\\n| Total revenues | 1,375.2 | 1,535.9 | -10.5 | % | 4,275.9 | 4,272.2 | 0.1 | % |\\n| CLAIMS AND EXPENSES: |\\n| Incurred losses and loss adjustment expenses | 888.1 | 837.8 | 6.0 | % | 2,401.2 | 2,192.9 | 9.5 | % |\\n| Commission, brokerage, taxes and fees | 300.0 | 290.5 | 3.3 | % | 882.1 | 820.2 | 7.5 | % |\\n| Other underwriting expenses | 70.7 | 63.1 | 12.0 | % | 195.3 | 172.2 | 13.4 | % |\\n| Corporate expenses | 5.9 | 10.0 | -40.5 | % | 17.3 | 18.8 | -7.9 | % |\\n| Interest, fees and bond issue cost amortization expense | 9.0 | 12.4 | -27.6 | % | 27.0 | 29.0 | -6.8 | % |\\n| Total claims and expenses | 1,273.7 | 1,213.8 | 4.9 | % | 3,523.0 | 3,233.0 | 9.0 | % |\\n| INCOME (LOSS) BEFORE TAXES | 101.4 | 322.1 | -68.5 | % | 753.0 | 1,039.1 | -27.5 | % |\\n| Income tax expense (benefit) | (6.1 | ) | 20.9 | -129.4 | % | 70.9 | 137.9 | -48.6 | % |\\n| NET INCOME (LOSS) | $ | 107.6 | $ | 301.3 | -64.3 | % | $ | 682.1 | $ | 901.2 | -24.3 | % |\\n| Net (income) loss attributable to noncontrolling interests | (19.0 | ) | (26.3 | ) | -27.8 | % | (61.5 | ) | (42.2 | ) | 45.9 | % |\\n| NET INCOME (LOSS) ATTRIBUTABLE TO EVEREST RE GROUP | $ | 88.6 | $ | 274.9 | -67.8 | % | $ | 620.6 | $ | 859.0 | -27.8 | % |\\n| RATIOS: | Point Change | Point Change |\\n| Loss ratio | 62.8 | % | 60.3 | % | 2.5 | 59.2 | % | 57.6 | % | 1.6 |\\n| Commission and brokerage ratio | 21.2 | % | 20.9 | % | 0.3 | 21.8 | % | 21.5 | % | 0.3 |\\n| Other underwriting expense ratio | 5.0 | % | 4.5 | % | 0.5 | 4.8 | % | 4.6 | % | 0.2 |\\n| Combined ratio | 89.0 | % | 85.7 | % | 3.3 | 85.8 | % | 83.7 | % | 2.1 |\\n| At | At | Percentage |\\n| September 30, | December 31, | Increase/ |\\n| (Dollars in millions, except per share amounts) | 2015 | 2014 | (Decrease) |\\n| Balance sheet data: |\\n| Total investments and cash | $ | 17,647.2 | $ | 17,435.9 | 1.2 | % |\\n| Total assets | 21,682.3 | 20,817.8 | 4.2 | % |\\n| Loss and loss adjustment expense reserves | 9,966.0 | 9,720.8 | 2.5 | % |\\n| Total debt | 638.4 | 638.4 | 0.0 | % |\\n| Total liabilities | 13,443.3 | 12,945.2 | 3.8 | % |\\n| Redeemable noncontrolling interests - Mt. Logan Re | 752.7 | 421.6 | 78.6 | % |\\n| Shareholders' equity | 7,486.3 | 7,451.1 | 0.5 | % |\\n| Book value per share | 173.76 | 166.75 | 4.2 | % |\\n| (NM, not meaningful) |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional (a) | $ | 848.1 | 60.1 | % | $ | - | 0.0 | % | $ | 848.1 | 60.1 | % |\\n| Catastrophes | 40.0 | 2.7 | % | - | 0.0 | % | 40.0 | 2.7 | % |\\n| Total | $ | 888.1 | 62.8 | % | $ | - | 0.0 | % | $ | 888.1 | 62.8 | % |\\n| 2014 |\\n| Attritional (a) | $ | 807.3 | 58.1 | % | $ | 0.5 | 0.0 | % | $ | 807.8 | 58.1 | % |\\n| Catastrophes | 30.0 | 2.2 | % | - | 0.0 | % | 30.0 | 2.2 | % |\\n| Total | $ | 837.3 | 60.3 | % | $ | 0.5 | 0.0 | % | $ | 837.8 | 60.3 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | 40.8 | 2.0 | pts | $ | (0.5 | ) | - | pts | $ | 40.3 | 2.0 | pts |\\n| Catastrophes | 10.0 | 0.5 | pts | - | - | pts | 10.0 | 0.4 | pts |\\n| Total segment | $ | 50.8 | 2.5 | pts | $ | (0.5 | ) | - | pts | $ | 50.3 | 2.5 | pts |\\n| Nine Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional (a) | $ | 2,332.1 | 57.5 | % | $ | (0.8 | ) | 0.0 | % | $ | 2,331.3 | 57.5 | % |\\n| Catastrophes | 80.0 | 2.0 | % | (10.0 | ) | -0.3 | % | 70.0 | 1.7 | % |\\n| Total | $ | 2,412.1 | 59.5 | % | $ | (10.8 | ) | -0.3 | % | $ | 2,401.2 | 59.2 | % |\\n| 2014 |\\n| Attritional (a) | $ | 2,120.8 | 55.7 | % | $ | (2.9 | ) | -0.1 | % | $ | 2,117.9 | 55.6 | % |\\n| Catastrophes | 75.0 | 2.0 | % | - | 0.0 | % | 75.0 | 2.0 | % |\\n| Total | $ | 2,195.8 | 57.7 | % | $ | (2.9 | ) | -0.1 | % | $ | 2,192.9 | 57.6 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | 211.3 | 1.8 | pts | $ | 2.1 | 0.1 | pts | $ | 213.4 | 1.9 | pts |\\n| Catastrophes | 5.0 | - | pts | (10.0 | ) | (0.3 | ) | pts | (5.0 | ) | (0.3 | ) | pts |\\n| Total segment | $ | 216.3 | 1.8 | pts | $ | (7.9 | ) | (0.2 | ) | pts | $ | 208.3 | 1.6 | pts |\\n| (a) Attritional losses exclude catastrophe losses. |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in millions) | 2015 | 2014 | 2015 | 2014 |\\n| Fixed maturities | $ | 108.1 | $ | 115.1 | $ | 327.0 | $ | 348.9 |\\n| Equity securities | 11.1 | 11.1 | 35.8 | 36.1 |\\n| Short-term investments and cash | 0.4 | 0.3 | 1.1 | 1.2 |\\n| Other invested assets |\\n| Limited partnerships | 0.4 | 21.7 | 14.0 | 25.7 |\\n| Other | (0.2 | ) | 0.9 | 1.4 | 3.2 |\\n| Gross investment income before adjustments | 119.7 | 149.0 | 379.2 | 415.1 |\\n| Funds held interest income (expense) | 2.6 | 1.8 | 8.2 | 6.9 |\\n| Future policy benefit reserve income (expense) | (0.3 | ) | (0.5 | ) | (1.4 | ) | (0.9 | ) |\\n| Gross investment income | 122.0 | 150.3 | 386.0 | 421.0 |\\n| Investment expenses | (6.5 | ) | (8.2 | ) | (22.8 | ) | (24.5 | ) |\\n| Net investment income | $ | 115.5 | $ | 142.1 | $ | 363.1 | $ | 396.5 |\\n| (Some amounts may not reconcile due to rounding.) |\\n| At | At |\\n| September 30, | December 31, |\\n| 2015 | 2014 |\\n| Imbedded pre-tax yield of cash and invested assets | 3.0% | 3.0% |\\n| Imbedded after-tax yield of cash and invested assets | 2.5% | 2.6% |\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| 2015 | 2014 | 2015 | 2014 |\\n| Annualized pre-tax yield on average cash and invested assets | 2.7% | 3.4% | 2.8% | 3.2% |\\n| Annualized after-tax yield on average cash and invested assets | 2.2% | 2.7% | 2.3% | 2.7% |\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (Dollars in millions) | 2015 | 2014 | Variance | 2015 | 2014 | Variance |\\n| Gains (losses) from sales: |\\n| Fixed maturity securities, market value: |\\n| Gains | $ | 11.8 | $ | 12.7 | $ | (0.9 | ) | $ | 37.5 | $ | 27.5 | $ | 10.0 |\\n| Losses | (17.0 | ) | (5.5 | ) | (11.5 | ) | (53.3 | ) | (23.9 | ) | (29.4 | ) |\\n| Total | (5.2 | ) | 7.3 | (12.5 | ) | (15.8 | ) | 3.7 | (19.5 | ) |\\n| Fixed maturity securities, fair value: |\\n| Gains | - | 0.1 | (0.1 | ) | - | 1.3 | (1.3 | ) |\\n| Losses | - | - | - | - | (0.3 | ) | 0.3 |\\n| Total | - | 0.1 | (0.1 | ) | - | 1.0 | (1.0 | ) |\\n| Equity securities, market value: |\\n| Gains | - | - | - | - | - | - |\\n| Losses | (3.6 | ) | (0.1 | ) | (3.5 | ) | (4.5 | ) | (1.2 | ) | (3.3 | ) |\\n| Total | (3.6 | ) | (0.1 | ) | (3.5 | ) | (4.5 | ) | (1.2 | ) | (3.3 | ) |\\n| Equity securities, fair value: |\\n| Gains | 5.3 | 2.5 | 2.8 | 18.9 | 13.0 | 5.9 |\\n| Losses | (18.9 | ) | (4.4 | ) | (14.5 | ) | (31.9 | ) | (14.9 | ) | (17.0 | ) |\\n| Total | (13.6 | ) | (1.9 | ) | (11.7 | ) | (13.0 | ) | (1.9 | ) | (11.1 | ) |\\n| Total net realized capital gains (losses) from sales: |\\n| Gains | 17.1 | 15.4 | 1.7 | 56.4 | 41.9 | 14.5 |\\n| Losses | (39.5 | ) | (10.0 | ) | (29.5 | ) | (89.7 | ) | (40.3 | ) | (49.4 | ) |\\n| Total | (22.5 | ) | 5.4 | (27.9 | ) | (33.3 | ) | 1.6 | (34.9 | ) |\\n| Other-than-temporary impairments: | (20.4 | ) | (0.1 | ) | (20.3 | ) | (62.7 | ) | (0.5 | ) | (62.2 | ) |\\n| Gains (losses) from fair value adjustments: |\\n| Fixed maturity securities, fair value | - | (0.9 | ) | 0.9 | 0.1 | (0.9 | ) | 1.0 |\\n| Equity securities, fair value | (117.1 | ) | (13.8 | ) | (103.3 | ) | (98.7 | ) | 70.5 | (169.2 | ) |\\n| Total | (117.1 | ) | (14.7 | ) | (102.4 | ) | (98.7 | ) | 69.6 | (168.3 | ) |\\n| Total net realized capital gains (losses) | $ | (160.0 | ) | $ | (9.4 | ) | $ | (150.6 | ) | $ | (194.7 | ) | $ | 70.7 | $ | (265.4 | ) |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\\n| Gross written premiums | $ | 537.5 | $ | 640.7 | $ | (103.2 | ) | -16.1 | % | $ | 1,464.8 | $ | 1,573.8 | $ | (108.9 | ) | -6.9 | % |\\n| Net written premiums | 511.2 | 615.1 | (103.8 | ) | -16.9 | % | 1,383.6 | 1,536.1 | (152.5 | ) | -9.9 | % |\\n| Premiums earned | $ | 488.5 | $ | 559.5 | $ | (71.0 | ) | -12.7 | % | $ | 1,480.4 | $ | 1,478.3 | $ | 2.2 | 0.1 | % |\\n| Incurred losses and LAE | 225.9 | 249.0 | (23.1 | ) | -9.3 | % | 699.6 | 701.5 | (1.9 | ) | -0.3 | % |\\n| Commission and brokerage | 121.1 | 123.4 | (2.4 | ) | -1.9 | % | 364.0 | 339.2 | 24.8 | 7.3 | % |\\n| Other underwriting expenses | 13.7 | 12.1 | 1.6 | 13.2 | % | 37.1 | 33.1 | 4.0 | 12.1 | % |\\n| Underwriting gain (loss) | $ | 127.8 | $ | 174.9 | $ | (47.2 | ) | -27.0 | % | $ | 379.8 | $ | 404.6 | $ | (24.8 | ) | -6.1 | % |\\n| Point Chg | Point Chg |\\n| Loss ratio | 46.3 | % | 44.5 | % | 1.8 | 47.3 | % | 47.5 | % | (0.2 | ) |\\n| Commission and brokerage ratio | 24.8 | % | 22.1 | % | 2.7 | 24.6 | % | 22.9 | % | 1.7 |\\n| Other underwriting expense ratio | 2.7 | % | 2.1 | % | 0.6 | 2.4 | % | 2.2 | % | 0.2 |\\n| Combined ratio | 73.8 | % | 68.7 | % | 5.1 | 74.3 | % | 72.6 | % | 1.7 |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional | $ | 225.5 | 46.2 | % | $ | 0.5 | 0.2 | % | $ | 226.0 | 46.4 | % |\\n| Catastrophes | 0.2 | 0.0 | % | (0.3 | ) | -0.1 | % | (0.1 | ) | -0.1 | % |\\n| Total segment | $ | 225.7 | 46.2 | % | $ | 0.2 | 0.1 | % | $ | 225.9 | 46.3 | % |\\n| 2014 |\\n| Attritional | $ | 246.7 | 44.1 | % | $ | 1.3 | 0.2 | % | $ | 248.1 | 44.3 | % |\\n| Catastrophes | - | 0.0 | % | 0.9 | 0.2 | % | 0.9 | 0.2 | % |\\n| Total segment | $ | 246.7 | 44.1 | % | $ | 2.3 | 0.4 | % | $ | 249.0 | 44.5 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | (21.2 | ) | 2.1 | pts | $ | (0.8 | ) | - | pts | $ | (22.1 | ) | 2.1 | pts |\\n| Catastrophes | 0.2 | - | pts | (1.2 | ) | (0.3 | ) | pts | (1.0 | ) | (0.3 | ) | pts |\\n| Total segment | $ | (21.0 | ) | 2.1 | pts | $ | (2.1 | ) | (0.3 | ) | pts | $ | (23.1 | ) | 1.8 | pts |\\n| Nine Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional | $ | 732.4 | 49.5 | % | $ | (24.3 | ) | -1.6 | % | $ | 708.1 | 47.9 | % |\\n| Catastrophes | 0.2 | 0.0 | % | (8.8 | ) | -0.6 | % | (8.5 | ) | -0.6 | % |\\n| Total segment | $ | 732.6 | 49.5 | % | $ | (33.1 | ) | -2.2 | % | $ | 699.6 | 47.3 | % |\\n| 2014 |\\n| Attritional | $ | 691.3 | 46.8 | % | $ | 2.3 | 0.2 | % | $ | 693.6 | 46.9 | % |\\n| Catastrophes | 6.3 | 0.4 | % | 1.5 | 0.1 | % | 7.8 | 0.5 | % |\\n| Total segment | $ | 697.7 | 47.2 | % | $ | 3.8 | 0.3 | % | $ | 701.5 | 47.5 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | 41.1 | 2.7 | pts | $ | (26.6 | ) | (1.8 | ) | pts | $ | 14.5 | 1.0 | pts |\\n| Catastrophes | (6.1 | ) | (0.4 | ) | pts | (10.3 | ) | (0.7 | ) | pts | (16.3 | ) | (1.1 | ) | pts |\\n| Total segment | $ | 34.9 | 2.3 | pts | $ | (36.9 | ) | (2.5 | ) | pts | $ | (1.9 | ) | (0.2 | ) | pts |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\\n| Gross written premiums | $ | 354.9 | $ | 406.3 | $ | (51.4 | ) | -12.6 | % | $ | 966.1 | $ | 1,181.5 | $ | (215.4 | ) | -18.2 | % |\\n| Net written premiums | 318.5 | 352.6 | (34.1 | ) | -9.7 | % | 896.9 | 977.2 | (80.4 | ) | -8.2 | % |\\n| Premiums earned | $ | 291.4 | $ | 320.0 | $ | (28.6 | ) | -8.9 | % | $ | 935.2 | $ | 958.4 | $ | (23.2 | ) | -2.4 | % |\\n| Incurred losses and LAE | 229.0 | 236.6 | (7.5 | ) | -3.2 | % | 630.8 | 604.2 | 26.6 | 4.4 | % |\\n| Commission and brokerage | 70.9 | 73.1 | (2.2 | ) | -3.1 | % | 226.3 | 215.7 | 10.6 | 4.9 | % |\\n| Other underwriting expenses | 9.1 | 8.8 | 0.4 | 4.2 | % | 25.3 | 24.7 | 0.6 | 2.5 | % |\\n| Underwriting gain (loss) | $ | (17.6 | ) | $ | 1.6 | $ | (19.2 | ) | NM | $ | 52.9 | $ | 113.8 | $ | (61.0 | ) | -53.6 | % |\\n| Point Chg | Point Chg |\\n| Loss ratio | 78.6 | % | 73.9 | % | 4.7 | 67.4 | % | 63.0 | % | 4.4 |\\n| Commission and brokerage ratio | 24.3 | % | 22.9 | % | 1.4 | 24.2 | % | 22.5 | % | 1.7 |\\n| Other underwriting expense ratio | 3.2 | % | 2.7 | % | 0.5 | 2.7 | % | 2.6 | % | 0.1 |\\n| Combined ratio | 106.1 | % | 99.5 | % | 6.6 | 94.3 | % | 88.1 | % | 6.2 |\\n| (NM, not meaningful) |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional | $ | 195.5 | 67.1 | % | $ | 0.4 | 0.1 | % | $ | 195.9 | 67.2 | % |\\n| Catastrophes | 34.4 | 11.8 | % | (1.3 | ) | -0.4 | % | 33.1 | 11.4 | % |\\n| Total segment | $ | 229.9 | 78.9 | % | $ | (0.9 | ) | -0.3 | % | $ | 229.0 | 78.6 | % |\\n| 2014 |\\n| Attritional | $ | 213.0 | 66.5 | % | $ | (4.6 | ) | -1.4 | % | $ | 208.4 | 65.1 | % |\\n| Catastrophes | 29.3 | 9.2 | % | (1.2 | ) | -0.4 | % | 28.1 | 8.8 | % |\\n| Total segment | $ | 242.3 | 75.7 | % | $ | (5.8 | ) | -1.8 | % | $ | 236.6 | 73.9 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | (17.5 | ) | 0.6 | pts | $ | 5.0 | 1.5 | pts | $ | (12.5 | ) | 2.1 | pts |\\n| Catastrophes | 5.1 | 2.6 | pts | (0.1 | ) | - | pts | 5.0 | 2.6 | pts |\\n| Total segment | $ | (12.4 | ) | 3.2 | pts | $ | 4.9 | 1.5 | pts | $ | (7.5 | ) | 4.7 | pts |\\n| Nine Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional | $ | 565.2 | 60.4 | % | $ | (2.7 | ) | -0.3 | % | $ | 562.5 | 60.1 | % |\\n| Catastrophes | 71.3 | 7.6 | % | (3.1 | ) | -0.3 | % | 68.2 | 7.3 | % |\\n| Total segment | $ | 636.6 | 68.0 | % | $ | (5.8 | ) | -0.6 | % | $ | 630.8 | 67.4 | % |\\n| 2014 |\\n| Attritional | $ | 548.2 | 57.1 | % | $ | (4.7 | ) | -0.5 | % | $ | 543.5 | 56.6 | % |\\n| Catastrophes | 63.9 | 6.7 | % | (3.3 | ) | -0.3 | % | 60.6 | 6.4 | % |\\n| Total segment | $ | 612.1 | 63.8 | % | $ | (8.0 | ) | -0.8 | % | $ | 604.2 | 63.0 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | 17.0 | 3.3 | pts | $ | 2.0 | 0.2 | pts | $ | 19.0 | 3.5 | pts |\\n| Catastrophes | 7.4 | 0.9 | pts | 0.2 | - | pts | 7.6 | 0.9 | pts |\\n| Total segment | $ | 24.5 | 4.2 | pts | $ | 2.2 | 0.2 | pts | $ | 26.6 | 4.4 | pts |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\\n| Gross written premiums | $ | 267.0 | $ | 205.3 | $ | 61.7 | 30.0 | % | $ | 605.4 | $ | 573.8 | $ | 31.6 | 5.5 | % |\\n| Net written premiums | 251.7 | 189.4 | 62.2 | 32.8 | % | 557.5 | 548.2 | 9.2 | 1.7 | % |\\n| Premiums earned | $ | 222.2 | $ | 181.8 | $ | 40.5 | 22.3 | % | $ | 616.2 | $ | 546.7 | $ | 69.5 | 12.7 | % |\\n| Incurred losses and LAE | 154.3 | 109.0 | 45.4 | 41.6 | % | 372.6 | 310.6 | 62.0 | 20.0 | % |\\n| Commission and brokerage | 53.0 | 48.4 | 4.6 | 9.4 | % | 151.4 | 141.0 | 10.4 | 7.4 | % |\\n| Other underwriting expenses | 9.5 | 9.4 | 0.1 | 1.0 | % | 27.0 | 25.8 | 1.2 | 4.8 | % |\\n| Underwriting gain (loss) | $ | 5.5 | $ | 15.0 | $ | (9.5 | ) | -63.5 | % | $ | 65.3 | $ | 69.3 | $ | (4.1 | ) | -5.9 | % |\\n| Point Chg | Point Chg |\\n| Loss ratio | 69.4 | % | 59.9 | % | 9.5 | 60.5 | % | 56.8 | % | 3.7 |\\n| Commission and brokerage ratio | 23.8 | % | 26.6 | % | (2.8 | ) | 24.6 | % | 25.8 | % | (1.2 | ) |\\n| Other underwriting expense ratio | 4.3 | % | 5.2 | % | (0.9 | ) | 4.3 | % | 4.7 | % | (0.4 | ) |\\n| Combined ratio | 97.5 | % | 91.7 | % | 5.8 | 89.4 | % | 87.3 | % | 2.1 |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional | $ | 153.4 | 69.0 | % | $ | - | 0.0 | % | $ | 153.4 | 69.0 | % |\\n| Catastrophes | - | 0.0 | % | 0.9 | 0.4 | % | 0.9 | 0.4 | % |\\n| Total segment | $ | 153.4 | 69.0 | % | $ | 0.9 | 0.4 | % | $ | 154.3 | 69.4 | % |\\n| 2014 |\\n| Attritional | $ | 108.8 | 59.8 | % | $ | - | 0.0 | % | $ | 108.8 | 59.8 | % |\\n| Catastrophes | - | 0.0 | % | 0.2 | 0.1 | % | 0.2 | 0.1 | % |\\n| Total segment | $ | 108.8 | 59.8 | % | $ | 0.2 | 0.1 | % | $ | 109.0 | 59.9 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | 44.6 | 9.2 | pts | $ | - | - | pts | $ | 44.6 | 9.2 | pts |\\n| Catastrophes | - | - | pts | 0.7 | 0.3 | pts | 0.7 | 0.3 | pts |\\n| Total segment | $ | 44.6 | 9.2 | pts | $ | 0.7 | 0.3 | pts | $ | 45.4 | 9.5 | pts |\\n| Nine Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional | $ | 376.5 | 61.1 | % | $ | (5.2 | ) | -0.8 | % | $ | 371.3 | 60.3 | % |\\n| Catastrophes | - | 0.0 | % | 1.3 | 0.2 | % | 1.3 | 0.2 | % |\\n| Total segment | $ | 376.5 | 61.1 | % | $ | (3.9 | ) | -0.6 | % | $ | 372.6 | 60.5 | % |\\n| 2014 |\\n| Attritional | $ | 313.7 | 57.4 | % | $ | (5.0 | ) | -0.9 | % | $ | 308.7 | 56.5 | % |\\n| Catastrophes | - | 0.0 | % | 1.9 | 0.3 | % | 1.9 | 0.3 | % |\\n| Total segment | $ | 313.7 | 57.4 | % | $ | (3.1 | ) | -0.6 | % | $ | 310.6 | 56.8 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | 62.8 | 3.7 | pts | $ | (0.2 | ) | 0.1 | pts | $ | 62.6 | 3.8 | pts |\\n| Catastrophes | - | - | pts | (0.6 | ) | (0.1 | ) | pts | (0.6 | ) | (0.1 | ) | pts |\\n| Total segment | $ | 62.8 | 3.7 | pts | $ | (0.8 | ) | - | pts | $ | 62.0 | 3.7 | pts |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\\n| Gross written premiums | $ | 489.1 | $ | 364.1 | $ | 125.0 | 34.3 | % | $ | 1,173.0 | $ | 911.2 | $ | 261.8 | 28.7 | % |\\n| Net written premiums | 419.0 | 310.7 | 108.3 | 34.8 | % | 1,022.4 | 802.4 | 220.0 | 27.4 | % |\\n| Premiums earned | $ | 360.7 | $ | 290.5 | $ | 70.2 | 24.2 | % | $ | 888.7 | $ | 742.0 | $ | 146.7 | 19.8 | % |\\n| Incurred losses and LAE | 262.3 | 239.8 | 22.5 | 9.4 | % | 662.1 | 557.0 | 105.0 | 18.9 | % |\\n| Commission and brokerage | 50.3 | 40.4 | 9.9 | 24.4 | % | 127.1 | 114.5 | 12.6 | 11.0 | % |\\n| Other underwriting expenses | 35.7 | 31.3 | 4.4 | 13.9 | % | 99.2 | 83.7 | 15.6 | 18.6 | % |\\n| Underwriting gain (loss) | $ | 12.5 | $ | (21.0 | ) | $ | 33.5 | -159.3 | % | $ | 0.3 | $ | (13.2 | ) | $ | 13.5 | -102.3 | % |\\n| Point Chg | Point Chg |\\n| Loss ratio | 72.7 | % | 82.5 | % | (9.8 | ) | 74.5 | % | 75.1 | % | (0.6 | ) |\\n| Commission and brokerage ratio | 13.9 | % | 13.9 | % | - | 14.3 | % | 15.4 | % | (1.1 | ) |\\n| Other underwriting expense ratio | 9.9 | % | 10.8 | % | (0.9 | ) | 11.2 | % | 11.3 | % | (0.1 | ) |\\n| Combined ratio | 96.5 | % | 107.2 | % | (10.7 | ) | 100.0 | % | 101.8 | % | (1.8 | ) |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional | $ | 262.9 | 72.9 | % | $ | (0.9 | ) | -0.3 | % | $ | 262.1 | 72.6 | % |\\n| Catastrophes | - | 0.0 | % | 0.2 | 0.1 | % | 0.2 | 0.1 | % |\\n| Total segment | $ | 262.9 | 72.9 | % | $ | (0.6 | ) | -0.2 | % | $ | 262.3 | 72.7 | % |\\n| 2014 |\\n| Attritional | $ | 236.1 | 81.2 | % | $ | 3.7 | 1.3 | % | $ | 239.8 | 82.5 | % |\\n| Catastrophes | - | 0.0 | % | - | 0.0 | % | - | 0.0 | % |\\n| Total segment | $ | 236.1 | 81.2 | % | $ | 3.7 | 1.3 | % | $ | 239.8 | 82.5 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | 26.8 | (8.3 | ) | pts | $ | (4.6 | ) | (1.6 | ) | pts | $ | 22.3 | (9.9 | ) | pts |\\n| Catastrophes | - | - | pts | 0.2 | 0.1 | pts | 0.2 | 0.1 | pts |\\n| Total segment | $ | 26.8 | (8.3 | ) | pts | $ | (4.3 | ) | (1.5 | ) | pts | $ | 22.5 | (9.8 | ) | pts |\\n| Nine Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional | $ | 630.5 | 70.9 | % | $ | 31.5 | 3.6 | % | $ | 662.0 | 74.5 | % |\\n| Catastrophes | - | 0.0 | % | 0.1 | 0.0 | % | 0.1 | 0.0 | % |\\n| Total segment | $ | 630.5 | 70.9 | % | $ | 31.6 | 3.6 | % | $ | 662.1 | 74.5 | % |\\n| 2014 |\\n| Attritional | $ | 552.5 | 74.5 | % | $ | 4.5 | 0.6 | % | $ | 557.0 | 75.1 | % |\\n| Catastrophes | - | 0.0 | % | 0.1 | 0.0 | % | 0.1 | 0.0 | % |\\n| Total segment | $ | 552.5 | 74.5 | % | $ | 4.6 | 0.6 | % | $ | 557.0 | 75.1 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | 78.0 | (3.6 | ) | pts | $ | 27.0 | 3.0 | pts | $ | 105.0 | (0.6 | ) | pts |\\n| Catastrophes | - | - | pts | - | - | pts | - | - | pts |\\n| Total segment | $ | 78.0 | (3.6 | ) | pts | $ | 27.0 | 3.0 | pts | $ | 105.0 | (0.6 | ) | pts |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\\n| Gross written premiums | $ | 72.2 | $ | 50.3 | $ | 21.9 | 43.4 | % | $ | 183.7 | $ | 109.2 | $ | 74.5 | 68.3 | % |\\n| Net written premiums | 60.9 | 49.8 | 11.1 | 22.4 | % | 153.3 | 98.7 | 54.6 | 55.4 | % |\\n| Premiums earned | $ | 50.8 | $ | 38.2 | $ | 12.6 | 32.9 | % | $ | 132.5 | $ | 81.4 | $ | 51.1 | 62.8 | % |\\n| Incurred losses and LAE | 16.5 | 3.4 | 13.1 | NM | 36.3 | 19.6 | 16.7 | 85.3 | % |\\n| Commission and brokerage | 4.9 | 5.1 | (0.2 | ) | -4.9 | % | 13.3 | 9.8 | 3.5 | 35.7 | % |\\n| Other underwriting expenses | 2.7 | 1.6 | 1.1 | 71.6 | % | 6.7 | 5.0 | 1.7 | 34.5 | % |\\n| Underwriting gain (loss) | $ | 26.7 | $ | 28.1 | $ | (1.4 | ) | -4.9 | % | $ | 76.3 | $ | 47.1 | $ | 29.2 | 62.0 | % |\\n| Point Chg | Point Chg |\\n| Loss ratio | 32.5 | % | 8.9 | % | 23.6 | 27.4 | % | 24.0 | % | 3.4 |\\n| Commission and brokerage ratio | 9.6 | % | 13.4 | % | (3.8 | ) | 10.1 | % | 12.1 | % | (2.0 | ) |\\n| Other underwriting expense ratio | 5.2 | % | 4.1 | % | 1.1 | 5.0 | % | 6.1 | % | (1.1 | ) |\\n| Combined ratio | 47.3 | % | 26.4 | % | 20.9 | 42.5 | % | 42.2 | % | 0.3 |\\n| (NM, not meaningful) |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional | $ | 10.7 | 21.1 | % | $ | - | 0.0 | % | $ | 10.7 | 21.1 | % |\\n| Catastrophes | 5.4 | 10.5 | % | 0.4 | 0.9 | % | 5.8 | 11.4 | % |\\n| Total segment | $ | 16.1 | 31.6 | % | $ | 0.4 | 0.9 | % | $ | 16.5 | 32.5 | % |\\n| 2014 |\\n| Attritional | $ | 2.7 | 7.2 | % | $ | - | 0.0 | % | $ | 2.7 | 7.2 | % |\\n| Catastrophes | 0.7 | 1.7 | % | - | 0.0 | % | 0.7 | 1.7 | % |\\n| Total segment | $ | 3.4 | 8.9 | % | $ | - | 0.0 | % | $ | 3.4 | 8.9 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | 8.0 | 13.9 | pts | $ | - | - | pts | $ | 8.0 | 13.9 | pts |\\n| Catastrophes | 4.7 | 8.8 | pts | 0.4 | 0.9 | pts | 5.1 | 9.7 | pts |\\n| Total segment | $ | 12.7 | 22.7 | pts | $ | 0.4 | 0.9 | pts | $ | 13.1 | 23.6 | pts |\\n| Nine Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional | $ | 27.4 | 20.7 | % | $ | - | 0.0 | % | $ | 27.4 | 20.7 | % |\\n| Catastrophes | 8.4 | 6.4 | % | 0.4 | 0.3 | % | 8.8 | 6.7 | % |\\n| Total segment | $ | 35.8 | 27.1 | % | $ | 0.4 | 0.3 | % | $ | 36.3 | 27.4 | % |\\n| 2014 |\\n| Attritional | $ | 15.0 | 18.4 | % | $ | - | 0.0 | % | $ | 15.0 | 18.4 | % |\\n| Catastrophes | 4.7 | 5.8 | % | (0.2 | ) | -0.2 | % | 4.5 | 5.6 | % |\\n| Total segment | $ | 19.8 | 24.2 | % | $ | (0.2 | ) | -0.2 | % | $ | 19.6 | 24.0 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | 12.4 | 2.3 | pts | $ | - | - | pts | $ | 12.4 | 2.3 | pts |\\n| Catastrophes | 3.7 | 0.6 | pts | 0.6 | 0.5 | pts | 4.3 | 1.1 | pts |\\n| Total segment | $ | 16.0 | 2.9 | pts | $ | 0.6 | 0.5 | pts | $ | 16.7 | 3.4 | pts |\\n| (Some amounts may not reconcile due to rounding.) |\\n| (Dollars in millions) | At September 30, 2015 | At December 31, 2014 |\\n| Fixed maturities, market value | $ | 13,491.0 | 76.4 | % | $ | 13,101.1 | 75.1 | % |\\n| Fixed maturities, fair value | - | 0.0 | % | 1.5 | 0.0 | % |\\n| Equity securities, market value | 113.0 | 0.6 | % | 140.2 | 0.8 | % |\\n| Equity securities, fair value | 1,357.3 | 7.7 | % | 1,447.8 | 8.3 | % |\\n| Short-term investments | 1,615.0 | 9.2 | % | 1,705.9 | 9.8 | % |\\n| Other invested assets | 669.7 | 3.8 | % | 601.9 | 3.5 | % |\\n| Cash | 401.2 | 2.3 | % | 437.5 | 2.5 | % |\\n| Total investments and cash | $ | 17,647.2 | 100.0 | % | $ | 17,435.9 | 100.0 | % |\\n| (Some amounts may not reconcile due to rounding.) |\\n| At | At |\\n| September 30, 2015 | December 31, 2014 |\\n| Fixed income portfolio duration (years) | 3.0 | 2.9 |\\n| Fixed income composite credit quality | A1 | A1 |\\n| Imbedded end of period yield, pre-tax | 3.0% | 3.0% |\\n| Imbedded end of period yield, after-tax | 2.5% | 2.6% |\\n| Nine Months Ended | Twelve Months Ended |\\n| September 30, 2015 | December 31, 2014 |\\n| Fixed income portfolio total return | 1.4% | 3.5% |\\n| Barclay's Capital - U.S. aggregate index | 1.1% | 6.0% |\\n| Common equity portfolio total return | -5.0% | 10.4% |\\n| S&P 500 index | -5.3% | 13.7% |\\n| Other invested asset portfolio total return | 4.1% | 11.8% |\\n| At September 30, 2015 |\\n| Case | IBNR | Total | % of |\\n| (Dollars in millions) | Reserves | Reserves | Reserves | Total |\\n| U.S. Reinsurance | $ | 1,290.2 | $ | 2,013.9 | $ | 3,304.1 | 33.2 | % |\\n| International | 775.7 | 1,069.5 | 1,845.3 | 18.5 | % |\\n| Bermuda | 862.4 | 1,225.5 | 2,087.8 | 20.9 | % |\\n| Insurance | 1,001.0 | 1,249.8 | 2,250.8 | 22.6 | % |\\n| Mt. Logan Re | 18.4 | 38.7 | 57.1 | 0.6 | % |\\n| Total excluding A&E | 3,947.7 | 5,597.4 | 9,545.1 | 95.8 | % |\\n| A&E | 236.1 | 184.8 | 420.9 | 4.2 | % |\\n| Total including A&E | $ | 4,183.8 | $ | 5,782.2 | $ | 9,966.0 | 100.0 | % |\\n| (Some amounts may not reconcile due to rounding.) |\\n| At December 31, 2014 |\\n| Case | IBNR | Total | % of |\\n| (Dollars in millions) | Reserves | Reserves | Reserves | Total |\\n| U.S. Reinsurance | $ | 1,409.5 | $ | 1,925.4 | $ | 3,334.9 | 34.3 | % |\\n| International | 902.5 | 868.6 | 1,771.0 | 18.2 | % |\\n| Bermuda | 783.9 | 1,108.2 | 1,892.0 | 19.5 | % |\\n| Insurance | 968.3 | 1,250.4 | 2,218.6 | 22.8 | % |\\n| Mt. Logan Re | 13.0 | 15.0 | 28.0 | 0.3 | % |\\n| Total excluding A&E | 4,077.1 | 5,167.5 | 9,244.6 | 95.1 | % |\\n| A&E | 251.1 | 225.1 | 476.2 | 4.9 | % |\\n| Total including A&E | $ | 4,328.2 | $ | 5,392.6 | $ | 9,720.8 | 100.0 | % |\\n| (Some amounts may not reconcile due to rounding.) |\\n| At | At |\\n| September 30, | December 31, |\\n| (Dollars in millions) | 2015 | 2014 |\\n| Gross reserves | $ | 420.9 | $ | 476.2 |\\n| Reinsurance receivable | (113.2 | ) | (18.0 | ) |\\n| Net reserves | $ | 307.6 | $ | 458.2 |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Bermuda Re (1) | Everest Re (2) |\\n| At December 31, | At December 31, |\\n| (Dollars in millions) | 2014 | 2013 | 2014 | 2013 |\\n| Regulatory targeted capital | $ | 2,050.0 | $ | 2,154.6 | $ | 1,209.6 | $ | 1,094.6 |\\n| Actual capital | $ | 2,748.0 | $ | 2,712.2 | $ | 2,893.0 | $ | 2,814.3 |\\n| Impact of Interest Rate Shift in Basis Points |\\n| At September 30, 2015 |\\n| -200 | -100 | 0 | 100 | 200 |\\n| (Dollars in millions) |\\n| Total Market/Fair Value | $ | 15,883.0 | $ | 15,507.1 | $ | 15,106.0 | $ | 14,677.4 | $ | 14,235.5 |\\n| Market/Fair Value Change from Base (%) | 5.1 | % | 2.7 | % | 0.0 | % | -2.8 | % | -5.8 | % |\\n| Change in Unrealized Appreciation |\\n| After-tax from Base ($) | $ | 657.8 | $ | 340.0 | $ | - | $ | (364.4 | ) | $ | (740.2 | ) |\\n| Impact of Percentage Change in Equity Fair/Market Values |\\n| At September 30, 2015 |\\n| (Dollars in millions) | -20% | -10% | 0% | 10% | 20% |\\n| Fair/Market Value of the Equity Portfolio | $ | 1,176.2 | $ | 1,323.3 | $ | 1,470.3 | $ | 1,617.3 | $ | 1,764.4 |\\n| After-tax Change in Fair/Market Value | $ | (201.7 | ) | $ | (100.9 | ) | $ | - | $ | 100.9 | $ | 201.7 |\\n\\nITEM 3.\\nQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nMarket Risk Instruments. See \\\"Liquidity and Capital Resources - Market Sensitive Instruments\\\" in PART I – ITEM 2.\\n57\\nITEM 4.\\nCONTROLS AND PROCEDURES\\nAs of the end of the period covered by this report, our management carried out an evaluation, with the participation of the Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the \\\"Exchange Act\\\")). Based on their evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission's rules and forms. Our management, with the participation of the Chief Executive Officer and Chief Financial Officer, also conducted an evaluation of our internal control over financial reporting to determine whether any changes occurred during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Based on that evaluation, there has been no such change during the quarter covered by this report.\\nPART II\\n\\nITEM 1.\\nLEGAL PROCEEDINGS\\nIn the ordinary course of business, the Company is involved in lawsuits, arbitrations and other formal and informal dispute resolution procedures, the outcomes of which will determine the Company's rights and obligations under insurance and reinsurance agreements. In some disputes, the Company seeks to enforce its rights under an agreement or to collect funds owing to it. In other matters, the Company is resisting attempts by others to collect funds or enforce alleged rights. These disputes arise from time to time and are ultimately resolved through both informal and formal means, including negotiated resolution, arbitration and litigation. In all such matters, the Company believes that its positions are legally and commercially reasonable. The Company considers the statuses of these proceedings when determining its reserves for unpaid loss and loss adjustment expenses.\\nAside from litigation and arbitrations related to these insurance and reinsurance agreements, the Company is not a party to any other material litigation or arbitration.\\n\\nITEM 1A.\\nRISK FACTORS\\nNo material changes.\\n58\\nITEM 2.\\nUNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\\nIssuer Purchases of Equity Securities.\\n| Issuer Purchases of Equity Securities |\\n| (a) | (b) | (c) | (d) |\\n| Maximum Number (or |\\n| Total Number of | Approximate Dollar |\\n| Shares (or Units) | Value) of Shares (or |\\n| Purchased as Part | Units) that May Yet |\\n| Total Number of | of Publicly | Be Purchased Under |\\n| Shares (or Units) | Average Price Paid | Announced Plans or | the Plans or |\\n| Period | Purchased | per Share (or Unit) | Programs | Programs (1) |\\n| July 1 - 31, 2015 | 1,756 | $ | 183.2850 | - | 5,631,185 |\\n| August 1 - 31, 2015 | 514,629 | $ | 177.4608 | 514,629 | 5,116,556 |\\n| September 1 - 30, 2015 | 626,078 | $ | 174.4833 | 622,844 | 4,493,712 |\\n| Total | 1,142,463 | $ | - | 1,137,473 | 4,493,712 |\\n\\n(1) On September 21, 2004, the Company's board of directors approved an amended share repurchase program authorizing the Company and/or its subsidiary Holdings to purchase up to an aggregate of 5,000,000 of the Company's common shares through open market transactions, privately negotiated transactions or both. On July 21, 2008; February 24, 2010; February 22, 2012; May 15, 2013; and November 19, 2014, the Company's executive committee of the Board of Directors has approved subsequent amendments to the share repurchase program authorizing the Company and/or its subsidiary Holdings, to purchase up to a current aggregate of 30,000,000 of the Company's shares (recognizing that the number of shares authorized for repurchase has been reduced by those shares that have already been purchased) in open market transactions, privately negotiated transactions or both.\\n\\nITEM 3.\\nDEFAULTS UPON SENIOR SECURITIES\\nNone.\\n\\nITEM 4.\\nMINE SAFETY DISCLOSURES\\nNot applicable.\\n\\nITEM 5\\n.\\nOTHER INFORMATION\\nNone.\\n59\\nITEM 6.\\nEXHIBITS\\n\\n| Exhibit Index: |\\n| Exhibit No. | Description |\\n| 31.1 | Section 302 Certification of Dominic J. Addesso |\\n| 31.2 | Section 302 Certification of Craig Howie |\\n| 32.1 | Section 906 Certification of Dominic J. Addesso and Craig Howie |\\n| 101.INS | XBRL Instance Document |\\n| 101.SCH | XBRL Taxonomy Extension Schema |\\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase |\\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase |\\n| 101.LAB | XBRL Taxonomy Extension Labels Linkbase |\\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase |\\n\\n60\\nEverest Re Group, Ltd.\\nSignatures\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n| Everest Re Group, Ltd. |\\n| (Registrant) |\\n| /S/ CRAIG HOWIE |\\n| Craig Howie |\\n| Executive Vice President and |\\n| Chief Financial Officer |\\n| (Duly Authorized Officer and Principal Financial Officer) |\\n\\n\\n \\n\\nWhat is the percent change in the total outstanding amount of the Citibank Bilateral Letter of Credit Agreement from September 30, 2015 to December 31, 2014?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is -15.72.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 34,\n \"input_length\": 49245\n}"}}},{"rowIdx":35,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nITEM 1. BUSINESS\nOverview\nHambrecht Asia Acquisition Corp. (“we”, “us”, “our” or the “Company”) is a Cayman Islands blank check company formed on July 18, 2007 to complete a business combination with one or more operating businesses that have its or their primary operations in the PRC. Our efforts in identifying a prospective target business will not be limited to a particular industry. We intend to effect a business combination using cash from the proceeds of our initial public offering and the private placements of the sponsors’ warrants, our capital stock, debt or a combination of cash, stock and debt. On March 7, 2008, we completed a private placement of 1,550,000 warrants (“Founder Warrants”). On March 12, 2008, we consummated our initial public offering of 4,000,000 units. On March 31, 2008, the underwriters of our initial public offering exercised their over-allotment option for a total of an additional 239,300 units (over and above the 4,000,000 units sold in the initial public offering) for an aggregate offering of 4,239,300 units (together the “IPO”). Each unit consists of one share of common stock and one redeemable common stock purchase warrant, resulting in a total of 4,239,300 common shares (“IPO Shares”) and 4,239,300 warrants (“IPO Warrants”) which are publicly held. The units were sold at an offering price of $8.00 per unit and the Founder Warrants we sold at an offering price of $1.00 per warrant, generating total gross proceeds of $35,464,400. Broadband Capital Management LLC acted as lead underwriter.\nThe net proceeds from the IPO and private placement, after deducting certain offering expenses of approximately $2,784,873 (including underwriting discounts of approximately $2,374,008), were approximately $32,679,527. Approximately $33,527,396 (or approximately $7.91 per IPO Share) of the proceeds from the IPO and the private placement was placed in a trust account for our benefit, which includes $1,187,004 of the underwriter’s compensation which will be paid to them only in the event of a business combination. The remaining $339,135 was not placed in the trust account. We will not be able to access the amounts held in the trust account until we consummate a business combination, except for up to $700,000 (plus up to an additional $350,000 if approved by our shareholders in connection with the extension of the period in which we must complete our initial business combination to March 12, 2011) in interest earned on the funds in the trust account, which may be released from the trust to us to be used for working capital. As of June 30, 2009, there was approximately $33,799,000 held in the trust account (or approximately $7.92 per IPO Share), and approximtely $286,000 of interest eanred on the trust account balance had been released to us for working capital purposes.\nInvestment Opportunities in China\nOpportunities for market expansion have emerged for businesses with operations in China due to certain changes in the PRC’s political, economic and social policies as well as certain fundamental changes affecting the PRC and his neighboring countries. We believe that China represents both a favorable environment for making acquisitions and an attractive operating environment for a target business for several reasons, including:\n\n| § | prolonged economic expansion within China, including gross domestic product growth of approximately 16.5% on average over the last 25 years, including 17.7% in 2004, 15.0% in 2005 and 14.7% in 2006 (National Bureau of Statistics of China) (China Statistical Yearbook – 2007, http://www.stats.gov.cn/tjsj/ndsj/2007/indexeh.htm, viewed February 24, 2009); |\n\n\n| § | increased government focus within China on privatizing assets, improving foreign trade and encouraging business and economic activity; |\n\n\n| § | the recent entry of China into the World Trade Organization, the sole global international organization dealing with the rules of trade between nations, which may lead to a reduction on tariffs for industrial products, a reduction in trade restrictions and an increase in trading with the United States. |\n\nWe believe that these factors and others should enable us to acquire a target business with growth potential on favorable terms.\n3\nEffecting a Business Combination\nWe intend to utilize the cash proceeds of the IPO and the private placement, our capital securities, debt or a combination of these as the consideration to be paid in a business combination. While substantially all of the net proceeds of the IPO are allocated to completing a business combination, the proceeds are not otherwise designated for more specific purposes. If the business combination is paid for using equity or debt securities, we may apply the cash released to us from the trust account for general corporate purposes, including for maintenance or expansion of operations of the acquired business or businesses, the payment of principal or interest due on indebtedness incurred in consummating our initial business combination, to fund the purchase of other companies, or for working capital. We may engage in a business combination with a company that does not require significant additional capital but is seeking a public trading market for its shares and that wants to merge with an already public company to add the experience of the public company’s management team to its company and to avoid the risk that market conditions will not be favorable for an initial public offering at the time this offering is ready to be sold, despite the fact that merging with us would require similar disclosures and, potentially, a similar timeframe as an initial public offering. We may seek to effect a business combination with more than one target business, although our limited resources may serve as a practical limitation on our ability to do so.\nPrior to consummation of a business combination, we will seek to have all vendors, prospective target businesses or other entities that we may engage, which we refer to as potential contracted parties or a potential contracted party, execute agreements with us waiving any right, title, interest or claim of any kind in or to any monies held in the trust account for the benefit of our public shareholders. There is no assurance that we will be able to get waivers from our vendors and there is no assurance that such waivers will be enforceable by operation of law or that creditors would be prevented from bringing claims against the trust. In the event that a potential contracted party were to refuse to execute such a waiver, we will execute an agreement with that entity only if our management first determines that we would be unable to obtain, on a reasonable basis, substantially similar services or opportunities from another entity willing to execute such a waiver. Examples of instances where we may engage a third party that refused to execute a waiver would be the engagement of a third party consultant whose particular expertise or skills are believed by management to be superior to those of other consultants that would agree to execute a waiver or a situation where management does not believe it would be able to find a provider of required services willing to provide the waiver. If we are unable to complete a business combination and are forced to dissolve and liquidate, each of our pre-initial public offering shareholders other than Stephen N. Cannon, will, by agreement, be personally liable (each in an amount proportional to the number of shares owned as compared to both of them as a group, except that John Wang and Robert Eu will indemnify us for the portion of the indemnification obligation attributable to the portion of our shares owned by Stephen N. Cannon) to ensure that the proceeds in the trust account are not reduced by the claims of prospective target businesses, vendors or other entities that are owed money by us for services rendered or products sold to us. Under these circumstances, our board of directors would have a fiduciary obligation to our shareholders to bring a claim against each of our pre-initial public offering shareholders other than Stephen N. Cannon to enforce their liability obligation.\nSubject to the requirement that a target business or businesses have a fair market value of at least 80% of the balance in the trust account (excluding deferred underwriting discounts and commissions of $1,187,004 and taxes payable) at the time of our initial business combination, we have virtually unrestricted flexibility in identifying and selecting one or more prospective target businesses.\nWe focus on potential target businesses with valuations between $70 million and $150 million. We believe that our available working capital, together with the issuance of additional equity and/or the issuance of debt, would support the acquisition of such a target business. The mix of additional equity and/or debt would depend on many factors. The proposed funding for any such business combination would be disclosed in the proxy statement relating to the required shareholder approval.\nAfter completion of the IPO, we began contacting investment bankers, private equity firms and other business contacts in order to generate ideas about a suitable business combination. We also received unsolicited inquiries from several investment banking firms, private equity firms and other business intermediaries. We informed these contacts that we were seeking an operating business for our initial business combination. We have not retained an investment banking firm or fairness or valuation advisor to conduct a formal search for a business combination. Criteria for suitability included our management’s assessment of the competitive strengths and weaknesses of the potential business targets, the strength of the management team, and the quality of the assets to be acquired.\n4\nWe may pay fees or compensation to third parties for their efforts in introducing us to potential target businesses. We may seek to engage someone to assist in finding a potential target business if our management feels that they need assistance to find a suitable target business. If a finder approaches us on an unsolicited basis, our management would decide whether to work with that finder (and pay a finders’ fee) depending on the potential target business such finder proposes. Such payments are typically, although not always, calculated as a percentage of the dollar value of the transaction. We have not anticipated use of a particular percentage fee, but instead will seek to negotiate the smallest reasonable percentage fee consistent with the attractiveness of the opportunity and the alternatives, if any, that are then available to us. We may make such payments to entities we engage for this purpose or entities that approach us on an unsolicited basis. Payment of finders’ fees is customarily tied to consummation of a transaction and certainly would be tied to a completed transaction in the case of an unsolicited proposal. Although it is possible that we may pay finders’ fees in the case of an uncompleted transaction, we consider this possibility to be extremely remote. In no event will we pay any of our directors or officers or any entity with which they are affiliated any finder’s fee or other compensation for services rendered to us prior to or in connection with the consummation of a business combination. In addition, none of our officers or directors will receive any finder’s fee, consulting fees or any similar fees from any person or entity in connection with any business combination involving us. Following such business combination, however, our officers or directors may receive compensation or fees including compensation approved by the board of directors for customary director’s fees for our directors that remain following such business combination. Our directors have advised us that they will not take an offer regarding their compensation or fees following a business combination into consideration when determining which target businesses to pursue.\nWe anticipate structuring a business combination to acquire 100% of the equity interests or assets of the target business. We may, however, structure a business combination to acquire less than 100% of such interests or assets of the target business but will not acquire less than a controlling interest (which would be greater than 50% of the voting securities of the target business). If we acquire only a controlling interest in a target business or businesses, the portion of such business that we acquire must have a fair market value equal to at least 80% of the amount in the trust account, (excluding deferred underwriting discounts and commissions and taxes payable), as described above. If we determine to simultaneously acquire several businesses and such businesses are owned by different sellers, we will need for each of such sellers to agree that our purchase of his business is contingent on the simultaneous closings of the other acquisitions, which may make it more difficult for us, and delay our ability, to complete the business combination. With multiple acquisitions, we could also face additional risks, including additional burdens and costs with respect to possible multiple negotiations and due diligence investigations (if there are multiple sellers) and the additional risks associated with the subsequent integration of the operations and services or products of the acquired companies in a single operating business.\nIn recent months, there has been severe volatility and overall significant declines in the international capital markets and a freezing of the international credit markets that together have led to severe constraints in private flows of capital and an acutely negative impact on the operating results of companies in a wide range of industries and geographic sectors. Declining valuations of potential target businesses and uncertainty regarding the future may make it more difficult for us to reach agreement on a business combination that satisfies our requirements and the lack of available credit sources may adversely impact our ability to structure a transaction in the most advantageous manner. In addition, certain of our shareholders may experience pressure to vote against any business combination that we may propose in order to liquidate their investment and free up their capital, without regard to the merits of any such transaction.\n5\nGovernment regulations\nGovernment regulations relating to foreign exchange controls\nThe principal regulation governing foreign exchange in China is the Foreign Currency Administration Rules (IPPS), as amended. Under these rules, the Renminbi, China’s currency, is freely convertible for trade and service related foreign exchange transactions (such as normal purchases and sales of goods and services from providers in foreign countries), but not for direct investment, loan or investment in securities outside of China without the prior approval of the State Administration for Foreign Exchange (“SAFE”) of China. Foreign investment enterprises (“FIEs”) are required to apply to the SAFE for “Foreign Exchange Registration Certificates for FIEs.” Following a business combination, involving a change of equity ownership of a PRC operating entity or through contractual arrangements with a PRC operating entity our subsidiary will likely be an FIE as a result of our ownership structure. With such registration certificates, which need to be renewed annually, FIEs are allowed to open foreign currency accounts including a “basic account” and “capital account.” Currency translation within the scope of the “basic account,” such as remittance of foreign currencies for payment of dividends, can be effected without requiring the approval of the SAFE. However, conversion of currency in the “capital account,” including capital items such as direct investment, loans and securities, still require approval of the SAFE. This prior approval may delay or impair our ability to operate following a business combination. On November 21, 2005, the SAFE issued Circular No. 75 on “Relevant Issues Concerning Foreign Exchange Control on Domestic Residents’ Corporate Financing and Roundtrip Investment Through Offshore Special Purpose Vehicles.” Circular No. 75 confirms that the use of offshore special purpose vehicles as holding companies for PRC investments are permitted as long as proper foreign exchange registrations are made with the SAFE.\nGovernment regulations relating to taxation\nPrior to January 1, 2008, the standard enterprise income tax rate was 33%, which consisted of a 30% national income tax and a 3% local surcharge, for a company’s domestic and overseas incomes.\nA new tax law, the PRC Enterprise Income Tax Law (“New EIT Law”), took effect on January 1, 2008. Under the new tax law, companies are subject to a uniform tax rate of 25%. The New EIT Law provides a five-year transition period starting from its effective date for those enterprises which were established before the promulgation date of the new tax law and which were entitled to a preferential lower tax rate under the then-effective tax laws or regulations. The New EIT Law significantly curtails tax incentives granted to foreign-invested enterprises under the previous tax law. The New EIT Law, however, (i) reduces the top rate of EIT from 33% to 25%, (ii) permits companies to continue to enjoy their existing tax incentives, subject to certain transitional phase-out rules, and (iii) introduces new tax incentives, subject to various qualification criteria. The New EIT Law and its implementing rules permit certain “high and new technology enterprises” to enjoy a reduced 15% EIT rate. Under the phase-out rules, enterprises established before the promulgation date of the New EIT Law and which were granted preferential EIT treatment under the then effective tax laws or regulations may continue to enjoy their preferential tax treatments until their expiration and will gradually transition to the uniform 25% EIT rate over a five-year transition period.\nAdditionally, under the New EIT Law, an income tax rate for dividends payable to non-PRC investors and derived from sources within the PRC may be increased to 20%. It is currently unclear in what circumstances a source will be considered as located within the PRC.\nThe new tax law provides only a framework of the enterprise tax provisions, leaving many details on the definitions of numerous terms as well as the interpretation and specific applications of various provisions unclear and unspecified.\nCompetition\nIn identifying, evaluating and selecting a target business for a business combination, we may encounter intense competition from other entities having a business objective similar to ours including other blank check companies, private equity groups and leveraged buyout funds, and operating businesses seeking acquisitions. Many of these entities are well established and have extensive experience identifying and effecting business combinations directly or through affiliates. Moreover, many of these competitors possess greater financial, technical, human and other resources than us. While we believe there are numerous potential target businesses with which we could combine, our ability to acquire larger target businesses will be limited by our available financial resources. This inherent limitation gives others an advantage in pursuing the acquisition of a target business. Furthermore:\n\n| § | our obligation to seek shareholder approval of our initial business combination or obtain necessary financial information may delay the consummation of a transaction; |\n\n6\n| § | our obligation to redeem for cash ordinary shares held by our public shareholders who vote against the business combination and exercise their redemption rights may reduce the resources available to us for a business combination; |\n\n\n| § | our outstanding warrants, and the future dilution they potentially represent, may not be viewed favorably by certain target businesses; and |\n\n\n| § | the requirement to acquire an operating business that has a fair market value equal to at least 80% of the balance of the trust account at the time of the acquisition (excluding deferred underwriting discounts and commissions of $1,187,004 and taxes payable) could require us to acquire the assets of several operating businesses at the same time, all of which sales would be contingent on the closings of the other sales, which could make it more difficult to consummate the business combination. |\n\nAny of these factors may place us at a competitive disadvantage in successfully negotiating a business combination.\nEmployees\nWe currently have three officers. These individuals are not obligated to devote any specific number of hours to our business and intend to devote only as much time as they deem necessary to our business. We intend to hire employees and/or consultants, possibly including certain full time employees and/or consultants, in order to assist us in the search, due diligence for and consummation of a business combination.\nEnforcement of Civil Liabilities\nWe are registered under the laws of the Cayman Islands by way of continuation as an exempted company with limited liability. We are registered in the Cayman Islands because of certain benefits associated with being a Cayman Islands corporation, such as political and economic stability, an effective judicial system, a favorable tax system, the absence of foreign exchange control or currency restrictions and the availability of professional and support services. However, the Cayman Islands has a less developed body of securities laws as compared to the United States and provides protections for investors to a significantly lesser extent. In addition, Cayman Islands companies do not have standing to sue before the federal courts of the United States.\nSubstantially all of our assets are located outside the United States. In addition, a majority of our directors and officers are nationals or residents of jurisdictions other than the United States and all or a substantial portion of their assets are located outside the United States. As a result, it may be difficult for investors to effect service of process within the United States upon us or these persons, or to enforce against us or them judgments obtained in United States courts, including judgments predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States. It may also be difficult for you to enforce in U.S. courts judgments obtained in U.S. courts based on the civil liability provisions of the U.S. federal securities laws against us, our officers and directors.\nWe have not appointed any agent to receive service of process with respect to any action brought against us in the United States District Court for the Southern District of New York under the federal securities laws of the United States or of any state in the United States or any action brought against us in the Supreme Court of the State of New York in the County of New York under the securities laws of the State of New York.\nWe believe that there is uncertainty as to whether the courts of the Cayman Islands or the PRC would, respectively, (1) recognize or enforce judgments of United States courts obtained against us or our directors or officers predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States, or (2) entertain original actions brought in the Cayman Islands or the PRC against us or our directors or officers predicated upon the securities laws of the United States or any state in the United States.\n\nITEM 1A. RISK FACTORS\nAs a smaller reporting company, we are not required to include this information in our transition report on Form 10-K.\n7\nITEM 1B. UNRESOLVED STAFF COMMENTS\nAs a smaller reporting company, we are not required to include this information in our transition report on Form 10-K.\n\nITEM 2. PROPERTIES\nWe currently maintain our executive offices at 13/F Tower 2, New World Tower, 18 Queens Road Central, Hong Kong. The cost for this space is included in the $7,500 per-month fee paid to Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, for office space, administrative services and secretarial support. We believe, based on rents and fees for similar services in Hong Kong, that the fees that will be charged by Hambrecht Eu Capital Management LLC is at least as favorable as we could have obtained from unaffiliated persons.\n\nITEM 3. LEGAL PROCEEDINGS\nThere is no litigation currently pending or threatened against us or any of our directors in their capacity as such.\n\nITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS\nNo matters were submitted to a vote of our shareholders during the quarter ended June 30, 2009.\n8\nPART II\n\nITEM 5. MARKET FOR COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.\nMarket Price Information\nThe shares of our common stock, warrants and units are traded on the OTC Bulletin Board, or OTCBB, under the symbols “HMAQF,” “HMAWF” and “HMAUF,” respectively. Each unit consists of one ordinary share and one warrant. Each warrant entitles the holder to purchase one ordinary share at a price of $5.00 commencing on the later of our consummation of a business combination or one year from the date of the IPO prospectus, provided in each case that there is an effective registration statement covering the ordinary shares underlying the warrants in effect. The warrants will expire five years from the date of the IPO, unless earlier redeemed. Our common stock and warrants commenced to trade separately from April 9, 2008.\nThe following table sets forth, for the calendar quarters indicated, the quarterly high and low bid information prices for our common stock, warrants and units as reported on the OTCBB, such over the counter market quotation reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.\n\n| Units | Ordinary Shares | Warrants |\n| High | Low | High | Low | High | Low |\n| Third Quarter of 2009 | $ | 7.65 | $ | 7.52 | $ | 7.98 | $ | 7.58 | $ | 0.16 | $ | 0.11 |\n| Second Quarter of 2009 | $ | 7.25 | $ | 7.25 | $ | 7.65 | $ | 7.35 | $ | 0.55 | $ | 0.05 |\n| First Quarter of 2009 | $ | 7.90 | $ | 7.00 | $ | 7.49 | $ | 7.10 | $ | 0.20 | $ | 0.05 |\n| Fourth Quarter of 2008 | $ | 7.15 | $ | 6.50 | $ | 7.00 | $ | 6.21 | $ | 0.42 | $ | 0.13 |\n| Third Quarter of 2008 | $ | 7.90 | $ | 7.60 | $ | 7.37 | $ | 6.85 | $ | 0.73 | $ | 0.50 |\n| Second Quarter of 2008 | $ | 7.90 | $ | 7.60 | $ | 7.16 | $ | 6.95 | $ | 0.85 | $ | 0.60 |\n| First Quarter of 2008 | $ | 8.15 | $ | 7.85 | - | - | - | - |\n\nNumber of Holders of Common Stock.\nThe number of holders of record of our Common Stock on January 21, 2010 was 10, which does not include beneficial owners of our securities.\nDividends.\nThere were no cash dividends or other cash distributions made by us during the fiscal year ended June 30, 2009. Future dividend policy will be determined by our Board of Directors based on our earnings, financial condition, capital requirements and other then existing conditions. It is anticipated that cash dividends will not be paid to the holders of our common stock in the foreseeable future.\n9\nRecent Sales of Unregistered Securities.\nOn July 18, 2007, John Wang, Robert J. Eu and Stephen N. Cannon purchased an aggregate of 1,150,000 of our ordinary shares (which includs 90,174 ordinary shares that were subsequently redeemed because the underwriters did not fully exercise their over-allotment option) for an aggregate purchase price of $25,000. Mr. Cannon subsequently transferred all of the shares he purchased to the Cannon Family Irrevocable Trust, of which Mr. Cannon is the sole trustee. Such shares were issued in connection with our organization pursuant to the exemption from registration contained in Section 4(2) of the Securities Act as they were sold in transactions not involving a public offering to a limited number of sophisticated, wealthy individuals. No underwriting commissions or offering discounts were paid with respect to such sales.\nOn February 21, 2008, John Wang, Robert Eu and the Cannon Family Irrevocable Trust transferred an aggregate of 463,334 shares to W.R. Hambrecht + Co., LLC, Shea Ventures LLC, Marbella Capital Partners Ltd., AEX Enterprises Limited and the Hambrecht 1980 Revocable Trust, each of which entities is an accredited investor for an aggregate purchase price of $10,193.35 or $0.022 per share. All such transfers were exempt from registration pursuant to Sections 4(1) and 4(2) of the Securities Act, due to the limited number of individuals involved, their status as accredited investors and transfer restrictions and legends on the share certificates.\nOn March 7, 2008, AEX Enterprises Limited, W.R. Hambrecht + Co., LLC and the Hambrecht 1980 Revocable Trust, companies controlled by Elizabeth B. Hambrecht, wife of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and William R. Hambrecht, Mr. Eu’s father-in-law, Shea Ventures LLC, a company controlled by Edmund H. Shea Jr. and Marbella Capital Partners Ltd., a company controlled by John Wang, our Chief Executive Officer, agreed to invest an aggregate of $1,550,000 in us in the form of private placement warrants to purchase 1,550,000 ordinary shares at a price of $1.00 per warrant. Elizabeth B. Hambrecht owns approximately 25% and William R. Hambrecht controls (through a trust of which he is the trustee) approximately 38% of the voting shares of AEX Enterprises Limited. William Hambrecht is a controlling person of the voting shares of W.R. Hambrecht + Co., LLC and is the trustee of the Hambrecht 1980 Revocable Trust. The proceeds of the sale of the warrants were placed in the trust account established for our benefit in connection with our IPO.\nOn March 31, 2008, following the partial exercise of the over-allotment option by the underwriters of the IPO, we cancelled an aggregate of 90,174 ordinary shares held by Robert J. Eu, Cannon Family Irrevocable Trust and WR Hambrecht + Co., LLC.\nOn December 21, 2008, AEX Enterprises Limited transferred an aggregate of 441,666 warrants to AEX Capital, LLC, for no consideration. Such transfer was exempt from registration pursuant to Sections 4(1) and 4(2) of the Securities Act, due to the limited number of individuals involved, their status as accredited investors and transfer restrictions and legends on the share certificates.\nIn each of the foregoing sales of securities the purchasers were our officers and directors or affiliates of our officers and directors and therefore had access to all relevant information about us when choosing to invest in our securities. As of January 21, 2010, these securities were held by the persons or entities as set forth in the following table:\n| Name | Ordinary Shares | Warrants |\n| John Wang | 230,000 | 0 |\n| W.R. Hambrecht + Co., LLC(1) | 178,275 | 25,000 |\n| Cannon Family Irrevocable Trust (2) | 173,275 | 0 |\n| Robert J. Eu | 173,275 | 0 |\n| AEX Enterprises Limited(3) | 88,333 | 0 |\n| Hambrecht 1980 Revocable Trust(4) | 88,333 | 441,667 |\n| Shea Ventures LLC(5) | 88,333 | 441,667 |\n| Marbella Capital Partners Ltd.(6) | 40,000 | 200,000 |\n| AEX Capital, LLC(7) | 0 | 441,666 |\n| Total: | 1,059,824 | 1,550,000 |\n\n10\n\n| (1) | William R. Hambrecht is the controlling person of W.R. Hambrecht + Co., LLC. |\n\n| (2) | Mr. Cannon is the sole Trustee of Cannon Family Irrevocable Trust. |\n\n| (3) | Elizabeth B. Hambrecht, Robert Eu’s wife, and William R. Hambrecht control AEX Enterprises Limited. |\n\n| (4) | William R. Hambrecht is the trustee of the Hambrecht 1980 Revocable Trust. |\n\n| (5) | Edmund H. Shea Jr. is the controlling person of Shea Ventures LLC. |\n\n| (6) | John Wang is the controlling person of Marbella Capital Partners Ltd. |\n\n| (7) | Elizabeth B. Hambrecht, Robert Eu’s wife, and Robert J. Eu control AEX Capital, LLC. |\n\nRepurchases of Equity Securities.\nNone.\nUse of Proceeds\nOn March 7, 2008, we completed a private placement of 1,550,000 warrants. On March 12, 2008, we consummated our initial public offering of 4,000,000 units. On March 31, 2008, the underwriters of our initial public offering exercised their over-allotment option for a total of an additional 239,300 units (over and above the 4,000,000 units sold in the initial public offering) for an aggregate offering of 4,239,300 units. Each unit consists of one share of common stock and one redeemable common stock purchase warrant. Each warrant entitles the holder to purchase from us one share of our common stock at an exercise price of $5.00. The units were sold at an offering price of $8.00 per unit and the warrants we sold at an offering price of $1.00 per warrant, generating total gross proceeds of $35,464,400. Broadband Capital Management LLC acted as lead underwriter. The securities sold in our initial public offering were registered under the Securities Act of 1933 on a registration statement on Form S-1 (No. 333-146147). The Securities and Exchange Commission declared the registration statement effective on March 7, 2008.\nWe incurred a total of $2,374,008 in underwriting discounts and commissions, of which $1,187,004 has been placed in the trust account. Such portion of the underwriter’s compensation will only be paid to the underwriters in the event that we consummate a business combination. The total expenses in connection with the sale of our warrants in the private placement and the initial public offering were $2,784,873.\nAfter deducting the underwriting discounts and commissions and the offering expenses, the total net proceeds to us from the private placement and the initial public offering were approximately $32,679,527. Approximately $33,527,396 (or approximately $7.91 per unit sold in our initial public offering) of the proceeds from the initial public offering and the private placement was placed in a Trust Account for our benefit and the remaining proceeds are available to be used to provide for business, legal and accounting due diligence on prospective business combinations and continuing general and administrative expenses. The Trust Account contains $1,187,004 of the underwriter’s compensation which will be paid to them only in the event of a business combination. The amounts held in the trust account may only be used by us upon the consummation of a business combination, except that we may use up to $700,000 (or $1,050,000 if approved by our shareholders) of the interest earned on the trust account to fund our working capital prior to a business combination. As of June 30, 2009, there was $ 33,838,155 held in the trust account, which includes deferred underwriting fees of $1,187,004. Through June 30, 2009, approximately $286,000 of interest earned on the trust account balance has been released to us for working capital purpose.\n\nITEM 6. SELECTED FINANCIAL DATA\nAs a smaller reporting company, we are not required to include this information in our transition report on Form 10-K.\n11\nITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nThe following discussion should be read in conjunction with the financial statements and related notes contained herein and the information included in our other filings with the SEC. This discussion includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements in this Transition Report on Form 10-K other than statements of historical fact are forward-looking statements. These forward-looking statements involve known and unknown risks and uncertainties. Our actual results may differ materially from those projected or assumed in such forward-looking statements. Among the factors that could cause actual results to differ materially are our being a development stage company with no operating history, our dependence on key personnel some of whom may join us following a business combination, our personnel allocating their time to other businesses and potentially having conflicts of interest with our business, our potentially being unable to obtain additional financing to complete a business combination and the ownership of our securities being concentrated. All forward-looking statements included in this document are made as of the date of this report, based on information available to us as of such date. We assume no obligation to update any forward-looking statement.\nOverview\nWe are a blank check company formed under the laws of the Cayman Islands on July 18, 2007. We were formed to acquire one or more operating businesses through a merger, stock exchange, asset acquisition or similar business combination or control through contractual arrangements having its primary operations in the People’s Republic of China, or PRC. We will not seek to acquire a business with its primary operations outside of the PRC.\nThe company has entered into a letter of intent with a company for a business combination. The target is a company with its principal business operations in the People’s Republic of China. Pursuant to the Company’s Amended and Restated Memorandum and Articles of Association, the execution of the letter of intent affords the Company a six-month extension for completion of a business combination, until March 12, 2010 However if we anticipate that we will not be able to consummate a business combination by March 12, 2010, we may seek shareholder approval to extend the period of time to consummate a business combination until March 12, 2011. In order to extend the period of March 12, 2011, (i) public shareholders must approve the extension and (ii) public shareholders owning no more than one share less than 30% of the shares sold in this offering may have exercised their redemption rights.\nResults of Operations for the Six Month Transition Period Ended June 30, 2009\nWe incurred a net loss of $87,677 for the six month period ended June 30, 2009 due to both a decrease in the interest earned on the Trust Account which did not exceed our expenses for the period, and an increase in expenses related to professional services. Until we enter into a business combination, we will not have any operating revenues.\nOverall, for the six month period ended June 30, 2009, we incurred $25,002 of insurance expense from the amortization of our pre-paid D&O insurance policy, $45,000 of rent expense and other operating costs of $114,868.\nFor the six months ended June 30, 2009, our trust account earned interest of $97,193 and our funds outside of the trust account did not earn interest income.\nResults of Operations for the Six Month Period Ended June 30, 2008\nWe had a net gain of $11,449 for the six month period ended June 30, 2008.\nOverall for six month period ended June 30, 2008, we incurred $16,668 of insurance expense from the amortization of our pre-paid D&O insurance policy, $45,000 of rent expense and other operating costs of $95,015.\n12\nFor the six months ended June 30, 2008, our trust account earned interest of $173,106.\nResults of Operations for the Year Ended December 31, 2008\nWe reported net income of $236,505 for the year ended December 31, 2008 due to interest earned on the trust account. Until we enter into a business combination, we will not have any operating revenues.\nFor the year ended December 31, 2008, we incurred $37,503 of insurance expense from the amortization of our pre-paid D&O insurance policy, $97,500 of rent, administrative services and secretary support expense and other operating costs of $132,384.\nFor the year ended December 31, 2008, our trust account earned gross interest of $510,361. $239,110 of this interest was withdrawn from the trust account to fund working capital and $271,251 remained in the trust account.\nResults of Operations for the Year Ended December 31, 2007\nWe reported a net loss of $21,736 for the year ended December 31, 2007 due to start-up expenses. Until we enter into a business combination, we will not have any operating revenues.\nFor the year ended December 31, 2007, we incurred $15,000 of rent as well as formation and administrative costs of $6,736.\nFor the year ended December 31, 2007, we did not earn any interest from our trust account.\nLiquidity and Capital Resources\nOn March 7, 2008, we completed a private placement of 1,550,000 warrants to AEX Enterprises Limited, a company controlled by Elizabeth B. Hambrecht, wife of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and William R. Hambrecht, Robert Eu’s father-in-law, W.R. Hambrecht + Co., LLC and the Hambrecht 1980 Revocable Trust, each an entity controlled by William Hambrecht, Shea Ventures LLC, a company controlled by Edmund H. Shea Jr., and Marbella Capital Partners Ltd., a company owned by John Wang, our Chief Executive Officer, and received net proceeds of $1,550,000. On March 12, 2008, we consummated our initial public offering of 4,000,000 units. On March 31, 2008, the underwriters of our initial public offering exercised a portion of their over-allotment option, for a total of an additional 239,300 units (over and above the 4,000,000 units sold in the initial public offering) for an aggregate offering of 4,239,300 units (collectively the “IPO”). Each unit in the public offering consisted of one share of common stock and one redeemable common stock purchase warrant. Each warrant entitles the holder to purchase from us one share of our common stock at an exercise price of $5.00. Our common stock and warrants started trading separately as of April 9, 2008.\nThe net proceeds from the sale of our warrants and units, after deducting certain offering expenses of approximately $2,784,873, including underwriting discounts of approximately $2,374,008, were approximately $32,679,527. Approximately $33,527,396 of the proceeds from the IPO and the private placement was placed in a trust account for our benefit, which includes $1,187,004 of the underwriter’s compensation which will be paid to them only in the event of a business combination. The remaining $339,135 was not held in the trust account. Except for up to $700,000 (plus up to and additional $350,000 if approved by our shareholders in connection with the extension of the period in which we must complete our initial business combination to March 12, 2011) in interest that is earned on the funds contained in the trust account that may be released to us to be used as working capital, we will not be able to access the amounts held in the trust until we consummate a business combination. The amounts held outside of the trust account are available to be used by us to provide for business, legal and accounting due diligence on prospective acquisitions and continuing general and administrative expenses. From July 18, 2007 (the date of our inception) through June 30, 2009, we had operating expenses of $473,993. From January 1, 2009 through June 30, 2009, we had operating expenses of $184,870. The net proceeds deposited into the trust fund remain on deposit in the trust account earning interest. Other than $700,000 (or $1,050,000 if approved by our shareholders) in interest which we may use to fund working capital, the amounts held in the trust account may only be used by us upon the consummation of a business combination. As of December 31, 2008, we had 33,798,651 held in the trust account and as of June 30, 2009 there was $33,838,155 held in the trust account, which includes deferred underwriting fees of $1,187,004. Additionally, as of June 30, 2009, we had $30,271 outside the trust account to fund our working capital requirements. Through June 30, 2009, approximately $286,000 of interest earned on the trust account balance has been released to us for working capital purpose.\n13\nWe will use substantially all of the net proceeds of our IPO to acquire one or more target businesses, and will use a portion of the interest earned on the trust account together with the funds not held in trust to identify and evaluate prospective target businesses, to select one or more target businesses, and to structure, negotiate and consummate the business combination. We do not believe we will need to raise additional funds following our IPO in order to meet the expenditures required for operating our business. However, we may need to raise additional funds through a private offering of debt or equity securities if such funds were required to consummate a business combination. Such debt securities may include a working capital revolving debt facility or a longer term debt facility. Subject to compliance with applicable securities laws, we would only consummate such financing simultaneously with the consummation of a business combination.\nCommencing on November 15, 2007, we began incurring a fee of approximately $7,500 per month for office space.\nOff-Balance Sheet Arrangements\nWe have never entered into any off-balance sheet financing arrangements and have never established any special purpose entities. We have not guaranteed any debt or commitments of other entities or entered into any options on non-financial assets.\nContractual Obligations\nWe do not have any long term debt, capital lease obligations, operating lease obligations, purchase obligations or other long term liabilities, except for our agreement with Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, for office space, administrative services and secretarial support pursuant to which we pay a monthly fee of $7,500.\n\nITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nMarket risk is the sensitivity of income to changes in interest rates, foreign exchanges, commodity prices, equity prices, and other market-driven rates or prices. We are not presently engaged in and, if a suitable business target is not identified by us prior to the prescribed liquidation date of the trust fund, we may not engage in, any substantive commercial business. Accordingly, we are not and, until such time as we consummate a business combination, we will not be, exposed to risks associated with foreign exchange rates, commodity prices, equity prices or other market-driven rates or prices. The net proceeds of our IPO held in the trust fund have been invested only in money market funds meeting certain conditions under Rule 2a-7 promulgated under the Investment Company Act of 1940. Given our limited risk in our exposure to money market funds, we do not view the interest rate risk to be significant.\n\nITEM 8. FINANCIAL AND SUPPLEMENTAL DATA\nFinancial statements are attached hereto beginning with page F-1\n\nITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE\nNone.\n14\nITEM 9A(T). CONTROLS AND PROCEDURES\nDisclosure Controls and Procedures\nAn evaluation of the effectiveness of our disclosure controls and procedures as of June 30, 2009 was made under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective as of the end of the period covered by this report.\nDisclosure Controls and Procedures are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. During the most recently completed fiscal quarter, there has been no significant change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\nManagement’s Report on Internal Control Over Financial Reporting\nOur internal control over financial reporting is a process designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer and effected by our board of directors to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of our financial statements for external reporting purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that in reasonable detail accurately reflect the transactions and dispositions of our assets; provide reasonable assurance that transactions are recorded as necessary to permit preparation of our financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with the authorization of our board of directors and management; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements.\nUnder the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation under the criteria established in Internal Control – Integrated Framework, our management concluded that our internal control over financial reporting was effective as of June 30, 2009.\nThis Transition Report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit us to provide only management’s report in this Transition Report.\n\nITEM 9B. OTHER INFORMATION\nNone.\n15\nPART III\n\nITEM 10. DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE\nDirectors and Executive Officer\nOur current directors and executive officers are as follows:\n| Name | Age | Position |\n| John Wang | 39 | Chief Executive Officer, President and Director |\n| Robert J. Eu | 46 | Chairman of the Board, |\n| Hao Wu | 35 | Chief Financial Officer, Secretary and Director |\n| Hong Xiang Liu | 44 | Director |\n\nJohn Wang has been our Chief Executive Officer, President and a director since our inception. Mr. Wang has over twelve years of investment banking and consulting experience. Since November 2004, Mr. Wang has been the Managing Director of Marbella Capital Partners Ltd., a financial advisory firm based in Shanghai which he founded. From January 2000 to November 2004, he helped develop and establish the U.S. operations of SBI USA as Executive Vice President of SBI E2-Capital (HK) Limited and was a Managing Director and Chief Operating Officer of SBI E2-Capital (USA) Ltd. Prior to SBI, from 1997 to 1999, he managed Accenture Consulting’s Greater China communications, media, and high tech strategy practice, where he acted as consultant to China Mobile’s IPO in 1997, among other high profile projects. From 1994 to 1997 he was also the lead telecom analyst covering Greater China and Southeast Asia for Pyramid Research, a Cambridge Massachusetts based emerging market telecom research firm that is part of the Economist Intelligence Unit. Last year, he advised on four late-stage deals that closed, of which one has already gone public in Hong Kong and another, Yingli Green Energy (NYSE: YGE), completed its IPO and listing on the New York Stock Exchange on June 8, 2007. Mr. Wang currently sits on the Board of Hong Kong Stock Exchange listed Wuyi International Pharmaceutical Company Limited (HKSE: 1889). Mr. Wang holds a Bachelor of Arts degree in international relations from Tufts University and is a graduate of the Washington International Studies Program at St. Catherine’s College at Oxford University. He has an M.A.L.D. in international law and business from The Fletcher School of Law and Diplomacy and is a graduate of the Private Equity course at Harvard Business School.\nRobert J. Eu has been our Chairman of the Board, Secretary and director since our inception. He has been our Chief Financial Officer since February 21, 2008. Since 1998, Mr. Eu has served as a Managing Director for W.R. Hambrecht + Co., LLC (“WR Hambrecht + Co”) a San Francisco-based investment bank. Mr. Eu founded WR Hambrecht + Co’s investment banking practice in Asia in 2003. Prior to WR Hambrecht + Co, Mr. Eu was a Managing Director of H&Q Asia Pacific from 1992 until 1998, an affiliate of Hambrecht & Quist, where he co-founded its Hong Kong office and China investment practice. In 1996, Mr. Eu led the buy-out and de-listing of Eu Yang Sang (Hong Kong) Limited from the Hong Kong stock exchange and the company is now listed on the Singapore Stock Exchange (SGX:EYSI). Mr. Eu has been a director of Eu Yang Sang since 1997. In 1992, prior to working at H&Q Asia Pacific, Mr. Eu was the Business Development Manager for Eu Yang Sang (Hong Kong) Limited, a manufacturer and retailer of Traditional Chinese medicine. Mr. Eu has been a director and the Chairman of AEX Enterprises Limited (“AEX Enterprises”) since 2003. AEX Enterprises’ primary operating subsidiary is Boom Securities (H.K.) Limited (“Boom Securities”). Boom Securities is a licensed broker / dealer regulated by the Securities and Futures Commission (SFC) of Hong Kong and headquartered in Hong Kong. Mr. Eu worked for Citibank from 1987 until 1992 in the Private Banking Group in Hong Kong. Mr. Eu is a graduate of Northwestern University with a B.A. in History.\nHao Wu has been our Chief Financial Officer, Secretary and Director since September 4, 2009. He has been the Executive Vice President of Marbella Capital Partners, a boutique California/Shanghai based investment and advisory company that focuses on investing on Chinese deals in the growth and late stage, since January 2008. Prior to that, he was the finance director in B&Q Holding Co. Ltd., a leading home improvement retail company in China, from July 2006 until December 2007. Prior to B&Q, Mr. Wu worked for Fortune Tech group Co. Ltd. as the finance director from March 2004 until June 2006. He started his career in Unilever China as a management trainee. David holds a Bachelor of Science degree from the management school of Shanghai Jiao Tong University. Mr. Wu is employed by Marbella Capital Partners, which is controlled by John Wang, our Chief Executive Officer and a Director. Mr. Wu is not a party to any transactions listed in Item 404(a) of Regulation S\n16\nHong Xiang Liu has been one of our directors since September 4, 2009. He has been the director of Jiangsu Performing Art & Culture Enterprises Inc. Ltd., a real estate developer in China, Jiangsu province, since July 2007. Prior to this, he was the Chief Executive Officer and Executive Director of Tongda Energy Limited, a piped gas provider & operator in 11 cities across China, from October 2002 until July 2007. From 1988 to September 2002, Mr. Liu held various positions in China Construction Bank. His last appointment was as Vice General manager of the Enterprise Banking Department, China Construction Bank, Beijing Branch. Mr. Liu received his Bachelor of Engineering (Infrastructure Management) from Tianjin University and was accredited as a senior economist by China Construction Bank in 1998. Mr. Liu is not a party to any transactions listed in Item 404(a) of Regulation S-K.\nBoard Committees\nThe board of directors is currently composed of four individuals and we do not have any committees, and, therefore, the entire board of directors performs the functions of the Audit Committee. It is intended that the board of directors will establish an Audit Committee upon the consummation of a business combination. The board of directors will take all reasonable actions to ensure that one of the members of the Audit Committee will be an “audit committee financial expert,” as such term is defined in the rules of the Securities and Exchange Commission. We are currently listed on the OTC Bulletin Board and are therefore not required to have a nominating committee or a compensation committee. We will evaluate establishing such committees in the future. There have been no changes to the procedures by which stockholders may recommend nominees to our board of directors.\nCode of Ethics\nWe currently do not have a formal code of ethics. Upon consummation of a business combination, we intend to adopt a code of ethics that applies to our principal executive officer, principal financial officer, principal accounting officer or controller or persons performing similar functions.\nSection 16(a) Beneficial Ownership Reporting Compliance\nSection 16(a) of the Securities Exchange Act requires our directors, executive officers and persons who own more than 10% of our common stock to file reports of ownership and changes in ownership of our common stock with the Securities and Exchange Commission. Directors, executive officers and persons who own more than 10% of our common stock are required by Securities and Exchange Commission regulations to furnish to us copies of all Section 16(a) forms they file.\nBased solely on our review of such forms furnished to us and written representations from certain reporting persons, we believe that all filing requirements applicable to our executive officers, directors and greater than 10% beneficial owners were complied with during 2009.\nLegal Proceedings\nJohn Wang, our Chief Executive Officer and President, who had been named a defendant in two lawsuits which were dismissed by the court in a summary judgement for the defendants. John Wang had been named as a defendant along with two other named individuals, SBI-USA, LLC, a U.S. investment firm, and several of SBI-USA’s subsidiaries. The lawsuits alleged several claims, including violation of federal civil RICO statutes, securities fraud, breach of escrow agreement and breach of fiduciary duty. The plaintiffs generally alleged that SBI-USA, through one of the other named defendants, breached the terms of an escrow agreement and distributed shares of common stock held for the benefit of a third party to the detriment of the plaintiffs. The complaints did not specify the damages sought but one suit claimed damages in excess of $1,600,000 and the other includes claims for damages in excess of $400,000. The first lawsuit was filed on June 8, 2007 and the second lawsuit was filed on December 7, 2007. Mr. Wang does not know if any additional lawsuits will be filed. Mr. Wang and the other defendants denied any wrongdoing in connection with the allegations in the complaints. On March 14, 2008, the lawsuits were dismissed by the court in a summary judgment for the defendants. The plaintiffs have filed a notice of their intent to appeal, and to date have requested and received extensions of time from the court to file a formal appeal brief, but have yet to do so.\n17\n\nITEM 11. EXECUTIVE COMPENSATION\nWe agreed to pay Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and Elizabeth B. Hambrecht, Mr. Eu’s wife, a total of $7,500 per month for office space, administrative services and secretarial support for the period from November 15, 2007 until the earlier of our consummation of a business combination or our liquidation. This arrangement was agreed to by Hambrecht Eu Capital Management LLC for our benefit and is not intended to provide Mr. Eu compensation. We believe that such fees are at least as favorable as we could have obtained from an unaffiliated third party.\nOther than the fees paid to Hambrecht Eu Capital Management LLC, we do not currently pay any cash fees to our officers and directors, nor do we pay their expenses in attending board meetings.\n\nITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT\nThe following table sets forth information regarding the beneficial ownership of our ordinary shares as of January 21, 2010 by:\n\n| § | each person known by us to be the beneficial owner of more than 5% of our outstanding ordinary shares; |\n\n\n| § | each of our officers and directors; and |\n\n\n| § | all our officers and directors as a group. |\n\nUnless otherwise indicated, we believe that all persons named in the table have sole voting and investment power with respect to all ordinary shares beneficially owned by them.\n| Number of Ordinary | Approx. Percentage |\n| Shares | of Outstanding |\n| Name and Address of Beneficial Owner(1) | Beneficially Owned | Ordinary Shares |\n| John Wang(2) | 270,000 | 5.1 | % |\n| Robert J. Eu(3) | 261,608 | 4.9 | % |\n| Stephen N. Cannon(4) | 173,275 | 3.3 | % |\n| Hao Wu | — | — |\n| Hong Xiang Liu | — | — |\n| William R. Hambrecht(5) | 354,941 | 6.7 | % |\n| W.R. Hambrecht + Co., LLC(6) | 178,275 | 3.4 | % |\n| Shea Ventures LLC(7) | 88,333 | 1.7 | % |\n| Marbella Capital Partners Ltd.(8) | 40,000 | * |\n| AEX Enterprises Limited(9) | 88,333 | 1.7 | % |\n| Hambrecht 1980 Revocable Trust(10) | 88,333 | 1.7 | % |\n| Loeb Arbitrage Management, LLC(11) | 483,872 | 9.13 | % |\n| HBK Investments L.P. (12) | 423,900 | 8.0 | % |\n| Integrated Core Strategies (US) LLC (13) | 520,500 | 9.8 | % |\n| Genesis Capital Advisors LLC. (14) | 367,500 | 6.9 | % |\n\n18\n| Number of Ordinary | Approx. Percentage |\n| Shares | of Outstanding |\n| Name and Address of Beneficial Owner(1) | Beneficially Owned | Ordinary Shares |\n| Bulldog Investors (15) | 300,000 | 5.7 | % |\n| Yarika Partners, L.P. (16) | 284,225 | 5.4 | % |\n| All directors and executive officer as a group (4 individuals) | 704,883 | 13.3 | % |\n\n* Less than 1%\n(1). Except as otherwise provided below, the address for each of our beneficial owners is 13/F Tower 2, New World Tower, 18 Queens Road Central, Hong Kong.\n(2). The number of shares beneficially owned includes the ordinary shares held by Marbella Capital Partners.\n(3). Includes ordinary shares held by AEX Enterprises Limited.\n(4). The ordinary shares beneficially owned by Stephen N. Cannon are held by the Cannon Family Irrevocable Trust, of which Mr. Cannon is the sole trustee.\n(5). Consists of ordinary shares held by W.R. Hambrecht + Co., LLC, AEX Enterprises Limited and the Hambrecht 1980 Revocable Trust.\n(6). William R. Hambrecht is the controlling person of W.R. Hambrecht + Co., LLC. Its address is Pier 1, Bay 3, San Francisco, CA 94111.\n(7). Edmund H. Shea Jr. is the controlling person of Shea Ventures LLC. Its address is P.O. Box 489, 655 Brea Canyon Rd. Walnut, CA 91788.\n(8). John Wang is the controlling person of Marbella Capital Partners Ltd.\n(9). Elizabeth B. Hambrecht, Robert Eu’s wife, and William R. Hambrecht control AEX Enterprises Limited. Its address is Suite 802, 8/F AIA Tower, 183 Electric Road, North Point, Hong Kong.\n(10). William R. Hambrecht is the trustee of the Hambrecht 1980 Revocable Trust. Its address is Pier 1, Bay 3, San Francisco, CA 94111.\n(11). Based on a 13G filed on November 10, 2009. The business address of Loeb Arbirtage Management, LLC is 61 Broadway, 24th Floor, New York, NY 10006. Loeb Arbirtage Management, LLC is a registered investment adviser. Loeb Arbirtage Management, LLC may invest on behalf of itself and clients for which it has investment discretion. Loeb Arbitrage Fund’s general partner is Loeb Arbitrage Management, LLC. Loeb Offshore Fund Ltd.’s registered investment advisor is Loeb Offshore Management, LLC.\n(12). Based on a 13G/A filed on January 28, 2009. The business address of HBK Investments L.P. is 2101 Cedar Springs Road Suite 700, Dallas, TX 75201. HBK Investments L.P. has delegated discretion to vote and dispose of the Securities to HBK Services LLC. HBK Services may, from time to time, delegate discretion to vote and dispose of certain of the securities to HBK New York LLC, a Delaware limited liability company, HBK Virginia LLC, a Delaware limited liability company, and/or HBK Europe Management LLP, a limited liability partnership organized under the laws of the United Kingdom (collectively, the “Subadvisors”). Each of HBK Services and the Subadvisors is under common control with HBK Investments L.P. Jamiel A. Akhtar, Richard L. Booth, David C. Haley, Lawrence H. Lebowitz, and William E. Rose are each managing members of HBK Management LLC.\n19\n(13). Based on a 13G/A filed on January 29, 2009. The business address of Integrated Core Strategies (US) LLC is c/o Millennium Management, LLC 666 Fifth Avenue 8th Floor, New York, NY 10103. Millennium Management LLC, a Delaware limited liability company (“Millennium Management”), is the general partner of the managing member of Integrated Core Strategies and may be deemed to have shared voting control and investment discretion over securities owned by Integrated Core Strategies. Israel A. Englander is the managing member of Millennium Management. Consequently, Mr. Englander may also be deemed to have shared voting control and investment discretion over securities owned by Integrated Core Strategies.\n(14). Based on a 13G/A filed on February 17, 2009. The business address of Genesis Capital Advisors LLC is 255 Huguenot Street, Suite 1103, New Rochelle, NY 10801. Jaime Hartman, Ethan Benovitz and Daniel Saks are the managing members of Genesis. As a result, Messrs. Hartman, Benovitz and Saks may be deemed to have shared voting control and investment discretion over securities deemed to be beneficially owned by Genesis.\n(15). Based on a 13G filed on August 1, 2008. The business address of Bulldog Investors is Park 80 West, Plaza Two, Saddle Brook, NJ 07663. Phillip Goldstein and Andrew Dakos are principals of Bulldog Investors.\n(16). Based on a 13G filed on October 21, 2009. The business address of Yakira Parterns, L.P. is 991 Post Road East Westport, CT 06880. Mr. Bruce M. Kallins is the managing member of Yakira Partners, L.P.\nAll 1,059,825 Founder Shares owned by our Founders have been placed in escrow with Continental Stock Transfer & Trust Company, as escrow agent, pursuant to an escrow agreement.\n\nITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTORS INDEPENDENCE\nOn July 18, 2007, John Wang, Robert J. Eu and Stephen N. Cannon purchased an aggregate of 1,150,000 of our ordinary shares (which includs 90,174 ordinary shares that we redeemed on March 31, 2008 because the IPO underwriters did not exercise their over-allotment option in full) for an aggregate purchase price of $25,000. Mr. Cannon subsequently transferred all of the shares he purchased to the Cannon Family Irrevocable Trust, of which Mr. Cannon is the sole trustee.\nOn February 21, 2008, John Wang, Robert Eu and the Cannon Family Irrevocable Trust transferred an aggregate of 463,334 shares to W.R. Hambrecht + Co., LLC, Shea Ventures LLC, Marbella Capital Partners Ltd., AEX Enterprises Limited and the Hambrecht 1980 Revocable Trust, each of which entities is an accredited investor for an aggregate purchase price of 10,193.35 or $0.022 per share.\nOn March 7, 2008, AEX Enterprises Limited, W.R. Hambrecht + Co., LLC and the Hambrecht 1980 Revocable Trust, companies controlled by Elizabeth B. Hambrecht, wife of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and William R. Hambrecht, Mr. Eu’s father-in-law, Shea Ventures LLC, a company controlled by Edmund H. Shea Jr. and Marbella Capital Partners Ltd., a company controlled by John Wang, our Chief Executive Officer, agreed to invest an aggregate of $1,550,000 in us in the form of private placement warrants to purchase 1,550,000 ordinary shares at a price of $1.00 per warrant. Elizabeth B. Hambrecht owns approximately 25% and William R. Hambrecht controls (through a trust of which he is the trustee) approximately 38% of the voting shares of AEX Enterprises Limited. William Hambrecht is a controlling person of the voting shares of W.R. Hambrecht + Co., LLC and is the trustee of the Hambrecht 1980 Revocable Trust. The proceeds of the sale of the warrants were placed in the trust account established for our benefit in connection with our IPO.\nOn March 31, 2008, following the partial exercise of the over-allotment option by the underwriters of the IPO, we cancelled an aggregate of 90,174 ordinary shares held by Robert J. Eu, Cannon Family Irrevocable Trust and WR Hambrecht + Co., LLC.\nOn December 21, 2008, AEX Enterprises Limited transferred an aggregate of 441,666 warrants to AEX Capital, LLC, for no consideration. Such transfer was exempt from registration pursuant to Sections 4(1) and 4(2) of the Securities Act, due to the limited number of individuals involved, their status as accredited investors and transfer restrictions and legends on the share certificates.\n20\nIn each of the foregoing sales of securities the purchasers were our officers and directors or affiliates of our officers and directors and therefore had access to all relevant information about us when choosing to invest in our securities. As of January 21, 2010, these securities were held by the persons or entities as set forth in the following table:\n\n| Name | Ordinary Shares | Warrants |\n| John Wang | 230,000 | 0 |\n| W.R. Hambrecht + Co., LLC(1) | 178,275 | 25,000 |\n| Cannon Family Irrevocable Trust (2) | 173,275 | 0 |\n| Robert J. Eu | 173,275 | 0 |\n| AEX Enterprises Limited(3) | 88,333 | 0 |\n| Hambrecht 1980 Revocable Trust(4) | 88,333 | 441,667 |\n| Shea Ventures LLC(5) | 88,333 | 441,667 |\n| Marbella Capital Partners Ltd.(6) | 40,000 | 200,000 |\n| AEX Capital, LLC(7) | 0 | 441,666 |\n| Total: | 1,059,824 | 1,550,000 |\n\n\n| (1) | William R. Hambrecht is the controlling person of W.R. Hambrecht + Co., LLC. |\n\n| (2) | Mr. Cannon is the sole Trustee of Cannon Family Irrevocable Trust. |\n\n| (3) | Elizabeth B. Hambrecht, Robert Eu’s wife, and William R. Hambrecht control AEX Enterprises Limited. |\n\n| (4) | William R. Hambrecht is the trustee of the Hambrecht 1980 Revocable Trust. |\n\n| (5) | Edmund H. Shea Jr. is the controlling person of Shea Ventures LLC. |\n\n| (6) | John Wang is the controlling person of Marbella Capital Partners Ltd. |\n\n| (7) | Elizabeth B. Hambrecht, Robert Eu’s wife, and Robert J. Eu control AEX Capital, LLC. |\n\nPursuant to a registration rights agreement between us and our pre-initial public offering shareholders and warrant holders such shareholders and warrant holders will be entitled to certain registration rights. Specifically, (i) the private placement warrants and the underlying ordinary shares will be entitled to certain registration rights immediately after the consummation of a business combination; and (ii) the ordinary shares will be entitled to certain registration rights one year from the consummation of a business combination. We are only required to use our best efforts to cause a registration statement relating to the resale of such securities to be declared effective and, once effective, only to use our best efforts to maintain the effectiveness of the registration statement. The holders of warrants do not have the rights or privileges of holders of our ordinary shares or any voting rights until such holders exercise their respective warrants and receive ordinary shares. Certain persons and entities that receive any of the above described securities from our founders will, under certain circumstances, be entitled to the registration rights described herein. We will bear the expenses incurred in connection with the filing of any such registration statements. In the event that we breach our obligations under the registration rights agreement, we could be obligated to purchase the securities owned by our pre-initial public offering shareholders for the then fair market value of the securities.\nWe agreed to pay Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and Elizabeth Hambrecht, Mr. Eu’s wife, a total of $7,500 per month for office space, administrative services and secretarial support for the period from November 15, 2007 until the earlier of our consummation of a business combination or our liquidation. This arrangement was agreed to by Hambrecht Eu Capital Management LLC for our benefit and is not intended to provide Mr. Eu compensation. We believe that such fees are at least as favorable as we could have obtained from an unaffiliated third party.\nWe will reimburse our officers and directors for any reasonable out-of-pocket business expenses incurred by them in connection with certain activities on our behalf such as identifying and investigating possible target businesses and business combinations. Subject to availability of proceeds not placed in the trust account and the interest income on the balance in the trust account to be released to us from time to time, there is no limit on the amount of out-of-pocket expenses that could be incurred. This formula was a result of a negotiation between us and the underwriters and was meant to help maximize the amount of money in the trust account that would be returned to the investors if we do not consummate a business combination within the permitted time. Our board of directors will review and approve all expense reimbursements made to our directors with the interested director or directors abstaining from such review and approval. To the extent such out-of-pocket expenses exceed the available proceeds not deposited in the trust account, such out-of-pocket expenses would not be reimbursed by us unless we consummate a business combination.\n21\nOther than the $7,500 per month administrative fee and reimbursable out-of-pocket expenses payable to Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and Elizabeth Hambrecht, Mr. Eu’s wife, no fees of any kind, including finders and consulting fees, will be paid to any of our directors who owned our ordinary shares prior to our IPO, or to any of their respective affiliates for services rendered to us prior to or with respect to the business combination.\nAfter a business combination, any of our directors who remain with us may be paid consulting, management or other fees from the combined company with any and all amounts being fully disclosed to shareholders, to the extent then known, in the proxy solicitation materials furnished to our shareholders. It is unlikely that the amount of such compensation will be known at the time of a shareholder meeting held to consider a business combination, as it will be up to the directors of the post-combination business to determine executive and director compensation. In this event, such compensation will be publicly disclosed at the time of its determination in a Current Report on Form 8-K, as required by the SEC.\nAll ongoing and future transactions between us and any of our directors or their respective affiliates, including loans by our directors, will be on terms believed by us at that time, based upon other similar arrangements known to us, to be no less favorable than are available from unaffiliated third parties. Such transactions or loans, including any forgiveness of loans, will require prior approval in each instance by a majority of our uninterested “independent” directors, to the extent we have independent directors, or the members of our board who do not have an interest in the transaction, in either case who had access, at our expense, to our attorneys or independent legal counsel. It is our intention to obtain estimates from unaffiliated third parties for similar goods or services to ascertain whether such transactions with affiliates are on terms that are no less favorable to us than are otherwise available from such unaffiliated third parties. If a transaction with an affiliated third party were found to be on terms less favorable to us than with an unaffiliated third party, we would not engage in such transaction.\nDirector Independence\nOur Board of Directors has not determined if any of our directors qualifies as independent. Our Board of Directors will make a determination about independence after the business combination is consummated. We do not have an audit committee, nominating committee or compensation committee and therefore the entire Board of Directors performs those functions for us.\n\nITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES\nRothstein Kass & Company, P.C. audited our financial statements for the years ended June 30, 2009; December 31, 2008 and 2007:\nAudit Fees\nFees for audit services provided by Rothstein Kass & Company, P.C. totaled approximately $55,000 in 2009, including fees associated with the audit of the annual financial statements for the fiscal year ended June 30, 2009 and the reviews of the Company’s quarterly reports on Form 10-Q.\nFees for audit services provided by Rothstein Kass & Company, P.C. totaled approximately $55,000 in 2008, including fees associated with the audit of the annual financial statements for the fiscal year ended December 31, 2008 and the reviews of the Company’s quarterly reports on Form 10-Q.\nFees for audit services provided by Rothstein Kass & Company, P.C. totaled approximately $80,000 in 2007, including fees associated with the audit of the annual financial statements for the fiscal year ended December 31, 2007, the audit of the financial statements as of August 31, 2007, the audit of the Company’s balance sheet at March 18, 2008 included in the Current Report on Form 8-K, and for services performed in connection with the Company’s registration statement on Form S-1 initially filed in 2007.\n22\nAudit-Related Fees\nRothstein Kass & Company, P.C. did not bill any fees for services rendered to us during fiscal years 2009, 2008 and 2007 for Audit-related services in connection with the audit or review of our financial statements.\nTax Fees\nRothstein Kass & Company, P.C. did not bill any fees for tax services, including tax compliance, tax advice, and tax planning, during fiscal years 2009, 2008 and 2007.\nAll Other Fees\nThere were no fees billed by Rothstein Kass & Company, P.C. for other professional services rendered during the fiscal years 2009, 2008 or 2007.\nPre-Approval of Services\nWe do not have an audit committee. As a result, our board of directors performs the duties of an audit committee. Our board of directors evaluates and approves in advance the scope and cost of the engagement of an auditor before the auditor renders the audit and non-audit services. We do not rely on pre-approval policies and procedures.\n23\nPART IV\n\nITEM 15. EXHIBITS\n| (a) | (1) | Financial Statements |\n\nBalance Sheets\nStatement of Operations\nStatement of Shareholders’ Equity\nStatement of Cash Flows\n| (2) | Schedules |\n\nNone.\n| (b) | Exhibits |\n\nThe following Exhibits are filed as part of this report\n| Exhibit No. | Description |\n| 3.1 | Memorandum of Association (1) |\n| 3.2 | Amended and Restated Articles of Association (1) |\n| 4.1 | Specimen Unit Certificate (1) |\n| 4.2 | Specimen Common Share Certificate (1) |\n| 4.3 | Specimen Public Warrant Certificate (1) |\n| 4.4 | Specimen Private Warrant Certificate (1) |\n| 4.5 | Form of Warrant Agreement between Continental Stock Transfer & Trust Company and the Registrant (1) |\n| 4.6 | Form of Unit Purchase Option (1) |\n| 10.1 | Form of Letter Agreement by John Wang (1) |\n| 10.2 | Form of Letter Agreement by Robert J. Eu (1) |\n| 10.3 | Form of Letter Agreement by Stephen N. Cannon (1) |\n| 10.4 | Form of Letter Agreement by Lee S. Ting (1) |\n| 10.5 | Form of Letter Agreement by AEX Enterprises Limited (1) |\n| 10.6 | Form of Letter Agreement by Feng Zhang (1) |\n| 10.7 | Investment Management Trust Agreement between Continental Stock Transfer & Trust Company and the Registrant |\n| 10.8 | Form of Securities Escrow Agreement between the Registrant, Continental Stock Transfer & Trust Company, the founding shareholders and the founders (1) |\n| 10.9 | Form of Services Agreement between the Registrant and Hambrecht Eu Capital Management LLC (1) |\n| 10.10 | Form of Registration Rights Agreement among the Registrant, the founding shareholders and the founders (1) |\n| 10.11 | Revolving Credit Agreement between the Registrant and Robert Eu (1) |\n| 10.12 | Promissory Note between Registrant and Robert Eu (1) |\n| 10.13 | Form of Warrant Purchase Agreement between the Registrant and AEX Enterprises Limited (1) |\n| 10.14 | Form of Right of First Refusal Agreement between the Registrant, Marbella Capital Partners and AEX Enterprises Limited (1) |\n| 31.1 | Certification of the Chief Executive Officer (Principal Executive Officer) pursuant to Rule 13a-14(a) of the Securities Exchange Act, as amended |\n| 31.2 | Certification of the Chief Financial Officer (Principal Financial Officer) pursuant to Rule 13a-14(a) of the Securities Exchange Act, as amended |\n| 32.1 | Certification of the Chief Executive Officers pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2 | Certification of the Chief Financial Officers pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n\n(1) Incorporated by reference to the Registrant’s Registration Statement on Form S-1 (File No. 333-146147).\n24\nSIGNATURES\nPursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant had duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n| January 22, 2010 | HAMBRECHT ASIA ACQUISITION CORP. |\n| By: | /s/ John Wang |\n| John Wang |\n| Chief Executive Officer, President and Director |\n| (Principal Executive Officer) |\n| January 22, 2010 | By: | /s/ Hao Wu |\n| Hao Wu |\n| Chief Financial Officer, Secretary and Director |\n| (Principal Financial and Accounting Officer) |\n\nPursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.\n| January 22, 2010 | By: | /s/ John Wang |\n| John Wang |\n| Chief Executive Officer, President and |\n| Director (Principal Executive Officer) |\n| January 22, 2010 | By: | /s/ Robert J. Eu |\n| Robert J. Eu |\n| Chairman of Board |\n| January 22, 2010 | By: | /s/ Hao Wu |\n| Hao Wu |\n| Chief Financial Officer, Secretary and Director |\n| (Principal Financial and Accounting Officer) |\n| January 22, 2010 | By: | /s/ Hong Xiang Liu |\n| Hong Xiang Liu |\n| Director |\n\n25\nHambrecht Asia Acquisition Corp.\n(a corporation in the development stage)\nINDEX TO FINANCIAL STATEMENTS\n| Page |\n| Report of Independent Registered Public Accounting Firm | F-2 |\n| Financial Statements: |\n| Balance Sheets | F-3 |\n| Statements of Operations | F-4 |\n| Statements of Shareholders’ Equity | F-5 |\n| Statements of Cash Flows | F-6 |\n| Notes to Financial Statements | F-7 |\n\nF-1\nReport of Independent Registered Public Accounting Firm\nTo the Board of Directors and Stockholders of\nHambrecht Asia Acquisition Corporation\nWe have audited the accompanying balance sheets of Hambrecht Asia Acquisition Corporation (a corporation in the development stage) (the “Company”) as of June 30, 2009 and December 31, 2008 and 2007, and the related statements of operations and cash flows for the six months ended June 30, 2009, the year ended December 31, 2008, the period from July 18, 2007 (date of inception) to December 31, 2007 and the periods from July 18, 2007 (date of inception) to June 30, 2009, and shareholders’ equity for the period from July 18, 2007 (date of inception) to June 30, 2009. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.\nWe conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.\nIn our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of June 30, 2009 and December 31, 2008, and the results of its operations and its cash flows for the six months ended June 30, 2009, the year ended December 31, 2008, the period from July 18, 2007 (date of inception) to December 31, 2007 and the periods from July 18, 2007 (date of inception) to June 30, 2009, and shareholders’ equity for the period from July 18, 2007 (date of inception) to June 30, 2009, in conformity with U.S. generally accepted accounting principles.\nThe accompanying financial statements have been prepared assuming that Hambrecht Asia Acquisition Corporation will continue as a going concern. As discussed in Note 7 to the financial statements, Hambrecht Asia Acquisition Corporation will face a mandatory liquidation if a business combination is not consummated by March 12, 2010, which raises substantial doubt about its ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.\nRoseland, New Jersey\nJanuary 22, 2010\n/s/ Rothstein Kass & Company, P.C.\nF-2\nHambrecht Asia Acquisition Corp.\n(a corporation in the development stage)\nBalance Sheets\n| June 30,2009 | December 31, 2008 | December 31, 2007 |\n| ASSETS |\n| Current assets |\n| Cash | $ | 30,271 | $ | 100,312 | $ | 101,671 |\n| Prepaid expenses | 95,686 | 108,330 | 183,254 |\n| Total current assets | 125,957 | 208,642 | 284,925 |\n| Other asset | — |\n| Investments held in the trust account | 33,838,155 | 33,798,651 |\n| Total assets | $ | 33,964,112 | $ | 34,007,293 | $ | 284,925 |\n| LIABILITIES AND SHAREHOLDERS’ EQUITY |\n| Current liabilities |\n| Accrued expenses | $ | 76,275 | $ | 31,780 | $ | — |\n| Note payable, shareholder | 281,661 |\n| — |\n| Total current liabilities | 76,275 | 31,780 | 281,661 |\n| Long-term liabilities |\n| Deferred underwriting fees, net of $356,101 subject to forfeiture in the event of possible redemption | 830,903 | 830,903 | — |\n| Ordinary shares, subject to possible redemption, (1,271,788 shares at redemption value of $7.92 per share) | 10,072,561 | 10,072,561 | — |\n| Shareholders’ equity |\n| Ordinary shares, $.001 par value, 50,000,000 shares authorized; 5,299,125, 5,299,125 and 1,150,000 shares issued and outstanding as of June 30, 2009, December 31, 2008 and December 31, 2007 (which includes 1,271,788, 1,271,788 shares and 0 shares respectively subject to possible redemption) | 5,299 | 5,299 | 1,150 |\n| Additional paid-in capital | 22,851,981 | 22,851,981 | 23,850 |\n| Earnings (deficit) accumulated during the development stage | 127,093 | 214,769 | (21,736 | ) |\n| Total shareholders’ equity | 22,984,373 | 23,072,049 | 3,264 |\n| Total liabilities and shareholders’ equity | $ | 33,964,112 | $ | 34,007,293 | $ | 284,925 |\n\nSee accompanying notes to financial statements.\nF-3\nHambrecht Asia Acquisition Corp.\n(a corporation in the development stage)\nStatements of Operations\n\n| For the Period Ended June 30, 2009 (six months) | For the Period Ended June 30, 2008 (six months) (unaudited) | Period from July 18,2007 (inception) to June 30,2009 | For the Year ended December 31,2008 | Period from July 18, 2007 to December 31,2007 |\n| Revenues | $ | — | $ | — | $ | — | $ | — | $ | — |\n| Formation and administrative costs | 184,870 | 156,683 | 473,993 | 267,387 | 21,736 |\n| Loss from operations | (184,870 | ) | (156,683 | ) | (473,993 | ) | (267,387 | ) | (21,736 | ) |\n| Interest income, net | 97,193 | 168,133 | 601,085 | 503,892 | — |\n| Net income (loss) | (87,677 | ) | 11,449 | 127,093 | 236,505 | (21,736 | ) |\n| Weighted average number of ordinary shares subject to possible redemption, basic and diluted | 1,271,788 | 808,223 | 793,378 | 1,037,742 | — |\n| Income (loss) per ordinary share subject to possible redemption, basic and diluted | $ | (0.07 | ) | $ | 0.01 | $ | 0.16 | $ | — | $ | — |\n| Weighted average number of ordinary shares outstanding (not subject to possible redemption) , basic | 4,027,337 | 3,789,581 | 3,085,775 | 3,503,402 | 1,150,000 |\n| Income (loss) per ordinary share not subject to possible redemption, basic | $ | (0.02 | ) | $ | 0.00 | $ | 0.04 | $ | 0.07 | $ | (0.02 | ) |\n| Weighted average number of ordinary shares outstanding (not subject to possible redemption), diluted | 4,027,337 | 5,164,193 | 4,267,656 | 5,213,337 | 1,150,000 |\n| Income (loss) per ordinary share not subject to possible redemption, diluted | $ | (0.02 | ) | $ | 0.00 | $ | 0.03 | $ | 0.05 | $ | (0.02 | ) |\n\nSee accompanying notes to financial statements.\nF-4\nHambrecht Asia Acquisition Corp.\n(a corporation in the development stage)\nStatements of Shareholders’ Equity\nFor the Period July 18, 2007 (date of inception) to June 30, 2009\n| Ordinary Shares | Earnings |\n| Shares | Amount | Additional Paid-in Capital | (Deficit) Accumulated During the Development Stage | TotalShareholders’ Equity |\n| Balances at July 18, 2007 | — | $ | — | $ | — | $ | — | $ | — |\n| Sale of units issued to founders on July 18, 2007 at approximately $0.02 per share | 1,150,000 | 1,150 | 23,850 | 25,000 |\n| Net loss | (21,736 | ) | (21,736 | ) |\n| Balances at December 31, 2007 | 1,150,000 | $ | 1,150 | $ | 23,850 | $ | (21,736 | ) | $ | 3,264 |\n| Proceeds from sale of warrants in a private placement to initial shareholders | 1,550,000 | 1,550,000 |\n| Sale of 4,000,000 units at $8.00 per unit in the public offering, net of underwriters’ discount and offering expenses (1,199,999 shares subject to possible redemption) | 4,000,000 | 4,000 | 29,550,348 | 29,554,348 |\n| Sale of 239,300 units at $8.00 per unit in the public offering from partial exercise of underwriters’ overallotment option, net of underwriters’ discount and offering expenses (71,789 shares subject to possible redemption) | 239,300 | 239 | 1,800,344 | 1,800,583 |\n| Forfeiture of founders shares from partial exercise of underwriters’ overallotment option | (90,175 | ) | (90 | ) | (90 | ) |\n| Proceeds subject to possible redemption of 1,271,788 shares at a redemption value of $7.92 per share | (10,072,561 | ) | (10,072,561 | ) |\n| Net income | 236,505 | 236,505 |\n| Balances at December 31, 2008 | 5,299,125 | $ | 5,299 | $ | 22,851,981 | $ | 214,769 | $ | 23,072,049 |\n| Net loss | (87,677 | ) | (87,677 | ) |\n| Balances at June 30, 2009 | 5,299,125 | $ | 5,299 | $ | 22,851,981 | $ | 127,093 | $ | 22,984,373 |\n\nSee accompanying notes to financial statements.\nF-5\nHambrecht Asia Acquisition Corp.\n(a corporation in the development stage)\nStatements of Cash Flows\n| For the PeriodEnded June 30,2009 (sixmonths) | For the PeriodEnded June 30,2008 (sixmonths) (unaudited) | Period from July18,2007(inception) toJune 30,2009 | For the Yearended December31,2008 | Period from July18, 2007 toDecember31,2007 |\n| Cash flows from operating activities: |\n| Net income (loss) | $ | (87,677 | ) | $ | 11,449 | $ | 127,093 | $ | 236,505 | $ | (21,736 | ) |\n| Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |\n| Change in operating assets and liabilities: |\n| Accrued expenses | 44,494 | 94,063 | 76,275 | 31,780 |\n| Prepaid expenses and other current asset | 12,644 | 49,922 | (95,686 | ) | (108,330 | ) |\n| Net cash provided by (used in) operating activities | (30,538 | ) | 155,434 | 107,682 | 159,955 | (21,736 | ) |\n| Cash used in investing activities: |\n| Proceeds from the public offering deposited in trust account | — | (33,527,400 | ) | (33,527,400 | ) | (33,527,400 | ) | — |\n| Interest income re-invested in trust account | (85,836 | ) | (173,102 | ) | (510,361 | ) | (510,361 | ) | — |\n| Redemption from the trust account | 46,332 | 65,709 | 285,442 | 239,110 | — |\n| Net cash used in investing activities | (39,504 | ) | (33,634,793 | ) | (33,838,155 | ) | (33,798,651 | ) | — |\n| Cash flows from financing activities: |\n| Proceeds from sale of ordinary shares to founders | — | — | 25,000 | — | 25,000 |\n| Proceeds from shareholder’s note payable | $ | — | $ | — | $ | 281,661 | $ | — | $ | 281,661 |\n| Proceeds from warrants purchased in private placement | — | 1,550,000 | 1,550,000 | 1,550,000 | — |\n| Proceeds from initial public offering | $ | — | $ | 32,000,000 | $ | 32,000,000 | $ | 32,000,000 | $ | — |\n| Proceeds from exercise of underwriters overallotment option | — | 1,914,400 | 1,914,400 | 1,914,400 | — |\n| Repayment of shareholder’s note payable | — | — | (281,661 | ) | (281,661 | ) | — |\n| Payment of underwriters’ fee and offering cost of initial public offering | — | (1,728,656 | ) | (1,728,656 | ) | (1,545,402 | ) | (183,254 | ) |\n| Net cash provided by financing activities | — | 33,454,083 | 33,760,744 | 33,637,337 | 123,407 |\n| Net increase (decrease) in cash | (70,042 | ) | (25,276 | ) | 30,271 | (1,359 | ) | 101,671 |\n| Cash at beginning of the period | 100,312 | 101,671 | — | 101,671 | — |\n| Cash at end of the period | $ | 30,271 | $ | 76,395 | $ | 30,271 | $ | 100,312 | $ | 101,671 |\n| Supplemental schedule of non-cash financing activities: |\n| Deferred underwriting fees, net | $ | — | $ | 830,903 | $ | 830,903 | $ | 830,903 | $ | — |\n| Ordinary shares subject to possible redemption | $ | — | $ | 10,072,561 | $ | 10,072,561 | $ | 10,072,561 | $ | — |\n\nSee accompanying notes to financial statements.\nF-6\nHambrecht Asia Acquisition Corp.\n(a corporation in the development stage)\nNotes to Financial Statements\nNOTE 1—ORGANIZATION AND BUSINESS OPERATIONS\nHambrecht Asia Acquisition Corp. (a corporation in the development stage) (the “Company”) was incorporated in the Cayman Islands on July 18, 2007 with an authorized share capital of 50,000,000 ordinary shares (par value $0.001 per share). The Company’s founders contributed $25,000 to the formation of the Company and were issued 1,150,000 ordinary shares. The Company was formed to acquire, through a stock exchange, asset acquisition or other similar business combination, one or more operating businesses having its primary operations located in the People’s Republic of China (“Business Combination”). The Company is considered to be in the development stage as defined in “Accounting and Reporting By Development Stage Enterprises”, and is subject to the risks associated with activities of development stage companies. The Company’s operations, if a Business Combination is consummated outside the United States, will be subject to local government regulations and to the uncertainties of the economic and political conditions of those areas.\nOn December 9, 2009 the Board of Directors of Hambrecht Asia Acquisition Corp. (the \"Company\") authorized a change in the Company's fiscal year end to June 30 from December 31. The Company reports its financial results for the six month transition period of December 31, 2008 through June 30, 2009 on a Transition Report on Form 10-K. After filing the Transition Report, the Company’s next fiscal year end will be June 30, 2010.\nAs of June 30, 2009, the Company had not commenced any operations or generated any revenues. All activity from the period July 18, 2007 (date of inception) through March 31, 2008 relates to the Company’s formation and its initial public offering as described below. Subsequent to that date to the present the Company has sought a target business to acquire. The Company will not generate any operating revenue until after the completion of the Business combination, at the earliest. The Company currently generates non-operating income from interest income earned on the investments held in a trust account (the “Trust Account”), from the proceeds derived from the public offering.\nThe registration statement for the Company’s initial public offering (the “Offering”) described in Note 3 was declared effective on March 7, 2008. The Company consummated the Offering on March 12, 2008 and immediately prior to such Offering, sold an aggregate of 1,550,000 warrants at $1.00 per warrant to certain officers and affiliates of the Company in a private placement (the “Private Placement”) described in Note 4. On March 31 2008, the underwriters of the Offering exercised their over-allotment option for a total of an additional 239,300 units. The net proceeds of the Offering and the Private Placement are intended to be generally applied toward consummating a business combination with one or more operating businesses having their primary operations in the People’s Republic of China (“Business Combination”). Net proceeds of $33,537,396 from the Offering, including the exercise of the underwriters’ over-allotment option, and the Private Placement are held in a Trust Account and will only be released to the Company upon the earlier of: (i) the consummation of a business combination; or (ii) the Company’s liquidation, except to satisfy shareholder conversion rights. The Trust Account includes the deferred underwriting discount from the Offering of up to $1,187,004 which will be paid to the underwriters upon consummation of a business combination, as described in Note 6. Additionally, up to an aggregate of $700,000, plus up to an additional $350,000 during the Extended Period (as described below) if approved by shareholders, of interest earned on the Trust Account balance (net of any taxes paid or payable) may be released to the Company to fund operating activities. Through June 30, 2009, approximately $286,000 of interest earned on the Trust Account balance has been released to the Company.\nOn September 4, 2009, the Company issued a press release announcing that it has entered into a letter of intent with a company for a business combination. The target is a company with its principal business operations in the People’s Republic of China. The Company, after signing a definitive agreement for the acquisition of a target business, is required to submit such transaction for shareholder approval. In the event that shareholders owning 30% or more of the shares sold in the Offering vote against the business combination and exercise their conversion rights described below, the business combination will not be consummated. All of the Company’s shareholders prior to the Offering, have agreed to vote their pre-initial public offering ordinary shares in accordance with the vote of the majority of the shares voted by all shareholders of the Company who purchased their shares in the Offering or the aftermarket (“Public Shareholders”) with respect to any business combination. After consummation of a business combination, these voting safeguards will no longer be applicable.\nF-7\nIn the event that the Company does not complete a business combination by March 12, 2010, or March 12, 2011 if extension is approved by the shareholders, the Company will be dissolved and the proceeds held in the Trust Account, plus certain interest, less certain costs, will be distributed to the Company’s public shareholders. If the Company receives Public Shareholder approval for the Extended Period and holders of 30% or more of the shares held by Public Shareholders do not vote against the Extended Period and elect to convert their ordinary shares in connection with the vote for the Extended Period, the Company will then have an additional 12 months in which to complete the initial business combination. If the Extended Period is approved, the Company will still be required to seek Public Shareholder approval before completing a business combination. In the event there is no business combination within the 24-month deadline (assuming the Extended Period is not approved) described above, the Company will dissolve and distribute to its Public Shareholders, in proportion to their respective equity interests, the amount held in the Trust Account, and any remaining net assets, after the distribution of the Trust Account. The Company’s corporate existence will automatically cease at the end of the 36-month period if the Company has not received shareholder approval for an initial business combination. In the event of liquidation, the per share value of the residual assets remaining available for distribution (including Trust Account assets) may be less than the initial public offering price per share in the Offering.\nWith respect to a business combination which is approved and consummated or a vote on the Extended Period which is approved, any Public Shareholders who voted against the business combination or Extended Period may contemporaneously with or prior to such vote exercise their conversion right and their ordinary shares would be cancelled and returned to the status of authorized but unissued shares. The per share conversion price will equal the amount in the Trust Account (including interest therein), calculated as of two business days prior to the consummation of the proposed business combination or vote on Extended Period, divided by the number of common shares sold in the Offering and partial exercise of the over-allotment option.\nA Public Shareholder’s election to convert ordinary shares in connection with the vote on the Extended Period will only be honored if the Extended Period is approved. Public Shareholders who vote their shares against the Extended Period and exercise their conversion rights, will not be able to vote these shares with respect to the initial business combination. All other Public Shareholders will be able to vote on the initial business combination.\nNOTE 2 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nBasis of Presentation:\nThe accompanying financial statements are presented in U.S. dollars and have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and pursuant to the accounting and disclosure rules and regulations of the Securities and Exchange Commission (the ‘SEC”). In the opinion of management, the accompanying financial statements reflect all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the Company’s financial statements.\nInvestments held in the Trust Account:\nThe amounts held in the Trust Account as of June 30, 2009 represent substantially all of the proceeds of the Offering plus partial exercise of the underwriters’ over-allotment option, the private placement and interest earned on the trust to date, and are classified as restricted assets since such amounts can only be used by the Company in connection with the consummation of a Business Combination. The funds held in the Trust Account are invested in a money market fund that invests in US and state government and government agency debt securities.\nF-8\nFair value of financial instruments:\nThe Company does not enter into financial instruments for trading or speculative purposes. The carrying amounts of financial instruments classified as current assets and current liabilities as disclosed in the accompanying balance sheets, approximate their fair value due to their short maturities.\nUse of estimates:\nThe preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.\nIncome taxes:\nUnder current Cayman Islands laws, the Company is not subject to income taxes or capital gains, and there is no Cayman Islands withholding tax imposed upon payments of dividends by the Company to its shareholders. In the future, the Company’s tax rate will be impacted by acquisitions of non-Cayman subsidiaries governed by the respective local income tax laws. Accordingly, no provision for income taxes has been made in the accompanying statements of operations.\nEffective January 1, 2007, the Company adopted the provisions of “Accounting for Uncertainty in Income Taxes”. There were no unrecognized tax benefits as of June 30, 2009. The provision prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. No amounts were accrued for the payment of interest and penalties at June 30, 2009. Management is currently unaware of any issues under review that could result in significant payments, accruals or material deviation from its position.\nOrdinary shares subject to possible redemption:\nAs discussed in Note 1, the Company will only proceed with a Business Combination if: (1) it is approved by a majority of the votes cast by the Company’s public shareholders; and (2) public shareholders holding less than 30% (1,271,788) of the ordinary shares sold in the Offering and partial exercise of the over-allotment option, choose to exercise their redemption rights thereby receiving their per share interest in the Trust Account. In accordance with FASB’s Emerging Issues Task Force (EITF) Topic No. D-98, “Classification and Measurement of Redeemable Securities”, the Company has classified 1,271,788 shares of its ordinary shares outside of permanent equity as “Ordinary shares subject to redemption,” at a redemption price of $7.92 per share as of June 30, 2009 . The Company will recognize changes in the conversion value as they occur and will adjust the carrying value of the ordinary shares subject to conversion to be equal to its conversion value at the end of each reporting period.\nIncome (loss) per ordinary share:\nBasic income per common share is computed by dividing net income by the weighted average common shares outstanding for the period. Diluted income per common share reflects the potential dilution that could occur if warrants were to be exercised or converted or otherwise resulted in the issuance of ordinary shares that then shared in the earnings of the entity.\nFor the period ended (six months) June 30, 2009, and for the period from July 18, 2007 (inception) to June 30, 2009, the Company had potentially dilutive securities in the form of 7,129,125 warrants, and 5,299,125 warrants issued as part of the Units (as defined below) in the Offering. Of the total warrants outstanding for the periods then ended, approximately 2,328,422 and 1,181,881, respectively, represent incremental shares of ordinary share, based on their assumed redemption, to be included in the weighted average number of shares of ordinary share outstanding (not subject to possible redemption) for the calculation of diluted income per ordinary share. The Company uses the “treasury stock method” to calculate potential dilutive shares, as if they were redeemed for ordinary share at the beginning of the period.\nF-9\nThe Company’s statements of operations includes a presentation of income per ordinary share subject to possible redemption in a manner similar to the two-class method of income per share. Basic and diluted income amount for the maximum number of shares subject to possible redemption is calculated by dividing the net interest attributable to common shares subject to redemption by the weighted average number of shares subject to possible redemption. Basic and diluted net income (loss) per share amount for the shares outstanding not subject to possible redemption is calculated by dividing the net income (loss) exclusive of the net interest income attributable to ordinary share subject to redemption by the weighted average number of shares not subject to possible redemption.\nNewly Adopted Accounting Pronouncements:\nIn December 2007, the FASB issued “Business Combinations”, which requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction; establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; and requires the acquirer to disclose to investors, and other users, all of the information they need to evaluate and understand the nature and financial effect of the business combination. “Business Combinations” will be effective for acquisitions with a date on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. We will apply “Business Combinations” for any of our applicable acquisitions beginning January 1, 2009.\nIn December 2007, the FASB issued “Noncontrolling Interests in Consolidated Financial Statements”, which requires the recognition of a noncontrolling interest (minority interest) as equity in the consolidated financial statements and separate from the parent’s equity; the inclusion of the amount of net income attributable to the noncontrolling interest in consolidated income on the face of the income statement; and a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. This guidance will be effective for the fiscal years beginning on or after December 15, 2008. We will apply to any applicable transactions beginning January 1, 2009.\nIn March 2008, the FASB issued “Disclosures about Derivative Instruments and Hedging Activities”, which is intended to improve financial standards for derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. Entities are required to provide enhanced disclosures about: (a) how and why an entity uses derivative instruments; (b) how derivative instruments and related hedged items are accounted for and its related interpretations; and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. It is effective for financial statements issued for fiscal years beginning after November 15, 2008, with early adoption encouraged. The adoption of this statement is not expected to have a material effect on the Company’s results of operations or financial position; however, it could impact future transactions entered into by the Company.\nOn April 9, 2009, the FASB issued the guidance of “Interim Disclosures about Fair Value of Financial Instruments” to require disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements. The guidance also amends Accounting Principles Board Opinion-Interim Financial Reporting, to require those disclosures in summarized financial information at interim reporting periods. The guidance shall be effective for interim reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. An entity may early adopt this if certain requirements are met. This guidance does not require disclosures for earlier periods presented for comparative purposes at initial adoption. In periods after initial adoption, this guidance requires comparative disclosures only for periods ending after initial adoption. The adoption of this guidance did not have a significant impact on the Company’s financial statements or related footnotes.\nF-10\nOn April 9, 2009, the FASB issued the guidance of “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly”, to affirms that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction; clarifies and includes additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is not active; eliminates the proposed presumption that all transactions are distressed (not orderly) unless proven otherwise. The guidance instead requires an entity to base its conclusion about whether a transaction was not orderly on the weight of the evidence. In addition, this guidance requires an entity to disclose a change in valuation technique (and the related inputs) resulting from the application of it and to quantify its effects, if practicable. This guidance is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009 if certain requirements are met. It must be applied prospectively and retrospective application is not permitted. The adoption of this guidance did not have a significant impact on the Company’s financial statements or related footnotes.\nOn April 9, 2009, the FASB issued “Recognition and Presentation of Other-Than-Temporary Impairments”, to be intended to bring consistency to the timing of impairment recognition, and provide improved disclosures about the credit and noncredit components of impaired debt securities that are not expected to be sold. The measure of impairment in comprehensive income remains fair value. The guidance also requires increased and more timely disclosures regarding expected cash flows, credit losses, and an aging of securities with unrealized losses. This guidance shall be effective for interim and annual reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. Earlier adoption for periods ending before March 15, 2009, is not permitted. If an entity elects to adopt early either “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly”, or “Interim Disclosures about Fair Value of Financial Instruments”, the entity also is required to adopt early this guidance. Additionally, if an entity elects to adopt early , it is required to adopt “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly”. This guidance does not require disclosures for earlier periods presented for comparative purposes at initial adoption. In periods after initial adoption, this guidance requires comparative disclosures only for periods ending after initial adoption. The adoption did not have a significant impact on the Company’s financial statement or footnotes.\nOn May 28, 2009, the FASB issued the guidance regarding subsequent events, which we adopted on a prospective basis beginning April 1, 2009. The guidance is intended to establish general standards of accounting and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. It requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for selecting that date. The application of the pronouncement did not have an impact on our financial position, results of operations or cash flows. These financial statements were approved by management and were issued on January 22, 2010. Subsequent events have been evaluated through this date.\nRecently Issued Accounting Pronouncements\nIn June 2009, the Financial Accounting Standards Board issued the statement of “Accounting Standards Codification TM and the Hierarchy of Generally Accepted Accounting Principles This statement confirmed that the FASB Accounting Standards Codification (the “Codification”) will become the single official source of authoritative U.S. GAAP (other than guidance issued by the SEC), superseding existing FASB, American Institute of Certified Public Accountants, Emerging Issues Task Force (“EITF”), and related literature. After that date, only one level of authoritative U.S. GAAP will exist. All other literature will be considered non-authoritative. The Codification does not change U.S. GAAP; instead, it introduces a new structure that is organized in an easily accessible, user-friendly online research system. The Codification, which changes the referencing of financial standards, becomes effective for interim and annual periods ending on or after September 15, 2009.. The Company has adopted this standard and did not have any substantive impact on our financial statements or related footnotes.\nManagement does not believe that any other recently issued, but no yet effective accounting standards, if currently adopted, would have a material effect on the accompanying financial statements.\nNOTE 3—PUBLIC OFFERING\nOn March 7, 2008, the Company sold 4,000,000 units in the Offering at a price of $8.00 per unit. On March 31, 2008, the Company consummated the closing of an additional 239,300 units which were subject to the over-allotment option. Each unit consists of one share of the Company’s ordinary shares, $0.001 par value, and one warrant. Each warrant will entitle the holder to purchase from the Company one of the Company’s ordinary shares at an exercise price of $5.00 per share commencing on the later of: (i) The consummation of the Business Combination, or (ii) March 7, 2009. The warrants will be exercisable only if the Company continues to provide for an effective registration statement covering the ordinary shares issueable upon exercise of the warrants. In no event will the holder of a warrant be entitled to receive a net cash settlement or other consideration in lieu of physical settlement in shares of the Company’s ordinary shares.\nF-11\nThe warrants expire on March 7, 2013, unless earlier redeemed. The warrants included in the units sold in the Offering are redeemable, at the Company’s option, in whole and not in part at a price of $0.01 per warrant upon a minimum of 30 days’ notice after the warrants become exercisable, only in the event that the last sale price of the ordinary shares exceeds $11.50 per share for any 20 trading days within a 30-trading day period.\nThe purchased warrants are recognized in additional paid-in-capital within shareholders’ equity since, under the terms of the warrants, the Company cannot be required to settle or redeem them for cash.\nNOTE 4—RELATED PARTY TRANSACTIONS\nThe Company has agreed to pay Hambrecht-Eu Capital, a company owned and managed by the Company’s Chairman of the Board, Chief Financial Officer and Secretary, $7,500 per month for office space and general and administrative services including secretarial support commencing on November 15, 2007 and continuing (i) until the consummation by the Company of a business combination (as described in Note 1), (ii) 18 months from commencement of the Offering if the Company does not effect a Business Combination, (iii) 24 months from the consummation of the Offering if a letter of intent, agreement in principle or definitive agreement, has been executed within 18 months of commencement of the Offering and the Company has not effected a business combination, or (iv) 36 months from the consummation of the Offering if an extension has been approved by the Company’s shareholders under certain circumstances.\nAEX Enterprises Limited, W.R. Hambrecht + Co., LLC and the Hambrecht 1980 Revocable Trust, companies controlled by Elizabeth B. Hambrecht, wife of Robert Eu, one of the Company’s founders and the Company’s Chairman, Chief Financial Officer and Secretary and William R. Hambrecht, Robert Eu’s father-in-law, Shea Ventures LLC, a company controlled by Edmund H. Shea Jr. and Marbella Capital Partners Ltd., a company controlled by John Wang, our Chief Executive Officer, purchased an aggregate of 1,550,000 warrants at a price of $1.00 per warrant ($1,550,000 in the aggregate) in a private placement immediately prior to the initial public offering (“private placement warrants”). Elizabeth B. Hambrecht owns approximately 25% and William R. Hambrecht controls (through a trust of which he is trustee) approximately 38% of the voting shares of AEX Enterprises Limited. William Hambrecht is a controlling person of W.R. Hambrecht + Co., LLC and is the trustee of the Hambrecht 1980 Revocable Trust. The proceeds from the sale of the private placement warrants were added to the proceeds from the Offering and are held in the Trust Account pending the Company’s consummation of a Business Combination. If the Company does not complete a Business Combination that meets the criteria described in the Offering, then the $1,550,000 purchase price of the private placement warrants will become part of any liquidating distribution to the Company’s public shareholders following the Company’s liquidation and dissolution and the private placement warrants will expire worthless.\nThe private placement warrants will be non-redeemable so long as they are held by the original holders of the warrants, the pre-initial public offering shareholders and directors or their permitted transferees. In addition, pursuant to the registration rights agreement, the holders of the private placement warrants and the underlying ordinary shares will be entitled to certain registration rights immediately after the consummation of the initial business combination and the warrants may be exercised on a cashless basis if held by the original holder, the pre-initial public offering shareholder and director or their permitted transferees. With those exceptions, the private placement warrants have terms and provisions that are otherwise identical to those of the warrants sold as part of the units in the Offering.\nThe sale of private placement warrants did not result in the recognition of stock-based compensation expense because the private placement warrants were sold at or above fair market value.\nAEX Enterprises Limited, W.R. Hambrecht + Co., LLC, the Hambrecht 1980 Revocable Trust, Shea Ventures LLC and Marbella Capital Partners Ltd. have agreed, subject to certain exceptions, not to transfer, assign or sell any of its private placement warrants until after the Company consummates a Business Combination. However, prior to the consummation of a business combination, the original holders of the warrants will be permitted to transfer their private placement warrants in certain limited circumstances, such as to the Company’s officers and directors, and other persons or entities associated with such persons, but the transferees receiving such private placement warrants will be subject to the same sale restrictions imposed on such entity.\nF-12\nRobert Eu, one of the Company’s founders, had provided to the Company advances totaling approximately $282,000 to pay a portion of the expenses of the Offering for the SEC registration fee, FINRA registration fee, and accounting and legal fees and expenses. The note was payable on demand with interest at 4% per annum. The note, plus interest of approximately $5,000, was repaid out of the proceeds of the Offering on March 12, 2008.\nNOTE 5—FAIR VALUE MEASUREMENTS\nThe Company complies with Fair Value Measurements, for its financial assets and liabilities that are re-measured and reported at fair value at each reporting period, and non-financial assets and liabilities that are re-measured and reported at fair value at least annually.\nThe following tables present information about the Company’s assets that are measured at fair value on a recurring basis as of June 30, 2009 and December 31, 2008, and indicates the fair value hierarchy of the valuation techniques the Company utilized to determine such fair value. In general, fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities. Fair values determined by Level 2 inputs utilize data points that are observable such as quoted prices, interest rates and yield curves. Fair values determined by Level 3 inputs are unobservable data points for the asset or liability, and includes situations where there is little, if any, market activity for the asset or liability:\nFair Value of Financial Assets as of June 30, 2009\n| Description | June 30, 2009 | Quoted Prices in Active Markets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) |\n| Assets: |\n| Cash equivalents | $ | 30,271 | $ | 30,271 | $ | — | $ | — |\n| Cash equivalents held in Trust Account | 33,838,155 | 33,838,155 | — | — |\n| Total | $ | 33,868,426 | $ | 33,868,426 | $ | — | $ | — |\n\nFair Value of Financial Assets as of December 31, 2008\n| Description | December 31, 2008 | Quoted Prices in Active Markets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) |\n| Assets: |\n| Cash equivalents | $ | 100,312 | $ | 100,312 | $ | — | $ | — |\n| Cash equivalents held in Trust Account | 33,798,651 | 33,798,651 | — | — |\n| Total | $ | 33,898,963 | $ | 33,898,963 | $ | — | $ | — |\n\nF-13\nThe fair values of the Company’s cash equivalents and cash and cash equivalents held on the Trust Account are determined through market, observable and corroborated sources.\nNOTE 6— COMMITMENTS AND UNDERWRITERS’ COMPENSATION\nThe Company consummated the Offering on March 12, 2008 and paid to the underwriters a $1,120,000 underwriting fee, representing 3.5% of the gross proceeds, and is committed to pay up to an additional $1,120,000, currently held in the Trust Account, representing an additional deferred underwriting fee of 3.5%, payable upon the Company’s consummation of a Business Combination.\nOn March 31, 2008, the underwriters exercised their over-allotment option and purchased from the Company an additional 239,300 units. The Company paid to the underwriters a $67,004 underwriting discount, representing 3.5% of the over-allotment gross proceeds, and is committed to pay up to an additional $67,004, currently held in the Trust Account, representing an additional deferred underwriting discount of 3.5%, payable upon the Company’s consummation of a Business Combination.\nThe Company also issued and sold to the underwriters on the closing date an option, as an additional compensation to purchase up to an aggregate of 280,000 units for an aggregate purchase price of $100. The Option shall be exercisable, in whole or in part, commencing on the later of the consummation of a Business Combination or six months from March 7, 2008 and expiring on March 7, 2013 at an initial exercise price of $10.00 per Unit.\nThe Company has determined based upon a Black-Scholes- Merton option pricing model, that the estimated fair value of the option on the date of sale would be approximately $3.36 per unit or an aggregate of approximately $941,000, assuming an expected term of five years, estimated volatility of 51.51% and a risk-free interest rate of 3.38%. Given the parameters used in the computation of the value of the option change over time, the actual fair value of the option on the date of sale is expected to be different from the estimated fair value computed above.\nThe volatility calculation of 51.51% is based on the latest five year average prior to the Offering, volatility of 62 companies drawn from the Shanghai Stock Exchange Composite Index that had market capitalizations between $70 million and $150 million. Because the Company does not have a trading history, the Company estimated the potential volatility of its ordinary share price, which will depend on a number of factors which cannot be ascertained at this time. The Company used the annualized volatility of the historical volatilities for a period of time equal in length to the term of the option because the Company believes that the volatility of these companies is a reasonable benchmark to use in estimating the expected volatility for the Company’s ordinary share post-Business Combination. Although an expected life of five years was taken into account for purposes of assigning value to this option, if the Company does not consummate a Business Combination within the prescribed time period and liquidates, this option would become worthless.\nPursuant to Rule 2710(g)(1) of FINRA Conduct Rule, the option to purchase 280,000 units is deemed to be underwriting compensation and therefore upon exercise, the underlying ordinary shares and warrants are subject to a 180-day lock-up. Additionally, the option may not be sold, transferred, assigned, pledged or hypothecated for a one-year period (including the foregoing 180-day period) following the date of the Offering.\nNOTE 7 — GOING CONCERN\nOn September 4, 2009, the Company has issued a press release announcing that it has entered into a letter of intent with a company for a business combination. The target is a company with its principal business operations in the People’s Republic of China. Pursuant to the Company’s Amended and Restated Memorandum and Articles of Association, the execution of the letter of intent affords the Company a six-month extension for completion of a business combination, until March 12, 2010.\nF-14\nThe consummation of the business combination is subject to, among other things, execution of a definitive agreement and required stockholder approval. There can be no assurance that a business combination will be consummated. However, if we anticipate that we will not be able to consummate a business combination by March 12, 2010, we may seek shareholder approval to extend the period of time to consummate a business combination until March 12, 2011. If we are unable to complete the business combination by March 12, 2010, or March 12, 2011 if extension period approved, our purposes and powers will be limited to dissolving, liquidating and winding up. Also contained in our articles of association is the requirement that our board of directors, to the fullest extent permitted by law, consider a resolution to dissolve our company at that time. Consistent with such obligations, our board of directors will seek shareholder approval for any such plan of distribution, and our pre-initial public offering shareholders and directors have agreed to vote in favor of such dissolution and liquidation. This provision will be amended only in connection with, and upon consummation of, its initial business combination by such date. The accompanying financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern and is required to liquidate.\nF-15\n\n \n\nWhat is the total capital generated by the company through various activities from July 18, 2007 to June 30, 2009, excluding net income and assuming the interest income re-invested in the trust account was paid out to increase capital instead of being reinvested, in USD?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nITEM 1. BUSINESS\\nOverview\\nHambrecht Asia Acquisition Corp. (“we”, “us”, “our” or the “Company”) is a Cayman Islands blank check company formed on July 18, 2007 to complete a business combination with one or more operating businesses that have its or their primary operations in the PRC. Our efforts in identifying a prospective target business will not be limited to a particular industry. We intend to effect a business combination using cash from the proceeds of our initial public offering and the private placements of the sponsors’ warrants, our capital stock, debt or a combination of cash, stock and debt. On March 7, 2008, we completed a private placement of 1,550,000 warrants (“Founder Warrants”). On March 12, 2008, we consummated our initial public offering of 4,000,000 units. On March 31, 2008, the underwriters of our initial public offering exercised their over-allotment option for a total of an additional 239,300 units (over and above the 4,000,000 units sold in the initial public offering) for an aggregate offering of 4,239,300 units (together the “IPO”). Each unit consists of one share of common stock and one redeemable common stock purchase warrant, resulting in a total of 4,239,300 common shares (“IPO Shares”) and 4,239,300 warrants (“IPO Warrants”) which are publicly held. The units were sold at an offering price of $8.00 per unit and the Founder Warrants we sold at an offering price of $1.00 per warrant, generating total gross proceeds of $35,464,400. Broadband Capital Management LLC acted as lead underwriter.\\nThe net proceeds from the IPO and private placement, after deducting certain offering expenses of approximately $2,784,873 (including underwriting discounts of approximately $2,374,008), were approximately $32,679,527. Approximately $33,527,396 (or approximately $7.91 per IPO Share) of the proceeds from the IPO and the private placement was placed in a trust account for our benefit, which includes $1,187,004 of the underwriter’s compensation which will be paid to them only in the event of a business combination. The remaining $339,135 was not placed in the trust account. We will not be able to access the amounts held in the trust account until we consummate a business combination, except for up to $700,000 (plus up to an additional $350,000 if approved by our shareholders in connection with the extension of the period in which we must complete our initial business combination to March 12, 2011) in interest earned on the funds in the trust account, which may be released from the trust to us to be used for working capital. As of June 30, 2009, there was approximately $33,799,000 held in the trust account (or approximately $7.92 per IPO Share), and approximtely $286,000 of interest eanred on the trust account balance had been released to us for working capital purposes.\\nInvestment Opportunities in China\\nOpportunities for market expansion have emerged for businesses with operations in China due to certain changes in the PRC’s political, economic and social policies as well as certain fundamental changes affecting the PRC and his neighboring countries. We believe that China represents both a favorable environment for making acquisitions and an attractive operating environment for a target business for several reasons, including:\\n\\n| § | prolonged economic expansion within China, including gross domestic product growth of approximately 16.5% on average over the last 25 years, including 17.7% in 2004, 15.0% in 2005 and 14.7% in 2006 (National Bureau of Statistics of China) (China Statistical Yearbook – 2007, http://www.stats.gov.cn/tjsj/ndsj/2007/indexeh.htm, viewed February 24, 2009); |\\n\\n\\n| § | increased government focus within China on privatizing assets, improving foreign trade and encouraging business and economic activity; |\\n\\n\\n| § | the recent entry of China into the World Trade Organization, the sole global international organization dealing with the rules of trade between nations, which may lead to a reduction on tariffs for industrial products, a reduction in trade restrictions and an increase in trading with the United States. |\\n\\nWe believe that these factors and others should enable us to acquire a target business with growth potential on favorable terms.\\n3\\nEffecting a Business Combination\\nWe intend to utilize the cash proceeds of the IPO and the private placement, our capital securities, debt or a combination of these as the consideration to be paid in a business combination. While substantially all of the net proceeds of the IPO are allocated to completing a business combination, the proceeds are not otherwise designated for more specific purposes. If the business combination is paid for using equity or debt securities, we may apply the cash released to us from the trust account for general corporate purposes, including for maintenance or expansion of operations of the acquired business or businesses, the payment of principal or interest due on indebtedness incurred in consummating our initial business combination, to fund the purchase of other companies, or for working capital. We may engage in a business combination with a company that does not require significant additional capital but is seeking a public trading market for its shares and that wants to merge with an already public company to add the experience of the public company’s management team to its company and to avoid the risk that market conditions will not be favorable for an initial public offering at the time this offering is ready to be sold, despite the fact that merging with us would require similar disclosures and, potentially, a similar timeframe as an initial public offering. We may seek to effect a business combination with more than one target business, although our limited resources may serve as a practical limitation on our ability to do so.\\nPrior to consummation of a business combination, we will seek to have all vendors, prospective target businesses or other entities that we may engage, which we refer to as potential contracted parties or a potential contracted party, execute agreements with us waiving any right, title, interest or claim of any kind in or to any monies held in the trust account for the benefit of our public shareholders. There is no assurance that we will be able to get waivers from our vendors and there is no assurance that such waivers will be enforceable by operation of law or that creditors would be prevented from bringing claims against the trust. In the event that a potential contracted party were to refuse to execute such a waiver, we will execute an agreement with that entity only if our management first determines that we would be unable to obtain, on a reasonable basis, substantially similar services or opportunities from another entity willing to execute such a waiver. Examples of instances where we may engage a third party that refused to execute a waiver would be the engagement of a third party consultant whose particular expertise or skills are believed by management to be superior to those of other consultants that would agree to execute a waiver or a situation where management does not believe it would be able to find a provider of required services willing to provide the waiver. If we are unable to complete a business combination and are forced to dissolve and liquidate, each of our pre-initial public offering shareholders other than Stephen N. Cannon, will, by agreement, be personally liable (each in an amount proportional to the number of shares owned as compared to both of them as a group, except that John Wang and Robert Eu will indemnify us for the portion of the indemnification obligation attributable to the portion of our shares owned by Stephen N. Cannon) to ensure that the proceeds in the trust account are not reduced by the claims of prospective target businesses, vendors or other entities that are owed money by us for services rendered or products sold to us. Under these circumstances, our board of directors would have a fiduciary obligation to our shareholders to bring a claim against each of our pre-initial public offering shareholders other than Stephen N. Cannon to enforce their liability obligation.\\nSubject to the requirement that a target business or businesses have a fair market value of at least 80% of the balance in the trust account (excluding deferred underwriting discounts and commissions of $1,187,004 and taxes payable) at the time of our initial business combination, we have virtually unrestricted flexibility in identifying and selecting one or more prospective target businesses.\\nWe focus on potential target businesses with valuations between $70 million and $150 million. We believe that our available working capital, together with the issuance of additional equity and/or the issuance of debt, would support the acquisition of such a target business. The mix of additional equity and/or debt would depend on many factors. The proposed funding for any such business combination would be disclosed in the proxy statement relating to the required shareholder approval.\\nAfter completion of the IPO, we began contacting investment bankers, private equity firms and other business contacts in order to generate ideas about a suitable business combination. We also received unsolicited inquiries from several investment banking firms, private equity firms and other business intermediaries. We informed these contacts that we were seeking an operating business for our initial business combination. We have not retained an investment banking firm or fairness or valuation advisor to conduct a formal search for a business combination. Criteria for suitability included our management’s assessment of the competitive strengths and weaknesses of the potential business targets, the strength of the management team, and the quality of the assets to be acquired.\\n4\\nWe may pay fees or compensation to third parties for their efforts in introducing us to potential target businesses. We may seek to engage someone to assist in finding a potential target business if our management feels that they need assistance to find a suitable target business. If a finder approaches us on an unsolicited basis, our management would decide whether to work with that finder (and pay a finders’ fee) depending on the potential target business such finder proposes. Such payments are typically, although not always, calculated as a percentage of the dollar value of the transaction. We have not anticipated use of a particular percentage fee, but instead will seek to negotiate the smallest reasonable percentage fee consistent with the attractiveness of the opportunity and the alternatives, if any, that are then available to us. We may make such payments to entities we engage for this purpose or entities that approach us on an unsolicited basis. Payment of finders’ fees is customarily tied to consummation of a transaction and certainly would be tied to a completed transaction in the case of an unsolicited proposal. Although it is possible that we may pay finders’ fees in the case of an uncompleted transaction, we consider this possibility to be extremely remote. In no event will we pay any of our directors or officers or any entity with which they are affiliated any finder’s fee or other compensation for services rendered to us prior to or in connection with the consummation of a business combination. In addition, none of our officers or directors will receive any finder’s fee, consulting fees or any similar fees from any person or entity in connection with any business combination involving us. Following such business combination, however, our officers or directors may receive compensation or fees including compensation approved by the board of directors for customary director’s fees for our directors that remain following such business combination. Our directors have advised us that they will not take an offer regarding their compensation or fees following a business combination into consideration when determining which target businesses to pursue.\\nWe anticipate structuring a business combination to acquire 100% of the equity interests or assets of the target business. We may, however, structure a business combination to acquire less than 100% of such interests or assets of the target business but will not acquire less than a controlling interest (which would be greater than 50% of the voting securities of the target business). If we acquire only a controlling interest in a target business or businesses, the portion of such business that we acquire must have a fair market value equal to at least 80% of the amount in the trust account, (excluding deferred underwriting discounts and commissions and taxes payable), as described above. If we determine to simultaneously acquire several businesses and such businesses are owned by different sellers, we will need for each of such sellers to agree that our purchase of his business is contingent on the simultaneous closings of the other acquisitions, which may make it more difficult for us, and delay our ability, to complete the business combination. With multiple acquisitions, we could also face additional risks, including additional burdens and costs with respect to possible multiple negotiations and due diligence investigations (if there are multiple sellers) and the additional risks associated with the subsequent integration of the operations and services or products of the acquired companies in a single operating business.\\nIn recent months, there has been severe volatility and overall significant declines in the international capital markets and a freezing of the international credit markets that together have led to severe constraints in private flows of capital and an acutely negative impact on the operating results of companies in a wide range of industries and geographic sectors. Declining valuations of potential target businesses and uncertainty regarding the future may make it more difficult for us to reach agreement on a business combination that satisfies our requirements and the lack of available credit sources may adversely impact our ability to structure a transaction in the most advantageous manner. In addition, certain of our shareholders may experience pressure to vote against any business combination that we may propose in order to liquidate their investment and free up their capital, without regard to the merits of any such transaction.\\n5\\nGovernment regulations\\nGovernment regulations relating to foreign exchange controls\\nThe principal regulation governing foreign exchange in China is the Foreign Currency Administration Rules (IPPS), as amended. Under these rules, the Renminbi, China’s currency, is freely convertible for trade and service related foreign exchange transactions (such as normal purchases and sales of goods and services from providers in foreign countries), but not for direct investment, loan or investment in securities outside of China without the prior approval of the State Administration for Foreign Exchange (“SAFE”) of China. Foreign investment enterprises (“FIEs”) are required to apply to the SAFE for “Foreign Exchange Registration Certificates for FIEs.” Following a business combination, involving a change of equity ownership of a PRC operating entity or through contractual arrangements with a PRC operating entity our subsidiary will likely be an FIE as a result of our ownership structure. With such registration certificates, which need to be renewed annually, FIEs are allowed to open foreign currency accounts including a “basic account” and “capital account.” Currency translation within the scope of the “basic account,” such as remittance of foreign currencies for payment of dividends, can be effected without requiring the approval of the SAFE. However, conversion of currency in the “capital account,” including capital items such as direct investment, loans and securities, still require approval of the SAFE. This prior approval may delay or impair our ability to operate following a business combination. On November 21, 2005, the SAFE issued Circular No. 75 on “Relevant Issues Concerning Foreign Exchange Control on Domestic Residents’ Corporate Financing and Roundtrip Investment Through Offshore Special Purpose Vehicles.” Circular No. 75 confirms that the use of offshore special purpose vehicles as holding companies for PRC investments are permitted as long as proper foreign exchange registrations are made with the SAFE.\\nGovernment regulations relating to taxation\\nPrior to January 1, 2008, the standard enterprise income tax rate was 33%, which consisted of a 30% national income tax and a 3% local surcharge, for a company’s domestic and overseas incomes.\\nA new tax law, the PRC Enterprise Income Tax Law (“New EIT Law”), took effect on January 1, 2008. Under the new tax law, companies are subject to a uniform tax rate of 25%. The New EIT Law provides a five-year transition period starting from its effective date for those enterprises which were established before the promulgation date of the new tax law and which were entitled to a preferential lower tax rate under the then-effective tax laws or regulations. The New EIT Law significantly curtails tax incentives granted to foreign-invested enterprises under the previous tax law. The New EIT Law, however, (i) reduces the top rate of EIT from 33% to 25%, (ii) permits companies to continue to enjoy their existing tax incentives, subject to certain transitional phase-out rules, and (iii) introduces new tax incentives, subject to various qualification criteria. The New EIT Law and its implementing rules permit certain “high and new technology enterprises” to enjoy a reduced 15% EIT rate. Under the phase-out rules, enterprises established before the promulgation date of the New EIT Law and which were granted preferential EIT treatment under the then effective tax laws or regulations may continue to enjoy their preferential tax treatments until their expiration and will gradually transition to the uniform 25% EIT rate over a five-year transition period.\\nAdditionally, under the New EIT Law, an income tax rate for dividends payable to non-PRC investors and derived from sources within the PRC may be increased to 20%. It is currently unclear in what circumstances a source will be considered as located within the PRC.\\nThe new tax law provides only a framework of the enterprise tax provisions, leaving many details on the definitions of numerous terms as well as the interpretation and specific applications of various provisions unclear and unspecified.\\nCompetition\\nIn identifying, evaluating and selecting a target business for a business combination, we may encounter intense competition from other entities having a business objective similar to ours including other blank check companies, private equity groups and leveraged buyout funds, and operating businesses seeking acquisitions. Many of these entities are well established and have extensive experience identifying and effecting business combinations directly or through affiliates. Moreover, many of these competitors possess greater financial, technical, human and other resources than us. While we believe there are numerous potential target businesses with which we could combine, our ability to acquire larger target businesses will be limited by our available financial resources. This inherent limitation gives others an advantage in pursuing the acquisition of a target business. Furthermore:\\n\\n| § | our obligation to seek shareholder approval of our initial business combination or obtain necessary financial information may delay the consummation of a transaction; |\\n\\n6\\n| § | our obligation to redeem for cash ordinary shares held by our public shareholders who vote against the business combination and exercise their redemption rights may reduce the resources available to us for a business combination; |\\n\\n\\n| § | our outstanding warrants, and the future dilution they potentially represent, may not be viewed favorably by certain target businesses; and |\\n\\n\\n| § | the requirement to acquire an operating business that has a fair market value equal to at least 80% of the balance of the trust account at the time of the acquisition (excluding deferred underwriting discounts and commissions of $1,187,004 and taxes payable) could require us to acquire the assets of several operating businesses at the same time, all of which sales would be contingent on the closings of the other sales, which could make it more difficult to consummate the business combination. |\\n\\nAny of these factors may place us at a competitive disadvantage in successfully negotiating a business combination.\\nEmployees\\nWe currently have three officers. These individuals are not obligated to devote any specific number of hours to our business and intend to devote only as much time as they deem necessary to our business. We intend to hire employees and/or consultants, possibly including certain full time employees and/or consultants, in order to assist us in the search, due diligence for and consummation of a business combination.\\nEnforcement of Civil Liabilities\\nWe are registered under the laws of the Cayman Islands by way of continuation as an exempted company with limited liability. We are registered in the Cayman Islands because of certain benefits associated with being a Cayman Islands corporation, such as political and economic stability, an effective judicial system, a favorable tax system, the absence of foreign exchange control or currency restrictions and the availability of professional and support services. However, the Cayman Islands has a less developed body of securities laws as compared to the United States and provides protections for investors to a significantly lesser extent. In addition, Cayman Islands companies do not have standing to sue before the federal courts of the United States.\\nSubstantially all of our assets are located outside the United States. In addition, a majority of our directors and officers are nationals or residents of jurisdictions other than the United States and all or a substantial portion of their assets are located outside the United States. As a result, it may be difficult for investors to effect service of process within the United States upon us or these persons, or to enforce against us or them judgments obtained in United States courts, including judgments predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States. It may also be difficult for you to enforce in U.S. courts judgments obtained in U.S. courts based on the civil liability provisions of the U.S. federal securities laws against us, our officers and directors.\\nWe have not appointed any agent to receive service of process with respect to any action brought against us in the United States District Court for the Southern District of New York under the federal securities laws of the United States or of any state in the United States or any action brought against us in the Supreme Court of the State of New York in the County of New York under the securities laws of the State of New York.\\nWe believe that there is uncertainty as to whether the courts of the Cayman Islands or the PRC would, respectively, (1) recognize or enforce judgments of United States courts obtained against us or our directors or officers predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States, or (2) entertain original actions brought in the Cayman Islands or the PRC against us or our directors or officers predicated upon the securities laws of the United States or any state in the United States.\\n\\nITEM 1A. RISK FACTORS\\nAs a smaller reporting company, we are not required to include this information in our transition report on Form 10-K.\\n7\\nITEM 1B. UNRESOLVED STAFF COMMENTS\\nAs a smaller reporting company, we are not required to include this information in our transition report on Form 10-K.\\n\\nITEM 2. PROPERTIES\\nWe currently maintain our executive offices at 13/F Tower 2, New World Tower, 18 Queens Road Central, Hong Kong. The cost for this space is included in the $7,500 per-month fee paid to Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, for office space, administrative services and secretarial support. We believe, based on rents and fees for similar services in Hong Kong, that the fees that will be charged by Hambrecht Eu Capital Management LLC is at least as favorable as we could have obtained from unaffiliated persons.\\n\\nITEM 3. LEGAL PROCEEDINGS\\nThere is no litigation currently pending or threatened against us or any of our directors in their capacity as such.\\n\\nITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS\\nNo matters were submitted to a vote of our shareholders during the quarter ended June 30, 2009.\\n8\\nPART II\\n\\nITEM 5. MARKET FOR COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.\\nMarket Price Information\\nThe shares of our common stock, warrants and units are traded on the OTC Bulletin Board, or OTCBB, under the symbols “HMAQF,” “HMAWF” and “HMAUF,” respectively. Each unit consists of one ordinary share and one warrant. Each warrant entitles the holder to purchase one ordinary share at a price of $5.00 commencing on the later of our consummation of a business combination or one year from the date of the IPO prospectus, provided in each case that there is an effective registration statement covering the ordinary shares underlying the warrants in effect. The warrants will expire five years from the date of the IPO, unless earlier redeemed. Our common stock and warrants commenced to trade separately from April 9, 2008.\\nThe following table sets forth, for the calendar quarters indicated, the quarterly high and low bid information prices for our common stock, warrants and units as reported on the OTCBB, such over the counter market quotation reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.\\n\\n| Units | Ordinary Shares | Warrants |\\n| High | Low | High | Low | High | Low |\\n| Third Quarter of 2009 | $ | 7.65 | $ | 7.52 | $ | 7.98 | $ | 7.58 | $ | 0.16 | $ | 0.11 |\\n| Second Quarter of 2009 | $ | 7.25 | $ | 7.25 | $ | 7.65 | $ | 7.35 | $ | 0.55 | $ | 0.05 |\\n| First Quarter of 2009 | $ | 7.90 | $ | 7.00 | $ | 7.49 | $ | 7.10 | $ | 0.20 | $ | 0.05 |\\n| Fourth Quarter of 2008 | $ | 7.15 | $ | 6.50 | $ | 7.00 | $ | 6.21 | $ | 0.42 | $ | 0.13 |\\n| Third Quarter of 2008 | $ | 7.90 | $ | 7.60 | $ | 7.37 | $ | 6.85 | $ | 0.73 | $ | 0.50 |\\n| Second Quarter of 2008 | $ | 7.90 | $ | 7.60 | $ | 7.16 | $ | 6.95 | $ | 0.85 | $ | 0.60 |\\n| First Quarter of 2008 | $ | 8.15 | $ | 7.85 | - | - | - | - |\\n\\nNumber of Holders of Common Stock.\\nThe number of holders of record of our Common Stock on January 21, 2010 was 10, which does not include beneficial owners of our securities.\\nDividends.\\nThere were no cash dividends or other cash distributions made by us during the fiscal year ended June 30, 2009. Future dividend policy will be determined by our Board of Directors based on our earnings, financial condition, capital requirements and other then existing conditions. It is anticipated that cash dividends will not be paid to the holders of our common stock in the foreseeable future.\\n9\\nRecent Sales of Unregistered Securities.\\nOn July 18, 2007, John Wang, Robert J. Eu and Stephen N. Cannon purchased an aggregate of 1,150,000 of our ordinary shares (which includs 90,174 ordinary shares that were subsequently redeemed because the underwriters did not fully exercise their over-allotment option) for an aggregate purchase price of $25,000. Mr. Cannon subsequently transferred all of the shares he purchased to the Cannon Family Irrevocable Trust, of which Mr. Cannon is the sole trustee. Such shares were issued in connection with our organization pursuant to the exemption from registration contained in Section 4(2) of the Securities Act as they were sold in transactions not involving a public offering to a limited number of sophisticated, wealthy individuals. No underwriting commissions or offering discounts were paid with respect to such sales.\\nOn February 21, 2008, John Wang, Robert Eu and the Cannon Family Irrevocable Trust transferred an aggregate of 463,334 shares to W.R. Hambrecht + Co., LLC, Shea Ventures LLC, Marbella Capital Partners Ltd., AEX Enterprises Limited and the Hambrecht 1980 Revocable Trust, each of which entities is an accredited investor for an aggregate purchase price of $10,193.35 or $0.022 per share. All such transfers were exempt from registration pursuant to Sections 4(1) and 4(2) of the Securities Act, due to the limited number of individuals involved, their status as accredited investors and transfer restrictions and legends on the share certificates.\\nOn March 7, 2008, AEX Enterprises Limited, W.R. Hambrecht + Co., LLC and the Hambrecht 1980 Revocable Trust, companies controlled by Elizabeth B. Hambrecht, wife of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and William R. Hambrecht, Mr. Eu’s father-in-law, Shea Ventures LLC, a company controlled by Edmund H. Shea Jr. and Marbella Capital Partners Ltd., a company controlled by John Wang, our Chief Executive Officer, agreed to invest an aggregate of $1,550,000 in us in the form of private placement warrants to purchase 1,550,000 ordinary shares at a price of $1.00 per warrant. Elizabeth B. Hambrecht owns approximately 25% and William R. Hambrecht controls (through a trust of which he is the trustee) approximately 38% of the voting shares of AEX Enterprises Limited. William Hambrecht is a controlling person of the voting shares of W.R. Hambrecht + Co., LLC and is the trustee of the Hambrecht 1980 Revocable Trust. The proceeds of the sale of the warrants were placed in the trust account established for our benefit in connection with our IPO.\\nOn March 31, 2008, following the partial exercise of the over-allotment option by the underwriters of the IPO, we cancelled an aggregate of 90,174 ordinary shares held by Robert J. Eu, Cannon Family Irrevocable Trust and WR Hambrecht + Co., LLC.\\nOn December 21, 2008, AEX Enterprises Limited transferred an aggregate of 441,666 warrants to AEX Capital, LLC, for no consideration. Such transfer was exempt from registration pursuant to Sections 4(1) and 4(2) of the Securities Act, due to the limited number of individuals involved, their status as accredited investors and transfer restrictions and legends on the share certificates.\\nIn each of the foregoing sales of securities the purchasers were our officers and directors or affiliates of our officers and directors and therefore had access to all relevant information about us when choosing to invest in our securities. As of January 21, 2010, these securities were held by the persons or entities as set forth in the following table:\\n| Name | Ordinary Shares | Warrants |\\n| John Wang | 230,000 | 0 |\\n| W.R. Hambrecht + Co., LLC(1) | 178,275 | 25,000 |\\n| Cannon Family Irrevocable Trust (2) | 173,275 | 0 |\\n| Robert J. Eu | 173,275 | 0 |\\n| AEX Enterprises Limited(3) | 88,333 | 0 |\\n| Hambrecht 1980 Revocable Trust(4) | 88,333 | 441,667 |\\n| Shea Ventures LLC(5) | 88,333 | 441,667 |\\n| Marbella Capital Partners Ltd.(6) | 40,000 | 200,000 |\\n| AEX Capital, LLC(7) | 0 | 441,666 |\\n| Total: | 1,059,824 | 1,550,000 |\\n\\n10\\n\\n| (1) | William R. Hambrecht is the controlling person of W.R. Hambrecht + Co., LLC. |\\n\\n| (2) | Mr. Cannon is the sole Trustee of Cannon Family Irrevocable Trust. |\\n\\n| (3) | Elizabeth B. Hambrecht, Robert Eu’s wife, and William R. Hambrecht control AEX Enterprises Limited. |\\n\\n| (4) | William R. Hambrecht is the trustee of the Hambrecht 1980 Revocable Trust. |\\n\\n| (5) | Edmund H. Shea Jr. is the controlling person of Shea Ventures LLC. |\\n\\n| (6) | John Wang is the controlling person of Marbella Capital Partners Ltd. |\\n\\n| (7) | Elizabeth B. Hambrecht, Robert Eu’s wife, and Robert J. Eu control AEX Capital, LLC. |\\n\\nRepurchases of Equity Securities.\\nNone.\\nUse of Proceeds\\nOn March 7, 2008, we completed a private placement of 1,550,000 warrants. On March 12, 2008, we consummated our initial public offering of 4,000,000 units. On March 31, 2008, the underwriters of our initial public offering exercised their over-allotment option for a total of an additional 239,300 units (over and above the 4,000,000 units sold in the initial public offering) for an aggregate offering of 4,239,300 units. Each unit consists of one share of common stock and one redeemable common stock purchase warrant. Each warrant entitles the holder to purchase from us one share of our common stock at an exercise price of $5.00. The units were sold at an offering price of $8.00 per unit and the warrants we sold at an offering price of $1.00 per warrant, generating total gross proceeds of $35,464,400. Broadband Capital Management LLC acted as lead underwriter. The securities sold in our initial public offering were registered under the Securities Act of 1933 on a registration statement on Form S-1 (No. 333-146147). The Securities and Exchange Commission declared the registration statement effective on March 7, 2008.\\nWe incurred a total of $2,374,008 in underwriting discounts and commissions, of which $1,187,004 has been placed in the trust account. Such portion of the underwriter’s compensation will only be paid to the underwriters in the event that we consummate a business combination. The total expenses in connection with the sale of our warrants in the private placement and the initial public offering were $2,784,873.\\nAfter deducting the underwriting discounts and commissions and the offering expenses, the total net proceeds to us from the private placement and the initial public offering were approximately $32,679,527. Approximately $33,527,396 (or approximately $7.91 per unit sold in our initial public offering) of the proceeds from the initial public offering and the private placement was placed in a Trust Account for our benefit and the remaining proceeds are available to be used to provide for business, legal and accounting due diligence on prospective business combinations and continuing general and administrative expenses. The Trust Account contains $1,187,004 of the underwriter’s compensation which will be paid to them only in the event of a business combination. The amounts held in the trust account may only be used by us upon the consummation of a business combination, except that we may use up to $700,000 (or $1,050,000 if approved by our shareholders) of the interest earned on the trust account to fund our working capital prior to a business combination. As of June 30, 2009, there was $ 33,838,155 held in the trust account, which includes deferred underwriting fees of $1,187,004. Through June 30, 2009, approximately $286,000 of interest earned on the trust account balance has been released to us for working capital purpose.\\n\\nITEM 6. SELECTED FINANCIAL DATA\\nAs a smaller reporting company, we are not required to include this information in our transition report on Form 10-K.\\n11\\nITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\\nThe following discussion should be read in conjunction with the financial statements and related notes contained herein and the information included in our other filings with the SEC. This discussion includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements in this Transition Report on Form 10-K other than statements of historical fact are forward-looking statements. These forward-looking statements involve known and unknown risks and uncertainties. Our actual results may differ materially from those projected or assumed in such forward-looking statements. Among the factors that could cause actual results to differ materially are our being a development stage company with no operating history, our dependence on key personnel some of whom may join us following a business combination, our personnel allocating their time to other businesses and potentially having conflicts of interest with our business, our potentially being unable to obtain additional financing to complete a business combination and the ownership of our securities being concentrated. All forward-looking statements included in this document are made as of the date of this report, based on information available to us as of such date. We assume no obligation to update any forward-looking statement.\\nOverview\\nWe are a blank check company formed under the laws of the Cayman Islands on July 18, 2007. We were formed to acquire one or more operating businesses through a merger, stock exchange, asset acquisition or similar business combination or control through contractual arrangements having its primary operations in the People’s Republic of China, or PRC. We will not seek to acquire a business with its primary operations outside of the PRC.\\nThe company has entered into a letter of intent with a company for a business combination. The target is a company with its principal business operations in the People’s Republic of China. Pursuant to the Company’s Amended and Restated Memorandum and Articles of Association, the execution of the letter of intent affords the Company a six-month extension for completion of a business combination, until March 12, 2010 However if we anticipate that we will not be able to consummate a business combination by March 12, 2010, we may seek shareholder approval to extend the period of time to consummate a business combination until March 12, 2011. In order to extend the period of March 12, 2011, (i) public shareholders must approve the extension and (ii) public shareholders owning no more than one share less than 30% of the shares sold in this offering may have exercised their redemption rights.\\nResults of Operations for the Six Month Transition Period Ended June 30, 2009\\nWe incurred a net loss of $87,677 for the six month period ended June 30, 2009 due to both a decrease in the interest earned on the Trust Account which did not exceed our expenses for the period, and an increase in expenses related to professional services. Until we enter into a business combination, we will not have any operating revenues.\\nOverall, for the six month period ended June 30, 2009, we incurred $25,002 of insurance expense from the amortization of our pre-paid D&O insurance policy, $45,000 of rent expense and other operating costs of $114,868.\\nFor the six months ended June 30, 2009, our trust account earned interest of $97,193 and our funds outside of the trust account did not earn interest income.\\nResults of Operations for the Six Month Period Ended June 30, 2008\\nWe had a net gain of $11,449 for the six month period ended June 30, 2008.\\nOverall for six month period ended June 30, 2008, we incurred $16,668 of insurance expense from the amortization of our pre-paid D&O insurance policy, $45,000 of rent expense and other operating costs of $95,015.\\n12\\nFor the six months ended June 30, 2008, our trust account earned interest of $173,106.\\nResults of Operations for the Year Ended December 31, 2008\\nWe reported net income of $236,505 for the year ended December 31, 2008 due to interest earned on the trust account. Until we enter into a business combination, we will not have any operating revenues.\\nFor the year ended December 31, 2008, we incurred $37,503 of insurance expense from the amortization of our pre-paid D&O insurance policy, $97,500 of rent, administrative services and secretary support expense and other operating costs of $132,384.\\nFor the year ended December 31, 2008, our trust account earned gross interest of $510,361. $239,110 of this interest was withdrawn from the trust account to fund working capital and $271,251 remained in the trust account.\\nResults of Operations for the Year Ended December 31, 2007\\nWe reported a net loss of $21,736 for the year ended December 31, 2007 due to start-up expenses. Until we enter into a business combination, we will not have any operating revenues.\\nFor the year ended December 31, 2007, we incurred $15,000 of rent as well as formation and administrative costs of $6,736.\\nFor the year ended December 31, 2007, we did not earn any interest from our trust account.\\nLiquidity and Capital Resources\\nOn March 7, 2008, we completed a private placement of 1,550,000 warrants to AEX Enterprises Limited, a company controlled by Elizabeth B. Hambrecht, wife of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and William R. Hambrecht, Robert Eu’s father-in-law, W.R. Hambrecht + Co., LLC and the Hambrecht 1980 Revocable Trust, each an entity controlled by William Hambrecht, Shea Ventures LLC, a company controlled by Edmund H. Shea Jr., and Marbella Capital Partners Ltd., a company owned by John Wang, our Chief Executive Officer, and received net proceeds of $1,550,000. On March 12, 2008, we consummated our initial public offering of 4,000,000 units. On March 31, 2008, the underwriters of our initial public offering exercised a portion of their over-allotment option, for a total of an additional 239,300 units (over and above the 4,000,000 units sold in the initial public offering) for an aggregate offering of 4,239,300 units (collectively the “IPO”). Each unit in the public offering consisted of one share of common stock and one redeemable common stock purchase warrant. Each warrant entitles the holder to purchase from us one share of our common stock at an exercise price of $5.00. Our common stock and warrants started trading separately as of April 9, 2008.\\nThe net proceeds from the sale of our warrants and units, after deducting certain offering expenses of approximately $2,784,873, including underwriting discounts of approximately $2,374,008, were approximately $32,679,527. Approximately $33,527,396 of the proceeds from the IPO and the private placement was placed in a trust account for our benefit, which includes $1,187,004 of the underwriter’s compensation which will be paid to them only in the event of a business combination. The remaining $339,135 was not held in the trust account. Except for up to $700,000 (plus up to and additional $350,000 if approved by our shareholders in connection with the extension of the period in which we must complete our initial business combination to March 12, 2011) in interest that is earned on the funds contained in the trust account that may be released to us to be used as working capital, we will not be able to access the amounts held in the trust until we consummate a business combination. The amounts held outside of the trust account are available to be used by us to provide for business, legal and accounting due diligence on prospective acquisitions and continuing general and administrative expenses. From July 18, 2007 (the date of our inception) through June 30, 2009, we had operating expenses of $473,993. From January 1, 2009 through June 30, 2009, we had operating expenses of $184,870. The net proceeds deposited into the trust fund remain on deposit in the trust account earning interest. Other than $700,000 (or $1,050,000 if approved by our shareholders) in interest which we may use to fund working capital, the amounts held in the trust account may only be used by us upon the consummation of a business combination. As of December 31, 2008, we had 33,798,651 held in the trust account and as of June 30, 2009 there was $33,838,155 held in the trust account, which includes deferred underwriting fees of $1,187,004. Additionally, as of June 30, 2009, we had $30,271 outside the trust account to fund our working capital requirements. Through June 30, 2009, approximately $286,000 of interest earned on the trust account balance has been released to us for working capital purpose.\\n13\\nWe will use substantially all of the net proceeds of our IPO to acquire one or more target businesses, and will use a portion of the interest earned on the trust account together with the funds not held in trust to identify and evaluate prospective target businesses, to select one or more target businesses, and to structure, negotiate and consummate the business combination. We do not believe we will need to raise additional funds following our IPO in order to meet the expenditures required for operating our business. However, we may need to raise additional funds through a private offering of debt or equity securities if such funds were required to consummate a business combination. Such debt securities may include a working capital revolving debt facility or a longer term debt facility. Subject to compliance with applicable securities laws, we would only consummate such financing simultaneously with the consummation of a business combination.\\nCommencing on November 15, 2007, we began incurring a fee of approximately $7,500 per month for office space.\\nOff-Balance Sheet Arrangements\\nWe have never entered into any off-balance sheet financing arrangements and have never established any special purpose entities. We have not guaranteed any debt or commitments of other entities or entered into any options on non-financial assets.\\nContractual Obligations\\nWe do not have any long term debt, capital lease obligations, operating lease obligations, purchase obligations or other long term liabilities, except for our agreement with Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, for office space, administrative services and secretarial support pursuant to which we pay a monthly fee of $7,500.\\n\\nITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nMarket risk is the sensitivity of income to changes in interest rates, foreign exchanges, commodity prices, equity prices, and other market-driven rates or prices. We are not presently engaged in and, if a suitable business target is not identified by us prior to the prescribed liquidation date of the trust fund, we may not engage in, any substantive commercial business. Accordingly, we are not and, until such time as we consummate a business combination, we will not be, exposed to risks associated with foreign exchange rates, commodity prices, equity prices or other market-driven rates or prices. The net proceeds of our IPO held in the trust fund have been invested only in money market funds meeting certain conditions under Rule 2a-7 promulgated under the Investment Company Act of 1940. Given our limited risk in our exposure to money market funds, we do not view the interest rate risk to be significant.\\n\\nITEM 8. FINANCIAL AND SUPPLEMENTAL DATA\\nFinancial statements are attached hereto beginning with page F-1\\n\\nITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE\\nNone.\\n14\\nITEM 9A(T). CONTROLS AND PROCEDURES\\nDisclosure Controls and Procedures\\nAn evaluation of the effectiveness of our disclosure controls and procedures as of June 30, 2009 was made under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective as of the end of the period covered by this report.\\nDisclosure Controls and Procedures are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. During the most recently completed fiscal quarter, there has been no significant change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\\nManagement’s Report on Internal Control Over Financial Reporting\\nOur internal control over financial reporting is a process designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer and effected by our board of directors to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of our financial statements for external reporting purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that in reasonable detail accurately reflect the transactions and dispositions of our assets; provide reasonable assurance that transactions are recorded as necessary to permit preparation of our financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with the authorization of our board of directors and management; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements.\\nUnder the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation under the criteria established in Internal Control – Integrated Framework, our management concluded that our internal control over financial reporting was effective as of June 30, 2009.\\nThis Transition Report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit us to provide only management’s report in this Transition Report.\\n\\nITEM 9B. OTHER INFORMATION\\nNone.\\n15\\nPART III\\n\\nITEM 10. DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE\\nDirectors and Executive Officer\\nOur current directors and executive officers are as follows:\\n| Name | Age | Position |\\n| John Wang | 39 | Chief Executive Officer, President and Director |\\n| Robert J. Eu | 46 | Chairman of the Board, |\\n| Hao Wu | 35 | Chief Financial Officer, Secretary and Director |\\n| Hong Xiang Liu | 44 | Director |\\n\\nJohn Wang has been our Chief Executive Officer, President and a director since our inception. Mr. Wang has over twelve years of investment banking and consulting experience. Since November 2004, Mr. Wang has been the Managing Director of Marbella Capital Partners Ltd., a financial advisory firm based in Shanghai which he founded. From January 2000 to November 2004, he helped develop and establish the U.S. operations of SBI USA as Executive Vice President of SBI E2-Capital (HK) Limited and was a Managing Director and Chief Operating Officer of SBI E2-Capital (USA) Ltd. Prior to SBI, from 1997 to 1999, he managed Accenture Consulting’s Greater China communications, media, and high tech strategy practice, where he acted as consultant to China Mobile’s IPO in 1997, among other high profile projects. From 1994 to 1997 he was also the lead telecom analyst covering Greater China and Southeast Asia for Pyramid Research, a Cambridge Massachusetts based emerging market telecom research firm that is part of the Economist Intelligence Unit. Last year, he advised on four late-stage deals that closed, of which one has already gone public in Hong Kong and another, Yingli Green Energy (NYSE: YGE), completed its IPO and listing on the New York Stock Exchange on June 8, 2007. Mr. Wang currently sits on the Board of Hong Kong Stock Exchange listed Wuyi International Pharmaceutical Company Limited (HKSE: 1889). Mr. Wang holds a Bachelor of Arts degree in international relations from Tufts University and is a graduate of the Washington International Studies Program at St. Catherine’s College at Oxford University. He has an M.A.L.D. in international law and business from The Fletcher School of Law and Diplomacy and is a graduate of the Private Equity course at Harvard Business School.\\nRobert J. Eu has been our Chairman of the Board, Secretary and director since our inception. He has been our Chief Financial Officer since February 21, 2008. Since 1998, Mr. Eu has served as a Managing Director for W.R. Hambrecht + Co., LLC (“WR Hambrecht + Co”) a San Francisco-based investment bank. Mr. Eu founded WR Hambrecht + Co’s investment banking practice in Asia in 2003. Prior to WR Hambrecht + Co, Mr. Eu was a Managing Director of H&Q Asia Pacific from 1992 until 1998, an affiliate of Hambrecht & Quist, where he co-founded its Hong Kong office and China investment practice. In 1996, Mr. Eu led the buy-out and de-listing of Eu Yang Sang (Hong Kong) Limited from the Hong Kong stock exchange and the company is now listed on the Singapore Stock Exchange (SGX:EYSI). Mr. Eu has been a director of Eu Yang Sang since 1997. In 1992, prior to working at H&Q Asia Pacific, Mr. Eu was the Business Development Manager for Eu Yang Sang (Hong Kong) Limited, a manufacturer and retailer of Traditional Chinese medicine. Mr. Eu has been a director and the Chairman of AEX Enterprises Limited (“AEX Enterprises”) since 2003. AEX Enterprises’ primary operating subsidiary is Boom Securities (H.K.) Limited (“Boom Securities”). Boom Securities is a licensed broker / dealer regulated by the Securities and Futures Commission (SFC) of Hong Kong and headquartered in Hong Kong. Mr. Eu worked for Citibank from 1987 until 1992 in the Private Banking Group in Hong Kong. Mr. Eu is a graduate of Northwestern University with a B.A. in History.\\nHao Wu has been our Chief Financial Officer, Secretary and Director since September 4, 2009. He has been the Executive Vice President of Marbella Capital Partners, a boutique California/Shanghai based investment and advisory company that focuses on investing on Chinese deals in the growth and late stage, since January 2008. Prior to that, he was the finance director in B&Q Holding Co. Ltd., a leading home improvement retail company in China, from July 2006 until December 2007. Prior to B&Q, Mr. Wu worked for Fortune Tech group Co. Ltd. as the finance director from March 2004 until June 2006. He started his career in Unilever China as a management trainee. David holds a Bachelor of Science degree from the management school of Shanghai Jiao Tong University. Mr. Wu is employed by Marbella Capital Partners, which is controlled by John Wang, our Chief Executive Officer and a Director. Mr. Wu is not a party to any transactions listed in Item 404(a) of Regulation S\\n16\\nHong Xiang Liu has been one of our directors since September 4, 2009. He has been the director of Jiangsu Performing Art & Culture Enterprises Inc. Ltd., a real estate developer in China, Jiangsu province, since July 2007. Prior to this, he was the Chief Executive Officer and Executive Director of Tongda Energy Limited, a piped gas provider & operator in 11 cities across China, from October 2002 until July 2007. From 1988 to September 2002, Mr. Liu held various positions in China Construction Bank. His last appointment was as Vice General manager of the Enterprise Banking Department, China Construction Bank, Beijing Branch. Mr. Liu received his Bachelor of Engineering (Infrastructure Management) from Tianjin University and was accredited as a senior economist by China Construction Bank in 1998. Mr. Liu is not a party to any transactions listed in Item 404(a) of Regulation S-K.\\nBoard Committees\\nThe board of directors is currently composed of four individuals and we do not have any committees, and, therefore, the entire board of directors performs the functions of the Audit Committee. It is intended that the board of directors will establish an Audit Committee upon the consummation of a business combination. The board of directors will take all reasonable actions to ensure that one of the members of the Audit Committee will be an “audit committee financial expert,” as such term is defined in the rules of the Securities and Exchange Commission. We are currently listed on the OTC Bulletin Board and are therefore not required to have a nominating committee or a compensation committee. We will evaluate establishing such committees in the future. There have been no changes to the procedures by which stockholders may recommend nominees to our board of directors.\\nCode of Ethics\\nWe currently do not have a formal code of ethics. Upon consummation of a business combination, we intend to adopt a code of ethics that applies to our principal executive officer, principal financial officer, principal accounting officer or controller or persons performing similar functions.\\nSection 16(a) Beneficial Ownership Reporting Compliance\\nSection 16(a) of the Securities Exchange Act requires our directors, executive officers and persons who own more than 10% of our common stock to file reports of ownership and changes in ownership of our common stock with the Securities and Exchange Commission. Directors, executive officers and persons who own more than 10% of our common stock are required by Securities and Exchange Commission regulations to furnish to us copies of all Section 16(a) forms they file.\\nBased solely on our review of such forms furnished to us and written representations from certain reporting persons, we believe that all filing requirements applicable to our executive officers, directors and greater than 10% beneficial owners were complied with during 2009.\\nLegal Proceedings\\nJohn Wang, our Chief Executive Officer and President, who had been named a defendant in two lawsuits which were dismissed by the court in a summary judgement for the defendants. John Wang had been named as a defendant along with two other named individuals, SBI-USA, LLC, a U.S. investment firm, and several of SBI-USA’s subsidiaries. The lawsuits alleged several claims, including violation of federal civil RICO statutes, securities fraud, breach of escrow agreement and breach of fiduciary duty. The plaintiffs generally alleged that SBI-USA, through one of the other named defendants, breached the terms of an escrow agreement and distributed shares of common stock held for the benefit of a third party to the detriment of the plaintiffs. The complaints did not specify the damages sought but one suit claimed damages in excess of $1,600,000 and the other includes claims for damages in excess of $400,000. The first lawsuit was filed on June 8, 2007 and the second lawsuit was filed on December 7, 2007. Mr. Wang does not know if any additional lawsuits will be filed. Mr. Wang and the other defendants denied any wrongdoing in connection with the allegations in the complaints. On March 14, 2008, the lawsuits were dismissed by the court in a summary judgment for the defendants. The plaintiffs have filed a notice of their intent to appeal, and to date have requested and received extensions of time from the court to file a formal appeal brief, but have yet to do so.\\n17\\n\\nITEM 11. EXECUTIVE COMPENSATION\\nWe agreed to pay Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and Elizabeth B. Hambrecht, Mr. Eu’s wife, a total of $7,500 per month for office space, administrative services and secretarial support for the period from November 15, 2007 until the earlier of our consummation of a business combination or our liquidation. This arrangement was agreed to by Hambrecht Eu Capital Management LLC for our benefit and is not intended to provide Mr. Eu compensation. We believe that such fees are at least as favorable as we could have obtained from an unaffiliated third party.\\nOther than the fees paid to Hambrecht Eu Capital Management LLC, we do not currently pay any cash fees to our officers and directors, nor do we pay their expenses in attending board meetings.\\n\\nITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT\\nThe following table sets forth information regarding the beneficial ownership of our ordinary shares as of January 21, 2010 by:\\n\\n| § | each person known by us to be the beneficial owner of more than 5% of our outstanding ordinary shares; |\\n\\n\\n| § | each of our officers and directors; and |\\n\\n\\n| § | all our officers and directors as a group. |\\n\\nUnless otherwise indicated, we believe that all persons named in the table have sole voting and investment power with respect to all ordinary shares beneficially owned by them.\\n| Number of Ordinary | Approx. Percentage |\\n| Shares | of Outstanding |\\n| Name and Address of Beneficial Owner(1) | Beneficially Owned | Ordinary Shares |\\n| John Wang(2) | 270,000 | 5.1 | % |\\n| Robert J. Eu(3) | 261,608 | 4.9 | % |\\n| Stephen N. Cannon(4) | 173,275 | 3.3 | % |\\n| Hao Wu | — | — |\\n| Hong Xiang Liu | — | — |\\n| William R. Hambrecht(5) | 354,941 | 6.7 | % |\\n| W.R. Hambrecht + Co., LLC(6) | 178,275 | 3.4 | % |\\n| Shea Ventures LLC(7) | 88,333 | 1.7 | % |\\n| Marbella Capital Partners Ltd.(8) | 40,000 | * |\\n| AEX Enterprises Limited(9) | 88,333 | 1.7 | % |\\n| Hambrecht 1980 Revocable Trust(10) | 88,333 | 1.7 | % |\\n| Loeb Arbitrage Management, LLC(11) | 483,872 | 9.13 | % |\\n| HBK Investments L.P. (12) | 423,900 | 8.0 | % |\\n| Integrated Core Strategies (US) LLC (13) | 520,500 | 9.8 | % |\\n| Genesis Capital Advisors LLC. (14) | 367,500 | 6.9 | % |\\n\\n18\\n| Number of Ordinary | Approx. Percentage |\\n| Shares | of Outstanding |\\n| Name and Address of Beneficial Owner(1) | Beneficially Owned | Ordinary Shares |\\n| Bulldog Investors (15) | 300,000 | 5.7 | % |\\n| Yarika Partners, L.P. (16) | 284,225 | 5.4 | % |\\n| All directors and executive officer as a group (4 individuals) | 704,883 | 13.3 | % |\\n\\n* Less than 1%\\n(1). Except as otherwise provided below, the address for each of our beneficial owners is 13/F Tower 2, New World Tower, 18 Queens Road Central, Hong Kong.\\n(2). The number of shares beneficially owned includes the ordinary shares held by Marbella Capital Partners.\\n(3). Includes ordinary shares held by AEX Enterprises Limited.\\n(4). The ordinary shares beneficially owned by Stephen N. Cannon are held by the Cannon Family Irrevocable Trust, of which Mr. Cannon is the sole trustee.\\n(5). Consists of ordinary shares held by W.R. Hambrecht + Co., LLC, AEX Enterprises Limited and the Hambrecht 1980 Revocable Trust.\\n(6). William R. Hambrecht is the controlling person of W.R. Hambrecht + Co., LLC. Its address is Pier 1, Bay 3, San Francisco, CA 94111.\\n(7). Edmund H. Shea Jr. is the controlling person of Shea Ventures LLC. Its address is P.O. Box 489, 655 Brea Canyon Rd. Walnut, CA 91788.\\n(8). John Wang is the controlling person of Marbella Capital Partners Ltd.\\n(9). Elizabeth B. Hambrecht, Robert Eu’s wife, and William R. Hambrecht control AEX Enterprises Limited. Its address is Suite 802, 8/F AIA Tower, 183 Electric Road, North Point, Hong Kong.\\n(10). William R. Hambrecht is the trustee of the Hambrecht 1980 Revocable Trust. Its address is Pier 1, Bay 3, San Francisco, CA 94111.\\n(11). Based on a 13G filed on November 10, 2009. The business address of Loeb Arbirtage Management, LLC is 61 Broadway, 24th Floor, New York, NY 10006. Loeb Arbirtage Management, LLC is a registered investment adviser. Loeb Arbirtage Management, LLC may invest on behalf of itself and clients for which it has investment discretion. Loeb Arbitrage Fund’s general partner is Loeb Arbitrage Management, LLC. Loeb Offshore Fund Ltd.’s registered investment advisor is Loeb Offshore Management, LLC.\\n(12). Based on a 13G/A filed on January 28, 2009. The business address of HBK Investments L.P. is 2101 Cedar Springs Road Suite 700, Dallas, TX 75201. HBK Investments L.P. has delegated discretion to vote and dispose of the Securities to HBK Services LLC. HBK Services may, from time to time, delegate discretion to vote and dispose of certain of the securities to HBK New York LLC, a Delaware limited liability company, HBK Virginia LLC, a Delaware limited liability company, and/or HBK Europe Management LLP, a limited liability partnership organized under the laws of the United Kingdom (collectively, the “Subadvisors”). Each of HBK Services and the Subadvisors is under common control with HBK Investments L.P. Jamiel A. Akhtar, Richard L. Booth, David C. Haley, Lawrence H. Lebowitz, and William E. Rose are each managing members of HBK Management LLC.\\n19\\n(13). Based on a 13G/A filed on January 29, 2009. The business address of Integrated Core Strategies (US) LLC is c/o Millennium Management, LLC 666 Fifth Avenue 8th Floor, New York, NY 10103. Millennium Management LLC, a Delaware limited liability company (“Millennium Management”), is the general partner of the managing member of Integrated Core Strategies and may be deemed to have shared voting control and investment discretion over securities owned by Integrated Core Strategies. Israel A. Englander is the managing member of Millennium Management. Consequently, Mr. Englander may also be deemed to have shared voting control and investment discretion over securities owned by Integrated Core Strategies.\\n(14). Based on a 13G/A filed on February 17, 2009. The business address of Genesis Capital Advisors LLC is 255 Huguenot Street, Suite 1103, New Rochelle, NY 10801. Jaime Hartman, Ethan Benovitz and Daniel Saks are the managing members of Genesis. As a result, Messrs. Hartman, Benovitz and Saks may be deemed to have shared voting control and investment discretion over securities deemed to be beneficially owned by Genesis.\\n(15). Based on a 13G filed on August 1, 2008. The business address of Bulldog Investors is Park 80 West, Plaza Two, Saddle Brook, NJ 07663. Phillip Goldstein and Andrew Dakos are principals of Bulldog Investors.\\n(16). Based on a 13G filed on October 21, 2009. The business address of Yakira Parterns, L.P. is 991 Post Road East Westport, CT 06880. Mr. Bruce M. Kallins is the managing member of Yakira Partners, L.P.\\nAll 1,059,825 Founder Shares owned by our Founders have been placed in escrow with Continental Stock Transfer & Trust Company, as escrow agent, pursuant to an escrow agreement.\\n\\nITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTORS INDEPENDENCE\\nOn July 18, 2007, John Wang, Robert J. Eu and Stephen N. Cannon purchased an aggregate of 1,150,000 of our ordinary shares (which includs 90,174 ordinary shares that we redeemed on March 31, 2008 because the IPO underwriters did not exercise their over-allotment option in full) for an aggregate purchase price of $25,000. Mr. Cannon subsequently transferred all of the shares he purchased to the Cannon Family Irrevocable Trust, of which Mr. Cannon is the sole trustee.\\nOn February 21, 2008, John Wang, Robert Eu and the Cannon Family Irrevocable Trust transferred an aggregate of 463,334 shares to W.R. Hambrecht + Co., LLC, Shea Ventures LLC, Marbella Capital Partners Ltd., AEX Enterprises Limited and the Hambrecht 1980 Revocable Trust, each of which entities is an accredited investor for an aggregate purchase price of 10,193.35 or $0.022 per share.\\nOn March 7, 2008, AEX Enterprises Limited, W.R. Hambrecht + Co., LLC and the Hambrecht 1980 Revocable Trust, companies controlled by Elizabeth B. Hambrecht, wife of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and William R. Hambrecht, Mr. Eu’s father-in-law, Shea Ventures LLC, a company controlled by Edmund H. Shea Jr. and Marbella Capital Partners Ltd., a company controlled by John Wang, our Chief Executive Officer, agreed to invest an aggregate of $1,550,000 in us in the form of private placement warrants to purchase 1,550,000 ordinary shares at a price of $1.00 per warrant. Elizabeth B. Hambrecht owns approximately 25% and William R. Hambrecht controls (through a trust of which he is the trustee) approximately 38% of the voting shares of AEX Enterprises Limited. William Hambrecht is a controlling person of the voting shares of W.R. Hambrecht + Co., LLC and is the trustee of the Hambrecht 1980 Revocable Trust. The proceeds of the sale of the warrants were placed in the trust account established for our benefit in connection with our IPO.\\nOn March 31, 2008, following the partial exercise of the over-allotment option by the underwriters of the IPO, we cancelled an aggregate of 90,174 ordinary shares held by Robert J. Eu, Cannon Family Irrevocable Trust and WR Hambrecht + Co., LLC.\\nOn December 21, 2008, AEX Enterprises Limited transferred an aggregate of 441,666 warrants to AEX Capital, LLC, for no consideration. Such transfer was exempt from registration pursuant to Sections 4(1) and 4(2) of the Securities Act, due to the limited number of individuals involved, their status as accredited investors and transfer restrictions and legends on the share certificates.\\n20\\nIn each of the foregoing sales of securities the purchasers were our officers and directors or affiliates of our officers and directors and therefore had access to all relevant information about us when choosing to invest in our securities. As of January 21, 2010, these securities were held by the persons or entities as set forth in the following table:\\n\\n| Name | Ordinary Shares | Warrants |\\n| John Wang | 230,000 | 0 |\\n| W.R. Hambrecht + Co., LLC(1) | 178,275 | 25,000 |\\n| Cannon Family Irrevocable Trust (2) | 173,275 | 0 |\\n| Robert J. Eu | 173,275 | 0 |\\n| AEX Enterprises Limited(3) | 88,333 | 0 |\\n| Hambrecht 1980 Revocable Trust(4) | 88,333 | 441,667 |\\n| Shea Ventures LLC(5) | 88,333 | 441,667 |\\n| Marbella Capital Partners Ltd.(6) | 40,000 | 200,000 |\\n| AEX Capital, LLC(7) | 0 | 441,666 |\\n| Total: | 1,059,824 | 1,550,000 |\\n\\n\\n| (1) | William R. Hambrecht is the controlling person of W.R. Hambrecht + Co., LLC. |\\n\\n| (2) | Mr. Cannon is the sole Trustee of Cannon Family Irrevocable Trust. |\\n\\n| (3) | Elizabeth B. Hambrecht, Robert Eu’s wife, and William R. Hambrecht control AEX Enterprises Limited. |\\n\\n| (4) | William R. Hambrecht is the trustee of the Hambrecht 1980 Revocable Trust. |\\n\\n| (5) | Edmund H. Shea Jr. is the controlling person of Shea Ventures LLC. |\\n\\n| (6) | John Wang is the controlling person of Marbella Capital Partners Ltd. |\\n\\n| (7) | Elizabeth B. Hambrecht, Robert Eu’s wife, and Robert J. Eu control AEX Capital, LLC. |\\n\\nPursuant to a registration rights agreement between us and our pre-initial public offering shareholders and warrant holders such shareholders and warrant holders will be entitled to certain registration rights. Specifically, (i) the private placement warrants and the underlying ordinary shares will be entitled to certain registration rights immediately after the consummation of a business combination; and (ii) the ordinary shares will be entitled to certain registration rights one year from the consummation of a business combination. We are only required to use our best efforts to cause a registration statement relating to the resale of such securities to be declared effective and, once effective, only to use our best efforts to maintain the effectiveness of the registration statement. The holders of warrants do not have the rights or privileges of holders of our ordinary shares or any voting rights until such holders exercise their respective warrants and receive ordinary shares. Certain persons and entities that receive any of the above described securities from our founders will, under certain circumstances, be entitled to the registration rights described herein. We will bear the expenses incurred in connection with the filing of any such registration statements. In the event that we breach our obligations under the registration rights agreement, we could be obligated to purchase the securities owned by our pre-initial public offering shareholders for the then fair market value of the securities.\\nWe agreed to pay Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and Elizabeth Hambrecht, Mr. Eu’s wife, a total of $7,500 per month for office space, administrative services and secretarial support for the period from November 15, 2007 until the earlier of our consummation of a business combination or our liquidation. This arrangement was agreed to by Hambrecht Eu Capital Management LLC for our benefit and is not intended to provide Mr. Eu compensation. We believe that such fees are at least as favorable as we could have obtained from an unaffiliated third party.\\nWe will reimburse our officers and directors for any reasonable out-of-pocket business expenses incurred by them in connection with certain activities on our behalf such as identifying and investigating possible target businesses and business combinations. Subject to availability of proceeds not placed in the trust account and the interest income on the balance in the trust account to be released to us from time to time, there is no limit on the amount of out-of-pocket expenses that could be incurred. This formula was a result of a negotiation between us and the underwriters and was meant to help maximize the amount of money in the trust account that would be returned to the investors if we do not consummate a business combination within the permitted time. Our board of directors will review and approve all expense reimbursements made to our directors with the interested director or directors abstaining from such review and approval. To the extent such out-of-pocket expenses exceed the available proceeds not deposited in the trust account, such out-of-pocket expenses would not be reimbursed by us unless we consummate a business combination.\\n21\\nOther than the $7,500 per month administrative fee and reimbursable out-of-pocket expenses payable to Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and Elizabeth Hambrecht, Mr. Eu’s wife, no fees of any kind, including finders and consulting fees, will be paid to any of our directors who owned our ordinary shares prior to our IPO, or to any of their respective affiliates for services rendered to us prior to or with respect to the business combination.\\nAfter a business combination, any of our directors who remain with us may be paid consulting, management or other fees from the combined company with any and all amounts being fully disclosed to shareholders, to the extent then known, in the proxy solicitation materials furnished to our shareholders. It is unlikely that the amount of such compensation will be known at the time of a shareholder meeting held to consider a business combination, as it will be up to the directors of the post-combination business to determine executive and director compensation. In this event, such compensation will be publicly disclosed at the time of its determination in a Current Report on Form 8-K, as required by the SEC.\\nAll ongoing and future transactions between us and any of our directors or their respective affiliates, including loans by our directors, will be on terms believed by us at that time, based upon other similar arrangements known to us, to be no less favorable than are available from unaffiliated third parties. Such transactions or loans, including any forgiveness of loans, will require prior approval in each instance by a majority of our uninterested “independent” directors, to the extent we have independent directors, or the members of our board who do not have an interest in the transaction, in either case who had access, at our expense, to our attorneys or independent legal counsel. It is our intention to obtain estimates from unaffiliated third parties for similar goods or services to ascertain whether such transactions with affiliates are on terms that are no less favorable to us than are otherwise available from such unaffiliated third parties. If a transaction with an affiliated third party were found to be on terms less favorable to us than with an unaffiliated third party, we would not engage in such transaction.\\nDirector Independence\\nOur Board of Directors has not determined if any of our directors qualifies as independent. Our Board of Directors will make a determination about independence after the business combination is consummated. We do not have an audit committee, nominating committee or compensation committee and therefore the entire Board of Directors performs those functions for us.\\n\\nITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES\\nRothstein Kass & Company, P.C. audited our financial statements for the years ended June 30, 2009; December 31, 2008 and 2007:\\nAudit Fees\\nFees for audit services provided by Rothstein Kass & Company, P.C. totaled approximately $55,000 in 2009, including fees associated with the audit of the annual financial statements for the fiscal year ended June 30, 2009 and the reviews of the Company’s quarterly reports on Form 10-Q.\\nFees for audit services provided by Rothstein Kass & Company, P.C. totaled approximately $55,000 in 2008, including fees associated with the audit of the annual financial statements for the fiscal year ended December 31, 2008 and the reviews of the Company’s quarterly reports on Form 10-Q.\\nFees for audit services provided by Rothstein Kass & Company, P.C. totaled approximately $80,000 in 2007, including fees associated with the audit of the annual financial statements for the fiscal year ended December 31, 2007, the audit of the financial statements as of August 31, 2007, the audit of the Company’s balance sheet at March 18, 2008 included in the Current Report on Form 8-K, and for services performed in connection with the Company’s registration statement on Form S-1 initially filed in 2007.\\n22\\nAudit-Related Fees\\nRothstein Kass & Company, P.C. did not bill any fees for services rendered to us during fiscal years 2009, 2008 and 2007 for Audit-related services in connection with the audit or review of our financial statements.\\nTax Fees\\nRothstein Kass & Company, P.C. did not bill any fees for tax services, including tax compliance, tax advice, and tax planning, during fiscal years 2009, 2008 and 2007.\\nAll Other Fees\\nThere were no fees billed by Rothstein Kass & Company, P.C. for other professional services rendered during the fiscal years 2009, 2008 or 2007.\\nPre-Approval of Services\\nWe do not have an audit committee. As a result, our board of directors performs the duties of an audit committee. Our board of directors evaluates and approves in advance the scope and cost of the engagement of an auditor before the auditor renders the audit and non-audit services. We do not rely on pre-approval policies and procedures.\\n23\\nPART IV\\n\\nITEM 15. EXHIBITS\\n| (a) | (1) | Financial Statements |\\n\\nBalance Sheets\\nStatement of Operations\\nStatement of Shareholders’ Equity\\nStatement of Cash Flows\\n| (2) | Schedules |\\n\\nNone.\\n| (b) | Exhibits |\\n\\nThe following Exhibits are filed as part of this report\\n| Exhibit No. | Description |\\n| 3.1 | Memorandum of Association (1) |\\n| 3.2 | Amended and Restated Articles of Association (1) |\\n| 4.1 | Specimen Unit Certificate (1) |\\n| 4.2 | Specimen Common Share Certificate (1) |\\n| 4.3 | Specimen Public Warrant Certificate (1) |\\n| 4.4 | Specimen Private Warrant Certificate (1) |\\n| 4.5 | Form of Warrant Agreement between Continental Stock Transfer & Trust Company and the Registrant (1) |\\n| 4.6 | Form of Unit Purchase Option (1) |\\n| 10.1 | Form of Letter Agreement by John Wang (1) |\\n| 10.2 | Form of Letter Agreement by Robert J. Eu (1) |\\n| 10.3 | Form of Letter Agreement by Stephen N. Cannon (1) |\\n| 10.4 | Form of Letter Agreement by Lee S. Ting (1) |\\n| 10.5 | Form of Letter Agreement by AEX Enterprises Limited (1) |\\n| 10.6 | Form of Letter Agreement by Feng Zhang (1) |\\n| 10.7 | Investment Management Trust Agreement between Continental Stock Transfer & Trust Company and the Registrant |\\n| 10.8 | Form of Securities Escrow Agreement between the Registrant, Continental Stock Transfer & Trust Company, the founding shareholders and the founders (1) |\\n| 10.9 | Form of Services Agreement between the Registrant and Hambrecht Eu Capital Management LLC (1) |\\n| 10.10 | Form of Registration Rights Agreement among the Registrant, the founding shareholders and the founders (1) |\\n| 10.11 | Revolving Credit Agreement between the Registrant and Robert Eu (1) |\\n| 10.12 | Promissory Note between Registrant and Robert Eu (1) |\\n| 10.13 | Form of Warrant Purchase Agreement between the Registrant and AEX Enterprises Limited (1) |\\n| 10.14 | Form of Right of First Refusal Agreement between the Registrant, Marbella Capital Partners and AEX Enterprises Limited (1) |\\n| 31.1 | Certification of the Chief Executive Officer (Principal Executive Officer) pursuant to Rule 13a-14(a) of the Securities Exchange Act, as amended |\\n| 31.2 | Certification of the Chief Financial Officer (Principal Financial Officer) pursuant to Rule 13a-14(a) of the Securities Exchange Act, as amended |\\n| 32.1 | Certification of the Chief Executive Officers pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 32.2 | Certification of the Chief Financial Officers pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n\\n(1) Incorporated by reference to the Registrant’s Registration Statement on Form S-1 (File No. 333-146147).\\n24\\nSIGNATURES\\nPursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant had duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\n| January 22, 2010 | HAMBRECHT ASIA ACQUISITION CORP. |\\n| By: | /s/ John Wang |\\n| John Wang |\\n| Chief Executive Officer, President and Director |\\n| (Principal Executive Officer) |\\n| January 22, 2010 | By: | /s/ Hao Wu |\\n| Hao Wu |\\n| Chief Financial Officer, Secretary and Director |\\n| (Principal Financial and Accounting Officer) |\\n\\nPursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.\\n| January 22, 2010 | By: | /s/ John Wang |\\n| John Wang |\\n| Chief Executive Officer, President and |\\n| Director (Principal Executive Officer) |\\n| January 22, 2010 | By: | /s/ Robert J. Eu |\\n| Robert J. Eu |\\n| Chairman of Board |\\n| January 22, 2010 | By: | /s/ Hao Wu |\\n| Hao Wu |\\n| Chief Financial Officer, Secretary and Director |\\n| (Principal Financial and Accounting Officer) |\\n| January 22, 2010 | By: | /s/ Hong Xiang Liu |\\n| Hong Xiang Liu |\\n| Director |\\n\\n25\\nHambrecht Asia Acquisition Corp.\\n(a corporation in the development stage)\\nINDEX TO FINANCIAL STATEMENTS\\n| Page |\\n| Report of Independent Registered Public Accounting Firm | F-2 |\\n| Financial Statements: |\\n| Balance Sheets | F-3 |\\n| Statements of Operations | F-4 |\\n| Statements of Shareholders’ Equity | F-5 |\\n| Statements of Cash Flows | F-6 |\\n| Notes to Financial Statements | F-7 |\\n\\nF-1\\nReport of Independent Registered Public Accounting Firm\\nTo the Board of Directors and Stockholders of\\nHambrecht Asia Acquisition Corporation\\nWe have audited the accompanying balance sheets of Hambrecht Asia Acquisition Corporation (a corporation in the development stage) (the “Company”) as of June 30, 2009 and December 31, 2008 and 2007, and the related statements of operations and cash flows for the six months ended June 30, 2009, the year ended December 31, 2008, the period from July 18, 2007 (date of inception) to December 31, 2007 and the periods from July 18, 2007 (date of inception) to June 30, 2009, and shareholders’ equity for the period from July 18, 2007 (date of inception) to June 30, 2009. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.\\nWe conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.\\nIn our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of June 30, 2009 and December 31, 2008, and the results of its operations and its cash flows for the six months ended June 30, 2009, the year ended December 31, 2008, the period from July 18, 2007 (date of inception) to December 31, 2007 and the periods from July 18, 2007 (date of inception) to June 30, 2009, and shareholders’ equity for the period from July 18, 2007 (date of inception) to June 30, 2009, in conformity with U.S. generally accepted accounting principles.\\nThe accompanying financial statements have been prepared assuming that Hambrecht Asia Acquisition Corporation will continue as a going concern. As discussed in Note 7 to the financial statements, Hambrecht Asia Acquisition Corporation will face a mandatory liquidation if a business combination is not consummated by March 12, 2010, which raises substantial doubt about its ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.\\nRoseland, New Jersey\\nJanuary 22, 2010\\n/s/ Rothstein Kass & Company, P.C.\\nF-2\\nHambrecht Asia Acquisition Corp.\\n(a corporation in the development stage)\\nBalance Sheets\\n| June 30,2009 | December 31, 2008 | December 31, 2007 |\\n| ASSETS |\\n| Current assets |\\n| Cash | $ | 30,271 | $ | 100,312 | $ | 101,671 |\\n| Prepaid expenses | 95,686 | 108,330 | 183,254 |\\n| Total current assets | 125,957 | 208,642 | 284,925 |\\n| Other asset | — |\\n| Investments held in the trust account | 33,838,155 | 33,798,651 |\\n| Total assets | $ | 33,964,112 | $ | 34,007,293 | $ | 284,925 |\\n| LIABILITIES AND SHAREHOLDERS’ EQUITY |\\n| Current liabilities |\\n| Accrued expenses | $ | 76,275 | $ | 31,780 | $ | — |\\n| Note payable, shareholder | 281,661 |\\n| — |\\n| Total current liabilities | 76,275 | 31,780 | 281,661 |\\n| Long-term liabilities |\\n| Deferred underwriting fees, net of $356,101 subject to forfeiture in the event of possible redemption | 830,903 | 830,903 | — |\\n| Ordinary shares, subject to possible redemption, (1,271,788 shares at redemption value of $7.92 per share) | 10,072,561 | 10,072,561 | — |\\n| Shareholders’ equity |\\n| Ordinary shares, $.001 par value, 50,000,000 shares authorized; 5,299,125, 5,299,125 and 1,150,000 shares issued and outstanding as of June 30, 2009, December 31, 2008 and December 31, 2007 (which includes 1,271,788, 1,271,788 shares and 0 shares respectively subject to possible redemption) | 5,299 | 5,299 | 1,150 |\\n| Additional paid-in capital | 22,851,981 | 22,851,981 | 23,850 |\\n| Earnings (deficit) accumulated during the development stage | 127,093 | 214,769 | (21,736 | ) |\\n| Total shareholders’ equity | 22,984,373 | 23,072,049 | 3,264 |\\n| Total liabilities and shareholders’ equity | $ | 33,964,112 | $ | 34,007,293 | $ | 284,925 |\\n\\nSee accompanying notes to financial statements.\\nF-3\\nHambrecht Asia Acquisition Corp.\\n(a corporation in the development stage)\\nStatements of Operations\\n\\n| For the Period Ended June 30, 2009 (six months) | For the Period Ended June 30, 2008 (six months) (unaudited) | Period from July 18,2007 (inception) to June 30,2009 | For the Year ended December 31,2008 | Period from July 18, 2007 to December 31,2007 |\\n| Revenues | $ | — | $ | — | $ | — | $ | — | $ | — |\\n| Formation and administrative costs | 184,870 | 156,683 | 473,993 | 267,387 | 21,736 |\\n| Loss from operations | (184,870 | ) | (156,683 | ) | (473,993 | ) | (267,387 | ) | (21,736 | ) |\\n| Interest income, net | 97,193 | 168,133 | 601,085 | 503,892 | — |\\n| Net income (loss) | (87,677 | ) | 11,449 | 127,093 | 236,505 | (21,736 | ) |\\n| Weighted average number of ordinary shares subject to possible redemption, basic and diluted | 1,271,788 | 808,223 | 793,378 | 1,037,742 | — |\\n| Income (loss) per ordinary share subject to possible redemption, basic and diluted | $ | (0.07 | ) | $ | 0.01 | $ | 0.16 | $ | — | $ | — |\\n| Weighted average number of ordinary shares outstanding (not subject to possible redemption) , basic | 4,027,337 | 3,789,581 | 3,085,775 | 3,503,402 | 1,150,000 |\\n| Income (loss) per ordinary share not subject to possible redemption, basic | $ | (0.02 | ) | $ | 0.00 | $ | 0.04 | $ | 0.07 | $ | (0.02 | ) |\\n| Weighted average number of ordinary shares outstanding (not subject to possible redemption), diluted | 4,027,337 | 5,164,193 | 4,267,656 | 5,213,337 | 1,150,000 |\\n| Income (loss) per ordinary share not subject to possible redemption, diluted | $ | (0.02 | ) | $ | 0.00 | $ | 0.03 | $ | 0.05 | $ | (0.02 | ) |\\n\\nSee accompanying notes to financial statements.\\nF-4\\nHambrecht Asia Acquisition Corp.\\n(a corporation in the development stage)\\nStatements of Shareholders’ Equity\\nFor the Period July 18, 2007 (date of inception) to June 30, 2009\\n| Ordinary Shares | Earnings |\\n| Shares | Amount | Additional Paid-in Capital | (Deficit) Accumulated During the Development Stage | TotalShareholders’ Equity |\\n| Balances at July 18, 2007 | — | $ | — | $ | — | $ | — | $ | — |\\n| Sale of units issued to founders on July 18, 2007 at approximately $0.02 per share | 1,150,000 | 1,150 | 23,850 | 25,000 |\\n| Net loss | (21,736 | ) | (21,736 | ) |\\n| Balances at December 31, 2007 | 1,150,000 | $ | 1,150 | $ | 23,850 | $ | (21,736 | ) | $ | 3,264 |\\n| Proceeds from sale of warrants in a private placement to initial shareholders | 1,550,000 | 1,550,000 |\\n| Sale of 4,000,000 units at $8.00 per unit in the public offering, net of underwriters’ discount and offering expenses (1,199,999 shares subject to possible redemption) | 4,000,000 | 4,000 | 29,550,348 | 29,554,348 |\\n| Sale of 239,300 units at $8.00 per unit in the public offering from partial exercise of underwriters’ overallotment option, net of underwriters’ discount and offering expenses (71,789 shares subject to possible redemption) | 239,300 | 239 | 1,800,344 | 1,800,583 |\\n| Forfeiture of founders shares from partial exercise of underwriters’ overallotment option | (90,175 | ) | (90 | ) | (90 | ) |\\n| Proceeds subject to possible redemption of 1,271,788 shares at a redemption value of $7.92 per share | (10,072,561 | ) | (10,072,561 | ) |\\n| Net income | 236,505 | 236,505 |\\n| Balances at December 31, 2008 | 5,299,125 | $ | 5,299 | $ | 22,851,981 | $ | 214,769 | $ | 23,072,049 |\\n| Net loss | (87,677 | ) | (87,677 | ) |\\n| Balances at June 30, 2009 | 5,299,125 | $ | 5,299 | $ | 22,851,981 | $ | 127,093 | $ | 22,984,373 |\\n\\nSee accompanying notes to financial statements.\\nF-5\\nHambrecht Asia Acquisition Corp.\\n(a corporation in the development stage)\\nStatements of Cash Flows\\n| For the PeriodEnded June 30,2009 (sixmonths) | For the PeriodEnded June 30,2008 (sixmonths) (unaudited) | Period from July18,2007(inception) toJune 30,2009 | For the Yearended December31,2008 | Period from July18, 2007 toDecember31,2007 |\\n| Cash flows from operating activities: |\\n| Net income (loss) | $ | (87,677 | ) | $ | 11,449 | $ | 127,093 | $ | 236,505 | $ | (21,736 | ) |\\n| Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |\\n| Change in operating assets and liabilities: |\\n| Accrued expenses | 44,494 | 94,063 | 76,275 | 31,780 |\\n| Prepaid expenses and other current asset | 12,644 | 49,922 | (95,686 | ) | (108,330 | ) |\\n| Net cash provided by (used in) operating activities | (30,538 | ) | 155,434 | 107,682 | 159,955 | (21,736 | ) |\\n| Cash used in investing activities: |\\n| Proceeds from the public offering deposited in trust account | — | (33,527,400 | ) | (33,527,400 | ) | (33,527,400 | ) | — |\\n| Interest income re-invested in trust account | (85,836 | ) | (173,102 | ) | (510,361 | ) | (510,361 | ) | — |\\n| Redemption from the trust account | 46,332 | 65,709 | 285,442 | 239,110 | — |\\n| Net cash used in investing activities | (39,504 | ) | (33,634,793 | ) | (33,838,155 | ) | (33,798,651 | ) | — |\\n| Cash flows from financing activities: |\\n| Proceeds from sale of ordinary shares to founders | — | — | 25,000 | — | 25,000 |\\n| Proceeds from shareholder’s note payable | $ | — | $ | — | $ | 281,661 | $ | — | $ | 281,661 |\\n| Proceeds from warrants purchased in private placement | — | 1,550,000 | 1,550,000 | 1,550,000 | — |\\n| Proceeds from initial public offering | $ | — | $ | 32,000,000 | $ | 32,000,000 | $ | 32,000,000 | $ | — |\\n| Proceeds from exercise of underwriters overallotment option | — | 1,914,400 | 1,914,400 | 1,914,400 | — |\\n| Repayment of shareholder’s note payable | — | — | (281,661 | ) | (281,661 | ) | — |\\n| Payment of underwriters’ fee and offering cost of initial public offering | — | (1,728,656 | ) | (1,728,656 | ) | (1,545,402 | ) | (183,254 | ) |\\n| Net cash provided by financing activities | — | 33,454,083 | 33,760,744 | 33,637,337 | 123,407 |\\n| Net increase (decrease) in cash | (70,042 | ) | (25,276 | ) | 30,271 | (1,359 | ) | 101,671 |\\n| Cash at beginning of the period | 100,312 | 101,671 | — | 101,671 | — |\\n| Cash at end of the period | $ | 30,271 | $ | 76,395 | $ | 30,271 | $ | 100,312 | $ | 101,671 |\\n| Supplemental schedule of non-cash financing activities: |\\n| Deferred underwriting fees, net | $ | — | $ | 830,903 | $ | 830,903 | $ | 830,903 | $ | — |\\n| Ordinary shares subject to possible redemption | $ | — | $ | 10,072,561 | $ | 10,072,561 | $ | 10,072,561 | $ | — |\\n\\nSee accompanying notes to financial statements.\\nF-6\\nHambrecht Asia Acquisition Corp.\\n(a corporation in the development stage)\\nNotes to Financial Statements\\nNOTE 1—ORGANIZATION AND BUSINESS OPERATIONS\\nHambrecht Asia Acquisition Corp. (a corporation in the development stage) (the “Company”) was incorporated in the Cayman Islands on July 18, 2007 with an authorized share capital of 50,000,000 ordinary shares (par value $0.001 per share). The Company’s founders contributed $25,000 to the formation of the Company and were issued 1,150,000 ordinary shares. The Company was formed to acquire, through a stock exchange, asset acquisition or other similar business combination, one or more operating businesses having its primary operations located in the People’s Republic of China (“Business Combination”). The Company is considered to be in the development stage as defined in “Accounting and Reporting By Development Stage Enterprises”, and is subject to the risks associated with activities of development stage companies. The Company’s operations, if a Business Combination is consummated outside the United States, will be subject to local government regulations and to the uncertainties of the economic and political conditions of those areas.\\nOn December 9, 2009 the Board of Directors of Hambrecht Asia Acquisition Corp. (the \\\"Company\\\") authorized a change in the Company's fiscal year end to June 30 from December 31. The Company reports its financial results for the six month transition period of December 31, 2008 through June 30, 2009 on a Transition Report on Form 10-K. After filing the Transition Report, the Company’s next fiscal year end will be June 30, 2010.\\nAs of June 30, 2009, the Company had not commenced any operations or generated any revenues. All activity from the period July 18, 2007 (date of inception) through March 31, 2008 relates to the Company’s formation and its initial public offering as described below. Subsequent to that date to the present the Company has sought a target business to acquire. The Company will not generate any operating revenue until after the completion of the Business combination, at the earliest. The Company currently generates non-operating income from interest income earned on the investments held in a trust account (the “Trust Account”), from the proceeds derived from the public offering.\\nThe registration statement for the Company’s initial public offering (the “Offering”) described in Note 3 was declared effective on March 7, 2008. The Company consummated the Offering on March 12, 2008 and immediately prior to such Offering, sold an aggregate of 1,550,000 warrants at $1.00 per warrant to certain officers and affiliates of the Company in a private placement (the “Private Placement”) described in Note 4. On March 31 2008, the underwriters of the Offering exercised their over-allotment option for a total of an additional 239,300 units. The net proceeds of the Offering and the Private Placement are intended to be generally applied toward consummating a business combination with one or more operating businesses having their primary operations in the People’s Republic of China (“Business Combination”). Net proceeds of $33,537,396 from the Offering, including the exercise of the underwriters’ over-allotment option, and the Private Placement are held in a Trust Account and will only be released to the Company upon the earlier of: (i) the consummation of a business combination; or (ii) the Company’s liquidation, except to satisfy shareholder conversion rights. The Trust Account includes the deferred underwriting discount from the Offering of up to $1,187,004 which will be paid to the underwriters upon consummation of a business combination, as described in Note 6. Additionally, up to an aggregate of $700,000, plus up to an additional $350,000 during the Extended Period (as described below) if approved by shareholders, of interest earned on the Trust Account balance (net of any taxes paid or payable) may be released to the Company to fund operating activities. Through June 30, 2009, approximately $286,000 of interest earned on the Trust Account balance has been released to the Company.\\nOn September 4, 2009, the Company issued a press release announcing that it has entered into a letter of intent with a company for a business combination. The target is a company with its principal business operations in the People’s Republic of China. The Company, after signing a definitive agreement for the acquisition of a target business, is required to submit such transaction for shareholder approval. In the event that shareholders owning 30% or more of the shares sold in the Offering vote against the business combination and exercise their conversion rights described below, the business combination will not be consummated. All of the Company’s shareholders prior to the Offering, have agreed to vote their pre-initial public offering ordinary shares in accordance with the vote of the majority of the shares voted by all shareholders of the Company who purchased their shares in the Offering or the aftermarket (“Public Shareholders”) with respect to any business combination. After consummation of a business combination, these voting safeguards will no longer be applicable.\\nF-7\\nIn the event that the Company does not complete a business combination by March 12, 2010, or March 12, 2011 if extension is approved by the shareholders, the Company will be dissolved and the proceeds held in the Trust Account, plus certain interest, less certain costs, will be distributed to the Company’s public shareholders. If the Company receives Public Shareholder approval for the Extended Period and holders of 30% or more of the shares held by Public Shareholders do not vote against the Extended Period and elect to convert their ordinary shares in connection with the vote for the Extended Period, the Company will then have an additional 12 months in which to complete the initial business combination. If the Extended Period is approved, the Company will still be required to seek Public Shareholder approval before completing a business combination. In the event there is no business combination within the 24-month deadline (assuming the Extended Period is not approved) described above, the Company will dissolve and distribute to its Public Shareholders, in proportion to their respective equity interests, the amount held in the Trust Account, and any remaining net assets, after the distribution of the Trust Account. The Company’s corporate existence will automatically cease at the end of the 36-month period if the Company has not received shareholder approval for an initial business combination. In the event of liquidation, the per share value of the residual assets remaining available for distribution (including Trust Account assets) may be less than the initial public offering price per share in the Offering.\\nWith respect to a business combination which is approved and consummated or a vote on the Extended Period which is approved, any Public Shareholders who voted against the business combination or Extended Period may contemporaneously with or prior to such vote exercise their conversion right and their ordinary shares would be cancelled and returned to the status of authorized but unissued shares. The per share conversion price will equal the amount in the Trust Account (including interest therein), calculated as of two business days prior to the consummation of the proposed business combination or vote on Extended Period, divided by the number of common shares sold in the Offering and partial exercise of the over-allotment option.\\nA Public Shareholder’s election to convert ordinary shares in connection with the vote on the Extended Period will only be honored if the Extended Period is approved. Public Shareholders who vote their shares against the Extended Period and exercise their conversion rights, will not be able to vote these shares with respect to the initial business combination. All other Public Shareholders will be able to vote on the initial business combination.\\nNOTE 2 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\\nBasis of Presentation:\\nThe accompanying financial statements are presented in U.S. dollars and have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and pursuant to the accounting and disclosure rules and regulations of the Securities and Exchange Commission (the ‘SEC”). In the opinion of management, the accompanying financial statements reflect all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the Company’s financial statements.\\nInvestments held in the Trust Account:\\nThe amounts held in the Trust Account as of June 30, 2009 represent substantially all of the proceeds of the Offering plus partial exercise of the underwriters’ over-allotment option, the private placement and interest earned on the trust to date, and are classified as restricted assets since such amounts can only be used by the Company in connection with the consummation of a Business Combination. The funds held in the Trust Account are invested in a money market fund that invests in US and state government and government agency debt securities.\\nF-8\\nFair value of financial instruments:\\nThe Company does not enter into financial instruments for trading or speculative purposes. The carrying amounts of financial instruments classified as current assets and current liabilities as disclosed in the accompanying balance sheets, approximate their fair value due to their short maturities.\\nUse of estimates:\\nThe preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.\\nIncome taxes:\\nUnder current Cayman Islands laws, the Company is not subject to income taxes or capital gains, and there is no Cayman Islands withholding tax imposed upon payments of dividends by the Company to its shareholders. In the future, the Company’s tax rate will be impacted by acquisitions of non-Cayman subsidiaries governed by the respective local income tax laws. Accordingly, no provision for income taxes has been made in the accompanying statements of operations.\\nEffective January 1, 2007, the Company adopted the provisions of “Accounting for Uncertainty in Income Taxes”. There were no unrecognized tax benefits as of June 30, 2009. The provision prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. No amounts were accrued for the payment of interest and penalties at June 30, 2009. Management is currently unaware of any issues under review that could result in significant payments, accruals or material deviation from its position.\\nOrdinary shares subject to possible redemption:\\nAs discussed in Note 1, the Company will only proceed with a Business Combination if: (1) it is approved by a majority of the votes cast by the Company’s public shareholders; and (2) public shareholders holding less than 30% (1,271,788) of the ordinary shares sold in the Offering and partial exercise of the over-allotment option, choose to exercise their redemption rights thereby receiving their per share interest in the Trust Account. In accordance with FASB’s Emerging Issues Task Force (EITF) Topic No. D-98, “Classification and Measurement of Redeemable Securities”, the Company has classified 1,271,788 shares of its ordinary shares outside of permanent equity as “Ordinary shares subject to redemption,” at a redemption price of $7.92 per share as of June 30, 2009 . The Company will recognize changes in the conversion value as they occur and will adjust the carrying value of the ordinary shares subject to conversion to be equal to its conversion value at the end of each reporting period.\\nIncome (loss) per ordinary share:\\nBasic income per common share is computed by dividing net income by the weighted average common shares outstanding for the period. Diluted income per common share reflects the potential dilution that could occur if warrants were to be exercised or converted or otherwise resulted in the issuance of ordinary shares that then shared in the earnings of the entity.\\nFor the period ended (six months) June 30, 2009, and for the period from July 18, 2007 (inception) to June 30, 2009, the Company had potentially dilutive securities in the form of 7,129,125 warrants, and 5,299,125 warrants issued as part of the Units (as defined below) in the Offering. Of the total warrants outstanding for the periods then ended, approximately 2,328,422 and 1,181,881, respectively, represent incremental shares of ordinary share, based on their assumed redemption, to be included in the weighted average number of shares of ordinary share outstanding (not subject to possible redemption) for the calculation of diluted income per ordinary share. The Company uses the “treasury stock method” to calculate potential dilutive shares, as if they were redeemed for ordinary share at the beginning of the period.\\nF-9\\nThe Company’s statements of operations includes a presentation of income per ordinary share subject to possible redemption in a manner similar to the two-class method of income per share. Basic and diluted income amount for the maximum number of shares subject to possible redemption is calculated by dividing the net interest attributable to common shares subject to redemption by the weighted average number of shares subject to possible redemption. Basic and diluted net income (loss) per share amount for the shares outstanding not subject to possible redemption is calculated by dividing the net income (loss) exclusive of the net interest income attributable to ordinary share subject to redemption by the weighted average number of shares not subject to possible redemption.\\nNewly Adopted Accounting Pronouncements:\\nIn December 2007, the FASB issued “Business Combinations”, which requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction; establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; and requires the acquirer to disclose to investors, and other users, all of the information they need to evaluate and understand the nature and financial effect of the business combination. “Business Combinations” will be effective for acquisitions with a date on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. We will apply “Business Combinations” for any of our applicable acquisitions beginning January 1, 2009.\\nIn December 2007, the FASB issued “Noncontrolling Interests in Consolidated Financial Statements”, which requires the recognition of a noncontrolling interest (minority interest) as equity in the consolidated financial statements and separate from the parent’s equity; the inclusion of the amount of net income attributable to the noncontrolling interest in consolidated income on the face of the income statement; and a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. This guidance will be effective for the fiscal years beginning on or after December 15, 2008. We will apply to any applicable transactions beginning January 1, 2009.\\nIn March 2008, the FASB issued “Disclosures about Derivative Instruments and Hedging Activities”, which is intended to improve financial standards for derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. Entities are required to provide enhanced disclosures about: (a) how and why an entity uses derivative instruments; (b) how derivative instruments and related hedged items are accounted for and its related interpretations; and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. It is effective for financial statements issued for fiscal years beginning after November 15, 2008, with early adoption encouraged. The adoption of this statement is not expected to have a material effect on the Company’s results of operations or financial position; however, it could impact future transactions entered into by the Company.\\nOn April 9, 2009, the FASB issued the guidance of “Interim Disclosures about Fair Value of Financial Instruments” to require disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements. The guidance also amends Accounting Principles Board Opinion-Interim Financial Reporting, to require those disclosures in summarized financial information at interim reporting periods. The guidance shall be effective for interim reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. An entity may early adopt this if certain requirements are met. This guidance does not require disclosures for earlier periods presented for comparative purposes at initial adoption. In periods after initial adoption, this guidance requires comparative disclosures only for periods ending after initial adoption. The adoption of this guidance did not have a significant impact on the Company’s financial statements or related footnotes.\\nF-10\\nOn April 9, 2009, the FASB issued the guidance of “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly”, to affirms that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction; clarifies and includes additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is not active; eliminates the proposed presumption that all transactions are distressed (not orderly) unless proven otherwise. The guidance instead requires an entity to base its conclusion about whether a transaction was not orderly on the weight of the evidence. In addition, this guidance requires an entity to disclose a change in valuation technique (and the related inputs) resulting from the application of it and to quantify its effects, if practicable. This guidance is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009 if certain requirements are met. It must be applied prospectively and retrospective application is not permitted. The adoption of this guidance did not have a significant impact on the Company’s financial statements or related footnotes.\\nOn April 9, 2009, the FASB issued “Recognition and Presentation of Other-Than-Temporary Impairments”, to be intended to bring consistency to the timing of impairment recognition, and provide improved disclosures about the credit and noncredit components of impaired debt securities that are not expected to be sold. The measure of impairment in comprehensive income remains fair value. The guidance also requires increased and more timely disclosures regarding expected cash flows, credit losses, and an aging of securities with unrealized losses. This guidance shall be effective for interim and annual reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. Earlier adoption for periods ending before March 15, 2009, is not permitted. If an entity elects to adopt early either “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly”, or “Interim Disclosures about Fair Value of Financial Instruments”, the entity also is required to adopt early this guidance. Additionally, if an entity elects to adopt early , it is required to adopt “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly”. This guidance does not require disclosures for earlier periods presented for comparative purposes at initial adoption. In periods after initial adoption, this guidance requires comparative disclosures only for periods ending after initial adoption. The adoption did not have a significant impact on the Company’s financial statement or footnotes.\\nOn May 28, 2009, the FASB issued the guidance regarding subsequent events, which we adopted on a prospective basis beginning April 1, 2009. The guidance is intended to establish general standards of accounting and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. It requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for selecting that date. The application of the pronouncement did not have an impact on our financial position, results of operations or cash flows. These financial statements were approved by management and were issued on January 22, 2010. Subsequent events have been evaluated through this date.\\nRecently Issued Accounting Pronouncements\\nIn June 2009, the Financial Accounting Standards Board issued the statement of “Accounting Standards Codification TM and the Hierarchy of Generally Accepted Accounting Principles This statement confirmed that the FASB Accounting Standards Codification (the “Codification”) will become the single official source of authoritative U.S. GAAP (other than guidance issued by the SEC), superseding existing FASB, American Institute of Certified Public Accountants, Emerging Issues Task Force (“EITF”), and related literature. After that date, only one level of authoritative U.S. GAAP will exist. All other literature will be considered non-authoritative. The Codification does not change U.S. GAAP; instead, it introduces a new structure that is organized in an easily accessible, user-friendly online research system. The Codification, which changes the referencing of financial standards, becomes effective for interim and annual periods ending on or after September 15, 2009.. The Company has adopted this standard and did not have any substantive impact on our financial statements or related footnotes.\\nManagement does not believe that any other recently issued, but no yet effective accounting standards, if currently adopted, would have a material effect on the accompanying financial statements.\\nNOTE 3—PUBLIC OFFERING\\nOn March 7, 2008, the Company sold 4,000,000 units in the Offering at a price of $8.00 per unit. On March 31, 2008, the Company consummated the closing of an additional 239,300 units which were subject to the over-allotment option. Each unit consists of one share of the Company’s ordinary shares, $0.001 par value, and one warrant. Each warrant will entitle the holder to purchase from the Company one of the Company’s ordinary shares at an exercise price of $5.00 per share commencing on the later of: (i) The consummation of the Business Combination, or (ii) March 7, 2009. The warrants will be exercisable only if the Company continues to provide for an effective registration statement covering the ordinary shares issueable upon exercise of the warrants. In no event will the holder of a warrant be entitled to receive a net cash settlement or other consideration in lieu of physical settlement in shares of the Company’s ordinary shares.\\nF-11\\nThe warrants expire on March 7, 2013, unless earlier redeemed. The warrants included in the units sold in the Offering are redeemable, at the Company’s option, in whole and not in part at a price of $0.01 per warrant upon a minimum of 30 days’ notice after the warrants become exercisable, only in the event that the last sale price of the ordinary shares exceeds $11.50 per share for any 20 trading days within a 30-trading day period.\\nThe purchased warrants are recognized in additional paid-in-capital within shareholders’ equity since, under the terms of the warrants, the Company cannot be required to settle or redeem them for cash.\\nNOTE 4—RELATED PARTY TRANSACTIONS\\nThe Company has agreed to pay Hambrecht-Eu Capital, a company owned and managed by the Company’s Chairman of the Board, Chief Financial Officer and Secretary, $7,500 per month for office space and general and administrative services including secretarial support commencing on November 15, 2007 and continuing (i) until the consummation by the Company of a business combination (as described in Note 1), (ii) 18 months from commencement of the Offering if the Company does not effect a Business Combination, (iii) 24 months from the consummation of the Offering if a letter of intent, agreement in principle or definitive agreement, has been executed within 18 months of commencement of the Offering and the Company has not effected a business combination, or (iv) 36 months from the consummation of the Offering if an extension has been approved by the Company’s shareholders under certain circumstances.\\nAEX Enterprises Limited, W.R. Hambrecht + Co., LLC and the Hambrecht 1980 Revocable Trust, companies controlled by Elizabeth B. Hambrecht, wife of Robert Eu, one of the Company’s founders and the Company’s Chairman, Chief Financial Officer and Secretary and William R. Hambrecht, Robert Eu’s father-in-law, Shea Ventures LLC, a company controlled by Edmund H. Shea Jr. and Marbella Capital Partners Ltd., a company controlled by John Wang, our Chief Executive Officer, purchased an aggregate of 1,550,000 warrants at a price of $1.00 per warrant ($1,550,000 in the aggregate) in a private placement immediately prior to the initial public offering (“private placement warrants”). Elizabeth B. Hambrecht owns approximately 25% and William R. Hambrecht controls (through a trust of which he is trustee) approximately 38% of the voting shares of AEX Enterprises Limited. William Hambrecht is a controlling person of W.R. Hambrecht + Co., LLC and is the trustee of the Hambrecht 1980 Revocable Trust. The proceeds from the sale of the private placement warrants were added to the proceeds from the Offering and are held in the Trust Account pending the Company’s consummation of a Business Combination. If the Company does not complete a Business Combination that meets the criteria described in the Offering, then the $1,550,000 purchase price of the private placement warrants will become part of any liquidating distribution to the Company’s public shareholders following the Company’s liquidation and dissolution and the private placement warrants will expire worthless.\\nThe private placement warrants will be non-redeemable so long as they are held by the original holders of the warrants, the pre-initial public offering shareholders and directors or their permitted transferees. In addition, pursuant to the registration rights agreement, the holders of the private placement warrants and the underlying ordinary shares will be entitled to certain registration rights immediately after the consummation of the initial business combination and the warrants may be exercised on a cashless basis if held by the original holder, the pre-initial public offering shareholder and director or their permitted transferees. With those exceptions, the private placement warrants have terms and provisions that are otherwise identical to those of the warrants sold as part of the units in the Offering.\\nThe sale of private placement warrants did not result in the recognition of stock-based compensation expense because the private placement warrants were sold at or above fair market value.\\nAEX Enterprises Limited, W.R. Hambrecht + Co., LLC, the Hambrecht 1980 Revocable Trust, Shea Ventures LLC and Marbella Capital Partners Ltd. have agreed, subject to certain exceptions, not to transfer, assign or sell any of its private placement warrants until after the Company consummates a Business Combination. However, prior to the consummation of a business combination, the original holders of the warrants will be permitted to transfer their private placement warrants in certain limited circumstances, such as to the Company’s officers and directors, and other persons or entities associated with such persons, but the transferees receiving such private placement warrants will be subject to the same sale restrictions imposed on such entity.\\nF-12\\nRobert Eu, one of the Company’s founders, had provided to the Company advances totaling approximately $282,000 to pay a portion of the expenses of the Offering for the SEC registration fee, FINRA registration fee, and accounting and legal fees and expenses. The note was payable on demand with interest at 4% per annum. The note, plus interest of approximately $5,000, was repaid out of the proceeds of the Offering on March 12, 2008.\\nNOTE 5—FAIR VALUE MEASUREMENTS\\nThe Company complies with Fair Value Measurements, for its financial assets and liabilities that are re-measured and reported at fair value at each reporting period, and non-financial assets and liabilities that are re-measured and reported at fair value at least annually.\\nThe following tables present information about the Company’s assets that are measured at fair value on a recurring basis as of June 30, 2009 and December 31, 2008, and indicates the fair value hierarchy of the valuation techniques the Company utilized to determine such fair value. In general, fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities. Fair values determined by Level 2 inputs utilize data points that are observable such as quoted prices, interest rates and yield curves. Fair values determined by Level 3 inputs are unobservable data points for the asset or liability, and includes situations where there is little, if any, market activity for the asset or liability:\\nFair Value of Financial Assets as of June 30, 2009\\n| Description | June 30, 2009 | Quoted Prices in Active Markets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) |\\n| Assets: |\\n| Cash equivalents | $ | 30,271 | $ | 30,271 | $ | — | $ | — |\\n| Cash equivalents held in Trust Account | 33,838,155 | 33,838,155 | — | — |\\n| Total | $ | 33,868,426 | $ | 33,868,426 | $ | — | $ | — |\\n\\nFair Value of Financial Assets as of December 31, 2008\\n| Description | December 31, 2008 | Quoted Prices in Active Markets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) |\\n| Assets: |\\n| Cash equivalents | $ | 100,312 | $ | 100,312 | $ | — | $ | — |\\n| Cash equivalents held in Trust Account | 33,798,651 | 33,798,651 | — | — |\\n| Total | $ | 33,898,963 | $ | 33,898,963 | $ | — | $ | — |\\n\\nF-13\\nThe fair values of the Company’s cash equivalents and cash and cash equivalents held on the Trust Account are determined through market, observable and corroborated sources.\\nNOTE 6— COMMITMENTS AND UNDERWRITERS’ COMPENSATION\\nThe Company consummated the Offering on March 12, 2008 and paid to the underwriters a $1,120,000 underwriting fee, representing 3.5% of the gross proceeds, and is committed to pay up to an additional $1,120,000, currently held in the Trust Account, representing an additional deferred underwriting fee of 3.5%, payable upon the Company’s consummation of a Business Combination.\\nOn March 31, 2008, the underwriters exercised their over-allotment option and purchased from the Company an additional 239,300 units. The Company paid to the underwriters a $67,004 underwriting discount, representing 3.5% of the over-allotment gross proceeds, and is committed to pay up to an additional $67,004, currently held in the Trust Account, representing an additional deferred underwriting discount of 3.5%, payable upon the Company’s consummation of a Business Combination.\\nThe Company also issued and sold to the underwriters on the closing date an option, as an additional compensation to purchase up to an aggregate of 280,000 units for an aggregate purchase price of $100. The Option shall be exercisable, in whole or in part, commencing on the later of the consummation of a Business Combination or six months from March 7, 2008 and expiring on March 7, 2013 at an initial exercise price of $10.00 per Unit.\\nThe Company has determined based upon a Black-Scholes- Merton option pricing model, that the estimated fair value of the option on the date of sale would be approximately $3.36 per unit or an aggregate of approximately $941,000, assuming an expected term of five years, estimated volatility of 51.51% and a risk-free interest rate of 3.38%. Given the parameters used in the computation of the value of the option change over time, the actual fair value of the option on the date of sale is expected to be different from the estimated fair value computed above.\\nThe volatility calculation of 51.51% is based on the latest five year average prior to the Offering, volatility of 62 companies drawn from the Shanghai Stock Exchange Composite Index that had market capitalizations between $70 million and $150 million. Because the Company does not have a trading history, the Company estimated the potential volatility of its ordinary share price, which will depend on a number of factors which cannot be ascertained at this time. The Company used the annualized volatility of the historical volatilities for a period of time equal in length to the term of the option because the Company believes that the volatility of these companies is a reasonable benchmark to use in estimating the expected volatility for the Company’s ordinary share post-Business Combination. Although an expected life of five years was taken into account for purposes of assigning value to this option, if the Company does not consummate a Business Combination within the prescribed time period and liquidates, this option would become worthless.\\nPursuant to Rule 2710(g)(1) of FINRA Conduct Rule, the option to purchase 280,000 units is deemed to be underwriting compensation and therefore upon exercise, the underlying ordinary shares and warrants are subject to a 180-day lock-up. Additionally, the option may not be sold, transferred, assigned, pledged or hypothecated for a one-year period (including the foregoing 180-day period) following the date of the Offering.\\nNOTE 7 — GOING CONCERN\\nOn September 4, 2009, the Company has issued a press release announcing that it has entered into a letter of intent with a company for a business combination. The target is a company with its principal business operations in the People’s Republic of China. Pursuant to the Company’s Amended and Restated Memorandum and Articles of Association, the execution of the letter of intent affords the Company a six-month extension for completion of a business combination, until March 12, 2010.\\nF-14\\nThe consummation of the business combination is subject to, among other things, execution of a definitive agreement and required stockholder approval. There can be no assurance that a business combination will be consummated. However, if we anticipate that we will not be able to consummate a business combination by March 12, 2010, we may seek shareholder approval to extend the period of time to consummate a business combination until March 12, 2011. If we are unable to complete the business combination by March 12, 2010, or March 12, 2011 if extension period approved, our purposes and powers will be limited to dissolving, liquidating and winding up. Also contained in our articles of association is the requirement that our board of directors, to the fullest extent permitted by law, consider a resolution to dissolve our company at that time. Consistent with such obligations, our board of directors will seek shareholder approval for any such plan of distribution, and our pre-initial public offering shareholders and directors have agreed to vote in favor of such dissolution and liquidation. This provision will be amended only in connection with, and upon consummation of, its initial business combination by such date. The accompanying financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern and is required to liquidate.\\nF-15\\n\\n \\n\\nWhat is the total capital generated by the company through various activities from July 18, 2007 to June 30, 2009, excluding net income and assuming the interest income re-invested in the trust account was paid out to increase capital instead of being reinvested, in USD?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 68083947.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 35,\n \"input_length\": 31804\n}"}}},{"rowIdx":36,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nItem 1 Financial Statements\nFast Lane Holdings, Inc.\nBalance Sheet\n\n| As of March 31, 2019 (Unaudited) | As of December 31, 2018 |\n| TOTAL ASSETS | $ | - | $ | - |\n| LIABILITIES AND STOCKHOLDERS’ DEFICIT |\n| CURRENT LIABILITIES: |\n| Accrued expenses | $ | 300 | $ | 5,550 |\n| Total current liabilities | 300 | 5,550 |\n| TOTAL LIABILITIES | $ | 300 | $ | 5,550 |\n| STOCKHOLDERS' DEFICIT: |\n| Preferred stock ($.001 par value, 20,000,000 shares authorized, 5,000 issued and outstanding as of March 31, 2019 and December 31, 2018) | 5 | 5 |\n| Common stock ($.001 par value, 500,000,000 shares authorized, 72,948,316 issued and outstanding as of March 31, 2019 and December 31, 2018) | 72,948 | 72,948 |\n| Additional paid in capital | (66,401) | (72,648) |\n| Accumulated deficit | (6,852) | (5,855) |\n| Total Stockholders' deficit | (300) | (5,550) |\n| TOTAL LIABILITIES &STOCKHOLDERS’ DEFICIT | $ | - | $ | - |\n\nThe accompanying notes are an integral part of these unaudited financial statements.\n\n| 4 |\n\n\n| Fast Lane Holdings, Inc. Statement of Operations (Unaudited) |\n| For Three Months Ended March 31, 2019 |\n| Operating expenses |\n| General and administrative expenses | $ | 997 |\n| Total operating expenses | 997 |\n| Net loss | $ | (997) |\n| Basic and Diluted net loss per common share | $ | (0.00) |\n| Weighted average number of common shares outstanding - Basic and Diluted | 72,948,316 |\n\nThe accompanying notes are an integral part of these unaudited financial statements.\n\n| 5 |\n\n\n| Fast Lane Holdings, Inc. Statement of Changes in Stockholders' Deficit For the period from December 6, 2018 (date of inception) to March 31, 2019 (Unaudited) |\n| Preferred Shares (Series A) | Par Value Preferred Shares (Series A) | Common Shares | Par Value Common Shares | Additional Paid-in Capital | Accumulated Deficit | Total |\n| Date of Inception, December 6, 2018 | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - |\n| Shares issued in Reorganization | 5,000 | 5 | 72,948,316 | 72,948 | (72,953) | - | - |\n| Expenses paid on behalf of the Company and contributed to capital | - | - | - | - | 305 | - | 305 |\n| Net loss | - | - | - | - | (5,855) | (5,855) |\n| Balances, December 31, 2018 | 5,000 | $ | 5 | 72,948,316 | $ | 72,948 | $ | (72,648) | $ | (5,855) | $ | (5,550) |\n| Expenses paid on behalf of the Company and contributed to capital | - | - | - | - | 6,247 | - | 6,247 |\n| Net loss | - | - | - | - | - | (997) | (997) |\n| Balances, March 31, 2019 | 5,000 | $ | 5 | 72,948,316 | $ | 72,948 | $ | (66,401) | $ | (6,852) | $ | (300) |\n\nThe accompanying notes are an integral part of these unaudited financial statements.\n\n| 6 |\n\nFast Lane Holdings, Inc.\nStatement of Cash Flows\n(Unaudited)\n\n| For the Three Months Ended March 31, 2019 |\n| CASH FLOWS FROM OPERATING ACTIVITIES |\n| Net loss | $ | (997) |\n| Adjustment to reconcile net loss to net cash used in operating activities: |\n| Expenses contributed to capital | 6,247 |\n| Changes in current assets and liabilities: |\n| Accrued expenses | (5,250) |\n| Net cash used in operating activities | - |\n| Net change in cash | $ | - |\n| Beginning cash balance | - |\n| Ending cash balance | $ | - |\n| SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: |\n| Interest paid | $ | - |\n| Income taxes paid | $ | - |\n\nThe accompanying notes are an integral part of these unaudited financial statements.\n\n| 7 |\n\nFast Lane Holdings, Inc.\nNotes to Unaudited Financial Statements\nNote 1 – Organization and Description of Business\nFast Lane Holdings, Inc. (we, us, our, or the \"Company\") was incorporated on December 6, 2018 in the State of Delaware. The Company was created for the sole purpose of participating in a Delaware holding company reorganization with Giant Motorsports Delaware Inc. (“GMOS Delaware”), a Delaware corporation incorporated on December 6, 2018 and parent company of Fast Lane Holding, Inc. and Giant Motorsports Merger Sub, Inc., a Delaware corporation incorporated on December 6, 2018 and a wholly owned subsidiary of Fast Lane Holdings, Inc. pursuant to Section 251(g) of the General Corporation Law of the state of Delaware, (the “DGCL”).\nOn December 6, 2018, Paul Moody was appointed Chief Executive Officer, Chief Financial Officer, and Director of Fast Lane Holdings, Inc., Giant Motorsports Delaware, Inc. and Giant Motorsports Merger Sub, Inc.\nOn December 28, 2018, Giant Motorsports, Inc. (“GMOS Nevada”), a Nevada corporation merged with and into GMOS Delaware, a wholly owned subsidiary of GMOS Nevada with GMOS Delaware as the surviving corporation. The sole purpose to merge GMOS Nevada with and into GMOS Delaware was to re-domesticate GMOS Nevada from Nevada to Delaware.\nOn December 28, 2018, Giant Motorsports Delaware, Inc. completed a holding company reorganization pursuant to Section 251(g) of the DGCL by merging with and into its indirect wholly owned subsidiary known as Giant Motorsports Merger Sub, Inc. with Giant Motorsports Delaware, Inc. as the surviving corporation and becoming a wholly owned subsidiary of Fast Lane Holdings, Inc. Fast Lane Holdings, Inc. as successor issuer to Giant\nMotorsports, Inc. continued to trade in the OTC MarketPlace under the previous ticker symbol “GMOS” until the new ticker symbol “FLHI” for the Company was released into the OTC MarketPlace on January 10, 2019. Concurrently, the Company cancelled all of its stock held in GMOS Delaware.\nThe Company intends to serve as a vehicle to affect an asset acquisition, merger, exchange of capital stock or other business combination with a domestic or foreign business. As of December 31, 2018, the Company had not yet commenced any operations.\nThe Company has elected December 31st as its year end.\nNote 2 – Summary of Significant Accounting Policies\nBasis of Presentation\nThis summary of significant accounting policies is presented to assist in understanding the Company's financial statements. These accounting policies conform to accounting principles, generally accepted in the United States of America, and have been consistently applied in the preparation of the financial statements.\nUse of Estimates\nThe preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. In the opinion of management, all adjustments necessary in order to make the financial statements not misleading have been included. Actual results could differ from those estimates.\nCash and Cash Equivalents\nThe Company considers all highly liquid investments with an original maturity of three months or less when purchased to be cash equivalents. Cash and cash equivalents at March 31, 2019 and December 31, 2018 were $0 for both periods.\n\n| 8 |\n\nIncome Taxes\nThe Company accounts for income taxes under ASC 740, “Income Taxes.” Under the asset and liability method of ASC 740, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statements carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period the enactment occurs. A valuation allowance is provided for certain deferred tax assets if it is more likely than not that the Company will not realize tax assets through future operations. No deferred tax assets or liabilities were recognized at March 31, 2019 and December 31, 2018.\nBasic Earnings (Loss) Per Share\nThe Company computes basic and diluted earnings (loss) per share in accordance with ASC Topic 260, Earnings per Share. Basic earnings (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the reporting period. Diluted earnings (loss) per share reflects the potential dilution that could occur if stock options and other commitments to issue common stock were exercised or equity awards vest resulting in the issuance of common stock that could share in the earnings of the Company.\nThe Company does not have any potentially dilutive instruments as of March 31, 2019 and, thus, anti-dilution issues are not applicable.\nFair Value of Financial Instruments\nThe Company’s balance sheet includes certain financial instruments. The carrying amounts of current assets and current liabilities approximate their fair value because of the relatively short period of time between the origination of these instruments and their expected realization.\nASC 820, Fair Value Measurements and Disclosures, defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820 also establishes a fair value hierarchy that distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are described below:\n- Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.\n- Level 2 - Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, including quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates); and inputs that are derived principally from or corroborated by observable market data by correlation or other means.\n- Level 3 - Inputs that are both significant to the fair value measurement and unobservable.\nFair value estimates discussed herein are based upon certain market assumptions and pertinent information available to management as of March 31, 2019. The respective carrying value of certain on-balance-sheet financial instruments approximated their fair values due to the short-term nature of these instruments. These financial instruments include accrued expenses.\n\n| 9 |\n\nRelated Parties\nThe Company follows ASC 850, Related Party Disclosures, for the identification of related parties and disclosure of related party transactions.\nShare-Based Compensation\nASC 718, “Compensation – Stock Compensation”, prescribes accounting and reporting standards for all share-based payment transactions in which employee services are acquired. Transactions include incurring liabilities, or issuing or offering to issue shares, options, and other equity instruments such as employee stock ownership plans and stock appreciation rights. Share-based payments to employees, including grants of employee stock options, are recognized as compensation expense in the financial statements based on their fair values. That expense is recognized over the period during which an employee is required to provide services in exchange for the award, known as the requisite service period (usually the vesting period).\nThe Company accounts for stock-based compensation issued to non-employees and consultants in accordance with the provisions of ASC 505-50, “Equity – Based Payments to Non-Employees.” Measurement of share-based payment transactions with non-employees is based on the fair value of whichever is more reliably measurable: (a) the goods or services received; or (b) the equity instruments issued. The fair value of the share-based payment transaction is determined at the earlier of performance commitment date or performance completion date.\nThe Company had no stock-based compensation plans as of March 31, 2019.\nThe Company’s stock based compensation for the periods ended March 31, 2019 and December 31, 2018 was $0 for both periods.\nRecently Issued Accounting Pronouncements\nIn February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). ASU 2016-02 is amended by ASU 2018-01, ASU2018-10, ASU 2018-11, ASU 2018-20 and ASU 2019-01, which FASB issued in January 2018, July 2018, July 2018, December 2018 and March 2019, respectively (collectively, the amended ASU 2016-02). The amended ASU 2016-02 requires lessees to recognize on the balance sheet a right-of-use asset, representing its right to use the underlying asset for the lease term, and a lease liability for all leases with terms greater than 12 months. The recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee have not significantly changed from current GAAP. The amended ASU 2016-02 retains a distinction between finance leases (i.e. capital leases under current GAAP) and operating leases. The classification criteria for distinguishing between finance leases and operating leases will be substantially similar to the classification criteria for distinguishing between capital leases and operating leases under current GAAP. The amended ASU 2016-02 also requires qualitative and quantitative disclosures designed to assess the amount, timing, and uncertainty of cash flows arising from leases. A modified retrospective transition approach is permitted to be used when an entity adopts the amended ASU 2016-02, which includes a number of optional practical expedients that entities may elect to apply.\nWe have no assets and or leases and do not believe we will be impacted in the foreseeable future by the newly adopted accounting standard(s) mentioned above.\nThe Company has implemented all new accounting pronouncements that are in effect and that may impact its financial statements and does not believe that there are any other new pronouncements that have been issued that might have a material impact on its financial position or results of operations.\nNote 3 – Going Concern\nThe Company’s financial statements are prepared in accordance with generally accepted accounting principles applicable to a going concern that contemplates the realization of assets and liquidation of liabilities in the normal course of business.\nThe Company demonstrates adverse conditions that raise substantial doubt about the Company's ability to continue as a going concern for one year following the issuance of these financial statements. These adverse conditions are negative financial trends, specifically operating loss, working capital deficiency, and other adverse key financial ratios.\nThe Company has not established any source of revenue to cover its operating costs. Management plans to fund operating expenses with related party contributions to capital. There is no assurance that management's plan will be successful. The financial statements do not include any adjustments relating to the recoverability and classification of recorded assets, or the amounts and classification of liabilities that might be necessary in the event that the Company cannot continue as a going concern.\nNote 4 – Income Taxes\nThe Company has not recognized an income tax benefit for its operating losses generated based on uncertainties concerning its ability to generate taxable income in future periods. The tax benefit for the period presented is offset by a valuation allowance established against deferred tax assets arising from the net operating losses, the realization of which could not be considered more likely than not. In future periods, tax benefits and related deferred tax assets will be recognized when management considers realization of such amounts to be more likely than not. As of March 31, 2019, the Company has incurred a net loss of approximately $6,852 which resulted in a net operating loss for income tax purposes. The loss results in a deferred tax asset of approximately $1,439 at the effective statutory rate of 21%. The deferred tax asset has been off-set by an equal valuation allowance. Given our inception on December 6, 2018, and our fiscal year end of December 31, 2018, we have completed only one taxable fiscal year.\nNote 5 – Commitments and Contingencies\nThe Company follows ASC 450-20, Loss Contingencies, to report accounting for contingencies. Liabilities for loss contingencies arising from claims, assessments, litigation, fines and penalties and other sources are recorded when it is probable that a liability has been incurred and the amount of the assessment can be reasonably estimated. There were no commitments or contingencies as of March 31, 2019.\nNote 6 – Accrued Expenses\nAccrued expenses totaled $300 as of March 31, 2019 and $5,550 as of December 31, 2018 and consisted primarily of professional fees for both periods.\nNote 7 – Shareholder Equity\nPreferred Stock\nThe authorized preferred stock of the Company consists of 20,000,000 shares with a par value of $0.001. There are 5,000,000 shares of Series “A” convertible Preferred Stock issued and outstanding as of March 31, 2019 and December 31, 2018.\nOn June 29, 2018, the Company issued 2,550 shares of Series “A” convertible Preferred Stock to Giant Consulting Services, LLC (“GCS”), a Wyoming Limited Liability Company, for helping the Company locate an acquisition or merger candidate. Jeffrey DeNunzio is the controlling member and Paul Moody, our sole director, is the Manager of GCS. The preferred stock is convertible into one share of common stock. The preferred stock has no voting rights in the Company other than the right to vote upon a change to its class rights, privileges or designations by the majority vote of the Series “A” convertible preferred class shareholders. The Board of Directors may, in the future, issue additional classes of preferred stock which shall have attributes and rights as determined by the Board of Directors at that time.\nCommon Stock\nThe authorized common stock of the Company consists of 500,000,000 shares with a par value of $0.001. There were 72,948,316 shares of common stock issued and outstanding as of March 31, 2019 and December 31, 2018.\nOn June 29, 2018, 60,000,000 common shares were issued by GMOS Nevada to GCS for development of the Company’s business plan.\nOn December 28, 2018, each share of capital stock of GMOS Delaware issued and outstanding immediately prior to the holding company reorganization was automatically converted into one fully paid and non-assessable share of capital stock of the Company.\nThe outstanding common shares were originally issued by GMOS Nevada prior to reorganization and are now listed as converted shares for the Company.\nAdditional Paid-In Capital\nThe Company’s sole officer and director, Paul Moody, paid expenses on behalf of the company totaling $305 as of December 31, 2018. During the three months ended March 31, 2019, Mr. Moody paid expenses on behalf of the company totaling $6,247. The $6,552 in total payments are considered a contribution to the company with no expectation of repayment and is posted as additional paid-in capital.\nNote 8 – Related-Party Transactions\nOffice Space\nWe utilize the home office space and equipment of our management at no cost.\nNote 9 – Subsequent Events\nManagement has reviewed financial transactions for the Company subsequent to the quarter ended March 31, 2019 and has found that there was nothing material to disclose.\n\n| 10 |\n\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations is designed to provide a reader of the financial statements with a narrative report on our financial condition, results of operations, and liquidity. This discussion and analysis should be read in conjunction with the attached unaudited Financial Statements and notes thereto and our Registration Statement on Form 10-12G, which contains audited Financial Statements and notes thereto for the period ended December 31, 2018. The following discussion contains forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations, and intentions. Our actual results could differ materially from those discussed in the forward-looking statements. Please also see the cautionary language at the beginning of this Quarterly Report regarding forward-looking statements.\nCorporate History\nFast Lane Holdings, Inc. (we, us, our, or the \"Company\") was incorporated on December 6, 2018 in the State of Delaware. The Company was created for the sole purpose of participating in a Delaware holding company reorganization pursuant to Section 251(g) of the General Corporation Law of the state of Delaware, (the “DGCL”) with Giant Motorsports Delaware Inc. (“GMOS Delaware”), a Delaware corporation incorporated on December 6, 2018 and parent company of Fast Lane Holdings, Inc.; and Giant Motorsports Merger Sub, Inc., a Delaware corporation incorporated on December 6, 2018 and a wholly owned subsidiary of Fast Lane Holdings, Inc. .\nOn December 6, 2018, Paul Moody was appointed Chief Executive Officer, Chief Financial Officer, and Director of Fast Lane Holdings, Inc., Giant Motorsports Delaware, Inc. and Giant Motorsports Merger Sub, Inc.\nOn December 28, 2018, Giant Motorsports, Inc. (“GMOS Nevada”), a Nevada corporation merged with and into GMOS Delaware, a wholly owned subsidiary of GMOS Nevada with GMOS Delaware as the surviving corporation. The sole purpose to merge GMOS Nevada with and into GMOS Delaware was to re-domesticate GMOS Nevada from Nevada to Delaware.\nOn December 28, 2018, Giant Motorsports Delaware, Inc. completed the holding company reorganization by merging with and into its indirect wholly owned subsidiary known as Giant Motorsports Merger Sub, Inc. with Giant Motorsports Delaware, Inc. as the surviving corporation and becoming a wholly owned subsidiary of Fast Lane Holdings, Inc. Fast Lane Holdings, Inc. as successor issuer to Giant Motorsports, Inc. continued to trade in the OTC MarketPlace under the previous ticker symbol “GMOS” until the new ticker symbol “FLHI” for the Company was released into the OTC MarketPlace on January 10, 2019. The Company was given a new CUSIP Number by CUSIP Global Services for its common stock of 31189D109. Concurrently, the Company cancelled all of its stock held in GMOS Delaware resulting in GMOS Delaware becoming a stand-alone company.\nThe Company intends to serve as a vehicle to affect an asset acquisition, merger, exchange of capital stock or other business combination with a domestic or foreign business. As of December 31, 2018, the Company had not yet commenced any operations.\n| 11 |\n\nBusiness Overview\nThe Company, based on current and proposed business activities, is considered a “blank check” company. The SEC defines a “blank check” company as “any development stage company that is issuing a penny stock, within the meaning of Section 3(a)(51)-1 of the Exchange Act, and that has no specific business plan or purpose, or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies or other entity or person.” Pursuant to Rule 12b-2 promulgated under the Exchange Act, the Company also qualifies as a shell company, because it has no or nominal assets (other than cash) and no or nominal operations. In addition, many states have enacted statutes, rules, and regulations limiting the sale of securities of “blank check” companies in their respective jurisdictions.\nIn addition, the Company is an “emerging growth company” (“EGC”), that is exempt from certain financial disclosure and governance requirements for up to five years as defined in the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), that eases restrictions on the sale of securities, and increases the number of stockholders a company must have before becoming subject to the SEC’s reporting and disclosure rules. We have elected to use the extended transition period for complying with new or revised accounting standards under Section 102(b)(2) of the Jobs Act, that allows us to delay the adoption of new or revised accounting standards that have different effective dates for public and private companies until those standards apply to private companies. As a result of this election, our financial statements may not be comparable to companies that comply with public company effective dates.\nThe Company intends to serve as a vehicle to affect an asset acquisition, merger, exchange of capital stock or other business combination with a domestic or foreign business. As of December 31, 2018 and March 31, 2019, the Company had not yet commenced any substantive operations.\nWe do not currently engage in any business activities that provide cash flow. The costs of investigating and analyzing business combinations and opportunities for the next 12 months and beyond such time will be paid with money in our treasury, if any, or with additional amounts, as necessary, to be loaned to or invested in us by our stockholders, management, or other investors. At this time, we are entirely reliant upon cash contributions made by our officers and directors to pay for any and all expenses.\n\n| 12 |\n\nWe have negative working capital, a stockholder deficit, and have no source of revenues. These conditions raise substantial doubt about our ability to continue as a going concern. For the foreseeable future, we will be devoting our efforts to exploring and evaluating business opportunities, which may include merger or acquisition candidates. Our ability to continue as a going concern is dependent upon our ability to develop additional sources of capital, locate and complete a merger with another company or otherwise commence business operations, and ultimately, achieve profitable operations.\nLiquidity and Capital Resources\nWe have no known demands or commitments and are not aware of any events or uncertainties as of March 31, 2019 that will result in or that are reasonably likely to materially increase or decrease our current liquidity.\nAs of March 31, 2019, the Company had no assets. The Company’s current liabilities as March 31, 2019 totaled $250, which consisted of accrued expenses.\nThe Company had no cash flows from operating activities for the three months ended March 31, 2019. The Company has generated no revenues since inception. The Company is dependent upon the receipt of capital investment or other financing to fund its ongoing operations and to execute its business plan. In addition, the Company is dependent upon certain related parties to provide continued funding and capital resources. If continued funding and capital resources are unavailable at reasonable terms, the Company may not be able to implement its plan of operations. The Company can provide no assurance that it can continue to satisfy its cash requirements for at least the next twelve months.\nResults of Operations\nThe Company has not conducted any substantive operations since inception. The Company intends to serve as a vehicle to affect an asset acquisition, merger, exchange of capital stock or other business combination with a domestic or foreign business.\nFor the three months ended March 31, 2019, the Company had a net loss of $922, which consisted of general and administrative expenses.\nOff-Balance Sheet Arrangements\nWe do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources that is material to investors.\n\n| 13 |\n\nEmerging Growth Company\nAs an EGC under the JOBS Act, the Company has elected to use the extended transition period for complying with new or revised accounting standards under Section 102(b)(1) of the JOBS Act. This election allows us to delay the adoption of new or revised accounting standards that have different effective dates for public and private companies until those standards apply to private companies. As a result of our election, our financial statements may not be comparable to companies that comply with public company effective dates.\n\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide the information required by this Item.\n\nEvaluation of Disclosure Controls and Procedures\nPaul Moody is our sole officer and director.\nUnder the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, Paul Moody, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of March 31, 2019, the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer, Paul Moody, concluded that because of material weakness in our internal control over financial reporting, our disclosure controls and procedures were not effective as of March 31, 2019.\nDisclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act, is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitations, controls and procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and our principal financial officer, to allow timely decisions regarding required disclosure.\nChances in Internal Control over Financial Reporting\nDuring the fiscal quarter ended March 31, 2019, there was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\n\n| 14 |\n\nPART II OTHER INFORMATION\n\nItem 1. Legal Proceedings\nThere are no material pending legal proceedings as defined by Item 103 of Regulation S-K, to which we are a party or of which any of our property is the subject, other than ordinary routine litigation incidental to the Company’s business.\n\nItem 1A. Risk Factors\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide the information required by this Item.\n\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nNone.\n\nItem 3. Defaults Upon Senior Securities\nNone.\n\nItem 4. Mine Safety Disclosures\nNone.\n\nItem 5. Other Information\nNone.\n\n| 15 |\n\n\nItem 6. Exhibits\nThe following exhibits are filed herewith as a part of this report.\n\n| Exhibit Number | Description |\n| 3.1 | Certificate of Incorporation, which was filed as Exhibit 3.1 to our Registration Statement on Form 10-12G/A filed with the Securities and Exchange Commission on April 24, 2019, and is incorporated herein by reference thereto. |\n| 3.2 | Bylaws, which were filed as Exhibit 3.2 to our Registration Statement on Form 10-12G/A filed with the Securities and Exchange Commission on April 24, 2019, and is incorporated herein by reference thereto. |\n| 31.1 | Certification of Chief Executive Officer and Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934* |\n| 32.1 | Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of Chapter 63 of Title 18 of the United States Code* |\n| 101.INS | XBRL Instance Document * |\n| 101.SCH | XBRL Taxonomy Extension Schema Document * |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document * |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document * |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document * |\n| 101.PRE | XBRL Taxonomy Presentation Linkbase Document * |\n\n*filed herewith\n\n| 16 |\n\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| Fast Lane HOLDINGS, INC. |\n| Date: May 10, 2019 | By: | /s/ Paul Moody |\n| Paul Moody |\n| Chief Executive Officer, and Chief Financial Officer |\n\n17\n\n \n\nWhat is the percentage change in the company's net operating loss for income tax purposes from December 31, 2018 to March 31, 2019?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nItem 1 Financial Statements\\nFast Lane Holdings, Inc.\\nBalance Sheet\\n\\n| As of March 31, 2019 (Unaudited) | As of December 31, 2018 |\\n| TOTAL ASSETS | $ | - | $ | - |\\n| LIABILITIES AND STOCKHOLDERS’ DEFICIT |\\n| CURRENT LIABILITIES: |\\n| Accrued expenses | $ | 300 | $ | 5,550 |\\n| Total current liabilities | 300 | 5,550 |\\n| TOTAL LIABILITIES | $ | 300 | $ | 5,550 |\\n| STOCKHOLDERS' DEFICIT: |\\n| Preferred stock ($.001 par value, 20,000,000 shares authorized, 5,000 issued and outstanding as of March 31, 2019 and December 31, 2018) | 5 | 5 |\\n| Common stock ($.001 par value, 500,000,000 shares authorized, 72,948,316 issued and outstanding as of March 31, 2019 and December 31, 2018) | 72,948 | 72,948 |\\n| Additional paid in capital | (66,401) | (72,648) |\\n| Accumulated deficit | (6,852) | (5,855) |\\n| Total Stockholders' deficit | (300) | (5,550) |\\n| TOTAL LIABILITIES &STOCKHOLDERS’ DEFICIT | $ | - | $ | - |\\n\\nThe accompanying notes are an integral part of these unaudited financial statements.\\n\\n| 4 |\\n\\n\\n| Fast Lane Holdings, Inc. Statement of Operations (Unaudited) |\\n| For Three Months Ended March 31, 2019 |\\n| Operating expenses |\\n| General and administrative expenses | $ | 997 |\\n| Total operating expenses | 997 |\\n| Net loss | $ | (997) |\\n| Basic and Diluted net loss per common share | $ | (0.00) |\\n| Weighted average number of common shares outstanding - Basic and Diluted | 72,948,316 |\\n\\nThe accompanying notes are an integral part of these unaudited financial statements.\\n\\n| 5 |\\n\\n\\n| Fast Lane Holdings, Inc. Statement of Changes in Stockholders' Deficit For the period from December 6, 2018 (date of inception) to March 31, 2019 (Unaudited) |\\n| Preferred Shares (Series A) | Par Value Preferred Shares (Series A) | Common Shares | Par Value Common Shares | Additional Paid-in Capital | Accumulated Deficit | Total |\\n| Date of Inception, December 6, 2018 | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - |\\n| Shares issued in Reorganization | 5,000 | 5 | 72,948,316 | 72,948 | (72,953) | - | - |\\n| Expenses paid on behalf of the Company and contributed to capital | - | - | - | - | 305 | - | 305 |\\n| Net loss | - | - | - | - | (5,855) | (5,855) |\\n| Balances, December 31, 2018 | 5,000 | $ | 5 | 72,948,316 | $ | 72,948 | $ | (72,648) | $ | (5,855) | $ | (5,550) |\\n| Expenses paid on behalf of the Company and contributed to capital | - | - | - | - | 6,247 | - | 6,247 |\\n| Net loss | - | - | - | - | - | (997) | (997) |\\n| Balances, March 31, 2019 | 5,000 | $ | 5 | 72,948,316 | $ | 72,948 | $ | (66,401) | $ | (6,852) | $ | (300) |\\n\\nThe accompanying notes are an integral part of these unaudited financial statements.\\n\\n| 6 |\\n\\nFast Lane Holdings, Inc.\\nStatement of Cash Flows\\n(Unaudited)\\n\\n| For the Three Months Ended March 31, 2019 |\\n| CASH FLOWS FROM OPERATING ACTIVITIES |\\n| Net loss | $ | (997) |\\n| Adjustment to reconcile net loss to net cash used in operating activities: |\\n| Expenses contributed to capital | 6,247 |\\n| Changes in current assets and liabilities: |\\n| Accrued expenses | (5,250) |\\n| Net cash used in operating activities | - |\\n| Net change in cash | $ | - |\\n| Beginning cash balance | - |\\n| Ending cash balance | $ | - |\\n| SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: |\\n| Interest paid | $ | - |\\n| Income taxes paid | $ | - |\\n\\nThe accompanying notes are an integral part of these unaudited financial statements.\\n\\n| 7 |\\n\\nFast Lane Holdings, Inc.\\nNotes to Unaudited Financial Statements\\nNote 1 – Organization and Description of Business\\nFast Lane Holdings, Inc. (we, us, our, or the \\\"Company\\\") was incorporated on December 6, 2018 in the State of Delaware. The Company was created for the sole purpose of participating in a Delaware holding company reorganization with Giant Motorsports Delaware Inc. (“GMOS Delaware”), a Delaware corporation incorporated on December 6, 2018 and parent company of Fast Lane Holding, Inc. and Giant Motorsports Merger Sub, Inc., a Delaware corporation incorporated on December 6, 2018 and a wholly owned subsidiary of Fast Lane Holdings, Inc. pursuant to Section 251(g) of the General Corporation Law of the state of Delaware, (the “DGCL”).\\nOn December 6, 2018, Paul Moody was appointed Chief Executive Officer, Chief Financial Officer, and Director of Fast Lane Holdings, Inc., Giant Motorsports Delaware, Inc. and Giant Motorsports Merger Sub, Inc.\\nOn December 28, 2018, Giant Motorsports, Inc. (“GMOS Nevada”), a Nevada corporation merged with and into GMOS Delaware, a wholly owned subsidiary of GMOS Nevada with GMOS Delaware as the surviving corporation. The sole purpose to merge GMOS Nevada with and into GMOS Delaware was to re-domesticate GMOS Nevada from Nevada to Delaware.\\nOn December 28, 2018, Giant Motorsports Delaware, Inc. completed a holding company reorganization pursuant to Section 251(g) of the DGCL by merging with and into its indirect wholly owned subsidiary known as Giant Motorsports Merger Sub, Inc. with Giant Motorsports Delaware, Inc. as the surviving corporation and becoming a wholly owned subsidiary of Fast Lane Holdings, Inc. Fast Lane Holdings, Inc. as successor issuer to Giant\\nMotorsports, Inc. continued to trade in the OTC MarketPlace under the previous ticker symbol “GMOS” until the new ticker symbol “FLHI” for the Company was released into the OTC MarketPlace on January 10, 2019. Concurrently, the Company cancelled all of its stock held in GMOS Delaware.\\nThe Company intends to serve as a vehicle to affect an asset acquisition, merger, exchange of capital stock or other business combination with a domestic or foreign business. As of December 31, 2018, the Company had not yet commenced any operations.\\nThe Company has elected December 31st as its year end.\\nNote 2 – Summary of Significant Accounting Policies\\nBasis of Presentation\\nThis summary of significant accounting policies is presented to assist in understanding the Company's financial statements. These accounting policies conform to accounting principles, generally accepted in the United States of America, and have been consistently applied in the preparation of the financial statements.\\nUse of Estimates\\nThe preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. In the opinion of management, all adjustments necessary in order to make the financial statements not misleading have been included. Actual results could differ from those estimates.\\nCash and Cash Equivalents\\nThe Company considers all highly liquid investments with an original maturity of three months or less when purchased to be cash equivalents. Cash and cash equivalents at March 31, 2019 and December 31, 2018 were $0 for both periods.\\n\\n| 8 |\\n\\nIncome Taxes\\nThe Company accounts for income taxes under ASC 740, “Income Taxes.” Under the asset and liability method of ASC 740, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statements carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period the enactment occurs. A valuation allowance is provided for certain deferred tax assets if it is more likely than not that the Company will not realize tax assets through future operations. No deferred tax assets or liabilities were recognized at March 31, 2019 and December 31, 2018.\\nBasic Earnings (Loss) Per Share\\nThe Company computes basic and diluted earnings (loss) per share in accordance with ASC Topic 260, Earnings per Share. Basic earnings (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the reporting period. Diluted earnings (loss) per share reflects the potential dilution that could occur if stock options and other commitments to issue common stock were exercised or equity awards vest resulting in the issuance of common stock that could share in the earnings of the Company.\\nThe Company does not have any potentially dilutive instruments as of March 31, 2019 and, thus, anti-dilution issues are not applicable.\\nFair Value of Financial Instruments\\nThe Company’s balance sheet includes certain financial instruments. The carrying amounts of current assets and current liabilities approximate their fair value because of the relatively short period of time between the origination of these instruments and their expected realization.\\nASC 820, Fair Value Measurements and Disclosures, defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820 also establishes a fair value hierarchy that distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are described below:\\n- Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.\\n- Level 2 - Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, including quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates); and inputs that are derived principally from or corroborated by observable market data by correlation or other means.\\n- Level 3 - Inputs that are both significant to the fair value measurement and unobservable.\\nFair value estimates discussed herein are based upon certain market assumptions and pertinent information available to management as of March 31, 2019. The respective carrying value of certain on-balance-sheet financial instruments approximated their fair values due to the short-term nature of these instruments. These financial instruments include accrued expenses.\\n\\n| 9 |\\n\\nRelated Parties\\nThe Company follows ASC 850, Related Party Disclosures, for the identification of related parties and disclosure of related party transactions.\\nShare-Based Compensation\\nASC 718, “Compensation – Stock Compensation”, prescribes accounting and reporting standards for all share-based payment transactions in which employee services are acquired. Transactions include incurring liabilities, or issuing or offering to issue shares, options, and other equity instruments such as employee stock ownership plans and stock appreciation rights. Share-based payments to employees, including grants of employee stock options, are recognized as compensation expense in the financial statements based on their fair values. That expense is recognized over the period during which an employee is required to provide services in exchange for the award, known as the requisite service period (usually the vesting period).\\nThe Company accounts for stock-based compensation issued to non-employees and consultants in accordance with the provisions of ASC 505-50, “Equity – Based Payments to Non-Employees.” Measurement of share-based payment transactions with non-employees is based on the fair value of whichever is more reliably measurable: (a) the goods or services received; or (b) the equity instruments issued. The fair value of the share-based payment transaction is determined at the earlier of performance commitment date or performance completion date.\\nThe Company had no stock-based compensation plans as of March 31, 2019.\\nThe Company’s stock based compensation for the periods ended March 31, 2019 and December 31, 2018 was $0 for both periods.\\nRecently Issued Accounting Pronouncements\\nIn February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). ASU 2016-02 is amended by ASU 2018-01, ASU2018-10, ASU 2018-11, ASU 2018-20 and ASU 2019-01, which FASB issued in January 2018, July 2018, July 2018, December 2018 and March 2019, respectively (collectively, the amended ASU 2016-02). The amended ASU 2016-02 requires lessees to recognize on the balance sheet a right-of-use asset, representing its right to use the underlying asset for the lease term, and a lease liability for all leases with terms greater than 12 months. The recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee have not significantly changed from current GAAP. The amended ASU 2016-02 retains a distinction between finance leases (i.e. capital leases under current GAAP) and operating leases. The classification criteria for distinguishing between finance leases and operating leases will be substantially similar to the classification criteria for distinguishing between capital leases and operating leases under current GAAP. The amended ASU 2016-02 also requires qualitative and quantitative disclosures designed to assess the amount, timing, and uncertainty of cash flows arising from leases. A modified retrospective transition approach is permitted to be used when an entity adopts the amended ASU 2016-02, which includes a number of optional practical expedients that entities may elect to apply.\\nWe have no assets and or leases and do not believe we will be impacted in the foreseeable future by the newly adopted accounting standard(s) mentioned above.\\nThe Company has implemented all new accounting pronouncements that are in effect and that may impact its financial statements and does not believe that there are any other new pronouncements that have been issued that might have a material impact on its financial position or results of operations.\\nNote 3 – Going Concern\\nThe Company’s financial statements are prepared in accordance with generally accepted accounting principles applicable to a going concern that contemplates the realization of assets and liquidation of liabilities in the normal course of business.\\nThe Company demonstrates adverse conditions that raise substantial doubt about the Company's ability to continue as a going concern for one year following the issuance of these financial statements. These adverse conditions are negative financial trends, specifically operating loss, working capital deficiency, and other adverse key financial ratios.\\nThe Company has not established any source of revenue to cover its operating costs. Management plans to fund operating expenses with related party contributions to capital. There is no assurance that management's plan will be successful. The financial statements do not include any adjustments relating to the recoverability and classification of recorded assets, or the amounts and classification of liabilities that might be necessary in the event that the Company cannot continue as a going concern.\\nNote 4 – Income Taxes\\nThe Company has not recognized an income tax benefit for its operating losses generated based on uncertainties concerning its ability to generate taxable income in future periods. The tax benefit for the period presented is offset by a valuation allowance established against deferred tax assets arising from the net operating losses, the realization of which could not be considered more likely than not. In future periods, tax benefits and related deferred tax assets will be recognized when management considers realization of such amounts to be more likely than not. As of March 31, 2019, the Company has incurred a net loss of approximately $6,852 which resulted in a net operating loss for income tax purposes. The loss results in a deferred tax asset of approximately $1,439 at the effective statutory rate of 21%. The deferred tax asset has been off-set by an equal valuation allowance. Given our inception on December 6, 2018, and our fiscal year end of December 31, 2018, we have completed only one taxable fiscal year.\\nNote 5 – Commitments and Contingencies\\nThe Company follows ASC 450-20, Loss Contingencies, to report accounting for contingencies. Liabilities for loss contingencies arising from claims, assessments, litigation, fines and penalties and other sources are recorded when it is probable that a liability has been incurred and the amount of the assessment can be reasonably estimated. There were no commitments or contingencies as of March 31, 2019.\\nNote 6 – Accrued Expenses\\nAccrued expenses totaled $300 as of March 31, 2019 and $5,550 as of December 31, 2018 and consisted primarily of professional fees for both periods.\\nNote 7 – Shareholder Equity\\nPreferred Stock\\nThe authorized preferred stock of the Company consists of 20,000,000 shares with a par value of $0.001. There are 5,000,000 shares of Series “A” convertible Preferred Stock issued and outstanding as of March 31, 2019 and December 31, 2018.\\nOn June 29, 2018, the Company issued 2,550 shares of Series “A” convertible Preferred Stock to Giant Consulting Services, LLC (“GCS”), a Wyoming Limited Liability Company, for helping the Company locate an acquisition or merger candidate. Jeffrey DeNunzio is the controlling member and Paul Moody, our sole director, is the Manager of GCS. The preferred stock is convertible into one share of common stock. The preferred stock has no voting rights in the Company other than the right to vote upon a change to its class rights, privileges or designations by the majority vote of the Series “A” convertible preferred class shareholders. The Board of Directors may, in the future, issue additional classes of preferred stock which shall have attributes and rights as determined by the Board of Directors at that time.\\nCommon Stock\\nThe authorized common stock of the Company consists of 500,000,000 shares with a par value of $0.001. There were 72,948,316 shares of common stock issued and outstanding as of March 31, 2019 and December 31, 2018.\\nOn June 29, 2018, 60,000,000 common shares were issued by GMOS Nevada to GCS for development of the Company’s business plan.\\nOn December 28, 2018, each share of capital stock of GMOS Delaware issued and outstanding immediately prior to the holding company reorganization was automatically converted into one fully paid and non-assessable share of capital stock of the Company.\\nThe outstanding common shares were originally issued by GMOS Nevada prior to reorganization and are now listed as converted shares for the Company.\\nAdditional Paid-In Capital\\nThe Company’s sole officer and director, Paul Moody, paid expenses on behalf of the company totaling $305 as of December 31, 2018. During the three months ended March 31, 2019, Mr. Moody paid expenses on behalf of the company totaling $6,247. The $6,552 in total payments are considered a contribution to the company with no expectation of repayment and is posted as additional paid-in capital.\\nNote 8 – Related-Party Transactions\\nOffice Space\\nWe utilize the home office space and equipment of our management at no cost.\\nNote 9 – Subsequent Events\\nManagement has reviewed financial transactions for the Company subsequent to the quarter ended March 31, 2019 and has found that there was nothing material to disclose.\\n\\n| 10 |\\n\\n\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations is designed to provide a reader of the financial statements with a narrative report on our financial condition, results of operations, and liquidity. This discussion and analysis should be read in conjunction with the attached unaudited Financial Statements and notes thereto and our Registration Statement on Form 10-12G, which contains audited Financial Statements and notes thereto for the period ended December 31, 2018. The following discussion contains forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations, and intentions. Our actual results could differ materially from those discussed in the forward-looking statements. Please also see the cautionary language at the beginning of this Quarterly Report regarding forward-looking statements.\\nCorporate History\\nFast Lane Holdings, Inc. (we, us, our, or the \\\"Company\\\") was incorporated on December 6, 2018 in the State of Delaware. The Company was created for the sole purpose of participating in a Delaware holding company reorganization pursuant to Section 251(g) of the General Corporation Law of the state of Delaware, (the “DGCL”) with Giant Motorsports Delaware Inc. (“GMOS Delaware”), a Delaware corporation incorporated on December 6, 2018 and parent company of Fast Lane Holdings, Inc.; and Giant Motorsports Merger Sub, Inc., a Delaware corporation incorporated on December 6, 2018 and a wholly owned subsidiary of Fast Lane Holdings, Inc. .\\nOn December 6, 2018, Paul Moody was appointed Chief Executive Officer, Chief Financial Officer, and Director of Fast Lane Holdings, Inc., Giant Motorsports Delaware, Inc. and Giant Motorsports Merger Sub, Inc.\\nOn December 28, 2018, Giant Motorsports, Inc. (“GMOS Nevada”), a Nevada corporation merged with and into GMOS Delaware, a wholly owned subsidiary of GMOS Nevada with GMOS Delaware as the surviving corporation. The sole purpose to merge GMOS Nevada with and into GMOS Delaware was to re-domesticate GMOS Nevada from Nevada to Delaware.\\nOn December 28, 2018, Giant Motorsports Delaware, Inc. completed the holding company reorganization by merging with and into its indirect wholly owned subsidiary known as Giant Motorsports Merger Sub, Inc. with Giant Motorsports Delaware, Inc. as the surviving corporation and becoming a wholly owned subsidiary of Fast Lane Holdings, Inc. Fast Lane Holdings, Inc. as successor issuer to Giant Motorsports, Inc. continued to trade in the OTC MarketPlace under the previous ticker symbol “GMOS” until the new ticker symbol “FLHI” for the Company was released into the OTC MarketPlace on January 10, 2019. The Company was given a new CUSIP Number by CUSIP Global Services for its common stock of 31189D109. Concurrently, the Company cancelled all of its stock held in GMOS Delaware resulting in GMOS Delaware becoming a stand-alone company.\\nThe Company intends to serve as a vehicle to affect an asset acquisition, merger, exchange of capital stock or other business combination with a domestic or foreign business. As of December 31, 2018, the Company had not yet commenced any operations.\\n| 11 |\\n\\nBusiness Overview\\nThe Company, based on current and proposed business activities, is considered a “blank check” company. The SEC defines a “blank check” company as “any development stage company that is issuing a penny stock, within the meaning of Section 3(a)(51)-1 of the Exchange Act, and that has no specific business plan or purpose, or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies or other entity or person.” Pursuant to Rule 12b-2 promulgated under the Exchange Act, the Company also qualifies as a shell company, because it has no or nominal assets (other than cash) and no or nominal operations. In addition, many states have enacted statutes, rules, and regulations limiting the sale of securities of “blank check” companies in their respective jurisdictions.\\nIn addition, the Company is an “emerging growth company” (“EGC”), that is exempt from certain financial disclosure and governance requirements for up to five years as defined in the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), that eases restrictions on the sale of securities, and increases the number of stockholders a company must have before becoming subject to the SEC’s reporting and disclosure rules. We have elected to use the extended transition period for complying with new or revised accounting standards under Section 102(b)(2) of the Jobs Act, that allows us to delay the adoption of new or revised accounting standards that have different effective dates for public and private companies until those standards apply to private companies. As a result of this election, our financial statements may not be comparable to companies that comply with public company effective dates.\\nThe Company intends to serve as a vehicle to affect an asset acquisition, merger, exchange of capital stock or other business combination with a domestic or foreign business. As of December 31, 2018 and March 31, 2019, the Company had not yet commenced any substantive operations.\\nWe do not currently engage in any business activities that provide cash flow. The costs of investigating and analyzing business combinations and opportunities for the next 12 months and beyond such time will be paid with money in our treasury, if any, or with additional amounts, as necessary, to be loaned to or invested in us by our stockholders, management, or other investors. At this time, we are entirely reliant upon cash contributions made by our officers and directors to pay for any and all expenses.\\n\\n| 12 |\\n\\nWe have negative working capital, a stockholder deficit, and have no source of revenues. These conditions raise substantial doubt about our ability to continue as a going concern. For the foreseeable future, we will be devoting our efforts to exploring and evaluating business opportunities, which may include merger or acquisition candidates. Our ability to continue as a going concern is dependent upon our ability to develop additional sources of capital, locate and complete a merger with another company or otherwise commence business operations, and ultimately, achieve profitable operations.\\nLiquidity and Capital Resources\\nWe have no known demands or commitments and are not aware of any events or uncertainties as of March 31, 2019 that will result in or that are reasonably likely to materially increase or decrease our current liquidity.\\nAs of March 31, 2019, the Company had no assets. The Company’s current liabilities as March 31, 2019 totaled $250, which consisted of accrued expenses.\\nThe Company had no cash flows from operating activities for the three months ended March 31, 2019. The Company has generated no revenues since inception. The Company is dependent upon the receipt of capital investment or other financing to fund its ongoing operations and to execute its business plan. In addition, the Company is dependent upon certain related parties to provide continued funding and capital resources. If continued funding and capital resources are unavailable at reasonable terms, the Company may not be able to implement its plan of operations. The Company can provide no assurance that it can continue to satisfy its cash requirements for at least the next twelve months.\\nResults of Operations\\nThe Company has not conducted any substantive operations since inception. The Company intends to serve as a vehicle to affect an asset acquisition, merger, exchange of capital stock or other business combination with a domestic or foreign business.\\nFor the three months ended March 31, 2019, the Company had a net loss of $922, which consisted of general and administrative expenses.\\nOff-Balance Sheet Arrangements\\nWe do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources that is material to investors.\\n\\n| 13 |\\n\\nEmerging Growth Company\\nAs an EGC under the JOBS Act, the Company has elected to use the extended transition period for complying with new or revised accounting standards under Section 102(b)(1) of the JOBS Act. This election allows us to delay the adoption of new or revised accounting standards that have different effective dates for public and private companies until those standards apply to private companies. As a result of our election, our financial statements may not be comparable to companies that comply with public company effective dates.\\n\\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide the information required by this Item.\\n\\nEvaluation of Disclosure Controls and Procedures\\nPaul Moody is our sole officer and director.\\nUnder the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, Paul Moody, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of March 31, 2019, the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer, Paul Moody, concluded that because of material weakness in our internal control over financial reporting, our disclosure controls and procedures were not effective as of March 31, 2019.\\nDisclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act, is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitations, controls and procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and our principal financial officer, to allow timely decisions regarding required disclosure.\\nChances in Internal Control over Financial Reporting\\nDuring the fiscal quarter ended March 31, 2019, there was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\\n\\n| 14 |\\n\\nPART II OTHER INFORMATION\\n\\nItem 1. Legal Proceedings\\nThere are no material pending legal proceedings as defined by Item 103 of Regulation S-K, to which we are a party or of which any of our property is the subject, other than ordinary routine litigation incidental to the Company’s business.\\n\\nItem 1A. Risk Factors\\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide the information required by this Item.\\n\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\\nNone.\\n\\nItem 3. Defaults Upon Senior Securities\\nNone.\\n\\nItem 4. Mine Safety Disclosures\\nNone.\\n\\nItem 5. Other Information\\nNone.\\n\\n| 15 |\\n\\n\\nItem 6. Exhibits\\nThe following exhibits are filed herewith as a part of this report.\\n\\n| Exhibit Number | Description |\\n| 3.1 | Certificate of Incorporation, which was filed as Exhibit 3.1 to our Registration Statement on Form 10-12G/A filed with the Securities and Exchange Commission on April 24, 2019, and is incorporated herein by reference thereto. |\\n| 3.2 | Bylaws, which were filed as Exhibit 3.2 to our Registration Statement on Form 10-12G/A filed with the Securities and Exchange Commission on April 24, 2019, and is incorporated herein by reference thereto. |\\n| 31.1 | Certification of Chief Executive Officer and Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934* |\\n| 32.1 | Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of Chapter 63 of Title 18 of the United States Code* |\\n| 101.INS | XBRL Instance Document * |\\n| 101.SCH | XBRL Taxonomy Extension Schema Document * |\\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document * |\\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document * |\\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document * |\\n| 101.PRE | XBRL Taxonomy Presentation Linkbase Document * |\\n\\n*filed herewith\\n\\n| 16 |\\n\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n\\n| Fast Lane HOLDINGS, INC. |\\n| Date: May 10, 2019 | By: | /s/ Paul Moody |\\n| Paul Moody |\\n| Chief Executive Officer, and Chief Financial Officer |\\n\\n17\\n\\n \\n\\nWhat is the percentage change in the company's net operating loss for income tax purposes from December 31, 2018 to March 31, 2019?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 17.02818104184458.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 36,\n \"input_length\": 7651\n}"}}},{"rowIdx":37,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nPart 1. Financial Information.\nItem 1. Financial Statements.\n\n| March 31, 2019 | December 31, 2018* |\n| ASSETS |\n| Investments: |\n| Investments available for sale: |\n| Fixed maturities, at fair value (amortized cost $158,812,233 and $160,895,869) | $ | 163,906,663 | $ | 160,960,784 |\n| Equity securities, at fair value (cost $34,883,412 and $34,885,107) | 82,450,417 | 67,664,482 |\n| Equity securities, at cost | 12,133,745 | 12,118,617 |\n| Mortgage loans on real estate at amortized cost | 10,703,553 | 9,069,111 |\n| Investment real estate | 51,530,162 | 52,518,577 |\n| Notes receivable | 26,595,336 | 23,717,312 |\n| Policy loans | 9,117,979 | 9,204,222 |\n| Total investments | 356,437,855 | 335,253,105 |\n| Cash and cash equivalents | 19,049,555 | 20,150,162 |\n| Accrued investment income | 1,887,094 | 2,119,882 |\n| Reinsurance receivables: |\n| Future policy benefits | 26,091,199 | 26,117,936 |\n| Policy claims and other benefits | 4,142,345 | 4,053,882 |\n| Cost of insurance acquired | 5,428,250 | 5,622,227 |\n| Property and equipment, net of accumulated depreciation | 581,680 | 688,567 |\n| Income tax receivable | - | 279,333 |\n| Other assets | 355,673 | 1,263,242 |\n| Total assets | $ | 413,973,651 | $ | 395,548,336 |\n| LIABILITIES & SHAREHOLDERS' EQUITY |\n| Liabilities: |\n| Policy liabilities and accruals: |\n| Future policyholder benefits | $ | 252,418,038 | $ | 253,852,368 |\n| Policy claims and benefits payable | 4,335,480 | 4,267,481 |\n| Other policyholder funds | 430,413 | 372,072 |\n| Dividend and endowment accumulations | 14,586,502 | 14,608,838 |\n| Income taxes payable | 333,283 | - |\n| Deferred income taxes | 13,231,079 | 9,113,480 |\n| Other liabilities | 6,105,232 | 6,257,387 |\n| Total liabilities | 291,440,027 | 288,471,626 |\n| Shareholders' equity: |\n| Common stock - no par value, stated value $.001 per share. Authorized 7,000,000 shares - 3,296,547 and 3,295,870 shares outstanding | 3,297 | 3,296 |\n| Additional paid-in capital | 36,585,277 | 36,567,865 |\n| Retained earnings | 81,353,780 | 69,708,901 |\n| Accumulated other comprehensive income | 3,949,134 | 62,495 |\n| Total UTG shareholders' equity | 121,891,488 | 106,342,557 |\n| Noncontrolling interests | 642,136 | 734,153 |\n| Total shareholders' equity | 122,533,624 | 107,076,710 |\n| Total liabilities and shareholders' equity | $ | 413,973,651 | $ | 395,548,336 |\n\n| Three Months Ended |\n| March 31, | March 31, |\n| 2019 | 2018 |\n| Revenue: |\n| Premiums and policy fees | $ | 2,503,205 | $ | 2,649,971 |\n| Ceded reinsurance premiums and policy fees | (517,055 | ) | (738,965 | ) |\n| Net investment income | 3,112,024 | 3,068,118 |\n| Other income | 63,838 | 60,935 |\n| Revenue before net investment gains (losses) | 5,162,012 | 5,040,059 |\n| Net investment gains (losses): |\n| Other-than-temporary impairments | - | - |\n| Other realized investment gains, net | 1,113,698 | 534,242 |\n| Change in fair value of equity securities | 14,787,631 | 4,129,236 |\n| Total net investment gains (losses) | 15,901,329 | 4,663,478 |\n| Total revenue | 21,063,341 | 9,703,537 |\n| Benefits and other expenses: |\n| Benefits, claims and settlement expenses: |\n| Life | 3,427,200 | 4,168,794 |\n| Ceded reinsurance benefits and claims | (474,622 | ) | (688,412 | ) |\n| Annuity | 197,670 | 256,884 |\n| Dividends to policyholders | 103,599 | 126,999 |\n| Commissions and amortization of deferred policy acquisition costs | (24,542 | ) | (40,571 | ) |\n| Amortization of cost of insurance acquired | 193,977 | 201,516 |\n| Operating expenses | 2,144,389 | 2,085,819 |\n| Total benefits and other expenses | 5,567,671 | 6,111,029 |\n| Income before income taxes | 15,495,670 | 3,592,508 |\n| Income tax expense | 3,697,058 | 905,763 |\n| Net income | 11,798,612 | 2,686,745 |\n| Net income attributable to noncontrolling interests | (153,733 | ) | (29,500 | ) |\n| Net income attributable to common shareholders | $ | $ 11,644,879 | $ | $ 2,657,245 |\n| Amounts attributable to common shareholders |\n| Basic income per share | $ | $ 3.53 | $ | $ 0.80 |\n| Diluted income per share | $ | $ 3.53 | $ | $ 0.80 |\n| Basic weighted average shares outstanding | 3,297,353 | 3,325,111 |\n| Diluted weighted average shares outstanding | 3,297,353 | 3,325,111 |\n\n| Three Months Ended |\n| March 31, | March 31, |\n| 2019 | 2018 |\n| Net income | $ | 11,798,612 | $ | 2,686,745 |\n| Other comprehensive income (loss): |\n| Unrealized holding gains (losses) arising during period, pre-tax | 4,934,851 | (4,285,303 | ) |\n| Tax (expense) benefit on unrealized holding gains (losses) arising during the period | (1,036,319 | ) | 899,914 |\n| Unrealized holding gains (losses) arising during period, net of tax | 3,898,532 | (3,385,389 | ) |\n| Less reclassification adjustment for gains included in net income | (15,055 | ) | - |\n| Tax expense for gains included in net income | 3,162 | - |\n| Reclassification adjustment for gains included in net income, net of tax | (11,893 | ) | - |\n| Subtotal: Other comprehensive income (loss), net of tax | 3,886,639 | (3,385,389 | ) |\n| Comprehensive income (loss) | 15,685,251 | (698,644 | ) |\n| Less comprehensive income attributable to noncontrolling interests | (153,733 | ) | (29,500 | ) |\n| Comprehensive income (loss) attributable to UTG, Inc. | $ | 15,531,518 | $ | (728,144 | ) |\n\n| Common Stock | Additional Paid-In Capital | Retained Earnings | Accumulated Other Comprehensive Income | Noncontrolling Interest | Total Shareholders' Equity |\n| Balance at December 31, 2018 | $ | 3,296 | 36,567,865 | 69,708,901 | 62,495 | 734,153 | $ | 107,076,710 |\n| Common stock issued during year | 8 | 229,792 | - | - | - | 229,800 |\n| Treasury shares acquired | (7 | ) | (212,380 | ) | - | - | - | (212,387 | ) |\n| Net income attributable to common shareholders | - | - | 11,644,879 | - | - | 11,644,879 |\n| Unrealized holding income on securities net of noncontrolling interest and reclassification adjustment and taxes | - | - | - | 3,886,639 | - | 3,886,639 |\n| Contributions | - | - | - | - | - | - |\n| Distributions | - | - | - | - | (245,750 | ) | (245,750 | ) |\n| Gain attributable to noncontrolling interest | - | - | - | - | 153,733 | 153,733 |\n| Balance at March 31, 2019 | $ | 3,297 | 36,585,277 | 81,353,780 | 3,949,134 | 642,136 | $ | 122,533,624 |\n| Common Stock | Additional Paid-In Capital | Retained Earnings | Accumulated Other Comprehensive Income | Noncontrolling Interest | Total Shareholders' Equity |\n| Balance at December 31, 2017 | $ | 3,333 | 37,536,164 | 39,040,456 | 32,952,338 | 899,227 | $ | 110,431,518 |\n| Adoption of Accounting Standards Update No 2016-01 | - | - | 18,277,328 | (18,277,328 | ) | - | - |\n| January 1, 2018 | 3,333 | 37,536,164 | 57,317,784 | 14,675,010 | 899,227 | 110,431,518 |\n| Common stock issued during year | 9 | 229,991 | - | - | - | 230,000 |\n| Treasury shares acquired | (24 | ) | (600,216 | ) | - | - | - | (600,240 | ) |\n| Net income attributable to common shareholders | - | - | 2,657,245 | - | - | 2,657,245 |\n| Unrealized holding income on securities net of noncontrolling interest and reclassification adjustment and taxes | - | - | - | (3,385,389 | ) | - | (3,385,389 | ) |\n| Contributions | - | - | - | - | - | - |\n| Distributions | - | - | - | - | (146 | ) | (146 | ) |\n| Gain attributable to noncontrolling interest | - | - | - | - | 29,500 | 29,500 |\n| Balance at March 31, 2018 | $ | 3,318 | 37,165,939 | 59,975,029 | 11,289,621 | 928,581 | $ | 109,362,488 |\n\n| Three Months Ended |\n| March 31, | March 31, |\n| 2019 | 2018 |\n| Cash flows from operating activities: |\n| Net income attributable to common shareholders | $ | 11,644,879 | $ | 2,657,245 |\n| Adjustments to reconcile net income to net cash used in operating activities: |\n| Amortization (accretion) of investments | (39,703 | ) | 17,036 |\n| Realized investment gains, net | (1,113,698 | ) | (534,242 | ) |\n| Change in fair value of equity securities | (14,787,631 | ) | (4,129,236 | ) |\n| Amortization of cost of insurance acquired | 193,977 | 201,516 |\n| Depreciation | 323,406 | 275,143 |\n| Net income attributable to noncontrolling interest | 153,733 | 29,500 |\n| Charges for mortality and administration of universal life and annuity products | (1,619,743 | ) | (1,650,201 | ) |\n| Interest credited to account balances | 1,029,303 | 883,563 |\n| Change in accrued investment income | 232,788 | (357,576 | ) |\n| Change in reinsurance receivables | (61,726 | ) | 35,546 |\n| Change in policy liabilities and accruals | (772,518 | ) | (6,961 | ) |\n| Change in income taxes receivable (payable) | 612,616 | 12,974 |\n| Change in other assets and liabilities, net | 3,839,857 | 5,894,257 |\n| Net cash provided by (used in) operating activities | (364,460 | ) | 3,328,564 |\n| Cash flows from investing activities: |\n| Proceeds from investments sold and matured: |\n| Fixed maturities available for sale | 2,023,974 | 14,515 |\n| Equity securities | 33,075 | 103,298 |\n| Mortgage loans | 1,945,760 | 2,009,715 |\n| Real estate | 3,045,226 | 7,941,649 |\n| Notes receivable | 1,537,984 | 563,926 |\n| Policy loans | 410,831 | 366,847 |\n| Short-term investments | - | 850,000 |\n| Total proceeds from investments sold and matured | 8,996,850 | 11,849,950 |\n| Cost of investments acquired: |\n| Fixed maturities available for sale | - | (4,971,517 | ) |\n| Equity securities | (46,509 | ) | (7,957,471 | ) |\n| Mortgage loans | (3,575,500 | ) | - |\n| Real estate | (1,174,688 | ) | (6,006,130 | ) |\n| Notes receivable | (4,416,008 | ) | - |\n| Policy loans | (324,587 | ) | (405,337 | ) |\n| Short-term investments | - | (850,000 | ) |\n| Total cost of investments acquired | (9,537,292 | ) | (20,190,455 | ) |\n| Net cash used in investing activities | (540,442 | ) | (8,340,505 | ) |\n| Cash flows from financing activities: |\n| Policyholder contract deposits | 1,264,011 | 1,149,533 |\n| Policyholder contract withdrawals | (1,231,379 | ) | (1,245,743 | ) |\n| Purchase of treasury stock | (212,387 | ) | (600,240 | ) |\n| Issuance of stock | 229,800 | 230,000 |\n| Non controlling contributions (distributions) of consolidated subsidiary | (245,750 | ) | (146 | ) |\n| Net cash used in financing activities | (195,705 | ) | (466,596 | ) |\n| Net decrease in cash and cash equivalents | (1,100,607 | ) | (5,478,537 | ) |\n| Cash and cash equivalents at beginning of period | 20,150,162 | 25,434,199 |\n| Cash and cash equivalents at end of period | $ | 19,049,555 | $ | 19,955,662 |\n\nUTG, Inc. Notes to Condensed Consolidated Financial Statements\nNote 1 – Basis of Presentation\nThe accompanying Condensed Consolidated Balance Sheet as of December 31, 2018, which has been derived from audited consolidated financial statements, and the unaudited interim Condensed Consolidated Financial Statements include the accounts of UTG, Inc. (the “Parent”) and its subsidiaries (collectively with the Parent, the “Company”). All significant intercompany accounts and transactions have been eliminated in consolidation. The accompanying Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 8 of regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for audited annual financial statements. The information furnished includes all adjustments and accruals of a normal recurring nature, which in the opinion of Management, are necessary for a fair presentation of the results for the interim periods. The unaudited Condensed Consolidated Financial Statements included herein and these related notes should be read in conjunction with the Company’s consolidated financial statements, and the notes thereto, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018. The Company’s results of operations for the three-month period ended March 31, 2019 are not necessarily indicative of the results that may be expected for the year ending December 31, 2019 or for any other future period.\nThis document at times will refer to the Registrant’s largest shareholder, Mr. Jesse T. Correll and certain companies controlled by Mr. Correll. Mr. Correll holds a majority ownership of First Southern Funding, LLC (“FSF”), a Kentucky corporation, and First Southern Bancorp, Inc. (“FSBI”), a financial services holding company. FSBI operates through its 100% owned subsidiary bank, First Southern National Bank (“FSNB”). Banking activities are conducted through multiple locations within south-central and western Kentucky. Mr. Correll is Chief Executive Officer and Chairman of the Board of Directors of UTG and is currently UTG’s largest shareholder through his ownership control of FSF, FSBI and affiliates. At March 31, 2019, Mr. Correll owns or controls directly and indirectly approximately 65.26% of UTG’s outstanding stock. UTG’s life insurance subsidiary, Universal Guaranty Life Insurance Company (“UG”), has several wholly-owned and majority-owned subsidiaries. The subsidiaries were formed to hold certain real estate investments. The real estate investments were placed into the limited liability companies and partnerships to provide additional protection to the policyholders and to UG.\nNote 2 – Recently Issued Accounting Standards\nDuring the three months ended March 31, 2019, there were no additions to or changes in the critical accounting policies disclosed in the 2018 Form 10-K.\nNote 3 – Investments Available for Sale Securities – Fixed Maturity Securities The Company’s insurance subsidiary is regulated by insurance statutes and regulations as to the type of investments they are permitted to make, and the amount of funds that may be used for any one type of investment.\n| March 31, 2019 | Original or Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Fair Value |\n| Investments available for sale: |\n| Fixed maturities |\n| U.S. Government and govt. agencies and authorities | $ | 25,652,896 | $ | 221,161 | $ | (98,738 | ) | $ | 25,775,319 |\n| U.S. special revenue and assessments | 16,350,071 | 545,717 | 0 | 16,895,788 |\n| All other corporate bonds | 116,809,266 | 5,163,923 | (737,633 | ) | 121,235,556 |\n| $ | 158,812,233 | $ | 5,930,801 | $ | (836,371 | ) | $ | 163,906,663 |\n| December 31, 2018 | Original or Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Fair Value |\n| Investments available for sale: |\n| Fixed maturities |\n| U.S. Government and govt. agencies and authorities | $ | 25,649,410 | $ | 149,006 | $ | (138,222 | ) | $ | 25,660,194 |\n| U.S. special revenue and assessments | 16,350,486 | 334,300 | (4,406 | ) | 16,680,380 |\n| All other corporate bonds | 118,895,973 | 2,569,287 | (2,845,050 | ) | 118,620,210 |\n| $ | 160,895,869 | $ | 3,052,593 | $ | (2,987,678 | ) | $ | 160,960,784 |\n\n| Fixed Maturities Available for Sale March 31, 2019 | Amortized Cost | Fair Value |\n| Due in one year or less | $ | 6,498,983 | $ | 6,525,131 |\n| Due after one year through five years | 51,055,408 | 53,028,854 |\n| Due after five years through ten years | 50,690,937 | 53,501,649 |\n| Due after ten years | 50,566,905 | 50,851,029 |\n| Total | $ | 158,812,233 | $ | 163,906,663 |\n\n| March 31, 2019 | Less than 12 months | 12 months or longer | Total |\n| Fair value | Unrealized losses | Fair value | Unrealized losses | Fair value | Unrealized losses |\n| U.S. Government and govt. agencies and authorities | $ | - | - | 5,578,536 | (98,738 | ) | 5,578,536 | $ | (98,738 | ) |\n| All other corporate bonds | 3,555,300 | (6,923 | ) | 26,553,550 | (730,710 | ) | 30,108,850 | (737,633 | ) |\n| Total fixed maturities | $ | 3,555,300 | (6,923 | ) | 32,132,086 | (829,448 | ) | 35,687,386 | $ | (836,371 | ) |\n| December 31, 2018 | Less than 12 months | 12 months or longer | Total |\n| Fair value | Unrealized losses | Fair value | Unrealized losses | Fair value | Unrealized losses |\n| U.S. Government and govt. agencies and authorities | $ | 6,429,700 | (49,904 | ) | 1,592,679 | (88,318 | ) | 8,022,379 | $ | (138,222 | ) |\n| U.S. special revenue and assessments | 4,023,920 | (4,406 | ) | - | - | 4,023,920 | (4,406 | ) |\n| All other corporate bonds | 49,270,729 | (2,033,507 | ) | 15,337,739 | (811,543 | ) | 64,608,468 | (2,845,050 | ) |\n| Total fixed maturities | $ | 59,724,349 | (2,087,817 | ) | 16,930,418 | (899,861 | ) | 76,654,767 | $ | (2,987,678 | ) |\n\n| Less than 12 months | 12 months or longer | Total |\n| As of March 31, 2019 |\n| Fixed maturities | 2 | 14 | 16 |\n| As of December 31, 2018 |\n| Fixed maturities | 30 | 10 | 40 |\n\nSubstantially all of the unrealized losses on fixed maturities and equity securities at March 31, 2019 and December 31, 2018 are attributable to changes in market interest rates and general disruptions in the credit market subsequent to purchase. The Company does not currently intend to sell nor does it expect to be required to sell any of the securities in an unrealized loss position. Based upon the Company’s expected continuation of receipt of contractually required principal and interest payments and its intent and ability to retain the securities until price recovery, as well as the Company’s evaluation of other relevant factors, the Company deems these securities to be temporarily impaired as of March 31, 2019 and December 31, 2018. Net Investment Gains (Losses)\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Realized gains on available-for-sale investments: |\n| Sales of fixed maturities | $ | 15,055 | $ | - |\n| Sales of equity securities | - | - |\n| Sales of real estate | 1,098,643 | - |\n| Other | - | 534,242 |\n| Total realized gains | 1,113,698 | 534,242 |\n| Realized losses on available-for-sale investments: |\n| Sales of fixed maturities | - | - |\n| Sales of equity securities | - | - |\n| Sales of real estate | - | - |\n| Other-than-temporary impairments | - | - |\n| Other | - | - |\n| Total realized losses | - | - |\n| Net realized investment gains (losses) | 1,113,698 | 534,242 |\n| Change in fair value of equity securities: |\n| Realized gains (losses) on equity securities sold during the period | - | - |\n| Change in fair value of equity securities held at the end of the period | 14,787,631 | 4,129,236 |\n| Change in fair value of equity securities | 14,787,631 | 4,129,236 |\n| Net investment gains (losses) | $ | 15,901,329 | $ | 4,663,478 |\n| Change in net unrealized gains (losses) on available-for-sale investments included in other comprehensive income: |\n| Fixed maturities | $ | 4,934,851 | $ | (4,285,303 | ) |\n| Equity securities | - | - |\n| Net increase (decrease) | $ | 4,934,851 | $ | (4,285,303 | ) |\n\nOther-Than-Temporary Impairments The Company regularly reviews its investment securities for factors that may indicate that a decline in fair value of an investment is other than temporary. The factors considered by Management in its regular review to identify and recognize other-than-temporary impairment losses on fixed maturities include, but are not limited to: the length of time and extent to which the fair value has been less than cost; the Company’s intent to sell, or be required to sell, the debt security before the anticipated recovery of its remaining amortized cost basis; the financial condition and near-term prospects of the issuer; adverse changes in ratings announced by one or more rating agencies; subordinated credit support, whether the issuer of a debt security has remained current on principal and interest payments; current expected cash flows; whether the decline in fair value appears to be issuer specific or, alternatively, a reflection of general market or industry conditions, including the effect of changes in market interest rates. If the Company intends to sell a debt security, or it is more likely than not that it would be required to sell a debt security before the recovery of its amortized cost basis, the entire difference between the security’s amortized cost basis and its fair value at the balance sheet date would be recognized by a charge to other-than-temporary losses in the Condensed Consolidated Statements of Operations. Management regularly reviews its real estate portfolio in comparison to appraisal valuations and current market conditions for indications of other-than-temporary impairments. If a decline in value is judged by Management to be other-than-temporary, a loss is recognized by a charge to other-than-temporary impairment losses in the Consolidated Statements of Operations. The Company did not recognize any other-than-temporary impairments during the first quarter of 2018 or 2019. Cost Method Investments The Company held equity investments with an aggregate cost of $12,133,745 and $12,118,617 at March 31, 2019 and December 31, 2018, respectively. These equity investments were not reported at fair value because it is not practicable to estimate their fair values due to insufficient information being available. Management did not identify any events or changes in circumstances that might have a significant adverse effect on the reported value of those investments. Based on Management's evaluation of the expected cash flow of the investments, and the Company's ability and intent to hold the investments for a reasonable period of time, the Company does not deem an other-than-temporary impairment necessary at March 31, 2019.\nMortgage Loans The Company, from time to time, acquires mortgage loans through participation agreements with FSNB. FSNB has been able to provide the Company with additional expertise and experience in underwriting commercial and residential mortgage loans, which provide more attractive yields than the traditional bond market. The Company is able to receive participations from FSNB for three primary reasons: 1) FSNB has already reached its maximum lending limit to a single borrower, but the borrower is still considered a suitable risk; 2) the interest rate on a particular loan may be fixed for a long period that is more suitable for UG given its asset-liability structure; and 3) FSNB’s loan growth might at times outpace its deposit growth, resulting in FSNB participating such excess loan growth rather than turning customers away. For originated loans, the Company’s Management is responsible for the final approval of such loans after evaluation. Before a new loan is issued, the applicant is subject to certain criteria set forth by Company Management to ensure quality control. These criteria include, but are not limited to, a credit report, personal financial information such as outstanding debt, sources of income, and personal equity. Once the loan is approved, the Company directly funds the loan to the borrower. The Company bears all risk of loss associated with the terms of the mortgage with the borrower. During the first quarter of 2019 and 2018, the Company acquired $3,575,500 and $0 in mortgage loans, respectively. FSNB services the majority of the Company’s mortgage loan portfolio. The Company pays FSNB a .25% servicing fee on these loans and a one-time fee at loan origination of .50% of the original loan cost to cover costs incurred by FSNB relating to the processing and establishment of the loan.\n| 2019 | 2018 |\n| Maximum rate | Minimum rate | Maximum rate | Minimum rate |\n| Farm Loans | 5.00% | 5.00% | 5.00% | 5.00% |\n| Commercial Loans | 7.50% | 4.00% | 7.50% | 4.00% |\n| Residential Loans | 8.00% | 8.00% | 8.00% | 8.00% |\n\nMost mortgage loans are first position loans. Loans issued are generally limited to no more than 80% of the appraised value of the property. The Company has in place a monitoring system to provide Management with information regarding potential troubled loans. Letters are sent to each mortgagee when the loan becomes 30 days or more delinquent. Management is provided with a monthly listing of loans that are 60 days or more past due along with a brief description of what steps are being taken to resolve the delinquency. All loans 90 days or more past due are placed on a non-performing status and classified as delinquent loans. Quarterly, coinciding with external financial reporting, the Company reviews each delinquent loan and determines how each delinquent loan should be classified. Management believes the current internal controls surrounding the mortgage loan selection process provide a quality portfolio with minimal risk of foreclosure and/or negative financial impact. Changes in the current economy could have a negative impact on the loans, including the financial stability of the borrowers, the borrowers’ ability to pay or to refinance, the value of the property held as collateral and the ability to find purchasers at favorable prices. Interest accruals are analyzed based on the likelihood of repayment. In no event will interest continue to accrue when accrued interest along with the outstanding principal exceeds the net realizable value of the property. The Company does not utilize a specified number of days delinquent to cause an automatic non-accrual status. A mortgage loan reserve is established and adjusted based on Management's quarterly analysis of the portfolio and any deterioration in value of the underlying property which would reduce the net realizable value of the property below its current carrying value. The mortgage loan reserve was $0 at March 31, 2019 and December 31, 2018.\n| March 31, 2019 | December 31, 2018 |\n| In good standing | $ | 8,829,640 | $ | 7,169,272 |\n| Overdue interest over 90 days | 1,873,913 | 1,899,839 |\n| Total mortgage loans | $ | 10,703,553 | $ | 9,069,111 |\n\nInvestment Real Estate Real estate acquired through foreclosure, consisting of properties obtained through foreclosure proceedings or acceptance of a deed in lieu of foreclosure, is reported on an individual asset basis at the lower of cost or fair value, less disposal costs. Fair value is determined on the basis of current appraisals, comparable sales, and other estimates of value obtained principally from independent sources. When properties are acquired through foreclosure, any excess of the loan balance at the time of foreclosure over the fair value of the real estate held as collateral is recognized and charged to the Consolidated Statements of Operations. Based upon Management’s evaluation of the real estate acquired through foreclosure, additional expense is recorded when necessary in an amount sufficient to reflect any declines in estimated fair value. Gains and losses recognized on the disposition of the properties are recorded as realized gains and losses in the Condensed Consolidated Statements of Operations. Notes Receivable Notes receivable represent collateral loans and promissory notes issued by the Company and are reported at their unpaid principal balances, adjusted for valuation allowances. Valuation allowances are established for impaired loans when it is probable that contractual principal and interest will not be collected. The valuation allowance as of March 31, 2019 and December 31, 2018 was $0. Interest accruals are analyzed based on the likelihood of repayment. The Company does not utilize a specified number of days delinquent to cause an automatic non-accrual status. Before a new note is issued, the applicant is subject to certain criteria set forth by Company Management to ensure quality control. Once the note is approved, the Company directly funds the note to the borrower. Several of the notes have participation agreements in place, whereas the Company has reduced its investment in the note receivable by participating a portion of the note to a third party. Similar to the mortgage loans, FSNB services several of the notes receivable. The Company, and the participants in the notes, share in the risk of loss associated with the terms of the note with the borrower, based upon their ownership percentage in the note. The Company has in place a monitoring system to provide Management with information regarding potential troubled loans.\nNote 4 – Fair Value Measurements The Company measures its assets and liabilities recorded at fair value in the Condensed Consolidated Balance Sheets based on the framework set forth in the GAAP fair value accounting guidance. The framework establishes a fair value hierarchy of three levels based upon the transparency of information used in measuring the fair value of assets or liabilities as of the measurement date. The fair value hierarchy prioritizes the inputs in the valuation techniques used to measure fair value into three categories. Level 1 – Valuation is based upon quoted prices for identical assets or liabilities in active markets that the Company is able to access. Level 1 fair value is not subject to valuation adjustments. Level 2 – Valuation is based upon quoted prices for similar assets and liabilities in active markets or quoted prices for identical or similar instruments in markets that are not active. In addition, the Company may use various valuation techniques or pricing models that use observable inputs to measure fair value. Level 3 – Valuation is based upon unobservable inputs that are supported by little or no market activity and are significant to the fair value of the assets or liabilities. Unobservable inputs reflect the Company’s own assumptions about the inputs that market participants would use in pricing the asset or liability. The Company determines the existence of an active market for an asset or liability based on its judgment as to whether transactions for the asset or liability occur in such market with sufficient frequency and volume to provide reliable pricing information. If the Company concludes that there has been a significant decrease in the volume and level of activity for an investment in relation to normal market activity for such investment, adjustments to transactions and quoted prices are made to estimate fair value. The inputs used in the valuation techniques employed by the Company are provided by nationally recognized pricing services, external investment managers and internal resources. To assess these inputs, the Company’s review process includes, but is not limited to, quantitative analysis including benchmarking, initial and ongoing evaluations of methodologies used by external parties to calculate fair value, and ongoing evaluations of fair value estimates based on the Company’s knowledge and monitoring of market conditions. The Company periodically reviews the pricing service provider’s policies and procedures for valuing securities. The assumptions underlying the valuations from external service providers, including unobservable inputs, are generally not readily available as this information is often deemed proprietary. Accordingly, the Company is unable to obtain comprehensive information regarding these assumptions and methodologies. The Company’s investments in fixed maturity securities available for sale, equity securities and trading securities assets and liabilities are carried at fair value. The following are the Company’s methodologies and valuation techniques for assets and liabilities measured at fair value. Fixed maturities available for sale mainly consist of U.S. treasury securities and corporate debt securities. The Company employs a market approach to the valuation of securities where there are sufficient market transactions involving identical or comparable assets. If sufficient market data is not available for identical or comparable assets, the Company uses an income approach to valuation. The majority of the financial instruments included in fixed maturity securities available for sale are evaluated utilizing observable inputs; accordingly, they are categorized in either Level 1 or Level 2 of the fair value hierarchy. However, in instances where significant inputs utilized in valuation of the securities are unobservable, the securities are categorized in Level 3 of the fair value hierarchy. Corporate securities primarily include fixed rate corporate bonds. Inputs utilized in connection with the Company’s valuation techniques relating to this class of securities include recently executed transactions, market price quotations, benchmark yields and issuer spreads. Corporate securities are categorized in Level 2 of the fair value hierarchy. U.S. treasury securities are based on quoted prices in active markets and are generally categorized in Level 1 of the fair value hierarchy. Equity securities consist of common and preferred stocks mainly in private equity investments, financial institutions and publicly traded corporations. Equity securities for which there is sufficient market data are categorized as Level 1 or 2 in the fair value hierarchy. For the equity securities in which quoted market prices are not available, the Company uses industry standard pricing methodologies, including discounted cash flow models that may incorporate various inputs such as payment expectations, risk of the investment, market data, and health of the underlying company. The inputs are based upon Management's assumptions and available market information. When evidence is believed to support a change to the carrying value from the transaction price, adjustments are made to reflect the expected cash flows, material events and market data. These investments are included in Level 3 of the fair value hierarchy.\n| Level 1 | Level 2 | Level 3 | Total |\n| Assets |\n| Fixed Maturities, available for sale | $ | 25,775,319 | $ | 137,696,500 | $ | 434,844 | $ | 163,906,663 |\n| Equity Securities | 37,355,757 | 12,176,923 | 32,917,737 | 82,450,417 |\n| Total | $ | 63,131,076 | $ | 149,873,423 | $ | 33,352,581 | $ | 246,357,080 |\n| Level 1 | Level 2 | Level 3 | Total |\n| Assets |\n| Fixed Maturities, available for sale | $ | 25,660,194 | $ | 134,865,746 | $ | 434,844 | $ | 160,960,784 |\n| Equity Securities | 27,634,283 | 10,557,031 | 29,473,168 | 67,664,482 |\n| Total | $ | 53,294,477 | $ | 145,422,777 | $ | 29,908,012 | $ | 228,625,266 |\n\n| Fixed Maturities, Available for Sale | Equity Securities | Total |\n| Balance at December 31, 2018 | $ | 434,844 | $ | 29,473,168 | $ | 29,908,012 |\n| Total unrealized gain or (losses): |\n| Included in net income (loss) | - | 3,444,569 | 3,444,569 |\n| Included in other comprehensive income | - | - | - |\n| Purchases | - | - | - |\n| Sales | - | - | - |\n| Balance at March 31, 2019 | $ | 434,844 | $ | 32,917,737 | $ | 33,352,581 |\n| March 31, 2019 | December 31, 2018 |\n| Change in fair value of equity securities included in net income (loss) relating to assets held | $ | 3,444,569 | $ | 4,633,751 |\n\nThe Level 3 securities include collateralized debt obligations of trust preferred securities issued by banks and insurance companies and certain equity securities with unobservable inputs. The Company computed fair value of Level 3 equity investments based on a review of current financial information, earnings trends and similar companies in the same industries. There were no transfers in or out of Level 3 as of March 31, 2019. Transfers occur when there is a change in the availability of observable market information. Certain assets are not carried at fair value on a recurring basis, including investments such as mortgage loans and policy loans. Accordingly, such investments are only included in the fair value hierarchy disclosure when the investment is subject to re-measurement at fair value after initial recognition and the resulting re-measurement is reflected in the Consolidated Financial Statements.\n| March 31, 2019 | December 31, 2018 |\n| Assets | Carrying Amount | Estimated Fair Value | Carrying Amount | Estimated Fair Value |\n| Equity securities | $ | 12,133,745 | $ | 12,133,745 | $ | 12,118,617 | $ | 12,118,617 |\n| Mortgage loans on real estate | 10,703,553 | 10,703,553 | 9,069,111 | 9,069,111 |\n| Investment real estate | 51,530,162 | 51,530,162 | 52,518,577 | 52,518,577 |\n| Notes receivable | 26,595,336 | 26,595,336 | 23,717,312 | 23,717,312 |\n| Policy loans | 9,117,979 | 9,117,979 | 9,204,222 | 9,204,222 |\n| Cash and cash equivalents | 19,049,555 | 19,049,555 | 20,150,162 | 20,150,162 |\n\nThe above estimated fair value amounts have been determined based upon the following valuation methodologies. Considerable judgment was required to interpret market data in order to develop these estimates. Accordingly, the estimates are not necessarily indicative of the amounts which could be realized in a current market exchange. The use of different market assumptions or estimation methodologies may have a material effect on the fair value amounts. The fair values of mortgage loans on real estate are estimated using discounted cash flow analyses and interest rates being offered for similar loans to borrowers with similar credit ratings. The inputs used to measure the fair value of our mortgage loans on real estate are classified as Level 3 within the fair value hierarchy. A portion of the mortgage loans balance consists of discounted mortgage loans. The Company has historically purchased non-performing discounted mortgage loans at a deep discount through an auction process led by the Federal Government. In general, the discounted loans are non-performing and there is a significant amount of uncertainty surrounding the timing and amount of cash flows to be received by the Company. Accordingly, the Company records its investment in the discounted loans at its original purchase price, which Management believes approximates fair value. The inputs used to measure the fair value of our discounted mortgage loans are classified as Level 3 within the fair value hierarchy Investment real estate is recorded at the lower of the net investment in the real estate or the fair value of the real estate less costs to sell. The determination of fair value assessments are performed on a periodic, non-recurring basis by external appraisal and assessment of property values by Management. The inputs used to measure the fair value of our investment real estate are classified as Level 3 within the fair value hierarchy. Notes receivable are carried at their unpaid principal balances, which approximates fair value. The inputs used to measure the fair value of the loans are classified as Level 3 within the fair value hierarchy. Policy loans are carried at the aggregate unpaid principal balances in the Condensed Consolidated Balance Sheets which approximate fair value, and earn interest at rates ranging from 4% to 8%. Individual policy liabilities in all cases equal or exceed outstanding policy loan balances. The inputs used to measure the fair value of our policy loans are classified as Level 3 within the fair value hierarchy. The carrying amount of cash and cash equivalents in the Condensed Consolidated Balance Sheets approximates fair value given the highly liquid nature of the instruments. The inputs used to measure the fair value of our cash and cash equivalents are classified as Level 1 within the fair value hierarchy. The carrying amount of short term investments in the Condensed Consolidated Balance Sheets approximates fair value. The inputs used to measure the fair value of our short term investments are classified as Level 3 within the fair value hierarchy.\nNote 5 – Credit Arrangements\n| Instrument | Issue Date | Maturity Date | Revolving Credit Limit | December 31, 2018 | Borrowings | Repayments | March 31, 2019 |\n| Lines of Credit: |\n| UTG | 11/20/2013 | 11/20/2019 | $ | 8,000,000 | - | - | - | - |\n| UG | 6/2/2015 | 5/10/2019 | 10,000,000 | - | - | - | - |\n\nThe UTG line of credit carries interest at a fixed rate of 5.125% and is payable monthly. As collateral, UTG has pledged 100% of the common voting stock of its wholly owned subsidiary, Universal Guaranty Life Insurance Company. The Company is currently in the process of renewing this line of credit. During May of 2018, the Federal Home Loan Bank approved UG’s Cash Management Advance Application (“CMA”). The CMA gives the Company the option of selecting a variable rate of interest for up to 90 days or a fixed rate for a maximum of 30 days. The variable rate CMA is prepayable at any time without a fee, while the fixed CMA is not prepayable prior to maturity. The Company is currently in the process of renewing the CMA.\nNote 6 – Shareholders’ Equity Stock Repurchase Program – The Board of Directors of UTG has authorized the repurchase in the open market or in privately negotiated transactions of UTG's common stock. At a meeting of the Board of Directors in September of 2018, the Board of Directors of UTG authorized the repurchase of up to an additional $1.5 million of UTG's common stock, for a total repurchase of up to $16.0 million of UTG's common stock in the open market or in privately negotiated transactions. Company Management has broad authority to operate the program, including the discretion of whether to purchase shares and the ability to suspend or terminate the program. Open market purchases are made based on the last available market price but may be limited. During the three months ended March 31, 2019, the Company repurchased 6,955 shares through the stock repurchase program for $212,387. Through March 31, 2019, UTG has spent $14,076,115 million in the acquisition of 1,147,061 shares under this program. During 2019, the Company issued 7,632 shares of stock to management and employees as compensation at a cost of $229,800. These awards are determined at the discretion of the Board of Directors. Earnings Per Share Calculations Earnings per share are based on the weighted average number of common shares outstanding during each period. For the three months ended March 31, 2019 and 2018, diluted earnings per share were the same as basic earnings per share since the Company had no dilutive instruments outstanding.\nNote 7 – Commitments and Contingencies The insurance industry has experienced a number of civil jury verdicts which have been returned against life and health insurers in the jurisdictions in which the Company does business involving the insurers' sales practices, alleged agent misconduct, failure to properly supervise agents, and other matters. Some of the lawsuits have resulted in the award of substantial judgments against the insurer, including material amounts of punitive damages. In some states, juries have substantial discretion in awarding punitive damages in these circumstances. In the normal course of business, the Company is involved from time to time in various legal actions and other state and federal proceedings. Management is of the opinion that the ultimate disposition of the matters will not have a materially adverse effect on the Company’s results of operations or financial position. Under the insurance guaranty fund laws in most states, insurance companies doing business in a participating state can be assessed up to prescribed limits for policyholder losses incurred by insolvent or failed insurance companies. Although the Company cannot predict the amount of any future assessments, most insurance guaranty fund laws currently provide that an assessment may be excused or deferred if it would threaten an insurer's financial strength. Mandatory assessments may be partially recovered through a reduction in future premium tax in some states. The Company does not believe such assessments will be materially different from amounts already provided for in the condensed consolidated financial statements, though the Company has no control over such assessments.\n| Total Funding Commitment | Unfunded Commitment |\n| RLF III, LLC | $ | 4,000,000 | $ | 398,120 |\n| Sovereign’s Capital, LP Fund I | 500,000 | 24,493 |\n| Sovereign's Capital, LP Fund II | 1,000,000 | 240,566 |\n| Sovereign's Capital, LP Fund III | 1,000,000 | 900,000 |\n| Barton Springs Music, LLC | 1,750,000 | 1,158,500 |\n| Master Mineral Holdings III, LP | 4,000,000 | 530,312 |\n\nDuring 2006, the Company committed to invest in RLF III, LLC (“RLF”), which makes land-based investments in undervalued assets. RLF makes capital calls as funds are needed for continued land purchases. During 2012, the Company committed to invest in Sovereign’s Capital, LP Fund I (“Sovereign’s”), which invests in companies in emerging markets. Sovereign’s makes capital calls to investors as funds are needed. During 2015, the Company committed to invest in Sovereign’s Capital, LP Fund II (“Sovereign’s II”), which invests in companies in emerging markets. Sovereign’s II makes capital calls to investors as funds are needed. During 2018, the Company committed to invest in Sovereign’s Capital, LP Fund III (“Sovereign’s III”), which invests in companies in emerging markets. Sovereign’s III makes capital calls to investors as funds are needed. During 2018, the Company committed to invest in Barton Springs Music, LLC (“Barton”), which invests in music royalties. Barton makes capital calls to its investors as funds are needed to acquire the royalty rights. During 2018, the Company committed to invest in Master Mineral Holdings III, LP (“MMH”), which purchases land for leasing opportunities to those looking to harvest natural resources. MMH makes capital calls to its investors as funds are needed for continued land purchases.\nNote 8 – Other Cash Flow Disclosures\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Interest | $ | - | $ | - |\n| Federal income tax | - | - |\n\nNote 9 – Concentrations of Credit Risk The Company maintains cash balances in financial institutions that at times may exceed federally insured limits. The Company maintains its primary operating cash accounts with First Southern National Bank, an affiliate of the largest shareholder of UTG, Mr. Jesse Correll, the Company’s CEO and Chairman. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risk on cash and cash equivalents. Because UTG serves primarily individuals located in four states, the ability of our customers to pay their insurance premiums is impacted by the economic conditions in these areas. As of March 31, 2019 and 2018 , approximately 55% and 56%, respectively, of the Company’s total direct premium was collected from Illinois, Ohio, Texas and West Virginia. Thus, results of operations are heavily dependent upon the strength of these economies. The Company reinsures that portion of insurance risk which is in excess of its retention limits. Retention limits range up to $125,000 per life. Life insurance ceded represented 20% of total life insurance in force at March 31, 2019 and December 31, 2018, respectively. Insurance ceded represented 24% and 29% of premium income for the three months ended March 31, 2019 and 2018, respectively. The Company would be liable for the reinsured risks ceded to other companies to the extent that such reinsuring companies are unable to meet their obligations. The Company owns a variety of investments associated with the oil and gas industry. These investments represent approximately 28% and 25% of the Company's total invested assets as of March 31, 2019 and December 31, 2018, respectively.\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nThe following is Management's discussion and analysis of the financial condition and results of operations of UTG, Inc. and its subsidiaries (collectively with the Parent, the \"Company\"). The following discussion of the financial condition and results of operations of the Company should be read in conjunction with, and is qualified in its entirety by reference to, the Consolidated Financial Statements of the Company and the related Notes thereto appearing in the Company's annual report on Form 10-K for the year ended December 31, 2018, as filed with the Securities and Exchange Commission, and our unaudited Condensed Consolidated Financial Statements and related Notes thereto appearing elsewhere in this quarterly report.\nCautionary Statement Regarding Forward-Looking Statements\nThis report on Form 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are intended to be covered by the safe harbors created by those laws. We have based our forward-looking statements on our current expectations and projections about future events. Our forward-looking statements include information about possible or assumed future results of operations. All statements, other than statements of historical facts, included or incorporated by reference in this report that address activities, events or developments that we expect or anticipate may occur in the future, including such things as the growth of our business and operations, our business strategy, competitive strengths, goals, plans, future capital expenditures and references to future successes may be considered forward-looking statements. Also, when we use words such as \"anticipate,\" \"believe,\" \"estimate,\" \"expect,\" \"intend,\" \"plan,\" \"probably,\" or similar expressions, we are making forward-looking statements.\nNumerous risks and uncertainties may impact the matters addressed by our forward-looking statements, any of which could negatively and materially affect our future financial results and performance.\nAlthough we believe that the assumptions underlying our forward-looking statements are reasonable, any of these assumptions, and, therefore, the forward-looking statements based on these assumptions, could themselves prove to be inaccurate. In light of the significant uncertainties inherent in the forward-looking statements that are included in this report, our inclusion of this information is not a representation by us or any other person that our objectives and plans will be achieved. In light of these risks, uncertainties and assumptions, any forward-looking event discussed in this report may not occur. Our forward-looking statements speak only as of the date made, and we undertake no obligation to update or review any forward-looking statement, whether as a result of new information, future events or other developments, unless the securities laws require us to do so.\nOverview\nUTG, Inc., a Delaware corporation, is a life insurance holding company. The Company's dominant business is individual life insurance, which includes the servicing of existing insurance policies in force, the acquisition of other companies in the life insurance business and the administration and processing of life insurance business for other entities. The Company's focus for the future includes growing the administrative portion of the business.\nCritical Accounting Policies\nThe preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect reported amounts and related disclosures. Actual results could differ significantly from those estimates. The Company has identified certain estimates that involve a higher degree of judgment and are subject to a significant degree of variability. The Company's critical accounting policies and the related estimates considered most significant by Management are disclosed in the Company's Annual Report on Form 10-K for the year ended December 31, 2018. Management has identified the accounting policies related to cost of insurance acquired, assumptions and judgments utilized in determining if declines in fair values of investments are other-than-temporary, and valuation methods for investments that are not actively traded as those, due to the judgments, estimates and assumptions inherent in those policies, are critical to an understanding of the Company's Condensed Consolidated Financial Statements and this Management's Discussion and Analysis.\nDuring the three months ended March 31, 2019, there were no additions to or changes in the critical accounting policies disclosed in the 2018 Form 10-K.\nResults of Operations\nOn a consolidated basis, the Company reported net income attributable to common shareholders' of approximately $11.6 million and $2.7 million for the three-month periods ended March 31, 2019 and 2018, respectively.\nRevenues\nThe Company reported total revenues of approximately $21.1 million for the three-month period ended March 31, 2019, an increase of approximately $11.4 million as compared to the same period in 2018. The variance in total revenues from the prior year to the current year is mainly attributable to the increase in the change in the fair value of equity securities.\nPremium and policy fee revenues, net of reinsurance, were comparable for the three-months ended March 31, 2019 and 2018. The Company writes minimal new business. Premium and policy fee revenues, net of reinsurance, represented 10% and 20% of the Company's revenues as of March 31, 2019 and 2018, respectively.\nThe following table summarizes the Company's investment performance.\n\n| Three Months Ended March 31, |\n| 2019 | 2018 |\n| Net investment income | $ | 3,112,024 | $ | 3,068,118 |\n| Net investment gains | $ | 15,901,329 | $ | 4,663,478 |\n| Change in net unrealized investment gains (losses) on available-for-sale securities, pre-tax | $ | 4,934,851 | $ | (4,285,303 | ) |\n\nThe following table reflects net investment income of the Company:\n\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Fixed maturities available for sale | $ | 1,589,985 | $ | 1,837,844 |\n| Equity securities | 668,108 | 532,067 |\n| Trading securities | (111,693 | ) | - |\n| Mortgage loans | 118,612 | 214,558 |\n| Real estate | 784,532 | 449,546 |\n| Notes receivable | 435,155 | 386,782 |\n| Policy loans | 141,552 | 150,081 |\n| Short-term | 41,364 | 48,172 |\n| Cash and cash equivalents | - | 12,434 |\n| Total consolidated investment income | 3,667,615 | 3,631,484 |\n| Investment expenses | (555,591 | ) | (563,366 | ) |\n| Consolidated net investment income | $ | 3,112,024 | $ | 3,068,118 |\n\nNet investment income represented 15% and 32% of the Company's total revenues as of March 31, 2019 and 2018, respectively. Net investment was comparable in the majority of the investment categories when comparing the first quarter 2019 activity to the same quarter in 2018.\nInvestment income from the real estate investment portfolio is up approximately $335,000 in the current year as compared to the same period in the prior year. The increase is not attributable to one specific investment or event. Several of the Company's real estate holdings produced more income in the current your as compared to the same period in the prior year. Income is expected to vary from quarter to quarter depending on the activity occurring in relation to each property.\nThe Company reported net investment gains of approximately $15.9 million and $4.7 million for the three-month periods ended March 31, 2019 and 2018, respectively. Realized investment gains of approximately $1.1 million and $534,000 were recognized by the Company during the first quarter of 2019 and 2018, respectively. These gains are the result of the Company selling a parcel of real estate in 2018 and 2019.\nRealized investment gains are the result of one-time events and are expected to vary from quarter to quarter.\nThe 2019 investment gains mainly consist of approximately $14.8 million in unrealized gains related to the change in the fair value of equity securities. For the same period in 2018, the Company reported approximately $4.1 million of unrealized gains related to the change in the fair value of equity securities.\nThe Company has seen significant unrealized gains on its equity investments during 2018 and 2019. A significant portion of these gains are from two equity holdings, both in the area of oil and gas. While the Company has had very strong unrealized gains during 2018 and 2019, a pull back in the stock market, particularly in the oil and gas arena, could slow these gains or even result in future period unrealized losses. Management believes these equity investments continue to be solid investments for the Company and have further growth potential; however, changes in market conditions could cause volatility in market prices.\nIn summary, the Company's basis for future revenue growth is expected to come from the following primary sources: conservation of business currently in-force, the maximization of investment earnings and the acquisition of other companies or policy blocks in the life insurance business. Management has placed a significant emphasis on the development of these revenue sources to enhance these opportunities.\nExpenses\nThe Company reported total benefits and other expenses of approximately $5.6 million for the three-month period ended March 31, 2019, a decrease of approximately 9% from the same period in 2018. Benefits, claims and settlement expenses represented approximately 59% and 63% of the Company's total expenses for the three-month periods ended March 31, 2019 and 2018, respectively. The other major expense category of the Company is operating expenses, which represented approximately 39% and 34% of the Company's total expenses for the three-month periods ended March 31, 2019 and 2018, respectively.\nLife benefits, claims and settlement expenses, net of reinsurance benefits and claims, decreased approximately 16% in the three-month period ended March 31, 2019, compared to the same period in 2018. Policy claims vary from period to period and therefore, fluctuations in mortality are to be expected and are not considered unusual by Management.\nNet amortization of cost of insurance acquired decreased 4% during the three-month period ended March 31, 2019 compared to the same period in 2018. Cost of insurance acquired is established when an insurance company is acquired or when the Company acquires a block of in-force business. The Company assigns a portion of its cost to the right to receive future profits from insurance contracts existing at the date of the acquisition. Cost of insurance acquired is amortized with interest in relation to expected future profits, including direct charge-offs for any excess of the unamortized asset over the projected future profits. The interest rates may vary due to risk analysis performed at the time of acquisition on the business acquired. The Company utilizes a 12% discount rate on the remaining unamortized business. The amortization is adjusted retrospectively when estimates of current or future gross profits to be realized from a group of products are revised. Amortization of cost of insurance acquired is particularly sensitive to changes in interest rate spreads and persistency of certain blocks of insurance in-force. This expense is expected to decrease, unless the Company acquires a new block of business.\nOperating expenses increased approximately 3% in the three-month period ended March 31, 2019 as compared to the same period in 2018. Overall, expenses were comparable in all of the major expense categories.\nManagement continues to place significant emphasis on expense monitoring and cost containment. Maintaining administrative efficiencies directly impacts net income.\nFinancial Condition\nInvestment Information\nInvestments represent approximately 86% and 85% of total assets at March 31, 2019 and December 31, 2018, respectively. Accordingly, investments are the largest asset group of the Company. The Company's insurance subsidiary is regulated by insurance statutes and regulations as to the type of investments that it is permitted to make and the amount of funds that may be used for any one type of investment. In light of these statutes and regulations, the majority of the Company's investment portfolio is invested in a diverse set of securities.\nAs of March 31, 2019, the carrying value of fixed maturity securities in default as to principal or interest was immaterial in the context of consolidated assets, shareholders' equity or results from operations. To provide additional flexibility and liquidity, the Company has identified all fixed maturity securities as \"investments available for sale\". Investments available-for-sale are carried at market, with changes in market value charged directly to shareholders' equity. Changes in the market value of available for sale securities resulted in a net unrealized gain of approximately $3.9 million and a net unrealized loss of approximately $3.4 million for the three-month periods ended March 31, 2019 and 2018, respectively. The variance in the net unrealized gains and losses is the result of normal market fluctuations and lower interest rates.\nCapital Resources\nTotal shareholders' equity increased by approximately 14% as of March 31, 2019 compared to December 31, 2018. The increase is mainly attributable to an increase in retained earnings, which is the result of the current year net income reported by the Company.\nThe Company's investments are predominately in fixed maturity investments such as bonds, which provide sufficient return to cover future obligations. The Company carries all of its fixed maturity holdings as available for sale, which are reported in the Condensed Consolidated Financial Statements at their market value.\nLiquidity\nThe Company has two principal needs for cash - the insurance company's contractual obligations to policyholders and the payment of operating expenses. Cash and cash equivalents represented 5% total assets as of March 31, 2019 and December 31, 2018. Fixed maturities as a percentage of total assets were approximately 40% and 41% as of March 31, 2019 and December 31, 2018, respectively.\nThe Company currently has access to funds for operating liquidity. UTG has an $8 million revolving credit note with Illinois National Bank. At March 31, 2019, the Company had no outstanding borrowings against the UTG line of credit. UG has a $10 million line of credit with the Federal Home Loan Bank. At March 31, 2019, the Company had no outstanding borrowings against the UG line of credit\nFuture policy benefits are primarily long-term in nature and therefore, the Company's investments are predominantly in long-term fixed maturity investments such as bonds and mortgage loans which provide sufficient return to cover these obligations. Many of the Company's products contain surrender charges and other features which reward persistency and penalize the early withdrawal of funds.\nFor the three months ended March 31, 2019 and 2018, operating activities used cash of approximately $364,000 and provided cash of approximately $3.3 million, respectively. Sources of operating cash flows of the Company, as with most insurance entities, is comprised primarily of premiums received on life insurance products and income earned on investments. Uses of operating cash flows consist primarily of payments of benefits to policyholders and beneficiaries and operating expenses. The Company has not marketed any significant new products for several years.\nThe Company used cash in investing activities of approximately $540,000 and $8.3 million for the three month periods ended March 31, 2019 and 2018, respectively. The net cash provided by or used in investing activities is expected to vary from quarter to quarter depending on market conditions and Management’s ability to find and negotiate favorable investment contracts.\nUTG is a holding Company that has no day-to-day operations of its own. Funds required to meet its expenses, generally costs associated with maintaining the Company in good standing with states in which it does business are primarily provided by its subsidiaries. On a parent only basis, UTG's cash flow is dependent on Management fees received from its insurance subsidiary, stockholder dividends from its subsidiary and earnings received on cash balances. At March 31, 2019, substantially all of the consolidated shareholders' equity represented net assets of its subsidiary. The Company's insurance subsidiary has maintained adequate statutory capital and surplus. The payment of cash dividends to shareholders by UTG is not legally restricted. However, the state insurance department regulates insurance Company dividend payments where the Company is domiciled. No dividends were paid to shareholders in 2018 or the three-month period ended March 31, 2019.\nUG is an Ohio domiciled insurance company, which requires notification within five business days to the insurance commissioner following the declaration of any ordinary dividend and at least ten calendar days prior to payment of such dividend. Ordinary dividends are defined as the greater of: a) prior year statutory net income or b) 10% of statutory capital and surplus. For the year ended December 31, 2018, UG had statutory net income of approximately $6.2 million. At December 31, 2018 UG's statutory capital and surplus amounted to approximately $60 million. Extraordinary dividends (amounts in excess of ordinary dividend limitations) require prior approval of the insurance commissioner and are not restricted to a specific calculation. During 2018 , UG paid UTG ordinary dividends of $5 million. During the second quarter of 2019, UG paid UTG a dividend of $2 million. UTG used the dividends received during 2018 and 2019 for general operations of the Company.\n\nITEM 4. CONTROLS AND PROCEDURES\nThe Company maintains a set of disclosure controls and procedures designed to ensure that information required to be disclosed in reports that it files or submits under the Securities Exchange Act of 1934, as amended (the Exchange Act), is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. In addition, the disclosure controls and procedures ensure that information required to be disclosed is accumulated and communicated to Management, including the principal executive officer and principal financial officer, allowing timely decisions regarding required disclosure. Under the supervision and with the participation of our Management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Exchange Act. Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.\nPART II. OTHER INFORMATION\n\nITEM 1. LEGAL PROCEEDINGS\nNONE\n\nITEM 1A. RISK FACTORS\nNONE\n\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nNONE\n\nITEM 3. DEFAULTS UPON SENIOR SECURITIES\nNONE\n\nITEM 4. MINE SAFETY DISCLOSURES\nNONE\n\nITEM 5. OTHER INFORMATION\nNONE\n\nITEM 6. EXHIBITS\n\n| *31.1 | Certification of Jesse T. Correll, Chief Executive Officer and Chairman of the Board of UTG, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| *31.2 | Certification of Theodore C. Miller, Chief Financial Officer, Senior Vice President and Corporate Secretary of UTG, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| *32.1 | Certificate of Jesse T. Correll, Chief Executive Officer and Chairman of the Board of UTG, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| *32.2 | Certificate of Theodore C. Miller, Chief Financial Officer, Senior Vice President and Corporate Secretary of UTG, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| **101 | Interactive Data File |\n\n*Filed herewith\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\nUTG, INC.\n(Registrant)\n\n| Date: | May 14, 2019 | By | /s/ James P. Rousey |\n| James P. Rousey |\n| President and Director |\n\n\n| Date: | May 14, 2019 | By | /s/ Theodore C. Miller |\n| Theodore C. Miller |\n| Senior Vice President |\n| and Chief Financial Officer |\n\nEXHIBIT INDEX\n\n| Exhibit Number | Description |\n| *31.1 | Certification of Jesse T. Correll, Chief Executive Officer and Chairman of the Board of UTG, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| *31.2 | Certification of Theodore C. Miller, Chief Financial Officer, Senior Vice President and Corporate Secretary of UTG, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| *32.1 | Certificate of Jesse T. Correll, Chief Executive Officer and Chairman of the Board of UTG, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| *32.2 | Certificate of Theodore C. Miller, Chief Financial Officer, Senior Vice President and Corporate Secretary of UTG, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| **101 | Interactive Data File |\n\n* Filed herewith\n\n \n\nWhat is the return on equity (ROE) for the year ended March 31, 2019, considering the net income for the three months ended March 31, 2019, and total shareholders' equity at the end of 2019 and 2018 in percentages?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nPart 1. Financial Information.\\nItem 1. Financial Statements.\\n\\n| March 31, 2019 | December 31, 2018* |\\n| ASSETS |\\n| Investments: |\\n| Investments available for sale: |\\n| Fixed maturities, at fair value (amortized cost $158,812,233 and $160,895,869) | $ | 163,906,663 | $ | 160,960,784 |\\n| Equity securities, at fair value (cost $34,883,412 and $34,885,107) | 82,450,417 | 67,664,482 |\\n| Equity securities, at cost | 12,133,745 | 12,118,617 |\\n| Mortgage loans on real estate at amortized cost | 10,703,553 | 9,069,111 |\\n| Investment real estate | 51,530,162 | 52,518,577 |\\n| Notes receivable | 26,595,336 | 23,717,312 |\\n| Policy loans | 9,117,979 | 9,204,222 |\\n| Total investments | 356,437,855 | 335,253,105 |\\n| Cash and cash equivalents | 19,049,555 | 20,150,162 |\\n| Accrued investment income | 1,887,094 | 2,119,882 |\\n| Reinsurance receivables: |\\n| Future policy benefits | 26,091,199 | 26,117,936 |\\n| Policy claims and other benefits | 4,142,345 | 4,053,882 |\\n| Cost of insurance acquired | 5,428,250 | 5,622,227 |\\n| Property and equipment, net of accumulated depreciation | 581,680 | 688,567 |\\n| Income tax receivable | - | 279,333 |\\n| Other assets | 355,673 | 1,263,242 |\\n| Total assets | $ | 413,973,651 | $ | 395,548,336 |\\n| LIABILITIES & SHAREHOLDERS' EQUITY |\\n| Liabilities: |\\n| Policy liabilities and accruals: |\\n| Future policyholder benefits | $ | 252,418,038 | $ | 253,852,368 |\\n| Policy claims and benefits payable | 4,335,480 | 4,267,481 |\\n| Other policyholder funds | 430,413 | 372,072 |\\n| Dividend and endowment accumulations | 14,586,502 | 14,608,838 |\\n| Income taxes payable | 333,283 | - |\\n| Deferred income taxes | 13,231,079 | 9,113,480 |\\n| Other liabilities | 6,105,232 | 6,257,387 |\\n| Total liabilities | 291,440,027 | 288,471,626 |\\n| Shareholders' equity: |\\n| Common stock - no par value, stated value $.001 per share. Authorized 7,000,000 shares - 3,296,547 and 3,295,870 shares outstanding | 3,297 | 3,296 |\\n| Additional paid-in capital | 36,585,277 | 36,567,865 |\\n| Retained earnings | 81,353,780 | 69,708,901 |\\n| Accumulated other comprehensive income | 3,949,134 | 62,495 |\\n| Total UTG shareholders' equity | 121,891,488 | 106,342,557 |\\n| Noncontrolling interests | 642,136 | 734,153 |\\n| Total shareholders' equity | 122,533,624 | 107,076,710 |\\n| Total liabilities and shareholders' equity | $ | 413,973,651 | $ | 395,548,336 |\\n\\n| Three Months Ended |\\n| March 31, | March 31, |\\n| 2019 | 2018 |\\n| Revenue: |\\n| Premiums and policy fees | $ | 2,503,205 | $ | 2,649,971 |\\n| Ceded reinsurance premiums and policy fees | (517,055 | ) | (738,965 | ) |\\n| Net investment income | 3,112,024 | 3,068,118 |\\n| Other income | 63,838 | 60,935 |\\n| Revenue before net investment gains (losses) | 5,162,012 | 5,040,059 |\\n| Net investment gains (losses): |\\n| Other-than-temporary impairments | - | - |\\n| Other realized investment gains, net | 1,113,698 | 534,242 |\\n| Change in fair value of equity securities | 14,787,631 | 4,129,236 |\\n| Total net investment gains (losses) | 15,901,329 | 4,663,478 |\\n| Total revenue | 21,063,341 | 9,703,537 |\\n| Benefits and other expenses: |\\n| Benefits, claims and settlement expenses: |\\n| Life | 3,427,200 | 4,168,794 |\\n| Ceded reinsurance benefits and claims | (474,622 | ) | (688,412 | ) |\\n| Annuity | 197,670 | 256,884 |\\n| Dividends to policyholders | 103,599 | 126,999 |\\n| Commissions and amortization of deferred policy acquisition costs | (24,542 | ) | (40,571 | ) |\\n| Amortization of cost of insurance acquired | 193,977 | 201,516 |\\n| Operating expenses | 2,144,389 | 2,085,819 |\\n| Total benefits and other expenses | 5,567,671 | 6,111,029 |\\n| Income before income taxes | 15,495,670 | 3,592,508 |\\n| Income tax expense | 3,697,058 | 905,763 |\\n| Net income | 11,798,612 | 2,686,745 |\\n| Net income attributable to noncontrolling interests | (153,733 | ) | (29,500 | ) |\\n| Net income attributable to common shareholders | $ | $ 11,644,879 | $ | $ 2,657,245 |\\n| Amounts attributable to common shareholders |\\n| Basic income per share | $ | $ 3.53 | $ | $ 0.80 |\\n| Diluted income per share | $ | $ 3.53 | $ | $ 0.80 |\\n| Basic weighted average shares outstanding | 3,297,353 | 3,325,111 |\\n| Diluted weighted average shares outstanding | 3,297,353 | 3,325,111 |\\n\\n| Three Months Ended |\\n| March 31, | March 31, |\\n| 2019 | 2018 |\\n| Net income | $ | 11,798,612 | $ | 2,686,745 |\\n| Other comprehensive income (loss): |\\n| Unrealized holding gains (losses) arising during period, pre-tax | 4,934,851 | (4,285,303 | ) |\\n| Tax (expense) benefit on unrealized holding gains (losses) arising during the period | (1,036,319 | ) | 899,914 |\\n| Unrealized holding gains (losses) arising during period, net of tax | 3,898,532 | (3,385,389 | ) |\\n| Less reclassification adjustment for gains included in net income | (15,055 | ) | - |\\n| Tax expense for gains included in net income | 3,162 | - |\\n| Reclassification adjustment for gains included in net income, net of tax | (11,893 | ) | - |\\n| Subtotal: Other comprehensive income (loss), net of tax | 3,886,639 | (3,385,389 | ) |\\n| Comprehensive income (loss) | 15,685,251 | (698,644 | ) |\\n| Less comprehensive income attributable to noncontrolling interests | (153,733 | ) | (29,500 | ) |\\n| Comprehensive income (loss) attributable to UTG, Inc. | $ | 15,531,518 | $ | (728,144 | ) |\\n\\n| Common Stock | Additional Paid-In Capital | Retained Earnings | Accumulated Other Comprehensive Income | Noncontrolling Interest | Total Shareholders' Equity |\\n| Balance at December 31, 2018 | $ | 3,296 | 36,567,865 | 69,708,901 | 62,495 | 734,153 | $ | 107,076,710 |\\n| Common stock issued during year | 8 | 229,792 | - | - | - | 229,800 |\\n| Treasury shares acquired | (7 | ) | (212,380 | ) | - | - | - | (212,387 | ) |\\n| Net income attributable to common shareholders | - | - | 11,644,879 | - | - | 11,644,879 |\\n| Unrealized holding income on securities net of noncontrolling interest and reclassification adjustment and taxes | - | - | - | 3,886,639 | - | 3,886,639 |\\n| Contributions | - | - | - | - | - | - |\\n| Distributions | - | - | - | - | (245,750 | ) | (245,750 | ) |\\n| Gain attributable to noncontrolling interest | - | - | - | - | 153,733 | 153,733 |\\n| Balance at March 31, 2019 | $ | 3,297 | 36,585,277 | 81,353,780 | 3,949,134 | 642,136 | $ | 122,533,624 |\\n| Common Stock | Additional Paid-In Capital | Retained Earnings | Accumulated Other Comprehensive Income | Noncontrolling Interest | Total Shareholders' Equity |\\n| Balance at December 31, 2017 | $ | 3,333 | 37,536,164 | 39,040,456 | 32,952,338 | 899,227 | $ | 110,431,518 |\\n| Adoption of Accounting Standards Update No 2016-01 | - | - | 18,277,328 | (18,277,328 | ) | - | - |\\n| January 1, 2018 | 3,333 | 37,536,164 | 57,317,784 | 14,675,010 | 899,227 | 110,431,518 |\\n| Common stock issued during year | 9 | 229,991 | - | - | - | 230,000 |\\n| Treasury shares acquired | (24 | ) | (600,216 | ) | - | - | - | (600,240 | ) |\\n| Net income attributable to common shareholders | - | - | 2,657,245 | - | - | 2,657,245 |\\n| Unrealized holding income on securities net of noncontrolling interest and reclassification adjustment and taxes | - | - | - | (3,385,389 | ) | - | (3,385,389 | ) |\\n| Contributions | - | - | - | - | - | - |\\n| Distributions | - | - | - | - | (146 | ) | (146 | ) |\\n| Gain attributable to noncontrolling interest | - | - | - | - | 29,500 | 29,500 |\\n| Balance at March 31, 2018 | $ | 3,318 | 37,165,939 | 59,975,029 | 11,289,621 | 928,581 | $ | 109,362,488 |\\n\\n| Three Months Ended |\\n| March 31, | March 31, |\\n| 2019 | 2018 |\\n| Cash flows from operating activities: |\\n| Net income attributable to common shareholders | $ | 11,644,879 | $ | 2,657,245 |\\n| Adjustments to reconcile net income to net cash used in operating activities: |\\n| Amortization (accretion) of investments | (39,703 | ) | 17,036 |\\n| Realized investment gains, net | (1,113,698 | ) | (534,242 | ) |\\n| Change in fair value of equity securities | (14,787,631 | ) | (4,129,236 | ) |\\n| Amortization of cost of insurance acquired | 193,977 | 201,516 |\\n| Depreciation | 323,406 | 275,143 |\\n| Net income attributable to noncontrolling interest | 153,733 | 29,500 |\\n| Charges for mortality and administration of universal life and annuity products | (1,619,743 | ) | (1,650,201 | ) |\\n| Interest credited to account balances | 1,029,303 | 883,563 |\\n| Change in accrued investment income | 232,788 | (357,576 | ) |\\n| Change in reinsurance receivables | (61,726 | ) | 35,546 |\\n| Change in policy liabilities and accruals | (772,518 | ) | (6,961 | ) |\\n| Change in income taxes receivable (payable) | 612,616 | 12,974 |\\n| Change in other assets and liabilities, net | 3,839,857 | 5,894,257 |\\n| Net cash provided by (used in) operating activities | (364,460 | ) | 3,328,564 |\\n| Cash flows from investing activities: |\\n| Proceeds from investments sold and matured: |\\n| Fixed maturities available for sale | 2,023,974 | 14,515 |\\n| Equity securities | 33,075 | 103,298 |\\n| Mortgage loans | 1,945,760 | 2,009,715 |\\n| Real estate | 3,045,226 | 7,941,649 |\\n| Notes receivable | 1,537,984 | 563,926 |\\n| Policy loans | 410,831 | 366,847 |\\n| Short-term investments | - | 850,000 |\\n| Total proceeds from investments sold and matured | 8,996,850 | 11,849,950 |\\n| Cost of investments acquired: |\\n| Fixed maturities available for sale | - | (4,971,517 | ) |\\n| Equity securities | (46,509 | ) | (7,957,471 | ) |\\n| Mortgage loans | (3,575,500 | ) | - |\\n| Real estate | (1,174,688 | ) | (6,006,130 | ) |\\n| Notes receivable | (4,416,008 | ) | - |\\n| Policy loans | (324,587 | ) | (405,337 | ) |\\n| Short-term investments | - | (850,000 | ) |\\n| Total cost of investments acquired | (9,537,292 | ) | (20,190,455 | ) |\\n| Net cash used in investing activities | (540,442 | ) | (8,340,505 | ) |\\n| Cash flows from financing activities: |\\n| Policyholder contract deposits | 1,264,011 | 1,149,533 |\\n| Policyholder contract withdrawals | (1,231,379 | ) | (1,245,743 | ) |\\n| Purchase of treasury stock | (212,387 | ) | (600,240 | ) |\\n| Issuance of stock | 229,800 | 230,000 |\\n| Non controlling contributions (distributions) of consolidated subsidiary | (245,750 | ) | (146 | ) |\\n| Net cash used in financing activities | (195,705 | ) | (466,596 | ) |\\n| Net decrease in cash and cash equivalents | (1,100,607 | ) | (5,478,537 | ) |\\n| Cash and cash equivalents at beginning of period | 20,150,162 | 25,434,199 |\\n| Cash and cash equivalents at end of period | $ | 19,049,555 | $ | 19,955,662 |\\n\\nUTG, Inc. Notes to Condensed Consolidated Financial Statements\\nNote 1 – Basis of Presentation\\nThe accompanying Condensed Consolidated Balance Sheet as of December 31, 2018, which has been derived from audited consolidated financial statements, and the unaudited interim Condensed Consolidated Financial Statements include the accounts of UTG, Inc. (the “Parent”) and its subsidiaries (collectively with the Parent, the “Company”). All significant intercompany accounts and transactions have been eliminated in consolidation. The accompanying Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 8 of regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for audited annual financial statements. The information furnished includes all adjustments and accruals of a normal recurring nature, which in the opinion of Management, are necessary for a fair presentation of the results for the interim periods. The unaudited Condensed Consolidated Financial Statements included herein and these related notes should be read in conjunction with the Company’s consolidated financial statements, and the notes thereto, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018. The Company’s results of operations for the three-month period ended March 31, 2019 are not necessarily indicative of the results that may be expected for the year ending December 31, 2019 or for any other future period.\\nThis document at times will refer to the Registrant’s largest shareholder, Mr. Jesse T. Correll and certain companies controlled by Mr. Correll. Mr. Correll holds a majority ownership of First Southern Funding, LLC (“FSF”), a Kentucky corporation, and First Southern Bancorp, Inc. (“FSBI”), a financial services holding company. FSBI operates through its 100% owned subsidiary bank, First Southern National Bank (“FSNB”). Banking activities are conducted through multiple locations within south-central and western Kentucky. Mr. Correll is Chief Executive Officer and Chairman of the Board of Directors of UTG and is currently UTG’s largest shareholder through his ownership control of FSF, FSBI and affiliates. At March 31, 2019, Mr. Correll owns or controls directly and indirectly approximately 65.26% of UTG’s outstanding stock. UTG’s life insurance subsidiary, Universal Guaranty Life Insurance Company (“UG”), has several wholly-owned and majority-owned subsidiaries. The subsidiaries were formed to hold certain real estate investments. The real estate investments were placed into the limited liability companies and partnerships to provide additional protection to the policyholders and to UG.\\nNote 2 – Recently Issued Accounting Standards\\nDuring the three months ended March 31, 2019, there were no additions to or changes in the critical accounting policies disclosed in the 2018 Form 10-K.\\nNote 3 – Investments Available for Sale Securities – Fixed Maturity Securities The Company’s insurance subsidiary is regulated by insurance statutes and regulations as to the type of investments they are permitted to make, and the amount of funds that may be used for any one type of investment.\\n| March 31, 2019 | Original or Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Fair Value |\\n| Investments available for sale: |\\n| Fixed maturities |\\n| U.S. Government and govt. agencies and authorities | $ | 25,652,896 | $ | 221,161 | $ | (98,738 | ) | $ | 25,775,319 |\\n| U.S. special revenue and assessments | 16,350,071 | 545,717 | 0 | 16,895,788 |\\n| All other corporate bonds | 116,809,266 | 5,163,923 | (737,633 | ) | 121,235,556 |\\n| $ | 158,812,233 | $ | 5,930,801 | $ | (836,371 | ) | $ | 163,906,663 |\\n| December 31, 2018 | Original or Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Fair Value |\\n| Investments available for sale: |\\n| Fixed maturities |\\n| U.S. Government and govt. agencies and authorities | $ | 25,649,410 | $ | 149,006 | $ | (138,222 | ) | $ | 25,660,194 |\\n| U.S. special revenue and assessments | 16,350,486 | 334,300 | (4,406 | ) | 16,680,380 |\\n| All other corporate bonds | 118,895,973 | 2,569,287 | (2,845,050 | ) | 118,620,210 |\\n| $ | 160,895,869 | $ | 3,052,593 | $ | (2,987,678 | ) | $ | 160,960,784 |\\n\\n| Fixed Maturities Available for Sale March 31, 2019 | Amortized Cost | Fair Value |\\n| Due in one year or less | $ | 6,498,983 | $ | 6,525,131 |\\n| Due after one year through five years | 51,055,408 | 53,028,854 |\\n| Due after five years through ten years | 50,690,937 | 53,501,649 |\\n| Due after ten years | 50,566,905 | 50,851,029 |\\n| Total | $ | 158,812,233 | $ | 163,906,663 |\\n\\n| March 31, 2019 | Less than 12 months | 12 months or longer | Total |\\n| Fair value | Unrealized losses | Fair value | Unrealized losses | Fair value | Unrealized losses |\\n| U.S. Government and govt. agencies and authorities | $ | - | - | 5,578,536 | (98,738 | ) | 5,578,536 | $ | (98,738 | ) |\\n| All other corporate bonds | 3,555,300 | (6,923 | ) | 26,553,550 | (730,710 | ) | 30,108,850 | (737,633 | ) |\\n| Total fixed maturities | $ | 3,555,300 | (6,923 | ) | 32,132,086 | (829,448 | ) | 35,687,386 | $ | (836,371 | ) |\\n| December 31, 2018 | Less than 12 months | 12 months or longer | Total |\\n| Fair value | Unrealized losses | Fair value | Unrealized losses | Fair value | Unrealized losses |\\n| U.S. Government and govt. agencies and authorities | $ | 6,429,700 | (49,904 | ) | 1,592,679 | (88,318 | ) | 8,022,379 | $ | (138,222 | ) |\\n| U.S. special revenue and assessments | 4,023,920 | (4,406 | ) | - | - | 4,023,920 | (4,406 | ) |\\n| All other corporate bonds | 49,270,729 | (2,033,507 | ) | 15,337,739 | (811,543 | ) | 64,608,468 | (2,845,050 | ) |\\n| Total fixed maturities | $ | 59,724,349 | (2,087,817 | ) | 16,930,418 | (899,861 | ) | 76,654,767 | $ | (2,987,678 | ) |\\n\\n| Less than 12 months | 12 months or longer | Total |\\n| As of March 31, 2019 |\\n| Fixed maturities | 2 | 14 | 16 |\\n| As of December 31, 2018 |\\n| Fixed maturities | 30 | 10 | 40 |\\n\\nSubstantially all of the unrealized losses on fixed maturities and equity securities at March 31, 2019 and December 31, 2018 are attributable to changes in market interest rates and general disruptions in the credit market subsequent to purchase. The Company does not currently intend to sell nor does it expect to be required to sell any of the securities in an unrealized loss position. Based upon the Company’s expected continuation of receipt of contractually required principal and interest payments and its intent and ability to retain the securities until price recovery, as well as the Company’s evaluation of other relevant factors, the Company deems these securities to be temporarily impaired as of March 31, 2019 and December 31, 2018. Net Investment Gains (Losses)\\n| Three Months Ended |\\n| March 31, |\\n| 2019 | 2018 |\\n| Realized gains on available-for-sale investments: |\\n| Sales of fixed maturities | $ | 15,055 | $ | - |\\n| Sales of equity securities | - | - |\\n| Sales of real estate | 1,098,643 | - |\\n| Other | - | 534,242 |\\n| Total realized gains | 1,113,698 | 534,242 |\\n| Realized losses on available-for-sale investments: |\\n| Sales of fixed maturities | - | - |\\n| Sales of equity securities | - | - |\\n| Sales of real estate | - | - |\\n| Other-than-temporary impairments | - | - |\\n| Other | - | - |\\n| Total realized losses | - | - |\\n| Net realized investment gains (losses) | 1,113,698 | 534,242 |\\n| Change in fair value of equity securities: |\\n| Realized gains (losses) on equity securities sold during the period | - | - |\\n| Change in fair value of equity securities held at the end of the period | 14,787,631 | 4,129,236 |\\n| Change in fair value of equity securities | 14,787,631 | 4,129,236 |\\n| Net investment gains (losses) | $ | 15,901,329 | $ | 4,663,478 |\\n| Change in net unrealized gains (losses) on available-for-sale investments included in other comprehensive income: |\\n| Fixed maturities | $ | 4,934,851 | $ | (4,285,303 | ) |\\n| Equity securities | - | - |\\n| Net increase (decrease) | $ | 4,934,851 | $ | (4,285,303 | ) |\\n\\nOther-Than-Temporary Impairments The Company regularly reviews its investment securities for factors that may indicate that a decline in fair value of an investment is other than temporary. The factors considered by Management in its regular review to identify and recognize other-than-temporary impairment losses on fixed maturities include, but are not limited to: the length of time and extent to which the fair value has been less than cost; the Company’s intent to sell, or be required to sell, the debt security before the anticipated recovery of its remaining amortized cost basis; the financial condition and near-term prospects of the issuer; adverse changes in ratings announced by one or more rating agencies; subordinated credit support, whether the issuer of a debt security has remained current on principal and interest payments; current expected cash flows; whether the decline in fair value appears to be issuer specific or, alternatively, a reflection of general market or industry conditions, including the effect of changes in market interest rates. If the Company intends to sell a debt security, or it is more likely than not that it would be required to sell a debt security before the recovery of its amortized cost basis, the entire difference between the security’s amortized cost basis and its fair value at the balance sheet date would be recognized by a charge to other-than-temporary losses in the Condensed Consolidated Statements of Operations. Management regularly reviews its real estate portfolio in comparison to appraisal valuations and current market conditions for indications of other-than-temporary impairments. If a decline in value is judged by Management to be other-than-temporary, a loss is recognized by a charge to other-than-temporary impairment losses in the Consolidated Statements of Operations. The Company did not recognize any other-than-temporary impairments during the first quarter of 2018 or 2019. Cost Method Investments The Company held equity investments with an aggregate cost of $12,133,745 and $12,118,617 at March 31, 2019 and December 31, 2018, respectively. These equity investments were not reported at fair value because it is not practicable to estimate their fair values due to insufficient information being available. Management did not identify any events or changes in circumstances that might have a significant adverse effect on the reported value of those investments. Based on Management's evaluation of the expected cash flow of the investments, and the Company's ability and intent to hold the investments for a reasonable period of time, the Company does not deem an other-than-temporary impairment necessary at March 31, 2019.\\nMortgage Loans The Company, from time to time, acquires mortgage loans through participation agreements with FSNB. FSNB has been able to provide the Company with additional expertise and experience in underwriting commercial and residential mortgage loans, which provide more attractive yields than the traditional bond market. The Company is able to receive participations from FSNB for three primary reasons: 1) FSNB has already reached its maximum lending limit to a single borrower, but the borrower is still considered a suitable risk; 2) the interest rate on a particular loan may be fixed for a long period that is more suitable for UG given its asset-liability structure; and 3) FSNB’s loan growth might at times outpace its deposit growth, resulting in FSNB participating such excess loan growth rather than turning customers away. For originated loans, the Company’s Management is responsible for the final approval of such loans after evaluation. Before a new loan is issued, the applicant is subject to certain criteria set forth by Company Management to ensure quality control. These criteria include, but are not limited to, a credit report, personal financial information such as outstanding debt, sources of income, and personal equity. Once the loan is approved, the Company directly funds the loan to the borrower. The Company bears all risk of loss associated with the terms of the mortgage with the borrower. During the first quarter of 2019 and 2018, the Company acquired $3,575,500 and $0 in mortgage loans, respectively. FSNB services the majority of the Company’s mortgage loan portfolio. The Company pays FSNB a .25% servicing fee on these loans and a one-time fee at loan origination of .50% of the original loan cost to cover costs incurred by FSNB relating to the processing and establishment of the loan.\\n| 2019 | 2018 |\\n| Maximum rate | Minimum rate | Maximum rate | Minimum rate |\\n| Farm Loans | 5.00% | 5.00% | 5.00% | 5.00% |\\n| Commercial Loans | 7.50% | 4.00% | 7.50% | 4.00% |\\n| Residential Loans | 8.00% | 8.00% | 8.00% | 8.00% |\\n\\nMost mortgage loans are first position loans. Loans issued are generally limited to no more than 80% of the appraised value of the property. The Company has in place a monitoring system to provide Management with information regarding potential troubled loans. Letters are sent to each mortgagee when the loan becomes 30 days or more delinquent. Management is provided with a monthly listing of loans that are 60 days or more past due along with a brief description of what steps are being taken to resolve the delinquency. All loans 90 days or more past due are placed on a non-performing status and classified as delinquent loans. Quarterly, coinciding with external financial reporting, the Company reviews each delinquent loan and determines how each delinquent loan should be classified. Management believes the current internal controls surrounding the mortgage loan selection process provide a quality portfolio with minimal risk of foreclosure and/or negative financial impact. Changes in the current economy could have a negative impact on the loans, including the financial stability of the borrowers, the borrowers’ ability to pay or to refinance, the value of the property held as collateral and the ability to find purchasers at favorable prices. Interest accruals are analyzed based on the likelihood of repayment. In no event will interest continue to accrue when accrued interest along with the outstanding principal exceeds the net realizable value of the property. The Company does not utilize a specified number of days delinquent to cause an automatic non-accrual status. A mortgage loan reserve is established and adjusted based on Management's quarterly analysis of the portfolio and any deterioration in value of the underlying property which would reduce the net realizable value of the property below its current carrying value. The mortgage loan reserve was $0 at March 31, 2019 and December 31, 2018.\\n| March 31, 2019 | December 31, 2018 |\\n| In good standing | $ | 8,829,640 | $ | 7,169,272 |\\n| Overdue interest over 90 days | 1,873,913 | 1,899,839 |\\n| Total mortgage loans | $ | 10,703,553 | $ | 9,069,111 |\\n\\nInvestment Real Estate Real estate acquired through foreclosure, consisting of properties obtained through foreclosure proceedings or acceptance of a deed in lieu of foreclosure, is reported on an individual asset basis at the lower of cost or fair value, less disposal costs. Fair value is determined on the basis of current appraisals, comparable sales, and other estimates of value obtained principally from independent sources. When properties are acquired through foreclosure, any excess of the loan balance at the time of foreclosure over the fair value of the real estate held as collateral is recognized and charged to the Consolidated Statements of Operations. Based upon Management’s evaluation of the real estate acquired through foreclosure, additional expense is recorded when necessary in an amount sufficient to reflect any declines in estimated fair value. Gains and losses recognized on the disposition of the properties are recorded as realized gains and losses in the Condensed Consolidated Statements of Operations. Notes Receivable Notes receivable represent collateral loans and promissory notes issued by the Company and are reported at their unpaid principal balances, adjusted for valuation allowances. Valuation allowances are established for impaired loans when it is probable that contractual principal and interest will not be collected. The valuation allowance as of March 31, 2019 and December 31, 2018 was $0. Interest accruals are analyzed based on the likelihood of repayment. The Company does not utilize a specified number of days delinquent to cause an automatic non-accrual status. Before a new note is issued, the applicant is subject to certain criteria set forth by Company Management to ensure quality control. Once the note is approved, the Company directly funds the note to the borrower. Several of the notes have participation agreements in place, whereas the Company has reduced its investment in the note receivable by participating a portion of the note to a third party. Similar to the mortgage loans, FSNB services several of the notes receivable. The Company, and the participants in the notes, share in the risk of loss associated with the terms of the note with the borrower, based upon their ownership percentage in the note. The Company has in place a monitoring system to provide Management with information regarding potential troubled loans.\\nNote 4 – Fair Value Measurements The Company measures its assets and liabilities recorded at fair value in the Condensed Consolidated Balance Sheets based on the framework set forth in the GAAP fair value accounting guidance. The framework establishes a fair value hierarchy of three levels based upon the transparency of information used in measuring the fair value of assets or liabilities as of the measurement date. The fair value hierarchy prioritizes the inputs in the valuation techniques used to measure fair value into three categories. Level 1 – Valuation is based upon quoted prices for identical assets or liabilities in active markets that the Company is able to access. Level 1 fair value is not subject to valuation adjustments. Level 2 – Valuation is based upon quoted prices for similar assets and liabilities in active markets or quoted prices for identical or similar instruments in markets that are not active. In addition, the Company may use various valuation techniques or pricing models that use observable inputs to measure fair value. Level 3 – Valuation is based upon unobservable inputs that are supported by little or no market activity and are significant to the fair value of the assets or liabilities. Unobservable inputs reflect the Company’s own assumptions about the inputs that market participants would use in pricing the asset or liability. The Company determines the existence of an active market for an asset or liability based on its judgment as to whether transactions for the asset or liability occur in such market with sufficient frequency and volume to provide reliable pricing information. If the Company concludes that there has been a significant decrease in the volume and level of activity for an investment in relation to normal market activity for such investment, adjustments to transactions and quoted prices are made to estimate fair value. The inputs used in the valuation techniques employed by the Company are provided by nationally recognized pricing services, external investment managers and internal resources. To assess these inputs, the Company’s review process includes, but is not limited to, quantitative analysis including benchmarking, initial and ongoing evaluations of methodologies used by external parties to calculate fair value, and ongoing evaluations of fair value estimates based on the Company’s knowledge and monitoring of market conditions. The Company periodically reviews the pricing service provider’s policies and procedures for valuing securities. The assumptions underlying the valuations from external service providers, including unobservable inputs, are generally not readily available as this information is often deemed proprietary. Accordingly, the Company is unable to obtain comprehensive information regarding these assumptions and methodologies. The Company’s investments in fixed maturity securities available for sale, equity securities and trading securities assets and liabilities are carried at fair value. The following are the Company’s methodologies and valuation techniques for assets and liabilities measured at fair value. Fixed maturities available for sale mainly consist of U.S. treasury securities and corporate debt securities. The Company employs a market approach to the valuation of securities where there are sufficient market transactions involving identical or comparable assets. If sufficient market data is not available for identical or comparable assets, the Company uses an income approach to valuation. The majority of the financial instruments included in fixed maturity securities available for sale are evaluated utilizing observable inputs; accordingly, they are categorized in either Level 1 or Level 2 of the fair value hierarchy. However, in instances where significant inputs utilized in valuation of the securities are unobservable, the securities are categorized in Level 3 of the fair value hierarchy. Corporate securities primarily include fixed rate corporate bonds. Inputs utilized in connection with the Company’s valuation techniques relating to this class of securities include recently executed transactions, market price quotations, benchmark yields and issuer spreads. Corporate securities are categorized in Level 2 of the fair value hierarchy. U.S. treasury securities are based on quoted prices in active markets and are generally categorized in Level 1 of the fair value hierarchy. Equity securities consist of common and preferred stocks mainly in private equity investments, financial institutions and publicly traded corporations. Equity securities for which there is sufficient market data are categorized as Level 1 or 2 in the fair value hierarchy. For the equity securities in which quoted market prices are not available, the Company uses industry standard pricing methodologies, including discounted cash flow models that may incorporate various inputs such as payment expectations, risk of the investment, market data, and health of the underlying company. The inputs are based upon Management's assumptions and available market information. When evidence is believed to support a change to the carrying value from the transaction price, adjustments are made to reflect the expected cash flows, material events and market data. These investments are included in Level 3 of the fair value hierarchy.\\n| Level 1 | Level 2 | Level 3 | Total |\\n| Assets |\\n| Fixed Maturities, available for sale | $ | 25,775,319 | $ | 137,696,500 | $ | 434,844 | $ | 163,906,663 |\\n| Equity Securities | 37,355,757 | 12,176,923 | 32,917,737 | 82,450,417 |\\n| Total | $ | 63,131,076 | $ | 149,873,423 | $ | 33,352,581 | $ | 246,357,080 |\\n| Level 1 | Level 2 | Level 3 | Total |\\n| Assets |\\n| Fixed Maturities, available for sale | $ | 25,660,194 | $ | 134,865,746 | $ | 434,844 | $ | 160,960,784 |\\n| Equity Securities | 27,634,283 | 10,557,031 | 29,473,168 | 67,664,482 |\\n| Total | $ | 53,294,477 | $ | 145,422,777 | $ | 29,908,012 | $ | 228,625,266 |\\n\\n| Fixed Maturities, Available for Sale | Equity Securities | Total |\\n| Balance at December 31, 2018 | $ | 434,844 | $ | 29,473,168 | $ | 29,908,012 |\\n| Total unrealized gain or (losses): |\\n| Included in net income (loss) | - | 3,444,569 | 3,444,569 |\\n| Included in other comprehensive income | - | - | - |\\n| Purchases | - | - | - |\\n| Sales | - | - | - |\\n| Balance at March 31, 2019 | $ | 434,844 | $ | 32,917,737 | $ | 33,352,581 |\\n| March 31, 2019 | December 31, 2018 |\\n| Change in fair value of equity securities included in net income (loss) relating to assets held | $ | 3,444,569 | $ | 4,633,751 |\\n\\nThe Level 3 securities include collateralized debt obligations of trust preferred securities issued by banks and insurance companies and certain equity securities with unobservable inputs. The Company computed fair value of Level 3 equity investments based on a review of current financial information, earnings trends and similar companies in the same industries. There were no transfers in or out of Level 3 as of March 31, 2019. Transfers occur when there is a change in the availability of observable market information. Certain assets are not carried at fair value on a recurring basis, including investments such as mortgage loans and policy loans. Accordingly, such investments are only included in the fair value hierarchy disclosure when the investment is subject to re-measurement at fair value after initial recognition and the resulting re-measurement is reflected in the Consolidated Financial Statements.\\n| March 31, 2019 | December 31, 2018 |\\n| Assets | Carrying Amount | Estimated Fair Value | Carrying Amount | Estimated Fair Value |\\n| Equity securities | $ | 12,133,745 | $ | 12,133,745 | $ | 12,118,617 | $ | 12,118,617 |\\n| Mortgage loans on real estate | 10,703,553 | 10,703,553 | 9,069,111 | 9,069,111 |\\n| Investment real estate | 51,530,162 | 51,530,162 | 52,518,577 | 52,518,577 |\\n| Notes receivable | 26,595,336 | 26,595,336 | 23,717,312 | 23,717,312 |\\n| Policy loans | 9,117,979 | 9,117,979 | 9,204,222 | 9,204,222 |\\n| Cash and cash equivalents | 19,049,555 | 19,049,555 | 20,150,162 | 20,150,162 |\\n\\nThe above estimated fair value amounts have been determined based upon the following valuation methodologies. Considerable judgment was required to interpret market data in order to develop these estimates. Accordingly, the estimates are not necessarily indicative of the amounts which could be realized in a current market exchange. The use of different market assumptions or estimation methodologies may have a material effect on the fair value amounts. The fair values of mortgage loans on real estate are estimated using discounted cash flow analyses and interest rates being offered for similar loans to borrowers with similar credit ratings. The inputs used to measure the fair value of our mortgage loans on real estate are classified as Level 3 within the fair value hierarchy. A portion of the mortgage loans balance consists of discounted mortgage loans. The Company has historically purchased non-performing discounted mortgage loans at a deep discount through an auction process led by the Federal Government. In general, the discounted loans are non-performing and there is a significant amount of uncertainty surrounding the timing and amount of cash flows to be received by the Company. Accordingly, the Company records its investment in the discounted loans at its original purchase price, which Management believes approximates fair value. The inputs used to measure the fair value of our discounted mortgage loans are classified as Level 3 within the fair value hierarchy Investment real estate is recorded at the lower of the net investment in the real estate or the fair value of the real estate less costs to sell. The determination of fair value assessments are performed on a periodic, non-recurring basis by external appraisal and assessment of property values by Management. The inputs used to measure the fair value of our investment real estate are classified as Level 3 within the fair value hierarchy. Notes receivable are carried at their unpaid principal balances, which approximates fair value. The inputs used to measure the fair value of the loans are classified as Level 3 within the fair value hierarchy. Policy loans are carried at the aggregate unpaid principal balances in the Condensed Consolidated Balance Sheets which approximate fair value, and earn interest at rates ranging from 4% to 8%. Individual policy liabilities in all cases equal or exceed outstanding policy loan balances. The inputs used to measure the fair value of our policy loans are classified as Level 3 within the fair value hierarchy. The carrying amount of cash and cash equivalents in the Condensed Consolidated Balance Sheets approximates fair value given the highly liquid nature of the instruments. The inputs used to measure the fair value of our cash and cash equivalents are classified as Level 1 within the fair value hierarchy. The carrying amount of short term investments in the Condensed Consolidated Balance Sheets approximates fair value. The inputs used to measure the fair value of our short term investments are classified as Level 3 within the fair value hierarchy.\\nNote 5 – Credit Arrangements\\n| Instrument | Issue Date | Maturity Date | Revolving Credit Limit | December 31, 2018 | Borrowings | Repayments | March 31, 2019 |\\n| Lines of Credit: |\\n| UTG | 11/20/2013 | 11/20/2019 | $ | 8,000,000 | - | - | - | - |\\n| UG | 6/2/2015 | 5/10/2019 | 10,000,000 | - | - | - | - |\\n\\nThe UTG line of credit carries interest at a fixed rate of 5.125% and is payable monthly. As collateral, UTG has pledged 100% of the common voting stock of its wholly owned subsidiary, Universal Guaranty Life Insurance Company. The Company is currently in the process of renewing this line of credit. During May of 2018, the Federal Home Loan Bank approved UG’s Cash Management Advance Application (“CMA”). The CMA gives the Company the option of selecting a variable rate of interest for up to 90 days or a fixed rate for a maximum of 30 days. The variable rate CMA is prepayable at any time without a fee, while the fixed CMA is not prepayable prior to maturity. The Company is currently in the process of renewing the CMA.\\nNote 6 – Shareholders’ Equity Stock Repurchase Program – The Board of Directors of UTG has authorized the repurchase in the open market or in privately negotiated transactions of UTG's common stock. At a meeting of the Board of Directors in September of 2018, the Board of Directors of UTG authorized the repurchase of up to an additional $1.5 million of UTG's common stock, for a total repurchase of up to $16.0 million of UTG's common stock in the open market or in privately negotiated transactions. Company Management has broad authority to operate the program, including the discretion of whether to purchase shares and the ability to suspend or terminate the program. Open market purchases are made based on the last available market price but may be limited. During the three months ended March 31, 2019, the Company repurchased 6,955 shares through the stock repurchase program for $212,387. Through March 31, 2019, UTG has spent $14,076,115 million in the acquisition of 1,147,061 shares under this program. During 2019, the Company issued 7,632 shares of stock to management and employees as compensation at a cost of $229,800. These awards are determined at the discretion of the Board of Directors. Earnings Per Share Calculations Earnings per share are based on the weighted average number of common shares outstanding during each period. For the three months ended March 31, 2019 and 2018, diluted earnings per share were the same as basic earnings per share since the Company had no dilutive instruments outstanding.\\nNote 7 – Commitments and Contingencies The insurance industry has experienced a number of civil jury verdicts which have been returned against life and health insurers in the jurisdictions in which the Company does business involving the insurers' sales practices, alleged agent misconduct, failure to properly supervise agents, and other matters. Some of the lawsuits have resulted in the award of substantial judgments against the insurer, including material amounts of punitive damages. In some states, juries have substantial discretion in awarding punitive damages in these circumstances. In the normal course of business, the Company is involved from time to time in various legal actions and other state and federal proceedings. Management is of the opinion that the ultimate disposition of the matters will not have a materially adverse effect on the Company’s results of operations or financial position. Under the insurance guaranty fund laws in most states, insurance companies doing business in a participating state can be assessed up to prescribed limits for policyholder losses incurred by insolvent or failed insurance companies. Although the Company cannot predict the amount of any future assessments, most insurance guaranty fund laws currently provide that an assessment may be excused or deferred if it would threaten an insurer's financial strength. Mandatory assessments may be partially recovered through a reduction in future premium tax in some states. The Company does not believe such assessments will be materially different from amounts already provided for in the condensed consolidated financial statements, though the Company has no control over such assessments.\\n| Total Funding Commitment | Unfunded Commitment |\\n| RLF III, LLC | $ | 4,000,000 | $ | 398,120 |\\n| Sovereign’s Capital, LP Fund I | 500,000 | 24,493 |\\n| Sovereign's Capital, LP Fund II | 1,000,000 | 240,566 |\\n| Sovereign's Capital, LP Fund III | 1,000,000 | 900,000 |\\n| Barton Springs Music, LLC | 1,750,000 | 1,158,500 |\\n| Master Mineral Holdings III, LP | 4,000,000 | 530,312 |\\n\\nDuring 2006, the Company committed to invest in RLF III, LLC (“RLF”), which makes land-based investments in undervalued assets. RLF makes capital calls as funds are needed for continued land purchases. During 2012, the Company committed to invest in Sovereign’s Capital, LP Fund I (“Sovereign’s”), which invests in companies in emerging markets. Sovereign’s makes capital calls to investors as funds are needed. During 2015, the Company committed to invest in Sovereign’s Capital, LP Fund II (“Sovereign’s II”), which invests in companies in emerging markets. Sovereign’s II makes capital calls to investors as funds are needed. During 2018, the Company committed to invest in Sovereign’s Capital, LP Fund III (“Sovereign’s III”), which invests in companies in emerging markets. Sovereign’s III makes capital calls to investors as funds are needed. During 2018, the Company committed to invest in Barton Springs Music, LLC (“Barton”), which invests in music royalties. Barton makes capital calls to its investors as funds are needed to acquire the royalty rights. During 2018, the Company committed to invest in Master Mineral Holdings III, LP (“MMH”), which purchases land for leasing opportunities to those looking to harvest natural resources. MMH makes capital calls to its investors as funds are needed for continued land purchases.\\nNote 8 – Other Cash Flow Disclosures\\n| Three Months Ended |\\n| March 31, |\\n| 2019 | 2018 |\\n| Interest | $ | - | $ | - |\\n| Federal income tax | - | - |\\n\\nNote 9 – Concentrations of Credit Risk The Company maintains cash balances in financial institutions that at times may exceed federally insured limits. The Company maintains its primary operating cash accounts with First Southern National Bank, an affiliate of the largest shareholder of UTG, Mr. Jesse Correll, the Company’s CEO and Chairman. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risk on cash and cash equivalents. Because UTG serves primarily individuals located in four states, the ability of our customers to pay their insurance premiums is impacted by the economic conditions in these areas. As of March 31, 2019 and 2018 , approximately 55% and 56%, respectively, of the Company’s total direct premium was collected from Illinois, Ohio, Texas and West Virginia. Thus, results of operations are heavily dependent upon the strength of these economies. The Company reinsures that portion of insurance risk which is in excess of its retention limits. Retention limits range up to $125,000 per life. Life insurance ceded represented 20% of total life insurance in force at March 31, 2019 and December 31, 2018, respectively. Insurance ceded represented 24% and 29% of premium income for the three months ended March 31, 2019 and 2018, respectively. The Company would be liable for the reinsured risks ceded to other companies to the extent that such reinsuring companies are unable to meet their obligations. The Company owns a variety of investments associated with the oil and gas industry. These investments represent approximately 28% and 25% of the Company's total invested assets as of March 31, 2019 and December 31, 2018, respectively.\\n\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\\nThe following is Management's discussion and analysis of the financial condition and results of operations of UTG, Inc. and its subsidiaries (collectively with the Parent, the \\\"Company\\\"). The following discussion of the financial condition and results of operations of the Company should be read in conjunction with, and is qualified in its entirety by reference to, the Consolidated Financial Statements of the Company and the related Notes thereto appearing in the Company's annual report on Form 10-K for the year ended December 31, 2018, as filed with the Securities and Exchange Commission, and our unaudited Condensed Consolidated Financial Statements and related Notes thereto appearing elsewhere in this quarterly report.\\nCautionary Statement Regarding Forward-Looking Statements\\nThis report on Form 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are intended to be covered by the safe harbors created by those laws. We have based our forward-looking statements on our current expectations and projections about future events. Our forward-looking statements include information about possible or assumed future results of operations. All statements, other than statements of historical facts, included or incorporated by reference in this report that address activities, events or developments that we expect or anticipate may occur in the future, including such things as the growth of our business and operations, our business strategy, competitive strengths, goals, plans, future capital expenditures and references to future successes may be considered forward-looking statements. Also, when we use words such as \\\"anticipate,\\\" \\\"believe,\\\" \\\"estimate,\\\" \\\"expect,\\\" \\\"intend,\\\" \\\"plan,\\\" \\\"probably,\\\" or similar expressions, we are making forward-looking statements.\\nNumerous risks and uncertainties may impact the matters addressed by our forward-looking statements, any of which could negatively and materially affect our future financial results and performance.\\nAlthough we believe that the assumptions underlying our forward-looking statements are reasonable, any of these assumptions, and, therefore, the forward-looking statements based on these assumptions, could themselves prove to be inaccurate. In light of the significant uncertainties inherent in the forward-looking statements that are included in this report, our inclusion of this information is not a representation by us or any other person that our objectives and plans will be achieved. In light of these risks, uncertainties and assumptions, any forward-looking event discussed in this report may not occur. Our forward-looking statements speak only as of the date made, and we undertake no obligation to update or review any forward-looking statement, whether as a result of new information, future events or other developments, unless the securities laws require us to do so.\\nOverview\\nUTG, Inc., a Delaware corporation, is a life insurance holding company. The Company's dominant business is individual life insurance, which includes the servicing of existing insurance policies in force, the acquisition of other companies in the life insurance business and the administration and processing of life insurance business for other entities. The Company's focus for the future includes growing the administrative portion of the business.\\nCritical Accounting Policies\\nThe preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect reported amounts and related disclosures. Actual results could differ significantly from those estimates. The Company has identified certain estimates that involve a higher degree of judgment and are subject to a significant degree of variability. The Company's critical accounting policies and the related estimates considered most significant by Management are disclosed in the Company's Annual Report on Form 10-K for the year ended December 31, 2018. Management has identified the accounting policies related to cost of insurance acquired, assumptions and judgments utilized in determining if declines in fair values of investments are other-than-temporary, and valuation methods for investments that are not actively traded as those, due to the judgments, estimates and assumptions inherent in those policies, are critical to an understanding of the Company's Condensed Consolidated Financial Statements and this Management's Discussion and Analysis.\\nDuring the three months ended March 31, 2019, there were no additions to or changes in the critical accounting policies disclosed in the 2018 Form 10-K.\\nResults of Operations\\nOn a consolidated basis, the Company reported net income attributable to common shareholders' of approximately $11.6 million and $2.7 million for the three-month periods ended March 31, 2019 and 2018, respectively.\\nRevenues\\nThe Company reported total revenues of approximately $21.1 million for the three-month period ended March 31, 2019, an increase of approximately $11.4 million as compared to the same period in 2018. The variance in total revenues from the prior year to the current year is mainly attributable to the increase in the change in the fair value of equity securities.\\nPremium and policy fee revenues, net of reinsurance, were comparable for the three-months ended March 31, 2019 and 2018. The Company writes minimal new business. Premium and policy fee revenues, net of reinsurance, represented 10% and 20% of the Company's revenues as of March 31, 2019 and 2018, respectively.\\nThe following table summarizes the Company's investment performance.\\n\\n| Three Months Ended March 31, |\\n| 2019 | 2018 |\\n| Net investment income | $ | 3,112,024 | $ | 3,068,118 |\\n| Net investment gains | $ | 15,901,329 | $ | 4,663,478 |\\n| Change in net unrealized investment gains (losses) on available-for-sale securities, pre-tax | $ | 4,934,851 | $ | (4,285,303 | ) |\\n\\nThe following table reflects net investment income of the Company:\\n\\n| Three Months Ended |\\n| March 31, |\\n| 2019 | 2018 |\\n| Fixed maturities available for sale | $ | 1,589,985 | $ | 1,837,844 |\\n| Equity securities | 668,108 | 532,067 |\\n| Trading securities | (111,693 | ) | - |\\n| Mortgage loans | 118,612 | 214,558 |\\n| Real estate | 784,532 | 449,546 |\\n| Notes receivable | 435,155 | 386,782 |\\n| Policy loans | 141,552 | 150,081 |\\n| Short-term | 41,364 | 48,172 |\\n| Cash and cash equivalents | - | 12,434 |\\n| Total consolidated investment income | 3,667,615 | 3,631,484 |\\n| Investment expenses | (555,591 | ) | (563,366 | ) |\\n| Consolidated net investment income | $ | 3,112,024 | $ | 3,068,118 |\\n\\nNet investment income represented 15% and 32% of the Company's total revenues as of March 31, 2019 and 2018, respectively. Net investment was comparable in the majority of the investment categories when comparing the first quarter 2019 activity to the same quarter in 2018.\\nInvestment income from the real estate investment portfolio is up approximately $335,000 in the current year as compared to the same period in the prior year. The increase is not attributable to one specific investment or event. Several of the Company's real estate holdings produced more income in the current your as compared to the same period in the prior year. Income is expected to vary from quarter to quarter depending on the activity occurring in relation to each property.\\nThe Company reported net investment gains of approximately $15.9 million and $4.7 million for the three-month periods ended March 31, 2019 and 2018, respectively. Realized investment gains of approximately $1.1 million and $534,000 were recognized by the Company during the first quarter of 2019 and 2018, respectively. These gains are the result of the Company selling a parcel of real estate in 2018 and 2019.\\nRealized investment gains are the result of one-time events and are expected to vary from quarter to quarter.\\nThe 2019 investment gains mainly consist of approximately $14.8 million in unrealized gains related to the change in the fair value of equity securities. For the same period in 2018, the Company reported approximately $4.1 million of unrealized gains related to the change in the fair value of equity securities.\\nThe Company has seen significant unrealized gains on its equity investments during 2018 and 2019. A significant portion of these gains are from two equity holdings, both in the area of oil and gas. While the Company has had very strong unrealized gains during 2018 and 2019, a pull back in the stock market, particularly in the oil and gas arena, could slow these gains or even result in future period unrealized losses. Management believes these equity investments continue to be solid investments for the Company and have further growth potential; however, changes in market conditions could cause volatility in market prices.\\nIn summary, the Company's basis for future revenue growth is expected to come from the following primary sources: conservation of business currently in-force, the maximization of investment earnings and the acquisition of other companies or policy blocks in the life insurance business. Management has placed a significant emphasis on the development of these revenue sources to enhance these opportunities.\\nExpenses\\nThe Company reported total benefits and other expenses of approximately $5.6 million for the three-month period ended March 31, 2019, a decrease of approximately 9% from the same period in 2018. Benefits, claims and settlement expenses represented approximately 59% and 63% of the Company's total expenses for the three-month periods ended March 31, 2019 and 2018, respectively. The other major expense category of the Company is operating expenses, which represented approximately 39% and 34% of the Company's total expenses for the three-month periods ended March 31, 2019 and 2018, respectively.\\nLife benefits, claims and settlement expenses, net of reinsurance benefits and claims, decreased approximately 16% in the three-month period ended March 31, 2019, compared to the same period in 2018. Policy claims vary from period to period and therefore, fluctuations in mortality are to be expected and are not considered unusual by Management.\\nNet amortization of cost of insurance acquired decreased 4% during the three-month period ended March 31, 2019 compared to the same period in 2018. Cost of insurance acquired is established when an insurance company is acquired or when the Company acquires a block of in-force business. The Company assigns a portion of its cost to the right to receive future profits from insurance contracts existing at the date of the acquisition. Cost of insurance acquired is amortized with interest in relation to expected future profits, including direct charge-offs for any excess of the unamortized asset over the projected future profits. The interest rates may vary due to risk analysis performed at the time of acquisition on the business acquired. The Company utilizes a 12% discount rate on the remaining unamortized business. The amortization is adjusted retrospectively when estimates of current or future gross profits to be realized from a group of products are revised. Amortization of cost of insurance acquired is particularly sensitive to changes in interest rate spreads and persistency of certain blocks of insurance in-force. This expense is expected to decrease, unless the Company acquires a new block of business.\\nOperating expenses increased approximately 3% in the three-month period ended March 31, 2019 as compared to the same period in 2018. Overall, expenses were comparable in all of the major expense categories.\\nManagement continues to place significant emphasis on expense monitoring and cost containment. Maintaining administrative efficiencies directly impacts net income.\\nFinancial Condition\\nInvestment Information\\nInvestments represent approximately 86% and 85% of total assets at March 31, 2019 and December 31, 2018, respectively. Accordingly, investments are the largest asset group of the Company. The Company's insurance subsidiary is regulated by insurance statutes and regulations as to the type of investments that it is permitted to make and the amount of funds that may be used for any one type of investment. In light of these statutes and regulations, the majority of the Company's investment portfolio is invested in a diverse set of securities.\\nAs of March 31, 2019, the carrying value of fixed maturity securities in default as to principal or interest was immaterial in the context of consolidated assets, shareholders' equity or results from operations. To provide additional flexibility and liquidity, the Company has identified all fixed maturity securities as \\\"investments available for sale\\\". Investments available-for-sale are carried at market, with changes in market value charged directly to shareholders' equity. Changes in the market value of available for sale securities resulted in a net unrealized gain of approximately $3.9 million and a net unrealized loss of approximately $3.4 million for the three-month periods ended March 31, 2019 and 2018, respectively. The variance in the net unrealized gains and losses is the result of normal market fluctuations and lower interest rates.\\nCapital Resources\\nTotal shareholders' equity increased by approximately 14% as of March 31, 2019 compared to December 31, 2018. The increase is mainly attributable to an increase in retained earnings, which is the result of the current year net income reported by the Company.\\nThe Company's investments are predominately in fixed maturity investments such as bonds, which provide sufficient return to cover future obligations. The Company carries all of its fixed maturity holdings as available for sale, which are reported in the Condensed Consolidated Financial Statements at their market value.\\nLiquidity\\nThe Company has two principal needs for cash - the insurance company's contractual obligations to policyholders and the payment of operating expenses. Cash and cash equivalents represented 5% total assets as of March 31, 2019 and December 31, 2018. Fixed maturities as a percentage of total assets were approximately 40% and 41% as of March 31, 2019 and December 31, 2018, respectively.\\nThe Company currently has access to funds for operating liquidity. UTG has an $8 million revolving credit note with Illinois National Bank. At March 31, 2019, the Company had no outstanding borrowings against the UTG line of credit. UG has a $10 million line of credit with the Federal Home Loan Bank. At March 31, 2019, the Company had no outstanding borrowings against the UG line of credit\\nFuture policy benefits are primarily long-term in nature and therefore, the Company's investments are predominantly in long-term fixed maturity investments such as bonds and mortgage loans which provide sufficient return to cover these obligations. Many of the Company's products contain surrender charges and other features which reward persistency and penalize the early withdrawal of funds.\\nFor the three months ended March 31, 2019 and 2018, operating activities used cash of approximately $364,000 and provided cash of approximately $3.3 million, respectively. Sources of operating cash flows of the Company, as with most insurance entities, is comprised primarily of premiums received on life insurance products and income earned on investments. Uses of operating cash flows consist primarily of payments of benefits to policyholders and beneficiaries and operating expenses. The Company has not marketed any significant new products for several years.\\nThe Company used cash in investing activities of approximately $540,000 and $8.3 million for the three month periods ended March 31, 2019 and 2018, respectively. The net cash provided by or used in investing activities is expected to vary from quarter to quarter depending on market conditions and Management’s ability to find and negotiate favorable investment contracts.\\nUTG is a holding Company that has no day-to-day operations of its own. Funds required to meet its expenses, generally costs associated with maintaining the Company in good standing with states in which it does business are primarily provided by its subsidiaries. On a parent only basis, UTG's cash flow is dependent on Management fees received from its insurance subsidiary, stockholder dividends from its subsidiary and earnings received on cash balances. At March 31, 2019, substantially all of the consolidated shareholders' equity represented net assets of its subsidiary. The Company's insurance subsidiary has maintained adequate statutory capital and surplus. The payment of cash dividends to shareholders by UTG is not legally restricted. However, the state insurance department regulates insurance Company dividend payments where the Company is domiciled. No dividends were paid to shareholders in 2018 or the three-month period ended March 31, 2019.\\nUG is an Ohio domiciled insurance company, which requires notification within five business days to the insurance commissioner following the declaration of any ordinary dividend and at least ten calendar days prior to payment of such dividend. Ordinary dividends are defined as the greater of: a) prior year statutory net income or b) 10% of statutory capital and surplus. For the year ended December 31, 2018, UG had statutory net income of approximately $6.2 million. At December 31, 2018 UG's statutory capital and surplus amounted to approximately $60 million. Extraordinary dividends (amounts in excess of ordinary dividend limitations) require prior approval of the insurance commissioner and are not restricted to a specific calculation. During 2018 , UG paid UTG ordinary dividends of $5 million. During the second quarter of 2019, UG paid UTG a dividend of $2 million. UTG used the dividends received during 2018 and 2019 for general operations of the Company.\\n\\nITEM 4. CONTROLS AND PROCEDURES\\nThe Company maintains a set of disclosure controls and procedures designed to ensure that information required to be disclosed in reports that it files or submits under the Securities Exchange Act of 1934, as amended (the Exchange Act), is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. In addition, the disclosure controls and procedures ensure that information required to be disclosed is accumulated and communicated to Management, including the principal executive officer and principal financial officer, allowing timely decisions regarding required disclosure. Under the supervision and with the participation of our Management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Exchange Act. Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.\\nPART II. OTHER INFORMATION\\n\\nITEM 1. LEGAL PROCEEDINGS\\nNONE\\n\\nITEM 1A. RISK FACTORS\\nNONE\\n\\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\\nNONE\\n\\nITEM 3. DEFAULTS UPON SENIOR SECURITIES\\nNONE\\n\\nITEM 4. MINE SAFETY DISCLOSURES\\nNONE\\n\\nITEM 5. OTHER INFORMATION\\nNONE\\n\\nITEM 6. EXHIBITS\\n\\n| *31.1 | Certification of Jesse T. Correll, Chief Executive Officer and Chairman of the Board of UTG, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| *31.2 | Certification of Theodore C. Miller, Chief Financial Officer, Senior Vice President and Corporate Secretary of UTG, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| *32.1 | Certificate of Jesse T. Correll, Chief Executive Officer and Chairman of the Board of UTG, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| *32.2 | Certificate of Theodore C. Miller, Chief Financial Officer, Senior Vice President and Corporate Secretary of UTG, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| **101 | Interactive Data File |\\n\\n*Filed herewith\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\nUTG, INC.\\n(Registrant)\\n\\n| Date: | May 14, 2019 | By | /s/ James P. Rousey |\\n| James P. Rousey |\\n| President and Director |\\n\\n\\n| Date: | May 14, 2019 | By | /s/ Theodore C. Miller |\\n| Theodore C. Miller |\\n| Senior Vice President |\\n| and Chief Financial Officer |\\n\\nEXHIBIT INDEX\\n\\n| Exhibit Number | Description |\\n| *31.1 | Certification of Jesse T. Correll, Chief Executive Officer and Chairman of the Board of UTG, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| *31.2 | Certification of Theodore C. Miller, Chief Financial Officer, Senior Vice President and Corporate Secretary of UTG, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| *32.1 | Certificate of Jesse T. Correll, Chief Executive Officer and Chairman of the Board of UTG, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| *32.2 | Certificate of Theodore C. Miller, Chief Financial Officer, Senior Vice President and Corporate Secretary of UTG, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| **101 | Interactive Data File |\\n\\n* Filed herewith\\n\\n \\n\\nWhat is the return on equity (ROE) for the year ended March 31, 2019, considering the net income for the three months ended March 31, 2019, and total shareholders' equity at the end of 2019 and 2018 in percentages?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 41.11.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 37,\n \"input_length\": 18914\n}"}}},{"rowIdx":38,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nPART I. FINANCIAL INFORMATION\nItem 1. Financial Statements.\nQUADRO ACQUISITION ONE CORP.\nCONDENSED BALANCE SHEETS\n\n| June 30, 2023 | December 31, 2022 |\n| (Unaudited) |\n| Assets |\n| Current assets: |\n| Cash | $ | — | $ | 964 |\n| Prepaid expenses | — | 33,402 |\n| Total current assets | — | 34,366 |\n| Cash and investments held in Trust Account | 26,731,243 | 233,304,515 |\n| Total Assets | $ | 26,731,243 | $ | 233,338,881 |\n| Liabilities, Class A Ordinary Shares Subject to Possible Redemption and Shareholders’ Deficit |\n| Current liabilities: |\n| Accounts payable | $ | 436,656 | $ | 107,269 |\n| Accrued expenses | 145,452 | 29,718 |\n| Extension loan - related party | 270,000 | — |\n| Advance from related parties | 188,722 | — |\n| Note payable - related party | 400,000 | 318,700 |\n| Total current liabilities | 1,440,830 | 455,687 |\n| Derivative liabilities - warrants | 809,673 | 30,167 |\n| Deferred underwriting commissions | 2,817,500 | 2,817,500 |\n| Total liabilities | 5,068,003 | 3,303,354 |\n| Commitments and Contingencies |\n| Class A ordinary shares subject to possible redemption, $ 0.001 par value; 2,548,153 and 23,000,000 shares at approximately $ 10.45 and $ 10.14 per share redemption value as of June 30, 2023 and December 31, 2022, respectively | 26,631,243 | 233,204,515 |\n| Shareholders’ Deficit: |\n| Class A ordinary shares, $ 0.001 par value; 200,000,000 shares authorized; 6,250,000 and 0 non-redeemable shares issued or outstanding as of June 30, 2023 and December 31, 2022, respectively | 6,250 | — |\n| Class B ordinary shares, $ 0.001 par value; 10,000,000 shares authorized; 0 and 6,250,000 shares issued and outstanding as of June 30, 2023 and December 31, 2022, respectively | — | 6,250 |\n| Accumulated deficit | ( 4,974,253 | ) | ( 3,175,238 | ) |\n| Total shareholders’ deficit | ( 4,968,003 | ) | ( 3,168,988 | ) |\n| Total Liabilities, Class A Ordinary Shares Subject to Possible Redemption and Shareholders’ Deficit | $ | 26,731,243 | $ | 233,338,881 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n1\nQUADRO ACQUISITION ONE CORP.\nUNAUDITED CONDENSED STATEMENTS OF OPERATIONS\n\n| For the Three Months Ended June 30, | For the Six Months Ended June 30, |\n| 2023 | 2022 | 2023 | 2022 |\n| Operating expenses |\n| General and administrative expenses | $ | 160,237 | $ | 106,509 | $ | 749,509 | $ | 299,896 |\n| Loss from operations | ( 160,237 | ) | ( 106,509 | ) | ( 749,509 | ) | ( 299,896 | ) |\n| Other income: |\n| Change in fair value of derivative assets and liabilities | ( 538,173 | ) | 863,544 | ( 779,506 | ) | 5,117,082 |\n| Income from investments held in Trust Account | 240,284 | — | 1,681,266 | — |\n| Unrealized gain from investments held in Trust Account | — | 292,182 | — | 312,752 |\n| Net (loss) income | $ | ( 458,126 | ) | $ | 1,049,217 | $ | 152,251 | $ | 5,129,938 |\n| Weighted average shares outstanding of Class A ordinary shares, basic and diluted | 8,798,153 | 23,000,000 | 13,551,176 | 23,000,000 |\n| Basic and diluted net (loss) income per share, Class A ordinary shares | $ | ( 0.05 | ) | $ | 0.04 | $ | 0.01 | $ | 0.18 |\n| Weighted average shares outstanding of Class B ordinary shares, basic and diluted | — | 6,250,000 | 1,041,667 | 6,250,000 |\n| Basic and diluted net (loss) income per share, Class B ordinary shares | $ | — | $ | 0.04 | $ | 0.01 | $ | 0.18 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n2\nQUADRO ACQUISITION ONE CORP.\nUNAUDITED CONDENSED STATEMENTS OF CHANGES IN SHAREHOLDERS’ DEFICIT\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2023\n\n| Ordinary Shares | Additional | Total |\n| Class A | Class B | Paid-in | Accumulated | Shareholders’ |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Deficit |\n| Balance - December 31, 2022 | — | $ | — | 6,250,000 | $ | 6,250 | $ | — | $ | ( 3,175,238 | ) | $ | ( 3,168,988 | ) |\n| Conversion of Class B ordinary shares to Class A ordinary shares | 6,250,000 | 6,250 | ( 6,250,000 | ) | ( 6,250 | ) | — | — | — |\n| Accretion on Class A ordinary shares subject to possible redemption amount | — | — | — | — | — | ( 1,560,982 | ) | ( 1,560,982 | ) |\n| Net income | — | — | — | — | — | 610,377 | 610,377 |\n| Balance - March 31, 2023 (unaudited) | 6,250,000 | 6,250 | — | — | — | ( 4,125,843 | ) | ( 4,119,593 | ) |\n| Accretion on Class A ordinary shares subject to possible redemption amount | — | — | — | — | — | ( 390,284 | ) | ( 390,284 | ) |\n| Net loss | — | — | — | — | — | ( 458,126 | ) | ( 458,126 | ) |\n| Balance - June 30, 2023 (unaudited) | 6,250,000 | $ | 6,250 | — | $ | — | $ | — | $ | ( 4,974,253 | ) | $ | ( 4,968,003 | ) |\n\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2022\n\n| Ordinary Shares | Additional | Total |\n| Class A | Class B | Paid-in | Accumulated | Shareholders’ |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Deficit |\n| Balance - December 31, 2021 | — | $ | — | 6,250,000 | $ | 6,250 | $ | — | $ | ( 13,769,504 | ) | $ | ( 13,763,254 | ) |\n| Net income | — | — | — | — | — | 4,080,721 | 4,080,721 |\n| Balance - March 31, 2022 (unaudited) | — | — | 6,250,000 | 6,250 | — | ( 9,688,783 | ) | ( 9,682,533 | ) |\n| Accretion on Class A ordinary shares subject to possible redemption amount | — | — | — | — | — | ( 251,264 | ) | ( 251,264 | ) |\n| Net income | — | — | — | — | — | 1,049,217 | 1,049,217 |\n| Balance - June 30, 2022 (unaudited) | — | $ | — | 6,250,000 | $ | 6,250 | $ | — | $ | ( 8,890,830 | ) | $ | ( 8,884,580 | ) |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n3\nQUADRO ACQUISITION ONE CORP.\nUNAUDITED CONDENSED STATEMENTS OF CASH FLOWS\n\n| For the Six Months Ended June 30, |\n| 2023 | 2022 |\n| Cash Flows from Operating Activities: |\n| Net income | $ | 152,251 | $ | 5,129,938 |\n| Adjustments to reconcile net income to net cash used in operating activities: |\n| Change in fair value of derivative assets and liabilities | 779,506 | ( 5,117,082 | ) |\n| Income from cash and investments held in Trust Account | ( 1,681,266 | ) | — |\n| Unrealized gain from investments held in Trust Account | — | ( 312,752 | ) |\n| Changes in operating assets and liabilities: |\n| Prepaid expenses | 33,402 | 105,379 |\n| Accounts payable | 346,708 | 12,240 |\n| Accounts payable - related party | ( 17,321 | ) | ( 17,321 | ) |\n| Accrued expenses | 115,734 | ( 60,094 | ) |\n| Net cash used in operating activities | ( 270,986 | ) | ( 259,692 | ) |\n| Cash Flows from Investing Activities: |\n| Cash deposited in Trust Account | ( 270,000 | ) | — |\n| Cash withdrawn from Trust Account in connection with redemption | 208,524,538 | — |\n| Net cash provided by investing activities | 208,254,538 | — |\n| Cash Flows from Financing Activities: |\n| Proceeds from related party advance | 188,722 | — |\n| Proceeds from extension loan | 270,000 | — |\n| Proceeds from note payable to related party | 81,300 | — |\n| Proceeds from promissory note to related party | — | 318,700 |\n| Offering costs paid | — | ( 70,000 | ) |\n| Redemption of Ordinary shares | ( 208,524,538 | ) | — |\n| Net cash used in financing activities | ( 207,984,516 | ) | 248,700 |\n| Net change in cash | ( 964 | ) | ( 10,992 | ) |\n| Cash - beginning of the period | 964 | 63,676 |\n| Cash - end of the period | $ | — | $ | 52,684 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n4\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nNote 1 - Description of Organization, Business Operations and Going Concern\nQuadro Acquisition One Corp. (the “Company”, formerly known as Kismet Acquisition Two Corp.) is a blank check company incorporated as a Cayman Islands exempted company on September 15, 2020. The Company was incorporated for the purpose of acquiring, engaging in a share exchange, share reconstruction and amalgamation, contractual control arrangement with, purchasing all or substantially all of the assets of, or engaging in any other similar initial business combination with one or more businesses or entities that the Company has not yet identified (“Business Combination”).\nAs of June 30, 2023, the Company had not yet commenced operations. All activity for the period from September 15, 2020 (inception) through June 30, 2023, relates to the Company’s formation and the initial public offering (the “Initial Public Offering” or “IPO”), which is described below, and since the Initial Public Offering, the search for a potential target. The Company will not generate any operating revenues until after the completion of its initial Business Combination, at the earliest. The Company generates non-operating income in the form of interest income on investments held in Trust Account (as defined below) from the proceeds derived from the Initial Public Offering and the sale of the Private Placement Warrants (as defined below).\nThe Company’s sponsor was Kismet Sponsor Limited, a British Virgin Islands company (the “Prior Sponsor”). The Registration Statement for the Initial Public Offering on Form S-1 initially filed with the U.S. Securities and Exchange Commission (“SEC”) on January 26, 2021, as amended (File No. 333- 252419), was declared effective on February 17, 2021 (the “Registration Statement”). On February 22, 2021, the Company consummated its Initial Public Offering of 23,000,000 units (the “Units” and, with respect to the Class A Ordinary shares included in the Units sold, the “Public Shares”), including 3,000,000 additional Units to cover over-allotments (the “Over-Allotment Units”), at $ 10.00 per Unit, generating gross proceeds of $ 230.0 million, and incurring offering costs of approximately $ 13.1 million, of which approximately $ 8.1 million was for deferred underwriting commissions (see Note 6).\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the private placement (“Private Placement”) of 4,400,000 warrants (each, a “Private Placement Warrant” and collectively, the “Private Placement Warrants”), at a price of $ 1.50 per Private Placement Warrant with the Prior Sponsor, generating gross proceeds of $ 6.6 million, and incurring offering costs of approximately $ 7,000 (see Note 4).\nOn June 15, 2022, the Prior Sponsor transferred 6,250,000 Class B ordinary shares and 4,400,000 Private Placement Warrants held by the Prior Sponsor to Quadro Sponsor LLC, a Delaware limited liability company and wholly owned subsidiary of the Prior Sponsor (the “New Sponsor” or “Sponsor”). On June 30, 2022, the Prior Sponsor transferred all the membership interests of the New Sponsor to Quadro IH DMCC (“Quadro”), a company registered in Dubai Multi Commodities Centre in the United Arab Emirates (the “Sponsor Transaction”). In connection with the Sponsor Transaction, the Prior Sponsor also assigned to the New Sponsor all of its rights and obligations under the (i) Letter Agreement, dated as of February 17, 2021, (ii) Registration Rights Agreement (as defined in Note 5) and (iii) Promissory Note (as defined below). In addition, the Company and Kismet Capital Group LLC (“Kismet LLC”) mutually terminated the Administrative Services Agreement, dated February 17, 2021 (the “Administrative Services Agreement”). As a result, the Company is no longer obligated to pay a $ 10,000 monthly fee to Kismet LLC pursuant to the Administrative Services Agreement.\nUpon the closing of the Initial Public Offering and the Private Placement, $ 230.0 million ($ 10.00 per Unit) of the net proceeds of the Initial Public Offering and certain of the proceeds of the Private Placement were placed in a trust account (“Trust Account”) with Continental Stock Transfer & Trust Company (“Continental”) acting as trustee and invested in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds meeting certain conditions under Rule 2a-7 under the Investment Company Act of 1940 (the “Investment Company Act”), which invest only in direct U.S. government treasury obligations, as determined by the Company, until the earlier of (i) the completion of a Business Combination and (ii) the distribution of the Trust Account as described below.\nThe Company’s management has broad discretion with respect to the specific application of the net proceeds of its Initial Public Offering and the sale of Private Placement Warrants, although substantially all of the net proceeds are intended to be applied generally toward consummating a Business Combination. The Company’s initial Business Combination must be with one or more operating businesses or assets with a fair market value equal to at least 80 % of the net assets held in the Trust Account (excluding the deferred underwriting commissions and taxes payable, if any, on the income accrued on the Trust Account) at the time the Company signs a definitive agreement in connection with the initial Business Combination. However, the Company will only complete a Business Combination if the post-transaction company owns or acquires 50 % or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act.\n5\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nThe Company will provide its holders of the Public Shares (the “Public Shareholders”) with the opportunity to redeem all or a portion of their Public Shares upon the completion of a Business Combination either (i) in connection with a shareholder meeting called to approve the Business Combination or (ii) by means of a tender offer. The decision as to whether the Company will seek shareholder approval of a Business Combination or conduct a tender offer will be made by the Company, solely in its discretion. The Public Shareholders will be entitled to redeem their Public Shares for a pro rata portion of the amount then in the Trust Account (initially at $ 10.00 per share, plus any pro rata interest earned on the funds held in the Trust Account and not previously released to the Company to pay its tax obligations). The per-share amount to be distributed to Public Shareholders who redeem their Public Shares will not be reduced by the deferred underwriting commissions the Company will pay to the underwriters (see Note 6). These Public Shares were recorded at a redemption value and classified as temporary equity upon the completion of the Initial Public Offering, in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 480, “Distinguishing Liabilities from Equity” (“ASC 480”). In such case, the Company will proceed with a Business Combination if the Company has net tangible assets of at least $ 5,000,001 upon such consummation of a Business Combination and a majority of the shares are voted in favor of the Business Combination. If a shareholder vote is not required by law and the Company does not decide to hold a shareholder vote for business or other legal reasons, the Company will, pursuant to the amended and restated memorandum and articles of association which were adopted by the Company upon the consummation of the Initial Public Offering (the “Memorandum and Articles of Association”), conduct the redemptions pursuant to the tender offer rules of the SEC, and file tender offer documents with the SEC prior to completing a Business Combination. If, however, a shareholder approval of the transactions is required by law, or the Company decides to obtain shareholder approval for business or legal reasons, the Company will offer to redeem shares in conjunction with a proxy solicitation pursuant to the proxy rules and not pursuant to the tender offer rules. Additionally, each Public Shareholder may elect to redeem their Public Shares irrespective of whether they vote for or against the proposed transaction. If the Company seeks shareholder approval in connection with a Business Combination, the holder of the Founder Shares (as defined in Note 5) prior to the Initial Public Offering (the “Initial Shareholder”) agreed to vote its Founder Shares and any Public Shares purchased during or after the Initial Public Offering in favor of a Business Combination. In addition, the Initial Shareholder agreed to waive its redemption rights with respect to their Founder Shares and Public Shares in connection with the completion of a Business Combination.\nNotwithstanding the foregoing, the Memorandum and Articles of Association provides that a Public Shareholder, together with any affiliate of such shareholder or any other person with whom such shareholder is acting in concert or as a “group” (as defined under Section 13 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), will be restricted from redeeming its shares with respect to more than an aggregate of 20 % or more of the Class A Ordinary shares sold in the Initial Public Offering, without the prior consent of the Company.\nThe Company’s Sponsor, executive officers, directors and director nominees agreed not to propose an amendment to the Memorandum and Articles of Association that would affect the substance or timing of the Company’s obligation to provide for the redemption of its Public Shares in connection with a Business Combination or to redeem 100 % of its Public Shares if the Company does not complete a Business Combination, unless the Company provides the Public Shareholders with the opportunity to redeem their Class A ordinary shares in conjunction with any such amendment.\nThe Company initially had until February 22, 2023 (the “Original Termination Date”) to complete the initial Business Combination. On February 20, 2023, the Company held the 2023 Extraordinary General Meeting at which the shareholders of the Company approved to extend the date by which the Company must consummate an initial Business Combination to April 22, 2023 and to allow the Company’s board, without another shareholder vote, to extend Combination Date on a monthly basis up to seven times for an additional one month each time until November 22, 2023, or a total of up to nine months after the Original Termination Date (the “Extension”).\nIn connection with the Extension, the Sponsor or its designees contributed to the Company as a loan the initial contribution of $ 120,000 (the “Initial Extension Loan”) in February 2023 for the portion of the extension ending on April 22, 2023. The Sponsor will also loan the company extension contributions of $ 60,000 per month for each subsequent calendar month (commencing on April 22, 2023 and on the 22nd day of each subsequent month) until November 22, 2023, or portion thereof, that is needed to complete an initial Business Combination, which amount will be deposited into the Trust Account (together with the Initial Extension Loan, the “Extension Loans”). On each of May 11, 2023 and June 6, 2023, the Company deposited an additional $ 60,000 , for an aggregate of $ 120,000 into the Trust Account to extend the date by which it has to consummate an initial Business Combination to June 22, 2023. On each of June 30, 2023 and July 11, 2023, the Company deposited an additional $ 30,000 , for an aggregate of $ 60,000 into the Trust Account to extend the date by which it has to consummate an initial Business Combination to July 22, 2023. On August 7, 2023, the Company deposited an additional $ 60,000 into the Trust Account to extend the date by which it has to consummate an initial business combination to August 22, 2023.\nIn connection with the Extension, shareholders holding 20,451,847 Class A ordinary shares exercised their right to redeem those shares for cash at an approximate price of $ 10.20 per share for an aggregate of approximately $ 208.5 million.\nOn January 31, 2023, the Company issued an aggregate of 6,250,000 Class A ordinary shares to the Sponsor, upon the conversion of an equal number of Class B ordinary shares held by the Sponsor (the “Conversion”). The 6,250,000 Class A ordinary shares issued in connection with the Conversion are subject to the same restrictions as applied to the Class B ordinary shares before the Conversion, including, among others, certain transfer restrictions, waiver of redemption rights and the obligation to vote in favor of an initial Business Combination as described in the prospectus for the Company’s initial public offering. Following the Conversion, there are 29,250,000 Class A ordinary shares issued and outstanding and no Class B ordinary shares issued and outstanding. As a result of the Conversion, the Sponsor held 21.4 % of the outstanding Class A ordinary shares.\n6\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nOn February 10, 2023, the Company instructed Continental to liquidate the investments held in the Trust Account and instead to hold the funds in the Trust Account in an interest-bearing demand deposit account at Morgan Stanley, with Continental continuing to act as trustee, until the earlier of the consummation of the Company’s initial Business Combination or the Company’s liquidation. As a result, following the liquidation of investments in the Trust Account, the remaining proceeds from the Initial Public Offering and Private Placement are no longer invested in U.S. government securities or money market funds.\nIf the Company is unable to complete a Business Combination by August 22, 2023 (or November 22, 2023 if the Company fully extends the time to complete a Business Combination, the “Combination Period”), the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem all Public Shares then outstanding at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including any amounts representing interest earned on the Trust Account, less any interest released to the Company for the payment of taxes, if any (and less up to $ 100,000 in interest reserved for expenses in connection with the Company’s dissolution), divided by the number of then outstanding Public Shares, which redemption will completely extinguish Public Shareholders’ rights as shareholders (including the right to receive further liquidation distributions, if any), and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the remaining shareholders and the Company’s board of directors, liquidate and dissolve, subject in the case of clauses (ii) and (iii) to the Company’s obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law.\nIn connection with the redemption of 100 % of the Company’s outstanding Public Shares for a portion of the funds held in the Trust Account, each holder will receive a full pro rata portion of the amount then in the Trust Account, plus any pro rata interest earned on the funds held in the Trust Account and not previously released to the Company to pay the Company’s taxes payable (less up to $ 100,000 of interest to pay dissolution expenses).\nThe Initial Shareholder agreed to waive its liquidation rights with respect to the Founder Shares if the Company fails to complete a Business Combination within the Combination Period. However, if the Initial Shareholder should acquire Public Shares in or after the Initial Public Offering, it will be entitled to liquidating distributions from the Trust Account with respect to such Public Shares if the Company fails to complete a Business Combination within the Combination Period. The underwriters agreed to waive their rights to their deferred underwriting commission (see Note 6) held in the Trust Account in the event the Company does not complete a Business Combination within the Combination Period, and, in such event, such amounts will be included with the funds held in the Trust Account that will be available to fund the redemption of the Public Shares. In the event of such distribution, it is possible that the per share value of the residual assets remaining available for distribution (including Trust Account assets) will be only $10.00 per share initially held in the Trust Account. In order to protect the amounts held in the Trust Account, the Sponsor agreed that it will be liable to the Company if and to the extent any claims by a third party for services rendered or products sold to the Company, or a prospective target business with which the Company has entered into a written letter of intent, confidentiality or other similar agreement or business combination agreement, reduce the amount of funds in the Trust Account to below the lesser of (i) $10.00 per Public Share and (ii) the actual amount per Public Share held in the Trust Account as of the date of the liquidation of the Trust Account, if less than $10.00 per share due to reductions in the value of the trust assets, less taxes payable, provided that such liability will not apply to any claims by a third party or prospective target business who executed a waiver of any and all rights to the monies held in the Trust Account (whether or not such waiver is enforceable) nor will it apply to any claims under the Company’s indemnity of the underwriters of the Initial Public Offering against certain liabilities, including liabilities under the Securities Act of 1933, as amended (the “Securities Act”). In the event that an executed waiver is deemed to be unenforceable against a third party, the Sponsor will not be responsible to the extent of any liability for such third-party claims. The Company will seek to reduce the possibility that the Sponsor will have to indemnify the Trust Account due to claims of creditors by endeavoring to have vendors, service providers (except the Company’s independent registered public accounting firm), prospective target businesses or other entities with which the Company does business, execute agreements with the Company waiving any right, title, interest or claim of any kind in or to monies held in the Trust Account.\n7\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nLiquidity and Going Concern\nAs of June 30, 2023, the Company had $ 0 in its operating bank account and working capital deficit of approximately $ 1.4 million.\nThe Company’s liquidity needs to date have been satisfied through a contribution of $ 25,000 from the Prior Sponsor to cover certain expenses in exchange for the issuance of the Founder Shares, a loan of approximately $ 111,000 from the Prior Sponsor pursuant to the IPO Note (as defined in Note 5), and a portion of the proceeds from the consummation of the Private Placement not held in the Trust Account. The Company repaid the IPO Note in full on February 24, 2021. In addition, in order to finance transaction costs in connection with a Business Combination, the Sponsor or an affiliate of the Sponsor, or certain of the Company’s officers and directors may, but are not obligated to, provide the Company Working Capital Loans (as defined in Note 5). As of June 30, 2023 and December 31, 2022, there were no amounts outstanding under any Working Capital Loans.\nOn April 13, 2022, the Company issued an unsecured promissory note in the amount of up to $ 200,000 to the Prior Sponsor (the “Promissory Note”). On May 25, 2022, the Company and the Prior Sponsor amended the Promissory Note agreement and increased the principal amount to $ 400,000 . The Promissory Note bears no interest and is due and payable within one year from the date of the first drawdown of the amended and restated note, or June 7, 2023. On June 30, 2022, the Prior Sponsor assigned all of its rights and obligations under the Promissory Note to the New Sponsor in connection with the Sponsor Transaction. As of June 30, 2023, the Company has fully drawn $ 400,000 under the Promissory Note. As of June 30, 2023 and December 31, 2022, approximately $ 400,000 and $ 319,000 were outstanding under the Promissory Note, respectively.\nThe Company may need to raise additional capital through loans or additional investments from its Sponsor, its officers or directors or their affiliates. The Company’s officers, directors and Sponsor, or their affiliates, may, but are not obligated to, loan the Company funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet the Company’s working capital needs. Accordingly, the Company may not be able to obtain additional financing. If the Company is unable to raise additional capital, it may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, reducing overhead expenses, and extending the terms and due dates of certain accrued expenses and other liabilities. The Company cannot provide any assurance that new financing will be available to it on commercially acceptable terms, if at all. In connection with the Company’s assessment of going concern considerations in accordance with FASB ASC Topic 205-40, “Presentation of Financial Statements - Going Concern” (“ASC 205-40”), management has determined that the liquidity condition, mandatory liquidation and subsequent dissolution raises substantial doubt about the Company’s ability to continue as a going concern. Management continues to seek to complete a Business Combination prior to the mandatory liquidation date. No adjustments have been made to the carrying amounts of assets or liabilities should the Company be required to liquidate after November 22, 2023. The accompanying financial statements do not include any adjustment that might be necessary if the Company is unable to continue as a going concern.\nNote 2 - Basis of Presentation and Summary of Significant Accounting Policies\nBasis of Presentation\nThe accompanying unaudited condensed financial statements are presented in U.S. dollars in conformity with accounting principles generally accepted in the United States of America (“GAAP”) for financial information and pursuant to the rules and regulations of the SEC. Accordingly, certain disclosures included in the annual financial statements have been condensed or omitted from the accompanying unaudited condensed financial statements as they are not required for interim financial statements under GAAP and the rules of the SEC. In the opinion of management, the accompanying unaudited condensed financial statements reflect all adjustments, which include only normal recurring adjustments necessary for the fair statement of the balances and results for the periods presented. Operating results for the three and six months ended June 30, 2023 are not necessarily indicative of the results that may be expected through December 31, 2023 or any future period.\nThe accompanying unaudited condensed financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Annual Report on Form 10-K for the fiscal year ended December 31, 2022, as filed by the Company with the SEC on April 18, 2023 (the “2022 Annual Report”).\n8\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nEmerging Growth Company\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the independent registered public accounting firm attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that an emerging growth company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such an election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the accompanying unaudited condensed financial statements with another public company that is neither an emerging growth company nor an emerging growth company that has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\nUse of Estimates\nThe preparation of the accompanying unaudited condensed financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited condensed financial statements and the reported amounts of revenues and expenses during the reporting periods. Making estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the accompanying unaudited condensed financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. One of the more significant accounting estimates included in the accompanying unaudited condensed financial statements is the determination of the fair value of the derivative liabilities. Accordingly, the actual results could differ from those estimates.\nCash and Cash Equivalents\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company had no cash equivalents as of June 30, 2023 and December 31, 2022.\nConcentration of Credit Risk\nFinancial instruments that potentially subject the Company to concentrations of credit risk consist of cash accounts in a financial institution, which, regularly exceed the Federal Deposit Insurance Corporation coverage limit of $ 250,000 . Any loss incurred or a lack of access to such funds could have a significant adverse impact on the Company’s financial condition, results of operations, and cash flows.\nCash and Investments Held in the Trust Account\nThe Company classifies its U.S. Treasury and equivalent securities as held to maturity in accordance with FASB Accounting Standard Codification (“ASC”) Topic 320, “Investments – Debt and Equity Securities.” Held-to-maturity securities are those securities which the Company has the ability and intent to hold until maturity. Held-to-maturity treasury securities are recorded at amortized cost on the accompanying consolidated balance sheets and adjusted for the amortization or accretion of premiums or discounts.\nAt June 30, 2023, substantially all of the assets held in the Trust Account were held in cash. At December 31, 2022, substantially all of the assets held in the Trust Account were held in money market funds which invest primarily in U.S. Treasury securities. The money market funds are presented at fair value within the accompanying consolidated balance sheets, and fair value of the investments in the Trust Account is equal to the amortized cost basis of the money market funds.\nFair Value of Financial Instruments\nThe fair value of the Company’s assets and liabilities which qualify as financial instruments under the FASB ASC Topic 820, “Fair Value Measurements,” equal or approximate the carrying amounts represented in the condensed balance sheets.\n9\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nFair Value Measurements\n“Fair value” is defined as “the price that would be received for sale of an asset or paid for transfer of a liability, in an orderly transaction between market participants at the measurement date.” GAAP establishes a three-tier fair value hierarchy, which prioritizes inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). These tiers consist of:\n\n| ● | Level 1, defined as observable inputs such as quoted prices (unadjusted) for identical instruments in active markets; |\n\n\n| ● | Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable such as quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active; and |\n\n\n| ● | Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions, such as valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable. |\n\nIn some circumstances, the inputs used to measure fair value might be categorized within different levels of the fair value hierarchy. In those instances, the fair value measurement is categorized in its entirety in the fair value hierarchy based on the lowest level input that is significant to the fair value measurement.\nDerivative Liabilities\nThe Company does not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks. The Company evaluates all of its financial instruments, including issued warrants, to determine if such instruments are derivatives or contain features that qualify as embedded derivatives, pursuant to ASC 480 and ASC 815-15. The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is re-assessed at the end of each reporting period.\nThe Company accounts for its warrants issued in connection with its Initial Public Offering and Private Placement and units that may be issued in connection with a forward purchase agreement (the “Forward Purchase Units”) as derivative liabilities in accordance with ASC 815-40. Accordingly, the Company recognizes the instruments as liabilities at fair value and adjusts the instruments to fair value at the end of each reporting period. The liabilities are subject to re-measurement at each balance sheet date until exercised, and any change in fair value of derivative liabilities is recognized in the Company’s unaudited condensed statements of operations. The fair value of warrants issued in connection with the Initial Public Offering was initially measured using Monte-Carlo simulation and has subsequently been measured on the market price of such warrants at each measurement date when separately listed and traded. The fair value of warrants issued in connection with the Private Placement was initially measured using Black-Scholes Option Pricing Model and subsequently using the market value of the public warrants. The fair value of the Forward Purchase Units has been measured using the John C Hull’s Options, Futures and Other Derivatives model at each measurement date.\nOffering Costs Associated with the Initial Public Offering\nOffering costs consisted of legal, accounting, underwriting fees and other costs incurred through the Initial Public Offering that were directly related to the Initial Public Offering. Offering costs are allocated to the separable financial instruments issued in the Initial Public Offering based on a relative fair value basis, compared to total proceeds received. Offering costs associated with derivative liabilities are expensed as incurred, presented as non-operating expenses in the statements of operations in the period that the costs occurred. Offering costs associated with the Class A ordinary shares were charged against the carrying value of the Class A ordinary shares upon the completion of the Initial Public Offering. The Company classifies deferred underwriting commissions as non-current liabilities as their liquidation is not reasonably expected to require the use of current assets or require the creation of current liabilities.\nClass A Ordinary Shares Subject to Possible Redemption\nThe Company accounts for its Class A ordinary shares subject to possible redemption in accordance with the guidance in ASC Topic 480 “Distinguishing Liabilities from Equity.” Class A ordinary shares subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable Class A ordinary shares (including Class A ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) are classified as temporary equity. At all other times, Class A ordinary shares are classified as shareholders’ equity. The Company’s Class A ordinary shares feature certain redemption rights that are considered to be outside of the Company’s control and subject to the occurrence of uncertain future events. Accordingly, as of June 30, 2023 and December 31, 2022, 2,548,153 and 23,000,000 Class A Ordinary Shares subject to possible redemption are presented as temporary equity, outside of the shareholders’ deficit section of the accompanying condensed balance sheets, respectively.\n10\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nThe Company recognizes changes in redemption value immediately as they occur and adjusts the carrying value of the Class A ordinary shares subject to possible redemption to equal the redemption value at the end of each reporting period. This method would view the end of the reporting period as if it were also the redemption date for the security. Effective with the closing of the Initial Public Offering, the Company recognized the accretion from initial book value to redemption amount, which resulted in charges against additional paid-in capital (to the extent available) and accumulated deficit.\nShare-Based Compensation\nThe Company complies with the accounting and disclosure requirement of ASC Topic 718, “Compensation – Stock Compensation.” Share-based compensation to employees and non-employees is recognized over the requisite service period based on the estimated grant-date fair value of the awards. Share-based awards with graded-vesting schedules are recognized on a straight-line basis over the requisite service period for each separately vesting portion of the award. The Company recognizes the expense for share-based compensation awards subject to performance-based milestone vesting over the remaining service period when management determines that achievement of the milestone is probable. Management evaluates when the achievement of a performance-based milestone is probable based on the expected satisfaction of the performance conditions at each reporting date. Share-based compensation will be recognized in general and administrative expense in the statements of operations. The Company issued option awards that contain both a performance condition and service condition. The option awards vest upon the consummation of the initial Business Combination and will expire in five years after the date on which they first become exercisable. The Company has determined that the consummation of an initial Business Combination is a performance condition subject to significant uncertainty. As such, the achievement of the performance is not deemed to be probable of achievement until the consummation of the event, and therefore no compensation has been recognized for the period from inception to June 30, 2023.\nIncome Taxes\nFASB ASC Topic 740, “Income Taxes,” prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The Company’s management determined that the Cayman Islands is the Company’s only major tax jurisdiction. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of June 30, 2023 and December 31, 2022. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position.\nThere is currently no taxation imposed on income by the Government of the Cayman Islands. In accordance with Cayman federal income tax regulations, income taxes are not levied on the Company. Consequently, income taxes are not reflected in the accompanying unaudited condensed financial statements. The Company’s management does not expect that the total amount of unrecognized tax benefits will materially change over the next twelve months.\nNet (Loss) Income per Ordinary Share\nThe Company complies with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share.” The Company has two classes of shares, which are referred to as Class A ordinary shares and Class B ordinary shares. Income and losses are shared pro rata between the two classes of shares. Net (loss) income per ordinary share is calculated by dividing the net (loss) income by the weighted average number of ordinary shares outstanding for the respective period.\nThe calculation of diluted net (loss) income per ordinary share does not consider the effect of the warrants underlying the Units sold in the Initial Public Offering and the Private Placement Warrants to purchase an aggregate of 12,066,667 Class A ordinary shares since their exercise is contingent upon future events. As a result, diluted net (loss) income per share is the same as basic net (loss) income per share for the three and six months ended June 30, 2023 and 2022. Accretion associated with the redeemable Class A ordinary shares is excluded from earnings per share as the redemption value approximates fair value.\n11\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nThe table below presents a reconciliation of the numerator and denominator used to compute basic and diluted net (loss) income per share for each class of Ordinary Shares:\n\n| For the Three Months Ended June 30, |\n| 2023 | 2022 |\n| Class A | Class B | Class A | Class B |\n| Numerator: |\n| Allocation of net (loss) income | $ | ( 458,126 | ) | $ | — | $ | 825,025 | $ | 224,192 |\n| Denominator: |\n| Weighted average ordinary shares outstanding, basic and diluted | 8,798,153 | — | 23,000,000 | 6,250,000 |\n| Basic and diluted net (loss) income per ordinary share | $ | ( 0.05 | ) | $ | — | $ | 0.04 | $ | 0.04 |\n\n\n| For the Six Months Ended June 30, |\n| 2023 | 2022 |\n| Class A | Class B | Class A | Class B |\n| Numerator: |\n| Allocation of net income | $ | 141,383 | $ | 10,868 | $ | 4,033,797 | $ | 1,096,141 |\n| Denominator: |\n| Weighted average ordinary shares outstanding, basic and diluted | 13,551,176 | 1,041,667 | 23,000,000 | 6,250,000 |\n| Basic and diluted net income per ordinary share | $ | 0.01 | $ | 0.01 | $ | 0.18 | $ | 0.18 |\n\nRecent Accounting Pronouncements\nThe Company’s management does not believe that any recently issued, but not yet effective, accounting standards updates, if currently adopted, would have a material effect on the accompanying unaudited condensed financial statements.\nNote 3 - Initial Public Offering\nOn February 22, 2021, the Company consummated its Initial Public Offering of 23,000,000 Units, including 3,000,000 Over-Allotment Units, at $ 10.00 per Unit, generating gross proceeds of $ 230.0 million, and incurring offering costs of approximately $ 13.1 million, of which approximately $ 8.1 million was for deferred underwriting commissions.\nEach Unit consists of one Class A ordinary share and one-third of one redeemable warrant (“Public Warrant”). Each whole Public Warrant will entitle the holder to purchase one Class A ordinary share at an exercise price of $ 11.50 per share, subject to adjustment (see Note 7).\nNote 4 - Private Placement\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the Private Placement of 4,400,000 Private Placement Warrants, at a price of $ 1.50 per Private Placement Warrant with the Prior Sponsor, generating gross proceeds of $ 6.6 million, and incurring offering costs of approximately $ 7,000 . On June 15, 2022, the Prior Sponsor transferred 4,400,000 Private Placement Warrants to the New Sponsor.\nEach whole Private Placement Warrant is exercisable for one whole Class A ordinary share at a price of $ 11.50 per share. A portion of the proceeds from the sale of the Private Placement Warrants to the Prior Sponsor was added to the proceeds from the Initial Public Offering held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the Private Placement Warrants will expire worthless. The Private Placement Warrants will be non-redeemable for cash and exercisable on a cashless basis so long as they are held by the Sponsor or its permitted transferees.\nThe Sponsor agreed, subject to limited exceptions, not to transfer, assign or sell any of its Private Placement Warrants until 30 days after the completion of the initial Business Combination.\n12\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nNote 5 - Related Party Transactions\nForward Purchase Agreement\nIn connection with the consummation of the Initial Public Offering, the Company entered into a forward purchase agreement (the “Forward Purchase Agreement”) with the Prior Sponsor, which provides for the purchase of $ 20.0 million Forward Purchase Units, which at the option of the Prior Sponsor, can be increased to $ 50.0 million, with each Forward Purchase Unit consisting of one Class A ordinary share (the “Forward Purchase Shares”) and one-third of one warrant to purchase one Class A ordinary share at $ 11.50 per share (the “Forward Purchase Warrants,” together with the Forward Purchase Units and the Forward Purchase Shares, the “Forward Purchase Securities”), for a purchase price of $ 10.00 per Forward Purchase Unit, in a private placement to occur concurrently with the closing of the initial Business Combination. The purchase under the Forward Purchase Agreement is required to be made regardless of whether any Class A ordinary shares are redeemed by the Public Shareholders. The Forward Purchase Securities will be issued only in connection with the closing of the initial Business Combination. The proceeds from the sale of Forward Purchase Securities may be used as part of the consideration to the sellers in the initial Business Combination, expenses in connection with the initial Business Combination or for working capital in the post-transaction company. The Company does not intend to implement the forward purchase agreement, and on April 17, 2023, the Company sent a notice of mutual termination of the forward purchase agreement to the prior sponsor. The Company classified the Forward Purchase Units as derivative instruments on the accompanying condensed balance sheets. The initial value of the Forward Purchase Units was insignificant, and the Company recognized a loss in the change in the fair value of the derivative assets (liabilities) of approximately $ 0 and $ 0 for the three and six months ended June 30, 2023, respectively, and approximately $ 19,000 and $ 49,000 for the three and six months ended June 30, 2022, respectively.\nFounder Shares\nOn September 21, 2020, the Company issued 4,812,500 Class B ordinary shares, par value $ 0.001 per share (the “Founder Shares”) to the Prior Sponsor. On September 23, 2020, the Prior Sponsor paid an aggregate of $ 25,000 for certain expenses on behalf of the Company in exchange for issuance of the Founder Shares. On January 25, 2021, the Company effected a stock dividend of 1,437,500 shares with respect to Class B ordinary shares, resulting in an aggregate of 6,250,000 Founder Shares outstanding. The Prior Sponsor agreed to forfeit up to an aggregate of 750,000 Founder Shares, on a pro rata basis, to the extent that the option to purchase additional Units was not exercised in full by the underwriters, so that the Founder Shares would represent 20 % of the Company’s issued and outstanding shares after the Initial Public Offering plus the 2,000,000 Forward Purchase Shares underlying the Forward Purchase Units (which at the option of the Prior Sponsor can be increased to up to 5,000,000 Forward Purchase Shares). On February 22, 2021, the underwriter fully exercised its over-allotment option; thus, these 750,000 Founder Shares were no longer subject to forfeiture.\nOn June 15, 2022, the Prior Sponsor transferred all 6,250,000 Founder Shares to the New Sponsor.\nThe New Sponsor agreed not to transfer, assign or sell any of its Founder Shares until the earlier to occur of (i) one year after the date of the consummation of the initial Business Combination, or earlier if, subsequent to the initial Business Combination, (x) the last reported sale price of the Class A ordinary shares equals or exceeds $ 12.00 per share (as adjusted for share splits, share dividends, reorganizations and recapitalizations) for any 20 trading days within any 30-trading day period commencing at least 150 days after the initial Business Combination or (y) the Company consummates a subsequent liquidation, merger, stock exchange or other similar transaction which results in all of the shareholders having the right to exchange their Ordinary shares for cash, securities or other property.\nRelated Party Loans\nOn September 23, 2020, the Prior Sponsor agreed to loan the Company up to $ 250,000 to cover costs related to the Initial Public Offering pursuant to a promissory note, which was later amended on January 22, 2021 (the “IPO Note”). The IPO Note was non-interest bearing, unsecured and due upon the closing of the Initial Public Offering. As of February 22, 2021, the Company borrowed approximately $ 111,000 under the IPO Note. The Company repaid the IPO Note in full on February 24, 2021. Subsequent to the repayment, the facility was no longer available to the Company.\n13\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nIn addition, in order to finance transaction costs in connection with a Business Combination, the Sponsor, members of the Company’s founding team or any of their affiliates may, but are not obligated to, loan the Company funds as may be required (“Working Capital Loans”). If the Company completes a Business Combination, the Company would repay the Working Capital Loans out of the proceeds of the Trust Account released to the Company. Otherwise, the Working Capital Loans would be repaid only out of funds held outside the Trust Account. In the event that a Business Combination does not close, the Company may use a portion of proceeds held outside the Trust Account to repay the Working Capital Loans but no proceeds held in the Trust Account would be used to repay the Working Capital Loans. The Working Capital Loans would either be repaid upon consummation of a Business Combination, without interest, or, at the lenders’ discretion, up to $ 1.5 million of such Working Capital Loans may be convertible into warrants of the post Business Combination entity at a price of $ 1.50 per warrant. The warrants would be identical to the Private Placement Warrants. Except for the foregoing, the terms of such Working Capital Loans, if any, have not been determined and no written agreements exist with respect to such loans. As of June 30, 2023 and December 31, 2022, the Company had no borrowings under any Working Capital Loans.\nOn April 13, 2022, the Company issued the Promissory Note to the Prior Sponsor for an aggregate of up to $ 200,000 . On May 25, 2022, the Prior Sponsor amended the Promissory Note agreement and increased the principal amount to $ 400,000 . The Promissory Note bears no interest, may be prepaid at any time and is due and payable within one year from the date of the first drawdown of the amended and restated note, or June 7, 2023. On June 30, 2022, the Prior Sponsor assigned all of its rights and obligations under the Promissory Note to the New Sponsor in connection with the Sponsor Transaction. As of June 30, 2023, the Company has fully drawn $ 400,000 under the Promissory Note. As of June 30, 2023 and December 31, 2022, approximately $ 400,000 and $ 319,000 were outstanding under the Promissory Note, respectively.\nExtension Loan\nPursuant to the Extension, as described in Note 1, the Sponsor or its designees contributed to the Company as a loan the initial contribution of $ 120,000 in February 2023 for the portion of the extension ending on April 22, 2023. The Sponsor will also loan the company extension contributions of $ 60,000 per month for each subsequent calendar month (commencing on April 22, 2023 and on the 22nd day of each subsequent month) until November 22, 2023, or portion thereof, that is needed to complete an initial Business Combination, which amount will be deposited into the Trust Account. As of June 30, 2023, the Company has drawn $ 270,000 on the Extension Loan and deposited it into the Trust Account.\nRelated Party Advance\nFor the three and six months ended June 30, 2023, the Sponsor had paid $ 164,081 and $ 188,722 , respectively, of expenses on behalf on Company, which are included in advance from related parties in the accompanying condensed balance sheets as of June 30, 2023.\nAdministrative Services Agreement\nCommencing on February 17, 2021, through the earlier of consummation of the initial Business Combination and the liquidation, the Company agreed to pay Kismet LLC, an affiliate of the Prior Sponsor, $ 10,000 per month for office space, utilities, secretarial support and administrative services.\nOn June 30, 2022, in connection with the Sponsor Transaction, the Company and Kismet LLC mutually terminated the Administrative Services Agreement. As a result, the Company is no longer obligated to pay a $ 10,000 monthly fee pursuant to the Administrative Services Agreement.\nDirector Compensation\nCommencing on February 18, 2021, the Company paid its initial directors $ 40,000 each. On May 25, 2022, Mr. Verdi Israelyan, a former director, waived his right to receive a payment of $ 40,000 . The Company also granted two of its independent directors, Messrs. Tompsett and Zilber, an option each to purchase 40,000 Class A ordinary shares at an exercise price of $ 10.00 per share, which will vest upon the consummation of the initial Business Combination and will expire five years after the date on which it first became exercisable Further, following the approval of the Extension, the compensation committee of the Company’s board of directors has approved the transfers by the Sponsor of (a) 15,000 Founder Shares to each of Messrs. Zilber and Tourevski and (b) 20,000 Founder Shares to Mr. Tompsett as additional compensation, which transfers will take place prior to the closing of the initial Business Combination. Both the Founder Shares and the options granted to the directors are subject to forfeiture in the event a director ceases to serve on the Company’s board prior to the closing of a Business Combination. In addition, the Sponsor, executive officers and directors, or any of their respective affiliates will be reimbursed for any out-of-pocket expenses incurred in connection with activities on the Company’s behalf such as identifying potential target businesses and performing due diligence on suitable Business Combinations. The Company’s audit committee reviews, on a quarterly basis, all payments that are made to the Sponsor, officers or directors, or the Company’s or their affiliates.\nOn May 25, 2022, one of the Company’s former directors waived his right to receive a payment of $ 40,000 and the Company recorded approximately $ 0 of director compensation during three and six months ended June 30, 2023 , and approximately $( 12,000 ) and $ 3,000 of director compensation during the three and six months ended June 30, 2022, respectively. As of June 30, 2023 and December 31, 2022, the Company had no amounts outstanding in relation to the director compensation.\n14\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nDeparture and Appointment of Officers\nOn June 30, 2022, concurrently with the Sponsor Transaction, Ivan Tavrin, Chief Executive Officer and Chairman of the Company’s board of directors, resigned as Chairman and Chief Executive Officer of the Company, and as the Company’s principal financial and accounting officer.\nEffective June 30, 2022, the Company’s board of directors appointed Mr. Dimitri Elkin to serve as the Company’s Chief Executive Officer. Mr. Elkin is also serving as the Company’s principal financial and accounting officer.\nOn September 5, 2022, Verdi Israelyan, resigned from the board of directors of the Company. Mr. Israelyan resignation was not the result of any dispute or disagreement with the Company or the Company’s board of directors on any matter relating to the Company’s operations, policies or practices. On March 27, 2023, the board of directors elected Konstantin Tourevski as a director and as a member of the audit committees to fill the vacancy caused by the resignation of Mr. Israelyan.\nNote 6 - Commitments and Contingencies\nRegistration Rights\nThe holders of the Founder Shares and Private Placement Warrants (and any Class A ordinary shares issuable upon the exercise of the Private Placement Warrants and warrants that may be issued upon conversion of Working Capital Loans) were entitled to registration rights pursuant to a registration rights agreement dated February 17, 2021 (the “Registration Rights Agreement”). The holders of these securities are entitled to make up to three demands, excluding short form demands, that the Company register such securities. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the completion of the initial Business Combination. The Company will bear the expenses incurred in connection with the filing of any such registration statements. On June 30, 2022, in connection with the Sponsor Transaction, the Prior Sponsor assigned to the New Sponsor all of its rights and obligations under the Registration Rights Agreement.\nPursuant to the Forward Purchase Agreement, the Company agreed to use its commercially reasonable efforts (i) to file within 30 days after the closing of the initial Business Combination a registration statement with the SEC for a secondary offering of the Forward Purchase Shares and the Forward Purchase Warrants (and underlying Class A Ordinary Shares), (ii) to cause such registration statement to be declared effective promptly thereafter but in no event later than sixty (60) days after the initial filing, and (iii) to maintain the effectiveness of such registration statement until the earliest of (A) the date on the Prior Sponsor or its assignees cease to hold the securities covered thereby and (B) the date all of the securities covered thereby can be sold publicly without restriction or limitation under Rule 144 under the Securities Act. In addition, the Forward Purchase Agreement provides for “piggy-back” registration rights to the holders of Forward Purchase Securities to include their securities in other registration statements filed by the Company.\nUnderwriting Agreement\nThe Company granted the underwriters a 45-day option from February 17, 2021, to purchase up to 3,000,000 additional Units at the Initial Public Offering price less the underwriting discounts and commissions. On February 22, 2021, the underwriters fully exercised their over-allotment option.\nThe underwriters were entitled to an underwriting discount of $ 0.20 per Unit, or $ 4.6 million in the aggregate, paid upon the closing of the Initial Public Offering. In addition, $ 0.35 per Unit, or approximately $ 8.1 million in the aggregate will be payable to the underwriters for deferred underwriting commissions. The deferred fee will become payable to the underwriters from the amounts held in the Trust Account solely in the event that the Company completes a Business Combination, subject to the terms of the underwriting agreement.\nOn August 11, 2022 and September 6, 2022, two of the underwriters in the initial public offering irrevocably waived their rights to receive an aggregate of approximately $ 5.2 million of deferred underwriting discounts due under the underwriting agreements consummated in connection with the initial public offering. The Company recognized the portion allocated to Public Shares of approximately $ 5.0 million as an adjustment to the carrying value of the Class A ordinary shares subject to possible redemption and the remaining balance of approximately $ 0.2 million as a gain from extinguishment of deferred underwriting commissions allocated to derivative warrant liabilities.\nRisks and Uncertainties\nManagement continues to evaluate the impact of the COVID-19 pandemic on the industry and has concluded that while it is reasonably possible that the virus could have a negative effect on the Company’s financial position, results of its operations and/or search for a target company, the specific impact is not readily determinable as of the date of these unaudited condensed financial statements. The accompanying unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty.\n15\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nIn February 2022, a military conflict started between Russia and Ukraine. The ongoing military conflict between Russia and Ukraine has provoked strong reactions from the United States, the United Kingdom, the European Union and various other countries around the world, including the imposition of broad financial and economic sanctions against Russia. Further, the precise effects of the ongoing military conflict and these sanctions on the global economies remain uncertain as of the date of the accompanying unaudited condensed financial statements. The specific impact on the Company’s financial condition, results of operations, and cash flows is also not determinable as of the date of the accompanying unaudited condensed financial statements.\nNote 7 - Warrants\nAs of June 30, 2023 and December 31, 2022, 7,666,667 Public Warrants and 4,400,000 Private Placement Warrants were outstanding.\nPublic Warrants may only be exercised for a whole number of Class A Ordinary Shares. No fractional Public Warrants will be issued upon separation of the Units and only whole Public Warrants will trade. The Public Warrants will become exercisable on the later of (a) 30 days after the completion of a Business Combination or (b) 12 months from the closing of the Initial Public Offering; provided in each case that the Company has an effective registration statement under the Securities Act covering the Class A Ordinary Shares issuable upon exercise of the Public Warrants and a current prospectus relating to them is available and such shares are registered, qualified or exempt from registration under the securities, or blue sky, laws of the state of residence of the holder (or the Company permits holders to exercise their warrants on a cashless basis under certain circumstances). The Company agreed that as soon as practicable, but in no event later than 15 business days after the closing of the initial Business Combination, the Company will use commercially reasonable efforts to file with the SEC and have an effective registration statement covering the Class A Ordinary Shares issuable upon exercise of the warrants and to maintain a current prospectus relating to those Class A Ordinary Shares until the warrants expire or are redeemed, as specified in the warrant agreement. If a registration statement covering the Class A Ordinary Shares issuable upon exercise of the warrants is not effective by the 60th day after the closing of the initial Business Combination, warrant holders may, until such time as there is an effective registration statement and during any period when the Company will have failed to maintain an effective registration statement, exercise warrants on a “cashless basis” in accordance with Section 3(a)(9) of the Securities Act or another exemption. Notwithstanding the above, if the Class A Ordinary Shares are at the time of any exercise of a warrant not listed on a national securities exchange such that they satisfy the definition of a “covered security” under Section 18(b)(1) of the Securities Act, the Company may, at its option, require holders of Public Warrants who exercise their warrants to do so on a “cashless basis” and, in the event the Company so elects, the Company will not be required to file or maintain in effect a registration statement, and in the event the Company does not so elect, it will use commercially reasonable efforts to register or qualify the shares under applicable blue sky laws to the extent an exemption is not available.\nThe warrants have an exercise price of $11.50 per share, subject to adjustments, and will expire five years after the completion of a Business Combination or earlier upon redemption or liquidation. In addition, if (x) the Company issues additional Class A Ordinary Shares or equity-linked securities for capital raising purposes in connection with the closing of the initial Business Combination at an issue price or effective issue price of less than $9.20 per Class A Ordinary Share (with such issue price or effective issue price to be determined in good faith by the Company’s board of directors and, in the case of any such issuance to the Sponsor or an affiliate of the Sponsor, without taking into account any Founder Shares held by the Sponsor or an affiliate of the Sponsor, as applicable, prior to such issuance) (the “Newly Issued Price”), (y) the aggregate gross proceeds from such issuances represent more than 60% of the total equity proceeds, and interest thereon, available for the funding of the initial Business Combination on the date of the completion of the initial Business Combination (net of redemptions), and (z) the volume-weighted average trading price of the Class A Ordinary Shares during the 20 trading day period starting on the trading day prior to the day on which the Company completes its initial Business Combination (such price, the “Market Value”) is below $9.20 per share, the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115% of the higher of the Market Value and the Newly Issued Price, and the $10.00 and $18.00 per share redemption trigger prices described under “Redemption of warrants when the price per Class A Ordinary Share equals or exceeds $18.00” and “Redemption of warrants when the price per Class A Ordinary Share equals or exceeds $10.00” will be adjusted (to the nearest cent) to be equal to 100% and 180% of the higher of the Market Value and the Newly Issued Price, respectively.\n16\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nThe Private Placement Warrants are identical to the Public Warrants underlying the Units sold in the Initial Public Offering, except that the Private Placement Warrants and the Class A Ordinary Shares issuable upon exercise of the Private Placement Warrants will not be transferable, assignable or sellable until 30 days after the completion of a Business Combination, subject to certain limited exceptions. Additionally, the Private Placement Warrants will be non-redeemable so long as they are held by the initial purchaser or such purchaser’s permitted transferees. If the Private Placement Warrants are held by someone other than the Initial Shareholder or its permitted transferees, the Private Placement Warrants will be redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants.\nRedemption of Warrants When the Price per Class A Ordinary Share Equals or Exceeds $ 18.00\nOnce the warrants become exercisable, the Company may call the outstanding warrants (excluding the Private Placement Warrants), in whole and not in part, at a price of $ 0.01 per warrant:\n\n| ● | upon a minimum of 30 days’ prior written notice of redemption; and |\n\n\n| ● | if, and only if, the last reported sale price of the Class A Ordinary Shares equals or exceeds $ 18.00 per share (as adjusted) for any 20 trading days within a 30 trading day period ending three business days before the Company sends the notice of redemption to the warrant holders (the “Reference Value”). |\n\nThe Company will not redeem the warrants as described above unless a registration statement under the Securities Act covering the Class A Ordinary Shares issuable upon exercise of the warrants is then effective and a current prospectus relating to those Class A Ordinary Shares is available throughout the 30-trading day redemption period.\nRedemption of Warrants When the Price per Class A Ordinary Share Equals or Exceeds $ 10.00\nOnce the warrants become exercisable, the Company may redeem the outstanding warrants, in whole and not in part, at a price of $ 0.10 per warrant:\n\n| ● | upon a minimum of 30 days’ prior written notice of redemption provided that holders will be able to exercise their warrants on a cashless basis prior to redemption and receive that number of Class A Ordinary Shares to be determined by reference to an agreed table based on the redemption date and the “fair market value” of Class A Ordinary Shares; and |\n\n\n| ● | if, and only if, and only if, the Reference Value equals or exceeds $ 10.00 per Public Share (as adjusted), and |\n\n\n| ● | if the Reference Value is less than $ 18.00 per share (as adjusted), the Private Placement Warrants must also be concurrently called for redemption on the same terms as the outstanding Public Warrants, as described above. |\n\nThe “fair market value” of Class A Ordinary Shares for the above purpose shall mean the volume-weighted average price of the Class A Ordinary Shares for the 10 trading days immediately following the date on which the notice of redemption is sent to the holders of warrants. In no event will the warrants be exercisable in connection with this redemption feature for more than 0.361 Class A Ordinary Shares per warrant (subject to adjustment).\nIn no event will the Company be required to net cash settle any warrant. If the Company is unable to complete a Business Combination within the Combination Period and the Company liquidates the funds held in the Trust Account, holders of warrants will not receive any of such funds with respect to their warrants, nor will they receive any distribution from the Company’s assets held outside of the Trust Account with the respect to such warrants. Accordingly, the warrants may expire worthless.\n17\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nNote 8 - Class A Ordinary Shares Subject to Possible Redemption\nThe Class A ordinary shares feature certain redemption rights that are considered to be outside of the Company’s control and subject to the occurrence of future events. The Company is authorized to issue 200,000,000 Class A ordinary shares with a par value of $ 0.001 per share. Holders of the Class A ordinary shares are entitled to one vote for each share. In connection with such shareholders’ meeting, shareholders holding 20,451,847 Class A ordinary shares exercised their right to redeem those shares for cash at an approximate price of $ 10.20 per share for an aggregate of approximately $ 208.5 million. As of June 30, 2023 and December 31, 2022, there were 2,548,153 and 23,000,000 Class A Ordinary Shares outstanding, respectively, which were all subject to possible redemption and are classified outside of permanent equity in the accompanying condensed balance sheets.\nThe Class A Ordinary Shares subject to possible redemption reflected on the accompanying condensed balance sheets are reconciled on the following table:\n\n| Gross proceeds received from Initial Public Offering | $ | 230,000,000 |\n| Less: |\n| Fair value of Public Warrants at issuance | ( 6,823,334 | ) |\n| Offering costs allocated to Class A ordinary shares | ( 12,685,596 | ) |\n| Plus: |\n| Accretion on Class A ordinary shares subject to possible redemption | 19,508,930 |\n| Class A ordinary shares subject to possible redemption as of December 31, 2021 | 230,000,000 |\n| Plus: |\n| Waiver of Class A ordinary shares issuance costs | 5,077,217 |\n| Less: |\n| Accretion on Class A ordinary shares subject to possible redemption | ( 1,872,702 | ) |\n| Class A ordinary shares subject to possible redemption as of December 31, 2022 | 233,204,515 |\n| Less: |\n| Redemptions | ( 208,524,538 | ) |\n| Plus: |\n| Accretion on Class A ordinary shares subject to possible redemption | 1,560,982 |\n| Class A ordinary shares subject to possible redemption as of March 31, 2023 | 26,240,959 |\n| Plus: |\n| Accretion on Class A ordinary shares subject to possible redemption | 390,284 |\n| Class A ordinary shares subject to possible redemption as of June 30, 2023 | $ | 26,631,243 |\n\nNote 9 - Shareholders’ Deficit\nClass A Ordinary Shares\nThe Company is authorized to issue 200,000,000 Class A Ordinary Shares with a par value of $ 0.001 per share. Holders of the Class A Ordinary Shares are entitled to one vote for each share. As of June 30, 2023 and December 31, 2022, there were 6,250,000 and 0 Class A Ordinary Shares issued and outstanding, excluding 2,548,153 and 23,000,000 which were subject to possible redemption and included as temporary equity, respectively (see Note 8).\nClass B Ordinary Shares\nThe Company is authorized to issue 10,000,000 Class B Ordinary Shares with a par value of $ 0.001 per share. As of June 30, 2023 and December 31, 2022, there were 0 and 6,250,000 Class B Ordinary Shares issued and outstanding, respectively.\nOrdinary shareholders of record are entitled to one vote for each share held on all matters to be voted on by shareholders. Except as described below, holders of Class A ordinary shares and holders of Class B ordinary shares vote together as a single class on all matters submitted to a vote of the shareholders except as required by law.\nThe Class B ordinary shares will automatically convert into Class A ordinary shares at the time of the initial Business Combination or earlier at the option of the holders thereof at a ratio such that the number of Class A ordinary shares issuable upon conversion of all Founder Shares will equal, in the aggregate, on an as-converted basis, 20 % of the sum of (i) the total number of the Ordinary Shares issued and outstanding upon completion of the Initial Public Offering, plus (ii) the total number of Class A ordinary shares issued or deemed issued or issuable upon conversion or exercise of any equity-linked securities or rights issued or deemed issued by the Company in connection with or in relation to the completion of the initial Business Combination (including the Forward Purchase Shares, but not the Forward Purchase Warrants), excluding any Class A ordinary shares or equity-linked securities exercisable for or convertible into Class A ordinary shares issued, deemed issued, or to be issued, to any seller in the initial Business Combination and any Private Placement Warrants issued to the Sponsor or any of its affiliates or any member of the Company’s management team upon conversion of Working Capital Loans. In no event will the Class B ordinary shares convert into Class A ordinary shares at a rate of less than one-to-one.\n18\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nNote 10 - Fair Value Measurements\nThe following tables present information about the Company’s assets and liabilities that are measured at fair value on a recurring basis as of June 30, 2023 and December 31, 2022 and indicates the fair value hierarchy of the valuation techniques that the Company utilized to determine such fair value.\n\n| Fair Value Measured as of June 30, 2023 |\n| Level 1 | Level 2 | Level 3 |\n| Liabilities: |\n| Derivative liabilities - Public Warrants | $ | — | $ | 514,433 | $ | — |\n| Derivative liabilities - Private Placement Warrants | $ | — | $ | 295,240 | $ | — |\n\n\n| Fair Value Measured as of December 31, 2022 |\n| Level 1 | Level 2 | Level 3 |\n| Assets |\n| Investments held in Trust Account - U.S. Treasury Securities | $ | 233,304,515 | $ | — | $ | — |\n| Liabilities: |\n| Derivative liabilities - Public Warrants | $ | — | $ | 19,167 | $ | — |\n| Derivative liabilities - Private Placement Warrants | $ | — | $ | 11,000 | $ | — |\n\nTransfers to/from Levels 1, 2, and 3 are recognized in the beginning of the reporting period. The estimated fair value of the Public Warrants was transferred from a Level 3 measurement to a Level 1 fair value measurement in April 2021, when the Public Warrants were separately listed and traded. The estimated fair value of the Private Placement Warrants was transferred from a Level 3 measurement to a Level 2 fair value measurement during the year ended December 31, 2021. The estimated fair value of the Public Warrants transferred to a Level 2 measurement during the quarter ending December 31, 2022 due to low trading volume. There were no transfers to/from Levels 1, 2, and 3 during the three and six months ended June 30, 2023.\nLevel 1 assets include investments in mutual funds that invest solely in U.S. government securities. The Company uses inputs such as actual trade data, quoted market prices from dealers or brokers, and other similar sources to determine the fair value of its investments.\nThe fair value of the Public Warrants was initially measured using a Monte-Carlo simulation and has subsequently been measured based on the market price of such warrants at each measurement date when separately listed and traded. The fair value of the Private Placement Warrants was initially measured using a Black-Scholes Option Pricing Model and subsequently using the market value of the Public Warrants. For the three months ended June 30, 2023 and 2022, the Company recognized a decrease/(increase) in the fair value of derivative warrant liabilities of approximately $( 538,000 ) and $ 845,000 , and approximately $( 780,000 ) and $ 5.1 million for the six months ended June 30, 2023 and 2022, respectively, presented on the accompanying condensed statements of operations.\nThe Company utilized John C. Hull’s Options, Futures, and Other Derivatives model to estimate the fair value of the Forward Purchase Units at each measurement date up until September 30, 2023. As the Company does not intend to implement the forward purchase agreement, the Company determined the fair value of the Forward Purchase Units as of June 30, 2023 and December 31, 2022 was deminimis. There was no change in fair value of the Forward Purchase Units for the three and six months ended June 30, 2023. The Company recognized expense in the change in fair value of the Forward Purchase Units of approximately $ 19,000 and $ 49,000 for the three and six months ended June 30, 2022, respectively.\n19\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nThe change in the fair value of the Level 3 derivative warrant liabilities for three and six months ended March 31, 2022 is summarized as follows:\n\n| Derivative assets (liabilities) as of January 1, 2022 | $ | 88,970 |\n| Change in fair value of derivative assets and liabilities | 30,204 |\n| Derivative assets (liabilities) as of March 31, 2022 | 119,174 |\n| Change in fair value of derivative assets and liabilities | 18,877 |\n| Derivative assets (liabilities) as of June 30, 2022 | $ | 138,051 |\n\nNote 11 - Subsequent Events\nManagement has evaluated subsequent events to determine if events or transactions occurring after the balance sheet date through the date the accompanying unaudited condensed financial statements were issued. Based upon this review, the Company did not, other than the below, identify any subsequent event that would have required adjustment or disclosure in the accompanying unaudited condensed financial statements.\nOn July 11, 2023 and August 7, 2023, pursuant to the Extension, as described in Note 1, the Sponsor or its designees contributed to the Company as a loan an additional contribution of $ 30,000 and $ 60,000 , respectively, into the trust to extend the date of which it has to consummate an initial business combination to August 22, 2023.\n20\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.\nReferences to the “Company,” “Quadro Acquisition One Corp.,” “our,” “us” or “we” refer to Quadro Acquisition One Corp. (formerly known as Kismet Acquisition Two Corp.). The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the unaudited condensed financial statements and the notes thereto under “Item 1. Financial Statements”. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\nCautionary Note Regarding Forward-Looking Statements\nAll statements other than statements of historical fact included in this Quarterly Report on Form 10-Q for the quarter ended June 30, 2023 (this “Report”) including, without limitation, statements under this “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward- looking statements. When used in this Report, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or our management, identify forward-looking statements. Such forward-looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company’s management. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors detailed in our filings with the SEC. All subsequent written or oral forward-looking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph.\nOverview\nWe are a blank check company incorporated as a Cayman Islands exempted company on September 15, 2020. We were incorporated for the purpose of engaging in an initial business combination with one or more businesses. We are an emerging growth company and, as such, we are subject to all of the risks associated with emerging growth companies.\nOur sponsor is Quadro Sponsor LLC, a Delaware limited liability company. The registration statement for our initial public offering was declared effective on February 17, 2021. On February 22, 2021, we consummated our initial public offering of 23,000,000 units, including 3,000,000 additional units to cover the underwriters’ over-allotment option, at $10.00 per unit, generating gross proceeds of $230.0 million, and incurring offering costs of approximately $13.1 million, of which approximately $8.1 million was for deferred underwriting commissions.\nSimultaneously with the closing of our initial public offering, we consummated the private placement of 4,400,000 warrants, at a price of $1.50 per private placement warrant, to our prior sponsor, generating gross proceeds of $6.6 million, and incurring offering costs of approximately $7,000.\nUpon the closing of the initial public offering and the private placement, $230.0 million ($10.00 per unit) of the net proceeds of the initial public offering and a portion of the proceeds of the private placement were placed in a trust account, with Continental acting as trustee, and invested in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds meeting certain conditions under Rule 2a-7 under the Investment Company Act, which invest only in direct U.S. government treasury obligations, as determined by us, until the earlier of: (i) the completion of a business combination and (ii) the distribution of the trust account as described below.\nOn February 10, 2023, we instructed Continental to liquidate the investments held in the trust account and instead to hold the funds in the trust account in an interest-bearing demand deposit account at Morgan Stanley, with Continental continuing to act as trustee, until the earlier of the consummation of our initial business combination or our liquidation. As a result, following the liquidation of investments in the trust account, the remaining proceeds from the initial public offering and private placement are no longer invested in U.S. government securities or money market funds.\nOur management has broad discretion with respect to the specific application of the net proceeds of our initial public offering and the private placement, although substantially all of the net proceeds are intended to be applied generally toward consummating a business combination. Our initial business combination must be with one or more operating businesses or assets with a fair market value equal to at least 80% of the net assets held in the trust account (excluding the deferred underwriting commissions and taxes payable, if any, on the income accrued on the trust account) at the time we sign a definitive agreement in connection with the initial business combination. However, we will only complete a business combination if the post-transaction company owns or acquires 50% or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act.\nIf we are unable to complete a business combination by the Termination Date, we will (i) cease all operations except for the purpose of winding up; (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account, including interest earned on the funds held in the trust account and not previously released to us to pay our taxes that were paid by us or are payable by us, if any (less up to $100,000 of interest to pay dissolution expenses), divided by the number of the then-outstanding public shares, which redemption will completely extinguish public shareholders’ rights as shareholders (including the right to receive further liquidation distributions, if any); and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the remaining shareholders and the board of directors, liquidate and dissolve, subject in the case of clauses (ii) and (iii) to our obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law.\n21\nRecent Developments\nOn January 31, 2023, we issued an aggregate of 6,250,000 Class A ordinary shares to the sponsor, upon the conversion of an equal number of Class B ordinary shares held by the sponsor in the Founder Conversion. The 6,250,000 Class A ordinary shares issued in connection with the Founder Conversion are subject to the same restrictions as applied to the Class B ordinary shares before the Founder Conversion, including, among others, certain transfer restrictions, waiver of redemption rights and the obligation to vote in favor of an initial business combination as described in the prospectus for the initial public offering.\nOn February 20, 2023, we held the 2023 Extraordinary General Meeting at which our shareholders approved an amendment to our amended and restated memorandum and articles of association to extend the date by which we must consummate an initial business combination to April 22, 2023, and to allow our board, without another shareholder vote, to extend the Termination Date on a monthly basis up to seven times for an additional one month each time until November 22, 2023, or a total of up to nine months after the Original Termination Date (the “Extension”). In connection with the vote to approve the Extension Amendment, the holders of 20,451,847 Class A ordinary shares properly exercised their right to redeem their shares for cash at a redemption price of approximately $10.20 per share, for an aggregate redemption amount of approximately $208,524,538, in connection with the Extension Amendment.\nIn connection with the Extension, our sponsor or its designees contributed to us as a loan the initial contribution of $120,000 (the “Initial Extension Loan”) in February 2023 for the portion of the Extension ending on April 22, 2023. Our sponsor will also loan us extension contributions of $60,000 per month for each subsequent calendar month (commencing on April 22, 2023 and on the 22nd day of each subsequent month) until November 22, 2023, or portion thereof, that is needed to complete an initial business combination, which amount will be deposited into the trust account (together with the Initial Extension Loan, the “Extension Loans”). The amount of the Extension Loans will not bear interest and will be repayable by us to the sponsor or its designees upon consummation of an initial business combination. In the event that a business combination does not close, we may use a portion of proceeds held outside the trust account to repay the Extension Loans, but no proceeds held in the trust account would be used to repay the Extension Loans.\nFollowing the Founder Conversion and the redemptions in connection with the Extension, there were 8,798,153 Class A ordinary shares issued and outstanding and no Class B Ordinary Shares issued and outstanding.\nAt the 2023 Extraordinary General Meeting, our shareholders also approved our company’s name change from Kismet Acquisition Two Corp. to Quadro Acquisition One Corp. to better reflect the Sponsor Transaction.\nOn March 27, 2023, our board of directors elected Konstantin Tourevski as a director and as a member of the audit committee to fill the vacancy caused by the resignation of Verdi Israelyan.\nLiquidity and Capital Resources\nAs of June 30, 2023, we had $0 in our operating bank account and working capital deficit of approximately $1.4 million.\nOur liquidity needs to date have been satisfied through a contribution of $25,000 from the prior sponsor to cover certain expenses in exchange for the issuance of the founder shares, a loan of approximately $111,000 from the prior sponsor pursuant to the First Note originally issued on September 23, 2020 and amended on January 22, 2021, and a portion of the proceeds from the consummation of the private placement not held in the trust account. We repaid the First Note in full on February 24, 2021. Subsequent to the repayment, the facility was no longer available to us. In addition, in order to finance transaction costs in connection with a business combination, the sponsor or an affiliate of the sponsor, or certain of our officers and directors may, but are not obligated to, provide us working capital loans in order to finance transaction costs in connection with a business combination. As of June 30, 2023 and December 31, 2022, there were no amounts outstanding under any working capital loans.\n22\nOn April 13, 2022, we issued the Second Note, a promissory note in the amount of up to $200,000 to the prior sponsor. On May 25, 2022, we and the prior sponsor amended and restated the Second Note and increased the principal amount to $400,000. The promissory note bears no interest and is due and payable within one year from the date of the first drawdown of the amended and restated note, or June 7, 2023. On June 30, 2022, the prior sponsor assigned all of its rights and obligations under the promissory note to our sponsor in connection with the Sponsor Transaction. As of June 30, 2023, we have fully drawn $400,000 under the Promissory Note. As of June 30, 2023 and December 31, 2022, approximately $400,000 and $319,000 were outstanding under the Promissory Note, respectively.\nWe may need to raise additional capital through loans or additional investments from our sponsor, our officers or directors or their affiliates. Our sponsor, officers, directors and or their affiliates, may, but are not obligated to, loan our company funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet our working capital needs. Accordingly, we may not be able to obtain additional financing. If we are unable to raise additional capital, we may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, reducing overhead expenses, and extending the terms and due dates of certain accrued expenses and other liabilities. We cannot provide any assurance that new financing will be available to it on commercially acceptable terms, if at all. In connection with our assessment of going concern considerations in accordance with ASC Topic 205-40, “Presentation of Financial Statements – Going Concern,” we have determined that the liquidity condition, mandatory liquidation and subsequent dissolution raises substantial doubt about our ability to continue as a going concern. Management continues to seek to complete a business combination prior to the mandatory liquidation date. No adjustments have been made to the carrying amounts of assets or liabilities should we be required to liquidate by November 22, 2023.\nContractual Obligations\nAdministrative Services Agreement\nWe do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities, except that, commencing on February 17, 2021, through the earlier of consummation of the initial business combination and the liquidation, we agreed to pay Kismet LLC, an affiliate of our prior sponsor, $10,000 per month for office space, utilities, secretarial support and administrative services.\nOn June 30, 2022, in connection with the Sponsor Transaction, the Company and Kismet LLC mutually terminated the Administrative Services Agreement. As a result, the Company is no longer obligated to pay a $10,000 monthly fee pursuant to the Administrative Services Agreement.\nResults of Operations\nOur entire activity since inception up to June 30, 2023, was in preparation for our formation and our initial public offering, and since the completion of our initial public offering, the search for business combination candidates. We will not be generating any operating revenues until the closing and completion of our initial business combination at the earliest.\nFor the three months ended June 30, 2023, we had net loss of approximately $458,000, which consisted of a non-operating loss of approximately $538,000 resulting from the change in fair value of derivative assets and liabilities and approximately $160,000 general and administrative expenses, partially offset by approximately $240,000 of income from investments held in trust account.\nFor the three months ended June 30, 2022, we had net income of approximately $1.0 million, which consisted of a non-operating gain of approximately $864,000 resulting from the change in fair value of derivative assets and liabilities and approximately $292,000 of net gain on the investments held in the Trust Account, partially offset by approximately $107,000 general and administrative expenses.\nFor the six months ended June 30, 2023, we had net income of approximately $152,000, which consisted of approximately $1.7 million of income from investments held in trust account, partially offset by a non-operating loss of approximately $780,000 resulting from the change in fair value of derivative assets and liabilities and approximately $750,000 general and administrative expenses.\nFor the six months ended June 30, 2022, we had net income of approximately $5.1 million, which consisted of a non-operating gain of approximately $5.1 million resulting from the change in fair value of derivative assets and liabilities and approximately $313,000 of net gain on the investments held in the Trust Account, partially offset by approximately $300,000 general and administrative expenses.\n23\nCommitments and Contingencies\nRegistration Rights\nThe holders of the founder shares, private placement warrants, and warrants that may be issued upon conversion of working capital loans (and any Class A ordinary shares issuable upon the exercise of the private placement warrants and warrants that may be issued upon conversion of working capital loans) are entitled to registration rights pursuant to a registration rights agreement dated February 17, 2021. The holders of these securities are entitled to make up to three demands, excluding short form demands, that we register such securities. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the completion of the initial business combination. We will bear the expenses incurred in connection with the filing of any such registration statements.\nPursuant to the forward purchase agreement (described below), we agreed to use our commercially reasonable efforts (i) to file within 30 days after the closing of the initial business combination a registration statement with the SEC for a secondary offering of the forward purchase shares and the forward purchase warrants (and underlying Class A ordinary shares), (ii) to cause such registration statement to be declared effective promptly thereafter but in no event later than sixty (60) days after the initial filing, and (iii) to maintain the effectiveness of such registration statement until the earliest of (A) the date on which our sponsor or its assignees cease to hold the securities covered thereby and (B) the date all of the securities covered thereby can be sold publicly without restriction or limitation under Rule 144 under the Securities Act. In addition, the forward purchase agreement provides for “piggy-back” registration rights to the holders of forward purchase securities to include their securities in other registration statements filed by us.\nForward Purchase Agreement\nIn connection with the consummation of our initial public offering, we entered into a forward purchase agreement with our prior sponsor, which provides for the purchase of $20.0 million of forward purchase units, which at the option of our prior sponsor can be increased to $50.0 million, with each forward purchase unit consisting of one Class A ordinary share and one-third of one warrant to purchase one Class A ordinary share at $11.50 per share, for a purchase price of $10.00 per forward purchase unit, in a private placement to occur concurrently with the closing of the initial business combination. The purchase under the forward purchase agreement is required to be made regardless of whether any Class A ordinary shares are redeemed by the public shareholders. The forward purchase securities will be issued only in connection with the closing of the initial business combination. The proceeds from the sale of forward purchase securities may be used as part of the consideration to the sellers in the initial business combination, expenses in connection with the initial business combination or for working capital in the post-transaction company. We do not intend to implement the forward purchase agreement, and on April 17, 2023, we sent a notice of mutual termination of the forward purchase agreement to the prior sponsor.\nUnderwriting Agreement\nWe granted the underwriters a 45-day option from February 17, 2021, to purchase up to 3,000,000 additional units at our initial public offering price less the underwriting discounts and commissions. On February 22, 2021, the underwriters fully exercised their over-allotment option.\nThe underwriters were entitled to an underwriting discount of $0.20 per unit, or approximately $4.6 million in the aggregate, paid upon the closing of our initial public offering. In addition, $0.35 per unit, or approximately $8.1 million in the aggregate will be payable to the underwriters for deferred underwriting commissions. The deferred fee will become payable to the underwriters from the amounts held in the trust account solely in the event that we complete an initial business combination, subject to the terms of the underwriting agreement.\nOn August 11, 2022 and September 6, 2022, two of the underwriters in the initial public offering irrevocably waived their rights to receive an aggregate of approximately $5.2 million of deferred underwriting discounts due under the underwriting agreements consummated in connection with the initial public offering. We recognized the portion allocated to Public Shares of approximately $5.0 million as an adjustment to the carrying value of the Class A ordinary shares subject to possible redemption and the remaining balance of approximately $0.2 million as a gain from extinguishment of deferred underwriting commissions allocated to derivative warrant liabilities.\n24\nCritical Accounting Policies and Estimates\nDerivative Assets and Liabilities\nWe do not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks. We evaluate all of our financial instruments, including issued stock purchase warrants, to determine if such instruments are derivatives or contain features that qualify as embedded derivatives, pursuant to ASC Topic 480, “Distinguishing Liabilities from Equity” (“ASC 480”) and ASC Topic 815-15, “Derivatives and Hedging”. The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is re-assessed at the end of each reporting period.\nWe account for our public warrants, private placement warrants and forward purchase units as derivative assets/liabilities in accordance with ASC 815-40, “Derivatives and Hedging”. Accordingly, we recognize the warrants and forward purchase units as assets/liabilities at fair value and adjust the instruments to fair value at each reporting period. The liabilities are subject to re-measurement at each balance sheet date until exercised, and any change in fair value of derivative assets and liabilities is recognized in our statements of operations. The fair value of our public warrants was initially measured using Monte-Carlo simulation and subsequently been measured on the market price of such warrants when separately listed and traded at each measurement date. The fair value of the private placement warrants was initially measured using Black-Scholes Option Pricing Model and subsequently using the market value of the public warrants. The fair value of the forward purchase units has been measured using the John C Hull’s Options, Futures and Other Derivatives model at each measurement date.\nClass A Ordinary Shares Subject to Possible Redemption\nWe account for the Class A ordinary shares subject to possible redemption in accordance with the guidance in ASC 480. Class A ordinary shares subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable Class A ordinary shares (including Class A ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, Class A ordinary shares are classified as shareholders’ equity. Our Class A ordinary shares feature certain redemption rights that are considered to be outside of our control and subject to the occurrence of uncertain future events. Accordingly, as of June 30, 2023 and December 31, 2022, 2,548,153 and 23,000,000 Class A Ordinary Shares subject to possible redemption, respectively, are presented as temporary equity, outside of the shareholders’ deficit section of the condensed balance sheets under “Item 1. Financial Statements”.\nWe recognize changes in redemption value immediately as they occur and adjust the carrying value of the Class A ordinary shares subject to possible redemption to equal the redemption value at the end of each reporting period. Effective with the closing of the initial public offering, we recognized the accretion from initial book value to redemption amount, which resulted in charges against additional paid-in capital (to the extent available) and accumulated deficit.\nNet (Loss) Income per Ordinary Share\nWe comply with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share.” We have two classes of shares, Class A ordinary shares and Class B ordinary shares. Income and losses are shared pro rata between the two classes of shares. Net (loss) income per ordinary share is calculated by dividing the net (loss) income by the weighted average number of ordinary shares outstanding for the respective period.\nThe calculation of diluted net (loss) income per ordinary share does not consider the effect of the warrants issued in connection with our initial public offering and the private placement to purchase an aggregate of 12,066,667 Class A ordinary shares because their exercise is contingent upon future events. Accretion associated with the redeemable Class A ordinary shares is excluded from (losses) earnings per share as the redemption value approximates fair value.\n25\nShare-Based Compensation\nWe comply with the accounting and disclosure requirement of ASC Topic 718, “Compensation - Stock Compensation.” We record share-based compensation to employees and non-employees over the requisite service period based on the estimated grant-date fair value of the awards. Share-based awards with graded-vesting schedules are recognized on a straight-line basis over the requisite service period for each separately vesting portion of the award. We recognize the expense for share-based compensation awards subject to performance-based milestone vesting over the remaining service period when management determines that achievement of the milestone is probable. Management evaluates when the achievement of a performance-based milestone is probable based on the expected satisfaction of the performance conditions at each reporting date. Share-based compensation will be recognized in general and administrative expense in the statements of operations. We issued option awards that contain both a performance condition and service condition. The option awards vest upon the consummation of the initial business combination and will expire in five years after the date on which they first become exercisable. We have determined that the consummation of an initial business combination is a performance condition subject to significant uncertainty. As such, the achievement of the performance is not deemed to be probable of achievement until the consummation of the event, and therefore no compensation has been recognized for the period from inception to June 30, 2023.\nRecent Accounting Pronouncements\nManagement does not believe that any recently issued, but not yet effective, accounting standards updates, if currently adopted, would have a material effect on the accompanying unaudited condensed financial statements.\nOff-Balance Sheet Arrangements and Contractual Obligations\nAs of June 30, 2023, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K and did not have any commitments or contractual obligations.\nJOBS Act\nThe JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We qualify as an “emerging growth company” and under the JOBS Act are allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) companies. We are electing to delay the adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As a result, the financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates.\nAdditionally, we are in the process of evaluating the benefits of relying on the other reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, if, as an “emerging growth company,” we choose to rely on such exemptions we may not be required to, among other things, (i) provide an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404, (ii) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (iii) comply with any requirement that may be adopted by the PCAOB regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis) and (iv) disclose certain executive compensation related items such as the correlation between executive compensation and performance and comparisons of the CEO’s compensation to median employee compensation. These exemptions will apply for a period of five years following the completion of our initial public offering or until we are no longer an “emerging growth company,” whichever is earlier.\nFactors That May Adversely Affect our Results of Operations\nOur results of operations and our ability to complete an initial business combination may be adversely affected by various factors that could cause economic uncertainty and volatility in the financial markets, many of which are beyond our control. Our business could be impacted by, among other things, downturns in the financial markets or in economic conditions, increases in oil prices, inflation, increases in interest rates, supply chain disruptions, declines in consumer confidence and spending, the ongoing effects of the COVID-19 pandemic, including resurgences and the emergence of new variants, and geopolitical instability, such as the military conflict in Ukraine. We cannot at this time fully predict the likelihood of one or more of the above events, their duration or magnitude or the extent to which they may negatively impact our business and our ability to complete an initial business combination.\n26\n\nItem 3. Quantitative and Qualitative Disclosures About Market Risk.\nWe are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act, and are not required to provide the information otherwise required under this item.\n\nItem 4. Controls and Procedures.\nEvaluation of Disclosure Controls and Procedures\nDisclosure controls and procedures are controls and other procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is accumulated and communicated to management, including our principal executive officer and principal financial officer (our “Certifying Officer”), to allow timely decisions regarding required disclosure.\nAs of June 30, 2023, as required by Rules 13a-15 and 15d-15 under the Exchange Act, our principal executive officer and principal financial and accounting officer carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were not effective because of a material weakness in our internal control over financial reporting. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis. Specifically, the Company’s management has concluded that our control around the interpretation and accounting for extinguishment of a significant contingent obligation was not effectively designed or maintained. In light of this material weakness, we performed additional analysis as deemed necessary to ensure that our financial statements were prepared in accordance with GAAP. Accordingly, management believes that the unaudited condensed financial statements included in this Quarterly Report on Form 10-Q present fairly in all material respects our financial position, results of operations and cash flows for the period presented.\nWe do not expect that our disclosure controls and procedures will prevent all errors and all instances of fraud. Disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Further, the design of disclosure controls and procedures must reflect the fact that there are resource constraints, and the benefits must be considered relative to their costs. Because of the inherent limitations in all disclosure controls and procedures, no evaluation of disclosure controls and procedures can provide absolute assurance that we have detected all our control deficiencies and instances of fraud, if any. The design of disclosure controls and procedures also is based partly on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.\nManagement has implemented remediation steps to improve our internal control over financial reporting. Specifically, we expanded and improved our review process for related accounting standards. We plan to further improve this process by enhancing access to accounting literature, identification of third-party professionals with whom to consult regarding complex accounting applications and consideration of additional staff with the requisite experience and training to supplement existing accounting professionals.\nChanges in Internal Control Over Financial Reporting\nOther than the above, there have been no changes to our internal control over financial reporting during the quarter ended June 30, 2023 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n27\nPART II - OTHER INFORMATION\n\nItem 1. Legal Proceedings.\nTo the knowledge of our management team, there is no litigation currently pending or contemplated against us, any of our officers or directors in their capacity as such or against any of our property.\n\nItem 1A. Risk Factors.\nAs a smaller reporting company under Rule 12b-2 of the Exchange Act, we are not required to include risk factors in this Report. However, as of the date of this Report, other than as set forth below, there have been no material changes with respect to those risk factors previously disclosed in our (i) Registration Statement, (ii) Annual Report on Form 10-K for the year ended December 31, 2021, as filed with the SEC on March 31, 2022, (iii) Quarterly Reports on Form 10-Q for the quarterly periods ended March 31, 2021, June 30, 2021, September 30, 2021, March 31, 2022, June 30, 2022 and September 30, 2022, as filed with the SEC on June 25, 2021, August 13, 2021, November 22, 2021, May 9, 2022, August 15, 2022, and November 14, 2022, respectively, (iv) Definitive Proxy Statement on Schedule 14A, as filed with the SEC on January 31, 2023, and (v) our 2022 Annual Report. Any of these factors could result in a significant or material adverse effect on our results of operations or financial condition. Additional risks could arise that may also affect our business or ability to consummate an initial Business Combination. We may disclose changes to such risk factors or disclose additional risk factors from time to time in our future filings with the SEC.\nTo mitigate the risk that we might be deemed to be an investment company for purposes of the Investment Company Act, we have instructed the trustee, on February 10, 2023, to liquidate the investments held in the Trust Account and instead to hold the funds in the Trust Account in an interest bearing demand deposit account at Morgan Stanley until the earlier of the consummation of our initial Business Combination or our liquidation. As a result, we may receive less interest on the funds held in the Trust Account than the interest we would have received pursuant to our original Trust Account investments, which could reduce the dollar amount our public shareholders would receive upon any redemption or liquidation of the Company.\nThe funds in the Trust Account had, since our IPO, been held only in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds investing solely in U.S. government treasury obligations and meeting certain conditions under Rule 2a-7 under the Investment Company Act. However, to mitigate the risk of us being deemed to be an unregistered investment company (including under the subjective test of Section 3(a)(1)(A) of the Investment Company Act) and thus subject to regulation under the Investment Company Act, we have instructed the trustee, on February 10, 2023, to liquidate the U.S. government treasury obligations or money market funds held in the Trust Account and thereafter to hold all funds in the Trust Account in an interest bearing demand deposit account at Morgan Stanley until the earlier of the consummation of our initial Business Combination or the liquidation of the Company. Following such liquidation, we may receive less interest on the funds held in the Trust Account than the interest we would have received pursuant to our original trust account investments. However, interest previously earned on the funds held in the Trust Account still may be released to us to pay our taxes, if any, and certain other expenses as permitted. As a result, our decision to liquidate the securities held in the Trust Account and thereafter to hold all funds in the Trust Account in an interest bearing demand deposit account at Morgan Stanley could reduce the dollar amount our public shareholders would receive upon any redemption or liquidation of the Company.\nMarket conditions, economic uncertainty or downturns could adversely affect our business, financial condition, operating results and our ability to consummate a Business Combination.\nIn recent years, the United States and other markets have experienced cyclical or episodic downturns, and worldwide economic conditions remain uncertain, including as a result of the COVID-19 pandemic, supply chain disruptions, the Ukraine-Russia conflict, instability in the U.S. and global banking systems, rising fuel prices, increasing interest rates or foreign exchange rates and high inflation and the possibility of a recession. A significant downturn in economic conditions may make it more difficult for us to consummate a Business Combination.\n28\nWe cannot predict the timing, strength, or duration of any future economic slowdown or any subsequent recovery generally, or in any industry. If the conditions in the general economy and the markets in which we operate worsen from present levels, our business, financial condition, operating results and our ability to consummate a Business Combination could be adversely affected. For example, in January 2023, the outstanding national debt of the U.S. government reached its statutory limit. The U.S. Department of the Treasury (the “Treasury Department”) has announced that, since then, it has been using extraordinary measures to prevent the U.S. government’s default on its payment obligations, and to extend the time that the U.S. government has to raise its statutory debt limit or otherwise resolve its funding situation. The failure by Congress to raise the federal debt ceiling could have severe repercussions within the U.S. and to global credit and financial markets. If Congress does not raise the debt ceiling, the U.S. government could default on its payment obligations, or experience delays in making payments when due. A payment default or delay by the U.S. government, or continued uncertainty surrounding the U.S. debt ceiling, could result in a variety of adverse effects for financial markets, market participants and U.S. and global economic conditions. In addition, U.S. debt ceiling and budget deficit concerns have increased the possibility a downgrade in the credit rating of the U.S. government and could result in economic slowdowns or a recession in the U.S. Although U.S. lawmakers have passed legislation to raise the federal debt ceiling on multiple occasions, ratings agencies have lowered or threatened to lower the long-term sovereign credit rating on the United States as a result of disputes over the debt ceiling. The impact of a potential downgrade to the U.S. government’s sovereign credit rating or its perceived creditworthiness could adversely affect economic conditions, as well as our business, financial condition, operating results and our ability to consummate a Business Combination.\nIf our initial Business Combination involves a company organized under the laws of a state of the United States, it is possible a 1% U.S. federal excise tax will be imposed on us in connection with redemptions of our common stock after or in connection with such initial Business Combination.\nOn August 16, 2022, the Inflation Reduction Act of 2022 became law in the United States, which, among other things, imposes a 1% excise tax on the fair market value of certain repurchases (including certain redemptions) of stock by publicly traded domestic (i.e., United States) corporations (and certain non-U.S. corporations treated as “surrogate foreign corporations”). The excise tax will apply to stock repurchases occurring in 2023 and beyond. The amount of the excise tax is generally 1% of the fair market value of the shares of stock repurchased at the time of the repurchase. The Treasury Department has been given authority to provide regulations and other guidance to carry out, and prevent the abuse or avoidance of, the excise tax; however, only limited guidance has been issued to date.\nAs an entity incorporated as a Cayman Islands exempted company, the 1% excise tax is not expected to apply to redemptions of our Class A ordinary shares (absent any regulations and other additional guidance that may be issued in the future with retroactive effect).\nHowever, in connection with an initial Business Combination involving a company organized under the laws of the United States, it is possible that we domesticate and continue as a Delaware corporation prior to certain redemptions and, because our securities are trading on the Nasdaq Capital Market, it is possible that we will be subject to the excise tax with respect to any subsequent redemptions, including redemptions in connection with the initial Business Combination, that are treated as repurchases for this purpose (other than, pursuant to recently issued guidance from the Treasury Department, redemptions in complete liquidation of the company). In all cases, the extent of the excise tax that may be incurred will depend on a number of factors, including the fair market value of our stock redeemed, the extent such redemptions could be treated as dividends and not repurchases, and the content of any regulations and other additional guidance from the Treasury Department that may be issued and applicable to the redemptions. Issuances of stock by a repurchasing corporation in a year in which such corporation repurchases stock may reduce the amount of excise tax imposed with respect to such repurchase. The excise tax is imposed on the repurchasing corporation itself, not the stockholders from which stock is repurchased. The imposition of the excise tax as a result of redemptions in connection with the initial Business Combination could, however, reduce the amount of cash available to pay redemptions or reduce the cash contribution to the target business in connection with our initial Business Combination, which could cause the other shareholders of the combined company to economically bear the impact of such excise tax.\n29\n\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\nNone. For a description of the use of proceeds generated in our Initial Public Offering and the Private Placement, see Part II, Item 2 of our Quarterly Report on Form 10-Q for the quarter ended March 31, 2021, as filed with the SEC on June 25, 2021. There has been no material change in the planned use of the proceeds from our Initial Public Offering and the Private Placement as described in the Registration Statement.\n\nItem 3. Defaults Upon Senior Securities.\nNone.\n\nItem 4. Mine Safety Disclosures\nNot applicable.\n\nItem 5. Other Information.\nNone.\n\nItem 6. Exhibits\nThe following exhibits are filed as part of, or incorporated by reference into, this Report.\n\n| Exhibit Number | Description of Exhibit |\n| 31.1 | Certification of the Principal Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |\n| 31.2 | Certification of the Principal Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |\n| 32.1 | Certification of the Principal Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.** |\n| 32.2 | Certification of the Principal Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.** |\n| 101.INS | Inline XBRL Instance Document.* |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document.* |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document.* |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document.* |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document.* |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document.* |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101).* |\n\n\n| * | Filed herewith. |\n\n\n| ** | Furnished herewith. |\n\n30\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| Dated: August 14, 2023 | QUADRO ACQUISITION ONE CORP. |\n| By: | /s/ Dimitri Elkin |\n| Name: | Dimitri Elkin |\n| Title: | Chief Executive Officer |\n\n31\n\n \n\nWhat is the total amount of loans that the company borrowed and to be repaid by June 30, 2023, including the IPO Note, Working Capital Loans, Promissory Note, Extension Loan, and Related Party Advance in dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nPART I. FINANCIAL INFORMATION\\nItem 1. Financial Statements.\\nQUADRO ACQUISITION ONE CORP.\\nCONDENSED BALANCE SHEETS\\n\\n| June 30, 2023 | December 31, 2022 |\\n| (Unaudited) |\\n| Assets |\\n| Current assets: |\\n| Cash | $ | — | $ | 964 |\\n| Prepaid expenses | — | 33,402 |\\n| Total current assets | — | 34,366 |\\n| Cash and investments held in Trust Account | 26,731,243 | 233,304,515 |\\n| Total Assets | $ | 26,731,243 | $ | 233,338,881 |\\n| Liabilities, Class A Ordinary Shares Subject to Possible Redemption and Shareholders’ Deficit |\\n| Current liabilities: |\\n| Accounts payable | $ | 436,656 | $ | 107,269 |\\n| Accrued expenses | 145,452 | 29,718 |\\n| Extension loan - related party | 270,000 | — |\\n| Advance from related parties | 188,722 | — |\\n| Note payable - related party | 400,000 | 318,700 |\\n| Total current liabilities | 1,440,830 | 455,687 |\\n| Derivative liabilities - warrants | 809,673 | 30,167 |\\n| Deferred underwriting commissions | 2,817,500 | 2,817,500 |\\n| Total liabilities | 5,068,003 | 3,303,354 |\\n| Commitments and Contingencies |\\n| Class A ordinary shares subject to possible redemption, $ 0.001 par value; 2,548,153 and 23,000,000 shares at approximately $ 10.45 and $ 10.14 per share redemption value as of June 30, 2023 and December 31, 2022, respectively | 26,631,243 | 233,204,515 |\\n| Shareholders’ Deficit: |\\n| Class A ordinary shares, $ 0.001 par value; 200,000,000 shares authorized; 6,250,000 and 0 non-redeemable shares issued or outstanding as of June 30, 2023 and December 31, 2022, respectively | 6,250 | — |\\n| Class B ordinary shares, $ 0.001 par value; 10,000,000 shares authorized; 0 and 6,250,000 shares issued and outstanding as of June 30, 2023 and December 31, 2022, respectively | — | 6,250 |\\n| Accumulated deficit | ( 4,974,253 | ) | ( 3,175,238 | ) |\\n| Total shareholders’ deficit | ( 4,968,003 | ) | ( 3,168,988 | ) |\\n| Total Liabilities, Class A Ordinary Shares Subject to Possible Redemption and Shareholders’ Deficit | $ | 26,731,243 | $ | 233,338,881 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\\n1\\nQUADRO ACQUISITION ONE CORP.\\nUNAUDITED CONDENSED STATEMENTS OF OPERATIONS\\n\\n| For the Three Months Ended June 30, | For the Six Months Ended June 30, |\\n| 2023 | 2022 | 2023 | 2022 |\\n| Operating expenses |\\n| General and administrative expenses | $ | 160,237 | $ | 106,509 | $ | 749,509 | $ | 299,896 |\\n| Loss from operations | ( 160,237 | ) | ( 106,509 | ) | ( 749,509 | ) | ( 299,896 | ) |\\n| Other income: |\\n| Change in fair value of derivative assets and liabilities | ( 538,173 | ) | 863,544 | ( 779,506 | ) | 5,117,082 |\\n| Income from investments held in Trust Account | 240,284 | — | 1,681,266 | — |\\n| Unrealized gain from investments held in Trust Account | — | 292,182 | — | 312,752 |\\n| Net (loss) income | $ | ( 458,126 | ) | $ | 1,049,217 | $ | 152,251 | $ | 5,129,938 |\\n| Weighted average shares outstanding of Class A ordinary shares, basic and diluted | 8,798,153 | 23,000,000 | 13,551,176 | 23,000,000 |\\n| Basic and diluted net (loss) income per share, Class A ordinary shares | $ | ( 0.05 | ) | $ | 0.04 | $ | 0.01 | $ | 0.18 |\\n| Weighted average shares outstanding of Class B ordinary shares, basic and diluted | — | 6,250,000 | 1,041,667 | 6,250,000 |\\n| Basic and diluted net (loss) income per share, Class B ordinary shares | $ | — | $ | 0.04 | $ | 0.01 | $ | 0.18 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\\n2\\nQUADRO ACQUISITION ONE CORP.\\nUNAUDITED CONDENSED STATEMENTS OF CHANGES IN SHAREHOLDERS’ DEFICIT\\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2023\\n\\n| Ordinary Shares | Additional | Total |\\n| Class A | Class B | Paid-in | Accumulated | Shareholders’ |\\n| Shares | Amount | Shares | Amount | Capital | Deficit | Deficit |\\n| Balance - December 31, 2022 | — | $ | — | 6,250,000 | $ | 6,250 | $ | — | $ | ( 3,175,238 | ) | $ | ( 3,168,988 | ) |\\n| Conversion of Class B ordinary shares to Class A ordinary shares | 6,250,000 | 6,250 | ( 6,250,000 | ) | ( 6,250 | ) | — | — | — |\\n| Accretion on Class A ordinary shares subject to possible redemption amount | — | — | — | — | — | ( 1,560,982 | ) | ( 1,560,982 | ) |\\n| Net income | — | — | — | — | — | 610,377 | 610,377 |\\n| Balance - March 31, 2023 (unaudited) | 6,250,000 | 6,250 | — | — | — | ( 4,125,843 | ) | ( 4,119,593 | ) |\\n| Accretion on Class A ordinary shares subject to possible redemption amount | — | — | — | — | — | ( 390,284 | ) | ( 390,284 | ) |\\n| Net loss | — | — | — | — | — | ( 458,126 | ) | ( 458,126 | ) |\\n| Balance - June 30, 2023 (unaudited) | 6,250,000 | $ | 6,250 | — | $ | — | $ | — | $ | ( 4,974,253 | ) | $ | ( 4,968,003 | ) |\\n\\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2022\\n\\n| Ordinary Shares | Additional | Total |\\n| Class A | Class B | Paid-in | Accumulated | Shareholders’ |\\n| Shares | Amount | Shares | Amount | Capital | Deficit | Deficit |\\n| Balance - December 31, 2021 | — | $ | — | 6,250,000 | $ | 6,250 | $ | — | $ | ( 13,769,504 | ) | $ | ( 13,763,254 | ) |\\n| Net income | — | — | — | — | — | 4,080,721 | 4,080,721 |\\n| Balance - March 31, 2022 (unaudited) | — | — | 6,250,000 | 6,250 | — | ( 9,688,783 | ) | ( 9,682,533 | ) |\\n| Accretion on Class A ordinary shares subject to possible redemption amount | — | — | — | — | — | ( 251,264 | ) | ( 251,264 | ) |\\n| Net income | — | — | — | — | — | 1,049,217 | 1,049,217 |\\n| Balance - June 30, 2022 (unaudited) | — | $ | — | 6,250,000 | $ | 6,250 | $ | — | $ | ( 8,890,830 | ) | $ | ( 8,884,580 | ) |\\n\\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\\n3\\nQUADRO ACQUISITION ONE CORP.\\nUNAUDITED CONDENSED STATEMENTS OF CASH FLOWS\\n\\n| For the Six Months Ended June 30, |\\n| 2023 | 2022 |\\n| Cash Flows from Operating Activities: |\\n| Net income | $ | 152,251 | $ | 5,129,938 |\\n| Adjustments to reconcile net income to net cash used in operating activities: |\\n| Change in fair value of derivative assets and liabilities | 779,506 | ( 5,117,082 | ) |\\n| Income from cash and investments held in Trust Account | ( 1,681,266 | ) | — |\\n| Unrealized gain from investments held in Trust Account | — | ( 312,752 | ) |\\n| Changes in operating assets and liabilities: |\\n| Prepaid expenses | 33,402 | 105,379 |\\n| Accounts payable | 346,708 | 12,240 |\\n| Accounts payable - related party | ( 17,321 | ) | ( 17,321 | ) |\\n| Accrued expenses | 115,734 | ( 60,094 | ) |\\n| Net cash used in operating activities | ( 270,986 | ) | ( 259,692 | ) |\\n| Cash Flows from Investing Activities: |\\n| Cash deposited in Trust Account | ( 270,000 | ) | — |\\n| Cash withdrawn from Trust Account in connection with redemption | 208,524,538 | — |\\n| Net cash provided by investing activities | 208,254,538 | — |\\n| Cash Flows from Financing Activities: |\\n| Proceeds from related party advance | 188,722 | — |\\n| Proceeds from extension loan | 270,000 | — |\\n| Proceeds from note payable to related party | 81,300 | — |\\n| Proceeds from promissory note to related party | — | 318,700 |\\n| Offering costs paid | — | ( 70,000 | ) |\\n| Redemption of Ordinary shares | ( 208,524,538 | ) | — |\\n| Net cash used in financing activities | ( 207,984,516 | ) | 248,700 |\\n| Net change in cash | ( 964 | ) | ( 10,992 | ) |\\n| Cash - beginning of the period | 964 | 63,676 |\\n| Cash - end of the period | $ | — | $ | 52,684 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\\n4\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nNote 1 - Description of Organization, Business Operations and Going Concern\\nQuadro Acquisition One Corp. (the “Company”, formerly known as Kismet Acquisition Two Corp.) is a blank check company incorporated as a Cayman Islands exempted company on September 15, 2020. The Company was incorporated for the purpose of acquiring, engaging in a share exchange, share reconstruction and amalgamation, contractual control arrangement with, purchasing all or substantially all of the assets of, or engaging in any other similar initial business combination with one or more businesses or entities that the Company has not yet identified (“Business Combination”).\\nAs of June 30, 2023, the Company had not yet commenced operations. All activity for the period from September 15, 2020 (inception) through June 30, 2023, relates to the Company’s formation and the initial public offering (the “Initial Public Offering” or “IPO”), which is described below, and since the Initial Public Offering, the search for a potential target. The Company will not generate any operating revenues until after the completion of its initial Business Combination, at the earliest. The Company generates non-operating income in the form of interest income on investments held in Trust Account (as defined below) from the proceeds derived from the Initial Public Offering and the sale of the Private Placement Warrants (as defined below).\\nThe Company’s sponsor was Kismet Sponsor Limited, a British Virgin Islands company (the “Prior Sponsor”). The Registration Statement for the Initial Public Offering on Form S-1 initially filed with the U.S. Securities and Exchange Commission (“SEC”) on January 26, 2021, as amended (File No. 333- 252419), was declared effective on February 17, 2021 (the “Registration Statement”). On February 22, 2021, the Company consummated its Initial Public Offering of 23,000,000 units (the “Units” and, with respect to the Class A Ordinary shares included in the Units sold, the “Public Shares”), including 3,000,000 additional Units to cover over-allotments (the “Over-Allotment Units”), at $ 10.00 per Unit, generating gross proceeds of $ 230.0 million, and incurring offering costs of approximately $ 13.1 million, of which approximately $ 8.1 million was for deferred underwriting commissions (see Note 6).\\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the private placement (“Private Placement”) of 4,400,000 warrants (each, a “Private Placement Warrant” and collectively, the “Private Placement Warrants”), at a price of $ 1.50 per Private Placement Warrant with the Prior Sponsor, generating gross proceeds of $ 6.6 million, and incurring offering costs of approximately $ 7,000 (see Note 4).\\nOn June 15, 2022, the Prior Sponsor transferred 6,250,000 Class B ordinary shares and 4,400,000 Private Placement Warrants held by the Prior Sponsor to Quadro Sponsor LLC, a Delaware limited liability company and wholly owned subsidiary of the Prior Sponsor (the “New Sponsor” or “Sponsor”). On June 30, 2022, the Prior Sponsor transferred all the membership interests of the New Sponsor to Quadro IH DMCC (“Quadro”), a company registered in Dubai Multi Commodities Centre in the United Arab Emirates (the “Sponsor Transaction”). In connection with the Sponsor Transaction, the Prior Sponsor also assigned to the New Sponsor all of its rights and obligations under the (i) Letter Agreement, dated as of February 17, 2021, (ii) Registration Rights Agreement (as defined in Note 5) and (iii) Promissory Note (as defined below). In addition, the Company and Kismet Capital Group LLC (“Kismet LLC”) mutually terminated the Administrative Services Agreement, dated February 17, 2021 (the “Administrative Services Agreement”). As a result, the Company is no longer obligated to pay a $ 10,000 monthly fee to Kismet LLC pursuant to the Administrative Services Agreement.\\nUpon the closing of the Initial Public Offering and the Private Placement, $ 230.0 million ($ 10.00 per Unit) of the net proceeds of the Initial Public Offering and certain of the proceeds of the Private Placement were placed in a trust account (“Trust Account”) with Continental Stock Transfer & Trust Company (“Continental”) acting as trustee and invested in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds meeting certain conditions under Rule 2a-7 under the Investment Company Act of 1940 (the “Investment Company Act”), which invest only in direct U.S. government treasury obligations, as determined by the Company, until the earlier of (i) the completion of a Business Combination and (ii) the distribution of the Trust Account as described below.\\nThe Company’s management has broad discretion with respect to the specific application of the net proceeds of its Initial Public Offering and the sale of Private Placement Warrants, although substantially all of the net proceeds are intended to be applied generally toward consummating a Business Combination. The Company’s initial Business Combination must be with one or more operating businesses or assets with a fair market value equal to at least 80 % of the net assets held in the Trust Account (excluding the deferred underwriting commissions and taxes payable, if any, on the income accrued on the Trust Account) at the time the Company signs a definitive agreement in connection with the initial Business Combination. However, the Company will only complete a Business Combination if the post-transaction company owns or acquires 50 % or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act.\\n5\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nThe Company will provide its holders of the Public Shares (the “Public Shareholders”) with the opportunity to redeem all or a portion of their Public Shares upon the completion of a Business Combination either (i) in connection with a shareholder meeting called to approve the Business Combination or (ii) by means of a tender offer. The decision as to whether the Company will seek shareholder approval of a Business Combination or conduct a tender offer will be made by the Company, solely in its discretion. The Public Shareholders will be entitled to redeem their Public Shares for a pro rata portion of the amount then in the Trust Account (initially at $ 10.00 per share, plus any pro rata interest earned on the funds held in the Trust Account and not previously released to the Company to pay its tax obligations). The per-share amount to be distributed to Public Shareholders who redeem their Public Shares will not be reduced by the deferred underwriting commissions the Company will pay to the underwriters (see Note 6). These Public Shares were recorded at a redemption value and classified as temporary equity upon the completion of the Initial Public Offering, in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 480, “Distinguishing Liabilities from Equity” (“ASC 480”). In such case, the Company will proceed with a Business Combination if the Company has net tangible assets of at least $ 5,000,001 upon such consummation of a Business Combination and a majority of the shares are voted in favor of the Business Combination. If a shareholder vote is not required by law and the Company does not decide to hold a shareholder vote for business or other legal reasons, the Company will, pursuant to the amended and restated memorandum and articles of association which were adopted by the Company upon the consummation of the Initial Public Offering (the “Memorandum and Articles of Association”), conduct the redemptions pursuant to the tender offer rules of the SEC, and file tender offer documents with the SEC prior to completing a Business Combination. If, however, a shareholder approval of the transactions is required by law, or the Company decides to obtain shareholder approval for business or legal reasons, the Company will offer to redeem shares in conjunction with a proxy solicitation pursuant to the proxy rules and not pursuant to the tender offer rules. Additionally, each Public Shareholder may elect to redeem their Public Shares irrespective of whether they vote for or against the proposed transaction. If the Company seeks shareholder approval in connection with a Business Combination, the holder of the Founder Shares (as defined in Note 5) prior to the Initial Public Offering (the “Initial Shareholder”) agreed to vote its Founder Shares and any Public Shares purchased during or after the Initial Public Offering in favor of a Business Combination. In addition, the Initial Shareholder agreed to waive its redemption rights with respect to their Founder Shares and Public Shares in connection with the completion of a Business Combination.\\nNotwithstanding the foregoing, the Memorandum and Articles of Association provides that a Public Shareholder, together with any affiliate of such shareholder or any other person with whom such shareholder is acting in concert or as a “group” (as defined under Section 13 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), will be restricted from redeeming its shares with respect to more than an aggregate of 20 % or more of the Class A Ordinary shares sold in the Initial Public Offering, without the prior consent of the Company.\\nThe Company’s Sponsor, executive officers, directors and director nominees agreed not to propose an amendment to the Memorandum and Articles of Association that would affect the substance or timing of the Company’s obligation to provide for the redemption of its Public Shares in connection with a Business Combination or to redeem 100 % of its Public Shares if the Company does not complete a Business Combination, unless the Company provides the Public Shareholders with the opportunity to redeem their Class A ordinary shares in conjunction with any such amendment.\\nThe Company initially had until February 22, 2023 (the “Original Termination Date”) to complete the initial Business Combination. On February 20, 2023, the Company held the 2023 Extraordinary General Meeting at which the shareholders of the Company approved to extend the date by which the Company must consummate an initial Business Combination to April 22, 2023 and to allow the Company’s board, without another shareholder vote, to extend Combination Date on a monthly basis up to seven times for an additional one month each time until November 22, 2023, or a total of up to nine months after the Original Termination Date (the “Extension”).\\nIn connection with the Extension, the Sponsor or its designees contributed to the Company as a loan the initial contribution of $ 120,000 (the “Initial Extension Loan”) in February 2023 for the portion of the extension ending on April 22, 2023. The Sponsor will also loan the company extension contributions of $ 60,000 per month for each subsequent calendar month (commencing on April 22, 2023 and on the 22nd day of each subsequent month) until November 22, 2023, or portion thereof, that is needed to complete an initial Business Combination, which amount will be deposited into the Trust Account (together with the Initial Extension Loan, the “Extension Loans”). On each of May 11, 2023 and June 6, 2023, the Company deposited an additional $ 60,000 , for an aggregate of $ 120,000 into the Trust Account to extend the date by which it has to consummate an initial Business Combination to June 22, 2023. On each of June 30, 2023 and July 11, 2023, the Company deposited an additional $ 30,000 , for an aggregate of $ 60,000 into the Trust Account to extend the date by which it has to consummate an initial Business Combination to July 22, 2023. On August 7, 2023, the Company deposited an additional $ 60,000 into the Trust Account to extend the date by which it has to consummate an initial business combination to August 22, 2023.\\nIn connection with the Extension, shareholders holding 20,451,847 Class A ordinary shares exercised their right to redeem those shares for cash at an approximate price of $ 10.20 per share for an aggregate of approximately $ 208.5 million.\\nOn January 31, 2023, the Company issued an aggregate of 6,250,000 Class A ordinary shares to the Sponsor, upon the conversion of an equal number of Class B ordinary shares held by the Sponsor (the “Conversion”). The 6,250,000 Class A ordinary shares issued in connection with the Conversion are subject to the same restrictions as applied to the Class B ordinary shares before the Conversion, including, among others, certain transfer restrictions, waiver of redemption rights and the obligation to vote in favor of an initial Business Combination as described in the prospectus for the Company’s initial public offering. Following the Conversion, there are 29,250,000 Class A ordinary shares issued and outstanding and no Class B ordinary shares issued and outstanding. As a result of the Conversion, the Sponsor held 21.4 % of the outstanding Class A ordinary shares.\\n6\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nOn February 10, 2023, the Company instructed Continental to liquidate the investments held in the Trust Account and instead to hold the funds in the Trust Account in an interest-bearing demand deposit account at Morgan Stanley, with Continental continuing to act as trustee, until the earlier of the consummation of the Company’s initial Business Combination or the Company’s liquidation. As a result, following the liquidation of investments in the Trust Account, the remaining proceeds from the Initial Public Offering and Private Placement are no longer invested in U.S. government securities or money market funds.\\nIf the Company is unable to complete a Business Combination by August 22, 2023 (or November 22, 2023 if the Company fully extends the time to complete a Business Combination, the “Combination Period”), the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem all Public Shares then outstanding at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including any amounts representing interest earned on the Trust Account, less any interest released to the Company for the payment of taxes, if any (and less up to $ 100,000 in interest reserved for expenses in connection with the Company’s dissolution), divided by the number of then outstanding Public Shares, which redemption will completely extinguish Public Shareholders’ rights as shareholders (including the right to receive further liquidation distributions, if any), and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the remaining shareholders and the Company’s board of directors, liquidate and dissolve, subject in the case of clauses (ii) and (iii) to the Company’s obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law.\\nIn connection with the redemption of 100 % of the Company’s outstanding Public Shares for a portion of the funds held in the Trust Account, each holder will receive a full pro rata portion of the amount then in the Trust Account, plus any pro rata interest earned on the funds held in the Trust Account and not previously released to the Company to pay the Company’s taxes payable (less up to $ 100,000 of interest to pay dissolution expenses).\\nThe Initial Shareholder agreed to waive its liquidation rights with respect to the Founder Shares if the Company fails to complete a Business Combination within the Combination Period. However, if the Initial Shareholder should acquire Public Shares in or after the Initial Public Offering, it will be entitled to liquidating distributions from the Trust Account with respect to such Public Shares if the Company fails to complete a Business Combination within the Combination Period. The underwriters agreed to waive their rights to their deferred underwriting commission (see Note 6) held in the Trust Account in the event the Company does not complete a Business Combination within the Combination Period, and, in such event, such amounts will be included with the funds held in the Trust Account that will be available to fund the redemption of the Public Shares. In the event of such distribution, it is possible that the per share value of the residual assets remaining available for distribution (including Trust Account assets) will be only $10.00 per share initially held in the Trust Account. In order to protect the amounts held in the Trust Account, the Sponsor agreed that it will be liable to the Company if and to the extent any claims by a third party for services rendered or products sold to the Company, or a prospective target business with which the Company has entered into a written letter of intent, confidentiality or other similar agreement or business combination agreement, reduce the amount of funds in the Trust Account to below the lesser of (i) $10.00 per Public Share and (ii) the actual amount per Public Share held in the Trust Account as of the date of the liquidation of the Trust Account, if less than $10.00 per share due to reductions in the value of the trust assets, less taxes payable, provided that such liability will not apply to any claims by a third party or prospective target business who executed a waiver of any and all rights to the monies held in the Trust Account (whether or not such waiver is enforceable) nor will it apply to any claims under the Company’s indemnity of the underwriters of the Initial Public Offering against certain liabilities, including liabilities under the Securities Act of 1933, as amended (the “Securities Act”). In the event that an executed waiver is deemed to be unenforceable against a third party, the Sponsor will not be responsible to the extent of any liability for such third-party claims. The Company will seek to reduce the possibility that the Sponsor will have to indemnify the Trust Account due to claims of creditors by endeavoring to have vendors, service providers (except the Company’s independent registered public accounting firm), prospective target businesses or other entities with which the Company does business, execute agreements with the Company waiving any right, title, interest or claim of any kind in or to monies held in the Trust Account.\\n7\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nLiquidity and Going Concern\\nAs of June 30, 2023, the Company had $ 0 in its operating bank account and working capital deficit of approximately $ 1.4 million.\\nThe Company’s liquidity needs to date have been satisfied through a contribution of $ 25,000 from the Prior Sponsor to cover certain expenses in exchange for the issuance of the Founder Shares, a loan of approximately $ 111,000 from the Prior Sponsor pursuant to the IPO Note (as defined in Note 5), and a portion of the proceeds from the consummation of the Private Placement not held in the Trust Account. The Company repaid the IPO Note in full on February 24, 2021. In addition, in order to finance transaction costs in connection with a Business Combination, the Sponsor or an affiliate of the Sponsor, or certain of the Company’s officers and directors may, but are not obligated to, provide the Company Working Capital Loans (as defined in Note 5). As of June 30, 2023 and December 31, 2022, there were no amounts outstanding under any Working Capital Loans.\\nOn April 13, 2022, the Company issued an unsecured promissory note in the amount of up to $ 200,000 to the Prior Sponsor (the “Promissory Note”). On May 25, 2022, the Company and the Prior Sponsor amended the Promissory Note agreement and increased the principal amount to $ 400,000 . The Promissory Note bears no interest and is due and payable within one year from the date of the first drawdown of the amended and restated note, or June 7, 2023. On June 30, 2022, the Prior Sponsor assigned all of its rights and obligations under the Promissory Note to the New Sponsor in connection with the Sponsor Transaction. As of June 30, 2023, the Company has fully drawn $ 400,000 under the Promissory Note. As of June 30, 2023 and December 31, 2022, approximately $ 400,000 and $ 319,000 were outstanding under the Promissory Note, respectively.\\nThe Company may need to raise additional capital through loans or additional investments from its Sponsor, its officers or directors or their affiliates. The Company’s officers, directors and Sponsor, or their affiliates, may, but are not obligated to, loan the Company funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet the Company’s working capital needs. Accordingly, the Company may not be able to obtain additional financing. If the Company is unable to raise additional capital, it may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, reducing overhead expenses, and extending the terms and due dates of certain accrued expenses and other liabilities. The Company cannot provide any assurance that new financing will be available to it on commercially acceptable terms, if at all. In connection with the Company’s assessment of going concern considerations in accordance with FASB ASC Topic 205-40, “Presentation of Financial Statements - Going Concern” (“ASC 205-40”), management has determined that the liquidity condition, mandatory liquidation and subsequent dissolution raises substantial doubt about the Company’s ability to continue as a going concern. Management continues to seek to complete a Business Combination prior to the mandatory liquidation date. No adjustments have been made to the carrying amounts of assets or liabilities should the Company be required to liquidate after November 22, 2023. The accompanying financial statements do not include any adjustment that might be necessary if the Company is unable to continue as a going concern.\\nNote 2 - Basis of Presentation and Summary of Significant Accounting Policies\\nBasis of Presentation\\nThe accompanying unaudited condensed financial statements are presented in U.S. dollars in conformity with accounting principles generally accepted in the United States of America (“GAAP”) for financial information and pursuant to the rules and regulations of the SEC. Accordingly, certain disclosures included in the annual financial statements have been condensed or omitted from the accompanying unaudited condensed financial statements as they are not required for interim financial statements under GAAP and the rules of the SEC. In the opinion of management, the accompanying unaudited condensed financial statements reflect all adjustments, which include only normal recurring adjustments necessary for the fair statement of the balances and results for the periods presented. Operating results for the three and six months ended June 30, 2023 are not necessarily indicative of the results that may be expected through December 31, 2023 or any future period.\\nThe accompanying unaudited condensed financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Annual Report on Form 10-K for the fiscal year ended December 31, 2022, as filed by the Company with the SEC on April 18, 2023 (the “2022 Annual Report”).\\n8\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nEmerging Growth Company\\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the independent registered public accounting firm attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that an emerging growth company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such an election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the accompanying unaudited condensed financial statements with another public company that is neither an emerging growth company nor an emerging growth company that has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\\nUse of Estimates\\nThe preparation of the accompanying unaudited condensed financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited condensed financial statements and the reported amounts of revenues and expenses during the reporting periods. Making estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the accompanying unaudited condensed financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. One of the more significant accounting estimates included in the accompanying unaudited condensed financial statements is the determination of the fair value of the derivative liabilities. Accordingly, the actual results could differ from those estimates.\\nCash and Cash Equivalents\\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company had no cash equivalents as of June 30, 2023 and December 31, 2022.\\nConcentration of Credit Risk\\nFinancial instruments that potentially subject the Company to concentrations of credit risk consist of cash accounts in a financial institution, which, regularly exceed the Federal Deposit Insurance Corporation coverage limit of $ 250,000 . Any loss incurred or a lack of access to such funds could have a significant adverse impact on the Company’s financial condition, results of operations, and cash flows.\\nCash and Investments Held in the Trust Account\\nThe Company classifies its U.S. Treasury and equivalent securities as held to maturity in accordance with FASB Accounting Standard Codification (“ASC”) Topic 320, “Investments – Debt and Equity Securities.” Held-to-maturity securities are those securities which the Company has the ability and intent to hold until maturity. Held-to-maturity treasury securities are recorded at amortized cost on the accompanying consolidated balance sheets and adjusted for the amortization or accretion of premiums or discounts.\\nAt June 30, 2023, substantially all of the assets held in the Trust Account were held in cash. At December 31, 2022, substantially all of the assets held in the Trust Account were held in money market funds which invest primarily in U.S. Treasury securities. The money market funds are presented at fair value within the accompanying consolidated balance sheets, and fair value of the investments in the Trust Account is equal to the amortized cost basis of the money market funds.\\nFair Value of Financial Instruments\\nThe fair value of the Company’s assets and liabilities which qualify as financial instruments under the FASB ASC Topic 820, “Fair Value Measurements,” equal or approximate the carrying amounts represented in the condensed balance sheets.\\n9\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nFair Value Measurements\\n“Fair value” is defined as “the price that would be received for sale of an asset or paid for transfer of a liability, in an orderly transaction between market participants at the measurement date.” GAAP establishes a three-tier fair value hierarchy, which prioritizes inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). These tiers consist of:\\n\\n| ● | Level 1, defined as observable inputs such as quoted prices (unadjusted) for identical instruments in active markets; |\\n\\n\\n| ● | Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable such as quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active; and |\\n\\n\\n| ● | Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions, such as valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable. |\\n\\nIn some circumstances, the inputs used to measure fair value might be categorized within different levels of the fair value hierarchy. In those instances, the fair value measurement is categorized in its entirety in the fair value hierarchy based on the lowest level input that is significant to the fair value measurement.\\nDerivative Liabilities\\nThe Company does not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks. The Company evaluates all of its financial instruments, including issued warrants, to determine if such instruments are derivatives or contain features that qualify as embedded derivatives, pursuant to ASC 480 and ASC 815-15. The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is re-assessed at the end of each reporting period.\\nThe Company accounts for its warrants issued in connection with its Initial Public Offering and Private Placement and units that may be issued in connection with a forward purchase agreement (the “Forward Purchase Units”) as derivative liabilities in accordance with ASC 815-40. Accordingly, the Company recognizes the instruments as liabilities at fair value and adjusts the instruments to fair value at the end of each reporting period. The liabilities are subject to re-measurement at each balance sheet date until exercised, and any change in fair value of derivative liabilities is recognized in the Company’s unaudited condensed statements of operations. The fair value of warrants issued in connection with the Initial Public Offering was initially measured using Monte-Carlo simulation and has subsequently been measured on the market price of such warrants at each measurement date when separately listed and traded. The fair value of warrants issued in connection with the Private Placement was initially measured using Black-Scholes Option Pricing Model and subsequently using the market value of the public warrants. The fair value of the Forward Purchase Units has been measured using the John C Hull’s Options, Futures and Other Derivatives model at each measurement date.\\nOffering Costs Associated with the Initial Public Offering\\nOffering costs consisted of legal, accounting, underwriting fees and other costs incurred through the Initial Public Offering that were directly related to the Initial Public Offering. Offering costs are allocated to the separable financial instruments issued in the Initial Public Offering based on a relative fair value basis, compared to total proceeds received. Offering costs associated with derivative liabilities are expensed as incurred, presented as non-operating expenses in the statements of operations in the period that the costs occurred. Offering costs associated with the Class A ordinary shares were charged against the carrying value of the Class A ordinary shares upon the completion of the Initial Public Offering. The Company classifies deferred underwriting commissions as non-current liabilities as their liquidation is not reasonably expected to require the use of current assets or require the creation of current liabilities.\\nClass A Ordinary Shares Subject to Possible Redemption\\nThe Company accounts for its Class A ordinary shares subject to possible redemption in accordance with the guidance in ASC Topic 480 “Distinguishing Liabilities from Equity.” Class A ordinary shares subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable Class A ordinary shares (including Class A ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) are classified as temporary equity. At all other times, Class A ordinary shares are classified as shareholders’ equity. The Company’s Class A ordinary shares feature certain redemption rights that are considered to be outside of the Company’s control and subject to the occurrence of uncertain future events. Accordingly, as of June 30, 2023 and December 31, 2022, 2,548,153 and 23,000,000 Class A Ordinary Shares subject to possible redemption are presented as temporary equity, outside of the shareholders’ deficit section of the accompanying condensed balance sheets, respectively.\\n10\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nThe Company recognizes changes in redemption value immediately as they occur and adjusts the carrying value of the Class A ordinary shares subject to possible redemption to equal the redemption value at the end of each reporting period. This method would view the end of the reporting period as if it were also the redemption date for the security. Effective with the closing of the Initial Public Offering, the Company recognized the accretion from initial book value to redemption amount, which resulted in charges against additional paid-in capital (to the extent available) and accumulated deficit.\\nShare-Based Compensation\\nThe Company complies with the accounting and disclosure requirement of ASC Topic 718, “Compensation – Stock Compensation.” Share-based compensation to employees and non-employees is recognized over the requisite service period based on the estimated grant-date fair value of the awards. Share-based awards with graded-vesting schedules are recognized on a straight-line basis over the requisite service period for each separately vesting portion of the award. The Company recognizes the expense for share-based compensation awards subject to performance-based milestone vesting over the remaining service period when management determines that achievement of the milestone is probable. Management evaluates when the achievement of a performance-based milestone is probable based on the expected satisfaction of the performance conditions at each reporting date. Share-based compensation will be recognized in general and administrative expense in the statements of operations. The Company issued option awards that contain both a performance condition and service condition. The option awards vest upon the consummation of the initial Business Combination and will expire in five years after the date on which they first become exercisable. The Company has determined that the consummation of an initial Business Combination is a performance condition subject to significant uncertainty. As such, the achievement of the performance is not deemed to be probable of achievement until the consummation of the event, and therefore no compensation has been recognized for the period from inception to June 30, 2023.\\nIncome Taxes\\nFASB ASC Topic 740, “Income Taxes,” prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The Company’s management determined that the Cayman Islands is the Company’s only major tax jurisdiction. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of June 30, 2023 and December 31, 2022. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position.\\nThere is currently no taxation imposed on income by the Government of the Cayman Islands. In accordance with Cayman federal income tax regulations, income taxes are not levied on the Company. Consequently, income taxes are not reflected in the accompanying unaudited condensed financial statements. The Company’s management does not expect that the total amount of unrecognized tax benefits will materially change over the next twelve months.\\nNet (Loss) Income per Ordinary Share\\nThe Company complies with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share.” The Company has two classes of shares, which are referred to as Class A ordinary shares and Class B ordinary shares. Income and losses are shared pro rata between the two classes of shares. Net (loss) income per ordinary share is calculated by dividing the net (loss) income by the weighted average number of ordinary shares outstanding for the respective period.\\nThe calculation of diluted net (loss) income per ordinary share does not consider the effect of the warrants underlying the Units sold in the Initial Public Offering and the Private Placement Warrants to purchase an aggregate of 12,066,667 Class A ordinary shares since their exercise is contingent upon future events. As a result, diluted net (loss) income per share is the same as basic net (loss) income per share for the three and six months ended June 30, 2023 and 2022. Accretion associated with the redeemable Class A ordinary shares is excluded from earnings per share as the redemption value approximates fair value.\\n11\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nThe table below presents a reconciliation of the numerator and denominator used to compute basic and diluted net (loss) income per share for each class of Ordinary Shares:\\n\\n| For the Three Months Ended June 30, |\\n| 2023 | 2022 |\\n| Class A | Class B | Class A | Class B |\\n| Numerator: |\\n| Allocation of net (loss) income | $ | ( 458,126 | ) | $ | — | $ | 825,025 | $ | 224,192 |\\n| Denominator: |\\n| Weighted average ordinary shares outstanding, basic and diluted | 8,798,153 | — | 23,000,000 | 6,250,000 |\\n| Basic and diluted net (loss) income per ordinary share | $ | ( 0.05 | ) | $ | — | $ | 0.04 | $ | 0.04 |\\n\\n\\n| For the Six Months Ended June 30, |\\n| 2023 | 2022 |\\n| Class A | Class B | Class A | Class B |\\n| Numerator: |\\n| Allocation of net income | $ | 141,383 | $ | 10,868 | $ | 4,033,797 | $ | 1,096,141 |\\n| Denominator: |\\n| Weighted average ordinary shares outstanding, basic and diluted | 13,551,176 | 1,041,667 | 23,000,000 | 6,250,000 |\\n| Basic and diluted net income per ordinary share | $ | 0.01 | $ | 0.01 | $ | 0.18 | $ | 0.18 |\\n\\nRecent Accounting Pronouncements\\nThe Company’s management does not believe that any recently issued, but not yet effective, accounting standards updates, if currently adopted, would have a material effect on the accompanying unaudited condensed financial statements.\\nNote 3 - Initial Public Offering\\nOn February 22, 2021, the Company consummated its Initial Public Offering of 23,000,000 Units, including 3,000,000 Over-Allotment Units, at $ 10.00 per Unit, generating gross proceeds of $ 230.0 million, and incurring offering costs of approximately $ 13.1 million, of which approximately $ 8.1 million was for deferred underwriting commissions.\\nEach Unit consists of one Class A ordinary share and one-third of one redeemable warrant (“Public Warrant”). Each whole Public Warrant will entitle the holder to purchase one Class A ordinary share at an exercise price of $ 11.50 per share, subject to adjustment (see Note 7).\\nNote 4 - Private Placement\\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the Private Placement of 4,400,000 Private Placement Warrants, at a price of $ 1.50 per Private Placement Warrant with the Prior Sponsor, generating gross proceeds of $ 6.6 million, and incurring offering costs of approximately $ 7,000 . On June 15, 2022, the Prior Sponsor transferred 4,400,000 Private Placement Warrants to the New Sponsor.\\nEach whole Private Placement Warrant is exercisable for one whole Class A ordinary share at a price of $ 11.50 per share. A portion of the proceeds from the sale of the Private Placement Warrants to the Prior Sponsor was added to the proceeds from the Initial Public Offering held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the Private Placement Warrants will expire worthless. The Private Placement Warrants will be non-redeemable for cash and exercisable on a cashless basis so long as they are held by the Sponsor or its permitted transferees.\\nThe Sponsor agreed, subject to limited exceptions, not to transfer, assign or sell any of its Private Placement Warrants until 30 days after the completion of the initial Business Combination.\\n12\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nNote 5 - Related Party Transactions\\nForward Purchase Agreement\\nIn connection with the consummation of the Initial Public Offering, the Company entered into a forward purchase agreement (the “Forward Purchase Agreement”) with the Prior Sponsor, which provides for the purchase of $ 20.0 million Forward Purchase Units, which at the option of the Prior Sponsor, can be increased to $ 50.0 million, with each Forward Purchase Unit consisting of one Class A ordinary share (the “Forward Purchase Shares”) and one-third of one warrant to purchase one Class A ordinary share at $ 11.50 per share (the “Forward Purchase Warrants,” together with the Forward Purchase Units and the Forward Purchase Shares, the “Forward Purchase Securities”), for a purchase price of $ 10.00 per Forward Purchase Unit, in a private placement to occur concurrently with the closing of the initial Business Combination. The purchase under the Forward Purchase Agreement is required to be made regardless of whether any Class A ordinary shares are redeemed by the Public Shareholders. The Forward Purchase Securities will be issued only in connection with the closing of the initial Business Combination. The proceeds from the sale of Forward Purchase Securities may be used as part of the consideration to the sellers in the initial Business Combination, expenses in connection with the initial Business Combination or for working capital in the post-transaction company. The Company does not intend to implement the forward purchase agreement, and on April 17, 2023, the Company sent a notice of mutual termination of the forward purchase agreement to the prior sponsor. The Company classified the Forward Purchase Units as derivative instruments on the accompanying condensed balance sheets. The initial value of the Forward Purchase Units was insignificant, and the Company recognized a loss in the change in the fair value of the derivative assets (liabilities) of approximately $ 0 and $ 0 for the three and six months ended June 30, 2023, respectively, and approximately $ 19,000 and $ 49,000 for the three and six months ended June 30, 2022, respectively.\\nFounder Shares\\nOn September 21, 2020, the Company issued 4,812,500 Class B ordinary shares, par value $ 0.001 per share (the “Founder Shares”) to the Prior Sponsor. On September 23, 2020, the Prior Sponsor paid an aggregate of $ 25,000 for certain expenses on behalf of the Company in exchange for issuance of the Founder Shares. On January 25, 2021, the Company effected a stock dividend of 1,437,500 shares with respect to Class B ordinary shares, resulting in an aggregate of 6,250,000 Founder Shares outstanding. The Prior Sponsor agreed to forfeit up to an aggregate of 750,000 Founder Shares, on a pro rata basis, to the extent that the option to purchase additional Units was not exercised in full by the underwriters, so that the Founder Shares would represent 20 % of the Company’s issued and outstanding shares after the Initial Public Offering plus the 2,000,000 Forward Purchase Shares underlying the Forward Purchase Units (which at the option of the Prior Sponsor can be increased to up to 5,000,000 Forward Purchase Shares). On February 22, 2021, the underwriter fully exercised its over-allotment option; thus, these 750,000 Founder Shares were no longer subject to forfeiture.\\nOn June 15, 2022, the Prior Sponsor transferred all 6,250,000 Founder Shares to the New Sponsor.\\nThe New Sponsor agreed not to transfer, assign or sell any of its Founder Shares until the earlier to occur of (i) one year after the date of the consummation of the initial Business Combination, or earlier if, subsequent to the initial Business Combination, (x) the last reported sale price of the Class A ordinary shares equals or exceeds $ 12.00 per share (as adjusted for share splits, share dividends, reorganizations and recapitalizations) for any 20 trading days within any 30-trading day period commencing at least 150 days after the initial Business Combination or (y) the Company consummates a subsequent liquidation, merger, stock exchange or other similar transaction which results in all of the shareholders having the right to exchange their Ordinary shares for cash, securities or other property.\\nRelated Party Loans\\nOn September 23, 2020, the Prior Sponsor agreed to loan the Company up to $ 250,000 to cover costs related to the Initial Public Offering pursuant to a promissory note, which was later amended on January 22, 2021 (the “IPO Note”). The IPO Note was non-interest bearing, unsecured and due upon the closing of the Initial Public Offering. As of February 22, 2021, the Company borrowed approximately $ 111,000 under the IPO Note. The Company repaid the IPO Note in full on February 24, 2021. Subsequent to the repayment, the facility was no longer available to the Company.\\n13\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nIn addition, in order to finance transaction costs in connection with a Business Combination, the Sponsor, members of the Company’s founding team or any of their affiliates may, but are not obligated to, loan the Company funds as may be required (“Working Capital Loans”). If the Company completes a Business Combination, the Company would repay the Working Capital Loans out of the proceeds of the Trust Account released to the Company. Otherwise, the Working Capital Loans would be repaid only out of funds held outside the Trust Account. In the event that a Business Combination does not close, the Company may use a portion of proceeds held outside the Trust Account to repay the Working Capital Loans but no proceeds held in the Trust Account would be used to repay the Working Capital Loans. The Working Capital Loans would either be repaid upon consummation of a Business Combination, without interest, or, at the lenders’ discretion, up to $ 1.5 million of such Working Capital Loans may be convertible into warrants of the post Business Combination entity at a price of $ 1.50 per warrant. The warrants would be identical to the Private Placement Warrants. Except for the foregoing, the terms of such Working Capital Loans, if any, have not been determined and no written agreements exist with respect to such loans. As of June 30, 2023 and December 31, 2022, the Company had no borrowings under any Working Capital Loans.\\nOn April 13, 2022, the Company issued the Promissory Note to the Prior Sponsor for an aggregate of up to $ 200,000 . On May 25, 2022, the Prior Sponsor amended the Promissory Note agreement and increased the principal amount to $ 400,000 . The Promissory Note bears no interest, may be prepaid at any time and is due and payable within one year from the date of the first drawdown of the amended and restated note, or June 7, 2023. On June 30, 2022, the Prior Sponsor assigned all of its rights and obligations under the Promissory Note to the New Sponsor in connection with the Sponsor Transaction. As of June 30, 2023, the Company has fully drawn $ 400,000 under the Promissory Note. As of June 30, 2023 and December 31, 2022, approximately $ 400,000 and $ 319,000 were outstanding under the Promissory Note, respectively.\\nExtension Loan\\nPursuant to the Extension, as described in Note 1, the Sponsor or its designees contributed to the Company as a loan the initial contribution of $ 120,000 in February 2023 for the portion of the extension ending on April 22, 2023. The Sponsor will also loan the company extension contributions of $ 60,000 per month for each subsequent calendar month (commencing on April 22, 2023 and on the 22nd day of each subsequent month) until November 22, 2023, or portion thereof, that is needed to complete an initial Business Combination, which amount will be deposited into the Trust Account. As of June 30, 2023, the Company has drawn $ 270,000 on the Extension Loan and deposited it into the Trust Account.\\nRelated Party Advance\\nFor the three and six months ended June 30, 2023, the Sponsor had paid $ 164,081 and $ 188,722 , respectively, of expenses on behalf on Company, which are included in advance from related parties in the accompanying condensed balance sheets as of June 30, 2023.\\nAdministrative Services Agreement\\nCommencing on February 17, 2021, through the earlier of consummation of the initial Business Combination and the liquidation, the Company agreed to pay Kismet LLC, an affiliate of the Prior Sponsor, $ 10,000 per month for office space, utilities, secretarial support and administrative services.\\nOn June 30, 2022, in connection with the Sponsor Transaction, the Company and Kismet LLC mutually terminated the Administrative Services Agreement. As a result, the Company is no longer obligated to pay a $ 10,000 monthly fee pursuant to the Administrative Services Agreement.\\nDirector Compensation\\nCommencing on February 18, 2021, the Company paid its initial directors $ 40,000 each. On May 25, 2022, Mr. Verdi Israelyan, a former director, waived his right to receive a payment of $ 40,000 . The Company also granted two of its independent directors, Messrs. Tompsett and Zilber, an option each to purchase 40,000 Class A ordinary shares at an exercise price of $ 10.00 per share, which will vest upon the consummation of the initial Business Combination and will expire five years after the date on which it first became exercisable Further, following the approval of the Extension, the compensation committee of the Company’s board of directors has approved the transfers by the Sponsor of (a) 15,000 Founder Shares to each of Messrs. Zilber and Tourevski and (b) 20,000 Founder Shares to Mr. Tompsett as additional compensation, which transfers will take place prior to the closing of the initial Business Combination. Both the Founder Shares and the options granted to the directors are subject to forfeiture in the event a director ceases to serve on the Company’s board prior to the closing of a Business Combination. In addition, the Sponsor, executive officers and directors, or any of their respective affiliates will be reimbursed for any out-of-pocket expenses incurred in connection with activities on the Company’s behalf such as identifying potential target businesses and performing due diligence on suitable Business Combinations. The Company’s audit committee reviews, on a quarterly basis, all payments that are made to the Sponsor, officers or directors, or the Company’s or their affiliates.\\nOn May 25, 2022, one of the Company’s former directors waived his right to receive a payment of $ 40,000 and the Company recorded approximately $ 0 of director compensation during three and six months ended June 30, 2023 , and approximately $( 12,000 ) and $ 3,000 of director compensation during the three and six months ended June 30, 2022, respectively. As of June 30, 2023 and December 31, 2022, the Company had no amounts outstanding in relation to the director compensation.\\n14\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nDeparture and Appointment of Officers\\nOn June 30, 2022, concurrently with the Sponsor Transaction, Ivan Tavrin, Chief Executive Officer and Chairman of the Company’s board of directors, resigned as Chairman and Chief Executive Officer of the Company, and as the Company’s principal financial and accounting officer.\\nEffective June 30, 2022, the Company’s board of directors appointed Mr. Dimitri Elkin to serve as the Company’s Chief Executive Officer. Mr. Elkin is also serving as the Company’s principal financial and accounting officer.\\nOn September 5, 2022, Verdi Israelyan, resigned from the board of directors of the Company. Mr. Israelyan resignation was not the result of any dispute or disagreement with the Company or the Company’s board of directors on any matter relating to the Company’s operations, policies or practices. On March 27, 2023, the board of directors elected Konstantin Tourevski as a director and as a member of the audit committees to fill the vacancy caused by the resignation of Mr. Israelyan.\\nNote 6 - Commitments and Contingencies\\nRegistration Rights\\nThe holders of the Founder Shares and Private Placement Warrants (and any Class A ordinary shares issuable upon the exercise of the Private Placement Warrants and warrants that may be issued upon conversion of Working Capital Loans) were entitled to registration rights pursuant to a registration rights agreement dated February 17, 2021 (the “Registration Rights Agreement”). The holders of these securities are entitled to make up to three demands, excluding short form demands, that the Company register such securities. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the completion of the initial Business Combination. The Company will bear the expenses incurred in connection with the filing of any such registration statements. On June 30, 2022, in connection with the Sponsor Transaction, the Prior Sponsor assigned to the New Sponsor all of its rights and obligations under the Registration Rights Agreement.\\nPursuant to the Forward Purchase Agreement, the Company agreed to use its commercially reasonable efforts (i) to file within 30 days after the closing of the initial Business Combination a registration statement with the SEC for a secondary offering of the Forward Purchase Shares and the Forward Purchase Warrants (and underlying Class A Ordinary Shares), (ii) to cause such registration statement to be declared effective promptly thereafter but in no event later than sixty (60) days after the initial filing, and (iii) to maintain the effectiveness of such registration statement until the earliest of (A) the date on the Prior Sponsor or its assignees cease to hold the securities covered thereby and (B) the date all of the securities covered thereby can be sold publicly without restriction or limitation under Rule 144 under the Securities Act. In addition, the Forward Purchase Agreement provides for “piggy-back” registration rights to the holders of Forward Purchase Securities to include their securities in other registration statements filed by the Company.\\nUnderwriting Agreement\\nThe Company granted the underwriters a 45-day option from February 17, 2021, to purchase up to 3,000,000 additional Units at the Initial Public Offering price less the underwriting discounts and commissions. On February 22, 2021, the underwriters fully exercised their over-allotment option.\\nThe underwriters were entitled to an underwriting discount of $ 0.20 per Unit, or $ 4.6 million in the aggregate, paid upon the closing of the Initial Public Offering. In addition, $ 0.35 per Unit, or approximately $ 8.1 million in the aggregate will be payable to the underwriters for deferred underwriting commissions. The deferred fee will become payable to the underwriters from the amounts held in the Trust Account solely in the event that the Company completes a Business Combination, subject to the terms of the underwriting agreement.\\nOn August 11, 2022 and September 6, 2022, two of the underwriters in the initial public offering irrevocably waived their rights to receive an aggregate of approximately $ 5.2 million of deferred underwriting discounts due under the underwriting agreements consummated in connection with the initial public offering. The Company recognized the portion allocated to Public Shares of approximately $ 5.0 million as an adjustment to the carrying value of the Class A ordinary shares subject to possible redemption and the remaining balance of approximately $ 0.2 million as a gain from extinguishment of deferred underwriting commissions allocated to derivative warrant liabilities.\\nRisks and Uncertainties\\nManagement continues to evaluate the impact of the COVID-19 pandemic on the industry and has concluded that while it is reasonably possible that the virus could have a negative effect on the Company’s financial position, results of its operations and/or search for a target company, the specific impact is not readily determinable as of the date of these unaudited condensed financial statements. The accompanying unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty.\\n15\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nIn February 2022, a military conflict started between Russia and Ukraine. The ongoing military conflict between Russia and Ukraine has provoked strong reactions from the United States, the United Kingdom, the European Union and various other countries around the world, including the imposition of broad financial and economic sanctions against Russia. Further, the precise effects of the ongoing military conflict and these sanctions on the global economies remain uncertain as of the date of the accompanying unaudited condensed financial statements. The specific impact on the Company’s financial condition, results of operations, and cash flows is also not determinable as of the date of the accompanying unaudited condensed financial statements.\\nNote 7 - Warrants\\nAs of June 30, 2023 and December 31, 2022, 7,666,667 Public Warrants and 4,400,000 Private Placement Warrants were outstanding.\\nPublic Warrants may only be exercised for a whole number of Class A Ordinary Shares. No fractional Public Warrants will be issued upon separation of the Units and only whole Public Warrants will trade. The Public Warrants will become exercisable on the later of (a) 30 days after the completion of a Business Combination or (b) 12 months from the closing of the Initial Public Offering; provided in each case that the Company has an effective registration statement under the Securities Act covering the Class A Ordinary Shares issuable upon exercise of the Public Warrants and a current prospectus relating to them is available and such shares are registered, qualified or exempt from registration under the securities, or blue sky, laws of the state of residence of the holder (or the Company permits holders to exercise their warrants on a cashless basis under certain circumstances). The Company agreed that as soon as practicable, but in no event later than 15 business days after the closing of the initial Business Combination, the Company will use commercially reasonable efforts to file with the SEC and have an effective registration statement covering the Class A Ordinary Shares issuable upon exercise of the warrants and to maintain a current prospectus relating to those Class A Ordinary Shares until the warrants expire or are redeemed, as specified in the warrant agreement. If a registration statement covering the Class A Ordinary Shares issuable upon exercise of the warrants is not effective by the 60th day after the closing of the initial Business Combination, warrant holders may, until such time as there is an effective registration statement and during any period when the Company will have failed to maintain an effective registration statement, exercise warrants on a “cashless basis” in accordance with Section 3(a)(9) of the Securities Act or another exemption. Notwithstanding the above, if the Class A Ordinary Shares are at the time of any exercise of a warrant not listed on a national securities exchange such that they satisfy the definition of a “covered security” under Section 18(b)(1) of the Securities Act, the Company may, at its option, require holders of Public Warrants who exercise their warrants to do so on a “cashless basis” and, in the event the Company so elects, the Company will not be required to file or maintain in effect a registration statement, and in the event the Company does not so elect, it will use commercially reasonable efforts to register or qualify the shares under applicable blue sky laws to the extent an exemption is not available.\\nThe warrants have an exercise price of $11.50 per share, subject to adjustments, and will expire five years after the completion of a Business Combination or earlier upon redemption or liquidation. In addition, if (x) the Company issues additional Class A Ordinary Shares or equity-linked securities for capital raising purposes in connection with the closing of the initial Business Combination at an issue price or effective issue price of less than $9.20 per Class A Ordinary Share (with such issue price or effective issue price to be determined in good faith by the Company’s board of directors and, in the case of any such issuance to the Sponsor or an affiliate of the Sponsor, without taking into account any Founder Shares held by the Sponsor or an affiliate of the Sponsor, as applicable, prior to such issuance) (the “Newly Issued Price”), (y) the aggregate gross proceeds from such issuances represent more than 60% of the total equity proceeds, and interest thereon, available for the funding of the initial Business Combination on the date of the completion of the initial Business Combination (net of redemptions), and (z) the volume-weighted average trading price of the Class A Ordinary Shares during the 20 trading day period starting on the trading day prior to the day on which the Company completes its initial Business Combination (such price, the “Market Value”) is below $9.20 per share, the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115% of the higher of the Market Value and the Newly Issued Price, and the $10.00 and $18.00 per share redemption trigger prices described under “Redemption of warrants when the price per Class A Ordinary Share equals or exceeds $18.00” and “Redemption of warrants when the price per Class A Ordinary Share equals or exceeds $10.00” will be adjusted (to the nearest cent) to be equal to 100% and 180% of the higher of the Market Value and the Newly Issued Price, respectively.\\n16\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nThe Private Placement Warrants are identical to the Public Warrants underlying the Units sold in the Initial Public Offering, except that the Private Placement Warrants and the Class A Ordinary Shares issuable upon exercise of the Private Placement Warrants will not be transferable, assignable or sellable until 30 days after the completion of a Business Combination, subject to certain limited exceptions. Additionally, the Private Placement Warrants will be non-redeemable so long as they are held by the initial purchaser or such purchaser’s permitted transferees. If the Private Placement Warrants are held by someone other than the Initial Shareholder or its permitted transferees, the Private Placement Warrants will be redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants.\\nRedemption of Warrants When the Price per Class A Ordinary Share Equals or Exceeds $ 18.00\\nOnce the warrants become exercisable, the Company may call the outstanding warrants (excluding the Private Placement Warrants), in whole and not in part, at a price of $ 0.01 per warrant:\\n\\n| ● | upon a minimum of 30 days’ prior written notice of redemption; and |\\n\\n\\n| ● | if, and only if, the last reported sale price of the Class A Ordinary Shares equals or exceeds $ 18.00 per share (as adjusted) for any 20 trading days within a 30 trading day period ending three business days before the Company sends the notice of redemption to the warrant holders (the “Reference Value”). |\\n\\nThe Company will not redeem the warrants as described above unless a registration statement under the Securities Act covering the Class A Ordinary Shares issuable upon exercise of the warrants is then effective and a current prospectus relating to those Class A Ordinary Shares is available throughout the 30-trading day redemption period.\\nRedemption of Warrants When the Price per Class A Ordinary Share Equals or Exceeds $ 10.00\\nOnce the warrants become exercisable, the Company may redeem the outstanding warrants, in whole and not in part, at a price of $ 0.10 per warrant:\\n\\n| ● | upon a minimum of 30 days’ prior written notice of redemption provided that holders will be able to exercise their warrants on a cashless basis prior to redemption and receive that number of Class A Ordinary Shares to be determined by reference to an agreed table based on the redemption date and the “fair market value” of Class A Ordinary Shares; and |\\n\\n\\n| ● | if, and only if, and only if, the Reference Value equals or exceeds $ 10.00 per Public Share (as adjusted), and |\\n\\n\\n| ● | if the Reference Value is less than $ 18.00 per share (as adjusted), the Private Placement Warrants must also be concurrently called for redemption on the same terms as the outstanding Public Warrants, as described above. |\\n\\nThe “fair market value” of Class A Ordinary Shares for the above purpose shall mean the volume-weighted average price of the Class A Ordinary Shares for the 10 trading days immediately following the date on which the notice of redemption is sent to the holders of warrants. In no event will the warrants be exercisable in connection with this redemption feature for more than 0.361 Class A Ordinary Shares per warrant (subject to adjustment).\\nIn no event will the Company be required to net cash settle any warrant. If the Company is unable to complete a Business Combination within the Combination Period and the Company liquidates the funds held in the Trust Account, holders of warrants will not receive any of such funds with respect to their warrants, nor will they receive any distribution from the Company’s assets held outside of the Trust Account with the respect to such warrants. Accordingly, the warrants may expire worthless.\\n17\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nNote 8 - Class A Ordinary Shares Subject to Possible Redemption\\nThe Class A ordinary shares feature certain redemption rights that are considered to be outside of the Company’s control and subject to the occurrence of future events. The Company is authorized to issue 200,000,000 Class A ordinary shares with a par value of $ 0.001 per share. Holders of the Class A ordinary shares are entitled to one vote for each share. In connection with such shareholders’ meeting, shareholders holding 20,451,847 Class A ordinary shares exercised their right to redeem those shares for cash at an approximate price of $ 10.20 per share for an aggregate of approximately $ 208.5 million. As of June 30, 2023 and December 31, 2022, there were 2,548,153 and 23,000,000 Class A Ordinary Shares outstanding, respectively, which were all subject to possible redemption and are classified outside of permanent equity in the accompanying condensed balance sheets.\\nThe Class A Ordinary Shares subject to possible redemption reflected on the accompanying condensed balance sheets are reconciled on the following table:\\n\\n| Gross proceeds received from Initial Public Offering | $ | 230,000,000 |\\n| Less: |\\n| Fair value of Public Warrants at issuance | ( 6,823,334 | ) |\\n| Offering costs allocated to Class A ordinary shares | ( 12,685,596 | ) |\\n| Plus: |\\n| Accretion on Class A ordinary shares subject to possible redemption | 19,508,930 |\\n| Class A ordinary shares subject to possible redemption as of December 31, 2021 | 230,000,000 |\\n| Plus: |\\n| Waiver of Class A ordinary shares issuance costs | 5,077,217 |\\n| Less: |\\n| Accretion on Class A ordinary shares subject to possible redemption | ( 1,872,702 | ) |\\n| Class A ordinary shares subject to possible redemption as of December 31, 2022 | 233,204,515 |\\n| Less: |\\n| Redemptions | ( 208,524,538 | ) |\\n| Plus: |\\n| Accretion on Class A ordinary shares subject to possible redemption | 1,560,982 |\\n| Class A ordinary shares subject to possible redemption as of March 31, 2023 | 26,240,959 |\\n| Plus: |\\n| Accretion on Class A ordinary shares subject to possible redemption | 390,284 |\\n| Class A ordinary shares subject to possible redemption as of June 30, 2023 | $ | 26,631,243 |\\n\\nNote 9 - Shareholders’ Deficit\\nClass A Ordinary Shares\\nThe Company is authorized to issue 200,000,000 Class A Ordinary Shares with a par value of $ 0.001 per share. Holders of the Class A Ordinary Shares are entitled to one vote for each share. As of June 30, 2023 and December 31, 2022, there were 6,250,000 and 0 Class A Ordinary Shares issued and outstanding, excluding 2,548,153 and 23,000,000 which were subject to possible redemption and included as temporary equity, respectively (see Note 8).\\nClass B Ordinary Shares\\nThe Company is authorized to issue 10,000,000 Class B Ordinary Shares with a par value of $ 0.001 per share. As of June 30, 2023 and December 31, 2022, there were 0 and 6,250,000 Class B Ordinary Shares issued and outstanding, respectively.\\nOrdinary shareholders of record are entitled to one vote for each share held on all matters to be voted on by shareholders. Except as described below, holders of Class A ordinary shares and holders of Class B ordinary shares vote together as a single class on all matters submitted to a vote of the shareholders except as required by law.\\nThe Class B ordinary shares will automatically convert into Class A ordinary shares at the time of the initial Business Combination or earlier at the option of the holders thereof at a ratio such that the number of Class A ordinary shares issuable upon conversion of all Founder Shares will equal, in the aggregate, on an as-converted basis, 20 % of the sum of (i) the total number of the Ordinary Shares issued and outstanding upon completion of the Initial Public Offering, plus (ii) the total number of Class A ordinary shares issued or deemed issued or issuable upon conversion or exercise of any equity-linked securities or rights issued or deemed issued by the Company in connection with or in relation to the completion of the initial Business Combination (including the Forward Purchase Shares, but not the Forward Purchase Warrants), excluding any Class A ordinary shares or equity-linked securities exercisable for or convertible into Class A ordinary shares issued, deemed issued, or to be issued, to any seller in the initial Business Combination and any Private Placement Warrants issued to the Sponsor or any of its affiliates or any member of the Company’s management team upon conversion of Working Capital Loans. In no event will the Class B ordinary shares convert into Class A ordinary shares at a rate of less than one-to-one.\\n18\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nNote 10 - Fair Value Measurements\\nThe following tables present information about the Company’s assets and liabilities that are measured at fair value on a recurring basis as of June 30, 2023 and December 31, 2022 and indicates the fair value hierarchy of the valuation techniques that the Company utilized to determine such fair value.\\n\\n| Fair Value Measured as of June 30, 2023 |\\n| Level 1 | Level 2 | Level 3 |\\n| Liabilities: |\\n| Derivative liabilities - Public Warrants | $ | — | $ | 514,433 | $ | — |\\n| Derivative liabilities - Private Placement Warrants | $ | — | $ | 295,240 | $ | — |\\n\\n\\n| Fair Value Measured as of December 31, 2022 |\\n| Level 1 | Level 2 | Level 3 |\\n| Assets |\\n| Investments held in Trust Account - U.S. Treasury Securities | $ | 233,304,515 | $ | — | $ | — |\\n| Liabilities: |\\n| Derivative liabilities - Public Warrants | $ | — | $ | 19,167 | $ | — |\\n| Derivative liabilities - Private Placement Warrants | $ | — | $ | 11,000 | $ | — |\\n\\nTransfers to/from Levels 1, 2, and 3 are recognized in the beginning of the reporting period. The estimated fair value of the Public Warrants was transferred from a Level 3 measurement to a Level 1 fair value measurement in April 2021, when the Public Warrants were separately listed and traded. The estimated fair value of the Private Placement Warrants was transferred from a Level 3 measurement to a Level 2 fair value measurement during the year ended December 31, 2021. The estimated fair value of the Public Warrants transferred to a Level 2 measurement during the quarter ending December 31, 2022 due to low trading volume. There were no transfers to/from Levels 1, 2, and 3 during the three and six months ended June 30, 2023.\\nLevel 1 assets include investments in mutual funds that invest solely in U.S. government securities. The Company uses inputs such as actual trade data, quoted market prices from dealers or brokers, and other similar sources to determine the fair value of its investments.\\nThe fair value of the Public Warrants was initially measured using a Monte-Carlo simulation and has subsequently been measured based on the market price of such warrants at each measurement date when separately listed and traded. The fair value of the Private Placement Warrants was initially measured using a Black-Scholes Option Pricing Model and subsequently using the market value of the Public Warrants. For the three months ended June 30, 2023 and 2022, the Company recognized a decrease/(increase) in the fair value of derivative warrant liabilities of approximately $( 538,000 ) and $ 845,000 , and approximately $( 780,000 ) and $ 5.1 million for the six months ended June 30, 2023 and 2022, respectively, presented on the accompanying condensed statements of operations.\\nThe Company utilized John C. Hull’s Options, Futures, and Other Derivatives model to estimate the fair value of the Forward Purchase Units at each measurement date up until September 30, 2023. As the Company does not intend to implement the forward purchase agreement, the Company determined the fair value of the Forward Purchase Units as of June 30, 2023 and December 31, 2022 was deminimis. There was no change in fair value of the Forward Purchase Units for the three and six months ended June 30, 2023. The Company recognized expense in the change in fair value of the Forward Purchase Units of approximately $ 19,000 and $ 49,000 for the three and six months ended June 30, 2022, respectively.\\n19\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nThe change in the fair value of the Level 3 derivative warrant liabilities for three and six months ended March 31, 2022 is summarized as follows:\\n\\n| Derivative assets (liabilities) as of January 1, 2022 | $ | 88,970 |\\n| Change in fair value of derivative assets and liabilities | 30,204 |\\n| Derivative assets (liabilities) as of March 31, 2022 | 119,174 |\\n| Change in fair value of derivative assets and liabilities | 18,877 |\\n| Derivative assets (liabilities) as of June 30, 2022 | $ | 138,051 |\\n\\nNote 11 - Subsequent Events\\nManagement has evaluated subsequent events to determine if events or transactions occurring after the balance sheet date through the date the accompanying unaudited condensed financial statements were issued. Based upon this review, the Company did not, other than the below, identify any subsequent event that would have required adjustment or disclosure in the accompanying unaudited condensed financial statements.\\nOn July 11, 2023 and August 7, 2023, pursuant to the Extension, as described in Note 1, the Sponsor or its designees contributed to the Company as a loan an additional contribution of $ 30,000 and $ 60,000 , respectively, into the trust to extend the date of which it has to consummate an initial business combination to August 22, 2023.\\n20\\n\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.\\nReferences to the “Company,” “Quadro Acquisition One Corp.,” “our,” “us” or “we” refer to Quadro Acquisition One Corp. (formerly known as Kismet Acquisition Two Corp.). The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the unaudited condensed financial statements and the notes thereto under “Item 1. Financial Statements”. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\\nCautionary Note Regarding Forward-Looking Statements\\nAll statements other than statements of historical fact included in this Quarterly Report on Form 10-Q for the quarter ended June 30, 2023 (this “Report”) including, without limitation, statements under this “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward- looking statements. When used in this Report, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or our management, identify forward-looking statements. Such forward-looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company’s management. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors detailed in our filings with the SEC. All subsequent written or oral forward-looking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph.\\nOverview\\nWe are a blank check company incorporated as a Cayman Islands exempted company on September 15, 2020. We were incorporated for the purpose of engaging in an initial business combination with one or more businesses. We are an emerging growth company and, as such, we are subject to all of the risks associated with emerging growth companies.\\nOur sponsor is Quadro Sponsor LLC, a Delaware limited liability company. The registration statement for our initial public offering was declared effective on February 17, 2021. On February 22, 2021, we consummated our initial public offering of 23,000,000 units, including 3,000,000 additional units to cover the underwriters’ over-allotment option, at $10.00 per unit, generating gross proceeds of $230.0 million, and incurring offering costs of approximately $13.1 million, of which approximately $8.1 million was for deferred underwriting commissions.\\nSimultaneously with the closing of our initial public offering, we consummated the private placement of 4,400,000 warrants, at a price of $1.50 per private placement warrant, to our prior sponsor, generating gross proceeds of $6.6 million, and incurring offering costs of approximately $7,000.\\nUpon the closing of the initial public offering and the private placement, $230.0 million ($10.00 per unit) of the net proceeds of the initial public offering and a portion of the proceeds of the private placement were placed in a trust account, with Continental acting as trustee, and invested in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds meeting certain conditions under Rule 2a-7 under the Investment Company Act, which invest only in direct U.S. government treasury obligations, as determined by us, until the earlier of: (i) the completion of a business combination and (ii) the distribution of the trust account as described below.\\nOn February 10, 2023, we instructed Continental to liquidate the investments held in the trust account and instead to hold the funds in the trust account in an interest-bearing demand deposit account at Morgan Stanley, with Continental continuing to act as trustee, until the earlier of the consummation of our initial business combination or our liquidation. As a result, following the liquidation of investments in the trust account, the remaining proceeds from the initial public offering and private placement are no longer invested in U.S. government securities or money market funds.\\nOur management has broad discretion with respect to the specific application of the net proceeds of our initial public offering and the private placement, although substantially all of the net proceeds are intended to be applied generally toward consummating a business combination. Our initial business combination must be with one or more operating businesses or assets with a fair market value equal to at least 80% of the net assets held in the trust account (excluding the deferred underwriting commissions and taxes payable, if any, on the income accrued on the trust account) at the time we sign a definitive agreement in connection with the initial business combination. However, we will only complete a business combination if the post-transaction company owns or acquires 50% or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act.\\nIf we are unable to complete a business combination by the Termination Date, we will (i) cease all operations except for the purpose of winding up; (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account, including interest earned on the funds held in the trust account and not previously released to us to pay our taxes that were paid by us or are payable by us, if any (less up to $100,000 of interest to pay dissolution expenses), divided by the number of the then-outstanding public shares, which redemption will completely extinguish public shareholders’ rights as shareholders (including the right to receive further liquidation distributions, if any); and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the remaining shareholders and the board of directors, liquidate and dissolve, subject in the case of clauses (ii) and (iii) to our obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law.\\n21\\nRecent Developments\\nOn January 31, 2023, we issued an aggregate of 6,250,000 Class A ordinary shares to the sponsor, upon the conversion of an equal number of Class B ordinary shares held by the sponsor in the Founder Conversion. The 6,250,000 Class A ordinary shares issued in connection with the Founder Conversion are subject to the same restrictions as applied to the Class B ordinary shares before the Founder Conversion, including, among others, certain transfer restrictions, waiver of redemption rights and the obligation to vote in favor of an initial business combination as described in the prospectus for the initial public offering.\\nOn February 20, 2023, we held the 2023 Extraordinary General Meeting at which our shareholders approved an amendment to our amended and restated memorandum and articles of association to extend the date by which we must consummate an initial business combination to April 22, 2023, and to allow our board, without another shareholder vote, to extend the Termination Date on a monthly basis up to seven times for an additional one month each time until November 22, 2023, or a total of up to nine months after the Original Termination Date (the “Extension”). In connection with the vote to approve the Extension Amendment, the holders of 20,451,847 Class A ordinary shares properly exercised their right to redeem their shares for cash at a redemption price of approximately $10.20 per share, for an aggregate redemption amount of approximately $208,524,538, in connection with the Extension Amendment.\\nIn connection with the Extension, our sponsor or its designees contributed to us as a loan the initial contribution of $120,000 (the “Initial Extension Loan”) in February 2023 for the portion of the Extension ending on April 22, 2023. Our sponsor will also loan us extension contributions of $60,000 per month for each subsequent calendar month (commencing on April 22, 2023 and on the 22nd day of each subsequent month) until November 22, 2023, or portion thereof, that is needed to complete an initial business combination, which amount will be deposited into the trust account (together with the Initial Extension Loan, the “Extension Loans”). The amount of the Extension Loans will not bear interest and will be repayable by us to the sponsor or its designees upon consummation of an initial business combination. In the event that a business combination does not close, we may use a portion of proceeds held outside the trust account to repay the Extension Loans, but no proceeds held in the trust account would be used to repay the Extension Loans.\\nFollowing the Founder Conversion and the redemptions in connection with the Extension, there were 8,798,153 Class A ordinary shares issued and outstanding and no Class B Ordinary Shares issued and outstanding.\\nAt the 2023 Extraordinary General Meeting, our shareholders also approved our company’s name change from Kismet Acquisition Two Corp. to Quadro Acquisition One Corp. to better reflect the Sponsor Transaction.\\nOn March 27, 2023, our board of directors elected Konstantin Tourevski as a director and as a member of the audit committee to fill the vacancy caused by the resignation of Verdi Israelyan.\\nLiquidity and Capital Resources\\nAs of June 30, 2023, we had $0 in our operating bank account and working capital deficit of approximately $1.4 million.\\nOur liquidity needs to date have been satisfied through a contribution of $25,000 from the prior sponsor to cover certain expenses in exchange for the issuance of the founder shares, a loan of approximately $111,000 from the prior sponsor pursuant to the First Note originally issued on September 23, 2020 and amended on January 22, 2021, and a portion of the proceeds from the consummation of the private placement not held in the trust account. We repaid the First Note in full on February 24, 2021. Subsequent to the repayment, the facility was no longer available to us. In addition, in order to finance transaction costs in connection with a business combination, the sponsor or an affiliate of the sponsor, or certain of our officers and directors may, but are not obligated to, provide us working capital loans in order to finance transaction costs in connection with a business combination. As of June 30, 2023 and December 31, 2022, there were no amounts outstanding under any working capital loans.\\n22\\nOn April 13, 2022, we issued the Second Note, a promissory note in the amount of up to $200,000 to the prior sponsor. On May 25, 2022, we and the prior sponsor amended and restated the Second Note and increased the principal amount to $400,000. The promissory note bears no interest and is due and payable within one year from the date of the first drawdown of the amended and restated note, or June 7, 2023. On June 30, 2022, the prior sponsor assigned all of its rights and obligations under the promissory note to our sponsor in connection with the Sponsor Transaction. As of June 30, 2023, we have fully drawn $400,000 under the Promissory Note. As of June 30, 2023 and December 31, 2022, approximately $400,000 and $319,000 were outstanding under the Promissory Note, respectively.\\nWe may need to raise additional capital through loans or additional investments from our sponsor, our officers or directors or their affiliates. Our sponsor, officers, directors and or their affiliates, may, but are not obligated to, loan our company funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet our working capital needs. Accordingly, we may not be able to obtain additional financing. If we are unable to raise additional capital, we may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, reducing overhead expenses, and extending the terms and due dates of certain accrued expenses and other liabilities. We cannot provide any assurance that new financing will be available to it on commercially acceptable terms, if at all. In connection with our assessment of going concern considerations in accordance with ASC Topic 205-40, “Presentation of Financial Statements – Going Concern,” we have determined that the liquidity condition, mandatory liquidation and subsequent dissolution raises substantial doubt about our ability to continue as a going concern. Management continues to seek to complete a business combination prior to the mandatory liquidation date. No adjustments have been made to the carrying amounts of assets or liabilities should we be required to liquidate by November 22, 2023.\\nContractual Obligations\\nAdministrative Services Agreement\\nWe do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities, except that, commencing on February 17, 2021, through the earlier of consummation of the initial business combination and the liquidation, we agreed to pay Kismet LLC, an affiliate of our prior sponsor, $10,000 per month for office space, utilities, secretarial support and administrative services.\\nOn June 30, 2022, in connection with the Sponsor Transaction, the Company and Kismet LLC mutually terminated the Administrative Services Agreement. As a result, the Company is no longer obligated to pay a $10,000 monthly fee pursuant to the Administrative Services Agreement.\\nResults of Operations\\nOur entire activity since inception up to June 30, 2023, was in preparation for our formation and our initial public offering, and since the completion of our initial public offering, the search for business combination candidates. We will not be generating any operating revenues until the closing and completion of our initial business combination at the earliest.\\nFor the three months ended June 30, 2023, we had net loss of approximately $458,000, which consisted of a non-operating loss of approximately $538,000 resulting from the change in fair value of derivative assets and liabilities and approximately $160,000 general and administrative expenses, partially offset by approximately $240,000 of income from investments held in trust account.\\nFor the three months ended June 30, 2022, we had net income of approximately $1.0 million, which consisted of a non-operating gain of approximately $864,000 resulting from the change in fair value of derivative assets and liabilities and approximately $292,000 of net gain on the investments held in the Trust Account, partially offset by approximately $107,000 general and administrative expenses.\\nFor the six months ended June 30, 2023, we had net income of approximately $152,000, which consisted of approximately $1.7 million of income from investments held in trust account, partially offset by a non-operating loss of approximately $780,000 resulting from the change in fair value of derivative assets and liabilities and approximately $750,000 general and administrative expenses.\\nFor the six months ended June 30, 2022, we had net income of approximately $5.1 million, which consisted of a non-operating gain of approximately $5.1 million resulting from the change in fair value of derivative assets and liabilities and approximately $313,000 of net gain on the investments held in the Trust Account, partially offset by approximately $300,000 general and administrative expenses.\\n23\\nCommitments and Contingencies\\nRegistration Rights\\nThe holders of the founder shares, private placement warrants, and warrants that may be issued upon conversion of working capital loans (and any Class A ordinary shares issuable upon the exercise of the private placement warrants and warrants that may be issued upon conversion of working capital loans) are entitled to registration rights pursuant to a registration rights agreement dated February 17, 2021. The holders of these securities are entitled to make up to three demands, excluding short form demands, that we register such securities. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the completion of the initial business combination. We will bear the expenses incurred in connection with the filing of any such registration statements.\\nPursuant to the forward purchase agreement (described below), we agreed to use our commercially reasonable efforts (i) to file within 30 days after the closing of the initial business combination a registration statement with the SEC for a secondary offering of the forward purchase shares and the forward purchase warrants (and underlying Class A ordinary shares), (ii) to cause such registration statement to be declared effective promptly thereafter but in no event later than sixty (60) days after the initial filing, and (iii) to maintain the effectiveness of such registration statement until the earliest of (A) the date on which our sponsor or its assignees cease to hold the securities covered thereby and (B) the date all of the securities covered thereby can be sold publicly without restriction or limitation under Rule 144 under the Securities Act. In addition, the forward purchase agreement provides for “piggy-back” registration rights to the holders of forward purchase securities to include their securities in other registration statements filed by us.\\nForward Purchase Agreement\\nIn connection with the consummation of our initial public offering, we entered into a forward purchase agreement with our prior sponsor, which provides for the purchase of $20.0 million of forward purchase units, which at the option of our prior sponsor can be increased to $50.0 million, with each forward purchase unit consisting of one Class A ordinary share and one-third of one warrant to purchase one Class A ordinary share at $11.50 per share, for a purchase price of $10.00 per forward purchase unit, in a private placement to occur concurrently with the closing of the initial business combination. The purchase under the forward purchase agreement is required to be made regardless of whether any Class A ordinary shares are redeemed by the public shareholders. The forward purchase securities will be issued only in connection with the closing of the initial business combination. The proceeds from the sale of forward purchase securities may be used as part of the consideration to the sellers in the initial business combination, expenses in connection with the initial business combination or for working capital in the post-transaction company. We do not intend to implement the forward purchase agreement, and on April 17, 2023, we sent a notice of mutual termination of the forward purchase agreement to the prior sponsor.\\nUnderwriting Agreement\\nWe granted the underwriters a 45-day option from February 17, 2021, to purchase up to 3,000,000 additional units at our initial public offering price less the underwriting discounts and commissions. On February 22, 2021, the underwriters fully exercised their over-allotment option.\\nThe underwriters were entitled to an underwriting discount of $0.20 per unit, or approximately $4.6 million in the aggregate, paid upon the closing of our initial public offering. In addition, $0.35 per unit, or approximately $8.1 million in the aggregate will be payable to the underwriters for deferred underwriting commissions. The deferred fee will become payable to the underwriters from the amounts held in the trust account solely in the event that we complete an initial business combination, subject to the terms of the underwriting agreement.\\nOn August 11, 2022 and September 6, 2022, two of the underwriters in the initial public offering irrevocably waived their rights to receive an aggregate of approximately $5.2 million of deferred underwriting discounts due under the underwriting agreements consummated in connection with the initial public offering. We recognized the portion allocated to Public Shares of approximately $5.0 million as an adjustment to the carrying value of the Class A ordinary shares subject to possible redemption and the remaining balance of approximately $0.2 million as a gain from extinguishment of deferred underwriting commissions allocated to derivative warrant liabilities.\\n24\\nCritical Accounting Policies and Estimates\\nDerivative Assets and Liabilities\\nWe do not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks. We evaluate all of our financial instruments, including issued stock purchase warrants, to determine if such instruments are derivatives or contain features that qualify as embedded derivatives, pursuant to ASC Topic 480, “Distinguishing Liabilities from Equity” (“ASC 480”) and ASC Topic 815-15, “Derivatives and Hedging”. The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is re-assessed at the end of each reporting period.\\nWe account for our public warrants, private placement warrants and forward purchase units as derivative assets/liabilities in accordance with ASC 815-40, “Derivatives and Hedging”. Accordingly, we recognize the warrants and forward purchase units as assets/liabilities at fair value and adjust the instruments to fair value at each reporting period. The liabilities are subject to re-measurement at each balance sheet date until exercised, and any change in fair value of derivative assets and liabilities is recognized in our statements of operations. The fair value of our public warrants was initially measured using Monte-Carlo simulation and subsequently been measured on the market price of such warrants when separately listed and traded at each measurement date. The fair value of the private placement warrants was initially measured using Black-Scholes Option Pricing Model and subsequently using the market value of the public warrants. The fair value of the forward purchase units has been measured using the John C Hull’s Options, Futures and Other Derivatives model at each measurement date.\\nClass A Ordinary Shares Subject to Possible Redemption\\nWe account for the Class A ordinary shares subject to possible redemption in accordance with the guidance in ASC 480. Class A ordinary shares subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable Class A ordinary shares (including Class A ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, Class A ordinary shares are classified as shareholders’ equity. Our Class A ordinary shares feature certain redemption rights that are considered to be outside of our control and subject to the occurrence of uncertain future events. Accordingly, as of June 30, 2023 and December 31, 2022, 2,548,153 and 23,000,000 Class A Ordinary Shares subject to possible redemption, respectively, are presented as temporary equity, outside of the shareholders’ deficit section of the condensed balance sheets under “Item 1. Financial Statements”.\\nWe recognize changes in redemption value immediately as they occur and adjust the carrying value of the Class A ordinary shares subject to possible redemption to equal the redemption value at the end of each reporting period. Effective with the closing of the initial public offering, we recognized the accretion from initial book value to redemption amount, which resulted in charges against additional paid-in capital (to the extent available) and accumulated deficit.\\nNet (Loss) Income per Ordinary Share\\nWe comply with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share.” We have two classes of shares, Class A ordinary shares and Class B ordinary shares. Income and losses are shared pro rata between the two classes of shares. Net (loss) income per ordinary share is calculated by dividing the net (loss) income by the weighted average number of ordinary shares outstanding for the respective period.\\nThe calculation of diluted net (loss) income per ordinary share does not consider the effect of the warrants issued in connection with our initial public offering and the private placement to purchase an aggregate of 12,066,667 Class A ordinary shares because their exercise is contingent upon future events. Accretion associated with the redeemable Class A ordinary shares is excluded from (losses) earnings per share as the redemption value approximates fair value.\\n25\\nShare-Based Compensation\\nWe comply with the accounting and disclosure requirement of ASC Topic 718, “Compensation - Stock Compensation.” We record share-based compensation to employees and non-employees over the requisite service period based on the estimated grant-date fair value of the awards. Share-based awards with graded-vesting schedules are recognized on a straight-line basis over the requisite service period for each separately vesting portion of the award. We recognize the expense for share-based compensation awards subject to performance-based milestone vesting over the remaining service period when management determines that achievement of the milestone is probable. Management evaluates when the achievement of a performance-based milestone is probable based on the expected satisfaction of the performance conditions at each reporting date. Share-based compensation will be recognized in general and administrative expense in the statements of operations. We issued option awards that contain both a performance condition and service condition. The option awards vest upon the consummation of the initial business combination and will expire in five years after the date on which they first become exercisable. We have determined that the consummation of an initial business combination is a performance condition subject to significant uncertainty. As such, the achievement of the performance is not deemed to be probable of achievement until the consummation of the event, and therefore no compensation has been recognized for the period from inception to June 30, 2023.\\nRecent Accounting Pronouncements\\nManagement does not believe that any recently issued, but not yet effective, accounting standards updates, if currently adopted, would have a material effect on the accompanying unaudited condensed financial statements.\\nOff-Balance Sheet Arrangements and Contractual Obligations\\nAs of June 30, 2023, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K and did not have any commitments or contractual obligations.\\nJOBS Act\\nThe JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We qualify as an “emerging growth company” and under the JOBS Act are allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) companies. We are electing to delay the adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As a result, the financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates.\\nAdditionally, we are in the process of evaluating the benefits of relying on the other reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, if, as an “emerging growth company,” we choose to rely on such exemptions we may not be required to, among other things, (i) provide an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404, (ii) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (iii) comply with any requirement that may be adopted by the PCAOB regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis) and (iv) disclose certain executive compensation related items such as the correlation between executive compensation and performance and comparisons of the CEO’s compensation to median employee compensation. These exemptions will apply for a period of five years following the completion of our initial public offering or until we are no longer an “emerging growth company,” whichever is earlier.\\nFactors That May Adversely Affect our Results of Operations\\nOur results of operations and our ability to complete an initial business combination may be adversely affected by various factors that could cause economic uncertainty and volatility in the financial markets, many of which are beyond our control. Our business could be impacted by, among other things, downturns in the financial markets or in economic conditions, increases in oil prices, inflation, increases in interest rates, supply chain disruptions, declines in consumer confidence and spending, the ongoing effects of the COVID-19 pandemic, including resurgences and the emergence of new variants, and geopolitical instability, such as the military conflict in Ukraine. We cannot at this time fully predict the likelihood of one or more of the above events, their duration or magnitude or the extent to which they may negatively impact our business and our ability to complete an initial business combination.\\n26\\n\\nItem 3. Quantitative and Qualitative Disclosures About Market Risk.\\nWe are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act, and are not required to provide the information otherwise required under this item.\\n\\nItem 4. Controls and Procedures.\\nEvaluation of Disclosure Controls and Procedures\\nDisclosure controls and procedures are controls and other procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is accumulated and communicated to management, including our principal executive officer and principal financial officer (our “Certifying Officer”), to allow timely decisions regarding required disclosure.\\nAs of June 30, 2023, as required by Rules 13a-15 and 15d-15 under the Exchange Act, our principal executive officer and principal financial and accounting officer carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were not effective because of a material weakness in our internal control over financial reporting. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis. Specifically, the Company’s management has concluded that our control around the interpretation and accounting for extinguishment of a significant contingent obligation was not effectively designed or maintained. In light of this material weakness, we performed additional analysis as deemed necessary to ensure that our financial statements were prepared in accordance with GAAP. Accordingly, management believes that the unaudited condensed financial statements included in this Quarterly Report on Form 10-Q present fairly in all material respects our financial position, results of operations and cash flows for the period presented.\\nWe do not expect that our disclosure controls and procedures will prevent all errors and all instances of fraud. Disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Further, the design of disclosure controls and procedures must reflect the fact that there are resource constraints, and the benefits must be considered relative to their costs. Because of the inherent limitations in all disclosure controls and procedures, no evaluation of disclosure controls and procedures can provide absolute assurance that we have detected all our control deficiencies and instances of fraud, if any. The design of disclosure controls and procedures also is based partly on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.\\nManagement has implemented remediation steps to improve our internal control over financial reporting. Specifically, we expanded and improved our review process for related accounting standards. We plan to further improve this process by enhancing access to accounting literature, identification of third-party professionals with whom to consult regarding complex accounting applications and consideration of additional staff with the requisite experience and training to supplement existing accounting professionals.\\nChanges in Internal Control Over Financial Reporting\\nOther than the above, there have been no changes to our internal control over financial reporting during the quarter ended June 30, 2023 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\n27\\nPART II - OTHER INFORMATION\\n\\nItem 1. Legal Proceedings.\\nTo the knowledge of our management team, there is no litigation currently pending or contemplated against us, any of our officers or directors in their capacity as such or against any of our property.\\n\\nItem 1A. Risk Factors.\\nAs a smaller reporting company under Rule 12b-2 of the Exchange Act, we are not required to include risk factors in this Report. However, as of the date of this Report, other than as set forth below, there have been no material changes with respect to those risk factors previously disclosed in our (i) Registration Statement, (ii) Annual Report on Form 10-K for the year ended December 31, 2021, as filed with the SEC on March 31, 2022, (iii) Quarterly Reports on Form 10-Q for the quarterly periods ended March 31, 2021, June 30, 2021, September 30, 2021, March 31, 2022, June 30, 2022 and September 30, 2022, as filed with the SEC on June 25, 2021, August 13, 2021, November 22, 2021, May 9, 2022, August 15, 2022, and November 14, 2022, respectively, (iv) Definitive Proxy Statement on Schedule 14A, as filed with the SEC on January 31, 2023, and (v) our 2022 Annual Report. Any of these factors could result in a significant or material adverse effect on our results of operations or financial condition. Additional risks could arise that may also affect our business or ability to consummate an initial Business Combination. We may disclose changes to such risk factors or disclose additional risk factors from time to time in our future filings with the SEC.\\nTo mitigate the risk that we might be deemed to be an investment company for purposes of the Investment Company Act, we have instructed the trustee, on February 10, 2023, to liquidate the investments held in the Trust Account and instead to hold the funds in the Trust Account in an interest bearing demand deposit account at Morgan Stanley until the earlier of the consummation of our initial Business Combination or our liquidation. As a result, we may receive less interest on the funds held in the Trust Account than the interest we would have received pursuant to our original Trust Account investments, which could reduce the dollar amount our public shareholders would receive upon any redemption or liquidation of the Company.\\nThe funds in the Trust Account had, since our IPO, been held only in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds investing solely in U.S. government treasury obligations and meeting certain conditions under Rule 2a-7 under the Investment Company Act. However, to mitigate the risk of us being deemed to be an unregistered investment company (including under the subjective test of Section 3(a)(1)(A) of the Investment Company Act) and thus subject to regulation under the Investment Company Act, we have instructed the trustee, on February 10, 2023, to liquidate the U.S. government treasury obligations or money market funds held in the Trust Account and thereafter to hold all funds in the Trust Account in an interest bearing demand deposit account at Morgan Stanley until the earlier of the consummation of our initial Business Combination or the liquidation of the Company. Following such liquidation, we may receive less interest on the funds held in the Trust Account than the interest we would have received pursuant to our original trust account investments. However, interest previously earned on the funds held in the Trust Account still may be released to us to pay our taxes, if any, and certain other expenses as permitted. As a result, our decision to liquidate the securities held in the Trust Account and thereafter to hold all funds in the Trust Account in an interest bearing demand deposit account at Morgan Stanley could reduce the dollar amount our public shareholders would receive upon any redemption or liquidation of the Company.\\nMarket conditions, economic uncertainty or downturns could adversely affect our business, financial condition, operating results and our ability to consummate a Business Combination.\\nIn recent years, the United States and other markets have experienced cyclical or episodic downturns, and worldwide economic conditions remain uncertain, including as a result of the COVID-19 pandemic, supply chain disruptions, the Ukraine-Russia conflict, instability in the U.S. and global banking systems, rising fuel prices, increasing interest rates or foreign exchange rates and high inflation and the possibility of a recession. A significant downturn in economic conditions may make it more difficult for us to consummate a Business Combination.\\n28\\nWe cannot predict the timing, strength, or duration of any future economic slowdown or any subsequent recovery generally, or in any industry. If the conditions in the general economy and the markets in which we operate worsen from present levels, our business, financial condition, operating results and our ability to consummate a Business Combination could be adversely affected. For example, in January 2023, the outstanding national debt of the U.S. government reached its statutory limit. The U.S. Department of the Treasury (the “Treasury Department”) has announced that, since then, it has been using extraordinary measures to prevent the U.S. government’s default on its payment obligations, and to extend the time that the U.S. government has to raise its statutory debt limit or otherwise resolve its funding situation. The failure by Congress to raise the federal debt ceiling could have severe repercussions within the U.S. and to global credit and financial markets. If Congress does not raise the debt ceiling, the U.S. government could default on its payment obligations, or experience delays in making payments when due. A payment default or delay by the U.S. government, or continued uncertainty surrounding the U.S. debt ceiling, could result in a variety of adverse effects for financial markets, market participants and U.S. and global economic conditions. In addition, U.S. debt ceiling and budget deficit concerns have increased the possibility a downgrade in the credit rating of the U.S. government and could result in economic slowdowns or a recession in the U.S. Although U.S. lawmakers have passed legislation to raise the federal debt ceiling on multiple occasions, ratings agencies have lowered or threatened to lower the long-term sovereign credit rating on the United States as a result of disputes over the debt ceiling. The impact of a potential downgrade to the U.S. government’s sovereign credit rating or its perceived creditworthiness could adversely affect economic conditions, as well as our business, financial condition, operating results and our ability to consummate a Business Combination.\\nIf our initial Business Combination involves a company organized under the laws of a state of the United States, it is possible a 1% U.S. federal excise tax will be imposed on us in connection with redemptions of our common stock after or in connection with such initial Business Combination.\\nOn August 16, 2022, the Inflation Reduction Act of 2022 became law in the United States, which, among other things, imposes a 1% excise tax on the fair market value of certain repurchases (including certain redemptions) of stock by publicly traded domestic (i.e., United States) corporations (and certain non-U.S. corporations treated as “surrogate foreign corporations”). The excise tax will apply to stock repurchases occurring in 2023 and beyond. The amount of the excise tax is generally 1% of the fair market value of the shares of stock repurchased at the time of the repurchase. The Treasury Department has been given authority to provide regulations and other guidance to carry out, and prevent the abuse or avoidance of, the excise tax; however, only limited guidance has been issued to date.\\nAs an entity incorporated as a Cayman Islands exempted company, the 1% excise tax is not expected to apply to redemptions of our Class A ordinary shares (absent any regulations and other additional guidance that may be issued in the future with retroactive effect).\\nHowever, in connection with an initial Business Combination involving a company organized under the laws of the United States, it is possible that we domesticate and continue as a Delaware corporation prior to certain redemptions and, because our securities are trading on the Nasdaq Capital Market, it is possible that we will be subject to the excise tax with respect to any subsequent redemptions, including redemptions in connection with the initial Business Combination, that are treated as repurchases for this purpose (other than, pursuant to recently issued guidance from the Treasury Department, redemptions in complete liquidation of the company). In all cases, the extent of the excise tax that may be incurred will depend on a number of factors, including the fair market value of our stock redeemed, the extent such redemptions could be treated as dividends and not repurchases, and the content of any regulations and other additional guidance from the Treasury Department that may be issued and applicable to the redemptions. Issuances of stock by a repurchasing corporation in a year in which such corporation repurchases stock may reduce the amount of excise tax imposed with respect to such repurchase. The excise tax is imposed on the repurchasing corporation itself, not the stockholders from which stock is repurchased. The imposition of the excise tax as a result of redemptions in connection with the initial Business Combination could, however, reduce the amount of cash available to pay redemptions or reduce the cash contribution to the target business in connection with our initial Business Combination, which could cause the other shareholders of the combined company to economically bear the impact of such excise tax.\\n29\\n\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\\nNone. For a description of the use of proceeds generated in our Initial Public Offering and the Private Placement, see Part II, Item 2 of our Quarterly Report on Form 10-Q for the quarter ended March 31, 2021, as filed with the SEC on June 25, 2021. There has been no material change in the planned use of the proceeds from our Initial Public Offering and the Private Placement as described in the Registration Statement.\\n\\nItem 3. Defaults Upon Senior Securities.\\nNone.\\n\\nItem 4. Mine Safety Disclosures\\nNot applicable.\\n\\nItem 5. Other Information.\\nNone.\\n\\nItem 6. Exhibits\\nThe following exhibits are filed as part of, or incorporated by reference into, this Report.\\n\\n| Exhibit Number | Description of Exhibit |\\n| 31.1 | Certification of the Principal Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |\\n| 31.2 | Certification of the Principal Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |\\n| 32.1 | Certification of the Principal Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.** |\\n| 32.2 | Certification of the Principal Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.** |\\n| 101.INS | Inline XBRL Instance Document.* |\\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document.* |\\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document.* |\\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document.* |\\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document.* |\\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document.* |\\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101).* |\\n\\n\\n| * | Filed herewith. |\\n\\n\\n| ** | Furnished herewith. |\\n\\n30\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n\\n| Dated: August 14, 2023 | QUADRO ACQUISITION ONE CORP. |\\n| By: | /s/ Dimitri Elkin |\\n| Name: | Dimitri Elkin |\\n| Title: | Chief Executive Officer |\\n\\n31\\n\\n \\n\\nWhat is the total amount of loans that the company borrowed and to be repaid by June 30, 2023, including the IPO Note, Working Capital Loans, Promissory Note, Extension Loan, and Related Party Advance in dollars?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 969722.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 38,\n \"input_length\": 30349\n}"}}},{"rowIdx":39,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nPART I. FINANCIAL INFORMATION\nITEM 1. FINANCIAL STATEMENTS\nEV Energy Partners, L.P.\nCondensed Consolidated Balance Sheets\n(In thousands, except number of units)\n(Unaudited)\n\n| June 30, | December 31, |\n| 2011 | 2010 |\n| ASSETS |\n| Current assets: |\n| Cash and cash equivalents | $ | 26,392 | $ | 23,127 |\n| Accounts receivable: |\n| Oil, natural gas and natural gas liquids revenues | 36,600 | 27,742 |\n| Related party | 3,967 | – |\n| Other | 300 | 441 |\n| Derivative asset | 51,215 | 55,100 |\n| Assets held for sale | 11,402 | – |\n| Other current assets | 1,047 | 1,158 |\n| Total current assets | 130,923 | 107,568 |\n| Oil and natural gas properties, net of accumulated depreciation, depletion and amortization; June 30, 2011, $210,073; December 31, 2010, $176,897 | 1,300,294 | 1,324,240 |\n| Other property, net of accumulated depreciation and amortization; June 30, 2011, $536; December 31, 2010, $465 | 1,495 | 1,567 |\n| Long–term derivative asset | 26,576 | 51,497 |\n| Other assets | 7,533 | 1,885 |\n| Total assets | $ | 1,466,821 | $ | 1,486,757 |\n| LIABILITIES AND OWNERS’ EQUITY |\n| Current liabilities: |\n| Accounts payable and accrued liabilities: |\n| Third party | $ | 27,642 | $ | 20,678 |\n| Related party | – | 182 |\n| Liabilities related to assets held for sale | 2,895 | – |\n| Derivative liability | 1,178 | 1,943 |\n| Total current liabilities | 31,715 | 22,803 |\n| Asset retirement obligations | 68,266 | 67,175 |\n| Long–term debt | 480,183 | 619,000 |\n| Long–term liabilities | 988 | 3,048 |\n| Long–term derivative liability | 6,594 | 784 |\n| Commitments and contingencies |\n| Owners’ equity: |\n| Common unitholders – 34,173,650 units and 30,510,313 units issued and outstanding as of June 30, 2011 and December 31, 2010, respectively | 887,843 | 779,327 |\n| General partner interest | (8,768 | ) | (5,380 | ) |\n| Total owners’ equity | 879,075 | 773,947 |\n| Total liabilities and owners’ equity | $ | 1,466,821 | $ | 1,486,757 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n2\nEV Energy Partners, L.P.\nCondensed Consolidated Statements of Operations\n(In thousands, except per unit data)\n(Unaudited)\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2011 | 2010 | 2011 | 2010 |\n| Revenues: |\n| Oil, natural gas and natural gas liquids revenues | $ | 68,109 | $ | 39,431 | $ | 127,730 | $ | 78,027 |\n| Transportation and marketing–related revenues | 1,484 | 1,476 | 2,885 | 3,054 |\n| Total revenues | 69,593 | 40,907 | 130,615 | 81,081 |\n| Operating costs and expenses: |\n| Lease operating expenses | 17,949 | 14,869 | 35,311 | 26,301 |\n| Cost of purchased natural gas | 1,120 | 1,095 | 2,170 | 2,315 |\n| Dry hole and exploration costs | 441 | – | 844 | – |\n| Production taxes | 3,119 | 1,673 | 5,770 | 3,800 |\n| Asset retirement obligations accretion expense | 970 | 764 | 1,936 | 1,274 |\n| Depreciation, depletion and amortization | 18,443 | 13,436 | 36,007 | 25,520 |\n| General and administrative expenses | 7,132 | 5,825 | 15,725 | 10,549 |\n| Impairment of oil and natural gas properties | 5,078 | – | 6,666 | – |\n| Gain on sale of oil and natural gas properties | – | (4,388 | ) | – | (3,824 | ) |\n| Total operating costs and expenses | 54,252 | 33,274 | 104,429 | 65,935 |\n| Operating income | 15,341 | 7,633 | 26,186 | 15,146 |\n| Other income (expense), net: |\n| Realized gains on derivatives, net | 14,242 | 13,901 | 27,784 | 21,866 |\n| Unrealized gains (losses) on derivatives, net | 17,422 | (2,158 | ) | (35,633 | ) | 30,502 |\n| Interest expense | (8,124 | ) | (3,269 | ) | (13,283 | ) | (5,372 | ) |\n| Other income, net | 313 | 252 | 233 | 393 |\n| Total other income (expense), net | 23,853 | 8,726 | (20,899 | ) | 47,389 |\n| Income before income taxes | 39,194 | 16,359 | 5,287 | 62,535 |\n| Income taxes | (31 | ) | (79 | ) | (113 | ) | (131 | ) |\n| Net income | $ | 39,163 | $ | 16,280 | $ | 5,174 | $ | 62,404 |\n| General partner’s interest in net income, including incentive distribution rights | $ | 3,728 | $ | 2,624 | $ | 5,982 | $ | 5,836 |\n| Limited partners’ interest in net income (loss) | $ | 35,435 | $ | 13,656 | $ | (808 | ) | $ | 56,568 |\n| Net income (loss) per limited partner unit: |\n| Basic | $ | 1.03 | $ | 0.50 | $ | (0.02 | ) | $ | 2.14 |\n| Diluted | $ | 1.03 | $ | 0.50 | $ | (0.02 | ) | $ | 2.14 |\n| Weighted average limited partner units outstanding: |\n| Basic | 34,294 | 27,210 | 33,002 | 26,403 |\n| Diluted | 34,534 | 27,264 | 33,002 | 26,438 |\n| Distributions declared per unit | $ | 0.761 | $ | 0.757 | $ | 1.521 | $ | 1.513 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n3\nEV Energy Partners, L.P.\nCondensed Consolidated Statements of Changes in Owners’ Equity\n(In thousands, except number of units)\n(Unaudited)\n\n| Common Unitholders | General Partner Interest | Total Owners’ Equity |\n| Balance, December 31, 2010 | $ | 779,327 | $ | (5,380 | ) | $ | 773,947 |\n| Conversion of 80,534 vested phantom units | 3,508 | – | 3,508 |\n| Proceeds from public equity offering, net of underwriters discount and offering costs of $308 | 146,800 | – | 146,800 |\n| Contributions from general partner | – | 3,191 | 3,191 |\n| Distributions | (49,291 | ) | (6,682 | ) | (55,973 | ) |\n| Equity–based compensation | 2,428 | – | 2,428 |\n| Net income | 5,071 | 103 | 5,174 |\n| Balance, June 30, 2011 | $ | 887,843 | $ | (8,768 | ) | $ | 879,075 |\n\n\n| Common Unitholders | General Partner Interest | Total Owners’ Equity |\n| Balance, December 31, 2009 | $ | 548,160 | $ | (729 | ) | $ | 547,431 |\n| Conversion of 84,842 vested phantom units | 2,580 | – | 2,580 |\n| Proceeds from public equity offering, net of underwriters discount and offering costs of $154 | 92,616 | – | 92,616 |\n| Contributions from general partner | – | 1,977 | 1,977 |\n| Distributions | (38,284 | ) | (5,149 | ) | (43,433 | ) |\n| Equity–based compensation | 827 | – | 827 |\n| Net income | 61,156 | 1,248 | 62,404 |\n| Balance, June 30, 2010 | $ | 667,055 | $ | (2,653 | ) | $ | 664,402 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n4\nEV Energy Partners, L.P. Condensed Consolidated Statements of Cash Flows (In thousands) (Unaudited)\n| Six Months Ended June 30, |\n| 2011 | 2010 |\n| Cash flows from operating activities: |\n| Net income | $ | 5,174 | $ | 62,404 |\n| Adjustments to reconcile net income to net cash flows provided by operating activities: |\n| Asset retirement obligations accretion expense | 1,936 | 1,274 |\n| Depreciation, depletion and amortization | 36,007 | 25,520 |\n| Equity–based compensation cost | 3,877 | 2,103 |\n| Impairment of oil and natural gas properties | 6,666 | – |\n| Gain on sale of oil and natural gas properties | – | (3,824 | ) |\n| Noncash derivative activity | 30,951 | (30,502 | ) |\n| Amortization of discount on long–term debt | 183 | – |\n| Amortization of deferred loan costs | 554 | 275 |\n| Other, net | 56 | (1 | ) |\n| Changes in operating assets and liabilities: |\n| Accounts receivable | (12,866 | ) | (4,098 | ) |\n| Other current assets | 111 | 2,625 |\n| Accounts payable and accrued liabilities | 7,630 | 879 |\n| Long–term liabilities | – | (734 | ) |\n| Other, net | (149 | ) | (119 | ) |\n| Net cash flows provided by operating activities | 80,130 | 55,802 |\n| Cash flows from investing activities: |\n| Acquisition of oil and natural gas properties | 3,101 | (147,769 | ) |\n| Development of oil and natural gas properties | (33,686 | ) | (8,170 | ) |\n| Proceeds from sale of oil and natural gas properties | 1,170 | 4,471 |\n| Settlements from acquired derivatives | 2,834 | – |\n| Earnest money received for sale of oil and natural gas properties | 900 | – |\n| Net cash flows used in investing activities | (25,681 | ) | (151,468 | ) |\n| Cash flows from financing activities: |\n| Long–term debt borrowings | – | 138,000 |\n| Repayment of long–term debt borrowings | (431,500 | ) | (95,000 | ) |\n| Proceeds from debt offering | 292,500 | – |\n| Loan costs incurred | (6,202 | ) | (8 | ) |\n| Proceeds from public equity offering | 147,108 | 92,770 |\n| Offering costs | (308 | ) | (154 | ) |\n| Contributions from general partner | 3,191 | 1,977 |\n| Distributions paid | (55,973 | ) | (43,433 | ) |\n| Net cash flows (used in) provided by financing activities | (51,184 | ) | 94,152 |\n| Increase (decrease) in cash and cash equivalents | 3,265 | (1,514 | ) |\n| Cash and cash equivalents – beginning of period | 23,127 | 18,806 |\n| Cash and cash equivalents – end of period | $ | 26,392 | $ | 17,292 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n5\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements\nNOTE 1. ORGANIZATION AND NATURE OF BUSINESS\nNature of Operations\nEV Energy Partners, L.P. (“we,” “our” or “us”) is a publicly held limited partnership that engages in the acquisition, development and production of oil and natural gas properties. Our general partner is EV Energy GP, L.P. (“EV Energy GP”), a Delaware limited partnership, and the general partner of our general partner is EV Management, LLC (“EV Management”), a Delaware limited liability company. EV Management is a wholly owned subsidiary of EnerVest, Ltd. (“EnerVest”), a Texas limited partnership. EnerVest and its affiliates also have a significant interest in us through their 71.25% ownership of EV Energy GP which, in turn, owns a 2% general partner interest in us and all of our incentive distribution rights.\nBasis of Presentation\nOur unaudited condensed consolidated financial statements included herein have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, certain information and disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. We believe that the presentations and disclosures herein are adequate to make the information not misleading. The unaudited condensed consolidated financial statements reflect all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the interim periods. The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the full year. These interim financial statements should be read in conjunction with our Annual Report on Form 10–K for the year ended December 31, 2010.\nAll intercompany accounts and transactions have been eliminated in consolidation. In the Notes to Unaudited Condensed Consolidated Financial Statements, all dollar and unit amounts in tabulations are in thousands of dollars and units, respectively, unless otherwise indicated.\nNOTE 2. EQUITY–BASED COMPENSATION\nWe grant various forms of equity–based awards to employees, consultants and directors of EV Management and its affiliates who perform services for us. These equity–based awards consist primarily of phantom units and performance units.\nWe account for the phantom units issued prior to 2009 as liability awards, and the fair value of these phantom units is remeasured at the end of each reporting period based on the current market price of our common units until settlement. Prior to settlement, compensation cost is recognized for these phantom units based on the proportionate amount of the requisite service period that has been rendered to date. We account for the phantom units issued beginning in 2009 as equity awards, and we estimated the fair value of these phantom units using the Black–Scholes option pricing model. We account for the performance units as equity awards, and we estimated the fair value of these performance units using the Monte Carlo simulation model.\nThe following table presents the compensation costs recognized in our unaudited condensed consolidated statements of operations:\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2011 | 2010 | 2011 | 2010 |\n| Liability awards | $ | 526 | $ | 608 | $ | 1,449 | $ | 1,276 |\n| Equity awards | 1,214 | 429 | 2,428 | 827 |\n| Total | $ | 1,740 | $ | 1,037 | $ | 3,877 | $ | 2,103 |\n\nThese costs are included in “General and administrative expenses” in our unaudited condensed consolidated statements of operations.\nIn January 2011, the performance criterion was achieved with respect to the remaining 0.1 million performance units.\n6\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nAs of June 30, 2011, total unrecognized compensation costs related to the unvested liability awards and equity awards and the period over which they are expected to be recognized are as follows:\n\n| Unrecognized Compensation Expense | Weighted Average Period (in years) |\n| Liability awards | $ | 3,355 | 1.5 |\n| Equity awards | 15,175 | 3.2 |\n\nNOTE 3. ACQUISITIONS\nIn April 2011, we received a final purchase price settlement of $1.9 million related to our acquisition of oil and natural gas properties in the Mid–Continent area in September 2010.\nIn June 2011, we received a final purchase price settlement of $2.2 million related to our acquisition of oil and natural gas properties in the Barnett Shale in December 2010.\nIn June 2011, we, along with certain institutional partnerships managed by EnerVest, acquired additional oil and natural gas properties in the Barnett Shale. We acquired a 31.02% proportional interest in these properties for $1.0 million.\nNOTE 4. RISK MANAGEMENT\nOur business activities expose us to risks associated with changes in the market price of oil, natural gas and natural gas liquids. In addition, our floating rate credit facility exposes us to risks associated with changes in interest rates. As such, future earnings are subject to fluctuation due to changes in the market prices of oil, natural gas and natural gas liquids and interest rates. We use derivatives to reduce our risk of changes in the prices of oil, natural gas and natural gas liquids and interest rates. Our policies do not permit the use of derivatives for speculative purposes.\nWe have elected not to designate any of our derivatives as hedging instruments. Accordingly, changes in the fair value of our derivatives are recorded immediately to net income as “Unrealized gains (losses) on derivatives, net” in our unaudited condensed consolidated statements of operations.\nAs of June 30, 2011, we had entered into oil commodity contracts with the following terms:\n\n| Period Covered | Hedged Volume (MBbls) | Weighted Average Fixed Price | Weighted Average Floor Price | Weighted Average Ceiling Price |\n| Swaps – July 2011 through December 2011 | 209.4 | $ | 95.01 | $ | $ |\n| Collars – July 2011 through December 2011 | 236.6 | 105.66 | 156.16 |\n| Swaps –2012 | 625.7 | 96.45 |\n| Collars – 2012 | 456.8 | 104.54 | 156.77 |\n| Swaps –2013 | 994.5 | 86.46 |\n| Swaps – 2014 | 897.2 | 91.90 |\n\n7\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nAs of June 30, 2011, we had entered into natural gas commodity contracts with the following terms:\n\n| Period Covered | Hedged Volume (MmmBtus) | Weighted Average Fixed Price | Weighted Average Floor Price | Weighted Average Ceiling Price |\n| Swaps – July 2011 through December 2011 | 8,322.9 | $ | 6.67 | $ | $ |\n| Collars – July 2011 through December 2011 | 3,330.6 | 7.54 | 9.90 |\n| Swaps –2012 | 14,307.6 | 6.84 |\n| Collars – 2012 | 6,618.7 | 7.94 | 9.90 |\n| Swaps – 2013 | 18,797.5 | 5.77 |\n| Swaps – 2014 | 14,600.0 | 5.75 |\n| Swaps – 2015 | 14,600.0 | 6.00 |\n\nAs of June 30, 2011, we had entered into natural gas liquids commodity contracts with the following terms:\n\n| Period Covered | Hedged Volume (MBbls) | Weighted Average Fixed Price |\n| Ethane (MBbls): |\n| Swaps – July 2011 through December 2011 | 188.6 | $ | 20.06 |\n| Propane (MBbls): |\n| Swaps – July 2011 through December 2011 | 112.7 | 49.77 |\n\nAs of June 30, 2011, we had entered into natural gas basis swaps with the following terms:\n\n| Period Covered | Floating Index 1 | Floating Index 2 | Hedged Volume (MmmBtus) | Spread |\n| July 2011 through December 2011 | NYMEX | Dominion Appalachia | 174.4 | $ | 0.1975 |\n| July 2011 through December 2011 | NYMEX | Appalachia Columbia | 47.7 | 0.1500 |\n\nAs of June 30, 2011, we had entered into interest rate swaps with the following terms:\n\n| Period Covered | Notional Amount | Floating Rate | Fixed Rate |\n| July 2011 – July 2012 | $ | 90,000 | 1 Month LIBOR | 4.157 | % |\n| July 2011 – September 2012 | 40,000 | 1 Month LIBOR | 2.145 | % |\n| July 2012 – July 2015 | 110,000 | 1 Month LIBOR | 3.315 | % |\n\n8\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nThe fair value of these derivatives was as follows:\n\n| Asset Derivatives | Liability Derivatives |\n| June 30, 2011 | December 31, 2010 | June 30, 2011 | December 31, 2010 |\n| Commodity contracts | $ | 89,564 | $ | 123,655 | $ | 10,620 | $ | 7,633 |\n| Interest rate swaps | – | – | 8,925 | 12,152 |\n| Total fair value | 89,564 | 123,655 | 19,545 | 19,785 |\n| Netting arrangements | (11,773 | ) | (17,058 | ) | (11,773 | ) | (17,058 | ) |\n| Net recorded fair value | $ | 77,791 | $ | 106,597 | $ | 7,772 | $ | 2,727 |\n| Location of derivatives in our unaudited condensed consolidated balance sheets: |\n| Derivative asset | $ | 51,215 | $ | 55,100 | $ | – | $ | – |\n| Long–term derivative asset | 26,576 | 51,497 | – | – |\n| Derivative liability | – | – | 1,178 | 1,943 |\n| Long–term derivative liability | – | – | 6,594 | 784 |\n| $ | 77,791 | $ | 106,597 | $ | 7,772 | $ | 2,727 |\n\nThe following table presents the impact of derivatives and their location within the unaudited condensed consolidated statements of operations:\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2011 | 2010 | 2011 | 2010 |\n| Realized gains on derivatives, net: |\n| Commodity contracts (1) | $ | 11,388 | $ | 16,044 | $ | 27,070 | $ | 26,167 |\n| Interest rate swaps (2) | 2,854 | (2,143 | ) | 714 | (4,301 | ) |\n| Total | $ | 14,242 | $ | 13,901 | $ | 27,784 | $ | 21,866 |\n| Unrealized gains (losses) on derivatives, net: |\n| Commodity contracts | $ | 20,380 | $ | (1,189 | ) | $ | (34,181 | ) | $ | 32,701 |\n| Interest rate swaps (2) | (2,958 | ) | (969 | ) | (1,452 | ) | (2,199 | ) |\n| Total | $ | 17,422 | $ | (2,158 | ) | $ | (35,633 | ) | $ | 30,502 |\n\n\n| (1) | Realized gains for the three months and six months ended June 30, 2011 exclude $1.4 million and $2.9 million, respectively, related to the initial value of derivatives acquired in our December 2010 acquisition of oil and natural gas properties that have been relieved through the settlement of such derivatives. |\n\n\n| (2) | In June 2011, we terminated three of our interest rate swaps and reclassified the $4.7 million non–cash gain from “Unrealized gains (losses) on derivatives, net” to “Realized gains on derivatives, net.” |\n\n9\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nNOTE 5. FAIR VALUE MEASUREMENTS\nRecurring Basis\nThe following table presents the fair value hierarchy table for our assets and liabilities that are required to be measured at fair value on a recurring basis:\n\n| Fair Value at Reporting Date Using: |\n| June 30, 2011 | Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) |\n| Derivative assets: |\n| Commodity contracts | $ | 89,564 | $ | – | $ | 89,564 | $ | – |\n| Derivative liabilities: |\n| Commodity contracts | $ | 10,620 | $ | – | $ | 10,620 | $ | – |\n| Interest rate swaps | 8,925 | – | 8,925 | – |\n| Total derivative liabilities | $ | 19,545 | $ | – | $ | 19,545 | $ | – |\n| Fair Value at Reporting Date Using: |\n| December 31, 2010 | Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) |\n| Derivative assets: |\n| Commodity contracts | $ | 123,655 | $ | – | $ | 123,655 | $ | – |\n| Derivative liabilities: |\n| Commodity contracts | $ | 7,633 | $ | – | $ | 7,633 | $ | – |\n| Interest rate swaps | 12,152 | – | 12,152 | – |\n| Total derivative liabilities | $ | 19,785 | $ | – | $ | 19,785 | $ | – |\n\nOur derivatives consist of over–the–counter (“OTC”) contracts which are not traded on a public exchange. These derivatives are indexed to active trading hubs for the underlying commodity and are commonly used in the energy industry and offered by a number of financial institutions and large energy companies.\nAs the fair value of these derivatives is based on inputs using market prices obtained from independent brokers or determined using quantitative models that use as their basis readily observable market parameters that are actively quoted and can be validated through external sources, including third party pricing services, brokers and market transactions, we have categorized these derivatives as Level 2. We value these derivatives based on observable market data for similar instruments. This observable data includes the forward curves for commodity prices based on quoted market prices and prospective volatility factors related to changes in the forward curves and yield curves based on money market rates and interest rate swap data. Our estimates of fair value have been determined at discrete points in time based on relevant market data. These estimates involve uncertainty and cannot be determined with precision. There were no changes in valuation techniques or related inputs in the three months ended June 30, 2011.\nNonrecurring Basis\nIn March 2011, in conjunction with the sale of oil and natural gas properties, we incurred impairment charges of $1.5 million as oil and natural gas properties with a net cost basis of $2.7 million were written down to their fair value of $1.2 million.\n10\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nIn June 2011, we incurred impairment charges of $5.2 million as oil and natural gas properties with a net cost basis of $13.7 million were written down to their fair value of $8.5 million.\nFinancial Instruments\nThe estimated fair values of our financial instruments have been determined at discrete points in time based on relevant market information. Our financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities, derivatives and long–term debt. The carrying amounts of our financial instruments other than derivatives and long–term debt approximate fair value because of the short–term nature of the items. Derivatives are recorded at fair value (see Note 4). The carrying value of debt outstanding under our credit facility approximates fair value because the credit facility’s variable interest rate resets frequently and approximates current market rates available to us. As of June 30, 2011, the estimated fair value of our senior notes due 2019 was $303.0 million, which differs from the carrying value of $292.7 million. The fair value of our senior notes due 2019 was estimated using quoted markets prices based on trades of such debt as of June 30, 2011.\nNOTE 6. ASSET RETIREMENT OBLIGATIONS\nWe record an asset retirement obligation (“ARO”) and capitalize the asset retirement cost in oil and natural gas properties in the period in which the retirement obligation is incurred based upon the fair value of an obligation to perform site reclamation, dismantle facilities or plug and abandon wells. After recording these amounts, the ARO is accreted to its future estimated value using an assumed cost of funds and the additional capitalized costs are depreciated on a unit–of–production basis. The changes in the aggregate ARO are as follows:\n\n| Balance as of December 31, 2010 | $ | 68,430 |\n| Liabilities incurred | 311 |\n| Accretion expense | 1,936 |\n| Revisions in estimated cash flows | 3,118 |\n| Settlements and divestitures | (4,275 | ) |\n| Balance as of June 30, 2011 | $ | 69,520 |\n\nAs of both June 30, 2011 and December 31, 2010, $1.3 million of our ARO is classified as current and is included in “Accounts payable and accrued liabilities” in our unaudited condensed consolidated balance sheets.\nNOTE 7. LONG–TERM DEBT\nLong–term debt consisted of the following:\n\n| June 30, 2011 | December 31, 2010 |\n| Credit facility | $ | 187,500 | $ | 619,000 |\n| 8.0% senior notes due 2019 | 300,000 | – |\n| Unamortized discount | (7,317 | ) | – |\n| Long–term debt | $ | 480,183 | $ | 619,000 |\n\nCredit Facility\nOn April 26, 2011, we replaced our existing $700.0 million credit facility with a $1.0 billion credit facility that expires in April 2016. Borrowings under the facility are secured by a first priority lien on substantially all of our assets and the assets of our subsidiaries. We may use borrowings under the facility for acquiring and developing oil and natural gas properties, for working capital purposes, for general corporate purposes and for funding distributions to partners. We also may use up to $100.0 million of available borrowing capacity for letters of credit. The facility requires the maintenance of a current ratio (as defined in the facility) of greater than 1.0 and a ratio of total debt to earnings plus interest expense, taxes, depreciation, depletion and amortization expense and exploration expense of no greater than 4.25 to 1.0. As of June 30, 2011, we were in compliance with these financial covenants.\n11\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nBorrowings under the facility bear interest at a floating rate based on, at our election, a base rate or the London Inter–Bank Offered Rate plus applicable premiums based on the percent of the borrowing base that we have outstanding (weighted average effective interest rate of 3.49% at June 30, 2011).\nBorrowings under the facility may not exceed a “borrowing base” determined by the lenders under the facility based on our oil and natural gas reserves. As of June 30, 2011, the borrowing base under the facility was $600.0 million. The borrowing base is subject to scheduled redeterminations as of April 1 and October 1 of each year with an additional redetermination once per calendar year at our request or at the request of the lenders and with one calculation that may be made at our request during each calendar year in connection with material acquisitions or divestitures of properties.\n8.0% Senior Notes due 2019\nOn March 22, 2011, we issued $300.0 million in aggregate principal amount of 8.0% senior unsecured notes due 2019 (the “Notes”) at an offering price equal to 100% of par. The Notes were sold in a private placement to eligible purchasers in a transaction exempt from the registration requirements of the Securities Act of 1933, as amended.\nWe received net proceeds of $291.6 million, after deducting the discount of $7.5 million and offering expenses of $0.9 million. We used the net proceeds to repay indebtedness under our existing credit facility. The discount and the offering expenses are being amortized over the life of the Notes. The amortization is included in “Interest expense” on our unaudited condensed consolidated statements of operations.\nThe Notes were issued under an indenture dated March 22, 2011, (the “Indenture”), mature April 15, 2019, and bear interest at 8.0%. Interest is payable semi–annually beginning October 15, 2011. The Notes are general unsecured obligations and are effectively junior in right of payment to any of our secured indebtedness to the extent of the value of the collateral securing such indebtedness.\nThe Notes are unconditionally guaranteed, jointly and severally, on a senior unsecured basis, by all of our existing subsidiaries other than EV Energy Finance Corp. (“Finance”), which is a co–issuer of the Notes. Neither we nor Finance have material independent assets or operations apart from the assets and operations of our subsidiaries.\nThe Indenture provides that, prior to April 15, 2014, we may redeem up to 35% of the aggregate principal amount of the Notes with the net proceeds of a public or private equity offering at a redemption price of 108.0% of the principal amount redeemed, plus accrued and unpaid interest, provided that:\n\n| · | at least 65% of the aggregate principal amount of Notes issued under the Indenture remains outstanding immediately after the occurrence of such redemption; and |\n\n\n| · | the redemption occurs within 180 days of the date of the closing of such public or private equity offering. |\n\nOn and after April 15, 2015, we may redeem all or a part of the Notes, at the redemption prices (expressed as percentages of principal amount) set forth below, plus accrued and unpaid interest, if any, on the Notes to be redeemed to the applicable redemption date, if redeemed during the twelve–month period beginning on April 15 of the years indicated below:\n\n| Year | Percentage |\n| 2015 | 104.0 | % |\n| 2016 | 102.0 | % |\n| 2017 and thereafter | 100.0 | % |\n\n12\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nPrior to April 15, 2015, we may redeem all or part of the Notes at a redemption price equal to the sum of:\n\n| · | the principal amount thereof, plus |\n\n\n| · | the Make Whole Premium (as defined in the Indenture) at the redemption date, plus accrued and unpaid interest, if any, to the redemption date. |\n\nThe Indenture also provides that, if a change of control (as defined in the Indenture) occurs, the holders have a right to require us to repurchase all or part of the Notes at a redemption price equal to 101%, plus accrued and unpaid interest.\nThe Indenture contains covenants that, among other things, limit our ability to: (i) pay distributions on, purchase or redeem our common units or redeem our subordinated debt; (ii) make investments; (iii) incur or guarantee additional indebtedness or issue certain types of equity securities; (iv) create certain liens; (v) sell assets; (vi) consolidate, merge or transfer all or substantially all of our assets; (vii) enter into intercompany agreements that restrict distributions or other payments from our restricted subsidiaries to us; (viii) engage in transactions with affiliates; and (ix) create unrestricted subsidiaries.\nNOTE 8. COMMITMENTS AND CONTINGENCIES\nWe are involved in disputes or legal actions arising in the ordinary course of business. We do not believe the outcome of such disputes or legal actions will have a material effect on our unaudited condensed consolidated financial statements, and no amounts have been accrued at June 30, 2011 or December 31, 2010.\nNOTE 9. OWNERS’ EQUITY\nUnits Outstanding\nAt June 30, 2011, owner’s equity consists of 34,173,650 common units, representing a 98% limited partnership interest in us, and a 2% general partnership interest.\nIssuance of Units\nIn January 2011, the following equity–based awards vested:\n\n| Phantom units accounted for as liability awards (1) | 80,534 |\n| Phantom units accounted for as equity awards | 70,610 |\n| Performance units | 80,000 |\n| Total units vested | 231,144 |\n| Performance units settled in cash | (17,807 | ) |\n| Units converted to common units | 213,337 |\n\n\n| (1) | These phantom units vested at a fair value of $3.5 million. |\n\nIn conjunction with the vesting of these units, we received a contribution of $0.2 million by our general partner to maintain its 2% interest in us.\nOn March 9, 2011, we closed a public offering of 3.45 million of our common units at an offering price of $44.42 per common unit. We received net proceeds of $149.8 million, including a contribution of $3.0 million by our general partner to maintain its 2% interest in us. We used a portion of the net proceeds to repay indebtedness outstanding under our credit facility.\n13\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nCash Distributions\nThe following sets forth the distributions we paid during the six months ended June 30, 2011:\n\n| Date Paid | Period Covered | Distribution per Unit | Total Distribution |\n| February 14, 2011 | October 1, 2010 – December 31, 2010 | $ | 0.759 | $ | 26,477 |\n| May 13, 2011 | January 1, 2011 – March 31, 2011 | 0.760 | 29,496 |\n| $ | 55,973 |\n\nOn July 28, 2011, the board of directors of EV Management declared a $0.761 per unit distribution for the second quarter of 2011 on all common units. The distribution of $29.5 million is to be paid on August 12, 2011 to unitholders of record at the close of business on August 8, 2011.\nNOTE 10. NET INCOME (LOSS) PER LIMITED PARTNER UNIT\nThe following sets forth the calculation of net income (loss) per limited partner unit:\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2011 | 2010 | 2011 | 2010 |\n| Net income | $ | 39,163 | $ | 16,280 | $ | 5,174 | $ | 62,404 |\n| Less: |\n| Incentive distribution rights | (2,945 | ) | (2,298 | ) | (5,879 | ) | (4,588 | ) |\n| General partner’s 2% interest in net income | (783 | ) | (326 | ) | (103 | ) | (1,248 | ) |\n| Limited partners’ interest in net income (loss) | $ | 35,435 | $ | 13,656 | $ | (808 | ) | 56,568 |\n| Weighted average limited partner units outstanding: |\n| Common units | 34,174 | 27,060 | 32,880 | 26,249 |\n| Performance units (1) | 120 | 150 | 122 | 154 |\n| Denominator for basic net income (loss) per limited partner unit | 34,294 | 27,210 | 33,002 | 26,403 |\n| Dilutive phantom units (2) | 240 | 54 | – | 35 |\n| Total | 34,534 | 27,264 | 33,002 | 26,438 |\n| Net income (loss) per limited partner unit: |\n| Basic | $ | 1.03 | $ | 0.50 | $ | (0.02 | ) | $ | 2.14 |\n| Diluted | $ | 1.03 | $ | 0.50 | $ | (0.02 | ) | $ | 2.14 |\n\n\n| (1) | Our earned but unvested performance units are considered to be participating securities for purposes of calculating our net income (loss) per limited partner unit and, accordingly, are included in the basic computation as such. |\n\n\n| (2) | Phantom units accounted for as equity awards totaling 0.5 million units were not included in the computation of diluted net income (loss) per limited partner unit because the effect would have been anti-dilutive for the six months ended June 30, 2011. |\n\nNOTE 11. RELATED PARTY TRANSACTIONS\nPursuant to an omnibus agreement, we paid EnerVest $2.8 million and $2.3 million in the three months ended June 30, 2011 and 2010, respectively, and $5.5 million and $4.3 million in the six months ended June 30, 2011 and 2010, respectively, in monthly administrative fees for providing us general and administrative services. These fees are based on an allocation of charges between EnerVest and us based on the estimated use of such services by each party, and we believe that the allocation method employed by EnerVest is reasonable and reflective of the estimated level of costs we would have incurred on a standalone basis. These fees are included in general and administrative expenses in our unaudited condensed consolidated statements of operations.\n14\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nWe have entered into operating agreements with EnerVest whereby a wholly owned subsidiary of EnerVest acts as contract operator of the oil and natural gas wells and related gathering systems and production facilities in which we own an interest. We reimbursed EnerVest $3.4 million and $3.2 million in the three months ended June 30, 2011 and 2010, respectively, and $7.2 million and $5.7 million in the six months ended June 30, 2011 and 2010, respectively, for direct expenses incurred in the operation of our wells and related gathering systems and production facilities and for the allocable share of the costs of EnerVest employees who performed services on our properties. As the vast majority of such expenses are charged to us on an actual basis (i.e., no mark–up or subsidy is charged or received by EnerVest), we believe that the aforementioned services were provided to us at fair and reasonable rates relative to the prevailing market and are representative of the costs that would have been incurred on a standalone basis. These costs are included in lease operating expenses in our unaudited condensed consolidated statements of operations. Additionally, in its role as contract operator, this EnerVest subsidiary also collects proceeds from oil and natural gas sales and distributes them to us and other working interest owners.\nNOTE 12. OTHER SUPPLEMENTAL INFORMATION\nSupplemental cash flows and non–cash transactions were as follows:\n\n| Six Months Ended June 30, |\n| 2011 | 2010 |\n| Supplemental cash flows information: |\n| Cash paid for interest | $ | 5,595 | $ | 4,755 |\n| Cash paid for income taxes | 250 | 245 |\n| Non–cash transactions: |\n| Costs for development of oil and natural gas properties in accounts payable and accrued liabilities | 5,241 | 2,533 |\n\nNOTE 13. NEW ACCOUNTING STANDARDS\nIn May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011–04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This ASU represents the converged guidance of the FASB and the International Accounting Standards Board on fair value measurement, and has resulted in common requirements for measuring fair value and for disclosing information about fair value measurements, including a consistent meaning of the term “fair value.” The provisions of ASU 2011–04 are applicable to interim and annual reporting periods subsequent to December 15, 2011. We will adopt the new requirements for our Form 10–K for the year ending December 31, 2011.\nNo other new accounting pronouncements issued or effective during the six months ended June 30, 2011 have had or are expected to have a material impact on our unaudited condensed consolidated financial statements.\nNOTE 14. SUBSEQUENT EVENT\nIn July 2011, we sold oil and natural gas properties for $8.5 million. We received a non–refundable deposit of $0.9 million in June 2011 and the remainder of the proceeds upon the closing of the sale. These oil and natural gas properties and the related ARO have been classified as “Assets held for sale” and “Liabilities related to assets held for sale” on our unaudited consolidated condensed balance sheet.\nIn July 2011, we agreed, subject to the execution of a final purchase and sale agreement, to acquire oil and natural gas properties from certain institutional partnerships managed by EnerVest for $34.3 million, subject to customary closing conditions and purchase price adjustments. The acquisition is expected to close in August 2011.\nWe evaluated subsequent events for appropriate accounting and disclosure through the date these unaudited condensed consolidated financial statements were issued.\n15\nITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our unaudited condensed consolidated financial statements and the related notes thereto, as well as our Annual Report on Form 10–K for the year ended December 31, 2010.\nOVERVIEW\nWe are a Delaware limited partnership formed in April 2006 by EnerVest to acquire, produce and develop oil and natural gas properties. Our general partner is EV Energy GP, a Delaware limited partnership, and the general partner of our general partner is EV Management, a Delaware limited liability company.\nOur properties are located in the Barnett Shale, the Appalachian Basin (primarily in Ohio and West Virginia), the Mid-Continent area in Oklahoma, Texas, Arkansas, Kansas and Louisiana, the San Juan Basin, the Monroe Field in Louisiana, the Permian Basin, Central and East Texas (which includes the Austin Chalk area), and Michigan. As of December 31, 2010, we had estimated net proved reserves of 12.9 MMBbls of oil, 27.5 MMBbls of natural gas liquids and 575.2 Bcf of natural gas, or 817.3 Bcfe, and a standardized measure of $1,020.2 million.\nCURRENT DEVELOPMENTS\nIn March 2011, we closed a public offering of 3.45 million common units at an offering price of $44.42 per common unit. We received net proceeds of $149.8 million, including a contribution of $3.0 million by our general partner to maintain its 2% interest in us. We used a portion of the net proceeds to repay indebtedness outstanding under our credit facility.\nIn March 2011, we issued $300.0 million in aggregate principal amount of 8.0% senior unsecured notes due 2019. We received net proceeds of $291.6 million, after deducting the discount of $7.5 million and offering expenses of $0.9 million. We used the net proceeds to repay indebtedness outstanding under our credit facility.\nIn April 2011, we entered into a second amended and restated $1.0 billion credit facility that expires in April 2016. The facility requires the maintenance of a current ratio (as defined in the facility) of greater than 1.0 and a ratio of total debt to earnings plus interest expense, taxes, depreciation, depletion and amortization expense and exploration expense of no greater than 4.25 to 1.0. The borrowing base, which was initially set at $600.0 million, is subject to scheduled redeterminations every six months beginning October 1, 2011.\nIn July 2011, we agreed, subject to the execution of a final purchase and sale agreement, to acquire oil and natural gas properties from certain institutional partnerships managed by EnerVest for $34.3 million, subject to customary closing conditions and purchase price adjustments. The acquisition is expected to close in August 2011.\nBUSINESS ENVIRONMENT\nOur primary business objective is to provide stability and growth in cash distributions per unit over time. The amount of cash we can distribute on our units principally depends upon the amount of cash generated from our operations, which will fluctuate from quarter to quarter based on, among other things:\n| · | the prices at which we will sell our oil, natural gas liquids and natural gas production; |\n\n\n| · | our ability to hedge commodity prices; |\n\n\n| · | the amount of oil, natural gas liquids and natural gas we produce; and |\n\n\n| · | the level of our operating and administrative costs. |\n\nOil and natural gas prices are expected to be volatile in the future. Factors affecting the price of oil include worldwide economic conditions, geopolitical activities, worldwide supply disruptions, weather conditions, actions taken by the Organization of Petroleum Exporting Countries and the value of the U.S. dollar in international currency markets. Factors affecting the price of natural gas include the discovery of substantial accumulations of natural gas in unconventional reservoirs due to technological advancements necessary to commercially produce these unconventional reserves, North American weather conditions, industrial and consumer demand for natural gas, storage levels of natural gas and the availability and accessibility of natural gas deposits in North America.\n16\nIn order to mitigate the impact of changes in oil and natural gas prices on our cash flows, we are a party to derivatives, and we intend to enter into derivatives in the future to reduce the impact of oil and natural gas price volatility on our cash flows. By removing a significant portion of this price volatility on our future oil and natural gas production through December 2015, we have mitigated, but not eliminated, the potential effects of changing oil and natural gas prices on our cash flows from operations for those periods. If commodity prices are depressed for an extended period of time, it could alter our acquisition and development plans, and adversely affect our growth strategy and ability to access additional capital in the capital markets.\nThe primary factors affecting our production levels are capital availability, our ability to make accretive acquisitions, the success of our drilling program and our inventory of drilling prospects. In addition, as initial reservoir pressures are depleted, production from our wells decreases. We attempt to overcome this natural decline through a combination of drilling and acquisitions. Our future growth will depend on our ability to continue to add reserves through drilling and acquisitions in excess of production. We will maintain our focus on the costs to add reserves through drilling and acquisitions as well as the costs necessary to produce such reserves. Our ability to add reserves through drilling is dependent on our capital resources and can be limited by many factors, including our ability to timely obtain drilling permits and regulatory approvals. Any delays in drilling, completion or connection to gathering lines of our new wells will negatively impact our production, which may have an adverse effect on our revenues and, as a result, cash available for distribution.\nWe focus our efforts on increasing oil and natural gas reserves and production while controlling costs at a level that is appropriate for long–term operations. Our future cash flows from operations are dependent upon our ability to manage our overall cost structure.\nRESULTS OF OPERATIONS\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2011 | 2010 | 2011 | 2010 |\n| Production data: |\n| Oil (MBbls) | 241 | 171 | 449 | 297 |\n| Natural gas liquids (MBbls) | 272 | 178 | 542 | 360 |\n| Natural gas (MMcf) | 6,999 | 4,734 | 14,003 | 8,719 |\n| Net production (MMcfe) | 10,080 | 6,831 | 19,951 | 12,665 |\n| Average sales price per unit: |\n| Oil (Bbl) | $ | 98.63 | $ | 73.20 | $ | 94.58 | $ | 73.73 |\n| Natural gas liquids (Bbl) | 54.80 | 40.23 | 51.45 | 42.91 |\n| Natural gas (Mcf) | 4.20 | 4.16 | 4.10 | 4.66 |\n| Mcfe | 6.76 | 5.77 | 6.40 | 6.16 |\n| Average unit cost per Mcfe: |\n| Production costs: |\n| Lease operating expenses | $ | 1.78 | $ | 2.18 | $ | 1.77 | $ | 2.08 |\n| Production taxes | 0.31 | 0.24 | 0.29 | 0.30 |\n| Total | 2.09 | 2.42 | 2.06 | 2.38 |\n| Asset retirement obligations accretion expense | 0.10 | 0.11 | 0.10 | 0.10 |\n| Depreciation, depletion and amortization | 1.83 | 1.97 | 1.80 | 2.02 |\n| General and administrative expenses | 0.71 | 0.85 | 0.79 | 0.83 |\n\n17\nThree Months Ended June 30, 2011 Compared with the Three Months Ended June 30, 2010\nNet income for the three months ended June 30, 2011 was $39.2 million compared with $16.3 million for the three months ended June 30, 2010. This improvement reflects (i) a $28.7 million increase in revenues due to increased production primarily from our acquisitions of oil and natural gas properties in 2010 and higher prices for oil, natural gas and natural gas liquids and (ii) a $19.6 million increase in non–cash changes in the fair value of our derivatives, partially offset by (iii) an $11.5 million increase in operating expenses mainly related to the properties acquired in 2010, (iv) an impairment loss of $5.1 million related to the write–down of oil and natural gas properties to their fair value (compared with a $4.4 million gain on the sale of oil and natural gas properties in the three months ended June 30, 2010), and (v) a $4.9 million increase in interest expense.\nOil, natural gas and natural gas liquids revenues for the three months ended June 30, 2011 totaled $68.1 million, an increase of $28.7 million compared with the three months ended June 30, 2010. This increase was the result of $21.6 million related to increased production and $7.1 million related to higher prices for oil, natural gas and natural gas liquids.\nLease operating expenses for the three months ended June 30, 2011 increased $3.1 million compared with the three months ended June 30, 2010 primarily as the result of $5.8 million related to our 2010 acquisitions and our expanded development drilling program partially offset by $0.4 million due to a lower unit cost per Mcfe for our December 2010 acquisition of oil and natural gas properties in the Barnett Shale and $2.3 million ($0.34 per Mcfe) of lease operating expenses in the three months ended June 30, 2010 associated with oil in tanks acquired in the March 2010 acquisition that was sold in the three months ended June 30, 2010. Lease operating expenses per Mcfe were $1.78 in the three months ended June 30, 2011 compared with $2.18 in the three months ended June 30, 2010. Production taxes, which are generally based on a percentage of our oil, natural gas and natural gas liquids revenues, for the three months ended June 30, 2011 increased $1.4 million compared with the three months ended June 30, 2010 primarily as the result of $1.0 million due to increased production and $0.4 million due to higher average realized prices. Production taxes for the three months ended June 30, 2011 were $0.31 per Mcfe compared with $0.24 per Mcfe for the three months ended June 30, 2010. Asset retirement obligations accretion expense for the three months ended June 30, 2011 increased $0.2 million compared with the three months ended June 30, 2010 primarily due to the oil and natural gas properties that we acquired in 2010. Asset retirement obligations accretion expense for the three months ended June 30, 2011 was $0.10 per Mcfe compared with $0.11 per Mcfe for the three months ended June 30, 2010. Depreciation, depletion and amortization for the three months ended June 30, 2011 increased $5.0 million compared with the three months ended June 30, 2010 primarily due to $5.9 million from higher production offset by a decrease of $0.9 million due to a lower average DD&A rate per unit. The lower average DD&A rate per unit reflects the effect of our acquisitions of oil and natural gas properties in 2010. Depreciation, depletion and amortization for the three months ended June 30, 2011 was $1.83 per Mcfe compared with $1.97 per Mcfe for the three months ended June 30, 2010.\nGeneral and administrative expenses for the three months ended June 30, 2011 totaled $7.1 million, an increase of $1.3 million compared with the three months ended June 30, 2010. This increase is primarily the result of $1.0 million of higher compensation costs primarily related to our equity–based compensation plans and $0.5 million of higher fees paid to EnerVest under the omnibus agreement due to an increase in operations from our acquisitions of oil and natural gas properties in 2010 partially offset by a $0.2 million decrease in acquisition due diligence costs. General and administrative expenses were $0.71 per Mcfe in the three months ended June 30, 2011 compared with $0.85 per Mcfe in the three months ended June 30, 2010.\nDuring the three months ended June 30, 2011, we incurred impairment charges of $5.1 million to write down oil and natural gas properties to their fair value. During the three months ended June 30, 2011 and 2010, we recorded cash settlements of $9.5 million and $13.9 million, respectively, as realized gains on derivatives, net, as the contract prices for our derivatives exceeded the underlying market price for that period. In June 2011, we also terminated three of our interest rate swaps and recorded a non–cash realized gain of $4.7 million, which represented the value of these interest rate swaps on the date of termination. The terminated interest rate swaps were rolled over into three new interest rate swaps with a value of $5.2 million at inception. Unrealized gains (losses) on derivatives, net represent the change in the fair value of our open derivatives during the period. In the three months ended June 30, 2011, the fair value of our open derivatives increased from a net asset of $49.3 million at March 31, 2011 to a net asset of $70.0 million at June 30, 2011. In the three months ended June 30, 2010, the fair value of our open derivatives decreased from a net asset of $125.8 million at March 31, 2010 to a net asset of $123.6 million at June 30, 2010.\n18\nInterest expense for the three months ended June 30, 2011 increased $4.9 million compared with the three months ended June 30, 2010 primarily due to increases of $2.4 million from a higher weighted average long–term debt balance and $2.5 million due to a higher weighted average effective interest rate attributable to our 8% senior notes due 2019.\nSix Months Ended June 30, 2011 Compared with the Six Months Ended June 30, 2010\nNet income for the six months ended June 30, 2011 was $5.2 million compared with $62.4 million for the six months ended June 30, 2010. This change reflects (i) a $49.5 million increase in revenues due to increased production primarily from our acquisitions of oil and natural gas properties in 2010 and higher prices for oil and natural gas liquids and (ii) a $5.9 million increase in realized gains on derivatives, partially offset by (iii) a.$66.1 million decrease in non–cash changes in the fair value of our derivatives, (iv) a $28.0 million increase in operating expenses mainly related to the properties acquired in 2010, (v) a $7.9 million increase in interest expense and (vi) an impairment loss of $6.7 million related to the write–down of oil and natural gas properties to their fair value (compared with a $3.8 million gain on the sale of oil and natural gas properties in the six months ended June 30, 2010).\nOil, natural gas and natural gas liquids revenues for the six months ended June 30, 2011 totaled $127.7 million, an increase of $49.7 million compared with the six months ended June 30, 2010. This increase was the result of $45.3 million related to increased production and $4.4 million related to higher prices for oil and natural gas liquids.\nLease operating expenses for the six months ended June 30, 2011 increased $9.0 million compared with the six months ended June 30, 2010 primarily as the result of $12.9 million related to our 2010 acquisitions and our expanded development drilling program partially offset by $1.5 million due to a lower unit cost per Mcfe for our December 2010 acquisition of oil and natural gas properties in the Barnett Shale and $2.3 million ($0.18 per Mcfe) of lease operating expenses in the six months ended June 30, 2010 associated with oil in tanks acquired in the March 2010 acquisition that was sold in the six months ended June 30, 2010. Lease operating expenses per Mcfe were $1.77 in the six months ended June 30, 2011 compared with $2.08 in the six months ended June 30, 2010. Production taxes for the six months ended June 30, 2011 increased $2.0 million compared with the six months ended June 30, 2010 primarily as the result of $2.1 million due to increased production partially offset by $0.1 million due to lower average realized prices for natural gas. Production taxes for the six months ended June 30, 2011 were $0.29 per Mcfe compared with $0.30 per Mcfe for the six months ended June 30, 2010. Asset retirement obligations accretion expense for the six months ended June 30, 2011 increased $0.7 million compared with the six months ended June 30, 2010 primarily due to the oil and natural gas properties that we acquired in 2010. Asset retirement obligations accretion expense for both the six months ended June 30, 2011 and June 30, 2010 was $0.10 per Mcfe. Depreciation, depletion and amortization for the six months ended June 30, 2011 increased $10.5 million compared with the six months ended June 30, 2010 primarily due to $13.1 million from higher production offset by a decrease of $2.8 million due to a lower average DD&A rate per unit. The lower average DD&A rate per unit reflects the effect of our acquisitions of oil and natural gas properties in 2010. Depreciation, depletion and amortization for the six months ended June 30, 2011 was $1.80 per Mcfe compared with $2.02 per Mcfe for the six months ended June 30, 2010.\nGeneral and administrative expenses for the six months ended June 30, 2011 totaled $15.7 million, an increase of $5.2 million compared with the six months ended June 30, 2010. This increase is primarily the result of (i) $3.5 million of higher compensation costs primarily related to our equity–based compensation plans, (ii) $1.3 million of higher fees paid to EnerVest under the omnibus agreement due to an increase in operations from our acquisitions of oil and natural gas properties in 2010, and (iii) an overall increase in costs related to our significant growth. General and administrative expenses were $0.79 per Mcfe in the six months ended June 30, 2011 compared with $0.83 per Mcfe in the six months ended June 30, 2010.\nDuring the six months ended June 30, 2011, we incurred impairment charges of $6.7 million to write down oil and natural gas properties to their fair value. During the six months ended June 30, 2011 and 2010, we recorded cash settlements of $23.1 million and $21.9 million, respectively, as realized gains on derivatives, net, as the contract prices for our derivatives exceeded the underlying market price for that period. In June 2011, we also terminated three of our interest rate swaps and recorded a non–cash realized gain of $4.7 million, which represented the value of these interest rate swaps on the date of termination. The terminated interest rate swaps were rolled over into three new interest rate swaps with a value of $5.2 million at inception.\n19\nUnrealized gains (losses) on derivatives, net represent the change in the fair value of our open derivatives during the period. In the six months ended June 30, 2011, the fair value of our open derivatives decreased from a net asset of $103.9 million at December 31, 2010 to a net asset of $70.0 million at June 30, 2011. In the six months ended June 30, 2010, the fair value of our open derivatives increased from a net asset of $93.1 million at December 31, 2009 to a net asset of $123.6 million at June 30, 2010.\nInterest expense for the six months ended June 30, 2011 increased $7.9 million compared with the six months ended June 30, 2010 primarily due to an increase of $5.8 million from a higher weighted average long–term debt balance and an increase of $2.1 million due to a higher weighted average effective interest rate attributable to our 8% senior notes due 2019.\nLIQUIDITY AND CAPITAL RESOURCES\nHistorically, our primary sources of liquidity and capital have been issuances of equity and debt securities, borrowings under our credit facility and cash flows from operations. Our primary uses of cash have been acquisitions of oil and natural gas properties and related assets, development of our oil and natural gas properties, distributions to our partners and working capital needs. For 2011, we believe that cash on hand and net cash flows generated from operations will be adequate to fund our capital budget and satisfy our short–term liquidity needs. We may also utilize various financing sources available to us, including the issuance of equity or debt securities through public offerings or private placements, to fund our acquisitions and long–term liquidity needs. Our ability to complete future offerings of equity or debt securities and the timing of these offerings will depend upon various factors including prevailing market conditions and our financial condition.\nIn the past we accessed the equity and debt markets to finance our significant acquisitions. While we have been successful in accessing the public equity and debt markets earlier this year and in prior years, any disruptions in the financial markets may limit our ability to access the public equity or debt markets in the future.\nLong–term Debt\nIn April 2011, we replaced our existing $700.0 million credit facility with a $1.0 billion credit facility that expires in April 2016. Borrowings under the facility may not exceed a “borrowing base” determined by the lenders based on our oil and natural gas reserves. As of June 30, 2011, the borrowing base was $600.0 million, and we had $187.5 million outstanding.\nIn March 2011, we issued $300.0 million in aggregate principal amount of 8.0% senior notes due 2019 and received net proceeds of approximately $291.6 million. We used the net proceeds to repay indebtedness outstanding under our credit facility. As of June 30, 2011, we had $300.0 million of notes outstanding. These notes are recorded on our unaudited condensed consolidated balance sheet as $292.7 million, which is net of the unamortized discount of $7.3 million.\nFor additional information about our long–term debt, such as interest rates and covenants, please see “Item 1. Condensed Consolidated Financial Statements (Unaudited)” contained herein.\nCash and Short–term Investments\nAt June 30, 2011, we had $26.4 million of cash and short–term investments, which included $22.0 million of short–term investments. With regard to our short–term investments, we invest in money market accounts with major financial institutions.\nCounterparty Exposure\nAt June 30, 2011, our open derivative contracts were in a net receivable position with a fair value of $70.0 million. All of our derivative contracts are with major financial institutions who are also lenders under our credit facility. Should one of these financial counterparties not perform, we may not realize the benefit of some of our derivative contracts and we could incur a loss. As of June 30, 2011, all of our counterparties have performed pursuant to their commodity derivative contracts.\n20\nCash Flows\nCash flows provided (used) by type of activity were as follows:\n\n| Six Months Ended June 30, |\n| 2011 | 2010 |\n| Operating activities | $ | 80,130 | $ | 55,802 |\n| Investing activities | (25,681 | ) | (151,468 | ) |\n| Financing activities | (51,184 | ) | 94,152 |\n\nOperating Activities\nCash flows from operating activities were $80.1 million and $55.8 million in the six months ended June 30, 2011 and 2010, respectively. The increase was primarily due to higher production and prices for oil and natural gas liquids, partially offset by higher operating expenses.\nInvesting Activities\nOur principal recurring investing activity is the acquisition and development of oil and natural gas properties. During the six months ended June 30, 2011, we spent $1.0 million for the acquisition of oil and natural gas properties and $33.7 million for development of our oil and natural gas properties. In addition, we received $4.1 million in final purchase price settlements, $2.8 million from settlements of derivatives acquired in our December 2010 acquisition of oil and natural gas properties and $1.2 million in proceeds from the sale of oil and natural gas properties.\nDuring the six months ended June 30, 2010, we spent $147.8 million on the acquisitions of oil and natural gas properties and $8.2 million for the development of our oil and natural gas properties. In addition, we received $4.5 million from the sales of oil and natural gas properties.\nFinancing Activities\nDuring the six months ended June 30, 2011, we received net proceeds of $146.8 million from our public equity offering in March 2011, and we received contributions of $3.2 million from our general partner in order to maintain its 2% interest in us. We also received net proceeds of $291.6 million from our debt offering in March 2011, after deducting offering expenses of $0.9 million. We used the proceeds from these offerings to repay $431.5 million of borrowings outstanding under our credit facility. In addition, we paid distributions of $56.0 million to holders of our common units and our general partner and $5.3 million in loan costs related to our new $1.0 billion credit facility.\nDuring the six months ended June 30, 2010, we received net proceeds of $92.6 million from our public equity offering in February 2010, and we received contributions of $2.0 million from our general partner in order to maintain its 2% interest in us. We borrowed $138.0 million under our credit facility to finance our acquisition of oil and natural gas properties in March 2010 and we repaid $95.0 million of borrowings outstanding under our credit facility with proceeds from our public equity offering and cash flows from operations. In addition, we paid distributions of $43.4 million to holders of our common units and our general partner.\nFORWARD–LOOKING STATEMENTS\nThis Form 10–Q contains forward–looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act (each a “forward–looking statement”). These forward–looking statements relate to, among other things, the following:\n\n| · | our future financial and operating performance and results; |\n\n\n| · | our business strategy; |\n\n\n| · | our estimated net proved reserves and standardized measure; |\n\n\n| · | market prices; |\n\n21\n\n| · | our future derivative activities; and |\n\n\n| · | our plans and forecasts. |\n\nWe have based these forward–looking statements on our current assumptions, expectations and projections about future events.\nThe words “anticipate,” “believe,” “ensure,” “expect,” “if,” “intend,” “estimate,” “project,” “forecasts,” “predict,” “outlook,” “aim,” “will,” “could,” “should,” “would,” “may,” “likely” and similar expressions, and the negative thereof, are intended to identify forward–looking statements. These statements discuss future expectations, contain projections of results of operations or of financial condition or state other “forward–looking” information. We do not undertake any obligation to update or revise publicly any forward–looking statements, except as required by law. These statements also involve risks and uncertainties that could cause our actual results or financial condition to materially differ from our expectations in this Form 10–Q including, but not limited to:\n\n| · | fluctuations in prices of oil and natural gas; |\n\n\n| · | significant disruptions in the financial markets; |\n\n\n| · | future capital requirements and availability of financing; |\n\n\n| · | uncertainty inherent in estimating our reserves; |\n\n\n| · | risks associated with drilling and operating wells; |\n\n\n| · | discovery, acquisition, development and replacement of oil and natural gas reserves; |\n\n\n| · | cash flows and liquidity; |\n\n\n| · | timing and amount of future production of oil and natural gas; |\n\n\n| · | availability of drilling and production equipment; |\n\n\n| · | marketing of oil and natural gas; |\n\n\n| · | developments in oil and natural gas producing countries; |\n\n\n| · | competition; |\n\n\n| · | general economic conditions; |\n\n\n| · | governmental regulations; |\n\n\n| · | receipt of amounts owed to us by purchasers of our production and counterparties to our derivative financial instrument contracts; |\n\n\n| · | hedging decisions, including whether or not to enter into derivative financial instruments; |\n\n\n| · | events similar to those of September 11, 2001; |\n\n\n| · | actions of third party co–owners of interest in properties in which we also own an interest; |\n\n\n| · | fluctuations in interest rates and the value of the U.S. dollar in international currency markets; and |\n\n\n| · | our ability to effectively integrate companies and properties that we acquire. |\n\n22\nAll of our forward–looking information is subject to risks and uncertainties that could cause actual results to differ materially from the results expected. Although it is not possible to identify all factors, these risks and uncertainties include the risk factors and the timing of any of those risk factors identified in the “Risk Factors” section included in Item 1A of our Annual Report on Form 10–K for the year ended December 31, 2010. This document is available through our web site or through the SEC’s Electronic Data Gathering and Analysis Retrieval System at http://www.sec.gov.\nOur revenues, operating results, financial condition and ability to borrow funds or obtain additional capital depend substantially on prevailing prices for oil and natural gas. Declines in oil or natural gas prices may materially adversely affect our financial condition, liquidity, ability to obtain financing and operating results. Lower oil or natural gas prices also may reduce the amount of oil or natural gas that we can produce economically. A decline in oil and/or natural gas prices could have a material adverse effect on the estimated value and estimated quantities of our oil and natural gas reserves, our ability to fund our operations and our financial condition, cash flows, results of operations and access to capital. Historically, oil and natural gas prices and markets have been volatile, with prices fluctuating widely, and they are likely to continue to be volatile.\n\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nWe are exposed to certain market risks that are inherent in our financial statements that arise in the normal course of business. We may enter into derivative instruments to manage or reduce market risk, but do not enter into derivative agreements for speculative purposes.\nWe do not designate these or plan to designate future derivative instruments as hedges for accounting purposes. Accordingly, the changes in the fair value of these instruments are recognized currently in earnings.\nCommodity Price Risk\nOur major market risk exposure is to prices for oil, natural gas and natural gas liquids. These prices have historically been volatile. As such, future earnings are subject to change due to changes in these prices. Realized prices are primarily driven by the prevailing worldwide price for oil and regional spot prices for natural gas production. We have used, and expect to continue to use, oil, natural gas and natural gas liquids commodity contracts to reduce our risk of changes in the prices of oil, natural gas and natural gas liquids. Pursuant to our risk management policy, we engage in these activities as a hedging mechanism against price volatility associated with pre–existing or anticipated sales of oil, natural gas and natural gas liquids.\nWe have entered into commodity contracts to hedge significant amounts of our anticipated oil, natural gas and natural gas liquids production through December 2015. As of June 30, 2011, we have commodity contracts covering approximately 53% of our production attributable to our estimated net proved reserves from July 2011 through December 2015, as estimated in our reserve report prepared by third party engineers using prices, costs and other assumptions required by SEC rules. Our actual production will vary from the amounts estimated in our reserve reports, perhaps materially.\nThe fair value of our commodity contracts and basis swaps at June 30, 2011 was a net asset of $78.9 million. A 10% change in oil, natural gas and natural gas liquids prices with all other factors held constant would result in a change in the fair value (generally correlated to our estimated future net cash flows from such instruments) of our oil and natural gas commodity contracts and basis swaps of approximately $60 million. Please see “Item 1. Condensed Consolidated Financial Statements (Unaudited)” contained herein for additional information.\nInterest Rate Risk\nOur floating rate credit facility also exposes us to risks associated with changes in interest rates and as such, future earnings are subject to change due to changes in these interest rates. If interest rates on our facility increased by 1%, interest expense for the six months ended June 30, 2011 would have increased by approximately $1.8 million. Please see “Item 1. Condensed Consolidated Financial Statements (Unaudited)” contained herein for additional information.\n23\nITEM 4. CONTROLS AND PROCEDURES\nEvaluation of Disclosure Controls and Procedures\nIn accordance with Exchange Act Rule 13a–15 and 15d–15, we carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of June 30, 2011 to provide reasonable assurance that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Our disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.\nChange in Internal Controls Over Financial Reporting\nThere have not been any changes in our internal controls over financial reporting that occurred during the quarterly period ended June 30, 2011 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.\nPART II. OTHER INFORMATION\n\nITEM 1. LEGAL PROCEEDINGS\nWe are involved in disputes or legal actions arising in the ordinary course of business. We do not believe the outcome of such disputes or legal actions will have a material effect on our unaudited condensed consolidated financial statements.\n\nITEM 1A. RISK FACTORS\nThere have been no material changes with respect to the risk factors disclosed in our Annual Report on Form 10–K for the year ended December 31, 2010.\n\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nNone.\n\nITEM 3. DEFAULTS UPON SENIOR SECURITIES\nNone.\nITEM 4. (Removed and Reserved)\n\nITEM 5. OTHER INFORMATION\nNone.\n\nITEM 6. EXHIBITS\nThe exhibits listed below are filed or furnished as part of this report:\n\n| 10.1 | Credit Agreement, dated as of April 26, 2011 by and among EV Energy Partners, L.P., EV Properties, L.P., and JPMorgan Chase Bank, N.A. as Administrative Agent for the lenders named therein. (Incorporated by reference from Exhibit 10.1 to EV Energy Partners L.P.’s current report on Form 8–K filed with the SEC on April 29, 2011). |\n\n\n| +31.1 | Rule 13a-14(a)/15d–14(a) Certification of Chief Executive Officer. |\n\n24\n\n| +31.2 | Rule 13a-14(a)/15d–14(a) Certification of Chief Financial Officer. |\n\n\n| +32.1 | Section 1350 Certification of Chief Executive Officer |\n\n\n| +32.2 | Section 1350 Certification of Chief Financial Officer |\n\n\n| ++101 | Interactive Data Files |\n\n\n| + | Filed herewith |\n\n\n| ++ | Pursuant to Rule 406T of Regulation S–T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Act of 1934, as amended, and otherwise are not subject to liability. |\n\n25\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| EV Energy Partners, L.P. |\n| (Registrant) |\n| Date: August 9, 2011 | By: | /s/ MICHAEL E. MERCER |\n| Michael E. Mercer |\n| Senior Vice President and Chief Financial Officer |\n\n26\nEXHIBIT INDEX\n\n| 10.1 | Credit Agreement, dated as of April 26, 2011 by and among EV Energy Partners, L.P., EV Properties, L.P., and JPMorgan Chase Bank, N.A. as Administrative Agent for the lenders named therein. (Incorporated by reference from Exhibit 10.1 to EV Energy Partners L.P.’s current report on Form 8–K filed with the SEC on April 29, 2011). |\n\n\n| +31.1 | Rule 13a-14(a)/15d–14(a) Certification of Chief Executive Officer. |\n\n\n| +31.2 | Rule 13a-14(a)/15d–14(a) Certification of Chief Financial Officer. |\n\n\n| +32.1 | Section 1350 Certification of Chief Executive Officer |\n\n\n| +32.2 | Section 1350 Certification of Chief Financial Officer |\n\n\n| ++101 | Interactive Data Files |\n\n+ Filed herewith\n\n| ++ | Pursuant to Rule 406T of Regulation S–T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Act of 1934, as amended, and otherwise are not subject to liability. |\n\n\n \n\nWhat is the total capital cost, combining both the offering cost of the senior notes and interest payment in the first year, in million dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nPART I. FINANCIAL INFORMATION\\nITEM 1. FINANCIAL STATEMENTS\\nEV Energy Partners, L.P.\\nCondensed Consolidated Balance Sheets\\n(In thousands, except number of units)\\n(Unaudited)\\n\\n| June 30, | December 31, |\\n| 2011 | 2010 |\\n| ASSETS |\\n| Current assets: |\\n| Cash and cash equivalents | $ | 26,392 | $ | 23,127 |\\n| Accounts receivable: |\\n| Oil, natural gas and natural gas liquids revenues | 36,600 | 27,742 |\\n| Related party | 3,967 | – |\\n| Other | 300 | 441 |\\n| Derivative asset | 51,215 | 55,100 |\\n| Assets held for sale | 11,402 | – |\\n| Other current assets | 1,047 | 1,158 |\\n| Total current assets | 130,923 | 107,568 |\\n| Oil and natural gas properties, net of accumulated depreciation, depletion and amortization; June 30, 2011, $210,073; December 31, 2010, $176,897 | 1,300,294 | 1,324,240 |\\n| Other property, net of accumulated depreciation and amortization; June 30, 2011, $536; December 31, 2010, $465 | 1,495 | 1,567 |\\n| Long–term derivative asset | 26,576 | 51,497 |\\n| Other assets | 7,533 | 1,885 |\\n| Total assets | $ | 1,466,821 | $ | 1,486,757 |\\n| LIABILITIES AND OWNERS’ EQUITY |\\n| Current liabilities: |\\n| Accounts payable and accrued liabilities: |\\n| Third party | $ | 27,642 | $ | 20,678 |\\n| Related party | – | 182 |\\n| Liabilities related to assets held for sale | 2,895 | – |\\n| Derivative liability | 1,178 | 1,943 |\\n| Total current liabilities | 31,715 | 22,803 |\\n| Asset retirement obligations | 68,266 | 67,175 |\\n| Long–term debt | 480,183 | 619,000 |\\n| Long–term liabilities | 988 | 3,048 |\\n| Long–term derivative liability | 6,594 | 784 |\\n| Commitments and contingencies |\\n| Owners’ equity: |\\n| Common unitholders – 34,173,650 units and 30,510,313 units issued and outstanding as of June 30, 2011 and December 31, 2010, respectively | 887,843 | 779,327 |\\n| General partner interest | (8,768 | ) | (5,380 | ) |\\n| Total owners’ equity | 879,075 | 773,947 |\\n| Total liabilities and owners’ equity | $ | 1,466,821 | $ | 1,486,757 |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n2\\nEV Energy Partners, L.P.\\nCondensed Consolidated Statements of Operations\\n(In thousands, except per unit data)\\n(Unaudited)\\n\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2011 | 2010 | 2011 | 2010 |\\n| Revenues: |\\n| Oil, natural gas and natural gas liquids revenues | $ | 68,109 | $ | 39,431 | $ | 127,730 | $ | 78,027 |\\n| Transportation and marketing–related revenues | 1,484 | 1,476 | 2,885 | 3,054 |\\n| Total revenues | 69,593 | 40,907 | 130,615 | 81,081 |\\n| Operating costs and expenses: |\\n| Lease operating expenses | 17,949 | 14,869 | 35,311 | 26,301 |\\n| Cost of purchased natural gas | 1,120 | 1,095 | 2,170 | 2,315 |\\n| Dry hole and exploration costs | 441 | – | 844 | – |\\n| Production taxes | 3,119 | 1,673 | 5,770 | 3,800 |\\n| Asset retirement obligations accretion expense | 970 | 764 | 1,936 | 1,274 |\\n| Depreciation, depletion and amortization | 18,443 | 13,436 | 36,007 | 25,520 |\\n| General and administrative expenses | 7,132 | 5,825 | 15,725 | 10,549 |\\n| Impairment of oil and natural gas properties | 5,078 | – | 6,666 | – |\\n| Gain on sale of oil and natural gas properties | – | (4,388 | ) | – | (3,824 | ) |\\n| Total operating costs and expenses | 54,252 | 33,274 | 104,429 | 65,935 |\\n| Operating income | 15,341 | 7,633 | 26,186 | 15,146 |\\n| Other income (expense), net: |\\n| Realized gains on derivatives, net | 14,242 | 13,901 | 27,784 | 21,866 |\\n| Unrealized gains (losses) on derivatives, net | 17,422 | (2,158 | ) | (35,633 | ) | 30,502 |\\n| Interest expense | (8,124 | ) | (3,269 | ) | (13,283 | ) | (5,372 | ) |\\n| Other income, net | 313 | 252 | 233 | 393 |\\n| Total other income (expense), net | 23,853 | 8,726 | (20,899 | ) | 47,389 |\\n| Income before income taxes | 39,194 | 16,359 | 5,287 | 62,535 |\\n| Income taxes | (31 | ) | (79 | ) | (113 | ) | (131 | ) |\\n| Net income | $ | 39,163 | $ | 16,280 | $ | 5,174 | $ | 62,404 |\\n| General partner’s interest in net income, including incentive distribution rights | $ | 3,728 | $ | 2,624 | $ | 5,982 | $ | 5,836 |\\n| Limited partners’ interest in net income (loss) | $ | 35,435 | $ | 13,656 | $ | (808 | ) | $ | 56,568 |\\n| Net income (loss) per limited partner unit: |\\n| Basic | $ | 1.03 | $ | 0.50 | $ | (0.02 | ) | $ | 2.14 |\\n| Diluted | $ | 1.03 | $ | 0.50 | $ | (0.02 | ) | $ | 2.14 |\\n| Weighted average limited partner units outstanding: |\\n| Basic | 34,294 | 27,210 | 33,002 | 26,403 |\\n| Diluted | 34,534 | 27,264 | 33,002 | 26,438 |\\n| Distributions declared per unit | $ | 0.761 | $ | 0.757 | $ | 1.521 | $ | 1.513 |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n3\\nEV Energy Partners, L.P.\\nCondensed Consolidated Statements of Changes in Owners’ Equity\\n(In thousands, except number of units)\\n(Unaudited)\\n\\n| Common Unitholders | General Partner Interest | Total Owners’ Equity |\\n| Balance, December 31, 2010 | $ | 779,327 | $ | (5,380 | ) | $ | 773,947 |\\n| Conversion of 80,534 vested phantom units | 3,508 | – | 3,508 |\\n| Proceeds from public equity offering, net of underwriters discount and offering costs of $308 | 146,800 | – | 146,800 |\\n| Contributions from general partner | – | 3,191 | 3,191 |\\n| Distributions | (49,291 | ) | (6,682 | ) | (55,973 | ) |\\n| Equity–based compensation | 2,428 | – | 2,428 |\\n| Net income | 5,071 | 103 | 5,174 |\\n| Balance, June 30, 2011 | $ | 887,843 | $ | (8,768 | ) | $ | 879,075 |\\n\\n\\n| Common Unitholders | General Partner Interest | Total Owners’ Equity |\\n| Balance, December 31, 2009 | $ | 548,160 | $ | (729 | ) | $ | 547,431 |\\n| Conversion of 84,842 vested phantom units | 2,580 | – | 2,580 |\\n| Proceeds from public equity offering, net of underwriters discount and offering costs of $154 | 92,616 | – | 92,616 |\\n| Contributions from general partner | – | 1,977 | 1,977 |\\n| Distributions | (38,284 | ) | (5,149 | ) | (43,433 | ) |\\n| Equity–based compensation | 827 | – | 827 |\\n| Net income | 61,156 | 1,248 | 62,404 |\\n| Balance, June 30, 2010 | $ | 667,055 | $ | (2,653 | ) | $ | 664,402 |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n4\\nEV Energy Partners, L.P. Condensed Consolidated Statements of Cash Flows (In thousands) (Unaudited)\\n| Six Months Ended June 30, |\\n| 2011 | 2010 |\\n| Cash flows from operating activities: |\\n| Net income | $ | 5,174 | $ | 62,404 |\\n| Adjustments to reconcile net income to net cash flows provided by operating activities: |\\n| Asset retirement obligations accretion expense | 1,936 | 1,274 |\\n| Depreciation, depletion and amortization | 36,007 | 25,520 |\\n| Equity–based compensation cost | 3,877 | 2,103 |\\n| Impairment of oil and natural gas properties | 6,666 | – |\\n| Gain on sale of oil and natural gas properties | – | (3,824 | ) |\\n| Noncash derivative activity | 30,951 | (30,502 | ) |\\n| Amortization of discount on long–term debt | 183 | – |\\n| Amortization of deferred loan costs | 554 | 275 |\\n| Other, net | 56 | (1 | ) |\\n| Changes in operating assets and liabilities: |\\n| Accounts receivable | (12,866 | ) | (4,098 | ) |\\n| Other current assets | 111 | 2,625 |\\n| Accounts payable and accrued liabilities | 7,630 | 879 |\\n| Long–term liabilities | – | (734 | ) |\\n| Other, net | (149 | ) | (119 | ) |\\n| Net cash flows provided by operating activities | 80,130 | 55,802 |\\n| Cash flows from investing activities: |\\n| Acquisition of oil and natural gas properties | 3,101 | (147,769 | ) |\\n| Development of oil and natural gas properties | (33,686 | ) | (8,170 | ) |\\n| Proceeds from sale of oil and natural gas properties | 1,170 | 4,471 |\\n| Settlements from acquired derivatives | 2,834 | – |\\n| Earnest money received for sale of oil and natural gas properties | 900 | – |\\n| Net cash flows used in investing activities | (25,681 | ) | (151,468 | ) |\\n| Cash flows from financing activities: |\\n| Long–term debt borrowings | – | 138,000 |\\n| Repayment of long–term debt borrowings | (431,500 | ) | (95,000 | ) |\\n| Proceeds from debt offering | 292,500 | – |\\n| Loan costs incurred | (6,202 | ) | (8 | ) |\\n| Proceeds from public equity offering | 147,108 | 92,770 |\\n| Offering costs | (308 | ) | (154 | ) |\\n| Contributions from general partner | 3,191 | 1,977 |\\n| Distributions paid | (55,973 | ) | (43,433 | ) |\\n| Net cash flows (used in) provided by financing activities | (51,184 | ) | 94,152 |\\n| Increase (decrease) in cash and cash equivalents | 3,265 | (1,514 | ) |\\n| Cash and cash equivalents – beginning of period | 23,127 | 18,806 |\\n| Cash and cash equivalents – end of period | $ | 26,392 | $ | 17,292 |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n5\\nEV Energy Partners, L.P.\\nNotes to Unaudited Condensed Consolidated Financial Statements\\nNOTE 1. ORGANIZATION AND NATURE OF BUSINESS\\nNature of Operations\\nEV Energy Partners, L.P. (“we,” “our” or “us”) is a publicly held limited partnership that engages in the acquisition, development and production of oil and natural gas properties. Our general partner is EV Energy GP, L.P. (“EV Energy GP”), a Delaware limited partnership, and the general partner of our general partner is EV Management, LLC (“EV Management”), a Delaware limited liability company. EV Management is a wholly owned subsidiary of EnerVest, Ltd. (“EnerVest”), a Texas limited partnership. EnerVest and its affiliates also have a significant interest in us through their 71.25% ownership of EV Energy GP which, in turn, owns a 2% general partner interest in us and all of our incentive distribution rights.\\nBasis of Presentation\\nOur unaudited condensed consolidated financial statements included herein have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, certain information and disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. We believe that the presentations and disclosures herein are adequate to make the information not misleading. The unaudited condensed consolidated financial statements reflect all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the interim periods. The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the full year. These interim financial statements should be read in conjunction with our Annual Report on Form 10–K for the year ended December 31, 2010.\\nAll intercompany accounts and transactions have been eliminated in consolidation. In the Notes to Unaudited Condensed Consolidated Financial Statements, all dollar and unit amounts in tabulations are in thousands of dollars and units, respectively, unless otherwise indicated.\\nNOTE 2. EQUITY–BASED COMPENSATION\\nWe grant various forms of equity–based awards to employees, consultants and directors of EV Management and its affiliates who perform services for us. These equity–based awards consist primarily of phantom units and performance units.\\nWe account for the phantom units issued prior to 2009 as liability awards, and the fair value of these phantom units is remeasured at the end of each reporting period based on the current market price of our common units until settlement. Prior to settlement, compensation cost is recognized for these phantom units based on the proportionate amount of the requisite service period that has been rendered to date. We account for the phantom units issued beginning in 2009 as equity awards, and we estimated the fair value of these phantom units using the Black–Scholes option pricing model. We account for the performance units as equity awards, and we estimated the fair value of these performance units using the Monte Carlo simulation model.\\nThe following table presents the compensation costs recognized in our unaudited condensed consolidated statements of operations:\\n\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2011 | 2010 | 2011 | 2010 |\\n| Liability awards | $ | 526 | $ | 608 | $ | 1,449 | $ | 1,276 |\\n| Equity awards | 1,214 | 429 | 2,428 | 827 |\\n| Total | $ | 1,740 | $ | 1,037 | $ | 3,877 | $ | 2,103 |\\n\\nThese costs are included in “General and administrative expenses” in our unaudited condensed consolidated statements of operations.\\nIn January 2011, the performance criterion was achieved with respect to the remaining 0.1 million performance units.\\n6\\nEV Energy Partners, L.P.\\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\\nAs of June 30, 2011, total unrecognized compensation costs related to the unvested liability awards and equity awards and the period over which they are expected to be recognized are as follows:\\n\\n| Unrecognized Compensation Expense | Weighted Average Period (in years) |\\n| Liability awards | $ | 3,355 | 1.5 |\\n| Equity awards | 15,175 | 3.2 |\\n\\nNOTE 3. ACQUISITIONS\\nIn April 2011, we received a final purchase price settlement of $1.9 million related to our acquisition of oil and natural gas properties in the Mid–Continent area in September 2010.\\nIn June 2011, we received a final purchase price settlement of $2.2 million related to our acquisition of oil and natural gas properties in the Barnett Shale in December 2010.\\nIn June 2011, we, along with certain institutional partnerships managed by EnerVest, acquired additional oil and natural gas properties in the Barnett Shale. We acquired a 31.02% proportional interest in these properties for $1.0 million.\\nNOTE 4. RISK MANAGEMENT\\nOur business activities expose us to risks associated with changes in the market price of oil, natural gas and natural gas liquids. In addition, our floating rate credit facility exposes us to risks associated with changes in interest rates. As such, future earnings are subject to fluctuation due to changes in the market prices of oil, natural gas and natural gas liquids and interest rates. We use derivatives to reduce our risk of changes in the prices of oil, natural gas and natural gas liquids and interest rates. Our policies do not permit the use of derivatives for speculative purposes.\\nWe have elected not to designate any of our derivatives as hedging instruments. Accordingly, changes in the fair value of our derivatives are recorded immediately to net income as “Unrealized gains (losses) on derivatives, net” in our unaudited condensed consolidated statements of operations.\\nAs of June 30, 2011, we had entered into oil commodity contracts with the following terms:\\n\\n| Period Covered | Hedged Volume (MBbls) | Weighted Average Fixed Price | Weighted Average Floor Price | Weighted Average Ceiling Price |\\n| Swaps – July 2011 through December 2011 | 209.4 | $ | 95.01 | $ | $ |\\n| Collars – July 2011 through December 2011 | 236.6 | 105.66 | 156.16 |\\n| Swaps –2012 | 625.7 | 96.45 |\\n| Collars – 2012 | 456.8 | 104.54 | 156.77 |\\n| Swaps –2013 | 994.5 | 86.46 |\\n| Swaps – 2014 | 897.2 | 91.90 |\\n\\n7\\nEV Energy Partners, L.P.\\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\\nAs of June 30, 2011, we had entered into natural gas commodity contracts with the following terms:\\n\\n| Period Covered | Hedged Volume (MmmBtus) | Weighted Average Fixed Price | Weighted Average Floor Price | Weighted Average Ceiling Price |\\n| Swaps – July 2011 through December 2011 | 8,322.9 | $ | 6.67 | $ | $ |\\n| Collars – July 2011 through December 2011 | 3,330.6 | 7.54 | 9.90 |\\n| Swaps –2012 | 14,307.6 | 6.84 |\\n| Collars – 2012 | 6,618.7 | 7.94 | 9.90 |\\n| Swaps – 2013 | 18,797.5 | 5.77 |\\n| Swaps – 2014 | 14,600.0 | 5.75 |\\n| Swaps – 2015 | 14,600.0 | 6.00 |\\n\\nAs of June 30, 2011, we had entered into natural gas liquids commodity contracts with the following terms:\\n\\n| Period Covered | Hedged Volume (MBbls) | Weighted Average Fixed Price |\\n| Ethane (MBbls): |\\n| Swaps – July 2011 through December 2011 | 188.6 | $ | 20.06 |\\n| Propane (MBbls): |\\n| Swaps – July 2011 through December 2011 | 112.7 | 49.77 |\\n\\nAs of June 30, 2011, we had entered into natural gas basis swaps with the following terms:\\n\\n| Period Covered | Floating Index 1 | Floating Index 2 | Hedged Volume (MmmBtus) | Spread |\\n| July 2011 through December 2011 | NYMEX | Dominion Appalachia | 174.4 | $ | 0.1975 |\\n| July 2011 through December 2011 | NYMEX | Appalachia Columbia | 47.7 | 0.1500 |\\n\\nAs of June 30, 2011, we had entered into interest rate swaps with the following terms:\\n\\n| Period Covered | Notional Amount | Floating Rate | Fixed Rate |\\n| July 2011 – July 2012 | $ | 90,000 | 1 Month LIBOR | 4.157 | % |\\n| July 2011 – September 2012 | 40,000 | 1 Month LIBOR | 2.145 | % |\\n| July 2012 – July 2015 | 110,000 | 1 Month LIBOR | 3.315 | % |\\n\\n8\\nEV Energy Partners, L.P.\\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\\nThe fair value of these derivatives was as follows:\\n\\n| Asset Derivatives | Liability Derivatives |\\n| June 30, 2011 | December 31, 2010 | June 30, 2011 | December 31, 2010 |\\n| Commodity contracts | $ | 89,564 | $ | 123,655 | $ | 10,620 | $ | 7,633 |\\n| Interest rate swaps | – | – | 8,925 | 12,152 |\\n| Total fair value | 89,564 | 123,655 | 19,545 | 19,785 |\\n| Netting arrangements | (11,773 | ) | (17,058 | ) | (11,773 | ) | (17,058 | ) |\\n| Net recorded fair value | $ | 77,791 | $ | 106,597 | $ | 7,772 | $ | 2,727 |\\n| Location of derivatives in our unaudited condensed consolidated balance sheets: |\\n| Derivative asset | $ | 51,215 | $ | 55,100 | $ | – | $ | – |\\n| Long–term derivative asset | 26,576 | 51,497 | – | – |\\n| Derivative liability | – | – | 1,178 | 1,943 |\\n| Long–term derivative liability | – | – | 6,594 | 784 |\\n| $ | 77,791 | $ | 106,597 | $ | 7,772 | $ | 2,727 |\\n\\nThe following table presents the impact of derivatives and their location within the unaudited condensed consolidated statements of operations:\\n\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2011 | 2010 | 2011 | 2010 |\\n| Realized gains on derivatives, net: |\\n| Commodity contracts (1) | $ | 11,388 | $ | 16,044 | $ | 27,070 | $ | 26,167 |\\n| Interest rate swaps (2) | 2,854 | (2,143 | ) | 714 | (4,301 | ) |\\n| Total | $ | 14,242 | $ | 13,901 | $ | 27,784 | $ | 21,866 |\\n| Unrealized gains (losses) on derivatives, net: |\\n| Commodity contracts | $ | 20,380 | $ | (1,189 | ) | $ | (34,181 | ) | $ | 32,701 |\\n| Interest rate swaps (2) | (2,958 | ) | (969 | ) | (1,452 | ) | (2,199 | ) |\\n| Total | $ | 17,422 | $ | (2,158 | ) | $ | (35,633 | ) | $ | 30,502 |\\n\\n\\n| (1) | Realized gains for the three months and six months ended June 30, 2011 exclude $1.4 million and $2.9 million, respectively, related to the initial value of derivatives acquired in our December 2010 acquisition of oil and natural gas properties that have been relieved through the settlement of such derivatives. |\\n\\n\\n| (2) | In June 2011, we terminated three of our interest rate swaps and reclassified the $4.7 million non–cash gain from “Unrealized gains (losses) on derivatives, net” to “Realized gains on derivatives, net.” |\\n\\n9\\nEV Energy Partners, L.P.\\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\\nNOTE 5. FAIR VALUE MEASUREMENTS\\nRecurring Basis\\nThe following table presents the fair value hierarchy table for our assets and liabilities that are required to be measured at fair value on a recurring basis:\\n\\n| Fair Value at Reporting Date Using: |\\n| June 30, 2011 | Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) |\\n| Derivative assets: |\\n| Commodity contracts | $ | 89,564 | $ | – | $ | 89,564 | $ | – |\\n| Derivative liabilities: |\\n| Commodity contracts | $ | 10,620 | $ | – | $ | 10,620 | $ | – |\\n| Interest rate swaps | 8,925 | – | 8,925 | – |\\n| Total derivative liabilities | $ | 19,545 | $ | – | $ | 19,545 | $ | – |\\n| Fair Value at Reporting Date Using: |\\n| December 31, 2010 | Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) |\\n| Derivative assets: |\\n| Commodity contracts | $ | 123,655 | $ | – | $ | 123,655 | $ | – |\\n| Derivative liabilities: |\\n| Commodity contracts | $ | 7,633 | $ | – | $ | 7,633 | $ | – |\\n| Interest rate swaps | 12,152 | – | 12,152 | – |\\n| Total derivative liabilities | $ | 19,785 | $ | – | $ | 19,785 | $ | – |\\n\\nOur derivatives consist of over–the–counter (“OTC”) contracts which are not traded on a public exchange. These derivatives are indexed to active trading hubs for the underlying commodity and are commonly used in the energy industry and offered by a number of financial institutions and large energy companies.\\nAs the fair value of these derivatives is based on inputs using market prices obtained from independent brokers or determined using quantitative models that use as their basis readily observable market parameters that are actively quoted and can be validated through external sources, including third party pricing services, brokers and market transactions, we have categorized these derivatives as Level 2. We value these derivatives based on observable market data for similar instruments. This observable data includes the forward curves for commodity prices based on quoted market prices and prospective volatility factors related to changes in the forward curves and yield curves based on money market rates and interest rate swap data. Our estimates of fair value have been determined at discrete points in time based on relevant market data. These estimates involve uncertainty and cannot be determined with precision. There were no changes in valuation techniques or related inputs in the three months ended June 30, 2011.\\nNonrecurring Basis\\nIn March 2011, in conjunction with the sale of oil and natural gas properties, we incurred impairment charges of $1.5 million as oil and natural gas properties with a net cost basis of $2.7 million were written down to their fair value of $1.2 million.\\n10\\nEV Energy Partners, L.P.\\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\\nIn June 2011, we incurred impairment charges of $5.2 million as oil and natural gas properties with a net cost basis of $13.7 million were written down to their fair value of $8.5 million.\\nFinancial Instruments\\nThe estimated fair values of our financial instruments have been determined at discrete points in time based on relevant market information. Our financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities, derivatives and long–term debt. The carrying amounts of our financial instruments other than derivatives and long–term debt approximate fair value because of the short–term nature of the items. Derivatives are recorded at fair value (see Note 4). The carrying value of debt outstanding under our credit facility approximates fair value because the credit facility’s variable interest rate resets frequently and approximates current market rates available to us. As of June 30, 2011, the estimated fair value of our senior notes due 2019 was $303.0 million, which differs from the carrying value of $292.7 million. The fair value of our senior notes due 2019 was estimated using quoted markets prices based on trades of such debt as of June 30, 2011.\\nNOTE 6. ASSET RETIREMENT OBLIGATIONS\\nWe record an asset retirement obligation (“ARO”) and capitalize the asset retirement cost in oil and natural gas properties in the period in which the retirement obligation is incurred based upon the fair value of an obligation to perform site reclamation, dismantle facilities or plug and abandon wells. After recording these amounts, the ARO is accreted to its future estimated value using an assumed cost of funds and the additional capitalized costs are depreciated on a unit–of–production basis. The changes in the aggregate ARO are as follows:\\n\\n| Balance as of December 31, 2010 | $ | 68,430 |\\n| Liabilities incurred | 311 |\\n| Accretion expense | 1,936 |\\n| Revisions in estimated cash flows | 3,118 |\\n| Settlements and divestitures | (4,275 | ) |\\n| Balance as of June 30, 2011 | $ | 69,520 |\\n\\nAs of both June 30, 2011 and December 31, 2010, $1.3 million of our ARO is classified as current and is included in “Accounts payable and accrued liabilities” in our unaudited condensed consolidated balance sheets.\\nNOTE 7. LONG–TERM DEBT\\nLong–term debt consisted of the following:\\n\\n| June 30, 2011 | December 31, 2010 |\\n| Credit facility | $ | 187,500 | $ | 619,000 |\\n| 8.0% senior notes due 2019 | 300,000 | – |\\n| Unamortized discount | (7,317 | ) | – |\\n| Long–term debt | $ | 480,183 | $ | 619,000 |\\n\\nCredit Facility\\nOn April 26, 2011, we replaced our existing $700.0 million credit facility with a $1.0 billion credit facility that expires in April 2016. Borrowings under the facility are secured by a first priority lien on substantially all of our assets and the assets of our subsidiaries. We may use borrowings under the facility for acquiring and developing oil and natural gas properties, for working capital purposes, for general corporate purposes and for funding distributions to partners. We also may use up to $100.0 million of available borrowing capacity for letters of credit. The facility requires the maintenance of a current ratio (as defined in the facility) of greater than 1.0 and a ratio of total debt to earnings plus interest expense, taxes, depreciation, depletion and amortization expense and exploration expense of no greater than 4.25 to 1.0. As of June 30, 2011, we were in compliance with these financial covenants.\\n11\\nEV Energy Partners, L.P.\\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\\nBorrowings under the facility bear interest at a floating rate based on, at our election, a base rate or the London Inter–Bank Offered Rate plus applicable premiums based on the percent of the borrowing base that we have outstanding (weighted average effective interest rate of 3.49% at June 30, 2011).\\nBorrowings under the facility may not exceed a “borrowing base” determined by the lenders under the facility based on our oil and natural gas reserves. As of June 30, 2011, the borrowing base under the facility was $600.0 million. The borrowing base is subject to scheduled redeterminations as of April 1 and October 1 of each year with an additional redetermination once per calendar year at our request or at the request of the lenders and with one calculation that may be made at our request during each calendar year in connection with material acquisitions or divestitures of properties.\\n8.0% Senior Notes due 2019\\nOn March 22, 2011, we issued $300.0 million in aggregate principal amount of 8.0% senior unsecured notes due 2019 (the “Notes”) at an offering price equal to 100% of par. The Notes were sold in a private placement to eligible purchasers in a transaction exempt from the registration requirements of the Securities Act of 1933, as amended.\\nWe received net proceeds of $291.6 million, after deducting the discount of $7.5 million and offering expenses of $0.9 million. We used the net proceeds to repay indebtedness under our existing credit facility. The discount and the offering expenses are being amortized over the life of the Notes. The amortization is included in “Interest expense” on our unaudited condensed consolidated statements of operations.\\nThe Notes were issued under an indenture dated March 22, 2011, (the “Indenture”), mature April 15, 2019, and bear interest at 8.0%. Interest is payable semi–annually beginning October 15, 2011. The Notes are general unsecured obligations and are effectively junior in right of payment to any of our secured indebtedness to the extent of the value of the collateral securing such indebtedness.\\nThe Notes are unconditionally guaranteed, jointly and severally, on a senior unsecured basis, by all of our existing subsidiaries other than EV Energy Finance Corp. (“Finance”), which is a co–issuer of the Notes. Neither we nor Finance have material independent assets or operations apart from the assets and operations of our subsidiaries.\\nThe Indenture provides that, prior to April 15, 2014, we may redeem up to 35% of the aggregate principal amount of the Notes with the net proceeds of a public or private equity offering at a redemption price of 108.0% of the principal amount redeemed, plus accrued and unpaid interest, provided that:\\n\\n| · | at least 65% of the aggregate principal amount of Notes issued under the Indenture remains outstanding immediately after the occurrence of such redemption; and |\\n\\n\\n| · | the redemption occurs within 180 days of the date of the closing of such public or private equity offering. |\\n\\nOn and after April 15, 2015, we may redeem all or a part of the Notes, at the redemption prices (expressed as percentages of principal amount) set forth below, plus accrued and unpaid interest, if any, on the Notes to be redeemed to the applicable redemption date, if redeemed during the twelve–month period beginning on April 15 of the years indicated below:\\n\\n| Year | Percentage |\\n| 2015 | 104.0 | % |\\n| 2016 | 102.0 | % |\\n| 2017 and thereafter | 100.0 | % |\\n\\n12\\nEV Energy Partners, L.P.\\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\\nPrior to April 15, 2015, we may redeem all or part of the Notes at a redemption price equal to the sum of:\\n\\n| · | the principal amount thereof, plus |\\n\\n\\n| · | the Make Whole Premium (as defined in the Indenture) at the redemption date, plus accrued and unpaid interest, if any, to the redemption date. |\\n\\nThe Indenture also provides that, if a change of control (as defined in the Indenture) occurs, the holders have a right to require us to repurchase all or part of the Notes at a redemption price equal to 101%, plus accrued and unpaid interest.\\nThe Indenture contains covenants that, among other things, limit our ability to: (i) pay distributions on, purchase or redeem our common units or redeem our subordinated debt; (ii) make investments; (iii) incur or guarantee additional indebtedness or issue certain types of equity securities; (iv) create certain liens; (v) sell assets; (vi) consolidate, merge or transfer all or substantially all of our assets; (vii) enter into intercompany agreements that restrict distributions or other payments from our restricted subsidiaries to us; (viii) engage in transactions with affiliates; and (ix) create unrestricted subsidiaries.\\nNOTE 8. COMMITMENTS AND CONTINGENCIES\\nWe are involved in disputes or legal actions arising in the ordinary course of business. We do not believe the outcome of such disputes or legal actions will have a material effect on our unaudited condensed consolidated financial statements, and no amounts have been accrued at June 30, 2011 or December 31, 2010.\\nNOTE 9. OWNERS’ EQUITY\\nUnits Outstanding\\nAt June 30, 2011, owner’s equity consists of 34,173,650 common units, representing a 98% limited partnership interest in us, and a 2% general partnership interest.\\nIssuance of Units\\nIn January 2011, the following equity–based awards vested:\\n\\n| Phantom units accounted for as liability awards (1) | 80,534 |\\n| Phantom units accounted for as equity awards | 70,610 |\\n| Performance units | 80,000 |\\n| Total units vested | 231,144 |\\n| Performance units settled in cash | (17,807 | ) |\\n| Units converted to common units | 213,337 |\\n\\n\\n| (1) | These phantom units vested at a fair value of $3.5 million. |\\n\\nIn conjunction with the vesting of these units, we received a contribution of $0.2 million by our general partner to maintain its 2% interest in us.\\nOn March 9, 2011, we closed a public offering of 3.45 million of our common units at an offering price of $44.42 per common unit. We received net proceeds of $149.8 million, including a contribution of $3.0 million by our general partner to maintain its 2% interest in us. We used a portion of the net proceeds to repay indebtedness outstanding under our credit facility.\\n13\\nEV Energy Partners, L.P.\\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\\nCash Distributions\\nThe following sets forth the distributions we paid during the six months ended June 30, 2011:\\n\\n| Date Paid | Period Covered | Distribution per Unit | Total Distribution |\\n| February 14, 2011 | October 1, 2010 – December 31, 2010 | $ | 0.759 | $ | 26,477 |\\n| May 13, 2011 | January 1, 2011 – March 31, 2011 | 0.760 | 29,496 |\\n| $ | 55,973 |\\n\\nOn July 28, 2011, the board of directors of EV Management declared a $0.761 per unit distribution for the second quarter of 2011 on all common units. The distribution of $29.5 million is to be paid on August 12, 2011 to unitholders of record at the close of business on August 8, 2011.\\nNOTE 10. NET INCOME (LOSS) PER LIMITED PARTNER UNIT\\nThe following sets forth the calculation of net income (loss) per limited partner unit:\\n\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2011 | 2010 | 2011 | 2010 |\\n| Net income | $ | 39,163 | $ | 16,280 | $ | 5,174 | $ | 62,404 |\\n| Less: |\\n| Incentive distribution rights | (2,945 | ) | (2,298 | ) | (5,879 | ) | (4,588 | ) |\\n| General partner’s 2% interest in net income | (783 | ) | (326 | ) | (103 | ) | (1,248 | ) |\\n| Limited partners’ interest in net income (loss) | $ | 35,435 | $ | 13,656 | $ | (808 | ) | 56,568 |\\n| Weighted average limited partner units outstanding: |\\n| Common units | 34,174 | 27,060 | 32,880 | 26,249 |\\n| Performance units (1) | 120 | 150 | 122 | 154 |\\n| Denominator for basic net income (loss) per limited partner unit | 34,294 | 27,210 | 33,002 | 26,403 |\\n| Dilutive phantom units (2) | 240 | 54 | – | 35 |\\n| Total | 34,534 | 27,264 | 33,002 | 26,438 |\\n| Net income (loss) per limited partner unit: |\\n| Basic | $ | 1.03 | $ | 0.50 | $ | (0.02 | ) | $ | 2.14 |\\n| Diluted | $ | 1.03 | $ | 0.50 | $ | (0.02 | ) | $ | 2.14 |\\n\\n\\n| (1) | Our earned but unvested performance units are considered to be participating securities for purposes of calculating our net income (loss) per limited partner unit and, accordingly, are included in the basic computation as such. |\\n\\n\\n| (2) | Phantom units accounted for as equity awards totaling 0.5 million units were not included in the computation of diluted net income (loss) per limited partner unit because the effect would have been anti-dilutive for the six months ended June 30, 2011. |\\n\\nNOTE 11. RELATED PARTY TRANSACTIONS\\nPursuant to an omnibus agreement, we paid EnerVest $2.8 million and $2.3 million in the three months ended June 30, 2011 and 2010, respectively, and $5.5 million and $4.3 million in the six months ended June 30, 2011 and 2010, respectively, in monthly administrative fees for providing us general and administrative services. These fees are based on an allocation of charges between EnerVest and us based on the estimated use of such services by each party, and we believe that the allocation method employed by EnerVest is reasonable and reflective of the estimated level of costs we would have incurred on a standalone basis. These fees are included in general and administrative expenses in our unaudited condensed consolidated statements of operations.\\n14\\nEV Energy Partners, L.P.\\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\\nWe have entered into operating agreements with EnerVest whereby a wholly owned subsidiary of EnerVest acts as contract operator of the oil and natural gas wells and related gathering systems and production facilities in which we own an interest. We reimbursed EnerVest $3.4 million and $3.2 million in the three months ended June 30, 2011 and 2010, respectively, and $7.2 million and $5.7 million in the six months ended June 30, 2011 and 2010, respectively, for direct expenses incurred in the operation of our wells and related gathering systems and production facilities and for the allocable share of the costs of EnerVest employees who performed services on our properties. As the vast majority of such expenses are charged to us on an actual basis (i.e., no mark–up or subsidy is charged or received by EnerVest), we believe that the aforementioned services were provided to us at fair and reasonable rates relative to the prevailing market and are representative of the costs that would have been incurred on a standalone basis. These costs are included in lease operating expenses in our unaudited condensed consolidated statements of operations. Additionally, in its role as contract operator, this EnerVest subsidiary also collects proceeds from oil and natural gas sales and distributes them to us and other working interest owners.\\nNOTE 12. OTHER SUPPLEMENTAL INFORMATION\\nSupplemental cash flows and non–cash transactions were as follows:\\n\\n| Six Months Ended June 30, |\\n| 2011 | 2010 |\\n| Supplemental cash flows information: |\\n| Cash paid for interest | $ | 5,595 | $ | 4,755 |\\n| Cash paid for income taxes | 250 | 245 |\\n| Non–cash transactions: |\\n| Costs for development of oil and natural gas properties in accounts payable and accrued liabilities | 5,241 | 2,533 |\\n\\nNOTE 13. NEW ACCOUNTING STANDARDS\\nIn May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011–04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This ASU represents the converged guidance of the FASB and the International Accounting Standards Board on fair value measurement, and has resulted in common requirements for measuring fair value and for disclosing information about fair value measurements, including a consistent meaning of the term “fair value.” The provisions of ASU 2011–04 are applicable to interim and annual reporting periods subsequent to December 15, 2011. We will adopt the new requirements for our Form 10–K for the year ending December 31, 2011.\\nNo other new accounting pronouncements issued or effective during the six months ended June 30, 2011 have had or are expected to have a material impact on our unaudited condensed consolidated financial statements.\\nNOTE 14. SUBSEQUENT EVENT\\nIn July 2011, we sold oil and natural gas properties for $8.5 million. We received a non–refundable deposit of $0.9 million in June 2011 and the remainder of the proceeds upon the closing of the sale. These oil and natural gas properties and the related ARO have been classified as “Assets held for sale” and “Liabilities related to assets held for sale” on our unaudited consolidated condensed balance sheet.\\nIn July 2011, we agreed, subject to the execution of a final purchase and sale agreement, to acquire oil and natural gas properties from certain institutional partnerships managed by EnerVest for $34.3 million, subject to customary closing conditions and purchase price adjustments. The acquisition is expected to close in August 2011.\\nWe evaluated subsequent events for appropriate accounting and disclosure through the date these unaudited condensed consolidated financial statements were issued.\\n15\\nITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our unaudited condensed consolidated financial statements and the related notes thereto, as well as our Annual Report on Form 10–K for the year ended December 31, 2010.\\nOVERVIEW\\nWe are a Delaware limited partnership formed in April 2006 by EnerVest to acquire, produce and develop oil and natural gas properties. Our general partner is EV Energy GP, a Delaware limited partnership, and the general partner of our general partner is EV Management, a Delaware limited liability company.\\nOur properties are located in the Barnett Shale, the Appalachian Basin (primarily in Ohio and West Virginia), the Mid-Continent area in Oklahoma, Texas, Arkansas, Kansas and Louisiana, the San Juan Basin, the Monroe Field in Louisiana, the Permian Basin, Central and East Texas (which includes the Austin Chalk area), and Michigan. As of December 31, 2010, we had estimated net proved reserves of 12.9 MMBbls of oil, 27.5 MMBbls of natural gas liquids and 575.2 Bcf of natural gas, or 817.3 Bcfe, and a standardized measure of $1,020.2 million.\\nCURRENT DEVELOPMENTS\\nIn March 2011, we closed a public offering of 3.45 million common units at an offering price of $44.42 per common unit. We received net proceeds of $149.8 million, including a contribution of $3.0 million by our general partner to maintain its 2% interest in us. We used a portion of the net proceeds to repay indebtedness outstanding under our credit facility.\\nIn March 2011, we issued $300.0 million in aggregate principal amount of 8.0% senior unsecured notes due 2019. We received net proceeds of $291.6 million, after deducting the discount of $7.5 million and offering expenses of $0.9 million. We used the net proceeds to repay indebtedness outstanding under our credit facility.\\nIn April 2011, we entered into a second amended and restated $1.0 billion credit facility that expires in April 2016. The facility requires the maintenance of a current ratio (as defined in the facility) of greater than 1.0 and a ratio of total debt to earnings plus interest expense, taxes, depreciation, depletion and amortization expense and exploration expense of no greater than 4.25 to 1.0. The borrowing base, which was initially set at $600.0 million, is subject to scheduled redeterminations every six months beginning October 1, 2011.\\nIn July 2011, we agreed, subject to the execution of a final purchase and sale agreement, to acquire oil and natural gas properties from certain institutional partnerships managed by EnerVest for $34.3 million, subject to customary closing conditions and purchase price adjustments. The acquisition is expected to close in August 2011.\\nBUSINESS ENVIRONMENT\\nOur primary business objective is to provide stability and growth in cash distributions per unit over time. The amount of cash we can distribute on our units principally depends upon the amount of cash generated from our operations, which will fluctuate from quarter to quarter based on, among other things:\\n| · | the prices at which we will sell our oil, natural gas liquids and natural gas production; |\\n\\n\\n| · | our ability to hedge commodity prices; |\\n\\n\\n| · | the amount of oil, natural gas liquids and natural gas we produce; and |\\n\\n\\n| · | the level of our operating and administrative costs. |\\n\\nOil and natural gas prices are expected to be volatile in the future. Factors affecting the price of oil include worldwide economic conditions, geopolitical activities, worldwide supply disruptions, weather conditions, actions taken by the Organization of Petroleum Exporting Countries and the value of the U.S. dollar in international currency markets. Factors affecting the price of natural gas include the discovery of substantial accumulations of natural gas in unconventional reservoirs due to technological advancements necessary to commercially produce these unconventional reserves, North American weather conditions, industrial and consumer demand for natural gas, storage levels of natural gas and the availability and accessibility of natural gas deposits in North America.\\n16\\nIn order to mitigate the impact of changes in oil and natural gas prices on our cash flows, we are a party to derivatives, and we intend to enter into derivatives in the future to reduce the impact of oil and natural gas price volatility on our cash flows. By removing a significant portion of this price volatility on our future oil and natural gas production through December 2015, we have mitigated, but not eliminated, the potential effects of changing oil and natural gas prices on our cash flows from operations for those periods. If commodity prices are depressed for an extended period of time, it could alter our acquisition and development plans, and adversely affect our growth strategy and ability to access additional capital in the capital markets.\\nThe primary factors affecting our production levels are capital availability, our ability to make accretive acquisitions, the success of our drilling program and our inventory of drilling prospects. In addition, as initial reservoir pressures are depleted, production from our wells decreases. We attempt to overcome this natural decline through a combination of drilling and acquisitions. Our future growth will depend on our ability to continue to add reserves through drilling and acquisitions in excess of production. We will maintain our focus on the costs to add reserves through drilling and acquisitions as well as the costs necessary to produce such reserves. Our ability to add reserves through drilling is dependent on our capital resources and can be limited by many factors, including our ability to timely obtain drilling permits and regulatory approvals. Any delays in drilling, completion or connection to gathering lines of our new wells will negatively impact our production, which may have an adverse effect on our revenues and, as a result, cash available for distribution.\\nWe focus our efforts on increasing oil and natural gas reserves and production while controlling costs at a level that is appropriate for long–term operations. Our future cash flows from operations are dependent upon our ability to manage our overall cost structure.\\nRESULTS OF OPERATIONS\\n\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2011 | 2010 | 2011 | 2010 |\\n| Production data: |\\n| Oil (MBbls) | 241 | 171 | 449 | 297 |\\n| Natural gas liquids (MBbls) | 272 | 178 | 542 | 360 |\\n| Natural gas (MMcf) | 6,999 | 4,734 | 14,003 | 8,719 |\\n| Net production (MMcfe) | 10,080 | 6,831 | 19,951 | 12,665 |\\n| Average sales price per unit: |\\n| Oil (Bbl) | $ | 98.63 | $ | 73.20 | $ | 94.58 | $ | 73.73 |\\n| Natural gas liquids (Bbl) | 54.80 | 40.23 | 51.45 | 42.91 |\\n| Natural gas (Mcf) | 4.20 | 4.16 | 4.10 | 4.66 |\\n| Mcfe | 6.76 | 5.77 | 6.40 | 6.16 |\\n| Average unit cost per Mcfe: |\\n| Production costs: |\\n| Lease operating expenses | $ | 1.78 | $ | 2.18 | $ | 1.77 | $ | 2.08 |\\n| Production taxes | 0.31 | 0.24 | 0.29 | 0.30 |\\n| Total | 2.09 | 2.42 | 2.06 | 2.38 |\\n| Asset retirement obligations accretion expense | 0.10 | 0.11 | 0.10 | 0.10 |\\n| Depreciation, depletion and amortization | 1.83 | 1.97 | 1.80 | 2.02 |\\n| General and administrative expenses | 0.71 | 0.85 | 0.79 | 0.83 |\\n\\n17\\nThree Months Ended June 30, 2011 Compared with the Three Months Ended June 30, 2010\\nNet income for the three months ended June 30, 2011 was $39.2 million compared with $16.3 million for the three months ended June 30, 2010. This improvement reflects (i) a $28.7 million increase in revenues due to increased production primarily from our acquisitions of oil and natural gas properties in 2010 and higher prices for oil, natural gas and natural gas liquids and (ii) a $19.6 million increase in non–cash changes in the fair value of our derivatives, partially offset by (iii) an $11.5 million increase in operating expenses mainly related to the properties acquired in 2010, (iv) an impairment loss of $5.1 million related to the write–down of oil and natural gas properties to their fair value (compared with a $4.4 million gain on the sale of oil and natural gas properties in the three months ended June 30, 2010), and (v) a $4.9 million increase in interest expense.\\nOil, natural gas and natural gas liquids revenues for the three months ended June 30, 2011 totaled $68.1 million, an increase of $28.7 million compared with the three months ended June 30, 2010. This increase was the result of $21.6 million related to increased production and $7.1 million related to higher prices for oil, natural gas and natural gas liquids.\\nLease operating expenses for the three months ended June 30, 2011 increased $3.1 million compared with the three months ended June 30, 2010 primarily as the result of $5.8 million related to our 2010 acquisitions and our expanded development drilling program partially offset by $0.4 million due to a lower unit cost per Mcfe for our December 2010 acquisition of oil and natural gas properties in the Barnett Shale and $2.3 million ($0.34 per Mcfe) of lease operating expenses in the three months ended June 30, 2010 associated with oil in tanks acquired in the March 2010 acquisition that was sold in the three months ended June 30, 2010. Lease operating expenses per Mcfe were $1.78 in the three months ended June 30, 2011 compared with $2.18 in the three months ended June 30, 2010. Production taxes, which are generally based on a percentage of our oil, natural gas and natural gas liquids revenues, for the three months ended June 30, 2011 increased $1.4 million compared with the three months ended June 30, 2010 primarily as the result of $1.0 million due to increased production and $0.4 million due to higher average realized prices. Production taxes for the three months ended June 30, 2011 were $0.31 per Mcfe compared with $0.24 per Mcfe for the three months ended June 30, 2010. Asset retirement obligations accretion expense for the three months ended June 30, 2011 increased $0.2 million compared with the three months ended June 30, 2010 primarily due to the oil and natural gas properties that we acquired in 2010. Asset retirement obligations accretion expense for the three months ended June 30, 2011 was $0.10 per Mcfe compared with $0.11 per Mcfe for the three months ended June 30, 2010. Depreciation, depletion and amortization for the three months ended June 30, 2011 increased $5.0 million compared with the three months ended June 30, 2010 primarily due to $5.9 million from higher production offset by a decrease of $0.9 million due to a lower average DD&A rate per unit. The lower average DD&A rate per unit reflects the effect of our acquisitions of oil and natural gas properties in 2010. Depreciation, depletion and amortization for the three months ended June 30, 2011 was $1.83 per Mcfe compared with $1.97 per Mcfe for the three months ended June 30, 2010.\\nGeneral and administrative expenses for the three months ended June 30, 2011 totaled $7.1 million, an increase of $1.3 million compared with the three months ended June 30, 2010. This increase is primarily the result of $1.0 million of higher compensation costs primarily related to our equity–based compensation plans and $0.5 million of higher fees paid to EnerVest under the omnibus agreement due to an increase in operations from our acquisitions of oil and natural gas properties in 2010 partially offset by a $0.2 million decrease in acquisition due diligence costs. General and administrative expenses were $0.71 per Mcfe in the three months ended June 30, 2011 compared with $0.85 per Mcfe in the three months ended June 30, 2010.\\nDuring the three months ended June 30, 2011, we incurred impairment charges of $5.1 million to write down oil and natural gas properties to their fair value. During the three months ended June 30, 2011 and 2010, we recorded cash settlements of $9.5 million and $13.9 million, respectively, as realized gains on derivatives, net, as the contract prices for our derivatives exceeded the underlying market price for that period. In June 2011, we also terminated three of our interest rate swaps and recorded a non–cash realized gain of $4.7 million, which represented the value of these interest rate swaps on the date of termination. The terminated interest rate swaps were rolled over into three new interest rate swaps with a value of $5.2 million at inception. Unrealized gains (losses) on derivatives, net represent the change in the fair value of our open derivatives during the period. In the three months ended June 30, 2011, the fair value of our open derivatives increased from a net asset of $49.3 million at March 31, 2011 to a net asset of $70.0 million at June 30, 2011. In the three months ended June 30, 2010, the fair value of our open derivatives decreased from a net asset of $125.8 million at March 31, 2010 to a net asset of $123.6 million at June 30, 2010.\\n18\\nInterest expense for the three months ended June 30, 2011 increased $4.9 million compared with the three months ended June 30, 2010 primarily due to increases of $2.4 million from a higher weighted average long–term debt balance and $2.5 million due to a higher weighted average effective interest rate attributable to our 8% senior notes due 2019.\\nSix Months Ended June 30, 2011 Compared with the Six Months Ended June 30, 2010\\nNet income for the six months ended June 30, 2011 was $5.2 million compared with $62.4 million for the six months ended June 30, 2010. This change reflects (i) a $49.5 million increase in revenues due to increased production primarily from our acquisitions of oil and natural gas properties in 2010 and higher prices for oil and natural gas liquids and (ii) a $5.9 million increase in realized gains on derivatives, partially offset by (iii) a.$66.1 million decrease in non–cash changes in the fair value of our derivatives, (iv) a $28.0 million increase in operating expenses mainly related to the properties acquired in 2010, (v) a $7.9 million increase in interest expense and (vi) an impairment loss of $6.7 million related to the write–down of oil and natural gas properties to their fair value (compared with a $3.8 million gain on the sale of oil and natural gas properties in the six months ended June 30, 2010).\\nOil, natural gas and natural gas liquids revenues for the six months ended June 30, 2011 totaled $127.7 million, an increase of $49.7 million compared with the six months ended June 30, 2010. This increase was the result of $45.3 million related to increased production and $4.4 million related to higher prices for oil and natural gas liquids.\\nLease operating expenses for the six months ended June 30, 2011 increased $9.0 million compared with the six months ended June 30, 2010 primarily as the result of $12.9 million related to our 2010 acquisitions and our expanded development drilling program partially offset by $1.5 million due to a lower unit cost per Mcfe for our December 2010 acquisition of oil and natural gas properties in the Barnett Shale and $2.3 million ($0.18 per Mcfe) of lease operating expenses in the six months ended June 30, 2010 associated with oil in tanks acquired in the March 2010 acquisition that was sold in the six months ended June 30, 2010. Lease operating expenses per Mcfe were $1.77 in the six months ended June 30, 2011 compared with $2.08 in the six months ended June 30, 2010. Production taxes for the six months ended June 30, 2011 increased $2.0 million compared with the six months ended June 30, 2010 primarily as the result of $2.1 million due to increased production partially offset by $0.1 million due to lower average realized prices for natural gas. Production taxes for the six months ended June 30, 2011 were $0.29 per Mcfe compared with $0.30 per Mcfe for the six months ended June 30, 2010. Asset retirement obligations accretion expense for the six months ended June 30, 2011 increased $0.7 million compared with the six months ended June 30, 2010 primarily due to the oil and natural gas properties that we acquired in 2010. Asset retirement obligations accretion expense for both the six months ended June 30, 2011 and June 30, 2010 was $0.10 per Mcfe. Depreciation, depletion and amortization for the six months ended June 30, 2011 increased $10.5 million compared with the six months ended June 30, 2010 primarily due to $13.1 million from higher production offset by a decrease of $2.8 million due to a lower average DD&A rate per unit. The lower average DD&A rate per unit reflects the effect of our acquisitions of oil and natural gas properties in 2010. Depreciation, depletion and amortization for the six months ended June 30, 2011 was $1.80 per Mcfe compared with $2.02 per Mcfe for the six months ended June 30, 2010.\\nGeneral and administrative expenses for the six months ended June 30, 2011 totaled $15.7 million, an increase of $5.2 million compared with the six months ended June 30, 2010. This increase is primarily the result of (i) $3.5 million of higher compensation costs primarily related to our equity–based compensation plans, (ii) $1.3 million of higher fees paid to EnerVest under the omnibus agreement due to an increase in operations from our acquisitions of oil and natural gas properties in 2010, and (iii) an overall increase in costs related to our significant growth. General and administrative expenses were $0.79 per Mcfe in the six months ended June 30, 2011 compared with $0.83 per Mcfe in the six months ended June 30, 2010.\\nDuring the six months ended June 30, 2011, we incurred impairment charges of $6.7 million to write down oil and natural gas properties to their fair value. During the six months ended June 30, 2011 and 2010, we recorded cash settlements of $23.1 million and $21.9 million, respectively, as realized gains on derivatives, net, as the contract prices for our derivatives exceeded the underlying market price for that period. In June 2011, we also terminated three of our interest rate swaps and recorded a non–cash realized gain of $4.7 million, which represented the value of these interest rate swaps on the date of termination. The terminated interest rate swaps were rolled over into three new interest rate swaps with a value of $5.2 million at inception.\\n19\\nUnrealized gains (losses) on derivatives, net represent the change in the fair value of our open derivatives during the period. In the six months ended June 30, 2011, the fair value of our open derivatives decreased from a net asset of $103.9 million at December 31, 2010 to a net asset of $70.0 million at June 30, 2011. In the six months ended June 30, 2010, the fair value of our open derivatives increased from a net asset of $93.1 million at December 31, 2009 to a net asset of $123.6 million at June 30, 2010.\\nInterest expense for the six months ended June 30, 2011 increased $7.9 million compared with the six months ended June 30, 2010 primarily due to an increase of $5.8 million from a higher weighted average long–term debt balance and an increase of $2.1 million due to a higher weighted average effective interest rate attributable to our 8% senior notes due 2019.\\nLIQUIDITY AND CAPITAL RESOURCES\\nHistorically, our primary sources of liquidity and capital have been issuances of equity and debt securities, borrowings under our credit facility and cash flows from operations. Our primary uses of cash have been acquisitions of oil and natural gas properties and related assets, development of our oil and natural gas properties, distributions to our partners and working capital needs. For 2011, we believe that cash on hand and net cash flows generated from operations will be adequate to fund our capital budget and satisfy our short–term liquidity needs. We may also utilize various financing sources available to us, including the issuance of equity or debt securities through public offerings or private placements, to fund our acquisitions and long–term liquidity needs. Our ability to complete future offerings of equity or debt securities and the timing of these offerings will depend upon various factors including prevailing market conditions and our financial condition.\\nIn the past we accessed the equity and debt markets to finance our significant acquisitions. While we have been successful in accessing the public equity and debt markets earlier this year and in prior years, any disruptions in the financial markets may limit our ability to access the public equity or debt markets in the future.\\nLong–term Debt\\nIn April 2011, we replaced our existing $700.0 million credit facility with a $1.0 billion credit facility that expires in April 2016. Borrowings under the facility may not exceed a “borrowing base” determined by the lenders based on our oil and natural gas reserves. As of June 30, 2011, the borrowing base was $600.0 million, and we had $187.5 million outstanding.\\nIn March 2011, we issued $300.0 million in aggregate principal amount of 8.0% senior notes due 2019 and received net proceeds of approximately $291.6 million. We used the net proceeds to repay indebtedness outstanding under our credit facility. As of June 30, 2011, we had $300.0 million of notes outstanding. These notes are recorded on our unaudited condensed consolidated balance sheet as $292.7 million, which is net of the unamortized discount of $7.3 million.\\nFor additional information about our long–term debt, such as interest rates and covenants, please see “Item 1. Condensed Consolidated Financial Statements (Unaudited)” contained herein.\\nCash and Short–term Investments\\nAt June 30, 2011, we had $26.4 million of cash and short–term investments, which included $22.0 million of short–term investments. With regard to our short–term investments, we invest in money market accounts with major financial institutions.\\nCounterparty Exposure\\nAt June 30, 2011, our open derivative contracts were in a net receivable position with a fair value of $70.0 million. All of our derivative contracts are with major financial institutions who are also lenders under our credit facility. Should one of these financial counterparties not perform, we may not realize the benefit of some of our derivative contracts and we could incur a loss. As of June 30, 2011, all of our counterparties have performed pursuant to their commodity derivative contracts.\\n20\\nCash Flows\\nCash flows provided (used) by type of activity were as follows:\\n\\n| Six Months Ended June 30, |\\n| 2011 | 2010 |\\n| Operating activities | $ | 80,130 | $ | 55,802 |\\n| Investing activities | (25,681 | ) | (151,468 | ) |\\n| Financing activities | (51,184 | ) | 94,152 |\\n\\nOperating Activities\\nCash flows from operating activities were $80.1 million and $55.8 million in the six months ended June 30, 2011 and 2010, respectively. The increase was primarily due to higher production and prices for oil and natural gas liquids, partially offset by higher operating expenses.\\nInvesting Activities\\nOur principal recurring investing activity is the acquisition and development of oil and natural gas properties. During the six months ended June 30, 2011, we spent $1.0 million for the acquisition of oil and natural gas properties and $33.7 million for development of our oil and natural gas properties. In addition, we received $4.1 million in final purchase price settlements, $2.8 million from settlements of derivatives acquired in our December 2010 acquisition of oil and natural gas properties and $1.2 million in proceeds from the sale of oil and natural gas properties.\\nDuring the six months ended June 30, 2010, we spent $147.8 million on the acquisitions of oil and natural gas properties and $8.2 million for the development of our oil and natural gas properties. In addition, we received $4.5 million from the sales of oil and natural gas properties.\\nFinancing Activities\\nDuring the six months ended June 30, 2011, we received net proceeds of $146.8 million from our public equity offering in March 2011, and we received contributions of $3.2 million from our general partner in order to maintain its 2% interest in us. We also received net proceeds of $291.6 million from our debt offering in March 2011, after deducting offering expenses of $0.9 million. We used the proceeds from these offerings to repay $431.5 million of borrowings outstanding under our credit facility. In addition, we paid distributions of $56.0 million to holders of our common units and our general partner and $5.3 million in loan costs related to our new $1.0 billion credit facility.\\nDuring the six months ended June 30, 2010, we received net proceeds of $92.6 million from our public equity offering in February 2010, and we received contributions of $2.0 million from our general partner in order to maintain its 2% interest in us. We borrowed $138.0 million under our credit facility to finance our acquisition of oil and natural gas properties in March 2010 and we repaid $95.0 million of borrowings outstanding under our credit facility with proceeds from our public equity offering and cash flows from operations. In addition, we paid distributions of $43.4 million to holders of our common units and our general partner.\\nFORWARD–LOOKING STATEMENTS\\nThis Form 10–Q contains forward–looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act (each a “forward–looking statement”). These forward–looking statements relate to, among other things, the following:\\n\\n| · | our future financial and operating performance and results; |\\n\\n\\n| · | our business strategy; |\\n\\n\\n| · | our estimated net proved reserves and standardized measure; |\\n\\n\\n| · | market prices; |\\n\\n21\\n\\n| · | our future derivative activities; and |\\n\\n\\n| · | our plans and forecasts. |\\n\\nWe have based these forward–looking statements on our current assumptions, expectations and projections about future events.\\nThe words “anticipate,” “believe,” “ensure,” “expect,” “if,” “intend,” “estimate,” “project,” “forecasts,” “predict,” “outlook,” “aim,” “will,” “could,” “should,” “would,” “may,” “likely” and similar expressions, and the negative thereof, are intended to identify forward–looking statements. These statements discuss future expectations, contain projections of results of operations or of financial condition or state other “forward–looking” information. We do not undertake any obligation to update or revise publicly any forward–looking statements, except as required by law. These statements also involve risks and uncertainties that could cause our actual results or financial condition to materially differ from our expectations in this Form 10–Q including, but not limited to:\\n\\n| · | fluctuations in prices of oil and natural gas; |\\n\\n\\n| · | significant disruptions in the financial markets; |\\n\\n\\n| · | future capital requirements and availability of financing; |\\n\\n\\n| · | uncertainty inherent in estimating our reserves; |\\n\\n\\n| · | risks associated with drilling and operating wells; |\\n\\n\\n| · | discovery, acquisition, development and replacement of oil and natural gas reserves; |\\n\\n\\n| · | cash flows and liquidity; |\\n\\n\\n| · | timing and amount of future production of oil and natural gas; |\\n\\n\\n| · | availability of drilling and production equipment; |\\n\\n\\n| · | marketing of oil and natural gas; |\\n\\n\\n| · | developments in oil and natural gas producing countries; |\\n\\n\\n| · | competition; |\\n\\n\\n| · | general economic conditions; |\\n\\n\\n| · | governmental regulations; |\\n\\n\\n| · | receipt of amounts owed to us by purchasers of our production and counterparties to our derivative financial instrument contracts; |\\n\\n\\n| · | hedging decisions, including whether or not to enter into derivative financial instruments; |\\n\\n\\n| · | events similar to those of September 11, 2001; |\\n\\n\\n| · | actions of third party co–owners of interest in properties in which we also own an interest; |\\n\\n\\n| · | fluctuations in interest rates and the value of the U.S. dollar in international currency markets; and |\\n\\n\\n| · | our ability to effectively integrate companies and properties that we acquire. |\\n\\n22\\nAll of our forward–looking information is subject to risks and uncertainties that could cause actual results to differ materially from the results expected. Although it is not possible to identify all factors, these risks and uncertainties include the risk factors and the timing of any of those risk factors identified in the “Risk Factors” section included in Item 1A of our Annual Report on Form 10–K for the year ended December 31, 2010. This document is available through our web site or through the SEC’s Electronic Data Gathering and Analysis Retrieval System at http://www.sec.gov.\\nOur revenues, operating results, financial condition and ability to borrow funds or obtain additional capital depend substantially on prevailing prices for oil and natural gas. Declines in oil or natural gas prices may materially adversely affect our financial condition, liquidity, ability to obtain financing and operating results. Lower oil or natural gas prices also may reduce the amount of oil or natural gas that we can produce economically. A decline in oil and/or natural gas prices could have a material adverse effect on the estimated value and estimated quantities of our oil and natural gas reserves, our ability to fund our operations and our financial condition, cash flows, results of operations and access to capital. Historically, oil and natural gas prices and markets have been volatile, with prices fluctuating widely, and they are likely to continue to be volatile.\\n\\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nWe are exposed to certain market risks that are inherent in our financial statements that arise in the normal course of business. We may enter into derivative instruments to manage or reduce market risk, but do not enter into derivative agreements for speculative purposes.\\nWe do not designate these or plan to designate future derivative instruments as hedges for accounting purposes. Accordingly, the changes in the fair value of these instruments are recognized currently in earnings.\\nCommodity Price Risk\\nOur major market risk exposure is to prices for oil, natural gas and natural gas liquids. These prices have historically been volatile. As such, future earnings are subject to change due to changes in these prices. Realized prices are primarily driven by the prevailing worldwide price for oil and regional spot prices for natural gas production. We have used, and expect to continue to use, oil, natural gas and natural gas liquids commodity contracts to reduce our risk of changes in the prices of oil, natural gas and natural gas liquids. Pursuant to our risk management policy, we engage in these activities as a hedging mechanism against price volatility associated with pre–existing or anticipated sales of oil, natural gas and natural gas liquids.\\nWe have entered into commodity contracts to hedge significant amounts of our anticipated oil, natural gas and natural gas liquids production through December 2015. As of June 30, 2011, we have commodity contracts covering approximately 53% of our production attributable to our estimated net proved reserves from July 2011 through December 2015, as estimated in our reserve report prepared by third party engineers using prices, costs and other assumptions required by SEC rules. Our actual production will vary from the amounts estimated in our reserve reports, perhaps materially.\\nThe fair value of our commodity contracts and basis swaps at June 30, 2011 was a net asset of $78.9 million. A 10% change in oil, natural gas and natural gas liquids prices with all other factors held constant would result in a change in the fair value (generally correlated to our estimated future net cash flows from such instruments) of our oil and natural gas commodity contracts and basis swaps of approximately $60 million. Please see “Item 1. Condensed Consolidated Financial Statements (Unaudited)” contained herein for additional information.\\nInterest Rate Risk\\nOur floating rate credit facility also exposes us to risks associated with changes in interest rates and as such, future earnings are subject to change due to changes in these interest rates. If interest rates on our facility increased by 1%, interest expense for the six months ended June 30, 2011 would have increased by approximately $1.8 million. Please see “Item 1. Condensed Consolidated Financial Statements (Unaudited)” contained herein for additional information.\\n23\\nITEM 4. CONTROLS AND PROCEDURES\\nEvaluation of Disclosure Controls and Procedures\\nIn accordance with Exchange Act Rule 13a–15 and 15d–15, we carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of June 30, 2011 to provide reasonable assurance that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Our disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.\\nChange in Internal Controls Over Financial Reporting\\nThere have not been any changes in our internal controls over financial reporting that occurred during the quarterly period ended June 30, 2011 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.\\nPART II. OTHER INFORMATION\\n\\nITEM 1. LEGAL PROCEEDINGS\\nWe are involved in disputes or legal actions arising in the ordinary course of business. We do not believe the outcome of such disputes or legal actions will have a material effect on our unaudited condensed consolidated financial statements.\\n\\nITEM 1A. RISK FACTORS\\nThere have been no material changes with respect to the risk factors disclosed in our Annual Report on Form 10–K for the year ended December 31, 2010.\\n\\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\\nNone.\\n\\nITEM 3. DEFAULTS UPON SENIOR SECURITIES\\nNone.\\nITEM 4. (Removed and Reserved)\\n\\nITEM 5. OTHER INFORMATION\\nNone.\\n\\nITEM 6. EXHIBITS\\nThe exhibits listed below are filed or furnished as part of this report:\\n\\n| 10.1 | Credit Agreement, dated as of April 26, 2011 by and among EV Energy Partners, L.P., EV Properties, L.P., and JPMorgan Chase Bank, N.A. as Administrative Agent for the lenders named therein. (Incorporated by reference from Exhibit 10.1 to EV Energy Partners L.P.’s current report on Form 8–K filed with the SEC on April 29, 2011). |\\n\\n\\n| +31.1 | Rule 13a-14(a)/15d–14(a) Certification of Chief Executive Officer. |\\n\\n24\\n\\n| +31.2 | Rule 13a-14(a)/15d–14(a) Certification of Chief Financial Officer. |\\n\\n\\n| +32.1 | Section 1350 Certification of Chief Executive Officer |\\n\\n\\n| +32.2 | Section 1350 Certification of Chief Financial Officer |\\n\\n\\n| ++101 | Interactive Data Files |\\n\\n\\n| + | Filed herewith |\\n\\n\\n| ++ | Pursuant to Rule 406T of Regulation S–T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Act of 1934, as amended, and otherwise are not subject to liability. |\\n\\n25\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n\\n| EV Energy Partners, L.P. |\\n| (Registrant) |\\n| Date: August 9, 2011 | By: | /s/ MICHAEL E. MERCER |\\n| Michael E. Mercer |\\n| Senior Vice President and Chief Financial Officer |\\n\\n26\\nEXHIBIT INDEX\\n\\n| 10.1 | Credit Agreement, dated as of April 26, 2011 by and among EV Energy Partners, L.P., EV Properties, L.P., and JPMorgan Chase Bank, N.A. as Administrative Agent for the lenders named therein. (Incorporated by reference from Exhibit 10.1 to EV Energy Partners L.P.’s current report on Form 8–K filed with the SEC on April 29, 2011). |\\n\\n\\n| +31.1 | Rule 13a-14(a)/15d–14(a) Certification of Chief Executive Officer. |\\n\\n\\n| +31.2 | Rule 13a-14(a)/15d–14(a) Certification of Chief Financial Officer. |\\n\\n\\n| +32.1 | Section 1350 Certification of Chief Executive Officer |\\n\\n\\n| +32.2 | Section 1350 Certification of Chief Financial Officer |\\n\\n\\n| ++101 | Interactive Data Files |\\n\\n+ Filed herewith\\n\\n| ++ | Pursuant to Rule 406T of Regulation S–T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Act of 1934, as amended, and otherwise are not subject to liability. |\\n\\n\\n \\n\\nWhat is the total capital cost, combining both the offering cost of the senior notes and interest payment in the first year, in million dollars?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 32.4.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 39,\n \"input_length\": 21246\n}"}}},{"rowIdx":40,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nPART I. Financial Information\nItem 1. Financial Statements\nConsolidated Condensed Statements of Operations\n(Unaudited)\nELI LILLY AND COMPANY AND SUBSIDIARIES\n(Dollars and shares in millions, except per-share data)\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Revenue (Note 2) | $ | 6,941.6 | $ | 6,772.8 | $ | 21,239.6 | $ | 20,318.5 |\n| Costs, expenses, and other: |\n| Cost of sales | 1,579.1 | 1,430.8 | 5,081.7 | 5,262.6 |\n| Research and development | 1,802.9 | 1,705.3 | 5,194.9 | 5,032.4 |\n| Marketing, selling, and administrative | 1,614.2 | 1,577.9 | 4,797.2 | 4,839.6 |\n| Acquired in-process research and development and development milestones (Note 3) | 62.4 | 177.6 | 668.4 | 532.4 |\n| Asset impairment, restructuring, and other special charges (Note 5) | 206.5 | — | 206.5 | 211.6 |\n| Other–net, (income) expense (Note 11) | 111.0 | 635.9 | 580.9 | 124.3 |\n| 5,376.1 | 5,527.5 | 16,529.6 | 16,002.9 |\n| Income before income taxes | 1,565.5 | 1,245.3 | 4,710.0 | 4,315.6 |\n| Income taxes (Note 7) | 113.8 | 135.2 | 402.9 | 460.0 |\n| Net income | $ | 1,451.7 | $ | 1,110.1 | $ | 4,307.1 | $ | 3,855.6 |\n| Earnings per share: |\n| Basic | $ | 1.61 | $ | 1.22 | $ | 4.78 | $ | 4.25 |\n| Diluted | $ | 1.61 | $ | 1.22 | $ | 4.76 | $ | 4.23 |\n| Shares used in calculation of earnings per share: |\n| Basic | 900.7 | 906.7 | 901.8 | 907.7 |\n| Diluted | 903.8 | 910.8 | 904.5 | 911.7 |\n\nSee notes to consolidated condensed financial statements.\n5\nConsolidated Condensed Statements of Comprehensive Income\n(Unaudited)\nELI LILLY AND COMPANY AND SUBSIDIARIES\n(Dollars in millions)\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Net income | $ | 1,451.7 | $ | 1,110.1 | $ | 4,307.1 | $ | 3,855.6 |\n| Other comprehensive income (loss), net of tax (Note 10) | ( 8.1 ) | 114.4 | 47.3 | 323.7 |\n| Comprehensive income | $ | 1,443.6 | $ | 1,224.5 | $ | 4,354.4 | $ | 4,179.3 |\n\nSee notes to consolidated condensed financial statements.\n6\nConsolidated Condensed Balance Sheets\nELI LILLY AND COMPANY AND SUBSIDIARIES\n(Dollars in millions)\n| September 30, 2022 | December 31, 2021 |\n| Assets | (Unaudited) |\n| Current Assets |\n| Cash and cash equivalents (Note 6) | $ | 2,617.4 | $ | 3,818.5 |\n| Short-term investments (Note 6) | 124.7 | 90.1 |\n| Accounts receivable, net of allowances of $ 17.7 (2022) and $ 22.5 (2021) | 6,715.3 | 6,672.8 |\n| Other receivables | 1,609.5 | 1,454.4 |\n| Inventories | 3,831.1 | 3,886.0 |\n| Prepaid expenses and other | 2,741.9 | 2,530.6 |\n| Total current assets | 17,639.9 | 18,452.4 |\n| Investments (Note 6) | 2,574.6 | 3,212.6 |\n| Goodwill | 3,891.6 | 3,892.0 |\n| Other intangibles, net | 7,124.1 | 7,691.9 |\n| Deferred tax assets | 2,384.3 | 2,489.3 |\n| Property and equipment, net of accumulated depreciation of $ 10,074.0 (2022) and $ 9,976.7 (2021) | 9,311.3 | 8,985.1 |\n| Other noncurrent assets | 4,535.7 | 4,082.7 |\n| Total assets | $ | 47,461.5 | $ | 48,806.0 |\n| Liabilities and Equity |\n| Current Liabilities |\n| Short-term borrowings and current maturities of long-term debt | $ | 1,744.6 | $ | 1,538.3 |\n| Accounts payable | 1,683.2 | 1,670.6 |\n| Employee compensation | 984.1 | 958.1 |\n| Sales rebates and discounts | 8,568.4 | 6,845.8 |\n| Dividends payable | — | 885.5 |\n| Income taxes payable | 685.6 | 126.9 |\n| Other current liabilities | 1,986.9 | 3,027.5 |\n| Total current liabilities | 15,652.8 | 15,052.7 |\n| Other Liabilities |\n| Long-term debt | 14,143.8 | 15,346.4 |\n| Accrued retirement benefits (Note 8) | 1,832.5 | 1,954.1 |\n| Long-term income taxes payable | 3,641.7 | 3,920.0 |\n| Deferred tax liabilities | 171.9 | 1,733.7 |\n| Other noncurrent liabilities | 1,852.9 | 1,644.3 |\n| Total other liabilities | 21,642.8 | 24,598.5 |\n| Commitments and Contingencies (Note 9) |\n| Eli Lilly and Company Shareholders' Equity |\n| Common stock | 594.1 | 596.3 |\n| Additional paid-in capital | 6,829.0 | 6,833.4 |\n| Retained earnings | 10,006.5 | 8,958.5 |\n| Employee benefit trust | ( 3,013.2 ) | ( 3,013.2 ) |\n| Accumulated other comprehensive loss (Note 10) | ( 4,295.8 ) | ( 4,343.1 ) |\n| Cost of common stock in treasury | ( 50.5 ) | ( 52.7 ) |\n| Total Eli Lilly and Company shareholders' equity | 10,070.1 | 8,979.2 |\n| Noncontrolling interests | 95.8 | 175.6 |\n| Total equity | 10,165.9 | 9,154.8 |\n| Total liabilities and equity | $ | 47,461.5 | $ | 48,806.0 |\n\nSee notes to consolidated condensed financial statements.\n7\nConsolidated Condensed Statements of Equity\n(Unaudited)\nELI LILLY AND COMPANY AND SUBSIDIARIES\n| Equity of Eli Lilly and Company Shareholders |\n| (Dollars in millions, except per-share data, and shares in thousands) | Common Stock | AdditionalPaid-inCapital | RetainedEarnings | Employee Benefit Trust | Accumulated Other Comprehensive Loss | Common Stock in Treasury(1) | Noncontrolling Interests |\n| Shares | Amount | Shares | Amount |\n| Balance at July 1, 2021 | 957,038 | $ | 598.1 | $ | 6,669.2 | $ | 8,530.1 | $ | ( 3,013.2 ) | $ | ( 6,287.1 ) | 463 | $ | ( 52.7 ) | $ | 219.1 |\n| Net income (loss) | 1,110.1 | ( 22.6 ) |\n| Other comprehensive income, net of tax | 114.4 |\n| Issuance of stock under employee stock plans, net | 14 | 0.1 | ( 1.3 ) |\n| Stock-based compensation | 90.1 |\n| Other | ( 0.8 ) | 0.6 |\n| Balance at September 30, 2021 | 957,052 | $ | 598.2 | $ | 6,758.0 | $ | 9,639.4 | $ | ( 3,013.2 ) | $ | ( 6,172.7 ) | 463 | $ | ( 52.7 ) | $ | 197.1 |\n| Balance at July 1, 2022 | 950,619 | $ | 594.1 | $ | 6,746.0 | $ | 8,556.0 | $ | ( 3,013.2 ) | $ | ( 4,287.7 ) | 450 | $ | ( 50.5 ) | $ | 114.5 |\n| Net income (loss) | 1,451.7 | ( 15.7 ) |\n| Other comprehensive loss, net of tax | ( 8.1 ) |\n| Issuance of stock under employee stock plans, net | 8 | ( 2.1 ) |\n| Stock-based compensation | 85.1 |\n| Other | ( 1.2 ) | ( 3.0 ) |\n| Balance at September 30, 2022 | 950,627 | $ | 594.1 | $ | 6,829.0 | $ | 10,006.5 | $ | ( 3,013.2 ) | $ | ( 4,295.8 ) | 450 | $ | ( 50.5 ) | $ | 95.8 |\n\n(1) As of September 30, 2022, there was $ 3.25 billion remaining under our $ 5.00 billion share repurchase program authorized in May 2021.\nSee notes to consolidated condensed financial statements.\n8\n| Equity of Eli Lilly and Company Shareholders |\n| (Dollars in millions, except per-share data, and shares in thousands) | Common Stock | AdditionalPaid-inCapital | RetainedEarnings | Employee Benefit Trust | Accumulated Other Comprehensive Loss | Common Stock in Treasury(1) | Noncontrolling Interests |\n| Shares | Amount | Shares | Amount |\n| Balance at January 1, 2021 | 957,077 | $ | 598.2 | $ | 6,778.5 | $ | 7,830.2 | $ | ( 3,013.2 ) | $ | ( 6,496.4 ) | 487 | $ | ( 55.7 ) | $ | 183.6 |\n| Net income | 3,855.6 | 25.2 |\n| Other comprehensive income, net of tax | 323.7 |\n| Cash dividends declared per share: $ 1.70 | ( 1,542.9 ) |\n| Retirement of treasury shares | ( 2,467 ) | ( 1.5 ) | ( 498.5 ) | ( 2,467 ) | 500.0 |\n| Purchase of treasury shares | 2,467 | ( 500.0 ) |\n| Issuance of stock under employee stock plans, net | 2,442 | 1.5 | ( 287.1 ) | ( 24 ) | 3.0 |\n| Stock-based compensation | 267.5 |\n| Other | ( 0.9 ) | ( 5.0 ) | ( 11.7 ) |\n| Balance at September 30, 2021 | 957,052 | $ | 598.2 | $ | 6,758.0 | $ | 9,639.4 | $ | ( 3,013.2 ) | $ | ( 6,172.7 ) | 463 | $ | ( 52.7 ) | $ | 197.1 |\n| Balance at January 1, 2022 | 954,116 | $ | 596.3 | $ | 6,833.4 | $ | 8,958.5 | $ | ( 3,013.2 ) | $ | ( 4,343.1 ) | 463 | $ | ( 52.7 ) | $ | 175.6 |\n| Net income (loss) | 4,307.1 | ( 63.7 ) |\n| Other comprehensive income, net of tax | 47.3 |\n| Cash dividends declared per share: $ 1.96 | ( 1,765.9 ) |\n| Retirement of treasury shares | ( 5,607 ) | ( 3.5 ) | ( 1,496.5 ) | ( 5,607 ) | 1,500.0 |\n| Purchase of treasury shares | 5,607 | ( 1,500.0 ) |\n| Issuance of stock under employee stock plans, net | 2,118 | 1.3 | ( 282.6 ) | ( 13 ) | 2.2 |\n| Stock-based compensation | 278.2 |\n| Other | 3.3 | ( 16.1 ) |\n| Balance at September 30, 2022 | 950,627 | $ | 594.1 | $ | 6,829.0 | $ | 10,006.5 | $ | ( 3,013.2 ) | $ | ( 4,295.8 ) | 450 | $ | ( 50.5 ) | $ | 95.8 |\n\n(1) As of September 30, 2022, there was $ 3.25 billion remaining under our $ 5.00 billion share repurchase program authorized in May 2021.\nSee notes to consolidated condensed financial statements.\n9\nConsolidated Condensed Statements of Cash Flows\n(Unaudited)\nELI LILLY AND COMPANY AND SUBSIDIARIES\n(Dollars in millions)\n\n| Nine Months Ended September 30, |\n| 2022 | 2021 |\n| Cash Flows from Operating Activities |\n| Net income | $ | 4,307.1 | $ | 3,855.6 |\n| Adjustments to Reconcile Net Income to Cash Flows from Operating Activities: |\n| Depreciation and amortization | 1,147.5 | 1,101.9 |\n| Change in deferred income taxes | ( 2,195.6 ) | ( 709.8 ) |\n| Debt extinguishment loss (Note 6) | — | 405.2 |\n| Stock-based compensation expense | 278.2 | 267.5 |\n| Net investment (gains) losses | 676.4 | ( 271.1 ) |\n| Acquired in-process research and development | 252.0 | 498.3 |\n| Other changes in operating assets and liabilities, net of acquisitions and divestitures | 821.5 | ( 548.1 ) |\n| Other non-cash operating activities, net | 217.6 | 504.7 |\n| Net Cash Provided by Operating Activities | 5,504.7 | 5,104.2 |\n| Cash Flows from Investing Activities |\n| Net purchases of property and equipment | ( 1,353.6 ) | ( 1,018.4 ) |\n| Proceeds from sales and maturities of short-term investments | 83.1 | 46.6 |\n| Purchases of short-term investments | ( 65.0 ) | ( 27.9 ) |\n| Proceeds from sales of noncurrent investments | 251.6 | 537.2 |\n| Purchases of noncurrent investments | ( 474.1 ) | ( 710.1 ) |\n| Cash paid for acquisitions, net of cash acquired (Note 3) | — | ( 747.4 ) |\n| Purchases of in-process research and development | ( 574.8 ) | ( 460.6 ) |\n| Other investing activities, net | ( 268.3 ) | ( 2.7 ) |\n| Net Cash Used for Investing Activities | ( 2,401.1 ) | ( 2,383.3 ) |\n| Cash Flows from Financing Activities |\n| Dividends paid | ( 2,651.4 ) | ( 2,313.5 ) |\n| Net change in short-term borrowings | 1,741.3 | ( 1.5 ) |\n| Proceeds from issuance of long-term debt | — | 2,410.8 |\n| Repayments of long-term debt | ( 1,560.0 ) | ( 1,905.3 ) |\n| Purchases of common stock | ( 1,500.0 ) | ( 500.0 ) |\n| Other financing activities, net | ( 295.2 ) | ( 295.3 ) |\n| Net Cash Used for Financing Activities | ( 4,265.3 ) | ( 2,604.8 ) |\n| Effect of exchange rate changes on cash and cash equivalents | ( 39.4 ) | 15.0 |\n| Net decrease in cash and cash equivalents | ( 1,201.1 ) | 131.1 |\n| Cash and cash equivalents at January 1 | 3,818.5 | 3,657.1 |\n| Cash and Cash Equivalents at September 30 | $ | 2,617.4 | $ | 3,788.2 |\n\nSee notes to consolidated condensed financial statements.\n10\nNotes to Consolidated Condensed Financial Statements\n(Tables present dollars in millions, except per-share data)\nNote 1: Basis of Presentation and Implementation of New Financial Accounting Standard\nWe have prepared the accompanying unaudited consolidated condensed financial statements in accordance with the requirements of Form 10-Q and, therefore, they do not include all information and footnotes necessary for a fair presentation of financial position, results of operations, and cash flows in conformity with accounting principles generally accepted in the United States (GAAP). In our opinion, the consolidated condensed financial statements reflect all adjustments (including those that are normal and recurring) that are necessary for a fair presentation of the results of operations for the periods shown. In preparing financial statements in conformity with GAAP, we must make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosures at the date of the financial statements and during the reporting period. Actual results could differ from those estimates.\nThe information included in this Quarterly Report on Form 10-Q should be read in conjunction with our consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the year ended December 31, 2021. We issue our financial statements by filing them with the Securities and Exchange Commission and have evaluated subsequent events up to the time of the filing of this Quarterly Report on Form 10-Q.\nCertain reclassifications have been made to prior periods in the consolidated condensed financial statements and accompanying notes to conform with the current presentation.\nAll per-share amounts, unless otherwise noted in the footnotes, are presented on a diluted basis; that is, based on the weighted-average number of common shares outstanding plus the effect of incremental shares from our stock-based compensation programs.\nWe operate as a single operating segment engaged in the discovery, development, manufacturing, marketing, and sales of pharmaceutical products worldwide. A global research and development organization and a supply chain organization are responsible for the discovery, development, manufacturing, and supply of our products. Regional commercial organizations market, distribute, and sell the products. The business is also supported by global corporate staff functions. Our determination that we operate as a single segment is consistent with the financial information regularly reviewed by the chief operating decision maker for purposes of evaluating performance, allocating resources, setting incentive compensation targets, and planning and forecasting for future periods.\nResearch and Development Expenses and Acquired In-Process Research and Development (IPR&D) and Development Milestones\nResearch and development costs are expensed as incurred. Research and development costs consist of expenses incurred in performing research and development activities, including but not limited to, compensation and benefits, facilities and overhead expense, clinical trial expense, and fees paid to contract research organizations.\nAcquired IPR&D and development milestones include the initial costs of externally developed IPR&D projects, acquired directly in a transaction other than a business combination, that do not have an alternative future use. Additionally, milestone payment obligations related to these transactions that are incurred prior to regulatory approval of the compound are expensed when the event triggering an obligation to pay the milestone occurs.\nImplementation of New Financial Accounting Standard\nAccounting Standards Update 2021-01, Reference Rate Reform, provides for temporary optional expedients and exceptions in applying current GAAP to contracts, hedging relationships, and other transactions affected by the transition from the use of the London Interbank Offered Rate (LIBOR) to an alternative reference rate. The standard is currently applicable to contracts entered into before January 1, 2023. We adopted the standard in the first quarter of 2022. The adoption did not have a material impact on our consolidated condensed financial statements.\n11\nNote 2: Revenue\nThe following table summarizes our revenue recognized in our consolidated condensed statements of operations:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Net product revenue | $ | 6,119.2 | $ | 6,189.0 | $ | 19,123.0 | $ | 18,579.5 |\n| Collaboration and other revenue(1) | 822.4 | 583.8 | 2,116.6 | 1,739.0 |\n| Revenue | $ | 6,941.6 | $ | 6,772.8 | $ | 21,239.6 | $ | 20,318.5 |\n\n(1) Collaboration and other revenue associated with prior period transfers of intellectual property was $ 43.3 million and $ 130.9 million during the three and nine months ended September 30, 2022, respectively, and $ 62.1 million and $ 136.1 million during the three and nine months ended September 30, 2021, respectively.\nWe recognize revenue primarily from two different types of contracts, product sales to customers (net product revenue) and collaborations and other arrangements. Revenue recognized from collaborations and other arrangements includes our share of profits from the collaborations, as well as royalties, upfront and milestone payments we receive under these types of contracts. See Note 4 for additional information related to our collaborations and other arrangements. Collaboration and other revenue disclosed above includes the revenue from the Jardiance® and Trajenta® families of products resulting from our collaboration with Boehringer Ingelheim discussed in Note 4. Substantially all of the remainder of collaboration and other revenue is related to contracts accounted for as contracts with customers.\nAdjustments to Revenue\nAdjustments to increase revenue recognized as a result of changes in estimates for our most significant United States (U.S.) sales returns, rebates, and discounts liability balances for products shipped in previous periods were 3 percent of U.S. revenue for the three months ended September 30, 2022 and less than 1 percent of U.S. revenue during the nine months ended September 30, 2022 and the three and nine months ended September 30, 2021.\nContract Liabilities\nOur contract liabilities result from arrangements where we have received payment in advance of performance under the contract and do not include sales returns, rebates, and discounts. Changes in contract liabilities are generally due to either receipt of additional advance payments or our performance under the contract.\nThe following table summarizes contract liability balances:\n| September 30, 2022 | December 31, 2021 |\n| Contract liabilities | $ | 232.5 | $ | 262.6 |\n\nDuring the three and nine months ended September 30, 2022 and 2021, revenue recognized from contract liabilities as of the beginning of the respective year was not material. Revenue expected to be recognized in the future from contract liabilities as the related performance obligations are satisfied is not expected to be material in any one year.\n12\nDisaggregation of Revenue\nThe following table summarizes revenue by product for the three months ended September 30, 2022 and 2021:\n| Three Months Ended September 30, |\n| 2022 | 2021 |\n| U.S. | Outside U.S. | Total | U.S. | Outside U.S. | Total |\n| Revenue—to unaffiliated customers: |\n| Diabetes: |\n| Trulicity® | $ | 1,418.3 | $ | 432.0 | $ | 1,850.4 | $ | 1,201.4 | $ | 398.8 | $ | 1,600.1 |\n| Jardiance(1) | 350.9 | 222.4 | 573.3 | 221.2 | 169.2 | 390.4 |\n| Humalog® (2) | 248.1 | 198.8 | 447.0 | 347.3 | 279.4 | 626.7 |\n| Humulin® | 169.5 | 68.7 | 238.2 | 193.4 | 93.4 | 286.7 |\n| Basaglar® | 124.8 | 68.1 | 193.0 | 114.7 | 78.1 | 192.8 |\n| Mounjaro® | 97.3 | 90.0 | 187.3 | — | — | — |\n| Other diabetes | 79.7 | 94.0 | 173.4 | 65.0 | 112.2 | 177.4 |\n| Total diabetes | 2,488.6 | 1,174.0 | 3,662.6 | 2,143.0 | 1,131.1 | 3,274.1 |\n| Oncology: |\n| Verzenio® | 414.8 | 202.9 | 617.7 | 199.6 | 135.9 | 335.5 |\n| Cyramza® | 87.5 | 144.6 | 232.1 | 84.8 | 168.6 | 253.4 |\n| Erbitux® | 126.3 | 18.7 | 144.9 | 114.0 | 20.3 | 134.3 |\n| Alimta® | 64.6 | 54.8 | 119.4 | 297.2 | 159.8 | 457.0 |\n| Tyvyt® | — | 76.8 | 76.8 | — | 125.6 | 125.6 |\n| Other oncology | 39.5 | 62.8 | 102.4 | 35.3 | 65.1 | 100.3 |\n| Total oncology | 732.7 | 560.6 | 1,293.3 | 730.9 | 675.3 | 1,406.1 |\n| Immunology: |\n| Taltz® | 493.8 | 186.1 | 679.9 | 422.2 | 170.9 | 593.1 |\n| Olumiant® (3) | 22.9 | 160.0 | 182.9 | 194.0 | 212.9 | 406.9 |\n| Other immunology | — | 3.6 | 3.6 | — | 4.9 | 4.9 |\n| Total immunology | 516.7 | 349.7 | 866.4 | 616.2 | 388.7 | 1,004.9 |\n| Neuroscience: |\n| Emgality® | 114.0 | 54.6 | 168.5 | 99.9 | 40.1 | 140.0 |\n| Zyprexa® | 8.0 | 73.4 | 81.4 | 13.0 | 88.7 | 101.7 |\n| Cymbalta® | 7.8 | 54.9 | 62.7 | 7.0 | 125.1 | 132.0 |\n| Other neuroscience | 16.0 | 44.5 | 60.6 | 24.7 | 51.6 | 76.5 |\n| Total neuroscience | 145.8 | 227.4 | 373.2 | 144.6 | 305.5 | 450.2 |\n| Other: |\n| COVID-19 antibodies(4) | 386.6 | — | 386.6 | 215.5 | 1.6 | 217.1 |\n| Forteo® | 112.7 | 64.4 | 177.1 | 109.6 | 91.3 | 200.9 |\n| Cialis® | 8.1 | 107.7 | 115.7 | ( 6.5 ) | 137.4 | 130.9 |\n| Other | 30.9 | 35.7 | 66.6 | 36.3 | 52.4 | 88.8 |\n| Total other | 538.3 | 207.8 | 746.0 | 354.9 | 282.7 | 637.7 |\n| Revenue | $ | 4,422.1 | $ | 2,519.4 | $ | 6,941.6 | $ | 3,989.6 | $ | 2,783.3 | $ | 6,772.8 |\n\nNumbers may not add due to rounding.\n(1) Jardiance revenue includes Glyxambi®, Synjardy®, and Trijardy® XR.\n(2) Humalog revenue includes insulin lispro.\n(3) Olumiant revenue includes sales for baricitinib that were made pursuant to Emergency Use Authorization (EUA) or similar regulatory authorizations.\n(4) COVID-19 antibodies include sales for bamlanivimab administered alone, for bamlanivimab and etesevimab administered together, and for bebtelovimab and were made pursuant to EUAs or similar regulatory authorizations.\n13\nThe following table summarizes revenue by product for the nine months ended September 30, 2022 and 2021:\n| Nine Months Ended September 30, |\n| 2022 | 2021 |\n| U.S. | Outside U.S. | Total | U.S. | Outside U.S. | Total |\n| Revenue—to unaffiliated customers: |\n| Diabetes: |\n| Trulicity | $ | 4,162.4 | $ | 1,341.1 | $ | 5,503.5 | $ | 3,465.7 | $ | 1,122.5 | $ | 4,588.2 |\n| Humalog(1) | 855.8 | 656.4 | 1,512.3 | 1,009.0 | 842.3 | 1,851.3 |\n| Jardiance(2) | 831.4 | 622.4 | 1,453.7 | 566.8 | 492.1 | 1,058.9 |\n| Humulin | 562.3 | 223.1 | 785.4 | 633.5 | 290.3 | 923.8 |\n| Basaglar | 339.9 | 218.8 | 558.7 | 423.3 | 226.8 | 650.1 |\n| Mounjaro | 109.9 | 93.3 | 203.2 | — | — | — |\n| Other diabetes | 195.6 | 276.5 | 472.2 | 185.7 | 302.6 | 488.3 |\n| Total diabetes | 7,057.3 | 3,431.6 | 10,489.0 | 6,284.0 | 3,276.6 | 9,560.6 |\n| Oncology: |\n| Verzenio | 1,100.5 | 575.1 | 1,675.6 | 582.1 | 363.7 | 945.8 |\n| Cyramza | 259.3 | 434.3 | 693.6 | 266.3 | 496.3 | 762.5 |\n| Alimta | 490.5 | 200.5 | 691.1 | 911.9 | 714.7 | 1,626.6 |\n| Erbitux | 361.0 | 47.4 | 408.3 | 357.7 | 45.9 | 403.7 |\n| Tyvyt | — | 235.8 | 235.8 | — | 340.2 | 340.2 |\n| Other oncology | 124.1 | 186.5 | 310.6 | 83.7 | 169.9 | 253.6 |\n| Total oncology | 2,335.4 | 1,679.6 | 4,015.0 | 2,201.7 | 2,130.7 | 4,332.4 |\n| Immunology: |\n| Taltz | 1,212.6 | 561.6 | 1,774.2 | 1,071.6 | 493.8 | 1,565.4 |\n| Olumiant(3) | 104.6 | 520.1 | 624.7 | 236.5 | 572.6 | 809.1 |\n| Other immunology | 0.1 | 12.1 | 12.1 | 15.2 | 14.5 | 29.7 |\n| Total immunology | 1,317.3 | 1,093.8 | 2,411.0 | 1,323.3 | 1,080.9 | 2,404.2 |\n| Neuroscience: |\n| Emgality | 330.8 | 144.4 | 475.2 | 313.5 | 102.2 | 415.7 |\n| Zyprexa | 26.2 | 235.5 | 261.7 | 28.3 | 264.5 | 292.8 |\n| Cymbalta | 25.0 | 194.3 | 219.3 | 30.3 | 454.0 | 484.3 |\n| Other neuroscience | 62.0 | 142.7 | 204.7 | 81.0 | 154.0 | 235.0 |\n| Total neuroscience | 444.0 | 716.9 | 1,160.9 | 453.1 | 974.7 | 1,427.8 |\n| Other: |\n| COVID-19 antibodies(4) | 1,970.9 | 14.7 | 1,985.5 | 949.5 | 226.7 | 1,176.2 |\n| Cialis | 25.8 | 454.7 | 480.4 | ( 3.1 ) | 541.8 | 538.7 |\n| Forteo | 261.4 | 191.7 | 453.0 | 330.1 | 287.7 | 617.8 |\n| Other | 119.4 | 125.1 | 244.8 | 96.5 | 164.3 | 260.8 |\n| Total other | 2,377.5 | 786.2 | 3,163.7 | 1,373.0 | 1,220.5 | 2,593.5 |\n| Revenue | $ | 13,531.5 | $ | 7,708.1 | $ | 21,239.6 | $ | 11,635.1 | $ | 8,683.4 | $ | 20,318.5 |\n\nNumbers may not add due to rounding.\n(1) Humalog revenue includes insulin lispro.\n(2) Jardiance revenue includes Glyxambi, Synjardy, and Trijardy XR.\n(3) Olumiant revenue includes sales for baricitinib that were made pursuant to EUA or similar regulatory authorizations.\n(4) COVID-19 antibodies include sales for bamlanivimab administered alone, for bamlanivimab and etesevimab administered together, and for bebtelovimab and were made pursuant to EUAs or similar regulatory authorizations.\n14\nThe following table summarizes revenue by geographical area:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Revenue—to unaffiliated customers(1): |\n| U.S. | $ | 4,422.1 | $ | 3,989.6 | $ | 13,531.5 | $ | 11,635.1 |\n| Europe | 1,056.4 | 1,098.6 | 3,224.8 | 3,629.6 |\n| Japan | 487.7 | 595.0 | 1,352.3 | 1,832.2 |\n| China | 343.4 | 400.3 | 1,102.0 | 1,285.0 |\n| Other foreign countries | 632.0 | 689.4 | 2,029.1 | 1,936.7 |\n| Revenue | $ | 6,941.6 | $ | 6,772.8 | $ | 21,239.6 | $ | 20,318.5 |\n\nNumbers may not add due to rounding.\n(1) Revenue is attributed to the countries based on the location of the customer.\nNote 3: Acquisitions\nWe engage in various forms of business development activities to enhance our product pipeline, including acquisitions, collaborations, investments, and licensing arrangements. In connection with these arrangements, our partners may be entitled to future royalties and/or commercial milestones based on sales should products be approved for commercialization and/or milestones based on the successful progress of compounds through the development process.\nIn January 2021, we completed the acquisition of Prevail Therapeutics Inc. (Prevail). This transaction, as further discussed below in Acquisition of a Business, was accounted for as a business combination under the acquisition method of accounting. Under this method, the assets acquired and liabilities assumed were recorded at their respective fair values as of the acquisition date in our consolidated condensed financial statements. The determination of estimated fair value required management to make significant estimates and assumptions. The excess of the purchase price over the fair value of the acquired net assets, where applicable, has been recorded as goodwill. The results of operations of this acquisition is included in our consolidated condensed financial statements from the date of acquisition.\nWe also acquired assets in development which are further discussed below in Asset Acquisitions. Upon each acquisition, the cost allocated to acquired IPR&D is immediately expensed if the compound has no alternative future use. Milestone payment obligations incurred prior to regulatory approval of the compound are expensed when the event triggering an obligation to pay the milestone occurs. We recognized acquired IPR&D and development milestone charges of $ 62.4 million and $ 668.4 million for the three and nine months ended September 30, 2022, respectively, and $ 177.6 million and $ 532.4 million for the three and nine months ended September 30, 2021, respectively.\nAcquisition of a Business\nPrevail Acquisition\nOverview of Transaction\nIn January 2021, we acquired all shares of Prevail for a purchase price that included $ 22.50 per share in cash (or an aggregate of $ 747.4 million, net of cash acquired) plus one non-tradable contingent value right (CVR) per share. The CVR entitles Prevail stockholders up to an additional $ 4.00 per share in cash (or an aggregate of approximately $ 160 million) payable, subject to certain terms and conditions, upon the first regulatory approval of a Prevail product in one of the following countries: U.S., Japan, United Kingdom, Germany, France, Italy, or Spain. To achieve the full value of the CVR, such regulatory approval must occur by December 31, 2024. If such regulatory approval occurs after December 31, 2024, the value of the CVR will be reduced by approximately 8.3 cents per month until December 1, 2028, at which point the CVR will expire without payment.\nUnder the terms of the agreement, we acquired potentially disease-modifying AAV9-based gene therapies for patients with neurodegenerative diseases. The acquisition established a new modality for drug discovery and development, extending our research efforts through the creation of a gene therapy program that is being anchored by Prevail's portfolio of assets. The lead gene therapies in clinical development that we acquired were PR001 for patients with Parkinson's disease with GBA1 mutations and neuronopathic Gaucher disease and PR006 for patients with frontotemporal dementia with GRN mutations. Both PR001 and PR006 were granted Fast Track designation from the U.S. Food and Drug Administration (FDA).\n15\nAssets Acquired and Liabilities Assumed\nThe following table summarizes the amounts recognized for assets acquired and liabilities assumed as of the acquisition date:\n| Estimated Fair Value at January 22, 2021 |\n| Cash | $ | 90.5 |\n| Acquired IPR&D(1) | 824.0 |\n| Goodwill(2) | 126.8 |\n| Deferred tax liabilities | ( 106.0 ) |\n| Other assets and liabilities, net | ( 31.5 ) |\n| Acquisition date fair value of consideration transferred | 903.8 |\n| Less: |\n| Cash acquired | ( 90.5 ) |\n| Fair value of CVR liability(3) | ( 65.9 ) |\n| Cash paid, net of cash acquired | $ | 747.4 |\n\n(1) Acquired IPR&D intangibles primarily relate to PR001. In the third quarter of 2022, we impaired the intangible asset related to PR001. See Note 5 for additional information.\n(2) The goodwill recognized from this acquisition is not deductible for tax purposes.\n(3) See Note 6 for a discussion on the estimation of the CVR liability.\nWe are unable to provide the results of operations for the three and nine months ended September 30, 2022 and 2021 attributable to Prevail as those operations were substantially integrated into our legacy business.\nPro forma information has not been included as this acquisition did not have a material impact on our consolidated condensed statements of operations for the three and nine months ended September 30, 2021.\nAsset Acquisitions\nThe following table summarizes our significant asset acquisitions during the nine months ended September 30, 2022 and 2021:\n| Counterparty | Compound(s), Therapy or Asset | Acquisition Month | Phase of Development(1) | Acquired IPR&D Expense |\n| BioMarin Pharmaceutical Inc. | Priority Review Voucher | February 2022 | Not applicable | $ | 110.0 |\n| Rigel Pharmaceuticals, Inc. | R552, a receptor-interacting serine/threonine-protein kinase 1 (RIPK1) inhibitor, for the potential treatment of autoimmune and inflammatory diseases | March 2021 | Phase I | 125.0 |\n| Precision Biosciences, Inc. | Potential in vivo therapies for genetic disorders | January 2021 | Pre-clinical | 107.8 |\n\n(1) The phase of development presented is as of the date of the arrangement and represents the phase of development of the most advanced asset acquired, where applicable.\nIn connection with our acquisition of Petra Pharma Corporation (Petra), we were required to make milestone payments to Petra shareholders contingent upon the occurrence of certain future events linked to the success of the mutant-selective PI3Kα inhibitor. In the second quarter of 2022, we entered into agreements with substantially all Petra shareholders to acquire their rights to receive any future milestone payments in exchange for a one-time payment. As a result of these agreements, we recognized a charge of $ 333.8 million as a development milestone during the nine months ended September 30, 2022. Any remaining contingent milestones payments linked to the success of the mutant-selective PI3Kα are not expected to be material. We recognized no other significant development milestones during the three and nine months ended September 30, 2022 and 2021.\n16\nSubsequent Event - Akouos, Inc. (Akouos) Acquisition\nOn October 17, 2022, we entered into a definitive agreement to acquire Akouos. Pursuant to the terms of the agreement, we have commenced a tender offer to acquire all outstanding shares of Akouos for a purchase price of $ 12.50 per share in cash (an aggregate of approximately $ 487 million), payable at closing, plus one non-tradable CVR per share that will entitle the holder to receive up to an additional $ 3.00 per CVR in cash (an aggregate of up to approximately $ 123 million) upon the achievement of certain specified milestones. The acquisition will expand our gene therapy portfolio to include potential treatments for hearing loss and other inner ear conditions. The acquisition is not subject to any financing condition and is expected to close in the fourth quarter of 2022, subject to customary closing conditions, including receipt of required antitrust clearance and the tender of a majority of the outstanding shares of Akouos's common stock.\nNote 4: Collaborations and Other Arrangements\nWe often enter into collaborative and other similar arrangements to develop and commercialize drug candidates. Collaborative activities may include research and development, marketing and selling (including promotional activities and physician detailing), manufacturing, and distribution. These arrangements often require milestone as well as royalty or profit-share payments, contingent upon the occurrence of certain future events linked to the success of the asset in development, as well as expense reimbursements from or payments to the collaboration partner. See Note 2 for amounts of collaboration and other revenue recognized from these types of arrangements.\nOperating expenses for costs incurred pursuant to these arrangements are reported in their respective expense line item, net of any payments due to or reimbursements due from our collaboration partners, with such reimbursements being recognized at the time the party becomes obligated to pay. Each collaboration is unique in nature, and our more significant arrangements are discussed below.\nBoehringer Ingelheim Diabetes Collaboration\nWe and Boehringer Ingelheim have a global agreement to jointly develop and commercialize a portfolio of diabetes compounds. Currently included in the collaboration are Boehringer Ingelheim's oral diabetes products: Jardiance, Glyxambi, Synjardy, Trijardy XR, Trajenta, and Jentadueto® as well as our basal insulin, Basaglar. Glyxambi, Synjardy, and Trijardy XR are included in the Jardiance product family. Jentadueto is included in the Trajenta product family.\nIn connection with the regulatory approvals of Jardiance, Trajenta, and Basaglar in the U.S., Europe, and Japan, milestone payments made for Jardiance and Trajenta were capitalized as intangible assets and are being amortized to cost of sales, and milestone payments received for Basaglar were recorded as contract liabilities and are being amortized to collaboration and other revenue. The milestones pertaining to Jardiance and Trajenta are being amortized through their respective term under the collaboration, which, depending on country or region, is determined based on the latest to occur of (a) a defined number of years following launch date, (b) the expiration of the compound patent, or (c) the expiration of marketing authorization exclusivity. The milestones pertaining to Basaglar are being amortized through 2029. The table below summarizes the net milestones capitalized with respect to the Jardiance and Trajenta families of products and the net milestones deferred with respect to Basaglar as of September 30, 2022 and December 31, 2021:\n| Net Milestones Capitalized (Deferred)(1) |\n| September 30, 2022 | December 31, 2021 |\n| Jardiance | $ | 121.2 | $ | 136.1 |\n| Trajenta | 69.6 | 88.5 |\n| Basaglar | ( 135.3 ) | ( 149.3 ) |\n\n(1) This represents the amounts that have been capitalized (deferred) from the start of this collaboration through the end of the reporting period, net of amount amortized.\n17\nFor the Jardiance product family, we and Boehringer Ingelheim share equally the ongoing development and commercialization costs in the most significant markets, and we record our portion of the development and commercialization costs as research and development expense and marketing, selling, and administrative expense, respectively. We receive a royalty on net sales of Boehringer Ingelheim's products in the most significant markets and recognize the royalty as collaboration and other revenue. Boehringer Ingelheim is entitled to potential performance payments depending on the net sales of the Jardiance product family; therefore, our reported revenue for Jardiance may be reduced by any potential performance payments we make related to this product family. The royalty received by us related to the Jardiance product family may also be increased or decreased depending on whether net sales for this product family exceed or fall below certain thresholds. We pay to Boehringer Ingelheim a royalty on net sales for Basaglar in the U.S. We record our sales of Basaglar to third parties as net product revenue with the royalty payments made to Boehringer Ingelheim recorded as cost of sales.\nThe following table summarizes our collaboration and other revenue recognized with respect to the Jardiance and Trajenta families of products and net product revenue recognized with respect to Basaglar:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Jardiance | $ | 573.3 | $ | 390.4 | $ | 1,453.7 | $ | 1,058.9 |\n| Basaglar | 193.0 | 192.8 | 558.7 | 650.1 |\n| Trajenta | 103.8 | 96.1 | 293.0 | 279.9 |\n\nOlumiant\nWe have a worldwide license and collaboration agreement with Incyte Corporation (Incyte), which provides us the development and commercialization rights to baricitinib, branded and trademarked as Olumiant, and certain follow-on compounds, for the treatment of inflammatory and autoimmune diseases and COVID-19. Incyte has the right to receive tiered, double digit royalty payments on worldwide net sales with rates ranging up to 20 percent. Incyte has the right to receive an additional royalty ranging up to the low teens on worldwide net sales for the treatment of COVID-19 that exceed a specified aggregate worldwide net sales threshold. The agreement calls for payments by us to Incyte associated with certain development, success-based regulatory, and sales-based milestones.\nIn connection with the regulatory approvals of Olumiant in the U.S., Europe, and Japan, as well as achievement of a sales-based milestone, milestone payments of $ 330.0 million and $ 260.0 million were capitalized as intangible assets as of September 30, 2022 and December 31, 2021, respectively, and are being amortized to cost of sales through the term of the collaboration. This represents the cumulative amounts that have been capitalized from the start of this collaboration through the end of each reporting period.\nAs of September 30, 2022, Incyte is eligible to receive up to $ 100.0 million of additional payments from us in potential sales-based milestones.\nWe record our sales of Olumiant, including sales of baricitinib that were made pursuant to EUA or similar regulatory authorizations, to third parties as net product revenue with the royalty payments made to Incyte recorded as cost of sales. The following table summarizes our net product revenue recognized with respect to Olumiant:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Olumiant | $ | 182.9 | $ | 406.9 | $ | 624.7 | $ | 809.1 |\n\n18\nCOVID-19 Antibodies\nWe have a worldwide license and collaboration agreement with AbCellera Biologics Inc. (AbCellera) to co-develop therapeutic antibodies for the potential prevention and treatment of COVID-19, including bamlanivimab and bebtelovimab, for which we hold development and commercialization rights. AbCellera has the right to receive tiered royalty payments on worldwide net sales of bamlanivimab and bebtelovimab with percentages ranging in the mid-teens to mid-twenties. Royalty payments made to AbCellera are recorded as cost of sales.\nWe have a license and collaboration agreement with Shanghai Junshi Biosciences Co., Ltd. (Junshi Biosciences) to co-develop therapeutic antibodies for the potential prevention and treatment of COVID-19, including etesevimab, for which we hold development and commercialization rights outside of mainland China and the Special Administrative Regions of Hong Kong and Macau, and for which Junshi Biosciences currently maintains all rights in mainland China and the Special Administrative Regions of Hong Kong and Macau. Junshi Biosciences has the right to receive royalty payments in the mid-teens on our net sales of etesevimab. Junshi Biosciences received certain development, success-based regulatory and sales-based milestones. Capitalized regulatory and sales-based milestones were fully amortized to cost of sales as of September 30, 2022.\nPursuant to EUAs or similar regulatory authorizations, we recognized net product revenue associated with our sales of our COVID-19 antibodies of $ 386.6 million and $ 1.99 billion for the three and nine months ended September 30, 2022, respectively, and $ 217.1 million and $ 1.18 billion for the three and nine months ended September 30, 2021, respectively.\nSintilimab Injection\nWe have a collaboration agreement with Innovent Biologics, Inc. (Innovent) to jointly develop and commercialize sintilimab injection in China, where it is branded and trademarked as Tyvyt. In connection with regulatory approvals for Tyvyt in China, milestone payments of $ 120.0 million and $ 40.0 million were capitalized as intangible assets as of September 30, 2022 and December 31, 2021, respectively, and are being amortized to cost of sales through the term of the collaboration. This represents the cumulative amounts that have been capitalized from the start of this collaboration through the end of each reporting period. As of September 30, 2022, Innovent is eligible to receive up to $ 115.0 million in success-based regulatory and sales-based milestones.\nWe record our sales of Tyvyt to third parties as net product revenue, with payments made to Innovent for its portion of the gross margin reported as cost of sales. We report as collaboration and other revenue our portion of the gross margin for Tyvyt sales made by Innovent to third parties. The following table summarizes our revenue recognized in China with respect to Tyvyt:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Tyvyt | $ | 76.8 | $ | 125.6 | $ | 235.8 | $ | 340.2 |\n\nIn 2020, we obtained an exclusive license for sintilimab injection from Innovent for geographies outside of China, which was subsequently terminated and rights have reverted to Innovent in October 2022.\nLebrikizumab\nWe have a worldwide license agreement with F. Hoffmann-La Roche Ltd and Genentech, Inc. (collectively, Roche), which provides us the worldwide development and commercialization rights to lebrikizumab. Roche has the right to receive tiered royalty payments on future worldwide net sales ranging in percentages from high single digits to high teens if the product is successfully commercialized. As of September 30, 2022, Roche is eligible to receive up to $ 180.0 million of payments from us contingent upon the achievement of success-based regulatory milestones and up to $ 1.03 billion in a series of sales-based milestones, contingent upon the commercial success of lebrikizumab.\nWe have a license agreement with Almirall, S.A. (Almirall), under which Almirall licensed the rights to develop and commercialize lebrikizumab for the treatment or prevention of dermatology indications, including, but not limited to, atopic dermatitis in Europe. We have the right to receive tiered royalty payments on future net sales in Europe ranging in percentages from low double digits to low twenties if the product is successfully commercialized. As of September 30, 2022, we are eligible to receive additional payments of $ 85.0 million from Almirall contingent upon the achievement of success-based regulatory milestones and up to $ 1.25 billion in a series of sales-based milestones, contingent upon the commercial success of lebrikizumab. There were no remaining contract liabilities as of September 30, 2022. As of December 31, 2021, contract liabilities were not material. During the three and nine months ended September 30, 2022 and 2021, collaboration and other revenue recognized was not material.\n19\nNote 5: Asset Impairment, Restructuring, and Other Special Charges\nThe components of the charges included in asset impairment, restructuring, and other special charges in our consolidated condensed statements of operations are described below.\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Severance | $ | — | $ | — | $ | — | $ | 11.5 |\n| Asset impairment and other special charges | 206.5 | — | 206.5 | 200.1 |\n| Total asset impairment, restructuring, and other special charges | $ | 206.5 | $ | — | $ | 206.5 | $ | 211.6 |\n\nAsset impairment, restructuring, and other special charges recognized during the three and nine months ended September 30, 2022 were primarily related to an intangible asset impairment for GBA1 Gene Therapy (PR001), acquired in the Prevail acquisition, as a result of changes in key assumptions used in the valuation due to delays in estimated launch timing.\nAsset impairment, restructuring, and other special charges recognized during the nine months ended September 30, 2021 were primarily related to an intangible asset impairment of $ 108.1 million resulting from the sale of the rights to Qbrexza®, as well as acquisition and integration costs associated with the acquisition of Prevail.\nWe recognized a net inventory impairment charge related to our COVID-19 antibodies of $ 435.1 million during the nine months ended September 30, 2021 in cost of sales in our consolidated condensed statements of operations. As part of our response to the COVID-19 pandemic, and at the request of the U.S. and international governments, we invested in large-scale manufacturing of COVID-19 antibodies at risk, in order to ensure rapid access to patients around the world. As the COVID-19 pandemic evolved during 2021, we incurred a net inventory impairment charge primarily due to the combination of changes to demand from U.S. and international governments, including changes to our agreement with the U.S. government, and near-term expiry dates of COVID-19 antibodies.\nNote 6: Financial Instruments\nFinancial instruments that potentially subject us to credit risk consist principally of trade receivables and interest-bearing investments. Wholesale distributors of life science products account for a substantial portion of our trade receivables; collateral is generally not required. We seek to mitigate the risk associated with this concentration through our ongoing credit-review procedures and insurance. A large portion of our cash is held by a few major financial institutions. We monitor our exposures with these institutions and do not expect any of these institutions to fail to meet their obligations. In accordance with documented corporate risk-management policies, we monitor the amount of credit exposure to any one financial institution or corporate issuer. We are exposed to credit-related losses in the event of nonperformance by counterparties to risk-management instruments but do not expect any counterparties to fail to meet their obligations given their investment grade credit ratings.\nWe consider all highly liquid investments with a maturity of three months or less from the date of purchase to be cash equivalents. The cost of these investments approximates fair value.\nOur equity investments are accounted for using three different methods depending on the type of equity investment:\n•Investments in companies over which we have significant influence but not a controlling interest are accounted for using the equity method, with our share of earnings or losses reported in other-net, (income) expense.\n•For equity investments that do not have readily determinable fair values, we measure these investments at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for the identical or similar investment of the same issuer. Any change in recorded value is recorded in other-net, (income) expense.\n•Our public equity investments are measured and carried at fair value. Any change in fair value is recognized in other-net, (income) expense.\nWe review equity investments other than public equity investments for indications of impairment and observable price changes on a regular basis.\n20\nOur derivative activities are initiated within the guidelines of documented corporate risk-management policies and are intended to offset losses and gains on the assets, liabilities, and transactions being hedged. Management reviews the correlation and effectiveness of our derivatives on a quarterly basis.\nFor derivative instruments that are designated and qualify as fair value hedges, the derivative instrument is marked to market, with gains and losses recognized currently in income to offset the respective losses and gains recognized on the underlying exposure. For derivative instruments that are designated and qualify as cash flow hedges, gains and losses are reported as a component of accumulated other comprehensive loss and reclassified into earnings in the same period the hedged transaction affects earnings. For derivative and non-derivative instruments that are designated and qualify as net investment hedges, the foreign currency translation gains or losses due to spot rate fluctuations are reported as a component of accumulated other comprehensive loss. Derivative contracts that are not designated as hedging instruments are recorded at fair value with the gain or loss recognized in earnings during the period of change.\nWe may enter into foreign currency forward or option contracts to reduce the effect of fluctuating currency exchange rates (principally the euro, British pound, Chinese yuan, and Japanese yen). Foreign currency derivatives used for hedging are put in place using the same or like currencies and duration as the underlying exposures. Forward and option contracts are principally used to manage exposures arising from subsidiary trade and loan payables and receivables denominated in foreign currencies. These contracts are recorded at fair value with the gain or loss recognized in other–net, (income) expense. We may enter into foreign currency forward and option contracts and currency swaps as fair value hedges of firm commitments. Forward contracts generally have maturities not exceeding 12 months. At September 30, 2022, we had outstanding foreign currency forward commitments to purchase 1.69 billion U.S. dollars and sell 1.71 billion euro; commitments to purchase 2.24 billion euro and sell 2.24 billion U.S. dollars; commitments to purchase 239.5 million U.S. dollars and sell 1.63 billion Chinese yuan; commitments to purchase 82.1 million U.S. dollars and sell 11.86 billion Japanese yen; and commitments to purchase 182.1 million British pounds and sell 206.9 million U.S. dollars, which all have settlement dates within 180 days.\nForeign currency exchange risk is also managed through the use of foreign currency debt, cross-currency interest rate swaps, and foreign currency forward contracts. Our foreign currency-denominated notes had carrying amounts of $ 6.23 billion and $ 7.90 billion as of September 30, 2022 and December 31, 2021, respectively, of which $ 4.94 billion and $ 5.79 billion have been designated as, and are effective as, economic hedges of net investments in certain of our foreign operations as of September 30, 2022 and December 31, 2021, respectively. At September 30, 2022, we had outstanding cross-currency swaps with notional amounts of $ 1.56 billion swapping U.S. dollars to euro and $ 1.00 billion swapping Swiss francs to U.S. dollars which have settlement dates ranging through 2028. Our cross-currency interest rate swaps, for which a majority convert a portion of our U.S. dollar-denominated fixed-rate debt to foreign-denominated fixed-rate debt, have also been designated as, and are effective as, economic hedges of net investments. At September 30, 2022, we had outstanding foreign currency forward contracts to sell 1.34 billion euro with settlement dates ranging through 2023, which have been designated as, and are effective as, economic hedges of net investments.\nIn the normal course of business, our operations are exposed to fluctuations in interest rates which can vary the costs of financing, investing, and operating. We seek to address a portion of these risks through a controlled program of risk management that includes the use of derivative financial instruments. The objective of controlling these risks is to limit the impact of fluctuations in interest rates on earnings. Our primary interest-rate risk exposure results from changes in short-term U.S. dollar interest rates. In an effort to manage interest-rate exposures, we strive to achieve an acceptable balance between fixed- and floating-rate debt and investment positions and may enter into interest rate swaps or collars to help maintain that balance.\nInterest rate swaps or collars that convert our fixed-rate debt to a floating rate are designated as fair value hedges of the underlying instruments. Interest rate swaps or collars that convert floating-rate debt to a fixed rate are designated as cash flow hedges. Interest expense on the debt is adjusted to include the payments made or received under the swap agreements. Cash proceeds from or payments to counterparties resulting from the termination of interest rate swaps are classified as operating activities in our consolidated condensed statements of cash flows. At September 30, 2022, substantially all of our total long-term debt is at a fixed rate. We have converted approximately 10 percent of our long-term fixed-rate notes to floating rates through the use of interest rate swaps.\n21\nWe also may enter into forward-starting interest rate swaps, which we designate as cash flow hedges, as part of any anticipated future debt issuances in order to reduce the risk of cash flow volatility from future changes in interest rates. The change in fair value of these instruments is recorded as part of other comprehensive income (loss) and, upon completion of a debt issuance and termination of the swap, is amortized to interest expense over the life of the underlying debt. As of September 30, 2022, the total notional amounts of forward-starting interest rate contracts in designated cash flow hedging instruments were $ 1.75 billion, which have settlement dates ranging between 2023 and 2025.\nEffective September 15, 2022, we increased our 364-day credit facility from $ 2.00 billion to $ 4.00 billion, which will expire in September 2023, and is available to support our commercial paper program. We have not drawn against the $ 4.00 billion 364-day credit facility as of September 30, 2022.\nIn September 2021, we issued euro-denominated notes consisting of € 600.0 million of 0.50 percent fixed-rate notes due in September 2033, with interest to be paid annually. The net proceeds from the offering have been, and will continue to be, used to fund, in whole or in part, eligible projects designed to advance one or more of our environmental, social, and governance objectives.\nIn September 2021, we issued euro-denominated notes consisting of € 500.0 million of 1.125 percent fixed-rate notes due in September 2051 and € 700.0 million of 1.375 percent fixed-rate notes due in September 2061, with interest to be paid annually, and British pound-denominated notes consisting of £ 250.0 million of 1.625 percent fixed-rate notes due in September 2043, with interest to be paid annually. We paid $ 1.91 billion of the net cash proceeds from the offering to purchase and redeem certain higher interest rate U.S. dollar-denominated notes with an aggregate principal amount of $ 1.50 billion, resulting in a debt extinguishment loss of $ 405.2 million. This loss was included in other net, (income) expense in our consolidated condensed statement of operations during the three and nine months ended September 30, 2021. The $ 1.50 billion principal amount of higher interest rate U.S. dollar-denominated notes that were redeemed primarily included $ 541.8 million of 3.95 percent notes due 2049, $ 408.7 million of 4.15 percent notes due 2059, and $ 219.4 million of 3.375 percent notes due 2029. We used the remaining net proceeds from the offering to prefund certain 2022 debt maturities and for general corporate purposes.\nThe Effect of Risk-Management Instruments on the Consolidated Condensed Statements of Operations\nThe following effects of risk-management instruments were recognized in other–net, (income) expense:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Fair value hedges: |\n| Effect from hedged fixed-rate debt | $ | ( 62.9 ) | $ | ( 10.1 ) | $ | ( 215.7 ) | $ | ( 60.5 ) |\n| Effect from interest rate contracts | 62.9 | 10.1 | 215.7 | 60.5 |\n| Cash flow hedges: |\n| Effective portion of losses on interest rate contracts reclassified from accumulated other comprehensive loss | 4.1 | 4.2 | 12.3 | 12.5 |\n| Cross-currency interest rate swaps | 33.1 | 10.0 | 75.0 | 58.1 |\n| Net (gains) losses on foreign currency exchange contracts not designated as hedging instruments | 129.6 | 50.8 | 280.7 | 110.6 |\n| Total | $ | 166.8 | $ | 65.0 | $ | 368.0 | $ | 181.2 |\n\nDuring the three and nine months ended September 30, 2022 and 2021, the amortization of losses related to the portion of our risk management hedging instruments, fair value hedges, and cash flow hedges that was excluded from the assessment of effectiveness was not material.\n22\nThe Effect of Risk-Management Instruments on Other Comprehensive Income (Loss)\nThe effective portion of risk-management instruments that was recognized in other comprehensive income (loss) is as follows:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Net investment hedges: |\n| Foreign currency-denominated notes | $ | 435.1 | $ | 119.0 | $ | 822.8 | $ | 268.8 |\n| Cross-currency interest rate swaps | 92.1 | 66.7 | 171.4 | 170.8 |\n| Foreign currency forward contracts | 107.8 | — | 121.4 | — |\n| Cash flow hedges: |\n| Forward-starting interest rate swaps | 57.5 | 19.4 | 337.7 | 149.3 |\n| Cross-currency interest rate swaps | 19.9 | 3.1 | 38.4 | 22.5 |\n\nDuring the next 12 months, we expect to reclassify $ 16.7 million of pretax net losses on cash flow hedges from accumulated other comprehensive loss to other–net, (income) expense. During the three and nine months ended September 30, 2022 and 2021, the amounts excluded from the assessment of hedge effectiveness recognized in other comprehensive income (loss) were not material.\n23\nFair Value of Financial Instruments\nThe following tables summarize certain fair value information at September 30, 2022 and December 31, 2021 for assets and liabilities measured at fair value on a recurring basis, as well as the carrying amount and amortized cost of certain other investments:\n| Fair Value Measurements Using |\n| CarryingAmount | Cost(1) | Quoted Prices in Active Markets for Identical Assets(Level 1) | Significant OtherObservable Inputs(Level 2) | SignificantUnobservableInputs(Level 3) | FairValue |\n| September 30, 2022 |\n| Cash equivalents | $ | 1,246.8 | $ | 1,246.8 | $ | 1,239.2 | $ | 7.6 | $ | — | $ | 1,246.8 |\n| Short-term investments: |\n| U.S. government and agency securities | $ | 43.0 | $ | 43.5 | $ | 43.0 | $ | — | $ | — | $ | 43.0 |\n| Corporate debt securities | 51.7 | 51.8 | — | 51.7 | — | 51.7 |\n| Asset-backed securities | 3.0 | 3.0 | — | 3.0 | — | 3.0 |\n| Other securities | 27.0 | 27.0 | — | 14.8 | 12.2 | 27.0 |\n| Short-term investments | $ | 124.7 |\n| Noncurrent investments: |\n| U.S. government and agency securities | $ | 131.4 | $ | 148.3 | $ | 131.4 | $ | — | $ | — | $ | 131.4 |\n| Corporate debt securities | 206.4 | 232.5 | — | 206.4 | — | 206.4 |\n| Mortgage-backed securities | 143.1 | 156.1 | — | 143.1 | — | 143.1 |\n| Asset-backed securities | 43.6 | 45.5 | — | 43.6 | — | 43.6 |\n| Other securities | 152.5 | 96.3 | — | 39.5 | 113.0 | 152.5 |\n| Marketable equity securities | 549.1 | 416.1 | 549.1 | — | — | 549.1 |\n| Equity investments without readily determinable fair values(2) | 583.7 |\n| Equity method investments(2) | 764.8 |\n| Noncurrent investments | $ | 2,574.6 |\n| December 31, 2021 |\n| Cash equivalents | $ | 2,379.5 | $ | 2,379.5 | $ | 2,361.0 | $ | 18.5 | $ | — | $ | 2,379.5 |\n| Short-term investments: |\n| U.S. government and agency securities | $ | 25.7 | $ | 25.6 | $ | 25.7 | $ | — | $ | — | $ | 25.7 |\n| Corporate debt securities | 43.7 | 43.7 | — | 43.7 | — | 43.7 |\n| Mortgage-backed securities | 0.2 | 0.2 | — | 0.2 | — | 0.2 |\n| Asset-backed securities | 6.2 | 6.2 | — | 6.2 | — | 6.2 |\n| Other securities | 14.3 | 14.3 | — | — | 14.3 | 14.3 |\n| Short-term investments | $ | 90.1 |\n| Noncurrent investments: |\n| U.S. government and agency securities | $ | 137.0 | $ | 136.8 | $ | 137.0 | $ | — | $ | — | $ | 137.0 |\n| Corporate debt securities | 235.3 | 232.7 | — | 235.3 | — | 235.3 |\n| Mortgage-backed securities | 109.8 | 108.1 | — | 109.8 | — | 109.8 |\n| Asset-backed securities | 23.1 | 23.1 | — | 23.1 | — | 23.1 |\n| Other securities | 108.1 | 22.2 | — | — | 108.1 | 108.1 |\n| Marketable equity securities | 1,279.7 | 487.0 | 1,279.7 | — | — | 1,279.7 |\n| Equity investments without readily determinable fair values(2) | 548.1 |\n| Equity method investments(2) | 771.5 |\n| Noncurrent investments | $ | 3,212.6 |\n\n(1) For available-for-sale debt securities, amounts disclosed represent the securities' amortized cost.\n(2) Fair value disclosures are not applicable for equity method investments and investments accounted for under the measurement alternative for equity investments.\n24\n| Fair Value Measurements Using |\n| CarryingAmount | Quoted Prices in Active Markets for Identical Assets(Level 1) | SignificantOther Observable Inputs(Level 2) | SignificantUnobservableInputs(Level 3) | FairValue |\n| Short-term commercial paper borrowings |\n| September 30, 2022 | $ | ( 1,741.3 ) | $ | — | $ | ( 1,738.0 ) | $ | — | $ | ( 1,738.0 ) |\n| December 31, 2021 | — | — | — | — | — |\n| Long-term debt, including current portion |\n| September 30, 2022 | $ | ( 14,147.1 ) | $ | — | $ | ( 11,848.6 ) | $ | — | $ | ( 11,848.6 ) |\n| December 31, 2021 | ( 16,884.7 ) | — | ( 18,157.7 ) | — | ( 18,157.7 ) |\n\n25\n| Fair Value Measurements Using |\n| CarryingAmount | Quoted Prices in Active Markets for Identical Assets(Level 1) | SignificantOther Observable Inputs(Level 2) | SignificantUnobservableInputs(Level 3) | FairValue |\n| September 30, 2022 |\n| Risk-management instruments: |\n| Interest rate contracts designated as fair value hedges: |\n| Other noncurrent liabilities | $ | ( 140.2 ) | $ | — | $ | ( 140.2 ) | $ | — | $ | ( 140.2 ) |\n| Interest rate contracts designated as cash flow hedges: |\n| Other noncurrent assets | 355.2 | — | 355.2 | — | 355.2 |\n| Cross-currency interest rate contracts designated as net investment hedges: |\n| Other receivables | 81.6 | — | 81.6 | — | 81.6 |\n| Other noncurrent assets | 116.9 | — | 116.9 | — | 116.9 |\n| Cross-currency interest rate contracts designated as cash flow hedges: |\n| Other noncurrent assets | 8.3 | — | 8.3 | — | 8.3 |\n| Other noncurrent liabilities | ( 12.9 ) | — | ( 12.9 ) | — | ( 12.9 ) |\n| Foreign exchange contracts designated as net investment hedges: |\n| Other receivables | 108.2 | — | 108.2 | — | 108.2 |\n| Other current liabilities | ( 2.9 ) | — | ( 2.9 ) | — | ( 2.9 ) |\n| Foreign exchange contracts not designated as hedging instruments: |\n| Other receivables | 48.1 | — | 48.1 | — | 48.1 |\n| Other current liabilities | ( 93.5 ) | — | ( 93.5 ) | — | ( 93.5 ) |\n| Contingent consideration liability: |\n| Other noncurrent liabilities | ( 42.1 ) | — | — | ( 42.1 ) | ( 42.1 ) |\n| December 31, 2021 |\n| Risk-management instruments: |\n| Interest rate contracts designated as fair value hedges: |\n| Other receivables | $ | 4.8 | $ | — | $ | 4.8 | $ | — | $ | 4.8 |\n| Other noncurrent assets | 78.3 | — | 78.3 | — | 78.3 |\n| Other noncurrent liabilities | ( 7.6 ) | — | ( 7.6 ) | — | ( 7.6 ) |\n| Interest rate contracts designated as cash flow hedges: |\n| Other noncurrent assets | 49.2 | — | 49.2 | — | 49.2 |\n| Other noncurrent liabilities | ( 31.7 ) | — | ( 31.7 ) | — | ( 31.7 ) |\n| Cross-currency interest rate contracts designated as net investment hedges: |\n| Other noncurrent assets | 31.3 | — | 31.3 | — | 31.3 |\n| Other current liabilities | ( 1.2 ) | — | ( 1.2 ) | — | ( 1.2 ) |\n| Cross-currency interest rate contracts designated as cash flow hedges: |\n| Other noncurrent assets | 33.2 | — | 33.2 | — | 33.2 |\n| Other noncurrent liabilities | ( 1.3 ) | — | ( 1.3 ) | — | ( 1.3 ) |\n| Foreign exchange contracts not designated as hedging instruments: |\n| Other receivables | 9.9 | — | 9.9 | — | 9.9 |\n| Other current liabilities | ( 35.3 ) | — | ( 35.3 ) | — | ( 35.3 ) |\n| Contingent consideration liabilities: |\n| Other noncurrent liabilities | ( 70.5 ) | — | — | ( 70.5 ) | ( 70.5 ) |\n\n26\nRisk-management instruments above are disclosed on a gross basis. There are various rights of setoff associated with certain of the risk-management instruments above that are subject to enforceable master netting arrangements or similar agreements. Although various rights of setoff and master netting arrangements or similar agreements may exist with the individual counterparties to the risk-management instruments above, individually, these financial rights are not material.\nWe determine our Level 1 and Level 2 fair value measurements based on a market approach using quoted market values, significant other observable inputs for identical or comparable assets or liabilities, or discounted cash flow analyses. Level 3 fair value measurements for other investment securities are determined using unobservable inputs, including the investments' cost adjusted for impairments and price changes from orderly transactions. Fair values are not readily available for certain equity investments measured under the measurement alternative.\nAs of September 30, 2022, we had approximately $ 854 million of unfunded commitments to invest in venture capital funds, which we anticipate will be paid over a period of up to 10 years.\nContingent consideration liability relates to our liability arising in connection with the CVR issued as a result of the Prevail acquisition. The fair value of the CVR liability was estimated using a discounted cash flow analysis and Level 3 inputs, including projections representative of a market participant's view of the expected cash payment associated with the first potential regulatory approval of a Prevail compound in the applicable countries based on probabilities of technical success, timing of the potential approval events for the compounds, and an estimated discount rate. See Note 3 for additional information related to the CVR arrangement.\nThe table below summarizes the contractual maturities of our investments in debt securities measured at fair value as of September 30, 2022:\n| Maturities by Period |\n| Total | Less Than1 Year | 1-5Years | 6-10Years | More Than10 Years |\n| Fair value of debt securities | $ | 622.2 | $ | 97.7 | $ | 197.8 | $ | 121.0 | $ | 205.7 |\n\nThe net gains (losses) recognized in our consolidated condensed statements of operations for equity securities were $( 123.3 ) million and $( 667.6 ) million for the three and nine months ended September 30, 2022, respectively, and $( 246.8 ) million and $ 270.1 million for the three and nine months ended September 30, 2021, respectively. The net gains (losses) recognized for the three and nine months ended September 30, 2022 and 2021 on equity securities sold during the respective periods were not material.\nWe adjust our equity investments without readily determinable fair values based upon changes in the equity instruments' values resulting from observable price changes in orderly transactions for an identical or similar investment of the same issuer. Downward adjustments resulting from an impairment are recorded based upon impairment considerations, including the financial condition and near term prospects of the issuer, general market conditions, and industry specific factors. Adjustments recorded for the three and nine months ended September 30, 2022 and 2021 were not material.\nA summary of the amount of unrealized gains and losses in accumulated other comprehensive loss and the fair value of available-for-sale securities in an unrealized gain or loss position follows:\n| September 30, 2022 | December 31, 2021 |\n| Unrealized gross gains | $ | 0.1 | $ | 9.7 |\n| Unrealized gross losses | 51.6 | 5.2 |\n| Fair value of securities in an unrealized gain position | 13.8 | 250.7 |\n| Fair value of securities in an unrealized loss position | 578.8 | 290.2 |\n\nWe periodically assess our investment in available-for-sale securities for impairment losses and credit losses. The amount of credit losses are determined by comparing the difference between the present value of future cash flows expected to be collected on these securities and the amortized cost. Factors considered in assessing credit losses include the position in the capital structure, vintage and amount of collateral, delinquency rates, current credit support, and geographic concentration. Impairment and credit losses related to available-for-sale securities were not material for the three and nine months ended September 30, 2022 and 2021.\n27\nAs of September 30, 2022, the available-for-sale securities in an unrealized loss position include primarily fixed-rate debt securities of varying maturities, which are sensitive to changes in the yield curve and other market conditions. Approximately 95 percent of the fixed-rate debt securities in a loss position are investment-grade debt securities. As of September 30, 2022, we do not intend to sell, and it is not more likely than not that we will be required to sell, the securities in a loss position before the market values recover or the underlying cash flows have been received, and there is no indication of a material default on interest or principal payments for our debt securities.\nActivity related to our available-for-sale securities was as follows:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Proceeds from sales | $ | 50.5 | $ | 49.6 | $ | 115.6 | $ | 137.3 |\n| Realized gross gains on sales | — | 0.4 | 0.2 | 2.2 |\n| Realized gross losses on sales | 7.5 | 0.3 | 9.0 | 1.1 |\n\nRealized gains and losses on sales of available-for-sale investments are computed based upon specific identification of the initial cost adjusted for any other-than-temporary declines in fair value that were recorded in earnings.\nAccounts Receivable Factoring Arrangements\nWe have entered into accounts receivable factoring agreements with financial institutions to sell certain of our non-U.S. accounts receivable. These transactions are accounted for as sales and result in a reduction in accounts receivable because the agreements transfer effective control over, and risk related to, the receivables to the buyers. Our factoring agreements do not allow for recourse in the event of uncollectibility, and we do not retain any interest in the underlying accounts receivable once sold. We derecognized $ 356.8 million and $ 550.5 million of accounts receivable as of September 30, 2022 and December 31, 2021, respectively, under these factoring arrangements. The costs of factoring such accounts receivable on our consolidated condensed results of operations for the three and nine months ended September 30, 2022 and 2021 were not material.\nNote 7: Income Taxes\nThe effective tax rates were 7.3 percent and 8.6 percent for the three and nine months ended September 30, 2022, respectively, reflecting the favorable tax impact of the implementation of a provision in the Tax Cuts and Jobs Act (2017 Tax Act) that requires capitalization and amortization of research and development expenses for tax purposes starting in 2022, net investment losses on equity securities, and an intangible asset impairment charge. We expect our effective tax rate to be approximately 13 percent to 14 percent for 2022 if the capitalization and amortization of research and development expenses provision of the 2017 Tax Act is deferred or repealed by the U.S. Congress effective for 2022.\nThe effective tax rate was 10.9 percent for the three months ended September 30, 2021, reflecting the favorable tax impact of a debt extinguishment loss and of net investment losses on equity securities, partially offset by a net discrete tax detriment. The effective tax rate was 10.7 percent for the nine months ended September 30, 2021, reflecting the favorable tax impact of a net discrete tax benefit, a debt extinguishment loss, and a net inventory impairment charge related to our COVID-19 antibodies.\nThe U.S. examination of tax years 2016-2018 began in the fourth quarter of 2019 and remains ongoing. The resolution of this audit period will likely extend beyond the next 12 months.\n28\nNote 8: Retirement Benefits\nNet pension and retiree health benefit (income) cost included the following components:\n| Defined Benefit Pension Plans |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Components of net periodic benefit cost: |\n| Service cost | $ | 87.1 | $ | 92.5 | $ | 264.4 | $ | 277.8 |\n| Interest cost | 98.9 | 84.5 | 299.0 | 253.6 |\n| Expected return on plan assets | ( 235.1 ) | ( 237.5 ) | ( 711.6 ) | ( 712.7 ) |\n| Amortization of prior service cost | 0.6 | 1.0 | 1.9 | 3.2 |\n| Recognized actuarial loss | 85.3 | 121.9 | 256.8 | 366.3 |\n| Net periodic benefit cost | $ | 36.8 | $ | 62.4 | $ | 110.5 | $ | 188.2 |\n\n| Retiree Health Benefit Plans |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Components of net periodic benefit income: |\n| Service cost | $ | 11.7 | $ | 12.4 | $ | 35.0 | $ | 37.0 |\n| Interest cost | 9.4 | 8.1 | 28.4 | 24.4 |\n| Expected return on plan assets | ( 38.0 ) | ( 36.5 ) | ( 114.1 ) | ( 109.6 ) |\n| Amortization of prior service benefit | ( 13.7 ) | ( 14.9 ) | ( 41.1 ) | ( 44.7 ) |\n| Recognized actuarial loss | 0.2 | 0.8 | 0.7 | 2.4 |\n| Net periodic benefit income | $ | ( 30.4 ) | $ | ( 30.1 ) | $ | ( 91.1 ) | $ | ( 90.5 ) |\n\nNote 9: Contingencies\nWe are involved in various lawsuits, claims, government investigations and other legal proceedings that arise in the ordinary course of business. These claims or proceedings can involve various types of parties, including governments, competitors, customers, suppliers, service providers, licensees, employees, or shareholders, among others. These matters may involve patent infringement, antitrust, securities, pricing, sales and marketing practices, environmental, commercial, contractual rights, licensing obligations, health and safety matters, consumer fraud, employment matters, product liability and insurance coverage, among others. The resolution of these matters often develops over a long period of time and expectations can change as a result of new findings, rulings, appeals or settlement arrangements. Legal proceedings that are significant or that we believe could become significant or material are described below.\nWe believe the legal proceedings in which we are named as defendants are without merit and we are defending against them vigorously. It is not possible to determine the final outcome of these matters, and we cannot reasonably estimate the maximum potential exposure or the range of possible loss in excess of amounts accrued for any of these matters; however, we believe that the resolution of all such matters will not have a material adverse effect on our consolidated financial position or liquidity, but could possibly be material to our consolidated results of operations in any one accounting period.\nLitigation accruals, environmental liabilities, and the related estimated insurance recoverables are reflected on a gross basis as liabilities and assets, respectively, on our consolidated condensed balance sheets. With respect to the product liability claims currently asserted against us, we have accrued for our estimated exposures to the extent they are both probable and reasonably estimable based on the information available to us. We accrue for certain product liability claims incurred but not filed to the extent we can formulate a reasonable estimate of their costs. We estimate these expenses based primarily on historical claims experience and data regarding product usage. Legal defense costs expected to be incurred in connection with significant product liability loss contingencies are accrued when both probable and reasonably estimable.\nBecause of the nature of pharmaceutical products, it is possible that we could become subject to large numbers of additional product liability and related claims in the future. Due to a very restrictive market for litigation liability insurance, we are self-insured for litigation liability losses for all our currently and previously marketed products.\n29\nPatent Litigation\nAlimta European Patent Litigation\nIn Europe, Alimta (pemetrexed) was protected by a patent through June 2021. A number of legal proceedings that were initiated prior to patent expiration are ongoing.\nEmgality Patent Litigation\nWe are a named defendant in litigation filed by Teva Pharmaceuticals International GMBH and Teva Pharmaceuticals USA, Inc. (collectively, Teva) in the U.S. District Court for the District of Massachusetts seeking a ruling that various claims in three different Teva patents would be infringed by our launch and continued sales of Emgality for the prevention of migraine in adults. Trial began in October 2022. In June 2021, we were named as a defendant in a second litigation filed by Teva in the U.S. District Court for the District of Massachusetts seeking a ruling that two of Teva's patents, which are directed toward use of the active ingredient in Emgality to treat migraine, would be infringed by our continued sales of Emgality. We challenged these two patents by filing requests for Inter Partes Review with the Patent Trial and Appeal Board (PTAB) and in October 2022, the PTAB granted our requests.The corresponding district court litigation is stayed while this PTAB proceeding is ongoing.\nJardiance Patent Litigation\nIn November 2018, Boehringer Ingelheim, our partner in marketing and development of Jardiance, initiated U.S. patent litigation in the U.S. District Court of Delaware alleging infringement arising from submissions of Abbreviated New Drug Applications (ANDA) by a number of generic companies seeking approval to market generic versions of Jardiance, Glyxambi, and Synjardy in accordance with the procedures set out in the Drug Price Competition and Patent Term Restoration Act of 1984 (the Hatch-Waxman Act). Particularly with respect to Jardiance, the generic companies' ANDAs seek approval to market generic versions of Jardiance prior to the expiration of the relevant patents, and allege that certain patents, including in some allegations the compound patent, are invalid or would not be infringed. We are not a party to this litigation. This litigation has been stayed.\nTaltz Patent Litigation\nIn April 2021, we petitioned the High Court of Ireland to declare invalid a patent that Novartis Pharma AG (Novartis) purchased from Genentech, Inc. in 2020. Novartis responded by filing a claim against us alleging patent infringement related to our commercialization of Taltz and seeking damages for past infringement and an injunction against future infringement.\nIn April 2021, Novartis petitioned the Court of Rome Intellectual Property Division for a preliminary injunction (PI) against us related to our commercialization of Taltz in Italy. In May 2021, We commenced patent revocation proceedings against Novartis before the Court of Milan’s IP Division where we also sought a declaration of non-infringement. Novartis counter-claimed for patent infringement and sought a permanent injunction. A hearing on the PI request before the Court of Rome Intellectual Property Division took place in May 2022 and in July 2022, the court rejected Novartis' request.\nIn November 2021, Novartis petitioned the Swiss Federal Patent Court for a PI and a permanent injunction in main infringement proceedings against us related to our commercialization of Taltz in Switzerland. We petitioned the court to revoke the patent and for a declaration of non-infringement. In April 2022, Novartis withdrew its PI request.\nIn January 2022, we commenced an action in the Hague District Court asking for a judgment that a Novartis Dutch patent is not infringed by our commercialization of Taltz in the Netherlands and is invalid. In October 2022, Novartis filed a counterclaim for infringement and sought a permanent injunction.\nIn October 2022, we entered into a settlement and mutual release agreement with Novartis, which resolves the above-described disputes. Without any admission of liability or wrongdoing, we and Novartis have agreed to mutual releases for past claims and mutual covenants not to sue the other in relation to Taltz and the patents Novartis purchased from Genentech.\n30\nZyprexa Canada Patent Litigation\nBeginning in the mid-2000s, several generic companies in Canada challenged the validity of our Zyprexa compound patent. In 2012, the Canadian Federal Court of Appeals denied our appeal of a lower court's decision that certain patent claims were invalid for lack of utility. In 2013, Apotex Inc. and Apotex Pharmachem Inc. (collectively, Apotex) brought claims against us in the Ontario Superior Court of Justice at Toronto for damages related to our enforcement of the Zyprexa compound patent under Canadian regulations governing patented drugs. Apotex seeks compensation based on novel legal theories under the Statute of Monopolies, Trademark Act, and common law. In March 2021, the Ontario Superior Court granted our motion for summary judgment, thereby dismissing Apotex's case. Apotex appealed that ruling to the Court of Appeal for Ontario in April 2021. In August 2022, the Court dismissed the appeal and in October 2022, Apotex appealed the decision. This matter is ongoing.\nProduct Liability Litigation\nByetta® Product Liability\nWe have been named as a defendant in over 500 Byetta product liability lawsuits in the U.S. that were first initiated in March 2009 and involved over 800 plaintiffs. These lawsuits have been filed in various state and federal jurisdictions, including California state court (coordinated in Los Angeles County Superior Court), and various federal courts, the majority of which are coordinated in a multi-district litigation (MDL) in the U.S. District Court for the Southern District of California. The majority of these suits contain allegations that Byetta caused or contributed to the plaintiffs' cancer (primarily pancreatic cancer or thyroid cancer). The federal MDL and coordinated California state trial courts granted summary judgment in our favor on claims pertaining to pancreatic cancer, and the plaintiffs have dismissed Lilly from their appeal of the MDL ruling (the parties still await the order of judgment in the Los Angeles County Superior Court). Most of the MDL and state court lawsuits have been dismissed as of November 2022.\nEnvironmental Proceedings\nUnder the Comprehensive Environmental Response, Compensation, and Liability Act, commonly known as \"Superfund,\" we have been designated as one of several potentially responsible parties with respect to the cleanup of fewer than 10 sites. Under Superfund, each responsible party may be jointly and severally liable for the entire amount of the cleanup.\nOther Matters\n340B Litigation and Investigations\nWe are the plaintiff in a lawsuit filed in January 2021 in the U.S. District Court for the Southern District of Indiana against the U.S. Department of Health and Human Services (HHS), the Secretary of HHS, the Health Resources and Services Administration (HRSA), and the Administrator of HRSA. The lawsuit challenges the HHS's December 30, 2020 advisory opinion stating that drug manufacturers are required to deliver discounts under the 340B program to all contract pharmacies. We seek a declaratory judgment that the defendants violated the Administrative Procedures Act and the U.S. Constitution, a preliminary injunction enjoining implementation of the administrative dispute resolution process created by defendants and, with it, their application of the advisory opinion, and other related relief. In March 2021, the court entered an order preliminarily enjoining the government's enforcement of the administrative dispute resolution process against us. In May 2021, HRSA notified us that it determined that our policy was contrary to the 340B statute. In response, in May 2021, we filed a motion for preliminary injunction and temporary restraining order requesting that the U.S. District Court for the Southern District of Indiana enjoin defendants from taking any action against us relating to the 340B drug pricing program until after the court issues a final judgment on the aforementioned litigation. In May 2021, the court denied our motion for a temporary restraining order but deferred resolution of our motion for preliminary injunction. In June 2021, the defendants withdrew the HHS December 30, 2020 advisory opinion. In July 2021, the court held oral argument on the parties' cross motions for summary judgment, the defendants' motion to dismiss, and our motion for preliminary injunction related to HRSA's May 2021 enforcement letter. In October 2021, the court denied the defendants' motion to dismiss, and granted in part and denied in part the parties' cross motions for summary judgment. Both parties filed notices of appeal related to the court's summary judgment order. Oral argument took place in October 2022 in the U.S. Court of Appeals for the Seventh Circuit. This matter is ongoing.\nIn January 2021, we, along with other pharmaceutical manufacturers, were named as a defendant in a petition currently pending before the HHS Administrative Dispute Resolution Panel. Petitioner seeks declaratory and other injunctive relief related to the 340B program. As described above, the U.S. District Court for the Southern District of Indiana has entered a preliminary injunction enjoining the government's enforcement of this administrative dispute resolution process against us.\n31\nIn July 2021, we, along with Sanofi-Aventis U.S., LLC (Sanofi), Novo Nordisk Inc. (Novo Nordisk), and AstraZeneca Pharmaceuticals LP, were named as a defendant in a purported class action lawsuit filed in the U.S. District Court for the Western District of New York by Mosaic Health, Inc. alleging antitrust and unjust enrichment claims related to the defendants' 340B distribution programs. We, with Sanofi and Novo Nordisk, filed a motion to dismiss the lawsuit, which was granted in September 2022. In October 2022, the plaintiffs filed a motion for leave to amend their complaint. This matter is ongoing.\nWe received a civil investigative subpoena in February 2021 from the Office of the Attorney General for the State of Vermont relating to the sale of pharmaceutical products to Vermont covered entities under the 340B program. We are cooperating with this subpoena.\nBranchburg Manufacturing Facility\nIn May 2021, we received a subpoena from the U.S. Department of Justice requesting the production of certain documents relating to our manufacturing site in Branchburg, New Jersey. We are cooperating with the subpoena.\nBrazil Litigation – Cosmopolis Facility\nLabor Attorney Litigation\nFirst initiated in 2008, our subsidiary in Brazil, Eli Lilly do Brasil Limitada (Lilly Brasil), is named in a Public Civil Action brought by the Labor Public Attorney (LPA) for the 15th Region in the Labor Court of Paulinia, State of Sao Paulo, Brazil, (the Labor Court) alleging possible harm to employees and former employees caused by alleged exposure to soil and groundwater contaminants at a former Lilly Brasil manufacturing facility in Cosmopolis, Brazil, operated by the company between 1977 and 2003. In May 2014, the Labor Court judge ruled against Lilly Brasil, ordering it to undertake several remedial and compensatory actions including health coverage for a class of individuals and certain of their children. In July 2018, the appeals court (TRT) generally affirmed our appeal of the Labor Court's ruling, which included a liquidated award of 300 million Brazilian real, which, when adjusted for inflation and the addition of pre and post judgment interest using the current Central Bank of Brazil's special system of clearance and custody rate, is approximately one billion Brazilian real (approximately $ 185 million as of September 30, 2022). In August 2019, Lilly Brasil filed an appeal to the superior labor court (TST) and in June 2021, the TRT published its decision on the admissibility of Lilly Brasil's appeal, allowing the majority of the elements, which were allowed to proceed in June 2021; elements not proceeding are subject to an interlocutory appeal to the TST that was filed in June 2021. In September 2019, the TRT stayed a number of elements of its trial court decision pending the determination of Lilly Brasil's appeal to the TST.\nIn June 2019 and September 2020, the LPA filed applications in the Labor Court for enforcement of certain remedies granted by the TRT in its July 2018 decision, requested restrictions on Lilly Brasil’s assets in Brazil, and required Lilly Brasil and Antibióticos do Brasil Ltda. (ABL) to submit a list of potential beneficiaries of the Public Civil Action. In July 2019, the Labor Court issued a ruling requiring a freeze of Lilly Brasil’s immovable property or, alternatively, a security deposit or lien of 500 million Brazilian real, which ruling was subsequently limited in scope and the security was reduced to 100 million Brazilian real. ABL and LPA appealed the June 2021 Labor Court ruling to the TST, which appeal is under review. The Labor Court is currently assessing the status of Lilly Brasil’s and ABL’s compliance with such portion of the July 2018 TRT decision and an inspection in the industrial plant is expected. These matters are ongoing.\nIndividual Former Employee Litigation\nLilly Brasil is also named in over 20 pending lawsuits filed in the Labor Court by individual former employees making similar claims. These individual lawsuits are at various stages in the litigation process.\nPuerto Rico Tax Matter\nIn May 2013, the Municipality of Carolina in Puerto Rico (Municipality) filed a lawsuit against us alleging noncompliance with respect to a contract with the Municipality and seeking a declaratory judgment. In December 2020, the Puerto Rico Appellate Court (AP) reversed the summary judgment previously granted by the Court of First Instance (CFI) in our favor, dismissing the Municipality's complaint in its entirety. The AP remanded the case to the CFI for trial on the merits. The trial began in May 2022; however, the Municipality filed a new motion requesting the CFI to award damages. The request was denied by the CFI in our favor and the Municipality filed for revision at the AP, which we opposed, staying the case. This matter is ongoing.\n32\nEastern District of Pennsylvania Pricing (Average Manufacturer Price) Inquiry\nIn November 2014, we, along with another pharmaceutical manufacturer, were named as co-defendants in United States et al. ex rel. Streck v. Takeda Pharm. Am., Inc., et al., which was filed in November 2014 and unsealed in the U.S. District Court for the Northern District of Illinois. The complaint alleges that the defendants should have treated certain credits from distributors as retroactive price increases and included such increases in calculating average manufacturer prices. Following a trial in August 2022, the jury returned a verdict in favor of the plaintiff. The case is proceeding with post-trial motions after which the court will enter final judgment in the case. This matter is ongoing.\nHealth Choice Alliance\nWe are named as a defendant in two lawsuits filed in Texas and New Jersey state courts in October 2019 seeking damages under the Texas Medicaid Fraud Prevention Act and New Jersey Medicaid False Claims Act, respectively, for certain patient support programs related to our products Humalog, Humulin, and Forteo. The Texas state court action has been stayed. The New Jersey state court action was dismissed with prejudice pending an ongoing appeal before the Appellate Division of the New Jersey Superior Court. This matter is ongoing.\nPricing Litigation\nIn December 2017 and February 2018, we, along with Sanofi and Novo Nordisk, were named as defendants in a consolidated purported class action lawsuit, In re. Insulin Pricing Litigation and in MSP Recovery Claims, Series, LLC et al. v. Sanofi Aventis U.S. LLC et al., both filed in the U.S. District Court for the District of New Jersey. The cases relate to insulin pricing and seek damages or other relief under various theories, including state consumer protection laws, common law fraud, unjust enrichment, and the Federal Racketeer Influenced and Corrupt Organization Act (federal RICO Act). In both cases, the court dismissed claims under the federal RICO Act and certain state laws. In April 2021, the plaintiffs in In re. Insulin Pricing Litigation amended their complaint to allege additional state law claims for civil conspiracy and violations of state RICO statutes. The court allowed the Arizona RICO statute and certain state civil conspiracy law claims to proceed. Additionally in 2020, we, along with Sanofi, Novo Nordisk, CVS, Express Scripts, and Optum, have been sued in a putative class action, FWK Holdings, LLC v. Novo Nordisk Inc., et al., filed in the same court, for alleged violations of the federal RICO Act as well as the New Jersey RICO Act and antitrust law. The same group of defendants, along with Medco Health and United Health Group, also have been sued in other purported class actions in the same court, Rochester Drug Co-Operative Inc. v. Eli Lilly & Co. et al. and Value Drug Co. v. Eli Lilly & Co. et al., which were both initiated in March 2020, with the plaintiffs seeking damages for alleged violations of the federal RICO Act. In September 2020, the U.S. District Court for the District of New Jersey granted plaintiffs' motion to consolidate FWK Holdings, LLC v. Novo Nordisk Inc., et al., Rochester Drug Co-Operative Inc. v. Eli Lilly & Co. et al., and Value Drug Co. v. Eli Lilly & Co. et al. In July 2021, the U.S. District Court for the District of New Jersey dismissed the three antitrust claims alleged by plaintiffs in the consolidated litigation and denied dismissal of the federal RICO Act claims.\nIn October 2018, the Minnesota Attorney General's Office initiated litigation against us, Sanofi, and Novo Nordisk, State of Minnesota v. Sanofi-Aventis U.S. LLC et al., in the U.S. District Court for the District of New Jersey, seeking damages for unjust enrichment, violations of various Minnesota state consumer protection laws, and the federal RICO Act. In March 2021, the U.S. District Court for the District of New Jersey dismissed with prejudice the Minnesota Attorney General's federal RICO claims and false advertising claims under state law; the consumer fraud and other related state law claims remain ongoing. Additionally, in May 2019, the Kentucky Attorney General's Office filed a complaint against us, Sanofi, and Novo Nordisk, Commonwealth of Kentucky v. Novo Nordisk, Inc. et al., in Kentucky state court, alleging violations of the Kentucky consumer protection law, false advertising, and unjust enrichment.\nIn June 2021, the Mississippi Attorney General's Office initiated litigation against us, Sanofi, Novo Nordisk, Evernorth/ESI, CVS/Caremark, and United/Optum in the Hinds County, Mississippi Chancery Court, alleging state law consumer protection, unjust enrichment, and civil conspiracy claims. After the case was removed to federal court, we, along with the other defendants, filed a motion to dismiss the lawsuit, which was denied. This matter is ongoing.\nIn May 2022, the state of Arkansas filed suit against us Sanofi, Novo Nordisk, ESI, CVS/Caremark/Aetna, and Optum, asserting state law consumer protection, civil conspiracy, and unjust enrichment claims. The case has been removed to federal court and is ongoing.\nIn September 2022, the County of Albany, New York filed a suit against us, Sanofi, Novo Nordisk, Evernorth/ESI, CVS/Caremark and United/Optum asserting violations of federal RICO statute and state law claims for deceptive trade practices, unjust enrichment, and civil conspiracy. This matter is ongoing.\n33\nIn September 2022, the State of Montana filed a suit against us, Sanofi, Novo Nordisk, Evernorth/ESI, Medco Health Solutions, CVS/Caremark and Optum asserting violations of the Montana Unfair Practices and Consumer Protection Act, unjust enrichment, and civil conspiracy. This matter is ongoing.\nInvestigations, Subpoenas, and Inquiries\nIn connection with the pricing and sale of our insulin and other products, we have been subject to various investigations and received subpoenas, civil investigative demand requests, information requests, interrogatories, and other inquiries from various governmental entities. These include subpoenas from the New York and Vermont Attorney General Offices, civil investigative demands from the Washington, New Mexico, Colorado, Illinois, Ohio Attorney General Offices, the Department of Justice and the Federal Trade Commission, as well as information requests from the Mississippi, Washington D.C., California, Florida, Hawaii, and Nevada Attorney General Offices. In January 2022, the Michigan Attorney General filed a petition in Michigan state court seeking authorization to investigate Lilly for potential violations of the Michigan Consumer Protection Act (MCPA), and a complaint seeking a declaratory judgment that the Attorney General has authority to investigate Lilly's sale of insulin under the MCPA. The court authorized the proposed investigation and the issuance of civil investigative subpoenas. In April 2022, the parties entered into a stipulation providing that the State will not issue any civil investigative subpoena to us under the MCPA until the declaratory judgment action is resolved. In July 2022, the court dismissed the case in its entirety. The Michigan Attorney General filed a notice of appeal and an application to obtain review by the Michigan Supreme Court, which remain pending.\nWe received a request in January 2019 from the House of Representatives' Committee on Oversight and Reform seeking commercial information and business records related to the pricing of insulin products, among other issues. We also received similar requests from the Senate Finance Committee and the Senate Committee on Health, Education, Labor, and Pensions, and separate requests from the House Committee on Energy and Commerce majority and minority members. In January 2021, the Senate Finance Committee released a report summarizing the findings of its investigation. In December 2021 the House of Representatives' Committee on Oversight and Reform majority and minority staffs released separate reports with findings from their investigations into drug pricing, including of insulin products.\nWe are cooperating with all of the aforementioned investigations, subpoenas, and inquiries.\nResearch Corporation Technologies, Inc.\nIn April 2016, we were named as a defendant in litigation filed by Research Corporation Technologies, Inc. (RCT) in the U.S. District Court for the District of Arizona. RCT is seeking damages for breach of contract, unjust enrichment, and conversion related to processes used to manufacture certain products, including Humalog and Humulin. In October 2021, the court issued a summary judgment decision finding in favor of RCT on certain issues, including with respect to a disputed royalty. Both parties filed motions for reconsideration, which were denied. We filed supplemental summary judgment motions. A trial date has not been set. Potential damages payable under the litigation, if finally awarded after an appeal, could be material but are not currently reasonably estimable. This matter is ongoing.\n34\nNote 10: Other Comprehensive Income (Loss)\nThe following tables summarize the activity related to each component of other comprehensive income (loss) during the three months ended September 30, 2022 and 2021:\n| (Amounts presented net of taxes) | Foreign Currency Translation Gains (Losses) | Unrealized Net Gains (Losses) on Securities | Defined Benefit Pension and Retiree Health Benefit Plans | Effective Portion of Cash Flow Hedges | Accumulated Other Comprehensive Loss |\n| Balance at July 1, 2022 | $ | ( 1,844.2 ) | $ | ( 27.9 ) | $ | ( 2,443.2 ) | $ | 27.6 | $ | ( 4,287.7 ) |\n| Other comprehensive income (loss) before reclassifications | ( 165.1 ) | ( 24.9 ) | 47.8 | 63.0 | ( 79.2 ) |\n| Net amount reclassified from accumulated other comprehensive loss | — | 13.5 | 57.2 | 0.4 | 71.1 |\n| Net other comprehensive income (loss) | ( 165.1 ) | ( 11.4 ) | 105.0 | 63.4 | ( 8.1 ) |\n| Balance at September 30, 2022 | $ | ( 2,009.3 ) | $ | ( 39.3 ) | $ | ( 2,338.2 ) | $ | 91.0 | $ | ( 4,295.8 ) |\n\n| (Amounts presented net of taxes) | Foreign Currency Translation Gains (Losses) | Unrealized Net Gains (Losses) on Securities | Defined Benefit Pension and Retiree Health Benefit Plans | Effective Portion of Cash Flow Hedges | Accumulated Other Comprehensive Loss |\n| Balance at July 1, 2021 | $ | ( 1,516.2 ) | $ | 9.1 | $ | ( 4,569.9 ) | $ | ( 210.1 ) | $ | ( 6,287.1 ) |\n| Other comprehensive income (loss) before reclassifications | ( 8.0 ) | ( 2.4 ) | 18.6 | 16.8 | 25.0 |\n| Net amount reclassified from accumulated other comprehensive loss | — | 0.1 | 86.0 | 3.3 | 89.4 |\n| Net other comprehensive income (loss) | ( 8.0 ) | ( 2.3 ) | 104.6 | 20.1 | 114.4 |\n| Balance at September 30, 2021 | $ | ( 1,524.2 ) | $ | 6.8 | $ | ( 4,465.3 ) | $ | ( 190.0 ) | $ | ( 6,172.7 ) |\n\nThe following tables summarize the activity related to each component of other comprehensive income (loss) during the nine months ended September 30, 2022 and 2021:\n| (Amounts presented net of taxes) | Foreign Currency Translation Gains (Losses) | Unrealized Net Gains (Losses) on Securities | Defined Benefit Pension and Retiree Health Benefit Plans | Effective Portion of Cash Flow Hedges | Accumulated Other Comprehensive Loss |\n| Balance at January 1, 2022 | $ | ( 1,550.2 ) | $ | 3.7 | $ | ( 2,583.6 ) | $ | ( 213.0 ) | $ | ( 4,343.1 ) |\n| Other comprehensive income (loss) before reclassifications | ( 459.7 ) | ( 55.5 ) | 72.9 | 297.2 | ( 145.1 ) |\n| Net amount reclassified from accumulated other comprehensive loss | 0.6 | 12.5 | 172.5 | 6.8 | 192.4 |\n| Net other comprehensive income (loss) | ( 459.1 ) | ( 43.0 ) | 245.4 | 304.0 | 47.3 |\n| Balance at September 30, 2022 | $ | ( 2,009.3 ) | $ | ( 39.3 ) | $ | ( 2,338.2 ) | $ | 91.0 | $ | ( 4,295.8 ) |\n\n| (Amounts presented net of taxes) | Foreign Currency Translation Gains (Losses) | Unrealized Net Gains (Losses) on Securities | Defined Benefit Pension and Retiree Health Benefit Plans | Effective Portion of Cash Flow Hedges | Accumulated Other Comprehensive Loss |\n| Balance at January 1, 2021 | $ | ( 1,427.5 ) | $ | 14.8 | $ | ( 4,751.0 ) | $ | ( 332.7 ) | $ | ( 6,496.4 ) |\n| Other comprehensive income (loss) before reclassifications | ( 96.7 ) | ( 8.8 ) | 27.2 | 132.8 | 54.5 |\n| Net amount reclassified from accumulated other comprehensive loss | — | 0.8 | 258.5 | 9.9 | 269.2 |\n| Net other comprehensive income (loss) | ( 96.7 ) | ( 8.0 ) | 285.7 | 142.7 | 323.7 |\n| Balance at September 30, 2021 | $ | ( 1,524.2 ) | $ | 6.8 | $ | ( 4,465.3 ) | $ | ( 190.0 ) | $ | ( 6,172.7 ) |\n\n35\nThe tax effects on the net activity related to each component of other comprehensive income (loss) were as follows:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| Tax benefit (expense) | 2022 | 2021 | 2022 | 2021 |\n| Foreign currency translation gains/losses | $ | ( 133.3 ) | $ | ( 39.0 ) | $ | ( 234.2 ) | $ | ( 92.3 ) |\n| Unrealized net gains/losses on securities | 3.4 | 0.8 | 13.1 | 3.8 |\n| Defined benefit pension and retiree health benefit plans | ( 22.4 ) | ( 28.2 ) | ( 73.2 ) | ( 79.7 ) |\n| Effective portion of cash flow hedges | ( 16.9 ) | ( 5.4 ) | ( 80.8 ) | ( 37.9 ) |\n| Benefit (expense) for income taxes allocated to other comprehensive income (loss) items | $ | ( 169.2 ) | $ | ( 71.8 ) | $ | ( 375.1 ) | $ | ( 206.1 ) |\n\nExcept for the tax effects of foreign currency translation gains and losses related to our foreign currency-denominated notes, cross-currency interest rate swaps, and other foreign currency exchange contracts designated as net investment hedges (see Note 6), income taxes were not provided for foreign currency translation. Generally, the assets and liabilities of foreign operations are translated into U.S. dollars using the current exchange rate. For those operations, changes in exchange rates generally do not affect cash flows; therefore, resulting translation adjustments are made in shareholders' equity rather than in the consolidated condensed statements of operations.\nReclassifications out of accumulated other comprehensive loss were as follows:\n| Details about Accumulated Other Comprehensive Loss Components | Three Months Ended September 30, | Nine Months Ended September 30, | Affected Line Item in the Consolidated Condensed Statements of Operations |\n| 2022 | 2021 | 2022 | 2021 |\n| Amortization of retirement benefit items: |\n| Prior service benefits, net | $ | ( 13.1 ) | $ | ( 13.9 ) | $ | ( 39.2 ) | $ | ( 41.5 ) | Other–net, (income) expense |\n| Actuarial losses, net | 85.5 | 122.7 | 257.5 | 368.7 | Other–net, (income) expense |\n| Total before tax | 72.4 | 108.8 | 218.3 | 327.2 |\n| Tax benefit | ( 15.2 ) | ( 22.8 ) | ( 45.8 ) | ( 68.7 ) | Income taxes |\n| Net of tax | 57.2 | 86.0 | 172.5 | 258.5 |\n| Other, net of tax | 13.9 | 3.4 | 19.9 | 10.7 | Other–net, (income) expense |\n| Total reclassifications, net of tax | $ | 71.1 | $ | 89.4 | $ | 192.4 | $ | 269.2 |\n\nNote 11: Other–Net, (Income) Expense\nOther–net, (income) expense consisted of the following:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Interest expense | $ | 81.5 | $ | 83.6 | $ | 247.6 | $ | 258.4 |\n| Interest income | ( 20.1 ) | ( 7.0 ) | ( 37.3 ) | ( 18.0 ) |\n| Net investment (gains) losses on equity securities (Note 6) | 123.3 | 246.8 | 667.6 | ( 270.1 ) |\n| Retirement benefit plans | ( 92.4 ) | ( 72.6 ) | ( 280.0 ) | ( 217.1 ) |\n| Debt extinguishment loss (Note 6) | — | 405.2 | — | 405.2 |\n| Other (income) expense | 18.7 | ( 20.1 ) | ( 17.0 ) | ( 34.1 ) |\n| Other–net, (income) expense | $ | 111.0 | $ | 635.9 | $ | 580.9 | $ | 124.3 |\n\n36\nItem 2. Management's Discussion and Analysis of Results of Operations and Financial Condition\nResults of Operations\n(Tables present dollars in millions, except per-share data)\nGeneral\nManagement's discussion and analysis of results of operations and financial condition is intended to assist the reader in understanding and assessing significant changes and trends related to the results of operations and financial position of our consolidated company. This discussion and analysis should be read in conjunction with the consolidated condensed financial statements and accompanying footnotes in Part I, Item 1 of this Quarterly Report on Form 10-Q. Certain statements in this Part I, Item 2 of this Quarterly Report on Form 10-Q constitute forward-looking statements. Various risks and uncertainties, including those discussed in \"Forward-Looking Statements\" in this Quarterly Report on Form 10-Q and \"Risk Factors\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2021, may cause our actual results, financial position, and cash generated from operations to differ materially from these forward-looking statements.\nExecutive Overview\nThis section provides an overview of our financial results, recent product and late-stage pipeline developments, and other matters affecting our company and the pharmaceutical industry. Earnings per share (EPS) data are presented on a diluted basis.\nCOVID-19 Pandemic\nIn response to the COVID-19 pandemic, we have focused on maintaining a supply of our medicines; reducing the strain on the medical system; developing treatments for COVID-19; protecting the health, safety, and well-being of our employees; supporting our communities; and ensuring affordability of and access to our medicines, particularly insulin.\nWe have received various regulatory authorizations, including Emergency Use Authorizations (EUA), for our COVID-19 therapies. We supplied the United States (U.S.) government approximately 810,000 doses of bebtelovimab during the nine months ended September 30, 2022. Beginning in the third quarter of 2022 and in collaboration with the U.S. government, we have made bebtelovimab commercially available for purchase by U.S. states/territories, hospitals, and certain other providers. We do not anticipate any further U.S. government orders. The U.S. Food and Drug Administration (FDA) has revised, and may in the future revise, any EUA for our COVID-19 therapies in response to the prevalence of variants against which our therapies have varying degrees of efficacy, including the new BQ variants. Based on early data, we do not believe that bebtelovimab will neutralize against the new BQ variants.\nThe COVID-19 pandemic has, and may continue to, adversely impact our business and operations. Strain on global transportation, logistics, manufacturing, and labor markets, including as aggravated by the pandemic and global unrest, the focus of resources on COVID-19, protective measures implemented to control the spread of COVID-19, and an increase in overall demand in our industry for certain resources and medicines, resulting in changed buying patterns, increased costs, and constrained supply, have negatively impacted and may continue to negatively impact the development, manufacturing, supply, distribution, and sales of our medicines.\nThe degree to which the COVID-19 pandemic and related challenges impact the development, manufacturing, supply, distribution, and sale of our medicines will depend on developments that are highly uncertain and beyond our knowledge or control.\n37\nProduct Supply\nContinued strong demand for Trulicity® in U.S. and international markets, partially due to the ongoing limited availability of competitor therapies, has challenged, and is expected to continue to challenge, our ability to meet demand in most international markets. In the U.S., as demand for Trulicity has continued to exceed historical levels, we anticipate tight supplies will persist until additional manufacturing capacity is operationalized, and U.S. wholesalers may experience intermittent restocking delays of Trulicity orders. Outside the U.S., we have implemented certain actions to minimize the impact to existing patients, but we expect to experience intermittent disruptions in our supply of Trulicity in international markets.\nIn addition, the uptake of Mounjaro® for type 2 diabetes following its launch in the U.S. has been very strong. We continue to carefully monitor demand, incretin competitor availability, and supply with a focus on access for Type 2 diabetes patients.\nWe anticipate that additional internal and contracted manufacturing capacity will become fully operational around the world in the next several years, with significant expansion in 2023, as part of our ongoing efforts to meet the significant demand for our incretin medicines.\nSee \"Risk Factors\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2021 for additional information on risk factors that could impact our business and operations.\nFinancial Results\nThe following table summarizes our key operating results:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | Percent Change | 2022 | 2021 | Percent Change |\n| Revenue | $ | 6,941.6 | $ | 6,772.8 | 2 | $ | 21,239.6 | $ | 20,318.5 | 5 |\n| Gross margin | 5,362.5 | 5,342.0 | — | 16,157.9 | 15,055.9 | 7 |\n| Gross margin as a percent of revenue | 77.3 | % | 78.9 | % | 76.1 | % | 74.1 | % |\n| Research and development | $ | 1,802.9 | $ | 1,705.3 | 6 | $ | 5,194.9 | $ | 5,032.4 | 3 |\n| Marketing, selling, and administrative | 1,614.2 | 1,577.9 | 2 | 4,797.2 | 4,839.6 | (1) |\n| Acquired in-process research and development (IPR&D) and development milestones | 62.4 | 177.6 | (65) | 668.4 | 532.4 | 26 |\n| Asset impairment, restructuring, and other special charges | 206.5 | — | NM | 206.5 | 211.6 | (2) |\n| Other–net, (income) expense | 111.0 | 635.9 | (83) | 580.9 | 124.3 | NM |\n| Net income | 1,451.7 | 1,110.1 | 31 | 4,307.1 | 3,855.6 | 12 |\n| EPS - diluted | 1.61 | 1.22 | 32 | 4.76 | 4.23 | 13 |\n\nNM - not meaningful\nRevenue increased for the three and nine months ended September 30, 2022, driven by increased volume, partially offset by lower realized prices and the unfavorable impact of foreign exchange rates. Research and development expenses increased for the three and nine months ended September 30, 2022, primarily driven by higher development expenses for late-stage assets, partially offset by lower development expenses for COVID-19 antibodies and the favorable impact of foreign exchange rates. Marketing, selling, and administrative expenses increased for the three months ended September 30, 2022, primarily driven by increased costs associated with the launch of Mounjaro, partially offset by the favorable impact of foreign exchange rates. Marketing, selling, and administrative expenses decreased for the nine months ended September 30, 2022, primarily driven by the favorable impact of foreign exchange rates as well as reduced marketing costs in the first half of 2022, partially offset by increased costs associated with the launch of Mounjaro.\n38\nThe following highlighted items also affect comparisons of our financial results for the three and nine months ended September 30, 2022 and 2021:\n2022\nAcquired IPR&D and Development Milestones (See Note 3 to the consolidated condensed financial statements)\n•We recognized $62.4 million and $668.4 million of acquired IPR&D and development milestones for the three and nine months ended September 30, 2022, respectively. The charges for the nine months ended September 30, 2022 included the buy-out of substantially all future obligations that were contingent upon the occurrence of certain events linked to the success of our mutant-selective PI3kα inhibitor and a purchase of a Priority Review Voucher.\nAsset Impairment, Restructuring, and Other Special Charges (See Note 5 to the consolidated condensed financial statements)\n•We recognized charges of $206.5 million for the three and nine months ended September 30, 2022, primarily related to an intangible asset impairment for GBA1 Gene Therapy (PR001) due to changes in estimated launch timing.\nOther-Net, (Income) Expense (See Note 11 to the consolidated condensed financial statements)\n•We recognized $123.3 million and $667.6 million of net investment losses on equity securities for the three and nine months ended September 30, 2022, respectively.\n2021\nCost of Sales (See Note 5 to the consolidated condensed financial statements)\n•We recognized a net inventory impairment charge related to our COVID-19 antibodies of $435.1 million for the nine months ended September 30, 2021. As part of our response to the COVID-19 pandemic, and at the request of the U.S. and international governments, we invested in large-scale manufacturing of COVID-19 antibodies at risk, in order to ensure rapid access to patients around the world. As the COVID-19 pandemic evolved during 2021, we incurred a net inventory impairment charge primarily due to the combination of changes to demand from U.S. and international governments, including changes to our agreement with the U.S. government, and near-term expiry dates of COVID-19 antibodies.\nAcquired IPR&D and Development Milestones (See Note 3 to the consolidated condensed financial statements)\n•We recognized $177.6 million and $532.4 million of acquired IPR&D and development milestones for the three and nine months ended September 30, 2021, respectively. The charges for the nine months ended September 30, 2021 included acquired IPR&D charges resulting from business development transactions with Rigel Pharmaceuticals, Inc. (Rigel) and Precision Biosciences, Inc. (Precision).\nAsset Impairment, Restructuring, and Other Special Charges (See Note 5 to the consolidated condensed financial statements)\n•We recognized charges of $211.6 million for the nine months ended September 30, 2021, primarily related to an intangible asset impairment resulting from the sale of the rights to Qbrexza®, as well as acquisition and integration costs associated with the acquisition of Prevail Therapeutics Inc. (Prevail).\nOther-Net, (Income) Expense (See Note 11 to the consolidated condensed financial statements)\n•We recognized a debt extinguishment loss of $405.2 million related to the repurchase of debt for the three and nine months ended September 30, 2021.\n•We recognized $246.8 million of net investment losses on equity securities for the three months ended September 30, 2021. We recognized $270.1 million of net investment gains on equity securities for the nine months ended September 30, 2021.\n39\nLate-Stage Pipeline\nOur long-term success depends on our ability to continually discover or acquire, develop, and commercialize innovative new medicines. We currently have approximately 45 new medicine candidates in clinical development or under regulatory review, and a larger number of projects in the discovery phase.\nThe following certain new molecular entities (NMEs) are currently in Phase II or Phase III clinical trials or have been submitted for regulatory review or have received regulatory approval in the U.S., Europe, or Japan. The following table reflects the status of these NMEs, including certain other developments since our Annual Report on Form 10-K for the year ended December 31, 2021.\n| Compound | Indication | Status | Developments |\n| Diabetes |\n| Tirzepatide (Mounjaro) | Type 2 diabetes | Approved | Approved in the U.S. in the second quarter of 2022 and in Europe and Japan in the third quarter of 2022. |\n| Heart failure with preserved ejection fraction | Phase III | Phase III trials are ongoing. |\n| Obesity | Phase III | Granted FDA Fast Track designation(1) in October 2022. Announced in the second quarter of 2022 that the initial Phase III trial met co-primary and all key secondary endpoints. Phase III trials are ongoing. |\n| Obstructive sleep apnea | Phase III | Phase III trial initiated in the third quarter of 2022. |\n| Nonalcoholic steatohepatitis | Phase II | Phase II trial is ongoing. |\n| Basal Insulin-Fc | Type 1 and 2 diabetes | Phase III | Phase III trials initiated in the first, second, and third quarters of 2022. |\n| Orforglipron (GLP-1R NPA) | Obesity | Phase II | Phase II trials are ongoing. |\n| Type 2 diabetes |\n| Retatrutide (GGG Tri-Agonist) | Obesity | Phase II | Phase II trials are ongoing. |\n| Type 2 diabetes |\n| Immunology |\n| Lebrikizumab(2) | Atopic dermatitis | Submitted | Granted FDA Fast Track designation(1). Submitted in the U.S. in the third quarter of 2022 and in Europe in October 2022. Phase III trials are ongoing. |\n| Mirikizumab | Ulcerative colitis | Submitted | Submitted in the U.S. in first quarter of 2022 and in Europe and Japan in the second quarter of 2022. |\n| Crohn's Disease | Phase III | Phase III trials are ongoing. |\n| ANGPTL3 siRNA | Cardiovascular disease | Phase II | Phase II trial initiated in the third quarter of 2022. |\n| BTLA MAB Agonist | Systemic lupus erythematosus | Phase II | Phase II trial initiated in the second quarter of 2022. |\n| CXCR1/2 Ligands Monoclonal Antibody | Hidradenitis suppurativa | Phase II | Phase II trial is ongoing. |\n| Peresolimab (PD-1 MAB Agonist) | Rheumatoid arthritis | Phase II | Phase II trial is ongoing. |\n| Rezpegaldesleukin (IL-2 Conjugate) | Systemic lupus erythematosus | Phase II | Phase II trial is ongoing. |\n\n40\n| Compound | Indication | Status | Developments |\n| Neuroscience |\n| Donanemab | Early Alzheimer's disease | Submitted | Granted FDA Breakthrough Therapy designation(3). Submitted in the U.S. in the second quarter of 2022. Received Priority Review designation under the accelerated approval pathway. Phase III trials are ongoing. |\n| Preclinical Alzheimer's disease | Phase III | Phase III trial is ongoing. |\n| Remternetug | Early Alzheimer's disease | Phase III | Phase III trial initiated in the third quarter of 2022. |\n| Solanezumab | Preclinical Alzheimer's disease | Phase III | Phase III trial is ongoing. |\n| GBA1 Gene Therapy (PR001) | Parkinson's disease | Phase II | Granted FDA Fast Track designation(1). Phase II trial is ongoing. |\n| GRN Gene Therapy (PR006) | Frontotemporal dementia | Phase II | Granted FDA Fast Track designation(1). Phase II trial is ongoing. |\n| O-GlcNAcase Inh | Alzheimer's disease | Phase II | Phase II trial is ongoing. |\n| SSTR4 Agonist | Pain | Phase II | Phase II trials are ongoing. |\n| TRPA1 Antagonist | Pain | Phase II | Phase II trials are ongoing. |\n| PACAP38 Antibody | Migraine | Discontinued | In the third quarter of 2022 based on the results of the Phase II trial, we discontinued development. |\n| Oncology |\n| Selpercatinib (Retevmo®) | Lung cancer | Approved(4) | Phase III trials are ongoing. In the third quarter of 2022, the FDA granted accelerated approval in tumor-agnostic RET fusion-positive advanced or metastatic solid tumors and traditional approval in locally advanced or metastatic RET fusion-positive non-small cell lung cancer. |\n| Thyroid cancer | Approved(4) | Phase III trial is ongoing. |\n| Pirtobrutinib (LOXO-305) | Mantle cell lymphoma | Submitted | Submitted in the U.S. in second quarter of 2022. Received Priority Review designation under the accelerated approval pathway. Phase III trial is ongoing. |\n| Chronic lymphocytic leukemia | Phase III | Phase III trials are ongoing. |\n| B-cell malignancies | Phase II | Phase II trial is ongoing. |\n| Imlunestrant | ER+HER2- metastatic breast cancer | Phase III | Phase III trial is ongoing. |\n\n(1) Fast Track designation is designed to facilitate the development and expedite the review of medicines to treat serious conditions and fill an unmet medical need.\n(2) In collaboration with Almirall, S.A. in Europe.\n(3) Breakthrough Therapy designation is designed to expedite the development and review of potential medicines that are intended to treat a serious condition where preliminary clinical evidence indicates that the treatment may demonstrate substantial improvement over available therapy on a clinically significant endpoint.\n(4) Continued approval may be contingent on verification and description of clinical benefit in confirmatory Phase III trials.\n41\nOur pipeline also contains several new indication line extension (NILEX) products. The following certain NILEX products for use in the indication described are currently in Phase II or Phase III clinical trials or have been submitted for regulatory review or have received regulatory approval in the U.S., Europe, or Japan. The following table reflects the status of these NILEX products, including certain other developments since our Annual Report on Form 10-K for the year ended December 31, 2021.\n| Compound | Indication | Status | Developments |\n| Diabetes |\n| Empagliflozin (Jardiance®)(1) | Heart failure with preserved ejection fraction | Approved | Approved in the U.S. and Europe in the first quarter of 2022 and in Japan in the second quarter of 2022. |\n| Chronic kidney disease | Phase III | Granted FDA Fast Track designation(2). In the first quarter of 2022 the Independent Data Monitoring Committee recommended stopping the Phase III trial early due to clear positive efficacy. |\n| Immunology |\n| Baricitinib (Olumiant®) | Alopecia areata | Approved | Approved in the U.S., Europe, and Japan in the second quarter of 2022. |\n| COVID-19 | Approved | Approved in the U.S. in the second quarter of 2022. |\n| Oncology |\n| Abemaciclib (Verzenio®) | Prostate cancer | Phase III | Phase III trials are ongoing. |\n\n(1) In collaboration with Boehringer Ingelheim.\n(2) Fast Track designation is designed to facilitate the development and expedite the review of medicines to treat serious conditions and fill an unmet medical need.\nOther Matters\nPatent Matters\nWe depend on patents or other forms of intellectual property protection for most of our revenue, cash flows, and earnings.\nFollowing the June 2021 loss of patent exclusivity for Alimta® in Europe and Japan, we faced, and expect to continue to face, generic competition that has rapidly and severely eroded revenue, and we expect will continue to erode revenue from current levels. In addition, as a result of the entry of multiple generics in the U.S. following the loss of patent and pediatric exclusivity in May 2022, we began facing, and expect to continue to face, additional generic competition that has eroded revenue, and we expect will continue to rapidly and severely erode revenue from current levels. This decline in revenue has had and will have a material adverse effect on our consolidated results of operations and cash flows. See Note 9 to the consolidated condensed financial statements for a description of legal proceedings currently pending regarding certain of our patents.\nOur compound patents for Humalog® (insulin lispro) have expired in the U.S. and major international markets, and we have also introduced lower-priced versions of Humalog as part of our insulin affordability solutions. A competitor has a similar version of insulin lispro in the U.S. and in certain European markets. Due to the impact of competition and pricing pressure in the U.S. and some international markets, we expect that lower revenue due to realized price decline will continue over time.\nOur formulation and use patents for Forteo® have expired in major markets. We expect further decline in revenue as a result of the entry of generic and biosimilar competition due to the loss of patent exclusivity in major markets.\nForeign Currency Exchange Rates\nAs a global company, we face foreign currency risk exposure from fluctuating currency exchange rates, primarily the U.S. dollar against the euro, Japanese yen, and Chinese yuan. While we seek to manage a portion of these exposures through hedging and other risk management techniques, significant fluctuations in currency rates can have a material impact, either positive or negative, on our consolidated results of operations in any given period. During the three and nine months ended September 30, 2022, revenue was unfavorably impacted by 4 percent and 3 percent, respectively, due to foreign exchange rates. While there is uncertainty in the future movements in foreign exchange rates, fluctuations in these rates have, and we currently expect in the near-term future will, adversely impact our consolidated results of operations and cash flows.\n42\nTrends Affecting Pharmaceutical Pricing, Reimbursement, and Access\nGlobal concern over access to and affordability of pharmaceutical products continues to drive regulatory and legislative debate and action, as well as worldwide cost containment efforts by governmental authorities. Such measures include the use of mandated discounts, price reporting requirements, mandated reference prices, restrictive formularies, changes to available intellectual property protections, as well as other efforts. In August 2022, the U.S. government enacted the Inflation Reduction Act (IRA). Among other measures, the IRA will allow the U.S. Department of Health and Human Services to effectively set prices for certain single-source drugs and biologics reimbursed under Medicare Part B and Part D. Generally, these government prices apply nine (medicines approved under a New Drug Application) or thirteen (medicines approved under a Biologics License Application) years following initial FDA approval and will be capped at a statutory ceiling price that is likely to represent a significant discount from average prices to wholesalers and direct purchasers. It is too soon to tell how the U.S. government will set these prices as the law specifies a ceiling price, but not a minimum or floor price. One or more significant Lilly products may be selected, which would have the effect of accelerating revenue erosion prior to patent expiry. The effect of reducing prices and reimbursement for certain of our products could significantly impact our business and consolidated results of operations.\nOther of the IRA’s provisions provide for penalties on drug manufacturers that increase prices of certain Medicare Part B and Part D medicines at a rate greater than the rate of inflation and replace the Part D coverage gap discount program with a new manufacturer discounting program. Manufacturers that fail to comply with the IRA may be subject to various penalties, including civil monetary penalties. The IRA takes effect progressively starting in 2023, with the first government set prices effective in 2026. The IRA may meaningfully influence our and pharmaceutical industry business strategies. In particular it may reduce the attractiveness of investment in small molecule innovation. Provisions of the IRA may be subject to legal challenges or other reformation, and the full effect of the IRA on our business and the pharmaceutical industry remains uncertain. Additional policies, regulations, legislation, or enforcement, including those proposed and/or pursued by the U.S. Congress and executive branch of the U.S. administration and other regulatory authorities worldwide, could adversely impact our business and consolidated results of operations.\nConsolidation of private payors in the U.S. has also significantly impacted the market for pharmaceuticals by increasing payor leverage in negotiating manufacturer price concessions and pharmacy reimbursement rates. Furthermore, restrictive or unfavorable pricing, coverage, or reimbursement determinations for our medicines or product candidates by governments, regulatory agencies, courts, or private payers, such as the Centers for Medicare & Medicaid Services' National Coverage Determination for monoclonal antibodies for the treatment of Alzheimer's Disease, may adversely impact our business and consolidated results of operations. We expect that these actions may intensify and could particularly affect certain products, such as insulin, as governments manage and emerge from the COVID-19 pandemic, which could adversely affect our business. In addition, we are engaged in litigation and investigations related to our 340B program and access to insulin that, if resolved adversely to us, could negatively impact our business and consolidated results of operations. It is not currently possible to predict the overall potential adverse impact to us or the general pharmaceutical industry of continued cost containment efforts worldwide.\nEvolving regulatory priorities have also intensified governmental scrutiny of our operations and our industry, including with respect to current Good Manufacturing Practices, quality assurance, and similar regulations, and increased focus on business combinations in our industry. Any regulatory issues concerning these matters could lead to regulatory and legal actions, product recalls and seizures, fines and penalties, interruption of production leading to product shortages, import bans or denials of import certifications, delays or denials in the approvals of new products or supplemental approvals of current products pending resolution of the issues, impediments to the completion of business combinations, and reputational harm, any of which would adversely affect our business.\nSee \"Business - Regulations and Private Payer Actions Affecting Pharmaceutical Pricing, Reimbursement, and Access\" in Part I, Item 1 and \"Risk Factors\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2021. See also Note 9 to the consolidated condensed financial statements.\n43\nTax Matters\nWe are subject to income taxes and various other taxes in the U.S. and in many foreign jurisdictions; therefore, changes in both domestic and international tax laws or regulations have affected and may affect our effective tax rate, results of operations, and cash flows. In 2017, the U.S. enacted the Tax Cuts and Jobs Act (the 2017 Tax Act), which contains a provision that requires capitalization and amortization of research and development expenses for tax purposes starting in 2022. Previously, these expenses could be deducted in the year incurred. The implementation of this provision has increased, and is expected to continue to increase, our 2022 cash payments of income taxes and subsequently decrease our cash payments of income taxes moderately over the five-year amortization period. We expect the implementation of this provision to impact our 2022 cash payments of income taxes by up to $1.50 billion. For the three and nine months ended September 30, 2022, the implementation of this provision favorably impacted other tax items that decreased our effective tax rate by approximately 4 percentage points. If this provision of the 2017 Tax Act is deferred or repealed by the U.S. Congress effective for 2022, we expect our effective tax rate to be approximately 13 percent to 14 percent for 2022.\nThe U.S. and countries around the world are actively considering and enacting tax law changes. Tax proposals have been introduced by the U.S. Congress and the U.S. administration containing significant changes, including increases to the tax rates at which both domestic and foreign income of U.S. companies would be taxed. In addition, tax authorities in the U.S. and other jurisdictions in which we do business routinely examine our tax returns and are intensifying their scrutiny and examinations of profit allocations among jurisdictions. Further, actions taken with respect to tax-related matters by associations, such as the Organisation for Economic Co-operation and Development and the European Commission, could influence tax laws in countries in which we operate. Changes to existing tax law and increased scrutiny by tax authorities in the U.S. and other jurisdictions could adversely impact our future consolidated results of operations and cash flows.\nAcquisitions\nWe opportunistically invest in external research and technologies that we believe complement and strengthen our own efforts. These investments can take many forms, including acquisitions, collaborations, investments, and licensing arrangements. We view our business development activity as a way to enhance our pipeline and strengthen our business.\nSee Note 3 to the consolidated condensed financial statements for further discussion regarding our recent acquisitions.\n44\nRevenue\nThe following table summarizes our revenue activity by region:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | Percent Change | 2022 | 2021 | Percent Change |\n| U.S. | $ | 4,422.1 | $ | 3,989.6 | 11 | $ | 13,531.5 | $ | 11,635.1 | 16 |\n| Outside U.S. | 2,519.4 | 2,783.3 | (9) | 7,708.1 | 8,683.4 | (11) |\n| Revenue | $ | 6,941.6 | $ | 6,772.8 | 2 | $ | 21,239.6 | $ | 20,318.5 | 5 |\n\nNumbers may not add due to rounding.\nThe following are components of the change in revenue compared with the prior year:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 vs. 2021 | 2022 vs. 2021 |\n| U.S. | Outside U.S. | Consolidated | U.S. | Outside U.S. | Consolidated |\n| Volume | 15 | % | 13 | % | 14 | % | 20 | % | 7 | % | 15 | % |\n| Price | (4) | (12) | (7) | (4) | (11) | (7) |\n| Foreign exchange rates | — | (11) | (4) | — | (7) | (3) |\n| Percent change | 11 | % | (9) | % | 2 | % | 16 | % | (11) | % | 5 | % |\n\nNumbers may not add due to rounding.\nIn the U.S. for the three and nine months ended September 30, 2022, the increase in volume was primarily driven by COVID-19 antibodies, Trulicity, Verzenio, Jardiance, Taltz®, and Mounjaro, partially offset by decreased volume for Alimta, resulting from the entry of multiple generics in the second quarter of 2022, and for Olumiant, due to the decline in utilization for COVID-19 treatment. In the U.S. for the three and nine months ended September 30, 2022, the decrease in realized prices was primarily driven by Humalog, due to a list price reduction of insulin lispro injection and unfavorable segment mix, and by Trulicity, due to unfavorable segment mix and higher contracted rebates. In the U.S. for the three months ended September 30, 2022, the decrease in realized prices for Trulicity was partially offset by changes to estimates for rebates and discounts.\nOutside the U.S. for the three and nine months ended September 30, 2022, the increase in volume was primarily driven by Verzenio, Trulicity, Tyvyt®, Jardiance, and Taltz, partially offset by Alimta and Cymbalta® resulting from generic competition. Additionally outside the U.S. for the three and nine months ended September 30, 2022, we recognized revenue related to a sales collaboration agreement for the right to sell and distribute Mounjaro in Japan. Outside the U.S. for the nine months ended September 30, 2022, the increase in volume was also partially offset by decreased sales of COVID-19 antibodies and the sale of the rights to Cialis® in China in the second quarter of 2021. Outside the U.S. for the three and nine months ended September 30, 2022, the decrease in realized prices was primarily driven by the impact of government pricing in China from the National Reimbursement Drug List (NRDL) formulary for certain products, particularly Tyvyt and Verzenio, and volume-based procurement (VBP) for Humalog.\n45\n| Three Months Ended September 30, |\n| 2022 | 2021 |\n| Product | U.S. | Outside U.S. | Total | Total | Percent Change |\n| Trulicity | $ | 1,418.3 | $ | 432.0 | $ | 1,850.4 | $ | 1,600.1 | 16 |\n| Taltz | 493.8 | 186.1 | 679.9 | 593.1 | 15 |\n| Verzenio | 414.8 | 202.9 | 617.7 | 335.5 | 84 |\n| Jardiance(1) | 350.9 | 222.4 | 573.3 | 390.4 | 47 |\n| Humalog(2) | 248.1 | 198.8 | 447.0 | 626.7 | (29) |\n| COVID-19 antibodies(3) | 386.6 | — | 386.6 | 217.1 | 78 |\n| Humulin® | 169.5 | 68.7 | 238.2 | 286.7 | (17) |\n| Cyramza® | 87.5 | 144.6 | 232.1 | 253.4 | (8) |\n| Basaglar® | 124.8 | 68.1 | 193.0 | 192.8 | — |\n| Mounjaro | 97.3 | 90.0 | 187.3 | — | NM |\n| Olumiant(4) | 22.9 | 160.0 | 182.9 | 406.9 | (55) |\n| Forteo | 112.7 | 64.4 | 177.1 | 200.9 | (12) |\n| Emgality® | 114.0 | 54.6 | 168.5 | 140.0 | 20 |\n| Erbitux® | 126.3 | 18.7 | 144.9 | 134.3 | 8 |\n| Alimta | 64.6 | 54.8 | 119.4 | 457.0 | (74) |\n| Cialis | 8.1 | 107.7 | 115.7 | 130.9 | (12) |\n| Zyprexa® | 8.0 | 73.4 | 81.4 | 101.7 | (20) |\n| Tyvyt | — | 76.8 | 76.8 | 125.6 | (39) |\n| Cymbalta | 7.8 | 54.9 | 62.7 | 132.0 | (53) |\n| Other products | 166.1 | 240.5 | 406.7 | 447.7 | (9) |\n| Revenue | $ | 4,422.1 | $ | 2,519.4 | $ | 6,941.6 | $ | 6,772.8 | 2 |\n\nNumbers may not add due to rounding.\nNM - not meaningful\n(1) Jardiance revenue includes Glyxambi®, Synjardy®, and Trijardy® XR.\n(2) Humalog revenue includes insulin lispro.\n(3) COVID-19 antibodies include sales for bamlanivimab administered alone, for bamlanivimab and etesevimab administered together, and for bebtelovimab and were made pursuant to EUAs or similar regulatory authorizations.\n(4) Olumiant revenue includes sales for baricitinib that were made pursuant to EUA or similar regulatory authorizations.\n46\n| Nine Months Ended September 30, |\n| 2022 | 2021 |\n| Product | U.S. | Outside U.S. | Total | Total | Percent Change |\n| Trulicity | $ | 4,162.4 | $ | 1,341.1 | $ | 5,503.5 | $ | 4,588.2 | 20 |\n| COVID-19 antibodies(1) | 1,970.9 | 14.7 | 1,985.5 | 1,176.2 | 69 |\n| Taltz | 1,212.6 | 561.6 | 1,774.2 | 1,565.4 | 13 |\n| Verzenio | 1,100.5 | 575.1 | 1,675.6 | 945.8 | 77 |\n| Humalog(2) | 855.8 | 656.4 | 1,512.3 | 1,851.3 | (18) |\n| Jardiance(3) | 831.4 | 622.4 | 1,453.7 | 1,058.9 | 37 |\n| Humulin | 562.3 | 223.1 | 785.4 | 923.8 | (15) |\n| Cyramza | 259.3 | 434.3 | 693.6 | 762.5 | (9) |\n| Alimta | 490.5 | 200.5 | 691.1 | 1,626.6 | (58) |\n| Olumiant(4) | 104.6 | 520.1 | 624.7 | 809.1 | (23) |\n| Basaglar | 339.9 | 218.8 | 558.7 | 650.1 | (14) |\n| Cialis | 25.8 | 454.7 | 480.4 | 538.7 | (11) |\n| Emgality | 330.8 | 144.4 | 475.2 | 415.7 | 14 |\n| Forteo | 261.4 | 191.7 | 453.0 | 617.8 | (27) |\n| Erbitux | 361.0 | 47.4 | 408.3 | 403.7 | 1 |\n| Zyprexa | 26.2 | 235.5 | 261.7 | 292.8 | (11) |\n| Tyvyt | — | 235.8 | 235.8 | 340.2 | (31) |\n| Cymbalta | 25.0 | 194.3 | 219.3 | 484.3 | (55) |\n| Mounjaro | 109.9 | 93.3 | 203.2 | — | NM |\n| Other products | 501.1 | 743.0 | 1,244.2 | 1,267.3 | (2) |\n| Revenue | $ | 13,531.5 | $ | 7,708.1 | $ | 21,239.6 | $ | 20,318.5 | 5 |\n\nNumbers may not add due to rounding.\nNM - not meaningful\n(1) COVID-19 antibodies include sales for bamlanivimab administered alone, for bamlanivimab and etesevimab administered together, and for bebtelovimab and were made pursuant to EUAs or similar regulatory authorizations.\n(2) Humalog revenue includes insulin lispro.\n(3) Jardiance revenue includes Glyxambi, Synjardy, and Trijardy XR.\n(4) Olumiant revenue includes sales for baricitinib that were made pursuant to EUA or similar regulatory authorizations.\nRevenue of Trulicity, a treatment for type 2 diabetes and to reduce the risk of major adverse cardiovascular events in adult patients with type 2 diabetes and established cardiovascular disease or multiple cardiovascular risk factors, increased 18 percent in the U.S. during the three months ended September 30, 2022, driven by increased demand, partially offset by lower realized prices. The lower realized prices in the U.S. for the three months ended September 30, 2022 were due to unfavorable segment mix and higher contracted rebates, partially offset by changes to estimates for rebates and discounts. Revenue in the U.S. increased 20 percent during the nine months ended September 30, 2022, driven by increased demand, partially offset by lower realized prices due to unfavorable segment mix and higher contracted rebates. Revenue outside the U.S. increased 8 percent and 19 percent during the three and nine months ended September 30, 2022, respectively, driven by increased demand, partially offset by the unfavorable impact of foreign exchange rates and, to a lesser extent, lower realized prices.\n47\nRevenue of COVID-19 antibodies, treatments for mild to moderate COVID-19 for higher-risk patients and for post-exposure prophylaxis in certain individuals for the prevention of SARS-CoV-2 infection, was $386.6 million and $1.97 billion in the U.S. during the three and nine months ended September 30, 2022, respectively. Revenue outside the U.S. was not material during the three and nine months ended September 30, 2022. The availability of superior or competitive therapies, including therapies that can be administered more easily, or preventative measures, such as vaccines, coupled with the unpredictable nature of pandemics, have and could further negatively impact or eliminate demand for these COVID-19 antibodies. The FDA has revised, and may in the future revise, any EUA for our COVID-19 antibodies in response to the prevalence of variants against which our antibodies have varying degrees of efficacy, including the new BQ variants. Based on early data, we do not believe that bebtelovimab will neutralize against the new BQ variants. We supplied the U.S. government approximately 810,000 doses of bebtelovimab during the nine months ended September 30, 2022. Beginning in the third quarter of 2022 and in collaboration with the U.S. government, we have made bebtelovimab commercially available for purchase by U.S. states/territories, hospitals, and certain other providers. We do not anticipate any further U.S. government orders.\nRevenue of Taltz, a treatment for moderate-to-severe plaque psoriasis, active psoriatic arthritis, ankylosing spondylitis, and active non-radiographic axial spondyloarthritis, increased 17 percent and 13 percent in the U.S. during the three and nine months ended September 30, 2022, respectively, driven by increased demand, partially offset by lower realized prices. Revenue outside the U.S. increased 9 percent and 14 percent during the three and nine months ended September 30, 2022, respectively, driven by increased volume, partially offset by unfavorable impact of foreign exchange rates and lower realized prices.\nRevenue of Verzenio, a treatment for HR+, HER2- metastatic breast cancer and high risk early breast cancer, increased $215.1 million and $518.4 million in the U.S. during the three and nine months ended September 30, 2022, respectively, primarily driven by increased demand. Revenue outside the U.S. increased 49 percent and 58 percent during the three and nine months ended September 30, 2022, respectively, driven by increased demand, partially offset by lower realized prices due to the impact of the NRDL formulary in China and the unfavorable impact of foreign exchange rates.\nRevenue of Humalog, an injectable human insulin analog for the treatment of diabetes, decreased 29 percent and 15 percent in the U.S. during the three and nine months ended September 30, 2022, respectively, driven by lower realized prices due to a list price reduction of insulin lispro injection and unfavorable segment mix. Revenue outside the U.S. decreased 29 percent and 22 percent during the three and nine months ended September 30, 2022, respectively, driven by lower realized prices due to the impact of VBP in China and the unfavorable impact of foreign exchange rates. Due to the impact of competition and pricing pressure in the U.S. and some international markets, we expect that lower revenue due to realized price decline will continue over time.\nRevenue of Jardiance, a treatment for type 2 diabetes, to reduce the risk of cardiovascular death in adult patients with type 2 diabetes and established cardiovascular disease, and to reduce the risk of cardiovascular death and hospitalization for heart failure in adults with heart failure, regardless of left ventricular ejection fraction, increased 59 percent and 47 percent in the U.S. during the three and nine months ended September 30, 2022, respectively, primarily driven by increased demand. The increase in revenue in the U.S. during the three months ended September 30, 2022 was also driven by changes to estimates for rebates and discounts. Revenue outside the U.S. increased 31 percent and 26 percent during the three and nine months ended September 30, 2022, respectively, primarily driven by increased demand, partially offset by the unfavorable impact of foreign exchange rates. See Note 4 to the consolidated condensed financial statements for information regarding our collaboration with Boehringer Ingelheim involving Jardiance.\nRevenue of Alimta, a treatment for various cancers, decreased 78 percent and 46 percent in the U.S. during the three and nine months ended September 30, 2022, respectively, primarily driven by decreased demand due to the entry of multiple generics in the second quarter of 2022. Revenue outside the U.S. decreased 66 percent and 72 percent during the three and nine months ended September 30, 2022, respectively, largely driven by decreased demand due to generic competition. Following the June 2021 loss of patent exclusivity for Alimta in Europe and Japan, we faced, and expect to continue to face, generic competition that has rapidly and severely eroded revenue, and we expect will continue to erode revenue from current levels. In addition, as a result of the entry of multiple generics in the U.S. following the loss of patent and pediatric exclusivity in May 2022, we began facing, and expect to continue to face, additional generic competition that has eroded revenue, and we expect will continue to rapidly and severely erode revenue from current levels. See \"Executive Overview - Other Matters- Patent Matters\" for additional information.\n48\nGross Margin, Costs, and Expenses\nGross margin as a percent of revenue decreased 1.6 percentage points to 77.3 percent and increased 2.0 percentage points to 76.1 percent for the three and nine months ended September 30, 2022, respectively. The decrease in the gross margin percent for the three months ended September 30, 2022 was primarily driven by a benefit in the gross margin for the three months ended September 30, 2021 due to the partial reversal of inventory impairment charges related to our COVID-19 antibodies that were recognized in the first and second quarters of 2021. The partial reversal of inventory impairment charges related to our COVID-19 antibodies was driven by an unexpected increase in our COVID-19 antibodies sales as the COVID-19 pandemic evolved during the third quarter of 2021. The increase in gross margin percent for the nine months ended September 30, 2022 was primarily driven by a net inventory impairment charge related to our COVID-19 antibodies recognized in 2021. Additionally, for the three and nine months ended September 30, 2022, lower realized prices and increased expenses due to inflation and logistics costs were offset by favorable product mix, including the impact of lower sales of Olumiant for the treatment of COVID-19, and the favorable impact of foreign exchange rates.\nResearch and development expenses increased 6 percent to $1.80 billion and 3 percent to $5.19 billion for the three and nine months ended September 30, 2022, respectively, primarily driven by higher development expenses for late-stage assets, partially offset by lower development expenses for COVID-19 antibodies and the favorable impact of foreign exchange rates.\nMarketing, selling, and administrative expenses increased 2 percent to $1.61 billion for the three months ended September 30, 2022, primarily driven by increased costs associated with the launch of Mounjaro, partially offset by the favorable impact of foreign exchange rates. Marketing, selling, and administrative expenses decreased 1 percent to $4.80 billion for the nine months ended September 30, 2022, primarily driven by the favorable impact of foreign exchange rates as well as reduced marketing costs in the first half of 2022, partially offset by increased costs associated with the launch of Mounjaro.\nWe plan to take compensatory actions to improve retention and address wage inflation which will impact our costs and consolidated results of operations.\nWe recognized $62.4 million and $668.4 million of acquired IPR&D and development milestones for the three and nine months ended September 30, 2022, respectively. The charges for the nine months ended September 30, 2022 included the buy-out of substantially all future obligations that were contingent upon the occurrence of certain events linked to the success of our mutant-selective PI3kα inhibitor and a purchase of a Priority Review Voucher. We recognized $177.6 million and $532.4 million of acquired IPR&D and development milestones for the three and nine months ended September 30, 2021, respectively. The charges for the nine months ended September 30, 2021 included acquired IPR&D charges from business development transactions with Rigel and Precision. See Note 3 to the consolidated condensed financial statements for additional information.\nWe recognized asset impairment, restructuring, and other special charges of $206.5 million for the three and nine months ended September 30, 2022, primarily related to an intangible asset impairment for GBA1 Gene Therapy (PR001) due to changes in estimated launch timing. There were no asset impairment, restructuring, and other special charges recognized for the three months ended September 30, 2021. We recognized asset impairment, restructuring, and other special charges of $211.6 million for the nine months ended September 30, 2021, primarily related to an intangible asset impairment resulting from the sale of the rights to Qbrexza, as well as acquisition and integration costs associated with the acquisition of Prevail. See Note 5 to the consolidated condensed financial statements for additional information.\nOther–net, (income) expense was expense of $111.0 million and $580.9 million for the three and nine months ended September 30, 2022, respectively, compared with expense of $635.9 million and $124.3 million for the three and nine months ended September 30, 2021, respectively. The decrease in other expense for the three months ended September 30, 2022 was primarily driven by a debt extinguishment loss of $405.2 million related to the repurchase of debt in 2021, as well as lower net investment losses on equity securities in 2022 compared to 2021. The increase in other expense for the nine months ended September 30, 2022 was primarily driven by net investment losses on equity securities in 2022 compared with net investment gains on equity securities in 2021, partially offset by a debt extinguishment loss of $405.2 million related to the repurchase of debt in 2021.\n49\nThe effective tax rates were 7.3 percent and 8.6 percent for the three and nine months ended September 30, 2022, respectively, reflecting the favorable tax impact of the implementation of a provision in the 2017 Tax Act that requires capitalization and amortization of research and development expenses for tax purposes starting in 2022, net investment losses on equity securities, and an intangible asset impairment charge. We expect our effective tax rate to be approximately 13 percent to 14 percent for 2022 if the capitalization and amortization of research and development expenses provision of the 2017 Tax Act is deferred or repealed by the U.S. Congress effective for 2022.\nThe effective tax rate was 10.9 percent for the three months ended September 30, 2021, reflecting the favorable tax impact of a debt extinguishment loss and of net investment losses on equity securities, partially offset by a net discrete tax detriment. The effective tax rate was 10.7 percent for the nine months ended September 30, 2021, reflecting the favorable tax impact of a net discrete tax benefit, a debt extinguishment loss, and a net inventory impairment charge related to our COVID-19 antibodies.\nFinancial Condition and Liquidity\nWe believe our available cash and cash equivalents, together with our ability to generate operating cash flow and our access to short-term and long-term borrowings, are sufficient to fund our existing and planned capital requirements. For a discussion of our capital requirements, see \"Management's Discussion and Analysis of Results of Operations and Financial Condition\" in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2021.\nWe plan to invest more than $2 billion over several years in two new facilities in Lebanon, Indiana to manufacture existing and future products and more than $1 billion over several years in a new facility in Concord, North Carolina to manufacture parenteral (injectable) products and devices. We plan to invest more than 400 million euro over several years in a new facility in Limerick, Ireland to expand our manufacturing network for biologic active ingredients. These investments, and other capital investments that support our operations, will result in capital expenditures being higher than recent historical levels for the next several years.\nCash and cash equivalents decreased to $2.62 billion as of September 30, 2022, compared with $3.82 billion as of December 31, 2021. Refer to the consolidated condensed statements of cash flows for additional information on the significant sources and uses of cash for the nine months ended September 30, 2022 and 2021.\nIn addition to our cash and cash equivalents, we held total investments of $2.70 billion and $3.30 billion as of September 30, 2022 and December 31, 2021, respectively. See Note 6 to the consolidated condensed financial statements for additional information.\nAs of September 30, 2022, total debt was $15.89 billion, a decrease of $996.3 million compared with $16.88 billion as of December 31, 2021. See Note 6 to the consolidated condensed financial statements for additional information.\nAs of September 30, 2022, we had a total of $7.26 billion of unused committed bank credit facilities, $7.00 billion of which is available to support our commercial paper program. We believe that amounts accessible through existing commercial paper markets should be adequate to fund short-term borrowing needs.\nDuring the nine months ended September 30, 2022, we repurchased $1.50 billion of shares under our $5.00 billion share repurchase program authorized in May 2021. As of September 30, 2022, we had $3.25 billion remaining under this program.\nDuring the nine months ended September 30, 2022, we paid dividends of $2.65 billion, or $2.94 per share, to our shareholders. In October 2022, we declared a dividend for the fourth quarter of 2022 of $0.98 per share on outstanding common stock. The dividend of approximately $882 million is payable on December 9, 2022 to shareholders of record at the close of business on November 15, 2022.\nSee \"Executive Overview - Other Matters - Patent Matters\" for information regarding recent losses of patent protection.\nBoth domestically and abroad, we continue to monitor the potential impacts of the economic environment; the creditworthiness of our wholesalers and other customers, including foreign government-backed agencies and suppliers; the uncertain impact of health care legislation; various international government funding levels; and fluctuations in interest rates, foreign currency exchange rates (see \"Executive Overview - Other Matters - Foreign Currency Exchange Rates\"), and fair values of equity securities.\n50\nCritical Accounting Estimates\nFor a discussion of our critical accounting estimates, refer to \"Management's Discussion and Analysis of Results of Operations and Financial Condition\" in Part II, Item 7 and the notes to our consolidated financial statements in Part II, Item 8 of our Annual Report on Form 10-K for the year ended December 31, 2021. See also Note 1 to the consolidated condensed financial statements. There have been no material changes to our critical accounting estimates since our Annual Report on Form 10-K for the year ended December 31, 2021.\nAvailable Information on our Website\nWe make available through our company website, free of charge, our company filings with the Securities and Exchange Commission (SEC) as soon as reasonably practicable after we electronically file them with, or furnish them to, the SEC. The reports we make available include annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements, registration statements, and any amendments to those documents.\nThe website link to our SEC filings is investor.lilly.com/financial-information/sec-filings.\nWe routinely post important information for investors in the “Investors” section of our website, www.lilly.com. We may use our website as a means of disclosing material, non-public information and for complying with our disclosure obligations under Regulation FD. Accordingly, investors should monitor the “Investors” section of our website, in addition to following our press releases, filings with the SEC, public conference calls, presentations, and webcasts. We may also use social media channels to communicate with investors and the public about our business, products and other matters, and those communications could be deemed to be material information. The information contained on, or that may be accessed through, our website or social media channels, is not incorporated by reference into, and is not a part of, this Quarterly Report on Form 10-Q.\n51\nItem 4. Controls and Procedures\n(a)Evaluation of Disclosure Controls and Procedures. Under applicable Securities and Exchange Commission (SEC) regulations, management of a reporting company, with the participation of the principal executive officer and principal financial officer, must periodically evaluate the company's \"disclosure controls and procedures,\" which are defined generally as controls and other procedures of a reporting company designed to ensure that information required to be disclosed by the reporting company in its periodic reports filed with the SEC (such as this Quarterly Report on Form 10-Q) is recorded, processed, summarized, and reported on a timely basis.\nOur management, with the participation of David A. Ricks, president and chief executive officer, and Anat Ashkenazi, executive vice president and chief financial officer, evaluated our disclosure controls and procedures (as such terms are defined in our Annual Report on Form 10-K for the year ended December 31, 2021) as of September 30, 2022, and concluded that they were effective.\n(b)Changes in Internal Controls. During the third quarter of 2022, there were no changes in our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n52\nPART II. Other Information\nItem 1. Legal Proceedings\nWe are a party to various currently pending legal actions, government investigations, and environmental proceedings. See Note 9 to the consolidated condensed financial statements for information on various legal proceedings.\nThis Item should be read in conjunction with \"Legal Proceedings\" in Part I, Item 3 of our Annual Report on Form 10-K for the year ended December 31, 2021.\nItem 1A. Risk Factors\nOur material risk factors are disclosed in \"Risk Factors\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2021. There have been no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2021.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nInformation relating to the principal market for our common stock and related shareholder matters is described in \"Management's Discussion and Analysis of Results of Operations and Financial Condition\" in Part II, Item 7 and in \"Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters\" in Part III, Item 12 of our Annual Report on Form 10-K for the year ended December 31, 2021.\nThe following table summarizes the activity related to repurchases of our equity securities during the three months ended September 30, 2022:\n| Period | Total Number ofShares Purchased(in thousands) | Average Price Paid per Share | Total Number of SharesPurchased as Part ofPublicly AnnouncedPlans or Programs(in thousands) | Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs (in millions) |\n| July 2022 | — | $ | — | — | $ | 3,250.0 |\n| August 2022 | — | — | — | 3,250.0 |\n| September 2022 | — | — | — | 3,250.0 |\n| Total | — | — | — |\n\nDuring the three months ended September 30, 2022, we did not repurchase any shares under our $5.00 billion share repurchase program authorized in May 2021.\n53\nItem 6. Exhibits\nThe following documents are filed as a part of this Quarterly Report:\n| Exhibit | Description |\n| EXHIBIT 3.1 | Amended Articles of Incorporation are incorporated by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K filed on May 4, 2022 |\n| EXHIBIT 3.2 | Bylaws, as amended, are incorporated by reference to Exhibit 3.2 to the Company's Current Report on Form 8-K filed on May 4, 2022 |\n| EXHIBIT 10.1 | Form of Performance Award under the 2002 Lilly Stock Plan (with non-compete)(1) |\n| EXHIBIT 10.2 | Form of Shareholder Value Award under the 2002 Lilly Stock Plan (with non-compete)(1) |\n| EXHIBIT 10.3 | Form of Relative Value Award under the 2002 Lilly Stock Plan (with non-compete)(1) |\n| EXHIBIT 31.1 | Rule 13a-14(a) Certification of David A. Ricks, Chair, President, and Chief Executive Officer |\n| EXHIBIT 31.2 | Rule 13a-14(a) Certification of Anat Ashkenazi, Executive Vice President and Chief Financial Officer |\n| EXHIBIT 32. | Section 1350 Certification |\n| EXHIBIT 101. | Interactive Data Files (embedded within the Inline XBRL document) |\n| EXHIBIT 104. | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\n\nLong-term debt instruments under which the total amount of securities authorized does not exceed 10 percent of our consolidated assets are not filed as exhibits to this Quarterly Report. We will furnish a copy of these agreements to the Securities and Exchange Commission upon request.\nSignatures\nPursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.\n| ELI LILLY AND COMPANY |\n| (Registrant) |\n| Date: | November 1, 2022 | /s/ Anat Ashkenazi |\n| Anat Ashkenazi |\n| Executive Vice President and Chief Financial Officer |\n| Date: | November 1, 2022 | /s/ Donald A. Zakrowski |\n| Donald A. Zakrowski |\n| Senior Vice President, Finance, and Chief Accounting Officer |\n\n54\n \n\nWhat is the difference in net income as a percentage of cash provided by operating activities between the years 2022 and 2021 in percentages?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nPART I. Financial Information\\nItem 1. Financial Statements\\nConsolidated Condensed Statements of Operations\\n(Unaudited)\\nELI LILLY AND COMPANY AND SUBSIDIARIES\\n(Dollars and shares in millions, except per-share data)\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Revenue (Note 2) | $ | 6,941.6 | $ | 6,772.8 | $ | 21,239.6 | $ | 20,318.5 |\\n| Costs, expenses, and other: |\\n| Cost of sales | 1,579.1 | 1,430.8 | 5,081.7 | 5,262.6 |\\n| Research and development | 1,802.9 | 1,705.3 | 5,194.9 | 5,032.4 |\\n| Marketing, selling, and administrative | 1,614.2 | 1,577.9 | 4,797.2 | 4,839.6 |\\n| Acquired in-process research and development and development milestones (Note 3) | 62.4 | 177.6 | 668.4 | 532.4 |\\n| Asset impairment, restructuring, and other special charges (Note 5) | 206.5 | — | 206.5 | 211.6 |\\n| Other–net, (income) expense (Note 11) | 111.0 | 635.9 | 580.9 | 124.3 |\\n| 5,376.1 | 5,527.5 | 16,529.6 | 16,002.9 |\\n| Income before income taxes | 1,565.5 | 1,245.3 | 4,710.0 | 4,315.6 |\\n| Income taxes (Note 7) | 113.8 | 135.2 | 402.9 | 460.0 |\\n| Net income | $ | 1,451.7 | $ | 1,110.1 | $ | 4,307.1 | $ | 3,855.6 |\\n| Earnings per share: |\\n| Basic | $ | 1.61 | $ | 1.22 | $ | 4.78 | $ | 4.25 |\\n| Diluted | $ | 1.61 | $ | 1.22 | $ | 4.76 | $ | 4.23 |\\n| Shares used in calculation of earnings per share: |\\n| Basic | 900.7 | 906.7 | 901.8 | 907.7 |\\n| Diluted | 903.8 | 910.8 | 904.5 | 911.7 |\\n\\nSee notes to consolidated condensed financial statements.\\n5\\nConsolidated Condensed Statements of Comprehensive Income\\n(Unaudited)\\nELI LILLY AND COMPANY AND SUBSIDIARIES\\n(Dollars in millions)\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Net income | $ | 1,451.7 | $ | 1,110.1 | $ | 4,307.1 | $ | 3,855.6 |\\n| Other comprehensive income (loss), net of tax (Note 10) | ( 8.1 ) | 114.4 | 47.3 | 323.7 |\\n| Comprehensive income | $ | 1,443.6 | $ | 1,224.5 | $ | 4,354.4 | $ | 4,179.3 |\\n\\nSee notes to consolidated condensed financial statements.\\n6\\nConsolidated Condensed Balance Sheets\\nELI LILLY AND COMPANY AND SUBSIDIARIES\\n(Dollars in millions)\\n| September 30, 2022 | December 31, 2021 |\\n| Assets | (Unaudited) |\\n| Current Assets |\\n| Cash and cash equivalents (Note 6) | $ | 2,617.4 | $ | 3,818.5 |\\n| Short-term investments (Note 6) | 124.7 | 90.1 |\\n| Accounts receivable, net of allowances of $ 17.7 (2022) and $ 22.5 (2021) | 6,715.3 | 6,672.8 |\\n| Other receivables | 1,609.5 | 1,454.4 |\\n| Inventories | 3,831.1 | 3,886.0 |\\n| Prepaid expenses and other | 2,741.9 | 2,530.6 |\\n| Total current assets | 17,639.9 | 18,452.4 |\\n| Investments (Note 6) | 2,574.6 | 3,212.6 |\\n| Goodwill | 3,891.6 | 3,892.0 |\\n| Other intangibles, net | 7,124.1 | 7,691.9 |\\n| Deferred tax assets | 2,384.3 | 2,489.3 |\\n| Property and equipment, net of accumulated depreciation of $ 10,074.0 (2022) and $ 9,976.7 (2021) | 9,311.3 | 8,985.1 |\\n| Other noncurrent assets | 4,535.7 | 4,082.7 |\\n| Total assets | $ | 47,461.5 | $ | 48,806.0 |\\n| Liabilities and Equity |\\n| Current Liabilities |\\n| Short-term borrowings and current maturities of long-term debt | $ | 1,744.6 | $ | 1,538.3 |\\n| Accounts payable | 1,683.2 | 1,670.6 |\\n| Employee compensation | 984.1 | 958.1 |\\n| Sales rebates and discounts | 8,568.4 | 6,845.8 |\\n| Dividends payable | — | 885.5 |\\n| Income taxes payable | 685.6 | 126.9 |\\n| Other current liabilities | 1,986.9 | 3,027.5 |\\n| Total current liabilities | 15,652.8 | 15,052.7 |\\n| Other Liabilities |\\n| Long-term debt | 14,143.8 | 15,346.4 |\\n| Accrued retirement benefits (Note 8) | 1,832.5 | 1,954.1 |\\n| Long-term income taxes payable | 3,641.7 | 3,920.0 |\\n| Deferred tax liabilities | 171.9 | 1,733.7 |\\n| Other noncurrent liabilities | 1,852.9 | 1,644.3 |\\n| Total other liabilities | 21,642.8 | 24,598.5 |\\n| Commitments and Contingencies (Note 9) |\\n| Eli Lilly and Company Shareholders' Equity |\\n| Common stock | 594.1 | 596.3 |\\n| Additional paid-in capital | 6,829.0 | 6,833.4 |\\n| Retained earnings | 10,006.5 | 8,958.5 |\\n| Employee benefit trust | ( 3,013.2 ) | ( 3,013.2 ) |\\n| Accumulated other comprehensive loss (Note 10) | ( 4,295.8 ) | ( 4,343.1 ) |\\n| Cost of common stock in treasury | ( 50.5 ) | ( 52.7 ) |\\n| Total Eli Lilly and Company shareholders' equity | 10,070.1 | 8,979.2 |\\n| Noncontrolling interests | 95.8 | 175.6 |\\n| Total equity | 10,165.9 | 9,154.8 |\\n| Total liabilities and equity | $ | 47,461.5 | $ | 48,806.0 |\\n\\nSee notes to consolidated condensed financial statements.\\n7\\nConsolidated Condensed Statements of Equity\\n(Unaudited)\\nELI LILLY AND COMPANY AND SUBSIDIARIES\\n| Equity of Eli Lilly and Company Shareholders |\\n| (Dollars in millions, except per-share data, and shares in thousands) | Common Stock | AdditionalPaid-inCapital | RetainedEarnings | Employee Benefit Trust | Accumulated Other Comprehensive Loss | Common Stock in Treasury(1) | Noncontrolling Interests |\\n| Shares | Amount | Shares | Amount |\\n| Balance at July 1, 2021 | 957,038 | $ | 598.1 | $ | 6,669.2 | $ | 8,530.1 | $ | ( 3,013.2 ) | $ | ( 6,287.1 ) | 463 | $ | ( 52.7 ) | $ | 219.1 |\\n| Net income (loss) | 1,110.1 | ( 22.6 ) |\\n| Other comprehensive income, net of tax | 114.4 |\\n| Issuance of stock under employee stock plans, net | 14 | 0.1 | ( 1.3 ) |\\n| Stock-based compensation | 90.1 |\\n| Other | ( 0.8 ) | 0.6 |\\n| Balance at September 30, 2021 | 957,052 | $ | 598.2 | $ | 6,758.0 | $ | 9,639.4 | $ | ( 3,013.2 ) | $ | ( 6,172.7 ) | 463 | $ | ( 52.7 ) | $ | 197.1 |\\n| Balance at July 1, 2022 | 950,619 | $ | 594.1 | $ | 6,746.0 | $ | 8,556.0 | $ | ( 3,013.2 ) | $ | ( 4,287.7 ) | 450 | $ | ( 50.5 ) | $ | 114.5 |\\n| Net income (loss) | 1,451.7 | ( 15.7 ) |\\n| Other comprehensive loss, net of tax | ( 8.1 ) |\\n| Issuance of stock under employee stock plans, net | 8 | ( 2.1 ) |\\n| Stock-based compensation | 85.1 |\\n| Other | ( 1.2 ) | ( 3.0 ) |\\n| Balance at September 30, 2022 | 950,627 | $ | 594.1 | $ | 6,829.0 | $ | 10,006.5 | $ | ( 3,013.2 ) | $ | ( 4,295.8 ) | 450 | $ | ( 50.5 ) | $ | 95.8 |\\n\\n(1) As of September 30, 2022, there was $ 3.25 billion remaining under our $ 5.00 billion share repurchase program authorized in May 2021.\\nSee notes to consolidated condensed financial statements.\\n8\\n| Equity of Eli Lilly and Company Shareholders |\\n| (Dollars in millions, except per-share data, and shares in thousands) | Common Stock | AdditionalPaid-inCapital | RetainedEarnings | Employee Benefit Trust | Accumulated Other Comprehensive Loss | Common Stock in Treasury(1) | Noncontrolling Interests |\\n| Shares | Amount | Shares | Amount |\\n| Balance at January 1, 2021 | 957,077 | $ | 598.2 | $ | 6,778.5 | $ | 7,830.2 | $ | ( 3,013.2 ) | $ | ( 6,496.4 ) | 487 | $ | ( 55.7 ) | $ | 183.6 |\\n| Net income | 3,855.6 | 25.2 |\\n| Other comprehensive income, net of tax | 323.7 |\\n| Cash dividends declared per share: $ 1.70 | ( 1,542.9 ) |\\n| Retirement of treasury shares | ( 2,467 ) | ( 1.5 ) | ( 498.5 ) | ( 2,467 ) | 500.0 |\\n| Purchase of treasury shares | 2,467 | ( 500.0 ) |\\n| Issuance of stock under employee stock plans, net | 2,442 | 1.5 | ( 287.1 ) | ( 24 ) | 3.0 |\\n| Stock-based compensation | 267.5 |\\n| Other | ( 0.9 ) | ( 5.0 ) | ( 11.7 ) |\\n| Balance at September 30, 2021 | 957,052 | $ | 598.2 | $ | 6,758.0 | $ | 9,639.4 | $ | ( 3,013.2 ) | $ | ( 6,172.7 ) | 463 | $ | ( 52.7 ) | $ | 197.1 |\\n| Balance at January 1, 2022 | 954,116 | $ | 596.3 | $ | 6,833.4 | $ | 8,958.5 | $ | ( 3,013.2 ) | $ | ( 4,343.1 ) | 463 | $ | ( 52.7 ) | $ | 175.6 |\\n| Net income (loss) | 4,307.1 | ( 63.7 ) |\\n| Other comprehensive income, net of tax | 47.3 |\\n| Cash dividends declared per share: $ 1.96 | ( 1,765.9 ) |\\n| Retirement of treasury shares | ( 5,607 ) | ( 3.5 ) | ( 1,496.5 ) | ( 5,607 ) | 1,500.0 |\\n| Purchase of treasury shares | 5,607 | ( 1,500.0 ) |\\n| Issuance of stock under employee stock plans, net | 2,118 | 1.3 | ( 282.6 ) | ( 13 ) | 2.2 |\\n| Stock-based compensation | 278.2 |\\n| Other | 3.3 | ( 16.1 ) |\\n| Balance at September 30, 2022 | 950,627 | $ | 594.1 | $ | 6,829.0 | $ | 10,006.5 | $ | ( 3,013.2 ) | $ | ( 4,295.8 ) | 450 | $ | ( 50.5 ) | $ | 95.8 |\\n\\n(1) As of September 30, 2022, there was $ 3.25 billion remaining under our $ 5.00 billion share repurchase program authorized in May 2021.\\nSee notes to consolidated condensed financial statements.\\n9\\nConsolidated Condensed Statements of Cash Flows\\n(Unaudited)\\nELI LILLY AND COMPANY AND SUBSIDIARIES\\n(Dollars in millions)\\n\\n| Nine Months Ended September 30, |\\n| 2022 | 2021 |\\n| Cash Flows from Operating Activities |\\n| Net income | $ | 4,307.1 | $ | 3,855.6 |\\n| Adjustments to Reconcile Net Income to Cash Flows from Operating Activities: |\\n| Depreciation and amortization | 1,147.5 | 1,101.9 |\\n| Change in deferred income taxes | ( 2,195.6 ) | ( 709.8 ) |\\n| Debt extinguishment loss (Note 6) | — | 405.2 |\\n| Stock-based compensation expense | 278.2 | 267.5 |\\n| Net investment (gains) losses | 676.4 | ( 271.1 ) |\\n| Acquired in-process research and development | 252.0 | 498.3 |\\n| Other changes in operating assets and liabilities, net of acquisitions and divestitures | 821.5 | ( 548.1 ) |\\n| Other non-cash operating activities, net | 217.6 | 504.7 |\\n| Net Cash Provided by Operating Activities | 5,504.7 | 5,104.2 |\\n| Cash Flows from Investing Activities |\\n| Net purchases of property and equipment | ( 1,353.6 ) | ( 1,018.4 ) |\\n| Proceeds from sales and maturities of short-term investments | 83.1 | 46.6 |\\n| Purchases of short-term investments | ( 65.0 ) | ( 27.9 ) |\\n| Proceeds from sales of noncurrent investments | 251.6 | 537.2 |\\n| Purchases of noncurrent investments | ( 474.1 ) | ( 710.1 ) |\\n| Cash paid for acquisitions, net of cash acquired (Note 3) | — | ( 747.4 ) |\\n| Purchases of in-process research and development | ( 574.8 ) | ( 460.6 ) |\\n| Other investing activities, net | ( 268.3 ) | ( 2.7 ) |\\n| Net Cash Used for Investing Activities | ( 2,401.1 ) | ( 2,383.3 ) |\\n| Cash Flows from Financing Activities |\\n| Dividends paid | ( 2,651.4 ) | ( 2,313.5 ) |\\n| Net change in short-term borrowings | 1,741.3 | ( 1.5 ) |\\n| Proceeds from issuance of long-term debt | — | 2,410.8 |\\n| Repayments of long-term debt | ( 1,560.0 ) | ( 1,905.3 ) |\\n| Purchases of common stock | ( 1,500.0 ) | ( 500.0 ) |\\n| Other financing activities, net | ( 295.2 ) | ( 295.3 ) |\\n| Net Cash Used for Financing Activities | ( 4,265.3 ) | ( 2,604.8 ) |\\n| Effect of exchange rate changes on cash and cash equivalents | ( 39.4 ) | 15.0 |\\n| Net decrease in cash and cash equivalents | ( 1,201.1 ) | 131.1 |\\n| Cash and cash equivalents at January 1 | 3,818.5 | 3,657.1 |\\n| Cash and Cash Equivalents at September 30 | $ | 2,617.4 | $ | 3,788.2 |\\n\\nSee notes to consolidated condensed financial statements.\\n10\\nNotes to Consolidated Condensed Financial Statements\\n(Tables present dollars in millions, except per-share data)\\nNote 1: Basis of Presentation and Implementation of New Financial Accounting Standard\\nWe have prepared the accompanying unaudited consolidated condensed financial statements in accordance with the requirements of Form 10-Q and, therefore, they do not include all information and footnotes necessary for a fair presentation of financial position, results of operations, and cash flows in conformity with accounting principles generally accepted in the United States (GAAP). In our opinion, the consolidated condensed financial statements reflect all adjustments (including those that are normal and recurring) that are necessary for a fair presentation of the results of operations for the periods shown. In preparing financial statements in conformity with GAAP, we must make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosures at the date of the financial statements and during the reporting period. Actual results could differ from those estimates.\\nThe information included in this Quarterly Report on Form 10-Q should be read in conjunction with our consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the year ended December 31, 2021. We issue our financial statements by filing them with the Securities and Exchange Commission and have evaluated subsequent events up to the time of the filing of this Quarterly Report on Form 10-Q.\\nCertain reclassifications have been made to prior periods in the consolidated condensed financial statements and accompanying notes to conform with the current presentation.\\nAll per-share amounts, unless otherwise noted in the footnotes, are presented on a diluted basis; that is, based on the weighted-average number of common shares outstanding plus the effect of incremental shares from our stock-based compensation programs.\\nWe operate as a single operating segment engaged in the discovery, development, manufacturing, marketing, and sales of pharmaceutical products worldwide. A global research and development organization and a supply chain organization are responsible for the discovery, development, manufacturing, and supply of our products. Regional commercial organizations market, distribute, and sell the products. The business is also supported by global corporate staff functions. Our determination that we operate as a single segment is consistent with the financial information regularly reviewed by the chief operating decision maker for purposes of evaluating performance, allocating resources, setting incentive compensation targets, and planning and forecasting for future periods.\\nResearch and Development Expenses and Acquired In-Process Research and Development (IPR&D) and Development Milestones\\nResearch and development costs are expensed as incurred. Research and development costs consist of expenses incurred in performing research and development activities, including but not limited to, compensation and benefits, facilities and overhead expense, clinical trial expense, and fees paid to contract research organizations.\\nAcquired IPR&D and development milestones include the initial costs of externally developed IPR&D projects, acquired directly in a transaction other than a business combination, that do not have an alternative future use. Additionally, milestone payment obligations related to these transactions that are incurred prior to regulatory approval of the compound are expensed when the event triggering an obligation to pay the milestone occurs.\\nImplementation of New Financial Accounting Standard\\nAccounting Standards Update 2021-01, Reference Rate Reform, provides for temporary optional expedients and exceptions in applying current GAAP to contracts, hedging relationships, and other transactions affected by the transition from the use of the London Interbank Offered Rate (LIBOR) to an alternative reference rate. The standard is currently applicable to contracts entered into before January 1, 2023. We adopted the standard in the first quarter of 2022. The adoption did not have a material impact on our consolidated condensed financial statements.\\n11\\nNote 2: Revenue\\nThe following table summarizes our revenue recognized in our consolidated condensed statements of operations:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Net product revenue | $ | 6,119.2 | $ | 6,189.0 | $ | 19,123.0 | $ | 18,579.5 |\\n| Collaboration and other revenue(1) | 822.4 | 583.8 | 2,116.6 | 1,739.0 |\\n| Revenue | $ | 6,941.6 | $ | 6,772.8 | $ | 21,239.6 | $ | 20,318.5 |\\n\\n(1) Collaboration and other revenue associated with prior period transfers of intellectual property was $ 43.3 million and $ 130.9 million during the three and nine months ended September 30, 2022, respectively, and $ 62.1 million and $ 136.1 million during the three and nine months ended September 30, 2021, respectively.\\nWe recognize revenue primarily from two different types of contracts, product sales to customers (net product revenue) and collaborations and other arrangements. Revenue recognized from collaborations and other arrangements includes our share of profits from the collaborations, as well as royalties, upfront and milestone payments we receive under these types of contracts. See Note 4 for additional information related to our collaborations and other arrangements. Collaboration and other revenue disclosed above includes the revenue from the Jardiance® and Trajenta® families of products resulting from our collaboration with Boehringer Ingelheim discussed in Note 4. Substantially all of the remainder of collaboration and other revenue is related to contracts accounted for as contracts with customers.\\nAdjustments to Revenue\\nAdjustments to increase revenue recognized as a result of changes in estimates for our most significant United States (U.S.) sales returns, rebates, and discounts liability balances for products shipped in previous periods were 3 percent of U.S. revenue for the three months ended September 30, 2022 and less than 1 percent of U.S. revenue during the nine months ended September 30, 2022 and the three and nine months ended September 30, 2021.\\nContract Liabilities\\nOur contract liabilities result from arrangements where we have received payment in advance of performance under the contract and do not include sales returns, rebates, and discounts. Changes in contract liabilities are generally due to either receipt of additional advance payments or our performance under the contract.\\nThe following table summarizes contract liability balances:\\n| September 30, 2022 | December 31, 2021 |\\n| Contract liabilities | $ | 232.5 | $ | 262.6 |\\n\\nDuring the three and nine months ended September 30, 2022 and 2021, revenue recognized from contract liabilities as of the beginning of the respective year was not material. Revenue expected to be recognized in the future from contract liabilities as the related performance obligations are satisfied is not expected to be material in any one year.\\n12\\nDisaggregation of Revenue\\nThe following table summarizes revenue by product for the three months ended September 30, 2022 and 2021:\\n| Three Months Ended September 30, |\\n| 2022 | 2021 |\\n| U.S. | Outside U.S. | Total | U.S. | Outside U.S. | Total |\\n| Revenue—to unaffiliated customers: |\\n| Diabetes: |\\n| Trulicity® | $ | 1,418.3 | $ | 432.0 | $ | 1,850.4 | $ | 1,201.4 | $ | 398.8 | $ | 1,600.1 |\\n| Jardiance(1) | 350.9 | 222.4 | 573.3 | 221.2 | 169.2 | 390.4 |\\n| Humalog® (2) | 248.1 | 198.8 | 447.0 | 347.3 | 279.4 | 626.7 |\\n| Humulin® | 169.5 | 68.7 | 238.2 | 193.4 | 93.4 | 286.7 |\\n| Basaglar® | 124.8 | 68.1 | 193.0 | 114.7 | 78.1 | 192.8 |\\n| Mounjaro® | 97.3 | 90.0 | 187.3 | — | — | — |\\n| Other diabetes | 79.7 | 94.0 | 173.4 | 65.0 | 112.2 | 177.4 |\\n| Total diabetes | 2,488.6 | 1,174.0 | 3,662.6 | 2,143.0 | 1,131.1 | 3,274.1 |\\n| Oncology: |\\n| Verzenio® | 414.8 | 202.9 | 617.7 | 199.6 | 135.9 | 335.5 |\\n| Cyramza® | 87.5 | 144.6 | 232.1 | 84.8 | 168.6 | 253.4 |\\n| Erbitux® | 126.3 | 18.7 | 144.9 | 114.0 | 20.3 | 134.3 |\\n| Alimta® | 64.6 | 54.8 | 119.4 | 297.2 | 159.8 | 457.0 |\\n| Tyvyt® | — | 76.8 | 76.8 | — | 125.6 | 125.6 |\\n| Other oncology | 39.5 | 62.8 | 102.4 | 35.3 | 65.1 | 100.3 |\\n| Total oncology | 732.7 | 560.6 | 1,293.3 | 730.9 | 675.3 | 1,406.1 |\\n| Immunology: |\\n| Taltz® | 493.8 | 186.1 | 679.9 | 422.2 | 170.9 | 593.1 |\\n| Olumiant® (3) | 22.9 | 160.0 | 182.9 | 194.0 | 212.9 | 406.9 |\\n| Other immunology | — | 3.6 | 3.6 | — | 4.9 | 4.9 |\\n| Total immunology | 516.7 | 349.7 | 866.4 | 616.2 | 388.7 | 1,004.9 |\\n| Neuroscience: |\\n| Emgality® | 114.0 | 54.6 | 168.5 | 99.9 | 40.1 | 140.0 |\\n| Zyprexa® | 8.0 | 73.4 | 81.4 | 13.0 | 88.7 | 101.7 |\\n| Cymbalta® | 7.8 | 54.9 | 62.7 | 7.0 | 125.1 | 132.0 |\\n| Other neuroscience | 16.0 | 44.5 | 60.6 | 24.7 | 51.6 | 76.5 |\\n| Total neuroscience | 145.8 | 227.4 | 373.2 | 144.6 | 305.5 | 450.2 |\\n| Other: |\\n| COVID-19 antibodies(4) | 386.6 | — | 386.6 | 215.5 | 1.6 | 217.1 |\\n| Forteo® | 112.7 | 64.4 | 177.1 | 109.6 | 91.3 | 200.9 |\\n| Cialis® | 8.1 | 107.7 | 115.7 | ( 6.5 ) | 137.4 | 130.9 |\\n| Other | 30.9 | 35.7 | 66.6 | 36.3 | 52.4 | 88.8 |\\n| Total other | 538.3 | 207.8 | 746.0 | 354.9 | 282.7 | 637.7 |\\n| Revenue | $ | 4,422.1 | $ | 2,519.4 | $ | 6,941.6 | $ | 3,989.6 | $ | 2,783.3 | $ | 6,772.8 |\\n\\nNumbers may not add due to rounding.\\n(1) Jardiance revenue includes Glyxambi®, Synjardy®, and Trijardy® XR.\\n(2) Humalog revenue includes insulin lispro.\\n(3) Olumiant revenue includes sales for baricitinib that were made pursuant to Emergency Use Authorization (EUA) or similar regulatory authorizations.\\n(4) COVID-19 antibodies include sales for bamlanivimab administered alone, for bamlanivimab and etesevimab administered together, and for bebtelovimab and were made pursuant to EUAs or similar regulatory authorizations.\\n13\\nThe following table summarizes revenue by product for the nine months ended September 30, 2022 and 2021:\\n| Nine Months Ended September 30, |\\n| 2022 | 2021 |\\n| U.S. | Outside U.S. | Total | U.S. | Outside U.S. | Total |\\n| Revenue—to unaffiliated customers: |\\n| Diabetes: |\\n| Trulicity | $ | 4,162.4 | $ | 1,341.1 | $ | 5,503.5 | $ | 3,465.7 | $ | 1,122.5 | $ | 4,588.2 |\\n| Humalog(1) | 855.8 | 656.4 | 1,512.3 | 1,009.0 | 842.3 | 1,851.3 |\\n| Jardiance(2) | 831.4 | 622.4 | 1,453.7 | 566.8 | 492.1 | 1,058.9 |\\n| Humulin | 562.3 | 223.1 | 785.4 | 633.5 | 290.3 | 923.8 |\\n| Basaglar | 339.9 | 218.8 | 558.7 | 423.3 | 226.8 | 650.1 |\\n| Mounjaro | 109.9 | 93.3 | 203.2 | — | — | — |\\n| Other diabetes | 195.6 | 276.5 | 472.2 | 185.7 | 302.6 | 488.3 |\\n| Total diabetes | 7,057.3 | 3,431.6 | 10,489.0 | 6,284.0 | 3,276.6 | 9,560.6 |\\n| Oncology: |\\n| Verzenio | 1,100.5 | 575.1 | 1,675.6 | 582.1 | 363.7 | 945.8 |\\n| Cyramza | 259.3 | 434.3 | 693.6 | 266.3 | 496.3 | 762.5 |\\n| Alimta | 490.5 | 200.5 | 691.1 | 911.9 | 714.7 | 1,626.6 |\\n| Erbitux | 361.0 | 47.4 | 408.3 | 357.7 | 45.9 | 403.7 |\\n| Tyvyt | — | 235.8 | 235.8 | — | 340.2 | 340.2 |\\n| Other oncology | 124.1 | 186.5 | 310.6 | 83.7 | 169.9 | 253.6 |\\n| Total oncology | 2,335.4 | 1,679.6 | 4,015.0 | 2,201.7 | 2,130.7 | 4,332.4 |\\n| Immunology: |\\n| Taltz | 1,212.6 | 561.6 | 1,774.2 | 1,071.6 | 493.8 | 1,565.4 |\\n| Olumiant(3) | 104.6 | 520.1 | 624.7 | 236.5 | 572.6 | 809.1 |\\n| Other immunology | 0.1 | 12.1 | 12.1 | 15.2 | 14.5 | 29.7 |\\n| Total immunology | 1,317.3 | 1,093.8 | 2,411.0 | 1,323.3 | 1,080.9 | 2,404.2 |\\n| Neuroscience: |\\n| Emgality | 330.8 | 144.4 | 475.2 | 313.5 | 102.2 | 415.7 |\\n| Zyprexa | 26.2 | 235.5 | 261.7 | 28.3 | 264.5 | 292.8 |\\n| Cymbalta | 25.0 | 194.3 | 219.3 | 30.3 | 454.0 | 484.3 |\\n| Other neuroscience | 62.0 | 142.7 | 204.7 | 81.0 | 154.0 | 235.0 |\\n| Total neuroscience | 444.0 | 716.9 | 1,160.9 | 453.1 | 974.7 | 1,427.8 |\\n| Other: |\\n| COVID-19 antibodies(4) | 1,970.9 | 14.7 | 1,985.5 | 949.5 | 226.7 | 1,176.2 |\\n| Cialis | 25.8 | 454.7 | 480.4 | ( 3.1 ) | 541.8 | 538.7 |\\n| Forteo | 261.4 | 191.7 | 453.0 | 330.1 | 287.7 | 617.8 |\\n| Other | 119.4 | 125.1 | 244.8 | 96.5 | 164.3 | 260.8 |\\n| Total other | 2,377.5 | 786.2 | 3,163.7 | 1,373.0 | 1,220.5 | 2,593.5 |\\n| Revenue | $ | 13,531.5 | $ | 7,708.1 | $ | 21,239.6 | $ | 11,635.1 | $ | 8,683.4 | $ | 20,318.5 |\\n\\nNumbers may not add due to rounding.\\n(1) Humalog revenue includes insulin lispro.\\n(2) Jardiance revenue includes Glyxambi, Synjardy, and Trijardy XR.\\n(3) Olumiant revenue includes sales for baricitinib that were made pursuant to EUA or similar regulatory authorizations.\\n(4) COVID-19 antibodies include sales for bamlanivimab administered alone, for bamlanivimab and etesevimab administered together, and for bebtelovimab and were made pursuant to EUAs or similar regulatory authorizations.\\n14\\nThe following table summarizes revenue by geographical area:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Revenue—to unaffiliated customers(1): |\\n| U.S. | $ | 4,422.1 | $ | 3,989.6 | $ | 13,531.5 | $ | 11,635.1 |\\n| Europe | 1,056.4 | 1,098.6 | 3,224.8 | 3,629.6 |\\n| Japan | 487.7 | 595.0 | 1,352.3 | 1,832.2 |\\n| China | 343.4 | 400.3 | 1,102.0 | 1,285.0 |\\n| Other foreign countries | 632.0 | 689.4 | 2,029.1 | 1,936.7 |\\n| Revenue | $ | 6,941.6 | $ | 6,772.8 | $ | 21,239.6 | $ | 20,318.5 |\\n\\nNumbers may not add due to rounding.\\n(1) Revenue is attributed to the countries based on the location of the customer.\\nNote 3: Acquisitions\\nWe engage in various forms of business development activities to enhance our product pipeline, including acquisitions, collaborations, investments, and licensing arrangements. In connection with these arrangements, our partners may be entitled to future royalties and/or commercial milestones based on sales should products be approved for commercialization and/or milestones based on the successful progress of compounds through the development process.\\nIn January 2021, we completed the acquisition of Prevail Therapeutics Inc. (Prevail). This transaction, as further discussed below in Acquisition of a Business, was accounted for as a business combination under the acquisition method of accounting. Under this method, the assets acquired and liabilities assumed were recorded at their respective fair values as of the acquisition date in our consolidated condensed financial statements. The determination of estimated fair value required management to make significant estimates and assumptions. The excess of the purchase price over the fair value of the acquired net assets, where applicable, has been recorded as goodwill. The results of operations of this acquisition is included in our consolidated condensed financial statements from the date of acquisition.\\nWe also acquired assets in development which are further discussed below in Asset Acquisitions. Upon each acquisition, the cost allocated to acquired IPR&D is immediately expensed if the compound has no alternative future use. Milestone payment obligations incurred prior to regulatory approval of the compound are expensed when the event triggering an obligation to pay the milestone occurs. We recognized acquired IPR&D and development milestone charges of $ 62.4 million and $ 668.4 million for the three and nine months ended September 30, 2022, respectively, and $ 177.6 million and $ 532.4 million for the three and nine months ended September 30, 2021, respectively.\\nAcquisition of a Business\\nPrevail Acquisition\\nOverview of Transaction\\nIn January 2021, we acquired all shares of Prevail for a purchase price that included $ 22.50 per share in cash (or an aggregate of $ 747.4 million, net of cash acquired) plus one non-tradable contingent value right (CVR) per share. The CVR entitles Prevail stockholders up to an additional $ 4.00 per share in cash (or an aggregate of approximately $ 160 million) payable, subject to certain terms and conditions, upon the first regulatory approval of a Prevail product in one of the following countries: U.S., Japan, United Kingdom, Germany, France, Italy, or Spain. To achieve the full value of the CVR, such regulatory approval must occur by December 31, 2024. If such regulatory approval occurs after December 31, 2024, the value of the CVR will be reduced by approximately 8.3 cents per month until December 1, 2028, at which point the CVR will expire without payment.\\nUnder the terms of the agreement, we acquired potentially disease-modifying AAV9-based gene therapies for patients with neurodegenerative diseases. The acquisition established a new modality for drug discovery and development, extending our research efforts through the creation of a gene therapy program that is being anchored by Prevail's portfolio of assets. The lead gene therapies in clinical development that we acquired were PR001 for patients with Parkinson's disease with GBA1 mutations and neuronopathic Gaucher disease and PR006 for patients with frontotemporal dementia with GRN mutations. Both PR001 and PR006 were granted Fast Track designation from the U.S. Food and Drug Administration (FDA).\\n15\\nAssets Acquired and Liabilities Assumed\\nThe following table summarizes the amounts recognized for assets acquired and liabilities assumed as of the acquisition date:\\n| Estimated Fair Value at January 22, 2021 |\\n| Cash | $ | 90.5 |\\n| Acquired IPR&D(1) | 824.0 |\\n| Goodwill(2) | 126.8 |\\n| Deferred tax liabilities | ( 106.0 ) |\\n| Other assets and liabilities, net | ( 31.5 ) |\\n| Acquisition date fair value of consideration transferred | 903.8 |\\n| Less: |\\n| Cash acquired | ( 90.5 ) |\\n| Fair value of CVR liability(3) | ( 65.9 ) |\\n| Cash paid, net of cash acquired | $ | 747.4 |\\n\\n(1) Acquired IPR&D intangibles primarily relate to PR001. In the third quarter of 2022, we impaired the intangible asset related to PR001. See Note 5 for additional information.\\n(2) The goodwill recognized from this acquisition is not deductible for tax purposes.\\n(3) See Note 6 for a discussion on the estimation of the CVR liability.\\nWe are unable to provide the results of operations for the three and nine months ended September 30, 2022 and 2021 attributable to Prevail as those operations were substantially integrated into our legacy business.\\nPro forma information has not been included as this acquisition did not have a material impact on our consolidated condensed statements of operations for the three and nine months ended September 30, 2021.\\nAsset Acquisitions\\nThe following table summarizes our significant asset acquisitions during the nine months ended September 30, 2022 and 2021:\\n| Counterparty | Compound(s), Therapy or Asset | Acquisition Month | Phase of Development(1) | Acquired IPR&D Expense |\\n| BioMarin Pharmaceutical Inc. | Priority Review Voucher | February 2022 | Not applicable | $ | 110.0 |\\n| Rigel Pharmaceuticals, Inc. | R552, a receptor-interacting serine/threonine-protein kinase 1 (RIPK1) inhibitor, for the potential treatment of autoimmune and inflammatory diseases | March 2021 | Phase I | 125.0 |\\n| Precision Biosciences, Inc. | Potential in vivo therapies for genetic disorders | January 2021 | Pre-clinical | 107.8 |\\n\\n(1) The phase of development presented is as of the date of the arrangement and represents the phase of development of the most advanced asset acquired, where applicable.\\nIn connection with our acquisition of Petra Pharma Corporation (Petra), we were required to make milestone payments to Petra shareholders contingent upon the occurrence of certain future events linked to the success of the mutant-selective PI3Kα inhibitor. In the second quarter of 2022, we entered into agreements with substantially all Petra shareholders to acquire their rights to receive any future milestone payments in exchange for a one-time payment. As a result of these agreements, we recognized a charge of $ 333.8 million as a development milestone during the nine months ended September 30, 2022. Any remaining contingent milestones payments linked to the success of the mutant-selective PI3Kα are not expected to be material. We recognized no other significant development milestones during the three and nine months ended September 30, 2022 and 2021.\\n16\\nSubsequent Event - Akouos, Inc. (Akouos) Acquisition\\nOn October 17, 2022, we entered into a definitive agreement to acquire Akouos. Pursuant to the terms of the agreement, we have commenced a tender offer to acquire all outstanding shares of Akouos for a purchase price of $ 12.50 per share in cash (an aggregate of approximately $ 487 million), payable at closing, plus one non-tradable CVR per share that will entitle the holder to receive up to an additional $ 3.00 per CVR in cash (an aggregate of up to approximately $ 123 million) upon the achievement of certain specified milestones. The acquisition will expand our gene therapy portfolio to include potential treatments for hearing loss and other inner ear conditions. The acquisition is not subject to any financing condition and is expected to close in the fourth quarter of 2022, subject to customary closing conditions, including receipt of required antitrust clearance and the tender of a majority of the outstanding shares of Akouos's common stock.\\nNote 4: Collaborations and Other Arrangements\\nWe often enter into collaborative and other similar arrangements to develop and commercialize drug candidates. Collaborative activities may include research and development, marketing and selling (including promotional activities and physician detailing), manufacturing, and distribution. These arrangements often require milestone as well as royalty or profit-share payments, contingent upon the occurrence of certain future events linked to the success of the asset in development, as well as expense reimbursements from or payments to the collaboration partner. See Note 2 for amounts of collaboration and other revenue recognized from these types of arrangements.\\nOperating expenses for costs incurred pursuant to these arrangements are reported in their respective expense line item, net of any payments due to or reimbursements due from our collaboration partners, with such reimbursements being recognized at the time the party becomes obligated to pay. Each collaboration is unique in nature, and our more significant arrangements are discussed below.\\nBoehringer Ingelheim Diabetes Collaboration\\nWe and Boehringer Ingelheim have a global agreement to jointly develop and commercialize a portfolio of diabetes compounds. Currently included in the collaboration are Boehringer Ingelheim's oral diabetes products: Jardiance, Glyxambi, Synjardy, Trijardy XR, Trajenta, and Jentadueto® as well as our basal insulin, Basaglar. Glyxambi, Synjardy, and Trijardy XR are included in the Jardiance product family. Jentadueto is included in the Trajenta product family.\\nIn connection with the regulatory approvals of Jardiance, Trajenta, and Basaglar in the U.S., Europe, and Japan, milestone payments made for Jardiance and Trajenta were capitalized as intangible assets and are being amortized to cost of sales, and milestone payments received for Basaglar were recorded as contract liabilities and are being amortized to collaboration and other revenue. The milestones pertaining to Jardiance and Trajenta are being amortized through their respective term under the collaboration, which, depending on country or region, is determined based on the latest to occur of (a) a defined number of years following launch date, (b) the expiration of the compound patent, or (c) the expiration of marketing authorization exclusivity. The milestones pertaining to Basaglar are being amortized through 2029. The table below summarizes the net milestones capitalized with respect to the Jardiance and Trajenta families of products and the net milestones deferred with respect to Basaglar as of September 30, 2022 and December 31, 2021:\\n| Net Milestones Capitalized (Deferred)(1) |\\n| September 30, 2022 | December 31, 2021 |\\n| Jardiance | $ | 121.2 | $ | 136.1 |\\n| Trajenta | 69.6 | 88.5 |\\n| Basaglar | ( 135.3 ) | ( 149.3 ) |\\n\\n(1) This represents the amounts that have been capitalized (deferred) from the start of this collaboration through the end of the reporting period, net of amount amortized.\\n17\\nFor the Jardiance product family, we and Boehringer Ingelheim share equally the ongoing development and commercialization costs in the most significant markets, and we record our portion of the development and commercialization costs as research and development expense and marketing, selling, and administrative expense, respectively. We receive a royalty on net sales of Boehringer Ingelheim's products in the most significant markets and recognize the royalty as collaboration and other revenue. Boehringer Ingelheim is entitled to potential performance payments depending on the net sales of the Jardiance product family; therefore, our reported revenue for Jardiance may be reduced by any potential performance payments we make related to this product family. The royalty received by us related to the Jardiance product family may also be increased or decreased depending on whether net sales for this product family exceed or fall below certain thresholds. We pay to Boehringer Ingelheim a royalty on net sales for Basaglar in the U.S. We record our sales of Basaglar to third parties as net product revenue with the royalty payments made to Boehringer Ingelheim recorded as cost of sales.\\nThe following table summarizes our collaboration and other revenue recognized with respect to the Jardiance and Trajenta families of products and net product revenue recognized with respect to Basaglar:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Jardiance | $ | 573.3 | $ | 390.4 | $ | 1,453.7 | $ | 1,058.9 |\\n| Basaglar | 193.0 | 192.8 | 558.7 | 650.1 |\\n| Trajenta | 103.8 | 96.1 | 293.0 | 279.9 |\\n\\nOlumiant\\nWe have a worldwide license and collaboration agreement with Incyte Corporation (Incyte), which provides us the development and commercialization rights to baricitinib, branded and trademarked as Olumiant, and certain follow-on compounds, for the treatment of inflammatory and autoimmune diseases and COVID-19. Incyte has the right to receive tiered, double digit royalty payments on worldwide net sales with rates ranging up to 20 percent. Incyte has the right to receive an additional royalty ranging up to the low teens on worldwide net sales for the treatment of COVID-19 that exceed a specified aggregate worldwide net sales threshold. The agreement calls for payments by us to Incyte associated with certain development, success-based regulatory, and sales-based milestones.\\nIn connection with the regulatory approvals of Olumiant in the U.S., Europe, and Japan, as well as achievement of a sales-based milestone, milestone payments of $ 330.0 million and $ 260.0 million were capitalized as intangible assets as of September 30, 2022 and December 31, 2021, respectively, and are being amortized to cost of sales through the term of the collaboration. This represents the cumulative amounts that have been capitalized from the start of this collaboration through the end of each reporting period.\\nAs of September 30, 2022, Incyte is eligible to receive up to $ 100.0 million of additional payments from us in potential sales-based milestones.\\nWe record our sales of Olumiant, including sales of baricitinib that were made pursuant to EUA or similar regulatory authorizations, to third parties as net product revenue with the royalty payments made to Incyte recorded as cost of sales. The following table summarizes our net product revenue recognized with respect to Olumiant:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Olumiant | $ | 182.9 | $ | 406.9 | $ | 624.7 | $ | 809.1 |\\n\\n18\\nCOVID-19 Antibodies\\nWe have a worldwide license and collaboration agreement with AbCellera Biologics Inc. (AbCellera) to co-develop therapeutic antibodies for the potential prevention and treatment of COVID-19, including bamlanivimab and bebtelovimab, for which we hold development and commercialization rights. AbCellera has the right to receive tiered royalty payments on worldwide net sales of bamlanivimab and bebtelovimab with percentages ranging in the mid-teens to mid-twenties. Royalty payments made to AbCellera are recorded as cost of sales.\\nWe have a license and collaboration agreement with Shanghai Junshi Biosciences Co., Ltd. (Junshi Biosciences) to co-develop therapeutic antibodies for the potential prevention and treatment of COVID-19, including etesevimab, for which we hold development and commercialization rights outside of mainland China and the Special Administrative Regions of Hong Kong and Macau, and for which Junshi Biosciences currently maintains all rights in mainland China and the Special Administrative Regions of Hong Kong and Macau. Junshi Biosciences has the right to receive royalty payments in the mid-teens on our net sales of etesevimab. Junshi Biosciences received certain development, success-based regulatory and sales-based milestones. Capitalized regulatory and sales-based milestones were fully amortized to cost of sales as of September 30, 2022.\\nPursuant to EUAs or similar regulatory authorizations, we recognized net product revenue associated with our sales of our COVID-19 antibodies of $ 386.6 million and $ 1.99 billion for the three and nine months ended September 30, 2022, respectively, and $ 217.1 million and $ 1.18 billion for the three and nine months ended September 30, 2021, respectively.\\nSintilimab Injection\\nWe have a collaboration agreement with Innovent Biologics, Inc. (Innovent) to jointly develop and commercialize sintilimab injection in China, where it is branded and trademarked as Tyvyt. In connection with regulatory approvals for Tyvyt in China, milestone payments of $ 120.0 million and $ 40.0 million were capitalized as intangible assets as of September 30, 2022 and December 31, 2021, respectively, and are being amortized to cost of sales through the term of the collaboration. This represents the cumulative amounts that have been capitalized from the start of this collaboration through the end of each reporting period. As of September 30, 2022, Innovent is eligible to receive up to $ 115.0 million in success-based regulatory and sales-based milestones.\\nWe record our sales of Tyvyt to third parties as net product revenue, with payments made to Innovent for its portion of the gross margin reported as cost of sales. We report as collaboration and other revenue our portion of the gross margin for Tyvyt sales made by Innovent to third parties. The following table summarizes our revenue recognized in China with respect to Tyvyt:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Tyvyt | $ | 76.8 | $ | 125.6 | $ | 235.8 | $ | 340.2 |\\n\\nIn 2020, we obtained an exclusive license for sintilimab injection from Innovent for geographies outside of China, which was subsequently terminated and rights have reverted to Innovent in October 2022.\\nLebrikizumab\\nWe have a worldwide license agreement with F. Hoffmann-La Roche Ltd and Genentech, Inc. (collectively, Roche), which provides us the worldwide development and commercialization rights to lebrikizumab. Roche has the right to receive tiered royalty payments on future worldwide net sales ranging in percentages from high single digits to high teens if the product is successfully commercialized. As of September 30, 2022, Roche is eligible to receive up to $ 180.0 million of payments from us contingent upon the achievement of success-based regulatory milestones and up to $ 1.03 billion in a series of sales-based milestones, contingent upon the commercial success of lebrikizumab.\\nWe have a license agreement with Almirall, S.A. (Almirall), under which Almirall licensed the rights to develop and commercialize lebrikizumab for the treatment or prevention of dermatology indications, including, but not limited to, atopic dermatitis in Europe. We have the right to receive tiered royalty payments on future net sales in Europe ranging in percentages from low double digits to low twenties if the product is successfully commercialized. As of September 30, 2022, we are eligible to receive additional payments of $ 85.0 million from Almirall contingent upon the achievement of success-based regulatory milestones and up to $ 1.25 billion in a series of sales-based milestones, contingent upon the commercial success of lebrikizumab. There were no remaining contract liabilities as of September 30, 2022. As of December 31, 2021, contract liabilities were not material. During the three and nine months ended September 30, 2022 and 2021, collaboration and other revenue recognized was not material.\\n19\\nNote 5: Asset Impairment, Restructuring, and Other Special Charges\\nThe components of the charges included in asset impairment, restructuring, and other special charges in our consolidated condensed statements of operations are described below.\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Severance | $ | — | $ | — | $ | — | $ | 11.5 |\\n| Asset impairment and other special charges | 206.5 | — | 206.5 | 200.1 |\\n| Total asset impairment, restructuring, and other special charges | $ | 206.5 | $ | — | $ | 206.5 | $ | 211.6 |\\n\\nAsset impairment, restructuring, and other special charges recognized during the three and nine months ended September 30, 2022 were primarily related to an intangible asset impairment for GBA1 Gene Therapy (PR001), acquired in the Prevail acquisition, as a result of changes in key assumptions used in the valuation due to delays in estimated launch timing.\\nAsset impairment, restructuring, and other special charges recognized during the nine months ended September 30, 2021 were primarily related to an intangible asset impairment of $ 108.1 million resulting from the sale of the rights to Qbrexza®, as well as acquisition and integration costs associated with the acquisition of Prevail.\\nWe recognized a net inventory impairment charge related to our COVID-19 antibodies of $ 435.1 million during the nine months ended September 30, 2021 in cost of sales in our consolidated condensed statements of operations. As part of our response to the COVID-19 pandemic, and at the request of the U.S. and international governments, we invested in large-scale manufacturing of COVID-19 antibodies at risk, in order to ensure rapid access to patients around the world. As the COVID-19 pandemic evolved during 2021, we incurred a net inventory impairment charge primarily due to the combination of changes to demand from U.S. and international governments, including changes to our agreement with the U.S. government, and near-term expiry dates of COVID-19 antibodies.\\nNote 6: Financial Instruments\\nFinancial instruments that potentially subject us to credit risk consist principally of trade receivables and interest-bearing investments. Wholesale distributors of life science products account for a substantial portion of our trade receivables; collateral is generally not required. We seek to mitigate the risk associated with this concentration through our ongoing credit-review procedures and insurance. A large portion of our cash is held by a few major financial institutions. We monitor our exposures with these institutions and do not expect any of these institutions to fail to meet their obligations. In accordance with documented corporate risk-management policies, we monitor the amount of credit exposure to any one financial institution or corporate issuer. We are exposed to credit-related losses in the event of nonperformance by counterparties to risk-management instruments but do not expect any counterparties to fail to meet their obligations given their investment grade credit ratings.\\nWe consider all highly liquid investments with a maturity of three months or less from the date of purchase to be cash equivalents. The cost of these investments approximates fair value.\\nOur equity investments are accounted for using three different methods depending on the type of equity investment:\\n•Investments in companies over which we have significant influence but not a controlling interest are accounted for using the equity method, with our share of earnings or losses reported in other-net, (income) expense.\\n•For equity investments that do not have readily determinable fair values, we measure these investments at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for the identical or similar investment of the same issuer. Any change in recorded value is recorded in other-net, (income) expense.\\n•Our public equity investments are measured and carried at fair value. Any change in fair value is recognized in other-net, (income) expense.\\nWe review equity investments other than public equity investments for indications of impairment and observable price changes on a regular basis.\\n20\\nOur derivative activities are initiated within the guidelines of documented corporate risk-management policies and are intended to offset losses and gains on the assets, liabilities, and transactions being hedged. Management reviews the correlation and effectiveness of our derivatives on a quarterly basis.\\nFor derivative instruments that are designated and qualify as fair value hedges, the derivative instrument is marked to market, with gains and losses recognized currently in income to offset the respective losses and gains recognized on the underlying exposure. For derivative instruments that are designated and qualify as cash flow hedges, gains and losses are reported as a component of accumulated other comprehensive loss and reclassified into earnings in the same period the hedged transaction affects earnings. For derivative and non-derivative instruments that are designated and qualify as net investment hedges, the foreign currency translation gains or losses due to spot rate fluctuations are reported as a component of accumulated other comprehensive loss. Derivative contracts that are not designated as hedging instruments are recorded at fair value with the gain or loss recognized in earnings during the period of change.\\nWe may enter into foreign currency forward or option contracts to reduce the effect of fluctuating currency exchange rates (principally the euro, British pound, Chinese yuan, and Japanese yen). Foreign currency derivatives used for hedging are put in place using the same or like currencies and duration as the underlying exposures. Forward and option contracts are principally used to manage exposures arising from subsidiary trade and loan payables and receivables denominated in foreign currencies. These contracts are recorded at fair value with the gain or loss recognized in other–net, (income) expense. We may enter into foreign currency forward and option contracts and currency swaps as fair value hedges of firm commitments. Forward contracts generally have maturities not exceeding 12 months. At September 30, 2022, we had outstanding foreign currency forward commitments to purchase 1.69 billion U.S. dollars and sell 1.71 billion euro; commitments to purchase 2.24 billion euro and sell 2.24 billion U.S. dollars; commitments to purchase 239.5 million U.S. dollars and sell 1.63 billion Chinese yuan; commitments to purchase 82.1 million U.S. dollars and sell 11.86 billion Japanese yen; and commitments to purchase 182.1 million British pounds and sell 206.9 million U.S. dollars, which all have settlement dates within 180 days.\\nForeign currency exchange risk is also managed through the use of foreign currency debt, cross-currency interest rate swaps, and foreign currency forward contracts. Our foreign currency-denominated notes had carrying amounts of $ 6.23 billion and $ 7.90 billion as of September 30, 2022 and December 31, 2021, respectively, of which $ 4.94 billion and $ 5.79 billion have been designated as, and are effective as, economic hedges of net investments in certain of our foreign operations as of September 30, 2022 and December 31, 2021, respectively. At September 30, 2022, we had outstanding cross-currency swaps with notional amounts of $ 1.56 billion swapping U.S. dollars to euro and $ 1.00 billion swapping Swiss francs to U.S. dollars which have settlement dates ranging through 2028. Our cross-currency interest rate swaps, for which a majority convert a portion of our U.S. dollar-denominated fixed-rate debt to foreign-denominated fixed-rate debt, have also been designated as, and are effective as, economic hedges of net investments. At September 30, 2022, we had outstanding foreign currency forward contracts to sell 1.34 billion euro with settlement dates ranging through 2023, which have been designated as, and are effective as, economic hedges of net investments.\\nIn the normal course of business, our operations are exposed to fluctuations in interest rates which can vary the costs of financing, investing, and operating. We seek to address a portion of these risks through a controlled program of risk management that includes the use of derivative financial instruments. The objective of controlling these risks is to limit the impact of fluctuations in interest rates on earnings. Our primary interest-rate risk exposure results from changes in short-term U.S. dollar interest rates. In an effort to manage interest-rate exposures, we strive to achieve an acceptable balance between fixed- and floating-rate debt and investment positions and may enter into interest rate swaps or collars to help maintain that balance.\\nInterest rate swaps or collars that convert our fixed-rate debt to a floating rate are designated as fair value hedges of the underlying instruments. Interest rate swaps or collars that convert floating-rate debt to a fixed rate are designated as cash flow hedges. Interest expense on the debt is adjusted to include the payments made or received under the swap agreements. Cash proceeds from or payments to counterparties resulting from the termination of interest rate swaps are classified as operating activities in our consolidated condensed statements of cash flows. At September 30, 2022, substantially all of our total long-term debt is at a fixed rate. We have converted approximately 10 percent of our long-term fixed-rate notes to floating rates through the use of interest rate swaps.\\n21\\nWe also may enter into forward-starting interest rate swaps, which we designate as cash flow hedges, as part of any anticipated future debt issuances in order to reduce the risk of cash flow volatility from future changes in interest rates. The change in fair value of these instruments is recorded as part of other comprehensive income (loss) and, upon completion of a debt issuance and termination of the swap, is amortized to interest expense over the life of the underlying debt. As of September 30, 2022, the total notional amounts of forward-starting interest rate contracts in designated cash flow hedging instruments were $ 1.75 billion, which have settlement dates ranging between 2023 and 2025.\\nEffective September 15, 2022, we increased our 364-day credit facility from $ 2.00 billion to $ 4.00 billion, which will expire in September 2023, and is available to support our commercial paper program. We have not drawn against the $ 4.00 billion 364-day credit facility as of September 30, 2022.\\nIn September 2021, we issued euro-denominated notes consisting of € 600.0 million of 0.50 percent fixed-rate notes due in September 2033, with interest to be paid annually. The net proceeds from the offering have been, and will continue to be, used to fund, in whole or in part, eligible projects designed to advance one or more of our environmental, social, and governance objectives.\\nIn September 2021, we issued euro-denominated notes consisting of € 500.0 million of 1.125 percent fixed-rate notes due in September 2051 and € 700.0 million of 1.375 percent fixed-rate notes due in September 2061, with interest to be paid annually, and British pound-denominated notes consisting of £ 250.0 million of 1.625 percent fixed-rate notes due in September 2043, with interest to be paid annually. We paid $ 1.91 billion of the net cash proceeds from the offering to purchase and redeem certain higher interest rate U.S. dollar-denominated notes with an aggregate principal amount of $ 1.50 billion, resulting in a debt extinguishment loss of $ 405.2 million. This loss was included in other net, (income) expense in our consolidated condensed statement of operations during the three and nine months ended September 30, 2021. The $ 1.50 billion principal amount of higher interest rate U.S. dollar-denominated notes that were redeemed primarily included $ 541.8 million of 3.95 percent notes due 2049, $ 408.7 million of 4.15 percent notes due 2059, and $ 219.4 million of 3.375 percent notes due 2029. We used the remaining net proceeds from the offering to prefund certain 2022 debt maturities and for general corporate purposes.\\nThe Effect of Risk-Management Instruments on the Consolidated Condensed Statements of Operations\\nThe following effects of risk-management instruments were recognized in other–net, (income) expense:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Fair value hedges: |\\n| Effect from hedged fixed-rate debt | $ | ( 62.9 ) | $ | ( 10.1 ) | $ | ( 215.7 ) | $ | ( 60.5 ) |\\n| Effect from interest rate contracts | 62.9 | 10.1 | 215.7 | 60.5 |\\n| Cash flow hedges: |\\n| Effective portion of losses on interest rate contracts reclassified from accumulated other comprehensive loss | 4.1 | 4.2 | 12.3 | 12.5 |\\n| Cross-currency interest rate swaps | 33.1 | 10.0 | 75.0 | 58.1 |\\n| Net (gains) losses on foreign currency exchange contracts not designated as hedging instruments | 129.6 | 50.8 | 280.7 | 110.6 |\\n| Total | $ | 166.8 | $ | 65.0 | $ | 368.0 | $ | 181.2 |\\n\\nDuring the three and nine months ended September 30, 2022 and 2021, the amortization of losses related to the portion of our risk management hedging instruments, fair value hedges, and cash flow hedges that was excluded from the assessment of effectiveness was not material.\\n22\\nThe Effect of Risk-Management Instruments on Other Comprehensive Income (Loss)\\nThe effective portion of risk-management instruments that was recognized in other comprehensive income (loss) is as follows:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Net investment hedges: |\\n| Foreign currency-denominated notes | $ | 435.1 | $ | 119.0 | $ | 822.8 | $ | 268.8 |\\n| Cross-currency interest rate swaps | 92.1 | 66.7 | 171.4 | 170.8 |\\n| Foreign currency forward contracts | 107.8 | — | 121.4 | — |\\n| Cash flow hedges: |\\n| Forward-starting interest rate swaps | 57.5 | 19.4 | 337.7 | 149.3 |\\n| Cross-currency interest rate swaps | 19.9 | 3.1 | 38.4 | 22.5 |\\n\\nDuring the next 12 months, we expect to reclassify $ 16.7 million of pretax net losses on cash flow hedges from accumulated other comprehensive loss to other–net, (income) expense. During the three and nine months ended September 30, 2022 and 2021, the amounts excluded from the assessment of hedge effectiveness recognized in other comprehensive income (loss) were not material.\\n23\\nFair Value of Financial Instruments\\nThe following tables summarize certain fair value information at September 30, 2022 and December 31, 2021 for assets and liabilities measured at fair value on a recurring basis, as well as the carrying amount and amortized cost of certain other investments:\\n| Fair Value Measurements Using |\\n| CarryingAmount | Cost(1) | Quoted Prices in Active Markets for Identical Assets(Level 1) | Significant OtherObservable Inputs(Level 2) | SignificantUnobservableInputs(Level 3) | FairValue |\\n| September 30, 2022 |\\n| Cash equivalents | $ | 1,246.8 | $ | 1,246.8 | $ | 1,239.2 | $ | 7.6 | $ | — | $ | 1,246.8 |\\n| Short-term investments: |\\n| U.S. government and agency securities | $ | 43.0 | $ | 43.5 | $ | 43.0 | $ | — | $ | — | $ | 43.0 |\\n| Corporate debt securities | 51.7 | 51.8 | — | 51.7 | — | 51.7 |\\n| Asset-backed securities | 3.0 | 3.0 | — | 3.0 | — | 3.0 |\\n| Other securities | 27.0 | 27.0 | — | 14.8 | 12.2 | 27.0 |\\n| Short-term investments | $ | 124.7 |\\n| Noncurrent investments: |\\n| U.S. government and agency securities | $ | 131.4 | $ | 148.3 | $ | 131.4 | $ | — | $ | — | $ | 131.4 |\\n| Corporate debt securities | 206.4 | 232.5 | — | 206.4 | — | 206.4 |\\n| Mortgage-backed securities | 143.1 | 156.1 | — | 143.1 | — | 143.1 |\\n| Asset-backed securities | 43.6 | 45.5 | — | 43.6 | — | 43.6 |\\n| Other securities | 152.5 | 96.3 | — | 39.5 | 113.0 | 152.5 |\\n| Marketable equity securities | 549.1 | 416.1 | 549.1 | — | — | 549.1 |\\n| Equity investments without readily determinable fair values(2) | 583.7 |\\n| Equity method investments(2) | 764.8 |\\n| Noncurrent investments | $ | 2,574.6 |\\n| December 31, 2021 |\\n| Cash equivalents | $ | 2,379.5 | $ | 2,379.5 | $ | 2,361.0 | $ | 18.5 | $ | — | $ | 2,379.5 |\\n| Short-term investments: |\\n| U.S. government and agency securities | $ | 25.7 | $ | 25.6 | $ | 25.7 | $ | — | $ | — | $ | 25.7 |\\n| Corporate debt securities | 43.7 | 43.7 | — | 43.7 | — | 43.7 |\\n| Mortgage-backed securities | 0.2 | 0.2 | — | 0.2 | — | 0.2 |\\n| Asset-backed securities | 6.2 | 6.2 | — | 6.2 | — | 6.2 |\\n| Other securities | 14.3 | 14.3 | — | — | 14.3 | 14.3 |\\n| Short-term investments | $ | 90.1 |\\n| Noncurrent investments: |\\n| U.S. government and agency securities | $ | 137.0 | $ | 136.8 | $ | 137.0 | $ | — | $ | — | $ | 137.0 |\\n| Corporate debt securities | 235.3 | 232.7 | — | 235.3 | — | 235.3 |\\n| Mortgage-backed securities | 109.8 | 108.1 | — | 109.8 | — | 109.8 |\\n| Asset-backed securities | 23.1 | 23.1 | — | 23.1 | — | 23.1 |\\n| Other securities | 108.1 | 22.2 | — | — | 108.1 | 108.1 |\\n| Marketable equity securities | 1,279.7 | 487.0 | 1,279.7 | — | — | 1,279.7 |\\n| Equity investments without readily determinable fair values(2) | 548.1 |\\n| Equity method investments(2) | 771.5 |\\n| Noncurrent investments | $ | 3,212.6 |\\n\\n(1) For available-for-sale debt securities, amounts disclosed represent the securities' amortized cost.\\n(2) Fair value disclosures are not applicable for equity method investments and investments accounted for under the measurement alternative for equity investments.\\n24\\n| Fair Value Measurements Using |\\n| CarryingAmount | Quoted Prices in Active Markets for Identical Assets(Level 1) | SignificantOther Observable Inputs(Level 2) | SignificantUnobservableInputs(Level 3) | FairValue |\\n| Short-term commercial paper borrowings |\\n| September 30, 2022 | $ | ( 1,741.3 ) | $ | — | $ | ( 1,738.0 ) | $ | — | $ | ( 1,738.0 ) |\\n| December 31, 2021 | — | — | — | — | — |\\n| Long-term debt, including current portion |\\n| September 30, 2022 | $ | ( 14,147.1 ) | $ | — | $ | ( 11,848.6 ) | $ | — | $ | ( 11,848.6 ) |\\n| December 31, 2021 | ( 16,884.7 ) | — | ( 18,157.7 ) | — | ( 18,157.7 ) |\\n\\n25\\n| Fair Value Measurements Using |\\n| CarryingAmount | Quoted Prices in Active Markets for Identical Assets(Level 1) | SignificantOther Observable Inputs(Level 2) | SignificantUnobservableInputs(Level 3) | FairValue |\\n| September 30, 2022 |\\n| Risk-management instruments: |\\n| Interest rate contracts designated as fair value hedges: |\\n| Other noncurrent liabilities | $ | ( 140.2 ) | $ | — | $ | ( 140.2 ) | $ | — | $ | ( 140.2 ) |\\n| Interest rate contracts designated as cash flow hedges: |\\n| Other noncurrent assets | 355.2 | — | 355.2 | — | 355.2 |\\n| Cross-currency interest rate contracts designated as net investment hedges: |\\n| Other receivables | 81.6 | — | 81.6 | — | 81.6 |\\n| Other noncurrent assets | 116.9 | — | 116.9 | — | 116.9 |\\n| Cross-currency interest rate contracts designated as cash flow hedges: |\\n| Other noncurrent assets | 8.3 | — | 8.3 | — | 8.3 |\\n| Other noncurrent liabilities | ( 12.9 ) | — | ( 12.9 ) | — | ( 12.9 ) |\\n| Foreign exchange contracts designated as net investment hedges: |\\n| Other receivables | 108.2 | — | 108.2 | — | 108.2 |\\n| Other current liabilities | ( 2.9 ) | — | ( 2.9 ) | — | ( 2.9 ) |\\n| Foreign exchange contracts not designated as hedging instruments: |\\n| Other receivables | 48.1 | — | 48.1 | — | 48.1 |\\n| Other current liabilities | ( 93.5 ) | — | ( 93.5 ) | — | ( 93.5 ) |\\n| Contingent consideration liability: |\\n| Other noncurrent liabilities | ( 42.1 ) | — | — | ( 42.1 ) | ( 42.1 ) |\\n| December 31, 2021 |\\n| Risk-management instruments: |\\n| Interest rate contracts designated as fair value hedges: |\\n| Other receivables | $ | 4.8 | $ | — | $ | 4.8 | $ | — | $ | 4.8 |\\n| Other noncurrent assets | 78.3 | — | 78.3 | — | 78.3 |\\n| Other noncurrent liabilities | ( 7.6 ) | — | ( 7.6 ) | — | ( 7.6 ) |\\n| Interest rate contracts designated as cash flow hedges: |\\n| Other noncurrent assets | 49.2 | — | 49.2 | — | 49.2 |\\n| Other noncurrent liabilities | ( 31.7 ) | — | ( 31.7 ) | — | ( 31.7 ) |\\n| Cross-currency interest rate contracts designated as net investment hedges: |\\n| Other noncurrent assets | 31.3 | — | 31.3 | — | 31.3 |\\n| Other current liabilities | ( 1.2 ) | — | ( 1.2 ) | — | ( 1.2 ) |\\n| Cross-currency interest rate contracts designated as cash flow hedges: |\\n| Other noncurrent assets | 33.2 | — | 33.2 | — | 33.2 |\\n| Other noncurrent liabilities | ( 1.3 ) | — | ( 1.3 ) | — | ( 1.3 ) |\\n| Foreign exchange contracts not designated as hedging instruments: |\\n| Other receivables | 9.9 | — | 9.9 | — | 9.9 |\\n| Other current liabilities | ( 35.3 ) | — | ( 35.3 ) | — | ( 35.3 ) |\\n| Contingent consideration liabilities: |\\n| Other noncurrent liabilities | ( 70.5 ) | — | — | ( 70.5 ) | ( 70.5 ) |\\n\\n26\\nRisk-management instruments above are disclosed on a gross basis. There are various rights of setoff associated with certain of the risk-management instruments above that are subject to enforceable master netting arrangements or similar agreements. Although various rights of setoff and master netting arrangements or similar agreements may exist with the individual counterparties to the risk-management instruments above, individually, these financial rights are not material.\\nWe determine our Level 1 and Level 2 fair value measurements based on a market approach using quoted market values, significant other observable inputs for identical or comparable assets or liabilities, or discounted cash flow analyses. Level 3 fair value measurements for other investment securities are determined using unobservable inputs, including the investments' cost adjusted for impairments and price changes from orderly transactions. Fair values are not readily available for certain equity investments measured under the measurement alternative.\\nAs of September 30, 2022, we had approximately $ 854 million of unfunded commitments to invest in venture capital funds, which we anticipate will be paid over a period of up to 10 years.\\nContingent consideration liability relates to our liability arising in connection with the CVR issued as a result of the Prevail acquisition. The fair value of the CVR liability was estimated using a discounted cash flow analysis and Level 3 inputs, including projections representative of a market participant's view of the expected cash payment associated with the first potential regulatory approval of a Prevail compound in the applicable countries based on probabilities of technical success, timing of the potential approval events for the compounds, and an estimated discount rate. See Note 3 for additional information related to the CVR arrangement.\\nThe table below summarizes the contractual maturities of our investments in debt securities measured at fair value as of September 30, 2022:\\n| Maturities by Period |\\n| Total | Less Than1 Year | 1-5Years | 6-10Years | More Than10 Years |\\n| Fair value of debt securities | $ | 622.2 | $ | 97.7 | $ | 197.8 | $ | 121.0 | $ | 205.7 |\\n\\nThe net gains (losses) recognized in our consolidated condensed statements of operations for equity securities were $( 123.3 ) million and $( 667.6 ) million for the three and nine months ended September 30, 2022, respectively, and $( 246.8 ) million and $ 270.1 million for the three and nine months ended September 30, 2021, respectively. The net gains (losses) recognized for the three and nine months ended September 30, 2022 and 2021 on equity securities sold during the respective periods were not material.\\nWe adjust our equity investments without readily determinable fair values based upon changes in the equity instruments' values resulting from observable price changes in orderly transactions for an identical or similar investment of the same issuer. Downward adjustments resulting from an impairment are recorded based upon impairment considerations, including the financial condition and near term prospects of the issuer, general market conditions, and industry specific factors. Adjustments recorded for the three and nine months ended September 30, 2022 and 2021 were not material.\\nA summary of the amount of unrealized gains and losses in accumulated other comprehensive loss and the fair value of available-for-sale securities in an unrealized gain or loss position follows:\\n| September 30, 2022 | December 31, 2021 |\\n| Unrealized gross gains | $ | 0.1 | $ | 9.7 |\\n| Unrealized gross losses | 51.6 | 5.2 |\\n| Fair value of securities in an unrealized gain position | 13.8 | 250.7 |\\n| Fair value of securities in an unrealized loss position | 578.8 | 290.2 |\\n\\nWe periodically assess our investment in available-for-sale securities for impairment losses and credit losses. The amount of credit losses are determined by comparing the difference between the present value of future cash flows expected to be collected on these securities and the amortized cost. Factors considered in assessing credit losses include the position in the capital structure, vintage and amount of collateral, delinquency rates, current credit support, and geographic concentration. Impairment and credit losses related to available-for-sale securities were not material for the three and nine months ended September 30, 2022 and 2021.\\n27\\nAs of September 30, 2022, the available-for-sale securities in an unrealized loss position include primarily fixed-rate debt securities of varying maturities, which are sensitive to changes in the yield curve and other market conditions. Approximately 95 percent of the fixed-rate debt securities in a loss position are investment-grade debt securities. As of September 30, 2022, we do not intend to sell, and it is not more likely than not that we will be required to sell, the securities in a loss position before the market values recover or the underlying cash flows have been received, and there is no indication of a material default on interest or principal payments for our debt securities.\\nActivity related to our available-for-sale securities was as follows:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Proceeds from sales | $ | 50.5 | $ | 49.6 | $ | 115.6 | $ | 137.3 |\\n| Realized gross gains on sales | — | 0.4 | 0.2 | 2.2 |\\n| Realized gross losses on sales | 7.5 | 0.3 | 9.0 | 1.1 |\\n\\nRealized gains and losses on sales of available-for-sale investments are computed based upon specific identification of the initial cost adjusted for any other-than-temporary declines in fair value that were recorded in earnings.\\nAccounts Receivable Factoring Arrangements\\nWe have entered into accounts receivable factoring agreements with financial institutions to sell certain of our non-U.S. accounts receivable. These transactions are accounted for as sales and result in a reduction in accounts receivable because the agreements transfer effective control over, and risk related to, the receivables to the buyers. Our factoring agreements do not allow for recourse in the event of uncollectibility, and we do not retain any interest in the underlying accounts receivable once sold. We derecognized $ 356.8 million and $ 550.5 million of accounts receivable as of September 30, 2022 and December 31, 2021, respectively, under these factoring arrangements. The costs of factoring such accounts receivable on our consolidated condensed results of operations for the three and nine months ended September 30, 2022 and 2021 were not material.\\nNote 7: Income Taxes\\nThe effective tax rates were 7.3 percent and 8.6 percent for the three and nine months ended September 30, 2022, respectively, reflecting the favorable tax impact of the implementation of a provision in the Tax Cuts and Jobs Act (2017 Tax Act) that requires capitalization and amortization of research and development expenses for tax purposes starting in 2022, net investment losses on equity securities, and an intangible asset impairment charge. We expect our effective tax rate to be approximately 13 percent to 14 percent for 2022 if the capitalization and amortization of research and development expenses provision of the 2017 Tax Act is deferred or repealed by the U.S. Congress effective for 2022.\\nThe effective tax rate was 10.9 percent for the three months ended September 30, 2021, reflecting the favorable tax impact of a debt extinguishment loss and of net investment losses on equity securities, partially offset by a net discrete tax detriment. The effective tax rate was 10.7 percent for the nine months ended September 30, 2021, reflecting the favorable tax impact of a net discrete tax benefit, a debt extinguishment loss, and a net inventory impairment charge related to our COVID-19 antibodies.\\nThe U.S. examination of tax years 2016-2018 began in the fourth quarter of 2019 and remains ongoing. The resolution of this audit period will likely extend beyond the next 12 months.\\n28\\nNote 8: Retirement Benefits\\nNet pension and retiree health benefit (income) cost included the following components:\\n| Defined Benefit Pension Plans |\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Components of net periodic benefit cost: |\\n| Service cost | $ | 87.1 | $ | 92.5 | $ | 264.4 | $ | 277.8 |\\n| Interest cost | 98.9 | 84.5 | 299.0 | 253.6 |\\n| Expected return on plan assets | ( 235.1 ) | ( 237.5 ) | ( 711.6 ) | ( 712.7 ) |\\n| Amortization of prior service cost | 0.6 | 1.0 | 1.9 | 3.2 |\\n| Recognized actuarial loss | 85.3 | 121.9 | 256.8 | 366.3 |\\n| Net periodic benefit cost | $ | 36.8 | $ | 62.4 | $ | 110.5 | $ | 188.2 |\\n\\n| Retiree Health Benefit Plans |\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Components of net periodic benefit income: |\\n| Service cost | $ | 11.7 | $ | 12.4 | $ | 35.0 | $ | 37.0 |\\n| Interest cost | 9.4 | 8.1 | 28.4 | 24.4 |\\n| Expected return on plan assets | ( 38.0 ) | ( 36.5 ) | ( 114.1 ) | ( 109.6 ) |\\n| Amortization of prior service benefit | ( 13.7 ) | ( 14.9 ) | ( 41.1 ) | ( 44.7 ) |\\n| Recognized actuarial loss | 0.2 | 0.8 | 0.7 | 2.4 |\\n| Net periodic benefit income | $ | ( 30.4 ) | $ | ( 30.1 ) | $ | ( 91.1 ) | $ | ( 90.5 ) |\\n\\nNote 9: Contingencies\\nWe are involved in various lawsuits, claims, government investigations and other legal proceedings that arise in the ordinary course of business. These claims or proceedings can involve various types of parties, including governments, competitors, customers, suppliers, service providers, licensees, employees, or shareholders, among others. These matters may involve patent infringement, antitrust, securities, pricing, sales and marketing practices, environmental, commercial, contractual rights, licensing obligations, health and safety matters, consumer fraud, employment matters, product liability and insurance coverage, among others. The resolution of these matters often develops over a long period of time and expectations can change as a result of new findings, rulings, appeals or settlement arrangements. Legal proceedings that are significant or that we believe could become significant or material are described below.\\nWe believe the legal proceedings in which we are named as defendants are without merit and we are defending against them vigorously. It is not possible to determine the final outcome of these matters, and we cannot reasonably estimate the maximum potential exposure or the range of possible loss in excess of amounts accrued for any of these matters; however, we believe that the resolution of all such matters will not have a material adverse effect on our consolidated financial position or liquidity, but could possibly be material to our consolidated results of operations in any one accounting period.\\nLitigation accruals, environmental liabilities, and the related estimated insurance recoverables are reflected on a gross basis as liabilities and assets, respectively, on our consolidated condensed balance sheets. With respect to the product liability claims currently asserted against us, we have accrued for our estimated exposures to the extent they are both probable and reasonably estimable based on the information available to us. We accrue for certain product liability claims incurred but not filed to the extent we can formulate a reasonable estimate of their costs. We estimate these expenses based primarily on historical claims experience and data regarding product usage. Legal defense costs expected to be incurred in connection with significant product liability loss contingencies are accrued when both probable and reasonably estimable.\\nBecause of the nature of pharmaceutical products, it is possible that we could become subject to large numbers of additional product liability and related claims in the future. Due to a very restrictive market for litigation liability insurance, we are self-insured for litigation liability losses for all our currently and previously marketed products.\\n29\\nPatent Litigation\\nAlimta European Patent Litigation\\nIn Europe, Alimta (pemetrexed) was protected by a patent through June 2021. A number of legal proceedings that were initiated prior to patent expiration are ongoing.\\nEmgality Patent Litigation\\nWe are a named defendant in litigation filed by Teva Pharmaceuticals International GMBH and Teva Pharmaceuticals USA, Inc. (collectively, Teva) in the U.S. District Court for the District of Massachusetts seeking a ruling that various claims in three different Teva patents would be infringed by our launch and continued sales of Emgality for the prevention of migraine in adults. Trial began in October 2022. In June 2021, we were named as a defendant in a second litigation filed by Teva in the U.S. District Court for the District of Massachusetts seeking a ruling that two of Teva's patents, which are directed toward use of the active ingredient in Emgality to treat migraine, would be infringed by our continued sales of Emgality. We challenged these two patents by filing requests for Inter Partes Review with the Patent Trial and Appeal Board (PTAB) and in October 2022, the PTAB granted our requests.The corresponding district court litigation is stayed while this PTAB proceeding is ongoing.\\nJardiance Patent Litigation\\nIn November 2018, Boehringer Ingelheim, our partner in marketing and development of Jardiance, initiated U.S. patent litigation in the U.S. District Court of Delaware alleging infringement arising from submissions of Abbreviated New Drug Applications (ANDA) by a number of generic companies seeking approval to market generic versions of Jardiance, Glyxambi, and Synjardy in accordance with the procedures set out in the Drug Price Competition and Patent Term Restoration Act of 1984 (the Hatch-Waxman Act). Particularly with respect to Jardiance, the generic companies' ANDAs seek approval to market generic versions of Jardiance prior to the expiration of the relevant patents, and allege that certain patents, including in some allegations the compound patent, are invalid or would not be infringed. We are not a party to this litigation. This litigation has been stayed.\\nTaltz Patent Litigation\\nIn April 2021, we petitioned the High Court of Ireland to declare invalid a patent that Novartis Pharma AG (Novartis) purchased from Genentech, Inc. in 2020. Novartis responded by filing a claim against us alleging patent infringement related to our commercialization of Taltz and seeking damages for past infringement and an injunction against future infringement.\\nIn April 2021, Novartis petitioned the Court of Rome Intellectual Property Division for a preliminary injunction (PI) against us related to our commercialization of Taltz in Italy. In May 2021, We commenced patent revocation proceedings against Novartis before the Court of Milan’s IP Division where we also sought a declaration of non-infringement. Novartis counter-claimed for patent infringement and sought a permanent injunction. A hearing on the PI request before the Court of Rome Intellectual Property Division took place in May 2022 and in July 2022, the court rejected Novartis' request.\\nIn November 2021, Novartis petitioned the Swiss Federal Patent Court for a PI and a permanent injunction in main infringement proceedings against us related to our commercialization of Taltz in Switzerland. We petitioned the court to revoke the patent and for a declaration of non-infringement. In April 2022, Novartis withdrew its PI request.\\nIn January 2022, we commenced an action in the Hague District Court asking for a judgment that a Novartis Dutch patent is not infringed by our commercialization of Taltz in the Netherlands and is invalid. In October 2022, Novartis filed a counterclaim for infringement and sought a permanent injunction.\\nIn October 2022, we entered into a settlement and mutual release agreement with Novartis, which resolves the above-described disputes. Without any admission of liability or wrongdoing, we and Novartis have agreed to mutual releases for past claims and mutual covenants not to sue the other in relation to Taltz and the patents Novartis purchased from Genentech.\\n30\\nZyprexa Canada Patent Litigation\\nBeginning in the mid-2000s, several generic companies in Canada challenged the validity of our Zyprexa compound patent. In 2012, the Canadian Federal Court of Appeals denied our appeal of a lower court's decision that certain patent claims were invalid for lack of utility. In 2013, Apotex Inc. and Apotex Pharmachem Inc. (collectively, Apotex) brought claims against us in the Ontario Superior Court of Justice at Toronto for damages related to our enforcement of the Zyprexa compound patent under Canadian regulations governing patented drugs. Apotex seeks compensation based on novel legal theories under the Statute of Monopolies, Trademark Act, and common law. In March 2021, the Ontario Superior Court granted our motion for summary judgment, thereby dismissing Apotex's case. Apotex appealed that ruling to the Court of Appeal for Ontario in April 2021. In August 2022, the Court dismissed the appeal and in October 2022, Apotex appealed the decision. This matter is ongoing.\\nProduct Liability Litigation\\nByetta® Product Liability\\nWe have been named as a defendant in over 500 Byetta product liability lawsuits in the U.S. that were first initiated in March 2009 and involved over 800 plaintiffs. These lawsuits have been filed in various state and federal jurisdictions, including California state court (coordinated in Los Angeles County Superior Court), and various federal courts, the majority of which are coordinated in a multi-district litigation (MDL) in the U.S. District Court for the Southern District of California. The majority of these suits contain allegations that Byetta caused or contributed to the plaintiffs' cancer (primarily pancreatic cancer or thyroid cancer). The federal MDL and coordinated California state trial courts granted summary judgment in our favor on claims pertaining to pancreatic cancer, and the plaintiffs have dismissed Lilly from their appeal of the MDL ruling (the parties still await the order of judgment in the Los Angeles County Superior Court). Most of the MDL and state court lawsuits have been dismissed as of November 2022.\\nEnvironmental Proceedings\\nUnder the Comprehensive Environmental Response, Compensation, and Liability Act, commonly known as \\\"Superfund,\\\" we have been designated as one of several potentially responsible parties with respect to the cleanup of fewer than 10 sites. Under Superfund, each responsible party may be jointly and severally liable for the entire amount of the cleanup.\\nOther Matters\\n340B Litigation and Investigations\\nWe are the plaintiff in a lawsuit filed in January 2021 in the U.S. District Court for the Southern District of Indiana against the U.S. Department of Health and Human Services (HHS), the Secretary of HHS, the Health Resources and Services Administration (HRSA), and the Administrator of HRSA. The lawsuit challenges the HHS's December 30, 2020 advisory opinion stating that drug manufacturers are required to deliver discounts under the 340B program to all contract pharmacies. We seek a declaratory judgment that the defendants violated the Administrative Procedures Act and the U.S. Constitution, a preliminary injunction enjoining implementation of the administrative dispute resolution process created by defendants and, with it, their application of the advisory opinion, and other related relief. In March 2021, the court entered an order preliminarily enjoining the government's enforcement of the administrative dispute resolution process against us. In May 2021, HRSA notified us that it determined that our policy was contrary to the 340B statute. In response, in May 2021, we filed a motion for preliminary injunction and temporary restraining order requesting that the U.S. District Court for the Southern District of Indiana enjoin defendants from taking any action against us relating to the 340B drug pricing program until after the court issues a final judgment on the aforementioned litigation. In May 2021, the court denied our motion for a temporary restraining order but deferred resolution of our motion for preliminary injunction. In June 2021, the defendants withdrew the HHS December 30, 2020 advisory opinion. In July 2021, the court held oral argument on the parties' cross motions for summary judgment, the defendants' motion to dismiss, and our motion for preliminary injunction related to HRSA's May 2021 enforcement letter. In October 2021, the court denied the defendants' motion to dismiss, and granted in part and denied in part the parties' cross motions for summary judgment. Both parties filed notices of appeal related to the court's summary judgment order. Oral argument took place in October 2022 in the U.S. Court of Appeals for the Seventh Circuit. This matter is ongoing.\\nIn January 2021, we, along with other pharmaceutical manufacturers, were named as a defendant in a petition currently pending before the HHS Administrative Dispute Resolution Panel. Petitioner seeks declaratory and other injunctive relief related to the 340B program. As described above, the U.S. District Court for the Southern District of Indiana has entered a preliminary injunction enjoining the government's enforcement of this administrative dispute resolution process against us.\\n31\\nIn July 2021, we, along with Sanofi-Aventis U.S., LLC (Sanofi), Novo Nordisk Inc. (Novo Nordisk), and AstraZeneca Pharmaceuticals LP, were named as a defendant in a purported class action lawsuit filed in the U.S. District Court for the Western District of New York by Mosaic Health, Inc. alleging antitrust and unjust enrichment claims related to the defendants' 340B distribution programs. We, with Sanofi and Novo Nordisk, filed a motion to dismiss the lawsuit, which was granted in September 2022. In October 2022, the plaintiffs filed a motion for leave to amend their complaint. This matter is ongoing.\\nWe received a civil investigative subpoena in February 2021 from the Office of the Attorney General for the State of Vermont relating to the sale of pharmaceutical products to Vermont covered entities under the 340B program. We are cooperating with this subpoena.\\nBranchburg Manufacturing Facility\\nIn May 2021, we received a subpoena from the U.S. Department of Justice requesting the production of certain documents relating to our manufacturing site in Branchburg, New Jersey. We are cooperating with the subpoena.\\nBrazil Litigation – Cosmopolis Facility\\nLabor Attorney Litigation\\nFirst initiated in 2008, our subsidiary in Brazil, Eli Lilly do Brasil Limitada (Lilly Brasil), is named in a Public Civil Action brought by the Labor Public Attorney (LPA) for the 15th Region in the Labor Court of Paulinia, State of Sao Paulo, Brazil, (the Labor Court) alleging possible harm to employees and former employees caused by alleged exposure to soil and groundwater contaminants at a former Lilly Brasil manufacturing facility in Cosmopolis, Brazil, operated by the company between 1977 and 2003. In May 2014, the Labor Court judge ruled against Lilly Brasil, ordering it to undertake several remedial and compensatory actions including health coverage for a class of individuals and certain of their children. In July 2018, the appeals court (TRT) generally affirmed our appeal of the Labor Court's ruling, which included a liquidated award of 300 million Brazilian real, which, when adjusted for inflation and the addition of pre and post judgment interest using the current Central Bank of Brazil's special system of clearance and custody rate, is approximately one billion Brazilian real (approximately $ 185 million as of September 30, 2022). In August 2019, Lilly Brasil filed an appeal to the superior labor court (TST) and in June 2021, the TRT published its decision on the admissibility of Lilly Brasil's appeal, allowing the majority of the elements, which were allowed to proceed in June 2021; elements not proceeding are subject to an interlocutory appeal to the TST that was filed in June 2021. In September 2019, the TRT stayed a number of elements of its trial court decision pending the determination of Lilly Brasil's appeal to the TST.\\nIn June 2019 and September 2020, the LPA filed applications in the Labor Court for enforcement of certain remedies granted by the TRT in its July 2018 decision, requested restrictions on Lilly Brasil’s assets in Brazil, and required Lilly Brasil and Antibióticos do Brasil Ltda. (ABL) to submit a list of potential beneficiaries of the Public Civil Action. In July 2019, the Labor Court issued a ruling requiring a freeze of Lilly Brasil’s immovable property or, alternatively, a security deposit or lien of 500 million Brazilian real, which ruling was subsequently limited in scope and the security was reduced to 100 million Brazilian real. ABL and LPA appealed the June 2021 Labor Court ruling to the TST, which appeal is under review. The Labor Court is currently assessing the status of Lilly Brasil’s and ABL’s compliance with such portion of the July 2018 TRT decision and an inspection in the industrial plant is expected. These matters are ongoing.\\nIndividual Former Employee Litigation\\nLilly Brasil is also named in over 20 pending lawsuits filed in the Labor Court by individual former employees making similar claims. These individual lawsuits are at various stages in the litigation process.\\nPuerto Rico Tax Matter\\nIn May 2013, the Municipality of Carolina in Puerto Rico (Municipality) filed a lawsuit against us alleging noncompliance with respect to a contract with the Municipality and seeking a declaratory judgment. In December 2020, the Puerto Rico Appellate Court (AP) reversed the summary judgment previously granted by the Court of First Instance (CFI) in our favor, dismissing the Municipality's complaint in its entirety. The AP remanded the case to the CFI for trial on the merits. The trial began in May 2022; however, the Municipality filed a new motion requesting the CFI to award damages. The request was denied by the CFI in our favor and the Municipality filed for revision at the AP, which we opposed, staying the case. This matter is ongoing.\\n32\\nEastern District of Pennsylvania Pricing (Average Manufacturer Price) Inquiry\\nIn November 2014, we, along with another pharmaceutical manufacturer, were named as co-defendants in United States et al. ex rel. Streck v. Takeda Pharm. Am., Inc., et al., which was filed in November 2014 and unsealed in the U.S. District Court for the Northern District of Illinois. The complaint alleges that the defendants should have treated certain credits from distributors as retroactive price increases and included such increases in calculating average manufacturer prices. Following a trial in August 2022, the jury returned a verdict in favor of the plaintiff. The case is proceeding with post-trial motions after which the court will enter final judgment in the case. This matter is ongoing.\\nHealth Choice Alliance\\nWe are named as a defendant in two lawsuits filed in Texas and New Jersey state courts in October 2019 seeking damages under the Texas Medicaid Fraud Prevention Act and New Jersey Medicaid False Claims Act, respectively, for certain patient support programs related to our products Humalog, Humulin, and Forteo. The Texas state court action has been stayed. The New Jersey state court action was dismissed with prejudice pending an ongoing appeal before the Appellate Division of the New Jersey Superior Court. This matter is ongoing.\\nPricing Litigation\\nIn December 2017 and February 2018, we, along with Sanofi and Novo Nordisk, were named as defendants in a consolidated purported class action lawsuit, In re. Insulin Pricing Litigation and in MSP Recovery Claims, Series, LLC et al. v. Sanofi Aventis U.S. LLC et al., both filed in the U.S. District Court for the District of New Jersey. The cases relate to insulin pricing and seek damages or other relief under various theories, including state consumer protection laws, common law fraud, unjust enrichment, and the Federal Racketeer Influenced and Corrupt Organization Act (federal RICO Act). In both cases, the court dismissed claims under the federal RICO Act and certain state laws. In April 2021, the plaintiffs in In re. Insulin Pricing Litigation amended their complaint to allege additional state law claims for civil conspiracy and violations of state RICO statutes. The court allowed the Arizona RICO statute and certain state civil conspiracy law claims to proceed. Additionally in 2020, we, along with Sanofi, Novo Nordisk, CVS, Express Scripts, and Optum, have been sued in a putative class action, FWK Holdings, LLC v. Novo Nordisk Inc., et al., filed in the same court, for alleged violations of the federal RICO Act as well as the New Jersey RICO Act and antitrust law. The same group of defendants, along with Medco Health and United Health Group, also have been sued in other purported class actions in the same court, Rochester Drug Co-Operative Inc. v. Eli Lilly & Co. et al. and Value Drug Co. v. Eli Lilly & Co. et al., which were both initiated in March 2020, with the plaintiffs seeking damages for alleged violations of the federal RICO Act. In September 2020, the U.S. District Court for the District of New Jersey granted plaintiffs' motion to consolidate FWK Holdings, LLC v. Novo Nordisk Inc., et al., Rochester Drug Co-Operative Inc. v. Eli Lilly & Co. et al., and Value Drug Co. v. Eli Lilly & Co. et al. In July 2021, the U.S. District Court for the District of New Jersey dismissed the three antitrust claims alleged by plaintiffs in the consolidated litigation and denied dismissal of the federal RICO Act claims.\\nIn October 2018, the Minnesota Attorney General's Office initiated litigation against us, Sanofi, and Novo Nordisk, State of Minnesota v. Sanofi-Aventis U.S. LLC et al., in the U.S. District Court for the District of New Jersey, seeking damages for unjust enrichment, violations of various Minnesota state consumer protection laws, and the federal RICO Act. In March 2021, the U.S. District Court for the District of New Jersey dismissed with prejudice the Minnesota Attorney General's federal RICO claims and false advertising claims under state law; the consumer fraud and other related state law claims remain ongoing. Additionally, in May 2019, the Kentucky Attorney General's Office filed a complaint against us, Sanofi, and Novo Nordisk, Commonwealth of Kentucky v. Novo Nordisk, Inc. et al., in Kentucky state court, alleging violations of the Kentucky consumer protection law, false advertising, and unjust enrichment.\\nIn June 2021, the Mississippi Attorney General's Office initiated litigation against us, Sanofi, Novo Nordisk, Evernorth/ESI, CVS/Caremark, and United/Optum in the Hinds County, Mississippi Chancery Court, alleging state law consumer protection, unjust enrichment, and civil conspiracy claims. After the case was removed to federal court, we, along with the other defendants, filed a motion to dismiss the lawsuit, which was denied. This matter is ongoing.\\nIn May 2022, the state of Arkansas filed suit against us Sanofi, Novo Nordisk, ESI, CVS/Caremark/Aetna, and Optum, asserting state law consumer protection, civil conspiracy, and unjust enrichment claims. The case has been removed to federal court and is ongoing.\\nIn September 2022, the County of Albany, New York filed a suit against us, Sanofi, Novo Nordisk, Evernorth/ESI, CVS/Caremark and United/Optum asserting violations of federal RICO statute and state law claims for deceptive trade practices, unjust enrichment, and civil conspiracy. This matter is ongoing.\\n33\\nIn September 2022, the State of Montana filed a suit against us, Sanofi, Novo Nordisk, Evernorth/ESI, Medco Health Solutions, CVS/Caremark and Optum asserting violations of the Montana Unfair Practices and Consumer Protection Act, unjust enrichment, and civil conspiracy. This matter is ongoing.\\nInvestigations, Subpoenas, and Inquiries\\nIn connection with the pricing and sale of our insulin and other products, we have been subject to various investigations and received subpoenas, civil investigative demand requests, information requests, interrogatories, and other inquiries from various governmental entities. These include subpoenas from the New York and Vermont Attorney General Offices, civil investigative demands from the Washington, New Mexico, Colorado, Illinois, Ohio Attorney General Offices, the Department of Justice and the Federal Trade Commission, as well as information requests from the Mississippi, Washington D.C., California, Florida, Hawaii, and Nevada Attorney General Offices. In January 2022, the Michigan Attorney General filed a petition in Michigan state court seeking authorization to investigate Lilly for potential violations of the Michigan Consumer Protection Act (MCPA), and a complaint seeking a declaratory judgment that the Attorney General has authority to investigate Lilly's sale of insulin under the MCPA. The court authorized the proposed investigation and the issuance of civil investigative subpoenas. In April 2022, the parties entered into a stipulation providing that the State will not issue any civil investigative subpoena to us under the MCPA until the declaratory judgment action is resolved. In July 2022, the court dismissed the case in its entirety. The Michigan Attorney General filed a notice of appeal and an application to obtain review by the Michigan Supreme Court, which remain pending.\\nWe received a request in January 2019 from the House of Representatives' Committee on Oversight and Reform seeking commercial information and business records related to the pricing of insulin products, among other issues. We also received similar requests from the Senate Finance Committee and the Senate Committee on Health, Education, Labor, and Pensions, and separate requests from the House Committee on Energy and Commerce majority and minority members. In January 2021, the Senate Finance Committee released a report summarizing the findings of its investigation. In December 2021 the House of Representatives' Committee on Oversight and Reform majority and minority staffs released separate reports with findings from their investigations into drug pricing, including of insulin products.\\nWe are cooperating with all of the aforementioned investigations, subpoenas, and inquiries.\\nResearch Corporation Technologies, Inc.\\nIn April 2016, we were named as a defendant in litigation filed by Research Corporation Technologies, Inc. (RCT) in the U.S. District Court for the District of Arizona. RCT is seeking damages for breach of contract, unjust enrichment, and conversion related to processes used to manufacture certain products, including Humalog and Humulin. In October 2021, the court issued a summary judgment decision finding in favor of RCT on certain issues, including with respect to a disputed royalty. Both parties filed motions for reconsideration, which were denied. We filed supplemental summary judgment motions. A trial date has not been set. Potential damages payable under the litigation, if finally awarded after an appeal, could be material but are not currently reasonably estimable. This matter is ongoing.\\n34\\nNote 10: Other Comprehensive Income (Loss)\\nThe following tables summarize the activity related to each component of other comprehensive income (loss) during the three months ended September 30, 2022 and 2021:\\n| (Amounts presented net of taxes) | Foreign Currency Translation Gains (Losses) | Unrealized Net Gains (Losses) on Securities | Defined Benefit Pension and Retiree Health Benefit Plans | Effective Portion of Cash Flow Hedges | Accumulated Other Comprehensive Loss |\\n| Balance at July 1, 2022 | $ | ( 1,844.2 ) | $ | ( 27.9 ) | $ | ( 2,443.2 ) | $ | 27.6 | $ | ( 4,287.7 ) |\\n| Other comprehensive income (loss) before reclassifications | ( 165.1 ) | ( 24.9 ) | 47.8 | 63.0 | ( 79.2 ) |\\n| Net amount reclassified from accumulated other comprehensive loss | — | 13.5 | 57.2 | 0.4 | 71.1 |\\n| Net other comprehensive income (loss) | ( 165.1 ) | ( 11.4 ) | 105.0 | 63.4 | ( 8.1 ) |\\n| Balance at September 30, 2022 | $ | ( 2,009.3 ) | $ | ( 39.3 ) | $ | ( 2,338.2 ) | $ | 91.0 | $ | ( 4,295.8 ) |\\n\\n| (Amounts presented net of taxes) | Foreign Currency Translation Gains (Losses) | Unrealized Net Gains (Losses) on Securities | Defined Benefit Pension and Retiree Health Benefit Plans | Effective Portion of Cash Flow Hedges | Accumulated Other Comprehensive Loss |\\n| Balance at July 1, 2021 | $ | ( 1,516.2 ) | $ | 9.1 | $ | ( 4,569.9 ) | $ | ( 210.1 ) | $ | ( 6,287.1 ) |\\n| Other comprehensive income (loss) before reclassifications | ( 8.0 ) | ( 2.4 ) | 18.6 | 16.8 | 25.0 |\\n| Net amount reclassified from accumulated other comprehensive loss | — | 0.1 | 86.0 | 3.3 | 89.4 |\\n| Net other comprehensive income (loss) | ( 8.0 ) | ( 2.3 ) | 104.6 | 20.1 | 114.4 |\\n| Balance at September 30, 2021 | $ | ( 1,524.2 ) | $ | 6.8 | $ | ( 4,465.3 ) | $ | ( 190.0 ) | $ | ( 6,172.7 ) |\\n\\nThe following tables summarize the activity related to each component of other comprehensive income (loss) during the nine months ended September 30, 2022 and 2021:\\n| (Amounts presented net of taxes) | Foreign Currency Translation Gains (Losses) | Unrealized Net Gains (Losses) on Securities | Defined Benefit Pension and Retiree Health Benefit Plans | Effective Portion of Cash Flow Hedges | Accumulated Other Comprehensive Loss |\\n| Balance at January 1, 2022 | $ | ( 1,550.2 ) | $ | 3.7 | $ | ( 2,583.6 ) | $ | ( 213.0 ) | $ | ( 4,343.1 ) |\\n| Other comprehensive income (loss) before reclassifications | ( 459.7 ) | ( 55.5 ) | 72.9 | 297.2 | ( 145.1 ) |\\n| Net amount reclassified from accumulated other comprehensive loss | 0.6 | 12.5 | 172.5 | 6.8 | 192.4 |\\n| Net other comprehensive income (loss) | ( 459.1 ) | ( 43.0 ) | 245.4 | 304.0 | 47.3 |\\n| Balance at September 30, 2022 | $ | ( 2,009.3 ) | $ | ( 39.3 ) | $ | ( 2,338.2 ) | $ | 91.0 | $ | ( 4,295.8 ) |\\n\\n| (Amounts presented net of taxes) | Foreign Currency Translation Gains (Losses) | Unrealized Net Gains (Losses) on Securities | Defined Benefit Pension and Retiree Health Benefit Plans | Effective Portion of Cash Flow Hedges | Accumulated Other Comprehensive Loss |\\n| Balance at January 1, 2021 | $ | ( 1,427.5 ) | $ | 14.8 | $ | ( 4,751.0 ) | $ | ( 332.7 ) | $ | ( 6,496.4 ) |\\n| Other comprehensive income (loss) before reclassifications | ( 96.7 ) | ( 8.8 ) | 27.2 | 132.8 | 54.5 |\\n| Net amount reclassified from accumulated other comprehensive loss | — | 0.8 | 258.5 | 9.9 | 269.2 |\\n| Net other comprehensive income (loss) | ( 96.7 ) | ( 8.0 ) | 285.7 | 142.7 | 323.7 |\\n| Balance at September 30, 2021 | $ | ( 1,524.2 ) | $ | 6.8 | $ | ( 4,465.3 ) | $ | ( 190.0 ) | $ | ( 6,172.7 ) |\\n\\n35\\nThe tax effects on the net activity related to each component of other comprehensive income (loss) were as follows:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| Tax benefit (expense) | 2022 | 2021 | 2022 | 2021 |\\n| Foreign currency translation gains/losses | $ | ( 133.3 ) | $ | ( 39.0 ) | $ | ( 234.2 ) | $ | ( 92.3 ) |\\n| Unrealized net gains/losses on securities | 3.4 | 0.8 | 13.1 | 3.8 |\\n| Defined benefit pension and retiree health benefit plans | ( 22.4 ) | ( 28.2 ) | ( 73.2 ) | ( 79.7 ) |\\n| Effective portion of cash flow hedges | ( 16.9 ) | ( 5.4 ) | ( 80.8 ) | ( 37.9 ) |\\n| Benefit (expense) for income taxes allocated to other comprehensive income (loss) items | $ | ( 169.2 ) | $ | ( 71.8 ) | $ | ( 375.1 ) | $ | ( 206.1 ) |\\n\\nExcept for the tax effects of foreign currency translation gains and losses related to our foreign currency-denominated notes, cross-currency interest rate swaps, and other foreign currency exchange contracts designated as net investment hedges (see Note 6), income taxes were not provided for foreign currency translation. Generally, the assets and liabilities of foreign operations are translated into U.S. dollars using the current exchange rate. For those operations, changes in exchange rates generally do not affect cash flows; therefore, resulting translation adjustments are made in shareholders' equity rather than in the consolidated condensed statements of operations.\\nReclassifications out of accumulated other comprehensive loss were as follows:\\n| Details about Accumulated Other Comprehensive Loss Components | Three Months Ended September 30, | Nine Months Ended September 30, | Affected Line Item in the Consolidated Condensed Statements of Operations |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Amortization of retirement benefit items: |\\n| Prior service benefits, net | $ | ( 13.1 ) | $ | ( 13.9 ) | $ | ( 39.2 ) | $ | ( 41.5 ) | Other–net, (income) expense |\\n| Actuarial losses, net | 85.5 | 122.7 | 257.5 | 368.7 | Other–net, (income) expense |\\n| Total before tax | 72.4 | 108.8 | 218.3 | 327.2 |\\n| Tax benefit | ( 15.2 ) | ( 22.8 ) | ( 45.8 ) | ( 68.7 ) | Income taxes |\\n| Net of tax | 57.2 | 86.0 | 172.5 | 258.5 |\\n| Other, net of tax | 13.9 | 3.4 | 19.9 | 10.7 | Other–net, (income) expense |\\n| Total reclassifications, net of tax | $ | 71.1 | $ | 89.4 | $ | 192.4 | $ | 269.2 |\\n\\nNote 11: Other–Net, (Income) Expense\\nOther–net, (income) expense consisted of the following:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Interest expense | $ | 81.5 | $ | 83.6 | $ | 247.6 | $ | 258.4 |\\n| Interest income | ( 20.1 ) | ( 7.0 ) | ( 37.3 ) | ( 18.0 ) |\\n| Net investment (gains) losses on equity securities (Note 6) | 123.3 | 246.8 | 667.6 | ( 270.1 ) |\\n| Retirement benefit plans | ( 92.4 ) | ( 72.6 ) | ( 280.0 ) | ( 217.1 ) |\\n| Debt extinguishment loss (Note 6) | — | 405.2 | — | 405.2 |\\n| Other (income) expense | 18.7 | ( 20.1 ) | ( 17.0 ) | ( 34.1 ) |\\n| Other–net, (income) expense | $ | 111.0 | $ | 635.9 | $ | 580.9 | $ | 124.3 |\\n\\n36\\nItem 2. Management's Discussion and Analysis of Results of Operations and Financial Condition\\nResults of Operations\\n(Tables present dollars in millions, except per-share data)\\nGeneral\\nManagement's discussion and analysis of results of operations and financial condition is intended to assist the reader in understanding and assessing significant changes and trends related to the results of operations and financial position of our consolidated company. This discussion and analysis should be read in conjunction with the consolidated condensed financial statements and accompanying footnotes in Part I, Item 1 of this Quarterly Report on Form 10-Q. Certain statements in this Part I, Item 2 of this Quarterly Report on Form 10-Q constitute forward-looking statements. Various risks and uncertainties, including those discussed in \\\"Forward-Looking Statements\\\" in this Quarterly Report on Form 10-Q and \\\"Risk Factors\\\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2021, may cause our actual results, financial position, and cash generated from operations to differ materially from these forward-looking statements.\\nExecutive Overview\\nThis section provides an overview of our financial results, recent product and late-stage pipeline developments, and other matters affecting our company and the pharmaceutical industry. Earnings per share (EPS) data are presented on a diluted basis.\\nCOVID-19 Pandemic\\nIn response to the COVID-19 pandemic, we have focused on maintaining a supply of our medicines; reducing the strain on the medical system; developing treatments for COVID-19; protecting the health, safety, and well-being of our employees; supporting our communities; and ensuring affordability of and access to our medicines, particularly insulin.\\nWe have received various regulatory authorizations, including Emergency Use Authorizations (EUA), for our COVID-19 therapies. We supplied the United States (U.S.) government approximately 810,000 doses of bebtelovimab during the nine months ended September 30, 2022. Beginning in the third quarter of 2022 and in collaboration with the U.S. government, we have made bebtelovimab commercially available for purchase by U.S. states/territories, hospitals, and certain other providers. We do not anticipate any further U.S. government orders. The U.S. Food and Drug Administration (FDA) has revised, and may in the future revise, any EUA for our COVID-19 therapies in response to the prevalence of variants against which our therapies have varying degrees of efficacy, including the new BQ variants. Based on early data, we do not believe that bebtelovimab will neutralize against the new BQ variants.\\nThe COVID-19 pandemic has, and may continue to, adversely impact our business and operations. Strain on global transportation, logistics, manufacturing, and labor markets, including as aggravated by the pandemic and global unrest, the focus of resources on COVID-19, protective measures implemented to control the spread of COVID-19, and an increase in overall demand in our industry for certain resources and medicines, resulting in changed buying patterns, increased costs, and constrained supply, have negatively impacted and may continue to negatively impact the development, manufacturing, supply, distribution, and sales of our medicines.\\nThe degree to which the COVID-19 pandemic and related challenges impact the development, manufacturing, supply, distribution, and sale of our medicines will depend on developments that are highly uncertain and beyond our knowledge or control.\\n37\\nProduct Supply\\nContinued strong demand for Trulicity® in U.S. and international markets, partially due to the ongoing limited availability of competitor therapies, has challenged, and is expected to continue to challenge, our ability to meet demand in most international markets. In the U.S., as demand for Trulicity has continued to exceed historical levels, we anticipate tight supplies will persist until additional manufacturing capacity is operationalized, and U.S. wholesalers may experience intermittent restocking delays of Trulicity orders. Outside the U.S., we have implemented certain actions to minimize the impact to existing patients, but we expect to experience intermittent disruptions in our supply of Trulicity in international markets.\\nIn addition, the uptake of Mounjaro® for type 2 diabetes following its launch in the U.S. has been very strong. We continue to carefully monitor demand, incretin competitor availability, and supply with a focus on access for Type 2 diabetes patients.\\nWe anticipate that additional internal and contracted manufacturing capacity will become fully operational around the world in the next several years, with significant expansion in 2023, as part of our ongoing efforts to meet the significant demand for our incretin medicines.\\nSee \\\"Risk Factors\\\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2021 for additional information on risk factors that could impact our business and operations.\\nFinancial Results\\nThe following table summarizes our key operating results:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | Percent Change | 2022 | 2021 | Percent Change |\\n| Revenue | $ | 6,941.6 | $ | 6,772.8 | 2 | $ | 21,239.6 | $ | 20,318.5 | 5 |\\n| Gross margin | 5,362.5 | 5,342.0 | — | 16,157.9 | 15,055.9 | 7 |\\n| Gross margin as a percent of revenue | 77.3 | % | 78.9 | % | 76.1 | % | 74.1 | % |\\n| Research and development | $ | 1,802.9 | $ | 1,705.3 | 6 | $ | 5,194.9 | $ | 5,032.4 | 3 |\\n| Marketing, selling, and administrative | 1,614.2 | 1,577.9 | 2 | 4,797.2 | 4,839.6 | (1) |\\n| Acquired in-process research and development (IPR&D) and development milestones | 62.4 | 177.6 | (65) | 668.4 | 532.4 | 26 |\\n| Asset impairment, restructuring, and other special charges | 206.5 | — | NM | 206.5 | 211.6 | (2) |\\n| Other–net, (income) expense | 111.0 | 635.9 | (83) | 580.9 | 124.3 | NM |\\n| Net income | 1,451.7 | 1,110.1 | 31 | 4,307.1 | 3,855.6 | 12 |\\n| EPS - diluted | 1.61 | 1.22 | 32 | 4.76 | 4.23 | 13 |\\n\\nNM - not meaningful\\nRevenue increased for the three and nine months ended September 30, 2022, driven by increased volume, partially offset by lower realized prices and the unfavorable impact of foreign exchange rates. Research and development expenses increased for the three and nine months ended September 30, 2022, primarily driven by higher development expenses for late-stage assets, partially offset by lower development expenses for COVID-19 antibodies and the favorable impact of foreign exchange rates. Marketing, selling, and administrative expenses increased for the three months ended September 30, 2022, primarily driven by increased costs associated with the launch of Mounjaro, partially offset by the favorable impact of foreign exchange rates. Marketing, selling, and administrative expenses decreased for the nine months ended September 30, 2022, primarily driven by the favorable impact of foreign exchange rates as well as reduced marketing costs in the first half of 2022, partially offset by increased costs associated with the launch of Mounjaro.\\n38\\nThe following highlighted items also affect comparisons of our financial results for the three and nine months ended September 30, 2022 and 2021:\\n2022\\nAcquired IPR&D and Development Milestones (See Note 3 to the consolidated condensed financial statements)\\n•We recognized $62.4 million and $668.4 million of acquired IPR&D and development milestones for the three and nine months ended September 30, 2022, respectively. The charges for the nine months ended September 30, 2022 included the buy-out of substantially all future obligations that were contingent upon the occurrence of certain events linked to the success of our mutant-selective PI3kα inhibitor and a purchase of a Priority Review Voucher.\\nAsset Impairment, Restructuring, and Other Special Charges (See Note 5 to the consolidated condensed financial statements)\\n•We recognized charges of $206.5 million for the three and nine months ended September 30, 2022, primarily related to an intangible asset impairment for GBA1 Gene Therapy (PR001) due to changes in estimated launch timing.\\nOther-Net, (Income) Expense (See Note 11 to the consolidated condensed financial statements)\\n•We recognized $123.3 million and $667.6 million of net investment losses on equity securities for the three and nine months ended September 30, 2022, respectively.\\n2021\\nCost of Sales (See Note 5 to the consolidated condensed financial statements)\\n•We recognized a net inventory impairment charge related to our COVID-19 antibodies of $435.1 million for the nine months ended September 30, 2021. As part of our response to the COVID-19 pandemic, and at the request of the U.S. and international governments, we invested in large-scale manufacturing of COVID-19 antibodies at risk, in order to ensure rapid access to patients around the world. As the COVID-19 pandemic evolved during 2021, we incurred a net inventory impairment charge primarily due to the combination of changes to demand from U.S. and international governments, including changes to our agreement with the U.S. government, and near-term expiry dates of COVID-19 antibodies.\\nAcquired IPR&D and Development Milestones (See Note 3 to the consolidated condensed financial statements)\\n•We recognized $177.6 million and $532.4 million of acquired IPR&D and development milestones for the three and nine months ended September 30, 2021, respectively. The charges for the nine months ended September 30, 2021 included acquired IPR&D charges resulting from business development transactions with Rigel Pharmaceuticals, Inc. (Rigel) and Precision Biosciences, Inc. (Precision).\\nAsset Impairment, Restructuring, and Other Special Charges (See Note 5 to the consolidated condensed financial statements)\\n•We recognized charges of $211.6 million for the nine months ended September 30, 2021, primarily related to an intangible asset impairment resulting from the sale of the rights to Qbrexza®, as well as acquisition and integration costs associated with the acquisition of Prevail Therapeutics Inc. (Prevail).\\nOther-Net, (Income) Expense (See Note 11 to the consolidated condensed financial statements)\\n•We recognized a debt extinguishment loss of $405.2 million related to the repurchase of debt for the three and nine months ended September 30, 2021.\\n•We recognized $246.8 million of net investment losses on equity securities for the three months ended September 30, 2021. We recognized $270.1 million of net investment gains on equity securities for the nine months ended September 30, 2021.\\n39\\nLate-Stage Pipeline\\nOur long-term success depends on our ability to continually discover or acquire, develop, and commercialize innovative new medicines. We currently have approximately 45 new medicine candidates in clinical development or under regulatory review, and a larger number of projects in the discovery phase.\\nThe following certain new molecular entities (NMEs) are currently in Phase II or Phase III clinical trials or have been submitted for regulatory review or have received regulatory approval in the U.S., Europe, or Japan. The following table reflects the status of these NMEs, including certain other developments since our Annual Report on Form 10-K for the year ended December 31, 2021.\\n| Compound | Indication | Status | Developments |\\n| Diabetes |\\n| Tirzepatide (Mounjaro) | Type 2 diabetes | Approved | Approved in the U.S. in the second quarter of 2022 and in Europe and Japan in the third quarter of 2022. |\\n| Heart failure with preserved ejection fraction | Phase III | Phase III trials are ongoing. |\\n| Obesity | Phase III | Granted FDA Fast Track designation(1) in October 2022. Announced in the second quarter of 2022 that the initial Phase III trial met co-primary and all key secondary endpoints. Phase III trials are ongoing. |\\n| Obstructive sleep apnea | Phase III | Phase III trial initiated in the third quarter of 2022. |\\n| Nonalcoholic steatohepatitis | Phase II | Phase II trial is ongoing. |\\n| Basal Insulin-Fc | Type 1 and 2 diabetes | Phase III | Phase III trials initiated in the first, second, and third quarters of 2022. |\\n| Orforglipron (GLP-1R NPA) | Obesity | Phase II | Phase II trials are ongoing. |\\n| Type 2 diabetes |\\n| Retatrutide (GGG Tri-Agonist) | Obesity | Phase II | Phase II trials are ongoing. |\\n| Type 2 diabetes |\\n| Immunology |\\n| Lebrikizumab(2) | Atopic dermatitis | Submitted | Granted FDA Fast Track designation(1). Submitted in the U.S. in the third quarter of 2022 and in Europe in October 2022. Phase III trials are ongoing. |\\n| Mirikizumab | Ulcerative colitis | Submitted | Submitted in the U.S. in first quarter of 2022 and in Europe and Japan in the second quarter of 2022. |\\n| Crohn's Disease | Phase III | Phase III trials are ongoing. |\\n| ANGPTL3 siRNA | Cardiovascular disease | Phase II | Phase II trial initiated in the third quarter of 2022. |\\n| BTLA MAB Agonist | Systemic lupus erythematosus | Phase II | Phase II trial initiated in the second quarter of 2022. |\\n| CXCR1/2 Ligands Monoclonal Antibody | Hidradenitis suppurativa | Phase II | Phase II trial is ongoing. |\\n| Peresolimab (PD-1 MAB Agonist) | Rheumatoid arthritis | Phase II | Phase II trial is ongoing. |\\n| Rezpegaldesleukin (IL-2 Conjugate) | Systemic lupus erythematosus | Phase II | Phase II trial is ongoing. |\\n\\n40\\n| Compound | Indication | Status | Developments |\\n| Neuroscience |\\n| Donanemab | Early Alzheimer's disease | Submitted | Granted FDA Breakthrough Therapy designation(3). Submitted in the U.S. in the second quarter of 2022. Received Priority Review designation under the accelerated approval pathway. Phase III trials are ongoing. |\\n| Preclinical Alzheimer's disease | Phase III | Phase III trial is ongoing. |\\n| Remternetug | Early Alzheimer's disease | Phase III | Phase III trial initiated in the third quarter of 2022. |\\n| Solanezumab | Preclinical Alzheimer's disease | Phase III | Phase III trial is ongoing. |\\n| GBA1 Gene Therapy (PR001) | Parkinson's disease | Phase II | Granted FDA Fast Track designation(1). Phase II trial is ongoing. |\\n| GRN Gene Therapy (PR006) | Frontotemporal dementia | Phase II | Granted FDA Fast Track designation(1). Phase II trial is ongoing. |\\n| O-GlcNAcase Inh | Alzheimer's disease | Phase II | Phase II trial is ongoing. |\\n| SSTR4 Agonist | Pain | Phase II | Phase II trials are ongoing. |\\n| TRPA1 Antagonist | Pain | Phase II | Phase II trials are ongoing. |\\n| PACAP38 Antibody | Migraine | Discontinued | In the third quarter of 2022 based on the results of the Phase II trial, we discontinued development. |\\n| Oncology |\\n| Selpercatinib (Retevmo®) | Lung cancer | Approved(4) | Phase III trials are ongoing. In the third quarter of 2022, the FDA granted accelerated approval in tumor-agnostic RET fusion-positive advanced or metastatic solid tumors and traditional approval in locally advanced or metastatic RET fusion-positive non-small cell lung cancer. |\\n| Thyroid cancer | Approved(4) | Phase III trial is ongoing. |\\n| Pirtobrutinib (LOXO-305) | Mantle cell lymphoma | Submitted | Submitted in the U.S. in second quarter of 2022. Received Priority Review designation under the accelerated approval pathway. Phase III trial is ongoing. |\\n| Chronic lymphocytic leukemia | Phase III | Phase III trials are ongoing. |\\n| B-cell malignancies | Phase II | Phase II trial is ongoing. |\\n| Imlunestrant | ER+HER2- metastatic breast cancer | Phase III | Phase III trial is ongoing. |\\n\\n(1) Fast Track designation is designed to facilitate the development and expedite the review of medicines to treat serious conditions and fill an unmet medical need.\\n(2) In collaboration with Almirall, S.A. in Europe.\\n(3) Breakthrough Therapy designation is designed to expedite the development and review of potential medicines that are intended to treat a serious condition where preliminary clinical evidence indicates that the treatment may demonstrate substantial improvement over available therapy on a clinically significant endpoint.\\n(4) Continued approval may be contingent on verification and description of clinical benefit in confirmatory Phase III trials.\\n41\\nOur pipeline also contains several new indication line extension (NILEX) products. The following certain NILEX products for use in the indication described are currently in Phase II or Phase III clinical trials or have been submitted for regulatory review or have received regulatory approval in the U.S., Europe, or Japan. The following table reflects the status of these NILEX products, including certain other developments since our Annual Report on Form 10-K for the year ended December 31, 2021.\\n| Compound | Indication | Status | Developments |\\n| Diabetes |\\n| Empagliflozin (Jardiance®)(1) | Heart failure with preserved ejection fraction | Approved | Approved in the U.S. and Europe in the first quarter of 2022 and in Japan in the second quarter of 2022. |\\n| Chronic kidney disease | Phase III | Granted FDA Fast Track designation(2). In the first quarter of 2022 the Independent Data Monitoring Committee recommended stopping the Phase III trial early due to clear positive efficacy. |\\n| Immunology |\\n| Baricitinib (Olumiant®) | Alopecia areata | Approved | Approved in the U.S., Europe, and Japan in the second quarter of 2022. |\\n| COVID-19 | Approved | Approved in the U.S. in the second quarter of 2022. |\\n| Oncology |\\n| Abemaciclib (Verzenio®) | Prostate cancer | Phase III | Phase III trials are ongoing. |\\n\\n(1) In collaboration with Boehringer Ingelheim.\\n(2) Fast Track designation is designed to facilitate the development and expedite the review of medicines to treat serious conditions and fill an unmet medical need.\\nOther Matters\\nPatent Matters\\nWe depend on patents or other forms of intellectual property protection for most of our revenue, cash flows, and earnings.\\nFollowing the June 2021 loss of patent exclusivity for Alimta® in Europe and Japan, we faced, and expect to continue to face, generic competition that has rapidly and severely eroded revenue, and we expect will continue to erode revenue from current levels. In addition, as a result of the entry of multiple generics in the U.S. following the loss of patent and pediatric exclusivity in May 2022, we began facing, and expect to continue to face, additional generic competition that has eroded revenue, and we expect will continue to rapidly and severely erode revenue from current levels. This decline in revenue has had and will have a material adverse effect on our consolidated results of operations and cash flows. See Note 9 to the consolidated condensed financial statements for a description of legal proceedings currently pending regarding certain of our patents.\\nOur compound patents for Humalog® (insulin lispro) have expired in the U.S. and major international markets, and we have also introduced lower-priced versions of Humalog as part of our insulin affordability solutions. A competitor has a similar version of insulin lispro in the U.S. and in certain European markets. Due to the impact of competition and pricing pressure in the U.S. and some international markets, we expect that lower revenue due to realized price decline will continue over time.\\nOur formulation and use patents for Forteo® have expired in major markets. We expect further decline in revenue as a result of the entry of generic and biosimilar competition due to the loss of patent exclusivity in major markets.\\nForeign Currency Exchange Rates\\nAs a global company, we face foreign currency risk exposure from fluctuating currency exchange rates, primarily the U.S. dollar against the euro, Japanese yen, and Chinese yuan. While we seek to manage a portion of these exposures through hedging and other risk management techniques, significant fluctuations in currency rates can have a material impact, either positive or negative, on our consolidated results of operations in any given period. During the three and nine months ended September 30, 2022, revenue was unfavorably impacted by 4 percent and 3 percent, respectively, due to foreign exchange rates. While there is uncertainty in the future movements in foreign exchange rates, fluctuations in these rates have, and we currently expect in the near-term future will, adversely impact our consolidated results of operations and cash flows.\\n42\\nTrends Affecting Pharmaceutical Pricing, Reimbursement, and Access\\nGlobal concern over access to and affordability of pharmaceutical products continues to drive regulatory and legislative debate and action, as well as worldwide cost containment efforts by governmental authorities. Such measures include the use of mandated discounts, price reporting requirements, mandated reference prices, restrictive formularies, changes to available intellectual property protections, as well as other efforts. In August 2022, the U.S. government enacted the Inflation Reduction Act (IRA). Among other measures, the IRA will allow the U.S. Department of Health and Human Services to effectively set prices for certain single-source drugs and biologics reimbursed under Medicare Part B and Part D. Generally, these government prices apply nine (medicines approved under a New Drug Application) or thirteen (medicines approved under a Biologics License Application) years following initial FDA approval and will be capped at a statutory ceiling price that is likely to represent a significant discount from average prices to wholesalers and direct purchasers. It is too soon to tell how the U.S. government will set these prices as the law specifies a ceiling price, but not a minimum or floor price. One or more significant Lilly products may be selected, which would have the effect of accelerating revenue erosion prior to patent expiry. The effect of reducing prices and reimbursement for certain of our products could significantly impact our business and consolidated results of operations.\\nOther of the IRA’s provisions provide for penalties on drug manufacturers that increase prices of certain Medicare Part B and Part D medicines at a rate greater than the rate of inflation and replace the Part D coverage gap discount program with a new manufacturer discounting program. Manufacturers that fail to comply with the IRA may be subject to various penalties, including civil monetary penalties. The IRA takes effect progressively starting in 2023, with the first government set prices effective in 2026. The IRA may meaningfully influence our and pharmaceutical industry business strategies. In particular it may reduce the attractiveness of investment in small molecule innovation. Provisions of the IRA may be subject to legal challenges or other reformation, and the full effect of the IRA on our business and the pharmaceutical industry remains uncertain. Additional policies, regulations, legislation, or enforcement, including those proposed and/or pursued by the U.S. Congress and executive branch of the U.S. administration and other regulatory authorities worldwide, could adversely impact our business and consolidated results of operations.\\nConsolidation of private payors in the U.S. has also significantly impacted the market for pharmaceuticals by increasing payor leverage in negotiating manufacturer price concessions and pharmacy reimbursement rates. Furthermore, restrictive or unfavorable pricing, coverage, or reimbursement determinations for our medicines or product candidates by governments, regulatory agencies, courts, or private payers, such as the Centers for Medicare & Medicaid Services' National Coverage Determination for monoclonal antibodies for the treatment of Alzheimer's Disease, may adversely impact our business and consolidated results of operations. We expect that these actions may intensify and could particularly affect certain products, such as insulin, as governments manage and emerge from the COVID-19 pandemic, which could adversely affect our business. In addition, we are engaged in litigation and investigations related to our 340B program and access to insulin that, if resolved adversely to us, could negatively impact our business and consolidated results of operations. It is not currently possible to predict the overall potential adverse impact to us or the general pharmaceutical industry of continued cost containment efforts worldwide.\\nEvolving regulatory priorities have also intensified governmental scrutiny of our operations and our industry, including with respect to current Good Manufacturing Practices, quality assurance, and similar regulations, and increased focus on business combinations in our industry. Any regulatory issues concerning these matters could lead to regulatory and legal actions, product recalls and seizures, fines and penalties, interruption of production leading to product shortages, import bans or denials of import certifications, delays or denials in the approvals of new products or supplemental approvals of current products pending resolution of the issues, impediments to the completion of business combinations, and reputational harm, any of which would adversely affect our business.\\nSee \\\"Business - Regulations and Private Payer Actions Affecting Pharmaceutical Pricing, Reimbursement, and Access\\\" in Part I, Item 1 and \\\"Risk Factors\\\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2021. See also Note 9 to the consolidated condensed financial statements.\\n43\\nTax Matters\\nWe are subject to income taxes and various other taxes in the U.S. and in many foreign jurisdictions; therefore, changes in both domestic and international tax laws or regulations have affected and may affect our effective tax rate, results of operations, and cash flows. In 2017, the U.S. enacted the Tax Cuts and Jobs Act (the 2017 Tax Act), which contains a provision that requires capitalization and amortization of research and development expenses for tax purposes starting in 2022. Previously, these expenses could be deducted in the year incurred. The implementation of this provision has increased, and is expected to continue to increase, our 2022 cash payments of income taxes and subsequently decrease our cash payments of income taxes moderately over the five-year amortization period. We expect the implementation of this provision to impact our 2022 cash payments of income taxes by up to $1.50 billion. For the three and nine months ended September 30, 2022, the implementation of this provision favorably impacted other tax items that decreased our effective tax rate by approximately 4 percentage points. If this provision of the 2017 Tax Act is deferred or repealed by the U.S. Congress effective for 2022, we expect our effective tax rate to be approximately 13 percent to 14 percent for 2022.\\nThe U.S. and countries around the world are actively considering and enacting tax law changes. Tax proposals have been introduced by the U.S. Congress and the U.S. administration containing significant changes, including increases to the tax rates at which both domestic and foreign income of U.S. companies would be taxed. In addition, tax authorities in the U.S. and other jurisdictions in which we do business routinely examine our tax returns and are intensifying their scrutiny and examinations of profit allocations among jurisdictions. Further, actions taken with respect to tax-related matters by associations, such as the Organisation for Economic Co-operation and Development and the European Commission, could influence tax laws in countries in which we operate. Changes to existing tax law and increased scrutiny by tax authorities in the U.S. and other jurisdictions could adversely impact our future consolidated results of operations and cash flows.\\nAcquisitions\\nWe opportunistically invest in external research and technologies that we believe complement and strengthen our own efforts. These investments can take many forms, including acquisitions, collaborations, investments, and licensing arrangements. We view our business development activity as a way to enhance our pipeline and strengthen our business.\\nSee Note 3 to the consolidated condensed financial statements for further discussion regarding our recent acquisitions.\\n44\\nRevenue\\nThe following table summarizes our revenue activity by region:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | Percent Change | 2022 | 2021 | Percent Change |\\n| U.S. | $ | 4,422.1 | $ | 3,989.6 | 11 | $ | 13,531.5 | $ | 11,635.1 | 16 |\\n| Outside U.S. | 2,519.4 | 2,783.3 | (9) | 7,708.1 | 8,683.4 | (11) |\\n| Revenue | $ | 6,941.6 | $ | 6,772.8 | 2 | $ | 21,239.6 | $ | 20,318.5 | 5 |\\n\\nNumbers may not add due to rounding.\\nThe following are components of the change in revenue compared with the prior year:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 vs. 2021 | 2022 vs. 2021 |\\n| U.S. | Outside U.S. | Consolidated | U.S. | Outside U.S. | Consolidated |\\n| Volume | 15 | % | 13 | % | 14 | % | 20 | % | 7 | % | 15 | % |\\n| Price | (4) | (12) | (7) | (4) | (11) | (7) |\\n| Foreign exchange rates | — | (11) | (4) | — | (7) | (3) |\\n| Percent change | 11 | % | (9) | % | 2 | % | 16 | % | (11) | % | 5 | % |\\n\\nNumbers may not add due to rounding.\\nIn the U.S. for the three and nine months ended September 30, 2022, the increase in volume was primarily driven by COVID-19 antibodies, Trulicity, Verzenio, Jardiance, Taltz®, and Mounjaro, partially offset by decreased volume for Alimta, resulting from the entry of multiple generics in the second quarter of 2022, and for Olumiant, due to the decline in utilization for COVID-19 treatment. In the U.S. for the three and nine months ended September 30, 2022, the decrease in realized prices was primarily driven by Humalog, due to a list price reduction of insulin lispro injection and unfavorable segment mix, and by Trulicity, due to unfavorable segment mix and higher contracted rebates. In the U.S. for the three months ended September 30, 2022, the decrease in realized prices for Trulicity was partially offset by changes to estimates for rebates and discounts.\\nOutside the U.S. for the three and nine months ended September 30, 2022, the increase in volume was primarily driven by Verzenio, Trulicity, Tyvyt®, Jardiance, and Taltz, partially offset by Alimta and Cymbalta® resulting from generic competition. Additionally outside the U.S. for the three and nine months ended September 30, 2022, we recognized revenue related to a sales collaboration agreement for the right to sell and distribute Mounjaro in Japan. Outside the U.S. for the nine months ended September 30, 2022, the increase in volume was also partially offset by decreased sales of COVID-19 antibodies and the sale of the rights to Cialis® in China in the second quarter of 2021. Outside the U.S. for the three and nine months ended September 30, 2022, the decrease in realized prices was primarily driven by the impact of government pricing in China from the National Reimbursement Drug List (NRDL) formulary for certain products, particularly Tyvyt and Verzenio, and volume-based procurement (VBP) for Humalog.\\n45\\n| Three Months Ended September 30, |\\n| 2022 | 2021 |\\n| Product | U.S. | Outside U.S. | Total | Total | Percent Change |\\n| Trulicity | $ | 1,418.3 | $ | 432.0 | $ | 1,850.4 | $ | 1,600.1 | 16 |\\n| Taltz | 493.8 | 186.1 | 679.9 | 593.1 | 15 |\\n| Verzenio | 414.8 | 202.9 | 617.7 | 335.5 | 84 |\\n| Jardiance(1) | 350.9 | 222.4 | 573.3 | 390.4 | 47 |\\n| Humalog(2) | 248.1 | 198.8 | 447.0 | 626.7 | (29) |\\n| COVID-19 antibodies(3) | 386.6 | — | 386.6 | 217.1 | 78 |\\n| Humulin® | 169.5 | 68.7 | 238.2 | 286.7 | (17) |\\n| Cyramza® | 87.5 | 144.6 | 232.1 | 253.4 | (8) |\\n| Basaglar® | 124.8 | 68.1 | 193.0 | 192.8 | — |\\n| Mounjaro | 97.3 | 90.0 | 187.3 | — | NM |\\n| Olumiant(4) | 22.9 | 160.0 | 182.9 | 406.9 | (55) |\\n| Forteo | 112.7 | 64.4 | 177.1 | 200.9 | (12) |\\n| Emgality® | 114.0 | 54.6 | 168.5 | 140.0 | 20 |\\n| Erbitux® | 126.3 | 18.7 | 144.9 | 134.3 | 8 |\\n| Alimta | 64.6 | 54.8 | 119.4 | 457.0 | (74) |\\n| Cialis | 8.1 | 107.7 | 115.7 | 130.9 | (12) |\\n| Zyprexa® | 8.0 | 73.4 | 81.4 | 101.7 | (20) |\\n| Tyvyt | — | 76.8 | 76.8 | 125.6 | (39) |\\n| Cymbalta | 7.8 | 54.9 | 62.7 | 132.0 | (53) |\\n| Other products | 166.1 | 240.5 | 406.7 | 447.7 | (9) |\\n| Revenue | $ | 4,422.1 | $ | 2,519.4 | $ | 6,941.6 | $ | 6,772.8 | 2 |\\n\\nNumbers may not add due to rounding.\\nNM - not meaningful\\n(1) Jardiance revenue includes Glyxambi®, Synjardy®, and Trijardy® XR.\\n(2) Humalog revenue includes insulin lispro.\\n(3) COVID-19 antibodies include sales for bamlanivimab administered alone, for bamlanivimab and etesevimab administered together, and for bebtelovimab and were made pursuant to EUAs or similar regulatory authorizations.\\n(4) Olumiant revenue includes sales for baricitinib that were made pursuant to EUA or similar regulatory authorizations.\\n46\\n| Nine Months Ended September 30, |\\n| 2022 | 2021 |\\n| Product | U.S. | Outside U.S. | Total | Total | Percent Change |\\n| Trulicity | $ | 4,162.4 | $ | 1,341.1 | $ | 5,503.5 | $ | 4,588.2 | 20 |\\n| COVID-19 antibodies(1) | 1,970.9 | 14.7 | 1,985.5 | 1,176.2 | 69 |\\n| Taltz | 1,212.6 | 561.6 | 1,774.2 | 1,565.4 | 13 |\\n| Verzenio | 1,100.5 | 575.1 | 1,675.6 | 945.8 | 77 |\\n| Humalog(2) | 855.8 | 656.4 | 1,512.3 | 1,851.3 | (18) |\\n| Jardiance(3) | 831.4 | 622.4 | 1,453.7 | 1,058.9 | 37 |\\n| Humulin | 562.3 | 223.1 | 785.4 | 923.8 | (15) |\\n| Cyramza | 259.3 | 434.3 | 693.6 | 762.5 | (9) |\\n| Alimta | 490.5 | 200.5 | 691.1 | 1,626.6 | (58) |\\n| Olumiant(4) | 104.6 | 520.1 | 624.7 | 809.1 | (23) |\\n| Basaglar | 339.9 | 218.8 | 558.7 | 650.1 | (14) |\\n| Cialis | 25.8 | 454.7 | 480.4 | 538.7 | (11) |\\n| Emgality | 330.8 | 144.4 | 475.2 | 415.7 | 14 |\\n| Forteo | 261.4 | 191.7 | 453.0 | 617.8 | (27) |\\n| Erbitux | 361.0 | 47.4 | 408.3 | 403.7 | 1 |\\n| Zyprexa | 26.2 | 235.5 | 261.7 | 292.8 | (11) |\\n| Tyvyt | — | 235.8 | 235.8 | 340.2 | (31) |\\n| Cymbalta | 25.0 | 194.3 | 219.3 | 484.3 | (55) |\\n| Mounjaro | 109.9 | 93.3 | 203.2 | — | NM |\\n| Other products | 501.1 | 743.0 | 1,244.2 | 1,267.3 | (2) |\\n| Revenue | $ | 13,531.5 | $ | 7,708.1 | $ | 21,239.6 | $ | 20,318.5 | 5 |\\n\\nNumbers may not add due to rounding.\\nNM - not meaningful\\n(1) COVID-19 antibodies include sales for bamlanivimab administered alone, for bamlanivimab and etesevimab administered together, and for bebtelovimab and were made pursuant to EUAs or similar regulatory authorizations.\\n(2) Humalog revenue includes insulin lispro.\\n(3) Jardiance revenue includes Glyxambi, Synjardy, and Trijardy XR.\\n(4) Olumiant revenue includes sales for baricitinib that were made pursuant to EUA or similar regulatory authorizations.\\nRevenue of Trulicity, a treatment for type 2 diabetes and to reduce the risk of major adverse cardiovascular events in adult patients with type 2 diabetes and established cardiovascular disease or multiple cardiovascular risk factors, increased 18 percent in the U.S. during the three months ended September 30, 2022, driven by increased demand, partially offset by lower realized prices. The lower realized prices in the U.S. for the three months ended September 30, 2022 were due to unfavorable segment mix and higher contracted rebates, partially offset by changes to estimates for rebates and discounts. Revenue in the U.S. increased 20 percent during the nine months ended September 30, 2022, driven by increased demand, partially offset by lower realized prices due to unfavorable segment mix and higher contracted rebates. Revenue outside the U.S. increased 8 percent and 19 percent during the three and nine months ended September 30, 2022, respectively, driven by increased demand, partially offset by the unfavorable impact of foreign exchange rates and, to a lesser extent, lower realized prices.\\n47\\nRevenue of COVID-19 antibodies, treatments for mild to moderate COVID-19 for higher-risk patients and for post-exposure prophylaxis in certain individuals for the prevention of SARS-CoV-2 infection, was $386.6 million and $1.97 billion in the U.S. during the three and nine months ended September 30, 2022, respectively. Revenue outside the U.S. was not material during the three and nine months ended September 30, 2022. The availability of superior or competitive therapies, including therapies that can be administered more easily, or preventative measures, such as vaccines, coupled with the unpredictable nature of pandemics, have and could further negatively impact or eliminate demand for these COVID-19 antibodies. The FDA has revised, and may in the future revise, any EUA for our COVID-19 antibodies in response to the prevalence of variants against which our antibodies have varying degrees of efficacy, including the new BQ variants. Based on early data, we do not believe that bebtelovimab will neutralize against the new BQ variants. We supplied the U.S. government approximately 810,000 doses of bebtelovimab during the nine months ended September 30, 2022. Beginning in the third quarter of 2022 and in collaboration with the U.S. government, we have made bebtelovimab commercially available for purchase by U.S. states/territories, hospitals, and certain other providers. We do not anticipate any further U.S. government orders.\\nRevenue of Taltz, a treatment for moderate-to-severe plaque psoriasis, active psoriatic arthritis, ankylosing spondylitis, and active non-radiographic axial spondyloarthritis, increased 17 percent and 13 percent in the U.S. during the three and nine months ended September 30, 2022, respectively, driven by increased demand, partially offset by lower realized prices. Revenue outside the U.S. increased 9 percent and 14 percent during the three and nine months ended September 30, 2022, respectively, driven by increased volume, partially offset by unfavorable impact of foreign exchange rates and lower realized prices.\\nRevenue of Verzenio, a treatment for HR+, HER2- metastatic breast cancer and high risk early breast cancer, increased $215.1 million and $518.4 million in the U.S. during the three and nine months ended September 30, 2022, respectively, primarily driven by increased demand. Revenue outside the U.S. increased 49 percent and 58 percent during the three and nine months ended September 30, 2022, respectively, driven by increased demand, partially offset by lower realized prices due to the impact of the NRDL formulary in China and the unfavorable impact of foreign exchange rates.\\nRevenue of Humalog, an injectable human insulin analog for the treatment of diabetes, decreased 29 percent and 15 percent in the U.S. during the three and nine months ended September 30, 2022, respectively, driven by lower realized prices due to a list price reduction of insulin lispro injection and unfavorable segment mix. Revenue outside the U.S. decreased 29 percent and 22 percent during the three and nine months ended September 30, 2022, respectively, driven by lower realized prices due to the impact of VBP in China and the unfavorable impact of foreign exchange rates. Due to the impact of competition and pricing pressure in the U.S. and some international markets, we expect that lower revenue due to realized price decline will continue over time.\\nRevenue of Jardiance, a treatment for type 2 diabetes, to reduce the risk of cardiovascular death in adult patients with type 2 diabetes and established cardiovascular disease, and to reduce the risk of cardiovascular death and hospitalization for heart failure in adults with heart failure, regardless of left ventricular ejection fraction, increased 59 percent and 47 percent in the U.S. during the three and nine months ended September 30, 2022, respectively, primarily driven by increased demand. The increase in revenue in the U.S. during the three months ended September 30, 2022 was also driven by changes to estimates for rebates and discounts. Revenue outside the U.S. increased 31 percent and 26 percent during the three and nine months ended September 30, 2022, respectively, primarily driven by increased demand, partially offset by the unfavorable impact of foreign exchange rates. See Note 4 to the consolidated condensed financial statements for information regarding our collaboration with Boehringer Ingelheim involving Jardiance.\\nRevenue of Alimta, a treatment for various cancers, decreased 78 percent and 46 percent in the U.S. during the three and nine months ended September 30, 2022, respectively, primarily driven by decreased demand due to the entry of multiple generics in the second quarter of 2022. Revenue outside the U.S. decreased 66 percent and 72 percent during the three and nine months ended September 30, 2022, respectively, largely driven by decreased demand due to generic competition. Following the June 2021 loss of patent exclusivity for Alimta in Europe and Japan, we faced, and expect to continue to face, generic competition that has rapidly and severely eroded revenue, and we expect will continue to erode revenue from current levels. In addition, as a result of the entry of multiple generics in the U.S. following the loss of patent and pediatric exclusivity in May 2022, we began facing, and expect to continue to face, additional generic competition that has eroded revenue, and we expect will continue to rapidly and severely erode revenue from current levels. See \\\"Executive Overview - Other Matters- Patent Matters\\\" for additional information.\\n48\\nGross Margin, Costs, and Expenses\\nGross margin as a percent of revenue decreased 1.6 percentage points to 77.3 percent and increased 2.0 percentage points to 76.1 percent for the three and nine months ended September 30, 2022, respectively. The decrease in the gross margin percent for the three months ended September 30, 2022 was primarily driven by a benefit in the gross margin for the three months ended September 30, 2021 due to the partial reversal of inventory impairment charges related to our COVID-19 antibodies that were recognized in the first and second quarters of 2021. The partial reversal of inventory impairment charges related to our COVID-19 antibodies was driven by an unexpected increase in our COVID-19 antibodies sales as the COVID-19 pandemic evolved during the third quarter of 2021. The increase in gross margin percent for the nine months ended September 30, 2022 was primarily driven by a net inventory impairment charge related to our COVID-19 antibodies recognized in 2021. Additionally, for the three and nine months ended September 30, 2022, lower realized prices and increased expenses due to inflation and logistics costs were offset by favorable product mix, including the impact of lower sales of Olumiant for the treatment of COVID-19, and the favorable impact of foreign exchange rates.\\nResearch and development expenses increased 6 percent to $1.80 billion and 3 percent to $5.19 billion for the three and nine months ended September 30, 2022, respectively, primarily driven by higher development expenses for late-stage assets, partially offset by lower development expenses for COVID-19 antibodies and the favorable impact of foreign exchange rates.\\nMarketing, selling, and administrative expenses increased 2 percent to $1.61 billion for the three months ended September 30, 2022, primarily driven by increased costs associated with the launch of Mounjaro, partially offset by the favorable impact of foreign exchange rates. Marketing, selling, and administrative expenses decreased 1 percent to $4.80 billion for the nine months ended September 30, 2022, primarily driven by the favorable impact of foreign exchange rates as well as reduced marketing costs in the first half of 2022, partially offset by increased costs associated with the launch of Mounjaro.\\nWe plan to take compensatory actions to improve retention and address wage inflation which will impact our costs and consolidated results of operations.\\nWe recognized $62.4 million and $668.4 million of acquired IPR&D and development milestones for the three and nine months ended September 30, 2022, respectively. The charges for the nine months ended September 30, 2022 included the buy-out of substantially all future obligations that were contingent upon the occurrence of certain events linked to the success of our mutant-selective PI3kα inhibitor and a purchase of a Priority Review Voucher. We recognized $177.6 million and $532.4 million of acquired IPR&D and development milestones for the three and nine months ended September 30, 2021, respectively. The charges for the nine months ended September 30, 2021 included acquired IPR&D charges from business development transactions with Rigel and Precision. See Note 3 to the consolidated condensed financial statements for additional information.\\nWe recognized asset impairment, restructuring, and other special charges of $206.5 million for the three and nine months ended September 30, 2022, primarily related to an intangible asset impairment for GBA1 Gene Therapy (PR001) due to changes in estimated launch timing. There were no asset impairment, restructuring, and other special charges recognized for the three months ended September 30, 2021. We recognized asset impairment, restructuring, and other special charges of $211.6 million for the nine months ended September 30, 2021, primarily related to an intangible asset impairment resulting from the sale of the rights to Qbrexza, as well as acquisition and integration costs associated with the acquisition of Prevail. See Note 5 to the consolidated condensed financial statements for additional information.\\nOther–net, (income) expense was expense of $111.0 million and $580.9 million for the three and nine months ended September 30, 2022, respectively, compared with expense of $635.9 million and $124.3 million for the three and nine months ended September 30, 2021, respectively. The decrease in other expense for the three months ended September 30, 2022 was primarily driven by a debt extinguishment loss of $405.2 million related to the repurchase of debt in 2021, as well as lower net investment losses on equity securities in 2022 compared to 2021. The increase in other expense for the nine months ended September 30, 2022 was primarily driven by net investment losses on equity securities in 2022 compared with net investment gains on equity securities in 2021, partially offset by a debt extinguishment loss of $405.2 million related to the repurchase of debt in 2021.\\n49\\nThe effective tax rates were 7.3 percent and 8.6 percent for the three and nine months ended September 30, 2022, respectively, reflecting the favorable tax impact of the implementation of a provision in the 2017 Tax Act that requires capitalization and amortization of research and development expenses for tax purposes starting in 2022, net investment losses on equity securities, and an intangible asset impairment charge. We expect our effective tax rate to be approximately 13 percent to 14 percent for 2022 if the capitalization and amortization of research and development expenses provision of the 2017 Tax Act is deferred or repealed by the U.S. Congress effective for 2022.\\nThe effective tax rate was 10.9 percent for the three months ended September 30, 2021, reflecting the favorable tax impact of a debt extinguishment loss and of net investment losses on equity securities, partially offset by a net discrete tax detriment. The effective tax rate was 10.7 percent for the nine months ended September 30, 2021, reflecting the favorable tax impact of a net discrete tax benefit, a debt extinguishment loss, and a net inventory impairment charge related to our COVID-19 antibodies.\\nFinancial Condition and Liquidity\\nWe believe our available cash and cash equivalents, together with our ability to generate operating cash flow and our access to short-term and long-term borrowings, are sufficient to fund our existing and planned capital requirements. For a discussion of our capital requirements, see \\\"Management's Discussion and Analysis of Results of Operations and Financial Condition\\\" in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2021.\\nWe plan to invest more than $2 billion over several years in two new facilities in Lebanon, Indiana to manufacture existing and future products and more than $1 billion over several years in a new facility in Concord, North Carolina to manufacture parenteral (injectable) products and devices. We plan to invest more than 400 million euro over several years in a new facility in Limerick, Ireland to expand our manufacturing network for biologic active ingredients. These investments, and other capital investments that support our operations, will result in capital expenditures being higher than recent historical levels for the next several years.\\nCash and cash equivalents decreased to $2.62 billion as of September 30, 2022, compared with $3.82 billion as of December 31, 2021. Refer to the consolidated condensed statements of cash flows for additional information on the significant sources and uses of cash for the nine months ended September 30, 2022 and 2021.\\nIn addition to our cash and cash equivalents, we held total investments of $2.70 billion and $3.30 billion as of September 30, 2022 and December 31, 2021, respectively. See Note 6 to the consolidated condensed financial statements for additional information.\\nAs of September 30, 2022, total debt was $15.89 billion, a decrease of $996.3 million compared with $16.88 billion as of December 31, 2021. See Note 6 to the consolidated condensed financial statements for additional information.\\nAs of September 30, 2022, we had a total of $7.26 billion of unused committed bank credit facilities, $7.00 billion of which is available to support our commercial paper program. We believe that amounts accessible through existing commercial paper markets should be adequate to fund short-term borrowing needs.\\nDuring the nine months ended September 30, 2022, we repurchased $1.50 billion of shares under our $5.00 billion share repurchase program authorized in May 2021. As of September 30, 2022, we had $3.25 billion remaining under this program.\\nDuring the nine months ended September 30, 2022, we paid dividends of $2.65 billion, or $2.94 per share, to our shareholders. In October 2022, we declared a dividend for the fourth quarter of 2022 of $0.98 per share on outstanding common stock. The dividend of approximately $882 million is payable on December 9, 2022 to shareholders of record at the close of business on November 15, 2022.\\nSee \\\"Executive Overview - Other Matters - Patent Matters\\\" for information regarding recent losses of patent protection.\\nBoth domestically and abroad, we continue to monitor the potential impacts of the economic environment; the creditworthiness of our wholesalers and other customers, including foreign government-backed agencies and suppliers; the uncertain impact of health care legislation; various international government funding levels; and fluctuations in interest rates, foreign currency exchange rates (see \\\"Executive Overview - Other Matters - Foreign Currency Exchange Rates\\\"), and fair values of equity securities.\\n50\\nCritical Accounting Estimates\\nFor a discussion of our critical accounting estimates, refer to \\\"Management's Discussion and Analysis of Results of Operations and Financial Condition\\\" in Part II, Item 7 and the notes to our consolidated financial statements in Part II, Item 8 of our Annual Report on Form 10-K for the year ended December 31, 2021. See also Note 1 to the consolidated condensed financial statements. There have been no material changes to our critical accounting estimates since our Annual Report on Form 10-K for the year ended December 31, 2021.\\nAvailable Information on our Website\\nWe make available through our company website, free of charge, our company filings with the Securities and Exchange Commission (SEC) as soon as reasonably practicable after we electronically file them with, or furnish them to, the SEC. The reports we make available include annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements, registration statements, and any amendments to those documents.\\nThe website link to our SEC filings is investor.lilly.com/financial-information/sec-filings.\\nWe routinely post important information for investors in the “Investors” section of our website, www.lilly.com. We may use our website as a means of disclosing material, non-public information and for complying with our disclosure obligations under Regulation FD. Accordingly, investors should monitor the “Investors” section of our website, in addition to following our press releases, filings with the SEC, public conference calls, presentations, and webcasts. We may also use social media channels to communicate with investors and the public about our business, products and other matters, and those communications could be deemed to be material information. The information contained on, or that may be accessed through, our website or social media channels, is not incorporated by reference into, and is not a part of, this Quarterly Report on Form 10-Q.\\n51\\nItem 4. Controls and Procedures\\n(a)Evaluation of Disclosure Controls and Procedures. Under applicable Securities and Exchange Commission (SEC) regulations, management of a reporting company, with the participation of the principal executive officer and principal financial officer, must periodically evaluate the company's \\\"disclosure controls and procedures,\\\" which are defined generally as controls and other procedures of a reporting company designed to ensure that information required to be disclosed by the reporting company in its periodic reports filed with the SEC (such as this Quarterly Report on Form 10-Q) is recorded, processed, summarized, and reported on a timely basis.\\nOur management, with the participation of David A. Ricks, president and chief executive officer, and Anat Ashkenazi, executive vice president and chief financial officer, evaluated our disclosure controls and procedures (as such terms are defined in our Annual Report on Form 10-K for the year ended December 31, 2021) as of September 30, 2022, and concluded that they were effective.\\n(b)Changes in Internal Controls. During the third quarter of 2022, there were no changes in our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\n52\\nPART II. Other Information\\nItem 1. Legal Proceedings\\nWe are a party to various currently pending legal actions, government investigations, and environmental proceedings. See Note 9 to the consolidated condensed financial statements for information on various legal proceedings.\\nThis Item should be read in conjunction with \\\"Legal Proceedings\\\" in Part I, Item 3 of our Annual Report on Form 10-K for the year ended December 31, 2021.\\nItem 1A. Risk Factors\\nOur material risk factors are disclosed in \\\"Risk Factors\\\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2021. There have been no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2021.\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\\nInformation relating to the principal market for our common stock and related shareholder matters is described in \\\"Management's Discussion and Analysis of Results of Operations and Financial Condition\\\" in Part II, Item 7 and in \\\"Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters\\\" in Part III, Item 12 of our Annual Report on Form 10-K for the year ended December 31, 2021.\\nThe following table summarizes the activity related to repurchases of our equity securities during the three months ended September 30, 2022:\\n| Period | Total Number ofShares Purchased(in thousands) | Average Price Paid per Share | Total Number of SharesPurchased as Part ofPublicly AnnouncedPlans or Programs(in thousands) | Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs (in millions) |\\n| July 2022 | — | $ | — | — | $ | 3,250.0 |\\n| August 2022 | — | — | — | 3,250.0 |\\n| September 2022 | — | — | — | 3,250.0 |\\n| Total | — | — | — |\\n\\nDuring the three months ended September 30, 2022, we did not repurchase any shares under our $5.00 billion share repurchase program authorized in May 2021.\\n53\\nItem 6. Exhibits\\nThe following documents are filed as a part of this Quarterly Report:\\n| Exhibit | Description |\\n| EXHIBIT 3.1 | Amended Articles of Incorporation are incorporated by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K filed on May 4, 2022 |\\n| EXHIBIT 3.2 | Bylaws, as amended, are incorporated by reference to Exhibit 3.2 to the Company's Current Report on Form 8-K filed on May 4, 2022 |\\n| EXHIBIT 10.1 | Form of Performance Award under the 2002 Lilly Stock Plan (with non-compete)(1) |\\n| EXHIBIT 10.2 | Form of Shareholder Value Award under the 2002 Lilly Stock Plan (with non-compete)(1) |\\n| EXHIBIT 10.3 | Form of Relative Value Award under the 2002 Lilly Stock Plan (with non-compete)(1) |\\n| EXHIBIT 31.1 | Rule 13a-14(a) Certification of David A. Ricks, Chair, President, and Chief Executive Officer |\\n| EXHIBIT 31.2 | Rule 13a-14(a) Certification of Anat Ashkenazi, Executive Vice President and Chief Financial Officer |\\n| EXHIBIT 32. | Section 1350 Certification |\\n| EXHIBIT 101. | Interactive Data Files (embedded within the Inline XBRL document) |\\n| EXHIBIT 104. | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\\n\\nLong-term debt instruments under which the total amount of securities authorized does not exceed 10 percent of our consolidated assets are not filed as exhibits to this Quarterly Report. We will furnish a copy of these agreements to the Securities and Exchange Commission upon request.\\nSignatures\\nPursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.\\n| ELI LILLY AND COMPANY |\\n| (Registrant) |\\n| Date: | November 1, 2022 | /s/ Anat Ashkenazi |\\n| Anat Ashkenazi |\\n| Executive Vice President and Chief Financial Officer |\\n| Date: | November 1, 2022 | /s/ Donald A. Zakrowski |\\n| Donald A. Zakrowski |\\n| Senior Vice President, Finance, and Chief Accounting Officer |\\n\\n54\\n \\n\\nWhat is the difference in net income as a percentage of cash provided by operating activities between the years 2022 and 2021 in percentages?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 2.7062535908033993.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 40,\n \"input_length\": 45623\n}"}}},{"rowIdx":41,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nItem 1. Financial Statements (unaudited).\n4\nEmbark Technology, Inc.\nCondensed Consolidated Balance Sheets\n(in thousands, except share and per share data)\n(unaudited)\n| March 31,2022 | December 31,2021 |\n| Assets |\n| Current assets: |\n| Cash and cash equivalents | $ | 244,488 | $ | 264,615 |\n| Restricted cash, short-term | 65 | 130 |\n| Prepaid expenses and other current assets | 12,005 | 12,746 |\n| Total current assets | 256,558 | 277,491 |\n| Restricted cash, long-term | 812 | 275 |\n| Property, equipment and software, net | 11,086 | 9,637 |\n| Operating lease right-of-use assets | 6,099 | — |\n| Other assets | 3,722 | 3,596 |\n| Total assets | $ | 278,277 | $ | 290,999 |\n| Liabilities and stockholders’ equity |\n| Current liabilities: |\n| Accounts payable | $ | 4,099 | $ | 2,497 |\n| Accrued expenses and other current liabilities | 6,151 | 3,142 |\n| Current portion of operating lease liabilities | 1,948 | — |\n| Short-term notes payable | 357 | 358 |\n| Total current liabilities | 12,555 | 5,997 |\n| Long-term notes payable | 641 | 722 |\n| Warrant liability | 27,264 | 49,419 |\n| Non-current portion of operating lease liabilities | 4,438 | — |\n| Other long-term liability | 111 | 50 |\n| Long-term deferred rent | — | 177 |\n| Total liabilities | 45,009 | 56,365 |\n| Commitments and contingencies (Note 10) |\n| Stockholders’ equity: |\n| Preferred stock, $ 0.0001 par value; 10,000,000 shares authorized, none issued and none outstanding as of March 31, 2022 and December 31, 2021 | — | — |\n| Class A common stock, $ 0.0001 par value; 4,000,000,000 shares authorized, 362,832,986 shares issued as of March 31, 2022; 4,000,000,000 shares authorized, 362,832,986 shares issued as of December 31, 2021 | 36 | 36 |\n| Class B common stock, $ 0.0001 par value; 100,000,000 shares authorized, 87,078,981 shares issued as of March 31, 2022 and December 31, 2021 | 9 | 9 |\n| Additional paid-in capital | 434,573 | 417,492 |\n| Accumulated deficit | ( 201,350 ) | ( 182,903 ) |\n| Total stockholders’ equity | 233,268 | 234,634 |\n| Total liabilities and stockholders’ equity | $ | 278,277 | $ | 290,999 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n5\nEmbark Technology, Inc.\nCondensed Consolidated Statements of Operations\n(in thousands, except share and per share data)\n(unaudited)\n| Three Months Ended March 31, |\n| 2022 | 2021 |\n| Operating expenses: |\n| Research and development | $ | 18,695 | $ | 6,231 |\n| General and administrative | 21,926 | 2,290 |\n| Total operating expenses | 40,621 | 8,521 |\n| Loss from operations | ( 40,621 ) | ( 8,521 ) |\n| Other income (expense): |\n| Change in fair value of warrant liability | 22,156 | — |\n| Other income | 26 | 9 |\n| Interest income | 13 | 30 |\n| Interest expense | ( 21 ) | — |\n| Loss before provision for income taxes | ( 18,447 ) | ( 8,482 ) |\n| Net loss | $ | ( 18,447 ) | $ | ( 8,482 ) |\n| Net loss attributable to common stockholders, basic and diluted | $ | ( 18,447 ) | $ | ( 8,482 ) |\n| Net loss per share attributable to common stockholders: |\n| Basic and diluted, Class A and Class B | $ | ( 0.04 ) | $ | ( 0.18 ) |\n| Weighted-average shares used in computing net loss per share attributable to common stockholders: |\n| Basic and diluted | 452,623,022 | 47,538,331 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n6\nEmbark Technology, Inc.\nCondensed Consolidated Statements of Comprehensive Loss\n(in thousands)\n(unaudited)\n| Three Months Ended March 31, |\n| 2022 | 2021 |\n| Net loss | $ | ( 18,447 ) | $ | ( 8,482 ) |\n| Other comprehensive loss (net of tax): |\n| Unrealized losses on available-for-sale securities, net | — | ( 19 ) |\n| Comprehensive loss | $ | ( 18,447 ) | $ | ( 8,501 ) |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n7\nEmbark Technology, Inc.\nCondensed Consolidated Statements of Preferred Stock and Stockholder’s Equity\n(in thousands, except number of shares)\n(unaudited)\n| Preferred Stock | Founders Preferred Stock | Common Stock | Class A | Class B | Warrants | Additional Paid-in Capital | Accumulated Deficit | Accumulated Other Comprehensive Income (Loss) | TotalStockholders'Equity |\n| Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount |\n| Balance at January 1, 2022 | — | $ | — | — | $ | — | — | $ | — | 362,832,986 | $ | 36 | 87,078,781 | $ | 9 | 23,153,266 | $ | 417,492 | $ | ( 182,903 ) | $ | — | $ | 234,634 |\n| Shares issued upon exercise of stock options | — | — | — | — | — | — | — | — | — | — | — | 372 | — | — | 372 |\n| Vesting of early exercised options | — | — | — | — | — | — | — | — | — | — | — | 11 | — | — | 11 |\n| Stock-based compensation | — | — | — | — | — | — | — | — | — | — | — | 16,698 | — | — | 16,698 |\n| Net loss | — | — | — | — | — | — | — | — | — | — | — | — | ( 18,447 ) | — | ( 18,447 ) |\n| Balance at March 31, 2022 | — | $ | — | — | $ | — | — | $ | — | 362,832,986 | $ | 36 | 87,078,781 | $ | 9 | 23,153,266 | $ | 434,573 | $ | ( 201,350 ) | $ | — | $ | 233,268 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n8\nEmbark Technology, Inc.\nCondensed Consolidated Statements of Preferred Stock and Stockholder’s Equity\n(in thousands, except number of shares)\n(unaudited)\n| Preferred Stock | Founders Preferred Stock | Common Stock | Class A | Class B | Warrants | Additional Paid-in Capital | Accumulated Deficit | Accumulated Other Comprehensive Income (Loss) | TotalStockholders'Equity |\n| Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount |\n| Balance at January 1, 2021 | 260,582,311 | $ | 1 | 484,912 | $ | — | 141,216,455 | $ | — | — | $ | — | — | $ | — | — | $ | 129,449 | $ | ( 58,690 ) | $ | 45 | $ | 70,805 |\n| Shares issued upon exercise of stock options | — | — | — | — | 1,244,349 | — | — | — | — | — | — | 94 | — | — | 94 |\n| Vesting of early exercised options | — | — | — | — | — | — | — | — | — | — | — | 5 | — | — | 5 |\n| Stock-based compensation | — | — | — | — | — | — | — | — | — | — | — | 598 | — | — | 598 |\n| Issuance of common stock warrants | — | — | — | — | — | — | — | — | — | — | — | 83 | — | — | 83 |\n| Other comprehensive loss | — | — | — | — | — | — | — | — | — | — | — | — | — | ( 19 ) | ( 19 ) |\n| Net loss | — | — | — | — | — | — | — | — | — | — | — | — | ( 8,482 ) | — | ( 8,482 ) |\n| Balance at March 31, 2021 | 260,582,311 | $ | 1 | 484,912 | $ | — | 142,460,804 | $ | — | — | $ | — | — | $ | — | — | $ | 130,229 | $ | ( 67,172 ) | $ | 26 | $ | 63,084 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n9\nEmbark Technology, Inc.\nCondensed Consolidated Statements of Cash Flows\n(in thousands)\n(unaudited)\n| Three Months Ended March 31, |\n| 2022 | 2021 |\n| Cash flows from operating activities |\n| Net loss | $ | ( 18,447 ) | $ | ( 8,482 ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: |\n| Depreciation and amortization | 383 | 222 |\n| Amortization expense - right-of-use assets - operating leases | 488 | — |\n| Stock-based compensation, net of amounts capitalized | 16,602 | 562 |\n| Issuance of warrants for services | — | 83 |\n| Change in fair value of warrants | ( 22,156 ) | — |\n| Net amortization of premiums and accretion of discounts on investments | — | 120 |\n| Changes in operating assets and liabilities: |\n| Prepaid expenses and other current assets | 682 | 29 |\n| Other assets | ( 126 ) | ( 65 ) |\n| Accounts payable | 1,644 | 264 |\n| Other long-term liabilities | 60 | — |\n| Accrued expenses and other current liabilities | 2,645 | 476 |\n| Net cash used in operating activities | ( 18,225 ) | ( 6,791 ) |\n| Cash flows from investing activities |\n| Maturities of investments | — | 18,243 |\n| Purchase of property, equipment and software | ( 1,717 ) | ( 973 ) |\n| Net cash provided by (used in) investing activities | ( 1,717 ) | 17,270 |\n| Cash flows from financing activities |\n| Payment towards notes payable | ( 81 ) | ( 66 ) |\n| Proceeds from exercise of stock options | 372 | 94 |\n| Repurchase of early exercised stock options | ( 4 ) | — |\n| Net cash provided by (used in) financing activities | 287 | 28 |\n| Net increase (decrease) in cash, cash equivalents and restricted cash | ( 19,655 ) | 10,507 |\n| Cash, cash equivalents and restricted cash at beginning of period | 265,020 | 11,460 |\n| Cash, cash equivalents and restricted cash at end of period | $ | 245,365 | $ | 21,967 |\n| Supplemental disclosures of cash flow information: |\n| Cash paid during the year for interest | $ | 18 | $ | 16 |\n| Supplemental schedule of noncash investing and financing activities |\n| Acquisition of property, equipment and software in accounts payable | $ | 284 | $ | 176 |\n| Acquisition of trucks by assuming notes payable | $ | — | $ | 278 |\n| Right-of-use assets obtained in exchange for lease obligations | $ | 6,587 | $ | — |\n| Stock-based compensation capitalized into internally developed software | $ | 156 | $ | 36 |\n| Vesting of early exercised stock options | $ | 15 | $ | 5 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n10\nNotes to Condensed Consolidated Financial Statements\n1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION\nEmbark Technology, Inc. was originally incorporated in Delaware on September 25, 2020 under the name Northern Genesis Acquisition Corp. II (“NGA”). The Company was formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. On November 10, 2021 (the “Closing Date”), the Company (at such time named Northern Genesis Acquisition Corp. II) consummated the business combination (the “Business Combination”) pursuant to the Agreement and Plan of Merger, dated June 22, 2021 with the pre-Business Combination company, Embark Trucks, Inc. (“Embark Trucks”). In connection with the consummation of the Business Combination, the Company changed its name from Northern Genesis Acquisition Corp. II to Embark Technology, Inc. and became the parent entity of Embark Trucks.\nThe Merger was accounted for as a reverse recapitalization with Embark as the accounting acquirer and NGA as the acquired company for accounting purposes. Accordingly, all historical financial information presented in the financial statements represent the accounts of Embark as if Embark is the predecessor to the Company. The shares and net loss per common share, prior to the Merger, have been retroactively restated as shares reflecting the exchange ratio established in the Merger (approximately 2.98 shares of Company Class A common stock for 1 share of Embark Class A common stock).\nThe principal activities of Embark Technology, Inc. (“Embark” or the “Company”) include design and development of autonomous driving software for the truck freight industry. The Company is headquartered in San Francisco, California and was incorporated in the State of Delaware in 2016. Other than Embark Trucks, the Company has no subsidiaries as of March 31, 2022.\nThe Company has devoted substantially all of its resources to develop its autonomous truck technology, to enable and expand its route models - transfer point and direct-to-customer, to expand its partnerships with shippers and carriers, to raising capital, and providing general and administrative support for these operations. The Company has not generated revenues from its principal operations through March 31, 2022.\nPrior to the Merger, NGA ordinary shares and warrants were traded on the New York Stock Exchange (“NYSE”) under the ticker symbols “NGAB” and “NGAB.WS”, respectively. On the Closing Date, the Company’s Class A common stock and warrants began trading on the NASDAQ under the ticker symbols “EMBK” and “EMBKW”, respectively. One of the primary purposes of the Merger was to provide a platform for Embark Trucks to gain access to the U.S. capital markets.\nBasis of Presentation\nThe accompanying financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and pursuant to the regulations of the U.S. Securities and Exchange Commission (“SEC”).\nUnaudited Interim Financial Information\nThese interim Unaudited Condensed Consolidated Financial Statements should be read in conjunction with the audited financial statements and notes thereto contained in Embark’s Annual Report. The condensed consolidated balance sheet at December 31, 2021, has been derived from the audited financial statements at that date, but does not include all disclosures, including notes, required by GAAP for complete financial statements. In management’s opinion, the unaudited interim financial statements have been prepared on the same basis as the annual financial statements and include all adjustments, which include only normal recurring adjustments, necessary for the fair presentation of the Company’s financial position as of March 31, 2022 and the Company’s results of operations and cash flows for the three months ended March 31, 2022 and 2021. The interim results are not necessarily indicative of the results for any future interim period or for the entire year.\nBusiness Combination\nThe Company entered into the Merger Agreement with NGA, a special purpose acquisition company, on June 22, 2021. On November 10, 2021, as part of the Business Combination, Merger Sub, a newly formed subsidiary of NGA, merged with and into Embark Trucks. In connection with the consummation of the Business Combination, the separate\n11\ncorporate existence of Merger Sub ceased; Embark Trucks survived and became a wholly owned subsidiary of NGA, which was renamed Embark Technology, Inc.\nThe Business Combination was accounted for as a reverse recapitalization, in accordance with GAAP. Under the guidance in ASC 805, Embark was treated as the “acquired” company for financial reporting purposes. Embark Trucks was deemed the accounting predecessor of the combined business, and Embark Technology, Inc., as the parent company of the combined business, was the successor SEC registrant, meaning that Embark’s financial statements for previous periods will be disclosed in the registrant’s periodic reports filed with the SEC. The Business Combination had a significant impact on Embark’s reported financial position and results as a consequence of the reverse recapitalization. The most significant changes in Embark’s reported financial position and results were a net increase in cash of $ 243.9 million, net of transaction costs for the Business Combination of $ 70.2 million. As of March 31, 2022 and December 31, 2021, the Company had warrant liabilities of $ 27.3 million and $ 49.4 million, respectively.\nLiquidity and Capital Resources\nOn November 10, 2021, Embark consummated the Business Combination, generating net increase in cash of $ 243.9 million, net of transaction costs for the Business Combination of $ 70.2 million.\nThe Company has incurred losses from operations since inception. The Company incurred net losses of $ 18.4 million and $ 8.5 million for the three months ended March 31, 2022 and 2021, respectively, and accumulated deficit amounts to $ 201.4 million and $ 182.9 million as of March 31, 2022 and December 31, 2021, respectively. Net cash used in operating activities was $ 18.2 million and $ 6.8 million for the three months ended March 31, 2022 and 2021, respectively.\nThe Company’s liquidity is based on its ability to enhance its operating cash flow position, obtain capital financing from equity interest investors and borrow funds to fund its general operations, research and development activities and capital expenditures. As of March 31, 2022 and December 31, 2021, the Company’s balance of cash and cash equivalents was $ 244.5 million and $ 264.6 million, respectively.\nBased on cash flow projections from operating and financing activities and existing balance of cash and cash equivalents and investments, management is of the opinion that the Company has sufficient funds for sustainable operations, and it will be able to meet its payment obligations from operations and debt related commitments for at least one year from the issuance date of these financial statements. Based on the above considerations, the Company’s financial statements have been prepared on a going concern basis, which contemplates the realization of assets and liquidation of liabilities during the normal course of operations.\nThe Company’s ability to continue as a going concern is dependent on management’s ability to control operating costs and demonstrate progress against its technical roadmap. This involves developing new capabilities for the Embark Driver software and improving the reliability and performance of the software on public roads. Demonstrating ongoing technical progress will enable the Company to obtain funds from outside sources of financing, including financing from equity interest investors and borrow funds to fund its general operations, research and development activities and capital expenditures.\nEmerging Growth Company\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the independent registered public accounting firm attestation requirements of Section 404 of the Sarbanes- Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies, but\n12\nany such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\nSegment Information\nUnder Accounting Standards Codification (“ASC 280”), Segment Reporting, operating segments are defined as components of an enterprise where discrete financial information is available that is evaluated regularly by the chief operating decision-maker (“CODM”), in deciding how to allocate resources and in assessing performance. The Company operates in one segment, the truck business unit, which is focused on enhancing self-driving truck software technology. Therefore, the Company’s chief executive officer, who is also the CODM, makes decisions and manages the Company’s operations as a single operating segment for purposes of allocating resources and evaluating financial performance. All long-lived assets are maintained in, and all losses are attributable to, the United States of America.\nConcentration of Risks\nEmbark’s financial instruments that are exposed to concentrations of credit risk consist primarily of cash and cash equivalents and restricted cash. Embark maintains its cash and cash equivalents, restricted cash and investments with high-quality financial institutions with investment-grade ratings. A majority of the cash balances are with U.S. banks and are insured to the extent defined by the Federal Deposit Insurance Corporation.\nImpact of COVID-19\nThe outbreak of the novel coronavirus COVID-19, which was declared a global pandemic by the World Health Organization on March 11, 2020 has led to adverse impacts on the U.S. and global economies and has impacted and continues to impact the Company’s supply chain, and operations. Even though the Company has taken measures to adapt to operating in this challenging environment, the pandemic could further affect the Company’s operations and the operations of, partners, suppliers and vendors due to additional shelter- in-place and other governmental orders, facility closures, travel and logistics restrictions, or other factors as circumstances continue to evolve. In response to this pandemic, many jurisdictions in which the Company operates issued stay-at-home orders and other measures aimed at slowing the spread of the virus. While the Company remains open in accordance with guidance from local authorities, the Company experienced a temporary pause in testing of its research and development truck fleet and operations in response to the stay- at-home orders in calendar year 2021. The impacts from stay-at-home orders and other updated local government indoor operation measures are no longer impacting the Company’s operations in 2021, however, there remains uncertainty around the potential disruptions the pandemic could cause looking forward. The Company has instituted policies across its offices to ensure compliance with these updated guidelines. At current, these changes have not impacted the Company’s operations. In response to the Delta and Omicron variants, local governments updated their guidelines for indoor operations. Therefore, the related financial impact and duration cannot be reasonably estimated at this time.\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nUse of Estimates\nThe preparation of financial statements in conformity with GAAP requires management to make certain estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the balance sheet date, as well as reported amounts of expenses during the reporting period.\nThe Company’s most significant estimates and judgments involve the useful lives of long-lived assets, the recoverability of long-lived assets, the incremental borrowing rate (“IBR”) applied in lease accounting, the capitalization of software development costs, the valuation of the Company’s stock-based compensation, including the valuation of warrants to purchase the Company’s stock and the valuation allowance for income taxes. Management bases its estimates on historical experience and on various other assumptions believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results could differ from those estimates.\n13\nCash, Cash Equivalents and Restricted Cash\nThe Company considers all highly liquid investments purchased with original maturities of three months or less to be cash equivalents. As of March 31, 2022 and December 31, 2021, the Company had $ 244.5 million and $ 264.6 million of cash and cash equivalents, respectively.\nThe Company maintains letters of credit to secure leases of the Company’s offices and facilities. A portion of the Company’s cash is collateralized in conjunction with the letter of credit and is classified as restricted cash on the Company’s condensed consolidated balance sheets. As of March 31, 2022 and December 31, 2021, the Company had $ 0.9 million and $ 0.4 million in restricted cash, respectively. At the end of each year of the lease, the face amount of the letter of credit is reduced by a fixed amount of approximately $ 0.1 million and reclassified into cash and cash equivalents on the Company’s condensed consolidated balance sheets. The Company determines short-term or long-term classification based on the expected duration of the restriction.\nThe reconciliation of cash and cash equivalents and restricted cash and cash equivalents to amounts presented in the condensed consolidated statements of cash flows are as follows (in thousands):\n| As of March 31, | As of December 31, |\n| 2022 | 2021 | 2021 |\n| Cash and cash equivalents | 244,488 | 21,562 | 264,615 |\n| Restricted cash, short-term | 65 | 65 | 130 |\n| Restricted cash, long-term | 812 | 340 | 275 |\n| Total cash, cash equivalents and restricted cash | 245,365 | 21,967 | 265,020 |\n\nFair Value of Financial Instruments\nThe Company’s financial instruments consist of cash and cash equivalents, restricted cash, prepaid expenses and other current assets, accounts payable and accrued expenses, short-term and long-term notes payable and other current liabilities. The assets and liabilities that were measured at fair value on a recurring basis are cash equivalents and warrant liabilities. The Company believes that the carrying values of the remaining financial instruments approximate their fair values. The Company applies fair value accounting in accordance with ASC 820, Fair Value Measurements for valuation of financial instruments. ASC 820 provides a framework for measuring fair value under GAAP that expands disclosures about fair value measurements, establishes a fair value hierarchy, and requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The three levels of the fair value hierarchy are summarized as follows:\nLevel 1 — Fair value is based on observable inputs such as quoted prices for identical assets or liabilities in active markets.\nLevel 2 — Fair value is determined using quoted prices for similar assets or liabilities in active markets or quoted prices for identical or similar assets or liabilities in markets that are not active or are directly or indirectly observable.\nLevel 3 — Fair value is determined using one or more significant inputs that are unobservable in active markets at the measurement date, such as an option pricing model, discounted cash flow, or similar technique.\nPublic and Private Warrants\nAs part of NGA’s initial public offering on October 13, 2020, NGA issued to third party investors 41.4 million units, consisting of one share of Class A common stock of NGA and one-third of one warrant, at a price of $ 10.00 per unit. Each whole warrant entitles the holder to purchase one share of Class A common stock at an exercise price of $ 11.50 per share (the \"Public Warrants\"). Further, NGA completed the private sale of 6.7 million warrants to NGA's sponsor at a purchase price of $ 1.50 per warrant (the \"Private Warrants\"). Each Private Warrant allows the sponsor to purchase one share of Class A common stock at $ 11.50 per share. Subsequent to the Business Combination, 13.8 million Public Warrants and 6.7 million Private Warrants remained outstanding as of March 31, 2022.\n14\nThe Private Placement Warrants are identical to the Public Warrants underlying the Units sold in the Initial Public Offering, except that the Private Placement Warrants and the Class A common stock issuable upon the exercise of the Private Placement Warrants did not become transferable, assignable or salable until 30 days after the completion of a Business Combination, subject to certain limited exceptions. Additionally, the Private Placement Warrants are exercisable on a cashless basis and are non-redeemable so long as they are held by the initial purchasers or their permitted transferees. If the Private Placement Warrants are held by someone other than the initial purchasers or their permitted transferees, the Private Placement Warrants are redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants.\nThe Company evaluated the Public and Private Warrants under ASC 815-40, Derivatives and Hedging-Contracts in Entity's Own Equity, and concluded that they do not meet the criteria to be classified in stockholders' equity. Since the Public and Private Warrants meet the definition of a derivative under ASC 815, the Company recorded these warrants as liabilities on the balance sheet at fair value upon the closing of the Business Combination, with subsequent changes in their respective fair values recognized in the condensed consolidated statement of operations and comprehensive income (loss) at each reporting date.\nConvertible Notes and Derivatives\nThe Company accounts for its derivatives in accordance with, ASC 815-10, Derivatives and Hedging, or ASC 815-15, Embedded Derivatives, depending on the nature of the derivative instrument. ASC 815 requires each contract that is not a derivative in its entirety be assessed to determine whether it contains embedded derivatives that are required to be bifurcated and accounted for as a derivative financial instrument. The embedded derivative is bifurcated from the host contract and accounted for as a freestanding derivative if the combined instrument is not accounted for in its entirety at fair value with changes in fair value recorded in earnings, the terms of the embedded derivative are not clearly and closely related to the economic characteristics of the host contract, and a separate instrument with the same terms as the embedded derivative would qualify as a derivative instrument. Embedded derivatives are measured at fair value and remeasured at each subsequent reporting period, and recorded within convertible notes, net on the accompanying Balance Sheets and changes in fair value recorded in other expense within the Statements of Operations. Upon the consummation of the Merger, the related convertible note liability was extinguished. As of March 31, 2022, the Company held no derivative instruments.\nProperty, Equipment and Software\nProperty, equipment and software is stated at cost less accumulated depreciation. Repair and maintenance costs are expensed as incurred. Depreciation and amortization are recorded on a straight-line basis over each asset’s estimated useful life.\n| Property, Equipment and Software | Useful life (years) |\n| Machinery and equipment | 5 years |\n| Electronic equipment | 3 years |\n| Vehicles and vehicle hardware | 3 – 7 years |\n| Leasehold improvements | Shorter of useful life or lease term |\n| Furniture and fixtures | 7 years |\n| Developed software | 2 – 4 years |\n\nLeases\nThe Company determines if a contract contains a lease at inception of the arrangement based on whether the Company has the right to obtain substantially all of the economic benefits from the use of an identified asset and whether the Company has the right to direct the use of an identified asset in exchange for consideration, which relates to an asset which the Company does not own. Right of use (“ROU”) assets represent the Company’s right to use an underlying asset for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from the lease. ROU assets are recognized as the lease liability, adjusted for lease incentives received. Lease liabilities are recognized at the present value of the future lease payments at the lease commencement date. The interest rate used to determine the present value of the future lease payments is the Company’s incremental borrowing rate (“IBR”), because the interest rate implicit in most of its leases is not readily determinable. The IBR is a hypothetical rate based on the Company’s understanding of what its credit rating would be to borrow and resulting interest we would pay to borrow an amount equal to the lease\n15\npayments in a similar economic environment over the lease term on a collateralized basis. Lease payments may be fixed or variable; however, only fixed payments or in-substance fixed payments are included in the Company’s lease liability calculation. Variable lease payments may include costs such as common area maintenance, utilities, real estate taxes or other costs. Variable lease payments are recognized in operating expenses in the period in which the obligation for those payments are incurred.\nOperating leases are included in operating lease ROU assets, operating lease liabilities, current and operating lease liabilities, non-current on the Company’s condensed consolidated balance sheets. For operating leases, lease expense is recognized on a straight-line basis in operations over the lease term. The Company elected the practical expedient not to separate non-lease components from lease components, therefore, the Company accounts for lease and non-lease components as a single lease component. The Company also elected the short-term lease recognition practical expedient for all leases that qualify.\nImpairment of Long-Lived Assets\nThe Company reviews its long-lived assets for impairment annually, or whenever events or circumstances indicate that the carrying amount of an asset may not be fully recoverable. The Company assesses the recoverability of these assets by comparing the carrying amount of such assets or asset group to the future undiscounted cash flows it expects the assets or asset group to generate. The Company recognizes an impairment loss if the sum of the expected long-term undiscounted cash flows that the long-lived asset is expected to generate is less than the carrying amount of the long-lived asset being evaluated.\nIncome Taxes\nThe Company accounts for income taxes using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.\nA valuation allowance is provided when it is more likely than not that some portion or all of a deferred tax asset will not be realized. Due to the Company’s lack of earnings history, the net deferred tax assets have been fully offset by a valuation allowance as of March 31, 2022 and December 31, 2021. Uncertain tax positions taken or expected to be taken in a tax return are accounted for using the more likely than not threshold for financial statement recognition and measurement.\nStock-based Compensation\nStock-based compensation expense related to stock option awards, restricted stock units (“RSUs”) and performance stock units (“PSUs”) granted to employees, directors and non-employees based on estimated grant-date fair values. For stock option awards, the Company uses the straight-line method to allocate compensation expense to reporting periods over each optionee’s requisite service period, which is generally the vesting period, and estimates the fair value of share-based awards to employees and directors using the Black-Scholes option- pricing model. The Black-Scholes model requires the input of subjective assumptions, including expected volatility, expected dividend yield, expected term, risk-free rate of return and the stock price of the underlying common shares on the date of grant. The fair value of each RSU is based on the fair value of the Company’s common stock on the date of grant. The related stock-based compensation is recognized on a graded vesting basis as the RSU awards are associated with a performance condition. For PSU awards, the Company uses the graded vesting to allocate compensation expense, as the PSU awards are associated with market conditions, over the holder’s derived service period, and estimates the fair value of the PSU awards using the Monte Carlo simulation. The Company accounts for the effect of forfeitures as they occur.\nInternal Use Software\nThe Company capitalizes certain costs associated with creating and enhancing internally developed software related to the Company’s technology infrastructure and such costs are recorded within property, equipment and software, net. These costs include personnel and related employee benefit expenses for employees who are directly associated with and who devote time to software development projects. Software development costs that do not qualify for capitalization are expensed as incurred and recorded in research and development expense in the Statements of Operations and comprehensive income (loss).\n16\nSoftware development activities typically consist of three stages: (1) the planning phase; (2) the application and infrastructure development stage; and (3) the post implementation stage. Costs incurred in the planning and post implementation phases, including costs associated with training and repairs and maintenance of the developed technologies, are expensed as incurred. The Company capitalizes costs associated with software developed when the preliminary project stage is completed, management implicitly or explicitly authorizes and commits to funding the project and it is probable that the project will be completed and perform as intended. Costs incurred in the application and infrastructure development phases, including significant enhancements and upgrades, are capitalized. Capitalization ends once a project is substantially complete, and the software is ready for its intended purpose. Software development costs are depreciated using a straight-line method over the estimated useful life, commencing when the software is ready for its intended use. The straight-line recognition method approximates the manner in which the expected benefit will be derived. Internal use software is tested for impairment in accordance with the Company’s long- lived assets impairment policy.\nResearch and Development Expense\nResearch and development expense consist of outsourced engineering services, allocated facilities costs, depreciation, internal engineering and development expenses, materials, labor and stock-based compensation related to development of the Company’s products and services. Research and development costs are expensed as incurred except for amounts capitalized to internal-use software.\nGeneral, and Administrative Expenses\nGeneral, and administrative expense consist of personnel costs, allocated facilities expenses, depreciation and amortization, travel, and business development costs.\nChange in fair value of warrant liability\nChange in fair value of warrant liability represents the change in fair value of Public, Private, Working Capital and Forward Purchase Agreement (“FPA”) Warrants. For each reporting period, Embark will determine the fair value of the warrant liability, and record a corresponding non-cash benefit or non-cash charge, due to a decrease or increase, respectively, in the calculated warrant liability.\nOther Income\nAs part of the Company’s research and development activities, we contract with shippers and freight carriers to transfer freight between the Company’s transfer hubs in return for cash consideration. Transferring freight with the Company’s research and development truck fleet are not and will not be considered an output of the Company’s ordinary activities. Consideration received from such arrangements is presented as other income in the Company’s Condensed Consolidated Statement of Operations.\nInterest Income\nInterest income primarily consists of investment and interest income from marketable securities, long- term investments and the Company’s cash and cash equivalents.\nInterest Expense\nInterest expense consisted primarily of interest on the Company’s various truck financing arrangements.\nNet Loss Per Share\nPrior to the Merger and prior to effecting the recapitalization, the Company had one class of common stock. Subsequent to the Merger, the Company has two classes of common stock: Class A and Class B common stock. The rights of the holders of Class A and Class B common stock are identical, including the liquidation and dividend rights, except with respect to electing members of the Board of Directors and voting rights. As the liquidation and dividend rights are identical, undistributed earnings and losses are allocated on a proportionate basis and the resulting net loss per share attributable to common stockholders are the same for both Class A and Class B common stock on an individual and combined basis.\n17\nBasic and diluted net loss per share attributable to common stockholders is presented in conformity with the two-class method required for participating securities. Net loss is attributed to common stockholders and participating securities based on their participation rights. Net loss attributable to common stockholders is not allocated to the redeemable convertible preferred stock as the holders of the redeemable convertible preferred stock do not have a contractual obligation to share in any losses. No dividends were declared or paid for the three months ended March 31, 2022 and March 31, 2021. No preferred stock was outstanding as of March 31, 2022.\nUnder the two-class method, basic net loss per share attributable to common stockholders is computed by dividing the net loss attributable to common stockholders by the weighted-average number of shares of common stock outstanding during the period.\nDiluted earnings per share attributable to common stockholders adjusts basic earnings per share for the potentially dilutive impact of redeemable convertible preferred stock, stock options, and warrants. As the Company has reported losses for all periods presented, all potentially dilutive securities including preferred stock, stock options, and warrants, are antidilutive and accordingly, basic net loss per share equals diluted net loss per share.\nComprehensive Income (Loss)\nComprehensive income (loss) is defined as the total change in stockholders’ equity during the period other than from transactions with stockholders. Comprehensive income (loss) consists of net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) is comprised of unrealized gains or losses on investments classified as available-for-sale.\nRecently Adopted Accounting Pronouncements\nIn February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which requires lessees to recognize leases on-balance sheet and disclose key information about leasing arrangements. The Company adopted “ASC 842” on January 1, 2022, using the modified retrospective transition method, specifically the \"Comparatives under ASC 840 approach\", and used the effective date as the date of initial application. The Company elected the “package of practical expedients,” which permits Embark not to reassess under ASC 842 its prior conclusions about lease identification, lease classification and initial direct costs. The Company also elected the use of hindsight in determining the lease term and in assessing impairment of the entity’s right-of-use assets. Upon adoption of the new leasing standard on January 1, 2022, the Company recognized right-of-use assets of $ 4.4 million and lease liabilities of $ 4.5 million, respectively, which are related to its various operating leases (Note 10). The difference between the right-of-use assets and lease liabilities is primarily attributed to the elimination of deferred rent. There was no adjustment to the opening balance of accumulated deficit as a result of the adoption of ASC 842.\nIn December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes, which is intended to simplify various aspects related to accounting for income taxes. The adoption of ASU 2019-12 is effective for the Company beginning January 1, 2022. The adoption of this standard did not have a material impact to its financial statements.\nIn May 2021, the FASB issued ASU 2021-04, Modification of equity-classified written call options. ASU 2021-04 provides clarification and reduces diversity in an issuer’s accounting for certain modifications or exchanges of freestanding equity-classified written call options, such as warrants, that remain equity classified after modification or exchange. This guidance will be effective for us on January 1, 2022 with early adoption permitted and will be applied prospectively. The adoption of ASU 2021-04 is effective for the Company beginning January 1, 2022. The adoption of this standard did not have a material impact to its financial statements.\nRecently Issued Accounting Pronouncements\nAs an emerging growth company (“EGC”), the Jumpstart Our Business Startups Act (“JOBS Act”) allows the Company to delay adoption of new or revised accounting pronouncements applicable to public companies until such pronouncements are applicable to private companies. The Company has elected to use this extended transition period under the JOBS Act until such time the Company is no longer considered to be an EGC. The adoption dates discussed below reflect this election.\n18\nIn June 2016, the FASB issued ASU 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses of Financial Instruments, which, together with subsequent amendments, amends the requirement on the measurement and recognition of expected credit losses for financial assets held. ASU 2016-13 is effective for the Company beginning January 1, 2023, with early adoption permitted. The Company is currently in the process of evaluating the effects of this pronouncement on the Company’s financial statements and does not expect it to have a material impact on its consolidated financial statements.\nIn August 2020, the FASB issued ASU 2020-06, Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging — Contracts in Entity’s Own Equity (Subtopic 815- 40): Accounting for convertible instruments and contracts in an entity’s own equity. The ASU simplifies accounting for convertible instruments by removing certain separation models required under current GAAP. The ASU also removes certain settlement conditions that are required for equity contracts to qualify for the derivative scope exception, and it revises the guidance in ASC 260, Earnings Per Share, to require entities to calculate diluted earnings per share for convertible instruments by using the if-converted method. The amendments are effective for the Company beginning January 1, 2024, including interim periods within those fiscal years. Early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. The Company is currently assessing the impact of this standard on its consolidated financial statements.\nIn October 2020, the FASB issued ASU No. 2020-10, Codification Improvements, which updates various codification topics by clarifying or improving disclosure requirements to align with the SEC’s regulations. For the Company, the ASU No. 2020-10 will be effective for annual reporting periods beginning after December 15, 2021 and interim periods within fiscal years beginning after December 15, 2022. The Company is currently evaluating the impact the adoption of this standard on its consolidated financial statements.\n3. BALANCE SHEET COMPONENTS\nPrepaid Expenses and Other Current Assets\nPrepaid expenses and other current assets consisted of the following as of March 31, 2022 and December 31, 2021, respectively (in thousands):\n| March 31,2022 | December 31,2021 |\n| (unaudited) |\n| Prepaid insurance | $ | 6,890 | $ | 7,459 |\n| Prepaid software | 2,224 | 2,564 |\n| Income tax receivable | 494 | 494 |\n| Short-term deposits | 570 | 448 |\n| Prepaid salary | 476 | 279 |\n| Prepaid warrant | 876 | 936 |\n| Other | 475 | 566 |\n| Total prepaid expenses and other current assets | $ | 12,005 | $ | 12,746 |\n\n19\nProperty, Equipment and Software\nProperty, equipment and software consist of the following as of March 31, 2022 and December 31, 2021, respectively (in thousands):\n| March 31,2022 | December 31,2021 |\n| (unaudited) |\n| Machinery and equipment | $ | 406 | $ | 344 |\n| Electronic equipment | 578 | 413 |\n| Vehicles and vehicle hardware | 6,929 | 6,268 |\n| Leasehold improvements | 278 | 258 |\n| Developed software | 6,108 | 5,184 |\n| Other | 27 | 26 |\n| Property, equipment and software, gross | 14,326 | 12,493 |\n| Less: accumulated depreciation and amortization | ( 3,240 ) | ( 2,856 ) |\n| Total property, equipment and software, net | $ | 11,086 | $ | 9,637 |\n\nDepreciation and amortization expense for the three months ended March 31, 2022 and 2021 was $ 0.4 million and $ 0.2 million, respectively.\nOther Assets\nOther assets consist of the following as of March 31, 2022 and December 31, 2021, respectively (in thousands):\n| March 31,2022 | December 31,2021 |\n| (unaudited) |\n| Intangible assets | $ | 3 | $ | 4 |\n| Long-term deposits | 3,719 | 3,592 |\n| Total Other Assets | $ | 3,722 | $ | 3,596 |\n\nAccrued Expenses and Other Current Liabilities\nAccrued expenses and other current liabilities consisted of the following as of March 31, 2022 and December 31, 2021, respectively (in thousands):\n| March 31,2022 | December 31,2021 |\n| (unaudited) |\n| Accrued payroll expenses | $ | 3,189 | $ | 823 |\n| Accrued legal expenses | 696 | 124 |\n| Accrued transaction costs | 1,092 | 1,092 |\n| Other | 1,174 | 1,103 |\n| Total accrued expenses and other current liabilities | $ | 6,151 | $ | 3,142 |\n\n4. FAIR VALUE MEASUREMENTS\n20\nThe carrying value and fair value of the Company’s financial instruments as of March 31, 2022 and December 31, 2021, respectively, are as follows:\n| As of March 31, 2022(in thousands) |\n| Level 1 | Level 2 | Level 3 | Total |\n| (unaudited) |\n| Assets |\n| Cash equivalents: |\n| United States money market funds | $ | 13,349 | $ | — | $ | — | $ | 13,349 |\n| Liabilities |\n| Warrant liabilities - FPA warrants | $ | 760 | $ | — | $ | — | $ | 760 |\n| Warrant liabilities - public warrants | $ | 15,732 | $ | — | $ | — | $ | 15,732 |\n| Warrant liabilities - working capital warrants | $ | — | $ | — | $ | 2,480 | $ | 2,480 |\n| Warrant liabilities - private warrants | $ | — | $ | — | $ | 8,292 | $ | 8,292 |\n\n| As of December 31, 2021(in thousands) |\n| Level 1 | Level 2 | Level 3 | Total |\n| Assets |\n| Cash equivalents: |\n| United States money market funds | $ | 22,349 | $ | — | $ | — | $ | 22,349 |\n| Liabilities |\n| Warrant liabilities - FPA warrants | $ | 1,337 | $ | — | $ | — | $ | 1,337 |\n| Warrant liabilities - public warrants | $ | 27,669 | $ | — | $ | — | $ | 27,669 |\n| Warrant liabilities - working capital warrants | $ | — | $ | — | $ | 4,700 | $ | 4,700 |\n| Warrant liabilities - private warrants | $ | — | $ | — | $ | 15,714 | $ | 15,714 |\n\nAs of March 31, 2022, there was no transfer from Level 2 to Level 3. As of December 31, 2021, transfers from Level 2 to Level 3 of the fair value hierarchy were $ 15.5 million for Private and Public Warrants.\nThe fair value of the above liability classified Public, Private, Working Capital and FPA Warrants have been measured based on the listed market price of such warrants on November 10, 2021. The FPA warrants and public warrants were valued using the public price as of March 31, 2022. The Private and Working Capital warrants were fair valued using the Black Scholes Option Pricing Model as of March 31, 2022. For the three months ended March 31, 2022, the Company recognized income in the condensed consolidated statement of operations resulting from a change in the fair value of warrants of approximately $ 22.2 million, presented as other income (expense) on the accompanying condensed consolidated statement of operations.\n5. STOCKHOLDERS’ EQUITY\nShares Authorized and Issued\nAs of March 31, 2022, the Company had authorized a total of 4,110,000,000 shares for issuance with 4,000,000,000 shares designated as Class A common stock, 100,000,000 shares designated as Class B common stock and 10,000,000 shares designated as preferred stock.\nAs of March 31, 2022, the Company had 362,832,986 issued as Class A common stock and 87,078,981 issued as Class B common stock.\n21\nPreferred Stock\nAs of March 31, 2022, there were 10,000,000 shares of preferred stock authorized and no shares of preferred and founders preferred stock was issued or outstanding. The Company’s preferred stock, as of March 31, 2022, does not contain any mandatory redemption features, nor are they redeemable at the option of the holder.\nClass A and Class B Common Stock\nThe Company’s Board of Directors has authorized two class of common stock, Class A and Class B. Holders of Class A and Class B common stock are not entitled to preemptive or other similar subscription rights to purchase any of Embark Technology’s securities.\nClass A common stock is neither convertible nor redeemable. Class B common stock is convertible into Class A common stock. Unless Embark Technology’s board of directors determines otherwise, Embark Technology will issue all of Embark Technology’s capital stock in certificated form. The Embark Founders held all outstanding shares of Class B common stock up on consummation of the Business Combination.\nIn connection with the merger with NGA on November 10, 2021, the Embark Founders exchanged 87,078,981 shares of Founder's common stock, which were entitled to one vote per share, into the same number of shares of Class B common stock, which are entitled to ten votes per share. The Company recorded the incremental value of $ 13.6 million associated with this transaction as stock-based compensation in general and administrative expenses.\nThe significant rights, privileges and preferences of common stock as of March 31, 2022 are as follows:\nLiquidation Preference\nIf Embark Technology is involved in voluntary or involuntary liquidation, dissolution or winding up of Embark’s affairs, or a similar event, each holder of Embark Common Stock will participate pro rata in all assets remaining after payment of liabilities, subject to prior distribution rights of Embark Technology preferred stock, if any, then outstanding.\nDividends\nEach holder of shares of Embark Common Stock is entitled to the payment of dividends and other distributions as may be declared by the Board from time to time out of Embark’s assets or funds legally available for dividends or other distributions. These rights are subject to the preferential rights of the holders of Embark’s Preferred Stock, if any, and any contractual limitations on Embark’s ability to declare and pay dividends.\nVoting\nEach holder of Class A common stock is entitled to one vote per share on each matter submitted to a vote of stockholders, as provided by the Second Amended and Restated Certificate of Incorporation of Northern Genesis Acquisition Corp. II (the “Charter”). Each holder of Class B common stock is entitled to ten votes per share on each matter submitted to a vote of stockholders, as provided by the Embark Charter. Following the Business Combination, holders of Class B Common Stock have the ability to control the business affairs of Embark. Embark’s Amended and Restated Bylaws (the “Bylaws”) provide that the holders of a majority of the capital stock issued and outstanding and entitled to vote thereat, present in person or represented by proxy, will constitute a quorum at all meetings of the stockholders for the transaction of business. When a quorum is present, the affirmative vote of a majority of the votes cast is required to take action, unless otherwise specified by law, the Bylaws or the Charter, and except for the election of directors, which is determined by a plurality vote. There are no cumulative voting rights.\n6. WARRANTS\n22\nAs of March 31, 2022, the following warrants were issued and outstanding:\n| Description | Classification | Issue Date | Warrants Outstanding | Fair Value Price Per Share | Exercise Price per Share | Expiration |\n| FPA warrants (1) | Liability | November 10, 2021 | 666,663 | $ | 1.14 | $ | 11.50 | November 10, 2026 |\n| Public warrants | Liability | November 10, 2021 | 13,799,936 | $ | 1.14 | $ | 11.50 | November 10, 2026 |\n| Private warrants | Liability | November 10, 2021 | 6,686,667 | $ | 1.24 | $ | 11.50 | November 10, 2026 |\n| Working capital warrants | Liability | November 10, 2021 | 2,000,000 | $ | 1.24 | $ | 11.50 | November 10, 2026 |\n\n(1)FPA are the “Forward Purchase Agreements” entered into, or amended and restated, by NGA on April 21, 2021\nThe Company determined the FPA, Public, Private and Working Capital warrants to be classified as a liability and fair valued the warrants on the issuance date using the publicly available price for the warrants, of $ 41.2 million. The fair value of the FPA and Public warrants were remeasured as of the reporting date with the change in value reflected as part of Other Expense.\nThe fair value of $ 27.3 million of Private and Working Capital warrants was determined using the Black-Scholes option valuation model using the following assumptions for values as of March 31, 2022:\n| Risk – free interest rate | 2.43 % |\n| Expected term (in years) | 4.61 |\n| Expected dividend yield | 0 % |\n| Expected volatility | 45.0 % |\n\nThe Company estimates the volatility of its warrants based on a combination of volatility from the Company’s traded warrants and from historical volatility of select peer company’s common stock that matches the expected remaining life of the warrants. The risk-free interest rate is based on the U.S. Treasury zero-coupon yield curve on the grant date for a maturity similar to the expected remaining life of the warrants. The expected life of the warrants is assumed to be equivalent to their remaining contractual term. The dividend rate is based on the historical rate, which the Company anticipates remaining at zero .\n7. STOCK-BASED COMPENSATION EXPENSE\nStock Option Plan\nIn connection with the Business Combination, the Company adopted the 2021 Incentive Award Plan (the “2021 Plan”), under which the Company grants cash and equity incentive awards to directors, employees (including named executive officers) and consultants in order to attract, motivate and retain the talent for which the Company competes. The Company terminated the 2016 Stock Plan, provided that the outstanding awards previously granted under the 2016 Plan continue to remain outstanding under the 2016 Plan. Under the 2021 Plan, as of March 31, 2022, the Company has authorized to issue a maximum number of 58,713,535 shares of Class A common stock, with annual increases beginning January 1, 2022 and ending on and including January 1, 2031 of 5 % of the aggregate number of shares of Class A common stock outstanding on the last day of the preceding calendar year.\nEmbark Trucks adopted the 2016 Stock Plan in October 2016 (the “2016 Plan”). The 2016 Plan authorized the grant of incentive stock options, non-statutory stock options, and restricted stock awards to employees, directors, and consultants. The 2016 Plan also initially reserved 993,542 shares of common stock ( 8,941,878 shares post-split in June 2018) for issuance and designated forfeited option shares to be returned to the option reserve. Options may be early exercised and are exercisable for a term of 10 years from the date of grant. As of March 31, 2022, the Company had registered 79,742,504 shares to be reserved for option grants, RSUs and PSUs previously issued under the 2016 Plan. The Company will not issue additional awards under the 2016 Plan.\n23\nStock Option Valuation\nThe Company utilizes the Black-Scholes option pricing model for estimating the fair value of options granted, which requires the input of highly subjective assumptions.\nThe Company calculates the fair value of each option grant on the grant date using the following assumptions:\nExpected Term — The Company uses the simplified method when calculating expected term due to insufficient historical exercise data.\nExpected Volatility — As the Company’s shares are not actively traded, the volatility is based on a benchmark of comparable companies within the automotive and energy storage industries.\nExpected Dividend Yield — The dividend rate used is zero as the Company does not have a history of paying dividends on its common stock and does not anticipate doing so in the foreseeable future.\nRisk-Free Interest Rate — The interest rates used are based on the implied yield available on U.S. Treasury zero-coupon issues with an equivalent remaining term equal to the expected life of the award.\n| Three Months Ended March 31, |\n| 2022 | 2021 |\n| Risk-free interest rate | n/a | 0.55 – 1.10 % |\n| Expected term (in years) | n/a | 5.47 – 6.07 |\n| Expected dividend yield | n/a | 0 % |\n| Expected volatility | n/a | 36.88 – 51.52 % |\n\nThe company did not grant any stock options for the three months ended March 31, 2022.\nOption Activity\nChanges in stock options are as follows:\n| Number ofOutstanding Options | Weighted Average Exercise Price Per Share | WeightedAverageRemaining Contractual Term (years) | AggregateIntrinsic (in thousands) |\n| Outstanding at December 31, 2021 | 25,358,455 | $ | 0.20 | 6.9 | $ | 215,093 |\n| Exercised | ( 3,615,572 ) | 0.11 | $ | 20,770 |\n| Repurchased | 13,984 | 0.29 |\n| Cancelled | ( 277,235 ) | 0.59 |\n| Outstanding at March 31, 2022 | 21,479,632 | $ | 0.21 | 6.7 | $ | 121,910 |\n| Vested and exercisable as of March 31, 2022 | 15,271,274 | $ | 0.13 | 6.0 | $ | 88,014 |\n\nThe aggregate intrinsic value in the above table is calculated as the difference between the estimated fair value of the Company's common stock price and the exercise price of the stock options. The company did not grant any stock options for the three months ended March 31, 2022. The weighted average grant date fair value per share for the stock option grants during the three months ended March 31, 2021 was $ 1.88 . As of March 31, 2022, the total unrecognized compensation related to unvested stock option awards granted was $ 5.02 million, which the Company expects to recognize over a weighted-average period of approximately 2.4 years.\nRestricted Stock Units\nPrior to the Business Combination, Embark Trucks also granted employees RSUs which are subject to performance and service-based vesting conditions. As the Company went public upon the completion of the Business Combination in November 2021, the performance condition had been met. The RSUs generally vest over either a four year period with\n24\n25 % of the awarded vesting after the first-year anniversary and one-thirty sixth of the remainder of the award vesting monthly thereafter. Vesting is contingent upon such employee’s continued service on such vesting date. RSUs are generally subject to forfeiture if employment terminates prior to the release of vesting restrictions. The Company may grant RSUs with different vesting terms from time to time.\nFor the three months ended March 31, 2022, the Company recognized $ 12.9 million stock-based expense associated with such RSUs. For the three months ended March 31, 2021, the Company did not recognize any stock-based expense associated with such RSUs as the performance condition had not been satisfied until November 10, 2021. As of March 31, 2022, there was $ 41.0 million unrecognized stock-based compensation expense related to outstanding RSUs granted to employees, with a weighted-average remaining vesting period of 3.9 years.\nA summary of the Company’s RSU activities and related information is as follows:\n| Number of Shares | Weighted AverageGrant date FairValue Per Share |\n| Balance as of December 31, 2021 | 9,616,774 | $ | 8.44 |\n| Forfeited | ( 111,572 ) | 8.96 |\n| Vested | ( 187,977 ) | 8.36 |\n| Balance as of March 31, 2022 | 9,317,225 | $ | 8.43 |\n\nPerformance Stock Units\nDuring 2021, Embark Trucks granted PSUs to its employees. The PSUs are subject to certain market and performance-based conditions which require the Company to become a registered public company and meet market conditions that are based on the Company achieving six different valuation tranches as derived from the achievement of escalating share price thresholds of $ 20.00 , $ 35.00 , $ 50.00 , $ 65.00 , $ 80.00 and $ 100.00 (calculated based on the 90-day volume weighted average price or, in the event of a change in control, the fair market value based on the terms of such change in control) following the first anniversary of the consummation of the Business Combination. The market condition can be achieved over ten years in relation to the pre-money valuation prior to the Business Combination. Once the performance condition has been achieved or is considered probably of being achieved, the related stock-based compensation is recognized based on a graded attribution method.\nFor the three months ended March 31, 2022, the Company recognized $ 2.6 million stock-based expense associated with such PSUs. For the three months ended March 31, 2021, the Company did not recognize any stock-based expense associated with such PSUs as the performance condition had not been satisfied until November 10, 2021. As of March 31, 2022, there was $ 81.0 million unrecognized stock-based compensation expense related to outstanding PSUs granted to employees, with a weighted-average remaining vesting period of 8.1 years.\nThe Company’s PSUs activity for the three months ended March 31, 2022 was as follows:\n| Number of Shares | Weighted AverageGrant date FairValue Per Share |\n| Balance as of December 31, 2021 | 44,715,756 | $ | 1.97 |\n| Granted | — | — |\n| Forfeited | — | — |\n| Vested | — | — |\n| Balance as of March 31, 2022 | 44,715,756 | $ | 1.97 |\n\nCommon Stock Units\nThe Company is obligated to issue shares of Class A common stock upon the vesting of certain restricted stock awards that resulted from Embark Trucks warrants that were issued prior to the Business Combination. Pursuant to the terms of\n25\nthese warrant awards, the restricted stock awards were issued for services at the time of consummation of the Business Combination, and are subject to service vesting terms, with the shares being subject to cancellation. The pre-Business Combination warrants were exercised in their entirety on a cashless basis, with the unvested shares being excluded from the stockholders’ equity and becoming subject to the service vesting condition going forward. Early exercises are reclassified to additional paid-in capital as the Company’s cancellation right lapses. The number of unvested shares of Class A common stock were 1,347,848 as of March 31, 2022.\nAs of March 31, 2022, there was $ 3.8 million unrecognized stock-based compensation expense related to outstanding Common Stock Units (“CSUs”) granted to non-employees, with a weighted-average remaining vesting period of 2.16 years.\nThe Company's CSUs activity for the three months ended March 31, 2022 was as follows:\n| Number of Shares | Weighted AverageGrant date FairValue Per Share |\n| Balance as of December 31, 2021 | 1,481,065 | $ | 2.48 |\n| Granted | — | — |\n| Forfeited | — | $ | — |\n| Vested | ( 133,217 ) | 2.48 |\n| Balance as of March 31, 2022 | 1,347,848 | $ | 2.48 |\n\nThe following table presents the impact of stock-based compensation expense on the condensed consolidated statements of operations for the three months ended March 31, 2022 and 2021, respectively (in thousands):\n| Three Months Ended March 31, |\n| 2022 | 2021 |\n| Research and development | $ | 3,765 | $ | 311 |\n| General, and administrative | 12,837 | 251 |\n| Total stock-based compensation expense | $ | 16,602 | $ | 562 |\n\nTotal stock-based compensation that was capitalized into internally developed software asset was $ 0.2 million and nil during the three months ended March 31, 2022 and 2021, respectively.\n8. RETIREMENT SAVINGS PLAN\nThe Company sponsored a savings plan available to all eligible employees, which qualifies under Section 401(k) of the Internal Revenue Code. Employees may contribute to the plan amounts of their pre-tax salary subject to statutory limitations. The Company does not currently offer a match and has not provided a match as of March 31, 2022.\n9. NOTES PAYABLE\nOn February 18, 2021 and January 5, 2021, the Company entered into financing agreement to finance the purchase of trucks that the Company utilizes for research and development. The financing agreements consisted of a loan of $ 0.1 million and $ 0.1 million at an interest rate equal to 6.99 % and 7.50 % per annum, with a maturity date of April 1, 2026 and January 19, 2027, respectively. The Company makes equal monthly installment payments over the term of each financing arrangement which are allocated between interest and principal.\nOn February 19, 2018, January 28, 2019, and May 23, 2019, the Company entered into financing agreements to finance the purchase of trucks that the Company utilizes for research and development. The financing agreements consisted of a loan of $ 0.3 million, $ 0.4 million, and $ 0.5 million at an interest rate equal to 8.25 % per annum, with a maturity date of March 5, 2023, February 14, 2024, and June 12, 2024, respectively. The Company makes equal monthly installment payments over the term of each financing arrangement which are allocated between interest and principal.\n26\nThe Company entered into a financing agreement on August 2, 2016 to finance the purchase of trucks that the Company utilizes for research and development. The financing agreements consisted of a loan of $ 0.1 million at an interest rate equal to 12.5 % per annum, with a maturity date of August 9, 2020. The Company makes equal monthly installment payments over the term of the financing arrangement, which is allocated between interest and principal.\nNotes payable as of March 31, 2022 and December 31, 2021 are $ 1.0 million and $ 1.1 million, respectively.\nThe following table presents future payments of principal as of March 31, 2022 (in thousands):\n| Years Ended December 31, | Amounts |\n| 2022 (remaining nine months) | $ | 273 |\n| 2023 | 313 |\n| 2024 | 176 |\n| 2025 | 111 |\n| 2026 and thereafter | 125 |\n| Total future payments | $ | 998 |\n\n10. COMMITMENTS AND CONTINGENCIES\nLegal Proceedings\nThe Company is subject to legal and regulatory actions that arise from time to time in the ordinary course of business. The assessment as to whether a loss is probable or reasonably possible, and as to whether such loss or a range of such loss is estimable, often involves significant judgment about future events. In the opinion of management, all such matters are not expected to have a material effect on the financial position, results of operations or cash flows of the Company. However, the outcome of litigation is inherently uncertain. There is no material pending or threatened litigation against the Company that remains outstanding as of March 31, 2022 and December 31, 2021.\nOperating leases\nThe Company’s leases primarily include corporate offices. The lease term of operating leases vary from less than a year to seven years . The Company has leases that include one or more options to extend the lease term to a total term of ten years as well as options to terminate the lease within one year. The Company’s lease terms may include options to extend or terminate the lease when it is reasonably certain that it will exercise such options. The Company’s lease agreements generally do not contain any residual value guarantees or restrictive covenants.\nThe components of lease expense were as follows (in thousands):\n| Three Months Ended March 31, 2022 |\n| Lease cost |\n| Operating lease cost | $ | 600 |\n| Short-term lease cost (1) | 102 |\n| Total lease cost | $ | 702 |\n\n(1) The Company elected to account for short-term leases in accordance with ASC 842. ASC 842 defines a short-term lease as a lease whose lease term, at commencement, is 12 months or less and that does not include a purchase option whose exercise is reasonable certain. The Company will recognize the lease payments in profit or loss on a straight-line basis over the lease term.\n27\nSupplemental cash flow information related to leases was as follows (in thousands):\n| Three Months Ended March 31, 2022 |\n| Other Information |\n| Cash paid for amounts included in the measurement of lease liabilities: |\n| Operating cash flows used in operating leases | $ | 477 |\n| Right-of-use assets obtained in exchange for lease obligations |\n| Operating lease liabilities | $ | 6,587 |\n\nSupplemental balance sheet information related to leases was as follows (in thousands, except lease term and discount rate):\n| March 31,2022 |\n| Assets |\n| Operating lease right-of-use assets | $ | 6,099 |\n| Liabilities |\n| Operating lease liability, current | $ | 1,948 |\n| Operating lease liability, non-current | $ | 4,438 |\n| Total operating lease liability | $ | 6,386 |\n\n| March 31,2022 |\n| Weighted Average Lease Term (in years) |\n| Operating Leases | 3.38 |\n| Weighted Average Discount Rate |\n| Operating Leases | 5.69 | % |\n\nTotal future minimum lease payments over the term of the lease as of March 31, 2022, are as follows (in thousands):\n| Years Ended December 31, | Operating leases |\n| 2022 (remaining nine months) | 1,723 |\n| 2023 | 2,108 |\n| 2024 | 1,976 |\n| 2025 | 548 |\n| 2026 | 563 |\n| 2027 and thereafter | 142 |\n| Total undiscounted lease payments | $ | 7,060 |\n| Less: imputed interest | ( 674 ) |\n| Total lease liabilities | $ | 6,386 |\n\nAs of March 31, 2022, the Company entered into additional operating leases for an office and a truck transfer point of $ 25.8 million, and $ 0.6 million respectively. These operating leases will commence in fiscal 2022 with lease terms of seven years and five years respectively, and contain options to renew and extend the terms of up to 60 months and 12 for each renewal, respectively.\n28\n11. NET LOSS PER SHARE\nThe following table sets forth the computation of the basic and diluted net loss per share attributable to common stockholders for the three months ended March 31, 2022 and 2021, respectively (in thousands, except share and per share data).\n| Three Months Ended March 31, |\n| 2022 | 2021 |\n| Numerator: |\n| Net loss | $ | ( 18,447 ) | $ | ( 8,482 ) |\n| Net loss attributable to common stockholders | $ | ( 18,447 ) | $ | ( 8,482 ) |\n| Denominator: |\n| Net loss per share attributable to Class A and Class B common stockholders, basic and diluted | $ | ( 0.04 ) | $ | ( 0.18 ) |\n| Weighted-average shares used in computing net loss per share attributable to common stockholders, basic and diluted | 452,623,022 | 47,538,331 |\n| Class A | 365,544,041 | n/a* |\n| Class B | 87,078,981 | n/a* |\n\n*Prior to the Merger and prior to effecting the recapitalization in 2021, the Company had one class of common stock. Subsequent to the Merger, the Company has two classes of common stock: Class A and Class B common stock.\nSince the Company was in a loss position for all periods presented, basic net loss per share is the same as diluted net loss per share for all periods as the inclusion of all potential common shares outstanding would have been anti-dilutive.\nThe following weighted-average outstanding common stock equivalents were excluded from the computation of diluted net loss per share attributable to common stockholders for the periods presented because including them would have been anti-dilutive.\n| March 31, |\n| 2022 | 2021 |\n| Founders Preferred shares | — | 162,558 |\n| Series A-1 convertible preferred shares | — | 3,654,873 |\n| Series A-2 convertible preferred shares | — | 5,372,703 |\n| Series A-3 convertible preferred shares | — | 2,485,296 |\n| Series A-4 convertible preferred shares | — | 590,688 |\n| Series A-5 convertible preferred shares | — | 2,680,236 |\n| Series A-6 convertible preferred shares | — | 3,647,817 |\n| Series A-7 convertible preferred shares | — | 15,139,917 |\n| Series B convertible preferred shares | — | 32,834,601 |\n| Series C convertible preferred shares | — | 20,949,454 |\n| Outstanding options | 21,479,632 | 8,975,275 |\n| Warrants issued and outstanding | 23,153,266 | 857,142 |\n| Restricted stock units | 9,317,225 | — |\n| Common stock units | 1,347,848 | — |\n| Performance stock units | 44,715,756 | — |\n| Total | 100,013,727 | 97,350,560 |\n\n12. SUBSEQUENT EVENTS\nOn April 1, 2022, Tyler Hardy filed a putative securities class action lawsuit against Embark and certain of our executive officers and the former executive officers of Northern Genesis Acquisition Corp., captioned Hardy v. Embark\n29\nTechnology, Inc., et al., Case No. 3:22-cv-02090-JSC, in the United States District Court for the Northern District of California, purportedly on behalf of a class consisting of those who purchased or otherwise acquired Embark common stock between January 12, 2021 and January 5, 2022. The complaint alleges that defendants made false and/or misleading statements in violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. Plaintiff Hardy does not quantify any damages in the complaint, but in addition to attorneys’ fees and costs, seeks to recover damages on behalf of himself and other persons who purchased or otherwise acquired Embark stock during the putative class period at allegedly inflated prices and purportedly sufferance financial harm as a result.\nEmbark disputes the allegations in the above-reference matter, intends to defend the matter vigorously, and believes that the claims are without merit. Legal and regulatory proceedings, including the above-reference matter, may be based on complex claims involving substantial uncertainties and unascertainable damages. Accordingly, it is not possible to determine the probability of loss or estimate damages for the above-referenced matter, and therefore, Embark has not established reserves for this proceeding. When Embark determines that a loss is both probable and reasonable estimable, Embark will record a liability, and, if the liability is material, will disclose the amount of the liability reserved. Given that such proceedings are subject to uncertainty, there can be no assurance that legal proceedings individually or in the aggregate will not have a material adverse effect on our business, results of operations, financial condition or cash flows.\n30\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nYou should read the following discussion and analysis of our financial condition and results of operations together with our condensed consolidated financial statements and the related notes appearing elsewhere in this Quarterly Report on Form 10-Q and the Annual Report. In addition to the historical financial information, this discussion contains forward-looking statements that involve risk, assumptions and uncertainties, such as statements of our plans, objectives, expectations, intentions, forecasts and projections. Our actual results and the timing of selected events could differ materially from those discussed in these forward-looking statements as a result of several factors. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Quarterly Report on Form 10-Q, particularly in the section titled “Forward-Looking Statements” above, and in the section entitled “Risk Factors” in the Annual Report.\nOverview\nEmbark develops technologically advanced autonomous driving software for the truck freight industry and offers a carefully constructed business model that is expected to provide the industry with the most attractive path to adopting autonomous driving. Specifically, Embark has developed a Software as a Service (“SaaS”) platform designed to interoperate with a broad range of truck OEM platforms, forgoing complicated and logistically challenging truck building or hardware manufacturing operations in favor of focusing on a superior driving technology. At scale, domestic fleets will be able to access Embark technology via a subscription software license selected as an option at the time they specify the build of new semi-trucks.\nHeadquartered in San Francisco, California, Embark’s history as the industry’s longest running autonomous truck driving program is replete with technological firsts that include, but are not limited to:\n•the first coast-to-coast autonomous truck drive,\n•the first to reach 100,000 autonomous miles on public roads, and\n•the first to successfully open autonomous transfer points for human- autonomous vehicle (“AV”) handoff.\nEmbark’s founding team includes roboticists and its broader team includes numerous computer scientists, many with advanced degrees and experience at other leading robotics and autonomous vehicle companies and academic programs. Embark intends to rapidly scale its engineering team to build on its industry-leading technology position.\nEmbark has also spent considerable time and effort refining its business model. Embark is initially deploying its technology in a very focused manner, targeting freight highway miles between transfer points located next to metropolitan areas in the lower “Sunbelt” region of the U.S., leaving the “last mile” of driving to and from the transfer points to the industry’s highly skilled human drivers. Embark’s strategy is distinct from other industry players which seek to provide more complicated “end to end” autonomous driving that would entirely displace human drivers and potentially place these companies in competition with the industry’s carriers. Unlike those competitors, Embark anticipates working with the industry’s existing players to help them bring autonomous driving technology to market on their own terms. In addition, Embark believes its solution will be the safest and most reliable in the industry because of its disciplined geographic focus and emphasis on software development, which stands in contrast to Embark’s competitors that focus on multiple markets simultaneously, manufacturing autonomous trucks and/or competing directly with semi-truck OEMs or legacy carriers.\nEmbark currently targets the growing $730 billion U.S. truck freight market, and its initial commercial phase targets 236 billion serviceable miles within this market. The freight industry that Embark serves has had to face significant pressures from the growth of e-commerce and the well-documented shortage of skilled drivers, and therefore has powerful incentives to adopt autonomous driving solutions to both improve capacity and reduce costs. In addition, Embark’s cooperative model has already had traction with many of the industry’s leading fleets.\nThe Business Combination\nEmbark entered into the Merger Agreement with NGA, a special purpose acquisition company, on June 22, 2021. On November 10, 2021, pursuant to the Merger Agreement, Merger Sub, a newly formed subsidiary of NGA, merged with and into Embark Trucks (the “Business Combination”). In connection with the consummation of the Business Combination, the separate corporate existence of Merger Sub ceased; Embark Trucks survived and became a wholly owned subsidiary of NGA, which was renamed Embark Technology, Inc.\n31\nThe Business Combination was accounted for as a reverse recapitalization, in accordance with GAAP. Under the guidance in ASC 805, Embark was treated as the “acquired” company for financial reporting purposes. Embark Trucks was deemed the accounting predecessor of the combined business, and Embark Technology, Inc., as the parent company of the combined business, was the successor SEC registrant, meaning that our financial statements for previous periods will be disclosed in the registrant’s periodic reports filed with the SEC. The Business Combination had a significant impact on Embark’s reported financial position and results as a consequence of the reverse recapitalization. The most significant changes in Embark’s reported financial position and results are a net increase in cash of $243.9 million, net of transaction costs for the Business Combination of $70.2 million. As of March 31, 2022 and December 31, 2021, the Company had warrant liabilities of $27.3 million and $49.4 million, respectively. The Company recorded the change in fair value in warrant liabilities were recorded in the other income (expense) on the condensed consolidated statement of operations.\nAs a result of the Business Combination, Embark became an SEC-registered and Nasdaq-listed company, which required Embark to hire additional personnel and implement procedures and processes to address public company regulatory requirements and customary practices. Embark incurs additional annual expenses as a public company for, among other things, directors’ and officers’ liability insurance, director fees, and additional internal and external accounting, legal and administrative resources.\nRecent Developments Affecting Comparability\nCOVID-19 Impact and the Conflict in Ukraine\nIn March 2020, the World Health Organization declared the 2019 novel coronavirus (“COVID-19”) a global pandemic. In the United States, as part of government-imposed restrictions, Embark was forced to temporarily pause fleet testing and operations in 2020. Embark also implemented a work-from-home policy for most of its non-operations team. However, a select group of workers remained on-site to continue advancing testing work for its test fleet. Since then, Embark has resumed its fleet testing and operations and has increased headcount to match its research and development requirements.\nThe future impact of the COVID-19 pandemic on Embark’s operational and financial performance will depend on certain developments, including the duration and end of the pandemic and the occurrence of future outbreaks from new variants, impact on Embark’s research and development efforts, and effect on Embark’s suppliers, all of which are uncertain and cannot be predicted. Public and private sector policies and initiatives to reduce the transmission of COVID-19 and disruptions to Embark’s operations and the operations of Embark’s third-party suppliers, along with the related global slowdown in economic activity, may result in increased costs. It is possible that the COVID-19 pandemic, the measures that have been taken or that may be taken by the federal, state, local authorities and businesses affected by government-mandated business closures, vaccination mandates and the resulting economic impact may materially and adversely affect Embark’s business, results of operations, cash flows and financial positions.\nWhile we have limited direct business exposure in Russia, Belarus and Ukraine, the Russian military actions and the resulting sanctions could adversely affect the global economy, as well as further disrupt the supply chain. A major disruption in the global economy and supply chain could have a material adverse effect on our business, partners, prospects, financial condition, results of operations, and cash flows. The extent and duration of the military action, sanctions, and resulting market and/or supply disruptions are impossible to predict, but could be substantial.\nKey Factors Affecting Embark’s Operating Performance\nEmbark’s financial condition, results of operations, and future success depend on several factors that present significant opportunities for Embark but also pose risks and challenges, including those set forth the section entitled “Risk Factors” in this quarterly report, the section entitled “Risk Factors” in the Annual Report and in as set forth below:\nEmbark’s Ability to Achieve Key Technical Milestones and Deliver a Commercial Product\nEmbark’s growth will depend on the introduction of Embark Driver and Embark Guardian products which will drive demand from potential customers. Embark has developed a platform agnostic interface, Embark Universal Interface, which will serve as the foundation to utilize Embark Driver and Guardian products in trucks manufactured by a broad range of OEMs. Embark’s ability to introduce its products will be driven by a variety of factors including Embark’s research and development fleet size, the number of autonomous miles driven (measured as the number of miles driven by Embark’s research & development fleet as well as partner fleet autonomous miles), and the ability to provide a safe and sustainable\n32\nsolution based on information gathered from the operation of Embark’s research and development fleet. Embark develops most key technologies in-house to achieve a rapid pace of innovation and tests it extensively through research and development fleet operations. Embark expects an increase in research and development fleet size in the foreseeable future to allow it to strategically focus on innovations, which it believes will help solidify its overall solution to customers and partners. To date, Embark has not generated any revenue and until its products reach commercialization, autonomous miles driven will be comprised of autonomous miles driven by its research and development fleet and the fleet of its partners. Embark believes that as the number of autonomous miles driven increases, the data will continually feed improvements to the platform, allowing it to innovate and introduce new products to the market and increase adoption of its products in the future.\nEmbark’s Ability to Expand its Coverage Map Across the United States\nEmbark’s long-term growth potential will benefit from strategic network expansion across the United States. Network breadth is measured by the number of transfer points on Embark’s coverage map, which are representative of the cities which Embark plans to support. Embark expects to achieve significant network growth by partnering with key real-estate partners which will enable it to quickly bring their properties into its coverage map. Additionally, Embark will partner with carriers and shippers who currently move, or have in the past moved, a significant amount of freight on Embark’s network to add their properties to the network. Embark believes that expanding its network will enable it to create a significant and sustainable competitive advantage. Embark believes that the continued growth of its partnerships will improve user experience and drive more users to its platform, which it believes will allow it to further densify its coverage map and reinforce rapid network growth. Embark will apply a highly scalable model nationally, with a tailored approach to each state, driven by the regulatory environment and local market dynamics. Embark believes that this will allow it to expand rapidly and efficiently across different geographies, while maintaining a high level of control over the specific strategy within each state.\nEmbark’s Ability to Expand its Partner Network\nThe growth of Embark’s business model is focused on driving the adoption of its technical products and maximizing their use across Embark’s partners’ operations. This is achieved by working closely with carrier management teams to prepare them to deploy and scale autonomous trucks. In April 2021, Embark formally announced the Embark Partner Development Program (PDP), which serves as the basis of its partnership network. The PDP is comprised of carriers and shippers from across the freight ecosystem working with Embark to refine and scale Embark’s offerings. Most recently, Embark announced the industry-first Truck Transfer Program to place Embark technology in the hands of Knight-Swift drivers.\nAdoption and Support of Autonomous Technology in the Freight Industry\nEmbark’s business model is supported by a large addressable market that Embark believes will benefit from the introduction of autonomous trucking technology. The freight industry is currently facing significant challenges, notably driver shortages and utilization limitations, which it believes it will address through its product offerings. Embark has identified participants from across the freight ecosystem who have expressed support for Embark’s offerings and the potential solutions they provide to the challenges they are facing.\nWhile Embark has confirmed general market support, the long-term success of its business model is dependent on broad scale adoption and support of autonomous trucking technology. Embark has engaged with notable partners in the freight industry who Embark believes will lead the industry in adopting autonomous vehicle technology. As Embark onboards more partners, it will increase miles driven by partners, which Embark believes will serve to validate its product offerings and generate interest and confidence from other partners. Embark believes customers will be motivated to integrate Embark’s technology to be price competitive with other freight participants who have achieved efficiencies with it.\nKey Components of Embark’s Results of Operations\nThe following discussion describes certain line items in Embark’s condensed consolidated statements of operations.\n33\nOperating Expenses\nOperating expenses consist of research and development expenses and general and administrative expenses. Personnel-related costs are the most significant component of Embark’s operating expenses and include salaries, benefits, and stock-based compensation expenses.\nEmbark’s full-time employee headcount in research and development has grown from 172 as of December 31, 2021 to 242 as of March 31, 2022 and in general and administrative functions has grown from 59 as of December 31, 2021 to 62 as of March 31, 2022. Embark expects to continue to hire new employees to support our growth. The timing of these additional hires could materially affect Embark’s operating expenses in any particular period.\nEmbark expects to continue to invest substantial resources to support its growth and anticipates that each of the following categories of operating expenses will increase in absolute dollar amounts for the foreseeable future.\nResearch and Development Expenses\nResearch and development expenses consist primarily of salaries, employee benefits, stock-based compensation expenses and travel expenses related to Embark’s engineers performing research and development activities to originate, develop and enhance Embark’s products. Additional expenses include consulting charges, component purchases, software licenses and other costs for performing research and development on Embark’s software products.\nGeneral and Administrative Expenses\nGeneral and administrative expenses consist primarily of salaries, employee benefits, stock-based compensation expenses, and travel expenses related to Embark’s executives, finance team, and the administrative employees. They also consists of legal, accounting, consulting, and professional fees, rent and lease expenses pertaining to Embark’s offices, business insurance costs and other costs. Embark expects its general and administrative expenses to increase for the foreseeable future as it scales headcount with the growth of its business, and as a result of operating as a public company, including as a result of compliance with the rules and regulations of the SEC, legal, audit, tax and other administrative and professional services.\nResults of Operations\nThe results of operations presented below should be reviewed in conjunction with the financial statements and notes included elsewhere in this Quarterly Report on Form 10-Q. The following table sets forth Embark’s results of operations data for the periods presented (in thousands):\nComparisons for the three months ended March 31, 2022 and 2021\nThe following table sets forth Embark’s condensed consolidated results of operations data for the periods presented (in thousands):\n| Three Months Ended | $ | % |\n| 2022 | 2021 | Change | Change |\n| Operating expenses: |\n| Research and development | $ | 18,695 | $ | 6,231 | $ | 12,464 | 200.0 | % |\n| General and administrative | 21,926 | 2,290 | 19,636 | 857.5 | % |\n| Total operating expenses | 40,621 | 8,521 | 32,100 | 376.7 | % |\n| Loss from operations | (40,621) | (8,521) | (32,100) | 376.7 | % |\n| Other income, net | 22,174 | 39 | 22,135 | N.M. |\n| Loss before provision for income taxes | (18,447) | (8,482) | (9,965) | 117.5 | % |\n| Provision for income taxes | — | — | — | N.M. |\n| Net loss | $ | (18,447) | $ | (8,482) | $ | (9,965) | 117.5 | % |\n\n_________________________________________________\nN.M. — Percentage change not meaningful\n34\nResearch and Development Expenses\nResearch and development expense increased by $12.5 million in the three months ended March 31, 2022, compared to the three months ended March 31, 2021. The increase was primarily due to $8.8 million higher headcount expenses including stock-based compensation, salaries and employee benefits, related to continued expansion of Embark’s research and development team, a $0.2 million increase in infrastructure expenditure related to increased R&D activities, a $0.3 million increase in prototype truck hardware expenses, a $1.8 million increase in general R&D costs primarily driven by engineering software & subscription costs and a $0.2 million increase in computer and equipment expenditure related to an increase in Embark’s research and development team.\nGeneral and Administrative Expense\nGeneral and administrative expense increased by $19.6 million in the three months ended March 31, 2022, compared to the three months ended March 31, 2021. The increase was primarily due to $16.5 million higher headcount expenses including stock-based compensation, salaries and employee benefits, related to growth in the business, a $0.5 million increase in occupancy expenses related to additional leases, a $0.2 million increase in fleet operation expenses due to increased activity, a $0.6 million increase in insurance expenses and a $0.3 million increase in travel and events expenditure.\nOther income (expense), net\nOther income increased by $22.1 million in the three months ended March 31, 2022 compared to the three months ended March 31, 2021. The increase was primarily due to the change in the estimated fair value of Public, Private, Working Capital and FPA Warrants of $22.2 million.\nLiquidity and Capital Resources\nSince Embark’s inception, it has financed its operations primarily through the sale of shares of common stock and preferred stock.\nIn connection with the Business Combination, a convertible promissory note (the “Convertible Note”) issued by Embark in April 2021 was converted in exchange for 3,774,951 shares of Embark Class A common stock. As of March 31, 2022, Embark had outstanding debt of $1.0 million from a financing of freight trucks that it utilizes for research and development. Embark makes monthly installment payments on its truck financing arrangements. The truck financings have varying maturities between March 2023 and January 2027. Embark’s principal uses of cash in recent periods have been to fund its operations, invest in research and development, repay borrowings, and make investments in accordance with its investments policy.\nEmbark believes existing cash and other components of working capital will be sufficient to meet its needs for at least the next 12 months. Embark’s long-term capital requirements will depend on many factors including timing and extent of spending to support research and development efforts as well as general and administrative activities for the business. If, at any time, Embark determines it requires more capital to execute upon its business plan, and /or that market conditions are favorable, Embark may seek additional equity or debt financing. Additionally, in the event Embark may in the future enter into arrangements to acquire or invest in related products, technologies, software and services, and Embark may need to seek additional equity or debt financing to support such growth. As of March 31, 2022, there were future minimum lease payments of $7.1 million.\nEmbark currently transports shipments using its research and development truck fleet, demonstrating proof of concept and paving the way for commercialization and revenue generating operations in the future. However, Embark has not earned any revenue to date, and had $244.5 million in cash and cash equivalents and an accumulated deficit of $201.4 million as of March 31, 2022. To the extent Embark is unable to commercialize its technology as expected, its liquidity may be negatively impacted.\nEmbark’s ability to continue as a going concern is dependent on management’s ability to control operating costs and demonstrate progress against its technical roadmap. This involves developing new capabilities for the Embark Driver software and improving the reliability and performance of the software on public roads. Demonstrating ongoing technical progress will enable Embark to obtain funds from outside sources of financing, including financing from equity interest investors and borrow funds to fund its general operations, research and development activities and capital expenditures.\n35\nThe following table shows Embark’s cash flows from operating activities, investing activities and financing activities for the stated periods:\n| Three Months Ended March 31, |\n| 2022 | 2021 |\n| Net cash (used in) provided by: | (unaudited) |\n| Operating activities | $ | (18,225) | $ | (6,791) |\n| Investing activities | $ | (1,717) | $ | 17,270 |\n| Financing activities | $ | 287 | $ | 28 |\n\nOperating Activities\nNet cash used in operating activities for the three months ended March 31, 2022 was $18.2 million, an increase of $11.4 million from $6.8 million for the three months ended March 31, 2021. The increase was primarily due to an increase of $10.0 million net loss for the three months ended March 31, 2022 compared to the three months ended March 31, 2021. In addition, the increase was partially attributable to $5.7 million of non-cash adjustments to net loss, including $0.6 million of depreciation and amortization, $22.2 million of change in fair value of warrant liability, as well as $16.0 million of stock-based compensation, and partially offset by $4.2 million net cash increase by changes in Embark’s operating assets and liabilities, which was primarily attributable to accounts payable, accrued expenses and other current liabilities primarily due to overall growth and timing of payables.\nInvesting Activities\nNet cash used in investing activities for the three months ended March 31, 2022 was $1.7 million, a decrease of $19.0 million from $17.3 million of net cash provided by investing activities for the three months ended March 31, 2021. The decrease was primarily due to a decrease of $18.2 million in proceeds received from maturities of investments, and an increase in purchase of property, equipment, and software of $0.7 million.\nFinancing Activities\nNet cash provided by financing activities for the three months ended March 31, 2022 was $0.3 million compared to $28,000 of net cash used in investing activities for the three months ended March 31, 2021. The increase was primarily due to an increase of $0.3 million in proceeds received from the exercise of employee stock options.\nFinancing Arrangements\nThere have been no material changes outside the ordinary course of business in Embark’s financing arrangements as previously disclosed in Embark’s Annual Report.\nOff-Balance Sheet Arrangements\nEmbark did not have any off-balance sheet arrangements as of March 31, 2022.\nCritical Accounting Policies and Significant Management Estimates\nThe preparation financial statements in conformity with generally accepted accounting principles requires management to make judgments, estimates and assumptions in the preparation of Embark’s financial statements and accompanying notes. Actual results could differ from those estimates. There have been no material changes to Embark’s critical accounting policies or estimates during the three months ended March 31, 2022, from those discussed in Embark’s Annual Report.\nRecent Accounting Pronouncements\n36\nFor information on recently issued accounting pronouncements, refer to Note 2. Summary of Significant Accounting Policies in Embark’s condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.\nJOBS Act Accounting Election\nEmbark is an emerging growth company (EGC), as defined in the JOBS Act. Under the JOBS Act, EGCs can delay adopting new or revised accounting standards until such time as those standards apply to private companies. Embark intends to elect to adopt new or revised accounting standards under private company adoption timelines. Accordingly, the timing of Embark’s adoption of new or revised accounting standards will not be the same as other public companies that are not emerging growth companies or that have opted out of using such extended transition period.\nItem 3. Quantitative and Qualitative Disclosures About Market.\nEmbark is exposed to certain market risks as part of its ongoing business operations.\nCredit Risk\nEmbark is exposed to credit risk on its investment portfolio. Investments that potentially subject us to credit risk consist principally of cash and investments in debt securities. Embark places cash and cash equivalents with financial institutions with high credit standing and excess cash in marketable investment grade debt securities.\nInterest Rate Risk\nEmbark is exposed to interest rate risk on its investment portfolio. Investments that potentially subject Embark to interest rate risk consist principally of cash and investments in debt securities. As of March 31, 2022, Embark has cash and cash equivalents of $244.5 million, consisting of U.S. Treasury securities and interest-bearing money market accounts for which the fair market value would be affected by changes in the general level of U.S. interest rates. However, due to the short-term maturities and the low-risk profile of Embark’s investments, an immediate 10% change in interest rates would not have a material effect on the fair market value of its cash, cash equivalents, and investments.\nInflation Risk\nEmbark is exposed to impact of wage inflation, and has experienced wage inflation during 2021. Although wages have increased during 2021, and the continuing supply chain crisis and geopolitical conflict in Ukraine may contribute to continuing inflation, Embark does not believe that inflation has had a material effect on its business, results of operations, or financial condition. If Embark’s costs were to become subject to more significant inflationary pressures before we commercialize and sell our technology, we will not be able to offset such higher costs through price increases. Embark’s inability to do so could harm its business, results of operations, and financial condition.\nItem 4. Controls and Procedures\nEvaluation of Disclosure Controls and Procedures\nOur management, with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, our CEO and CFO concluded that, as of March 31, 2022, due to the material weakness described in the Annual Report, our disclosure controls and procedures were not effective.\nAs disclosed in Part II, Item 9A, “Controls and Procedures” in our Annual Report, we identified a material weakness in our internal control over financial reporting resulting from a lack of sufficient number of qualified personnel within our accounting function who possessed an appropriate level of expertise to effectively perform the following functions:\n•identify, select and apply GAAP sufficiently to provide reasonable assurance that transactions were being appropriately recorded; and\n37\n•assess risk and design appropriate control activities over information technology systems and financial and reporting processes necessary to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements.\nStatus of remediation efforts\nIn response to the material weaknesses identified and described above, our management, with the oversight of the Audit Committee of our Board of Directors, will continue through 2022 to dedicate significant efforts and resources to further improve our control environment and to take steps to remediate these material weaknesses.\nChanges in Internal Control Over Financial Reporting\nExcept for changes in connection with our implementation of the remediation measures or as described above, there were no changes in our internal control over financial reporting during the three months ended March 31, 2022, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n38\nPart II - OTHER INFORMATION\nItem 1. Legal Proceedings\nFrom time to time, Embark may be involved in actions, claims, suits, and other proceedings in the ordinary course of its business. In addition, from time to time, third parties may in the future assert intellectual property infringement claims against Embark in the form of letters and other forms of communication. Litigation or any other legal or administrative proceeding, regardless of the outcome, can result in substantial cost and diversion of its resources, including its management’s time and attention. Such matters are subject to uncertainty and there can be no assurance that such legal proceedings will not have a material adverse effect on our business, the results of operations, financial position or cash flows.\nOn April 1, 2022, Tyler Hardy filed a putative securities class action lawsuit against Embark and certain of our executive officers and the former executive officers of Northern Genesis Acquisition Corp., captioned Hardy v. Embark Technology, Inc., et al., Case No. 3:22-cv-02090-JSC, in the United States District Court for the Northern District of California, purportedly on behalf of a class consisting of those who purchased or otherwise acquired Embark common stock between January 12, 2021 and January 5, 2022. The complaint alleges that defendants made false and/or misleading statements in violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. Plaintiff Hardy does not quantify any damages in the complaint, but in addition to attorneys’ fees and costs, seeks to recover damages on behalf of himself and other persons who purchased or otherwise acquired Embark stock during the putative class period at allegedly inflated prices and purportedly suffered financial harm as a result.\nEmbark disputes the allegations in the above-reference matter, intends to defend the matter vigorously, and believes that the claims are without merit. Legal and regulatory proceedings, including the above-referenced matter, may be based on complex claims involving substantial uncertainties and unascertainable damages. Accordingly, it is not possible to determine the probability of loss or estimate damages for the above-referenced matter, and therefore, Embark has not established reserves for this proceeding. When Embark determines that a loss is both probable and reasonably estimable, Embark will record a liability, and, if the liability is material, will disclose the amount of the liability reserved. Given that such proceedings are subject to uncertainty, there can be no assurance that legal proceedings individually or in the aggregate will not have a material adverse effect on our business, results of operations, financial condition or cash flows.\nItem 1A. Risk Factors\nThere are no material changes to the risk factors discussed in Embark’s Annual Report under the heading “Risk Factors.” You should carefully consider these risks, together with management’s discussion and analysis of Embark’s financial condition and results of operations in conjunction with the condensed consolidated financial statements and the notes thereto included elsewhere in this Quarterly Report on Form 10-Q. If any of the events contemplated should occur, Embark’s business, results of operations, financial condition and cash flows could suffer significantly.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nNone.\nItem 3. Defaults Upon Senior Securities\nNone.\nItem 4. Mine Safety Disclosures\nNot Applicable.\nItem 5. Other Information\nNone.\n39\nItem 6. Exhibits\n| Incorporated by Reference |\n| ExhibitNumber | Description | Form | File No. | Date | Exhibit | Filed Herewith |\n| 2.1+ | Agreement and Plan of Merger, dated as of June 22, 2021, by and among Northern Genesis Acquisition Corp. II, NGAB Merger Sub Inc. and Embark Trucks Inc. | 8-K | 001-39881 | 6/23/2021 | 2.1 |\n| 3.1 | Second Amended and Restated Certificate of Incorporation of Northern Genesis Acquisition Corp. II. | 8-K | 001-39881 | 11/17/2021 | 3.1 |\n| 3.2 | Amended and Restated Bylaws of Embark Technology, Inc. | 8-K | 001-39881 | 11/17/2021 | 3.2 |\n| 4.1 | Specimen Warrant Certificate of Embark Technology, Inc. | S-4 | 333-257647 | 10/13/2021 | 4.5 |\n| 4.2 | Specimen Class A Common Stock Certificate of Embark Technology, Inc. | S-4 | 333-257647 | 10/13/2021 | 4.6 |\n| 4.3 | Warrant Agreement, dated as of January 12, 2021, by and among Northern Genesis Acquisition Corp. II and Continental Stock Transfer & Trust Company, as warrant agent. | 8-K | 001-39881 | 1/19/2021 | 4.1 |\n| 31.1** | Certification of Principal Executive Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | X |\n| 31.2** | Certification of Principal Financial Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | X |\n| 32.1** | Certification of Principal Executive Officer and Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | X |\n| 101.INS | Inline XBRL Instance Document – the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRIL document. | X |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document. | X |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document. | X |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document. | X |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document. | X |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document. | X |\n| 104 | Cover Page Interactive Data File - the cover page interactive data file does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL Document. | X |\n\n________________________\n* Filed herewith.\n** Furnished herewith. The certifications attached as Exhibit 31.1, Exhibit 31.2 and Exhibit 32.1 that accompanies this Quarterly Report on Form 10-Q is deemed furnished and not filed with the Securities and Exchange Commission and is not to be incorporated by reference into any filing of Embark Technology, Inc. under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this Quarterly Report on Form 10-Q, irrespective of any general incorporation language contained in such filing.\n+ Schedules and exhibits have been omitted pursuant to Item 601(b)(2) of Regulation S-K. The Registrant agrees to furnish supplementally a copy of any omitted schedule or exhibit to the SEC upon request.\n40\nSIGNATURES\nPursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the registrant has duly caused this Quarterly Report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized, on May 11, 2022.\n| EMBARK TECHNOLOGY, INC. |\n| By: | /s/ Alex Rodrigues |\n| Name: | Alex Rodrigues |\n| Title: | Chief Executive Officer |\n| (Principal Executive Officer) |\n\n| EMBARK TECHNOLOGY, INC. |\n| By: | /s/ Richard Hawwa |\n| Name: | Richard Hawwa |\n| Title: | Chief Financial Officer |\n| (Principal Financial and Principal Accounting) |\n\n41\n \n\nWhat is the year on year percentage change in the Accumulated Deficit for the first quarter of 2022 compared to the first quarter of 2021?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nItem 1. Financial Statements (unaudited).\\n4\\nEmbark Technology, Inc.\\nCondensed Consolidated Balance Sheets\\n(in thousands, except share and per share data)\\n(unaudited)\\n| March 31,2022 | December 31,2021 |\\n| Assets |\\n| Current assets: |\\n| Cash and cash equivalents | $ | 244,488 | $ | 264,615 |\\n| Restricted cash, short-term | 65 | 130 |\\n| Prepaid expenses and other current assets | 12,005 | 12,746 |\\n| Total current assets | 256,558 | 277,491 |\\n| Restricted cash, long-term | 812 | 275 |\\n| Property, equipment and software, net | 11,086 | 9,637 |\\n| Operating lease right-of-use assets | 6,099 | — |\\n| Other assets | 3,722 | 3,596 |\\n| Total assets | $ | 278,277 | $ | 290,999 |\\n| Liabilities and stockholders’ equity |\\n| Current liabilities: |\\n| Accounts payable | $ | 4,099 | $ | 2,497 |\\n| Accrued expenses and other current liabilities | 6,151 | 3,142 |\\n| Current portion of operating lease liabilities | 1,948 | — |\\n| Short-term notes payable | 357 | 358 |\\n| Total current liabilities | 12,555 | 5,997 |\\n| Long-term notes payable | 641 | 722 |\\n| Warrant liability | 27,264 | 49,419 |\\n| Non-current portion of operating lease liabilities | 4,438 | — |\\n| Other long-term liability | 111 | 50 |\\n| Long-term deferred rent | — | 177 |\\n| Total liabilities | 45,009 | 56,365 |\\n| Commitments and contingencies (Note 10) |\\n| Stockholders’ equity: |\\n| Preferred stock, $ 0.0001 par value; 10,000,000 shares authorized, none issued and none outstanding as of March 31, 2022 and December 31, 2021 | — | — |\\n| Class A common stock, $ 0.0001 par value; 4,000,000,000 shares authorized, 362,832,986 shares issued as of March 31, 2022; 4,000,000,000 shares authorized, 362,832,986 shares issued as of December 31, 2021 | 36 | 36 |\\n| Class B common stock, $ 0.0001 par value; 100,000,000 shares authorized, 87,078,981 shares issued as of March 31, 2022 and December 31, 2021 | 9 | 9 |\\n| Additional paid-in capital | 434,573 | 417,492 |\\n| Accumulated deficit | ( 201,350 ) | ( 182,903 ) |\\n| Total stockholders’ equity | 233,268 | 234,634 |\\n| Total liabilities and stockholders’ equity | $ | 278,277 | $ | 290,999 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\\n5\\nEmbark Technology, Inc.\\nCondensed Consolidated Statements of Operations\\n(in thousands, except share and per share data)\\n(unaudited)\\n| Three Months Ended March 31, |\\n| 2022 | 2021 |\\n| Operating expenses: |\\n| Research and development | $ | 18,695 | $ | 6,231 |\\n| General and administrative | 21,926 | 2,290 |\\n| Total operating expenses | 40,621 | 8,521 |\\n| Loss from operations | ( 40,621 ) | ( 8,521 ) |\\n| Other income (expense): |\\n| Change in fair value of warrant liability | 22,156 | — |\\n| Other income | 26 | 9 |\\n| Interest income | 13 | 30 |\\n| Interest expense | ( 21 ) | — |\\n| Loss before provision for income taxes | ( 18,447 ) | ( 8,482 ) |\\n| Net loss | $ | ( 18,447 ) | $ | ( 8,482 ) |\\n| Net loss attributable to common stockholders, basic and diluted | $ | ( 18,447 ) | $ | ( 8,482 ) |\\n| Net loss per share attributable to common stockholders: |\\n| Basic and diluted, Class A and Class B | $ | ( 0.04 ) | $ | ( 0.18 ) |\\n| Weighted-average shares used in computing net loss per share attributable to common stockholders: |\\n| Basic and diluted | 452,623,022 | 47,538,331 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\\n6\\nEmbark Technology, Inc.\\nCondensed Consolidated Statements of Comprehensive Loss\\n(in thousands)\\n(unaudited)\\n| Three Months Ended March 31, |\\n| 2022 | 2021 |\\n| Net loss | $ | ( 18,447 ) | $ | ( 8,482 ) |\\n| Other comprehensive loss (net of tax): |\\n| Unrealized losses on available-for-sale securities, net | — | ( 19 ) |\\n| Comprehensive loss | $ | ( 18,447 ) | $ | ( 8,501 ) |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\\n7\\nEmbark Technology, Inc.\\nCondensed Consolidated Statements of Preferred Stock and Stockholder’s Equity\\n(in thousands, except number of shares)\\n(unaudited)\\n| Preferred Stock | Founders Preferred Stock | Common Stock | Class A | Class B | Warrants | Additional Paid-in Capital | Accumulated Deficit | Accumulated Other Comprehensive Income (Loss) | TotalStockholders'Equity |\\n| Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount |\\n| Balance at January 1, 2022 | — | $ | — | — | $ | — | — | $ | — | 362,832,986 | $ | 36 | 87,078,781 | $ | 9 | 23,153,266 | $ | 417,492 | $ | ( 182,903 ) | $ | — | $ | 234,634 |\\n| Shares issued upon exercise of stock options | — | — | — | — | — | — | — | — | — | — | — | 372 | — | — | 372 |\\n| Vesting of early exercised options | — | — | — | — | — | — | — | — | — | — | — | 11 | — | — | 11 |\\n| Stock-based compensation | — | — | — | — | — | — | — | — | — | — | — | 16,698 | — | — | 16,698 |\\n| Net loss | — | — | — | — | — | — | — | — | — | — | — | — | ( 18,447 ) | — | ( 18,447 ) |\\n| Balance at March 31, 2022 | — | $ | — | — | $ | — | — | $ | — | 362,832,986 | $ | 36 | 87,078,781 | $ | 9 | 23,153,266 | $ | 434,573 | $ | ( 201,350 ) | $ | — | $ | 233,268 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\\n8\\nEmbark Technology, Inc.\\nCondensed Consolidated Statements of Preferred Stock and Stockholder’s Equity\\n(in thousands, except number of shares)\\n(unaudited)\\n| Preferred Stock | Founders Preferred Stock | Common Stock | Class A | Class B | Warrants | Additional Paid-in Capital | Accumulated Deficit | Accumulated Other Comprehensive Income (Loss) | TotalStockholders'Equity |\\n| Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount |\\n| Balance at January 1, 2021 | 260,582,311 | $ | 1 | 484,912 | $ | — | 141,216,455 | $ | — | — | $ | — | — | $ | — | — | $ | 129,449 | $ | ( 58,690 ) | $ | 45 | $ | 70,805 |\\n| Shares issued upon exercise of stock options | — | — | — | — | 1,244,349 | — | — | — | — | — | — | 94 | — | — | 94 |\\n| Vesting of early exercised options | — | — | — | — | — | — | — | — | — | — | — | 5 | — | — | 5 |\\n| Stock-based compensation | — | — | — | — | — | — | — | — | — | — | — | 598 | — | — | 598 |\\n| Issuance of common stock warrants | — | — | — | — | — | — | — | — | — | — | — | 83 | — | — | 83 |\\n| Other comprehensive loss | — | — | — | — | — | — | — | — | — | — | — | — | — | ( 19 ) | ( 19 ) |\\n| Net loss | — | — | — | — | — | — | — | — | — | — | — | — | ( 8,482 ) | — | ( 8,482 ) |\\n| Balance at March 31, 2021 | 260,582,311 | $ | 1 | 484,912 | $ | — | 142,460,804 | $ | — | — | $ | — | — | $ | — | — | $ | 130,229 | $ | ( 67,172 ) | $ | 26 | $ | 63,084 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\\n9\\nEmbark Technology, Inc.\\nCondensed Consolidated Statements of Cash Flows\\n(in thousands)\\n(unaudited)\\n| Three Months Ended March 31, |\\n| 2022 | 2021 |\\n| Cash flows from operating activities |\\n| Net loss | $ | ( 18,447 ) | $ | ( 8,482 ) |\\n| Adjustments to reconcile net loss to net cash used in operating activities: |\\n| Depreciation and amortization | 383 | 222 |\\n| Amortization expense - right-of-use assets - operating leases | 488 | — |\\n| Stock-based compensation, net of amounts capitalized | 16,602 | 562 |\\n| Issuance of warrants for services | — | 83 |\\n| Change in fair value of warrants | ( 22,156 ) | — |\\n| Net amortization of premiums and accretion of discounts on investments | — | 120 |\\n| Changes in operating assets and liabilities: |\\n| Prepaid expenses and other current assets | 682 | 29 |\\n| Other assets | ( 126 ) | ( 65 ) |\\n| Accounts payable | 1,644 | 264 |\\n| Other long-term liabilities | 60 | — |\\n| Accrued expenses and other current liabilities | 2,645 | 476 |\\n| Net cash used in operating activities | ( 18,225 ) | ( 6,791 ) |\\n| Cash flows from investing activities |\\n| Maturities of investments | — | 18,243 |\\n| Purchase of property, equipment and software | ( 1,717 ) | ( 973 ) |\\n| Net cash provided by (used in) investing activities | ( 1,717 ) | 17,270 |\\n| Cash flows from financing activities |\\n| Payment towards notes payable | ( 81 ) | ( 66 ) |\\n| Proceeds from exercise of stock options | 372 | 94 |\\n| Repurchase of early exercised stock options | ( 4 ) | — |\\n| Net cash provided by (used in) financing activities | 287 | 28 |\\n| Net increase (decrease) in cash, cash equivalents and restricted cash | ( 19,655 ) | 10,507 |\\n| Cash, cash equivalents and restricted cash at beginning of period | 265,020 | 11,460 |\\n| Cash, cash equivalents and restricted cash at end of period | $ | 245,365 | $ | 21,967 |\\n| Supplemental disclosures of cash flow information: |\\n| Cash paid during the year for interest | $ | 18 | $ | 16 |\\n| Supplemental schedule of noncash investing and financing activities |\\n| Acquisition of property, equipment and software in accounts payable | $ | 284 | $ | 176 |\\n| Acquisition of trucks by assuming notes payable | $ | — | $ | 278 |\\n| Right-of-use assets obtained in exchange for lease obligations | $ | 6,587 | $ | — |\\n| Stock-based compensation capitalized into internally developed software | $ | 156 | $ | 36 |\\n| Vesting of early exercised stock options | $ | 15 | $ | 5 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\\n10\\nNotes to Condensed Consolidated Financial Statements\\n1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION\\nEmbark Technology, Inc. was originally incorporated in Delaware on September 25, 2020 under the name Northern Genesis Acquisition Corp. II (“NGA”). The Company was formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. On November 10, 2021 (the “Closing Date”), the Company (at such time named Northern Genesis Acquisition Corp. II) consummated the business combination (the “Business Combination”) pursuant to the Agreement and Plan of Merger, dated June 22, 2021 with the pre-Business Combination company, Embark Trucks, Inc. (“Embark Trucks”). In connection with the consummation of the Business Combination, the Company changed its name from Northern Genesis Acquisition Corp. II to Embark Technology, Inc. and became the parent entity of Embark Trucks.\\nThe Merger was accounted for as a reverse recapitalization with Embark as the accounting acquirer and NGA as the acquired company for accounting purposes. Accordingly, all historical financial information presented in the financial statements represent the accounts of Embark as if Embark is the predecessor to the Company. The shares and net loss per common share, prior to the Merger, have been retroactively restated as shares reflecting the exchange ratio established in the Merger (approximately 2.98 shares of Company Class A common stock for 1 share of Embark Class A common stock).\\nThe principal activities of Embark Technology, Inc. (“Embark” or the “Company”) include design and development of autonomous driving software for the truck freight industry. The Company is headquartered in San Francisco, California and was incorporated in the State of Delaware in 2016. Other than Embark Trucks, the Company has no subsidiaries as of March 31, 2022.\\nThe Company has devoted substantially all of its resources to develop its autonomous truck technology, to enable and expand its route models - transfer point and direct-to-customer, to expand its partnerships with shippers and carriers, to raising capital, and providing general and administrative support for these operations. The Company has not generated revenues from its principal operations through March 31, 2022.\\nPrior to the Merger, NGA ordinary shares and warrants were traded on the New York Stock Exchange (“NYSE”) under the ticker symbols “NGAB” and “NGAB.WS”, respectively. On the Closing Date, the Company’s Class A common stock and warrants began trading on the NASDAQ under the ticker symbols “EMBK” and “EMBKW”, respectively. One of the primary purposes of the Merger was to provide a platform for Embark Trucks to gain access to the U.S. capital markets.\\nBasis of Presentation\\nThe accompanying financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and pursuant to the regulations of the U.S. Securities and Exchange Commission (“SEC”).\\nUnaudited Interim Financial Information\\nThese interim Unaudited Condensed Consolidated Financial Statements should be read in conjunction with the audited financial statements and notes thereto contained in Embark’s Annual Report. The condensed consolidated balance sheet at December 31, 2021, has been derived from the audited financial statements at that date, but does not include all disclosures, including notes, required by GAAP for complete financial statements. In management’s opinion, the unaudited interim financial statements have been prepared on the same basis as the annual financial statements and include all adjustments, which include only normal recurring adjustments, necessary for the fair presentation of the Company’s financial position as of March 31, 2022 and the Company’s results of operations and cash flows for the three months ended March 31, 2022 and 2021. The interim results are not necessarily indicative of the results for any future interim period or for the entire year.\\nBusiness Combination\\nThe Company entered into the Merger Agreement with NGA, a special purpose acquisition company, on June 22, 2021. On November 10, 2021, as part of the Business Combination, Merger Sub, a newly formed subsidiary of NGA, merged with and into Embark Trucks. In connection with the consummation of the Business Combination, the separate\\n11\\ncorporate existence of Merger Sub ceased; Embark Trucks survived and became a wholly owned subsidiary of NGA, which was renamed Embark Technology, Inc.\\nThe Business Combination was accounted for as a reverse recapitalization, in accordance with GAAP. Under the guidance in ASC 805, Embark was treated as the “acquired” company for financial reporting purposes. Embark Trucks was deemed the accounting predecessor of the combined business, and Embark Technology, Inc., as the parent company of the combined business, was the successor SEC registrant, meaning that Embark’s financial statements for previous periods will be disclosed in the registrant’s periodic reports filed with the SEC. The Business Combination had a significant impact on Embark’s reported financial position and results as a consequence of the reverse recapitalization. The most significant changes in Embark’s reported financial position and results were a net increase in cash of $ 243.9 million, net of transaction costs for the Business Combination of $ 70.2 million. As of March 31, 2022 and December 31, 2021, the Company had warrant liabilities of $ 27.3 million and $ 49.4 million, respectively.\\nLiquidity and Capital Resources\\nOn November 10, 2021, Embark consummated the Business Combination, generating net increase in cash of $ 243.9 million, net of transaction costs for the Business Combination of $ 70.2 million.\\nThe Company has incurred losses from operations since inception. The Company incurred net losses of $ 18.4 million and $ 8.5 million for the three months ended March 31, 2022 and 2021, respectively, and accumulated deficit amounts to $ 201.4 million and $ 182.9 million as of March 31, 2022 and December 31, 2021, respectively. Net cash used in operating activities was $ 18.2 million and $ 6.8 million for the three months ended March 31, 2022 and 2021, respectively.\\nThe Company’s liquidity is based on its ability to enhance its operating cash flow position, obtain capital financing from equity interest investors and borrow funds to fund its general operations, research and development activities and capital expenditures. As of March 31, 2022 and December 31, 2021, the Company’s balance of cash and cash equivalents was $ 244.5 million and $ 264.6 million, respectively.\\nBased on cash flow projections from operating and financing activities and existing balance of cash and cash equivalents and investments, management is of the opinion that the Company has sufficient funds for sustainable operations, and it will be able to meet its payment obligations from operations and debt related commitments for at least one year from the issuance date of these financial statements. Based on the above considerations, the Company’s financial statements have been prepared on a going concern basis, which contemplates the realization of assets and liquidation of liabilities during the normal course of operations.\\nThe Company’s ability to continue as a going concern is dependent on management’s ability to control operating costs and demonstrate progress against its technical roadmap. This involves developing new capabilities for the Embark Driver software and improving the reliability and performance of the software on public roads. Demonstrating ongoing technical progress will enable the Company to obtain funds from outside sources of financing, including financing from equity interest investors and borrow funds to fund its general operations, research and development activities and capital expenditures.\\nEmerging Growth Company\\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the independent registered public accounting firm attestation requirements of Section 404 of the Sarbanes- Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies, but\\n12\\nany such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\\nSegment Information\\nUnder Accounting Standards Codification (“ASC 280”), Segment Reporting, operating segments are defined as components of an enterprise where discrete financial information is available that is evaluated regularly by the chief operating decision-maker (“CODM”), in deciding how to allocate resources and in assessing performance. The Company operates in one segment, the truck business unit, which is focused on enhancing self-driving truck software technology. Therefore, the Company’s chief executive officer, who is also the CODM, makes decisions and manages the Company’s operations as a single operating segment for purposes of allocating resources and evaluating financial performance. All long-lived assets are maintained in, and all losses are attributable to, the United States of America.\\nConcentration of Risks\\nEmbark’s financial instruments that are exposed to concentrations of credit risk consist primarily of cash and cash equivalents and restricted cash. Embark maintains its cash and cash equivalents, restricted cash and investments with high-quality financial institutions with investment-grade ratings. A majority of the cash balances are with U.S. banks and are insured to the extent defined by the Federal Deposit Insurance Corporation.\\nImpact of COVID-19\\nThe outbreak of the novel coronavirus COVID-19, which was declared a global pandemic by the World Health Organization on March 11, 2020 has led to adverse impacts on the U.S. and global economies and has impacted and continues to impact the Company’s supply chain, and operations. Even though the Company has taken measures to adapt to operating in this challenging environment, the pandemic could further affect the Company’s operations and the operations of, partners, suppliers and vendors due to additional shelter- in-place and other governmental orders, facility closures, travel and logistics restrictions, or other factors as circumstances continue to evolve. In response to this pandemic, many jurisdictions in which the Company operates issued stay-at-home orders and other measures aimed at slowing the spread of the virus. While the Company remains open in accordance with guidance from local authorities, the Company experienced a temporary pause in testing of its research and development truck fleet and operations in response to the stay- at-home orders in calendar year 2021. The impacts from stay-at-home orders and other updated local government indoor operation measures are no longer impacting the Company’s operations in 2021, however, there remains uncertainty around the potential disruptions the pandemic could cause looking forward. The Company has instituted policies across its offices to ensure compliance with these updated guidelines. At current, these changes have not impacted the Company’s operations. In response to the Delta and Omicron variants, local governments updated their guidelines for indoor operations. Therefore, the related financial impact and duration cannot be reasonably estimated at this time.\\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\\nUse of Estimates\\nThe preparation of financial statements in conformity with GAAP requires management to make certain estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the balance sheet date, as well as reported amounts of expenses during the reporting period.\\nThe Company’s most significant estimates and judgments involve the useful lives of long-lived assets, the recoverability of long-lived assets, the incremental borrowing rate (“IBR”) applied in lease accounting, the capitalization of software development costs, the valuation of the Company’s stock-based compensation, including the valuation of warrants to purchase the Company’s stock and the valuation allowance for income taxes. Management bases its estimates on historical experience and on various other assumptions believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results could differ from those estimates.\\n13\\nCash, Cash Equivalents and Restricted Cash\\nThe Company considers all highly liquid investments purchased with original maturities of three months or less to be cash equivalents. As of March 31, 2022 and December 31, 2021, the Company had $ 244.5 million and $ 264.6 million of cash and cash equivalents, respectively.\\nThe Company maintains letters of credit to secure leases of the Company’s offices and facilities. A portion of the Company’s cash is collateralized in conjunction with the letter of credit and is classified as restricted cash on the Company’s condensed consolidated balance sheets. As of March 31, 2022 and December 31, 2021, the Company had $ 0.9 million and $ 0.4 million in restricted cash, respectively. At the end of each year of the lease, the face amount of the letter of credit is reduced by a fixed amount of approximately $ 0.1 million and reclassified into cash and cash equivalents on the Company’s condensed consolidated balance sheets. The Company determines short-term or long-term classification based on the expected duration of the restriction.\\nThe reconciliation of cash and cash equivalents and restricted cash and cash equivalents to amounts presented in the condensed consolidated statements of cash flows are as follows (in thousands):\\n| As of March 31, | As of December 31, |\\n| 2022 | 2021 | 2021 |\\n| Cash and cash equivalents | 244,488 | 21,562 | 264,615 |\\n| Restricted cash, short-term | 65 | 65 | 130 |\\n| Restricted cash, long-term | 812 | 340 | 275 |\\n| Total cash, cash equivalents and restricted cash | 245,365 | 21,967 | 265,020 |\\n\\nFair Value of Financial Instruments\\nThe Company’s financial instruments consist of cash and cash equivalents, restricted cash, prepaid expenses and other current assets, accounts payable and accrued expenses, short-term and long-term notes payable and other current liabilities. The assets and liabilities that were measured at fair value on a recurring basis are cash equivalents and warrant liabilities. The Company believes that the carrying values of the remaining financial instruments approximate their fair values. The Company applies fair value accounting in accordance with ASC 820, Fair Value Measurements for valuation of financial instruments. ASC 820 provides a framework for measuring fair value under GAAP that expands disclosures about fair value measurements, establishes a fair value hierarchy, and requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The three levels of the fair value hierarchy are summarized as follows:\\nLevel 1 — Fair value is based on observable inputs such as quoted prices for identical assets or liabilities in active markets.\\nLevel 2 — Fair value is determined using quoted prices for similar assets or liabilities in active markets or quoted prices for identical or similar assets or liabilities in markets that are not active or are directly or indirectly observable.\\nLevel 3 — Fair value is determined using one or more significant inputs that are unobservable in active markets at the measurement date, such as an option pricing model, discounted cash flow, or similar technique.\\nPublic and Private Warrants\\nAs part of NGA’s initial public offering on October 13, 2020, NGA issued to third party investors 41.4 million units, consisting of one share of Class A common stock of NGA and one-third of one warrant, at a price of $ 10.00 per unit. Each whole warrant entitles the holder to purchase one share of Class A common stock at an exercise price of $ 11.50 per share (the \\\"Public Warrants\\\"). Further, NGA completed the private sale of 6.7 million warrants to NGA's sponsor at a purchase price of $ 1.50 per warrant (the \\\"Private Warrants\\\"). Each Private Warrant allows the sponsor to purchase one share of Class A common stock at $ 11.50 per share. Subsequent to the Business Combination, 13.8 million Public Warrants and 6.7 million Private Warrants remained outstanding as of March 31, 2022.\\n14\\nThe Private Placement Warrants are identical to the Public Warrants underlying the Units sold in the Initial Public Offering, except that the Private Placement Warrants and the Class A common stock issuable upon the exercise of the Private Placement Warrants did not become transferable, assignable or salable until 30 days after the completion of a Business Combination, subject to certain limited exceptions. Additionally, the Private Placement Warrants are exercisable on a cashless basis and are non-redeemable so long as they are held by the initial purchasers or their permitted transferees. If the Private Placement Warrants are held by someone other than the initial purchasers or their permitted transferees, the Private Placement Warrants are redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants.\\nThe Company evaluated the Public and Private Warrants under ASC 815-40, Derivatives and Hedging-Contracts in Entity's Own Equity, and concluded that they do not meet the criteria to be classified in stockholders' equity. Since the Public and Private Warrants meet the definition of a derivative under ASC 815, the Company recorded these warrants as liabilities on the balance sheet at fair value upon the closing of the Business Combination, with subsequent changes in their respective fair values recognized in the condensed consolidated statement of operations and comprehensive income (loss) at each reporting date.\\nConvertible Notes and Derivatives\\nThe Company accounts for its derivatives in accordance with, ASC 815-10, Derivatives and Hedging, or ASC 815-15, Embedded Derivatives, depending on the nature of the derivative instrument. ASC 815 requires each contract that is not a derivative in its entirety be assessed to determine whether it contains embedded derivatives that are required to be bifurcated and accounted for as a derivative financial instrument. The embedded derivative is bifurcated from the host contract and accounted for as a freestanding derivative if the combined instrument is not accounted for in its entirety at fair value with changes in fair value recorded in earnings, the terms of the embedded derivative are not clearly and closely related to the economic characteristics of the host contract, and a separate instrument with the same terms as the embedded derivative would qualify as a derivative instrument. Embedded derivatives are measured at fair value and remeasured at each subsequent reporting period, and recorded within convertible notes, net on the accompanying Balance Sheets and changes in fair value recorded in other expense within the Statements of Operations. Upon the consummation of the Merger, the related convertible note liability was extinguished. As of March 31, 2022, the Company held no derivative instruments.\\nProperty, Equipment and Software\\nProperty, equipment and software is stated at cost less accumulated depreciation. Repair and maintenance costs are expensed as incurred. Depreciation and amortization are recorded on a straight-line basis over each asset’s estimated useful life.\\n| Property, Equipment and Software | Useful life (years) |\\n| Machinery and equipment | 5 years |\\n| Electronic equipment | 3 years |\\n| Vehicles and vehicle hardware | 3 – 7 years |\\n| Leasehold improvements | Shorter of useful life or lease term |\\n| Furniture and fixtures | 7 years |\\n| Developed software | 2 – 4 years |\\n\\nLeases\\nThe Company determines if a contract contains a lease at inception of the arrangement based on whether the Company has the right to obtain substantially all of the economic benefits from the use of an identified asset and whether the Company has the right to direct the use of an identified asset in exchange for consideration, which relates to an asset which the Company does not own. Right of use (“ROU”) assets represent the Company’s right to use an underlying asset for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from the lease. ROU assets are recognized as the lease liability, adjusted for lease incentives received. Lease liabilities are recognized at the present value of the future lease payments at the lease commencement date. The interest rate used to determine the present value of the future lease payments is the Company’s incremental borrowing rate (“IBR”), because the interest rate implicit in most of its leases is not readily determinable. The IBR is a hypothetical rate based on the Company’s understanding of what its credit rating would be to borrow and resulting interest we would pay to borrow an amount equal to the lease\\n15\\npayments in a similar economic environment over the lease term on a collateralized basis. Lease payments may be fixed or variable; however, only fixed payments or in-substance fixed payments are included in the Company’s lease liability calculation. Variable lease payments may include costs such as common area maintenance, utilities, real estate taxes or other costs. Variable lease payments are recognized in operating expenses in the period in which the obligation for those payments are incurred.\\nOperating leases are included in operating lease ROU assets, operating lease liabilities, current and operating lease liabilities, non-current on the Company’s condensed consolidated balance sheets. For operating leases, lease expense is recognized on a straight-line basis in operations over the lease term. The Company elected the practical expedient not to separate non-lease components from lease components, therefore, the Company accounts for lease and non-lease components as a single lease component. The Company also elected the short-term lease recognition practical expedient for all leases that qualify.\\nImpairment of Long-Lived Assets\\nThe Company reviews its long-lived assets for impairment annually, or whenever events or circumstances indicate that the carrying amount of an asset may not be fully recoverable. The Company assesses the recoverability of these assets by comparing the carrying amount of such assets or asset group to the future undiscounted cash flows it expects the assets or asset group to generate. The Company recognizes an impairment loss if the sum of the expected long-term undiscounted cash flows that the long-lived asset is expected to generate is less than the carrying amount of the long-lived asset being evaluated.\\nIncome Taxes\\nThe Company accounts for income taxes using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.\\nA valuation allowance is provided when it is more likely than not that some portion or all of a deferred tax asset will not be realized. Due to the Company’s lack of earnings history, the net deferred tax assets have been fully offset by a valuation allowance as of March 31, 2022 and December 31, 2021. Uncertain tax positions taken or expected to be taken in a tax return are accounted for using the more likely than not threshold for financial statement recognition and measurement.\\nStock-based Compensation\\nStock-based compensation expense related to stock option awards, restricted stock units (“RSUs”) and performance stock units (“PSUs”) granted to employees, directors and non-employees based on estimated grant-date fair values. For stock option awards, the Company uses the straight-line method to allocate compensation expense to reporting periods over each optionee’s requisite service period, which is generally the vesting period, and estimates the fair value of share-based awards to employees and directors using the Black-Scholes option- pricing model. The Black-Scholes model requires the input of subjective assumptions, including expected volatility, expected dividend yield, expected term, risk-free rate of return and the stock price of the underlying common shares on the date of grant. The fair value of each RSU is based on the fair value of the Company’s common stock on the date of grant. The related stock-based compensation is recognized on a graded vesting basis as the RSU awards are associated with a performance condition. For PSU awards, the Company uses the graded vesting to allocate compensation expense, as the PSU awards are associated with market conditions, over the holder’s derived service period, and estimates the fair value of the PSU awards using the Monte Carlo simulation. The Company accounts for the effect of forfeitures as they occur.\\nInternal Use Software\\nThe Company capitalizes certain costs associated with creating and enhancing internally developed software related to the Company’s technology infrastructure and such costs are recorded within property, equipment and software, net. These costs include personnel and related employee benefit expenses for employees who are directly associated with and who devote time to software development projects. Software development costs that do not qualify for capitalization are expensed as incurred and recorded in research and development expense in the Statements of Operations and comprehensive income (loss).\\n16\\nSoftware development activities typically consist of three stages: (1) the planning phase; (2) the application and infrastructure development stage; and (3) the post implementation stage. Costs incurred in the planning and post implementation phases, including costs associated with training and repairs and maintenance of the developed technologies, are expensed as incurred. The Company capitalizes costs associated with software developed when the preliminary project stage is completed, management implicitly or explicitly authorizes and commits to funding the project and it is probable that the project will be completed and perform as intended. Costs incurred in the application and infrastructure development phases, including significant enhancements and upgrades, are capitalized. Capitalization ends once a project is substantially complete, and the software is ready for its intended purpose. Software development costs are depreciated using a straight-line method over the estimated useful life, commencing when the software is ready for its intended use. The straight-line recognition method approximates the manner in which the expected benefit will be derived. Internal use software is tested for impairment in accordance with the Company’s long- lived assets impairment policy.\\nResearch and Development Expense\\nResearch and development expense consist of outsourced engineering services, allocated facilities costs, depreciation, internal engineering and development expenses, materials, labor and stock-based compensation related to development of the Company’s products and services. Research and development costs are expensed as incurred except for amounts capitalized to internal-use software.\\nGeneral, and Administrative Expenses\\nGeneral, and administrative expense consist of personnel costs, allocated facilities expenses, depreciation and amortization, travel, and business development costs.\\nChange in fair value of warrant liability\\nChange in fair value of warrant liability represents the change in fair value of Public, Private, Working Capital and Forward Purchase Agreement (“FPA”) Warrants. For each reporting period, Embark will determine the fair value of the warrant liability, and record a corresponding non-cash benefit or non-cash charge, due to a decrease or increase, respectively, in the calculated warrant liability.\\nOther Income\\nAs part of the Company’s research and development activities, we contract with shippers and freight carriers to transfer freight between the Company’s transfer hubs in return for cash consideration. Transferring freight with the Company’s research and development truck fleet are not and will not be considered an output of the Company’s ordinary activities. Consideration received from such arrangements is presented as other income in the Company’s Condensed Consolidated Statement of Operations.\\nInterest Income\\nInterest income primarily consists of investment and interest income from marketable securities, long- term investments and the Company’s cash and cash equivalents.\\nInterest Expense\\nInterest expense consisted primarily of interest on the Company’s various truck financing arrangements.\\nNet Loss Per Share\\nPrior to the Merger and prior to effecting the recapitalization, the Company had one class of common stock. Subsequent to the Merger, the Company has two classes of common stock: Class A and Class B common stock. The rights of the holders of Class A and Class B common stock are identical, including the liquidation and dividend rights, except with respect to electing members of the Board of Directors and voting rights. As the liquidation and dividend rights are identical, undistributed earnings and losses are allocated on a proportionate basis and the resulting net loss per share attributable to common stockholders are the same for both Class A and Class B common stock on an individual and combined basis.\\n17\\nBasic and diluted net loss per share attributable to common stockholders is presented in conformity with the two-class method required for participating securities. Net loss is attributed to common stockholders and participating securities based on their participation rights. Net loss attributable to common stockholders is not allocated to the redeemable convertible preferred stock as the holders of the redeemable convertible preferred stock do not have a contractual obligation to share in any losses. No dividends were declared or paid for the three months ended March 31, 2022 and March 31, 2021. No preferred stock was outstanding as of March 31, 2022.\\nUnder the two-class method, basic net loss per share attributable to common stockholders is computed by dividing the net loss attributable to common stockholders by the weighted-average number of shares of common stock outstanding during the period.\\nDiluted earnings per share attributable to common stockholders adjusts basic earnings per share for the potentially dilutive impact of redeemable convertible preferred stock, stock options, and warrants. As the Company has reported losses for all periods presented, all potentially dilutive securities including preferred stock, stock options, and warrants, are antidilutive and accordingly, basic net loss per share equals diluted net loss per share.\\nComprehensive Income (Loss)\\nComprehensive income (loss) is defined as the total change in stockholders’ equity during the period other than from transactions with stockholders. Comprehensive income (loss) consists of net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) is comprised of unrealized gains or losses on investments classified as available-for-sale.\\nRecently Adopted Accounting Pronouncements\\nIn February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which requires lessees to recognize leases on-balance sheet and disclose key information about leasing arrangements. The Company adopted “ASC 842” on January 1, 2022, using the modified retrospective transition method, specifically the \\\"Comparatives under ASC 840 approach\\\", and used the effective date as the date of initial application. The Company elected the “package of practical expedients,” which permits Embark not to reassess under ASC 842 its prior conclusions about lease identification, lease classification and initial direct costs. The Company also elected the use of hindsight in determining the lease term and in assessing impairment of the entity’s right-of-use assets. Upon adoption of the new leasing standard on January 1, 2022, the Company recognized right-of-use assets of $ 4.4 million and lease liabilities of $ 4.5 million, respectively, which are related to its various operating leases (Note 10). The difference between the right-of-use assets and lease liabilities is primarily attributed to the elimination of deferred rent. There was no adjustment to the opening balance of accumulated deficit as a result of the adoption of ASC 842.\\nIn December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes, which is intended to simplify various aspects related to accounting for income taxes. The adoption of ASU 2019-12 is effective for the Company beginning January 1, 2022. The adoption of this standard did not have a material impact to its financial statements.\\nIn May 2021, the FASB issued ASU 2021-04, Modification of equity-classified written call options. ASU 2021-04 provides clarification and reduces diversity in an issuer’s accounting for certain modifications or exchanges of freestanding equity-classified written call options, such as warrants, that remain equity classified after modification or exchange. This guidance will be effective for us on January 1, 2022 with early adoption permitted and will be applied prospectively. The adoption of ASU 2021-04 is effective for the Company beginning January 1, 2022. The adoption of this standard did not have a material impact to its financial statements.\\nRecently Issued Accounting Pronouncements\\nAs an emerging growth company (“EGC”), the Jumpstart Our Business Startups Act (“JOBS Act”) allows the Company to delay adoption of new or revised accounting pronouncements applicable to public companies until such pronouncements are applicable to private companies. The Company has elected to use this extended transition period under the JOBS Act until such time the Company is no longer considered to be an EGC. The adoption dates discussed below reflect this election.\\n18\\nIn June 2016, the FASB issued ASU 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses of Financial Instruments, which, together with subsequent amendments, amends the requirement on the measurement and recognition of expected credit losses for financial assets held. ASU 2016-13 is effective for the Company beginning January 1, 2023, with early adoption permitted. The Company is currently in the process of evaluating the effects of this pronouncement on the Company’s financial statements and does not expect it to have a material impact on its consolidated financial statements.\\nIn August 2020, the FASB issued ASU 2020-06, Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging — Contracts in Entity’s Own Equity (Subtopic 815- 40): Accounting for convertible instruments and contracts in an entity’s own equity. The ASU simplifies accounting for convertible instruments by removing certain separation models required under current GAAP. The ASU also removes certain settlement conditions that are required for equity contracts to qualify for the derivative scope exception, and it revises the guidance in ASC 260, Earnings Per Share, to require entities to calculate diluted earnings per share for convertible instruments by using the if-converted method. The amendments are effective for the Company beginning January 1, 2024, including interim periods within those fiscal years. Early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. The Company is currently assessing the impact of this standard on its consolidated financial statements.\\nIn October 2020, the FASB issued ASU No. 2020-10, Codification Improvements, which updates various codification topics by clarifying or improving disclosure requirements to align with the SEC’s regulations. For the Company, the ASU No. 2020-10 will be effective for annual reporting periods beginning after December 15, 2021 and interim periods within fiscal years beginning after December 15, 2022. The Company is currently evaluating the impact the adoption of this standard on its consolidated financial statements.\\n3. BALANCE SHEET COMPONENTS\\nPrepaid Expenses and Other Current Assets\\nPrepaid expenses and other current assets consisted of the following as of March 31, 2022 and December 31, 2021, respectively (in thousands):\\n| March 31,2022 | December 31,2021 |\\n| (unaudited) |\\n| Prepaid insurance | $ | 6,890 | $ | 7,459 |\\n| Prepaid software | 2,224 | 2,564 |\\n| Income tax receivable | 494 | 494 |\\n| Short-term deposits | 570 | 448 |\\n| Prepaid salary | 476 | 279 |\\n| Prepaid warrant | 876 | 936 |\\n| Other | 475 | 566 |\\n| Total prepaid expenses and other current assets | $ | 12,005 | $ | 12,746 |\\n\\n19\\nProperty, Equipment and Software\\nProperty, equipment and software consist of the following as of March 31, 2022 and December 31, 2021, respectively (in thousands):\\n| March 31,2022 | December 31,2021 |\\n| (unaudited) |\\n| Machinery and equipment | $ | 406 | $ | 344 |\\n| Electronic equipment | 578 | 413 |\\n| Vehicles and vehicle hardware | 6,929 | 6,268 |\\n| Leasehold improvements | 278 | 258 |\\n| Developed software | 6,108 | 5,184 |\\n| Other | 27 | 26 |\\n| Property, equipment and software, gross | 14,326 | 12,493 |\\n| Less: accumulated depreciation and amortization | ( 3,240 ) | ( 2,856 ) |\\n| Total property, equipment and software, net | $ | 11,086 | $ | 9,637 |\\n\\nDepreciation and amortization expense for the three months ended March 31, 2022 and 2021 was $ 0.4 million and $ 0.2 million, respectively.\\nOther Assets\\nOther assets consist of the following as of March 31, 2022 and December 31, 2021, respectively (in thousands):\\n| March 31,2022 | December 31,2021 |\\n| (unaudited) |\\n| Intangible assets | $ | 3 | $ | 4 |\\n| Long-term deposits | 3,719 | 3,592 |\\n| Total Other Assets | $ | 3,722 | $ | 3,596 |\\n\\nAccrued Expenses and Other Current Liabilities\\nAccrued expenses and other current liabilities consisted of the following as of March 31, 2022 and December 31, 2021, respectively (in thousands):\\n| March 31,2022 | December 31,2021 |\\n| (unaudited) |\\n| Accrued payroll expenses | $ | 3,189 | $ | 823 |\\n| Accrued legal expenses | 696 | 124 |\\n| Accrued transaction costs | 1,092 | 1,092 |\\n| Other | 1,174 | 1,103 |\\n| Total accrued expenses and other current liabilities | $ | 6,151 | $ | 3,142 |\\n\\n4. FAIR VALUE MEASUREMENTS\\n20\\nThe carrying value and fair value of the Company’s financial instruments as of March 31, 2022 and December 31, 2021, respectively, are as follows:\\n| As of March 31, 2022(in thousands) |\\n| Level 1 | Level 2 | Level 3 | Total |\\n| (unaudited) |\\n| Assets |\\n| Cash equivalents: |\\n| United States money market funds | $ | 13,349 | $ | — | $ | — | $ | 13,349 |\\n| Liabilities |\\n| Warrant liabilities - FPA warrants | $ | 760 | $ | — | $ | — | $ | 760 |\\n| Warrant liabilities - public warrants | $ | 15,732 | $ | — | $ | — | $ | 15,732 |\\n| Warrant liabilities - working capital warrants | $ | — | $ | — | $ | 2,480 | $ | 2,480 |\\n| Warrant liabilities - private warrants | $ | — | $ | — | $ | 8,292 | $ | 8,292 |\\n\\n| As of December 31, 2021(in thousands) |\\n| Level 1 | Level 2 | Level 3 | Total |\\n| Assets |\\n| Cash equivalents: |\\n| United States money market funds | $ | 22,349 | $ | — | $ | — | $ | 22,349 |\\n| Liabilities |\\n| Warrant liabilities - FPA warrants | $ | 1,337 | $ | — | $ | — | $ | 1,337 |\\n| Warrant liabilities - public warrants | $ | 27,669 | $ | — | $ | — | $ | 27,669 |\\n| Warrant liabilities - working capital warrants | $ | — | $ | — | $ | 4,700 | $ | 4,700 |\\n| Warrant liabilities - private warrants | $ | — | $ | — | $ | 15,714 | $ | 15,714 |\\n\\nAs of March 31, 2022, there was no transfer from Level 2 to Level 3. As of December 31, 2021, transfers from Level 2 to Level 3 of the fair value hierarchy were $ 15.5 million for Private and Public Warrants.\\nThe fair value of the above liability classified Public, Private, Working Capital and FPA Warrants have been measured based on the listed market price of such warrants on November 10, 2021. The FPA warrants and public warrants were valued using the public price as of March 31, 2022. The Private and Working Capital warrants were fair valued using the Black Scholes Option Pricing Model as of March 31, 2022. For the three months ended March 31, 2022, the Company recognized income in the condensed consolidated statement of operations resulting from a change in the fair value of warrants of approximately $ 22.2 million, presented as other income (expense) on the accompanying condensed consolidated statement of operations.\\n5. STOCKHOLDERS’ EQUITY\\nShares Authorized and Issued\\nAs of March 31, 2022, the Company had authorized a total of 4,110,000,000 shares for issuance with 4,000,000,000 shares designated as Class A common stock, 100,000,000 shares designated as Class B common stock and 10,000,000 shares designated as preferred stock.\\nAs of March 31, 2022, the Company had 362,832,986 issued as Class A common stock and 87,078,981 issued as Class B common stock.\\n21\\nPreferred Stock\\nAs of March 31, 2022, there were 10,000,000 shares of preferred stock authorized and no shares of preferred and founders preferred stock was issued or outstanding. The Company’s preferred stock, as of March 31, 2022, does not contain any mandatory redemption features, nor are they redeemable at the option of the holder.\\nClass A and Class B Common Stock\\nThe Company’s Board of Directors has authorized two class of common stock, Class A and Class B. Holders of Class A and Class B common stock are not entitled to preemptive or other similar subscription rights to purchase any of Embark Technology’s securities.\\nClass A common stock is neither convertible nor redeemable. Class B common stock is convertible into Class A common stock. Unless Embark Technology’s board of directors determines otherwise, Embark Technology will issue all of Embark Technology’s capital stock in certificated form. The Embark Founders held all outstanding shares of Class B common stock up on consummation of the Business Combination.\\nIn connection with the merger with NGA on November 10, 2021, the Embark Founders exchanged 87,078,981 shares of Founder's common stock, which were entitled to one vote per share, into the same number of shares of Class B common stock, which are entitled to ten votes per share. The Company recorded the incremental value of $ 13.6 million associated with this transaction as stock-based compensation in general and administrative expenses.\\nThe significant rights, privileges and preferences of common stock as of March 31, 2022 are as follows:\\nLiquidation Preference\\nIf Embark Technology is involved in voluntary or involuntary liquidation, dissolution or winding up of Embark’s affairs, or a similar event, each holder of Embark Common Stock will participate pro rata in all assets remaining after payment of liabilities, subject to prior distribution rights of Embark Technology preferred stock, if any, then outstanding.\\nDividends\\nEach holder of shares of Embark Common Stock is entitled to the payment of dividends and other distributions as may be declared by the Board from time to time out of Embark’s assets or funds legally available for dividends or other distributions. These rights are subject to the preferential rights of the holders of Embark’s Preferred Stock, if any, and any contractual limitations on Embark’s ability to declare and pay dividends.\\nVoting\\nEach holder of Class A common stock is entitled to one vote per share on each matter submitted to a vote of stockholders, as provided by the Second Amended and Restated Certificate of Incorporation of Northern Genesis Acquisition Corp. II (the “Charter”). Each holder of Class B common stock is entitled to ten votes per share on each matter submitted to a vote of stockholders, as provided by the Embark Charter. Following the Business Combination, holders of Class B Common Stock have the ability to control the business affairs of Embark. Embark’s Amended and Restated Bylaws (the “Bylaws”) provide that the holders of a majority of the capital stock issued and outstanding and entitled to vote thereat, present in person or represented by proxy, will constitute a quorum at all meetings of the stockholders for the transaction of business. When a quorum is present, the affirmative vote of a majority of the votes cast is required to take action, unless otherwise specified by law, the Bylaws or the Charter, and except for the election of directors, which is determined by a plurality vote. There are no cumulative voting rights.\\n6. WARRANTS\\n22\\nAs of March 31, 2022, the following warrants were issued and outstanding:\\n| Description | Classification | Issue Date | Warrants Outstanding | Fair Value Price Per Share | Exercise Price per Share | Expiration |\\n| FPA warrants (1) | Liability | November 10, 2021 | 666,663 | $ | 1.14 | $ | 11.50 | November 10, 2026 |\\n| Public warrants | Liability | November 10, 2021 | 13,799,936 | $ | 1.14 | $ | 11.50 | November 10, 2026 |\\n| Private warrants | Liability | November 10, 2021 | 6,686,667 | $ | 1.24 | $ | 11.50 | November 10, 2026 |\\n| Working capital warrants | Liability | November 10, 2021 | 2,000,000 | $ | 1.24 | $ | 11.50 | November 10, 2026 |\\n\\n(1)FPA are the “Forward Purchase Agreements” entered into, or amended and restated, by NGA on April 21, 2021\\nThe Company determined the FPA, Public, Private and Working Capital warrants to be classified as a liability and fair valued the warrants on the issuance date using the publicly available price for the warrants, of $ 41.2 million. The fair value of the FPA and Public warrants were remeasured as of the reporting date with the change in value reflected as part of Other Expense.\\nThe fair value of $ 27.3 million of Private and Working Capital warrants was determined using the Black-Scholes option valuation model using the following assumptions for values as of March 31, 2022:\\n| Risk – free interest rate | 2.43 % |\\n| Expected term (in years) | 4.61 |\\n| Expected dividend yield | 0 % |\\n| Expected volatility | 45.0 % |\\n\\nThe Company estimates the volatility of its warrants based on a combination of volatility from the Company’s traded warrants and from historical volatility of select peer company’s common stock that matches the expected remaining life of the warrants. The risk-free interest rate is based on the U.S. Treasury zero-coupon yield curve on the grant date for a maturity similar to the expected remaining life of the warrants. The expected life of the warrants is assumed to be equivalent to their remaining contractual term. The dividend rate is based on the historical rate, which the Company anticipates remaining at zero .\\n7. STOCK-BASED COMPENSATION EXPENSE\\nStock Option Plan\\nIn connection with the Business Combination, the Company adopted the 2021 Incentive Award Plan (the “2021 Plan”), under which the Company grants cash and equity incentive awards to directors, employees (including named executive officers) and consultants in order to attract, motivate and retain the talent for which the Company competes. The Company terminated the 2016 Stock Plan, provided that the outstanding awards previously granted under the 2016 Plan continue to remain outstanding under the 2016 Plan. Under the 2021 Plan, as of March 31, 2022, the Company has authorized to issue a maximum number of 58,713,535 shares of Class A common stock, with annual increases beginning January 1, 2022 and ending on and including January 1, 2031 of 5 % of the aggregate number of shares of Class A common stock outstanding on the last day of the preceding calendar year.\\nEmbark Trucks adopted the 2016 Stock Plan in October 2016 (the “2016 Plan”). The 2016 Plan authorized the grant of incentive stock options, non-statutory stock options, and restricted stock awards to employees, directors, and consultants. The 2016 Plan also initially reserved 993,542 shares of common stock ( 8,941,878 shares post-split in June 2018) for issuance and designated forfeited option shares to be returned to the option reserve. Options may be early exercised and are exercisable for a term of 10 years from the date of grant. As of March 31, 2022, the Company had registered 79,742,504 shares to be reserved for option grants, RSUs and PSUs previously issued under the 2016 Plan. The Company will not issue additional awards under the 2016 Plan.\\n23\\nStock Option Valuation\\nThe Company utilizes the Black-Scholes option pricing model for estimating the fair value of options granted, which requires the input of highly subjective assumptions.\\nThe Company calculates the fair value of each option grant on the grant date using the following assumptions:\\nExpected Term — The Company uses the simplified method when calculating expected term due to insufficient historical exercise data.\\nExpected Volatility — As the Company’s shares are not actively traded, the volatility is based on a benchmark of comparable companies within the automotive and energy storage industries.\\nExpected Dividend Yield — The dividend rate used is zero as the Company does not have a history of paying dividends on its common stock and does not anticipate doing so in the foreseeable future.\\nRisk-Free Interest Rate — The interest rates used are based on the implied yield available on U.S. Treasury zero-coupon issues with an equivalent remaining term equal to the expected life of the award.\\n| Three Months Ended March 31, |\\n| 2022 | 2021 |\\n| Risk-free interest rate | n/a | 0.55 – 1.10 % |\\n| Expected term (in years) | n/a | 5.47 – 6.07 |\\n| Expected dividend yield | n/a | 0 % |\\n| Expected volatility | n/a | 36.88 – 51.52 % |\\n\\nThe company did not grant any stock options for the three months ended March 31, 2022.\\nOption Activity\\nChanges in stock options are as follows:\\n| Number ofOutstanding Options | Weighted Average Exercise Price Per Share | WeightedAverageRemaining Contractual Term (years) | AggregateIntrinsic (in thousands) |\\n| Outstanding at December 31, 2021 | 25,358,455 | $ | 0.20 | 6.9 | $ | 215,093 |\\n| Exercised | ( 3,615,572 ) | 0.11 | $ | 20,770 |\\n| Repurchased | 13,984 | 0.29 |\\n| Cancelled | ( 277,235 ) | 0.59 |\\n| Outstanding at March 31, 2022 | 21,479,632 | $ | 0.21 | 6.7 | $ | 121,910 |\\n| Vested and exercisable as of March 31, 2022 | 15,271,274 | $ | 0.13 | 6.0 | $ | 88,014 |\\n\\nThe aggregate intrinsic value in the above table is calculated as the difference between the estimated fair value of the Company's common stock price and the exercise price of the stock options. The company did not grant any stock options for the three months ended March 31, 2022. The weighted average grant date fair value per share for the stock option grants during the three months ended March 31, 2021 was $ 1.88 . As of March 31, 2022, the total unrecognized compensation related to unvested stock option awards granted was $ 5.02 million, which the Company expects to recognize over a weighted-average period of approximately 2.4 years.\\nRestricted Stock Units\\nPrior to the Business Combination, Embark Trucks also granted employees RSUs which are subject to performance and service-based vesting conditions. As the Company went public upon the completion of the Business Combination in November 2021, the performance condition had been met. The RSUs generally vest over either a four year period with\\n24\\n25 % of the awarded vesting after the first-year anniversary and one-thirty sixth of the remainder of the award vesting monthly thereafter. Vesting is contingent upon such employee’s continued service on such vesting date. RSUs are generally subject to forfeiture if employment terminates prior to the release of vesting restrictions. The Company may grant RSUs with different vesting terms from time to time.\\nFor the three months ended March 31, 2022, the Company recognized $ 12.9 million stock-based expense associated with such RSUs. For the three months ended March 31, 2021, the Company did not recognize any stock-based expense associated with such RSUs as the performance condition had not been satisfied until November 10, 2021. As of March 31, 2022, there was $ 41.0 million unrecognized stock-based compensation expense related to outstanding RSUs granted to employees, with a weighted-average remaining vesting period of 3.9 years.\\nA summary of the Company’s RSU activities and related information is as follows:\\n| Number of Shares | Weighted AverageGrant date FairValue Per Share |\\n| Balance as of December 31, 2021 | 9,616,774 | $ | 8.44 |\\n| Forfeited | ( 111,572 ) | 8.96 |\\n| Vested | ( 187,977 ) | 8.36 |\\n| Balance as of March 31, 2022 | 9,317,225 | $ | 8.43 |\\n\\nPerformance Stock Units\\nDuring 2021, Embark Trucks granted PSUs to its employees. The PSUs are subject to certain market and performance-based conditions which require the Company to become a registered public company and meet market conditions that are based on the Company achieving six different valuation tranches as derived from the achievement of escalating share price thresholds of $ 20.00 , $ 35.00 , $ 50.00 , $ 65.00 , $ 80.00 and $ 100.00 (calculated based on the 90-day volume weighted average price or, in the event of a change in control, the fair market value based on the terms of such change in control) following the first anniversary of the consummation of the Business Combination. The market condition can be achieved over ten years in relation to the pre-money valuation prior to the Business Combination. Once the performance condition has been achieved or is considered probably of being achieved, the related stock-based compensation is recognized based on a graded attribution method.\\nFor the three months ended March 31, 2022, the Company recognized $ 2.6 million stock-based expense associated with such PSUs. For the three months ended March 31, 2021, the Company did not recognize any stock-based expense associated with such PSUs as the performance condition had not been satisfied until November 10, 2021. As of March 31, 2022, there was $ 81.0 million unrecognized stock-based compensation expense related to outstanding PSUs granted to employees, with a weighted-average remaining vesting period of 8.1 years.\\nThe Company’s PSUs activity for the three months ended March 31, 2022 was as follows:\\n| Number of Shares | Weighted AverageGrant date FairValue Per Share |\\n| Balance as of December 31, 2021 | 44,715,756 | $ | 1.97 |\\n| Granted | — | — |\\n| Forfeited | — | — |\\n| Vested | — | — |\\n| Balance as of March 31, 2022 | 44,715,756 | $ | 1.97 |\\n\\nCommon Stock Units\\nThe Company is obligated to issue shares of Class A common stock upon the vesting of certain restricted stock awards that resulted from Embark Trucks warrants that were issued prior to the Business Combination. Pursuant to the terms of\\n25\\nthese warrant awards, the restricted stock awards were issued for services at the time of consummation of the Business Combination, and are subject to service vesting terms, with the shares being subject to cancellation. The pre-Business Combination warrants were exercised in their entirety on a cashless basis, with the unvested shares being excluded from the stockholders’ equity and becoming subject to the service vesting condition going forward. Early exercises are reclassified to additional paid-in capital as the Company’s cancellation right lapses. The number of unvested shares of Class A common stock were 1,347,848 as of March 31, 2022.\\nAs of March 31, 2022, there was $ 3.8 million unrecognized stock-based compensation expense related to outstanding Common Stock Units (“CSUs”) granted to non-employees, with a weighted-average remaining vesting period of 2.16 years.\\nThe Company's CSUs activity for the three months ended March 31, 2022 was as follows:\\n| Number of Shares | Weighted AverageGrant date FairValue Per Share |\\n| Balance as of December 31, 2021 | 1,481,065 | $ | 2.48 |\\n| Granted | — | — |\\n| Forfeited | — | $ | — |\\n| Vested | ( 133,217 ) | 2.48 |\\n| Balance as of March 31, 2022 | 1,347,848 | $ | 2.48 |\\n\\nThe following table presents the impact of stock-based compensation expense on the condensed consolidated statements of operations for the three months ended March 31, 2022 and 2021, respectively (in thousands):\\n| Three Months Ended March 31, |\\n| 2022 | 2021 |\\n| Research and development | $ | 3,765 | $ | 311 |\\n| General, and administrative | 12,837 | 251 |\\n| Total stock-based compensation expense | $ | 16,602 | $ | 562 |\\n\\nTotal stock-based compensation that was capitalized into internally developed software asset was $ 0.2 million and nil during the three months ended March 31, 2022 and 2021, respectively.\\n8. RETIREMENT SAVINGS PLAN\\nThe Company sponsored a savings plan available to all eligible employees, which qualifies under Section 401(k) of the Internal Revenue Code. Employees may contribute to the plan amounts of their pre-tax salary subject to statutory limitations. The Company does not currently offer a match and has not provided a match as of March 31, 2022.\\n9. NOTES PAYABLE\\nOn February 18, 2021 and January 5, 2021, the Company entered into financing agreement to finance the purchase of trucks that the Company utilizes for research and development. The financing agreements consisted of a loan of $ 0.1 million and $ 0.1 million at an interest rate equal to 6.99 % and 7.50 % per annum, with a maturity date of April 1, 2026 and January 19, 2027, respectively. The Company makes equal monthly installment payments over the term of each financing arrangement which are allocated between interest and principal.\\nOn February 19, 2018, January 28, 2019, and May 23, 2019, the Company entered into financing agreements to finance the purchase of trucks that the Company utilizes for research and development. The financing agreements consisted of a loan of $ 0.3 million, $ 0.4 million, and $ 0.5 million at an interest rate equal to 8.25 % per annum, with a maturity date of March 5, 2023, February 14, 2024, and June 12, 2024, respectively. The Company makes equal monthly installment payments over the term of each financing arrangement which are allocated between interest and principal.\\n26\\nThe Company entered into a financing agreement on August 2, 2016 to finance the purchase of trucks that the Company utilizes for research and development. The financing agreements consisted of a loan of $ 0.1 million at an interest rate equal to 12.5 % per annum, with a maturity date of August 9, 2020. The Company makes equal monthly installment payments over the term of the financing arrangement, which is allocated between interest and principal.\\nNotes payable as of March 31, 2022 and December 31, 2021 are $ 1.0 million and $ 1.1 million, respectively.\\nThe following table presents future payments of principal as of March 31, 2022 (in thousands):\\n| Years Ended December 31, | Amounts |\\n| 2022 (remaining nine months) | $ | 273 |\\n| 2023 | 313 |\\n| 2024 | 176 |\\n| 2025 | 111 |\\n| 2026 and thereafter | 125 |\\n| Total future payments | $ | 998 |\\n\\n10. COMMITMENTS AND CONTINGENCIES\\nLegal Proceedings\\nThe Company is subject to legal and regulatory actions that arise from time to time in the ordinary course of business. The assessment as to whether a loss is probable or reasonably possible, and as to whether such loss or a range of such loss is estimable, often involves significant judgment about future events. In the opinion of management, all such matters are not expected to have a material effect on the financial position, results of operations or cash flows of the Company. However, the outcome of litigation is inherently uncertain. There is no material pending or threatened litigation against the Company that remains outstanding as of March 31, 2022 and December 31, 2021.\\nOperating leases\\nThe Company’s leases primarily include corporate offices. The lease term of operating leases vary from less than a year to seven years . The Company has leases that include one or more options to extend the lease term to a total term of ten years as well as options to terminate the lease within one year. The Company’s lease terms may include options to extend or terminate the lease when it is reasonably certain that it will exercise such options. The Company’s lease agreements generally do not contain any residual value guarantees or restrictive covenants.\\nThe components of lease expense were as follows (in thousands):\\n| Three Months Ended March 31, 2022 |\\n| Lease cost |\\n| Operating lease cost | $ | 600 |\\n| Short-term lease cost (1) | 102 |\\n| Total lease cost | $ | 702 |\\n\\n(1) The Company elected to account for short-term leases in accordance with ASC 842. ASC 842 defines a short-term lease as a lease whose lease term, at commencement, is 12 months or less and that does not include a purchase option whose exercise is reasonable certain. The Company will recognize the lease payments in profit or loss on a straight-line basis over the lease term.\\n27\\nSupplemental cash flow information related to leases was as follows (in thousands):\\n| Three Months Ended March 31, 2022 |\\n| Other Information |\\n| Cash paid for amounts included in the measurement of lease liabilities: |\\n| Operating cash flows used in operating leases | $ | 477 |\\n| Right-of-use assets obtained in exchange for lease obligations |\\n| Operating lease liabilities | $ | 6,587 |\\n\\nSupplemental balance sheet information related to leases was as follows (in thousands, except lease term and discount rate):\\n| March 31,2022 |\\n| Assets |\\n| Operating lease right-of-use assets | $ | 6,099 |\\n| Liabilities |\\n| Operating lease liability, current | $ | 1,948 |\\n| Operating lease liability, non-current | $ | 4,438 |\\n| Total operating lease liability | $ | 6,386 |\\n\\n| March 31,2022 |\\n| Weighted Average Lease Term (in years) |\\n| Operating Leases | 3.38 |\\n| Weighted Average Discount Rate |\\n| Operating Leases | 5.69 | % |\\n\\nTotal future minimum lease payments over the term of the lease as of March 31, 2022, are as follows (in thousands):\\n| Years Ended December 31, | Operating leases |\\n| 2022 (remaining nine months) | 1,723 |\\n| 2023 | 2,108 |\\n| 2024 | 1,976 |\\n| 2025 | 548 |\\n| 2026 | 563 |\\n| 2027 and thereafter | 142 |\\n| Total undiscounted lease payments | $ | 7,060 |\\n| Less: imputed interest | ( 674 ) |\\n| Total lease liabilities | $ | 6,386 |\\n\\nAs of March 31, 2022, the Company entered into additional operating leases for an office and a truck transfer point of $ 25.8 million, and $ 0.6 million respectively. These operating leases will commence in fiscal 2022 with lease terms of seven years and five years respectively, and contain options to renew and extend the terms of up to 60 months and 12 for each renewal, respectively.\\n28\\n11. NET LOSS PER SHARE\\nThe following table sets forth the computation of the basic and diluted net loss per share attributable to common stockholders for the three months ended March 31, 2022 and 2021, respectively (in thousands, except share and per share data).\\n| Three Months Ended March 31, |\\n| 2022 | 2021 |\\n| Numerator: |\\n| Net loss | $ | ( 18,447 ) | $ | ( 8,482 ) |\\n| Net loss attributable to common stockholders | $ | ( 18,447 ) | $ | ( 8,482 ) |\\n| Denominator: |\\n| Net loss per share attributable to Class A and Class B common stockholders, basic and diluted | $ | ( 0.04 ) | $ | ( 0.18 ) |\\n| Weighted-average shares used in computing net loss per share attributable to common stockholders, basic and diluted | 452,623,022 | 47,538,331 |\\n| Class A | 365,544,041 | n/a* |\\n| Class B | 87,078,981 | n/a* |\\n\\n*Prior to the Merger and prior to effecting the recapitalization in 2021, the Company had one class of common stock. Subsequent to the Merger, the Company has two classes of common stock: Class A and Class B common stock.\\nSince the Company was in a loss position for all periods presented, basic net loss per share is the same as diluted net loss per share for all periods as the inclusion of all potential common shares outstanding would have been anti-dilutive.\\nThe following weighted-average outstanding common stock equivalents were excluded from the computation of diluted net loss per share attributable to common stockholders for the periods presented because including them would have been anti-dilutive.\\n| March 31, |\\n| 2022 | 2021 |\\n| Founders Preferred shares | — | 162,558 |\\n| Series A-1 convertible preferred shares | — | 3,654,873 |\\n| Series A-2 convertible preferred shares | — | 5,372,703 |\\n| Series A-3 convertible preferred shares | — | 2,485,296 |\\n| Series A-4 convertible preferred shares | — | 590,688 |\\n| Series A-5 convertible preferred shares | — | 2,680,236 |\\n| Series A-6 convertible preferred shares | — | 3,647,817 |\\n| Series A-7 convertible preferred shares | — | 15,139,917 |\\n| Series B convertible preferred shares | — | 32,834,601 |\\n| Series C convertible preferred shares | — | 20,949,454 |\\n| Outstanding options | 21,479,632 | 8,975,275 |\\n| Warrants issued and outstanding | 23,153,266 | 857,142 |\\n| Restricted stock units | 9,317,225 | — |\\n| Common stock units | 1,347,848 | — |\\n| Performance stock units | 44,715,756 | — |\\n| Total | 100,013,727 | 97,350,560 |\\n\\n12. SUBSEQUENT EVENTS\\nOn April 1, 2022, Tyler Hardy filed a putative securities class action lawsuit against Embark and certain of our executive officers and the former executive officers of Northern Genesis Acquisition Corp., captioned Hardy v. Embark\\n29\\nTechnology, Inc., et al., Case No. 3:22-cv-02090-JSC, in the United States District Court for the Northern District of California, purportedly on behalf of a class consisting of those who purchased or otherwise acquired Embark common stock between January 12, 2021 and January 5, 2022. The complaint alleges that defendants made false and/or misleading statements in violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. Plaintiff Hardy does not quantify any damages in the complaint, but in addition to attorneys’ fees and costs, seeks to recover damages on behalf of himself and other persons who purchased or otherwise acquired Embark stock during the putative class period at allegedly inflated prices and purportedly sufferance financial harm as a result.\\nEmbark disputes the allegations in the above-reference matter, intends to defend the matter vigorously, and believes that the claims are without merit. Legal and regulatory proceedings, including the above-reference matter, may be based on complex claims involving substantial uncertainties and unascertainable damages. Accordingly, it is not possible to determine the probability of loss or estimate damages for the above-referenced matter, and therefore, Embark has not established reserves for this proceeding. When Embark determines that a loss is both probable and reasonable estimable, Embark will record a liability, and, if the liability is material, will disclose the amount of the liability reserved. Given that such proceedings are subject to uncertainty, there can be no assurance that legal proceedings individually or in the aggregate will not have a material adverse effect on our business, results of operations, financial condition or cash flows.\\n30\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\\nYou should read the following discussion and analysis of our financial condition and results of operations together with our condensed consolidated financial statements and the related notes appearing elsewhere in this Quarterly Report on Form 10-Q and the Annual Report. In addition to the historical financial information, this discussion contains forward-looking statements that involve risk, assumptions and uncertainties, such as statements of our plans, objectives, expectations, intentions, forecasts and projections. Our actual results and the timing of selected events could differ materially from those discussed in these forward-looking statements as a result of several factors. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Quarterly Report on Form 10-Q, particularly in the section titled “Forward-Looking Statements” above, and in the section entitled “Risk Factors” in the Annual Report.\\nOverview\\nEmbark develops technologically advanced autonomous driving software for the truck freight industry and offers a carefully constructed business model that is expected to provide the industry with the most attractive path to adopting autonomous driving. Specifically, Embark has developed a Software as a Service (“SaaS”) platform designed to interoperate with a broad range of truck OEM platforms, forgoing complicated and logistically challenging truck building or hardware manufacturing operations in favor of focusing on a superior driving technology. At scale, domestic fleets will be able to access Embark technology via a subscription software license selected as an option at the time they specify the build of new semi-trucks.\\nHeadquartered in San Francisco, California, Embark’s history as the industry’s longest running autonomous truck driving program is replete with technological firsts that include, but are not limited to:\\n•the first coast-to-coast autonomous truck drive,\\n•the first to reach 100,000 autonomous miles on public roads, and\\n•the first to successfully open autonomous transfer points for human- autonomous vehicle (“AV”) handoff.\\nEmbark’s founding team includes roboticists and its broader team includes numerous computer scientists, many with advanced degrees and experience at other leading robotics and autonomous vehicle companies and academic programs. Embark intends to rapidly scale its engineering team to build on its industry-leading technology position.\\nEmbark has also spent considerable time and effort refining its business model. Embark is initially deploying its technology in a very focused manner, targeting freight highway miles between transfer points located next to metropolitan areas in the lower “Sunbelt” region of the U.S., leaving the “last mile” of driving to and from the transfer points to the industry’s highly skilled human drivers. Embark’s strategy is distinct from other industry players which seek to provide more complicated “end to end” autonomous driving that would entirely displace human drivers and potentially place these companies in competition with the industry’s carriers. Unlike those competitors, Embark anticipates working with the industry’s existing players to help them bring autonomous driving technology to market on their own terms. In addition, Embark believes its solution will be the safest and most reliable in the industry because of its disciplined geographic focus and emphasis on software development, which stands in contrast to Embark’s competitors that focus on multiple markets simultaneously, manufacturing autonomous trucks and/or competing directly with semi-truck OEMs or legacy carriers.\\nEmbark currently targets the growing $730 billion U.S. truck freight market, and its initial commercial phase targets 236 billion serviceable miles within this market. The freight industry that Embark serves has had to face significant pressures from the growth of e-commerce and the well-documented shortage of skilled drivers, and therefore has powerful incentives to adopt autonomous driving solutions to both improve capacity and reduce costs. In addition, Embark’s cooperative model has already had traction with many of the industry’s leading fleets.\\nThe Business Combination\\nEmbark entered into the Merger Agreement with NGA, a special purpose acquisition company, on June 22, 2021. On November 10, 2021, pursuant to the Merger Agreement, Merger Sub, a newly formed subsidiary of NGA, merged with and into Embark Trucks (the “Business Combination”). In connection with the consummation of the Business Combination, the separate corporate existence of Merger Sub ceased; Embark Trucks survived and became a wholly owned subsidiary of NGA, which was renamed Embark Technology, Inc.\\n31\\nThe Business Combination was accounted for as a reverse recapitalization, in accordance with GAAP. Under the guidance in ASC 805, Embark was treated as the “acquired” company for financial reporting purposes. Embark Trucks was deemed the accounting predecessor of the combined business, and Embark Technology, Inc., as the parent company of the combined business, was the successor SEC registrant, meaning that our financial statements for previous periods will be disclosed in the registrant’s periodic reports filed with the SEC. The Business Combination had a significant impact on Embark’s reported financial position and results as a consequence of the reverse recapitalization. The most significant changes in Embark’s reported financial position and results are a net increase in cash of $243.9 million, net of transaction costs for the Business Combination of $70.2 million. As of March 31, 2022 and December 31, 2021, the Company had warrant liabilities of $27.3 million and $49.4 million, respectively. The Company recorded the change in fair value in warrant liabilities were recorded in the other income (expense) on the condensed consolidated statement of operations.\\nAs a result of the Business Combination, Embark became an SEC-registered and Nasdaq-listed company, which required Embark to hire additional personnel and implement procedures and processes to address public company regulatory requirements and customary practices. Embark incurs additional annual expenses as a public company for, among other things, directors’ and officers’ liability insurance, director fees, and additional internal and external accounting, legal and administrative resources.\\nRecent Developments Affecting Comparability\\nCOVID-19 Impact and the Conflict in Ukraine\\nIn March 2020, the World Health Organization declared the 2019 novel coronavirus (“COVID-19”) a global pandemic. In the United States, as part of government-imposed restrictions, Embark was forced to temporarily pause fleet testing and operations in 2020. Embark also implemented a work-from-home policy for most of its non-operations team. However, a select group of workers remained on-site to continue advancing testing work for its test fleet. Since then, Embark has resumed its fleet testing and operations and has increased headcount to match its research and development requirements.\\nThe future impact of the COVID-19 pandemic on Embark’s operational and financial performance will depend on certain developments, including the duration and end of the pandemic and the occurrence of future outbreaks from new variants, impact on Embark’s research and development efforts, and effect on Embark’s suppliers, all of which are uncertain and cannot be predicted. Public and private sector policies and initiatives to reduce the transmission of COVID-19 and disruptions to Embark’s operations and the operations of Embark’s third-party suppliers, along with the related global slowdown in economic activity, may result in increased costs. It is possible that the COVID-19 pandemic, the measures that have been taken or that may be taken by the federal, state, local authorities and businesses affected by government-mandated business closures, vaccination mandates and the resulting economic impact may materially and adversely affect Embark’s business, results of operations, cash flows and financial positions.\\nWhile we have limited direct business exposure in Russia, Belarus and Ukraine, the Russian military actions and the resulting sanctions could adversely affect the global economy, as well as further disrupt the supply chain. A major disruption in the global economy and supply chain could have a material adverse effect on our business, partners, prospects, financial condition, results of operations, and cash flows. The extent and duration of the military action, sanctions, and resulting market and/or supply disruptions are impossible to predict, but could be substantial.\\nKey Factors Affecting Embark’s Operating Performance\\nEmbark’s financial condition, results of operations, and future success depend on several factors that present significant opportunities for Embark but also pose risks and challenges, including those set forth the section entitled “Risk Factors” in this quarterly report, the section entitled “Risk Factors” in the Annual Report and in as set forth below:\\nEmbark’s Ability to Achieve Key Technical Milestones and Deliver a Commercial Product\\nEmbark’s growth will depend on the introduction of Embark Driver and Embark Guardian products which will drive demand from potential customers. Embark has developed a platform agnostic interface, Embark Universal Interface, which will serve as the foundation to utilize Embark Driver and Guardian products in trucks manufactured by a broad range of OEMs. Embark’s ability to introduce its products will be driven by a variety of factors including Embark’s research and development fleet size, the number of autonomous miles driven (measured as the number of miles driven by Embark’s research & development fleet as well as partner fleet autonomous miles), and the ability to provide a safe and sustainable\\n32\\nsolution based on information gathered from the operation of Embark’s research and development fleet. Embark develops most key technologies in-house to achieve a rapid pace of innovation and tests it extensively through research and development fleet operations. Embark expects an increase in research and development fleet size in the foreseeable future to allow it to strategically focus on innovations, which it believes will help solidify its overall solution to customers and partners. To date, Embark has not generated any revenue and until its products reach commercialization, autonomous miles driven will be comprised of autonomous miles driven by its research and development fleet and the fleet of its partners. Embark believes that as the number of autonomous miles driven increases, the data will continually feed improvements to the platform, allowing it to innovate and introduce new products to the market and increase adoption of its products in the future.\\nEmbark’s Ability to Expand its Coverage Map Across the United States\\nEmbark’s long-term growth potential will benefit from strategic network expansion across the United States. Network breadth is measured by the number of transfer points on Embark’s coverage map, which are representative of the cities which Embark plans to support. Embark expects to achieve significant network growth by partnering with key real-estate partners which will enable it to quickly bring their properties into its coverage map. Additionally, Embark will partner with carriers and shippers who currently move, or have in the past moved, a significant amount of freight on Embark’s network to add their properties to the network. Embark believes that expanding its network will enable it to create a significant and sustainable competitive advantage. Embark believes that the continued growth of its partnerships will improve user experience and drive more users to its platform, which it believes will allow it to further densify its coverage map and reinforce rapid network growth. Embark will apply a highly scalable model nationally, with a tailored approach to each state, driven by the regulatory environment and local market dynamics. Embark believes that this will allow it to expand rapidly and efficiently across different geographies, while maintaining a high level of control over the specific strategy within each state.\\nEmbark’s Ability to Expand its Partner Network\\nThe growth of Embark’s business model is focused on driving the adoption of its technical products and maximizing their use across Embark’s partners’ operations. This is achieved by working closely with carrier management teams to prepare them to deploy and scale autonomous trucks. In April 2021, Embark formally announced the Embark Partner Development Program (PDP), which serves as the basis of its partnership network. The PDP is comprised of carriers and shippers from across the freight ecosystem working with Embark to refine and scale Embark’s offerings. Most recently, Embark announced the industry-first Truck Transfer Program to place Embark technology in the hands of Knight-Swift drivers.\\nAdoption and Support of Autonomous Technology in the Freight Industry\\nEmbark’s business model is supported by a large addressable market that Embark believes will benefit from the introduction of autonomous trucking technology. The freight industry is currently facing significant challenges, notably driver shortages and utilization limitations, which it believes it will address through its product offerings. Embark has identified participants from across the freight ecosystem who have expressed support for Embark’s offerings and the potential solutions they provide to the challenges they are facing.\\nWhile Embark has confirmed general market support, the long-term success of its business model is dependent on broad scale adoption and support of autonomous trucking technology. Embark has engaged with notable partners in the freight industry who Embark believes will lead the industry in adopting autonomous vehicle technology. As Embark onboards more partners, it will increase miles driven by partners, which Embark believes will serve to validate its product offerings and generate interest and confidence from other partners. Embark believes customers will be motivated to integrate Embark’s technology to be price competitive with other freight participants who have achieved efficiencies with it.\\nKey Components of Embark’s Results of Operations\\nThe following discussion describes certain line items in Embark’s condensed consolidated statements of operations.\\n33\\nOperating Expenses\\nOperating expenses consist of research and development expenses and general and administrative expenses. Personnel-related costs are the most significant component of Embark’s operating expenses and include salaries, benefits, and stock-based compensation expenses.\\nEmbark’s full-time employee headcount in research and development has grown from 172 as of December 31, 2021 to 242 as of March 31, 2022 and in general and administrative functions has grown from 59 as of December 31, 2021 to 62 as of March 31, 2022. Embark expects to continue to hire new employees to support our growth. The timing of these additional hires could materially affect Embark’s operating expenses in any particular period.\\nEmbark expects to continue to invest substantial resources to support its growth and anticipates that each of the following categories of operating expenses will increase in absolute dollar amounts for the foreseeable future.\\nResearch and Development Expenses\\nResearch and development expenses consist primarily of salaries, employee benefits, stock-based compensation expenses and travel expenses related to Embark’s engineers performing research and development activities to originate, develop and enhance Embark’s products. Additional expenses include consulting charges, component purchases, software licenses and other costs for performing research and development on Embark’s software products.\\nGeneral and Administrative Expenses\\nGeneral and administrative expenses consist primarily of salaries, employee benefits, stock-based compensation expenses, and travel expenses related to Embark’s executives, finance team, and the administrative employees. They also consists of legal, accounting, consulting, and professional fees, rent and lease expenses pertaining to Embark’s offices, business insurance costs and other costs. Embark expects its general and administrative expenses to increase for the foreseeable future as it scales headcount with the growth of its business, and as a result of operating as a public company, including as a result of compliance with the rules and regulations of the SEC, legal, audit, tax and other administrative and professional services.\\nResults of Operations\\nThe results of operations presented below should be reviewed in conjunction with the financial statements and notes included elsewhere in this Quarterly Report on Form 10-Q. The following table sets forth Embark’s results of operations data for the periods presented (in thousands):\\nComparisons for the three months ended March 31, 2022 and 2021\\nThe following table sets forth Embark’s condensed consolidated results of operations data for the periods presented (in thousands):\\n| Three Months Ended | $ | % |\\n| 2022 | 2021 | Change | Change |\\n| Operating expenses: |\\n| Research and development | $ | 18,695 | $ | 6,231 | $ | 12,464 | 200.0 | % |\\n| General and administrative | 21,926 | 2,290 | 19,636 | 857.5 | % |\\n| Total operating expenses | 40,621 | 8,521 | 32,100 | 376.7 | % |\\n| Loss from operations | (40,621) | (8,521) | (32,100) | 376.7 | % |\\n| Other income, net | 22,174 | 39 | 22,135 | N.M. |\\n| Loss before provision for income taxes | (18,447) | (8,482) | (9,965) | 117.5 | % |\\n| Provision for income taxes | — | — | — | N.M. |\\n| Net loss | $ | (18,447) | $ | (8,482) | $ | (9,965) | 117.5 | % |\\n\\n_________________________________________________\\nN.M. — Percentage change not meaningful\\n34\\nResearch and Development Expenses\\nResearch and development expense increased by $12.5 million in the three months ended March 31, 2022, compared to the three months ended March 31, 2021. The increase was primarily due to $8.8 million higher headcount expenses including stock-based compensation, salaries and employee benefits, related to continued expansion of Embark’s research and development team, a $0.2 million increase in infrastructure expenditure related to increased R&D activities, a $0.3 million increase in prototype truck hardware expenses, a $1.8 million increase in general R&D costs primarily driven by engineering software & subscription costs and a $0.2 million increase in computer and equipment expenditure related to an increase in Embark’s research and development team.\\nGeneral and Administrative Expense\\nGeneral and administrative expense increased by $19.6 million in the three months ended March 31, 2022, compared to the three months ended March 31, 2021. The increase was primarily due to $16.5 million higher headcount expenses including stock-based compensation, salaries and employee benefits, related to growth in the business, a $0.5 million increase in occupancy expenses related to additional leases, a $0.2 million increase in fleet operation expenses due to increased activity, a $0.6 million increase in insurance expenses and a $0.3 million increase in travel and events expenditure.\\nOther income (expense), net\\nOther income increased by $22.1 million in the three months ended March 31, 2022 compared to the three months ended March 31, 2021. The increase was primarily due to the change in the estimated fair value of Public, Private, Working Capital and FPA Warrants of $22.2 million.\\nLiquidity and Capital Resources\\nSince Embark’s inception, it has financed its operations primarily through the sale of shares of common stock and preferred stock.\\nIn connection with the Business Combination, a convertible promissory note (the “Convertible Note”) issued by Embark in April 2021 was converted in exchange for 3,774,951 shares of Embark Class A common stock. As of March 31, 2022, Embark had outstanding debt of $1.0 million from a financing of freight trucks that it utilizes for research and development. Embark makes monthly installment payments on its truck financing arrangements. The truck financings have varying maturities between March 2023 and January 2027. Embark’s principal uses of cash in recent periods have been to fund its operations, invest in research and development, repay borrowings, and make investments in accordance with its investments policy.\\nEmbark believes existing cash and other components of working capital will be sufficient to meet its needs for at least the next 12 months. Embark’s long-term capital requirements will depend on many factors including timing and extent of spending to support research and development efforts as well as general and administrative activities for the business. If, at any time, Embark determines it requires more capital to execute upon its business plan, and /or that market conditions are favorable, Embark may seek additional equity or debt financing. Additionally, in the event Embark may in the future enter into arrangements to acquire or invest in related products, technologies, software and services, and Embark may need to seek additional equity or debt financing to support such growth. As of March 31, 2022, there were future minimum lease payments of $7.1 million.\\nEmbark currently transports shipments using its research and development truck fleet, demonstrating proof of concept and paving the way for commercialization and revenue generating operations in the future. However, Embark has not earned any revenue to date, and had $244.5 million in cash and cash equivalents and an accumulated deficit of $201.4 million as of March 31, 2022. To the extent Embark is unable to commercialize its technology as expected, its liquidity may be negatively impacted.\\nEmbark’s ability to continue as a going concern is dependent on management’s ability to control operating costs and demonstrate progress against its technical roadmap. This involves developing new capabilities for the Embark Driver software and improving the reliability and performance of the software on public roads. Demonstrating ongoing technical progress will enable Embark to obtain funds from outside sources of financing, including financing from equity interest investors and borrow funds to fund its general operations, research and development activities and capital expenditures.\\n35\\nThe following table shows Embark’s cash flows from operating activities, investing activities and financing activities for the stated periods:\\n| Three Months Ended March 31, |\\n| 2022 | 2021 |\\n| Net cash (used in) provided by: | (unaudited) |\\n| Operating activities | $ | (18,225) | $ | (6,791) |\\n| Investing activities | $ | (1,717) | $ | 17,270 |\\n| Financing activities | $ | 287 | $ | 28 |\\n\\nOperating Activities\\nNet cash used in operating activities for the three months ended March 31, 2022 was $18.2 million, an increase of $11.4 million from $6.8 million for the three months ended March 31, 2021. The increase was primarily due to an increase of $10.0 million net loss for the three months ended March 31, 2022 compared to the three months ended March 31, 2021. In addition, the increase was partially attributable to $5.7 million of non-cash adjustments to net loss, including $0.6 million of depreciation and amortization, $22.2 million of change in fair value of warrant liability, as well as $16.0 million of stock-based compensation, and partially offset by $4.2 million net cash increase by changes in Embark’s operating assets and liabilities, which was primarily attributable to accounts payable, accrued expenses and other current liabilities primarily due to overall growth and timing of payables.\\nInvesting Activities\\nNet cash used in investing activities for the three months ended March 31, 2022 was $1.7 million, a decrease of $19.0 million from $17.3 million of net cash provided by investing activities for the three months ended March 31, 2021. The decrease was primarily due to a decrease of $18.2 million in proceeds received from maturities of investments, and an increase in purchase of property, equipment, and software of $0.7 million.\\nFinancing Activities\\nNet cash provided by financing activities for the three months ended March 31, 2022 was $0.3 million compared to $28,000 of net cash used in investing activities for the three months ended March 31, 2021. The increase was primarily due to an increase of $0.3 million in proceeds received from the exercise of employee stock options.\\nFinancing Arrangements\\nThere have been no material changes outside the ordinary course of business in Embark’s financing arrangements as previously disclosed in Embark’s Annual Report.\\nOff-Balance Sheet Arrangements\\nEmbark did not have any off-balance sheet arrangements as of March 31, 2022.\\nCritical Accounting Policies and Significant Management Estimates\\nThe preparation financial statements in conformity with generally accepted accounting principles requires management to make judgments, estimates and assumptions in the preparation of Embark’s financial statements and accompanying notes. Actual results could differ from those estimates. There have been no material changes to Embark’s critical accounting policies or estimates during the three months ended March 31, 2022, from those discussed in Embark’s Annual Report.\\nRecent Accounting Pronouncements\\n36\\nFor information on recently issued accounting pronouncements, refer to Note 2. Summary of Significant Accounting Policies in Embark’s condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.\\nJOBS Act Accounting Election\\nEmbark is an emerging growth company (EGC), as defined in the JOBS Act. Under the JOBS Act, EGCs can delay adopting new or revised accounting standards until such time as those standards apply to private companies. Embark intends to elect to adopt new or revised accounting standards under private company adoption timelines. Accordingly, the timing of Embark’s adoption of new or revised accounting standards will not be the same as other public companies that are not emerging growth companies or that have opted out of using such extended transition period.\\nItem 3. Quantitative and Qualitative Disclosures About Market.\\nEmbark is exposed to certain market risks as part of its ongoing business operations.\\nCredit Risk\\nEmbark is exposed to credit risk on its investment portfolio. Investments that potentially subject us to credit risk consist principally of cash and investments in debt securities. Embark places cash and cash equivalents with financial institutions with high credit standing and excess cash in marketable investment grade debt securities.\\nInterest Rate Risk\\nEmbark is exposed to interest rate risk on its investment portfolio. Investments that potentially subject Embark to interest rate risk consist principally of cash and investments in debt securities. As of March 31, 2022, Embark has cash and cash equivalents of $244.5 million, consisting of U.S. Treasury securities and interest-bearing money market accounts for which the fair market value would be affected by changes in the general level of U.S. interest rates. However, due to the short-term maturities and the low-risk profile of Embark’s investments, an immediate 10% change in interest rates would not have a material effect on the fair market value of its cash, cash equivalents, and investments.\\nInflation Risk\\nEmbark is exposed to impact of wage inflation, and has experienced wage inflation during 2021. Although wages have increased during 2021, and the continuing supply chain crisis and geopolitical conflict in Ukraine may contribute to continuing inflation, Embark does not believe that inflation has had a material effect on its business, results of operations, or financial condition. If Embark’s costs were to become subject to more significant inflationary pressures before we commercialize and sell our technology, we will not be able to offset such higher costs through price increases. Embark’s inability to do so could harm its business, results of operations, and financial condition.\\nItem 4. Controls and Procedures\\nEvaluation of Disclosure Controls and Procedures\\nOur management, with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, our CEO and CFO concluded that, as of March 31, 2022, due to the material weakness described in the Annual Report, our disclosure controls and procedures were not effective.\\nAs disclosed in Part II, Item 9A, “Controls and Procedures” in our Annual Report, we identified a material weakness in our internal control over financial reporting resulting from a lack of sufficient number of qualified personnel within our accounting function who possessed an appropriate level of expertise to effectively perform the following functions:\\n•identify, select and apply GAAP sufficiently to provide reasonable assurance that transactions were being appropriately recorded; and\\n37\\n•assess risk and design appropriate control activities over information technology systems and financial and reporting processes necessary to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements.\\nStatus of remediation efforts\\nIn response to the material weaknesses identified and described above, our management, with the oversight of the Audit Committee of our Board of Directors, will continue through 2022 to dedicate significant efforts and resources to further improve our control environment and to take steps to remediate these material weaknesses.\\nChanges in Internal Control Over Financial Reporting\\nExcept for changes in connection with our implementation of the remediation measures or as described above, there were no changes in our internal control over financial reporting during the three months ended March 31, 2022, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\n38\\nPart II - OTHER INFORMATION\\nItem 1. Legal Proceedings\\nFrom time to time, Embark may be involved in actions, claims, suits, and other proceedings in the ordinary course of its business. In addition, from time to time, third parties may in the future assert intellectual property infringement claims against Embark in the form of letters and other forms of communication. Litigation or any other legal or administrative proceeding, regardless of the outcome, can result in substantial cost and diversion of its resources, including its management’s time and attention. Such matters are subject to uncertainty and there can be no assurance that such legal proceedings will not have a material adverse effect on our business, the results of operations, financial position or cash flows.\\nOn April 1, 2022, Tyler Hardy filed a putative securities class action lawsuit against Embark and certain of our executive officers and the former executive officers of Northern Genesis Acquisition Corp., captioned Hardy v. Embark Technology, Inc., et al., Case No. 3:22-cv-02090-JSC, in the United States District Court for the Northern District of California, purportedly on behalf of a class consisting of those who purchased or otherwise acquired Embark common stock between January 12, 2021 and January 5, 2022. The complaint alleges that defendants made false and/or misleading statements in violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. Plaintiff Hardy does not quantify any damages in the complaint, but in addition to attorneys’ fees and costs, seeks to recover damages on behalf of himself and other persons who purchased or otherwise acquired Embark stock during the putative class period at allegedly inflated prices and purportedly suffered financial harm as a result.\\nEmbark disputes the allegations in the above-reference matter, intends to defend the matter vigorously, and believes that the claims are without merit. Legal and regulatory proceedings, including the above-referenced matter, may be based on complex claims involving substantial uncertainties and unascertainable damages. Accordingly, it is not possible to determine the probability of loss or estimate damages for the above-referenced matter, and therefore, Embark has not established reserves for this proceeding. When Embark determines that a loss is both probable and reasonably estimable, Embark will record a liability, and, if the liability is material, will disclose the amount of the liability reserved. Given that such proceedings are subject to uncertainty, there can be no assurance that legal proceedings individually or in the aggregate will not have a material adverse effect on our business, results of operations, financial condition or cash flows.\\nItem 1A. Risk Factors\\nThere are no material changes to the risk factors discussed in Embark’s Annual Report under the heading “Risk Factors.” You should carefully consider these risks, together with management’s discussion and analysis of Embark’s financial condition and results of operations in conjunction with the condensed consolidated financial statements and the notes thereto included elsewhere in this Quarterly Report on Form 10-Q. If any of the events contemplated should occur, Embark’s business, results of operations, financial condition and cash flows could suffer significantly.\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\\nNone.\\nItem 3. Defaults Upon Senior Securities\\nNone.\\nItem 4. Mine Safety Disclosures\\nNot Applicable.\\nItem 5. Other Information\\nNone.\\n39\\nItem 6. Exhibits\\n| Incorporated by Reference |\\n| ExhibitNumber | Description | Form | File No. | Date | Exhibit | Filed Herewith |\\n| 2.1+ | Agreement and Plan of Merger, dated as of June 22, 2021, by and among Northern Genesis Acquisition Corp. II, NGAB Merger Sub Inc. and Embark Trucks Inc. | 8-K | 001-39881 | 6/23/2021 | 2.1 |\\n| 3.1 | Second Amended and Restated Certificate of Incorporation of Northern Genesis Acquisition Corp. II. | 8-K | 001-39881 | 11/17/2021 | 3.1 |\\n| 3.2 | Amended and Restated Bylaws of Embark Technology, Inc. | 8-K | 001-39881 | 11/17/2021 | 3.2 |\\n| 4.1 | Specimen Warrant Certificate of Embark Technology, Inc. | S-4 | 333-257647 | 10/13/2021 | 4.5 |\\n| 4.2 | Specimen Class A Common Stock Certificate of Embark Technology, Inc. | S-4 | 333-257647 | 10/13/2021 | 4.6 |\\n| 4.3 | Warrant Agreement, dated as of January 12, 2021, by and among Northern Genesis Acquisition Corp. II and Continental Stock Transfer & Trust Company, as warrant agent. | 8-K | 001-39881 | 1/19/2021 | 4.1 |\\n| 31.1** | Certification of Principal Executive Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | X |\\n| 31.2** | Certification of Principal Financial Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | X |\\n| 32.1** | Certification of Principal Executive Officer and Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | X |\\n| 101.INS | Inline XBRL Instance Document – the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRIL document. | X |\\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document. | X |\\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document. | X |\\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document. | X |\\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document. | X |\\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document. | X |\\n| 104 | Cover Page Interactive Data File - the cover page interactive data file does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL Document. | X |\\n\\n________________________\\n* Filed herewith.\\n** Furnished herewith. The certifications attached as Exhibit 31.1, Exhibit 31.2 and Exhibit 32.1 that accompanies this Quarterly Report on Form 10-Q is deemed furnished and not filed with the Securities and Exchange Commission and is not to be incorporated by reference into any filing of Embark Technology, Inc. under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this Quarterly Report on Form 10-Q, irrespective of any general incorporation language contained in such filing.\\n+ Schedules and exhibits have been omitted pursuant to Item 601(b)(2) of Regulation S-K. The Registrant agrees to furnish supplementally a copy of any omitted schedule or exhibit to the SEC upon request.\\n40\\nSIGNATURES\\nPursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the registrant has duly caused this Quarterly Report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized, on May 11, 2022.\\n| EMBARK TECHNOLOGY, INC. |\\n| By: | /s/ Alex Rodrigues |\\n| Name: | Alex Rodrigues |\\n| Title: | Chief Executive Officer |\\n| (Principal Executive Officer) |\\n\\n| EMBARK TECHNOLOGY, INC. |\\n| By: | /s/ Richard Hawwa |\\n| Name: | Richard Hawwa |\\n| Title: | Chief Financial Officer |\\n| (Principal Financial and Principal Accounting) |\\n\\n41\\n \\n\\nWhat is the year on year percentage change in the Accumulated Deficit for the first quarter of 2022 compared to the first quarter of 2021?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is -199.75287322098495.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 41,\n \"input_length\": 27711\n}"}}},{"rowIdx":42,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nItem 1. Financial Statements\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED BALANCE SHEETS\n\n| June 30, | December 31, |\n| 2023 | 2022 |\n| (unaudited) |\n| Assets |\n| Current Assets |\n| Cash | $ | 810,139 | $ | 300,185 |\n| Accounts receivable, net of allowance of $ 14,600 and $ 21,229 at June 30, 2023 and December 31, 2022, respectively | 58,944 | 106,156 |\n| Accounts receivable - related parties, net of allowance of $ 470,516 and $ 339,503 at June 30, 2023 and December 31, 2022, respectively | 1,075,102 | 1,115,816 |\n| Accounts receivable | 1,075,102 | 1,115,816 |\n| Mortgages receivable, net of allowance $ 55,682 and $ 46,424 at June 30, 2023 and December 31, 2022, respectively | 729,833 | 586,631 |\n| Inventory | 1,960,988 | 1,888,962 |\n| Real estate lots held for sale | 445,412 | 559,487 |\n| Prepaid expenses and other current assets | 423,658 | 461,637 |\n| Total Current Assets | 5,504,076 | 5,018,874 |\n| Long Term Assets |\n| Mortgages receivable, non-current portion, net of allowance of $ 178,541 and $ 150,126 at June 30, 2023 and December 31, 2022, respectively | 3,091,222 | 3,278,617 |\n| Advances to employees | 281,783 | 282,055 |\n| Property and equipment, net | 7,857,485 | 7,621,257 |\n| Operating lease right-of-use asset | 1,335,698 | 1,449,442 |\n| Prepaid foreign taxes, net | 985,470 | 916,823 |\n| Intangible assets, net | 108,967 | 69,787 |\n| Deposits, non-current | 54,713 | 56,130 |\n| Total Assets | $ | 19,219,414 | $ | 18,692,985 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 1 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED BALANCE SHEETS, CONTINUED\n\n| June 30, | December 31, |\n| 2023 | 2022 |\n| (unaudited) |\n| Liabilities and Stockholders’ Equity |\n| Current Liabilities |\n| Accounts payable | $ | 691,739 | $ | 917,270 |\n| Accrued expenses, current portion | 1,258,163 | 1,664,816 |\n| Deferred revenue | 1,368,921 | 1,373,906 |\n| Operating lease liabilities, current portion | 220,416 | 202,775 |\n| Loans payable, current portion | 252,014 | 164,656 |\n| Convertible debt obligations, net, current portion | 3,372,291 | - |\n| Derivative liability, current portion | 2,088,617 |\n| Other current liabilities | 80,200 | 100,331 |\n| Total Current Liabilities | 9,332,361 | 4,423,754 |\n| Long Term Liabilities |\n| Accrued expenses, non-current portion | 81,638 | 66,018 |\n| Operating lease liabilities, non-current portion | 1,212,641 | 1,328,408 |\n| Loans payable, non-current portion | 90,468 | 91,665 |\n| Convertible debt obligations, net, non-current portion | 84,674 | 1,991,459 |\n| Derivative liability | 52,500 | - |\n| Total Liabilities | 10,854,282 | 7,901,304 |\n| Commitments and Contingencies (Note 15) | - | - |\n| Stockholders’ Equity |\n| Preferred stock, 902,670 shares authorized | - | - |\n| Common stock, par value $ 0.01 per share; 150,000,000 shares authorized; 6,809,348 and 3,653,401 shares issued and 6,809,067 and 3,653,120 shares outstanding as of June 30, 2023 and December 31, 2022, respectively | 68,091 | 36,534 |\n| Additional paid-in capital | 144,532,185 | 139,123,642 |\n| Accumulated other comprehensive loss | ( 10,920,361 | ) | ( 10,842,569 | ) |\n| Accumulated deficit | ( 125,268,428 | ) | ( 117,479,571 | ) |\n| Treasury stock, at cost, 281 shares at June 30, 2023 and December 31, 2022 | ( 46,355 | ) | ( 46,355 | ) |\n| Total Stockholders’ Equity | 8,365,132 | 10,791,681 |\n| Total Liabilities and Stockholders’ Equity | $ | 19,219,414 | $ | 18,692,985 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 2 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\n(unaudited)\n\n| 2023 | 2022 | 2023 | 2022 |\n| For the Three Months Ended | For the Six Months Ended |\n| June 30, | June 30, |\n| 2023 | 2022 | 2023 | 2022 |\n| Sales | $ | 710,975 | $ | 405,335 | $ | 1,158,742 | $ | 830,932 |\n| Cost of sales | ( 668,619 | ) | ( 533,466 | ) | ( 961,918 | ) | ( 771,593 | ) |\n| Gross profit (loss) | 42,356 | ( 128,131 | ) | 196,824 | 59,339 |\n| Operating Expenses |\n| Selling and marketing | 213,157 | 333,410 | 447,736 | 505,230 |\n| General and administrative | 1,710,505 | 1,928,892 | 3,467,193 | 3,674,126 |\n| Depreciation and amortization | 104,281 | 49,000 | 213,487 | 95,219 |\n| Total operating expenses | 2,027,943 | 2,311,302 | 4,128,416 | 4,274,575 |\n| Loss from Operations | ( 1,985,587 | ) | ( 2,439,433 | ) | ( 3,931,592 | ) | ( 4,215,236 | ) |\n| Other Expense (Income) |\n| Interest income | ( 64,375 | ) | ( 26,552 | ) | ( 114,719 | ) | ( 30,404 | ) |\n| Interest expense | 1,065,620 | 694,708 | 1,667,912 | 1,452,780 |\n| Other income, related party | ( 75,000 | ) | ( 75,000 | ) | ( 150,000 | ) | ( 150,000 | ) |\n| Loss on extinguishment of debt | 32,094 | 2,105,119 | 416,081 | 2,105,119 |\n| Gains from foreign currency translation | ( 102,916 | ) | ( 43,005 | ) | ( 214,708 | ) | ( 225,927 | ) |\n| Change in fair value of derivative liability | 2,141,117 | - | 2,141,117 | - |\n| Inducement expense | - | 198,096 | - | 198,096 |\n| Total other expense | 2,996,540 | 2,853,366 | 3,745,683 | 3,349,664 |\n| Net Loss | ( 4,982,127 | ) | ( 5,292,799 | ) | ( 7,677,275 | ) | ( 7,564,900 | ) |\n| Net loss attributable to non-controlling interest | - | - | - | 72,261 |\n| Net Loss Attributable to Common Stockholders | $ | ( 4,982,127 | ) | $ | ( 5,292,799 | ) | $ | ( 7,677,275 | ) | $ | ( 7,492,639 | ) |\n| Net Loss per Common Share |\n| Basic and Diluted | $ | ( 0.80 | ) | $ | ( 4.80 | ) | $ | 1.41 | ) | $ | ( 7.59 | ) |\n| Weighted Average Number of Common Shares Outstanding: |\n| Basic and Diluted | 6,236,737 | 1,103,130 | 5,453,539 | 987,109 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 3 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME\n(unaudited)\n\n| 2023 | 2022 | 2023 | 2022 |\n| For the Three Months Ended | For the Six Months Ended |\n| June 30, | June 30, |\n| 2023 | 2022 | 2023 | 2022 |\n| Net loss | $ | ( 4,982,127 | ) | $ | ( 5,292,799 | ) | $ | ( 7,677,275 | ) | $ | ( 7,564,900 | ) |\n| Other comprehensive (loss) income : |\n| Foreign currency translation adjustments | ( 37,993 | ) | 358,056 | ( 77,792 | ) | 621,462 |\n| Comprehensive loss | $ | ( 5,020,120 | ) | $ | ( 4,934,743 | ) | $ | ( 7,755,067 | ) | $ | ( 6,943,438 | ) |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 4 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDER’S EQUITY\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2023\n(unaudited)\n\n| Common Stock | Treasury Stock | Additional Paid-In | Accumulated Other Comprehensive | Accumulated | Total Stockholders’ |\n| Shares | Amount | Shares | Amount | Capital | Loss | Deficit | Equity |\n| Balance - January 1, 2023 | 3,653,401 | $ | 36,534 | 281 | $ | ( 46,355 | ) | $ | 139,123,642 | $ | ( 10,842,569 | ) | $ | ( 117,479,571 | ) | - | - | $ | 10,791,681 |\n| Cumulative effect of change upon adoption of ASU 2016-13 | - | - | - | - | - | - | ( 111,582 | ) | - | - | ( 111,582 | ) |\n| Stock-based compensation: |\n| Options | - | - | - | - | 38,834 | - | - | 38,834 |\n| Restricted stock units | 3,890 | 39 | - | - | 79,383 | - | - | 79,422 |\n| Common stock issued for 401(k) employer matching | 24,160 | 242 | - | - | 32,375 | - | - | 32,617 |\n| Shares issued under the New ELOC, net of offering costs [1] | 364,430 | 3,644 | - | - | 437,765 | - | - | 441,409 |\n| Relative fair value of warrants issued with 2023 Note, net of issuance costs [2] | - | - | - | - | 1,506,319 | - | - | 1,506,319 |\n| Warrants issued for modification of GGH Notes | - | - | - | - | 134,779 | - | - | 134,779 |\n| Reduction of warrant exercise price on new debt issuance | - | - | - | - | 63,502 | - | - | 63,502 |\n| Shares issued upon conversion of debt and interest | 833,333 | 8,333 | - | - | 1,563,220 | - | - | 1,571,553 |\n| Common stock issued for cash in private placement | 591,000 | 5,910 | - | - | 585,090 | - | - | 591,000 |\n| Cashless warrant exercise | 51,305 | 513 | - | - | ( 513 | ) | - | - | - |\n| True-up adjustment | 281 | - | - | - | - | - | - | - |\n| Net loss | - | - | - | - | - | - | ( 2,695,148 | ) | - | - | ( 2,695,148 | ) |\n| Other comprehensive loss | - | - | - | - | - | ( 39,799 | ) | - | ( 39,799 | ) |\n| Balance - March 31, 2023 | 5,521,800 | 55,215 | 281 | ( 46,355 | ) | 143,564,396 | ( 10,882,368 | ) | ( 120,286,301 | ) | - | - | 12,404,587 |\n| Stock-based compensation: |\n| Options | - | - | - | - | 38,834 | - | - | 38,834 |\n| Restricted stock units | - | - | - | - | 74,978 | - | - | 74,978 |\n| Shares issued under the New ELOC, net of offering costs [3] | 458,768 | 4,588 | - | - | 287,009 | - | - | 291,597 |\n| Shares issued upon conversion of debt and interest | 828,780 | 8,288 | - | - | 566,968 | - | - | 575,256 |\n| Net loss | - | - | - | - | - | - | ( 4,982,127 | ) | - | - | ( 4,982,127 | ) |\n| Other comprehensive loss | - | - | - | - | - | ( 37,993 | ) | - | ( 37,993 | ) |\n| Balance - June 30, 2023 | 6,809,348 | $ | 68,091 | 281 | $ | ( 46,355 | ) | $ | 144,532,185 | $ | ( 10,920,361 | ) | $ | ( 125,268,428 | ) | - | - | $ | 8,365,132 |\n\n\n| [1] | Includes gross proceeds of $ 480,670 , less $ 39,261 offering costs |\n\n| [2] | Represents $ 1,609,935 relative fair value of warrants, less $ 103,616 of allocable issuance costs |\n\n| [3] | Includes gross proceeds of $ 316,953 , less $ 25,356 offering costs |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 5 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDER’S EQUITY\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2022\n(unaudited)\n\n| Common Stock | Treasury Stock | Additional Paid-In | Accumulated Other Comprehensive | Accumulated | Gaucho Group Holdings Stockholders’ | Non- controlling | Total Stockholders’ |\n| Shares | Amount | Shares | Amount | Capital | Loss | Deficit | Deficiency | Interest | Equity |\n| Balance - January 1, 2022 | 823,496 | $ | 8,235 | 281 | $ | ( 46,355 | ) | $ | 121,633,826 | $ | ( 11,607,446 | ) | $ | ( 95,726,534 | ) | $ | 14,261,726 | $ | ( 169,882 | ) | $ | 14,091,844 |\n| Stock-based compensation: |\n| Options | - | - | - | - | 72,700 | - | - | 72,700 | 10,354 | 83,054 |\n| Common stock issued for 401(k) employer matching | 1,040 | 10 | - | - | 27,811 | - | - | 27,821 | - | 27,821 |\n| Common stock issued for purchase of minority interest | 86,899 | 869 | - | - | ( 232,658 | ) | - | - | ( 231,789 | ) | 231,789 | - |\n| Common stock issued for acquisition of GDS | 106,952 | 1,070 | - | - | 2,193,583 | - | - | 2,194,653 | - | 2,194,653 |\n| Common stock issued for purchase of domain name | 1,250 | 13 | - | - | 39,587 | - | - | 39,600 | - | 39,600 |\n| Warrants issued for modification of convertible debt principal | - | - | - | - | 731,856 | - | - | 731,856 | - | 731,856 |\n| Net loss | - | - | - | - | - | - | ( 2,199,840 | ) | ( 2,199,840 | ) | ( 72,261 | ) | ( 2,272,101 | ) |\n| Other comprehensive income | - | - | - | - | - | 263,406 | - | 263,406 | - | 263,406 |\n| Balance - March 31, 2022 | 1,019,637 | 10,197 | 281 | ( 46,355 | ) | 124,466,705 | ( 11,344,040 | ) | ( 97,926,374 | ) | 15,160,133 | - | 15,160,133 |\n| Balance | 1,019,637 | 10,197 | 281 | ( 46,355 | ) | 124,466,705 | ( 11,344,040 | ) | ( 97,926,374 | ) | 15,160,133 | - | 15,160,133 |\n| Stock-based compensation: |\n| Options | - | - | - | - | 87,134 | - | - | 87,134 | - | 87,134 |\n| Common stock | 54,214 | 542 | - | - | 524,458 | - | - | 525,000 | - | 525,000 |\n| Shares issued upon conversion of debt and interest | 74,589 | 746 | - | - | 1,521,851 | - | - | 1,522,597 | - | 1,522,597 |\n| Inducement loss on debt conversions | - | - | - | - | 198,096 | - | - | 198,096 | - | 198,096 |\n| Substantial premium on convertible debt | - | - | - | - | 1,683,847 | - | - | 1,683,847 | - | 1,683,847 |\n| Common stock issued for cash, net of offering costs | 50,049 | 500 | - | - | 510,846 | - | - | 511,346 | - | 511,346 |\n| Common stock issued upon exchange of subsidiary stock options | 183,942 | 1,839 | - | - | ( 1,839 | ) | - | - | - | - | - |\n| True up adjustment | 41 | - | - | - | - | - | - | - | - | - |\n| Net loss | - | - | - | - | - | - | ( 5,292,799 | ) | ( 5,292,799 | ) | - | ( 5,292,799 | ) |\n| Other comprehensive income | - | - | - | - | - | 358,056 | - | 358,056 | - | 358,056 |\n| Balance - June 30, 2022 | 1,382,472 | $ | 13,824 | 281 | $ | ( 46,355 | ) | $ | 128,991,098 | $ | ( 10,985,984 | ) | $ | ( 103,219,173 | ) | $ | 14,753,410 | $ | - | $ | 14,753,410 |\n| Balance | 1,382,472 | $ | 13,824 | 281 | $ | ( 46,355 | ) | $ | 128,991,098 | $ | ( 10,985,984 | ) | $ | ( 103,219,173 | ) | $ | 14,753,410 | $ | - | $ | 14,753,410 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 6 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(unaudited)\n\n| 2023 | 2022 |\n| For the Six Months Ended |\n| June 30, |\n| 2023 | 2022 |\n| Cash Flows from Operating Activities |\n| Net loss | $ | ( 7,677,275 | ) | $ | ( 7,564,900 | ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: |\n| Stock-based compensation: |\n| 401(k) stock | 5,908 | 22,384 |\n| Common stock | - | 525,000 |\n| Stock options and warrants | 77,668 | 170,188 |\n| Restricted stock units | 154,400 | - |\n| Noncash lease expense | 113,744 | 107,343 |\n| Gain on foreign currency translation | ( 214,708 | ) | ( 225,927 | ) |\n| Depreciation and amortization | 213,487 | 95,219 |\n| Amortization of debt discount | 1,079,034 | 1,061,936 |\n| Provision for credit losses | 57,104 | 28,848 |\n| Provision for obsolete inventory | 99,323 | - |\n| Change in fair value of derivative liability | 2,141,117 |\n| Loss on extinguishment of debt | 416,081 | 2,105,119 |\n| Inducement expense | - | 198,096 |\n| Decrease (increase) in assets: |\n| Accounts receivable and mortgages receivable | ( 126,017 | ) | ( 137,652 | ) |\n| Employee advances | ( 571 | ) | 4,964 |\n| Inventory | ( 57,274 | ) | ( 84,917 | ) |\n| Deposits | 1,417 | - |\n| Prepaid expenses and other current assets | ( 30,668 | ) | ( 201,778 | ) |\n| Increase (decrease) in liabilities: |\n| Accounts payable and accrued expenses | ( 162,671 | ) | 774,709 |\n| Operating lease liabilities | ( 98,126 | ) | ( 82,296 | ) |\n| Deferred revenue | ( 4,985 | ) | 517,741 |\n| Other liabilities | ( 20,131 | ) | ( 68,633 | ) |\n| Total Adjustments | 3,644,132 | 4,810,344 |\n| Net Cash Used in Operating Activities | ( 4,033,143 | ) | ( 2,754,556 | ) |\n| Cash Flow from Investing Activities |\n| Cash paid to acquire Gaucho Development S.R.L., net of cash acquired | - | ( 7,560 | ) |\n| Purchase of property and equipment | ( 438,895 | ) | ( 1,677,082 | ) |\n| Purchase of intangible asset | ( 50,000 | ) | ( 34,999 | ) |\n| Net Cash Used in Investing Activities | ( 488,895 | ) | ( 1,719,641 | ) |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 7 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED\n(unaudited)\n\n| For the Six Months Ended |\n| June 30, |\n| 2023 | 2022 |\n| Cash Flow from Financing Activities |\n| Proceeds from loans payable | 185,000 | - |\n| Repayments of loans payable | ( 58,718 | ) | ( 53,333 | ) |\n| Proceeds from common stock issued for cash | 591,000 | 511,346 |\n| Proceeds from the issuance of convertible debt | 5,000,000 | - |\n| Financing costs in connection with the issuance of convertible debt | ( 321,803 | ) | - |\n| Repayments of convertible debt obligations | ( 862,541 | ) | - |\n| Redemption premiums paid on convertible debt obligations | ( 156,160 | ) | - |\n| Proceeds from issuance of shares under the New ELOC, net of offering costs [1] | 733,006 | - |\n| Net Cash Provided by Financing Activities | 5,109,784 | 458,013 |\n| Effect of Exchange Rate Changes on Cash | ( 77,792 | ) | 621,462 |\n| Net (Decrease) Increase in Cash | 509,954 | ( 3,394,722 | ) |\n| Cash - Beginning of Period | 300,185 | 3,649,407 |\n| Cash - End of Period | $ | 810,139 | $ | 254,685 |\n| Supplemental Disclosures of Cash Flow Information: |\n| Interest paid | $ | 561,876 | $ | 140,355 |\n| Income taxes paid | $ | - | $ | - |\n| Non-Cash Investing and Financing Activity |\n| Equity issued to satisfy accrued stock-based compensation obligation | $ | 32,617 | $ | 27,821 |\n| Equity issued as consideration for intangible assets | $ | - | $ | 39,600 |\n| Equity issued for purchase of non-controlling interest | $ | - | $ | 231,789 |\n| Equity issued for acquisition of Gaucho Development, S.R.L. | $ | - | $ | 2,194,653 |\n| Warrants issued and debt principal exchanged upon modification of convertible debt | $ | - | $ | 731,856 |\n| Shares issued upon conversion of debt and interest | $ | 2,146,809 | $ | 1,522,597 |\n| Common stock and restricted stock units in GGH issued upon exchange of GGI options | $ | - | $ | 1,576,648 |\n| Cashless warrant exercise | $ | 513 | $ | - |\n| Relative fair value of warrants issued with 2023 Note, net of allocable issuance costs [2] | $ | 1,506,319 | $ | - |\n| Warrants issued and debt principal exchanged upon modification of convertible debt | $ | 63,502 | $ | - |\n\n\n| [1] | Gross proceeds of $ 797,623 , less offering costs of $ 64,617 |\n\n| [2] | Represents $ 1,609,935 relative fair value of warrants, less $ 103,616 in allocable issuance costs |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 8 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\n1. BUSINESS ORGANIZATION AND NATURE OF OPERATIONS\nOrganization and Operations\nThrough its subsidiaries, Gaucho Group Holdings, Inc. (“Company”, “GGH”), a Delaware corporation that was incorporated on April 5, 1999, currently invests in, develops, and operates a collection of luxury assets, including real estate development, fine wines, and a boutique hotel in Argentina, as well as an e-commerce platform for the sale of high-end fashion and accessories.\nAs wholly owned subsidiaries of GGH, InvestProperty Group, LLC (“IPG”), Algodon Global Properties, LLC (“AGP”) and Gaucho Ventures I – Las Vegas, LLC (“GVI”) operate as holding companies that invest in, develop and operate global real estate and other lifestyle businesses such as wine production and distribution, golf, tennis, and restaurants. GGH operates its properties through its ALGODON® brand. IPG and AGP have invested in two ALGODON® brand projects located in Argentina. The first project is Algodon Mansion, a Buenos Aires-based luxury boutique hotel property that opened in 2010 and is owned by the Company’s subsidiary, The Algodon – Recoleta, SRL (“TAR”). The second project is the redevelopment, expansion and repositioning of a Mendoza-based winery and golf resort property now called Algodon Wine Estates (“AWE”), the integration of adjoining wine producing properties, and the subdivision of a portion of this property for residential development. (“GDS”). GVI is a party to an agreement with LVH Holdings (“LVH”) to develop a project in Las Vegas, Nevada.\nOn February 3, 2022, the Company acquired additional real estate through the acquisition of 100 % ownership in Hollywood Burger Argentina S.R.L., now Gaucho Development S.R.L.\nGGH also manufactures, distributes, and sells high-end luxury fashion and accessories through its subsidiary, Gaucho Group, Inc. (“GGI”). GGH held a 79 % ownership interest in GGI through March 28, 2022, at which time GGH acquired the remaining 21 % ownership interest in GGI. See Non-Controlling Interest, below.\nNon-Controlling interest\nAs a result of a 2019 conversion of certain convertible debt into shares of Gaucho Group, Inc. (“GGI”) common stock, GGI investors obtained a 21 % ownership interest in GGI, which was recorded as a non-controlling interest. The profits and losses of GGI for the period from January 1, 2022 through March 28, 2022 are allocated between the controlling interest and the non-controlling interest in the same proportions as their membership interest. On March 28, 2022, the Company issued 86,899 shares of its common stock to the minority holders of GGI, in exchange for the remaining 21 % ownership of GGI. Consequently, the Company owns 100 % of the outstanding common stock of GGI.\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nThere have been no material changes to the Company’s significant accounting policies as set forth in the Company’s audited consolidated financial statements included in the annual report on Form 10-K for the year ended December 31, 2022, except as disclosed below.\n\n| 9 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nBasis of Presentation\nThe accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information. Accordingly, they do not include all of the information and disclosures required by accounting principles generally accepted in the United States of America for annual financial statements. In the opinion of management, such statements include all adjustments (consisting only of normal recurring items) which are considered necessary for a fair presentation of the unaudited condensed consolidated financial statements of the Company as of June 30, 2023 and for the three and six months ended June 30, 2023 and 2022. The results of operations for the three and six months ended June 30, 2023 are not necessarily indicative of the operating results for the full year. It is suggested that these unaudited condensed consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2022, filed with the Securities and Exchange Commission (“SEC”) on April 17, 2023.\nOn November 4, 2022, the Company effected a reverse stock split in a ratio of 1 share of common stock for 12 issued shares of common stock. As a result of the reverse stock split, prior period shares and per share amounts appearing in the accompanying condensed consolidated financial statements and all references in this Quarterly Report to our common stock, as well as amounts per share of our common stock, have been retroactively restated as if the reverse stock split occurred at the beginning of the period presented.\nGoing Concern and Management’s Liquidity Plans\nThe accompanying condensed consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The condensed financial statements do not include any adjustments relating to the recoverability and classification of asset amounts or the classification of liabilities that might be necessary should the company be unable to continue as a going concern.\nAs of June 30, 2023, the Company had cash and a working capital deficit of approximately $ 810,000 and $ 3.8 million, respectively. During the six months ended June 30, 2023 and 2022, the Company incurred net losses of approximately $ 7.7 million and $ 7.6 million, respectively, and used cash in operating activities of approximately $ 4.0 million and $ 2.8 million, respectively. Further, as of June 30, 2023, approximately $ 4.8 million owed in connection with the Company’s convertible debt matures on February 21, 2024 , and approximately $ 252,000 represents the current portion of the Company’s loans payable which are payable on demand or for which payments are due within twelve months after June 30, 2023. During the six months ended June 30, 2023, the Company funded its operations with proceeds from a convertible debt financing of $ 5.0 million, proceeds of $ 733,000 from draws on the Company’s equity line of credit, $ 185,000 of proceeds from a loan payable and $ 591,000 from the sale of common stock.\n\n| 10 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nThe Company’s operating needs include the planned costs to operate its business, including amounts required to fund working capital and capital expenditures. Based upon projected revenues and expenses, the Company believes that it may not have sufficient funds to operate for the next twelve months from the date these financial statements are made available. Since inception, the Company’s operations have primarily been funded through proceeds received from equity and debt financings. The Company believes it has access to capital resources and continues to evaluate additional financing opportunities. There is no assurance that the Company will be able to obtain funds on commercially acceptable terms, if at all. There is also no assurance that the amount of funds the Company might raise will enable the Company to complete its development initiatives or attain profitable operations. The aforementioned factors raise substantial doubt about the Company’s ability to continue as a going concern for a period of one year from the issuance of these financial statements.\nHighly Inflationary Status in Argentina\nThe Company recorded gains on foreign currency transactions of approximately $ 103,000 and $ 215,000 during the three and six months ended June 30, 2023, respectively, and approximately $ 43,000 and $ 226,000 during the three and six months ended June 30, 2022, respectively, as a result of the net monetary liability position of its Argentine subsidiaries.\nConcentrations\nThe Company maintains cash with major financial institutions. Cash held in US bank institutions is currently insured by the Federal Deposit Insurance Corporation (“FDIC”) up to $ 250,000 at each institution. No similar insurance or guarantee exists for cash held in Argentina bank accounts. There were aggregate uninsured cash balances of approximately $ 519,000 at June 30, 2023, of which approximately $ 378,000 represents cash held in Argentine bank accounts.\nRevenue Recognition\nThe Company recognizes revenue in accordance with ASC Topic 606, Revenue from Contracts with Customers. ASC Topic 606 provides a single comprehensive model to use in accounting for revenue arising from contracts with customers, and gains and losses arising from transfers of non-financial assets including sales of property and equipment, real estate, and intangible assets.\nThe Company earns revenues from the sale of real estate lots, as well as hospitality, food and beverage, other related services, and from the sale of clothing and accessories. The Company recognizes revenue when goods or services are transferred to customers in an amount that reflects the consideration which it expects to receive in exchange for those goods or services. In determining when and how revenue is recognized from contracts with customers, the Company performs the following five-step analysis: (i) identification of contract with customer; (ii) determination of performance obligations; (iii) measurement of the transaction price; (iv) allocation of the transaction price to the performance obligations; and (v) recognition of revenue when (or as) the Company satisfies each performance obligation.\n\n| 11 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nThe following table summarizes the revenue recognized in the Company’s condensed consolidated statements of operations:\nSCHEDULE OF DISAGGREGATION OF REVENUE\n| 2023 | 2022 | 2023 | 2022 |\n| For the Three Months Ended | For the Six Months Ended |\n| June 30, | June 30, |\n| 2023 | 2022 | 2023 | 2022 |\n| Real estate sales | $ | 154,959 | $ | - | $ | 154,959 | $ | 184,658 |\n| Hotel rooms and events | 218,838 | 144,123 | 464,525 | 283,222 |\n| Restaurants | 56,989 | 40,323 | 136,007 | 57,593 |\n| Winemaking | 45,918 | 32,880 | 75,741 | 59,689 |\n| Agricultural | 162,764 | 153,531 | 162,764 | 181,029 |\n| Golf, tennis and other | 29,126 | 28,366 | 56,983 | 53,467 |\n| Clothes and accessories | 42,381 | 6,112 | 107,763 | 11,274 |\n| Total revenues | $ | 710,975 | $ | 405,335 | $ | 1,158,742 | $ | 830,932 |\n\nRevenue from the sale of food, wine, agricultural products, clothes and accessories is recorded when the customer obtains control of the goods purchased. Revenues from hospitality and other services are recognized as earned at the point in time that the related service is rendered, and the performance obligation has been satisfied. Revenues from gift card sales are recognized when the card is redeemed by the customer. The Company does not adjust revenue for the portion of gift card values that is not expected to be redeemed (“breakage”) due to the lack of historical data. Revenue from real estate lot sales is recorded when the lot is deeded, and legal ownership of the lot is transferred to the customer.\nThe timing of the Company’s revenue recognition may differ from the timing of payment by its customers. A receivable is recorded when revenue is recognized prior to payment and the Company has an unconditional right to payment. Alternatively, when payment precedes the provision of the related services, the Company records deferred revenue until the performance obligations are satisfied. Deferred revenues associated with real estate lot sale deposits are recognized as revenues (along with any outstanding balance) when the lot sale closes, and the deed is provided to the purchaser. Other deferred revenues primarily consist of deposits accepted by the Company in connection with agreements to sell barrels of wine, advance deposits received for grapes and other agricultural products, and hotel deposits. Wine barrel and agricultural product advance deposits are recognized as revenues (along with any outstanding balance) when the product is shipped to the purchaser. Hotel deposits are recognized as revenue upon occupancy of rooms, or the provision of services.\nContracts related to the sale of wine, agricultural products and hotel services have an original expected length of less than one year. The Company has elected not to disclose information about remaining performance obligations pertaining to contracts with an original expected length of one year or less, as permitted under the guidance.\n\n| 12 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nAs of June 30, 2023 and December 31, 2022, the Company had deferred revenue of $ 1,368,921 and $ 1,373,906 , respectively, consisting of $ 1,332,695 and $ 1,179,654 , respectively, associated with real estate lot sale deposits, $ 36,225 and $ 44,252 , respectively, related to hotel deposits and $ 0 and $ 150,000 , respectively, related to prepaid management fees received.\nNet Loss per Common Share\nBasic loss per common share is computed by dividing net loss attributable to GGH common stockholders by the weighted average number of common shares outstanding during the period. Diluted loss per common share is computed by dividing net loss attributable to common stockholders by the weighted average number of common shares outstanding, plus the impact of common shares, if dilutive, resulting from the exercise of outstanding stock options and warrants and the conversion of convertible instruments.\nThe following securities are excluded from the calculation of weighted average dilutive common shares because their inclusion would have been anti-dilutive:\nSCHEDULE OF ANTIDILUTIVE SECURITIES EXCLUDED FROM COMPUTATION OF EARNINGS PER SHARE\n| 2023 | 2022 |\n| As of June 30, |\n| 2023 | 2022 |\n| Options | 34,806 | 561,027 |\n| Warrants | 4,839,254 | 2,024,166 |\n| Unvested restricted stock units | 516,277 | - |\n| Convertible debt | 12,516,374 | [1] | 5,479,255 | [2] |\n| Total potentially dilutive shares | 17,906,711 | 8,064,448 |\n\n\n| [1] | Represents shares issuable upon conversion of $ 4,893,983 of convertible debt, $ 734,097 of redemption premium and $ 8,293 of related accrued interest outstanding as of June 30, 2023, at a conversion price of $ 0.4503 per share, which represents the conversion price in effect as of June 30, 2023. The conversion price of such debt is variable and is not subject to a floor price (see Note 10, Convertible Debt Obligations). |\n| [2] | Represents shares issuable upon conversion of principal and interest outstanding in the aggregate amount of $ 5,205,292 at a conversion price of $ 0.95 per share. |\n\nSequencing Policy\nUnder ASC 815, the Company has adopted a sequencing policy, whereby, in the event that reclassification of contracts from equity to assets or liabilities is necessary pursuant to ASC 815 due to the Company’s inability to demonstrate it has sufficient authorized shares as a result of certain securities with a potentially indeterminable number of shares or the Company’s total potentially dilutive shares exceed the Company’s authorized share limit, shares will be allocated on the basis of the earliest issuance date of potentially dilutive instruments, with the earliest grants receiving the first allocation of shares. Pursuant to ASC 815, issuances of securities granted as compensation in a share-based payment arrangement are not subject to the sequencing policy.\n\n| 13 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nDerivative Instruments\nThe Company evaluates its convertible instruments to determine if those contracts or embedded components of those contracts qualify as derivative financial instruments to be separately accounted for in accordance with Topic 815 “Derivatives and Hedging” (“ASC 815”) of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”). The accounting treatment of derivative financial instruments requires that the Company record any bifurcated embedded features at their fair values as of the inception date of the agreement and at fair value as of each subsequent balance sheet date. Any change in fair value is recorded in earnings each period as non-operating, non-cash income or expense. The Company reassesses the classification of its derivative instruments at each balance sheet date. If the classification changes as a result of events during the period, the contract is reclassified as of the date of the event that caused the reclassification. Bifurcated embedded features are recorded upon note issuance at their initial fair values which create additional debt discount to the host instrument.\nRecently Adopted Accounting Pronouncements\nIn June 2016, the FASB issued ASU No. 2016-13 “Financial Instruments – Credit Losses (Topic 326)” and also issued subsequent amendments to the initial guidance under ASU 2018-19, ASU 2019-04, ASU 2019-05 and ASU 2020-02 (collectively Topic 326). Topic 326 requires the measurement and recognition of expected credit losses for financial assets held at amortized cost. This replaces the existing incurred loss model with an expected loss model and requires the use of forward-looking information to calculate credit loss estimates. The Company adopted the provisions of this ASU on January 1, 2023 using the modified retrospective method for all financial assets measured at amortized cost. Results for reporting periods beginning after December 31, 2022 are presented under Topic 326 while prior period amounts continue to be reported in accordance with previously applicable GAAP. The Company recorded an adjustment to accumulated deficit of $ 111,582 as of January 1, 2023 for the cumulative effect of adopting Topic 326.\nReclassifications\nCertain reclassifications have been made to prior period amounts to conform to the current period financial statement presentation.\n3. MORTGAGES RECEIVABLE\nThe Company offers loans to purchasers in connection with the sale of real estate lots. The loans bear interest at 7.2 % per annum and terms generally range from eight to ten years. Principal and interest for each loan is billed and receivable on a monthly basis. The loans are secured by a first mortgage lien on the property purchased by the borrower. Mortgages receivable include the related interest receivable and are presented at amortized cost, less bad debt allowances, in the condensed consolidated financial statements.\nManagement evaluates each loan individually on a quarterly basis, to assess collectability and estimate a reserve for past due amounts. Management recorded an additional provision for uncollectible accounts in the amount of $ 37,673 for the six months ended June 30, 2023. The total allowance for uncollectable mortgages as of June 30, 2023 and December 31, 2022 was $ 234,223 and $ 196,550 , respectively. Past due principal amounts of $ 346,680 and $ 254,683 are included in mortgages, receivable, current as of June 30, 2023 and December 31, 2022, respectively. In the case of each of the past due loans, the Company believes that the value of the collateral exceeds the outstanding balance on the loan, plus accrued interest.\n\n| 14 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nThe following represents the maturities of mortgages receivable as of June 30, 2023:\nSCHEDULE OF MATURITIES OF MORTGAGES RECEIVABLE\n| July 1 through December 31, 2023 | $ | 776,657 |\n| For the years ended December 31, |\n| 2024 | 381,532 |\n| 2025 | 409,927 |\n| 2026 | 440,436 |\n| 2027 | 473,215 |\n| 2028 | 480,227 |\n| Thereafter | 1,093,286 |\n| Gross Receivable | 4,055,278 |\n| Less: Allowance | ( 234,223 | ) |\n| Net Receivable | $ | 3,821,055 |\n\nAs of June 30, 2023 and December 31, 2022, no single borrower had loans outstanding representing more than 10 % of the total balance of mortgages receivable.\nThe Company recorded interest income from mortgages receivable of $ 109,816 and $ 28,654 for the six months ended June 30, 2023 and 2022, respectively. As of June 30, 2023 and December 31, 2022, there is $ 261,919 and $ 185,197 , respectively, of interest receivable included in mortgages receivable on the accompanying condensed consolidated balance sheets.\n4. INVENTORY\nInventory at June 30, 2023 and December 31, 2022 was comprised of the following:\nSCHEDULE OF INVENTORY\n| June 30, 2023 | December 31, 2022 |\n| Vineyard in process | $ | 240,619 | $ | 516,096 |\n| Wine in process | 1,031,823 | 797,862 |\n| Finished wine | 42,370 | 40,735 |\n| Clothes and accessories | 720,569 | 552,581 |\n| Other | 125,665 | 82,423 |\n| Inventory gross | 2,161,046 | 1,989,697 |\n| Less: Reserve for obsolescence | ( 200,058 | ) | ( 100,735 | ) |\n| Total | $ | 1,960,988 | $ | 1,888,962 |\n\nThe Company recorded a provision for obsolete inventory in the amount of $ 93,389 and $ 99,323 during the three and six months ended June 30, 2023, respectively. There was no provision for obsolete inventory recognized during the three and six months ended June 30, 2022.\n\n| 15 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\n5. INTANGIBLE ASSETS\nOn February 3, 2022, the Company purchased the domain name Gaucho.com, in exchange for cash consideration of $ 34,999 and 15,000 shares of common stock valued at $ 39,600 (see Note 14 – Stockholders’ Equity, Common Stock). The domain name is being amortized over its useful life of 15 years.\nOn June 15, 2023, the Company purchased a music video to be used in certain marketing mediums for $ 50,000 in cash. The music video is being amortized over its useful life of 3 years.\nThe Company recognized $ 5,410 and $ 10,819 of amortization expense during the three and six months ended June 30, 2023, respectively, related to the domain name. The Company recognized $ 1,489 and $ 2,072 of amortization expense during the three and six months ended June 30, 2022, respectively, related to the domain name. Future amortization of the Company’s intangible asset is as follows:\nSCHEDULE OF INTANGIBLE ASSETS FUTURE AMORTIZATION\n| July 1 through December 31, 2023 | $ | 10,819 |\n| For the years ended December 31, |\n| 2024 | 21,640 |\n| 2025 | 21,640 |\n| 2026 | 4,973 |\n| 2027 | 4,973 |\n| 2028 | 4,973 |\n| Thereafter | 39,949 |\n| Total | $ | 108,967 |\n\n6. FAIR VALUE OF FINANCIAL INSTRUMENTS\nFair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In determining fair value, the Company often utilizes certain assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and/or the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated, or developed by the Company. The fair value hierarchy ranks the quality and reliability of the information used to determine fair values. Financial assets and liabilities carried at fair value are classified and disclosed in one of the following three categories:\nLevel 1 - Valued based on quoted prices at the measurement date for identical assets or liabilities trading in active markets. Financial instruments in this category generally include actively traded equity securities.\nLevel 2 - Valued based on (a) quoted prices for similar assets or liabilities in active markets; (b) quoted prices for identical or similar assets or liabilities in markets that are not active; (c) inputs other than quoted prices that are observable for the asset or liability; or (d) from market corroborated inputs. Financial instruments in this category include certain corporate equities that are not actively traded or are otherwise restricted.\nLevel 3 - Valued based on valuation techniques in which one or more significant inputs is not readily observable. Included in this category are certain corporate debt instruments, certain private equity investments, and certain commitments and guarantees.\nThe carrying amounts of the Company’s short-term financial instruments including cash, accounts receivable, advances and loans to employees, prepaid taxes and expenses, accounts payable, accrued expenses and other liabilities approximate fair value due to the short-term nature of these instruments. The carrying value of the Company’s loans payable, debt obligations, convertible debt obligations and derivative liability approximate fair value, as they bear terms and conditions comparable to market for obligations with similar terms and maturities.\n\n| 16 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\n7. ACCRUED EXPENSES\nAccrued expenses are comprised of the following:\nSCHEDULE OF ACCRUED EXPENSES\n| June 30, | December 31, |\n| 2023 | 2022 |\n| Accrued compensation and payroll taxes | $ | 542,659 | $ | 652,943 |\n| Accrued taxes payable - Argentina | 189,722 | 270,239 |\n| Accrued interest | 141,303 | 78,368 |\n| Other accrued expenses | 384,479 | 663,266 |\n| Accrued expenses, current | 1,258,163 | 1,664,816 |\n| Accrued payroll tax obligations, non-current | 81,638 | 66,018 |\n| Total accrued expenses | $ | 1,339,801 | $ | 1,730,834 |\n\nOn November 27, 2020, the Company entered into various payment plans, pursuant to which it agreed to pay its Argentine payroll tax obligations over a period of 60 to 120 months. The current portion of payments due under the plan is $ 84,929 and $ 209,938 as of June 30, 2023 and December 31, 2022, respectively, which is included in accrued taxes payable – Argentina, above. The non-current portion of accrued payroll tax obligations represents payments under the plan that are scheduled to be paid after twelve months. The Company incurred interest expense of $ 64,283 and $ 81,587 during the three and six months ended June 30, 2023, respectively, and incurred interest expense of $ 28,690 and $ 33,177 during the three and six months ended June 30, 2022, respectively, related to these payment plans.\n8. DEFERRED REVENUE\nDeferred revenue is comprised of the following:\nSCHEDULE OF DEFERRED REVENUES\n| June 30, 2023 | December 31, 2022 |\n| Real estate lot sales deposits | $ | 1,332,695 | $ | 1,179,654 |\n| Prepaid management fees | - | 150,000 |\n| Other | 36,226 | 44,252 |\n| Total | $ | 1,368,921 | $ | 1,373,906 |\n\n\n| 17 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nThe Company accepts deposits in conjunction with agreements to sell real estate building lots at Algodon Wine Estates in the Mendoza wine region of Argentina. These lot sale deposits are generally denominated in U.S. dollars. The Company received deposits for eleven additional lots and recorded deferred revenues in the amount of $ 308,000 during the six months ended June 30, 2023. Revenue is recorded when the sale closes, and the deeds are issued. The Company recorded the sale of one lot and recorded revenue in the amount of $ 154,959 during the three and six months ended June 30, 2023.\n9. LOANS PAYABLE\nThe Company’s loans payable are summarized below:\nSCHEDULE OF LOANS PAYABLE\n| June 30, | December 31, |\n| 2023 | 2022 |\n| EIDL | $ | 92,527 | $ | 93,541 |\n| 2018 Loan | 40,678 | 111,137 |\n| 2022 Loan | 24,277 | 51,643 |\n| 2023 Loan | 185,000 | - |\n| Total Loans Payable | 342,482 | 256,321 |\n| Less: current portion | 252,014 | 164,656 |\n| Loans Payable, non-current | $ | 90,468 | $ | 91,665 |\n\nOn January 9, 2023, the Company received $ 185,000 in proceeds on the issuance of a one-year, non-convertible promissory note with a February 20, 2024 maturity date. The note bears interest at a rate of 8 % per annum. In addition, during the six months ended June 30, 2023, the Company made principal payments in the amount of $ 42,066 on the 2018 Loan payable, $ 15,638 on the 2022 Loan payable and $ 1,014 on the EIDL loan.\nThe Company incurred interest expense related to the loans payable in the amount of $ 33,248 and $ 36,514 during the three and six months ended June 30, 2023, respectively, and incurred interest expense related to the loans payable in the amount of $ 2,986 and $ 6,378 during the three and six months ended June 30, 2022. Other decreases in loan balances are the result of changes in exchange rates during the period. As of June 30, 2023 and December 31, 2022, there is accrued interest of $ 15,996 and $ 9,437 , respectively, related to the Company’s loans payable.\n\n| 18 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\n10. CONVERTIBLE DEBT OBLIGATIONS\nAmounts owed pursuant to the Company’s convertible debt obligations are as follows:\nSCHEDULE OF CONVERTIBLE NOTES\n| GGH Notes | 2023 Note | Total Principal | Debt Discount | Convertible debt, net of discount |\n| Balance at January 1, 2023 | $ | 1,997,909 | $ | - | $ | 1,997,909 | $ | ( 6,450 | ) | $ | 1,991,459 |\n| Note issued | - | 5,617,978 | 5,617,978 | ( 2,509,601 | ) | 3,108,377 |\n| Debt principal converted to common stock: | ( 1,335,439 | ) | ( 523,925 | ) | ( 1,859,364 | ) | - | ( 1,859,364 | ) |\n| Principal repayments | ( 662,470 | ) | ( 200,071 | ) | ( 862,541 | ) | - | ( 862,541 | ) |\n| Amortization of debt discount | - | - | - | 1,079,034 | 1,079,034 |\n| Balance at June 30, 2023 | $ | - | $ | 4,893,982 | $ | 4,893,982 | $ | ( 1,437,017 | ) | $ | 3,456,965 |\n| Less: current portion | - | 4,773,982 | 4,773,982 | ( 1,401,781 | ) | 3,372,201 |\n| Equals: convertible debt, non-current | $ | - | $ | 120,000 | $ | 120,000 | $ | ( 35,236 | ) | $ | 84,764 |\n\nGGH Convertible Notes\nOn February 2, 2023, the Company and the holders of the remaining GGH Notes entered into a fourth letter agreement (“Letter Agreement #4). Pursuant to Letter Agreement #4, the parties agreed to reduce the conversion price of the GGH Notes to the lower of: (i) the closing sale price on the trading day immediately preceding the conversion date; and (ii) the average closing sale price of the common stock for the five trading days immediately preceding the conversion date. The conversion price is not subject to a floor price. Between February 3 and February 15, 2023, the holders elected to convert $ 1,571,553 in principal and interest, of which $ 1,335,439 , $ 124,049 , and $ 112,065 was principal, interest and premium paid on conversion, into 833,333 shares of common stock at prices ranging from $ 1.45 and $ 2.40 . The premium paid on conversion of the GGH Notes was recorded as a loss on extinguishment.\nOn February 8, 2023, the Company and the holders of the remaining GGH Notes entered into a fifth letter agreement (“Letter Agreement #5). Pursuant to Letter Agreement #5, the parties agreed to extend the maturity date of the notes from February 9, 2023 to February 28, 2023.\nOn February 20, 2023, the Company entered into another exchange agreement (the “Exchange Agreement #4”) with the remaining holders of the GGH Notes, pursuant to which warrants for the purchase up to an aggregate of 150,000 shares of the Company’s common stock at an exercise price of $ 1.00 were issued as consideration for extending the maturity date in connection with Letter Agreement #5. The warrants have a grant date fair value of $ 134,779 and expire on the second anniversary of the date of issuance. Because the value of the new warrants was deemed to be substantial as compared to the $ 662,470 remaining principal of the GGH Notes, the transaction was accounted for as an extinguishment of old notes which were replaced with the new note. The fair value of the warrants was recorded as a loss on extinguishment and is reflected under Other Expense (Income) in the accompanying condensed consolidated statement of operations.\nOn February 21, 2023, the Company redeemed the remaining GGH Notes for $ 905,428 , which includes the $ 662,470 of principal, $ 118,909 of accrued interest and $ 124,049 of redemption premium, the latter of which was charged to extinguishment loss.\n\n| 19 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\n2023 Convertible Note\nOn February 21, 2023, the Company entered into a securities purchase agreement (the “SPA”) with an institutional investor, (the “Investor”) pursuant to which the Company received proceeds of $ 5,000,000 in exchange for a senior secured convertible note (the “2023 Note”) of the Company in the aggregate original principal amount of $ 5,617,978 , and a three-year common stock purchase warrant exercisable into an aggregate of 3,377,099 shares of common stock of the Company at an exercise price equal to $ 1.34 (the “2023 Note Warrant”). In addition to other terms, conditions and rights, both the Company and the Investor have the right to initiate additional closings for up to $ 5 million of cash for additional 2023 Notes and warrants.\nPursuant to the SPA, the exercise price of certain warrants for the purchase of 62,500 common shares exercisable at $ 21.00 per share and warrants for the purchase of 43,814 shares exercisable at $ 6.00 per share was reduced to $ 1.00 per share. The increase in the value of the warrants in the aggregate amount of $ 63,502 as a result of the reduction in exercise price was recorded as debt discount on the 2023 Note.\nThe 2023 Note is convertible into shares of common stock of the Company at a conversion price equal to the lower of (i) $ 1.34 (subject to adjustment for standard anti-dilution events, the non-exempt issuance of common stock for less than $ 1.34 per share and the issuance of additional variable price securities); (ii) the trading price on the day immediately prior to conversion or (iii) the average trading price of the Company’s common stock for the 5 days preceding conversion (collectively the “Conversion Price”), subject to a floor price of $0.27. If the Conversion Price in effect on the date of conversion is less than $ 0.27 , the Investor is entitled to a cash true up payment equal to the difference between the conversion dollar amount and the value of shares issued upon conversion (the “Cash True Up Provision”).\nThe 2023 Note matures on the first anniversary of the issuance date (the “Maturity Date”) and bears interest at a rate of 7 % per annum, which is payable either in cash monthly, or by way of inclusion in the accrued interest in the conversion amount on the conversion date. Interest includes a make-whole amount equal to the additional interest that would accrue if the entire 2023 Note principal remained outstanding through the Maturity Date.\nThe 2023 Note is redeemable at the Company’s election, so long as the Company is not in default, at the greater of (a) 115 % of the conversion amount, or (b) the amount equal to the shares issuable times the greatest closing price from the redemption notice date through the date the Company makes the redemption payment. The minimum redemption amount is $ 500,000 and the Company can only deliver one redemption notice in a 20-day period.\nUpon an event of default on the 2023 Note, the Conversion Price is reduced to the lesser of (a) $1.34 (subject to adjustment as described above); (b) 80% of the volume-weighted average price on the day preceding receipt of the conversion notice; or (c) 80% of the average of the three lowest volume-weighted average prices over the fifteen trading days which precede receipt of the conversion notice, subject to a floor price of $ 0.27 (the “Event of Default Conversion Price”). In addition, the Investor may require the Company to redeem the 2023 Note using the same formula that would be used for a Company-initiated redemption, described above.\nThe Event of Default Conversion Price represents a redemption feature, which was bifurcated from the debt host and recorded as a derivative liability. As of the date of issuance of the 2023 Note, management had estimated that the probability of an event of default was negligible; accordingly, the fair value of the derivative liability was de minimis at the date of issuance.\n\n| 20 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nPursuant to the terms of the 2023 Note, the Company must pay, convert or redeem one quarter of the initial principal, plus any outstanding interest and make-whole amount by each three-month anniversary of the issuance date. As of June 30, 2023, the Company is in default on the 2023 Note as a result of not making the required quarterly payment due on May 21, 2023. Consequently, the Company remeasured the derivative liability and recorded a change in fair value of the derivative liability of $ 2,141,117 during the three and six months ended June 30, 2023.\nThe following table sets forth a summary of the changes in the fair value of the derivative liability that are measured at fair value on a recurring basis:\nSUMMARY OF THE CHANGES IN THE FAIR VALUE OF DERIVATIVE LIABILITIES\n| Balance as of January 1, 2023 | $ | - |\n| Fair value of derivative liability upon issuance of 2023 Note | - |\n| Change in fair value of derivative liability | 2,141,117 |\n| Balance as of June 30, 2023 | 2,141,117 |\n| Less: current portion of derivative liability | 2,088,617 |\n| Equals: derivative liability, non-current portion | $ | 52,500 |\n\nThe Company incurred financing costs of $ 321,803 in connection with the SPA, of which $ 218,187 was allocated to the 2023 Note and recorded as debt discount and $ 103,616 was allocated to the 2023 Note Warrant and charged against additional paid-in capital.\nUpon the issuance of the 2023 Note, the Company recorded a debt discount at issuance in the aggregate amount $ 2,509,601 , consisting of (i) the $ 617,978 difference between the aggregate principal amount of the 2023 Note and the cash proceeds received, (ii) financing costs in the aggregate amount of $ 218,187 , (iii) value of warrant modification of $ 63,502 , and (iv) the $ 1,609,935 relative fair value of the 2023 Note Warrant. The debt discount is being amortized using the effective interest method over the term of the 2023 Note.\nDuring the six months ended June 30, 2023, the Company made redemption payments in the aggregate amount of $ 246,186 related to the 2023 Note, which included principal repayments of $ 200,070 , accrued interest of $ 14,005 and redemption premiums of $ 32,094 . The Company recorded a loss on extinguishment for the amount of redemption premiums paid.\nDuring the three and six months ended June 30, 2023, a total of $ 575,256 , which included principal of $ 523,925 , accrued interest of $ 38,254 and conversion premiums of $ 13,077 , was converted into 828,780 shares at conversion prices between $ 0.46 and $ 0.78 per share.\nInterest Expense on Convertible Debt Obligations\nThe Company incurred total interest expense of $ 987,037 and $ 661,695 related to its convertible debt obligations during the three months ended June 30, 2023 and 2022, respectively. The Company incurred total interest expense of $ 1,553,077 and $ 1,410,926 related to its convertible debt obligations during the six months ended June 30, 2023 and 2022, respectively.\nInterest expense during the three months ended June 30, 2023 and 2022 consists of (i) $ 211,260 and $ 151,200 , respectively, of make-whole interest accrued at 7 % per annum; (ii) $ 58,907 and $ 0 , respectively, of incremental default interest, respectively, and (iv) amortization of debt discount in the amount of $ 716,867 and $ 510,495 , respectively, during the six months ended June 30, 2023.\nInterest expense during the six months ended June 30, 2023 and 2022 consists of (i) $ 415,135 and $ 348,990 , respectively, of make-whole interest accrued at 7 % per annum; (ii) $ 58,907 and $ 0 , respectively, of incremental default interest, respectively, and (iv) amortization of debt discount in the amount of $ 1,079,033 and $ 1,061,936 , respectively, during the six months ended June 30, 2023.\nSee Note 17 - Subsequent Events.\n\n| 21 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\n11. SEGMENT DATA\nThe Company’s financial position and results of operations are classified into three reportable segments, consistent with how the CODM makes decisions about resource allocation and assesses the Company’s performance.\n\n| ● | Real Estate Development, through AWE and TAR, including hospitality and winery operations, which support the ALGODON® brand. |\n| ● | Fashion (e-commerce), through GGI, including the manufacture and sale of high-end fashion and accessories sold through an e-commerce platform. |\n| ● | Corporate, consisting of general corporate overhead expenses not directly attributable to any one of the business segments. |\n\nThe following tables present segment information for the three months ended June 30, 2023 and 2022:\nSCHEDULE OF SEGMENT INFORMATION\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\n| For the Three Months Ended June 30, 2023 | For the Six Months Ended June 30, 2023 |\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\n| Revenues | $ | 670,594 | $ | 40,381 | $ | - | $ | 710,975 | $ | 1,052,979 | $ | 105,763 | $ | - | $ | 1,158,742 |\n| Revenues from Foreign Operations | $ | 670,594 | $ | - | $ | - | $ | 670,594 | $ | 1,052,979 | $ | - | $ | - | $ | 1,052,979 |\n| Loss from Operations | $ | ( 123,767 | ) | $ | ( 463,126 | ) | $ | ( 1,398,694 | ) | $ | ( 1,985,587 | ) | $ | ( 457,771 | ) | $ | ( 955,325 | ) | $ | ( 2,518,496 | ) | $ | ( 3,931,592 | ) |\n\n\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\n| For the Three Months Ended June 30, 2022 | For the Six Months Ended June 30, 2022 |\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\n| Revenues | $ | 399,223 | $ | 6,112 | $ | - | $ | 405,335 | $ | 819,658 | $ | 11,274 | $ | - | $ | 830,932 |\n| Revenues from Foreign Operations | $ | 399,223 | $ | - | $ | - | $ | 399,223 | $ | 819,658 | $ | - | $ | - | $ | 819,658 |\n| Loss from Operations | $ | ( 1,339,272 | ) | $ | ( 341,668 | ) | $ | ( 758,493 | ) | $ | ( 2,439,433 | ) | $ | ( 1,725,125 | ) | $ | ( 700,201 | ) | $ | ( 1,789,910 | ) | $ | ( 4,215,236 | ) |\n\n\n| 22 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nThe following tables present segment information as of June 30, 2023 and December 31, 2022:\n\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\n| As of June 30, 2023 | As of December 31, 2022 |\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\n| Total Property and Equipment, net | $ | 6,586,322 | $ | 1,271,163 | $ | - | $ | 7,857,485 | $ | 6,234,856 | $ | 1,369,205 | $ | 17,196 | $ | 7,621,257 |\n| Total Property and Equipment, net in Foreign Countries | $ | 6,586,322 | $ | - | $ | - | $ | 6,586,322 | $ | 6,234,856 | $ | - | $ | - | $ | 6,234,856 |\n| Total Assets | $ | 14,282,151 | $ | 3,330,807 | $ | 1,606,456 | $ | 19,219,414 | $ | 13,504,914 | $ | 3,522,415 | $ | 1,665,656 | $ | 18,692,985 |\n\n12. RELATED PARTY TRANSACTIONS\nAccounts Receivable – Related Parties\nAs of June 30, 2023 and December 31, 2022 the Company had accounts receivable – related parties of $ 1,075,102 and $ 1,115,816 net of allowances for expected credit losses of $ 470,516 and $ 339,503 , respectively, representing the net realizable value of advances made to, and expense sharing obligations receivable from, separate entities under common management. During the three and six months ended June 30, 2023, the Company made advances in the amount of $ 0 and $ 85,644 , respectively, to the related entities. During the three and six months ended June 30, 2022, the Company made advances in the amount of $ 0 and $ 36,000 , respectively to the related entities. During the three and six months ended June 30, 2023, the Company received repayments in the amount of $ 237,813 and $ 367,813 , respectively, from the related entities. During the three and six months ended June 30, 2022, the Company received repayments in the amount of $ 583,000 and $ 703,000 , respectively, from the related entities. Receivables recorded in the amount of $ 383,529 and $ 417,413 in connection with an expense sharing agreement during the six months ended June 30, 2023 and 2022 are discussed below.\nThe Company recorded credit losses related to accounts receivable, related parties of $ 0 and $ 19,431 during the three and six months ended June 30, 2023, respectively. The Company recorded credit losses of $ 0 during the three and six months ended June 30, 2022. Credit losses are recorded as bad debt expense which is reflected in the general and administrative expenses on the on the accompanying unaudited consolidated statements of operations.\nExpense Sharing\nOn April 1, 2010, the Company entered into an agreement with a Related Party to share expenses such as office space, support staff, professional services, and other operating expenses (the “Related Party ESA”). During the six months ended June 30, 2023 and 2022, the Company recorded a contra-expense of $ 383,529 and $ 417,413 , respectively, related to the reimbursement of general and administrative expenses as a result of the agreement. During the three months ended June 30, 2023 and 2022, the Company recorded a contra-expense of $ 208,103 and $ 189,188 , respectively, related to the reimbursement of general and administrative expenses as a result of the agreement.\n\n| 23 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nManagement Fee Income\nThe Company earns management fees of $ 75,000 per quarter from LVH. A member of the Company’s board of directors is the managing member of SLVH, LLC, and holds a 20 % membership interest in SLVH. SLVH owns 88 % of the limited liability interest of LVH.\nAmendment to LVH Limited Liability Company Agreement\nOn June 30, 2023, the Company through its wholly owned subsidiary, GVI, executed a Fourth Amendment to the Amended and Restated Limited Liability Company Agreement of LVH to extend the outside date for execution of the ground lease from June 30, 2023 to December 29, 2023.\n13. BENEFIT CONTRIBUTION PLAN\nThe Company sponsors a 401(k) profit-sharing plan (“401(k) Plan”) that covers substantially all of its employees in the United States. The 401(k) Plan provides for a discretionary annual contribution, which is allocated in proportion to compensation. In addition, each participant may elect to contribute to the 401(k) Plan by way of a salary deduction.\nA participant is always fully vested in their account, including the Company’s contribution. For the six months ended June 30, 2023 and 2022, the Company recorded a charge associated with its contribution of $ 9,208 and $ 22,384 , respectively. For the three months ended June 30, 2023 and 2022, the Company recorded a charge associated with its contribution of $ 3,300 and $ 3,408 , respectively. This charge has been included as a component of general and administrative expenses in the accompanying condensed consolidated statements of operations. The Company issues shares of its common stock to settle these obligations based on the fair value of its common stock on the date the shares are issued. During the six months ended June 30, 2023, the Company issued 24,160 shares at $ 1.35 per share in satisfaction of $ 32,617 of 401(k) contribution liabilities. During the six months ended June 30, 2022, the Company issued 1,040 shares at $ 26.76 per share in satisfaction of $ 27,821 of 401(k) contribution liabilities.\n14. STOCKHOLDERS’ EQUITY\nCommon Stock\nOn February 2, 2023, the Company issued 51,305 shares of common stock upon the cashless exercise of 134,730 warrants at exercise prices ranging from $ 2.40 and $ 3.82 .\nOn February 10, 2023, the Company sold 591,000 shares of common stock and warrants to purchase 147,750 shares at an exercise price of $ 1.00 for aggregate proceeds of $ 591,000 . The warrants are immediately exercisable and expire two years from the date of issuance.\nDuring the six months ended June 30, 2023, the Company sold an aggregate of 823,198 shares of the Company’s common stock for gross proceeds of $ 797,623 less placement agent fees of $ 64,617 pursuant to a Common Stock Purchase Agreement (the “New ELOC”).\nSee Note 10 – Convertible Debt Obligations for additional details regarding common shares issued during the three and six months ended June 30, 2023.\nAccumulated Other Comprehensive Loss\nFor the three and six months ended June 30, 2023, the Company recorded a loss of $ 37,993 and $ 77,792 , respectively, and for the three and six months ended June 30, 2022, the Company recorded a gain of $ 358,056 and $ 621,462 , respectively, related to foreign currency translation adjustments as accumulated other comprehensive income, primarily related to fluctuations in the Argentine peso to United States dollar exchange rates (see Note 2 – Summary of Significant Accounting Policies, Highly Inflationary Status in Argentina).\n\n| 24 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nWarrants\nA summary of warrant activity during the six months ended June 30, 2023 is presented below:\nSUMMARY OF WARRANTS ACTIVITY\n| Number of Warrants | Weighted Average Exercise Price | Weighted Average Remaining Life in Years | Intrinsic Value |\n| Outstanding, January 1, 2023 | 1,299,135 | $ | 5.77 |\n| Issued | 3,674,849 | 1.31 |\n| Exercised | ( 134,730 | ) | 3.36 |\n| Expired | - | - |\n| Canceled | - | - |\n| Outstanding, June 30, 2023 | 4,839,254 | $ | 2.15 | 2.1 | $ | - |\n| Exercisable, June 30, 2023 | 4,839,254 | $ | 2.15 | 2.1 | $ | - |\n\nSee Common Stock, above, and Note 10 – Convertible Debt Obligations for additional details regarding warrants issued during the six months ended June 30, 2023.\nA summary of outstanding and exercisable warrants as of June 30, 2023 is presented below:\nSCHEDULE OF WARRANTS OUTSTANDING AND EXERCISABLE\n| Warrants Outstanding | Warrants Exercisable |\n| Exercise Price | Exercisable Into | Outstanding Number of Warrants | Weighted Average Remaining Life in Years | Exercisable Number of Warrants |\n| $ | 1.00 | Common Stock | 404,064 | 1.6 | 404,064 |\n| $ | 1.34 | Common Stock | 3,377,099 | 2.7 | 3,377,099 |\n| $ | 3.82 | Common Stock | 454,588 | 0.2 | 454,588 |\n| $ | 6.00 | Common Stock | 602,225 | 0.5 | 602,225 |\n| $ | 90.00 | Common Stock | 1,278 | 2.6 | 1,278 |\n| Total | 4,839,254 | 2.1 | 4,839,254 |\n\n\n| 25 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nRestricted Stock Units\nA summary of RSU activity during the six months ended June 30, 2023 is presented below:\nSCHEDULE OF RESTRICTED STOCK UNITS AND WEIGHTED AVERAGE GRANT DATE FAIR VALUES\n| Weighted Average |\n| Number of | Grant Date Value |\n| RSUs | Per Share |\n| RSUs non-vested January 1, 2023 | 511,500 | $ | 1.16 |\n| Granted | 10,000 | 1.31 |\n| Vested | ( 3,890 | ) | 1.31 |\n| Forfeited | ( 1,333 | ) | 1.16 |\n| RSUs non-vested June 30, 2023 | 516,277 | $ | 1.16 |\n\nOn January 23, 2023, the Company granted 10,000 restricted stock units (“RSUs”) to certain employees and advisors for their service, of which 3,890 RSUs vested on the grant date and 3,055 RSUs will vest on each of the next two anniversaries of the date of the grant.\nDuring the three and six months ended June 30, 2023, the Company recorded stock-based compensation expense of $ 74,978 and $ 154,400 respectively, related to the amortization of RSUs. No expense related to the amortization of RSUs was recorded for the three or six months ended June 30, 2022.\nStock Options\nNo stock options were granted during the six months ended June 30, 2023 or the six months ended June 30, 2022. The following table presents information related to GGH stock options outstanding as of June 30, 2023:\nSCHEDULE OF STOCK OPTION ACTIVITY\n| Weighted | Weighted |\n| Average | Average |\n| Number of | Exercise | Remaining | Intrinsic |\n| Options | Price | Term (Years) | Value |\n| Outstanding, January 1, 2023 | 40,612 | 85.35 |\n| Granted | - | - |\n| Exercised | - | - |\n| Expired | ( 5,806 | ) | 138.60 |\n| Forfeited | - | - |\n| Outstanding, June 30, 2023 | 34,806 | $ | 76.47 | 1.1 | $ | - |\n| Exercisable, June 30, 2023 | 29,698 | $ | 75.78 | 1.0 | $ | - |\n\n\n| 26 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nDuring the three and six months ended June 30, 2023, the Company recorded stock-based compensation expense of $ 38,834 and $ 77,668 , respectively, and during the three and six months ended June 30, 2022, the Company recorded stock-based compensation expense of $ 57,403 and $ 130,103 , respectively, related to the amortization of options for the purchase of GGH common stock.\nThe Company recorded no stock-based compensation expense related to options for the purchase of GGI common stock for the three and six months ended June 30, 2023 as all of the GGI options were exchanged and cancelled as of June 22, 2022. For the three and six months ended June 30, 2022, the Company recorded stock-based compensation expense of $ 29,731 and $ 40,085 , respectively, related to the options for the purchase of GGI common stock.\nStock-based compensation expense is reflected in general and administrative expenses (classified in the same manner as the grantees’ wage compensation) in the accompanying condensed consolidated statements of operations. As of June 30, 2023, there was $ 91,921 of unrecognized stock-based compensation expense related to stock option grants that will be amortized over a weighted average period of 1.1 years.\n15. COMMITMENTS AND CONTINGENCIES\nLegal Matters\nThe Company may be involved in litigation and arbitrations from time to time in the ordinary course of business. At the present time, the Company is not involved in any ongoing litigation. The Company records legal costs associated with loss contingencies as incurred. Settlements are accrued when, and if, they become probable and estimable.\n16. LEASES\nOn April 8, 2021, GGI entered into a lease agreement to lease a retail space in Miami, Florida for 7 years, which expires May 1, 2028 . As of June 30, 2023, the lease had a remaining term of approximately 4.8 years. Lease payments begin at $26,758 per month and escalate 3% every year over the duration of the lease. The Company was granted rent abatements of 15% for the first year of the lease term, and 10% for the second and third year of the lease term. The Company was required to pay a $ 56,130 security deposit.\nAs of June 30, 2023, the Company had no leases that were classified as a financing lease.\nTotal operating lease expense was $ 82,965 and $ 165,931 during the three and six months ended June 30, 2023, respectively, and $ 82,965 and $ 165,931 during the three and six months ended June 30, 2022, respectively. Lease expenses are recorded in general and administrative expenses on the accompanying condensed consolidated statements of operations.\n\n| 27 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nSupplemental cash flow information related to leases was as follows:\nSCHEDULE OF SUPPLEMENTAL CASH FLOWS INFORMATION RELATED TO LEASES\n| For the Six Months Ended June 30, |\n| 2023 | 2022 |\n| Cash paid for amounts included in the measurement of lease liabilities: |\n| Operating cash flows from operating leases | $ | 98,125 | $ | 82,296 |\n| Right-of-use assets obtained in exchange for lease obligations: |\n| Operating leases | $ | - | $ | - |\n| Weighted Average Remaining Lease Term: |\n| Operating leases | 4.8 | 5.8 |\n| Weighted Average Discount Rate: |\n| Operating leases | 7.0 | % | 7.0 | % |\n\nFuture minimum lease commitments are as follows:\nSCHEDULE OF FUTURE MINIMUM LEASE COMMITMENT\n| For the period July 1 through December 31, 2023 | $ | 153,290 |\n| For the years ended December 31, |\n| 2024 | 336,102 |\n| 2025 | 357,881 |\n| 2026 | 368,617 |\n| 2027 | 365,004 |\n| 2028 | 120,463 |\n| Total future minimum lease payments | 1,701,357 |\n| Less: imputed interest | ( 268,300 | ) |\n| Net future minimum lease payments | 1,433,057 |\n| Less: operating lease liabilities, current portion | 220,416 |\n| Operating lease liabilities, non-current portion | $ | 1,212,641 |\n\nThe Company is the lessor of a building and land that it purchased in connection with acquisition of GDS, pursuant to an operating lease which expires on August 31, 2031. At the end of the leases, the lessee may enter into a new lease or return the asset, which would be available to the Company for releasing. The Company recorded lease revenue of $ 10,937 and $ 21,565 during the three and six months ended June 30, 2023, respectively, related to this lease agreement. The Company recorded lease revenue of $ 10,594 and $ 14,339 during the three and six months ended June 30, 2022, respectively, related to this lease agreement.\n17. SUBSEQUENT EVENTS\nThere have been no subsequent events that occurred during the period subsequent to the date of these condensed consolidated financial statements that would require adjustment to our disclosure in the condensed consolidated financial statements as presented, except as described below:\n2023 Convertible Note\nOn July 3, 2023, $ 120,000 of principal, $ 9,979 of interest, and $ 19,467 of premium owed in connection with the 2023 Note were converted into 329,416 shares of common stock of the Company at a conversion price of $ 0.4538 per share.\nOn August 11, 2023, the Company and the Investor entered into a letter agreement pursuant to which, among other things: i) the Investor agreed to forbear from issuing an Event of Default Notice and Event of Default Redemption Notice; (ii) the requirement in the 2023 Note to pay interest monthly in cash is waived for payments due August 1, 2023 through December 31, 2023; (iii) the application of the default interest rate on the 2023 Note is waived for the period from May 21, 2023 through December 31, 2023, (iv) the requirement for the Company to prepay, redeem, or convert one quarter the initial principal owe on the 2023 Note, plus any outstanding interest and make-whole amount by each three-month anniversary of the issuance date.is waived through December 31, 2023; (v) the Company adjusted the exercise price of the 2023 Note Warrant from $1.34 to $0.45; and (vi) the Investor may continue to convert the 2023 Note at the Alternate Conversion Price or at $0.45.\nBoard Compensation\nOn July 14, 2023, the Company issued a total of 270,272 shares at $ 0.555 per share for a total value of $ 150,000 to the non-executive directors of the Company as compensation for service as members of the Board of Directors of the Company for the first half of 2023.\n\n| 28 |\n\n\n\nThe following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and notes thereto included herein. In connection with, and because we desire to take advantage of, the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, we caution readers regarding certain forward-looking statements in the following discussion and elsewhere in this report and in any other statement made by, or on our behalf, whether or not in future filings with the Securities and Exchange Commission. Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results or other developments. Forward looking statements are necessarily based upon estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control and many of which, with respect to future business decisions, are subject to change. These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on our behalf. Words such as “anticipate,” “estimate,” “plan,” “continuing,” “ongoing,” “expect,” “believe,” “intend,” “may,” “will,” “should,” “could,” and similar expressions are used to identify forward-looking statements. We disclaim any obligation to update forward-looking statements.\nUnless the context requires otherwise, references in this document to “GGH”, “we”, “our”, “us” or the “Company” are to Gaucho Group Holdings, Inc. and its subsidiaries.\nPlease note that because we qualify as an emerging growth company and as a smaller reporting company, we have elected to follow the smaller reporting company rules in preparing this Quarterly Report on Form 10-Q.\nOverview\nGaucho Group Holdings, Inc. (“GGH” or the “Company”) positions its e-commerce leather goods, accessories, and fashion brand, Gaucho – Buenos Aires™, as one of luxury, creating a platform for the global consumer to access their piece of Argentine style and high-end products. With a concentration on leather goods, ready-to-wear and accessories, this is the luxury brand in which Argentina finds its contemporary expression. During the first quarter of 2022, the Company launched Gaucho Casa, a Home & Living line of luxury textiles and home accessories, which will be marketed and sold on the Gaucho – Buenos Aires e-commerce platform. Gaucho Casa challenges traditional lifestyle collections with its luxury textiles and home accessories rooted in the singular spirit of the gaucho aesthetic. GGH seeks to grow its direct-to-consumer online products to global markets in the United States, Asia, the United Kingdom, Europe, and Argentina. We intend to focus on e-commerce and scalability of the Gaucho – Buenos Aires and Gaucho Casa brands, as real estate in Argentina is politically sensitive.\nGGH’s goal is to become recognized as the LVMH (“Louis Vuitton Moët Hennessy”) of South America’s leading luxury brands. Through one of its wholly owned subsidiaries, GGH also owns and operates legacy investments in the boutique hotel, hospitality and luxury vineyard property markets. This includes a golf, tennis and wellness resort, as well as an award-winning wine production company concentrating on Malbecs and Malbec blends. Utilizing these wines as its ambassador, GGH seeks to further develop its legacy real estate, which includes developing residential vineyard lots located within its resort.\nAs a result of the COVID-19 pandemic, we terminated the corporate office lease and senior management now works remotely. GGH’s local operations are managed by professional staff with substantial hotel, hospitality and resort experience in Buenos Aires and San Rafael, Argentina.\n\n| 29 |\n\n\nRecent Developments and Trends\nWhile the World Health Organization declared an end to the COVID-19 global health emergency on May 5, 2023, we continue to closely monitor the outbreak of COVID-19 and the related impact on our operations, financial position and cash flows, as well as the impact on our employees. Due to the continued fluidity of this situation, and the magnitude and duration of the pandemic, its impact on our future operations and liquidity remains uncertain as of the date of this report.\nWe have faced, and may continue to face, significant cost inflation, specifically in raw materials and other supply chain costs due to increased demand for raw materials and the broad disruption of the global supply chain associated with the impact of COVID-19. International conflicts or other geopolitical events, including the 2022 Russian invasion of Ukraine, may further contribute to increased supply chain costs due to shortages in raw materials, increased costs for transportation and energy, disruptions in supply chains, and heightened inflation. Further escalation of geopolitical tensions may also lead to changes to foreign exchange rates and financial markets, any of which may adversely affect our business and supply chain, and consequently our results of operation. While there could ultimately be a material impact on the operations and liquidity of the Company, at the time of issuance, the impact could not be determined.\nDuring the three months ended June 30, 2023, the Company and the holder of a senior secured convertible note of the Company (the “2023 Note”) converted an aggregate of $575,256 of principal, interest and conversion premiums, and the Company issued an aggregate of 828,780 shares upon conversion.\nOn June 30, 2023, the Company through its wholly owned subsidiary, Gaucho Ventures I – Las Vegas, LLC (“GVI”), executed a Fourth Amendment to the Amended and Restated Limited Liability Company Agreement of LVH Holdings LLC (“LVH”) to extend the outside date for execution of the ground lease from June 30, 2023 to December 29, 2023.\nOn July 3, 2023, the Company and the holder of the 2023 Note converted an aggregate of $149,446 of principal, interest and conversion premiums and the Company issued an aggregate of 329,416 shares upon conversion.\nOn July 14, 2023, the Company issued a total of 270,272 shares at $0.555 per share for a total value of $150,000 to the non-executive directors of the Company as compensation for service as members of the Board of Directors of the Company for the first half of 2023.\nConsolidated Results of Operations\nThree months ended June 30, 2023 compared to the three months ended June 30, 2022\nOverview\nWe reported a net loss of approximately $5.0 million and $5.3 million for the three months ended June 30, 2023 and 2022, respectively.\nRevenues\nRevenues from operations were approximately $711,000 and $405,000 during the three months ended June 30, 2023 and 2022, respectively, reflecting an increase of approximately $306,000 or 76%. The overall increase in sales was driven by increases in hotel, restaurant and wine revenues of approximately $443,000, an increase of approximately $143,000 in lot sales, an increase of agricultural sales of approximately $178,000, and an increase in clothes, accessories and other sales of approximately $61,000, resulting from the easing of COVID restrictions and the Argentine government’s efforts to promote tourism and revitalize local businesses, and from the opening of our flagship retail store in Miami. These revenue increases were partially offset by a decrease of approximately $519,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\n\n| 30 |\n\n\nGross profit\nWe generated a gross profit of approximately $42,000 for the three months ended June 30, 2023 and a gross loss of approximately $128,000 for the three months ended June 30, 2022, representing an increase in gross profit of approximately $170,000 or 133%, primarily resulting from profits earned from the sale of real estate lots during the period.\nCost of sales, which consists of real estate lots, raw materials, direct labor and indirect labor associated with our business activities, increased by approximately $136,000 or 26%, from approximately $533,000 for the three months ended June 30, 2022 to approximately $669,000 for the three months ended June 30, 2023. The increase in cost of sales resulted from the increases in hotel, restaurant and wine costs of approximately $335,000, an increase in clothes, accessories and other costs of approximately $124,000, and an increase of approximately $102,000 in costs associated with lot sales, which correspond to the increases in the related revenues as discussed above. In addition, a higher number of agricultural sales, which are sold at a loss, provided an increase of approximately $199,000 in cost of sales. These increases in cost of sales were partially offset by a decrease of approximately $625,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\nSelling and marketing expenses\nSelling and marketing expenses were approximately $213,000 and $333,000 for the three months ended June 30, 2023 and 2022, respectively, representing a decrease of $120,000 or 36%, primarily related to lower GGI advertising and marketing expenses for GGI’s new retail space as well as the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\nGeneral and administrative expenses\nGeneral and administrative expenses were approximately $1,711,000 and $1,929,000 for the three months ended June 30, 2023 and 2022, respectively, representing a decrease of $218,000 or 11%. Decreases of approximately $225,000 in employee compensation, and approximately $759,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar were partially offset by increases of approximately $482,000 in professional and consulting fees (primarily business development and investor relations consulting) and approximately $284,000 in other aggregated expenses that are not individually material.\nDepreciation and amortization expense\nDepreciation and amortization expense was approximately $104,000 and $49,000 during the three months ended June 30, 2023 and 2022, respectively, representing an increase of $55,000 or 112%, related to new asset purchases.\nInterest income\nInterest income was approximately $64,000 and $27,000 during the three months ended June 30, 2023 and 2022, respectively, representing an increase of $37,000 or 137%, related to the increase in mortgages receivable.\nInterest expense\nInterest expense was approximately $1,066,000 and $695,000 during the three months ended June 30, 2023 and 2022, respectively, representing an increase of $371,000 or 53%. The increase is primarily related to a rise in the interest and debt discount related to convertible debt issued during February 2023.\n\n| 31 |\n\n\nOther income, related party\nOther income of approximately $75,000 during the three months ended June 30, 2023 and 2022 represents the management fee earned from LVH.\nLoss on extinguishment of debt\nLoss on extinguishment of debt in the aggregate amount of $32,094 during the three months ended June 30, 2023 consists of extinguishment loss recognized related to premiums paid on the cash redemption of convertible debt. Loss on extinguishment of debt in the aggregate amount of $2,105,119 during the three months ended June 30, 2022 consists of extinguishment loss recognized upon the reduction of the conversion price on the GGH Notes during the second quarter of 2022.\nGains from foreign currency translation\nThe Company recorded gains from foreign currency translation of approximately $103,000 and $43,000 during the three months ended June 30, 2023 and 2022, respectively. The increase of approximately $60,000 in gains from foreign currency translation is due to the fluctuation in the Argentine peso to United States dollar exchange rates.\nChange in fair value of derivative liability\nThe Company recorded a change in fair value of derivative liability of approximately $2,141,000 and $0 during the three months ended June 30, 2023 and 2022, respectively. The change in fair value during the six months ended June 30, 2023 is associated with the default of the 2023 Convertible Note as of June 30, 2023.\nInducement expense\nInducement expense decreased to $0 for the three months ended June 30, 2023 from approximately $198,000 during the three months ended June 30, 2022. Inducement expense during the three months ended June 30, 2022 resulted from a temporary reduction in the conversion price on convertible debt.\nSix months ended June 30, 2023 compared to the six months ended June 30, 2022\nOverview\nWe reported a net loss of approximately $7.7 million and $7.6 million for the six months ended June 30, 2023 and 2022, respectively.\nRevenues\nRevenues from operations were approximately $1,159,000 and $831,000 during the six months ended June 30, 2023 and 2022, respectively, reflecting an increase of approximately $328,000 or 39%. The overall increase in sales was driven by increases in hotel, restaurant and wine revenues of approximately $863,000, increases in agricultural revenues of $122,000, and increases in clothes, accessories and other sales of approximately $145,000 resulting from the easing of COVID restrictions and the Argentine government’s efforts to promote tourism and revitalize local businesses, and from the opening of our flagship retail store in Miami. These revenue increases were partially offset by a decrease in lot sales of approximately $42,000 and approximately $760,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\n\n| 32 |\n\n\nGross profit\nWe generated a gross profit of approximately $197,000 and $59,000 for the six months ended June 30, 2023 and 2022, respectively, representing an increase of approximately $138,000 or 234%. The increase in gross profit during the six months ended June 30, 2023 is primarily related to hotel sales during the period. The Company’s hotel was being renovated during the first half of 2022, resulting in limited revenues, with fixed costs related to hotel operations.\nCost of sales, which consists of real estate lots, raw materials, direct labor and indirect labor associated with our business activities, increased by approximately $190,000 or 25%, from approximately $772,000 for the six months ended June 30, 2022 to approximately $962,000 for the six months ended June 30, 2023. The increase in cost of sales includes increases in hotel, restaurant and wine costs of approximately $534,000, an increase in clothes, accessories and other costs of approximately $166,000, and an increase of approximately $75,000 in costs associated with lot sales, which correspond to the increases in the related revenues as discussed above. In addition, a higher number of agricultural sales, which are sold at a loss, provided an increase of approximately $158,000 in cost of sales. These increases in cost of sales were partially offset by a decrease of approximately $743,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\nSelling and marketing expenses\nSelling and marketing expenses were approximately $448,000 and $505,000 for the six months ended June 30, 2023 and 2022, respectively, representing a decrease of approximately $57,000 or 11%, primarily related to lower GGI advertising and marketing expenses for GGI’s new retail space as well as the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\nGeneral and administrative expenses\nGeneral and administrative expenses were approximately $3,467,000 and $3,674,000 for the six months ended June 30, 2023 and 2022, respectively, representing a decrease of $207,000 or 6%. A decrease of approximately $739,000 resulting from gains recognized on transactions denominated in foreign currency, as well as a decrease of approximately $460,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar were partially offset by increases of approximately $596,000 in professional and consulting fees (primarily business development and investor relations consulting), approximately $85,000 of compensation expense, as well as approximately $307,000 in other aggregated expenses that are not individually material. Gains recognized on transactions denominated in a foreign currency result from the difference between the official exchange rate, and the actual exchange rate applied to the peso.\nDepreciation and amortization expense\nDepreciation and amortization expense was approximately $213,000 and $95,000 during the six months ended June 30, 2023 and 2022, respectively, representing an increase of $118,000 or 124%, related to new asset purchases.\nInterest income\nInterest income was approximately $115,000 and $30,000 during the six months ended June 30, 2023 and 2022, respectively, representing an increase of $85,000 or 283% as the result of increases in mortgages receivable during the period.\nInterest expense\nInterest expense was approximately $1,668,000 and $1,453,000 during the six months ended June 30, 2023 and 2022, respectively, representing an increase of $215,000 or 15%. The increase is primarily related to a rise in the interest and debt discount related to convertible debt issued during February 2023.\nOther income\nOther income of approximately $150,000 during the six months ended June 30, 2023 and 2022 represents the management fee received from LVH.\n\n| 33 |\n\n\nGains from foreign currency translation.\nThe Company recorded gains from foreign currency translation of approximately $215,000 and $226,000 during the six months ended June 30, 2023 and 2022, respectively, as the result of the highly inflationary status of Argentina. The decrease of approximately $11,000 in gains from foreign currency translation is due to the fluctuation in the Argentine peso to United States dollar exchange rates.\nLoss on extinguishment of debt\nLoss on extinguishment of debt was approximately $416,000 during the six months ended June 30, 2023, as compared to approximately $2.1 million during the six months ended June 30, 2022. Loss on extinguishment of debt during the six months ended June 30, 2023 in the approximate amount of $416,000 is comprised of (i) premium paid on the conversion of GGH Notes of approximately $112,000, (ii) premium paid on the cash redemption of GGH Notes of approximately $124,000, (iii) premium paid on the 2023 Note for cash redemption of principal in the amount of approximately $32,000; (iv) premium in the amount of approximately $13,000 paid on the conversion an aggregate of $87,179 of principal and interest owed on the 2023 Note, and (iv) the fair value of approximately $135,000 in warrants issued in the exchange agreement for the GGH Notes (See Note 10—Convertible Debt Obligations for additional details).\nLiquidity and Capital Resources\nWe measure our liquidity a variety of ways, including the following:\n\n| June 30, 2023 | December 31, 2022 |\n| (unaudited) |\n| Cash | $ | 810,139 | $ | 300,185 |\n| Working capital (deficiency) | $ | (3,828,285 | ) | $ | 595,120 |\n| Convertible debt obligations | $ | 4,893,983 | $ | 1,997,909 |\n| Loans payable | $ | 342,482 | $ | 256,321 |\n\nCash requirements for our current liabilities include approximately $2.0 million for accounts payable and accrued expenses, approximately $220,000 for lease liabilities, and approximately $332,000 for loans payable and other current liabilities. We also have convertible debt obligations in the approximate amount of $4.8 million which, if not converted prior to maturity, are due on February 21, 2024. Cash requirements for our long-term liabilities include approximately $1.2 million for operating lease liabilities, approximately $90,000 in loans payable, and approximately $82,000 of long-term accrued expenses.\nDuring the six months ended June 30, 2023, we financed a portion of our activities from proceeds derived from debt and equity financings. A significant portion of the funds have been used to cover working capital needs and personnel, office expenses and various consulting and professional fees.\nNet cash used in operating activities for the six months ended June 30, 2023 and 2022 amounted to approximately $4,033,000 and $2,755,000, respectively. During the six months ended June 30, 2023, the net cash used in operating activities was primarily attributable to the net loss of approximately $7.7 million adjusted for approximately $4.1 million of net non-cash expenses, and approximately $0.5 million of cash used to fund changes in the levels of operating assets and liabilities. During the six months ended June 30, 2022, the net cash used in operating activities was primarily attributable to the net loss of approximately $7.6 million adjusted for approximately $4.1 million of net non-cash expenses, and approximately $0.7 million of cash used to fund changes in the levels of operating assets and liabilities.\nCash used in investing activities for the six months ended June 30, 2023 and 2022 amounted to approximately $489,000 and $1,720,000, respectively, resulting primarily from the purchase of property and equipment in the approximate amount of $438,000 and $1,677,000 million, respectively, and approximately $50,000 and $35,000 respectively, used to purchase certain intangible assets.\n\n| 34 |\n\n\nNet cash provided by financing activities for the six months ended June 30, 2023 and 2022 amounted to approximately $5.1 million and $0.5 million, respectively. For the six months ended June 30, 2023, the net cash provided by financing activities resulted from approximately $4.7 million in net proceeds from the issuance of debt, $0.6 million in proceeds from the issuance of common stock in a private placement, approximately $0.7 million in proceeds from the issuance of stock under the New ELOC and $0.2 million in proceeds from the issuance of a note payable, partially offset by the repayment of convertible debt obligations and related redemption premiums in the approximate amount of $1.0 million, and repayment of loans payable of approximately $0.1 million. Net cash used in financing activities for the six months ended June 30, 2022 resulted from approximately $0.5 million of cash proceeds from the sale of commons stock, partially offset by approximately $0.1 million in repayments of loans payable.\nAs of June 30, 2023, the Company had cash and a working capital deficit of approximately $810,000 and $3,109,000, respectively. During the six months ended June 30, 2023 and 2022, the Company incurred net losses of approximately $7.7 million and $7.6 million, respectively, and used cash in operating activities of approximately $4.0 million and $2.8 million, respectively. Further, as of June 30, 2023, approximately $4.8 million owed in connection with the Company’s convertible debt matures on February 21, 2024, and approximately $0.3 million represents the current portion of the Company’s loans payable which are payable on demand or for which payments are due within twelve months after June 30, 2023. During the six months ended June 30, 2023, the Company funded its operations with net proceeds from convertible debt financing of approximately $4.7 million, proceeds of approximately $0.7 million from draws on the Company’s equity line of credit, and $0.6 million from the sale of common stock.\nThe Company’s operating needs include the planned costs to operate its business, including amounts required to fund working capital and capital expenditures. Based upon projected revenues and expenses, the Company believes that it may not have sufficient funds to operate for the next twelve months from the date these financial statements are made available. Since inception, the Company’s operations have primarily been funded through proceeds received from equity and debt financings. The Company believes it has access to capital resources and continues to evaluate additional financing opportunities. There is no assurance that the Company will be able to obtain funds on commercially acceptable terms, if at all. There is also no assurance that the amount of funds the Company might raise will enable the Company to complete its development initiatives or attain profitable operations. The aforementioned factors raise substantial doubt about the Company’s ability to continue as a going concern.\nAvailability of Additional Funds\nAs a result of our financings, we have been able to sustain operations. However, we will need to raise additional capital in order to meet our future liquidity needs for operating expenses and capital expenditures, including GGI inventory production, continued development of the GGI e-commerce platform, expansion of our winery and additional investments in real estate development. If we are unable to obtain adequate funds on reasonable terms, we may be required to significantly curtail or discontinue operations.\nOff-Balance Sheet Arrangements\nNone.\nContractual Obligations\nAs a smaller reporting company, we are not required to provide the information requested by paragraph (a)(5) of this Item.\nCritical Accounting Policies and Estimates\nThere are no material changes from the critical accounting policies, estimates and new accounting pronouncements set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” set forth in our Annual Report on Form 10-K filed with the SEC on April 17, 2023, except as described below. Please refer to that document for disclosures regarding the critical accounting policies related to our business.\n\n| 35 |\n\n\nConvertible Promissory Notes\nThe Company evaluates its convertible instruments to determine if those contracts or embedded components of those contracts qualify as derivative financial instruments to be separately accounted for in accordance with Topic 815 “Derivatives and Hedging” (“ASC 815”) of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”). The accounting treatment of derivative financial instruments requires that the Company record any bifurcated embedded features at their fair values as of the inception date of the agreement and at fair value as of each subsequent balance sheet date. Any change in fair value is recorded in earnings each period as non-operating, non-cash income or expense. The Company reassesses the classification of its derivative instruments at each balance sheet date. If the classification changes as a result of events during the period, the contract is reclassified as of the date of the event that caused the reclassification. Bifurcated embedded features are recorded upon note issuance at their initial fair values which create additional debt discount to the host instrument.\nSequencing Policy\nUnder ASC 815, we have adopted a sequencing policy, whereby, in the event that reclassification of contracts from equity to assets or liabilities is necessary pursuant to ASC 815 due to the Company’s inability to demonstrate it has sufficient authorized shares as a result of certain securities with a potentially indeterminable number of shares or the Company’s total potentially dilutive shares exceed the Company’s authorized share limit, shares will be allocated on the basis of the earliest issuance date of potentially dilutive instruments, with the earliest grants receiving the first allocation of shares. Pursuant to ASC 815, issuances of securities granted as compensation in a share-based payment arrangement are not subject to the sequencing policy.\n\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, we are not required to provide the information required by this Item.\n\nDisclosure Controls and Procedures\nOur management carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer (who is our Principal Executive Officer) and our Chief Financial Officer (who is our Principal Financial Officer and Principal Accounting Officer), of the effectiveness of the design of our disclosure controls and procedures (as defined by Exchange Act Rules 13a-15(e) or 15d-15(e)) as of June 30, 2023, pursuant to Exchange Act Rule 13a-15(b). Based upon that evaluation, our Principal Executive Officer and Principal Financial Officer concluded that our disclosure controls and procedures were not effective as of June 30, 2023, resulting from a lack of segregation of duties due to our small size, and lack of testing of the operating effectiveness of the controls.\n\n| 36 |\n\n\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting identified in management’s evaluation pursuant to Rules 13a-15(d) or 15d-15(d) of the Exchange Act during the quarter ended June 30, 2023 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\nInherent Limitations of Controls\nManagement does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all errors and all fraud. Controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or deterioration in the degree of compliance with the policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.\n\n| 37 |\n\n\nPART II - OTHER INFORMATION\n\nFrom time to time, the Company and its subsidiaries and affiliates are subject to litigation and arbitration claims incidental to its business. Such claims may not be covered by its insurance coverage, and even if they are, if claims against GGH and its subsidiaries are successful, they may exceed the limits of applicable insurance coverage. We are not involved in any litigation that we believe is likely, individually or in the aggregate, to have a material adverse effect on our condensed consolidated financial condition, results of operations or cash flows.\n\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, we are not required to provide information required by this Item. However, our current risk factors are set forth in Item 1A of the Company’s Annual Report on Form 10-K as filed with the SEC on April 17, 2023 and in Item 1A of the Company’s Quarterly Report on Form 10-Q as filed with the SEC on May 19, 2023.\nOur stock has been trading below $1.00 and our failure to maintain compliance with Nasdaq’s continued listing requirements could result in the delisting of our common stock.\nOur common stock is currently listed for trading on The Nasdaq Capital Market. We must satisfy the continued listing requirements of The Nasdaq Stock Market LLC (or Nasdaq), to maintain the listing of our common stock on The Nasdaq Capital Market.\nOn June 1, 2023, the Company received a deficiency letter from the Listing Qualifications Department (the “Staff”) of the Nasdaq Stock Market notifying the Company that, for the preceding 30 consecutive business days, the closing bid price for the Company’s common stock was trading below the minimum $1.00 per share requirement for continued inclusion on The Nasdaq Capital Market pursuant to Nasdaq Listing Rule 5450(a)(1) (the “Bid Price Requirement”). The notification has no immediate effect on the Company’s Nasdaq listing and the Company’s common stock will continue to trade on Nasdaq under the ticker symbol “VINO.”\nIn accordance with Nasdaq Rules, the Company was provided with an initial period of 180 calendar days, or until November 28, 2023 (the “Compliance Date”), to regain compliance with the Bid Price Requirement. If at any time before the Compliance Date the closing bid price for the Company’s common stock is at least $1.00 for a minimum of 10 consecutive business days, the Staff will provide the Company written confirmation of compliance with the Bid Price Requirement.\nIf the Company does not regain compliance with the Bid Price Requirement by the Compliance Date, the Company may be eligible for an additional 180 calendar day compliance period. To qualify, the Company would then be required to meet the continued listing requirement for market value of publicly held shares and all other initial listing standards for The Nasdaq Capital Market, with the exception of the Bid Price Requirement, and will need to provide written notice of its intention to cure the deficiency during the additional 180 calendar day compliance period, which compliance could be achieved by effecting a reverse stock split, if necessary. If the Company does not regain compliance with the Bid Price Requirement by the Compliance Date and is not eligible for an additional compliance period at that time, the Staff will provide written notification to the Company that its common stock will be subject to delisting. At that time, the Company may appeal the Staff’s delisting determination to a Nasdaq Hearings Panel.\n\n| 38 |\n\n\nThe Company is holding its Annual General Meeting on August 24, 2023, at which, among other things, the Company has requested stockholder approval to grant the Board of Directors discretion (if necessary to prevent the delisting of the Company’s common stock on Nasdaq) on or before June 30, 2024, to implement a reverse stock split of the outstanding shares of common stock in a range from one-for-two (1:2) up to one-for-ten (1:10), or anywhere between, while maintaining the number of authorized shares of common stock at 150,000,000 shares, as required for Nasdaq listing. The Company will need shareholders representing a majority of the outstanding shares of the Company to approve this proposal, which is not guaranteed.\nIf our common stock were delisted from Nasdaq, trading of our common stock would most likely take place on an over-the-counter market established for unlisted securities, such as the OTCQB or the Pink Market maintained by OTC Markets Group Inc. An investor would likely find it less convenient to sell, or to obtain accurate quotations in seeking to buy, our common stock on an over-the-counter market, and many investors would likely not buy or sell our common stock due to difficulty in accessing over-the-counter markets, policies preventing them from trading in securities not listed on a national exchange or other reasons. In addition, as a delisted security, our common stock would be subject to SEC rules as a “penny stock”, which impose additional disclosure requirements on broker-dealers. The regulations relating to penny stocks, coupled with the typically higher cost per trade to the investor of penny stocks due to factors such as broker commissions generally representing a higher percentage of the price of a penny stock than of a higher-priced stock, would further limit the ability of investors to trade in our common stock. In addition, delisting would materially and adversely affect our ability to raise capital on terms acceptable to us, or at all, and may result in the potential loss of confidence by investors, suppliers, customers and employees and fewer business development opportunities. For these reasons and others, delisting would adversely affect the liquidity, trading volume and price of our common stock, causing the value of an investment in us to decrease and having an adverse effect on our business, financial condition and results of operations, including our ability to attract and retain qualified employees and to raise capital.\nThe Company is currently in default under one of its convertible promissory notes, which allows the holder to redeem all or a portion of the Note.\nPursuant to the 2023 Purchase Agreement and Notes, as of May 21, 2023, the Company failed to prepay, redeem or convert one quarter of the initial principal and interest on the Notes. The holder may require the Company to redeem all or a portion of the Notes by written notice, which would have a material adverse effect on the Company. On August 11, 2023, the Company and the holder of the Notes entered into an agreement (the “Letter Agreement”) pursuant to which, among other things: the holder agreed to forbear from issuing an event of default notice and event of default redemption notice through December 31, 2023. See Item 5 for additional information.\nIf LVH does not sign a ground lease by December 29, 2023, LVH will be dissolved and we may not receive a complete return of our investment.\nCurrently, the Company, through its wholly-owned subsidiary, Gaucho Ventures I – Las Vegas, LLC (“GVI”), contributed total capital of $7.0 million to LVH Holdings LLC (“LVH”) to develop a project in Las Vegas, Nevada and received 396 limited liability company interests, representing an 11.9% equity interest in LVH. Pursuant to the Fourth Amendment to the Amended and Restated Limited Liability Company Agreement of LVH dated June 30, 2023, if a ground lease for the premises within which the luxury hotel, casino, entertainment and retail project will be developed and constructed has not been executed by LVH on or before December 29, 2023, then as promptly as reasonably practicable after such date, LVH will be liquidated and dissolved.\nAs of June 30, 2023, LVH has used our cash contribution to LVH for land improvement expenses, such as architectural, legal, engineering, and accounting fees. Should LVH be liquidated and dissolved on or before December 29, 2023, we most likely will not receive our entire contribution back from LVH and may lose our entire investment.\n\n| 39 |\n\n\n\nEquity Line of Credit\nPursuant to the Purchase Agreement with Tumim Capital dated November 8, 2022, the Company requested draw-downs and issued shares of common stock and received gross proceeds of the following for the three months ended June 30, 2023: (i) April 19, 2023, the Company issued 195,970 shares of common stock to Tumim for gross proceeds of $144,339; and (ii) on May 5, 2023, the Company issued 262,798 shares of common stock to Tumim for gross proceeds of $172,614. No general solicitation was used, and a commission of 8% of the total gross proceeds was paid to Benchmark Investments, Inc. pursuant to the Underwriting Agreement between the Company and Kingswood Capital Markets, a division of Benchmark Investments, Inc., f/k/a EF Hutton, dated February 16, 2021. The Company relied on the exemptions from registration available under Section 4(a)(2) and/or Rule 506(b) of Regulation D of the Securities Act, in connection with the sales. A Form D was filed with the SEC on November 21, 2022.\n\nPursuant to the 2023 Purchase Agreement and Notes, as of each three-month anniversary of the Notes, the Company was required to prepay, redeem or convert one quarter of the initial principal and interest on the Notes. The Company did not meet that requirement as of May 21, 2023, which is the first three-month anniversary. The Company is required to deliver notice of default to the holder within one (1) business day. The holder may require the Company to redeem all or a portion of the Notes by written notice. On August 11, 2023, the Company and the holder of the Notes entered into an agreement pursuant to which, among other things: the holder agreed to forbear from issuing an event of default notice and event of default redemption notice through December 31, 2023. See Item 5 for additional information.\n\nNot applicable.\n\nSpecial Meeting of Stockholders\nOn May 8, 2023, the Company held a special stockholder meeting (the “Special Meeting”) at 12:00 p.m. Eastern Time at which a quorum was present. At the Special Meeting, a proposal to approve, for purposes of complying with Nasdaq Listing Rule 5635(d), the full issuance and exercise of shares of our common stock to be issued pursuant to that certain Securities Purchase Agreement, dated February 21, 2023 (the “Purchase Agreement”), that certain senior secured convertible promissory note dated February 21, 2023 (the “Note”), that certain common stock purchase warrant dated February 21, 2023 (the “Warrants”), and that certain Registration Rights Agreement, dated February 21, 2023 (the “Registration Rights Agreement”) by and between the Company and an institutional investor was approved by the stockholders.\nAnnual General Meeting\nOn June 29, 2023, the Company filed a Preliminary Proxy Statement on Form 14-A, a Definitive Proxy Statement on Form 14-A on July 10, 2023, and additional definitive proxy materials on Form 14-A on July 11, 2023, which request stockholder approval of the following proposals: (i) To elect two (2) Class III nominees to the board of directors (Scott L. Mathis and William A. Allen) to hold office for a three-year term; (ii) to grant the Board of Directors discretion (if necessary to prevent the delisting of the Company’s common stock on Nasdaq) on or before June 30, 2024, to implement a reverse stock split of the outstanding shares of common stock in a range from one-for-two (1:2) up to one-for-ten (1:10), or anywhere between, while maintaining the number of authorized shares of common stock at 150,000,000 shares, as required for Nasdaq listing; (iii) to conduct an advisory vote on executive compensation; (iv) to conduct an advisory vote on the frequency of advisory votes on executive compensation; and (v) to ratify and approve the appointment of Marcum LLP as the Company’s independent registered accounting firm for the year ended December 31, 2023.\n\n| 40 |\n\n\nLVH Holdings LLC\nOn June 30, 2023, the Company, through its wholly owned subsidiary, Gaucho Ventures I – Las Vegas, LLC (“GVI”), executed a Fourth Amendment to the Amended and Restated Limited Liability Company Agreement of LVH Holdings LLC (“LVH”) to extend the outside date for execution of the ground lease from June 30, 2023 to December 29, 2023.\nAs previously disclosed, on June 16, 2021, the Company, through GVI, entered into the Amended and Restated Limited Liability Company Agreement of LVH; on November 16, 2022, entered into the First Amendment to the Amended and Restated Limited Liability Company Agreement of LVH; on June 7, 2022, entered into the Second Amendment to the Amended and Restated Limited Liability Company Agreement of LVH; and on December 12, 2022, entered into the Third Amendment to the Amended and Restated Limited Liability Company Agreement of LVH.\nAs of the date of the Fourth Amendment to the Amended and Restated Limited Liability Company Agreement, GVI and SLVH LLC comprise all of the members of LVH.\nBoard Compensation\nOn July 14, 2023, the Company issued a total of 270,272 shares at $0.555 per share to the non-executive directors of the Company as compensation for service as members of the Board of Directors of the Company for the first half of 2023. For this sale of securities, no general solicitation was used, no commissions were paid, all persons were accredited investors, and the Company relied on the exemption from registration available under Section 4(a)(2) and/or Rule 506(b) of Regulation D promulgated under the Securities Act with respect to transactions by an issuer not involving any public offering. A Form D was filed with the SEC on July 28, 2023.\nConvertible Promissory Notes\nAs previously reported on our Current Report on Form 8-K filed on February 21, 2023, the Company and an institutional investor (the “Holder”) entered into that certain Securities Purchase Agreement, dated as of February 21, 2023 (the “Securities Purchase Agreement”) and the Company issued to the Holder a senior secured convertible note (the “Note”) and warrant to purchase 3,377,099 shares of common stock of the Company (the “Warrant” and together with the Securities Purchase Agreement and the Note, the “Note Documents”).\nFor the full description of the Note Documents, please refer to our Current Report on Form 8-K and the exhibits attached thereto as filed with the SEC on February 21, 2023.\nAs previously reported on our Current Report on Form 8-K filed on August 11, 2023, an Event of Default occurred with respect to the Note. As a result, on August 11, 2023, the Company and the Holder entered into an agreement (the “Letter Agreement”) pursuant to which, among other things: (i) the Holder agreed to forbear from issuing an Event of Default Notice and Event of Default Redemption Notice; (ii) the Holder waived the requirement in the Note to pay Interest on the Note monthly in cash for a certain period of time; (iii) the Holder agreed to waive application of the Default Rate in Note for a certain period of time; (iv) the Holder agreed to waive the requirement in the Note for the Company to prepay, redeem, or convert one quarter of the initial Principal and Interest on the Note by each three (3) month anniversary of the Issuance Date for a certain period of time; (v) the Company adjusted the exercise price of the Warrant from $1.34 to $0.45; and (vi) the Holder may continue to convert the Note at the Alternate Conversion Price or at $0.45.\nAll terms not defined herein shall refer to the defined terms in the Note Documents.\nSee also Items 1A and 3 above.\n\n| 41 |\n\n\n\nThe following documents are being filed with the Commission as exhibits to this Current Report on Form 10-Q.\n\n| Exhibit | Description |\n| 1.1 | Underwriting Agreement, dated February 16, 2021 (5) |\n| 1.2 | Warrant Agreement, including the form of Warrant, made as of February 19, 2021, between the Company and Continental. (6) |\n| 3.1 | Amended and Restated Certificate of Incorporation filed with the Delaware Secretary of State effective November 4, 2022 (15) |\n| 3.2 | Amended and Restated Bylaws (1) |\n| 3.3 | Amendment to the Company’s Amended and Restated Bylaws as approved on July 8, 2019 (4) |\n| 4.1 | 2016 Stock Option Plan. (2) |\n| 4.2 | First Amendment to 2016 Stock Option Plan as adopted by the Board of Directors on October 20, 2016. (2) |\n| 4.3 | 2018 Equity Incentive Plan. (3) |\n| 4.4 | Amendment to the Company’s 2018 Equity Incentive Plan as approved by the Board of Directors on May 13, 2019 and the stockholders on July 8, 2019 (4) |\n| 4.5 | Amendment to the Company’s 2018 Equity Incentive Plan as approved by the Board of Directors on July 12, 2021 and the stockholders on August 26, 2021 (14) |\n| 4.6 | Amendment to the Company’s 2018 Equity Incentive Plan as approved by the Board of Directors on July 1, 2022 and the stockholders on August 30, 2022 (20) |\n| 4.7 | Underwriters’ Warrant (5) |\n| 4.8 | Form of Warrant (11) |\n| 4.9 | Form Amended and Restated Warrant (17) |\n| 4.10 | Form Warrant (18) |\n| 4.11 | Form Warrant (21) |\n| 4.12 | Form Warrant (25) |\n| 4.13 | Form Warrant (26) |\n| 10.1 | Employment Agreement by and between the Company and Scott L. Mathis dated September 28, 2015 (24) |\n| 10.2 | Retention Bonus Agreement by and between the Company and Scott L. Mathis dated March 29, 2020 (7) |\n| 10.3 | Employment Agreement by and between the Company and its Chief Financial Officer dated December 14, 2022 (23) |\n| 10.4 | Commercial Lease Agreement between Gaucho Group, Inc. and Design District Development Partners, LLC, dated April 8, 2021 (8) |\n| 10.5 | Amended and Restated Limited Liability Company Agreement of LVH Holdings LLC, dated June 16, 2021 (9) |\n| 10.6 | First Amendment to Amended and Restated Limited Liability Agreement dated November 16, 2021 (10) |\n| 10.7 | Second Amendment to Amended and Restated Limited Liability Agreement dated June 7, 2022 (13) |\n| 10.8 | Third Amendment to Amended and Restated Limited Liability Agreement dated June 7, 2022 (22) |\n| 10.9 | Common Stock Purchase Agreement by and between Gaucho Group Holdings, Inc. and Tumim Stone Capital LLC, dated November 8, 2022 (19) |\n| 10.10 | Registration Rights Agreement by and between Gaucho Group Holdings, Inc. and Tumim Stone Capital LLC, dated November 8, 2022 (16) |\n| 10.11 | Securities Purchase Agreement dated February 21, 2023 (26) |\n| 10.12 | Form of Senior Secured Convertible Note Issued by the Company (26) |\n| 10.13 | Form of Security and Pledge Agreement (26) |\n| 10.14 | Form of Stockholder Pledge Agreement (26) |\n| 10.15 | Form of Registration Rights Agreement (26) |\n| 10.16 | Fourth Amendment to Amended and Restated Limited Liability Agreement dated June 30, 2023 (28) |\n| 10.17 | Letter Agreement, dated as of August 11, 2023, by and among the Company and the subscriber listed therein (29) |\n| 22.1 | Subsidiary guarantors and issuers of guaranteed securities and affiliates whose securities collateralize securities of the registrant (12) |\n| 31.1 | Certification of Principal Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act.* |\n| 31.2 | Certification of Principal Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act.* |\n| 32 | Certification of the Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002** |\n| 99.1 | Algodon Wine Estates Property Map (27) |\n| 101.INS | Inline XBRL Instance Document* |\n| 101.SCH | Inline XBRL Schema Document* |\n| 101.CAL | Inline XBRL Calculation Linkbase Document* |\n| 101.DEF | Inline XBRL Definition Linkbase Document* |\n| 101.LAB | Inline XBRL Label Linkbase Document* |\n| 101.PRE | Inline XBRL Presentation Linkbase Document* |\n| 104 | Cover Page Interactive Data File (embedded within the Inline XBRL document) * |\n\n\n| 42 |\n\n\n\n| 1. | Incorporated by reference from the Company’s Registration of Securities Pursuant to Section 12(g) on Form 10 dated May 14, 2014. |\n| 2. | Incorporated by reference from the Company’s Annual Report on Form 10-K, filed on March 31, 2017. |\n| 3. | Incorporated by reference from the Company’s Quarterly Report on Form 10-Q, filed on November 19, 2018. |\n| 4. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on July 9, 2019. |\n| 5. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on February 18, 2021. |\n| 6. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on February 22, 2021. |\n| 7. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on April 1, 2020. |\n| 8. | Incorporated by reference to the Company’s Annual Report on Form 10-K filed on April 12, 2021. |\n| 9. | Incorporated by reference to the Company’s Quarterly Report on Form 10-Q filed on August 16, 2021. |\n| 10. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on November 17, 2021. |\n| 11. | Incorporated by reference to the Company’s Current Report on Form 8-K as filed on March 1, 2022. |\n| 12. | Incorporated by reference to the Company’s Annual Report on Form 10-K, filed on April 14, 2022. |\n| 13. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on June 8, 2022. |\n| 14. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on August 31, 2021. |\n| 15. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on November 3, 2022. |\n| 16. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on November 9, 2022. |\n| 17. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on October 24, 2022. |\n| 18. | Incorporated by reference to the Company’s Amended Current Report on Form 8-K/A, filed on September 8, 2022. |\n| 19. | Incorporated by reference to the Company’s Current Report as amended on Form 8-K/A, filed on November 14, 2022. |\n| 20. | Incorporated by reference to the Company’s Quarterly Report on Form 10-Q, filed on November 18, 2022. |\n| 21. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on December 1, 2022. |\n| 22. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on December 13, 2022. |\n| 23. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on December 15, 2022. |\n| 24. | Incorporated by reference to the Company’s Quarterly Report on Form 10-Q, filed on November 16, 2015. |\n| 25. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on February 21, 2023. |\n| 26. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on February 21, 2023. |\n| 27. | Incorporated by reference to the Company’s Annual Report on Form 10-K, filed on April 17, 2023. |\n| 28. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on July 5, 2023. |\n| 29. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on August 11, 2023. |\n| * | Filed herewith. |\n| ** | Furnished, not filed herewith. |\n\n\n| 43 |\n\n\nSIGNATURES\nPursuant to the requirements of Section 12 of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| Date: August 14, 2023 | GAUCHO GROUP HOLDINGS, INC. |\n| By: |\n| Scott L. Mathis |\n| Chief Executive Officer |\n| By: |\n| Maria Echevarria |\n| Chief Financial Officer and Chief Operating Officer |\n\n\n| 44 |\n\n\n \n\nIf the company can maintain its current cash inflows and outflows in the future, how many months can the company continue to operate while paying off its convertible debt obligations, excluding the cash requirements for current liabilities and long-term liabilities?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nItem 1. Financial Statements\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nCONDENSED CONSOLIDATED BALANCE SHEETS\\n\\n| June 30, | December 31, |\\n| 2023 | 2022 |\\n| (unaudited) |\\n| Assets |\\n| Current Assets |\\n| Cash | $ | 810,139 | $ | 300,185 |\\n| Accounts receivable, net of allowance of $ 14,600 and $ 21,229 at June 30, 2023 and December 31, 2022, respectively | 58,944 | 106,156 |\\n| Accounts receivable - related parties, net of allowance of $ 470,516 and $ 339,503 at June 30, 2023 and December 31, 2022, respectively | 1,075,102 | 1,115,816 |\\n| Accounts receivable | 1,075,102 | 1,115,816 |\\n| Mortgages receivable, net of allowance $ 55,682 and $ 46,424 at June 30, 2023 and December 31, 2022, respectively | 729,833 | 586,631 |\\n| Inventory | 1,960,988 | 1,888,962 |\\n| Real estate lots held for sale | 445,412 | 559,487 |\\n| Prepaid expenses and other current assets | 423,658 | 461,637 |\\n| Total Current Assets | 5,504,076 | 5,018,874 |\\n| Long Term Assets |\\n| Mortgages receivable, non-current portion, net of allowance of $ 178,541 and $ 150,126 at June 30, 2023 and December 31, 2022, respectively | 3,091,222 | 3,278,617 |\\n| Advances to employees | 281,783 | 282,055 |\\n| Property and equipment, net | 7,857,485 | 7,621,257 |\\n| Operating lease right-of-use asset | 1,335,698 | 1,449,442 |\\n| Prepaid foreign taxes, net | 985,470 | 916,823 |\\n| Intangible assets, net | 108,967 | 69,787 |\\n| Deposits, non-current | 54,713 | 56,130 |\\n| Total Assets | $ | 19,219,414 | $ | 18,692,985 |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n\\n| 1 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nCONDENSED CONSOLIDATED BALANCE SHEETS, CONTINUED\\n\\n| June 30, | December 31, |\\n| 2023 | 2022 |\\n| (unaudited) |\\n| Liabilities and Stockholders’ Equity |\\n| Current Liabilities |\\n| Accounts payable | $ | 691,739 | $ | 917,270 |\\n| Accrued expenses, current portion | 1,258,163 | 1,664,816 |\\n| Deferred revenue | 1,368,921 | 1,373,906 |\\n| Operating lease liabilities, current portion | 220,416 | 202,775 |\\n| Loans payable, current portion | 252,014 | 164,656 |\\n| Convertible debt obligations, net, current portion | 3,372,291 | - |\\n| Derivative liability, current portion | 2,088,617 |\\n| Other current liabilities | 80,200 | 100,331 |\\n| Total Current Liabilities | 9,332,361 | 4,423,754 |\\n| Long Term Liabilities |\\n| Accrued expenses, non-current portion | 81,638 | 66,018 |\\n| Operating lease liabilities, non-current portion | 1,212,641 | 1,328,408 |\\n| Loans payable, non-current portion | 90,468 | 91,665 |\\n| Convertible debt obligations, net, non-current portion | 84,674 | 1,991,459 |\\n| Derivative liability | 52,500 | - |\\n| Total Liabilities | 10,854,282 | 7,901,304 |\\n| Commitments and Contingencies (Note 15) | - | - |\\n| Stockholders’ Equity |\\n| Preferred stock, 902,670 shares authorized | - | - |\\n| Common stock, par value $ 0.01 per share; 150,000,000 shares authorized; 6,809,348 and 3,653,401 shares issued and 6,809,067 and 3,653,120 shares outstanding as of June 30, 2023 and December 31, 2022, respectively | 68,091 | 36,534 |\\n| Additional paid-in capital | 144,532,185 | 139,123,642 |\\n| Accumulated other comprehensive loss | ( 10,920,361 | ) | ( 10,842,569 | ) |\\n| Accumulated deficit | ( 125,268,428 | ) | ( 117,479,571 | ) |\\n| Treasury stock, at cost, 281 shares at June 30, 2023 and December 31, 2022 | ( 46,355 | ) | ( 46,355 | ) |\\n| Total Stockholders’ Equity | 8,365,132 | 10,791,681 |\\n| Total Liabilities and Stockholders’ Equity | $ | 19,219,414 | $ | 18,692,985 |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n\\n| 2 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\\n(unaudited)\\n\\n| 2023 | 2022 | 2023 | 2022 |\\n| For the Three Months Ended | For the Six Months Ended |\\n| June 30, | June 30, |\\n| 2023 | 2022 | 2023 | 2022 |\\n| Sales | $ | 710,975 | $ | 405,335 | $ | 1,158,742 | $ | 830,932 |\\n| Cost of sales | ( 668,619 | ) | ( 533,466 | ) | ( 961,918 | ) | ( 771,593 | ) |\\n| Gross profit (loss) | 42,356 | ( 128,131 | ) | 196,824 | 59,339 |\\n| Operating Expenses |\\n| Selling and marketing | 213,157 | 333,410 | 447,736 | 505,230 |\\n| General and administrative | 1,710,505 | 1,928,892 | 3,467,193 | 3,674,126 |\\n| Depreciation and amortization | 104,281 | 49,000 | 213,487 | 95,219 |\\n| Total operating expenses | 2,027,943 | 2,311,302 | 4,128,416 | 4,274,575 |\\n| Loss from Operations | ( 1,985,587 | ) | ( 2,439,433 | ) | ( 3,931,592 | ) | ( 4,215,236 | ) |\\n| Other Expense (Income) |\\n| Interest income | ( 64,375 | ) | ( 26,552 | ) | ( 114,719 | ) | ( 30,404 | ) |\\n| Interest expense | 1,065,620 | 694,708 | 1,667,912 | 1,452,780 |\\n| Other income, related party | ( 75,000 | ) | ( 75,000 | ) | ( 150,000 | ) | ( 150,000 | ) |\\n| Loss on extinguishment of debt | 32,094 | 2,105,119 | 416,081 | 2,105,119 |\\n| Gains from foreign currency translation | ( 102,916 | ) | ( 43,005 | ) | ( 214,708 | ) | ( 225,927 | ) |\\n| Change in fair value of derivative liability | 2,141,117 | - | 2,141,117 | - |\\n| Inducement expense | - | 198,096 | - | 198,096 |\\n| Total other expense | 2,996,540 | 2,853,366 | 3,745,683 | 3,349,664 |\\n| Net Loss | ( 4,982,127 | ) | ( 5,292,799 | ) | ( 7,677,275 | ) | ( 7,564,900 | ) |\\n| Net loss attributable to non-controlling interest | - | - | - | 72,261 |\\n| Net Loss Attributable to Common Stockholders | $ | ( 4,982,127 | ) | $ | ( 5,292,799 | ) | $ | ( 7,677,275 | ) | $ | ( 7,492,639 | ) |\\n| Net Loss per Common Share |\\n| Basic and Diluted | $ | ( 0.80 | ) | $ | ( 4.80 | ) | $ | 1.41 | ) | $ | ( 7.59 | ) |\\n| Weighted Average Number of Common Shares Outstanding: |\\n| Basic and Diluted | 6,236,737 | 1,103,130 | 5,453,539 | 987,109 |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n\\n| 3 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nCONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME\\n(unaudited)\\n\\n| 2023 | 2022 | 2023 | 2022 |\\n| For the Three Months Ended | For the Six Months Ended |\\n| June 30, | June 30, |\\n| 2023 | 2022 | 2023 | 2022 |\\n| Net loss | $ | ( 4,982,127 | ) | $ | ( 5,292,799 | ) | $ | ( 7,677,275 | ) | $ | ( 7,564,900 | ) |\\n| Other comprehensive (loss) income : |\\n| Foreign currency translation adjustments | ( 37,993 | ) | 358,056 | ( 77,792 | ) | 621,462 |\\n| Comprehensive loss | $ | ( 5,020,120 | ) | $ | ( 4,934,743 | ) | $ | ( 7,755,067 | ) | $ | ( 6,943,438 | ) |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n\\n| 4 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nCONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDER’S EQUITY\\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2023\\n(unaudited)\\n\\n| Common Stock | Treasury Stock | Additional Paid-In | Accumulated Other Comprehensive | Accumulated | Total Stockholders’ |\\n| Shares | Amount | Shares | Amount | Capital | Loss | Deficit | Equity |\\n| Balance - January 1, 2023 | 3,653,401 | $ | 36,534 | 281 | $ | ( 46,355 | ) | $ | 139,123,642 | $ | ( 10,842,569 | ) | $ | ( 117,479,571 | ) | - | - | $ | 10,791,681 |\\n| Cumulative effect of change upon adoption of ASU 2016-13 | - | - | - | - | - | - | ( 111,582 | ) | - | - | ( 111,582 | ) |\\n| Stock-based compensation: |\\n| Options | - | - | - | - | 38,834 | - | - | 38,834 |\\n| Restricted stock units | 3,890 | 39 | - | - | 79,383 | - | - | 79,422 |\\n| Common stock issued for 401(k) employer matching | 24,160 | 242 | - | - | 32,375 | - | - | 32,617 |\\n| Shares issued under the New ELOC, net of offering costs [1] | 364,430 | 3,644 | - | - | 437,765 | - | - | 441,409 |\\n| Relative fair value of warrants issued with 2023 Note, net of issuance costs [2] | - | - | - | - | 1,506,319 | - | - | 1,506,319 |\\n| Warrants issued for modification of GGH Notes | - | - | - | - | 134,779 | - | - | 134,779 |\\n| Reduction of warrant exercise price on new debt issuance | - | - | - | - | 63,502 | - | - | 63,502 |\\n| Shares issued upon conversion of debt and interest | 833,333 | 8,333 | - | - | 1,563,220 | - | - | 1,571,553 |\\n| Common stock issued for cash in private placement | 591,000 | 5,910 | - | - | 585,090 | - | - | 591,000 |\\n| Cashless warrant exercise | 51,305 | 513 | - | - | ( 513 | ) | - | - | - |\\n| True-up adjustment | 281 | - | - | - | - | - | - | - |\\n| Net loss | - | - | - | - | - | - | ( 2,695,148 | ) | - | - | ( 2,695,148 | ) |\\n| Other comprehensive loss | - | - | - | - | - | ( 39,799 | ) | - | ( 39,799 | ) |\\n| Balance - March 31, 2023 | 5,521,800 | 55,215 | 281 | ( 46,355 | ) | 143,564,396 | ( 10,882,368 | ) | ( 120,286,301 | ) | - | - | 12,404,587 |\\n| Stock-based compensation: |\\n| Options | - | - | - | - | 38,834 | - | - | 38,834 |\\n| Restricted stock units | - | - | - | - | 74,978 | - | - | 74,978 |\\n| Shares issued under the New ELOC, net of offering costs [3] | 458,768 | 4,588 | - | - | 287,009 | - | - | 291,597 |\\n| Shares issued upon conversion of debt and interest | 828,780 | 8,288 | - | - | 566,968 | - | - | 575,256 |\\n| Net loss | - | - | - | - | - | - | ( 4,982,127 | ) | - | - | ( 4,982,127 | ) |\\n| Other comprehensive loss | - | - | - | - | - | ( 37,993 | ) | - | ( 37,993 | ) |\\n| Balance - June 30, 2023 | 6,809,348 | $ | 68,091 | 281 | $ | ( 46,355 | ) | $ | 144,532,185 | $ | ( 10,920,361 | ) | $ | ( 125,268,428 | ) | - | - | $ | 8,365,132 |\\n\\n\\n| [1] | Includes gross proceeds of $ 480,670 , less $ 39,261 offering costs |\\n\\n| [2] | Represents $ 1,609,935 relative fair value of warrants, less $ 103,616 of allocable issuance costs |\\n\\n| [3] | Includes gross proceeds of $ 316,953 , less $ 25,356 offering costs |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n\\n| 5 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nCONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDER’S EQUITY\\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2022\\n(unaudited)\\n\\n| Common Stock | Treasury Stock | Additional Paid-In | Accumulated Other Comprehensive | Accumulated | Gaucho Group Holdings Stockholders’ | Non- controlling | Total Stockholders’ |\\n| Shares | Amount | Shares | Amount | Capital | Loss | Deficit | Deficiency | Interest | Equity |\\n| Balance - January 1, 2022 | 823,496 | $ | 8,235 | 281 | $ | ( 46,355 | ) | $ | 121,633,826 | $ | ( 11,607,446 | ) | $ | ( 95,726,534 | ) | $ | 14,261,726 | $ | ( 169,882 | ) | $ | 14,091,844 |\\n| Stock-based compensation: |\\n| Options | - | - | - | - | 72,700 | - | - | 72,700 | 10,354 | 83,054 |\\n| Common stock issued for 401(k) employer matching | 1,040 | 10 | - | - | 27,811 | - | - | 27,821 | - | 27,821 |\\n| Common stock issued for purchase of minority interest | 86,899 | 869 | - | - | ( 232,658 | ) | - | - | ( 231,789 | ) | 231,789 | - |\\n| Common stock issued for acquisition of GDS | 106,952 | 1,070 | - | - | 2,193,583 | - | - | 2,194,653 | - | 2,194,653 |\\n| Common stock issued for purchase of domain name | 1,250 | 13 | - | - | 39,587 | - | - | 39,600 | - | 39,600 |\\n| Warrants issued for modification of convertible debt principal | - | - | - | - | 731,856 | - | - | 731,856 | - | 731,856 |\\n| Net loss | - | - | - | - | - | - | ( 2,199,840 | ) | ( 2,199,840 | ) | ( 72,261 | ) | ( 2,272,101 | ) |\\n| Other comprehensive income | - | - | - | - | - | 263,406 | - | 263,406 | - | 263,406 |\\n| Balance - March 31, 2022 | 1,019,637 | 10,197 | 281 | ( 46,355 | ) | 124,466,705 | ( 11,344,040 | ) | ( 97,926,374 | ) | 15,160,133 | - | 15,160,133 |\\n| Balance | 1,019,637 | 10,197 | 281 | ( 46,355 | ) | 124,466,705 | ( 11,344,040 | ) | ( 97,926,374 | ) | 15,160,133 | - | 15,160,133 |\\n| Stock-based compensation: |\\n| Options | - | - | - | - | 87,134 | - | - | 87,134 | - | 87,134 |\\n| Common stock | 54,214 | 542 | - | - | 524,458 | - | - | 525,000 | - | 525,000 |\\n| Shares issued upon conversion of debt and interest | 74,589 | 746 | - | - | 1,521,851 | - | - | 1,522,597 | - | 1,522,597 |\\n| Inducement loss on debt conversions | - | - | - | - | 198,096 | - | - | 198,096 | - | 198,096 |\\n| Substantial premium on convertible debt | - | - | - | - | 1,683,847 | - | - | 1,683,847 | - | 1,683,847 |\\n| Common stock issued for cash, net of offering costs | 50,049 | 500 | - | - | 510,846 | - | - | 511,346 | - | 511,346 |\\n| Common stock issued upon exchange of subsidiary stock options | 183,942 | 1,839 | - | - | ( 1,839 | ) | - | - | - | - | - |\\n| True up adjustment | 41 | - | - | - | - | - | - | - | - | - |\\n| Net loss | - | - | - | - | - | - | ( 5,292,799 | ) | ( 5,292,799 | ) | - | ( 5,292,799 | ) |\\n| Other comprehensive income | - | - | - | - | - | 358,056 | - | 358,056 | - | 358,056 |\\n| Balance - June 30, 2022 | 1,382,472 | $ | 13,824 | 281 | $ | ( 46,355 | ) | $ | 128,991,098 | $ | ( 10,985,984 | ) | $ | ( 103,219,173 | ) | $ | 14,753,410 | $ | - | $ | 14,753,410 |\\n| Balance | 1,382,472 | $ | 13,824 | 281 | $ | ( 46,355 | ) | $ | 128,991,098 | $ | ( 10,985,984 | ) | $ | ( 103,219,173 | ) | $ | 14,753,410 | $ | - | $ | 14,753,410 |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n\\n| 6 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\\n(unaudited)\\n\\n| 2023 | 2022 |\\n| For the Six Months Ended |\\n| June 30, |\\n| 2023 | 2022 |\\n| Cash Flows from Operating Activities |\\n| Net loss | $ | ( 7,677,275 | ) | $ | ( 7,564,900 | ) |\\n| Adjustments to reconcile net loss to net cash used in operating activities: |\\n| Stock-based compensation: |\\n| 401(k) stock | 5,908 | 22,384 |\\n| Common stock | - | 525,000 |\\n| Stock options and warrants | 77,668 | 170,188 |\\n| Restricted stock units | 154,400 | - |\\n| Noncash lease expense | 113,744 | 107,343 |\\n| Gain on foreign currency translation | ( 214,708 | ) | ( 225,927 | ) |\\n| Depreciation and amortization | 213,487 | 95,219 |\\n| Amortization of debt discount | 1,079,034 | 1,061,936 |\\n| Provision for credit losses | 57,104 | 28,848 |\\n| Provision for obsolete inventory | 99,323 | - |\\n| Change in fair value of derivative liability | 2,141,117 |\\n| Loss on extinguishment of debt | 416,081 | 2,105,119 |\\n| Inducement expense | - | 198,096 |\\n| Decrease (increase) in assets: |\\n| Accounts receivable and mortgages receivable | ( 126,017 | ) | ( 137,652 | ) |\\n| Employee advances | ( 571 | ) | 4,964 |\\n| Inventory | ( 57,274 | ) | ( 84,917 | ) |\\n| Deposits | 1,417 | - |\\n| Prepaid expenses and other current assets | ( 30,668 | ) | ( 201,778 | ) |\\n| Increase (decrease) in liabilities: |\\n| Accounts payable and accrued expenses | ( 162,671 | ) | 774,709 |\\n| Operating lease liabilities | ( 98,126 | ) | ( 82,296 | ) |\\n| Deferred revenue | ( 4,985 | ) | 517,741 |\\n| Other liabilities | ( 20,131 | ) | ( 68,633 | ) |\\n| Total Adjustments | 3,644,132 | 4,810,344 |\\n| Net Cash Used in Operating Activities | ( 4,033,143 | ) | ( 2,754,556 | ) |\\n| Cash Flow from Investing Activities |\\n| Cash paid to acquire Gaucho Development S.R.L., net of cash acquired | - | ( 7,560 | ) |\\n| Purchase of property and equipment | ( 438,895 | ) | ( 1,677,082 | ) |\\n| Purchase of intangible asset | ( 50,000 | ) | ( 34,999 | ) |\\n| Net Cash Used in Investing Activities | ( 488,895 | ) | ( 1,719,641 | ) |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n\\n| 7 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED\\n(unaudited)\\n\\n| For the Six Months Ended |\\n| June 30, |\\n| 2023 | 2022 |\\n| Cash Flow from Financing Activities |\\n| Proceeds from loans payable | 185,000 | - |\\n| Repayments of loans payable | ( 58,718 | ) | ( 53,333 | ) |\\n| Proceeds from common stock issued for cash | 591,000 | 511,346 |\\n| Proceeds from the issuance of convertible debt | 5,000,000 | - |\\n| Financing costs in connection with the issuance of convertible debt | ( 321,803 | ) | - |\\n| Repayments of convertible debt obligations | ( 862,541 | ) | - |\\n| Redemption premiums paid on convertible debt obligations | ( 156,160 | ) | - |\\n| Proceeds from issuance of shares under the New ELOC, net of offering costs [1] | 733,006 | - |\\n| Net Cash Provided by Financing Activities | 5,109,784 | 458,013 |\\n| Effect of Exchange Rate Changes on Cash | ( 77,792 | ) | 621,462 |\\n| Net (Decrease) Increase in Cash | 509,954 | ( 3,394,722 | ) |\\n| Cash - Beginning of Period | 300,185 | 3,649,407 |\\n| Cash - End of Period | $ | 810,139 | $ | 254,685 |\\n| Supplemental Disclosures of Cash Flow Information: |\\n| Interest paid | $ | 561,876 | $ | 140,355 |\\n| Income taxes paid | $ | - | $ | - |\\n| Non-Cash Investing and Financing Activity |\\n| Equity issued to satisfy accrued stock-based compensation obligation | $ | 32,617 | $ | 27,821 |\\n| Equity issued as consideration for intangible assets | $ | - | $ | 39,600 |\\n| Equity issued for purchase of non-controlling interest | $ | - | $ | 231,789 |\\n| Equity issued for acquisition of Gaucho Development, S.R.L. | $ | - | $ | 2,194,653 |\\n| Warrants issued and debt principal exchanged upon modification of convertible debt | $ | - | $ | 731,856 |\\n| Shares issued upon conversion of debt and interest | $ | 2,146,809 | $ | 1,522,597 |\\n| Common stock and restricted stock units in GGH issued upon exchange of GGI options | $ | - | $ | 1,576,648 |\\n| Cashless warrant exercise | $ | 513 | $ | - |\\n| Relative fair value of warrants issued with 2023 Note, net of allocable issuance costs [2] | $ | 1,506,319 | $ | - |\\n| Warrants issued and debt principal exchanged upon modification of convertible debt | $ | 63,502 | $ | - |\\n\\n\\n| [1] | Gross proceeds of $ 797,623 , less offering costs of $ 64,617 |\\n\\n| [2] | Represents $ 1,609,935 relative fair value of warrants, less $ 103,616 in allocable issuance costs |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n\\n| 8 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\n1. BUSINESS ORGANIZATION AND NATURE OF OPERATIONS\\nOrganization and Operations\\nThrough its subsidiaries, Gaucho Group Holdings, Inc. (“Company”, “GGH”), a Delaware corporation that was incorporated on April 5, 1999, currently invests in, develops, and operates a collection of luxury assets, including real estate development, fine wines, and a boutique hotel in Argentina, as well as an e-commerce platform for the sale of high-end fashion and accessories.\\nAs wholly owned subsidiaries of GGH, InvestProperty Group, LLC (“IPG”), Algodon Global Properties, LLC (“AGP”) and Gaucho Ventures I – Las Vegas, LLC (“GVI”) operate as holding companies that invest in, develop and operate global real estate and other lifestyle businesses such as wine production and distribution, golf, tennis, and restaurants. GGH operates its properties through its ALGODON® brand. IPG and AGP have invested in two ALGODON® brand projects located in Argentina. The first project is Algodon Mansion, a Buenos Aires-based luxury boutique hotel property that opened in 2010 and is owned by the Company’s subsidiary, The Algodon – Recoleta, SRL (“TAR”). The second project is the redevelopment, expansion and repositioning of a Mendoza-based winery and golf resort property now called Algodon Wine Estates (“AWE”), the integration of adjoining wine producing properties, and the subdivision of a portion of this property for residential development. (“GDS”). GVI is a party to an agreement with LVH Holdings (“LVH”) to develop a project in Las Vegas, Nevada.\\nOn February 3, 2022, the Company acquired additional real estate through the acquisition of 100 % ownership in Hollywood Burger Argentina S.R.L., now Gaucho Development S.R.L.\\nGGH also manufactures, distributes, and sells high-end luxury fashion and accessories through its subsidiary, Gaucho Group, Inc. (“GGI”). GGH held a 79 % ownership interest in GGI through March 28, 2022, at which time GGH acquired the remaining 21 % ownership interest in GGI. See Non-Controlling Interest, below.\\nNon-Controlling interest\\nAs a result of a 2019 conversion of certain convertible debt into shares of Gaucho Group, Inc. (“GGI”) common stock, GGI investors obtained a 21 % ownership interest in GGI, which was recorded as a non-controlling interest. The profits and losses of GGI for the period from January 1, 2022 through March 28, 2022 are allocated between the controlling interest and the non-controlling interest in the same proportions as their membership interest. On March 28, 2022, the Company issued 86,899 shares of its common stock to the minority holders of GGI, in exchange for the remaining 21 % ownership of GGI. Consequently, the Company owns 100 % of the outstanding common stock of GGI.\\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\\nThere have been no material changes to the Company’s significant accounting policies as set forth in the Company’s audited consolidated financial statements included in the annual report on Form 10-K for the year ended December 31, 2022, except as disclosed below.\\n\\n| 9 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nBasis of Presentation\\nThe accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information. Accordingly, they do not include all of the information and disclosures required by accounting principles generally accepted in the United States of America for annual financial statements. In the opinion of management, such statements include all adjustments (consisting only of normal recurring items) which are considered necessary for a fair presentation of the unaudited condensed consolidated financial statements of the Company as of June 30, 2023 and for the three and six months ended June 30, 2023 and 2022. The results of operations for the three and six months ended June 30, 2023 are not necessarily indicative of the operating results for the full year. It is suggested that these unaudited condensed consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2022, filed with the Securities and Exchange Commission (“SEC”) on April 17, 2023.\\nOn November 4, 2022, the Company effected a reverse stock split in a ratio of 1 share of common stock for 12 issued shares of common stock. As a result of the reverse stock split, prior period shares and per share amounts appearing in the accompanying condensed consolidated financial statements and all references in this Quarterly Report to our common stock, as well as amounts per share of our common stock, have been retroactively restated as if the reverse stock split occurred at the beginning of the period presented.\\nGoing Concern and Management’s Liquidity Plans\\nThe accompanying condensed consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The condensed financial statements do not include any adjustments relating to the recoverability and classification of asset amounts or the classification of liabilities that might be necessary should the company be unable to continue as a going concern.\\nAs of June 30, 2023, the Company had cash and a working capital deficit of approximately $ 810,000 and $ 3.8 million, respectively. During the six months ended June 30, 2023 and 2022, the Company incurred net losses of approximately $ 7.7 million and $ 7.6 million, respectively, and used cash in operating activities of approximately $ 4.0 million and $ 2.8 million, respectively. Further, as of June 30, 2023, approximately $ 4.8 million owed in connection with the Company’s convertible debt matures on February 21, 2024 , and approximately $ 252,000 represents the current portion of the Company’s loans payable which are payable on demand or for which payments are due within twelve months after June 30, 2023. During the six months ended June 30, 2023, the Company funded its operations with proceeds from a convertible debt financing of $ 5.0 million, proceeds of $ 733,000 from draws on the Company’s equity line of credit, $ 185,000 of proceeds from a loan payable and $ 591,000 from the sale of common stock.\\n\\n| 10 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nThe Company’s operating needs include the planned costs to operate its business, including amounts required to fund working capital and capital expenditures. Based upon projected revenues and expenses, the Company believes that it may not have sufficient funds to operate for the next twelve months from the date these financial statements are made available. Since inception, the Company’s operations have primarily been funded through proceeds received from equity and debt financings. The Company believes it has access to capital resources and continues to evaluate additional financing opportunities. There is no assurance that the Company will be able to obtain funds on commercially acceptable terms, if at all. There is also no assurance that the amount of funds the Company might raise will enable the Company to complete its development initiatives or attain profitable operations. The aforementioned factors raise substantial doubt about the Company’s ability to continue as a going concern for a period of one year from the issuance of these financial statements.\\nHighly Inflationary Status in Argentina\\nThe Company recorded gains on foreign currency transactions of approximately $ 103,000 and $ 215,000 during the three and six months ended June 30, 2023, respectively, and approximately $ 43,000 and $ 226,000 during the three and six months ended June 30, 2022, respectively, as a result of the net monetary liability position of its Argentine subsidiaries.\\nConcentrations\\nThe Company maintains cash with major financial institutions. Cash held in US bank institutions is currently insured by the Federal Deposit Insurance Corporation (“FDIC”) up to $ 250,000 at each institution. No similar insurance or guarantee exists for cash held in Argentina bank accounts. There were aggregate uninsured cash balances of approximately $ 519,000 at June 30, 2023, of which approximately $ 378,000 represents cash held in Argentine bank accounts.\\nRevenue Recognition\\nThe Company recognizes revenue in accordance with ASC Topic 606, Revenue from Contracts with Customers. ASC Topic 606 provides a single comprehensive model to use in accounting for revenue arising from contracts with customers, and gains and losses arising from transfers of non-financial assets including sales of property and equipment, real estate, and intangible assets.\\nThe Company earns revenues from the sale of real estate lots, as well as hospitality, food and beverage, other related services, and from the sale of clothing and accessories. The Company recognizes revenue when goods or services are transferred to customers in an amount that reflects the consideration which it expects to receive in exchange for those goods or services. In determining when and how revenue is recognized from contracts with customers, the Company performs the following five-step analysis: (i) identification of contract with customer; (ii) determination of performance obligations; (iii) measurement of the transaction price; (iv) allocation of the transaction price to the performance obligations; and (v) recognition of revenue when (or as) the Company satisfies each performance obligation.\\n\\n| 11 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nThe following table summarizes the revenue recognized in the Company’s condensed consolidated statements of operations:\\nSCHEDULE OF DISAGGREGATION OF REVENUE\\n| 2023 | 2022 | 2023 | 2022 |\\n| For the Three Months Ended | For the Six Months Ended |\\n| June 30, | June 30, |\\n| 2023 | 2022 | 2023 | 2022 |\\n| Real estate sales | $ | 154,959 | $ | - | $ | 154,959 | $ | 184,658 |\\n| Hotel rooms and events | 218,838 | 144,123 | 464,525 | 283,222 |\\n| Restaurants | 56,989 | 40,323 | 136,007 | 57,593 |\\n| Winemaking | 45,918 | 32,880 | 75,741 | 59,689 |\\n| Agricultural | 162,764 | 153,531 | 162,764 | 181,029 |\\n| Golf, tennis and other | 29,126 | 28,366 | 56,983 | 53,467 |\\n| Clothes and accessories | 42,381 | 6,112 | 107,763 | 11,274 |\\n| Total revenues | $ | 710,975 | $ | 405,335 | $ | 1,158,742 | $ | 830,932 |\\n\\nRevenue from the sale of food, wine, agricultural products, clothes and accessories is recorded when the customer obtains control of the goods purchased. Revenues from hospitality and other services are recognized as earned at the point in time that the related service is rendered, and the performance obligation has been satisfied. Revenues from gift card sales are recognized when the card is redeemed by the customer. The Company does not adjust revenue for the portion of gift card values that is not expected to be redeemed (“breakage”) due to the lack of historical data. Revenue from real estate lot sales is recorded when the lot is deeded, and legal ownership of the lot is transferred to the customer.\\nThe timing of the Company’s revenue recognition may differ from the timing of payment by its customers. A receivable is recorded when revenue is recognized prior to payment and the Company has an unconditional right to payment. Alternatively, when payment precedes the provision of the related services, the Company records deferred revenue until the performance obligations are satisfied. Deferred revenues associated with real estate lot sale deposits are recognized as revenues (along with any outstanding balance) when the lot sale closes, and the deed is provided to the purchaser. Other deferred revenues primarily consist of deposits accepted by the Company in connection with agreements to sell barrels of wine, advance deposits received for grapes and other agricultural products, and hotel deposits. Wine barrel and agricultural product advance deposits are recognized as revenues (along with any outstanding balance) when the product is shipped to the purchaser. Hotel deposits are recognized as revenue upon occupancy of rooms, or the provision of services.\\nContracts related to the sale of wine, agricultural products and hotel services have an original expected length of less than one year. The Company has elected not to disclose information about remaining performance obligations pertaining to contracts with an original expected length of one year or less, as permitted under the guidance.\\n\\n| 12 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nAs of June 30, 2023 and December 31, 2022, the Company had deferred revenue of $ 1,368,921 and $ 1,373,906 , respectively, consisting of $ 1,332,695 and $ 1,179,654 , respectively, associated with real estate lot sale deposits, $ 36,225 and $ 44,252 , respectively, related to hotel deposits and $ 0 and $ 150,000 , respectively, related to prepaid management fees received.\\nNet Loss per Common Share\\nBasic loss per common share is computed by dividing net loss attributable to GGH common stockholders by the weighted average number of common shares outstanding during the period. Diluted loss per common share is computed by dividing net loss attributable to common stockholders by the weighted average number of common shares outstanding, plus the impact of common shares, if dilutive, resulting from the exercise of outstanding stock options and warrants and the conversion of convertible instruments.\\nThe following securities are excluded from the calculation of weighted average dilutive common shares because their inclusion would have been anti-dilutive:\\nSCHEDULE OF ANTIDILUTIVE SECURITIES EXCLUDED FROM COMPUTATION OF EARNINGS PER SHARE\\n| 2023 | 2022 |\\n| As of June 30, |\\n| 2023 | 2022 |\\n| Options | 34,806 | 561,027 |\\n| Warrants | 4,839,254 | 2,024,166 |\\n| Unvested restricted stock units | 516,277 | - |\\n| Convertible debt | 12,516,374 | [1] | 5,479,255 | [2] |\\n| Total potentially dilutive shares | 17,906,711 | 8,064,448 |\\n\\n\\n| [1] | Represents shares issuable upon conversion of $ 4,893,983 of convertible debt, $ 734,097 of redemption premium and $ 8,293 of related accrued interest outstanding as of June 30, 2023, at a conversion price of $ 0.4503 per share, which represents the conversion price in effect as of June 30, 2023. The conversion price of such debt is variable and is not subject to a floor price (see Note 10, Convertible Debt Obligations). |\\n| [2] | Represents shares issuable upon conversion of principal and interest outstanding in the aggregate amount of $ 5,205,292 at a conversion price of $ 0.95 per share. |\\n\\nSequencing Policy\\nUnder ASC 815, the Company has adopted a sequencing policy, whereby, in the event that reclassification of contracts from equity to assets or liabilities is necessary pursuant to ASC 815 due to the Company’s inability to demonstrate it has sufficient authorized shares as a result of certain securities with a potentially indeterminable number of shares or the Company’s total potentially dilutive shares exceed the Company’s authorized share limit, shares will be allocated on the basis of the earliest issuance date of potentially dilutive instruments, with the earliest grants receiving the first allocation of shares. Pursuant to ASC 815, issuances of securities granted as compensation in a share-based payment arrangement are not subject to the sequencing policy.\\n\\n| 13 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nDerivative Instruments\\nThe Company evaluates its convertible instruments to determine if those contracts or embedded components of those contracts qualify as derivative financial instruments to be separately accounted for in accordance with Topic 815 “Derivatives and Hedging” (“ASC 815”) of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”). The accounting treatment of derivative financial instruments requires that the Company record any bifurcated embedded features at their fair values as of the inception date of the agreement and at fair value as of each subsequent balance sheet date. Any change in fair value is recorded in earnings each period as non-operating, non-cash income or expense. The Company reassesses the classification of its derivative instruments at each balance sheet date. If the classification changes as a result of events during the period, the contract is reclassified as of the date of the event that caused the reclassification. Bifurcated embedded features are recorded upon note issuance at their initial fair values which create additional debt discount to the host instrument.\\nRecently Adopted Accounting Pronouncements\\nIn June 2016, the FASB issued ASU No. 2016-13 “Financial Instruments – Credit Losses (Topic 326)” and also issued subsequent amendments to the initial guidance under ASU 2018-19, ASU 2019-04, ASU 2019-05 and ASU 2020-02 (collectively Topic 326). Topic 326 requires the measurement and recognition of expected credit losses for financial assets held at amortized cost. This replaces the existing incurred loss model with an expected loss model and requires the use of forward-looking information to calculate credit loss estimates. The Company adopted the provisions of this ASU on January 1, 2023 using the modified retrospective method for all financial assets measured at amortized cost. Results for reporting periods beginning after December 31, 2022 are presented under Topic 326 while prior period amounts continue to be reported in accordance with previously applicable GAAP. The Company recorded an adjustment to accumulated deficit of $ 111,582 as of January 1, 2023 for the cumulative effect of adopting Topic 326.\\nReclassifications\\nCertain reclassifications have been made to prior period amounts to conform to the current period financial statement presentation.\\n3. MORTGAGES RECEIVABLE\\nThe Company offers loans to purchasers in connection with the sale of real estate lots. The loans bear interest at 7.2 % per annum and terms generally range from eight to ten years. Principal and interest for each loan is billed and receivable on a monthly basis. The loans are secured by a first mortgage lien on the property purchased by the borrower. Mortgages receivable include the related interest receivable and are presented at amortized cost, less bad debt allowances, in the condensed consolidated financial statements.\\nManagement evaluates each loan individually on a quarterly basis, to assess collectability and estimate a reserve for past due amounts. Management recorded an additional provision for uncollectible accounts in the amount of $ 37,673 for the six months ended June 30, 2023. The total allowance for uncollectable mortgages as of June 30, 2023 and December 31, 2022 was $ 234,223 and $ 196,550 , respectively. Past due principal amounts of $ 346,680 and $ 254,683 are included in mortgages, receivable, current as of June 30, 2023 and December 31, 2022, respectively. In the case of each of the past due loans, the Company believes that the value of the collateral exceeds the outstanding balance on the loan, plus accrued interest.\\n\\n| 14 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nThe following represents the maturities of mortgages receivable as of June 30, 2023:\\nSCHEDULE OF MATURITIES OF MORTGAGES RECEIVABLE\\n| July 1 through December 31, 2023 | $ | 776,657 |\\n| For the years ended December 31, |\\n| 2024 | 381,532 |\\n| 2025 | 409,927 |\\n| 2026 | 440,436 |\\n| 2027 | 473,215 |\\n| 2028 | 480,227 |\\n| Thereafter | 1,093,286 |\\n| Gross Receivable | 4,055,278 |\\n| Less: Allowance | ( 234,223 | ) |\\n| Net Receivable | $ | 3,821,055 |\\n\\nAs of June 30, 2023 and December 31, 2022, no single borrower had loans outstanding representing more than 10 % of the total balance of mortgages receivable.\\nThe Company recorded interest income from mortgages receivable of $ 109,816 and $ 28,654 for the six months ended June 30, 2023 and 2022, respectively. As of June 30, 2023 and December 31, 2022, there is $ 261,919 and $ 185,197 , respectively, of interest receivable included in mortgages receivable on the accompanying condensed consolidated balance sheets.\\n4. INVENTORY\\nInventory at June 30, 2023 and December 31, 2022 was comprised of the following:\\nSCHEDULE OF INVENTORY\\n| June 30, 2023 | December 31, 2022 |\\n| Vineyard in process | $ | 240,619 | $ | 516,096 |\\n| Wine in process | 1,031,823 | 797,862 |\\n| Finished wine | 42,370 | 40,735 |\\n| Clothes and accessories | 720,569 | 552,581 |\\n| Other | 125,665 | 82,423 |\\n| Inventory gross | 2,161,046 | 1,989,697 |\\n| Less: Reserve for obsolescence | ( 200,058 | ) | ( 100,735 | ) |\\n| Total | $ | 1,960,988 | $ | 1,888,962 |\\n\\nThe Company recorded a provision for obsolete inventory in the amount of $ 93,389 and $ 99,323 during the three and six months ended June 30, 2023, respectively. There was no provision for obsolete inventory recognized during the three and six months ended June 30, 2022.\\n\\n| 15 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\n5. INTANGIBLE ASSETS\\nOn February 3, 2022, the Company purchased the domain name Gaucho.com, in exchange for cash consideration of $ 34,999 and 15,000 shares of common stock valued at $ 39,600 (see Note 14 – Stockholders’ Equity, Common Stock). The domain name is being amortized over its useful life of 15 years.\\nOn June 15, 2023, the Company purchased a music video to be used in certain marketing mediums for $ 50,000 in cash. The music video is being amortized over its useful life of 3 years.\\nThe Company recognized $ 5,410 and $ 10,819 of amortization expense during the three and six months ended June 30, 2023, respectively, related to the domain name. The Company recognized $ 1,489 and $ 2,072 of amortization expense during the three and six months ended June 30, 2022, respectively, related to the domain name. Future amortization of the Company’s intangible asset is as follows:\\nSCHEDULE OF INTANGIBLE ASSETS FUTURE AMORTIZATION\\n| July 1 through December 31, 2023 | $ | 10,819 |\\n| For the years ended December 31, |\\n| 2024 | 21,640 |\\n| 2025 | 21,640 |\\n| 2026 | 4,973 |\\n| 2027 | 4,973 |\\n| 2028 | 4,973 |\\n| Thereafter | 39,949 |\\n| Total | $ | 108,967 |\\n\\n6. FAIR VALUE OF FINANCIAL INSTRUMENTS\\nFair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In determining fair value, the Company often utilizes certain assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and/or the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated, or developed by the Company. The fair value hierarchy ranks the quality and reliability of the information used to determine fair values. Financial assets and liabilities carried at fair value are classified and disclosed in one of the following three categories:\\nLevel 1 - Valued based on quoted prices at the measurement date for identical assets or liabilities trading in active markets. Financial instruments in this category generally include actively traded equity securities.\\nLevel 2 - Valued based on (a) quoted prices for similar assets or liabilities in active markets; (b) quoted prices for identical or similar assets or liabilities in markets that are not active; (c) inputs other than quoted prices that are observable for the asset or liability; or (d) from market corroborated inputs. Financial instruments in this category include certain corporate equities that are not actively traded or are otherwise restricted.\\nLevel 3 - Valued based on valuation techniques in which one or more significant inputs is not readily observable. Included in this category are certain corporate debt instruments, certain private equity investments, and certain commitments and guarantees.\\nThe carrying amounts of the Company’s short-term financial instruments including cash, accounts receivable, advances and loans to employees, prepaid taxes and expenses, accounts payable, accrued expenses and other liabilities approximate fair value due to the short-term nature of these instruments. The carrying value of the Company’s loans payable, debt obligations, convertible debt obligations and derivative liability approximate fair value, as they bear terms and conditions comparable to market for obligations with similar terms and maturities.\\n\\n| 16 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\n7. ACCRUED EXPENSES\\nAccrued expenses are comprised of the following:\\nSCHEDULE OF ACCRUED EXPENSES\\n| June 30, | December 31, |\\n| 2023 | 2022 |\\n| Accrued compensation and payroll taxes | $ | 542,659 | $ | 652,943 |\\n| Accrued taxes payable - Argentina | 189,722 | 270,239 |\\n| Accrued interest | 141,303 | 78,368 |\\n| Other accrued expenses | 384,479 | 663,266 |\\n| Accrued expenses, current | 1,258,163 | 1,664,816 |\\n| Accrued payroll tax obligations, non-current | 81,638 | 66,018 |\\n| Total accrued expenses | $ | 1,339,801 | $ | 1,730,834 |\\n\\nOn November 27, 2020, the Company entered into various payment plans, pursuant to which it agreed to pay its Argentine payroll tax obligations over a period of 60 to 120 months. The current portion of payments due under the plan is $ 84,929 and $ 209,938 as of June 30, 2023 and December 31, 2022, respectively, which is included in accrued taxes payable – Argentina, above. The non-current portion of accrued payroll tax obligations represents payments under the plan that are scheduled to be paid after twelve months. The Company incurred interest expense of $ 64,283 and $ 81,587 during the three and six months ended June 30, 2023, respectively, and incurred interest expense of $ 28,690 and $ 33,177 during the three and six months ended June 30, 2022, respectively, related to these payment plans.\\n8. DEFERRED REVENUE\\nDeferred revenue is comprised of the following:\\nSCHEDULE OF DEFERRED REVENUES\\n| June 30, 2023 | December 31, 2022 |\\n| Real estate lot sales deposits | $ | 1,332,695 | $ | 1,179,654 |\\n| Prepaid management fees | - | 150,000 |\\n| Other | 36,226 | 44,252 |\\n| Total | $ | 1,368,921 | $ | 1,373,906 |\\n\\n\\n| 17 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nThe Company accepts deposits in conjunction with agreements to sell real estate building lots at Algodon Wine Estates in the Mendoza wine region of Argentina. These lot sale deposits are generally denominated in U.S. dollars. The Company received deposits for eleven additional lots and recorded deferred revenues in the amount of $ 308,000 during the six months ended June 30, 2023. Revenue is recorded when the sale closes, and the deeds are issued. The Company recorded the sale of one lot and recorded revenue in the amount of $ 154,959 during the three and six months ended June 30, 2023.\\n9. LOANS PAYABLE\\nThe Company’s loans payable are summarized below:\\nSCHEDULE OF LOANS PAYABLE\\n| June 30, | December 31, |\\n| 2023 | 2022 |\\n| EIDL | $ | 92,527 | $ | 93,541 |\\n| 2018 Loan | 40,678 | 111,137 |\\n| 2022 Loan | 24,277 | 51,643 |\\n| 2023 Loan | 185,000 | - |\\n| Total Loans Payable | 342,482 | 256,321 |\\n| Less: current portion | 252,014 | 164,656 |\\n| Loans Payable, non-current | $ | 90,468 | $ | 91,665 |\\n\\nOn January 9, 2023, the Company received $ 185,000 in proceeds on the issuance of a one-year, non-convertible promissory note with a February 20, 2024 maturity date. The note bears interest at a rate of 8 % per annum. In addition, during the six months ended June 30, 2023, the Company made principal payments in the amount of $ 42,066 on the 2018 Loan payable, $ 15,638 on the 2022 Loan payable and $ 1,014 on the EIDL loan.\\nThe Company incurred interest expense related to the loans payable in the amount of $ 33,248 and $ 36,514 during the three and six months ended June 30, 2023, respectively, and incurred interest expense related to the loans payable in the amount of $ 2,986 and $ 6,378 during the three and six months ended June 30, 2022. Other decreases in loan balances are the result of changes in exchange rates during the period. As of June 30, 2023 and December 31, 2022, there is accrued interest of $ 15,996 and $ 9,437 , respectively, related to the Company’s loans payable.\\n\\n| 18 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\n10. CONVERTIBLE DEBT OBLIGATIONS\\nAmounts owed pursuant to the Company’s convertible debt obligations are as follows:\\nSCHEDULE OF CONVERTIBLE NOTES\\n| GGH Notes | 2023 Note | Total Principal | Debt Discount | Convertible debt, net of discount |\\n| Balance at January 1, 2023 | $ | 1,997,909 | $ | - | $ | 1,997,909 | $ | ( 6,450 | ) | $ | 1,991,459 |\\n| Note issued | - | 5,617,978 | 5,617,978 | ( 2,509,601 | ) | 3,108,377 |\\n| Debt principal converted to common stock: | ( 1,335,439 | ) | ( 523,925 | ) | ( 1,859,364 | ) | - | ( 1,859,364 | ) |\\n| Principal repayments | ( 662,470 | ) | ( 200,071 | ) | ( 862,541 | ) | - | ( 862,541 | ) |\\n| Amortization of debt discount | - | - | - | 1,079,034 | 1,079,034 |\\n| Balance at June 30, 2023 | $ | - | $ | 4,893,982 | $ | 4,893,982 | $ | ( 1,437,017 | ) | $ | 3,456,965 |\\n| Less: current portion | - | 4,773,982 | 4,773,982 | ( 1,401,781 | ) | 3,372,201 |\\n| Equals: convertible debt, non-current | $ | - | $ | 120,000 | $ | 120,000 | $ | ( 35,236 | ) | $ | 84,764 |\\n\\nGGH Convertible Notes\\nOn February 2, 2023, the Company and the holders of the remaining GGH Notes entered into a fourth letter agreement (“Letter Agreement #4). Pursuant to Letter Agreement #4, the parties agreed to reduce the conversion price of the GGH Notes to the lower of: (i) the closing sale price on the trading day immediately preceding the conversion date; and (ii) the average closing sale price of the common stock for the five trading days immediately preceding the conversion date. The conversion price is not subject to a floor price. Between February 3 and February 15, 2023, the holders elected to convert $ 1,571,553 in principal and interest, of which $ 1,335,439 , $ 124,049 , and $ 112,065 was principal, interest and premium paid on conversion, into 833,333 shares of common stock at prices ranging from $ 1.45 and $ 2.40 . The premium paid on conversion of the GGH Notes was recorded as a loss on extinguishment.\\nOn February 8, 2023, the Company and the holders of the remaining GGH Notes entered into a fifth letter agreement (“Letter Agreement #5). Pursuant to Letter Agreement #5, the parties agreed to extend the maturity date of the notes from February 9, 2023 to February 28, 2023.\\nOn February 20, 2023, the Company entered into another exchange agreement (the “Exchange Agreement #4”) with the remaining holders of the GGH Notes, pursuant to which warrants for the purchase up to an aggregate of 150,000 shares of the Company’s common stock at an exercise price of $ 1.00 were issued as consideration for extending the maturity date in connection with Letter Agreement #5. The warrants have a grant date fair value of $ 134,779 and expire on the second anniversary of the date of issuance. Because the value of the new warrants was deemed to be substantial as compared to the $ 662,470 remaining principal of the GGH Notes, the transaction was accounted for as an extinguishment of old notes which were replaced with the new note. The fair value of the warrants was recorded as a loss on extinguishment and is reflected under Other Expense (Income) in the accompanying condensed consolidated statement of operations.\\nOn February 21, 2023, the Company redeemed the remaining GGH Notes for $ 905,428 , which includes the $ 662,470 of principal, $ 118,909 of accrued interest and $ 124,049 of redemption premium, the latter of which was charged to extinguishment loss.\\n\\n| 19 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\n2023 Convertible Note\\nOn February 21, 2023, the Company entered into a securities purchase agreement (the “SPA”) with an institutional investor, (the “Investor”) pursuant to which the Company received proceeds of $ 5,000,000 in exchange for a senior secured convertible note (the “2023 Note”) of the Company in the aggregate original principal amount of $ 5,617,978 , and a three-year common stock purchase warrant exercisable into an aggregate of 3,377,099 shares of common stock of the Company at an exercise price equal to $ 1.34 (the “2023 Note Warrant”). In addition to other terms, conditions and rights, both the Company and the Investor have the right to initiate additional closings for up to $ 5 million of cash for additional 2023 Notes and warrants.\\nPursuant to the SPA, the exercise price of certain warrants for the purchase of 62,500 common shares exercisable at $ 21.00 per share and warrants for the purchase of 43,814 shares exercisable at $ 6.00 per share was reduced to $ 1.00 per share. The increase in the value of the warrants in the aggregate amount of $ 63,502 as a result of the reduction in exercise price was recorded as debt discount on the 2023 Note.\\nThe 2023 Note is convertible into shares of common stock of the Company at a conversion price equal to the lower of (i) $ 1.34 (subject to adjustment for standard anti-dilution events, the non-exempt issuance of common stock for less than $ 1.34 per share and the issuance of additional variable price securities); (ii) the trading price on the day immediately prior to conversion or (iii) the average trading price of the Company’s common stock for the 5 days preceding conversion (collectively the “Conversion Price”), subject to a floor price of $0.27. If the Conversion Price in effect on the date of conversion is less than $ 0.27 , the Investor is entitled to a cash true up payment equal to the difference between the conversion dollar amount and the value of shares issued upon conversion (the “Cash True Up Provision”).\\nThe 2023 Note matures on the first anniversary of the issuance date (the “Maturity Date”) and bears interest at a rate of 7 % per annum, which is payable either in cash monthly, or by way of inclusion in the accrued interest in the conversion amount on the conversion date. Interest includes a make-whole amount equal to the additional interest that would accrue if the entire 2023 Note principal remained outstanding through the Maturity Date.\\nThe 2023 Note is redeemable at the Company’s election, so long as the Company is not in default, at the greater of (a) 115 % of the conversion amount, or (b) the amount equal to the shares issuable times the greatest closing price from the redemption notice date through the date the Company makes the redemption payment. The minimum redemption amount is $ 500,000 and the Company can only deliver one redemption notice in a 20-day period.\\nUpon an event of default on the 2023 Note, the Conversion Price is reduced to the lesser of (a) $1.34 (subject to adjustment as described above); (b) 80% of the volume-weighted average price on the day preceding receipt of the conversion notice; or (c) 80% of the average of the three lowest volume-weighted average prices over the fifteen trading days which precede receipt of the conversion notice, subject to a floor price of $ 0.27 (the “Event of Default Conversion Price”). In addition, the Investor may require the Company to redeem the 2023 Note using the same formula that would be used for a Company-initiated redemption, described above.\\nThe Event of Default Conversion Price represents a redemption feature, which was bifurcated from the debt host and recorded as a derivative liability. As of the date of issuance of the 2023 Note, management had estimated that the probability of an event of default was negligible; accordingly, the fair value of the derivative liability was de minimis at the date of issuance.\\n\\n| 20 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nPursuant to the terms of the 2023 Note, the Company must pay, convert or redeem one quarter of the initial principal, plus any outstanding interest and make-whole amount by each three-month anniversary of the issuance date. As of June 30, 2023, the Company is in default on the 2023 Note as a result of not making the required quarterly payment due on May 21, 2023. Consequently, the Company remeasured the derivative liability and recorded a change in fair value of the derivative liability of $ 2,141,117 during the three and six months ended June 30, 2023.\\nThe following table sets forth a summary of the changes in the fair value of the derivative liability that are measured at fair value on a recurring basis:\\nSUMMARY OF THE CHANGES IN THE FAIR VALUE OF DERIVATIVE LIABILITIES\\n| Balance as of January 1, 2023 | $ | - |\\n| Fair value of derivative liability upon issuance of 2023 Note | - |\\n| Change in fair value of derivative liability | 2,141,117 |\\n| Balance as of June 30, 2023 | 2,141,117 |\\n| Less: current portion of derivative liability | 2,088,617 |\\n| Equals: derivative liability, non-current portion | $ | 52,500 |\\n\\nThe Company incurred financing costs of $ 321,803 in connection with the SPA, of which $ 218,187 was allocated to the 2023 Note and recorded as debt discount and $ 103,616 was allocated to the 2023 Note Warrant and charged against additional paid-in capital.\\nUpon the issuance of the 2023 Note, the Company recorded a debt discount at issuance in the aggregate amount $ 2,509,601 , consisting of (i) the $ 617,978 difference between the aggregate principal amount of the 2023 Note and the cash proceeds received, (ii) financing costs in the aggregate amount of $ 218,187 , (iii) value of warrant modification of $ 63,502 , and (iv) the $ 1,609,935 relative fair value of the 2023 Note Warrant. The debt discount is being amortized using the effective interest method over the term of the 2023 Note.\\nDuring the six months ended June 30, 2023, the Company made redemption payments in the aggregate amount of $ 246,186 related to the 2023 Note, which included principal repayments of $ 200,070 , accrued interest of $ 14,005 and redemption premiums of $ 32,094 . The Company recorded a loss on extinguishment for the amount of redemption premiums paid.\\nDuring the three and six months ended June 30, 2023, a total of $ 575,256 , which included principal of $ 523,925 , accrued interest of $ 38,254 and conversion premiums of $ 13,077 , was converted into 828,780 shares at conversion prices between $ 0.46 and $ 0.78 per share.\\nInterest Expense on Convertible Debt Obligations\\nThe Company incurred total interest expense of $ 987,037 and $ 661,695 related to its convertible debt obligations during the three months ended June 30, 2023 and 2022, respectively. The Company incurred total interest expense of $ 1,553,077 and $ 1,410,926 related to its convertible debt obligations during the six months ended June 30, 2023 and 2022, respectively.\\nInterest expense during the three months ended June 30, 2023 and 2022 consists of (i) $ 211,260 and $ 151,200 , respectively, of make-whole interest accrued at 7 % per annum; (ii) $ 58,907 and $ 0 , respectively, of incremental default interest, respectively, and (iv) amortization of debt discount in the amount of $ 716,867 and $ 510,495 , respectively, during the six months ended June 30, 2023.\\nInterest expense during the six months ended June 30, 2023 and 2022 consists of (i) $ 415,135 and $ 348,990 , respectively, of make-whole interest accrued at 7 % per annum; (ii) $ 58,907 and $ 0 , respectively, of incremental default interest, respectively, and (iv) amortization of debt discount in the amount of $ 1,079,033 and $ 1,061,936 , respectively, during the six months ended June 30, 2023.\\nSee Note 17 - Subsequent Events.\\n\\n| 21 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\n11. SEGMENT DATA\\nThe Company’s financial position and results of operations are classified into three reportable segments, consistent with how the CODM makes decisions about resource allocation and assesses the Company’s performance.\\n\\n| ● | Real Estate Development, through AWE and TAR, including hospitality and winery operations, which support the ALGODON® brand. |\\n| ● | Fashion (e-commerce), through GGI, including the manufacture and sale of high-end fashion and accessories sold through an e-commerce platform. |\\n| ● | Corporate, consisting of general corporate overhead expenses not directly attributable to any one of the business segments. |\\n\\nThe following tables present segment information for the three months ended June 30, 2023 and 2022:\\nSCHEDULE OF SEGMENT INFORMATION\\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\\n| For the Three Months Ended June 30, 2023 | For the Six Months Ended June 30, 2023 |\\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\\n| Revenues | $ | 670,594 | $ | 40,381 | $ | - | $ | 710,975 | $ | 1,052,979 | $ | 105,763 | $ | - | $ | 1,158,742 |\\n| Revenues from Foreign Operations | $ | 670,594 | $ | - | $ | - | $ | 670,594 | $ | 1,052,979 | $ | - | $ | - | $ | 1,052,979 |\\n| Loss from Operations | $ | ( 123,767 | ) | $ | ( 463,126 | ) | $ | ( 1,398,694 | ) | $ | ( 1,985,587 | ) | $ | ( 457,771 | ) | $ | ( 955,325 | ) | $ | ( 2,518,496 | ) | $ | ( 3,931,592 | ) |\\n\\n\\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\\n| For the Three Months Ended June 30, 2022 | For the Six Months Ended June 30, 2022 |\\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\\n| Revenues | $ | 399,223 | $ | 6,112 | $ | - | $ | 405,335 | $ | 819,658 | $ | 11,274 | $ | - | $ | 830,932 |\\n| Revenues from Foreign Operations | $ | 399,223 | $ | - | $ | - | $ | 399,223 | $ | 819,658 | $ | - | $ | - | $ | 819,658 |\\n| Loss from Operations | $ | ( 1,339,272 | ) | $ | ( 341,668 | ) | $ | ( 758,493 | ) | $ | ( 2,439,433 | ) | $ | ( 1,725,125 | ) | $ | ( 700,201 | ) | $ | ( 1,789,910 | ) | $ | ( 4,215,236 | ) |\\n\\n\\n| 22 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nThe following tables present segment information as of June 30, 2023 and December 31, 2022:\\n\\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\\n| As of June 30, 2023 | As of December 31, 2022 |\\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\\n| Total Property and Equipment, net | $ | 6,586,322 | $ | 1,271,163 | $ | - | $ | 7,857,485 | $ | 6,234,856 | $ | 1,369,205 | $ | 17,196 | $ | 7,621,257 |\\n| Total Property and Equipment, net in Foreign Countries | $ | 6,586,322 | $ | - | $ | - | $ | 6,586,322 | $ | 6,234,856 | $ | - | $ | - | $ | 6,234,856 |\\n| Total Assets | $ | 14,282,151 | $ | 3,330,807 | $ | 1,606,456 | $ | 19,219,414 | $ | 13,504,914 | $ | 3,522,415 | $ | 1,665,656 | $ | 18,692,985 |\\n\\n12. RELATED PARTY TRANSACTIONS\\nAccounts Receivable – Related Parties\\nAs of June 30, 2023 and December 31, 2022 the Company had accounts receivable – related parties of $ 1,075,102 and $ 1,115,816 net of allowances for expected credit losses of $ 470,516 and $ 339,503 , respectively, representing the net realizable value of advances made to, and expense sharing obligations receivable from, separate entities under common management. During the three and six months ended June 30, 2023, the Company made advances in the amount of $ 0 and $ 85,644 , respectively, to the related entities. During the three and six months ended June 30, 2022, the Company made advances in the amount of $ 0 and $ 36,000 , respectively to the related entities. During the three and six months ended June 30, 2023, the Company received repayments in the amount of $ 237,813 and $ 367,813 , respectively, from the related entities. During the three and six months ended June 30, 2022, the Company received repayments in the amount of $ 583,000 and $ 703,000 , respectively, from the related entities. Receivables recorded in the amount of $ 383,529 and $ 417,413 in connection with an expense sharing agreement during the six months ended June 30, 2023 and 2022 are discussed below.\\nThe Company recorded credit losses related to accounts receivable, related parties of $ 0 and $ 19,431 during the three and six months ended June 30, 2023, respectively. The Company recorded credit losses of $ 0 during the three and six months ended June 30, 2022. Credit losses are recorded as bad debt expense which is reflected in the general and administrative expenses on the on the accompanying unaudited consolidated statements of operations.\\nExpense Sharing\\nOn April 1, 2010, the Company entered into an agreement with a Related Party to share expenses such as office space, support staff, professional services, and other operating expenses (the “Related Party ESA”). During the six months ended June 30, 2023 and 2022, the Company recorded a contra-expense of $ 383,529 and $ 417,413 , respectively, related to the reimbursement of general and administrative expenses as a result of the agreement. During the three months ended June 30, 2023 and 2022, the Company recorded a contra-expense of $ 208,103 and $ 189,188 , respectively, related to the reimbursement of general and administrative expenses as a result of the agreement.\\n\\n| 23 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nManagement Fee Income\\nThe Company earns management fees of $ 75,000 per quarter from LVH. A member of the Company’s board of directors is the managing member of SLVH, LLC, and holds a 20 % membership interest in SLVH. SLVH owns 88 % of the limited liability interest of LVH.\\nAmendment to LVH Limited Liability Company Agreement\\nOn June 30, 2023, the Company through its wholly owned subsidiary, GVI, executed a Fourth Amendment to the Amended and Restated Limited Liability Company Agreement of LVH to extend the outside date for execution of the ground lease from June 30, 2023 to December 29, 2023.\\n13. BENEFIT CONTRIBUTION PLAN\\nThe Company sponsors a 401(k) profit-sharing plan (“401(k) Plan”) that covers substantially all of its employees in the United States. The 401(k) Plan provides for a discretionary annual contribution, which is allocated in proportion to compensation. In addition, each participant may elect to contribute to the 401(k) Plan by way of a salary deduction.\\nA participant is always fully vested in their account, including the Company’s contribution. For the six months ended June 30, 2023 and 2022, the Company recorded a charge associated with its contribution of $ 9,208 and $ 22,384 , respectively. For the three months ended June 30, 2023 and 2022, the Company recorded a charge associated with its contribution of $ 3,300 and $ 3,408 , respectively. This charge has been included as a component of general and administrative expenses in the accompanying condensed consolidated statements of operations. The Company issues shares of its common stock to settle these obligations based on the fair value of its common stock on the date the shares are issued. During the six months ended June 30, 2023, the Company issued 24,160 shares at $ 1.35 per share in satisfaction of $ 32,617 of 401(k) contribution liabilities. During the six months ended June 30, 2022, the Company issued 1,040 shares at $ 26.76 per share in satisfaction of $ 27,821 of 401(k) contribution liabilities.\\n14. STOCKHOLDERS’ EQUITY\\nCommon Stock\\nOn February 2, 2023, the Company issued 51,305 shares of common stock upon the cashless exercise of 134,730 warrants at exercise prices ranging from $ 2.40 and $ 3.82 .\\nOn February 10, 2023, the Company sold 591,000 shares of common stock and warrants to purchase 147,750 shares at an exercise price of $ 1.00 for aggregate proceeds of $ 591,000 . The warrants are immediately exercisable and expire two years from the date of issuance.\\nDuring the six months ended June 30, 2023, the Company sold an aggregate of 823,198 shares of the Company’s common stock for gross proceeds of $ 797,623 less placement agent fees of $ 64,617 pursuant to a Common Stock Purchase Agreement (the “New ELOC”).\\nSee Note 10 – Convertible Debt Obligations for additional details regarding common shares issued during the three and six months ended June 30, 2023.\\nAccumulated Other Comprehensive Loss\\nFor the three and six months ended June 30, 2023, the Company recorded a loss of $ 37,993 and $ 77,792 , respectively, and for the three and six months ended June 30, 2022, the Company recorded a gain of $ 358,056 and $ 621,462 , respectively, related to foreign currency translation adjustments as accumulated other comprehensive income, primarily related to fluctuations in the Argentine peso to United States dollar exchange rates (see Note 2 – Summary of Significant Accounting Policies, Highly Inflationary Status in Argentina).\\n\\n| 24 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nWarrants\\nA summary of warrant activity during the six months ended June 30, 2023 is presented below:\\nSUMMARY OF WARRANTS ACTIVITY\\n| Number of Warrants | Weighted Average Exercise Price | Weighted Average Remaining Life in Years | Intrinsic Value |\\n| Outstanding, January 1, 2023 | 1,299,135 | $ | 5.77 |\\n| Issued | 3,674,849 | 1.31 |\\n| Exercised | ( 134,730 | ) | 3.36 |\\n| Expired | - | - |\\n| Canceled | - | - |\\n| Outstanding, June 30, 2023 | 4,839,254 | $ | 2.15 | 2.1 | $ | - |\\n| Exercisable, June 30, 2023 | 4,839,254 | $ | 2.15 | 2.1 | $ | - |\\n\\nSee Common Stock, above, and Note 10 – Convertible Debt Obligations for additional details regarding warrants issued during the six months ended June 30, 2023.\\nA summary of outstanding and exercisable warrants as of June 30, 2023 is presented below:\\nSCHEDULE OF WARRANTS OUTSTANDING AND EXERCISABLE\\n| Warrants Outstanding | Warrants Exercisable |\\n| Exercise Price | Exercisable Into | Outstanding Number of Warrants | Weighted Average Remaining Life in Years | Exercisable Number of Warrants |\\n| $ | 1.00 | Common Stock | 404,064 | 1.6 | 404,064 |\\n| $ | 1.34 | Common Stock | 3,377,099 | 2.7 | 3,377,099 |\\n| $ | 3.82 | Common Stock | 454,588 | 0.2 | 454,588 |\\n| $ | 6.00 | Common Stock | 602,225 | 0.5 | 602,225 |\\n| $ | 90.00 | Common Stock | 1,278 | 2.6 | 1,278 |\\n| Total | 4,839,254 | 2.1 | 4,839,254 |\\n\\n\\n| 25 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nRestricted Stock Units\\nA summary of RSU activity during the six months ended June 30, 2023 is presented below:\\nSCHEDULE OF RESTRICTED STOCK UNITS AND WEIGHTED AVERAGE GRANT DATE FAIR VALUES\\n| Weighted Average |\\n| Number of | Grant Date Value |\\n| RSUs | Per Share |\\n| RSUs non-vested January 1, 2023 | 511,500 | $ | 1.16 |\\n| Granted | 10,000 | 1.31 |\\n| Vested | ( 3,890 | ) | 1.31 |\\n| Forfeited | ( 1,333 | ) | 1.16 |\\n| RSUs non-vested June 30, 2023 | 516,277 | $ | 1.16 |\\n\\nOn January 23, 2023, the Company granted 10,000 restricted stock units (“RSUs”) to certain employees and advisors for their service, of which 3,890 RSUs vested on the grant date and 3,055 RSUs will vest on each of the next two anniversaries of the date of the grant.\\nDuring the three and six months ended June 30, 2023, the Company recorded stock-based compensation expense of $ 74,978 and $ 154,400 respectively, related to the amortization of RSUs. No expense related to the amortization of RSUs was recorded for the three or six months ended June 30, 2022.\\nStock Options\\nNo stock options were granted during the six months ended June 30, 2023 or the six months ended June 30, 2022. The following table presents information related to GGH stock options outstanding as of June 30, 2023:\\nSCHEDULE OF STOCK OPTION ACTIVITY\\n| Weighted | Weighted |\\n| Average | Average |\\n| Number of | Exercise | Remaining | Intrinsic |\\n| Options | Price | Term (Years) | Value |\\n| Outstanding, January 1, 2023 | 40,612 | 85.35 |\\n| Granted | - | - |\\n| Exercised | - | - |\\n| Expired | ( 5,806 | ) | 138.60 |\\n| Forfeited | - | - |\\n| Outstanding, June 30, 2023 | 34,806 | $ | 76.47 | 1.1 | $ | - |\\n| Exercisable, June 30, 2023 | 29,698 | $ | 75.78 | 1.0 | $ | - |\\n\\n\\n| 26 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nDuring the three and six months ended June 30, 2023, the Company recorded stock-based compensation expense of $ 38,834 and $ 77,668 , respectively, and during the three and six months ended June 30, 2022, the Company recorded stock-based compensation expense of $ 57,403 and $ 130,103 , respectively, related to the amortization of options for the purchase of GGH common stock.\\nThe Company recorded no stock-based compensation expense related to options for the purchase of GGI common stock for the three and six months ended June 30, 2023 as all of the GGI options were exchanged and cancelled as of June 22, 2022. For the three and six months ended June 30, 2022, the Company recorded stock-based compensation expense of $ 29,731 and $ 40,085 , respectively, related to the options for the purchase of GGI common stock.\\nStock-based compensation expense is reflected in general and administrative expenses (classified in the same manner as the grantees’ wage compensation) in the accompanying condensed consolidated statements of operations. As of June 30, 2023, there was $ 91,921 of unrecognized stock-based compensation expense related to stock option grants that will be amortized over a weighted average period of 1.1 years.\\n15. COMMITMENTS AND CONTINGENCIES\\nLegal Matters\\nThe Company may be involved in litigation and arbitrations from time to time in the ordinary course of business. At the present time, the Company is not involved in any ongoing litigation. The Company records legal costs associated with loss contingencies as incurred. Settlements are accrued when, and if, they become probable and estimable.\\n16. LEASES\\nOn April 8, 2021, GGI entered into a lease agreement to lease a retail space in Miami, Florida for 7 years, which expires May 1, 2028 . As of June 30, 2023, the lease had a remaining term of approximately 4.8 years. Lease payments begin at $26,758 per month and escalate 3% every year over the duration of the lease. The Company was granted rent abatements of 15% for the first year of the lease term, and 10% for the second and third year of the lease term. The Company was required to pay a $ 56,130 security deposit.\\nAs of June 30, 2023, the Company had no leases that were classified as a financing lease.\\nTotal operating lease expense was $ 82,965 and $ 165,931 during the three and six months ended June 30, 2023, respectively, and $ 82,965 and $ 165,931 during the three and six months ended June 30, 2022, respectively. Lease expenses are recorded in general and administrative expenses on the accompanying condensed consolidated statements of operations.\\n\\n| 27 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nSupplemental cash flow information related to leases was as follows:\\nSCHEDULE OF SUPPLEMENTAL CASH FLOWS INFORMATION RELATED TO LEASES\\n| For the Six Months Ended June 30, |\\n| 2023 | 2022 |\\n| Cash paid for amounts included in the measurement of lease liabilities: |\\n| Operating cash flows from operating leases | $ | 98,125 | $ | 82,296 |\\n| Right-of-use assets obtained in exchange for lease obligations: |\\n| Operating leases | $ | - | $ | - |\\n| Weighted Average Remaining Lease Term: |\\n| Operating leases | 4.8 | 5.8 |\\n| Weighted Average Discount Rate: |\\n| Operating leases | 7.0 | % | 7.0 | % |\\n\\nFuture minimum lease commitments are as follows:\\nSCHEDULE OF FUTURE MINIMUM LEASE COMMITMENT\\n| For the period July 1 through December 31, 2023 | $ | 153,290 |\\n| For the years ended December 31, |\\n| 2024 | 336,102 |\\n| 2025 | 357,881 |\\n| 2026 | 368,617 |\\n| 2027 | 365,004 |\\n| 2028 | 120,463 |\\n| Total future minimum lease payments | 1,701,357 |\\n| Less: imputed interest | ( 268,300 | ) |\\n| Net future minimum lease payments | 1,433,057 |\\n| Less: operating lease liabilities, current portion | 220,416 |\\n| Operating lease liabilities, non-current portion | $ | 1,212,641 |\\n\\nThe Company is the lessor of a building and land that it purchased in connection with acquisition of GDS, pursuant to an operating lease which expires on August 31, 2031. At the end of the leases, the lessee may enter into a new lease or return the asset, which would be available to the Company for releasing. The Company recorded lease revenue of $ 10,937 and $ 21,565 during the three and six months ended June 30, 2023, respectively, related to this lease agreement. The Company recorded lease revenue of $ 10,594 and $ 14,339 during the three and six months ended June 30, 2022, respectively, related to this lease agreement.\\n17. SUBSEQUENT EVENTS\\nThere have been no subsequent events that occurred during the period subsequent to the date of these condensed consolidated financial statements that would require adjustment to our disclosure in the condensed consolidated financial statements as presented, except as described below:\\n2023 Convertible Note\\nOn July 3, 2023, $ 120,000 of principal, $ 9,979 of interest, and $ 19,467 of premium owed in connection with the 2023 Note were converted into 329,416 shares of common stock of the Company at a conversion price of $ 0.4538 per share.\\nOn August 11, 2023, the Company and the Investor entered into a letter agreement pursuant to which, among other things: i) the Investor agreed to forbear from issuing an Event of Default Notice and Event of Default Redemption Notice; (ii) the requirement in the 2023 Note to pay interest monthly in cash is waived for payments due August 1, 2023 through December 31, 2023; (iii) the application of the default interest rate on the 2023 Note is waived for the period from May 21, 2023 through December 31, 2023, (iv) the requirement for the Company to prepay, redeem, or convert one quarter the initial principal owe on the 2023 Note, plus any outstanding interest and make-whole amount by each three-month anniversary of the issuance date.is waived through December 31, 2023; (v) the Company adjusted the exercise price of the 2023 Note Warrant from $1.34 to $0.45; and (vi) the Investor may continue to convert the 2023 Note at the Alternate Conversion Price or at $0.45.\\nBoard Compensation\\nOn July 14, 2023, the Company issued a total of 270,272 shares at $ 0.555 per share for a total value of $ 150,000 to the non-executive directors of the Company as compensation for service as members of the Board of Directors of the Company for the first half of 2023.\\n\\n| 28 |\\n\\n\\n\\nThe following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and notes thereto included herein. In connection with, and because we desire to take advantage of, the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, we caution readers regarding certain forward-looking statements in the following discussion and elsewhere in this report and in any other statement made by, or on our behalf, whether or not in future filings with the Securities and Exchange Commission. Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results or other developments. Forward looking statements are necessarily based upon estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control and many of which, with respect to future business decisions, are subject to change. These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on our behalf. Words such as “anticipate,” “estimate,” “plan,” “continuing,” “ongoing,” “expect,” “believe,” “intend,” “may,” “will,” “should,” “could,” and similar expressions are used to identify forward-looking statements. We disclaim any obligation to update forward-looking statements.\\nUnless the context requires otherwise, references in this document to “GGH”, “we”, “our”, “us” or the “Company” are to Gaucho Group Holdings, Inc. and its subsidiaries.\\nPlease note that because we qualify as an emerging growth company and as a smaller reporting company, we have elected to follow the smaller reporting company rules in preparing this Quarterly Report on Form 10-Q.\\nOverview\\nGaucho Group Holdings, Inc. (“GGH” or the “Company”) positions its e-commerce leather goods, accessories, and fashion brand, Gaucho – Buenos Aires™, as one of luxury, creating a platform for the global consumer to access their piece of Argentine style and high-end products. With a concentration on leather goods, ready-to-wear and accessories, this is the luxury brand in which Argentina finds its contemporary expression. During the first quarter of 2022, the Company launched Gaucho Casa, a Home & Living line of luxury textiles and home accessories, which will be marketed and sold on the Gaucho – Buenos Aires e-commerce platform. Gaucho Casa challenges traditional lifestyle collections with its luxury textiles and home accessories rooted in the singular spirit of the gaucho aesthetic. GGH seeks to grow its direct-to-consumer online products to global markets in the United States, Asia, the United Kingdom, Europe, and Argentina. We intend to focus on e-commerce and scalability of the Gaucho – Buenos Aires and Gaucho Casa brands, as real estate in Argentina is politically sensitive.\\nGGH’s goal is to become recognized as the LVMH (“Louis Vuitton Moët Hennessy”) of South America’s leading luxury brands. Through one of its wholly owned subsidiaries, GGH also owns and operates legacy investments in the boutique hotel, hospitality and luxury vineyard property markets. This includes a golf, tennis and wellness resort, as well as an award-winning wine production company concentrating on Malbecs and Malbec blends. Utilizing these wines as its ambassador, GGH seeks to further develop its legacy real estate, which includes developing residential vineyard lots located within its resort.\\nAs a result of the COVID-19 pandemic, we terminated the corporate office lease and senior management now works remotely. GGH’s local operations are managed by professional staff with substantial hotel, hospitality and resort experience in Buenos Aires and San Rafael, Argentina.\\n\\n| 29 |\\n\\n\\nRecent Developments and Trends\\nWhile the World Health Organization declared an end to the COVID-19 global health emergency on May 5, 2023, we continue to closely monitor the outbreak of COVID-19 and the related impact on our operations, financial position and cash flows, as well as the impact on our employees. Due to the continued fluidity of this situation, and the magnitude and duration of the pandemic, its impact on our future operations and liquidity remains uncertain as of the date of this report.\\nWe have faced, and may continue to face, significant cost inflation, specifically in raw materials and other supply chain costs due to increased demand for raw materials and the broad disruption of the global supply chain associated with the impact of COVID-19. International conflicts or other geopolitical events, including the 2022 Russian invasion of Ukraine, may further contribute to increased supply chain costs due to shortages in raw materials, increased costs for transportation and energy, disruptions in supply chains, and heightened inflation. Further escalation of geopolitical tensions may also lead to changes to foreign exchange rates and financial markets, any of which may adversely affect our business and supply chain, and consequently our results of operation. While there could ultimately be a material impact on the operations and liquidity of the Company, at the time of issuance, the impact could not be determined.\\nDuring the three months ended June 30, 2023, the Company and the holder of a senior secured convertible note of the Company (the “2023 Note”) converted an aggregate of $575,256 of principal, interest and conversion premiums, and the Company issued an aggregate of 828,780 shares upon conversion.\\nOn June 30, 2023, the Company through its wholly owned subsidiary, Gaucho Ventures I – Las Vegas, LLC (“GVI”), executed a Fourth Amendment to the Amended and Restated Limited Liability Company Agreement of LVH Holdings LLC (“LVH”) to extend the outside date for execution of the ground lease from June 30, 2023 to December 29, 2023.\\nOn July 3, 2023, the Company and the holder of the 2023 Note converted an aggregate of $149,446 of principal, interest and conversion premiums and the Company issued an aggregate of 329,416 shares upon conversion.\\nOn July 14, 2023, the Company issued a total of 270,272 shares at $0.555 per share for a total value of $150,000 to the non-executive directors of the Company as compensation for service as members of the Board of Directors of the Company for the first half of 2023.\\nConsolidated Results of Operations\\nThree months ended June 30, 2023 compared to the three months ended June 30, 2022\\nOverview\\nWe reported a net loss of approximately $5.0 million and $5.3 million for the three months ended June 30, 2023 and 2022, respectively.\\nRevenues\\nRevenues from operations were approximately $711,000 and $405,000 during the three months ended June 30, 2023 and 2022, respectively, reflecting an increase of approximately $306,000 or 76%. The overall increase in sales was driven by increases in hotel, restaurant and wine revenues of approximately $443,000, an increase of approximately $143,000 in lot sales, an increase of agricultural sales of approximately $178,000, and an increase in clothes, accessories and other sales of approximately $61,000, resulting from the easing of COVID restrictions and the Argentine government’s efforts to promote tourism and revitalize local businesses, and from the opening of our flagship retail store in Miami. These revenue increases were partially offset by a decrease of approximately $519,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\\n\\n| 30 |\\n\\n\\nGross profit\\nWe generated a gross profit of approximately $42,000 for the three months ended June 30, 2023 and a gross loss of approximately $128,000 for the three months ended June 30, 2022, representing an increase in gross profit of approximately $170,000 or 133%, primarily resulting from profits earned from the sale of real estate lots during the period.\\nCost of sales, which consists of real estate lots, raw materials, direct labor and indirect labor associated with our business activities, increased by approximately $136,000 or 26%, from approximately $533,000 for the three months ended June 30, 2022 to approximately $669,000 for the three months ended June 30, 2023. The increase in cost of sales resulted from the increases in hotel, restaurant and wine costs of approximately $335,000, an increase in clothes, accessories and other costs of approximately $124,000, and an increase of approximately $102,000 in costs associated with lot sales, which correspond to the increases in the related revenues as discussed above. In addition, a higher number of agricultural sales, which are sold at a loss, provided an increase of approximately $199,000 in cost of sales. These increases in cost of sales were partially offset by a decrease of approximately $625,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\\nSelling and marketing expenses\\nSelling and marketing expenses were approximately $213,000 and $333,000 for the three months ended June 30, 2023 and 2022, respectively, representing a decrease of $120,000 or 36%, primarily related to lower GGI advertising and marketing expenses for GGI’s new retail space as well as the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\\nGeneral and administrative expenses\\nGeneral and administrative expenses were approximately $1,711,000 and $1,929,000 for the three months ended June 30, 2023 and 2022, respectively, representing a decrease of $218,000 or 11%. Decreases of approximately $225,000 in employee compensation, and approximately $759,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar were partially offset by increases of approximately $482,000 in professional and consulting fees (primarily business development and investor relations consulting) and approximately $284,000 in other aggregated expenses that are not individually material.\\nDepreciation and amortization expense\\nDepreciation and amortization expense was approximately $104,000 and $49,000 during the three months ended June 30, 2023 and 2022, respectively, representing an increase of $55,000 or 112%, related to new asset purchases.\\nInterest income\\nInterest income was approximately $64,000 and $27,000 during the three months ended June 30, 2023 and 2022, respectively, representing an increase of $37,000 or 137%, related to the increase in mortgages receivable.\\nInterest expense\\nInterest expense was approximately $1,066,000 and $695,000 during the three months ended June 30, 2023 and 2022, respectively, representing an increase of $371,000 or 53%. The increase is primarily related to a rise in the interest and debt discount related to convertible debt issued during February 2023.\\n\\n| 31 |\\n\\n\\nOther income, related party\\nOther income of approximately $75,000 during the three months ended June 30, 2023 and 2022 represents the management fee earned from LVH.\\nLoss on extinguishment of debt\\nLoss on extinguishment of debt in the aggregate amount of $32,094 during the three months ended June 30, 2023 consists of extinguishment loss recognized related to premiums paid on the cash redemption of convertible debt. Loss on extinguishment of debt in the aggregate amount of $2,105,119 during the three months ended June 30, 2022 consists of extinguishment loss recognized upon the reduction of the conversion price on the GGH Notes during the second quarter of 2022.\\nGains from foreign currency translation\\nThe Company recorded gains from foreign currency translation of approximately $103,000 and $43,000 during the three months ended June 30, 2023 and 2022, respectively. The increase of approximately $60,000 in gains from foreign currency translation is due to the fluctuation in the Argentine peso to United States dollar exchange rates.\\nChange in fair value of derivative liability\\nThe Company recorded a change in fair value of derivative liability of approximately $2,141,000 and $0 during the three months ended June 30, 2023 and 2022, respectively. The change in fair value during the six months ended June 30, 2023 is associated with the default of the 2023 Convertible Note as of June 30, 2023.\\nInducement expense\\nInducement expense decreased to $0 for the three months ended June 30, 2023 from approximately $198,000 during the three months ended June 30, 2022. Inducement expense during the three months ended June 30, 2022 resulted from a temporary reduction in the conversion price on convertible debt.\\nSix months ended June 30, 2023 compared to the six months ended June 30, 2022\\nOverview\\nWe reported a net loss of approximately $7.7 million and $7.6 million for the six months ended June 30, 2023 and 2022, respectively.\\nRevenues\\nRevenues from operations were approximately $1,159,000 and $831,000 during the six months ended June 30, 2023 and 2022, respectively, reflecting an increase of approximately $328,000 or 39%. The overall increase in sales was driven by increases in hotel, restaurant and wine revenues of approximately $863,000, increases in agricultural revenues of $122,000, and increases in clothes, accessories and other sales of approximately $145,000 resulting from the easing of COVID restrictions and the Argentine government’s efforts to promote tourism and revitalize local businesses, and from the opening of our flagship retail store in Miami. These revenue increases were partially offset by a decrease in lot sales of approximately $42,000 and approximately $760,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\\n\\n| 32 |\\n\\n\\nGross profit\\nWe generated a gross profit of approximately $197,000 and $59,000 for the six months ended June 30, 2023 and 2022, respectively, representing an increase of approximately $138,000 or 234%. The increase in gross profit during the six months ended June 30, 2023 is primarily related to hotel sales during the period. The Company’s hotel was being renovated during the first half of 2022, resulting in limited revenues, with fixed costs related to hotel operations.\\nCost of sales, which consists of real estate lots, raw materials, direct labor and indirect labor associated with our business activities, increased by approximately $190,000 or 25%, from approximately $772,000 for the six months ended June 30, 2022 to approximately $962,000 for the six months ended June 30, 2023. The increase in cost of sales includes increases in hotel, restaurant and wine costs of approximately $534,000, an increase in clothes, accessories and other costs of approximately $166,000, and an increase of approximately $75,000 in costs associated with lot sales, which correspond to the increases in the related revenues as discussed above. In addition, a higher number of agricultural sales, which are sold at a loss, provided an increase of approximately $158,000 in cost of sales. These increases in cost of sales were partially offset by a decrease of approximately $743,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\\nSelling and marketing expenses\\nSelling and marketing expenses were approximately $448,000 and $505,000 for the six months ended June 30, 2023 and 2022, respectively, representing a decrease of approximately $57,000 or 11%, primarily related to lower GGI advertising and marketing expenses for GGI’s new retail space as well as the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\\nGeneral and administrative expenses\\nGeneral and administrative expenses were approximately $3,467,000 and $3,674,000 for the six months ended June 30, 2023 and 2022, respectively, representing a decrease of $207,000 or 6%. A decrease of approximately $739,000 resulting from gains recognized on transactions denominated in foreign currency, as well as a decrease of approximately $460,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar were partially offset by increases of approximately $596,000 in professional and consulting fees (primarily business development and investor relations consulting), approximately $85,000 of compensation expense, as well as approximately $307,000 in other aggregated expenses that are not individually material. Gains recognized on transactions denominated in a foreign currency result from the difference between the official exchange rate, and the actual exchange rate applied to the peso.\\nDepreciation and amortization expense\\nDepreciation and amortization expense was approximately $213,000 and $95,000 during the six months ended June 30, 2023 and 2022, respectively, representing an increase of $118,000 or 124%, related to new asset purchases.\\nInterest income\\nInterest income was approximately $115,000 and $30,000 during the six months ended June 30, 2023 and 2022, respectively, representing an increase of $85,000 or 283% as the result of increases in mortgages receivable during the period.\\nInterest expense\\nInterest expense was approximately $1,668,000 and $1,453,000 during the six months ended June 30, 2023 and 2022, respectively, representing an increase of $215,000 or 15%. The increase is primarily related to a rise in the interest and debt discount related to convertible debt issued during February 2023.\\nOther income\\nOther income of approximately $150,000 during the six months ended June 30, 2023 and 2022 represents the management fee received from LVH.\\n\\n| 33 |\\n\\n\\nGains from foreign currency translation.\\nThe Company recorded gains from foreign currency translation of approximately $215,000 and $226,000 during the six months ended June 30, 2023 and 2022, respectively, as the result of the highly inflationary status of Argentina. The decrease of approximately $11,000 in gains from foreign currency translation is due to the fluctuation in the Argentine peso to United States dollar exchange rates.\\nLoss on extinguishment of debt\\nLoss on extinguishment of debt was approximately $416,000 during the six months ended June 30, 2023, as compared to approximately $2.1 million during the six months ended June 30, 2022. Loss on extinguishment of debt during the six months ended June 30, 2023 in the approximate amount of $416,000 is comprised of (i) premium paid on the conversion of GGH Notes of approximately $112,000, (ii) premium paid on the cash redemption of GGH Notes of approximately $124,000, (iii) premium paid on the 2023 Note for cash redemption of principal in the amount of approximately $32,000; (iv) premium in the amount of approximately $13,000 paid on the conversion an aggregate of $87,179 of principal and interest owed on the 2023 Note, and (iv) the fair value of approximately $135,000 in warrants issued in the exchange agreement for the GGH Notes (See Note 10—Convertible Debt Obligations for additional details).\\nLiquidity and Capital Resources\\nWe measure our liquidity a variety of ways, including the following:\\n\\n| June 30, 2023 | December 31, 2022 |\\n| (unaudited) |\\n| Cash | $ | 810,139 | $ | 300,185 |\\n| Working capital (deficiency) | $ | (3,828,285 | ) | $ | 595,120 |\\n| Convertible debt obligations | $ | 4,893,983 | $ | 1,997,909 |\\n| Loans payable | $ | 342,482 | $ | 256,321 |\\n\\nCash requirements for our current liabilities include approximately $2.0 million for accounts payable and accrued expenses, approximately $220,000 for lease liabilities, and approximately $332,000 for loans payable and other current liabilities. We also have convertible debt obligations in the approximate amount of $4.8 million which, if not converted prior to maturity, are due on February 21, 2024. Cash requirements for our long-term liabilities include approximately $1.2 million for operating lease liabilities, approximately $90,000 in loans payable, and approximately $82,000 of long-term accrued expenses.\\nDuring the six months ended June 30, 2023, we financed a portion of our activities from proceeds derived from debt and equity financings. A significant portion of the funds have been used to cover working capital needs and personnel, office expenses and various consulting and professional fees.\\nNet cash used in operating activities for the six months ended June 30, 2023 and 2022 amounted to approximately $4,033,000 and $2,755,000, respectively. During the six months ended June 30, 2023, the net cash used in operating activities was primarily attributable to the net loss of approximately $7.7 million adjusted for approximately $4.1 million of net non-cash expenses, and approximately $0.5 million of cash used to fund changes in the levels of operating assets and liabilities. During the six months ended June 30, 2022, the net cash used in operating activities was primarily attributable to the net loss of approximately $7.6 million adjusted for approximately $4.1 million of net non-cash expenses, and approximately $0.7 million of cash used to fund changes in the levels of operating assets and liabilities.\\nCash used in investing activities for the six months ended June 30, 2023 and 2022 amounted to approximately $489,000 and $1,720,000, respectively, resulting primarily from the purchase of property and equipment in the approximate amount of $438,000 and $1,677,000 million, respectively, and approximately $50,000 and $35,000 respectively, used to purchase certain intangible assets.\\n\\n| 34 |\\n\\n\\nNet cash provided by financing activities for the six months ended June 30, 2023 and 2022 amounted to approximately $5.1 million and $0.5 million, respectively. For the six months ended June 30, 2023, the net cash provided by financing activities resulted from approximately $4.7 million in net proceeds from the issuance of debt, $0.6 million in proceeds from the issuance of common stock in a private placement, approximately $0.7 million in proceeds from the issuance of stock under the New ELOC and $0.2 million in proceeds from the issuance of a note payable, partially offset by the repayment of convertible debt obligations and related redemption premiums in the approximate amount of $1.0 million, and repayment of loans payable of approximately $0.1 million. Net cash used in financing activities for the six months ended June 30, 2022 resulted from approximately $0.5 million of cash proceeds from the sale of commons stock, partially offset by approximately $0.1 million in repayments of loans payable.\\nAs of June 30, 2023, the Company had cash and a working capital deficit of approximately $810,000 and $3,109,000, respectively. During the six months ended June 30, 2023 and 2022, the Company incurred net losses of approximately $7.7 million and $7.6 million, respectively, and used cash in operating activities of approximately $4.0 million and $2.8 million, respectively. Further, as of June 30, 2023, approximately $4.8 million owed in connection with the Company’s convertible debt matures on February 21, 2024, and approximately $0.3 million represents the current portion of the Company’s loans payable which are payable on demand or for which payments are due within twelve months after June 30, 2023. During the six months ended June 30, 2023, the Company funded its operations with net proceeds from convertible debt financing of approximately $4.7 million, proceeds of approximately $0.7 million from draws on the Company’s equity line of credit, and $0.6 million from the sale of common stock.\\nThe Company’s operating needs include the planned costs to operate its business, including amounts required to fund working capital and capital expenditures. Based upon projected revenues and expenses, the Company believes that it may not have sufficient funds to operate for the next twelve months from the date these financial statements are made available. Since inception, the Company’s operations have primarily been funded through proceeds received from equity and debt financings. The Company believes it has access to capital resources and continues to evaluate additional financing opportunities. There is no assurance that the Company will be able to obtain funds on commercially acceptable terms, if at all. There is also no assurance that the amount of funds the Company might raise will enable the Company to complete its development initiatives or attain profitable operations. The aforementioned factors raise substantial doubt about the Company’s ability to continue as a going concern.\\nAvailability of Additional Funds\\nAs a result of our financings, we have been able to sustain operations. However, we will need to raise additional capital in order to meet our future liquidity needs for operating expenses and capital expenditures, including GGI inventory production, continued development of the GGI e-commerce platform, expansion of our winery and additional investments in real estate development. If we are unable to obtain adequate funds on reasonable terms, we may be required to significantly curtail or discontinue operations.\\nOff-Balance Sheet Arrangements\\nNone.\\nContractual Obligations\\nAs a smaller reporting company, we are not required to provide the information requested by paragraph (a)(5) of this Item.\\nCritical Accounting Policies and Estimates\\nThere are no material changes from the critical accounting policies, estimates and new accounting pronouncements set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” set forth in our Annual Report on Form 10-K filed with the SEC on April 17, 2023, except as described below. Please refer to that document for disclosures regarding the critical accounting policies related to our business.\\n\\n| 35 |\\n\\n\\nConvertible Promissory Notes\\nThe Company evaluates its convertible instruments to determine if those contracts or embedded components of those contracts qualify as derivative financial instruments to be separately accounted for in accordance with Topic 815 “Derivatives and Hedging” (“ASC 815”) of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”). The accounting treatment of derivative financial instruments requires that the Company record any bifurcated embedded features at their fair values as of the inception date of the agreement and at fair value as of each subsequent balance sheet date. Any change in fair value is recorded in earnings each period as non-operating, non-cash income or expense. The Company reassesses the classification of its derivative instruments at each balance sheet date. If the classification changes as a result of events during the period, the contract is reclassified as of the date of the event that caused the reclassification. Bifurcated embedded features are recorded upon note issuance at their initial fair values which create additional debt discount to the host instrument.\\nSequencing Policy\\nUnder ASC 815, we have adopted a sequencing policy, whereby, in the event that reclassification of contracts from equity to assets or liabilities is necessary pursuant to ASC 815 due to the Company’s inability to demonstrate it has sufficient authorized shares as a result of certain securities with a potentially indeterminable number of shares or the Company’s total potentially dilutive shares exceed the Company’s authorized share limit, shares will be allocated on the basis of the earliest issuance date of potentially dilutive instruments, with the earliest grants receiving the first allocation of shares. Pursuant to ASC 815, issuances of securities granted as compensation in a share-based payment arrangement are not subject to the sequencing policy.\\n\\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, we are not required to provide the information required by this Item.\\n\\nDisclosure Controls and Procedures\\nOur management carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer (who is our Principal Executive Officer) and our Chief Financial Officer (who is our Principal Financial Officer and Principal Accounting Officer), of the effectiveness of the design of our disclosure controls and procedures (as defined by Exchange Act Rules 13a-15(e) or 15d-15(e)) as of June 30, 2023, pursuant to Exchange Act Rule 13a-15(b). Based upon that evaluation, our Principal Executive Officer and Principal Financial Officer concluded that our disclosure controls and procedures were not effective as of June 30, 2023, resulting from a lack of segregation of duties due to our small size, and lack of testing of the operating effectiveness of the controls.\\n\\n| 36 |\\n\\n\\nChanges in Internal Control over Financial Reporting\\nThere were no changes in our internal control over financial reporting identified in management’s evaluation pursuant to Rules 13a-15(d) or 15d-15(d) of the Exchange Act during the quarter ended June 30, 2023 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\nInherent Limitations of Controls\\nManagement does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all errors and all fraud. Controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or deterioration in the degree of compliance with the policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.\\n\\n| 37 |\\n\\n\\nPART II - OTHER INFORMATION\\n\\nFrom time to time, the Company and its subsidiaries and affiliates are subject to litigation and arbitration claims incidental to its business. Such claims may not be covered by its insurance coverage, and even if they are, if claims against GGH and its subsidiaries are successful, they may exceed the limits of applicable insurance coverage. We are not involved in any litigation that we believe is likely, individually or in the aggregate, to have a material adverse effect on our condensed consolidated financial condition, results of operations or cash flows.\\n\\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, we are not required to provide information required by this Item. However, our current risk factors are set forth in Item 1A of the Company’s Annual Report on Form 10-K as filed with the SEC on April 17, 2023 and in Item 1A of the Company’s Quarterly Report on Form 10-Q as filed with the SEC on May 19, 2023.\\nOur stock has been trading below $1.00 and our failure to maintain compliance with Nasdaq’s continued listing requirements could result in the delisting of our common stock.\\nOur common stock is currently listed for trading on The Nasdaq Capital Market. We must satisfy the continued listing requirements of The Nasdaq Stock Market LLC (or Nasdaq), to maintain the listing of our common stock on The Nasdaq Capital Market.\\nOn June 1, 2023, the Company received a deficiency letter from the Listing Qualifications Department (the “Staff”) of the Nasdaq Stock Market notifying the Company that, for the preceding 30 consecutive business days, the closing bid price for the Company’s common stock was trading below the minimum $1.00 per share requirement for continued inclusion on The Nasdaq Capital Market pursuant to Nasdaq Listing Rule 5450(a)(1) (the “Bid Price Requirement”). The notification has no immediate effect on the Company’s Nasdaq listing and the Company’s common stock will continue to trade on Nasdaq under the ticker symbol “VINO.”\\nIn accordance with Nasdaq Rules, the Company was provided with an initial period of 180 calendar days, or until November 28, 2023 (the “Compliance Date”), to regain compliance with the Bid Price Requirement. If at any time before the Compliance Date the closing bid price for the Company’s common stock is at least $1.00 for a minimum of 10 consecutive business days, the Staff will provide the Company written confirmation of compliance with the Bid Price Requirement.\\nIf the Company does not regain compliance with the Bid Price Requirement by the Compliance Date, the Company may be eligible for an additional 180 calendar day compliance period. To qualify, the Company would then be required to meet the continued listing requirement for market value of publicly held shares and all other initial listing standards for The Nasdaq Capital Market, with the exception of the Bid Price Requirement, and will need to provide written notice of its intention to cure the deficiency during the additional 180 calendar day compliance period, which compliance could be achieved by effecting a reverse stock split, if necessary. If the Company does not regain compliance with the Bid Price Requirement by the Compliance Date and is not eligible for an additional compliance period at that time, the Staff will provide written notification to the Company that its common stock will be subject to delisting. At that time, the Company may appeal the Staff’s delisting determination to a Nasdaq Hearings Panel.\\n\\n| 38 |\\n\\n\\nThe Company is holding its Annual General Meeting on August 24, 2023, at which, among other things, the Company has requested stockholder approval to grant the Board of Directors discretion (if necessary to prevent the delisting of the Company’s common stock on Nasdaq) on or before June 30, 2024, to implement a reverse stock split of the outstanding shares of common stock in a range from one-for-two (1:2) up to one-for-ten (1:10), or anywhere between, while maintaining the number of authorized shares of common stock at 150,000,000 shares, as required for Nasdaq listing. The Company will need shareholders representing a majority of the outstanding shares of the Company to approve this proposal, which is not guaranteed.\\nIf our common stock were delisted from Nasdaq, trading of our common stock would most likely take place on an over-the-counter market established for unlisted securities, such as the OTCQB or the Pink Market maintained by OTC Markets Group Inc. An investor would likely find it less convenient to sell, or to obtain accurate quotations in seeking to buy, our common stock on an over-the-counter market, and many investors would likely not buy or sell our common stock due to difficulty in accessing over-the-counter markets, policies preventing them from trading in securities not listed on a national exchange or other reasons. In addition, as a delisted security, our common stock would be subject to SEC rules as a “penny stock”, which impose additional disclosure requirements on broker-dealers. The regulations relating to penny stocks, coupled with the typically higher cost per trade to the investor of penny stocks due to factors such as broker commissions generally representing a higher percentage of the price of a penny stock than of a higher-priced stock, would further limit the ability of investors to trade in our common stock. In addition, delisting would materially and adversely affect our ability to raise capital on terms acceptable to us, or at all, and may result in the potential loss of confidence by investors, suppliers, customers and employees and fewer business development opportunities. For these reasons and others, delisting would adversely affect the liquidity, trading volume and price of our common stock, causing the value of an investment in us to decrease and having an adverse effect on our business, financial condition and results of operations, including our ability to attract and retain qualified employees and to raise capital.\\nThe Company is currently in default under one of its convertible promissory notes, which allows the holder to redeem all or a portion of the Note.\\nPursuant to the 2023 Purchase Agreement and Notes, as of May 21, 2023, the Company failed to prepay, redeem or convert one quarter of the initial principal and interest on the Notes. The holder may require the Company to redeem all or a portion of the Notes by written notice, which would have a material adverse effect on the Company. On August 11, 2023, the Company and the holder of the Notes entered into an agreement (the “Letter Agreement”) pursuant to which, among other things: the holder agreed to forbear from issuing an event of default notice and event of default redemption notice through December 31, 2023. See Item 5 for additional information.\\nIf LVH does not sign a ground lease by December 29, 2023, LVH will be dissolved and we may not receive a complete return of our investment.\\nCurrently, the Company, through its wholly-owned subsidiary, Gaucho Ventures I – Las Vegas, LLC (“GVI”), contributed total capital of $7.0 million to LVH Holdings LLC (“LVH”) to develop a project in Las Vegas, Nevada and received 396 limited liability company interests, representing an 11.9% equity interest in LVH. Pursuant to the Fourth Amendment to the Amended and Restated Limited Liability Company Agreement of LVH dated June 30, 2023, if a ground lease for the premises within which the luxury hotel, casino, entertainment and retail project will be developed and constructed has not been executed by LVH on or before December 29, 2023, then as promptly as reasonably practicable after such date, LVH will be liquidated and dissolved.\\nAs of June 30, 2023, LVH has used our cash contribution to LVH for land improvement expenses, such as architectural, legal, engineering, and accounting fees. Should LVH be liquidated and dissolved on or before December 29, 2023, we most likely will not receive our entire contribution back from LVH and may lose our entire investment.\\n\\n| 39 |\\n\\n\\n\\nEquity Line of Credit\\nPursuant to the Purchase Agreement with Tumim Capital dated November 8, 2022, the Company requested draw-downs and issued shares of common stock and received gross proceeds of the following for the three months ended June 30, 2023: (i) April 19, 2023, the Company issued 195,970 shares of common stock to Tumim for gross proceeds of $144,339; and (ii) on May 5, 2023, the Company issued 262,798 shares of common stock to Tumim for gross proceeds of $172,614. No general solicitation was used, and a commission of 8% of the total gross proceeds was paid to Benchmark Investments, Inc. pursuant to the Underwriting Agreement between the Company and Kingswood Capital Markets, a division of Benchmark Investments, Inc., f/k/a EF Hutton, dated February 16, 2021. The Company relied on the exemptions from registration available under Section 4(a)(2) and/or Rule 506(b) of Regulation D of the Securities Act, in connection with the sales. A Form D was filed with the SEC on November 21, 2022.\\n\\nPursuant to the 2023 Purchase Agreement and Notes, as of each three-month anniversary of the Notes, the Company was required to prepay, redeem or convert one quarter of the initial principal and interest on the Notes. The Company did not meet that requirement as of May 21, 2023, which is the first three-month anniversary. The Company is required to deliver notice of default to the holder within one (1) business day. The holder may require the Company to redeem all or a portion of the Notes by written notice. On August 11, 2023, the Company and the holder of the Notes entered into an agreement pursuant to which, among other things: the holder agreed to forbear from issuing an event of default notice and event of default redemption notice through December 31, 2023. See Item 5 for additional information.\\n\\nNot applicable.\\n\\nSpecial Meeting of Stockholders\\nOn May 8, 2023, the Company held a special stockholder meeting (the “Special Meeting”) at 12:00 p.m. Eastern Time at which a quorum was present. At the Special Meeting, a proposal to approve, for purposes of complying with Nasdaq Listing Rule 5635(d), the full issuance and exercise of shares of our common stock to be issued pursuant to that certain Securities Purchase Agreement, dated February 21, 2023 (the “Purchase Agreement”), that certain senior secured convertible promissory note dated February 21, 2023 (the “Note”), that certain common stock purchase warrant dated February 21, 2023 (the “Warrants”), and that certain Registration Rights Agreement, dated February 21, 2023 (the “Registration Rights Agreement”) by and between the Company and an institutional investor was approved by the stockholders.\\nAnnual General Meeting\\nOn June 29, 2023, the Company filed a Preliminary Proxy Statement on Form 14-A, a Definitive Proxy Statement on Form 14-A on July 10, 2023, and additional definitive proxy materials on Form 14-A on July 11, 2023, which request stockholder approval of the following proposals: (i) To elect two (2) Class III nominees to the board of directors (Scott L. Mathis and William A. Allen) to hold office for a three-year term; (ii) to grant the Board of Directors discretion (if necessary to prevent the delisting of the Company’s common stock on Nasdaq) on or before June 30, 2024, to implement a reverse stock split of the outstanding shares of common stock in a range from one-for-two (1:2) up to one-for-ten (1:10), or anywhere between, while maintaining the number of authorized shares of common stock at 150,000,000 shares, as required for Nasdaq listing; (iii) to conduct an advisory vote on executive compensation; (iv) to conduct an advisory vote on the frequency of advisory votes on executive compensation; and (v) to ratify and approve the appointment of Marcum LLP as the Company’s independent registered accounting firm for the year ended December 31, 2023.\\n\\n| 40 |\\n\\n\\nLVH Holdings LLC\\nOn June 30, 2023, the Company, through its wholly owned subsidiary, Gaucho Ventures I – Las Vegas, LLC (“GVI”), executed a Fourth Amendment to the Amended and Restated Limited Liability Company Agreement of LVH Holdings LLC (“LVH”) to extend the outside date for execution of the ground lease from June 30, 2023 to December 29, 2023.\\nAs previously disclosed, on June 16, 2021, the Company, through GVI, entered into the Amended and Restated Limited Liability Company Agreement of LVH; on November 16, 2022, entered into the First Amendment to the Amended and Restated Limited Liability Company Agreement of LVH; on June 7, 2022, entered into the Second Amendment to the Amended and Restated Limited Liability Company Agreement of LVH; and on December 12, 2022, entered into the Third Amendment to the Amended and Restated Limited Liability Company Agreement of LVH.\\nAs of the date of the Fourth Amendment to the Amended and Restated Limited Liability Company Agreement, GVI and SLVH LLC comprise all of the members of LVH.\\nBoard Compensation\\nOn July 14, 2023, the Company issued a total of 270,272 shares at $0.555 per share to the non-executive directors of the Company as compensation for service as members of the Board of Directors of the Company for the first half of 2023. For this sale of securities, no general solicitation was used, no commissions were paid, all persons were accredited investors, and the Company relied on the exemption from registration available under Section 4(a)(2) and/or Rule 506(b) of Regulation D promulgated under the Securities Act with respect to transactions by an issuer not involving any public offering. A Form D was filed with the SEC on July 28, 2023.\\nConvertible Promissory Notes\\nAs previously reported on our Current Report on Form 8-K filed on February 21, 2023, the Company and an institutional investor (the “Holder”) entered into that certain Securities Purchase Agreement, dated as of February 21, 2023 (the “Securities Purchase Agreement”) and the Company issued to the Holder a senior secured convertible note (the “Note”) and warrant to purchase 3,377,099 shares of common stock of the Company (the “Warrant” and together with the Securities Purchase Agreement and the Note, the “Note Documents”).\\nFor the full description of the Note Documents, please refer to our Current Report on Form 8-K and the exhibits attached thereto as filed with the SEC on February 21, 2023.\\nAs previously reported on our Current Report on Form 8-K filed on August 11, 2023, an Event of Default occurred with respect to the Note. As a result, on August 11, 2023, the Company and the Holder entered into an agreement (the “Letter Agreement”) pursuant to which, among other things: (i) the Holder agreed to forbear from issuing an Event of Default Notice and Event of Default Redemption Notice; (ii) the Holder waived the requirement in the Note to pay Interest on the Note monthly in cash for a certain period of time; (iii) the Holder agreed to waive application of the Default Rate in Note for a certain period of time; (iv) the Holder agreed to waive the requirement in the Note for the Company to prepay, redeem, or convert one quarter of the initial Principal and Interest on the Note by each three (3) month anniversary of the Issuance Date for a certain period of time; (v) the Company adjusted the exercise price of the Warrant from $1.34 to $0.45; and (vi) the Holder may continue to convert the Note at the Alternate Conversion Price or at $0.45.\\nAll terms not defined herein shall refer to the defined terms in the Note Documents.\\nSee also Items 1A and 3 above.\\n\\n| 41 |\\n\\n\\n\\nThe following documents are being filed with the Commission as exhibits to this Current Report on Form 10-Q.\\n\\n| Exhibit | Description |\\n| 1.1 | Underwriting Agreement, dated February 16, 2021 (5) |\\n| 1.2 | Warrant Agreement, including the form of Warrant, made as of February 19, 2021, between the Company and Continental. (6) |\\n| 3.1 | Amended and Restated Certificate of Incorporation filed with the Delaware Secretary of State effective November 4, 2022 (15) |\\n| 3.2 | Amended and Restated Bylaws (1) |\\n| 3.3 | Amendment to the Company’s Amended and Restated Bylaws as approved on July 8, 2019 (4) |\\n| 4.1 | 2016 Stock Option Plan. (2) |\\n| 4.2 | First Amendment to 2016 Stock Option Plan as adopted by the Board of Directors on October 20, 2016. (2) |\\n| 4.3 | 2018 Equity Incentive Plan. (3) |\\n| 4.4 | Amendment to the Company’s 2018 Equity Incentive Plan as approved by the Board of Directors on May 13, 2019 and the stockholders on July 8, 2019 (4) |\\n| 4.5 | Amendment to the Company’s 2018 Equity Incentive Plan as approved by the Board of Directors on July 12, 2021 and the stockholders on August 26, 2021 (14) |\\n| 4.6 | Amendment to the Company’s 2018 Equity Incentive Plan as approved by the Board of Directors on July 1, 2022 and the stockholders on August 30, 2022 (20) |\\n| 4.7 | Underwriters’ Warrant (5) |\\n| 4.8 | Form of Warrant (11) |\\n| 4.9 | Form Amended and Restated Warrant (17) |\\n| 4.10 | Form Warrant (18) |\\n| 4.11 | Form Warrant (21) |\\n| 4.12 | Form Warrant (25) |\\n| 4.13 | Form Warrant (26) |\\n| 10.1 | Employment Agreement by and between the Company and Scott L. Mathis dated September 28, 2015 (24) |\\n| 10.2 | Retention Bonus Agreement by and between the Company and Scott L. Mathis dated March 29, 2020 (7) |\\n| 10.3 | Employment Agreement by and between the Company and its Chief Financial Officer dated December 14, 2022 (23) |\\n| 10.4 | Commercial Lease Agreement between Gaucho Group, Inc. and Design District Development Partners, LLC, dated April 8, 2021 (8) |\\n| 10.5 | Amended and Restated Limited Liability Company Agreement of LVH Holdings LLC, dated June 16, 2021 (9) |\\n| 10.6 | First Amendment to Amended and Restated Limited Liability Agreement dated November 16, 2021 (10) |\\n| 10.7 | Second Amendment to Amended and Restated Limited Liability Agreement dated June 7, 2022 (13) |\\n| 10.8 | Third Amendment to Amended and Restated Limited Liability Agreement dated June 7, 2022 (22) |\\n| 10.9 | Common Stock Purchase Agreement by and between Gaucho Group Holdings, Inc. and Tumim Stone Capital LLC, dated November 8, 2022 (19) |\\n| 10.10 | Registration Rights Agreement by and between Gaucho Group Holdings, Inc. and Tumim Stone Capital LLC, dated November 8, 2022 (16) |\\n| 10.11 | Securities Purchase Agreement dated February 21, 2023 (26) |\\n| 10.12 | Form of Senior Secured Convertible Note Issued by the Company (26) |\\n| 10.13 | Form of Security and Pledge Agreement (26) |\\n| 10.14 | Form of Stockholder Pledge Agreement (26) |\\n| 10.15 | Form of Registration Rights Agreement (26) |\\n| 10.16 | Fourth Amendment to Amended and Restated Limited Liability Agreement dated June 30, 2023 (28) |\\n| 10.17 | Letter Agreement, dated as of August 11, 2023, by and among the Company and the subscriber listed therein (29) |\\n| 22.1 | Subsidiary guarantors and issuers of guaranteed securities and affiliates whose securities collateralize securities of the registrant (12) |\\n| 31.1 | Certification of Principal Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act.* |\\n| 31.2 | Certification of Principal Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act.* |\\n| 32 | Certification of the Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002** |\\n| 99.1 | Algodon Wine Estates Property Map (27) |\\n| 101.INS | Inline XBRL Instance Document* |\\n| 101.SCH | Inline XBRL Schema Document* |\\n| 101.CAL | Inline XBRL Calculation Linkbase Document* |\\n| 101.DEF | Inline XBRL Definition Linkbase Document* |\\n| 101.LAB | Inline XBRL Label Linkbase Document* |\\n| 101.PRE | Inline XBRL Presentation Linkbase Document* |\\n| 104 | Cover Page Interactive Data File (embedded within the Inline XBRL document) * |\\n\\n\\n| 42 |\\n\\n\\n\\n| 1. | Incorporated by reference from the Company’s Registration of Securities Pursuant to Section 12(g) on Form 10 dated May 14, 2014. |\\n| 2. | Incorporated by reference from the Company’s Annual Report on Form 10-K, filed on March 31, 2017. |\\n| 3. | Incorporated by reference from the Company’s Quarterly Report on Form 10-Q, filed on November 19, 2018. |\\n| 4. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on July 9, 2019. |\\n| 5. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on February 18, 2021. |\\n| 6. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on February 22, 2021. |\\n| 7. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on April 1, 2020. |\\n| 8. | Incorporated by reference to the Company’s Annual Report on Form 10-K filed on April 12, 2021. |\\n| 9. | Incorporated by reference to the Company’s Quarterly Report on Form 10-Q filed on August 16, 2021. |\\n| 10. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on November 17, 2021. |\\n| 11. | Incorporated by reference to the Company’s Current Report on Form 8-K as filed on March 1, 2022. |\\n| 12. | Incorporated by reference to the Company’s Annual Report on Form 10-K, filed on April 14, 2022. |\\n| 13. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on June 8, 2022. |\\n| 14. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on August 31, 2021. |\\n| 15. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on November 3, 2022. |\\n| 16. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on November 9, 2022. |\\n| 17. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on October 24, 2022. |\\n| 18. | Incorporated by reference to the Company’s Amended Current Report on Form 8-K/A, filed on September 8, 2022. |\\n| 19. | Incorporated by reference to the Company’s Current Report as amended on Form 8-K/A, filed on November 14, 2022. |\\n| 20. | Incorporated by reference to the Company’s Quarterly Report on Form 10-Q, filed on November 18, 2022. |\\n| 21. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on December 1, 2022. |\\n| 22. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on December 13, 2022. |\\n| 23. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on December 15, 2022. |\\n| 24. | Incorporated by reference to the Company’s Quarterly Report on Form 10-Q, filed on November 16, 2015. |\\n| 25. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on February 21, 2023. |\\n| 26. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on February 21, 2023. |\\n| 27. | Incorporated by reference to the Company’s Annual Report on Form 10-K, filed on April 17, 2023. |\\n| 28. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on July 5, 2023. |\\n| 29. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on August 11, 2023. |\\n| * | Filed herewith. |\\n| ** | Furnished, not filed herewith. |\\n\\n\\n| 43 |\\n\\n\\nSIGNATURES\\nPursuant to the requirements of Section 12 of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\n\\n| Date: August 14, 2023 | GAUCHO GROUP HOLDINGS, INC. |\\n| By: |\\n| Scott L. Mathis |\\n| Chief Executive Officer |\\n| By: |\\n| Maria Echevarria |\\n| Chief Financial Officer and Chief Operating Officer |\\n\\n\\n| 44 |\\n\\n\\n \\n\\nIf the company can maintain its current cash inflows and outflows in the future, how many months can the company continue to operate while paying off its convertible debt obligations, excluding the cash requirements for current liabilities and long-term liabilities?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 82.15080622837371.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 42,\n \"input_length\": 38868\n}"}}},{"rowIdx":43,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nASSISTED 4 LIVING, INC.\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\nCONDENSED CONSOLIDATED BALANCE SHEETS\n(UNAUDITED)\n\n| March 31, 2021 | December 31, 2020 |\n| ASSETS |\n| Current assets: |\n| Cash | $ | 3,441,841 | $ | 345,982 |\n| Accounts receivable, net allowance for doubtful accounts | 102,020 | 97,073 |\n| Prepaid expenses and other current assets | 408,397 | 207,592 |\n| Assets of discontinued operations | 45,777 | - |\n| Total current assets | 3,998,035 | 650,647 |\n| Lease right of use asset | 3,917,812 | 3,977,988 |\n| Goodwill | 3,431,148 | 3,431,148 |\n| Leasehold improvements, net of accumulated amortization | 2,571,910 | 2,614,391 |\n| Property and equipment, net | 152,376 | 128,475 |\n| Total assets | $ | 14,071,281 | $ | 10,802,649 |\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\n| Current liabilities: |\n| Notes payable, net of discounts current | $ | 393,899 | $ | 2,385,010 |\n| Accrued interest, included related party | 95,079 | 48,601 |\n| Accounts payable and accrued expenses | 572,891 | 148,180 |\n| Loan payable – other | 66,851 | 63,907 |\n| Lease liability - current portion | 198,759 | 189,397 |\n| Liability to issue shares of common stock | 2,325,000 | - |\n| Deferred revenue | 25,703 | 25,703 |\n| Liabilities of discontinued operations | 53,929 | - |\n| Total current liabilities | 3,732,111 | 2,860,798 |\n| Lease liability - net of current portion | 3,821,666 | 3,864,321 |\n| Notes payable, net of discounts and current portion | 298,498 | 322,490 |\n| Total liabilities | 7,852,275 | 7,047,609 |\n| Stockholders’ equity: |\n| Common stock, par value $ 0.0001 ; 100,000,000 shares authorized, 35,395,418 and 4,165,418 issued and outstanding at March 31, 2021 and December 31, 2020, respectively | 3,540 | 417 |\n| Additional paid-in capital | 10,500,222 | 7,460,348 |\n| Subscription receivable | - | ( 30 | ) |\n| Accumulated deficit | ( 4,284,756 | ) | ( 3,705,695 | ) |\n| Total stockholders’ equity | 6,219,006 | 3,755,040 |\n| Total liabilities and stockholders’ equity | $ | 14,071,281 | $ | 10,802,649 |\n\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\n\n| F-1 |\n\nASSISTED 4 LIVING, INC.\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\n(UNAUDITED)\n\n| 2021 | 2020 |\n| For the Three Months Ended March 31, |\n| 2021 | 2020 |\n| Program revenue | $ | 601,115 | $ | - |\n| Rental income | 5,625 | - |\n| Other revenue | 185 | 915 |\n| Net revenue | 606,925 | 915 |\n| Cost of services provided | 232,460 | - |\n| Gross profit | 374,465 | 915 |\n| Operating expenses |\n| Salaries and payroll expense | 293,114 | 245,712 |\n| General and administrative | 298,200 | 99,083 |\n| Lease expense | 141,675 | 24,061 |\n| Professional fees | 95,691 | 62,800 |\n| Marketing and advertising | 5,670 | 12,631 |\n| Depreciation and amortization expense | 50,583 | - |\n| Total operating expenses | 884,933 | 444,287 |\n| Loss from operations | ( 510,468 | ) | ( 443,372 | ) |\n| Other expense |\n| Interest expense | ( 59,516 | ) | ( 3 | ) |\n| Total other expense | ( 59,516 | ) | ( 3 | ) |\n| LOSS FROM CONTINUING OPERATIONS BEFORE PROVISION FOR INCOME TAXES AND LOSS FROM DISCONTINUED OPERATIONS | ( 569,984 | ) | ( 443,375 | ) |\n| Income taxes | - | - |\n| LOSS FROM CONTINUING OPERATIONS BEFORE DISCONTINUED OPERATIONS | ( 569,984 | ) | ( 443,375 | ) |\n| LOSS FROM DISCONTINUED OPERATIONS | ( 9,077 | ) | - |\n| Net loss | $ | ( 579,061 | ) | $ | ( 443,375 | ) |\n| Loss per share - basic and diluted - Continuing operations | $ | ( 0.08 | ) | $ | ( 0.11 | ) |\n| Loss per share - basic and diluted - Discontinued operations | $ | ( 0.00 | ) | $ | - |\n| Weighted average number of shares outstanding - basic and diluted | 7,288,419 | 4,008,443 |\n\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\n\n| F-2 |\n\nASSISTED 4 LIVING, INC.\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\nCONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY\nFOR THE THREE MONTHS ENDED MARCH 31, 2020 AND 2021\n(UNAUDITED)\n\n| Shares | Amount | Capital | Receivable | Deficit | Total |\n| Common Stock | Additional | Total |\n| Number of | paid-in | Subscription | Accumulated | stockholders’ |\n| shares | Amount | Capital | Receivable | deficit | deficit |\n| For the Three Months Ended March 31, 2020 |\n| Balance at December 31, 2019 | 4,008,443 | 401 | 6,618,364 | ( 170 | ) | ( 2,407,760 | ) | 4,210,835 |\n| Collection on subscription receivable |\n| Shares issuable for Banyan Acquisition |\n| Shares issuable for Banyan Acquisition, shares |\n| Net loss for the period | - | - | - | - | ( 443,375 | ) | ( 443,375 | ) |\n| Balance at March 31, 2020 | 4,008,443 | 401 | 6,618,364 | ( 170 | ) | ( 2,851,135 | ) | 3,767,460 |\n| For the Three months ended March 31, 2021 |\n| - | - | - |\n| Balance at December 31, 2020 | 4,165,418 | 417 | 7,460,348 | ( 30 | ) | ( 3,705,695 | ) | 3,755,040 |\n| Collection on subscription receivable | - | - | - | 30 | - | 30 |\n| Shares issued for Acquisition | 31,230,000 | 3,123 | 3,039,874 | - | - | 3,042,997 |\n| Net loss for the period | - | - | - | ( 579,061 | ) | ( 579,061 | ) |\n| Balance at March 31, 2021 | 35,395,418 | 3,540 | 10,500,222 | - | ( 4,284,756 | ) | 6,219,006 |\n\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\n\n| F-3 |\n\nASSISTED 4 LIVING, INC.\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(UNAUDITED)\n\n| 2021 | 2020 |\n| For the Three Months Ended March 31, |\n| 2021 | 2020 |\n| Cash flows from operating activities |\n| Net loss | $ | ( 579,061 | ) | $ | ( 443,375 | ) |\n| Adjustments to reconcile net loss to cash used in operating activities: |\n| Net loss from discontinued operations | ( 9,077 | ) | - |\n| Non-cash operating lease expense | 26,883 | ( 4,070 | ) |\n| Depreciation and amortization | 50,583 | - |\n| (Increase) decrease in assets |\n| Prepaid expenses | ( 200,805 | ) | 4,564 |\n| Accounts receivable | ( 4,947 | ) | - |\n| Increase (decrease) in liabilities |\n| Accounts payable | - | ( 13,420 | ) |\n| Accrued payroll and other expenses | 441,940 | 28,544 |\n| Accrued interest | 46,478 | - |\n| Cash used in operating activities | ( 228,006 | ) | ( 427,757 | ) |\n| Cash flows from investing activities |\n| Cash from acquisition | 3,042,997 | - |\n| Purchase of property and equipment | ( 32,003 | ) | - |\n| Cash provided by investing activities | 3,010,994 | - |\n| Cash flows from financing activities |\n| Repayment of principal on notes payable to individuals and companies | ( 15,103 | ) | - |\n| Proceeds from the sale of common stock issued and issuable | 325,030 | 139 |\n| Proceeds from other notes payable | 2,944 | 11,746 |\n| Cash provided by financing activities | 312,871 | 11,885 |\n| Net increase (decrease) in cash | 3,095,859 | ( 415,872 | ) |\n| Cash, beginning of year | 345,982 | 4,044,700 |\n| Cash, end of period | $ | 3,441,841 | $ | 3,628,828 |\n| SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: |\n| Interest paid | $ | 13,037 | $ | - |\n| Taxes paid |\n| NON-CASH ITEMS |\n| Recognition of lease liability and right of use asset at inception | $ | - | $ | 1,897,995 |\n| Conversion of notes payable and accrued interest for common stock | $ | 2,000,000 | $ | - |\n\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\n\n| F-4 |\n\nASSISTED 4 LIVING, INC.\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\nNOTE 1 – ORGANIZATION AND DESCRIPTION OF BUSINESS\nAssisted 4 Living, Inc. (“the Company,” “we”, “our” or “us”) was incorporated in the state of Nevada on May 24, 2017 and is based in Sarasota, Florida. The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America (“GAAP”), and the Company’s fiscal year end is December 31.\nAs discussed in NOTE 4, on March 23, 2021, we entered into a Plan of Merger with our wholly-owned subsidiary, BPCC Acquisition, Inc., a Florida corporation (“Merger Sub”) and Banyan Pediatric Care Centers, Inc. (“Banyan”). Under the terms of the Plan of Merger, Merger Sub merged with and into Banyan with Banyan surviving the merger (the “Surviving Entity”) and becoming a wholly-owned subsidiary of the Company (the “Merger”). Pursuant to the Merger, we succeeded to the business of Banyan. The Merger has been treated as a recapitalization and reverse acquisition of the Company for financial accounting purposes, and Banyan is considered the acquirer for financial reporting purposes. This means that the Company’s historical financial statements before the Merger have been replaced with the historical financial statements of Banyan before the Merger in this Quarterly Report and future filings with the SEC\nThrough Banyan, we operate three pediatric extended care centers (“PPECs”) is southwest Florida. A PPEC is a nurse-staffed pediatric day care center for medically complex children age birth to 21 years. Our staff includes Registered Nurses (RNs), Licensed Practical Nurses (LPNs), Certified Nursing Assistants (CNAs) and Caregivers, who attend to the children’s medical conditions throughout the day in classroom, dining, play, and clinical settings. Banyan is fully licensed and accepts Florida Medicaid.\nWe are headquartered at 6801 Energy Court, Suite 201 Sarasota, Florida 34240.\nThe corporate website is www.assisted4living.com.\nCOVID-19\nIn March 2020, the World Health Organization declared the outbreak of COVID-19 as a pandemic based on the rapid increase in global exposure. COVID-19 continues to spread throughout the world. We are closely monitoring developments and are taking steps to mitigate the potential risks related to the COVID-19 pandemic to the Company, its employees, as well as its residential and consulting clients.\nTo date COVID-19 has not substantially negatively impacted our revenues or operations. Our evaluations of our practices, procedures, and operations, related to COVID-19, is ongoing. Additional updates to policies, procedures and operations will occur as best practices are adopted and as we deem necessary or advisable, or as further governmental guidance or regulations are implemented.\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nBasis of Presentation\nThe accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with GAAP for interim financial statements and with the instructions to Form 10-Q and Regulation S-X of the United States Securities and Exchange Commission (“SEC”). Accordingly, they do not contain all information and footnotes required by accounting principles generally accepted in the United States of America for annual financial statements.\nIn the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all the adjustments necessary (consisting only of normal recurring accruals) to present the financial position of the Company as of March 31, 2021 and the results of operations and cash flows for the periods presented. The results of operations for the three months ended March 31, 2021 are not necessarily indicative of the operating results for the full fiscal year or any future period. These unaudited condensed consolidated financial statements should be read in conjunction with the condensed consolidated financial statements and related notes thereto included in the Company’s Annual Report on Form 10-K filed with the SEC on March 1, 2021. As of March 23, 2021 we had discontinued operations reflected in the accompanying unaudited condensed consolidated financial statements. As a result of the Plan of Merger completed on March 23, 2021 (see NOTE 4) we have changed our year end reporting period from November to December.\n\n| F-5 |\n\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)\nBasis of Consolidation\nThese condensed consolidated financial statements include the accounts of the Company and the wholly-owned subsidiaries, Banyan Pediatric Care Centers, Inc, Banyan Pediatric Care Centers – OPS, LLC, Banyan Pediatric Care Centers – St. Petersburg, LLC, Banyan Pediatric Care Centers, - Pasco, LLC and Banyan Pediatric Care Centers – Sarasota, LLC and the discontinued operations of Assisted 2 Live, Inc., the wholly owned subsidiary that was discontinued as of March 23, 2021. All material intercompany balances and transactions have been eliminated.\nCash and Cash Equivalents\nThe Company considers all short-term investments with an original maturity of three months or less to be cash equivalents. The Company had no cash equivalents at March 31, 2021 and December 31, 2020.\nAccounts Receivable\nAccounts receivable primarily consists of amounts due from third-party payers (non-governmental), governmental payers and private pay patients and is recorded net of allowances for doubtful accounts and contractual discounts. The Company’s ability to collect outstanding receivables is critical to its results of operations and cash flows. Accordingly, accounts receivable reported in the Company’s condensed consolidated financial statements is recorded at the net amount expected to be received. The Company’s primary collection risks are (i) the risk of overestimation of net revenues at the time of billing that may result in the Company receiving less than the recorded receivable, (ii) the risk of non-payment as a result of commercial insurance companies’ denial of claims, (iii) the risk that patients will fail to remit insurance payments to the Company when the commercial insurance company pays out-of-network claims directly to the patient, (iv) resource and capacity constraints that may prevent the Company from handling the volume of billing and collection issues in a timely manner, (v) the risk that patients do not pay the Company for their self-pay balances (including co-pays, deductibles and any portion of the claim not covered by insurance) and (vi) the risk of non-payment from uninsured patients.\nThe Company’s accounts receivable from third-party payers are recorded net of estimated contractual adjustments and allowances from third-party payers, which are estimated based on the historical trend of the Company’s facilities’ cash collections and contractual write-offs, accounts receivable aging, established fee schedules, relationships with payers and procedure statistics. While changes in estimated reimbursement from third-party payers remain a possibility, the Company expects that any such changes would be minimal and, therefore, would not have a material effect on the Company’s financial condition or results of operations. The Company’s collection policies and procedures are based on the type of payor, size of claim and estimated collection percentage for each patient account. The Company analyzes accounts receivable at each of the facilities to ensure the proper collection and aged category. The operating systems generate reports that assist in the collection efforts by prioritizing patient accounts. Collection efforts include direct contact with insurance carriers or patients and written correspondence.\nAllowance for Doubtful Accounts, Contractual and Other Discounts\nManagement estimates the allowance for contractual and other discounts based on its historical collection experience and contracted relationship with the payers. The services authorized and provided and related reimbursement are often subject to interpretation and negotiation that could result in payments that differ from the Company’s estimates. The Company’s allowance for doubtful accounts is based on historical experience, but management also takes into consideration the age of accounts, creditworthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts. An account may be written-off only after the Company has pursued collection efforts or otherwise determines an account to be uncollectible. Uncollectible balances are written-off against the allowance. Recoveries of previously written-off balances are credited to income when the recoveries are made.\nFair Value of Financial Instruments\nThe carrying amount of accounts receivable and accounts payable approximate their respective fair values due to the short- term nature. The carrying amount of the line of credit and note payable approximates fair values due to their market interest rates. Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents and accounts receivable.\nProperty and Equipment\nProperty and equipment are stated at cost, less accumulated depreciation. Additions and improvements to property and equipment are capitalized at cost. Depreciation of owned assets and amortization of leasehold improvements are computed using the straight-line method over the shorter of the estimated useful lives of the related assets or the lease term. The cost of assets sold or retired, and the related accumulated depreciation are removed from the accounts and any resulting gains or losses are reflected in other income (expense) for the year. Expenditures for maintenance and repairs are charged to expense as incurred.\n\n| F-6 |\n\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)\nGoodwill\nOur goodwill represents the excess of the purchase price over the fair value of the net identifiable assets acquired in business combinations. The goodwill generated from the business combinations is primarily related to the value placed on the employee workforce and expected synergies. Judgment is involved in determining if an indicator or change in circumstances relating to impairment has occurred. Such changes may include, among others, a significant decline in expected future cash flows, a significant adverse change in the business climate, and unforeseen competition. There was no goodwill impairment for the years presented.\nThe Company tests goodwill for impairment on an annual basis, and when events or circumstances indicate the fair value of a reporting unit may be below its carrying value.\nLong-Lived Assets\nLong-lived assets are evaluated for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. There were no impairments of long-lived assets for the years presented.\nAdvertising and Marketing\nThe Company uses advertising and marketing to promote its services. Advertising and marketing costs are expensed as incurred.\nNet Loss Per Share\nBasic net loss per common share is computed by dividing net loss applicable to common stockholders by the weighted-average number of common shares outstanding during the period. Diluted net loss per common share is determined using the weighted-average of common shares outstanding during the period, adjusted for the dilutive effect of common stock equivalents, consisting of the conversion option embedded in convertible debt. The weighted-average number of common shares outstanding excludes common stock equivalents because their inclusion would have an anti-dilutive effect.\nIncome Taxes\nThe Company uses the liability method of accounting for income taxes. Under the liability method, deferred tax assets and liabilities are determined based on differences between financial reporting and the tax basis of assets, liabilities, the carry forward of operating losses and tax credits, and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. An allowance against deferred tax assets is recorded when it is more likely than not that such tax benefits will not be realized.\nAny future benefit arising from losses have been offset by a valuation allowance. Accordingly, no provision for income taxes is reflected in the condensed consolidated financial statements. The Company records a liability for uncertain tax positions when it is probable that a loss has been incurred and the amount can be reasonably estimated. Interest and penalties related to income tax matters, if any, would be recognized as a component of income tax expense. At March 31, 2021 and December 31, 2020, the Company had no liabilities for uncertain tax positions. The Company continually evaluates expiring statutes of limitations, audits, proposed settlements, changes in tax law and new authoritative rulings. Currently, the tax years subsequent to 2017 are open and subject to examination by the taxing authorities.\n\n| F-7 |\n\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)\nUse of Estimates and Assumptions\nThe preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. The estimates and judgments will also affect the reported amounts for certain revenues and expenses during the reporting period. Actual results could differ from these good faith estimates and judgments.\nRevenue Recognition\nWe follow ASC 606, “Revenue from Contracts with Customers.” Revenues are recognized when promised goods or services are transferred to a customer, in an amount that reflects the consideration that we expect to receive in exchange for those goods or services. We derive our revenues from the rendering of services, such as skilled nursing services. The five-step model defined by ASC 606 requires us to: (i) identify our contracts with customers, (ii) identify our performance obligations under those contracts, (iii) determine the transaction prices of those contracts, (iv) allocate the transaction prices to our performance obligations in those contracts and (v) recognize revenue when each performance obligation under those contracts is satisfied.\nReimbursement rates to provide skilled nursing services in our PPEC facilities are determined by the Medicaid program. Fees are billed to the Medicaid program and other payors weekly following the Medicaid billing guidelines.\nReclassification\nCertain amounts from prior periods have been reclassified to conform to the current period presentation.\nNOTE 3 – ACCRUED LIABILITIES\nOur accrued liabilities at March 31, 2021 and December 31, 2020 consisted of the following:\nSCHEDULE OF ACCRUED LIABILITIES\n| March 31, 2021 | December 31, 2020 |\n| Accounts payable | $ | 70,675 | $ | 16,298 |\n| Credit card | - | 1,050 |\n| Accrued expenses | 354,193 | 130,832 |\n| Accrued salary | 139,952 | - |\n| Payroll tax payable | 8,070 | - |\n| Accrued Liabilities | $ | 572,890 | $ | 148,180 |\n\n\n| F-8 |\n\nNOTE 4 – BANYAN MERGER\nOn March 23, 2021, we entered into a Plan of Merger with Merger Sub and Banyan. Under the terms of the Plan of Merger, Merger Sub merged with and into Banyan with Banyan as the Surviving Entity and wholly-owned subsidiary of the Company. The Merger was effective on March 23, 2021.\nThe Merger has been treated as a recapitalization and reverse acquisition of the Company for financial accounting purposes, and Banyan is considered the acquirer for accounting purposes. This means that the Company’s historical financial statements before the Merger have been replaced with the historical financial statements of Banyan.\nIn connection with the Merger, we issued 4,165,418 shares of our common stock in exchange for 49,984,649 outstanding shares of Banyan’s common stock held by 64 shareholders, based on an exchange ratio of one (1) share of our common stock for every twelve (12) shares of Banyan common stock. We also issued a warrant to purchase 75,000 shares of our common stock (the “Warrant”) in exchange for a warrant to purchase 900,000 shares of Banyan’s common stock. The Warrant is held by one investor and is exercisable for cash only until May 2, 2030 at an exercise price of $ 0.38 per share. The number of shares of common stock deliverable upon exercise of the Warrant contains provisions for standard anti-dilution adjustments.\nThe Surviving Entity assumed Banyan’s $ 2,300,000 of outstanding debt, and the $ 2,000,000 of such debt that was convertible into 20,000,000 shares of Banyan common stock was converted at $ 0.50 per share into 4,000,000 shares of our common stock, effective as of March 30, 2021. The remaining $ 300,000 of outstanding debt, evidenced by a promissory note dated November 6, 2020 (the “Note”), accrues interest at the annual rate of 12 %. Interest is payable on the sixth day of each month in the amount of $ 3,000 until the maturity date of the Note on November 6, 2021 , at which time, the remaining principal balance, if any, is due and payable.\n\n| F-9 |\n\nNOTE 5 – DISCONTINUED OPERATIONS\nOn April 30, 2021, our Board of Directors (the “Board”) approved the discontinuance of our wholly-owned subsidiary, Assisted 2 Live, Inc. (the “Discontinued Subsidiary”). The operations of the Discontinued Subsidiary are reflected on our condensed consolidated statement of operations from the date of the Merger as a loss from discontinued operations in the amount of $ 9,077 .\nThe April 30, 2021 Board decision was the result of the Purchase and Sale Option Agreement (the “Option Agreement”) with Romulus Barr (“Barr”) which we entered into on November 7, 2020. The Option Agreement provided us with the option to sell all of our interest in Assisted 2 Live, Inc., consisting of 1,000 shares of common stock of the Discontinued Subsidiary, to Barr in exchange for 200,000 shares of our common stock (the “Shares”) held by Barr. The returned Shares were cancelled, and included in authorized but unissued shares of common stock of the Company. The number of issued and outstanding shares of common stock was decreased by 200,000 as of April 30, 2021.\nThe following table presents the aggregate carrying amounts of the classes of assets and liabilities of discontinued operations for the three months ended:\nSUMMARY OF CARRYING AMOUNTS OF ASSETS AND LIABILITIES AND CASH FLOWS OF DISCONTINUED OPERATIONS\n| March 31, 2021 | December 31, 2020 |\n| Current assets of discontinued operations | $ | 15,928 | $ | - |\n| Non-current assets of discontinued operations | 29,849 | - |\n| $ | 45,777 | $ | - |\n| Current liabilities of discontinued operations | $ | 53,929 | $ | - |\n| $ | 53,929 | $ | - |\n\nThe following table presents cash flows of discontinued operations for the three months ended March 31:\n\n| 2021 | 2020 |\n| Net cash used in discontinued operating activities | $ | ( 14,386 | ) | $ | - |\n| Net cash from discontinued investing activities | - | - |\n| Net cash from discontinued financing activities | - | - |\n| $ | ( 14,386 | ) | $ | - |\n\n\n| Three months ended March 31, |\n| 2021 | 2020 |\n| Net revenues | $ | 5,362 | $ | - |\n| Cost of net revenues | - | - |\n| Gross profit | 5,362 | - |\n| Operating expenses: |\n| Salary and tax expense | 12,890 | - |\n| General and administrative | 763 | - |\n| Lease expense | 733 | - |\n| Total operating expenses | 14,386 | - |\n| Income from operations of discontinued operations | ( 9,024 | ) | - |\n| Interest and other, net | ( 53 | ) | - |\n| Income from discontinued operations before income taxes | ( 9,077 | ) | - |\n| Provision for income taxes | - | - |\n| Income from discontinued operations, net of income taxes | $ | ( 9,077 | ) | $ | - |\n\n\n| F-10 |\n\nNOTE 6 – NOTES PAYABLE\nNotes payable at March 31, 2021 and December 31, 2020 consisted of the following:\nSCHEDULE OF NOTES PAYABLE\n| March 31, 2021 | December 31, 2020 |\n| (Unaudited) |\n| a. Excel Family Partners, LLLP / Banyan Pediatric Investment, Inc. (Sep 2020) | $ | - | $ | 2,000,000 |\n| b. NuView Trust Co. (Nov 2020) | 300,000 | 300,000 |\n| c. Grand Trinity Plaza, LLC (Dec 2020) | 392,397 | 407,500 |\n| $ | 692,397 | $ | 2,707,500 |\n\n\n| a) | On September 18, 2020, through Banyan, we entered into a Convertible Note and Securities Purchase Agreement with two investors for the aggregate principal in the amount of $ 2,000,000 . The note had a maturity date of September 18, 2022 and an interest rate of 8 % to be paid quarterly. The principal was funded by two investors (“Purchasers”), both related parties. Excel Family Partners, LLLP invested $ 1,500,000 and Banyan Pediatric Investments, LLC invested $ 500,000 . The proceeds of this note were used for operational expenses and for the payment of the remainder of the buildout of the Pasco County and the Sarasota locations. Written consent from shareholders holding a majority of the issued and outstanding shares of common stock of Banyan was obtained, not including such shares currently held by the Purchasers or their affiliates, consenting to the note contemplated hereby, in a form and substance acceptable to the Purchasers, in their respective reasonable discretion. Both Purchasers were permitted to convert their respective portions of the note at a conversion price of $ 0.10 per share. Subsequent to the Merger (see NOTE 4), the Board revised the conversion price of the note to $ 0.50 per share. Effective March 30, 2021 the Purchasers exercised their right to convert all outstanding principal. As of March 31, 2021 and December 31, 2020, there was $ 90,740 and $ 45,589 of accrued interest, respectively and is reflected in accrued interest balances on the condensed consolidated balance sheet at March 31, 2021 and December 31, 2020. |\n\n\n| b) | On November 6, 2020, through Banyan, we entered into a one-year note in the principal amount of $ 300,000 with NuView Trust Company. The note has a 12 % interest rate with interest only payments until date of maturity. The proceeds of this no were used for operational expenses and for the payment of the remainder of the buildout of the Pasco County and the Sarasota locations. As of March 31, 2021 and December 31, 2020 there was no accrued interest. (see NOTE 4) |\n\n\n| c) | On December 15, 2020, through Banyan Pediatric Care Centers – Pasco, LLC, we entered into a note payable with Grand Trinity Plaza, LLC in the principal amount of $ 407,500 , which is guaranteed by Banyan. The term of the note is 48 months with an interest rate of 6 %. The maturity date of the note is January 1, 2025 . The note is in conjunction with the 84 -month facility lease for the Pasco County location, pursuant to which the landlord also provided the construction of the buildout and financed $ 407,500 of the construction costs. |\n\nNOTE 7 – LEASEHOLD IMPROVEMENTS\nThe Company had the following leasehold improvements as of March 31, 2021 and December 31, 2020:\nSCHEDULE OF LEASESHOLD IMPROVEMENTS\n| March 31, 2021 | December 31, 2020 | Amortization Period |\n| Leasehold improvements | $ | 2,669,047 | $ | 2,669,047 | 15 - 17 years |\n| Less: amortization | ( 97,137 | ) | ( 54,656 | ) |\n| Net | $ | 2,571,910 | $ | 2,614,391 |\n\nDuring the year ended December 31, 2020, we recorded $ 2,669,047 of leasehold improvements. These amounts include costs related to the build out of the Sarasota location in the amount of $ 1,245,950 . These costs will be amortized over the expected term of the lease including extensions that management expects to be 15 years. We also recorded costs in the amount of $ 1,021,793 related to the New Port Richey location buildout. The expected amortization of the improvements for the New Port Richey location is 17 years. Also recorded were $ 401,303 of improvements as part of the St. Petersburg-Kidz Club Acquisition. The expected amortization of the improvements for the St. Petersburg location is 15 years.\nAmortization expense for the three months ended March 31, 2021 and 2020 was $ 42,481 and $ 0 , respectively.\n\n| F-11 |\n\nNOTE 8 – OPERATING LEASES\nOn August 24, 2019, through Banyan Pediatric Care Centers-Sarasota, LLC, we entered into an operating lease with Northeast Plaza Venture I, LLC for the premises located in the Northeast Plaza Shopping Center located on the Northeast corner of 17th Street & Lockwood Ridge Road, in the County of Sarasota, Florida. The initial term of the lease is five years with minimum annual rent of $ 180,000 . The landlord granted rent abatement for this lease until February 24, 2020 . The lease end date, including two successive 5 -year renewal options, is January 31, 2035. A right of use asset and lease liability in the amount of $ 1,899,869 associated with this lease was recognized. This lease is treated as an operating lease for accounting purposes.\nOn October 15, 2019, through Banyan, we entered into an assignment and assumption of lease agreement with The Kidz Club – St. Pete, LLC whereby we assumed approximately 12,137 square feet of space at the southeast corner of 3rd Avenue S. and 9th Street N., Webb’s Plaza, St. Petersburg, FL 33701. The minimum annual rent for the first year of the lease was $ 113,681 . The current lease termination date, with extensions expected to be exercised, is October 31, 2024 . Upon the exercise of each extension the base rent shall increase by 1.5 %. This assignment of lease was subject to the terms of the Asset Purchase Agreement with The Kidz Club-St. Pete, LLC. A right of use asset and lease liability in the amount of $ 875,539 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\nEffective April 1, 2020, through Banyan Pediatric Care Centers – Pasco, LLC, we entered into an 84 -month facility lease with Grand Trinity Plaza, LLC for the premises located in the shopping center known as the Grand Trinity Plaza located in New Port Richey, Florida. The initial term of the lease had a minimum annual base rent of $ 94,500 . The landlord granted rent abatement until September 2020. The lease end date, including two successive 5 -year renewals is August 31, 2037. A right of use asset and lease liability in the amount of $ 1,143,743 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\nOn June 9, 2020, through Banyan, we entered into a 63 -month copier lease with Dex Imaging. The lease was for one copier and a printer. The minimum annual lease payment is $ 5,376 with annual increases not to exceed 12 % annually. This lease will auto renew in 12 -month increments. The equipment under this lease has a fixed $1 payment buyout option . This equipment was purchased for the St. Petersburg location. A right of use asset and lease liability in the amount of $ 16,066 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\nOn August 25, 2020, through Banyan, we entered into a 60 -month financing agreement with Ascentium Capital LLC for two 2020 Turtletop Terra Transit passenger buses for the St. Petersburg location. This lease is considered an operating lease for accounting purposes because the lease period is less than the economic life of the asset being leased . Minimum annual rent payments under this lease are $ 24,859 . At our discretion, we may exercise a purchase option, by giving written notice no later than 30 days but not more than 120 days before the expiration of the initial term. The purchase option price is $ 23,920 for each bus, based on reasonably predicted fair market value. A right of use asset and lease liability in the amount of $ 102,393 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\nOn October 20, 2020, through Banyan, we entered into a 60 -month financing agreement with Ascentium Capital LLC for a 2020 Eldorado National Advance 220 p/t 14 passenger bus for the St. Petersburg location. This lease is considered an operating lease for accounting purposes because the lease period is less than the economic life of the asset being leased . Minimum annual rent payments under this lease are $ 13,381 . At our discretion, we may exercise a purchase option, by giving written notice no later than 180 days but not more than 360 days before the expiration of the initial term. The purchase option price is $ 12,891 based on reasonably predicted fair market value. A right of use asset and lease liability in the amount of $ 55,345 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\nIn accordance with ASC 842, we recorded the operating lease right of use asset and lease liability as follows:\nSCHEDULE OF OPERATING LEASE RIGHT OF USE ASSET AND LEASE LIABILITY\n| March 31, 2021 | December 31,2020 |\n| Right of Use (ROU) asset | $ | 3,917,812 | $ | 3,977,988 |\n\n\n| March 31, 2021 | December 31, 2020 |\n| Operating lease liability: |\n| Current | $ | 198,759 | $ | 189,397 |\n| Non-Current | 3,821,666 | 3,864,321 |\n| Total | $ | 4,020,425 | $ | 4,053,718 |\n\n\n| F-12 |\n\nNOTE 8 – OPERATING LEASES (CONTINUED)\nMaturity of Operating Lease Liability for fiscal year ended December 31,\nSCHEDULE OF MATURITY OF OPERATING LEASE LIABILITY\n| 2021 |\n| 2021 (nine months) | $ | 156,105 |\n| 2022 | 213,747 |\n| 2023 | 232,829 |\n| 2024 | 251,264 |\n| 2025 | 267,134 |\n| After 2025 | 2,899,346 |\n| Total lease liability | $ | 4,020,425 |\n\nInformation associated with the measurement of our remaining operating lease obligations as of March 31, 2021 is as follows:\nThe operating leases range from a term of 2.48 years to 16.68 years with a weighted average lease term of 13.35 years.\nThe weighted average discount rate is 6.07 %.\nThe lease expense for the three months ended March 31, 2021 and 2020 was $ 141,675 and $ 24,061 , respectively.\nNOTE 9 - EQUITY\nPreferred Stock\nWe have authorized 25,000,000 preferred shares with a par value of 0.0001 per share. The Board is authorized to divide the authorized preferred shares into one or more series, each of which shall be so designated as to distinguish the shares thereof from the shares of all other series and classes. As of March 31, 2021 and December 31, 2020, we had no classes of preferred shares designated.\nCommon Stock\nWe have authorized 100,000,000 common shares with a par value of $ 0.0001 per share. Each common share entitles the holder to one vote, in person or proxy, on any matter on which action of the stockholders of the corporation is sought. As of March 31, 2021, we had 35,395,418 common shares issued and outstanding.\n\n| F-13 |\n\nNOTE 9 – EQUITY (CONTINUED)\nFiscal Year 2021\nOn March 23, 2021, we entered into a Plan of Merger with Banyan (See NOTE 4).\nIn connection with the Merger, we issued 4,165,418 shares of our common stock in exchange for 49,984,649 outstanding shares of Banyan’s common stock held by 64 shareholders, based on an exchange ratio of one (1) share of our common stock for every twelve (12) shares of Banyan common stock.\nIn conjunction with the Merger, the previously issued 31,230,000 shares of common stock of the Company prior to the Merger were deemed issued for the Merger.\nDuring the period of February 11, 2021 through March 31, 2021 we issued shares of common stock at $ 0.50 per share for an aggregate consideration of $ 3,540,000\nOn March 31, 2021, we had recorded a liability to issue shares in the amount of $ 325,000 to record stock purchases of 650,000 common shares at $ 0.50 per share that were to be issued in the following month, April 2021. On March 30, 2021, the Noteholders of the $ 2,000,000 convertible note exercised their right to convert the note (see NOTE 4). The shares were not issued as of March 31,2021. The conversion was recorded as a liability to issue shares in the amount of $ 2,000,000 , as reflected on our condensed consolidated balance sheet.\nFiscal Year 2020\nDuring the year ended December 31, 2020, $ 140 was received against a subscription receivable balance for the 2019 authorization of the issuance of Founders shares. On December 31, 2020, we had a subscription receivable of $ 30 for shares issued where payments were not received.\nOn September 19, 2020, we issued 2,000,000 restricted common shares to a noteholder for the conversion of $ 500,000 of note principal.\nWarrants\nIn association with the September 27, 2019 Asset Purchase Agreement (The Kidz Club St Pete, LLC), we issued 75,000 common stock warrants (post-merger exchange adjusted) having an exercise price of $ 0.38 per share. These warrants have an expiration of September 27, 2029 .\nSCHEDULE OF WARRANTS OUTSTANDING\n| Weighted |\n| Weighted- | Average |\n| Average | Remaining | Aggregate |\n| Exercise | Contractual | Intrinsic |\n| Shares | Price | Term | Value |\n| Outstanding at January 1, 2020 | - | - | - | $ | - |\n| Granted | 75,000 | $ | 0.38 | 10.0 Years | $ | - |\n| Expired | - | - | - |\n| Exercised | - | - | - |\n| Outstanding at December 31, 2020 | 75,000 | $ | 0.38 | 9.74 Years | $ | - |\n| Outstanding at January 1, 2020 | 75,000 | 0.38 | 9.74 Years | - |\n| Granted | - | - | - |\n| Expired | - | - | - |\n| Exercised | - | - | - |\n| Outstanding and exercisable March 31, 2020 | 75,000 | $ | 0.38 | 9.49 Years | $ | - |\n\n\n| F-14 |\n\nNOTE 10 – RELATED PARTY TRANSACTIONS\nOn February 1, 2021 (the “Effective Date”), we signed an employment agreement with our new CEO, Louis Collier (“Collier”). Collier will be paid a base salary of $ 400,000 , which will be reassessed and renegotiated in good faith after we are profitable over a fiscal year. Collier will also receive a signing bonus of $ 150,000 , which will be payable as follows: $ 50,000 within five days of the Effective Date (paid); $ 50,000 within 90 days of the Effective Date; and $ 50,000 within 180 days of the Effective Date. Collier will also be issued 1,250,000 phantom shares within ten days after the approval and adoption a Phantom Equity Plan. The phantom shares will be subject to a phantom unit interest award agreement, which will set forth the vesting of the phantom shares.\nOn March 23, 2021, we entered into a Plan of Merger (See NOTE 4) whereas we assumed debt of $ 2,000,000 that was convertible into 20,000,000 shares of common stock. After the Merger the debt was converted into 4,000,000 restricted common shares of the Company at $ 0.50 per share. One of the debt holders is majority owned by a director of the Company. As of March 31, 2021, these shares were not issued and are reflected as share liability on our condensed consolidated balance sheet.\nDuring the three months ended March 31, 2021 and 2020, we compensated members of the Board $ 20,769 and $ 0 , respectively.\nAs of March 31, 2021, we had accrued payroll of $ 60,000 and accrued interest on that payroll in the amount of $ 4,340 for the President and the Chief Financial Officer of Banyan. These unpaid amounts were the result of 2020 furloughed salaries. Interest is being accrued on these unpaid balances effective May 15, 2020 at a rate of 8 % per annum and is reflected in accrued interest balance as of March 31, 2021 and December 31, 2020 on the condensed consolidated balance sheet. Accrued salaries of $ 60,000 is reflected in accrued liabilities at March 31, 2021 and December 31, 2020 on the condensed consolidated balance sheet.\nNOTE 11 – SUBSEQUENT EVENTS\nWe have evaluated subsequent events from March 31, 2021 through the date these financial statements were issued and determined the following events require disclosure:\nSubsequent to March 31, 2021, we issued additional shares of restricted common stock as follow: (i) 1,150,000 shares to five (5) investors at a price of $ 0.50 per share for aggregate proceeds of $ 575,000 , including $ 325,000 issuance to satisfy the liability to issue shares; and (ii) 4,000,000 shares for note conversion.\nOn April 30, 2021, pursuant to the Option Agreement, the number of issued and outstanding shares of common stock was decreased by 200,000 (see NOTE 5).\nDiscontinued Operations\nSee NOTE 5 – DISCONTINUED OPERATIONS regarding the discontinuance of the operations in our wholly-owned subsidiary, Assisted 2 Live, Inc.\nTrillium Healthcare Group, LLC\nOn April 29, 2021, we entered into a Third Amendment (the “Third Amendment”) to a Membership Interest Purchase Agreement dated as of January 29, 2021 (the “Purchase Agreement”), by and among the Company, Richard T. Mason (“Mason”), G. Shayne Bench (“Bench”) and Trillium Healthcare Group, LLC, a Florida limited liability company (“Trillium”) to acquire all of the issued and outstanding ownership interests of Fairway Healthcare Properties, LLC and Trillium Healthcare Consulting, LLC from Trillium.\nAmong other things, the Third Amendment extends the date to May 28, 2021, after which either party may terminate the Purchase Agreement if the closing has not yet occurred.\n\n| F-15 |\n\n\nThe following discussion and analysis of our results of operations and financial condition for period ended March 31, 2021, should be read in conjunction with our consolidated financial statements and the related notes and the other financial information that are included elsewhere in this Quarterly Report. This discussion includes forward-looking statements based upon current expectations that involve risks and uncertainties, such as our plans, objectives, expectations, and intentions. Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results, or other developments. Forward-looking statements are based upon estimates, forecasts, and assumptions that are inherently subject to significant business, economic, and competitive uncertainties and contingencies, many of which are beyond our control and many of which, with respect to future business decisions, are subject to change. These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements. Actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of a number of factors. We use words such as “anticipate,” “estimate,” “plan,” “project,” “continuing,” “ongoing,” “expect,” “believe,” “intend,” “may,” “will,” “should,” “could,” and similar expressions to identify forward-looking statements.\nAs used in this quarterly report, the terms “we,” “us,” “our” and the “Company” means, collectively, Assisted 4 Living, Inc. (“A4L””) and its wholly-owned subsidiaries, Banyan Pediatric Care Centers, Inc, Banyan Pediatric Care Centers – OPS, LLC, Banyan Pediatric Care Centers – St Petersburg, LLC, Banyan Pediatric Care Centers – Sarasota, LLC and Banyan Pediatric Care Centers – Pasco, LLC, unless otherwise indicated.\nGeneral Overview\nA4L was incorporated in Nevada on May 24, 2017, with an objective to operate as a facilitator of assisted living projects and related services. On March 23, 2021, A4L entered into a Plan of Merger (the “Plan of Merger”) with its wholly-owned subsidiary, BPCC Acquisition, Inc., a Florida corporation (“Merger Sub”), and Banyan Pediatric Care Centers, Inc., a Florida corporation (“Banyan”).\nUnder the terms of the Plan of Merger, Merger Sub merged with and into Banyan with Banyan surviving the merger and becoming a wholly-owned subsidiary of A4L (the “Merger”).\nA4L also had a wholly-owned subsidiary, Assisted 2 Live, Inc., a Florida corporation (“A2L”), which was incorporated on June 15, 2017. On April 30, 2021, the Board of Directors of A4L approved the discontinuance of the operations in A2L. The operations of A2L are reflected on our condensed consolidated statement of operations for the last eight days of the three month period ended March 31, 2021 as a loss from discontinued operations.\nOur principal executive office is located at 6801 Energy Court, Suite 201 Sarasota, Florida 34240 and our telephone number is (855) 668-3331. Our office is provided to us at no charge by our largest shareholder and former President. Our corporate website is www.assisted4living.com.\nWe have not been subject to any bankruptcy, receivership or similar proceeding.\n\n| 3 |\n\nOur Current Business\nBanyan was organized under the laws of the State of Florida on January 15, 2019 for the purpose of providing health care services for medically fragile and chronically ill children. Specifically, to open and operate Prescribed Pediatric Extended Care (“PPEC”) centers in the State of Florida. Our PPEC centers provide, among other services, daily medical care for medically fragile and chronically ill children whose current locations are in Florida.\nPPEC centers provide up to 12 hours of daily care for families struggling with the unique and complex medical needs of their children and allow the parents of children with special needs some independence and the opportunity to still pursue their professional goals.\nOn May 1, 2020, we acquired a PPEC facility located in St. Petersburg, FL. The facility is licensed to provide PPEC services for up to 81 children. All State and County accreditations to run the facility through January 2022 are in place.\nOn October 12, 2019, we entered into a lease for commercial real estate in New Port Richey Florida. The lease commenced on September 1, 2020 with an initial term of 7 years. Construction for this location has been completed and we are in the process of applying for the necessary licenses and certifications to provide PPEC services at this location.\nOn August 24, 2019, we entered into a lease for commercial real estate in Sarasota Florida. The lease commenced on February 1, 2020 with an initial term of 5 years. Construction for this location has been completed and we are in the process of applying for the necessary licenses and certifications to provide PPEC services at this location.\nRegulatory Matters\nHealth care operations are highly regulated by both state and federal government agencies. Regulation of health care services is an ever-evolving area of law that varies from jurisdiction to jurisdiction. Regulatory agencies generally have discretion to issue regulations and interpret and enforce laws and rules. Changes in applicable laws, statutes, regulations and interpretive guidance occur frequently. In addition, government agencies may impose taxes, fees or other assessments upon Banyan at any time.\nBanyan is also subject to certain state laws prohibiting the payment of remuneration for patient or business referrals and the provision of services where a financial relationship exists between a referring person or entity and the entity providing the service. Federal laws governing our activities include regulation under the Medicare and Medicaid programs. Federal fraud and abuse laws prohibit or restrict, among other things, the payment of remuneration to parties in a position to influence or cause the referral of patients or business, as well as the filing of false claims. Government enforcement authorities have become increasingly active in recent years in their review and scrutiny of various sectors of the health care industry.\nChanges in or new interpretations of these laws could have an adverse effect on our methods and costs of doing business. Further, failure by Banyan to comply with such laws could adversely affect the ability to continue to provide, or receive reimbursement for, our services, and could subject Banyan and its officers and employees to civil and criminal penalties. There can be no assurance that Banyan will not encounter regulatory impediments that could adversely affect the ability to open facilities or to expand the services currently planned to provide at the facilities.\n\n| 4 |\n\nHIPAA, HITECH Act, State Privacy Laws and Breach Notification Laws.\nHIPAA and the regulations adopted under HIPAA are intended to improve the portability and continuity of health insurance coverage and simplify the administration of health insurance claims and related transactions.\nThe HITECH Act modified certain provisions of HIPAA by, among other things, extending the privacy and security provisions to business associates, mandating new regulations around electronic health records, expanding enforcement mechanisms, and increasing penalties for violations.\nOn January 25, 2013, the U.S. Department of Health and Human Services (“HHS”), as required by the HITECH Act, issued the Final Omnibus Rules that provide final modifications to HIPAA rules to implement the HITECH Act.\nThe HITECH Act also contains a number of provisions that provide incentives for states to initiate certain programs related to health care and health care technology, such as electronic health records. While provisions such as these will not apply to us directly, states wishing to apply for grants under the HITECH Act, or otherwise participating in such programs, may impose new health care technology requirements on us through our expected contracts with state Medicaid agencies.\nAll health plans are considered covered entities subject to HIPAA. HIPAA generally requires health plans, as well as their providers and vendors, to: (1) protect patient privacy and safeguard individually identifiable health information; and (2) establish the capability to receive and transmit electronically certain administrative health care transactions, such as claims payments, in a standardized format.\nSpecifically, the HIPAA Privacy Rule regulates use and disclosure of individually identifiable health information, known as “protected health information” (“PHI”). The HIPAA Security Rule requires covered entities to implement administrative, physical and technical safeguards to protect the security of electronic PHI. Certain provisions of the security and privacy regulations apply to business associates (entities that handle PHI on behalf of covered entities), and business associates are subject to direct liability for violation of these provisions. Furthermore, a covered entity may be subject to penalties as a result of a business associate violating HIPAA, if the business associate is found to be an agent of the covered entity.\nCovered entities must report breaches of unsecured PHI to affected individuals without unreasonable delay, but not to exceed 60 days of discovery of the breach by a covered entity or its agents. Notification must also be made to HHS and, in certain situations involving large breaches, to the media. HHS is required to publish on its website a list of all covered entities that report a breach involving more than 500 individuals. All non-permitted uses or disclosures of unsecured PHI are presumed to be breaches unless the covered entity or business associate establishes that there is a low probability the information has been compromised. Various state laws and regulations may also require us to notify affected individuals in the event of a data breach involving individually identifiable information.\nHIPAA violations by covered entities may result in civil and criminal penalties. Covered entities could face civil monetary penalties up to an annual maximum of $1,500,000 for uncorrected violations based on willful neglect. HHS enforces the regulations and performs audits to confirm compliance. Investigations of violations that indicate willful neglect, for which penalties are mandatory, are statutorily required. HHS may also resolve HIPAA violations through informal means, such as allowing a covered entity to implement a corrective action plan, but HHS has the discretion to move directly to impose monetary penalties and is required to impose penalties for violations resulting from willful neglect. In addition, state attorneys general are authorized to bring civil actions seeking either injunctions or damages in response to violations of HIPAA privacy and security regulations that threaten the privacy of state residents.\nBanyan enforces a HIPAA compliance plan, which complies with the HIPAA privacy and security regulations. Banyan also has dedicated resources to monitor compliance with our HIPAA compliance program.\n\n| 5 |\n\nBanyan, its providers, and certain of its vendors are also subject to numerous other privacy and security laws and regulations at the federal and state levels. Banyan remains subject to any federal or state privacy-related laws that are more restrictive than the privacy regulations issued under HIPAA. These laws vary and violations may result in additional penalties.\nFraud and Abuse Laws. Federal and state enforcement authorities have prioritized the investigation and prosecution of health care fraud, waste and abuse. Fraud, waste and abuse prohibitions encompass a wide range of operating activities, including kickbacks or other inducements for referral of members, billing for unnecessary medical services by a provider and improper marketing and violation of patient privacy rights. Companies involved in public health care programs such as Medicaid and Medicare are required to maintain compliance programs to detect and deter fraud, waste and abuse, and are often the subject of fraud, waste and abuse investigations and audits. The regulations and contractual requirements applicable to participants in these public-sector programs are complex and subject to change. Although Banyan has structured a compliance program with care in an effort to meet all statutory and regulatory requirements, our policies and procedures will be continuously under review and subject to updates and our training and education programs will always be evolving. We intend to invest significant resources towards our compliance efforts.\nFalse Claims Act. We are subject to federal and state laws and regulations that apply to the submission of information and claims to various agencies. For example, the federal False Claims Act provides, in part, that the federal government may bring a lawsuit against any person or entity who it believes has knowingly presented, or caused to be presented, a false or fraudulent request for payment from the federal government, or who has made a false statement or used a false record to get a claim approved. The federal government has taken the position that claims presented in violation of the federal anti-kickback statute may be considered a violation of the federal False Claims Act. Violations of the False Claims Act are punishable by treble damages and penalties of up to a specified dollar amount per false claim. In addition, a special provision under the False Claims Act allows a private person (for example, a “whistleblower” such as a disgruntled former associate, competitor or member) to bring an action under the False Claims Act on behalf of the government alleging that an entity has defrauded the federal government and permits the private person to share in any settlement of, or judgment entered in, the lawsuit. A number of states, including Florida, have adopted false claims acts that are similar to the federal False Claims Act.\nMedicare and Medicaid Regulations. As a provider of services under the Medicare and Medicaid programs (the “Programs”), we are subject to federal and state laws and regulations governing reimbursement procedures and practices. These laws include the Medicare and Medicaid fraud and abuse statutes and regulations which, among other provisions, prohibit the payment or receipt of any form of remuneration in return for referring business or patients to providers for which payments are made by a governmental health care program. Violation of these laws may result in civil and criminal penalties, including substantial fines, loss of the right to participate in the Programs and imprisonment of responsible individuals. In addition, HIPAA expanded the federal government’s fraud and abuse enforcement powers. Among other provisions, HIPAA expands the federal government’s authority to prosecute fraud and abuse beyond Medicare and Medicaid to all payors; makes exclusion from the Programs mandatory for a minimum of five years for any felony conviction relating to fraud; requires that organizations contracting with another organization or individual take steps to be informed as to whether the organization or individual is excluded from Medicare and Medicaid participation; and enhances civil penalties by increasing the amount of fines permitted. These laws also include a prohibition on referrals contained in the Omnibus Budget Reconciliation Act of 1989, which prohibits referrals by physicians to clinical laboratories where the physician has a financial interest, and further prohibitions contained in the Omnibus Budget Reconciliation Act of 1993, which prohibits such referrals for a more extensive range of services, including durable medical equipment. Various federal and state laws impose civil and criminal penalties against participants in the Programs who make false claims for payment for services or otherwise engage in false billing practices.\nMany state laws prohibit the payment or receipt or the offer of anything of value in return for, or to induce, a referral for health care goods or services. In addition, there are several other statutes that, although they do not explicitly address payments for referrals, could be interpreted as prohibiting the practice. While similar in many respects to the federal laws, these state laws vary from state to state, are often vague and have sometimes been interpreted inconsistently by courts and regulatory agencies. Private insurers and various state enforcement agencies have also increased their scrutiny of health care providers’ practices and claims.\n\n| 6 |\n\nThere can be no assurance that Banyan will not become the subject of a regulatory or other investigation or proceeding or that our interpretations of applicable health care laws and regulations will not be challenged. The defense of any such challenge could result in substantial cost to us, diversion of management’s time and attention, and could have a material adverse effect on The Company.\nThe Social Security Act, as amended by HIPAA, provides for the mandatory exclusion of providers and related persons from participation in the Programs if the individual or entity has been convicted of a criminal offense related to the delivery of an item or service under the Programs or relating to neglect or abuse of patients. Further, individuals or entities may be, but are not required to be, excluded from the Programs in circumstances including, but not limited to, convictions relating to fraud; obstruction of an investigation of a controlled substance; license revocation or suspension; filing claims for excessive charges or unnecessary services or failure to furnish medically necessary services; or ownership or control by an individual who has been excluded from the Programs, against whom a civil monetary penalty related to the Programs has been assessed, or who has been convicted of a crime described in this section. The illegal remuneration provisions of the Social Security Act make it a felony to solicit, receive, offer to pay, or pay any kickback, bribe, or rebate in return for referring a patient for any item or service, or in return for purchasing, leasing or ordering any good, service or item, for which payment may be made under the Programs. Other provisions in HIPAA proscribe false statements in billing and in meeting reporting requirements and in representations made with respect to the conditions or operations of providers. A violation of the illegal remuneration statute is a felony and may result in the imposition of criminal penalties, including imprisonment for up to five years and/or a fine of up to $25,000. Further, a civil action to exclude a provider from participation in the Programs could occur. There are also other civil and criminal statutes applicable to the industry, such as those governing false billings and the health care/services offenses contained in HIPAA, including health care/services fraud, theft or embezzlement, false statements and obstruction of criminal investigation of offenses. Criminal sanctions for these health care criminal offenses can be severe, including imprisonment for up to 20 years.\nResults of Operations\nCOVID-19\nIn March 2020, the World Health Organization declared the outbreak of COVID-19 as a pandemic based on the rapid increase in global exposure. COVID-19 continues to spread throughout the world. We are closely monitoring developments and taking steps to mitigate the potential risks related to the COVID-19 pandemic to the Company, its employees, as well as its residential and consulting clients.\nTo date COVID-19 has not substantially negatively impacted our revenues or operations. Our evaluations of our practices, procedures, and operations, related to COVID-19, is ongoing. Additional updates to policies, procedures and operations will occur as best practices are adopted and as we deem necessary or advisable, or as further governmental guidance or regulations are implemented.\nThe following summary of our operations should be read in conjunction with our unaudited financial statements for the three months ended March 31, 2021 which are included in this quarterly report.\nFor the three months ended March 31, 2021 compared to the three months ended March 31, 2020\n\n| Three Months Ended March 31, |\n| 2021 | 2020 | Change |\n| Revenue | $ | 606,925 | $ | 915 | $ | 606,010 |\n| Cost of services | 232,460 | - | 232,460 |\n| Operating expenses | 884,933 | 444,287 | 440,646 |\n| Other expense | (59,516 | ) | (3 | ) | (59,513 | ) |\n| Net Loss from continuing operations | $ | (569,984 | ) | $ | (443,375 | ) | $ | (126,609 | ) |\n\nWe recognized revenue of $606,925 for the three months ended March 31, 2021 compared to $915 for the three months ended March 31, 2020. The first operating facility began in May of 2020 with the acquisition of the St. Petersburg location and revenues began being reported at that time.\n\n| 7 |\n\nOperating expenses for the three months ended March 31, 2021 increased to $884,933 from $444,287 from the three months ended March 31, 2020. Operating expenses consist of salary expenses, general and administrative and professional fees. The increase in operating expense was primarily due to the acquisition of the St. Petersburg location in May of 2020 increasing general and administrative costs by $199,117 and an increase in lease expense of $117,614 from additional leases entered into during 2020.\nOther expenses consist of an increase in interest expense from notes entered into starting September 2020.\nOur net loss for the three months ended March 31, 2021 increased to 569,984 from $443,375 for the three months ended March 31, 2020 as net result of the factors mentioned above.\nLiquidity and Capital Resources\nThe following table provides selected financial data about us as of March 31, 2021 and December 31, 2020.\n\n| March 31, | December 30, |\n| 2021 | 2020 | Change |\n| Cash | $ | 3,441,841 | $ | 345,982 | $ | 3,095,859 |\n| Current assets | $ | 3,998,035 | $ | 650,647 | $ | 3,347,388 |\n| Current liabilities | 4,030,609 | 3,183,288 | 847,321 |\n| Working capital | $ | (32,574) | $ | (2,532,641) | $ | 2,500,067 |\n\nAs of March 31, 2021, our working capital increased $2,500,067, primarily due to an increase in cash offset by an increase in current liabilities.\nAs of March 31, 2021 and December 31, 2020, current assets consisted of cash, accounts receivable and other current assets. The increase in cash was primarily due to the issuance of 7,080,000 shares of restricted common stock at a purchase price of $0.50 per share for an aggregate amount of $3,540,000.\nAs of March 31, 2021, current liabilities consisted of notes and loans payable in the amount of $759,248, accrued interest of $95,079, accrued expenses of $572,891, lease liability of $198,759, share liability of $2,325,000, deferred revenue of $25,703 and liabilities from discontinued operations of $53,929.\nCash Flows\n\n| March 31, | March 31, |\n| 2021 | 2020 | Change |\n| Cash used in operating activities | $ | (228,006 | ) | $ | (427,757 | ) | $ | 199,751 |\n| Cash provided by investing activities | 3,010,994 | - | 3,010,994 |\n| Cash provided by financing activities | 312,871 | 11,885 | 300,986 |\n| Net change in cash for period | $ | 3,095,859 | $ | (415,872 | ) | $ | 3,511,731 |\n\nCash flow from Operating Activities\nDuring the three months ended March 31, 2021, we used $228,006 for operating activities compared to $427,757 cash used for operating activities during the three months ended March 31, 2020. The change in cash used for operating activities is due to an increase in non-cash lease operating expense, depreciation and amortization, accrued interest, and liabilities as well as $53,929 in liabilities from discontinued operations for the three months ended March 31, 2021.\nCash flow from Financing Activities\nThe cash flow from financing activities in the three months ended March 31, 2021 is $312,871, and $0 for the three months ended March 31, 2020. The increase is primarily due to $325,030 cash received for restricted common stock to be issued.\nCash flow from Investing Activities\nThe cash flow from investing activities for the three months ended March 31, 2021 was $3,010,994, and $0 for the three months ended March 31, 2020. This is primarily due to the cash from the first-time consolidation of the Company as a result of the Merger.\nCritical Accounting Policies\nWe prepare our financial statements in conformity with GAAP, which requires management to make certain estimates and apply judgments. We base our estimates and judgments on historical experience, current trends and other factors that management believes to be important at the time the financial statements are prepared. On a regular basis, we review our accounting policies and how they are applied and disclosed in our financial statements.\nWhile we believe that the historical experience, current trends, and other factors considered support the preparation of our financial statements in conformity with GAAP, actual results could differ from our estimates and such differences could be material.\nSee Note 2 - Significant Accounting Policies and the unaudited condensed consolidated financial statements that are included in this Report.\n\n| 8 |\n\nOff Balance Sheet Arrangements\nWe do not engage in any activities involving variable interest entities or off-balance sheet arrangements.\n\nAs a “smaller reporting company,” we are not required to provide the information required by this Item.\n\nItem 4. Controls and Procedures\nEvaluation of Disclosure Controls and Procedures\nWe maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Securities Exchange Act of 1934, as amended (the “Exchange Act”) reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, we recognize that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.\nAs further discussed below, we carried out an evaluation, under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act. Based on that evaluation, our chief executive officer and chief financial officer concluded that, because of certain material weaknesses in our internal control over financial reporting our disclosure controls and procedures as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act were not effective as of March 31, 2021. The material weaknesses relate to the absence of in-house accounting personnel with the ability to properly account for complex transactions and a lack of separation of duties between accounting and other functions.\nWe hired a consulting firm to advise on technical issues related to U.S. GAAP as related to the maintenance of our accounting books and records and the preparation of our consolidated financial statements. Although we are aware of the risks associated with not having dedicated accounting personnel, we are also at an early stage in the development of our business. We anticipate expanding our accounting functions with dedicated staff and improving our internal accounting procedures and separation of duties when we can absorb the costs of such expansion and improvement with additional capital resources. In the meantime, management will continue to observe and assess our internal accounting function and make necessary improvements whenever they may be required. If our remedial measures are insufficient to address the material weakness, or if additional material weaknesses or significant deficiencies in our internal control over financial reporting are discovered or occur in the future, our consolidated financial statements may contain material misstatements, and we could be required to restate our financial results. In addition, if we are unable to successfully remediate this material weakness and if we are unable to produce accurate and timely financial statements, our stock price may be adversely affected, and we may be unable to maintain compliance with applicable stock exchange listing requirements.\nOur management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act. Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Because of its inherent limitations, internal control over financial reporting may not prevent or detect all misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Based on our evaluation under the framework in Internal Control—Integrated Framework (2013), our management concluded that, because of certain material weaknesses in our internal control over financial reporting our disclosure controls and procedures as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act were not effective as of March 31, 2021.\n\n| 9 |\n\nChanges in Internal Control over Financial Reporting\nThere have been no changes in our internal control over financial reporting during the quarter ended March 31, 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\nPART II - OTHER INFORMATION\n\nFrom time to time, we may become involved in litigation relating to claims arising out of its operations in the normal course of business. We are not involved in any pending legal proceeding or litigation and, to the best of our knowledge, no governmental authority is contemplating any proceeding to which we area party or to which any of our properties is subject, which would reasonably be likely to have a material adverse effect on us.\n\nAs a “smaller reporting company,” we are not required to provide the information required by this Item.\n\nDuring the quarterly period ended March 31, 2021, we sold an aggregate of 7,080,000 shares of our common stock to 35 investors at a price of $0.50 per share for an aggregate purchase price of $3,540,000. The offers, sales and issuances of shares were deemed to be exempt from registration under the Securities Act of 1933, as amended (the “Securities Act”), in reliance on Section 4(a)(2) of the Securities Act and Rule 506(b) of Regulation D promulgated thereunder, as transactions by an issuer not involving a public offering. The recipients of shares in each of these transactions acquired the shares for investment only and not with a view to or for sale in connection with any distribution thereof and represented to us that they could bear the risks of the investment and could hold the securities for an indefinite period of time, and appropriate legends were affixed to the shares issued in these transactions. Each of the recipients of shares in these transactions represented to us in connection with their purchase that they were an accredited investor within the meaning of Rule 501 of Regulation D under the Securities Act.\n\n\n| Exhibit No. | Description |\n| 2.1 | Plan of Merger by and among Assisted 4 Living, Inc., BPCC Acquisition, Inc. and Banyan Pediatric Care Centers, Inc. dated March 23, 2021. (Previously filed on March 29, 2021 as Exhibit 2.1 of the Company’s Current Report on Form 8-K) |\n| 31.1 | Certification of Principal Executive Officer filed pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2 | Certification of Principal Financial Officer filed pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1 | Certification of Chief Executive Officer furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2 | Certification of Chief Financial Officer furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS | XBRL Instance Document |\n| 101.SCH | XBRL Taxonomy Extension Schema Document |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document |\n\n\n| 10 |\n\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| ASSISTED 4 LIVING, INC. |\n| (Registrant) |\n| Dated: May 18, 2021 | /s/ Louis Collier |\n| Louis Collier |\n| Chief Executive Officer (principal executive officer) |\n\n\n| 11 |\n\n \n\nWhat is the growth rate of the shareholders' deficit from the period of three months ended March 31, 2020 to the same period in 2021 in percentage?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nASSISTED 4 LIVING, INC.\\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\\nCONDENSED CONSOLIDATED BALANCE SHEETS\\n(UNAUDITED)\\n\\n| March 31, 2021 | December 31, 2020 |\\n| ASSETS |\\n| Current assets: |\\n| Cash | $ | 3,441,841 | $ | 345,982 |\\n| Accounts receivable, net allowance for doubtful accounts | 102,020 | 97,073 |\\n| Prepaid expenses and other current assets | 408,397 | 207,592 |\\n| Assets of discontinued operations | 45,777 | - |\\n| Total current assets | 3,998,035 | 650,647 |\\n| Lease right of use asset | 3,917,812 | 3,977,988 |\\n| Goodwill | 3,431,148 | 3,431,148 |\\n| Leasehold improvements, net of accumulated amortization | 2,571,910 | 2,614,391 |\\n| Property and equipment, net | 152,376 | 128,475 |\\n| Total assets | $ | 14,071,281 | $ | 10,802,649 |\\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\\n| Current liabilities: |\\n| Notes payable, net of discounts current | $ | 393,899 | $ | 2,385,010 |\\n| Accrued interest, included related party | 95,079 | 48,601 |\\n| Accounts payable and accrued expenses | 572,891 | 148,180 |\\n| Loan payable – other | 66,851 | 63,907 |\\n| Lease liability - current portion | 198,759 | 189,397 |\\n| Liability to issue shares of common stock | 2,325,000 | - |\\n| Deferred revenue | 25,703 | 25,703 |\\n| Liabilities of discontinued operations | 53,929 | - |\\n| Total current liabilities | 3,732,111 | 2,860,798 |\\n| Lease liability - net of current portion | 3,821,666 | 3,864,321 |\\n| Notes payable, net of discounts and current portion | 298,498 | 322,490 |\\n| Total liabilities | 7,852,275 | 7,047,609 |\\n| Stockholders’ equity: |\\n| Common stock, par value $ 0.0001 ; 100,000,000 shares authorized, 35,395,418 and 4,165,418 issued and outstanding at March 31, 2021 and December 31, 2020, respectively | 3,540 | 417 |\\n| Additional paid-in capital | 10,500,222 | 7,460,348 |\\n| Subscription receivable | - | ( 30 | ) |\\n| Accumulated deficit | ( 4,284,756 | ) | ( 3,705,695 | ) |\\n| Total stockholders’ equity | 6,219,006 | 3,755,040 |\\n| Total liabilities and stockholders’ equity | $ | 14,071,281 | $ | 10,802,649 |\\n\\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\\n\\n| F-1 |\\n\\nASSISTED 4 LIVING, INC.\\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\\n(UNAUDITED)\\n\\n| 2021 | 2020 |\\n| For the Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| Program revenue | $ | 601,115 | $ | - |\\n| Rental income | 5,625 | - |\\n| Other revenue | 185 | 915 |\\n| Net revenue | 606,925 | 915 |\\n| Cost of services provided | 232,460 | - |\\n| Gross profit | 374,465 | 915 |\\n| Operating expenses |\\n| Salaries and payroll expense | 293,114 | 245,712 |\\n| General and administrative | 298,200 | 99,083 |\\n| Lease expense | 141,675 | 24,061 |\\n| Professional fees | 95,691 | 62,800 |\\n| Marketing and advertising | 5,670 | 12,631 |\\n| Depreciation and amortization expense | 50,583 | - |\\n| Total operating expenses | 884,933 | 444,287 |\\n| Loss from operations | ( 510,468 | ) | ( 443,372 | ) |\\n| Other expense |\\n| Interest expense | ( 59,516 | ) | ( 3 | ) |\\n| Total other expense | ( 59,516 | ) | ( 3 | ) |\\n| LOSS FROM CONTINUING OPERATIONS BEFORE PROVISION FOR INCOME TAXES AND LOSS FROM DISCONTINUED OPERATIONS | ( 569,984 | ) | ( 443,375 | ) |\\n| Income taxes | - | - |\\n| LOSS FROM CONTINUING OPERATIONS BEFORE DISCONTINUED OPERATIONS | ( 569,984 | ) | ( 443,375 | ) |\\n| LOSS FROM DISCONTINUED OPERATIONS | ( 9,077 | ) | - |\\n| Net loss | $ | ( 579,061 | ) | $ | ( 443,375 | ) |\\n| Loss per share - basic and diluted - Continuing operations | $ | ( 0.08 | ) | $ | ( 0.11 | ) |\\n| Loss per share - basic and diluted - Discontinued operations | $ | ( 0.00 | ) | $ | - |\\n| Weighted average number of shares outstanding - basic and diluted | 7,288,419 | 4,008,443 |\\n\\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\\n\\n| F-2 |\\n\\nASSISTED 4 LIVING, INC.\\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\\nCONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY\\nFOR THE THREE MONTHS ENDED MARCH 31, 2020 AND 2021\\n(UNAUDITED)\\n\\n| Shares | Amount | Capital | Receivable | Deficit | Total |\\n| Common Stock | Additional | Total |\\n| Number of | paid-in | Subscription | Accumulated | stockholders’ |\\n| shares | Amount | Capital | Receivable | deficit | deficit |\\n| For the Three Months Ended March 31, 2020 |\\n| Balance at December 31, 2019 | 4,008,443 | 401 | 6,618,364 | ( 170 | ) | ( 2,407,760 | ) | 4,210,835 |\\n| Collection on subscription receivable |\\n| Shares issuable for Banyan Acquisition |\\n| Shares issuable for Banyan Acquisition, shares |\\n| Net loss for the period | - | - | - | - | ( 443,375 | ) | ( 443,375 | ) |\\n| Balance at March 31, 2020 | 4,008,443 | 401 | 6,618,364 | ( 170 | ) | ( 2,851,135 | ) | 3,767,460 |\\n| For the Three months ended March 31, 2021 |\\n| - | - | - |\\n| Balance at December 31, 2020 | 4,165,418 | 417 | 7,460,348 | ( 30 | ) | ( 3,705,695 | ) | 3,755,040 |\\n| Collection on subscription receivable | - | - | - | 30 | - | 30 |\\n| Shares issued for Acquisition | 31,230,000 | 3,123 | 3,039,874 | - | - | 3,042,997 |\\n| Net loss for the period | - | - | - | ( 579,061 | ) | ( 579,061 | ) |\\n| Balance at March 31, 2021 | 35,395,418 | 3,540 | 10,500,222 | - | ( 4,284,756 | ) | 6,219,006 |\\n\\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\\n\\n| F-3 |\\n\\nASSISTED 4 LIVING, INC.\\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\\n(UNAUDITED)\\n\\n| 2021 | 2020 |\\n| For the Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| Cash flows from operating activities |\\n| Net loss | $ | ( 579,061 | ) | $ | ( 443,375 | ) |\\n| Adjustments to reconcile net loss to cash used in operating activities: |\\n| Net loss from discontinued operations | ( 9,077 | ) | - |\\n| Non-cash operating lease expense | 26,883 | ( 4,070 | ) |\\n| Depreciation and amortization | 50,583 | - |\\n| (Increase) decrease in assets |\\n| Prepaid expenses | ( 200,805 | ) | 4,564 |\\n| Accounts receivable | ( 4,947 | ) | - |\\n| Increase (decrease) in liabilities |\\n| Accounts payable | - | ( 13,420 | ) |\\n| Accrued payroll and other expenses | 441,940 | 28,544 |\\n| Accrued interest | 46,478 | - |\\n| Cash used in operating activities | ( 228,006 | ) | ( 427,757 | ) |\\n| Cash flows from investing activities |\\n| Cash from acquisition | 3,042,997 | - |\\n| Purchase of property and equipment | ( 32,003 | ) | - |\\n| Cash provided by investing activities | 3,010,994 | - |\\n| Cash flows from financing activities |\\n| Repayment of principal on notes payable to individuals and companies | ( 15,103 | ) | - |\\n| Proceeds from the sale of common stock issued and issuable | 325,030 | 139 |\\n| Proceeds from other notes payable | 2,944 | 11,746 |\\n| Cash provided by financing activities | 312,871 | 11,885 |\\n| Net increase (decrease) in cash | 3,095,859 | ( 415,872 | ) |\\n| Cash, beginning of year | 345,982 | 4,044,700 |\\n| Cash, end of period | $ | 3,441,841 | $ | 3,628,828 |\\n| SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: |\\n| Interest paid | $ | 13,037 | $ | - |\\n| Taxes paid |\\n| NON-CASH ITEMS |\\n| Recognition of lease liability and right of use asset at inception | $ | - | $ | 1,897,995 |\\n| Conversion of notes payable and accrued interest for common stock | $ | 2,000,000 | $ | - |\\n\\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\\n\\n| F-4 |\\n\\nASSISTED 4 LIVING, INC.\\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\nNOTE 1 – ORGANIZATION AND DESCRIPTION OF BUSINESS\\nAssisted 4 Living, Inc. (“the Company,” “we”, “our” or “us”) was incorporated in the state of Nevada on May 24, 2017 and is based in Sarasota, Florida. The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America (“GAAP”), and the Company’s fiscal year end is December 31.\\nAs discussed in NOTE 4, on March 23, 2021, we entered into a Plan of Merger with our wholly-owned subsidiary, BPCC Acquisition, Inc., a Florida corporation (“Merger Sub”) and Banyan Pediatric Care Centers, Inc. (“Banyan”). Under the terms of the Plan of Merger, Merger Sub merged with and into Banyan with Banyan surviving the merger (the “Surviving Entity”) and becoming a wholly-owned subsidiary of the Company (the “Merger”). Pursuant to the Merger, we succeeded to the business of Banyan. The Merger has been treated as a recapitalization and reverse acquisition of the Company for financial accounting purposes, and Banyan is considered the acquirer for financial reporting purposes. This means that the Company’s historical financial statements before the Merger have been replaced with the historical financial statements of Banyan before the Merger in this Quarterly Report and future filings with the SEC\\nThrough Banyan, we operate three pediatric extended care centers (“PPECs”) is southwest Florida. A PPEC is a nurse-staffed pediatric day care center for medically complex children age birth to 21 years. Our staff includes Registered Nurses (RNs), Licensed Practical Nurses (LPNs), Certified Nursing Assistants (CNAs) and Caregivers, who attend to the children’s medical conditions throughout the day in classroom, dining, play, and clinical settings. Banyan is fully licensed and accepts Florida Medicaid.\\nWe are headquartered at 6801 Energy Court, Suite 201 Sarasota, Florida 34240.\\nThe corporate website is www.assisted4living.com.\\nCOVID-19\\nIn March 2020, the World Health Organization declared the outbreak of COVID-19 as a pandemic based on the rapid increase in global exposure. COVID-19 continues to spread throughout the world. We are closely monitoring developments and are taking steps to mitigate the potential risks related to the COVID-19 pandemic to the Company, its employees, as well as its residential and consulting clients.\\nTo date COVID-19 has not substantially negatively impacted our revenues or operations. Our evaluations of our practices, procedures, and operations, related to COVID-19, is ongoing. Additional updates to policies, procedures and operations will occur as best practices are adopted and as we deem necessary or advisable, or as further governmental guidance or regulations are implemented.\\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\\nBasis of Presentation\\nThe accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with GAAP for interim financial statements and with the instructions to Form 10-Q and Regulation S-X of the United States Securities and Exchange Commission (“SEC”). Accordingly, they do not contain all information and footnotes required by accounting principles generally accepted in the United States of America for annual financial statements.\\nIn the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all the adjustments necessary (consisting only of normal recurring accruals) to present the financial position of the Company as of March 31, 2021 and the results of operations and cash flows for the periods presented. The results of operations for the three months ended March 31, 2021 are not necessarily indicative of the operating results for the full fiscal year or any future period. These unaudited condensed consolidated financial statements should be read in conjunction with the condensed consolidated financial statements and related notes thereto included in the Company’s Annual Report on Form 10-K filed with the SEC on March 1, 2021. As of March 23, 2021 we had discontinued operations reflected in the accompanying unaudited condensed consolidated financial statements. As a result of the Plan of Merger completed on March 23, 2021 (see NOTE 4) we have changed our year end reporting period from November to December.\\n\\n| F-5 |\\n\\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)\\nBasis of Consolidation\\nThese condensed consolidated financial statements include the accounts of the Company and the wholly-owned subsidiaries, Banyan Pediatric Care Centers, Inc, Banyan Pediatric Care Centers – OPS, LLC, Banyan Pediatric Care Centers – St. Petersburg, LLC, Banyan Pediatric Care Centers, - Pasco, LLC and Banyan Pediatric Care Centers – Sarasota, LLC and the discontinued operations of Assisted 2 Live, Inc., the wholly owned subsidiary that was discontinued as of March 23, 2021. All material intercompany balances and transactions have been eliminated.\\nCash and Cash Equivalents\\nThe Company considers all short-term investments with an original maturity of three months or less to be cash equivalents. The Company had no cash equivalents at March 31, 2021 and December 31, 2020.\\nAccounts Receivable\\nAccounts receivable primarily consists of amounts due from third-party payers (non-governmental), governmental payers and private pay patients and is recorded net of allowances for doubtful accounts and contractual discounts. The Company’s ability to collect outstanding receivables is critical to its results of operations and cash flows. Accordingly, accounts receivable reported in the Company’s condensed consolidated financial statements is recorded at the net amount expected to be received. The Company’s primary collection risks are (i) the risk of overestimation of net revenues at the time of billing that may result in the Company receiving less than the recorded receivable, (ii) the risk of non-payment as a result of commercial insurance companies’ denial of claims, (iii) the risk that patients will fail to remit insurance payments to the Company when the commercial insurance company pays out-of-network claims directly to the patient, (iv) resource and capacity constraints that may prevent the Company from handling the volume of billing and collection issues in a timely manner, (v) the risk that patients do not pay the Company for their self-pay balances (including co-pays, deductibles and any portion of the claim not covered by insurance) and (vi) the risk of non-payment from uninsured patients.\\nThe Company’s accounts receivable from third-party payers are recorded net of estimated contractual adjustments and allowances from third-party payers, which are estimated based on the historical trend of the Company’s facilities’ cash collections and contractual write-offs, accounts receivable aging, established fee schedules, relationships with payers and procedure statistics. While changes in estimated reimbursement from third-party payers remain a possibility, the Company expects that any such changes would be minimal and, therefore, would not have a material effect on the Company’s financial condition or results of operations. The Company’s collection policies and procedures are based on the type of payor, size of claim and estimated collection percentage for each patient account. The Company analyzes accounts receivable at each of the facilities to ensure the proper collection and aged category. The operating systems generate reports that assist in the collection efforts by prioritizing patient accounts. Collection efforts include direct contact with insurance carriers or patients and written correspondence.\\nAllowance for Doubtful Accounts, Contractual and Other Discounts\\nManagement estimates the allowance for contractual and other discounts based on its historical collection experience and contracted relationship with the payers. The services authorized and provided and related reimbursement are often subject to interpretation and negotiation that could result in payments that differ from the Company’s estimates. The Company’s allowance for doubtful accounts is based on historical experience, but management also takes into consideration the age of accounts, creditworthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts. An account may be written-off only after the Company has pursued collection efforts or otherwise determines an account to be uncollectible. Uncollectible balances are written-off against the allowance. Recoveries of previously written-off balances are credited to income when the recoveries are made.\\nFair Value of Financial Instruments\\nThe carrying amount of accounts receivable and accounts payable approximate their respective fair values due to the short- term nature. The carrying amount of the line of credit and note payable approximates fair values due to their market interest rates. Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents and accounts receivable.\\nProperty and Equipment\\nProperty and equipment are stated at cost, less accumulated depreciation. Additions and improvements to property and equipment are capitalized at cost. Depreciation of owned assets and amortization of leasehold improvements are computed using the straight-line method over the shorter of the estimated useful lives of the related assets or the lease term. The cost of assets sold or retired, and the related accumulated depreciation are removed from the accounts and any resulting gains or losses are reflected in other income (expense) for the year. Expenditures for maintenance and repairs are charged to expense as incurred.\\n\\n| F-6 |\\n\\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)\\nGoodwill\\nOur goodwill represents the excess of the purchase price over the fair value of the net identifiable assets acquired in business combinations. The goodwill generated from the business combinations is primarily related to the value placed on the employee workforce and expected synergies. Judgment is involved in determining if an indicator or change in circumstances relating to impairment has occurred. Such changes may include, among others, a significant decline in expected future cash flows, a significant adverse change in the business climate, and unforeseen competition. There was no goodwill impairment for the years presented.\\nThe Company tests goodwill for impairment on an annual basis, and when events or circumstances indicate the fair value of a reporting unit may be below its carrying value.\\nLong-Lived Assets\\nLong-lived assets are evaluated for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. There were no impairments of long-lived assets for the years presented.\\nAdvertising and Marketing\\nThe Company uses advertising and marketing to promote its services. Advertising and marketing costs are expensed as incurred.\\nNet Loss Per Share\\nBasic net loss per common share is computed by dividing net loss applicable to common stockholders by the weighted-average number of common shares outstanding during the period. Diluted net loss per common share is determined using the weighted-average of common shares outstanding during the period, adjusted for the dilutive effect of common stock equivalents, consisting of the conversion option embedded in convertible debt. The weighted-average number of common shares outstanding excludes common stock equivalents because their inclusion would have an anti-dilutive effect.\\nIncome Taxes\\nThe Company uses the liability method of accounting for income taxes. Under the liability method, deferred tax assets and liabilities are determined based on differences between financial reporting and the tax basis of assets, liabilities, the carry forward of operating losses and tax credits, and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. An allowance against deferred tax assets is recorded when it is more likely than not that such tax benefits will not be realized.\\nAny future benefit arising from losses have been offset by a valuation allowance. Accordingly, no provision for income taxes is reflected in the condensed consolidated financial statements. The Company records a liability for uncertain tax positions when it is probable that a loss has been incurred and the amount can be reasonably estimated. Interest and penalties related to income tax matters, if any, would be recognized as a component of income tax expense. At March 31, 2021 and December 31, 2020, the Company had no liabilities for uncertain tax positions. The Company continually evaluates expiring statutes of limitations, audits, proposed settlements, changes in tax law and new authoritative rulings. Currently, the tax years subsequent to 2017 are open and subject to examination by the taxing authorities.\\n\\n| F-7 |\\n\\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)\\nUse of Estimates and Assumptions\\nThe preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. The estimates and judgments will also affect the reported amounts for certain revenues and expenses during the reporting period. Actual results could differ from these good faith estimates and judgments.\\nRevenue Recognition\\nWe follow ASC 606, “Revenue from Contracts with Customers.” Revenues are recognized when promised goods or services are transferred to a customer, in an amount that reflects the consideration that we expect to receive in exchange for those goods or services. We derive our revenues from the rendering of services, such as skilled nursing services. The five-step model defined by ASC 606 requires us to: (i) identify our contracts with customers, (ii) identify our performance obligations under those contracts, (iii) determine the transaction prices of those contracts, (iv) allocate the transaction prices to our performance obligations in those contracts and (v) recognize revenue when each performance obligation under those contracts is satisfied.\\nReimbursement rates to provide skilled nursing services in our PPEC facilities are determined by the Medicaid program. Fees are billed to the Medicaid program and other payors weekly following the Medicaid billing guidelines.\\nReclassification\\nCertain amounts from prior periods have been reclassified to conform to the current period presentation.\\nNOTE 3 – ACCRUED LIABILITIES\\nOur accrued liabilities at March 31, 2021 and December 31, 2020 consisted of the following:\\nSCHEDULE OF ACCRUED LIABILITIES\\n| March 31, 2021 | December 31, 2020 |\\n| Accounts payable | $ | 70,675 | $ | 16,298 |\\n| Credit card | - | 1,050 |\\n| Accrued expenses | 354,193 | 130,832 |\\n| Accrued salary | 139,952 | - |\\n| Payroll tax payable | 8,070 | - |\\n| Accrued Liabilities | $ | 572,890 | $ | 148,180 |\\n\\n\\n| F-8 |\\n\\nNOTE 4 – BANYAN MERGER\\nOn March 23, 2021, we entered into a Plan of Merger with Merger Sub and Banyan. Under the terms of the Plan of Merger, Merger Sub merged with and into Banyan with Banyan as the Surviving Entity and wholly-owned subsidiary of the Company. The Merger was effective on March 23, 2021.\\nThe Merger has been treated as a recapitalization and reverse acquisition of the Company for financial accounting purposes, and Banyan is considered the acquirer for accounting purposes. This means that the Company’s historical financial statements before the Merger have been replaced with the historical financial statements of Banyan.\\nIn connection with the Merger, we issued 4,165,418 shares of our common stock in exchange for 49,984,649 outstanding shares of Banyan’s common stock held by 64 shareholders, based on an exchange ratio of one (1) share of our common stock for every twelve (12) shares of Banyan common stock. We also issued a warrant to purchase 75,000 shares of our common stock (the “Warrant”) in exchange for a warrant to purchase 900,000 shares of Banyan’s common stock. The Warrant is held by one investor and is exercisable for cash only until May 2, 2030 at an exercise price of $ 0.38 per share. The number of shares of common stock deliverable upon exercise of the Warrant contains provisions for standard anti-dilution adjustments.\\nThe Surviving Entity assumed Banyan’s $ 2,300,000 of outstanding debt, and the $ 2,000,000 of such debt that was convertible into 20,000,000 shares of Banyan common stock was converted at $ 0.50 per share into 4,000,000 shares of our common stock, effective as of March 30, 2021. The remaining $ 300,000 of outstanding debt, evidenced by a promissory note dated November 6, 2020 (the “Note”), accrues interest at the annual rate of 12 %. Interest is payable on the sixth day of each month in the amount of $ 3,000 until the maturity date of the Note on November 6, 2021 , at which time, the remaining principal balance, if any, is due and payable.\\n\\n| F-9 |\\n\\nNOTE 5 – DISCONTINUED OPERATIONS\\nOn April 30, 2021, our Board of Directors (the “Board”) approved the discontinuance of our wholly-owned subsidiary, Assisted 2 Live, Inc. (the “Discontinued Subsidiary”). The operations of the Discontinued Subsidiary are reflected on our condensed consolidated statement of operations from the date of the Merger as a loss from discontinued operations in the amount of $ 9,077 .\\nThe April 30, 2021 Board decision was the result of the Purchase and Sale Option Agreement (the “Option Agreement”) with Romulus Barr (“Barr”) which we entered into on November 7, 2020. The Option Agreement provided us with the option to sell all of our interest in Assisted 2 Live, Inc., consisting of 1,000 shares of common stock of the Discontinued Subsidiary, to Barr in exchange for 200,000 shares of our common stock (the “Shares”) held by Barr. The returned Shares were cancelled, and included in authorized but unissued shares of common stock of the Company. The number of issued and outstanding shares of common stock was decreased by 200,000 as of April 30, 2021.\\nThe following table presents the aggregate carrying amounts of the classes of assets and liabilities of discontinued operations for the three months ended:\\nSUMMARY OF CARRYING AMOUNTS OF ASSETS AND LIABILITIES AND CASH FLOWS OF DISCONTINUED OPERATIONS\\n| March 31, 2021 | December 31, 2020 |\\n| Current assets of discontinued operations | $ | 15,928 | $ | - |\\n| Non-current assets of discontinued operations | 29,849 | - |\\n| $ | 45,777 | $ | - |\\n| Current liabilities of discontinued operations | $ | 53,929 | $ | - |\\n| $ | 53,929 | $ | - |\\n\\nThe following table presents cash flows of discontinued operations for the three months ended March 31:\\n\\n| 2021 | 2020 |\\n| Net cash used in discontinued operating activities | $ | ( 14,386 | ) | $ | - |\\n| Net cash from discontinued investing activities | - | - |\\n| Net cash from discontinued financing activities | - | - |\\n| $ | ( 14,386 | ) | $ | - |\\n\\n\\n| Three months ended March 31, |\\n| 2021 | 2020 |\\n| Net revenues | $ | 5,362 | $ | - |\\n| Cost of net revenues | - | - |\\n| Gross profit | 5,362 | - |\\n| Operating expenses: |\\n| Salary and tax expense | 12,890 | - |\\n| General and administrative | 763 | - |\\n| Lease expense | 733 | - |\\n| Total operating expenses | 14,386 | - |\\n| Income from operations of discontinued operations | ( 9,024 | ) | - |\\n| Interest and other, net | ( 53 | ) | - |\\n| Income from discontinued operations before income taxes | ( 9,077 | ) | - |\\n| Provision for income taxes | - | - |\\n| Income from discontinued operations, net of income taxes | $ | ( 9,077 | ) | $ | - |\\n\\n\\n| F-10 |\\n\\nNOTE 6 – NOTES PAYABLE\\nNotes payable at March 31, 2021 and December 31, 2020 consisted of the following:\\nSCHEDULE OF NOTES PAYABLE\\n| March 31, 2021 | December 31, 2020 |\\n| (Unaudited) |\\n| a. Excel Family Partners, LLLP / Banyan Pediatric Investment, Inc. (Sep 2020) | $ | - | $ | 2,000,000 |\\n| b. NuView Trust Co. (Nov 2020) | 300,000 | 300,000 |\\n| c. Grand Trinity Plaza, LLC (Dec 2020) | 392,397 | 407,500 |\\n| $ | 692,397 | $ | 2,707,500 |\\n\\n\\n| a) | On September 18, 2020, through Banyan, we entered into a Convertible Note and Securities Purchase Agreement with two investors for the aggregate principal in the amount of $ 2,000,000 . The note had a maturity date of September 18, 2022 and an interest rate of 8 % to be paid quarterly. The principal was funded by two investors (“Purchasers”), both related parties. Excel Family Partners, LLLP invested $ 1,500,000 and Banyan Pediatric Investments, LLC invested $ 500,000 . The proceeds of this note were used for operational expenses and for the payment of the remainder of the buildout of the Pasco County and the Sarasota locations. Written consent from shareholders holding a majority of the issued and outstanding shares of common stock of Banyan was obtained, not including such shares currently held by the Purchasers or their affiliates, consenting to the note contemplated hereby, in a form and substance acceptable to the Purchasers, in their respective reasonable discretion. Both Purchasers were permitted to convert their respective portions of the note at a conversion price of $ 0.10 per share. Subsequent to the Merger (see NOTE 4), the Board revised the conversion price of the note to $ 0.50 per share. Effective March 30, 2021 the Purchasers exercised their right to convert all outstanding principal. As of March 31, 2021 and December 31, 2020, there was $ 90,740 and $ 45,589 of accrued interest, respectively and is reflected in accrued interest balances on the condensed consolidated balance sheet at March 31, 2021 and December 31, 2020. |\\n\\n\\n| b) | On November 6, 2020, through Banyan, we entered into a one-year note in the principal amount of $ 300,000 with NuView Trust Company. The note has a 12 % interest rate with interest only payments until date of maturity. The proceeds of this no were used for operational expenses and for the payment of the remainder of the buildout of the Pasco County and the Sarasota locations. As of March 31, 2021 and December 31, 2020 there was no accrued interest. (see NOTE 4) |\\n\\n\\n| c) | On December 15, 2020, through Banyan Pediatric Care Centers – Pasco, LLC, we entered into a note payable with Grand Trinity Plaza, LLC in the principal amount of $ 407,500 , which is guaranteed by Banyan. The term of the note is 48 months with an interest rate of 6 %. The maturity date of the note is January 1, 2025 . The note is in conjunction with the 84 -month facility lease for the Pasco County location, pursuant to which the landlord also provided the construction of the buildout and financed $ 407,500 of the construction costs. |\\n\\nNOTE 7 – LEASEHOLD IMPROVEMENTS\\nThe Company had the following leasehold improvements as of March 31, 2021 and December 31, 2020:\\nSCHEDULE OF LEASESHOLD IMPROVEMENTS\\n| March 31, 2021 | December 31, 2020 | Amortization Period |\\n| Leasehold improvements | $ | 2,669,047 | $ | 2,669,047 | 15 - 17 years |\\n| Less: amortization | ( 97,137 | ) | ( 54,656 | ) |\\n| Net | $ | 2,571,910 | $ | 2,614,391 |\\n\\nDuring the year ended December 31, 2020, we recorded $ 2,669,047 of leasehold improvements. These amounts include costs related to the build out of the Sarasota location in the amount of $ 1,245,950 . These costs will be amortized over the expected term of the lease including extensions that management expects to be 15 years. We also recorded costs in the amount of $ 1,021,793 related to the New Port Richey location buildout. The expected amortization of the improvements for the New Port Richey location is 17 years. Also recorded were $ 401,303 of improvements as part of the St. Petersburg-Kidz Club Acquisition. The expected amortization of the improvements for the St. Petersburg location is 15 years.\\nAmortization expense for the three months ended March 31, 2021 and 2020 was $ 42,481 and $ 0 , respectively.\\n\\n| F-11 |\\n\\nNOTE 8 – OPERATING LEASES\\nOn August 24, 2019, through Banyan Pediatric Care Centers-Sarasota, LLC, we entered into an operating lease with Northeast Plaza Venture I, LLC for the premises located in the Northeast Plaza Shopping Center located on the Northeast corner of 17th Street & Lockwood Ridge Road, in the County of Sarasota, Florida. The initial term of the lease is five years with minimum annual rent of $ 180,000 . The landlord granted rent abatement for this lease until February 24, 2020 . The lease end date, including two successive 5 -year renewal options, is January 31, 2035. A right of use asset and lease liability in the amount of $ 1,899,869 associated with this lease was recognized. This lease is treated as an operating lease for accounting purposes.\\nOn October 15, 2019, through Banyan, we entered into an assignment and assumption of lease agreement with The Kidz Club – St. Pete, LLC whereby we assumed approximately 12,137 square feet of space at the southeast corner of 3rd Avenue S. and 9th Street N., Webb’s Plaza, St. Petersburg, FL 33701. The minimum annual rent for the first year of the lease was $ 113,681 . The current lease termination date, with extensions expected to be exercised, is October 31, 2024 . Upon the exercise of each extension the base rent shall increase by 1.5 %. This assignment of lease was subject to the terms of the Asset Purchase Agreement with The Kidz Club-St. Pete, LLC. A right of use asset and lease liability in the amount of $ 875,539 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\\nEffective April 1, 2020, through Banyan Pediatric Care Centers – Pasco, LLC, we entered into an 84 -month facility lease with Grand Trinity Plaza, LLC for the premises located in the shopping center known as the Grand Trinity Plaza located in New Port Richey, Florida. The initial term of the lease had a minimum annual base rent of $ 94,500 . The landlord granted rent abatement until September 2020. The lease end date, including two successive 5 -year renewals is August 31, 2037. A right of use asset and lease liability in the amount of $ 1,143,743 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\\nOn June 9, 2020, through Banyan, we entered into a 63 -month copier lease with Dex Imaging. The lease was for one copier and a printer. The minimum annual lease payment is $ 5,376 with annual increases not to exceed 12 % annually. This lease will auto renew in 12 -month increments. The equipment under this lease has a fixed $1 payment buyout option . This equipment was purchased for the St. Petersburg location. A right of use asset and lease liability in the amount of $ 16,066 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\\nOn August 25, 2020, through Banyan, we entered into a 60 -month financing agreement with Ascentium Capital LLC for two 2020 Turtletop Terra Transit passenger buses for the St. Petersburg location. This lease is considered an operating lease for accounting purposes because the lease period is less than the economic life of the asset being leased . Minimum annual rent payments under this lease are $ 24,859 . At our discretion, we may exercise a purchase option, by giving written notice no later than 30 days but not more than 120 days before the expiration of the initial term. The purchase option price is $ 23,920 for each bus, based on reasonably predicted fair market value. A right of use asset and lease liability in the amount of $ 102,393 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\\nOn October 20, 2020, through Banyan, we entered into a 60 -month financing agreement with Ascentium Capital LLC for a 2020 Eldorado National Advance 220 p/t 14 passenger bus for the St. Petersburg location. This lease is considered an operating lease for accounting purposes because the lease period is less than the economic life of the asset being leased . Minimum annual rent payments under this lease are $ 13,381 . At our discretion, we may exercise a purchase option, by giving written notice no later than 180 days but not more than 360 days before the expiration of the initial term. The purchase option price is $ 12,891 based on reasonably predicted fair market value. A right of use asset and lease liability in the amount of $ 55,345 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\\nIn accordance with ASC 842, we recorded the operating lease right of use asset and lease liability as follows:\\nSCHEDULE OF OPERATING LEASE RIGHT OF USE ASSET AND LEASE LIABILITY\\n| March 31, 2021 | December 31,2020 |\\n| Right of Use (ROU) asset | $ | 3,917,812 | $ | 3,977,988 |\\n\\n\\n| March 31, 2021 | December 31, 2020 |\\n| Operating lease liability: |\\n| Current | $ | 198,759 | $ | 189,397 |\\n| Non-Current | 3,821,666 | 3,864,321 |\\n| Total | $ | 4,020,425 | $ | 4,053,718 |\\n\\n\\n| F-12 |\\n\\nNOTE 8 – OPERATING LEASES (CONTINUED)\\nMaturity of Operating Lease Liability for fiscal year ended December 31,\\nSCHEDULE OF MATURITY OF OPERATING LEASE LIABILITY\\n| 2021 |\\n| 2021 (nine months) | $ | 156,105 |\\n| 2022 | 213,747 |\\n| 2023 | 232,829 |\\n| 2024 | 251,264 |\\n| 2025 | 267,134 |\\n| After 2025 | 2,899,346 |\\n| Total lease liability | $ | 4,020,425 |\\n\\nInformation associated with the measurement of our remaining operating lease obligations as of March 31, 2021 is as follows:\\nThe operating leases range from a term of 2.48 years to 16.68 years with a weighted average lease term of 13.35 years.\\nThe weighted average discount rate is 6.07 %.\\nThe lease expense for the three months ended March 31, 2021 and 2020 was $ 141,675 and $ 24,061 , respectively.\\nNOTE 9 - EQUITY\\nPreferred Stock\\nWe have authorized 25,000,000 preferred shares with a par value of 0.0001 per share. The Board is authorized to divide the authorized preferred shares into one or more series, each of which shall be so designated as to distinguish the shares thereof from the shares of all other series and classes. As of March 31, 2021 and December 31, 2020, we had no classes of preferred shares designated.\\nCommon Stock\\nWe have authorized 100,000,000 common shares with a par value of $ 0.0001 per share. Each common share entitles the holder to one vote, in person or proxy, on any matter on which action of the stockholders of the corporation is sought. As of March 31, 2021, we had 35,395,418 common shares issued and outstanding.\\n\\n| F-13 |\\n\\nNOTE 9 – EQUITY (CONTINUED)\\nFiscal Year 2021\\nOn March 23, 2021, we entered into a Plan of Merger with Banyan (See NOTE 4).\\nIn connection with the Merger, we issued 4,165,418 shares of our common stock in exchange for 49,984,649 outstanding shares of Banyan’s common stock held by 64 shareholders, based on an exchange ratio of one (1) share of our common stock for every twelve (12) shares of Banyan common stock.\\nIn conjunction with the Merger, the previously issued 31,230,000 shares of common stock of the Company prior to the Merger were deemed issued for the Merger.\\nDuring the period of February 11, 2021 through March 31, 2021 we issued shares of common stock at $ 0.50 per share for an aggregate consideration of $ 3,540,000\\nOn March 31, 2021, we had recorded a liability to issue shares in the amount of $ 325,000 to record stock purchases of 650,000 common shares at $ 0.50 per share that were to be issued in the following month, April 2021. On March 30, 2021, the Noteholders of the $ 2,000,000 convertible note exercised their right to convert the note (see NOTE 4). The shares were not issued as of March 31,2021. The conversion was recorded as a liability to issue shares in the amount of $ 2,000,000 , as reflected on our condensed consolidated balance sheet.\\nFiscal Year 2020\\nDuring the year ended December 31, 2020, $ 140 was received against a subscription receivable balance for the 2019 authorization of the issuance of Founders shares. On December 31, 2020, we had a subscription receivable of $ 30 for shares issued where payments were not received.\\nOn September 19, 2020, we issued 2,000,000 restricted common shares to a noteholder for the conversion of $ 500,000 of note principal.\\nWarrants\\nIn association with the September 27, 2019 Asset Purchase Agreement (The Kidz Club St Pete, LLC), we issued 75,000 common stock warrants (post-merger exchange adjusted) having an exercise price of $ 0.38 per share. These warrants have an expiration of September 27, 2029 .\\nSCHEDULE OF WARRANTS OUTSTANDING\\n| Weighted |\\n| Weighted- | Average |\\n| Average | Remaining | Aggregate |\\n| Exercise | Contractual | Intrinsic |\\n| Shares | Price | Term | Value |\\n| Outstanding at January 1, 2020 | - | - | - | $ | - |\\n| Granted | 75,000 | $ | 0.38 | 10.0 Years | $ | - |\\n| Expired | - | - | - |\\n| Exercised | - | - | - |\\n| Outstanding at December 31, 2020 | 75,000 | $ | 0.38 | 9.74 Years | $ | - |\\n| Outstanding at January 1, 2020 | 75,000 | 0.38 | 9.74 Years | - |\\n| Granted | - | - | - |\\n| Expired | - | - | - |\\n| Exercised | - | - | - |\\n| Outstanding and exercisable March 31, 2020 | 75,000 | $ | 0.38 | 9.49 Years | $ | - |\\n\\n\\n| F-14 |\\n\\nNOTE 10 – RELATED PARTY TRANSACTIONS\\nOn February 1, 2021 (the “Effective Date”), we signed an employment agreement with our new CEO, Louis Collier (“Collier”). Collier will be paid a base salary of $ 400,000 , which will be reassessed and renegotiated in good faith after we are profitable over a fiscal year. Collier will also receive a signing bonus of $ 150,000 , which will be payable as follows: $ 50,000 within five days of the Effective Date (paid); $ 50,000 within 90 days of the Effective Date; and $ 50,000 within 180 days of the Effective Date. Collier will also be issued 1,250,000 phantom shares within ten days after the approval and adoption a Phantom Equity Plan. The phantom shares will be subject to a phantom unit interest award agreement, which will set forth the vesting of the phantom shares.\\nOn March 23, 2021, we entered into a Plan of Merger (See NOTE 4) whereas we assumed debt of $ 2,000,000 that was convertible into 20,000,000 shares of common stock. After the Merger the debt was converted into 4,000,000 restricted common shares of the Company at $ 0.50 per share. One of the debt holders is majority owned by a director of the Company. As of March 31, 2021, these shares were not issued and are reflected as share liability on our condensed consolidated balance sheet.\\nDuring the three months ended March 31, 2021 and 2020, we compensated members of the Board $ 20,769 and $ 0 , respectively.\\nAs of March 31, 2021, we had accrued payroll of $ 60,000 and accrued interest on that payroll in the amount of $ 4,340 for the President and the Chief Financial Officer of Banyan. These unpaid amounts were the result of 2020 furloughed salaries. Interest is being accrued on these unpaid balances effective May 15, 2020 at a rate of 8 % per annum and is reflected in accrued interest balance as of March 31, 2021 and December 31, 2020 on the condensed consolidated balance sheet. Accrued salaries of $ 60,000 is reflected in accrued liabilities at March 31, 2021 and December 31, 2020 on the condensed consolidated balance sheet.\\nNOTE 11 – SUBSEQUENT EVENTS\\nWe have evaluated subsequent events from March 31, 2021 through the date these financial statements were issued and determined the following events require disclosure:\\nSubsequent to March 31, 2021, we issued additional shares of restricted common stock as follow: (i) 1,150,000 shares to five (5) investors at a price of $ 0.50 per share for aggregate proceeds of $ 575,000 , including $ 325,000 issuance to satisfy the liability to issue shares; and (ii) 4,000,000 shares for note conversion.\\nOn April 30, 2021, pursuant to the Option Agreement, the number of issued and outstanding shares of common stock was decreased by 200,000 (see NOTE 5).\\nDiscontinued Operations\\nSee NOTE 5 – DISCONTINUED OPERATIONS regarding the discontinuance of the operations in our wholly-owned subsidiary, Assisted 2 Live, Inc.\\nTrillium Healthcare Group, LLC\\nOn April 29, 2021, we entered into a Third Amendment (the “Third Amendment”) to a Membership Interest Purchase Agreement dated as of January 29, 2021 (the “Purchase Agreement”), by and among the Company, Richard T. Mason (“Mason”), G. Shayne Bench (“Bench”) and Trillium Healthcare Group, LLC, a Florida limited liability company (“Trillium”) to acquire all of the issued and outstanding ownership interests of Fairway Healthcare Properties, LLC and Trillium Healthcare Consulting, LLC from Trillium.\\nAmong other things, the Third Amendment extends the date to May 28, 2021, after which either party may terminate the Purchase Agreement if the closing has not yet occurred.\\n\\n| F-15 |\\n\\n\\nThe following discussion and analysis of our results of operations and financial condition for period ended March 31, 2021, should be read in conjunction with our consolidated financial statements and the related notes and the other financial information that are included elsewhere in this Quarterly Report. This discussion includes forward-looking statements based upon current expectations that involve risks and uncertainties, such as our plans, objectives, expectations, and intentions. Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results, or other developments. Forward-looking statements are based upon estimates, forecasts, and assumptions that are inherently subject to significant business, economic, and competitive uncertainties and contingencies, many of which are beyond our control and many of which, with respect to future business decisions, are subject to change. These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements. Actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of a number of factors. We use words such as “anticipate,” “estimate,” “plan,” “project,” “continuing,” “ongoing,” “expect,” “believe,” “intend,” “may,” “will,” “should,” “could,” and similar expressions to identify forward-looking statements.\\nAs used in this quarterly report, the terms “we,” “us,” “our” and the “Company” means, collectively, Assisted 4 Living, Inc. (“A4L””) and its wholly-owned subsidiaries, Banyan Pediatric Care Centers, Inc, Banyan Pediatric Care Centers – OPS, LLC, Banyan Pediatric Care Centers – St Petersburg, LLC, Banyan Pediatric Care Centers – Sarasota, LLC and Banyan Pediatric Care Centers – Pasco, LLC, unless otherwise indicated.\\nGeneral Overview\\nA4L was incorporated in Nevada on May 24, 2017, with an objective to operate as a facilitator of assisted living projects and related services. On March 23, 2021, A4L entered into a Plan of Merger (the “Plan of Merger”) with its wholly-owned subsidiary, BPCC Acquisition, Inc., a Florida corporation (“Merger Sub”), and Banyan Pediatric Care Centers, Inc., a Florida corporation (“Banyan”).\\nUnder the terms of the Plan of Merger, Merger Sub merged with and into Banyan with Banyan surviving the merger and becoming a wholly-owned subsidiary of A4L (the “Merger”).\\nA4L also had a wholly-owned subsidiary, Assisted 2 Live, Inc., a Florida corporation (“A2L”), which was incorporated on June 15, 2017. On April 30, 2021, the Board of Directors of A4L approved the discontinuance of the operations in A2L. The operations of A2L are reflected on our condensed consolidated statement of operations for the last eight days of the three month period ended March 31, 2021 as a loss from discontinued operations.\\nOur principal executive office is located at 6801 Energy Court, Suite 201 Sarasota, Florida 34240 and our telephone number is (855) 668-3331. Our office is provided to us at no charge by our largest shareholder and former President. Our corporate website is www.assisted4living.com.\\nWe have not been subject to any bankruptcy, receivership or similar proceeding.\\n\\n| 3 |\\n\\nOur Current Business\\nBanyan was organized under the laws of the State of Florida on January 15, 2019 for the purpose of providing health care services for medically fragile and chronically ill children. Specifically, to open and operate Prescribed Pediatric Extended Care (“PPEC”) centers in the State of Florida. Our PPEC centers provide, among other services, daily medical care for medically fragile and chronically ill children whose current locations are in Florida.\\nPPEC centers provide up to 12 hours of daily care for families struggling with the unique and complex medical needs of their children and allow the parents of children with special needs some independence and the opportunity to still pursue their professional goals.\\nOn May 1, 2020, we acquired a PPEC facility located in St. Petersburg, FL. The facility is licensed to provide PPEC services for up to 81 children. All State and County accreditations to run the facility through January 2022 are in place.\\nOn October 12, 2019, we entered into a lease for commercial real estate in New Port Richey Florida. The lease commenced on September 1, 2020 with an initial term of 7 years. Construction for this location has been completed and we are in the process of applying for the necessary licenses and certifications to provide PPEC services at this location.\\nOn August 24, 2019, we entered into a lease for commercial real estate in Sarasota Florida. The lease commenced on February 1, 2020 with an initial term of 5 years. Construction for this location has been completed and we are in the process of applying for the necessary licenses and certifications to provide PPEC services at this location.\\nRegulatory Matters\\nHealth care operations are highly regulated by both state and federal government agencies. Regulation of health care services is an ever-evolving area of law that varies from jurisdiction to jurisdiction. Regulatory agencies generally have discretion to issue regulations and interpret and enforce laws and rules. Changes in applicable laws, statutes, regulations and interpretive guidance occur frequently. In addition, government agencies may impose taxes, fees or other assessments upon Banyan at any time.\\nBanyan is also subject to certain state laws prohibiting the payment of remuneration for patient or business referrals and the provision of services where a financial relationship exists between a referring person or entity and the entity providing the service. Federal laws governing our activities include regulation under the Medicare and Medicaid programs. Federal fraud and abuse laws prohibit or restrict, among other things, the payment of remuneration to parties in a position to influence or cause the referral of patients or business, as well as the filing of false claims. Government enforcement authorities have become increasingly active in recent years in their review and scrutiny of various sectors of the health care industry.\\nChanges in or new interpretations of these laws could have an adverse effect on our methods and costs of doing business. Further, failure by Banyan to comply with such laws could adversely affect the ability to continue to provide, or receive reimbursement for, our services, and could subject Banyan and its officers and employees to civil and criminal penalties. There can be no assurance that Banyan will not encounter regulatory impediments that could adversely affect the ability to open facilities or to expand the services currently planned to provide at the facilities.\\n\\n| 4 |\\n\\nHIPAA, HITECH Act, State Privacy Laws and Breach Notification Laws.\\nHIPAA and the regulations adopted under HIPAA are intended to improve the portability and continuity of health insurance coverage and simplify the administration of health insurance claims and related transactions.\\nThe HITECH Act modified certain provisions of HIPAA by, among other things, extending the privacy and security provisions to business associates, mandating new regulations around electronic health records, expanding enforcement mechanisms, and increasing penalties for violations.\\nOn January 25, 2013, the U.S. Department of Health and Human Services (“HHS”), as required by the HITECH Act, issued the Final Omnibus Rules that provide final modifications to HIPAA rules to implement the HITECH Act.\\nThe HITECH Act also contains a number of provisions that provide incentives for states to initiate certain programs related to health care and health care technology, such as electronic health records. While provisions such as these will not apply to us directly, states wishing to apply for grants under the HITECH Act, or otherwise participating in such programs, may impose new health care technology requirements on us through our expected contracts with state Medicaid agencies.\\nAll health plans are considered covered entities subject to HIPAA. HIPAA generally requires health plans, as well as their providers and vendors, to: (1) protect patient privacy and safeguard individually identifiable health information; and (2) establish the capability to receive and transmit electronically certain administrative health care transactions, such as claims payments, in a standardized format.\\nSpecifically, the HIPAA Privacy Rule regulates use and disclosure of individually identifiable health information, known as “protected health information” (“PHI”). The HIPAA Security Rule requires covered entities to implement administrative, physical and technical safeguards to protect the security of electronic PHI. Certain provisions of the security and privacy regulations apply to business associates (entities that handle PHI on behalf of covered entities), and business associates are subject to direct liability for violation of these provisions. Furthermore, a covered entity may be subject to penalties as a result of a business associate violating HIPAA, if the business associate is found to be an agent of the covered entity.\\nCovered entities must report breaches of unsecured PHI to affected individuals without unreasonable delay, but not to exceed 60 days of discovery of the breach by a covered entity or its agents. Notification must also be made to HHS and, in certain situations involving large breaches, to the media. HHS is required to publish on its website a list of all covered entities that report a breach involving more than 500 individuals. All non-permitted uses or disclosures of unsecured PHI are presumed to be breaches unless the covered entity or business associate establishes that there is a low probability the information has been compromised. Various state laws and regulations may also require us to notify affected individuals in the event of a data breach involving individually identifiable information.\\nHIPAA violations by covered entities may result in civil and criminal penalties. Covered entities could face civil monetary penalties up to an annual maximum of $1,500,000 for uncorrected violations based on willful neglect. HHS enforces the regulations and performs audits to confirm compliance. Investigations of violations that indicate willful neglect, for which penalties are mandatory, are statutorily required. HHS may also resolve HIPAA violations through informal means, such as allowing a covered entity to implement a corrective action plan, but HHS has the discretion to move directly to impose monetary penalties and is required to impose penalties for violations resulting from willful neglect. In addition, state attorneys general are authorized to bring civil actions seeking either injunctions or damages in response to violations of HIPAA privacy and security regulations that threaten the privacy of state residents.\\nBanyan enforces a HIPAA compliance plan, which complies with the HIPAA privacy and security regulations. Banyan also has dedicated resources to monitor compliance with our HIPAA compliance program.\\n\\n| 5 |\\n\\nBanyan, its providers, and certain of its vendors are also subject to numerous other privacy and security laws and regulations at the federal and state levels. Banyan remains subject to any federal or state privacy-related laws that are more restrictive than the privacy regulations issued under HIPAA. These laws vary and violations may result in additional penalties.\\nFraud and Abuse Laws. Federal and state enforcement authorities have prioritized the investigation and prosecution of health care fraud, waste and abuse. Fraud, waste and abuse prohibitions encompass a wide range of operating activities, including kickbacks or other inducements for referral of members, billing for unnecessary medical services by a provider and improper marketing and violation of patient privacy rights. Companies involved in public health care programs such as Medicaid and Medicare are required to maintain compliance programs to detect and deter fraud, waste and abuse, and are often the subject of fraud, waste and abuse investigations and audits. The regulations and contractual requirements applicable to participants in these public-sector programs are complex and subject to change. Although Banyan has structured a compliance program with care in an effort to meet all statutory and regulatory requirements, our policies and procedures will be continuously under review and subject to updates and our training and education programs will always be evolving. We intend to invest significant resources towards our compliance efforts.\\nFalse Claims Act. We are subject to federal and state laws and regulations that apply to the submission of information and claims to various agencies. For example, the federal False Claims Act provides, in part, that the federal government may bring a lawsuit against any person or entity who it believes has knowingly presented, or caused to be presented, a false or fraudulent request for payment from the federal government, or who has made a false statement or used a false record to get a claim approved. The federal government has taken the position that claims presented in violation of the federal anti-kickback statute may be considered a violation of the federal False Claims Act. Violations of the False Claims Act are punishable by treble damages and penalties of up to a specified dollar amount per false claim. In addition, a special provision under the False Claims Act allows a private person (for example, a “whistleblower” such as a disgruntled former associate, competitor or member) to bring an action under the False Claims Act on behalf of the government alleging that an entity has defrauded the federal government and permits the private person to share in any settlement of, or judgment entered in, the lawsuit. A number of states, including Florida, have adopted false claims acts that are similar to the federal False Claims Act.\\nMedicare and Medicaid Regulations. As a provider of services under the Medicare and Medicaid programs (the “Programs”), we are subject to federal and state laws and regulations governing reimbursement procedures and practices. These laws include the Medicare and Medicaid fraud and abuse statutes and regulations which, among other provisions, prohibit the payment or receipt of any form of remuneration in return for referring business or patients to providers for which payments are made by a governmental health care program. Violation of these laws may result in civil and criminal penalties, including substantial fines, loss of the right to participate in the Programs and imprisonment of responsible individuals. In addition, HIPAA expanded the federal government’s fraud and abuse enforcement powers. Among other provisions, HIPAA expands the federal government’s authority to prosecute fraud and abuse beyond Medicare and Medicaid to all payors; makes exclusion from the Programs mandatory for a minimum of five years for any felony conviction relating to fraud; requires that organizations contracting with another organization or individual take steps to be informed as to whether the organization or individual is excluded from Medicare and Medicaid participation; and enhances civil penalties by increasing the amount of fines permitted. These laws also include a prohibition on referrals contained in the Omnibus Budget Reconciliation Act of 1989, which prohibits referrals by physicians to clinical laboratories where the physician has a financial interest, and further prohibitions contained in the Omnibus Budget Reconciliation Act of 1993, which prohibits such referrals for a more extensive range of services, including durable medical equipment. Various federal and state laws impose civil and criminal penalties against participants in the Programs who make false claims for payment for services or otherwise engage in false billing practices.\\nMany state laws prohibit the payment or receipt or the offer of anything of value in return for, or to induce, a referral for health care goods or services. In addition, there are several other statutes that, although they do not explicitly address payments for referrals, could be interpreted as prohibiting the practice. While similar in many respects to the federal laws, these state laws vary from state to state, are often vague and have sometimes been interpreted inconsistently by courts and regulatory agencies. Private insurers and various state enforcement agencies have also increased their scrutiny of health care providers’ practices and claims.\\n\\n| 6 |\\n\\nThere can be no assurance that Banyan will not become the subject of a regulatory or other investigation or proceeding or that our interpretations of applicable health care laws and regulations will not be challenged. The defense of any such challenge could result in substantial cost to us, diversion of management’s time and attention, and could have a material adverse effect on The Company.\\nThe Social Security Act, as amended by HIPAA, provides for the mandatory exclusion of providers and related persons from participation in the Programs if the individual or entity has been convicted of a criminal offense related to the delivery of an item or service under the Programs or relating to neglect or abuse of patients. Further, individuals or entities may be, but are not required to be, excluded from the Programs in circumstances including, but not limited to, convictions relating to fraud; obstruction of an investigation of a controlled substance; license revocation or suspension; filing claims for excessive charges or unnecessary services or failure to furnish medically necessary services; or ownership or control by an individual who has been excluded from the Programs, against whom a civil monetary penalty related to the Programs has been assessed, or who has been convicted of a crime described in this section. The illegal remuneration provisions of the Social Security Act make it a felony to solicit, receive, offer to pay, or pay any kickback, bribe, or rebate in return for referring a patient for any item or service, or in return for purchasing, leasing or ordering any good, service or item, for which payment may be made under the Programs. Other provisions in HIPAA proscribe false statements in billing and in meeting reporting requirements and in representations made with respect to the conditions or operations of providers. A violation of the illegal remuneration statute is a felony and may result in the imposition of criminal penalties, including imprisonment for up to five years and/or a fine of up to $25,000. Further, a civil action to exclude a provider from participation in the Programs could occur. There are also other civil and criminal statutes applicable to the industry, such as those governing false billings and the health care/services offenses contained in HIPAA, including health care/services fraud, theft or embezzlement, false statements and obstruction of criminal investigation of offenses. Criminal sanctions for these health care criminal offenses can be severe, including imprisonment for up to 20 years.\\nResults of Operations\\nCOVID-19\\nIn March 2020, the World Health Organization declared the outbreak of COVID-19 as a pandemic based on the rapid increase in global exposure. COVID-19 continues to spread throughout the world. We are closely monitoring developments and taking steps to mitigate the potential risks related to the COVID-19 pandemic to the Company, its employees, as well as its residential and consulting clients.\\nTo date COVID-19 has not substantially negatively impacted our revenues or operations. Our evaluations of our practices, procedures, and operations, related to COVID-19, is ongoing. Additional updates to policies, procedures and operations will occur as best practices are adopted and as we deem necessary or advisable, or as further governmental guidance or regulations are implemented.\\nThe following summary of our operations should be read in conjunction with our unaudited financial statements for the three months ended March 31, 2021 which are included in this quarterly report.\\nFor the three months ended March 31, 2021 compared to the three months ended March 31, 2020\\n\\n| Three Months Ended March 31, |\\n| 2021 | 2020 | Change |\\n| Revenue | $ | 606,925 | $ | 915 | $ | 606,010 |\\n| Cost of services | 232,460 | - | 232,460 |\\n| Operating expenses | 884,933 | 444,287 | 440,646 |\\n| Other expense | (59,516 | ) | (3 | ) | (59,513 | ) |\\n| Net Loss from continuing operations | $ | (569,984 | ) | $ | (443,375 | ) | $ | (126,609 | ) |\\n\\nWe recognized revenue of $606,925 for the three months ended March 31, 2021 compared to $915 for the three months ended March 31, 2020. The first operating facility began in May of 2020 with the acquisition of the St. Petersburg location and revenues began being reported at that time.\\n\\n| 7 |\\n\\nOperating expenses for the three months ended March 31, 2021 increased to $884,933 from $444,287 from the three months ended March 31, 2020. Operating expenses consist of salary expenses, general and administrative and professional fees. The increase in operating expense was primarily due to the acquisition of the St. Petersburg location in May of 2020 increasing general and administrative costs by $199,117 and an increase in lease expense of $117,614 from additional leases entered into during 2020.\\nOther expenses consist of an increase in interest expense from notes entered into starting September 2020.\\nOur net loss for the three months ended March 31, 2021 increased to 569,984 from $443,375 for the three months ended March 31, 2020 as net result of the factors mentioned above.\\nLiquidity and Capital Resources\\nThe following table provides selected financial data about us as of March 31, 2021 and December 31, 2020.\\n\\n| March 31, | December 30, |\\n| 2021 | 2020 | Change |\\n| Cash | $ | 3,441,841 | $ | 345,982 | $ | 3,095,859 |\\n| Current assets | $ | 3,998,035 | $ | 650,647 | $ | 3,347,388 |\\n| Current liabilities | 4,030,609 | 3,183,288 | 847,321 |\\n| Working capital | $ | (32,574) | $ | (2,532,641) | $ | 2,500,067 |\\n\\nAs of March 31, 2021, our working capital increased $2,500,067, primarily due to an increase in cash offset by an increase in current liabilities.\\nAs of March 31, 2021 and December 31, 2020, current assets consisted of cash, accounts receivable and other current assets. The increase in cash was primarily due to the issuance of 7,080,000 shares of restricted common stock at a purchase price of $0.50 per share for an aggregate amount of $3,540,000.\\nAs of March 31, 2021, current liabilities consisted of notes and loans payable in the amount of $759,248, accrued interest of $95,079, accrued expenses of $572,891, lease liability of $198,759, share liability of $2,325,000, deferred revenue of $25,703 and liabilities from discontinued operations of $53,929.\\nCash Flows\\n\\n| March 31, | March 31, |\\n| 2021 | 2020 | Change |\\n| Cash used in operating activities | $ | (228,006 | ) | $ | (427,757 | ) | $ | 199,751 |\\n| Cash provided by investing activities | 3,010,994 | - | 3,010,994 |\\n| Cash provided by financing activities | 312,871 | 11,885 | 300,986 |\\n| Net change in cash for period | $ | 3,095,859 | $ | (415,872 | ) | $ | 3,511,731 |\\n\\nCash flow from Operating Activities\\nDuring the three months ended March 31, 2021, we used $228,006 for operating activities compared to $427,757 cash used for operating activities during the three months ended March 31, 2020. The change in cash used for operating activities is due to an increase in non-cash lease operating expense, depreciation and amortization, accrued interest, and liabilities as well as $53,929 in liabilities from discontinued operations for the three months ended March 31, 2021.\\nCash flow from Financing Activities\\nThe cash flow from financing activities in the three months ended March 31, 2021 is $312,871, and $0 for the three months ended March 31, 2020. The increase is primarily due to $325,030 cash received for restricted common stock to be issued.\\nCash flow from Investing Activities\\nThe cash flow from investing activities for the three months ended March 31, 2021 was $3,010,994, and $0 for the three months ended March 31, 2020. This is primarily due to the cash from the first-time consolidation of the Company as a result of the Merger.\\nCritical Accounting Policies\\nWe prepare our financial statements in conformity with GAAP, which requires management to make certain estimates and apply judgments. We base our estimates and judgments on historical experience, current trends and other factors that management believes to be important at the time the financial statements are prepared. On a regular basis, we review our accounting policies and how they are applied and disclosed in our financial statements.\\nWhile we believe that the historical experience, current trends, and other factors considered support the preparation of our financial statements in conformity with GAAP, actual results could differ from our estimates and such differences could be material.\\nSee Note 2 - Significant Accounting Policies and the unaudited condensed consolidated financial statements that are included in this Report.\\n\\n| 8 |\\n\\nOff Balance Sheet Arrangements\\nWe do not engage in any activities involving variable interest entities or off-balance sheet arrangements.\\n\\nAs a “smaller reporting company,” we are not required to provide the information required by this Item.\\n\\nItem 4. Controls and Procedures\\nEvaluation of Disclosure Controls and Procedures\\nWe maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Securities Exchange Act of 1934, as amended (the “Exchange Act”) reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, we recognize that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.\\nAs further discussed below, we carried out an evaluation, under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act. Based on that evaluation, our chief executive officer and chief financial officer concluded that, because of certain material weaknesses in our internal control over financial reporting our disclosure controls and procedures as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act were not effective as of March 31, 2021. The material weaknesses relate to the absence of in-house accounting personnel with the ability to properly account for complex transactions and a lack of separation of duties between accounting and other functions.\\nWe hired a consulting firm to advise on technical issues related to U.S. GAAP as related to the maintenance of our accounting books and records and the preparation of our consolidated financial statements. Although we are aware of the risks associated with not having dedicated accounting personnel, we are also at an early stage in the development of our business. We anticipate expanding our accounting functions with dedicated staff and improving our internal accounting procedures and separation of duties when we can absorb the costs of such expansion and improvement with additional capital resources. In the meantime, management will continue to observe and assess our internal accounting function and make necessary improvements whenever they may be required. If our remedial measures are insufficient to address the material weakness, or if additional material weaknesses or significant deficiencies in our internal control over financial reporting are discovered or occur in the future, our consolidated financial statements may contain material misstatements, and we could be required to restate our financial results. In addition, if we are unable to successfully remediate this material weakness and if we are unable to produce accurate and timely financial statements, our stock price may be adversely affected, and we may be unable to maintain compliance with applicable stock exchange listing requirements.\\nOur management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act. Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Because of its inherent limitations, internal control over financial reporting may not prevent or detect all misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Based on our evaluation under the framework in Internal Control—Integrated Framework (2013), our management concluded that, because of certain material weaknesses in our internal control over financial reporting our disclosure controls and procedures as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act were not effective as of March 31, 2021.\\n\\n| 9 |\\n\\nChanges in Internal Control over Financial Reporting\\nThere have been no changes in our internal control over financial reporting during the quarter ended March 31, 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\nPART II - OTHER INFORMATION\\n\\nFrom time to time, we may become involved in litigation relating to claims arising out of its operations in the normal course of business. We are not involved in any pending legal proceeding or litigation and, to the best of our knowledge, no governmental authority is contemplating any proceeding to which we area party or to which any of our properties is subject, which would reasonably be likely to have a material adverse effect on us.\\n\\nAs a “smaller reporting company,” we are not required to provide the information required by this Item.\\n\\nDuring the quarterly period ended March 31, 2021, we sold an aggregate of 7,080,000 shares of our common stock to 35 investors at a price of $0.50 per share for an aggregate purchase price of $3,540,000. The offers, sales and issuances of shares were deemed to be exempt from registration under the Securities Act of 1933, as amended (the “Securities Act”), in reliance on Section 4(a)(2) of the Securities Act and Rule 506(b) of Regulation D promulgated thereunder, as transactions by an issuer not involving a public offering. The recipients of shares in each of these transactions acquired the shares for investment only and not with a view to or for sale in connection with any distribution thereof and represented to us that they could bear the risks of the investment and could hold the securities for an indefinite period of time, and appropriate legends were affixed to the shares issued in these transactions. Each of the recipients of shares in these transactions represented to us in connection with their purchase that they were an accredited investor within the meaning of Rule 501 of Regulation D under the Securities Act.\\n\\n\\n| Exhibit No. | Description |\\n| 2.1 | Plan of Merger by and among Assisted 4 Living, Inc., BPCC Acquisition, Inc. and Banyan Pediatric Care Centers, Inc. dated March 23, 2021. (Previously filed on March 29, 2021 as Exhibit 2.1 of the Company’s Current Report on Form 8-K) |\\n| 31.1 | Certification of Principal Executive Officer filed pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 31.2 | Certification of Principal Financial Officer filed pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 32.1 | Certification of Chief Executive Officer furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 32.2 | Certification of Chief Financial Officer furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 101.INS | XBRL Instance Document |\\n| 101.SCH | XBRL Taxonomy Extension Schema Document |\\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document |\\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document |\\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document |\\n\\n\\n| 10 |\\n\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n\\n| ASSISTED 4 LIVING, INC. |\\n| (Registrant) |\\n| Dated: May 18, 2021 | /s/ Louis Collier |\\n| Louis Collier |\\n| Chief Executive Officer (principal executive officer) |\\n\\n\\n| 11 |\\n\\n \\n\\nWhat is the growth rate of the shareholders' deficit from the period of three months ended March 31, 2020 to the same period in 2021 in percentage?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is -11.259563739001619.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 43,\n \"input_length\": 19987\n}"}}},{"rowIdx":44,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nTITAN COMPUTER SERVICES, INC.\n(UNAUDITED)\nContents\n\n| Page |\n| Condensed Consolidated Financial Statements (unaudited) |\n| Condensed Consolidated Balance Sheets as of March 31, 2018 (unaudited) and December 31, 2017 | 4 |\n| Condensed Consolidated Statements of Operations for the three months ended March 31, 2018 (unaudited) | 5 |\n| Condensed Consolidated Statement of Cash Flows for the three months ended March 31, 2018 (unaudited) | 6 |\n| Notes to Condensed Consolidated Financial Statements (unaudited) | 7-16 |\n\n3\n\n| TITAN COMPUTER SERVICES, INC. |\n| and Subsidiary |\n| Condensed Consolidated Balance Sheets |\n\n\n| March 31, | December 31, |\n| 2018 | 2017 |\n| (unaudited) |\n| ASSETS |\n| Current assets |\n| Cash | $ | 18,667 | $ | 24,867 |\n| Prepaid expense | 4,166 | 4,167 |\n| Total current assets | 22,833 | 29,034 |\n| Fixed assets, net | 7,842 | 8,713 |\n| Intangible assets, net | 11,824 | 11,977 |\n| Total assets | $ | 42,499 | $ | 49,724 |\n| LIABILITIES AND STOCKHOLDERS’ DEFICIT |\n| Current liabilities |\n| Notes payable - related party | $ | 60,000 | $ | - |\n| Accounts payable - related party | 7,707 | 4,167 |\n| Accrued expenses | 221,993 | 189,198 |\n| Accrued expenses - related party | 9,923 | - |\n| Shareholder’s advance | 26,764 | 26,764 |\n| Total current liabilities | 326,387 | 220,129 |\n| Total liabilities | 326,387 | 220,129 |\n| Commitments and contingencies - Note 6 |\n| Stockholders’ deficit |\n| Preferred stock - no par value, 5,000,000 shares authorized, no shares issued and outstanding at March 31, 2018 and December 31, 2017, respectively | - | - |\n| Common stock - no par value, 70,000,000 shares authorized, 22,803,659 and 21,728,659 shares issued, issuable, and outstanding at March 31, 2018 and December 31, 2017, respectively | 1,717,894 | 269,769 |\n| Additional paid in capital | (149,769 | ) | (149,769 | ) |\n| Accumulated deficit | (1,852,013 | ) | (290,405 | ) |\n| Total stockholders’ deficit | (283,888 | ) | (170,405 | ) |\n| Total liabilities and stockholders’ deficit | $ | 42,499 | $ | 49,724 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n4\n\n| TITAN COMPUTER SERVICES, INC. |\n| and Subsidiary |\n| Condensed Consolidated Statement of Operations |\n| For the three months ended March 31, 2018 |\n| (unaudited) |\n\n\n| Revenue | $ | - |\n| Operating expenses |\n| Professional fees | 12,900 |\n| Corporate expenses | 13,559 |\n| Salary expenses | 31,250 |\n| Stock-based compensation | 1,448,125 |\n| Other general and administrative expenses | 39,748 |\n| Total operating expenses | 1,545,582 |\n| Loss from operations | (1,545,582 | ) |\n| Other income (expenses) |\n| Interest expense | (16,026 | ) |\n| Total other income (expenses) | (16,026 | ) |\n| Net loss | $ | (1,561,608 | ) |\n| Earnings per share - basic and fully diluted | $ | (0.07 | ) |\n| Weighted average number of shares of common stock - basic and fully diluted | 22,768,103 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n5\n\n| TITAN COMPUTER SERVICES, INC. |\n| and Subsidiary |\n| Condensed Consolidated Statement of Cash Flows |\n| For the three months ended March 31, 2018 |\n| (unaudited) |\n\n\n| Cash flows from operating activities: |\n| Net loss | $ | (1,561,608 | ) |\n| Adjustments to reconcile net loss to net cash used in operations: |\n| Depreciation expense | 871 |\n| Amortization expense | 153 |\n| Stock-based compensation | 1,448,125 |\n| Change in assets and liabilities: |\n| Accrued expenses | 30,233 |\n| Accrued expenses - related party | 16,026 |\n| Net cash used in operating activities | (66,200 | ) |\n| Cash flows from financing activities: |\n| Proceeds from notes payable - related party | 60,000 |\n| Net cash provided by financing activities | 60,000 |\n| Net decrease in cash | (6,200 | ) |\n| Cash at beginning of period | 24,867 |\n| Cash at end of period | $ | 18,667 |\n| Supplemental disclosure of cash flow information: |\n| Cash paid for interest | $ | - |\n| Cash paid for taxes | $ | - |\n\n\n| The accompanying notes are an integral part of these consolidated financial statements. |\n| The financial statements only reflect the current year as the Company was established on May 18, 2017. |\n\n6\nTITAN COMPUTER SERVICES, INC.\nAnd Subsidiary\nNotes to the Condensed Consolidated Financial Statements\nMarch 31, 2018\n(unaudited)\nNOTE 1 – NATURE OF OPERATIONS\nCompany Background\nTitan Computer Services, Inc. (the “Company,” “we,” “us,” “our,” or “Altitude - NY”), was incorporated in the State of New York on July 13, 1994.\nOn June 27, 2017, the Company successfully closed a Share Exchange transaction (“Share Exchange”) with the shareholders of Altitude International, Inc, (“Altitude”) a Wisconsin corporation. Altitude was incorporated on May 18, 2017 under the laws of the state of Wisconsin. Altitude will operate through Northern, Central, and South America sales by way of its sole distribution agreement with Woodway Inc. to execute the current business plan of athletic training industry, specifically altitude training. Our objective is to be recognized as one of the upper tier specialty altitude training equipment providers.\nEffective February 13, 2018, majority of the shareholders of the Company approved the following changes to the Company’s Articles of Incorporation:\nAmend the Bylaws to Permit a Simple Majority Vote and Allow for the Appointment of up to Seven\nArticle II Section 10 of the Company’s Bylaws stated, “Any action required or permitted to be taken by the Shareholders thereof may be taken without a meeting if all Shareholders entitled to vote thereon consent in writing to the adoption of a resolution authorizing the action except as otherwise permitted by the Certificate of Incorporation.”\nThe Bylaws were amended to allow for a simple majority vote as permitted by §615 of the New York Business Corporation Law. The amended section shall read, “Any action required or permitted to be taken by the Shareholders thereof may be taken without a meeting if a majority of the Shareholders entitled to vote thereon consent in writing to the adoption of a resolution authorizing the action.”\nArticle III Section 2 of the Company’s Bylaws provided that the number of Directors constituting the entire Board “shall not be less than one nor more than three, as may be fixed by resolution of the Board of Director.” The Bylaws were amended to allow for additional directors as proposed herein (up to four) and to allow for additional directors as the Company grows (up to seven). The amended section shall include the number “seven” instead of “three” as the maximum number of directors.\nName Change from “Titan Computer Services, Inc.” to “Altitude International, Inc.”\nOn February 13, 2018, the majority of the shareholders of the Company approved the amendment to the Articles of Incorporation to change the Company’s name from “Titan Computer Services, Inc.” to “Altitude International, Inc.” The purpose of the name change will help further our brand identity and will reflect the major focus of our business operations, the manufacturing and distribution of products in the athletic training industry, specifically altitude training. The filing of the name change with the state of New York has not been completed as of the date of this report. Once processed by New York, the Company will apply for a name and symbol change with FINRA.\nNature of Operations\nThe product designs to be licensed from Sporting Edge UK, Ltd (“Sporting Edge UK”) are proven and cover a wide range of room sizes. The only requirement is to change from metric to imperial sizes where necessary.\nThere are three unique elements to the Altitude product:\n\n| · | Sophisticated Touch Screen control systems capable of integrating the control of simulated altitude, temperature and humidity. |\n\n\n| · | A unique design of Air Separation Unit with only a single active part that provides for ultra-reliable operation and a design life of greater than fifteen years. |\n\n\n| · | Proven training protocols that allow the desired training benefits to be achieved. |\n\n7\nAltitude has leased space in the Woodway facility in Waukesha, Wisconsin to undertake the manufacture of systems. The work will primarily consist of the assembly of components into the unique licensed designs. Initial recruitment of technically-capable persons will be necessary, followed by short training blocks to pass on the required skills. At least one person is likely to visit the UK to see systems in operation and obtain hands-on experience of the manufacturing requirement. Woodway is an engineering-based company and provides the perfect environment to establish an operation which is in many ways similar to their own. In addition, many aspects of infrastructure – goods handling, welfare facilities, etc. – can be accessed immediately without expense to Altitude.\nRecapitalization of Altitude\nOn June 27, 2017, the Company entered into a share exchange transaction with Altitude which resulted in a change of control of the Company. Pursuant to the terms of the Share Exchange, the Company agreed to issue 6,102,000 shares of its common stock to all the individual shareholders of Altitude on a pro rata basis (one to one share exchange). In exchange for this stock issuance, the Company received 100% of the outstanding shares of Altitude. Following this Share Exchange, Altitude became a wholly-owned subsidiary of Titan. There was a cancellation of 14,700,000 shares of common stock of the Company that was held by the Company’s former majority stockholder as part of the share exchange agreement, which all had a net effect of a decrease of 8,598,000 shares in the Company’s outstanding shares. The business, assets and liabilities of the Company changed as a result of this reverse acquisition to Altitude’s business plan.\nThis share exchange transaction resulted in those shareholders obtaining a majority voting interest in –the Company and control of the Board of Directors of the Company. Generally accepted accounting principles require that the Company whose shareholders retain the majority interest and control in a combined business be treated as the acquirer for accounting purposes, resulting in a reverse acquisition with Altitude as the accounting acquirer and the Company as the acquired party. Accordingly, the share exchange transaction has been accounted for as a recapitalization of Altitude, whereby is deemed to be the continuing, surviving entity for accounting purposes but through reorganization, has deemed to have adopted the capital structure of Altitude - NY. The equity section of the accompanying condensed consolidated financial statements has been restated to reflect the recapitalization of the Company due to the reverse acquisition.\nAccordingly, all references to common shares of Altitude’s common stock have been restated to reflect the equivalent number of the Company’s common shares. In other words, the 6,102,000 Altitude shares outstanding at the time of the share exchange are restated to 21,228,659 common shares (prior to the 500,000 common share capital raise mentioned below that was conducted after the share exchange agreement), as of June 27, 2017. Each share of Altitude is accordingly restated at a multiple of approximately 3.48 shares of the Company for the weighted average shares outstanding for the loss per share calculations in the accompanying condensed consolidated statement of operations.\nThe book value of the net assets that for accounting purposes, were deemed to have been acquired by Altitude from the Company, as of the date of acquisition (June 27, 2017) were $0, after the waiver of all debts from officers and third parties.\nA condition to the closing of the Share Exchange Agreement was raising $100,000 in the Company. On June 27, 2017, the Company issued 500,000 shares of its common stock to an accredited investor pursuant to a Subscription Agreement for $100,000, or $0.20 per share which was kept at escrow account. During the recapitalization, the Company incurred legal fees of $12,500 which was paid through the attorney’s escrow account and recorded as transaction costs which were netted against the $100,000 proceeds.\nAltitude International, Inc.\nAltitude International, Inc. (“Altitude”) was incorporated on May 18, 2017 under the laws of the state of Wisconsin with 100,000,000 authorized common stock with $0.001 par value. On May 18, 2017, 6,102,000 shares of common stock at $0.001 (par) were issued as founder shares, valued at a total of $6,102 to 15 individuals, including Mr. Dave Vincent who is the majority equity interest shareholder and the director of the Company. These shares were issued for future potential services from these various individuals and as of the date of this issuance, no value was placed on these future potential services and were therefore recorded at par value as stock-based compensation to the founders.\nOn June 27, 2017, after the closing of certain Stock Purchase Agreements, in private sale transaction and the Share Exchange Agreement, a change of control of the Company occurred, see recapitalization of Altitude mentioned above. Dave Vincent was the majority shareholder of the Company, owning 51.3 % of the issued and outstanding common shares of –the Company. See Notes 6 and 8.\nAltitude will operate through Northern, Central, and South America sales by way of its sole distribution agreement with Woodway Inc. to execute the current business plan of athletic training industry, specifically altitude training. Our objective is to be recognized as one of the upper tier specialty altitude training equipment providers.\n8\nChanges in Management and the Board of Directors\nOn June 27, 2017, pursuant to the Closing of the Share Exchange Agreement, Mr. Dave Vincent was appointed as the Company’s new CEO and Abraham Rosenblum resigned as CEO. Additionally, Mr. Vincent and Mr. Robert Kanuth were appointed as directors of the Company and Mr. Robert Klein resigned. On October 20, 2017, Greg Whyte was appointed to fill the vacancy as a director of the Company. On January 8, 2018, Joseph B. Frost was appointed to serve as the Chief Operating Officer and on February 13, 2018 Lesley Visser and Joseph B. Frost were elected to serve on the Board of Directors.\nNOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nBasis of presentation\nThe Company follows the accrual basis of accounting in accordance with generally accepted accounting principles in the United States of America and has a year-end of December 31.\nThe preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.\nManagement further acknowledges that it is solely responsible for adopting sound accounting practices, establishing and maintaining a system of internal accounting control and preventing and detecting fraud. The Company’s system of internal accounting control is designed to assure, among other items, that 1) recorded transactions are valid; 2) valid transactions are recorded; and 3) transactions are recorded in the proper period in a timely manner to produce financial statements which present fairly the financial condition, results of operations and cash flows of the Company for the respective periods being presented.\nGoing Concern and Liquidity\nWe have incurred recurring losses since inception and expect to continue to incur losses as a result of legal and professional fees and our corporate general and administrative expenses. At March 31, 2018, we had $18,667 in cash. Our net losses incurred for the three months ended March 31, 2018 amounted to $1,561,608 and working capital deficit was $303,554 at March 31, 2018. As a result, there is substantial doubt about our ability to continue as a going concern. In the event that we are unable to generate sufficient cash from our operating activities or raise additional funds, we may be required to delay, reduce or severely curtail our operations or otherwise impede our on-going business efforts, which could\nhave a material adverse effect on our business, operating results, financial condition and long-term prospects. The Company expects to seek to obtain additional funding through increased revenues and future financings. There can be no assurance as to the availability or terms upon which such financing and capital might be available.\nPrinciples of Consolidation\nThe consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Altitude. All significant intercompany balances and transactions have been eliminated in the consolidation. The consolidated financial statements included herein, presented in accordance with United States generally accepted accounting principles (“GAAP”) and stated in United States dollars, have been prepared by the Company, pursuant to the rules and regulations of the Securities and Exchange Commission.\nUse of Estimates\nThe preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.\nSignificant Estimates, Risks and Concentrations\nThese accompanying financial statements include some amounts that are based on management’s best estimates and judgments. The most significant estimates relate to the valuation of the software rights and redeemable common stock liability. It is reasonably possible that the above-mentioned estimate and others may be adjusted as more current information becomes available, and any adjustment could be significant in future reporting periods.\n9\nThe Company is dependent on its ability to handle rapidly substantial quantities of data and transactions on computer-based networks and the capacity, reliability and security of the electronic delivery systems and the Internet. Any significant failure or interruption of these systems could cause our systems to operate slowly or interrupt service for periods of time and could have a material adverse effect on our business and results of our operations. The Company may experience shortage of capacity and increased costs associated with such usage. These events may affect our ability to store, handle and deliver data and services to our customers.\nCash and Cash Equivalents\nThe Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents.\nProperty, Plant and Equipment\nProperty and equipment are stated at cost, net of accumulated depreciation. Expenditures that extend the life, increase the capacity, or improve the efficiency of property and equipment are capitalized, while expenditures for repairs and maintenance are expensed as incurred. Depreciation is recognized using the straight-line method over the following approximate useful lives:\nMachinery and equipment\n3-5 Years\nIntangible Assets\nCosts incurred to file patent applications and acquired intangibles are capitalized when the Company believes that there is a high likelihood that the patent will be issued and there will be future economic benefit associated with the patent. These costs will be amortized on a straight-line basis over a 20 years life from the date of patent filing. All costs associated with abandoned patent applications are expensed. In addition, the Company will review the carrying value of patents for indicators of impairment on a periodic basis and if it determines that the carrying value is impaired, it values the patent at fair value. As of March 31, 2018, carrying value of patent was $11,824.\nIn accordance with the provisions of the applicable authoritative guidance, the Company’s long-lived assets and amortizable intangible assets are tested for impairment whenever events or changes in circumstances indicate that their carrying value may not be recoverable. The Company assesses the recoverability of such assets by determining whether their carrying value can be recovered through undiscounted future operating cash flows, including its estimates of revenue driven by assumed market segment share and estimated costs. If impairment is indicated, the\nCompany measures the amount of such impairment by comparing the fair value to the carrying value. The amortization of the trademark was not significant for the period ended March 31, 2018.\nImpairment of Long-Lived Assets\nThe Company’s long-lived assets and other assets (consisting of property and equipment) are reviewed for impairment in accordance with the guidance of the FASB ASC Topic 360-10, Property, Plant, and Equipment, and FASB ASC Topic 205, Presentation of Financial Statements. Long lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the undiscounted future net cash flows expected to be generated by that asset. If the carrying amount of an asset exceeds its estimated future undiscounted cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. For the three months ended March 31, 2018, the Company had not experienced impairment losses on its long-lived assets.\nRevenue Recognition\nThe Company recognizes revenue in accordance with ASC 605 Revenue Recognition (“ASC 605”). Revenue is recognized when all of the following four criteria are met: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services rendered, (3) the fee is fixed and determinable, and (4) collectability is reasonably assured. Determining whether and when some of these criteria have been satisfied often involves assumptions and judgments that can have a significant impact on the timing and amount of revenue we report.\nAdvertising Costs\nAdvertising costs are expensed as incurred. Advertising costs for the three months ended March 31, 2018 was $0.\n10\nStock-Based Compensation\nThe Company accounts for stock-based instruments issued to employees in accordance with ASC Topic 718. ASC Topic 718 requires companies to recognize in the statement of operations the grant-date fair value of stock options and other equity-based compensation issued to employees. The value of the portion of an award that is ultimately expected to vest is recognized as an expense over the requisite service periods using the straight-line attribution method. The Company accounts for non-employee share-based awards in accordance with the measurement and recognition provisions ASC Topic 505-50. The Company estimates the fair value of stock options at the grant date by using the Black-Scholes option-pricing model.\nFair Value of Financial Instruments\nThe book values of cash, prepaid expenses, and accounts payable approximate their respective fair values due to the short-term nature of these instruments. The fair value hierarchy under GAAP distinguishes between assumptions based on market data (observable inputs) and an entity’s own assumptions (unobservable inputs).\nThe hierarchy consists of three levels\n\n| · | Level one — Quoted market prices in active markets for identical assets or liabilities; |\n| · | Level two — Inputs other than level one inputs that are either directly or indirectly observable; and |\n| · | Level three — Unobservable inputs developed using estimates and assumptions, which are developed by the reporting entity and reflect those assumptions that a market participant would use. |\n\nDetermining which category an asset or liability falls within the hierarchy requires significant judgment. We evaluate our hierarchy disclosures each quarter.\nEarnings (Loss) Per Share\nBasic earnings (loss) per share are computed by dividing the net income by the weighted-average number of shares of common stock and common stock equivalents (primarily outstanding options and warrants). Common stock equivalents represent the dilutive effect of the assumed exercise of the outstanding stock options and warrants, using the treasury stock method. The calculation of fully diluted earnings per share assumes the dilutive effect of the exercise of outstanding options and warrants at either the beginning of the respective period presented or the date of issuance, whichever is later.\nIncome Taxes\nThe Company accounts for income taxes in accordance with FASB ASC 740, “Income Taxes”. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statements carrying amounts of existing assets and liabilities and loss carry-forwards and their respective tax bases.\nDeferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income (loss) in the years in which those temporary differences are expected to be recovered or settled.\nThe effect of a change in tax rules on deferred tax assets and liabilities is recognized in operations in the year of change. A valuation allowance is recorded when it is “more likely-than-not” that a deferred tax asset will not be realized.\nTax benefits of uncertain tax positions are recognized only if it is more likely than not that the Company will be able to sustain a position taken on an income tax return. The Company has no liability for uncertain tax positions as of December 31, 2017. Interest and penalties in any, related to unrecognized tax benefits would be recognized as interest expense. The Company does not have any accrued interest or penalties associated with unrecognized tax benefits, nor was any significant interest expense recognized during the three months ended March 31, 2018.\nOn December 22, 2017, the United States Government passed new tax legislation that, among other provisions, will lower the corporate tax rate from 35% to 21%. In addition to applying the new lower corporate tax rate in 2018 and thereafter to any taxable income we may have, the legislation affects the way we can use and carry forward net operating losses previously accumulated and results in a revaluation of deferred tax assets recorded on our balance sheet. Given that the deferred tax assets are offset by a full valuation allowance, these changes will have no net impact on the Company’s financial position and net loss. However, if and when we become profitable, we will receive a reduced benefit from such deferred tax assets. Had this legislation been effective prior to our December 31, 2017, fiscal year-end, the effect of the legislation would have been a reduction in deferred tax assets and the corresponding valuation allowance.\n11\nContingencies\nCertain conditions may exist as of the date the financial statements are issued, which may result in a loss to the Company, but which will only be resolved when one or more future events occur or fail to occur. The Company’s management and its legal counsel assess such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or unasserted claims that may result in such proceedings, the Company’s legal counsel evaluates the perceived merits of any legal proceedings or unasserted claims as well as the perceived merits of the amount of relief sought or expected to be sought therein.\nIf the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s financial statements. If the assessment indicates that a potentially material loss contingency is not probable, but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, together with an estimate of the range of possible loss if determinable and material, would be disclosed.\nLoss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the nature of the guarantee would be disclosed.\nEffect of Recent Accounting Pronouncements\nGoing Concern\nASU 2014-15 – “Presentation of Financial Statements—Going Concern—Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (“ASU 2014-15”).” In August 2014, FASB issued guidance that requires management to perform interim and annual assessments of an entity’s ability to continue as a going concern within one year of the date the financial statements are issued. An entity must provide certain disclosures if conditions or events raise substantial doubt about the entity’s ability to continue as a going concern. The updated accounting guidance was effective for the Company on March 31, 2018. We have implemented this new accounting standard and we will update our liquidity disclosures as necessary.\nRecent Accounting Pronouncements\nRecently-Issued Accounting Standards: Management does not believe that any recently issued, but not yet effective, accounting standards if currently adopted would have a material effect on the accompanying financial statements.\nFinancial Instruments\nIn January 2016, the FASB issued ASU No. 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”), which updates certain aspects of recognition, measurement, presentation and disclosure of financial instruments. ASU 2016-01 will be effective for the Company beginning in its first quarter of 2019. The Company does not believe the adoption of ASU 2016-01 will have a material impact on its consolidated financial statements.\nIn June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which modifies the measurement of expected credit losses of certain financial instruments. ASU 2016-13 will be effective for the Company beginning in its first quarter of 2021 and early adoption is permitted. The Company does not believe the adoption of ASU 2016-13 will have a material impact on its consolidated financial statements.\nLeases\nIn February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”), which modified lease accounting for both lessees and lessors to increase transparency and comparability by recognizing lease assets and lease liabilities by lessees for those leases classified as operating leases under previous accounting standards and disclosing key information about leasing arrangements. ASU 2016-02 will be effective for the Company beginning in its first quarter of 2020, and early adoption is permitted. The Company is currently evaluating the timing of its adoption and the impact of adopting ASU 2016-02 on its financial statements.\nStock Compensation\nIn March 2016, the FASB issued ASU No. 2016-09, Compensation – Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”), which simplified certain aspects of the accounting for share-based payment transactions, including income taxes, classification of awards and classification on the statement of cash flows. ASU 2016-09 will be effective for the Company beginning in its first quarter of 2018. The Company is currently evaluating the impact of adopting ASU 2016-09 on its consolidated financial statements.\n12\nIncome Taxes\nIn October 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-16, Income Taxes (Topic 740): Intra-Entity Transfer of Assets Other than Inventory (“ASU 2016-16”), which requires the recognition of the income tax consequences of an intra-entity transfer of an asset, other than inventory, when the transfer occurs. ASU 2016-06 will be effective for the Company in its first quarter of 2019. The Company is currently evaluating the impact of adopting ASU 2016-16 on its consolidated financial statements.\nRevenue Recognition\nIn May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”), which amends the existing accounting standards for revenue recognition. ASU 2014-09 is based on principles that govern the recognition of revenue at an amount an entity expects to be entitled when products are transferred to customers. ASU 2014-09 will be effective for the Company beginning in its first quarter of 2019, and early adoption is permitted.\nSubsequently, the FASB has issued the following standards related to ASU 2014-09: ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (“ASU 2016-08”); ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing (“ASU 2016-10”); and ASU No. 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients (“ASU 2016-12”). The Company must adopt ASU 2016-08, ASU 2016-10 and ASU 2016-12 with ASU 2014-09 (collectively, the “new revenue standards”).\nThe new revenue standards may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of adoption. The Company currently expects to adopt the new revenue standards in its first quarter of 2018 utilizing the full retrospective transition method. The Company is evaluating the effect of the adoption of the new revenue recognition standard as to whether it will have a material impact on its consolidated financial statements.\nNOTE 3 – FIXED ASSETS\nThe Company has fixed assets related to office equipment. The depreciation of the equipment is over a three-year period. As of March 31, 2018, and December 31, 2017, the Company had fixed assets, net of accumulated depreciation, of $7,842 and $8,713, respectively. The fixed assets are as follows:\n\n| March 31, | December 31, |\n| 2018 | 2017 |\n| Office equipment | $ | 10,455 | $ | 10,455 |\n| Total fixed assets | 10,455 | 10,455 |\n| Less: Accumulated depreciation | 2,613 | 1,742 |\n| Fixed assets, net | $ | 7,842 | $ | 8,713 |\n\nDepreciation of the office equipment for the three months ended March 31, 2018 was $871.\nNOTE 4 – INTANGIBLE ASSETS - TRADEMARK\nThe Company has intangible assets related to a trademark. The amortization of the intangible asset is over a twenty-year period. As of March 31, 2018, and December 31, 2017, the Company had intangible assets, net of accumulated amortization, of $11,824 and $11,977, respectively. The intangible assets are as follows:\n\n| March 31, | December 31, |\n| 2018 | 2017 |\n| Trademark | $ | 12,284 | $ | 12,284 |\n| Total intangible assets | 12,284 | 12,284 |\n| Less: Accumulated amortization | 460 | 307 |\n| Intangible assets, net | $ | 11,824 | $ | 11,977 |\n\nAmortization expense of the trademark for the three months ended March 31, 2018 was $153.\n13\nNOTE 5 – NOTES PAYABLE\n\n| Notes payable |\n| March 31, 2018 | December 31, 2017 |\n| Accrued | Accrued |\n| Principal | Interest | Total | Principal | Interest | Total |\n| Dave Vincent | $ | 20,000 | $ | 581 | $ | 20,581 | $ | - | $ | - | $ | - |\n| Joseph B. Frost | 40,000 | 679 | 40,679 | - | - | - |\n| Total | $ | 60,000 | $ | 1,260 | $ | 61,260 | $ | - | $ | - | $ | - |\n\nOn February 7, 2018, Dave Vincent, the Company’s majority shareholder and director, loaned the Company $20,000 in the form of a promissory note. The note bears interest of 20% and has the term of one year, at which time all principal and interest will be paid in a balloon payment. As of March 31, 2018, the accrued interest was $581, and the principal balance was $20,000. See Note 7.\nOn March 2, 2018, Joseph B. Frost, a director, loaned the Company $40,000 in the form of a promissory note. The note bears interest of 20% and has the term of one year, at which time all principal and interest will be paid in a balloon payment. As of March 31, 2018, the accrued interest was $679, and the principal balance was $40,000. See Note 7.\nNOTE 6 – COMMITMENTS AND CONTINGENCIES\nThe Company is subject, from time to time, to claims by third parties under various legal disputes. The defense of such claims, or any adverse outcome relating to any such claims, could have a material adverse effect on the Company’s liquidity, financial condition and cash flows. As of May 14, 2018, the Company did not have any legal actions pending against it.\nOn June 27, 2017, Altitude entered a license agreement with Sporting Edge UK (see Note 1), Sporting Edge UK is the sole and exclusive owner of and has the right to license to licensee the ability to manufacture and sell rights to the full range of membrane-based systems for the production of reduced oxygen environments and associated services as well as the use of patents and trademarks held by Sporting Edge UK or Mr. David Vincent.\nSporting Edge UK agreed to grant the licensee exclusive right and license to the Manufacturing and Sales Rights in the Territory including the Continent of North America, Central America and the Continent of South America. On the effective date of this agreement and for a period of 5 years thereafter, the Company (“Licensee”) shall pay upfront payment of $10,000 to Licensor annually. In addition, commencing on the sixth anniversary of the effective date the licensee shall pay continuing royalty fees on all sales of product manufactured using the IP. The royalty payable shall be calculated as 0.5% of the Sale Price. The Company recorded the payment due of $4,167 under Prepaid expenses and accounts payable as of December 31, 2017.\nNOTE 7 – RELATED PARTY TRANSACTIONS\nAs of December 31, 2017, the balance due to our current CEO, David Vincent, was recorded under shareholder’s advance of $26,764, which is a verbal agreement, non-interest bearing, unsecured and payable on demand. These advances included $10,455 of acquisition of office equipment and $12,284 of acquisition of trademark which were disclosed at supplemental disclosure of non-cash flow investing activities of the statement of cash flow. On February 9, 2018, the Board of Directors changed the arrangement whereas the advance would begin accruing interest at the rate of 20%.\nAltitude has an oral agreement with its Chairman of the Board, Robert Kanuth, in which it will provide for reimbursement of private airline travel expenses incurred on behalf of the Company, for his use of an aircraft in which he has an interest in. These travel expenses totaled $123,750 for the period ended December 31, 2017 and is included in accrued expenses at March 31, 2018. In January 2018, the Board of Directors issued a one-time bonus to Mr. Kanuth, in the amount of $7,525, to compensate for the significant payable and what would have been interest. Additionally, the open balance will accrue interest at the rate of 20% per annum and, as of March 31, 2018, the accrued interest was $6,103.\nOn January 2, 2018, the Company issued 1,000,000 shares of common stock to Joseph B. Frost, the Company’s Chief Operating Officer, under his employment agreement. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $1,350,000. See Note 8.\n14\nOn February 7, 2018, Dave Vincent, the Company’s majority shareholder and director, loaned the Company $20,000 in the form of a promissory note. The note bears interest of 20% and has the term of one year, at which time all principal and interest will be paid in a balloon payment. As of March 31, 2018, the accrued interest was $581, and the principal balance was $20,000. See Note 5.\nOn March 2, 2018, Joseph B. Frost, a director, loaned the Company $40,000 in the form of a promissory note. The note bears interest of 20% and has the term of one year, at which time all principal and interest will be paid in a balloon payment. As of March 31, 2018, the accrued interest was $679, and the principal balance was $40,000. See Note 5.\nNOTE 8 – STOCKHOLDERS’ EQUITY\nPreferred Stock\nOn February 5, 2015, the Board of Directors of the Company authorized 5,000,000 shares of preferred stock with no par value. Each share of the preferred stock is entitled to one vote and is convertible into one share of common stock.\nAs of March 31, 2018, and December 31, 2017, the Company has no preferred stock issued and outstanding.\nCommon Stock\nAltitude was incorporated on May 18, 2017 under the laws of the state of Wisconsin with 100,000,000 authorized common stock with $0.001 par value.\nOn June 12, 2017, Altitude issued 6,102,000 shares of its common stock at par value of $0.001 per share as founder shares for future potential services from 15 individuals, including David Vincent, who is the majority equity interest shareholder and the director of the Company, with a total recorded at par value of $6,102.\nOn June 27, 2017, the Company entered into a share exchange transaction with Altitude and the shareholders of Altitude. Pursuant to the terms of the Share Exchange, the Company agreed to issue 6,102,000 shares of its common stock to the individual shareholders of Altitude on a pro rata basis in exchange for receive 100% of the shares of Altitude. Following the Share Exchange, Altitude became a wholly-owned subsidiary of the Company. See Note 1.\nPrior to the Share Exchange Agreement, there were 22,828,659 shares of common stock of the Company issued and outstanding, 14,700,000 of which were cancelled on June 27, 2017. As consideration for the Share Exchange Agreement, the shareholders of Altitude received a total of 6,102,000 restricted shares of –the Company, proportionate to their shareholdings in Altitude.\nOn June 27, 2017, the date of closing of the Share Exchange Agreement, the Company issued 500,000 shares of its common stock to an accredited investor pursuant to a Subscription Agreement for $100,000, or $0.20 per share. Total proceed received was $87,500 after paying transaction costs of $12,500. Immediately following the Share Exchange agreement, there will are 21,728,659 shares of common stock issued and outstanding and no shares of preferred stock outstanding.\nOn January 1, 2018, the Company was contractually obligated to issue its legal counsel 37,500 shares of common stock for legal work to date. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $50,625.\nOn January 1, 2018, the Company was contractually obligated to issue its legal counsel 12,500 shares of common stock for legal work for January 2018. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $16,875.\nOn January 2, 2018, the Company issued 1,000,000 shares of common stock to Joseph B. Frost, the Company’s Chief Operating Officer, under his employment agreement. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $1,350,000. See Note 7.\nOn February 1, 2018, the Company was contractually obligated to issue its legal counsel 12,500 shares of common stock for legal work for February 2018. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $16,875.\nOn March 1, 2018, the Company was contractually obligated to issue its legal counsel 12,500 shares of common stock for legal work for March 2018. The common stock of the Company is thinly traded and had a value of $1.10 per share, therefore the Company recorded the transaction at $13,750. As of March 31, 2018, these shares had not been issued.\n15\nAs of March 31, 2018, and December 31, 2017, the Company has 22,803,659 and 21,728,659 shares of no par common stock issued, issuable, and outstanding.\nStock Option Plan\nOn February 13, 2018, the Company’s shareholders and Board of Directors approved the 2017 Incentive Stock Plan.\nNOTE 9 – INCOME TAXES\nAs of March 31, 2018, and December 31, 2017, the Company has net operating loss carry forwards of $403,890 and $290,405. The carry forward expires through the year 2038. The Company’s net operating loss carry forwards may be subject to annual limitations, which could reduce or defer the utilization of the losses as a result of an ownership change as defined in Section 382 of the Internal Revenue Code.\nThe Company’s tax expense differs from the “expected” tax expense for Federal income tax purposes (computed by applying the United States Federal tax rate of 21% to loss before taxes for fiscal year 2018 and 34% to loss before taxes for fiscal year 2017), as follows:\n\n| March 31, | December 31, |\n| 2018 | 2017 |\n| Tax expense (benefit) at the statutory rate | $ | (23,832 | ) | $ | (60,985 | ) |\n| State income taxes, net of federal income tax benefit |\n| Change in valuation allowance | 23,832 | 60,985 |\n| Total | $ | - | $ | - |\n\nThe tax effects of the temporary differences between reportable financial statement income and taxable income are recognized as deferred tax assets and liabilities.\nThe tax year 2017 remains to examination by federal agencies and other jurisdictions in which it operates.\nThe tax effect of significant components of the Company’s deferred tax assets and liabilities at March 31, 2018 and December 31, 2017, are as follows:\n\n| March 31, | December 31, |\n| 2018 | 2017 |\n| Deferred tax assets: |\n| Net operating loss carryforward | $ | 84,817 | $ | 60,985 |\n| Timing differences | - | - |\n| Total gross deferred tax assets | 84,817 | 60,985 |\n| Less: Deferred tax asset valuation allowance | (84,817 | ) | (60,985 | ) |\n| Total net deferred taxes | $ | - | $ | - |\n\nIn assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment.\nBecause of the historical earnings history of the Company, the net deferred tax assets for 2018 and 2017 were fully offset by a 100% valuation allowance. The valuation allowance for the remaining net deferred tax assets was $84,817 and $60,985 as of March 31, 2018 and December 31, 2017, respectively.\nOn December 22, 2017, the United States Government passed new tax legislation that, among other provisions, will lower the corporate tax rate from 34% to 21%. In addition to applying the new lower corporate tax rate in 2018 and thereafter to any taxable income we may have, the legislation affects the way we can use and carry forward net operating losses previously accumulated and results in a revaluation of deferred tax assets recorded on our balance sheet. Given that the deferred tax assets are offset by a full valuation allowance, these changes will have no net impact on the Company’s financial position and net loss. However, if and when we become profitable, we will receive a reduced benefit from such deferred tax assets. Had this legislation been effective prior to our December 31, 2017, fiscal year-end, the effect of the legislation would have been a reduction in deferred tax assets and the corresponding valuation allowance.\n16\n\nResults of Operations\nFor the three months ended March 31, 2018 Revenue The Company had no revenue for the three months ended March 31, 2018. Operating Expenses The Company had operating expenses of $1,545,582 for the three months ended March 31, 2018, which primarily consisted of stock-based compensation of $1,448,125. Net Loss The Company had a net loss of $1,561,608 for the three months ended March 31, 2018. The net loss was primarily to the abovementioned effect. Liquidity and Capital Resources As of March 31, 2018, the Company had cash and cash equivalents of $18,667. We do not have sufficient resources to effectuate our business. We expect to incur a minimum of $320,000 in expenses during the next twelve months of operations. We estimate that these expenses will be comprised primarily of general expenses including overhead, legal and accounting fees.\nWe used cash in operations of $66,200 for the three months ended March 31, 2018. The negative cash flow from operating activities for the three months ended March 31, 2018 is attributable to the Company’s net loss from operations of $1,561,608 primarily due to the issuance of common stock for services ($1,448,125).\nWe used cash in investing or financing activities of $0 for the three months ended March 31, 2018.\nWe had cash provided by financing activities of $60,000 for the three months ended March 31, 2018, consisting of loans from Dave Vincent and Joseph B. Frost.\nWe will have to raise funds to pay for our expenses. We may have to borrow money from shareholders or issue debt or equity or enter into a strategic arrangement with a third party. There can be no assurance that additional capital will be available to us. We currently have no arrangements or understandings with any person to obtain funds through bank loans, lines of credit or any other sources. Since we have no such arrangements or plans currently in effect, our inability to raise funds for our operations will have a severe negative impact on our ability to remain a viable company.\nPlan of Operation\nThe Company will produce systems under license from Sporting Edge UK Ltd. These systems include the control of simulated altitude as a minimum and often the simultaneous control of temperature and humidity, providing a full environmental capability. Also included in the license are the Training Protocols that Sporting Edge has established to ensure that the optimum results are achieved by athletes using the altitude facilities. The Company will lease space in the Woodway facility in Waukesha to undertake the manufacture of systems. This will consist primarily of manufacturing space, but with a small office content. The work will primarily consist of the assembly of components into the unique licensed designs. Initial recruitment of technically capable persons will be necessary, followed by short training blocks to pass on the required skills. At least one person is likely to visit the UK to see systems in operation and obtain hands-on experience of the manufacturing requirement. Woodway is an engineering-based company and so is a perfect environment in which to establish an operation which is in many ways similar to their own. In addition, many aspects of infrastructure – goods handling, welfare facilities, etc. – can be accessed immediately without expense to Altitude.\nThe Company has two approaches to penetrating the market.\n| · | The Company has appointed Woodway as the sole Distributor for North, South and Central America. This provides access to every professional Sports Club, College and University as well as many Hospitals and Military facilities. As a result, the time and cost associated with establishing and operating a sales force is avoided. |\n\n\n| · | The Company also has Board members and Company Ambassadors who are able to access key, top level decision makers via their personal contact networks. |\n\n17\nA demonstration Altitude Room has been installed at the Woodway facility in Waukesha to allow effective demonstration of the physiological changes brought about be reduced oxygen air. Customer support and installation activities will be carried out in association with the existing network of Woodway Service Centers. Once again, the cost and time of establishing such a network is avoided whilst ensuring that the vital support element is in place.\nCommercial operations will center in Florida where a second demonstration facility will be located, working in association with an existing top end Fitness facility.\nOff-balance Sheet Arrangements\nWe do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.\n\nNot required.\n\nEvaluation of Disclosure Controls and Procedures\nThe Securities and Exchange Commission defines the term “disclosure controls and procedures” to mean a company’s controls and other procedures of an issuer that are designed to ensure that information required to be disclosed in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Securities Exchange Act of 1934 is accumulated and communicated to the issuer’s management, including its chief executive and chief financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. The Company maintains such a system of controls and procedures in an effort to ensure that all information which it is required to disclose in the reports it files under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified under the SEC’s rules and forms and that information required to be disclosed is accumulated and communicated to the chief executive and interim chief financial officer to allow timely decisions regarding disclosure.\nAs of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures are not effective as of such date. The Chief Executive Officer and Chief Financial Officer have determined that the Company continues to have the following deficiencies which represent a material weakness:\n\n| · | The Company does not have independent directors; |\n| · | Lack of in-house personnel with the technical knowledge to identify and address some of the reporting issues surrounding certain complex or non-routine transactions. With material, complex and non-routine transactions, management has and will continue to seek guidance from third-party experts and/or consultants to gain a thorough understanding of these transactions; |\n| · | Insufficient personnel resources within the accounting function to segregate the duties over financial transaction processing and reporting; and |\n| · | Insufficient written policies and procedures over accounting transaction processing and period end financial disclosure and reporting processes. |\n| · | To remediate our internal control weaknesses, management intends to implement the following measures: |\n| · | As funding permits, the Company will add sufficient accounting personnel to properly segregate duties and to effect a timely, accurate preparation of the financial statements. |\n| · | The Company will hire staff technically proficient at applying U.S. GAAP to financial transactions and reporting. |\n| · | Upon the hiring of additional accounting personnel, the Company will develop and maintain adequate written accounting policies and procedures. |\n\n18\nThe additional hiring is contingent upon The Company’s efforts to obtain additional funding through equity or debt and the results of its operations. Management hopes to secure funds in the coming fiscal year but provides no assurances that it will be able to do so.\nLimitations on the Effectiveness of Controls\nThe Company’s officers do not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of the control system must reflect that there are resource constraints and that the benefits must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Changes in Internal Control Over Financial Reporting During the fiscal quarter covered by this Quarterly Report, there has been no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\n19\nPART II. OTHER INFORMATION\n\nNone.\n\nNot required.\n\nDuring the quarter ending March 31, 2018, the Company issued the following unregistered securities. These securities were issued in reliance upon the exemption from registration provided by Section 4(2) of the Securities Act of 1933, as amended, Regulation D promulgated thereunder as there was no general solicitation, and the transactions did not involve a public offering.\nEffective as of January 2, 2018, the Company issued 1,000,000 shares of the Company’s common stock to the Chief Operating Officer of the Company as payment for services rendered pursuant to an employment agreement.\nOn January 1, 2018, the Company issued 50,000 shares of the Company’s common stock to its legal counsel as payment for services rendered pursuant to an engagement agreement.\nEffective February 1, 2018, the Company issued 12,500 shares of the Company’s common stock to its legal counsel as payment for services rendered pursuant to an engagement agreement.\nNone.\n\nNot applicable.\n\nNone.\n20\n\n\n| Exhibit |\n| Number | Description |\n| 3.1 | Articles of Incorporation (incorporated by reference from the Company’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on January 19, 2016). |\n| 3.1.1 | Amended Articles of Incorporation (incorporated by reference from the Company’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on January 19, 2016). |\n| 3.1.2 | Articles of Incorporation of Altitude International (incorporated by reference to the form 8-K filed by the Company on July 3, 2017). |\n| 3.2 | Amended Articles of Incorporation (incorporated by reference from the Company’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on January 19, 2016). |\n| 10.1 | Share Exchange Agreement (incorporated by reference to exhibit 10.1 to the form 8-K filed by the Company on July 3, 2017). |\n| 10.2 | Licensing Agreement (incorporated by reference to exhibit 10.2 to the form 8-K filed by the Company on July 3, 2017). |\n| 10.3 | Sole Distribution Agreement (incorporated by reference to exhibit 10.3 to the form 8-K filed by the Company on July 3, 2017). |\n| 31.1 | Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2 | Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 32.2 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 101 INS | XBRL Instance Document |\n| 101 SCH | XBRL Taxonomy Extension Schema Document |\n| 101 CAL | XBRL Taxonomy Calculation Linkbase Document |\n| 101 DEF | XBRL Taxonomy Extension Definition Linkbase Document |\n| 101 LAB | XBRL Taxonomy Labels Linkbase Document |\n| 101 PRE | XBRL Taxonomy Presentation Linkbase Document |\n\n21\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| SIGNATURE | TITLE | DATE |\n| /s/ Dave Vincent | Principal Executive Officer and Principal Financial and Accounting Officer | May 21, 2018 |\n| Dave Vincent |\n\n22\n \n\nWhat is the total net value of fixed assets and intangible assets at the end of Q2 2018 (June 30, 2018) in dollars if the yearly depreciation rate of both fixed assets and intangible assets stays unchanged?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nTITAN COMPUTER SERVICES, INC.\\n(UNAUDITED)\\nContents\\n\\n| Page |\\n| Condensed Consolidated Financial Statements (unaudited) |\\n| Condensed Consolidated Balance Sheets as of March 31, 2018 (unaudited) and December 31, 2017 | 4 |\\n| Condensed Consolidated Statements of Operations for the three months ended March 31, 2018 (unaudited) | 5 |\\n| Condensed Consolidated Statement of Cash Flows for the three months ended March 31, 2018 (unaudited) | 6 |\\n| Notes to Condensed Consolidated Financial Statements (unaudited) | 7-16 |\\n\\n3\\n\\n| TITAN COMPUTER SERVICES, INC. |\\n| and Subsidiary |\\n| Condensed Consolidated Balance Sheets |\\n\\n\\n| March 31, | December 31, |\\n| 2018 | 2017 |\\n| (unaudited) |\\n| ASSETS |\\n| Current assets |\\n| Cash | $ | 18,667 | $ | 24,867 |\\n| Prepaid expense | 4,166 | 4,167 |\\n| Total current assets | 22,833 | 29,034 |\\n| Fixed assets, net | 7,842 | 8,713 |\\n| Intangible assets, net | 11,824 | 11,977 |\\n| Total assets | $ | 42,499 | $ | 49,724 |\\n| LIABILITIES AND STOCKHOLDERS’ DEFICIT |\\n| Current liabilities |\\n| Notes payable - related party | $ | 60,000 | $ | - |\\n| Accounts payable - related party | 7,707 | 4,167 |\\n| Accrued expenses | 221,993 | 189,198 |\\n| Accrued expenses - related party | 9,923 | - |\\n| Shareholder’s advance | 26,764 | 26,764 |\\n| Total current liabilities | 326,387 | 220,129 |\\n| Total liabilities | 326,387 | 220,129 |\\n| Commitments and contingencies - Note 6 |\\n| Stockholders’ deficit |\\n| Preferred stock - no par value, 5,000,000 shares authorized, no shares issued and outstanding at March 31, 2018 and December 31, 2017, respectively | - | - |\\n| Common stock - no par value, 70,000,000 shares authorized, 22,803,659 and 21,728,659 shares issued, issuable, and outstanding at March 31, 2018 and December 31, 2017, respectively | 1,717,894 | 269,769 |\\n| Additional paid in capital | (149,769 | ) | (149,769 | ) |\\n| Accumulated deficit | (1,852,013 | ) | (290,405 | ) |\\n| Total stockholders’ deficit | (283,888 | ) | (170,405 | ) |\\n| Total liabilities and stockholders’ deficit | $ | 42,499 | $ | 49,724 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\\n4\\n\\n| TITAN COMPUTER SERVICES, INC. |\\n| and Subsidiary |\\n| Condensed Consolidated Statement of Operations |\\n| For the three months ended March 31, 2018 |\\n| (unaudited) |\\n\\n\\n| Revenue | $ | - |\\n| Operating expenses |\\n| Professional fees | 12,900 |\\n| Corporate expenses | 13,559 |\\n| Salary expenses | 31,250 |\\n| Stock-based compensation | 1,448,125 |\\n| Other general and administrative expenses | 39,748 |\\n| Total operating expenses | 1,545,582 |\\n| Loss from operations | (1,545,582 | ) |\\n| Other income (expenses) |\\n| Interest expense | (16,026 | ) |\\n| Total other income (expenses) | (16,026 | ) |\\n| Net loss | $ | (1,561,608 | ) |\\n| Earnings per share - basic and fully diluted | $ | (0.07 | ) |\\n| Weighted average number of shares of common stock - basic and fully diluted | 22,768,103 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\\n5\\n\\n| TITAN COMPUTER SERVICES, INC. |\\n| and Subsidiary |\\n| Condensed Consolidated Statement of Cash Flows |\\n| For the three months ended March 31, 2018 |\\n| (unaudited) |\\n\\n\\n| Cash flows from operating activities: |\\n| Net loss | $ | (1,561,608 | ) |\\n| Adjustments to reconcile net loss to net cash used in operations: |\\n| Depreciation expense | 871 |\\n| Amortization expense | 153 |\\n| Stock-based compensation | 1,448,125 |\\n| Change in assets and liabilities: |\\n| Accrued expenses | 30,233 |\\n| Accrued expenses - related party | 16,026 |\\n| Net cash used in operating activities | (66,200 | ) |\\n| Cash flows from financing activities: |\\n| Proceeds from notes payable - related party | 60,000 |\\n| Net cash provided by financing activities | 60,000 |\\n| Net decrease in cash | (6,200 | ) |\\n| Cash at beginning of period | 24,867 |\\n| Cash at end of period | $ | 18,667 |\\n| Supplemental disclosure of cash flow information: |\\n| Cash paid for interest | $ | - |\\n| Cash paid for taxes | $ | - |\\n\\n\\n| The accompanying notes are an integral part of these consolidated financial statements. |\\n| The financial statements only reflect the current year as the Company was established on May 18, 2017. |\\n\\n6\\nTITAN COMPUTER SERVICES, INC.\\nAnd Subsidiary\\nNotes to the Condensed Consolidated Financial Statements\\nMarch 31, 2018\\n(unaudited)\\nNOTE 1 – NATURE OF OPERATIONS\\nCompany Background\\nTitan Computer Services, Inc. (the “Company,” “we,” “us,” “our,” or “Altitude - NY”), was incorporated in the State of New York on July 13, 1994.\\nOn June 27, 2017, the Company successfully closed a Share Exchange transaction (“Share Exchange”) with the shareholders of Altitude International, Inc, (“Altitude”) a Wisconsin corporation. Altitude was incorporated on May 18, 2017 under the laws of the state of Wisconsin. Altitude will operate through Northern, Central, and South America sales by way of its sole distribution agreement with Woodway Inc. to execute the current business plan of athletic training industry, specifically altitude training. Our objective is to be recognized as one of the upper tier specialty altitude training equipment providers.\\nEffective February 13, 2018, majority of the shareholders of the Company approved the following changes to the Company’s Articles of Incorporation:\\nAmend the Bylaws to Permit a Simple Majority Vote and Allow for the Appointment of up to Seven\\nArticle II Section 10 of the Company’s Bylaws stated, “Any action required or permitted to be taken by the Shareholders thereof may be taken without a meeting if all Shareholders entitled to vote thereon consent in writing to the adoption of a resolution authorizing the action except as otherwise permitted by the Certificate of Incorporation.”\\nThe Bylaws were amended to allow for a simple majority vote as permitted by §615 of the New York Business Corporation Law. The amended section shall read, “Any action required or permitted to be taken by the Shareholders thereof may be taken without a meeting if a majority of the Shareholders entitled to vote thereon consent in writing to the adoption of a resolution authorizing the action.”\\nArticle III Section 2 of the Company’s Bylaws provided that the number of Directors constituting the entire Board “shall not be less than one nor more than three, as may be fixed by resolution of the Board of Director.” The Bylaws were amended to allow for additional directors as proposed herein (up to four) and to allow for additional directors as the Company grows (up to seven). The amended section shall include the number “seven” instead of “three” as the maximum number of directors.\\nName Change from “Titan Computer Services, Inc.” to “Altitude International, Inc.”\\nOn February 13, 2018, the majority of the shareholders of the Company approved the amendment to the Articles of Incorporation to change the Company’s name from “Titan Computer Services, Inc.” to “Altitude International, Inc.” The purpose of the name change will help further our brand identity and will reflect the major focus of our business operations, the manufacturing and distribution of products in the athletic training industry, specifically altitude training. The filing of the name change with the state of New York has not been completed as of the date of this report. Once processed by New York, the Company will apply for a name and symbol change with FINRA.\\nNature of Operations\\nThe product designs to be licensed from Sporting Edge UK, Ltd (“Sporting Edge UK”) are proven and cover a wide range of room sizes. The only requirement is to change from metric to imperial sizes where necessary.\\nThere are three unique elements to the Altitude product:\\n\\n| · | Sophisticated Touch Screen control systems capable of integrating the control of simulated altitude, temperature and humidity. |\\n\\n\\n| · | A unique design of Air Separation Unit with only a single active part that provides for ultra-reliable operation and a design life of greater than fifteen years. |\\n\\n\\n| · | Proven training protocols that allow the desired training benefits to be achieved. |\\n\\n7\\nAltitude has leased space in the Woodway facility in Waukesha, Wisconsin to undertake the manufacture of systems. The work will primarily consist of the assembly of components into the unique licensed designs. Initial recruitment of technically-capable persons will be necessary, followed by short training blocks to pass on the required skills. At least one person is likely to visit the UK to see systems in operation and obtain hands-on experience of the manufacturing requirement. Woodway is an engineering-based company and provides the perfect environment to establish an operation which is in many ways similar to their own. In addition, many aspects of infrastructure – goods handling, welfare facilities, etc. – can be accessed immediately without expense to Altitude.\\nRecapitalization of Altitude\\nOn June 27, 2017, the Company entered into a share exchange transaction with Altitude which resulted in a change of control of the Company. Pursuant to the terms of the Share Exchange, the Company agreed to issue 6,102,000 shares of its common stock to all the individual shareholders of Altitude on a pro rata basis (one to one share exchange). In exchange for this stock issuance, the Company received 100% of the outstanding shares of Altitude. Following this Share Exchange, Altitude became a wholly-owned subsidiary of Titan. There was a cancellation of 14,700,000 shares of common stock of the Company that was held by the Company’s former majority stockholder as part of the share exchange agreement, which all had a net effect of a decrease of 8,598,000 shares in the Company’s outstanding shares. The business, assets and liabilities of the Company changed as a result of this reverse acquisition to Altitude’s business plan.\\nThis share exchange transaction resulted in those shareholders obtaining a majority voting interest in –the Company and control of the Board of Directors of the Company. Generally accepted accounting principles require that the Company whose shareholders retain the majority interest and control in a combined business be treated as the acquirer for accounting purposes, resulting in a reverse acquisition with Altitude as the accounting acquirer and the Company as the acquired party. Accordingly, the share exchange transaction has been accounted for as a recapitalization of Altitude, whereby is deemed to be the continuing, surviving entity for accounting purposes but through reorganization, has deemed to have adopted the capital structure of Altitude - NY. The equity section of the accompanying condensed consolidated financial statements has been restated to reflect the recapitalization of the Company due to the reverse acquisition.\\nAccordingly, all references to common shares of Altitude’s common stock have been restated to reflect the equivalent number of the Company’s common shares. In other words, the 6,102,000 Altitude shares outstanding at the time of the share exchange are restated to 21,228,659 common shares (prior to the 500,000 common share capital raise mentioned below that was conducted after the share exchange agreement), as of June 27, 2017. Each share of Altitude is accordingly restated at a multiple of approximately 3.48 shares of the Company for the weighted average shares outstanding for the loss per share calculations in the accompanying condensed consolidated statement of operations.\\nThe book value of the net assets that for accounting purposes, were deemed to have been acquired by Altitude from the Company, as of the date of acquisition (June 27, 2017) were $0, after the waiver of all debts from officers and third parties.\\nA condition to the closing of the Share Exchange Agreement was raising $100,000 in the Company. On June 27, 2017, the Company issued 500,000 shares of its common stock to an accredited investor pursuant to a Subscription Agreement for $100,000, or $0.20 per share which was kept at escrow account. During the recapitalization, the Company incurred legal fees of $12,500 which was paid through the attorney’s escrow account and recorded as transaction costs which were netted against the $100,000 proceeds.\\nAltitude International, Inc.\\nAltitude International, Inc. (“Altitude”) was incorporated on May 18, 2017 under the laws of the state of Wisconsin with 100,000,000 authorized common stock with $0.001 par value. On May 18, 2017, 6,102,000 shares of common stock at $0.001 (par) were issued as founder shares, valued at a total of $6,102 to 15 individuals, including Mr. Dave Vincent who is the majority equity interest shareholder and the director of the Company. These shares were issued for future potential services from these various individuals and as of the date of this issuance, no value was placed on these future potential services and were therefore recorded at par value as stock-based compensation to the founders.\\nOn June 27, 2017, after the closing of certain Stock Purchase Agreements, in private sale transaction and the Share Exchange Agreement, a change of control of the Company occurred, see recapitalization of Altitude mentioned above. Dave Vincent was the majority shareholder of the Company, owning 51.3 % of the issued and outstanding common shares of –the Company. See Notes 6 and 8.\\nAltitude will operate through Northern, Central, and South America sales by way of its sole distribution agreement with Woodway Inc. to execute the current business plan of athletic training industry, specifically altitude training. Our objective is to be recognized as one of the upper tier specialty altitude training equipment providers.\\n8\\nChanges in Management and the Board of Directors\\nOn June 27, 2017, pursuant to the Closing of the Share Exchange Agreement, Mr. Dave Vincent was appointed as the Company’s new CEO and Abraham Rosenblum resigned as CEO. Additionally, Mr. Vincent and Mr. Robert Kanuth were appointed as directors of the Company and Mr. Robert Klein resigned. On October 20, 2017, Greg Whyte was appointed to fill the vacancy as a director of the Company. On January 8, 2018, Joseph B. Frost was appointed to serve as the Chief Operating Officer and on February 13, 2018 Lesley Visser and Joseph B. Frost were elected to serve on the Board of Directors.\\nNOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\\nBasis of presentation\\nThe Company follows the accrual basis of accounting in accordance with generally accepted accounting principles in the United States of America and has a year-end of December 31.\\nThe preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.\\nManagement further acknowledges that it is solely responsible for adopting sound accounting practices, establishing and maintaining a system of internal accounting control and preventing and detecting fraud. The Company’s system of internal accounting control is designed to assure, among other items, that 1) recorded transactions are valid; 2) valid transactions are recorded; and 3) transactions are recorded in the proper period in a timely manner to produce financial statements which present fairly the financial condition, results of operations and cash flows of the Company for the respective periods being presented.\\nGoing Concern and Liquidity\\nWe have incurred recurring losses since inception and expect to continue to incur losses as a result of legal and professional fees and our corporate general and administrative expenses. At March 31, 2018, we had $18,667 in cash. Our net losses incurred for the three months ended March 31, 2018 amounted to $1,561,608 and working capital deficit was $303,554 at March 31, 2018. As a result, there is substantial doubt about our ability to continue as a going concern. In the event that we are unable to generate sufficient cash from our operating activities or raise additional funds, we may be required to delay, reduce or severely curtail our operations or otherwise impede our on-going business efforts, which could\\nhave a material adverse effect on our business, operating results, financial condition and long-term prospects. The Company expects to seek to obtain additional funding through increased revenues and future financings. There can be no assurance as to the availability or terms upon which such financing and capital might be available.\\nPrinciples of Consolidation\\nThe consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Altitude. All significant intercompany balances and transactions have been eliminated in the consolidation. The consolidated financial statements included herein, presented in accordance with United States generally accepted accounting principles (“GAAP”) and stated in United States dollars, have been prepared by the Company, pursuant to the rules and regulations of the Securities and Exchange Commission.\\nUse of Estimates\\nThe preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.\\nSignificant Estimates, Risks and Concentrations\\nThese accompanying financial statements include some amounts that are based on management’s best estimates and judgments. The most significant estimates relate to the valuation of the software rights and redeemable common stock liability. It is reasonably possible that the above-mentioned estimate and others may be adjusted as more current information becomes available, and any adjustment could be significant in future reporting periods.\\n9\\nThe Company is dependent on its ability to handle rapidly substantial quantities of data and transactions on computer-based networks and the capacity, reliability and security of the electronic delivery systems and the Internet. Any significant failure or interruption of these systems could cause our systems to operate slowly or interrupt service for periods of time and could have a material adverse effect on our business and results of our operations. The Company may experience shortage of capacity and increased costs associated with such usage. These events may affect our ability to store, handle and deliver data and services to our customers.\\nCash and Cash Equivalents\\nThe Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents.\\nProperty, Plant and Equipment\\nProperty and equipment are stated at cost, net of accumulated depreciation. Expenditures that extend the life, increase the capacity, or improve the efficiency of property and equipment are capitalized, while expenditures for repairs and maintenance are expensed as incurred. Depreciation is recognized using the straight-line method over the following approximate useful lives:\\nMachinery and equipment\\n3-5 Years\\nIntangible Assets\\nCosts incurred to file patent applications and acquired intangibles are capitalized when the Company believes that there is a high likelihood that the patent will be issued and there will be future economic benefit associated with the patent. These costs will be amortized on a straight-line basis over a 20 years life from the date of patent filing. All costs associated with abandoned patent applications are expensed. In addition, the Company will review the carrying value of patents for indicators of impairment on a periodic basis and if it determines that the carrying value is impaired, it values the patent at fair value. As of March 31, 2018, carrying value of patent was $11,824.\\nIn accordance with the provisions of the applicable authoritative guidance, the Company’s long-lived assets and amortizable intangible assets are tested for impairment whenever events or changes in circumstances indicate that their carrying value may not be recoverable. The Company assesses the recoverability of such assets by determining whether their carrying value can be recovered through undiscounted future operating cash flows, including its estimates of revenue driven by assumed market segment share and estimated costs. If impairment is indicated, the\\nCompany measures the amount of such impairment by comparing the fair value to the carrying value. The amortization of the trademark was not significant for the period ended March 31, 2018.\\nImpairment of Long-Lived Assets\\nThe Company’s long-lived assets and other assets (consisting of property and equipment) are reviewed for impairment in accordance with the guidance of the FASB ASC Topic 360-10, Property, Plant, and Equipment, and FASB ASC Topic 205, Presentation of Financial Statements. Long lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the undiscounted future net cash flows expected to be generated by that asset. If the carrying amount of an asset exceeds its estimated future undiscounted cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. For the three months ended March 31, 2018, the Company had not experienced impairment losses on its long-lived assets.\\nRevenue Recognition\\nThe Company recognizes revenue in accordance with ASC 605 Revenue Recognition (“ASC 605”). Revenue is recognized when all of the following four criteria are met: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services rendered, (3) the fee is fixed and determinable, and (4) collectability is reasonably assured. Determining whether and when some of these criteria have been satisfied often involves assumptions and judgments that can have a significant impact on the timing and amount of revenue we report.\\nAdvertising Costs\\nAdvertising costs are expensed as incurred. Advertising costs for the three months ended March 31, 2018 was $0.\\n10\\nStock-Based Compensation\\nThe Company accounts for stock-based instruments issued to employees in accordance with ASC Topic 718. ASC Topic 718 requires companies to recognize in the statement of operations the grant-date fair value of stock options and other equity-based compensation issued to employees. The value of the portion of an award that is ultimately expected to vest is recognized as an expense over the requisite service periods using the straight-line attribution method. The Company accounts for non-employee share-based awards in accordance with the measurement and recognition provisions ASC Topic 505-50. The Company estimates the fair value of stock options at the grant date by using the Black-Scholes option-pricing model.\\nFair Value of Financial Instruments\\nThe book values of cash, prepaid expenses, and accounts payable approximate their respective fair values due to the short-term nature of these instruments. The fair value hierarchy under GAAP distinguishes between assumptions based on market data (observable inputs) and an entity’s own assumptions (unobservable inputs).\\nThe hierarchy consists of three levels\\n\\n| · | Level one — Quoted market prices in active markets for identical assets or liabilities; |\\n| · | Level two — Inputs other than level one inputs that are either directly or indirectly observable; and |\\n| · | Level three — Unobservable inputs developed using estimates and assumptions, which are developed by the reporting entity and reflect those assumptions that a market participant would use. |\\n\\nDetermining which category an asset or liability falls within the hierarchy requires significant judgment. We evaluate our hierarchy disclosures each quarter.\\nEarnings (Loss) Per Share\\nBasic earnings (loss) per share are computed by dividing the net income by the weighted-average number of shares of common stock and common stock equivalents (primarily outstanding options and warrants). Common stock equivalents represent the dilutive effect of the assumed exercise of the outstanding stock options and warrants, using the treasury stock method. The calculation of fully diluted earnings per share assumes the dilutive effect of the exercise of outstanding options and warrants at either the beginning of the respective period presented or the date of issuance, whichever is later.\\nIncome Taxes\\nThe Company accounts for income taxes in accordance with FASB ASC 740, “Income Taxes”. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statements carrying amounts of existing assets and liabilities and loss carry-forwards and their respective tax bases.\\nDeferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income (loss) in the years in which those temporary differences are expected to be recovered or settled.\\nThe effect of a change in tax rules on deferred tax assets and liabilities is recognized in operations in the year of change. A valuation allowance is recorded when it is “more likely-than-not” that a deferred tax asset will not be realized.\\nTax benefits of uncertain tax positions are recognized only if it is more likely than not that the Company will be able to sustain a position taken on an income tax return. The Company has no liability for uncertain tax positions as of December 31, 2017. Interest and penalties in any, related to unrecognized tax benefits would be recognized as interest expense. The Company does not have any accrued interest or penalties associated with unrecognized tax benefits, nor was any significant interest expense recognized during the three months ended March 31, 2018.\\nOn December 22, 2017, the United States Government passed new tax legislation that, among other provisions, will lower the corporate tax rate from 35% to 21%. In addition to applying the new lower corporate tax rate in 2018 and thereafter to any taxable income we may have, the legislation affects the way we can use and carry forward net operating losses previously accumulated and results in a revaluation of deferred tax assets recorded on our balance sheet. Given that the deferred tax assets are offset by a full valuation allowance, these changes will have no net impact on the Company’s financial position and net loss. However, if and when we become profitable, we will receive a reduced benefit from such deferred tax assets. Had this legislation been effective prior to our December 31, 2017, fiscal year-end, the effect of the legislation would have been a reduction in deferred tax assets and the corresponding valuation allowance.\\n11\\nContingencies\\nCertain conditions may exist as of the date the financial statements are issued, which may result in a loss to the Company, but which will only be resolved when one or more future events occur or fail to occur. The Company’s management and its legal counsel assess such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or unasserted claims that may result in such proceedings, the Company’s legal counsel evaluates the perceived merits of any legal proceedings or unasserted claims as well as the perceived merits of the amount of relief sought or expected to be sought therein.\\nIf the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s financial statements. If the assessment indicates that a potentially material loss contingency is not probable, but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, together with an estimate of the range of possible loss if determinable and material, would be disclosed.\\nLoss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the nature of the guarantee would be disclosed.\\nEffect of Recent Accounting Pronouncements\\nGoing Concern\\nASU 2014-15 – “Presentation of Financial Statements—Going Concern—Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (“ASU 2014-15”).” In August 2014, FASB issued guidance that requires management to perform interim and annual assessments of an entity’s ability to continue as a going concern within one year of the date the financial statements are issued. An entity must provide certain disclosures if conditions or events raise substantial doubt about the entity’s ability to continue as a going concern. The updated accounting guidance was effective for the Company on March 31, 2018. We have implemented this new accounting standard and we will update our liquidity disclosures as necessary.\\nRecent Accounting Pronouncements\\nRecently-Issued Accounting Standards: Management does not believe that any recently issued, but not yet effective, accounting standards if currently adopted would have a material effect on the accompanying financial statements.\\nFinancial Instruments\\nIn January 2016, the FASB issued ASU No. 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”), which updates certain aspects of recognition, measurement, presentation and disclosure of financial instruments. ASU 2016-01 will be effective for the Company beginning in its first quarter of 2019. The Company does not believe the adoption of ASU 2016-01 will have a material impact on its consolidated financial statements.\\nIn June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which modifies the measurement of expected credit losses of certain financial instruments. ASU 2016-13 will be effective for the Company beginning in its first quarter of 2021 and early adoption is permitted. The Company does not believe the adoption of ASU 2016-13 will have a material impact on its consolidated financial statements.\\nLeases\\nIn February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”), which modified lease accounting for both lessees and lessors to increase transparency and comparability by recognizing lease assets and lease liabilities by lessees for those leases classified as operating leases under previous accounting standards and disclosing key information about leasing arrangements. ASU 2016-02 will be effective for the Company beginning in its first quarter of 2020, and early adoption is permitted. The Company is currently evaluating the timing of its adoption and the impact of adopting ASU 2016-02 on its financial statements.\\nStock Compensation\\nIn March 2016, the FASB issued ASU No. 2016-09, Compensation – Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”), which simplified certain aspects of the accounting for share-based payment transactions, including income taxes, classification of awards and classification on the statement of cash flows. ASU 2016-09 will be effective for the Company beginning in its first quarter of 2018. The Company is currently evaluating the impact of adopting ASU 2016-09 on its consolidated financial statements.\\n12\\nIncome Taxes\\nIn October 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-16, Income Taxes (Topic 740): Intra-Entity Transfer of Assets Other than Inventory (“ASU 2016-16”), which requires the recognition of the income tax consequences of an intra-entity transfer of an asset, other than inventory, when the transfer occurs. ASU 2016-06 will be effective for the Company in its first quarter of 2019. The Company is currently evaluating the impact of adopting ASU 2016-16 on its consolidated financial statements.\\nRevenue Recognition\\nIn May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”), which amends the existing accounting standards for revenue recognition. ASU 2014-09 is based on principles that govern the recognition of revenue at an amount an entity expects to be entitled when products are transferred to customers. ASU 2014-09 will be effective for the Company beginning in its first quarter of 2019, and early adoption is permitted.\\nSubsequently, the FASB has issued the following standards related to ASU 2014-09: ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (“ASU 2016-08”); ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing (“ASU 2016-10”); and ASU No. 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients (“ASU 2016-12”). The Company must adopt ASU 2016-08, ASU 2016-10 and ASU 2016-12 with ASU 2014-09 (collectively, the “new revenue standards”).\\nThe new revenue standards may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of adoption. The Company currently expects to adopt the new revenue standards in its first quarter of 2018 utilizing the full retrospective transition method. The Company is evaluating the effect of the adoption of the new revenue recognition standard as to whether it will have a material impact on its consolidated financial statements.\\nNOTE 3 – FIXED ASSETS\\nThe Company has fixed assets related to office equipment. The depreciation of the equipment is over a three-year period. As of March 31, 2018, and December 31, 2017, the Company had fixed assets, net of accumulated depreciation, of $7,842 and $8,713, respectively. The fixed assets are as follows:\\n\\n| March 31, | December 31, |\\n| 2018 | 2017 |\\n| Office equipment | $ | 10,455 | $ | 10,455 |\\n| Total fixed assets | 10,455 | 10,455 |\\n| Less: Accumulated depreciation | 2,613 | 1,742 |\\n| Fixed assets, net | $ | 7,842 | $ | 8,713 |\\n\\nDepreciation of the office equipment for the three months ended March 31, 2018 was $871.\\nNOTE 4 – INTANGIBLE ASSETS - TRADEMARK\\nThe Company has intangible assets related to a trademark. The amortization of the intangible asset is over a twenty-year period. As of March 31, 2018, and December 31, 2017, the Company had intangible assets, net of accumulated amortization, of $11,824 and $11,977, respectively. The intangible assets are as follows:\\n\\n| March 31, | December 31, |\\n| 2018 | 2017 |\\n| Trademark | $ | 12,284 | $ | 12,284 |\\n| Total intangible assets | 12,284 | 12,284 |\\n| Less: Accumulated amortization | 460 | 307 |\\n| Intangible assets, net | $ | 11,824 | $ | 11,977 |\\n\\nAmortization expense of the trademark for the three months ended March 31, 2018 was $153.\\n13\\nNOTE 5 – NOTES PAYABLE\\n\\n| Notes payable |\\n| March 31, 2018 | December 31, 2017 |\\n| Accrued | Accrued |\\n| Principal | Interest | Total | Principal | Interest | Total |\\n| Dave Vincent | $ | 20,000 | $ | 581 | $ | 20,581 | $ | - | $ | - | $ | - |\\n| Joseph B. Frost | 40,000 | 679 | 40,679 | - | - | - |\\n| Total | $ | 60,000 | $ | 1,260 | $ | 61,260 | $ | - | $ | - | $ | - |\\n\\nOn February 7, 2018, Dave Vincent, the Company’s majority shareholder and director, loaned the Company $20,000 in the form of a promissory note. The note bears interest of 20% and has the term of one year, at which time all principal and interest will be paid in a balloon payment. As of March 31, 2018, the accrued interest was $581, and the principal balance was $20,000. See Note 7.\\nOn March 2, 2018, Joseph B. Frost, a director, loaned the Company $40,000 in the form of a promissory note. The note bears interest of 20% and has the term of one year, at which time all principal and interest will be paid in a balloon payment. As of March 31, 2018, the accrued interest was $679, and the principal balance was $40,000. See Note 7.\\nNOTE 6 – COMMITMENTS AND CONTINGENCIES\\nThe Company is subject, from time to time, to claims by third parties under various legal disputes. The defense of such claims, or any adverse outcome relating to any such claims, could have a material adverse effect on the Company’s liquidity, financial condition and cash flows. As of May 14, 2018, the Company did not have any legal actions pending against it.\\nOn June 27, 2017, Altitude entered a license agreement with Sporting Edge UK (see Note 1), Sporting Edge UK is the sole and exclusive owner of and has the right to license to licensee the ability to manufacture and sell rights to the full range of membrane-based systems for the production of reduced oxygen environments and associated services as well as the use of patents and trademarks held by Sporting Edge UK or Mr. David Vincent.\\nSporting Edge UK agreed to grant the licensee exclusive right and license to the Manufacturing and Sales Rights in the Territory including the Continent of North America, Central America and the Continent of South America. On the effective date of this agreement and for a period of 5 years thereafter, the Company (“Licensee”) shall pay upfront payment of $10,000 to Licensor annually. In addition, commencing on the sixth anniversary of the effective date the licensee shall pay continuing royalty fees on all sales of product manufactured using the IP. The royalty payable shall be calculated as 0.5% of the Sale Price. The Company recorded the payment due of $4,167 under Prepaid expenses and accounts payable as of December 31, 2017.\\nNOTE 7 – RELATED PARTY TRANSACTIONS\\nAs of December 31, 2017, the balance due to our current CEO, David Vincent, was recorded under shareholder’s advance of $26,764, which is a verbal agreement, non-interest bearing, unsecured and payable on demand. These advances included $10,455 of acquisition of office equipment and $12,284 of acquisition of trademark which were disclosed at supplemental disclosure of non-cash flow investing activities of the statement of cash flow. On February 9, 2018, the Board of Directors changed the arrangement whereas the advance would begin accruing interest at the rate of 20%.\\nAltitude has an oral agreement with its Chairman of the Board, Robert Kanuth, in which it will provide for reimbursement of private airline travel expenses incurred on behalf of the Company, for his use of an aircraft in which he has an interest in. These travel expenses totaled $123,750 for the period ended December 31, 2017 and is included in accrued expenses at March 31, 2018. In January 2018, the Board of Directors issued a one-time bonus to Mr. Kanuth, in the amount of $7,525, to compensate for the significant payable and what would have been interest. Additionally, the open balance will accrue interest at the rate of 20% per annum and, as of March 31, 2018, the accrued interest was $6,103.\\nOn January 2, 2018, the Company issued 1,000,000 shares of common stock to Joseph B. Frost, the Company’s Chief Operating Officer, under his employment agreement. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $1,350,000. See Note 8.\\n14\\nOn February 7, 2018, Dave Vincent, the Company’s majority shareholder and director, loaned the Company $20,000 in the form of a promissory note. The note bears interest of 20% and has the term of one year, at which time all principal and interest will be paid in a balloon payment. As of March 31, 2018, the accrued interest was $581, and the principal balance was $20,000. See Note 5.\\nOn March 2, 2018, Joseph B. Frost, a director, loaned the Company $40,000 in the form of a promissory note. The note bears interest of 20% and has the term of one year, at which time all principal and interest will be paid in a balloon payment. As of March 31, 2018, the accrued interest was $679, and the principal balance was $40,000. See Note 5.\\nNOTE 8 – STOCKHOLDERS’ EQUITY\\nPreferred Stock\\nOn February 5, 2015, the Board of Directors of the Company authorized 5,000,000 shares of preferred stock with no par value. Each share of the preferred stock is entitled to one vote and is convertible into one share of common stock.\\nAs of March 31, 2018, and December 31, 2017, the Company has no preferred stock issued and outstanding.\\nCommon Stock\\nAltitude was incorporated on May 18, 2017 under the laws of the state of Wisconsin with 100,000,000 authorized common stock with $0.001 par value.\\nOn June 12, 2017, Altitude issued 6,102,000 shares of its common stock at par value of $0.001 per share as founder shares for future potential services from 15 individuals, including David Vincent, who is the majority equity interest shareholder and the director of the Company, with a total recorded at par value of $6,102.\\nOn June 27, 2017, the Company entered into a share exchange transaction with Altitude and the shareholders of Altitude. Pursuant to the terms of the Share Exchange, the Company agreed to issue 6,102,000 shares of its common stock to the individual shareholders of Altitude on a pro rata basis in exchange for receive 100% of the shares of Altitude. Following the Share Exchange, Altitude became a wholly-owned subsidiary of the Company. See Note 1.\\nPrior to the Share Exchange Agreement, there were 22,828,659 shares of common stock of the Company issued and outstanding, 14,700,000 of which were cancelled on June 27, 2017. As consideration for the Share Exchange Agreement, the shareholders of Altitude received a total of 6,102,000 restricted shares of –the Company, proportionate to their shareholdings in Altitude.\\nOn June 27, 2017, the date of closing of the Share Exchange Agreement, the Company issued 500,000 shares of its common stock to an accredited investor pursuant to a Subscription Agreement for $100,000, or $0.20 per share. Total proceed received was $87,500 after paying transaction costs of $12,500. Immediately following the Share Exchange agreement, there will are 21,728,659 shares of common stock issued and outstanding and no shares of preferred stock outstanding.\\nOn January 1, 2018, the Company was contractually obligated to issue its legal counsel 37,500 shares of common stock for legal work to date. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $50,625.\\nOn January 1, 2018, the Company was contractually obligated to issue its legal counsel 12,500 shares of common stock for legal work for January 2018. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $16,875.\\nOn January 2, 2018, the Company issued 1,000,000 shares of common stock to Joseph B. Frost, the Company’s Chief Operating Officer, under his employment agreement. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $1,350,000. See Note 7.\\nOn February 1, 2018, the Company was contractually obligated to issue its legal counsel 12,500 shares of common stock for legal work for February 2018. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $16,875.\\nOn March 1, 2018, the Company was contractually obligated to issue its legal counsel 12,500 shares of common stock for legal work for March 2018. The common stock of the Company is thinly traded and had a value of $1.10 per share, therefore the Company recorded the transaction at $13,750. As of March 31, 2018, these shares had not been issued.\\n15\\nAs of March 31, 2018, and December 31, 2017, the Company has 22,803,659 and 21,728,659 shares of no par common stock issued, issuable, and outstanding.\\nStock Option Plan\\nOn February 13, 2018, the Company’s shareholders and Board of Directors approved the 2017 Incentive Stock Plan.\\nNOTE 9 – INCOME TAXES\\nAs of March 31, 2018, and December 31, 2017, the Company has net operating loss carry forwards of $403,890 and $290,405. The carry forward expires through the year 2038. The Company’s net operating loss carry forwards may be subject to annual limitations, which could reduce or defer the utilization of the losses as a result of an ownership change as defined in Section 382 of the Internal Revenue Code.\\nThe Company’s tax expense differs from the “expected” tax expense for Federal income tax purposes (computed by applying the United States Federal tax rate of 21% to loss before taxes for fiscal year 2018 and 34% to loss before taxes for fiscal year 2017), as follows:\\n\\n| March 31, | December 31, |\\n| 2018 | 2017 |\\n| Tax expense (benefit) at the statutory rate | $ | (23,832 | ) | $ | (60,985 | ) |\\n| State income taxes, net of federal income tax benefit |\\n| Change in valuation allowance | 23,832 | 60,985 |\\n| Total | $ | - | $ | - |\\n\\nThe tax effects of the temporary differences between reportable financial statement income and taxable income are recognized as deferred tax assets and liabilities.\\nThe tax year 2017 remains to examination by federal agencies and other jurisdictions in which it operates.\\nThe tax effect of significant components of the Company’s deferred tax assets and liabilities at March 31, 2018 and December 31, 2017, are as follows:\\n\\n| March 31, | December 31, |\\n| 2018 | 2017 |\\n| Deferred tax assets: |\\n| Net operating loss carryforward | $ | 84,817 | $ | 60,985 |\\n| Timing differences | - | - |\\n| Total gross deferred tax assets | 84,817 | 60,985 |\\n| Less: Deferred tax asset valuation allowance | (84,817 | ) | (60,985 | ) |\\n| Total net deferred taxes | $ | - | $ | - |\\n\\nIn assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment.\\nBecause of the historical earnings history of the Company, the net deferred tax assets for 2018 and 2017 were fully offset by a 100% valuation allowance. The valuation allowance for the remaining net deferred tax assets was $84,817 and $60,985 as of March 31, 2018 and December 31, 2017, respectively.\\nOn December 22, 2017, the United States Government passed new tax legislation that, among other provisions, will lower the corporate tax rate from 34% to 21%. In addition to applying the new lower corporate tax rate in 2018 and thereafter to any taxable income we may have, the legislation affects the way we can use and carry forward net operating losses previously accumulated and results in a revaluation of deferred tax assets recorded on our balance sheet. Given that the deferred tax assets are offset by a full valuation allowance, these changes will have no net impact on the Company’s financial position and net loss. However, if and when we become profitable, we will receive a reduced benefit from such deferred tax assets. Had this legislation been effective prior to our December 31, 2017, fiscal year-end, the effect of the legislation would have been a reduction in deferred tax assets and the corresponding valuation allowance.\\n16\\n\\nResults of Operations\\nFor the three months ended March 31, 2018 Revenue The Company had no revenue for the three months ended March 31, 2018. Operating Expenses The Company had operating expenses of $1,545,582 for the three months ended March 31, 2018, which primarily consisted of stock-based compensation of $1,448,125. Net Loss The Company had a net loss of $1,561,608 for the three months ended March 31, 2018. The net loss was primarily to the abovementioned effect. Liquidity and Capital Resources As of March 31, 2018, the Company had cash and cash equivalents of $18,667. We do not have sufficient resources to effectuate our business. We expect to incur a minimum of $320,000 in expenses during the next twelve months of operations. We estimate that these expenses will be comprised primarily of general expenses including overhead, legal and accounting fees.\\nWe used cash in operations of $66,200 for the three months ended March 31, 2018. The negative cash flow from operating activities for the three months ended March 31, 2018 is attributable to the Company’s net loss from operations of $1,561,608 primarily due to the issuance of common stock for services ($1,448,125).\\nWe used cash in investing or financing activities of $0 for the three months ended March 31, 2018.\\nWe had cash provided by financing activities of $60,000 for the three months ended March 31, 2018, consisting of loans from Dave Vincent and Joseph B. Frost.\\nWe will have to raise funds to pay for our expenses. We may have to borrow money from shareholders or issue debt or equity or enter into a strategic arrangement with a third party. There can be no assurance that additional capital will be available to us. We currently have no arrangements or understandings with any person to obtain funds through bank loans, lines of credit or any other sources. Since we have no such arrangements or plans currently in effect, our inability to raise funds for our operations will have a severe negative impact on our ability to remain a viable company.\\nPlan of Operation\\nThe Company will produce systems under license from Sporting Edge UK Ltd. These systems include the control of simulated altitude as a minimum and often the simultaneous control of temperature and humidity, providing a full environmental capability. Also included in the license are the Training Protocols that Sporting Edge has established to ensure that the optimum results are achieved by athletes using the altitude facilities. The Company will lease space in the Woodway facility in Waukesha to undertake the manufacture of systems. This will consist primarily of manufacturing space, but with a small office content. The work will primarily consist of the assembly of components into the unique licensed designs. Initial recruitment of technically capable persons will be necessary, followed by short training blocks to pass on the required skills. At least one person is likely to visit the UK to see systems in operation and obtain hands-on experience of the manufacturing requirement. Woodway is an engineering-based company and so is a perfect environment in which to establish an operation which is in many ways similar to their own. In addition, many aspects of infrastructure – goods handling, welfare facilities, etc. – can be accessed immediately without expense to Altitude.\\nThe Company has two approaches to penetrating the market.\\n| · | The Company has appointed Woodway as the sole Distributor for North, South and Central America. This provides access to every professional Sports Club, College and University as well as many Hospitals and Military facilities. As a result, the time and cost associated with establishing and operating a sales force is avoided. |\\n\\n\\n| · | The Company also has Board members and Company Ambassadors who are able to access key, top level decision makers via their personal contact networks. |\\n\\n17\\nA demonstration Altitude Room has been installed at the Woodway facility in Waukesha to allow effective demonstration of the physiological changes brought about be reduced oxygen air. Customer support and installation activities will be carried out in association with the existing network of Woodway Service Centers. Once again, the cost and time of establishing such a network is avoided whilst ensuring that the vital support element is in place.\\nCommercial operations will center in Florida where a second demonstration facility will be located, working in association with an existing top end Fitness facility.\\nOff-balance Sheet Arrangements\\nWe do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.\\n\\nNot required.\\n\\nEvaluation of Disclosure Controls and Procedures\\nThe Securities and Exchange Commission defines the term “disclosure controls and procedures” to mean a company’s controls and other procedures of an issuer that are designed to ensure that information required to be disclosed in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Securities Exchange Act of 1934 is accumulated and communicated to the issuer’s management, including its chief executive and chief financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. The Company maintains such a system of controls and procedures in an effort to ensure that all information which it is required to disclose in the reports it files under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified under the SEC’s rules and forms and that information required to be disclosed is accumulated and communicated to the chief executive and interim chief financial officer to allow timely decisions regarding disclosure.\\nAs of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures are not effective as of such date. The Chief Executive Officer and Chief Financial Officer have determined that the Company continues to have the following deficiencies which represent a material weakness:\\n\\n| · | The Company does not have independent directors; |\\n| · | Lack of in-house personnel with the technical knowledge to identify and address some of the reporting issues surrounding certain complex or non-routine transactions. With material, complex and non-routine transactions, management has and will continue to seek guidance from third-party experts and/or consultants to gain a thorough understanding of these transactions; |\\n| · | Insufficient personnel resources within the accounting function to segregate the duties over financial transaction processing and reporting; and |\\n| · | Insufficient written policies and procedures over accounting transaction processing and period end financial disclosure and reporting processes. |\\n| · | To remediate our internal control weaknesses, management intends to implement the following measures: |\\n| · | As funding permits, the Company will add sufficient accounting personnel to properly segregate duties and to effect a timely, accurate preparation of the financial statements. |\\n| · | The Company will hire staff technically proficient at applying U.S. GAAP to financial transactions and reporting. |\\n| · | Upon the hiring of additional accounting personnel, the Company will develop and maintain adequate written accounting policies and procedures. |\\n\\n18\\nThe additional hiring is contingent upon The Company’s efforts to obtain additional funding through equity or debt and the results of its operations. Management hopes to secure funds in the coming fiscal year but provides no assurances that it will be able to do so.\\nLimitations on the Effectiveness of Controls\\nThe Company’s officers do not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of the control system must reflect that there are resource constraints and that the benefits must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Changes in Internal Control Over Financial Reporting During the fiscal quarter covered by this Quarterly Report, there has been no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\\n19\\nPART II. OTHER INFORMATION\\n\\nNone.\\n\\nNot required.\\n\\nDuring the quarter ending March 31, 2018, the Company issued the following unregistered securities. These securities were issued in reliance upon the exemption from registration provided by Section 4(2) of the Securities Act of 1933, as amended, Regulation D promulgated thereunder as there was no general solicitation, and the transactions did not involve a public offering.\\nEffective as of January 2, 2018, the Company issued 1,000,000 shares of the Company’s common stock to the Chief Operating Officer of the Company as payment for services rendered pursuant to an employment agreement.\\nOn January 1, 2018, the Company issued 50,000 shares of the Company’s common stock to its legal counsel as payment for services rendered pursuant to an engagement agreement.\\nEffective February 1, 2018, the Company issued 12,500 shares of the Company’s common stock to its legal counsel as payment for services rendered pursuant to an engagement agreement.\\nNone.\\n\\nNot applicable.\\n\\nNone.\\n20\\n\\n\\n| Exhibit |\\n| Number | Description |\\n| 3.1 | Articles of Incorporation (incorporated by reference from the Company’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on January 19, 2016). |\\n| 3.1.1 | Amended Articles of Incorporation (incorporated by reference from the Company’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on January 19, 2016). |\\n| 3.1.2 | Articles of Incorporation of Altitude International (incorporated by reference to the form 8-K filed by the Company on July 3, 2017). |\\n| 3.2 | Amended Articles of Incorporation (incorporated by reference from the Company’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on January 19, 2016). |\\n| 10.1 | Share Exchange Agreement (incorporated by reference to exhibit 10.1 to the form 8-K filed by the Company on July 3, 2017). |\\n| 10.2 | Licensing Agreement (incorporated by reference to exhibit 10.2 to the form 8-K filed by the Company on July 3, 2017). |\\n| 10.3 | Sole Distribution Agreement (incorporated by reference to exhibit 10.3 to the form 8-K filed by the Company on July 3, 2017). |\\n| 31.1 | Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| 31.2 | Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| 32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\\n| 32.2 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\\n| 101 INS | XBRL Instance Document |\\n| 101 SCH | XBRL Taxonomy Extension Schema Document |\\n| 101 CAL | XBRL Taxonomy Calculation Linkbase Document |\\n| 101 DEF | XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101 LAB | XBRL Taxonomy Labels Linkbase Document |\\n| 101 PRE | XBRL Taxonomy Presentation Linkbase Document |\\n\\n21\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\n\\n| SIGNATURE | TITLE | DATE |\\n| /s/ Dave Vincent | Principal Executive Officer and Principal Financial and Accounting Officer | May 21, 2018 |\\n| Dave Vincent |\\n\\n22\\n \\n\\nWhat is the total net value of fixed assets and intangible assets at the end of Q2 2018 (June 30, 2018) in dollars if the yearly depreciation rate of both fixed assets and intangible assets stays unchanged?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 18642.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 44,\n \"input_length\": 14657\n}"}}},{"rowIdx":45,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nItem 1. Financial Statements\nPOOL CORPORATION\nConsolidated Statements of Income\n(Unaudited)\n(In thousands, except per share data)\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Net sales | $ | 597,456 | $ | 585,900 |\n| Cost of sales | 422,825 | 419,827 |\n| Gross profit | 174,631 | 166,073 |\n| Selling and administrative expenses | 136,245 | 132,532 |\n| Operating income | 38,386 | 33,541 |\n| Interest and other non-operating expenses, net | 6,616 | 3,527 |\n| Income before income taxes and equity earnings | 31,770 | 30,014 |\n| Income tax benefit | (802 | ) | (1,279 | ) |\n| Equity earnings in unconsolidated investments, net | 65 | 46 |\n| Net income | $ | 32,637 | $ | 31,339 |\n| Earnings per share: |\n| Basic | $ | 0.83 | $ | 0.78 |\n| Diluted | $ | 0.80 | $ | 0.75 |\n| Weighted average shares outstanding: |\n| Basic | 39,479 | 40,370 |\n| Diluted | 40,696 | 41,862 |\n| Cash dividends declared per common share | $ | 0.45 | $ | 0.37 |\n\nThe accompanying Notes are an integral part of the Consolidated Financial Statements.\n1\nPOOL CORPORATION\nConsolidated Statements of Comprehensive Income\n(Unaudited)\n(In thousands)\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Net income | $ | 32,637 | $ | 31,339 |\n| Other comprehensive (loss) income: |\n| Foreign currency translation gains | 214 | 976 |\n| Change in unrealized (losses) gains on interest rate swaps, net of change in taxes of $90 and $(275) | (269 | ) | 824 |\n| Total other comprehensive (loss) income | (55 | ) | 1,800 |\n| Comprehensive income | $ | 32,582 | $ | 33,139 |\n\nThe accompanying Notes are an integral part of the Consolidated Financial Statements.\n2\nPOOL CORPORATION\nConsolidated Balance Sheets\n(In thousands, except share data)\n| March 31, | March 31, | December 31, |\n| 2019 | 2018 | 2018 (1) |\n| (Unaudited) | (Unaudited) |\n| Assets |\n| Current assets: |\n| Cash and cash equivalents | $ | 28,581 | $ | 8,803 | $ | 16,358 |\n| Receivables, net | 72,352 | 75,889 | 69,493 |\n| Receivables pledged under receivables facility | 240,775 | 238,707 | 138,308 |\n| Product inventories, net | 815,742 | 703,793 | 672,579 |\n| Prepaid expenses and other current assets | 16,116 | 23,714 | 18,506 |\n| Total current assets | 1,173,566 | 1,050,906 | 915,244 |\n| Property and equipment, net | 107,690 | 109,310 | 106,964 |\n| Goodwill | 188,478 | 189,759 | 188,472 |\n| Other intangible assets, net | 11,744 | 12,926 | 12,004 |\n| Equity interest investments | 1,200 | 1,150 | 1,213 |\n| Operating lease assets | 177,293 | — | — |\n| Other assets | 18,379 | 15,615 | 16,974 |\n| Total assets | $ | 1,678,350 | $ | 1,379,666 | $ | 1,240,871 |\n| Liabilities and stockholders’ equity |\n| Current liabilities: |\n| Accounts payable | $ | 472,487 | $ | 467,795 | $ | 237,835 |\n| Accrued expenses and other current liabilities | 47,658 | 45,504 | 58,607 |\n| Short-term borrowings and current portion of long-term debt | 21,734 | 20,786 | 9,168 |\n| Current operating lease liabilities | 55,744 | — | — |\n| Total current liabilities | 597,623 | 534,085 | 305,610 |\n| Deferred income taxes | 29,368 | 24,947 | 29,399 |\n| Long-term debt, net | 677,243 | 547,324 | 657,593 |\n| Other long-term liabilities | 26,469 | 23,525 | 24,679 |\n| Non-current operating lease liabilities | 122,770 | — | — |\n| Total liabilities | 1,453,473 | 1,129,881 | 1,017,281 |\n| Stockholders’ equity: |\n| Common stock, $0.001 par value; 100,000,000 shares authorized;39,679,157, 40,568,775 and 39,506,067 shares issued andoutstanding at March 31, 2019, March 31, 2018 andDecember 31, 2018, respectively | 40 | 41 | 40 |\n| Additional paid-in capital | 463,522 | 437,878 | 453,193 |\n| Retained deficit | (227,633 | ) | (182,580 | ) | (218,646 | ) |\n| Accumulated other comprehensive loss | (11,052 | ) | (5,554 | ) | (10,997 | ) |\n| Total stockholders’ equity | 224,877 | 249,785 | 223,590 |\n| Total liabilities and stockholders’ equity | $ | 1,678,350 | $ | 1,379,666 | $ | 1,240,871 |\n\n(1) Derived from audited financial statements.\nThe accompanying Notes are an integral part of the Consolidated Financial Statements.\n3\nPOOL CORPORATION\nCondensed Consolidated Statements of Cash Flows\n(Unaudited)\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Operating activities |\n| Net income | $ | 32,637 | $ | 31,339 |\n| Adjustments to reconcile net income to net cash provided by (used in) operating activities: |\n| Depreciation | 6,649 | 6,299 |\n| Amortization | 375 | 470 |\n| Share-based compensation | 3,259 | 3,321 |\n| Equity earnings in unconsolidated investments, net | (65 | ) | (46 | ) |\n| Other | 512 | 681 |\n| Changes in operating assets and liabilities, net of effects of acquisitions: |\n| Receivables | (103,122 | ) | (117,377 | ) |\n| Product inventories | (128,206 | ) | (168,518 | ) |\n| Prepaid expenses and other assets | (1,427 | ) | (3,843 | ) |\n| Accounts payable | 230,030 | 222,285 |\n| Accrued expenses and other current liabilities | (11,838 | ) | (18,760 | ) |\n| Net cash provided by (used in) operating activities | 28,804 | (44,149 | ) |\n| Investing activities |\n| Acquisition of businesses, net of cash acquired | (9,370 | ) | (578 | ) |\n| Purchases of property and equipment, net of sale proceeds | (6,739 | ) | (14,639 | ) |\n| Net cash used in investing activities | (16,109 | ) | (15,217 | ) |\n| Financing activities |\n| Proceeds from revolving line of credit | 206,190 | 148,335 |\n| Payments on revolving line of credit | (253,249 | ) | (170,012 | ) |\n| Proceeds from asset-backed financing | 80,100 | 80,000 |\n| Payments on asset-backed financing | (13,500 | ) | (20,000 | ) |\n| Proceeds from short-term borrowings and current portion of long-term debt | 13,713 | 10,798 |\n| Payments on short-term borrowings and current portion of long-term debt | (1,148 | ) | (848 | ) |\n| Payments of deferred and contingent acquisition consideration | (311 | ) | (265 | ) |\n| Payments of deferred financing costs | — | (8 | ) |\n| Proceeds from stock issued under share-based compensation plans | 7,071 | 7,808 |\n| Payments of cash dividends | (17,819 | ) | (15,011 | ) |\n| Purchases of treasury stock | (23,097 | ) | (2,592 | ) |\n| Net cash (used in) provided by financing activities | (2,050 | ) | 38,205 |\n| Effect of exchange rate changes on cash and cash equivalents | 1,578 | 24 |\n| Change in cash and cash equivalents | 12,223 | (21,137 | ) |\n| Cash and cash equivalents at beginning of period | 16,358 | 29,940 |\n| Cash and cash equivalents at end of period | $ | 28,581 | $ | 8,803 |\n\nThe accompanying Notes are an integral part of the Consolidated Financial Statements.\n4\nPOOL CORPORATION\nConsolidated Statements of Changes in Stockholders’ Equity\n(Unaudited)\n(In thousands)\n| Common Stock | AdditionalPaid-In | Retained | AccumulatedOtherComprehensive |\n| Shares | Amount | Capital | Deficit | Loss | Total |\n| Balance at December 31, 2018 | 39,506 | $ | 40 | $ | 453,193 | $ | (218,646 | ) | $ | (10,997 | ) | $ | 223,590 |\n| Net income | — | — | — | 32,637 | — | 32,637 |\n| Foreign currency translation | — | — | — | — | 214 | 214 |\n| Interest rate swaps, net of the change in taxes of $90 | — | — | — | — | (269 | ) | (269 | ) |\n| Repurchases of common stock, net of retirements | (155 | ) | (1 | ) | — | (23,096 | ) | — | (23,097 | ) |\n| Share-based compensation | — | — | 3,259 | — | — | 3,259 |\n| Adoption of ASU 2016-02 | — | — | — | (709 | ) | — | (709 | ) |\n| Issuance of shares under share-based compensation plans | 328 | 1 | 7,070 | — | — | 7,071 |\n| Declaration of cash dividends | — | — | — | (17,819 | ) | — | (17,819 | ) |\n| Balance at March 31, 2019 | 39,679 | $ | 40 | $ | 463,522 | $ | (227,633 | ) | $ | (11,052 | ) | $ | 224,877 |\n\n| Common Stock | AdditionalPaid-In | Retained | AccumulatedOtherComprehensive |\n| Shares | Amount | Capital | Deficit | Loss | Total |\n| Balance at December 31, 2017 | 40,212 | $ | 40 | $ | 426,750 | $ | (196,316 | ) | $ | (7,328 | ) | $ | 223,146 |\n| Net income | — | — | — | 31,339 | — | 31,339 |\n| Foreign currency translation | — | — | — | — | 976 | 976 |\n| Interest rate swaps, net of the change in taxes of $(275) | — | — | — | — | 824 | 824 |\n| Repurchases of common stock, net of retirements | (18 | ) | — | — | (2,592 | ) | — | (2,592 | ) |\n| Share-based compensation | — | — | 3,321 | — | — | 3,321 |\n| Issuance of shares under share-based compensation plans | 375 | 1 | 7,807 | — | — | 7,808 |\n| Declaration of cash dividends | — | — | — | (15,011 | ) | — | (15,011 | ) |\n| Other | — | — | — | — | (26 | ) | (26 | ) |\n| Balance at March 31, 2018 | 40,569 | $ | 41 | $ | 437,878 | $ | (182,580 | ) | $ | (5,554 | ) | $ | 249,785 |\n\n5\nPOOL CORPORATION\nNotes to Consolidated Financial Statements\n(Unaudited)\nNote 1 – Summary of Significant Accounting Policies\nPool Corporation (the Company, which may be referred to as we, us or our) prepared the unaudited interim Consolidated Financial Statements following U.S. generally accepted accounting principles (GAAP) and the requirements of the Securities and Exchange Commission (SEC) for interim financial information. As permitted under those rules, we have condensed or omitted certain footnotes and other financial information required for complete financial statements.\nThe Consolidated Financial Statements include all normal and recurring adjustments that are necessary for a fair presentation of our financial position and operating results. All significant intercompany accounts and intercompany transactions have been eliminated.\nA description of our significant accounting policies is included in our 2018 Annual Report on Form 10-K. You should read the interim Consolidated Financial Statements in conjunction with the Consolidated Financial Statements and accompanying notes in our 2018 Annual Report on Form 10-K. The results for our three month period ended March 31, 2019 are not necessarily indicative of the expected results for our fiscal year ending December 31, 2019.\nNewly Adopted Accounting Pronouncements\nOn January 1, 2019, we adopted Accounting Standards Update (ASU) 2016-02, Leases (Topic 842) and all the related amendments, which are codified into Accounting Standards Codification (ASC) 842. The adoption of ASU 2016-02 significantly increased assets and liabilities on our Consolidated Balance Sheets as we recorded a right-of-use asset and corresponding liability for each of our existing operating leases. We adopted this guidance using the modified retrospective approach by recognizing a cumulative adjustment to retained earnings on the adoption date, which was not material. Additionally, we elected to apply the practical expedient that allows us to exclude comparative presentation; thus, we did not restate our prior period balance sheets to reflect the new guidance.\nWe recorded operating lease assets and operating lease liabilities of approximately $175.7 million and $181.6 million, respectively, as of January 1, 2019. The difference between the operating lease assets and operating lease liabilities primarily represents our straight-line rent liability of $5.1 million recorded under previous accounting guidance. Under ASU 2016-02, this liability is considered a reduction of the operating lease asset. We recorded the remaining difference between our operating lease assets and operating lease liabilities, net of the deferred tax impact, as an adjustment to retained earnings. Additionally, we reclassified prepaid rent of $4.9 million as of January 1, 2019 to our operating lease asset resulting in a balance of $180.6 million as of the adoption date.\nThe adoption of this guidance did not materially impact our results of operations or cash flows. See Commitments and Contingencies within this note below for additional information regarding our adoption of this new guidance.\nOn January 1, 2019, we adopted ASU 2017-12, Derivatives and Hedging (Topic 815), Targeted Improvements to Accounting for Hedging Activities. This new standard expands and refines hedge accounting for both financial and non-financial risk components, aligns the recognition and presentation of the effects of hedging instruments and hedge items in the financial statements and includes certain targeted improvements to ease the application of current guidance related to the assessment of hedge effectiveness. The adoption of this guidance did not impact our results of operations, statement of financial position or cash flows.\nCommitments and Contingencies\nWe lease facilities for our corporate and administrative offices, sales centers and centralized shipping locations under operating leases that expire in various years through 2032. Most of our leases contain five-year terms with renewal options that allow us to extend the lease term beyond the initial period, subject to terms agreed upon at lease inception. Based on our leasing practices and contract negotiations, we determined that we are not reasonably certain to exercise the renewal options and, as such, we have not included optional renewal periods in our measurement of operating lease assets, liabilities and expected lease terms.\nWe elected to apply the package of practical expedients available within ASU 2016-02, which is intended to provide some relief to issuers. Electing this option allowed us to retain our existing assessment of whether an arrangement is or contains a lease, is classified as an operating or financing lease and contains initial direct costs. We also elected the practical expedients that allow us to exclude short-term leases from our Consolidated Balance Sheets and to combine lease and non-lease components.\n6\nFor leases with step rent provisions whereby the rental payments increase incrementally over the life of the lease, we recognize expense on a straight-line basis determined by the total lease payments over the lease term. To the extent we determine that future obligations related to real estate taxes, insurance and other lease components are variable, we exclude them from the measurement of our operating lease assets and liabilities.\nSome of our real estate agreements include rental payments adjusted periodically for inflation. Our lease agreements do not contain any material residual value guarantees or material restrictive covenants.\nThe table below presents expense associated with facility and vehicle operating leases (in thousands):\n| Three Months Ended |\n| March 31, |\n| Lease Cost | Classification | 2019 | 2018 |\n| Operating lease cost (1) | Selling and administrative expenses | $ | 15,070 | $ | 14,553 |\n| Variable lease cost | Selling and administrative expenses | 3,259 | 3,021 |\n\n(1) Includes short-term lease cost, which is not material\nBased on our lease portfolio as of March 31, 2019, the table below sets forth the approximate future lease payments related to operating leases with initial terms of one year or more (in thousands):\n| 2019 | $ | 38,389 |\n| 2020 | 50,443 |\n| 2021 | 39,184 |\n| 2022 | 29,883 |\n| 2023 | 18,089 |\n| Thereafter | 17,554 |\n| Total lease payments | 193,542 |\n| Less: interest | 15,028 |\n| Present value of lease liabilities | 178,514 |\n\nTo calculate the present value of our lease liabilities, we determined our incremental borrowing rate based on the effective interest rate on our unsecured syndicated senior credit facility (the Credit Facility) adjusted for a collateral feature similar to that of our leased properties. The table below presents the weighted-average remaining lease term (years) of our operating leases and the weighted-average discount rate used in the above calculation:\n| March 31, |\n| Lease Term and Discount Rate | 2019 |\n| Weighted-average remaining lease term (years) |\n| Operating leases | 5.21 |\n| Weighted-average discount rate |\n| Operating leases | 3.5 | % |\n\n7\nThe table below presents the amount of cash paid for amounts included in the measurement of lease liabilities (in thousands):\n| Three Months Ended |\n| March 31, |\n| 2019 |\n| Operating cash flows for lease liabilities | $ | 14,080 |\n\nWe lease corporate and administrative offices from Northpark Corporate Center, LLC (NCC), an entity in which we have held a 50% ownership interest since May 2005. NCC owns and operates an office building in Covington, Louisiana. As of March 31, 2019, we occupy approximately 60,293 square feet of office space and we pay rent of $97,976 per month. Our lease term ends in May 2025. We recorded rent expense of $0.3 million for each of the three month periods ended March 31, 2019 and March 31, 2018.\nIncome Taxes\nWe reduce federal and state income taxes payable by the tax benefits associated with the exercise of nonqualified stock options and the lapse of restrictions on restricted stock awards. To the extent realized tax deductions exceed the amount of previously recognized deferred tax benefits related to share-based compensation, we record an excess tax benefit. We record all excess tax benefits as a component of income tax benefit or expense on the Consolidated Statements of Income in the period in which stock options are exercised or restrictions on awards lapse. We recorded excess tax benefits of $8.8 million in the first three months of 2019 compared to $9.0 million in the same period of 2018.\nRetained Deficit\nWe account for the retirement of treasury shares as a reduction of retained earnings (deficit). As of March 31, 2019, the Retained deficit on our Consolidated Balance Sheets reflects cumulative net income, the cumulative impact of adjustments for changes in accounting pronouncements, treasury share retirements since the inception of our share repurchase programs of $1,449.9 million and cumulative dividends of $512.9 million.\nAccumulated Other Comprehensive Loss\nThe table below presents the components of our Accumulated other comprehensive loss balance (in thousands):\n| March 31, | December 31, |\n| 2019 | 2018 | 2018 |\n| Foreign currency translation adjustments | $ | (12,208 | ) | $ | (6,528 | ) | $ | (12,422 | ) |\n| Unrealized gains on interest rate swaps, net of tax (1) | 1,156 | 974 | 1,425 |\n| Accumulated other comprehensive loss | $ | (11,052 | ) | $ | (5,554 | ) | $ | (10,997 | ) |\n\n| (1) | In February 2018, the Financial Accounting Standards Board (FASB) issued guidance that allows entities the option to reclassify the tax effects related to items in accumulated other comprehensive income (loss) to retained earnings (deficit) if deemed to be stranded in accumulated other comprehensive income (loss) due to U.S. tax reform. We do not have any material amounts stranded in Accumulated other comprehensive loss as a result of U.S. tax reform. |\n\n8\nRecent Accounting Pronouncements Pending Adoption\n| Standard | Description | Effective Date | Effect on Financial Statements and Other Significant Matters |\n| ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments | Changes the way companies evaluate credit losses for most financial assets and certain other instruments. For trade and other receivables, held-to-maturity debt securities, loans and other instruments, entities will be required to use a new forward-looking “expected loss” model to evaluate impairment, potentially resulting in earlier recognition of allowances for losses. The new standard also requires enhanced disclosures, including the requirement to disclose the information used to track credit quality by year of origination for most financing receivables. The guidance must be applied using a cumulative-effect transition method. | Annual periods beginning after December 15, 2019 | We are currently evaluating the effect this will have on our financial position, results of operations and related disclosures. |\n| ASU 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment | Eliminates the requirement to calculate the implied fair value of goodwill to measure a goodwill impairment charge (commonly referred to as Step 2 under the current guidance). Rather, the measurement of a goodwill impairment charge will be based on the excess of a reporting unit’s carrying value over its fair value (Step 1 under the current guidance). This guidance should be applied prospectively. | Annual and interim impairment tests performed in periods beginning after December 15, 2019 | We are currently evaluating the effect this will have on our financial position, results of operations and related disclosures. |\n\nNote 2 – Earnings Per Share\nWe calculate basic earnings per share (EPS) by dividing Net income by the weighted average number of common shares outstanding. We include outstanding unvested restricted stock awards of our common stock in the basic weighted average share calculation. Diluted EPS reflects the dilutive effects of potentially dilutive securities, which include in-the-money outstanding stock options and shares to be purchased under our employee stock purchase plan. Using the treasury stock method, the effect of dilutive securities includes these additional shares of common stock that would have been outstanding based on the assumption that these potentially dilutive securities had been issued.\nStock options with exercise prices that are higher than the average market prices of our common stock for the periods presented are excluded from the diluted EPS calculation because the effect is anti-dilutive.\n9\nThe table below presents the computation of EPS, including the reconciliation of basic and diluted weighted average shares outstanding (in thousands, except EPS):\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Net income | $ | 32,637 | $ | 31,339 |\n| Weighted average shares outstanding: |\n| Basic | 39,479 | 40,370 |\n| Effect of dilutive securities: |\n| Stock options and employee stock purchase plan | 1,217 | 1,492 |\n| Diluted | 40,696 | 41,862 |\n| Earnings per share: |\n| Basic | $ | 0.83 | $ | 0.78 |\n| Diluted | $ | 0.80 | $ | 0.75 |\n| Anti-dilutive stock options excluded from diluted earnings per share computations | 65 | 85 |\n\nNote 3 – Acquisitions\nIn January 2019, we acquired the distribution assets of W.W. Adcock, Inc., a wholesale distributor of swimming pool products, equipment, parts and supplies adding two locations in Pennsylvania, one location in North Carolina and one location in Virginia.\nIn November 2018, we acquired the distribution assets of Turf & Garden, Inc., a wholesale distributor of irrigation products and landscape maintenance equipment, parts and supplies with three locations in Virginia and one location in North Carolina.\nWe have completed our acquisition accounting for these acquisitions, subject to adjustments for standard holdback provisions per the terms of the purchase agreements, which are not material.\nIn January 2018, we acquired the distribution assets of Tore Pty. Ltd. (doing business as Pool Power), a wholesale distributor of pool and spa equipment in South Australia, with one distribution center in Adelaide, Australia. We have completed our acquisition accounting for this acquisition.\nThese acquisitions did not have a material impact on our financial position or results of operations, either individually or in the aggregate.\nNote 4 – Fair Value Measurements and Interest Rate Swaps\nOur assets and liabilities that are measured at fair value on a recurring basis include the unrealized gains or losses on our interest rate swap contracts and contingent consideration related to recent acquisitions. The three levels of the fair value hierarchy under the accounting guidance are described below:\n| Level 1 | Inputs to the valuation methodology are unadjusted quoted prices for identical assets or liabilities in active markets. |\n\n| Level 2 | Inputs to the valuation methodology include: |\n\n| • | quoted prices for similar assets or liabilities in active markets; |\n\n| • | quoted prices for identical or similar assets or liabilities in inactive markets; |\n\n| • | inputs other than quoted prices that are observable for the asset or liability; or |\n\n10\n| • | inputs that are derived principally from or corroborated by observable market data by correlation or other means. |\n\n| Level 3 | Inputs to the valuation methodology are unobservable and significant to the fair value measurement. |\n\nThe table below presents the estimated fair values of our interest rate swap contracts, our forward-starting interest rate swap contract and our contingent consideration liabilities (in thousands):\n| Fair Value at March 31, |\n| 2019 | 2018 |\n| Level 2 |\n| Unrealized gains on interest rate swaps | $ | 1,785 | $ | 2,451 |\n| Level 3 |\n| Contingent consideration liabilities | $ | 833 | $ | 1,617 |\n\nInterest Rate Swaps\nWe utilize interest rate swap contracts and forward-starting interest rate swap contracts to reduce our exposure to fluctuations in variable interest rates for future interest payments on our unsecured syndicated senior credit facility (the Credit Facility).\nFor determining the fair value of our interest rate swap and forward-starting interest rate swap contracts, we use significant other observable market data or assumptions (Level 2 inputs) that we believe market participants would use in pricing similar assets or liabilities, including assumptions about counterparty risk. Our fair value estimates reflect an income approach based on the terms of the interest rate swap contracts and inputs corroborated by observable market data including interest rate curves. We include unrealized gains in Prepaid expenses and other current assets and unrealized losses in Accrued expenses and other current liabilities on the Consolidated Balance Sheets.\nWe recognize any differences between the variable interest rate payments and the fixed interest rate settlements from our swap counterparties as an adjustment to interest expense over the life of the swaps. If determined to be effective cash flow hedges, we record the changes in the estimated fair value of the swaps to Accumulated other comprehensive loss on our Consolidated Balance Sheets. To the extent our interest rate swaps are determined to be ineffective, we recognize the changes in the estimated fair value of our swaps in Interest and other non-operating expenses, net on our Consolidated Statements of Income.\nWe currently have three interest rate swap contracts in place, which became effective on October 19, 2016. These swaps were previously forward-starting contracts that were amended in October 2015 to bring the fixed rates per our forward-starting contracts in line with current market rates at that time and extend the hedged period for future interest payments on our Credit Facility. As amended, these swap contracts terminate on November 20, 2019. In the first three months of 2019, we recognized a loss of $0.2 million as a result of ineffectiveness.\nThe following table provides additional details related to each of these amended swap contracts:\n| Derivative | Amendment Date | NotionalAmount(in millions) | FixedInterestRate |\n| Interest rate swap 1 | October 1, 2015 | $75.0 | 2.273% |\n| Interest rate swap 2 | October 1, 2015 | $25.0 | 2.111% |\n| Interest rate swap 3 | October 1, 2015 | $50.0 | 2.111% |\n\nFor the three interest rate swap contracts in effect at March 31, 2019, a portion of the change in the estimated fair value between periods relates to future interest expense. Recognition of the change in fair value between periods attributable to accrued interest is reclassified from Accumulated other comprehensive loss on the Consolidated Balance Sheets to Interest and other non-operating expenses, net on the Consolidated Statements of Income. These amounts were not material in the three month periods ended March 31, 2019 and March 31, 2018.\n11\nIn July 2016, we entered into an additional forward-starting interest rate swap contract to extend the hedged period for future interest payments on our Credit Facility to its maturity date at that time. This swap contract will convert the variable interest rate to a fixed interest rate on borrowings under the Credit Facility. This contract becomes effective on November 20, 2019 and terminates on November 20, 2020. The following table provides additional details related to this swap contract:\n| Derivative | Inception Date | NotionalAmount(in millions) | FixedInterestRate |\n| Forward-starting interest rate swap | July 6, 2016 | $150.0 | 1.1425% |\n\nFailure of our swap counterparties would result in the loss of any potential benefit to us under our swap agreements. In this case, we would still be obligated to pay the variable interest payments underlying our debt agreements. Additionally, failure of our swap counterparties would not eliminate our obligation to continue to make payments under our existing swap agreements if we continue to be in a net pay position.\nOur interest rate swap and forward-starting interest rate swap contracts are subject to master netting arrangements. According to our accounting policy, we do not offset the fair values of assets with the fair values of liabilities related to these contracts.\nOther\nThe carrying values of cash, receivables, accounts payable and accrued liabilities approximate fair value due to the short maturity of those instruments (Level 1 inputs). The carrying value of long-term debt approximates fair value (Level 3 inputs). Our determination of the estimated fair value reflects a discounted cash flow model using our estimates, including assumptions related to borrowing rates (Level 3 inputs).\nNote 5 – Debt\nThe table below presents the components of our debt (in thousands):\n| March 31, |\n| 2019 | 2018 |\n| Variable rate debt |\n| Short-term borrowings | $ | 13,714 | $ | 12,263 |\n| Current portion of long-term debt: |\n| Australian credit facility | 8,020 | 8,523 |\n| Short-term borrowings and current portion of long-term debt | 21,734 | 20,786 |\n| Long-term portion: |\n| Revolving credit facility | 503,073 | 388,762 |\n| Receivables securitization facility | 175,100 | 160,000 |\n| Less: financing costs, net | 930 | 1,438 |\n| Long-term debt, net | 677,243 | 547,324 |\n| Total debt | $ | 698,977 | $ | 568,110 |\n\nOur accounts receivable securitization facility (the Receivables Facility) provides for the sale of certain of our receivables to a wholly owned subsidiary (the Securitization Subsidiary). The Securitization Subsidiary transfers variable undivided percentage interests in the receivables and related rights to certain third-party financial institutions in exchange for cash proceeds, limited to the applicable funding capacities.\nWe account for the sale of the receivable interests as a secured borrowing on our Consolidated Balance Sheets. The receivables subject to the agreement collateralize the cash proceeds received from the third-party financial institutions. We classify the entire outstanding balance as Long-term debt on our Consolidated Balance Sheets as we intend and have the ability to refinance the obligations on a long‑term basis. We present the receivables that collateralize the cash proceeds separately as Receivables pledged under receivables facility on our Consolidated Balance Sheets.\n12\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nYou should read the following discussion in conjunction with Management’s Discussion and Analysis included in our 2018 Annual Report on Form 10-K.\nFor a discussion of our base business calculations, see the Results of Operations section below.\nCautionary Statement for Purposes of the “Safe Harbor” Provisions of the Private Securities Litigation Reform Act of 1995\nThis report contains forward-looking information that involves risks and uncertainties. Our forward‑looking statements express our current expectations or forecasts of possible future results or events, including projections of earnings and other financial performance measures, statements of management’s expectations regarding our plans and objectives and industry, general economic and other forecasts of trends, future dividend payments and share repurchases, and other matters. Forward-looking statements speak only as of the date of this filing, and we undertake no obligation to update or revise such statements to reflect new circumstances or unanticipated events as they occur. You can identify these statements by the fact that they do not relate strictly to historic or current facts and often use words such as “anticipate,” “estimate,” “expect,” “intend,” “believe,” “will likely result,” “outlook,” “project,” “may,” “can,” “plan,” “target,” “potential,” “should” and other words and expressions of similar meaning.\nNo assurance can be given that the expected results in any forward-looking statement will be achieved, and actual results may differ materially due to one or more factors, including the sensitivity of our business to weather conditions, changes in the economy and the housing market, our ability to maintain favorable relationships with suppliers and manufacturers, competition from other leisure product alternatives and mass merchants, excess tax benefits or deficiencies recognized under ASU 2016-09 and other risks detailed in our 2018 Annual Report on Form 10-K. For these statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act.\nOVERVIEW\nFinancial Results\nWe produced solid results in the first quarter of 2019 despite wetter and cooler conditions throughout most of the quarter in some of our major markets. Our team’s strong execution, coupled with modest top line growth, delivered favorable results in the quarter.\nNet sales increased 2% to $597.5 million in the first quarter of 2019 compared to $585.9 million in the first quarter of 2018, while base business sales grew 1%. Cooler and wetter weather, particularly in the western United States, combined with a later Easter holiday adversely impacted first quarter sales. Pool openings and normal spring early buys from customers in seasonal markets are influenced by the timing of the Easter holiday. In addition, sales were negatively impacted approximately 2% by the loss of a selling day compared to the first quarter of 2018 and 1% from unfavorable foreign currency exchange rate fluctuations.\nGross profit increased 5% to $174.6 million in the first quarter of 2019 from $166.1 million in the same period in 2018. Base business gross profit improved 4% over the first quarter of 2018, including a negative currency exchange impact of 1%. Gross margin increased 90 basis points to 29.2% in the first quarter of 2019 compared to 28.3% in the first quarter of 2018, reflecting benefits from our strategic inventory purchases in 2018 and lower customer early buys in the first quarter of 2019.\nSelling and administrative expenses (operating expenses) increased 3% to $136.2 million in the first quarter of 2019 compared to the first quarter of 2018. Base business operating expenses were up 1% over the comparable 2018 period including a 1% currency benefit. As a percentage of net sales, base business operating expenses increased to 22.6% in the first quarter of 2019 compared to 22.5% in the first quarter of 2018.\nOperating income for the first quarter of 2019 increased to $38.4 million, up 14% compared to the same period in 2018. Operating margin was 6.4% in the first quarter of 2019 and 5.7% in the same period in 2018, while base business operating margin improved 90 basis points from the prior year to 6.7% in the first quarter of 2019.\nWe recorded an $8.8 million tax benefit from Accounting Standards Update (ASU) 2016-09, Improvements to Employee Share-Based Payment Accounting, in the quarter ended March 31, 2019 compared to a tax benefit of $9.0 million realized in the same period of 2018.\n13\nNet income was $32.6 million in the first quarter of 2019 compared to $31.3 million in the first quarter of 2018. Earnings per share increased 7% to $0.80 per diluted share in the three months ended March 31, 2019 compared to $0.75 per diluted share in the same period of 2018. The benefit from ASU 2016-09 increased diluted earnings per share by $0.21 and $0.22 in the first quarters of 2019 and 2018, respectively. Excluding the impact from ASU 2016-09 in both periods, earnings per diluted share increased 11% to $0.59 in the first quarter of 2019 compared to $0.53 in the first quarter of 2018.\nReferences to product line and product category data throughout this report generally reflect data related to the North American swimming pool market, as it is more readily available for analysis and represents the largest component of our operations.\nFinancial Position and Liquidity\nAs of March 31, 2019, total net receivables, including pledged receivables, remained flat compared to March 31, 2018. Our days sales outstanding (DSO), as calculated on a trailing four quarters basis, was 29.8 days at March 31, 2019 and 30.1 days at March 31, 2018. Our allowance for doubtful accounts balance was $5.6 million at March 31, 2019 and $4.0 million at March 31, 2018.\nNet inventory levels grew 16% compared to levels at March 31, 2018. The increase of $111.9 million in inventory reflects strategic inventory purchases we made in the second half of 2018 in advance of greater than normal vendor price increases, inventory from acquired businesses and normal business growth, as well as the slower start to the season. The inventory reserve was $8.5 million at March 31, 2019 and $7.4 million at March 31, 2018. Our inventory turns, as calculated on a trailing four quarters basis, were 3.1 times at March 31, 2019 and 3.5 times at March 31, 2018.\nTotal debt outstanding at March 31, 2019 was $699.0 million, up 23% compared to total debt at March 31, 2018 primarily to fund business driven working capital growth, acquisitions and share repurchases over the past 12 months.\nCurrent Trends and Outlook\nFor a detailed discussion of trends through 2018, see the Current Trends and Outlook section of Management’s Discussion and Analysis included in Part II, Item 7 of our 2018 Annual Report on Form 10-K.\nAs a result of the additional tax benefits realized from ASU 2016-09 in the first quarter of 2019 beyond what was included in our initial earnings guidance range, we are updating our 2019 earnings guidance to a range of $6.09 to $6.39 from $6.05 to $6.35 per diluted share. Other than the additional $0.04 per diluted share tax benefit, our earnings expectation for 2019 remains unchanged.\nConsistent with our original 2019 projections, we expect base business sales growth of approximately 7% to 9% for 2019 and expect gross margin will be similar to 2018. Unfavorable weather impacts, the loss of a selling day and a later Easter holiday in 2019 led to delayed pool openings, lower customer early buys and lower construction and remodeling activity. We believe these factors negatively impacted our first quarter of 2019 sales by an estimated $30.0 to $45.0 million but will lead to increased sales growth later in the year, depending on customer capacity and weather.\nWe expect a slight improvement in our gross margin in the second quarter of 2019 as we sell through the strategic inventory purchases we made in the second half of 2018; we expect margins to decline in the fourth quarter of 2019 in comparison to the same quarter in the prior year due to a difficult comparison.\nWe expect base business operating expenses will grow at a rate of approximately 60% of gross margin growth for the year, which will enable us to achieve operating margin improvement of approximately 20 to 40 basis points for the full year of 2019 compared to 2018.\nAs discussed further in Results of Operations below, our average outstanding debt for the three months ended March 31, 2019 increased 31% over the same period last year, and given the increase in the 30-Day LIBOR, our effective interest rate increased approximately 70 basis points between periods. Based on these trends, we expect Interest and other non-operating expenses, net will increase for the full year of 2019 compared to 2018.\nWe expect our annual effective tax rate (excluding the benefit from ASU 2016-09) for 2019 will approximate 25.5%, which is consistent with 2018 and a reduction compared to our historical rate of approximately 38.5% due to the impact of U.S. tax reform.\nOur effective tax rate is dependent on our results of operations and may change if actual results differ materially from our current expectations, particularly any significant changes in our geographic mix. Due to ASU 2016-09, we expect our effective tax rate will fluctuate from quarter to quarter, particularly in periods when employees elect to exercise their vested stock options or when restrictions on share-based awards lapse. We recorded an $8.8 million tax benefit from ASU 2016-09 for the three months ended\n14\nMarch 31, 2019. Additional tax benefits could be recognized related to stock option exercises in 2019 from grants that expire in years after 2019, for which we have not included any expected benefits in our guidance. The estimated impact related to ASU 2016-09 is subject to several assumptions which can vary significantly, including our estimated share price and the periods in which our employees will exercise vested stock options.\nExcluding the impact of timing differences from our strategic inventory purchases made in the second half of 2018, we expect cash provided by operations will approximate net income for the 2019 fiscal year. We anticipate that we may use approximately $150.0 million to $200.0 million in cash for share repurchases in 2019, subject to additional authorization by our Board of Directors.\nRESULTS OF OPERATIONS\nAs of March 31, 2019, we conducted operations through 369 sales centers in North America, Europe, South America and Australia.\nThe following table presents information derived from the Consolidated Statements of Income expressed as a percentage of net sales:\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Net sales | 100.0 | % | 100.0 | % |\n| Cost of sales | 70.8 | 71.7 |\n| Gross profit | 29.2 | 28.3 |\n| Operating expenses | 22.8 | 22.6 |\n| Operating income | 6.4 | 5.7 |\n| Interest and other non-operating expenses, net | 1.1 | 0.6 |\n| Income before income taxes and equity earnings | 5.3 | % | 5.1 | % |\n\nWe have included the results of operations from the acquisitions in 2019 and 2018 in our consolidated results since the acquisition dates.\nThree Months Ended March 31, 2019 Compared to Three Months Ended March 31, 2018\nThe following table breaks out our consolidated results into the base business component and the excluded component (sales centers excluded from base business):\n| (Unaudited) | Base Business | Excluded | Total |\n| (in thousands) | Three Months Ended | Three Months Ended | Three Months Ended |\n| March 31, | March 31, | March 31, |\n| 2019 | 2018 | 2019 | 2018 | 2019 | 2018 |\n| Net sales | $ | 587,320 | $ | 582,822 | $ | 10,136 | $ | 3,078 | $ | 597,456 | $ | 585,900 |\n| Gross profit | 171,706 | 165,334 | 2,925 | 739 | 174,631 | 166,073 |\n| Gross margin | 29.2 | % | 28.4 | % | 28.9 | % | 24.0 | % | 29.2 | % | 28.3 | % |\n| Operating expenses | 132,548 | 131,250 | 3,697 | 1,282 | 136,245 | 132,532 |\n| Expenses as a % of net sales | 22.6 | % | 22.5 | % | 36.5 | % | 41.7 | % | 22.8 | % | 22.6 | % |\n| Operating income (loss) | 39,158 | 34,084 | (772 | ) | (543 | ) | 38,386 | 33,541 |\n| Operating margin | 6.7 | % | 5.8 | % | (7.6 | )% | (17.6 | )% | 6.4 | % | 5.7 | % |\n\n15\nIn our calculation of base business results, we have excluded the following acquisitions for the periods identified:\n| Acquired | AcquisitionDate | NetSales CentersAcquired | PeriodsExcluded |\n| W.W. Adcock, Inc. (1) | January 2019 | 4 | January - March 2019 |\n| Turf & Garden, Inc. (1) | November 2018 | 4 | January - March 2019 |\n| Tore Pty. Ltd. (Pool Power) (1) | January 2018 | 1 | January - March 2019 andJanuary - March 2018 |\n| Chem Quip, Inc. (1) | December 2017 | 5 | January - March 2019 and January - March 2018 |\n| Intermark | December 2017 | 1 | January - February 2019 and January - February 2018 |\n\n| (1) | We acquired certain distribution assets of each of these companies. |\n\nWhen calculating our base business results, we exclude sales centers that are acquired, closed, or opened in new markets for a period of 15 months. We also exclude consolidated sales centers when we do not expect to maintain the majority of the existing business and existing sales centers that are consolidated with acquired sales centers.\nWe generally allocate corporate overhead expenses to excluded sales centers on the basis of their net sales as a percentage of total net sales. After 15 months of operations, we include acquired, consolidated and new market sales centers in the base business calculation including the comparative prior year period.\nThe table below summarizes the changes in our sales center count during the first three months of 2019:\n| December 31, 2018 | 364 |\n| Acquired locations | 4 |\n| New locations, existing markets | 2 |\n| Consolidated location | (1 | ) |\n| March 31, 2019 | 369 |\n\nNet Sales\n| Three Months Ended |\n| March 31, |\n| (in millions) | 2019 | 2018 | Change |\n| Net sales | $ | 597.5 | $ | 585.9 | $ | 11.6 | 2% |\n\nNet sales increased 2% in the first quarter of 2019 compared to the first quarter of 2018, with base business sales up 1% for the period. Cooler and wetter weather, particularly in the western United States, combined with a later Easter holiday adversely impacted first quarter sales. Pool openings and normal spring early buys from customers in seasonal markets are influenced by the timing of the Easter holiday. In addition, sales were negatively impacted approximately 2% by the loss of a selling day compared to the first quarter of 2018 and 1% from unfavorable foreign currency exchange rate fluctuations.\nThe following factors benefited our sales (listed in order of estimated magnitude):\n| • | inflationary product cost increases (estimated at approximately 2% above our historical average of 1% to 2%); |\n\n| • | strong demand for discretionary products, as evidenced by improvements in sales growth rates for product offerings such as building materials (see discussion below); |\n\n| • | acquisitions; and |\n\n| • | market share gains, particularly in building materials and commercial products (see discussion below). |\n\n16\nWe believe that sales growth rates for certain product offerings, such as equipment and building materials, evidence increased spending in traditionally discretionary areas, such as pool construction, pool remodeling and equipment upgrades. In the first quarter of 2019, sales for equipment, which includes swimming pool heaters, pumps, lights and filters, remained relatively flat compared to the same period last year. These products collectively represented approximately 30% of net sales for the period. Sales of building materials grew 8% compared to the first quarter of 2018 and represented approximately 13% of net sales in the first quarter of 2019.\nSales to customers who service large commercial swimming pools such as hotels, universities and community recreational facilities are included in the appropriate existing product categories, and growth in this area is reflected in the numbers above. Sales to these customers represented approximately 6% of our consolidated net sales for the first quarter of 2019 and increased 2% compared to the first quarter of 2018.\nGross Profit\n| Three Months Ended |\n| March 31, |\n| (in millions) | 2019 | 2018 | Change |\n| Gross profit | $ | 174.6 | $ | 166.1 | $ | 8.5 | 5% |\n| Gross margin | 29.2 | % | 28.3 | % |\n\nThe increase in gross margin between periods primarily reflects benefits from strategic inventory purchases in the second half of 2018 and lower customer early buys in the first quarter of 2019.\nOperating Expenses\n| Three Months Ended |\n| March 31, |\n| (in millions) | 2019 | 2018 | Change |\n| Operating expenses | $ | 136.2 | $ | 132.5 | $ | 3.7 | 3% |\n| Operating expenses as a % of net sales | 22.8 | % | 22.6 | % |\n\nOperating expenses increased 3% in the first quarter of 2019 compared to the first quarter of 2018, with base business operating expenses up approximately 1% compared to the same period last year. This increase is largely due to growth-driven increases in labor expenses and increased facility costs offset by a 1% benefit from foreign currency exchange rate fluctuations.\nInterest and Other Non-Operating Expenses, Net\nInterest and other non-operating expenses, net for the first quarter of 2019 increased $3.1 million compared to the first quarter of 2018. The increase mostly reflects higher debt levels and higher interest rates between periods. Our weighted average effective interest rate increased to 3.7% for the first quarter of 2019 from 3.0% for the first quarter of 2018 on higher average outstanding debt of $674.6 million versus $515.9 million for the respective periods.\nIncome Taxes\nOur effective income tax rate was a 2.5% benefit for the three months ended March 31, 2019, compared to a 4.3% benefit for the three months ended March 31, 2018. We recorded an $8.8 million tax benefit from ASU 2016-09 in the quarter ended March 31, 2019 compared to a benefit of $9.0 million realized in the same period last year. Excluding the benefits from ASU 2016-09, our effective tax rate was 25.1% and 25.7% for the first quarters of 2019 and 2018, respectively.\nNet Income and Earnings Per Share\nNet income increased 4% to $32.6 million in the first quarter of 2019 compared to the first quarter of 2018. Earnings per diluted share increased to $0.80 in the first quarter of 2019 versus $0.75 per diluted share for the comparable 2018 period. The benefit from ASU 2016-09 increased diluted earnings per share by $0.21 and $0.22 in the first quarters of 2019 and 2018, respectively. Excluding the impact from ASU 2016-09 in both periods, earnings per diluted share increased 11% to $0.59 in the first quarter of 2019 compared to $0.53 in the first quarter of 2018.\n17\nSeasonality and Quarterly Fluctuations\nOur business is highly seasonal. In general, sales and operating income are highest during the second and third quarters, which represent the peak months of both swimming pool use and installation and irrigation and landscape installations and maintenance. Sales are substantially lower during the first and fourth quarters, when we may incur net losses. In 2018, we generated approximately 62% of our net sales and 81% of our operating income in the second and third quarters of the year.\nWe typically experience a build-up of product inventories and accounts payable during the winter months in anticipation of the peak selling season. Excluding borrowings to finance acquisitions and share repurchases, our peak borrowing usually occurs during the second quarter, primarily because extended payment terms offered by our suppliers typically are payable in April, May and June, while our peak accounts receivable collections typically occur in June, July and August.\nThe following table presents certain unaudited quarterly data for the first quarter of 2019, the four quarters of 2018 and the fourth, third and second quarters of 2017. We have included income statement and balance sheet data for the most recent eight quarters to allow for a meaningful comparison of the seasonal fluctuations in these amounts. In our opinion, this information reflects all normal and recurring adjustments considered necessary for a fair presentation of this data. Due to the seasonal nature of our industry, the results of any one or more quarters are not necessarily a good indication of results for an entire fiscal year or of continuing trends.\n| (Unaudited) | QUARTER |\n| (in thousands) | 2019 | 2018 | 2017 |\n| First | Fourth | Third | Second | First | Fourth | Third | Second |\n| Statement of Income Data |\n| Net sales | $ | 597,456 | $ | 543,082 | $ | 811,311 | $ | 1,057,804 | $ | 585,900 | $ | 510,183 | $ | 743,401 | $ | 988,163 |\n| Gross profit | 174,631 | 160,442 | 235,003 | 308,655 | 166,073 | 145,398 | 216,606 | 289,664 |\n| Operating income | 38,386 | 25,970 | 92,337 | 162,042 | 33,541 | 17,259 | 81,928 | 154,186 |\n| Net income | 32,637 | 16,811 | 69,261 | 117,049 | 31,339 | 25,665 | 48,783 | 94,620 |\n| Balance Sheet Data |\n| Total receivables, net | $ | 313,127 | $ | 207,801 | $ | 287,773 | $ | 404,415 | $ | 314,596 | $ | 196,265 | $ | 262,796 | $ | 370,285 |\n| Product inventories, net | 815,742 | 672,579 | 609,983 | 606,583 | 703,793 | 536,474 | 484,287 | 542,805 |\n| Accounts payable | 472,487 | 237,835 | 204,706 | 300,232 | 467,795 | 245,249 | 209,062 | 273,309 |\n| Total debt | 698,977 | 666,761 | 580,703 | 657,120 | 568,110 | 519,650 | 564,573 | 553,480 |\n\nWe expect that our quarterly results of operations will continue to fluctuate depending on the timing and amount of revenue contributed by new and acquired sales centers. Based on our peak summer selling season, we generally open new sales centers and close or consolidate sales centers, when warranted, either in the first quarter before the peak selling season begins or in the fourth quarter after the peak selling season ends.\n18\nWeather is one of the principal external factors affecting our business. The table below presents some of the possible effects resulting from various weather conditions.\n| Weather | Possible Effects |\n| Hot and dry | • | Increased purchases of chemicals and suppliesfor existing swimming pools |\n| • | Increased purchases of above-ground pools andirrigation products |\n| Unseasonably cool weather or extraordinary amounts of rain | • | Fewer pool and irrigation and landscape installations |\n| • | Decreased purchases of chemicals and supplies |\n| • | Decreased purchases of impulse items such asabove-ground pools and accessories |\n| Unseasonably early warming trends in spring/late cooling trends in fall | • | A longer pool and landscape season, thus positively impacting our sales |\n| (primarily in the northern half of the U.S. and Canada) |\n| Unseasonably late warming trends in spring/early cooling trends in fall | • | A shorter pool and landscape season, thus negatively impacting our sales |\n| (primarily in the northern half of the U.S. and Canada) |\n\nWeather Impacts on 2019 and 2018 Results\nWetter and cooler-than-normal temperatures to begin the year hindered our first quarter of 2019 sales growth. Much of the western United States, particularly California and Arizona, experienced cold to record cold temperatures in January and February. The latter half of March benefited from warmer weather throughout most of the country and provided some relief from the slow start earlier in the year. The first quarter of 2018 experienced similar, though less significant, unfavorable weather in certain markets, leading to adverse conditions in 2019 compared to 2018.\n19\nLIQUIDITY AND CAPITAL RESOURCES\nLiquidity is defined as the ability to generate adequate amounts of cash to meet short-term and long-term cash needs. We assess our liquidity in terms of our ability to generate cash to fund our operating activities, taking into consideration the seasonal nature of our business. Significant factors which could affect our liquidity include the following:\n| • | cash flows generated from operating activities; |\n\n| • | the adequacy of available bank lines of credit; |\n\n| • | the quality of our receivables; |\n\n| • | acquisitions; |\n\n| • | dividend payments; |\n\n| • | capital expenditures; |\n\n| • | changes in income tax laws and regulations; |\n\n| • | the timing and extent of share repurchases; and |\n\n| • | the ability to attract long-term capital with satisfactory terms. |\n\nOur primary capital needs are seasonal working capital requirements and other general corporate purposes, including acquisitions, dividend payments and share repurchases. Our primary sources of working capital are cash from operations supplemented by borrowings, which have historically been sufficient to support our growth and finance acquisitions. The same principles apply to funds used for capital expenditures and share repurchases.\nWe prioritize our use of cash based on investing in our business, maintaining a prudent debt structure, including a modest amount of debt, and returning cash to our shareholders through dividends and share repurchases. Our specific priorities for the use of cash are as follows:\n| • | capital expenditures primarily for maintenance and growth of our sales center structure, technology-related investments and fleet vehicles; |\n\n| • | strategic acquisitions executed opportunistically; |\n\n| • | payment of cash dividends as and when declared by our Board of Directors (Board); |\n\n| • | repayment of debt to maintain an average total leverage ratio (as defined below) between 1.5 and 2.0; and |\n\n| • | repurchases of our common stock under our Board-authorized share repurchase program. |\n\nCapital expenditures were 1.1% of net sales in 2018 and 1.4% of net sales in both 2017 and 2016. Our higher capital spending in 2017 and 2016 related to expanding our facilities and purchasing delivery vehicles to address growth. Over the last five years, capital expenditures have averaged roughly 1.0% of net sales. Going forward, we project capital expenditures will continue to approximate this average.\nSources and Uses of Cash\nThe following table summarizes our cash flows (in thousands):\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Operating activities | $ | 28,804 | $ | (44,149 | ) |\n| Investing activities | (16,109 | ) | (15,217 | ) |\n| Financing activities | (2,050 | ) | 38,205 |\n\nCash provided by operating activities increased $73.0 million during the first three months of 2019 compared to the first three months of 2018 primarily due to payments for pre-price increase inventory purchases in 2018 ahead of the 2019 season, which resulted in decreased inventory purchases in the first quarter of 2019.\nCash used in investing activities for the first three months of 2019 increased compared to the first three months of 2018 primarily due to the acquisition of W.W. Adcock, Inc. which we completed in January 2019.\nCash used in financing activities increased for the first three months of 2019 compared to the first three months of 2018, which reflects a $20.5 million increase in share repurchases as well as a $16.2 million decrease in amounts provided by net borrowings.\n20\nFuture Sources and Uses of Cash\nRevolving Credit Facility\nOur Credit Facility provides for $750.0 million in borrowing capacity under a five-year unsecured revolving credit facility and includes sublimits for the issuance of swingline loans and standby letters of credit. Pursuant to an accordion feature, the aggregate maximum principal amount of the commitments under the Credit Facility may be increased at our request and with agreement by the lenders by up to $75.0 million, to a total of $825.0 million. The Credit Facility matures on September 29, 2022. We intend to use the Credit Facility for general corporate purposes, for future share repurchases and to fund future growth initiatives.\nAt March 31, 2019, there was $503.1 million outstanding, a $4.8 million standby letter of credit outstanding and $242.1 million available for borrowing under the Credit Facility. We utilize interest rate swap contracts and forward-starting interest rate swap contracts to reduce our exposure to fluctuations in variable interest rates for future interest payments on the Credit Facility. As of March 31, 2019, we had three interest rate swap contracts in place that became effective on October 19, 2016. These swap contracts were previously forward-starting and were amended in October 2015 to bring the fixed rates per our forward-starting contracts in line with current market rates and extend the hedged period for future interest payments on our Credit Facility. Now effective, these amended swap contracts convert the Credit Facility’s variable interest rate to fixed rates of 2.273% on a notional amount of $75.0 million and 2.111% on two separate notional amounts, one $25.0 million and the other $50.0 million, totaling $75.0 million. Interest expense related to the notional amounts under these swap contracts is based on the fixed rates plus the applicable margin on the Credit Facility. These interest rate swap contracts will terminate on November 20, 2019.\nIn July 2016, we entered into a forward-starting interest rate swap contract to extend the hedged period for future interest payments on our Credit Facility to its maturity date at that time. This swap contract will convert the Credit Facility’s variable interest rate to a fixed rate of 1.1425% on a notional amount of $150.0 million. The contract becomes effective on November 20, 2019 and terminates on November 20, 2020.\nThe weighted average effective interest rate for the Credit Facility as of March 31, 2019 was approximately 3.5%, excluding commitment fees.\nFinancial covenants on the Credit Facility include maintenance of a maximum average total leverage ratio and a minimum fixed charge coverage ratio. As of March 31, 2019, the calculations of these two covenants are detailed below:\n| • | Maximum Average Total Leverage Ratio. On the last day of each fiscal quarter, our average total leverage ratio must be less than 3.25 to 1.00. Average Total Leverage Ratio is the ratio of the trailing twelve months (TTM) Average Total Funded Indebtedness plus the TTM Average Accounts Securitization Proceeds divided by the TTM EBITDA (as those terms are defined in the Credit Facility). As of March 31, 2019, our average total leverage ratio equaled 1.80 (compared to 1.72 as of December 31, 2018) and the TTM average total debt amount used in this calculation was $646.7 million. |\n\n| • | Minimum Fixed Charge Coverage Ratio. On the last day of each fiscal quarter, our fixed charge ratio must be greater than or equal to 2.25 to 1.00. Fixed Charge Ratio is the ratio of the TTM EBITDAR divided by TTM Interest Expense paid or payable in cash plus TTM Rental Expense (as those terms are defined in the Credit Facility). As of March 31, 2019, our fixed charge ratio equaled 5.17 (compared to 5.33 as of December 31, 2018) and TTM Rental Expense was $57.8 million. |\n\nThe Credit Facility also limits the declaration and payment of dividends on our common stock to no more than 50% of the preceding year’s Net Income (as defined in the Credit Facility), provided no default or event of default has occurred and is continuing, or would result from the payment of dividends. Additionally, we may declare and pay quarterly dividends notwithstanding that the aggregate amount of dividends paid would be in excess of the 50% limit described above so long as (i) the amount per share of such dividends does not exceed the amount per share paid during the most recent fiscal year in which we were in compliance with the 50% limit and (ii) our Average Total Leverage Ratio is less than 3.00 to 1.00 both immediately before and after giving pro forma effect to such dividends. Further, dividends must be declared and paid in a manner consistent with our past practice.\nUnder the Credit Facility, we may repurchase shares of our common stock provided no default or event of default has occurred and is continuing, or would result from the repurchase of shares, and our maximum average total leverage ratio (determined on a pro forma basis) is less than 2.50 to 1.00. Other covenants include restrictions on our ability to grant liens, incur indebtedness, make investments, merge or consolidate, and sell or transfer assets. Failure to comply with any of our financial covenants or any other terms of the Credit Facility could result in higher interest rates on our borrowings or the acceleration of the maturities of our outstanding debt.\n21\nReceivables Securitization Facility\nOur two-year accounts receivable securitization facility (the Receivables Facility) offers us a lower cost form of financing, with a peak funding capacity of up to $295.0 million between May 1 and June 30, which includes an additional seasonal funding capacity that is available between March 1 and July 31. Other funding capacities range from $95.0 million to $280.0 million throughout the remaining months of the year.\nThe Receivables Facility provides for the sale of certain of our receivables to a wholly owned subsidiary (the Securitization Subsidiary). The Securitization Subsidiary transfers variable undivided percentage interests in the receivables and related rights to certain third-party financial institutions in exchange for cash proceeds, limited to the applicable funding capacities. Upon payment of the receivables by customers, rather than remitting to the financial institutions the amounts collected, we retain such collections as proceeds for the sale of new receivables until payments become due.\nThe Receivables Facility contains terms and conditions (including representations, covenants and conditions precedent) customary for transactions of this type. Additionally, an amortization event will occur if we fail to maintain a maximum average total leverage ratio (average total funded debt/EBITDA) of 3.25 to 1.00 and a minimum fixed charge coverage ratio (EBITDAR/cash interest expense plus rental expense) of 2.25 to 1.00.\nAt March 31, 2019, there was $175.1 million outstanding under the Receivables Facility at a weighted average effective interest rate of 3.3%, excluding commitment fees.\nCompliance and Future Availability\nAs of March 31, 2019, we believe we were in compliance with all covenants and financial ratio requirements under our Credit Facility and our Receivables Facility. We believe we will remain in compliance with all covenants and financial ratio requirements throughout the next twelve months. For additional information regarding our debt arrangements, see Note 5 of “Notes to Consolidated Financial Statements,” included in Part II, Item 8 of our 2018 Annual Report on Form 10-K.\nWe believe we have adequate availability of capital to fund present operations and the current capacity to finance any working capital needs that may arise. We continually evaluate potential acquisitions and hold discussions with acquisition candidates. If suitable acquisition opportunities arise that would require financing, we believe that we have the ability to finance any such transactions.\nAs of April 25, 2019, $49.2 million of the current Board-authorized amount under our share repurchase program remained available. We expect to repurchase additional shares on the open market from time to time depending on market conditions. We plan to fund these repurchases with cash provided by operations and borrowings under the Credit and Receivables Facilities.\nCRITICAL ACCOUNTING ESTIMATES\nWe prepare our Consolidated Financial Statements in accordance with U.S. generally accepted accounting principles (GAAP), which require management to make estimates and assumptions that affect reported amounts and related disclosures. Management identifies critical accounting estimates as:\n| • | those that require the use of assumptions about matters that are inherently and highly uncertain at the time the estimates are made; and |\n\n| • | those for which changes in the estimates or assumptions, or the use of different estimates and assumptions, could have a material impact on our consolidated results of operations or financial condition. |\n\nManagement has discussed the development, selection and disclosure of our critical accounting estimates with the Audit Committee of our Board. For a description of our critical accounting estimates that require us to make the most difficult, subjective or complex judgments, please see our 2018 Annual Report on Form 10-K. We have not changed these policies from those previously disclosed.\nRecent Accounting Pronouncements\nSee Note 1 of “Notes to Consolidated Financial Statements,” included in Item 1 of this Form 10-Q for detail.\n22\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\nInterest Rate Risk\nThere have been no material changes during the three months ended March 31, 2019 from what we reported in our 2018 Annual Report on Form 10-K. For additional information on our interest rate risk, refer to “Quantitative and Qualitative Disclosures about Market Risk” included in Part II, Item 7A. in our 2018 Annual Report on Form 10-K.\nCurrency Risk\nThere have been no material changes during the three months ended March 31, 2019 from what we reported in our 2018 Annual Report on Form 10-K. For additional information on our currency risk, refer to “Quantitative and Qualitative Disclosures about Market Risk” included in Part II, Item 7A. in our 2018 Annual Report on Form 10-K.\nItem 4. Controls and Procedures\nThe term “disclosure controls and procedures” is defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the Act). The rules refer to the controls and other procedures designed to ensure that information required to be disclosed in reports that we file or submit under the Act is (1) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and (2) accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. As of March 31, 2019, management, including the CEO and CFO, performed an evaluation of the effectiveness of our disclosure controls and procedures. Based on that evaluation, management, including the CEO and CFO, concluded that as of March 31, 2019, our disclosure controls and procedures were effective.\nWe maintain a system of internal control over financial reporting that is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. Based on the most recent evaluation, we have concluded that no change in our internal control over financial reporting occurred during the last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\n23\nPART II. OTHER INFORMATION\nItem 1. Legal Proceedings\nFrom time to time, we are subject to various claims and litigation arising in the ordinary course of business, including product liability, personal injury, commercial, contract and employment matters. While the outcome of any litigation is inherently unpredictable, based on currently available facts we do not believe that the ultimate resolution of any of these matters will have a material adverse impact on our financial condition, results of operations or cash flows.\nItem 1A. Risk Factors\nThere have been no material changes from the risk factors disclosed in Part I, Item 1A “Risk Factors” in our 2018 Annual Report on Form 10-K.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nThe table below summarizes the repurchases of our common stock in the first quarter of 2019:\n| Period | Total Number of Shares Purchased (1) | Average Price Paid per Share | Total Number ofShares Purchasedas Part of Publicly Announced Plan (2) | Maximum ApproximateDollar Value of SharesThat May Yet be Purchased Under the Plan (3) |\n| January 1 - 31, 2019 | 116,946 | $ | 147.77 | 116,946 | $ | 52,498,367 |\n| February 1 - 28, 2019 | 28,513 | $ | 152.25 | 22,019 | $ | 49,200,474 |\n| March 1 - 31, 2019 | 9,401 | $ | 156.98 | — | $ | 49,200,474 |\n| Total | 154,860 | $ | 149.15 | 138,965 |\n\n| (1) | These shares may include shares of our common stock surrendered to us by employees in order to satisfy minimum tax withholding obligations in connection with certain exercises of employee stock options or lapses upon vesting of restrictions on previously restricted share awards, and/or to cover the exercise price of such options granted under our share-based compensation plans. There were 15,895 shares surrendered for this purpose in the first quarter of 2019. |\n\n| (2) | In May 2018, our Board authorized an additional $200.0 million under our share repurchase program for the repurchase of shares of our common stock in the open market at prevailing market prices or in privately negotiated transactions. |\n\n| (3) | As of April 25, 2019, $49.2 million of the authorized amount remained available under our current share repurchase program. |\n\n24\nItem 6. Exhibits\nExhibits filed as part of this report are listed below.\n| Incorporated by Reference |\n| No. | Description | Filed/ Furnished with thisForm 10-Q | Form | File No. | Date Filed |\n| 3.1 | Restated Certificate of Incorporation of the Company. | 10-Q | 000-26640 | 8/9/2006 |\n| 3.2 | Amended and Restated Bylaws of the Company. | 8-K | 000-26640 | 2/8/2019 |\n| 4.1 | Form of certificate representing shares of common stock of the Company. | 8-K | 000-26640 | 5/19/2006 |\n| 31.1 | Certification by Mark W. Joslin pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | X |\n| 31.2 | Certification by Peter D. Arvan pursuant to Rule 13a-14(a) and 15d‑14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | X |\n| 32.1 | Certification by Peter D.Arvan and Mark W. Joslin furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | X |\n| 101.INS | + | XBRL Instance Document | X |\n| 101.SCH | + | XBRL Taxonomy Extension Schema Document | X |\n| 101.CAL | + | XBRL Taxonomy Extension Calculation Linkbase Document | X |\n| 101.DEF | + | XBRL Taxonomy Extension Definition Linkbase Document | X |\n| 101.LAB | + | XBRL Taxonomy Extension Label Linkbase Document | X |\n| 101.PRE | + | XBRL Taxonomy Extension Presentation Linkbase Document | X |\n\n+ Attached as Exhibit 101 to this report are the following items formatted in XBRL (Extensible Business Reporting Language):\n| 1. | Consolidated Statements of Income for the three months ended March 31, 2019 and March 31, 2018; |\n\n| 2. | Consolidated Statements of Comprehensive Income for the three months ended March 31, 2019 and March 31, 2018; |\n\n| 3. | Consolidated Balance Sheets at March 31, 2019, December 31, 2018 and March 31, 2018; |\n\n| 4. | Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2019 and |\n\nMarch 31, 2018;\n| 5. | Consolidated Statements of Changes in Stockholders’ Equity for the three months ended March 31, 2019 and |\n\nMarch 31, 2018; and\n| 6. | Notes to Consolidated Financial Statements. |\n\n25\nSIGNATURE\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on April 30, 2019.\n| POOL CORPORATION |\n| By: | /s/ Mark W. Joslin |\n| Mark W. Joslin |\n| Senior Vice President and Chief Financial Officer, and duly authorized signatory on behalf of the registrant |\n\n26\n \n\nHow much should the company anticipate to pay for operating lease liabilities in 2021 if the inflation rate for that year is projected to be 2% (in thousands)?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nItem 1. Financial Statements\\nPOOL CORPORATION\\nConsolidated Statements of Income\\n(Unaudited)\\n(In thousands, except per share data)\\n| Three Months Ended |\\n| March 31, |\\n| 2019 | 2018 |\\n| Net sales | $ | 597,456 | $ | 585,900 |\\n| Cost of sales | 422,825 | 419,827 |\\n| Gross profit | 174,631 | 166,073 |\\n| Selling and administrative expenses | 136,245 | 132,532 |\\n| Operating income | 38,386 | 33,541 |\\n| Interest and other non-operating expenses, net | 6,616 | 3,527 |\\n| Income before income taxes and equity earnings | 31,770 | 30,014 |\\n| Income tax benefit | (802 | ) | (1,279 | ) |\\n| Equity earnings in unconsolidated investments, net | 65 | 46 |\\n| Net income | $ | 32,637 | $ | 31,339 |\\n| Earnings per share: |\\n| Basic | $ | 0.83 | $ | 0.78 |\\n| Diluted | $ | 0.80 | $ | 0.75 |\\n| Weighted average shares outstanding: |\\n| Basic | 39,479 | 40,370 |\\n| Diluted | 40,696 | 41,862 |\\n| Cash dividends declared per common share | $ | 0.45 | $ | 0.37 |\\n\\nThe accompanying Notes are an integral part of the Consolidated Financial Statements.\\n1\\nPOOL CORPORATION\\nConsolidated Statements of Comprehensive Income\\n(Unaudited)\\n(In thousands)\\n| Three Months Ended |\\n| March 31, |\\n| 2019 | 2018 |\\n| Net income | $ | 32,637 | $ | 31,339 |\\n| Other comprehensive (loss) income: |\\n| Foreign currency translation gains | 214 | 976 |\\n| Change in unrealized (losses) gains on interest rate swaps, net of change in taxes of $90 and $(275) | (269 | ) | 824 |\\n| Total other comprehensive (loss) income | (55 | ) | 1,800 |\\n| Comprehensive income | $ | 32,582 | $ | 33,139 |\\n\\nThe accompanying Notes are an integral part of the Consolidated Financial Statements.\\n2\\nPOOL CORPORATION\\nConsolidated Balance Sheets\\n(In thousands, except share data)\\n| March 31, | March 31, | December 31, |\\n| 2019 | 2018 | 2018 (1) |\\n| (Unaudited) | (Unaudited) |\\n| Assets |\\n| Current assets: |\\n| Cash and cash equivalents | $ | 28,581 | $ | 8,803 | $ | 16,358 |\\n| Receivables, net | 72,352 | 75,889 | 69,493 |\\n| Receivables pledged under receivables facility | 240,775 | 238,707 | 138,308 |\\n| Product inventories, net | 815,742 | 703,793 | 672,579 |\\n| Prepaid expenses and other current assets | 16,116 | 23,714 | 18,506 |\\n| Total current assets | 1,173,566 | 1,050,906 | 915,244 |\\n| Property and equipment, net | 107,690 | 109,310 | 106,964 |\\n| Goodwill | 188,478 | 189,759 | 188,472 |\\n| Other intangible assets, net | 11,744 | 12,926 | 12,004 |\\n| Equity interest investments | 1,200 | 1,150 | 1,213 |\\n| Operating lease assets | 177,293 | — | — |\\n| Other assets | 18,379 | 15,615 | 16,974 |\\n| Total assets | $ | 1,678,350 | $ | 1,379,666 | $ | 1,240,871 |\\n| Liabilities and stockholders’ equity |\\n| Current liabilities: |\\n| Accounts payable | $ | 472,487 | $ | 467,795 | $ | 237,835 |\\n| Accrued expenses and other current liabilities | 47,658 | 45,504 | 58,607 |\\n| Short-term borrowings and current portion of long-term debt | 21,734 | 20,786 | 9,168 |\\n| Current operating lease liabilities | 55,744 | — | — |\\n| Total current liabilities | 597,623 | 534,085 | 305,610 |\\n| Deferred income taxes | 29,368 | 24,947 | 29,399 |\\n| Long-term debt, net | 677,243 | 547,324 | 657,593 |\\n| Other long-term liabilities | 26,469 | 23,525 | 24,679 |\\n| Non-current operating lease liabilities | 122,770 | — | — |\\n| Total liabilities | 1,453,473 | 1,129,881 | 1,017,281 |\\n| Stockholders’ equity: |\\n| Common stock, $0.001 par value; 100,000,000 shares authorized;39,679,157, 40,568,775 and 39,506,067 shares issued andoutstanding at March 31, 2019, March 31, 2018 andDecember 31, 2018, respectively | 40 | 41 | 40 |\\n| Additional paid-in capital | 463,522 | 437,878 | 453,193 |\\n| Retained deficit | (227,633 | ) | (182,580 | ) | (218,646 | ) |\\n| Accumulated other comprehensive loss | (11,052 | ) | (5,554 | ) | (10,997 | ) |\\n| Total stockholders’ equity | 224,877 | 249,785 | 223,590 |\\n| Total liabilities and stockholders’ equity | $ | 1,678,350 | $ | 1,379,666 | $ | 1,240,871 |\\n\\n(1) Derived from audited financial statements.\\nThe accompanying Notes are an integral part of the Consolidated Financial Statements.\\n3\\nPOOL CORPORATION\\nCondensed Consolidated Statements of Cash Flows\\n(Unaudited)\\n| Three Months Ended |\\n| March 31, |\\n| 2019 | 2018 |\\n| Operating activities |\\n| Net income | $ | 32,637 | $ | 31,339 |\\n| Adjustments to reconcile net income to net cash provided by (used in) operating activities: |\\n| Depreciation | 6,649 | 6,299 |\\n| Amortization | 375 | 470 |\\n| Share-based compensation | 3,259 | 3,321 |\\n| Equity earnings in unconsolidated investments, net | (65 | ) | (46 | ) |\\n| Other | 512 | 681 |\\n| Changes in operating assets and liabilities, net of effects of acquisitions: |\\n| Receivables | (103,122 | ) | (117,377 | ) |\\n| Product inventories | (128,206 | ) | (168,518 | ) |\\n| Prepaid expenses and other assets | (1,427 | ) | (3,843 | ) |\\n| Accounts payable | 230,030 | 222,285 |\\n| Accrued expenses and other current liabilities | (11,838 | ) | (18,760 | ) |\\n| Net cash provided by (used in) operating activities | 28,804 | (44,149 | ) |\\n| Investing activities |\\n| Acquisition of businesses, net of cash acquired | (9,370 | ) | (578 | ) |\\n| Purchases of property and equipment, net of sale proceeds | (6,739 | ) | (14,639 | ) |\\n| Net cash used in investing activities | (16,109 | ) | (15,217 | ) |\\n| Financing activities |\\n| Proceeds from revolving line of credit | 206,190 | 148,335 |\\n| Payments on revolving line of credit | (253,249 | ) | (170,012 | ) |\\n| Proceeds from asset-backed financing | 80,100 | 80,000 |\\n| Payments on asset-backed financing | (13,500 | ) | (20,000 | ) |\\n| Proceeds from short-term borrowings and current portion of long-term debt | 13,713 | 10,798 |\\n| Payments on short-term borrowings and current portion of long-term debt | (1,148 | ) | (848 | ) |\\n| Payments of deferred and contingent acquisition consideration | (311 | ) | (265 | ) |\\n| Payments of deferred financing costs | — | (8 | ) |\\n| Proceeds from stock issued under share-based compensation plans | 7,071 | 7,808 |\\n| Payments of cash dividends | (17,819 | ) | (15,011 | ) |\\n| Purchases of treasury stock | (23,097 | ) | (2,592 | ) |\\n| Net cash (used in) provided by financing activities | (2,050 | ) | 38,205 |\\n| Effect of exchange rate changes on cash and cash equivalents | 1,578 | 24 |\\n| Change in cash and cash equivalents | 12,223 | (21,137 | ) |\\n| Cash and cash equivalents at beginning of period | 16,358 | 29,940 |\\n| Cash and cash equivalents at end of period | $ | 28,581 | $ | 8,803 |\\n\\nThe accompanying Notes are an integral part of the Consolidated Financial Statements.\\n4\\nPOOL CORPORATION\\nConsolidated Statements of Changes in Stockholders’ Equity\\n(Unaudited)\\n(In thousands)\\n| Common Stock | AdditionalPaid-In | Retained | AccumulatedOtherComprehensive |\\n| Shares | Amount | Capital | Deficit | Loss | Total |\\n| Balance at December 31, 2018 | 39,506 | $ | 40 | $ | 453,193 | $ | (218,646 | ) | $ | (10,997 | ) | $ | 223,590 |\\n| Net income | — | — | — | 32,637 | — | 32,637 |\\n| Foreign currency translation | — | — | — | — | 214 | 214 |\\n| Interest rate swaps, net of the change in taxes of $90 | — | — | — | — | (269 | ) | (269 | ) |\\n| Repurchases of common stock, net of retirements | (155 | ) | (1 | ) | — | (23,096 | ) | — | (23,097 | ) |\\n| Share-based compensation | — | — | 3,259 | — | — | 3,259 |\\n| Adoption of ASU 2016-02 | — | — | — | (709 | ) | — | (709 | ) |\\n| Issuance of shares under share-based compensation plans | 328 | 1 | 7,070 | — | — | 7,071 |\\n| Declaration of cash dividends | — | — | — | (17,819 | ) | — | (17,819 | ) |\\n| Balance at March 31, 2019 | 39,679 | $ | 40 | $ | 463,522 | $ | (227,633 | ) | $ | (11,052 | ) | $ | 224,877 |\\n\\n| Common Stock | AdditionalPaid-In | Retained | AccumulatedOtherComprehensive |\\n| Shares | Amount | Capital | Deficit | Loss | Total |\\n| Balance at December 31, 2017 | 40,212 | $ | 40 | $ | 426,750 | $ | (196,316 | ) | $ | (7,328 | ) | $ | 223,146 |\\n| Net income | — | — | — | 31,339 | — | 31,339 |\\n| Foreign currency translation | — | — | — | — | 976 | 976 |\\n| Interest rate swaps, net of the change in taxes of $(275) | — | — | — | — | 824 | 824 |\\n| Repurchases of common stock, net of retirements | (18 | ) | — | — | (2,592 | ) | — | (2,592 | ) |\\n| Share-based compensation | — | — | 3,321 | — | — | 3,321 |\\n| Issuance of shares under share-based compensation plans | 375 | 1 | 7,807 | — | — | 7,808 |\\n| Declaration of cash dividends | — | — | — | (15,011 | ) | — | (15,011 | ) |\\n| Other | — | — | — | — | (26 | ) | (26 | ) |\\n| Balance at March 31, 2018 | 40,569 | $ | 41 | $ | 437,878 | $ | (182,580 | ) | $ | (5,554 | ) | $ | 249,785 |\\n\\n5\\nPOOL CORPORATION\\nNotes to Consolidated Financial Statements\\n(Unaudited)\\nNote 1 – Summary of Significant Accounting Policies\\nPool Corporation (the Company, which may be referred to as we, us or our) prepared the unaudited interim Consolidated Financial Statements following U.S. generally accepted accounting principles (GAAP) and the requirements of the Securities and Exchange Commission (SEC) for interim financial information. As permitted under those rules, we have condensed or omitted certain footnotes and other financial information required for complete financial statements.\\nThe Consolidated Financial Statements include all normal and recurring adjustments that are necessary for a fair presentation of our financial position and operating results. All significant intercompany accounts and intercompany transactions have been eliminated.\\nA description of our significant accounting policies is included in our 2018 Annual Report on Form 10-K. You should read the interim Consolidated Financial Statements in conjunction with the Consolidated Financial Statements and accompanying notes in our 2018 Annual Report on Form 10-K. The results for our three month period ended March 31, 2019 are not necessarily indicative of the expected results for our fiscal year ending December 31, 2019.\\nNewly Adopted Accounting Pronouncements\\nOn January 1, 2019, we adopted Accounting Standards Update (ASU) 2016-02, Leases (Topic 842) and all the related amendments, which are codified into Accounting Standards Codification (ASC) 842. The adoption of ASU 2016-02 significantly increased assets and liabilities on our Consolidated Balance Sheets as we recorded a right-of-use asset and corresponding liability for each of our existing operating leases. We adopted this guidance using the modified retrospective approach by recognizing a cumulative adjustment to retained earnings on the adoption date, which was not material. Additionally, we elected to apply the practical expedient that allows us to exclude comparative presentation; thus, we did not restate our prior period balance sheets to reflect the new guidance.\\nWe recorded operating lease assets and operating lease liabilities of approximately $175.7 million and $181.6 million, respectively, as of January 1, 2019. The difference between the operating lease assets and operating lease liabilities primarily represents our straight-line rent liability of $5.1 million recorded under previous accounting guidance. Under ASU 2016-02, this liability is considered a reduction of the operating lease asset. We recorded the remaining difference between our operating lease assets and operating lease liabilities, net of the deferred tax impact, as an adjustment to retained earnings. Additionally, we reclassified prepaid rent of $4.9 million as of January 1, 2019 to our operating lease asset resulting in a balance of $180.6 million as of the adoption date.\\nThe adoption of this guidance did not materially impact our results of operations or cash flows. See Commitments and Contingencies within this note below for additional information regarding our adoption of this new guidance.\\nOn January 1, 2019, we adopted ASU 2017-12, Derivatives and Hedging (Topic 815), Targeted Improvements to Accounting for Hedging Activities. This new standard expands and refines hedge accounting for both financial and non-financial risk components, aligns the recognition and presentation of the effects of hedging instruments and hedge items in the financial statements and includes certain targeted improvements to ease the application of current guidance related to the assessment of hedge effectiveness. The adoption of this guidance did not impact our results of operations, statement of financial position or cash flows.\\nCommitments and Contingencies\\nWe lease facilities for our corporate and administrative offices, sales centers and centralized shipping locations under operating leases that expire in various years through 2032. Most of our leases contain five-year terms with renewal options that allow us to extend the lease term beyond the initial period, subject to terms agreed upon at lease inception. Based on our leasing practices and contract negotiations, we determined that we are not reasonably certain to exercise the renewal options and, as such, we have not included optional renewal periods in our measurement of operating lease assets, liabilities and expected lease terms.\\nWe elected to apply the package of practical expedients available within ASU 2016-02, which is intended to provide some relief to issuers. Electing this option allowed us to retain our existing assessment of whether an arrangement is or contains a lease, is classified as an operating or financing lease and contains initial direct costs. We also elected the practical expedients that allow us to exclude short-term leases from our Consolidated Balance Sheets and to combine lease and non-lease components.\\n6\\nFor leases with step rent provisions whereby the rental payments increase incrementally over the life of the lease, we recognize expense on a straight-line basis determined by the total lease payments over the lease term. To the extent we determine that future obligations related to real estate taxes, insurance and other lease components are variable, we exclude them from the measurement of our operating lease assets and liabilities.\\nSome of our real estate agreements include rental payments adjusted periodically for inflation. Our lease agreements do not contain any material residual value guarantees or material restrictive covenants.\\nThe table below presents expense associated with facility and vehicle operating leases (in thousands):\\n| Three Months Ended |\\n| March 31, |\\n| Lease Cost | Classification | 2019 | 2018 |\\n| Operating lease cost (1) | Selling and administrative expenses | $ | 15,070 | $ | 14,553 |\\n| Variable lease cost | Selling and administrative expenses | 3,259 | 3,021 |\\n\\n(1) Includes short-term lease cost, which is not material\\nBased on our lease portfolio as of March 31, 2019, the table below sets forth the approximate future lease payments related to operating leases with initial terms of one year or more (in thousands):\\n| 2019 | $ | 38,389 |\\n| 2020 | 50,443 |\\n| 2021 | 39,184 |\\n| 2022 | 29,883 |\\n| 2023 | 18,089 |\\n| Thereafter | 17,554 |\\n| Total lease payments | 193,542 |\\n| Less: interest | 15,028 |\\n| Present value of lease liabilities | 178,514 |\\n\\nTo calculate the present value of our lease liabilities, we determined our incremental borrowing rate based on the effective interest rate on our unsecured syndicated senior credit facility (the Credit Facility) adjusted for a collateral feature similar to that of our leased properties. The table below presents the weighted-average remaining lease term (years) of our operating leases and the weighted-average discount rate used in the above calculation:\\n| March 31, |\\n| Lease Term and Discount Rate | 2019 |\\n| Weighted-average remaining lease term (years) |\\n| Operating leases | 5.21 |\\n| Weighted-average discount rate |\\n| Operating leases | 3.5 | % |\\n\\n7\\nThe table below presents the amount of cash paid for amounts included in the measurement of lease liabilities (in thousands):\\n| Three Months Ended |\\n| March 31, |\\n| 2019 |\\n| Operating cash flows for lease liabilities | $ | 14,080 |\\n\\nWe lease corporate and administrative offices from Northpark Corporate Center, LLC (NCC), an entity in which we have held a 50% ownership interest since May 2005. NCC owns and operates an office building in Covington, Louisiana. As of March 31, 2019, we occupy approximately 60,293 square feet of office space and we pay rent of $97,976 per month. Our lease term ends in May 2025. We recorded rent expense of $0.3 million for each of the three month periods ended March 31, 2019 and March 31, 2018.\\nIncome Taxes\\nWe reduce federal and state income taxes payable by the tax benefits associated with the exercise of nonqualified stock options and the lapse of restrictions on restricted stock awards. To the extent realized tax deductions exceed the amount of previously recognized deferred tax benefits related to share-based compensation, we record an excess tax benefit. We record all excess tax benefits as a component of income tax benefit or expense on the Consolidated Statements of Income in the period in which stock options are exercised or restrictions on awards lapse. We recorded excess tax benefits of $8.8 million in the first three months of 2019 compared to $9.0 million in the same period of 2018.\\nRetained Deficit\\nWe account for the retirement of treasury shares as a reduction of retained earnings (deficit). As of March 31, 2019, the Retained deficit on our Consolidated Balance Sheets reflects cumulative net income, the cumulative impact of adjustments for changes in accounting pronouncements, treasury share retirements since the inception of our share repurchase programs of $1,449.9 million and cumulative dividends of $512.9 million.\\nAccumulated Other Comprehensive Loss\\nThe table below presents the components of our Accumulated other comprehensive loss balance (in thousands):\\n| March 31, | December 31, |\\n| 2019 | 2018 | 2018 |\\n| Foreign currency translation adjustments | $ | (12,208 | ) | $ | (6,528 | ) | $ | (12,422 | ) |\\n| Unrealized gains on interest rate swaps, net of tax (1) | 1,156 | 974 | 1,425 |\\n| Accumulated other comprehensive loss | $ | (11,052 | ) | $ | (5,554 | ) | $ | (10,997 | ) |\\n\\n| (1) | In February 2018, the Financial Accounting Standards Board (FASB) issued guidance that allows entities the option to reclassify the tax effects related to items in accumulated other comprehensive income (loss) to retained earnings (deficit) if deemed to be stranded in accumulated other comprehensive income (loss) due to U.S. tax reform. We do not have any material amounts stranded in Accumulated other comprehensive loss as a result of U.S. tax reform. |\\n\\n8\\nRecent Accounting Pronouncements Pending Adoption\\n| Standard | Description | Effective Date | Effect on Financial Statements and Other Significant Matters |\\n| ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments | Changes the way companies evaluate credit losses for most financial assets and certain other instruments. For trade and other receivables, held-to-maturity debt securities, loans and other instruments, entities will be required to use a new forward-looking “expected loss” model to evaluate impairment, potentially resulting in earlier recognition of allowances for losses. The new standard also requires enhanced disclosures, including the requirement to disclose the information used to track credit quality by year of origination for most financing receivables. The guidance must be applied using a cumulative-effect transition method. | Annual periods beginning after December 15, 2019 | We are currently evaluating the effect this will have on our financial position, results of operations and related disclosures. |\\n| ASU 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment | Eliminates the requirement to calculate the implied fair value of goodwill to measure a goodwill impairment charge (commonly referred to as Step 2 under the current guidance). Rather, the measurement of a goodwill impairment charge will be based on the excess of a reporting unit’s carrying value over its fair value (Step 1 under the current guidance). This guidance should be applied prospectively. | Annual and interim impairment tests performed in periods beginning after December 15, 2019 | We are currently evaluating the effect this will have on our financial position, results of operations and related disclosures. |\\n\\nNote 2 – Earnings Per Share\\nWe calculate basic earnings per share (EPS) by dividing Net income by the weighted average number of common shares outstanding. We include outstanding unvested restricted stock awards of our common stock in the basic weighted average share calculation. Diluted EPS reflects the dilutive effects of potentially dilutive securities, which include in-the-money outstanding stock options and shares to be purchased under our employee stock purchase plan. Using the treasury stock method, the effect of dilutive securities includes these additional shares of common stock that would have been outstanding based on the assumption that these potentially dilutive securities had been issued.\\nStock options with exercise prices that are higher than the average market prices of our common stock for the periods presented are excluded from the diluted EPS calculation because the effect is anti-dilutive.\\n9\\nThe table below presents the computation of EPS, including the reconciliation of basic and diluted weighted average shares outstanding (in thousands, except EPS):\\n| Three Months Ended |\\n| March 31, |\\n| 2019 | 2018 |\\n| Net income | $ | 32,637 | $ | 31,339 |\\n| Weighted average shares outstanding: |\\n| Basic | 39,479 | 40,370 |\\n| Effect of dilutive securities: |\\n| Stock options and employee stock purchase plan | 1,217 | 1,492 |\\n| Diluted | 40,696 | 41,862 |\\n| Earnings per share: |\\n| Basic | $ | 0.83 | $ | 0.78 |\\n| Diluted | $ | 0.80 | $ | 0.75 |\\n| Anti-dilutive stock options excluded from diluted earnings per share computations | 65 | 85 |\\n\\nNote 3 – Acquisitions\\nIn January 2019, we acquired the distribution assets of W.W. Adcock, Inc., a wholesale distributor of swimming pool products, equipment, parts and supplies adding two locations in Pennsylvania, one location in North Carolina and one location in Virginia.\\nIn November 2018, we acquired the distribution assets of Turf & Garden, Inc., a wholesale distributor of irrigation products and landscape maintenance equipment, parts and supplies with three locations in Virginia and one location in North Carolina.\\nWe have completed our acquisition accounting for these acquisitions, subject to adjustments for standard holdback provisions per the terms of the purchase agreements, which are not material.\\nIn January 2018, we acquired the distribution assets of Tore Pty. Ltd. (doing business as Pool Power), a wholesale distributor of pool and spa equipment in South Australia, with one distribution center in Adelaide, Australia. We have completed our acquisition accounting for this acquisition.\\nThese acquisitions did not have a material impact on our financial position or results of operations, either individually or in the aggregate.\\nNote 4 – Fair Value Measurements and Interest Rate Swaps\\nOur assets and liabilities that are measured at fair value on a recurring basis include the unrealized gains or losses on our interest rate swap contracts and contingent consideration related to recent acquisitions. The three levels of the fair value hierarchy under the accounting guidance are described below:\\n| Level 1 | Inputs to the valuation methodology are unadjusted quoted prices for identical assets or liabilities in active markets. |\\n\\n| Level 2 | Inputs to the valuation methodology include: |\\n\\n| • | quoted prices for similar assets or liabilities in active markets; |\\n\\n| • | quoted prices for identical or similar assets or liabilities in inactive markets; |\\n\\n| • | inputs other than quoted prices that are observable for the asset or liability; or |\\n\\n10\\n| • | inputs that are derived principally from or corroborated by observable market data by correlation or other means. |\\n\\n| Level 3 | Inputs to the valuation methodology are unobservable and significant to the fair value measurement. |\\n\\nThe table below presents the estimated fair values of our interest rate swap contracts, our forward-starting interest rate swap contract and our contingent consideration liabilities (in thousands):\\n| Fair Value at March 31, |\\n| 2019 | 2018 |\\n| Level 2 |\\n| Unrealized gains on interest rate swaps | $ | 1,785 | $ | 2,451 |\\n| Level 3 |\\n| Contingent consideration liabilities | $ | 833 | $ | 1,617 |\\n\\nInterest Rate Swaps\\nWe utilize interest rate swap contracts and forward-starting interest rate swap contracts to reduce our exposure to fluctuations in variable interest rates for future interest payments on our unsecured syndicated senior credit facility (the Credit Facility).\\nFor determining the fair value of our interest rate swap and forward-starting interest rate swap contracts, we use significant other observable market data or assumptions (Level 2 inputs) that we believe market participants would use in pricing similar assets or liabilities, including assumptions about counterparty risk. Our fair value estimates reflect an income approach based on the terms of the interest rate swap contracts and inputs corroborated by observable market data including interest rate curves. We include unrealized gains in Prepaid expenses and other current assets and unrealized losses in Accrued expenses and other current liabilities on the Consolidated Balance Sheets.\\nWe recognize any differences between the variable interest rate payments and the fixed interest rate settlements from our swap counterparties as an adjustment to interest expense over the life of the swaps. If determined to be effective cash flow hedges, we record the changes in the estimated fair value of the swaps to Accumulated other comprehensive loss on our Consolidated Balance Sheets. To the extent our interest rate swaps are determined to be ineffective, we recognize the changes in the estimated fair value of our swaps in Interest and other non-operating expenses, net on our Consolidated Statements of Income.\\nWe currently have three interest rate swap contracts in place, which became effective on October 19, 2016. These swaps were previously forward-starting contracts that were amended in October 2015 to bring the fixed rates per our forward-starting contracts in line with current market rates at that time and extend the hedged period for future interest payments on our Credit Facility. As amended, these swap contracts terminate on November 20, 2019. In the first three months of 2019, we recognized a loss of $0.2 million as a result of ineffectiveness.\\nThe following table provides additional details related to each of these amended swap contracts:\\n| Derivative | Amendment Date | NotionalAmount(in millions) | FixedInterestRate |\\n| Interest rate swap 1 | October 1, 2015 | $75.0 | 2.273% |\\n| Interest rate swap 2 | October 1, 2015 | $25.0 | 2.111% |\\n| Interest rate swap 3 | October 1, 2015 | $50.0 | 2.111% |\\n\\nFor the three interest rate swap contracts in effect at March 31, 2019, a portion of the change in the estimated fair value between periods relates to future interest expense. Recognition of the change in fair value between periods attributable to accrued interest is reclassified from Accumulated other comprehensive loss on the Consolidated Balance Sheets to Interest and other non-operating expenses, net on the Consolidated Statements of Income. These amounts were not material in the three month periods ended March 31, 2019 and March 31, 2018.\\n11\\nIn July 2016, we entered into an additional forward-starting interest rate swap contract to extend the hedged period for future interest payments on our Credit Facility to its maturity date at that time. This swap contract will convert the variable interest rate to a fixed interest rate on borrowings under the Credit Facility. This contract becomes effective on November 20, 2019 and terminates on November 20, 2020. The following table provides additional details related to this swap contract:\\n| Derivative | Inception Date | NotionalAmount(in millions) | FixedInterestRate |\\n| Forward-starting interest rate swap | July 6, 2016 | $150.0 | 1.1425% |\\n\\nFailure of our swap counterparties would result in the loss of any potential benefit to us under our swap agreements. In this case, we would still be obligated to pay the variable interest payments underlying our debt agreements. Additionally, failure of our swap counterparties would not eliminate our obligation to continue to make payments under our existing swap agreements if we continue to be in a net pay position.\\nOur interest rate swap and forward-starting interest rate swap contracts are subject to master netting arrangements. According to our accounting policy, we do not offset the fair values of assets with the fair values of liabilities related to these contracts.\\nOther\\nThe carrying values of cash, receivables, accounts payable and accrued liabilities approximate fair value due to the short maturity of those instruments (Level 1 inputs). The carrying value of long-term debt approximates fair value (Level 3 inputs). Our determination of the estimated fair value reflects a discounted cash flow model using our estimates, including assumptions related to borrowing rates (Level 3 inputs).\\nNote 5 – Debt\\nThe table below presents the components of our debt (in thousands):\\n| March 31, |\\n| 2019 | 2018 |\\n| Variable rate debt |\\n| Short-term borrowings | $ | 13,714 | $ | 12,263 |\\n| Current portion of long-term debt: |\\n| Australian credit facility | 8,020 | 8,523 |\\n| Short-term borrowings and current portion of long-term debt | 21,734 | 20,786 |\\n| Long-term portion: |\\n| Revolving credit facility | 503,073 | 388,762 |\\n| Receivables securitization facility | 175,100 | 160,000 |\\n| Less: financing costs, net | 930 | 1,438 |\\n| Long-term debt, net | 677,243 | 547,324 |\\n| Total debt | $ | 698,977 | $ | 568,110 |\\n\\nOur accounts receivable securitization facility (the Receivables Facility) provides for the sale of certain of our receivables to a wholly owned subsidiary (the Securitization Subsidiary). The Securitization Subsidiary transfers variable undivided percentage interests in the receivables and related rights to certain third-party financial institutions in exchange for cash proceeds, limited to the applicable funding capacities.\\nWe account for the sale of the receivable interests as a secured borrowing on our Consolidated Balance Sheets. The receivables subject to the agreement collateralize the cash proceeds received from the third-party financial institutions. We classify the entire outstanding balance as Long-term debt on our Consolidated Balance Sheets as we intend and have the ability to refinance the obligations on a long‑term basis. We present the receivables that collateralize the cash proceeds separately as Receivables pledged under receivables facility on our Consolidated Balance Sheets.\\n12\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\\nYou should read the following discussion in conjunction with Management’s Discussion and Analysis included in our 2018 Annual Report on Form 10-K.\\nFor a discussion of our base business calculations, see the Results of Operations section below.\\nCautionary Statement for Purposes of the “Safe Harbor” Provisions of the Private Securities Litigation Reform Act of 1995\\nThis report contains forward-looking information that involves risks and uncertainties. Our forward‑looking statements express our current expectations or forecasts of possible future results or events, including projections of earnings and other financial performance measures, statements of management’s expectations regarding our plans and objectives and industry, general economic and other forecasts of trends, future dividend payments and share repurchases, and other matters. Forward-looking statements speak only as of the date of this filing, and we undertake no obligation to update or revise such statements to reflect new circumstances or unanticipated events as they occur. You can identify these statements by the fact that they do not relate strictly to historic or current facts and often use words such as “anticipate,” “estimate,” “expect,” “intend,” “believe,” “will likely result,” “outlook,” “project,” “may,” “can,” “plan,” “target,” “potential,” “should” and other words and expressions of similar meaning.\\nNo assurance can be given that the expected results in any forward-looking statement will be achieved, and actual results may differ materially due to one or more factors, including the sensitivity of our business to weather conditions, changes in the economy and the housing market, our ability to maintain favorable relationships with suppliers and manufacturers, competition from other leisure product alternatives and mass merchants, excess tax benefits or deficiencies recognized under ASU 2016-09 and other risks detailed in our 2018 Annual Report on Form 10-K. For these statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act.\\nOVERVIEW\\nFinancial Results\\nWe produced solid results in the first quarter of 2019 despite wetter and cooler conditions throughout most of the quarter in some of our major markets. Our team’s strong execution, coupled with modest top line growth, delivered favorable results in the quarter.\\nNet sales increased 2% to $597.5 million in the first quarter of 2019 compared to $585.9 million in the first quarter of 2018, while base business sales grew 1%. Cooler and wetter weather, particularly in the western United States, combined with a later Easter holiday adversely impacted first quarter sales. Pool openings and normal spring early buys from customers in seasonal markets are influenced by the timing of the Easter holiday. In addition, sales were negatively impacted approximately 2% by the loss of a selling day compared to the first quarter of 2018 and 1% from unfavorable foreign currency exchange rate fluctuations.\\nGross profit increased 5% to $174.6 million in the first quarter of 2019 from $166.1 million in the same period in 2018. Base business gross profit improved 4% over the first quarter of 2018, including a negative currency exchange impact of 1%. Gross margin increased 90 basis points to 29.2% in the first quarter of 2019 compared to 28.3% in the first quarter of 2018, reflecting benefits from our strategic inventory purchases in 2018 and lower customer early buys in the first quarter of 2019.\\nSelling and administrative expenses (operating expenses) increased 3% to $136.2 million in the first quarter of 2019 compared to the first quarter of 2018. Base business operating expenses were up 1% over the comparable 2018 period including a 1% currency benefit. As a percentage of net sales, base business operating expenses increased to 22.6% in the first quarter of 2019 compared to 22.5% in the first quarter of 2018.\\nOperating income for the first quarter of 2019 increased to $38.4 million, up 14% compared to the same period in 2018. Operating margin was 6.4% in the first quarter of 2019 and 5.7% in the same period in 2018, while base business operating margin improved 90 basis points from the prior year to 6.7% in the first quarter of 2019.\\nWe recorded an $8.8 million tax benefit from Accounting Standards Update (ASU) 2016-09, Improvements to Employee Share-Based Payment Accounting, in the quarter ended March 31, 2019 compared to a tax benefit of $9.0 million realized in the same period of 2018.\\n13\\nNet income was $32.6 million in the first quarter of 2019 compared to $31.3 million in the first quarter of 2018. Earnings per share increased 7% to $0.80 per diluted share in the three months ended March 31, 2019 compared to $0.75 per diluted share in the same period of 2018. The benefit from ASU 2016-09 increased diluted earnings per share by $0.21 and $0.22 in the first quarters of 2019 and 2018, respectively. Excluding the impact from ASU 2016-09 in both periods, earnings per diluted share increased 11% to $0.59 in the first quarter of 2019 compared to $0.53 in the first quarter of 2018.\\nReferences to product line and product category data throughout this report generally reflect data related to the North American swimming pool market, as it is more readily available for analysis and represents the largest component of our operations.\\nFinancial Position and Liquidity\\nAs of March 31, 2019, total net receivables, including pledged receivables, remained flat compared to March 31, 2018. Our days sales outstanding (DSO), as calculated on a trailing four quarters basis, was 29.8 days at March 31, 2019 and 30.1 days at March 31, 2018. Our allowance for doubtful accounts balance was $5.6 million at March 31, 2019 and $4.0 million at March 31, 2018.\\nNet inventory levels grew 16% compared to levels at March 31, 2018. The increase of $111.9 million in inventory reflects strategic inventory purchases we made in the second half of 2018 in advance of greater than normal vendor price increases, inventory from acquired businesses and normal business growth, as well as the slower start to the season. The inventory reserve was $8.5 million at March 31, 2019 and $7.4 million at March 31, 2018. Our inventory turns, as calculated on a trailing four quarters basis, were 3.1 times at March 31, 2019 and 3.5 times at March 31, 2018.\\nTotal debt outstanding at March 31, 2019 was $699.0 million, up 23% compared to total debt at March 31, 2018 primarily to fund business driven working capital growth, acquisitions and share repurchases over the past 12 months.\\nCurrent Trends and Outlook\\nFor a detailed discussion of trends through 2018, see the Current Trends and Outlook section of Management’s Discussion and Analysis included in Part II, Item 7 of our 2018 Annual Report on Form 10-K.\\nAs a result of the additional tax benefits realized from ASU 2016-09 in the first quarter of 2019 beyond what was included in our initial earnings guidance range, we are updating our 2019 earnings guidance to a range of $6.09 to $6.39 from $6.05 to $6.35 per diluted share. Other than the additional $0.04 per diluted share tax benefit, our earnings expectation for 2019 remains unchanged.\\nConsistent with our original 2019 projections, we expect base business sales growth of approximately 7% to 9% for 2019 and expect gross margin will be similar to 2018. Unfavorable weather impacts, the loss of a selling day and a later Easter holiday in 2019 led to delayed pool openings, lower customer early buys and lower construction and remodeling activity. We believe these factors negatively impacted our first quarter of 2019 sales by an estimated $30.0 to $45.0 million but will lead to increased sales growth later in the year, depending on customer capacity and weather.\\nWe expect a slight improvement in our gross margin in the second quarter of 2019 as we sell through the strategic inventory purchases we made in the second half of 2018; we expect margins to decline in the fourth quarter of 2019 in comparison to the same quarter in the prior year due to a difficult comparison.\\nWe expect base business operating expenses will grow at a rate of approximately 60% of gross margin growth for the year, which will enable us to achieve operating margin improvement of approximately 20 to 40 basis points for the full year of 2019 compared to 2018.\\nAs discussed further in Results of Operations below, our average outstanding debt for the three months ended March 31, 2019 increased 31% over the same period last year, and given the increase in the 30-Day LIBOR, our effective interest rate increased approximately 70 basis points between periods. Based on these trends, we expect Interest and other non-operating expenses, net will increase for the full year of 2019 compared to 2018.\\nWe expect our annual effective tax rate (excluding the benefit from ASU 2016-09) for 2019 will approximate 25.5%, which is consistent with 2018 and a reduction compared to our historical rate of approximately 38.5% due to the impact of U.S. tax reform.\\nOur effective tax rate is dependent on our results of operations and may change if actual results differ materially from our current expectations, particularly any significant changes in our geographic mix. Due to ASU 2016-09, we expect our effective tax rate will fluctuate from quarter to quarter, particularly in periods when employees elect to exercise their vested stock options or when restrictions on share-based awards lapse. We recorded an $8.8 million tax benefit from ASU 2016-09 for the three months ended\\n14\\nMarch 31, 2019. Additional tax benefits could be recognized related to stock option exercises in 2019 from grants that expire in years after 2019, for which we have not included any expected benefits in our guidance. The estimated impact related to ASU 2016-09 is subject to several assumptions which can vary significantly, including our estimated share price and the periods in which our employees will exercise vested stock options.\\nExcluding the impact of timing differences from our strategic inventory purchases made in the second half of 2018, we expect cash provided by operations will approximate net income for the 2019 fiscal year. We anticipate that we may use approximately $150.0 million to $200.0 million in cash for share repurchases in 2019, subject to additional authorization by our Board of Directors.\\nRESULTS OF OPERATIONS\\nAs of March 31, 2019, we conducted operations through 369 sales centers in North America, Europe, South America and Australia.\\nThe following table presents information derived from the Consolidated Statements of Income expressed as a percentage of net sales:\\n| Three Months Ended |\\n| March 31, |\\n| 2019 | 2018 |\\n| Net sales | 100.0 | % | 100.0 | % |\\n| Cost of sales | 70.8 | 71.7 |\\n| Gross profit | 29.2 | 28.3 |\\n| Operating expenses | 22.8 | 22.6 |\\n| Operating income | 6.4 | 5.7 |\\n| Interest and other non-operating expenses, net | 1.1 | 0.6 |\\n| Income before income taxes and equity earnings | 5.3 | % | 5.1 | % |\\n\\nWe have included the results of operations from the acquisitions in 2019 and 2018 in our consolidated results since the acquisition dates.\\nThree Months Ended March 31, 2019 Compared to Three Months Ended March 31, 2018\\nThe following table breaks out our consolidated results into the base business component and the excluded component (sales centers excluded from base business):\\n| (Unaudited) | Base Business | Excluded | Total |\\n| (in thousands) | Three Months Ended | Three Months Ended | Three Months Ended |\\n| March 31, | March 31, | March 31, |\\n| 2019 | 2018 | 2019 | 2018 | 2019 | 2018 |\\n| Net sales | $ | 587,320 | $ | 582,822 | $ | 10,136 | $ | 3,078 | $ | 597,456 | $ | 585,900 |\\n| Gross profit | 171,706 | 165,334 | 2,925 | 739 | 174,631 | 166,073 |\\n| Gross margin | 29.2 | % | 28.4 | % | 28.9 | % | 24.0 | % | 29.2 | % | 28.3 | % |\\n| Operating expenses | 132,548 | 131,250 | 3,697 | 1,282 | 136,245 | 132,532 |\\n| Expenses as a % of net sales | 22.6 | % | 22.5 | % | 36.5 | % | 41.7 | % | 22.8 | % | 22.6 | % |\\n| Operating income (loss) | 39,158 | 34,084 | (772 | ) | (543 | ) | 38,386 | 33,541 |\\n| Operating margin | 6.7 | % | 5.8 | % | (7.6 | )% | (17.6 | )% | 6.4 | % | 5.7 | % |\\n\\n15\\nIn our calculation of base business results, we have excluded the following acquisitions for the periods identified:\\n| Acquired | AcquisitionDate | NetSales CentersAcquired | PeriodsExcluded |\\n| W.W. Adcock, Inc. (1) | January 2019 | 4 | January - March 2019 |\\n| Turf & Garden, Inc. (1) | November 2018 | 4 | January - March 2019 |\\n| Tore Pty. Ltd. (Pool Power) (1) | January 2018 | 1 | January - March 2019 andJanuary - March 2018 |\\n| Chem Quip, Inc. (1) | December 2017 | 5 | January - March 2019 and January - March 2018 |\\n| Intermark | December 2017 | 1 | January - February 2019 and January - February 2018 |\\n\\n| (1) | We acquired certain distribution assets of each of these companies. |\\n\\nWhen calculating our base business results, we exclude sales centers that are acquired, closed, or opened in new markets for a period of 15 months. We also exclude consolidated sales centers when we do not expect to maintain the majority of the existing business and existing sales centers that are consolidated with acquired sales centers.\\nWe generally allocate corporate overhead expenses to excluded sales centers on the basis of their net sales as a percentage of total net sales. After 15 months of operations, we include acquired, consolidated and new market sales centers in the base business calculation including the comparative prior year period.\\nThe table below summarizes the changes in our sales center count during the first three months of 2019:\\n| December 31, 2018 | 364 |\\n| Acquired locations | 4 |\\n| New locations, existing markets | 2 |\\n| Consolidated location | (1 | ) |\\n| March 31, 2019 | 369 |\\n\\nNet Sales\\n| Three Months Ended |\\n| March 31, |\\n| (in millions) | 2019 | 2018 | Change |\\n| Net sales | $ | 597.5 | $ | 585.9 | $ | 11.6 | 2% |\\n\\nNet sales increased 2% in the first quarter of 2019 compared to the first quarter of 2018, with base business sales up 1% for the period. Cooler and wetter weather, particularly in the western United States, combined with a later Easter holiday adversely impacted first quarter sales. Pool openings and normal spring early buys from customers in seasonal markets are influenced by the timing of the Easter holiday. In addition, sales were negatively impacted approximately 2% by the loss of a selling day compared to the first quarter of 2018 and 1% from unfavorable foreign currency exchange rate fluctuations.\\nThe following factors benefited our sales (listed in order of estimated magnitude):\\n| • | inflationary product cost increases (estimated at approximately 2% above our historical average of 1% to 2%); |\\n\\n| • | strong demand for discretionary products, as evidenced by improvements in sales growth rates for product offerings such as building materials (see discussion below); |\\n\\n| • | acquisitions; and |\\n\\n| • | market share gains, particularly in building materials and commercial products (see discussion below). |\\n\\n16\\nWe believe that sales growth rates for certain product offerings, such as equipment and building materials, evidence increased spending in traditionally discretionary areas, such as pool construction, pool remodeling and equipment upgrades. In the first quarter of 2019, sales for equipment, which includes swimming pool heaters, pumps, lights and filters, remained relatively flat compared to the same period last year. These products collectively represented approximately 30% of net sales for the period. Sales of building materials grew 8% compared to the first quarter of 2018 and represented approximately 13% of net sales in the first quarter of 2019.\\nSales to customers who service large commercial swimming pools such as hotels, universities and community recreational facilities are included in the appropriate existing product categories, and growth in this area is reflected in the numbers above. Sales to these customers represented approximately 6% of our consolidated net sales for the first quarter of 2019 and increased 2% compared to the first quarter of 2018.\\nGross Profit\\n| Three Months Ended |\\n| March 31, |\\n| (in millions) | 2019 | 2018 | Change |\\n| Gross profit | $ | 174.6 | $ | 166.1 | $ | 8.5 | 5% |\\n| Gross margin | 29.2 | % | 28.3 | % |\\n\\nThe increase in gross margin between periods primarily reflects benefits from strategic inventory purchases in the second half of 2018 and lower customer early buys in the first quarter of 2019.\\nOperating Expenses\\n| Three Months Ended |\\n| March 31, |\\n| (in millions) | 2019 | 2018 | Change |\\n| Operating expenses | $ | 136.2 | $ | 132.5 | $ | 3.7 | 3% |\\n| Operating expenses as a % of net sales | 22.8 | % | 22.6 | % |\\n\\nOperating expenses increased 3% in the first quarter of 2019 compared to the first quarter of 2018, with base business operating expenses up approximately 1% compared to the same period last year. This increase is largely due to growth-driven increases in labor expenses and increased facility costs offset by a 1% benefit from foreign currency exchange rate fluctuations.\\nInterest and Other Non-Operating Expenses, Net\\nInterest and other non-operating expenses, net for the first quarter of 2019 increased $3.1 million compared to the first quarter of 2018. The increase mostly reflects higher debt levels and higher interest rates between periods. Our weighted average effective interest rate increased to 3.7% for the first quarter of 2019 from 3.0% for the first quarter of 2018 on higher average outstanding debt of $674.6 million versus $515.9 million for the respective periods.\\nIncome Taxes\\nOur effective income tax rate was a 2.5% benefit for the three months ended March 31, 2019, compared to a 4.3% benefit for the three months ended March 31, 2018. We recorded an $8.8 million tax benefit from ASU 2016-09 in the quarter ended March 31, 2019 compared to a benefit of $9.0 million realized in the same period last year. Excluding the benefits from ASU 2016-09, our effective tax rate was 25.1% and 25.7% for the first quarters of 2019 and 2018, respectively.\\nNet Income and Earnings Per Share\\nNet income increased 4% to $32.6 million in the first quarter of 2019 compared to the first quarter of 2018. Earnings per diluted share increased to $0.80 in the first quarter of 2019 versus $0.75 per diluted share for the comparable 2018 period. The benefit from ASU 2016-09 increased diluted earnings per share by $0.21 and $0.22 in the first quarters of 2019 and 2018, respectively. Excluding the impact from ASU 2016-09 in both periods, earnings per diluted share increased 11% to $0.59 in the first quarter of 2019 compared to $0.53 in the first quarter of 2018.\\n17\\nSeasonality and Quarterly Fluctuations\\nOur business is highly seasonal. In general, sales and operating income are highest during the second and third quarters, which represent the peak months of both swimming pool use and installation and irrigation and landscape installations and maintenance. Sales are substantially lower during the first and fourth quarters, when we may incur net losses. In 2018, we generated approximately 62% of our net sales and 81% of our operating income in the second and third quarters of the year.\\nWe typically experience a build-up of product inventories and accounts payable during the winter months in anticipation of the peak selling season. Excluding borrowings to finance acquisitions and share repurchases, our peak borrowing usually occurs during the second quarter, primarily because extended payment terms offered by our suppliers typically are payable in April, May and June, while our peak accounts receivable collections typically occur in June, July and August.\\nThe following table presents certain unaudited quarterly data for the first quarter of 2019, the four quarters of 2018 and the fourth, third and second quarters of 2017. We have included income statement and balance sheet data for the most recent eight quarters to allow for a meaningful comparison of the seasonal fluctuations in these amounts. In our opinion, this information reflects all normal and recurring adjustments considered necessary for a fair presentation of this data. Due to the seasonal nature of our industry, the results of any one or more quarters are not necessarily a good indication of results for an entire fiscal year or of continuing trends.\\n| (Unaudited) | QUARTER |\\n| (in thousands) | 2019 | 2018 | 2017 |\\n| First | Fourth | Third | Second | First | Fourth | Third | Second |\\n| Statement of Income Data |\\n| Net sales | $ | 597,456 | $ | 543,082 | $ | 811,311 | $ | 1,057,804 | $ | 585,900 | $ | 510,183 | $ | 743,401 | $ | 988,163 |\\n| Gross profit | 174,631 | 160,442 | 235,003 | 308,655 | 166,073 | 145,398 | 216,606 | 289,664 |\\n| Operating income | 38,386 | 25,970 | 92,337 | 162,042 | 33,541 | 17,259 | 81,928 | 154,186 |\\n| Net income | 32,637 | 16,811 | 69,261 | 117,049 | 31,339 | 25,665 | 48,783 | 94,620 |\\n| Balance Sheet Data |\\n| Total receivables, net | $ | 313,127 | $ | 207,801 | $ | 287,773 | $ | 404,415 | $ | 314,596 | $ | 196,265 | $ | 262,796 | $ | 370,285 |\\n| Product inventories, net | 815,742 | 672,579 | 609,983 | 606,583 | 703,793 | 536,474 | 484,287 | 542,805 |\\n| Accounts payable | 472,487 | 237,835 | 204,706 | 300,232 | 467,795 | 245,249 | 209,062 | 273,309 |\\n| Total debt | 698,977 | 666,761 | 580,703 | 657,120 | 568,110 | 519,650 | 564,573 | 553,480 |\\n\\nWe expect that our quarterly results of operations will continue to fluctuate depending on the timing and amount of revenue contributed by new and acquired sales centers. Based on our peak summer selling season, we generally open new sales centers and close or consolidate sales centers, when warranted, either in the first quarter before the peak selling season begins or in the fourth quarter after the peak selling season ends.\\n18\\nWeather is one of the principal external factors affecting our business. The table below presents some of the possible effects resulting from various weather conditions.\\n| Weather | Possible Effects |\\n| Hot and dry | • | Increased purchases of chemicals and suppliesfor existing swimming pools |\\n| • | Increased purchases of above-ground pools andirrigation products |\\n| Unseasonably cool weather or extraordinary amounts of rain | • | Fewer pool and irrigation and landscape installations |\\n| • | Decreased purchases of chemicals and supplies |\\n| • | Decreased purchases of impulse items such asabove-ground pools and accessories |\\n| Unseasonably early warming trends in spring/late cooling trends in fall | • | A longer pool and landscape season, thus positively impacting our sales |\\n| (primarily in the northern half of the U.S. and Canada) |\\n| Unseasonably late warming trends in spring/early cooling trends in fall | • | A shorter pool and landscape season, thus negatively impacting our sales |\\n| (primarily in the northern half of the U.S. and Canada) |\\n\\nWeather Impacts on 2019 and 2018 Results\\nWetter and cooler-than-normal temperatures to begin the year hindered our first quarter of 2019 sales growth. Much of the western United States, particularly California and Arizona, experienced cold to record cold temperatures in January and February. The latter half of March benefited from warmer weather throughout most of the country and provided some relief from the slow start earlier in the year. The first quarter of 2018 experienced similar, though less significant, unfavorable weather in certain markets, leading to adverse conditions in 2019 compared to 2018.\\n19\\nLIQUIDITY AND CAPITAL RESOURCES\\nLiquidity is defined as the ability to generate adequate amounts of cash to meet short-term and long-term cash needs. We assess our liquidity in terms of our ability to generate cash to fund our operating activities, taking into consideration the seasonal nature of our business. Significant factors which could affect our liquidity include the following:\\n| • | cash flows generated from operating activities; |\\n\\n| • | the adequacy of available bank lines of credit; |\\n\\n| • | the quality of our receivables; |\\n\\n| • | acquisitions; |\\n\\n| • | dividend payments; |\\n\\n| • | capital expenditures; |\\n\\n| • | changes in income tax laws and regulations; |\\n\\n| • | the timing and extent of share repurchases; and |\\n\\n| • | the ability to attract long-term capital with satisfactory terms. |\\n\\nOur primary capital needs are seasonal working capital requirements and other general corporate purposes, including acquisitions, dividend payments and share repurchases. Our primary sources of working capital are cash from operations supplemented by borrowings, which have historically been sufficient to support our growth and finance acquisitions. The same principles apply to funds used for capital expenditures and share repurchases.\\nWe prioritize our use of cash based on investing in our business, maintaining a prudent debt structure, including a modest amount of debt, and returning cash to our shareholders through dividends and share repurchases. Our specific priorities for the use of cash are as follows:\\n| • | capital expenditures primarily for maintenance and growth of our sales center structure, technology-related investments and fleet vehicles; |\\n\\n| • | strategic acquisitions executed opportunistically; |\\n\\n| • | payment of cash dividends as and when declared by our Board of Directors (Board); |\\n\\n| • | repayment of debt to maintain an average total leverage ratio (as defined below) between 1.5 and 2.0; and |\\n\\n| • | repurchases of our common stock under our Board-authorized share repurchase program. |\\n\\nCapital expenditures were 1.1% of net sales in 2018 and 1.4% of net sales in both 2017 and 2016. Our higher capital spending in 2017 and 2016 related to expanding our facilities and purchasing delivery vehicles to address growth. Over the last five years, capital expenditures have averaged roughly 1.0% of net sales. Going forward, we project capital expenditures will continue to approximate this average.\\nSources and Uses of Cash\\nThe following table summarizes our cash flows (in thousands):\\n| Three Months Ended |\\n| March 31, |\\n| 2019 | 2018 |\\n| Operating activities | $ | 28,804 | $ | (44,149 | ) |\\n| Investing activities | (16,109 | ) | (15,217 | ) |\\n| Financing activities | (2,050 | ) | 38,205 |\\n\\nCash provided by operating activities increased $73.0 million during the first three months of 2019 compared to the first three months of 2018 primarily due to payments for pre-price increase inventory purchases in 2018 ahead of the 2019 season, which resulted in decreased inventory purchases in the first quarter of 2019.\\nCash used in investing activities for the first three months of 2019 increased compared to the first three months of 2018 primarily due to the acquisition of W.W. Adcock, Inc. which we completed in January 2019.\\nCash used in financing activities increased for the first three months of 2019 compared to the first three months of 2018, which reflects a $20.5 million increase in share repurchases as well as a $16.2 million decrease in amounts provided by net borrowings.\\n20\\nFuture Sources and Uses of Cash\\nRevolving Credit Facility\\nOur Credit Facility provides for $750.0 million in borrowing capacity under a five-year unsecured revolving credit facility and includes sublimits for the issuance of swingline loans and standby letters of credit. Pursuant to an accordion feature, the aggregate maximum principal amount of the commitments under the Credit Facility may be increased at our request and with agreement by the lenders by up to $75.0 million, to a total of $825.0 million. The Credit Facility matures on September 29, 2022. We intend to use the Credit Facility for general corporate purposes, for future share repurchases and to fund future growth initiatives.\\nAt March 31, 2019, there was $503.1 million outstanding, a $4.8 million standby letter of credit outstanding and $242.1 million available for borrowing under the Credit Facility. We utilize interest rate swap contracts and forward-starting interest rate swap contracts to reduce our exposure to fluctuations in variable interest rates for future interest payments on the Credit Facility. As of March 31, 2019, we had three interest rate swap contracts in place that became effective on October 19, 2016. These swap contracts were previously forward-starting and were amended in October 2015 to bring the fixed rates per our forward-starting contracts in line with current market rates and extend the hedged period for future interest payments on our Credit Facility. Now effective, these amended swap contracts convert the Credit Facility’s variable interest rate to fixed rates of 2.273% on a notional amount of $75.0 million and 2.111% on two separate notional amounts, one $25.0 million and the other $50.0 million, totaling $75.0 million. Interest expense related to the notional amounts under these swap contracts is based on the fixed rates plus the applicable margin on the Credit Facility. These interest rate swap contracts will terminate on November 20, 2019.\\nIn July 2016, we entered into a forward-starting interest rate swap contract to extend the hedged period for future interest payments on our Credit Facility to its maturity date at that time. This swap contract will convert the Credit Facility’s variable interest rate to a fixed rate of 1.1425% on a notional amount of $150.0 million. The contract becomes effective on November 20, 2019 and terminates on November 20, 2020.\\nThe weighted average effective interest rate for the Credit Facility as of March 31, 2019 was approximately 3.5%, excluding commitment fees.\\nFinancial covenants on the Credit Facility include maintenance of a maximum average total leverage ratio and a minimum fixed charge coverage ratio. As of March 31, 2019, the calculations of these two covenants are detailed below:\\n| • | Maximum Average Total Leverage Ratio. On the last day of each fiscal quarter, our average total leverage ratio must be less than 3.25 to 1.00. Average Total Leverage Ratio is the ratio of the trailing twelve months (TTM) Average Total Funded Indebtedness plus the TTM Average Accounts Securitization Proceeds divided by the TTM EBITDA (as those terms are defined in the Credit Facility). As of March 31, 2019, our average total leverage ratio equaled 1.80 (compared to 1.72 as of December 31, 2018) and the TTM average total debt amount used in this calculation was $646.7 million. |\\n\\n| • | Minimum Fixed Charge Coverage Ratio. On the last day of each fiscal quarter, our fixed charge ratio must be greater than or equal to 2.25 to 1.00. Fixed Charge Ratio is the ratio of the TTM EBITDAR divided by TTM Interest Expense paid or payable in cash plus TTM Rental Expense (as those terms are defined in the Credit Facility). As of March 31, 2019, our fixed charge ratio equaled 5.17 (compared to 5.33 as of December 31, 2018) and TTM Rental Expense was $57.8 million. |\\n\\nThe Credit Facility also limits the declaration and payment of dividends on our common stock to no more than 50% of the preceding year’s Net Income (as defined in the Credit Facility), provided no default or event of default has occurred and is continuing, or would result from the payment of dividends. Additionally, we may declare and pay quarterly dividends notwithstanding that the aggregate amount of dividends paid would be in excess of the 50% limit described above so long as (i) the amount per share of such dividends does not exceed the amount per share paid during the most recent fiscal year in which we were in compliance with the 50% limit and (ii) our Average Total Leverage Ratio is less than 3.00 to 1.00 both immediately before and after giving pro forma effect to such dividends. Further, dividends must be declared and paid in a manner consistent with our past practice.\\nUnder the Credit Facility, we may repurchase shares of our common stock provided no default or event of default has occurred and is continuing, or would result from the repurchase of shares, and our maximum average total leverage ratio (determined on a pro forma basis) is less than 2.50 to 1.00. Other covenants include restrictions on our ability to grant liens, incur indebtedness, make investments, merge or consolidate, and sell or transfer assets. Failure to comply with any of our financial covenants or any other terms of the Credit Facility could result in higher interest rates on our borrowings or the acceleration of the maturities of our outstanding debt.\\n21\\nReceivables Securitization Facility\\nOur two-year accounts receivable securitization facility (the Receivables Facility) offers us a lower cost form of financing, with a peak funding capacity of up to $295.0 million between May 1 and June 30, which includes an additional seasonal funding capacity that is available between March 1 and July 31. Other funding capacities range from $95.0 million to $280.0 million throughout the remaining months of the year.\\nThe Receivables Facility provides for the sale of certain of our receivables to a wholly owned subsidiary (the Securitization Subsidiary). The Securitization Subsidiary transfers variable undivided percentage interests in the receivables and related rights to certain third-party financial institutions in exchange for cash proceeds, limited to the applicable funding capacities. Upon payment of the receivables by customers, rather than remitting to the financial institutions the amounts collected, we retain such collections as proceeds for the sale of new receivables until payments become due.\\nThe Receivables Facility contains terms and conditions (including representations, covenants and conditions precedent) customary for transactions of this type. Additionally, an amortization event will occur if we fail to maintain a maximum average total leverage ratio (average total funded debt/EBITDA) of 3.25 to 1.00 and a minimum fixed charge coverage ratio (EBITDAR/cash interest expense plus rental expense) of 2.25 to 1.00.\\nAt March 31, 2019, there was $175.1 million outstanding under the Receivables Facility at a weighted average effective interest rate of 3.3%, excluding commitment fees.\\nCompliance and Future Availability\\nAs of March 31, 2019, we believe we were in compliance with all covenants and financial ratio requirements under our Credit Facility and our Receivables Facility. We believe we will remain in compliance with all covenants and financial ratio requirements throughout the next twelve months. For additional information regarding our debt arrangements, see Note 5 of “Notes to Consolidated Financial Statements,” included in Part II, Item 8 of our 2018 Annual Report on Form 10-K.\\nWe believe we have adequate availability of capital to fund present operations and the current capacity to finance any working capital needs that may arise. We continually evaluate potential acquisitions and hold discussions with acquisition candidates. If suitable acquisition opportunities arise that would require financing, we believe that we have the ability to finance any such transactions.\\nAs of April 25, 2019, $49.2 million of the current Board-authorized amount under our share repurchase program remained available. We expect to repurchase additional shares on the open market from time to time depending on market conditions. We plan to fund these repurchases with cash provided by operations and borrowings under the Credit and Receivables Facilities.\\nCRITICAL ACCOUNTING ESTIMATES\\nWe prepare our Consolidated Financial Statements in accordance with U.S. generally accepted accounting principles (GAAP), which require management to make estimates and assumptions that affect reported amounts and related disclosures. Management identifies critical accounting estimates as:\\n| • | those that require the use of assumptions about matters that are inherently and highly uncertain at the time the estimates are made; and |\\n\\n| • | those for which changes in the estimates or assumptions, or the use of different estimates and assumptions, could have a material impact on our consolidated results of operations or financial condition. |\\n\\nManagement has discussed the development, selection and disclosure of our critical accounting estimates with the Audit Committee of our Board. For a description of our critical accounting estimates that require us to make the most difficult, subjective or complex judgments, please see our 2018 Annual Report on Form 10-K. We have not changed these policies from those previously disclosed.\\nRecent Accounting Pronouncements\\nSee Note 1 of “Notes to Consolidated Financial Statements,” included in Item 1 of this Form 10-Q for detail.\\n22\\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\\nInterest Rate Risk\\nThere have been no material changes during the three months ended March 31, 2019 from what we reported in our 2018 Annual Report on Form 10-K. For additional information on our interest rate risk, refer to “Quantitative and Qualitative Disclosures about Market Risk” included in Part II, Item 7A. in our 2018 Annual Report on Form 10-K.\\nCurrency Risk\\nThere have been no material changes during the three months ended March 31, 2019 from what we reported in our 2018 Annual Report on Form 10-K. For additional information on our currency risk, refer to “Quantitative and Qualitative Disclosures about Market Risk” included in Part II, Item 7A. in our 2018 Annual Report on Form 10-K.\\nItem 4. Controls and Procedures\\nThe term “disclosure controls and procedures” is defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the Act). The rules refer to the controls and other procedures designed to ensure that information required to be disclosed in reports that we file or submit under the Act is (1) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and (2) accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. As of March 31, 2019, management, including the CEO and CFO, performed an evaluation of the effectiveness of our disclosure controls and procedures. Based on that evaluation, management, including the CEO and CFO, concluded that as of March 31, 2019, our disclosure controls and procedures were effective.\\nWe maintain a system of internal control over financial reporting that is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. Based on the most recent evaluation, we have concluded that no change in our internal control over financial reporting occurred during the last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\\n23\\nPART II. OTHER INFORMATION\\nItem 1. Legal Proceedings\\nFrom time to time, we are subject to various claims and litigation arising in the ordinary course of business, including product liability, personal injury, commercial, contract and employment matters. While the outcome of any litigation is inherently unpredictable, based on currently available facts we do not believe that the ultimate resolution of any of these matters will have a material adverse impact on our financial condition, results of operations or cash flows.\\nItem 1A. Risk Factors\\nThere have been no material changes from the risk factors disclosed in Part I, Item 1A “Risk Factors” in our 2018 Annual Report on Form 10-K.\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\\nThe table below summarizes the repurchases of our common stock in the first quarter of 2019:\\n| Period | Total Number of Shares Purchased (1) | Average Price Paid per Share | Total Number ofShares Purchasedas Part of Publicly Announced Plan (2) | Maximum ApproximateDollar Value of SharesThat May Yet be Purchased Under the Plan (3) |\\n| January 1 - 31, 2019 | 116,946 | $ | 147.77 | 116,946 | $ | 52,498,367 |\\n| February 1 - 28, 2019 | 28,513 | $ | 152.25 | 22,019 | $ | 49,200,474 |\\n| March 1 - 31, 2019 | 9,401 | $ | 156.98 | — | $ | 49,200,474 |\\n| Total | 154,860 | $ | 149.15 | 138,965 |\\n\\n| (1) | These shares may include shares of our common stock surrendered to us by employees in order to satisfy minimum tax withholding obligations in connection with certain exercises of employee stock options or lapses upon vesting of restrictions on previously restricted share awards, and/or to cover the exercise price of such options granted under our share-based compensation plans. There were 15,895 shares surrendered for this purpose in the first quarter of 2019. |\\n\\n| (2) | In May 2018, our Board authorized an additional $200.0 million under our share repurchase program for the repurchase of shares of our common stock in the open market at prevailing market prices or in privately negotiated transactions. |\\n\\n| (3) | As of April 25, 2019, $49.2 million of the authorized amount remained available under our current share repurchase program. |\\n\\n24\\nItem 6. Exhibits\\nExhibits filed as part of this report are listed below.\\n| Incorporated by Reference |\\n| No. | Description | Filed/ Furnished with thisForm 10-Q | Form | File No. | Date Filed |\\n| 3.1 | Restated Certificate of Incorporation of the Company. | 10-Q | 000-26640 | 8/9/2006 |\\n| 3.2 | Amended and Restated Bylaws of the Company. | 8-K | 000-26640 | 2/8/2019 |\\n| 4.1 | Form of certificate representing shares of common stock of the Company. | 8-K | 000-26640 | 5/19/2006 |\\n| 31.1 | Certification by Mark W. Joslin pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | X |\\n| 31.2 | Certification by Peter D. Arvan pursuant to Rule 13a-14(a) and 15d‑14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | X |\\n| 32.1 | Certification by Peter D.Arvan and Mark W. Joslin furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | X |\\n| 101.INS | + | XBRL Instance Document | X |\\n| 101.SCH | + | XBRL Taxonomy Extension Schema Document | X |\\n| 101.CAL | + | XBRL Taxonomy Extension Calculation Linkbase Document | X |\\n| 101.DEF | + | XBRL Taxonomy Extension Definition Linkbase Document | X |\\n| 101.LAB | + | XBRL Taxonomy Extension Label Linkbase Document | X |\\n| 101.PRE | + | XBRL Taxonomy Extension Presentation Linkbase Document | X |\\n\\n+ Attached as Exhibit 101 to this report are the following items formatted in XBRL (Extensible Business Reporting Language):\\n| 1. | Consolidated Statements of Income for the three months ended March 31, 2019 and March 31, 2018; |\\n\\n| 2. | Consolidated Statements of Comprehensive Income for the three months ended March 31, 2019 and March 31, 2018; |\\n\\n| 3. | Consolidated Balance Sheets at March 31, 2019, December 31, 2018 and March 31, 2018; |\\n\\n| 4. | Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2019 and |\\n\\nMarch 31, 2018;\\n| 5. | Consolidated Statements of Changes in Stockholders’ Equity for the three months ended March 31, 2019 and |\\n\\nMarch 31, 2018; and\\n| 6. | Notes to Consolidated Financial Statements. |\\n\\n25\\nSIGNATURE\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on April 30, 2019.\\n| POOL CORPORATION |\\n| By: | /s/ Mark W. Joslin |\\n| Mark W. Joslin |\\n| Senior Vice President and Chief Financial Officer, and duly authorized signatory on behalf of the registrant |\\n\\n26\\n \\n\\nHow much should the company anticipate to pay for operating lease liabilities in 2021 if the inflation rate for that year is projected to be 2% (in thousands)?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 39967.68.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 45,\n \"input_length\": 20071\n}"}}},{"rowIdx":46,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n| Item 1. | Financial Statements. |\n\nDonegal Group Inc. and Subsidiaries\nConsolidated Balance Sheets\n\n| September 30,2016 | December 31,2015 |\n| (Unaudited) |\n| Assets |\n| Investments |\n| Fixed maturities |\n| Held to maturity, at amortized cost | $ | 332,272,969 | $ | 310,258,704 |\n| Available for sale, at fair value | 515,821,393 | 501,393,559 |\n| Equity securities, available for sale, at fair value | 46,311,943 | 37,260,821 |\n| Investment in affiliate | 40,145,067 | 38,476,708 |\n| Short-term investments, at cost, which approximates fair value | 9,251,153 | 13,432,482 |\n| Total investments | 943,802,525 | 900,822,274 |\n| Cash | 32,130,534 | 28,139,144 |\n| Accrued investment income | 6,817,760 | 5,991,197 |\n| Premiums receivable | 165,761,900 | 141,267,411 |\n| Reinsurance receivable | 259,428,626 | 259,728,113 |\n| Deferred policy acquisition costs | 57,404,289 | 52,108,388 |\n| Deferred tax asset, net | 14,721,101 | 19,443,807 |\n| Prepaid reinsurance premiums | 127,431,503 | 113,522,505 |\n| Property and equipment, net | 6,705,671 | 7,027,143 |\n| Federal income taxes receivable | 1,823,273 | 1,487,656 |\n| Goodwill | 5,625,354 | 5,625,354 |\n| Other intangible assets | 958,010 | 958,010 |\n| Other | 1,453,864 | 1,713,413 |\n| Total assets | $ | 1,624,064,410 | $ | 1,537,834,415 |\n| Liabilities and Stockholders Equity |\n| Liabilities |\n| Unpaid losses and loss expenses | $ | 594,267,943 | $ | 578,205,109 |\n| Unearned premiums | 476,432,783 | 429,493,203 |\n| Accrued expenses | 21,067,170 | 22,460,475 |\n| Reinsurance balances payable | 3,058,225 | 3,480,406 |\n| Borrowings under lines of credit | 74,000,000 | 81,000,000 |\n| Cash dividends declared | | 3,511,881 |\n| Subordinated debentures | 5,000,000 | 5,000,000 |\n| Accounts payable - securities | 540,311 | 582,560 |\n| Due to affiliate | 3,978,958 | 3,557,177 |\n| Other | 1,710,209 | 2,155,036 |\n| Total liabilities | 1,180,055,599 | 1,129,445,847 |\n| Stockholders Equity |\n| Preferred stock, $.01 par value, authorized 2,000,000 shares; none issued | | |\n| Class A common stock, $.01 par value, authorized 40,000,000 shares, issued 24,189,133 and 23,501,805 shares and outstanding 21,186,545 and 20,499,217 shares | 241,892 | 235,018 |\n| Class B common stock, $.01 par value, authorized 10,000,000 shares, issued 5,649,240 shares and outstanding 5,576,775 shares | 56,492 | 56,492 |\n| Additional paid-in capital | 231,885,764 | 219,525,301 |\n| Accumulated other comprehensive income | 6,340,292 | 773,744 |\n| Retained earnings | 246,710,728 | 229,024,370 |\n| Treasury stock, at cost | (41,226,357 | ) | (41,226,357 | ) |\n| Total stockholders equity | 444,008,811 | 408,388,568 |\n| Total liabilities and stockholders equity | $ | 1,624,064,410 | $ | 1,537,834,415 |\n\nSee accompanying notes to consolidated financial statements.\n1\nDonegal Group Inc. and Subsidiaries Consolidated Statements of Income (Unaudited) Three Months Ended September 30, 2016 2015 Revenues: Net premiums earned $ 166,809,851 $ 153,096,075 Investment income, net of investment expenses 5,581,238 5,399,080 Net realized investment gains (losses) (includes $1,018,415 and ($754,050) accumulated other comprehensive income (loss) reclassifications) 1,018,415 (754,050 ) Lease income 163,779 178,827 Installment payment fees 1,380,024 1,473,447 Equity in earnings of Donegal Financial Services Corporation 357,956 408,405 Total revenues 175,311,263 159,801,784 Expenses: Net losses and loss expenses 111,174,963 102,233,708 Amortization of deferred policy acquisition costs 27,524,000 25,036,000 Other underwriting expenses 28,340,135 24,155,566 Policyholder dividends 1,143,026 886,210 Interest 473,917 188,000 Other expenses 226,183 301,367 Total expenses 168,882,224 152,800,851 Income before income tax expense 6,429,039 7,000,933 Income tax expense (includes $356,446 and ($263,918) income tax expense (benefit) from reclassification items) 1,615,635 1,314,102 Net income $ 4,813,404 $ 5,686,831 Earnings per common share: Class A common stock - basic $ 0.19 $ 0.21 Class A common stock - diluted $ 0.18 $ 0.21 Class B common stock - basic and diluted $ 0.16 $ 0.18 Donegal Group Inc. and Subsidiaries Consolidated Statements of Comprehensive Income (Unaudited) Three Months Ended September 30, 2016 2015 Net income $ 4,813,404 $ 5,686,831 Other comprehensive (loss) income, net of tax Unrealized (loss) gain on securities: Unrealized holding (loss) gain during the period, net of income tax (benefit) expense of ($595,724) and 463,221 (1,106,346 ) 860,268 Reclassification adjustment for (gains) losses included in net income, net of income tax expense (benefit) of $356,446 and ($263,918) (661,969 ) 490,132 Other comprehensive (loss) income (1,768,315 ) 1,350,400 Comprehensive income $ 3,045,089 $ 7,037,231 See accompanying notes to consolidated financial statements. 2 Donegal Group Inc. and Subsidiaries Consolidated Statements of Income (Unaudited) Nine Months Ended September 30, 2016 2015 Revenues: Net premiums earned $ 487,227,767 $ 450,083,676 Investment income, net of investment expenses 16,471,630 15,505,429 Net realized investment gains (includes $2,204,533 and $682,932 accumulated other comprehensive income reclassifications) 2,204,533 682,932 Lease income 514,768 568,552 Installment payment fees 4,109,550 4,473,905 Equity in earnings of Donegal Financial Services Corporation 698,658 1,276,692 Total revenues 511,226,906 472,591,186 Expenses: Net losses and loss expenses 309,946,943 296,012,311 Amortization of deferred policy acquisition costs 80,034,000 73,872,000 Other underwriting expenses 81,557,159 73,192,072 Policyholder dividends 2,729,595 2,491,919 Interest 1,286,279 908,615 Other expenses 1,179,660 1,704,680 Total expenses 476,733,636 448,181,597 Income before income tax expense 34,493,270 24,409,589 Income tax expense (includes $771,587 and $239,026 income tax expense from reclassification items) 9,246,299 5,403,395 Net income $ 25,246,971 $ 19,006,194 Earnings per common share: Class A common stock - basic $ 0.98 $ 0.71 Class A common stock - diluted $ 0.95 $ 0.69 Class B common stock - basic and diluted $ 0.88 $ 0.63 Donegal Group Inc. and Subsidiaries Consolidated Statements of Comprehensive Income (Unaudited) Nine Months Ended September 30, 2016 2015 Net income $ 25,246,971 $ 19,006,194 Other comprehensive income (loss), net of tax Unrealized gain (loss) on securities: Unrealized holding gain (loss) during the period, net of income tax expense (benefit) of $3,768,959 and ($1,141,726) 6,999,494 (2,120,347 ) Reclassification adjustment for gains included in net income, net of income tax expense of $771,587 and $239,026 (1,432,946 ) (443,906 ) Other comprehensive income (loss) 5,566,548 (2,564,253 ) Comprehensive income $ 30,813,519 $ 16,441,941 See accompanying notes to consolidated financial statements. 3 Donegal Group Inc. and Subsidiaries Consolidated Statement of Stockholders’ Equity (Unaudited) Nine Months Ended September 30, 2016 Class A Shares Class B Shares Class A Amount Class B Amount Additional Paid-In Capital Accumulated Other Comprehensive Income Retained Earnings Treasury Stock Total Stockholders’ Equity Balance, December 31, 2015 23,501,805 5,649,240 $ 235,018 $ 56,492 $ 219,525,301 $ 773,744 $ 229,024,370 $ (41,226,357 ) $ 408,388,568 Issuance of common stock 104,271 — 1,043 — 1,389,022 — — — 1,390,065 Share-based compensation 583,057 5,831 10,396,351 10,402,182 Net income — — — — — — 25,246,971 — 25,246,971 Cash dividends declared — — — — — — (6,985,523 ) — (6,985,523 ) Grant of stock options — — — — 575,090 — (575,090 ) — — Other comprehensive income — — — — — 5,566,548 — — 5,566,548 Balance, September 30, 2016 24,189,133 5,649,240 $ 241,892 $ 56,492 $ 231,885,764 $ 6,340,292 $ 246,710,728 $ (41,226,357 ) $ 444,008,811 See accompanying notes to consolidated financial statements. 4 Donegal Group Inc. and Subsidiaries Consolidated Statements of Cash Flows (Unaudited) Nine Months Ended September 30, 2016 2015 Cash Flows from Operating Activities: Net income $ 25,246,971 $ 19,006,194 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation, amortization and other non-cash items 5,365,877 2,890,128 Net realized investment gains (2,204,533 ) (682,932 ) Equity in earnings of Donegal Financial Services Corporation (698,658 ) (1,276,692 ) Changes in assets and liabilities: Losses and loss expenses 16,062,834 30,888,062 Unearned premiums 46,939,580 32,671,922 Premiums receivable (24,494,489 ) (13,301,356 ) Deferred acquisition costs (5,295,901 ) (5,212,051 ) Deferred income taxes 1,725,335 225,409 Reinsurance receivable 299,487 (6,254,559 ) Prepaid reinsurance premiums (13,908,998 ) (1,631,341 ) Accrued investment income (826,563 ) (929,722 ) Due to affiliate 421,781 (1,655,351 ) Reinsurance balances payable (422,181 ) (3,900,348 ) Current income taxes (335,617 ) 242,849 Accrued expenses (1,393,305 ) (601,830 ) Other, net (185,278 ) (1,943,559 ) Net adjustments 21,049,371 29,528,629 Net cash provided by operating activities 46,296,342 48,534,823 Cash Flows from Investing Activities: Purchases of fixed maturities, held to maturity (35,461,529 ) (18,483,546 ) Purchases of fixed maturities, available for sale (127,113,153 ) (132,823,136 ) Purchases of equity securities, available for sale (10,753,187 ) (9,011,957 ) Maturity of fixed maturities: Held to maturity 13,603,700 22,416,840 Available for sale 64,406,512 56,293,130 Sales of fixed maturities, available for sale 52,032,208 23,485,311 Sales of equity securities, available for sale 5,068,287 2,704,425 Net purchases of property and equipment (260,968 ) (78,292 ) Net decrease in investment in affiliate — 675,100 Net sales (purchases) of short-term investments 4,181,329 (4,302,571 ) Net cash used in investing activities (34,296,801 ) (59,124,696 ) Cash Flows from Financing Activities: Cash dividends paid (10,497,404 ) (10,762,609 ) Issuance of common stock 9,489,253 17,106,300 Purchase of treasury stock — (904,675 ) Payments on lines of credit (7,000,000 ) (9,500,000 ) Borrowings under lines of credit — 4,000,000 Net cash used in financing activities (8,008,151 ) (60,984 ) Net increase (decrease) in cash 3,991,390 (10,650,857 ) Cash at beginning of period 28,139,144 35,578,509 Cash at end of period $ 32,130,534 $ 24,927,652 Cash paid during period - Interest $ 1,001,870 $ 757,175 Net cash paid during period - Taxes $ 8,255,000 $ 4,500,000 See accompanying notes to consolidated financial statements. 5 DONEGAL GROUP INC. AND SUBSIDIARIES (Unaudited) Notes to Consolidated Financial Statements 1 - Organization Donegal Mutual Insurance Company (“Donegal Mutual”) organized us as an insurance holding company on August 26, 1986. Our insurance subsidiaries, Atlantic States Insurance Company (“Atlantic States”), Southern Insurance Company of Virginia (“Southern”), Le Mars Insurance Company (“Le Mars”), the Peninsula Insurance Group (“Peninsula”), which consists of Peninsula Indemnity Company and The Peninsula Insurance Company, Sheboygan Falls Insurance Company (“Sheboygan”) and Michigan Insurance Company (“MICO”), write personal and commercial lines of property and casualty coverages exclusively through a network of independent insurance agents in certain Mid-Atlantic, Midwestern, New England and Southern states. We also own 48.2% of the outstanding stock of Donegal Financial Services Corporation (“DFSC”), a grandfathered unitary savings and loan holding company that owns Union Community Bank (“UCB”), a state savings bank. Donegal Mutual owns the remaining 51.8% of the outstanding stock of DFSC. We have four segments: our investment function, our personal lines of insurance, our commercial lines of insurance and our investment in DFSC. The personal lines products of our insurance subsidiaries consist primarily of homeowners and private passenger automobile policies. The commercial lines products of our insurance subsidiaries consist primarily of commercial automobile, commercial multi-peril and workers’ compensation policies. At September 30, 2016, Donegal Mutual held approximately 47% of our outstanding Class A common stock and approximately 83% of our outstanding Class B common stock. This ownership provides Donegal Mutual with approximately 73% of the total voting power of our outstanding common stock. We believe Donegal Mutual’s voting control of us benefits us for the reasons we describe in our Annual Reports on Form 10-K and in our proxy statements. Our insurance subsidiaries and Donegal Mutual have interrelated operations due to a pooling agreement and other intercompany agreements and transactions. While each company maintains its separate corporate existence, our insurance subsidiaries and Donegal Mutual conduct business together as the Donegal Insurance Group. As such, Donegal Mutual and our insurance subsidiaries share the same business philosophy, the same management, the same employees and the same facilities and offer the same types of insurance products. Atlantic States, our largest subsidiary, participates in a pooling agreement with Donegal Mutual. Under the pooling agreement, Donegal Mutual and Atlantic States pool their insurance business and each company receives an allocated percentage of the pooled business. Atlantic States has an 80% share of the results of the pooled business, and Donegal Mutual has a 20% share of the results of the pooled business. The same executive management and underwriting personnel administer products, classes of business underwritten, pricing practices and underwriting standards of Donegal Mutual and our insurance subsidiaries. In addition, as the Donegal Insurance Group, Donegal Mutual and our insurance subsidiaries share a combined business plan to achieve market penetration and underwriting profitability objectives. The products our insurance subsidiaries and Donegal Mutual market are generally complementary, thereby allowing the Donegal Insurance Group to offer a broader range of products to a given market and to expand the Donegal Insurance Group’s ability to service an entire personal lines or commercial lines account. Distinctions within the products Donegal Mutual and our insurance subsidiaries offer relate generally to specific risk profiles targeted within similar classes of business, such as preferred tier products versus standard tier products, but we do not allocate all of the standard risk gradients to one company. Therefore, the underwriting profitability of the business the individual companies write directly will vary. However, as the risk characteristics of all business Donegal Mutual and Atlantic States write directly are homogenized within the underwriting pool, Donegal Mutual and Atlantic States share the underwriting results in proportion to their respective participation in the pool. Pooled business represents the predominant percentage of the net underwriting activity of both Donegal Mutual and Atlantic States. On July 18, 2013, our board of directors authorized a share repurchase program pursuant to which we have the authority to purchase up to 500,000 additional shares of our Class A common stock at prices prevailing from time to time in the open market subject to the provisions of applicable rules of the SEC and in privately negotiated transactions. We did not purchase any shares of our Class A common stock under this program during the nine months ended September 30, 2016. We purchased 57,658 shares of our Class A common stock under this program during the nine months ended September 30, 2015. We have purchased a total of 57,658 shares of our Class A common stock under this program from its inception through September 30, 2016. 6 2 - Basis of Presentation Our financial information for the interim periods included in this Form 10-Q Report is unaudited; however, our financial information we include in this Form 10-Q Report reflects all adjustments, consisting only of normal recurring adjustments that, in the opinion of our management, are necessary for a fair presentation of our financial position, results of operations and cash flows for those interim periods. Our results of operations for the nine months ended September 30, 2016 are not necessarily indicative of the results of operations we expect for the year ending December 31, 2016. You should read the interim financial statements we include in this Form 10-Q Report in conjunction with the financial statements and the notes to our financial statements contained in our Annual Report on Form 10-K for the year ended December 31, 2015. 3 - Earnings Per Share We have two classes of common stock, which we refer to as our Class A common stock and our Class B common stock. Our certificate of incorporation provides that whenever our board of directors declares a dividend on our Class B common stock, our board of directors shall simultaneously declare a dividend on our Class A common stock that is payable to the holders of our Class A common stock at the same time and as of the same record date at a rate that is at least 10% greater than the rate at which our board of directors declared a dividend on our Class B common stock. Accordingly, we use the two-class method to compute our earnings per common share. The two-class method is an earnings allocation formula that determines earnings per share separately for each class of common stock based on dividends we have declared and an allocation of our remaining undistributed earnings using a participation percentage that reflects the dividend rights of each class. The table below presents for the periods indicated a reconciliation of the numerators and denominators we used to compute basic and diluted net income per share for each class of our common stock: Three Months Ended September 30, 2016 2015 Class A Class B Class A Class B (in thousands, except per share data) Basic net income per share: Numerator: Allocation of net income $ 3,901 $ 912 $ 4,663 $ 1,024 Denominator: Weighted-average shares outstanding 21,078 5,577 22,442 5,577 Basic net income per share $ 0.19 $ 0.16 $ 0.21 $ 0.18 Diluted net income per share: Numerator: Allocation of net income $ 3,901 $ 912 $ 4,663 $ 1,024 Denominator: Number of shares used in basic computation 21,078 5,577 22,442 5,577 Weighted-average shares effect of dilutive securities Add: Director and employee stock options 831 — 242 — Number of shares used in diluted computation 21,909 5,577 22,684 5,577 Diluted net income per share $ 0.18 $ 0.16 $ 0.21 $ 0.18 7 Nine Months Ended September 30, 2016 2015 Class A Class B Class A Class B (in thousands, except per share data) Basic net income per share: Numerator: Allocation of net income $ 20,329 $ 4,918 $ 15,502 $ 3,504 Denominator: Weighted-average shares outstanding 20,791 5,577 21,996 5,577 Basic net income per share $ 0.98 $ 0.88 $ 0.71 $ 0.63 Diluted net income per share: Numerator: Allocation of net income $ 20,329 $ 4,918 $ 15,502 $ 3,504 Denominator: Number of shares used in basic computation 20,791 5,577 21,996 5,577 Weighted-average shares effect of dilutive securities Add: Director and employee stock options 560 — 400 — Number of shares used in diluted computation 21,351 5,577 22,396 5,577 Diluted net income per share $ 0.95 $ 0.88 $ 0.69 $ 0.63 We did not include outstanding options to purchase the following number of shares of Class A common stock in our computation of diluted earnings per share because the exercise price of the options exceeded the average market price of our Class A common stock during the applicable periods: Three Months Ended September 30, Nine Months Ended September 30, 2016 2015 2016 2015 Number of options to purchase Class A shares excluded — 4,014,501 — — 4 - Reinsurance Atlantic States and Donegal Mutual have participated in a pooling agreement since 1986 under which each company places all of its direct written premiums into the pool the pooling agreement established, and Atlantic States and Donegal Mutual then share the underwriting results of the pool in accordance with the terms of the pooling agreement. Atlantic States has an 80% share of the results of the pool, and Donegal Mutual has a 20% share of the results of the pool. Our insurance subsidiaries and Donegal Mutual purchase certain third-party reinsurance on a combined basis. Le Mars, MICO, Peninsula and Sheboygan also purchase separate third-party reinsurance that provides coverage that we believe is commensurate with their relative size and risk exposures. Our insurance subsidiaries use several different reinsurers, all of which, consistent with the requirements of our insurance subsidiaries and Donegal Mutual, have an A.M. Best rating of A- (Excellent) or better or, with respect to foreign reinsurers, have a financial condition that, in the opinion of our management, is equivalent to a company with at least an A- rating from A.M. Best. The following information describes the external reinsurance our insurance subsidiaries have in place for 2016: • excess of loss reinsurance, under which Donegal Mutual and our insurance subsidiaries recover, through a series of reinsurance agreements, losses over a set retention (generally $1.0 million), and • catastrophe reinsurance, under which Donegal Mutual and our insurance subsidiaries recover, through a series of reinsurance agreements, 100% of an accumulation of many losses resulting from a single event, including natural 8 disasters, over a set retention (generally $5.0 million) and after exceeding an annual aggregate deductible (generally $1.0 million) up to aggregate losses of $170.0 million per occurrence. Our insurance subsidiaries and Donegal Mutual also purchase facultative reinsurance to cover exposures in excess of the covered limits of their third-party reinsurance agreements. In addition to the pooling agreement and third-party reinsurance, our insurance subsidiaries have various reinsurance agreements with Donegal Mutual. We have made no significant changes to our third-party reinsurance or the reinsurance agreements between our insurance subsidiaries and Donegal Mutual during the nine months ended September 30, 2016. 5 - Investments The amortized cost and estimated fair values of our fixed maturities and equity securities at September 30, 2016 were as follows: Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value (in thousands) Held to Maturity U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 59,254 $ 3,130 $ 7 $ 62,377 Obligations of states and political subdivisions 122,203 14,292 4 136,491 Corporate securities 86,582 3,360 598 89,344 Mortgage-backed securities 64,234 2,425 — 66,659 Totals $ 332,273 $ 23,207 $ 609 $ 354,871 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value (in thousands) Available for Sale U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 36,009 $ 368 $ 2 $ 36,375 Obligations of states and political subdivisions 184,068 10,219 11 194,276 Corporate securities 88,826 2,156 141 90,841 Mortgage-backed securities 190,936 3,444 51 194,329 Fixed maturities 499,839 16,187 205 515,821 Equity securities 41,806 4,917 411 46,312 Totals $ 541,645 $ 21,104 $ 616 $ 562,133 At September 30, 2016, our holdings of obligations of states and political subdivisions included general obligation bonds with an aggregate fair value of $229.6 million and an amortized cost of $213.6 million. Our holdings at September 30, 2016 also included special revenue bonds with an aggregate fair value of $101.2 million and an amortized cost of $92.7 million. With respect to both categories of those bonds at September 30, 2016, we held no securities of any issuer that constituted more than 10% of our holdings of either bond category. Education bonds and water and sewer utility bonds represented 62% and 24%, respectively, of our total investments in special revenue bonds based on the carrying values of these investments at September 30, 2016. Many of the issuers of the special revenue bonds we held at September 30, 2016 have the authority to impose ad valorem taxes. In that respect, many of the special revenue bonds we held at September 30, 2016 were similar to general obligation bonds. 9 The amortized cost and estimated fair values of our fixed maturities and equity securities at December 31, 2015 were as follows: Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value (in thousands) Held to Maturity U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 51,194 $ 1,544 $ — $ 52,738 Obligations of states and political subdivisions 119,115 10,828 119 129,824 Corporate securities 65,307 816 1,561 64,562 Mortgage-backed securities 74,643 1,181 149 75,675 Totals $ 310,259 $ 14,369 $ 1,829 $ 322,799 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value (in thousands) Available for Sale U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 37,080 $ 160 $ 51 $ 37,189 Obligations of states and political subdivisions 223,769 13,151 364 236,556 Corporate securities 73,474 350 1,012 72,812 Mortgage-backed securities 154,687 1,045 896 154,836 Fixed maturities 489,010 14,706 2,323 501,393 Equity securities 35,765 2,269 773 37,261 Totals $ 524,775 $ 16,975 $ 3,096 $ 538,654 At December 31, 2015, our holdings of obligations of states and political subdivisions included general obligation bonds with an aggregate fair value of $256.9 million and an amortized cost of $241.1 million. Our holdings also included special revenue bonds with an aggregate fair value of $109.5 million and an amortized cost of $101.8 million. With respect to both categories of bonds, we held no securities of any issuer that comprised more than 10% of that category at December 31, 2015. Education bonds and water and sewer utility bonds represented 57% and 26%, respectively, of our total investments in special revenue bonds based on their carrying values at December 31, 2015. Many of the issuers of the special revenue bonds we held at December 31, 2015 have the authority to impose ad valorem taxes. In that respect, many of the special revenue bonds we held are similar to general obligation bonds. We made reclassifications from available for sale to held to maturity of certain fixed maturities at fair value on November 30, 2013. We segregated within accumulated other comprehensive income the net unrealized losses of $15.1 million arising prior to the November 30, 2013 reclassification date for fixed maturities we reclassified from available for sale to held to maturity. We are amortizing this balance over the remaining life of the related securities as an adjustment to yield in a manner consistent with the accretion of discount on the same fixed maturities. We recorded amortization of $1.0 million and $905,446 in accumulated other comprehensive income during the nine months ended September 30, 2016 and 2015, respectively. At September 30, 2016 and December 31, 2015, net unrealized losses of $11.3 million and $12.3 million, respectively, remained within accumulated other comprehensive income. 10 We show below the amortized cost and estimated fair value of our fixed maturities at September 30, 2016 by contractual maturity. Expected maturities may differ from contractual maturities because issuers of the securities may have the right to call or prepay obligations with or without call or prepayment penalties. Amortized Cost Estimated Fair Value (in thousands) Held to maturity Due in one year or less $ 9,643 $ 9,657 Due after one year through five years 42,967 44,275 Due after five years through ten years 86,925 92,926 Due after ten years 128,504 141,354 Mortgage-backed securities 64,234 66,659 Total held to maturity $ 332,273 $ 354,871 Available for sale Due in one year or less $ 36,476 $ 37,158 Due after one year through five years 115,204 119,709 Due after five years through ten years 105,689 109,631 Due after ten years 51,534 54,994 Mortgage-backed securities 190,936 194,329 Total available for sale $ 499,839 $ 515,821 Gross realized gains and losses from investments before applicable income taxes for the three and nine months ended September 30, 2016 and 2015 were as follows: Three Months Ended September 30, Nine Months Ended September 30, 2016 2015 2016 2015 (in thousands) Gross realized gains: Fixed maturities $ 289 $ 7 $ 2,129 $ 974 Equity securities 1,170 30 1,226 733 1,459 37 3,355 1,707 Gross realized losses: Fixed maturities 22 27 280 105 Equity securities 419 764 870 919 441 791 1,150 1,024 Net realized gains (losses) $ 1,018 $ (754 ) $ 2,205 $ 683 We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at September 30, 2016 as follows: Less Than 12 Months More Than 12 Months Fair Value Unrealized Losses Fair Value Unrealized Losses (in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 2,988 $ 9 $ — $ — Obligations of states and political subdivisions 4,248 13 722 2 Corporate securities 21,006 205 2,911 534 Mortgage-backed securities 20,567 49 831 2 Equity securities 4,515 308 163 103 Totals $ 53,324 $ 584 $ 4,627 $ 641 11 We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at December 31, 2015 as follows: Less Than 12 Months More Than 12 Months Fair Value Unrealized Losses Fair Value Unrealized Losses (in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 10,168 $ 51 $ — $ — Obligations of states and political subdivisions 19,437 483 — — Corporate securities 69,482 1,615 11,324 958 Mortgage-backed securities 105,300 876 7,538 168 Equity securities 9,245 773 — — Totals $ 213,632 $ 3,798 $ 18,862 $ 1,126 We make estimates concerning the valuation of our investments and the recognition of other-than-temporary declines in the value of our investments. For equity securities, we write down the investment to its fair value, and we reflect the amount of the write-down as a realized loss in our results of operations when we consider the decline in value of an individual equity security investment to be other than temporary. We monitor all investments individually for other-than-temporary declines in value. Generally, we assume there has been an other-than-temporary decline in value if an individual equity security has depreciated in value by more than 20% of our original cost and has been in such an unrealized loss position for more than six months. We held seven equity securities that were in an unrealized loss position at September 30, 2016. Based upon our analysis of general market conditions and underlying factors impacting these equity securities, we considered these declines in value to be temporary. With respect to a debt security that is in an unrealized loss position, we first assess if we intend to sell the debt security. If we determine we intend to sell the debt security, we recognize the impairment loss in our results of operations. If we do not intend to sell the debt security, we determine whether it is more likely than not that we will be required to sell the debt security prior to recovery. If we determine it is more likely than not that we will be required to sell the debt security prior to recovery, we recognize an impairment loss in our results of operations. If we determine it is more likely than not that we will not be required to sell the debt security prior to recovery, we then evaluate whether a credit loss has occurred. We determine whether a credit loss has occurred by comparing the amortized cost of the debt security to the present value of the cash flows we expect to collect. If we expect a cash flow shortfall, we consider that a credit loss has occurred. If we determine that a credit loss has occurred, we consider the impairment to be other than temporary. We then recognize the amount of the impairment loss related to the credit loss in our results of operations, and we recognize the remaining portion of the impairment loss in our other comprehensive income, net of applicable taxes. In addition, we may write down securities in an unrealized loss position based on a number of other factors, including when the fair value of an investment is significantly below its cost, when the financial condition of the issuer of a security has deteriorated, the occurrence of industry, issuer or geographic events that have negatively impacted the value of a security and rating agency downgrades. We held 55 debt securities that were in an unrealized loss position at September 30, 2016. Based upon our analysis of general market conditions and underlying factors impacting these debt securities, we considered these declines in value to be temporary. We amortize premiums and discounts on debt securities over the life of the security as an adjustment to yield using the effective interest method. We compute realized investment gains and losses using the specific identification method. We amortize premiums and discounts on mortgage-backed debt securities using anticipated prepayments. We account for our investment in affiliate using the equity method of accounting. Under this method, we record our investment at cost, with adjustments for our share of our affiliate’s earnings and losses as well as changes in the equity of our affiliate due to unrealized gains and losses. Our investment in affiliate represents our 48.2% ownership interest in DFSC. We include our share of DFSC’s net income in our results of operations. We have compiled the following summary financial information for DFSC at September 30, 2016 and December 31, 2015 and for the three and nine months ended September 30, 2016 and 2015, respectively, from the financial statements of DFSC. The financial information of DFSC at September 30, 2016 and 2015 and for the three and nine months then ended is unaudited. 12 Balance sheets: September 30, 2016 December 31, 2015 (in thousands) Total assets $ 522,118 $ 507,139 Total liabilities $ 438,942 $ 427,423 Stockholders’ equity 83,176 79,716 Total liabilities and stockholders’ equity $ 522,118 $ 507,139 Three Months Ended September 30, Nine Months Ended September 30, Income statements: 2016 2015 2016 2015 (in thousands) Net income $ 742 $ 847 $ 1,449 $ 2,372 13 6 - Segment Information We evaluate the performance of our personal lines and commercial lines segments based upon the underwriting results of our insurance subsidiaries using statutory accounting principles (“SAP”) that various state insurance departments prescribe or permit. Our management uses SAP to measure the performance of our insurance subsidiaries instead of United States generally accepted accounting principles (“GAAP”). Financial data by segment for the three and nine months ended September 30, 2016 and 2015 is as follows: Three Months Ended September 30, 2016 2015 (in thousands) Revenues: Premiums earned Commercial lines $ 75,571 $ 66,456 Personal lines 91,239 86,640 GAAP premiums earned 166,810 153,096 Net investment income 5,581 5,399 Realized investment gains (losses) 1,018 (754 ) Equity in earnings of DFSC 358 408 Other 1,544 1,653 Total revenues $ 175,311 $ 159,802 Income before income taxes: Underwriting (loss) income: Commercial lines $ 3,701 $ 4,447 Personal lines (5,861 ) (3,727 ) SAP underwriting (loss) income (2,160 ) 720 GAAP adjustments 788 65 GAAP underwriting (loss) income (1,372 ) 785 Net investment income 5,581 5,399 Realized investment gains (losses) 1,018 (754 ) Equity in earnings of DFSC 358 408 Other 844 1,163 Income before income taxes $ 6,429 $ 7,001 14 Nine Months Ended September 30, 2016 2015 (in thousands) Revenues: Premiums earned Commercial lines $ 218,405 $ 193,036 Personal lines 268,823 257,048 GAAP premiums earned 487,228 450,084 Net investment income 16,472 15,505 Realized investment gains 2,205 683 Equity in earnings of DFSC 699 1,277 Other 4,623 5,042 Total revenues $ 511,227 $ 472,591 Income before income taxes: Underwriting income (loss): Commercial lines $ 14,118 $ 6,449 Personal lines (6,953 ) (6,499 ) SAP underwriting income (loss) 7,165 (50 ) GAAP adjustments 5,795 4,565 GAAP underwriting income 12,960 4,515 Net investment income 16,472 15,505 Realized investment gains 2,205 683 Equity in earnings of DFSC 699 1,277 Other 2,157 2,430 Income before income taxes $ 34,493 $ 24,410 7 - Borrowings Lines of Credit In July 2016, we renewed our existing credit agreement with Manufacturers and Traders Trust Company (“M&T”) relating to a $60.0 million unsecured, revolving line of credit. The line of credit expires in July 2019. We have the right to request a one-year extension of the credit agreement as of each anniversary date of the credit agreement. At September 30, 2016, we had $39.0 million in outstanding borrowings and had the ability to borrow an additional $21.0 million at interest rates equal to M&T’s current prime rate or the then current LIBOR rate plus 2.25%. The interest rate on our outstanding borrowings from M&T is adjustable quarterly, and, at September 30, 2016, that interest rate was 2.78%. We pay a fee of 0.2% per annum on the loan commitment amount regardless of usage. The credit agreement requires our compliance with certain covenants. These covenants include minimum levels of our net worth, leverage ratio, statutory surplus and the A.M. Best ratings of our insurance subsidiaries. We were in compliance with all requirements of the M&T credit agreement during the nine months ended September 30, 2016. MICO is a member of the Federal Home Loan Bank (“FHLB”) of Indianapolis. Through its membership, MICO has the ability to issue debt to the FHLB of Indianapolis in exchange for cash advances. MICO had no outstanding borrowings with the FHLB of Indianapolis at September 30, 2016. The table below presents the amount of FHLB of Indianapolis stock MICO purchased, collateral pledged and assets related to MICO’s membership at September 30, 2016. FHLB of Indianapolis stock purchased and owned $ 236,700 Collateral pledged, at par (carrying value $2,180,650) 2,177,558 Borrowing capacity currently available 2,143,057 Atlantic States is a member of the FHLB of Pittsburgh. Through its membership, Atlantic States has the ability to issue debt to the FHLB of Pittsburgh in exchange for cash advances. Atlantic States had $35.0 million in outstanding advances at 15 September 30, 2016. The interest rate on the advances was .59% at September 30, 2016. The table below presents the amount of FHLB of Pittsburgh stock Atlantic States purchased, collateral pledged and assets related to Atlantic States’ membership in the FHLB of Pittsburgh at September 30, 2016. FHLB of Pittsburgh stock purchased and owned $ 1,574,700 Collateral pledged, at par (carrying value $36,058,067) 36,085,816 Borrowing capacity currently available 310,732 Subordinated Debentures Donegal Mutual holds a $5.0 million surplus note that MICO issued to increase MICO’s statutory surplus. The surplus note carries an interest rate of 5.00%, and any repayment of principal or payment of interest on the surplus note requires prior approval of the Michigan Department of Insurance and Financial Services. 8 - Share–Based Compensation We measure all share-based payments to employees, including grants of stock options, and use a fair-value-based method for the recording of related compensation expense in our consolidated statements of income. In determining the expense we record for stock options granted to directors and employees of our subsidiaries and affiliates, we estimate the fair value of each option award on the date of grant using the Black-Scholes option pricing model. The significant assumptions we utilize in applying the Black-Scholes option pricing model are the risk-free interest rate, the expected term, the dividend yield and the expected volatility. We charged compensation expense related to our stock compensation plans against income before income taxes of $414,696 and $598,516 for the three months ended September 30, 2016 and 2015, respectively, with a corresponding income tax benefit of $145,143 and $209,481, respectively. We charged compensation expense related to our stock compensation plans against income before income taxes of $2.0 million and $1.9 million for the nine months ended September 30, 2016 and 2015, respectively, with a corresponding income tax benefit of $710,584 and $671,607, respectively. At September 30, 2016, we had $2.0 million of unrecognized compensation expense related to nonvested share-based compensation granted under our stock compensation plans. We expect to recognize this compensation expense over a weighted average period of approximately 1.3 years. We received cash from option exercises under all stock compensation plans during the three months ended September 30, 2016 and 2015 of $3.7 million and $181,488, respectively. We received cash from option exercises under all stock compensation plans during the nine months ended September 30, 2016 and 2015 of $7.8 million and $13.7 million, respectively. We realized actual tax benefits for the tax deductions related to option exercises of $243,656 and $4,802 for the three months ended September 30, 2016 and 2015, respectively. We realized actual tax benefits for the tax deductions related to option exercises of $521,852 and $424,537 for the nine months ended September 30, 2016 and 2015, respectively. 9 - Fair Value Measurements We account for financial assets using a framework that establishes a hierarchy that ranks the quality and reliability of the inputs, or assumptions, we use in the determination of fair value, and we classify financial assets and liabilities carried at fair value in one of the following three categories: Level 1 – quoted prices in active markets for identical assets and liabilities; Level 2 – directly or indirectly observable inputs other than Level 1 quoted prices; and Level 3 – unobservable inputs not corroborated by market data. For investments that have quoted market prices in active markets, we use the quoted market price as fair value and include these investments in Level 1 of the fair value hierarchy. We classify publicly-traded equity securities as Level 1. When quoted market prices in active markets are not available, we base fair values on quoted market prices of comparable instruments or price estimates we obtain from independent pricing services and include these investments in Level 2 of the fair value hierarchy. We classify our fixed maturity investments as Level 2. Our fixed maturity investments consist of U.S. Treasury 16 securities and obligations of U.S. government corporations and agencies, obligations of states and political subdivisions, corporate securities and mortgage-backed securities. We present our investments in available-for-sale fixed maturity and equity securities at estimated fair value. The estimated fair value of a security may differ from the amount that could be realized if we sold the security in a forced transaction. In addition, the valuation of fixed maturity investments is more subjective when markets are less liquid, increasing the potential that the estimated fair value does not reflect the price at which an actual transaction would occur. We utilize nationally recognized independent pricing services to estimate fair values or obtain market quotations for substantially all of our fixed maturity and equity investments. These pricing services utilize market quotations for fixed maturity and equity securities that have quoted prices in active markets. For fixed maturity securities that generally do not trade on a daily basis, the pricing services prepare estimates of fair value measurements based predominantly on observable market inputs. The pricing services do not use broker quotes in determining the fair values of our investments. Our investment personnel review the estimates of fair value the pricing services provide to determine if the estimates we obtain from the pricing services are representative of fair values based upon our investment personnel’s general knowledge of the market, their research findings related to unusual fluctuations in value and their comparison of such values to execution prices for similar securities. Our investment personnel regularly monitor the market, current trading ranges for similar securities and the pricing of specific investments. Our investment personnel review all pricing estimates that we receive from the pricing services against their expectations with respect to pricing based on fair market curves, security ratings, coupon rates, security type and recent trading activity. Our investment personnel review documentation with respect to the pricing services’ pricing methodology that they obtain periodically to determine if the primary pricing sources, market inputs and pricing frequency for various security types are reasonable. At September 30, 2016, we received two estimates per security from the pricing services, and we priced substantially all of our Level 1 and Level 2 investments using those prices. In our review of the estimates the pricing services provided at September 30, 2016, we did not identify any material discrepancies, and we did not make any adjustments to the estimates the pricing services provided. We present our cash and short-term investments at estimated fair value. We classify these items as Level 1. The carrying values we report in our balance sheet for premium receivables and reinsurance receivables and payables for premiums and paid losses and loss expenses approximate their fair values. The carrying amounts we report in our balance sheet for our subordinated debentures and borrowings under lines of credit approximate their fair values. We classify these items as Level 3. We evaluate our assets and liabilities on a recurring basis to determine the appropriate level at which to classify them for each reporting period. The following table presents our fair value measurements for our investments in available-for-sale fixed maturity and equity securities at September 30, 2016: Fair Value Measurements Using Fair Value Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) (in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 36,375 $ — $ 36,375 $ — Obligations of states and political subdivisions 194,276 — 194,276 — Corporate securities 90,841 — 90,841 — Mortgage-backed securities 194,329 — 194,329 — Equity securities 35,167 35,167 — — Total investments in the fair value hierarchy 550,988 35,167 515,821 — Investment measured at net asset value 11,145 — — — Totals $ 562,133 $ 35,167 $ 515,821 $ — We did not transfer any investments between Levels 1 and 2 during the nine months ended September 30, 2016. 17 The following table presents our fair value measurements for our investments in available-for-sale fixed maturity and equity securities at December 31, 2015: Fair Value Measurements Using Fair Value Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) (in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 37,189 $ — $ 37,189 $ — Obligations of states and political subdivisions 236,556 — 236,556 — Corporate securities 72,812 — 72,812 — Mortgage-backed securities 154,836 — 154,836 — Equity securities 26,727 26,727 — — Total investments in the fair value hierarchy 528,120 26,727 501,393 — Investment measured at net asset value 10,534 — — — Totals $ 538,654 $ 26,727 $ 501,393 $ — 10 - Income Taxes At September 30, 2016 and December 31, 2015, respectively, we had no material unrecognized tax benefits or accrued interest and penalties. Tax years 2013 through 2016 remained open for examination at September 30, 2016. We provide a valuation allowance when we believe it is more likely than not that we will not realize some portion of our tax assets. We established a valuation allowance of $440,778 related to a portion of the net operating loss carryforward of Le Mars at January 1, 2004. We have determined that we are not required to establish a valuation allowance for our other deferred tax assets of $43.4 million and $42.7 million at September 30, 2016 and December 31, 2015, respectively, because it is more likely than not that we will realize these deferred tax assets through reversals of existing temporary differences, future taxable income and the implementation of tax planning strategies. Our deferred tax assets include a net operating loss carryforward of $3.6 million related to Le Mars, which will begin to expire in 2020 if not previously utilized. This carryforward is subject to an annual limitation in the amount that we can use in any one year of approximately $376,000. Our deferred tax assets also include an alternative minimum tax credit carryforward of $7.6 million with an indefinite life. 11 - Impact of New Accounting Standards In May 2014, the Financial Accounting Standards Board (the “FASB”) issued guidance that requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. While the guidance will replace most existing GAAP revenue recognition guidance, the scope of the guidance excludes insurance contracts. The new standard is effective on January 1, 2018. The standard permits the use of either the retrospective or the cumulative effect transition method. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In February 2015, the FASB issued a new standard that amends the current consolidation guidance affecting both the variable interest entity (“VIE”) and voting interest entity (“VOE”) consolidation models. The standard does not add or remove any of the characteristics in determining if an entity is a VIE or a VOE, but rather, the standard enhances assessment of some of these characteristics. The new standard was effective on December 15, 2015. The adoption of this new guidance did not have a significant impact on our financial position, results of operations or cash flows. In May 2015, the FASB issued guidance that removes the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value per share practical expedient. The guidance also removes the requirement to make certain disclosures for all investments that are eligible to be measured at fair value using the net asset value per share practical expedient. The guidance instead limits disclosure to investments for which the entity has elected to measure fair value using that practical expedient. The guidance was effective for annual reporting periods beginning after December 15, 2015, and interim reporting periods within those annual reporting periods. The adoption of this new guidance did not have a significant impact on our financial position, results of operations or cash flows. 18 In May 2015, the FASB issued guidance that requires entities to provide additional disclosures about their liability for unpaid claims and claim adjustment expenses to increase the transparency of significant estimates. The guidance also requires entities to disclose information about significant changes in methodologies and assumptions used to calculate the liability for unpaid claims and claim adjustment expenses, including the reasons for the changes and the effects on the entities’ financial statements, and the timing, frequency and severity of claims. The guidance also requires entities to disclose a rollforward of the liability for unpaid claims and claim adjustment expenses for annual and interim reporting periods. The guidance is effective for annual reporting periods beginning after December 15, 2015, and interim reporting periods within annual reporting periods beginning after December 15, 2016. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In January 2016, the FASB issued guidance that generally requires entities to measure equity investments at fair value and recognize changes in fair value in their results of operations. The guidance also simplifies the impairment assessment of equity investments without readily determinable fair values by requiring entities to perform a qualitative assessment to identify impairment. The FASB issued other disclosure and presentation improvements related to financial instruments within the guidance. The guidance is effective for annual and interim reporting periods beginning after December 15, 2017. As a result of this guidance, we will reflect changes in the fair value of our equity investments in our results of operations beginning January 1, 2018. In February 2016, the FASB issued guidance that requires lessees to recognize leases, including operating leases, on the lessee’s balance sheet, unless a lease is considered a short-term lease. The guidance also requires entities to make new judgments to identify leases. The guidance is effective for annual and interim reporting periods beginning after December 15, 2018 and permits early adoption. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In March 2016, the FASB issued guidance that simplifies and improves several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities and classification on the statement of cash flows. The guidance is effective for annual and interim reporting periods beginning after December 15, 2016. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In June 2016, the FASB issued guidance that amends previous guidance on the impairment of financial instruments by adding an impairment model that allows an entity to recognize expected credit losses as an allowance rather than impairments as credit losses are incurred. The new guidance is intended to reduce complexity and result in a more timely recognition of expected credit losses. The guidance is effective for annual and interim reporting periods beginning after December 15, 2019. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In August 2016, the FASB issued guidance that clarifies how certain cash receipts and cash payments shall be presented and classified in the statement of cash flows. This guidance addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. The guidance is effective for annual and interim reporting periods beginning after December 15, 2017. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. 19\nWe recommend that you read the following information in conjunction with the historical financial information and the footnotes to that financial information we include in this Quarterly Report on Form 10-Q. We also recommend you read Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2015.\nCritical Accounting Policies and Estimates\nWe combine our financial statements with those of our insurance subsidiaries and present our financial statements on a consolidated basis in accordance with GAAP.\nOur insurance subsidiaries make estimates and assumptions that can have a significant effect on amounts and disclosures we report in our financial statements. The most significant estimates relate to the reserves of our insurance subsidiaries for property and casualty insurance unpaid losses and loss expenses, the valuation of investments and the determination of other-than-temporary investment impairments and the policy acquisition costs of our insurance subsidiaries. While we believe our estimates and the estimates of our insurance subsidiaries are appropriate, the ultimate amounts of these liabilities may differ from the estimates we provided. We regularly review our methods for making these estimates and we reflect any adjustment we consider necessary in our current consolidated results of operations.\nLiability for Unpaid Losses and Loss Expenses\nLiabilities for losses and loss expenses are estimates at a given point in time of the amounts an insurer expects to pay with respect to incurred policyholder claims based on facts and circumstances the insurer knows at that point in time. At the time of establishing its estimates, an insurer recognizes that its ultimate liability for losses and loss expenses will exceed or be less than such estimates. Our insurance subsidiaries base their estimates of liabilities for losses and loss expenses on assumptions as to future loss trends, expected claims severity, judicial theories of liability and other factors. However, during the loss adjustment period, our insurance subsidiaries may learn additional facts regarding individual claims, and, consequently, it often becomes necessary for our insurance subsidiaries to refine and adjust their estimates for these liabilities. We reflect any adjustments to our insurance subsidiaries’ liabilities for losses and loss expenses in our consolidated results of operations in the period in which our insurance subsidiaries make the changes in estimates.\nOur insurance subsidiaries maintain liabilities for the payment of losses and loss expenses with respect to both reported and unreported claims. Our insurance subsidiaries establish these liabilities for the purpose of covering the ultimate costs of settling all losses, including investigation and litigation costs. Our insurance subsidiaries base the amount of their liability for reported losses primarily upon a case-by-case evaluation of the type of risk involved, knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss the policyholder incurred. Our insurance subsidiaries determine the amount of their liability for unreported claims and loss expenses on the basis of historical information by line of insurance. Our insurance subsidiaries account for inflation in the reserving function through analysis of costs and trends and reviews of historical reserving results. Our insurance subsidiaries monitor their liabilities closely and recompute them periodically using new information on reported claims and a variety of statistical techniques. Our insurance subsidiaries do not discount their liabilities for losses and loss expenses.\nReserve estimates can change over time because of unexpected changes in assumptions related to our insurance subsidiaries’ external environment and, to a lesser extent, assumptions related to our insurance subsidiaries’ internal operations. For example, our insurance subsidiaries have experienced a decrease in claims frequency on workers’ compensation claims during the past several years while the severity of these claims has gradually increased. These trend changes give rise to greater uncertainty as to the pattern of future loss settlements on workers’ compensation claims. Related uncertainties regarding future trends include the cost of medical technologies and procedures and changes in the utilization of medical procedures. Assumptions related to our insurance subsidiaries’ external environment include the absence of significant changes in tort law and the legal environment that increase liability exposure, consistency in judicial interpretations of insurance coverage and policy provisions and the rate of loss cost inflation. Internal assumptions include consistency in the recording of premium and loss statistics, consistency in the recording of claims, payment and case reserving methodology, accurate measurement of the impact of rate changes and changes in policy provisions, consistency in the quality and characteristics of business written within a given line of business and consistency in reinsurance coverage and collectability of reinsured losses, among other items. To the extent our insurance subsidiaries determine that underlying factors impacting their assumptions have changed, our insurance subsidiaries make adjustments in their reserves that they consider appropriate for such changes. Accordingly, our insurance subsidiaries’ ultimate liability for unpaid losses and loss expenses will likely differ\n20\nfrom the amount recorded at September 30, 2016. For every 1% change in our insurance subsidiaries’ estimate for loss and loss expense reserves, net of reinsurance recoverable, the effect on our pre-tax results of operations would be approximately $3.4 million. The establishment of appropriate liabilities is an inherently uncertain process and we can provide no assurance that our insurance subsidiaries’ ultimate liability will not exceed our insurance subsidiaries’ loss and loss expense reserves and have an adverse effect on our results of operations and financial condition. Furthermore, we cannot predict the timing, frequency and extent of adjustments to our insurance subsidiaries’ estimated future liabilities, because the historical conditions and events that serve as a basis for our insurance subsidiaries’ estimates of ultimate claim costs may change. As is the case for substantially all property and casualty insurance companies, our insurance subsidiaries have found it necessary in the past to increase their estimated future liabilities for losses and loss expenses in certain periods and, in other periods, their estimates of future liabilities have exceeded their actual liabilities. Changes in our insurance subsidiaries’ estimates of their liability for losses and loss expenses generally reflect actual payments and their evaluation of information received since the prior reporting date. Excluding the impact of severe weather events, our insurance subsidiaries have noted stable amounts in the number of claims incurred and a slight downward trend in the number of claims outstanding at period ends relative to their premium base in recent years across most of their lines of business. However, the amount of the average claim outstanding has increased gradually over the past several years as the United States property and casualty insurance industry has experienced increased litigation trends and economic conditions that have extended the estimated length of disabilities and contributed to increased medical loss costs. We have also experienced a general slowing of settlement rates in litigated claims. Our insurance subsidiaries could have to make further adjustments to their estimates in the future. However, on the basis of our insurance subsidiaries’ internal procedures, which analyze, among other things, their prior assumptions, their experience with similar cases and historical trends such as reserving patterns, loss payments, pending levels of unpaid claims and product mix, as well as court decisions, economic conditions and public attitudes, we believe that our insurance subsidiaries have made adequate provision for their liability for losses and loss expenses. Atlantic States’ participation in the pool with Donegal Mutual exposes Atlantic States to adverse loss development on the business of Donegal Mutual that the pool includes. However, pooled business represents the predominant percentage of the net underwriting activity of both companies, and Donegal Mutual and Atlantic States share proportionately any adverse risk development of the pooled business. The business in the pool is homogeneous and each company has a pro-rata share of the entire pool. Since substantially all of the business of Atlantic States and Donegal Mutual is pooled and the results shared by each company according to its participation level under the terms of the pooling agreement, the intent of the underwriting pool is to produce a more uniform and stable underwriting result from year to year for each company than either would experience individually and to spread the risk of loss between the companies. 21 Donegal Mutual and our insurance subsidiaries operate together as the Donegal Insurance Group and share a combined business plan designed to achieve market penetration and underwriting profitability objectives. The products our insurance subsidiaries and Donegal Mutual offer are generally complementary, thereby allowing Donegal Insurance Group to offer a broader range of products to a given market and to expand Donegal Insurance Group’s ability to service an entire personal lines or commercial lines account. Distinctions within the products of Donegal Mutual and our insurance subsidiaries generally relate to specific risk profiles targeted within similar classes of business, such as preferred tier products compared to standard tier products, but we do not allocate all of the standard risk gradients to one company. Therefore, the underwriting profitability of the business the individual companies write directly will vary. However, because the pool homogenizes the risk characteristics of all business Donegal Mutual and Atlantic States write directly and each company shares the results according to each company’s participation percentage, each company realizes its percentage share of the underwriting results of the pool. Our insurance subsidiaries’ unpaid liability for losses and loss expenses by major line of business at September 30, 2016 and December 31, 2015 consisted of the following: September 30, 2016 December 31, 2015 (in thousands) Commercial lines: Automobile $ 55,079 $ 53,938 Workers’ compensation 105,873 99,212 Commercial multi-peril 59,279 54,395 Other 3,639 3,119 Total commercial lines 223,870 210,664 Personal lines: Automobile 97,102 93,923 Homeowners 16,947 15,816 Other 2,122 1,651 Total personal lines 116,171 111,390 Total commercial and personal lines 340,041 322,054 Plus reinsurance recoverable 254,227 256,151 Total liability for unpaid losses and loss expenses $ 594,268 $ 578,205 We have evaluated the effect on our insurance subsidiaries’ unpaid loss and loss expense reserves and our stockholders’ equity in the event of reasonably likely changes in the variables we consider in establishing the loss and loss expense reserves of our insurance subsidiaries. We established the range of reasonably likely changes based on a review of changes in accident-year development by line of business and applied those changes to our insurance subsidiaries’ loss reserves as a whole. The selected range does not necessarily indicate what could be the potential best or worst case or the most likely scenario. The following table sets forth the estimated effect on our insurance subsidiaries’ unpaid loss and loss expense reserves and our stockholders’ equity in the event of reasonably likely changes in the variables we considered in establishing the loss and loss expense reserves of our insurance subsidiaries: Percentage Change in Loss and Loss Expense Reserves Net of Reinsurance Adjusted Loss and Loss Expense Reserves Net of Reinsurance at September 30, 2016 Percentage Change in Stockholders’ Equity at September 30, 2016(1) Adjusted Loss and Loss Expense Reserves Net of Reinsurance at December 31, 2015 Percentage Change in Stockholders’ Equity at December 31, 2015(1) (dollars in thousands) (10.0)% $ 306,037 5.0 % $ 289,849 5.1 % (7.5) 314,538 3.7 297,900 3.8 (5.0) 323,039 2.5 305,951 2.6 (2.5) 331,540 1.2 314,003 1.3 Base 340,041 — 322,054 — 2.5 348,542 (1.2 ) 330,105 (1.3 ) 5.0 357,043 (2.5 ) 338,157 (2.6 ) 7.5 365,544 (3.7 ) 346,208 (3.8 ) 10.0 374,045 (5.0 ) 354,259 (5.1 ) (1) Net of income tax effect. 22 Statutory Combined Ratios We evaluate our insurance operations by monitoring certain key measures of growth and profitability. In addition to using GAAP-based performance measurements, we also utilize certain non-GAAP financial measures that we believe are valuable in managing our business and for comparison to our peers. These non-GAAP measures are underwriting income, combined ratio and net premiums written. An insurance company’s statutory combined ratio is a standard measure of underwriting profitability. This ratio is the sum of the ratio of calendar-year incurred losses and loss expenses to premiums earned; the ratio of expenses incurred for commissions, premium taxes and underwriting expenses to net premiums written and the ratio of dividends to policyholders to premiums earned. The combined ratio does not reflect investment income, federal income taxes or other non-operating income or expense. A combined ratio of less than 100 percent generally indicates underwriting profitability. The statutory combined ratio differs from the GAAP combined ratio. In calculating the GAAP combined ratio, we do not deduct installment payment fees from incurred expenses, and we base the expense ratio on premiums earned instead of premiums written. Differences between our GAAP loss ratios reported in our financial statements and our insurance subsidiaries’ statutory loss ratios result from anticipating salvage and subrogation recoveries for the GAAP loss ratios but not for the statutory loss ratios. The following table sets forth our insurance subsidiaries’ statutory combined ratios by major line of business for the three and nine months ended September 30, 2016 and 2015: Three Months Ended September 30, Nine Months Ended September 30, 2016 2015 2016 2015 Commercial lines: Automobile 110.8 % 118.0 % 106.5 % 106.1 % Workers’ compensation 86.8 79.1 85.3 89.0 Commercial multi-peril 94.7 92.2 88.5 93.2 Total commercial lines 94.3 92.0 90.3 93.2 Personal lines: Automobile 105.9 98.8 102.6 100.0 Homeowners 101.5 108.0 97.1 101.7 Total personal lines 103.6 101.4 99.9 99.8 Total commercial and personal lines 99.5 97.4 95.6 96.9 Investments We make estimates concerning the valuation of our investments and the recognition of other-than-temporary declines in the value of our investments. For equity securities, we write down an individual investment to its fair value and we reflect the amount of the write-down as a realized loss in our results of operations when we consider the decline in value of the individual investment to be other than temporary. We individually monitor all investments for other-than-temporary declines in value. Generally, we assume there has been an other-than-temporary decline in value if an individual equity security has depreciated in value by more than 20% of our original cost and has been in such an unrealized loss position for more than six months. We held seven equity securities that were in an unrealized loss position at September 30, 2016. Based upon our analysis of general market conditions and underlying factors impacting these equity securities, we considered these declines in value to be temporary. With respect to a debt security that is in an unrealized loss position, we first assess if we intend to sell the debt security. If we determine we intend to sell the debt security, we recognize the impairment loss in our results of operations. If we do not intend to sell the debt security, we determine whether it is more likely than not that we will be required to sell the debt security prior to recovery. If we determine it is more likely than not that we will be required to sell the debt security prior to recovery, we recognize an impairment loss in our results of operations. If we determine it is more likely than not that we will not be required to sell the debt security prior to recovery, we then evaluate whether a credit loss has occurred. We determine whether a credit loss has occurred by comparing the amortized cost of the debt security to the present value of the cash flows we expect to collect on the debt security. If we expect a cash flow shortfall, we consider that a credit loss has occurred. If we determine that a credit loss has occurred, we consider the impairment to be other than temporary. We then recognize the amount of the impairment loss related to the credit loss in our results of operations, and we recognize the remaining portion of the impairment loss in our other comprehensive income, net of applicable taxes. In addition, we may write down securities in an unrealized loss position based on a number of other factors, including when the fair value of an investment is significantly below its cost, when the financial condition of the issuer of a security has deteriorated, the occurrence of industry, company or geographic events that have negatively impacted the value of a security or rating agency 23 downgrades. We held 55 debt securities that were in an unrealized loss position at September 30, 2016. Based upon our analysis of general market conditions and underlying factors impacting these debt securities, we considered these declines in value to be temporary. We did not recognize any impairment losses in our results of operations for the first nine months of 2016 or 2015. We present our investments in available-for-sale fixed maturity and equity securities at estimated fair value. The estimated fair value of a security may differ from the amount we could realize if we sold the security in a forced transaction. In addition, the valuation of fixed maturity investments is more subjective when markets are less liquid, increasing the potential that the estimated fair value does not reflect the price at which an actual transaction would occur. We utilize nationally recognized independent pricing services to estimate fair values or obtain market quotations for substantially all of our fixed maturity and equity investments. The pricing services utilize market quotations for fixed maturity and equity securities that have quoted prices in active markets. For fixed maturity securities that generally do not trade on a daily basis, the pricing services prepare estimates of fair value measurements based predominantly on observable market inputs. The pricing services do not use broker quotes in determining the fair values of our investments. Our investment personnel review the estimates of fair value the pricing services provide to determine if the estimates we obtain from the pricing services are representative of fair values based upon the general market knowledge of our investment personnel, their research findings related to unusual fluctuations in value and their comparison of such values to execution prices for similar securities. Our investment personnel monitor the market and are familiar with current trading ranges for similar securities and pricing of specific investments. Our investment personnel review all pricing estimates that we receive from the pricing services against their expectations with respect to pricing based on fair market curves, security ratings, coupon rates, security type and recent trading activity. Our investment personnel review documentation with respect to the pricing services’ pricing methodology that they obtain periodically to determine if the primary pricing sources, market inputs and pricing frequency for various security types are reasonable. At September 30, 2016, we received two estimates per security from the pricing services, and we priced substantially all of our Level 1 and Level 2 investments using those prices. In our review of the estimates the pricing services provided at September 30, 2016, we did not identify any material discrepancies, and we did not make any adjustments to the estimates the pricing services provided. Policy Acquisition Costs Our insurance subsidiaries defer their policy acquisition costs, consisting primarily of commissions, premium taxes and certain other underwriting costs that relate directly to the successful acquisition of insurance policies. We amortize these costs over the period in which our insurance subsidiaries earn the related premiums. The method we follow in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. This method gives effect to the premiums to be earned, related investment income, losses and loss expenses and certain other costs we expect to incur as our insurance subsidiaries earn the premiums. Results of Operations - Three Months Ended September 30, 2016 Compared to Three Months Ended September 30, 2015 Net Premiums Written. Our insurance subsidiaries’ net premiums written for the three months ended September 30, 2016 were $171.9 million, an increase of $13.0 million, or 8.2%, from the $158.9 million of net premiums written for the third quarter of 2015. We attribute the increase to the impact of premium rate increases and an increase in the writing of commercial lines of business. Personal lines net premiums written increased $5.2 million, or 5.6%, for the third quarter of 2016 compared to the third quarter of 2015. The increase was attributable primarily to premium rate increases our insurance subsidiaries implemented throughout 2015 and 2016. Commercial lines net premiums written increased $7.8 million, or 12.0%, for the third quarter of 2016 compared to the third quarter of 2015. The increase was primarily attributable to premium rate increases and increased writings of new commercial accounts. Net Premiums Earned. Our insurance subsidiaries’ net premiums earned for the third quarter of 2016 were $166.8 million, an increase of $13.7 million, or 9.0%, compared to $153.1 million for the third quarter of 2015, reflecting increases in net premiums written during 2016 and 2015. Our insurance subsidiaries earn premiums and recognize them as revenue over the terms of their policies, which are one year or less in duration. Therefore, increases or decreases in net premiums earned generally reflect increases or decreases in net premiums written in the preceding 12-month period compared to the comparable period one year earlier. Investment Income. Our net investment income increased to $5.6 million for the third quarter of 2016, compared to $5.4 million for the third quarter of 2015. We attribute the increase primarily to an increase in average invested assets. 24 Net Realized Investment Gains (Losses). Net realized investment gains for the third quarter of 2016 were $1.0 million, compared to net realized investment losses of $754,050 for the third quarter of 2015. The net realized investment gains for the third quarter of 2016 resulted primarily from unrealized gains within a limited partnership that invests in equity securities. The net realized investment losses for the third quarter of 2015 resulted primarily from unrealized losses within the limited partnership. We did not recognize any impairment losses in our investment portfolio during the third quarters of 2016 or 2015. Equity in Earnings of DFSC. Our equity in the earnings of DFSC was $357,956 for the third quarter of 2016, compared to $408,405 for the third quarter of 2015. Losses and Loss Expenses. Our insurance subsidiaries’ loss ratio, which is the ratio of incurred losses and loss expenses to premiums earned, for the third quarter of 2016 was 66.6%, a slight decrease from our insurance subsidiaries’ loss ratio of 66.8% for the third quarter of 2015. On a statutory basis, our insurance subsidiaries’ commercial lines loss ratio was 62.5% for the third quarter of 2016, compared to 62.3% for the third quarter of 2015, primarily due to an increase in the workers’ compensation loss ratio. The personal lines statutory loss ratio of our insurance subsidiaries increased to 70.4% for the third quarter of 2016, compared to 69.9% for the third quarter of 2015, primarily due to an increase in the personal automobile loss ratio. Our insurance subsidiaries experienced favorable loss reserve development of approximately $1.6 million during the third quarter of 2016 in their reserves for prior accident years, compared to unfavorable loss reserve development of approximately $1.5 million during the third quarter of 2015. The improvement in loss reserve development patterns occurred primarily within our insurance subsidiaries’ commercial multi-peril and personal automobile reserves. Underwriting Expenses. The expense ratio for an insurance company is the ratio of policy acquisition costs and other underwriting expenses to premiums earned. The expense ratio of our insurance subsidiaries was 33.5% for the third quarter of 2016, compared to 32.1% for the third quarter of 2015. We attribute the 2016 increase primarily to higher underwriting incentive costs in the third quarter of 2016 compared to the third quarter of 2015. Combined Ratio. The combined ratio represents the sum of the loss ratio, the expense ratio and the dividend ratio, which is the ratio of policyholder dividends incurred to premiums earned. Our insurance subsidiaries’ combined ratios were 100.8% and 99.5% for the three months ended September 30, 2016 and 2015, respectively. Interest Expense. Our interest expense for the third quarter of 2016 was $473,917, compared to $188,000 for the third quarter of 2015. We attribute the increase to higher average borrowings during the third quarter of 2016 compared to the third quarter of 2015. Income Taxes. Income tax expense was $1.6 million for the third quarter of 2016, representing an effective tax rate of 25.1%, compared to income tax expense of $1.3 million for the third quarter of 2015, representing an effective tax rate of 18.8% . The effective tax rate in both periods represented an estimate based on our projected annual taxable income. The increase in the effective tax rate reflects our expectation that tax-exempt interest income will represent a lesser proportion of our 2016 taxable income compared to 2015. Net Income and Earnings Per Share. Our net income for the third quarter of 2016 was $4.8 million, or $.18 per share of Class A common stock on a diluted basis and $.16 per share of Class B common stock, compared to net income of $5.7 million, or $.21 per share of Class A common stock and $.18 per share of Class B common stock, for the third quarter of 2015. We had 21.2 million and 22.4 million Class A shares outstanding at September 30, 2016 and 2015, respectively. We had 5.6 million Class B shares outstanding at the end of both periods. Results of Operations - Nine Months Ended September 30, 2016 Compared to Nine Months Ended September 30, 2015 Net Premiums Written. Our insurance subsidiaries’ net premiums written for the nine months ended September 30, 2016 were $520.3 million, an increase of $39.2 million, or 8.1%, from the $481.1 million of net premiums written for the comparable period of 2015. We attribute the increase to the impact of premium rate increases and an increase in the writing of commercial lines of business. Personal lines net premiums written increased $13.4 million, or 5.0%, for the first nine months of 2016 compared to the first nine months of 2015. The increase was attributable primarily to premium rate increases our insurance subsidiaries implemented throughout 2015 and 2016. Commercial lines net premiums written increased $25.8 million, or 12.1%, for the first nine months of 2016 compared to the first nine months of 2015. The increase was primarily attributable to premium rate increases and increased writings of new commercial accounts. Net Premiums Earned. Our insurance subsidiaries’ net premiums earned for the first nine months of 2016 were $487.2 million, an increase of $37.1 million, or 8.3%, compared to $450.1 million for the first nine months of 2015, reflecting increases in net premiums written during 2016 and 2015. Our insurance subsidiaries earn premiums and recognize them as 25 revenue over the terms of their policies, which are one year or less in duration. Therefore, increases or decreases in net premiums earned generally reflect increases or decreases in net premiums written in the preceding 12-month period compared to the comparable period one year earlier. Investment Income. Our net investment income increased to $16.5 million for the first nine months of 2016, compared to $15.5 million for the first nine months of 2015. We attribute the increase primarily to an increase in average invested assets. Net Realized Investment Gains. Net realized investment gains for the first nine months of 2016 were $2.2 million, compared to $682,932 for the first nine months of 2015. The net realized investment gains for the first nine months of 2016 and 2015 resulted primarily from calls and strategic sales of fixed maturities and equity securities within our investment portfolio. We did not recognize any impairment losses in our investment portfolio during the first nine months of 2016 or 2015. Equity in Earnings of DFSC. Our equity in the earnings of DFSC was $698,658 for the first nine months of 2016, compared to $1.3 million for the first nine months of 2015. Losses and Loss Expenses. Our insurance subsidiaries’ loss ratio, which is the ratio of incurred losses and loss expenses to premiums earned, for the first nine months of 2016 was 63.6%, a decrease from our insurance subsidiaries’ loss ratio of 65.8% for the first nine months of 2015. On a statutory basis, our insurance subsidiaries’ commercial lines loss ratio was 59.4% for the first nine months of 2016, compared to 62.7% for the first nine months of 2015, primarily due to decreases in the commercial multi-peril and workers’ compensation loss ratios. The personal lines statutory loss ratio of our insurance subsidiaries decreased to 67.2% for the first nine months of 2016, compared to 68.1% for the first nine months of 2015, primarily due to a decrease in the homeowners loss ratio. Our insurance subsidiaries experienced unfavorable loss reserve development of approximately $2.1 million during the first nine months of 2016 in their reserves for prior accident years, compared to approximately $4.8 million during the first nine months of 2015. The improvement in loss reserve development patterns occurred primarily within our insurance subsidiaries’ workers’ compensation reserves. Underwriting Expenses. The expense ratio for an insurance company is the ratio of policy acquisition costs and other underwriting expenses to premiums earned. The expense ratio of our insurance subsidiaries was 33.2% for the first nine months of 2016, compared to 32.7% for the first nine months of 2015. We attribute the 2016 increase primarily to higher underwriting incentive costs related to the lower loss ratio in the first nine months of 2016 compared to the first nine months of 2015. Combined Ratio. The combined ratio represents the sum of the loss ratio, the expense ratio and the dividend ratio, which is the ratio of policyholder dividends incurred to premiums earned. Our insurance subsidiaries’ combined ratios were 97.3% and 99.0% for the nine months ended September 30, 2016 and 2015, respectively. Interest Expense. Our interest expense for the first nine months of 2016 was $1.3 million, compared to $908,615 for the first nine months of 2015. We attribute the increase to higher average borrowings during the first nine months of 2016 compared to the first nine months of 2015. Income Taxes. Income tax expense was $9.2 million for the first nine months of 2016, representing an effective tax rate of 26.8%, compared to income tax expense of $5.4 million for the first nine months of 2015, representing an effective tax rate of 22.1% . The effective tax rate in both periods represented an estimate based on our projected annual taxable income. The increase in the effective tax rate reflects our expectation that tax-exempt interest income will represent a lesser proportion of our 2016 taxable income compared to 2015. Net Income and Earnings Per Share. Our net income for the first nine months of 2016 was $25.2 million, or $.95 per share of Class A common stock on a diluted basis and $.88 per share of Class B common stock, compared to net income of $19.0 million, or $.69 per share of Class A common stock on a diluted basis and $.63 per share of Class B common stock, for the first nine months of 2015. We had 21.2 million and 22.4 million Class A shares outstanding at September 30, 2016 and 2015, respectively. We had 5.6 million Class B shares outstanding at the end of both periods. Liquidity and Capital Resources Liquidity is a measure of an entity’s ability to secure enough cash to meet its contractual obligations and operating needs as such obligations and needs arise. Our major sources of funds from operations are the net cash flows we generate from our insurance subsidiaries’ underwriting results, investment income and investment maturities. 26 Our operations have historically generated sufficient net positive cash flow to fund our commitments and add to our investment portfolio, thereby increasing future investment returns and enhancing our liquidity. The impact of the pooling agreement between Donegal Mutual and Atlantic States has historically been cash-flow positive because of the consistent underwriting profitability of the pool. Donegal Mutual and Atlantic States settle their respective obligations to each other under the pool monthly, thereby resulting in cash flows substantially similar to the cash flows that would result from each company writing the business directly. We have not experienced any unusual variations in the timing of claim payments associated with the loss reserves of our insurance subsidiaries. We maintain significant liquidity in our investment portfolio in the form of readily marketable fixed maturities, equity securities and short-term investments. We structure our fixed-maturity investment portfolio following a “laddering” approach, so that projected cash flows from investment income and principal maturities are evenly distributed from a timing perspective, thereby providing an additional measure of liquidity to meet our obligations should an unexpected variation occur in the future. Our operating activities provided net cash flows in the first nine months of 2016 and 2015 of $46.3 million and $48.5 million, respectively. At September 30, 2016, we had $39.0 million in outstanding borrowings under our line of credit with M&T and had the ability to borrow an additional $21.0 million at interest rates equal to M&T’s current prime rate or the then current LIBOR rate plus 2.25%. The interest rate on these borrowings was 2.78% at September 30, 2016. At September 30, 2016, Atlantic States had $35.0 million in outstanding advances with the FHLB of Pittsburgh. The interest rate on these advances was .59% at September 30, 2016. The following table shows our expected payments for significant contractual obligations at September 30, 2016: Total Less than 1 year 1-3 years 4-5 years After 5 years (in thousands) Net liability for unpaid losses and loss expenses of our insurance subsidiaries $ 340,041 $ 158,779 $ 155,378 $ 12,372 $ 13,512 Subordinated debentures 5,000 — — — 5,000 Borrowings under lines of credit 74,000 35,000 39,000 — — Total contractual obligations $ 419,041 $ 193,779 $ 194,378 $ 12,372 $ 18,512 We estimate the date of payment for the net liability for unpaid losses and loss expenses of our insurance subsidiaries based on historical experience and expectations of future payment patterns. We show the liability net of reinsurance recoverable on unpaid losses and loss expenses to reflect expected future cash flows related to such liability. Amounts Atlantic States assumes pursuant to the pooling agreement with Donegal Mutual represent a substantial portion of our insurance subsidiaries’ gross liability for unpaid losses and loss expenses, and amounts Atlantic States cedes pursuant to the pooling agreement represent a substantial portion of our insurance subsidiaries’ reinsurance recoverable on unpaid losses and loss expenses. We include cash settlement of Atlantic States’ assumed liability from the pool in monthly settlements of pooled activity, as we net amounts ceded to and assumed from the pool. Although Donegal Mutual and we do not anticipate any changes in the pool participation levels in the foreseeable future, any such change would be prospective in nature and therefore would not impact the timing of expected payments by Atlantic States for its percentage share of pooled losses occurring in periods prior to the effective date of such change. We discuss in Note 7 – Borrowings our estimate of the timing of the amounts for the borrowings under our lines of credit based on their contractual maturities. The borrowings under our lines of credit carry interest rates that vary as we discuss in Note 7 – Borrowings. Based upon the interest rates in effect at September 30, 2016, our annual interest cost associated with the borrowings under our lines of credit is approximately $1.3 million. For every 1% change in the interest rate associated with the borrowings under our lines of credit, the effect on our annual interest cost would be approximately $740,000. We discuss in Note 7 – Borrowings our estimate of the timing of the amounts for the subordinated debentures based on their contractual maturity. The subordinated debentures carry an interest rate of 5%, and any repayment of principal or payment of interest on the subordinated debentures requires prior approval of the Michigan Department of Insurance and Financial Services. Our annual interest cost associated with the subordinated debentures is approximately $250,000. On July 18, 2013, our board of directors authorized a share repurchase program pursuant to which we have the authority to purchase up to 500,000 additional shares of our Class A common stock at prices prevailing from time to time in the open market subject to the provisions of applicable rules of the SEC and in privately negotiated transactions. We did not purchase any shares of our Class A common stock under this program during the nine months ended September 30, 2016. We purchased 27 57,658 shares of our Class A common stock under this program during the nine months ended September 30, 2015. We have purchased a total of 57,658 shares of our Class A common stock under this program from its inception through September 30, 2016. On October 20, 2016, our board of directors declared quarterly cash dividends of 13.75 cents per share of our Class A common stock and 12.00 cents per share of our Class B common stock, payable on November 15, 2016 to our stockholders of record as of the close of business on November 1, 2016. We are not subject to any restrictions on our payment of dividends to our stockholders, although there are state law restrictions on the payment of dividends by our insurance subsidiaries to us. Dividends from our insurance subsidiaries are our principal source of cash for payment of dividends to our stockholders. Our insurance subsidiaries are subject to regulations that restrict the payment of dividends from statutory surplus and may require prior approval of their domiciliary insurance regulatory authorities. Our insurance subsidiaries are also subject to risk based capital (“RBC”) requirements that limit their ability to pay dividends to us. Our insurance subsidiaries’ statutory capital and surplus at December 31, 2015 exceeded the amount of statutory capital and surplus necessary to satisfy regulatory requirements, including the RBC requirements, by a significant margin. Our insurance subsidiaries paid $9.5 million in dividends to us during the first nine months of 2016. Amounts remaining available for distribution to us as dividends from our insurance subsidiaries without prior approval of their domiciliary insurance regulatory authorities in 2016 are $18.8 million from Atlantic States, $1.3 million from Southern, $1.1 million from Le Mars, $4.2 million from Peninsula, $325,412 from Sheboygan and $619,953 from MICO, or a total of approximately $26.3 million. At September 30, 2016, we had no material commitments for capital expenditures. Equity Price Risk Our portfolio of marketable equity securities, which we carry on our consolidated balance sheets at estimated fair value, has exposure to the risk of loss resulting from an adverse change in prices. We manage this risk by having our investment staff perform an analysis of prospective investments and regular reviews of our portfolio of equity securities. Credit Risk Our portfolio of fixed-maturity securities and, to a lesser extent, our portfolio of short-term investments is subject to credit risk, which we define as the potential loss in market value resulting from adverse changes in the borrower’s ability to repay its debt. We manage this risk by having our investment staff perform an analysis of prospective investments and regular reviews of our portfolio of fixed-maturity securities. We also limit the percentage and amount of our total investment portfolio that we invest in the securities of any one issuer. Our insurance subsidiaries provide property and casualty insurance coverages through independent insurance agencies. We bill the majority of this business directly to the insured, although we bill a portion of our commercial business through licensed insurance agents to whom our insurance subsidiaries extend credit in the normal course of business. Because the pooling agreement does not relieve Atlantic States of primary liability as the originating insurer, Atlantic States is subject to a concentration of credit risk arising from the business it cedes to Donegal Mutual. Our insurance subsidiaries maintain reinsurance agreements with Donegal Mutual and with a number of other major unaffiliated authorized reinsurers. Impact of Inflation We establish property and casualty insurance premium rates before we know the amount of unpaid losses and loss expenses or the extent to which inflation may impact such losses and expenses. Consequently, our insurance subsidiaries attempt, in establishing rates, to anticipate the potential impact of inflation.\nOur market risk generally represents the risk of gain or loss that may result from the potential change in the fair value of the securities we hold in our investment portfolio as a result of fluctuations in prices and interest rates and, to a lesser extent, our debt obligations. We manage our interest rate risk by maintaining an appropriate relationship between the average duration of our investment portfolio and the approximate duration of our liabilities, i.e., policy claims of our insurance subsidiaries and our debt obligations.\n28\nThere have been no material changes to our quantitative or qualitative market risk exposure from December 31, 2015 through September 30, 2016.\nEvaluation of Disclosure Controls and Procedures\nOur management, with the participation of our Chief Executive Officer and our Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Based on such evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that, at September 30, 2016, our disclosure controls and procedures were effective in recording, processing, summarizing and reporting, on a timely basis, information we are required to disclose in the reports that we file or submit under the Exchange Act, and our disclosure controls and procedures were also effective to ensure that information we disclose in the reports we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, to allow timely decisions regarding required disclosure.\nChanges in Internal Control Over Financial Reporting\nThere has been no change in our internal control over financial reporting during the quarter covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to affect materially, our internal control over financial reporting.\nSafe Harbor Statement Under the Private Securities Litigation Reform Act of 1995\nWe base all statements contained in this Quarterly Report on Form 10-Q that are not historic facts on our current expectations. Such statements are forward-looking in nature (as defined in the Private Securities Litigation Reform Act of 1995) and necessarily involve risks and uncertainties. Forward-looking statements we make may be identified by our use of words such as “will,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “seeks,” “estimates” and similar expressions. Our actual results could vary materially from our forward-looking statements. The factors that could cause our actual results to vary materially from the forward-looking statements we have previously made include, but are not limited to, our ability to maintain profitable operations, the adequacy of the loss and loss expense reserves of our insurance subsidiaries, business and economic conditions in the areas in which we and our insurance subsidiaries operate, interest rates, competition from various insurance and other financial businesses, terrorism, the availability and cost of reinsurance, adverse and catastrophic weather events, legal and judicial developments, changes in regulatory requirements, our ability to integrate and manage successfully the companies we may acquire from time to time and the other risks that we describe from time to time in our filings with the SEC. We disclaim any obligation to update such statements or to announce publicly the results of any revisions that we may make to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.\n29\nPart II. Other Information\nNone.\nOur business, results of operations and financial condition, and, therefore, the value of our Class A common stock and our Class B common stock, are subject to a number of risks. For a description of certain risks, we refer to “Risk Factors” in our 2015 Annual Report on Form 10-K we filed with the SEC on March 18, 2016. There have been no material changes in the risk factors we disclosed in that Form 10-K Report during the nine months ended September 30, 2016.\nNone.\nNone.\nItem 4. Removed and Reserved.\nNone.\n30\n\n\n| Exhibit No. | Description |\n| Exhibit 31.1 | Certification of Chief Executive Officer |\n| Exhibit 31.2 | Certification of Chief Financial Officer |\n| Exhibit 32.1 | Statement of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 of Title 18 of the United States Code |\n| Exhibit 32.2 | Statement of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of Title 18 of the United States Code |\n| Exhibit 101.INS | XBRL Instance Document |\n| Exhibit 101.SCH | XBRL Taxonomy Extension Schema Document |\n| Exhibit 101.PRE | XBRL Taxonomy Presentation Linkbase Document |\n| Exhibit 101.CAL | XBRL Taxonomy Calculation Linkbase Document |\n| Exhibit 101.LAB | XBRL Taxonomy Label Linkbase Document |\n| Exhibit 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\n\n31\nSignatures Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. DONEGAL GROUP INC. November 7, 2016 By: /s/ Kevin G. Burke Kevin G. Burke, President and Chief Executive Officer November 7, 2016 By: /s/ Jeffrey D. Miller Jeffrey D. Miller, Executive Vice President and Chief Financial Officer\n \n\nWhat is the annual growth rate of the company's total investments from December 31, 2015 to September 30, 2016 in percent?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n| Item 1. | Financial Statements. |\\n\\nDonegal Group Inc. and Subsidiaries\\nConsolidated Balance Sheets\\n\\n| September 30,2016 | December 31,2015 |\\n| (Unaudited) |\\n| Assets |\\n| Investments |\\n| Fixed maturities |\\n| Held to maturity, at amortized cost | $ | 332,272,969 | $ | 310,258,704 |\\n| Available for sale, at fair value | 515,821,393 | 501,393,559 |\\n| Equity securities, available for sale, at fair value | 46,311,943 | 37,260,821 |\\n| Investment in affiliate | 40,145,067 | 38,476,708 |\\n| Short-term investments, at cost, which approximates fair value | 9,251,153 | 13,432,482 |\\n| Total investments | 943,802,525 | 900,822,274 |\\n| Cash | 32,130,534 | 28,139,144 |\\n| Accrued investment income | 6,817,760 | 5,991,197 |\\n| Premiums receivable | 165,761,900 | 141,267,411 |\\n| Reinsurance receivable | 259,428,626 | 259,728,113 |\\n| Deferred policy acquisition costs | 57,404,289 | 52,108,388 |\\n| Deferred tax asset, net | 14,721,101 | 19,443,807 |\\n| Prepaid reinsurance premiums | 127,431,503 | 113,522,505 |\\n| Property and equipment, net | 6,705,671 | 7,027,143 |\\n| Federal income taxes receivable | 1,823,273 | 1,487,656 |\\n| Goodwill | 5,625,354 | 5,625,354 |\\n| Other intangible assets | 958,010 | 958,010 |\\n| Other | 1,453,864 | 1,713,413 |\\n| Total assets | $ | 1,624,064,410 | $ | 1,537,834,415 |\\n| Liabilities and Stockholders Equity |\\n| Liabilities |\\n| Unpaid losses and loss expenses | $ | 594,267,943 | $ | 578,205,109 |\\n| Unearned premiums | 476,432,783 | 429,493,203 |\\n| Accrued expenses | 21,067,170 | 22,460,475 |\\n| Reinsurance balances payable | 3,058,225 | 3,480,406 |\\n| Borrowings under lines of credit | 74,000,000 | 81,000,000 |\\n| Cash dividends declared | | 3,511,881 |\\n| Subordinated debentures | 5,000,000 | 5,000,000 |\\n| Accounts payable - securities | 540,311 | 582,560 |\\n| Due to affiliate | 3,978,958 | 3,557,177 |\\n| Other | 1,710,209 | 2,155,036 |\\n| Total liabilities | 1,180,055,599 | 1,129,445,847 |\\n| Stockholders Equity |\\n| Preferred stock, $.01 par value, authorized 2,000,000 shares; none issued | | |\\n| Class A common stock, $.01 par value, authorized 40,000,000 shares, issued 24,189,133 and 23,501,805 shares and outstanding 21,186,545 and 20,499,217 shares | 241,892 | 235,018 |\\n| Class B common stock, $.01 par value, authorized 10,000,000 shares, issued 5,649,240 shares and outstanding 5,576,775 shares | 56,492 | 56,492 |\\n| Additional paid-in capital | 231,885,764 | 219,525,301 |\\n| Accumulated other comprehensive income | 6,340,292 | 773,744 |\\n| Retained earnings | 246,710,728 | 229,024,370 |\\n| Treasury stock, at cost | (41,226,357 | ) | (41,226,357 | ) |\\n| Total stockholders equity | 444,008,811 | 408,388,568 |\\n| Total liabilities and stockholders equity | $ | 1,624,064,410 | $ | 1,537,834,415 |\\n\\nSee accompanying notes to consolidated financial statements.\\n1\\nDonegal Group Inc. and Subsidiaries Consolidated Statements of Income (Unaudited) Three Months Ended September 30, 2016 2015 Revenues: Net premiums earned $ 166,809,851 $ 153,096,075 Investment income, net of investment expenses 5,581,238 5,399,080 Net realized investment gains (losses) (includes $1,018,415 and ($754,050) accumulated other comprehensive income (loss) reclassifications) 1,018,415 (754,050 ) Lease income 163,779 178,827 Installment payment fees 1,380,024 1,473,447 Equity in earnings of Donegal Financial Services Corporation 357,956 408,405 Total revenues 175,311,263 159,801,784 Expenses: Net losses and loss expenses 111,174,963 102,233,708 Amortization of deferred policy acquisition costs 27,524,000 25,036,000 Other underwriting expenses 28,340,135 24,155,566 Policyholder dividends 1,143,026 886,210 Interest 473,917 188,000 Other expenses 226,183 301,367 Total expenses 168,882,224 152,800,851 Income before income tax expense 6,429,039 7,000,933 Income tax expense (includes $356,446 and ($263,918) income tax expense (benefit) from reclassification items) 1,615,635 1,314,102 Net income $ 4,813,404 $ 5,686,831 Earnings per common share: Class A common stock - basic $ 0.19 $ 0.21 Class A common stock - diluted $ 0.18 $ 0.21 Class B common stock - basic and diluted $ 0.16 $ 0.18 Donegal Group Inc. and Subsidiaries Consolidated Statements of Comprehensive Income (Unaudited) Three Months Ended September 30, 2016 2015 Net income $ 4,813,404 $ 5,686,831 Other comprehensive (loss) income, net of tax Unrealized (loss) gain on securities: Unrealized holding (loss) gain during the period, net of income tax (benefit) expense of ($595,724) and 463,221 (1,106,346 ) 860,268 Reclassification adjustment for (gains) losses included in net income, net of income tax expense (benefit) of $356,446 and ($263,918) (661,969 ) 490,132 Other comprehensive (loss) income (1,768,315 ) 1,350,400 Comprehensive income $ 3,045,089 $ 7,037,231 See accompanying notes to consolidated financial statements. 2 Donegal Group Inc. and Subsidiaries Consolidated Statements of Income (Unaudited) Nine Months Ended September 30, 2016 2015 Revenues: Net premiums earned $ 487,227,767 $ 450,083,676 Investment income, net of investment expenses 16,471,630 15,505,429 Net realized investment gains (includes $2,204,533 and $682,932 accumulated other comprehensive income reclassifications) 2,204,533 682,932 Lease income 514,768 568,552 Installment payment fees 4,109,550 4,473,905 Equity in earnings of Donegal Financial Services Corporation 698,658 1,276,692 Total revenues 511,226,906 472,591,186 Expenses: Net losses and loss expenses 309,946,943 296,012,311 Amortization of deferred policy acquisition costs 80,034,000 73,872,000 Other underwriting expenses 81,557,159 73,192,072 Policyholder dividends 2,729,595 2,491,919 Interest 1,286,279 908,615 Other expenses 1,179,660 1,704,680 Total expenses 476,733,636 448,181,597 Income before income tax expense 34,493,270 24,409,589 Income tax expense (includes $771,587 and $239,026 income tax expense from reclassification items) 9,246,299 5,403,395 Net income $ 25,246,971 $ 19,006,194 Earnings per common share: Class A common stock - basic $ 0.98 $ 0.71 Class A common stock - diluted $ 0.95 $ 0.69 Class B common stock - basic and diluted $ 0.88 $ 0.63 Donegal Group Inc. and Subsidiaries Consolidated Statements of Comprehensive Income (Unaudited) Nine Months Ended September 30, 2016 2015 Net income $ 25,246,971 $ 19,006,194 Other comprehensive income (loss), net of tax Unrealized gain (loss) on securities: Unrealized holding gain (loss) during the period, net of income tax expense (benefit) of $3,768,959 and ($1,141,726) 6,999,494 (2,120,347 ) Reclassification adjustment for gains included in net income, net of income tax expense of $771,587 and $239,026 (1,432,946 ) (443,906 ) Other comprehensive income (loss) 5,566,548 (2,564,253 ) Comprehensive income $ 30,813,519 $ 16,441,941 See accompanying notes to consolidated financial statements. 3 Donegal Group Inc. and Subsidiaries Consolidated Statement of Stockholders’ Equity (Unaudited) Nine Months Ended September 30, 2016 Class A Shares Class B Shares Class A Amount Class B Amount Additional Paid-In Capital Accumulated Other Comprehensive Income Retained Earnings Treasury Stock Total Stockholders’ Equity Balance, December 31, 2015 23,501,805 5,649,240 $ 235,018 $ 56,492 $ 219,525,301 $ 773,744 $ 229,024,370 $ (41,226,357 ) $ 408,388,568 Issuance of common stock 104,271 — 1,043 — 1,389,022 — — — 1,390,065 Share-based compensation 583,057 5,831 10,396,351 10,402,182 Net income — — — — — — 25,246,971 — 25,246,971 Cash dividends declared — — — — — — (6,985,523 ) — (6,985,523 ) Grant of stock options — — — — 575,090 — (575,090 ) — — Other comprehensive income — — — — — 5,566,548 — — 5,566,548 Balance, September 30, 2016 24,189,133 5,649,240 $ 241,892 $ 56,492 $ 231,885,764 $ 6,340,292 $ 246,710,728 $ (41,226,357 ) $ 444,008,811 See accompanying notes to consolidated financial statements. 4 Donegal Group Inc. and Subsidiaries Consolidated Statements of Cash Flows (Unaudited) Nine Months Ended September 30, 2016 2015 Cash Flows from Operating Activities: Net income $ 25,246,971 $ 19,006,194 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation, amortization and other non-cash items 5,365,877 2,890,128 Net realized investment gains (2,204,533 ) (682,932 ) Equity in earnings of Donegal Financial Services Corporation (698,658 ) (1,276,692 ) Changes in assets and liabilities: Losses and loss expenses 16,062,834 30,888,062 Unearned premiums 46,939,580 32,671,922 Premiums receivable (24,494,489 ) (13,301,356 ) Deferred acquisition costs (5,295,901 ) (5,212,051 ) Deferred income taxes 1,725,335 225,409 Reinsurance receivable 299,487 (6,254,559 ) Prepaid reinsurance premiums (13,908,998 ) (1,631,341 ) Accrued investment income (826,563 ) (929,722 ) Due to affiliate 421,781 (1,655,351 ) Reinsurance balances payable (422,181 ) (3,900,348 ) Current income taxes (335,617 ) 242,849 Accrued expenses (1,393,305 ) (601,830 ) Other, net (185,278 ) (1,943,559 ) Net adjustments 21,049,371 29,528,629 Net cash provided by operating activities 46,296,342 48,534,823 Cash Flows from Investing Activities: Purchases of fixed maturities, held to maturity (35,461,529 ) (18,483,546 ) Purchases of fixed maturities, available for sale (127,113,153 ) (132,823,136 ) Purchases of equity securities, available for sale (10,753,187 ) (9,011,957 ) Maturity of fixed maturities: Held to maturity 13,603,700 22,416,840 Available for sale 64,406,512 56,293,130 Sales of fixed maturities, available for sale 52,032,208 23,485,311 Sales of equity securities, available for sale 5,068,287 2,704,425 Net purchases of property and equipment (260,968 ) (78,292 ) Net decrease in investment in affiliate — 675,100 Net sales (purchases) of short-term investments 4,181,329 (4,302,571 ) Net cash used in investing activities (34,296,801 ) (59,124,696 ) Cash Flows from Financing Activities: Cash dividends paid (10,497,404 ) (10,762,609 ) Issuance of common stock 9,489,253 17,106,300 Purchase of treasury stock — (904,675 ) Payments on lines of credit (7,000,000 ) (9,500,000 ) Borrowings under lines of credit — 4,000,000 Net cash used in financing activities (8,008,151 ) (60,984 ) Net increase (decrease) in cash 3,991,390 (10,650,857 ) Cash at beginning of period 28,139,144 35,578,509 Cash at end of period $ 32,130,534 $ 24,927,652 Cash paid during period - Interest $ 1,001,870 $ 757,175 Net cash paid during period - Taxes $ 8,255,000 $ 4,500,000 See accompanying notes to consolidated financial statements. 5 DONEGAL GROUP INC. AND SUBSIDIARIES (Unaudited) Notes to Consolidated Financial Statements 1 - Organization Donegal Mutual Insurance Company (“Donegal Mutual”) organized us as an insurance holding company on August 26, 1986. Our insurance subsidiaries, Atlantic States Insurance Company (“Atlantic States”), Southern Insurance Company of Virginia (“Southern”), Le Mars Insurance Company (“Le Mars”), the Peninsula Insurance Group (“Peninsula”), which consists of Peninsula Indemnity Company and The Peninsula Insurance Company, Sheboygan Falls Insurance Company (“Sheboygan”) and Michigan Insurance Company (“MICO”), write personal and commercial lines of property and casualty coverages exclusively through a network of independent insurance agents in certain Mid-Atlantic, Midwestern, New England and Southern states. We also own 48.2% of the outstanding stock of Donegal Financial Services Corporation (“DFSC”), a grandfathered unitary savings and loan holding company that owns Union Community Bank (“UCB”), a state savings bank. Donegal Mutual owns the remaining 51.8% of the outstanding stock of DFSC. We have four segments: our investment function, our personal lines of insurance, our commercial lines of insurance and our investment in DFSC. The personal lines products of our insurance subsidiaries consist primarily of homeowners and private passenger automobile policies. The commercial lines products of our insurance subsidiaries consist primarily of commercial automobile, commercial multi-peril and workers’ compensation policies. At September 30, 2016, Donegal Mutual held approximately 47% of our outstanding Class A common stock and approximately 83% of our outstanding Class B common stock. This ownership provides Donegal Mutual with approximately 73% of the total voting power of our outstanding common stock. We believe Donegal Mutual’s voting control of us benefits us for the reasons we describe in our Annual Reports on Form 10-K and in our proxy statements. Our insurance subsidiaries and Donegal Mutual have interrelated operations due to a pooling agreement and other intercompany agreements and transactions. While each company maintains its separate corporate existence, our insurance subsidiaries and Donegal Mutual conduct business together as the Donegal Insurance Group. As such, Donegal Mutual and our insurance subsidiaries share the same business philosophy, the same management, the same employees and the same facilities and offer the same types of insurance products. Atlantic States, our largest subsidiary, participates in a pooling agreement with Donegal Mutual. Under the pooling agreement, Donegal Mutual and Atlantic States pool their insurance business and each company receives an allocated percentage of the pooled business. Atlantic States has an 80% share of the results of the pooled business, and Donegal Mutual has a 20% share of the results of the pooled business. The same executive management and underwriting personnel administer products, classes of business underwritten, pricing practices and underwriting standards of Donegal Mutual and our insurance subsidiaries. In addition, as the Donegal Insurance Group, Donegal Mutual and our insurance subsidiaries share a combined business plan to achieve market penetration and underwriting profitability objectives. The products our insurance subsidiaries and Donegal Mutual market are generally complementary, thereby allowing the Donegal Insurance Group to offer a broader range of products to a given market and to expand the Donegal Insurance Group’s ability to service an entire personal lines or commercial lines account. Distinctions within the products Donegal Mutual and our insurance subsidiaries offer relate generally to specific risk profiles targeted within similar classes of business, such as preferred tier products versus standard tier products, but we do not allocate all of the standard risk gradients to one company. Therefore, the underwriting profitability of the business the individual companies write directly will vary. However, as the risk characteristics of all business Donegal Mutual and Atlantic States write directly are homogenized within the underwriting pool, Donegal Mutual and Atlantic States share the underwriting results in proportion to their respective participation in the pool. Pooled business represents the predominant percentage of the net underwriting activity of both Donegal Mutual and Atlantic States. On July 18, 2013, our board of directors authorized a share repurchase program pursuant to which we have the authority to purchase up to 500,000 additional shares of our Class A common stock at prices prevailing from time to time in the open market subject to the provisions of applicable rules of the SEC and in privately negotiated transactions. We did not purchase any shares of our Class A common stock under this program during the nine months ended September 30, 2016. We purchased 57,658 shares of our Class A common stock under this program during the nine months ended September 30, 2015. We have purchased a total of 57,658 shares of our Class A common stock under this program from its inception through September 30, 2016. 6 2 - Basis of Presentation Our financial information for the interim periods included in this Form 10-Q Report is unaudited; however, our financial information we include in this Form 10-Q Report reflects all adjustments, consisting only of normal recurring adjustments that, in the opinion of our management, are necessary for a fair presentation of our financial position, results of operations and cash flows for those interim periods. Our results of operations for the nine months ended September 30, 2016 are not necessarily indicative of the results of operations we expect for the year ending December 31, 2016. You should read the interim financial statements we include in this Form 10-Q Report in conjunction with the financial statements and the notes to our financial statements contained in our Annual Report on Form 10-K for the year ended December 31, 2015. 3 - Earnings Per Share We have two classes of common stock, which we refer to as our Class A common stock and our Class B common stock. Our certificate of incorporation provides that whenever our board of directors declares a dividend on our Class B common stock, our board of directors shall simultaneously declare a dividend on our Class A common stock that is payable to the holders of our Class A common stock at the same time and as of the same record date at a rate that is at least 10% greater than the rate at which our board of directors declared a dividend on our Class B common stock. Accordingly, we use the two-class method to compute our earnings per common share. The two-class method is an earnings allocation formula that determines earnings per share separately for each class of common stock based on dividends we have declared and an allocation of our remaining undistributed earnings using a participation percentage that reflects the dividend rights of each class. The table below presents for the periods indicated a reconciliation of the numerators and denominators we used to compute basic and diluted net income per share for each class of our common stock: Three Months Ended September 30, 2016 2015 Class A Class B Class A Class B (in thousands, except per share data) Basic net income per share: Numerator: Allocation of net income $ 3,901 $ 912 $ 4,663 $ 1,024 Denominator: Weighted-average shares outstanding 21,078 5,577 22,442 5,577 Basic net income per share $ 0.19 $ 0.16 $ 0.21 $ 0.18 Diluted net income per share: Numerator: Allocation of net income $ 3,901 $ 912 $ 4,663 $ 1,024 Denominator: Number of shares used in basic computation 21,078 5,577 22,442 5,577 Weighted-average shares effect of dilutive securities Add: Director and employee stock options 831 — 242 — Number of shares used in diluted computation 21,909 5,577 22,684 5,577 Diluted net income per share $ 0.18 $ 0.16 $ 0.21 $ 0.18 7 Nine Months Ended September 30, 2016 2015 Class A Class B Class A Class B (in thousands, except per share data) Basic net income per share: Numerator: Allocation of net income $ 20,329 $ 4,918 $ 15,502 $ 3,504 Denominator: Weighted-average shares outstanding 20,791 5,577 21,996 5,577 Basic net income per share $ 0.98 $ 0.88 $ 0.71 $ 0.63 Diluted net income per share: Numerator: Allocation of net income $ 20,329 $ 4,918 $ 15,502 $ 3,504 Denominator: Number of shares used in basic computation 20,791 5,577 21,996 5,577 Weighted-average shares effect of dilutive securities Add: Director and employee stock options 560 — 400 — Number of shares used in diluted computation 21,351 5,577 22,396 5,577 Diluted net income per share $ 0.95 $ 0.88 $ 0.69 $ 0.63 We did not include outstanding options to purchase the following number of shares of Class A common stock in our computation of diluted earnings per share because the exercise price of the options exceeded the average market price of our Class A common stock during the applicable periods: Three Months Ended September 30, Nine Months Ended September 30, 2016 2015 2016 2015 Number of options to purchase Class A shares excluded — 4,014,501 — — 4 - Reinsurance Atlantic States and Donegal Mutual have participated in a pooling agreement since 1986 under which each company places all of its direct written premiums into the pool the pooling agreement established, and Atlantic States and Donegal Mutual then share the underwriting results of the pool in accordance with the terms of the pooling agreement. Atlantic States has an 80% share of the results of the pool, and Donegal Mutual has a 20% share of the results of the pool. Our insurance subsidiaries and Donegal Mutual purchase certain third-party reinsurance on a combined basis. Le Mars, MICO, Peninsula and Sheboygan also purchase separate third-party reinsurance that provides coverage that we believe is commensurate with their relative size and risk exposures. Our insurance subsidiaries use several different reinsurers, all of which, consistent with the requirements of our insurance subsidiaries and Donegal Mutual, have an A.M. Best rating of A- (Excellent) or better or, with respect to foreign reinsurers, have a financial condition that, in the opinion of our management, is equivalent to a company with at least an A- rating from A.M. Best. The following information describes the external reinsurance our insurance subsidiaries have in place for 2016: • excess of loss reinsurance, under which Donegal Mutual and our insurance subsidiaries recover, through a series of reinsurance agreements, losses over a set retention (generally $1.0 million), and • catastrophe reinsurance, under which Donegal Mutual and our insurance subsidiaries recover, through a series of reinsurance agreements, 100% of an accumulation of many losses resulting from a single event, including natural 8 disasters, over a set retention (generally $5.0 million) and after exceeding an annual aggregate deductible (generally $1.0 million) up to aggregate losses of $170.0 million per occurrence. Our insurance subsidiaries and Donegal Mutual also purchase facultative reinsurance to cover exposures in excess of the covered limits of their third-party reinsurance agreements. In addition to the pooling agreement and third-party reinsurance, our insurance subsidiaries have various reinsurance agreements with Donegal Mutual. We have made no significant changes to our third-party reinsurance or the reinsurance agreements between our insurance subsidiaries and Donegal Mutual during the nine months ended September 30, 2016. 5 - Investments The amortized cost and estimated fair values of our fixed maturities and equity securities at September 30, 2016 were as follows: Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value (in thousands) Held to Maturity U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 59,254 $ 3,130 $ 7 $ 62,377 Obligations of states and political subdivisions 122,203 14,292 4 136,491 Corporate securities 86,582 3,360 598 89,344 Mortgage-backed securities 64,234 2,425 — 66,659 Totals $ 332,273 $ 23,207 $ 609 $ 354,871 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value (in thousands) Available for Sale U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 36,009 $ 368 $ 2 $ 36,375 Obligations of states and political subdivisions 184,068 10,219 11 194,276 Corporate securities 88,826 2,156 141 90,841 Mortgage-backed securities 190,936 3,444 51 194,329 Fixed maturities 499,839 16,187 205 515,821 Equity securities 41,806 4,917 411 46,312 Totals $ 541,645 $ 21,104 $ 616 $ 562,133 At September 30, 2016, our holdings of obligations of states and political subdivisions included general obligation bonds with an aggregate fair value of $229.6 million and an amortized cost of $213.6 million. Our holdings at September 30, 2016 also included special revenue bonds with an aggregate fair value of $101.2 million and an amortized cost of $92.7 million. With respect to both categories of those bonds at September 30, 2016, we held no securities of any issuer that constituted more than 10% of our holdings of either bond category. Education bonds and water and sewer utility bonds represented 62% and 24%, respectively, of our total investments in special revenue bonds based on the carrying values of these investments at September 30, 2016. Many of the issuers of the special revenue bonds we held at September 30, 2016 have the authority to impose ad valorem taxes. In that respect, many of the special revenue bonds we held at September 30, 2016 were similar to general obligation bonds. 9 The amortized cost and estimated fair values of our fixed maturities and equity securities at December 31, 2015 were as follows: Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value (in thousands) Held to Maturity U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 51,194 $ 1,544 $ — $ 52,738 Obligations of states and political subdivisions 119,115 10,828 119 129,824 Corporate securities 65,307 816 1,561 64,562 Mortgage-backed securities 74,643 1,181 149 75,675 Totals $ 310,259 $ 14,369 $ 1,829 $ 322,799 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value (in thousands) Available for Sale U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 37,080 $ 160 $ 51 $ 37,189 Obligations of states and political subdivisions 223,769 13,151 364 236,556 Corporate securities 73,474 350 1,012 72,812 Mortgage-backed securities 154,687 1,045 896 154,836 Fixed maturities 489,010 14,706 2,323 501,393 Equity securities 35,765 2,269 773 37,261 Totals $ 524,775 $ 16,975 $ 3,096 $ 538,654 At December 31, 2015, our holdings of obligations of states and political subdivisions included general obligation bonds with an aggregate fair value of $256.9 million and an amortized cost of $241.1 million. Our holdings also included special revenue bonds with an aggregate fair value of $109.5 million and an amortized cost of $101.8 million. With respect to both categories of bonds, we held no securities of any issuer that comprised more than 10% of that category at December 31, 2015. Education bonds and water and sewer utility bonds represented 57% and 26%, respectively, of our total investments in special revenue bonds based on their carrying values at December 31, 2015. Many of the issuers of the special revenue bonds we held at December 31, 2015 have the authority to impose ad valorem taxes. In that respect, many of the special revenue bonds we held are similar to general obligation bonds. We made reclassifications from available for sale to held to maturity of certain fixed maturities at fair value on November 30, 2013. We segregated within accumulated other comprehensive income the net unrealized losses of $15.1 million arising prior to the November 30, 2013 reclassification date for fixed maturities we reclassified from available for sale to held to maturity. We are amortizing this balance over the remaining life of the related securities as an adjustment to yield in a manner consistent with the accretion of discount on the same fixed maturities. We recorded amortization of $1.0 million and $905,446 in accumulated other comprehensive income during the nine months ended September 30, 2016 and 2015, respectively. At September 30, 2016 and December 31, 2015, net unrealized losses of $11.3 million and $12.3 million, respectively, remained within accumulated other comprehensive income. 10 We show below the amortized cost and estimated fair value of our fixed maturities at September 30, 2016 by contractual maturity. Expected maturities may differ from contractual maturities because issuers of the securities may have the right to call or prepay obligations with or without call or prepayment penalties. Amortized Cost Estimated Fair Value (in thousands) Held to maturity Due in one year or less $ 9,643 $ 9,657 Due after one year through five years 42,967 44,275 Due after five years through ten years 86,925 92,926 Due after ten years 128,504 141,354 Mortgage-backed securities 64,234 66,659 Total held to maturity $ 332,273 $ 354,871 Available for sale Due in one year or less $ 36,476 $ 37,158 Due after one year through five years 115,204 119,709 Due after five years through ten years 105,689 109,631 Due after ten years 51,534 54,994 Mortgage-backed securities 190,936 194,329 Total available for sale $ 499,839 $ 515,821 Gross realized gains and losses from investments before applicable income taxes for the three and nine months ended September 30, 2016 and 2015 were as follows: Three Months Ended September 30, Nine Months Ended September 30, 2016 2015 2016 2015 (in thousands) Gross realized gains: Fixed maturities $ 289 $ 7 $ 2,129 $ 974 Equity securities 1,170 30 1,226 733 1,459 37 3,355 1,707 Gross realized losses: Fixed maturities 22 27 280 105 Equity securities 419 764 870 919 441 791 1,150 1,024 Net realized gains (losses) $ 1,018 $ (754 ) $ 2,205 $ 683 We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at September 30, 2016 as follows: Less Than 12 Months More Than 12 Months Fair Value Unrealized Losses Fair Value Unrealized Losses (in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 2,988 $ 9 $ — $ — Obligations of states and political subdivisions 4,248 13 722 2 Corporate securities 21,006 205 2,911 534 Mortgage-backed securities 20,567 49 831 2 Equity securities 4,515 308 163 103 Totals $ 53,324 $ 584 $ 4,627 $ 641 11 We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at December 31, 2015 as follows: Less Than 12 Months More Than 12 Months Fair Value Unrealized Losses Fair Value Unrealized Losses (in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 10,168 $ 51 $ — $ — Obligations of states and political subdivisions 19,437 483 — — Corporate securities 69,482 1,615 11,324 958 Mortgage-backed securities 105,300 876 7,538 168 Equity securities 9,245 773 — — Totals $ 213,632 $ 3,798 $ 18,862 $ 1,126 We make estimates concerning the valuation of our investments and the recognition of other-than-temporary declines in the value of our investments. For equity securities, we write down the investment to its fair value, and we reflect the amount of the write-down as a realized loss in our results of operations when we consider the decline in value of an individual equity security investment to be other than temporary. We monitor all investments individually for other-than-temporary declines in value. Generally, we assume there has been an other-than-temporary decline in value if an individual equity security has depreciated in value by more than 20% of our original cost and has been in such an unrealized loss position for more than six months. We held seven equity securities that were in an unrealized loss position at September 30, 2016. Based upon our analysis of general market conditions and underlying factors impacting these equity securities, we considered these declines in value to be temporary. With respect to a debt security that is in an unrealized loss position, we first assess if we intend to sell the debt security. If we determine we intend to sell the debt security, we recognize the impairment loss in our results of operations. If we do not intend to sell the debt security, we determine whether it is more likely than not that we will be required to sell the debt security prior to recovery. If we determine it is more likely than not that we will be required to sell the debt security prior to recovery, we recognize an impairment loss in our results of operations. If we determine it is more likely than not that we will not be required to sell the debt security prior to recovery, we then evaluate whether a credit loss has occurred. We determine whether a credit loss has occurred by comparing the amortized cost of the debt security to the present value of the cash flows we expect to collect. If we expect a cash flow shortfall, we consider that a credit loss has occurred. If we determine that a credit loss has occurred, we consider the impairment to be other than temporary. We then recognize the amount of the impairment loss related to the credit loss in our results of operations, and we recognize the remaining portion of the impairment loss in our other comprehensive income, net of applicable taxes. In addition, we may write down securities in an unrealized loss position based on a number of other factors, including when the fair value of an investment is significantly below its cost, when the financial condition of the issuer of a security has deteriorated, the occurrence of industry, issuer or geographic events that have negatively impacted the value of a security and rating agency downgrades. We held 55 debt securities that were in an unrealized loss position at September 30, 2016. Based upon our analysis of general market conditions and underlying factors impacting these debt securities, we considered these declines in value to be temporary. We amortize premiums and discounts on debt securities over the life of the security as an adjustment to yield using the effective interest method. We compute realized investment gains and losses using the specific identification method. We amortize premiums and discounts on mortgage-backed debt securities using anticipated prepayments. We account for our investment in affiliate using the equity method of accounting. Under this method, we record our investment at cost, with adjustments for our share of our affiliate’s earnings and losses as well as changes in the equity of our affiliate due to unrealized gains and losses. Our investment in affiliate represents our 48.2% ownership interest in DFSC. We include our share of DFSC’s net income in our results of operations. We have compiled the following summary financial information for DFSC at September 30, 2016 and December 31, 2015 and for the three and nine months ended September 30, 2016 and 2015, respectively, from the financial statements of DFSC. The financial information of DFSC at September 30, 2016 and 2015 and for the three and nine months then ended is unaudited. 12 Balance sheets: September 30, 2016 December 31, 2015 (in thousands) Total assets $ 522,118 $ 507,139 Total liabilities $ 438,942 $ 427,423 Stockholders’ equity 83,176 79,716 Total liabilities and stockholders’ equity $ 522,118 $ 507,139 Three Months Ended September 30, Nine Months Ended September 30, Income statements: 2016 2015 2016 2015 (in thousands) Net income $ 742 $ 847 $ 1,449 $ 2,372 13 6 - Segment Information We evaluate the performance of our personal lines and commercial lines segments based upon the underwriting results of our insurance subsidiaries using statutory accounting principles (“SAP”) that various state insurance departments prescribe or permit. Our management uses SAP to measure the performance of our insurance subsidiaries instead of United States generally accepted accounting principles (“GAAP”). Financial data by segment for the three and nine months ended September 30, 2016 and 2015 is as follows: Three Months Ended September 30, 2016 2015 (in thousands) Revenues: Premiums earned Commercial lines $ 75,571 $ 66,456 Personal lines 91,239 86,640 GAAP premiums earned 166,810 153,096 Net investment income 5,581 5,399 Realized investment gains (losses) 1,018 (754 ) Equity in earnings of DFSC 358 408 Other 1,544 1,653 Total revenues $ 175,311 $ 159,802 Income before income taxes: Underwriting (loss) income: Commercial lines $ 3,701 $ 4,447 Personal lines (5,861 ) (3,727 ) SAP underwriting (loss) income (2,160 ) 720 GAAP adjustments 788 65 GAAP underwriting (loss) income (1,372 ) 785 Net investment income 5,581 5,399 Realized investment gains (losses) 1,018 (754 ) Equity in earnings of DFSC 358 408 Other 844 1,163 Income before income taxes $ 6,429 $ 7,001 14 Nine Months Ended September 30, 2016 2015 (in thousands) Revenues: Premiums earned Commercial lines $ 218,405 $ 193,036 Personal lines 268,823 257,048 GAAP premiums earned 487,228 450,084 Net investment income 16,472 15,505 Realized investment gains 2,205 683 Equity in earnings of DFSC 699 1,277 Other 4,623 5,042 Total revenues $ 511,227 $ 472,591 Income before income taxes: Underwriting income (loss): Commercial lines $ 14,118 $ 6,449 Personal lines (6,953 ) (6,499 ) SAP underwriting income (loss) 7,165 (50 ) GAAP adjustments 5,795 4,565 GAAP underwriting income 12,960 4,515 Net investment income 16,472 15,505 Realized investment gains 2,205 683 Equity in earnings of DFSC 699 1,277 Other 2,157 2,430 Income before income taxes $ 34,493 $ 24,410 7 - Borrowings Lines of Credit In July 2016, we renewed our existing credit agreement with Manufacturers and Traders Trust Company (“M&T”) relating to a $60.0 million unsecured, revolving line of credit. The line of credit expires in July 2019. We have the right to request a one-year extension of the credit agreement as of each anniversary date of the credit agreement. At September 30, 2016, we had $39.0 million in outstanding borrowings and had the ability to borrow an additional $21.0 million at interest rates equal to M&T’s current prime rate or the then current LIBOR rate plus 2.25%. The interest rate on our outstanding borrowings from M&T is adjustable quarterly, and, at September 30, 2016, that interest rate was 2.78%. We pay a fee of 0.2% per annum on the loan commitment amount regardless of usage. The credit agreement requires our compliance with certain covenants. These covenants include minimum levels of our net worth, leverage ratio, statutory surplus and the A.M. Best ratings of our insurance subsidiaries. We were in compliance with all requirements of the M&T credit agreement during the nine months ended September 30, 2016. MICO is a member of the Federal Home Loan Bank (“FHLB”) of Indianapolis. Through its membership, MICO has the ability to issue debt to the FHLB of Indianapolis in exchange for cash advances. MICO had no outstanding borrowings with the FHLB of Indianapolis at September 30, 2016. The table below presents the amount of FHLB of Indianapolis stock MICO purchased, collateral pledged and assets related to MICO’s membership at September 30, 2016. FHLB of Indianapolis stock purchased and owned $ 236,700 Collateral pledged, at par (carrying value $2,180,650) 2,177,558 Borrowing capacity currently available 2,143,057 Atlantic States is a member of the FHLB of Pittsburgh. Through its membership, Atlantic States has the ability to issue debt to the FHLB of Pittsburgh in exchange for cash advances. Atlantic States had $35.0 million in outstanding advances at 15 September 30, 2016. The interest rate on the advances was .59% at September 30, 2016. The table below presents the amount of FHLB of Pittsburgh stock Atlantic States purchased, collateral pledged and assets related to Atlantic States’ membership in the FHLB of Pittsburgh at September 30, 2016. FHLB of Pittsburgh stock purchased and owned $ 1,574,700 Collateral pledged, at par (carrying value $36,058,067) 36,085,816 Borrowing capacity currently available 310,732 Subordinated Debentures Donegal Mutual holds a $5.0 million surplus note that MICO issued to increase MICO’s statutory surplus. The surplus note carries an interest rate of 5.00%, and any repayment of principal or payment of interest on the surplus note requires prior approval of the Michigan Department of Insurance and Financial Services. 8 - Share–Based Compensation We measure all share-based payments to employees, including grants of stock options, and use a fair-value-based method for the recording of related compensation expense in our consolidated statements of income. In determining the expense we record for stock options granted to directors and employees of our subsidiaries and affiliates, we estimate the fair value of each option award on the date of grant using the Black-Scholes option pricing model. The significant assumptions we utilize in applying the Black-Scholes option pricing model are the risk-free interest rate, the expected term, the dividend yield and the expected volatility. We charged compensation expense related to our stock compensation plans against income before income taxes of $414,696 and $598,516 for the three months ended September 30, 2016 and 2015, respectively, with a corresponding income tax benefit of $145,143 and $209,481, respectively. We charged compensation expense related to our stock compensation plans against income before income taxes of $2.0 million and $1.9 million for the nine months ended September 30, 2016 and 2015, respectively, with a corresponding income tax benefit of $710,584 and $671,607, respectively. At September 30, 2016, we had $2.0 million of unrecognized compensation expense related to nonvested share-based compensation granted under our stock compensation plans. We expect to recognize this compensation expense over a weighted average period of approximately 1.3 years. We received cash from option exercises under all stock compensation plans during the three months ended September 30, 2016 and 2015 of $3.7 million and $181,488, respectively. We received cash from option exercises under all stock compensation plans during the nine months ended September 30, 2016 and 2015 of $7.8 million and $13.7 million, respectively. We realized actual tax benefits for the tax deductions related to option exercises of $243,656 and $4,802 for the three months ended September 30, 2016 and 2015, respectively. We realized actual tax benefits for the tax deductions related to option exercises of $521,852 and $424,537 for the nine months ended September 30, 2016 and 2015, respectively. 9 - Fair Value Measurements We account for financial assets using a framework that establishes a hierarchy that ranks the quality and reliability of the inputs, or assumptions, we use in the determination of fair value, and we classify financial assets and liabilities carried at fair value in one of the following three categories: Level 1 – quoted prices in active markets for identical assets and liabilities; Level 2 – directly or indirectly observable inputs other than Level 1 quoted prices; and Level 3 – unobservable inputs not corroborated by market data. For investments that have quoted market prices in active markets, we use the quoted market price as fair value and include these investments in Level 1 of the fair value hierarchy. We classify publicly-traded equity securities as Level 1. When quoted market prices in active markets are not available, we base fair values on quoted market prices of comparable instruments or price estimates we obtain from independent pricing services and include these investments in Level 2 of the fair value hierarchy. We classify our fixed maturity investments as Level 2. Our fixed maturity investments consist of U.S. Treasury 16 securities and obligations of U.S. government corporations and agencies, obligations of states and political subdivisions, corporate securities and mortgage-backed securities. We present our investments in available-for-sale fixed maturity and equity securities at estimated fair value. The estimated fair value of a security may differ from the amount that could be realized if we sold the security in a forced transaction. In addition, the valuation of fixed maturity investments is more subjective when markets are less liquid, increasing the potential that the estimated fair value does not reflect the price at which an actual transaction would occur. We utilize nationally recognized independent pricing services to estimate fair values or obtain market quotations for substantially all of our fixed maturity and equity investments. These pricing services utilize market quotations for fixed maturity and equity securities that have quoted prices in active markets. For fixed maturity securities that generally do not trade on a daily basis, the pricing services prepare estimates of fair value measurements based predominantly on observable market inputs. The pricing services do not use broker quotes in determining the fair values of our investments. Our investment personnel review the estimates of fair value the pricing services provide to determine if the estimates we obtain from the pricing services are representative of fair values based upon our investment personnel’s general knowledge of the market, their research findings related to unusual fluctuations in value and their comparison of such values to execution prices for similar securities. Our investment personnel regularly monitor the market, current trading ranges for similar securities and the pricing of specific investments. Our investment personnel review all pricing estimates that we receive from the pricing services against their expectations with respect to pricing based on fair market curves, security ratings, coupon rates, security type and recent trading activity. Our investment personnel review documentation with respect to the pricing services’ pricing methodology that they obtain periodically to determine if the primary pricing sources, market inputs and pricing frequency for various security types are reasonable. At September 30, 2016, we received two estimates per security from the pricing services, and we priced substantially all of our Level 1 and Level 2 investments using those prices. In our review of the estimates the pricing services provided at September 30, 2016, we did not identify any material discrepancies, and we did not make any adjustments to the estimates the pricing services provided. We present our cash and short-term investments at estimated fair value. We classify these items as Level 1. The carrying values we report in our balance sheet for premium receivables and reinsurance receivables and payables for premiums and paid losses and loss expenses approximate their fair values. The carrying amounts we report in our balance sheet for our subordinated debentures and borrowings under lines of credit approximate their fair values. We classify these items as Level 3. We evaluate our assets and liabilities on a recurring basis to determine the appropriate level at which to classify them for each reporting period. The following table presents our fair value measurements for our investments in available-for-sale fixed maturity and equity securities at September 30, 2016: Fair Value Measurements Using Fair Value Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) (in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 36,375 $ — $ 36,375 $ — Obligations of states and political subdivisions 194,276 — 194,276 — Corporate securities 90,841 — 90,841 — Mortgage-backed securities 194,329 — 194,329 — Equity securities 35,167 35,167 — — Total investments in the fair value hierarchy 550,988 35,167 515,821 — Investment measured at net asset value 11,145 — — — Totals $ 562,133 $ 35,167 $ 515,821 $ — We did not transfer any investments between Levels 1 and 2 during the nine months ended September 30, 2016. 17 The following table presents our fair value measurements for our investments in available-for-sale fixed maturity and equity securities at December 31, 2015: Fair Value Measurements Using Fair Value Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) (in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 37,189 $ — $ 37,189 $ — Obligations of states and political subdivisions 236,556 — 236,556 — Corporate securities 72,812 — 72,812 — Mortgage-backed securities 154,836 — 154,836 — Equity securities 26,727 26,727 — — Total investments in the fair value hierarchy 528,120 26,727 501,393 — Investment measured at net asset value 10,534 — — — Totals $ 538,654 $ 26,727 $ 501,393 $ — 10 - Income Taxes At September 30, 2016 and December 31, 2015, respectively, we had no material unrecognized tax benefits or accrued interest and penalties. Tax years 2013 through 2016 remained open for examination at September 30, 2016. We provide a valuation allowance when we believe it is more likely than not that we will not realize some portion of our tax assets. We established a valuation allowance of $440,778 related to a portion of the net operating loss carryforward of Le Mars at January 1, 2004. We have determined that we are not required to establish a valuation allowance for our other deferred tax assets of $43.4 million and $42.7 million at September 30, 2016 and December 31, 2015, respectively, because it is more likely than not that we will realize these deferred tax assets through reversals of existing temporary differences, future taxable income and the implementation of tax planning strategies. Our deferred tax assets include a net operating loss carryforward of $3.6 million related to Le Mars, which will begin to expire in 2020 if not previously utilized. This carryforward is subject to an annual limitation in the amount that we can use in any one year of approximately $376,000. Our deferred tax assets also include an alternative minimum tax credit carryforward of $7.6 million with an indefinite life. 11 - Impact of New Accounting Standards In May 2014, the Financial Accounting Standards Board (the “FASB”) issued guidance that requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. While the guidance will replace most existing GAAP revenue recognition guidance, the scope of the guidance excludes insurance contracts. The new standard is effective on January 1, 2018. The standard permits the use of either the retrospective or the cumulative effect transition method. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In February 2015, the FASB issued a new standard that amends the current consolidation guidance affecting both the variable interest entity (“VIE”) and voting interest entity (“VOE”) consolidation models. The standard does not add or remove any of the characteristics in determining if an entity is a VIE or a VOE, but rather, the standard enhances assessment of some of these characteristics. The new standard was effective on December 15, 2015. The adoption of this new guidance did not have a significant impact on our financial position, results of operations or cash flows. In May 2015, the FASB issued guidance that removes the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value per share practical expedient. The guidance also removes the requirement to make certain disclosures for all investments that are eligible to be measured at fair value using the net asset value per share practical expedient. The guidance instead limits disclosure to investments for which the entity has elected to measure fair value using that practical expedient. The guidance was effective for annual reporting periods beginning after December 15, 2015, and interim reporting periods within those annual reporting periods. The adoption of this new guidance did not have a significant impact on our financial position, results of operations or cash flows. 18 In May 2015, the FASB issued guidance that requires entities to provide additional disclosures about their liability for unpaid claims and claim adjustment expenses to increase the transparency of significant estimates. The guidance also requires entities to disclose information about significant changes in methodologies and assumptions used to calculate the liability for unpaid claims and claim adjustment expenses, including the reasons for the changes and the effects on the entities’ financial statements, and the timing, frequency and severity of claims. The guidance also requires entities to disclose a rollforward of the liability for unpaid claims and claim adjustment expenses for annual and interim reporting periods. The guidance is effective for annual reporting periods beginning after December 15, 2015, and interim reporting periods within annual reporting periods beginning after December 15, 2016. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In January 2016, the FASB issued guidance that generally requires entities to measure equity investments at fair value and recognize changes in fair value in their results of operations. The guidance also simplifies the impairment assessment of equity investments without readily determinable fair values by requiring entities to perform a qualitative assessment to identify impairment. The FASB issued other disclosure and presentation improvements related to financial instruments within the guidance. The guidance is effective for annual and interim reporting periods beginning after December 15, 2017. As a result of this guidance, we will reflect changes in the fair value of our equity investments in our results of operations beginning January 1, 2018. In February 2016, the FASB issued guidance that requires lessees to recognize leases, including operating leases, on the lessee’s balance sheet, unless a lease is considered a short-term lease. The guidance also requires entities to make new judgments to identify leases. The guidance is effective for annual and interim reporting periods beginning after December 15, 2018 and permits early adoption. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In March 2016, the FASB issued guidance that simplifies and improves several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities and classification on the statement of cash flows. The guidance is effective for annual and interim reporting periods beginning after December 15, 2016. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In June 2016, the FASB issued guidance that amends previous guidance on the impairment of financial instruments by adding an impairment model that allows an entity to recognize expected credit losses as an allowance rather than impairments as credit losses are incurred. The new guidance is intended to reduce complexity and result in a more timely recognition of expected credit losses. The guidance is effective for annual and interim reporting periods beginning after December 15, 2019. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In August 2016, the FASB issued guidance that clarifies how certain cash receipts and cash payments shall be presented and classified in the statement of cash flows. This guidance addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. The guidance is effective for annual and interim reporting periods beginning after December 15, 2017. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. 19\\nWe recommend that you read the following information in conjunction with the historical financial information and the footnotes to that financial information we include in this Quarterly Report on Form 10-Q. We also recommend you read Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2015.\\nCritical Accounting Policies and Estimates\\nWe combine our financial statements with those of our insurance subsidiaries and present our financial statements on a consolidated basis in accordance with GAAP.\\nOur insurance subsidiaries make estimates and assumptions that can have a significant effect on amounts and disclosures we report in our financial statements. The most significant estimates relate to the reserves of our insurance subsidiaries for property and casualty insurance unpaid losses and loss expenses, the valuation of investments and the determination of other-than-temporary investment impairments and the policy acquisition costs of our insurance subsidiaries. While we believe our estimates and the estimates of our insurance subsidiaries are appropriate, the ultimate amounts of these liabilities may differ from the estimates we provided. We regularly review our methods for making these estimates and we reflect any adjustment we consider necessary in our current consolidated results of operations.\\nLiability for Unpaid Losses and Loss Expenses\\nLiabilities for losses and loss expenses are estimates at a given point in time of the amounts an insurer expects to pay with respect to incurred policyholder claims based on facts and circumstances the insurer knows at that point in time. At the time of establishing its estimates, an insurer recognizes that its ultimate liability for losses and loss expenses will exceed or be less than such estimates. Our insurance subsidiaries base their estimates of liabilities for losses and loss expenses on assumptions as to future loss trends, expected claims severity, judicial theories of liability and other factors. However, during the loss adjustment period, our insurance subsidiaries may learn additional facts regarding individual claims, and, consequently, it often becomes necessary for our insurance subsidiaries to refine and adjust their estimates for these liabilities. We reflect any adjustments to our insurance subsidiaries’ liabilities for losses and loss expenses in our consolidated results of operations in the period in which our insurance subsidiaries make the changes in estimates.\\nOur insurance subsidiaries maintain liabilities for the payment of losses and loss expenses with respect to both reported and unreported claims. Our insurance subsidiaries establish these liabilities for the purpose of covering the ultimate costs of settling all losses, including investigation and litigation costs. Our insurance subsidiaries base the amount of their liability for reported losses primarily upon a case-by-case evaluation of the type of risk involved, knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss the policyholder incurred. Our insurance subsidiaries determine the amount of their liability for unreported claims and loss expenses on the basis of historical information by line of insurance. Our insurance subsidiaries account for inflation in the reserving function through analysis of costs and trends and reviews of historical reserving results. Our insurance subsidiaries monitor their liabilities closely and recompute them periodically using new information on reported claims and a variety of statistical techniques. Our insurance subsidiaries do not discount their liabilities for losses and loss expenses.\\nReserve estimates can change over time because of unexpected changes in assumptions related to our insurance subsidiaries’ external environment and, to a lesser extent, assumptions related to our insurance subsidiaries’ internal operations. For example, our insurance subsidiaries have experienced a decrease in claims frequency on workers’ compensation claims during the past several years while the severity of these claims has gradually increased. These trend changes give rise to greater uncertainty as to the pattern of future loss settlements on workers’ compensation claims. Related uncertainties regarding future trends include the cost of medical technologies and procedures and changes in the utilization of medical procedures. Assumptions related to our insurance subsidiaries’ external environment include the absence of significant changes in tort law and the legal environment that increase liability exposure, consistency in judicial interpretations of insurance coverage and policy provisions and the rate of loss cost inflation. Internal assumptions include consistency in the recording of premium and loss statistics, consistency in the recording of claims, payment and case reserving methodology, accurate measurement of the impact of rate changes and changes in policy provisions, consistency in the quality and characteristics of business written within a given line of business and consistency in reinsurance coverage and collectability of reinsured losses, among other items. To the extent our insurance subsidiaries determine that underlying factors impacting their assumptions have changed, our insurance subsidiaries make adjustments in their reserves that they consider appropriate for such changes. Accordingly, our insurance subsidiaries’ ultimate liability for unpaid losses and loss expenses will likely differ\\n20\\nfrom the amount recorded at September 30, 2016. For every 1% change in our insurance subsidiaries’ estimate for loss and loss expense reserves, net of reinsurance recoverable, the effect on our pre-tax results of operations would be approximately $3.4 million. The establishment of appropriate liabilities is an inherently uncertain process and we can provide no assurance that our insurance subsidiaries’ ultimate liability will not exceed our insurance subsidiaries’ loss and loss expense reserves and have an adverse effect on our results of operations and financial condition. Furthermore, we cannot predict the timing, frequency and extent of adjustments to our insurance subsidiaries’ estimated future liabilities, because the historical conditions and events that serve as a basis for our insurance subsidiaries’ estimates of ultimate claim costs may change. As is the case for substantially all property and casualty insurance companies, our insurance subsidiaries have found it necessary in the past to increase their estimated future liabilities for losses and loss expenses in certain periods and, in other periods, their estimates of future liabilities have exceeded their actual liabilities. Changes in our insurance subsidiaries’ estimates of their liability for losses and loss expenses generally reflect actual payments and their evaluation of information received since the prior reporting date. Excluding the impact of severe weather events, our insurance subsidiaries have noted stable amounts in the number of claims incurred and a slight downward trend in the number of claims outstanding at period ends relative to their premium base in recent years across most of their lines of business. However, the amount of the average claim outstanding has increased gradually over the past several years as the United States property and casualty insurance industry has experienced increased litigation trends and economic conditions that have extended the estimated length of disabilities and contributed to increased medical loss costs. We have also experienced a general slowing of settlement rates in litigated claims. Our insurance subsidiaries could have to make further adjustments to their estimates in the future. However, on the basis of our insurance subsidiaries’ internal procedures, which analyze, among other things, their prior assumptions, their experience with similar cases and historical trends such as reserving patterns, loss payments, pending levels of unpaid claims and product mix, as well as court decisions, economic conditions and public attitudes, we believe that our insurance subsidiaries have made adequate provision for their liability for losses and loss expenses. Atlantic States’ participation in the pool with Donegal Mutual exposes Atlantic States to adverse loss development on the business of Donegal Mutual that the pool includes. However, pooled business represents the predominant percentage of the net underwriting activity of both companies, and Donegal Mutual and Atlantic States share proportionately any adverse risk development of the pooled business. The business in the pool is homogeneous and each company has a pro-rata share of the entire pool. Since substantially all of the business of Atlantic States and Donegal Mutual is pooled and the results shared by each company according to its participation level under the terms of the pooling agreement, the intent of the underwriting pool is to produce a more uniform and stable underwriting result from year to year for each company than either would experience individually and to spread the risk of loss between the companies. 21 Donegal Mutual and our insurance subsidiaries operate together as the Donegal Insurance Group and share a combined business plan designed to achieve market penetration and underwriting profitability objectives. The products our insurance subsidiaries and Donegal Mutual offer are generally complementary, thereby allowing Donegal Insurance Group to offer a broader range of products to a given market and to expand Donegal Insurance Group’s ability to service an entire personal lines or commercial lines account. Distinctions within the products of Donegal Mutual and our insurance subsidiaries generally relate to specific risk profiles targeted within similar classes of business, such as preferred tier products compared to standard tier products, but we do not allocate all of the standard risk gradients to one company. Therefore, the underwriting profitability of the business the individual companies write directly will vary. However, because the pool homogenizes the risk characteristics of all business Donegal Mutual and Atlantic States write directly and each company shares the results according to each company’s participation percentage, each company realizes its percentage share of the underwriting results of the pool. Our insurance subsidiaries’ unpaid liability for losses and loss expenses by major line of business at September 30, 2016 and December 31, 2015 consisted of the following: September 30, 2016 December 31, 2015 (in thousands) Commercial lines: Automobile $ 55,079 $ 53,938 Workers’ compensation 105,873 99,212 Commercial multi-peril 59,279 54,395 Other 3,639 3,119 Total commercial lines 223,870 210,664 Personal lines: Automobile 97,102 93,923 Homeowners 16,947 15,816 Other 2,122 1,651 Total personal lines 116,171 111,390 Total commercial and personal lines 340,041 322,054 Plus reinsurance recoverable 254,227 256,151 Total liability for unpaid losses and loss expenses $ 594,268 $ 578,205 We have evaluated the effect on our insurance subsidiaries’ unpaid loss and loss expense reserves and our stockholders’ equity in the event of reasonably likely changes in the variables we consider in establishing the loss and loss expense reserves of our insurance subsidiaries. We established the range of reasonably likely changes based on a review of changes in accident-year development by line of business and applied those changes to our insurance subsidiaries’ loss reserves as a whole. The selected range does not necessarily indicate what could be the potential best or worst case or the most likely scenario. The following table sets forth the estimated effect on our insurance subsidiaries’ unpaid loss and loss expense reserves and our stockholders’ equity in the event of reasonably likely changes in the variables we considered in establishing the loss and loss expense reserves of our insurance subsidiaries: Percentage Change in Loss and Loss Expense Reserves Net of Reinsurance Adjusted Loss and Loss Expense Reserves Net of Reinsurance at September 30, 2016 Percentage Change in Stockholders’ Equity at September 30, 2016(1) Adjusted Loss and Loss Expense Reserves Net of Reinsurance at December 31, 2015 Percentage Change in Stockholders’ Equity at December 31, 2015(1) (dollars in thousands) (10.0)% $ 306,037 5.0 % $ 289,849 5.1 % (7.5) 314,538 3.7 297,900 3.8 (5.0) 323,039 2.5 305,951 2.6 (2.5) 331,540 1.2 314,003 1.3 Base 340,041 — 322,054 — 2.5 348,542 (1.2 ) 330,105 (1.3 ) 5.0 357,043 (2.5 ) 338,157 (2.6 ) 7.5 365,544 (3.7 ) 346,208 (3.8 ) 10.0 374,045 (5.0 ) 354,259 (5.1 ) (1) Net of income tax effect. 22 Statutory Combined Ratios We evaluate our insurance operations by monitoring certain key measures of growth and profitability. In addition to using GAAP-based performance measurements, we also utilize certain non-GAAP financial measures that we believe are valuable in managing our business and for comparison to our peers. These non-GAAP measures are underwriting income, combined ratio and net premiums written. An insurance company’s statutory combined ratio is a standard measure of underwriting profitability. This ratio is the sum of the ratio of calendar-year incurred losses and loss expenses to premiums earned; the ratio of expenses incurred for commissions, premium taxes and underwriting expenses to net premiums written and the ratio of dividends to policyholders to premiums earned. The combined ratio does not reflect investment income, federal income taxes or other non-operating income or expense. A combined ratio of less than 100 percent generally indicates underwriting profitability. The statutory combined ratio differs from the GAAP combined ratio. In calculating the GAAP combined ratio, we do not deduct installment payment fees from incurred expenses, and we base the expense ratio on premiums earned instead of premiums written. Differences between our GAAP loss ratios reported in our financial statements and our insurance subsidiaries’ statutory loss ratios result from anticipating salvage and subrogation recoveries for the GAAP loss ratios but not for the statutory loss ratios. The following table sets forth our insurance subsidiaries’ statutory combined ratios by major line of business for the three and nine months ended September 30, 2016 and 2015: Three Months Ended September 30, Nine Months Ended September 30, 2016 2015 2016 2015 Commercial lines: Automobile 110.8 % 118.0 % 106.5 % 106.1 % Workers’ compensation 86.8 79.1 85.3 89.0 Commercial multi-peril 94.7 92.2 88.5 93.2 Total commercial lines 94.3 92.0 90.3 93.2 Personal lines: Automobile 105.9 98.8 102.6 100.0 Homeowners 101.5 108.0 97.1 101.7 Total personal lines 103.6 101.4 99.9 99.8 Total commercial and personal lines 99.5 97.4 95.6 96.9 Investments We make estimates concerning the valuation of our investments and the recognition of other-than-temporary declines in the value of our investments. For equity securities, we write down an individual investment to its fair value and we reflect the amount of the write-down as a realized loss in our results of operations when we consider the decline in value of the individual investment to be other than temporary. We individually monitor all investments for other-than-temporary declines in value. Generally, we assume there has been an other-than-temporary decline in value if an individual equity security has depreciated in value by more than 20% of our original cost and has been in such an unrealized loss position for more than six months. We held seven equity securities that were in an unrealized loss position at September 30, 2016. Based upon our analysis of general market conditions and underlying factors impacting these equity securities, we considered these declines in value to be temporary. With respect to a debt security that is in an unrealized loss position, we first assess if we intend to sell the debt security. If we determine we intend to sell the debt security, we recognize the impairment loss in our results of operations. If we do not intend to sell the debt security, we determine whether it is more likely than not that we will be required to sell the debt security prior to recovery. If we determine it is more likely than not that we will be required to sell the debt security prior to recovery, we recognize an impairment loss in our results of operations. If we determine it is more likely than not that we will not be required to sell the debt security prior to recovery, we then evaluate whether a credit loss has occurred. We determine whether a credit loss has occurred by comparing the amortized cost of the debt security to the present value of the cash flows we expect to collect on the debt security. If we expect a cash flow shortfall, we consider that a credit loss has occurred. If we determine that a credit loss has occurred, we consider the impairment to be other than temporary. We then recognize the amount of the impairment loss related to the credit loss in our results of operations, and we recognize the remaining portion of the impairment loss in our other comprehensive income, net of applicable taxes. In addition, we may write down securities in an unrealized loss position based on a number of other factors, including when the fair value of an investment is significantly below its cost, when the financial condition of the issuer of a security has deteriorated, the occurrence of industry, company or geographic events that have negatively impacted the value of a security or rating agency 23 downgrades. We held 55 debt securities that were in an unrealized loss position at September 30, 2016. Based upon our analysis of general market conditions and underlying factors impacting these debt securities, we considered these declines in value to be temporary. We did not recognize any impairment losses in our results of operations for the first nine months of 2016 or 2015. We present our investments in available-for-sale fixed maturity and equity securities at estimated fair value. The estimated fair value of a security may differ from the amount we could realize if we sold the security in a forced transaction. In addition, the valuation of fixed maturity investments is more subjective when markets are less liquid, increasing the potential that the estimated fair value does not reflect the price at which an actual transaction would occur. We utilize nationally recognized independent pricing services to estimate fair values or obtain market quotations for substantially all of our fixed maturity and equity investments. The pricing services utilize market quotations for fixed maturity and equity securities that have quoted prices in active markets. For fixed maturity securities that generally do not trade on a daily basis, the pricing services prepare estimates of fair value measurements based predominantly on observable market inputs. The pricing services do not use broker quotes in determining the fair values of our investments. Our investment personnel review the estimates of fair value the pricing services provide to determine if the estimates we obtain from the pricing services are representative of fair values based upon the general market knowledge of our investment personnel, their research findings related to unusual fluctuations in value and their comparison of such values to execution prices for similar securities. Our investment personnel monitor the market and are familiar with current trading ranges for similar securities and pricing of specific investments. Our investment personnel review all pricing estimates that we receive from the pricing services against their expectations with respect to pricing based on fair market curves, security ratings, coupon rates, security type and recent trading activity. Our investment personnel review documentation with respect to the pricing services’ pricing methodology that they obtain periodically to determine if the primary pricing sources, market inputs and pricing frequency for various security types are reasonable. At September 30, 2016, we received two estimates per security from the pricing services, and we priced substantially all of our Level 1 and Level 2 investments using those prices. In our review of the estimates the pricing services provided at September 30, 2016, we did not identify any material discrepancies, and we did not make any adjustments to the estimates the pricing services provided. Policy Acquisition Costs Our insurance subsidiaries defer their policy acquisition costs, consisting primarily of commissions, premium taxes and certain other underwriting costs that relate directly to the successful acquisition of insurance policies. We amortize these costs over the period in which our insurance subsidiaries earn the related premiums. The method we follow in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. This method gives effect to the premiums to be earned, related investment income, losses and loss expenses and certain other costs we expect to incur as our insurance subsidiaries earn the premiums. Results of Operations - Three Months Ended September 30, 2016 Compared to Three Months Ended September 30, 2015 Net Premiums Written. Our insurance subsidiaries’ net premiums written for the three months ended September 30, 2016 were $171.9 million, an increase of $13.0 million, or 8.2%, from the $158.9 million of net premiums written for the third quarter of 2015. We attribute the increase to the impact of premium rate increases and an increase in the writing of commercial lines of business. Personal lines net premiums written increased $5.2 million, or 5.6%, for the third quarter of 2016 compared to the third quarter of 2015. The increase was attributable primarily to premium rate increases our insurance subsidiaries implemented throughout 2015 and 2016. Commercial lines net premiums written increased $7.8 million, or 12.0%, for the third quarter of 2016 compared to the third quarter of 2015. The increase was primarily attributable to premium rate increases and increased writings of new commercial accounts. Net Premiums Earned. Our insurance subsidiaries’ net premiums earned for the third quarter of 2016 were $166.8 million, an increase of $13.7 million, or 9.0%, compared to $153.1 million for the third quarter of 2015, reflecting increases in net premiums written during 2016 and 2015. Our insurance subsidiaries earn premiums and recognize them as revenue over the terms of their policies, which are one year or less in duration. Therefore, increases or decreases in net premiums earned generally reflect increases or decreases in net premiums written in the preceding 12-month period compared to the comparable period one year earlier. Investment Income. Our net investment income increased to $5.6 million for the third quarter of 2016, compared to $5.4 million for the third quarter of 2015. We attribute the increase primarily to an increase in average invested assets. 24 Net Realized Investment Gains (Losses). Net realized investment gains for the third quarter of 2016 were $1.0 million, compared to net realized investment losses of $754,050 for the third quarter of 2015. The net realized investment gains for the third quarter of 2016 resulted primarily from unrealized gains within a limited partnership that invests in equity securities. The net realized investment losses for the third quarter of 2015 resulted primarily from unrealized losses within the limited partnership. We did not recognize any impairment losses in our investment portfolio during the third quarters of 2016 or 2015. Equity in Earnings of DFSC. Our equity in the earnings of DFSC was $357,956 for the third quarter of 2016, compared to $408,405 for the third quarter of 2015. Losses and Loss Expenses. Our insurance subsidiaries’ loss ratio, which is the ratio of incurred losses and loss expenses to premiums earned, for the third quarter of 2016 was 66.6%, a slight decrease from our insurance subsidiaries’ loss ratio of 66.8% for the third quarter of 2015. On a statutory basis, our insurance subsidiaries’ commercial lines loss ratio was 62.5% for the third quarter of 2016, compared to 62.3% for the third quarter of 2015, primarily due to an increase in the workers’ compensation loss ratio. The personal lines statutory loss ratio of our insurance subsidiaries increased to 70.4% for the third quarter of 2016, compared to 69.9% for the third quarter of 2015, primarily due to an increase in the personal automobile loss ratio. Our insurance subsidiaries experienced favorable loss reserve development of approximately $1.6 million during the third quarter of 2016 in their reserves for prior accident years, compared to unfavorable loss reserve development of approximately $1.5 million during the third quarter of 2015. The improvement in loss reserve development patterns occurred primarily within our insurance subsidiaries’ commercial multi-peril and personal automobile reserves. Underwriting Expenses. The expense ratio for an insurance company is the ratio of policy acquisition costs and other underwriting expenses to premiums earned. The expense ratio of our insurance subsidiaries was 33.5% for the third quarter of 2016, compared to 32.1% for the third quarter of 2015. We attribute the 2016 increase primarily to higher underwriting incentive costs in the third quarter of 2016 compared to the third quarter of 2015. Combined Ratio. The combined ratio represents the sum of the loss ratio, the expense ratio and the dividend ratio, which is the ratio of policyholder dividends incurred to premiums earned. Our insurance subsidiaries’ combined ratios were 100.8% and 99.5% for the three months ended September 30, 2016 and 2015, respectively. Interest Expense. Our interest expense for the third quarter of 2016 was $473,917, compared to $188,000 for the third quarter of 2015. We attribute the increase to higher average borrowings during the third quarter of 2016 compared to the third quarter of 2015. Income Taxes. Income tax expense was $1.6 million for the third quarter of 2016, representing an effective tax rate of 25.1%, compared to income tax expense of $1.3 million for the third quarter of 2015, representing an effective tax rate of 18.8% . The effective tax rate in both periods represented an estimate based on our projected annual taxable income. The increase in the effective tax rate reflects our expectation that tax-exempt interest income will represent a lesser proportion of our 2016 taxable income compared to 2015. Net Income and Earnings Per Share. Our net income for the third quarter of 2016 was $4.8 million, or $.18 per share of Class A common stock on a diluted basis and $.16 per share of Class B common stock, compared to net income of $5.7 million, or $.21 per share of Class A common stock and $.18 per share of Class B common stock, for the third quarter of 2015. We had 21.2 million and 22.4 million Class A shares outstanding at September 30, 2016 and 2015, respectively. We had 5.6 million Class B shares outstanding at the end of both periods. Results of Operations - Nine Months Ended September 30, 2016 Compared to Nine Months Ended September 30, 2015 Net Premiums Written. Our insurance subsidiaries’ net premiums written for the nine months ended September 30, 2016 were $520.3 million, an increase of $39.2 million, or 8.1%, from the $481.1 million of net premiums written for the comparable period of 2015. We attribute the increase to the impact of premium rate increases and an increase in the writing of commercial lines of business. Personal lines net premiums written increased $13.4 million, or 5.0%, for the first nine months of 2016 compared to the first nine months of 2015. The increase was attributable primarily to premium rate increases our insurance subsidiaries implemented throughout 2015 and 2016. Commercial lines net premiums written increased $25.8 million, or 12.1%, for the first nine months of 2016 compared to the first nine months of 2015. The increase was primarily attributable to premium rate increases and increased writings of new commercial accounts. Net Premiums Earned. Our insurance subsidiaries’ net premiums earned for the first nine months of 2016 were $487.2 million, an increase of $37.1 million, or 8.3%, compared to $450.1 million for the first nine months of 2015, reflecting increases in net premiums written during 2016 and 2015. Our insurance subsidiaries earn premiums and recognize them as 25 revenue over the terms of their policies, which are one year or less in duration. Therefore, increases or decreases in net premiums earned generally reflect increases or decreases in net premiums written in the preceding 12-month period compared to the comparable period one year earlier. Investment Income. Our net investment income increased to $16.5 million for the first nine months of 2016, compared to $15.5 million for the first nine months of 2015. We attribute the increase primarily to an increase in average invested assets. Net Realized Investment Gains. Net realized investment gains for the first nine months of 2016 were $2.2 million, compared to $682,932 for the first nine months of 2015. The net realized investment gains for the first nine months of 2016 and 2015 resulted primarily from calls and strategic sales of fixed maturities and equity securities within our investment portfolio. We did not recognize any impairment losses in our investment portfolio during the first nine months of 2016 or 2015. Equity in Earnings of DFSC. Our equity in the earnings of DFSC was $698,658 for the first nine months of 2016, compared to $1.3 million for the first nine months of 2015. Losses and Loss Expenses. Our insurance subsidiaries’ loss ratio, which is the ratio of incurred losses and loss expenses to premiums earned, for the first nine months of 2016 was 63.6%, a decrease from our insurance subsidiaries’ loss ratio of 65.8% for the first nine months of 2015. On a statutory basis, our insurance subsidiaries’ commercial lines loss ratio was 59.4% for the first nine months of 2016, compared to 62.7% for the first nine months of 2015, primarily due to decreases in the commercial multi-peril and workers’ compensation loss ratios. The personal lines statutory loss ratio of our insurance subsidiaries decreased to 67.2% for the first nine months of 2016, compared to 68.1% for the first nine months of 2015, primarily due to a decrease in the homeowners loss ratio. Our insurance subsidiaries experienced unfavorable loss reserve development of approximately $2.1 million during the first nine months of 2016 in their reserves for prior accident years, compared to approximately $4.8 million during the first nine months of 2015. The improvement in loss reserve development patterns occurred primarily within our insurance subsidiaries’ workers’ compensation reserves. Underwriting Expenses. The expense ratio for an insurance company is the ratio of policy acquisition costs and other underwriting expenses to premiums earned. The expense ratio of our insurance subsidiaries was 33.2% for the first nine months of 2016, compared to 32.7% for the first nine months of 2015. We attribute the 2016 increase primarily to higher underwriting incentive costs related to the lower loss ratio in the first nine months of 2016 compared to the first nine months of 2015. Combined Ratio. The combined ratio represents the sum of the loss ratio, the expense ratio and the dividend ratio, which is the ratio of policyholder dividends incurred to premiums earned. Our insurance subsidiaries’ combined ratios were 97.3% and 99.0% for the nine months ended September 30, 2016 and 2015, respectively. Interest Expense. Our interest expense for the first nine months of 2016 was $1.3 million, compared to $908,615 for the first nine months of 2015. We attribute the increase to higher average borrowings during the first nine months of 2016 compared to the first nine months of 2015. Income Taxes. Income tax expense was $9.2 million for the first nine months of 2016, representing an effective tax rate of 26.8%, compared to income tax expense of $5.4 million for the first nine months of 2015, representing an effective tax rate of 22.1% . The effective tax rate in both periods represented an estimate based on our projected annual taxable income. The increase in the effective tax rate reflects our expectation that tax-exempt interest income will represent a lesser proportion of our 2016 taxable income compared to 2015. Net Income and Earnings Per Share. Our net income for the first nine months of 2016 was $25.2 million, or $.95 per share of Class A common stock on a diluted basis and $.88 per share of Class B common stock, compared to net income of $19.0 million, or $.69 per share of Class A common stock on a diluted basis and $.63 per share of Class B common stock, for the first nine months of 2015. We had 21.2 million and 22.4 million Class A shares outstanding at September 30, 2016 and 2015, respectively. We had 5.6 million Class B shares outstanding at the end of both periods. Liquidity and Capital Resources Liquidity is a measure of an entity’s ability to secure enough cash to meet its contractual obligations and operating needs as such obligations and needs arise. Our major sources of funds from operations are the net cash flows we generate from our insurance subsidiaries’ underwriting results, investment income and investment maturities. 26 Our operations have historically generated sufficient net positive cash flow to fund our commitments and add to our investment portfolio, thereby increasing future investment returns and enhancing our liquidity. The impact of the pooling agreement between Donegal Mutual and Atlantic States has historically been cash-flow positive because of the consistent underwriting profitability of the pool. Donegal Mutual and Atlantic States settle their respective obligations to each other under the pool monthly, thereby resulting in cash flows substantially similar to the cash flows that would result from each company writing the business directly. We have not experienced any unusual variations in the timing of claim payments associated with the loss reserves of our insurance subsidiaries. We maintain significant liquidity in our investment portfolio in the form of readily marketable fixed maturities, equity securities and short-term investments. We structure our fixed-maturity investment portfolio following a “laddering” approach, so that projected cash flows from investment income and principal maturities are evenly distributed from a timing perspective, thereby providing an additional measure of liquidity to meet our obligations should an unexpected variation occur in the future. Our operating activities provided net cash flows in the first nine months of 2016 and 2015 of $46.3 million and $48.5 million, respectively. At September 30, 2016, we had $39.0 million in outstanding borrowings under our line of credit with M&T and had the ability to borrow an additional $21.0 million at interest rates equal to M&T’s current prime rate or the then current LIBOR rate plus 2.25%. The interest rate on these borrowings was 2.78% at September 30, 2016. At September 30, 2016, Atlantic States had $35.0 million in outstanding advances with the FHLB of Pittsburgh. The interest rate on these advances was .59% at September 30, 2016. The following table shows our expected payments for significant contractual obligations at September 30, 2016: Total Less than 1 year 1-3 years 4-5 years After 5 years (in thousands) Net liability for unpaid losses and loss expenses of our insurance subsidiaries $ 340,041 $ 158,779 $ 155,378 $ 12,372 $ 13,512 Subordinated debentures 5,000 — — — 5,000 Borrowings under lines of credit 74,000 35,000 39,000 — — Total contractual obligations $ 419,041 $ 193,779 $ 194,378 $ 12,372 $ 18,512 We estimate the date of payment for the net liability for unpaid losses and loss expenses of our insurance subsidiaries based on historical experience and expectations of future payment patterns. We show the liability net of reinsurance recoverable on unpaid losses and loss expenses to reflect expected future cash flows related to such liability. Amounts Atlantic States assumes pursuant to the pooling agreement with Donegal Mutual represent a substantial portion of our insurance subsidiaries’ gross liability for unpaid losses and loss expenses, and amounts Atlantic States cedes pursuant to the pooling agreement represent a substantial portion of our insurance subsidiaries’ reinsurance recoverable on unpaid losses and loss expenses. We include cash settlement of Atlantic States’ assumed liability from the pool in monthly settlements of pooled activity, as we net amounts ceded to and assumed from the pool. Although Donegal Mutual and we do not anticipate any changes in the pool participation levels in the foreseeable future, any such change would be prospective in nature and therefore would not impact the timing of expected payments by Atlantic States for its percentage share of pooled losses occurring in periods prior to the effective date of such change. We discuss in Note 7 – Borrowings our estimate of the timing of the amounts for the borrowings under our lines of credit based on their contractual maturities. The borrowings under our lines of credit carry interest rates that vary as we discuss in Note 7 – Borrowings. Based upon the interest rates in effect at September 30, 2016, our annual interest cost associated with the borrowings under our lines of credit is approximately $1.3 million. For every 1% change in the interest rate associated with the borrowings under our lines of credit, the effect on our annual interest cost would be approximately $740,000. We discuss in Note 7 – Borrowings our estimate of the timing of the amounts for the subordinated debentures based on their contractual maturity. The subordinated debentures carry an interest rate of 5%, and any repayment of principal or payment of interest on the subordinated debentures requires prior approval of the Michigan Department of Insurance and Financial Services. Our annual interest cost associated with the subordinated debentures is approximately $250,000. On July 18, 2013, our board of directors authorized a share repurchase program pursuant to which we have the authority to purchase up to 500,000 additional shares of our Class A common stock at prices prevailing from time to time in the open market subject to the provisions of applicable rules of the SEC and in privately negotiated transactions. We did not purchase any shares of our Class A common stock under this program during the nine months ended September 30, 2016. We purchased 27 57,658 shares of our Class A common stock under this program during the nine months ended September 30, 2015. We have purchased a total of 57,658 shares of our Class A common stock under this program from its inception through September 30, 2016. On October 20, 2016, our board of directors declared quarterly cash dividends of 13.75 cents per share of our Class A common stock and 12.00 cents per share of our Class B common stock, payable on November 15, 2016 to our stockholders of record as of the close of business on November 1, 2016. We are not subject to any restrictions on our payment of dividends to our stockholders, although there are state law restrictions on the payment of dividends by our insurance subsidiaries to us. Dividends from our insurance subsidiaries are our principal source of cash for payment of dividends to our stockholders. Our insurance subsidiaries are subject to regulations that restrict the payment of dividends from statutory surplus and may require prior approval of their domiciliary insurance regulatory authorities. Our insurance subsidiaries are also subject to risk based capital (“RBC”) requirements that limit their ability to pay dividends to us. Our insurance subsidiaries’ statutory capital and surplus at December 31, 2015 exceeded the amount of statutory capital and surplus necessary to satisfy regulatory requirements, including the RBC requirements, by a significant margin. Our insurance subsidiaries paid $9.5 million in dividends to us during the first nine months of 2016. Amounts remaining available for distribution to us as dividends from our insurance subsidiaries without prior approval of their domiciliary insurance regulatory authorities in 2016 are $18.8 million from Atlantic States, $1.3 million from Southern, $1.1 million from Le Mars, $4.2 million from Peninsula, $325,412 from Sheboygan and $619,953 from MICO, or a total of approximately $26.3 million. At September 30, 2016, we had no material commitments for capital expenditures. Equity Price Risk Our portfolio of marketable equity securities, which we carry on our consolidated balance sheets at estimated fair value, has exposure to the risk of loss resulting from an adverse change in prices. We manage this risk by having our investment staff perform an analysis of prospective investments and regular reviews of our portfolio of equity securities. Credit Risk Our portfolio of fixed-maturity securities and, to a lesser extent, our portfolio of short-term investments is subject to credit risk, which we define as the potential loss in market value resulting from adverse changes in the borrower’s ability to repay its debt. We manage this risk by having our investment staff perform an analysis of prospective investments and regular reviews of our portfolio of fixed-maturity securities. We also limit the percentage and amount of our total investment portfolio that we invest in the securities of any one issuer. Our insurance subsidiaries provide property and casualty insurance coverages through independent insurance agencies. We bill the majority of this business directly to the insured, although we bill a portion of our commercial business through licensed insurance agents to whom our insurance subsidiaries extend credit in the normal course of business. Because the pooling agreement does not relieve Atlantic States of primary liability as the originating insurer, Atlantic States is subject to a concentration of credit risk arising from the business it cedes to Donegal Mutual. Our insurance subsidiaries maintain reinsurance agreements with Donegal Mutual and with a number of other major unaffiliated authorized reinsurers. Impact of Inflation We establish property and casualty insurance premium rates before we know the amount of unpaid losses and loss expenses or the extent to which inflation may impact such losses and expenses. Consequently, our insurance subsidiaries attempt, in establishing rates, to anticipate the potential impact of inflation.\\nOur market risk generally represents the risk of gain or loss that may result from the potential change in the fair value of the securities we hold in our investment portfolio as a result of fluctuations in prices and interest rates and, to a lesser extent, our debt obligations. We manage our interest rate risk by maintaining an appropriate relationship between the average duration of our investment portfolio and the approximate duration of our liabilities, i.e., policy claims of our insurance subsidiaries and our debt obligations.\\n28\\nThere have been no material changes to our quantitative or qualitative market risk exposure from December 31, 2015 through September 30, 2016.\\nEvaluation of Disclosure Controls and Procedures\\nOur management, with the participation of our Chief Executive Officer and our Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Based on such evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that, at September 30, 2016, our disclosure controls and procedures were effective in recording, processing, summarizing and reporting, on a timely basis, information we are required to disclose in the reports that we file or submit under the Exchange Act, and our disclosure controls and procedures were also effective to ensure that information we disclose in the reports we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, to allow timely decisions regarding required disclosure.\\nChanges in Internal Control Over Financial Reporting\\nThere has been no change in our internal control over financial reporting during the quarter covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to affect materially, our internal control over financial reporting.\\nSafe Harbor Statement Under the Private Securities Litigation Reform Act of 1995\\nWe base all statements contained in this Quarterly Report on Form 10-Q that are not historic facts on our current expectations. Such statements are forward-looking in nature (as defined in the Private Securities Litigation Reform Act of 1995) and necessarily involve risks and uncertainties. Forward-looking statements we make may be identified by our use of words such as “will,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “seeks,” “estimates” and similar expressions. Our actual results could vary materially from our forward-looking statements. The factors that could cause our actual results to vary materially from the forward-looking statements we have previously made include, but are not limited to, our ability to maintain profitable operations, the adequacy of the loss and loss expense reserves of our insurance subsidiaries, business and economic conditions in the areas in which we and our insurance subsidiaries operate, interest rates, competition from various insurance and other financial businesses, terrorism, the availability and cost of reinsurance, adverse and catastrophic weather events, legal and judicial developments, changes in regulatory requirements, our ability to integrate and manage successfully the companies we may acquire from time to time and the other risks that we describe from time to time in our filings with the SEC. We disclaim any obligation to update such statements or to announce publicly the results of any revisions that we may make to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.\\n29\\nPart II. Other Information\\nNone.\\nOur business, results of operations and financial condition, and, therefore, the value of our Class A common stock and our Class B common stock, are subject to a number of risks. For a description of certain risks, we refer to “Risk Factors” in our 2015 Annual Report on Form 10-K we filed with the SEC on March 18, 2016. There have been no material changes in the risk factors we disclosed in that Form 10-K Report during the nine months ended September 30, 2016.\\nNone.\\nNone.\\nItem 4. Removed and Reserved.\\nNone.\\n30\\n\\n\\n| Exhibit No. | Description |\\n| Exhibit 31.1 | Certification of Chief Executive Officer |\\n| Exhibit 31.2 | Certification of Chief Financial Officer |\\n| Exhibit 32.1 | Statement of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 of Title 18 of the United States Code |\\n| Exhibit 32.2 | Statement of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of Title 18 of the United States Code |\\n| Exhibit 101.INS | XBRL Instance Document |\\n| Exhibit 101.SCH | XBRL Taxonomy Extension Schema Document |\\n| Exhibit 101.PRE | XBRL Taxonomy Presentation Linkbase Document |\\n| Exhibit 101.CAL | XBRL Taxonomy Calculation Linkbase Document |\\n| Exhibit 101.LAB | XBRL Taxonomy Label Linkbase Document |\\n| Exhibit 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\\n\\n31\\nSignatures Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. DONEGAL GROUP INC. November 7, 2016 By: /s/ Kevin G. Burke Kevin G. Burke, President and Chief Executive Officer November 7, 2016 By: /s/ Jeffrey D. Miller Jeffrey D. Miller, Executive Vice President and Chief Financial Officer\\n \\n\\nWhat is the annual growth rate of the company's total investments from December 31, 2015 to September 30, 2016 in percent?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 6.411694352303821.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 46,\n \"input_length\": 26460\n}"}}},{"rowIdx":47,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nItem 1.\nFinancial Statements.\nConsolidated Balance Sheets 4\nConsolidated Statements of Operations 5\nConsolidated Statements of Comprehensive Income (Loss) 7\nConsolidated Statements of Equity 8\nConsolidated Statements of Cash Flows 12\nNotes to the Consolidated Financial Statements 14\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 40\nItem 3. Quantitative and Qualitative Disclosures About Market Risk 51\nItem 4. Controls and Procedures 53\nPART II. OTHER INFORMATION\nItem 1. Legal Proceedings 54\nItem 1A. Risk Factors 54\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds 54\nItem 3. Defaults Upon Senior Securities 54\nItem 4. Mine Safety Disclosures 54\nItem 5. Other Information 54\nItem 6. Exhibits 55\nSignatures 56\n3\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSAS OF JUNE 30, 2021 [UNAUDITED] AND DECEMBER 31, 2020[IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\n| June 30, 2021 | December 31, 2020 |\n| Assets: |\n| Investment in Hotel Properties, Net of Accumulated Depreciation | $ | 1,699,230 | $ | 1,784,838 |\n| Investment in Unconsolidated Joint Ventures | 5,936 | 6,633 |\n| Cash and Cash Equivalents | 69,083 | 16,637 |\n| Escrow Deposits | 11,067 | 6,970 |\n| Hotel Accounts Receivable | 5,539 | 5,690 |\n| Due from Related Parties | 1,552 | 2,641 |\n| Intangible Assets, Net of Accumulated Amortization of $ 6,827 and $ 6,840 | 1,465 | 1,739 |\n| Right of Use Assets | 43,467 | 44,126 |\n| Other Assets | 20,395 | 15,494 |\n| Hotel Assets Held for Sale | — | 96,220 |\n| Total Assets | $ | 1,857,734 | $ | 1,980,988 |\n| Liabilities and Equity: |\n| Line of Credit | $ | 118,684 | $ | 133,053 |\n| Term Loans, Net of Unamortized Deferred Financing Costs (Note 5) | 495,657 | 681,744 |\n| Unsecured Notes Payable, Net of Unamortized Discount and Unamortized Deferred Financing Costs (Note 5) | 193,725 | 50,789 |\n| Mortgages Payable, Net of Unamortized Premium and Unamortized Deferred Financing Costs | 304,426 | 330,848 |\n| Lease Liabilities | 53,455 | 53,852 |\n| Accounts Payable, Accrued Expenses and Other Liabilities | 49,088 | 58,453 |\n| Dividends and Distributions Payable | 6,044 | — |\n| Total Liabilities | $ | 1,221,079 | $ | 1,308,739 |\n| Redeemable Noncontrolling Interests - Consolidated Joint Venture (Note 1) | $ | 1,968 | $ | — |\n| Equity: |\n| Shareholders' Equity: |\n| Preferred Shares: $ .01 Par Value, 29,000,000 Shares Authorized, 3,000,000 Series C, 7,701,700 Series D and 4,001,514 Series E Shares Issued and Outstanding at June 30, 2021 and December 31, 2020, with Liquidation Preferences of $ 25.00 Per Share (Note 1) | $ | 147 | $ | 147 |\n| Common Shares: Class A, $ .01 Par Value, 104,000,000 Shares Authorized at June 30, 2021 and December 31, 2020; 39,217,475 and 38,843,482 Shares Issued and Outstanding at June 30, 2021 and December 31, 2020, respectively | 392 | 389 |\n| Common Shares: Class B, $ .01 Par Value, 1,000,000 Shares Authorized, None Issued and Outstanding at June 30, 2021 and December 31, 2020 | — | — |\n| Accumulated Other Comprehensive Loss | ( 11,024 ) | ( 19,275 ) |\n| Additional Paid-in Capital | 1,153,657 | 1,150,985 |\n| Distributions in Excess of Net Income | ( 557,157 ) | ( 509,243 ) |\n| Total Shareholders' Equity | 586,015 | 623,003 |\n| Noncontrolling Interests (Note 1) | 48,672 | 49,246 |\n| Total Equity | 634,687 | 672,249 |\n| Total Liabilities and Equity | $ | 1,857,734 | $ | 1,980,988 |\n\nThe Accompanying Notes Are an Integral Part of These Consolidated Financial Statements.\n4\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\n| Three Months Ended June 30, | Six months ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Revenue: |\n| Hotel Operating Revenues: |\n| Room | $ | 56,539 | $ | 15,139 | $ | 95,889 | $ | 86,222 |\n| Food & Beverage | 7,230 | 136 | 10,304 | 10,211 |\n| Other Operating Revenues | 6,314 | 2,137 | 11,043 | 10,917 |\n| Other Revenues | 13 | 29 | 25 | 228 |\n| Total Revenues | 70,096 | 17,441 | 117,261 | 107,578 |\n| Operating Expenses: |\n| Hotel Operating Expenses: |\n| Room | 12,350 | 3,622 | 21,548 | 22,714 |\n| Food & Beverage | 5,409 | 721 | 8,282 | 11,342 |\n| Other Operating Expenses | 23,551 | 14,035 | 43,660 | 49,841 |\n| Insurance recoveries in excess of property loss | ( 711 ) | — | ( 711 ) | — |\n| Hotel Ground Rent | 1,064 | 1,058 | 2,164 | 2,121 |\n| Real Estate and Personal Property Taxes and Property Insurance | 9,466 | 9,969 | 19,537 | 19,911 |\n| General and Administrative (including Share Based Payments of $ 2,589 and $ 1,799 and $ 4,758 and $ 4,255 for the three and six months ended June 30, 2021 and 2020, respectively) | 5,287 | 4,187 | 10,231 | 10,021 |\n| Terminated Transaction Costs | 36 | — | 390 | — |\n| Loss on Impairment of Assets | 222 | 1,069 | 222 | 1,069 |\n| Depreciation and Amortization | 21,014 | 24,322 | 42,816 | 48,510 |\n| Total Operating Expenses | 77,688 | 58,983 | 148,139 | 165,529 |\n| Operating Loss | ( 7,592 ) | ( 41,542 ) | ( 30,878 ) | ( 57,951 ) |\n| Interest Income | 4 | 2 | 5 | 38 |\n| Interest Expense | ( 14,982 ) | ( 13,481 ) | ( 28,411 ) | ( 26,488 ) |\n| Other Income (Expense) | ( 84 ) | ( 385 ) | 377 | ( 457 ) |\n| Gain on Disposition of Hotel Properties | — | — | 48,352 | — |\n| Loss on Debt Extinguishment | ( 129 ) | — | ( 3,069 ) | — |\n| Loss Before Results from Unconsolidated Joint Venture Investments and Income Taxes | ( 22,783 ) | ( 55,406 ) | ( 13,624 ) | ( 84,858 ) |\n| Loss from Unconsolidated Joint Ventures | ( 589 ) | ( 502 ) | ( 1,247 ) | ( 1,520 ) |\n| Loss Before Income Taxes | ( 23,372 ) | ( 55,908 ) | ( 14,871 ) | ( 86,378 ) |\n| Income Tax Benefit (Expense) | ( 151 ) | ( 15,872 ) | 438 | ( 11,374 ) |\n| Net Loss | ( 23,523 ) | ( 71,780 ) | ( 14,433 ) | ( 97,752 ) |\n| Loss Allocated to Noncontrolling Interests - Common Units | 2,945 | 7,164 | 2,623 | 10,061 |\n| (Income) Loss Allocated to Noncontrolling Interests - Consolidated Joint Venture | ( 1,968 ) | 3,196 | ( 1,810 ) | 3,196 |\n| Preferred Distributions | ( 6,044 ) | ( 6,044 ) | ( 12,087 ) | ( 12,088 ) |\n| Net Loss Applicable to Common Shareholders | $ | ( 28,590 ) | $ | ( 67,464 ) | $ | ( 25,707 ) | $ | ( 96,583 ) |\n\nThe Accompanying Notes Are an Integral Part of These Consolidated Financial Statements.\n5\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Earnings Per Share: |\n| BASIC |\n| Loss from Continuing Operations Applicable to Common Shareholders | $ | ( 0.73 ) | $ | ( 1.75 ) | $ | ( 0.66 ) | $ | ( 2.50 ) |\n| DILUTED |\n| Loss from Continuing Operations Applicable to Common Shareholders | $ | ( 0.73 ) | $ | ( 1.75 ) | $ | ( 0.66 ) | $ | ( 2.50 ) |\n| Weighted Average Common Shares Outstanding: |\n| Basic | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\n| Diluted* | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\n\n* Income (Loss) allocated to noncontrolling interest in Hersha Hospitality Limited Partnership (the “Operating Partnership” or “HHLP”) has been excluded from the numerator and the Class A common shares issuable upon any redemption of the Operating Partnership’s common units of limited partnership interest (“Common Units”) and the Operating Partnership’s vested LTIP units (“Vested LTIP Units”) have been omitted from the denominator for the purpose of computing diluted earnings per share because the effect of including these shares and units in the numerator and denominator would have no impact. In addition, potentially dilutive common shares, if any, have been excluded from the denominator if they are anti-dilutive to income (loss) applicable to common shareholders.\nThe following table summarizes potentially dilutive securities that have been excluded from the denominator for the purpose of computing diluted earnings per share:\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Common Units and Vested LTIP Units | 4,279,355 | 3,943,319 | 4,314,347 | 3,891,032 |\n| Unvested Stock Awards and LTIP Units Outstanding | 939,591 | 547,315 | 581,989 | 267,443 |\n| Contingently Issuable Share Awards | 408,202 | 185,754 | 594,125 | 680,979 |\n| Total Potentially Dilutive Securities Excluded from the Denominator | 5,627,148 | 4,676,388 | 5,490,461 | 4,839,454 |\n\nThe Accompanying Notes Are an Integral Part of These Consolidated Financial Statements.\n6\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS]\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Net Loss | $ | ( 23,523 ) | $ | ( 71,780 ) | $ | ( 14,433 ) | $ | ( 97,752 ) |\n| Other Comprehensive Income (Loss) |\n| Change in Fair Value of Derivative Instruments | 2,539 | ( 2,020 ) | 9,004 | ( 33,146 ) |\n| Reclassification Adjustment for Change in Fair Value of Derivative Instruments Included in Net Income (Loss) | ( 141 ) | 1,228 | 159 | 2,205 |\n| Total Other Comprehensive Income (Loss) | $ | 2,398 | $ | ( 792 ) | $ | 9,163 | $ | ( 30,941 ) |\n| Comprehensive Loss | ( 21,125 ) | ( 72,572 ) | ( 5,270 ) | ( 128,693 ) |\n| Less: Comprehensive Loss Attributable to Noncontrolling Interests - Common Units | 2,712 | 7,270 | 1,711 | 12,895 |\n| Less: Comprehensive (Income) Loss Attributable to Noncontrolling Interests - Consolidated Joint Venture | ( 1,968 ) | 3,196 | ( 1,810 ) | 3,196 |\n| Less: Preferred Distributions | ( 6,044 ) | ( 6,044 ) | ( 12,087 ) | ( 12,088 ) |\n| Comprehensive Loss Attributable to Common Shareholders | $ | ( 26,425 ) | $ | ( 68,150 ) | $ | ( 17,456 ) | $ | ( 124,690 ) |\n\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\n7\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF EQUITYFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARES]\n| Redeemable Noncontrolling Interests | Shareholders' Equity | Noncontrolling Interests |\n| Consolidated Joint Venture ($) | Common Shares | Class A Common Shares ($) | Class B Common Shares ($) | Preferred Shares | Preferred Shares ($) | Additional Paid-In Capital ($) | Accumulated Other Comprehensive Loss ($) | Distributions in Excess of Net Income ($) | Total Shareholders' Equity ($) | Common Units and LTIP Units | Common Units and LTIP Units ($) | Total Equity ($) |\n| Balance at March 31, 2021 | — | 39,132,307 | 391 | — | 14,703,214 | 147 | 1,154,579 | ( 12,509 ) | ( 530,535 ) | 612,073 | 5,943,014 | 49,172 | 661,245 |\n| Dividends and Distributions declared: |\n| Preferred Shares | — | — | — | — | — | — | — | — | ( 6,044 ) | ( 6,044 ) | — | — | ( 6,044 ) |\n| Share Based Compensation: |\n| Grants | — | 85,168 | 1 | — | — | — | 365 | — | — | 366 | 19,477 | 65 | 431 |\n| Amortization | — | — | — | — | — | — | 681 | — | — | 681 | 1,468 | 2,149 |\n| Change in Fair Value of Derivative Instruments | — | — | — | — | — | — | — | 1,485 | — | 1,485 | — | 912 | 2,397 |\n| Adjustment to Record Noncontrolling Interest at Redemption Value | 1,968 | — | — | — | — | — | ( 1,968 ) | — | — | ( 1,968 ) | — | — | ( 1,968 ) |\n| Net Loss | — | — | — | — | — | — | — | — | ( 20,578 ) | ( 20,578 ) | — | ( 2,945 ) | ( 23,523 ) |\n| Balance at June 30, 2021 | 1,968 | 39,217,475 | 392 | — | 14,703,214 | 147 | 1,153,657 | ( 11,024 ) | ( 557,157 ) | 586,015 | 5,962,491 | 48,672 | 634,687 |\n\n8\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF EQUITYFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARES]\n| Redeemable Noncontrolling Interests | Shareholders' Equity | Noncontrolling Interests |\n| Consolidated Joint Venture ($) | Common Shares | Class A Common Shares ($) | Class B Common Shares ($) | Preferred Shares | Preferred Shares ($) | Additional Paid-In Capital ($) | Accumulated Other Comprehensive Loss ($) | Distributions in Excess of Net Income ($) | Total Shareholders' Equity ($) | Common Units and LTIP Units | Common Units and LTIP Units ($) | Total Equity ($) |\n| Balance at March 31, 2020 | 3,196 | 38,673,242 | 387 | — | 14,703,214 | 147 | 1,145,450 | ( 26,411 ) | ( 362,777 ) | 756,796 | 4,279,946 | 59,162 | 815,958 |\n| Issuance Costs | — | — | — | — | — | — | ( 10 ) | — | — | ( 10 ) | — | — | ( 10 ) |\n| Share Based Compensation: |\n| Grants | — | 116,129 | 1 | — | — | — | — | — | — | 1 | 1,101,924 | — | 1 |\n| Amortization | — | — | — | — | — | — | 655 | — | — | 655 | — | 3,823 | 4,478 |\n| Change in Fair Value of Derivative Instruments | — | — | — | — | — | — | — | ( 686 ) | — | ( 686 ) | — | ( 106 ) | ( 792 ) |\n| Adjustment to Record Noncontrolling Interest at Redemption Value | ( 3,196 ) | — | — | — | — | — | 3,196 | — | — | 3,196 | — | — | 3,196 |\n| Net Income | — | — | — | — | — | — | — | — | ( 64,616 ) | ( 64,616 ) | ( 7,164 ) | ( 71,780 ) |\n| Balance at June 30, 2020 | — | 38,789,371 | 388 | — | 14,703,214 | 147 | 1,149,291 | ( 27,097 ) | ( 427,393 ) | 695,336 | 5,381,870 | 55,715 | 751,051 |\n\n9\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF EQUITYFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARES]\n| Redeemable Noncontrolling Interests | Shareholders' Equity | Noncontrolling Interests |\n| Consolidated Joint Venture ($) | Common Shares | Class A Common Shares ($) | Class B Common Shares ($) | Preferred Shares | Preferred Shares ($) | Additional Paid-In Capital ($) | Accumulated Other Comprehensive Loss ($) | Distributions in Excess of Net Income ($) | Total Shareholders' Equity ($) | Common Units and LTIP Units | Common Units and LTIP Units ($) | Total Equity ($) |\n| Balance at December 31, 2020 | — | 38,843,482 | 389 | — | 14,703,214 | 147 | 1,150,985 | ( 19,275 ) | ( 509,243 ) | 623,003 | 5,392,808 | 49,246 | 672,249 |\n| Unit Conversion | — | 225,000 | 2 | — | — | — | 2,870 | — | — | 2,872 | ( 225,000 ) | ( 2,872 ) | — |\n| Dividends and Distributions declared: |\n| Preferred Shares | — | — | — | — | — | — | — | — | ( 36,262 ) | ( 36,262 ) | — | — | ( 36,262 ) |\n| Share Based Compensation: |\n| Grants | — | 148,993 | 1 | — | — | — | 356 | — | — | 357 | 794,683 | 1,683 | 2,040 |\n| Amortization | — | — | — | — | — | — | 1,414 | — | — | 1,414 | 2,326 | 3,740 |\n| Change in Fair Value of Derivative Instruments | — | — | — | — | — | — | — | 8,251 | — | 8,251 | — | 912 | 9,163 |\n| Equity Contribution to Consolidated Joint Venture | 158 | — | — | — | — | — | — | — | — | — | — | — | — |\n| Adjustment to Record Noncontrolling Interest at Redemption Value | 1,968 | — | — | — | — | — | ( 1,968 ) | — | — | ( 1,968 ) | — | — | ( 1,968 ) |\n| Net Income | ( 158 ) | — | — | — | — | — | — | — | ( 11,652 ) | ( 11,652 ) | — | ( 2,623 ) | ( 14,275 ) |\n| Balance at June 30, 2021 | 1,968 | 39,217,475 | 392 | — | 14,703,214 | 147 | 1,153,657 | ( 11,024 ) | ( 557,157 ) | 586,015 | 5,962,491 | 48,672 | 634,687 |\n\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\n10\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF EQUITYFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARES]\n| Redeemable Noncontrolling Interests | Shareholders' Equity | Noncontrolling Interests |\n| Consolidated Joint Venture ($) | Common Shares | Class A Common Shares ($) | Class B Common Shares ($) | Preferred Shares | Preferred Shares ($) | Additional Paid-In Capital ($) | Accumulated Other Comprehensive Loss ($) | Distributions in Excess of Net Income ($) | Total Shareholders' Equity ($) | Common Units and LTIP Units | Common Units and LTIP Units ($) | Total Equity ($) |\n| Balance at December 31, 2019 | 3,196 | 38,652,650 | 387 | — | 14,703,214 | 147 | 1,144,808 | 1,010 | ( 338,695 ) | 807,657 | 4,279,946 | 64,144 | 871,801 |\n| Unit Conversion | — | — | — | — | — | — | ( 30 ) | — | — | ( 30 ) | — | — | ( 30 ) |\n| Dividends and Distributions declared: |\n| Preferred Shares | — | — | — | — | — | — | — | — | ( 1,007 ) | ( 1,007 ) | — | — | ( 1,007 ) |\n| Dividend Reinvestment Plan | — | 1,094 | — | — | — | — | 14 | — | — | 14 | — | — | 14 |\n| Share Based Compensation: |\n| Grants | — | 135,627 | 1 | — | — | — | — | — | — | 1 | 1,101,924 | — | 1 |\n| Amortization | — | — | — | — | — | — | 1,303 | — | — | 1,303 | — | 4,466 | 5,769 |\n| Change in Fair Value of Derivative Instruments | — | — | — | — | — | — | — | ( 28,107 ) | — | ( 28,107 ) | — | ( 2,834 ) | ( 30,941 ) |\n| Adjustment to Record Noncontrolling Interest at Redemption Value | ( 3,196 ) | — | — | — | — | — | 3,196 | — | — | 3,196 | — | — | 3,196 |\n| Net Loss | — | — | — | — | — | — | — | — | ( 87,691 ) | ( 87,691 ) | ( 10,061 ) | ( 97,752 ) |\n| Balance at June 30, 2020 | — | 38,789,371 | 388 | — | 14,703,214 | 147 | 1,149,291 | ( 27,097 ) | ( 427,393 ) | 695,336 | 5,381,870 | 55,715 | 751,051 |\n\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\n11\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSFOR THE SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS]\n| Six Months Ended June 30, |\n| 2021 | 2020 |\n| Operating Activities: |\n| Net Loss | $ | ( 14,433 ) | $ | ( 97,752 ) |\n| Adjustments to Reconcile Net Loss to Net Cash Provided by Operating Activities: |\n| Gain on Disposition of Hotel Properties | ( 48,352 ) | — |\n| Loss on Impairment of Assets | 222 | 1,069 |\n| Insurance recoveries in excess of property loss | ( 711 ) | — |\n| Junior Note PIK Interest Added to Principal | 2,514 | — |\n| Deferred Taxes | ( 499 ) | 11,390 |\n| Depreciation | 42,642 | 48,273 |\n| Amortization | 2,594 | 1,116 |\n| Loss on Debt Extinguishment | 634 | — |\n| Equity in Loss of Unconsolidated Joint Ventures | 1,247 | 1,520 |\n| Loss Recognized on Change in Fair Value of Derivative Instrument | 159 | 2,205 |\n| Share Based Compensation Expense | 4,758 | 4,255 |\n| Change in Assets and Liabilities: |\n| (Increase) Decrease in: |\n| Hotel Accounts Receivable | 151 | 5,412 |\n| Other Assets | ( 4,055 ) | 4,884 |\n| Due from Related Parties | 1,089 | 3,750 |\n| Increase (Decrease) in: |\n| Accounts Payable, Accrued Expenses and Other Liabilities | 4,933 | ( 2,479 ) |\n| Net Cash Used in Operating Activities | $ | ( 7,107 ) | $ | ( 16,357 ) |\n| Investing Activities: |\n| Capital Expenditures | ( 5,374 ) | ( 15,612 ) |\n| Hotel Development Projects | — | 21 |\n| Proceeds from Disposition of Hotel Properties | 163,583 | — |\n| Contributions to Unconsolidated Joint Ventures | ( 550 ) | ( 600 ) |\n| Net Cash Provided by (Used in) Investing Activities | $ | 157,659 | $ | ( 16,191 ) |\n\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\n12\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSFOR THE SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS]\n| Six Months Ended June 30, |\n| 2021 | 2020 |\n| Financing Activities: |\n| (Repayments) Borrowings on Line of Credit, Net | $ | ( 14,369 ) | $ | 47,000 |\n| Payments on Term Loans | ( 187,024 ) | — |\n| Proceeds from Notes Payable | 144,750 | — |\n| Principal Repayment of Mortgages | ( 1,353 ) | ( 650 ) |\n| Proceeds of Paycheck Protection Program (\"PPP\") Loans | — | 18,936 |\n| Repayment of PPP Loans | — | ( 18,936 ) |\n| Deferred Financing Costs | ( 5,795 ) | ( 2,104 ) |\n| Dividends Paid on Common Shares | — | ( 10,809 ) |\n| Dividends Paid on Preferred Shares | ( 30,218 ) | ( 6,044 ) |\n| Distributions Paid on Common Units and LTIP Units | — | ( 1,198 ) |\n| Other Financing Activities | — | ( 30 ) |\n| Net Cash (Used in) Provided by Financing Activities | $ | ( 94,009 ) | $ | 26,165 |\n| Net Increase (Decrease) in Cash, Cash Equivalents, and Restricted Cash | $ | 56,543 | $ | ( 6,383 ) |\n| Cash, Cash Equivalents, and Restricted Cash - Beginning of Period | 23,607 | 36,985 |\n| Cash, Cash Equivalents, and Restricted Cash - End of Period | $ | 80,150 | $ | 30,602 |\n\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\n13\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 1 - BASIS OF PRESENTATION\nThe accompanying unaudited consolidated financial statements of Hersha Hospitality Trust (“we,” “us,” “our” or the “Company”) have been prepared in accordance with U.S. generally accepted accounting principles (“US GAAP”) for interim financial information and with the general instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required by US GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals), considered necessary for a fair presentation have been included. Operating results for the three and six months ended June 30, 2021 are not necessarily indicative of the results that may be expected for the year ending December 31, 2021 or any future period. Accordingly, readers of these consolidated interim financial statements should refer to the Company’s audited financial statements prepared in accordance with US GAAP, and the related notes thereto, for the year ended December 31, 2020, which are included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2020, as certain footnote disclosures normally included in financial statements prepared in accordance with US GAAP have been condensed or omitted from this report pursuant to the rules of the Securities and Exchange Commission.\nWe are a self-administered Maryland real estate investment trust that was organized in May 1998 and completed our initial public offering in January 1999. Our common shares are traded on the New York Stock Exchange (the “NYSE”) under the symbol “HT.” We own our hotels and our investments in joint ventures through our operating partnership, Hersha Hospitality Limited Partnership (“HHLP” or “the Partnership”), for which we serve as the sole general partner. As of June 30, 2021, we owned an approximate 86.8 % partnership interest in HHLP, including a 1.0 % general partnership interest.\nPrinciples of Consolidation and Presentation\nThe accompanying consolidated financial statements have been prepared in accordance with US GAAP and include all of our accounts as well as accounts of the Partnership, subsidiary partnerships and our wholly owned Taxable REIT Subsidiary Lessee (“TRS Lessee”), 44 New England Management Company. All significant inter-company amounts have been eliminated.\nConsolidated properties are either wholly owned or owned less than 100% by the Partnership and are controlled by the Company as general partner of the Partnership. Properties owned in joint ventures are also consolidated if the determination is made that we are the primary beneficiary in a variable interest entity (“VIE”) or we maintain control of the asset through our voting interest in the entity.\nVariable Interest Entities\nWe evaluate each of our investments and contractual relationships to determine whether they meet the guidelines for consolidation. To determine if we are the primary beneficiary of a VIE, we evaluate whether we have a controlling financial interest in that VIE. An enterprise is deemed to have a controlling financial interest if it has i) the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance, and ii) the obligation to absorb losses of the VIE that could be significant to the VIE or the rights to receive benefits from the VIE that could be significant to the VIE. Control can also be demonstrated by the ability of a member to manage day-to-day operations, refinance debt and sell the assets of the partnerships without the consent of the other member and the inability of the members to replace the managing member. Based on our examination, there have been no changes to the operating structure of our legal entities during the three and six months ended June 30, 2021 and, therefore, there are no changes to our evaluation of VIE's as presented within our annual report presented on Form 10-K for the year ended December 31, 2020.\n14\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\nNOTE 1 - BASIS OF PRESENTATION (CONTINUED)\nNoncontrolling Interest\nWe classify the noncontrolling interests of our common units of limited partnership interest in HHLP (“Common Units”), and Long Term Incentive Plan Units (“LTIP Units”) as equity. LTIP Units are a separate class of limited partnership interest in the Operating Partnership that are convertible into Common Units under certain circumstances. The noncontrolling interest of Common Units and LTIP Units totaled $ 48,672 as of June 30, 2021 and $ 49,246 as of December 31, 2020. As of June 30, 2021, there were 5,962,491 Common Units and LTIP Units outstanding with a fair market value of $ 64,156 , based on the price per share of our common shares on the NYSE on such date. In accordance with the partnership agreement of HHLP, holders of these Common Units may redeem them for cash unless we, in our sole and absolute discretion, elect to issue common shares on a one -for-one basis in lieu of paying cash.\nNet income or loss attributed to Common Units and LTIP Units is included in net income or loss but excluded from net income or loss applicable to common shareholders in the consolidated statements of operations.\nWe are party to a joint venture that owns the Ritz-Carlton Coconut Grove, FL, in which our joint venture partner has a noncontrolling equity interest of 15 % in the property. Hersha Holding RC Owner, LLC, the owner entity of the Ritz-Carlton Coconut Grove joint venture (\"Ritz Coconut Grove\"), will distribute income based on cash available for distribution which will be distributed as follows: (1) to us until we receive a cumulative return on our contributed senior common equity interest, currently at 8 %, and (2) then to the owner of the noncontrolling interest until they receive a cumulative return on their contributed junior common equity interest, currently at 8 %, and (3) then 75 % to us and 25 % to the owner of the noncontrolling interest until we both receive a cumulative return on our contributed senior common equity interest, currently at 12 %, and (4) finally, any remaining operating profit shall be distributed 70 % to us and 30 % to the owner of the noncontrolling interest. Additionally, the noncontrolling interest in the Ritz Coconut Grove has the right to put their ownership interest to us for cash consideration at any time during the life of the venture. The balance sheets and financial results of the Ritz Coconut Grove are included in our consolidated financial statements and book value of the noncontrolling interest in the Ritz Coconut Grove is classified as temporary equity within our Consolidated Balance Sheets. The noncontrolling interest in the Ritz Coconut Grove is measured at the greater of historical cost or the put option redemption value. For the three and six months ended June 30, 2021, based on the income allocation methodology described above, the noncontrolling interest in this joint venture was allocated losses of $ 0 and $ 158 , respectively. For the three and six months ended June 30, 2020, based on the income allocation methodology described above, the noncontrolling interest in this joint venture was allocated loss of $ 0 . This is recorded as part of the Loss Allocated to Noncontrolling Interests line item within the Consolidated Statements of Operations. On June 30, 2021, we reclassified $ 1,968 from Additional Paid in Capital to Redeemable Noncontrolling Interests - Consolidated Joint Venture to value the noncontrolling interest at the put option redemption value of $ 1,968 .\nShareholders’ Equity\n| Dividend Per Share (1) |\n| Shares Outstanding | Six Months Ended June 30, |\n| Series | June 30, 2021 | December 31, 2020 | Aggregate Liquidation Preference | Distribution Rate | 2021 | 2020 |\n| Series C | 3,000,000 | 3,000,000 | $ | 75,000 | 6.875 | % | $ | 2.5782 | $ | — |\n| Series D | 7,701,700 | 7,701,700 | $ | 192,500 | 6.500 | % | $ | 2.4378 | $ | — |\n| Series E | 4,001,514 | 4,001,514 | $ | 100,000 | 6.500 | % | $ | 2.4378 | $ | — |\n| Total | 14,703,214 | 14,703,214 |\n\n15\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\nNOTE 1 - BASIS OF PRESENTATION (CONTINUED)\n(1) During the six months ended June 30, 2020, we suspended the payment of our preferred dividends. During the six months ended June 30, 2021, the Company paid cash dividends on the Company's Series C, Series D and Series E cumulative redeemable preferred stock reflecting accrued and unpaid dividends for the dividend periods ended April 15, 2020, July 15, 2020, October 15, 2020 and January 15, 2021. In addition, the Company paid a cash dividend on all Series of cumulative redeemable preferred stock for the first dividend period ending April 15, 2021 and declared a similar cash dividend for the second dividend period ending July 15, 2021, which is payable July 15, 2021 to holders of record as of July 1, 2021.\nLiquidity and Management's Plan\nDue to the COVID-19 pandemic and the effects of travel restrictions both globally and in the United States, the hospitality industry has experienced drastic drops in demand. The global impact of the pandemic has been rapidly evolving and, in the United States, certain states and cities, including most of the states and cities where we own properties, have reacted by instituting various restrictive measures such as quarantines, restrictions on travel, school closings, \"stay at home\" rules and restrictions on types of business that may continue to operate. We believe the ongoing effects of the COVID-19 pandemic on our operations have had, and will continue to have a material negative impact on our financial results and liquidity, and such negative impact may continue beyond the containment of the pandemic.\nIn February of 2021, we entered into an unsecured notes facility that provided net proceeds of $ 144,750 and access to an incremental $ 50,000 , which can be drawn through September 30, 2021. The initial net proceeds of $ 144,750 provided by this facility, along with a portion of the proceeds from asset sales, were used to repay amounts outstanding under our senior secured credit facility and our two secured term loans and allowed us to negotiate amendments to this senior facility. The amendments to the senior secured credit facility and two secured term loans eliminated term loan maturities until August of 2022, waived all financial covenants through March 31, 2022, established accommodative covenant testing methodology through December 31, 2022, enabled the Company to pay down the accrual of the Company's preferred dividends, allow the ongoing preferred dividend accrual to be kept current, and provided additional liquidity to be used at the Company's discretion.\nWe cannot assure you that our assumptions used to estimate our liquidity requirements will be correct because the lodging industry has not previously experienced such an abrupt and drastic reduction in hotel demand, and as a consequence, our ability to be predictive is uncertain. In addition, the magnitude, duration, and speed of the pandemic is uncertain and we cannot estimate when travel demand will recover. Based on the amendments, the Company believes that it has sufficient liquidity to meet its obligations for the next twelve months.\nInvestment in Hotel Properties\nInvestments in hotel properties are recorded at cost. Improvements and replacements are capitalized when they extend the useful life of the asset. Costs of repairs and maintenance are expensed as incurred. Depreciation is computed using the straight-line method over the estimated useful life of up to 40 years for buildings and improvements, two to seven years for furniture, fixtures and equipment. We are required to make subjective assessments as to the useful lives of our properties for purposes of determining the amount of depreciation to record on an annual basis with respect to our investments in hotel properties. These assessments have a direct impact on our net income because if we were to shorten the expected useful lives of our investments in hotel properties we would depreciate these investments over fewer years, resulting in more depreciation expense and lower net income on an annual basis.\nIdentifiable assets, liabilities, and noncontrolling interests related to hotel properties acquired are recorded at fair value. Estimating techniques and assumptions used in determining fair values involve significant estimates and judgments. These estimates and judgments have a direct impact on the carrying value of our assets and liabilities which can directly impact the amount of depreciation expense recorded on an annual basis and could have an impact on our assessment of potential impairment of our investment in hotel properties.\nWe consider a hotel to be held for sale when management and our independent trustees commit to a plan to sell the property, the property is available for sale, management engages in an active program to locate a buyer for the property and it is probable the sale will be completed within a year of the initiation of the plan to sell. We evaluate each disposition to determine whether we need to classify the disposition as discontinued operations. We generally include the operations of a hotel that was sold or a hotel that has been classified as held for sale in continuing operations unless the sale represents a strategic shift that will have a major impact on our future operations and financial results. We anticipate that most of our hotel dispositions will not be classified as discontinued operations as most will not fit this definition.\n16\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\nNOTE 1 - BASIS OF PRESENTATION (CONTINUED)\nBased on the occurrence of certain events or changes in circumstances, we review the recoverability of the property’s carrying value. Such events or changes in circumstances include the following:\n•a significant decrease in the market price of a long-lived asset;\n•a significant adverse change in the extent or manner in which a long-lived asset is being used or in its physical condition;\n•a significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset, including an adverse action or assessment by a regulator;\n•an accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset;\n•a current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset; and\n•a current expectation that, it is more likely than not that, a long-lived asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life.\nWe review our portfolio on an ongoing basis to evaluate the existence of any of the aforementioned events or changes in circumstances that would require us to test for recoverability. In general, our review of recoverability is based on an estimate of the future undiscounted cash flows, excluding interest charges, expected to result from the property’s use and eventual disposition. These estimates consider factors such as expected future operating income, market and other applicable trends and residual value expected, as well as the effects of hotel demand, competition and other factors. Other assumptions used in the review of recoverability include the holding period and expected terminal capitalization rate. If impairment exists due to the inability to recover the carrying value of a property, an impairment loss is recorded to the extent that the carrying value exceeds the estimated fair value of the property. We are required to make subjective assessments as to whether there are impairments in the values of our investments in hotel properties.\nAs of June 30, 2021, based on our analysis, we have determined that the estimated future cash flow of each of the properties in our portfolio is sufficient to recover its respective carrying value, after recording an impairment charge prior to the disposition of the Duane Street hotel.\n17\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\nNOTE 1 - BASIS OF PRESENTATION (CONTINUED)\nNew Accounting Pronouncements\nIn March 2020, the Financial Accounting Standards Board (\"FASB\") issued ASU No. 2020-4, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting and in January 2021, the FASB issued 2021-01, Reference Rate Reform (Topic 848), Scope, which further clarified the scope of the reference rate reform optional practical expedients and exceptions outlined in Topic 848. As a result of identified structural risks of interbank offered rates, in particular, the London Interbank Offered Rate (LIBOR), reference rate reform is underway to identify alternative reference rates that are more observable or transaction based. The update provides guidance in accounting for changes in contracts, hedging relationships, and other transactions as a result of this reference rate reform. The optional expedients and exceptions contained within these updates, in general, only apply to contract amendments and modifications entered into prior to January 1, 2023. The provisions of these updates that will most likely affect our financial reporting process related to modifications of contracts with lenders and the related hedging contracts associated with each respective modified borrowing contract. In general, the provisions of these updates would impact the Company by allowing, among other things, the following:\n•Allowing modifications of debt contracts with lenders that fall under the guidance of ASC Topic 470 to be accounted for as a non-substantial modification and not be considered a debt extinguishment.\n•Allowing a change to contractual terms of a hedging instrument in conjunction with reference rate reform to not require a dedesignation of the hedging relationship.\n•Allowing a change to the interest rate used for margining, discounting, or contract price alignment for a derivative that is a cash flow hedge to not be considered a change to the critical terms of the hedge and will not require a dedesignation of the hedging relationship.\nWe have not entered into any contract modifications yet, as it directly relates to reference rate reform but we anticipate having to undertake such modifications in the future as a majority of our contracts with lenders and hedging counterparties are indexed to LIBOR. While we anticipate the impact of this update to be to the benefit of the Company, we are still evaluating the overall impact to the Company.\n18\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 2 - INVESTMENT IN HOTEL PROPERTIES\nInvestment in hotel properties consists of the following at June 30, 2021 and December 31, 2020:\n\n| June 30, 2021 | December 31, 2020 |\n| Land | $ | 478,413 | $ | 488,463 |\n| Buildings and Improvements | 1,557,840 | 1,611,144 |\n| Furniture, Fixtures and Equipment | 271,977 | 281,440 |\n| Construction in Progress | 1,489 | 987 |\n| 2,309,719 | 2,382,034 |\n| Less Accumulated Depreciation | ( 610,489 ) | ( 597,196 ) |\n| Total Investment in Hotel Properties * | $ | 1,699,230 | $ | 1,784,838 |\n\n* The net book value of investment in hotel property at Ritz Coconut Grove, which is a variable interest entity, is $ 40,937 and $ 42,487 at June 30, 2021 and December 31, 2020, respectively.\nAcquisitions\nFor the six months ended June 30, 2021 and 2020, we acquired no hotel properties.\nHotel Dispositions\nFor the six months ended June 30, 2020, we had no hotel dispositions. During the six months ended June 30, 2021, we had the following hotel dispositions:\n| Hotel | AcquisitionDate | DispositionDate | Consideration | Gain onDisposition |\n| Courtyard San Diego, CA | 05/30/2013 | 02/19/2021 | $ | 64,500 | $ | 5,037 |\n| The Capitol Hill Hotel Washington, DC | 04/15/2011 | 03/09/2021 | 51,000 | 12,990 |\n| Holiday Inn Express Cambridge, MA | 05/03/2006 | 03/09/2021 | 32,000 | 20,281 |\n| Residence Inn Miami Coconut Grove, FL | 06/12/2013 | 03/10/2021 | 31,000 | 10,005 |\n| Duane Street Hotel (1) | 01/04/2008 | 05/13/2021 | 18,000 | — |\n| 2021 Total | $ | 48,313 |\n\n(1)During the second quarter of 2020, the Company determined that the carrying value of the Duane Street hotel exceeded the anticipated net proceeds from sale, resulting in a $ 1,069 impairment charge recorded during the second quarter of 2020. We recorded an additional impairment charge of $ 147 prior to the disposition of the hotel property during the six months ended June 30, 2021.\n19\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 2 – INVESTMENT IN HOTEL PROPERTIES (CONTINUED)\nAssets Held For Sale\nWe classified the assets of the Duane Street Hotel, the Residence Inn Coconut Grove and the Courtyard San Diego as held for sale as of December 31, 2020, all of which closed during the six months ended June 30, 2021.\nThe table below shows the balances for the properties that were classified as assets held for sale as of December 31, 2020:\n| December 31, 2020 |\n| Land | $ | 28,015 |\n| Buildings and Improvements | 93,314 |\n| Furniture, Fixtures and Equipment | 15,469 |\n| 136,798 |\n| Less Accumulated Depreciation | ( 40,578 ) |\n| Assets Held for Sale | $ | 96,220 |\n\n20\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 3 - INVESTMENT IN UNCONSOLIDATED JOINT VENTURES\nAs of June 30, 2021 and December 31, 2020, our investment in unconsolidated joint ventures consisted of the following:\n\n| Joint Venture | Hotel Properties | Percent Owned | June 30, 2021 | December 31, 2020 |\n| Cindat Hersha Owner JV, LLC | Hilton and IHG branded hotels in NYC | 31.2 | % | * | $ | — | $ | — |\n| Hiren Boston, LLC | Courtyard by Marriott, South Boston, MA | 50 | % | 29 | 219 |\n| SB Partners, LLC | Holiday Inn Express, South Boston, MA | 50 | % | — | — |\n| SB Partners Three, LLC | Home2 Suites, South Boston, MA | 50 | % | 5,907 | 6,414 |\n| $ | 5,936 | $ | 6,633 |\n\n*On February 7, 2021, all of the assets of the properties owned by this joint venture were transferred to the mezzanine lender of Cindat Hersha Owner JV, LLC. As a result, upon dissolution of the venture, we will no longer maintain an interest in this venture.\nIncome/Loss Allocation\nPrior to February 7, 2021, based on the income allocation methodology within Cindat Hersha Owner JV, LLC, the Company had absorbed cumulative losses equal to our accounting basis in the joint venture resulting in a $ 0 investment balance in the table above as of December 31, 2020, however, we maintained a positive equity balance within the venture. This difference is due to the difference in our basis inside the venture versus our basis outside of the venture, which is explained later in this note.\nFor SB Partners, LLC, Hiren Boston, LLC, and SB Partners Three, LLC, income or loss is allocated to us and our joint venture partners consistent with the allocation of cash distributions in accordance with the joint venture agreements. This results in an income allocation consistent with our percentage of ownership interests.\nAny difference between the carrying amount of any of our investments noted above and the underlying equity in net assets is amortized over the expected useful lives of the properties and other intangible assets.\n21\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 3 – INVESTMENT IN UNCONSOLIDATED JOINT VENTURES (CONTINUED)\nLoss recognized during the three and six months ended June 30, 2021 and 2020, for our investments in unconsolidated joint ventures is as follows:\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Hiren Boston, LLC | $ | ( 354 ) | $ | ( 477 ) | $ | ( 689 ) | $ | ( 880 ) |\n| SB Partners, LLC | ( 50 ) | — | ( 50 ) | ( 600 ) |\n| SB Partners Three, LLC | ( 185 ) | ( 25 ) | ( 508 ) | ( 40 ) |\n| Loss from Unconsolidated Joint Venture Investments | $ | ( 589 ) | $ | ( 502 ) | $ | ( 1,247 ) | $ | ( 1,520 ) |\n\nThe following tables set forth the total assets, liabilities, equity and components of net income or loss, including the Company’s share, related to the unconsolidated joint ventures discussed above as of June 30, 2021 and December 31, 2020 and for the three and six months ended June 30, 2021 and 2020.\nBalance Sheets\n\n| June 30, 2021 | December 31, 2020 |\n| Assets |\n| Investment in Hotel Properties, Net | $ | 65,956 | $ | 581,452 |\n| Other Assets | 14,126 | 32,048 |\n| Total Assets | $ | 80,082 | $ | 613,500 |\n| Liabilities and Equity |\n| Mortgages and Notes Payable | $ | 65,457 | $ | 452,284 |\n| Other Liabilities | 14,939 | 42,197 |\n| Equity: |\n| Hersha Hospitality Trust | 4,099 | 5,699 |\n| Joint Venture Partner(s) | ( 4,413 ) | 113,452 |\n| Accumulated Other Comprehensive Loss | — | ( 132 ) |\n| Total Equity | ( 314 ) | 119,019 |\n| Total Liabilities and Equity | $ | 80,082 | $ | 613,500 |\n\n22\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 3 – INVESTMENT IN UNCONSOLIDATED JOINT VENTURES (CONTINUED)\nStatements of Operations\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Room Revenue | $ | 1,888 | $ | 5,588 | $ | 4,143 | $ | 16,932 |\n| Other Revenue | 125 | — | 242 | 787 |\n| Operating Expenses | ( 1,205 ) | ( 3,265 ) | ( 3,015 ) | ( 11,613 ) |\n| Lease Expense | ( 245 ) | ( 170 ) | ( 516 ) | ( 354 ) |\n| Property Taxes and Insurance | ( 382 ) | ( 3,154 ) | ( 1,948 ) | ( 6,438 ) |\n| General and Administrative | ( 26 ) | ( 553 ) | ( 247 ) | ( 1,516 ) |\n| Depreciation and Amortization | ( 1,300 ) | ( 3,925 ) | ( 3,612 ) | ( 7,840 ) |\n| Interest Expense | ( 642 ) | ( 5,582 ) | ( 3,334 ) | ( 11,869 ) |\n| Loss on Dissolution of Joint Venture | — | — | ( 112,429 ) | — |\n| Net Loss | $ | ( 1,787 ) | $ | ( 11,061 ) | $ | ( 120,716 ) | $ | ( 21,911 ) |\n\nThe following table is a reconciliation of our share in the unconsolidated joint ventures’ equity to our investment in the unconsolidated joint ventures as presented on our balance sheets as of June 30, 2021 and December 31, 2020.\n| June 30, 2021 | December 31, 2020 |\n| Our share of equity recorded on the joint ventures' financial statements | $ | 4,099 | $ | 5,699 |\n| Adjustment to reconcile our share of equity recorded on the joint ventures' financial statements to our investment in unconsolidated joint ventures(1) | 1,837 | 934 |\n| Investment in Unconsolidated Joint Ventures | $ | 5,936 | $ | 6,633 |\n\n(1) Adjustment to reconcile our share of equity recorded on the joint ventures' financial statements to our investment in unconsolidated joint ventures consists of the following:\n•the difference between our basis in the investment in joint ventures and the equity recorded on the joint ventures' financial statements;\n•accumulated amortization of our equity in joint ventures that reflects the difference in our portion of the fair value of joint ventures' assets on the date of our investment when compared to the carrying value of the assets recorded on the joint ventures’ financial statements (this excess or deficit investment is amortized over the life of the properties, and the amortization is included in Income (Loss) from Unconsolidated Joint Venture Investments on our consolidated statement of operations); and\n• cumulative impairment of our investment in joint ventures not reflected on the joint ventures' financial statements, if any.\n23\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 4 - OTHER ASSETS\nOther Assets\nOther Assets consisted of the following at June 30, 2021 and December 31, 2020:\n| June 30, 2021 | December 31, 2020 |\n| Deferred Financing Costs | $ | 1,783 | $ | 2,395 |\n| Prepaid Expenses | 9,540 | 5,692 |\n| Investment in Statutory Trusts | 1,548 | 1,548 |\n| Investment in Non-Hotel Property and Inventories | 2,318 | 2,443 |\n| Deposits with Unaffiliated Third Parties | 2,456 | 2,561 |\n| Deferred Tax Asset, Net of Valuation Allowance of $ 23,438 and $ 23,591 , respectively | 499 | — |\n| Other | 2,251 | 855 |\n| $ | 20,395 | $ | 15,494 |\n\nDeferred Financing Costs – This category represents financing costs paid by the Company to establish our Line of Credit. These costs have been capitalized and will amortize to interest expense over the term of the Line of Credit.\nPrepaid Expenses – Prepaid expenses include amounts paid for property tax, insurance and other expenditures that will be expensed in the next twelve months.\nInvestment in Statutory Trusts – We have an investment in the common stock of Hersha Statutory Trust I and Hersha Statutory Trust II.\nInvestment in Non-Hotel Property and Inventories – This category represents the costs paid and capitalized by the Company for items such as office leasehold improvements, furniture and equipment, and property inventories.\nDeposits with Unaffiliated Third Parties – These deposits represent deposits made by the Company with unaffiliated third parties for items such as lease security deposits, utility deposits, and deposits with unaffiliated third party management companies.\nDeferred Tax Asset – We have recorded a valuation allowance resulting in net deferred tax assets of $ 499 as of June 30, 2021. We have considered various factors, including future reversals of existing taxable temporary differences, future projected taxable income and tax planning strategies in determining a valuation allowance for our deferred tax assets, and we believe that it is more likely than not that we will not be able to realize the net deferred tax assets in the future, and a valuation allowance for the entire deferred tax asset has been recorded, with the exception of a city net operating loss that we believe that we will be able to realize.\n24\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT\nMortgages\nMortgages payable at June 30, 2021 and December 31, 2020 consisted of the following:\n| June 30, 2021 | December 31, 2020 |\n| Mortgage Indebtedness | $ | 305,911 | $ | 332,264 |\n| Net Unamortized Premium | 127 | 354 |\n| Net Unamortized Deferred Financing Costs | ( 1,612 ) | ( 1,770 ) |\n| Mortgages Payable | $ | 304,426 | $ | 330,848 |\n\nNet Unamortized Deferred Financing Costs associated with entering into mortgage indebtedness are deferred and amortized over the life of the mortgages. Net Unamortized Premiums are also amortized over the remaining life of the loans. Mortgage indebtedness balances are subject to fixed and variable interest rates, which ranged from 2.75 % to 6.30 % as of June 30, 2021.\nOur mortgage indebtedness contains various financial and non-financial covenants customarily found in secured, non-recourse financing arrangements. Our mortgage loans typically require that specified debt service coverage ratios be maintained with respect to the financed properties before we can exercise certain rights under the loan agreements relating to such properties. If the specified criteria are not satisfied, the lender may be able to escrow cash flow generated by the property securing the applicable mortgage loan. We have determined that all debt covenants contained in the loan agreements securing our consolidated hotel properties with the exception of two mortgages were met as of June 30, 2021.\nDuring the six months ended June 30, 2021, we refinanced the outstanding mortgages secured by the Hilton Garden Inn 52nd Street, the Courtyard Los Angeles Westside, the Hilton Garden Inn Tribeca, and the Hyatt Union Square, which resulted in $ 90 of debt modification expense.\nAs of June 30, 2021, the maturity dates for the outstanding mortgage loans ranged from September 2021 to September 2025. One mortgage with a total principal balance of $ 21,663 will mature within the next twelve months. We are in active discussions with lenders to refinance this mortgage with property level debt prior to its maturity.\n25\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT (CONTINUED)\nCredit Facilities\nWe maintain three secured credit arrangements which aggregate to $ 747,481 with Citigroup Global Markets Inc., Wells Fargo Bank, Inc. and various other lenders. Our credit agreement (the \"Credit Agreement\") provides for a $ 442,404 senior secured credit facility (“Credit Facility”). The Credit Facility consists of a $ 250,000 senior secured revolving line of credit (“Line of Credit”) and a $ 192,404 senior secured term loan (\"First Term Loan\"), and expires on August 10, 2022.\nWe maintain another credit agreement which provides for a $ 278,846 senior secured term loan agreement (“Second Term Loan”) and expires on September 10, 2024.\nA separate credit agreement provides for a $ 26,231 senior secured term loan agreement (“Third Term Loan” and collectively with the Credit Agreement and the Second Term Loan, the \"Credit Agreements\") and expires on August 10, 2022. Management intends to explore options including, but not limited to, additional asset sales, the refinancing of debt and the offering of equity or equity-linked securities prior to the maturity of the First Term Loan and the Third Term Loan on August 10, 2022.\nOn February 17, 2021, the Company signed amendments to the Credit Agreements which resulted in debt extinguishment expense $2,977. Debt extinguishment expense consists of $ 635 of debt extinguishment losses and $ 2,342 of debt modification losses. The signed amendments to the Credit Agreements, among other things, provide for:\n•an extension of the maturity date of the Third Term Loan to August 10, 2022;\n•a limited waiver of financial covenants through March 31, 2022; and\n•the ability to borrow up to $ 174,729 , inclusive of amounts already outstanding, under the Line of Credit, the proceeds of which may only be used to fund certain costs and expenses.\nCertain conditions, such as minimum liquid assets in an aggregate amount of at least $ 30,000 , and certain negative covenants and restrictions that are considered normal and customary, must be met on a recurring basis as outlined within the amendments.\nThe amendments to the Credit Agreements make certain other amendments to financial covenants in place beginning in the second quarter of 2022:\n•a fixed charge coverage ratio of not less than 1.20 to 1.00 (was 1.50 to 1.00);\n•a maximum leverage ratio of not more than 65 % (was 60 %); and\n•a new financial covenant that requires the borrowing base leverage ratio to not exceed 60 % at any time.\nThe amount that we can borrow at any given time under our Line of Credit, and the individual term loans (each a “Term Loan” and together the “Term Loans”) is governed by certain operating metrics of designated hotel properties known as borrowing base assets. As of June 30, 2021, the following hotel properties secured the amended facilities under the Credit Agreements:\n26\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT (CONTINUED)\n| - Courtyard by Marriott Brookline, Brookline, MA | - Hampton Inn, Washington, DC |\n| - The Envoy Boston Seaport, Boston, MA | - Ritz-Carlton Georgetown, Washington, DC |\n| - The Boxer, Boston, MA | - Hilton Garden Inn, M Street, Washington, DC |\n| - Hampton Inn Seaport, Seaport, New York, NY | - The Winter Haven Hotel Miami Beach, Miami, FL |\n| - Holiday Inn Express Chelsea, 29th Street, New York, NY | - The Blue Moon Hotel Miami Beach, Miami, FL |\n| - Gate Hotel JFK Airport, New York, NY | - Cadillac Hotel & Beach Club, Miami, FL |\n| - Hilton Garden Inn JFK Airport, New York, NY | - The Parrot Key Hotel & Villas, Key West, FL |\n| - NU Hotel, Brooklyn, New York, NY | - TownePlace Suites, Sunnyvale, CA |\n| - Hyatt House White Plains, White Plains, NY | - The Ambrose Hotel, Santa Monica, CA |\n| - Hampton Inn Center City/ Convention Center, Philadelphia, PA | - The Pan Pacific Hotel Seattle, Seattle, WA |\n| - The Rittenhouse, Philadelphia, PA | - Mystic Marriott Hotel & Spa, Groton, CT |\n| - Philadelphia Westin, Philadelphia, PA |\n\nThe interest rate for borrowings under the Line of Credit and Term Loans are based on a pricing grid with a range of one month U.S. LIBOR plus a spread. The following table summarizes the balances outstanding and interest rate spread for each borrowing:\n| Outstanding Balance |\n| Borrowing | Spread | June 30, 2021 | December 31, 2020 |\n| Line of Credit | 1.50 % to 2.25 % | $ | 118,684 | $ | 133,053 |\n| Term Loans: |\n| First Term Loan | 1.45 % to 2.20 % | $ | 192,404 | $ | 202,158 |\n| Second Term Loan | 1.35 % to 2.00 % | 278,846 | 292,983 |\n| Third Term Loan | 1.45 % to 2.20 % | 26,231 | 189,365 |\n| Deferred Loan Costs | ( 1,824 ) | ( 2,762 ) |\n| Total Term Loans | $ | 495,657 | $ | 681,744 |\n\nPrior to the amendments noted above, the Credit Agreements included certain financial covenants and required that we maintain: (1) a minimum tangible net worth (calculated as total assets, plus accumulated depreciation, less total liabilities, intangibles and other defined adjustments) of $ 1,119,500 , plus an amount equal to 75 % of the net cash proceeds of all issuances and primary sales of equity interests of the parent guarantor or any of its subsidiaries consummated following the closing date; (2) annual distributions not to exceed 95 % of adjusted funds from operations; and (3) certain financial ratios, including the following:\n•a fixed charge coverage ratio of not less than 1.50 to 1.00;\n•a maximum leverage ratio of not more than 60 %; and\n•a maximum secured debt leverage ratio of 45 %.\nThe weighted average interest rate, inclusive of the effect of derivative instruments, on the Credit Agreements was 3.92 % and 4.23 %, and 3.73 % and 4.21 %, for the three and six months ended June 30, 2021 and 2020, respectively.\n27\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT (CONTINUED)\nNotes Payable\nNotes payable at June 30, 2021 and December 31, 2020 consisted of the following:\n| June 30, 2021 | December 31, 2020 |\n| Notes Payable | $ | 204,062 | $ | 51,548 |\n| Net Unamortized Discount | ( 4,899 ) | — |\n| Net Unamortized Deferred Financing Costs | ( 5,438 ) | ( 759 ) |\n| Notes Payable | $ | 193,725 | $ | 50,789 |\n\nStatutory Trust I and Statutory Trust II Notes Payable\nWe have two junior subordinated notes payable in the aggregate amount of $ 51,548 related to the Hersha Statutory Trusts pursuant to indenture agreements which will mature on July 30, 2035, but may be redeemed at our option, in whole or in part, prior to maturity in accordance with the provisions of the indenture agreements. The $ 25,774 of notes issued to each of Hersha Statutory Trust I and Hersha Statutory Trust II bear interest at a variable rate of LIBOR plus 3 % per annum. This rate resets 2 business days prior to each quarterly payment. The related deferred financing costs are amortized over the life of the notes payable. The weighted average interest rate on our two junior subordinated notes payable was 3.19 % and 4.08 % for the three months ended June 30, 2021 and 2020, respectively, and 3.20 % and 4.45 % for the six months ended June 30, 2021 and 2020, respectively.\nJunior Notes Payable\nOn February 17, 2021, the Company entered into a note purchase agreement (the “Purchase Agreement”) with several purchasers (the “Purchasers”). The Company agreed to issue and sell to the Purchasers an initial $ 150,000 aggregate principal amount (the “Initial Notes”) of the Company’s 9.50 % Unsecured PIK Toggle Notes due 2026 (the “Notes”), and an incremental $ 50,000 aggregate principal amount of the Notes that can be drawn at the Company’s discretion, subject to certain conditions, in minimum installments of $ 25,000 on or prior to September 30, 2021.\nThe Initial Notes were issued on February 23, 2021. The Notes will mature on February 23, 2026. The Notes bear interest at a rate of 9.50 % per year, payable in arrears on June 30, September 30, December 31 and March 31 of each year, beginning on June 30, 2021. For any interest period ending on or prior to March 31, 2022, the Issuer, in its sole discretion may elect to pay interest (a) in cash at a rate per annum equal to 4.75 % per annum, and (b) in kind at a rate per annum equal to 4.75 % per annum (“PIK Interest”). Any PIK Interest will be paid by increasing the principal amount of the Notes at the end of the applicable interest period by the amount of such PIK Interest. We elected the PIK Interest option for the interest period ended June 30, 2021, increasing the principal balance $ 2,514 to $ 152,514 as of June 30, 2021.\nThe Notes may not be redeemed prior to February 23, 2022. The notes may be redeemed during the 12 month period beginning February 23, 2022 and the 12 month period beginning February 23, 2023, at a redemption price equal to 104 % and 102 % of the principal amount of the Notes being redeemed, respectively. After February 23, 2024, the notes may be redeemed at the principal amount.\nThe Notes are subject to representations, warranties, covenants, terms and conditions customary for transactions of this type, including limitations on liens, incurrence of new debt, investments, mergers and asset dispositions, covenants to preserve corporate existence and comply with laws and default provisions.\nThe Company may only use the net proceeds from the issuance of the Notes in accordance with the mandatory prepayment waterfalls, which includes the repayment of outstanding borrowings under the Credit Agreement and use for certain other general corporate purposes.\n28\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT (CONTINUED)\nInterest Expense\nThe table below shows the interest expense incurred by the Company during the three and six months ended June 30, 2021 and 2020:\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Mortgage Loans Payable | $ | 2,680 | $ | 3,031 | $ | 5,415 | $ | 6,516 |\n| Interest Rate Swap Contracts on Mortgages | 627 | 552 | 1,230 | 585 |\n| Unsecured Notes Payable | 4,311 | 532 | 6,248 | 1,160 |\n| Credit Facility and Term Loans | 3,754 | 5,370 | 8,122 | 12,404 |\n| Interest Rate Swap Contracts on Credit Agreements | 2,417 | 3,133 | 4,841 | 4,219 |\n| Deferred Financing Costs Amortization | 1,088 | 702 | 2,380 | 1,267 |\n| Other | 105 | 161 | 175 | 337 |\n| Total Interest Expense | $ | 14,982 | $ | 13,481 | $ | 28,411 | $ | 26,488 |\n\n29\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 6 – LEASES\nWe own five hotels within our consolidated portfolio of hotels where we do not own the land on which the hotels reside, rather we lease the land from an unrelated third-party lessor. All of our land leases are classified as operating leases and have initial terms with extension options that range from May 2062 to October 2103. We also have two additional office space leases with terms ranging from March 2023 to December 2027.\nThe components of lease costs for the three months ended June 30, 2021 and 2020 were as follows:\n| Three Months Ended June 30, 2021 | Three Months Ended June 30, 2020 |\n| Ground Lease | Office Lease | Total | Ground Lease | Office Lease | Total |\n| Operating lease costs | $ | 1,050 | $ | 121 | $ | 1,171 | $ | 1,050 | $ | 121 | $ | 1,171 |\n| Variable lease costs | 14 | 83 | 97 | 8 | 87 | 95 |\n| Total lease costs | $ | 1,064 | $ | 204 | $ | 1,268 | $ | 1,058 | $ | 208 | $ | 1,266 |\n\nThe components of lease costs for the six months ended June 30, 2021 and 2020 were as follows:\n| Six months ended June 30, 2021 | Six months ended June 30, 2020 |\n| Ground Lease | Office Lease | Total | Ground Lease | Office Lease | Total |\n| Operating lease costs | $ | 2,126 | $ | 242 | $ | 2,368 | $ | 2,100 | $ | 242 | $ | 2,342 |\n| Variable lease costs | 38 | 167 | 205 | 21 | 154 | 175 |\n| Total lease costs | $ | 2,164 | $ | 409 | $ | 2,573 | $ | 2,121 | $ | 396 | $ | 2,517 |\n\nOther information related to leases as of and for the six months ended June 30, 2021 and 2020 is as follows:\n| June 30, 2021 | June 30, 2020 |\n| Cash paid from operating cash flow for operating leases | $ | 2,246 | $ | 1,951 |\n| Weighted average remaining lease term | 64.2 | 64.2 |\n| Weighted average discount rate | 7.87 | % | 7.86 | % |\n\n30\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 7 – COMMITMENTS AND CONTINGENCIES AND RELATED PARTY TRANSACTIONS\nManagement Agreements\nOur wholly-owned TRS, 44 New England Management Company, and certain of our joint venture entities engage eligible independent contractors in accordance with the requirements for qualification as a REIT under the Internal Revenue Code of 1986, as amended, including Hersha Hospitality Management Limited Partnership (“HHMLP”), as the property managers for hotels it leases from us pursuant to management agreements. HHMLP is owned, in part, by certain executives and trustees of the Company. Our management agreements with HHMLP provide for a term of five years and are subject to early termination upon the occurrence of defaults and certain other events described therein. As required under the REIT qualification rules, HHMLP must qualify as an “eligible independent contractor” during the term of the management agreements. Under the management agreements, HHMLP generally pays the operating expenses of our hotels. All operating expenses or other expenses incurred by HHMLP in performing its authorized duties are reimbursed or borne by our TRS to the extent the operating expenses or other expenses are incurred within the limits of the applicable approved hotel operating budget. HHMLP is not obligated to advance any of its own funds for operating expenses of a hotel or to incur any liability in connection with operating a hotel. Management agreements with other unaffiliated hotel management companies have similar terms.\nFor its services, HHMLP receives a base management fee and, if a hotel exceeds certain thresholds, an incentive management fee. The base management fee for a hotel is due monthly and is equal to 3 % of gross revenues associated with each hotel managed for the related month. The incentive management fee, if any, for a hotel is due annually in arrears on the ninetieth day following the end of each fiscal year and is based upon the financial performance of the hotels. For the three and six months ended June 30, 2021 and 2020, base management fees incurred to HHMLP totaled $ 1,745 and $ 564 , and $ 2,925 and $ 2,933 , respectively, and are recorded as Hotel Operating Expenses. For the three and six months ended June 30, 2021 and 2020, we did no t incur incentive management fees.\nFranchise Agreements\nOur branded hotel properties are operated under franchise agreements assumed by the hotel property lessee. The franchise agreements have 10 to 20 year terms, but may be terminated by either the franchisee or franchisor on certain anniversary dates specified in the agreements. The franchise agreements require annual payments for franchise royalties, reservation, and advertising services, and such payments are based upon percentages of gross room revenue. These payments are paid by the hotels and charged to expense as incurred. Franchise fee expenses for the three and six months ended June 30, 2021 and 2020 were $ 2,465 and $ 775 , and $ 4,287 and $ 4,603 , respectively, and are recorded in Hotel Operating Expenses. The initial fees incurred to enter into the franchise agreements are amortized over the life of the franchise agreements.\nAccounting and Information Technology Fees\nEach of the wholly-owned hotels and consolidated joint venture hotel properties managed by HHMLP incurs a monthly accounting and information technology fee. Monthly fees for accounting services are between $ 2 and $ 3 per property and monthly information technology fees range from $ 1 to $ 2 per property. For the three and six months ended June 30, 2021 and 2020, the Company incurred accounting fees of $ 277 and $ 319 , and $ 590 and $ 644 , respectively. For the three and six months ended June 30, 2021 and 2020, the Company incurred information technology fees of $ 90 and $ 103 , and $ 191 and $ 208 , respectively. Accounting fees and information technology fees are included in Hotel Operating Expenses.\nCapital Expenditure Fees\nHHMLP charges a 5 % fee on certain capital expenditures and pending renovation projects at the properties as compensation for procurement services related to capital expenditures and for project management of renovation projects. For the three and six months ended June 30, 2021 and 2020, we incurred fees of $ 78 and $ 56 , and $ 197 and $ 956 , respectively, which were capitalized with the cost of capital expenditures.\n31\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 7 – COMMITMENTS AND CONTINGENCIES AND RELATED PARTY TRANSACTIONS (CONTINUED)\nAcquisitions from Affiliates\nWe have entered into an option agreement with certain of our officers and trustees such that we obtain a right of first refusal to purchase any hotel owned or developed in the future by these individuals or entities controlled by them at fair market value. This right of first refusal would apply to each party until one year after such party ceases to be an officer or trustee of the Company. Our Acquisition Committee of the Board of Trustees is comprised solely of independent trustees, and the purchase prices and all material terms of the purchase of hotels from related parties are approved by the Acquisition Committee.\nHotel Supplies\nFor the three and six months ended June 30, 2021 and 2020, we incurred charges for hotel supplies of $ 0 and $ 11 , and $ 1 and $ 63 , respectively. For the three and six months ended June 30, 2021 and 2020, we incurred charges for capital expenditure purchases of $ 86 and $ 176 , and $ 220 and $ 1,056 , respectively. These purchases were made from Hersha Purchasing and Design, a hotel supply company owned, in part, by certain executives and trustees of the Company. Hotel supplies are expensed and included in Hotel Operating Expenses on our consolidated statements of operations, and capital expenditure purchases are included in investment in hotel properties on our consolidated balance sheets.\nInsurance Services\nPrior to January 1, 2021, the Company utilized the services of the Hersha Group, a risk management business owned, in part, by certain executives and trustees of the Company. The Hersha Group provided consulting and procurement services to the Company related to the placement of property and casualty insurance, placement of general liability insurance, and for claims handling for our hotel properties. Beginning January 1, 2021, these services were provided by a third-party service provider. For the three and six months ended June 30, 2020, the total cost of property insurance that we paid through the Hersha Group were $ 1,388 and $ 2,984 , respectively. This amount paid to the Hersha Group included insurance premiums and brokerage fees as compensation for brokerage services.\nRestaurant Lease Agreements with Independent Restaurant Group\nThe Company enters into lease agreements with a number of restaurant management companies for the lease of restaurants located within our hotels. The Company previously entered into lease agreements with Independent Restaurant Group (\"IRG\") for restaurants at three of its hotel properties. Jay H. Shah and Neil H. Shah, executive officers and/or trustees of the Company, collectively own a 70.0 % interest in IRG. The Company’s restaurant lease agreements with IRG generally provided for a term of five years and the payment of base rents and percentage rents, which were based on IRG’s revenue in excess of defined thresholds. Effective April 1, 2020, each of these lease agreements became a management agreement between the Company and IRG, subject to the supervision of HHMLP, as property manager. At the time of the conversion of the lease agreements to management agreements there was rent due of $ 103 , which was forgiven due to the impact of the COVID-19 pandemic on the operations of our hotels and IRG's restaurants. For the six months ended June 30, 2021 and 2020, we did no t recognize any revenue from IRG.\nDue From Related Parties\nThe due from related parties balance as of June 30, 2021 and December 31, 2020 was approximately $ 1,552 and $ 2,641 , respectively. The balances primarily consisted of working capital deposits made to HHMLP and other entities owned, in part, by certain executives and trustees of the Company.\nDue to Related Parties\nThe balance due to related parties as of June 30, 2021 and December 31, 2020 was $ 0 .\n32\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 8 – FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS\nFair Value Measurements\nOur determination of fair value measurements are based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, we utilize a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).\nLevel 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Level 2 inputs are inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs may include quoted prices for similar assets and liabilities in active markets, as well as inputs that are observable for the asset or liability (other than quoted prices), such as interest rates, foreign exchange rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liabilities, which are typically based on an entity’s own assumptions, as there is little, if any, related market activity. In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.\nAs of June 30, 2021, the Company’s derivative instruments represented the only financial instruments measured at fair value. Currently, the Company uses derivative instruments, such as interest rate swaps and caps, to manage its interest rate risk. The valuation of these instruments is determined using widely accepted valuation techniques, including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs.\nWe incorporate credit valuation adjustments to appropriately reflect both our own nonperformance risk and the respective counter-party’s nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, we have considered the impact of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts and guarantees.\nAlthough we have determined that the majority of the inputs used to value our derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with our derivatives utilize Level 3 inputs, such as estimates of current credit spreads, to evaluate the likelihood of default by us and the counter-parties. However, as of June 30, 2021 we have assessed the significance of the effect of the credit valuation adjustments on the overall valuation of our derivative positions and have determined that the credit valuation adjustments are not significant to the overall valuation of our derivatives. As a result, we have determined that our derivative valuations in their entirety are classified in Level 2 of the fair value hierarchy.\nDerivative Instruments\nThe Company’s objective in using derivatives is to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps and interest rate caps as part of its cash flow hedging strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts in exchange for fixed-rate payments over the life of the agreements without exchange of the underlying principal amount. Interest rate caps designated as cash flow hedges limit the Company’s exposure to increased cash payments due to increases in variable interest rates. The table on the following page presents our derivative instruments as of June 30, 2021 and December 31, 2020.\n33\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 8 – FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS (CONTINUED)\n| Estimated Fair Value |\n| (Liability) Balance |\n| Hedged Debt | Type | Strike Rate | Effective Date | Derivative Contract Maturity Date | Notional Amount | June 30, 2021 | December 31, 2020 |\n| Term Loan Instruments: |\n| Credit Facility | Swap | 1.341 | % | 1-Month LIBOR + 2.20 % | October 3, 2019 | August 2, 2021 | 150,000 | $ | ( 165 ) | $ | ( 1,070 ) |\n| Credit Facility (1) | Swap | 1.316 | % | 1-Month LIBOR + 2.20 % | September 3, 2019 | August 2, 2021 | 43,900 | ( 47 ) | ( 307 ) |\n| Credit Facility | Swap | 1.824 | % | 1-Month LIBOR + 2.20 % | September 3, 2019 | August 10, 2022 | 103,500 | ( 1,944 ) | ( 2,793 ) |\n| Credit Facility | Swap | 1.824 | % | 1-Month LIBOR + 2.20 % | September 3, 2019 | August 10, 2022 | 103,500 | ( 1,944 ) | ( 2,793 ) |\n| Credit Facility | Swap | 1.460 | % | 1-Month LIBOR + 2.00 % | September 10, 2019 | September 10, 2024 | 300,000 | ( 8,790 ) | ( 13,286 ) |\n| Mortgages: |\n| Annapolis Waterfront Hotel, MD | Cap | 3.350 | % | 1-Month LIBOR + 2.65 % | May 1, 2018 | May 1, 2021 | 28,000 | — | — |\n| Hyatt, Union Square, New York, NY | Swap | 1.870 | % | 1-Month LIBOR + 2.30 % | June 7, 2019 | June 7, 2023 | 56,000 | ( 1,743 ) | ( 2,305 ) |\n| Hilton Garden Inn Tribeca, New York, NY | Swap | 1.768 | % | 1-Month LIBOR + 2.25 % | July 25, 2019 | July 25, 2024 | 22,725 | ( 869 ) | ( 1,222 ) |\n| Hilton Garden Inn Tribeca, New York, NY | Swap | 1.768 | % | 1-Month LIBOR + 2.25 % | July 25, 2019 | July 25, 2024 | 22,725 | ( 869 ) | ( 1,222 ) |\n| Hilton Garden Inn 52nd Street, New York, NY | Swap | 1.540 | % | 1-Month LIBOR + 2.30 % | December 4, 2019 | December 4, 2022 | 44,325 | ( 869 ) | ( 1,186 ) |\n| Courtyard, LA Westside, Culver City, CA (2) | Swap | 0.495 | % | 1-Month LIBOR + 3.75 % | June 1, 2020 | August 1, 2021 | 35,000 | ( 12 ) | ( 75 ) |\n| $ | ( 17,252 ) | $ | ( 26,259 ) |\n\n(1) During the six months ended June 30, 2021, we dedesignated this swap as a cash flow hedge and recorded expense of $ 330 accordingly.\n(2) Subsequent to June 30, 2021, we entered into an interest rate cap for this debt, which is effective on August 1, 2021.\nThe fair value of our interest rate swaps is included in accounts payable, accrued expenses and other liabilities at June 30, 2021 and December 31, 2020.\nThe net change related to derivative instruments designated as cash flow hedges recognized as unrealized gains and losses reflected on our consolidated balance sheet in accumulated other comprehensive income was a gain of $ 2,398 and a loss of $ 792 for the three months ended June 30, 2021 and 2020, respectively, and a gain of $ 9,163 and a loss of $ 30,941 for the six months ended June 30, 2021 and 2020, respectively.\n34\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 8 – FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS (CONTINUED)\nAmounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are made on the Company’s variable-rate derivatives. The change in net unrealized gains/losses on cash flow hedges reflects a reclassification of $( 141 ) and $ 1,228 and $ 159 and $ 2,205 of net unrealized gains from accumulated other comprehensive income as an increase/decrease to interest expense for the three and six months ended June 30, 2021 and 2020, respectively. For the next twelve months ending June 30, 2022, we estimate that an additional $ 10,059 will be reclassified as an increase to interest expense.\nFair Value of Debt\nWe estimate the fair value of our fixed rate debt and the credit spreads over variable market rates on our variable rate debt by discounting the future cash flows of each instrument at estimated market rates or credit spreads consistent with the maturity of the debt obligation with similar credit policies. Credit spreads take into consideration general market conditions and maturity. The inputs utilized in estimating the fair value of debt are classified in Level 2 of the fair value hierarchy. As of June 30, 2021, the carrying value and estimated fair value of our debt was $ 1,112,492 and $ 1,141,023 respectively. As of December 31, 2020, the carrying value and estimated fair value of our debt was $ 1,196,434 and $ 1,176,625 , respectively.\n35\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 9 – SHARE BASED PAYMENTS\nOur shareholders approved the Hersha Hospitality Trust 2012 Equity Incentive Plan, as amended, (the “2012 Plan”) for the purpose of attracting and retaining executive officers, employees, trustees and other persons and entities that provide services to the Company.\nThe Short Term Incentive Program (\"STIP\") and the Long-Term Incentive Program (\"LTIP\") were incentive compensation programs the Compensation Committee of our Board of Trustees established to align executive compensation with the performance of the Company. Prior to 2019, executives participated in our legacy incentive compensation programs, including the Multi-Year Long Term Equity Incentive Program (\"Multi-Year EIP\").\nOn March 17, 2021, based on the achievement of certain metrics established under the 2020 STIP for the performance period ended December 31, 2020, the Compensation Committee awarded 519,732 LTIP Units. The awards issued pursuant to the STIP vest on December 31, 2022, the two year anniversary following the end of the performance period.\nOn March 3, 2021, the Compensation Committee approved the 2021 LTIP in which 50 % of the awards provide for time based vesting and the remaining 50 % are issuable based on the Company's achievement of a certain level of (1) absolute total shareholder return ( 37.5 % of the award), (2) relative total shareholder return as compared to the Company’s peer\ngroup ( 37.5 % of the award), and (3) relative growth in revenue per available room (\"RevPar\") compared to the Company’s peer group ( 25.0 % of the award). On March 17, 2021, the Compensation Committee awarded 247,689 LTIP Units related to the time based portion of the plan. These Units will vest over a three year period from January 1, 2021 to December 31, 2023. The 50 % market-based portion of the 2021 LTIP has a three-year performance period which commenced on January 1, 2021 and ends December 31, 2023. As of June 30, 2021, no shares or LTIP Units have been issued to the executive officers in settlement of 2021 LTIP market-based awards.\nThe LTIP Units awarded under both the 2020 STIP and the 2021 LTIP were determined by dividing the dollar amount of award earned by $ 8.43 , the per share volume weighted average trading price of the Company’s common shares on the NYSE for the 20 trading days prior to December 31, 2020.\n| LTIP Unit Awards | Restricted Share Awards | Share Awards |\n| Number of Units | Weighted Average Grant Date Fair Value | Number of Restricted Shares | Weighted Average Grant Date Fair Value | Number of Shares | Weighted Average Grant Date Fair Value |\n| Unvested Balance as of December 31, 2020 | 898,126 | $ | 6.15 | 202,878 | $ | 7.87 | — |\n| Granted | 794,683 | 12.86 | 116,743 | 10.18 | 32,460 | 11.31 |\n| Vested | ( 13,512 ) | 12.23 | ( 239,736 ) | 7.73 | ( 32,460 ) | 11.31 |\n| Forfeited | — | N/A | ( 150 ) | 11.31 | — | N/A |\n| Unvested Balance as of June 30, 2021 | 1,679,297 | $ | 9.28 | 79,735 | $ | 11.68 | — |\n\n36\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 9 – SHARE BASED PAYMENTS (CONTINUED)\n| Share BasedCompensation Expense | UnearnedCompensation |\n| For the Three Months Ended | For the Six Months Ended | As of |\n| June 30, 2021 | June 30, 2020 | June 30, 2021 | June 30, 2020 | June 30, 2021 | December 31, 2020 |\n| Issued Awards |\n| LTIP Unit Awards | $ | 1,534 | $ | 1,142 | $ | 3,258 | $ | 2,951 | $ | 8,049 | $ | 1,842 |\n| Restricted Share Awards | 254 | 342 | 422 | 674 | 762 | 276 |\n| Share Awards | 367 | — | 367 | — | — | — |\n| Unissued Awards |\n| Market Based | 434 | 315 | 711 | 630 | 3,019 | 1,933 |\n| Performance Based | — | — | — | — | — | — |\n| Total | $ | 2,589 | $ | 1,799 | $ | 4,758 | $ | 4,255 | $ | 11,830 | $ | 4,051 |\n\nThe weighted-average period of which the unrecognized compensation expense will be recorded is approximately 2.0 years for LTIP Unit Awards and 1.1 years for Restricted Share Awards.\n| 2021 | 2022 | 2023 | 2024 |\n| LTIP Unit Awards | 960,046 | 595,406 | 61,921 | 61,924 |\n| Restricted Share Awards | — | 66,202 | 10,533 | 3,000 |\n| 960,046 | 661,608 | 72,454 | 64,924 |\n\n37\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 10 – EARNINGS PER SHARE\nThe following table is a reconciliation of the income or loss (numerator) and the weighted average shares (denominator) used in the calculation of basic and diluted earnings per common share. The computation of basic and diluted earnings per share is presented below.\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| NUMERATOR: |\n| Basic and Diluted* |\n| Net Loss | $ | ( 23,523 ) | $ | ( 71,780 ) | $ | ( 14,433 ) | $ | ( 97,752 ) |\n| Loss allocated to Noncontrolling Interests | 977 | 10,360 | 813 | 13,257 |\n| Distributions to Preferred Shareholders | ( 6,044 ) | ( 6,044 ) | ( 12,087 ) | ( 12,088 ) |\n| Net loss applicable to Common Shareholders | $ | ( 28,590 ) | $ | ( 67,464 ) | $ | ( 25,707 ) | $ | ( 96,583 ) |\n| DENOMINATOR: |\n| Weighted average number of common shares - basic | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\n| Effect of dilutive securities: |\n| Restricted Stock Awards and LTIP Units (unvested) | — | — | — | — |\n| Contingently Issued Shares and Units | — | — | — | — |\n| Weighted average number of common shares - diluted | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\n\n*Income (loss) allocated to noncontrolling interest in HHLP has been excluded from the numerator and Common Units and Vested LTIP Units have been omitted from the denominator for the purpose of computing diluted earnings per share since including these amounts in the numerator and denominator would have no impact. In addition, potentially dilutive common shares, if any, have been excluded from the denominator if they are anti-dilutive to income (loss) applicable to common shareholders.\n38\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 11 – CASH FLOW DISCLOSURES AND NON CASH INVESTING AND FINANCING ACTIVITIES\nInterest paid during the six months ended June 30, 2021 and 2020 totaled $ 20,052 and $ 21,488 , respectively. Net Cash paid on Interest Rate Derivative contracts during the six months ended June 30, 2021 and 2020 totaled $ 6,259 and $ 1,505 , respectively. Cash paid for income taxes during the six months ended June 30, 2021 and 2020 totaled $ 60 and $ 233 , respectively. The following non-cash investing and financing activities occurred during the six months ended June 30, 2021 and 2020:\n| 2021 | 2020 |\n| Common Shares issued as part of the Dividend Reinvestment Plan | $ | — | $ | 14 |\n| Issuance of share based payments | 13,103 | 6,404 |\n| Accrued payables for capital expenditures placed into service | 230 | 1,398 |\n| Adjustment to Record Noncontrolling Interest at Redemption Value | 1,968 | ( 3,196 ) |\n\nThe following table provides a reconciliation of cash, cash equivalents, and restricted cash reported within the consolidated balance sheets that sum to the total of the same such amounts shown in the consolidated statements of cash flows for the six months ended June 30, 2021 and 2020:\n| 2021 | 2020 |\n| Cash and cash equivalents | $ | 69,083 | $ | 23,228 |\n| Escrowed cash | 11,067 | 7,374 |\n| Total cash, cash equivalents, and restricted cash shown in the consolidated statements of cash flows | $ | 80,150 | $ | 30,602 |\n\nAmounts included in restricted cash represent those required to be set aside in escrow by contractual agreement with various lenders for the payment of specific items such as property insurance, property tax, and capital expenditures.\n39\nItem 2.\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations\nCautionary Statement Regarding Forward Looking Statements\nThis report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including, without limitation, statements containing the words, “believe,” “expect,” “anticipate,” “estimate,” “plan,” “continue,” “intend,” “should,” “may” and words of similar import. Such forward-looking statements relate to future events, our plans, strategies, prospects and future financial performance, and involve known and unknown risks that are difficult to predict, uncertainties and other factors which may cause our actual results, performance or achievements or industry results to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Readers should specifically consider the various factors identified in this report and other reports filed by us with the U.S. Securities and Exchange Commission (the \"SEC\"), including, but not limited to those discussed in the sections entitled “Risk Factors” and \"Management's Discussion and Analysis of Financial Conditions and Results of Operations\" of our Annual Report on Form 10-K for the year ended December 31, 2020 and in this Quarterly Report on Form 10-Q, that could cause actual results to differ. Statements regarding the following subjects are forward-looking by their nature:\n● our business or investment strategy;\n● our projected operating results;\n● our ability to generate positive cash flow from operations;\n● our distribution policy;\n● our liquidity and management's plans with respect thereto;\n● completion of any pending transactions;\n● our ability to maintain existing financing arrangements, including compliance with covenants and our ability to obtain future financing arrangements or refinance or extend the maturity of existing financing arrangements as they come due;\n● our ability to negotiate with lenders;\n● our understanding of our competition;\n● market trends;\n● projected capital expenditures;\n● the impact of and changes to various government programs, including in response to the novel coronavirus, or COVID-19, including those specifically affecting New York City;\n● the efficacy of any treatment for COVID-19;\n● our access to capital on the terms and timing we expect;\n● the restoration of public confidence in domestic and international travel;\n● permanent structural changes in demand for conference centers by business and leisure clientele; and\n● our ability to dispose of selected hotel properties on the terms and timing we expect, if at all.\nForward-looking statements are based on our beliefs, assumptions and expectations, taking into account all information currently available to us. These beliefs, assumptions and expectations are subject to risks and uncertainties and can change as a result of many possible events or factors, not all of which are known to us. If a change occurs, our business, financial condition, liquidity and results of operations may vary materially from those expressed in our forward-looking statements. Readers should not place undue reliance on forward-looking statements.\nImportant factors that we think could cause our actual results to differ materially from expected results are summarized below. One of the most significant factors, however, is the ongoing impact of the current outbreak of the novel coronavirus on the United States, regional and global economies, the broader financial markets, our customers and employees, governmental responses thereto and the operation changes we have and may implement in response thereto. The current outbreak of COVID-19 has also impacted, and is likely to continue to impact, directly or indirectly, many other important factors below.\nNew factors emerge from time to time, and it is not possible for us to predict which factors will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. In particular, it is difficult to fully assess the impact of COVID-19 at this time due to, among other factors, uncertainty regarding the severity and duration of the outbreak domestically and internationally, and the possibility of additional subsequent widespread outbreaks and variant strains and the impacts of actions taken in response, and the effectiveness of federal, state and local governments’ efforts to contain the spread of COVID-19 and respond to its direct and indirect impact on the U.S. economy and economic activity.\n40\nThe following non-exclusive list of factors could also cause actual results to vary from our forward-looking statements:\n● general volatility of the capital markets and the market price of our common shares;\n● changes in our business or investment strategy;\n● availability, terms and deployment of capital;\n● changes in our industry and the market in which we operate, interest rates, or the general economy;\n● decreased international travel because of geopolitical events, including terrorism and current U.S. government policies such as immigration policies, border closings, and travel bans related to COVID-19;\n● the degree and nature of our competition;\n● financing risks, including (i) the risk of leverage and the corresponding risk of default on our mortgage loans and other debt, including default with respect to applicable covenants, (ii) potential inability to obtain waivers of covenants or refinance or extend the maturity of existing indebtedness and (iii) our ability to negotiate with lenders;\n● levels of spending in the business, travel and leisure industries, as well as consumer confidence;\n● declines in occupancy, average daily rate and RevPAR and other hotel operating metrics;\n● hostilities, including future terrorist attacks, or fear of hostilities that affect travel;\n● financial condition of, and our relationships with, our joint venture partners, third-party property managers, and franchisors;\n● increased interest rates and operating costs;\n● ability to complete development and redevelopment projects;\n● risks associated with potential dispositions of hotel properties;\n● availability of and our ability to retain qualified personnel;\n● decreases in tourism due to pandemics, geopolitical instability or changes in foreign exchange rates;\n● our failure to maintain our qualification as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended, or the \"Code\";\n● environmental uncertainties and risks related to natural disasters and increases in costs to insure against those risks;\n● changes in real estate and zoning laws and increases in real property tax rates;\n● the uncertainty and economic impact of pandemics, epidemics, or other public health emergencies or fear of such events, such as the recent outbreak of COVID-19, including with respect to New York City;\n● the current COVID-19 pandemic had, and will continue to have, adverse effects on our financial conditions, results of operations, cash flows, and performance for an indefinite period of time. Future pandemics may also have adverse effects on our financial condition, results of operations, cash flows, and performance;\n● world events impacting the ability or desire of people to travel may lead to a decline in demand for hotels; and\n● the factors discussed in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2020 under the headings “Risk Factors” and \"Management's Discussion and Analysis of Financial Condition and Results of Operations\" and in other reports we file with the SEC from time to time.\nThese factors are not necessarily all of the important factors that could cause our actual results, performance or achievements to differ materially from those expressed in or implied by any of our forward-looking statements. Other unknown or unpredictable factors, many of which are beyond our control, also could harm our results, performance or achievements.\nAll forward-looking statements contained in this report are expressly qualified in their entirety by the cautionary statements set forth above. Forward-looking statements speak only as of the date they are made, and we do not undertake or assume any obligation to update publicly any of these statements to reflect actual results, new information or future events, changes in assumptions or changes in other factors affecting forward-looking statements, except to the extent required by applicable laws. If we update one or more forward-looking statements, no inference should be drawn that we will make additional updates with respect to those or other forward-looking statements.\nBACKGROUND\nAs of June 30, 2021, we owned interests in 36 hotels in major urban gateway markets including New York, Washington DC, Boston, Philadelphia, San Diego, Los Angeles, Seattle, and Miami, including 32 wholly-owned hotels, 1 hotel through our interest in a consolidated joint venture, and interests in 3 hotels owned through unconsolidated joint ventures. We have elected to be taxed as a REIT for federal income tax purposes, beginning with the taxable year ended December 31, 1999. For purposes of the REIT qualification rules, we cannot directly operate any of our hotels. Instead, we must lease our hotels to a third party lessee or to a TRS, provided that the TRS engages an eligible independent contractor to manage the\n41\nhotels. As of June 30, 2021, we have leased all of our hotels to a wholly-owned TRS, a joint venture owned TRS, or an entity owned by our wholly-owned TRS. Each of these TRS entities will pay qualifying rent, and the TRS entities have entered into management contracts with qualified independent managers, including HHMLP, with respect to our hotels. We intend to lease all newly acquired hotels to a TRS. The TRS structure enables us to participate more directly in the operating performance of our hotels. The TRS directly receives all revenue from, and funds all expenses relating to, hotel operations. The TRS is also subject to income tax on its earnings.\nOVERVIEW\nWe started to realize the effects from the global economic slowdown caused by the COVID-19 pandemic in March of 2020. As a result of the COVID-19 pandemic and subsequent government mandates and health official recommendations, hotel demand has been substantially reduced across the United States.\nFollowing the government mandates and health official recommendations, and after evaluating the cost of running our respective properties at low occupancy levels versus closing the properties, we originally closed 21 hotel properties and dramatically reduced staffing at the hotels that remained open and at the corporate level; however, we have subsequently reopened all of our consolidated hotels. The reopening of our consolidated hotels provided us the opportunity to capture incremental demand through the end of 2020 and we believe we are prepared to capture market share during the early stages of an economic recovery in 2021.\nIn addition to our focus on strategically reopening hotels and driving occupancy at these hotels, we have remained focused on executing expense mitigation measures and shoring up our liquidity position as we continue to face a challenging operating environment. We suspended our common and preferred dividends in 2020 and during the six months ended June 30, 2021, we paid approximately $24.2 million in preferred dividend arrearage that was not paid in 2020. We also deferred certain planned capital expenditures for 2020 and we will continue to reduce capital expenditures in 2021 with planned allocations estimated between $15.0 and $18.0 million. In February 2021, the Company entered into an unsecured notes facility that provided net proceeds of $144.75 million at closing. An incremental $50 million may be drawn, at the Company’s discretion, in minimum installments of $25.0 million, at any point on or prior to September 30, 2021. The initial net proceeds of $144.75 million provided by this facility, along with a portion of the proceeds from asset sales, were used to repay amounts outstanding under our Credit Facility, allowing us to amend our Credit Facility on February 17, 2021, eliminating maturities under the Credit Facility until August of 2022. The Credit Facility amendment also waived all financial covenants through March 31, 2022, established accommodative covenant testing methodology through December 31, 2022, and provided additional liquidity at the Company’s discretion.\nThe manner in which the ongoing COVID-19 pandemic will be resolved or the manner that the hospitality and tourism industries will return to historical performance norms, and whether the economy will contract or grow are not reasonably predictable. As a result, there can be no assurances that we will be able to achieve the hotel operating metrics or the results at our properties we have forecasted. Factors that might contribute to less-than-anticipated performance include those described under the headings “Risk Factors” and \"Management's Discussion and Analysis of Financial Condition and Results of Operations\" in our Annual Report on Form 10-K for the year ended December 31, 2020 and other documents that we may file with the SEC in the future. We will continue to cautiously monitor lodging demand and rates, our third-party hotel managers, and our performance generally.\n42\nSUMMARY OF OPERATING RESULTS\nCOMPARISON OF THE THREE MONTHS ENDED JUNE 30, 2021 AND 2020\n(dollars in thousands, except ADR, RevPAR, and per share data)\nRevenue\nOur total revenues for the three months ended June 30, 2021 consisted of hotel operating revenues and other revenue. Hotel operating revenues were approximately 99% of total revenues for the three months ended June 30, 2021 and 2020. Hotel operating revenues are recorded for wholly-owned hotels that are leased to our wholly owned TRS and hotels owned through joint venture or other interests that are consolidated in our financial statements. Hotel operating revenues increased $52,671, or 302.5%, to $70,083 for the three months ended June 30, 2021 compared to $17,412 for the same period in 2020. This increase is primarily attributable to an increase in demand across our portfolio in 2021 as the comparable period in 2020 was at the nadir of the reduction in operations across our portfolio due to the decrease in demand caused by the COVID-19 pandemic. The increase in demand is partially offset by the sale of five hotels during the six months ended June 30, 2021 and the sale of one hotel in December of 2020. Total revenues for the three months ended June 30, 2020 includes hotel operating revenue for these six hotels for the entire period.\nExpenses\nTotal hotel operating expenses increased 124.8% to approximately $41,310 for the three months ended June 30, 2021 from $18,378 for the three months ended June 30, 2020. The increase in hotel operating expenses is due to increased operations at our hotels for the three months ended June 30, 2021 as we had temporary closed certain of our hotels and reduced operations at the remaining hotels as a result of the decrease in demand caused by the COVID-19 pandemic during the comparable period in 2020. This increase in hotel operating expense is partially offset by the sale of hotels noted above.\nDepreciation and amortization decreased by 13.6%, or $3,308, to $21,014 for the three months ended June 30, 2021 from $24,322 for the three months ended June 30, 2020. The decrease is primarily attributable to the disposition of the Sheraton Wilmington in December 2020, and the Courtyard San Diego, the Residence Inn Coconut Grove, the Capitol Hill Hotel, the Holiday Inn Express Cambridge, and the Duane Street Hotel in the first half of 2021.\nReal estate and personal property tax and property insurance decreased $503, or 5.0%, for the three months ended June 30, 2021 when compared to the same period in 2020. This decrease is primarily driven by reductions in real estate tax expense due to the sale of hotels noted above. The decrease is partially offset by increased real estate tax that had been re-assessed by the applicable taxing authority, resulting in increases in real estate tax expense for the quarter as we cumulatively catch up, in certain instances, our estimated tax accruals at the time the new assessment is received. We typically experience increases in tax assessments and tax rates as the economy improves which could be offset by reductions resulting from successful real estate tax appeals. The Company regularly appeals property taxes but cannot predict property tax reductions from real estate tax appeals.\nGeneral and administrative expense increased by 26.3%, or approximately $1,100, from $4,187 for the three months ended June 30, 2020 to $5,287 for the same period in 2021. General and administrative expense includes expenses related to payroll, rents, and other corporate level administrative costs as well as non-cash share based payments issued as incentive compensation to the Company’s trustees, executives, and employees. Expenses related to non-cash share based compensation increased $790 when comparing the three months ended June 30, 2021 to the same period in 2020. This increase resulted primarily from an increase in the valuation of certain market based award programs and a difference in the timing of share based compensation recognition. In addition, during the three months ended June 30, 2020, we executed cost containment strategies in our payroll and other administrative costs. Please refer to “Note 9 – Share Based Payments” of the notes to the consolidated financial statements for more information about our share based compensation.\nOperating Loss\nOperating loss for the three months ended June 30, 2021 was $7,592 compared to operating loss of $41,542 during the same period in 2020. The decrease in our operating loss of $33,950 is primarily due to an increase in demand during the three months ended June 30, 2021 as compared to the same period in 2020 when we had temporary closed certain of our hotels and reduced operations at the remaining hotels as a result of the decrease in demand caused by the COVID-19 pandemic.\n43\nInterest Expense\nInterest expense increased $1,501 from $13,481 for the three months ended June 30, 2020 to $14,982 for the three months ended June 30, 2021. The primary driver of the increased interest expense is due to the issuance of the Junior Notes, which is partially offset by a decrease in interest expense on our term loans and decreases in the amortization of our interest rate hedges. Resulting primarily from the proceeds of the sales of assets, the balance of our borrowings, excluding discounts and deferred costs, have decreased by $57,256 in total between June 30, 2020 and June 30, 2021.\nIncome Tax Benefit\nDuring the three months ended June 30, 2021, the Company recorded an income tax expense of $151 compared to an income tax expense of $15,872 for the three months ended June 30, 2020. After considering various factors, including future reversals of existing taxable temporary differences, future taxable income and tax planning strategies, we believe that as of June 30, 2021, it is not more likely than not that we will be able to realize our net deferred tax asset and therefore, maintained the full valuation allowance that was established during the second quarter of 2020, with the exception of a city net operating loss that we believe that we will be able to realize. As a result, the balance of our net deferred tax asset at June 30, 2021 is $499. Absent the valuation allowance, the amount of income tax expense or benefit that the Company typically records depends mostly on the amount of taxable income or loss that is generated by our consolidated taxable REIT subsidiaries (“TRS”).\nNet Loss Applicable to Common Shareholders\nNet loss applicable to common shareholders for the three months ended June 30, 2021 was $28,590 compared to net loss of $67,464 during the same period in 2020. This decrease is primarily due to an increase in demand during the three months ended June 30, 2021 as compared to the same period in 2020, as discussed above, partially offset by increased interest expense during the three months ended June 30, 2021, as discussed above.\nCOMPARISON OF THE SIX MONTHS ENDED JUNE 30, 2021 AND 2020\n(dollars in thousands, except ADR, RevPAR, and per share data)\nRevenue\nOur total revenues for the six months ended June 30, 2021 consisted of hotel operating revenues and other revenue. Hotel operating revenues were approximately 99% of total revenues for the six months ended June 30, 2021 and 2020. Hotel operating revenues are recorded for wholly-owned hotels that are leased to our wholly owned TRS and hotels owned through joint venture or other interests that are consolidated in our financial statements. Hotel operating revenues increased $9,886, or 9.2%, to $117,236 for the six months ended June 30, 2021 compared to $107,350 for the same period in 2020. This increase is attributable to an increase in RevPAR across our portfolio during the six months ended June 30, 2021 as compared to the six months ended June 30, 2020, when beginning in March 2020, we experienced a significant decrease in demand caused by the COVID-19 pandemic. The increase in demand is partially offset by the sale of five hotels during the six months ended June 30, 2021 and the sale of one hotel in December of 2020. Total revenues for the six months ended June 30, 2020 includes hotel operating revenue for these six hotels for the entire period.\nExpenses\nTotal hotel operating expenses decreased 12.4% to approximately $73,490 for the six months ended June 30, 2021 from $83,897 for the six months ended June 30, 2020. The decrease in hotel operating expenses is attributable to the cost saving measures implemented to mitigate the impact of the decrease in demand in 2020, as well the sale of hotels noted above.\nDepreciation and amortization decreased by 11.7%, or $5,694, to $42,816 for the six months ended June 30, 2021 from $48,510 for the six months ended June 30, 2020 due to the dispositions noted above.\nReal estate and personal property tax and property insurance decreased $374, or 1.9%, for the six months ended June 30, 2021 when compared to the same period in 2020, which is primarily due to the sale of hotels noted above. This decrease is partially offset by an increase in real estate taxes at our remaining hotels as a result of properties that had been re-assessed by the applicable taxing authority, resulting in increases in real estate tax expense. We typically experience increases in tax assessments and tax rates as the economy improves which could be offset by reductions resulting from successful real estate tax appeals. In general, our property insurance costs continue to rise annually.\n44\nGeneral and administrative expense increased by 2.1%, or $210 from $10,021 for the six months ended June 30, 2020 to $10,231 for the same period in 2021. General and administrative expense includes expenses related to payroll, rents, and other corporate level administrative costs as well as non-cash share based payments issued as incentive compensation to the Company’s trustees, executives, and employees. Expenses related to non-cash share based compensation increased $503 when comparing the six months ended June 30, 2021 to 2020, which was partially offset by the execution of our cost containment strategies in other administrative costs. The increase in shared based compensation resulted primarily from an increase in the valuation of certain market based award programs and a difference in the timing of shared based compensation recognition. Please refer to “Note 9 – Share Based Payments” of the notes to the consolidated financial statements for more information about our share based compensation.\nOperating Loss\nOperating loss for the six months ended June 30, 2021 was $30,878 compared to operating loss of $57,951 during the same period in 2020. Our decrease in operating loss was largely the result of a decrease in hotel operating expenses for the six months ended June 30, 2021 and an increase in hotel operating revenues, which is the result of an increase in demand across our portfolio, while maintaining certain cost containment strategies in place due to the COVID-19 pandemic. Additionally, we had a decrease in depreciation and amortization expense during the first half of 2021 compared to 2020 as a result of the disposals noted above.\nInterest Expense\nInterest expense increased $1,923 from $26,488 for the six months ended June 30, 2020 to $28,411 for the six months ended June 30, 2021. The balance of our borrowings, excluding discounts and deferred costs, has decreased by $57,256 in total between June 30, 2020 and June 30, 2021. However, we experienced an increase in our weighted average interest rate, driven by the unsecured junior notes payable facility we entered into in February 2021, and increased interest expense related to the amortization of additional deferred costs incurred during the six months ended June 30, 2021. Proceeds from the junior notes payable were used to reduce borrowings under our secured credit facility and term loans.\nIncome Tax Expense\nDuring the six months ended June 30, 2021, the Company recorded an income tax benefit of $438 compared to an income tax expense of $11,374 for the six months ended June 30, 2020. After considering various factors, including future reversals of existing taxable temporary differences, future taxable income and tax planning strategies, we believe that as of June 30, 2021, it is not more likely than not that we will be able to realize our net deferred tax asset and therefore, maintained the full valuation allowance that was established during the second quarter of 2020, with the exception of a city net operating loss that we believe that we will be able to realize. As a result, the balance of our net deferred tax asset at June 30, 2021 is $499. Absent the valuation allowance, the amount of income tax expense or benefit that the Company typically records depends mostly on the amount of taxable income or loss that is generated by our consolidated taxable REIT subsidiaries (“TRS”).\nNet Loss Applicable to Common Shareholders\nNet loss applicable to common shareholders for the six months ended June 30, 2021 was $25,707 compared to net loss of $96,583 during the same period in 2020, resulting in a decreased loss of $70,876. This decrease in loss is primarily related to gain on hotel dispositions of $48,352, as well as a decrease in operating loss.\n45\nLIQUIDITY, CAPITAL RESOURCES, AND EQUITY OFFERINGS\n(dollars in thousands, except per share data)\nPotential Sources of Capital\nOur organizational documents do not limit the amount of indebtedness that we may incur. Our ability to incur additional debt is dependent upon a number of factors, including the current state of the overall credit markets, our degree of leverage and borrowing restrictions imposed by existing lenders. Our ability to raise funds through the issuance of debt and equity securities is dependent upon, among other things, capital market volatility, risk tolerance of investors, general market conditions for REITs and market perceptions related to the Company’s ability to generate cash flow and positive returns on its investments.\nIn addition, our mortgage indebtedness contains various financial and non-financial covenants customarily found in secured, nonrecourse financing arrangements. If the specified criteria are not satisfied, the lender may be able to escrow cash flow generated by the property securing the applicable mortgage loan. At June 30, 2021, we failed our debt service coverage ratio (\"DSCR\") requirement related to two of our mortgage borrowings. After considering the effect of the COVID-19 pandemic on our consolidated operations, it is possible that we could fail certain financial covenants within certain property-level mortgage borrowings. For mortgages with financial covenants, the lenders' remedy of a covenant failure would be a requirement to escrow funds for the purpose of meeting our future debt payment obligations.\nIn February 2021, the Company entered into a junior unsecured notes facility (“Junior Notes”) that provided net proceeds of $144,750 at closing. An incremental $50,000 may be drawn, at the Company’s discretion, in minimum installments of $25,000 at any point on or prior to September 30, 2021. The Junior Notes bear interest at a rate of 9.50%, of which half, or 4.75%, will be paid in cash with the remaining half added to the principal of the note through March 31, 2022 at our discretion. The Junior Notes mature in February of 2026 and are non-callable through February 2022. The Junior Notes are callable at 104% beginning February of 2022, 102% beginning in February 2023, and at par any time beginning in February 2024.\nThe net proceeds of $144,750 provided by the Junior Notes, along with a portion of the proceeds from asset sales, were used to repay amounts outstanding under the Credit Facility, the Second Term Loan, and the Third Term Loan. The Junior Notes and asset sales that closed in the first quarter of 2021 allowed the Company to execute amendments to Credit Agreements governing the Credit Facility, the Second Term Loan, and the Third Term Loan. These amendments eliminated term loan maturities until August of 2022, waived all financial covenants through March 31, 2022, established accommodative covenant testing methodology through December 31, 2022, enabled the Company to pay down the accrual of the Company’s preferred dividends and allow the ongoing preferred dividend accrual to be kept current, and provided additional liquidity at the Company’s discretion.\nOur secured debt facilities aggregate to $747,481 which is comprised of a $442,404 senior credit facility and two term loans totaling $305,077. The credit facility (“Credit Facility”) contains a $192,404 term loan (“First Term Loan”) and a $250,000 revolving line of credit (“Line of Credit”), and expires on August 10, 2022. As of June 30, 2021, we had $118,684 outstanding under the Line of Credit. Our two additional term loans are $278,846 (“Second Term Loan”) and $26,231 (“Third Term Loan”), which mature on September 10, 2024 and August 10, 2022, respectively.\nWe will continue to monitor our debt maturities to manage our liquidity needs. However, no assurances can be given that we will be successful in refinancing all or a portion of our future debt obligations due to factors beyond our control or that, if refinanced, the terms of such debt will not vary from the existing terms. As of June 30, 2021, we have $23,431 of indebtedness due on or before June 30, 2022. We currently expect that cash requirements for all debt that is not refinanced by our existing lenders for which the maturity date is not extended will be met through a combination of cash on hand, refinancing the existing debt with new lenders, draws on the Line of Credit or Junior Notes and the issuance of our securities.\nIn addition to the incurrence of debt and the offering of equity securities, dispositions of property may serve as additional capital resources and sources of liquidity. We may recycle capital from stabilized assets or from sales of non-core hotels in secondary and tertiary markets. Capital from these types of transactions is intended to be redeployed into high growth acquisitions, share buybacks, or to pay down existing debt.\n46\nAcquisitions\nDuring the six months ended June 30, 2021, we acquired no hotel properties. We intend to invest in additional hotels only as suitable opportunities arise and adequate sources of capital are available. We expect that future investments in hotels will depend upon and will be financed by, in whole or in part, our existing cash, the proceeds from additional issuances of common or preferred shares, proceeds from the sale of assets, issuances of Common Units, issuances of preferred units or other securities or borrowings secured by hotel assets and under our Line of Credit.\nDispositions\nDuring the six months ended June 30, 2021, we disposed of five hotel properties for an aggregate sales price of $196,500 resulting in a gain on disposition of $48,313. The net proceeds were used to repay existing debt.\nOperating Liquidity and Capital Expenditures\nWe expect to meet our short-term liquidity requirements generally through net cash provided by operations, existing cash balances and, if necessary, short-term borrowings under the Line of Credit. We believe that the net cash provided by operations in the coming year and borrowings drawn on the Line of Credit will be adequate to fund the Company’s operating requirements, monthly recurring debt service and the payment of dividends in accordance with REIT requirements of the Code.\nTo qualify as a REIT, we must distribute annually at least 90% of our taxable income. This distribution requirement limits our ability to retain earnings and requires us to raise additional capital in order to grow our business and acquire additional hotel properties. However, there is no assurance that we will be able to borrow funds or raise additional equity capital on terms acceptable to us, if at all. In addition, we cannot guarantee that we will be able to make distributions to our shareholders.\nWe will seek to satisfy long-term liquidity requirements through various sources of capital, including borrowings under the Line of Credit and through secured, non-recourse mortgage financings with respect to our unencumbered hotel properties. In addition, we may seek to raise capital through public or private offerings of our securities. Certain factors may have a material adverse effect on our ability to access these capital sources, including our degree of leverage, the value of our unencumbered hotel properties and borrowing restrictions imposed by lenders or franchisors. We will continue to analyze which source of capital is most advantageous to us at any particular point in time, but financing may not be consistently available to us on terms that are attractive, or at all.\nSpending on capital improvements during the six months ended June 30, 2021 decreased when compared to spending on capital improvements during the six months ended June 30, 2020. During the six months ended June 30, 2021, we spent $5,374 on capital expenditures to renovate, improve or replace assets at our hotels. This compares to $15,612 during the same period in 2020. These capital expenditures were undertaken to comply with brand mandated improvements and to initiate projects that we believe will generate a return on investment. We may spend additional amounts, if necessary, to comply with the requirements of any franchise license under which any of our hotels operate and otherwise to the extent we deem such expenditures to be prudent. We are also obligated to fund the cost of certain capital improvements to our hotels.\nWe expect to use operating cash flow, borrowings under the Line of Credit, and proceeds from issuances of our securities and hotel dispositions to pay for the cost of capital improvements and any furniture, fixture and equipment requirements.\n47\nCASH FLOW ANALYSIS\n(dollars in thousands, except per share data)\nComparison of the Six Months Ended June 30, 2021 and 2020\nNet cash used in operating activities decreased $9,250 from $16,357 for the six months ended June 30, 2020 to $7,107 for the comparable period in 2021. The increase in cash flow is primarily attributable to an increase in hotel property cash flow as a result of an increase in demand since the onset of the COVID-19 pandemic.\nNet cash provided by investing activities for the six months ended June 30, 2021 was $157,659 compared to net cash used in investing activities of $16,191 for the six months ended June 30, 2020. The following items are the major contributing factors for the change in investing cash flows:\n•Proceeds of $163,583 received related to the disposition of the Courtyard San Diego, the Capitol Hill Hotel, the Holiday Inn Express Cambridge, the Residence Inn Coconut Grove, and the Duane Street Hotel during the six months ended June 30, 2021.\n•An increase in comparative cash flows of $10,217 related to a decrease in spending on capital expenditures and hotel development projects for the six months ended June 30, 2021 compared to 2020.\n•An increase in comparative cash flows of $50 related to contributions of $600 to unconsolidated joint ventures for the six months ended June 30, 2020 compared to contributions of $550 for the six months ended June 30, 2021.\nNet cash used in financing activities for the six months ended June 30, 2021 was $94,009 compared to net cash provided by financing activities for the six months ended June 30, 2020 of $26,165. The following items are the major contributing factors for the change in financing cash flows:\n•The primary use of cash was the payment of $187,024 of outstanding borrowings under the Term Loan agreements. We received proceeds of $144,750 from the issuance of the Junior Notes, a portion of which, in addition to the proceeds received from the hotel dispositions noted above, were used to pay down the Term Loans.\n•An increase in mortgage payments of $703 for the six months ended June 30, 2021 as compared to the six months ended June 30, 2020.\n•Payment of $5,795 of deferred financing costs for the six months ended June 30, 2021 which primarily relate to the Junior Notes issuance noted above, as compared to the payment of $2,104 during the six months ended June 30, 2020.\n•A decrease in comparative cash flows as we drew $47,000 on our Line of Credit during the six months ended June 30, 2020 when compared to $14,369 in net repayments during the same period in 2021.\n•An increase in cash payments of $12,167 related to dividends paid. During the six months ended June 30, 2021, our executed amendments to the Credit Agreements allowed for the payment of the total arrearage of unpaid cash dividends due on each of our 6.875% Series C Cumulative Redeemable Preferred Shares, 6.50% Series D Cumulative Redeemable Preferred Shares and 6.50% Series E Cumulative Redeemable Preferred Shares of approximately $24,174, which was paid on March 26, 2021, as well as dividends of $6,044 on these preferred shares in April 2021. During the six months ended June 30, 2020 we paid dividends of $6,044 on these preferred shares and $12,007 on our Common Shares, Common Units and LTIP Units.\nOFF BALANCE SHEET ARRANGEMENTS\nThe Company does not have off balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.\n48\nFUNDS FROM OPERATIONS\n(in thousands, except share data)\nThe National Association of Real Estate Investment Trusts (“NAREIT”) developed Funds from Operations (“FFO”) as a non-GAAP financial measure of performance of an equity REIT in order to recognize that income-producing real estate historically has not depreciated on the basis determined under GAAP. We calculate FFO applicable to common shares and Common Units in accordance with the December 2018 Financial Standards White Paper of NAREIT, which we refer to as the White Paper. The White Paper defines FFO as net income (loss) (computed in accordance with GAAP) excluding depreciation and amortization related to real estate, gains and losses from the sale of certain real estate assets, gains and losses from change in control, and impairment write-downs of certain real estate assets and investments in entities when the impairment is directly attributable to decreases in the value of depreciable real estate held by an entity. Our interpretation of the NAREIT definition is that noncontrolling interest in net income (loss) should be added back to (deducted from) net income (loss) as part of reconciling net income (loss) to FFO. Our FFO computation may not be comparable to FFO reported by other REITs that do not compute FFO in accordance with the NAREIT definition, or that interpret the NAREIT definition differently than we do.\nThe GAAP measure that we believe to be most directly comparable to FFO, net income (loss) applicable to common shareholders, includes loss from the impairment of certain depreciable assets, our investment in unconsolidated joint ventures and land, depreciation and amortization expenses, gains or losses on property sales, noncontrolling interest and preferred dividends. In computing FFO, we eliminate these items because, in our view, they are not indicative of the results from our property operations. We determined that the loss from the impairment of certain depreciable assets including investments in unconsolidated joint ventures and land, was driven by a measurable decrease in the fair value of certain hotel properties and other assets as determined by our analysis of those assets in accordance with applicable GAAP. As such, these impairments have been eliminated from net loss to determine FFO.\nFFO does not represent cash flows from operating activities in accordance with GAAP and should not be considered an alternative to net income as an indication of the Company’s performance or to cash flow as a measure of liquidity or ability to make distributions. We consider FFO to be a meaningful, additional measure of operating performance because it excludes the effects of the assumption that the value of real estate assets diminishes predictably over time, and because it is widely used by industry analysts as a performance measure. We show both FFO from consolidated hotel operations and FFO from unconsolidated joint ventures because we believe it is meaningful for the investor to understand the relative contributions from our consolidated and unconsolidated hotels. The display of both FFO from consolidated hotels and FFO from unconsolidated joint ventures allows for a detailed analysis of the operating performance of our hotel portfolio by management and investors. We present FFO applicable to common shares and Common Units because our Common Units are redeemable for common shares. We believe it is meaningful for the investor to understand FFO applicable to all common shares and Common Units.\n49\nThe following table reconciles FFO for the periods presented to the most directly comparable GAAP measure, net income, for the same periods (dollars in thousands):\n| Three Months Ended | Six Months Ended |\n| June 30, 2021 | June 30, 2020 | June 30, 2021 | June 30, 2020 |\n| Net loss applicable to common shareholders | $ | (28,590) | $ | (67,464) | $ | (25,707) | $ | (96,583) |\n| Loss allocated to noncontrolling interest | (977) | (10,360) | (813) | (13,257) |\n| Loss from unconsolidated joint ventures | 589 | 502 | 1,247 | 1,520 |\n| Gain on disposition of hotel properties | — | — | (48,352) | — |\n| Loss from impairment of depreciable assets | 222 | 1,069 | 222 | 1,069 |\n| Depreciation and amortization | 21,014 | 24,322 | 42,816 | 48,510 |\n| Funds from consolidated hotel operations applicable to common shareholders and Partnership Units | (7,742) | (51,931) | (30,587) | (58,741) |\n| Loss from unconsolidated joint ventures | (589) | (502) | (1,247) | (1,520) |\n| Unrecognized pro rata interest in loss (1) | (318) | (511) | (814) | (361) |\n| Depreciation and amortization of difference between purchase price and historical cost (2) | 21 | 21 | 42 | 42 |\n| Interest in depreciation and amortization of unconsolidated joint ventures (3) | 652 | 393 | 1,282 | 796 |\n| Funds from unconsolidated joint ventures operations applicable to common shareholders and Partnership Units | (234) | (599) | (737) | (1,043) |\n| Funds from Operations applicable to common shareholders and Partnership Units | $ | (7,976) | $ | (52,530) | $ | (31,324) | $ | (59,784) |\n| Weighted Average Common Shares and Common Units |\n| Basic | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\n| Diluted | 44,724,968 | 43,286,310 | 44,525,168 | 43,426,465 |\n\n(1) For U.S. GAAP reporting purposes, our interest in the joint venture's loss is not recognized since our U.S. GAAP basis in the joint venture has been reduced to $0. Our interest in FFO from the joint venture equals our percentage ownership in the venture's FFO, including loss we have not recognized for U.S. GAAP reporting.\n(2) Adjustment made to add depreciation of purchase price in excess of historical cost of the assets in the unconsolidated joint venture at the time of our investment.\n(3) Adjustment made to add our interest in real estate related depreciation and amortization of our unconsolidated joint ventures.\nINFLATION\nOperators of hotel properties, in general, possess the ability to adjust room rates daily to reflect the effects of inflation. However, competitive pressures may limit the ability of our management companies to raise room rates. Additionally, our management companies will face challenges to raise room rates to reflect the impact of inflation until there is a substantial economic recovery from the COVID-19 pandemic.\nCRITICAL ACCOUNTING POLICIES AND ESTIMATES\nRefer to Note 1 – Basis of Presentation of the notes to our consolidated financial statements included herein for information regarding critical accounting policies and estimates.\n50\nItem 3. Quantitative and Qualitative Disclosures About Market Risk (in thousands, except per share data)\nOur primary market risk exposure is to changes in interest rates on our variable rate debt. As of June 30, 2021, we are exposed to interest rate risk with respect to variable rate borrowings under our Line of Credit, certain variable rate mortgages, and notes payable. As of June 30, 2021, we had total variable rate debt outstanding of $233,077 with a weighted average interest rate of 2.94%. The effect of a 100 basis point increase or decrease in the interest rate on our variable rate debt outstanding as of June 30, 2021 would be an increase or decrease in our interest expense for the three and six months ended June 30, 2021 of $577 and $1,198, respectively.\nOur interest rate risk objectives are to limit the impact of interest rate fluctuations on earnings and cash flows and to lower our overall borrowing costs. To achieve these objectives, we manage our exposure to fluctuations in market interest rates for a portion of our borrowings through the use of fixed rate debt instruments to the extent that reasonably favorable rates are obtainable with such arrangements. We have also entered into derivative financial instruments such as interest rate swaps or caps, and in the future may enter into treasury options or locks, to mitigate our interest rate risk on a related financial instrument or to effectively lock the interest rate on a portion of our variable rate debt. As of June 30, 2021, we have ten interest rate swaps related to debt on Hilton Garden Inn, 52nd Street, New York, NY; Courtyard, LA Westside, Culver City, CA; Hyatt Union Square, New York, NY; Hilton Garden Inn Tribeca, New York, NY; and our Credit Facility. We do not intend to enter into derivative or interest rate transactions for speculative purposes.\nAs of June 30, 2021, approximately 79.3% of our outstanding consolidated long-term indebtedness was subject to fixed rates or effectively capped, while 20.7% of our outstanding long term indebtedness is subject to floating rates, including borrowings under our Line of Credit. The majority of our floating rate debt and any corresponding derivative instruments are indexed to various tenors of LIBOR.\nOn March 5, 2021, the Financial Conduct Authority (“FCA”) announced that USD LIBOR will no longer be published after June 30, 2023. This announcement has several implications, including setting the spread that may be used to automatically convert contracts from LIBOR to the Secured Overnight Financing Rate (\"SOFR\"). Additionally, banking regulators are encouraging banks to discontinue new LIBOR debt issuances by December 31, 2021.\nThe Company anticipates that LIBOR will continue to be available at least until June 30, 2023. Any changes adopted by the FCA or other governing bodies in the method used for determining LIBOR may result in a sudden or prolonged increase or decrease in reported LIBOR. If that were to occur, our interest payments could change. In addition, uncertainty about the extent and manner of future changes may result in interest rates and/or payments that are higher or lower than if LIBOR were to remain available in its current form.\nThe Company is monitoring and evaluating the related risks that arise in connection with transitioning contracts to an alternative rate, including any resulting value transfer that may occur, and are likely to vary by contract. The value of loans, securities, or derivative instruments tied to LIBOR, as well as interest rates on our current or future indebtedness, may also be impacted if LIBOR is limited or discontinued. For some instruments the method of transitioning to an alternative reference rate may be challenging, especially if we cannot agree with the respective counterparty about how to make the transition.\nWhile we expect LIBOR to be available in substantially its current form until at least June 30, 2023, it is possible that LIBOR will become unavailable prior to that point. This could result, for example, if sufficient banks decline to make submissions to the LIBOR administrator. In that case, the risks associated with the transition to an alternative reference rate will be accelerated and magnified.\nAlternative rates and other market changes related to the replacement of LIBOR, including the introduction of financial products and changes in market practices, may lead to risk modeling and valuation challenges, such as adjusting interest rate accrual calculations and building a term structure for an alternative rate.\nThe introduction of an alternative rate also may create additional basis risk and increased volatility as alternative rates are phased in and utilized in parallel with LIBOR.\nAdjustments to systems and mathematical models to properly process and account for alternative rates will be required, which may strain the model risk management and information technology functions and result in substantial incremental costs for the company.\nChanges in market interest rates on our fixed-rate debt impact the fair value of the debt, but such changes have no impact on interest expense incurred. If interest rates rise 100 basis points and our fixed rate debt balance remains constant, we expect the fair value of our debt to decrease. The sensitivity analysis related to our fixed-rate debt assumes an immediate 100 basis point move in interest rates from their June 30, 2021 levels, with all other variables held constant. A 100 basis point increase in market interest rates would cause the fair value of our fixed-rate debt outstanding at June 30, 2021 to be\n51\napproximately $1,114,810 and a 100 basis point decrease in market interest rates would cause the fair value of our fixed-rate debt outstanding at June 30, 2021 to be approximately $1,168,182.\nWe regularly review interest rate exposure on our outstanding borrowings in an effort to minimize the risk of interest rate fluctuations. For debt obligations outstanding as of June 30, 2021, the following table presents expected principal repayments and related weighted average interest rates by expected maturity dates:\n| 2021 | 2022 - 2023 | 2024 - 2025 | Thereafter | Total |\n| Fixed Rate Debt | $ | 23,431 | $ | 346,889 | $ | 381,977 | $ | 140,764 | $ | 893,061 |\n| Weighted Average Interest Rate | 4.84 | % | 5.27 | % | 8.94 | % | 9.50 | % | 7.14 | % |\n| Floating Rate Debt | $ | 298 | $ | 1,240 | $ | 61,306 | $ | 51,548 | $ | 114,392 |\n| Weighted Average Interest Rate | 3.29 | % | 3.30 | % | 3.10 | % | 3.10 | % | 3.20 | % |\n| $ | 23,729 | $ | 348,129 | $ | 443,283 | $ | 192,312 | $ | 1,007,453 |\n| Line of Credit | $ | — | $ | 118,684 | $ | — | $ | — | $ | 118,684 |\n| Weighted Average Interest Rate | — | 2.50 | % | — | — | 2.50 | % |\n| $ | 23,729 | $ | 466,813 | $ | 443,283 | $ | 192,312 | $ | 1,126,137 |\n\n52\nItem 4. Controls and Procedures\nBased on the most recent evaluation, the Company’s Chief Executive Officer and Chief Financial Officer believe the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) were effective as of June 30, 2021.\nThere were no changes to the Company’s internal controls over financial reporting during the three months ended June 30, 2021, that materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.\n53\nPART II. OTHER INFORMATION\nItem 1. Legal Proceedings.\nNone.\nItem 1A. Risk Factors.\nThere have been no material changes from our risk factors as previously reported in our Annual Report on Form 10-K for the year ended December 31, 2020.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\nNone.\n\nItem 3. Defaults Upon Senior Securities.\nNone.\nItem 4. Mine Safety Disclosures.\nNot Applicable.\nItem 5. Other Information.\nNone.\n54\nItem 6. Exhibits.\n| Exhibit No. |\n| 31.1 | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |\n| 31.2 | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |\n| 32.1 | Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.* |\n| 32.2 | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.* |\n| 101.INS | The instance document does not appear in the interactive data file because its XBRL tags are embedded within the inline XBRL document |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document* |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document* |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document* |\n| 101.LAB | Inline XBRL Taxonomy Extension Labels Linkbase Document* |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document* |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\n| * | Filed herewith |\n| + | Compensatory plan or arrangement |\n\n55\nSIGNATURES\n\n| HERSHA HOSPITALITY TRUST |\n| July 28, 2021 | /s/ Ashish R. Parikh |\n| Ashish R. Parikh |\n| Chief Financial Officer(Principal Financial Officer) |\n\n56\n \n\nWhat is the percentage change in Total Shareholders' Equity from December 31, 2020, to June 30, 2021?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nItem 1.\\nFinancial Statements.\\nConsolidated Balance Sheets 4\\nConsolidated Statements of Operations 5\\nConsolidated Statements of Comprehensive Income (Loss) 7\\nConsolidated Statements of Equity 8\\nConsolidated Statements of Cash Flows 12\\nNotes to the Consolidated Financial Statements 14\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 40\\nItem 3. Quantitative and Qualitative Disclosures About Market Risk 51\\nItem 4. Controls and Procedures 53\\nPART II. OTHER INFORMATION\\nItem 1. Legal Proceedings 54\\nItem 1A. Risk Factors 54\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds 54\\nItem 3. Defaults Upon Senior Securities 54\\nItem 4. Mine Safety Disclosures 54\\nItem 5. Other Information 54\\nItem 6. Exhibits 55\\nSignatures 56\\n3\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSAS OF JUNE 30, 2021 [UNAUDITED] AND DECEMBER 31, 2020[IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\\n| June 30, 2021 | December 31, 2020 |\\n| Assets: |\\n| Investment in Hotel Properties, Net of Accumulated Depreciation | $ | 1,699,230 | $ | 1,784,838 |\\n| Investment in Unconsolidated Joint Ventures | 5,936 | 6,633 |\\n| Cash and Cash Equivalents | 69,083 | 16,637 |\\n| Escrow Deposits | 11,067 | 6,970 |\\n| Hotel Accounts Receivable | 5,539 | 5,690 |\\n| Due from Related Parties | 1,552 | 2,641 |\\n| Intangible Assets, Net of Accumulated Amortization of $ 6,827 and $ 6,840 | 1,465 | 1,739 |\\n| Right of Use Assets | 43,467 | 44,126 |\\n| Other Assets | 20,395 | 15,494 |\\n| Hotel Assets Held for Sale | — | 96,220 |\\n| Total Assets | $ | 1,857,734 | $ | 1,980,988 |\\n| Liabilities and Equity: |\\n| Line of Credit | $ | 118,684 | $ | 133,053 |\\n| Term Loans, Net of Unamortized Deferred Financing Costs (Note 5) | 495,657 | 681,744 |\\n| Unsecured Notes Payable, Net of Unamortized Discount and Unamortized Deferred Financing Costs (Note 5) | 193,725 | 50,789 |\\n| Mortgages Payable, Net of Unamortized Premium and Unamortized Deferred Financing Costs | 304,426 | 330,848 |\\n| Lease Liabilities | 53,455 | 53,852 |\\n| Accounts Payable, Accrued Expenses and Other Liabilities | 49,088 | 58,453 |\\n| Dividends and Distributions Payable | 6,044 | — |\\n| Total Liabilities | $ | 1,221,079 | $ | 1,308,739 |\\n| Redeemable Noncontrolling Interests - Consolidated Joint Venture (Note 1) | $ | 1,968 | $ | — |\\n| Equity: |\\n| Shareholders' Equity: |\\n| Preferred Shares: $ .01 Par Value, 29,000,000 Shares Authorized, 3,000,000 Series C, 7,701,700 Series D and 4,001,514 Series E Shares Issued and Outstanding at June 30, 2021 and December 31, 2020, with Liquidation Preferences of $ 25.00 Per Share (Note 1) | $ | 147 | $ | 147 |\\n| Common Shares: Class A, $ .01 Par Value, 104,000,000 Shares Authorized at June 30, 2021 and December 31, 2020; 39,217,475 and 38,843,482 Shares Issued and Outstanding at June 30, 2021 and December 31, 2020, respectively | 392 | 389 |\\n| Common Shares: Class B, $ .01 Par Value, 1,000,000 Shares Authorized, None Issued and Outstanding at June 30, 2021 and December 31, 2020 | — | — |\\n| Accumulated Other Comprehensive Loss | ( 11,024 ) | ( 19,275 ) |\\n| Additional Paid-in Capital | 1,153,657 | 1,150,985 |\\n| Distributions in Excess of Net Income | ( 557,157 ) | ( 509,243 ) |\\n| Total Shareholders' Equity | 586,015 | 623,003 |\\n| Noncontrolling Interests (Note 1) | 48,672 | 49,246 |\\n| Total Equity | 634,687 | 672,249 |\\n| Total Liabilities and Equity | $ | 1,857,734 | $ | 1,980,988 |\\n\\nThe Accompanying Notes Are an Integral Part of These Consolidated Financial Statements.\\n4\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\\n| Three Months Ended June 30, | Six months ended June 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Revenue: |\\n| Hotel Operating Revenues: |\\n| Room | $ | 56,539 | $ | 15,139 | $ | 95,889 | $ | 86,222 |\\n| Food & Beverage | 7,230 | 136 | 10,304 | 10,211 |\\n| Other Operating Revenues | 6,314 | 2,137 | 11,043 | 10,917 |\\n| Other Revenues | 13 | 29 | 25 | 228 |\\n| Total Revenues | 70,096 | 17,441 | 117,261 | 107,578 |\\n| Operating Expenses: |\\n| Hotel Operating Expenses: |\\n| Room | 12,350 | 3,622 | 21,548 | 22,714 |\\n| Food & Beverage | 5,409 | 721 | 8,282 | 11,342 |\\n| Other Operating Expenses | 23,551 | 14,035 | 43,660 | 49,841 |\\n| Insurance recoveries in excess of property loss | ( 711 ) | — | ( 711 ) | — |\\n| Hotel Ground Rent | 1,064 | 1,058 | 2,164 | 2,121 |\\n| Real Estate and Personal Property Taxes and Property Insurance | 9,466 | 9,969 | 19,537 | 19,911 |\\n| General and Administrative (including Share Based Payments of $ 2,589 and $ 1,799 and $ 4,758 and $ 4,255 for the three and six months ended June 30, 2021 and 2020, respectively) | 5,287 | 4,187 | 10,231 | 10,021 |\\n| Terminated Transaction Costs | 36 | — | 390 | — |\\n| Loss on Impairment of Assets | 222 | 1,069 | 222 | 1,069 |\\n| Depreciation and Amortization | 21,014 | 24,322 | 42,816 | 48,510 |\\n| Total Operating Expenses | 77,688 | 58,983 | 148,139 | 165,529 |\\n| Operating Loss | ( 7,592 ) | ( 41,542 ) | ( 30,878 ) | ( 57,951 ) |\\n| Interest Income | 4 | 2 | 5 | 38 |\\n| Interest Expense | ( 14,982 ) | ( 13,481 ) | ( 28,411 ) | ( 26,488 ) |\\n| Other Income (Expense) | ( 84 ) | ( 385 ) | 377 | ( 457 ) |\\n| Gain on Disposition of Hotel Properties | — | — | 48,352 | — |\\n| Loss on Debt Extinguishment | ( 129 ) | — | ( 3,069 ) | — |\\n| Loss Before Results from Unconsolidated Joint Venture Investments and Income Taxes | ( 22,783 ) | ( 55,406 ) | ( 13,624 ) | ( 84,858 ) |\\n| Loss from Unconsolidated Joint Ventures | ( 589 ) | ( 502 ) | ( 1,247 ) | ( 1,520 ) |\\n| Loss Before Income Taxes | ( 23,372 ) | ( 55,908 ) | ( 14,871 ) | ( 86,378 ) |\\n| Income Tax Benefit (Expense) | ( 151 ) | ( 15,872 ) | 438 | ( 11,374 ) |\\n| Net Loss | ( 23,523 ) | ( 71,780 ) | ( 14,433 ) | ( 97,752 ) |\\n| Loss Allocated to Noncontrolling Interests - Common Units | 2,945 | 7,164 | 2,623 | 10,061 |\\n| (Income) Loss Allocated to Noncontrolling Interests - Consolidated Joint Venture | ( 1,968 ) | 3,196 | ( 1,810 ) | 3,196 |\\n| Preferred Distributions | ( 6,044 ) | ( 6,044 ) | ( 12,087 ) | ( 12,088 ) |\\n| Net Loss Applicable to Common Shareholders | $ | ( 28,590 ) | $ | ( 67,464 ) | $ | ( 25,707 ) | $ | ( 96,583 ) |\\n\\nThe Accompanying Notes Are an Integral Part of These Consolidated Financial Statements.\\n5\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Earnings Per Share: |\\n| BASIC |\\n| Loss from Continuing Operations Applicable to Common Shareholders | $ | ( 0.73 ) | $ | ( 1.75 ) | $ | ( 0.66 ) | $ | ( 2.50 ) |\\n| DILUTED |\\n| Loss from Continuing Operations Applicable to Common Shareholders | $ | ( 0.73 ) | $ | ( 1.75 ) | $ | ( 0.66 ) | $ | ( 2.50 ) |\\n| Weighted Average Common Shares Outstanding: |\\n| Basic | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\\n| Diluted* | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\\n\\n* Income (Loss) allocated to noncontrolling interest in Hersha Hospitality Limited Partnership (the “Operating Partnership” or “HHLP”) has been excluded from the numerator and the Class A common shares issuable upon any redemption of the Operating Partnership’s common units of limited partnership interest (“Common Units”) and the Operating Partnership’s vested LTIP units (“Vested LTIP Units”) have been omitted from the denominator for the purpose of computing diluted earnings per share because the effect of including these shares and units in the numerator and denominator would have no impact. In addition, potentially dilutive common shares, if any, have been excluded from the denominator if they are anti-dilutive to income (loss) applicable to common shareholders.\\nThe following table summarizes potentially dilutive securities that have been excluded from the denominator for the purpose of computing diluted earnings per share:\\n\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Common Units and Vested LTIP Units | 4,279,355 | 3,943,319 | 4,314,347 | 3,891,032 |\\n| Unvested Stock Awards and LTIP Units Outstanding | 939,591 | 547,315 | 581,989 | 267,443 |\\n| Contingently Issuable Share Awards | 408,202 | 185,754 | 594,125 | 680,979 |\\n| Total Potentially Dilutive Securities Excluded from the Denominator | 5,627,148 | 4,676,388 | 5,490,461 | 4,839,454 |\\n\\nThe Accompanying Notes Are an Integral Part of These Consolidated Financial Statements.\\n6\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS]\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Net Loss | $ | ( 23,523 ) | $ | ( 71,780 ) | $ | ( 14,433 ) | $ | ( 97,752 ) |\\n| Other Comprehensive Income (Loss) |\\n| Change in Fair Value of Derivative Instruments | 2,539 | ( 2,020 ) | 9,004 | ( 33,146 ) |\\n| Reclassification Adjustment for Change in Fair Value of Derivative Instruments Included in Net Income (Loss) | ( 141 ) | 1,228 | 159 | 2,205 |\\n| Total Other Comprehensive Income (Loss) | $ | 2,398 | $ | ( 792 ) | $ | 9,163 | $ | ( 30,941 ) |\\n| Comprehensive Loss | ( 21,125 ) | ( 72,572 ) | ( 5,270 ) | ( 128,693 ) |\\n| Less: Comprehensive Loss Attributable to Noncontrolling Interests - Common Units | 2,712 | 7,270 | 1,711 | 12,895 |\\n| Less: Comprehensive (Income) Loss Attributable to Noncontrolling Interests - Consolidated Joint Venture | ( 1,968 ) | 3,196 | ( 1,810 ) | 3,196 |\\n| Less: Preferred Distributions | ( 6,044 ) | ( 6,044 ) | ( 12,087 ) | ( 12,088 ) |\\n| Comprehensive Loss Attributable to Common Shareholders | $ | ( 26,425 ) | $ | ( 68,150 ) | $ | ( 17,456 ) | $ | ( 124,690 ) |\\n\\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\\n7\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF EQUITYFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARES]\\n| Redeemable Noncontrolling Interests | Shareholders' Equity | Noncontrolling Interests |\\n| Consolidated Joint Venture ($) | Common Shares | Class A Common Shares ($) | Class B Common Shares ($) | Preferred Shares | Preferred Shares ($) | Additional Paid-In Capital ($) | Accumulated Other Comprehensive Loss ($) | Distributions in Excess of Net Income ($) | Total Shareholders' Equity ($) | Common Units and LTIP Units | Common Units and LTIP Units ($) | Total Equity ($) |\\n| Balance at March 31, 2021 | — | 39,132,307 | 391 | — | 14,703,214 | 147 | 1,154,579 | ( 12,509 ) | ( 530,535 ) | 612,073 | 5,943,014 | 49,172 | 661,245 |\\n| Dividends and Distributions declared: |\\n| Preferred Shares | — | — | — | — | — | — | — | — | ( 6,044 ) | ( 6,044 ) | — | — | ( 6,044 ) |\\n| Share Based Compensation: |\\n| Grants | — | 85,168 | 1 | — | — | — | 365 | — | — | 366 | 19,477 | 65 | 431 |\\n| Amortization | — | — | — | — | — | — | 681 | — | — | 681 | 1,468 | 2,149 |\\n| Change in Fair Value of Derivative Instruments | — | — | — | — | — | — | — | 1,485 | — | 1,485 | — | 912 | 2,397 |\\n| Adjustment to Record Noncontrolling Interest at Redemption Value | 1,968 | — | — | — | — | — | ( 1,968 ) | — | — | ( 1,968 ) | — | — | ( 1,968 ) |\\n| Net Loss | — | — | — | — | — | — | — | — | ( 20,578 ) | ( 20,578 ) | — | ( 2,945 ) | ( 23,523 ) |\\n| Balance at June 30, 2021 | 1,968 | 39,217,475 | 392 | — | 14,703,214 | 147 | 1,153,657 | ( 11,024 ) | ( 557,157 ) | 586,015 | 5,962,491 | 48,672 | 634,687 |\\n\\n8\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF EQUITYFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARES]\\n| Redeemable Noncontrolling Interests | Shareholders' Equity | Noncontrolling Interests |\\n| Consolidated Joint Venture ($) | Common Shares | Class A Common Shares ($) | Class B Common Shares ($) | Preferred Shares | Preferred Shares ($) | Additional Paid-In Capital ($) | Accumulated Other Comprehensive Loss ($) | Distributions in Excess of Net Income ($) | Total Shareholders' Equity ($) | Common Units and LTIP Units | Common Units and LTIP Units ($) | Total Equity ($) |\\n| Balance at March 31, 2020 | 3,196 | 38,673,242 | 387 | — | 14,703,214 | 147 | 1,145,450 | ( 26,411 ) | ( 362,777 ) | 756,796 | 4,279,946 | 59,162 | 815,958 |\\n| Issuance Costs | — | — | — | — | — | — | ( 10 ) | — | — | ( 10 ) | — | — | ( 10 ) |\\n| Share Based Compensation: |\\n| Grants | — | 116,129 | 1 | — | — | — | — | — | — | 1 | 1,101,924 | — | 1 |\\n| Amortization | — | — | — | — | — | — | 655 | — | — | 655 | — | 3,823 | 4,478 |\\n| Change in Fair Value of Derivative Instruments | — | — | — | — | — | — | — | ( 686 ) | — | ( 686 ) | — | ( 106 ) | ( 792 ) |\\n| Adjustment to Record Noncontrolling Interest at Redemption Value | ( 3,196 ) | — | — | — | — | — | 3,196 | — | — | 3,196 | — | — | 3,196 |\\n| Net Income | — | — | — | — | — | — | — | — | ( 64,616 ) | ( 64,616 ) | ( 7,164 ) | ( 71,780 ) |\\n| Balance at June 30, 2020 | — | 38,789,371 | 388 | — | 14,703,214 | 147 | 1,149,291 | ( 27,097 ) | ( 427,393 ) | 695,336 | 5,381,870 | 55,715 | 751,051 |\\n\\n9\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF EQUITYFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARES]\\n| Redeemable Noncontrolling Interests | Shareholders' Equity | Noncontrolling Interests |\\n| Consolidated Joint Venture ($) | Common Shares | Class A Common Shares ($) | Class B Common Shares ($) | Preferred Shares | Preferred Shares ($) | Additional Paid-In Capital ($) | Accumulated Other Comprehensive Loss ($) | Distributions in Excess of Net Income ($) | Total Shareholders' Equity ($) | Common Units and LTIP Units | Common Units and LTIP Units ($) | Total Equity ($) |\\n| Balance at December 31, 2020 | — | 38,843,482 | 389 | — | 14,703,214 | 147 | 1,150,985 | ( 19,275 ) | ( 509,243 ) | 623,003 | 5,392,808 | 49,246 | 672,249 |\\n| Unit Conversion | — | 225,000 | 2 | — | — | — | 2,870 | — | — | 2,872 | ( 225,000 ) | ( 2,872 ) | — |\\n| Dividends and Distributions declared: |\\n| Preferred Shares | — | — | — | — | — | — | — | — | ( 36,262 ) | ( 36,262 ) | — | — | ( 36,262 ) |\\n| Share Based Compensation: |\\n| Grants | — | 148,993 | 1 | — | — | — | 356 | — | — | 357 | 794,683 | 1,683 | 2,040 |\\n| Amortization | — | — | — | — | — | — | 1,414 | — | — | 1,414 | 2,326 | 3,740 |\\n| Change in Fair Value of Derivative Instruments | — | — | — | — | — | — | — | 8,251 | — | 8,251 | — | 912 | 9,163 |\\n| Equity Contribution to Consolidated Joint Venture | 158 | — | — | — | — | — | — | — | — | — | — | — | — |\\n| Adjustment to Record Noncontrolling Interest at Redemption Value | 1,968 | — | — | — | — | — | ( 1,968 ) | — | — | ( 1,968 ) | — | — | ( 1,968 ) |\\n| Net Income | ( 158 ) | — | — | — | — | — | — | — | ( 11,652 ) | ( 11,652 ) | — | ( 2,623 ) | ( 14,275 ) |\\n| Balance at June 30, 2021 | 1,968 | 39,217,475 | 392 | — | 14,703,214 | 147 | 1,153,657 | ( 11,024 ) | ( 557,157 ) | 586,015 | 5,962,491 | 48,672 | 634,687 |\\n\\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\\n10\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF EQUITYFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARES]\\n| Redeemable Noncontrolling Interests | Shareholders' Equity | Noncontrolling Interests |\\n| Consolidated Joint Venture ($) | Common Shares | Class A Common Shares ($) | Class B Common Shares ($) | Preferred Shares | Preferred Shares ($) | Additional Paid-In Capital ($) | Accumulated Other Comprehensive Loss ($) | Distributions in Excess of Net Income ($) | Total Shareholders' Equity ($) | Common Units and LTIP Units | Common Units and LTIP Units ($) | Total Equity ($) |\\n| Balance at December 31, 2019 | 3,196 | 38,652,650 | 387 | — | 14,703,214 | 147 | 1,144,808 | 1,010 | ( 338,695 ) | 807,657 | 4,279,946 | 64,144 | 871,801 |\\n| Unit Conversion | — | — | — | — | — | — | ( 30 ) | — | — | ( 30 ) | — | — | ( 30 ) |\\n| Dividends and Distributions declared: |\\n| Preferred Shares | — | — | — | — | — | — | — | — | ( 1,007 ) | ( 1,007 ) | — | — | ( 1,007 ) |\\n| Dividend Reinvestment Plan | — | 1,094 | — | — | — | — | 14 | — | — | 14 | — | — | 14 |\\n| Share Based Compensation: |\\n| Grants | — | 135,627 | 1 | — | — | — | — | — | — | 1 | 1,101,924 | — | 1 |\\n| Amortization | — | — | — | — | — | — | 1,303 | — | — | 1,303 | — | 4,466 | 5,769 |\\n| Change in Fair Value of Derivative Instruments | — | — | — | — | — | — | — | ( 28,107 ) | — | ( 28,107 ) | — | ( 2,834 ) | ( 30,941 ) |\\n| Adjustment to Record Noncontrolling Interest at Redemption Value | ( 3,196 ) | — | — | — | — | — | 3,196 | — | — | 3,196 | — | — | 3,196 |\\n| Net Loss | — | — | — | — | — | — | — | — | ( 87,691 ) | ( 87,691 ) | ( 10,061 ) | ( 97,752 ) |\\n| Balance at June 30, 2020 | — | 38,789,371 | 388 | — | 14,703,214 | 147 | 1,149,291 | ( 27,097 ) | ( 427,393 ) | 695,336 | 5,381,870 | 55,715 | 751,051 |\\n\\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\\n11\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSFOR THE SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS]\\n| Six Months Ended June 30, |\\n| 2021 | 2020 |\\n| Operating Activities: |\\n| Net Loss | $ | ( 14,433 ) | $ | ( 97,752 ) |\\n| Adjustments to Reconcile Net Loss to Net Cash Provided by Operating Activities: |\\n| Gain on Disposition of Hotel Properties | ( 48,352 ) | — |\\n| Loss on Impairment of Assets | 222 | 1,069 |\\n| Insurance recoveries in excess of property loss | ( 711 ) | — |\\n| Junior Note PIK Interest Added to Principal | 2,514 | — |\\n| Deferred Taxes | ( 499 ) | 11,390 |\\n| Depreciation | 42,642 | 48,273 |\\n| Amortization | 2,594 | 1,116 |\\n| Loss on Debt Extinguishment | 634 | — |\\n| Equity in Loss of Unconsolidated Joint Ventures | 1,247 | 1,520 |\\n| Loss Recognized on Change in Fair Value of Derivative Instrument | 159 | 2,205 |\\n| Share Based Compensation Expense | 4,758 | 4,255 |\\n| Change in Assets and Liabilities: |\\n| (Increase) Decrease in: |\\n| Hotel Accounts Receivable | 151 | 5,412 |\\n| Other Assets | ( 4,055 ) | 4,884 |\\n| Due from Related Parties | 1,089 | 3,750 |\\n| Increase (Decrease) in: |\\n| Accounts Payable, Accrued Expenses and Other Liabilities | 4,933 | ( 2,479 ) |\\n| Net Cash Used in Operating Activities | $ | ( 7,107 ) | $ | ( 16,357 ) |\\n| Investing Activities: |\\n| Capital Expenditures | ( 5,374 ) | ( 15,612 ) |\\n| Hotel Development Projects | — | 21 |\\n| Proceeds from Disposition of Hotel Properties | 163,583 | — |\\n| Contributions to Unconsolidated Joint Ventures | ( 550 ) | ( 600 ) |\\n| Net Cash Provided by (Used in) Investing Activities | $ | 157,659 | $ | ( 16,191 ) |\\n\\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\\n12\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSFOR THE SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS]\\n| Six Months Ended June 30, |\\n| 2021 | 2020 |\\n| Financing Activities: |\\n| (Repayments) Borrowings on Line of Credit, Net | $ | ( 14,369 ) | $ | 47,000 |\\n| Payments on Term Loans | ( 187,024 ) | — |\\n| Proceeds from Notes Payable | 144,750 | — |\\n| Principal Repayment of Mortgages | ( 1,353 ) | ( 650 ) |\\n| Proceeds of Paycheck Protection Program (\\\"PPP\\\") Loans | — | 18,936 |\\n| Repayment of PPP Loans | — | ( 18,936 ) |\\n| Deferred Financing Costs | ( 5,795 ) | ( 2,104 ) |\\n| Dividends Paid on Common Shares | — | ( 10,809 ) |\\n| Dividends Paid on Preferred Shares | ( 30,218 ) | ( 6,044 ) |\\n| Distributions Paid on Common Units and LTIP Units | — | ( 1,198 ) |\\n| Other Financing Activities | — | ( 30 ) |\\n| Net Cash (Used in) Provided by Financing Activities | $ | ( 94,009 ) | $ | 26,165 |\\n| Net Increase (Decrease) in Cash, Cash Equivalents, and Restricted Cash | $ | 56,543 | $ | ( 6,383 ) |\\n| Cash, Cash Equivalents, and Restricted Cash - Beginning of Period | 23,607 | 36,985 |\\n| Cash, Cash Equivalents, and Restricted Cash - End of Period | $ | 80,150 | $ | 30,602 |\\n\\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\\n13\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 1 - BASIS OF PRESENTATION\\nThe accompanying unaudited consolidated financial statements of Hersha Hospitality Trust (“we,” “us,” “our” or the “Company”) have been prepared in accordance with U.S. generally accepted accounting principles (“US GAAP”) for interim financial information and with the general instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required by US GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals), considered necessary for a fair presentation have been included. Operating results for the three and six months ended June 30, 2021 are not necessarily indicative of the results that may be expected for the year ending December 31, 2021 or any future period. Accordingly, readers of these consolidated interim financial statements should refer to the Company’s audited financial statements prepared in accordance with US GAAP, and the related notes thereto, for the year ended December 31, 2020, which are included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2020, as certain footnote disclosures normally included in financial statements prepared in accordance with US GAAP have been condensed or omitted from this report pursuant to the rules of the Securities and Exchange Commission.\\nWe are a self-administered Maryland real estate investment trust that was organized in May 1998 and completed our initial public offering in January 1999. Our common shares are traded on the New York Stock Exchange (the “NYSE”) under the symbol “HT.” We own our hotels and our investments in joint ventures through our operating partnership, Hersha Hospitality Limited Partnership (“HHLP” or “the Partnership”), for which we serve as the sole general partner. As of June 30, 2021, we owned an approximate 86.8 % partnership interest in HHLP, including a 1.0 % general partnership interest.\\nPrinciples of Consolidation and Presentation\\nThe accompanying consolidated financial statements have been prepared in accordance with US GAAP and include all of our accounts as well as accounts of the Partnership, subsidiary partnerships and our wholly owned Taxable REIT Subsidiary Lessee (“TRS Lessee”), 44 New England Management Company. All significant inter-company amounts have been eliminated.\\nConsolidated properties are either wholly owned or owned less than 100% by the Partnership and are controlled by the Company as general partner of the Partnership. Properties owned in joint ventures are also consolidated if the determination is made that we are the primary beneficiary in a variable interest entity (“VIE”) or we maintain control of the asset through our voting interest in the entity.\\nVariable Interest Entities\\nWe evaluate each of our investments and contractual relationships to determine whether they meet the guidelines for consolidation. To determine if we are the primary beneficiary of a VIE, we evaluate whether we have a controlling financial interest in that VIE. An enterprise is deemed to have a controlling financial interest if it has i) the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance, and ii) the obligation to absorb losses of the VIE that could be significant to the VIE or the rights to receive benefits from the VIE that could be significant to the VIE. Control can also be demonstrated by the ability of a member to manage day-to-day operations, refinance debt and sell the assets of the partnerships without the consent of the other member and the inability of the members to replace the managing member. Based on our examination, there have been no changes to the operating structure of our legal entities during the three and six months ended June 30, 2021 and, therefore, there are no changes to our evaluation of VIE's as presented within our annual report presented on Form 10-K for the year ended December 31, 2020.\\n14\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\\nNOTE 1 - BASIS OF PRESENTATION (CONTINUED)\\nNoncontrolling Interest\\nWe classify the noncontrolling interests of our common units of limited partnership interest in HHLP (“Common Units”), and Long Term Incentive Plan Units (“LTIP Units”) as equity. LTIP Units are a separate class of limited partnership interest in the Operating Partnership that are convertible into Common Units under certain circumstances. The noncontrolling interest of Common Units and LTIP Units totaled $ 48,672 as of June 30, 2021 and $ 49,246 as of December 31, 2020. As of June 30, 2021, there were 5,962,491 Common Units and LTIP Units outstanding with a fair market value of $ 64,156 , based on the price per share of our common shares on the NYSE on such date. In accordance with the partnership agreement of HHLP, holders of these Common Units may redeem them for cash unless we, in our sole and absolute discretion, elect to issue common shares on a one -for-one basis in lieu of paying cash.\\nNet income or loss attributed to Common Units and LTIP Units is included in net income or loss but excluded from net income or loss applicable to common shareholders in the consolidated statements of operations.\\nWe are party to a joint venture that owns the Ritz-Carlton Coconut Grove, FL, in which our joint venture partner has a noncontrolling equity interest of 15 % in the property. Hersha Holding RC Owner, LLC, the owner entity of the Ritz-Carlton Coconut Grove joint venture (\\\"Ritz Coconut Grove\\\"), will distribute income based on cash available for distribution which will be distributed as follows: (1) to us until we receive a cumulative return on our contributed senior common equity interest, currently at 8 %, and (2) then to the owner of the noncontrolling interest until they receive a cumulative return on their contributed junior common equity interest, currently at 8 %, and (3) then 75 % to us and 25 % to the owner of the noncontrolling interest until we both receive a cumulative return on our contributed senior common equity interest, currently at 12 %, and (4) finally, any remaining operating profit shall be distributed 70 % to us and 30 % to the owner of the noncontrolling interest. Additionally, the noncontrolling interest in the Ritz Coconut Grove has the right to put their ownership interest to us for cash consideration at any time during the life of the venture. The balance sheets and financial results of the Ritz Coconut Grove are included in our consolidated financial statements and book value of the noncontrolling interest in the Ritz Coconut Grove is classified as temporary equity within our Consolidated Balance Sheets. The noncontrolling interest in the Ritz Coconut Grove is measured at the greater of historical cost or the put option redemption value. For the three and six months ended June 30, 2021, based on the income allocation methodology described above, the noncontrolling interest in this joint venture was allocated losses of $ 0 and $ 158 , respectively. For the three and six months ended June 30, 2020, based on the income allocation methodology described above, the noncontrolling interest in this joint venture was allocated loss of $ 0 . This is recorded as part of the Loss Allocated to Noncontrolling Interests line item within the Consolidated Statements of Operations. On June 30, 2021, we reclassified $ 1,968 from Additional Paid in Capital to Redeemable Noncontrolling Interests - Consolidated Joint Venture to value the noncontrolling interest at the put option redemption value of $ 1,968 .\\nShareholders’ Equity\\n| Dividend Per Share (1) |\\n| Shares Outstanding | Six Months Ended June 30, |\\n| Series | June 30, 2021 | December 31, 2020 | Aggregate Liquidation Preference | Distribution Rate | 2021 | 2020 |\\n| Series C | 3,000,000 | 3,000,000 | $ | 75,000 | 6.875 | % | $ | 2.5782 | $ | — |\\n| Series D | 7,701,700 | 7,701,700 | $ | 192,500 | 6.500 | % | $ | 2.4378 | $ | — |\\n| Series E | 4,001,514 | 4,001,514 | $ | 100,000 | 6.500 | % | $ | 2.4378 | $ | — |\\n| Total | 14,703,214 | 14,703,214 |\\n\\n15\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\\nNOTE 1 - BASIS OF PRESENTATION (CONTINUED)\\n(1) During the six months ended June 30, 2020, we suspended the payment of our preferred dividends. During the six months ended June 30, 2021, the Company paid cash dividends on the Company's Series C, Series D and Series E cumulative redeemable preferred stock reflecting accrued and unpaid dividends for the dividend periods ended April 15, 2020, July 15, 2020, October 15, 2020 and January 15, 2021. In addition, the Company paid a cash dividend on all Series of cumulative redeemable preferred stock for the first dividend period ending April 15, 2021 and declared a similar cash dividend for the second dividend period ending July 15, 2021, which is payable July 15, 2021 to holders of record as of July 1, 2021.\\nLiquidity and Management's Plan\\nDue to the COVID-19 pandemic and the effects of travel restrictions both globally and in the United States, the hospitality industry has experienced drastic drops in demand. The global impact of the pandemic has been rapidly evolving and, in the United States, certain states and cities, including most of the states and cities where we own properties, have reacted by instituting various restrictive measures such as quarantines, restrictions on travel, school closings, \\\"stay at home\\\" rules and restrictions on types of business that may continue to operate. We believe the ongoing effects of the COVID-19 pandemic on our operations have had, and will continue to have a material negative impact on our financial results and liquidity, and such negative impact may continue beyond the containment of the pandemic.\\nIn February of 2021, we entered into an unsecured notes facility that provided net proceeds of $ 144,750 and access to an incremental $ 50,000 , which can be drawn through September 30, 2021. The initial net proceeds of $ 144,750 provided by this facility, along with a portion of the proceeds from asset sales, were used to repay amounts outstanding under our senior secured credit facility and our two secured term loans and allowed us to negotiate amendments to this senior facility. The amendments to the senior secured credit facility and two secured term loans eliminated term loan maturities until August of 2022, waived all financial covenants through March 31, 2022, established accommodative covenant testing methodology through December 31, 2022, enabled the Company to pay down the accrual of the Company's preferred dividends, allow the ongoing preferred dividend accrual to be kept current, and provided additional liquidity to be used at the Company's discretion.\\nWe cannot assure you that our assumptions used to estimate our liquidity requirements will be correct because the lodging industry has not previously experienced such an abrupt and drastic reduction in hotel demand, and as a consequence, our ability to be predictive is uncertain. In addition, the magnitude, duration, and speed of the pandemic is uncertain and we cannot estimate when travel demand will recover. Based on the amendments, the Company believes that it has sufficient liquidity to meet its obligations for the next twelve months.\\nInvestment in Hotel Properties\\nInvestments in hotel properties are recorded at cost. Improvements and replacements are capitalized when they extend the useful life of the asset. Costs of repairs and maintenance are expensed as incurred. Depreciation is computed using the straight-line method over the estimated useful life of up to 40 years for buildings and improvements, two to seven years for furniture, fixtures and equipment. We are required to make subjective assessments as to the useful lives of our properties for purposes of determining the amount of depreciation to record on an annual basis with respect to our investments in hotel properties. These assessments have a direct impact on our net income because if we were to shorten the expected useful lives of our investments in hotel properties we would depreciate these investments over fewer years, resulting in more depreciation expense and lower net income on an annual basis.\\nIdentifiable assets, liabilities, and noncontrolling interests related to hotel properties acquired are recorded at fair value. Estimating techniques and assumptions used in determining fair values involve significant estimates and judgments. These estimates and judgments have a direct impact on the carrying value of our assets and liabilities which can directly impact the amount of depreciation expense recorded on an annual basis and could have an impact on our assessment of potential impairment of our investment in hotel properties.\\nWe consider a hotel to be held for sale when management and our independent trustees commit to a plan to sell the property, the property is available for sale, management engages in an active program to locate a buyer for the property and it is probable the sale will be completed within a year of the initiation of the plan to sell. We evaluate each disposition to determine whether we need to classify the disposition as discontinued operations. We generally include the operations of a hotel that was sold or a hotel that has been classified as held for sale in continuing operations unless the sale represents a strategic shift that will have a major impact on our future operations and financial results. We anticipate that most of our hotel dispositions will not be classified as discontinued operations as most will not fit this definition.\\n16\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\\nNOTE 1 - BASIS OF PRESENTATION (CONTINUED)\\nBased on the occurrence of certain events or changes in circumstances, we review the recoverability of the property’s carrying value. Such events or changes in circumstances include the following:\\n•a significant decrease in the market price of a long-lived asset;\\n•a significant adverse change in the extent or manner in which a long-lived asset is being used or in its physical condition;\\n•a significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset, including an adverse action or assessment by a regulator;\\n•an accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset;\\n•a current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset; and\\n•a current expectation that, it is more likely than not that, a long-lived asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life.\\nWe review our portfolio on an ongoing basis to evaluate the existence of any of the aforementioned events or changes in circumstances that would require us to test for recoverability. In general, our review of recoverability is based on an estimate of the future undiscounted cash flows, excluding interest charges, expected to result from the property’s use and eventual disposition. These estimates consider factors such as expected future operating income, market and other applicable trends and residual value expected, as well as the effects of hotel demand, competition and other factors. Other assumptions used in the review of recoverability include the holding period and expected terminal capitalization rate. If impairment exists due to the inability to recover the carrying value of a property, an impairment loss is recorded to the extent that the carrying value exceeds the estimated fair value of the property. We are required to make subjective assessments as to whether there are impairments in the values of our investments in hotel properties.\\nAs of June 30, 2021, based on our analysis, we have determined that the estimated future cash flow of each of the properties in our portfolio is sufficient to recover its respective carrying value, after recording an impairment charge prior to the disposition of the Duane Street hotel.\\n17\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\\nNOTE 1 - BASIS OF PRESENTATION (CONTINUED)\\nNew Accounting Pronouncements\\nIn March 2020, the Financial Accounting Standards Board (\\\"FASB\\\") issued ASU No. 2020-4, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting and in January 2021, the FASB issued 2021-01, Reference Rate Reform (Topic 848), Scope, which further clarified the scope of the reference rate reform optional practical expedients and exceptions outlined in Topic 848. As a result of identified structural risks of interbank offered rates, in particular, the London Interbank Offered Rate (LIBOR), reference rate reform is underway to identify alternative reference rates that are more observable or transaction based. The update provides guidance in accounting for changes in contracts, hedging relationships, and other transactions as a result of this reference rate reform. The optional expedients and exceptions contained within these updates, in general, only apply to contract amendments and modifications entered into prior to January 1, 2023. The provisions of these updates that will most likely affect our financial reporting process related to modifications of contracts with lenders and the related hedging contracts associated with each respective modified borrowing contract. In general, the provisions of these updates would impact the Company by allowing, among other things, the following:\\n•Allowing modifications of debt contracts with lenders that fall under the guidance of ASC Topic 470 to be accounted for as a non-substantial modification and not be considered a debt extinguishment.\\n•Allowing a change to contractual terms of a hedging instrument in conjunction with reference rate reform to not require a dedesignation of the hedging relationship.\\n•Allowing a change to the interest rate used for margining, discounting, or contract price alignment for a derivative that is a cash flow hedge to not be considered a change to the critical terms of the hedge and will not require a dedesignation of the hedging relationship.\\nWe have not entered into any contract modifications yet, as it directly relates to reference rate reform but we anticipate having to undertake such modifications in the future as a majority of our contracts with lenders and hedging counterparties are indexed to LIBOR. While we anticipate the impact of this update to be to the benefit of the Company, we are still evaluating the overall impact to the Company.\\n18\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 2 - INVESTMENT IN HOTEL PROPERTIES\\nInvestment in hotel properties consists of the following at June 30, 2021 and December 31, 2020:\\n\\n| June 30, 2021 | December 31, 2020 |\\n| Land | $ | 478,413 | $ | 488,463 |\\n| Buildings and Improvements | 1,557,840 | 1,611,144 |\\n| Furniture, Fixtures and Equipment | 271,977 | 281,440 |\\n| Construction in Progress | 1,489 | 987 |\\n| 2,309,719 | 2,382,034 |\\n| Less Accumulated Depreciation | ( 610,489 ) | ( 597,196 ) |\\n| Total Investment in Hotel Properties * | $ | 1,699,230 | $ | 1,784,838 |\\n\\n* The net book value of investment in hotel property at Ritz Coconut Grove, which is a variable interest entity, is $ 40,937 and $ 42,487 at June 30, 2021 and December 31, 2020, respectively.\\nAcquisitions\\nFor the six months ended June 30, 2021 and 2020, we acquired no hotel properties.\\nHotel Dispositions\\nFor the six months ended June 30, 2020, we had no hotel dispositions. During the six months ended June 30, 2021, we had the following hotel dispositions:\\n| Hotel | AcquisitionDate | DispositionDate | Consideration | Gain onDisposition |\\n| Courtyard San Diego, CA | 05/30/2013 | 02/19/2021 | $ | 64,500 | $ | 5,037 |\\n| The Capitol Hill Hotel Washington, DC | 04/15/2011 | 03/09/2021 | 51,000 | 12,990 |\\n| Holiday Inn Express Cambridge, MA | 05/03/2006 | 03/09/2021 | 32,000 | 20,281 |\\n| Residence Inn Miami Coconut Grove, FL | 06/12/2013 | 03/10/2021 | 31,000 | 10,005 |\\n| Duane Street Hotel (1) | 01/04/2008 | 05/13/2021 | 18,000 | — |\\n| 2021 Total | $ | 48,313 |\\n\\n(1)During the second quarter of 2020, the Company determined that the carrying value of the Duane Street hotel exceeded the anticipated net proceeds from sale, resulting in a $ 1,069 impairment charge recorded during the second quarter of 2020. We recorded an additional impairment charge of $ 147 prior to the disposition of the hotel property during the six months ended June 30, 2021.\\n19\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 2 – INVESTMENT IN HOTEL PROPERTIES (CONTINUED)\\nAssets Held For Sale\\nWe classified the assets of the Duane Street Hotel, the Residence Inn Coconut Grove and the Courtyard San Diego as held for sale as of December 31, 2020, all of which closed during the six months ended June 30, 2021.\\nThe table below shows the balances for the properties that were classified as assets held for sale as of December 31, 2020:\\n| December 31, 2020 |\\n| Land | $ | 28,015 |\\n| Buildings and Improvements | 93,314 |\\n| Furniture, Fixtures and Equipment | 15,469 |\\n| 136,798 |\\n| Less Accumulated Depreciation | ( 40,578 ) |\\n| Assets Held for Sale | $ | 96,220 |\\n\\n20\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 3 - INVESTMENT IN UNCONSOLIDATED JOINT VENTURES\\nAs of June 30, 2021 and December 31, 2020, our investment in unconsolidated joint ventures consisted of the following:\\n\\n| Joint Venture | Hotel Properties | Percent Owned | June 30, 2021 | December 31, 2020 |\\n| Cindat Hersha Owner JV, LLC | Hilton and IHG branded hotels in NYC | 31.2 | % | * | $ | — | $ | — |\\n| Hiren Boston, LLC | Courtyard by Marriott, South Boston, MA | 50 | % | 29 | 219 |\\n| SB Partners, LLC | Holiday Inn Express, South Boston, MA | 50 | % | — | — |\\n| SB Partners Three, LLC | Home2 Suites, South Boston, MA | 50 | % | 5,907 | 6,414 |\\n| $ | 5,936 | $ | 6,633 |\\n\\n*On February 7, 2021, all of the assets of the properties owned by this joint venture were transferred to the mezzanine lender of Cindat Hersha Owner JV, LLC. As a result, upon dissolution of the venture, we will no longer maintain an interest in this venture.\\nIncome/Loss Allocation\\nPrior to February 7, 2021, based on the income allocation methodology within Cindat Hersha Owner JV, LLC, the Company had absorbed cumulative losses equal to our accounting basis in the joint venture resulting in a $ 0 investment balance in the table above as of December 31, 2020, however, we maintained a positive equity balance within the venture. This difference is due to the difference in our basis inside the venture versus our basis outside of the venture, which is explained later in this note.\\nFor SB Partners, LLC, Hiren Boston, LLC, and SB Partners Three, LLC, income or loss is allocated to us and our joint venture partners consistent with the allocation of cash distributions in accordance with the joint venture agreements. This results in an income allocation consistent with our percentage of ownership interests.\\nAny difference between the carrying amount of any of our investments noted above and the underlying equity in net assets is amortized over the expected useful lives of the properties and other intangible assets.\\n21\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 3 – INVESTMENT IN UNCONSOLIDATED JOINT VENTURES (CONTINUED)\\nLoss recognized during the three and six months ended June 30, 2021 and 2020, for our investments in unconsolidated joint ventures is as follows:\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Hiren Boston, LLC | $ | ( 354 ) | $ | ( 477 ) | $ | ( 689 ) | $ | ( 880 ) |\\n| SB Partners, LLC | ( 50 ) | — | ( 50 ) | ( 600 ) |\\n| SB Partners Three, LLC | ( 185 ) | ( 25 ) | ( 508 ) | ( 40 ) |\\n| Loss from Unconsolidated Joint Venture Investments | $ | ( 589 ) | $ | ( 502 ) | $ | ( 1,247 ) | $ | ( 1,520 ) |\\n\\nThe following tables set forth the total assets, liabilities, equity and components of net income or loss, including the Company’s share, related to the unconsolidated joint ventures discussed above as of June 30, 2021 and December 31, 2020 and for the three and six months ended June 30, 2021 and 2020.\\nBalance Sheets\\n\\n| June 30, 2021 | December 31, 2020 |\\n| Assets |\\n| Investment in Hotel Properties, Net | $ | 65,956 | $ | 581,452 |\\n| Other Assets | 14,126 | 32,048 |\\n| Total Assets | $ | 80,082 | $ | 613,500 |\\n| Liabilities and Equity |\\n| Mortgages and Notes Payable | $ | 65,457 | $ | 452,284 |\\n| Other Liabilities | 14,939 | 42,197 |\\n| Equity: |\\n| Hersha Hospitality Trust | 4,099 | 5,699 |\\n| Joint Venture Partner(s) | ( 4,413 ) | 113,452 |\\n| Accumulated Other Comprehensive Loss | — | ( 132 ) |\\n| Total Equity | ( 314 ) | 119,019 |\\n| Total Liabilities and Equity | $ | 80,082 | $ | 613,500 |\\n\\n22\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 3 – INVESTMENT IN UNCONSOLIDATED JOINT VENTURES (CONTINUED)\\nStatements of Operations\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Room Revenue | $ | 1,888 | $ | 5,588 | $ | 4,143 | $ | 16,932 |\\n| Other Revenue | 125 | — | 242 | 787 |\\n| Operating Expenses | ( 1,205 ) | ( 3,265 ) | ( 3,015 ) | ( 11,613 ) |\\n| Lease Expense | ( 245 ) | ( 170 ) | ( 516 ) | ( 354 ) |\\n| Property Taxes and Insurance | ( 382 ) | ( 3,154 ) | ( 1,948 ) | ( 6,438 ) |\\n| General and Administrative | ( 26 ) | ( 553 ) | ( 247 ) | ( 1,516 ) |\\n| Depreciation and Amortization | ( 1,300 ) | ( 3,925 ) | ( 3,612 ) | ( 7,840 ) |\\n| Interest Expense | ( 642 ) | ( 5,582 ) | ( 3,334 ) | ( 11,869 ) |\\n| Loss on Dissolution of Joint Venture | — | — | ( 112,429 ) | — |\\n| Net Loss | $ | ( 1,787 ) | $ | ( 11,061 ) | $ | ( 120,716 ) | $ | ( 21,911 ) |\\n\\nThe following table is a reconciliation of our share in the unconsolidated joint ventures’ equity to our investment in the unconsolidated joint ventures as presented on our balance sheets as of June 30, 2021 and December 31, 2020.\\n| June 30, 2021 | December 31, 2020 |\\n| Our share of equity recorded on the joint ventures' financial statements | $ | 4,099 | $ | 5,699 |\\n| Adjustment to reconcile our share of equity recorded on the joint ventures' financial statements to our investment in unconsolidated joint ventures(1) | 1,837 | 934 |\\n| Investment in Unconsolidated Joint Ventures | $ | 5,936 | $ | 6,633 |\\n\\n(1) Adjustment to reconcile our share of equity recorded on the joint ventures' financial statements to our investment in unconsolidated joint ventures consists of the following:\\n•the difference between our basis in the investment in joint ventures and the equity recorded on the joint ventures' financial statements;\\n•accumulated amortization of our equity in joint ventures that reflects the difference in our portion of the fair value of joint ventures' assets on the date of our investment when compared to the carrying value of the assets recorded on the joint ventures’ financial statements (this excess or deficit investment is amortized over the life of the properties, and the amortization is included in Income (Loss) from Unconsolidated Joint Venture Investments on our consolidated statement of operations); and\\n• cumulative impairment of our investment in joint ventures not reflected on the joint ventures' financial statements, if any.\\n23\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 4 - OTHER ASSETS\\nOther Assets\\nOther Assets consisted of the following at June 30, 2021 and December 31, 2020:\\n| June 30, 2021 | December 31, 2020 |\\n| Deferred Financing Costs | $ | 1,783 | $ | 2,395 |\\n| Prepaid Expenses | 9,540 | 5,692 |\\n| Investment in Statutory Trusts | 1,548 | 1,548 |\\n| Investment in Non-Hotel Property and Inventories | 2,318 | 2,443 |\\n| Deposits with Unaffiliated Third Parties | 2,456 | 2,561 |\\n| Deferred Tax Asset, Net of Valuation Allowance of $ 23,438 and $ 23,591 , respectively | 499 | — |\\n| Other | 2,251 | 855 |\\n| $ | 20,395 | $ | 15,494 |\\n\\nDeferred Financing Costs – This category represents financing costs paid by the Company to establish our Line of Credit. These costs have been capitalized and will amortize to interest expense over the term of the Line of Credit.\\nPrepaid Expenses – Prepaid expenses include amounts paid for property tax, insurance and other expenditures that will be expensed in the next twelve months.\\nInvestment in Statutory Trusts – We have an investment in the common stock of Hersha Statutory Trust I and Hersha Statutory Trust II.\\nInvestment in Non-Hotel Property and Inventories – This category represents the costs paid and capitalized by the Company for items such as office leasehold improvements, furniture and equipment, and property inventories.\\nDeposits with Unaffiliated Third Parties – These deposits represent deposits made by the Company with unaffiliated third parties for items such as lease security deposits, utility deposits, and deposits with unaffiliated third party management companies.\\nDeferred Tax Asset – We have recorded a valuation allowance resulting in net deferred tax assets of $ 499 as of June 30, 2021. We have considered various factors, including future reversals of existing taxable temporary differences, future projected taxable income and tax planning strategies in determining a valuation allowance for our deferred tax assets, and we believe that it is more likely than not that we will not be able to realize the net deferred tax assets in the future, and a valuation allowance for the entire deferred tax asset has been recorded, with the exception of a city net operating loss that we believe that we will be able to realize.\\n24\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT\\nMortgages\\nMortgages payable at June 30, 2021 and December 31, 2020 consisted of the following:\\n| June 30, 2021 | December 31, 2020 |\\n| Mortgage Indebtedness | $ | 305,911 | $ | 332,264 |\\n| Net Unamortized Premium | 127 | 354 |\\n| Net Unamortized Deferred Financing Costs | ( 1,612 ) | ( 1,770 ) |\\n| Mortgages Payable | $ | 304,426 | $ | 330,848 |\\n\\nNet Unamortized Deferred Financing Costs associated with entering into mortgage indebtedness are deferred and amortized over the life of the mortgages. Net Unamortized Premiums are also amortized over the remaining life of the loans. Mortgage indebtedness balances are subject to fixed and variable interest rates, which ranged from 2.75 % to 6.30 % as of June 30, 2021.\\nOur mortgage indebtedness contains various financial and non-financial covenants customarily found in secured, non-recourse financing arrangements. Our mortgage loans typically require that specified debt service coverage ratios be maintained with respect to the financed properties before we can exercise certain rights under the loan agreements relating to such properties. If the specified criteria are not satisfied, the lender may be able to escrow cash flow generated by the property securing the applicable mortgage loan. We have determined that all debt covenants contained in the loan agreements securing our consolidated hotel properties with the exception of two mortgages were met as of June 30, 2021.\\nDuring the six months ended June 30, 2021, we refinanced the outstanding mortgages secured by the Hilton Garden Inn 52nd Street, the Courtyard Los Angeles Westside, the Hilton Garden Inn Tribeca, and the Hyatt Union Square, which resulted in $ 90 of debt modification expense.\\nAs of June 30, 2021, the maturity dates for the outstanding mortgage loans ranged from September 2021 to September 2025. One mortgage with a total principal balance of $ 21,663 will mature within the next twelve months. We are in active discussions with lenders to refinance this mortgage with property level debt prior to its maturity.\\n25\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT (CONTINUED)\\nCredit Facilities\\nWe maintain three secured credit arrangements which aggregate to $ 747,481 with Citigroup Global Markets Inc., Wells Fargo Bank, Inc. and various other lenders. Our credit agreement (the \\\"Credit Agreement\\\") provides for a $ 442,404 senior secured credit facility (“Credit Facility”). The Credit Facility consists of a $ 250,000 senior secured revolving line of credit (“Line of Credit”) and a $ 192,404 senior secured term loan (\\\"First Term Loan\\\"), and expires on August 10, 2022.\\nWe maintain another credit agreement which provides for a $ 278,846 senior secured term loan agreement (“Second Term Loan”) and expires on September 10, 2024.\\nA separate credit agreement provides for a $ 26,231 senior secured term loan agreement (“Third Term Loan” and collectively with the Credit Agreement and the Second Term Loan, the \\\"Credit Agreements\\\") and expires on August 10, 2022. Management intends to explore options including, but not limited to, additional asset sales, the refinancing of debt and the offering of equity or equity-linked securities prior to the maturity of the First Term Loan and the Third Term Loan on August 10, 2022.\\nOn February 17, 2021, the Company signed amendments to the Credit Agreements which resulted in debt extinguishment expense $2,977. Debt extinguishment expense consists of $ 635 of debt extinguishment losses and $ 2,342 of debt modification losses. The signed amendments to the Credit Agreements, among other things, provide for:\\n•an extension of the maturity date of the Third Term Loan to August 10, 2022;\\n•a limited waiver of financial covenants through March 31, 2022; and\\n•the ability to borrow up to $ 174,729 , inclusive of amounts already outstanding, under the Line of Credit, the proceeds of which may only be used to fund certain costs and expenses.\\nCertain conditions, such as minimum liquid assets in an aggregate amount of at least $ 30,000 , and certain negative covenants and restrictions that are considered normal and customary, must be met on a recurring basis as outlined within the amendments.\\nThe amendments to the Credit Agreements make certain other amendments to financial covenants in place beginning in the second quarter of 2022:\\n•a fixed charge coverage ratio of not less than 1.20 to 1.00 (was 1.50 to 1.00);\\n•a maximum leverage ratio of not more than 65 % (was 60 %); and\\n•a new financial covenant that requires the borrowing base leverage ratio to not exceed 60 % at any time.\\nThe amount that we can borrow at any given time under our Line of Credit, and the individual term loans (each a “Term Loan” and together the “Term Loans”) is governed by certain operating metrics of designated hotel properties known as borrowing base assets. As of June 30, 2021, the following hotel properties secured the amended facilities under the Credit Agreements:\\n26\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT (CONTINUED)\\n| - Courtyard by Marriott Brookline, Brookline, MA | - Hampton Inn, Washington, DC |\\n| - The Envoy Boston Seaport, Boston, MA | - Ritz-Carlton Georgetown, Washington, DC |\\n| - The Boxer, Boston, MA | - Hilton Garden Inn, M Street, Washington, DC |\\n| - Hampton Inn Seaport, Seaport, New York, NY | - The Winter Haven Hotel Miami Beach, Miami, FL |\\n| - Holiday Inn Express Chelsea, 29th Street, New York, NY | - The Blue Moon Hotel Miami Beach, Miami, FL |\\n| - Gate Hotel JFK Airport, New York, NY | - Cadillac Hotel & Beach Club, Miami, FL |\\n| - Hilton Garden Inn JFK Airport, New York, NY | - The Parrot Key Hotel & Villas, Key West, FL |\\n| - NU Hotel, Brooklyn, New York, NY | - TownePlace Suites, Sunnyvale, CA |\\n| - Hyatt House White Plains, White Plains, NY | - The Ambrose Hotel, Santa Monica, CA |\\n| - Hampton Inn Center City/ Convention Center, Philadelphia, PA | - The Pan Pacific Hotel Seattle, Seattle, WA |\\n| - The Rittenhouse, Philadelphia, PA | - Mystic Marriott Hotel & Spa, Groton, CT |\\n| - Philadelphia Westin, Philadelphia, PA |\\n\\nThe interest rate for borrowings under the Line of Credit and Term Loans are based on a pricing grid with a range of one month U.S. LIBOR plus a spread. The following table summarizes the balances outstanding and interest rate spread for each borrowing:\\n| Outstanding Balance |\\n| Borrowing | Spread | June 30, 2021 | December 31, 2020 |\\n| Line of Credit | 1.50 % to 2.25 % | $ | 118,684 | $ | 133,053 |\\n| Term Loans: |\\n| First Term Loan | 1.45 % to 2.20 % | $ | 192,404 | $ | 202,158 |\\n| Second Term Loan | 1.35 % to 2.00 % | 278,846 | 292,983 |\\n| Third Term Loan | 1.45 % to 2.20 % | 26,231 | 189,365 |\\n| Deferred Loan Costs | ( 1,824 ) | ( 2,762 ) |\\n| Total Term Loans | $ | 495,657 | $ | 681,744 |\\n\\nPrior to the amendments noted above, the Credit Agreements included certain financial covenants and required that we maintain: (1) a minimum tangible net worth (calculated as total assets, plus accumulated depreciation, less total liabilities, intangibles and other defined adjustments) of $ 1,119,500 , plus an amount equal to 75 % of the net cash proceeds of all issuances and primary sales of equity interests of the parent guarantor or any of its subsidiaries consummated following the closing date; (2) annual distributions not to exceed 95 % of adjusted funds from operations; and (3) certain financial ratios, including the following:\\n•a fixed charge coverage ratio of not less than 1.50 to 1.00;\\n•a maximum leverage ratio of not more than 60 %; and\\n•a maximum secured debt leverage ratio of 45 %.\\nThe weighted average interest rate, inclusive of the effect of derivative instruments, on the Credit Agreements was 3.92 % and 4.23 %, and 3.73 % and 4.21 %, for the three and six months ended June 30, 2021 and 2020, respectively.\\n27\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT (CONTINUED)\\nNotes Payable\\nNotes payable at June 30, 2021 and December 31, 2020 consisted of the following:\\n| June 30, 2021 | December 31, 2020 |\\n| Notes Payable | $ | 204,062 | $ | 51,548 |\\n| Net Unamortized Discount | ( 4,899 ) | — |\\n| Net Unamortized Deferred Financing Costs | ( 5,438 ) | ( 759 ) |\\n| Notes Payable | $ | 193,725 | $ | 50,789 |\\n\\nStatutory Trust I and Statutory Trust II Notes Payable\\nWe have two junior subordinated notes payable in the aggregate amount of $ 51,548 related to the Hersha Statutory Trusts pursuant to indenture agreements which will mature on July 30, 2035, but may be redeemed at our option, in whole or in part, prior to maturity in accordance with the provisions of the indenture agreements. The $ 25,774 of notes issued to each of Hersha Statutory Trust I and Hersha Statutory Trust II bear interest at a variable rate of LIBOR plus 3 % per annum. This rate resets 2 business days prior to each quarterly payment. The related deferred financing costs are amortized over the life of the notes payable. The weighted average interest rate on our two junior subordinated notes payable was 3.19 % and 4.08 % for the three months ended June 30, 2021 and 2020, respectively, and 3.20 % and 4.45 % for the six months ended June 30, 2021 and 2020, respectively.\\nJunior Notes Payable\\nOn February 17, 2021, the Company entered into a note purchase agreement (the “Purchase Agreement”) with several purchasers (the “Purchasers”). The Company agreed to issue and sell to the Purchasers an initial $ 150,000 aggregate principal amount (the “Initial Notes”) of the Company’s 9.50 % Unsecured PIK Toggle Notes due 2026 (the “Notes”), and an incremental $ 50,000 aggregate principal amount of the Notes that can be drawn at the Company’s discretion, subject to certain conditions, in minimum installments of $ 25,000 on or prior to September 30, 2021.\\nThe Initial Notes were issued on February 23, 2021. The Notes will mature on February 23, 2026. The Notes bear interest at a rate of 9.50 % per year, payable in arrears on June 30, September 30, December 31 and March 31 of each year, beginning on June 30, 2021. For any interest period ending on or prior to March 31, 2022, the Issuer, in its sole discretion may elect to pay interest (a) in cash at a rate per annum equal to 4.75 % per annum, and (b) in kind at a rate per annum equal to 4.75 % per annum (“PIK Interest”). Any PIK Interest will be paid by increasing the principal amount of the Notes at the end of the applicable interest period by the amount of such PIK Interest. We elected the PIK Interest option for the interest period ended June 30, 2021, increasing the principal balance $ 2,514 to $ 152,514 as of June 30, 2021.\\nThe Notes may not be redeemed prior to February 23, 2022. The notes may be redeemed during the 12 month period beginning February 23, 2022 and the 12 month period beginning February 23, 2023, at a redemption price equal to 104 % and 102 % of the principal amount of the Notes being redeemed, respectively. After February 23, 2024, the notes may be redeemed at the principal amount.\\nThe Notes are subject to representations, warranties, covenants, terms and conditions customary for transactions of this type, including limitations on liens, incurrence of new debt, investments, mergers and asset dispositions, covenants to preserve corporate existence and comply with laws and default provisions.\\nThe Company may only use the net proceeds from the issuance of the Notes in accordance with the mandatory prepayment waterfalls, which includes the repayment of outstanding borrowings under the Credit Agreement and use for certain other general corporate purposes.\\n28\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT (CONTINUED)\\nInterest Expense\\nThe table below shows the interest expense incurred by the Company during the three and six months ended June 30, 2021 and 2020:\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Mortgage Loans Payable | $ | 2,680 | $ | 3,031 | $ | 5,415 | $ | 6,516 |\\n| Interest Rate Swap Contracts on Mortgages | 627 | 552 | 1,230 | 585 |\\n| Unsecured Notes Payable | 4,311 | 532 | 6,248 | 1,160 |\\n| Credit Facility and Term Loans | 3,754 | 5,370 | 8,122 | 12,404 |\\n| Interest Rate Swap Contracts on Credit Agreements | 2,417 | 3,133 | 4,841 | 4,219 |\\n| Deferred Financing Costs Amortization | 1,088 | 702 | 2,380 | 1,267 |\\n| Other | 105 | 161 | 175 | 337 |\\n| Total Interest Expense | $ | 14,982 | $ | 13,481 | $ | 28,411 | $ | 26,488 |\\n\\n29\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 6 – LEASES\\nWe own five hotels within our consolidated portfolio of hotels where we do not own the land on which the hotels reside, rather we lease the land from an unrelated third-party lessor. All of our land leases are classified as operating leases and have initial terms with extension options that range from May 2062 to October 2103. We also have two additional office space leases with terms ranging from March 2023 to December 2027.\\nThe components of lease costs for the three months ended June 30, 2021 and 2020 were as follows:\\n| Three Months Ended June 30, 2021 | Three Months Ended June 30, 2020 |\\n| Ground Lease | Office Lease | Total | Ground Lease | Office Lease | Total |\\n| Operating lease costs | $ | 1,050 | $ | 121 | $ | 1,171 | $ | 1,050 | $ | 121 | $ | 1,171 |\\n| Variable lease costs | 14 | 83 | 97 | 8 | 87 | 95 |\\n| Total lease costs | $ | 1,064 | $ | 204 | $ | 1,268 | $ | 1,058 | $ | 208 | $ | 1,266 |\\n\\nThe components of lease costs for the six months ended June 30, 2021 and 2020 were as follows:\\n| Six months ended June 30, 2021 | Six months ended June 30, 2020 |\\n| Ground Lease | Office Lease | Total | Ground Lease | Office Lease | Total |\\n| Operating lease costs | $ | 2,126 | $ | 242 | $ | 2,368 | $ | 2,100 | $ | 242 | $ | 2,342 |\\n| Variable lease costs | 38 | 167 | 205 | 21 | 154 | 175 |\\n| Total lease costs | $ | 2,164 | $ | 409 | $ | 2,573 | $ | 2,121 | $ | 396 | $ | 2,517 |\\n\\nOther information related to leases as of and for the six months ended June 30, 2021 and 2020 is as follows:\\n| June 30, 2021 | June 30, 2020 |\\n| Cash paid from operating cash flow for operating leases | $ | 2,246 | $ | 1,951 |\\n| Weighted average remaining lease term | 64.2 | 64.2 |\\n| Weighted average discount rate | 7.87 | % | 7.86 | % |\\n\\n30\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 7 – COMMITMENTS AND CONTINGENCIES AND RELATED PARTY TRANSACTIONS\\nManagement Agreements\\nOur wholly-owned TRS, 44 New England Management Company, and certain of our joint venture entities engage eligible independent contractors in accordance with the requirements for qualification as a REIT under the Internal Revenue Code of 1986, as amended, including Hersha Hospitality Management Limited Partnership (“HHMLP”), as the property managers for hotels it leases from us pursuant to management agreements. HHMLP is owned, in part, by certain executives and trustees of the Company. Our management agreements with HHMLP provide for a term of five years and are subject to early termination upon the occurrence of defaults and certain other events described therein. As required under the REIT qualification rules, HHMLP must qualify as an “eligible independent contractor” during the term of the management agreements. Under the management agreements, HHMLP generally pays the operating expenses of our hotels. All operating expenses or other expenses incurred by HHMLP in performing its authorized duties are reimbursed or borne by our TRS to the extent the operating expenses or other expenses are incurred within the limits of the applicable approved hotel operating budget. HHMLP is not obligated to advance any of its own funds for operating expenses of a hotel or to incur any liability in connection with operating a hotel. Management agreements with other unaffiliated hotel management companies have similar terms.\\nFor its services, HHMLP receives a base management fee and, if a hotel exceeds certain thresholds, an incentive management fee. The base management fee for a hotel is due monthly and is equal to 3 % of gross revenues associated with each hotel managed for the related month. The incentive management fee, if any, for a hotel is due annually in arrears on the ninetieth day following the end of each fiscal year and is based upon the financial performance of the hotels. For the three and six months ended June 30, 2021 and 2020, base management fees incurred to HHMLP totaled $ 1,745 and $ 564 , and $ 2,925 and $ 2,933 , respectively, and are recorded as Hotel Operating Expenses. For the three and six months ended June 30, 2021 and 2020, we did no t incur incentive management fees.\\nFranchise Agreements\\nOur branded hotel properties are operated under franchise agreements assumed by the hotel property lessee. The franchise agreements have 10 to 20 year terms, but may be terminated by either the franchisee or franchisor on certain anniversary dates specified in the agreements. The franchise agreements require annual payments for franchise royalties, reservation, and advertising services, and such payments are based upon percentages of gross room revenue. These payments are paid by the hotels and charged to expense as incurred. Franchise fee expenses for the three and six months ended June 30, 2021 and 2020 were $ 2,465 and $ 775 , and $ 4,287 and $ 4,603 , respectively, and are recorded in Hotel Operating Expenses. The initial fees incurred to enter into the franchise agreements are amortized over the life of the franchise agreements.\\nAccounting and Information Technology Fees\\nEach of the wholly-owned hotels and consolidated joint venture hotel properties managed by HHMLP incurs a monthly accounting and information technology fee. Monthly fees for accounting services are between $ 2 and $ 3 per property and monthly information technology fees range from $ 1 to $ 2 per property. For the three and six months ended June 30, 2021 and 2020, the Company incurred accounting fees of $ 277 and $ 319 , and $ 590 and $ 644 , respectively. For the three and six months ended June 30, 2021 and 2020, the Company incurred information technology fees of $ 90 and $ 103 , and $ 191 and $ 208 , respectively. Accounting fees and information technology fees are included in Hotel Operating Expenses.\\nCapital Expenditure Fees\\nHHMLP charges a 5 % fee on certain capital expenditures and pending renovation projects at the properties as compensation for procurement services related to capital expenditures and for project management of renovation projects. For the three and six months ended June 30, 2021 and 2020, we incurred fees of $ 78 and $ 56 , and $ 197 and $ 956 , respectively, which were capitalized with the cost of capital expenditures.\\n31\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 7 – COMMITMENTS AND CONTINGENCIES AND RELATED PARTY TRANSACTIONS (CONTINUED)\\nAcquisitions from Affiliates\\nWe have entered into an option agreement with certain of our officers and trustees such that we obtain a right of first refusal to purchase any hotel owned or developed in the future by these individuals or entities controlled by them at fair market value. This right of first refusal would apply to each party until one year after such party ceases to be an officer or trustee of the Company. Our Acquisition Committee of the Board of Trustees is comprised solely of independent trustees, and the purchase prices and all material terms of the purchase of hotels from related parties are approved by the Acquisition Committee.\\nHotel Supplies\\nFor the three and six months ended June 30, 2021 and 2020, we incurred charges for hotel supplies of $ 0 and $ 11 , and $ 1 and $ 63 , respectively. For the three and six months ended June 30, 2021 and 2020, we incurred charges for capital expenditure purchases of $ 86 and $ 176 , and $ 220 and $ 1,056 , respectively. These purchases were made from Hersha Purchasing and Design, a hotel supply company owned, in part, by certain executives and trustees of the Company. Hotel supplies are expensed and included in Hotel Operating Expenses on our consolidated statements of operations, and capital expenditure purchases are included in investment in hotel properties on our consolidated balance sheets.\\nInsurance Services\\nPrior to January 1, 2021, the Company utilized the services of the Hersha Group, a risk management business owned, in part, by certain executives and trustees of the Company. The Hersha Group provided consulting and procurement services to the Company related to the placement of property and casualty insurance, placement of general liability insurance, and for claims handling for our hotel properties. Beginning January 1, 2021, these services were provided by a third-party service provider. For the three and six months ended June 30, 2020, the total cost of property insurance that we paid through the Hersha Group were $ 1,388 and $ 2,984 , respectively. This amount paid to the Hersha Group included insurance premiums and brokerage fees as compensation for brokerage services.\\nRestaurant Lease Agreements with Independent Restaurant Group\\nThe Company enters into lease agreements with a number of restaurant management companies for the lease of restaurants located within our hotels. The Company previously entered into lease agreements with Independent Restaurant Group (\\\"IRG\\\") for restaurants at three of its hotel properties. Jay H. Shah and Neil H. Shah, executive officers and/or trustees of the Company, collectively own a 70.0 % interest in IRG. The Company’s restaurant lease agreements with IRG generally provided for a term of five years and the payment of base rents and percentage rents, which were based on IRG’s revenue in excess of defined thresholds. Effective April 1, 2020, each of these lease agreements became a management agreement between the Company and IRG, subject to the supervision of HHMLP, as property manager. At the time of the conversion of the lease agreements to management agreements there was rent due of $ 103 , which was forgiven due to the impact of the COVID-19 pandemic on the operations of our hotels and IRG's restaurants. For the six months ended June 30, 2021 and 2020, we did no t recognize any revenue from IRG.\\nDue From Related Parties\\nThe due from related parties balance as of June 30, 2021 and December 31, 2020 was approximately $ 1,552 and $ 2,641 , respectively. The balances primarily consisted of working capital deposits made to HHMLP and other entities owned, in part, by certain executives and trustees of the Company.\\nDue to Related Parties\\nThe balance due to related parties as of June 30, 2021 and December 31, 2020 was $ 0 .\\n32\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 8 – FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS\\nFair Value Measurements\\nOur determination of fair value measurements are based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, we utilize a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).\\nLevel 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Level 2 inputs are inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs may include quoted prices for similar assets and liabilities in active markets, as well as inputs that are observable for the asset or liability (other than quoted prices), such as interest rates, foreign exchange rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liabilities, which are typically based on an entity’s own assumptions, as there is little, if any, related market activity. In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.\\nAs of June 30, 2021, the Company’s derivative instruments represented the only financial instruments measured at fair value. Currently, the Company uses derivative instruments, such as interest rate swaps and caps, to manage its interest rate risk. The valuation of these instruments is determined using widely accepted valuation techniques, including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs.\\nWe incorporate credit valuation adjustments to appropriately reflect both our own nonperformance risk and the respective counter-party’s nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, we have considered the impact of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts and guarantees.\\nAlthough we have determined that the majority of the inputs used to value our derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with our derivatives utilize Level 3 inputs, such as estimates of current credit spreads, to evaluate the likelihood of default by us and the counter-parties. However, as of June 30, 2021 we have assessed the significance of the effect of the credit valuation adjustments on the overall valuation of our derivative positions and have determined that the credit valuation adjustments are not significant to the overall valuation of our derivatives. As a result, we have determined that our derivative valuations in their entirety are classified in Level 2 of the fair value hierarchy.\\nDerivative Instruments\\nThe Company’s objective in using derivatives is to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps and interest rate caps as part of its cash flow hedging strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts in exchange for fixed-rate payments over the life of the agreements without exchange of the underlying principal amount. Interest rate caps designated as cash flow hedges limit the Company’s exposure to increased cash payments due to increases in variable interest rates. The table on the following page presents our derivative instruments as of June 30, 2021 and December 31, 2020.\\n33\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 8 – FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS (CONTINUED)\\n| Estimated Fair Value |\\n| (Liability) Balance |\\n| Hedged Debt | Type | Strike Rate | Effective Date | Derivative Contract Maturity Date | Notional Amount | June 30, 2021 | December 31, 2020 |\\n| Term Loan Instruments: |\\n| Credit Facility | Swap | 1.341 | % | 1-Month LIBOR + 2.20 % | October 3, 2019 | August 2, 2021 | 150,000 | $ | ( 165 ) | $ | ( 1,070 ) |\\n| Credit Facility (1) | Swap | 1.316 | % | 1-Month LIBOR + 2.20 % | September 3, 2019 | August 2, 2021 | 43,900 | ( 47 ) | ( 307 ) |\\n| Credit Facility | Swap | 1.824 | % | 1-Month LIBOR + 2.20 % | September 3, 2019 | August 10, 2022 | 103,500 | ( 1,944 ) | ( 2,793 ) |\\n| Credit Facility | Swap | 1.824 | % | 1-Month LIBOR + 2.20 % | September 3, 2019 | August 10, 2022 | 103,500 | ( 1,944 ) | ( 2,793 ) |\\n| Credit Facility | Swap | 1.460 | % | 1-Month LIBOR + 2.00 % | September 10, 2019 | September 10, 2024 | 300,000 | ( 8,790 ) | ( 13,286 ) |\\n| Mortgages: |\\n| Annapolis Waterfront Hotel, MD | Cap | 3.350 | % | 1-Month LIBOR + 2.65 % | May 1, 2018 | May 1, 2021 | 28,000 | — | — |\\n| Hyatt, Union Square, New York, NY | Swap | 1.870 | % | 1-Month LIBOR + 2.30 % | June 7, 2019 | June 7, 2023 | 56,000 | ( 1,743 ) | ( 2,305 ) |\\n| Hilton Garden Inn Tribeca, New York, NY | Swap | 1.768 | % | 1-Month LIBOR + 2.25 % | July 25, 2019 | July 25, 2024 | 22,725 | ( 869 ) | ( 1,222 ) |\\n| Hilton Garden Inn Tribeca, New York, NY | Swap | 1.768 | % | 1-Month LIBOR + 2.25 % | July 25, 2019 | July 25, 2024 | 22,725 | ( 869 ) | ( 1,222 ) |\\n| Hilton Garden Inn 52nd Street, New York, NY | Swap | 1.540 | % | 1-Month LIBOR + 2.30 % | December 4, 2019 | December 4, 2022 | 44,325 | ( 869 ) | ( 1,186 ) |\\n| Courtyard, LA Westside, Culver City, CA (2) | Swap | 0.495 | % | 1-Month LIBOR + 3.75 % | June 1, 2020 | August 1, 2021 | 35,000 | ( 12 ) | ( 75 ) |\\n| $ | ( 17,252 ) | $ | ( 26,259 ) |\\n\\n(1) During the six months ended June 30, 2021, we dedesignated this swap as a cash flow hedge and recorded expense of $ 330 accordingly.\\n(2) Subsequent to June 30, 2021, we entered into an interest rate cap for this debt, which is effective on August 1, 2021.\\nThe fair value of our interest rate swaps is included in accounts payable, accrued expenses and other liabilities at June 30, 2021 and December 31, 2020.\\nThe net change related to derivative instruments designated as cash flow hedges recognized as unrealized gains and losses reflected on our consolidated balance sheet in accumulated other comprehensive income was a gain of $ 2,398 and a loss of $ 792 for the three months ended June 30, 2021 and 2020, respectively, and a gain of $ 9,163 and a loss of $ 30,941 for the six months ended June 30, 2021 and 2020, respectively.\\n34\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 8 – FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS (CONTINUED)\\nAmounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are made on the Company’s variable-rate derivatives. The change in net unrealized gains/losses on cash flow hedges reflects a reclassification of $( 141 ) and $ 1,228 and $ 159 and $ 2,205 of net unrealized gains from accumulated other comprehensive income as an increase/decrease to interest expense for the three and six months ended June 30, 2021 and 2020, respectively. For the next twelve months ending June 30, 2022, we estimate that an additional $ 10,059 will be reclassified as an increase to interest expense.\\nFair Value of Debt\\nWe estimate the fair value of our fixed rate debt and the credit spreads over variable market rates on our variable rate debt by discounting the future cash flows of each instrument at estimated market rates or credit spreads consistent with the maturity of the debt obligation with similar credit policies. Credit spreads take into consideration general market conditions and maturity. The inputs utilized in estimating the fair value of debt are classified in Level 2 of the fair value hierarchy. As of June 30, 2021, the carrying value and estimated fair value of our debt was $ 1,112,492 and $ 1,141,023 respectively. As of December 31, 2020, the carrying value and estimated fair value of our debt was $ 1,196,434 and $ 1,176,625 , respectively.\\n35\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 9 – SHARE BASED PAYMENTS\\nOur shareholders approved the Hersha Hospitality Trust 2012 Equity Incentive Plan, as amended, (the “2012 Plan”) for the purpose of attracting and retaining executive officers, employees, trustees and other persons and entities that provide services to the Company.\\nThe Short Term Incentive Program (\\\"STIP\\\") and the Long-Term Incentive Program (\\\"LTIP\\\") were incentive compensation programs the Compensation Committee of our Board of Trustees established to align executive compensation with the performance of the Company. Prior to 2019, executives participated in our legacy incentive compensation programs, including the Multi-Year Long Term Equity Incentive Program (\\\"Multi-Year EIP\\\").\\nOn March 17, 2021, based on the achievement of certain metrics established under the 2020 STIP for the performance period ended December 31, 2020, the Compensation Committee awarded 519,732 LTIP Units. The awards issued pursuant to the STIP vest on December 31, 2022, the two year anniversary following the end of the performance period.\\nOn March 3, 2021, the Compensation Committee approved the 2021 LTIP in which 50 % of the awards provide for time based vesting and the remaining 50 % are issuable based on the Company's achievement of a certain level of (1) absolute total shareholder return ( 37.5 % of the award), (2) relative total shareholder return as compared to the Company’s peer\\ngroup ( 37.5 % of the award), and (3) relative growth in revenue per available room (\\\"RevPar\\\") compared to the Company’s peer group ( 25.0 % of the award). On March 17, 2021, the Compensation Committee awarded 247,689 LTIP Units related to the time based portion of the plan. These Units will vest over a three year period from January 1, 2021 to December 31, 2023. The 50 % market-based portion of the 2021 LTIP has a three-year performance period which commenced on January 1, 2021 and ends December 31, 2023. As of June 30, 2021, no shares or LTIP Units have been issued to the executive officers in settlement of 2021 LTIP market-based awards.\\nThe LTIP Units awarded under both the 2020 STIP and the 2021 LTIP were determined by dividing the dollar amount of award earned by $ 8.43 , the per share volume weighted average trading price of the Company’s common shares on the NYSE for the 20 trading days prior to December 31, 2020.\\n| LTIP Unit Awards | Restricted Share Awards | Share Awards |\\n| Number of Units | Weighted Average Grant Date Fair Value | Number of Restricted Shares | Weighted Average Grant Date Fair Value | Number of Shares | Weighted Average Grant Date Fair Value |\\n| Unvested Balance as of December 31, 2020 | 898,126 | $ | 6.15 | 202,878 | $ | 7.87 | — |\\n| Granted | 794,683 | 12.86 | 116,743 | 10.18 | 32,460 | 11.31 |\\n| Vested | ( 13,512 ) | 12.23 | ( 239,736 ) | 7.73 | ( 32,460 ) | 11.31 |\\n| Forfeited | — | N/A | ( 150 ) | 11.31 | — | N/A |\\n| Unvested Balance as of June 30, 2021 | 1,679,297 | $ | 9.28 | 79,735 | $ | 11.68 | — |\\n\\n36\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 9 – SHARE BASED PAYMENTS (CONTINUED)\\n| Share BasedCompensation Expense | UnearnedCompensation |\\n| For the Three Months Ended | For the Six Months Ended | As of |\\n| June 30, 2021 | June 30, 2020 | June 30, 2021 | June 30, 2020 | June 30, 2021 | December 31, 2020 |\\n| Issued Awards |\\n| LTIP Unit Awards | $ | 1,534 | $ | 1,142 | $ | 3,258 | $ | 2,951 | $ | 8,049 | $ | 1,842 |\\n| Restricted Share Awards | 254 | 342 | 422 | 674 | 762 | 276 |\\n| Share Awards | 367 | — | 367 | — | — | — |\\n| Unissued Awards |\\n| Market Based | 434 | 315 | 711 | 630 | 3,019 | 1,933 |\\n| Performance Based | — | — | — | — | — | — |\\n| Total | $ | 2,589 | $ | 1,799 | $ | 4,758 | $ | 4,255 | $ | 11,830 | $ | 4,051 |\\n\\nThe weighted-average period of which the unrecognized compensation expense will be recorded is approximately 2.0 years for LTIP Unit Awards and 1.1 years for Restricted Share Awards.\\n| 2021 | 2022 | 2023 | 2024 |\\n| LTIP Unit Awards | 960,046 | 595,406 | 61,921 | 61,924 |\\n| Restricted Share Awards | — | 66,202 | 10,533 | 3,000 |\\n| 960,046 | 661,608 | 72,454 | 64,924 |\\n\\n37\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 10 – EARNINGS PER SHARE\\nThe following table is a reconciliation of the income or loss (numerator) and the weighted average shares (denominator) used in the calculation of basic and diluted earnings per common share. The computation of basic and diluted earnings per share is presented below.\\n\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| NUMERATOR: |\\n| Basic and Diluted* |\\n| Net Loss | $ | ( 23,523 ) | $ | ( 71,780 ) | $ | ( 14,433 ) | $ | ( 97,752 ) |\\n| Loss allocated to Noncontrolling Interests | 977 | 10,360 | 813 | 13,257 |\\n| Distributions to Preferred Shareholders | ( 6,044 ) | ( 6,044 ) | ( 12,087 ) | ( 12,088 ) |\\n| Net loss applicable to Common Shareholders | $ | ( 28,590 ) | $ | ( 67,464 ) | $ | ( 25,707 ) | $ | ( 96,583 ) |\\n| DENOMINATOR: |\\n| Weighted average number of common shares - basic | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\\n| Effect of dilutive securities: |\\n| Restricted Stock Awards and LTIP Units (unvested) | — | — | — | — |\\n| Contingently Issued Shares and Units | — | — | — | — |\\n| Weighted average number of common shares - diluted | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\\n\\n*Income (loss) allocated to noncontrolling interest in HHLP has been excluded from the numerator and Common Units and Vested LTIP Units have been omitted from the denominator for the purpose of computing diluted earnings per share since including these amounts in the numerator and denominator would have no impact. In addition, potentially dilutive common shares, if any, have been excluded from the denominator if they are anti-dilutive to income (loss) applicable to common shareholders.\\n38\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 11 – CASH FLOW DISCLOSURES AND NON CASH INVESTING AND FINANCING ACTIVITIES\\nInterest paid during the six months ended June 30, 2021 and 2020 totaled $ 20,052 and $ 21,488 , respectively. Net Cash paid on Interest Rate Derivative contracts during the six months ended June 30, 2021 and 2020 totaled $ 6,259 and $ 1,505 , respectively. Cash paid for income taxes during the six months ended June 30, 2021 and 2020 totaled $ 60 and $ 233 , respectively. The following non-cash investing and financing activities occurred during the six months ended June 30, 2021 and 2020:\\n| 2021 | 2020 |\\n| Common Shares issued as part of the Dividend Reinvestment Plan | $ | — | $ | 14 |\\n| Issuance of share based payments | 13,103 | 6,404 |\\n| Accrued payables for capital expenditures placed into service | 230 | 1,398 |\\n| Adjustment to Record Noncontrolling Interest at Redemption Value | 1,968 | ( 3,196 ) |\\n\\nThe following table provides a reconciliation of cash, cash equivalents, and restricted cash reported within the consolidated balance sheets that sum to the total of the same such amounts shown in the consolidated statements of cash flows for the six months ended June 30, 2021 and 2020:\\n| 2021 | 2020 |\\n| Cash and cash equivalents | $ | 69,083 | $ | 23,228 |\\n| Escrowed cash | 11,067 | 7,374 |\\n| Total cash, cash equivalents, and restricted cash shown in the consolidated statements of cash flows | $ | 80,150 | $ | 30,602 |\\n\\nAmounts included in restricted cash represent those required to be set aside in escrow by contractual agreement with various lenders for the payment of specific items such as property insurance, property tax, and capital expenditures.\\n39\\nItem 2.\\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations\\nCautionary Statement Regarding Forward Looking Statements\\nThis report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including, without limitation, statements containing the words, “believe,” “expect,” “anticipate,” “estimate,” “plan,” “continue,” “intend,” “should,” “may” and words of similar import. Such forward-looking statements relate to future events, our plans, strategies, prospects and future financial performance, and involve known and unknown risks that are difficult to predict, uncertainties and other factors which may cause our actual results, performance or achievements or industry results to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Readers should specifically consider the various factors identified in this report and other reports filed by us with the U.S. Securities and Exchange Commission (the \\\"SEC\\\"), including, but not limited to those discussed in the sections entitled “Risk Factors” and \\\"Management's Discussion and Analysis of Financial Conditions and Results of Operations\\\" of our Annual Report on Form 10-K for the year ended December 31, 2020 and in this Quarterly Report on Form 10-Q, that could cause actual results to differ. Statements regarding the following subjects are forward-looking by their nature:\\n● our business or investment strategy;\\n● our projected operating results;\\n● our ability to generate positive cash flow from operations;\\n● our distribution policy;\\n● our liquidity and management's plans with respect thereto;\\n● completion of any pending transactions;\\n● our ability to maintain existing financing arrangements, including compliance with covenants and our ability to obtain future financing arrangements or refinance or extend the maturity of existing financing arrangements as they come due;\\n● our ability to negotiate with lenders;\\n● our understanding of our competition;\\n● market trends;\\n● projected capital expenditures;\\n● the impact of and changes to various government programs, including in response to the novel coronavirus, or COVID-19, including those specifically affecting New York City;\\n● the efficacy of any treatment for COVID-19;\\n● our access to capital on the terms and timing we expect;\\n● the restoration of public confidence in domestic and international travel;\\n● permanent structural changes in demand for conference centers by business and leisure clientele; and\\n● our ability to dispose of selected hotel properties on the terms and timing we expect, if at all.\\nForward-looking statements are based on our beliefs, assumptions and expectations, taking into account all information currently available to us. These beliefs, assumptions and expectations are subject to risks and uncertainties and can change as a result of many possible events or factors, not all of which are known to us. If a change occurs, our business, financial condition, liquidity and results of operations may vary materially from those expressed in our forward-looking statements. Readers should not place undue reliance on forward-looking statements.\\nImportant factors that we think could cause our actual results to differ materially from expected results are summarized below. One of the most significant factors, however, is the ongoing impact of the current outbreak of the novel coronavirus on the United States, regional and global economies, the broader financial markets, our customers and employees, governmental responses thereto and the operation changes we have and may implement in response thereto. The current outbreak of COVID-19 has also impacted, and is likely to continue to impact, directly or indirectly, many other important factors below.\\nNew factors emerge from time to time, and it is not possible for us to predict which factors will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. In particular, it is difficult to fully assess the impact of COVID-19 at this time due to, among other factors, uncertainty regarding the severity and duration of the outbreak domestically and internationally, and the possibility of additional subsequent widespread outbreaks and variant strains and the impacts of actions taken in response, and the effectiveness of federal, state and local governments’ efforts to contain the spread of COVID-19 and respond to its direct and indirect impact on the U.S. economy and economic activity.\\n40\\nThe following non-exclusive list of factors could also cause actual results to vary from our forward-looking statements:\\n● general volatility of the capital markets and the market price of our common shares;\\n● changes in our business or investment strategy;\\n● availability, terms and deployment of capital;\\n● changes in our industry and the market in which we operate, interest rates, or the general economy;\\n● decreased international travel because of geopolitical events, including terrorism and current U.S. government policies such as immigration policies, border closings, and travel bans related to COVID-19;\\n● the degree and nature of our competition;\\n● financing risks, including (i) the risk of leverage and the corresponding risk of default on our mortgage loans and other debt, including default with respect to applicable covenants, (ii) potential inability to obtain waivers of covenants or refinance or extend the maturity of existing indebtedness and (iii) our ability to negotiate with lenders;\\n● levels of spending in the business, travel and leisure industries, as well as consumer confidence;\\n● declines in occupancy, average daily rate and RevPAR and other hotel operating metrics;\\n● hostilities, including future terrorist attacks, or fear of hostilities that affect travel;\\n● financial condition of, and our relationships with, our joint venture partners, third-party property managers, and franchisors;\\n● increased interest rates and operating costs;\\n● ability to complete development and redevelopment projects;\\n● risks associated with potential dispositions of hotel properties;\\n● availability of and our ability to retain qualified personnel;\\n● decreases in tourism due to pandemics, geopolitical instability or changes in foreign exchange rates;\\n● our failure to maintain our qualification as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended, or the \\\"Code\\\";\\n● environmental uncertainties and risks related to natural disasters and increases in costs to insure against those risks;\\n● changes in real estate and zoning laws and increases in real property tax rates;\\n● the uncertainty and economic impact of pandemics, epidemics, or other public health emergencies or fear of such events, such as the recent outbreak of COVID-19, including with respect to New York City;\\n● the current COVID-19 pandemic had, and will continue to have, adverse effects on our financial conditions, results of operations, cash flows, and performance for an indefinite period of time. Future pandemics may also have adverse effects on our financial condition, results of operations, cash flows, and performance;\\n● world events impacting the ability or desire of people to travel may lead to a decline in demand for hotels; and\\n● the factors discussed in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2020 under the headings “Risk Factors” and \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations\\\" and in other reports we file with the SEC from time to time.\\nThese factors are not necessarily all of the important factors that could cause our actual results, performance or achievements to differ materially from those expressed in or implied by any of our forward-looking statements. Other unknown or unpredictable factors, many of which are beyond our control, also could harm our results, performance or achievements.\\nAll forward-looking statements contained in this report are expressly qualified in their entirety by the cautionary statements set forth above. Forward-looking statements speak only as of the date they are made, and we do not undertake or assume any obligation to update publicly any of these statements to reflect actual results, new information or future events, changes in assumptions or changes in other factors affecting forward-looking statements, except to the extent required by applicable laws. If we update one or more forward-looking statements, no inference should be drawn that we will make additional updates with respect to those or other forward-looking statements.\\nBACKGROUND\\nAs of June 30, 2021, we owned interests in 36 hotels in major urban gateway markets including New York, Washington DC, Boston, Philadelphia, San Diego, Los Angeles, Seattle, and Miami, including 32 wholly-owned hotels, 1 hotel through our interest in a consolidated joint venture, and interests in 3 hotels owned through unconsolidated joint ventures. We have elected to be taxed as a REIT for federal income tax purposes, beginning with the taxable year ended December 31, 1999. For purposes of the REIT qualification rules, we cannot directly operate any of our hotels. Instead, we must lease our hotels to a third party lessee or to a TRS, provided that the TRS engages an eligible independent contractor to manage the\\n41\\nhotels. As of June 30, 2021, we have leased all of our hotels to a wholly-owned TRS, a joint venture owned TRS, or an entity owned by our wholly-owned TRS. Each of these TRS entities will pay qualifying rent, and the TRS entities have entered into management contracts with qualified independent managers, including HHMLP, with respect to our hotels. We intend to lease all newly acquired hotels to a TRS. The TRS structure enables us to participate more directly in the operating performance of our hotels. The TRS directly receives all revenue from, and funds all expenses relating to, hotel operations. The TRS is also subject to income tax on its earnings.\\nOVERVIEW\\nWe started to realize the effects from the global economic slowdown caused by the COVID-19 pandemic in March of 2020. As a result of the COVID-19 pandemic and subsequent government mandates and health official recommendations, hotel demand has been substantially reduced across the United States.\\nFollowing the government mandates and health official recommendations, and after evaluating the cost of running our respective properties at low occupancy levels versus closing the properties, we originally closed 21 hotel properties and dramatically reduced staffing at the hotels that remained open and at the corporate level; however, we have subsequently reopened all of our consolidated hotels. The reopening of our consolidated hotels provided us the opportunity to capture incremental demand through the end of 2020 and we believe we are prepared to capture market share during the early stages of an economic recovery in 2021.\\nIn addition to our focus on strategically reopening hotels and driving occupancy at these hotels, we have remained focused on executing expense mitigation measures and shoring up our liquidity position as we continue to face a challenging operating environment. We suspended our common and preferred dividends in 2020 and during the six months ended June 30, 2021, we paid approximately $24.2 million in preferred dividend arrearage that was not paid in 2020. We also deferred certain planned capital expenditures for 2020 and we will continue to reduce capital expenditures in 2021 with planned allocations estimated between $15.0 and $18.0 million. In February 2021, the Company entered into an unsecured notes facility that provided net proceeds of $144.75 million at closing. An incremental $50 million may be drawn, at the Company’s discretion, in minimum installments of $25.0 million, at any point on or prior to September 30, 2021. The initial net proceeds of $144.75 million provided by this facility, along with a portion of the proceeds from asset sales, were used to repay amounts outstanding under our Credit Facility, allowing us to amend our Credit Facility on February 17, 2021, eliminating maturities under the Credit Facility until August of 2022. The Credit Facility amendment also waived all financial covenants through March 31, 2022, established accommodative covenant testing methodology through December 31, 2022, and provided additional liquidity at the Company’s discretion.\\nThe manner in which the ongoing COVID-19 pandemic will be resolved or the manner that the hospitality and tourism industries will return to historical performance norms, and whether the economy will contract or grow are not reasonably predictable. As a result, there can be no assurances that we will be able to achieve the hotel operating metrics or the results at our properties we have forecasted. Factors that might contribute to less-than-anticipated performance include those described under the headings “Risk Factors” and \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations\\\" in our Annual Report on Form 10-K for the year ended December 31, 2020 and other documents that we may file with the SEC in the future. We will continue to cautiously monitor lodging demand and rates, our third-party hotel managers, and our performance generally.\\n42\\nSUMMARY OF OPERATING RESULTS\\nCOMPARISON OF THE THREE MONTHS ENDED JUNE 30, 2021 AND 2020\\n(dollars in thousands, except ADR, RevPAR, and per share data)\\nRevenue\\nOur total revenues for the three months ended June 30, 2021 consisted of hotel operating revenues and other revenue. Hotel operating revenues were approximately 99% of total revenues for the three months ended June 30, 2021 and 2020. Hotel operating revenues are recorded for wholly-owned hotels that are leased to our wholly owned TRS and hotels owned through joint venture or other interests that are consolidated in our financial statements. Hotel operating revenues increased $52,671, or 302.5%, to $70,083 for the three months ended June 30, 2021 compared to $17,412 for the same period in 2020. This increase is primarily attributable to an increase in demand across our portfolio in 2021 as the comparable period in 2020 was at the nadir of the reduction in operations across our portfolio due to the decrease in demand caused by the COVID-19 pandemic. The increase in demand is partially offset by the sale of five hotels during the six months ended June 30, 2021 and the sale of one hotel in December of 2020. Total revenues for the three months ended June 30, 2020 includes hotel operating revenue for these six hotels for the entire period.\\nExpenses\\nTotal hotel operating expenses increased 124.8% to approximately $41,310 for the three months ended June 30, 2021 from $18,378 for the three months ended June 30, 2020. The increase in hotel operating expenses is due to increased operations at our hotels for the three months ended June 30, 2021 as we had temporary closed certain of our hotels and reduced operations at the remaining hotels as a result of the decrease in demand caused by the COVID-19 pandemic during the comparable period in 2020. This increase in hotel operating expense is partially offset by the sale of hotels noted above.\\nDepreciation and amortization decreased by 13.6%, or $3,308, to $21,014 for the three months ended June 30, 2021 from $24,322 for the three months ended June 30, 2020. The decrease is primarily attributable to the disposition of the Sheraton Wilmington in December 2020, and the Courtyard San Diego, the Residence Inn Coconut Grove, the Capitol Hill Hotel, the Holiday Inn Express Cambridge, and the Duane Street Hotel in the first half of 2021.\\nReal estate and personal property tax and property insurance decreased $503, or 5.0%, for the three months ended June 30, 2021 when compared to the same period in 2020. This decrease is primarily driven by reductions in real estate tax expense due to the sale of hotels noted above. The decrease is partially offset by increased real estate tax that had been re-assessed by the applicable taxing authority, resulting in increases in real estate tax expense for the quarter as we cumulatively catch up, in certain instances, our estimated tax accruals at the time the new assessment is received. We typically experience increases in tax assessments and tax rates as the economy improves which could be offset by reductions resulting from successful real estate tax appeals. The Company regularly appeals property taxes but cannot predict property tax reductions from real estate tax appeals.\\nGeneral and administrative expense increased by 26.3%, or approximately $1,100, from $4,187 for the three months ended June 30, 2020 to $5,287 for the same period in 2021. General and administrative expense includes expenses related to payroll, rents, and other corporate level administrative costs as well as non-cash share based payments issued as incentive compensation to the Company’s trustees, executives, and employees. Expenses related to non-cash share based compensation increased $790 when comparing the three months ended June 30, 2021 to the same period in 2020. This increase resulted primarily from an increase in the valuation of certain market based award programs and a difference in the timing of share based compensation recognition. In addition, during the three months ended June 30, 2020, we executed cost containment strategies in our payroll and other administrative costs. Please refer to “Note 9 – Share Based Payments” of the notes to the consolidated financial statements for more information about our share based compensation.\\nOperating Loss\\nOperating loss for the three months ended June 30, 2021 was $7,592 compared to operating loss of $41,542 during the same period in 2020. The decrease in our operating loss of $33,950 is primarily due to an increase in demand during the three months ended June 30, 2021 as compared to the same period in 2020 when we had temporary closed certain of our hotels and reduced operations at the remaining hotels as a result of the decrease in demand caused by the COVID-19 pandemic.\\n43\\nInterest Expense\\nInterest expense increased $1,501 from $13,481 for the three months ended June 30, 2020 to $14,982 for the three months ended June 30, 2021. The primary driver of the increased interest expense is due to the issuance of the Junior Notes, which is partially offset by a decrease in interest expense on our term loans and decreases in the amortization of our interest rate hedges. Resulting primarily from the proceeds of the sales of assets, the balance of our borrowings, excluding discounts and deferred costs, have decreased by $57,256 in total between June 30, 2020 and June 30, 2021.\\nIncome Tax Benefit\\nDuring the three months ended June 30, 2021, the Company recorded an income tax expense of $151 compared to an income tax expense of $15,872 for the three months ended June 30, 2020. After considering various factors, including future reversals of existing taxable temporary differences, future taxable income and tax planning strategies, we believe that as of June 30, 2021, it is not more likely than not that we will be able to realize our net deferred tax asset and therefore, maintained the full valuation allowance that was established during the second quarter of 2020, with the exception of a city net operating loss that we believe that we will be able to realize. As a result, the balance of our net deferred tax asset at June 30, 2021 is $499. Absent the valuation allowance, the amount of income tax expense or benefit that the Company typically records depends mostly on the amount of taxable income or loss that is generated by our consolidated taxable REIT subsidiaries (“TRS”).\\nNet Loss Applicable to Common Shareholders\\nNet loss applicable to common shareholders for the three months ended June 30, 2021 was $28,590 compared to net loss of $67,464 during the same period in 2020. This decrease is primarily due to an increase in demand during the three months ended June 30, 2021 as compared to the same period in 2020, as discussed above, partially offset by increased interest expense during the three months ended June 30, 2021, as discussed above.\\nCOMPARISON OF THE SIX MONTHS ENDED JUNE 30, 2021 AND 2020\\n(dollars in thousands, except ADR, RevPAR, and per share data)\\nRevenue\\nOur total revenues for the six months ended June 30, 2021 consisted of hotel operating revenues and other revenue. Hotel operating revenues were approximately 99% of total revenues for the six months ended June 30, 2021 and 2020. Hotel operating revenues are recorded for wholly-owned hotels that are leased to our wholly owned TRS and hotels owned through joint venture or other interests that are consolidated in our financial statements. Hotel operating revenues increased $9,886, or 9.2%, to $117,236 for the six months ended June 30, 2021 compared to $107,350 for the same period in 2020. This increase is attributable to an increase in RevPAR across our portfolio during the six months ended June 30, 2021 as compared to the six months ended June 30, 2020, when beginning in March 2020, we experienced a significant decrease in demand caused by the COVID-19 pandemic. The increase in demand is partially offset by the sale of five hotels during the six months ended June 30, 2021 and the sale of one hotel in December of 2020. Total revenues for the six months ended June 30, 2020 includes hotel operating revenue for these six hotels for the entire period.\\nExpenses\\nTotal hotel operating expenses decreased 12.4% to approximately $73,490 for the six months ended June 30, 2021 from $83,897 for the six months ended June 30, 2020. The decrease in hotel operating expenses is attributable to the cost saving measures implemented to mitigate the impact of the decrease in demand in 2020, as well the sale of hotels noted above.\\nDepreciation and amortization decreased by 11.7%, or $5,694, to $42,816 for the six months ended June 30, 2021 from $48,510 for the six months ended June 30, 2020 due to the dispositions noted above.\\nReal estate and personal property tax and property insurance decreased $374, or 1.9%, for the six months ended June 30, 2021 when compared to the same period in 2020, which is primarily due to the sale of hotels noted above. This decrease is partially offset by an increase in real estate taxes at our remaining hotels as a result of properties that had been re-assessed by the applicable taxing authority, resulting in increases in real estate tax expense. We typically experience increases in tax assessments and tax rates as the economy improves which could be offset by reductions resulting from successful real estate tax appeals. In general, our property insurance costs continue to rise annually.\\n44\\nGeneral and administrative expense increased by 2.1%, or $210 from $10,021 for the six months ended June 30, 2020 to $10,231 for the same period in 2021. General and administrative expense includes expenses related to payroll, rents, and other corporate level administrative costs as well as non-cash share based payments issued as incentive compensation to the Company’s trustees, executives, and employees. Expenses related to non-cash share based compensation increased $503 when comparing the six months ended June 30, 2021 to 2020, which was partially offset by the execution of our cost containment strategies in other administrative costs. The increase in shared based compensation resulted primarily from an increase in the valuation of certain market based award programs and a difference in the timing of shared based compensation recognition. Please refer to “Note 9 – Share Based Payments” of the notes to the consolidated financial statements for more information about our share based compensation.\\nOperating Loss\\nOperating loss for the six months ended June 30, 2021 was $30,878 compared to operating loss of $57,951 during the same period in 2020. Our decrease in operating loss was largely the result of a decrease in hotel operating expenses for the six months ended June 30, 2021 and an increase in hotel operating revenues, which is the result of an increase in demand across our portfolio, while maintaining certain cost containment strategies in place due to the COVID-19 pandemic. Additionally, we had a decrease in depreciation and amortization expense during the first half of 2021 compared to 2020 as a result of the disposals noted above.\\nInterest Expense\\nInterest expense increased $1,923 from $26,488 for the six months ended June 30, 2020 to $28,411 for the six months ended June 30, 2021. The balance of our borrowings, excluding discounts and deferred costs, has decreased by $57,256 in total between June 30, 2020 and June 30, 2021. However, we experienced an increase in our weighted average interest rate, driven by the unsecured junior notes payable facility we entered into in February 2021, and increased interest expense related to the amortization of additional deferred costs incurred during the six months ended June 30, 2021. Proceeds from the junior notes payable were used to reduce borrowings under our secured credit facility and term loans.\\nIncome Tax Expense\\nDuring the six months ended June 30, 2021, the Company recorded an income tax benefit of $438 compared to an income tax expense of $11,374 for the six months ended June 30, 2020. After considering various factors, including future reversals of existing taxable temporary differences, future taxable income and tax planning strategies, we believe that as of June 30, 2021, it is not more likely than not that we will be able to realize our net deferred tax asset and therefore, maintained the full valuation allowance that was established during the second quarter of 2020, with the exception of a city net operating loss that we believe that we will be able to realize. As a result, the balance of our net deferred tax asset at June 30, 2021 is $499. Absent the valuation allowance, the amount of income tax expense or benefit that the Company typically records depends mostly on the amount of taxable income or loss that is generated by our consolidated taxable REIT subsidiaries (“TRS”).\\nNet Loss Applicable to Common Shareholders\\nNet loss applicable to common shareholders for the six months ended June 30, 2021 was $25,707 compared to net loss of $96,583 during the same period in 2020, resulting in a decreased loss of $70,876. This decrease in loss is primarily related to gain on hotel dispositions of $48,352, as well as a decrease in operating loss.\\n45\\nLIQUIDITY, CAPITAL RESOURCES, AND EQUITY OFFERINGS\\n(dollars in thousands, except per share data)\\nPotential Sources of Capital\\nOur organizational documents do not limit the amount of indebtedness that we may incur. Our ability to incur additional debt is dependent upon a number of factors, including the current state of the overall credit markets, our degree of leverage and borrowing restrictions imposed by existing lenders. Our ability to raise funds through the issuance of debt and equity securities is dependent upon, among other things, capital market volatility, risk tolerance of investors, general market conditions for REITs and market perceptions related to the Company’s ability to generate cash flow and positive returns on its investments.\\nIn addition, our mortgage indebtedness contains various financial and non-financial covenants customarily found in secured, nonrecourse financing arrangements. If the specified criteria are not satisfied, the lender may be able to escrow cash flow generated by the property securing the applicable mortgage loan. At June 30, 2021, we failed our debt service coverage ratio (\\\"DSCR\\\") requirement related to two of our mortgage borrowings. After considering the effect of the COVID-19 pandemic on our consolidated operations, it is possible that we could fail certain financial covenants within certain property-level mortgage borrowings. For mortgages with financial covenants, the lenders' remedy of a covenant failure would be a requirement to escrow funds for the purpose of meeting our future debt payment obligations.\\nIn February 2021, the Company entered into a junior unsecured notes facility (“Junior Notes”) that provided net proceeds of $144,750 at closing. An incremental $50,000 may be drawn, at the Company’s discretion, in minimum installments of $25,000 at any point on or prior to September 30, 2021. The Junior Notes bear interest at a rate of 9.50%, of which half, or 4.75%, will be paid in cash with the remaining half added to the principal of the note through March 31, 2022 at our discretion. The Junior Notes mature in February of 2026 and are non-callable through February 2022. The Junior Notes are callable at 104% beginning February of 2022, 102% beginning in February 2023, and at par any time beginning in February 2024.\\nThe net proceeds of $144,750 provided by the Junior Notes, along with a portion of the proceeds from asset sales, were used to repay amounts outstanding under the Credit Facility, the Second Term Loan, and the Third Term Loan. The Junior Notes and asset sales that closed in the first quarter of 2021 allowed the Company to execute amendments to Credit Agreements governing the Credit Facility, the Second Term Loan, and the Third Term Loan. These amendments eliminated term loan maturities until August of 2022, waived all financial covenants through March 31, 2022, established accommodative covenant testing methodology through December 31, 2022, enabled the Company to pay down the accrual of the Company’s preferred dividends and allow the ongoing preferred dividend accrual to be kept current, and provided additional liquidity at the Company’s discretion.\\nOur secured debt facilities aggregate to $747,481 which is comprised of a $442,404 senior credit facility and two term loans totaling $305,077. The credit facility (“Credit Facility”) contains a $192,404 term loan (“First Term Loan”) and a $250,000 revolving line of credit (“Line of Credit”), and expires on August 10, 2022. As of June 30, 2021, we had $118,684 outstanding under the Line of Credit. Our two additional term loans are $278,846 (“Second Term Loan”) and $26,231 (“Third Term Loan”), which mature on September 10, 2024 and August 10, 2022, respectively.\\nWe will continue to monitor our debt maturities to manage our liquidity needs. However, no assurances can be given that we will be successful in refinancing all or a portion of our future debt obligations due to factors beyond our control or that, if refinanced, the terms of such debt will not vary from the existing terms. As of June 30, 2021, we have $23,431 of indebtedness due on or before June 30, 2022. We currently expect that cash requirements for all debt that is not refinanced by our existing lenders for which the maturity date is not extended will be met through a combination of cash on hand, refinancing the existing debt with new lenders, draws on the Line of Credit or Junior Notes and the issuance of our securities.\\nIn addition to the incurrence of debt and the offering of equity securities, dispositions of property may serve as additional capital resources and sources of liquidity. We may recycle capital from stabilized assets or from sales of non-core hotels in secondary and tertiary markets. Capital from these types of transactions is intended to be redeployed into high growth acquisitions, share buybacks, or to pay down existing debt.\\n46\\nAcquisitions\\nDuring the six months ended June 30, 2021, we acquired no hotel properties. We intend to invest in additional hotels only as suitable opportunities arise and adequate sources of capital are available. We expect that future investments in hotels will depend upon and will be financed by, in whole or in part, our existing cash, the proceeds from additional issuances of common or preferred shares, proceeds from the sale of assets, issuances of Common Units, issuances of preferred units or other securities or borrowings secured by hotel assets and under our Line of Credit.\\nDispositions\\nDuring the six months ended June 30, 2021, we disposed of five hotel properties for an aggregate sales price of $196,500 resulting in a gain on disposition of $48,313. The net proceeds were used to repay existing debt.\\nOperating Liquidity and Capital Expenditures\\nWe expect to meet our short-term liquidity requirements generally through net cash provided by operations, existing cash balances and, if necessary, short-term borrowings under the Line of Credit. We believe that the net cash provided by operations in the coming year and borrowings drawn on the Line of Credit will be adequate to fund the Company’s operating requirements, monthly recurring debt service and the payment of dividends in accordance with REIT requirements of the Code.\\nTo qualify as a REIT, we must distribute annually at least 90% of our taxable income. This distribution requirement limits our ability to retain earnings and requires us to raise additional capital in order to grow our business and acquire additional hotel properties. However, there is no assurance that we will be able to borrow funds or raise additional equity capital on terms acceptable to us, if at all. In addition, we cannot guarantee that we will be able to make distributions to our shareholders.\\nWe will seek to satisfy long-term liquidity requirements through various sources of capital, including borrowings under the Line of Credit and through secured, non-recourse mortgage financings with respect to our unencumbered hotel properties. In addition, we may seek to raise capital through public or private offerings of our securities. Certain factors may have a material adverse effect on our ability to access these capital sources, including our degree of leverage, the value of our unencumbered hotel properties and borrowing restrictions imposed by lenders or franchisors. We will continue to analyze which source of capital is most advantageous to us at any particular point in time, but financing may not be consistently available to us on terms that are attractive, or at all.\\nSpending on capital improvements during the six months ended June 30, 2021 decreased when compared to spending on capital improvements during the six months ended June 30, 2020. During the six months ended June 30, 2021, we spent $5,374 on capital expenditures to renovate, improve or replace assets at our hotels. This compares to $15,612 during the same period in 2020. These capital expenditures were undertaken to comply with brand mandated improvements and to initiate projects that we believe will generate a return on investment. We may spend additional amounts, if necessary, to comply with the requirements of any franchise license under which any of our hotels operate and otherwise to the extent we deem such expenditures to be prudent. We are also obligated to fund the cost of certain capital improvements to our hotels.\\nWe expect to use operating cash flow, borrowings under the Line of Credit, and proceeds from issuances of our securities and hotel dispositions to pay for the cost of capital improvements and any furniture, fixture and equipment requirements.\\n47\\nCASH FLOW ANALYSIS\\n(dollars in thousands, except per share data)\\nComparison of the Six Months Ended June 30, 2021 and 2020\\nNet cash used in operating activities decreased $9,250 from $16,357 for the six months ended June 30, 2020 to $7,107 for the comparable period in 2021. The increase in cash flow is primarily attributable to an increase in hotel property cash flow as a result of an increase in demand since the onset of the COVID-19 pandemic.\\nNet cash provided by investing activities for the six months ended June 30, 2021 was $157,659 compared to net cash used in investing activities of $16,191 for the six months ended June 30, 2020. The following items are the major contributing factors for the change in investing cash flows:\\n•Proceeds of $163,583 received related to the disposition of the Courtyard San Diego, the Capitol Hill Hotel, the Holiday Inn Express Cambridge, the Residence Inn Coconut Grove, and the Duane Street Hotel during the six months ended June 30, 2021.\\n•An increase in comparative cash flows of $10,217 related to a decrease in spending on capital expenditures and hotel development projects for the six months ended June 30, 2021 compared to 2020.\\n•An increase in comparative cash flows of $50 related to contributions of $600 to unconsolidated joint ventures for the six months ended June 30, 2020 compared to contributions of $550 for the six months ended June 30, 2021.\\nNet cash used in financing activities for the six months ended June 30, 2021 was $94,009 compared to net cash provided by financing activities for the six months ended June 30, 2020 of $26,165. The following items are the major contributing factors for the change in financing cash flows:\\n•The primary use of cash was the payment of $187,024 of outstanding borrowings under the Term Loan agreements. We received proceeds of $144,750 from the issuance of the Junior Notes, a portion of which, in addition to the proceeds received from the hotel dispositions noted above, were used to pay down the Term Loans.\\n•An increase in mortgage payments of $703 for the six months ended June 30, 2021 as compared to the six months ended June 30, 2020.\\n•Payment of $5,795 of deferred financing costs for the six months ended June 30, 2021 which primarily relate to the Junior Notes issuance noted above, as compared to the payment of $2,104 during the six months ended June 30, 2020.\\n•A decrease in comparative cash flows as we drew $47,000 on our Line of Credit during the six months ended June 30, 2020 when compared to $14,369 in net repayments during the same period in 2021.\\n•An increase in cash payments of $12,167 related to dividends paid. During the six months ended June 30, 2021, our executed amendments to the Credit Agreements allowed for the payment of the total arrearage of unpaid cash dividends due on each of our 6.875% Series C Cumulative Redeemable Preferred Shares, 6.50% Series D Cumulative Redeemable Preferred Shares and 6.50% Series E Cumulative Redeemable Preferred Shares of approximately $24,174, which was paid on March 26, 2021, as well as dividends of $6,044 on these preferred shares in April 2021. During the six months ended June 30, 2020 we paid dividends of $6,044 on these preferred shares and $12,007 on our Common Shares, Common Units and LTIP Units.\\nOFF BALANCE SHEET ARRANGEMENTS\\nThe Company does not have off balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.\\n48\\nFUNDS FROM OPERATIONS\\n(in thousands, except share data)\\nThe National Association of Real Estate Investment Trusts (“NAREIT”) developed Funds from Operations (“FFO”) as a non-GAAP financial measure of performance of an equity REIT in order to recognize that income-producing real estate historically has not depreciated on the basis determined under GAAP. We calculate FFO applicable to common shares and Common Units in accordance with the December 2018 Financial Standards White Paper of NAREIT, which we refer to as the White Paper. The White Paper defines FFO as net income (loss) (computed in accordance with GAAP) excluding depreciation and amortization related to real estate, gains and losses from the sale of certain real estate assets, gains and losses from change in control, and impairment write-downs of certain real estate assets and investments in entities when the impairment is directly attributable to decreases in the value of depreciable real estate held by an entity. Our interpretation of the NAREIT definition is that noncontrolling interest in net income (loss) should be added back to (deducted from) net income (loss) as part of reconciling net income (loss) to FFO. Our FFO computation may not be comparable to FFO reported by other REITs that do not compute FFO in accordance with the NAREIT definition, or that interpret the NAREIT definition differently than we do.\\nThe GAAP measure that we believe to be most directly comparable to FFO, net income (loss) applicable to common shareholders, includes loss from the impairment of certain depreciable assets, our investment in unconsolidated joint ventures and land, depreciation and amortization expenses, gains or losses on property sales, noncontrolling interest and preferred dividends. In computing FFO, we eliminate these items because, in our view, they are not indicative of the results from our property operations. We determined that the loss from the impairment of certain depreciable assets including investments in unconsolidated joint ventures and land, was driven by a measurable decrease in the fair value of certain hotel properties and other assets as determined by our analysis of those assets in accordance with applicable GAAP. As such, these impairments have been eliminated from net loss to determine FFO.\\nFFO does not represent cash flows from operating activities in accordance with GAAP and should not be considered an alternative to net income as an indication of the Company’s performance or to cash flow as a measure of liquidity or ability to make distributions. We consider FFO to be a meaningful, additional measure of operating performance because it excludes the effects of the assumption that the value of real estate assets diminishes predictably over time, and because it is widely used by industry analysts as a performance measure. We show both FFO from consolidated hotel operations and FFO from unconsolidated joint ventures because we believe it is meaningful for the investor to understand the relative contributions from our consolidated and unconsolidated hotels. The display of both FFO from consolidated hotels and FFO from unconsolidated joint ventures allows for a detailed analysis of the operating performance of our hotel portfolio by management and investors. We present FFO applicable to common shares and Common Units because our Common Units are redeemable for common shares. We believe it is meaningful for the investor to understand FFO applicable to all common shares and Common Units.\\n49\\nThe following table reconciles FFO for the periods presented to the most directly comparable GAAP measure, net income, for the same periods (dollars in thousands):\\n| Three Months Ended | Six Months Ended |\\n| June 30, 2021 | June 30, 2020 | June 30, 2021 | June 30, 2020 |\\n| Net loss applicable to common shareholders | $ | (28,590) | $ | (67,464) | $ | (25,707) | $ | (96,583) |\\n| Loss allocated to noncontrolling interest | (977) | (10,360) | (813) | (13,257) |\\n| Loss from unconsolidated joint ventures | 589 | 502 | 1,247 | 1,520 |\\n| Gain on disposition of hotel properties | — | — | (48,352) | — |\\n| Loss from impairment of depreciable assets | 222 | 1,069 | 222 | 1,069 |\\n| Depreciation and amortization | 21,014 | 24,322 | 42,816 | 48,510 |\\n| Funds from consolidated hotel operations applicable to common shareholders and Partnership Units | (7,742) | (51,931) | (30,587) | (58,741) |\\n| Loss from unconsolidated joint ventures | (589) | (502) | (1,247) | (1,520) |\\n| Unrecognized pro rata interest in loss (1) | (318) | (511) | (814) | (361) |\\n| Depreciation and amortization of difference between purchase price and historical cost (2) | 21 | 21 | 42 | 42 |\\n| Interest in depreciation and amortization of unconsolidated joint ventures (3) | 652 | 393 | 1,282 | 796 |\\n| Funds from unconsolidated joint ventures operations applicable to common shareholders and Partnership Units | (234) | (599) | (737) | (1,043) |\\n| Funds from Operations applicable to common shareholders and Partnership Units | $ | (7,976) | $ | (52,530) | $ | (31,324) | $ | (59,784) |\\n| Weighted Average Common Shares and Common Units |\\n| Basic | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\\n| Diluted | 44,724,968 | 43,286,310 | 44,525,168 | 43,426,465 |\\n\\n(1) For U.S. GAAP reporting purposes, our interest in the joint venture's loss is not recognized since our U.S. GAAP basis in the joint venture has been reduced to $0. Our interest in FFO from the joint venture equals our percentage ownership in the venture's FFO, including loss we have not recognized for U.S. GAAP reporting.\\n(2) Adjustment made to add depreciation of purchase price in excess of historical cost of the assets in the unconsolidated joint venture at the time of our investment.\\n(3) Adjustment made to add our interest in real estate related depreciation and amortization of our unconsolidated joint ventures.\\nINFLATION\\nOperators of hotel properties, in general, possess the ability to adjust room rates daily to reflect the effects of inflation. However, competitive pressures may limit the ability of our management companies to raise room rates. Additionally, our management companies will face challenges to raise room rates to reflect the impact of inflation until there is a substantial economic recovery from the COVID-19 pandemic.\\nCRITICAL ACCOUNTING POLICIES AND ESTIMATES\\nRefer to Note 1 – Basis of Presentation of the notes to our consolidated financial statements included herein for information regarding critical accounting policies and estimates.\\n50\\nItem 3. Quantitative and Qualitative Disclosures About Market Risk (in thousands, except per share data)\\nOur primary market risk exposure is to changes in interest rates on our variable rate debt. As of June 30, 2021, we are exposed to interest rate risk with respect to variable rate borrowings under our Line of Credit, certain variable rate mortgages, and notes payable. As of June 30, 2021, we had total variable rate debt outstanding of $233,077 with a weighted average interest rate of 2.94%. The effect of a 100 basis point increase or decrease in the interest rate on our variable rate debt outstanding as of June 30, 2021 would be an increase or decrease in our interest expense for the three and six months ended June 30, 2021 of $577 and $1,198, respectively.\\nOur interest rate risk objectives are to limit the impact of interest rate fluctuations on earnings and cash flows and to lower our overall borrowing costs. To achieve these objectives, we manage our exposure to fluctuations in market interest rates for a portion of our borrowings through the use of fixed rate debt instruments to the extent that reasonably favorable rates are obtainable with such arrangements. We have also entered into derivative financial instruments such as interest rate swaps or caps, and in the future may enter into treasury options or locks, to mitigate our interest rate risk on a related financial instrument or to effectively lock the interest rate on a portion of our variable rate debt. As of June 30, 2021, we have ten interest rate swaps related to debt on Hilton Garden Inn, 52nd Street, New York, NY; Courtyard, LA Westside, Culver City, CA; Hyatt Union Square, New York, NY; Hilton Garden Inn Tribeca, New York, NY; and our Credit Facility. We do not intend to enter into derivative or interest rate transactions for speculative purposes.\\nAs of June 30, 2021, approximately 79.3% of our outstanding consolidated long-term indebtedness was subject to fixed rates or effectively capped, while 20.7% of our outstanding long term indebtedness is subject to floating rates, including borrowings under our Line of Credit. The majority of our floating rate debt and any corresponding derivative instruments are indexed to various tenors of LIBOR.\\nOn March 5, 2021, the Financial Conduct Authority (“FCA”) announced that USD LIBOR will no longer be published after June 30, 2023. This announcement has several implications, including setting the spread that may be used to automatically convert contracts from LIBOR to the Secured Overnight Financing Rate (\\\"SOFR\\\"). Additionally, banking regulators are encouraging banks to discontinue new LIBOR debt issuances by December 31, 2021.\\nThe Company anticipates that LIBOR will continue to be available at least until June 30, 2023. Any changes adopted by the FCA or other governing bodies in the method used for determining LIBOR may result in a sudden or prolonged increase or decrease in reported LIBOR. If that were to occur, our interest payments could change. In addition, uncertainty about the extent and manner of future changes may result in interest rates and/or payments that are higher or lower than if LIBOR were to remain available in its current form.\\nThe Company is monitoring and evaluating the related risks that arise in connection with transitioning contracts to an alternative rate, including any resulting value transfer that may occur, and are likely to vary by contract. The value of loans, securities, or derivative instruments tied to LIBOR, as well as interest rates on our current or future indebtedness, may also be impacted if LIBOR is limited or discontinued. For some instruments the method of transitioning to an alternative reference rate may be challenging, especially if we cannot agree with the respective counterparty about how to make the transition.\\nWhile we expect LIBOR to be available in substantially its current form until at least June 30, 2023, it is possible that LIBOR will become unavailable prior to that point. This could result, for example, if sufficient banks decline to make submissions to the LIBOR administrator. In that case, the risks associated with the transition to an alternative reference rate will be accelerated and magnified.\\nAlternative rates and other market changes related to the replacement of LIBOR, including the introduction of financial products and changes in market practices, may lead to risk modeling and valuation challenges, such as adjusting interest rate accrual calculations and building a term structure for an alternative rate.\\nThe introduction of an alternative rate also may create additional basis risk and increased volatility as alternative rates are phased in and utilized in parallel with LIBOR.\\nAdjustments to systems and mathematical models to properly process and account for alternative rates will be required, which may strain the model risk management and information technology functions and result in substantial incremental costs for the company.\\nChanges in market interest rates on our fixed-rate debt impact the fair value of the debt, but such changes have no impact on interest expense incurred. If interest rates rise 100 basis points and our fixed rate debt balance remains constant, we expect the fair value of our debt to decrease. The sensitivity analysis related to our fixed-rate debt assumes an immediate 100 basis point move in interest rates from their June 30, 2021 levels, with all other variables held constant. A 100 basis point increase in market interest rates would cause the fair value of our fixed-rate debt outstanding at June 30, 2021 to be\\n51\\napproximately $1,114,810 and a 100 basis point decrease in market interest rates would cause the fair value of our fixed-rate debt outstanding at June 30, 2021 to be approximately $1,168,182.\\nWe regularly review interest rate exposure on our outstanding borrowings in an effort to minimize the risk of interest rate fluctuations. For debt obligations outstanding as of June 30, 2021, the following table presents expected principal repayments and related weighted average interest rates by expected maturity dates:\\n| 2021 | 2022 - 2023 | 2024 - 2025 | Thereafter | Total |\\n| Fixed Rate Debt | $ | 23,431 | $ | 346,889 | $ | 381,977 | $ | 140,764 | $ | 893,061 |\\n| Weighted Average Interest Rate | 4.84 | % | 5.27 | % | 8.94 | % | 9.50 | % | 7.14 | % |\\n| Floating Rate Debt | $ | 298 | $ | 1,240 | $ | 61,306 | $ | 51,548 | $ | 114,392 |\\n| Weighted Average Interest Rate | 3.29 | % | 3.30 | % | 3.10 | % | 3.10 | % | 3.20 | % |\\n| $ | 23,729 | $ | 348,129 | $ | 443,283 | $ | 192,312 | $ | 1,007,453 |\\n| Line of Credit | $ | — | $ | 118,684 | $ | — | $ | — | $ | 118,684 |\\n| Weighted Average Interest Rate | — | 2.50 | % | — | — | 2.50 | % |\\n| $ | 23,729 | $ | 466,813 | $ | 443,283 | $ | 192,312 | $ | 1,126,137 |\\n\\n52\\nItem 4. Controls and Procedures\\nBased on the most recent evaluation, the Company’s Chief Executive Officer and Chief Financial Officer believe the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) were effective as of June 30, 2021.\\nThere were no changes to the Company’s internal controls over financial reporting during the three months ended June 30, 2021, that materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.\\n53\\nPART II. OTHER INFORMATION\\nItem 1. Legal Proceedings.\\nNone.\\nItem 1A. Risk Factors.\\nThere have been no material changes from our risk factors as previously reported in our Annual Report on Form 10-K for the year ended December 31, 2020.\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\\nNone.\\n\\nItem 3. Defaults Upon Senior Securities.\\nNone.\\nItem 4. Mine Safety Disclosures.\\nNot Applicable.\\nItem 5. Other Information.\\nNone.\\n54\\nItem 6. Exhibits.\\n| Exhibit No. |\\n| 31.1 | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |\\n| 31.2 | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |\\n| 32.1 | Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.* |\\n| 32.2 | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.* |\\n| 101.INS | The instance document does not appear in the interactive data file because its XBRL tags are embedded within the inline XBRL document |\\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document* |\\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document* |\\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document* |\\n| 101.LAB | Inline XBRL Taxonomy Extension Labels Linkbase Document* |\\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document* |\\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\\n| * | Filed herewith |\\n| + | Compensatory plan or arrangement |\\n\\n55\\nSIGNATURES\\n\\n| HERSHA HOSPITALITY TRUST |\\n| July 28, 2021 | /s/ Ashish R. Parikh |\\n| Ashish R. Parikh |\\n| Chief Financial Officer(Principal Financial Officer) |\\n\\n56\\n \\n\\nWhat is the percentage change in Total Shareholders' Equity from December 31, 2020, to June 30, 2021?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is -5.93705006235925.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 47,\n \"input_length\": 41981\n}"}}},{"rowIdx":48,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nPART I\nFINANCIAL INFORMATION\nThis quarterly report contains forward-looking statements within the meaning of the U.S. federal securities laws. We intend these forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in the United States securities laws. In some cases, these statements can be identified by the use of forward-looking words such as “may”, “should”, “could”, “anticipate”, “estimate”, “expect”, “plan”, “believe”, “predict”, “potential” and “intend”. Forward-looking statements contained in this report may include information regarding our estimates of losses related to catastrophes and other large losses, measurements of potential losses in the fair value of our investment portfolio and derivative contracts, our expectations regarding pricing and other market conditions, our growth prospects, and valuations of the potential impact of movements in interest rates, equity prices, credit spreads and foreign currency rates. Forward-looking statements only reflect our expectations and are not guarantees of performance.\nThese statements involve risks, uncertainties and assumptions. Accordingly, there are or will be important factors that could cause actual results to differ materially from those indicated in such statements. We believe that these factors include, but are not limited to, the following:\n| • | the occurrence and magnitude of natural and man-made disasters, |\n\n| • | actual claims exceeding our loss reserves, |\n\n| • | general economic, capital and credit market conditions, |\n\n| • | the failure of any of the loss limitation methods we employ, |\n\n| • | the effects of emerging claims, coverage and regulatory issues, including uncertainty related to coverage definitions, limits, terms and conditions, |\n\n| • | the failure of our cedants to adequately evaluate risks, |\n\n| • | inability to obtain additional capital on favorable terms, or at all, |\n\n| • | the loss of one or more key executives, |\n\n| • | a decline in our ratings with rating agencies, |\n\n| • | loss of business provided to us by our major brokers, |\n\n| • | changes in accounting policies or practices, |\n\n| • | the use of industry catastrophe models and changes to these models, |\n\n| • | changes in governmental regulations, |\n\n| • | increased competition, |\n\n| • | changes in the political environment of certain countries in which we operate or underwrite business including the United Kingdom’s expected withdrawal from the European Union, |\n\n| • | fluctuations in interest rates, credit spreads, equity prices and/or currency values, and |\n\n| • | the other matters set forth under Item 1A, ‘Risk Factors’ and Item 7, ‘Management’s Discussion and Analysis of Financial Condition and Results of Operations’ included in our Annual Report on Form 10-K for the year ended December 31, 2015. |\n\nWe undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.\n3\nITEM 1. CONSOLIDATED FINANCIAL STATEMENTS\n\n| Page |\n| Consolidated Balance Sheets at September 30, 2016 (Unaudited) and December 31, 2015 | 5 |\n| Consolidated Statements of Operations for the three and nine months ended September 30, 2016 and 2015 (Unaudited) | 6 |\n| Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2016 and 2015 (Unaudited) | 7 |\n| Consolidated Statements of Changes in Shareholders' Equity for the nine months ended September 30, 2016 and 2015 (Unaudited) | 8 |\n| Consolidated Statements of Cash Flows for the nine months ended September 30, 2016 and 2015 (Unaudited) | 9 |\n| Notes to Consolidated Financial Statements (Unaudited) | 10 |\n| Note 1 - Basis of Presentation and Accounting Policies | 10 |\n| Note 2 - Segment Information | 12 |\n| Note 3 - Investments | 14 |\n| Note 4 - Fair Value Measurements | 22 |\n| Note 5 - Derivative Instruments | 32 |\n| Note 6 - Reserve for Losses and Loss Expenses | 35 |\n| Note 7 - Share-Based Compensation | 36 |\n| Note 8 - Earnings Per Common Share | 38 |\n| Note 9 - Shareholders' Equity | 39 |\n| Note 10 - Commitments and Contingencies | 40 |\n| Note 11 - Other Comprehensive Income (Loss) | 41 |\n| Note 12 - Subsequent Event | 42 |\n\n4\nAXIS CAPITAL HOLDINGS LIMITED\nCONSOLIDATED BALANCE SHEETS\nSEPTEMBER 30, 2016 (UNAUDITED) AND DECEMBER 31, 2015\n\n| 2016 | 2015 |\n| (in thousands) |\n| Assets |\n| Investments: |\n| Fixed maturities, available for sale, at fair value(Amortized cost 2016: $11,462,399; 2015: $11,897,639) | $ | 11,566,860 | $ | 11,719,749 |\n| Equity securities, available for sale, at fair value(Cost 2016: $600,604; 2015: $575,776) | 644,344 | 597,998 |\n| Mortgage loans, held for investment, at amortized cost and fair value | 332,753 | 206,277 |\n| Other investments, at fair value | 847,262 | 816,756 |\n| Equity method investments | 111,295 | 10,932 |\n| Short-term investments, at amortized cost and fair value | 39,877 | 34,406 |\n| Total investments | 13,542,391 | 13,386,118 |\n| Cash and cash equivalents | 848,200 | 988,133 |\n| Restricted cash and cash equivalents | 229,063 | 186,618 |\n| Accrued interest receivable | 71,096 | 73,729 |\n| Insurance and reinsurance premium balances receivable | 2,694,976 | 1,967,535 |\n| Reinsurance recoverable on unpaid and paid losses | 2,336,741 | 2,096,104 |\n| Deferred acquisition costs | 545,618 | 471,782 |\n| Prepaid reinsurance premiums | 582,551 | 396,201 |\n| Receivable for investments sold | 2,285 | 26,478 |\n| Goodwill and intangible assets | 85,501 | 86,858 |\n| Other assets | 283,969 | 302,335 |\n| Total assets | $ | 21,222,391 | $ | 19,981,891 |\n| Liabilities |\n| Reserve for losses and loss expenses | $ | 9,874,807 | $ | 9,646,285 |\n| Unearned premiums | 3,453,655 | 2,760,889 |\n| Insurance and reinsurance balances payable | 461,519 | 356,417 |\n| Senior notes | 992,633 | 991,825 |\n| Payable for investments purchased | 141,245 | 9,356 |\n| Other liabilities | 272,874 | 350,237 |\n| Total liabilities | 15,196,733 | 14,115,009 |\n| Shareholders’ equity |\n| Preferred shares | 625,000 | 627,843 |\n| Common shares (2016: 176,575; 2015: 176,240 shares issued and2016: 88,439; 2015: 96,066 shares outstanding) | 2,206 | 2,202 |\n| Additional paid-in capital | 2,307,866 | 2,241,388 |\n| Accumulated other comprehensive income (loss) | 98,505 | (188,465 | ) |\n| Retained earnings | 6,430,573 | 6,194,353 |\n| Treasury shares, at cost (2016: 88,136; 2015: 80,174 shares) | (3,438,492 | ) | (3,010,439 | ) |\n| Total shareholders’ equity | 6,025,658 | 5,866,882 |\n| Total liabilities and shareholders’ equity | $ | 21,222,391 | $ | 19,981,891 |\n\nSee accompanying notes to Consolidated Financial Statements.5\nAXIS CAPITAL HOLDINGS LIMITED\nCONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015\n| Three months ended | Nine months ended |\n| 2016 | 2015 | 2016 | 2015 |\n| (in thousands, except for per share amounts) |\n| Revenues |\n| Net premiums earned | $ | 934,415 | $ | 919,341 | $ | 2,783,746 | $ | 2,764,605 |\n| Net investment income | 116,923 | 45,685 | 257,818 | 226,336 |\n| Other insurance related income | 5,944 | 1,158 | 4,850 | 12,319 |\n| Termination fee received | — | 280,000 | — | 280,000 |\n| Net realized investment gains (losses): |\n| Other-than-temporary impairment (\"OTTI\") losses | (4,247 | ) | (32,301 | ) | (20,346 | ) | (62,762 | ) |\n| Other realized investment gains (losses) | 9,452 | (37,656 | ) | (19,949 | ) | (60,856 | ) |\n| Total net realized investment gains (losses) | 5,205 | (69,957 | ) | (40,295 | ) | (123,618 | ) |\n| Total revenues | 1,062,487 | 1,176,227 | 3,006,119 | 3,159,642 |\n| Expenses |\n| Net losses and loss expenses | 532,328 | 560,387 | 1,663,584 | 1,652,868 |\n| Acquisition costs | 189,810 | 182,744 | 559,570 | 537,549 |\n| General and administrative expenses | 142,906 | 144,727 | 439,554 | 456,451 |\n| Foreign exchange gains | (13,795 | ) | (28,088 | ) | (69,781 | ) | (69,200 | ) |\n| Interest expense and financing costs | 12,839 | 12,918 | 38,586 | 38,114 |\n| Reorganization and related expenses | — | 45,867 | — | 45,867 |\n| Total expenses | 864,088 | 918,555 | 2,631,513 | 2,661,649 |\n| Income before income taxes and interest in income (loss) of equity method investments | 198,399 | 257,672 | 374,606 | 497,993 |\n| Income tax expense | 9,352 | 30 | 7,712 | 1,155 |\n| Interest in loss of equity method investments | (2,434 | ) | — | (2,434 | ) | — |\n| Net income | 186,613 | 257,642 | 364,460 | 496,838 |\n| Preferred share dividends | 9,969 | 10,022 | 29,906 | 30,066 |\n| Net income available to common shareholders | $ | 176,644 | $ | 247,620 | $ | 334,554 | $ | 466,772 |\n| Per share data |\n| Net income per common share: |\n| Basic net income | $ | 1.97 | $ | 2.52 | $ | 3.64 | $ | 4.69 |\n| Diluted net income | $ | 1.96 | $ | 2.50 | $ | 3.61 | $ | 4.65 |\n| Weighted average number of common shares outstanding - basic | 89,621 | 98,226 | 91,852 | 99,464 |\n| Weighted average number of common shares outstanding - diluted | 90,351 | 99,124 | 92,579 | 100,468 |\n| Cash dividends declared per common share | $ | 0.35 | $ | 0.29 | $ | 1.05 | $ | 0.87 |\n\nSee accompanying notes to Consolidated Financial Statements.6\nAXIS CAPITAL HOLDINGS LIMITED\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015\n| Three months ended | Nine months ended |\n| 2016 | 2015 | 2016 | 2015 |\n| (in thousands) |\n| Net income | $ | 186,613 | $ | 257,642 | $ | 364,460 | $ | 496,838 |\n| Other comprehensive income (loss), net of tax: |\n| Available for sale investments: |\n| Unrealized investment gains (losses) arising during the period | 36,336 | (99,711 | ) | 238,656 | (176,938 | ) |\n| Adjustment for reclassification of net realized investment gains (losses) and OTTI losses recognized in net income | (2,642 | ) | 74,810 | 42,620 | 128,770 |\n| Unrealized investment gains (losses) arising during the period, net of reclassification adjustment | 33,694 | (24,901 | ) | 281,276 | (48,168 | ) |\n| Foreign currency translation adjustment | 1,722 | (14,626 | ) | 5,694 | (23,851 | ) |\n| Total other comprehensive income (loss), net of tax | 35,416 | (39,527 | ) | 286,970 | (72,019 | ) |\n| Comprehensive income | $ | 222,029 | $ | 218,115 | $ | 651,430 | $ | 424,819 |\n\nSee accompanying notes to Consolidated Financial Statements.7\nAXIS CAPITAL HOLDINGS LIMITED\nCONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (UNAUDITED)\nFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015\n| 2016 | 2015 |\n| (in thousands) |\n| Preferred shares |\n| Balance at beginning of period | $ | 627,843 | $ | 627,843 |\n| Shares repurchased | (2,843 | ) | — |\n| Balance at end of period | 625,000 | 627,843 |\n| Common shares (par value) |\n| Balance at beginning of period | 2,202 | 2,191 |\n| Shares issued | 4 | 11 |\n| Balance at end of period | 2,206 | 2,202 |\n| Additional paid-in capital |\n| Balance at beginning of period | 2,241,388 | 2,285,016 |\n| Shares issued - common shares | (4 | ) | 2,472 |\n| Cost of treasury shares reissued | (19,647 | ) | (17,674 | ) |\n| Settlement of accelerated share repurchase | 60,000 | (60,000 | ) |\n| Stock options exercised | — | 558 |\n| Share-based compensation expense | 26,129 | 19,906 |\n| Balance at end of period | 2,307,866 | 2,230,278 |\n| Accumulated other comprehensive income (loss) |\n| Balance at beginning of period | (188,465 | ) | (45,574 | ) |\n| Unrealized gains (losses) on available for sale investments, net of tax: |\n| Balance at beginning of period | (149,585 | ) | (28,192 | ) |\n| Unrealized gains (losses) arising during the period, net of reclassification adjustment | 281,276 | (48,168 | ) |\n| Non-credit portion of OTTI losses | — | — |\n| Balance at end of period | 131,691 | (76,360 | ) |\n| Cumulative foreign currency translation adjustments, net of tax: |\n| Balance at beginning of period | (38,880 | ) | (17,382 | ) |\n| Foreign currency translation adjustments | 5,694 | (23,851 | ) |\n| Balance at end of period | (33,186 | ) | (41,233 | ) |\n| Balance at end of period | 98,505 | (117,593 | ) |\n| Retained earnings |\n| Balance at beginning of period | 6,194,353 | 5,715,504 |\n| Net income | 364,460 | 496,838 |\n| Preferred share dividends | (29,906 | ) | (30,066 | ) |\n| Common share dividends | (98,334 | ) | (88,379 | ) |\n| Balance at end of period | 6,430,573 | 6,093,897 |\n| Treasury shares, at cost |\n| Balance at beginning of period | (3,010,439 | ) | (2,763,859 | ) |\n| Shares repurchased for treasury | (449,086 | ) | (264,076 | ) |\n| Cost of treasury shares reissued | 21,033 | 17,674 |\n| Balance at end of period | (3,438,492 | ) | (3,010,261 | ) |\n| Total shareholders’ equity | $ | 6,025,658 | $ | 5,826,366 |\n\nSee accompanying notes to Consolidated Financial Statements.8\nAXIS CAPITAL HOLDINGS LIMITED\nCONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)\nFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015\n| 2016 | 2015 |\n| (in thousands) |\n| Cash flows from operating activities: |\n| Net income | $ | 364,460 | $ | 496,838 |\n| Adjustments to reconcile net income to net cash provided by operating activities: |\n| Net realized investment losses | 40,295 | 123,618 |\n| Net realized and unrealized gains on other investments | (23,117 | ) | (17,616 | ) |\n| Amortization of fixed maturities | 51,660 | 75,645 |\n| Interest in loss of equity method investments | 2,434 | — |\n| Other amortization and depreciation | 17,370 | 26,219 |\n| Share-based compensation expense, net of cash payments | 28,580 | 25,435 |\n| Changes in: |\n| Accrued interest receivable | 3,286 | 7,128 |\n| Reinsurance recoverable balances | (163,212 | ) | (158,362 | ) |\n| Deferred acquisition costs | (73,759 | ) | (77,348 | ) |\n| Prepaid reinsurance premiums | (184,648 | ) | (69,016 | ) |\n| Reserve for loss and loss expenses | 216,828 | 212,066 |\n| Unearned premiums | 682,686 | 380,610 |\n| Insurance and reinsurance balances, net | (623,170 | ) | (330,128 | ) |\n| Other items | (74,383 | ) | 7,841 |\n| Net cash provided by operating activities | 265,310 | 702,930 |\n| Cash flows from investing activities: |\n| Purchases of: |\n| Fixed maturities | (6,624,573 | ) | (8,110,841 | ) |\n| Equity securities | (295,827 | ) | (240,415 | ) |\n| Mortgage loans | (131,087 | ) | (129,431 | ) |\n| Other investments | (177,500 | ) | (61,591 | ) |\n| Equity method investments | (103,548 | ) | — |\n| Short-term investments | (81,479 | ) | (34,147 | ) |\n| Proceeds from the sale of: |\n| Fixed maturities | 6,067,663 | 6,797,585 |\n| Equity securities | 296,182 | 112,794 |\n| Other investments | 170,111 | 244,353 |\n| Short-term investments | 67,408 | 112,694 |\n| Proceeds from redemption of fixed maturities | 977,852 | 1,107,175 |\n| Proceeds from redemption of short-term investments | 8,185 | 22,337 |\n| Proceeds from the repayment of mortgage loans | 4,808 | — |\n| Purchase of other assets | (19,055 | ) | (18,401 | ) |\n| Change in restricted cash and cash equivalents | (42,445 | ) | 27,996 |\n| Net cash provided by (used in) investing activities | 116,695 | (169,892 | ) |\n| Cash flows from financing activities: |\n| Repurchase of common shares | (389,086 | ) | (332,097 | ) |\n| Dividends paid - common shares | (100,670 | ) | (89,611 | ) |\n| Dividends paid - preferred shares | (29,940 | ) | (30,066 | ) |\n| Repurchase of preferred shares | (2,843 | ) | — |\n| Proceeds from issuance of common shares | 8 | 3,042 |\n| Net cash used in financing activities | (522,531 | ) | (448,732 | ) |\n| Effect of exchange rate changes on foreign currency cash and cash equivalents | 593 | (13,883 | ) |\n| Increase (decrease) in cash and cash equivalents | (139,933 | ) | 70,423 |\n| Cash and cash equivalents - beginning of period | 988,133 | 921,830 |\n| Cash and cash equivalents - end of period | $ | 848,200 | $ | 992,253 |\n\nSupplemental disclosures of cash flow information: Total consideration paid for a quota share and adverse development reinsurance cover was $170 million of which $92 million was settled by transfer of securities and was treated as a non cash activity on the Consolidated Statement of Cash Flows.\nSee accompanying notes to Consolidated Financial Statements.9\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)\n| 1. | BASIS OF PRESENTATION AND ACCOUNTING POLICIES |\n\nBasis of Presentation\nThese interim consolidated financial statements include the accounts of AXIS Capital Holdings Limited (“AXIS Capital”) and its subsidiaries (herein referred to as “we,” “us,” “our,” or the “Company”).\nThe consolidated balance sheet at September 30, 2016 and the consolidated statements of operations, comprehensive income, shareholders' equity and cash flows for the periods ended September 30, 2016 and 2015 have not been audited. The balance sheet at December 31, 2015 is derived from our audited financial statements.\nThese financial statements have been prepared in accordance with U.S. Generally Accepted Accounting Principles (“U.S. GAAP”) for interim financial information and with the Securities and Exchange Commission's (“SEC”) instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. In the opinion of management, these financial statements reflect all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of our financial position and results of operations for the periods presented. The results of operations for any interim period are not necessarily indicative of the results for a full year. All inter-company accounts and transactions have been eliminated.\nThe following information should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2015. Tabular dollar and share amounts are in thousands, except per share amounts. All amounts are reported in U.S. dollars. To facilitate comparison of information across periods, certain reclassifications have been made to prior year amounts to conform to the current year's presentation. These reclassifications did not impact our results of operations, financial condition or liquidity.\nSignificant Accounting Policies\nThere were no notable changes in our significant accounting policies subsequent to our Annual Report on Form 10-K for the year ended December 31, 2015, with the exception of the addition of accounting policies for equity method investments and retroactive accounting noted below.\nEquity Method Investments\nInvestments in which the Company has significant influence over the operating and financial policies of the investee are classified as equity method investments and are accounted for using the equity method of accounting. In applying the equity method of accounting, investments are initially recorded at cost and are subsequently adjusted based on the Company’s proportionate share of net income or loss of the investee. Adjustments are based on the most recently available financial information from the investee.Changes in the carrying value of such investments are recorded in net income as interest in income (loss) of equity method investments.\nRetroactive Reinsurance\nRetroactive reinsurance reimburses a ceding company for liabilities incurred as a result of past insurable events covered under contracts subject to the reinsurance. In certain instances, reinsurance contracts cover losses both on a prospective basis and on a retroactive basis and where practical the Company bifurcates the prospective and retrospective elements of these reinsurance contracts and accounts for each element separately. Initial gains in connection with retroactive reinsurance contracts are deferred and amortized into income over the settlement period while losses are recognized immediately. When changes in the estimated amount recoverable from the reinsurer or in the timing of receipts related to that amount occur, a cumulative amortization adjustment is recognized in earnings in the period of the change so that the deferred gain reflects the balance that would have existed had the revised estimate been available at the inception of the reinsurance transaction.\nNew Accounting Standards Adopted in 2016\nShare-Based Compensation\nEffective January 1, 2016, the Company adopted the Accounting Standards Update (\"ASU\") 2014-12, \"Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could be Achieved after the Requisite Service Period\" issued by the Financial Accounting Standards Board (the \"FASB\"). This guidance requires that compensation costs be recognized in the period in which it becomes probable that the performance target will be achieved and to represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered. This guidance was issued to clarify treatment where there was a divergence in accounting practice and its adoption did not impact our results of operations, financial condition or liquidity.\nDebt Issuance Costs\nEffective January 1, 2016, the Company adopted ASU 2015-03, \"Simplifying the Presentation of Debt Issuance Costs\" issued by the FASB. This guidance requires the debt issuance costs related to a recognized debt liability to be presented in the balance sheet as a direct deduction from the debt liability rather than as an asset. This guidance was issued to simplify the presentation of debt issuance costs and to resolve conflicting guidance. This guidance did not impact our results of operations, financial condition or liquidity.\nInvestments Measured Using The Net Asset Value Per Share (\"NAV\") Practical Expedient\nEffective January 1, 2016, the Company adopted ASU 2015-07, \"Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or its Equivalent)\" issued by the FASB. This guidance eliminated the requirement to categorize investments measured using the net asset value (\"NAV\") practical expedient in the fair value hierarchy table. As this new guidance related solely to disclosures, the adoption did not impact our results of operations, financial condition or liquidity. The updated disclosures have been provided in Note 4 'Fair Value Measurements'.\nRecently Issued Accounting Standards Not Yet Adopted\nLeases\nIn February 2016, the FASB issued guidance that provides a new comprehensive model for lease accounting. The guidance will require most leases to be recognized on the balance sheet by recording a right-of-use asset and a corresponding lease liability. This guidance is effective for reporting periods beginning after December 15, 2018, and interim periods within those fiscal years with early adoption permitted. The Company is currently evaluating the impact of this guidance on our results of operations, financial condition and liquidity.\nTransition To Equity Method Of Accounting\nIn March 2016, the FASB issued new guidance eliminating the requirement that an investor retrospectively apply equity method accounting when an existing investment qualifies for equity method accounting. The guidance is effective for annual periods beginning after December 15, 2016, and interim periods within those fiscal years with early adoption permitted. The guidance will be adopted on a prospective basis. The adoption of this guidance is not expected to materially impact our results of operations, financial condition or liquidity.\nShare-Based Compensation Accounting\nIn March 2016, the FASB issued new guidance that will change the accounting for certain aspects of share-based compensation payments to employees. The guidance will require all income tax effects of awards to be recognized in the income statement when the awards vest or are settled. The guidance will also allow employers to increase the amounts withheld to cover income taxes on\n10\n| 1. | BASIS OF PRESENTATION AND ACCOUNTING POLICIES (CONTINUED) |\n\nshare-based compensation awards without requiring liability classification. Additionally, companies will be required to elect whether they will account for award forfeitures by recognizing forfeitures only as they occur or by estimating the number of awards expected to be forfeited. This guidance is effective for annual periods beginning after December 15, 2016, and interim periods within those fiscal years with early adoption permitted. The Company is currently evaluating the impact of this guidance on our results of operations, financial condition and liquidity.\nCredit Losses\nIn June 2016, the FASB issued a new credit loss standard that changes the impairment model for most financial assets and certain other instruments. The guidance will replace the current \"incurred loss\" approach with a more forward looking \"expected loss\" model for instruments measured at amortized cost and will require entities to record allowances for available-for-sale debt securities rather than reduce the carrying amount. This guidance is effective for annual periods beginning after December 15, 2019, and interim periods within those fiscal years. Early adoption is permitted for annual periods beginning after December 15, 2018, and interim periods within those fiscal years. The Company is currently evaluating the impact of this guidance on our results of operations, financial condition and liquidity.\nCash Flows\nIn August 2016, the FASB issued new guidance to clarify how certain cash receipts and cash payments should be classified on the statement of cash flows. This guidance is effective for annual periods beginning after December 15, 2017, and interim periods within those fiscal years with early adoption permitted. The adoption of this guidance is not expected to impact our results of operations, financial condition or liquidity.\n11\n| 2. | SEGMENT INFORMATION |\n\nOur underwriting operations are organized around our global underwriting platforms, AXIS Insurance and AXIS Re. Therefore we have determined that we have two reportable segments, insurance and reinsurance. We do not allocate our assets by segment, with the exception of goodwill and intangible assets, as we evaluate the underwriting results of each segment separately from the results of our investment portfolio.\nThe following tables summarize the underwriting results of our reportable segments, as well as the carrying values of allocated goodwill and intangible assets:\n| 2016 | 2015 |\n| Three months ended and at September 30, | Insurance | Reinsurance | Total | Insurance | Reinsurance | Total |\n| Gross premiums written | $ | 675,430 | $ | 284,532 | $ | 959,962 | $ | 606,704 | $ | 329,879 | $ | 936,583 |\n| Net premiums written | 433,131 | 162,300 | 595,431 | 381,118 | 296,099 | 677,217 |\n| Net premiums earned | 444,691 | 489,724 | 934,415 | 444,550 | 474,791 | 919,341 |\n| Other insurance related income | 39 | 5,905 | 5,944 | 542 | 616 | 1,158 |\n| Net losses and loss expenses | (273,226 | ) | (259,102 | ) | (532,328 | ) | (283,272 | ) | (277,115 | ) | (560,387 | ) |\n| Acquisition costs | (61,755 | ) | (128,055 | ) | (189,810 | ) | (69,118 | ) | (113,626 | ) | (182,744 | ) |\n| General and administrative expenses | (84,588 | ) | (29,635 | ) | (114,223 | ) | (85,814 | ) | (35,309 | ) | (121,123 | ) |\n| Underwriting income | $ | 25,161 | $ | 78,837 | 103,998 | $ | 6,888 | $ | 49,357 | 56,245 |\n| Corporate expenses | (28,683 | ) | (23,604 | ) |\n| Net investment income | 116,923 | 45,685 |\n| Net realized investment gains (losses) | 5,205 | (69,957 | ) |\n| Foreign exchange gains | 13,795 | 28,088 |\n| Interest expense and financing costs | (12,839 | ) | (12,918 | ) |\n| Termination fee received | — | 280,000 |\n| Reorganization and related expenses | — | (45,867 | ) |\n| Income before income taxes and interest in income (loss) of equity method investments | $ | 198,399 | $ | 257,672 |\n| Net loss and loss expense ratio | 61.4 | % | 52.9 | % | 57.0 | % | 63.7 | % | 58.4 | % | 61.0 | % |\n| Acquisition cost ratio | 13.9 | % | 26.1 | % | 20.3 | % | 15.5 | % | 23.9 | % | 19.9 | % |\n| General and administrative expense ratio | 19.1 | % | 6.1 | % | 15.3 | % | 19.4 | % | 7.4 | % | 15.7 | % |\n| Combined ratio | 94.4 | % | 85.1 | % | 92.6 | % | 98.6 | % | 89.7 | % | 96.6 | % |\n| Goodwill and intangible assets | $ | 85,501 | $ | — | $ | 85,501 | $ | 87,329 | $ | — | $ | 87,329 |\n\n12\n| 2. | SEGMENT INFORMATION (CONTINUED) |\n\n| 2016 | 2015 |\n| Nine months ended and at September 30, | Insurance | Reinsurance | Total | Insurance | Reinsurance | Total |\n| Gross premiums written | $ | 2,112,796 | $ | 2,126,762 | $ | 4,239,558 | $ | 1,970,554 | $ | 1,833,374 | $ | 3,803,928 |\n| Net premiums written | 1,433,058 | 1,855,529 | 3,288,587 | 1,352,122 | 1,727,185 | 3,079,307 |\n| Net premiums earned | 1,322,649 | 1,461,097 | 2,783,746 | 1,344,339 | 1,420,266 | 2,764,605 |\n| Other insurance related income (loss) | (57 | ) | 4,907 | 4,850 | 811 | 11,508 | 12,319 |\n| Net losses and loss expenses | (853,771 | ) | (809,813 | ) | (1,663,584 | ) | (866,580 | ) | (786,288 | ) | (1,652,868 | ) |\n| Acquisition costs | (184,982 | ) | (374,588 | ) | (559,570 | ) | (200,493 | ) | (337,056 | ) | (537,549 | ) |\n| General and administrative expenses | (252,652 | ) | (99,980 | ) | (352,632 | ) | (261,924 | ) | (110,701 | ) | (372,625 | ) |\n| Underwriting income | $ | 31,187 | $ | 181,623 | 212,810 | $ | 16,153 | $ | 197,729 | 213,882 |\n| Corporate expenses | (86,922 | ) | (83,826 | ) |\n| Net investment income | 257,818 | 226,336 |\n| Net realized investment losses | (40,295 | ) | (123,618 | ) |\n| Foreign exchange gains | 69,781 | 69,200 |\n| Interest expense and financing costs | (38,586 | ) | (38,114 | ) |\n| Termination fee received | — | 280,000 |\n| Reorganization and related expenses | — | (45,867 | ) |\n| Income before income taxes and interest in income (loss) of equity method investments | $ | 374,606 | $ | 497,993 |\n| Net loss and loss expense ratio | 64.6 | % | 55.4 | % | 59.8 | % | 64.5 | % | 55.4 | % | 59.8 | % |\n| Acquisition cost ratio | 14.0 | % | 25.6 | % | 20.1 | % | 14.9 | % | 23.7 | % | 19.4 | % |\n| General and administrative expense ratio | 19.0 | % | 6.9 | % | 15.8 | % | 19.5 | % | 7.8 | % | 16.5 | % |\n| Combined ratio | 97.6 | % | 87.9 | % | 95.7 | % | 98.9 | % | 86.9 | % | 95.7 | % |\n| Goodwill and intangible assets | $ | 85,501 | $ | — | $ | 85,501 | $ | 87,329 | $ | — | $ | 87,329 |\n\n13\n| 3. | INVESTMENTS |\n\na) Fixed Maturities and Equities\nThe amortized cost or cost and fair values of our fixed maturities and equities were as follows:\n| AmortizedCost orCost | GrossUnrealizedGains | GrossUnrealizedLosses | FairValue | Non-creditOTTIin AOCI(5) |\n| At September 30, 2016 |\n| Fixed maturities |\n| U.S. government and agency | $ | 1,542,943 | $ | 22,349 | $ | (2,415 | ) | $ | 1,562,877 | $ | — |\n| Non-U.S. government | 620,601 | 4,799 | (43,344 | ) | 582,056 | — |\n| Corporate debt | 4,516,290 | 87,184 | (34,974 | ) | 4,568,500 | — |\n| Agency RMBS(1) | 2,473,832 | 49,661 | (762 | ) | 2,522,731 | — |\n| CMBS(2) | 877,732 | 18,546 | (2,003 | ) | 894,275 | — |\n| Non-Agency RMBS | 71,842 | 1,636 | (1,648 | ) | 71,830 | (870 | ) |\n| ABS(3) | 1,234,292 | 4,028 | (2,724 | ) | 1,235,596 | — |\n| Municipals(4) | 124,867 | 4,215 | (87 | ) | 128,995 | — |\n| Total fixed maturities | $ | 11,462,399 | $ | 192,418 | $ | (87,957 | ) | $ | 11,566,860 | $ | (870 | ) |\n| Equity securities |\n| Common stocks | $ | 379 | $ | 38 | $ | (348 | ) | $ | 69 |\n| Exchange-traded funds | 463,655 | 41,611 | (1,060 | ) | 504,206 |\n| Bond mutual funds | 136,570 | 3,499 | — | 140,069 |\n| Total equity securities | $ | 600,604 | $ | 45,148 | $ | (1,408 | ) | $ | 644,344 |\n| At December 31, 2015 |\n| Fixed maturities |\n| U.S. government and agency | $ | 1,673,617 | $ | 1,545 | $ | (23,213 | ) | $ | 1,651,949 | $ | — |\n| Non-U.S. government | 809,025 | 2,312 | (72,332 | ) | 739,005 | — |\n| Corporate debt | 4,442,315 | 16,740 | (96,286 | ) | 4,362,769 | — |\n| Agency RMBS(1) | 2,236,138 | 22,773 | (9,675 | ) | 2,249,236 | — |\n| CMBS(2) | 1,088,595 | 3,885 | (9,182 | ) | 1,083,298 | — |\n| Non-Agency RMBS | 99,989 | 1,992 | (973 | ) | 101,008 | (875 | ) |\n| ABS(3) | 1,387,919 | 952 | (17,601 | ) | 1,371,270 | — |\n| Municipals(4) | 160,041 | 2,319 | (1,146 | ) | 161,214 | — |\n| Total fixed maturities | $ | 11,897,639 | $ | 52,518 | $ | (230,408 | ) | $ | 11,719,749 | $ | (875 | ) |\n| Equity securities |\n| Common stocks | $ | — | $ | — | $ | — | $ | — |\n| Exchange-traded funds | 447,524 | 31,211 | (4,762 | ) | 473,973 |\n| Bond mutual funds | 128,252 | — | (4,227 | ) | 124,025 |\n| Total equity securities | $ | 575,776 | $ | 31,211 | $ | (8,989 | ) | $ | 597,998 |\n\n| (1) | Residential mortgage-backed securities (RMBS) originated by U.S. agencies. |\n\n| (2) | Commercial mortgage-backed securities (CMBS). |\n\n| (3) | Asset-backed securities (ABS) include debt tranched securities collateralized primarily by auto loans, student loans, credit cards, and other asset types. This asset class also includes collateralized loan obligations (CLOs) and collateralized debt obligations (CDOs). |\n\n| (4) | Municipals include bonds issued by states, municipalities and political subdivisions. |\n\n| (5) | Represents the non-credit component of the other-than-temporary impairment (OTTI) losses, adjusted for subsequent sales, maturities and redemptions. It does not include the change in fair value subsequent to the impairment measurement date. |\n\n14\n| 3. | INVESTMENTS (CONTINUED) |\n\nIn the normal course of investing activities, we actively manage allocations to non-controlling tranches of structured securities (variable interests) issued by VIEs. These structured securities include RMBS, CMBS and ABS and are included in the above table. Additionally, within our other investments portfolio, we also invest in limited partnerships (hedge funds, direct lending funds, real estate funds and private equity funds) and CLO equity tranched securities, which are all variable interests issued by VIEs (see Note 3(c)). For these variable interests, we do not have the power to direct the activities that are most significant to the economic performance of the VIEs therefore we are not the primary beneficiary of any of these VIEs. Our maximum exposure to loss on these interests is limited to the amount of our investment. We have not provided financial or other support with respect to these structured securities other than our original investment.\nContractual Maturities\nThe contractual maturities of fixed maturities are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.\n| AmortizedCost | FairValue | % of TotalFair Value |\n| At September 30, 2016 |\n| Maturity |\n| Due in one year or less | $ | 363,821 | $ | 356,706 | 3.0 | % |\n| Due after one year through five years | 3,809,515 | 3,801,104 | 32.9 | % |\n| Due after five years through ten years | 2,286,970 | 2,330,895 | 20.2 | % |\n| Due after ten years | 344,395 | 353,723 | 3.1 | % |\n| 6,804,701 | 6,842,428 | 59.2 | % |\n| Agency RMBS | 2,473,832 | 2,522,731 | 21.8 | % |\n| CMBS | 877,732 | 894,275 | 7.7 | % |\n| Non-Agency RMBS | 71,842 | 71,830 | 0.6 | % |\n| ABS | 1,234,292 | 1,235,596 | 10.7 | % |\n| Total | $ | 11,462,399 | $ | 11,566,860 | 100.0 | % |\n| At December 31, 2015 |\n| Maturity |\n| Due in one year or less | $ | 291,368 | $ | 289,571 | 2.5 | % |\n| Due after one year through five years | 4,217,515 | 4,142,802 | 35.3 | % |\n| Due after five years through ten years | 2,263,684 | 2,181,525 | 18.6 | % |\n| Due after ten years | 312,431 | 301,039 | 2.6 | % |\n| 7,084,998 | 6,914,937 | 59.0 | % |\n| Agency RMBS | 2,236,138 | 2,249,236 | 19.2 | % |\n| CMBS | 1,088,595 | 1,083,298 | 9.2 | % |\n| Non-Agency RMBS | 99,989 | 101,008 | 0.9 | % |\n| ABS | 1,387,919 | 1,371,270 | 11.7 | % |\n| Total | $ | 11,897,639 | $ | 11,719,749 | 100.0 | % |\n\n15\n| 3. | INVESTMENTS (CONTINUED) |\n\nGross Unrealized Losses\nThe following table summarizes fixed maturities and equities in an unrealized loss position and the aggregate fair value and gross unrealized loss by length of time the security has continuously been in an unrealized loss position:\n| 12 months or greater | Less than 12 months | Total |\n| FairValue | UnrealizedLosses | FairValue | UnrealizedLosses | FairValue | UnrealizedLosses |\n| At September 30, 2016 |\n| Fixed maturities |\n| U.S. government and agency | $ | 55,000 | $ | (1,635 | ) | $ | 422,681 | $ | (780 | ) | $ | 477,681 | $ | (2,415 | ) |\n| Non-U.S. government | 104,441 | (24,061 | ) | 254,694 | (19,283 | ) | 359,135 | (43,344 | ) |\n| Corporate debt | 285,848 | (26,202 | ) | 639,722 | (8,772 | ) | 925,570 | (34,974 | ) |\n| Agency RMBS | 80,375 | (556 | ) | 121,203 | (206 | ) | 201,578 | (762 | ) |\n| CMBS | 99,004 | (1,260 | ) | 173,795 | (743 | ) | 272,799 | (2,003 | ) |\n| Non-Agency RMBS | 10,184 | (1,306 | ) | 5,187 | (342 | ) | 15,371 | (1,648 | ) |\n| ABS | 518,647 | (2,253 | ) | 50,402 | (471 | ) | 569,049 | (2,724 | ) |\n| Municipals | 2,384 | (18 | ) | 15,567 | (69 | ) | 17,951 | (87 | ) |\n| Total fixed maturities | $ | 1,155,883 | $ | (57,291 | ) | $ | 1,683,251 | $ | (30,666 | ) | $ | 2,839,134 | $ | (87,957 | ) |\n| Equity securities |\n| Common stocks | $ | — | $ | — | $ | 31 | $ | (348 | ) | $ | 31 | $ | (348 | ) |\n| Exchange-traded funds | 6,153 | (425 | ) | 39,097 | (635 | ) | 45,250 | (1,060 | ) |\n| Bond mutual funds | — | — | — | — | — | — |\n| Total equity securities | $ | 6,153 | $ | (425 | ) | $ | 39,128 | $ | (983 | ) | $ | 45,281 | $ | (1,408 | ) |\n| At December 31, 2015 |\n| Fixed maturities |\n| U.S. government and agency | $ | 84,179 | $ | (7,622 | ) | $ | 1,474,202 | $ | (15,591 | ) | $ | 1,558,381 | $ | (23,213 | ) |\n| Non-U.S. government | 170,269 | (50,841 | ) | 317,693 | (21,491 | ) | 487,962 | (72,332 | ) |\n| Corporate debt | 340,831 | (33,441 | ) | 2,845,375 | (62,845 | ) | 3,186,206 | (96,286 | ) |\n| Agency RMBS | 64,792 | (1,609 | ) | 1,073,566 | (8,066 | ) | 1,138,358 | (9,675 | ) |\n| CMBS | 75,627 | (1,579 | ) | 659,480 | (7,603 | ) | 735,107 | (9,182 | ) |\n| Non-Agency RMBS | 5,283 | (210 | ) | 43,199 | (763 | ) | 48,482 | (973 | ) |\n| ABS | 562,599 | (11,158 | ) | 667,448 | (6,443 | ) | 1,230,047 | (17,601 | ) |\n| Municipals | 14,214 | (310 | ) | 64,104 | (836 | ) | 78,318 | (1,146 | ) |\n| Total fixed maturities | $ | 1,317,794 | $ | (106,770 | ) | $ | 7,145,067 | $ | (123,638 | ) | $ | 8,462,861 | $ | (230,408 | ) |\n| Equity securities |\n| Common stocks | $ | — | $ | — | $ | — | $ | — | $ | — | $ | — |\n| Exchange-traded funds | 2,331 | (313 | ) | 110,972 | (4,449 | ) | 113,303 | (4,762 | ) |\n| Bond mutual funds | — | — | 124,025 | (4,227 | ) | 124,025 | (4,227 | ) |\n| Total equity securities | $ | 2,331 | $ | (313 | ) | $ | 234,997 | $ | (8,676 | ) | $ | 237,328 | $ | (8,989 | ) |\n\n16\n| 3. | INVESTMENTS (CONTINUED) |\n\nFixed Maturities\nAt September 30, 2016, 935 fixed maturities (2015: 2,314) were in an unrealized loss position of $88 million (2015: $230 million), of which $13 million (2015: $39 million) was related to securities below investment grade or not rated.\nAt September 30, 2016, 399 (2015: 383) securities had been in a continuous unrealized loss position for 12 months or greater and had a fair value of $1,156 million (2015: $1,318 million). Following our credit impairment review, we concluded that these securities as well as the remaining securities in an unrealized loss position in the above table were temporarily impaired at September 30, 2016, and were expected to recover in value as the securities approach maturity. Further, at September 30, 2016, we did not intend to sell these securities in an unrealized loss position and it is more likely than not that we will not be required to sell these securities before the anticipated recovery of their amortized costs.\nEquity Securities\nAt September 30, 2016, 20 securities (2015: 35) were in an unrealized loss position of $1 million (2015: $9 million).\nAt September 30, 2016, 5 securities (2015: 1) were in a continuous unrealized loss position for 12 months or greater. Based on our impairment review process and our ability and intent to hold these securities for a reasonable period of time sufficient for a full recovery, we concluded that the above equities in an unrealized loss position were temporarily impaired at September 30, 2016.\nb) Mortgage Loans\n| September 30, 2016 | December 31, 2015 |\n| Carrying Value | % of Total | Carrying Value | % of Total |\n| Mortgage Loans held-for-investment: |\n| Commercial | $ | 332,753 | 100 | % | $ | 206,277 | 100 | % |\n| 332,753 | 100 | % | 206,277 | 100 | % |\n| Valuation allowances | — | — | % | — | — | % |\n| Total Mortgage Loans held-for-investment | $ | 332,753 | 100 | % | $ | 206,277 | 100 | % |\n\nFor commercial mortgage loans, the primary credit quality indicator is the debt service coverage ratio (which compares a property’s net operating income to amounts needed to service the principal and interest due under the loan, generally, the lower the debt service coverage ratio, the higher the risk of experiencing a credit loss) and the loan-to-value ratio (loan-to-value ratios compare the unpaid principal balance of the loan to the estimated fair value of the underlying collateral, generally, the higher the loan-to-value ratio, the higher the risk of experiencing a credit loss). The debt service coverage ratio and loan-to-value ratio, as well as the values utilized in calculating these ratios, are updated annually, on a rolling basis.\nWe have a high quality mortgage portfolio with debt service coverage ratios in excess of 1.1x and loan-to-value ratios of less than 70%; there are no credit losses associated with the commercial mortgage loans that we hold at September 30, 2016.\nThere are no past due amounts at September 30, 2016.\n17\n| 3. | INVESTMENTS (CONTINUED) |\n\nc) Other Investments\nThe following table provides a breakdown of our investments in hedge funds, direct lending funds, private equity funds, real estate funds, CLO Equities and other privately held investments, together with additional information relating to the liquidity of each category:\n| Fair Value | Redemption Frequency(if currently eligible) | Redemption Notice Period |\n| At September 30, 2016 |\n| Long/short equity funds | $ | 139,460 | 16 | % | Quarterly, Semi-annually, Annually | 45-60 days |\n| Multi-strategy funds | 281,153 | 33 | % | Quarterly, Semi-annually | 60-95 days |\n| Event-driven funds | 94,012 | 11 | % | Quarterly, Annually | 45-60 days |\n| Leveraged bank loan funds | — | — | % | n/a | n/a |\n| Direct lending funds | 125,002 | 15 | % | n/a | n/a |\n| Private equity funds | 89,170 | 11 | % | n/a | n/a |\n| Real estate funds | 11,782 | 1 | % | n/a | n/a |\n| CLO - Equities | 63,783 | 8 | % | n/a | n/a |\n| Other privately held investments | 42,900 | 5 | % | n/a | n/a |\n| Total other investments | $ | 847,262 | 100 | % |\n| At December 31, 2015 |\n| Long/short equity funds | $ | 154,348 | 19 | % | Quarterly, Semi-annually, Annually | 45-60 days |\n| Multi-strategy funds | 355,073 | 43 | % | Quarterly, Semi-annually | 60-95 days |\n| Event-driven funds | 147,287 | 18 | % | Quarterly, Annually | 45-60 days |\n| Leveraged bank loan funds | 65 | — | % | n/a | n/a |\n| Direct lending funds | 90,120 | 11 | % | n/a | n/a |\n| Private equity funds | — | — | % | n/a | n/a |\n| Real estate funds | 4,929 | 1 | % | n/a | n/a |\n| CLO - Equities | 64,934 | 8 | % | n/a | n/a |\n| Other privately held investments | — | — | % | n/a | n/a |\n| Total other investments | $ | 816,756 | 100 | % |\n\nn/a - not applicable\nThe investment strategies for the above funds are as follows:\n| • | Long/short equity funds: Seek to achieve attractive returns primarily by executing an equity trading strategy involving both long and short investments in publicly-traded equities. |\n\n| • | Multi-strategy funds: Seek to achieve above-market returns by pursuing multiple investment strategies to diversify risks and reduce volatility. This category includes funds of hedge funds which invest in a large pool of hedge funds across a diversified range of hedge fund strategies. |\n\n| • | Event-driven funds: Seek to achieve attractive returns by exploiting situations where announced or anticipated events create opportunities. |\n\n| • | Leveraged bank loan funds: Seek to achieve attractive returns by investing primarily in bank loan collateral that has limited interest rate risk exposure. |\n\n18\n| 3. | INVESTMENTS (CONTINUED) |\n\n| • | Direct lending funds: Seek to achieve attractive risk-adjusted returns, including current income generation, by investing in funds which provide financing directly to borrowers. |\n\n| • | Real estate funds: Seek to achieve attractive risk-adjusted returns by making and managing investments in real estate and real estate securities and businesses. |\n\n| • | Private equity funds: Seek to achieve attractive risk-adjusted returns by investing in private transactions over the course of several years. |\n\nTwo common redemption restrictions which may impact our ability to redeem our hedge funds are gates and lockups. A gate is a suspension of redemptions which may be implemented by the general partner or investment manager of the fund in order to defer, in whole or in part, the redemption request in the event the aggregate amount of redemption requests exceeds a predetermined percentage of the fund's net assets which may otherwise hinder the general partner or investment manager's ability to liquidate holdings in an orderly fashion in order to generate the cash necessary to fund extraordinarily large redemption payouts. A lockup period is the initial amount of time an investor is contractually required to hold the security before having the ability to redeem. During 2016 and 2015, neither of these restrictions impacted our redemption requests. At September 30, 2016, $87 million (2015: $66 million), representing 17% (2015: 10%) of our total hedge funds, relate to holdings where we are still within the lockup period. The expiration of these lockup periods range from September 2016 to March 2019.\nAt September 30, 2016, we have $189 million (2015: $222 million) of unfunded commitments within our other investments portfolio relating to our future investments in direct lending funds. Once the full amount of committed capital has been called by the General Partner of each of these funds, the assets will not be fully returned until the completion of the fund's investment term. These funds have investment terms ranging from 5-10 years and the General Partners of certain funds have the option to extend the term by up to three years.\nAt September 30, 2016, we have $12 million (2015: $12 million) of unfunded commitments as a limited partner in a multi-strategy hedge fund. Once the full amount of committed capital has been called by the General Partner, the assets will not be fully returned until the completion of the fund's investment term which ends in March, 2019. The General Partner then has the option to extend the term by up to three years.\nAt September 30, 2016, we have $90 million (2015: $95 million) of unfunded commitments as a limited partner in a fund which invests in real estate and real estate securities and businesses. The fund is subject to a three year commitment period and a total fund life of eight years during which time we are not eligible to redeem our investment.\nDuring 2016, we made a $135 million commitment as a limited partner in a private equity fund. At September 30, 2016, $40 million of our commitment remains unfunded and the current fair value of the funds called to date are included in the private equity funds line of the table above. The fund invests in underlying private equity funds and the life of the fund is subject to the dissolution of the underlying funds. We expect the overall holding period to be over ten years.\nDuring 2015, we made a $50 million commitment as a limited partner of a bank revolver opportunity fund. The fund is subject to an investment term of seven years and the General Partners have the option to extend the term by up to two years. At September 30, 2016, this commitment remains unfunded. It is not anticipated that the full amount of this fund will be drawn.\n19\n| 3. | INVESTMENTS (CONTINUED) |\n\nd) Equity Method Investments\nDuring 2016, we paid $104 million including direct transaction costs to acquire 18% of the common equity of Harrington Reinsurance Holdings Limited (\"Harrington\"), the parent company of Harrington Re Ltd. (\"Harrington Re\"), an independent reinsurance company jointly sponsored by AXIS Capital and The Blackstone Group L.P. (\"Blackstone\"). Through long-term service agreements, AXIS Capital will serve as Harrington Re's reinsurance underwriting manager and Blackstone will serve as exclusive investment management service provider. As an investor, we expect to benefit from underwriting profit generated by Harrington Re and the income and capital appreciation Blackstone seeks to deliver through its investment management services. In addition, we have entered into an arrangement with Blackstone under which underwriting and investment related fees will be shared equally. Harrington is not a variable interest entity and given that we exercise significant influence over this investee we account for our ownership in Harrington under the equity method of accounting. The Company's proportionate share of the underlying equity in net assets resulted in a basis difference of $5 million which represents initial transactions costs.\nThe Company also has investments in other equity method investments with a carrying value of $9 million.\ne) Net Investment Income\nNet investment income was derived from the following sources:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Fixed maturities | $ | 75,827 | $ | 75,980 | $ | 229,423 | $ | 220,066 |\n| Other investments | 38,248 | (27,421 | ) | 25,770 | 17,616 |\n| Equity securities | 4,633 | 3,445 | 12,843 | 7,795 |\n| Mortgage loans | 2,191 | 482 | 5,683 | 776 |\n| Cash and cash equivalents | 3,768 | 993 | 7,071 | 3,770 |\n| Short-term investments | 337 | 83 | 708 | 277 |\n| Gross investment income | 125,004 | 53,562 | 281,498 | 250,300 |\n| Investment expenses | (8,081 | ) | (7,877 | ) | (23,680 | ) | (23,964 | ) |\n| Net investment income | $ | 116,923 | $ | 45,685 | $ | 257,818 | $ | 226,336 |\n\n20\n| 3. | INVESTMENTS (CONTINUED) |\n\nf) Net Realized Investment Gains (Losses)\nThe following table provides an analysis of net realized investment gains (losses):\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Gross realized gains |\n| Fixed maturities and short-term investments | $ | 26,211 | $ | 12,126 | $ | 67,833 | $ | 44,853 |\n| Equities | 5,570 | 232 | 18,804 | 447 |\n| Gross realized gains | 31,781 | 12,358 | 86,637 | 45,300 |\n| Gross realized losses |\n| Fixed maturities and short-term investments | (21,908 | ) | (54,867 | ) | (90,702 | ) | (111,432 | ) |\n| Equities | (576 | ) | (1,559 | ) | (15,923 | ) | (1,952 | ) |\n| Gross realized losses | (22,484 | ) | (56,426 | ) | (106,625 | ) | (113,384 | ) |\n| Net OTTI recognized in earnings | (4,247 | ) | (32,301 | ) | (20,346 | ) | (62,762 | ) |\n| Change in fair value of investment derivatives(1) | 155 | 6,412 | 39 | 7,228 |\n| Net realized investment gains (losses) | $ | 5,205 | $ | (69,957 | ) | $ | (40,295 | ) | $ | (123,618 | ) |\n\n(1) Refer to Note 5 – Derivative Instruments\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Fixed maturities: |\n| Non-U.S. government | $ | 2,456 | $ | 1,295 | $ | 2,953 | $ | 2,717 |\n| Corporate debt | 1,791 | 20,587 | 14,833 | 38,396 |\n| Non-Agency RMBS | — | — | — | 4 |\n| ABS | — | 84 | — | 124 |\n| 4,247 | 21,966 | 17,786 | 41,241 |\n| Equity Securities |\n| Exchange-traded funds | — | 10,335 | 2,560 | 10,335 |\n| Bond mutual funds | — | — | — | 11,186 |\n| — | 10,335 | 2,560 | 21,521 |\n| Total OTTI recognized in earnings | $ | 4,247 | $ | 32,301 | $ | 20,346 | $ | 62,762 |\n\n21\n| 3. | INVESTMENTS (CONTINUED) |\n\nThe following table provides a roll forward of the credit losses, before income taxes, for which a portion of the OTTI was recognized in AOCI:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Balance at beginning of period | $ | 1,513 | $ | 1,564 | $ | 1,506 | $ | 1,531 |\n| Credit impairments recognized on securities not previously impaired | — | — | — | — |\n| Additional credit impairments recognized on securities previously impaired | — | — | 7 | 33 |\n| Change in timing of future cash flows on securities previously impaired | — | — | — | — |\n| Intent to sell of securities previously impaired | — | — | — | — |\n| Securities sold/redeemed/matured | (33 | ) | (43 | ) | (33 | ) | (43 | ) |\n| Balance at end of period | $ | 1,480 | $ | 1,521 | $ | 1,480 | $ | 1,521 |\n\ng) Reverse Repurchase Agreements\nAt September 30, 2016, we held $160 million (December 31, 2015: $30 million) of reverse repurchase agreements. These loans are fully collateralized, are generally outstanding for a short period of time and are presented on a gross basis as part of cash and cash equivalents on our consolidated balance sheet. The required collateral for these loans is either cash or U.S. Treasuries at a minimum rate of 102% of the loan principal. Upon maturity, we receive principal and interest income. We monitor the estimated fair value of the securities loaned and borrowed on a daily basis with additional collateral obtained as necessary throughout the duration of the transaction.\nFair Value Hierarchy\nFair value is defined as the price to sell an asset or transfer a liability (i.e. the “exit price”) in an orderly transaction between market participants. We use a fair value hierarchy that gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data. The level in the hierarchy within which a given fair value measurement falls is determined based on the lowest level input that is significant to the measurement. The hierarchy is broken down into three levels as follows:\n| • | Level 1 - Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that we have the ability to access. |\n\n| • | Level 2 - Valuations based on quoted prices in active markets for similar assets or liabilities, quoted prices for identical assets or liabilities in inactive markets, or for which significant inputs are observable (e.g. interest rates, yield curves, prepayment speeds, default rates, loss severities, etc.) or can be corroborated by observable market data. |\n\n| • | Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement. The unobservable inputs reflect our own judgments about assumptions that market participants might use. |\n\nThe availability of observable inputs can vary from financial instrument to financial instrument and is affected by a wide variety of factors including, for example, the type of financial instrument, whether the financial instrument is new and not yet established in the marketplace, and other characteristics particular to the transaction. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires significantly more judgment.\nAccordingly, the degree of judgment exercised by management in determining fair value is greatest for instruments categorized in Level 3. In periods of market dislocation, the observability of prices and inputs may be reduced for many instruments. This may lead us to change the selection of our valuation technique (from market to cash flow approach) or may cause us to use multiple valuation techniques to estimate the fair value of a financial instrument. This circumstance could cause an instrument to be reclassified between levels within the fair value hierarchy.\nWe used the following valuation techniques including significant inputs and assumptions in estimating the fair value of our financial instruments as well as the general classification of such financial instruments pursuant to the above fair value hierarchy.\nFixed Maturities\nAt each valuation date, we use the market approach valuation technique to estimate the fair value of our fixed maturities portfolio, when possible. This market approach includes, but is not limited to, prices obtained from third party pricing services for identical or comparable securities and the use of “pricing matrix models” using observable market inputs such as yield curves, credit risks and spreads, measures of volatility, and prepayment speeds. Pricing from third party pricing services is sourced from multiple vendors, when available, and we maintain a vendor hierarchy by asset type based on historical pricing experience and vendor expertise. When prices are unavailable from pricing services, we obtain non-binding quotes from broker-dealers who are active in the corresponding markets.\nThe valuation techniques including significant inputs generally used to determine the fair value of our fixed maturities by asset class as well as the classification in the fair value hierarchy are described in detail below.\nU.S. government and agency\nU.S. government and agency securities consist primarily of bonds issued by the U.S. Treasury and mortgage pass-through agencies such as the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation and the Government National Mortgage Association. As the fair values of U.S. Treasury securities are based on unadjusted market prices in active markets, these securities are classified within Level 1. The fair values of U.S. government agency securities are priced using the spread above the risk-free yield curve. As the yields for the risk-free yield curve and the spreads for these securities are observable market inputs, the fair values of U.S. government agency securities are classified within Level 2.\n22\n| 4. | FAIR VALUE MEASUREMENTS |\n\nNon-U.S. government\nNon-U.S. government securities comprise bonds issued by non-U.S. governments and their agencies along with supranational organizations (collectively also known as sovereign debt securities). The fair values of these securities are based on prices obtained from international indices or a valuation model which uses inputs including interest rate yield curves, cross-currency basis index spreads, and country credit spreads for structures similar to the sovereign bond in terms of issuer, maturity and seniority. As the significant inputs are observable market inputs, the fair value of non-U.S. government securities are classified within Level 2.\nCorporate debt\nCorporate debt securities consist primarily of investment-grade debt of a wide variety of corporate issuers and industries. The fair values of these securities are generally determined using the spread above the risk-free yield curve. These spreads are generally obtained from the new issue market, secondary trading and broker-dealer quotes. As these spreads and the yields for the risk-free yield curve are observable market inputs, the fair values of corporate debt securities are classified within Level 2. Where pricing is unavailable from pricing services, we obtain non-binding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. In this event, securities are classified within Level 3.\nAgency RMBS\nAgency RMBS securities consist of bonds issued by the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation and the Government National Mortgage Association. The fair values of these securities are priced using a mortgage pool specific model which uses daily inputs from the active to be announced market and the spread associated with each mortgage pool based on vintage. As the significant inputs are observable market inputs, the fair values of Agency RMBS securities are classified within Level 2.\nCMBS\nCMBS include mostly investment-grade bonds originated by non-agencies. The fair values of these securities are determined using a pricing model which uses dealer quotes and other available trade information along with security level characteristics to determine deal specific spreads. As the significant inputs are observable market inputs, the fair values of CMBS securities are classified within Level 2. Where pricing is unavailable from pricing services, we obtain non-binding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. In this event, securities are classified within Level 3.\nNon-Agency RMBS\nNon-Agency RMBS include mostly investment-grade bonds originated by non-agencies. The fair values of these securities are determined using an option adjusted spread model or other relevant models, which use inputs including available trade information or broker quotes, prepayment and default projections based on historical statistics of the underlying collateral and current market data. As the significant inputs are observable market inputs, the fair values of Non-Agency RMBS securities are classified within Level 2.\nABS\nABS include mostly investment-grade bonds backed by pools of loans with a variety of underlying collateral, including automobile loan receivables, student loans, credit card receivables, and CLO Debt originated by a variety of financial institutions. The fair values of ABS are priced using a model which uses prepayment speeds and spreads sourced primarily from the new issue market. As the significant inputs used to price ABS are observable market inputs, the fair values of ABS are classified within Level 2. Where pricing is unavailable from pricing services, we obtain non-binding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. In this event, securities are classified within Level 3.\n23\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\nMunicipals\nMunicipals comprise revenue and general obligation bonds issued by U.S. domiciled state and municipal entities. The fair values of these securities are determined using spreads obtained from broker-dealers, trade prices and the new issue market. As the significant inputs used to price the municipals are observable market inputs, municipals are classified within Level 2.\nEquity Securities\nEquity securities include common stocks, exchange-traded funds and bond mutual funds. As the fair values of common stocks and exchange-traded funds are based on unadjusted quoted market prices in active markets, these securities are classified within Level 1.\nAs bond mutual funds have daily liquidity with redemption based on the NAV of the funds, the fair values of these securities are classified within Level 2.\nOther Investments\nAt September 30, 2016, our investments in CLO - Equities were classified within Level 3 as we estimated the fair value for these securities using an income approach valuation technique (discounted cash flow model) due to the lack of observable and relevant trades in the secondary markets.\nOther privately held securities include convertible preferred shares, convertible notes and notes payable. In the reporting period of investment, the cost of these investments approximates fair value. In subsequent measurement periods, a discounted cash flow model is used to determine the fair value of these securities. These securities are classified within Level 3.\nShort-Term Investments\nShort-term investments primarily comprise highly liquid securities with maturities greater than three months but less than one year from the date of purchase. These securities are classified within Level 2 because these securities are typically not actively traded due to their approaching maturity and, as such, their amortized cost approximates fair value.\nDerivative Instruments\nOur foreign currency forward contracts, interest rate swaps and commodity contracts are customized to our economic hedging strategies and trade in the over-the-counter derivative market. We use the market approach valuation technique to estimate the fair value for these derivatives based on significant observable market inputs from third party pricing vendors, non-binding broker-dealer quotes and/or recent trading activity. Accordingly, we classified these derivatives within Level 2.\nWe also participate in non-exchange traded derivative-based risk management products addressing weather risks. We use observable market inputs and unobservable inputs in combination with industry or internally-developed valuation and forecasting techniques to determine fair value. We classify these instruments within Level 3.\nInsurance-linked Securities\nInsurance-linked securities comprise an investment in a catastrophe bond. We obtain non-binding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. These securities are classified within Level 3.\nCash Settled Awards\nCash settled awards comprise restricted stock units that form part of our compensation program. Although the fair value of these awards is determined using observable quoted market prices in active markets, the stock units themselves are not actively traded. Accordingly, we have classified these liabilities within Level 2.\n24\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\nThe tables below present the financial instruments measured at fair value on a recurring basis for the periods indicated:\n| Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | Fair value based on NAV practical expedient | Total Fair Value |\n| At September 30, 2016 |\n| Assets |\n| Fixed maturities |\n| U.S. government and agency | $ | 1,522,246 | $ | 40,631 | $ | — | $ | — | $ | 1,562,877 |\n| Non-U.S. government | — | 582,056 | — | — | 582,056 |\n| Corporate debt | — | 4,499,408 | 69,092 | — | 4,568,500 |\n| Agency RMBS | — | 2,522,731 | — | — | 2,522,731 |\n| CMBS | — | 885,355 | 8,920 | — | 894,275 |\n| Non-Agency RMBS | — | 71,830 | — | — | 71,830 |\n| ABS | — | 1,235,596 | — | — | 1,235,596 |\n| Municipals | — | 128,995 | — | — | 128,995 |\n| 1,522,246 | 9,966,602 | 78,012 | — | 11,566,860 |\n| Equity securities |\n| Common stocks | 69 | — | — | — | 69 |\n| Exchange-traded funds | 504,206 | — | — | — | 504,206 |\n| Bond mutual funds | — | 140,069 | — | — | 140,069 |\n| 504,275 | 140,069 | — | — | 644,344 |\n| Other investments |\n| Hedge funds | — | — | — | 514,625 | 514,625 |\n| Direct lending funds | — | — | — | 125,002 | 125,002 |\n| Private equity funds | — | — | — | 89,170 | 89,170 |\n| Real estate funds | — | — | — | 11,782 | 11,782 |\n| Other privately held investments | — | — | 42,900 | — | 42,900 |\n| CLO - Equities | — | — | 63,783 | — | 63,783 |\n| — | — | 106,683 | 740,579 | 847,262 |\n| Short-term investments | — | 39,877 | — | — | 39,877 |\n| Other assets |\n| Derivative instruments (see Note 5) | — | 4,469 | 2,488 | — | 6,957 |\n| Insurance-linked securities | — | — | 25,283 | — | 25,283 |\n| Total Assets | $ | 2,026,521 | $ | 10,151,017 | $ | 212,466 | $ | 740,579 | $ | 13,130,583 |\n| Liabilities |\n| Derivative instruments (see Note 5) | $ | — | $ | 4,411 | $ | 8,184 | $ | — | $ | 12,595 |\n| Cash settled awards (see Note 7) | — | 34,288 | — | — | 34,288 |\n| Total Liabilities | $ | — | $ | 38,699 | $ | 8,184 | $ | — | $ | 46,883 |\n\n25\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\n| Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | Fair value based on NAV practical expedient | Total Fair Value |\n| At December 31, 2015 |\n| Assets |\n| Fixed maturities |\n| U.S. government and agency | $ | 1,632,355 | $ | 19,594 | $ | — | $ | — | $ | 1,651,949 |\n| Non-U.S. government | — | 739,005 | — | — | 739,005 |\n| Corporate debt | — | 4,324,251 | 38,518 | — | 4,362,769 |\n| Agency RMBS | — | 2,249,236 | — | — | 2,249,236 |\n| CMBS | — | 1,072,376 | 10,922 | — | 1,083,298 |\n| Non-Agency RMBS | — | 101,008 | — | — | 101,008 |\n| ABS | — | 1,371,270 | — | — | 1,371,270 |\n| Municipals | — | 161,214 | — | — | 161,214 |\n| 1,632,355 | 10,037,954 | 49,440 | — | 11,719,749 |\n| Equity securities |\n| Common stocks | — | — | — | — | — |\n| Exchange-traded funds | 473,973 | — | — | — | 473,973 |\n| Bond mutual funds | — | 124,025 | — | — | 124,025 |\n| 473,973 | 124,025 | — | — | 597,998 |\n| Other investments |\n| Hedge funds | — | — | — | 656,773 | 656,773 |\n| Direct lending funds | — | — | — | 90,120 | 90,120 |\n| Private equity funds | — | — | — | — | — |\n| Real estate funds | — | — | — | 4,929 | 4,929 |\n| Other privately held investments | — | — | — | — | — |\n| CLO - Equities | — | — | 27,257 | 37,677 | 64,934 |\n| — | — | 27,257 | 789,499 | 816,756 |\n| Short-term investments | — | 34,406 | — | — | 34,406 |\n| Other assets |\n| Derivative instruments (see Note 5) | — | 2,072 | 4,395 | — | 6,467 |\n| Insurance-linked securities | — | — | 24,925 | — | 24,925 |\n| Total Assets | $ | 2,106,328 | $ | 10,198,457 | $ | 106,017 | $ | 789,499 | $ | 13,200,301 |\n| Liabilities |\n| Derivative instruments (see Note 5) | $ | — | $ | 7,692 | $ | 10,937 | $ | — | $ | 18,629 |\n| Cash settled awards (see Note 7) | — | 33,215 | — | — | 33,215 |\n| Total Liabilities | $ | — | $ | 40,907 | $ | 10,937 | $ | — | $ | 51,844 |\n\nDuring 2016 and 2015, there were no transfers between Levels 1 and 2.\n26\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\nExcept certain fixed maturities and insurance-linked securities priced using broker-dealer quotes (underlying inputs are not available), the following table quantifies the significant unobservable inputs we have used in estimating fair value at September 30, 2016 for our investments classified as Level 3 in the fair value hierarchy.\n| Fair Value | Valuation Technique | Unobservable Input | Range | Weighted Average |\n| Other investments - CLO - Equities | $ | 35,594 | Discounted cash flow | Default rates | 4.0% | 4.0% |\n| Loss severity rate | 35.0% - 53.5% | 35.4% |\n| Collateral spreads | 3.6% - 4.0% | 4.0% |\n| Estimated maturity dates | 2 - 6 years | 6 years |\n| 28,189 | Liquidation value | Fair value of collateral | 100% | 100% |\n| Discount margin | 0.1% - 19.1% | 2.4% |\n| Other investments - Other privately held investments | 42,900 | Discounted cash flow | Discount rate | 5.0% - 8.0% | 7.2% |\n| Derivatives - Weather derivatives, net | $ | (5,696 | ) | Simulation model | Weather curve | 1 - 2294(1) | n/a (2) |\n| Weather standard deviation | 1 - 1029(1) | n/a (2) |\n\n(1) Measured in Heating Degree Days (\"HDD\") which is the number of degrees the daily temperature is below a reference temperature. The cumulative HDD for the duration of the derivatives contract is compared to the strike value to determine the necessary settlement.\n| (2) | Due to the diversity of the portfolio, the range of unobservable inputs can be widespread; therefore, presentation of a weighted average is not useful. Weather parameters may include various temperature and/or precipitation measures that will naturally vary by geographic location of each counterparty's operations. |\n\nThe CLO - Equities market continues to be mostly inactive with only a small number of transactions being observed and fewer still involving transactions in our CLO - Equities. Accordingly, we use models to estimate the fair value of our investments in CLO - Equities. Given that all of our direct investments in CLO - Equities are past their reinvestment period, there is uncertainty over the remaining time to maturity. As such our direct investments in CLO - Equities are valued at the lower of the liquidation value and fair value based on an internally developed discounted cash flow model.\nThe liquidation valuation is based on the fair value of the net underlying collateral which is determined by applying market discount margins by credit quality bucket. An increase (decrease) in the market discount margin would result in a decrease (increase) in value of our CLO - Equities. Regarding the discounted cash flow model, the default and loss severity rates are the most judgmental unobservable market inputs to which the valuation of CLO - Equities is most sensitive. A significant increase (decrease) in either of these significant inputs in isolation would result in lower (higher) fair value estimates for direct investments in our CLO - Equities and, in general, a change in default rate assumptions will be accompanied by a directionally similar change in loss severity rate assumptions. Collateral spreads and estimated maturity dates are less judgmental inputs as they are based on the historical average of actual spreads and the weighted average life of the current underlying portfolios, respectively. A significant increase (decrease) in either of these significant inputs in isolation would result in higher (lower) fair value estimates for direct investments in our CLO - Equities. In general, these inputs have no significant interrelationship with each other or with default and loss severity rates.\nOn a quarterly basis, our valuation process for CLO - Equities includes a review of the underlying collateral along with related discount margins by credit quality bucket used in the liquidation valuation and a review of the underlying cash flows and key assumptions used in the discounted cash flow model. We review and update the above significant unobservable inputs based on information obtained from secondary markets, including information received from the managers of our CLO - Equities portfolio.\nIn order to assess the reasonableness of the inputs we use in our models, we maintain an understanding of current market conditions, historical results, as well as emerging trends that may impact future cash flows. In addition,we update the assumptions we use in our models through regular communication with industry participants and ongoing monitoring of the deals in which we participate (e.g. default and loss severity rate trends).\n27\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\nOther privately held securities are initially valued at cost which approximates fair value. In subsequent measurement periods, a discounted cash flow model is used to determine the fair value of these securities. These models include inputs specific to each investment. The inputs used in the fair value measurement include dividend or interest rates and a discount rate. The discount rate is judgmental and the most significant unobservable input used in the valuation of the other privately held securities. Significant increases (decreases) in this input in isolation could result in a significantly higher (lower) fair value measurement. In order to assess the reasonableness of the inputs we use in our models, we maintain an understanding of current market conditions, historical results, as well as investee specific information that may impact future cash flows.\nWeather derivatives relate to non-exchange traded risk management products addressing weather risks. We use observable market inputs and unobservable inputs in combination with industry or internally-developed valuation and forecasting techniques to determine fair value. The models may reference market price information for similar instruments. The pricing models are internally reviewed by Risk Management personnel prior to implementation and are reviewed periodically thereafter.\nObservable and unobservable inputs to these models vary by contract type but would typically include the following:\n| • | Observable inputs: market prices for similar instruments, notional price, option strike price, term to expiry, contractual limits; |\n\n| • | Unobservable inputs: correlation; and |\n\n| • | Both observable and unobservable inputs: weather curves, weather standard deviation. |\n\nIn general, weather curves are the most significant contributing input to fair value determination. Changes in this variable can result in higher or lower fair value depending on the underlying position. In addition, changes in any or all of the unobservable inputs identified above may contribute positively or negatively to overall portfolio value. The correlation input will quantify the interrelationship, if any, amongst the other variables.\n28\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\n| OpeningBalance | TransfersintoLevel 3 | Transfersout ofLevel 3 | Included inearnings (1) | Includedin OCI (2) | Purchases | Sales | Settlements/Distributions | ClosingBalance | Change inunrealizedinvestmentgain/(loss) (3) |\n| Three months ended September 30, 2016 |\n| Fixed maturities |\n| Corporate debt | $ | 62,022 | $ | — | $ | — | $ | (9 | ) | $ | 100 | $ | 7,563 | $ | — | $ | (584 | ) | $ | 69,092 | $ | — |\n| CMBS | 10,210 | — | — | — | (48 | ) | — | — | (1,242 | ) | 8,920 | — |\n| ABS | — | — | — | — | — | — | — | — | — | — |\n| 72,232 | — | — | (9 | ) | 52 | 7,563 | — | (1,826 | ) | 78,012 | — |\n| Other investments |\n| Other privately held investments | 41,755 | — | — | (355 | ) | — | 1,500 | — | — | 42,900 | (355 | ) |\n| CLO - Equities | 65,883 | — | — | 8,419 | — | — | — | (10,519 | ) | 63,783 | 8,419 |\n| 107,638 | — | — | 8,064 | — | 1,500 | — | (10,519 | ) | 106,683 | 8,064 |\n| Other assets |\n| Derivative instruments | 5 | — | — | 665 | — | 1,818 | — | — | 2,488 | 665 |\n| Insurance-linked securities | 25,025 | — | — | 258 | — | — | — | — | 25,283 | 258 |\n| 25,030 | — | — | 923 | — | 1,818 | — | — | 27,771 | 923 |\n| Total assets | $ | 204,900 | $ | — | $ | — | $ | 8,978 | $ | 52 | $ | 10,881 | $ | — | $ | (12,345 | ) | $ | 212,466 | $ | 8,987 |\n| Other liabilities |\n| Derivative instruments | $ | 1,978 | $ | — | $ | — | $ | (169 | ) | $ | — | $ | 6,384 | $ | — | $ | (9 | ) | $ | 8,184 | $ | 335 |\n| Total liabilities | $ | 1,978 | $ | — | $ | — | $ | (169 | ) | $ | — | $ | 6,384 | $ | — | $ | (9 | ) | $ | 8,184 | $ | 335 |\n| Nine months ended September 30, 2016 |\n| Fixed maturities |\n| Corporate debt | $ | 38,518 | $ | 20,412 | $ | (1,955 | ) | $ | (988 | ) | $ | 1,188 | $ | 17,107 | $ | (4,015 | ) | $ | (1,175 | ) | $ | 69,092 | $ | — |\n| CMBS | 10,922 | — | — | — | (134 | ) | — | — | (1,868 | ) | 8,920 | — |\n| ABS | — | — | — | — | — | — | — | — | — | — |\n| 49,440 | 20,412 | (1,955 | ) | (988 | ) | 1,054 | 17,107 | (4,015 | ) | (3,043 | ) | 78,012 | — |\n| Other investments |\n| Other privately held investments | — | — | — | (1,505 | ) | — | 44,405 | — | — | 42,900 | (1,505 | ) |\n| CLO - Equities | 27,257 | 36,378 | — | 17,431 | — | — | — | (17,283 | ) | 63,783 | 17,431 |\n| 27,257 | 36,378 | — | 15,926 | — | 44,405 | — | (17,283 | ) | 106,683 | 15,926 |\n| Other assets |\n| Derivative instruments | 4,395 | — | — | 3,255 | — | 3,623 | — | (8,785 | ) | 2,488 | 669 |\n| Insurance-linked securities | 24,925 | — | — | 358 | — | — | — | — | 25,283 | 358 |\n| 29,320 | — | — | 3,613 | — | 3,623 | — | (8,785 | ) | 27,771 | 1,027 |\n| Total assets | $ | 106,017 | $ | 56,790 | $ | (1,955 | ) | $ | 18,551 | $ | 1,054 | $ | 65,135 | $ | (4,015 | ) | $ | (29,111 | ) | $ | 212,466 | $ | 16,953 |\n| Other liabilities |\n| Derivative instruments | $ | 10,937 | $ | — | $ | — | $ | 2,445 | $ | — | $ | 7,189 | $ | — | $ | (12,387 | ) | $ | 8,184 | $ | 457 |\n| Total liabilities | $ | 10,937 | $ | — | $ | — | $ | 2,445 | $ | — | $ | 7,189 | $ | — | $ | (12,387 | ) | $ | 8,184 | $ | 457 |\n\n29\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\n| OpeningBalance | TransfersintoLevel 3 | Transfersout ofLevel 3 | Included inearnings (1) | Includedin OCI (2) | Purchases | Sales | Settlements/Distributions | ClosingBalance | Change inunrealizedinvestmentgain/(loss) (3) |\n| Three months ended September 30, 2015 |\n| Fixed maturities |\n| Corporate debt | $ | 43,008 | $ | — | $ | — | $ | (2 | ) | $ | 300 | $ | 22,821 | $ | — | $ | (4,403 | ) | $ | 61,724 | $ | — |\n| CMBS | 21,900 | — | (9,902 | ) | — | (219 | ) | — | — | (461 | ) | 11,318 | — |\n| ABS | 110 | — | — | — | — | — | — | (3 | ) | 107 | — |\n| 65,018 | — | (9,902 | ) | (2 | ) | 81 | 22,821 | — | (4,867 | ) | 73,149 | — |\n| Other investments |\n| Other privately held investments | — | — | — | — | — | — | — | — | — | — |\n| CLO - Equities | 36,921 | — | — | 1,192 | — | — | — | (3,118 | ) | 34,995 | 1,192 |\n| 36,921 | — | — | 1,192 | — | — | — | (3,118 | ) | 34,995 | 1,192 |\n| Other assets |\n| Derivative instruments | 240 | — | — | 35 | — | — | — | (240 | ) | 35 | 35 |\n| Insurance-linked securities | 24,837 | — | — | 175 | — | — | — | — | 25,012 | 175 |\n| 25,077 | — | — | 210 | — | — | — | (240 | ) | 25,047 | 210 |\n| Total assets | $ | 127,016 | $ | — | $ | (9,902 | ) | $ | 1,400 | $ | 81 | $ | 22,821 | $ | — | $ | (8,225 | ) | $ | 133,191 | $ | 1,402 |\n| Other liabilities |\n| Derivative instruments | $ | 818 | $ | — | $ | — | $ | (331 | ) | $ | — | $ | 6,475 | $ | — | $ | — | $ | 6,962 | $ | (331 | ) |\n| Total liabilities | $ | 818 | $ | — | $ | — | $ | (331 | ) | $ | — | $ | 6,475 | $ | — | $ | — | $ | 6,962 | $ | (331 | ) |\n| Nine months ended September 30, 2015 |\n| Fixed maturities |\n| Corporate debt | $ | 15,837 | $ | — | $ | — | $ | (2 | ) | $ | 724 | $ | 54,445 | $ | — | $ | (9,280 | ) | $ | 61,724 | $ | — |\n| CMBS | 17,763 | 5,072 | (9,902 | ) | — | (543 | ) | — | — | (1,072 | ) | 11,318 | — |\n| ABS | 40,031 | — | (39,851 | ) | — | 105 | — | — | (178 | ) | 107 | — |\n| 73,631 | 5,072 | (49,753 | ) | (2 | ) | 286 | 54,445 | — | (10,530 | ) | 73,149 | — |\n| Other investments |\n| Other privately held investments | — | — | — | — | — | — | — | — | — | — |\n| CLO - Equities | 37,046 | — | — | 7,930 | — | — | — | (9,981 | ) | 34,995 | 7,930 |\n| 37,046 | — | — | 7,930 | — | — | — | (9,981 | ) | 34,995 | 7,930 |\n| Other assets |\n| Derivative instruments | 111 | — | — | (792 | ) | — | — | — | 716 | 35 | 35 |\n| Insurance-linked securities | — | — | — | 12 | — | 25,000 | — | — | 25,012 | 12 |\n| 111 | — | — | (780 | ) | — | 25,000 | — | 716 | 25,047 | 47 |\n| Total assets | $ | 110,788 | $ | 5,072 | $ | (49,753 | ) | $ | 7,148 | $ | 286 | $ | 79,445 | $ | — | $ | (19,795 | ) | $ | 133,191 | $ | 7,977 |\n| Other liabilities |\n| Derivative instruments | $ | 15,288 | $ | — | $ | — | $ | (12,053 | ) | $ | — | $ | 8,698 | $ | — | $ | (4,971 | ) | $ | 6,962 | $ | (318 | ) |\n| Total liabilities | $ | 15,288 | $ | — | $ | — | $ | (12,053 | ) | $ | — | $ | 8,698 | $ | — | $ | (4,971 | ) | $ | 6,962 | $ | (318 | ) |\n\n| (1) | Gains and losses included in earnings on fixed maturities are included in net realized investment gains (losses). Gains and (losses) included in earnings on other investments are included in net investment income. Gains (losses) on weather derivatives included in earnings are included in other insurance-related income. |\n\n| (2) | Gains and losses included in other comprehensive income (“OCI”) on fixed maturities are included in unrealized gains (losses) arising during the period. |\n\n| (3) | Change in unrealized investment gain (loss) relating to assets held at the reporting date. |\n\nThe transfers into and out of fair value hierarchy levels reflect the fair value of the securities at the end of the reporting period.\n30\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\nTransfers into Level 3 from Level 2\nThere were no transfers to Level 3 from Level 2 made during the three months ended September 30, 2016 and 2015.\nThe transfers to Level 3 from Level 2 made during the nine months ended September 30, 2016 were primarily due to the lack of observable market inputs and multiple quotes from pricing vendors and broker-dealers for certain fixed maturities and as the result of a change in valuation methodology relating to our CLO equity fund. An income approach valuation technique (discounted cash flow model) is used to estimate fair value at September 30, 2016. As the NAV practical expedient is no longer used the CLO equity fund is now categorized within the fair value hierarchy.\nThe transfers to Level 3 from Level 2 made during the nine months ended September 30, 2015 were primarily due to the lack of observable market inputs and multiple quotes from pricing vendors and broker-dealers for certain fixed maturities.\nTransfers out of Level 3 into Level 2\nThere were no transfers to Level 2 from Level 3 made during the three months ended September 30, 2016. The transfers to Level 2 from Level 3 made during the nine months ended September 30, 2016 were primarily due to the availability of observable market\ninputs and quotes from pricing vendors on certain fixed maturities.\nThe transfers to Level 2 from Level 3 made during the three and nine months ended September 30, 2015 were primarily due to the availability of observable market inputs and quotes from pricing vendors on certain fixed maturities and CLO Debt securities.\nMeasuring the Fair Value of Other Investments Using Net Asset Valuations\nAs a practical expedient, we estimate fair values for hedge funds, direct lending funds, private equity funds and real estate funds using NAVs as advised by external fund managers or third party administrators. For each of these funds, the NAV is based on the manager's or administrator's valuation of the underlying holdings in accordance with the fund's governing documents and in accordance with U.S. GAAP.\nIf there is a reporting lag between the current period end and reporting date of the latest available fund valuation for any hedge fund, we estimate the change in fair value by starting with the most recently available fund valuation and adjusting for return estimates as well as any subscriptions, redemptions and distributions that took place during the current period. Return estimates are obtained from the relevant fund managers. Accordingly, we do not typically have a reporting lag in our fair value measurements for these funds. Historically, our valuation estimates incorporating these return estimates have not significantly diverged from the subsequently received NAVs.\nFor private equity funds, direct lending funds and the real estate fund, valuation statements are typically released on a three month reporting lag therefore the Company estimates fair value of these funds by starting with the prior quarter-end fund valuations and adjusting for capital calls, redemptions, drawdowns and distributions. Return estimates are not available from the relevant fund managers for these funds. Accordingly, we typically have a reporting lag in our fair value measurements for these funds.\nThe Company often does not have access to financial information relating to the underlying securities held within the funds, therefore management is unable to corroborate the fair values placed on the securities underlying the asset valuations provided by the fund manager or fund administrator. To address this, on a quarterly basis, we perform a number of monitoring procedures to assess the quality of the information provided by managers and administrators. These procedures include, but are not limited to, regular review and discussion of each fund's performance with its manager, regular evaluation of fund performance against applicable benchmarks and the backtesting of our fair value estimates against subsequently received NAVs. Backtesting involves comparing our previously reported values for each individual fund against NAVs per audited financial statements (for year-end values) and final NAVs from fund managers and fund administrators (for interim values).\nThe fair value of our hedge funds, direct lending funds, private equity funds and real estate funds are measured using the NAV practical expedient and therefore have not been categorized with the fair value hierarchy.\n31\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\nFinancial Instruments Not Carried at Fair Value\nU.S. GAAP guidance over disclosures about the fair value of financial instruments are also applicable to financial instruments not carried at fair value, except for certain financial instruments, including insurance contracts.\nThe carrying values of cash equivalents (including restricted amounts), accrued investment income, receivable for investments sold, certain other assets, payable for investments purchased and certain other liabilities approximated their fair values at September 30, 2016, due to their respective short maturities. As these financial instruments are not actively traded, their respective fair values are classified within Level 2.\nThe carrying value of mortgage loans held-for-investment approximated their fair value at September 30, 2016, as the loans are within their first two years of issue. The estimated fair value of mortgage loans is primarily determined by estimating expected future cash flows and discounting them using current interest rates for similar mortgage loans with similar credit risk, or is determined from pricing for similar loans. As mortgage loans are not actively traded, their respective fair values are classified within Level 3.\nAt September 30, 2016, our senior notes are recorded at amortized cost with a carrying value of $993 million (2015: $992 million) and have a fair value of $1,083 million (2015: $1,058 million). The fair values of these securities were obtained from a third party pricing service and pricing was based on the spread above the risk-free yield curve. These spreads are generally obtained from the new issue market, secondary trading and broker-dealer quotes. As these spreads and the yields for the risk-free yield curve are observable market inputs, the fair values of our senior notes are classified within Level 2.\n| 5. | DERIVATIVE INSTRUMENTS |\n\nThe following table summarizes the balance sheet classification of derivatives recorded at fair values. The notional amount of derivative contracts represents the basis upon which pay or receive amounts are calculated and is presented in the table to quantify the volume of our derivative activities. Notional amounts are not reflective of credit risk.\nNone of our derivative instruments are designated as hedges under current accounting guidance.\n| September 30, 2016 | December 31, 2015 |\n| DerivativeNotionalAmount | DerivativeAssetFairValue(1) | DerivativeLiabilityFairValue(1) | DerivativeNotionalAmount | DerivativeAssetFairValue(1) | DerivativeLiabilityFairValue(1) |\n| Relating to investment portfolio: |\n| Foreign exchange forward contracts | $ | 40,367 | $ | 279 | $ | 17 | $ | 198,406 | $ | 490 | $ | 837 |\n| Interest rate swaps | — | — | — | — | — | — |\n| Relating to underwriting portfolio: |\n| Foreign exchange forward contracts | 560,477 | 25 | 4,394 | 692,023 | 1,582 | 6,855 |\n| Weather-related contracts | 59,436 | 2,488 | 8,184 | 51,395 | 4,395 | 10,937 |\n| Commodity contracts | 181,000 | 4,165 | — | — | — | — |\n| Total derivatives | $ | 6,957 | $ | 12,595 | $ | 6,467 | $ | 18,629 |\n\n| (1) | Asset and liability derivatives are classified within other assets and other liabilities in the Consolidated Balance Sheets. |\n\n32\n| 5. | DERIVATIVE INSTRUMENTS (CONTINUED) |\n\nOffsetting Assets and Liabilities\nOur derivative instruments are generally traded under International Swaps and Derivatives Association master netting agreements, which establish terms that apply to all transactions. In the event of a bankruptcy or other stipulated event, master netting agreements provide that individual positions be replaced with a new amount, usually referred to as the termination amount, determined by taking into account market prices and converting into a single currency. Effectively, this contractual close-out netting reduces credit exposure from gross to net exposure. The table below presents a reconciliation of our gross derivative assets and liabilities to the net amounts presented in our Consolidated Balance Sheets, with the difference being attributable to the impact of master netting agreements.\n| September 30, 2016 | December 31, 2015 |\n| Gross Amounts | Gross Amounts Offset | NetAmounts(1) | Gross Amounts | Gross Amounts Offset | NetAmounts(1) |\n| Derivative assets | $ | 9,370 | $ | (2,413 | ) | $ | 6,957 | $ | 14,336 | $ | (7,869 | ) | $ | 6,467 |\n| Derivative liabilities | $ | 15,008 | $ | (2,413 | ) | $ | 12,595 | $ | 26,498 | $ | (7,869 | ) | $ | 18,629 |\n\n| (1) | Net asset and liability derivatives are classified within other assets and other liabilities in the Consolidated Balance Sheets. |\n\nRefer to Note 3 - Investments for information on reverse repurchase agreements.\nDerivative Instruments not Designated as Hedging Instruments\na) Relating to Investment Portfolio\nForeign Currency Risk\nWithin our investment portfolio we are exposed to foreign currency risk. Accordingly, the fair values for our investment portfolio are partially influenced by the change in foreign exchange rates. We may enter into foreign exchange forward contracts to manage the effect of this foreign currency risk. These foreign currency hedging activities are not designated as specific hedges for financial reporting purposes.\nInterest Rate Risk\nOur investment portfolio contains a large percentage of fixed maturities which exposes us to significant interest rate risk. As part of our overall management of this risk, we may use interest rate swaps.\nb) Relating to Underwriting Portfolio\nForeign Currency Risk\nOur (re)insurance subsidiaries and branches operate in various foreign countries. Consequently, some of our business is written in currencies other than the U.S. dollar and, therefore, our underwriting portfolio is exposed to significant foreign currency risk. We manage foreign currency risk by seeking to match our foreign-denominated net liabilities under (re)insurance contracts with cash and investments that are denominated in such currencies. We may also use derivative instruments, specifically forward contracts and currency options, to economically hedge foreign currency exposures.\n33\n| 5. | DERIVATIVE INSTRUMENTS (CONTINUED) |\n\nWeather Risk\nWe write derivative-based risk management products designed to address weather risks with the objective of generating profits on a portfolio basis. The majority of this business consists of receiving a payment at contract inception in exchange for bearing the risk of variations in a quantifiable weather-related phenomenon, such as temperature. Where a client wishes to minimize the upfront payment, these transactions may be structured as swaps or collars. In general, our portfolio of such derivative contracts is of short duration, with contracts being predominantly seasonal in nature. In order to economically hedge a portion of this portfolio, we may also purchase weather derivatives.\nCommodity Risk\nWithin our (re)insurance portfolio we are exposed to commodity price risk. We may hedge a portion of this price risk by entering into commodity derivative contracts.\nThe total unrealized and realized gains (losses) recognized in earnings for derivatives not designated as hedges were as follows:\n| Location of Gain (Loss) Recognized in Income on Derivative | Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Derivatives not designated as hedging instruments |\n| Relating to investment portfolio: |\n| Foreign exchange forward contracts | Net realized investment gains (losses) | $ | 155 | $ | 6,412 | $ | 39 | $ | 11,234 |\n| Interest rate swaps | Net realized investment gains (losses) | — | — | — | (4,006 | ) |\n| Relating to underwriting portfolio: |\n| Foreign exchange forward contracts | Foreign exchange losses (gains) | (182 | ) | (5,210 | ) | (2,958 | ) | (21,494 | ) |\n| Weather-related contracts | Other insurance related income (losses) | 833 | 307 | 809 | 11,274 |\n| Commodity contracts | Other insurance related income (losses) | 1,799 | (33 | ) | 1,499 | (923 | ) |\n| Total | $ | 2,605 | $ | 1,476 | $ | (611 | ) | $ | (3,915 | ) |\n\n34\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)6. RESERVE FOR LOSSES AND LOSS EXPENSES\nThe following table presents a reconciliation of our beginning and ending gross reserve for losses and loss expenses and net reserve for unpaid losses and loss expenses for the periods indicated:\n| Nine months ended September 30, | 2016 | 2015 |\n| Gross reserve for losses and loss expenses, beginning of period | $ | 9,646,285 | $ | 9,596,797 |\n| Less reinsurance recoverable on unpaid losses, beginning of period | (2,031,309 | ) | (1,890,280 | ) |\n| Net reserve for unpaid losses and loss expenses, beginning of period | 7,614,976 | 7,706,517 |\n| Net incurred losses and loss expenses related to: |\n| Current year | 1,887,715 | 1,818,672 |\n| Prior years | (224,131 | ) | (165,804 | ) |\n| 1,663,584 | 1,652,868 |\n| Net paid losses and loss expenses related to: |\n| Current year | (233,124 | ) | (185,953 | ) |\n| Prior years | (1,334,772 | ) | (1,293,776 | ) |\n| (1,567,896 | ) | (1,479,729 | ) |\n| Foreign exchange and other | (112,649 | ) | (183,360 | ) |\n| Net reserve for unpaid losses and loss expenses, end of period | 7,598,015 | 7,696,296 |\n| Reinsurance recoverable on unpaid losses, end of period | 2,276,792 | 2,007,287 |\n| Gross reserve for losses and loss expenses, end of period | $ | 9,874,807 | $ | 9,703,583 |\n\nWe write business with loss experience generally characterized as low frequency and high severity in nature, which can result\nin volatility in our financial results. During the nine months ended September 30, 2016 and 2015, we recognized aggregate net losses and loss expenses, net of reinstatement premiums of $145 million and $90 million, respectively, in relation to catastrophe and weather-related events.\nDuring April 2016, the Company entered into a quota share and adverse development cover reinsurance agreement, a retroactive contract which was deemed to have met the established criteria for retroactive reinsurance accounting. Foreign exchange and other includes reinsurance recoverables of $159 million related to this reinsurance agreement.\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Insurance | $ | 20,688 | $ | 2,444 | $ | 43,181 | $ | 21,225 |\n| Reinsurance | 55,331 | 42,681 | 180,950 | 144,579 |\n| Total | $ | 76,019 | $ | 45,125 | $ | 224,131 | $ | 165,804 |\n\nThe majority of the net favorable prior year reserve development in each period related to short-tail reserve classes. Net favorable prior year reserve development for professional, reinsurance liability and motor reserve classes also contributed in the three and nine months ended September 30, 2016.\n35\n| 6. | RESERVE FOR LOSSES AND LOSS EXPENSES (CONTINUED) |\n\nOur short tail business includes the underlying exposures in the property and other, marine and aviation reserving classes within our insurance segment and the property and other reserving class within our reinsurance segment. Development from these classes contributed $41 million and $38 million of the total net favorable prior year reserve development for the three months ended September 30, 2016 and 2015, respectively. For the nine months ended September 30, 2016 and 2015, these short-tail lines contributed $116 million and $112 million, respectively, of net favorable prior year reserve development. The net favorable prior year reserve development for these classes primarily reflected the recognition of better than expected loss emergence.\nOur medium-tail business consists primarily of professional insurance and reinsurance reserve classes, credit and political risk insurance reserve class and the credit and surety reinsurance reserve class. In the three and nine months ended September 30, 2016, the professional reserve classes contributed net favorable prior year reserve development of $12 million and $28 million, respectively. In the nine months ended September 30, 2015, the reinsurance professional reserve class contributed $25 million of net favorable development. The net favorable prior year development on these reserve classes continued to reflect the generally favorable experience on earlier accident years as we continued to transition to more experience based methods on these years. As our loss experience has generally been better than expected, this resulted in the recognition of net favorable prior year reserve development. In the three and nine months ended September 30, 2015, the insurance professional reserve class recorded net adverse prior year reserve development of $15 million and $16 million, respectively. This adverse development was primarily the result of strengthening in our Australian book of business during the third quarter of 2015.\nIn the three and nine months ended September 30, 2015, the credit and surety reserve class recorded net favorable prior year reserve development of $7 million and $19 million, respectively. This net favorable prior year reserve development reflected the recognition of generally better than expected loss emergence.\nIn the nine months ended September 30, 2015, we recorded net adverse prior year reserve development of $15 million in our credit and political risk reserve class relating to an increase in our loss portfolio estimates.\nOur long-tail business consists primarily of liability and motor reserve classes. Our motor and liability reinsurance reserve classes contributed additional net favorable prior year reserve development of $17 million and $20 million in the three months ended September 30, 2016 and 2015, respectively. For the nine months ended September 30, 2016 and 2015, these long-tail reserve classes contributed $72 million and $64 million, respectively. The net favorable prior year reserve development for the motor reserve class related to favorable loss emergence trends on several classes of business spanning multiple accident years. The net favorable prior year reserve development for the liability reinsurance reserve class primarily reflected the progressively increased weight given by management to experience based indications on older accident years, which has generally been favorable. In the three and nine months ended September 30, 2015, we recorded net adverse prior year reserve development of $6 million and $23 million, respectively, in our insurance liability reserve class related primarily to an increase in loss estimates for specific individual claim reserves, as well as a higher frequency of large auto liability claims.\nOur September 30, 2016 net reserves for losses and loss expenses includes estimated amounts for numerous catastrophe events. We caution that the magnitude and/or complexity of losses arising from certain of these events, in particular the Fort McMurray wildfires, Storm Sandy, the 2011 Japanese earthquake and tsunami, the three New Zealand earthquakes and the Tianjin port explosion, inherently increases the level of uncertainty and, therefore, the level of management judgment involved in arriving at our estimated net reserves for losses and loss expenses. As a result, our actual losses for these events may ultimately differ materially from our current estimates.\n| 7. | SHARE-BASED COMPENSATION |\n\nFor the three months ended September 30, 2016, we incurred share-based compensation costs of $14 million (2015: $11 million) and recorded associated tax benefits of $3 million (2015: $3 million). For the nine months ended September 30, 2016, we incurred share-based compensation costs of $50 million (2015: $41 million) and recorded associated tax benefits of $11 million (2015: $11 million).\nThe total fair value of restricted stock, restricted stock units and cash settled awards vested during the nine months ended September 30, 2016 was $66 million (2015: $73 million). At September 30, 2016 there were $104 million of unrecognized compensation costs, which are expected to be recognized over the weighted average period of 2.4 years.\n36\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)7. SHARE-BASED COMPENSATION (CONTINUED)\nAwards to settle in shares\nThe following table provides a reconciliation of the beginning and ending balance of nonvested restricted stock (including restricted stock units) for the nine months ended September 30, 2016:\n| Performance-based Stock Awards | Service-based Stock Awards |\n| Number ofRestrictedStock | Weighted AverageGrant DateFair Value | Number ofRestrictedStock | Weighted AverageGrant DateFair Value(1) |\n| Nonvested restricted stock - beginning of period | 201 | $ | 49.24 | 1,954 | $ | 43.34 |\n| Granted | 104 | 53.80 | 586 | 53.81 |\n| Vested | (48 | ) | 45.38 | (779 | ) | 39.26 |\n| Forfeited | — | — | (94 | ) | 47.03 |\n| Nonvested restricted stock - end of period | 257 | $ | 52.04 | 1,667 | $ | 48.77 |\n\n(1) Fair value is based on the closing price of our common shares on the New York Stock Exchange on the day of the grant.\nCash-settled awards\nThe following table provides a reconciliation of the beginning and ending balance of nonvested cash settled restricted stock units for the nine months ended September 30, 2016:\n| Performance-based Cash Settled RSUs | Service-based Cash Settled RSUs |\n| Number ofRestrictedStock Units | Number ofRestrictedStock Units |\n| Nonvested restricted stock units - beginning of period | 70 | 1,433 |\n| Granted | 18 | 494 |\n| Vested | (32 | ) | (371 | ) |\n| Forfeited | — | (94 | ) |\n| Nonvested restricted stock units - end of period | 56 | 1,462 |\n\nAt September 30, 2016, the corresponding liability for cash-settled units, included in other liabilities on the Consolidated Balance Sheets, was $34 million (2015: $23 million).\n37\n| 8. | EARNINGS PER COMMON SHARE |\n\nThe following table sets forth the comparison of basic and diluted earnings per common share:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Basic earnings per common share |\n| Net income | $ | 186,613 | $ | 257,642 | $ | 364,460 | $ | 496,838 |\n| Less: preferred share dividends | 9,969 | 10,022 | 29,906 | 30,066 |\n| Net income available to common shareholders | 176,644 | 247,620 | 334,554 | 466,772 |\n| Weighted average common shares outstanding - basic(1) | 89,621 | 98,226 | 91,852 | 99,464 |\n| Basic earnings per common share | $ | 1.97 | $ | 2.52 | $ | 3.64 | $ | 4.69 |\n| Diluted earnings per common share |\n| Net income available to common shareholders | $ | 176,644 | $ | 247,620 | $ | 334,554 | $ | 466,772 |\n| Weighted average common shares outstanding - basic(1) | 89,621 | 98,226 | 91,852 | 99,464 |\n| Share based compensation plans | 730 | 898 | 727 | 1,004 |\n| Weighted average common shares outstanding - diluted(1) | 90,351 | 99,124 | 92,579 | 100,468 |\n| Diluted earnings per common share | $ | 1.96 | $ | 2.50 | $ | 3.61 | $ | 4.65 |\n| Anti-dilutive shares excluded from the dilutive computation | — | — | 226 | 219 |\n\n| (1) | On August 17, 2015, the Company entered into an Accelerated Share Repurchase (“ASR”) agreement (see 'Note 9 - Shareholders' Equity' for additional detail). The weighted-average number of shares outstanding used in the computation of basic and diluted earnings per share reflects the Company’s receipt of 4,149,378 common shares delivered to the Company on August 20, 2015, and 1,358,380 common shares delivered to the company on January 15, 2016 under the Company's ASR agreement. |\n\n38\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)9. SHAREHOLDERS' EQUITY\nThe following table presents our common shares issued and outstanding:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Shares issued, balance at beginning of period | 176,575 | 176,206 | 176,240 | 175,478 |\n| Shares issued | — | 16 | 335 | 744 |\n| Total shares issued at end of period | 176,575 | 176,222 | 176,575 | 176,222 |\n| Treasury shares, balance at beginning of period | (85,921 | ) | (75,922 | ) | (80,174 | ) | (76,052 | ) |\n| Shares repurchased | (2,252 | ) | (4,257 | ) | (8,499 | ) | (4,607 | ) |\n| Shares reissued from treasury | 37 | 6 | 537 | 486 |\n| Total treasury shares at end of period | (88,136 | ) | (80,173 | ) | (88,136 | ) | (80,173 | ) |\n| Total shares outstanding | 88,439 | 96,049 | 88,439 | 96,049 |\n\nTreasury Shares\nThe following table presents our share repurchases:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| In the open market: |\n| Total shares(1) | 2,232 | 4,248 | 8,236 | 4,264 |\n| Total cost | $ | 124,948 | $ | 245,658 | $ | 434,948 | $ | 246,490 |\n| Average price per share(2) | $ | 56.00 | $ | 57.83 | $ | 52.81 | $ | 57.80 |\n| From employees: |\n| Total shares | 20 | 9 | 263 | 343 |\n| Total cost | $ | 1,088 | $ | 489 | $ | 14,137 | $ | 17,586 |\n| Average price per share(2) | $ | 54.13 | $ | 55.59 | $ | 53.68 | $ | 51.28 |\n| Total shares repurchased: |\n| Total shares | 2,252 | 4,257 | 8,499 | 4,607 |\n| Total cost | $ | 126,036 | $ | 246,147 | $ | 449,085 | $ | 264,076 |\n| Average price per share(2) | $ | 55.98 | $ | 57.83 | $ | 52.84 | $ | 57.32 |\n\n(1) The nine months ended September 30, 2016 includes 1,358,380 common shares acquired under the accelerated share repurchase program (see below for more detail).\n(2) Calculated using whole figures.\n39\n| 9. | SHAREHOLDERS' EQUITY (CONTINUED) |\n\nAccelerated Share Repurchase Program\nOn August 17, 2015, the Company entered into an Accelerated Share Repurchase agreement with Goldman, Sachs & Co. (“Goldman Sachs”) to repurchase an aggregate of $300 million of the Company’s ordinary shares under an accelerated share repurchase program.\nDuring August, 2015, under the terms of this agreement, the Company paid $300 million to Goldman Sachs and initially repurchased 4,149,378 ordinary shares. The initial shares acquired represented 80% of the $300 million total paid to Goldman Sachs and were calculated using the Company’s stock price at activation of the program. The ASR program is accounted for as an equity transaction. Accordingly, as at December 31, 2015, $240 million of common shares repurchased were included as treasury shares in the Consolidated Balance Sheet with the remaining $60 million included as a reduction to additional paid-in capital.\nOn January 15, 2016, Goldman Sachs early terminated the ASR agreement and delivered 1,358,380 additional common shares to the Company, resulting in the reduction from additional paid-in capital of $60 million being reclassified to treasury shares. In total, the Company repurchased 5,507,758 common shares under the ASR agreement at an average price of $54.47.\nSeries B Preferred Shares\nOn January 27, 2016 we redeemed the remaining 28,430 Series B preferred shares, for an aggregate liquidation preference of $3 million.\n| 10. | COMMITMENTS AND CONTINGENCIES |\n\nReinsurance Agreements\nWe purchase reinsurance coverage for various lines of our business. The minimum reinsurance premiums are contractually due in advance on a quarterly basis. Accordingly at September 30, 2016, we have unrecorded outstanding reinsurance purchase commitments of $33 million, of which $3 million is due in 2016 while the remaining $30 million is due in 2017. Actual payments under the reinsurance contracts will depend on the underlying subject premium and may exceed the minimum premium.\nInvestments\nRefer 'Note 3 - Investments' for information on commitments related to our other investments.\n40\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)11. OTHER COMPREHENSIVE INCOME (LOSS)\n| 2016 | 2015 |\n| Before Tax Amount | Tax (Expense) Benefit | Net of Tax Amount | Before Tax Amount | Tax (Expense) Benefit | Net of Tax Amount |\n| Three months ended September 30, |\n| Available for sale investments: |\n| Unrealized investment gains (losses) arising during the period | $ | 40,125 | $ | (3,789 | ) | $ | 36,336 | $ | (102,810 | ) | $ | 3,099 | $ | (99,711 | ) |\n| Adjustment for reclassification of net realized investment gains (losses) and OTTI losses recognized in net income | (5,050 | ) | 2,408 | (2,642 | ) | 76,368 | (1,558 | ) | 74,810 |\n| Unrealized investment gains (losses) arising during the period, net of reclassification adjustment | 35,075 | (1,381 | ) | 33,694 | (26,442 | ) | 1,541 | (24,901 | ) |\n| Non-credit portion of OTTI losses | — | — | — | — | — | — |\n| Foreign currency translation adjustment | 1,722 | — | 1,722 | (14,626 | ) | — | (14,626 | ) |\n| Total other comprehensive income (loss), net of tax | $ | 36,797 | $ | (1,381 | ) | $ | 35,416 | $ | (41,068 | ) | $ | 1,541 | $ | (39,527 | ) |\n| Nine months ended September 30, |\n| Available for sale investments: |\n| Unrealized investment gains (losses) arising during the period | $ | 263,235 | $ | (24,579 | ) | $ | 238,656 | $ | (183,822 | ) | $ | 6,884 | $ | (176,938 | ) |\n| Adjustment for reclassification of net realized investment gains and OTTI losses recognized in net income | 40,338 | 2,282 | 42,620 | 130,858 | (2,088 | ) | 128,770 |\n| Unrealized investment gains (losses) arising during the period, net of reclassification adjustment | 303,573 | (22,297 | ) | 281,276 | (52,964 | ) | 4,796 | (48,168 | ) |\n| Non-credit portion of OTTI losses | — | — | — | — | — | — |\n| Foreign currency translation adjustment | 5,694 | — | 5,694 | (23,851 | ) | — | (23,851 | ) |\n| Total other comprehensive income (loss), net of tax | $ | 309,267 | $ | (22,297 | ) | $ | 286,970 | $ | (76,815 | ) | $ | 4,796 | $ | (72,019 | ) |\n\nReclassifications out of AOCI into net income available to common shareholders were as follows:\n| Amount Reclassified from AOCI(1) |\n| Details About AOCI Components | Consolidated Statement of Operations Line Item That Includes Reclassification | Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Unrealized investment gains (losses) on available for sale investments |\n| Other realized investment gains (losses) | $ | 9,297 | $ | (44,067 | ) | $ | (19,992 | ) | $ | (68,096 | ) |\n| OTTI losses | (4,247 | ) | (32,301 | ) | (20,346 | ) | (62,762 | ) |\n| Total before tax | 5,050 | (76,368 | ) | (40,338 | ) | (130,858 | ) |\n| Income tax (expense) benefit | (2,408 | ) | 1,558 | (2,282 | ) | 2,088 |\n| Net of tax | $ | 2,642 | $ | (74,810 | ) | $ | (42,620 | ) | $ | (128,770 | ) |\n\n| (1) | Amounts in parentheses are debits to net income available to common shareholders. |\n\n41\n| 12. | SUBSEQUENT EVENT |\n\nIn October 2016, the landfall of Hurricane Matthew impacted the Caribbean, southeastern United States and Canada, causing catastrophic loss of life, property damage and flooding.\nOur preliminary after-tax net loss estimate for this event is in the range of $45 million to $60 million. The Company's loss estimate is primarily based on a ground-up assessment of losses from individual contracts and treaties exposed to the affected regions, including preliminary information from clients, brokers and loss adjusters. Industry insured loss estimates, market share analyses and catastrophe modeling analyses were also taken into account where appropriate.\nDue to the nature of this event, including the complexity of loss assessment, factors contributing to the losses and the preliminary nature of the information available to prepare these estimates, the actual net ultimate amount of losses for this event may be materially different from this current estimate.\nITEM 2.\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nThe following is a discussion and analysis of our financial condition and results of operations. This should be read in conjunction with the consolidated financial statements and related notes included in Item 1 of this report and also our Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended December 31, 2015. Tabular dollars are in thousands, except per share amounts. Amounts in tables may not reconcile due to rounding differences.\n\n| Page |\n| Third Quarter 2016 Financial Highlights | 43 |\n| Executive Summary | 44 |\n| Underwriting Results – Group | 49 |\n| Results by Segment: For the three and nine months ended September 30, 2016 and 2015 | 57 |\n| i) Insurance Segment | 57 |\n| ii) Reinsurance Segment | 61 |\n| Other Expenses (Revenues), Net | 64 |\n| Net Investment Income and Net Realized Investment Gains (Losses) | 65 |\n| Cash and Investments | 67 |\n| Liquidity and Capital Resources | 70 |\n| Critical Accounting Estimates | 72 |\n| New Accounting Standards | 72 |\n| Off-Balance Sheet and Special Purpose Entity Arrangements | 72 |\n| Non-GAAP Financial Measures | 72 |\n\n42\nTHIRD QUARTER 2016 FINANCIAL HIGHLIGHTS\nThird Quarter 2016 Consolidated Results of Operations\n\n| • | Net income available to common shareholders of $177 million, or $1.97 per common share and $1.96 per diluted common share |\n\n| • | Operating income of $161 million, or $1.78 per diluted common share(1) |\n\n| • | Gross premiums written of $1.0 billion |\n\n| • | Net premiums written of $595 million, impacted by a large new retrocessional cover entered into with Harrington Re Ltd. |\n\n| • | Net premiums earned of $934 million |\n\n| • | Net favorable prior year reserve development of $76 million |\n\n| • | Estimated catastrophe and weather-related pre-tax net losses, net of reinstatement premiums, of $22 million compared to $43 million during the third quarter of 2015 |\n\n| • | Underwriting income of $104 million and combined ratio of 92.6% |\n\n| • | Net investment income of $117 million |\n\n| • | Net realized investment gains of $5 million |\n\n| • | Foreign exchange gains of $14 million |\n\nThird Quarter 2016 Consolidated Financial Condition\n| • | Total cash and investments of $14.6 billion; fixed maturities, cash and short-term securities comprise 87% of total cash and investments and have an average credit rating of AA- |\n\n| • | Total assets of $21.2 billion |\n\n| • | Reserve for losses and loss expenses of $9.9 billion and reinsurance recoverable of $2.3 billion |\n\n| • | Total debt of $1.0 billion and the debt to total capital ratio of 14.1% |\n\n| • | Repurchased 2.3 million common shares. At October 27, 2016 the remaining authorization under the repurchase program approved by our Board of Directors was $375 million |\n\n| • | Common shareholders’ equity of $5.4 billion and diluted book value per common share of $59.77 |\n\n| (1) | Operating income is a non-GAAP financial measure as defined in SEC Regulation G. Refer to ‘Non-GAAP Financial Measures’ for reconciliation to nearest GAAP financial measure (net income available to common shareholders). |\n\n43\nEXECUTIVE SUMMARY\nBusiness Overview\nWe are a Bermuda-based global provider of specialty lines insurance and treaty reinsurance products with operations in Bermuda, the United States, Europe, Singapore, Canada, Latin America and the Middle East. Our underwriting operations are organized around our two global underwriting platforms, AXIS Insurance and AXIS Re.\nOur mission is to provide our clients and distribution partners with a broad range of risk transfer products and services and meaningful capacity, backed by significant financial strength. We manage our portfolio holistically, aiming to construct the optimum consolidated portfolio of funded and unfunded risks, consistent with our risk appetite and development of our franchise. We nurture an ethical, entrepreneurial and disciplined culture that promotes outstanding client service, intelligent risk taking and the achievement of superior risk-adjusted returns for our shareholders. We believe that the achievement of our objectives will position us as a global leader in specialty risks. Our execution on this strategy in the first nine months of 2016 included:\n| • | continued growth of our accident and health lines, which is focused on specialty accident and health products; |\n\n| • | growth of our Weather and Commodity Markets business unit which offers parametric risk management solutions to clients |\n\nwhose profit margins are exposed to adverse weather and commodity price risks;\n| • | growth of our syndicate at Lloyd's which provides us with access to Lloyd's worldwide licenses and an extensive distribution network. During the first quarter of 2016 we commenced writing business through our underwriting division at Lloyd's in China; |\n\n| • | continued rebalancing of our portfolio towards less-volatile lines of business that carry attractive rates; and |\n\n| • | continued expansion of our broad range of third-party capital capabilities through: |\n\n| • | Our investment in Harrington Reinsurance Holdings Limited (\"Harrington\"), the parent company of Harrington Re Ltd. (\"Harrington Re\"), an independent reinsurance company jointly sponsored by AXIS Capital and The Blackstone Group L.P. (\"Blackstone\"). Harrington Re’s strategy is to combine a multi-line reinsurance portfolio with a diversified allocation to alternative investment strategies to earn attractive risk-adjusted returns. Harrington plans to develop a portfolio that optimizes the risk-reward characteristics of both assets and liabilities, leveraging the respective strengths of AXIS Capital and Blackstone while deploying a disciplined and fully integrated approach to both underwriting and investing; |\n\n| • | AXIS Ventures Reinsurance Limited, which manages capital for investors interested in deploying funds directly into the property-catastrophe and other short-tail business; and |\n\n| • | increased use of available reinsurance and retrocessional protection to optimize the risk-adjusted returns on our portfolio. |\n\n44\nResults of Operations\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Underwriting income: |\n| Insurance | $ | 25,161 | 265% | $ | 6,888 | $ | 31,187 | 93% | $ | 16,153 |\n| Reinsurance | 78,837 | 60% | 49,357 | 181,623 | (8%) | 197,729 |\n| Net investment income | 116,923 | 156% | 45,685 | 257,818 | 14% | 226,336 |\n| Net realized investment gains (losses) | 5,205 | nm | (69,957 | ) | (40,295 | ) | (67%) | (123,618 | ) |\n| Other expenses, net | (37,079 | ) | nm | (8,464 | ) | (63,439 | ) | 18% | (53,895 | ) |\n| Termination fee received | — | nm | 280,000 | — | nm | 280,000 |\n| Reorganization and related fees | — | nm | (45,867 | ) | — | nm | (45,867 | ) |\n| Interest in loss of equity method investments | (2,434 | ) | nm | — | (2,434 | ) | nm | — |\n| Net income | 186,613 | (28%) | 257,642 | 364,460 | (27%) | 496,838 |\n| Preferred share dividends | (9,969 | ) | (1%) | (10,022 | ) | (29,906 | ) | (1%) | (30,066 | ) |\n| Net income available to common shareholders | $ | 176,644 | (29%) | $ | 247,620 | $ | 334,554 | (28%) | $ | 466,772 |\n| Operating income | $ | 160,689 | 215% | $ | 51,031 | $ | 309,450 | 10% | $ | 280,682 |\n\nnm – not meaningful\nUnderwriting Results\nTotal underwriting income in the three months ended September 30, 2016 was $104 million, an increase of $48 million compared to $56 million in the three months ended September 30, 2015. The increase in underwriting income was primarily driven by an increase in net favorable prior year development, decreased catastrophe and weather-related losses, lower general and administrative expenses and an increase in other insurance related income, partially offset by an increase in the current accident year loss ratio excluding catastrophe and weather-related losses.\nThe reinsurance segment underwriting income increased by $29 million in the three months ended September 30, 2016, compared to the three months ended September 30, 2015. The increase in underwriting income was primarily driven by decreased catastrophe and weather-related losses, an increase in net favorable prior year development, lower general and administrative expenses and an increase in other insurance related income, partially offset by an increase in the acquisition cost ratio.\nThe insurance segment underwriting income increased by $18 million in the three months ended September 30, 2016, compared to the three months ended September 30, 2015. The increase in underwriting income was primarily due to an increase in net favorable prior year development and a decrease in the acquisition cost ratio, partially offset by an increase in the current accident year loss ratio excluding catastrophe and weather-related losses.\nTotal underwriting income in the nine months ended September 30, 2016 was $213 million, a decrease of $1 million compared to $214 million in the nine months ended September 30, 2015. The decrease in underwriting income was primarily driven by increased catastrophe and weather-related losses, an increase in the acquisition cost ratio and a decrease in other insurance income, partially offset by an increase in net favorable prior year development and lower general and administrative expenses.\nThe reinsurance segment underwriting income decreased by $16 million in the nine months ended September 30, 2016, compared to the nine months ended September 30, 2015. The decrease in underwriting income was primarily driven by an increase in the acquisition cost ratio, increased catastrophe and weather-related losses and a decrease in other insurance related income, partially offset by an increase in net favorable prior year development and lower general and administrative expenses.\nThe insurance segment underwriting income increased by $15 million in the nine months ended September 30, 2016, compared to the nine months ended September 30, 2015. The increase in underwriting income was primarily due to an increase in net favorable prior year development, a decrease in the acquisition cost ratio and lower general and administrative expenses, partially offset by increased catastrophe and weather-related losses.\n45\nNet Investment Income\nNet investment income in the three months ended September 30, 2016 was $117 million, an increase of $71 million compared to $46 million in the three months ended September 30, 2015. The increase was primarily driven by our other investments. These investments generated a gain of $38 million in the three months ended September 30, 2016, compared to a loss of $27 million in three months ended September 30, 2015. Net investment income for the nine months ended September 30, 2016 was $258 million, an increase of $31 million compared to the same period in 2015. The increase was mainly attributable to income from fixed maturities and other investments. Income from fixed maturities increased as a result of an emphasis on longer duration assets and income from other investments increased as a result of improved valuations on our CLO - Equity holdings.\nNet Realized Investment Gains (Losses)\nRealized gains were $5 million in the three months ended September 30, 2016 compared to realized losses of $70 million for the same period of 2015. The gains were mainly attributable to corporates, agency MBS, CMBS and ETFs which benefited from improvements in pricing in 2016. The realized losses in the three months ended September 30, 2015 were attributable to foreign currency losses on non-U.S. denominated securities as a result of the strengthening of the U.S. dollar and other-than-temporary impairment (\"OTTI\") charges. Realized losses were $40 million in the nine months ended September 30, 2016, compared to realized losses of $124 million for the same period of 2015. The losses for the three and nine months ended September 30, 2016 and 2015 were primarily attributable to foreign currency losses on non-U.S. denominated securities as a result of the strengthening of the U.S. dollar and OTTI charges.\nOther Revenues (Expenses), Net\nCorporate expenses increased to $29 million for the three months ended September 30, 2016, from $24 million for the three months ended September 30, 2015. The increase is primarily attributable to the net reimbursement of PartnerRe Ltd. (\"PartnerRe\") merger-related expenses benefiting 2015 and senior executive transition costs in 2016, partially offset by reorganization related expenses adverse to 2015. For the nine months ended September 30, 2016, corporate expenses increased to $87 million compared to $84 million in the same period in 2015. The slight increase is attributable to adjustments to senior leadership executive stock-compensation awards benefiting 2015, senior executive transition costs in 2016, and an increase in personnel costs in 2016, partially offset by expenses attributable to the proposed merger with PartnerRe and reorganization related expenses adverse to 2015.\nThe foreign exchange gains for the three and nine months ended September 30, 2016 of $14 million and $70 million, respectively, were primarily driven by the depreciation of the pound sterling against the U.S dollar. The foreign exchange gains of $28 million for the three months ended September 30, 2015 were primarily driven by depreciation of the pound sterling and the Australian dollar against the U.S. dollar, while the foreign exchange gains for the nine months ended September 30, 2015 of $69 million were primarily driven by the depreciation of the euro, pound sterling and Australian dollar.\nThe financial results for the three months ended September 30, 2016 resulted in a tax expense of $9 million, compared to an expense of nil for the three months ended September 30, 2015. Operations in the nine months ended September 30, 2016 resulted in a tax expense of $8 million compared to a tax expense of $1 million in the nine months ended September 30, 2015. The effective tax rate, which drives the tax expense, can vary between periods depending on the distribution of net income amongst tax jurisdictions, as well as other factors. The primary driver of the increase in both periods is the generation of consolidated pre-tax net income in our operations in Europe compared to net losses in 2015.\nTermination Fee Received\nDuring the third quarter of 2015, the Company announced that we had accepted a request from PartnerRe to terminate the Agreement and Plan of Amalgamation (the \"Amalgamation Agreement\") with the Company. PartnerRe paid the Company $315 million to immediately terminate the Amalgamation Agreement, the amount was comprised of a termination fee of $280 million and a reimbursement of merger related expenses of $35 million.\n46\nReorganization and Related Expenses\nDuring the third quarter of 2015, the Company implemented a number of profitability enhancement initiatives which resulted in a recognition of reorganization and related expenses of $46 million and additional corporate expenses of $5 million in the Consolidated Statement of Operations in the three months ended September 30, 2015.\nInterest in Loss of Equity Method Investments\nInterest in losses of equity method investments represents the Company’s aggregate share of losses related to investments in which the Company has significant influence over the operating and financial policies of the investee.\nOutlook\nManagement expects to achieve an increase in gross premiums written in 2016, with variances between our lines of business within the operating segments driven by market conditions and available opportunities, as we maintain our focus on diversification and pursuit of those opportunities that will expand our reach in areas where we believe the returns to be most attractive. We also expect the increase in gross premiums written to be substantially offset by greater cessions of risk to reinsurers and third party capital partners.\nCompetitive conditions continue to impact worldwide insurance markets with greatest pressures impacting catastrophe exposed property and certain global specialty lines of business. We also observed greater competitiveness for large accounts compared to smaller risks. These competitive pressures have led to price reductions across most lines of business, with decreases in international markets generally more severe than those observed in the United States. We expect this trend to continue in the short-term but believe that there are still attractive risks in the market. In this challenging market environment, we are focusing on lines and markets that remain adequately priced or continue to deliver price increases and those that provide opportunities for profitable growth. Where necessary we also continue to shift our business mix toward smaller, less volatile risk accounts which we believe will enable us to achieve a better, more stable attritional loss experience with lower severity.\nThe reinsurance markets' trading environment remains challenging in the majority of lines of business and geographical regions. The market continues to be influenced by excess capacity, strong balance sheets of established market participants and a consolidation of reinsurance purchasing. Despite these conditions we observed recent favorable trends which we expect to impact our business including many cedants reducing the size of their reinsurer panels, some moderation of pricing pressures, increased resistance to demands for greater commission rates as well as more generous terms and conditions, an increase in the number of cedants looking to buy more reinsurance protection and Solvency II-driven opportunities. These factors, combined with AXIS customer-centric approach and opportunities in specific lines of business and geographies allow us to execute on our targeted growth strategy. We continue to address the difficult market conditions by taking actions to protect the quality and profitability of our existing book, targeting larger shares of the more attractive treaties, managing the overall volatility of our reinsurance book, and expanding our already strong group of third party capital partners with whom to share our risks and earn fee income.\n47\nFinancial Measures\nWe believe the following financial indicators are important in evaluating our performance and measuring the overall growth in value generated for our common shareholders:\n| Three months ended and at September 30, | Nine months ended and at September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| ROACE (annualized)(1) | 13.2 | % | 18.8 | % | 8.4 | % | 12.0 | % |\n| Operating ROACE (annualized)(2) | 12.0 | % | 3.9 | % | 7.8 | % | 7.2 | % |\n| DBV per common share(3) | $ | 59.77 | $ | 53.68 | $ | 59.77 | $ | 53.68 |\n| Cash dividends declared per common share | 0.35 | 0.29 | 1.05 | 0.87 |\n| Increase in diluted book value per common share adjusted for dividends | $ | 2.50 | $ | 2.16 | $ | 6.74 | $ | 4.67 |\n\n| (1) | Return on average common equity (“ROACE”) is calculated by dividing annualized net income available to common shareholders for the period by the average shareholders’ equity determined by using the common shareholders’ equity balances at the beginning and end of the period. |\n\n| (2) | Operating ROACE is calculated by dividing annualized operating income for the period by the average common shareholders’ equity determined by using the common shareholders’ equity balances at the beginning and end of the period. Annualized operating ROACE is a non-GAAP financial measure as defined in SEC Regulation G. Refer to‘Non-GAAP Financial Measures’ for additional information and reconciliation to the nearest GAAP financial measure (ROACE). |\n\n| (3) | Diluted book value (“DBV”) per common share represents total common shareholders’ equity divided by the number of common shares and diluted common share equivalents outstanding, determined using the treasury stock method. Cash settled awards are excluded from the denominator. |\n\nReturn on Equity\nThe decrease in ROACE in the three months ended September 30, 2016, compared to the three months ended September 30, 2015, was primarily driven by the termination fee received from PartnerRe in the third quarter of 2015, partially offset by net realized gains in the current quarter compared to net realized losses in the same period in 2015, an increase in net investment income and underwriting income in the current quarter compared to the same period in 2015 and reorganization and related expenses incurred in the third quarter of 2015.\nThe increase in operating ROACE for the three months ended September 30, 2016, compared to the three months ended September 30, 2015 was primarily driven by an increase in net investment income and underwriting income in the three months ended September 30, 2016 compared to the same period in 2015.\nThe decrease in ROACE in the nine months ended September 30, 2016, compared to the nine months ended September 30, 2015, was primarily driven by the termination fee received from PartnerRe in the third quarter of 2015, partially offset by a decrease in net realized losses and an increase in net investment income in the nine months ended September 30, 2016 compared to the same period in 2015 and reorganization and related expenses incurred in the third quarter of 2015.\nThe increase in operating ROACE in the nine months ended September 30, 2016, compared to the nine months ended September 30, 2015, was primarily driven by an increase in net investment income in the nine months ended September 30, 2016 compared to the same period in 2015.\nDiluted Book Value per Common Share\nOur diluted book value per common share increase of 11% from $53.68 at September 30, 2015, to $59.77 at September 30, 2016, primarily reflected the generation of $469 million in net income available to common shareholders over the past twelve months and the increase over the last twelve months in unrealized gains on investments which are included in accumulated other comprehensive income, which was partially offset by common share dividends declared.\n48\nDiluted Book Value per Common Share Adjusted for Dividends\nOur diluted book value per common share adjusted for dividends increased by $2.50, or 4%, per common share for the three month period ended September 30, 2016 and $7.49, or 14%, per common share over the past twelve months.\nTaken together, we believe that growth in diluted book value per common share and common share dividends declared represent the total value created for our common shareholders. As companies in the insurance industry have differing dividend payout policies, we believe investors use the diluted book value per common share adjusted for dividends metric to measure comparable performance across the industry.\nDuring the three and nine months ended September 30, 2016, total value created consisted primarily of our net income and an increase in unrealized gains on investments, reported in accumulated other comprehensive income.\nDuring the three and nine months ended September 30, 2015, total value created consisted primarily of our net income, partially offset by an increase in unrealized losses on investments and foreign exchange translation adjustment losses included in accumulated other comprehensive income.\nUNDERWRITING RESULTS – GROUP\nThe following table provides our group underwriting results for the periods indicated. Underwriting income is a pre-tax measure of underwriting profitability that takes into account net premiums earned and other insurance related income as revenues and net losses and loss expenses, acquisition costs and underwriting-related general and administrative costs as expenses.\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Revenues: |\n| Gross premiums written | $ | 959,962 | 2% | $ | 936,583 | $ | 4,239,558 | 11% | $ | 3,803,928 |\n| Net premiums written | 595,431 | (12%) | 677,217 | 3,288,587 | 7% | 3,079,307 |\n| Net premiums earned | 934,415 | 2% | 919,341 | 2,783,746 | 1% | 2,764,605 |\n| Other insurance related income | 5,944 | 413% | 1,158 | 4,850 | (61%) | 12,319 |\n| Expenses: |\n| Current year net losses and loss expenses | (608,347 | ) | (605,512 | ) | (1,887,715 | ) | (1,818,672 | ) |\n| Prior year reserve development | 76,019 | 45,125 | 224,131 | 165,804 |\n| Acquisition costs | (189,810 | ) | (182,744 | ) | (559,570 | ) | (537,549 | ) |\n| Underwriting-related general and administrative |\n| expenses(1) | (114,223 | ) | (121,123 | ) | (352,632 | ) | (372,625 | ) |\n| Underwriting income(2) | $ | 103,998 | 85% | $ | 56,245 | $ | 212,810 | (1%) | $ | 213,882 |\n| General and administrative expenses(1) | $ | 142,906 | $ | 144,727 | $ | 439,554 | $ | 456,451 |\n| Income before income taxes and interest in income (loss) of equity method investments(2) | $ | 198,399 | $ | 257,672 | $ | 374,606 | $ | 497,993 |\n\n| (1) | Underwriting-related general and administrative expenses is a non-GAAP measure as defined in SEC Regulation G. Our total general and administrative expenses also included corporate expenses of $28,683 and $23,604 for the three months ended September 30, 2016 and 2015, respectively, and $86,922 and $83,826 for the nine months ended September 30, 2016 and 2015, respectively. Refer to 'Other Expenses (Revenues), Net' for additional information related to these corporate expenses. Also, refer to 'Non-GAAP Financial Measures' for further information. |\n\n| (2) | Underwriting income is a non-GAAP financial measure as defined in SEC Regulation G. Refer to Item 1, Note 2 to the Consolidated Financial Statements for a reconciliation of underwriting income to the nearest GAAP financial measure (income before income taxes and interest in income (loss) of equity method investments) for the periods indicated above. Also, refer to 'Non-GAAP Financial Measures' for additional information related to the presentation of underwriting income. |\n\n49\nUNDERWRITING REVENUES\nPremiums Written:\n| Gross Premiums Written |\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Insurance | $ | 675,430 | 11% | $ | 606,704 | $ | 2,112,796 | 7% | $ | 1,970,554 |\n| Reinsurance | 284,532 | (14%) | 329,879 | 2,126,762 | 16% | 1,833,374 |\n| Total | $ | 959,962 | 2% | $ | 936,583 | $ | 4,239,558 | 11% | $ | 3,803,928 |\n| % ceded |\n| Insurance | 36% | (1) pts | 37% | 32% | 1 pts | 31% |\n| Reinsurance | 43% | 33 pts | 10% | 13% | 7 pts | 6% |\n| Total | 38% | 10 pts | 28% | 22% | 3 pts | 19% |\n| Net Premiums Written |\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Insurance | $ | 433,131 | 14% | $ | 381,118 | $ | 1,433,058 | 6% | $ | 1,352,122 |\n| Reinsurance | 162,300 | (45%) | 296,099 | 1,855,529 | 7% | 1,727,185 |\n| Total | $ | 595,431 | (12%) | $ | 677,217 | $ | 3,288,587 | 7% | $ | 3,079,307 |\n\nGross premiums written in the three and nine months ended September 30, 2016, increased by $23 million or 2% (3% on a constant currency basis(1)) and $436 million or 11% (13% on a constant currency basis) compared to the three and nine months ended September 30, 2015, respectively. The increase for the three months ended September 30, 2016 compared to the same period in 2015 was due to an increase in the insurance segment, partially offset by a decrease in the reinsurance segment. The increase for the nine months ended September 30, 2016 compared to the same period in 2015 was due to increases in both our reinsurance and insurance segments.\nOur reinsurance segment's gross premiums written decreased by $45 million or 14% (13% on a constant currency basis) and increased by $293 million, or 16% (19% on a constant currency basis) in the three and nine months ended September 30, 2016, compared to the same periods in 2015, respectively. The decrease in the reinsurance segment gross written premiums in the three months ended September 30, 2016, compared to the same period of 2015 was primarily driven by timing differences impacting our professional and liability lines. The increase in the reinsurance segment gross written premiums in the nine months ended September 30, 2016, compared to the same period of 2015 was impacted by an increase in the level of premiums written on a multi-year basis. This increase in multi-year contracts increased the amount of premium recorded in the current period relating to future years compared to the same period in 2015. The increase in the nine months ended September 30, 2016 compared to the same period in 2015 was partially offset by foreign exchange movements as the strength of the U.S. dollar drove comparative premium decreases in treaties denominated in foreign currencies. After adjusting for the impact of the multi-year contracts and foreign exchange movements, our reinsurance segment gross premiums written increased by $204 million in the nine months ended September 30, 2016, compared to the same period in 2015. The growth was driven by new business in our liability, marine and other, catastrophe, professional as well as our credit and surety lines, with favorable treaty restructurings and timing differences also contributing to increased premium written in our liability and professional lines. These increases were partially offset by a decrease in our property lines primarily driven by non-renewals and decreases in the line sizes on several treaties.\n| (1) | Amounts presented on a constant currency basis are “non-GAAP financial measures” as defined in Regulation G. The constant currency basis is calculated by applying the average foreign exchange rate from the current year to the prior year balance. |\n\n50\nOur insurance segment's gross written premiums increased by $69 million or 11% (12% on a constant currency basis) and $142 million or 7% (8% on a constant currency basis) in the three and nine months ended September 30, 2016, compared to the same periods of 2015. Increased premiums written were reported in both periods in our accident and health and property lines primarily related to new business. The increase in the nine months ended September 30, 2016, compared to the same period in 2015 was partially offset by decreased premiums written in our marine lines and the impact of our exit from retail insurance operations in Australia.\nIn the three and nine months ended September 30, 2016, the ceded ratio increased by 10% and 3%, compared to the three and nine months ended September 30, 2015, respectively, with the increases primarily attributable to the reinsurance segment. The reinsurance segment ceded ratio increased in the three and nine months ended September 30, 2016 compared to the same periods in 2015, largely due to a new retrocessional cover entered into with Harrington Re.\nNet Premiums Earned:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | %Change | 2016 | 2015 | %Change |\n| Insurance | $ | 444,691 | 48 | % | $ | 444,550 | 48 | % | —% | $ | 1,322,649 | 48 | % | $ | 1,344,339 | 49 | % | (2%) |\n| Reinsurance | 489,724 | 52 | % | 474,791 | 52 | % | 3% | 1,461,097 | 52 | % | 1,420,266 | 51 | % | 3% |\n| Total | $ | 934,415 | 100 | % | $ | 919,341 | 100 | % | 2% | $ | 2,783,746 | 100 | % | $ | 2,764,605 | 100 | % | 1% |\n\nChanges in net premiums earned reflect period to period changes in net premiums written and business mix, together with normal variability in premium earning patterns.\nNet premiums earned increased by 2% (4% on a constant currency basis) and 1% (4% on a constant currency basis) in the three and nine months ended September 30, 2016, compared to the same periods in 2015, respectively. The increases were driven by the reinsurance segment in both periods, with a reduction in the insurance segment for the nine months ended September 30, 2016 compared to the same period in 2015, partially offsetting the increase in the reinsurance segment.\nThe increase in the reinsurance segment for both periods was primarily driven by strong premium growth in our liability, marine and other as well as our catastrophe lines in recent periods together with favorable premium adjustments impacting our credit and surety lines. The growth for both periods was partially offset by increased premiums ceded in our catastrophe and property lines, as well as the impact on our liability and professional lines of the new retrocession to Harrington Re.\nThe decrease in the insurance segment for the nine months ended September 30, 2016, compared to the same period in 2015, was primarily driven by an increase in our professional lines' ceded reinsurance programs, decreased business written in our marine lines and the impact of our exit from retail insurance operations in Australia, partially offset by growth in premiums written in recent periods in our accident and health lines.\nOther Insurance Related Income (Loss):\nThe increase in other insurance related income of $5 million in the three months ended September 30, 2016, compared to the same period in 2015, reflected fees from strategic capital partners and favorable fair value adjustments to economic hedges purchased to protect our agriculture line of business against fluctuations in commodity prices. The decrease in other insurance related income of $7 million in the nine months ended September 30, 2016, compared to the same period in 2015, reflected the impact of the realized gains on our weather and commodities derivative portfolio in the nine months ended September 30, 2015 compared to an immaterial impact in the nine months ended September 30, 2016, partially offset by third party capital fees and favorable fair value adjustments to economic hedges purchased to protect our agriculture line of business against fluctuations in commodity prices.\n51\nUNDERWRITING EXPENSES\nThe following table provides a breakdown of our combined ratio:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % PointChange | 2015 | 2016 | % PointChange | 2015 |\n| Current accident year loss ratio | 65.1 | % | (0.8) | 65.9 | % | 67.8 | % | 2.0 | 65.8 | % |\n| Prior year reserve development | (8.1 | %) | (3.2) | (4.9 | %) | (8.0 | %) | (2.0) | (6.0 | %) |\n| Acquisition cost ratio | 20.3 | % | 0.4 | 19.9 | % | 20.1 | % | 0.7 | 19.4 | % |\n| General and administrative expense ratio(1) | 15.3 | % | (0.4) | 15.7 | % | 15.8 | % | (0.7) | 16.5 | % |\n| Combined ratio | 92.6 | % | (4.0) | 96.6 | % | 95.7 | % | — | 95.7 | % |\n\n| (1) | The general and administrative expense ratio includes corporate expenses not allocated to reportable segments of 3.1% and 2.6% for the three months ended September 30, 2016 and 2015, respectively, and 3.1% and 3.0% for the nine months ended September 30, 2016 and 2015, respectively. These costs are further discussed in the ‘Other Expenses (Revenues), Net’ section. |\n\nCurrent Accident Year Loss Ratio:\nThe current accident year loss ratio decreased to 65.1% in the three months ended September 30, 2016 from 65.9% in the same period in 2015, while the current accident year loss ratio increased to 67.8% in the nine months ended September 30, 2016 from 65.8% in the same period in 2015.\nThe decrease for the three months ended September 30, 2016 compared to the same period in 2015 was impacted by a lower level of catastrophe and weather-related losses and the increase for the nine months ended September 30, 2016 compared to the same period in 2015 was impacted by an increased level of catastrophe and weather-related losses. During the three and nine months ended September 30, 2016, we incurred $22 million, or 2.3 points, and $145 million, or 5.3 points, respectively, in pre-tax catastrophe and weather-related losses, net of reinstatement premiums, attributable to the weather-related events, Fort McMurray wildfires, the Japanese and Ecuadorian earthquakes, North Calgary hailstorm and European floods. Comparatively, during the three and nine months ended September 30, 2015 we incurred $43 million, or 4.7 points, and $90 million, or 3.3 points, respectively.\nAfter adjusting for the impact of the catastrophe and weather-related losses, our current accident year loss ratios in the three and nine months ended September 30, 2016, were 62.8% and 62.5%, respectively, compared to 61.2% and 62.5% in the three and nine months ended September 30, 2015, respectively. The increase in the current accident year loss ratios after adjusting for the impact of the catastrophe and weather-related losses for the three months ended September 30, 2016, compared to the same period in 2015, was mainly due to business mix changes as well as the ongoing adverse impact of rate and trend, partially offset by a decrease in the mid-size loss experience in our insurance marine and property lines. The current accident year loss ratio after adjusting for the impact of the catastrophe and weather-related losses for the nine months ended September 30, 2016 was comparable to the same periods in 2015. The adverse impact of rate and trend together with business mix changes were offset by a decrease in the mid-size loss experience in our insurance marine and property lines.\nPrior Year Reserve Development:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Insurance | $ | 20,688 | $ | 2,444 | $ | 43,181 | $ | 21,225 |\n| Reinsurance | 55,331 | 42,681 | 180,950 | 144,579 |\n| Total | $ | 76,019 | $ | 45,125 | $ | 224,131 | $ | 165,804 |\n\n52\nOverview\nThe majority of the net favorable prior year reserve development in each period related to short-tail reserve classes. Net favorable prior year reserve development for professional, reinsurance liability and motor reserve classes also contributed in the three and nine months ended September 30, 2016.\nOur short tail business includes the underlying exposures in the property and other, marine and aviation reserving classes within our insurance segment and the property and other reserving class within our reinsurance segment . Development from these classes contributed $41 million and $38 million of the total net favorable prior year reserve development for the three months ended September 30, 2016 and 2015, respectively. For the nine months ended September 30, 2016 and 2015, these short-tail lines contributed $116 million and $112 million, respectively, of net favorable prior year reserve development. The net favorable prior year reserve development for these classes primarily reflected the recognition of better than expected loss emergence.\nOur medium-tail business consists primarily of professional insurance and reinsurance reserve classes, credit and political risk insurance reserve class and the credit and surety reinsurance reserve class. In the three and nine months ended September 30, 2016, the professional reserve classes contributed net favorable prior year reserve development of $12 million and $28 million, respectively. In the nine months ended September 30, 2015, the reinsurance professional reserve class contributed $25 million of net favorable development. The net favorable prior year development on these reserve classes continued to reflect the generally favorable experience on earlier accident years as we continued to transition to more experience based methods on these years. As our loss experience has generally been better than expected, this resulted in the recognition of net favorable prior year reserve development. In the three and nine months ended September 30, 2015, the insurance professional reserve class recorded net adverse prior year reserve development of $15 million and $16 million, respectively. This adverse development was primarily the result of strengthening in our Australian book of business during the third quarter of 2015.\nIn the three and nine months ended September 30, 2015, the credit and surety reserve class recorded net favorable prior year reserve development of $7 million and $19 million, respectively. This net favorable prior year reserve development reflected the recognition of generally better than expected loss emergence.\nIn the nine months ended September 30, 2015, we recorded net adverse prior year reserve development of $15 million in our credit and political risk reserve class relating to an increase in our loss portfolio estimates.\nOur long-tail business consists primarily of liability and motor reserve classes. Our motor and liability reinsurance reserve classes contributed additional net favorable prior year reserve development of $17 million and $20 million in the three months ended September 30, 2016 and 2015, respectively. For the nine months ended September 30, 2016 and 2015, these long-tail reserve classes contributed $72 million and $64 million, respectively. The net favorable prior year reserve development for the motor reserve class related to favorable loss emergence trends on several classes of business spanning multiple accident years. The net favorable prior year reserve development for the liability reinsurance reserve class primarily reflected the progressively increased weight given by management to experience based indications on older accident years, which has generally been favorable. In the three and nine months ended September 30, 2015, we recorded net adverse prior year reserve development of $6 million and $23 million, respectively, in our insurance liability reserve class related primarily to an increase in loss estimates for specific individual claim reserves, as well as a higher frequency of large auto liability claims.\nWe caution that conditions and trends that impacted the development of our liabilities in the past may not necessarily occur in the future.\nEstimates of Significant Catastrophe Events\nOur September 30, 2016 net reserves for losses and loss expenses includes estimated amounts for numerous catastrophe events. We caution that the magnitude and/or complexity of losses arising from certain of these events, in particular the Fort McMurray wildfires, Storm Sandy, the 2011 Japanese earthquake and tsunami, the three New Zealand earthquakes and the Tianjin port explosion, inherently increases the level of uncertainty and, therefore, the level of management judgment involved in arriving at our estimated net reserves for losses and loss expenses. As a result, our actual losses for these events may ultimately differ materially from our current estimates.\n53\nOur estimated net losses in relation to the catastrophe events described above were derived from ground-up assessments of our in-force contracts and treaties providing coverage in the affected regions. These assessments take into account the latest information available from clients, brokers and loss adjusters. In addition, we consider industry insured loss estimates, market share analyses and catastrophe modeling analyses, when appropriate. Our estimates remain subject to change, as additional loss data becomes available.\nThe following sections provide further details on prior year reserve development by segment, reserving class and accident year.\nInsurance Segment:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Property and other | $ | 10,061 | $ | 20,518 | $ | 24,048 | $ | 49,705 |\n| Marine | 4,682 | 2,831 | 8,382 | 23,156 |\n| Aviation | 517 | 667 | 437 | 2,884 |\n| Credit and political risk | (25 | ) | (28 | ) | (232 | ) | (15,427 | ) |\n| Professional lines | 3,378 | (15,279 | ) | 8,956 | (15,887 | ) |\n| Liability | 2,075 | (6,265 | ) | 1,590 | (23,206 | ) |\n| Total | $ | 20,688 | $ | 2,444 | $ | 43,181 | $ | 21,225 |\n\nIn the three months ended September 30, 2016, we recognized $21 million of net favorable prior year reserve development, the principal components of which were:\n| • | $10 million of net favorable prior year reserve development on property and other business, driven by better than expected loss emergence, primarily driven by reductions in mid-size loss estimates impacting accident year 2015 and favorable loss experience in our accident and health lines impacting accident year 2014. |\n\n| • | $5 million of net favorable prior year reserve development on marine business, driven by better than expected loss emergence, primarily driven by reductions in mid-size loss estimates impacting accident year 2015. |\n\nIn the three months ended September 30, 2015, we recognized $2 million of net favorable prior year reserve development, the principal components of which were:\n| • | $21 million of net favorable prior year reserve development on property and other business, driven by better than expected loss emergence including reserve reductions related to Storm Sandy of $15 million. |\n\n| • | $6 million of net adverse prior year reserve development on liability business, primarily related to a higher frequency of large auto liability claims in accident year 2014. |\n\n| • | $15 million of net adverse prior year reserve development on professional lines business, predominately reflecting reserve strengthening resulting from updated actuarial assumptions for our Australian professional lines and impacting accident years 2010 to 2014, partially offset by favorable development in certain US professional lines. |\n\nIn the nine months ended September 30, 2016, we recognized $43 million of net favorable prior year reserve development, the principal components of which were:\n| • | $24 million of net favorable prior year reserve development on property and other business, driven by better than expected loss emergence primarily related to accident year 2014. |\n\n| • | $9 million of net favorable prior year reserve development on professional lines business, driven by better than expected development related to various accident years, partially offset by reserve strengthening relating to updated information on one specific claim impacting accident year 2010. |\n\n54\n| • | $8 million of net favorable prior year reserve development on marine business, driven by better than expected loss emergence, primarily driven by reductions in mid-size loss estimates impacting accident year 2015. |\n\nIn the nine months ended September 30, 2015, we recognized $21 million of net favorable prior year development, the principal components of which were:\n| • | $50 million of net favorable prior year reserve development on property and other business, related to the 2012 and 2013 accident years and driven by better than expected loss emergence, including reserve reductions related to Storm Sandy of $16 million. |\n\n| • | $23 million of net favorable prior year reserve development on marine business, largely related to better than expected loss emergence in our energy offshore business spanning multiple years, particularly accident year 2014. |\n\n| • | $15 million of net adverse prior year reserve development on credit and political risk business, related to updated information on one specific claim impacting accident year 2014. |\n\n| • | $16 million of net adverse prior year reserve development on professional lines business, predominately reflecting reserve strengthening resulting from updated actuarial assumptions for our Australian professional lines and impacting accident years 2010 to 2014, partially offset by favorable development in certain US professional lines. |\n\n| • | $23 million of net adverse prior year reserve development on liability business, related to strengthening of specific individual claim reserves and a higher frequency of large auto liability claims in accident year 2014. |\n\nReinsurance Segment:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Property and other | $ | 25,831 | $ | 14,115 | $ | 83,522 | $ | 36,120 |\n| Credit and surety | 3,900 | 7,051 | 6,761 | 18,851 |\n| Professional lines | 8,761 | 1,250 | 18,918 | 25,331 |\n| Motor | 6,653 | 8,997 | 39,794 | 27,321 |\n| Liability | 10,186 | 11,268 | 31,955 | 36,956 |\n| Total | $ | 55,331 | $ | 42,681 | $ | 180,950 | $ | 144,579 |\n\nIn the three months ended September 30, 2016, we recognized $55 million of net favorable prior year reserve development, the principal components of which were:\n| • | $26 million of net favorable prior year reserve development on property and other business, related to the 2011 through 2015 accident years driven by better than expected loss emergence including a reserve reduction of $7 million related to Storm Sandy. |\n\n| • | $10 million of net favorable prior year reserve development on liability business, primarily related to the 2007 through 2010 accident years, for reasons discussed in the overview. |\n\n| • | $9 million of net favorable prior year reserve development on professional lines business, primarily related to the 2005 through 2010 accident years, for reasons discussed in the overview. |\n\n| • | $7 million of net favorable prior year reserve development on motor business, related to non-proportional business spanning multiple accident years, driven by better than expected loss emergence. |\n\nIn the three months ended September 30, 2015, we recognized $43 million of net favorable prior year reserve development, the principal components of which were:\n55\n| • | $14 million of net favorable prior year reserve development on property and other business, related to multiple prior accident years and driven by better than expected loss emergence. |\n\n| • | $11 million of net favorable prior year reserve development on liability business, primarily related to the 2003 through 2010 accident years, for reasons discussed in the overview. |\n\n| • | $9 million of net favorable prior year reserve development on motor business, largely related to favorable loss emergence trends on several classes spanning multiple accident years. |\n\n| • | $7 million of net favorable prior year reserve development on credit and surety business, related to the 2012 accident year and driven by additional information obtained about a specific claim. |\n\nIn the nine months ended September 30, 2016, we recognized $181 million of net favorable prior year reserve development, the principal components of which were:\n| • | $84 million of net favorable prior year development on property and other business, primarily related to the 2010 through 2015 accident years driven by better than expected loss emergence. |\n\n| • | $40 million of net favorable prior year reserve development on motor business, primarily related to non-proportional business spanning multiple accident years, driven by better than expected loss emergence. |\n\n| • | $32 million of net favorable prior year reserve development on liability business, primarily related to the 2006 through 2011 accident years, for reasons discussed in the overview. |\n\n| • | $19 million of net favorable prior year reserve development on professional lines business, primarily related to the 2005 through 2010 accident years, for reasons discussed in the overview. |\n\nIn the nine months ended September 30, 2015, we recognized $145 million of net favorable prior year reserve development, the principal components of which were:\n| • | $37 million of net favorable prior year reserve development on liability business, primarily related to the 2003 through 2010 accident years, for reasons discussed in the overview. |\n\n| • | $36 million of net favorable prior year reserve development on property and other business, spanning a number of accident years and driven by better than expected loss emergence. Included in this net development is $20 million of adverse development on agriculture reserves relating to loss developments on the 2014 accident year driven by lower than expected crop yields reported for two specific treaties. |\n\n| • | $27 million of net favorable prior year reserve development on motor business, predominantly related to non-proportional business in accident years 2011 and prior, driven by better than expected loss emergence. |\n\n| • | $25 million of net favorable prior year reserve development on professional lines business, primarily related to the 2009 through 2010 accident years, for reasons discussed in the overview. |\n\n\n| • | $19 million of net favorable prior year reserve development on credit and surety business, spanning multiple accident years and driven by better than expected loss emergence, as well as additional information obtained about a specific claim. |\n\nAcquisition Cost Ratio: The increase in the acquisition cost ratio in the three and nine months ended September 30, 2016 to 20.3% and 20.1%, respectively, compared to 19.9% and 19.4% in the three and nine months ended September 30, 2015, respectively, was driven by increases in our reinsurance segment. The reinsurance segment's increase in the three months ended September 30, 2016 compared to the same period in 2015 was primarily due to the impact of retrocessional contracts, an increase in the amount of business being written on a proportional basis, higher acquisition costs in certain lines of business and fees from strategic capital partners which were a benefit in 2015. The reinsurance segment's increase in the nine months ended September 30, 2016 compared to the same period in 2015 was primarily due to an increase in the amount of business being written on a proportional basis, higher acquisition costs in certain lines of business and the impact of retrocessional contracts.\n56\nGeneral and Administrative Expense Ratio: The general and administrative expense ratio in the three and nine months ended September 30, 2016, decreased to 15.3% and 15.8%, respectively, compared to 15.7% and 16.5% in the three and nine months ended September 30, 2015, respectively. The decrease in the expense ratio in the three months ended September 30, 2016 compared to the same period in 2015 was primarily attributable to growth in net premiums earned, reorganization related expenses adverse to 2015 and increased fees from strategic capital partners, partially offset by the net reimbursement of PartnerRe merger-related expenses benefiting 2015 and senior executive transition costs in 2016. The decrease in the expense ratio in the nine months ended September 30, 2016 compared to the same period in 2015 was primarily driven by growth in net earned premiums, increased fees from strategic capital partners, decreased personnel costs and expenses attributable to the proposed merger with PartnerRe and reorganization related expenses adverse to 2015, partially offset by adjustments to senior leadership executive stock-compensation awards benefiting 2015 and senior executive transition costs in 2016.\nRESULTS BY SEGMENT\nINSURANCE SEGMENT\nResults from our insurance segment were as follows:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Revenues: |\n| Gross premiums written | $ | 675,430 | 11% | $ | 606,704 | $ | 2,112,796 | 7% | $ | 1,970,554 |\n| Net premiums written | 433,131 | 14% | 381,118 | 1,433,058 | 6% | 1,352,122 |\n| Net premiums earned | 444,691 | —% | 444,550 | 1,322,649 | (2%) | 1,344,339 |\n| Other insurance related income (loss) | 39 | (93%) | 542 | (57 | ) | nm | 811 |\n| Expenses: |\n| Current year net losses and loss expenses | (293,914 | ) | (285,716 | ) | (896,952 | ) | (887,805 | ) |\n| Prior year reserve development | 20,688 | 2,444 | 43,181 | 21,225 |\n| Acquisition costs | (61,755 | ) | (69,118 | ) | (184,982 | ) | (200,493 | ) |\n| General and administrative expenses | (84,588 | ) | (85,814 | ) | (252,652 | ) | (261,924 | ) |\n| Underwriting income | $ | 25,161 | 265% | $ | 6,888 | $ | 31,187 | 93% | $ | 16,153 |\n| Ratios: | % PointChange | % PointChange |\n| Current year loss ratio | 66.1 | % | 1.8 | 64.3 | % | 67.8 | % | 1.8 | 66.0 | % |\n| Prior year reserve development | (4.7 | %) | (4.1) | (0.6 | %) | (3.2 | %) | (1.7) | (1.5 | %) |\n| Acquisition cost ratio | 13.9 | % | (1.6) | 15.5 | % | 14.0 | % | (0.9) | 14.9 | % |\n| General and administrative expense ratio | 19.1 | % | (0.3) | 19.4 | % | 19.0 | % | (0.5) | 19.5 | % |\n| Combined ratio | 94.4 | % | (4.2) | 98.6 | % | 97.6 | % | (1.3) | 98.9 | % |\n\nnm – not meaningful\n57\nGross Premiums Written:\nThe following table provides gross premiums written by line of business:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | % Change | 2016 | 2015 | % Change |\n| Property | $ | 164,605 | 25 | % | $ | 139,488 | 24 | % | 18% | $ | 522,380 | 24 | % | $ | 465,929 | 24 | % | 12% |\n| Marine | 33,677 | 5 | % | 38,817 | 6 | % | (13%) | 191,298 | 9 | % | 215,885 | 11 | % | (11%) |\n| Terrorism | 9,394 | 1 | % | 11,192 | 2 | % | (16%) | 28,090 | 1 | % | 25,737 | 1 | % | 9% |\n| Aviation | 9,684 | 1 | % | 10,222 | 2 | % | (5%) | 37,111 | 2 | % | 29,755 | 2 | % | 25% |\n| Credit and Political Risk | 5,423 | 1 | % | 8,542 | 1 | % | (37%) | 34,299 | 2 | % | 29,640 | 2 | % | 16% |\n| Professional Lines | 204,926 | 30 | % | 196,218 | 32 | % | 4% | 590,417 | 28 | % | 598,370 | 30 | % | (1%) |\n| Liability | 108,447 | 16 | % | 104,666 | 17 | % | 4% | 310,797 | 15 | % | 300,204 | 15 | % | 4% |\n| Accident and Health | 139,274 | 21 | % | 97,559 | 16 | % | 43% | 398,404 | 19 | % | 305,034 | 15 | % | 31% |\n| Total | $ | 675,430 | 100 | % | $ | 606,704 | 100 | % | 11% | $ | 2,112,796 | 100 | % | $ | 1,970,554 | 100 | % | 7% |\n\nGross premiums written in the three months ended September 30, 2016, increased by $69 million or 11% (12% on a constant currency basis) compared to the three months ended September 30, 2015. The increase was primarily attributable to growth in our accident and health and property lines related to new business opportunities.\nGross premiums written in the nine months ended September 30, 2016 increased by $142 million or 7% (8% on a constant currency basis) compared to the nine months ended September 30, 2015. The increase was primarily attributable to increases in our accident and health and property lines driven by new business. These increases were partially offset by a decrease in our marine and professional lines. Our marine lines decreased primarily due to reduced new business opportunities, lower rates and timing differences. The professional lines' decrease was due to the impact of our exit from retail insurance operations in Australia, as mentioned above in the quarterly results.\nPremiums Ceded: In the three and nine months ended September 30, 2016, premiums ceded were $242 million, or 36% of gross premiums written and $680 million, or 32% of gross premiums written, respectively, compared to $226 million, or 37% of gross premiums written and $618 million or 31% of gross premiums written, in the three and nine months ended September 30, 2015, respectively. The decrease in the ceded ratio for the three months ended September 30, 2016 compared to the same period in 2015 was primarily driven by changes in our accident and health line, partially offset by increased premiums ceded in our liability and professional lines. The increase in the ceded ratio for the nine months ended September 30, 2016 compared to the same period in 2015 was primarily driven by increased ceded premiums in our professional lines, partially offset by changes in our accident and health line.\n58\nNet Premiums Earned:\nThe following table provides net premiums earned by line of business:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | % Change | 2016 | 2015 | % Change |\n| Property | $ | 106,578 | 25 | % | $ | 112,017 | 27 | % | (5%) | $ | 312,804 | 23 | % | $ | 324,720 | 24 | % | (4%) |\n| Marine | 36,218 | 8 | % | 36,837 | 8 | % | (2%) | 113,693 | 9 | % | 143,878 | 11 | % | (21%) |\n| Terrorism | 8,276 | 2 | % | 7,985 | 2 | % | 4% | 26,011 | 2 | % | 26,565 | 2 | % | (2%) |\n| Aviation | 9,015 | 2 | % | 9,982 | 2 | % | (10%) | 33,528 | 3 | % | 32,097 | 2 | % | 4% |\n| Credit and Political Risk | 12,274 | 3 | % | 14,671 | 3 | % | (16%) | 42,661 | 3 | % | 45,993 | 3 | % | (7%) |\n| Professional Lines | 126,574 | 28 | % | 148,110 | 33 | % | (15%) | 386,241 | 29 | % | 451,944 | 34 | % | (15%) |\n| Liability | 42,205 | 9 | % | 41,817 | 9 | % | 1% | 126,429 | 10 | % | 120,181 | 9 | % | 5% |\n| Accident and Health | 103,551 | 23 | % | 73,131 | 16 | % | 42% | 281,282 | 21 | % | 198,961 | 15 | % | 41% |\n| Total | $ | 444,691 | 100 | % | $ | 444,550 | 100 | % | —% | $ | 1,322,649 | 100 | % | $ | 1,344,339 | 100 | % | (2%) |\n\nNet premiums earned in the three months ended September 30, 2016, were comparable (up 2% on a constant currency basis) to the three months ended September 30, 2015, driven by growth in premiums written in recent periods, primarily in our accident and health lines, offset by an increase in our professional lines' ceded reinsurance programs. Net premiums earned in the nine months ended September 30, 2015 decreased by $22 million or 2% (comparable on a constant currency basis) compared to the nine months ended September 30, 2015. The decrease in net premiums earned in the nine months ended September 30, 2016 compared to the same period in 2015 was primarily driven by an increase in our professional lines' ceded reinsurance programs, a reduction in business written in our marine lines and the impact of our exit from retail insurance operations in Australia partially offset by growth in our accident and health lines.\nLoss Ratio:\nThe table below shows the components of our loss ratio:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % PointChange | 2015 | 2016 | % PointChange | 2015 |\n| Current accident year | 66.1 | % | 1.8 | 64.3 | % | 67.8 | % | 1.8 | 66.0 | % |\n| Prior year reserve development | (4.7 | %) | (4.1) | (0.6 | %) | (3.2 | %) | (1.7) | (1.5 | %) |\n| Loss ratio | 61.4 | % | (2.3) | 63.7 | % | 64.6 | % | 0.1 | 64.5 | % |\n\n59\nCurrent Accident Year Loss Ratio:\nThe current accident year loss ratios increased to 66.1% and 67.8% in the three and nine months ended September 30, 2016, respectively, from 64.3% and 66.0% in the three and nine months ended September 30, 2015, respectively.\nDuring the three and nine months ended September 30, 2016, we incurred $15 million, or 3.3 points, and $73 million, or 5.5 points, respectively, in pre-tax catastrophe and weather-related losses related to the U.S. weather events, Japanese earthquake and Fort McMurray wildfires. Comparatively, during the three and nine months ended September 30, 2015 we incurred $19 million, or 4.3 points, and $45 million, or 3.4 points, respectively.\nAfter adjusting for the impact of the catastrophe and weather-related losses, our current accident year loss ratios in the three and nine months ended September 30, 2016, were 62.8% and 62.3%, respectively, compared to 60.0% and 62.7% in the three and nine months ended September 30, 2015, respectively. The increases in the current accident year loss ratios after adjusting for the impact of the catastrophe and weather-related losses for the three and nine months ended September 30, 2016 compared to the same periods in 2015 was driven by the adverse impact of rate and trend on most lines of business and changes in business mix, partially offset by a decrease in the mid-size loss experience particularly in our marine and property lines.\nRefer to the ‘Prior Year Reserve Development’ section for further details.\nAcquisition Cost Ratio: The decrease in the acquisition cost ratio in the three and nine months ended September 30, 2016 compared to the three and nine months ended September 30, 2015, was driven by an increase in ceding commissions following the expansion of our professional lines' ceded reinsurance programs and a lower acquisition cost ratio in our accident and health line resulting from a change in business mix.\nGeneral and Administrative Expense Ratio: The decrease in the general and administrative expense ratio in the nine months ended September 30, 2016 compared nine months ended September 30, 2015 primarily reflected a decrease in personnel expenses and a reduction in the allocation of certain corporate expenses.\n60\nREINSURANCE SEGMENT\nResults from our reinsurance segment were as follows:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Revenues: |\n| Gross premiums written | $ | 284,532 | (14%) | $ | 329,879 | $ | 2,126,762 | 16% | $ | 1,833,374 |\n| Net premiums written | 162,300 | (45%) | 296,099 | 1,855,529 | 7% | 1,727,185 |\n| Net premiums earned | 489,724 | 3% | 474,791 | 1,461,097 | 3% | 1,420,266 |\n| Other insurance related income | 5,905 | nm | 616 | 4,907 | (57%) | 11,508 |\n| Expenses: |\n| Current year net losses and loss expenses | (314,433 | ) | (319,796 | ) | (990,763 | ) | (930,867 | ) |\n| Prior year reserve development | 55,331 | 42,681 | 180,950 | 144,579 |\n| Acquisition costs | (128,055 | ) | (113,626 | ) | (374,588 | ) | (337,056 | ) |\n| General and administrative expenses | (29,635 | ) | (35,309 | ) | (99,980 | ) | (110,701 | ) |\n| Underwriting income | $ | 78,837 | 60% | $ | 49,357 | $ | 181,623 | (8%) | $ | 197,729 |\n| Ratios: | % PointChange | % PointChange |\n| Current year loss ratio | 64.2 | % | (3.2) | 67.4 | % | 67.8 | % | 2.3 | 65.5 | % |\n| Prior year reserve development | (11.3 | %) | (2.3) | (9.0 | %) | (12.4 | %) | (2.3) | (10.1 | %) |\n| Acquisition cost ratio | 26.1 | % | 2.2 | 23.9 | % | 25.6 | % | 1.9 | 23.7 | % |\n| General and administrative expense ratio | 6.1 | % | (1.3) | 7.4 | % | 6.9 | % | (0.9) | 7.8 | % |\n| Combined ratio | 85.1 | % | (4.6) | 89.7 | % | 87.9 | % | 1.0 | 86.9 | % |\n\nnm – not meaningful\nGross Premiums Written:\nThe following table provides gross premiums written by line of business for the periods indicated:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | % Change | 2016 | 2015 | % Change |\n| Catastrophe | $ | 46,338 | 16 | % | $ | 56,693 | 18 | % | (18%) | $ | 316,692 | 15 | % | $ | 283,562 | 15 | % | 12% |\n| Property | 61,957 | 22 | % | 67,539 | 20 | % | (8%) | 283,555 | 13 | % | 307,809 | 17 | % | (8%) |\n| Professional Lines | 19,479 | 7 | % | 45,509 | 14 | % | (57%) | 235,094 | 11 | % | 204,685 | 11 | % | 15% |\n| Credit and Surety | 36,174 | 13 | % | 23,390 | 7 | % | 55% | 315,102 | 15 | % | 230,958 | 13 | % | 36% |\n| Motor | 13,344 | 5 | % | 21,359 | 6 | % | (38%) | 338,403 | 16 | % | 333,245 | 18 | % | 2% |\n| Liability | 91,387 | 32 | % | 111,361 | 34 | % | (18%) | 365,380 | 17 | % | 258,862 | 14 | % | 41% |\n| Agriculture | 1,286 | — | % | (3,303 | ) | (1 | %) | nm | 151,315 | 7 | % | 139,135 | 8 | % | 9% |\n| Engineering | 13,588 | 5 | % | 4,397 | 1 | % | 209% | 56,719 | 3 | % | 58,163 | 3 | % | (2%) |\n| Marine and Other | 979 | — | % | 2,934 | 1 | % | (67%) | 64,502 | 3 | % | 16,955 | 1 | % | 280% |\n| Total | $ | 284,532 | 100 | % | $ | 329,879 | 100 | % | (14%) | $ | 2,126,762 | 100 | % | $ | 1,833,374 | 100 | % | 16% |\n\nGross premiums written decreased by $45 million and increased by $293 million in the three and nine months ended September 30, 2016, compared to the same periods in 2015, respectively.\n61\nThe decrease in gross premiums written in the three months ended September 30, 2016 compared to the same period in 2015, was primarily driven by our professional and liability lines, largely due to timing differences.\nThe increase in gross premiums written in the nine months ended September 30, 2016 compared to the same period in 2015, was impacted by treaties written on a multi-year basis. In the nine months ended September 30, 2016, the reinsurance segment reported an increase in the level of multi-year contracts written compared to the same period in 2015. This increase in multi-year contracts increased the amount of premium recorded in the current periods relating to future years compared to the same periods in 2015, most notably in the credit & surety and liability lines. On a comparative basis the impact of the multi-year premiums resulted in an increase in gross premiums written of $141 million in the nine months ended September 30, 2016, compared to the same period in 2015. The increase in written premiums was partially offset by the impact of foreign exchange movements in the nine months ended September 30, 2016, compared to the same period in 2015, as the strength of the U.S. dollar drove comparative premium decreases in the treaties denominated in foreign currencies. Foreign exchange movements resulted in a relative decrease of $52 million in gross premiums written in the nine months ended September 30, 2016, compared to the same period in 2015.\nAfter adjusting for the impact of multi-year contracts and on a constant currency basis, our gross premiums written increased by $204 million, or 11% in the nine months ended September 30, 2016, compared to the same period in 2015. The growth was driven by increases in our liability, marine and other, catastrophe, professional as well as our credit and surety lines primarily driven by new business. Favorable treaty restructurings and timing differences also contributed to the increases in liability and professional lines. These increases were partially offset by a decrease in our property lines, primarily relating to non-renewals and decreases in line sizes on several treaties.\nPremiums Ceded: In the three and nine months ended September 30, 2016, the ratio of ceded premium to gross written premium increased to 43% and 13%, respectively, from 10% and 6% in the three and nine months ended September 30, 2015, respectively. The increase for the three months ended September 30, 2016 compared to the prior period, was due to the impact of a new retrocessional cover entered into with Harrington Re which increased premiums ceded in our liability and professional lines. The increase for the nine months ended September 30, 2016 compared to the prior period was largely due to the new retrocessions to Harrington Re and increased premiums ceded in our catastrophe and property business.\nNet Premiums Earned:\nThe following table provides net premiums earned by line of business:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | % Change | 2016 | 2015 | % Change |\n| Catastrophe | $ | 48,799 | 10 | % | $ | 51,116 | 11 | % | (5%) | $ | 151,416 | 12 | % | $ | 165,840 | 12 | % | (9%) |\n| Property | 71,649 | 15 | % | 78,343 | 17 | % | (9%) | 208,179 | 14 | % | 235,828 | 17 | % | (12%) |\n| Professional Lines | 73,109 | 15 | % | 81,986 | 17 | % | (11%) | 225,813 | 15 | % | 231,024 | 16 | % | (2%) |\n| Credit and Surety | 67,430 | 14 | % | 59,601 | 13 | % | 13% | 192,135 | 13 | % | 182,508 | 13 | % | 5% |\n| Motor | 77,786 | 16 | % | 72,893 | 15 | % | 7% | 232,383 | 16 | % | 228,433 | 16 | % | 2% |\n| Liability | 80,137 | 16 | % | 77,441 | 16 | % | 3% | 247,103 | 17 | % | 218,829 | 15 | % | 13% |\n| Agriculture | 36,704 | 7 | % | 33,684 | 7 | % | 9% | 106,251 | 7 | % | 101,335 | 7 | % | 5% |\n| Engineering | 18,573 | 4 | % | 15,128 | 3 | % | 23% | 51,024 | 3 | % | 43,133 | 3 | % | 18% |\n| Marine and Other | 15,537 | 3 | % | 4,599 | 1 | % | 238% | 46,793 | 3 | % | 13,336 | 1 | % | 251% |\n| Total | $ | 489,724 | 100 | % | $ | 474,791 | 100 | % | 3% | $ | 1,461,097 | 100 | % | $ | 1,420,266 | 100 | % | 3% |\n\nNet premiums earned increased by $15 million or 3% (7% on a constant currency basis) and $41 million or 3% (7% on a constant currency basis) in the three and nine months ended September 30, 2016, compared to the same periods in 2015, respectively.\nThe increase for both periods was primarily driven by the growth in the business written in our liability, marine and other as well as our catastrophe lines in recent periods together with a favorable premium adjustments impacting our credit and surety lines. The growth for both periods was partially offset by increased premiums ceded in our catastrophe and property lines, as well as the impact on our liability and professional lines of the new retrocession to Harrington Re.\n62\nOther Insurance Related Income (Losses):\nThe increase in other insurance related income of $5 million in the three months ended September 30, 2016, compared to the same period in 2015, reflected fees from strategic capital partners and favorable fair value adjustments to economic hedges purchased to protect our agriculture line of business against fluctuations in commodity prices. The decrease in other insurance related income of $7 million in the nine months ended September 30, 2016, compared to the same period in 2015, reflected the impact of the realized gains on our weather and commodities derivative portfolio in the nine months ended September 30, 2015 compared to an immaterial impact in the nine months ended September 30, 2016, partially offset by fees from strategic capital partners and favorable fair value adjustments to economic hedges purchased to protect our agriculture line of business against fluctuations in commodity prices.\nLoss Ratio:\nThe table below shows the components of our loss ratio:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % PointChange | 2015 | 2016 | % PointChange | 2015 |\n| Current accident year | 64.2 | % | (3.2) | 67.4 | % | 67.8 | % | 2.3 | 65.5 | % |\n| Prior year reserve development | (11.3 | %) | (2.3) | (9.0 | %) | (12.4 | %) | (2.3) | (10.1 | %) |\n| Loss ratio | 52.9 | % | (5.5) | 58.4 | % | 55.4 | % | — | 55.4 | % |\n\nCurrent Accident Year Loss Ratio:\nThe current accident year loss ratio decreased to 64.2% in the three months ended September 30, 2016 from 67.4% in the same period in 2015, while the current accident year loss ratio increased to 67.8% in the nine months ended September 30, 2016 from 65.5% in the same period in 2015.\nThe decrease for the three months ended September 30, 2016 compared to the same period in 2015 was impacted by a lower level of catastrophe and weather-related losses and the increase for the nine months ended September 30, 2016 compared to the same period in 2015 was impacted by an increased level of catastrophe and weather-related losses. During the three and nine months ended September 30, 2016, we incurred $7 million, or 1.5 points, and $72 million, or 5.0 points, respectively, in pre-tax catastrophe and weather-related losses, net of reinstatement premiums, attributable to the weather-related events, Fort McMurray wildfires, the Japanese and Ecuadorian earthquakes, North Calgary hailstorm and European floods. Comparatively, during the three and nine months ended September 30, 2015 we incurred $24 million, or 5.1 points, and $45 million, or 3.2 points, respectively.\nAfter adjusting for the impact of the catastrophe and weather-related losses, our current accident year loss ratios in the three and nine months ended September 30, 2016, were 62.7% and 62.8%, respectively, compared to 62.3% in both the three and nine months ended September 30, 2015. The increases in the current accident year loss ratios after adjusting for the impact of the catastrophe and weather-related losses for the three and nine months ended September 30, 2016 compared to the same periods in 2015 was mainly due to the ongoing adverse impact of rate and trend, partially offset by the recognition of better than expected recent attritional loss experience across our long tail lines of business.\nRefer ‘Prior Year Reserve Development’ for further details.\nAcquisition Cost Ratio: The acquisition cost ratio increased in both the three and nine months ended September 30, 2016 compared to the same periods in 2015. The increase in the three months ended September 30, 2016 was primarily due to the impact of retrocessional contracts, an increase in the amount of business being written on a proportional basis together with higher acquisition costs in certain lines of business and fees from strategic capital partners which were a benefit in 2015. The increase in the nine months ended September 30, 2016 compared to the same period in 2015 was primarily due to an increase in the amount of business being written on a proportional basis, higher acquisition costs in certain lines of business and the impact of retrocessional contracts.\n63\nGeneral and Administrative Expense Ratio: The general and administrative expense ratio decreased in both the three and nine months ended September 30, 2016 compared to the same periods in 2015. The decrease in the general and administrative expense ratio primarily reflects lower personnel expense, benefits of arrangements with our strategic capital partners and the impact of increased net earned premiums.\nOTHER EXPENSES (REVENUES), NET\nThe following table provides a breakdown of our other expenses (revenues), net:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Corporate expenses | $ | 28,683 | 22% | $ | 23,604 | $ | 86,922 | 4% | $ | 83,826 |\n| Foreign exchange gains | (13,795 | ) | (51%) | (28,088 | ) | (69,781 | ) | 1% | (69,200 | ) |\n| Interest expense and financing costs | 12,839 | (1%) | 12,918 | 38,586 | 1% | 38,114 |\n| Income tax expense | 9,352 | nm | 30 | 7,712 | nm | 1,155 |\n| Total | $ | 37,079 | nm | $ | 8,464 | $ | 63,439 | 18% | $ | 53,895 |\n\nnm – not meaningful\nCorporate Expenses: Our corporate expenses include holding company costs necessary to support our worldwide insurance and reinsurance operations and costs associated with operating as a publicly-traded company. As a percentage of net premiums earned, corporate expenses were 3.1% for the three and nine months ended September 30, 2016, compared to 2.6% and 3.0%, respectively, for the same periods of 2015. The increase in corporate expenses in the three month period ended September 30, 2016 is primarily attributable to the net reimbursement of PartnerRe merger-related expenses benefiting 2015 and senior executive transition costs in 2016, partially offset by reorganization related expenses adverse to 2015. The slight increase in corporate expenses in the nine month period ended September 30, 2016 is attributable to adjustments to senior leadership executive stock-compensation awards benefiting 2015, senior executive transition costs in 2016 and an increase in personnel costs in 2016, partially offset by expenses attributable to the proposed merger with PartnerRe and reorganization related expenses adverse to 2015.\nForeign Exchange Gains: Some of our business is written in currencies other than the U.S. dollar. The foreign exchange gains for the periods presented were largely driven by the re-measurement of our net insurance related liabilities. The foreign exchange gains for the three and nine months ended September 30, 2016 were primarily driven by the depreciation of pound sterling against the U.S dollar. Comparatively, the foreign exchange gains for the three months ended September 30, 2015 were primarily driven by depreciation of the pound sterling and the Australian dollar against the U.S. dollar. The foreign exchange gains for the nine months ended September 30, 2015 were primarily driven by the depreciation of the euro, pound sterling and Australian dollar.\nIncome Tax Expense: Income tax expense primarily results from income generated by our foreign operations in the United States and Europe. Our effective tax rate, which is calculated as income tax expense divided by net income before tax including interest in loss of equity method investments, was 4.8% and 2.1% in the three and nine months ended September 30, 2016, and was insignificant and 0.2% in the three and nine months ended September 30, 2015. This effective rate can vary between periods depending on the distribution of net income amongst tax jurisdictions, as well as other factors. The primary driver of the current quarter and year-to-date increase is the generation of consolidated pre-tax net income in our operations in Europe compared to a net loss in each of these periods in 2015.\n64\nNET INVESTMENT INCOME AND NET REALIZED INVESTMENT GAINS (LOSSES)\nNet Investment Income\nThe following table provides a breakdown of income earned from our cash and investment portfolio by major asset class:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Fixed maturities | $ | 75,827 | —% | $ | 75,980 | $ | 229,423 | 4% | $ | 220,066 |\n| Other investments | 38,248 | nm | (27,421 | ) | 25,770 | 46% | 17,616 |\n| Equity securities | 4,633 | 34% | 3,445 | 12,843 | 65% | 7,795 |\n| Mortgage loans | 2,191 | nm | 482 | 5,683 | nm | 776 |\n| Cash and cash equivalents | 3,768 | nm | 993 | 7,071 | 88% | 3,770 |\n| Short-term investments | 337 | nm | 83 | 708 | 156% | 277 |\n| Gross investment income | 125,004 | 133% | 53,562 | 281,498 | 12% | 250,300 |\n| Investment expense | (8,081 | ) | 3% | (7,877 | ) | (23,680 | ) | (1%) | (23,964 | ) |\n| Net investment income | $ | 116,923 | 156% | $ | 45,685 | $ | 257,818 | 14% | $ | 226,336 |\n| Pre-tax yield:(1) |\n| Fixed maturities | 2.7% | 2.5% | 2.6% | 2.4% |\n\nnm - not meaningful\n| (1) | Pre-tax yield is annualized and calculated as net investment income divided by the average month-end amortized cost balances for the periods indicated. |\n\nFixed Maturities\nThe net investment income increase for the nine months ended September 30, 2016 attributable to fixed maturities was due to an emphasis on longer duration assets and an improvement in CPI adjustments following a reduction in our exposure to treasury inflation-protected securities.\nOther Investments\nThe following table provides a breakdown of total net investment income from other investments:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Hedge, direct lending, private equity and real estate funds | $ | 29,459 | $ | (23,483 | ) | $ | 6,127 | $ | 10,357 |\n| Other privately held investments | 370 | — | 177 | — |\n| CLO - Equities | 8,419 | (3,938 | ) | 19,466 | 7,259 |\n| Total net investment income from other investments | $ | 38,248 | $ | (27,421 | ) | $ | 25,770 | $ | 17,616 |\n| Pre-tax return on other investments(1) | 4.5 | % | (3.3 | %) | 3.1 | % | 2.0 | % |\n\n| (1) | The pre-tax return on other investments is non-annualized and calculated by dividing total net investment income from other investments by the average month-end fair value balances held for the periods indicated. |\n\nThe total net investment income from other investments increased for the three and nine months ended September 30, 2016 compared to the same periods in 2015 due to an improvement in the performance of the global equity markets which translated into higher valuations on our hedge funds. CLO - Equities also benefited from an increase in the valuation of the underlying collateral balances.\n65\nNet Realized Investment Gains (Losses)\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| On sale of investments: |\n| Fixed maturities and short-term investments | $ | 4,303 | $ | (42,741 | ) | $ | (22,869 | ) | $ | (66,579 | ) |\n| Equity securities | 4,994 | (1,327 | ) | 2,881 | (1,505 | ) |\n| 9,297 | (44,068 | ) | (19,988 | ) | (68,084 | ) |\n| OTTI charges recognized in earnings | (4,247 | ) | (32,301 | ) | (20,346 | ) | (62,762 | ) |\n| Change in fair value of investment derivatives | 155 | 6,412 | 39 | 7,228 |\n| Net realized investment gains (losses) | $ | 5,205 | $ | (69,957 | ) | $ | (40,295 | ) | $ | (123,618 | ) |\n\nOn sale of investments\nGenerally, sales of individual securities occur when there are changes in the relative value, credit quality or duration of a particular issue. We may also sell to rebalance our investment portfolio in order to change exposure to particular asset classes or sectors. Net realized investment gains in the three months ended September 30, 2016 are reflective of the improvement in pricing of our fixed maturities and equities. Net realized investment losses in the nine months ended September 30, 2016 are primarily due to foreign exchange losses on non-U.S. denominated securities, as a result of the strengthening of the U.S. dollar.\nOTTI charges\nFor the three months ended September 30, 2016, OTTI charges were driven by impairments on corporate debt securities and losses on non-U.S. denominated securities as a result of the decline in foreign exchange rates against the U.S. dollar. The nine months ended September 30, 2016 also included impairments on high yield corporate debt securities which are exposed to the energy sector and exchange-traded funds (ETFs) which are unlikely to recover in the near term.\nChange in fair value of investment derivatives\nFrom time to time, we may economically hedge the foreign exchange exposure of non-U.S. denominated securities by entering into foreign exchange forward contracts.\n66\nTotal Return\nThe following table provides a breakdown of the total return on cash and investments for the period indicated:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Net investment income | $ | 116,923 | $ | 45,685 | $ | 257,818 | $ | 226,336 |\n| Net realized investments gains (losses) | 5,205 | (69,957 | ) | (40,295 | ) | (123,618 | ) |\n| Change in net unrealized gains (losses) | 35,075 | (26,441 | ) | 303,573 | (52,965 | ) |\n| Interest in loss of equity method investments | (2,434 | ) | — | (2,434 | ) | — |\n| Total | $ | 154,769 | $ | (50,713 | ) | $ | 518,662 | $ | 49,753 |\n| Average cash and investments(1) | $ | 14,470,231 | $ | 14,893,376 | $ | 14,457,978 | $ | 14,919,752 |\n| Total return on average cash and investments, pre-tax: |\n| Inclusive of investment related foreign exchange movements | 1.1 | % | (0.3 | %) | 3.6 | % | 0.3 | % |\n| Exclusive of investment related foreign exchange movements | 1.1 | % | (0.1 | %) | 3.9 | % | 0.9 | % |\n\n| (1) | The average cash and investments balance is calculated by taking the average of the month-end fair value balances held for the periods indicated. |\n\nCASH AND INVESTMENTS\nThe table below provides a breakdown of our cash and investments:\n| September 30, 2016 | December 31, 2015 |\n| Fair Value | Fair Value |\n| Fixed maturities | $ | 11,566,860 | $ | 11,719,749 |\n| Equities | 644,344 | 597,998 |\n| Mortgage loans | 332,753 | 206,277 |\n| Other investments | 847,262 | 816,756 |\n| Equity method investments | 111,295 | 10,932 |\n| Short-term investments | 39,877 | 34,406 |\n| Total investments | $ | 13,542,391 | $ | 13,386,118 |\n| Cash and cash equivalents(1) | $ | 1,077,263 | $ | 1,174,751 |\n\n| (1) | Includes restricted cash and cash equivalents of $229 million and $187 million at September 30, 2016 and at December 31, 2015, respectively. |\n\nThe $156m increase in the fair value of our total investments was driven by the downward shift in sovereign yield curves and the tightening of credit spreads on both investment grade and high-yield corporate debt. This was partially offset by the funding of financing and operating activities.\n67\nThe following provides a further analysis on our investment portfolio by asset classes:\nFixed Maturities\nThe following provides a breakdown of our investment in fixed maturities:\n| September 30, 2016 | December 31, 2015 |\n| Fair Value | % of Total | Fair Value | % of Total |\n| Fixed maturities: |\n| U.S. government and agency | $ | 1,562,877 | 14 | % | $ | 1,651,949 | 14 | % |\n| Non-U.S. government | 582,056 | 5 | % | 739,005 | 6 | % |\n| Corporate debt | 4,568,500 | 39 | % | 4,362,769 | 37 | % |\n| Agency RMBS | 2,522,731 | 22 | % | 2,249,236 | 19 | % |\n| CMBS | 894,275 | 8 | % | 1,083,298 | 9 | % |\n| Non-Agency RMBS | 71,830 | — | % | 101,008 | 1 | % |\n| ABS | 1,235,596 | 11 | % | 1,371,270 | 12 | % |\n| Municipals(1) | 128,995 | 1 | % | 161,214 | 2 | % |\n| Total | $ | 11,566,860 | 100 | % | $ | 11,719,749 | 100 | % |\n| Credit ratings: |\n| U.S. government and agency | $ | 1,562,877 | 14 | % | $ | 1,651,949 | 14 | % |\n| AAA(2) | 4,359,640 | 38 | % | 4,266,673 | 36 | % |\n| AA | 1,165,958 | 10 | % | 1,273,941 | 11 | % |\n| A | 1,770,161 | 15 | % | 2,065,192 | 18 | % |\n| BBB | 1,607,798 | 14 | % | 1,442,938 | 12 | % |\n| Below BBB(3) | 1,100,426 | 9 | % | 1,019,056 | 9 | % |\n| Total | $ | 11,566,860 | 100 | % | $ | 11,719,749 | 100 | % |\n\n| (1) | Includes bonds issued by states, municipalities, and political subdivisions. |\n\n| (2) | Includes U.S. government-sponsored agency RMBS and CMBS. |\n\n| (3) | Non-investment grade and non-rated securities. |\n\nAt September 30, 2016, our fixed maturities had a weighted average credit rating of AA- (2015: AA-) and an average duration of 3.2 years (2015: 3.3 years). When incorporating short-term investments and cash and cash equivalents into the calculation (bringing the total to $12.5 billion), the average credit rating would be AA- (2015: AA-) and duration would be 2.9 years (2015: 3.0 years).\nDuring the year, net unrealized investment gains (losses) on fixed maturities moved from a net unrealized investment loss of $178 million at December 31, 2015 to a net unrealized gain of $104 million at September 30, 2016.\nEquities\nNet unrealized investment gains on equities increased from $22 million at December 31, 2015 to $44 million at September 30, 2016, an increase of $22 million due to an improvement in valuations reflective of performance of the global equity markets.\nMortgage Loans\nDuring the year, we increased our investment in commercial mortgage loans from $206 million to $333 million, an increase of $127m. The commercial mortgage loans are high quality and collateralized by a variety of commercial properties and are diversified both geographically throughout the United States and by property type to reduce the risk of concentration.\n68\nOther Investments\nThe composition of our other investments portfolio is summarized as follows:\n| September 30, 2016 | December 31, 2015 |\n| Hedge funds |\n| Long/short equity funds | $ | 139,460 | 16 | % | $ | 154,348 | 19 | % |\n| Multi-strategy funds | 281,153 | 33 | % | 355,073 | 43 | % |\n| Event-driven funds | 94,012 | 11 | % | 147,287 | 18 | % |\n| Leveraged bank loan funds | — | — | % | 65 | — | % |\n| Total hedge funds | 514,625 | 60 | % | 656,773 | 80 | % |\n| Direct lending funds | 125,002 | 15 | % | 90,120 | 11 | % |\n| Private equity funds | 89,170 | 11 | % | — | — | % |\n| Real estate funds | 11,782 | 1 | % | 4,929 | 1 | % |\n| Total hedge, direct lending and real estate funds | 740,579 | 87 | % | 751,822 | 92 | % |\n| Other privately held investments | 42,900 | 5 | % | — | — | % |\n| CLO - Equities | 63,783 | 8 | % | 64,934 | 8 | % |\n| Total other investments | $ | 847,262 | 100 | % | $ | 816,756 | 100 | % |\n\nThe $142 million decrease in the fair value of our total hedge funds in 2016 was driven by $138 million of net redemptions and $4 million of price depreciation.\nWe have made total commitments of $310 million to managers of direct lending funds, of which $121 million of our total commitment has been called to date.\nWe have also made a total commitment of $60 million as a limited partner in a multi-strategy hedge fund, of which $48 million has been called to date.\nWe have made a total commitment of $100 million to a real estate fund, of which $10 million has been called to date.\nDuring 2016, we made a total commitment of $135 million to a private equity fund, of which $95 million has been called to date.\nEquity Method Investments\nDuring 2016, we paid $104 million including direct transactions costs to acquire 18% of the common equity of Harrington, the parent company of Harrington Re, an independent reinsurance company jointly sponsored by AXIS Capital and Blackstone. Harrington is not a variable interest entity and given that we exercise significant influence over this investee we account for our ownership in Harrington under the equity method of accounting.\nThe Company also has investments in other equity method investments with a carrying value of $9 million.\n69\nLIQUIDITY AND CAPITAL RESOURCES\nRefer to the ‘Liquidity and Capital Resources’ section included under Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2015 for a general discussion of our liquidity and capital resources.\nThe following table summarizes our consolidated capital as at:\n| September 30, 2016 | December 31, 2015 |\n| Senior notes | $ | 992,633 | $ | 991,825 |\n| Preferred shares | 625,000 | 627,843 |\n| Common equity | 5,400,658 | 5,239,039 |\n| Shareholders’ equity | 6,025,658 | 5,866,882 |\n| Total capital | $ | 7,018,291 | $ | 6,858,707 |\n| Ratio of debt to total capital | 14.1 | % | 14.5 | % |\n| Ratio of debt and preferred equity to total capital | 23.0 | % | 23.6 | % |\n\nWe finance our operations with a combination of debt and equity capital. Our debt to total capital and debt and preferred equity to total capital ratios provide an indication of our capital structure, along with some insight into our financial strength. A company with higher ratios in comparison to industry average may show weak financial strength because the cost of its debts may adversely affect results of operations and/or increase its default risk. We believe that our financial flexibility remains strong.\nPreferred Shares\nOn January 27, 2016 we redeemed the remaining 28,430 Series B preferred shares, for an aggregate liquidation preference of\n$3 million.\n70\nCommon Equity\n| Nine months ended September 30, | 2016 |\n| Common equity - opening | $ | 5,239,039 |\n| Net income | 364,460 |\n| Shares repurchased for treasury | (449,086 | ) |\n| Change in unrealized appreciation on available for sale investments, net of tax | 281,276 |\n| Settlement of accelerated share repurchase | 60,000 |\n| Common share dividends | (98,334 | ) |\n| Preferred share dividends | (29,906 | ) |\n| Share-based compensation expense recognized in equity | 26,129 |\n| Foreign currency translation adjustment | 5,694 |\n| Cost of treasury shares reissued | 1,386 |\n| Common equity - closing | $ | 5,400,658 |\n\nDuring the nine months ended September 30, 2016, we repurchased 8.5 million common shares, including 7.1 million of common shares repurchased for a total of $389 million (including $375 million pursuant to our Board-authorized share repurchase program and $14 million relating to shares purchased in connection with the vesting of restricted stock awards granted under our 2007 Long-Term Equity Compensation Plan), and 1.4 million common shares acquired under the ASR which terminated on January 15, 2016. At October 27, 2016, the remaining authorization under the common share repurchase program approved by our Board of Directors was $375 million (refer to Part II, Item 2 'Unregistered Sales of Equity Securities and Use of Proceeds' for additional information).\nWe continue to expect that cash flows generated from our operations, combined with the liquidity provided by our investment portfolio, will be sufficient to cover our required cash outflows and other contractual commitments through the foreseeable future.\n71\nCRITICAL ACCOUNTING ESTIMATES\nOur Consolidated Financial Statements include certain amounts that are inherently uncertain and judgmental in nature. As a result, we are required to make assumptions and best estimates in order to determine the reported values. We consider an accounting estimate to be critical if: (1) it requires that significant assumptions be made in order to deal with uncertainties and (2) changes in the estimate could have a material impact on our results of operations, financial condition or liquidity.\nAs disclosed in our 2015 Annual Report on Form 10-K, we believe that the material items requiring such subjective and complex estimates are our:\n| • | reserves for losses and loss expenses; |\n\n| • | reinsurance recoverable balances; |\n\n| • | premiums; |\n\n| • | fair value measurements for our financial assets and liabilities; and |\n\n| • | assessments of other-than-temporary impairments. |\n\nWe believe that the critical accounting estimates discussion in Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2015, continues to describe the significant estimates and judgments included in the preparation of our Consolidated Financial Statements.\nNEW ACCOUNTING STANDARDS\nRefer to Item 1, Note 1 'Basis of Presentation and Accounting policies' to the Consolidated Financial Statements and Item 8, Note 2 'Significant Accounting Policies' to the Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2015, for a discussion of recently issued accounting pronouncements that we have not yet adopted.\nOFF-BALANCE SHEET AND SPECIAL PURPOSE ENTITY ARRANGEMENTS\nAt September 30, 2016, we have not entered into any off-balance sheet arrangements, as defined by Item 303(a)(4) of Regulation S-K.\nNON-GAAP FINANCIAL MEASURES\nIn this report, we present operating income, consolidated underwriting income, underwriting-related general and administrative expenses and amounts presented on a constant currency basis, which are “non-GAAP financial measures” as defined in Regulation G.\nOperating income represents after-tax operational results without consideration of after-tax net realized investment gains (losses), foreign exchange losses (gains), termination fee received and reorganization and related expenses. We also present diluted operating income per common share and operating return on average common equity (“operating ROACE”), which are derived from the non-GAAP operating income measure.\nConsolidated underwriting income is a pre-tax measure of underwriting profitability that takes into account net premiums earned and other insurance related income as revenues and net losses and loss expenses, acquisition costs and underwriting-related general and administrative costs as expenses. Underwriting-related general and administrative expenses include those general and administrative expenses that are incremental and/or directly attributable to our individual underwriting operations. While these measures are presented in Item 1, Note 2 to our Consolidated Financial Statements, they are considered non-GAAP financial measures when presented elsewhere on a consolidated basis.\nAmounts presented on a constant currency basis are calculated by applying the average foreign exchange rate from the current year to prior year amounts.\n72\nOperating income, diluted operating income per common share and operating ROACE can be reconciled to the nearest GAAP financial measures as follows:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Net income available to common shareholders | $ | 176,644 | $ | 247,620 | $ | 334,554 | $ | 466,772 |\n| Net realized investment (gains) losses, net of tax(1) | (2,726 | ) | 67,897 | 42,667 | 119,442 |\n| Foreign exchange gains, net of tax(2) | (13,229 | ) | (27,410 | ) | (67,771 | ) | (68,456 | ) |\n| Termination fee received(3) | — | (280,000 | ) | — | (280,000 | ) |\n| Reorganization and related expenses, net of tax(4) | — | 42,924 | — | 42,924 |\n| Operating income | $ | 160,689 | $ | 51,031 | $ | 309,450 | $ | 280,682 |\n| Earnings per common share - diluted | $ | 1.96 | $ | 2.50 | $ | 3.61 | $ | 4.65 |\n| Net realized investment (gains) losses, net of tax | (0.03 | ) | 0.68 | 0.46 | 1.19 |\n| Foreign exchange gains, net of tax | (0.15 | ) | (0.28 | ) | (0.73 | ) | (0.69 | ) |\n| Termination fee received | — | (2.82 | ) | — | (2.79 | ) |\n| Reorganization and related expenses, net of tax | — | 0.43 | — | 0.43 |\n| Operating income per common share - diluted | $ | 1.78 | $ | 0.51 | $ | 3.34 | $ | 2.79 |\n| Weighted average common shares and common share equivalents - diluted(5) | 90,351 | 99,124 | 92,579 | 100,468 |\n| Average common shareholders’ equity | $ | 5,369,921 | $ | 5,259,619 | $ | 5,319,849 | $ | 5,195,901 |\n| ROACE (annualized) | 13.2 | % | 18.8 | % | 8.4 | % | 12.0 | % |\n| Operating ROACE (annualized) | 12.0 | % | 3.9 | % | 7.8 | % | 7.2 | % |\n\n| (1) | Tax cost (benefit) of $2,479 and ($2,060) for the three months ended September 30, 2016 and 2015, respectively, and $2,372 and ($4,176) for the nine months ended September 30, 2016 and 2015, respectively. Tax impact is estimated by applying the statutory rates of applicable jurisdictions, after consideration of other relevant factors including the ability to utilize capital losses. |\n\n| (2) | Tax cost of $566 and $678 for the three months ended September 30, 2016 and 2015, respectively, and $2,010 and $744 for the nine months ended September 30, 2016 and 2015, respectively. Tax impact is estimated by applying the statutory rates of applicable jurisdictions, after consideration of other relevant factors including the tax status of specific foreign exchange transactions. |\n\n| (3) | Tax impact is nil. |\n\n| (4) | Tax benefit of nil and $2,943 for the three months ended September 30, 2016 and 2015, respectively, and nil and $2,943 for the nine months ended September 30, 2016 and 2015, respectively. Tax impact is estimated by applying the statutory rates of applicable jurisdictions, reflecting the jurisdictional apportionment and related tax treatment of the individual components of the reorganization and related expenses. |\n\n| (5) | Refer to Item 1, Note 8 to our Consolidated Financial Statements for further details on the dilution calculation. |\n\nA reconciliation of consolidated underwriting income to income before income taxes (the nearest GAAP financial measure) can be found in Item 1, Note 2 to the Consolidated Financial Statements. Underwriting-related general and administrative expenses are reconciled to general and administrative expenses (the nearest GAAP financial measure) within 'Underwriting Results - Group'.\nWe present our results of operations in the way we believe will be most meaningful and useful to investors, analysts, rating agencies and others who use our financial information to evaluate our performance. This includes the presentation of “operating income”, (in total and on a per share basis), “annualized operating ROACE” (which is based on the “operating income” measure) and “consolidated underwriting income”, which incorporates “underwriting-related general and administrative expenses”.\nOperating Income\nAlthough the investment of premiums to generate income and realized investment gains (losses) is an integral part of our operations, the determination to realize investment gains (losses) is independent of the underwriting process and is heavily influenced by the availability of market opportunities. Furthermore, many users believe that the timing of the realization of investment gains (losses) is somewhat opportunistic for many companies.\n73\nForeign exchange losses (gains) in our Consolidated Statements of Operations are primarily driven by the impact of foreign exchange rate movements on net insurance related-liabilities. However, this movement is only one element of the overall impact of foreign exchange rate fluctuations on our financial position. In addition, we recognize unrealized foreign exchange losses (gains) on our available-for-sale investments in other comprehensive income and foreign exchange losses (gains) realized upon the sale of these investments in net realized investments gains (losses). These unrealized and realized foreign exchange rate movements generally offset a large portion of the foreign exchange losses (gains) reported separately in earnings, thereby minimizing the impact of foreign exchange rate movements on total shareholders' equity. As such, the Statement of Operations foreign exchange losses (gains) in isolation are not a fair representation of the performance of our business.\nThe termination fee received represents the break-up fee paid by PartnerRe Ltd. following the cancellation of the amalgamation agreement with AXIS Capital and is not indicative of future revenues of the Company.\nReorganization and related expenses are primarily driven by business decisions, the nature and timing of which is unrelated to the underwriting process and which are not representative of underlying business performance.\nIn this regard, certain users of our financial statements evaluate earnings excluding after-tax net realized investment gains (losses) and foreign exchange losses (gains) to understand the profitability of recurring sources of income.\nWe believe that showing net income available to common shareholders exclusive of net realized gains (losses), foreign exchange losses (gains), termination fee received and reorganization and related expenses reflects the underlying fundamentals of our business. In addition, we believe that this presentation enables investors and other users of our financial information to analyze performance in a manner similar to how our management analyzes the underlying business performance. We also believe this measure follows industry practice and, therefore, facilitates comparison of our performance with our peer group. We believe that equity analysts and certain rating agencies that follow us, and the insurance industry as a whole, generally exclude these items from their analyses for the same reasons.\nConsolidated Underwriting Income/Underwriting-Related General and Administrative Expenses\nCorporate expenses include holding company costs necessary to support our worldwide insurance and reinsurance operations and costs associated with operating as a publicly-traded company. As these costs are not incremental and/or directly attributable to our individual underwriting operations, we exclude them from underwriting-related general and administrative expenses and, therefore, consolidated underwriting income. Interest expense and financing costs primarily relate to interest payable on our senior notes and are excluded from consolidated underwriting income for the same reason.\nWe evaluate our underwriting results separately from the performance of our investment portfolio. As such, we believe it appropriate to exclude net investment income and net realized investment gains (losses) from our underwriting profitability measure.\nAs noted above, foreign exchange losses (gains) in our Consolidated Statements of Operations primarily relate to our net insurance-related liabilities. However, we manage our investment portfolio in such a way that unrealized and realized foreign exchange rate losses (gains) on our investment portfolio generally offset a large portion of the foreign exchange losses (gains) arising from our underwriting portfolio. As a result, we believe that foreign exchange losses (gains) are not a meaningful contributor to our underwriting performance and, therefore, exclude them from consolidated underwriting income.\nThe termination fee received represents the break-up fee received on the cancellation of the amalgamation agreement between PartnerRe Ltd. and AXIS Capital and should be excluded from consolidated underwriting income since it is not related to underwriting operations.\nReorganization and related expenses are driven by business decisions, the nature and timing of which are unrelated to the underwriting process and for this reason they are excluded from consolidated underwriting income.\nWe believe that presentation of underwriting-related general and administrative expenses and consolidated underwriting income provides investors with an enhanced understanding of our results of operations, by highlighting the underlying pre-tax profitability of our underwriting activities.\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nRefer to Item 7A included in our 2015 Form 10-K. With the exception of the changes in exposure to foreign currency risk presented below, there have been no material changes to this item since December 31, 2015.\nForeign Currency Risk\nThe table below provides a sensitivity analysis of our total net foreign currency exposures.\n| AUD | NZD | CAD | EUR | GBP | JPY | Other | Total |\n| At September 30, 2016 |\n| Net managed assets (liabilities), excluding derivatives | $ | 85,933 | $ | (6,574 | ) | $ | 74,859 | $ | (159,487 | ) | $ | (59,745 | ) | $ | 21,593 | $ | 132,185 | $ | 88,764 |\n| Foreign currency derivatives, net | (79,700 | ) | 7,287 | (80,621 | ) | 204,334 | 5,836 | (26,126 | ) | 11,790 | 42,800 |\n| Net managed foreign currency exposure | 6,233 | 713 | (5,762 | ) | 44,847 | (53,909 | ) | (4,533 | ) | 143,975 | 131,564 |\n| Other net foreign currency exposure | 2,060 | — | — | 22,881 | 1,011 | — | 68,969 | 94,921 |\n| Total net foreign currency exposure | $ | 8,293 | $ | 713 | $ | (5,762 | ) | $ | 67,728 | $ | (52,898 | ) | $ | (4,533 | ) | $ | 212,944 | $ | 226,485 |\n| Net foreign currency exposure as a percentage of total shareholders’ equity | 0.1 | % | — | % | (0.1 | %) | 1.1 | % | (0.9 | %) | (0.1 | %) | 3.5 | % | 3.8 | % |\n| Pre-tax impact of net foreign currency exposure on shareholders’ equity given a hypothetical 10% rate movement(1) | $ | 829 | $ | 71 | $ | (576 | ) | $ | 6,773 | $ | (5,290 | ) | $ | (453 | ) | $ | 21,294 | $ | 22,648 |\n\n| (1) | Assumes 10% change in underlying currencies relative to the U.S. dollar. |\n\nTotal Net Foreign Currency Exposure\nAt September 30, 2016, our total net foreign currency exposure was $226 million net long, driven by increases in our exposures to the euro and other non-core currencies primarily due to new business written during the first nine months of 2016.\nITEM 4. CONTROLS AND PROCEDURES\nThe Company’s management has performed an evaluation, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the “Exchange Act”)) as of September 30, 2016. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of September 30, 2016, our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and is accumulated and communicated to\n74\nmanagement, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.\nThe Company’s management has performed an evaluation, with the participation of the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of changes in the Company’s internal control over financial reporting that occurred during the three months ended September 30, 2016. Based upon that evaluation, there were no changes in our internal control over financial reporting that occurred during the three months ended September 30, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\nPART II OTHER INFORMATION\n\nITEM 1. LEGAL PROCEEDINGS\nFrom time to time, we are subject to routine legal proceedings, including arbitrations, arising in the ordinary course of business. These legal proceedings generally relate to claims asserted by or against us in the ordinary course of insurance or reinsurance operations; estimated amounts payable under such proceedings are included in the reserve for losses and loss expenses in our Consolidated Balance Sheets.\nWe are not a party to any material legal proceedings arising outside the ordinary course of business.\nITEM 1A. RISK FACTORS\nThere were no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2015.\n75\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nThe following table presents information regarding the number of shares we repurchased during the three months ended September 30, 2016:\nISSUER PURCHASES OF EQUITY SECURITIES\nCommon Shares\n| Period | Total Numberof SharesPurchased | AveragePrice PaidPer Share | Total Number of SharesPurchased as Part ofPublicly AnnouncedPlans or Programs(1) | Maximum Number (or ApproximateDollar Value) of Shares That May Yet BePurchased Under the Announced Plansor Programs(2) |\n| July 1-31, 2016 | 127 | $55.45 | 108 | $494.0 million |\n| August 1-31, 2016 | 1,552 | $55.88 | 1,552 | $407.3 million |\n| September 1-30, 2016 | 572 | $56.36 | 571 | $375.1 million |\n| Total | 2,251 | 2,231 | $375.1 million |\n\n| (1) | From time to time, we purchase shares in connection with the vesting of restricted stock awards granted to our employees under our 2007 Long-Term Equity Compensation Plan. The purchase of these shares is separately authorized and is not part of our Board-authorized share repurchase program, described below. |\n\n| (2) | On December 7, 2015, our Board of Directors authorized a share repurchase plan to repurchase up to $750 million of our common shares through to December 31, 2016. The share repurchase authorization which became effective on December 31, 2015, replaced the previous plan which had $444 million available through the end of 2016. Share repurchases may be effected from time to time in the open market or privately negotiated transactions, depending on market conditions. |\n\nITEM 5. OTHER INFORMATION\nDisclosure of Certain Activities Under Section 13(r) of the Securities Exchange Act of 1934\nSection 13(r) of the Securities Exchange Act of 1934, as amended, requires issuers to disclose in their annual and quarterly reports whether they or any of their affiliates knowingly engaged in certain activities with Iran or with individuals or entities that are subject to certain sanctions under U.S. law. Issuers are required to provide this disclosure even where the activities, transactions or dealings are conducted outside of the United States in compliance with applicable law.\nAs and when allowed by the applicable law and regulations, certain of our non-U.S. subsidiaries provide treaty reinsurance coverage to non-U.S. insurers of marine, aviation and energy risks on a worldwide basis, and as a result, these underlying reinsurance portfolios may have some exposure to Iran. In addition, we underwrite insurance and facultative reinsurance on a global basis to non-U.S. insureds and reinsureds for marine, aviation and energy risks. Coverage provided to non-Iranian business may indirectly cover an exposure in Iran. For example, certain of our operations underwrite global marine hull and cargo policies that provide coverage for vessels navigating into and out of ports worldwide, including Iran. For the quarter ended September 30, 2016, no premium has been allocated or apportioned to activities relating to Iran. As we believe these activities are permitted under applicable laws and regulations, we intend for our non-U.S. subsidiaries to continue to provide such coverage to the extent permitted by applicable law.\n76\nITEM 6. EXHIBITS\n| 3.1 | Certificate of Incorporation and Memorandum of Association (incorporated by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-1(Amendment No. 1) (No. 333-103620) filed on April 16, 2003). |\n| 3.2 | Amended and Restated Bye-Laws (incorporated by reference to Exhibit 4.2 to the Company’s Registration Statement on Form S-8 filed on May 15, 2009). |\n| 4.1 | Specimen Common Share Certificate (incorporated by reference to Exhibit 4.1 to the Company’s Registration Statement on Form S-1 (Amendment No. 3) (No. 333-103620) filed on June 10, 2003). |\n| 4.2 | Certificate of Designations establishing the specific rights, preferences, limitations and other terms of the Series C Preferred Shares (incorporated by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K filed on March 19, 2012). |\n| 4.3 | Certificate of Designations establishing the specific rights, preferences, limitations and other terms of the Series D Preferred Shares (incorporated by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K filed on May 20, 2013). |\n| 10.1 | Amendment No. 1 to Employment Agreement dated June 23, 2014 by and between Peter W. Wilson and AXIS Specialty U.S. Services, Inc. effective September 21, 2016 (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed on September 27, 2016). |\n| †31.1 | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| †31.2 | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| †32.1 | Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| †32.2 | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| †101 | The following financial information from AXIS Capital Holdings Limited’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2016 formatted in XBRL: (i) Consolidated Balance Sheets at September 30, 2016 and December 31, 2015; (ii) Consolidated Statements of Operations for the three and nine months ended September 30, 2016 and 2015; (iii) Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2016 and 2015; (iv) Consolidated Statements of Changes in Shareholders' Equity for the nine months ended September 30, 2016 and 2015; (v) Consolidated Statements of Cash Flows for the nine months ended September 30, 2016 and 2015; and (vi) Notes to Consolidated Financial Statements, tagged as blocks of text and in detail. |\n\n| † | Filed herewith. |\n\nThe agreements and other documents filed as exhibits to this report are not intended to provide factual information or other disclosure other than with respect to the terms of the agreements or other documents themselves, and you should not rely on them for that purpose. In particular, any representations and warranties made by us in these agreements or other documents were made solely within the specific context of the relevant agreement or document and may not describe the actual state of affairs as of the date they were made or at any other time.\n77\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\nDated: October 27, 2016\n\n| AXIS CAPITAL HOLDINGS LIMITED |\n| By: | /S/ ALBERT BENCHIMOL |\n| Albert Benchimol |\n| President and Chief Executive Officer |\n| /S/ JOSEPH HENRY |\n| Joseph Henry |\n| Executive Vice President and Chief Financial Officer |\n| (Principal Financial Officer) |\n\n78\n \n\nWhat would the return on investment be if the net investment income from the third quarter was invested in acquiring new common shares (in percent)?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nPART I\\nFINANCIAL INFORMATION\\nThis quarterly report contains forward-looking statements within the meaning of the U.S. federal securities laws. We intend these forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in the United States securities laws. In some cases, these statements can be identified by the use of forward-looking words such as “may”, “should”, “could”, “anticipate”, “estimate”, “expect”, “plan”, “believe”, “predict”, “potential” and “intend”. Forward-looking statements contained in this report may include information regarding our estimates of losses related to catastrophes and other large losses, measurements of potential losses in the fair value of our investment portfolio and derivative contracts, our expectations regarding pricing and other market conditions, our growth prospects, and valuations of the potential impact of movements in interest rates, equity prices, credit spreads and foreign currency rates. Forward-looking statements only reflect our expectations and are not guarantees of performance.\\nThese statements involve risks, uncertainties and assumptions. Accordingly, there are or will be important factors that could cause actual results to differ materially from those indicated in such statements. We believe that these factors include, but are not limited to, the following:\\n| • | the occurrence and magnitude of natural and man-made disasters, |\\n\\n| • | actual claims exceeding our loss reserves, |\\n\\n| • | general economic, capital and credit market conditions, |\\n\\n| • | the failure of any of the loss limitation methods we employ, |\\n\\n| • | the effects of emerging claims, coverage and regulatory issues, including uncertainty related to coverage definitions, limits, terms and conditions, |\\n\\n| • | the failure of our cedants to adequately evaluate risks, |\\n\\n| • | inability to obtain additional capital on favorable terms, or at all, |\\n\\n| • | the loss of one or more key executives, |\\n\\n| • | a decline in our ratings with rating agencies, |\\n\\n| • | loss of business provided to us by our major brokers, |\\n\\n| • | changes in accounting policies or practices, |\\n\\n| • | the use of industry catastrophe models and changes to these models, |\\n\\n| • | changes in governmental regulations, |\\n\\n| • | increased competition, |\\n\\n| • | changes in the political environment of certain countries in which we operate or underwrite business including the United Kingdom’s expected withdrawal from the European Union, |\\n\\n| • | fluctuations in interest rates, credit spreads, equity prices and/or currency values, and |\\n\\n| • | the other matters set forth under Item 1A, ‘Risk Factors’ and Item 7, ‘Management’s Discussion and Analysis of Financial Condition and Results of Operations’ included in our Annual Report on Form 10-K for the year ended December 31, 2015. |\\n\\nWe undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.\\n3\\nITEM 1. CONSOLIDATED FINANCIAL STATEMENTS\\n\\n| Page |\\n| Consolidated Balance Sheets at September 30, 2016 (Unaudited) and December 31, 2015 | 5 |\\n| Consolidated Statements of Operations for the three and nine months ended September 30, 2016 and 2015 (Unaudited) | 6 |\\n| Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2016 and 2015 (Unaudited) | 7 |\\n| Consolidated Statements of Changes in Shareholders' Equity for the nine months ended September 30, 2016 and 2015 (Unaudited) | 8 |\\n| Consolidated Statements of Cash Flows for the nine months ended September 30, 2016 and 2015 (Unaudited) | 9 |\\n| Notes to Consolidated Financial Statements (Unaudited) | 10 |\\n| Note 1 - Basis of Presentation and Accounting Policies | 10 |\\n| Note 2 - Segment Information | 12 |\\n| Note 3 - Investments | 14 |\\n| Note 4 - Fair Value Measurements | 22 |\\n| Note 5 - Derivative Instruments | 32 |\\n| Note 6 - Reserve for Losses and Loss Expenses | 35 |\\n| Note 7 - Share-Based Compensation | 36 |\\n| Note 8 - Earnings Per Common Share | 38 |\\n| Note 9 - Shareholders' Equity | 39 |\\n| Note 10 - Commitments and Contingencies | 40 |\\n| Note 11 - Other Comprehensive Income (Loss) | 41 |\\n| Note 12 - Subsequent Event | 42 |\\n\\n4\\nAXIS CAPITAL HOLDINGS LIMITED\\nCONSOLIDATED BALANCE SHEETS\\nSEPTEMBER 30, 2016 (UNAUDITED) AND DECEMBER 31, 2015\\n\\n| 2016 | 2015 |\\n| (in thousands) |\\n| Assets |\\n| Investments: |\\n| Fixed maturities, available for sale, at fair value(Amortized cost 2016: $11,462,399; 2015: $11,897,639) | $ | 11,566,860 | $ | 11,719,749 |\\n| Equity securities, available for sale, at fair value(Cost 2016: $600,604; 2015: $575,776) | 644,344 | 597,998 |\\n| Mortgage loans, held for investment, at amortized cost and fair value | 332,753 | 206,277 |\\n| Other investments, at fair value | 847,262 | 816,756 |\\n| Equity method investments | 111,295 | 10,932 |\\n| Short-term investments, at amortized cost and fair value | 39,877 | 34,406 |\\n| Total investments | 13,542,391 | 13,386,118 |\\n| Cash and cash equivalents | 848,200 | 988,133 |\\n| Restricted cash and cash equivalents | 229,063 | 186,618 |\\n| Accrued interest receivable | 71,096 | 73,729 |\\n| Insurance and reinsurance premium balances receivable | 2,694,976 | 1,967,535 |\\n| Reinsurance recoverable on unpaid and paid losses | 2,336,741 | 2,096,104 |\\n| Deferred acquisition costs | 545,618 | 471,782 |\\n| Prepaid reinsurance premiums | 582,551 | 396,201 |\\n| Receivable for investments sold | 2,285 | 26,478 |\\n| Goodwill and intangible assets | 85,501 | 86,858 |\\n| Other assets | 283,969 | 302,335 |\\n| Total assets | $ | 21,222,391 | $ | 19,981,891 |\\n| Liabilities |\\n| Reserve for losses and loss expenses | $ | 9,874,807 | $ | 9,646,285 |\\n| Unearned premiums | 3,453,655 | 2,760,889 |\\n| Insurance and reinsurance balances payable | 461,519 | 356,417 |\\n| Senior notes | 992,633 | 991,825 |\\n| Payable for investments purchased | 141,245 | 9,356 |\\n| Other liabilities | 272,874 | 350,237 |\\n| Total liabilities | 15,196,733 | 14,115,009 |\\n| Shareholders’ equity |\\n| Preferred shares | 625,000 | 627,843 |\\n| Common shares (2016: 176,575; 2015: 176,240 shares issued and2016: 88,439; 2015: 96,066 shares outstanding) | 2,206 | 2,202 |\\n| Additional paid-in capital | 2,307,866 | 2,241,388 |\\n| Accumulated other comprehensive income (loss) | 98,505 | (188,465 | ) |\\n| Retained earnings | 6,430,573 | 6,194,353 |\\n| Treasury shares, at cost (2016: 88,136; 2015: 80,174 shares) | (3,438,492 | ) | (3,010,439 | ) |\\n| Total shareholders’ equity | 6,025,658 | 5,866,882 |\\n| Total liabilities and shareholders’ equity | $ | 21,222,391 | $ | 19,981,891 |\\n\\nSee accompanying notes to Consolidated Financial Statements.5\\nAXIS CAPITAL HOLDINGS LIMITED\\nCONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)\\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015\\n| Three months ended | Nine months ended |\\n| 2016 | 2015 | 2016 | 2015 |\\n| (in thousands, except for per share amounts) |\\n| Revenues |\\n| Net premiums earned | $ | 934,415 | $ | 919,341 | $ | 2,783,746 | $ | 2,764,605 |\\n| Net investment income | 116,923 | 45,685 | 257,818 | 226,336 |\\n| Other insurance related income | 5,944 | 1,158 | 4,850 | 12,319 |\\n| Termination fee received | — | 280,000 | — | 280,000 |\\n| Net realized investment gains (losses): |\\n| Other-than-temporary impairment (\\\"OTTI\\\") losses | (4,247 | ) | (32,301 | ) | (20,346 | ) | (62,762 | ) |\\n| Other realized investment gains (losses) | 9,452 | (37,656 | ) | (19,949 | ) | (60,856 | ) |\\n| Total net realized investment gains (losses) | 5,205 | (69,957 | ) | (40,295 | ) | (123,618 | ) |\\n| Total revenues | 1,062,487 | 1,176,227 | 3,006,119 | 3,159,642 |\\n| Expenses |\\n| Net losses and loss expenses | 532,328 | 560,387 | 1,663,584 | 1,652,868 |\\n| Acquisition costs | 189,810 | 182,744 | 559,570 | 537,549 |\\n| General and administrative expenses | 142,906 | 144,727 | 439,554 | 456,451 |\\n| Foreign exchange gains | (13,795 | ) | (28,088 | ) | (69,781 | ) | (69,200 | ) |\\n| Interest expense and financing costs | 12,839 | 12,918 | 38,586 | 38,114 |\\n| Reorganization and related expenses | — | 45,867 | — | 45,867 |\\n| Total expenses | 864,088 | 918,555 | 2,631,513 | 2,661,649 |\\n| Income before income taxes and interest in income (loss) of equity method investments | 198,399 | 257,672 | 374,606 | 497,993 |\\n| Income tax expense | 9,352 | 30 | 7,712 | 1,155 |\\n| Interest in loss of equity method investments | (2,434 | ) | — | (2,434 | ) | — |\\n| Net income | 186,613 | 257,642 | 364,460 | 496,838 |\\n| Preferred share dividends | 9,969 | 10,022 | 29,906 | 30,066 |\\n| Net income available to common shareholders | $ | 176,644 | $ | 247,620 | $ | 334,554 | $ | 466,772 |\\n| Per share data |\\n| Net income per common share: |\\n| Basic net income | $ | 1.97 | $ | 2.52 | $ | 3.64 | $ | 4.69 |\\n| Diluted net income | $ | 1.96 | $ | 2.50 | $ | 3.61 | $ | 4.65 |\\n| Weighted average number of common shares outstanding - basic | 89,621 | 98,226 | 91,852 | 99,464 |\\n| Weighted average number of common shares outstanding - diluted | 90,351 | 99,124 | 92,579 | 100,468 |\\n| Cash dividends declared per common share | $ | 0.35 | $ | 0.29 | $ | 1.05 | $ | 0.87 |\\n\\nSee accompanying notes to Consolidated Financial Statements.6\\nAXIS CAPITAL HOLDINGS LIMITED\\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)\\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015\\n| Three months ended | Nine months ended |\\n| 2016 | 2015 | 2016 | 2015 |\\n| (in thousands) |\\n| Net income | $ | 186,613 | $ | 257,642 | $ | 364,460 | $ | 496,838 |\\n| Other comprehensive income (loss), net of tax: |\\n| Available for sale investments: |\\n| Unrealized investment gains (losses) arising during the period | 36,336 | (99,711 | ) | 238,656 | (176,938 | ) |\\n| Adjustment for reclassification of net realized investment gains (losses) and OTTI losses recognized in net income | (2,642 | ) | 74,810 | 42,620 | 128,770 |\\n| Unrealized investment gains (losses) arising during the period, net of reclassification adjustment | 33,694 | (24,901 | ) | 281,276 | (48,168 | ) |\\n| Foreign currency translation adjustment | 1,722 | (14,626 | ) | 5,694 | (23,851 | ) |\\n| Total other comprehensive income (loss), net of tax | 35,416 | (39,527 | ) | 286,970 | (72,019 | ) |\\n| Comprehensive income | $ | 222,029 | $ | 218,115 | $ | 651,430 | $ | 424,819 |\\n\\nSee accompanying notes to Consolidated Financial Statements.7\\nAXIS CAPITAL HOLDINGS LIMITED\\nCONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (UNAUDITED)\\nFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015\\n| 2016 | 2015 |\\n| (in thousands) |\\n| Preferred shares |\\n| Balance at beginning of period | $ | 627,843 | $ | 627,843 |\\n| Shares repurchased | (2,843 | ) | — |\\n| Balance at end of period | 625,000 | 627,843 |\\n| Common shares (par value) |\\n| Balance at beginning of period | 2,202 | 2,191 |\\n| Shares issued | 4 | 11 |\\n| Balance at end of period | 2,206 | 2,202 |\\n| Additional paid-in capital |\\n| Balance at beginning of period | 2,241,388 | 2,285,016 |\\n| Shares issued - common shares | (4 | ) | 2,472 |\\n| Cost of treasury shares reissued | (19,647 | ) | (17,674 | ) |\\n| Settlement of accelerated share repurchase | 60,000 | (60,000 | ) |\\n| Stock options exercised | — | 558 |\\n| Share-based compensation expense | 26,129 | 19,906 |\\n| Balance at end of period | 2,307,866 | 2,230,278 |\\n| Accumulated other comprehensive income (loss) |\\n| Balance at beginning of period | (188,465 | ) | (45,574 | ) |\\n| Unrealized gains (losses) on available for sale investments, net of tax: |\\n| Balance at beginning of period | (149,585 | ) | (28,192 | ) |\\n| Unrealized gains (losses) arising during the period, net of reclassification adjustment | 281,276 | (48,168 | ) |\\n| Non-credit portion of OTTI losses | — | — |\\n| Balance at end of period | 131,691 | (76,360 | ) |\\n| Cumulative foreign currency translation adjustments, net of tax: |\\n| Balance at beginning of period | (38,880 | ) | (17,382 | ) |\\n| Foreign currency translation adjustments | 5,694 | (23,851 | ) |\\n| Balance at end of period | (33,186 | ) | (41,233 | ) |\\n| Balance at end of period | 98,505 | (117,593 | ) |\\n| Retained earnings |\\n| Balance at beginning of period | 6,194,353 | 5,715,504 |\\n| Net income | 364,460 | 496,838 |\\n| Preferred share dividends | (29,906 | ) | (30,066 | ) |\\n| Common share dividends | (98,334 | ) | (88,379 | ) |\\n| Balance at end of period | 6,430,573 | 6,093,897 |\\n| Treasury shares, at cost |\\n| Balance at beginning of period | (3,010,439 | ) | (2,763,859 | ) |\\n| Shares repurchased for treasury | (449,086 | ) | (264,076 | ) |\\n| Cost of treasury shares reissued | 21,033 | 17,674 |\\n| Balance at end of period | (3,438,492 | ) | (3,010,261 | ) |\\n| Total shareholders’ equity | $ | 6,025,658 | $ | 5,826,366 |\\n\\nSee accompanying notes to Consolidated Financial Statements.8\\nAXIS CAPITAL HOLDINGS LIMITED\\nCONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)\\nFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015\\n| 2016 | 2015 |\\n| (in thousands) |\\n| Cash flows from operating activities: |\\n| Net income | $ | 364,460 | $ | 496,838 |\\n| Adjustments to reconcile net income to net cash provided by operating activities: |\\n| Net realized investment losses | 40,295 | 123,618 |\\n| Net realized and unrealized gains on other investments | (23,117 | ) | (17,616 | ) |\\n| Amortization of fixed maturities | 51,660 | 75,645 |\\n| Interest in loss of equity method investments | 2,434 | — |\\n| Other amortization and depreciation | 17,370 | 26,219 |\\n| Share-based compensation expense, net of cash payments | 28,580 | 25,435 |\\n| Changes in: |\\n| Accrued interest receivable | 3,286 | 7,128 |\\n| Reinsurance recoverable balances | (163,212 | ) | (158,362 | ) |\\n| Deferred acquisition costs | (73,759 | ) | (77,348 | ) |\\n| Prepaid reinsurance premiums | (184,648 | ) | (69,016 | ) |\\n| Reserve for loss and loss expenses | 216,828 | 212,066 |\\n| Unearned premiums | 682,686 | 380,610 |\\n| Insurance and reinsurance balances, net | (623,170 | ) | (330,128 | ) |\\n| Other items | (74,383 | ) | 7,841 |\\n| Net cash provided by operating activities | 265,310 | 702,930 |\\n| Cash flows from investing activities: |\\n| Purchases of: |\\n| Fixed maturities | (6,624,573 | ) | (8,110,841 | ) |\\n| Equity securities | (295,827 | ) | (240,415 | ) |\\n| Mortgage loans | (131,087 | ) | (129,431 | ) |\\n| Other investments | (177,500 | ) | (61,591 | ) |\\n| Equity method investments | (103,548 | ) | — |\\n| Short-term investments | (81,479 | ) | (34,147 | ) |\\n| Proceeds from the sale of: |\\n| Fixed maturities | 6,067,663 | 6,797,585 |\\n| Equity securities | 296,182 | 112,794 |\\n| Other investments | 170,111 | 244,353 |\\n| Short-term investments | 67,408 | 112,694 |\\n| Proceeds from redemption of fixed maturities | 977,852 | 1,107,175 |\\n| Proceeds from redemption of short-term investments | 8,185 | 22,337 |\\n| Proceeds from the repayment of mortgage loans | 4,808 | — |\\n| Purchase of other assets | (19,055 | ) | (18,401 | ) |\\n| Change in restricted cash and cash equivalents | (42,445 | ) | 27,996 |\\n| Net cash provided by (used in) investing activities | 116,695 | (169,892 | ) |\\n| Cash flows from financing activities: |\\n| Repurchase of common shares | (389,086 | ) | (332,097 | ) |\\n| Dividends paid - common shares | (100,670 | ) | (89,611 | ) |\\n| Dividends paid - preferred shares | (29,940 | ) | (30,066 | ) |\\n| Repurchase of preferred shares | (2,843 | ) | — |\\n| Proceeds from issuance of common shares | 8 | 3,042 |\\n| Net cash used in financing activities | (522,531 | ) | (448,732 | ) |\\n| Effect of exchange rate changes on foreign currency cash and cash equivalents | 593 | (13,883 | ) |\\n| Increase (decrease) in cash and cash equivalents | (139,933 | ) | 70,423 |\\n| Cash and cash equivalents - beginning of period | 988,133 | 921,830 |\\n| Cash and cash equivalents - end of period | $ | 848,200 | $ | 992,253 |\\n\\nSupplemental disclosures of cash flow information: Total consideration paid for a quota share and adverse development reinsurance cover was $170 million of which $92 million was settled by transfer of securities and was treated as a non cash activity on the Consolidated Statement of Cash Flows.\\nSee accompanying notes to Consolidated Financial Statements.9\\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)\\n| 1. | BASIS OF PRESENTATION AND ACCOUNTING POLICIES |\\n\\nBasis of Presentation\\nThese interim consolidated financial statements include the accounts of AXIS Capital Holdings Limited (“AXIS Capital”) and its subsidiaries (herein referred to as “we,” “us,” “our,” or the “Company”).\\nThe consolidated balance sheet at September 30, 2016 and the consolidated statements of operations, comprehensive income, shareholders' equity and cash flows for the periods ended September 30, 2016 and 2015 have not been audited. The balance sheet at December 31, 2015 is derived from our audited financial statements.\\nThese financial statements have been prepared in accordance with U.S. Generally Accepted Accounting Principles (“U.S. GAAP”) for interim financial information and with the Securities and Exchange Commission's (“SEC”) instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. In the opinion of management, these financial statements reflect all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of our financial position and results of operations for the periods presented. The results of operations for any interim period are not necessarily indicative of the results for a full year. All inter-company accounts and transactions have been eliminated.\\nThe following information should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2015. Tabular dollar and share amounts are in thousands, except per share amounts. All amounts are reported in U.S. dollars. To facilitate comparison of information across periods, certain reclassifications have been made to prior year amounts to conform to the current year's presentation. These reclassifications did not impact our results of operations, financial condition or liquidity.\\nSignificant Accounting Policies\\nThere were no notable changes in our significant accounting policies subsequent to our Annual Report on Form 10-K for the year ended December 31, 2015, with the exception of the addition of accounting policies for equity method investments and retroactive accounting noted below.\\nEquity Method Investments\\nInvestments in which the Company has significant influence over the operating and financial policies of the investee are classified as equity method investments and are accounted for using the equity method of accounting. In applying the equity method of accounting, investments are initially recorded at cost and are subsequently adjusted based on the Company’s proportionate share of net income or loss of the investee. Adjustments are based on the most recently available financial information from the investee.Changes in the carrying value of such investments are recorded in net income as interest in income (loss) of equity method investments.\\nRetroactive Reinsurance\\nRetroactive reinsurance reimburses a ceding company for liabilities incurred as a result of past insurable events covered under contracts subject to the reinsurance. In certain instances, reinsurance contracts cover losses both on a prospective basis and on a retroactive basis and where practical the Company bifurcates the prospective and retrospective elements of these reinsurance contracts and accounts for each element separately. Initial gains in connection with retroactive reinsurance contracts are deferred and amortized into income over the settlement period while losses are recognized immediately. When changes in the estimated amount recoverable from the reinsurer or in the timing of receipts related to that amount occur, a cumulative amortization adjustment is recognized in earnings in the period of the change so that the deferred gain reflects the balance that would have existed had the revised estimate been available at the inception of the reinsurance transaction.\\nNew Accounting Standards Adopted in 2016\\nShare-Based Compensation\\nEffective January 1, 2016, the Company adopted the Accounting Standards Update (\\\"ASU\\\") 2014-12, \\\"Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could be Achieved after the Requisite Service Period\\\" issued by the Financial Accounting Standards Board (the \\\"FASB\\\"). This guidance requires that compensation costs be recognized in the period in which it becomes probable that the performance target will be achieved and to represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered. This guidance was issued to clarify treatment where there was a divergence in accounting practice and its adoption did not impact our results of operations, financial condition or liquidity.\\nDebt Issuance Costs\\nEffective January 1, 2016, the Company adopted ASU 2015-03, \\\"Simplifying the Presentation of Debt Issuance Costs\\\" issued by the FASB. This guidance requires the debt issuance costs related to a recognized debt liability to be presented in the balance sheet as a direct deduction from the debt liability rather than as an asset. This guidance was issued to simplify the presentation of debt issuance costs and to resolve conflicting guidance. This guidance did not impact our results of operations, financial condition or liquidity.\\nInvestments Measured Using The Net Asset Value Per Share (\\\"NAV\\\") Practical Expedient\\nEffective January 1, 2016, the Company adopted ASU 2015-07, \\\"Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or its Equivalent)\\\" issued by the FASB. This guidance eliminated the requirement to categorize investments measured using the net asset value (\\\"NAV\\\") practical expedient in the fair value hierarchy table. As this new guidance related solely to disclosures, the adoption did not impact our results of operations, financial condition or liquidity. The updated disclosures have been provided in Note 4 'Fair Value Measurements'.\\nRecently Issued Accounting Standards Not Yet Adopted\\nLeases\\nIn February 2016, the FASB issued guidance that provides a new comprehensive model for lease accounting. The guidance will require most leases to be recognized on the balance sheet by recording a right-of-use asset and a corresponding lease liability. This guidance is effective for reporting periods beginning after December 15, 2018, and interim periods within those fiscal years with early adoption permitted. The Company is currently evaluating the impact of this guidance on our results of operations, financial condition and liquidity.\\nTransition To Equity Method Of Accounting\\nIn March 2016, the FASB issued new guidance eliminating the requirement that an investor retrospectively apply equity method accounting when an existing investment qualifies for equity method accounting. The guidance is effective for annual periods beginning after December 15, 2016, and interim periods within those fiscal years with early adoption permitted. The guidance will be adopted on a prospective basis. The adoption of this guidance is not expected to materially impact our results of operations, financial condition or liquidity.\\nShare-Based Compensation Accounting\\nIn March 2016, the FASB issued new guidance that will change the accounting for certain aspects of share-based compensation payments to employees. The guidance will require all income tax effects of awards to be recognized in the income statement when the awards vest or are settled. The guidance will also allow employers to increase the amounts withheld to cover income taxes on\\n10\\n| 1. | BASIS OF PRESENTATION AND ACCOUNTING POLICIES (CONTINUED) |\\n\\nshare-based compensation awards without requiring liability classification. Additionally, companies will be required to elect whether they will account for award forfeitures by recognizing forfeitures only as they occur or by estimating the number of awards expected to be forfeited. This guidance is effective for annual periods beginning after December 15, 2016, and interim periods within those fiscal years with early adoption permitted. The Company is currently evaluating the impact of this guidance on our results of operations, financial condition and liquidity.\\nCredit Losses\\nIn June 2016, the FASB issued a new credit loss standard that changes the impairment model for most financial assets and certain other instruments. The guidance will replace the current \\\"incurred loss\\\" approach with a more forward looking \\\"expected loss\\\" model for instruments measured at amortized cost and will require entities to record allowances for available-for-sale debt securities rather than reduce the carrying amount. This guidance is effective for annual periods beginning after December 15, 2019, and interim periods within those fiscal years. Early adoption is permitted for annual periods beginning after December 15, 2018, and interim periods within those fiscal years. The Company is currently evaluating the impact of this guidance on our results of operations, financial condition and liquidity.\\nCash Flows\\nIn August 2016, the FASB issued new guidance to clarify how certain cash receipts and cash payments should be classified on the statement of cash flows. This guidance is effective for annual periods beginning after December 15, 2017, and interim periods within those fiscal years with early adoption permitted. The adoption of this guidance is not expected to impact our results of operations, financial condition or liquidity.\\n11\\n| 2. | SEGMENT INFORMATION |\\n\\nOur underwriting operations are organized around our global underwriting platforms, AXIS Insurance and AXIS Re. Therefore we have determined that we have two reportable segments, insurance and reinsurance. We do not allocate our assets by segment, with the exception of goodwill and intangible assets, as we evaluate the underwriting results of each segment separately from the results of our investment portfolio.\\nThe following tables summarize the underwriting results of our reportable segments, as well as the carrying values of allocated goodwill and intangible assets:\\n| 2016 | 2015 |\\n| Three months ended and at September 30, | Insurance | Reinsurance | Total | Insurance | Reinsurance | Total |\\n| Gross premiums written | $ | 675,430 | $ | 284,532 | $ | 959,962 | $ | 606,704 | $ | 329,879 | $ | 936,583 |\\n| Net premiums written | 433,131 | 162,300 | 595,431 | 381,118 | 296,099 | 677,217 |\\n| Net premiums earned | 444,691 | 489,724 | 934,415 | 444,550 | 474,791 | 919,341 |\\n| Other insurance related income | 39 | 5,905 | 5,944 | 542 | 616 | 1,158 |\\n| Net losses and loss expenses | (273,226 | ) | (259,102 | ) | (532,328 | ) | (283,272 | ) | (277,115 | ) | (560,387 | ) |\\n| Acquisition costs | (61,755 | ) | (128,055 | ) | (189,810 | ) | (69,118 | ) | (113,626 | ) | (182,744 | ) |\\n| General and administrative expenses | (84,588 | ) | (29,635 | ) | (114,223 | ) | (85,814 | ) | (35,309 | ) | (121,123 | ) |\\n| Underwriting income | $ | 25,161 | $ | 78,837 | 103,998 | $ | 6,888 | $ | 49,357 | 56,245 |\\n| Corporate expenses | (28,683 | ) | (23,604 | ) |\\n| Net investment income | 116,923 | 45,685 |\\n| Net realized investment gains (losses) | 5,205 | (69,957 | ) |\\n| Foreign exchange gains | 13,795 | 28,088 |\\n| Interest expense and financing costs | (12,839 | ) | (12,918 | ) |\\n| Termination fee received | — | 280,000 |\\n| Reorganization and related expenses | — | (45,867 | ) |\\n| Income before income taxes and interest in income (loss) of equity method investments | $ | 198,399 | $ | 257,672 |\\n| Net loss and loss expense ratio | 61.4 | % | 52.9 | % | 57.0 | % | 63.7 | % | 58.4 | % | 61.0 | % |\\n| Acquisition cost ratio | 13.9 | % | 26.1 | % | 20.3 | % | 15.5 | % | 23.9 | % | 19.9 | % |\\n| General and administrative expense ratio | 19.1 | % | 6.1 | % | 15.3 | % | 19.4 | % | 7.4 | % | 15.7 | % |\\n| Combined ratio | 94.4 | % | 85.1 | % | 92.6 | % | 98.6 | % | 89.7 | % | 96.6 | % |\\n| Goodwill and intangible assets | $ | 85,501 | $ | — | $ | 85,501 | $ | 87,329 | $ | — | $ | 87,329 |\\n\\n12\\n| 2. | SEGMENT INFORMATION (CONTINUED) |\\n\\n| 2016 | 2015 |\\n| Nine months ended and at September 30, | Insurance | Reinsurance | Total | Insurance | Reinsurance | Total |\\n| Gross premiums written | $ | 2,112,796 | $ | 2,126,762 | $ | 4,239,558 | $ | 1,970,554 | $ | 1,833,374 | $ | 3,803,928 |\\n| Net premiums written | 1,433,058 | 1,855,529 | 3,288,587 | 1,352,122 | 1,727,185 | 3,079,307 |\\n| Net premiums earned | 1,322,649 | 1,461,097 | 2,783,746 | 1,344,339 | 1,420,266 | 2,764,605 |\\n| Other insurance related income (loss) | (57 | ) | 4,907 | 4,850 | 811 | 11,508 | 12,319 |\\n| Net losses and loss expenses | (853,771 | ) | (809,813 | ) | (1,663,584 | ) | (866,580 | ) | (786,288 | ) | (1,652,868 | ) |\\n| Acquisition costs | (184,982 | ) | (374,588 | ) | (559,570 | ) | (200,493 | ) | (337,056 | ) | (537,549 | ) |\\n| General and administrative expenses | (252,652 | ) | (99,980 | ) | (352,632 | ) | (261,924 | ) | (110,701 | ) | (372,625 | ) |\\n| Underwriting income | $ | 31,187 | $ | 181,623 | 212,810 | $ | 16,153 | $ | 197,729 | 213,882 |\\n| Corporate expenses | (86,922 | ) | (83,826 | ) |\\n| Net investment income | 257,818 | 226,336 |\\n| Net realized investment losses | (40,295 | ) | (123,618 | ) |\\n| Foreign exchange gains | 69,781 | 69,200 |\\n| Interest expense and financing costs | (38,586 | ) | (38,114 | ) |\\n| Termination fee received | — | 280,000 |\\n| Reorganization and related expenses | — | (45,867 | ) |\\n| Income before income taxes and interest in income (loss) of equity method investments | $ | 374,606 | $ | 497,993 |\\n| Net loss and loss expense ratio | 64.6 | % | 55.4 | % | 59.8 | % | 64.5 | % | 55.4 | % | 59.8 | % |\\n| Acquisition cost ratio | 14.0 | % | 25.6 | % | 20.1 | % | 14.9 | % | 23.7 | % | 19.4 | % |\\n| General and administrative expense ratio | 19.0 | % | 6.9 | % | 15.8 | % | 19.5 | % | 7.8 | % | 16.5 | % |\\n| Combined ratio | 97.6 | % | 87.9 | % | 95.7 | % | 98.9 | % | 86.9 | % | 95.7 | % |\\n| Goodwill and intangible assets | $ | 85,501 | $ | — | $ | 85,501 | $ | 87,329 | $ | — | $ | 87,329 |\\n\\n13\\n| 3. | INVESTMENTS |\\n\\na) Fixed Maturities and Equities\\nThe amortized cost or cost and fair values of our fixed maturities and equities were as follows:\\n| AmortizedCost orCost | GrossUnrealizedGains | GrossUnrealizedLosses | FairValue | Non-creditOTTIin AOCI(5) |\\n| At September 30, 2016 |\\n| Fixed maturities |\\n| U.S. government and agency | $ | 1,542,943 | $ | 22,349 | $ | (2,415 | ) | $ | 1,562,877 | $ | — |\\n| Non-U.S. government | 620,601 | 4,799 | (43,344 | ) | 582,056 | — |\\n| Corporate debt | 4,516,290 | 87,184 | (34,974 | ) | 4,568,500 | — |\\n| Agency RMBS(1) | 2,473,832 | 49,661 | (762 | ) | 2,522,731 | — |\\n| CMBS(2) | 877,732 | 18,546 | (2,003 | ) | 894,275 | — |\\n| Non-Agency RMBS | 71,842 | 1,636 | (1,648 | ) | 71,830 | (870 | ) |\\n| ABS(3) | 1,234,292 | 4,028 | (2,724 | ) | 1,235,596 | — |\\n| Municipals(4) | 124,867 | 4,215 | (87 | ) | 128,995 | — |\\n| Total fixed maturities | $ | 11,462,399 | $ | 192,418 | $ | (87,957 | ) | $ | 11,566,860 | $ | (870 | ) |\\n| Equity securities |\\n| Common stocks | $ | 379 | $ | 38 | $ | (348 | ) | $ | 69 |\\n| Exchange-traded funds | 463,655 | 41,611 | (1,060 | ) | 504,206 |\\n| Bond mutual funds | 136,570 | 3,499 | — | 140,069 |\\n| Total equity securities | $ | 600,604 | $ | 45,148 | $ | (1,408 | ) | $ | 644,344 |\\n| At December 31, 2015 |\\n| Fixed maturities |\\n| U.S. government and agency | $ | 1,673,617 | $ | 1,545 | $ | (23,213 | ) | $ | 1,651,949 | $ | — |\\n| Non-U.S. government | 809,025 | 2,312 | (72,332 | ) | 739,005 | — |\\n| Corporate debt | 4,442,315 | 16,740 | (96,286 | ) | 4,362,769 | — |\\n| Agency RMBS(1) | 2,236,138 | 22,773 | (9,675 | ) | 2,249,236 | — |\\n| CMBS(2) | 1,088,595 | 3,885 | (9,182 | ) | 1,083,298 | — |\\n| Non-Agency RMBS | 99,989 | 1,992 | (973 | ) | 101,008 | (875 | ) |\\n| ABS(3) | 1,387,919 | 952 | (17,601 | ) | 1,371,270 | — |\\n| Municipals(4) | 160,041 | 2,319 | (1,146 | ) | 161,214 | — |\\n| Total fixed maturities | $ | 11,897,639 | $ | 52,518 | $ | (230,408 | ) | $ | 11,719,749 | $ | (875 | ) |\\n| Equity securities |\\n| Common stocks | $ | — | $ | — | $ | — | $ | — |\\n| Exchange-traded funds | 447,524 | 31,211 | (4,762 | ) | 473,973 |\\n| Bond mutual funds | 128,252 | — | (4,227 | ) | 124,025 |\\n| Total equity securities | $ | 575,776 | $ | 31,211 | $ | (8,989 | ) | $ | 597,998 |\\n\\n| (1) | Residential mortgage-backed securities (RMBS) originated by U.S. agencies. |\\n\\n| (2) | Commercial mortgage-backed securities (CMBS). |\\n\\n| (3) | Asset-backed securities (ABS) include debt tranched securities collateralized primarily by auto loans, student loans, credit cards, and other asset types. This asset class also includes collateralized loan obligations (CLOs) and collateralized debt obligations (CDOs). |\\n\\n| (4) | Municipals include bonds issued by states, municipalities and political subdivisions. |\\n\\n| (5) | Represents the non-credit component of the other-than-temporary impairment (OTTI) losses, adjusted for subsequent sales, maturities and redemptions. It does not include the change in fair value subsequent to the impairment measurement date. |\\n\\n14\\n| 3. | INVESTMENTS (CONTINUED) |\\n\\nIn the normal course of investing activities, we actively manage allocations to non-controlling tranches of structured securities (variable interests) issued by VIEs. These structured securities include RMBS, CMBS and ABS and are included in the above table. Additionally, within our other investments portfolio, we also invest in limited partnerships (hedge funds, direct lending funds, real estate funds and private equity funds) and CLO equity tranched securities, which are all variable interests issued by VIEs (see Note 3(c)). For these variable interests, we do not have the power to direct the activities that are most significant to the economic performance of the VIEs therefore we are not the primary beneficiary of any of these VIEs. Our maximum exposure to loss on these interests is limited to the amount of our investment. We have not provided financial or other support with respect to these structured securities other than our original investment.\\nContractual Maturities\\nThe contractual maturities of fixed maturities are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.\\n| AmortizedCost | FairValue | % of TotalFair Value |\\n| At September 30, 2016 |\\n| Maturity |\\n| Due in one year or less | $ | 363,821 | $ | 356,706 | 3.0 | % |\\n| Due after one year through five years | 3,809,515 | 3,801,104 | 32.9 | % |\\n| Due after five years through ten years | 2,286,970 | 2,330,895 | 20.2 | % |\\n| Due after ten years | 344,395 | 353,723 | 3.1 | % |\\n| 6,804,701 | 6,842,428 | 59.2 | % |\\n| Agency RMBS | 2,473,832 | 2,522,731 | 21.8 | % |\\n| CMBS | 877,732 | 894,275 | 7.7 | % |\\n| Non-Agency RMBS | 71,842 | 71,830 | 0.6 | % |\\n| ABS | 1,234,292 | 1,235,596 | 10.7 | % |\\n| Total | $ | 11,462,399 | $ | 11,566,860 | 100.0 | % |\\n| At December 31, 2015 |\\n| Maturity |\\n| Due in one year or less | $ | 291,368 | $ | 289,571 | 2.5 | % |\\n| Due after one year through five years | 4,217,515 | 4,142,802 | 35.3 | % |\\n| Due after five years through ten years | 2,263,684 | 2,181,525 | 18.6 | % |\\n| Due after ten years | 312,431 | 301,039 | 2.6 | % |\\n| 7,084,998 | 6,914,937 | 59.0 | % |\\n| Agency RMBS | 2,236,138 | 2,249,236 | 19.2 | % |\\n| CMBS | 1,088,595 | 1,083,298 | 9.2 | % |\\n| Non-Agency RMBS | 99,989 | 101,008 | 0.9 | % |\\n| ABS | 1,387,919 | 1,371,270 | 11.7 | % |\\n| Total | $ | 11,897,639 | $ | 11,719,749 | 100.0 | % |\\n\\n15\\n| 3. | INVESTMENTS (CONTINUED) |\\n\\nGross Unrealized Losses\\nThe following table summarizes fixed maturities and equities in an unrealized loss position and the aggregate fair value and gross unrealized loss by length of time the security has continuously been in an unrealized loss position:\\n| 12 months or greater | Less than 12 months | Total |\\n| FairValue | UnrealizedLosses | FairValue | UnrealizedLosses | FairValue | UnrealizedLosses |\\n| At September 30, 2016 |\\n| Fixed maturities |\\n| U.S. government and agency | $ | 55,000 | $ | (1,635 | ) | $ | 422,681 | $ | (780 | ) | $ | 477,681 | $ | (2,415 | ) |\\n| Non-U.S. government | 104,441 | (24,061 | ) | 254,694 | (19,283 | ) | 359,135 | (43,344 | ) |\\n| Corporate debt | 285,848 | (26,202 | ) | 639,722 | (8,772 | ) | 925,570 | (34,974 | ) |\\n| Agency RMBS | 80,375 | (556 | ) | 121,203 | (206 | ) | 201,578 | (762 | ) |\\n| CMBS | 99,004 | (1,260 | ) | 173,795 | (743 | ) | 272,799 | (2,003 | ) |\\n| Non-Agency RMBS | 10,184 | (1,306 | ) | 5,187 | (342 | ) | 15,371 | (1,648 | ) |\\n| ABS | 518,647 | (2,253 | ) | 50,402 | (471 | ) | 569,049 | (2,724 | ) |\\n| Municipals | 2,384 | (18 | ) | 15,567 | (69 | ) | 17,951 | (87 | ) |\\n| Total fixed maturities | $ | 1,155,883 | $ | (57,291 | ) | $ | 1,683,251 | $ | (30,666 | ) | $ | 2,839,134 | $ | (87,957 | ) |\\n| Equity securities |\\n| Common stocks | $ | — | $ | — | $ | 31 | $ | (348 | ) | $ | 31 | $ | (348 | ) |\\n| Exchange-traded funds | 6,153 | (425 | ) | 39,097 | (635 | ) | 45,250 | (1,060 | ) |\\n| Bond mutual funds | — | — | — | — | — | — |\\n| Total equity securities | $ | 6,153 | $ | (425 | ) | $ | 39,128 | $ | (983 | ) | $ | 45,281 | $ | (1,408 | ) |\\n| At December 31, 2015 |\\n| Fixed maturities |\\n| U.S. government and agency | $ | 84,179 | $ | (7,622 | ) | $ | 1,474,202 | $ | (15,591 | ) | $ | 1,558,381 | $ | (23,213 | ) |\\n| Non-U.S. government | 170,269 | (50,841 | ) | 317,693 | (21,491 | ) | 487,962 | (72,332 | ) |\\n| Corporate debt | 340,831 | (33,441 | ) | 2,845,375 | (62,845 | ) | 3,186,206 | (96,286 | ) |\\n| Agency RMBS | 64,792 | (1,609 | ) | 1,073,566 | (8,066 | ) | 1,138,358 | (9,675 | ) |\\n| CMBS | 75,627 | (1,579 | ) | 659,480 | (7,603 | ) | 735,107 | (9,182 | ) |\\n| Non-Agency RMBS | 5,283 | (210 | ) | 43,199 | (763 | ) | 48,482 | (973 | ) |\\n| ABS | 562,599 | (11,158 | ) | 667,448 | (6,443 | ) | 1,230,047 | (17,601 | ) |\\n| Municipals | 14,214 | (310 | ) | 64,104 | (836 | ) | 78,318 | (1,146 | ) |\\n| Total fixed maturities | $ | 1,317,794 | $ | (106,770 | ) | $ | 7,145,067 | $ | (123,638 | ) | $ | 8,462,861 | $ | (230,408 | ) |\\n| Equity securities |\\n| Common stocks | $ | — | $ | — | $ | — | $ | — | $ | — | $ | — |\\n| Exchange-traded funds | 2,331 | (313 | ) | 110,972 | (4,449 | ) | 113,303 | (4,762 | ) |\\n| Bond mutual funds | — | — | 124,025 | (4,227 | ) | 124,025 | (4,227 | ) |\\n| Total equity securities | $ | 2,331 | $ | (313 | ) | $ | 234,997 | $ | (8,676 | ) | $ | 237,328 | $ | (8,989 | ) |\\n\\n16\\n| 3. | INVESTMENTS (CONTINUED) |\\n\\nFixed Maturities\\nAt September 30, 2016, 935 fixed maturities (2015: 2,314) were in an unrealized loss position of $88 million (2015: $230 million), of which $13 million (2015: $39 million) was related to securities below investment grade or not rated.\\nAt September 30, 2016, 399 (2015: 383) securities had been in a continuous unrealized loss position for 12 months or greater and had a fair value of $1,156 million (2015: $1,318 million). Following our credit impairment review, we concluded that these securities as well as the remaining securities in an unrealized loss position in the above table were temporarily impaired at September 30, 2016, and were expected to recover in value as the securities approach maturity. Further, at September 30, 2016, we did not intend to sell these securities in an unrealized loss position and it is more likely than not that we will not be required to sell these securities before the anticipated recovery of their amortized costs.\\nEquity Securities\\nAt September 30, 2016, 20 securities (2015: 35) were in an unrealized loss position of $1 million (2015: $9 million).\\nAt September 30, 2016, 5 securities (2015: 1) were in a continuous unrealized loss position for 12 months or greater. Based on our impairment review process and our ability and intent to hold these securities for a reasonable period of time sufficient for a full recovery, we concluded that the above equities in an unrealized loss position were temporarily impaired at September 30, 2016.\\nb) Mortgage Loans\\n| September 30, 2016 | December 31, 2015 |\\n| Carrying Value | % of Total | Carrying Value | % of Total |\\n| Mortgage Loans held-for-investment: |\\n| Commercial | $ | 332,753 | 100 | % | $ | 206,277 | 100 | % |\\n| 332,753 | 100 | % | 206,277 | 100 | % |\\n| Valuation allowances | — | — | % | — | — | % |\\n| Total Mortgage Loans held-for-investment | $ | 332,753 | 100 | % | $ | 206,277 | 100 | % |\\n\\nFor commercial mortgage loans, the primary credit quality indicator is the debt service coverage ratio (which compares a property’s net operating income to amounts needed to service the principal and interest due under the loan, generally, the lower the debt service coverage ratio, the higher the risk of experiencing a credit loss) and the loan-to-value ratio (loan-to-value ratios compare the unpaid principal balance of the loan to the estimated fair value of the underlying collateral, generally, the higher the loan-to-value ratio, the higher the risk of experiencing a credit loss). The debt service coverage ratio and loan-to-value ratio, as well as the values utilized in calculating these ratios, are updated annually, on a rolling basis.\\nWe have a high quality mortgage portfolio with debt service coverage ratios in excess of 1.1x and loan-to-value ratios of less than 70%; there are no credit losses associated with the commercial mortgage loans that we hold at September 30, 2016.\\nThere are no past due amounts at September 30, 2016.\\n17\\n| 3. | INVESTMENTS (CONTINUED) |\\n\\nc) Other Investments\\nThe following table provides a breakdown of our investments in hedge funds, direct lending funds, private equity funds, real estate funds, CLO Equities and other privately held investments, together with additional information relating to the liquidity of each category:\\n| Fair Value | Redemption Frequency(if currently eligible) | Redemption Notice Period |\\n| At September 30, 2016 |\\n| Long/short equity funds | $ | 139,460 | 16 | % | Quarterly, Semi-annually, Annually | 45-60 days |\\n| Multi-strategy funds | 281,153 | 33 | % | Quarterly, Semi-annually | 60-95 days |\\n| Event-driven funds | 94,012 | 11 | % | Quarterly, Annually | 45-60 days |\\n| Leveraged bank loan funds | — | — | % | n/a | n/a |\\n| Direct lending funds | 125,002 | 15 | % | n/a | n/a |\\n| Private equity funds | 89,170 | 11 | % | n/a | n/a |\\n| Real estate funds | 11,782 | 1 | % | n/a | n/a |\\n| CLO - Equities | 63,783 | 8 | % | n/a | n/a |\\n| Other privately held investments | 42,900 | 5 | % | n/a | n/a |\\n| Total other investments | $ | 847,262 | 100 | % |\\n| At December 31, 2015 |\\n| Long/short equity funds | $ | 154,348 | 19 | % | Quarterly, Semi-annually, Annually | 45-60 days |\\n| Multi-strategy funds | 355,073 | 43 | % | Quarterly, Semi-annually | 60-95 days |\\n| Event-driven funds | 147,287 | 18 | % | Quarterly, Annually | 45-60 days |\\n| Leveraged bank loan funds | 65 | — | % | n/a | n/a |\\n| Direct lending funds | 90,120 | 11 | % | n/a | n/a |\\n| Private equity funds | — | — | % | n/a | n/a |\\n| Real estate funds | 4,929 | 1 | % | n/a | n/a |\\n| CLO - Equities | 64,934 | 8 | % | n/a | n/a |\\n| Other privately held investments | — | — | % | n/a | n/a |\\n| Total other investments | $ | 816,756 | 100 | % |\\n\\nn/a - not applicable\\nThe investment strategies for the above funds are as follows:\\n| • | Long/short equity funds: Seek to achieve attractive returns primarily by executing an equity trading strategy involving both long and short investments in publicly-traded equities. |\\n\\n| • | Multi-strategy funds: Seek to achieve above-market returns by pursuing multiple investment strategies to diversify risks and reduce volatility. This category includes funds of hedge funds which invest in a large pool of hedge funds across a diversified range of hedge fund strategies. |\\n\\n| • | Event-driven funds: Seek to achieve attractive returns by exploiting situations where announced or anticipated events create opportunities. |\\n\\n| • | Leveraged bank loan funds: Seek to achieve attractive returns by investing primarily in bank loan collateral that has limited interest rate risk exposure. |\\n\\n18\\n| 3. | INVESTMENTS (CONTINUED) |\\n\\n| • | Direct lending funds: Seek to achieve attractive risk-adjusted returns, including current income generation, by investing in funds which provide financing directly to borrowers. |\\n\\n| • | Real estate funds: Seek to achieve attractive risk-adjusted returns by making and managing investments in real estate and real estate securities and businesses. |\\n\\n| • | Private equity funds: Seek to achieve attractive risk-adjusted returns by investing in private transactions over the course of several years. |\\n\\nTwo common redemption restrictions which may impact our ability to redeem our hedge funds are gates and lockups. A gate is a suspension of redemptions which may be implemented by the general partner or investment manager of the fund in order to defer, in whole or in part, the redemption request in the event the aggregate amount of redemption requests exceeds a predetermined percentage of the fund's net assets which may otherwise hinder the general partner or investment manager's ability to liquidate holdings in an orderly fashion in order to generate the cash necessary to fund extraordinarily large redemption payouts. A lockup period is the initial amount of time an investor is contractually required to hold the security before having the ability to redeem. During 2016 and 2015, neither of these restrictions impacted our redemption requests. At September 30, 2016, $87 million (2015: $66 million), representing 17% (2015: 10%) of our total hedge funds, relate to holdings where we are still within the lockup period. The expiration of these lockup periods range from September 2016 to March 2019.\\nAt September 30, 2016, we have $189 million (2015: $222 million) of unfunded commitments within our other investments portfolio relating to our future investments in direct lending funds. Once the full amount of committed capital has been called by the General Partner of each of these funds, the assets will not be fully returned until the completion of the fund's investment term. These funds have investment terms ranging from 5-10 years and the General Partners of certain funds have the option to extend the term by up to three years.\\nAt September 30, 2016, we have $12 million (2015: $12 million) of unfunded commitments as a limited partner in a multi-strategy hedge fund. Once the full amount of committed capital has been called by the General Partner, the assets will not be fully returned until the completion of the fund's investment term which ends in March, 2019. The General Partner then has the option to extend the term by up to three years.\\nAt September 30, 2016, we have $90 million (2015: $95 million) of unfunded commitments as a limited partner in a fund which invests in real estate and real estate securities and businesses. The fund is subject to a three year commitment period and a total fund life of eight years during which time we are not eligible to redeem our investment.\\nDuring 2016, we made a $135 million commitment as a limited partner in a private equity fund. At September 30, 2016, $40 million of our commitment remains unfunded and the current fair value of the funds called to date are included in the private equity funds line of the table above. The fund invests in underlying private equity funds and the life of the fund is subject to the dissolution of the underlying funds. We expect the overall holding period to be over ten years.\\nDuring 2015, we made a $50 million commitment as a limited partner of a bank revolver opportunity fund. The fund is subject to an investment term of seven years and the General Partners have the option to extend the term by up to two years. At September 30, 2016, this commitment remains unfunded. It is not anticipated that the full amount of this fund will be drawn.\\n19\\n| 3. | INVESTMENTS (CONTINUED) |\\n\\nd) Equity Method Investments\\nDuring 2016, we paid $104 million including direct transaction costs to acquire 18% of the common equity of Harrington Reinsurance Holdings Limited (\\\"Harrington\\\"), the parent company of Harrington Re Ltd. (\\\"Harrington Re\\\"), an independent reinsurance company jointly sponsored by AXIS Capital and The Blackstone Group L.P. (\\\"Blackstone\\\"). Through long-term service agreements, AXIS Capital will serve as Harrington Re's reinsurance underwriting manager and Blackstone will serve as exclusive investment management service provider. As an investor, we expect to benefit from underwriting profit generated by Harrington Re and the income and capital appreciation Blackstone seeks to deliver through its investment management services. In addition, we have entered into an arrangement with Blackstone under which underwriting and investment related fees will be shared equally. Harrington is not a variable interest entity and given that we exercise significant influence over this investee we account for our ownership in Harrington under the equity method of accounting. The Company's proportionate share of the underlying equity in net assets resulted in a basis difference of $5 million which represents initial transactions costs.\\nThe Company also has investments in other equity method investments with a carrying value of $9 million.\\ne) Net Investment Income\\nNet investment income was derived from the following sources:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Fixed maturities | $ | 75,827 | $ | 75,980 | $ | 229,423 | $ | 220,066 |\\n| Other investments | 38,248 | (27,421 | ) | 25,770 | 17,616 |\\n| Equity securities | 4,633 | 3,445 | 12,843 | 7,795 |\\n| Mortgage loans | 2,191 | 482 | 5,683 | 776 |\\n| Cash and cash equivalents | 3,768 | 993 | 7,071 | 3,770 |\\n| Short-term investments | 337 | 83 | 708 | 277 |\\n| Gross investment income | 125,004 | 53,562 | 281,498 | 250,300 |\\n| Investment expenses | (8,081 | ) | (7,877 | ) | (23,680 | ) | (23,964 | ) |\\n| Net investment income | $ | 116,923 | $ | 45,685 | $ | 257,818 | $ | 226,336 |\\n\\n20\\n| 3. | INVESTMENTS (CONTINUED) |\\n\\nf) Net Realized Investment Gains (Losses)\\nThe following table provides an analysis of net realized investment gains (losses):\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Gross realized gains |\\n| Fixed maturities and short-term investments | $ | 26,211 | $ | 12,126 | $ | 67,833 | $ | 44,853 |\\n| Equities | 5,570 | 232 | 18,804 | 447 |\\n| Gross realized gains | 31,781 | 12,358 | 86,637 | 45,300 |\\n| Gross realized losses |\\n| Fixed maturities and short-term investments | (21,908 | ) | (54,867 | ) | (90,702 | ) | (111,432 | ) |\\n| Equities | (576 | ) | (1,559 | ) | (15,923 | ) | (1,952 | ) |\\n| Gross realized losses | (22,484 | ) | (56,426 | ) | (106,625 | ) | (113,384 | ) |\\n| Net OTTI recognized in earnings | (4,247 | ) | (32,301 | ) | (20,346 | ) | (62,762 | ) |\\n| Change in fair value of investment derivatives(1) | 155 | 6,412 | 39 | 7,228 |\\n| Net realized investment gains (losses) | $ | 5,205 | $ | (69,957 | ) | $ | (40,295 | ) | $ | (123,618 | ) |\\n\\n(1) Refer to Note 5 – Derivative Instruments\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Fixed maturities: |\\n| Non-U.S. government | $ | 2,456 | $ | 1,295 | $ | 2,953 | $ | 2,717 |\\n| Corporate debt | 1,791 | 20,587 | 14,833 | 38,396 |\\n| Non-Agency RMBS | — | — | — | 4 |\\n| ABS | — | 84 | — | 124 |\\n| 4,247 | 21,966 | 17,786 | 41,241 |\\n| Equity Securities |\\n| Exchange-traded funds | — | 10,335 | 2,560 | 10,335 |\\n| Bond mutual funds | — | — | — | 11,186 |\\n| — | 10,335 | 2,560 | 21,521 |\\n| Total OTTI recognized in earnings | $ | 4,247 | $ | 32,301 | $ | 20,346 | $ | 62,762 |\\n\\n21\\n| 3. | INVESTMENTS (CONTINUED) |\\n\\nThe following table provides a roll forward of the credit losses, before income taxes, for which a portion of the OTTI was recognized in AOCI:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Balance at beginning of period | $ | 1,513 | $ | 1,564 | $ | 1,506 | $ | 1,531 |\\n| Credit impairments recognized on securities not previously impaired | — | — | — | — |\\n| Additional credit impairments recognized on securities previously impaired | — | — | 7 | 33 |\\n| Change in timing of future cash flows on securities previously impaired | — | — | — | — |\\n| Intent to sell of securities previously impaired | — | — | — | — |\\n| Securities sold/redeemed/matured | (33 | ) | (43 | ) | (33 | ) | (43 | ) |\\n| Balance at end of period | $ | 1,480 | $ | 1,521 | $ | 1,480 | $ | 1,521 |\\n\\ng) Reverse Repurchase Agreements\\nAt September 30, 2016, we held $160 million (December 31, 2015: $30 million) of reverse repurchase agreements. These loans are fully collateralized, are generally outstanding for a short period of time and are presented on a gross basis as part of cash and cash equivalents on our consolidated balance sheet. The required collateral for these loans is either cash or U.S. Treasuries at a minimum rate of 102% of the loan principal. Upon maturity, we receive principal and interest income. We monitor the estimated fair value of the securities loaned and borrowed on a daily basis with additional collateral obtained as necessary throughout the duration of the transaction.\\nFair Value Hierarchy\\nFair value is defined as the price to sell an asset or transfer a liability (i.e. the “exit price”) in an orderly transaction between market participants. We use a fair value hierarchy that gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data. The level in the hierarchy within which a given fair value measurement falls is determined based on the lowest level input that is significant to the measurement. The hierarchy is broken down into three levels as follows:\\n| • | Level 1 - Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that we have the ability to access. |\\n\\n| • | Level 2 - Valuations based on quoted prices in active markets for similar assets or liabilities, quoted prices for identical assets or liabilities in inactive markets, or for which significant inputs are observable (e.g. interest rates, yield curves, prepayment speeds, default rates, loss severities, etc.) or can be corroborated by observable market data. |\\n\\n| • | Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement. The unobservable inputs reflect our own judgments about assumptions that market participants might use. |\\n\\nThe availability of observable inputs can vary from financial instrument to financial instrument and is affected by a wide variety of factors including, for example, the type of financial instrument, whether the financial instrument is new and not yet established in the marketplace, and other characteristics particular to the transaction. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires significantly more judgment.\\nAccordingly, the degree of judgment exercised by management in determining fair value is greatest for instruments categorized in Level 3. In periods of market dislocation, the observability of prices and inputs may be reduced for many instruments. This may lead us to change the selection of our valuation technique (from market to cash flow approach) or may cause us to use multiple valuation techniques to estimate the fair value of a financial instrument. This circumstance could cause an instrument to be reclassified between levels within the fair value hierarchy.\\nWe used the following valuation techniques including significant inputs and assumptions in estimating the fair value of our financial instruments as well as the general classification of such financial instruments pursuant to the above fair value hierarchy.\\nFixed Maturities\\nAt each valuation date, we use the market approach valuation technique to estimate the fair value of our fixed maturities portfolio, when possible. This market approach includes, but is not limited to, prices obtained from third party pricing services for identical or comparable securities and the use of “pricing matrix models” using observable market inputs such as yield curves, credit risks and spreads, measures of volatility, and prepayment speeds. Pricing from third party pricing services is sourced from multiple vendors, when available, and we maintain a vendor hierarchy by asset type based on historical pricing experience and vendor expertise. When prices are unavailable from pricing services, we obtain non-binding quotes from broker-dealers who are active in the corresponding markets.\\nThe valuation techniques including significant inputs generally used to determine the fair value of our fixed maturities by asset class as well as the classification in the fair value hierarchy are described in detail below.\\nU.S. government and agency\\nU.S. government and agency securities consist primarily of bonds issued by the U.S. Treasury and mortgage pass-through agencies such as the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation and the Government National Mortgage Association. As the fair values of U.S. Treasury securities are based on unadjusted market prices in active markets, these securities are classified within Level 1. The fair values of U.S. government agency securities are priced using the spread above the risk-free yield curve. As the yields for the risk-free yield curve and the spreads for these securities are observable market inputs, the fair values of U.S. government agency securities are classified within Level 2.\\n22\\n| 4. | FAIR VALUE MEASUREMENTS |\\n\\nNon-U.S. government\\nNon-U.S. government securities comprise bonds issued by non-U.S. governments and their agencies along with supranational organizations (collectively also known as sovereign debt securities). The fair values of these securities are based on prices obtained from international indices or a valuation model which uses inputs including interest rate yield curves, cross-currency basis index spreads, and country credit spreads for structures similar to the sovereign bond in terms of issuer, maturity and seniority. As the significant inputs are observable market inputs, the fair value of non-U.S. government securities are classified within Level 2.\\nCorporate debt\\nCorporate debt securities consist primarily of investment-grade debt of a wide variety of corporate issuers and industries. The fair values of these securities are generally determined using the spread above the risk-free yield curve. These spreads are generally obtained from the new issue market, secondary trading and broker-dealer quotes. As these spreads and the yields for the risk-free yield curve are observable market inputs, the fair values of corporate debt securities are classified within Level 2. Where pricing is unavailable from pricing services, we obtain non-binding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. In this event, securities are classified within Level 3.\\nAgency RMBS\\nAgency RMBS securities consist of bonds issued by the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation and the Government National Mortgage Association. The fair values of these securities are priced using a mortgage pool specific model which uses daily inputs from the active to be announced market and the spread associated with each mortgage pool based on vintage. As the significant inputs are observable market inputs, the fair values of Agency RMBS securities are classified within Level 2.\\nCMBS\\nCMBS include mostly investment-grade bonds originated by non-agencies. The fair values of these securities are determined using a pricing model which uses dealer quotes and other available trade information along with security level characteristics to determine deal specific spreads. As the significant inputs are observable market inputs, the fair values of CMBS securities are classified within Level 2. Where pricing is unavailable from pricing services, we obtain non-binding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. In this event, securities are classified within Level 3.\\nNon-Agency RMBS\\nNon-Agency RMBS include mostly investment-grade bonds originated by non-agencies. The fair values of these securities are determined using an option adjusted spread model or other relevant models, which use inputs including available trade information or broker quotes, prepayment and default projections based on historical statistics of the underlying collateral and current market data. As the significant inputs are observable market inputs, the fair values of Non-Agency RMBS securities are classified within Level 2.\\nABS\\nABS include mostly investment-grade bonds backed by pools of loans with a variety of underlying collateral, including automobile loan receivables, student loans, credit card receivables, and CLO Debt originated by a variety of financial institutions. The fair values of ABS are priced using a model which uses prepayment speeds and spreads sourced primarily from the new issue market. As the significant inputs used to price ABS are observable market inputs, the fair values of ABS are classified within Level 2. Where pricing is unavailable from pricing services, we obtain non-binding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. In this event, securities are classified within Level 3.\\n23\\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\\n\\nMunicipals\\nMunicipals comprise revenue and general obligation bonds issued by U.S. domiciled state and municipal entities. The fair values of these securities are determined using spreads obtained from broker-dealers, trade prices and the new issue market. As the significant inputs used to price the municipals are observable market inputs, municipals are classified within Level 2.\\nEquity Securities\\nEquity securities include common stocks, exchange-traded funds and bond mutual funds. As the fair values of common stocks and exchange-traded funds are based on unadjusted quoted market prices in active markets, these securities are classified within Level 1.\\nAs bond mutual funds have daily liquidity with redemption based on the NAV of the funds, the fair values of these securities are classified within Level 2.\\nOther Investments\\nAt September 30, 2016, our investments in CLO - Equities were classified within Level 3 as we estimated the fair value for these securities using an income approach valuation technique (discounted cash flow model) due to the lack of observable and relevant trades in the secondary markets.\\nOther privately held securities include convertible preferred shares, convertible notes and notes payable. In the reporting period of investment, the cost of these investments approximates fair value. In subsequent measurement periods, a discounted cash flow model is used to determine the fair value of these securities. These securities are classified within Level 3.\\nShort-Term Investments\\nShort-term investments primarily comprise highly liquid securities with maturities greater than three months but less than one year from the date of purchase. These securities are classified within Level 2 because these securities are typically not actively traded due to their approaching maturity and, as such, their amortized cost approximates fair value.\\nDerivative Instruments\\nOur foreign currency forward contracts, interest rate swaps and commodity contracts are customized to our economic hedging strategies and trade in the over-the-counter derivative market. We use the market approach valuation technique to estimate the fair value for these derivatives based on significant observable market inputs from third party pricing vendors, non-binding broker-dealer quotes and/or recent trading activity. Accordingly, we classified these derivatives within Level 2.\\nWe also participate in non-exchange traded derivative-based risk management products addressing weather risks. We use observable market inputs and unobservable inputs in combination with industry or internally-developed valuation and forecasting techniques to determine fair value. We classify these instruments within Level 3.\\nInsurance-linked Securities\\nInsurance-linked securities comprise an investment in a catastrophe bond. We obtain non-binding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. These securities are classified within Level 3.\\nCash Settled Awards\\nCash settled awards comprise restricted stock units that form part of our compensation program. Although the fair value of these awards is determined using observable quoted market prices in active markets, the stock units themselves are not actively traded. Accordingly, we have classified these liabilities within Level 2.\\n24\\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\\n\\nThe tables below present the financial instruments measured at fair value on a recurring basis for the periods indicated:\\n| Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | Fair value based on NAV practical expedient | Total Fair Value |\\n| At September 30, 2016 |\\n| Assets |\\n| Fixed maturities |\\n| U.S. government and agency | $ | 1,522,246 | $ | 40,631 | $ | — | $ | — | $ | 1,562,877 |\\n| Non-U.S. government | — | 582,056 | — | — | 582,056 |\\n| Corporate debt | — | 4,499,408 | 69,092 | — | 4,568,500 |\\n| Agency RMBS | — | 2,522,731 | — | — | 2,522,731 |\\n| CMBS | — | 885,355 | 8,920 | — | 894,275 |\\n| Non-Agency RMBS | — | 71,830 | — | — | 71,830 |\\n| ABS | — | 1,235,596 | — | — | 1,235,596 |\\n| Municipals | — | 128,995 | — | — | 128,995 |\\n| 1,522,246 | 9,966,602 | 78,012 | — | 11,566,860 |\\n| Equity securities |\\n| Common stocks | 69 | — | — | — | 69 |\\n| Exchange-traded funds | 504,206 | — | — | — | 504,206 |\\n| Bond mutual funds | — | 140,069 | — | — | 140,069 |\\n| 504,275 | 140,069 | — | — | 644,344 |\\n| Other investments |\\n| Hedge funds | — | — | — | 514,625 | 514,625 |\\n| Direct lending funds | — | — | — | 125,002 | 125,002 |\\n| Private equity funds | — | — | — | 89,170 | 89,170 |\\n| Real estate funds | — | — | — | 11,782 | 11,782 |\\n| Other privately held investments | — | — | 42,900 | — | 42,900 |\\n| CLO - Equities | — | — | 63,783 | — | 63,783 |\\n| — | — | 106,683 | 740,579 | 847,262 |\\n| Short-term investments | — | 39,877 | — | — | 39,877 |\\n| Other assets |\\n| Derivative instruments (see Note 5) | — | 4,469 | 2,488 | — | 6,957 |\\n| Insurance-linked securities | — | — | 25,283 | — | 25,283 |\\n| Total Assets | $ | 2,026,521 | $ | 10,151,017 | $ | 212,466 | $ | 740,579 | $ | 13,130,583 |\\n| Liabilities |\\n| Derivative instruments (see Note 5) | $ | — | $ | 4,411 | $ | 8,184 | $ | — | $ | 12,595 |\\n| Cash settled awards (see Note 7) | — | 34,288 | — | — | 34,288 |\\n| Total Liabilities | $ | — | $ | 38,699 | $ | 8,184 | $ | — | $ | 46,883 |\\n\\n25\\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\\n\\n| Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | Fair value based on NAV practical expedient | Total Fair Value |\\n| At December 31, 2015 |\\n| Assets |\\n| Fixed maturities |\\n| U.S. government and agency | $ | 1,632,355 | $ | 19,594 | $ | — | $ | — | $ | 1,651,949 |\\n| Non-U.S. government | — | 739,005 | — | — | 739,005 |\\n| Corporate debt | — | 4,324,251 | 38,518 | — | 4,362,769 |\\n| Agency RMBS | — | 2,249,236 | — | — | 2,249,236 |\\n| CMBS | — | 1,072,376 | 10,922 | — | 1,083,298 |\\n| Non-Agency RMBS | — | 101,008 | — | — | 101,008 |\\n| ABS | — | 1,371,270 | — | — | 1,371,270 |\\n| Municipals | — | 161,214 | — | — | 161,214 |\\n| 1,632,355 | 10,037,954 | 49,440 | — | 11,719,749 |\\n| Equity securities |\\n| Common stocks | — | — | — | — | — |\\n| Exchange-traded funds | 473,973 | — | — | — | 473,973 |\\n| Bond mutual funds | — | 124,025 | — | — | 124,025 |\\n| 473,973 | 124,025 | — | — | 597,998 |\\n| Other investments |\\n| Hedge funds | — | — | — | 656,773 | 656,773 |\\n| Direct lending funds | — | — | — | 90,120 | 90,120 |\\n| Private equity funds | — | — | — | — | — |\\n| Real estate funds | — | — | — | 4,929 | 4,929 |\\n| Other privately held investments | — | — | — | — | — |\\n| CLO - Equities | — | — | 27,257 | 37,677 | 64,934 |\\n| — | — | 27,257 | 789,499 | 816,756 |\\n| Short-term investments | — | 34,406 | — | — | 34,406 |\\n| Other assets |\\n| Derivative instruments (see Note 5) | — | 2,072 | 4,395 | — | 6,467 |\\n| Insurance-linked securities | — | — | 24,925 | — | 24,925 |\\n| Total Assets | $ | 2,106,328 | $ | 10,198,457 | $ | 106,017 | $ | 789,499 | $ | 13,200,301 |\\n| Liabilities |\\n| Derivative instruments (see Note 5) | $ | — | $ | 7,692 | $ | 10,937 | $ | — | $ | 18,629 |\\n| Cash settled awards (see Note 7) | — | 33,215 | — | — | 33,215 |\\n| Total Liabilities | $ | — | $ | 40,907 | $ | 10,937 | $ | — | $ | 51,844 |\\n\\nDuring 2016 and 2015, there were no transfers between Levels 1 and 2.\\n26\\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\\n\\nExcept certain fixed maturities and insurance-linked securities priced using broker-dealer quotes (underlying inputs are not available), the following table quantifies the significant unobservable inputs we have used in estimating fair value at September 30, 2016 for our investments classified as Level 3 in the fair value hierarchy.\\n| Fair Value | Valuation Technique | Unobservable Input | Range | Weighted Average |\\n| Other investments - CLO - Equities | $ | 35,594 | Discounted cash flow | Default rates | 4.0% | 4.0% |\\n| Loss severity rate | 35.0% - 53.5% | 35.4% |\\n| Collateral spreads | 3.6% - 4.0% | 4.0% |\\n| Estimated maturity dates | 2 - 6 years | 6 years |\\n| 28,189 | Liquidation value | Fair value of collateral | 100% | 100% |\\n| Discount margin | 0.1% - 19.1% | 2.4% |\\n| Other investments - Other privately held investments | 42,900 | Discounted cash flow | Discount rate | 5.0% - 8.0% | 7.2% |\\n| Derivatives - Weather derivatives, net | $ | (5,696 | ) | Simulation model | Weather curve | 1 - 2294(1) | n/a (2) |\\n| Weather standard deviation | 1 - 1029(1) | n/a (2) |\\n\\n(1) Measured in Heating Degree Days (\\\"HDD\\\") which is the number of degrees the daily temperature is below a reference temperature. The cumulative HDD for the duration of the derivatives contract is compared to the strike value to determine the necessary settlement.\\n| (2) | Due to the diversity of the portfolio, the range of unobservable inputs can be widespread; therefore, presentation of a weighted average is not useful. Weather parameters may include various temperature and/or precipitation measures that will naturally vary by geographic location of each counterparty's operations. |\\n\\nThe CLO - Equities market continues to be mostly inactive with only a small number of transactions being observed and fewer still involving transactions in our CLO - Equities. Accordingly, we use models to estimate the fair value of our investments in CLO - Equities. Given that all of our direct investments in CLO - Equities are past their reinvestment period, there is uncertainty over the remaining time to maturity. As such our direct investments in CLO - Equities are valued at the lower of the liquidation value and fair value based on an internally developed discounted cash flow model.\\nThe liquidation valuation is based on the fair value of the net underlying collateral which is determined by applying market discount margins by credit quality bucket. An increase (decrease) in the market discount margin would result in a decrease (increase) in value of our CLO - Equities. Regarding the discounted cash flow model, the default and loss severity rates are the most judgmental unobservable market inputs to which the valuation of CLO - Equities is most sensitive. A significant increase (decrease) in either of these significant inputs in isolation would result in lower (higher) fair value estimates for direct investments in our CLO - Equities and, in general, a change in default rate assumptions will be accompanied by a directionally similar change in loss severity rate assumptions. Collateral spreads and estimated maturity dates are less judgmental inputs as they are based on the historical average of actual spreads and the weighted average life of the current underlying portfolios, respectively. A significant increase (decrease) in either of these significant inputs in isolation would result in higher (lower) fair value estimates for direct investments in our CLO - Equities. In general, these inputs have no significant interrelationship with each other or with default and loss severity rates.\\nOn a quarterly basis, our valuation process for CLO - Equities includes a review of the underlying collateral along with related discount margins by credit quality bucket used in the liquidation valuation and a review of the underlying cash flows and key assumptions used in the discounted cash flow model. We review and update the above significant unobservable inputs based on information obtained from secondary markets, including information received from the managers of our CLO - Equities portfolio.\\nIn order to assess the reasonableness of the inputs we use in our models, we maintain an understanding of current market conditions, historical results, as well as emerging trends that may impact future cash flows. In addition,we update the assumptions we use in our models through regular communication with industry participants and ongoing monitoring of the deals in which we participate (e.g. default and loss severity rate trends).\\n27\\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\\n\\nOther privately held securities are initially valued at cost which approximates fair value. In subsequent measurement periods, a discounted cash flow model is used to determine the fair value of these securities. These models include inputs specific to each investment. The inputs used in the fair value measurement include dividend or interest rates and a discount rate. The discount rate is judgmental and the most significant unobservable input used in the valuation of the other privately held securities. Significant increases (decreases) in this input in isolation could result in a significantly higher (lower) fair value measurement. In order to assess the reasonableness of the inputs we use in our models, we maintain an understanding of current market conditions, historical results, as well as investee specific information that may impact future cash flows.\\nWeather derivatives relate to non-exchange traded risk management products addressing weather risks. We use observable market inputs and unobservable inputs in combination with industry or internally-developed valuation and forecasting techniques to determine fair value. The models may reference market price information for similar instruments. The pricing models are internally reviewed by Risk Management personnel prior to implementation and are reviewed periodically thereafter.\\nObservable and unobservable inputs to these models vary by contract type but would typically include the following:\\n| • | Observable inputs: market prices for similar instruments, notional price, option strike price, term to expiry, contractual limits; |\\n\\n| • | Unobservable inputs: correlation; and |\\n\\n| • | Both observable and unobservable inputs: weather curves, weather standard deviation. |\\n\\nIn general, weather curves are the most significant contributing input to fair value determination. Changes in this variable can result in higher or lower fair value depending on the underlying position. In addition, changes in any or all of the unobservable inputs identified above may contribute positively or negatively to overall portfolio value. The correlation input will quantify the interrelationship, if any, amongst the other variables.\\n28\\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\\n\\n| OpeningBalance | TransfersintoLevel 3 | Transfersout ofLevel 3 | Included inearnings (1) | Includedin OCI (2) | Purchases | Sales | Settlements/Distributions | ClosingBalance | Change inunrealizedinvestmentgain/(loss) (3) |\\n| Three months ended September 30, 2016 |\\n| Fixed maturities |\\n| Corporate debt | $ | 62,022 | $ | — | $ | — | $ | (9 | ) | $ | 100 | $ | 7,563 | $ | — | $ | (584 | ) | $ | 69,092 | $ | — |\\n| CMBS | 10,210 | — | — | — | (48 | ) | — | — | (1,242 | ) | 8,920 | — |\\n| ABS | — | — | — | — | — | — | — | — | — | — |\\n| 72,232 | — | — | (9 | ) | 52 | 7,563 | — | (1,826 | ) | 78,012 | — |\\n| Other investments |\\n| Other privately held investments | 41,755 | — | — | (355 | ) | — | 1,500 | — | — | 42,900 | (355 | ) |\\n| CLO - Equities | 65,883 | — | — | 8,419 | — | — | — | (10,519 | ) | 63,783 | 8,419 |\\n| 107,638 | — | — | 8,064 | — | 1,500 | — | (10,519 | ) | 106,683 | 8,064 |\\n| Other assets |\\n| Derivative instruments | 5 | — | — | 665 | — | 1,818 | — | — | 2,488 | 665 |\\n| Insurance-linked securities | 25,025 | — | — | 258 | — | — | — | — | 25,283 | 258 |\\n| 25,030 | — | — | 923 | — | 1,818 | — | — | 27,771 | 923 |\\n| Total assets | $ | 204,900 | $ | — | $ | — | $ | 8,978 | $ | 52 | $ | 10,881 | $ | — | $ | (12,345 | ) | $ | 212,466 | $ | 8,987 |\\n| Other liabilities |\\n| Derivative instruments | $ | 1,978 | $ | — | $ | — | $ | (169 | ) | $ | — | $ | 6,384 | $ | — | $ | (9 | ) | $ | 8,184 | $ | 335 |\\n| Total liabilities | $ | 1,978 | $ | — | $ | — | $ | (169 | ) | $ | — | $ | 6,384 | $ | — | $ | (9 | ) | $ | 8,184 | $ | 335 |\\n| Nine months ended September 30, 2016 |\\n| Fixed maturities |\\n| Corporate debt | $ | 38,518 | $ | 20,412 | $ | (1,955 | ) | $ | (988 | ) | $ | 1,188 | $ | 17,107 | $ | (4,015 | ) | $ | (1,175 | ) | $ | 69,092 | $ | — |\\n| CMBS | 10,922 | — | — | — | (134 | ) | — | — | (1,868 | ) | 8,920 | — |\\n| ABS | — | — | — | — | — | — | — | — | — | — |\\n| 49,440 | 20,412 | (1,955 | ) | (988 | ) | 1,054 | 17,107 | (4,015 | ) | (3,043 | ) | 78,012 | — |\\n| Other investments |\\n| Other privately held investments | — | — | — | (1,505 | ) | — | 44,405 | — | — | 42,900 | (1,505 | ) |\\n| CLO - Equities | 27,257 | 36,378 | — | 17,431 | — | — | — | (17,283 | ) | 63,783 | 17,431 |\\n| 27,257 | 36,378 | — | 15,926 | — | 44,405 | — | (17,283 | ) | 106,683 | 15,926 |\\n| Other assets |\\n| Derivative instruments | 4,395 | — | — | 3,255 | — | 3,623 | — | (8,785 | ) | 2,488 | 669 |\\n| Insurance-linked securities | 24,925 | — | — | 358 | — | — | — | — | 25,283 | 358 |\\n| 29,320 | — | — | 3,613 | — | 3,623 | — | (8,785 | ) | 27,771 | 1,027 |\\n| Total assets | $ | 106,017 | $ | 56,790 | $ | (1,955 | ) | $ | 18,551 | $ | 1,054 | $ | 65,135 | $ | (4,015 | ) | $ | (29,111 | ) | $ | 212,466 | $ | 16,953 |\\n| Other liabilities |\\n| Derivative instruments | $ | 10,937 | $ | — | $ | — | $ | 2,445 | $ | — | $ | 7,189 | $ | — | $ | (12,387 | ) | $ | 8,184 | $ | 457 |\\n| Total liabilities | $ | 10,937 | $ | — | $ | — | $ | 2,445 | $ | — | $ | 7,189 | $ | — | $ | (12,387 | ) | $ | 8,184 | $ | 457 |\\n\\n29\\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\\n\\n| OpeningBalance | TransfersintoLevel 3 | Transfersout ofLevel 3 | Included inearnings (1) | Includedin OCI (2) | Purchases | Sales | Settlements/Distributions | ClosingBalance | Change inunrealizedinvestmentgain/(loss) (3) |\\n| Three months ended September 30, 2015 |\\n| Fixed maturities |\\n| Corporate debt | $ | 43,008 | $ | — | $ | — | $ | (2 | ) | $ | 300 | $ | 22,821 | $ | — | $ | (4,403 | ) | $ | 61,724 | $ | — |\\n| CMBS | 21,900 | — | (9,902 | ) | — | (219 | ) | — | — | (461 | ) | 11,318 | — |\\n| ABS | 110 | — | — | — | — | — | — | (3 | ) | 107 | — |\\n| 65,018 | — | (9,902 | ) | (2 | ) | 81 | 22,821 | — | (4,867 | ) | 73,149 | — |\\n| Other investments |\\n| Other privately held investments | — | — | — | — | — | — | — | — | — | — |\\n| CLO - Equities | 36,921 | — | — | 1,192 | — | — | — | (3,118 | ) | 34,995 | 1,192 |\\n| 36,921 | — | — | 1,192 | — | — | — | (3,118 | ) | 34,995 | 1,192 |\\n| Other assets |\\n| Derivative instruments | 240 | — | — | 35 | — | — | — | (240 | ) | 35 | 35 |\\n| Insurance-linked securities | 24,837 | — | — | 175 | — | — | — | — | 25,012 | 175 |\\n| 25,077 | — | — | 210 | — | — | — | (240 | ) | 25,047 | 210 |\\n| Total assets | $ | 127,016 | $ | — | $ | (9,902 | ) | $ | 1,400 | $ | 81 | $ | 22,821 | $ | — | $ | (8,225 | ) | $ | 133,191 | $ | 1,402 |\\n| Other liabilities |\\n| Derivative instruments | $ | 818 | $ | — | $ | — | $ | (331 | ) | $ | — | $ | 6,475 | $ | — | $ | — | $ | 6,962 | $ | (331 | ) |\\n| Total liabilities | $ | 818 | $ | — | $ | — | $ | (331 | ) | $ | — | $ | 6,475 | $ | — | $ | — | $ | 6,962 | $ | (331 | ) |\\n| Nine months ended September 30, 2015 |\\n| Fixed maturities |\\n| Corporate debt | $ | 15,837 | $ | — | $ | — | $ | (2 | ) | $ | 724 | $ | 54,445 | $ | — | $ | (9,280 | ) | $ | 61,724 | $ | — |\\n| CMBS | 17,763 | 5,072 | (9,902 | ) | — | (543 | ) | — | — | (1,072 | ) | 11,318 | — |\\n| ABS | 40,031 | — | (39,851 | ) | — | 105 | — | — | (178 | ) | 107 | — |\\n| 73,631 | 5,072 | (49,753 | ) | (2 | ) | 286 | 54,445 | — | (10,530 | ) | 73,149 | — |\\n| Other investments |\\n| Other privately held investments | — | — | — | — | — | — | — | — | — | — |\\n| CLO - Equities | 37,046 | — | — | 7,930 | — | — | — | (9,981 | ) | 34,995 | 7,930 |\\n| 37,046 | — | — | 7,930 | — | — | — | (9,981 | ) | 34,995 | 7,930 |\\n| Other assets |\\n| Derivative instruments | 111 | — | — | (792 | ) | — | — | — | 716 | 35 | 35 |\\n| Insurance-linked securities | — | — | — | 12 | — | 25,000 | — | — | 25,012 | 12 |\\n| 111 | — | — | (780 | ) | — | 25,000 | — | 716 | 25,047 | 47 |\\n| Total assets | $ | 110,788 | $ | 5,072 | $ | (49,753 | ) | $ | 7,148 | $ | 286 | $ | 79,445 | $ | — | $ | (19,795 | ) | $ | 133,191 | $ | 7,977 |\\n| Other liabilities |\\n| Derivative instruments | $ | 15,288 | $ | — | $ | — | $ | (12,053 | ) | $ | — | $ | 8,698 | $ | — | $ | (4,971 | ) | $ | 6,962 | $ | (318 | ) |\\n| Total liabilities | $ | 15,288 | $ | — | $ | — | $ | (12,053 | ) | $ | — | $ | 8,698 | $ | — | $ | (4,971 | ) | $ | 6,962 | $ | (318 | ) |\\n\\n| (1) | Gains and losses included in earnings on fixed maturities are included in net realized investment gains (losses). Gains and (losses) included in earnings on other investments are included in net investment income. Gains (losses) on weather derivatives included in earnings are included in other insurance-related income. |\\n\\n| (2) | Gains and losses included in other comprehensive income (“OCI”) on fixed maturities are included in unrealized gains (losses) arising during the period. |\\n\\n| (3) | Change in unrealized investment gain (loss) relating to assets held at the reporting date. |\\n\\nThe transfers into and out of fair value hierarchy levels reflect the fair value of the securities at the end of the reporting period.\\n30\\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\\n\\nTransfers into Level 3 from Level 2\\nThere were no transfers to Level 3 from Level 2 made during the three months ended September 30, 2016 and 2015.\\nThe transfers to Level 3 from Level 2 made during the nine months ended September 30, 2016 were primarily due to the lack of observable market inputs and multiple quotes from pricing vendors and broker-dealers for certain fixed maturities and as the result of a change in valuation methodology relating to our CLO equity fund. An income approach valuation technique (discounted cash flow model) is used to estimate fair value at September 30, 2016. As the NAV practical expedient is no longer used the CLO equity fund is now categorized within the fair value hierarchy.\\nThe transfers to Level 3 from Level 2 made during the nine months ended September 30, 2015 were primarily due to the lack of observable market inputs and multiple quotes from pricing vendors and broker-dealers for certain fixed maturities.\\nTransfers out of Level 3 into Level 2\\nThere were no transfers to Level 2 from Level 3 made during the three months ended September 30, 2016. The transfers to Level 2 from Level 3 made during the nine months ended September 30, 2016 were primarily due to the availability of observable market\\ninputs and quotes from pricing vendors on certain fixed maturities.\\nThe transfers to Level 2 from Level 3 made during the three and nine months ended September 30, 2015 were primarily due to the availability of observable market inputs and quotes from pricing vendors on certain fixed maturities and CLO Debt securities.\\nMeasuring the Fair Value of Other Investments Using Net Asset Valuations\\nAs a practical expedient, we estimate fair values for hedge funds, direct lending funds, private equity funds and real estate funds using NAVs as advised by external fund managers or third party administrators. For each of these funds, the NAV is based on the manager's or administrator's valuation of the underlying holdings in accordance with the fund's governing documents and in accordance with U.S. GAAP.\\nIf there is a reporting lag between the current period end and reporting date of the latest available fund valuation for any hedge fund, we estimate the change in fair value by starting with the most recently available fund valuation and adjusting for return estimates as well as any subscriptions, redemptions and distributions that took place during the current period. Return estimates are obtained from the relevant fund managers. Accordingly, we do not typically have a reporting lag in our fair value measurements for these funds. Historically, our valuation estimates incorporating these return estimates have not significantly diverged from the subsequently received NAVs.\\nFor private equity funds, direct lending funds and the real estate fund, valuation statements are typically released on a three month reporting lag therefore the Company estimates fair value of these funds by starting with the prior quarter-end fund valuations and adjusting for capital calls, redemptions, drawdowns and distributions. Return estimates are not available from the relevant fund managers for these funds. Accordingly, we typically have a reporting lag in our fair value measurements for these funds.\\nThe Company often does not have access to financial information relating to the underlying securities held within the funds, therefore management is unable to corroborate the fair values placed on the securities underlying the asset valuations provided by the fund manager or fund administrator. To address this, on a quarterly basis, we perform a number of monitoring procedures to assess the quality of the information provided by managers and administrators. These procedures include, but are not limited to, regular review and discussion of each fund's performance with its manager, regular evaluation of fund performance against applicable benchmarks and the backtesting of our fair value estimates against subsequently received NAVs. Backtesting involves comparing our previously reported values for each individual fund against NAVs per audited financial statements (for year-end values) and final NAVs from fund managers and fund administrators (for interim values).\\nThe fair value of our hedge funds, direct lending funds, private equity funds and real estate funds are measured using the NAV practical expedient and therefore have not been categorized with the fair value hierarchy.\\n31\\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\\n\\nFinancial Instruments Not Carried at Fair Value\\nU.S. GAAP guidance over disclosures about the fair value of financial instruments are also applicable to financial instruments not carried at fair value, except for certain financial instruments, including insurance contracts.\\nThe carrying values of cash equivalents (including restricted amounts), accrued investment income, receivable for investments sold, certain other assets, payable for investments purchased and certain other liabilities approximated their fair values at September 30, 2016, due to their respective short maturities. As these financial instruments are not actively traded, their respective fair values are classified within Level 2.\\nThe carrying value of mortgage loans held-for-investment approximated their fair value at September 30, 2016, as the loans are within their first two years of issue. The estimated fair value of mortgage loans is primarily determined by estimating expected future cash flows and discounting them using current interest rates for similar mortgage loans with similar credit risk, or is determined from pricing for similar loans. As mortgage loans are not actively traded, their respective fair values are classified within Level 3.\\nAt September 30, 2016, our senior notes are recorded at amortized cost with a carrying value of $993 million (2015: $992 million) and have a fair value of $1,083 million (2015: $1,058 million). The fair values of these securities were obtained from a third party pricing service and pricing was based on the spread above the risk-free yield curve. These spreads are generally obtained from the new issue market, secondary trading and broker-dealer quotes. As these spreads and the yields for the risk-free yield curve are observable market inputs, the fair values of our senior notes are classified within Level 2.\\n| 5. | DERIVATIVE INSTRUMENTS |\\n\\nThe following table summarizes the balance sheet classification of derivatives recorded at fair values. The notional amount of derivative contracts represents the basis upon which pay or receive amounts are calculated and is presented in the table to quantify the volume of our derivative activities. Notional amounts are not reflective of credit risk.\\nNone of our derivative instruments are designated as hedges under current accounting guidance.\\n| September 30, 2016 | December 31, 2015 |\\n| DerivativeNotionalAmount | DerivativeAssetFairValue(1) | DerivativeLiabilityFairValue(1) | DerivativeNotionalAmount | DerivativeAssetFairValue(1) | DerivativeLiabilityFairValue(1) |\\n| Relating to investment portfolio: |\\n| Foreign exchange forward contracts | $ | 40,367 | $ | 279 | $ | 17 | $ | 198,406 | $ | 490 | $ | 837 |\\n| Interest rate swaps | — | — | — | — | — | — |\\n| Relating to underwriting portfolio: |\\n| Foreign exchange forward contracts | 560,477 | 25 | 4,394 | 692,023 | 1,582 | 6,855 |\\n| Weather-related contracts | 59,436 | 2,488 | 8,184 | 51,395 | 4,395 | 10,937 |\\n| Commodity contracts | 181,000 | 4,165 | — | — | — | — |\\n| Total derivatives | $ | 6,957 | $ | 12,595 | $ | 6,467 | $ | 18,629 |\\n\\n| (1) | Asset and liability derivatives are classified within other assets and other liabilities in the Consolidated Balance Sheets. |\\n\\n32\\n| 5. | DERIVATIVE INSTRUMENTS (CONTINUED) |\\n\\nOffsetting Assets and Liabilities\\nOur derivative instruments are generally traded under International Swaps and Derivatives Association master netting agreements, which establish terms that apply to all transactions. In the event of a bankruptcy or other stipulated event, master netting agreements provide that individual positions be replaced with a new amount, usually referred to as the termination amount, determined by taking into account market prices and converting into a single currency. Effectively, this contractual close-out netting reduces credit exposure from gross to net exposure. The table below presents a reconciliation of our gross derivative assets and liabilities to the net amounts presented in our Consolidated Balance Sheets, with the difference being attributable to the impact of master netting agreements.\\n| September 30, 2016 | December 31, 2015 |\\n| Gross Amounts | Gross Amounts Offset | NetAmounts(1) | Gross Amounts | Gross Amounts Offset | NetAmounts(1) |\\n| Derivative assets | $ | 9,370 | $ | (2,413 | ) | $ | 6,957 | $ | 14,336 | $ | (7,869 | ) | $ | 6,467 |\\n| Derivative liabilities | $ | 15,008 | $ | (2,413 | ) | $ | 12,595 | $ | 26,498 | $ | (7,869 | ) | $ | 18,629 |\\n\\n| (1) | Net asset and liability derivatives are classified within other assets and other liabilities in the Consolidated Balance Sheets. |\\n\\nRefer to Note 3 - Investments for information on reverse repurchase agreements.\\nDerivative Instruments not Designated as Hedging Instruments\\na) Relating to Investment Portfolio\\nForeign Currency Risk\\nWithin our investment portfolio we are exposed to foreign currency risk. Accordingly, the fair values for our investment portfolio are partially influenced by the change in foreign exchange rates. We may enter into foreign exchange forward contracts to manage the effect of this foreign currency risk. These foreign currency hedging activities are not designated as specific hedges for financial reporting purposes.\\nInterest Rate Risk\\nOur investment portfolio contains a large percentage of fixed maturities which exposes us to significant interest rate risk. As part of our overall management of this risk, we may use interest rate swaps.\\nb) Relating to Underwriting Portfolio\\nForeign Currency Risk\\nOur (re)insurance subsidiaries and branches operate in various foreign countries. Consequently, some of our business is written in currencies other than the U.S. dollar and, therefore, our underwriting portfolio is exposed to significant foreign currency risk. We manage foreign currency risk by seeking to match our foreign-denominated net liabilities under (re)insurance contracts with cash and investments that are denominated in such currencies. We may also use derivative instruments, specifically forward contracts and currency options, to economically hedge foreign currency exposures.\\n33\\n| 5. | DERIVATIVE INSTRUMENTS (CONTINUED) |\\n\\nWeather Risk\\nWe write derivative-based risk management products designed to address weather risks with the objective of generating profits on a portfolio basis. The majority of this business consists of receiving a payment at contract inception in exchange for bearing the risk of variations in a quantifiable weather-related phenomenon, such as temperature. Where a client wishes to minimize the upfront payment, these transactions may be structured as swaps or collars. In general, our portfolio of such derivative contracts is of short duration, with contracts being predominantly seasonal in nature. In order to economically hedge a portion of this portfolio, we may also purchase weather derivatives.\\nCommodity Risk\\nWithin our (re)insurance portfolio we are exposed to commodity price risk. We may hedge a portion of this price risk by entering into commodity derivative contracts.\\nThe total unrealized and realized gains (losses) recognized in earnings for derivatives not designated as hedges were as follows:\\n| Location of Gain (Loss) Recognized in Income on Derivative | Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Derivatives not designated as hedging instruments |\\n| Relating to investment portfolio: |\\n| Foreign exchange forward contracts | Net realized investment gains (losses) | $ | 155 | $ | 6,412 | $ | 39 | $ | 11,234 |\\n| Interest rate swaps | Net realized investment gains (losses) | — | — | — | (4,006 | ) |\\n| Relating to underwriting portfolio: |\\n| Foreign exchange forward contracts | Foreign exchange losses (gains) | (182 | ) | (5,210 | ) | (2,958 | ) | (21,494 | ) |\\n| Weather-related contracts | Other insurance related income (losses) | 833 | 307 | 809 | 11,274 |\\n| Commodity contracts | Other insurance related income (losses) | 1,799 | (33 | ) | 1,499 | (923 | ) |\\n| Total | $ | 2,605 | $ | 1,476 | $ | (611 | ) | $ | (3,915 | ) |\\n\\n34\\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)6. RESERVE FOR LOSSES AND LOSS EXPENSES\\nThe following table presents a reconciliation of our beginning and ending gross reserve for losses and loss expenses and net reserve for unpaid losses and loss expenses for the periods indicated:\\n| Nine months ended September 30, | 2016 | 2015 |\\n| Gross reserve for losses and loss expenses, beginning of period | $ | 9,646,285 | $ | 9,596,797 |\\n| Less reinsurance recoverable on unpaid losses, beginning of period | (2,031,309 | ) | (1,890,280 | ) |\\n| Net reserve for unpaid losses and loss expenses, beginning of period | 7,614,976 | 7,706,517 |\\n| Net incurred losses and loss expenses related to: |\\n| Current year | 1,887,715 | 1,818,672 |\\n| Prior years | (224,131 | ) | (165,804 | ) |\\n| 1,663,584 | 1,652,868 |\\n| Net paid losses and loss expenses related to: |\\n| Current year | (233,124 | ) | (185,953 | ) |\\n| Prior years | (1,334,772 | ) | (1,293,776 | ) |\\n| (1,567,896 | ) | (1,479,729 | ) |\\n| Foreign exchange and other | (112,649 | ) | (183,360 | ) |\\n| Net reserve for unpaid losses and loss expenses, end of period | 7,598,015 | 7,696,296 |\\n| Reinsurance recoverable on unpaid losses, end of period | 2,276,792 | 2,007,287 |\\n| Gross reserve for losses and loss expenses, end of period | $ | 9,874,807 | $ | 9,703,583 |\\n\\nWe write business with loss experience generally characterized as low frequency and high severity in nature, which can result\\nin volatility in our financial results. During the nine months ended September 30, 2016 and 2015, we recognized aggregate net losses and loss expenses, net of reinstatement premiums of $145 million and $90 million, respectively, in relation to catastrophe and weather-related events.\\nDuring April 2016, the Company entered into a quota share and adverse development cover reinsurance agreement, a retroactive contract which was deemed to have met the established criteria for retroactive reinsurance accounting. Foreign exchange and other includes reinsurance recoverables of $159 million related to this reinsurance agreement.\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Insurance | $ | 20,688 | $ | 2,444 | $ | 43,181 | $ | 21,225 |\\n| Reinsurance | 55,331 | 42,681 | 180,950 | 144,579 |\\n| Total | $ | 76,019 | $ | 45,125 | $ | 224,131 | $ | 165,804 |\\n\\nThe majority of the net favorable prior year reserve development in each period related to short-tail reserve classes. Net favorable prior year reserve development for professional, reinsurance liability and motor reserve classes also contributed in the three and nine months ended September 30, 2016.\\n35\\n| 6. | RESERVE FOR LOSSES AND LOSS EXPENSES (CONTINUED) |\\n\\nOur short tail business includes the underlying exposures in the property and other, marine and aviation reserving classes within our insurance segment and the property and other reserving class within our reinsurance segment. Development from these classes contributed $41 million and $38 million of the total net favorable prior year reserve development for the three months ended September 30, 2016 and 2015, respectively. For the nine months ended September 30, 2016 and 2015, these short-tail lines contributed $116 million and $112 million, respectively, of net favorable prior year reserve development. The net favorable prior year reserve development for these classes primarily reflected the recognition of better than expected loss emergence.\\nOur medium-tail business consists primarily of professional insurance and reinsurance reserve classes, credit and political risk insurance reserve class and the credit and surety reinsurance reserve class. In the three and nine months ended September 30, 2016, the professional reserve classes contributed net favorable prior year reserve development of $12 million and $28 million, respectively. In the nine months ended September 30, 2015, the reinsurance professional reserve class contributed $25 million of net favorable development. The net favorable prior year development on these reserve classes continued to reflect the generally favorable experience on earlier accident years as we continued to transition to more experience based methods on these years. As our loss experience has generally been better than expected, this resulted in the recognition of net favorable prior year reserve development. In the three and nine months ended September 30, 2015, the insurance professional reserve class recorded net adverse prior year reserve development of $15 million and $16 million, respectively. This adverse development was primarily the result of strengthening in our Australian book of business during the third quarter of 2015.\\nIn the three and nine months ended September 30, 2015, the credit and surety reserve class recorded net favorable prior year reserve development of $7 million and $19 million, respectively. This net favorable prior year reserve development reflected the recognition of generally better than expected loss emergence.\\nIn the nine months ended September 30, 2015, we recorded net adverse prior year reserve development of $15 million in our credit and political risk reserve class relating to an increase in our loss portfolio estimates.\\nOur long-tail business consists primarily of liability and motor reserve classes. Our motor and liability reinsurance reserve classes contributed additional net favorable prior year reserve development of $17 million and $20 million in the three months ended September 30, 2016 and 2015, respectively. For the nine months ended September 30, 2016 and 2015, these long-tail reserve classes contributed $72 million and $64 million, respectively. The net favorable prior year reserve development for the motor reserve class related to favorable loss emergence trends on several classes of business spanning multiple accident years. The net favorable prior year reserve development for the liability reinsurance reserve class primarily reflected the progressively increased weight given by management to experience based indications on older accident years, which has generally been favorable. In the three and nine months ended September 30, 2015, we recorded net adverse prior year reserve development of $6 million and $23 million, respectively, in our insurance liability reserve class related primarily to an increase in loss estimates for specific individual claim reserves, as well as a higher frequency of large auto liability claims.\\nOur September 30, 2016 net reserves for losses and loss expenses includes estimated amounts for numerous catastrophe events. We caution that the magnitude and/or complexity of losses arising from certain of these events, in particular the Fort McMurray wildfires, Storm Sandy, the 2011 Japanese earthquake and tsunami, the three New Zealand earthquakes and the Tianjin port explosion, inherently increases the level of uncertainty and, therefore, the level of management judgment involved in arriving at our estimated net reserves for losses and loss expenses. As a result, our actual losses for these events may ultimately differ materially from our current estimates.\\n| 7. | SHARE-BASED COMPENSATION |\\n\\nFor the three months ended September 30, 2016, we incurred share-based compensation costs of $14 million (2015: $11 million) and recorded associated tax benefits of $3 million (2015: $3 million). For the nine months ended September 30, 2016, we incurred share-based compensation costs of $50 million (2015: $41 million) and recorded associated tax benefits of $11 million (2015: $11 million).\\nThe total fair value of restricted stock, restricted stock units and cash settled awards vested during the nine months ended September 30, 2016 was $66 million (2015: $73 million). At September 30, 2016 there were $104 million of unrecognized compensation costs, which are expected to be recognized over the weighted average period of 2.4 years.\\n36\\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)7. SHARE-BASED COMPENSATION (CONTINUED)\\nAwards to settle in shares\\nThe following table provides a reconciliation of the beginning and ending balance of nonvested restricted stock (including restricted stock units) for the nine months ended September 30, 2016:\\n| Performance-based Stock Awards | Service-based Stock Awards |\\n| Number ofRestrictedStock | Weighted AverageGrant DateFair Value | Number ofRestrictedStock | Weighted AverageGrant DateFair Value(1) |\\n| Nonvested restricted stock - beginning of period | 201 | $ | 49.24 | 1,954 | $ | 43.34 |\\n| Granted | 104 | 53.80 | 586 | 53.81 |\\n| Vested | (48 | ) | 45.38 | (779 | ) | 39.26 |\\n| Forfeited | — | — | (94 | ) | 47.03 |\\n| Nonvested restricted stock - end of period | 257 | $ | 52.04 | 1,667 | $ | 48.77 |\\n\\n(1) Fair value is based on the closing price of our common shares on the New York Stock Exchange on the day of the grant.\\nCash-settled awards\\nThe following table provides a reconciliation of the beginning and ending balance of nonvested cash settled restricted stock units for the nine months ended September 30, 2016:\\n| Performance-based Cash Settled RSUs | Service-based Cash Settled RSUs |\\n| Number ofRestrictedStock Units | Number ofRestrictedStock Units |\\n| Nonvested restricted stock units - beginning of period | 70 | 1,433 |\\n| Granted | 18 | 494 |\\n| Vested | (32 | ) | (371 | ) |\\n| Forfeited | — | (94 | ) |\\n| Nonvested restricted stock units - end of period | 56 | 1,462 |\\n\\nAt September 30, 2016, the corresponding liability for cash-settled units, included in other liabilities on the Consolidated Balance Sheets, was $34 million (2015: $23 million).\\n37\\n| 8. | EARNINGS PER COMMON SHARE |\\n\\nThe following table sets forth the comparison of basic and diluted earnings per common share:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Basic earnings per common share |\\n| Net income | $ | 186,613 | $ | 257,642 | $ | 364,460 | $ | 496,838 |\\n| Less: preferred share dividends | 9,969 | 10,022 | 29,906 | 30,066 |\\n| Net income available to common shareholders | 176,644 | 247,620 | 334,554 | 466,772 |\\n| Weighted average common shares outstanding - basic(1) | 89,621 | 98,226 | 91,852 | 99,464 |\\n| Basic earnings per common share | $ | 1.97 | $ | 2.52 | $ | 3.64 | $ | 4.69 |\\n| Diluted earnings per common share |\\n| Net income available to common shareholders | $ | 176,644 | $ | 247,620 | $ | 334,554 | $ | 466,772 |\\n| Weighted average common shares outstanding - basic(1) | 89,621 | 98,226 | 91,852 | 99,464 |\\n| Share based compensation plans | 730 | 898 | 727 | 1,004 |\\n| Weighted average common shares outstanding - diluted(1) | 90,351 | 99,124 | 92,579 | 100,468 |\\n| Diluted earnings per common share | $ | 1.96 | $ | 2.50 | $ | 3.61 | $ | 4.65 |\\n| Anti-dilutive shares excluded from the dilutive computation | — | — | 226 | 219 |\\n\\n| (1) | On August 17, 2015, the Company entered into an Accelerated Share Repurchase (“ASR”) agreement (see 'Note 9 - Shareholders' Equity' for additional detail). The weighted-average number of shares outstanding used in the computation of basic and diluted earnings per share reflects the Company’s receipt of 4,149,378 common shares delivered to the Company on August 20, 2015, and 1,358,380 common shares delivered to the company on January 15, 2016 under the Company's ASR agreement. |\\n\\n38\\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)9. SHAREHOLDERS' EQUITY\\nThe following table presents our common shares issued and outstanding:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Shares issued, balance at beginning of period | 176,575 | 176,206 | 176,240 | 175,478 |\\n| Shares issued | — | 16 | 335 | 744 |\\n| Total shares issued at end of period | 176,575 | 176,222 | 176,575 | 176,222 |\\n| Treasury shares, balance at beginning of period | (85,921 | ) | (75,922 | ) | (80,174 | ) | (76,052 | ) |\\n| Shares repurchased | (2,252 | ) | (4,257 | ) | (8,499 | ) | (4,607 | ) |\\n| Shares reissued from treasury | 37 | 6 | 537 | 486 |\\n| Total treasury shares at end of period | (88,136 | ) | (80,173 | ) | (88,136 | ) | (80,173 | ) |\\n| Total shares outstanding | 88,439 | 96,049 | 88,439 | 96,049 |\\n\\nTreasury Shares\\nThe following table presents our share repurchases:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| In the open market: |\\n| Total shares(1) | 2,232 | 4,248 | 8,236 | 4,264 |\\n| Total cost | $ | 124,948 | $ | 245,658 | $ | 434,948 | $ | 246,490 |\\n| Average price per share(2) | $ | 56.00 | $ | 57.83 | $ | 52.81 | $ | 57.80 |\\n| From employees: |\\n| Total shares | 20 | 9 | 263 | 343 |\\n| Total cost | $ | 1,088 | $ | 489 | $ | 14,137 | $ | 17,586 |\\n| Average price per share(2) | $ | 54.13 | $ | 55.59 | $ | 53.68 | $ | 51.28 |\\n| Total shares repurchased: |\\n| Total shares | 2,252 | 4,257 | 8,499 | 4,607 |\\n| Total cost | $ | 126,036 | $ | 246,147 | $ | 449,085 | $ | 264,076 |\\n| Average price per share(2) | $ | 55.98 | $ | 57.83 | $ | 52.84 | $ | 57.32 |\\n\\n(1) The nine months ended September 30, 2016 includes 1,358,380 common shares acquired under the accelerated share repurchase program (see below for more detail).\\n(2) Calculated using whole figures.\\n39\\n| 9. | SHAREHOLDERS' EQUITY (CONTINUED) |\\n\\nAccelerated Share Repurchase Program\\nOn August 17, 2015, the Company entered into an Accelerated Share Repurchase agreement with Goldman, Sachs & Co. (“Goldman Sachs”) to repurchase an aggregate of $300 million of the Company’s ordinary shares under an accelerated share repurchase program.\\nDuring August, 2015, under the terms of this agreement, the Company paid $300 million to Goldman Sachs and initially repurchased 4,149,378 ordinary shares. The initial shares acquired represented 80% of the $300 million total paid to Goldman Sachs and were calculated using the Company’s stock price at activation of the program. The ASR program is accounted for as an equity transaction. Accordingly, as at December 31, 2015, $240 million of common shares repurchased were included as treasury shares in the Consolidated Balance Sheet with the remaining $60 million included as a reduction to additional paid-in capital.\\nOn January 15, 2016, Goldman Sachs early terminated the ASR agreement and delivered 1,358,380 additional common shares to the Company, resulting in the reduction from additional paid-in capital of $60 million being reclassified to treasury shares. In total, the Company repurchased 5,507,758 common shares under the ASR agreement at an average price of $54.47.\\nSeries B Preferred Shares\\nOn January 27, 2016 we redeemed the remaining 28,430 Series B preferred shares, for an aggregate liquidation preference of $3 million.\\n| 10. | COMMITMENTS AND CONTINGENCIES |\\n\\nReinsurance Agreements\\nWe purchase reinsurance coverage for various lines of our business. The minimum reinsurance premiums are contractually due in advance on a quarterly basis. Accordingly at September 30, 2016, we have unrecorded outstanding reinsurance purchase commitments of $33 million, of which $3 million is due in 2016 while the remaining $30 million is due in 2017. Actual payments under the reinsurance contracts will depend on the underlying subject premium and may exceed the minimum premium.\\nInvestments\\nRefer 'Note 3 - Investments' for information on commitments related to our other investments.\\n40\\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)11. OTHER COMPREHENSIVE INCOME (LOSS)\\n| 2016 | 2015 |\\n| Before Tax Amount | Tax (Expense) Benefit | Net of Tax Amount | Before Tax Amount | Tax (Expense) Benefit | Net of Tax Amount |\\n| Three months ended September 30, |\\n| Available for sale investments: |\\n| Unrealized investment gains (losses) arising during the period | $ | 40,125 | $ | (3,789 | ) | $ | 36,336 | $ | (102,810 | ) | $ | 3,099 | $ | (99,711 | ) |\\n| Adjustment for reclassification of net realized investment gains (losses) and OTTI losses recognized in net income | (5,050 | ) | 2,408 | (2,642 | ) | 76,368 | (1,558 | ) | 74,810 |\\n| Unrealized investment gains (losses) arising during the period, net of reclassification adjustment | 35,075 | (1,381 | ) | 33,694 | (26,442 | ) | 1,541 | (24,901 | ) |\\n| Non-credit portion of OTTI losses | — | — | — | — | — | — |\\n| Foreign currency translation adjustment | 1,722 | — | 1,722 | (14,626 | ) | — | (14,626 | ) |\\n| Total other comprehensive income (loss), net of tax | $ | 36,797 | $ | (1,381 | ) | $ | 35,416 | $ | (41,068 | ) | $ | 1,541 | $ | (39,527 | ) |\\n| Nine months ended September 30, |\\n| Available for sale investments: |\\n| Unrealized investment gains (losses) arising during the period | $ | 263,235 | $ | (24,579 | ) | $ | 238,656 | $ | (183,822 | ) | $ | 6,884 | $ | (176,938 | ) |\\n| Adjustment for reclassification of net realized investment gains and OTTI losses recognized in net income | 40,338 | 2,282 | 42,620 | 130,858 | (2,088 | ) | 128,770 |\\n| Unrealized investment gains (losses) arising during the period, net of reclassification adjustment | 303,573 | (22,297 | ) | 281,276 | (52,964 | ) | 4,796 | (48,168 | ) |\\n| Non-credit portion of OTTI losses | — | — | — | — | — | — |\\n| Foreign currency translation adjustment | 5,694 | — | 5,694 | (23,851 | ) | — | (23,851 | ) |\\n| Total other comprehensive income (loss), net of tax | $ | 309,267 | $ | (22,297 | ) | $ | 286,970 | $ | (76,815 | ) | $ | 4,796 | $ | (72,019 | ) |\\n\\nReclassifications out of AOCI into net income available to common shareholders were as follows:\\n| Amount Reclassified from AOCI(1) |\\n| Details About AOCI Components | Consolidated Statement of Operations Line Item That Includes Reclassification | Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Unrealized investment gains (losses) on available for sale investments |\\n| Other realized investment gains (losses) | $ | 9,297 | $ | (44,067 | ) | $ | (19,992 | ) | $ | (68,096 | ) |\\n| OTTI losses | (4,247 | ) | (32,301 | ) | (20,346 | ) | (62,762 | ) |\\n| Total before tax | 5,050 | (76,368 | ) | (40,338 | ) | (130,858 | ) |\\n| Income tax (expense) benefit | (2,408 | ) | 1,558 | (2,282 | ) | 2,088 |\\n| Net of tax | $ | 2,642 | $ | (74,810 | ) | $ | (42,620 | ) | $ | (128,770 | ) |\\n\\n| (1) | Amounts in parentheses are debits to net income available to common shareholders. |\\n\\n41\\n| 12. | SUBSEQUENT EVENT |\\n\\nIn October 2016, the landfall of Hurricane Matthew impacted the Caribbean, southeastern United States and Canada, causing catastrophic loss of life, property damage and flooding.\\nOur preliminary after-tax net loss estimate for this event is in the range of $45 million to $60 million. The Company's loss estimate is primarily based on a ground-up assessment of losses from individual contracts and treaties exposed to the affected regions, including preliminary information from clients, brokers and loss adjusters. Industry insured loss estimates, market share analyses and catastrophe modeling analyses were also taken into account where appropriate.\\nDue to the nature of this event, including the complexity of loss assessment, factors contributing to the losses and the preliminary nature of the information available to prepare these estimates, the actual net ultimate amount of losses for this event may be materially different from this current estimate.\\nITEM 2.\\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\\nThe following is a discussion and analysis of our financial condition and results of operations. This should be read in conjunction with the consolidated financial statements and related notes included in Item 1 of this report and also our Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended December 31, 2015. Tabular dollars are in thousands, except per share amounts. Amounts in tables may not reconcile due to rounding differences.\\n\\n| Page |\\n| Third Quarter 2016 Financial Highlights | 43 |\\n| Executive Summary | 44 |\\n| Underwriting Results – Group | 49 |\\n| Results by Segment: For the three and nine months ended September 30, 2016 and 2015 | 57 |\\n| i) Insurance Segment | 57 |\\n| ii) Reinsurance Segment | 61 |\\n| Other Expenses (Revenues), Net | 64 |\\n| Net Investment Income and Net Realized Investment Gains (Losses) | 65 |\\n| Cash and Investments | 67 |\\n| Liquidity and Capital Resources | 70 |\\n| Critical Accounting Estimates | 72 |\\n| New Accounting Standards | 72 |\\n| Off-Balance Sheet and Special Purpose Entity Arrangements | 72 |\\n| Non-GAAP Financial Measures | 72 |\\n\\n42\\nTHIRD QUARTER 2016 FINANCIAL HIGHLIGHTS\\nThird Quarter 2016 Consolidated Results of Operations\\n\\n| • | Net income available to common shareholders of $177 million, or $1.97 per common share and $1.96 per diluted common share |\\n\\n| • | Operating income of $161 million, or $1.78 per diluted common share(1) |\\n\\n| • | Gross premiums written of $1.0 billion |\\n\\n| • | Net premiums written of $595 million, impacted by a large new retrocessional cover entered into with Harrington Re Ltd. |\\n\\n| • | Net premiums earned of $934 million |\\n\\n| • | Net favorable prior year reserve development of $76 million |\\n\\n| • | Estimated catastrophe and weather-related pre-tax net losses, net of reinstatement premiums, of $22 million compared to $43 million during the third quarter of 2015 |\\n\\n| • | Underwriting income of $104 million and combined ratio of 92.6% |\\n\\n| • | Net investment income of $117 million |\\n\\n| • | Net realized investment gains of $5 million |\\n\\n| • | Foreign exchange gains of $14 million |\\n\\nThird Quarter 2016 Consolidated Financial Condition\\n| • | Total cash and investments of $14.6 billion; fixed maturities, cash and short-term securities comprise 87% of total cash and investments and have an average credit rating of AA- |\\n\\n| • | Total assets of $21.2 billion |\\n\\n| • | Reserve for losses and loss expenses of $9.9 billion and reinsurance recoverable of $2.3 billion |\\n\\n| • | Total debt of $1.0 billion and the debt to total capital ratio of 14.1% |\\n\\n| • | Repurchased 2.3 million common shares. At October 27, 2016 the remaining authorization under the repurchase program approved by our Board of Directors was $375 million |\\n\\n| • | Common shareholders’ equity of $5.4 billion and diluted book value per common share of $59.77 |\\n\\n| (1) | Operating income is a non-GAAP financial measure as defined in SEC Regulation G. Refer to ‘Non-GAAP Financial Measures’ for reconciliation to nearest GAAP financial measure (net income available to common shareholders). |\\n\\n43\\nEXECUTIVE SUMMARY\\nBusiness Overview\\nWe are a Bermuda-based global provider of specialty lines insurance and treaty reinsurance products with operations in Bermuda, the United States, Europe, Singapore, Canada, Latin America and the Middle East. Our underwriting operations are organized around our two global underwriting platforms, AXIS Insurance and AXIS Re.\\nOur mission is to provide our clients and distribution partners with a broad range of risk transfer products and services and meaningful capacity, backed by significant financial strength. We manage our portfolio holistically, aiming to construct the optimum consolidated portfolio of funded and unfunded risks, consistent with our risk appetite and development of our franchise. We nurture an ethical, entrepreneurial and disciplined culture that promotes outstanding client service, intelligent risk taking and the achievement of superior risk-adjusted returns for our shareholders. We believe that the achievement of our objectives will position us as a global leader in specialty risks. Our execution on this strategy in the first nine months of 2016 included:\\n| • | continued growth of our accident and health lines, which is focused on specialty accident and health products; |\\n\\n| • | growth of our Weather and Commodity Markets business unit which offers parametric risk management solutions to clients |\\n\\nwhose profit margins are exposed to adverse weather and commodity price risks;\\n| • | growth of our syndicate at Lloyd's which provides us with access to Lloyd's worldwide licenses and an extensive distribution network. During the first quarter of 2016 we commenced writing business through our underwriting division at Lloyd's in China; |\\n\\n| • | continued rebalancing of our portfolio towards less-volatile lines of business that carry attractive rates; and |\\n\\n| • | continued expansion of our broad range of third-party capital capabilities through: |\\n\\n| • | Our investment in Harrington Reinsurance Holdings Limited (\\\"Harrington\\\"), the parent company of Harrington Re Ltd. (\\\"Harrington Re\\\"), an independent reinsurance company jointly sponsored by AXIS Capital and The Blackstone Group L.P. (\\\"Blackstone\\\"). Harrington Re’s strategy is to combine a multi-line reinsurance portfolio with a diversified allocation to alternative investment strategies to earn attractive risk-adjusted returns. Harrington plans to develop a portfolio that optimizes the risk-reward characteristics of both assets and liabilities, leveraging the respective strengths of AXIS Capital and Blackstone while deploying a disciplined and fully integrated approach to both underwriting and investing; |\\n\\n| • | AXIS Ventures Reinsurance Limited, which manages capital for investors interested in deploying funds directly into the property-catastrophe and other short-tail business; and |\\n\\n| • | increased use of available reinsurance and retrocessional protection to optimize the risk-adjusted returns on our portfolio. |\\n\\n44\\nResults of Operations\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\\n| Underwriting income: |\\n| Insurance | $ | 25,161 | 265% | $ | 6,888 | $ | 31,187 | 93% | $ | 16,153 |\\n| Reinsurance | 78,837 | 60% | 49,357 | 181,623 | (8%) | 197,729 |\\n| Net investment income | 116,923 | 156% | 45,685 | 257,818 | 14% | 226,336 |\\n| Net realized investment gains (losses) | 5,205 | nm | (69,957 | ) | (40,295 | ) | (67%) | (123,618 | ) |\\n| Other expenses, net | (37,079 | ) | nm | (8,464 | ) | (63,439 | ) | 18% | (53,895 | ) |\\n| Termination fee received | — | nm | 280,000 | — | nm | 280,000 |\\n| Reorganization and related fees | — | nm | (45,867 | ) | — | nm | (45,867 | ) |\\n| Interest in loss of equity method investments | (2,434 | ) | nm | — | (2,434 | ) | nm | — |\\n| Net income | 186,613 | (28%) | 257,642 | 364,460 | (27%) | 496,838 |\\n| Preferred share dividends | (9,969 | ) | (1%) | (10,022 | ) | (29,906 | ) | (1%) | (30,066 | ) |\\n| Net income available to common shareholders | $ | 176,644 | (29%) | $ | 247,620 | $ | 334,554 | (28%) | $ | 466,772 |\\n| Operating income | $ | 160,689 | 215% | $ | 51,031 | $ | 309,450 | 10% | $ | 280,682 |\\n\\nnm – not meaningful\\nUnderwriting Results\\nTotal underwriting income in the three months ended September 30, 2016 was $104 million, an increase of $48 million compared to $56 million in the three months ended September 30, 2015. The increase in underwriting income was primarily driven by an increase in net favorable prior year development, decreased catastrophe and weather-related losses, lower general and administrative expenses and an increase in other insurance related income, partially offset by an increase in the current accident year loss ratio excluding catastrophe and weather-related losses.\\nThe reinsurance segment underwriting income increased by $29 million in the three months ended September 30, 2016, compared to the three months ended September 30, 2015. The increase in underwriting income was primarily driven by decreased catastrophe and weather-related losses, an increase in net favorable prior year development, lower general and administrative expenses and an increase in other insurance related income, partially offset by an increase in the acquisition cost ratio.\\nThe insurance segment underwriting income increased by $18 million in the three months ended September 30, 2016, compared to the three months ended September 30, 2015. The increase in underwriting income was primarily due to an increase in net favorable prior year development and a decrease in the acquisition cost ratio, partially offset by an increase in the current accident year loss ratio excluding catastrophe and weather-related losses.\\nTotal underwriting income in the nine months ended September 30, 2016 was $213 million, a decrease of $1 million compared to $214 million in the nine months ended September 30, 2015. The decrease in underwriting income was primarily driven by increased catastrophe and weather-related losses, an increase in the acquisition cost ratio and a decrease in other insurance income, partially offset by an increase in net favorable prior year development and lower general and administrative expenses.\\nThe reinsurance segment underwriting income decreased by $16 million in the nine months ended September 30, 2016, compared to the nine months ended September 30, 2015. The decrease in underwriting income was primarily driven by an increase in the acquisition cost ratio, increased catastrophe and weather-related losses and a decrease in other insurance related income, partially offset by an increase in net favorable prior year development and lower general and administrative expenses.\\nThe insurance segment underwriting income increased by $15 million in the nine months ended September 30, 2016, compared to the nine months ended September 30, 2015. The increase in underwriting income was primarily due to an increase in net favorable prior year development, a decrease in the acquisition cost ratio and lower general and administrative expenses, partially offset by increased catastrophe and weather-related losses.\\n45\\nNet Investment Income\\nNet investment income in the three months ended September 30, 2016 was $117 million, an increase of $71 million compared to $46 million in the three months ended September 30, 2015. The increase was primarily driven by our other investments. These investments generated a gain of $38 million in the three months ended September 30, 2016, compared to a loss of $27 million in three months ended September 30, 2015. Net investment income for the nine months ended September 30, 2016 was $258 million, an increase of $31 million compared to the same period in 2015. The increase was mainly attributable to income from fixed maturities and other investments. Income from fixed maturities increased as a result of an emphasis on longer duration assets and income from other investments increased as a result of improved valuations on our CLO - Equity holdings.\\nNet Realized Investment Gains (Losses)\\nRealized gains were $5 million in the three months ended September 30, 2016 compared to realized losses of $70 million for the same period of 2015. The gains were mainly attributable to corporates, agency MBS, CMBS and ETFs which benefited from improvements in pricing in 2016. The realized losses in the three months ended September 30, 2015 were attributable to foreign currency losses on non-U.S. denominated securities as a result of the strengthening of the U.S. dollar and other-than-temporary impairment (\\\"OTTI\\\") charges. Realized losses were $40 million in the nine months ended September 30, 2016, compared to realized losses of $124 million for the same period of 2015. The losses for the three and nine months ended September 30, 2016 and 2015 were primarily attributable to foreign currency losses on non-U.S. denominated securities as a result of the strengthening of the U.S. dollar and OTTI charges.\\nOther Revenues (Expenses), Net\\nCorporate expenses increased to $29 million for the three months ended September 30, 2016, from $24 million for the three months ended September 30, 2015. The increase is primarily attributable to the net reimbursement of PartnerRe Ltd. (\\\"PartnerRe\\\") merger-related expenses benefiting 2015 and senior executive transition costs in 2016, partially offset by reorganization related expenses adverse to 2015. For the nine months ended September 30, 2016, corporate expenses increased to $87 million compared to $84 million in the same period in 2015. The slight increase is attributable to adjustments to senior leadership executive stock-compensation awards benefiting 2015, senior executive transition costs in 2016, and an increase in personnel costs in 2016, partially offset by expenses attributable to the proposed merger with PartnerRe and reorganization related expenses adverse to 2015.\\nThe foreign exchange gains for the three and nine months ended September 30, 2016 of $14 million and $70 million, respectively, were primarily driven by the depreciation of the pound sterling against the U.S dollar. The foreign exchange gains of $28 million for the three months ended September 30, 2015 were primarily driven by depreciation of the pound sterling and the Australian dollar against the U.S. dollar, while the foreign exchange gains for the nine months ended September 30, 2015 of $69 million were primarily driven by the depreciation of the euro, pound sterling and Australian dollar.\\nThe financial results for the three months ended September 30, 2016 resulted in a tax expense of $9 million, compared to an expense of nil for the three months ended September 30, 2015. Operations in the nine months ended September 30, 2016 resulted in a tax expense of $8 million compared to a tax expense of $1 million in the nine months ended September 30, 2015. The effective tax rate, which drives the tax expense, can vary between periods depending on the distribution of net income amongst tax jurisdictions, as well as other factors. The primary driver of the increase in both periods is the generation of consolidated pre-tax net income in our operations in Europe compared to net losses in 2015.\\nTermination Fee Received\\nDuring the third quarter of 2015, the Company announced that we had accepted a request from PartnerRe to terminate the Agreement and Plan of Amalgamation (the \\\"Amalgamation Agreement\\\") with the Company. PartnerRe paid the Company $315 million to immediately terminate the Amalgamation Agreement, the amount was comprised of a termination fee of $280 million and a reimbursement of merger related expenses of $35 million.\\n46\\nReorganization and Related Expenses\\nDuring the third quarter of 2015, the Company implemented a number of profitability enhancement initiatives which resulted in a recognition of reorganization and related expenses of $46 million and additional corporate expenses of $5 million in the Consolidated Statement of Operations in the three months ended September 30, 2015.\\nInterest in Loss of Equity Method Investments\\nInterest in losses of equity method investments represents the Company’s aggregate share of losses related to investments in which the Company has significant influence over the operating and financial policies of the investee.\\nOutlook\\nManagement expects to achieve an increase in gross premiums written in 2016, with variances between our lines of business within the operating segments driven by market conditions and available opportunities, as we maintain our focus on diversification and pursuit of those opportunities that will expand our reach in areas where we believe the returns to be most attractive. We also expect the increase in gross premiums written to be substantially offset by greater cessions of risk to reinsurers and third party capital partners.\\nCompetitive conditions continue to impact worldwide insurance markets with greatest pressures impacting catastrophe exposed property and certain global specialty lines of business. We also observed greater competitiveness for large accounts compared to smaller risks. These competitive pressures have led to price reductions across most lines of business, with decreases in international markets generally more severe than those observed in the United States. We expect this trend to continue in the short-term but believe that there are still attractive risks in the market. In this challenging market environment, we are focusing on lines and markets that remain adequately priced or continue to deliver price increases and those that provide opportunities for profitable growth. Where necessary we also continue to shift our business mix toward smaller, less volatile risk accounts which we believe will enable us to achieve a better, more stable attritional loss experience with lower severity.\\nThe reinsurance markets' trading environment remains challenging in the majority of lines of business and geographical regions. The market continues to be influenced by excess capacity, strong balance sheets of established market participants and a consolidation of reinsurance purchasing. Despite these conditions we observed recent favorable trends which we expect to impact our business including many cedants reducing the size of their reinsurer panels, some moderation of pricing pressures, increased resistance to demands for greater commission rates as well as more generous terms and conditions, an increase in the number of cedants looking to buy more reinsurance protection and Solvency II-driven opportunities. These factors, combined with AXIS customer-centric approach and opportunities in specific lines of business and geographies allow us to execute on our targeted growth strategy. We continue to address the difficult market conditions by taking actions to protect the quality and profitability of our existing book, targeting larger shares of the more attractive treaties, managing the overall volatility of our reinsurance book, and expanding our already strong group of third party capital partners with whom to share our risks and earn fee income.\\n47\\nFinancial Measures\\nWe believe the following financial indicators are important in evaluating our performance and measuring the overall growth in value generated for our common shareholders:\\n| Three months ended and at September 30, | Nine months ended and at September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| ROACE (annualized)(1) | 13.2 | % | 18.8 | % | 8.4 | % | 12.0 | % |\\n| Operating ROACE (annualized)(2) | 12.0 | % | 3.9 | % | 7.8 | % | 7.2 | % |\\n| DBV per common share(3) | $ | 59.77 | $ | 53.68 | $ | 59.77 | $ | 53.68 |\\n| Cash dividends declared per common share | 0.35 | 0.29 | 1.05 | 0.87 |\\n| Increase in diluted book value per common share adjusted for dividends | $ | 2.50 | $ | 2.16 | $ | 6.74 | $ | 4.67 |\\n\\n| (1) | Return on average common equity (“ROACE”) is calculated by dividing annualized net income available to common shareholders for the period by the average shareholders’ equity determined by using the common shareholders’ equity balances at the beginning and end of the period. |\\n\\n| (2) | Operating ROACE is calculated by dividing annualized operating income for the period by the average common shareholders’ equity determined by using the common shareholders’ equity balances at the beginning and end of the period. Annualized operating ROACE is a non-GAAP financial measure as defined in SEC Regulation G. Refer to‘Non-GAAP Financial Measures’ for additional information and reconciliation to the nearest GAAP financial measure (ROACE). |\\n\\n| (3) | Diluted book value (“DBV”) per common share represents total common shareholders’ equity divided by the number of common shares and diluted common share equivalents outstanding, determined using the treasury stock method. Cash settled awards are excluded from the denominator. |\\n\\nReturn on Equity\\nThe decrease in ROACE in the three months ended September 30, 2016, compared to the three months ended September 30, 2015, was primarily driven by the termination fee received from PartnerRe in the third quarter of 2015, partially offset by net realized gains in the current quarter compared to net realized losses in the same period in 2015, an increase in net investment income and underwriting income in the current quarter compared to the same period in 2015 and reorganization and related expenses incurred in the third quarter of 2015.\\nThe increase in operating ROACE for the three months ended September 30, 2016, compared to the three months ended September 30, 2015 was primarily driven by an increase in net investment income and underwriting income in the three months ended September 30, 2016 compared to the same period in 2015.\\nThe decrease in ROACE in the nine months ended September 30, 2016, compared to the nine months ended September 30, 2015, was primarily driven by the termination fee received from PartnerRe in the third quarter of 2015, partially offset by a decrease in net realized losses and an increase in net investment income in the nine months ended September 30, 2016 compared to the same period in 2015 and reorganization and related expenses incurred in the third quarter of 2015.\\nThe increase in operating ROACE in the nine months ended September 30, 2016, compared to the nine months ended September 30, 2015, was primarily driven by an increase in net investment income in the nine months ended September 30, 2016 compared to the same period in 2015.\\nDiluted Book Value per Common Share\\nOur diluted book value per common share increase of 11% from $53.68 at September 30, 2015, to $59.77 at September 30, 2016, primarily reflected the generation of $469 million in net income available to common shareholders over the past twelve months and the increase over the last twelve months in unrealized gains on investments which are included in accumulated other comprehensive income, which was partially offset by common share dividends declared.\\n48\\nDiluted Book Value per Common Share Adjusted for Dividends\\nOur diluted book value per common share adjusted for dividends increased by $2.50, or 4%, per common share for the three month period ended September 30, 2016 and $7.49, or 14%, per common share over the past twelve months.\\nTaken together, we believe that growth in diluted book value per common share and common share dividends declared represent the total value created for our common shareholders. As companies in the insurance industry have differing dividend payout policies, we believe investors use the diluted book value per common share adjusted for dividends metric to measure comparable performance across the industry.\\nDuring the three and nine months ended September 30, 2016, total value created consisted primarily of our net income and an increase in unrealized gains on investments, reported in accumulated other comprehensive income.\\nDuring the three and nine months ended September 30, 2015, total value created consisted primarily of our net income, partially offset by an increase in unrealized losses on investments and foreign exchange translation adjustment losses included in accumulated other comprehensive income.\\nUNDERWRITING RESULTS – GROUP\\nThe following table provides our group underwriting results for the periods indicated. Underwriting income is a pre-tax measure of underwriting profitability that takes into account net premiums earned and other insurance related income as revenues and net losses and loss expenses, acquisition costs and underwriting-related general and administrative costs as expenses.\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\\n| Revenues: |\\n| Gross premiums written | $ | 959,962 | 2% | $ | 936,583 | $ | 4,239,558 | 11% | $ | 3,803,928 |\\n| Net premiums written | 595,431 | (12%) | 677,217 | 3,288,587 | 7% | 3,079,307 |\\n| Net premiums earned | 934,415 | 2% | 919,341 | 2,783,746 | 1% | 2,764,605 |\\n| Other insurance related income | 5,944 | 413% | 1,158 | 4,850 | (61%) | 12,319 |\\n| Expenses: |\\n| Current year net losses and loss expenses | (608,347 | ) | (605,512 | ) | (1,887,715 | ) | (1,818,672 | ) |\\n| Prior year reserve development | 76,019 | 45,125 | 224,131 | 165,804 |\\n| Acquisition costs | (189,810 | ) | (182,744 | ) | (559,570 | ) | (537,549 | ) |\\n| Underwriting-related general and administrative |\\n| expenses(1) | (114,223 | ) | (121,123 | ) | (352,632 | ) | (372,625 | ) |\\n| Underwriting income(2) | $ | 103,998 | 85% | $ | 56,245 | $ | 212,810 | (1%) | $ | 213,882 |\\n| General and administrative expenses(1) | $ | 142,906 | $ | 144,727 | $ | 439,554 | $ | 456,451 |\\n| Income before income taxes and interest in income (loss) of equity method investments(2) | $ | 198,399 | $ | 257,672 | $ | 374,606 | $ | 497,993 |\\n\\n| (1) | Underwriting-related general and administrative expenses is a non-GAAP measure as defined in SEC Regulation G. Our total general and administrative expenses also included corporate expenses of $28,683 and $23,604 for the three months ended September 30, 2016 and 2015, respectively, and $86,922 and $83,826 for the nine months ended September 30, 2016 and 2015, respectively. Refer to 'Other Expenses (Revenues), Net' for additional information related to these corporate expenses. Also, refer to 'Non-GAAP Financial Measures' for further information. |\\n\\n| (2) | Underwriting income is a non-GAAP financial measure as defined in SEC Regulation G. Refer to Item 1, Note 2 to the Consolidated Financial Statements for a reconciliation of underwriting income to the nearest GAAP financial measure (income before income taxes and interest in income (loss) of equity method investments) for the periods indicated above. Also, refer to 'Non-GAAP Financial Measures' for additional information related to the presentation of underwriting income. |\\n\\n49\\nUNDERWRITING REVENUES\\nPremiums Written:\\n| Gross Premiums Written |\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\\n| Insurance | $ | 675,430 | 11% | $ | 606,704 | $ | 2,112,796 | 7% | $ | 1,970,554 |\\n| Reinsurance | 284,532 | (14%) | 329,879 | 2,126,762 | 16% | 1,833,374 |\\n| Total | $ | 959,962 | 2% | $ | 936,583 | $ | 4,239,558 | 11% | $ | 3,803,928 |\\n| % ceded |\\n| Insurance | 36% | (1) pts | 37% | 32% | 1 pts | 31% |\\n| Reinsurance | 43% | 33 pts | 10% | 13% | 7 pts | 6% |\\n| Total | 38% | 10 pts | 28% | 22% | 3 pts | 19% |\\n| Net Premiums Written |\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\\n| Insurance | $ | 433,131 | 14% | $ | 381,118 | $ | 1,433,058 | 6% | $ | 1,352,122 |\\n| Reinsurance | 162,300 | (45%) | 296,099 | 1,855,529 | 7% | 1,727,185 |\\n| Total | $ | 595,431 | (12%) | $ | 677,217 | $ | 3,288,587 | 7% | $ | 3,079,307 |\\n\\nGross premiums written in the three and nine months ended September 30, 2016, increased by $23 million or 2% (3% on a constant currency basis(1)) and $436 million or 11% (13% on a constant currency basis) compared to the three and nine months ended September 30, 2015, respectively. The increase for the three months ended September 30, 2016 compared to the same period in 2015 was due to an increase in the insurance segment, partially offset by a decrease in the reinsurance segment. The increase for the nine months ended September 30, 2016 compared to the same period in 2015 was due to increases in both our reinsurance and insurance segments.\\nOur reinsurance segment's gross premiums written decreased by $45 million or 14% (13% on a constant currency basis) and increased by $293 million, or 16% (19% on a constant currency basis) in the three and nine months ended September 30, 2016, compared to the same periods in 2015, respectively. The decrease in the reinsurance segment gross written premiums in the three months ended September 30, 2016, compared to the same period of 2015 was primarily driven by timing differences impacting our professional and liability lines. The increase in the reinsurance segment gross written premiums in the nine months ended September 30, 2016, compared to the same period of 2015 was impacted by an increase in the level of premiums written on a multi-year basis. This increase in multi-year contracts increased the amount of premium recorded in the current period relating to future years compared to the same period in 2015. The increase in the nine months ended September 30, 2016 compared to the same period in 2015 was partially offset by foreign exchange movements as the strength of the U.S. dollar drove comparative premium decreases in treaties denominated in foreign currencies. After adjusting for the impact of the multi-year contracts and foreign exchange movements, our reinsurance segment gross premiums written increased by $204 million in the nine months ended September 30, 2016, compared to the same period in 2015. The growth was driven by new business in our liability, marine and other, catastrophe, professional as well as our credit and surety lines, with favorable treaty restructurings and timing differences also contributing to increased premium written in our liability and professional lines. These increases were partially offset by a decrease in our property lines primarily driven by non-renewals and decreases in the line sizes on several treaties.\\n| (1) | Amounts presented on a constant currency basis are “non-GAAP financial measures” as defined in Regulation G. The constant currency basis is calculated by applying the average foreign exchange rate from the current year to the prior year balance. |\\n\\n50\\nOur insurance segment's gross written premiums increased by $69 million or 11% (12% on a constant currency basis) and $142 million or 7% (8% on a constant currency basis) in the three and nine months ended September 30, 2016, compared to the same periods of 2015. Increased premiums written were reported in both periods in our accident and health and property lines primarily related to new business. The increase in the nine months ended September 30, 2016, compared to the same period in 2015 was partially offset by decreased premiums written in our marine lines and the impact of our exit from retail insurance operations in Australia.\\nIn the three and nine months ended September 30, 2016, the ceded ratio increased by 10% and 3%, compared to the three and nine months ended September 30, 2015, respectively, with the increases primarily attributable to the reinsurance segment. The reinsurance segment ceded ratio increased in the three and nine months ended September 30, 2016 compared to the same periods in 2015, largely due to a new retrocessional cover entered into with Harrington Re.\\nNet Premiums Earned:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | %Change | 2016 | 2015 | %Change |\\n| Insurance | $ | 444,691 | 48 | % | $ | 444,550 | 48 | % | —% | $ | 1,322,649 | 48 | % | $ | 1,344,339 | 49 | % | (2%) |\\n| Reinsurance | 489,724 | 52 | % | 474,791 | 52 | % | 3% | 1,461,097 | 52 | % | 1,420,266 | 51 | % | 3% |\\n| Total | $ | 934,415 | 100 | % | $ | 919,341 | 100 | % | 2% | $ | 2,783,746 | 100 | % | $ | 2,764,605 | 100 | % | 1% |\\n\\nChanges in net premiums earned reflect period to period changes in net premiums written and business mix, together with normal variability in premium earning patterns.\\nNet premiums earned increased by 2% (4% on a constant currency basis) and 1% (4% on a constant currency basis) in the three and nine months ended September 30, 2016, compared to the same periods in 2015, respectively. The increases were driven by the reinsurance segment in both periods, with a reduction in the insurance segment for the nine months ended September 30, 2016 compared to the same period in 2015, partially offsetting the increase in the reinsurance segment.\\nThe increase in the reinsurance segment for both periods was primarily driven by strong premium growth in our liability, marine and other as well as our catastrophe lines in recent periods together with favorable premium adjustments impacting our credit and surety lines. The growth for both periods was partially offset by increased premiums ceded in our catastrophe and property lines, as well as the impact on our liability and professional lines of the new retrocession to Harrington Re.\\nThe decrease in the insurance segment for the nine months ended September 30, 2016, compared to the same period in 2015, was primarily driven by an increase in our professional lines' ceded reinsurance programs, decreased business written in our marine lines and the impact of our exit from retail insurance operations in Australia, partially offset by growth in premiums written in recent periods in our accident and health lines.\\nOther Insurance Related Income (Loss):\\nThe increase in other insurance related income of $5 million in the three months ended September 30, 2016, compared to the same period in 2015, reflected fees from strategic capital partners and favorable fair value adjustments to economic hedges purchased to protect our agriculture line of business against fluctuations in commodity prices. The decrease in other insurance related income of $7 million in the nine months ended September 30, 2016, compared to the same period in 2015, reflected the impact of the realized gains on our weather and commodities derivative portfolio in the nine months ended September 30, 2015 compared to an immaterial impact in the nine months ended September 30, 2016, partially offset by third party capital fees and favorable fair value adjustments to economic hedges purchased to protect our agriculture line of business against fluctuations in commodity prices.\\n51\\nUNDERWRITING EXPENSES\\nThe following table provides a breakdown of our combined ratio:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | % PointChange | 2015 | 2016 | % PointChange | 2015 |\\n| Current accident year loss ratio | 65.1 | % | (0.8) | 65.9 | % | 67.8 | % | 2.0 | 65.8 | % |\\n| Prior year reserve development | (8.1 | %) | (3.2) | (4.9 | %) | (8.0 | %) | (2.0) | (6.0 | %) |\\n| Acquisition cost ratio | 20.3 | % | 0.4 | 19.9 | % | 20.1 | % | 0.7 | 19.4 | % |\\n| General and administrative expense ratio(1) | 15.3 | % | (0.4) | 15.7 | % | 15.8 | % | (0.7) | 16.5 | % |\\n| Combined ratio | 92.6 | % | (4.0) | 96.6 | % | 95.7 | % | — | 95.7 | % |\\n\\n| (1) | The general and administrative expense ratio includes corporate expenses not allocated to reportable segments of 3.1% and 2.6% for the three months ended September 30, 2016 and 2015, respectively, and 3.1% and 3.0% for the nine months ended September 30, 2016 and 2015, respectively. These costs are further discussed in the ‘Other Expenses (Revenues), Net’ section. |\\n\\nCurrent Accident Year Loss Ratio:\\nThe current accident year loss ratio decreased to 65.1% in the three months ended September 30, 2016 from 65.9% in the same period in 2015, while the current accident year loss ratio increased to 67.8% in the nine months ended September 30, 2016 from 65.8% in the same period in 2015.\\nThe decrease for the three months ended September 30, 2016 compared to the same period in 2015 was impacted by a lower level of catastrophe and weather-related losses and the increase for the nine months ended September 30, 2016 compared to the same period in 2015 was impacted by an increased level of catastrophe and weather-related losses. During the three and nine months ended September 30, 2016, we incurred $22 million, or 2.3 points, and $145 million, or 5.3 points, respectively, in pre-tax catastrophe and weather-related losses, net of reinstatement premiums, attributable to the weather-related events, Fort McMurray wildfires, the Japanese and Ecuadorian earthquakes, North Calgary hailstorm and European floods. Comparatively, during the three and nine months ended September 30, 2015 we incurred $43 million, or 4.7 points, and $90 million, or 3.3 points, respectively.\\nAfter adjusting for the impact of the catastrophe and weather-related losses, our current accident year loss ratios in the three and nine months ended September 30, 2016, were 62.8% and 62.5%, respectively, compared to 61.2% and 62.5% in the three and nine months ended September 30, 2015, respectively. The increase in the current accident year loss ratios after adjusting for the impact of the catastrophe and weather-related losses for the three months ended September 30, 2016, compared to the same period in 2015, was mainly due to business mix changes as well as the ongoing adverse impact of rate and trend, partially offset by a decrease in the mid-size loss experience in our insurance marine and property lines. The current accident year loss ratio after adjusting for the impact of the catastrophe and weather-related losses for the nine months ended September 30, 2016 was comparable to the same periods in 2015. The adverse impact of rate and trend together with business mix changes were offset by a decrease in the mid-size loss experience in our insurance marine and property lines.\\nPrior Year Reserve Development:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Insurance | $ | 20,688 | $ | 2,444 | $ | 43,181 | $ | 21,225 |\\n| Reinsurance | 55,331 | 42,681 | 180,950 | 144,579 |\\n| Total | $ | 76,019 | $ | 45,125 | $ | 224,131 | $ | 165,804 |\\n\\n52\\nOverview\\nThe majority of the net favorable prior year reserve development in each period related to short-tail reserve classes. Net favorable prior year reserve development for professional, reinsurance liability and motor reserve classes also contributed in the three and nine months ended September 30, 2016.\\nOur short tail business includes the underlying exposures in the property and other, marine and aviation reserving classes within our insurance segment and the property and other reserving class within our reinsurance segment . Development from these classes contributed $41 million and $38 million of the total net favorable prior year reserve development for the three months ended September 30, 2016 and 2015, respectively. For the nine months ended September 30, 2016 and 2015, these short-tail lines contributed $116 million and $112 million, respectively, of net favorable prior year reserve development. The net favorable prior year reserve development for these classes primarily reflected the recognition of better than expected loss emergence.\\nOur medium-tail business consists primarily of professional insurance and reinsurance reserve classes, credit and political risk insurance reserve class and the credit and surety reinsurance reserve class. In the three and nine months ended September 30, 2016, the professional reserve classes contributed net favorable prior year reserve development of $12 million and $28 million, respectively. In the nine months ended September 30, 2015, the reinsurance professional reserve class contributed $25 million of net favorable development. The net favorable prior year development on these reserve classes continued to reflect the generally favorable experience on earlier accident years as we continued to transition to more experience based methods on these years. As our loss experience has generally been better than expected, this resulted in the recognition of net favorable prior year reserve development. In the three and nine months ended September 30, 2015, the insurance professional reserve class recorded net adverse prior year reserve development of $15 million and $16 million, respectively. This adverse development was primarily the result of strengthening in our Australian book of business during the third quarter of 2015.\\nIn the three and nine months ended September 30, 2015, the credit and surety reserve class recorded net favorable prior year reserve development of $7 million and $19 million, respectively. This net favorable prior year reserve development reflected the recognition of generally better than expected loss emergence.\\nIn the nine months ended September 30, 2015, we recorded net adverse prior year reserve development of $15 million in our credit and political risk reserve class relating to an increase in our loss portfolio estimates.\\nOur long-tail business consists primarily of liability and motor reserve classes. Our motor and liability reinsurance reserve classes contributed additional net favorable prior year reserve development of $17 million and $20 million in the three months ended September 30, 2016 and 2015, respectively. For the nine months ended September 30, 2016 and 2015, these long-tail reserve classes contributed $72 million and $64 million, respectively. The net favorable prior year reserve development for the motor reserve class related to favorable loss emergence trends on several classes of business spanning multiple accident years. The net favorable prior year reserve development for the liability reinsurance reserve class primarily reflected the progressively increased weight given by management to experience based indications on older accident years, which has generally been favorable. In the three and nine months ended September 30, 2015, we recorded net adverse prior year reserve development of $6 million and $23 million, respectively, in our insurance liability reserve class related primarily to an increase in loss estimates for specific individual claim reserves, as well as a higher frequency of large auto liability claims.\\nWe caution that conditions and trends that impacted the development of our liabilities in the past may not necessarily occur in the future.\\nEstimates of Significant Catastrophe Events\\nOur September 30, 2016 net reserves for losses and loss expenses includes estimated amounts for numerous catastrophe events. We caution that the magnitude and/or complexity of losses arising from certain of these events, in particular the Fort McMurray wildfires, Storm Sandy, the 2011 Japanese earthquake and tsunami, the three New Zealand earthquakes and the Tianjin port explosion, inherently increases the level of uncertainty and, therefore, the level of management judgment involved in arriving at our estimated net reserves for losses and loss expenses. As a result, our actual losses for these events may ultimately differ materially from our current estimates.\\n53\\nOur estimated net losses in relation to the catastrophe events described above were derived from ground-up assessments of our in-force contracts and treaties providing coverage in the affected regions. These assessments take into account the latest information available from clients, brokers and loss adjusters. In addition, we consider industry insured loss estimates, market share analyses and catastrophe modeling analyses, when appropriate. Our estimates remain subject to change, as additional loss data becomes available.\\nThe following sections provide further details on prior year reserve development by segment, reserving class and accident year.\\nInsurance Segment:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Property and other | $ | 10,061 | $ | 20,518 | $ | 24,048 | $ | 49,705 |\\n| Marine | 4,682 | 2,831 | 8,382 | 23,156 |\\n| Aviation | 517 | 667 | 437 | 2,884 |\\n| Credit and political risk | (25 | ) | (28 | ) | (232 | ) | (15,427 | ) |\\n| Professional lines | 3,378 | (15,279 | ) | 8,956 | (15,887 | ) |\\n| Liability | 2,075 | (6,265 | ) | 1,590 | (23,206 | ) |\\n| Total | $ | 20,688 | $ | 2,444 | $ | 43,181 | $ | 21,225 |\\n\\nIn the three months ended September 30, 2016, we recognized $21 million of net favorable prior year reserve development, the principal components of which were:\\n| • | $10 million of net favorable prior year reserve development on property and other business, driven by better than expected loss emergence, primarily driven by reductions in mid-size loss estimates impacting accident year 2015 and favorable loss experience in our accident and health lines impacting accident year 2014. |\\n\\n| • | $5 million of net favorable prior year reserve development on marine business, driven by better than expected loss emergence, primarily driven by reductions in mid-size loss estimates impacting accident year 2015. |\\n\\nIn the three months ended September 30, 2015, we recognized $2 million of net favorable prior year reserve development, the principal components of which were:\\n| • | $21 million of net favorable prior year reserve development on property and other business, driven by better than expected loss emergence including reserve reductions related to Storm Sandy of $15 million. |\\n\\n| • | $6 million of net adverse prior year reserve development on liability business, primarily related to a higher frequency of large auto liability claims in accident year 2014. |\\n\\n| • | $15 million of net adverse prior year reserve development on professional lines business, predominately reflecting reserve strengthening resulting from updated actuarial assumptions for our Australian professional lines and impacting accident years 2010 to 2014, partially offset by favorable development in certain US professional lines. |\\n\\nIn the nine months ended September 30, 2016, we recognized $43 million of net favorable prior year reserve development, the principal components of which were:\\n| • | $24 million of net favorable prior year reserve development on property and other business, driven by better than expected loss emergence primarily related to accident year 2014. |\\n\\n| • | $9 million of net favorable prior year reserve development on professional lines business, driven by better than expected development related to various accident years, partially offset by reserve strengthening relating to updated information on one specific claim impacting accident year 2010. |\\n\\n54\\n| • | $8 million of net favorable prior year reserve development on marine business, driven by better than expected loss emergence, primarily driven by reductions in mid-size loss estimates impacting accident year 2015. |\\n\\nIn the nine months ended September 30, 2015, we recognized $21 million of net favorable prior year development, the principal components of which were:\\n| • | $50 million of net favorable prior year reserve development on property and other business, related to the 2012 and 2013 accident years and driven by better than expected loss emergence, including reserve reductions related to Storm Sandy of $16 million. |\\n\\n| • | $23 million of net favorable prior year reserve development on marine business, largely related to better than expected loss emergence in our energy offshore business spanning multiple years, particularly accident year 2014. |\\n\\n| • | $15 million of net adverse prior year reserve development on credit and political risk business, related to updated information on one specific claim impacting accident year 2014. |\\n\\n| • | $16 million of net adverse prior year reserve development on professional lines business, predominately reflecting reserve strengthening resulting from updated actuarial assumptions for our Australian professional lines and impacting accident years 2010 to 2014, partially offset by favorable development in certain US professional lines. |\\n\\n| • | $23 million of net adverse prior year reserve development on liability business, related to strengthening of specific individual claim reserves and a higher frequency of large auto liability claims in accident year 2014. |\\n\\nReinsurance Segment:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Property and other | $ | 25,831 | $ | 14,115 | $ | 83,522 | $ | 36,120 |\\n| Credit and surety | 3,900 | 7,051 | 6,761 | 18,851 |\\n| Professional lines | 8,761 | 1,250 | 18,918 | 25,331 |\\n| Motor | 6,653 | 8,997 | 39,794 | 27,321 |\\n| Liability | 10,186 | 11,268 | 31,955 | 36,956 |\\n| Total | $ | 55,331 | $ | 42,681 | $ | 180,950 | $ | 144,579 |\\n\\nIn the three months ended September 30, 2016, we recognized $55 million of net favorable prior year reserve development, the principal components of which were:\\n| • | $26 million of net favorable prior year reserve development on property and other business, related to the 2011 through 2015 accident years driven by better than expected loss emergence including a reserve reduction of $7 million related to Storm Sandy. |\\n\\n| • | $10 million of net favorable prior year reserve development on liability business, primarily related to the 2007 through 2010 accident years, for reasons discussed in the overview. |\\n\\n| • | $9 million of net favorable prior year reserve development on professional lines business, primarily related to the 2005 through 2010 accident years, for reasons discussed in the overview. |\\n\\n| • | $7 million of net favorable prior year reserve development on motor business, related to non-proportional business spanning multiple accident years, driven by better than expected loss emergence. |\\n\\nIn the three months ended September 30, 2015, we recognized $43 million of net favorable prior year reserve development, the principal components of which were:\\n55\\n| • | $14 million of net favorable prior year reserve development on property and other business, related to multiple prior accident years and driven by better than expected loss emergence. |\\n\\n| • | $11 million of net favorable prior year reserve development on liability business, primarily related to the 2003 through 2010 accident years, for reasons discussed in the overview. |\\n\\n| • | $9 million of net favorable prior year reserve development on motor business, largely related to favorable loss emergence trends on several classes spanning multiple accident years. |\\n\\n| • | $7 million of net favorable prior year reserve development on credit and surety business, related to the 2012 accident year and driven by additional information obtained about a specific claim. |\\n\\nIn the nine months ended September 30, 2016, we recognized $181 million of net favorable prior year reserve development, the principal components of which were:\\n| • | $84 million of net favorable prior year development on property and other business, primarily related to the 2010 through 2015 accident years driven by better than expected loss emergence. |\\n\\n| • | $40 million of net favorable prior year reserve development on motor business, primarily related to non-proportional business spanning multiple accident years, driven by better than expected loss emergence. |\\n\\n| • | $32 million of net favorable prior year reserve development on liability business, primarily related to the 2006 through 2011 accident years, for reasons discussed in the overview. |\\n\\n| • | $19 million of net favorable prior year reserve development on professional lines business, primarily related to the 2005 through 2010 accident years, for reasons discussed in the overview. |\\n\\nIn the nine months ended September 30, 2015, we recognized $145 million of net favorable prior year reserve development, the principal components of which were:\\n| • | $37 million of net favorable prior year reserve development on liability business, primarily related to the 2003 through 2010 accident years, for reasons discussed in the overview. |\\n\\n| • | $36 million of net favorable prior year reserve development on property and other business, spanning a number of accident years and driven by better than expected loss emergence. Included in this net development is $20 million of adverse development on agriculture reserves relating to loss developments on the 2014 accident year driven by lower than expected crop yields reported for two specific treaties. |\\n\\n| • | $27 million of net favorable prior year reserve development on motor business, predominantly related to non-proportional business in accident years 2011 and prior, driven by better than expected loss emergence. |\\n\\n| • | $25 million of net favorable prior year reserve development on professional lines business, primarily related to the 2009 through 2010 accident years, for reasons discussed in the overview. |\\n\\n\\n| • | $19 million of net favorable prior year reserve development on credit and surety business, spanning multiple accident years and driven by better than expected loss emergence, as well as additional information obtained about a specific claim. |\\n\\nAcquisition Cost Ratio: The increase in the acquisition cost ratio in the three and nine months ended September 30, 2016 to 20.3% and 20.1%, respectively, compared to 19.9% and 19.4% in the three and nine months ended September 30, 2015, respectively, was driven by increases in our reinsurance segment. The reinsurance segment's increase in the three months ended September 30, 2016 compared to the same period in 2015 was primarily due to the impact of retrocessional contracts, an increase in the amount of business being written on a proportional basis, higher acquisition costs in certain lines of business and fees from strategic capital partners which were a benefit in 2015. The reinsurance segment's increase in the nine months ended September 30, 2016 compared to the same period in 2015 was primarily due to an increase in the amount of business being written on a proportional basis, higher acquisition costs in certain lines of business and the impact of retrocessional contracts.\\n56\\nGeneral and Administrative Expense Ratio: The general and administrative expense ratio in the three and nine months ended September 30, 2016, decreased to 15.3% and 15.8%, respectively, compared to 15.7% and 16.5% in the three and nine months ended September 30, 2015, respectively. The decrease in the expense ratio in the three months ended September 30, 2016 compared to the same period in 2015 was primarily attributable to growth in net premiums earned, reorganization related expenses adverse to 2015 and increased fees from strategic capital partners, partially offset by the net reimbursement of PartnerRe merger-related expenses benefiting 2015 and senior executive transition costs in 2016. The decrease in the expense ratio in the nine months ended September 30, 2016 compared to the same period in 2015 was primarily driven by growth in net earned premiums, increased fees from strategic capital partners, decreased personnel costs and expenses attributable to the proposed merger with PartnerRe and reorganization related expenses adverse to 2015, partially offset by adjustments to senior leadership executive stock-compensation awards benefiting 2015 and senior executive transition costs in 2016.\\nRESULTS BY SEGMENT\\nINSURANCE SEGMENT\\nResults from our insurance segment were as follows:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\\n| Revenues: |\\n| Gross premiums written | $ | 675,430 | 11% | $ | 606,704 | $ | 2,112,796 | 7% | $ | 1,970,554 |\\n| Net premiums written | 433,131 | 14% | 381,118 | 1,433,058 | 6% | 1,352,122 |\\n| Net premiums earned | 444,691 | —% | 444,550 | 1,322,649 | (2%) | 1,344,339 |\\n| Other insurance related income (loss) | 39 | (93%) | 542 | (57 | ) | nm | 811 |\\n| Expenses: |\\n| Current year net losses and loss expenses | (293,914 | ) | (285,716 | ) | (896,952 | ) | (887,805 | ) |\\n| Prior year reserve development | 20,688 | 2,444 | 43,181 | 21,225 |\\n| Acquisition costs | (61,755 | ) | (69,118 | ) | (184,982 | ) | (200,493 | ) |\\n| General and administrative expenses | (84,588 | ) | (85,814 | ) | (252,652 | ) | (261,924 | ) |\\n| Underwriting income | $ | 25,161 | 265% | $ | 6,888 | $ | 31,187 | 93% | $ | 16,153 |\\n| Ratios: | % PointChange | % PointChange |\\n| Current year loss ratio | 66.1 | % | 1.8 | 64.3 | % | 67.8 | % | 1.8 | 66.0 | % |\\n| Prior year reserve development | (4.7 | %) | (4.1) | (0.6 | %) | (3.2 | %) | (1.7) | (1.5 | %) |\\n| Acquisition cost ratio | 13.9 | % | (1.6) | 15.5 | % | 14.0 | % | (0.9) | 14.9 | % |\\n| General and administrative expense ratio | 19.1 | % | (0.3) | 19.4 | % | 19.0 | % | (0.5) | 19.5 | % |\\n| Combined ratio | 94.4 | % | (4.2) | 98.6 | % | 97.6 | % | (1.3) | 98.9 | % |\\n\\nnm – not meaningful\\n57\\nGross Premiums Written:\\nThe following table provides gross premiums written by line of business:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | % Change | 2016 | 2015 | % Change |\\n| Property | $ | 164,605 | 25 | % | $ | 139,488 | 24 | % | 18% | $ | 522,380 | 24 | % | $ | 465,929 | 24 | % | 12% |\\n| Marine | 33,677 | 5 | % | 38,817 | 6 | % | (13%) | 191,298 | 9 | % | 215,885 | 11 | % | (11%) |\\n| Terrorism | 9,394 | 1 | % | 11,192 | 2 | % | (16%) | 28,090 | 1 | % | 25,737 | 1 | % | 9% |\\n| Aviation | 9,684 | 1 | % | 10,222 | 2 | % | (5%) | 37,111 | 2 | % | 29,755 | 2 | % | 25% |\\n| Credit and Political Risk | 5,423 | 1 | % | 8,542 | 1 | % | (37%) | 34,299 | 2 | % | 29,640 | 2 | % | 16% |\\n| Professional Lines | 204,926 | 30 | % | 196,218 | 32 | % | 4% | 590,417 | 28 | % | 598,370 | 30 | % | (1%) |\\n| Liability | 108,447 | 16 | % | 104,666 | 17 | % | 4% | 310,797 | 15 | % | 300,204 | 15 | % | 4% |\\n| Accident and Health | 139,274 | 21 | % | 97,559 | 16 | % | 43% | 398,404 | 19 | % | 305,034 | 15 | % | 31% |\\n| Total | $ | 675,430 | 100 | % | $ | 606,704 | 100 | % | 11% | $ | 2,112,796 | 100 | % | $ | 1,970,554 | 100 | % | 7% |\\n\\nGross premiums written in the three months ended September 30, 2016, increased by $69 million or 11% (12% on a constant currency basis) compared to the three months ended September 30, 2015. The increase was primarily attributable to growth in our accident and health and property lines related to new business opportunities.\\nGross premiums written in the nine months ended September 30, 2016 increased by $142 million or 7% (8% on a constant currency basis) compared to the nine months ended September 30, 2015. The increase was primarily attributable to increases in our accident and health and property lines driven by new business. These increases were partially offset by a decrease in our marine and professional lines. Our marine lines decreased primarily due to reduced new business opportunities, lower rates and timing differences. The professional lines' decrease was due to the impact of our exit from retail insurance operations in Australia, as mentioned above in the quarterly results.\\nPremiums Ceded: In the three and nine months ended September 30, 2016, premiums ceded were $242 million, or 36% of gross premiums written and $680 million, or 32% of gross premiums written, respectively, compared to $226 million, or 37% of gross premiums written and $618 million or 31% of gross premiums written, in the three and nine months ended September 30, 2015, respectively. The decrease in the ceded ratio for the three months ended September 30, 2016 compared to the same period in 2015 was primarily driven by changes in our accident and health line, partially offset by increased premiums ceded in our liability and professional lines. The increase in the ceded ratio for the nine months ended September 30, 2016 compared to the same period in 2015 was primarily driven by increased ceded premiums in our professional lines, partially offset by changes in our accident and health line.\\n58\\nNet Premiums Earned:\\nThe following table provides net premiums earned by line of business:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | % Change | 2016 | 2015 | % Change |\\n| Property | $ | 106,578 | 25 | % | $ | 112,017 | 27 | % | (5%) | $ | 312,804 | 23 | % | $ | 324,720 | 24 | % | (4%) |\\n| Marine | 36,218 | 8 | % | 36,837 | 8 | % | (2%) | 113,693 | 9 | % | 143,878 | 11 | % | (21%) |\\n| Terrorism | 8,276 | 2 | % | 7,985 | 2 | % | 4% | 26,011 | 2 | % | 26,565 | 2 | % | (2%) |\\n| Aviation | 9,015 | 2 | % | 9,982 | 2 | % | (10%) | 33,528 | 3 | % | 32,097 | 2 | % | 4% |\\n| Credit and Political Risk | 12,274 | 3 | % | 14,671 | 3 | % | (16%) | 42,661 | 3 | % | 45,993 | 3 | % | (7%) |\\n| Professional Lines | 126,574 | 28 | % | 148,110 | 33 | % | (15%) | 386,241 | 29 | % | 451,944 | 34 | % | (15%) |\\n| Liability | 42,205 | 9 | % | 41,817 | 9 | % | 1% | 126,429 | 10 | % | 120,181 | 9 | % | 5% |\\n| Accident and Health | 103,551 | 23 | % | 73,131 | 16 | % | 42% | 281,282 | 21 | % | 198,961 | 15 | % | 41% |\\n| Total | $ | 444,691 | 100 | % | $ | 444,550 | 100 | % | —% | $ | 1,322,649 | 100 | % | $ | 1,344,339 | 100 | % | (2%) |\\n\\nNet premiums earned in the three months ended September 30, 2016, were comparable (up 2% on a constant currency basis) to the three months ended September 30, 2015, driven by growth in premiums written in recent periods, primarily in our accident and health lines, offset by an increase in our professional lines' ceded reinsurance programs. Net premiums earned in the nine months ended September 30, 2015 decreased by $22 million or 2% (comparable on a constant currency basis) compared to the nine months ended September 30, 2015. The decrease in net premiums earned in the nine months ended September 30, 2016 compared to the same period in 2015 was primarily driven by an increase in our professional lines' ceded reinsurance programs, a reduction in business written in our marine lines and the impact of our exit from retail insurance operations in Australia partially offset by growth in our accident and health lines.\\nLoss Ratio:\\nThe table below shows the components of our loss ratio:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | % PointChange | 2015 | 2016 | % PointChange | 2015 |\\n| Current accident year | 66.1 | % | 1.8 | 64.3 | % | 67.8 | % | 1.8 | 66.0 | % |\\n| Prior year reserve development | (4.7 | %) | (4.1) | (0.6 | %) | (3.2 | %) | (1.7) | (1.5 | %) |\\n| Loss ratio | 61.4 | % | (2.3) | 63.7 | % | 64.6 | % | 0.1 | 64.5 | % |\\n\\n59\\nCurrent Accident Year Loss Ratio:\\nThe current accident year loss ratios increased to 66.1% and 67.8% in the three and nine months ended September 30, 2016, respectively, from 64.3% and 66.0% in the three and nine months ended September 30, 2015, respectively.\\nDuring the three and nine months ended September 30, 2016, we incurred $15 million, or 3.3 points, and $73 million, or 5.5 points, respectively, in pre-tax catastrophe and weather-related losses related to the U.S. weather events, Japanese earthquake and Fort McMurray wildfires. Comparatively, during the three and nine months ended September 30, 2015 we incurred $19 million, or 4.3 points, and $45 million, or 3.4 points, respectively.\\nAfter adjusting for the impact of the catastrophe and weather-related losses, our current accident year loss ratios in the three and nine months ended September 30, 2016, were 62.8% and 62.3%, respectively, compared to 60.0% and 62.7% in the three and nine months ended September 30, 2015, respectively. The increases in the current accident year loss ratios after adjusting for the impact of the catastrophe and weather-related losses for the three and nine months ended September 30, 2016 compared to the same periods in 2015 was driven by the adverse impact of rate and trend on most lines of business and changes in business mix, partially offset by a decrease in the mid-size loss experience particularly in our marine and property lines.\\nRefer to the ‘Prior Year Reserve Development’ section for further details.\\nAcquisition Cost Ratio: The decrease in the acquisition cost ratio in the three and nine months ended September 30, 2016 compared to the three and nine months ended September 30, 2015, was driven by an increase in ceding commissions following the expansion of our professional lines' ceded reinsurance programs and a lower acquisition cost ratio in our accident and health line resulting from a change in business mix.\\nGeneral and Administrative Expense Ratio: The decrease in the general and administrative expense ratio in the nine months ended September 30, 2016 compared nine months ended September 30, 2015 primarily reflected a decrease in personnel expenses and a reduction in the allocation of certain corporate expenses.\\n60\\nREINSURANCE SEGMENT\\nResults from our reinsurance segment were as follows:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\\n| Revenues: |\\n| Gross premiums written | $ | 284,532 | (14%) | $ | 329,879 | $ | 2,126,762 | 16% | $ | 1,833,374 |\\n| Net premiums written | 162,300 | (45%) | 296,099 | 1,855,529 | 7% | 1,727,185 |\\n| Net premiums earned | 489,724 | 3% | 474,791 | 1,461,097 | 3% | 1,420,266 |\\n| Other insurance related income | 5,905 | nm | 616 | 4,907 | (57%) | 11,508 |\\n| Expenses: |\\n| Current year net losses and loss expenses | (314,433 | ) | (319,796 | ) | (990,763 | ) | (930,867 | ) |\\n| Prior year reserve development | 55,331 | 42,681 | 180,950 | 144,579 |\\n| Acquisition costs | (128,055 | ) | (113,626 | ) | (374,588 | ) | (337,056 | ) |\\n| General and administrative expenses | (29,635 | ) | (35,309 | ) | (99,980 | ) | (110,701 | ) |\\n| Underwriting income | $ | 78,837 | 60% | $ | 49,357 | $ | 181,623 | (8%) | $ | 197,729 |\\n| Ratios: | % PointChange | % PointChange |\\n| Current year loss ratio | 64.2 | % | (3.2) | 67.4 | % | 67.8 | % | 2.3 | 65.5 | % |\\n| Prior year reserve development | (11.3 | %) | (2.3) | (9.0 | %) | (12.4 | %) | (2.3) | (10.1 | %) |\\n| Acquisition cost ratio | 26.1 | % | 2.2 | 23.9 | % | 25.6 | % | 1.9 | 23.7 | % |\\n| General and administrative expense ratio | 6.1 | % | (1.3) | 7.4 | % | 6.9 | % | (0.9) | 7.8 | % |\\n| Combined ratio | 85.1 | % | (4.6) | 89.7 | % | 87.9 | % | 1.0 | 86.9 | % |\\n\\nnm – not meaningful\\nGross Premiums Written:\\nThe following table provides gross premiums written by line of business for the periods indicated:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | % Change | 2016 | 2015 | % Change |\\n| Catastrophe | $ | 46,338 | 16 | % | $ | 56,693 | 18 | % | (18%) | $ | 316,692 | 15 | % | $ | 283,562 | 15 | % | 12% |\\n| Property | 61,957 | 22 | % | 67,539 | 20 | % | (8%) | 283,555 | 13 | % | 307,809 | 17 | % | (8%) |\\n| Professional Lines | 19,479 | 7 | % | 45,509 | 14 | % | (57%) | 235,094 | 11 | % | 204,685 | 11 | % | 15% |\\n| Credit and Surety | 36,174 | 13 | % | 23,390 | 7 | % | 55% | 315,102 | 15 | % | 230,958 | 13 | % | 36% |\\n| Motor | 13,344 | 5 | % | 21,359 | 6 | % | (38%) | 338,403 | 16 | % | 333,245 | 18 | % | 2% |\\n| Liability | 91,387 | 32 | % | 111,361 | 34 | % | (18%) | 365,380 | 17 | % | 258,862 | 14 | % | 41% |\\n| Agriculture | 1,286 | — | % | (3,303 | ) | (1 | %) | nm | 151,315 | 7 | % | 139,135 | 8 | % | 9% |\\n| Engineering | 13,588 | 5 | % | 4,397 | 1 | % | 209% | 56,719 | 3 | % | 58,163 | 3 | % | (2%) |\\n| Marine and Other | 979 | — | % | 2,934 | 1 | % | (67%) | 64,502 | 3 | % | 16,955 | 1 | % | 280% |\\n| Total | $ | 284,532 | 100 | % | $ | 329,879 | 100 | % | (14%) | $ | 2,126,762 | 100 | % | $ | 1,833,374 | 100 | % | 16% |\\n\\nGross premiums written decreased by $45 million and increased by $293 million in the three and nine months ended September 30, 2016, compared to the same periods in 2015, respectively.\\n61\\nThe decrease in gross premiums written in the three months ended September 30, 2016 compared to the same period in 2015, was primarily driven by our professional and liability lines, largely due to timing differences.\\nThe increase in gross premiums written in the nine months ended September 30, 2016 compared to the same period in 2015, was impacted by treaties written on a multi-year basis. In the nine months ended September 30, 2016, the reinsurance segment reported an increase in the level of multi-year contracts written compared to the same period in 2015. This increase in multi-year contracts increased the amount of premium recorded in the current periods relating to future years compared to the same periods in 2015, most notably in the credit & surety and liability lines. On a comparative basis the impact of the multi-year premiums resulted in an increase in gross premiums written of $141 million in the nine months ended September 30, 2016, compared to the same period in 2015. The increase in written premiums was partially offset by the impact of foreign exchange movements in the nine months ended September 30, 2016, compared to the same period in 2015, as the strength of the U.S. dollar drove comparative premium decreases in the treaties denominated in foreign currencies. Foreign exchange movements resulted in a relative decrease of $52 million in gross premiums written in the nine months ended September 30, 2016, compared to the same period in 2015.\\nAfter adjusting for the impact of multi-year contracts and on a constant currency basis, our gross premiums written increased by $204 million, or 11% in the nine months ended September 30, 2016, compared to the same period in 2015. The growth was driven by increases in our liability, marine and other, catastrophe, professional as well as our credit and surety lines primarily driven by new business. Favorable treaty restructurings and timing differences also contributed to the increases in liability and professional lines. These increases were partially offset by a decrease in our property lines, primarily relating to non-renewals and decreases in line sizes on several treaties.\\nPremiums Ceded: In the three and nine months ended September 30, 2016, the ratio of ceded premium to gross written premium increased to 43% and 13%, respectively, from 10% and 6% in the three and nine months ended September 30, 2015, respectively. The increase for the three months ended September 30, 2016 compared to the prior period, was due to the impact of a new retrocessional cover entered into with Harrington Re which increased premiums ceded in our liability and professional lines. The increase for the nine months ended September 30, 2016 compared to the prior period was largely due to the new retrocessions to Harrington Re and increased premiums ceded in our catastrophe and property business.\\nNet Premiums Earned:\\nThe following table provides net premiums earned by line of business:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | % Change | 2016 | 2015 | % Change |\\n| Catastrophe | $ | 48,799 | 10 | % | $ | 51,116 | 11 | % | (5%) | $ | 151,416 | 12 | % | $ | 165,840 | 12 | % | (9%) |\\n| Property | 71,649 | 15 | % | 78,343 | 17 | % | (9%) | 208,179 | 14 | % | 235,828 | 17 | % | (12%) |\\n| Professional Lines | 73,109 | 15 | % | 81,986 | 17 | % | (11%) | 225,813 | 15 | % | 231,024 | 16 | % | (2%) |\\n| Credit and Surety | 67,430 | 14 | % | 59,601 | 13 | % | 13% | 192,135 | 13 | % | 182,508 | 13 | % | 5% |\\n| Motor | 77,786 | 16 | % | 72,893 | 15 | % | 7% | 232,383 | 16 | % | 228,433 | 16 | % | 2% |\\n| Liability | 80,137 | 16 | % | 77,441 | 16 | % | 3% | 247,103 | 17 | % | 218,829 | 15 | % | 13% |\\n| Agriculture | 36,704 | 7 | % | 33,684 | 7 | % | 9% | 106,251 | 7 | % | 101,335 | 7 | % | 5% |\\n| Engineering | 18,573 | 4 | % | 15,128 | 3 | % | 23% | 51,024 | 3 | % | 43,133 | 3 | % | 18% |\\n| Marine and Other | 15,537 | 3 | % | 4,599 | 1 | % | 238% | 46,793 | 3 | % | 13,336 | 1 | % | 251% |\\n| Total | $ | 489,724 | 100 | % | $ | 474,791 | 100 | % | 3% | $ | 1,461,097 | 100 | % | $ | 1,420,266 | 100 | % | 3% |\\n\\nNet premiums earned increased by $15 million or 3% (7% on a constant currency basis) and $41 million or 3% (7% on a constant currency basis) in the three and nine months ended September 30, 2016, compared to the same periods in 2015, respectively.\\nThe increase for both periods was primarily driven by the growth in the business written in our liability, marine and other as well as our catastrophe lines in recent periods together with a favorable premium adjustments impacting our credit and surety lines. The growth for both periods was partially offset by increased premiums ceded in our catastrophe and property lines, as well as the impact on our liability and professional lines of the new retrocession to Harrington Re.\\n62\\nOther Insurance Related Income (Losses):\\nThe increase in other insurance related income of $5 million in the three months ended September 30, 2016, compared to the same period in 2015, reflected fees from strategic capital partners and favorable fair value adjustments to economic hedges purchased to protect our agriculture line of business against fluctuations in commodity prices. The decrease in other insurance related income of $7 million in the nine months ended September 30, 2016, compared to the same period in 2015, reflected the impact of the realized gains on our weather and commodities derivative portfolio in the nine months ended September 30, 2015 compared to an immaterial impact in the nine months ended September 30, 2016, partially offset by fees from strategic capital partners and favorable fair value adjustments to economic hedges purchased to protect our agriculture line of business against fluctuations in commodity prices.\\nLoss Ratio:\\nThe table below shows the components of our loss ratio:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | % PointChange | 2015 | 2016 | % PointChange | 2015 |\\n| Current accident year | 64.2 | % | (3.2) | 67.4 | % | 67.8 | % | 2.3 | 65.5 | % |\\n| Prior year reserve development | (11.3 | %) | (2.3) | (9.0 | %) | (12.4 | %) | (2.3) | (10.1 | %) |\\n| Loss ratio | 52.9 | % | (5.5) | 58.4 | % | 55.4 | % | — | 55.4 | % |\\n\\nCurrent Accident Year Loss Ratio:\\nThe current accident year loss ratio decreased to 64.2% in the three months ended September 30, 2016 from 67.4% in the same period in 2015, while the current accident year loss ratio increased to 67.8% in the nine months ended September 30, 2016 from 65.5% in the same period in 2015.\\nThe decrease for the three months ended September 30, 2016 compared to the same period in 2015 was impacted by a lower level of catastrophe and weather-related losses and the increase for the nine months ended September 30, 2016 compared to the same period in 2015 was impacted by an increased level of catastrophe and weather-related losses. During the three and nine months ended September 30, 2016, we incurred $7 million, or 1.5 points, and $72 million, or 5.0 points, respectively, in pre-tax catastrophe and weather-related losses, net of reinstatement premiums, attributable to the weather-related events, Fort McMurray wildfires, the Japanese and Ecuadorian earthquakes, North Calgary hailstorm and European floods. Comparatively, during the three and nine months ended September 30, 2015 we incurred $24 million, or 5.1 points, and $45 million, or 3.2 points, respectively.\\nAfter adjusting for the impact of the catastrophe and weather-related losses, our current accident year loss ratios in the three and nine months ended September 30, 2016, were 62.7% and 62.8%, respectively, compared to 62.3% in both the three and nine months ended September 30, 2015. The increases in the current accident year loss ratios after adjusting for the impact of the catastrophe and weather-related losses for the three and nine months ended September 30, 2016 compared to the same periods in 2015 was mainly due to the ongoing adverse impact of rate and trend, partially offset by the recognition of better than expected recent attritional loss experience across our long tail lines of business.\\nRefer ‘Prior Year Reserve Development’ for further details.\\nAcquisition Cost Ratio: The acquisition cost ratio increased in both the three and nine months ended September 30, 2016 compared to the same periods in 2015. The increase in the three months ended September 30, 2016 was primarily due to the impact of retrocessional contracts, an increase in the amount of business being written on a proportional basis together with higher acquisition costs in certain lines of business and fees from strategic capital partners which were a benefit in 2015. The increase in the nine months ended September 30, 2016 compared to the same period in 2015 was primarily due to an increase in the amount of business being written on a proportional basis, higher acquisition costs in certain lines of business and the impact of retrocessional contracts.\\n63\\nGeneral and Administrative Expense Ratio: The general and administrative expense ratio decreased in both the three and nine months ended September 30, 2016 compared to the same periods in 2015. The decrease in the general and administrative expense ratio primarily reflects lower personnel expense, benefits of arrangements with our strategic capital partners and the impact of increased net earned premiums.\\nOTHER EXPENSES (REVENUES), NET\\nThe following table provides a breakdown of our other expenses (revenues), net:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\\n| Corporate expenses | $ | 28,683 | 22% | $ | 23,604 | $ | 86,922 | 4% | $ | 83,826 |\\n| Foreign exchange gains | (13,795 | ) | (51%) | (28,088 | ) | (69,781 | ) | 1% | (69,200 | ) |\\n| Interest expense and financing costs | 12,839 | (1%) | 12,918 | 38,586 | 1% | 38,114 |\\n| Income tax expense | 9,352 | nm | 30 | 7,712 | nm | 1,155 |\\n| Total | $ | 37,079 | nm | $ | 8,464 | $ | 63,439 | 18% | $ | 53,895 |\\n\\nnm – not meaningful\\nCorporate Expenses: Our corporate expenses include holding company costs necessary to support our worldwide insurance and reinsurance operations and costs associated with operating as a publicly-traded company. As a percentage of net premiums earned, corporate expenses were 3.1% for the three and nine months ended September 30, 2016, compared to 2.6% and 3.0%, respectively, for the same periods of 2015. The increase in corporate expenses in the three month period ended September 30, 2016 is primarily attributable to the net reimbursement of PartnerRe merger-related expenses benefiting 2015 and senior executive transition costs in 2016, partially offset by reorganization related expenses adverse to 2015. The slight increase in corporate expenses in the nine month period ended September 30, 2016 is attributable to adjustments to senior leadership executive stock-compensation awards benefiting 2015, senior executive transition costs in 2016 and an increase in personnel costs in 2016, partially offset by expenses attributable to the proposed merger with PartnerRe and reorganization related expenses adverse to 2015.\\nForeign Exchange Gains: Some of our business is written in currencies other than the U.S. dollar. The foreign exchange gains for the periods presented were largely driven by the re-measurement of our net insurance related liabilities. The foreign exchange gains for the three and nine months ended September 30, 2016 were primarily driven by the depreciation of pound sterling against the U.S dollar. Comparatively, the foreign exchange gains for the three months ended September 30, 2015 were primarily driven by depreciation of the pound sterling and the Australian dollar against the U.S. dollar. The foreign exchange gains for the nine months ended September 30, 2015 were primarily driven by the depreciation of the euro, pound sterling and Australian dollar.\\nIncome Tax Expense: Income tax expense primarily results from income generated by our foreign operations in the United States and Europe. Our effective tax rate, which is calculated as income tax expense divided by net income before tax including interest in loss of equity method investments, was 4.8% and 2.1% in the three and nine months ended September 30, 2016, and was insignificant and 0.2% in the three and nine months ended September 30, 2015. This effective rate can vary between periods depending on the distribution of net income amongst tax jurisdictions, as well as other factors. The primary driver of the current quarter and year-to-date increase is the generation of consolidated pre-tax net income in our operations in Europe compared to a net loss in each of these periods in 2015.\\n64\\nNET INVESTMENT INCOME AND NET REALIZED INVESTMENT GAINS (LOSSES)\\nNet Investment Income\\nThe following table provides a breakdown of income earned from our cash and investment portfolio by major asset class:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\\n| Fixed maturities | $ | 75,827 | —% | $ | 75,980 | $ | 229,423 | 4% | $ | 220,066 |\\n| Other investments | 38,248 | nm | (27,421 | ) | 25,770 | 46% | 17,616 |\\n| Equity securities | 4,633 | 34% | 3,445 | 12,843 | 65% | 7,795 |\\n| Mortgage loans | 2,191 | nm | 482 | 5,683 | nm | 776 |\\n| Cash and cash equivalents | 3,768 | nm | 993 | 7,071 | 88% | 3,770 |\\n| Short-term investments | 337 | nm | 83 | 708 | 156% | 277 |\\n| Gross investment income | 125,004 | 133% | 53,562 | 281,498 | 12% | 250,300 |\\n| Investment expense | (8,081 | ) | 3% | (7,877 | ) | (23,680 | ) | (1%) | (23,964 | ) |\\n| Net investment income | $ | 116,923 | 156% | $ | 45,685 | $ | 257,818 | 14% | $ | 226,336 |\\n| Pre-tax yield:(1) |\\n| Fixed maturities | 2.7% | 2.5% | 2.6% | 2.4% |\\n\\nnm - not meaningful\\n| (1) | Pre-tax yield is annualized and calculated as net investment income divided by the average month-end amortized cost balances for the periods indicated. |\\n\\nFixed Maturities\\nThe net investment income increase for the nine months ended September 30, 2016 attributable to fixed maturities was due to an emphasis on longer duration assets and an improvement in CPI adjustments following a reduction in our exposure to treasury inflation-protected securities.\\nOther Investments\\nThe following table provides a breakdown of total net investment income from other investments:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Hedge, direct lending, private equity and real estate funds | $ | 29,459 | $ | (23,483 | ) | $ | 6,127 | $ | 10,357 |\\n| Other privately held investments | 370 | — | 177 | — |\\n| CLO - Equities | 8,419 | (3,938 | ) | 19,466 | 7,259 |\\n| Total net investment income from other investments | $ | 38,248 | $ | (27,421 | ) | $ | 25,770 | $ | 17,616 |\\n| Pre-tax return on other investments(1) | 4.5 | % | (3.3 | %) | 3.1 | % | 2.0 | % |\\n\\n| (1) | The pre-tax return on other investments is non-annualized and calculated by dividing total net investment income from other investments by the average month-end fair value balances held for the periods indicated. |\\n\\nThe total net investment income from other investments increased for the three and nine months ended September 30, 2016 compared to the same periods in 2015 due to an improvement in the performance of the global equity markets which translated into higher valuations on our hedge funds. CLO - Equities also benefited from an increase in the valuation of the underlying collateral balances.\\n65\\nNet Realized Investment Gains (Losses)\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| On sale of investments: |\\n| Fixed maturities and short-term investments | $ | 4,303 | $ | (42,741 | ) | $ | (22,869 | ) | $ | (66,579 | ) |\\n| Equity securities | 4,994 | (1,327 | ) | 2,881 | (1,505 | ) |\\n| 9,297 | (44,068 | ) | (19,988 | ) | (68,084 | ) |\\n| OTTI charges recognized in earnings | (4,247 | ) | (32,301 | ) | (20,346 | ) | (62,762 | ) |\\n| Change in fair value of investment derivatives | 155 | 6,412 | 39 | 7,228 |\\n| Net realized investment gains (losses) | $ | 5,205 | $ | (69,957 | ) | $ | (40,295 | ) | $ | (123,618 | ) |\\n\\nOn sale of investments\\nGenerally, sales of individual securities occur when there are changes in the relative value, credit quality or duration of a particular issue. We may also sell to rebalance our investment portfolio in order to change exposure to particular asset classes or sectors. Net realized investment gains in the three months ended September 30, 2016 are reflective of the improvement in pricing of our fixed maturities and equities. Net realized investment losses in the nine months ended September 30, 2016 are primarily due to foreign exchange losses on non-U.S. denominated securities, as a result of the strengthening of the U.S. dollar.\\nOTTI charges\\nFor the three months ended September 30, 2016, OTTI charges were driven by impairments on corporate debt securities and losses on non-U.S. denominated securities as a result of the decline in foreign exchange rates against the U.S. dollar. The nine months ended September 30, 2016 also included impairments on high yield corporate debt securities which are exposed to the energy sector and exchange-traded funds (ETFs) which are unlikely to recover in the near term.\\nChange in fair value of investment derivatives\\nFrom time to time, we may economically hedge the foreign exchange exposure of non-U.S. denominated securities by entering into foreign exchange forward contracts.\\n66\\nTotal Return\\nThe following table provides a breakdown of the total return on cash and investments for the period indicated:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Net investment income | $ | 116,923 | $ | 45,685 | $ | 257,818 | $ | 226,336 |\\n| Net realized investments gains (losses) | 5,205 | (69,957 | ) | (40,295 | ) | (123,618 | ) |\\n| Change in net unrealized gains (losses) | 35,075 | (26,441 | ) | 303,573 | (52,965 | ) |\\n| Interest in loss of equity method investments | (2,434 | ) | — | (2,434 | ) | — |\\n| Total | $ | 154,769 | $ | (50,713 | ) | $ | 518,662 | $ | 49,753 |\\n| Average cash and investments(1) | $ | 14,470,231 | $ | 14,893,376 | $ | 14,457,978 | $ | 14,919,752 |\\n| Total return on average cash and investments, pre-tax: |\\n| Inclusive of investment related foreign exchange movements | 1.1 | % | (0.3 | %) | 3.6 | % | 0.3 | % |\\n| Exclusive of investment related foreign exchange movements | 1.1 | % | (0.1 | %) | 3.9 | % | 0.9 | % |\\n\\n| (1) | The average cash and investments balance is calculated by taking the average of the month-end fair value balances held for the periods indicated. |\\n\\nCASH AND INVESTMENTS\\nThe table below provides a breakdown of our cash and investments:\\n| September 30, 2016 | December 31, 2015 |\\n| Fair Value | Fair Value |\\n| Fixed maturities | $ | 11,566,860 | $ | 11,719,749 |\\n| Equities | 644,344 | 597,998 |\\n| Mortgage loans | 332,753 | 206,277 |\\n| Other investments | 847,262 | 816,756 |\\n| Equity method investments | 111,295 | 10,932 |\\n| Short-term investments | 39,877 | 34,406 |\\n| Total investments | $ | 13,542,391 | $ | 13,386,118 |\\n| Cash and cash equivalents(1) | $ | 1,077,263 | $ | 1,174,751 |\\n\\n| (1) | Includes restricted cash and cash equivalents of $229 million and $187 million at September 30, 2016 and at December 31, 2015, respectively. |\\n\\nThe $156m increase in the fair value of our total investments was driven by the downward shift in sovereign yield curves and the tightening of credit spreads on both investment grade and high-yield corporate debt. This was partially offset by the funding of financing and operating activities.\\n67\\nThe following provides a further analysis on our investment portfolio by asset classes:\\nFixed Maturities\\nThe following provides a breakdown of our investment in fixed maturities:\\n| September 30, 2016 | December 31, 2015 |\\n| Fair Value | % of Total | Fair Value | % of Total |\\n| Fixed maturities: |\\n| U.S. government and agency | $ | 1,562,877 | 14 | % | $ | 1,651,949 | 14 | % |\\n| Non-U.S. government | 582,056 | 5 | % | 739,005 | 6 | % |\\n| Corporate debt | 4,568,500 | 39 | % | 4,362,769 | 37 | % |\\n| Agency RMBS | 2,522,731 | 22 | % | 2,249,236 | 19 | % |\\n| CMBS | 894,275 | 8 | % | 1,083,298 | 9 | % |\\n| Non-Agency RMBS | 71,830 | — | % | 101,008 | 1 | % |\\n| ABS | 1,235,596 | 11 | % | 1,371,270 | 12 | % |\\n| Municipals(1) | 128,995 | 1 | % | 161,214 | 2 | % |\\n| Total | $ | 11,566,860 | 100 | % | $ | 11,719,749 | 100 | % |\\n| Credit ratings: |\\n| U.S. government and agency | $ | 1,562,877 | 14 | % | $ | 1,651,949 | 14 | % |\\n| AAA(2) | 4,359,640 | 38 | % | 4,266,673 | 36 | % |\\n| AA | 1,165,958 | 10 | % | 1,273,941 | 11 | % |\\n| A | 1,770,161 | 15 | % | 2,065,192 | 18 | % |\\n| BBB | 1,607,798 | 14 | % | 1,442,938 | 12 | % |\\n| Below BBB(3) | 1,100,426 | 9 | % | 1,019,056 | 9 | % |\\n| Total | $ | 11,566,860 | 100 | % | $ | 11,719,749 | 100 | % |\\n\\n| (1) | Includes bonds issued by states, municipalities, and political subdivisions. |\\n\\n| (2) | Includes U.S. government-sponsored agency RMBS and CMBS. |\\n\\n| (3) | Non-investment grade and non-rated securities. |\\n\\nAt September 30, 2016, our fixed maturities had a weighted average credit rating of AA- (2015: AA-) and an average duration of 3.2 years (2015: 3.3 years). When incorporating short-term investments and cash and cash equivalents into the calculation (bringing the total to $12.5 billion), the average credit rating would be AA- (2015: AA-) and duration would be 2.9 years (2015: 3.0 years).\\nDuring the year, net unrealized investment gains (losses) on fixed maturities moved from a net unrealized investment loss of $178 million at December 31, 2015 to a net unrealized gain of $104 million at September 30, 2016.\\nEquities\\nNet unrealized investment gains on equities increased from $22 million at December 31, 2015 to $44 million at September 30, 2016, an increase of $22 million due to an improvement in valuations reflective of performance of the global equity markets.\\nMortgage Loans\\nDuring the year, we increased our investment in commercial mortgage loans from $206 million to $333 million, an increase of $127m. The commercial mortgage loans are high quality and collateralized by a variety of commercial properties and are diversified both geographically throughout the United States and by property type to reduce the risk of concentration.\\n68\\nOther Investments\\nThe composition of our other investments portfolio is summarized as follows:\\n| September 30, 2016 | December 31, 2015 |\\n| Hedge funds |\\n| Long/short equity funds | $ | 139,460 | 16 | % | $ | 154,348 | 19 | % |\\n| Multi-strategy funds | 281,153 | 33 | % | 355,073 | 43 | % |\\n| Event-driven funds | 94,012 | 11 | % | 147,287 | 18 | % |\\n| Leveraged bank loan funds | — | — | % | 65 | — | % |\\n| Total hedge funds | 514,625 | 60 | % | 656,773 | 80 | % |\\n| Direct lending funds | 125,002 | 15 | % | 90,120 | 11 | % |\\n| Private equity funds | 89,170 | 11 | % | — | — | % |\\n| Real estate funds | 11,782 | 1 | % | 4,929 | 1 | % |\\n| Total hedge, direct lending and real estate funds | 740,579 | 87 | % | 751,822 | 92 | % |\\n| Other privately held investments | 42,900 | 5 | % | — | — | % |\\n| CLO - Equities | 63,783 | 8 | % | 64,934 | 8 | % |\\n| Total other investments | $ | 847,262 | 100 | % | $ | 816,756 | 100 | % |\\n\\nThe $142 million decrease in the fair value of our total hedge funds in 2016 was driven by $138 million of net redemptions and $4 million of price depreciation.\\nWe have made total commitments of $310 million to managers of direct lending funds, of which $121 million of our total commitment has been called to date.\\nWe have also made a total commitment of $60 million as a limited partner in a multi-strategy hedge fund, of which $48 million has been called to date.\\nWe have made a total commitment of $100 million to a real estate fund, of which $10 million has been called to date.\\nDuring 2016, we made a total commitment of $135 million to a private equity fund, of which $95 million has been called to date.\\nEquity Method Investments\\nDuring 2016, we paid $104 million including direct transactions costs to acquire 18% of the common equity of Harrington, the parent company of Harrington Re, an independent reinsurance company jointly sponsored by AXIS Capital and Blackstone. Harrington is not a variable interest entity and given that we exercise significant influence over this investee we account for our ownership in Harrington under the equity method of accounting.\\nThe Company also has investments in other equity method investments with a carrying value of $9 million.\\n69\\nLIQUIDITY AND CAPITAL RESOURCES\\nRefer to the ‘Liquidity and Capital Resources’ section included under Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2015 for a general discussion of our liquidity and capital resources.\\nThe following table summarizes our consolidated capital as at:\\n| September 30, 2016 | December 31, 2015 |\\n| Senior notes | $ | 992,633 | $ | 991,825 |\\n| Preferred shares | 625,000 | 627,843 |\\n| Common equity | 5,400,658 | 5,239,039 |\\n| Shareholders’ equity | 6,025,658 | 5,866,882 |\\n| Total capital | $ | 7,018,291 | $ | 6,858,707 |\\n| Ratio of debt to total capital | 14.1 | % | 14.5 | % |\\n| Ratio of debt and preferred equity to total capital | 23.0 | % | 23.6 | % |\\n\\nWe finance our operations with a combination of debt and equity capital. Our debt to total capital and debt and preferred equity to total capital ratios provide an indication of our capital structure, along with some insight into our financial strength. A company with higher ratios in comparison to industry average may show weak financial strength because the cost of its debts may adversely affect results of operations and/or increase its default risk. We believe that our financial flexibility remains strong.\\nPreferred Shares\\nOn January 27, 2016 we redeemed the remaining 28,430 Series B preferred shares, for an aggregate liquidation preference of\\n$3 million.\\n70\\nCommon Equity\\n| Nine months ended September 30, | 2016 |\\n| Common equity - opening | $ | 5,239,039 |\\n| Net income | 364,460 |\\n| Shares repurchased for treasury | (449,086 | ) |\\n| Change in unrealized appreciation on available for sale investments, net of tax | 281,276 |\\n| Settlement of accelerated share repurchase | 60,000 |\\n| Common share dividends | (98,334 | ) |\\n| Preferred share dividends | (29,906 | ) |\\n| Share-based compensation expense recognized in equity | 26,129 |\\n| Foreign currency translation adjustment | 5,694 |\\n| Cost of treasury shares reissued | 1,386 |\\n| Common equity - closing | $ | 5,400,658 |\\n\\nDuring the nine months ended September 30, 2016, we repurchased 8.5 million common shares, including 7.1 million of common shares repurchased for a total of $389 million (including $375 million pursuant to our Board-authorized share repurchase program and $14 million relating to shares purchased in connection with the vesting of restricted stock awards granted under our 2007 Long-Term Equity Compensation Plan), and 1.4 million common shares acquired under the ASR which terminated on January 15, 2016. At October 27, 2016, the remaining authorization under the common share repurchase program approved by our Board of Directors was $375 million (refer to Part II, Item 2 'Unregistered Sales of Equity Securities and Use of Proceeds' for additional information).\\nWe continue to expect that cash flows generated from our operations, combined with the liquidity provided by our investment portfolio, will be sufficient to cover our required cash outflows and other contractual commitments through the foreseeable future.\\n71\\nCRITICAL ACCOUNTING ESTIMATES\\nOur Consolidated Financial Statements include certain amounts that are inherently uncertain and judgmental in nature. As a result, we are required to make assumptions and best estimates in order to determine the reported values. We consider an accounting estimate to be critical if: (1) it requires that significant assumptions be made in order to deal with uncertainties and (2) changes in the estimate could have a material impact on our results of operations, financial condition or liquidity.\\nAs disclosed in our 2015 Annual Report on Form 10-K, we believe that the material items requiring such subjective and complex estimates are our:\\n| • | reserves for losses and loss expenses; |\\n\\n| • | reinsurance recoverable balances; |\\n\\n| • | premiums; |\\n\\n| • | fair value measurements for our financial assets and liabilities; and |\\n\\n| • | assessments of other-than-temporary impairments. |\\n\\nWe believe that the critical accounting estimates discussion in Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2015, continues to describe the significant estimates and judgments included in the preparation of our Consolidated Financial Statements.\\nNEW ACCOUNTING STANDARDS\\nRefer to Item 1, Note 1 'Basis of Presentation and Accounting policies' to the Consolidated Financial Statements and Item 8, Note 2 'Significant Accounting Policies' to the Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2015, for a discussion of recently issued accounting pronouncements that we have not yet adopted.\\nOFF-BALANCE SHEET AND SPECIAL PURPOSE ENTITY ARRANGEMENTS\\nAt September 30, 2016, we have not entered into any off-balance sheet arrangements, as defined by Item 303(a)(4) of Regulation S-K.\\nNON-GAAP FINANCIAL MEASURES\\nIn this report, we present operating income, consolidated underwriting income, underwriting-related general and administrative expenses and amounts presented on a constant currency basis, which are “non-GAAP financial measures” as defined in Regulation G.\\nOperating income represents after-tax operational results without consideration of after-tax net realized investment gains (losses), foreign exchange losses (gains), termination fee received and reorganization and related expenses. We also present diluted operating income per common share and operating return on average common equity (“operating ROACE”), which are derived from the non-GAAP operating income measure.\\nConsolidated underwriting income is a pre-tax measure of underwriting profitability that takes into account net premiums earned and other insurance related income as revenues and net losses and loss expenses, acquisition costs and underwriting-related general and administrative costs as expenses. Underwriting-related general and administrative expenses include those general and administrative expenses that are incremental and/or directly attributable to our individual underwriting operations. While these measures are presented in Item 1, Note 2 to our Consolidated Financial Statements, they are considered non-GAAP financial measures when presented elsewhere on a consolidated basis.\\nAmounts presented on a constant currency basis are calculated by applying the average foreign exchange rate from the current year to prior year amounts.\\n72\\nOperating income, diluted operating income per common share and operating ROACE can be reconciled to the nearest GAAP financial measures as follows:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Net income available to common shareholders | $ | 176,644 | $ | 247,620 | $ | 334,554 | $ | 466,772 |\\n| Net realized investment (gains) losses, net of tax(1) | (2,726 | ) | 67,897 | 42,667 | 119,442 |\\n| Foreign exchange gains, net of tax(2) | (13,229 | ) | (27,410 | ) | (67,771 | ) | (68,456 | ) |\\n| Termination fee received(3) | — | (280,000 | ) | — | (280,000 | ) |\\n| Reorganization and related expenses, net of tax(4) | — | 42,924 | — | 42,924 |\\n| Operating income | $ | 160,689 | $ | 51,031 | $ | 309,450 | $ | 280,682 |\\n| Earnings per common share - diluted | $ | 1.96 | $ | 2.50 | $ | 3.61 | $ | 4.65 |\\n| Net realized investment (gains) losses, net of tax | (0.03 | ) | 0.68 | 0.46 | 1.19 |\\n| Foreign exchange gains, net of tax | (0.15 | ) | (0.28 | ) | (0.73 | ) | (0.69 | ) |\\n| Termination fee received | — | (2.82 | ) | — | (2.79 | ) |\\n| Reorganization and related expenses, net of tax | — | 0.43 | — | 0.43 |\\n| Operating income per common share - diluted | $ | 1.78 | $ | 0.51 | $ | 3.34 | $ | 2.79 |\\n| Weighted average common shares and common share equivalents - diluted(5) | 90,351 | 99,124 | 92,579 | 100,468 |\\n| Average common shareholders’ equity | $ | 5,369,921 | $ | 5,259,619 | $ | 5,319,849 | $ | 5,195,901 |\\n| ROACE (annualized) | 13.2 | % | 18.8 | % | 8.4 | % | 12.0 | % |\\n| Operating ROACE (annualized) | 12.0 | % | 3.9 | % | 7.8 | % | 7.2 | % |\\n\\n| (1) | Tax cost (benefit) of $2,479 and ($2,060) for the three months ended September 30, 2016 and 2015, respectively, and $2,372 and ($4,176) for the nine months ended September 30, 2016 and 2015, respectively. Tax impact is estimated by applying the statutory rates of applicable jurisdictions, after consideration of other relevant factors including the ability to utilize capital losses. |\\n\\n| (2) | Tax cost of $566 and $678 for the three months ended September 30, 2016 and 2015, respectively, and $2,010 and $744 for the nine months ended September 30, 2016 and 2015, respectively. Tax impact is estimated by applying the statutory rates of applicable jurisdictions, after consideration of other relevant factors including the tax status of specific foreign exchange transactions. |\\n\\n| (3) | Tax impact is nil. |\\n\\n| (4) | Tax benefit of nil and $2,943 for the three months ended September 30, 2016 and 2015, respectively, and nil and $2,943 for the nine months ended September 30, 2016 and 2015, respectively. Tax impact is estimated by applying the statutory rates of applicable jurisdictions, reflecting the jurisdictional apportionment and related tax treatment of the individual components of the reorganization and related expenses. |\\n\\n| (5) | Refer to Item 1, Note 8 to our Consolidated Financial Statements for further details on the dilution calculation. |\\n\\nA reconciliation of consolidated underwriting income to income before income taxes (the nearest GAAP financial measure) can be found in Item 1, Note 2 to the Consolidated Financial Statements. Underwriting-related general and administrative expenses are reconciled to general and administrative expenses (the nearest GAAP financial measure) within 'Underwriting Results - Group'.\\nWe present our results of operations in the way we believe will be most meaningful and useful to investors, analysts, rating agencies and others who use our financial information to evaluate our performance. This includes the presentation of “operating income”, (in total and on a per share basis), “annualized operating ROACE” (which is based on the “operating income” measure) and “consolidated underwriting income”, which incorporates “underwriting-related general and administrative expenses”.\\nOperating Income\\nAlthough the investment of premiums to generate income and realized investment gains (losses) is an integral part of our operations, the determination to realize investment gains (losses) is independent of the underwriting process and is heavily influenced by the availability of market opportunities. Furthermore, many users believe that the timing of the realization of investment gains (losses) is somewhat opportunistic for many companies.\\n73\\nForeign exchange losses (gains) in our Consolidated Statements of Operations are primarily driven by the impact of foreign exchange rate movements on net insurance related-liabilities. However, this movement is only one element of the overall impact of foreign exchange rate fluctuations on our financial position. In addition, we recognize unrealized foreign exchange losses (gains) on our available-for-sale investments in other comprehensive income and foreign exchange losses (gains) realized upon the sale of these investments in net realized investments gains (losses). These unrealized and realized foreign exchange rate movements generally offset a large portion of the foreign exchange losses (gains) reported separately in earnings, thereby minimizing the impact of foreign exchange rate movements on total shareholders' equity. As such, the Statement of Operations foreign exchange losses (gains) in isolation are not a fair representation of the performance of our business.\\nThe termination fee received represents the break-up fee paid by PartnerRe Ltd. following the cancellation of the amalgamation agreement with AXIS Capital and is not indicative of future revenues of the Company.\\nReorganization and related expenses are primarily driven by business decisions, the nature and timing of which is unrelated to the underwriting process and which are not representative of underlying business performance.\\nIn this regard, certain users of our financial statements evaluate earnings excluding after-tax net realized investment gains (losses) and foreign exchange losses (gains) to understand the profitability of recurring sources of income.\\nWe believe that showing net income available to common shareholders exclusive of net realized gains (losses), foreign exchange losses (gains), termination fee received and reorganization and related expenses reflects the underlying fundamentals of our business. In addition, we believe that this presentation enables investors and other users of our financial information to analyze performance in a manner similar to how our management analyzes the underlying business performance. We also believe this measure follows industry practice and, therefore, facilitates comparison of our performance with our peer group. We believe that equity analysts and certain rating agencies that follow us, and the insurance industry as a whole, generally exclude these items from their analyses for the same reasons.\\nConsolidated Underwriting Income/Underwriting-Related General and Administrative Expenses\\nCorporate expenses include holding company costs necessary to support our worldwide insurance and reinsurance operations and costs associated with operating as a publicly-traded company. As these costs are not incremental and/or directly attributable to our individual underwriting operations, we exclude them from underwriting-related general and administrative expenses and, therefore, consolidated underwriting income. Interest expense and financing costs primarily relate to interest payable on our senior notes and are excluded from consolidated underwriting income for the same reason.\\nWe evaluate our underwriting results separately from the performance of our investment portfolio. As such, we believe it appropriate to exclude net investment income and net realized investment gains (losses) from our underwriting profitability measure.\\nAs noted above, foreign exchange losses (gains) in our Consolidated Statements of Operations primarily relate to our net insurance-related liabilities. However, we manage our investment portfolio in such a way that unrealized and realized foreign exchange rate losses (gains) on our investment portfolio generally offset a large portion of the foreign exchange losses (gains) arising from our underwriting portfolio. As a result, we believe that foreign exchange losses (gains) are not a meaningful contributor to our underwriting performance and, therefore, exclude them from consolidated underwriting income.\\nThe termination fee received represents the break-up fee received on the cancellation of the amalgamation agreement between PartnerRe Ltd. and AXIS Capital and should be excluded from consolidated underwriting income since it is not related to underwriting operations.\\nReorganization and related expenses are driven by business decisions, the nature and timing of which are unrelated to the underwriting process and for this reason they are excluded from consolidated underwriting income.\\nWe believe that presentation of underwriting-related general and administrative expenses and consolidated underwriting income provides investors with an enhanced understanding of our results of operations, by highlighting the underlying pre-tax profitability of our underwriting activities.\\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nRefer to Item 7A included in our 2015 Form 10-K. With the exception of the changes in exposure to foreign currency risk presented below, there have been no material changes to this item since December 31, 2015.\\nForeign Currency Risk\\nThe table below provides a sensitivity analysis of our total net foreign currency exposures.\\n| AUD | NZD | CAD | EUR | GBP | JPY | Other | Total |\\n| At September 30, 2016 |\\n| Net managed assets (liabilities), excluding derivatives | $ | 85,933 | $ | (6,574 | ) | $ | 74,859 | $ | (159,487 | ) | $ | (59,745 | ) | $ | 21,593 | $ | 132,185 | $ | 88,764 |\\n| Foreign currency derivatives, net | (79,700 | ) | 7,287 | (80,621 | ) | 204,334 | 5,836 | (26,126 | ) | 11,790 | 42,800 |\\n| Net managed foreign currency exposure | 6,233 | 713 | (5,762 | ) | 44,847 | (53,909 | ) | (4,533 | ) | 143,975 | 131,564 |\\n| Other net foreign currency exposure | 2,060 | — | — | 22,881 | 1,011 | — | 68,969 | 94,921 |\\n| Total net foreign currency exposure | $ | 8,293 | $ | 713 | $ | (5,762 | ) | $ | 67,728 | $ | (52,898 | ) | $ | (4,533 | ) | $ | 212,944 | $ | 226,485 |\\n| Net foreign currency exposure as a percentage of total shareholders’ equity | 0.1 | % | — | % | (0.1 | %) | 1.1 | % | (0.9 | %) | (0.1 | %) | 3.5 | % | 3.8 | % |\\n| Pre-tax impact of net foreign currency exposure on shareholders’ equity given a hypothetical 10% rate movement(1) | $ | 829 | $ | 71 | $ | (576 | ) | $ | 6,773 | $ | (5,290 | ) | $ | (453 | ) | $ | 21,294 | $ | 22,648 |\\n\\n| (1) | Assumes 10% change in underlying currencies relative to the U.S. dollar. |\\n\\nTotal Net Foreign Currency Exposure\\nAt September 30, 2016, our total net foreign currency exposure was $226 million net long, driven by increases in our exposures to the euro and other non-core currencies primarily due to new business written during the first nine months of 2016.\\nITEM 4. CONTROLS AND PROCEDURES\\nThe Company’s management has performed an evaluation, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the “Exchange Act”)) as of September 30, 2016. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of September 30, 2016, our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and is accumulated and communicated to\\n74\\nmanagement, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.\\nThe Company’s management has performed an evaluation, with the participation of the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of changes in the Company’s internal control over financial reporting that occurred during the three months ended September 30, 2016. Based upon that evaluation, there were no changes in our internal control over financial reporting that occurred during the three months ended September 30, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\nPART II OTHER INFORMATION\\n\\nITEM 1. LEGAL PROCEEDINGS\\nFrom time to time, we are subject to routine legal proceedings, including arbitrations, arising in the ordinary course of business. These legal proceedings generally relate to claims asserted by or against us in the ordinary course of insurance or reinsurance operations; estimated amounts payable under such proceedings are included in the reserve for losses and loss expenses in our Consolidated Balance Sheets.\\nWe are not a party to any material legal proceedings arising outside the ordinary course of business.\\nITEM 1A. RISK FACTORS\\nThere were no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2015.\\n75\\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\\nThe following table presents information regarding the number of shares we repurchased during the three months ended September 30, 2016:\\nISSUER PURCHASES OF EQUITY SECURITIES\\nCommon Shares\\n| Period | Total Numberof SharesPurchased | AveragePrice PaidPer Share | Total Number of SharesPurchased as Part ofPublicly AnnouncedPlans or Programs(1) | Maximum Number (or ApproximateDollar Value) of Shares That May Yet BePurchased Under the Announced Plansor Programs(2) |\\n| July 1-31, 2016 | 127 | $55.45 | 108 | $494.0 million |\\n| August 1-31, 2016 | 1,552 | $55.88 | 1,552 | $407.3 million |\\n| September 1-30, 2016 | 572 | $56.36 | 571 | $375.1 million |\\n| Total | 2,251 | 2,231 | $375.1 million |\\n\\n| (1) | From time to time, we purchase shares in connection with the vesting of restricted stock awards granted to our employees under our 2007 Long-Term Equity Compensation Plan. The purchase of these shares is separately authorized and is not part of our Board-authorized share repurchase program, described below. |\\n\\n| (2) | On December 7, 2015, our Board of Directors authorized a share repurchase plan to repurchase up to $750 million of our common shares through to December 31, 2016. The share repurchase authorization which became effective on December 31, 2015, replaced the previous plan which had $444 million available through the end of 2016. Share repurchases may be effected from time to time in the open market or privately negotiated transactions, depending on market conditions. |\\n\\nITEM 5. OTHER INFORMATION\\nDisclosure of Certain Activities Under Section 13(r) of the Securities Exchange Act of 1934\\nSection 13(r) of the Securities Exchange Act of 1934, as amended, requires issuers to disclose in their annual and quarterly reports whether they or any of their affiliates knowingly engaged in certain activities with Iran or with individuals or entities that are subject to certain sanctions under U.S. law. Issuers are required to provide this disclosure even where the activities, transactions or dealings are conducted outside of the United States in compliance with applicable law.\\nAs and when allowed by the applicable law and regulations, certain of our non-U.S. subsidiaries provide treaty reinsurance coverage to non-U.S. insurers of marine, aviation and energy risks on a worldwide basis, and as a result, these underlying reinsurance portfolios may have some exposure to Iran. In addition, we underwrite insurance and facultative reinsurance on a global basis to non-U.S. insureds and reinsureds for marine, aviation and energy risks. Coverage provided to non-Iranian business may indirectly cover an exposure in Iran. For example, certain of our operations underwrite global marine hull and cargo policies that provide coverage for vessels navigating into and out of ports worldwide, including Iran. For the quarter ended September 30, 2016, no premium has been allocated or apportioned to activities relating to Iran. As we believe these activities are permitted under applicable laws and regulations, we intend for our non-U.S. subsidiaries to continue to provide such coverage to the extent permitted by applicable law.\\n76\\nITEM 6. EXHIBITS\\n| 3.1 | Certificate of Incorporation and Memorandum of Association (incorporated by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-1(Amendment No. 1) (No. 333-103620) filed on April 16, 2003). |\\n| 3.2 | Amended and Restated Bye-Laws (incorporated by reference to Exhibit 4.2 to the Company’s Registration Statement on Form S-8 filed on May 15, 2009). |\\n| 4.1 | Specimen Common Share Certificate (incorporated by reference to Exhibit 4.1 to the Company’s Registration Statement on Form S-1 (Amendment No. 3) (No. 333-103620) filed on June 10, 2003). |\\n| 4.2 | Certificate of Designations establishing the specific rights, preferences, limitations and other terms of the Series C Preferred Shares (incorporated by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K filed on March 19, 2012). |\\n| 4.3 | Certificate of Designations establishing the specific rights, preferences, limitations and other terms of the Series D Preferred Shares (incorporated by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K filed on May 20, 2013). |\\n| 10.1 | Amendment No. 1 to Employment Agreement dated June 23, 2014 by and between Peter W. Wilson and AXIS Specialty U.S. Services, Inc. effective September 21, 2016 (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed on September 27, 2016). |\\n| †31.1 | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| †31.2 | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| †32.1 | Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\\n| †32.2 | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\\n| †101 | The following financial information from AXIS Capital Holdings Limited’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2016 formatted in XBRL: (i) Consolidated Balance Sheets at September 30, 2016 and December 31, 2015; (ii) Consolidated Statements of Operations for the three and nine months ended September 30, 2016 and 2015; (iii) Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2016 and 2015; (iv) Consolidated Statements of Changes in Shareholders' Equity for the nine months ended September 30, 2016 and 2015; (v) Consolidated Statements of Cash Flows for the nine months ended September 30, 2016 and 2015; and (vi) Notes to Consolidated Financial Statements, tagged as blocks of text and in detail. |\\n\\n| † | Filed herewith. |\\n\\nThe agreements and other documents filed as exhibits to this report are not intended to provide factual information or other disclosure other than with respect to the terms of the agreements or other documents themselves, and you should not rely on them for that purpose. In particular, any representations and warranties made by us in these agreements or other documents were made solely within the specific context of the relevant agreement or document and may not describe the actual state of affairs as of the date they were made or at any other time.\\n77\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\nDated: October 27, 2016\\n\\n| AXIS CAPITAL HOLDINGS LIMITED |\\n| By: | /S/ ALBERT BENCHIMOL |\\n| Albert Benchimol |\\n| President and Chief Executive Officer |\\n| /S/ JOSEPH HENRY |\\n| Joseph Henry |\\n| Executive Vice President and Chief Financial Officer |\\n| (Principal Financial Officer) |\\n\\n78\\n \\n\\nWhat would the return on investment be if the net investment income from the third quarter was invested in acquiring new common shares (in percent)?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 31.2.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 48,\n \"input_length\": 70675\n}"}}},{"rowIdx":49,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nPART I—FINANCIAL INFORMATION\nItem 1. Condensed Consolidated Financial Statements.\nUnaudited Condensed Consolidated Balance Sheets\n\n| As of | June 30, 2022 | December 31, 2021 |\n| ASSETS |\n| Current assets: |\n| Cash and cash equivalents | $ | 149,824 | $ | 905,051 |\n| Accounts receivable, net of allowance for doubtful accounts of $ 0 and $ 0 , respectively | 1,293 | - |\n| Inventories, net | 102,981 | 88,877 |\n| Prepaid expense and other current assets | 220,113 | 191,838 |\n| Total current assets | 474,211 | 1,185,766 |\n| Property and equipment, net | 1,181,365 | 1,110,890 |\n| Operating lease right-of-use asset | 2,937,437 | 2,466,873 |\n| Total assets | $ | 4,593,013 | $ | 4,763,529 |\n| LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT) |\n| Current liabilities: |\n| Accounts payable | $ | 158 | $ | 45,748 |\n| Accrued expenses and current liabilities | 171,070 | 124,535 |\n| Line of credit | 594,529 | - |\n| Loans payable to financial institutions – current portion | - | 98,475 |\n| Loans payable to shareholders | 150,000 | - |\n| Loan payable, emergency injury disaster loan (EIDL) – current portion | 10,760 | 7,957 |\n| Loan payable, payroll protection program (PPP) – current portion | 39,169 | 42,345 |\n| Equipment loan payable – current portion | 6,312 | 15,989 |\n| Operating lease liabilities – current portion | 655,603 | 578,419 |\n| Total current liabilities | 1,627,601 | 913,468 |\n| Loans payable to financial institutions – net of current portion | - | 23,228 |\n| Loan payable, emergency injury disaster loan (EIDL), net of current portion | 489,240 | 492,043 |\n| Loan payable, payroll protection program (PPP), net of current portion | 127,969 | 124,793 |\n| Operating lease liabilities, net of current portion | 2,427,168 | 2,011,702 |\n| Total liabilities | 4,671,978 | 3,565,234 |\n| Commitments and Contingencies |\n| Stockholders’ equity (deficit) |\n| Common Stock, $ 0.0001 par value, 40,000,000 shares authorized; 11,679,523 and 11,634,523 shares issued and outstanding at June 30, 2022 and December 31, 2021 | 1,168 | 1,163 |\n| Preferred Stock, $ 0.0001 par value, 1,000,000 shares authorized; no shares issued and outstanding at June 30, 2022 and December 31, 2021 | - | - |\n| Additional paid-in capital | 9,899,031 | 9,674,036 |\n| Accumulated deficit | ( 9,979,164 | ) | ( 8,476,904 | ) |\n| Total stockholders’ equity (deficit) | ( 78,965 | ) | 1,198,295 |\n| Total liabilities and stockholders’ equity | $ | 4,593,013 | $ | 4,763,529 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n1\nUnaudited Condensed Consolidated Statements of Operations\n\n| Six Months Ended June 30, | Three Months Ended June 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Net revenues: |\n| Stores | $ | 1,511,952 | $ | 851,785 | $ | 775,956 | $ | 475,824 |\n| Wholesale and online | 29,674 | 28,336 | 12,520 | 15,368 |\n| Total net revenues | 1,541,626 | 880,121 | 788,476 | 491,192 |\n| Operating costs and expenses: |\n| Product, food and drink costs—stores | 563,906 | 270,148 | 278,952 | 135,452 |\n| Cost of sales—wholesale and online | 12,997 | 12,412 | 5,484 | 6,732 |\n| General and administrative | 2,468,447 | 1,226,951 | 1,432,432 | 656,310 |\n| Total operating costs and expenses | 3,045,350 | 1,509,511 | 1,716,868 | 798,494 |\n| Loss from operations | ( 1,503,724 | ) | ( 629,390 | ) | ( 928,392 | ) | ( 307,302 | ) |\n| Other income (expense): |\n| Other income | 16,440 | - | 1,440 | - |\n| Interest expense | ( 14,976 | ) | ( 5,773 | ) | ( 10,196 | ) | ( 382 | ) |\n| Total other income (expense), net | 1,464 | ( 5,773 | ) | ( 8,756 | ) | ( 382 | ) |\n| Loss before income taxes | ( 1,502,260 | ) | ( 635,163 | ) | ( 937,148 | ) | ( 307,684 | ) |\n| Provision for income taxes | - | - | - | - |\n| Net loss | $ | ( 1,502,260 | ) | $ | ( 635,163 | ) | $ | ( 937,148 | ) | $ | ( 307,684 | ) |\n| Loss per share: |\n| Basic and diluted | $ | ( 0.13 | ) | ( 0.06 | ) | ( 0.08 | ) | ( 0.03 | ) |\n| Weighted average number of common shares outstanding: |\n| Basic and diluted | 11,642,550 | 10,282,669 | 11,667,545 | 10,380,944 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n2\nUnaudited Condensed Consolidated Stockholders’ Equity (Deficit)\n\n| Common Stock | Preferred Stock | Additional Paid-in | Subscription of Common | Accumulated | Total Shareholders’ |\n| Shares | Amount | Shares | Amount | Capital | Stock | Deficit | Deficit |\n| Balance as of December 31, 2021 | 11,634,523 | $ | 1,163 | - | $ | - | $ | 9,674,036 | $ | - | $ | ( 8,476,904 | ) | $ | 1,198,295 |\n| Net loss | - | - | - | - | - | - | ( 565,112 | ) | ( 565,112 | ) |\n| Balance as of March 31, 2022 | 11,634,523 | $ | 1,163 | - | $ | - | $ | 9,674,036 | $ | - | $ | ( 9,042,016 | ) | $ | 633,183 |\n| Stock compensation | 45,000 | 5 | - | - | 224,995 | - | - | 225,000 |\n| Net loss | - | - | - | - | - | - | ( 937,148 | ) | ( 937,148 | ) |\n| Balance as of June 30, 2022 | 11,679,523 | $ | 1,168 | - | $ | - | $ | 9,899,031 | $ | - | $ | ( 9,979,164 | ) | $ | ( 78,965 | ) |\n\n\n| Common Stock | Preferred Stock | Additional Paid-in | Subscription of Common | Accumulated | Total Shareholders’ |\n| Shares | Amount | Shares | Amount | Capital | Stock | Deficit | Deficit |\n| Balance as of December 31, 2020 | 10,443,721 | $ | 1,045 | - | $ | - | $ | 4,733,063 | $ | ( 450,000 | ) | $ | ( 5,036,504 | ) | $ | ( 752,396 | ) |\n| Net loss | - | - | - | - | - | - | ( 327,479 | ) | ( 327,479 | ) |\n| Payments received for prior year subscription | - | - | - | - | - | 450,000 | - | 450,000 |\n| Stock issued for store acquisition | 232,558 | 23 | - | - | 149,977 | - | - | 150,000 |\n| Balance as of March 31, 2021 | 10,676,279 | $ | 1,068 | - | $ | - | $ | 4,883,040 | $ | - | $ | ( 5,363,983 | ) | $ | ( 479,875 | ) |\n| Net loss | - | - | - | - | - | - | ( 307,684 | ) | ( 307,684 | ) |\n| Stock subscription | 30,950 | 3 | - | - | 154,747 | ( 154,750 | ) | - | - |\n| Payments received for prior year subscription | - | - | - | - | - | 103,500 | - | 103,500 |\n| Balance as of June 30, 2021 | 10,707,229 | $ | 1,071 | - | $ | - | $ | 5,037,787 | $ | ( 51,250 | ) | $ | ( 5,671,667 | ) | $ | ( 684,059 | ) |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n3\nUnaudited Condensed Consolidated Statements of Cash Flows\n\n| For the Six Months Ended June 30, | 2022 | 2021 |\n| Cash flows from operating activities: |\n| Net loss | $ | ( 1,502,260 | ) | $ | ( 635,163 | ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: |\n| Stock compensation | 225,000 | - |\n| Operating lease | 22,086 | 20,559 |\n| Depreciation | 97,922 | 81,926 |\n| Changes in operating assets and liabilities: |\n| Accounts receivable | ( 1,293 | ) | ( 269 | ) |\n| Inventories | ( 14,104 | ) | ( 7,245 | ) |\n| Prepaid expense and other current assets | ( 28,275 | ) | ( 65,083 | ) |\n| Accounts payable | ( 45,590 | ) | 49,508 |\n| Accrued expenses and current liabilities | 46,535 | 17,415 |\n| Net cash used in operating activities | ( 1,199,979 | ) | ( 538,352 | ) |\n| Cash flows from investing activities: |\n| Purchases of property and equipment | ( 168,397 | ) | ( 167,152 | ) |\n| Reacquisition of store | - | ( 150,000 | ) |\n| Net cash used in investing activities | ( 168,397 | ) | ( 317,152 | ) |\n| Cash flows from financing activities: |\n| Proceeds from issuance of common stock | - | 553,499 |\n| Proceeds from line of credit | 594,529 | - |\n| Proceeds from loan payable to shareholders | 150,000 | 533,127 |\n| Repayment of loans | ( 121,703 | ) | ( 210,453 | ) |\n| Repayment of equipment loan payable | ( 9,677 | ) | ( 9,594 | ) |\n| Net cash provided by financing activities | 613,149 | 866,579 |\n| Net (decrease) increase in cash | ( 755,227 | ) | 11,075 |\n| Cash at beginning of period | 905,051 | 128,568 |\n| Cash at end of period | $ | 149,824 | $ | 139,643 |\n| Supplemental disclosures of non-cash financing activities: |\n| Issuance of common shares for repurchase of store | $ | - | $ | 150,000 |\n| Issuance of common shares for compensation | $ | 225,000 | $ | - |\n| Supplemental disclosure of cash flow information: |\n| Cash paid during the years for: |\n| Lease liabilities | $ | 435,635 | $ | 224,988 |\n| Interest | $ | 367 | $ | 5,773 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n4\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n1. NATURE OF OPERATIONS\nReborn Coffee, Inc. (“Reborn”) was incorporated in the State of Florida in January 2018. In July 2022, Reborn was migrated from Florida to Delaware, and filed a certificate of incorporation with the Secretary of State of the State of Delaware having the same capitalization structure as the Florida predecessor entity. Reborn has the following wholly owned subsidiaries:\n\n| ● | Reborn Global Holdings, Inc. (“Reborn Holdings”), a California Corporation incorporated in November 2014. Reborn Holdings is engaged in the operation of wholesale distribution and retail coffee stores in California to sell a variety of coffee, tea, Reborn brand name water and other beverages along with bakery and dessert products. |\n\n\n| ● | Reborn Coffee Franchise, LLC (the “Reborn Coffee Franchise”), a California limited liability corporation formed in December 2020, is a franchisor providing premier roaster specialty coffee to franchisees or customers. Reborn Coffee Franchise continues to develop the Reborn Coffee system for the establishment and operation of Reborn Coffee stores using one or more Reborn Coffee marks. The franchisee obtains a license to develop and operate a store under the strict compliance with terms of the agreement. The specific rights the franchisee is granted is to develop, own, and/or operate franchisee’s Reborn Coffee stores. The non-refundable initial franchise fee is $ 20,000 . In addition, the franchisee is required to pay the company a royalty fee equal to 5 % of the weekly gross sales of their respective store. |\n\nReborn Coffee, Inc., Reborn Global Holdings, Inc., and Reborn Coffee Franchise, LLC will be collectively referred as the “Company”.\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nReporting\nThe unaudited condensed consolidated financial statements include Reborn Coffee, Inc. and its wholly owned subsidiaries as of June 30, 2022 and December 31, 2021 and for the three and six month periods ended June 30, 2022 and 2021.\nBasis of Presentation and Consolidation\nThe accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”) as promulgated in the United States of America. The consolidated financial statements include Reborn Coffee, Inc. and its wholly owned subsidiaries. All intercompany accounts, transactions, and profits have been eliminated upon consolidation.\nReverse Stock Split\nIn June 2022, the Company approved (a) the conversion of all Class B Common Stock into Class A Common Stock, (b) a 1 for 100 reverse stock split , and (c) an amendment to Articles of Incorporation to eliminate Class B and to change “Class A” to simply “common stock”. All share and earnings per share information have been retroactively adjusted to reflect the stock split and the incremental par value of the newly issued shares was recorded with the offset to additional paid-in capital.\nGoing Concern\nThe accompanying unaudited condensed consolidated financial statements have been prepared assuming the Company will continue as a going concern, which contemplates, among other things, the realization of assets and satisfaction of liabilities in the normal course of business. The Company had an accumulated deficit of $ 9,979,164 at June 30, 2022, had a net loss of $ 1,502,260 for the six-month period ended June 30, 2022 and net cash used in operating activities of $ 1,199,979 for the six-month period ended June 30, 2022. These matters raise substantial doubt about the Company’s ability to continue as a going concern.\n5\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\nWhile the Company is attempting to expand operations and increase revenues, the Company’s cash position may not be significant enough to support the Company’s daily operations. Management intends to raise additional funds by way of public or private offerings. Management believes that the actions presently being taken to further implement its business plan and generate revenues provide the opportunity for the Company to continue as a going concern. While management believes in the viability of its strategy to generate revenues and in its ability to raise additional funds, there can be no assurances to that effect or if available, on terms acceptable to the Company. The ability of the Company to continue as a going concern is dependent upon the Company’s ability to further implement its business plan and generate additional profit. Compared to the revenue for the six-month period ended June 30, 2021, however, net revenue for the six-month period ended June 30, 2022 has increased from $ 880,121 to $ 1,541,626 , and the Company expects consistent increase in sales with the opening of more stores. In August 2022, the Company consummated its initial public offering (the “IPO”) of 1,440,000 shares of its common stock at a public offering price of $ 5.00 per share, generating gross proceeds of $ 7,200,000 . The initial public offering is summarized in Note 12 to the unaudited condensed consolidated financial statements.\nThe unaudited condensed consolidated financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.\nUse of Estimates\nThe preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States (“U.S. GAAP”) requires the Company to make estimates and assumptions that affect the amounts reported in our consolidated financial statements and the accompanying notes. Such estimates include accounts receivables, accrued liabilities, income taxes, long-lived assets, and deferred tax valuation allowances. These estimates generally involve complex issues and require management to make judgments, involve analysis of historical and future trends that can require extended periods of time to resolve, and are subject to change from period to period. In all cases, actual results could differ materially from estimates.\nRevenue Recognition\nThe Company recognizes revenue in accordance with Accounting Standards Codification (“ASC”) 606, Revenue from Contracts with Customers. The Company’s net revenue primarily consists of revenues from its retail stores and wholesale and online store. Accordingly, the Company recognizes revenue as follows:\n\n| ● | Retail Store Revenue |\n\nRetail store revenues are recognized when payment is tendered at the point of sale. Retail store revenues are reported net of sales, use or other transaction taxes that are collected from customers and remitted to taxing authorities. Sales taxes that are payable are recorded as accrued as other current liabilities. Retail store revenue makes up approximately 98 % of the Company’s total revenue.\n\n| ● | Wholesale and Online Revenue |\n\nWholesale and online revenues are recognized when the products are delivered, and title passes to the customers or to the wholesale distributors. When customers pick up products at the Company’s warehouse, or distributed to the wholesale distributors, the title passes, and revenue is recognized. Wholesale revenues make up approximately 2 % of the Company’s total revenue.\n\n| ● | Royalties and Other Fees |\n\nFranchise revenues consists of royalties and other franchise fees. Royalties are based on a percentage of franchisee’s weekly gross sales revenue at 5 %. The Company recognizes the royalties as the underlying sales occur. The Company recorded revenue from royalties of $ 0 for the six-month periods ended June 30, 2022 and 2021. Other fees are earned as incurred and the Company did not have any other fee revenue for the six-month periods ended June 30, 2022 and 2021.\nShipping and Handling Costs\nThe Company incurred freight out cost and is included in the Company’s cost of sales - wholesale and online.\n6\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\nGeneral and Administrative Expense\nGeneral and administrative expense includes store-related expense as well as the Company’s corporate headquarters’ expenses.\nAdvertising Expense\nAdvertising costs are expensed as incurred. Advertising expenses amounted to $ 20,513 and $ 50,160 for the six-month periods ended June 30, 2022 and 2021, respectively, and is recorded under general and administrative expenses in the accompanying consolidated statements of operations.\nPre-opening Costs\nPre-opening costs for new stores, consist primarily of store and leasehold improvements, and are capitalized and depreciated over the shorter of the useful life of the improvement or the lease term, including renewal periods that are reasonably assured.\nAccounts Receivable\nAccounts receivables are stated net of allowance for doubtful accounts. The allowance for doubtful accounts is determined primarily on the basis of past collection experience and general economic conditions. The Company determines terms and conditions for its customers based on volume transacted by the customer, customer creditworthiness and past transaction history. At June 30, 2022 and December 31, 2021, allowance for doubtful accounts was $ 0 and $ 0 , respectively. The Company does not have any off-balance sheet exposure related to its customers.\nInventories\nInventories consisted primarily of coffee beans, drink products, and supplies which are recorded at cost or at net realizable value.\nProperty and Equipment\nProperty and equipment are recorded at cost. Maintenance and repairs are charged to expense as incurred. Depreciation and amortization are provided using both the straight-line and declining balance methods over the following estimated useful lives:\n\n| Furniture and fixtures | 5 - 7 Years |\n| Store construction | Lesser of the lease term or the estimated useful lives of the improvements, generally 6 years |\n| Leasehold improvement | Lesser of the lease term or the estimated useful lives of the improvements, generally 6 years |\n\nWhen assets are retired or disposed of, the cost and accumulated depreciation thereon are removed, and any resulting gains or losses are included in the consolidated statements of operations. Leasehold improvements are amortized using the straight-line method over the estimated life of the asset, not to exceed the length of the lease. Repair and maintenance costs are expensed as incurred.\nOperating Leases\nThe Company adopted FASB Accounting Standards Codification, or ASC, Topic 842, Leases (“ASC 842”) which requires the recognition of the right-of-use assets and relating operating and finance lease liabilities on the balance sheet. Under ASC 842, all leases are required to be recorded on the balance sheet and are classified as either operating leases or finance leases. The lease classification affects the expense recognition in the income statement. Operating lease charges are recorded entirely in operating expenses. Finance lease charges are split, where amortization of the right-of-use asset is recorded in operating expenses and an implied interest component is recorded in interest expense.\nEarnings Per Share\nFinancial Accounting Standard Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 260, Earnings Per Share, requires a reconciliation of the numerator and denominator of the basic and diluted earnings (loss) per share (EPS) computations.\n7\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\nBasic earnings (loss) per share are computed by dividing net earnings available to common shareholders by the weighted-average number of common shares outstanding during the period. Diluted earnings (loss) per share is computed similar to basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common shares had been issued and if the additional common shares were dilutive. In periods where losses are reported, the weighted-average number of common stock outstanding excludes common stock equivalents, because their inclusion would be anti-dilutive.\nThe Company did not have any dilutive shares for the three and six month periods ended June 30, 2022 and 2021.\nSegment Reporting\nFASB ASC Topic 280, Segment Reporting, requires public companies to report financial and descriptive information about their reportable operating segments. The Company’s management identifies operating segments based on how the Company’s management internally evaluate separate financial information, business activities and management responsibility. At the current time, the Company has only one reportable segment, consisting of both the wholesale and retail sales of coffee, water, and other beverages. The Company’s franchisor subsidiary was not material as of and for the three and six month periods ended June 30, 2022 and 2021.\nLong-lived Assets\nIn accordance with FASB ASC Topic 360, Property, Plant, and Equipment, the Company reviews for impairment of long-lived assets and certain identifiable intangibles whenever events or circumstances indicate that the carrying amount of assets may not be recoverable. The Company considers the carrying value of assets may not be recoverable based upon our review of the following events or changes in circumstances: the asset’s ability to continue to generate income from operations and positive cash flow in future periods; loss of legal ownership or title to the assets; significant changes in our strategic business objectives and utilization of the asset; or significant negative industry or economic trends. An impairment loss would be recognized when estimated future cash flows expected to result from the use of the asset are less than its carrying amount. As of June 30, 2022 and December 31, 2021, the Company was not aware of any events or changes in circumstances that would indicate that the long-lived assets are impaired.\nFair Value of Financial Instruments\nThe Company records its financial assets and liabilities at fair value, which is defined under the applicable accounting standards as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measure date. The Company uses valuation techniques to measure fair value, maximizing the use of observable outputs and minimizing the use of unobservable inputs. The standard describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value which are the following:\nLevel 1 – Quoted prices in active markets for identical assets or liabilities.\nLevel 2 – Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.\nLevel 3 – Inputs include management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. The inputs are unobservable in the market and significant to the instrument’s valuation.\nAs of June 30, 2022 and December 31, 2021, the Company believes that the carrying value of accounts receivable, accounts payable, accrued expenses, and other current assets and liabilities approximate fair value due to the short maturity of theses financial instruments. The financial statements do not include any financial instruments at fair value on a recurring or non-recurring basis.\n8\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\nIncome Taxes\nIncome taxes are provided for the tax effects of transactions reported in the financial statements and consisted of taxes currently due and deferred taxes. Deferred taxes are recognized for the differences between the basis of assets and liabilities for financial statement and income tax purposes.\nThe Company follows FASB ASC Topic 740, Income Taxes, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each period end based on enacted tax laws and statutory tax rates, applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. ASC 740-10-25 provides criteria for the recognition, measurement, presentation and disclosure of uncertain tax position. The Company must recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate resolution. The Company did not recognize additional liabilities for uncertain tax positions pursuant to ASC 740-10-25 for the three and six month periods ended June 30, 2022 and 2021.\nConcentration of Credit Risk\nFinancial instruments that potentially subject the Company to concentrations of credit risk are accounts receivable arising from its normal business activities. The Company performs ongoing credit evaluations to its customers and establishes allowances when appropriate.\nCompany purchases from various vendors for its operations. For the three and six month periods ended June 30, 2022 and 2021, no purchases from any vendors accounted for a significant amount of the Company’s bean coffee purchases.\nRelated Parties\nRelated parties are any entities or individuals that, through employment, ownership, or other means, possess the ability to direct or cause the direction of management and policies of the Company.\nSignificant Recent Developments Regarding COVID-19\nThe novel coronavirus, known as the global pandemic COVID-19, was first identified in December 2019. During March 2020, a global pandemic was declared by the World Health Organization related to the rapidly spreading outbreak of a novel strain of coronavirus designated COVID-19. The pandemic has significantly impacted economic conditions in the United States. The outbreak of the virus impacted our company-owned retail locations in Southern California.\nThe Company first began to experience impacts from COVID-19 around the middle of March 2020 as federal, state and local governments began to react to the public health crisis by encouraging or requiring social distancing, instituting stay-at-home orders, and requiring, in varying degrees, restaurant dine-in limitations, capacity limitations or other restrictions that largely limited restaurants to take-out, drive-thru and delivery sales. Although we have experienced some recovery from the initial impact of COVID-19, the long-term impact of COVID-19 on the economy and on our business remains uncertain, the duration and scope of which cannot currently be predicted.\n9\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\nRecent Accounting Pronouncement\nIn June 2016, the FASB issued Accounting Standards Update No. 2016-13, “Financial Instruments - Credit Losses (Topic 326)” (“ASU 2016-13”). ASU 2016-13 revises the methodology for measuring credit losses on financial instruments and the timing of when such losses are recorded. Originally, ASU 2016-13 was effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2019, with early adoption permitted. In November 2019, FASB issued ASU 2019-10, “Financial Instruments – Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842).” This ASU defers the effective date of ASU 2016-13 for public companies that are considered smaller reporting companies as defined by the SEC to fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. The Company is planning to adopt this standard in the first quarter of fiscal 2023.The Company is currently evaluating the potential effects of adopting the provisions of ASU No. 2016-13 on its consolidated financial statements, particularly its recognition of allowances for accounts receivable.\nOther recently issued accounting updates are not expected to have a material impact on the Company’s consolidated financial statements.\n3. PROPERTY AND EQUIPMENT\nProperty and equipment consisted of the following:\n\n| June 30, 2022 | December 31, 2021 |\n| Furniture and equipment | $ | 849,809 | $ | 779,649 |\n| Leasehold improvement | 639,602 | 639,602 |\n| Store construction | 150,399 | 52,161 |\n| Store | 300,000 | 300,000 |\n| Total property and equipment | 1,939,810 | 1,771,412 |\n| Less accumulated depreciation | ( 758,445 | ) | ( 660,522 | ) |\n| Total property and equipment, net | $ | 1,181,365 | $ | 1,110,890 |\n\nIn February 2021, the Company repurchased its retail location in Corona Del Mar. The purchase price was $ 300,000 , comprised of $ 150,000 in cash and 232,558 shares of the Company’s common stock. The Company recorded the assumption of the ongoing lease for the store, which included a right of use asset of $ 183,442 and a lease liability of $ 193,463 .\nDepreciation expense on property and equipment amounted to approximately $ 97,922 and $ 81,926 for the six-month periods ended and $ 48,479 and $ 45,797 for the three-month periods ended June 30, 2022 and 2021, respectively.\n10\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n4. LOANS PAYABLE TO FINANCIAL INSTITUTIONS\nLoans payable to financial institutions consist of the following:\n\n| June 30, 2022 | December 31, 2021 |\n| July 2021 - Loan agreement with principal amount of $ 90,000 and repayment rate of 19 % for a total of $ 101,700 . The loan payable matures on January 31, 2023 . | $ | - | $ | 52,819 |\n| August 2021 - Loan agreement with principal amount of $72,500 and repayment rate of 18.5 % for a total of $ 81,925 . The loan payable matures on February 10, 2023 . | - | 36,502 |\n| August 2021 - Loan agreement with principal amount of $ 67,500 and repayment rate of 18.5 % for a total of $ 76,275 . The loan payable matures on February 11, 2023 . | - | 32,382 |\n| Total loan payable | $ | - | $ | 121,703 |\n| Less: current portion | - | ( 98,475 | ) |\n| Total loan payable, net of current | $ | - | $ | 23,228 |\n\nJuly 2021 - $ 101,700 loan payable\nIn July 2021, the Company entered into a loan agreement with Square Capital in the principal amount of $ 90,000 with loan cost $ 11,700 . The loan payable has a maturity date on January 31, 2023 . As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $ 0 and $ 52,819 , respectively.\nAugust 2021 - $ 81,925 loan payable\nIn August 2021, the Company entered into a loan agreement with Square Capital in the principal amount of $ 72,500 with loan cost $ 9,425 . The loan payable has a maturity date on February 10, 2023 . As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $ 0 and $ 36,502 , respectively.\nAugust 2021 - $ 76,275 loan payable\nIn August 2021, the Company entered into a loan agreement with Square Capital in the principal amount of $ 67,500 with loan cost $ 8,775 . The loan payable has a maturity date on February 11, 2023 . As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $ 0 and $ 32,382 , respectively.\n11\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n5. LOAN PAYABLES, EMERGENCY INJURY DISASTER LOAN (EIDL)\n\n| June 30, 2022 | December 31, 2021 |\n| May 16, 2020 ($ 150,000 ) - Loan agreement with principal amount of $150,000 with an interest rate of 3.75 % and maturity date on May 16, 2050 | $ | 150,000 | $ | 150,000 |\n| June 28, 2021 ($ 350,000 ) – Loan agreement with principal amount of $350,000 with an interest rate of 3.75 % and maturity date on May 18, 2050 | 350,000 | 350,000 |\n| Total long-term loan payable, emergency injury disaster loan (EIDL) | 500,000 | 500,000 |\n| Less - current portion | ( 10,760 | ) | ( 7,957 | ) |\n| Total loan payable, emergency injury disaster loan (EIDL), less current portion | $ | 489,240 | $ | 492,043 |\n\nThe following table provides future minimum payments:\n\n| For the years ended December 31, | Amount |\n| 2022 (remaining six months) | 5,330 |\n| 2023 | 10,964 |\n| 2024 | 11,382 |\n| 2025 | 11,816 |\n| 2026 | 12,267 |\n| Thereafter | 448,241 |\n| Total | $ | 500,000 |\n\nMay 16, 2020 – $ 150,000\nOn May 16, 2020, the Company executed the standard loan documents required for securing a loan (the “EIDL Loan”) from the SBA under its Economic Injury Disaster Loan (“EIDL”) assistance program in light of the impact of the COVID-19 pandemic on the TNB’s business. As of June 30, 2022, the loan payable, Emergency Injury Disaster Loan noted above is not in default.\nPursuant to that certain Loan Authorization and Agreement (the “SBA Loan Agreement”), the Company borrowed an aggregate principal amount of the EIDL Loan of $ 150,000 , with proceeds to be used for working capital purposes. Interest accrues at the rate of 3.75 % per annum and will accrue only on funds actually advanced from the date of each advance. Installment payments, including principal and interest, are due monthly beginning May 16, 2021 (twelve months from the date of the SBA Loan) in the amount of $ 731 . The balance of principal and interest is payable thirty years from the date of the SBA Loan.\nIn connection therewith, the Company executed (i) a loan for the benefit of the SBA (the “SBA Loan”), which contains customary events of default and (ii) a Security Agreement, granting the SBA a security interest in all tangible and intangible personal property of the Company, which also contains customary events of default (the “SBA Security Agreement”).\n12\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n5. LOAN PAYABLES, EMERGENCY INJURY DISASTER LOAN (EIDL) (continued)\nJune 28, 2021 – $ 350,000\nOn June 28, 2021, the Company executed the standard loan documents required for securing a loan (the “EIDL Loan”) from the SBA under its Economic Injury Disaster Loan (“EIDL”) assistance program in light of the impact of the COVID-19 pandemic on the TNB’s business. As of June 30, 2022, the loan payable, Emergency Injury Disaster Loan noted above is not in default.\nPursuant to that certain Amended Loan Authorization and Agreement (the “SBA Loan Agreement”), the Company borrowed an aggregate principal amount of the EIDL Loan of $ 500,000 , with proceeds to be used for working capital purposes. Interest accrues at the rate of 3.75 % per annum and will accrue only on funds actually advanced from the date of each advance. Installment payments, including principal and interest, are due monthly beginning October 16, 2022 (thirty months from the original date of the SBA Loan) in the amount of $ 2,505 . The balance of principal and interest is payable thirty years from the original date of the SBA Loan.\n6. LOAN PAYABLE, PAYROLL PROTECTION LOAN PROGRAM (PPP)\n\n| June 30, 2022 | December 31, 2021 |\n| Loan payable, payroll protection program (PPP) – February 10, 2021 | $ | 167,138 | $ | 167,138 |\n| Total long-term loan payable, payroll protection program (PPP) | 167,138 | 167,138 |\n| Less - current portion | ( 39,169 | ) | ( 42,345 | ) |\n| Total loan payable, payroll protection program (PPP), less current portion | $ | 127,969 | $ | 124,793 |\n\nThe Paycheck Protection Program Loan (the “PPP Loan”) is administered by the U.S. Small Business Administration (the “SBA”). The interest rate of the loan is 1.00 % per annum and accrues on the unpaid principal balance computed on the basis of the actual number of days elapsed in a year of 360 days. Commencing seven months after the effective date of the PPP Loan, the Company is required to pay the Lender equal monthly payments of principal and interest as required to fully amortize any unforgiven principal balance of the loan by the two-year anniversary of the effective date of the PPP Loan (the “Maturity Date”). The PPP Loan contains customary events of default relating to, among other things, payment defaults, making materially false or misleading representations to the SBA or the Lender, or breaching the terms of the PPP Loan. The occurrence of an event of default may result in the repayment of all amounts outstanding under the PPP Loan, collection of all amounts owing from the Company, or filing suit and obtaining judgment against the Company. Under the terms of the CARES Act, PPP loan recipients can apply for and be granted forgiveness for all or a portion of the loan granted under the PPP. Such forgiveness will be determined, subject to limitations, based on the use of loan proceeds for payment of payroll costs and any payments of mortgage interest, rent, and utilities. Recent modifications to the PPP by the U.S. Treasury and Congress have extended the time period for loan forgiveness beyond the original eight-week period, making it possible for the Company to apply for forgiveness of its PPP loan.\n13\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n7. EQUIPMENT LOAN PAYABLE\nEquipment loan payable consist of the following:\n\n| June 30, 2022 | December 31, 2021 |\n| October 2017 - Loan agreement with principal amount of $ 82,011 with an interest rate of 6.40 % and maturity date on October 1, 2022 | $ | 6,312 | $ | 15,989 |\n| Total long-term equipment loan payable | 6,312 | 15,989 |\n| Less – current portion | ( 6,312 | ) | ( 15,989 | ) |\n| Total long-term debt, net of current portion | $ | - | $ | - |\n\n\n| For the year ended December 31, | Amount |\n| 2022 (remaining six months) | $ | 6,312 |\n| Total long-term equipment loan payable | $ | 6,312 |\n\nOctober 2017 - $ 82,011 equipment loan payable\nIn October 2017, the Company entered into equipment finance loan agreement with US Bank Equipment Finance in the amount of $ 82,011 with an interest rate of 6.40 % and maturity date on October 1, 2022 , payable in 60 payments. All principal, together with interest cost is due and payable on October 1, 2022. As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $ 6,312 and $ 15,989 , respectively.\n8. INCOME TAX\nTotal income tax (benefit) expense consists of the following:\n\n| For the Six-Month Periods Ended June 30, | 2022 | 2021 |\n| Current provision (benefit): |\n| Federal | $ | - | $ | - |\n| State | - | - |\n| Total current provision (benefit) | - | - |\n| Deferred provision (benefit): |\n| Federal | - | - |\n| State | - | - |\n| Total deferred provision (benefit) | - | - |\n| Total tax provision (benefit) | $ | - | $ | - |\n\nA reconciliation of the Company’s effective tax rate to the statutory federal rate is as follows:\n\n| Description | Rate |\n| Statutory federal rate | 21.00 | % |\n| State income taxes net of federal income tax benefit and others | 8.84 | % |\n| Permanent differences for tax purposes and others | 0.00 | % |\n| Change in valuation allowance | - 29.84 | % |\n| Effective tax rate | 0 | % |\n\n14\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n8. INCOME TAX (continued)\nThe income tax benefit differs from the amount computed by applying the U.S. federal statutory tax rate of 21 % and California state income taxes of 8.84 % due to the change in the valuation allowance.\nDeferred income taxes reflect the temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The components of deferred tax assets and liabilities are as follows:\n\n| Deferred tax assets | June 30, 2022 | December 31, 2021 |\n| Deferred tax assets: |\n| Net operating loss | $ | 2,961,949 | $ | 2,513,674 |\n| Other temporary differences | - | - |\n| Total deferred tax assets | 2,961,949 | 2,513,674 |\n| Less - valuation allowance | ( 2,961,949 | ) | ( 2,513,674 | ) |\n| Total deferred tax assets, net of valuation allowance | $ | - | $ | - |\n\nAs of December 31, 2021, the Company had available net operating loss carryovers of approximately $ 8,423,841 . Per the Tax Cuts and Jobs Act (TCJA) implemented in 2018, the two-year carryback provision was removed and now allows for an indefinite carryforward period. The carryforwards are limited to 80 % of each subsequent year’s net income. As a result, net operating loss may be applied against future taxable income and expires at various dates subject to certain limitations. The Company has a deferred tax asset arising substantially from the benefits of such net operating loss deduction and has recorded a valuation allowance for the full amount of this deferred tax asset since it is more likely than not that some or all of the deferred tax asset may not be realized.\nThe Company files income tax returns in the U.S. federal jurisdiction and California and is subject to income tax examinations by federal tax authorities for tax year ended 2017 and later and subject to California authorities for tax year ended 2016 and later. The Company currently is not under examination by any tax authority. The Company’s policy is to record interest and penalties on uncertain tax positions as income tax expense. As of June 30, 2022 and December 31, 2021, the Company has no accrued interest or penalties related to uncertain tax positions.\nAs of June 30, 2022, the Company had cumulative net operating loss carryforwards for federal tax purposes of approximately $ 9,926,101 . In addition, the Company had state tax net operating loss carryforwards of approximately $ 9,926,101 . The carryforwards may be applied against future taxable income and expires at various dates subject to certain limitations.\n15\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n9. COMMITMENTS AND CONTINGENCIES\nOperating Leases\nThe Company entered into the following operating facility leases\n\n| ● | La Floresta - On July 25, 2016, the Company entered into an operating facility lease for its store located at La Floresta Shopping Village in Brea, California with 60 months term with option to extend. The lease started on July 2016 and expires on November 2024. |\n\n\n| ● | La Crescenta - On May 2017, the Company entered into an operating facility lease for its store located in La Crescenta, California with 120 months term with option to extend. The lease started on May 2017 and expires in May 2027. The Company entered into non-cancellable lease agreement for a coffee shop approximately 1,607 square feet located in La Crescenta, California commencing in May 2017 and expiring in April 2027. The monthly lease payment under the lease agreement approximately $ 6,026 . |\n\n\n| ● | Brea - On September 1, 2018, the Company entered into an operating facility lease for its corporate office located in Brea, California with 72 months term with option to extend. The lease starts on September 2018 and expires on August 2024. |\n\n\n| ● | Glendale – On October 27, 2020, The Company entered a 7-year operating facility lease for its store located at the Glendale Galleria in Glendale, California. The lease starts on November 2020 and expires in October 2027. |\n| ● | San Francisco - On December 22, 2020, the Company entered into an operating facility lease for its store located at Stonestown Galleria in San Francisco, California with 84 months term with option to extend. The lease starts in June 2021 and expires in April 2028. |\n\n\n| ● | Santa Anita - On December 22, 2020, the Company entered into an operating facility lease for its store located at Arcadia, California with 36 months term with option to extend. The lease starts in February 2021 and expires in January 2024. |\n| ● | Riverside - On February 4, 2021, the Company entered into an operating facility lease for its store located at Galleria at Tyler in Riverside, California with 84 months term with option to extend. The lease starts in April 2021 and expires in March 2028. |\n\n\n| ● | Corona Del Mar - On February 5, 2021, the Company repurchased its retail store in Corona Del Mar, California. As part of that repurchase, the Company assumed the original operating lease on the facility, with 66 months term with an option to extend. The lease expires in December 2022. |\n\n\n| ● | Laguna Woods - On February 12, 2021, the Company entered into an operating facility lease for its store located at Home Depot Center in Laguna Woods, California with 60 months term with option to extend. The lease starts in June 2021 and expires in May 2026. |\n\n\n| ● | Huntington Beach - On November 1 2021, the Company entered into an operating facility lease for its store located at Huntington Beach, California with 124 months term with option to extend. The lease starts in November 2021 and expires in February 2032. |\n\n\n| ● | Manhattan Village - On March 1 2022, the Company entered into an operating facility lease for its store located at Manhattan Beach, California with 60 months term with option to extend. The lease starts in March 2022 and expires in February 2027. |\n\nThe Company adopted ASC 842 as of January 2018 (date of formation). The Company has operating leases for the Company’s corporate office and stores and accounts for these leases in accordance with ASC 842, which resulted in the recognition of ROU assets and operating lease liabilities of $ 2,937,437 and $ 3,082,771 , respectively, as of June 30, 2022. Certain of the leases for the Company’s retail store facilities provide for variable payments for property taxes, insurance and common area maintenance payments related to rental payments based on future sales volumes at the leased location, which are not measurable at the inception of the lease, or rental payments that are adjusted periodically for inflation.\nFor the new lease and adjustments, the Company recorded an additional non-cash increase of $470,564 to ROU assets and $492,650 to operational lease liabilities for the six-month period ended June 30, 2022.\n16\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n9. COMMITMENTS AND CONTINGENCIES (continued)\nIn accordance with ASC 842, the components of lease expense were as follows:\n\n| Six-month period ended June 30, | 2022 | 2021 |\n| Operating lease expense | $ | 452,155 | $ | 279,888 |\n| Total lease expense | $ | 452,155 | $ | 279,888 |\n\nIn accordance with ASC 842, other information related to leases was as follows:\n\n| Six-month period ended June 30, | 2022 | 2021 |\n| Operating cash flows from operating leases | $ | 435,635 | $ | 224,988 |\n| Cash paid for amounts included in the measurement of lease liabilities | $ | 435,635 | $ | 224,988 |\n| Weighted-average remaining lease term—operating leases | 4.1 Years |\n| Weighted-average discount rate—operating leases | 8.9 | % |\n\nIn accordance with ASC 842, maturities of operating lease liabilities as of June 30, 2022 were as follows:\n\n| Operating |\n| For the years ended December 31, | Lease |\n| 2022 (remaining six months) | $ | 467,758 |\n| 2023 | 864,887 |\n| 2024 | 785,267 |\n| 2025 | 642,387 |\n| 2026 | 574,150 |\n| Thereafter | 456,435 |\n| Total undiscounted cash flows | $ | 3,790,884 |\n| Reconciliation of lease liabilities: |\n| Weighted-average remaining lease terms | 4.1 Years |\n| Weighted-average discount rate | 8.9 | % |\n| Present values | $ | 3,082,771 |\n| Lease liabilities—current | 655,603 |\n| Lease liabilities—long-term | 2,427,168 |\n| Lease liabilities—total | $ | 3,082,771 |\n| Difference between undiscounted and discounted cash flows | $ | 708,113 |\n\nContingencies\nThe Company is subject to various legal proceedings from time to time as part of its business. As of June 30, 2022, the Company was not currently party to any legal proceedings or threatened legal proceedings, the adverse outcome of which, individually or in the aggregate, it believes would have a material adverse effect on its business, financial condition, and results of operations.\n17\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n10. SHAREHOLDERS’ EQUITY\nCommon Stock\nThe Company has authorization to issue and have outstanding at any one time 40,000,000 share of common stock with a par value of $ 0.0001 per share. The shareholders of common stock shall be entitled to one vote per share and dividends declared by the Company’s Board of Directors.\nIn June 2022, the Company approved (a) the conversion of all Class B Common Stock into Class A Common Stock, (b) a 1 for 100 reverse split, and (c) an amendment to Articles of Incorporation to eliminate Class B and to change “Class A” to simply “common stock”. All share and earnings per share information have been retroactively adjusted to reflect the stock split and the incremental par value of the newly issued shares was recorded with the offset to additional paid-in capital.\nPreferred Stock\nThe Company has authorization to issue and have outstanding at any one time 1,000,000 share of preferred stock with a par value of $ 0.0001 per share, in one or more classes or series within a class as may be determined by our board of directors, who establish, from time to time, the number of shares to be included in each class or series, fix the designation, powers, preferences and rights of the shares of each such class or series and any qualifications, limitations or restrictions thereof. Any preferred stock so issued is senior to other existing classes of common stock with respect to the payment of dividends or amounts upon liquidation or dissolution. As of June 30, 2022 and December 31, 2021, no shares of our preferred stock had been designated any rights and we had no shares of preferred stock issued and outstanding.\nSubscription of Common Stock Receivables\nThe Company issued 1,569,768 shares of common stock to several individuals in March 2020 and in December 2020 for total proceeds of $ 1,350,000 , of which $ 553,500 was received in January, February, and June 2021.\nIssuance of Common Stock in Settlement of Antidilution Provisions\nIn May 2018, the Company had entered into a share exchange agreement wherein Capax, Inc., the predecessor entity of Reborn Coffee, Inc. (“Capax”) effectively merged with Reborn Global Holdings, Inc. to form the Company. In this share exchange agreement, the preexisting shareholder of Capax were provided covenants that for a period of one year following the date upon which the Company is approved for quotation or trading on a public exchange (“IPO”), the percentage of ownership of the prior shareholders of Capax would not be less than the 5% of the total number of shares of voting common stock outstanding of the Company that they owned following the share exchange. In the event the ownership of the pre-merger shareholders of Capax fell below 5%, the Company was obligated to issue that number of shares of common stock to those shareholders which would increase the ownership of all of the Pre-Merger Shareholders to five percent (5%) of the total outstanding voting common shares of the Company. During the year ended December 31, 2021, the Company issued 325,495 shares of common stock under these provisions.\nOn January 25, 2022, the Company modified this agreement with the preexisting shareholders to effectively end the antidilution protection at the time of a successful IPO, eliminating the one-year period following an IPO as provided under the original agreement. The shareholders would be entitled to additional protection through the IPO date should the Company issue any additional shares between December 31, 2021 and the IPO date. The Company has not issued any additional shares subsequent to December 31, 2021.\nDividend policy\nDividends are paid at the discretion of the Board of Directors. There were no dividends declared for the six-month periods ended June 30, 2022 and 2021.\n18\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n11. EARNINGS PER SHARE\nThe Company calculates earnings per share in accordance with FASB ASC 260, Earnings Per Share, which requires a dual presentation of basic and diluted earnings per share. Basic earnings per share are computed using the weighted average number of shares outstanding during the fiscal year. Potentially dilutive common shares consist of stock options outstanding (using the treasury method).\nThe following table sets forth the computation of basic and diluted net income per common share:\n\n| Six-Month Period | Three-Month Period |\n| Ended June 30, | Ended June 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Net Loss | $ | ( 1,502,260 | ) | $ | ( 635,163 | ) | $ | ( 937,148 | ) | $ | ( 307,684 | ) |\n| Weighted Average Shares of Common Stock Outstanding |\n| Basic | 11,642,550 | 10,282,669 | 11,667,545 | 10,380,944 |\n| Diluted | 11,642,550 | 10,282,669 | 11,667,545 | 10,380,944 |\n| Earnings Per Share - Basic |\n| Net Loss Per Share | ( 0.13 | ) | ( 0.06 | ) | ( 0.08 | ) | ( 0.03 | ) |\n| Earnings Per Share - Diluted |\n| Net Loss Per Share | ( 0.13 | ) | ( 0.06 | ) | ( 0.08 | ) | ( 0.03 | ) |\n\n12. SUBSEQUENT EVENTS\nThe Company evaluated all events or transactions that occurred after June 30, 2022 up through the date the unaudited condensed consolidated financial statements were available to be issued. During this period, the Company did not have any material recognizable subsequent events required to be disclosed as of and for the six-month period ended June 30, 2022, except for the following:\nInitial Public Offering\nIn August 2022, the Company consummated its initial public offering (the “IPO”) of 1,440,000 shares of its common stock at a public offering price of $5.00 per share, generating gross proceeds of $ 7,200,000 . Net proceeds from the IPO was approximately $ 6.2 million after deducting underwriting discounts and commissions and other offering expenses of approximately $ 998,000 .\nThe Company had granted the underwriters a 45-day option to purchase up to 216,000 additional shares (equal to 15 % of the shares of common stock sold in the offering) to cover over-allotments. In addition, the Company had agreed to issue to the representative of the several underwriters warrants to purchase the number of shares of common stock in the aggregate equal to five percent ( 5 %) of the shares of common stock to be issued and sold in the IPO. The warrants are exercisable for a price per share equal to 125 % of the public offering price. No over-allotment option or representative’s warrants have been exercised.\n19\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.\nYou should read the following discussion and analysis of our financial condition and results of operations together with our condensed consolidated financial statements and the related notes and other financial information included elsewhere in this Quarterly Report on Form 10-Q and with our audited consolidated financial statements included in our Prospectus on Form S-1. As discussed in the section titled “Note Regarding Forward-Looking Statements,” the following discussion and analysis contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. Factors that could cause or contribute to these differences include, but are not limited to, those identified below and those discussed in the section titled “Risk Factors” in our Prospectus filed on Form S-1 (File No: 333-261937).\nBusiness\nReborn Coffee is focused on serving high quality, specialty-roasted coffee at retail locations, kiosks and cafes. We are an innovative company that strives for constant improvement in the coffee experience through exploration of new technology and premier service, guided by traditional brewing techniques. We believe Reborn differentiates itself from other coffee roasters through its innovative techniques, including sourcing, washing, roasting, and brewing our coffee beans with a balance of precision and craft.\nFounded in 2015 by Jay Kim, our Chief Executive Officer, Mr. Kim and his team launched Reborn Coffee with the vision of using the finest pure ingredients and pristine water. We currently serve customers through our retail store locations in California: Brea, La Crescenta, Glendale, Corona Del Mar, Arcadia, Laguna Woods, Riverside, San Francisco and Manhattan Beach, with four other locations in development. Additionally, we expect to begin franchising in 2022 and expect to continue to develop additional retail locations as we expand outside of California. We estimate that the average development cost of a company-owned retail location is approximately $150,000. Therefore, taking into account the proceeds from this offering and within a year from its completion, we expect to open up to 20 company-owned retail locations (using approximately $3,000,000 of the proceeds of this offering) and 20 franchise locations (all costs and expenses associated with a franchise store location development are borne by the franchisees). We acknowledge that we have not yet signed any franchise agreements and that such number of franchise locations is purely speculative. Reborn Coffee continues to elevate the high-end coffee experience and we received 1st place traditional still in “America’s Best Cold Brew” competition by Coffee Fest in 2017 in Portland and 2018 in Los Angeles.\nThe Experience, Reborn\nAs leading pioneers of the emerging “Fourth Wave” movement, Reborn Coffee is redefining specialty coffee as an experience that demands much more than premium quality. We consider ourselves leaders of the “fourth wave” coffee movement because we are constantly developing our bean processing methods, researching design concepts, and reinventing new ways of drinking coffee. For instance, the current transition from the K-Cup trend to the pour over drip concept allowed us to reinvent the way people consume coffee, by merging convenience and quality. We took the pour over drip concept and made it available and affordable to the public through our Reborn Coffee Pour Over packs. Our Pour Over Packs allow our consumers to consume our specialty coffee outdoors and on-the-go.\nOur success in innovating within the “fourth wave” coffee movement is measured by our success in B2B sales with our introduction of Reborn Coffee Pour Over Packs to hotels. With the introduction of our Pour Over Packs to major hotels (including one hotel company with 7 locations), our B2B sales increased as these companies recognized the convenience and functionality our Pour Over Packs serve to their customers.\nReborn Coffee’s continuous Research and Development is essential to developing new parameters in the production of new blends. Our 1st place position in “America’s Best Cold Brew” competition by Coffee Fest in 2017 in Portland and 2018 in Los Angeles is a testament to the way we believe we lead the “fourth wave” movement by example.\nCentered around its core values of service, trust, and well-being, Reborn Coffee delivers an appreciation of coffee as both a science and an art. Developing innovative processes such as washing green coffee beans with magnetized water, we challenge traditional preparation methods by focusing on the relationship between water chemistry, health, and flavor profile. Leading research studies, testing brewing equipment, and refining roasting/brewing methods to a specific, Reborn Coffee proactively distinguishes exceptional quality from good quality by starting at the foundation and paying attention to the details. Our mission places an equal emphasis on humanizing the coffee experience, delivering a fresh take on “farm-to-table” by sourcing internationally. In this way, Reborn Coffee creates opportunities to develop transparency by paying homage to origin stories and spark new conversations by building cross-cultural communities united by a passion for the finest coffee.\nThrough a broad product offering, Reborn Coffee provides customers with a wide variety of beverages and coffee options. As a result, we believe we can capture share of any experience where customers seek to consume great beverages whether in our inviting store atmospheres which are designed for comfort, or on the go through our pour over packs, or at home with our whole bean ground coffee bags. We believe that the retail coffee market in the US is large and growing. According to IBIS, in 2021, the retail market for coffee in the United States is expected to be $46.2 billion. This is expected to grow due to a shift in consumer preferences to premium coffee, including specialized blends, espresso-based beverages, and cold brew options. Reborn aims to capture a growing portion of the market as we expand and increase consumer awareness of our brand.\n20\nPlan of Operation\nWe have a production and distribution center at our headquarters that we use to process and roast coffee for wholesale and retail distribution.\nCurrently, we have the following nine retail coffee locations, and four locations in development (i.e., Cabazon, Huntington Beach, Irvine and Mission Viejo, California):\n\n| ● | La Floresta Shopping Village in Brea, California; |\n| ● | La Crescenta, California; |\n\n\n| ● | Glendale Galleria in Glendale, California; |\n| ● | Galleria at Tyler in Riverside, California; |\n| ● | Home Depot Center in Laguna Woods, California; |\n| ● | Stonestown Galleria in San Francisco, California (opened in first quarter of 2022); |\n| ● | Corona Del Mar, California; |\n| ● | Santa Anita Westfield Mall in Arcadia, California; and |\n| ● | Manhattan Village at Manhattan Beach, California. |\n\nImpact of COVID-19\nThe COVID-19 pandemic and resulting disruptions including, without limitation, governmental lockdown mandates and restrictions, made 2020 a challenging year for businesses, particularly in the foodservice and restaurant industries. Reborn Coffee took immediate action to protect the health and safety of our employees and customers including the implementation of all operating protocols dictated by state and local guidelines and instituting strict health and safety practices. Fortunately, we did not experience any significant disruptions in our supply chain operations.\nDespite efforts to ensure a safe consumer experience, we did experience repressed customer flow through periods when malls and shopping centers were restricted or closed entirely due to governmental lockdown mandates and restrictions. Our current retail locations are within popular shopping areas with anticipated regular customer traffic. Such closures or limitations and restrictions were at times mandated the government, and at other times due to natural customer uncertainties regarding the status of COVID-19. Such restrictions and uncertainties not only impacted anticipated revenues from current locations, but added additional risk to us related to the opening of new locations. Thus, the uncertainty regarding the scope and longevity of such restrictions modified our plans as to how quickly we could enact our expansion plans.\nMore specifically, COVID-19 has challenged our performance at our kiosk locations, though our cafe locations have improved in performance. Shopping mall restrictions and mandates during the pandemic made it difficult for our kiosks to operate at maximum performance, as indoor restrictions of shopping malls affected the way we had to operate business. For instance, we had to offer only to-go/pickup operations to operate while meeting regulations. We have learned how to move forward aggressively despite such regulations and mandates, doing what we can to serve the coffee we are so proud to serve, whether this means offering to-go orders only or working with delivery services.\nIn May 2020, the Company availed itself of a loan under the Paycheck Protection Program (PPP) administered by the U.S. Small Business Administration (SBA) in the amount of $115,000, and $500,000 under the SBA’s Economic Injury Disaster Loan assistance program, all of which is currently outstanding as of December 31, 2021, provided however that repayment was deferred to commence in May 2022. In February 2021, the Company secured a second PPP loan under this program in the amount of approximately $167,000. The Company was granted forgiveness for the initial PPP Loan prior to December 31, 2021 and expects to be granted forgiveness on the remainder subsequently.\n21\nIn January 2022 we announced a price increase of our whole roasted beans by 15% on our website which we attribute to increases due to inflation in the cost of raw green coffee beans, the cost of shipping and supplies, and nationwide increases in labor costs-- factors that may or may not be attributable to the pandemic and/or the governmental policies and mandates that were implemented during and in the wake of COVID-19. As of the date hereof and in January 2022 at the time of our price increase, inflation has not had a material effect on our results of operations since we have been able to offset such increased costs by increasing the price of our whole roasted beans by 15% in January 2022, through increased sales and growth in opening 2 new company-owned retail locations, better lease terms on such new company-owned retail locations, more efficient purchasing practices (e.g., volume purchase discounts), productivity improvements and greater economies of scale. Severe increases in inflation, however, could affect the global and U.S. economies and could have a materially adverse impact on our business, financial condition or results of operations.\nWe do not expect COVID-19 to affect our future operating results significantly, as we are confident that coffee is an essential product that people rely on and will always drink. We intend to meet all governmental business operation regulations and improve sales by whatever means necessary, utilizing resources such as food delivery services and to-go/pickup orders. However, the impact of COVID-19 continues to evolve, and we cannot easily predict the future potential impacts of the pandemic on our business or operations or on the United States or global economy in general. This may include any recurrence of the disease, actions taken in response to the evolving pandemic, any ongoing effects on consumer demand and spending patterns or other impacts of the pandemic. Whether these or other currently unanticipated consequences of the pandemic are reasonably likely to materially affect our results of operations, cash flows or financial condition is yet to be determined. For additional details regarding the impact of COVID-19 on our business, see “Risk Factors-Risks Related to Our Business-Pandemics or disease outbreaks such as the COVID-19 have had, and may continue to have, an effect on our business and results of operations.”\nComponents of Our Results of Operations\nRevenue\nThe Company recognizes revenue in accordance with Accounting Standards Codification (“ASC”) 606, Revenue from Contracts with Customers. The Company’s net revenue primarily consists of revenues from its retail locations and wholesale and online store. Accordingly, the Company recognizes revenue as follows:\n\n| ● | Retail Store Revenue |\n| Retail store revenues are recognized when payment is tendered at the point of sale. Retail store revenues are reported net of sales, use or other transaction taxes that are collected from customers and remitted to taxing authorities. Sales taxes that are payable are recorded as accrued as other current liabilities. Retail store revenue makes up approximately 97% of the Company’s total revenue. |\n| ● | Wholesale and Online Revenue |\n| Wholesale and online revenues are recognized when the products are delivered, and title passes to customers or to the wholesale distributors. When customers pick up products at the Company’s warehouse, or distributed to the wholesale distributors, the title passes, and revenue is recognized. Wholesale revenues make up approximately 3% of the Company’s total revenue. |\n\n\n| ● | Royalties and Other Fees |\n| Franchise revenues consist of royalty fee and other franchise fees. Royalty fee is based on a percentage of franchisee’s weekly gross sales revenue at 5%. The Company recognizes the fee as the underlying sales occur. The Company recorded revenue from royalty of $0 for the three and six month periods ended June 30, 2022 and 2021. Other fees are earned as incurred and the Company did not have any other fee revenue for the three and six month periods ended June 30, 2022 and 2021. |\n\nCost of Sales\nCost of sales includes costs associated with generating revenue within our company-owned retail locations, and franchising operations (of which, as of the date of this prospectus, we had none).\nShipping and Handling Costs\nThe Company incurred freight out cost and is included in the Company’s cost of sale.\nGeneral and Administrative Expense\nGeneral and administrative expense includes store-related expense as well as the Company’s corporate headquarters’ expenses.\nAdvertising Expense\nAdvertising expense are expensed as incurred. Advertising expenses amounted to $20,513 and $50,160 for the six month periods ended June 30, 2022 and 2021, respectively, and is recorded under general and administrative expenses in the accompanying unaudited condensed consolidated statements of operations.\n22\nPre-opening Costs\nPre-opening costs for new stores, which are not material, consist primarily of payroll and recruiting expense, training, marketing, rent, travel, and supplies, and are expensed as incurred depreciated over the shorter of the useful life of the improvement or the lease term, including renewal periods that are reasonably assured.\nResults of Operations\nThree and six months ended June 30, 2022 Compared to three and six months ended June 30, 2021\nThe following table presents selected comparative results of operations from our unaudited financial statements for the three and six months ended June 30, 2022 compared to three and six months ended June 30, 2021. Our financial results for these periods are not necessarily indicative of the financial results that we will achieve in future periods. Certain totals for the table below may not sum to 100% due to rounding.\n\n| Six Months Ended June 30, | Increase / (Decrease) |\n| 2022 | 2021 | Dollars | Percentage |\n| Net revenues: |\n| Stores | $ | 1,511,952 | $ | 851,785 | $ | 660,167 | 77.5 | % |\n| Wholesale and online | 29,674 | 28,336 | 1,338 | 4.7 | % |\n| Total net revenues | 1,541,626 | 880,121 | 661,505 | 75.2 | % |\n| Operating costs and expenses: |\n| Product, food and drink costs—stores | 563,906 | 270,148 | 293,758 | 108.7 | % |\n| Cost of sales—wholesale and online | 12,997 | 12,412 | 585 | 4.7 | % |\n| General and administrative | 2,468,447 | 1,226,951 | 1,241,496 | 101.2 | % |\n| Loss from operations | (1,503,724 | ) | (629,390 | ) | (874,334 | ) | 138.9 | % |\n| Other income | 16,440 | - | 16,440 | N/A | % |\n| Interest expense | (14,976 | ) | (5,773 | ) | (9,203 | ) | 159.4 | % |\n| Loss before income taxes | (1,502,260 | ) | (635,163 | ) | (867,097 | ) | 136.5 | % |\n| Provision for income taxes | - | - | - | 0.0 | % |\n| Net loss | $ | (1,502,260 | ) | $ | (635,163 | ) | $ | (867,097 | ) | 136.5 | % |\n\n\n| Three Months Ended June 30, | Increase / (Decrease) |\n| 2022 | 2021 | Dollars | Percentage |\n| Net revenues: |\n| Stores | $ | 775,956 | $ | 475,824 | $ | 300,132 | 63.1 | % |\n| Wholesale and online | 12,520 | 15,368 | (2,848 | ) | -18.5 | % |\n| Total net revenues | 788,476 | 491,192 | 297,284 | 60.5 | % |\n| Operating costs and expenses: |\n| Product, food and drink costs—stores | 278,952 | 135,452 | 143,500 | 105.9 | % |\n| Cost of sales—wholesale and online | 5,484 | 6,732 | (1,248 | ) | -18.5 | % |\n| General and administrative | 1,432,432 | 656,310 | 776,122 | 118.3 | % |\n| Loss from operations | (928,392 | ) | (307,302 | ) | (621,090 | ) | 202.1 | % |\n| Other income | 1,440 | - | 1,440 | N/A | % |\n| Interest expense | (10,196 | ) | (382 | ) | (9,814 | ) | 2569.1 | % |\n| Loss before income taxes | (937,148 | ) | (307,684 | ) | (629,464 | ) | 204.6 | % |\n| Provision for income taxes | - | - | - | 0.0 | % |\n| Net loss | $ | (937,148 | ) | $ | (307,684 | ) | $ | (629,464 | ) | 204.6 | % |\n\n23\n\n| Six months ended June 30, | Three months ended June 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Net revenues: |\n| Stores | 98.1 | % | 96.8 | % | 98.4 | % | 96.9 | % |\n| Wholesale and online | 1.9 | % | 3.2 | % | 1.6 | % | 3.1 | % |\n| Total net revenues | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % |\n| Operating costs and expenses: |\n| Product, food and drink costs—stores | 36.6 | % | 30.7 | % | 35.4 | % | 27.6 | % |\n| Cost of sales—wholesale and online | 0.8 | % | 1.4 | % | 0.7 | % | 1.4 | % |\n| General and administrative | 160.1 | % | 139.4 | % | 181.7 | % | 133.6 | % |\n| Loss from operations | -97.5 | % | -71.5 | % | -117.7 | % | -62.6 | % |\n| Other income | 1.1 | % | 0.0 | % | 0.2 | % | 0.0 | % |\n| Interest expense | -1.0 | % | -0.7 | % | -1.3 | % | -0.1 | % |\n| Loss before income taxes | -97.4 | % | -72.2 | % | -118.9 | % | -62.6 | % |\n| Provision for income taxes | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % |\n| Net loss | -97.4 | % | -72.2 | % | -118.9 | % | -62.6 | % |\n\nRevenues. Revenues were approximately $1.5 million for the six-month period ended June 30, 2022, compared to $880,000 for the comparable period in 2021, representing an increase of $661,000, or 75.2%. Revenues were approximately $788,000 million for the three-month period ended June 30, 2022, compared to $491,000 for the comparable period in 2021, representing an increase of $297,000, or 60.5%. The increase in sales for the periods was primarily driven by the opening of the Corona Del Mar, Laguna Woods and Santa Anita locations during 2021, and to the continued focus on marketing efforts to grow brand recognition.\nProduct, food and drink costs. Product, food and drink costs were approximately $564,000 for the six-month period ended June 30, 2022 compared to $270,000 for the comparable period in 2021, representing an increase of approximately $294,000, or 108.7%, and were approximately $279,000 for the three-month period ended June 30, 2022 compared to $135,000 for the comparable period in the prior year, representing an increase of $144,000 of 105.9%. The increase in costs for the periods was partially driven by the opening of new locations and the overall increase in sales for the period. As a percentage of revenues, product, food and drink costs increased to 36.6% in the six-month period ended June 30, 2022 compared to 30.7% in the comparable period in 2021 and increased to 35.4% in the three-month period ended June 30, 2022 compared to 27.6% in the comparable period in 2021. The increase in costs as a percentage of sales was primarily driven by general inflationary pressures and the seasonal fluctuations in cost of ingredients. We monitor these fluctuations in product costs to analyze whether they are considered to be representative of general economic conditions, such as inflation, or to be related to commodity specific changes. For example, green bean suppliers raised pricing by 15 to 20% throughout 2021, higher than the overall rate of inflation, however it has been more stable recently and even decreasing slightly in the second quarter of 2022.\nGeneral and administrative expenses. General and administrative expenses were approximately $2.5 million for the six-month period ended June 30, 2022 compared to $1.2 million for the comparable period in the prior year, representing an increase of approximately $1.2 million, or 101.2%, and were approximately $1.4 million for the three-month period ended June 30, 2022 compared to $656,000 for the comparable period in 2021, representing an increase of approximately $775,000, or 118.3%. This increase in general and administrative expenses was primarily due to the hiring of additional administrative employees, increases in professional services and corporate-level costs to support growth plans, the opening of new restaurants, as well as costs associated with outside administrative, legal and professional fees and other general corporate expenses associated with preparing to become a public company. As a percentage of sales, general and administrative expenses increased to 160.1% in the six-month period ended June 30, 2022 from 139.4% in the comparable period of 2021, and increased to 181.7% for the three-month period ended June 30, 2022 from 133.6% in the comparable period in 2021, primarily due to the increased administrative expenditures for the reasons mentioned above.\n24\nLiquidity and Capital Resources\n\n| Six Months Ended June 30, |\n| 2022 | 2021 |\n| Statement of Cash Flow Data: |\n| Net cash used in operating activities | (1,199,979 | ) | (538,352 | ) |\n| Net cash used in investing activities | (168,397 | ) | (317,152 | ) |\n| Net cash provided by financing activities | 613,149 | 866,579 |\n\nCash Flows Provided by Operating Activities\nNet cash used in operating activities during the six-month period ended June 30, 2022 was $1.2 million, which resulted from net loss of $1.5 million, non-cash charges of $225,000 for stock compensation and $98,000 for depreciation and net cash outflows of $43,000 from changes in operating assets and liabilities. The net cash outflows from changes in operating assets and liabilities were primarily the result of increases in inventory of $14,000 and prepaid and other assets of $28,000 and a decrease in accounts payable of $46,000, partially offset by increase of $47,000 in accrued liabilities. The increase in accrued liabilities was primarily due to the timing of cash payments for sales tax and payroll.\nNet cash used in operating activities during the six-month period ended June 30, 2021 was $538,000, which resulted from net loss of $635,000, non-cash charges of $82,000 for depreciation, and net cash outflows of $6,000 from changes in operating assets and liabilities. The net cash outflows from changes in operating assets and liabilities were primarily the result of increases in inventories of $7,000 and prepaids and other assets of $65,000, partially offset by increases of $50,000 in accounts payable and $17,000 in accrued liabilities.\nCash Flows Used in Investing Activities\nNet cash used in investing activities during the six-month periods ended June 30, 2022 and 2021 was $168,000 and $317,000, respectively, These expenditures in each period are primarily related to purchases of property and equipment in connection with current and future location openings and maintaining our existing locations.\nCash Flows Provided by (Used in) Financing Activities\nNet cash provided by financing activities during the six-month period ended June 30, 2022 was $613,000, primarily due to $595,000 of borrowings under a line of credit, and $150,000 of loans from shareholders. This was partially offset by $131,000 of repayments of borrowings.\nNet cash provided by financing activities during the six-month period ended June 30, 2021 was $867,000, primarily due to approximately $533,000 cash received through borrowings and $553,000 of proceeds from issuance of common stock, offset by approximately $220,000 of repayments of borrowings.\nAs of June 30, 2022, the Company had total assets of $4,593,013. Our cash balance as of June 30, 2022 was approximately $150,000. From inception (of Reborn Global in November 2014) to June 30, 2022, we have not had any positive operating cash flow.\nCredit Facilities\nLoan with Fora Financial\nIn October 2019, the Company entered into a loan agreement with Fora Financial in the principal amount of $138,600 and remaining principal amount of $48,510. The loan payable has a maturity date on October 11, 2019. The loan was due on demand. As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $0.\nLoans with Square Capital\nBetween April and August 2021, the Company entered into loan agreements with Square Capital in the aggregate principal amount of approximately $268,000 with loan costs of $34,840. The loans have maturity dates ranging from September 2022 to February 2023. As of June 20, 2022 and December 31, 2021, there was a balance outstanding of approximately $0 and $122,000, respectively.\n25\nEconomic Injury Disaster Loan\nOn May 16, 2020, the Company executed the standard loan documents required for securing a loan (the “EIDL Loan”) from the SBA under its Economic Injury Disaster Loan (“EIDL”) assistance program in light of the impact of the COVID-19 pandemic on the Company’s business. As of June 30, 2022, the loan payable, Emergency Injury Disaster Loan noted above is not in default.\nPursuant to that certain Loan Authorization and Agreement (the “SBA Loan Agreement”), the Company borrowed an aggregate principal amount of the EIDL Loan of $500,000, with proceeds to be used for working capital purposes. Interest accrues at the rate of 3.75% per annum and will accrue only on funds actually advanced from the date of each advance. Installment payments, including principal and interest, are due monthly beginning May 16, 2021 (twelve months from the date of the SBA Loan) in the amount of $731. The balance of principal and interest is payable thirty years from the date of the SBA Loan. In connection therewith, the Company also received a $10,000 grant, which does not have to be repaid. During the year ended December 31, 2020, $10,000 was recorded in Economy injury disaster loan (EIDL) grant income in the Statements of Operations. The schedule of payments on this loan was later deferred to commence 24 months from the date of loan, and therefore, the full amount of the loan is outstanding as of June 30, 2022 and payments shall commence starting in May 2022.\nIn connection therewith, the Company executed (i) a loan for the benefit of the SBA (the “SBA Loan”), which contains customary events of default and (ii) a Security Agreement, granting the SBA a security interest in all tangible and intangible personal property of the Company, which also contains customary events of default (the “SBA Security Agreement”).\nPaycheck Protection Program Loan\nIn May 2020, the Company secured a loan under the Paycheck Protection Program administered by the U.S. Small Business Administration (the “SBA”) in the amount of $115,000. In February 2021, the Company secured a second loan under this program in the amount of approximately $167,000. The interest rate of the loan is 1.00% per annum and accrues on the unpaid principal balance computed on the basis of the actual number of days elapsed in a year of 360 days. Commencing seven months after the effective date of each PPP Loan, the Company is required to pay the Lender equal monthly payments of principal and interest as required to fully amortize any unforgiven principal balance of the loan by the two-year anniversary of the effective date of the loan. The PPP Loan contains customary events of default relating to, among other things, payment defaults, making materially false or misleading representations to the SBA or the Lender, or breaching the terms of the PPP Loan. The occurrence of an event of default may result in the repayment of all amounts outstanding under the PPP Loan, collection of all amounts owing from the Company, or filing suit and obtaining judgment against the Company. Under the terms of the CARES Act, PPP loan recipients can apply for and be granted forgiveness for all or a portion of the loan granted under the PPP. Such forgiveness will be determined, subject to limitations, based on the use of loan proceeds for payment of payroll costs and any payments of mortgage interest, rent, and utilities. Recent modifications to the PPP by the U.S. Treasury and Congress have extended the time period for loan forgiveness beyond the original eight-week period, making it possible for the Company to apply for forgiveness of its PPP loan. The Company was granted forgiveness for the initial PPP Loan prior to December 31, 2021 and expects to be granted forgiveness on the remainder subsequently.\nLine of Credit Facility\nDuring the second quarter of 2022, the Company entered into a line of credit agreement with a financial institution that provides a maximum borrowing limit of $2,000,000 with interest at 5% per annum. This line of credit facility matures on December 31, 2022. Total balance as of June 30, 2022 was $594,529.\nLeases\nOperating Leases\nWe currently lease all company-owned retail locations. Operating leases typically contain escalating rentals over the lease term, as well as optional renewal periods. Rent expense for operating leases is recorded on a straight-line basis over the lease term and begins when Reborn has the right to use the property. The difference between rent expense and cash payment is recorded as deferred rent on the accompanying consolidated balance sheets. Pre-opening rent is included in selling, general and administrative expenses on the accompanying consolidated statements of income. Tenant incentives used to fund leasehold improvements are recorded in deferred rent and amortized as reductions to rent expense over the term of the lease.\n26\nIncome Taxes\nReborn files income tax returns in the U.S. federal and California state jurisdictions.\nUpon the closing of this offering, we will be taxed at the prevailing U.S. corporate tax rates. We will be treated as a U.S. corporation and a regarded entity for U.S. federal, state and local income taxes. Accordingly, a provision will be recorded for the anticipated tax consequences of our reported results of operations for U.S. federal, state and foreign income taxes.\nJOBS Act Accounting Election\nWe are an “emerging growth company,” as defined in the JOBS Act, and may take advantage of certain exemptions from various public company reporting requirements for up to five years or until we are no longer an emerging growth company, whichever is earlier. The JOBS Act provides that an “emerging growth company” can delay adopting new or revised accounting standards until those standards apply to private companies. We have elected to use this extended transition period under the JOBS Act. Accordingly, our financial statements may not be comparable to the financial statements of public companies that comply with such new or revised accounting standards.\nOff Balance Sheet Arrangements\nWe do not have any off-balance sheet arrangements that we are required to disclose pursuant to these regulations. In the ordinary course of business, we enter into operating lease commitments, purchase commitments and other contractual obligations. These transactions are recognized in our financial statements in accordance with GAAP.\nCritical Accounting Policies\nThe preparation of financial statements requires management to utilize estimates and make judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. These estimates are based on historical experience and on various other assumptions that management believes to be reasonable under the circumstances. The estimates are evaluated by management on an ongoing basis, and the results of these evaluations form a basis for making decisions about the carrying value of assets and liabilities that are not readily apparent from other sources. Although actual results may differ from these estimates under different assumptions or conditions, management believes that the estimates used in the preparation of our financial statements are reasonable. The critical accounting policies affecting our financial reporting are summarized in Note 2 to the financial statements included elsewhere in this prospectus.\nRecent Accounting Pronouncements\nWe have determined that all other issued, but not yet effective accounting pronouncements are inapplicable or insignificant to us and once adopted are not expected to have a material impact on our financial position.\n27\n\nItem 3. Quantitative and Qualitative Disclosures About Market Risk.\nWe are a smaller reporting company as defined by 17 C.F.R. 229 (10)(f)(i) and are not required to provide information under this item.\n\nItem 4. Controls and Procedures.\nEvaluation of Disclosure Controls and Procedures\nOur management has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)), as of June 30, 2022. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that as of June 30, 2022, our disclosure controls and procedures were ineffective to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act (a) is recorded, processed, summarized and reported within the time periods specified by Securities and Exchange Commission (“SEC”) rules and forms and (b) is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding any required disclosure.\nChanges in Internal Control Over Financial Reporting\nDuring the period ended June 30, 2022, our management has evaluated the internal control over financial reporting pursuant to Rules 13a-15(d) or 15d-15(d) under the Exchange Act. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our internal controls over financial reporting were ineffective as of June 30, 2022. Management of the Company believes that the ineffectiveness of internal controls was due to the lack of accounting and financial team.\n28\nPART II—OTHER INFORMATION\n\nItem 1. Legal Proceedings.\nIn the future, the Company may be subject to various legal proceedings from time to time as part of its business. We are currently not involved in litigation that we believe will have a materially adverse effect on our financial condition or results of operations. As of June 30, 2022, there is no action, suit, proceeding, inquiry or investigation before or by any court, public board, government agency, self- regulatory organization or body pending or, to the knowledge of the executive officers of our company or any of our subsidiaries threatened against or affecting our company, our common stock, any of our subsidiaries or of our company’s or our company’s subsidiaries’ officers or directors in their capacities as such, in which an adverse decision is expected to have a material adverse effect.\n\nItem 1A. Risk Factors.\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, we are not required to provide information required by this item.\n\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\nWe have not made any sales of unregistered equity securities during the quarterly period ended June 30, 2022.\nIn August 2022, the Company consummated its initial public offering (the “IPO”) of 1,440,000 shares of its common stock at a public offering price of $5.00 per share, generating gross proceeds of $7,200,000 pursuant to our Registration Statement on Form S-1 (as amended) (File No. 333-261937), which was declared effective by the SEC on August 11, 2022. . EF Hutton, division of Benchmark Investments, LLC, acted as the representative of the underwriters of the IPO. After deducting underwriting discounts and commissions and other offering expenses payable by us, we received approximately $6.2 million in net proceeds from our initial public offering.\nThere has been no material change in the planned use of proceeds from our initial public offering as described in our final prospectus, dated August 11, 2022, which was filed with the SEC on August 16, 2021 pursuant to Rule 424(b) under the Securities Act. The primary use of the net proceeds from our initial public offering continues to be, as follows: (i) approximately $8.0 million for the acquisition of property and the development of a manufacturing plant to build, design and manufacture our new line of electric boats; (ii) approximately $2.0 million for ramp up of production and inventory; (iii) approximately $2.6 million for working capital.\nNo payments were made by us to directors, officers or persons owning ten percent or more of our common stock or to their associates, or to our affiliates, other than payments in the ordinary course of business to officers for salaries. Pending the uses described, we have invested the net proceeds in our operating cash account.\n29\n\nItem 6. Exhibits.\nThe following exhibits are included herein or incorporated herein by reference:\n\n| 3.1 | Certificate of Incorporation (Delaware), dated July 27, 2022 (incorporated by reference to Exhibit 3.1 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\n| 3.2 | Bylaws of Registrant (Delaware) (incorporated by reference to Exhibit 3.2 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\n| 4.1 | Specimen Common Stock Certificate (Delaware) (incorporated by reference to Exhibit 4.1 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\n| 4.2 | Form of Representative’s Warrant (incorporated by reference to Exhibit 4.5 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.1 | Share Exchange Agreement, dated May 7, 2018 by and among Capax, Reborn and each of the RB shareholders (incorporated by reference to Exhibit 10.1 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.2 | Form of Letter Agreement (Lockup) by and among Registrant, officers and directors of the Company and EF Hutton (incorporated by reference to Exhibit 10.2 to Amendment No. 6 to our Registration Statement on Form S-1 filed on August 9, 2022) |\n| 10.3 | Form of Director and Officer Indemnity Agreement (incorporated by reference to Exhibit 10.3 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.4 | Shopping Center Lease by and between Reborn Global Holdings, Inc. and La Floresta Regency, LLC, effective July 25, 2016 (incorporated by reference to Exhibit 10.4 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.5 | Standard Industrial/Commercial Multi-Tenant Lease, as amended, by and between Reborn Global Holdings, Inc. and Foothill Crescenta, LLC, effective December 6, 2016 (incorporated by reference to Exhibit 10.5 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.6 | Shopping Center Lease by and between Reborn Global Holdings, Inc. and Sibling Associates, LLC, effective July 12, 2017 (incorporated by reference to Exhibit 10.6 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.7 | Standard Lease by and between Reborn Global Holdings, Inc. and El Toro, LP, effective February 12, 2021 (incorporated by reference to Exhibit 10.7 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.8 | Form of Subscription Agreement (Regulation A+ Offering) (incorporated by reference to Exhibit 10.11 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.9 | Consulting Agreement by and between the Company and Kevin Hartley, effective September 15, 2021 (incorporated by reference to Exhibit 10.12 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.10 | Amendment to Share Exchange Agreement, dated January 25, 2022, by and among Reborn Coffee Inc., Andrew Weeraratne and each of the former shareholders of Reborn Global Holdings, Inc., a California corporation (incorporated by reference to Exhibit 10.10 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\n| 10.11 | Offer of Employment by and between the Company and Stephan Kim, dated July 27, 2022 (incorporated by reference to Exhibit 10.11 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\n| 31.1* | Certification of Jay Kim pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2* | Certification of Stephan Kim pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1** | Certification of Jay Kim pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2** | Certification of Stephan Kim pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS | Inline XBRL Instance Document. |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document. |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document. |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document. |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document. |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document. |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101). |\n\n\n| * | Filed herewith. |\n\n\n| ** | Furnished herewith. |\n\n30\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| Signature | Title | Date |\n| /s/ Jay Kim | Chief Executive Officer (Principal Executive Officer) | September 30, 2022 |\n| Jay Kim |\n| /s/ Stephan Kim | Chief Financial Officer (Principal Financial and Accounting Officer) | September 30, 2022 |\n\n31\n\n \n\nWhat was the percentage change in earnings per share (EPS) year over year?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nPART I—FINANCIAL INFORMATION\\nItem 1. Condensed Consolidated Financial Statements.\\nUnaudited Condensed Consolidated Balance Sheets\\n\\n| As of | June 30, 2022 | December 31, 2021 |\\n| ASSETS |\\n| Current assets: |\\n| Cash and cash equivalents | $ | 149,824 | $ | 905,051 |\\n| Accounts receivable, net of allowance for doubtful accounts of $ 0 and $ 0 , respectively | 1,293 | - |\\n| Inventories, net | 102,981 | 88,877 |\\n| Prepaid expense and other current assets | 220,113 | 191,838 |\\n| Total current assets | 474,211 | 1,185,766 |\\n| Property and equipment, net | 1,181,365 | 1,110,890 |\\n| Operating lease right-of-use asset | 2,937,437 | 2,466,873 |\\n| Total assets | $ | 4,593,013 | $ | 4,763,529 |\\n| LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT) |\\n| Current liabilities: |\\n| Accounts payable | $ | 158 | $ | 45,748 |\\n| Accrued expenses and current liabilities | 171,070 | 124,535 |\\n| Line of credit | 594,529 | - |\\n| Loans payable to financial institutions – current portion | - | 98,475 |\\n| Loans payable to shareholders | 150,000 | - |\\n| Loan payable, emergency injury disaster loan (EIDL) – current portion | 10,760 | 7,957 |\\n| Loan payable, payroll protection program (PPP) – current portion | 39,169 | 42,345 |\\n| Equipment loan payable – current portion | 6,312 | 15,989 |\\n| Operating lease liabilities – current portion | 655,603 | 578,419 |\\n| Total current liabilities | 1,627,601 | 913,468 |\\n| Loans payable to financial institutions – net of current portion | - | 23,228 |\\n| Loan payable, emergency injury disaster loan (EIDL), net of current portion | 489,240 | 492,043 |\\n| Loan payable, payroll protection program (PPP), net of current portion | 127,969 | 124,793 |\\n| Operating lease liabilities, net of current portion | 2,427,168 | 2,011,702 |\\n| Total liabilities | 4,671,978 | 3,565,234 |\\n| Commitments and Contingencies |\\n| Stockholders’ equity (deficit) |\\n| Common Stock, $ 0.0001 par value, 40,000,000 shares authorized; 11,679,523 and 11,634,523 shares issued and outstanding at June 30, 2022 and December 31, 2021 | 1,168 | 1,163 |\\n| Preferred Stock, $ 0.0001 par value, 1,000,000 shares authorized; no shares issued and outstanding at June 30, 2022 and December 31, 2021 | - | - |\\n| Additional paid-in capital | 9,899,031 | 9,674,036 |\\n| Accumulated deficit | ( 9,979,164 | ) | ( 8,476,904 | ) |\\n| Total stockholders’ equity (deficit) | ( 78,965 | ) | 1,198,295 |\\n| Total liabilities and stockholders’ equity | $ | 4,593,013 | $ | 4,763,529 |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n1\\nUnaudited Condensed Consolidated Statements of Operations\\n\\n| Six Months Ended June 30, | Three Months Ended June 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Net revenues: |\\n| Stores | $ | 1,511,952 | $ | 851,785 | $ | 775,956 | $ | 475,824 |\\n| Wholesale and online | 29,674 | 28,336 | 12,520 | 15,368 |\\n| Total net revenues | 1,541,626 | 880,121 | 788,476 | 491,192 |\\n| Operating costs and expenses: |\\n| Product, food and drink costs—stores | 563,906 | 270,148 | 278,952 | 135,452 |\\n| Cost of sales—wholesale and online | 12,997 | 12,412 | 5,484 | 6,732 |\\n| General and administrative | 2,468,447 | 1,226,951 | 1,432,432 | 656,310 |\\n| Total operating costs and expenses | 3,045,350 | 1,509,511 | 1,716,868 | 798,494 |\\n| Loss from operations | ( 1,503,724 | ) | ( 629,390 | ) | ( 928,392 | ) | ( 307,302 | ) |\\n| Other income (expense): |\\n| Other income | 16,440 | - | 1,440 | - |\\n| Interest expense | ( 14,976 | ) | ( 5,773 | ) | ( 10,196 | ) | ( 382 | ) |\\n| Total other income (expense), net | 1,464 | ( 5,773 | ) | ( 8,756 | ) | ( 382 | ) |\\n| Loss before income taxes | ( 1,502,260 | ) | ( 635,163 | ) | ( 937,148 | ) | ( 307,684 | ) |\\n| Provision for income taxes | - | - | - | - |\\n| Net loss | $ | ( 1,502,260 | ) | $ | ( 635,163 | ) | $ | ( 937,148 | ) | $ | ( 307,684 | ) |\\n| Loss per share: |\\n| Basic and diluted | $ | ( 0.13 | ) | ( 0.06 | ) | ( 0.08 | ) | ( 0.03 | ) |\\n| Weighted average number of common shares outstanding: |\\n| Basic and diluted | 11,642,550 | 10,282,669 | 11,667,545 | 10,380,944 |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n2\\nUnaudited Condensed Consolidated Stockholders’ Equity (Deficit)\\n\\n| Common Stock | Preferred Stock | Additional Paid-in | Subscription of Common | Accumulated | Total Shareholders’ |\\n| Shares | Amount | Shares | Amount | Capital | Stock | Deficit | Deficit |\\n| Balance as of December 31, 2021 | 11,634,523 | $ | 1,163 | - | $ | - | $ | 9,674,036 | $ | - | $ | ( 8,476,904 | ) | $ | 1,198,295 |\\n| Net loss | - | - | - | - | - | - | ( 565,112 | ) | ( 565,112 | ) |\\n| Balance as of March 31, 2022 | 11,634,523 | $ | 1,163 | - | $ | - | $ | 9,674,036 | $ | - | $ | ( 9,042,016 | ) | $ | 633,183 |\\n| Stock compensation | 45,000 | 5 | - | - | 224,995 | - | - | 225,000 |\\n| Net loss | - | - | - | - | - | - | ( 937,148 | ) | ( 937,148 | ) |\\n| Balance as of June 30, 2022 | 11,679,523 | $ | 1,168 | - | $ | - | $ | 9,899,031 | $ | - | $ | ( 9,979,164 | ) | $ | ( 78,965 | ) |\\n\\n\\n| Common Stock | Preferred Stock | Additional Paid-in | Subscription of Common | Accumulated | Total Shareholders’ |\\n| Shares | Amount | Shares | Amount | Capital | Stock | Deficit | Deficit |\\n| Balance as of December 31, 2020 | 10,443,721 | $ | 1,045 | - | $ | - | $ | 4,733,063 | $ | ( 450,000 | ) | $ | ( 5,036,504 | ) | $ | ( 752,396 | ) |\\n| Net loss | - | - | - | - | - | - | ( 327,479 | ) | ( 327,479 | ) |\\n| Payments received for prior year subscription | - | - | - | - | - | 450,000 | - | 450,000 |\\n| Stock issued for store acquisition | 232,558 | 23 | - | - | 149,977 | - | - | 150,000 |\\n| Balance as of March 31, 2021 | 10,676,279 | $ | 1,068 | - | $ | - | $ | 4,883,040 | $ | - | $ | ( 5,363,983 | ) | $ | ( 479,875 | ) |\\n| Net loss | - | - | - | - | - | - | ( 307,684 | ) | ( 307,684 | ) |\\n| Stock subscription | 30,950 | 3 | - | - | 154,747 | ( 154,750 | ) | - | - |\\n| Payments received for prior year subscription | - | - | - | - | - | 103,500 | - | 103,500 |\\n| Balance as of June 30, 2021 | 10,707,229 | $ | 1,071 | - | $ | - | $ | 5,037,787 | $ | ( 51,250 | ) | $ | ( 5,671,667 | ) | $ | ( 684,059 | ) |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n3\\nUnaudited Condensed Consolidated Statements of Cash Flows\\n\\n| For the Six Months Ended June 30, | 2022 | 2021 |\\n| Cash flows from operating activities: |\\n| Net loss | $ | ( 1,502,260 | ) | $ | ( 635,163 | ) |\\n| Adjustments to reconcile net loss to net cash used in operating activities: |\\n| Stock compensation | 225,000 | - |\\n| Operating lease | 22,086 | 20,559 |\\n| Depreciation | 97,922 | 81,926 |\\n| Changes in operating assets and liabilities: |\\n| Accounts receivable | ( 1,293 | ) | ( 269 | ) |\\n| Inventories | ( 14,104 | ) | ( 7,245 | ) |\\n| Prepaid expense and other current assets | ( 28,275 | ) | ( 65,083 | ) |\\n| Accounts payable | ( 45,590 | ) | 49,508 |\\n| Accrued expenses and current liabilities | 46,535 | 17,415 |\\n| Net cash used in operating activities | ( 1,199,979 | ) | ( 538,352 | ) |\\n| Cash flows from investing activities: |\\n| Purchases of property and equipment | ( 168,397 | ) | ( 167,152 | ) |\\n| Reacquisition of store | - | ( 150,000 | ) |\\n| Net cash used in investing activities | ( 168,397 | ) | ( 317,152 | ) |\\n| Cash flows from financing activities: |\\n| Proceeds from issuance of common stock | - | 553,499 |\\n| Proceeds from line of credit | 594,529 | - |\\n| Proceeds from loan payable to shareholders | 150,000 | 533,127 |\\n| Repayment of loans | ( 121,703 | ) | ( 210,453 | ) |\\n| Repayment of equipment loan payable | ( 9,677 | ) | ( 9,594 | ) |\\n| Net cash provided by financing activities | 613,149 | 866,579 |\\n| Net (decrease) increase in cash | ( 755,227 | ) | 11,075 |\\n| Cash at beginning of period | 905,051 | 128,568 |\\n| Cash at end of period | $ | 149,824 | $ | 139,643 |\\n| Supplemental disclosures of non-cash financing activities: |\\n| Issuance of common shares for repurchase of store | $ | - | $ | 150,000 |\\n| Issuance of common shares for compensation | $ | 225,000 | $ | - |\\n| Supplemental disclosure of cash flow information: |\\n| Cash paid during the years for: |\\n| Lease liabilities | $ | 435,635 | $ | 224,988 |\\n| Interest | $ | 367 | $ | 5,773 |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n4\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n1. NATURE OF OPERATIONS\\nReborn Coffee, Inc. (“Reborn”) was incorporated in the State of Florida in January 2018. In July 2022, Reborn was migrated from Florida to Delaware, and filed a certificate of incorporation with the Secretary of State of the State of Delaware having the same capitalization structure as the Florida predecessor entity. Reborn has the following wholly owned subsidiaries:\\n\\n| ● | Reborn Global Holdings, Inc. (“Reborn Holdings”), a California Corporation incorporated in November 2014. Reborn Holdings is engaged in the operation of wholesale distribution and retail coffee stores in California to sell a variety of coffee, tea, Reborn brand name water and other beverages along with bakery and dessert products. |\\n\\n\\n| ● | Reborn Coffee Franchise, LLC (the “Reborn Coffee Franchise”), a California limited liability corporation formed in December 2020, is a franchisor providing premier roaster specialty coffee to franchisees or customers. Reborn Coffee Franchise continues to develop the Reborn Coffee system for the establishment and operation of Reborn Coffee stores using one or more Reborn Coffee marks. The franchisee obtains a license to develop and operate a store under the strict compliance with terms of the agreement. The specific rights the franchisee is granted is to develop, own, and/or operate franchisee’s Reborn Coffee stores. The non-refundable initial franchise fee is $ 20,000 . In addition, the franchisee is required to pay the company a royalty fee equal to 5 % of the weekly gross sales of their respective store. |\\n\\nReborn Coffee, Inc., Reborn Global Holdings, Inc., and Reborn Coffee Franchise, LLC will be collectively referred as the “Company”.\\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\\nReporting\\nThe unaudited condensed consolidated financial statements include Reborn Coffee, Inc. and its wholly owned subsidiaries as of June 30, 2022 and December 31, 2021 and for the three and six month periods ended June 30, 2022 and 2021.\\nBasis of Presentation and Consolidation\\nThe accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”) as promulgated in the United States of America. The consolidated financial statements include Reborn Coffee, Inc. and its wholly owned subsidiaries. All intercompany accounts, transactions, and profits have been eliminated upon consolidation.\\nReverse Stock Split\\nIn June 2022, the Company approved (a) the conversion of all Class B Common Stock into Class A Common Stock, (b) a 1 for 100 reverse stock split , and (c) an amendment to Articles of Incorporation to eliminate Class B and to change “Class A” to simply “common stock”. All share and earnings per share information have been retroactively adjusted to reflect the stock split and the incremental par value of the newly issued shares was recorded with the offset to additional paid-in capital.\\nGoing Concern\\nThe accompanying unaudited condensed consolidated financial statements have been prepared assuming the Company will continue as a going concern, which contemplates, among other things, the realization of assets and satisfaction of liabilities in the normal course of business. The Company had an accumulated deficit of $ 9,979,164 at June 30, 2022, had a net loss of $ 1,502,260 for the six-month period ended June 30, 2022 and net cash used in operating activities of $ 1,199,979 for the six-month period ended June 30, 2022. These matters raise substantial doubt about the Company’s ability to continue as a going concern.\\n5\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\\nWhile the Company is attempting to expand operations and increase revenues, the Company’s cash position may not be significant enough to support the Company’s daily operations. Management intends to raise additional funds by way of public or private offerings. Management believes that the actions presently being taken to further implement its business plan and generate revenues provide the opportunity for the Company to continue as a going concern. While management believes in the viability of its strategy to generate revenues and in its ability to raise additional funds, there can be no assurances to that effect or if available, on terms acceptable to the Company. The ability of the Company to continue as a going concern is dependent upon the Company’s ability to further implement its business plan and generate additional profit. Compared to the revenue for the six-month period ended June 30, 2021, however, net revenue for the six-month period ended June 30, 2022 has increased from $ 880,121 to $ 1,541,626 , and the Company expects consistent increase in sales with the opening of more stores. In August 2022, the Company consummated its initial public offering (the “IPO”) of 1,440,000 shares of its common stock at a public offering price of $ 5.00 per share, generating gross proceeds of $ 7,200,000 . The initial public offering is summarized in Note 12 to the unaudited condensed consolidated financial statements.\\nThe unaudited condensed consolidated financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.\\nUse of Estimates\\nThe preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States (“U.S. GAAP”) requires the Company to make estimates and assumptions that affect the amounts reported in our consolidated financial statements and the accompanying notes. Such estimates include accounts receivables, accrued liabilities, income taxes, long-lived assets, and deferred tax valuation allowances. These estimates generally involve complex issues and require management to make judgments, involve analysis of historical and future trends that can require extended periods of time to resolve, and are subject to change from period to period. In all cases, actual results could differ materially from estimates.\\nRevenue Recognition\\nThe Company recognizes revenue in accordance with Accounting Standards Codification (“ASC”) 606, Revenue from Contracts with Customers. The Company’s net revenue primarily consists of revenues from its retail stores and wholesale and online store. Accordingly, the Company recognizes revenue as follows:\\n\\n| ● | Retail Store Revenue |\\n\\nRetail store revenues are recognized when payment is tendered at the point of sale. Retail store revenues are reported net of sales, use or other transaction taxes that are collected from customers and remitted to taxing authorities. Sales taxes that are payable are recorded as accrued as other current liabilities. Retail store revenue makes up approximately 98 % of the Company’s total revenue.\\n\\n| ● | Wholesale and Online Revenue |\\n\\nWholesale and online revenues are recognized when the products are delivered, and title passes to the customers or to the wholesale distributors. When customers pick up products at the Company’s warehouse, or distributed to the wholesale distributors, the title passes, and revenue is recognized. Wholesale revenues make up approximately 2 % of the Company’s total revenue.\\n\\n| ● | Royalties and Other Fees |\\n\\nFranchise revenues consists of royalties and other franchise fees. Royalties are based on a percentage of franchisee’s weekly gross sales revenue at 5 %. The Company recognizes the royalties as the underlying sales occur. The Company recorded revenue from royalties of $ 0 for the six-month periods ended June 30, 2022 and 2021. Other fees are earned as incurred and the Company did not have any other fee revenue for the six-month periods ended June 30, 2022 and 2021.\\nShipping and Handling Costs\\nThe Company incurred freight out cost and is included in the Company’s cost of sales - wholesale and online.\\n6\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\\nGeneral and Administrative Expense\\nGeneral and administrative expense includes store-related expense as well as the Company’s corporate headquarters’ expenses.\\nAdvertising Expense\\nAdvertising costs are expensed as incurred. Advertising expenses amounted to $ 20,513 and $ 50,160 for the six-month periods ended June 30, 2022 and 2021, respectively, and is recorded under general and administrative expenses in the accompanying consolidated statements of operations.\\nPre-opening Costs\\nPre-opening costs for new stores, consist primarily of store and leasehold improvements, and are capitalized and depreciated over the shorter of the useful life of the improvement or the lease term, including renewal periods that are reasonably assured.\\nAccounts Receivable\\nAccounts receivables are stated net of allowance for doubtful accounts. The allowance for doubtful accounts is determined primarily on the basis of past collection experience and general economic conditions. The Company determines terms and conditions for its customers based on volume transacted by the customer, customer creditworthiness and past transaction history. At June 30, 2022 and December 31, 2021, allowance for doubtful accounts was $ 0 and $ 0 , respectively. The Company does not have any off-balance sheet exposure related to its customers.\\nInventories\\nInventories consisted primarily of coffee beans, drink products, and supplies which are recorded at cost or at net realizable value.\\nProperty and Equipment\\nProperty and equipment are recorded at cost. Maintenance and repairs are charged to expense as incurred. Depreciation and amortization are provided using both the straight-line and declining balance methods over the following estimated useful lives:\\n\\n| Furniture and fixtures | 5 - 7 Years |\\n| Store construction | Lesser of the lease term or the estimated useful lives of the improvements, generally 6 years |\\n| Leasehold improvement | Lesser of the lease term or the estimated useful lives of the improvements, generally 6 years |\\n\\nWhen assets are retired or disposed of, the cost and accumulated depreciation thereon are removed, and any resulting gains or losses are included in the consolidated statements of operations. Leasehold improvements are amortized using the straight-line method over the estimated life of the asset, not to exceed the length of the lease. Repair and maintenance costs are expensed as incurred.\\nOperating Leases\\nThe Company adopted FASB Accounting Standards Codification, or ASC, Topic 842, Leases (“ASC 842”) which requires the recognition of the right-of-use assets and relating operating and finance lease liabilities on the balance sheet. Under ASC 842, all leases are required to be recorded on the balance sheet and are classified as either operating leases or finance leases. The lease classification affects the expense recognition in the income statement. Operating lease charges are recorded entirely in operating expenses. Finance lease charges are split, where amortization of the right-of-use asset is recorded in operating expenses and an implied interest component is recorded in interest expense.\\nEarnings Per Share\\nFinancial Accounting Standard Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 260, Earnings Per Share, requires a reconciliation of the numerator and denominator of the basic and diluted earnings (loss) per share (EPS) computations.\\n7\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\\nBasic earnings (loss) per share are computed by dividing net earnings available to common shareholders by the weighted-average number of common shares outstanding during the period. Diluted earnings (loss) per share is computed similar to basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common shares had been issued and if the additional common shares were dilutive. In periods where losses are reported, the weighted-average number of common stock outstanding excludes common stock equivalents, because their inclusion would be anti-dilutive.\\nThe Company did not have any dilutive shares for the three and six month periods ended June 30, 2022 and 2021.\\nSegment Reporting\\nFASB ASC Topic 280, Segment Reporting, requires public companies to report financial and descriptive information about their reportable operating segments. The Company’s management identifies operating segments based on how the Company’s management internally evaluate separate financial information, business activities and management responsibility. At the current time, the Company has only one reportable segment, consisting of both the wholesale and retail sales of coffee, water, and other beverages. The Company’s franchisor subsidiary was not material as of and for the three and six month periods ended June 30, 2022 and 2021.\\nLong-lived Assets\\nIn accordance with FASB ASC Topic 360, Property, Plant, and Equipment, the Company reviews for impairment of long-lived assets and certain identifiable intangibles whenever events or circumstances indicate that the carrying amount of assets may not be recoverable. The Company considers the carrying value of assets may not be recoverable based upon our review of the following events or changes in circumstances: the asset’s ability to continue to generate income from operations and positive cash flow in future periods; loss of legal ownership or title to the assets; significant changes in our strategic business objectives and utilization of the asset; or significant negative industry or economic trends. An impairment loss would be recognized when estimated future cash flows expected to result from the use of the asset are less than its carrying amount. As of June 30, 2022 and December 31, 2021, the Company was not aware of any events or changes in circumstances that would indicate that the long-lived assets are impaired.\\nFair Value of Financial Instruments\\nThe Company records its financial assets and liabilities at fair value, which is defined under the applicable accounting standards as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measure date. The Company uses valuation techniques to measure fair value, maximizing the use of observable outputs and minimizing the use of unobservable inputs. The standard describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value which are the following:\\nLevel 1 – Quoted prices in active markets for identical assets or liabilities.\\nLevel 2 – Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.\\nLevel 3 – Inputs include management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. The inputs are unobservable in the market and significant to the instrument’s valuation.\\nAs of June 30, 2022 and December 31, 2021, the Company believes that the carrying value of accounts receivable, accounts payable, accrued expenses, and other current assets and liabilities approximate fair value due to the short maturity of theses financial instruments. The financial statements do not include any financial instruments at fair value on a recurring or non-recurring basis.\\n8\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\\nIncome Taxes\\nIncome taxes are provided for the tax effects of transactions reported in the financial statements and consisted of taxes currently due and deferred taxes. Deferred taxes are recognized for the differences between the basis of assets and liabilities for financial statement and income tax purposes.\\nThe Company follows FASB ASC Topic 740, Income Taxes, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each period end based on enacted tax laws and statutory tax rates, applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. ASC 740-10-25 provides criteria for the recognition, measurement, presentation and disclosure of uncertain tax position. The Company must recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate resolution. The Company did not recognize additional liabilities for uncertain tax positions pursuant to ASC 740-10-25 for the three and six month periods ended June 30, 2022 and 2021.\\nConcentration of Credit Risk\\nFinancial instruments that potentially subject the Company to concentrations of credit risk are accounts receivable arising from its normal business activities. The Company performs ongoing credit evaluations to its customers and establishes allowances when appropriate.\\nCompany purchases from various vendors for its operations. For the three and six month periods ended June 30, 2022 and 2021, no purchases from any vendors accounted for a significant amount of the Company’s bean coffee purchases.\\nRelated Parties\\nRelated parties are any entities or individuals that, through employment, ownership, or other means, possess the ability to direct or cause the direction of management and policies of the Company.\\nSignificant Recent Developments Regarding COVID-19\\nThe novel coronavirus, known as the global pandemic COVID-19, was first identified in December 2019. During March 2020, a global pandemic was declared by the World Health Organization related to the rapidly spreading outbreak of a novel strain of coronavirus designated COVID-19. The pandemic has significantly impacted economic conditions in the United States. The outbreak of the virus impacted our company-owned retail locations in Southern California.\\nThe Company first began to experience impacts from COVID-19 around the middle of March 2020 as federal, state and local governments began to react to the public health crisis by encouraging or requiring social distancing, instituting stay-at-home orders, and requiring, in varying degrees, restaurant dine-in limitations, capacity limitations or other restrictions that largely limited restaurants to take-out, drive-thru and delivery sales. Although we have experienced some recovery from the initial impact of COVID-19, the long-term impact of COVID-19 on the economy and on our business remains uncertain, the duration and scope of which cannot currently be predicted.\\n9\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\\nRecent Accounting Pronouncement\\nIn June 2016, the FASB issued Accounting Standards Update No. 2016-13, “Financial Instruments - Credit Losses (Topic 326)” (“ASU 2016-13”). ASU 2016-13 revises the methodology for measuring credit losses on financial instruments and the timing of when such losses are recorded. Originally, ASU 2016-13 was effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2019, with early adoption permitted. In November 2019, FASB issued ASU 2019-10, “Financial Instruments – Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842).” This ASU defers the effective date of ASU 2016-13 for public companies that are considered smaller reporting companies as defined by the SEC to fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. The Company is planning to adopt this standard in the first quarter of fiscal 2023.The Company is currently evaluating the potential effects of adopting the provisions of ASU No. 2016-13 on its consolidated financial statements, particularly its recognition of allowances for accounts receivable.\\nOther recently issued accounting updates are not expected to have a material impact on the Company’s consolidated financial statements.\\n3. PROPERTY AND EQUIPMENT\\nProperty and equipment consisted of the following:\\n\\n| June 30, 2022 | December 31, 2021 |\\n| Furniture and equipment | $ | 849,809 | $ | 779,649 |\\n| Leasehold improvement | 639,602 | 639,602 |\\n| Store construction | 150,399 | 52,161 |\\n| Store | 300,000 | 300,000 |\\n| Total property and equipment | 1,939,810 | 1,771,412 |\\n| Less accumulated depreciation | ( 758,445 | ) | ( 660,522 | ) |\\n| Total property and equipment, net | $ | 1,181,365 | $ | 1,110,890 |\\n\\nIn February 2021, the Company repurchased its retail location in Corona Del Mar. The purchase price was $ 300,000 , comprised of $ 150,000 in cash and 232,558 shares of the Company’s common stock. The Company recorded the assumption of the ongoing lease for the store, which included a right of use asset of $ 183,442 and a lease liability of $ 193,463 .\\nDepreciation expense on property and equipment amounted to approximately $ 97,922 and $ 81,926 for the six-month periods ended and $ 48,479 and $ 45,797 for the three-month periods ended June 30, 2022 and 2021, respectively.\\n10\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n4. LOANS PAYABLE TO FINANCIAL INSTITUTIONS\\nLoans payable to financial institutions consist of the following:\\n\\n| June 30, 2022 | December 31, 2021 |\\n| July 2021 - Loan agreement with principal amount of $ 90,000 and repayment rate of 19 % for a total of $ 101,700 . The loan payable matures on January 31, 2023 . | $ | - | $ | 52,819 |\\n| August 2021 - Loan agreement with principal amount of $72,500 and repayment rate of 18.5 % for a total of $ 81,925 . The loan payable matures on February 10, 2023 . | - | 36,502 |\\n| August 2021 - Loan agreement with principal amount of $ 67,500 and repayment rate of 18.5 % for a total of $ 76,275 . The loan payable matures on February 11, 2023 . | - | 32,382 |\\n| Total loan payable | $ | - | $ | 121,703 |\\n| Less: current portion | - | ( 98,475 | ) |\\n| Total loan payable, net of current | $ | - | $ | 23,228 |\\n\\nJuly 2021 - $ 101,700 loan payable\\nIn July 2021, the Company entered into a loan agreement with Square Capital in the principal amount of $ 90,000 with loan cost $ 11,700 . The loan payable has a maturity date on January 31, 2023 . As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $ 0 and $ 52,819 , respectively.\\nAugust 2021 - $ 81,925 loan payable\\nIn August 2021, the Company entered into a loan agreement with Square Capital in the principal amount of $ 72,500 with loan cost $ 9,425 . The loan payable has a maturity date on February 10, 2023 . As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $ 0 and $ 36,502 , respectively.\\nAugust 2021 - $ 76,275 loan payable\\nIn August 2021, the Company entered into a loan agreement with Square Capital in the principal amount of $ 67,500 with loan cost $ 8,775 . The loan payable has a maturity date on February 11, 2023 . As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $ 0 and $ 32,382 , respectively.\\n11\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n5. LOAN PAYABLES, EMERGENCY INJURY DISASTER LOAN (EIDL)\\n\\n| June 30, 2022 | December 31, 2021 |\\n| May 16, 2020 ($ 150,000 ) - Loan agreement with principal amount of $150,000 with an interest rate of 3.75 % and maturity date on May 16, 2050 | $ | 150,000 | $ | 150,000 |\\n| June 28, 2021 ($ 350,000 ) – Loan agreement with principal amount of $350,000 with an interest rate of 3.75 % and maturity date on May 18, 2050 | 350,000 | 350,000 |\\n| Total long-term loan payable, emergency injury disaster loan (EIDL) | 500,000 | 500,000 |\\n| Less - current portion | ( 10,760 | ) | ( 7,957 | ) |\\n| Total loan payable, emergency injury disaster loan (EIDL), less current portion | $ | 489,240 | $ | 492,043 |\\n\\nThe following table provides future minimum payments:\\n\\n| For the years ended December 31, | Amount |\\n| 2022 (remaining six months) | 5,330 |\\n| 2023 | 10,964 |\\n| 2024 | 11,382 |\\n| 2025 | 11,816 |\\n| 2026 | 12,267 |\\n| Thereafter | 448,241 |\\n| Total | $ | 500,000 |\\n\\nMay 16, 2020 – $ 150,000\\nOn May 16, 2020, the Company executed the standard loan documents required for securing a loan (the “EIDL Loan”) from the SBA under its Economic Injury Disaster Loan (“EIDL”) assistance program in light of the impact of the COVID-19 pandemic on the TNB’s business. As of June 30, 2022, the loan payable, Emergency Injury Disaster Loan noted above is not in default.\\nPursuant to that certain Loan Authorization and Agreement (the “SBA Loan Agreement”), the Company borrowed an aggregate principal amount of the EIDL Loan of $ 150,000 , with proceeds to be used for working capital purposes. Interest accrues at the rate of 3.75 % per annum and will accrue only on funds actually advanced from the date of each advance. Installment payments, including principal and interest, are due monthly beginning May 16, 2021 (twelve months from the date of the SBA Loan) in the amount of $ 731 . The balance of principal and interest is payable thirty years from the date of the SBA Loan.\\nIn connection therewith, the Company executed (i) a loan for the benefit of the SBA (the “SBA Loan”), which contains customary events of default and (ii) a Security Agreement, granting the SBA a security interest in all tangible and intangible personal property of the Company, which also contains customary events of default (the “SBA Security Agreement”).\\n12\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n5. LOAN PAYABLES, EMERGENCY INJURY DISASTER LOAN (EIDL) (continued)\\nJune 28, 2021 – $ 350,000\\nOn June 28, 2021, the Company executed the standard loan documents required for securing a loan (the “EIDL Loan”) from the SBA under its Economic Injury Disaster Loan (“EIDL”) assistance program in light of the impact of the COVID-19 pandemic on the TNB’s business. As of June 30, 2022, the loan payable, Emergency Injury Disaster Loan noted above is not in default.\\nPursuant to that certain Amended Loan Authorization and Agreement (the “SBA Loan Agreement”), the Company borrowed an aggregate principal amount of the EIDL Loan of $ 500,000 , with proceeds to be used for working capital purposes. Interest accrues at the rate of 3.75 % per annum and will accrue only on funds actually advanced from the date of each advance. Installment payments, including principal and interest, are due monthly beginning October 16, 2022 (thirty months from the original date of the SBA Loan) in the amount of $ 2,505 . The balance of principal and interest is payable thirty years from the original date of the SBA Loan.\\n6. LOAN PAYABLE, PAYROLL PROTECTION LOAN PROGRAM (PPP)\\n\\n| June 30, 2022 | December 31, 2021 |\\n| Loan payable, payroll protection program (PPP) – February 10, 2021 | $ | 167,138 | $ | 167,138 |\\n| Total long-term loan payable, payroll protection program (PPP) | 167,138 | 167,138 |\\n| Less - current portion | ( 39,169 | ) | ( 42,345 | ) |\\n| Total loan payable, payroll protection program (PPP), less current portion | $ | 127,969 | $ | 124,793 |\\n\\nThe Paycheck Protection Program Loan (the “PPP Loan”) is administered by the U.S. Small Business Administration (the “SBA”). The interest rate of the loan is 1.00 % per annum and accrues on the unpaid principal balance computed on the basis of the actual number of days elapsed in a year of 360 days. Commencing seven months after the effective date of the PPP Loan, the Company is required to pay the Lender equal monthly payments of principal and interest as required to fully amortize any unforgiven principal balance of the loan by the two-year anniversary of the effective date of the PPP Loan (the “Maturity Date”). The PPP Loan contains customary events of default relating to, among other things, payment defaults, making materially false or misleading representations to the SBA or the Lender, or breaching the terms of the PPP Loan. The occurrence of an event of default may result in the repayment of all amounts outstanding under the PPP Loan, collection of all amounts owing from the Company, or filing suit and obtaining judgment against the Company. Under the terms of the CARES Act, PPP loan recipients can apply for and be granted forgiveness for all or a portion of the loan granted under the PPP. Such forgiveness will be determined, subject to limitations, based on the use of loan proceeds for payment of payroll costs and any payments of mortgage interest, rent, and utilities. Recent modifications to the PPP by the U.S. Treasury and Congress have extended the time period for loan forgiveness beyond the original eight-week period, making it possible for the Company to apply for forgiveness of its PPP loan.\\n13\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n7. EQUIPMENT LOAN PAYABLE\\nEquipment loan payable consist of the following:\\n\\n| June 30, 2022 | December 31, 2021 |\\n| October 2017 - Loan agreement with principal amount of $ 82,011 with an interest rate of 6.40 % and maturity date on October 1, 2022 | $ | 6,312 | $ | 15,989 |\\n| Total long-term equipment loan payable | 6,312 | 15,989 |\\n| Less – current portion | ( 6,312 | ) | ( 15,989 | ) |\\n| Total long-term debt, net of current portion | $ | - | $ | - |\\n\\n\\n| For the year ended December 31, | Amount |\\n| 2022 (remaining six months) | $ | 6,312 |\\n| Total long-term equipment loan payable | $ | 6,312 |\\n\\nOctober 2017 - $ 82,011 equipment loan payable\\nIn October 2017, the Company entered into equipment finance loan agreement with US Bank Equipment Finance in the amount of $ 82,011 with an interest rate of 6.40 % and maturity date on October 1, 2022 , payable in 60 payments. All principal, together with interest cost is due and payable on October 1, 2022. As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $ 6,312 and $ 15,989 , respectively.\\n8. INCOME TAX\\nTotal income tax (benefit) expense consists of the following:\\n\\n| For the Six-Month Periods Ended June 30, | 2022 | 2021 |\\n| Current provision (benefit): |\\n| Federal | $ | - | $ | - |\\n| State | - | - |\\n| Total current provision (benefit) | - | - |\\n| Deferred provision (benefit): |\\n| Federal | - | - |\\n| State | - | - |\\n| Total deferred provision (benefit) | - | - |\\n| Total tax provision (benefit) | $ | - | $ | - |\\n\\nA reconciliation of the Company’s effective tax rate to the statutory federal rate is as follows:\\n\\n| Description | Rate |\\n| Statutory federal rate | 21.00 | % |\\n| State income taxes net of federal income tax benefit and others | 8.84 | % |\\n| Permanent differences for tax purposes and others | 0.00 | % |\\n| Change in valuation allowance | - 29.84 | % |\\n| Effective tax rate | 0 | % |\\n\\n14\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n8. INCOME TAX (continued)\\nThe income tax benefit differs from the amount computed by applying the U.S. federal statutory tax rate of 21 % and California state income taxes of 8.84 % due to the change in the valuation allowance.\\nDeferred income taxes reflect the temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The components of deferred tax assets and liabilities are as follows:\\n\\n| Deferred tax assets | June 30, 2022 | December 31, 2021 |\\n| Deferred tax assets: |\\n| Net operating loss | $ | 2,961,949 | $ | 2,513,674 |\\n| Other temporary differences | - | - |\\n| Total deferred tax assets | 2,961,949 | 2,513,674 |\\n| Less - valuation allowance | ( 2,961,949 | ) | ( 2,513,674 | ) |\\n| Total deferred tax assets, net of valuation allowance | $ | - | $ | - |\\n\\nAs of December 31, 2021, the Company had available net operating loss carryovers of approximately $ 8,423,841 . Per the Tax Cuts and Jobs Act (TCJA) implemented in 2018, the two-year carryback provision was removed and now allows for an indefinite carryforward period. The carryforwards are limited to 80 % of each subsequent year’s net income. As a result, net operating loss may be applied against future taxable income and expires at various dates subject to certain limitations. The Company has a deferred tax asset arising substantially from the benefits of such net operating loss deduction and has recorded a valuation allowance for the full amount of this deferred tax asset since it is more likely than not that some or all of the deferred tax asset may not be realized.\\nThe Company files income tax returns in the U.S. federal jurisdiction and California and is subject to income tax examinations by federal tax authorities for tax year ended 2017 and later and subject to California authorities for tax year ended 2016 and later. The Company currently is not under examination by any tax authority. The Company’s policy is to record interest and penalties on uncertain tax positions as income tax expense. As of June 30, 2022 and December 31, 2021, the Company has no accrued interest or penalties related to uncertain tax positions.\\nAs of June 30, 2022, the Company had cumulative net operating loss carryforwards for federal tax purposes of approximately $ 9,926,101 . In addition, the Company had state tax net operating loss carryforwards of approximately $ 9,926,101 . The carryforwards may be applied against future taxable income and expires at various dates subject to certain limitations.\\n15\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n9. COMMITMENTS AND CONTINGENCIES\\nOperating Leases\\nThe Company entered into the following operating facility leases\\n\\n| ● | La Floresta - On July 25, 2016, the Company entered into an operating facility lease for its store located at La Floresta Shopping Village in Brea, California with 60 months term with option to extend. The lease started on July 2016 and expires on November 2024. |\\n\\n\\n| ● | La Crescenta - On May 2017, the Company entered into an operating facility lease for its store located in La Crescenta, California with 120 months term with option to extend. The lease started on May 2017 and expires in May 2027. The Company entered into non-cancellable lease agreement for a coffee shop approximately 1,607 square feet located in La Crescenta, California commencing in May 2017 and expiring in April 2027. The monthly lease payment under the lease agreement approximately $ 6,026 . |\\n\\n\\n| ● | Brea - On September 1, 2018, the Company entered into an operating facility lease for its corporate office located in Brea, California with 72 months term with option to extend. The lease starts on September 2018 and expires on August 2024. |\\n\\n\\n| ● | Glendale – On October 27, 2020, The Company entered a 7-year operating facility lease for its store located at the Glendale Galleria in Glendale, California. The lease starts on November 2020 and expires in October 2027. |\\n| ● | San Francisco - On December 22, 2020, the Company entered into an operating facility lease for its store located at Stonestown Galleria in San Francisco, California with 84 months term with option to extend. The lease starts in June 2021 and expires in April 2028. |\\n\\n\\n| ● | Santa Anita - On December 22, 2020, the Company entered into an operating facility lease for its store located at Arcadia, California with 36 months term with option to extend. The lease starts in February 2021 and expires in January 2024. |\\n| ● | Riverside - On February 4, 2021, the Company entered into an operating facility lease for its store located at Galleria at Tyler in Riverside, California with 84 months term with option to extend. The lease starts in April 2021 and expires in March 2028. |\\n\\n\\n| ● | Corona Del Mar - On February 5, 2021, the Company repurchased its retail store in Corona Del Mar, California. As part of that repurchase, the Company assumed the original operating lease on the facility, with 66 months term with an option to extend. The lease expires in December 2022. |\\n\\n\\n| ● | Laguna Woods - On February 12, 2021, the Company entered into an operating facility lease for its store located at Home Depot Center in Laguna Woods, California with 60 months term with option to extend. The lease starts in June 2021 and expires in May 2026. |\\n\\n\\n| ● | Huntington Beach - On November 1 2021, the Company entered into an operating facility lease for its store located at Huntington Beach, California with 124 months term with option to extend. The lease starts in November 2021 and expires in February 2032. |\\n\\n\\n| ● | Manhattan Village - On March 1 2022, the Company entered into an operating facility lease for its store located at Manhattan Beach, California with 60 months term with option to extend. The lease starts in March 2022 and expires in February 2027. |\\n\\nThe Company adopted ASC 842 as of January 2018 (date of formation). The Company has operating leases for the Company’s corporate office and stores and accounts for these leases in accordance with ASC 842, which resulted in the recognition of ROU assets and operating lease liabilities of $ 2,937,437 and $ 3,082,771 , respectively, as of June 30, 2022. Certain of the leases for the Company’s retail store facilities provide for variable payments for property taxes, insurance and common area maintenance payments related to rental payments based on future sales volumes at the leased location, which are not measurable at the inception of the lease, or rental payments that are adjusted periodically for inflation.\\nFor the new lease and adjustments, the Company recorded an additional non-cash increase of $470,564 to ROU assets and $492,650 to operational lease liabilities for the six-month period ended June 30, 2022.\\n16\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n9. COMMITMENTS AND CONTINGENCIES (continued)\\nIn accordance with ASC 842, the components of lease expense were as follows:\\n\\n| Six-month period ended June 30, | 2022 | 2021 |\\n| Operating lease expense | $ | 452,155 | $ | 279,888 |\\n| Total lease expense | $ | 452,155 | $ | 279,888 |\\n\\nIn accordance with ASC 842, other information related to leases was as follows:\\n\\n| Six-month period ended June 30, | 2022 | 2021 |\\n| Operating cash flows from operating leases | $ | 435,635 | $ | 224,988 |\\n| Cash paid for amounts included in the measurement of lease liabilities | $ | 435,635 | $ | 224,988 |\\n| Weighted-average remaining lease term—operating leases | 4.1 Years |\\n| Weighted-average discount rate—operating leases | 8.9 | % |\\n\\nIn accordance with ASC 842, maturities of operating lease liabilities as of June 30, 2022 were as follows:\\n\\n| Operating |\\n| For the years ended December 31, | Lease |\\n| 2022 (remaining six months) | $ | 467,758 |\\n| 2023 | 864,887 |\\n| 2024 | 785,267 |\\n| 2025 | 642,387 |\\n| 2026 | 574,150 |\\n| Thereafter | 456,435 |\\n| Total undiscounted cash flows | $ | 3,790,884 |\\n| Reconciliation of lease liabilities: |\\n| Weighted-average remaining lease terms | 4.1 Years |\\n| Weighted-average discount rate | 8.9 | % |\\n| Present values | $ | 3,082,771 |\\n| Lease liabilities—current | 655,603 |\\n| Lease liabilities—long-term | 2,427,168 |\\n| Lease liabilities—total | $ | 3,082,771 |\\n| Difference between undiscounted and discounted cash flows | $ | 708,113 |\\n\\nContingencies\\nThe Company is subject to various legal proceedings from time to time as part of its business. As of June 30, 2022, the Company was not currently party to any legal proceedings or threatened legal proceedings, the adverse outcome of which, individually or in the aggregate, it believes would have a material adverse effect on its business, financial condition, and results of operations.\\n17\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n10. SHAREHOLDERS’ EQUITY\\nCommon Stock\\nThe Company has authorization to issue and have outstanding at any one time 40,000,000 share of common stock with a par value of $ 0.0001 per share. The shareholders of common stock shall be entitled to one vote per share and dividends declared by the Company’s Board of Directors.\\nIn June 2022, the Company approved (a) the conversion of all Class B Common Stock into Class A Common Stock, (b) a 1 for 100 reverse split, and (c) an amendment to Articles of Incorporation to eliminate Class B and to change “Class A” to simply “common stock”. All share and earnings per share information have been retroactively adjusted to reflect the stock split and the incremental par value of the newly issued shares was recorded with the offset to additional paid-in capital.\\nPreferred Stock\\nThe Company has authorization to issue and have outstanding at any one time 1,000,000 share of preferred stock with a par value of $ 0.0001 per share, in one or more classes or series within a class as may be determined by our board of directors, who establish, from time to time, the number of shares to be included in each class or series, fix the designation, powers, preferences and rights of the shares of each such class or series and any qualifications, limitations or restrictions thereof. Any preferred stock so issued is senior to other existing classes of common stock with respect to the payment of dividends or amounts upon liquidation or dissolution. As of June 30, 2022 and December 31, 2021, no shares of our preferred stock had been designated any rights and we had no shares of preferred stock issued and outstanding.\\nSubscription of Common Stock Receivables\\nThe Company issued 1,569,768 shares of common stock to several individuals in March 2020 and in December 2020 for total proceeds of $ 1,350,000 , of which $ 553,500 was received in January, February, and June 2021.\\nIssuance of Common Stock in Settlement of Antidilution Provisions\\nIn May 2018, the Company had entered into a share exchange agreement wherein Capax, Inc., the predecessor entity of Reborn Coffee, Inc. (“Capax”) effectively merged with Reborn Global Holdings, Inc. to form the Company. In this share exchange agreement, the preexisting shareholder of Capax were provided covenants that for a period of one year following the date upon which the Company is approved for quotation or trading on a public exchange (“IPO”), the percentage of ownership of the prior shareholders of Capax would not be less than the 5% of the total number of shares of voting common stock outstanding of the Company that they owned following the share exchange. In the event the ownership of the pre-merger shareholders of Capax fell below 5%, the Company was obligated to issue that number of shares of common stock to those shareholders which would increase the ownership of all of the Pre-Merger Shareholders to five percent (5%) of the total outstanding voting common shares of the Company. During the year ended December 31, 2021, the Company issued 325,495 shares of common stock under these provisions.\\nOn January 25, 2022, the Company modified this agreement with the preexisting shareholders to effectively end the antidilution protection at the time of a successful IPO, eliminating the one-year period following an IPO as provided under the original agreement. The shareholders would be entitled to additional protection through the IPO date should the Company issue any additional shares between December 31, 2021 and the IPO date. The Company has not issued any additional shares subsequent to December 31, 2021.\\nDividend policy\\nDividends are paid at the discretion of the Board of Directors. There were no dividends declared for the six-month periods ended June 30, 2022 and 2021.\\n18\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n11. EARNINGS PER SHARE\\nThe Company calculates earnings per share in accordance with FASB ASC 260, Earnings Per Share, which requires a dual presentation of basic and diluted earnings per share. Basic earnings per share are computed using the weighted average number of shares outstanding during the fiscal year. Potentially dilutive common shares consist of stock options outstanding (using the treasury method).\\nThe following table sets forth the computation of basic and diluted net income per common share:\\n\\n| Six-Month Period | Three-Month Period |\\n| Ended June 30, | Ended June 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Net Loss | $ | ( 1,502,260 | ) | $ | ( 635,163 | ) | $ | ( 937,148 | ) | $ | ( 307,684 | ) |\\n| Weighted Average Shares of Common Stock Outstanding |\\n| Basic | 11,642,550 | 10,282,669 | 11,667,545 | 10,380,944 |\\n| Diluted | 11,642,550 | 10,282,669 | 11,667,545 | 10,380,944 |\\n| Earnings Per Share - Basic |\\n| Net Loss Per Share | ( 0.13 | ) | ( 0.06 | ) | ( 0.08 | ) | ( 0.03 | ) |\\n| Earnings Per Share - Diluted |\\n| Net Loss Per Share | ( 0.13 | ) | ( 0.06 | ) | ( 0.08 | ) | ( 0.03 | ) |\\n\\n12. SUBSEQUENT EVENTS\\nThe Company evaluated all events or transactions that occurred after June 30, 2022 up through the date the unaudited condensed consolidated financial statements were available to be issued. During this period, the Company did not have any material recognizable subsequent events required to be disclosed as of and for the six-month period ended June 30, 2022, except for the following:\\nInitial Public Offering\\nIn August 2022, the Company consummated its initial public offering (the “IPO”) of 1,440,000 shares of its common stock at a public offering price of $5.00 per share, generating gross proceeds of $ 7,200,000 . Net proceeds from the IPO was approximately $ 6.2 million after deducting underwriting discounts and commissions and other offering expenses of approximately $ 998,000 .\\nThe Company had granted the underwriters a 45-day option to purchase up to 216,000 additional shares (equal to 15 % of the shares of common stock sold in the offering) to cover over-allotments. In addition, the Company had agreed to issue to the representative of the several underwriters warrants to purchase the number of shares of common stock in the aggregate equal to five percent ( 5 %) of the shares of common stock to be issued and sold in the IPO. The warrants are exercisable for a price per share equal to 125 % of the public offering price. No over-allotment option or representative’s warrants have been exercised.\\n19\\n\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.\\nYou should read the following discussion and analysis of our financial condition and results of operations together with our condensed consolidated financial statements and the related notes and other financial information included elsewhere in this Quarterly Report on Form 10-Q and with our audited consolidated financial statements included in our Prospectus on Form S-1. As discussed in the section titled “Note Regarding Forward-Looking Statements,” the following discussion and analysis contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. Factors that could cause or contribute to these differences include, but are not limited to, those identified below and those discussed in the section titled “Risk Factors” in our Prospectus filed on Form S-1 (File No: 333-261937).\\nBusiness\\nReborn Coffee is focused on serving high quality, specialty-roasted coffee at retail locations, kiosks and cafes. We are an innovative company that strives for constant improvement in the coffee experience through exploration of new technology and premier service, guided by traditional brewing techniques. We believe Reborn differentiates itself from other coffee roasters through its innovative techniques, including sourcing, washing, roasting, and brewing our coffee beans with a balance of precision and craft.\\nFounded in 2015 by Jay Kim, our Chief Executive Officer, Mr. Kim and his team launched Reborn Coffee with the vision of using the finest pure ingredients and pristine water. We currently serve customers through our retail store locations in California: Brea, La Crescenta, Glendale, Corona Del Mar, Arcadia, Laguna Woods, Riverside, San Francisco and Manhattan Beach, with four other locations in development. Additionally, we expect to begin franchising in 2022 and expect to continue to develop additional retail locations as we expand outside of California. We estimate that the average development cost of a company-owned retail location is approximately $150,000. Therefore, taking into account the proceeds from this offering and within a year from its completion, we expect to open up to 20 company-owned retail locations (using approximately $3,000,000 of the proceeds of this offering) and 20 franchise locations (all costs and expenses associated with a franchise store location development are borne by the franchisees). We acknowledge that we have not yet signed any franchise agreements and that such number of franchise locations is purely speculative. Reborn Coffee continues to elevate the high-end coffee experience and we received 1st place traditional still in “America’s Best Cold Brew” competition by Coffee Fest in 2017 in Portland and 2018 in Los Angeles.\\nThe Experience, Reborn\\nAs leading pioneers of the emerging “Fourth Wave” movement, Reborn Coffee is redefining specialty coffee as an experience that demands much more than premium quality. We consider ourselves leaders of the “fourth wave” coffee movement because we are constantly developing our bean processing methods, researching design concepts, and reinventing new ways of drinking coffee. For instance, the current transition from the K-Cup trend to the pour over drip concept allowed us to reinvent the way people consume coffee, by merging convenience and quality. We took the pour over drip concept and made it available and affordable to the public through our Reborn Coffee Pour Over packs. Our Pour Over Packs allow our consumers to consume our specialty coffee outdoors and on-the-go.\\nOur success in innovating within the “fourth wave” coffee movement is measured by our success in B2B sales with our introduction of Reborn Coffee Pour Over Packs to hotels. With the introduction of our Pour Over Packs to major hotels (including one hotel company with 7 locations), our B2B sales increased as these companies recognized the convenience and functionality our Pour Over Packs serve to their customers.\\nReborn Coffee’s continuous Research and Development is essential to developing new parameters in the production of new blends. Our 1st place position in “America’s Best Cold Brew” competition by Coffee Fest in 2017 in Portland and 2018 in Los Angeles is a testament to the way we believe we lead the “fourth wave” movement by example.\\nCentered around its core values of service, trust, and well-being, Reborn Coffee delivers an appreciation of coffee as both a science and an art. Developing innovative processes such as washing green coffee beans with magnetized water, we challenge traditional preparation methods by focusing on the relationship between water chemistry, health, and flavor profile. Leading research studies, testing brewing equipment, and refining roasting/brewing methods to a specific, Reborn Coffee proactively distinguishes exceptional quality from good quality by starting at the foundation and paying attention to the details. Our mission places an equal emphasis on humanizing the coffee experience, delivering a fresh take on “farm-to-table” by sourcing internationally. In this way, Reborn Coffee creates opportunities to develop transparency by paying homage to origin stories and spark new conversations by building cross-cultural communities united by a passion for the finest coffee.\\nThrough a broad product offering, Reborn Coffee provides customers with a wide variety of beverages and coffee options. As a result, we believe we can capture share of any experience where customers seek to consume great beverages whether in our inviting store atmospheres which are designed for comfort, or on the go through our pour over packs, or at home with our whole bean ground coffee bags. We believe that the retail coffee market in the US is large and growing. According to IBIS, in 2021, the retail market for coffee in the United States is expected to be $46.2 billion. This is expected to grow due to a shift in consumer preferences to premium coffee, including specialized blends, espresso-based beverages, and cold brew options. Reborn aims to capture a growing portion of the market as we expand and increase consumer awareness of our brand.\\n20\\nPlan of Operation\\nWe have a production and distribution center at our headquarters that we use to process and roast coffee for wholesale and retail distribution.\\nCurrently, we have the following nine retail coffee locations, and four locations in development (i.e., Cabazon, Huntington Beach, Irvine and Mission Viejo, California):\\n\\n| ● | La Floresta Shopping Village in Brea, California; |\\n| ● | La Crescenta, California; |\\n\\n\\n| ● | Glendale Galleria in Glendale, California; |\\n| ● | Galleria at Tyler in Riverside, California; |\\n| ● | Home Depot Center in Laguna Woods, California; |\\n| ● | Stonestown Galleria in San Francisco, California (opened in first quarter of 2022); |\\n| ● | Corona Del Mar, California; |\\n| ● | Santa Anita Westfield Mall in Arcadia, California; and |\\n| ● | Manhattan Village at Manhattan Beach, California. |\\n\\nImpact of COVID-19\\nThe COVID-19 pandemic and resulting disruptions including, without limitation, governmental lockdown mandates and restrictions, made 2020 a challenging year for businesses, particularly in the foodservice and restaurant industries. Reborn Coffee took immediate action to protect the health and safety of our employees and customers including the implementation of all operating protocols dictated by state and local guidelines and instituting strict health and safety practices. Fortunately, we did not experience any significant disruptions in our supply chain operations.\\nDespite efforts to ensure a safe consumer experience, we did experience repressed customer flow through periods when malls and shopping centers were restricted or closed entirely due to governmental lockdown mandates and restrictions. Our current retail locations are within popular shopping areas with anticipated regular customer traffic. Such closures or limitations and restrictions were at times mandated the government, and at other times due to natural customer uncertainties regarding the status of COVID-19. Such restrictions and uncertainties not only impacted anticipated revenues from current locations, but added additional risk to us related to the opening of new locations. Thus, the uncertainty regarding the scope and longevity of such restrictions modified our plans as to how quickly we could enact our expansion plans.\\nMore specifically, COVID-19 has challenged our performance at our kiosk locations, though our cafe locations have improved in performance. Shopping mall restrictions and mandates during the pandemic made it difficult for our kiosks to operate at maximum performance, as indoor restrictions of shopping malls affected the way we had to operate business. For instance, we had to offer only to-go/pickup operations to operate while meeting regulations. We have learned how to move forward aggressively despite such regulations and mandates, doing what we can to serve the coffee we are so proud to serve, whether this means offering to-go orders only or working with delivery services.\\nIn May 2020, the Company availed itself of a loan under the Paycheck Protection Program (PPP) administered by the U.S. Small Business Administration (SBA) in the amount of $115,000, and $500,000 under the SBA’s Economic Injury Disaster Loan assistance program, all of which is currently outstanding as of December 31, 2021, provided however that repayment was deferred to commence in May 2022. In February 2021, the Company secured a second PPP loan under this program in the amount of approximately $167,000. The Company was granted forgiveness for the initial PPP Loan prior to December 31, 2021 and expects to be granted forgiveness on the remainder subsequently.\\n21\\nIn January 2022 we announced a price increase of our whole roasted beans by 15% on our website which we attribute to increases due to inflation in the cost of raw green coffee beans, the cost of shipping and supplies, and nationwide increases in labor costs-- factors that may or may not be attributable to the pandemic and/or the governmental policies and mandates that were implemented during and in the wake of COVID-19. As of the date hereof and in January 2022 at the time of our price increase, inflation has not had a material effect on our results of operations since we have been able to offset such increased costs by increasing the price of our whole roasted beans by 15% in January 2022, through increased sales and growth in opening 2 new company-owned retail locations, better lease terms on such new company-owned retail locations, more efficient purchasing practices (e.g., volume purchase discounts), productivity improvements and greater economies of scale. Severe increases in inflation, however, could affect the global and U.S. economies and could have a materially adverse impact on our business, financial condition or results of operations.\\nWe do not expect COVID-19 to affect our future operating results significantly, as we are confident that coffee is an essential product that people rely on and will always drink. We intend to meet all governmental business operation regulations and improve sales by whatever means necessary, utilizing resources such as food delivery services and to-go/pickup orders. However, the impact of COVID-19 continues to evolve, and we cannot easily predict the future potential impacts of the pandemic on our business or operations or on the United States or global economy in general. This may include any recurrence of the disease, actions taken in response to the evolving pandemic, any ongoing effects on consumer demand and spending patterns or other impacts of the pandemic. Whether these or other currently unanticipated consequences of the pandemic are reasonably likely to materially affect our results of operations, cash flows or financial condition is yet to be determined. For additional details regarding the impact of COVID-19 on our business, see “Risk Factors-Risks Related to Our Business-Pandemics or disease outbreaks such as the COVID-19 have had, and may continue to have, an effect on our business and results of operations.”\\nComponents of Our Results of Operations\\nRevenue\\nThe Company recognizes revenue in accordance with Accounting Standards Codification (“ASC”) 606, Revenue from Contracts with Customers. The Company’s net revenue primarily consists of revenues from its retail locations and wholesale and online store. Accordingly, the Company recognizes revenue as follows:\\n\\n| ● | Retail Store Revenue |\\n| Retail store revenues are recognized when payment is tendered at the point of sale. Retail store revenues are reported net of sales, use or other transaction taxes that are collected from customers and remitted to taxing authorities. Sales taxes that are payable are recorded as accrued as other current liabilities. Retail store revenue makes up approximately 97% of the Company’s total revenue. |\\n| ● | Wholesale and Online Revenue |\\n| Wholesale and online revenues are recognized when the products are delivered, and title passes to customers or to the wholesale distributors. When customers pick up products at the Company’s warehouse, or distributed to the wholesale distributors, the title passes, and revenue is recognized. Wholesale revenues make up approximately 3% of the Company’s total revenue. |\\n\\n\\n| ● | Royalties and Other Fees |\\n| Franchise revenues consist of royalty fee and other franchise fees. Royalty fee is based on a percentage of franchisee’s weekly gross sales revenue at 5%. The Company recognizes the fee as the underlying sales occur. The Company recorded revenue from royalty of $0 for the three and six month periods ended June 30, 2022 and 2021. Other fees are earned as incurred and the Company did not have any other fee revenue for the three and six month periods ended June 30, 2022 and 2021. |\\n\\nCost of Sales\\nCost of sales includes costs associated with generating revenue within our company-owned retail locations, and franchising operations (of which, as of the date of this prospectus, we had none).\\nShipping and Handling Costs\\nThe Company incurred freight out cost and is included in the Company’s cost of sale.\\nGeneral and Administrative Expense\\nGeneral and administrative expense includes store-related expense as well as the Company’s corporate headquarters’ expenses.\\nAdvertising Expense\\nAdvertising expense are expensed as incurred. Advertising expenses amounted to $20,513 and $50,160 for the six month periods ended June 30, 2022 and 2021, respectively, and is recorded under general and administrative expenses in the accompanying unaudited condensed consolidated statements of operations.\\n22\\nPre-opening Costs\\nPre-opening costs for new stores, which are not material, consist primarily of payroll and recruiting expense, training, marketing, rent, travel, and supplies, and are expensed as incurred depreciated over the shorter of the useful life of the improvement or the lease term, including renewal periods that are reasonably assured.\\nResults of Operations\\nThree and six months ended June 30, 2022 Compared to three and six months ended June 30, 2021\\nThe following table presents selected comparative results of operations from our unaudited financial statements for the three and six months ended June 30, 2022 compared to three and six months ended June 30, 2021. Our financial results for these periods are not necessarily indicative of the financial results that we will achieve in future periods. Certain totals for the table below may not sum to 100% due to rounding.\\n\\n| Six Months Ended June 30, | Increase / (Decrease) |\\n| 2022 | 2021 | Dollars | Percentage |\\n| Net revenues: |\\n| Stores | $ | 1,511,952 | $ | 851,785 | $ | 660,167 | 77.5 | % |\\n| Wholesale and online | 29,674 | 28,336 | 1,338 | 4.7 | % |\\n| Total net revenues | 1,541,626 | 880,121 | 661,505 | 75.2 | % |\\n| Operating costs and expenses: |\\n| Product, food and drink costs—stores | 563,906 | 270,148 | 293,758 | 108.7 | % |\\n| Cost of sales—wholesale and online | 12,997 | 12,412 | 585 | 4.7 | % |\\n| General and administrative | 2,468,447 | 1,226,951 | 1,241,496 | 101.2 | % |\\n| Loss from operations | (1,503,724 | ) | (629,390 | ) | (874,334 | ) | 138.9 | % |\\n| Other income | 16,440 | - | 16,440 | N/A | % |\\n| Interest expense | (14,976 | ) | (5,773 | ) | (9,203 | ) | 159.4 | % |\\n| Loss before income taxes | (1,502,260 | ) | (635,163 | ) | (867,097 | ) | 136.5 | % |\\n| Provision for income taxes | - | - | - | 0.0 | % |\\n| Net loss | $ | (1,502,260 | ) | $ | (635,163 | ) | $ | (867,097 | ) | 136.5 | % |\\n\\n\\n| Three Months Ended June 30, | Increase / (Decrease) |\\n| 2022 | 2021 | Dollars | Percentage |\\n| Net revenues: |\\n| Stores | $ | 775,956 | $ | 475,824 | $ | 300,132 | 63.1 | % |\\n| Wholesale and online | 12,520 | 15,368 | (2,848 | ) | -18.5 | % |\\n| Total net revenues | 788,476 | 491,192 | 297,284 | 60.5 | % |\\n| Operating costs and expenses: |\\n| Product, food and drink costs—stores | 278,952 | 135,452 | 143,500 | 105.9 | % |\\n| Cost of sales—wholesale and online | 5,484 | 6,732 | (1,248 | ) | -18.5 | % |\\n| General and administrative | 1,432,432 | 656,310 | 776,122 | 118.3 | % |\\n| Loss from operations | (928,392 | ) | (307,302 | ) | (621,090 | ) | 202.1 | % |\\n| Other income | 1,440 | - | 1,440 | N/A | % |\\n| Interest expense | (10,196 | ) | (382 | ) | (9,814 | ) | 2569.1 | % |\\n| Loss before income taxes | (937,148 | ) | (307,684 | ) | (629,464 | ) | 204.6 | % |\\n| Provision for income taxes | - | - | - | 0.0 | % |\\n| Net loss | $ | (937,148 | ) | $ | (307,684 | ) | $ | (629,464 | ) | 204.6 | % |\\n\\n23\\n\\n| Six months ended June 30, | Three months ended June 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Net revenues: |\\n| Stores | 98.1 | % | 96.8 | % | 98.4 | % | 96.9 | % |\\n| Wholesale and online | 1.9 | % | 3.2 | % | 1.6 | % | 3.1 | % |\\n| Total net revenues | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % |\\n| Operating costs and expenses: |\\n| Product, food and drink costs—stores | 36.6 | % | 30.7 | % | 35.4 | % | 27.6 | % |\\n| Cost of sales—wholesale and online | 0.8 | % | 1.4 | % | 0.7 | % | 1.4 | % |\\n| General and administrative | 160.1 | % | 139.4 | % | 181.7 | % | 133.6 | % |\\n| Loss from operations | -97.5 | % | -71.5 | % | -117.7 | % | -62.6 | % |\\n| Other income | 1.1 | % | 0.0 | % | 0.2 | % | 0.0 | % |\\n| Interest expense | -1.0 | % | -0.7 | % | -1.3 | % | -0.1 | % |\\n| Loss before income taxes | -97.4 | % | -72.2 | % | -118.9 | % | -62.6 | % |\\n| Provision for income taxes | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % |\\n| Net loss | -97.4 | % | -72.2 | % | -118.9 | % | -62.6 | % |\\n\\nRevenues. Revenues were approximately $1.5 million for the six-month period ended June 30, 2022, compared to $880,000 for the comparable period in 2021, representing an increase of $661,000, or 75.2%. Revenues were approximately $788,000 million for the three-month period ended June 30, 2022, compared to $491,000 for the comparable period in 2021, representing an increase of $297,000, or 60.5%. The increase in sales for the periods was primarily driven by the opening of the Corona Del Mar, Laguna Woods and Santa Anita locations during 2021, and to the continued focus on marketing efforts to grow brand recognition.\\nProduct, food and drink costs. Product, food and drink costs were approximately $564,000 for the six-month period ended June 30, 2022 compared to $270,000 for the comparable period in 2021, representing an increase of approximately $294,000, or 108.7%, and were approximately $279,000 for the three-month period ended June 30, 2022 compared to $135,000 for the comparable period in the prior year, representing an increase of $144,000 of 105.9%. The increase in costs for the periods was partially driven by the opening of new locations and the overall increase in sales for the period. As a percentage of revenues, product, food and drink costs increased to 36.6% in the six-month period ended June 30, 2022 compared to 30.7% in the comparable period in 2021 and increased to 35.4% in the three-month period ended June 30, 2022 compared to 27.6% in the comparable period in 2021. The increase in costs as a percentage of sales was primarily driven by general inflationary pressures and the seasonal fluctuations in cost of ingredients. We monitor these fluctuations in product costs to analyze whether they are considered to be representative of general economic conditions, such as inflation, or to be related to commodity specific changes. For example, green bean suppliers raised pricing by 15 to 20% throughout 2021, higher than the overall rate of inflation, however it has been more stable recently and even decreasing slightly in the second quarter of 2022.\\nGeneral and administrative expenses. General and administrative expenses were approximately $2.5 million for the six-month period ended June 30, 2022 compared to $1.2 million for the comparable period in the prior year, representing an increase of approximately $1.2 million, or 101.2%, and were approximately $1.4 million for the three-month period ended June 30, 2022 compared to $656,000 for the comparable period in 2021, representing an increase of approximately $775,000, or 118.3%. This increase in general and administrative expenses was primarily due to the hiring of additional administrative employees, increases in professional services and corporate-level costs to support growth plans, the opening of new restaurants, as well as costs associated with outside administrative, legal and professional fees and other general corporate expenses associated with preparing to become a public company. As a percentage of sales, general and administrative expenses increased to 160.1% in the six-month period ended June 30, 2022 from 139.4% in the comparable period of 2021, and increased to 181.7% for the three-month period ended June 30, 2022 from 133.6% in the comparable period in 2021, primarily due to the increased administrative expenditures for the reasons mentioned above.\\n24\\nLiquidity and Capital Resources\\n\\n| Six Months Ended June 30, |\\n| 2022 | 2021 |\\n| Statement of Cash Flow Data: |\\n| Net cash used in operating activities | (1,199,979 | ) | (538,352 | ) |\\n| Net cash used in investing activities | (168,397 | ) | (317,152 | ) |\\n| Net cash provided by financing activities | 613,149 | 866,579 |\\n\\nCash Flows Provided by Operating Activities\\nNet cash used in operating activities during the six-month period ended June 30, 2022 was $1.2 million, which resulted from net loss of $1.5 million, non-cash charges of $225,000 for stock compensation and $98,000 for depreciation and net cash outflows of $43,000 from changes in operating assets and liabilities. The net cash outflows from changes in operating assets and liabilities were primarily the result of increases in inventory of $14,000 and prepaid and other assets of $28,000 and a decrease in accounts payable of $46,000, partially offset by increase of $47,000 in accrued liabilities. The increase in accrued liabilities was primarily due to the timing of cash payments for sales tax and payroll.\\nNet cash used in operating activities during the six-month period ended June 30, 2021 was $538,000, which resulted from net loss of $635,000, non-cash charges of $82,000 for depreciation, and net cash outflows of $6,000 from changes in operating assets and liabilities. The net cash outflows from changes in operating assets and liabilities were primarily the result of increases in inventories of $7,000 and prepaids and other assets of $65,000, partially offset by increases of $50,000 in accounts payable and $17,000 in accrued liabilities.\\nCash Flows Used in Investing Activities\\nNet cash used in investing activities during the six-month periods ended June 30, 2022 and 2021 was $168,000 and $317,000, respectively, These expenditures in each period are primarily related to purchases of property and equipment in connection with current and future location openings and maintaining our existing locations.\\nCash Flows Provided by (Used in) Financing Activities\\nNet cash provided by financing activities during the six-month period ended June 30, 2022 was $613,000, primarily due to $595,000 of borrowings under a line of credit, and $150,000 of loans from shareholders. This was partially offset by $131,000 of repayments of borrowings.\\nNet cash provided by financing activities during the six-month period ended June 30, 2021 was $867,000, primarily due to approximately $533,000 cash received through borrowings and $553,000 of proceeds from issuance of common stock, offset by approximately $220,000 of repayments of borrowings.\\nAs of June 30, 2022, the Company had total assets of $4,593,013. Our cash balance as of June 30, 2022 was approximately $150,000. From inception (of Reborn Global in November 2014) to June 30, 2022, we have not had any positive operating cash flow.\\nCredit Facilities\\nLoan with Fora Financial\\nIn October 2019, the Company entered into a loan agreement with Fora Financial in the principal amount of $138,600 and remaining principal amount of $48,510. The loan payable has a maturity date on October 11, 2019. The loan was due on demand. As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $0.\\nLoans with Square Capital\\nBetween April and August 2021, the Company entered into loan agreements with Square Capital in the aggregate principal amount of approximately $268,000 with loan costs of $34,840. The loans have maturity dates ranging from September 2022 to February 2023. As of June 20, 2022 and December 31, 2021, there was a balance outstanding of approximately $0 and $122,000, respectively.\\n25\\nEconomic Injury Disaster Loan\\nOn May 16, 2020, the Company executed the standard loan documents required for securing a loan (the “EIDL Loan”) from the SBA under its Economic Injury Disaster Loan (“EIDL”) assistance program in light of the impact of the COVID-19 pandemic on the Company’s business. As of June 30, 2022, the loan payable, Emergency Injury Disaster Loan noted above is not in default.\\nPursuant to that certain Loan Authorization and Agreement (the “SBA Loan Agreement”), the Company borrowed an aggregate principal amount of the EIDL Loan of $500,000, with proceeds to be used for working capital purposes. Interest accrues at the rate of 3.75% per annum and will accrue only on funds actually advanced from the date of each advance. Installment payments, including principal and interest, are due monthly beginning May 16, 2021 (twelve months from the date of the SBA Loan) in the amount of $731. The balance of principal and interest is payable thirty years from the date of the SBA Loan. In connection therewith, the Company also received a $10,000 grant, which does not have to be repaid. During the year ended December 31, 2020, $10,000 was recorded in Economy injury disaster loan (EIDL) grant income in the Statements of Operations. The schedule of payments on this loan was later deferred to commence 24 months from the date of loan, and therefore, the full amount of the loan is outstanding as of June 30, 2022 and payments shall commence starting in May 2022.\\nIn connection therewith, the Company executed (i) a loan for the benefit of the SBA (the “SBA Loan”), which contains customary events of default and (ii) a Security Agreement, granting the SBA a security interest in all tangible and intangible personal property of the Company, which also contains customary events of default (the “SBA Security Agreement”).\\nPaycheck Protection Program Loan\\nIn May 2020, the Company secured a loan under the Paycheck Protection Program administered by the U.S. Small Business Administration (the “SBA”) in the amount of $115,000. In February 2021, the Company secured a second loan under this program in the amount of approximately $167,000. The interest rate of the loan is 1.00% per annum and accrues on the unpaid principal balance computed on the basis of the actual number of days elapsed in a year of 360 days. Commencing seven months after the effective date of each PPP Loan, the Company is required to pay the Lender equal monthly payments of principal and interest as required to fully amortize any unforgiven principal balance of the loan by the two-year anniversary of the effective date of the loan. The PPP Loan contains customary events of default relating to, among other things, payment defaults, making materially false or misleading representations to the SBA or the Lender, or breaching the terms of the PPP Loan. The occurrence of an event of default may result in the repayment of all amounts outstanding under the PPP Loan, collection of all amounts owing from the Company, or filing suit and obtaining judgment against the Company. Under the terms of the CARES Act, PPP loan recipients can apply for and be granted forgiveness for all or a portion of the loan granted under the PPP. Such forgiveness will be determined, subject to limitations, based on the use of loan proceeds for payment of payroll costs and any payments of mortgage interest, rent, and utilities. Recent modifications to the PPP by the U.S. Treasury and Congress have extended the time period for loan forgiveness beyond the original eight-week period, making it possible for the Company to apply for forgiveness of its PPP loan. The Company was granted forgiveness for the initial PPP Loan prior to December 31, 2021 and expects to be granted forgiveness on the remainder subsequently.\\nLine of Credit Facility\\nDuring the second quarter of 2022, the Company entered into a line of credit agreement with a financial institution that provides a maximum borrowing limit of $2,000,000 with interest at 5% per annum. This line of credit facility matures on December 31, 2022. Total balance as of June 30, 2022 was $594,529.\\nLeases\\nOperating Leases\\nWe currently lease all company-owned retail locations. Operating leases typically contain escalating rentals over the lease term, as well as optional renewal periods. Rent expense for operating leases is recorded on a straight-line basis over the lease term and begins when Reborn has the right to use the property. The difference between rent expense and cash payment is recorded as deferred rent on the accompanying consolidated balance sheets. Pre-opening rent is included in selling, general and administrative expenses on the accompanying consolidated statements of income. Tenant incentives used to fund leasehold improvements are recorded in deferred rent and amortized as reductions to rent expense over the term of the lease.\\n26\\nIncome Taxes\\nReborn files income tax returns in the U.S. federal and California state jurisdictions.\\nUpon the closing of this offering, we will be taxed at the prevailing U.S. corporate tax rates. We will be treated as a U.S. corporation and a regarded entity for U.S. federal, state and local income taxes. Accordingly, a provision will be recorded for the anticipated tax consequences of our reported results of operations for U.S. federal, state and foreign income taxes.\\nJOBS Act Accounting Election\\nWe are an “emerging growth company,” as defined in the JOBS Act, and may take advantage of certain exemptions from various public company reporting requirements for up to five years or until we are no longer an emerging growth company, whichever is earlier. The JOBS Act provides that an “emerging growth company” can delay adopting new or revised accounting standards until those standards apply to private companies. We have elected to use this extended transition period under the JOBS Act. Accordingly, our financial statements may not be comparable to the financial statements of public companies that comply with such new or revised accounting standards.\\nOff Balance Sheet Arrangements\\nWe do not have any off-balance sheet arrangements that we are required to disclose pursuant to these regulations. In the ordinary course of business, we enter into operating lease commitments, purchase commitments and other contractual obligations. These transactions are recognized in our financial statements in accordance with GAAP.\\nCritical Accounting Policies\\nThe preparation of financial statements requires management to utilize estimates and make judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. These estimates are based on historical experience and on various other assumptions that management believes to be reasonable under the circumstances. The estimates are evaluated by management on an ongoing basis, and the results of these evaluations form a basis for making decisions about the carrying value of assets and liabilities that are not readily apparent from other sources. Although actual results may differ from these estimates under different assumptions or conditions, management believes that the estimates used in the preparation of our financial statements are reasonable. The critical accounting policies affecting our financial reporting are summarized in Note 2 to the financial statements included elsewhere in this prospectus.\\nRecent Accounting Pronouncements\\nWe have determined that all other issued, but not yet effective accounting pronouncements are inapplicable or insignificant to us and once adopted are not expected to have a material impact on our financial position.\\n27\\n\\nItem 3. Quantitative and Qualitative Disclosures About Market Risk.\\nWe are a smaller reporting company as defined by 17 C.F.R. 229 (10)(f)(i) and are not required to provide information under this item.\\n\\nItem 4. Controls and Procedures.\\nEvaluation of Disclosure Controls and Procedures\\nOur management has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)), as of June 30, 2022. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that as of June 30, 2022, our disclosure controls and procedures were ineffective to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act (a) is recorded, processed, summarized and reported within the time periods specified by Securities and Exchange Commission (“SEC”) rules and forms and (b) is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding any required disclosure.\\nChanges in Internal Control Over Financial Reporting\\nDuring the period ended June 30, 2022, our management has evaluated the internal control over financial reporting pursuant to Rules 13a-15(d) or 15d-15(d) under the Exchange Act. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our internal controls over financial reporting were ineffective as of June 30, 2022. Management of the Company believes that the ineffectiveness of internal controls was due to the lack of accounting and financial team.\\n28\\nPART II—OTHER INFORMATION\\n\\nItem 1. Legal Proceedings.\\nIn the future, the Company may be subject to various legal proceedings from time to time as part of its business. We are currently not involved in litigation that we believe will have a materially adverse effect on our financial condition or results of operations. As of June 30, 2022, there is no action, suit, proceeding, inquiry or investigation before or by any court, public board, government agency, self- regulatory organization or body pending or, to the knowledge of the executive officers of our company or any of our subsidiaries threatened against or affecting our company, our common stock, any of our subsidiaries or of our company’s or our company’s subsidiaries’ officers or directors in their capacities as such, in which an adverse decision is expected to have a material adverse effect.\\n\\nItem 1A. Risk Factors.\\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, we are not required to provide information required by this item.\\n\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\\nWe have not made any sales of unregistered equity securities during the quarterly period ended June 30, 2022.\\nIn August 2022, the Company consummated its initial public offering (the “IPO”) of 1,440,000 shares of its common stock at a public offering price of $5.00 per share, generating gross proceeds of $7,200,000 pursuant to our Registration Statement on Form S-1 (as amended) (File No. 333-261937), which was declared effective by the SEC on August 11, 2022. . EF Hutton, division of Benchmark Investments, LLC, acted as the representative of the underwriters of the IPO. After deducting underwriting discounts and commissions and other offering expenses payable by us, we received approximately $6.2 million in net proceeds from our initial public offering.\\nThere has been no material change in the planned use of proceeds from our initial public offering as described in our final prospectus, dated August 11, 2022, which was filed with the SEC on August 16, 2021 pursuant to Rule 424(b) under the Securities Act. The primary use of the net proceeds from our initial public offering continues to be, as follows: (i) approximately $8.0 million for the acquisition of property and the development of a manufacturing plant to build, design and manufacture our new line of electric boats; (ii) approximately $2.0 million for ramp up of production and inventory; (iii) approximately $2.6 million for working capital.\\nNo payments were made by us to directors, officers or persons owning ten percent or more of our common stock or to their associates, or to our affiliates, other than payments in the ordinary course of business to officers for salaries. Pending the uses described, we have invested the net proceeds in our operating cash account.\\n29\\n\\nItem 6. Exhibits.\\nThe following exhibits are included herein or incorporated herein by reference:\\n\\n| 3.1 | Certificate of Incorporation (Delaware), dated July 27, 2022 (incorporated by reference to Exhibit 3.1 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\\n| 3.2 | Bylaws of Registrant (Delaware) (incorporated by reference to Exhibit 3.2 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\\n| 4.1 | Specimen Common Stock Certificate (Delaware) (incorporated by reference to Exhibit 4.1 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\\n| 4.2 | Form of Representative’s Warrant (incorporated by reference to Exhibit 4.5 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\\n| 10.1 | Share Exchange Agreement, dated May 7, 2018 by and among Capax, Reborn and each of the RB shareholders (incorporated by reference to Exhibit 10.1 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\\n| 10.2 | Form of Letter Agreement (Lockup) by and among Registrant, officers and directors of the Company and EF Hutton (incorporated by reference to Exhibit 10.2 to Amendment No. 6 to our Registration Statement on Form S-1 filed on August 9, 2022) |\\n| 10.3 | Form of Director and Officer Indemnity Agreement (incorporated by reference to Exhibit 10.3 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\\n| 10.4 | Shopping Center Lease by and between Reborn Global Holdings, Inc. and La Floresta Regency, LLC, effective July 25, 2016 (incorporated by reference to Exhibit 10.4 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\\n| 10.5 | Standard Industrial/Commercial Multi-Tenant Lease, as amended, by and between Reborn Global Holdings, Inc. and Foothill Crescenta, LLC, effective December 6, 2016 (incorporated by reference to Exhibit 10.5 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\\n| 10.6 | Shopping Center Lease by and between Reborn Global Holdings, Inc. and Sibling Associates, LLC, effective July 12, 2017 (incorporated by reference to Exhibit 10.6 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\\n| 10.7 | Standard Lease by and between Reborn Global Holdings, Inc. and El Toro, LP, effective February 12, 2021 (incorporated by reference to Exhibit 10.7 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\\n| 10.8 | Form of Subscription Agreement (Regulation A+ Offering) (incorporated by reference to Exhibit 10.11 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\\n| 10.9 | Consulting Agreement by and between the Company and Kevin Hartley, effective September 15, 2021 (incorporated by reference to Exhibit 10.12 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\\n| 10.10 | Amendment to Share Exchange Agreement, dated January 25, 2022, by and among Reborn Coffee Inc., Andrew Weeraratne and each of the former shareholders of Reborn Global Holdings, Inc., a California corporation (incorporated by reference to Exhibit 10.10 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\\n| 10.11 | Offer of Employment by and between the Company and Stephan Kim, dated July 27, 2022 (incorporated by reference to Exhibit 10.11 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\\n| 31.1* | Certification of Jay Kim pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 31.2* | Certification of Stephan Kim pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 32.1** | Certification of Jay Kim pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 32.2** | Certification of Stephan Kim pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 101.INS | Inline XBRL Instance Document. |\\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document. |\\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document. |\\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document. |\\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document. |\\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document. |\\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101). |\\n\\n\\n| * | Filed herewith. |\\n\\n\\n| ** | Furnished herewith. |\\n\\n30\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n\\n| Signature | Title | Date |\\n| /s/ Jay Kim | Chief Executive Officer (Principal Executive Officer) | September 30, 2022 |\\n| Jay Kim |\\n| /s/ Stephan Kim | Chief Financial Officer (Principal Financial and Accounting Officer) | September 30, 2022 |\\n\\n31\\n\\n \\n\\nWhat was the percentage change in earnings per share (EPS) year over year?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 108.89000325379874.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 49,\n \"input_length\": 26349\n}"}}},{"rowIdx":50,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nItem 1. Financial Statements\nSEMRUSH HOLDINGS, INC.\nUNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS\n(in thousands, except share and per share data)\n| As of |\n| March 31, 2021 | December 31, 2020 |\n| Assets |\n| Current assets |\n| Cash and cash equivalents | $ | 171,867 | $ | 35,531 |\n| Accounts receivable | 2,383 | 1,399 |\n| Deferred contract costs, current portion | 4,817 | 4,049 |\n| Prepaid expenses and other current assets | 3,626 | 2,649 |\n| Total current assets | 182,693 | 43,628 |\n| Property and equipment, net | 3,876 | 2,968 |\n| Intangible assets, net | 2,176 | 2,231 |\n| Goodwill | 1,991 | 1,991 |\n| Deferred contract costs, net of current portion | 2,000 | 1,670 |\n| Other long-term assets | 1,130 | 2,470 |\n| Total assets | $ | 193,866 | $ | 54,958 |\n| Liabilities, redeemable convertible preferred stock and stockholders’ equity (deficit) |\n| Current liabilities |\n| Accounts payable | $ | 10,233 | $ | 8,654 |\n| Accrued expenses | 10,286 | 7,719 |\n| Deferred revenue | 32,078 | 26,537 |\n| Total current liabilities | 52,597 | 42,910 |\n| Long-term liabilities |\n| Deferred revenue, net of current portion | 181 | 123 |\n| Deferred tax liability | 153 | 209 |\n| Other long-term liabilities | 1,024 | 497 |\n| Total liabilities | 53,955 | 43,739 |\n| Commitments and contingencies (Note 11) |\n| Series A redeemable convertible preferred stock, $ 0.00001 par value - no shares authorized, issued or outstanding as of March 31, 2021; 3,379,400 shares authorized, issued and outstanding as of December 31, 2020 (liquidation value of $ 8,000 at December 31, 2020) | — | 7,789 |\n| Series A-1 redeemable convertible preferred stock, $ 0.00001 par value - no shares authorized, issued or outstanding as of March 31, 2021; 1,837,600 shares authorized, issued and outstanding as of December 31, 2020 (liquidation value of $ 5,000 at December 31, 2020) | — | 10,270 |\n| Stockholders' equity (deficit) |\n| Series B convertible preferred stock, $ 0.00001 par value - no shares authorized, issued or outstanding as of March 31, 2021; 4,681,400 shares authorized, issued and outstanding as of December 31, 2020 (liquidation value of $ 24,000 at December 31, 2020) | — | 24,000 |\n| Undesignated preferred stock, $ 0.00001 par value - 100,000,000 shares authorized, and no shares issued or outstanding as of March 31, 2021; no shares authorized, issued, or outstanding as of December 31, 2020 | — | — |\n| Common stock, $ 0.00001 par value - no shares authorized, issued, or outstanding as of March 31, 2021; 300,000,000 shares authorized, and 95,206,893 shares issued and 95,050,041 shares outstanding at December 31, 2020 | — | — |\n| Class A common stock, $ 0.00001 par value - 1,000,000,000 shares authorized, and 10,000,000 shares issued and outstanding as of March 31, 2021; no shares authorized, issued or outstanding as of December 31, 2020 | — | — |\n| Class B common stock, $ 0.00001 par value - 160,000,000 shares authorized, and 124,905,954 shares issued and 124,749,102 outstanding as of March 31, 2021; no shares authorized, issued or outstanding as of December 31, 2020 | 1 | — |\n| Additional paid-in capital | 174,254 | 4,975 |\n| Accumulated deficit | ( 34,344 ) | ( 35,815 ) |\n| Total stockholders’ equity (deficit) | 139,911 | ( 6,840 ) |\n| Total liabilities, redeemable convertible preferred stock, and stockholders' deficit | $ | 193,866 | $ | 54,958 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.1\nSEMRUSH HOLDINGS, INC.\nUNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)\n(in thousands, except per share data)\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| Revenue | $ | 39,998 | $ | 27,787 |\n| Cost of revenue | 8,773 | 6,611 |\n| Gross profit | 31,225 | 21,176 |\n| Operating expenses |\n| Sales and marketing | 16,457 | 12,877 |\n| Research and development | 5,358 | 4,237 |\n| General and administrative | 7,904 | 5,933 |\n| Total operating expenses | 29,719 | 23,047 |\n| Income (loss) from operations | 1,506 | ( 1,871 ) |\n| Other income, net | 51 | 56 |\n| Income (loss) before income taxes | 1,557 | ( 1,815 ) |\n| Provision for income taxes | 86 | 116 |\n| Net income (loss) and comprehensive income (loss) | $ | 1,471 | $ | ( 1,931 ) |\n| Net income (loss) per share attributable to common stockholders: |\n| Basic | $ | 0.02 | $ | ( 0.02 ) |\n| Diluted | $ | 0.01 | $ | ( 0.02 ) |\n| Weighted-average number of shares of common stock used in computing net income (loss) per share attributable to common stockholders: |\n| Basic | 96,376 | 94,593 |\n| Diluted | 131,356 | 94,593 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.2\nSEMRUSH HOLDINGS, INC.\nUNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY (DEFICIT)\n(in thousands, except share data)\n| Series A | Series A-1 | Series B | Common Stock | Class A Common Stock | Class B Common Stock | AdditionalPaid-inCapital | AccumulatedDeficit | TotalStockholders’Equity(Deficit) |\n| Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount |\n| Balances at December 31, 2019 | 3,379,400 | $ | 7,789 | 1,837,600 | $ | 10,270 | 4,681,400 | $ | 24,000 | 94,592,700 | $ | — | — | $ | — | — | $ | — | $ | 3,644 | $ | ( 28,803 ) | $ | ( 1,159 ) |\n| Stock-based compensation expense | — | — | — | — | — | — | — | — | — | — | — | — | 205 | — | 205 |\n| Net loss | — | — | — | — | — | — | — | — | — | — | — | — | — | ( 1,931 ) | ( 1,931 ) |\n| Balances at March 31, 2020 | 3,379,400 | $ | 7,789 | 1,837,600 | $ | 10,270 | 4,681,400 | $ | 24,000 | 94,592,700 | $ | — | — | $ | — | — | $ | — | 3,849 | ( 30,734 ) | ( 2,885 ) |\n| Balances at December 31, 2020 | 3,379,400 | $ | 7,789 | 1,837,600 | $ | 10,270 | 4,681,400 | $ | 24,000 | 95,050,041 | $ | — | — | $ | — | — | $ | — | 4,975 | ( 35,815 ) | $ | ( 6,840 ) |\n| Conversion of Preferred Stock | ( 3,379,400 ) | ( 7,789 ) | ( 1,837,600 ) | ( 10,270 ) | ( 4,681,400 ) | ( 24,000 ) | 29,695,200 | — | — | — | — | — | 42,058 | — | 18,058 |\n| Issuance of Class A Common Stock in connection with the initial public offering, net of $ 13,378 in issuance costs | — | — | — | — | — | — | — | — | 10,000,000 | — | — | — | 126,622 | — | 126,622 |\n| Reclassification of Common Stock to Class B Common Stock in connection with the initial public offering | — | — | — | — | — | — | ( 124,745,241 ) | — | — | — | 124,745,241 | 1 | ( 1 ) | — | — |\n| Exercise of stock options | — | — | — | — | — | — | — | — | — | — | 3,861 | — | 7 | — | 7 |\n| Stock-based compensation expense | — | — | — | — | — | — | — | — | — | — | — | — | 593 | — | 593 |\n| Net Income | — | — | — | — | — | — | — | — | — | — | — | — | — | 1,471 | 1,471 |\n| Balances at March 31, 2021 | — | $ | — | — | $ | — | — | $ | — | — | $ | — | 10,000,000 | $ | — | 124,749,102 | $ | 1 | $ | 174,254 | $ | ( 34,344 ) | $ | 139,911 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.3\nSEMRUSH HOLDINGS, INC.\nUNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(in thousands)\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| Operating Activities |\n| Net income (loss) | $ | 1,471 | $ | ( 1,931 ) |\n| Adjustments to reconcile net income (loss) to net cash provided by operating activities |\n| Depreciation and amortization expense | 460 | 232 |\n| Amortization of deferred contract costs | 1,322 | 1,104 |\n| Stock-based compensation expense | 593 | 205 |\n| Deferred taxes | ( 56 ) | ( 57 ) |\n| Changes in operating assets and liabilities |\n| Accounts receivable | ( 985 ) | 745 |\n| Deferred contract costs | ( 2,420 ) | ( 1,704 ) |\n| Prepaid expenses and other current assets | ( 976 ) | ( 747 ) |\n| Accounts payable | 1,579 | 58 |\n| Accrued expenses | 2,420 | 1,002 |\n| Deferred revenue | 5,599 | 1,654 |\n| Net cash provided by operating activities | 9,007 | 561 |\n| Investing Activities |\n| Purchases of property and equipment | ( 166 ) | ( 1,084 ) |\n| Purchases of convertible debt securities | ( 500 ) | — |\n| Capitalization of internal-use software development costs | ( 123 ) | ( 297 ) |\n| Cash paid for acquisition of business, net of cash acquired | ( 350 ) | — |\n| Net cash used in investing activities | ( 1,139 ) | ( 1,381 ) |\n| Financing Activities |\n| Proceeds from exercise of stock options | 7 | — |\n| Net proceeds from completing initial public offering | 128,461 | — |\n| Payment of deferred offering costs | — | ( 16 ) |\n| Net cash provided by (used in) financing activities | 128,468 | ( 16 ) |\n| Increase in cash, cash equivalents and restricted cash | 136,336 | ( 836 ) |\n| Cash, cash equivalents and restricted cash, at beginning of period | 35,619 | 37,523 |\n| Cash, cash equivalents and restricted cash, at end of period | $ | 171,955 | $ | 36,687 |\n| Supplemental cash flow disclosures |\n| Cash paid for income taxes | $ | 158 | $ | 154 |\n| Deferred offering costs incurred and not paid | $ | 1,839 | $ | — |\n| Acquisition of fixed asset under capital lease | $ | 1,024 | $ | — |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.4\nSEMRUSH HOLDINGS, INC.\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\nThree months ended March 31, 2021 and 2020\n(in thousands, except share and per share data, unless otherwise noted)\n1. Overview and Basis of Presentation\nDescription of Business\nSemrush Holdings, Inc. (“Semrush Holdings”) and its subsidiaries (together the “Group”, the “Company”, or “Semrush”) provide an online visibility management software-as-a-service (“SaaS”) platform. The Company’s platform enables its subscribers to improve their online visibility and drive traffic, including on their websites and social media pages, and distribute highly relevant content to their customers on a targeted basis across various channels to drive high-quality traffic and measure the effectiveness of their digital marketing campaigns. The Company is headquartered in Boston, Massachusetts, and has wholly owned subsidiaries in Cyprus, Russia, the Czech Republic, Poland, and the United States.\nThe Company is subject to a number of risks and uncertainties common to companies in similar industries and stages of development that could affect future operations and financial performance. These risks include, but are not limited to, rapid technological change, competitive pressure from substitute products or larger companies, protection of proprietary technology, management of international activities, the need to obtain additional financing to support growth, and dependence on third parties and key individuals.\n2019 Reorganization\nOn December 19, 2019, Semrush Holdings was incorporated in the state of Delaware and entered into a Contribution and Exchange Agreement with SEMrush CY Ltd (“SEMrush CY”) (a private limited liability company organized under the Cyprus Companies Law, Cap 113), pursuant to which the holders of all outstanding shares of capital stock of SEMrush CY contributed those shares to Semrush Holdings in exchange for identical shares of capital stock of Semrush Holdings (the “2019 Share Exchange”). Upon the 2019 Share Exchange, Semrush Holdings became the holding company of SEMrush CY and its wholly owned subsidiaries and the historical consolidated financial statements of SEMrush CY became the historical consolidated financial statements of Semrush Holdings. The 2019 Share Exchange and related transactions were completed on December 27, 2019.\nInitial Public Offering\nOn March 29, 2021, the Company closed its initial public offering (“IPO”) in which it sold 10,000,000 shares of its Class A common stock at a price to the public of $ 14.00 per share. The Company received $ 126.6 million in net proceeds after deducting approximately $ 13.4 million for underwriting discounts, commissions and offering expenses. Immediately prior to the completion of the IPO, all shares of common stock then outstanding were reclassified as Class B common stock, and all shares of redeemable convertible preferred stock and convertible preferred stock then outstanding were converted into shares of common stock on a one -to-one basis and then reclassified into Class B common stock.\nEffects of COVID-19\nThe Company considered the potential effects of the novel strain of coronavirus (“COVID-19”) pandemic on the Company. In March 2020, the World Health Organization declared the outbreak of COVID–19 a pandemic, and numerous new strains of COVID-19 have subsequently spread throughout\n5\nthe world. COVID–19 has continued to impact market and economic conditions globally. In an attempt to limit the spread of the virus, various governmental restrictions have been implemented, including restrictions with respect to business activities and travel restrictions, and “shelter–at–home” orders, that have had and may continue to have an adverse impact on the Company’s business and operations. In light of the evolving nature of COVID–19 and the uncertainty it has produced around the world, it is not possible to predict the COVID–19 pandemic’s cumulative and ultimate impact on the Company’s future business operations, results of operations, financial position, liquidity, and cash flows. The extent of the impact of the pandemic on the Company’s business and financial results will depend largely on future developments, including the duration of the spread of the outbreak both globally and within the U.S., the impact on capital, foreign currencies exchange and financial markets, and governmental or regulatory orders that impact the Company’s business, all of which are highly uncertain and cannot be predicted.\nThe Company will continue to actively monitor the current international and domestic impacts of and responses to COVID-19 and its related risks.\nBasis of Presentation\nThe accompanying unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and applicable rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Any reference in these notes to applicable guidance is meant to refer to the authoritative United States generally accepted accounting principles as found in the Accounting Standards Codification (“ASC”) and Accounting Standards Update (“ASU”) of the Financial Accounting Standards Board (“FASB”).\nThe unaudited condensed consolidated interim financial statements have been prepared on the same basis as the audited annual consolidated financial statements as of and for the year ended December 31, 2020, and, in the opinion of management, reflect all adjustments, consisting of normal recurring adjustments, necessary for the fair presentation of the Company’s financial position as of March 31, 2021, and the results of its operations and its cash flows for the three months ended March 31, 2021 and 2020. The consolidated balance sheet as of December 31, 2020 included herein was derived from the audited financial statements as of that date.\nThe results for the three months ended March 31, 2021 are not necessarily indicative of the results to be expected for the year ending December 31, 2021, any other interim periods, or any future year or period.\nThe unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes included in the Company’s final prospectus dated March 24, 2021 (the “Prospectus”) as filed with the SEC on March 25, 2021 pursuant to Rule 424(b) under the Securities Act of 1933, as amended (the “Securities Act”).\nThe accompanying unaudited condensed consolidated financial statements reflect the application of certain significant accounting policies as described below and elsewhere in these notes to the unaudited condensed consolidated financial statements. As of March 31, 2021, there have been no material changes in the Company's significant accounting policies from those that were disclosed in the Prospectus except as discussed below.\n2. Summary of Significant Accounting Policies\nPrinciples of Consolidation\n6\nThe unaudited condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany transactions and balances have been eliminated in consolidation.\nUse of Estimates\nThe preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. Significant estimates relied upon in preparing these financial statements include, but are not limited to, revenue recognition, expected future cash flows used to evaluate the recoverability of long-lived assets, contingent liabilities, expensing and capitalization of research and development costs for internal-use software, the average period of benefit associated with costs capitalized to obtain revenue contracts, the determination of the fair value of stock-based awards issued, stock-based compensation expense, and the recoverability of the Company’s net deferred tax assets and related valuation allowance.\nAlthough the Company regularly assesses these estimates, actual results could differ materially from these estimates. Changes in estimates are recorded in the period in which they become known. The Company bases its estimates on historical experience and various other assumptions that it believes to be reasonable under the circumstances. Actual results may differ from management’s estimates if these results differ from historical experience, or other assumptions do not turn out to be substantially accurate, even if such assumptions are reasonable when made.\nSubsequent Events Considerations\nThe Company considers events or transactions that occur after the balance sheet date but prior to the issuance of the financial statements to provide additional evidence for certain estimates or to identify matters that require additional disclosure. Subsequent events have been evaluated as required. The Company has evaluated all subsequent events and determined that there are no material recognized or unrecognized subsequent events requiring disclosure, other than those disclosed in this Quarterly Report on Form 10-Q.\nEmerging Growth Company Status\nThe Company is an \"emerging growth company,\" as defined in the Jumpstart Our Business Startups Act, or JOBS Act, and may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not \"emerging growth companies.\" The Company may take advantage of these exemptions until the Company is no longer an \"emerging growth company.\" Section 107 of the JOBS Act provides that an \"emerging growth company\" can take advantage of the extended transition period afforded by the JOBS Act for the implementation of new or revised accounting standards. The Company has elected to use the extended transition period for complying with new or revised accounting standards and, as a result of this election, its financial statements may not be comparable to companies that comply with public company effective dates. The Company may take advantage of these exemptions up until the last day of the year following the fifth anniversary of an offering or such earlier time that it is no longer an emerging growth company. The Company would cease to be an emerging growth company if it has more than $1.07 billion in annual revenue, has more than $700.0 million in market value of its stock held by non-affiliates (and it has been a public company for at least 12 months, and has filed one annual report on Form 10-K), or it issues more than $1.0 billion of non-convertible debt securities over a three-year period.\n7\nRevenue Recognition\nThe Company derives revenue from two sources: (1) subscription revenues via the Semrush Online Visibility Management Platform and the Prowly Public Relations Platform, which are comprised of subscription fees from customers accessing the Company’s SaaS services and related customer support; and (2) the Semrush Marketplace, which allows customers to pay a set fee for services or products offered through the marketplace.\nThe Company recognizes revenue in accordance with ASC 606, Revenue from Contracts with Customers (“ASC 606”). Revenue is recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration it expects to receive in exchange for those products or services. There were no changes to the Company’s revenue recognition policies since the filing of the Prospectus.\nFor the three months ended March 31, 2021 and 2020, subscription revenue accounted for nearly all of the Company’s revenue. Revenue related to the Semrush Marketplace was not material for the three months ended March 31, 2021 and 2020.\nAmounts that have been invoiced are recorded in accounts receivable and in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met. The Company primarily invoices and collects payments from customers for its services in advance on a monthly or annual basis.\nDeferred revenue represents amounts billed for which revenue has not yet been recognized. Deferred revenue that will be recognized during the succeeding 12-month period is recorded as current deferred revenue, and the remaining portion is recorded as long-term deferred revenue. Deferred revenue increased by $ 5,599 as of March 31, 2021 compared December 31, 2020. During the three months ended March 31, 2021 and 2020, $ 13,303 and $ 9,583 of revenue was recognized that was included in deferred revenue at the beginning of each respective period.\nThe Company has elected to exclude amounts charged to customers for sales tax from the transaction price. Accordingly, revenue is presented net of any sales tax collected from customers.\nTransaction Price Allocated to Future Performance Obligations\nASC 606 requires that the Company disclose the aggregate amount of the transaction price that is allocated to performance obligations that have not yet been satisfied as of the balance sheet dates reported.\nFor contracts with an original expected duration greater than one year, the aggregate amount of the transaction price allocated to the performance obligations that were unsatisfied as of March 31, 2021 and December 31, 2020 was $ 866 and $ 1,280 , respectively, which the Company expects to recognize over the next 12 months.\nFor contracts with an original expected duration of one year or less, the Company has applied the practical expedient available under ASC 606 to not disclose the amount of transaction price allocated to unsatisfied performance obligations as of March 31, 2021 and December 31, 2020. For performance obligations not satisfied as of March 31, 2021 and December 31, 2020, and to which this expedient applies, the nature of the performance obligations is consistent with performance obligations satisfied as of December 31, 2019. The remaining durations are less than one year.\nCosts to Obtain a Contract\nThe incremental direct costs of obtaining a contract, which primarily consist of sales commissions paid for new subscription contracts, are deferred and recorded as deferred contract costs in the\n8\nconsolidated balance sheet and are amortized over a period of approximately 24 months on a systematic basis, consistent with the pattern of transfer of the goods or services to which the asset relates. The 24-month period represents the estimated benefit period of the customer relationship and has been determined by taking into consideration the type of product sold, the commitment term of the customer contract, the nature of the Company’s technology development life-cycle, and an estimated customer relationship period based on historical experience and future expectations. Sales commissions for renewals and upgrade contracts are deferred and amortized on a straight-line basis over the remaining estimated customer relationship period of the related customer. Deferred contract costs that will be recorded as expense during the succeeding 12-month period are recorded as current deferred contract costs, and the remaining portion is recorded as deferred contract costs, net of current portion. Amortization of deferred contract costs is included in sales and marketing expense in the accompanying consolidated statement of operations and comprehensive loss.\nCash, Cash Equivalents, and Restricted Cash\nThe Company considers all highly liquid instruments purchased with an original maturity date of 90 days or less from the date of purchase to be cash equivalents. Management determines the appropriate classification of investments at the time of purchase and re-evaluates such determination at each balance sheet date.\nCash and cash equivalents consist of cash on deposit with banks and amounts held in interest-bearing money market funds. Cash equivalents are carried at cost, which approximates their fair market value. At both March 31, 2021 and December 31, 2020, restricted cash was $ 88 , and related to cash held at a financial institution in an interest-bearing cash account as collateral for a letter of credit related to the contractual provisions for one of the Company’s building leases.\nThe following table is a reconciliation of cash, cash equivalents and restricted cash included in the accompanying condensed consolidated balance sheets that sum to the total cash, cash equivalents and restricted cash included in the accompanying condensed consolidated statements of cash flows for the three months ended March 31, 2021 and 2020.\n| March 31, 2021 | March 31, 2020 |\n| Cash and cash equivalents | $ | 171,867 | $ | 36,599 |\n| Restricted cash included in “prepaid expenses and other current assets” and “other long-term assets,” respectively | 88 | 88 |\n| $ | 171,955 | $ | 36,687 |\n\nConcentrations of Credit Risk and Significant Customers\nThe Company has no off-balance sheet risk, such as foreign exchange contracts, option contracts, or other hedging arrangements. Credit losses historically have not been significant and the Company generally has not experienced any material losses related to receivables from individual customers, or groups of customers. Due to these factors, no additional credit risk beyond amounts provided for collection losses is believed by management to be probable in the Company's accounts receivable.\nCredit risk with respect to accounts receivable is dispersed due to the large number of customers of the Company. The Company routinely assesses the creditworthiness of its customers and generally does not require its customers to provide collateral or other security to support accounts receivable. Credit losses historically have not been significant and the Company generally has not experienced any material losses related to receivables from individual customers, or groups of customers. Due to these factors, no additional credit risk beyond amounts provided for collection losses is believed by management to be probable in the Company's accounts receivable.\n9\nAs of March 31, 2021 and December 31, 2020, no individual customer represented more than 10% of the Company’s accounts receivable. During the three months ended March 31, 2021 and 2020, no individual customer represented more than 10% of the Company’s revenue.\nDisclosure of Fair Value of Financial Instruments\nThe carrying amounts of the Company’s financial instruments, which include cash and cash equivalents, accounts receivable, accounts payable, and accrued expenses, approximated their fair values at March 31, 2021 and December 31, 2020, due to the short-term nature of these instruments.\nThe Company has evaluated the estimated fair value of financial instruments using available market information. The use of different market assumptions and/or estimation methodologies could have a significant effect on the estimated fair value amounts. See below for further discussion.\nFair Value Measurements\nASC 820, Fair Value Measurements and Disclosures (“ASC 820”), establishes a three-level valuation hierarchy for instruments measured at fair value that distinguishes between assumptions based on market data (observable inputs) and the Company’s own assumptions (unobservable inputs). Observable inputs are those that market participants would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions about the inputs that market participants would use in pricing the asset or liability and are developed based on the best information available in the circumstances.\nThis guidance further identifies fair value as the exchange price, or exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants based on the highest and best use of the asset or liability. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. The Company uses valuation techniques to measure fair value that maximize the use of observable inputs and minimize the use of unobservable inputs. These inputs are prioritized as follows:\nLevel 1 inputs—Unadjusted observable quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.\nLevel 2 inputs—Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly.\nLevel 3 inputs—Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity.\nTo the extent that the valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Accordingly, the degree of judgment exercised by the Company in determining fair value is greatest for instruments categorized in Level 3. A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement.\nThe Company evaluates assets and liabilities subject to fair value measurements on a recurring and nonrecurring basis to determine the appropriate level to classify them for each reporting period.\nCash equivalents include money market funds with original maturities of 90 days or less from the date of purchase. The fair value measurement of these assets is based on quoted market prices in active markets for identical assets and, therefore, these assets are recorded at fair value on a recurring basis\n10\nand classified as Level 1 in the fair value hierarchy. As of March 31, 2021 and December 31, 2020, cash equivalents held in money market funds totaled $ 35,505 and $ 29,369 , respectively.\nAs of March 31, 2021, the Company measured its investments in convertible notes (see Note 4) and its contingent consideration associated with the acquisition of Prowly.com sp. z o.o (“Prowly”) on a recurring basis using significant unobservable inputs (Level 3) and did not have any assets or liabilities measured at fair value on a recurring basis using significant other observable inputs (Level 2). Changes in fair value of the convertible notes were not material for the three months ended March 31, 2021 due to the short time period between when the investment was made and the balance sheet date. Changes in fair value of the contingent consideration associated with the Prowly acquisition were not material for the three months ended March 31, 2021. As of December 31, 2020, the Company did not have any assets or liabilities measured at fair value on a recurring basis using significant other observable inputs (Level 2).\nForeign Currency Translation\nThe Group operates in a multi-currency environment having transactions in such currencies as the U.S. dollar, Russian rubles, Czech koruna, euros, and others. The reporting currency of the Company is the U.S. dollar. The functional currency of the Company’s foreign subsidiaries is the U.S. dollar, with the exception of Prowly, where the functional currency is the local currency, the Zloty. The foreign currency translation adjustment as it relates to Prowly was immaterial for the three months ended March 31, 2021 and 2020. For all other entities, foreign currency transactions are measured initially in the functional currency of the recording entity by use of the exchange rate in effect at that date. At each subsequent balance sheet date, foreign currency denominated assets and liabilities of these international subsidiaries are remeasured into U.S. dollars using the exchange rates in effect at the balance sheet date or historical rates, as appropriate. Any differences resulting from the remeasurement of foreign denominated assets and liabilities of the international subsidiaries to the U.S. dollar functional currency are recorded within other income (expense) in the unaudited condensed consolidated statement of operations and comprehensive loss. The foreign currency exchange gain (loss) included in other income for the three months ended March 31, 2021 and 2020 was $ 44 and $( 107 ), respectively.\nNet Income (Loss) Per Share\nNet income (loss) per share information is determined using the two-class method, which includes the weighted-average number of shares of common stock outstanding during the period and other securities that participate in dividends (a participating security). Prior to the completion of the IPO, the Company considered the shares of Preferred Stock to be participating securities because they include rights to participate in dividends with the common stock. As of March 31, 2021, the Company did not have any participating securities outstanding.\nUnder the two-class method, basic net income (loss) per share attributable to common stockholders is computed by dividing the net income (loss) attributable to common stockholders by the weighted-average number of shares of common stock outstanding during the period. Diluted net income (loss) per share attributable to common stockholders is computed using the more dilutive of (1) the two-class method or (2) the if-converted method. The Company allocates net income first to preferred stockholders based on dividend rights under the Company’s certificate of incorporation and then to preferred and common stockholders based on ownership interests. Net losses are not allocated to preferred stockholders as they do not have an obligation to share in the Company’s net losses.\nDuring the three months ended March 31, 2021, the Company amended its certificate of incorporation to create two classes of common stock outstanding: Class A common stock and Class B common stock. As more fully described in Note 9, the rights of the holders of Class A and Class B common stock are identical, except with respect to voting and conversion. Each share of Class A common stock is entitled to one (1) vote per share and each share of Class B common stock is entitled to ten (10) votes per share. Each share of Class B common stock is convertible into one share of Class A common stock at the option\n11\nof the holder at any time. Shares of Class B common stock are automatically converted into Class A common stock upon sale or transfer, subject to certain limited exceptions. Shares of Class A common stock are not convertible. See Note 9 to these unaudited condensed consolidated financial statements for additional information regarding the current conversion and transfer terms of the Company’s common stock. The Company allocates undistributed earnings attributable to common stock between the common stock classes on a one to one basis when computing net income (loss) per share. As a result, basic and diluted net income (loss) per share of Class A common stock and share of Class B common stock are equivalent.\nDiluted net income (loss) per share gives effect to all potentially dilutive securities. Potential dilutive securities consist of shares of common stock issuable upon the exercise of stock options, shares of common stock issuable upon the conversion of the outstanding shares of Preferred Stock, and shares of common stock issuable upon the vesting of restricted stock awards or restricted stock units.\nFor the three months ended March 31, 2021, dilutive net income per share was calculated by dividing net income by the weighted-average number of shares of common stock outstanding during the period, the dilutive impact of stock options, shares of common stock issuable upon the vesting of RSUs, and the dilutive impact of shares issuable upon the conversion of the outstanding shares of Preferred Stock.\nFor the three months ended March 31, 2020, the net loss attributable to common stockholders is divided by the weighted-average number of shares of common stock outstanding during the period to calculate diluted earnings per share. The dilutive effect of common stock equivalents has been excluded from the calculation for the three months ended March 31, 2020 as their effect would have been anti-dilutive due to the net losses incurred for the period.\nThe following table presents a reconciliation of the weighted-average shares outstanding used in the calculation of basic and diluted net income (loss) per share:\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| Weighted-average shares outstanding: |\n| Weighted-average number of shares of common stock used in computing net income (loss) per share attributable to common stockholders—basic | 96,375,531 | 94,592,700 |\n| Dilutive effect of share equivalents resulting from stock options | 6,151,361 | — |\n| Dilutive effect of share equivalents resulting from RSAs | 123,841 | — |\n| Dilutive effect of shares issuable upon conversion of preferred stock | 28,705,360 | — |\n| Weighted-average number of shares of common stock used in computing net income (loss) per share attributable to common stockholders—diluted | 131,356,093 | 94,592,700 |\n\nThe following potentially dilutive common stock equivalents have been excluded from the calculation of diluted weighted-average shares outstanding for the three months ended March 31, 2021 and 2020:\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| Stock options outstanding | — | 6,286,357 |\n| Shares of Preferred Stock | — | 29,695,200 |\n| Restricted stock units outstanding | 1,733 | — |\n\n12\nComprehensive income (loss)\nComprehensive income (loss) is comprised of two components: net income (loss) and other comprehensive income (loss), which includes other changes in stockholders’ deficit that result from transactions and economic events other than those with stockholders. The Company had no items qualifying as other comprehensive income (loss) with the exception of an immaterial cumulative translation adjustment related to the Prowly entity and an immaterial fair-value adjustment related to the convertible note investments; accordingly, comprehensive income (loss) equaled total net loss for the three months ended March 31, 2021 and 2020.\nRecent Accounting Pronouncements\nIn February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). ASU 2016-02 requires a lessee to recognize most leases on the balance sheet but recognize expenses on the income statement in a manner similar to current practice. The update states that a lessee will recognize a lease liability for the obligation to make lease payments and a right-to-use asset for the right to use the underlying assets for the lease term. Leases will continue to be classified as either financing or operating, with classification affecting the recognition, measurement, and presentation of expenses and cash flows arising from a lease. For public entities, ASU 2016-02 is effective for years beginning after December 15, 2019. For non-public companies, ASU 2016-02 is effective for fiscal years beginning after December 15, 2021 and interim periods in annual periods beginning after December 15, 2022. Early adoption is permitted. The Company plans to adopt this guidance in the year ended December 31, 2022. The Company is currently assessing the impact that adopting this guidance will have on its consolidated financial statements.\nIn June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. ASU 2016-13 requires that credit losses be reported as an allowance using an expected losses model, representing the entity's current estimate of credit losses expected to be incurred. The accounting guidance currently in effect is based on an incurred loss model. ASU 2016-13 affect loans, debt securities, trade receivables, net investments in leases, off balance sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash. ASU 2016-13 is effective for public entities for annual reporting periods beginning after December 15, 2019, including interim periods within those fiscal years. For non-public companies, ASU 2016-13 is effective for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021. The Company plans to adopt this guidance in the year ended December 31, 2021. The Company is currently evaluating ASU 2016-13 and the potential impact on its condensed consolidated financial statements and financial statement disclosures.\nIn August 2018, the FASB issued ASU No. 2018-15, Intangible-Goodwill and Other Internal-Use Software (Subtopic 350-40). ASU 2018-15 updates guidance regarding accounting for implementation costs associated with a cloud computing arrangement that is a service contract. The amendments under ASU 2018-15 are effective for public entities for years beginning after December 15, 2019, and interim periods within those years. For non-public companies, ASU 2081-15 is effective for annual reporting periods beginning after December 15, 2020, and interim periods within annual periods beginning after December 15, 2021, with early adoption permitted. The Company plans to adopt this guidance in the year ended December 31, 2021. The Company is currently assessing the impact that adopting this guidance will have on its condensed consolidated financial statements.\nIn December 2019, the FASB issued ASU 2019-12, Income Taxes – Simplifying the Accounting for Income Taxes. The new guidance simplifies the accounting for income taxes by removing several exceptions in the current standard and adding guidance to reduce complexity in certain areas, such as requiring that an entity reflect the effect of an enacted change in tax laws or rates in the annual effective tax rate computation in the interim period that includes the enactment date. For public companies, the ASU is effective for years beginning after December 15, 2020, and interim periods within those years,\n13\nwith early adoption permitted. For non-public companies, the new standard is effective for years beginning after December 15, 2021, with early adoption permitted. The Company plans to adopt this guidance in the year ended December 31, 2021. The Company is currently assessing the impact that adopting this guidance will have on its condensed consolidated financial statements.\n3. Property and Equipment, Net\nProperty and equipment consists of the following (in thousands):\n| As of |\n| March 31,2021 | December 31,2020 |\n| Computer equipment | $ | 3,383 | $ | 3,513 |\n| Furniture and office equipment | 877 | 1,041 |\n| Leasehold improvements | 1,142 | 667 |\n| Capital leases | 1,024 | — |\n| Total property and equipment | 6,426 | 5,221 |\n| Less: accumulated depreciation and amortization | ( 2,550 ) | ( 2,253 ) |\n| Property and equipment, net | $ | 3,876 | $ | 2,968 |\n\nDepreciation and amortization expense related to property and equipment was $ 344 and $ 203 for the three months ended March 31, 2021 and 2020, respectively.\n4. Other Long-Term Assets\nDeferred Offering Costs\nDeferred offering costs, which primarily consist of direct incremental legal and accounting fees relating to the IPO and to a credit facility, are deferred. The deferred issuance costs relating to the IPO were offset against IPO proceeds upon the consummation of the Company’s offering. The deferred costs relating to the credit facility are being amortized to interest expense up through the maturity date of the facility. As of March 31, 2021 and December 31, 2020, the Company had deferred offering costs relating to the IPO of $ 0 and $ 1,839 . As of March 31, 2021 and December 31, 2020, the Company had $ 578 and $ 630 , respectively, in issuance costs relating to the credit facility. The issuance costs for the IPO and credit facility are classified in other long-term assets in the accompanying unaudited condensed consolidated balance sheets.\nInvestments in Convertible Debt\nIn January 2021, the Company purchased two convertible debt securities for a total aggregate investment of $ 500 . Both investments mature on January 1, 2023 and receive interest at an annual rate of 6 %. Interest accrues and becomes payable upon conversion of the convertible notes, or will be paid in connection with the repayment in full of the principal amount of such convertible notes.\nThese convertible note investments are classified as available-for-sale securities with changes in fair value reported in other comprehensive income (loss). Changes in fair value were not material for the three months ended March 31, 2021 due to the short time period between when the investment was made and the balance sheet date. These investments are classified in other long-term assets in the accompanying unaudited condensed consolidated balance sheets based on the maturity date.\n14\n5. Acquisitions, Acquired Intangible Assets, and Goodwill\nAcquisitions\nOn August 27, 2020, the Company acquired 100 % of the outstanding capital of Prowly for cash consideration of $ 3,317 . In addition to the purchase consideration, the founders of Prowly are eligible to earn up to a maximum of $ 2,750 in aggregate additional consideration based on the satisfaction of certain earnings targets as defined in the purchase agreement. For the three months ended March 31, 2021, the Company recognized compensation expense of $ 56 as compensation expense related to the additional consideration.\nIntangible Assets\nIntangible assets consisted of intangible assets resulting from the acquisition of Prowly and capitalized internal-use software development costs. Intangible assets consists of the following:\n| As of March 31, 2021 |\n| Gross | Net |\n| Carrying | Accumulated | Carrying |\n| Amount | Amortization | Amount |\n| Developed technology | 1,194 | ( 109 ) | 1,085 |\n| Trade name | 68 | ( 9 ) | 59 |\n| Capitalized internal-use software | 1,684 | ( 652 ) | 1,032 |\n| Total as of March 31, 2021 | $ | 2,946 | $ | ( 770 ) | $ | 2,176 |\n\n| As of December 31, 2020 |\n| Gross | Net |\n| Carrying | Accumulated | Carrying |\n| Amount | Amortization | Amount |\n| Developed technology | 1,194 | ( 66 ) | 1,128 |\n| Trade name | 68 | ( 3 ) | 65 |\n| Capitalized internal-use software | 1,561 | ( 523 ) | 1,038 |\n| Total as of December 31, 2020 | $ | 2,823 | $ | ( 592 ) | $ | 2,231 |\n\nDuring the three months ended March 31, 2021 and 2020, the Company capitalized $ 123 and $ 200 , respectively, of software development costs, which are classified as intangible assets on the accompanying consolidated balance sheets. The Company recorded amortization expense associated with its capitalized development costs of $ 129 and $ 52 for the three months ended March 31, 2021 and 2020, respectively. As of March 31, 2021 and December 31, 2020, the capitalized internal-use software asset balances totaled $ 1,032 and $ 1,038 , respectively.\nAmortization expense for acquired intangible assets was $ 55 for the three months ended March 31, 2021.\n15\nAs of March 31, 2021, future amortization expense is expected to be as follows:\n| Amount |\n| Remainder of 2021 | $ | 519 |\n| 2022 | 559 |\n| 2023 | 428 |\n| 2024 | 199 |\n| 2025 and thereafter | 471 |\n| Total | $ | 2,176 |\n\nGoodwill\nThe was no change in the carrying value of goodwill of $ 1,991 from December 31, 2020 through March 31, 2021.\n6. Accrued expenses\nAccrued expenses consist of the following:\n| As of |\n| March 31,2021 | December 31,2020 |\n| Employee compensation | $ | 4,776 | $ | 4,478 |\n| Vacation reserves | 464 | 465 |\n| Other current liabilities | 5,046 | 2,776 |\n| Total accrued expenses | $ | 10,286 | $ | 7,719 |\n\n7. Revolving Credit Facility\nSenior Secured Revolving Credit Facility\nOn January 12, 2021, the Company executed a credit agreement with JPMorgan Chase Bank, N.A., in the form of a revolving credit facility, that consists of a $ 45.0 million revolving credit facility and a letter of credit sub-facility with an aggregate limit equal to the lesser of $ 5.0 million and the aggregate unused amount of the revolving commitments then in effect. The availability of the credit facility is subject to the borrowing base based on an advance rate of 400 % multiplied by annualized retention applied to monthly recurring revenue. The credit facility has a maturity of three years and will mature on January 12, 2024.\nBorrowings under the credit facility bear interest at the Company’s option at (i) LIBOR, subject to a 0.50 % floor, plus a margin, or (ii) the alternate base rate, subject to a 3.25 % floor (or 1.50 % prior to positive consolidated adjusted earnings before interest, taxes, depreciation, and amortization (“adjusted EBITDA”) for the twelve months most recently ended), plus a margin. For LIBOR borrowings, the applicable rate margin is 2.75 % (or 3.50 % prior to positive consolidated adjusted EBITDA as of the twelve months most recently ended). For base rate borrowings, the applicable margin is 0.00 % (or 2.50 % prior to positive consolidated adjusted EBITDA as of the twelve months most recently ended). The Company is also required to pay a 0.25 % per annum fee on undrawn amounts under the Company’s revolving credit facility, payable quarterly in arrears.\n16\nAs of March 31, 2021, the Company has not drawn on this revolving credit facility. For the three months ended March 31, 2021, the Company incurred $ 53 in interest expense relating to this credit facility.\n8. Income Taxes\nWe are subject to U.S. federal, state, and foreign income taxes. For the three months ended March 31, 2021 and 2020, we recorded provisions for income taxes of $ 86 and $ 116 , respectively. Our effective tax rate for the three months ended March 31, 2021 and 2020 was lower than the U.S. statutory rate primarily due to the valuation allowance.\nWe recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities. These differences are measured using the enacted statutory tax rates that are expected to be in effect for the years in which differences are expected to reverse. On a periodic basis, we reassess any valuation allowances that we maintain on our deferred tax assets, weighing positive and negative evidence to assess the recoverability of the deferred tax assets. We will maintain a valuation allowance on certain federal, state, and foreign tax attributes that we expect will expire prior to the utilization.\nIn March 2020, the Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”) was signed into law. The CARES Act includes provisions relating to several aspects of corporate income taxes. We do not currently expect the CARES Act to have a significant impact on our provision for income taxes.\n9. Redeemable Convertible Preferred Stock and Stockholders’ Equity\nPrior to the IPO, the authorized capital stock of the Company included 9,898,400 shares of preferred stock, of which 3,379,400 shares have been designated as Series A Redeemable Convertible Preferred Stock, 1,837,600 shares have been designated as Series A-1 Redeemable Convertible Preferred Stock and 4,681,400 shares have been designated as Series B Convertible Preferred Stock (collectively the “Preferred Stock”).\nImmediately prior to the closing of the IPO, the outstanding shares of Preferred Stock were converted on a three -for-one basis into 29,695,200 shares of common stock. The holders of the Company’s Preferred Stock had certain voting, dividend, and redemption rights, as well as liquidation preferences and conversion privileges. All rights, preferences, and privileges associated with the preferred stock were terminated at the time of the Company’s IPO in conjunction with the conversion of all outstanding shares of Preferred Stock into shares of common stock.\nAs of March 31, 2021, the total number of shares of all classes of stock which the Company shall have authority to issue was (i) 1,000,000,000 shares of Class A common stock, par value $ 0.00001 per share, and (ii) 160,000,000 shares of Class B common stock, par value $ 0.00001 per share, and (iii) 100,000,000 undesignated shares of Preferred Stock, par value $ 0.00001 per share.\nEach share of Class A common stock entitles the holder to one vote for each share on all matters submitted to a vote of the Company's stockholders at all meetings of stockholders and written actions in lieu of meetings. Each share of Class B common stock entitles the holder to ten votes for each share on all matters submitted to a vote of the Company's stockholders at all meetings of stockholders and written actions in lieu of meetings.\nHolders of Class A common stock and Class B common stock are entitled to receive dividends, when and if declared by the board of directors (the “Board”).\n17\nEach share of Class B common stock is convertible into one share of Class A common stock at the option of the holder at any time. Automatic conversion shall occur upon the occurrence of (i) a Transfer, as defined in the amended and restated certificate of incorporation, of such share of Class B common stock, (ii) the affirmative vote of at least two-thirds of the outstanding shares of Class B common stock, voting as a single class, or (iii) on or after the earlier to occur of (a) the seventh year anniversary of the effectiveness of the amended and restated certificate of incorporation or (b) the date on which the outstanding shares of Class B common stock represents less than 10 % of the aggregate number of the then outstanding shares of Class A common stock and Class B common stock. Further, upon either the death or incapacitation of a holder of Class B common stock, the shares held by such shareholder shall automatically be converted into one share of Class A common stock.\nStock Split\nOn March 15, 2021, the Board approved a 3 -for-1 stock-split of the Company’s common stock. The stock split was approved by the stockholders on March 15, 2021 and became effective on March 15, 2021. Upon the effectiveness of the stock split, (i) every one share of common stock outstanding was increased to 3 shares of common stock, (ii) the number of shares of common stock into which each outstanding option to purchase common stock is exercisable was proportionally increased on a 3 -for-1 basis, and (iii) the exercise price of each outstanding option to purchase common stock was proportionately decreased on a 3 -for-1 basis. Additionally, shares of common stock reserved for issuance upon the conversion of the Company’s Preferred Stock were proportionately increased on a 3 -for-1 basis and the respective conversion prices of the Preferred Stock were proportionately reduced. All share and per share data shown in the accompanying consolidated financial statements and related notes have been retroactively revised to reflect the stock split.\nCommon Stock Reserved for Future Issuance\nAs of March 31, 2021, the Company had reserved the following shares of common stock for future issuance:\n| Options outstanding | 7,591,554 |\n| Options reserved for future issuance | 13,483,501 |\n| Restricted stock outstanding | 156,852 |\n| Restricted stock units | 19,500 |\n| Total authorized shares of common stock reserved for future issuance | 21,251,407 |\n\nn\n10. Stock-Based Compensation\nIn 2019, the Board adopted the Semrush Holdings, Inc. 2019 Stock Option and Grant Plan (the “2019 Plan”), which provides for the grant of qualified incentive stock options and nonqualified stock options or other awards, including restricted stock unit awards, to the Company’s employees, officers, directors, advisors, and outside consultants for the purchase of up to 8,682,600 shares of the Company’s common stock. In July 2020, the Plan was amended to provide for the grant of qualified incentive stock options and nonqualified stock options or other awards to the Company’s employees, officers, directors, advisors, and outside consultants for the purchase of up to 10,163,772 shares of the Company’s common stock. Stock options generally vest over a 4 year period and expire 10 years from the date of grant. Certain options provide for accelerated vesting if there is a change in control (as defined in the Plan).\nThe Semrush Holdings, Inc. 2021 Stock Option and Incentive Plan (the “2021 Plan”) was adopted by the Board March 3, 2021 and approved by stockholders on March 15, 2021 and became effective immediately prior to the effectiveness of the Company’s registration statement in connection with its IPO. The 2021 Plan replaced the 2019 Plan as the Board determined not to make additional awards under the\n18\n2019 Plan following the pricing of the Company’s IPO. The 2021 Plan allows the compensation committee of the Board to make equity-based and cash-based incentive awards to the Company’s officers, employees, directors and other key persons (including consultants).\nThe Company initially reserved 13,503,001 shares of Class A common stock for the issuance of awards under the 2021 Plan. The 2021 Plan provides that the number of shares reserved and available for issuance under the plan will automatically increase each January 1, beginning on January 1, 2022, by the lesser of 5 % of the outstanding number of shares of Class A and Class B common stock on the immediately preceding December 31, or such lesser number of shares as determined by the compensation committee. This number is subject to adjustment in the event of a stock split, stock dividend or other change in our capitalization.\nThe Company accounts for stock-based compensation in accordance with the provisions of ASC 718, which requires the recognition of expense related to the fair value of stock-based compensation awards in the statements of operations. For stock-based awards issued under the Company’s stock-based compensation plans to employees and members of the Board for their services on the Board, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model as discussed further below. For service-based awards, the Company recognizes compensation expense on a straight-line basis over the requisite service period of the award with actual forfeitures recognized as they occur.\nGiven the absence of an active market for the Company’s common stock prior to the completion of the IPO, the Board, the members of which the Company believes have extensive business, finance, and venture capital experience, were required to estimate the fair value of the Company’s common stock at the time of each grant of a stock-based award. The Company and the Board utilized various valuation methodologies in accordance with the framework of the American Institute of Certified Public Accountants’ Technical Practice Aid, Valuation of Privately-Held Company Equity Securities Issued as Compensation, to estimate the fair value of its common stock. Each valuation methodology included estimates and assumptions that require the Company’s judgment. These estimates and assumptions include a number of objective and subjective factors, in determining the value of the Company’s common stock at each grant date, including the following factors: (1) prices paid for the Company’s Preferred Stock, which the Company had sold to outside investors in arm’s-length transactions, and the rights, preferences, and privileges of the Company’s Preferred Stock and common stock; (2) valuations performed by an independent valuation specialist; (3) the Company’s stage of development and revenue growth; (4) the fact that the grants of stock-based awards involved illiquid securities in a private company; and (5) the likelihood of achieving a liquidity event for the common stock underlying the stock-based awards, such as an IPO or sale of the Company, given prevailing market conditions.\nThe Company believes this methodology to be reasonable based upon the Company’s internal peer company analyses, and further supported by several arm’s-length transactions involving the Company’s Preferred Stock. As the Company’s common stock is not actively traded, the determination of fair value involves assumptions, judgments, and estimates. If different assumptions were made, stock-based compensation expense, consolidated net income (loss) and consolidated net income (loss) per share could have been significantly different.\nThe Company has recorded stock-based compensation expense for stock options of $ 593 and $ 205 during the three months ended March 31, 2021 and 2020, respectively. The following table shows stock-\n19\nbased compensation expense by where the stock-based compensation expense is recorded in the Company’s unaudited condensed consolidated statement of operations:\n| For the Three Months EndedMarch 31, |\n| 2021 | 2020 |\n| Cost of revenue | $ | 7 | $ | 5 |\n| Sales and marketing | 190 | 27 |\n| Research and development | 67 | 29 |\n| General and administrative | 329 | 144 |\n| Total stock-based compensation | $ | 593 | $ | 205 |\n\nAs of March 31, 2021, there was $ 5,024 of unrecognized compensation cost related to unvested common stock option arrangements granted under the 2021 Plan, which is expected to be recognized over a weighted-average period of 3.12 years.\nThe fair value of each option award was estimated on the date of grant using the Black-Scholes option-pricing model. As there was no public market for its common stock prior to March 25, 2021, which was the first day of trading, and as the trading history of the Company’s common stock was limited through March 31, 2021, the Company determined the expected volatility for options granted based on an analysis of reported data for a peer group of companies that issued options with substantially similar terms. The expected volatility of options granted has been determined using an average of the historical volatility measures of this peer group of companies. The expected life of options granted to employees was calculated using the simplified method, which represents the average of the contractual term of the option and the weighted-average vesting period of the option. The Company uses the simplified method because it does not have sufficient historical option exercise data to provide a reasonable basis upon which to estimate expected term. The risk-free interest rate is based on a treasury instrument whose term is consistent with the expected life of the share option. The Company has not paid, nor anticipates paying, cash dividends on its ordinary shares; therefore, the expected dividend yield is assumed to be zero .\n20\nThe weighted-average assumptions utilized to determine the fair value of options granted to employees are presented in the following table:\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| Expected volatility | 52.0 | % | 46.7 | % |\n| Weighted-average risk-free interest rate | 0.58 | % | 1.46 | % |\n| Expected dividend yield | — | — |\n| Expected life – in years | 6 | 6 |\n\nA summary of the Company’s option activity as of March 31, 2021, which all occurred under the Semrush Holdings, Inc. Amended and Restated 2019 Stock Option and Grant Plan (the “2019 Plan”), and changes during the three months then ended are as follows:\n| Number of Options | Weighted-Average Exercise Price (per share) | Weighted-Average Remaining Contractual Term (in years) |\n| Outstanding at December 31, 2020 | 7,611,258 | $ | 1.37 | 8.40 |\n| Granted | 34,500 | 6.21 |\n| Exercised | ( 3,861 ) | 1.35 |\n| Forfeited | ( 50,343 ) | 2.00 |\n| Outstanding at March 31, 2021 | 7,591,554 | 1.39 | 8.28 |\n| Options exercisable at March 31, 2021 | 3,309,264 | 0.94 | 7.60 |\n\nThe weighted-average grant-date fair value of options granted during the three months ended March 31, 2021 and 2020 was $ 9.09 and $ 1.70 per share, respectively. No tax benefits were realized from options during the three months ended March 31, 2021.\nThe aggregate intrinsic value of options outstanding as of March 31, 2021 and December 31, 2020 was $ 79,858 and $ 36,816 , respectively.\nThe aggregate intrinsic value for options exercised during the three months ended March 31, 2021 was $ 19 . No options were exercised for the three months ended March 31,2020.\nThe aggregate intrinsic value for options exercisable as of March 31, 2021 was $ 36,313 .\nThe aggregate intrinsic value was calculated based on the positive difference, if any, between the estimated fair value of the Company’s common stock on March 31, 2021 and December 31, 2020, respectively, or the date of exercise, as appropriate, and the exercise price of the underlying options.\nOn July 28, 2020, the Company issued 156,852 shares of its restricted common stock (“Restricted Stock Issuance”) to the founders of Prowly for a total fair value of $ 291 under the 2019 Plan. This Restricted Stock Issuance vests over a three-year service period, applicable to both founders. On March 3, 2021, the Company granted, to an employee, a restricted stock unit award for 19,500 shares of Class A common stock under the 2021 Plan.\n2021 Employee Stock Purchase Plan\nThe Semrush Holdings, Inc. 2021 Employee Stock Purchase Plan (the “ESPP”) was adopted by the Board on March 3, 2021 and approved by stockholders on March 15, 2021 and became effective\n21\nimmediately prior to the effectiveness of the Company’s registration statement in connection with its IPO. The ESPP initially reserves and authorizes the issuance of up to a total of 3,000,667 shares of Class A common stock to participating employees. The ESPP provides that the number of shares reserved and available for issuance will automatically increase each January 1, beginning on January 1, 2022 and each January 1 thereafter through January 1, 2031, by the least of (i) 1 % of the outstanding number of shares of Class A and Class B common stock on the immediately preceding December 31; (ii) 3,000,667 shares or (iii) such lesser number of shares of Class A common stock as determined by the ESPP administrator. The number of shares reserved under the ESPP is subject to adjustment in the event of a stock split, stock dividend or other change in our capitalization. The Company expects to offer, sell and issue shares of common stock under the ESPP from time to time based on various factors and conditions, although the Company is under no obligation to sell any shares under the ESPP. The Company has not issued any shares of Class A common stock under the ESPP.\n11. Commitments and Contingencies\nThe Company leases office facilities under noncancelable operating leases that expire at various dates through 2024. In addition, the Company has multi-year commitments with data centers. Some of these lease agreements contain escalating rent payments. Rent expense is recorded on a straight-line basis. Rent expense was $ 928 and $ 1,086 for the three months ended March 31, 2021 and 2020, respectively. The Company also has non-cancelable commitments related to its data centers.\nFuture minimum amounts payable as of March 31, 2021, under the office facilities operating leases and data center agreements are as follows:\n| Operating Leases |\n| Remainder of 2021 | $ | 3,070 |\n| 2022 | 3,109 |\n| 2023 | 1,515 |\n| 2024 | 459 |\n| 2025 and thereafter | — |\n| Total minimum lease payments | $ | 8,153 |\n\nDuring the year ended December 31, 2020, the Company entered into leasing arrangements for certain data center equipment under non-cancelable capital leases. The leasing arrangements have terms of 36 months beginning on the date the Company accepts the installation of the equipment subject to the lease. As of December 31, 2020, the equipment had not been installed and the Company had not accepted the equipment under these leases, and as such the lease commencement date had not begun. During the three months ended March 31, 2021, a portion of the equipment was installed and the related lease commenced. The Company is required to make total payments of $ 6,045 over the term of the leases which is excluded from the table above. The Company recorded $ 1,024 in capital leases to property and equipment, net, as of March 31, 2021 (see Note 3), which is being depreciated over the lease term of 36 months. The $ 1,024 of capital leases represents the total balance of other-long term liabilities on the unaudited condensed consolidated balance sheet as of March 31, 2021.\nIn addition to the lease commitments above, the Company also has multi-year commitments with certain data providers. The Company is committed to spend approximately $ 4,124 , $ 6,776 , and $ 1,933 for the remainder of the year ending December 31, 2021, and for the years ending December 31, 2022, and 2023, respectively, for data services.\n22\nLitigation\nThe Company, from time to time, may be party to litigation arising in the ordinary course of its business. The Company was not subject to any material legal proceedings during the three months ended March 31, 2021, and, to the best of its knowledge, no material legal proceedings are currently pending or threatened.\nIndemnification\nThe Company typically enters into indemnification agreements with customers in the ordinary course of business. Pursuant to these agreements, the Company indemnifies and agrees to reimburse the indemnified party for losses suffered or incurred as a result of claims of intellectual property infringement. These indemnification agreements are provisions of the applicable customer agreement. Based on when clients first sign an agreement for the Company’s service, the maximum potential amount of future payments the Company could be required to make under certain of these indemnification agreements is unlimited. Based on historical experience and information known as of March 31, 2021, the Company has not incurred any costs for the above guarantees and indemnities.\nIn certain circumstances, the Company warrants that its services will perform in all material respects in accordance with its standard published specification documentation in effect at the time of delivery of the services to the customer for the term of the agreement. To date, the Company has not incurred significant expense under its warranties and, as a result, the Company believes the estimated fair value of these agreements is immaterial.\n12. Components of Other Income, Net\nThe components of other income, net, are as follows:\n| For the Three Months EndedMarch 31, |\n| 2021 | 2020 |\n| Foreign currency exchange gain (loss) | 44 | ( 107 ) |\n| Other, net | 7 | 163 |\n| Other income, net | $ | 51 | $ | 56 |\n\n13. Employee Benefit Plan\nThe Company maintains a defined contribution savings plan under Section 401(k) of the Internal Revenue Code (the “401(k) Plan”) covering all U.S. employees who satisfy certain eligibility requirements. The 401(k) Plan allows each participant to defer a percentage of their eligible compensation subject to applicable annual limits pursuant to the limits established by the Internal Revenue Service. The Company may, at the discretion of the Board, make contributions in the form of matching contributions or profit-sharing contributions. For the three months ended March 31, 2021 and 2020, the Company made matching contributions of $ 90 and $ 34 , respectively, to the 401(k) Plan.\n14. Segment and Geographic Information\nDisclosure requirements about segments of an enterprise and related information establishes standards for reporting information regarding operating segments in annual financial statements and requires selected information of those segments to be presented in interim financial reports issued to shareholders. Operating segments are defined as components of an enterprise about which separate discrete financial information is available that is evaluated regularly by the chief operating decision maker,\n23\nor decision-making group, in deciding how to allocate resources and in assessing performance. The Company’s chief operating decision maker is the chief executive officer. The Company and the chief executive officer view the Company’s operations and manage its business as one operating segment.\nGeographic Data\nThe Company allocates, for the purpose of geographic data reporting, its revenue based upon the location of the customer. Total revenue by geographic area was as follows:\n| For the Three Months EndedMarch 31, |\n| 2021 | 2020 |\n| Revenue: |\n| United States | $ | 18,132 | $ | 12,886 |\n| United Kingdom | 4,195 | 2,994 |\n| Other | 17,671 | 11,907 |\n| Total revenue | $ | 39,998 | $ | 27,787 |\n\nProperty and equipment, net by geographic location consists of the following:\n| As of |\n| March 31,2021 | December 31,2020 |\n| Property and equipment, net: |\n| United States | $ | 2,020 | $ | 1,023 |\n| Russia | 1,360 | 1,450 |\n| Czech Republic | 440 | 439 |\n| Other | 56 | 56 |\n| Total assets | $ | 3,876 | $ | 2,968 |\n\n15. Subsequent Events\nThe Company has completed an evaluation of all subsequent events after the balance sheet date of March 31, 2021 through the date this Quarterly Report on Form 10-Q was filed with the SEC, to ensure that this filing includes appropriate disclosure of events both recognized in the financial statements as of March 31, 2021, and events which occurred subsequently but were not recognized in the financial statements. The Company has concluded that no subsequent events have occurred that require disclosure, except as disclosed within these financial statements and except as disclosed below.\nExercise of Overallotment Option\nOn April 20, 2021, the underwriters of the Company’s IPO partially exercised their option to purchase additional shares of Class A common stock. In connection with the closing of the partial exercise on April 23, 2021, the underwriters purchased 719,266 shares of the Company’s Class A common stock for net proceeds to the Company of $ 9.4 million.\n24\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nYou should read the following discussion and analysis of our financial condition and results of operations together with the unaudited condensed consolidated financial statements, and related notes that are included elsewhere in this Quarterly Report on Form 10-Q, along with the financial information included in our prospectus dated March 24, 2021 (the “Prospectus”) as filed with the Securities Exchange Commission (the “SEC”) on March 25, 2021 pursuant to Rule 424(b) under the Securities Act of 1933, as amended (the “Securities Act”). Some of the information contained in this discussion and analysis, including information with respect to our planned investments in our research and development, sales and marketing, and general and administrative functions, contains forward-looking statements based upon current plans, beliefs, and expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under the sections titled “Special Note Regarding Forward-Looking Statements” and “Risk Factors” included elsewhere in this Quarterly Report on Form 10-Q.\nSPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS\nThis Quarterly Report on Form 10-Q contains forward-looking statements about Semrush Holdings, Inc. (“Semrush Holdings”) and our subsidiaries (collectively, the “Group”, the “Company”, “Semrush”, “we”, “us”, or “our”) and our industry that involve substantial risks and uncertainties. All statements other than statements of historical facts contained in this Quarterly Report on Form 10-Q, including statements regarding our future results of operations, financial condition, business strategy and plans and objectives of management for future operations, are forward-looking statements. In some cases, you can identify forward-looking statements because they contain words such as “anticipate,” “believe,” “contemplate,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “predict,” “project,” “should,” “target,” “will,” or “would,” or the negative of these words or other similar terms or expressions. Forward-looking statements contained in this Quarterly Report on Form 10-Q include, but are not limited to, statements about:\n•our future financial performance, including our revenue, annual recurring revenue (“ARR”), costs of revenue, gross profit or gross margin and operating expenses;\n•the sufficiency of our cash and cash equivalents to meet our liquidity needs;\n•anticipated trends and growth rates in our business and in the markets in which we operate;\n•our ability to maintain the security and availability of our internal networks and platform;\n•our ability to attract new paying customers and convert free customers into paying customers;\n•our ability to retain and expand sales to our existing paying customers, including upgrades to premium subscriptions, purchases of add-on offerings, and increasing the number of authorized users per paying customer;\n•our ability to access, collect, and analyze data;\n•our ability to successfully expand in our existing markets and into new markets;\n•our ability to effectively manage our growth and future expenses;\n•our ability to continue to innovate and develop new products and features, improve our data assets, and enhance our technological capabilities;\n•our estimated total addressable market;\n25\n•our ability to maintain, protect, and enhance our intellectual property;\n•our ability to comply with modified or new laws and regulations applying to our business;\n•the attraction and retention of qualified employees and key personnel;\n•our anticipated investments in sales and marketing, and research and development;\n•our ability to successfully defend litigation brought against us;\n•our ability to successfully acquire and integrate companies and assets;\n•the increased expenses associated with being a public company;\n•our use of the net proceeds from our initial public offering (“IPO”); and\n•the impact of the novel strain of coronavirus (“COVID-19”) on our business and industry.\nYou should not rely upon forward-looking statements as predictions of future events. We have based the forward-looking statements contained in this Quarterly Report on Form 10-Q primarily on our current expectations and projections about future events and trends that we believe may affect our business, financial condition, results of operations and prospects. The outcome of the events described in these forward-looking statements is subject to risks, uncertainties, and other factors described in the section titled “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q. Moreover, we operate in a very competitive and rapidly changing environment. New risks and uncertainties emerge from time to time, and it is not possible for us to predict all risks and uncertainties that could have an impact on the forward-looking statements contained in this Quarterly Report on Form 10-Q. The results, events, and circumstances reflected in the forward-looking statements may not be achieved or occur, and actual results, events, or circumstances could differ materially from those described in the forward-looking statements.\nThe forward-looking statements made in this Quarterly Report on Form 10-Q relate only to events as of the date on which the statements are made. We undertake no obligation to update any forward-looking statements made in this Quarterly Report on Form 10-Q to reflect events or circumstances after the date of this Quarterly Report on Form 10-Q or to reflect new information or the occurrence of unanticipated events, except as required by law. We may not actually achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. Our forward-looking statements do not reflect the potential impact of any future acquisitions, mergers, dispositions, joint ventures or investments we may make.\nIn addition, statements that “we believe” and similar statements reflect our beliefs and opinions on the relevant subject. These statements are based upon information available to us as of the date of this Quarterly Report on Form 10-Q, and while we believe such information forms a reasonable basis for such statements, such information may be limited or incomplete, and our statements should not be read to indicate that we have conducted an exhaustive inquiry into, or review of, all potentially available relevant information. These statements are inherently uncertain and you are cautioned not to unduly rely upon these statements.\nCompany Overview\nWe are a leading online visibility management software-as-a-service (“SaaS”) platform, enabling companies globally to identify and reach the right audience in the right context and through the right channels. Online visibility represents how effectively companies connect with consumers across a variety of digital channels, including search, social and digital media, digital public relations, and review websites.\n26\nOur proprietary SaaS platform enables us to aggregate and enrich trillions of data points collected from hundreds of millions of unique domains, social media platforms, online ads, and web traffic. This allows our customers to understand trends, derive unique and actionable insights to improve their websites and social media pages, and distribute highly relevant content to their targeted customers across channels to drive high-quality traffic.\nOn March 29, 2021, we completed our IPO in which we issued and sold 10,000,000 shares of our Class A common stock at a public offering price of $14.00 per share for aggregate gross proceeds of $140.0 million. We received approximately $126.6 million in net proceeds after deducting $9.8 million of underwriting discounts and commissions and approximately $3.6 million in offering costs. In connection with the closing of the IPO, all of the outstanding shares of our Preferred Stock and Common Stock automatically converted into 124,905,954 shares of Class B common stock.\nWe generate substantially all of our revenue from monthly and annual subscriptions to our online visibility management platform under a SaaS model. Subscription revenue is recognized ratably over the contract term beginning on the date the product is made available to customers.\nWe have one reportable segment. See Note 14 of our Unaudited Condensed Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q for more information.\nKey Factors Affecting Our Performance\nWe regularly review a number of factors that have impacted, and we believe will continue to impact, our results of operations and growth. These factors include:\nAcquiring New Paying Customers\nWe expect increasing demand for third-party online visibility software to accelerate adoption of our platform. Our recurring subscription model provides significant visibility into our future results and we believe ARR is the best indicator of the scale of our platform, while mitigating fluctuations due to seasonality and contract term. We define ARR as the daily revenue of all paid subscription agreements that are actively generating revenue as of the last day of the reporting period multiplied by 365. We include both monthly recurring paid subscriptions, which renew automatically unless cancelled, as well as the annual recurring paid subscriptions so long as we do not have any indication that a customer has cancelled or intends to cancel its subscription and we continue to generate revenue from them. As of March 31, 2021 and 2020, we had more than 72,000 paying customers and 56,000 paying customers, respectively, accounting for $167.6 million and $109.5 million in ARR, respectively.\nRetaining and Expanding Sales to Our Existing Customers\nWe serve a diverse customer base across a variety of sizes and industries that is focused on maximizing their online visibility. We believe there is a significant opportunity to expand within our existing customer base as customers often initially purchase our entry-level subscription, which offers lower usage limits and limited user licenses, as well as fewer features. We have demonstrated the ability to expand contract values with our existing customers as they use our products and recognize the critical nature of our platform and often seek premium offerings through incremental usage, features, add-ons, and additional user licenses.\nWe have successfully increased ARR per paying customer over time and believe this metric is an indicator of our ability to grow the long-term value of our platform. We expect ARR per paying customer to continue to increase as customers adopt our premium offerings and we continue to introduce new products and functionality. Our ARR per paying customer as of March 31, 2021 and 2020 was $2,274 and $1,942, respectively. We define ARR per paying customer during a given period as ARR from our paying customers at the end of the period divided by the number of paying customers as of the end of the same\n27\nperiod. We define the number of paying customers as the number of unique business and individual customers at the end of a particular period. We define a business customer as all accounts that contain a common non-individual business email domain (e.g., all subscriptions with an email domain of @XYZ.com will be considered to be one customer), and an individual customer as an account that uses an individual non-business email domain.\nSustaining Product and Technology Innovation\nWe have a strong track record of developing new products that have high adoption rates among our paying customers. Our product development organization plays a critical role in continuing to enhance the effectiveness and differentiation of our technology in an evolving landscape and maximizing retention of our existing customers. We intend to continue investing in product development to improve our data assets, expand our products and enhance our technological capabilities.\nNon-GAAP Financial Measures\nIn addition to our financial results determined in accordance with U.S. generally accepted accounting principles (“GAAP”), we believe that free cash flow and free cash flow margin, each a non-GAAP financial measure, are useful in evaluating the performance of our business.\nFree cash flow and free cash flow margin\nWe define free cash flow, a non-GAAP financial measure, as net cash provided by operating activities less purchases of property and equipment and capitalized software development costs. We define free cash flow margin as free cash flow divided by total revenue. We monitor free cash flow and free cash flow margin as two measures of our overall business performance, which enables us to analyze our future performance without the effects of non-cash items and allow us to better understand the cash needs of our business. While we believe that free cash flow and free cash flow margin are useful in evaluating our business, free cash flow and free cash flow margin are each a non-GAAP financial measure that have limitations as an analytical tool, and free cash flow and free cash flow margin should not be considered as an alternative to, or substitute for, net cash used in operating activities in accordance with GAAP. The utility of each of free cash flow and free cash flow margin as a measure of our liquidity is further limited as each measure does not represent the total increase or decrease in our cash balance for any given period. In addition, other companies, including companies in our industry, may calculate free cash flow and free cash flow margin differently or not at all, which reduces the usefulness of free cash flow and free cash flow margin as tool for comparison. A summary of our cash flows from operating, investing and financing activities is provided below. We recommend that you review the reconciliation of free cash flow to net cash used in operating activities, the most directly comparable GAAP financial measure, and the reconciliation of free cash flow margin to net cash used in operating activities (as a percentage of revenue), the most directly comparable GAAP financial measure, provided below, and that you not rely on free cash flow, free cash flow margin or any single financial measure to evaluate our business.\n| Three Months Ended March 31,(in thousands) |\n| 2021 | 2020 |\n| Net cash provided by operating activities | $ | 9,007 | $ | 561 |\n| Net cash used in investing activities | (1,139) | (1,381) |\n| Net cash provided by (used in) financing activities | 128,468 | (16) |\n| Net increase (decrease) in cash, cash equivalents and restricted cash | $ | 136,336 | (836) |\n\n28\n| Three Months Ended March 31,(in thousands) |\n| 2021 | 2020 |\n| Net cash provided by operating activities | $ | 9,007 | $ | 561 |\n| Purchases of property and equipment | (166) | (1,084) |\n| Capitalization of internal-use software costs | (123) | (297) |\n| Free cash flow | $ | 8,718 | $ | (820) |\n\n| Three Months Ended March 31,(in thousands) |\n| 2021 | 2020 |\n| Net cash provided by operating activities (as a percentage of revenue) | 22.5 | % | 2.0 | % |\n| Purchases of property and equipment (as a percentage of revenue) | (0.4) | % | (3.9) | % |\n| Capitalization of internal-use software costs (as a percentage of revenue) | (0.3) | % | (1.1) | % |\n| Free cash flow margin | 21.8 | % | (3.0) | % |\n\nComponents of our Results of Operations\nRevenue\nWe generate nearly all of our revenue from subscriptions to our online visibility management platform under a SaaS model. Subscription revenue is recognized ratably over the contract term beginning on the date on which we provide the customer access to our platform. Our customers do not have the right to take possession of our software. Our subscriptions are generally non-cancellable during the contractual subscription term, however our subscription contracts contain a right to a refund if requested within seven days of purchase.\nWe offer our paid products to customers via monthly or annual subscription plans, as well as one-time and ongoing add-ons. As of March 31, 2021 and 2020, approximately 77% and 76%, respectively, of our paying customers purchased monthly subscription plans. Our subscription-based model enables customers to select a plan based on their needs and license our platform on a per user per month basis.\nAs of March 31, 2021, we served approximately 72,000 paying customers in various industries, and our revenue is not concentrated with any single customer or industry. For the three months ended March 31, 2021 and 2020, no single customer accounted for more than 1% of our revenue.\nCost of Revenue\nCost of revenue primarily consists of expenses related to hosting our platform, acquiring data, and providing support to our customers. These expenses are comprised of personnel and related costs, including salaries, benefits, incentive compensation, and stock-based compensation expense related to the management of our data centers, our customer support team and our customer success team, and data acquisition costs. In addition to these expenses, we incur third-party service provider costs, such as data center and networking expenses, allocated overhead costs, depreciation expense and amortization associated with the Company’s property and equipment, and amortization of capitalized software development costs and other intangible assets. We allocate overhead costs, such as rent and facility costs, information technology costs, and employee benefit costs to all departments based on headcount. As such, general overhead expenses are reflected in cost of revenue and each operating expense category.\n29\nWe expect our cost of revenue to increase in absolute dollars due to expenditures related to the purchase of hardware, data, expansion, and support of our data center operations and customer support teams. We also expect that cost of revenue as a percentage of revenue will decrease over time as we are able to achieve economies of scale in our business, although it may fluctuate from period to period depending on the timing of significant expenditures. To the extent that our customer base grows, we intend to continue to invest additional resources in expanding the delivery capability of our products and other services. The timing of these additional expenses could affect our cost of revenue, both in terms of absolute dollars and as a percentage of revenue in any particular quarterly or annual period.\nOperating Expenses\nResearch and Development\nResearch and development expenses primarily consist of personnel and related costs, including salaries, benefits, incentive compensation, stock-based compensation, and allocated overhead costs. Research and development expenses also include depreciation expense and other expenses associated with product development. Other than internal-use software costs that qualify for capitalization, research and development costs are expensed as incurred. We plan to increase the dollar amount of our investment in research and development for the foreseeable future as we focus on developing new products, features, and enhancements to our platform. We believe that investing in the development of new products, features, and enhancements improves customer experience, makes our platform more attractive to new paying customers and provides us with opportunities to expand sales to existing paying customers and convert free customers to paying customers. However, we expect our research and development expenses to decrease as a percentage of our revenue over time.\nSales and Marketing\nSales and marketing expenses primarily consist of personnel and related costs directly associated with our sales and marketing department, including salaries, benefits, incentive compensation, and stock-based compensation, online advertising expenses, and marketing and promotional expenses, as well as allocated overhead costs. We expense all costs as they are incurred, excluding sales commissions identified as incremental costs to obtain a contract, which are capitalized and amortized on a straight-line basis over the average period of benefit, which we estimate to be two years. We expect that our sales and marketing expenses will continue to increase in absolute dollars in the year ending December 31, 2021. New sales personnel require training and may take several months or more to achieve productivity; as such, the costs we incur in connection with the hiring of new sales personnel in a given period are not typically offset by increased revenue in that period and may not result in new revenue if these sales personnel fail to become productive. We expect to increase our investment in sales and marketing as we add new services, which will increase these expenses in absolute dollars. Over the long term, we believe that sales and marketing expenses as a percentage of revenue will vary depending upon the mix of revenue from new and existing customers, as well as changes in the productivity of our sales and marketing programs.\nGeneral and Administrative\nGeneral and administrative expenses primarily consist of personnel and related expenses, including salaries, benefits, incentive compensation, and stock-based compensation, associated with our finance, legal, human resources, and other administrative employees. Our general and administrative expenses also include professional fees for external legal, accounting, and other consulting services, insurance, depreciation and amortization expense, as well as allocated overhead. We expect to increase the size of our general and administrative functions to support the growth of our business. We expect to continue to incur additional expenses as a result of operating as a public company, including costs to comply with rules and regulations applicable to companies listed on a U.S. securities exchange, costs related to compliance and reporting obligations pursuant to the rules and regulations of the SEC, increases in\n30\ninsurance premiums, investor relations and professional services. We expect the dollar amount of our general and administrative expenses to increase for the foreseeable future. However, we expect our general and administrative expenses to decrease as a percentage of revenue over time.\nOther Income, Net\nIncluded in other income, net are foreign currency transaction gains and losses. The functional currency of our international operations is the U.S. dollar except for Prowly, which is Polish Zloty. Any differences resulting from the re-measurement of assets and liabilities denominated in a currency other than the functional currency are recorded within other income, net. We expect our foreign currency exchange gains and losses to continue to fluctuate in the future as foreign currency exchange rates change.\nOther income, net also includes amounts for other miscellaneous income and expense unrelated to our core operations.\nIncome Tax Provision\nWe operate in several tax jurisdictions and are subject to taxes in each country or jurisdiction in which we conduct business. We account for income taxes in accordance with the asset and liability method. Under this method, deferred tax assets and liabilities are recognized based on temporary differences between the financial reporting and income tax bases of assets and liabilities using statutory rates. In addition, this method requires a valuation allowance against net deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. To date, we have incurred cumulative net losses and maintain a full valuation allowance on our net deferred tax assets. We expect this trend to continue for the foreseeable future. Our tax expense for the three months ended March 31, 2021 and 2020 primarily relates to income earned in certain foreign jurisdictions.\nResults of Operations\nThe following tables set forth information comparing our results of operations in dollars and as a percentage of total revenue for the periods presented. The period-to-period comparison of results is not necessarily indicative of results for future periods.\n31\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (in thousands) |\n| Revenue | $ | 39,998 | $ | 27,787 |\n| Cost of revenue (1) | 8,773 | 6,611 |\n| Gross profit | 31,225 | 21,176 |\n| Operating expenses |\n| Sales and marketing (1) | 16,457 | 12,877 |\n| Research and development (1) | 5,358 | 4,237 |\n| General and administrative (1) | 7,904 | 5,933 |\n| Total operating expenses | 29,719 | 23,047 |\n| Income (loss) from operations | 1,506 | (1,871) |\n| Other income, net | 51 | 56 |\n| Income (loss) before income taxes | 1,557 | (1,815) |\n| Provision for income taxes | 86 | 116 |\n| Net income (loss) | $ | 1,471 | $ | (1,931) |\n\n__________________\n(1)Includes stock-based compensation expense as follows:\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (in thousands) |\n| Cost of revenue | $ | 7 | $ | 5 |\n| Sales and marketing | 190 | 27 |\n| Research and development | 67 | 29 |\n| General and administrative | 329 | 144 |\n| Total stock-based compensation | $ | 593 | $ | 205 |\n\n32\nThe following table sets forth our unaudited condensed consolidated statements of operations data expressed as a percentage of revenue for the periods indicated:\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (as a percentage of total revenue) |\n| Revenue | 100 | % | 100 | % |\n| Cost of revenue | 22 | % | 24 | % |\n| Gross profit | 78 | % | 76 | % |\n| Operating expenses |\n| Sales and marketing | 41 | % | 46 | % |\n| Research and development | 13 | % | 15 | % |\n| General and administrative | 20 | % | 22 | % |\n| Total operating expenses | 74 | % | 83 | % |\n| Income (loss) from operations | 4 | % | (6) | % |\n| Other income, net | — | % | — | % |\n| Income (loss) before income taxes | 4 | % | (6) | % |\n| Provision for income taxes | — | % | — | % |\n| Net income (loss) | 4 | % | (6) | % |\n\nComparison of the Three Months Ended March 31, 2021 and 2020\nRevenue\nOur revenue during the three months ended March 31, 2021 and 2020 was as follows:\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Revenue | $ | 39,998 | 27,787 | $ | 12,211 | 44 | % |\n\nRevenue increased in all regions and was most pronounced in the United States. The majority of this increase was driven by an increase in the number of paying customers from 56,000 as of March 31, 2020 to 72,000 as of March 31, 2021. The net income for the three months ended March 31, 2021 was partially driven by an increase in the subscription price of our core product.\n33\nThe locations of our paying customers during the three months ended March 31, 2021 and 2020 were as follows:\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (in thousands) |\n| Revenue: |\n| United States | $ | 18,132 | $ | 12,886 |\n| United Kingdom | 4,195 | 2,994 |\n| Other | 17,671 | 11,907 |\n| Total revenue | $ | 39,998 | $ | 27,787 |\n\nCost of Revenue, Gross Profit and Gross Margin\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Cost of revenue | $ | 8,773 | $ | 6,611 | $ | 2,162 | 33 | % |\n| Gross profit | $ | 31,225 | $ | 21,176 | $ | 10,049 | 47 | % |\n| Gross margin | 78.1 | % | 76.2 | % |\n\nThe increase in cost of revenue for the three months ended March 31, 2021 compared to the three months ended March 31, 2020 was primarily due to the following changes:\n| Change |\n| (in thousands) |\n| Hosting fees | $ | 446 |\n| Integration and data costs | 787 |\n| Merchant fees | 309 |\n| Other | 620 |\n| Cost of revenue | $ | 2,162 |\n\nHosting fees increased, driven by the additional costs associated with our growth in subscription revenue and the additional costs associated with expanding our relationships with our current paying subscribers. Integration and data costs increased primarily as a result of increasing costs incurred related to new products and customer growth. Merchant fees increased commensurate with sales growth. Other costs increased primarily as a result of a 95% increase in headcount as we continue to grow our customer support and customer success teams to support our customer growth.\n34\nOperating Expenses\nSales and Marketing\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Sales and marketing | $ | 16,457 | $ | 12,877 | $ | 3,580 | 28 | % |\n| Percentage of total revenue | 41 | % | 46 | % |\n\nThe increase in sales and marketing expense for the three months ended March 31, 2021 compared to the three months ended March 31, 2020 was primarily due to the following:\n| Change |\n| (in thousands) |\n| Personnel costs | $ | 2,156 |\n| Advertising expense | 1,503 |\n| Other | (79) |\n| Sales and marketing | $ | 3,580 |\n\nPersonnel costs increased primarily as a result of a 24% increase in headcount as we continue to expand our sales teams to grow our customer base. Personnel costs include the amortization of capitalized commission costs, which increased quarter over quarter partially due to the amortization of commissions paid in prior periods, as well as expense associated with the amortization of commissions paid and capitalized during the three months ended March 31, 2021, which increased compared to the three months ended March 31, 2020 due to the overall growth in sales. Advertising expense increased primarily as a result of increasing expenses to acquire new paying customers.\nResearch and Development\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Research and development | $ | 5,358 | $ | 4,237 | $ | 1,121 | 26 | % |\n| Percentage of total revenue | 13 | % | 15 | % |\n\nResearch and development costs increased primarily as a result of a 31% increase in headcount as we continue to expand our product development teams.\nGeneral and administrative\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| General and administrative | $ | 7,904 | $ | 5,933 | $ | 1,971 | 33 | % |\n| Percentage of total revenue | 20 | % | 21 | % |\n\n35\nThe increase in general and administrative expense was primarily driven by a 47% increase in headcount as we continue to expand our accounting and reporting, legal and compliance, and internal support teams. It was also driven by a 167% increase in stock-based compensation applicable to these teams.\nOther Income, Net\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Other income, net | $ | 51 | $ | 56 | $ | (5) | (9) | % |\n| Percentage of total revenue | — | % | — | % |\n\nThe relatively small decrease in other income was partially driven by changes in the foreign exchange gains or losses from foreign currency translation adjustments associated with our international activities.\nProvision for Income Taxes\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Provision for income taxes | $ | 86 | $ | 116 | $ | (30) | (26) | % |\n| Percentage of total revenue | — | % | — | % |\n\nThe provision for income taxes is primarily attributable to estimated taxes related to our foreign jurisdictions.\nLiquidity and Capital Resources\nTo date, our principal sources of liquidity have been the net proceeds of $126.6 million, after deducting underwriting discounts and offering expenses paid or payable by us, from our IPO in March 2021, the net proceeds we received through private sales of equity securities, as well as sales of premium subscriptions to our platform.\nAs of March 31, 2021, our principal sources of liquidity were cash and cash equivalents of $171.9 million and accounts receivable of $2.4 million. With the exception of this three month period ended March 31, 2021, we have generated losses from operations since inception. With the exception of this three month period ended March 31, 2021, we expect to continue to incur operating losses and negative cash flows for the foreseeable future due to the investments in our business we intend to make as described above.\nOur principal uses of cash in recent periods have been to fund operations and invest in capital expenditures, and are held in cash deposits and money market funds.\nWe believe our existing cash will be sufficient to meet our operating and capital needs for at least the next 12 months. Our future capital requirements will depend on many factors, including our subscription growth rate, subscription renewal activity, billing frequency, the timing and extent of spending to support our research and development efforts, the expansion of sales and marketing activities, the introduction of new and enhanced product offerings, and the continuing market acceptance of our platform and products. In the future, we may enter into arrangements to acquire or invest in complementary companies,\n36\nproducts, and technologies, including intellectual property rights. We may be required to seek additional equity or debt financing. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us, or at all. If we are unable to raise additional capital or generate cash flows necessary to expand our operations, our business, results of operations, and financial condition could be adversely affected.\nOur Credit Facility\nPursuant to the Credit Agreement among us and Semrush Inc., a Delaware corporation (“Semrush US Sub”), each as a borrower, the lenders party thereto from time to time and JPMorgan Chase Bank, N.A., as the administrative agent, as amended from time to time, we have a senior secured credit facility that consists of a $45.0 million revolving credit facility and a letter of credit sub-facility with an aggregate limit equal to the lesser of $5.0 million and the aggregate unused amount of the revolving commitments then in effect. The availability of the credit facility is subject to the borrowing base based on an advance rate of 400% multiplied by annualized retention applied to monthly recurring revenue. The credit facility has a maturity of three years and will mature on January 12, 2024.\nBorrowings under our credit facility bear interest at our option at (i) LIBOR, subject to a 0.50% floor, plus a margin, or (ii) the alternate base rate, subject to a 3.25% floor (or 1.50% prior to positive consolidated adjusted earnings before interest, taxes, depreciation, and amortization (“adjusted EBITDA”) for the twelve months most recently ended), plus a margin. For LIBOR borrowings, the applicable rate margin is 2.75% (or 3.50% prior to positive consolidated adjusted EBITDA as of the twelve months most recently ended). For base rate borrowings, the applicable margin is 0.00% (or 2.50% prior to positive consolidated adjusted EBITDA as of the twelve months most recently ended). We are also required to pay a 0.25% per annum fee on undrawn amounts under our revolving credit facility, payable quarterly in arrears.\nOperating Activities\nOur largest source of operating cash is cash collections from our customers for subscription services. Our primary uses of cash from operating activities are for online advertising, personnel costs across the sales and marketing and product and development departments, and hosting costs.\nNet cash provided by operating activities during the three months ended March 31, 2021 was $9.0 million, which resulted from a net income of $1.5 million adjusted for non-cash charges of $2.3 million and a net cash inflow of $5.2 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of $0.5 million of depreciation and amortization expense, $1.3 million for amortization of deferred contract acquisition costs related to capitalized commissions, and $0.6 million of stock-based compensation expense. The changes in operating assets and liabilities was primarily the result of a $5.6 million increase in deferred revenue due to the addition of new customers and expansion of the business, a $2.4 million increase in accrued expenses, and a $1.6 million increase in accounts payable. These inflows were partially offset by a $2.4 million increase in deferred contract costs, a $1.0 million increase in prepaid expenses and other current assets, and a $1.0 million increase in accounts receivable.\nNet cash provided by operating activities during the three months ended March 31, 2020 was $0.6 million, which resulted from a net loss of $1.9 million adjusted for non-cash charges of $1.5 million and net cash inflow of $1.0 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of $1.1 million for amortization of deferred contract acquisition costs related to capitalized commissions, $0.2 million of stock-based compensation expense, and $0.2 million of depreciation and amortization expense. The changes in operating assets and liabilities was primarily the result of a $1.7 million increase in deferred revenue due to the addition of new customers and expansion of the business, a $1.0 million increase in accrued expenses, a $0.7 million decrease in accounts receivable, and a $0.1 million increase in accounts payable. These inflows were partially offset by\n37\na $1.7 million increase in deferred contract costs and a $0.7 million increase in prepaid expenses and other current assets.\nInvesting Activities\nNet cash used in investing activities for the three months ended March 31, 2021 and 2020 was $1.1 million and $1.4 million, respectively. The decrease of $0.2 million of cash used in investing activities was primarily due to the reduced purchases of computer equipment and hardware, as well as a decrease in capitalized costs associated with internal use software. During the three months ended March 31, 2021, cash used in investing activities also included $500 paid for two convertible debt securities.\nFinancing Activities\nNet cash provided by financing activities for the three months ended March 31, 2021 was $128.5 million, primarily consisting of the net proceeds from the IPO. Net cash used in financing activities for the three months ended March 31, 2020 was insignificant and consisted entirely of payments of deferred offering costs.\nContractual Obligations\nAs of March 31, 2021, there were no material changes in our contractual obligations and commitments from those disclosed in the Prospectus, other than those appearing in the notes to the Unaudited Condensed Consolidated Financial Statements appearing elsewhere in this Quarterly Report on Form 10-Q.\nOff-Balance Sheet Arrangements\nAs of March 31, 2021, we did not have any relationships with any entities or financial partnerships, such as structured finance or special purpose entities, that would have been established for the purpose of facilitating off-balance sheet arrangements or other purposes. As a result, we are not exposed to related financing, liquidity, market or credit risks that could arise if we had engaged in those types of arrangements.\nRecent Accounting Pronouncements\nRefer to the section titled “Recent Accounting Pronouncements” in Note 2 of the notes to our Unaudited Condensed Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q for more information.\nCritical Accounting Policies and Estimates\nOur Unaudited Condensed Consolidated Financial Statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these Unaudited Condensed Consolidated Financial Statements in conformity with GAAP requires management to make estimates, judgments, and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may differ from these estimates.\nOur critical accounting policies are described under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations— Critical Accounting Policies and Estimates” in the Prospectus and in Note 2 of the notes to our Unaudited Condensed Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q.\n38\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\nWe are exposed to market risk in the ordinary course of our business. Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in foreign currency exchange rates, interest rates and inflation. We do not hold or issue financial instruments for trading purposes.\nInterest Rate Risk\nWe had cash and cash equivalents of $171.9 million and $35.5 million as of March 31, 2021 and December 31, 2020, respectively. Our cash and cash equivalents are held in cash deposits and money market funds. Due to the short-term nature of these instruments, we do not believe that we have any material exposure to changes in the fair value of our investment portfolio as a result of changes in interest rates.\nAs of March 31, 2021, we had $45.0 million available under the revolving credit facility, with $5.0 million of such revolving commitments available under the letter of credit sub-facility. Borrowings under our credit facility bear interest at our option at (i) LIBOR, subject to a 0.50% floor, plus a margin, or (ii) the base rate, subject to a 3.25% floor (or 1.50% prior to an IPO or positive consolidated adjusted EBITDA as of the twelve months most recently ended), plus a margin. For LIBOR borrowings, the applicable rate margin is 2.75% (or 3.50% prior to an IPO or positive consolidated adjusted EBITDA as of the twelve months most recently ended). For base rate borrowings, the applicable margin is 0.00% (or 2.50% prior to an IPO or positive consolidated adjusted EBITDA as of the twelve months most recently ended). We are also required to pay a 0.25% per annum fee on undrawn amounts under our revolving credit facility, payable quarterly in arrears.\nWe did not have any current investments in marketable securities as of March 31, 2021 and 2020.\nForeign Currency Exchange Risk\nWe are not currently subject to significant foreign currency exchange risk with respect to revenue as our U.S. and international sales are predominantly denominated in U.S. dollars. However, we have some foreign currency risk related to a small amount of sales denominated in euros, and expenses denominated in euros, rubles, korunas, and zloty. Sales denominated in euros reflect the prevailing U.S. dollar exchange rate on the date of invoice for such sales. Increases in the relative value of the U.S. dollar to the euro may negatively affect revenue and other operating results as expressed in U.S. dollars. We incur significant expenses outside the United States denominated in these foreign currencies, primarily the ruble. If the average exchange rates of any of these foreign currencies strengthen against the dollar, the dollar value of our expenses outside the United States will increase. For example, an immediate 10% decrease or increase in the relative value of the U.S. dollar to the ruble would result in a $3.4 million loss or gain on our unaudited condensed consolidated statements of operations and cash flows.\nWe have not engaged in the hedging of foreign currency transactions to date. However, as our international operations expand, our foreign currency exchange risk may increase. If our foreign currency exchange risk increases in the future, we may evaluate the costs and benefits of initiating a foreign currency hedge program in connection with non-U.S. dollar denominated transactions.\n39\nItem 4. Controls and Procedures\nEvaluation of Disclosure Controls and Procedures\nOur management, including our Chief Executive Officer and Chief Financial Officer, have evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on management’s review, with participation of our Chief Executive Officer and Chief Financial Officer, the Chief Executive Officer and Chief Financial Officer have concluded that, as of the quarter ended March 31, 2021, the Company’s disclosure controls and procedures were not effective.\nAs previously disclosed under the section titled “Risk Factors” of the Prospectus, in connection with the audit of our consolidated financial statements for the year ended December 31, 2019, we and our independent registered public accounting firm identified a material weakness in our internal control over financial reporting related to deficiencies in our controls over the financial statement close process. Specifically, there were deficiencies in the design and operation of internal controls over the identification and review of complex accounting issues involving significant judgment or estimates with respect to certain prior period transactions.\nNotwithstanding the identified material weakness, our management believes the Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q fairly present, in all material respects, our financial condition, results of operations and cash flows as of and for the periods presented in accordance with U.S. generally accepted accounting principles.\nRemediation Plan for Material Weakness\nRemediation generally requires making changes to how controls are designed and implemented and then adhering to those changes for a sufficient period of time such that the effectiveness of those changes is demonstrated with an appropriate amount of consistency. In response to the material weakness, we implemented, and are continuing to implement, measures designed to improve our internal control over financial reporting. These measures include formalizing our processes and internal control documentation, strengthening supervisory reviews by our financial management, hiring additional qualified accounting and finance personnel, and engaging financial consultants to enable the implementation of internal control over financial reporting. Further, changes and improvements in our internal control over financial reporting environment will be implemented based on ongoing management reviews and the continued implementation of the remediation plan.\nChanges in Internal Control Over Financial Reporting\nExcept for the remediation measures in connection with the material weakness described above, there were no other changes to our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended March 31, 2021, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\nInherent Limitations on Effectiveness of Controls\nOur management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitation in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of\n40\nfraud, if any, within our company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the controls. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with policies or procedures may deteriorate. Due to inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.\n41\nPART II — OTHER INFORMATION\nItem 1. Legal Proceedings\nFrom time to time we may become in involved in legal proceedings or be subject to claims arising in the ordinary course of our business. We are not presently a party to any legal proceedings that, if determined adversely to us, would individually or taken together have a material adverse effect on our business, operating results, financial condition or cash flows. Regardless of the outcome, litigation can have an adverse impact on us because of defense and settlement costs, diversion of management resources and other factors.\nItem 1A. Risk Factors\nInvesting in our Class A common stock involves a high degree of risk. You should carefully consider the risks and uncertainties described below, together with all of the other information in this Quarterly Report on Form 10-Q, before making a decision to invest in our Class A common stock. If any of the risks actually occur, our business, results of operations, financial condition, and prospects could be harmed. In that event, the trading price of our Class A common stock could decline, and you could lose part or all of your investment.\nSummary of the Material Risks Associated with Our Business\nOur business is subject to numerous risks and uncertainties that you should be aware of in evaluating our business. These risks and uncertainties include, but are not limited to, the following:\n• We derive, and expect to continue to derive, substantially all of our revenue and cash flows from our paying customers with premium subscriptions, and our business and operating results will be harmed if our paying customers do not renew their premium subscriptions.\n• Our business and operating results will be harmed if our paying customers do not upgrade their premium subscriptions or if they fail to purchase additional products.\n• If we fail to attract new potential customers through unpaid and paid marketing efforts, register them for trials, and convert them into paying customers, our operating results would be harmed.\n• The market in which we operate is intensely competitive, and if we do not compete effectively, our ability to attract and retain free and paying customers could be harmed, which would negatively impact our business and operating results.\n• Our products depend on publicly available and paid third-party data sources, and, if we lose access to data provided by such data sources or the terms and conditions on which we obtain such access become less favorable, our business could suffer.\n• Our ability to introduce new products and add-ons is dependent on adequate research and development resources. If we do not adequately fund our research and development efforts or use product and development teams effectively, our business and operating results may be harmed.\n• If we are unable to maintain and enhance our brand, or if events occur that damage our reputation and brand, our ability to maintain and expand our customer base may be impaired, and our business and financial results may be harmed.\n42\n• We depend on our executive officers and other key employees, and the loss of one or more of these employees could harm our business.\n• An inability to attract and retain other highly skilled employees could harm our business.\n• Changes by search engines, social networking sites, and other third-party services to their underlying technology configurations or policies regarding the use of their platforms and/or technologies for commercial purposes, including anti-spam policies, may limit the efficacy of certain of our products, tools, and add-ons and as a result, our business may suffer.\n• If the security of the confidential information or personal information of any customers of our platform is breached or otherwise subjected to unauthorized access or disclosure, our reputation may be harmed and we may be exposed to liability.\n• The effects of the COVID-19 pandemic are uncertain and may materially affect our customers or potential customers and how we operate our business, and the duration and extent to which the pandemic continues to threaten our future operating results remains uncertain.\n• If the use of cookies or other tracking technologies becomes subject to unfavorable legislation or regulation, is restricted by internet users or other third parties or is blocked or limited by users or by technical changes on end users’ devices, our ability to attract new customers and to develop and provide certain products could be diminished or eliminated.\n• We may not be able to adequately protect our proprietary and intellectual property rights in our data or technology.\nMost Material Risks to Us\nWe derive, and expect to continue to derive, substantially all of our revenue and cash flows from our paying customers with premium subscriptions, and our business and operating results will be harmed if our paying customers do not renew their premium subscriptions.\nWe derive, and expect to continue to derive, substantially all of our revenue and cash flows from our paying customers with premium subscriptions. Our business and financial results depend on our paying customers renewing their subscriptions for our products when existing contract terms expire. Although our customer agreements provide for auto-renewal of subscriptions, our paying customers have no obligation to renew their premium subscriptions if they provide proper notice of their desire not to renew, and we cannot guarantee that they will renew their premium subscriptions for the same or longer terms, the same or a greater number of user licenses or products and add-ons, or at all. We offer premium subscriptions on a monthly or annual basis with our annual subscriptions receiving a discount for the longer-term commitment. Our paying customers predominantly choose monthly subscription terms, which allow them to terminate or adjust their premium subscriptions with us on a monthly basis as external factors change and could cause our results of operations to fluctuate significantly from quarter to quarter. Our renewal rates, including our dollar-based net revenue retention rate, may decline or fluctuate as a result of a number of factors, including customer satisfaction with our platform and products, reliability of our products, our customer success and support experience, the price and functionality of our platform, products, and add-ons relative to those of our competitors, mergers and acquisitions affecting our customer base, the effects of global economic conditions and other external factors, or reductions in our customers’ spending levels. Our business and operating results will be adversely affected if our paying customers do not renew their premium subscriptions.\n43\nOur business and operating results will be harmed if our paying customers do not upgrade their premium subscriptions or if they fail to purchase additional products.\nOur future financial performance also depends in part on our ability to continue to upgrade paying customers to higher-price point subscriptions and sell additional user licenses, and products and add-ons such as Prowly, Sellerly, and Competitive Intelligence. Conversely, our paying customers may convert to lower-cost or free subscriptions if they do not perceive value in paying for our higher-price point subscriptions, thereby impacting our ability to increase revenue. For example, a paying customer subscribing to our core product through a “Business” subscription may downgrade to the “Guru” subscription if they do not deem the additional features and functionality worth the incremental costs. To expand our relationships with our customers, we must demonstrate to existing paying and free customers that the additional functionality associated with an upgraded subscription outweighs the incremental costs. Our customers’ decisions as to whether to upgrade their subscriptions or not is driven by a number of factors, including customer satisfaction with the security, performance, and reliability of our platform and products, general economic conditions, the price and functionality of our platform and products relative to those of our competitors, and customer reaction to the price for additional products. If our efforts to expand our relationships with our existing paying and free customers are not successful, our revenue growth rate may decline and our business and operating results will be adversely affected.\nIf we fail to attract new potential customers through unpaid and paid marketing efforts, register them for trials, and convert them into paying customers, our operating results would be harmed.\nThe number of new customers we attract, whether as free or paying customers, is a key factor in growing our customer and premium subscription base which drive our revenues and collections. We utilize various unpaid content marketing strategies, including blogs, webinars, thought leadership, and social media engagement, as well as paid advertising, to attract visitors to our websites. We cannot guarantee that these unpaid or paid marketing efforts will continue to attract the same volume and quality of traffic to our websites or will continue to result in the same level of registrations for premium subscriptions as they have in the past. In the future, we may be required to increase our marketing spend to maintain the same volume and quality of traffic. Moreover, we cannot be certain that increased sales and marketing spend will generate more paying customers without increasing our customer acquisition costs on a per paying customer basis. We offer potential customers several tiered subscription options for our online visibility management platform, including free subscriptions of a limited-functionality product and premium subscriptions of our “Pro”, “Guru” or “Business” offerings for our core product, depending on the level of functionality they seek. We have materially grown our number of paying customers through the provision of free subscriptions and through trials of a premium version of our online visibility and marketing insight products. Trial subscriptions automatically become premium subscriptions if the customer does not opt out of the trial subscription after the trial period is over, and such trial subscriptions can be upgraded to obtain additional features, functionality, and varying levels of access and report generating capabilities. In the future, we may be required to provide additional functionality to our free subscriptions to attract visitors to our websites and incent visitors to sign up for free subscriptions. In addition, we encourage our free customers to upgrade to premium subscriptions through in-product prompts and notifications, by recommending additional features and functionality, and by providing customer support to explain such additional features and functionality. Our failure to attract new free customers and convert them into paying customers could have a material adverse effect on our operating results as our business may be adversely affected by the costs of, and sales lost from, making certain of our products available on a free basis. While we do not receive any revenue from our customers who use our platform on a free basis, we bear incremental expenses as a result of their continuing free access to our platform and certain of our products.\n44\nThe market in which we operate is intensely competitive, and if we do not compete effectively, our ability to attract and retain free and paying customers could be harmed, which would negatively impact our business and operating results.\nThe market for our products is fragmented, rapidly evolving, and highly competitive, with relatively low barriers to entry. Our all-in-one SaaS platform competes with software products and solutions that are focused on a particular customer need, or point solutions. For example, we compete with point solutions for search advertising and search engine optimization, marketing analytics and social media management, market intelligence, and web analytics services. Our ability to attract and retain free and paying customers depends in part on the actual and perceived quality and design of our platform, products, and add-ons compared to competitive point solutions and continued market acceptance of our platform, products, and add-ons for existing and new use-cases. To remain competitive and to acquire new customers, we must deliver features and functionality that enhance the utility and perceived value of our platform, products, and add-ons to our prospective and existing customers. Our platform, products, and add-ons must (i) operate without the presence of material software defects, whether actual or perceived, (ii) maintain deep and rich data sources, (iii) adapt to the changing needs of our current and prospective customers including by developing new technology, (iv) adapt to changing functionality and provide interoperability with third-party application programming interfaces (“APIs”), (v) maintain and develop integrations with complementary third-party services that provide value to our customers, (vi) be easy to use and visually pleasing, (vii) deliver rapid return on investment to our customers across multiple functions within their organizations, and (viii) be delivered with a superior customer support experience. We may not be successful in delivering on some or all of the foregoing or in doing so while maintaining competitive pricing, which could result in customer dissatisfaction leading to termination or downgrades of premium subscriptions, fewer new free customers, fewer subscription upgrades or lower dollar-based net revenue retention rates, prospective customers’ selection of our competitors’ products over our own, and other adverse effects on our business.\nMany of our current and future competitors benefit from competitive advantages over us, such as greater name recognition, longer operating histories, more targeted products for specific use cases, larger sales and more established relationships or integrations with third-party data providers, search engines, online retail platforms, and social media networking sites, and more established relationships with customers in the market. Additionally, many of our competitors may expend a considerably greater amount of funds on their research and development efforts, and those that do not, may be acquired by larger companies that would allocate greater resources to our competitors’ research and development programs. Specifically, our competitors focusing on point solutions may have the ability to expend greater funds in a more targeted manner to develop superior solutions that address a specific need, as compared to our research and development expenditures which are allocated across our platform. In addition, some of our competitors may enter into strategic relationships or consummate strategic acquisitions to offer a broader range of functionality than we do, a more competitive multi-point solution, or to address needs that our platform does not. These types of business combinations may make it more difficult for us to acquire new free customers or maintain or upgrade our free and paying customers, any of which could ultimately impact our ability to compete effectively. We expect these competitive pressures to continue as competitors attempt to strengthen or preserve their market positions and as new competitors enter the market.\nDemand for our platform is also price sensitive. Many factors, including our marketing, sales and technology costs, and the pricing and marketing strategies of our competitors, can significantly affect our pricing strategies. Certain competitors offer, or may in the future offer, lower-priced or free products that compete with our platform, products, and/or add-ons, or may bundle their solutions with other companies’ offerings to provide a broader range of functionality at reduced volume pricing. Similarly, certain competitors may use marketing strategies that enable them to acquire customers at a lower cost than we do. Even if such competitive products do not include all the features and functionality that our platform provides, we could face pricing pressure to the extent that customers find such alternative products to be sufficient to meet their needs or do not perceive a material return on investment from the additional\n45\nfeatures and functionality they would obtain by purchasing our platform relative to the competitive point solutions. Additionally, our competitors may further drive down the price through strategic business combinations. We may be forced to engage in price-cutting initiatives, offer other discounts, or increase our sales and marketing and other expenses to attract and retain free and paying customers in response to competitive pressures, any of which would harm our business and operating results.\nWe have incurred losses in the past and may not consistently achieve profitability in the future.\nWe have a history of incurring net losses and although we have achieved profitability in certain periods we expect to continue to incur net losses in the future. We incurred net losses of $10.2 million and $7.0 million for the years ended December 31, 2019 and 2020, respectively. As of March 31, 2021, we had an accumulated deficit of $34.3 million. We do not know if we will be able to achieve or sustain profitability in the future. We plan to continue to invest in our research and development, and sales and marketing efforts, and we anticipate that our operating expenses will continue to increase as we scale our business and expand our operations. We also expect our general and administrative expenses to increase as a result of our growth and operating as a public company. Our ability to achieve and sustain profitability is based on numerous factors, many of which are beyond our control.\nOur products depend on publicly available and paid third-party data sources, and, if we lose access to data provided by such data sources or the terms and conditions on which we obtain such access become less favorable, our business could suffer.\nWe have developed our platform, products, and add-ons to rely in part on access to data from third-party sources. The primary sources of third-party data include data collected from third-party websites algorithmically through our proprietary data collection techniques, including web crawling of third-party websites, data purchased from independent third-party data providers, which includes clickstream data, search engine data, online advertising data, and data from social media sources, and reference data that our customers grant us access to, which includes our customers’ website and social media data. We obtain social media data through APIs that connect to social media platform operators, including Facebook, Twitter, Instagram, Pinterest, and LinkedIn. We also collect data from our customers in connection with their use of our platform.\nTo date, our relationships with most data providers (including social media platforms) are governed by such data providers’ respective standard terms and conditions, which govern the availability and access to, and permitted uses of such data (including via APIs), and which are subject to change by such providers from time to time, with little or no notice and with little or no right of redress. Similarly, our access to publicly available data may depend on restrictions that website owners may impose through technical measures or otherwise, including restrictions on automated data collection. We cannot accurately predict the impact of changes in the terms of data providers that may impede our access to the data. If these data providers or websites choose not to make their data available on the same terms, or at all, we would have to seek alternative sources, which could prove expensive and time-consuming, and may be less efficient or effective. Such changes could impact our ability to provide our services in a timely manner, if at all, and could negatively impact the perceived value of our platform and our business. There can be no assurance that following any such modification of terms or termination we would be able to maintain the current level of functionality of our platform in such circumstances, which could adversely affect our results of operations.\nWe also rely on negotiated agreements with other data providers from whom we purchase independently sourced data, including clickstream data, search engine data, online advertising data, data from social media, and other sources. These negotiated agreements provide access to additional data that allow us to provide a more comprehensive solution for our customers. These agreements are subject to termination in certain circumstances, and there can be no assurance that we will be able to renew those agreements or that the terms of any such renewal, including pricing and levels of service, will be favorable. In addition, there can be no assurance that we will not be required to enter into new negotiated\n46\nagreements with data providers in the future to maintain or enhance the level of functionality of our platform, or that the terms and conditions of such agreements, including pricing and levels of service, will not be less favorable, which could adversely affect our results of operations. Further, third-party data providers have previously, and may again, cease operations or a specific business line or cease providing products or data to their customers, including us. If we are not able to obtain third-party data on commercially reasonable terms, if these data providers stop making their data available to us, or if our competitors are able to purchase such data on better terms, the functionality of our platform and our ability to compete could be harmed.\nTo the extent that we license or obtain data from third parties, we may be subject to contractual obligations to satisfy certain requirements under applicable laws including, but not limited to, providing public notice of our data processing activities and obtaining appropriate consents where required. If one or more of those third-party data providers considers that we have failed to satisfy these requirements, such third-party data provider may bring claims against us seeking damages, and/or seeking to prevent our future use of any data already provided. Such claims could potentially adversely affect our ability to provide our services and the current level of functionality of our platform in such circumstances, which could adversely affect our results of operations.\nOur business may be harmed if any of our data sources:\n•changes, limits or discontinues our access to their data;\n•modifies its terms of service or other policies, including imposing prohibitive fees or restrictions on our use of their data or our ability to access it;\n•changes or limits how customer information is accessed by us or our customers and their users;\n•changes or limits how we can use such data;\n•establishes more favorable relationships with one or more of our competitors; or\n•experiences disruptions of its technology, services or business generally.\nRisks Related to our Business\nOur ability to introduce new products and add-ons is dependent on adequate research and development resources. If we do not adequately fund our research and development efforts or use product and development teams effectively, our business and operating results may be harmed.\nTo remain competitive, we must continue to develop new product offerings, as well as features and enhancements to our existing platform and products. Maintaining adequate research and development personnel and resources to meet the demands of the market is essential. If we experience high turnover of our product and development personnel, a lack of management ability to guide our research and development, or a lack of other research and development resources, we may miss or fail to execute on new product development and strategic opportunities and consequently lose potential and actual market share. The success of our business is dependent on our product and development teams developing and executing on a product roadmap that allows us to retain and increase the spending of our existing customers, attract new customers and upgrade our free customers to premium subscriptions. Our failure to maintain adequate research and development resources, to use our research and development resources efficiently, and to address the demands of our prospective and actual customers could materially adversely affect our business.\n47\nIf we are unable to maintain and enhance our brand, or if events occur that damage our reputation and brand, our ability to maintain and expand our customer base may be impaired, and our business and financial results may be harmed.\nMaintaining, promoting, and enhancing our brand is critical to maintaining and expanding our customer base. We seek to build our brand through a mix of free and paid initiatives. We market our platform and products through free information resources on our website, including our blog and online digital marketing courses (including through our Semrush Academy), pay-per-click advertisements on search engines and social networking sites, participation in social networking sites, and free and paid banner advertisements on other websites. The strength of our brand further drives free traffic sources, including customer referrals, word-of-mouth, and direct searches for our “Semrush” name, or web presence solutions, in search engines. In addition, we maintain relationships with agencies and affiliates to further increase brand awareness and generate customer demand. To the extent that new customers are increasingly derived from paid as opposed to free marketing initiatives, our customer acquisition cost will increase.\nBeyond direct sales and marketing efforts, maintaining and enhancing our brand will depend largely on our ability to continue to provide a well-designed, useful, reliable, and innovative platform, efficient sales process, and high-quality customer service, which we may not do successfully. For a discussion of other factors that will impact our brand recognition see the risk factors described elsewhere in this section, including without limitation, those risk factors entitled “The market in which we operate is intensely competitive, and if we do not compete effectively, our ability to attract and retain free customers and paying customers could be harmed, which would negatively impact our business and operating results.”; “If we fail to offer high-quality customer service and provide a positive customer experience, it may be more difficult to add and retain paying customers and increase the number of user licenses per paying customer, especially from large enterprises.”; “If third-party applications change such that we do not or cannot maintain the compatibility of our platform with these applications or if we fail to integrate with or provide third-party applications that our customers desire to use with our products, demand for our solutions and platform could decline.”; “We rely on search engines and social networking sites to attract a meaningful portion of our customers, and if those search engines or social networking sites change their listings or policies regarding advertising, or increase their pricing or suffer problems, it may limit our ability to attract new customers.”; and “If we fail to anticipate and adapt to new and increasingly prevalent social media platforms, other competing products and services that do so more effectively could surpass us and lead to decreased demand for our platform and products.”\nWe depend on our executive officers and other key employees, and the loss of one or more of these employees could harm our business.\nOur success depends largely upon the continued services of our executive officers and other key employees. We rely on our leadership team in the areas of research and development, operations, security, marketing, sales, customer service, and general and administrative functions, and on individual contributors and team leaders in our research and development and operations. From time to time, there may be changes in our executive management team resulting from the hiring or departure of executives, which could disrupt our business. The loss of one or more of our executive officers or key employees could harm our business. Changes in our executive management team may also cause disruptions in, and harm to, our business.\nWe are led by our CEO and co-founder, Oleg Shchegolev, our COO and co-founder, Dmitry Melnikov, and our Chief Product Officer, Vitalii Obishchenko, each of whom plays an important role in driving our culture, determining our strategy, and executing against that strategy companywide. If the services of Mr. Shchegolev, Mr. Melnikov, and/or Mr. Obishchenko become unavailable to us for any reason, it may be difficult or impossible for us to find an adequate and timely replacement, which could cause us to be less successful in maintaining our culture, and developing and effectively executing on our strategies and initiatives.\n48\nAn inability to attract and retain other highly skilled employees could harm our business.\nTo execute our growth plan, we must attract and retain highly qualified personnel. Competition for highly qualified personnel in Boston, Massachusetts, where our headquarters is located, and Trevose, Pennsylvania, Dallas, Texas, Prague, Czech Republic, Limassol, Cyprus, St. Petersburg, Russia, and Warsaw, Poland where we have offices. Competition in these locations is intense, especially for software engineers experienced in designing and developing software and SaaS applications, and experienced sales professionals who understand our products and the market in which we operate. We have from time to time experienced, and we expect to continue to experience, difficulty in hiring and retaining employees with appropriate qualifications. In addition, immigration laws in the locations in which we have offices and operations restrict or limit our ability to recruit internationally. Any changes to the immigration policies applicable to locations in which we have offices and operations that restrain the flow of technical and professional talent may inhibit our ability to recruit and retain highly qualified employees. Many of the companies with which we compete for experienced personnel may be able to offer more attractive terms of employment to potential candidates. If we hire employees from competitors or other companies, their former employers may attempt to assert that these employees have breached their legal obligations to such former employers, resulting in a diversion of our time and resources.\nIn addition, job candidates and existing employees often consider the value of the equity awards they receive in connection with their employment as part of their overall compensation package. If the perceived value of our equity awards declines or does not compare favorably to the value of equity offered by other companies competing for the same personnel resources, it may harm our ability to recruit and retain highly skilled employees. In addition, we invest significant time and expense in training our employees, which increases their value to competitors who may seek to recruit them. For example, our software developers gain deep and direct experience in data analytics, machine learning, and search optimization, making them increasingly attractive to our competitors and other similar businesses. If we fail to attract new personnel or fail to retain and motivate our current personnel, our business and future growth prospects could be harmed.\nChanges by search engines, social networking sites, and other third-party services to their underlying technology configurations or policies regarding the use of their platforms and/or technologies for commercial purposes, including anti-spam policies, may limit the efficacy of certain of our products, tools, and add-ons and as a result, our business may suffer.\nOur online visibility platform is designed to help our customers connect with consumers across a variety of digital channels, search engines, social networking sites, and other third-party services. These services may adapt and change their strategies and policies over time. Search engines typically provide two types of search results, organic (i.e., non-paid) and purchased listings. Organic search results are determined and organized solely by automated criteria set by the search engine, and a ranking level cannot be purchased. Search engines revise their algorithms from time to time in an attempt to optimize their search result listings. Changes to search engine algorithms may diminish the efficacy of certain of our products, tools, and add-ons, and potentially render them obsolete. For example, if a given search engine stopped using backlinks in its ranking algorithm, our customers’ perception of our backlink analytics tool, which enables customers to analyze and monitor the backlink profile of their own and other websites, may be adversely impacted. Similarly, if a search engine ceases to manually penalize or take action against web pages for unnatural backlinks, then our customers may determine that auditing their backlinks is unnecessary which could cause them to devalue our backlink audit tool, which enables companies to check whether malicious websites have links to their sites, or cease using it altogether. In response to these types of changes we may be required to recalibrate our product offerings by reducing prices, discontinuing the affected product, or otherwise. These responses may be costly, may not be effective, and our business may suffer.\nAdditionally, search engines, social networking sites, and other third-party services typically have terms of service, guidelines, and other policies to which its users are contractually obligated to adhere.\n49\nFor example, Google’s Gmail offering has a spam and abuse policy that prohibits sending spam, distributing viruses, or otherwise abusing the service. Prowly and our link building tool enable our customers to send emails to their desired recipients, such as marketing and affiliate partners, social media influencers, journalists, and bloggers. Our link building tool relies on a direct Gmail integration through which our customers are able to send emails using our platform as if they were sending emails directly from their Gmail account, and our Prowly product involves emails initiated by customers over Prowly servers. Our customers’ actions using either the link building tool or Prowly could be flagged under Google’s spam and abuse policy or in the future such actions may be prohibited by subsequent changes to Google’s policies. Any change to the policies of the third-party services with which our products, tools, and add-ons integrate or interact, or with which our products are intended to be used, including any anti-spam policies, or any actions taken by these third-party service providers under their policies could adversely impact the efficacy and perceived value of our products, tools, and add-ons, and as a result, our business may be harmed.\nIf third-party applications change such that we do not or cannot maintain the compatibility of our platform with these applications or if we fail to integrate with or provide third-party applications that our customers desire to use with our products, demand for our solutions and platform could decline.\nThe attractiveness of our platform depends, in part, on our ability to integrate via APIs with third-party applications that our customers desire to use with our products, such as Google, Facebook, Instagram, Twitter, YouTube, LinkedIn, Pinterest, Majestic, and others. Third-party application providers may change the features of their applications and platforms, including their APIs, or alter the terms governing use of their applications and platforms in an adverse manner. Further, third-party application providers may refuse to partner with us, or limit or restrict our access to their applications and platforms. Such changes could functionally limit or terminate our ability to use these third-party applications with our platform, which could negatively impact our offerings and the customer experience, and ultimately harm our business. If we fail to integrate our platform with new third-party applications that our customers desire, or to adapt to the data transfer requirements of such third-party applications and platforms, we may not be able to offer the functionality that our customers expect, which would negatively impact our offerings and, as a result, harm our business. Additionally, our business could be harmed if our customers have negative experiences in using the third-party integrations that we offer.\nIf we fail to maintain and improve our methods and technologies, or fail to anticipate new methods or technologies for data collection and analysis, hardware, software, and software related technologies, competing products and services could surpass ours in depth, breadth, or accuracy of our data, the insights that we offer or in other respects.\nWe expect continuous development in the market with respect to data matching, data filtering, data predicting, algorithms, machine learning, and other related technologies and methods for gathering, cataloging, updating, processing, analyzing, and communicating data and other information about how consumers find, interact with, and digest digital content. Similarly, we expect continuous changes in computer hardware, network operating systems, programming tools, programming languages, operating systems, the use of the internet, and the variety of network, hardware, browser, mobile, and browser-side platforms, and related technologies with which our platform and products must integrate. Further, changes in customer preferences or regulatory requirements may require changes in the technology used to gather and process the data necessary to deliver our customers the insights that they expect. Any of these developments and changes could create opportunities for a competitor to create products or a platform comparable or superior to ours, or that takes material market share from us in one or more product categories, and create challenges and risks for us if we are unable to successfully modify and enhance our products to adapt accordingly.\n50\nIf we fail to anticipate and adapt to new and increasingly prevalent social media platforms, other competing products and services that do so more effectively could surpass us and lead to decreased demand for our platform and products.\nThe use of social media throughout the world is pervasive and growing. According to a survey by GlobalWebIndex of individuals ages 16 to 64, 97% of digital consumers have used social media during the first quarter of 2020, with digital consumers spending an average of 2 hours and 22 minutes per day on social networks and messaging apps between January and March 2020. The social media industry has experienced, and is likely to continue to experience, rapid change due to the evolving trends, tastes and preferences of users. If consumers widely adopt new social media networks and platforms, we will need to develop integrations and functionality related to these new networks and platforms. This development effort may require significant research and development and sales and marketing resources, as well as licensing fees, all of which could adversely affect our business and operating results. In addition, new social media networks and platforms may not provide us with sufficient access to data from their platforms, preventing us from building effective integrations with our platform and products. Changing consumer tastes may also render our current integrations or functionality obsolete and the financial terms, if any, under which we would obtain integrations or functionality, unfavorable. Any failure of our products to operate effectively with the social media networks used most frequently by consumers could reduce the demand for our products. If we are unable to respond to these changes in a cost-effective manner, our products and aspects of our platform may become less marketable and less competitive or obsolete, and our operating results may be negatively affected.\nIf we fail to offer high-quality customer service and provide a positive customer experience, it may be more difficult to add and retain paying customers, secure upgrades, sell add-ons, and increase the number of user licenses per paying customer.\nOur ability to add and retain paying customers, secure subscription upgrades, and sell add-ons depends in part on our customer service. Our sales and customer success team engages with customers to onboard them onto our platform, responds to support requests and other general inquiries, and assists with other account management matters. The perceived quality of customer service is one of the key facets potential customers evaluate when deciding between competing products and if our customer service is not viewed favorably, potential customers may choose our competitors’ products over our own. Additionally, our large enterprise customers from time to time demand custom solutions, such as custom APIs and custom reporting, and customer support that do not fit within one of our pre-packaged premium subscriptions, and addressing such demands often requires additional one-on-one engagement with our sales and customer success team members in order to finalize and service the commercial relationship. As we add more large enterprise customers and increase the number of user licenses per paying customer, we may need to devote more resources to customer service, and we may find it difficult and costly to effectively scale. If we do not adequately scale our customer success teams to meet the demands of new and existing customers, or if we otherwise fail to provide high-quality customer service during onboarding or at any other stage of the customer relationship, or a positive customer experience, we may lose such customers to our competition and fewer customers could renew or upgrade their subscriptions and purchase add-ons, which would harm our business, results of operations, and financial condition.\nFailures or loss of, or material changes with respect to, the third-party hardware, software, and infrastructure on which we rely, including third-party data center hosting facilities and third-party distribution channels to support our operations, could adversely affect our business.\nWe rely on leased and third-party owned hardware, software and infrastructure, including third-party data center hosting facilities and third-party distribution channels to support our operations. We primarily use three data centers in the United States, two located in Virginia and one in Georgia, as well as two Google Cloud locations in Virginia and South Carolina. We host each of our products and the data processed through such products in a combination of two of the foregoing locations for redundancy. If any\n51\nof our data center suppliers experience disruptions or failures, it would take time for the applicable backup data center to become fully functioning, and we would likely experience delays in delivering the affected products and segments of our platform, which may involve incurring significant additional expenses.\nFurthermore, the owners and operators of our data center facilities do not guarantee that access to our platform will be uninterrupted or error-free. We do not control the operation of these third-party providers’ facilities, which could be subject to break-ins, computer viruses, sabotage, intentional acts of vandalism and other misconduct. Further, our leased servers and data centers are vulnerable to damage or interruption from natural disasters, terrorist attacks, power loss, telecommunications failures or similar catastrophic events. The COVID-19 pandemic could cause our third-party data center hosting facilities and cloud computing platform providers, which are critical to our infrastructure, to shut down their operations, experience technical or security incidents that delay or disrupt performance or delivery of services to us, or experience interference with the supply chain of hardware required by their systems and services, any of which could materially adversely affect our business. For example, we have experienced delays in migrating to our new data center in Virginia, due to the limited availability of certain required hardware components resulting from supply chain delays caused by the COVID-19 pandemic. If there were to be a significant outage or disaster that rendered one of our servers or data centers inoperable for any length of time, we would have to undertake recovery operations for the impacted products, which could interrupt the availability of our platform. If we were unable to restore the availability of our platform and products within a reasonable period of time, our customer satisfaction could suffer, damaging our reputation as a result, and we could lose customers to our competition, which would materially and adversely affect our business and results of operations.\nIn addition, third-party data hosting and transmission services comprise a significant portion of our operating costs. If the costs for such services increase due to vendor consolidation, regulation, contract renegotiation, or otherwise, we may not be able to increase the fees for our platform or products to cover the changes, which would have a negative impact on our results of operations.\nIf the security of the confidential information or personal information of any customers of our platform is breached or otherwise subjected to unauthorized access or disclosure, our reputation may be harmed and we may be exposed to liability.\nWith consent from our customers, we obtain confidential and other customer data from our customers’ websites, social media accounts, and Google Analytics’ accounts to operate certain functionality on our platform. We rely on credit card purchases as the primary means of collecting our premium subscription fees. In addition, with consent from our customers, we collect and store certain personally identifiable information (“personal data”), credit card information, and other data needed to create, support, and administer the customer account, conduct our business, and comply with legal obligations, including rules imposed by the Payment Card Industry networks.\nWe believe that we take reasonable steps to protect the security, integrity, availability, and confidentiality of the information we and our third-party service providers hold, but there is no guarantee that despite our efforts, inadvertent disclosure (such as may arise from software bugs or other technical malfunctions, employee error or malfeasance, or other factors) or unauthorized disclosure or loss of personal or other confidential information will not occur or that third parties will not gain unauthorized access to this information. We have experienced, and may experience in the future, breaches of our security due to human error, malfeasance, system errors or vulnerabilities, or other irregularities. For example, we have been the target of attempts to identify and exploit system vulnerabilities and/or penetrate or bypass our security measures to gain unauthorized access to our systems, including a brute force attack that resulted in access to our affiliate program partner contact information. Since techniques used to obtain unauthorized access change frequently, we and our third-party service providers may be unable to anticipate these techniques or to implement adequate preventative measures. If our security measures or the security measures of our third-party service providers are breached because of third-party action, employee error, malfeasance or otherwise, or if design flaws in our software are exposed\n52\nand exploited, and, as a result, a third-party obtains unauthorized access to any customers’ data, our relationships with our customers may be damaged, and we could incur liability. Further, our customers with annual subscription terms may have the right to terminate their subscriptions before the end of the subscription term due to our uncured material breach of agreement, including with respect to our data security obligations. It is also possible that unauthorized access to customer data may be obtained through inadequate use of security controls by customers, suppliers or other vendors. While we are not currently aware of any impact that the SolarWinds supply chain attack had on our business, this is a recent event, and the scope of the attack is yet unknown. Therefore, there is residual risk that we may experience a security breach arising from the SolarWinds supply chain attack. We may also be subject to additional liability risks for failing to disclose data breaches or other security incidents under state data breach notification laws or under the private right of action granted to individuals under certain data privacy laws for actions arising from certain data security incidents, such as the California Consumer Privacy Act (“CCPA”) (which is further discussed below in this “Risk Factors” section). In addition, some regions, such as the EU, the United Kingdom (“UK”), and the United States, have enacted mandatory data breach notification requirements for companies to notify data protection authorities, state and federal agencies, or individuals of data security incidents or personal data breaches. We may also be contractually required to notify certain customers in the event of a security incident pursuant to the applicable customer agreement. These mandatory disclosures regarding a security breach may lead to negative publicity and may cause our customers to lose confidence in the effectiveness of our data security measures. Any security breach, whether actual or perceived, may harm our reputation, and we could lose customers or fail to acquire new customers.\nFederal, state, and provincial regulators and industry groups may also consider and implement from time to time new privacy and security requirements that apply to our business, such as the long established Massachusetts data security law and the recently enacted New York Stop Hacks and Improve Electronic Data Act, both of which establish prescriptive administrative, technical, and physical data security requirements on companies, and permits civil penalties for each violation. Compliance with evolving privacy and security laws, requirements, and regulations may result in cost increases due to necessary systems changes, new limitations or constraints on our business models and the development of new administrative processes. They also may impose further restrictions on our collection, disclosure, and use of personally identifiable information kept in our databases or those of our vendors. If our security measures fail to protect credit card information adequately, we could be liable to both our customers and their users for their losses, as well as the vendors under our agreements with them such that we could be subject to fines and higher transaction fees, we could face regulatory action, and our customers and vendors could end their relationships with us, any of which could harm our business, results of operations or financial condition. Any willful or accidental security breaches or other unauthorized access to or disclosure of personal data could expose us to enforcement actions, regulatory or governmental audits, investigations, litigation, fines, penalties, adverse publicity, downtime of our systems, and other possible liabilities. There can be no assurance that the limitations of liability in our contracts would be enforceable or adequate or would otherwise protect us from any such liabilities or damages with respect to any particular claim. In addition, our cybersecurity insurance coverage may be inadequate to cover all costs and expenses associated with a security breach that may occur in the future.\nIn recent periods, we have experienced, and expect to continue to experience, rapid growth and organizational change. If we fail to manage our growth effectively, we may be unable to execute our business plan, maintain high levels of service and customer satisfaction or attract new employees and customers.\nWe have experienced, and expect to continue to experience, rapid growth in our number of customers, sales, revenues, locations, and headcount, which has placed, and may continue to place, significant demands on our management, and our operational and financial resources. We have paying customers in over 142 countries, and the number of our paying customers has grown from over 56,000 as of March 31, 2020 to over 72,000 as of March 31, 2021. We have seven offices across the globe with salespeople dispersed in various other locations, and the continued domestic and international growth\n53\nthat we anticipate will require us to continue to expand our global employee headcount. It may be difficult for us to identify, recruit, train, and manage enough personnel to efficiently scale our operations, manage our product development effectively and to match the growth of our customer base. As we continue to grow, we face challenges of integrating, developing, training, and motivating a rapidly growing and dispersed employee base. We are facing novel challenges with respect to integrating new employees and managing multi-geographic teams as COVID-19 prevents certain of our onboarding personnel from travelling between our offices to assist with such integration and training. Certain members of our executive management team have not previously worked together for an extended period of time, which may affect how they manage our growth. If we fail to manage our anticipated growth effectively, our brand and reputation could be negatively affected, which could harm our ability to attract employees and customers.\nTo manage growth in our operations and personnel, we will need to continue to scale and improve our operational, financial, and management controls, and our reporting systems and procedures, which will require significant capital expenditures increasing our cost of operations and the reallocation of valuable management resources. As we scale, it may become more difficult and will require additional capital expenditures to maintain and increase the productivity of our employees, to address the needs of our actual and prospective customers, and provide high-quality customer service, to further develop and enhance our products, and remain competitive against our competitors’ products. Additionally, our expansion has placed, and our expected future growth will continue to place, a significant strain on our management, customer service teams, product and development, sales and marketing, administrative, financial, and other resources.\nTechnical problems or disruptions that affect either our customers’ (and their users’) ability to access our platform and products, or the software, internal applications, database, and network systems underlying our platform and products, could damage our reputation and brands, lead to reduced demand for our platform and products, lower revenues, and increased costs.\nOur business, brands, reputation, and ability to attract and retain customers depend upon the satisfactory performance, reliability, and availability of our platform, which in turn depend upon the availability of the internet and our third-party service providers. Interruptions in these systems, whether due to system failures, computer viruses, software errors, physical or electronic break-ins, malicious hacks or attacks on our systems (such as denial of service attacks), or force majeure events, could affect the security and availability of our products and prevent or inhibit the ability of customers to access our platform. In addition, the software, internal applications, and systems underlying our products and platform are complex and may not be error-free. We may encounter technical problems when we attempt to perform routine maintenance or enhance our software, internal applications, and systems. In addition, our platform may be negatively impacted by technical issues experienced by our third-party service providers. Any inefficiencies, errors, or technical problems with our software, internal applications, and systems could reduce the quality of our platform and products or interfere with our customers’ (and their users’) use of our platform and products, which could negatively impact our brand, reduce demand, lower our revenues, and increase our costs.\nWe are exposed to risks associated with premium subscription and payment processing and any disruption to such processing systems could adversely affect our business and results of operations.\nWe primarily rely on our own billing systems to manage our subscriptions and billing frequencies, and we use third-party subscription management and payment processing platforms for some of our products. If we or any of our third-party vendors were to experience an interruption, delay, or outage in service and availability, we may be unable to process new and renewals of subscriptions and our ability to process such subscription and credit card payments would be delayed while we activate an alternative billing platform. Although alternative third-party providers may be available to us, we may incur significant expenses and research and development efforts to deploy any alternative providers. To the extent there\n54\nare disruptions in our billing systems or third-party subscription and payment processing systems, we could experience revenue loss, accounting issues, and harm to our reputation and customer relationships, which would adversely affect our business and results of operations.\nWe are subject to a number of risks related to credit and debit card payments, including:\n•we pay interchange and other fees, which may increase over time and could require us to either increase the prices we charge for our products or experience an increase in our operating expenses;\n•if our billing systems fail to work properly and the failure has an adverse effect on our customer satisfaction, causes credit and debit card issuers to disallow our continued use of their payment products, or, does not permit us to automatically charge our paying customers’ credit and debit cards on a timely basis or at all, we could lose or experience a delay in collection of customer payments;\n•if we are unable to maintain our chargeback rate at acceptable levels, we may face civil liability, diminished public perception of our security measures and our credit card fees for chargeback transactions, or our fees for other credit and debit card transactions or issuers, may increase, or issuers may terminate their relationship with us; and\n•we could be significantly impaired in our ability to operate our business if we lose our ability to process payments on any major credit or debit card.\nA significant portion of our operations is located outside of the United States, which subjects us to additional risks, including increased complexity, the costs of managing international operations, geopolitical instability, and fluctuations in currency exchange rates.\nThe design and development of our products is primarily conducted by our subsidiaries in Russia, the Czech Republic, Cyprus, and Poland. We also have marketing and administrative operations in the same jurisdictions. In addition, members of our sales force are located in Russia, Europe, the United Kingdom and Australia. Approximately 55% of our revenue for the three months ended March 31, 2021 was generated from sales to paying customers located outside the United States, including indirect sales through our resellers outside of the United States. As a result of our international operations and sales efforts, we face numerous challenges and risks that could harm our international operations, delay new product releases, increase our operating costs, and hinder our ability to grow and detect underlying trends in our operations and business, and consequently adversely impact our business, financial condition, and results of operations. Such risks include but are not limited to the following:\n•geopolitical and economic instability in and impacting the localities where we have foreign operations, such as Russia;\n•military conflicts impacting the localities where we have foreign operations;\n•limited protection for, and vulnerability to theft of, our intellectual property rights, including our trade secrets;\n•compliance with local laws and regulations, and unanticipated changes in local laws and regulations, including tax laws and regulations;\n•trade and foreign exchange restrictions and higher tariffs;\n•the complexity of managing international trade sanctions and export restrictions from the jurisdictions in which we have foreign operations;\n55\n•fluctuations in foreign currency exchange rates which may make our premium subscriptions more expensive for international paying customers and which may increase our expenses for employee compensation and other operating expenses that are paid in currencies other than U.S. dollars;\n•restrictions imposed by the United States government against other countries, or foreign governments restrictions imposed on the United States, impacting our ability to do business with certain companies or in certain countries and the complexity of complying with those restrictions;\n•power outages, natural disasters, and other local events that could affect the availability of the internet and the consequences of disruptions, such as large-scale outages or interruptions of service from utilities or telecommunications providers;\n•difficulties in staffing international operations;\n•changes in immigration policies which may impact our ability to hire personnel;\n•differing employment practices, laws, and labor relations;\n•regional health issues and the impact of public health epidemics and pandemics on employees and the global economy, such as the COVID-19 pandemic; and\n•travel, work-from-home or other restrictions or work stoppages, like those currently imposed by governments around the world as a result of the COVID-19 pandemic.\nFurther, it is possible that governments of one or more foreign countries may seek to limit access to the internet or our platform, products or certain features in their countries, or impose other restrictions that may affect the availability of our platform, products, or certain features in their countries for an extended period of time or indefinitely. For example, Russia and China are among a number of countries that have recently blocked certain online services, including Amazon Web Services, making it difficult for such services to access those markets. In addition, governments in certain countries may seek to restrict or prohibit access to our platform if they consider us to be in violation of their laws (including privacy laws) and may require us to disclose or provide access to information in our possession. If we fail to anticipate developments in the law or fail for any reason to comply with relevant laws, our platforms could be further blocked or restricted and we could be exposed to significant liability that could harm our business. In the event that access to our platform is restricted, in whole or in part, in one or more countries or our competitors are able to successfully penetrate geographic markets that we cannot access, our ability to acquire new customers or renew or grow the premium subscriptions of existing paying customers may be adversely affected, we may not be able to maintain or grow our revenue as anticipated and our business, results of operations, and financial condition could be adversely affected.\nThe effects of the COVID-19 pandemic are uncertain and may materially affect our customers or potential customers and how we operate our business, and the duration and extent to which the pandemic continues to threaten our future operating results remains uncertain.\nThe global COVID-19 pandemic has disrupted the economy and put unprecedented strains on governments, health care systems, educational institutions, companies, and individuals around the world. The impact and duration of the COVID-19 pandemic are difficult to assess or predict and will depend in part upon the actions taken by governments, companies, and other enterprises in response to the pandemic. The pandemic has already caused, and is likely to result in further, significant disruption of global financial markets and economic uncertainty. Adverse market conditions resulting from the COVID-19 pandemic could materially adversely affect our revenues, business and the value of our Class A common stock.\n56\nOur customers, particularly small-to-medium sized businesses (“SMBs”) and marketing agencies focused on SMBs, which have been particularly impacted by the COVID-19 pandemic, have reduced and may further reduce their technology or sales and marketing spending or delay purchasing decisions, which could result in slowed growth, reduced demand from new and existing SMB customers, and/or lower dollar-based net revenue retention rates, which could materially and adversely impact our business. In March 2020, our paying customer growth rate was relatively flat compared to our paying customer growth rate in February 2020. However, in April 2020 our paying customer growth rate declined, which we believe was primarily a result of the COVID-19 pandemic and the related socioeconomic impacts. In response, we offered free or discounted pricing to certain paying customers contemplating canceling their premium subscriptions as a remedial measure to retain them. Our paying customer growth rate started to increase again by May 2020. Depending on the duration of the COVID-19 pandemic, we may in the future be required to take further remedial measures, including changing our terms or offering further discounts, which may materially adversely impact our revenues and business in future periods.\nIn response to the COVID-19 pandemic, we temporarily closed all of our offices (including our headquarters in Boston, Massachusetts, and offices in Trevose, Pennsylvania, Dallas, Texas, Prague, Czech Republic, Limassol, Cyprus, and St. Petersburg, Russia), subsequently reopened certain offices at reduced capacity, enabled our employees to work remotely, implemented temporary travel restrictions for all non-essential business, and shifted company events to virtual-only experiences. We may deem it advisable to similarly alter, postpone, or cancel additional events in the future. If the COVID-19 pandemic worsens, especially in regions where we have offices, our business activities conducted from those offices could be adversely affected and we may have to invest additional capital into improving our technology and remote working capabilities and in relocating those activities to alternate locations from which we operate. We may take further actions that alter our business operations as may be required by local, state, or federal authorities or that we determine are in the best interests of our employees. Such measures could negatively affect our sales and marketing efforts, sales cycles, employee productivity, or customer retention, any of which could harm our financial condition and business operations.\nFurther, the COVID-19 pandemic has resulted in our employees and the employees of many of our customers and vendors working remotely. If the network and infrastructure of internet providers becomes overburdened by increased usage or is otherwise unreliable or unavailable, our employees’, and our customers’ and vendors’ employees’ access to the internet and ability to conduct business could be negatively impacted. We and our vendors may experience an increase in attempted cyber-attacks, targeted intrusion, ransomware, and phishing campaigns seeking to take advantage of shifts to employees working remotely using their household or personal internet networks. Any of these factors could interrupt our ability to provide our platform, decrease the productivity of our workforce, and significantly harm our business operations, financial condition, and results of operations.\nTo the extent the COVID-19 pandemic adversely affects our business and financial results, it may also have the effect of heightening many of the other risks described in this ‘‘Risk Factors’’ section.\nAdverse or weakened general economic and market conditions may reduce spending on sales and marketing technology and information, which could harm our revenue, results of operations, and cash flows.\nOur revenue, results of operations, and cash flows depend on the overall demand for and use of technology and information for sales and marketing, which depends in part on the amount of spending allocated by our paying customers or potential paying customers on sales and marketing technology and information. In addition to the internal strategy of our paying customers, which is not predictable and is subject to change, this spending depends on worldwide economic and geopolitical conditions. The United States, EU, and other key international economies have experienced cyclical downturns from time to time in which economic activity was impacted by falling demand for a variety of goods and services, restricted credit, poor liquidity, reduced corporate profitability, volatility in credit, equity, and foreign exchange markets, bankruptcies, public health crises, and pandemics such as COVID-19, and overall economic\n57\nuncertainty. These economic conditions can arise suddenly, may disproportionately impact SMBs that make up an important segment of our paying customer base, and the full impact of such conditions often remains uncertain for extended periods of time. Further actions or inactions of the United States or other major national governments, including the UK’s 2016 vote in favor of the UK’s exit from the EU, may also impact economic conditions, which could result in financial market disruptions or an economic downturn.\nConcerns about the systemic impact of an economic recession, energy costs, geopolitical issues, or the availability and cost of credit could lead to increased market volatility, decreased consumer confidence, and diminished growth expectations in the U.S. economy and abroad, which could affect the rate of information technology spending and adversely affect our paying customers’ ability or willingness to purchase our products, delay prospective paying customers’ purchasing decisions, reduce the value or duration of their premium subscription contracts, or affect retention rates. Any of these conditions or occurrences could adversely affect our future sales and operating results because most of our paying customers are on month-to-month premium subscriptions that can be cancelled at any time. Further, some of our paying customers may view a premium subscription to our platform as a discretionary purchase, and our paying customers may reduce their discretionary spending on our platform during an economic downturn and consequently reduce or terminate their premium subscription or decide not to upgrade another premium subscription. In particular, spending patterns of the SMBs that make up a large portion of our paying customer base are difficult to predict and are sensitive to the general economic climate, the economic outlook specific to small businesses, the then-current level of profitability experienced by SMBs and overall consumer confidence. In addition, weak economic conditions can result in paying customers seeking to utilize free or lower-cost solutions from alternative sources. Prolonged economic slowdowns may result in requests to renegotiate existing contracts on less advantageous terms to us than those currently in place, payment defaults on existing contracts, or non-renewal at the end of a contract term.\nFailure of our commercial liability insurance policy to cover claims and any changes to the availability or coverage amounts in our existing policy could have a material adverse effect on our business, financial condition, and results of operations.\nWe cannot assure you that our existing general liability insurance coverage and coverage for errors and omissions in our products will be fully covered by our existing policies and will continue to be available on acceptable terms, or will be available in sufficient amounts to cover one or more large claims, or that the insurer will not deny coverage as to any future claim. The successful assertion of one or more large claims against us that exceeds available insurance coverage, or the occurrence of changes in our insurance policies, including premium increases or the imposition of large deductible or co-insurance requirements, could have a material adverse effect on our business, financial condition, and results of operations.\nAs we acquire and invest in companies or technologies, we may not realize expected business or financial benefits and the acquisitions or investments could prove difficult to integrate, disrupt our business, dilute stockholder value and adversely affect our business, results of operations, and financial condition.\nAs part of our business strategy, we evaluate and may make investments in, or acquisitions of, complementary companies, services, databases, and technologies, and we expect that we will continue to evaluate and pursue such investments and acquisitions in the future to further grow and augment our business, our platform, and product offerings. For example, in August 2020, we acquired Prowly, an advertising and public relations technology company based in Poland. We have incurred and will continue to incur costs to integrate Prowly’s business and selling process into our business and to integrate Prowly’s products into our platform, such as software integration expenses and costs related to the renegotiation of redundant vendor agreements, and we expect to incur similar costs to integrate future acquisitions. We may have difficulty effectively integrating the personnel, businesses, and technologies of these acquisitions into our company and platform, and achieving the strategic goals of those acquisitions.\n58\nOur strategy to make selective acquisitions to complement our platform depends in part on the availability of, our ability to identify, and our ability to engage and pursue suitable acquisition candidates. We may not be able to find suitable acquisition candidates, and we may not be able to complete acquisitions on favorable terms, if at all. Acquired assets, data, or companies may not be successfully integrated into our operations, costs in connection with acquisitions and integrations may be higher than expected, and we may also incur unanticipated acquisition-related costs. These costs could adversely affect our financial condition, results of operations, or prospects. Any acquisition we complete could be viewed negatively by customers, users, developers, and other employees, partners, or investors, and could have adverse effects on our existing business relationships and company culture.\nAcquisitions and other transactions, arrangements, and investments involve numerous risks and could create unforeseen operating difficulties and expenditures, including:\n•difficulties in, and the cost of, integrating personnel and cultures, operations, technologies, products, services, and platforms which may lead to failure to achieve the expected benefits on a timely basis or at all;\n•diversion of financial and managerial resources from existing operations;\n•the potential entry into new markets in which we have little or no experience or where competitors may have stronger market positions;\n•potential write-offs of acquired assets or investments, and potential financial and credit risks associated with acquired customers;\n•additional stock-based compensation and difficulties in, and financial costs of, addressing acquired compensation structures inconsistent with our compensation structure;\n•inability to generate sufficient revenue to offset acquisition and/or investment costs;\n•inability to maintain, or changes in, relationships with customers and partners of the acquired business;\n•challenges converting the revenue recognition policies of companies we may acquire and forecasting the recognition of their revenue, including subscription-based revenue and revenue based on the transfer of control, as well as appropriate allocation of the customer consideration to the individual deliverables;\n•difficulty with, and costs related to, transitioning the acquired technology onto our existing platform, augmenting the acquired technologies and platforms to the levels that are consistent with our brand and reputation, augmenting or maintaining the security standards for acquired technology consistent with our platform and other products, and customer acceptance of multiple platforms on a temporary or permanent basis;\n•potential unknown liabilities associated with the acquired companies, including risks associated with acquired intellectual property and/or technologies;\n•challenges relating to the structure of an investment, such as governance, accountability, and decision-making conflicts;\n•negative impact to our results of operations because of the depreciation and amortization of amounts related to acquired intangible assets, fixed assets, and deferred compensation;\n•the loss of acquired unearned revenue and unbilled unearned revenue;\n59\n•delays in customer purchases due to uncertainty related to any acquisition;\n•ineffective or inadequate controls, procedures, and policies at the acquired company;\n•challenges caused by integrating operations over distance, and across different languages, cultures, and political environments;\n•currency and regulatory risks associated with conducting operations in foreign countries and potential additional cybersecurity and compliance risks resulting from entry into new markets;\n•tax effects and costs of any such acquisitions, including the related integration into our tax structure and assessment of the impact on the realizability of our future tax assets or liabilities; and\n•potential challenges by governmental authorities for anti-competitive or other reasons.\nAny of these risks could harm our business. In addition, to facilitate these acquisitions or investments, we may seek additional equity or debt financing, which may not be available on terms favorable to us or at all, may affect our ability to complete subsequent acquisitions or investments and may affect the risks of owning our Class A common stock. For example, if we finance acquisitions by issuing equity or convertible debt securities or loans, our existing stockholders may be diluted, or we could face constraints related to the terms of, and repayment obligations related to, the incurrence of indebtedness that could affect the market price of our Class A common stock.\nOur debt obligations contain restrictions that impact our business and expose us to risks that could adversely affect our liquidity and financial condition.\nOn January 12, 2021, we executed a credit agreement with JPMorgan Chase Bank, N.A., in the form of a revolving credit facility, that consists of a $45.0 million revolving credit facility and a letter of credit sub-facility with an aggregate limit equal to the lesser of $5.0 million and the aggregate unused amount of the revolving commitments then in effect. The amount of borrowings permitted at any one time under the revolving credit facility is subject to a borrowing base based on an advance rate of 400% multiplied by annualized retention applied to monthly recurring revenue. As a result, our access to the revolving credit facility is potentially subject to significant fluctuations depending on the value of the borrowing base as of any measurement date.\nThe credit agreement (as amended, restated, amended and restated, supplemented or otherwise modified from time to time, the “Credit Agreement”) governing our revolving credit facility (collectively, our “credit facility”) contains various covenants that are operative so long as our credit facility remains outstanding. The covenants, among other things, limit our and certain of our subsidiaries’ abilities to:\n•incur additional indebtedness or guarantee indebtedness of others;\n•create additional liens on our assets;\n•pay dividends and make other distributions on our capital stock, and redeem and repurchase our capital stock;\n•make investments, including acquisitions;\n•make capital expenditures;\n•enter into mergers or consolidations or sell assets;\n•sell our subsidiaries; or\n60\n•enter into transactions with affiliates.\nOur credit facility also contains numerous affirmative covenants and a financial covenant of either minimum liquidity or a maximum leverage ratio.\nIf we experience a decline in cash flow due to any of the factors described in this “Risk Factors” section or otherwise, we could have difficulty paying interest due on our indebtedness and meeting the financial covenants set forth in our credit facility. If we fail to comply with the various requirements of our indebtedness, we could default under our credit facility. Any such default that is not cured or waived could result in an acceleration of indebtedness then outstanding under our credit facility, an increase in the applicable interest rates under our credit facility, and a requirement that Semrush US Sub, which is a co-borrower under the facility, pay the obligations in full, and would permit the lenders to exercise remedies with respect to all of the collateral that is securing our credit facility, including substantially all of our and Semrush US Sub’s assets. Thus, any such default could have a material adverse effect on our liquidity and financial condition.\nIf we cannot maintain our company culture as we grow, we could lose the innovation, teamwork, passion, and focus on execution that we believe contribute to our success and our business may be harmed.\nWe believe that a critical component to our success has been our company culture, which is based on transparency, innovation, creativity, and personal autonomy to take on challenges and initiatives. We have invested substantial time and resources in building our team within this company culture across our offices. Any failure to preserve our culture could negatively affect our ability to retain and recruit personnel and to effectively focus on and pursue our corporate objectives. As we grow and develop the infrastructure of a public company, we may find it difficult to maintain these foundational aspects of our company culture. If we fail to maintain our company culture, we may fail to recruit qualified employees, our existing employees may terminate their employment, our ability to execute on marketing, sales, product and development, and other initiatives may suffer, and our business may be adversely impacted in other ways.\nChanges in the sizes or types of paying customers that purchase premium subscriptions to our platform or products could affect our business, and our financial results may fluctuate due to increasing variability in our sales cycles.\nOur strategy is to sell premium subscriptions of our platform to paying customers of all sizes, from sole proprietors, to SMBs, to large enterprise customers. Selling monthly premium subscriptions to SMBs generally involves lower or plateauing premium subscription upgrade potential, lower retention rates (especially in times of economic uncertainty where marketing and sales budgets are subject to increased scrutiny and reduction), and more limited interaction with our sales and other personnel than sales to large enterprises. Conversely, sales to large enterprises generally entail longer sales cycles, more significant and costly selling and support efforts, and greater uncertainty of completing the sale than sales to SMBs. We plan our expenses based on certain assumptions about the length and variability of our sales cycle based upon historical trends for sales and conversion rates associated with our existing paying customers. If and as our paying customer base expands to include more large enterprise customers, our sales expenses may increase, sales cycles may lengthen and become less predictable, and we may see a greater number of paying customers with longer terms and extended payment terms which, in turn, may increase our paying customer acquisition costs, increase our credit risk, and may in other ways adversely affect our financial results. Additional factors that may influence the length and variability of our sales cycle include:\n•the need to educate prospective customers about the different products available on our platform, and their uses and benefits;\n61\n•the discretionary nature of purchase and budget cycles and decisions;\n•the competitive nature of evaluation and purchasing processes;\n•economic and political stability and other external factors;\n•evolving functionality demands;\n•announcements of planned introductions of new products, features or functionality by us or our competitors; and\n•lengthy and multi-faceted purchasing approval processes required by our customers, especially large enterprise customers.\nIf there are changes in, or we fail to adequately predict, the mix of paying customers that purchase premium subscriptions to our platform, our gross margins and operating results could be adversely affected, and fluctuations increasing the variability in our sales cycles could negatively affect our financial results.\nForecasts of our market and market growth may prove to be inaccurate, and even if the markets in which we compete achieve the forecasted growth, there can be no assurance that our business will grow at similar rates, or at all.\nGrowth forecasts that we have provided and may provide, including those in the Prospectus and in this Quarterly Report on Form 10-Q, relating to our market opportunities and the expected growth thereof are subject to significant uncertainty and are based on assumptions and estimates which may prove to be inaccurate. Even if these markets grow at the forecasted rates, we may not grow our business at a similar rate, or at all. Our growth is subject to many factors, including our success in implementing our business strategy, which is subject to many risks and uncertainties. Accordingly, the forecasts of market growth that we have provided and may in the future provide should not be taken as indicative of our future growth.\nOur management has broad discretion over the use of the proceeds from the IPO, and might not use the net proceeds effectively.\nOur management has broad discretion to use the net proceeds from the IPO, including for any of the purposes described in the section titled “Use of Proceeds” included in the Prospectus, and you will be relying on the judgment of our management regarding the application of these proceeds. Our management might not apply the net proceeds in ways that increase the value of your investment. Until we use the net proceeds from the IPO, we plan to invest them, and these investments may not yield a favorable rate of return. If we do not invest or apply the net proceeds from the IPO in ways that enhance stockholder value, we may fail to achieve expected financial results, which could cause our stock price to decline.\nWe may be subject to litigation for any of a variety of claims, which could harm our reputation and adversely affect our business, results of operations, and financial condition.\nIn the ordinary course of business, we may be involved in and subject to litigation for a variety of claims or disputes and receive regulatory inquiries. These claims, lawsuits, and proceedings could include labor and employment, wage and hour, income tax, commercial, data privacy, antitrust, alleged securities law violations or other investor claims, and other matters. The number and significance of these potential claims and disputes may increase as our business expands. Any claim against us, regardless of its merit, could be costly, divert management’s attention and operational resources, and harm our reputation. As litigation is inherently unpredictable, we cannot assure you that any potential claims or disputes will not\n62\nhave a material adverse effect on our business, results of operations, and financial condition. Any claims or litigation, even if fully indemnified or insured, could make it more difficult to compete effectively or to obtain adequate insurance in the future.\nIn addition, we may be required to spend significant resources to monitor and protect our contractual, intellectual property, and other rights, including collection of payments and fees. Litigation has been and may be necessary in the future to enforce such rights. Such litigation could be costly, time consuming, and distracting to management and could result in the impairment or loss of our rights. Furthermore, our efforts to enforce our rights may be met with defenses, counterclaims, and countersuits attacking the validity and enforceability of such rights. Our inability to protect our rights, as well as any costly litigation or diversion of our management’s attention and resources, could have an adverse effect on our business, results of operations, and financial condition or harm our reputation.\nOur failure to raise additional capital or generate cash flows necessary to expand our operations and invest in new technologies in the future could reduce our ability to compete successfully and harm our results of operations.\nWe may require additional financing, and we may not be able to obtain debt or equity financing on favorable terms, if at all. Any debt financing obtained by us could involve restrictive covenants relating to financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities, including potential acquisitions. If we raise additional funds through further issuances of equity, convertible debt securities or other securities convertible into equity, our existing stockholders could experience significant dilution, and any new equity securities we issue could have rights, preferences, and privileges senior to those of holders of our Class A common stock. The terms of any debt financing may include liquidity requirements, restrict our ability to pay dividends, and require us to comply with other covenants restrictions. If we need additional capital and cannot raise it on acceptable terms, or at all, we may not be able to, among other things:\n•develop new features, integrations, capabilities, and enhancements;\n•continue to expand our product and development, and sales and marketing teams;\n•hire, train, and retain employees;\n•respond to competitive pressures or unanticipated working capital requirements; or\n•pursue acquisition opportunities.\nOur referral partners and resellers provide revenue to our business, and we benefit from our association with them. Our failure to maintain successful relationships with these partners could adversely affect our business.\nOur referral partners and resellers drive revenue to our business and our agreements with these partners and resellers are non-exclusive, with the exception of one exclusive reseller agreement in Japan. While most of these partners and resellers offer products or services that are complementary to our platform and products, some offer point solutions that compete with certain functionalities of our platform. These referral partners and resellers may decide in the future to terminate their agreements with us and/or to market and sell a competitor’s or their own products or services rather than ours, which could cause our revenue to decline. Our competitors may in some cases be effective in causing our referral partners and resellers, or potential referrals and resellers, to favor their products and services or to prevent or reduce sales of our platform and products. Also, we derive tangible and intangible benefits from our association with some of our referral partners and members of our affiliate networking programs, particularly high-profile partners that reach a large number of companies through the internet. If a\n63\nsubstantial number of these partners or networking affiliates reduce or cease their relationships with us, our business, financial condition, and results of operations could be adversely affected.\nWe expect that we will need to continue to expand and maintain a network of referral partners and resellers in order to expand into certain international markets. A loss of or reduction in sales through these third parties could reduce our revenue. Recruiting and retaining qualified resellers in our network and training them in our technology and product offerings requires significant time and resources. If we decide to further develop and expand our indirect sales channels, we must continue to scale and improve our processes and procedures to support these channels, including investment in systems and training. Many resellers may not be willing to invest the time and resources required to train their staff to effectively sell our platform. If we fail to maintain relationships with our referral partners and resellers, fail to develop relationships with new referral partners and resellers in new markets or expand the same in existing markets, or fail to manage, train, or provide appropriate incentives to our existing referral partners and resellers, our ability to increase the number of new paying customers and increase sales to existing paying customers could be adversely impacted, which would harm our business.\nOur ability to utilize our net operating loss carryforwards may be limited.\nAs of December 31, 2020, we had U.S. federal and state net operating loss carryforwards of approximately $28.0 million and $14.1 million, respectively. Our ability to utilize our federal net operating loss carryforwards may be limited under Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”). The limitations apply if we experience an “ownership change,” which is generally defined as a greater than 50 percentage point change (by value) in the ownership of our equity by certain stockholders over a rolling three-year period. Similar provisions of state tax law may also apply to limit the use of our state net operating loss carryforwards. Future changes in our stock ownership, which may be outside of our control, may trigger an ownership change and, consequently, the limitations under Section 382 of the Code. As a result, if or when we earn net taxable income, our ability to use our pre-change net operating loss carryforwards to offset such taxable income may be subject to limitations, which could adversely affect our future cash flows.\nWe could be required to collect additional sales and other similar taxes or be subject to other tax liabilities that may increase the costs our customers would have to pay for our subscriptions and adversely affect our operating results.\nSales and use, value-added, goods and services, and similar tax laws and rates are complicated and vary greatly by jurisdiction. There is significant uncertainty as to what constitutes sufficient nexus for a national, state or local jurisdiction to levy taxes, fees, and surcharges for sales made over the internet, as well as whether our subscriptions are subject to tax in various jurisdictions. Certain countries and the vast majority of states have considered or adopted laws that impose tax collection obligations on out-of-state companies. Additionally, in the United States, the Supreme Court of the United States recently ruled in South Dakota v. Wayfair, Inc. et. al. (“Wayfair”) that online sellers can be required to collect sales and use tax despite not having a physical presence in the buyer’s state. In response to the Wayfair case, or otherwise, national, states or local governments may enforce laws requiring us to calculate, collect, and remit taxes on sales in their jurisdictions. We have not always collected sales and other similar taxes in all jurisdictions in which we are required to. We may be obligated to collect and remit sales tax in jurisdictions in which we have not previously collected and remitted sales tax. We could also be subject to audits in states and non-U.S. jurisdictions for which we have not accrued tax liabilities. A successful assertion by one or more countries or states requiring us to collect taxes where we historically have not or presently do not do so could result in substantial tax liabilities, including taxes on past sales, as well as penalties and interest. The imposition by national, state or local governments of sales tax collection obligations on out-of-state sellers could also create additional administrative burdens for us and decrease our future sales, which could adversely affect our business and operating results.\nRisks Related to the Regulatory Framework that Governs Us\n64\nIf the use of cookies or other tracking technologies becomes subject to unfavorable legislation or regulation, is restricted by internet users or other third parties or is blocked or limited by users or by technical changes on end users’ devices, our ability to attract new customers and to develop and provide certain products could be diminished or eliminated.\nWe rely on small text files and other technologies, such as web beacons (collectively, “cookies”) which are placed on internet browsers to gather data regarding the content of a user’s web browsing activity. We use cookies to store users’ settings between sessions and to enable visitors to our website to use certain features, such as gaining access to secure areas of the website. We also use cookies, including cookies placed by third-party services with which we integrate, to enable us to gather statistics about our visitors’ use of our website and to allow our website visitors to connect our platform to their social networking sites, which enables us to advertise our products to them using retargeting methods. The availability of this data may be limited by numerous potential factors, including government legislation or regulation restricting the use of cookies for certain purposes, such as retargeting, browser limitations on the collection or use of cookies, or internet users deleting or blocking cookies on their web browsers or on our website.\nOur ability, like those of other technology companies, to collect, augment, analyze, use, and share information collected through the use of third-party cookies for online behavioral advertising is governed by U.S. and foreign laws and regulations which change from time to time, such as those regulating the level of consumer notice and consent required before a company can employ cookies to collect data about interactions with users online. In the United States, both state and federal legislation govern activities such as the collection and use of data, and privacy in the advertising technology industry has frequently been subject to review, and occasional enforcement, by the Federal Trade Commission, or the FTC, U.S. Congress, and individual states.\nAs our business is global, our activities are also subject to foreign legislation and regulation. In the EU, the EU Directive 2002/58/EC (as amended by Directive 2009/136/EC), commonly referred to as the e-Privacy Directive, and related implementing legislation in the EU and the UK requires that accessing or storing information on an internet user’s device, such as through a cookie, is allowed only if the internet user has been informed thereof, and provided prior unambiguous, specific, and informed consent for the placement of a cookie on a user’s device. A new e-Privacy Regulation is currently under discussion by EU member states to replace the e-Privacy Directive. Although it remains under debate, the proposed e-Privacy Regulation would amend rules on third-party cookies and significantly increase penalties for non-compliance. We cannot yet determine the impact such future laws, regulations, and standards may have on our use of third-party cookies. Additionally, the use of third-party cookies in the digital advertising ecosystem, particularly in the context of real-time bidding advertising auctions, is subject to increased regulatory scrutiny in the EU. Several European data protection authorities (including in Belgium, Ireland, UK, Poland, Spain, Luxembourg, and the Netherlands) have launched investigations or inquiries over Google’s and other AdTech companies’ practices concerning the collection and sharing of consumer data through cookies, the outcome of which is still uncertain. These investigations or inquiries could result in the imposition of more stringent standards around consent to place cookies or otherwise restrict the use of third-party cookies for online behavioral advertising. We have also received inquiries from, and engaged in correspondence with, European data protection authorities regarding our practices regarding cookies used on our websites, and the outcome of these inquiries is still uncertain.\nAdditionally, new and expanding “Do Not Track” regulations have recently been enacted or proposed that protect users’ right to choose whether or not to be tracked online. These regulations seek, among other things, to allow end users to have greater control over the use of private information collected online, to forbid the collection or use of online information, to demand a business to comply with their choice to opt out of such collection or use, and to place limits upon the disclosure of information to third-party websites.\n65\nContinued regulation of cookies, and changes in the interpretation and enforcement of existing laws, regulations, standards, and other obligations, as well as increased enforcement by industry groups or data protection authorities, could restrict our activities, such as efforts to understand users’ internet usage and engage in marketing activities, or require changes to our practices. Any inability to obtain information through cookies or to obtain it on the terms we anticipate, could cause a significant impact on the operation of our platform, impair our ability to target and attract new customers, and reduce our ability to predict our customers’ interests in or need for one or more of our products, any of which may cause a reduction in revenue or a reduction in revenue growth, negatively impact our ability to obtain new subscriptions and retain or grow the subscriptions of existing customers.\nAdditionally, cookies may easily be deleted or blocked by internet users. All of the most commonly used internet browsers (including Chrome, Firefox, Internet Explorer, and Safari) allow internet users to prevent cookies from being accepted by their browsers. Internet users can also delete cookies from their computers at any time. Some internet users also download “ad blocking” software that prevents cookies from being stored on a user’s device. If more internet users adopt these settings or delete their cookies more frequently than they currently do, our business could be harmed. In addition, the Safari and Firefox browsers block third-party cookies by default, and other browsers may do so in the future. Unless such default settings in browsers were altered by internet users to permit the placement of third-party cookies, fewer cookies would be available, which could adversely affect our business. In addition, companies such as Google LLC have publicly disclosed their intention to move away from cookies to another form of persistent unique identifier, or ID, to identify individual internet users or internet-connected devices in the bidding process on advertising exchanges. If companies do not use shared IDs across the entire ecosystem, this could have a negative impact on our ability obtain content consumption data.\nChanges in laws, regulations, and public perception concerning data protection and privacy, or changes in the interpretation or patterns of enforcement of existing laws and regulations, could impair our efforts to maintain and expand our customer base or the ability of our customers and users to use our platform and some or all of our products. Breaches of laws and regulations concerning data protection and privacy could expose us to significant fines and other penalties.\nWe hold personal data about a variety of individuals, such as our customers, users, employees, contractors, and business partners, and we use such personal data as needed to collect payment from our customers, communicate with and recommend products to our customers and prospective customers through our marketing and advertising efforts, and comply with legal obligations. Processing of personal data is increasingly subject to legislation and regulation in numerous jurisdictions around the world.\nFor example, relevant applicable laws and regulations governing the collection, use, disclosure or other processing of personal information include, in the United States, rules and regulations promulgated under the authority of the Federal Trade Commission, the California Consumer Privacy Act of 2018 (the “CCPA”), and state breach notification laws. In particular, in California, the CCPA was enacted in June 2018, became effective back on January 1, 2020 and became subject to enforcement by the California Attorney General’s office on July 1, 2020. The CCPA broadly defines personal information and provides an expansive meaning to activity considered to be a sale of personal information, and gives California residents expanded privacy rights and protections, including the right to opt out of the sale of personal information. The CCPA also provides for civil penalties for violations and a private right of action for data breaches. Moreover, a new privacy law that amends and expands the CCPA, the California Privacy Rights Act, or CPRA, was passed on November 3, 2020. The CPRA creates additional obligations relating to personal information that take effect on January 1, 2023 (with certain provisions having retroactive effect to January 1, 2022). The CPRA also establishes a new enforcement agency dedicated to consumer privacy. The CPRA’s implementing regulations are expected on or before July 1, 2022, and enforcement is scheduled to begin July 1, 2023. We will continue to monitor developments related to the CPRA and anticipate additional costs and expenses associated with CPRA compliance. In addition, since the enactment of CCPA, new privacy and data security laws have been proposed in more than half of the states in the United States and in the U.S. Congress, reflecting a trend toward more stringent privacy\n66\nlegislation in the United States, which trend may accelerate depending on the results of the 2020 U.S. presidential election. The effects of the CCPA, CPRA, and other similar state or federal laws, are potentially significant and may require us to modify our data processing practices and policies, and to incur substantial costs and potential liability in an effort to comply with such legislation.\nWe maintain offices in the EU (including Poland, the Czech Republic, and Cyprus) and we have customers in the EU and the UK. Accordingly, we are subject to the General Data Protection Regulation (EU) 2016/679 (the “GDPR”), and related member state implementing legislation, and to the UK’s Data Protection Act 2018 (collectively, “European Data Protection Law”). European Data Protection Law places obligations on controllers and processors of personal data, while establishing rights for individuals with respect to their personal data, including rights of access and deletion in certain circumstances. European Data Protection Law is also explicitly extraterritorial in its application, and could affect our business activities in jurisdictions outside the EU and the UK.\nWe have implemented measures designed to comply with the requirements of European Data Protection Law. In respect of these measures, we rely on positions and interpretations of the law (including European Data Protection Law) that have yet to be fully tested before the relevant courts and regulators. If a regulator or court of competent jurisdiction determined that one or more of our compliance efforts does not satisfy the applicable requirements of the law (including European Data Protection Law), or if any party brought a claim in this regard, we could be subject to governmental or regulatory investigations, enforcement actions, regulatory fines, compliance orders, litigation or public statements against us by consumer advocacy groups or others, any of which could cause customers to lose trust in us or otherwise damage our reputation. Likewise, a change in guidance could be costly and have an adverse effect on our business.\nThe requirements of European Data Protection Law pertaining to the licensing of data or obtaining such data from third parties are not entirely clear in all cases. It is possible that third parties may bring claims against us, alleging non-compliance with such requirements, and seeking damages, seeking to prevent us from using certain data, or seeking to prevent us from using data in particular ways. Such claims could potentially adversely affect our ability to provide our services and the current level of functionality of our platform in such circumstances, which could adversely affect our results of operations.\nEuropean Data Protection Law also imposes strict rules on the transfer of personal data out of the EU/UK to third countries deemed to lack adequate privacy protections (including the United States), unless an appropriate safeguard specified by the GDPR is implemented, such as the Standard Contractual Clauses (“SCCs”), approved by the European Commission, or a derogation applies. The Court of Justice of the EU (the “CJEU”), recently deemed that the SCCs are valid. However, the CJEU ruled that transfers made pursuant to the SCCs and other alternative transfer mechanisms need to be analyzed on a case-by-case basis to ensure EU standards of data protection are met in the jurisdiction where the data importer is based, and there continue to be concerns about whether the SCCs and other mechanisms will face additional challenges. EU regulators have announced that there will be further guidance issued on these topics, but such guidance has yet to be finalized. We rely on SCCs and certain derogations to transfer personal data from the EU and the UK to the United States and Russia. Until the remaining legal uncertainties regarding how to legally continue transfers pursuant to the SCCs and other mechanisms are settled, we will continue to face uncertainty as to whether our efforts to comply with our obligations under European Data Protection Law are sufficient. European or multi-national customers may refuse or be reluctant to use or continue to use our platform or products as a result of such developments until law makers and regulators in the EU and the United States have resolved the issues that instigated the decision of the CJEU noted above. This and other future developments regarding the flow of data across borders could increase the cost and complexity of delivering our platform and products in some markets and may lead to governmental enforcement actions, litigation, fines, and penalties or adverse publicity, which could have an adverse effect on our reputation and business.\n67\nThe relationship between the UK and the EU in relation to certain aspects of data protection law remains unclear. In addition, it is likely that documentation will need to be put in place between UK entities and entities in EU member states to ensure adequate safeguards are in place for data transfers, which may result in us incurring additional costs with respect to transfers of personal data between the EU and the UK. We may find it necessary or advantageous to join industry bodies, or self-regulatory organizations, that impose stricter compliance requirements than those set out in applicable laws, including European Data Protection Laws. We may also be bound by contractual restrictions that prevent us from participating in data processing activities that would otherwise be permissible under applicable laws, including European Data Protection Laws. Such strategic choices may impact our ability to exploit data and may have an adverse impact on our business.\nAs we maintain offices in Russia, we face particular privacy, data security, and data protection risks in connection with requirements of Russia’s data protection and security laws, including Federal Law of 21 July 2014 No. 242-FZ, which entered into effect September 1, 2015, Federal Law of 27 July 2006 No. 152-FZ (as amended) and Federal Law of 27 July 2006 No. 149-FZ (as amended). Among other stringent requirements, these laws require ensuring that certain operations on personal data of Russian citizens are conducted in database(s) located in Russia.\nWe expect that there will continue to be new proposed laws, regulations, and industry standards concerning privacy, data protection, and information security in the United States, the EU, and other jurisdictions, and we cannot yet determine the impact such future laws, regulations, and standards may have on our business.\nThese and other legal requirements could require us to make additional changes to our platform or products in order for us or our customers to comply with such legal requirements or reduce our ability to lawfully collect personal data used in our platform and products. These changes could reduce demand for our platform or products, require us to take on more onerous obligations in our contracts, restrict our ability to store, transfer, and process personal data or, in some cases, impact our ability or our customers’ ability to offer our products in certain locations, to deploy our solutions, to reach current and prospective customers, or to derive insights from data globally.\nThe costs of complying with existing or new data privacy or data protection laws and regulations, regulatory guidance, our privacy policies and contractual obligations to customers, users, or other third parties, may limit the use and adoption of our platform and products, reduce overall demand for our products, make it more difficult for us to meet expectations from or commitments to customers and users, lead to significant fines, penalties, or liabilities for noncompliance, impact our reputation, or slow the pace at which we close sales transactions, any of which could harm our business.\nFurthermore, the uncertain and shifting regulatory environment and trust climate may cause concerns regarding data privacy and may cause our vendors, customers and users to resist providing the data necessary to allow us to offer our platform and products to our customers and users effectively, or could prompt individuals to opt out of our collection of their personal data. Even the perception that the privacy of personal data is not satisfactorily protected or does not meet regulatory requirements could discourage prospective customers from subscribing to our products or discourage current customers from renewing their subscriptions.\nCompliance with any of the foregoing laws and regulations can be costly and can delay or impede the development of new products. We may incur substantial fines if we violate any laws or regulations relating to the collection or use of personal data. For example, the GDPR imposes sanctions for violations up to the greater of €20 million and 4% of worldwide gross annual revenue, enables individuals to claim damages resulting from infringement of the GDPR and introduces the right for non-profit organizations to bring claims on behalf of data subjects. CCPA allows for fines of up to $7,500 for each violation (affected individual) that a business does not cure within 30 days of receiving notice of the violation. Non-compliance with Russian data localization rules may result in imposition of an administrative fine of up to\n68\nRUB 18 million, or approximately $240,000, for each violation. Our actual or alleged failure to comply with applicable privacy or data security laws, regulations, and policies, or to protect personal data, could result in enforcement actions and significant penalties against us, which could result in negative publicity or costs, subject us to claims or other remedies, and have a material adverse effect on our business, financial condition, and results of operations.\nMany aspects of data protection and privacy laws are relatively new and their scope has not been tested in the courts. As a result, these laws and regulations are subject to differing interpretations and may be inconsistent among jurisdictions. It is possible that these laws and regulations may be interpreted and applied in a manner that is inconsistent with our interpretations and existing data management practices or the features of our products. Certain of our activities could be found by a court, government or regulatory authority to be noncompliant or become noncompliant in the future with one or more data protection or data privacy laws, even if we have implemented and maintained a strategy that we believe to be compliant. Further, we may be subject to additional risks associated with data security breaches or other incidents, in particular because certain data privacy laws, including the GDPR and CCPA, grant individuals a private right of action arising from certain data security incidents. If so, in addition to the possibility of fines, lawsuits, and other claims and penalties, we could be required to fundamentally change our business activities and practices or modify our products, which could harm our business.\nWe also receive personal data from third-party vendors (e.g., data brokers). We may not be able to verify with complete certainty the source of such data, how it was collected, and that such data was collected and is being shared with us in compliance with all applicable data protection and privacy laws. Our use of personal data obtained from third-party vendors could result in potential regulatory investigations, fines, penalties, compliance orders, liability, litigation, and remediation costs, as well as reputational harm, any of which could materially adversely affect our business and financial results. The requirements of European Data Protection Law pertaining to the licensing of data or obtaining such data from third parties are not entirely clear in all cases. It is possible that third parties may bring claims against us, alleging non-compliance with such requirements, and seeking damages, seeking to prevent us from using certain data, or seeking to prevent us from using data in particular ways. Such claims could potentially adversely affect our ability to provide our services and the current level of functionality of our platform in such circumstances, which could adversely affect our results of operations.\nChanges in legislation or requirements related to automatically renewing subscription plans, or our failure to comply with existing or future regulations, may adversely impact our business.\nOur business relies heavily on the fact that customers enter subscription contracts where they agree that the subscription will automatically renew for a new term, and their credit or debit cards will automatically be charged on an ongoing basis, unless the subscription is canceled by the customer. Some states have passed or considered legislation limiting the duration for which subscriptions can automatically renew, if at all.\nAlthough this enacted and proposed legislation generally would not affect companies that sell subscriptions to other companies, like ours does, there could be variances and inconsistencies in these rules or requirements among jurisdictions that expose us to compliance risks that would have a material adverse effect on our business operations and financial condition, and could result in fines, penalties, damages, civil liability, and higher transaction fees. In addition, any costs that result from future legislation and regulations, or from changes in the interpretation of existing legislation and regulations, could individually or in the aggregate cause us to change or limit our business practices, which may make our subscription business model less attractive.\nChanges in laws and regulations related to the internet or changes in the internet infrastructure itself may diminish the demand for our platform and could harm our business.\n69\nThe future success of our business depends upon the continued use of the internet as a primary medium for commerce, communication, and business applications. Federal, state, or foreign governmental bodies or agencies have in the past adopted, and may in the future adopt, laws or regulations affecting the use of the internet as a commercial medium. The adoption of any laws or regulations that could reduce the growth or use of the internet, including laws or practices limiting internet neutrality, could decrease the demand for, or the usage of, our platform and products, increase our cost of doing business, require us to modify our platform or financial systems, and may harm our results of operations. In addition, government agencies or private organizations have imposed and may impose additional taxes, fees, or other charges for accessing the internet or commerce conducted via the internet, which could limit the growth of internet-related commerce or communications generally, result in higher prices for our products and platform, or result in reduced demand for internet-based products such as ours.\nAs the internet continues to experience growth in the number of users, frequency of use, and amount of data transmitted, the internet infrastructure that we and our customers rely on may be unable to support the demands placed upon it. In addition, there could be adverse effects from delays in the development or adoption of new standards and protocols to handle increased demands of internet activity, security, reliability, cost, ease-of-use, accessibility, and quality of service. Further, our platform depends on the quality of our customers’ access to the internet. The failure of the internet infrastructure that we or our customers rely on, even for a short period of time, could undermine our operations and harm our results of operations.\nInternet access is frequently provided by companies that have significant market power that could take actions that degrade, disrupt, or increase the cost of customer access to our platform, any of which would negatively impact our business. On June 11, 2018, the repeal of the Federal Communications Commission’s, or the FCC, “net neutrality” rules took effect and returned to a “light-touch” regulatory framework. The prior rules were designed to ensure that all online content is treated the same by internet service providers and other companies that provide broadband services. Additionally, on September 30, 2018, California enacted the California internet Consumer Protection and Net Neutrality Act of 2018, making California the fourth state to enact a state-level net neutrality law since the FCC repealed its nationwide regulations, mandating that all broadband services in California must be provided in accordance with state net neutrality requirements. The U.S. Department of Justice has sued to block the law going into effect, and California has agreed to delay enforcement until the resolution of the FCC’s repeal of the federal rules. A number of other states are considering legislation or executive actions that would regulate the conduct of broadband providers. We cannot predict whether the FCC order or state initiatives will be modified, overturned, or vacated by legal action of the court, federal legislation or the FCC. With the repeal of net neutrality rules, network operators may choose to implement usage-based pricing, discount pricing charged to providers of competitive products, otherwise materially change their pricing rates or schemes, charge us to deliver our traffic or throttle its delivery, implement bandwidth caps or other usage restrictions or otherwise try to monetize or control access to their networks, any of which could increase our costs, or those of our customers in accessing our platform, and negatively impact our business and results of operations.\nFederal, state, and foreign laws regulate internet tracking software, the sending of commercial emails and text messages, and other activities, which could impact the use of our platform and products, and potentially subject us to regulatory enforcement or private litigation.\nWe are subject to laws and regulations that govern sending marketing and advertising by electronic means, such email and telephone. For example, in the United States, the Controlling the Assault of Non-Solicited Pornography and Marketing Act of 2003, or the CAN-SPAM Act, among other things, obligates the sender of commercial emails to provide recipients with the ability to opt out of receiving future commercial emails from the sender. In addition, the Telephone Consumer Protection Act imposes certain notice, consent, and opt-out obligations on companies that send telephone or text communications using auto dialers to consumers, and provides consumers with private rights of action for violations. Further,\n70\ncertain states and foreign jurisdictions, such as Australia, Canada, and the EU, have enacted laws that prohibit sending unsolicited marketing emails unless the recipient has provided its prior consent to receipt of such email, or in other words has “opted-in” to receiving it. A requirement that recipients opt into, or the ability of recipients to opt out of, receiving commercial emails may minimize the effectiveness of our marketing, which could adversely affect our ability to attract new customers or entice existing customers to upgrade their subscriptions.\nWe are subject to U.S. economic sanctions, export control and anti-corruption laws, and regulations that could impair our ability to compete in international markets or subject us to liability if we violate such laws and regulations.\nWe are subject to U.S. economic sanctions, export control and anti-corruption laws, and regulations that prohibit the provision of certain products and services to certain countries, governments, and persons targeted by U.S. sanctions. We are in the process of implementing certain precautions to prevent our platform and products from being exported or accessed in violation of U.S. export controls or U.S. sanctions laws and regulations. However, we cannot be certain that the precautions we take will prevent all violations of these laws.\nWe have previously identified, and may continue to identify, customer accounts for our platform and products that may originate from, or are intended to benefit, persons in countries that are subject to U.S. embargoes, including transactions or events in or relating to Cuba, Iran, North Korea, Syria, and the Crimea region of Ukraine. We have recently submitted a voluntary self-disclosure to the U.S. Department of the Treasury’s Office of Foreign Assets Control, or OFAC, regarding potential violations of OFAC regulations that may have involved the provision of services to customers in sanctioned countries. We have not yet obtained a determination from OFAC.\nIf we are found to be in violation of U.S. sanctions or export control laws, we may be fined or other penalties could be imposed. Furthermore, changes in export control or economic sanctions laws and enforcement could also result in increased compliance requirements and related costs, which could materially adversely affect our business, results of operations, financial condition and/or cash flows.\nWe are also subject to various U.S. and international anti-corruption laws, such as the U.S. Foreign Corrupt Practices Act and the UK Bribery Act, as well as other similar anti-bribery and anti-kickback laws and regulations. These laws and regulations generally prohibit companies and their employees and intermediaries from authorizing, offering, or providing improper payments or benefits to government officials and other recipients for improper purposes. Our exposure for violating these laws may increase as we continue to expand our international presence, and any failure to comply with such laws could harm our business.\nOur internal controls over financial reporting currently do not meet all of the standards contemplated by Section 404 of the Sarbanes-Oxley Act of 2002, as amended (“SOX”), and failure to achieve and maintain effective internal controls over financial reporting in accordance with Section 404 of SOX could impair our ability to produce timely and accurate financial statements or comply with applicable regulations and have a material adverse effect on our business. In the future, our disclosure controls and procedures may not prevent or detect all errors or acts of fraud.\nAs a public company, we are subject to certain reporting requirements of the Exchange Act and have significant requirements for enhanced financial reporting and internal controls. Our disclosure controls and procedures are designed to reasonably assure that information required to be disclosed by us in reports we file or submit under the Exchange Act is accumulated and communicated to management, recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the SEC. The process of designing and implementing effective internal controls is a continuous effort that requires us to anticipate and react to changes in our business and the economic and regulatory environments, and to expend significant resources to maintain a system of internal controls that is\n71\nadequate to satisfy our reporting obligations as a public company. If we are unable to establish or maintain appropriate internal financial reporting controls and procedures, it could cause us to fail to meet our reporting obligations on a timely basis, result in material misstatements in our consolidated financial statements, and harm our operating results. We believe that any disclosure controls and procedures or internal controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by an unauthorized override of the controls. Accordingly, because of the inherent limitations in our control system, misstatements or insufficient disclosures due to error or fraud may occur and not be detected.\nIn addition, we are required pursuant to Section 404 of SOX, to furnish a report by management on, among other things, the effectiveness of our internal control over financial reporting in the Annual Report on Form 10-K for the year ended December 31, 2022. This assessment will need to include disclosure of any material weaknesses identified by our management in our internal control over financial reporting. The rules governing the standards that must be met for our management to assess our internal control over financial reporting are complex and require significant documentation, testing, and possible remediation. Testing and maintaining internal controls may divert management’s attention from other matters that are important to our business. Beginning with our Annual Report on Form 10-K for the year ended December 31, 2022, our independent registered public accounting firm may be required to attest to the effectiveness of our internal control over financial reporting on an annual basis. However, while we remain an emerging growth company, our independent registered public accounting firm will not be required to attest to the effectiveness of our internal control over financial reporting. If we are not able to complete our initial assessment of our internal controls and otherwise implement the requirements of Section 404 of SOX in a timely manner or with adequate compliance, our independent registered public accounting firm may not be able to certify as to the adequacy of our internal controls over financial reporting. Additionally, when required, an independent assessment of the effectiveness of our internal controls over financial reporting could detect problems that our management’s assessment might not. Undetected material weaknesses in our internal controls over financial reporting could lead to financial statement restatements and require us to incur the expense of remediation.\nMatters impacting our internal controls may cause us to be unable to report our financial information on a timely basis and thereby subject us to adverse regulatory consequences, including sanctions by the SEC or violations of applicable stock exchange listing rules, which may result in a breach of the covenants under existing or future financing arrangements. There also could be a negative reaction in the financial markets due to a loss of investor confidence in us and the reliability of our financial statements. Confidence in the reliability of our financial statements also could suffer if we or our independent registered public accounting firm report a material weakness in our internal controls over financial reporting. This could materially adversely affect us and lead to a decline in the market price of our Class A common stock.\nIn connection with the audit of our consolidated financial statements for the year ended December 31, 2019, we and our independent registered public accounting firm identified a material weakness in our internal control over financial reporting related to deficiencies in our controls over the financial statement close process. Specifically, there were deficiencies in the design and operations of internal controls over the identification and review of complex accounting issues involving significant judgment or estimates with respect to certain prior period transactions.\nWe have implemented, and are continuing to implement, measures designed to improve our internal control over financial reporting to remediate this material weakness. These measures include formalizing our processes and internal control documentation, strengthening supervisory reviews by our financial management, hiring additional qualified accounting and finance personnel, and engaging financial consultants to enable the implementation of internal control over financial reporting.\n72\nWe expect to incur additional costs to remediate the control deficiencies identified, though there can be no assurance that our efforts will be successful or avoid potential future material weaknesses. If we are unable to successfully remediate our existing or any future material weaknesses in our internal control over financial reporting, or if we identify any additional material weaknesses, the accuracy and timing of our financial reporting may be adversely affected, we may be unable to maintain compliance with securities law requirements regarding timely filing of periodic reports in addition to applicable stock exchange listing requirements, investors may lose confidence in our financial reporting, and our stock price may decline as a result. We also could become subject to investigations by the New York Stock Exchange (“NYSE”), the SEC or other regulatory authorities.\nOur internal resources and personnel may in the future be insufficient to avoid accounting errors and there can be no assurance that we will not have additional material weaknesses in the future. Any failure to develop or maintain effective controls or any difficulties encountered implementing required new or improved controls could harm our operating results or cause us to fail to meet our reporting obligations and may result in a restatement of our financial statements for prior periods. Any failure to implement and maintain effective internal control over financial reporting also could adversely affect the results of periodic management evaluations and annual independent registered public accounting firm attestation reports regarding the effectiveness of our internal control over financial reporting that we will eventually be required to include in our periodic reports that will be filed with the SEC. Ineffective disclosure controls, procedures, and internal control over financial reporting could also cause investors to lose confidence in our reported financial and other information, which would likely have a negative effect on the trading price of our common stock. In addition, if we are unable to continue to meet these requirements, we may not be able to remain listed on the NYSE.\nUnanticipated changes in our effective tax rate and additional tax liabilities may impact our financial results.\nWe are subject to income taxes in the United States and various jurisdictions outside of the United States. Our income tax obligations are generally determined based on our business operations in these jurisdictions. Significant judgment is often required in the determination of our worldwide provision for income taxes. Our effective tax rate could be impacted by changes in the earnings and losses in countries with differing statutory tax rates, changes in non-deductible expenses, changes in excess tax benefits of stock-based compensation, changes in the valuation of deferred tax assets and liabilities and our ability to utilize them, the applicability of withholding taxes, effects from acquisitions, changes in accounting principles and tax laws in jurisdictions where we operate. Any changes, ambiguity, or uncertainty in taxing jurisdictions’ administrative interpretations, decisions, policies, and positions could also materially impact our income tax liabilities.\nAs our business continues to grow and if we become more profitable, we anticipate that our income tax obligations could significantly increase. If our existing tax credits and net operating loss carry-forwards become fully utilized, we may be unable to offset or otherwise mitigate our tax obligations to the same extent as in prior years. This could have a material impact to our future cash flows or operating results.\nIn addition, recent global tax developments applicable to multinational companies, including certain approaches of addressing taxation of digital economy recently proposed or enacted by the Organisation for Economic Co-operation and Development, the European Commission or certain major jurisdictions where we operate or might in the future operate, might have a material impact to our business and future cash flow from operating activities, or future financial results. We are also subject to tax examinations in multiple jurisdictions. While we regularly evaluate new information that may change our judgment resulting in recognition, derecognition, or changes in measurement of a tax position taken, there can be no assurance that the final determination of any examinations will not have an adverse effect on our operating results and financial position. In addition, our operations may change, which may impact our tax liabilities. As our brand becomes increasingly recognizable both domestically and internationally, our tax\n73\nplanning structure and corresponding profile may be subject to increased scrutiny, and if we are perceived negatively, we may experience brand or reputational harm.\nWe may also be subject to additional tax liabilities and penalties due to changes in non-income based taxes resulting from changes in federal, state, or international tax laws, changes in taxing jurisdictions’ administrative interpretations, decisions, policies and positions, results of tax examinations, settlements or judicial decisions, changes in accounting principles, and changes to the business operations, including acquisitions, as well as the evaluation of new information that results in a change to a tax position taken in a prior period. Any resulting increase in our tax obligation or cash taxes paid could adversely affect our cash flows and financial results.\nOur international operations may subject us to greater than anticipated tax liabilities.\nWe are expanding our international operations to better support our growth into international markets. Our corporate structure and associated transfer pricing policies contemplate future growth in international markets, and consider the functions, risks, and assets of the various entities involved in intercompany transactions. The amount of taxes we pay in different jurisdictions may depend on the application of the tax laws of various jurisdictions, including the United States, to our international business activities, changes in tax rates, new or revised tax laws or interpretations of existing tax laws and policies, and our ability to operate our business in a manner consistent with our corporate structure and intercompany arrangements. The taxing authorities of the jurisdictions in which we operate may challenge our methodologies for pricing intercompany transactions pursuant to our intercompany arrangements or disagree with our determinations as to the income and expenses attributable to specific jurisdictions. If such a challenge or disagreement were to occur, and our position was not sustained, we could be required to pay additional taxes, interest, and penalties, which could result in one-time tax charges, higher effective tax rates, reduced cash flows, and lower overall profitability of our operations and we may be required to revise our intercompany agreements. Our financial statements could fail to reflect adequate reserves to cover such a contingency.\nRisks Related to Our Intellectual Property\nWe may not be able to adequately protect our proprietary and intellectual property rights in our data or technology.\nOur success is dependent, in part, upon protecting our proprietary information and technology. Our intellectual property portfolio primarily consists of registered and unregistered trademarks, unregistered copyrights, domain names, know-how, and trade secrets. We may be unsuccessful in adequately protecting our intellectual property. No assurance can be given that confidentiality, non-disclosure, or invention or copyright assignment agreements with employees, consultants, partners or other parties have been entered into, will not be breached, or will otherwise be effective in establishing our rights in intellectual property and in controlling access to and distribution of our platform, or certain aspects of our platform, and proprietary information. Further, these agreements do not prevent our competitors from independently developing technologies that are substantially equivalent or superior to our platform. Additionally, certain unauthorized use of our intellectual property may go undetected, or we may face legal or practical barriers to enforcing our legal rights even where unauthorized use is detected.\nCurrent laws may not provide for adequate protection of our platform or data, especially in foreign jurisdictions which may have laws that provide insufficient protections to companies. In addition, legal standards relating to the validity, enforceability, and scope of protection of proprietary rights in internet-related businesses are uncertain and evolving, and changes in these standards may adversely impact the viability or value of our proprietary rights. Some license provisions protecting against unauthorized use, copying, transfer, and disclosure of our products, or certain aspects of our platform, or our data may be unenforceable under the laws of certain jurisdictions. Further, the laws of some countries do not protect\n74\nproprietary rights to the same extent as the laws of the United States, and the laws and mechanisms for protection and enforcement of intellectual property rights in some foreign countries may be inadequate. As we continue to operate in foreign countries and expand our international activities, we have encountered and may in the future encounter challenges in navigating the laws of foreign countries, which may adversely affect our ability to protect our proprietary rights and subject us to claims from current or former personnel and other third parties. Moreover, our exposure to unauthorized copying of certain aspects of our platform, or our data may increase. Further, competitors, foreign governments, foreign government-backed actors, criminals, or other third parties may gain unauthorized access to our proprietary information and technology. Accordingly, despite our efforts, we may be unable to prevent third parties from infringing upon or misappropriating our technology and intellectual property or claiming that we infringe upon or misappropriate their technology and intellectual property.\nTo protect our intellectual property rights, we may be required to spend significant resources to monitor, protect, and defend these rights, and we may or may not be able to detect infringement by our customers or third parties. Litigation has been and may be necessary in the future to enforce our intellectual property rights and to protect our trade secrets. Such litigation could be costly, time consuming, and distracting to management and could result in the impairment or loss of portions of our intellectual property. Furthermore, our efforts to enforce our intellectual property rights may be met with defenses, counterclaims, and countersuits attacking the validity and enforceability of our intellectual property rights. Our inability to protect our proprietary technology against unauthorized copying or use, as well as any costly litigation or diversion of our management’s attention and resources, could delay further sales or the implementation of our platform, impair the functionality of our platform, delay introductions of new features, integrations, and capabilities, result in our substituting inferior or more costly technologies into our platform, or injure our reputation. In addition, we may be required to license additional technology from third parties to develop and market new features, integrations, and capabilities, and we cannot be certain that we could license that technology on commercially reasonable terms or at all, and our inability to license this technology could harm our ability to compete.\nIf third parties claim that we infringe upon or otherwise violate their intellectual property rights, our business could be adversely affected.\nWe have in the past and may in the future be subject to claims that we have infringed or otherwise violated third parties’ intellectual property rights. There is patent, copyright, and other intellectual property development and enforcement activity in our industry and relating to the technology we use in our business. Our future success depends in part on not infringing upon or otherwise violating the intellectual property rights of others. From time to time, our competitors or other third parties (including non-practicing entities and patent holding companies) may claim that we are infringing upon or otherwise violating their intellectual property rights, and we may be found to be infringing upon or otherwise violating such rights. In addition, we do not own any issued, nor do we have any pending patents, which limits our ability to deter patent infringement claims by competitors and other third parties who hold patents. We may be unaware of the intellectual property rights of others that may cover some or all of our current or future technology or conflict with our rights, and the patent, copyright, and other intellectual property rights of others may limit our ability to improve our technology and compete effectively. Any claims of intellectual property infringement or other intellectual property violations, even those without merit, could:\n•be expensive and time consuming to defend;\n•cause us to cease making, licensing or using our platform or products that incorporate the challenged intellectual property;\n•require us to modify, redesign, reengineer or rebrand our platform or products, if feasible;\n•divert management’s attention and resources; or\n75\n•require us to enter into royalty or licensing agreements to obtain the right to use a third-party’s intellectual property.\nAny royalty or licensing agreements, if required, may not be available to us on acceptable terms or at all. A successful claim of infringement against us could result in our being required to pay significant damages, enter into costly settlement agreements, or prevent us from offering our platform or products, any of which could have a negative impact on our operating profits and harm our future prospects. We may also be obligated to indemnify our customers or business partners in connection with any such litigation and to obtain licenses, modify our platform or products, or refund premium subscription fees, which could further exhaust our resources. Such disputes could also disrupt our platform or products, adversely affecting our customer satisfaction and ability to attract customers.\nOur use of “open source” software could negatively affect our ability to offer and sell access to our platform and products, and subject us to possible litigation.\nWe use open source software in our platform and products, and expect to continue to use open source software in the future. There are uncertainties regarding the proper interpretation of and compliance with open source licenses, and there is a risk that such licenses could be construed in a manner that imposes unanticipated conditions or restrictions on our ability to use such open source software, and consequently to provide or distribute our platform and products. Although use of open source software has historically been free, recently several open source providers have begun to charge license fees for use of their software. If our current open source providers were to begin to charge for these licenses or increase their license fees significantly, we would have to choose between paying such license fees or incurring the expense to replace the open source software with other software or with our own software, which would increase our research and development costs, and have a negative impact on our results of operations and financial condition.\nAdditionally, we may from time to time face claims from third parties claiming ownership of, or seeking to enforce the terms of, an open source license, including by demanding release of source code for the open source software, derivative works or our proprietary source code that was developed using or that is distributed with such open source software. These claims could also result in litigation and could require us to make our proprietary software source code freely available, require us to devote additional research and development resources to change our platform or incur additional costs and expenses, any of which could result in reputational harm and would have a negative effect on our business and operating results. In addition, if the license terms for the open source software we utilize change, we may be forced to reengineer our platform or incur additional costs to comply with the changed license terms or to replace the affected open source software. Further, use of certain open source software can lead to greater risks than use of third-party commercial software, as open source licensors generally do not provide warranties or controls on the origin of software or indemnification for third-party infringement claims. Although we have implemented policies to regulate the use and incorporation of open source software into our platform and products, we cannot be certain that we have not incorporated open source software in our platform and products in a manner that is inconsistent with such policies.\nIndemnity provisions in various agreements potentially expose us to substantial liability for intellectual property infringement and other losses.\nOur agreements with resellers and other third parties may include indemnification or other provisions under which we agree to indemnify or otherwise be liable to them for losses suffered or incurred as a result of claims of intellectual property infringement, damages caused by us to property or persons, or other liabilities relating to or arising from our platform, products or other acts or omissions. For some of our larger customers, we sometimes negotiate similar indemnification provisions or indemnification for breaches of our obligations, representations or warranties in the subscription agreement, gross negligence or willful misconduct, breaches of confidentiality, losses related to security incidents, breach of the data processing addendum or violations of applicable law. In some instances, the term of these\n76\ncontractual provisions survives the termination or expiration of the applicable agreement. Large indemnity payments or damage claims from contractual breach could harm our business, operating results, and financial condition.\nFrom time to time, third parties may assert infringement claims against our customers or resellers. These claims may require us to initiate or defend protracted and costly litigation on behalf of customers and resellers, regardless of the merits of these claims. If any of these claims succeed, we may be forced to pay damages on behalf of our customers and resellers or may be required to obtain licenses for the platform or products they use or resell or modify our platform or products. We may not be able to obtain all necessary licenses on commercially reasonable terms, or at all, or to make such modifications to avoid a claim, in which case our customers and resellers may be required to stop using or reselling our platform or products. Further, customers may require us to indemnify or otherwise be liable to them for breach of confidentiality or failure to implement adequate security measures with respect to their data stored, transmitted or processed by our employees or platform. Although we normally contractually limit our liability with respect to such obligations, we may still incur substantial liability related to them. Any dispute with a customer with respect to such obligations could have adverse effects on our relationship with that customer and other current and prospective customers, reduce demand for our platform or products, and harm our revenue, business, and operating results.\nRisks Related to Ownership of Our Class A Common Stock\nWe are an emerging growth company and we cannot be certain that the reduced disclosure requirements applicable to emerging growth companies will not make our Class A common stock less attractive to investors.\nWe are an “emerging growth company” as defined in the Jumpstart Our Business Startups Act, or the JOBS Act. Under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards until such time as those standards apply to private companies. We have elected to use this extended transition period for complying with new or revised accounting standards that have different effective dates for public and private companies until the earlier of the date we (i) are no longer an emerging growth company or (ii) affirmatively and irrevocably opt out of the extended transition period provided in the JOBS Act. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates.\nFor as long as we continue to be an emerging growth company, we also intend to take advantage of certain other exemptions from various reporting requirements that are applicable to other public companies including, but not limited to, reduced disclosure obligations regarding executive compensation in our periodic reports, proxy statements, and registration statements, and exemptions from the requirements of holding a non-binding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. We cannot predict if investors will find our Class A common stock less attractive because we will rely on these exemptions. If some investors find our Class A common stock less attractive as a result, there may be a less active trading market for our Class A common stock and our stock price may be more volatile.\nWe will remain an emerging growth company until the earliest of (i) the last day of the year in which we have total annual gross revenue of $1.07 billion or more, (ii) December 31, 2026, (iii) the date on which we have issued more than $1.0 billion in nonconvertible debt during the previous three years, or (iv) the date on which we are deemed to be a large accelerated filer under the rules of the SEC.\n77\nWe are subject to costs, regulations and requirements as a result of being a public company, which could impair our profitability, make it more difficult to run our business, or divert management’s attention from our business.\nAs a public company, and particularly after we are no longer an emerging growth company, we are required to commit significant resources, management time, and attention to the requirements of being a public company, which causes us to incur significant legal, accounting, and other expenses, including costs associated with public company reporting requirements, and recruiting and retaining independent directors. We also have incurred and will continue to incur costs associated with SOX and the Dodd-Frank Wall Street Reform and Consumer Protection Act and related rules implemented by the SEC and the NYSE, and compliance with these requirements will place significant demands on our legal, accounting, and finance staff and on our accounting, financial, and information systems. The expenses incurred by public companies generally for reporting and corporate governance purposes have been increasing. These rules and regulations may increase our legal and financial compliance costs and to make some activities more time-consuming and costly, although we are currently unable to estimate these costs with any degree of certainty. In addition, we might not be successful in implementing these requirements. These laws and regulations also could make it more difficult or costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. These laws and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors (the “Board”) or Board committees or as our executive officers. Furthermore, if we are unable to continue to satisfy our obligations as a public company, we could be subject to delisting of our Class A common stock, fines, sanctions, and other regulatory action and potentially civil litigation.\nAn active public market for our Class A common stock may not be sustained and could be highly volatile, and you may not be able to resell your shares at or above your original purchase price, if at all.\nWe have a limited trading history. The market price of our Class A common stock could be highly volatile and may fluctuate substantially as a result of many factors, including:\n•actual or anticipated fluctuations in our results of operations;\n•variance in our results of operation from the expectations of market analysts;\n•announcements by us or our competitors of significant business developments, changes in service provider relationships, acquisitions or expansion plans;\n•changes in the prices of our products;\n•our involvement in litigation;\n•our sale of Class A common stock or other securities in the future;\n•market conditions in our industry;\n•changes in key personnel;\n•the trading volume of our Class A common stock;\n•changes in the estimation of the future size and growth rate of our markets; and\n•general economic and market conditions.\n78\nIn addition, the stock markets have experienced extreme price and volume fluctuations. Broad market and industry factors may materially harm the market price of our Class A common stock, regardless of our results of operation. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted against that company. If we were involved in any similar litigation we could incur substantial costs, and our management’s attention and resources could be diverted.\nIf you purchase shares of our Class A common stock, you may not be able to resell those shares at or above the price you originally paid. An active or liquid market in our Class A common stock may not be sustainable, which could adversely affect your ability to sell your shares and could depress the market price of our Class A common stock.\nThe issuance of additional stock in connection with financings, acquisitions, investments, our stock incentive plans or otherwise will dilute all other stockholders.\nOur amended and restated certificate of incorporation authorizes us to issue up to 1,000,000,000 shares of Class A common stock and up to 100,000,000 shares of preferred stock with such rights and preferences as may be determined by our Board. Subject to compliance with applicable rules and regulations, we may issue our shares of Class A common stock or securities convertible into our Class A common stock from time to time in connection with a financing, acquisition, investment, our stock incentive plans or otherwise. Any such issuance could result in substantial dilution to our existing stockholders and cause the trading price of our Class A common stock to decline.\nA total of 124,905,954, or approximately 93%, of the outstanding shares of our Class A and Class B common stock are restricted from immediate resale, but may be sold on a stock exchange in the near future. The large number of shares eligible for public sale or subject to rights requiring us to register them for public sale could depress the market price of our Class A common stock.\nThe market price of our Class A common stock could decline as a result of sales of a large number of shares of our Class A common stock in the market, and the perception that these sales could occur may also depress the market price of our Class A common stock. We, our executive officers, directors, and the holders of substantially all of our capital stock and securities convertible into or exchangeable for our capital stock outstanding prior to our IPO have entered into lock-up agreements with the underwriters under which they have agreed, subject to specific exceptions and early release triggers, not to sell any of our stock for 180 days following March 24, 2021. Following the expiration of this period and subject to applicable securities laws, such shares may be sold on the public market.\nStockholders owning an aggregate of up to 36,750,000 shares of our Class B common stock are entitled, under contracts providing for registration rights, to require us to register shares owned by them for public sale in the United States. In addition, we filed a registration statement on Form S-8 on March 25, 2021, to register 24,114,926 shares of our Class A common stock under our equity compensation plans.\nSales of our shares as restrictions end or pursuant to registration rights may make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate. These sales also could cause the trading price of our Class A common stock to fall and make it more difficult for you to sell shares of our Class A common stock.\nIf we do not meet the expectations of equity research analysts, if they do not publish research or reports about our business or if they issue unfavorable commentary or downgrade our Class A common stock, the price of our Class A common stock could decline.\nThe trading market for our Class A common stock will depend in part on the research and reports that equity research analysts publish about us and our business. The analysts’ estimates are based upon their\n79\nown opinions and are often different from our estimates or expectations. If our results of operations are below the estimates or expectations of public market analysts and investors, our stock price could decline. Moreover, the price of our Class A common stock could decline if one or more securities analysts downgrade our Class A common stock or if those analysts issue other unfavorable commentary or cease publishing reports about us or our business.\nWe cannot predict the impact our dual structure may have on the market price of our Class A common stock.\nWe cannot predict whether our dual class structure, combined with the concentrated control of our stockholders who held our capital stock prior to the completion of our IPO, including our executive officers, employees, and directors and their affiliates, will result in a lower or more volatile market price of our Class A common stock or in adverse publicity or other adverse consequences. For example, certain index providers have announced restrictions on including companies with multiple class share structures in certain of their indices. In July 2017, FTSE Russell and Standard & Poor’s announced that they would cease to allow most newly public companies utilizing dual or multi-class capital structures to be included in their indices. Under the announced policies, our dual class capital structure would make us ineligible for inclusion in any of these indices. Given the sustained flow of investment funds into passive strategies that seek to track certain indexes, exclusion from stock indexes would likely preclude investment by many of these funds and could make our Class A common stock less attractive to other investors. As a result, the market price of our Class A common stock could be adversely affected.\nThe dual class structure of our common stock has the effect of concentrating voting control with those stockholders who held our capital stock prior to the completion of our IPO, including our directors, executive officers, and their affiliates, who as of March 31, 2021 held in aggregate 93% of the voting power of our capital stock, which will limit or preclude your ability to influence corporate matters.\nOur Class B common stock has ten votes per share, and our Class A common stock has one vote per share. As of March 31, 2021, our directors, executive officers, and their affiliates, held in the aggregate 93% of the voting power of our capital stock. Because of the ten-to-one voting ratio between our Class B common stock and Class A common stock, the holders of our Class B common stock collectively will continue to control a majority of the combined voting power of our common stock and therefore will be able to control all matters submitted to our stockholders for approval until the earlier of (a) the seven year anniversary of the closing of our IPO (b) such time as the outstanding shares of Class B common stock represent less than ten percent of the aggregate number of shares of our outstanding common stock and (c) the date the holders of two-thirds of our Class B common stock elect to convert the Class B common stock to Class A common stock. This concentrated control may limit or preclude your ability to influence corporate matters for the foreseeable future, including the election of directors, amendments of our organizational documents, and any merger, consolidation, sale of all or substantially all of our assets, or other major corporate transaction requiring stockholder approval. In addition, this may prevent or discourage unsolicited acquisition proposals or offers for our capital stock that you may feel are in your best interest as one of our stockholders.\nFuture transfers by holders of Class B common stock will generally result in those shares converting to Class A common stock, subject to limited exceptions, such as certain transfers effected for estate planning purposes. The conversion of Class B common stock to Class A common stock will have the effect, over time, of increasing the relative voting power of those holders of Class B common stock who retain their shares in the long term.\nWe do not expect to declare any dividends in the foreseeable future.\nWe do not anticipate declaring any cash dividends to holders of our common stock in the foreseeable future. In addition, our credit facility places restrictions on our ability to pay cash dividends. Consequently,\n80\ninvestors may need to rely on sales of their Class A common stock after price appreciation, which may never occur, as the only way to realize any future gains on their investment. Investors seeking cash dividends should not purchase our Class A common stock.\nProvisions in our charter documents and under Delaware law could make an acquisition of our company more difficult, limit attempts by our stockholders to replace or remove our current Board, and limit the market price of our Class A common stock.\nProvisions in our amended and restated certificate of incorporation and amended and restated bylaws may have the effect of delaying or preventing a change of control or changes in our management. Our amended and restated certificate of incorporation and amended and restated bylaws, include provisions that:\n•provide that the authorized but unissued shares of our common stock and our preferred stock are available for future issuance without stockholder approval;\n•provide that our Board is classified into three classes of directors with staggered three-year terms;\n•permit the Board to establish the number of directors and fill any vacancies and newly created directorships;\n•require super-majority voting to amend some provisions in our amended and restated certificate of incorporation and amended and restated bylaws;\n•authorize the issuance of “blank check” preferred stock that our Board could use to implement a stockholder rights plan;\n•provide that only the Chairperson of our Board, our Chief Executive Officer, or a majority of our Board will be authorized to call a special meeting of stockholders;\n•provide for a dual class common stock structure in which holders of our Class B common stock have the ability to control the outcome of matters requiring stockholder approval, even if they own significantly less than a majority of the outstanding shares of our Class A and Class B common stock, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or its assets;\n•prohibit stockholder action by written consent, which requires all stockholder actions to be taken at a meeting of our stockholders;\n•provide that the Board is expressly authorized to make, alter or repeal our bylaws; and\n•advance notice requirements for nominations for election to our Board or for proposing matters that can be acted upon by stockholders at annual stockholder meetings.\nMoreover, Section 203 of the Delaware General Corporation Law may discourage, delay, or prevent a change in control of our company. Section 203 imposes certain restrictions on mergers, business combinations, and other transactions between us and holders of 15% or more of our common stock.\nOur bylaws designate certain courts as the sole and exclusive forum for certain types of actions and proceedings that may be initiated by our stockholders, which could limit our stockholders’\n81\nability to obtain a favorable judicial forum for disputes with us or our directors, officers, or employees.\nOur bylaws provide that, unless we consent in writing to an alternative forum, the Court of Chancery of the State of Delaware will be the sole and exclusive forum for any state law claim for (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of or based on a fiduciary duty owed by any of our current or former directors, officers, or employees to us or our stockholders, (iii) any action asserting a claim arising pursuant to any provision of the Delaware General Corporation Law, our amended and restated certificate of incorporation or our amended and restated bylaws (including the interpretation, validity or enforceability thereof) or (iv) any action asserting a claim that is governed by the internal affairs doctrine, in each case subject to the Court of Chancery having personal jurisdiction over the indispensable parties named as defendants therein, or the Delaware Forum Provision. The Delaware Forum Provision will not apply to any causes of action arising under the Securities Act or the Exchange Act. Our amended and restated bylaws further provide that, unless we consent in writing to the selection of an alternative forum, the federal district courts of the United States shall be the sole and exclusive forum for resolving any complaint asserting a cause of action arising under the Securities Act, or the Federal Forum Provision. In addition, our amended and restated bylaws provide that any person or entity purchasing or otherwise acquiring any interest in shares of our common stock is deemed to have notice of and consented to the foregoing provisions; provided, however, that stockholders cannot and will not be deemed to have waived our compliance with the federal securities laws and the rules and regulations thereunder.\nThe Delaware Forum Provision and the Federal Forum Provision in our amended and restated bylaws may impose additional litigation costs on stockholders in pursuing any such claims, particularly if the stockholders do not reside in or near the State of Delaware. Additionally, the forum selection clauses in our amended and restated bylaws may limit our stockholders’ ability to bring a claim in a forum that they find favorable for disputes with us or our directors, officers or employees, which may discourage such lawsuits against us and our directors, officers and employees even though an action, if successful, might benefit our stockholders. In addition, while the Delaware Supreme Court ruled in March 2020 that federal forum selection provisions purporting to require claims under the Securities Act be brought in federal court were “facially valid” under Delaware law, there is uncertainty as to whether other courts will enforce our Federal Forum Provision. If the Federal Forum Provision is found to be unenforceable, we may incur additional costs associated with resolving such matters. The Federal Forum Provision may also impose additional litigation costs on stockholders who assert that the provision is not enforceable or invalid. The Court of Chancery of the State of Delaware and the federal district courts of the United States may also reach different judgments or results than would other courts, including courts where a stockholder considering an action may be located or would otherwise choose to bring the action, and such judgments may be more or less favorable to us than our stockholders.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nUnregistered Sales of Equity Securities\nFrom January 1, 2021 through March 31, 2021, pursuant to our Amended and Restated 2019 Stock Option and Grant Plan (the “2019 Plan”) we issued and sold to our employees, consultants and other service providers an aggregate of 3,861 shares of common stock upon the exercise of options under our 2019 Plan at exercise prices ranging from $1.23 to $1.68 per share, for an aggregate exercise price of $5,207. These 3,861 shares of common stock were exchanged for an equal number of shares of our Class B common stock in connection with our IPO.\nFrom January 1, 2021 through March 31, 2021, pursuant to our 2021 Stock Option and Grant Plan we granted one employee an aggregate of 19,500 restricted stock units, with a grant date fair value $14 per restricted stock unit.\n82\nNone of the foregoing transactions involved any underwriters, underwriting discounts or commissions, or any public offering. The sales of the above securities were deemed to be exempt from registration under the Securities Act in reliance on Section 4(a)(2) of the Securities Act or Rule 701 promulgated under Section 3(b) of the Securities Act as transactions by an issuer not involving any public offering or pursuant to benefit plans and contracts relating to compensation as provided under Rule 701. The recipients of the securities in each of these transactions represented their intentions to acquire the securities for investment only and not with a view to or for sale in connection with any distribution thereof, and appropriate legends were affixed to the securities issued in these transactions. All recipients had adequate access, through their relationships with us, to information about us. The sales of these securities were made without any general solicitation or advertising.\nUse of Proceeds From the IPO\nOn March 29, 2021, we closed the IPO, in which we issued 10,000,000 shares of Class A common stock, and on April 23, 2021 we closed the partial exercise of the underwriter’s option to purchase additional shares of our Class A common stock, in which we issued an additional 719,266 shares of Class A common stock, at a price to the public of $14.00 for aggregate net proceeds of $135,987 after deducting underwriting discounts and commissions of $10,505 and expenses payable by us of $3,578. The offer and sale of all of the shares in the IPO were registered under the Securities Act pursuant to the Prospectus. No payments were made by us to directors, officers or persons owning ten percent or more of our common stock or to their associates, or to our affiliates, other than payments in the ordinary course of business to officers for salaries and to non-employee directors pursuant to our director compensation policy. There has been no material change in the planned use of proceeds from the IPO as described in the Prospectus. We invested the funds received in accordance with our Board approved investment policy, which provides for investments in obligations of the U.S. and foreign governments, money market instruments, registered money market funds, corporate and municipal bonds. Goldman, Sachs & Co. LLC, J.P. Morgan Securities LLC and Jefferies LLC acted as joint lead bookrunning managers of the IPO.\nItem 3. Defaults Upon Senior Securities\nNone.\nItem 4. Mine Safety Disclosures\nNot applicable.\nItem 5. Other Information\nNone.\nItem 6. Exhibits\nThe exhibits listed below are filed or incorporated by reference in this Quarterly Report on Form 10-Q.\n| Exhibit Number | Exhibit Title |\n| 3.1(1) | Amended and Restated Certificate of Incorporation of the Registrant |\n| 3.2(2) | Amended and Restated Bylaws of the Registrant |\n| 4.1(3) | Form of Common Stock certificate of the Registrant |\n\n83\n| 31.1* | Certification of Principal Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended |\n| 31.2* | Certification of Principal Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended |\n| 32.1+ | Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act |\n| 101.INS* | XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document |\n| 101.SCH* | XBRL Taxonomy Extension Schema Document |\n| 101.CAL* | XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF* | XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB* | XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE* | XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104 | Cover Page with Interactive Data File (formatted as Inline XBRL with applicable taxonomy extension information contained in Exhibits 101) |\n\n(1) File as Exhibit 3.2 to Registrant’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on March 16, 2021, and incorporated herein by reference.\n(2) Filed as Exhibit 3.4 to Registrant’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on March 16, 2021, and incorporated herein by reference.\n(3) Filed as Exhibit 4.1 to Registrant’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on March 16, 2021, and incorporated herein by reference.\n* Filed herewith.\n+ The certifications furnished in Exhibit 32.1 hereto are deemed to accompany this Quarterly Report on Form 10-Q and will not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, except to the extent that the Registrant specifically incorporates it by reference. Such certifications will not be deemed to be incorporated by reference into any filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, except to the extent that the Registrant specifically incorporates it by reference.\n84\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n| SEMRUSH HOLDINGS, INC. |\n| May 11, 2021 | By: | /s/ Oleg Shchegolev |\n| Oleg Shchegolev |\n| Chief Executive Officer |\n| (Principal Executive Officer) |\n| May 11, 2021 | By: | /s/ Evgeny Fetisov |\n| Evgeny Fetisov |\n| Chief Financial Officer |\n| (Principal Financial Officer and Principal Accounting Officer) |\n\n85\n \n\nIf the company plans to maintain an equal distribution of total assets and total liabilities and stockholders' equity by the end of 2021, along with a 10% increase in \"Deferred contract costs, net of current portion\" and \"Other long-term assets\" from March 2021 levels, what should be the new total of current assets in dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nItem 1. Financial Statements\\nSEMRUSH HOLDINGS, INC.\\nUNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS\\n(in thousands, except share and per share data)\\n| As of |\\n| March 31, 2021 | December 31, 2020 |\\n| Assets |\\n| Current assets |\\n| Cash and cash equivalents | $ | 171,867 | $ | 35,531 |\\n| Accounts receivable | 2,383 | 1,399 |\\n| Deferred contract costs, current portion | 4,817 | 4,049 |\\n| Prepaid expenses and other current assets | 3,626 | 2,649 |\\n| Total current assets | 182,693 | 43,628 |\\n| Property and equipment, net | 3,876 | 2,968 |\\n| Intangible assets, net | 2,176 | 2,231 |\\n| Goodwill | 1,991 | 1,991 |\\n| Deferred contract costs, net of current portion | 2,000 | 1,670 |\\n| Other long-term assets | 1,130 | 2,470 |\\n| Total assets | $ | 193,866 | $ | 54,958 |\\n| Liabilities, redeemable convertible preferred stock and stockholders’ equity (deficit) |\\n| Current liabilities |\\n| Accounts payable | $ | 10,233 | $ | 8,654 |\\n| Accrued expenses | 10,286 | 7,719 |\\n| Deferred revenue | 32,078 | 26,537 |\\n| Total current liabilities | 52,597 | 42,910 |\\n| Long-term liabilities |\\n| Deferred revenue, net of current portion | 181 | 123 |\\n| Deferred tax liability | 153 | 209 |\\n| Other long-term liabilities | 1,024 | 497 |\\n| Total liabilities | 53,955 | 43,739 |\\n| Commitments and contingencies (Note 11) |\\n| Series A redeemable convertible preferred stock, $ 0.00001 par value - no shares authorized, issued or outstanding as of March 31, 2021; 3,379,400 shares authorized, issued and outstanding as of December 31, 2020 (liquidation value of $ 8,000 at December 31, 2020) | — | 7,789 |\\n| Series A-1 redeemable convertible preferred stock, $ 0.00001 par value - no shares authorized, issued or outstanding as of March 31, 2021; 1,837,600 shares authorized, issued and outstanding as of December 31, 2020 (liquidation value of $ 5,000 at December 31, 2020) | — | 10,270 |\\n| Stockholders' equity (deficit) |\\n| Series B convertible preferred stock, $ 0.00001 par value - no shares authorized, issued or outstanding as of March 31, 2021; 4,681,400 shares authorized, issued and outstanding as of December 31, 2020 (liquidation value of $ 24,000 at December 31, 2020) | — | 24,000 |\\n| Undesignated preferred stock, $ 0.00001 par value - 100,000,000 shares authorized, and no shares issued or outstanding as of March 31, 2021; no shares authorized, issued, or outstanding as of December 31, 2020 | — | — |\\n| Common stock, $ 0.00001 par value - no shares authorized, issued, or outstanding as of March 31, 2021; 300,000,000 shares authorized, and 95,206,893 shares issued and 95,050,041 shares outstanding at December 31, 2020 | — | — |\\n| Class A common stock, $ 0.00001 par value - 1,000,000,000 shares authorized, and 10,000,000 shares issued and outstanding as of March 31, 2021; no shares authorized, issued or outstanding as of December 31, 2020 | — | — |\\n| Class B common stock, $ 0.00001 par value - 160,000,000 shares authorized, and 124,905,954 shares issued and 124,749,102 outstanding as of March 31, 2021; no shares authorized, issued or outstanding as of December 31, 2020 | 1 | — |\\n| Additional paid-in capital | 174,254 | 4,975 |\\n| Accumulated deficit | ( 34,344 ) | ( 35,815 ) |\\n| Total stockholders’ equity (deficit) | 139,911 | ( 6,840 ) |\\n| Total liabilities, redeemable convertible preferred stock, and stockholders' deficit | $ | 193,866 | $ | 54,958 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.1\\nSEMRUSH HOLDINGS, INC.\\nUNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)\\n(in thousands, except per share data)\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| Revenue | $ | 39,998 | $ | 27,787 |\\n| Cost of revenue | 8,773 | 6,611 |\\n| Gross profit | 31,225 | 21,176 |\\n| Operating expenses |\\n| Sales and marketing | 16,457 | 12,877 |\\n| Research and development | 5,358 | 4,237 |\\n| General and administrative | 7,904 | 5,933 |\\n| Total operating expenses | 29,719 | 23,047 |\\n| Income (loss) from operations | 1,506 | ( 1,871 ) |\\n| Other income, net | 51 | 56 |\\n| Income (loss) before income taxes | 1,557 | ( 1,815 ) |\\n| Provision for income taxes | 86 | 116 |\\n| Net income (loss) and comprehensive income (loss) | $ | 1,471 | $ | ( 1,931 ) |\\n| Net income (loss) per share attributable to common stockholders: |\\n| Basic | $ | 0.02 | $ | ( 0.02 ) |\\n| Diluted | $ | 0.01 | $ | ( 0.02 ) |\\n| Weighted-average number of shares of common stock used in computing net income (loss) per share attributable to common stockholders: |\\n| Basic | 96,376 | 94,593 |\\n| Diluted | 131,356 | 94,593 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.2\\nSEMRUSH HOLDINGS, INC.\\nUNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY (DEFICIT)\\n(in thousands, except share data)\\n| Series A | Series A-1 | Series B | Common Stock | Class A Common Stock | Class B Common Stock | AdditionalPaid-inCapital | AccumulatedDeficit | TotalStockholders’Equity(Deficit) |\\n| Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount |\\n| Balances at December 31, 2019 | 3,379,400 | $ | 7,789 | 1,837,600 | $ | 10,270 | 4,681,400 | $ | 24,000 | 94,592,700 | $ | — | — | $ | — | — | $ | — | $ | 3,644 | $ | ( 28,803 ) | $ | ( 1,159 ) |\\n| Stock-based compensation expense | — | — | — | — | — | — | — | — | — | — | — | — | 205 | — | 205 |\\n| Net loss | — | — | — | — | — | — | — | — | — | — | — | — | — | ( 1,931 ) | ( 1,931 ) |\\n| Balances at March 31, 2020 | 3,379,400 | $ | 7,789 | 1,837,600 | $ | 10,270 | 4,681,400 | $ | 24,000 | 94,592,700 | $ | — | — | $ | — | — | $ | — | 3,849 | ( 30,734 ) | ( 2,885 ) |\\n| Balances at December 31, 2020 | 3,379,400 | $ | 7,789 | 1,837,600 | $ | 10,270 | 4,681,400 | $ | 24,000 | 95,050,041 | $ | — | — | $ | — | — | $ | — | 4,975 | ( 35,815 ) | $ | ( 6,840 ) |\\n| Conversion of Preferred Stock | ( 3,379,400 ) | ( 7,789 ) | ( 1,837,600 ) | ( 10,270 ) | ( 4,681,400 ) | ( 24,000 ) | 29,695,200 | — | — | — | — | — | 42,058 | — | 18,058 |\\n| Issuance of Class A Common Stock in connection with the initial public offering, net of $ 13,378 in issuance costs | — | — | — | — | — | — | — | — | 10,000,000 | — | — | — | 126,622 | — | 126,622 |\\n| Reclassification of Common Stock to Class B Common Stock in connection with the initial public offering | — | — | — | — | — | — | ( 124,745,241 ) | — | — | — | 124,745,241 | 1 | ( 1 ) | — | — |\\n| Exercise of stock options | — | — | — | — | — | — | — | — | — | — | 3,861 | — | 7 | — | 7 |\\n| Stock-based compensation expense | — | — | — | — | — | — | — | — | — | — | — | — | 593 | — | 593 |\\n| Net Income | — | — | — | — | — | — | — | — | — | — | — | — | — | 1,471 | 1,471 |\\n| Balances at March 31, 2021 | — | $ | — | — | $ | — | — | $ | — | — | $ | — | 10,000,000 | $ | — | 124,749,102 | $ | 1 | $ | 174,254 | $ | ( 34,344 ) | $ | 139,911 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.3\\nSEMRUSH HOLDINGS, INC.\\nUNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\\n(in thousands)\\n| Three Months Ended |\\n| March 31, |\\n| 2021 | 2020 |\\n| Operating Activities |\\n| Net income (loss) | $ | 1,471 | $ | ( 1,931 ) |\\n| Adjustments to reconcile net income (loss) to net cash provided by operating activities |\\n| Depreciation and amortization expense | 460 | 232 |\\n| Amortization of deferred contract costs | 1,322 | 1,104 |\\n| Stock-based compensation expense | 593 | 205 |\\n| Deferred taxes | ( 56 ) | ( 57 ) |\\n| Changes in operating assets and liabilities |\\n| Accounts receivable | ( 985 ) | 745 |\\n| Deferred contract costs | ( 2,420 ) | ( 1,704 ) |\\n| Prepaid expenses and other current assets | ( 976 ) | ( 747 ) |\\n| Accounts payable | 1,579 | 58 |\\n| Accrued expenses | 2,420 | 1,002 |\\n| Deferred revenue | 5,599 | 1,654 |\\n| Net cash provided by operating activities | 9,007 | 561 |\\n| Investing Activities |\\n| Purchases of property and equipment | ( 166 ) | ( 1,084 ) |\\n| Purchases of convertible debt securities | ( 500 ) | — |\\n| Capitalization of internal-use software development costs | ( 123 ) | ( 297 ) |\\n| Cash paid for acquisition of business, net of cash acquired | ( 350 ) | — |\\n| Net cash used in investing activities | ( 1,139 ) | ( 1,381 ) |\\n| Financing Activities |\\n| Proceeds from exercise of stock options | 7 | — |\\n| Net proceeds from completing initial public offering | 128,461 | — |\\n| Payment of deferred offering costs | — | ( 16 ) |\\n| Net cash provided by (used in) financing activities | 128,468 | ( 16 ) |\\n| Increase in cash, cash equivalents and restricted cash | 136,336 | ( 836 ) |\\n| Cash, cash equivalents and restricted cash, at beginning of period | 35,619 | 37,523 |\\n| Cash, cash equivalents and restricted cash, at end of period | $ | 171,955 | $ | 36,687 |\\n| Supplemental cash flow disclosures |\\n| Cash paid for income taxes | $ | 158 | $ | 154 |\\n| Deferred offering costs incurred and not paid | $ | 1,839 | $ | — |\\n| Acquisition of fixed asset under capital lease | $ | 1,024 | $ | — |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.4\\nSEMRUSH HOLDINGS, INC.\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\nThree months ended March 31, 2021 and 2020\\n(in thousands, except share and per share data, unless otherwise noted)\\n1. Overview and Basis of Presentation\\nDescription of Business\\nSemrush Holdings, Inc. (“Semrush Holdings”) and its subsidiaries (together the “Group”, the “Company”, or “Semrush”) provide an online visibility management software-as-a-service (“SaaS”) platform. The Company’s platform enables its subscribers to improve their online visibility and drive traffic, including on their websites and social media pages, and distribute highly relevant content to their customers on a targeted basis across various channels to drive high-quality traffic and measure the effectiveness of their digital marketing campaigns. The Company is headquartered in Boston, Massachusetts, and has wholly owned subsidiaries in Cyprus, Russia, the Czech Republic, Poland, and the United States.\\nThe Company is subject to a number of risks and uncertainties common to companies in similar industries and stages of development that could affect future operations and financial performance. These risks include, but are not limited to, rapid technological change, competitive pressure from substitute products or larger companies, protection of proprietary technology, management of international activities, the need to obtain additional financing to support growth, and dependence on third parties and key individuals.\\n2019 Reorganization\\nOn December 19, 2019, Semrush Holdings was incorporated in the state of Delaware and entered into a Contribution and Exchange Agreement with SEMrush CY Ltd (“SEMrush CY”) (a private limited liability company organized under the Cyprus Companies Law, Cap 113), pursuant to which the holders of all outstanding shares of capital stock of SEMrush CY contributed those shares to Semrush Holdings in exchange for identical shares of capital stock of Semrush Holdings (the “2019 Share Exchange”). Upon the 2019 Share Exchange, Semrush Holdings became the holding company of SEMrush CY and its wholly owned subsidiaries and the historical consolidated financial statements of SEMrush CY became the historical consolidated financial statements of Semrush Holdings. The 2019 Share Exchange and related transactions were completed on December 27, 2019.\\nInitial Public Offering\\nOn March 29, 2021, the Company closed its initial public offering (“IPO”) in which it sold 10,000,000 shares of its Class A common stock at a price to the public of $ 14.00 per share. The Company received $ 126.6 million in net proceeds after deducting approximately $ 13.4 million for underwriting discounts, commissions and offering expenses. Immediately prior to the completion of the IPO, all shares of common stock then outstanding were reclassified as Class B common stock, and all shares of redeemable convertible preferred stock and convertible preferred stock then outstanding were converted into shares of common stock on a one -to-one basis and then reclassified into Class B common stock.\\nEffects of COVID-19\\nThe Company considered the potential effects of the novel strain of coronavirus (“COVID-19”) pandemic on the Company. In March 2020, the World Health Organization declared the outbreak of COVID–19 a pandemic, and numerous new strains of COVID-19 have subsequently spread throughout\\n5\\nthe world. COVID–19 has continued to impact market and economic conditions globally. In an attempt to limit the spread of the virus, various governmental restrictions have been implemented, including restrictions with respect to business activities and travel restrictions, and “shelter–at–home” orders, that have had and may continue to have an adverse impact on the Company’s business and operations. In light of the evolving nature of COVID–19 and the uncertainty it has produced around the world, it is not possible to predict the COVID–19 pandemic’s cumulative and ultimate impact on the Company’s future business operations, results of operations, financial position, liquidity, and cash flows. The extent of the impact of the pandemic on the Company’s business and financial results will depend largely on future developments, including the duration of the spread of the outbreak both globally and within the U.S., the impact on capital, foreign currencies exchange and financial markets, and governmental or regulatory orders that impact the Company’s business, all of which are highly uncertain and cannot be predicted.\\nThe Company will continue to actively monitor the current international and domestic impacts of and responses to COVID-19 and its related risks.\\nBasis of Presentation\\nThe accompanying unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and applicable rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Any reference in these notes to applicable guidance is meant to refer to the authoritative United States generally accepted accounting principles as found in the Accounting Standards Codification (“ASC”) and Accounting Standards Update (“ASU”) of the Financial Accounting Standards Board (“FASB”).\\nThe unaudited condensed consolidated interim financial statements have been prepared on the same basis as the audited annual consolidated financial statements as of and for the year ended December 31, 2020, and, in the opinion of management, reflect all adjustments, consisting of normal recurring adjustments, necessary for the fair presentation of the Company’s financial position as of March 31, 2021, and the results of its operations and its cash flows for the three months ended March 31, 2021 and 2020. The consolidated balance sheet as of December 31, 2020 included herein was derived from the audited financial statements as of that date.\\nThe results for the three months ended March 31, 2021 are not necessarily indicative of the results to be expected for the year ending December 31, 2021, any other interim periods, or any future year or period.\\nThe unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes included in the Company’s final prospectus dated March 24, 2021 (the “Prospectus”) as filed with the SEC on March 25, 2021 pursuant to Rule 424(b) under the Securities Act of 1933, as amended (the “Securities Act”).\\nThe accompanying unaudited condensed consolidated financial statements reflect the application of certain significant accounting policies as described below and elsewhere in these notes to the unaudited condensed consolidated financial statements. As of March 31, 2021, there have been no material changes in the Company's significant accounting policies from those that were disclosed in the Prospectus except as discussed below.\\n2. Summary of Significant Accounting Policies\\nPrinciples of Consolidation\\n6\\nThe unaudited condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany transactions and balances have been eliminated in consolidation.\\nUse of Estimates\\nThe preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. Significant estimates relied upon in preparing these financial statements include, but are not limited to, revenue recognition, expected future cash flows used to evaluate the recoverability of long-lived assets, contingent liabilities, expensing and capitalization of research and development costs for internal-use software, the average period of benefit associated with costs capitalized to obtain revenue contracts, the determination of the fair value of stock-based awards issued, stock-based compensation expense, and the recoverability of the Company’s net deferred tax assets and related valuation allowance.\\nAlthough the Company regularly assesses these estimates, actual results could differ materially from these estimates. Changes in estimates are recorded in the period in which they become known. The Company bases its estimates on historical experience and various other assumptions that it believes to be reasonable under the circumstances. Actual results may differ from management’s estimates if these results differ from historical experience, or other assumptions do not turn out to be substantially accurate, even if such assumptions are reasonable when made.\\nSubsequent Events Considerations\\nThe Company considers events or transactions that occur after the balance sheet date but prior to the issuance of the financial statements to provide additional evidence for certain estimates or to identify matters that require additional disclosure. Subsequent events have been evaluated as required. The Company has evaluated all subsequent events and determined that there are no material recognized or unrecognized subsequent events requiring disclosure, other than those disclosed in this Quarterly Report on Form 10-Q.\\nEmerging Growth Company Status\\nThe Company is an \\\"emerging growth company,\\\" as defined in the Jumpstart Our Business Startups Act, or JOBS Act, and may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not \\\"emerging growth companies.\\\" The Company may take advantage of these exemptions until the Company is no longer an \\\"emerging growth company.\\\" Section 107 of the JOBS Act provides that an \\\"emerging growth company\\\" can take advantage of the extended transition period afforded by the JOBS Act for the implementation of new or revised accounting standards. The Company has elected to use the extended transition period for complying with new or revised accounting standards and, as a result of this election, its financial statements may not be comparable to companies that comply with public company effective dates. The Company may take advantage of these exemptions up until the last day of the year following the fifth anniversary of an offering or such earlier time that it is no longer an emerging growth company. The Company would cease to be an emerging growth company if it has more than $1.07 billion in annual revenue, has more than $700.0 million in market value of its stock held by non-affiliates (and it has been a public company for at least 12 months, and has filed one annual report on Form 10-K), or it issues more than $1.0 billion of non-convertible debt securities over a three-year period.\\n7\\nRevenue Recognition\\nThe Company derives revenue from two sources: (1) subscription revenues via the Semrush Online Visibility Management Platform and the Prowly Public Relations Platform, which are comprised of subscription fees from customers accessing the Company’s SaaS services and related customer support; and (2) the Semrush Marketplace, which allows customers to pay a set fee for services or products offered through the marketplace.\\nThe Company recognizes revenue in accordance with ASC 606, Revenue from Contracts with Customers (“ASC 606”). Revenue is recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration it expects to receive in exchange for those products or services. There were no changes to the Company’s revenue recognition policies since the filing of the Prospectus.\\nFor the three months ended March 31, 2021 and 2020, subscription revenue accounted for nearly all of the Company’s revenue. Revenue related to the Semrush Marketplace was not material for the three months ended March 31, 2021 and 2020.\\nAmounts that have been invoiced are recorded in accounts receivable and in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met. The Company primarily invoices and collects payments from customers for its services in advance on a monthly or annual basis.\\nDeferred revenue represents amounts billed for which revenue has not yet been recognized. Deferred revenue that will be recognized during the succeeding 12-month period is recorded as current deferred revenue, and the remaining portion is recorded as long-term deferred revenue. Deferred revenue increased by $ 5,599 as of March 31, 2021 compared December 31, 2020. During the three months ended March 31, 2021 and 2020, $ 13,303 and $ 9,583 of revenue was recognized that was included in deferred revenue at the beginning of each respective period.\\nThe Company has elected to exclude amounts charged to customers for sales tax from the transaction price. Accordingly, revenue is presented net of any sales tax collected from customers.\\nTransaction Price Allocated to Future Performance Obligations\\nASC 606 requires that the Company disclose the aggregate amount of the transaction price that is allocated to performance obligations that have not yet been satisfied as of the balance sheet dates reported.\\nFor contracts with an original expected duration greater than one year, the aggregate amount of the transaction price allocated to the performance obligations that were unsatisfied as of March 31, 2021 and December 31, 2020 was $ 866 and $ 1,280 , respectively, which the Company expects to recognize over the next 12 months.\\nFor contracts with an original expected duration of one year or less, the Company has applied the practical expedient available under ASC 606 to not disclose the amount of transaction price allocated to unsatisfied performance obligations as of March 31, 2021 and December 31, 2020. For performance obligations not satisfied as of March 31, 2021 and December 31, 2020, and to which this expedient applies, the nature of the performance obligations is consistent with performance obligations satisfied as of December 31, 2019. The remaining durations are less than one year.\\nCosts to Obtain a Contract\\nThe incremental direct costs of obtaining a contract, which primarily consist of sales commissions paid for new subscription contracts, are deferred and recorded as deferred contract costs in the\\n8\\nconsolidated balance sheet and are amortized over a period of approximately 24 months on a systematic basis, consistent with the pattern of transfer of the goods or services to which the asset relates. The 24-month period represents the estimated benefit period of the customer relationship and has been determined by taking into consideration the type of product sold, the commitment term of the customer contract, the nature of the Company’s technology development life-cycle, and an estimated customer relationship period based on historical experience and future expectations. Sales commissions for renewals and upgrade contracts are deferred and amortized on a straight-line basis over the remaining estimated customer relationship period of the related customer. Deferred contract costs that will be recorded as expense during the succeeding 12-month period are recorded as current deferred contract costs, and the remaining portion is recorded as deferred contract costs, net of current portion. Amortization of deferred contract costs is included in sales and marketing expense in the accompanying consolidated statement of operations and comprehensive loss.\\nCash, Cash Equivalents, and Restricted Cash\\nThe Company considers all highly liquid instruments purchased with an original maturity date of 90 days or less from the date of purchase to be cash equivalents. Management determines the appropriate classification of investments at the time of purchase and re-evaluates such determination at each balance sheet date.\\nCash and cash equivalents consist of cash on deposit with banks and amounts held in interest-bearing money market funds. Cash equivalents are carried at cost, which approximates their fair market value. At both March 31, 2021 and December 31, 2020, restricted cash was $ 88 , and related to cash held at a financial institution in an interest-bearing cash account as collateral for a letter of credit related to the contractual provisions for one of the Company’s building leases.\\nThe following table is a reconciliation of cash, cash equivalents and restricted cash included in the accompanying condensed consolidated balance sheets that sum to the total cash, cash equivalents and restricted cash included in the accompanying condensed consolidated statements of cash flows for the three months ended March 31, 2021 and 2020.\\n| March 31, 2021 | March 31, 2020 |\\n| Cash and cash equivalents | $ | 171,867 | $ | 36,599 |\\n| Restricted cash included in “prepaid expenses and other current assets” and “other long-term assets,” respectively | 88 | 88 |\\n| $ | 171,955 | $ | 36,687 |\\n\\nConcentrations of Credit Risk and Significant Customers\\nThe Company has no off-balance sheet risk, such as foreign exchange contracts, option contracts, or other hedging arrangements. Credit losses historically have not been significant and the Company generally has not experienced any material losses related to receivables from individual customers, or groups of customers. Due to these factors, no additional credit risk beyond amounts provided for collection losses is believed by management to be probable in the Company's accounts receivable.\\nCredit risk with respect to accounts receivable is dispersed due to the large number of customers of the Company. The Company routinely assesses the creditworthiness of its customers and generally does not require its customers to provide collateral or other security to support accounts receivable. Credit losses historically have not been significant and the Company generally has not experienced any material losses related to receivables from individual customers, or groups of customers. Due to these factors, no additional credit risk beyond amounts provided for collection losses is believed by management to be probable in the Company's accounts receivable.\\n9\\nAs of March 31, 2021 and December 31, 2020, no individual customer represented more than 10% of the Company’s accounts receivable. During the three months ended March 31, 2021 and 2020, no individual customer represented more than 10% of the Company’s revenue.\\nDisclosure of Fair Value of Financial Instruments\\nThe carrying amounts of the Company’s financial instruments, which include cash and cash equivalents, accounts receivable, accounts payable, and accrued expenses, approximated their fair values at March 31, 2021 and December 31, 2020, due to the short-term nature of these instruments.\\nThe Company has evaluated the estimated fair value of financial instruments using available market information. The use of different market assumptions and/or estimation methodologies could have a significant effect on the estimated fair value amounts. See below for further discussion.\\nFair Value Measurements\\nASC 820, Fair Value Measurements and Disclosures (“ASC 820”), establishes a three-level valuation hierarchy for instruments measured at fair value that distinguishes between assumptions based on market data (observable inputs) and the Company’s own assumptions (unobservable inputs). Observable inputs are those that market participants would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions about the inputs that market participants would use in pricing the asset or liability and are developed based on the best information available in the circumstances.\\nThis guidance further identifies fair value as the exchange price, or exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants based on the highest and best use of the asset or liability. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. The Company uses valuation techniques to measure fair value that maximize the use of observable inputs and minimize the use of unobservable inputs. These inputs are prioritized as follows:\\nLevel 1 inputs—Unadjusted observable quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.\\nLevel 2 inputs—Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly.\\nLevel 3 inputs—Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity.\\nTo the extent that the valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Accordingly, the degree of judgment exercised by the Company in determining fair value is greatest for instruments categorized in Level 3. A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement.\\nThe Company evaluates assets and liabilities subject to fair value measurements on a recurring and nonrecurring basis to determine the appropriate level to classify them for each reporting period.\\nCash equivalents include money market funds with original maturities of 90 days or less from the date of purchase. The fair value measurement of these assets is based on quoted market prices in active markets for identical assets and, therefore, these assets are recorded at fair value on a recurring basis\\n10\\nand classified as Level 1 in the fair value hierarchy. As of March 31, 2021 and December 31, 2020, cash equivalents held in money market funds totaled $ 35,505 and $ 29,369 , respectively.\\nAs of March 31, 2021, the Company measured its investments in convertible notes (see Note 4) and its contingent consideration associated with the acquisition of Prowly.com sp. z o.o (“Prowly”) on a recurring basis using significant unobservable inputs (Level 3) and did not have any assets or liabilities measured at fair value on a recurring basis using significant other observable inputs (Level 2). Changes in fair value of the convertible notes were not material for the three months ended March 31, 2021 due to the short time period between when the investment was made and the balance sheet date. Changes in fair value of the contingent consideration associated with the Prowly acquisition were not material for the three months ended March 31, 2021. As of December 31, 2020, the Company did not have any assets or liabilities measured at fair value on a recurring basis using significant other observable inputs (Level 2).\\nForeign Currency Translation\\nThe Group operates in a multi-currency environment having transactions in such currencies as the U.S. dollar, Russian rubles, Czech koruna, euros, and others. The reporting currency of the Company is the U.S. dollar. The functional currency of the Company’s foreign subsidiaries is the U.S. dollar, with the exception of Prowly, where the functional currency is the local currency, the Zloty. The foreign currency translation adjustment as it relates to Prowly was immaterial for the three months ended March 31, 2021 and 2020. For all other entities, foreign currency transactions are measured initially in the functional currency of the recording entity by use of the exchange rate in effect at that date. At each subsequent balance sheet date, foreign currency denominated assets and liabilities of these international subsidiaries are remeasured into U.S. dollars using the exchange rates in effect at the balance sheet date or historical rates, as appropriate. Any differences resulting from the remeasurement of foreign denominated assets and liabilities of the international subsidiaries to the U.S. dollar functional currency are recorded within other income (expense) in the unaudited condensed consolidated statement of operations and comprehensive loss. The foreign currency exchange gain (loss) included in other income for the three months ended March 31, 2021 and 2020 was $ 44 and $( 107 ), respectively.\\nNet Income (Loss) Per Share\\nNet income (loss) per share information is determined using the two-class method, which includes the weighted-average number of shares of common stock outstanding during the period and other securities that participate in dividends (a participating security). Prior to the completion of the IPO, the Company considered the shares of Preferred Stock to be participating securities because they include rights to participate in dividends with the common stock. As of March 31, 2021, the Company did not have any participating securities outstanding.\\nUnder the two-class method, basic net income (loss) per share attributable to common stockholders is computed by dividing the net income (loss) attributable to common stockholders by the weighted-average number of shares of common stock outstanding during the period. Diluted net income (loss) per share attributable to common stockholders is computed using the more dilutive of (1) the two-class method or (2) the if-converted method. The Company allocates net income first to preferred stockholders based on dividend rights under the Company’s certificate of incorporation and then to preferred and common stockholders based on ownership interests. Net losses are not allocated to preferred stockholders as they do not have an obligation to share in the Company’s net losses.\\nDuring the three months ended March 31, 2021, the Company amended its certificate of incorporation to create two classes of common stock outstanding: Class A common stock and Class B common stock. As more fully described in Note 9, the rights of the holders of Class A and Class B common stock are identical, except with respect to voting and conversion. Each share of Class A common stock is entitled to one (1) vote per share and each share of Class B common stock is entitled to ten (10) votes per share. Each share of Class B common stock is convertible into one share of Class A common stock at the option\\n11\\nof the holder at any time. Shares of Class B common stock are automatically converted into Class A common stock upon sale or transfer, subject to certain limited exceptions. Shares of Class A common stock are not convertible. See Note 9 to these unaudited condensed consolidated financial statements for additional information regarding the current conversion and transfer terms of the Company’s common stock. The Company allocates undistributed earnings attributable to common stock between the common stock classes on a one to one basis when computing net income (loss) per share. As a result, basic and diluted net income (loss) per share of Class A common stock and share of Class B common stock are equivalent.\\nDiluted net income (loss) per share gives effect to all potentially dilutive securities. Potential dilutive securities consist of shares of common stock issuable upon the exercise of stock options, shares of common stock issuable upon the conversion of the outstanding shares of Preferred Stock, and shares of common stock issuable upon the vesting of restricted stock awards or restricted stock units.\\nFor the three months ended March 31, 2021, dilutive net income per share was calculated by dividing net income by the weighted-average number of shares of common stock outstanding during the period, the dilutive impact of stock options, shares of common stock issuable upon the vesting of RSUs, and the dilutive impact of shares issuable upon the conversion of the outstanding shares of Preferred Stock.\\nFor the three months ended March 31, 2020, the net loss attributable to common stockholders is divided by the weighted-average number of shares of common stock outstanding during the period to calculate diluted earnings per share. The dilutive effect of common stock equivalents has been excluded from the calculation for the three months ended March 31, 2020 as their effect would have been anti-dilutive due to the net losses incurred for the period.\\nThe following table presents a reconciliation of the weighted-average shares outstanding used in the calculation of basic and diluted net income (loss) per share:\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| Weighted-average shares outstanding: |\\n| Weighted-average number of shares of common stock used in computing net income (loss) per share attributable to common stockholders—basic | 96,375,531 | 94,592,700 |\\n| Dilutive effect of share equivalents resulting from stock options | 6,151,361 | — |\\n| Dilutive effect of share equivalents resulting from RSAs | 123,841 | — |\\n| Dilutive effect of shares issuable upon conversion of preferred stock | 28,705,360 | — |\\n| Weighted-average number of shares of common stock used in computing net income (loss) per share attributable to common stockholders—diluted | 131,356,093 | 94,592,700 |\\n\\nThe following potentially dilutive common stock equivalents have been excluded from the calculation of diluted weighted-average shares outstanding for the three months ended March 31, 2021 and 2020:\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| Stock options outstanding | — | 6,286,357 |\\n| Shares of Preferred Stock | — | 29,695,200 |\\n| Restricted stock units outstanding | 1,733 | — |\\n\\n12\\nComprehensive income (loss)\\nComprehensive income (loss) is comprised of two components: net income (loss) and other comprehensive income (loss), which includes other changes in stockholders’ deficit that result from transactions and economic events other than those with stockholders. The Company had no items qualifying as other comprehensive income (loss) with the exception of an immaterial cumulative translation adjustment related to the Prowly entity and an immaterial fair-value adjustment related to the convertible note investments; accordingly, comprehensive income (loss) equaled total net loss for the three months ended March 31, 2021 and 2020.\\nRecent Accounting Pronouncements\\nIn February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). ASU 2016-02 requires a lessee to recognize most leases on the balance sheet but recognize expenses on the income statement in a manner similar to current practice. The update states that a lessee will recognize a lease liability for the obligation to make lease payments and a right-to-use asset for the right to use the underlying assets for the lease term. Leases will continue to be classified as either financing or operating, with classification affecting the recognition, measurement, and presentation of expenses and cash flows arising from a lease. For public entities, ASU 2016-02 is effective for years beginning after December 15, 2019. For non-public companies, ASU 2016-02 is effective for fiscal years beginning after December 15, 2021 and interim periods in annual periods beginning after December 15, 2022. Early adoption is permitted. The Company plans to adopt this guidance in the year ended December 31, 2022. The Company is currently assessing the impact that adopting this guidance will have on its consolidated financial statements.\\nIn June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. ASU 2016-13 requires that credit losses be reported as an allowance using an expected losses model, representing the entity's current estimate of credit losses expected to be incurred. The accounting guidance currently in effect is based on an incurred loss model. ASU 2016-13 affect loans, debt securities, trade receivables, net investments in leases, off balance sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash. ASU 2016-13 is effective for public entities for annual reporting periods beginning after December 15, 2019, including interim periods within those fiscal years. For non-public companies, ASU 2016-13 is effective for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021. The Company plans to adopt this guidance in the year ended December 31, 2021. The Company is currently evaluating ASU 2016-13 and the potential impact on its condensed consolidated financial statements and financial statement disclosures.\\nIn August 2018, the FASB issued ASU No. 2018-15, Intangible-Goodwill and Other Internal-Use Software (Subtopic 350-40). ASU 2018-15 updates guidance regarding accounting for implementation costs associated with a cloud computing arrangement that is a service contract. The amendments under ASU 2018-15 are effective for public entities for years beginning after December 15, 2019, and interim periods within those years. For non-public companies, ASU 2081-15 is effective for annual reporting periods beginning after December 15, 2020, and interim periods within annual periods beginning after December 15, 2021, with early adoption permitted. The Company plans to adopt this guidance in the year ended December 31, 2021. The Company is currently assessing the impact that adopting this guidance will have on its condensed consolidated financial statements.\\nIn December 2019, the FASB issued ASU 2019-12, Income Taxes – Simplifying the Accounting for Income Taxes. The new guidance simplifies the accounting for income taxes by removing several exceptions in the current standard and adding guidance to reduce complexity in certain areas, such as requiring that an entity reflect the effect of an enacted change in tax laws or rates in the annual effective tax rate computation in the interim period that includes the enactment date. For public companies, the ASU is effective for years beginning after December 15, 2020, and interim periods within those years,\\n13\\nwith early adoption permitted. For non-public companies, the new standard is effective for years beginning after December 15, 2021, with early adoption permitted. The Company plans to adopt this guidance in the year ended December 31, 2021. The Company is currently assessing the impact that adopting this guidance will have on its condensed consolidated financial statements.\\n3. Property and Equipment, Net\\nProperty and equipment consists of the following (in thousands):\\n| As of |\\n| March 31,2021 | December 31,2020 |\\n| Computer equipment | $ | 3,383 | $ | 3,513 |\\n| Furniture and office equipment | 877 | 1,041 |\\n| Leasehold improvements | 1,142 | 667 |\\n| Capital leases | 1,024 | — |\\n| Total property and equipment | 6,426 | 5,221 |\\n| Less: accumulated depreciation and amortization | ( 2,550 ) | ( 2,253 ) |\\n| Property and equipment, net | $ | 3,876 | $ | 2,968 |\\n\\nDepreciation and amortization expense related to property and equipment was $ 344 and $ 203 for the three months ended March 31, 2021 and 2020, respectively.\\n4. Other Long-Term Assets\\nDeferred Offering Costs\\nDeferred offering costs, which primarily consist of direct incremental legal and accounting fees relating to the IPO and to a credit facility, are deferred. The deferred issuance costs relating to the IPO were offset against IPO proceeds upon the consummation of the Company’s offering. The deferred costs relating to the credit facility are being amortized to interest expense up through the maturity date of the facility. As of March 31, 2021 and December 31, 2020, the Company had deferred offering costs relating to the IPO of $ 0 and $ 1,839 . As of March 31, 2021 and December 31, 2020, the Company had $ 578 and $ 630 , respectively, in issuance costs relating to the credit facility. The issuance costs for the IPO and credit facility are classified in other long-term assets in the accompanying unaudited condensed consolidated balance sheets.\\nInvestments in Convertible Debt\\nIn January 2021, the Company purchased two convertible debt securities for a total aggregate investment of $ 500 . Both investments mature on January 1, 2023 and receive interest at an annual rate of 6 %. Interest accrues and becomes payable upon conversion of the convertible notes, or will be paid in connection with the repayment in full of the principal amount of such convertible notes.\\nThese convertible note investments are classified as available-for-sale securities with changes in fair value reported in other comprehensive income (loss). Changes in fair value were not material for the three months ended March 31, 2021 due to the short time period between when the investment was made and the balance sheet date. These investments are classified in other long-term assets in the accompanying unaudited condensed consolidated balance sheets based on the maturity date.\\n14\\n5. Acquisitions, Acquired Intangible Assets, and Goodwill\\nAcquisitions\\nOn August 27, 2020, the Company acquired 100 % of the outstanding capital of Prowly for cash consideration of $ 3,317 . In addition to the purchase consideration, the founders of Prowly are eligible to earn up to a maximum of $ 2,750 in aggregate additional consideration based on the satisfaction of certain earnings targets as defined in the purchase agreement. For the three months ended March 31, 2021, the Company recognized compensation expense of $ 56 as compensation expense related to the additional consideration.\\nIntangible Assets\\nIntangible assets consisted of intangible assets resulting from the acquisition of Prowly and capitalized internal-use software development costs. Intangible assets consists of the following:\\n| As of March 31, 2021 |\\n| Gross | Net |\\n| Carrying | Accumulated | Carrying |\\n| Amount | Amortization | Amount |\\n| Developed technology | 1,194 | ( 109 ) | 1,085 |\\n| Trade name | 68 | ( 9 ) | 59 |\\n| Capitalized internal-use software | 1,684 | ( 652 ) | 1,032 |\\n| Total as of March 31, 2021 | $ | 2,946 | $ | ( 770 ) | $ | 2,176 |\\n\\n| As of December 31, 2020 |\\n| Gross | Net |\\n| Carrying | Accumulated | Carrying |\\n| Amount | Amortization | Amount |\\n| Developed technology | 1,194 | ( 66 ) | 1,128 |\\n| Trade name | 68 | ( 3 ) | 65 |\\n| Capitalized internal-use software | 1,561 | ( 523 ) | 1,038 |\\n| Total as of December 31, 2020 | $ | 2,823 | $ | ( 592 ) | $ | 2,231 |\\n\\nDuring the three months ended March 31, 2021 and 2020, the Company capitalized $ 123 and $ 200 , respectively, of software development costs, which are classified as intangible assets on the accompanying consolidated balance sheets. The Company recorded amortization expense associated with its capitalized development costs of $ 129 and $ 52 for the three months ended March 31, 2021 and 2020, respectively. As of March 31, 2021 and December 31, 2020, the capitalized internal-use software asset balances totaled $ 1,032 and $ 1,038 , respectively.\\nAmortization expense for acquired intangible assets was $ 55 for the three months ended March 31, 2021.\\n15\\nAs of March 31, 2021, future amortization expense is expected to be as follows:\\n| Amount |\\n| Remainder of 2021 | $ | 519 |\\n| 2022 | 559 |\\n| 2023 | 428 |\\n| 2024 | 199 |\\n| 2025 and thereafter | 471 |\\n| Total | $ | 2,176 |\\n\\nGoodwill\\nThe was no change in the carrying value of goodwill of $ 1,991 from December 31, 2020 through March 31, 2021.\\n6. Accrued expenses\\nAccrued expenses consist of the following:\\n| As of |\\n| March 31,2021 | December 31,2020 |\\n| Employee compensation | $ | 4,776 | $ | 4,478 |\\n| Vacation reserves | 464 | 465 |\\n| Other current liabilities | 5,046 | 2,776 |\\n| Total accrued expenses | $ | 10,286 | $ | 7,719 |\\n\\n7. Revolving Credit Facility\\nSenior Secured Revolving Credit Facility\\nOn January 12, 2021, the Company executed a credit agreement with JPMorgan Chase Bank, N.A., in the form of a revolving credit facility, that consists of a $ 45.0 million revolving credit facility and a letter of credit sub-facility with an aggregate limit equal to the lesser of $ 5.0 million and the aggregate unused amount of the revolving commitments then in effect. The availability of the credit facility is subject to the borrowing base based on an advance rate of 400 % multiplied by annualized retention applied to monthly recurring revenue. The credit facility has a maturity of three years and will mature on January 12, 2024.\\nBorrowings under the credit facility bear interest at the Company’s option at (i) LIBOR, subject to a 0.50 % floor, plus a margin, or (ii) the alternate base rate, subject to a 3.25 % floor (or 1.50 % prior to positive consolidated adjusted earnings before interest, taxes, depreciation, and amortization (“adjusted EBITDA”) for the twelve months most recently ended), plus a margin. For LIBOR borrowings, the applicable rate margin is 2.75 % (or 3.50 % prior to positive consolidated adjusted EBITDA as of the twelve months most recently ended). For base rate borrowings, the applicable margin is 0.00 % (or 2.50 % prior to positive consolidated adjusted EBITDA as of the twelve months most recently ended). The Company is also required to pay a 0.25 % per annum fee on undrawn amounts under the Company’s revolving credit facility, payable quarterly in arrears.\\n16\\nAs of March 31, 2021, the Company has not drawn on this revolving credit facility. For the three months ended March 31, 2021, the Company incurred $ 53 in interest expense relating to this credit facility.\\n8. Income Taxes\\nWe are subject to U.S. federal, state, and foreign income taxes. For the three months ended March 31, 2021 and 2020, we recorded provisions for income taxes of $ 86 and $ 116 , respectively. Our effective tax rate for the three months ended March 31, 2021 and 2020 was lower than the U.S. statutory rate primarily due to the valuation allowance.\\nWe recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities. These differences are measured using the enacted statutory tax rates that are expected to be in effect for the years in which differences are expected to reverse. On a periodic basis, we reassess any valuation allowances that we maintain on our deferred tax assets, weighing positive and negative evidence to assess the recoverability of the deferred tax assets. We will maintain a valuation allowance on certain federal, state, and foreign tax attributes that we expect will expire prior to the utilization.\\nIn March 2020, the Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”) was signed into law. The CARES Act includes provisions relating to several aspects of corporate income taxes. We do not currently expect the CARES Act to have a significant impact on our provision for income taxes.\\n9. Redeemable Convertible Preferred Stock and Stockholders’ Equity\\nPrior to the IPO, the authorized capital stock of the Company included 9,898,400 shares of preferred stock, of which 3,379,400 shares have been designated as Series A Redeemable Convertible Preferred Stock, 1,837,600 shares have been designated as Series A-1 Redeemable Convertible Preferred Stock and 4,681,400 shares have been designated as Series B Convertible Preferred Stock (collectively the “Preferred Stock”).\\nImmediately prior to the closing of the IPO, the outstanding shares of Preferred Stock were converted on a three -for-one basis into 29,695,200 shares of common stock. The holders of the Company’s Preferred Stock had certain voting, dividend, and redemption rights, as well as liquidation preferences and conversion privileges. All rights, preferences, and privileges associated with the preferred stock were terminated at the time of the Company’s IPO in conjunction with the conversion of all outstanding shares of Preferred Stock into shares of common stock.\\nAs of March 31, 2021, the total number of shares of all classes of stock which the Company shall have authority to issue was (i) 1,000,000,000 shares of Class A common stock, par value $ 0.00001 per share, and (ii) 160,000,000 shares of Class B common stock, par value $ 0.00001 per share, and (iii) 100,000,000 undesignated shares of Preferred Stock, par value $ 0.00001 per share.\\nEach share of Class A common stock entitles the holder to one vote for each share on all matters submitted to a vote of the Company's stockholders at all meetings of stockholders and written actions in lieu of meetings. Each share of Class B common stock entitles the holder to ten votes for each share on all matters submitted to a vote of the Company's stockholders at all meetings of stockholders and written actions in lieu of meetings.\\nHolders of Class A common stock and Class B common stock are entitled to receive dividends, when and if declared by the board of directors (the “Board”).\\n17\\nEach share of Class B common stock is convertible into one share of Class A common stock at the option of the holder at any time. Automatic conversion shall occur upon the occurrence of (i) a Transfer, as defined in the amended and restated certificate of incorporation, of such share of Class B common stock, (ii) the affirmative vote of at least two-thirds of the outstanding shares of Class B common stock, voting as a single class, or (iii) on or after the earlier to occur of (a) the seventh year anniversary of the effectiveness of the amended and restated certificate of incorporation or (b) the date on which the outstanding shares of Class B common stock represents less than 10 % of the aggregate number of the then outstanding shares of Class A common stock and Class B common stock. Further, upon either the death or incapacitation of a holder of Class B common stock, the shares held by such shareholder shall automatically be converted into one share of Class A common stock.\\nStock Split\\nOn March 15, 2021, the Board approved a 3 -for-1 stock-split of the Company’s common stock. The stock split was approved by the stockholders on March 15, 2021 and became effective on March 15, 2021. Upon the effectiveness of the stock split, (i) every one share of common stock outstanding was increased to 3 shares of common stock, (ii) the number of shares of common stock into which each outstanding option to purchase common stock is exercisable was proportionally increased on a 3 -for-1 basis, and (iii) the exercise price of each outstanding option to purchase common stock was proportionately decreased on a 3 -for-1 basis. Additionally, shares of common stock reserved for issuance upon the conversion of the Company’s Preferred Stock were proportionately increased on a 3 -for-1 basis and the respective conversion prices of the Preferred Stock were proportionately reduced. All share and per share data shown in the accompanying consolidated financial statements and related notes have been retroactively revised to reflect the stock split.\\nCommon Stock Reserved for Future Issuance\\nAs of March 31, 2021, the Company had reserved the following shares of common stock for future issuance:\\n| Options outstanding | 7,591,554 |\\n| Options reserved for future issuance | 13,483,501 |\\n| Restricted stock outstanding | 156,852 |\\n| Restricted stock units | 19,500 |\\n| Total authorized shares of common stock reserved for future issuance | 21,251,407 |\\n\\nn\\n10. Stock-Based Compensation\\nIn 2019, the Board adopted the Semrush Holdings, Inc. 2019 Stock Option and Grant Plan (the “2019 Plan”), which provides for the grant of qualified incentive stock options and nonqualified stock options or other awards, including restricted stock unit awards, to the Company’s employees, officers, directors, advisors, and outside consultants for the purchase of up to 8,682,600 shares of the Company’s common stock. In July 2020, the Plan was amended to provide for the grant of qualified incentive stock options and nonqualified stock options or other awards to the Company’s employees, officers, directors, advisors, and outside consultants for the purchase of up to 10,163,772 shares of the Company’s common stock. Stock options generally vest over a 4 year period and expire 10 years from the date of grant. Certain options provide for accelerated vesting if there is a change in control (as defined in the Plan).\\nThe Semrush Holdings, Inc. 2021 Stock Option and Incentive Plan (the “2021 Plan”) was adopted by the Board March 3, 2021 and approved by stockholders on March 15, 2021 and became effective immediately prior to the effectiveness of the Company’s registration statement in connection with its IPO. The 2021 Plan replaced the 2019 Plan as the Board determined not to make additional awards under the\\n18\\n2019 Plan following the pricing of the Company’s IPO. The 2021 Plan allows the compensation committee of the Board to make equity-based and cash-based incentive awards to the Company’s officers, employees, directors and other key persons (including consultants).\\nThe Company initially reserved 13,503,001 shares of Class A common stock for the issuance of awards under the 2021 Plan. The 2021 Plan provides that the number of shares reserved and available for issuance under the plan will automatically increase each January 1, beginning on January 1, 2022, by the lesser of 5 % of the outstanding number of shares of Class A and Class B common stock on the immediately preceding December 31, or such lesser number of shares as determined by the compensation committee. This number is subject to adjustment in the event of a stock split, stock dividend or other change in our capitalization.\\nThe Company accounts for stock-based compensation in accordance with the provisions of ASC 718, which requires the recognition of expense related to the fair value of stock-based compensation awards in the statements of operations. For stock-based awards issued under the Company’s stock-based compensation plans to employees and members of the Board for their services on the Board, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model as discussed further below. For service-based awards, the Company recognizes compensation expense on a straight-line basis over the requisite service period of the award with actual forfeitures recognized as they occur.\\nGiven the absence of an active market for the Company’s common stock prior to the completion of the IPO, the Board, the members of which the Company believes have extensive business, finance, and venture capital experience, were required to estimate the fair value of the Company’s common stock at the time of each grant of a stock-based award. The Company and the Board utilized various valuation methodologies in accordance with the framework of the American Institute of Certified Public Accountants’ Technical Practice Aid, Valuation of Privately-Held Company Equity Securities Issued as Compensation, to estimate the fair value of its common stock. Each valuation methodology included estimates and assumptions that require the Company’s judgment. These estimates and assumptions include a number of objective and subjective factors, in determining the value of the Company’s common stock at each grant date, including the following factors: (1) prices paid for the Company’s Preferred Stock, which the Company had sold to outside investors in arm’s-length transactions, and the rights, preferences, and privileges of the Company’s Preferred Stock and common stock; (2) valuations performed by an independent valuation specialist; (3) the Company’s stage of development and revenue growth; (4) the fact that the grants of stock-based awards involved illiquid securities in a private company; and (5) the likelihood of achieving a liquidity event for the common stock underlying the stock-based awards, such as an IPO or sale of the Company, given prevailing market conditions.\\nThe Company believes this methodology to be reasonable based upon the Company’s internal peer company analyses, and further supported by several arm’s-length transactions involving the Company’s Preferred Stock. As the Company’s common stock is not actively traded, the determination of fair value involves assumptions, judgments, and estimates. If different assumptions were made, stock-based compensation expense, consolidated net income (loss) and consolidated net income (loss) per share could have been significantly different.\\nThe Company has recorded stock-based compensation expense for stock options of $ 593 and $ 205 during the three months ended March 31, 2021 and 2020, respectively. The following table shows stock-\\n19\\nbased compensation expense by where the stock-based compensation expense is recorded in the Company’s unaudited condensed consolidated statement of operations:\\n| For the Three Months EndedMarch 31, |\\n| 2021 | 2020 |\\n| Cost of revenue | $ | 7 | $ | 5 |\\n| Sales and marketing | 190 | 27 |\\n| Research and development | 67 | 29 |\\n| General and administrative | 329 | 144 |\\n| Total stock-based compensation | $ | 593 | $ | 205 |\\n\\nAs of March 31, 2021, there was $ 5,024 of unrecognized compensation cost related to unvested common stock option arrangements granted under the 2021 Plan, which is expected to be recognized over a weighted-average period of 3.12 years.\\nThe fair value of each option award was estimated on the date of grant using the Black-Scholes option-pricing model. As there was no public market for its common stock prior to March 25, 2021, which was the first day of trading, and as the trading history of the Company’s common stock was limited through March 31, 2021, the Company determined the expected volatility for options granted based on an analysis of reported data for a peer group of companies that issued options with substantially similar terms. The expected volatility of options granted has been determined using an average of the historical volatility measures of this peer group of companies. The expected life of options granted to employees was calculated using the simplified method, which represents the average of the contractual term of the option and the weighted-average vesting period of the option. The Company uses the simplified method because it does not have sufficient historical option exercise data to provide a reasonable basis upon which to estimate expected term. The risk-free interest rate is based on a treasury instrument whose term is consistent with the expected life of the share option. The Company has not paid, nor anticipates paying, cash dividends on its ordinary shares; therefore, the expected dividend yield is assumed to be zero .\\n20\\nThe weighted-average assumptions utilized to determine the fair value of options granted to employees are presented in the following table:\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| Expected volatility | 52.0 | % | 46.7 | % |\\n| Weighted-average risk-free interest rate | 0.58 | % | 1.46 | % |\\n| Expected dividend yield | — | — |\\n| Expected life – in years | 6 | 6 |\\n\\nA summary of the Company’s option activity as of March 31, 2021, which all occurred under the Semrush Holdings, Inc. Amended and Restated 2019 Stock Option and Grant Plan (the “2019 Plan”), and changes during the three months then ended are as follows:\\n| Number of Options | Weighted-Average Exercise Price (per share) | Weighted-Average Remaining Contractual Term (in years) |\\n| Outstanding at December 31, 2020 | 7,611,258 | $ | 1.37 | 8.40 |\\n| Granted | 34,500 | 6.21 |\\n| Exercised | ( 3,861 ) | 1.35 |\\n| Forfeited | ( 50,343 ) | 2.00 |\\n| Outstanding at March 31, 2021 | 7,591,554 | 1.39 | 8.28 |\\n| Options exercisable at March 31, 2021 | 3,309,264 | 0.94 | 7.60 |\\n\\nThe weighted-average grant-date fair value of options granted during the three months ended March 31, 2021 and 2020 was $ 9.09 and $ 1.70 per share, respectively. No tax benefits were realized from options during the three months ended March 31, 2021.\\nThe aggregate intrinsic value of options outstanding as of March 31, 2021 and December 31, 2020 was $ 79,858 and $ 36,816 , respectively.\\nThe aggregate intrinsic value for options exercised during the three months ended March 31, 2021 was $ 19 . No options were exercised for the three months ended March 31,2020.\\nThe aggregate intrinsic value for options exercisable as of March 31, 2021 was $ 36,313 .\\nThe aggregate intrinsic value was calculated based on the positive difference, if any, between the estimated fair value of the Company’s common stock on March 31, 2021 and December 31, 2020, respectively, or the date of exercise, as appropriate, and the exercise price of the underlying options.\\nOn July 28, 2020, the Company issued 156,852 shares of its restricted common stock (“Restricted Stock Issuance”) to the founders of Prowly for a total fair value of $ 291 under the 2019 Plan. This Restricted Stock Issuance vests over a three-year service period, applicable to both founders. On March 3, 2021, the Company granted, to an employee, a restricted stock unit award for 19,500 shares of Class A common stock under the 2021 Plan.\\n2021 Employee Stock Purchase Plan\\nThe Semrush Holdings, Inc. 2021 Employee Stock Purchase Plan (the “ESPP”) was adopted by the Board on March 3, 2021 and approved by stockholders on March 15, 2021 and became effective\\n21\\nimmediately prior to the effectiveness of the Company’s registration statement in connection with its IPO. The ESPP initially reserves and authorizes the issuance of up to a total of 3,000,667 shares of Class A common stock to participating employees. The ESPP provides that the number of shares reserved and available for issuance will automatically increase each January 1, beginning on January 1, 2022 and each January 1 thereafter through January 1, 2031, by the least of (i) 1 % of the outstanding number of shares of Class A and Class B common stock on the immediately preceding December 31; (ii) 3,000,667 shares or (iii) such lesser number of shares of Class A common stock as determined by the ESPP administrator. The number of shares reserved under the ESPP is subject to adjustment in the event of a stock split, stock dividend or other change in our capitalization. The Company expects to offer, sell and issue shares of common stock under the ESPP from time to time based on various factors and conditions, although the Company is under no obligation to sell any shares under the ESPP. The Company has not issued any shares of Class A common stock under the ESPP.\\n11. Commitments and Contingencies\\nThe Company leases office facilities under noncancelable operating leases that expire at various dates through 2024. In addition, the Company has multi-year commitments with data centers. Some of these lease agreements contain escalating rent payments. Rent expense is recorded on a straight-line basis. Rent expense was $ 928 and $ 1,086 for the three months ended March 31, 2021 and 2020, respectively. The Company also has non-cancelable commitments related to its data centers.\\nFuture minimum amounts payable as of March 31, 2021, under the office facilities operating leases and data center agreements are as follows:\\n| Operating Leases |\\n| Remainder of 2021 | $ | 3,070 |\\n| 2022 | 3,109 |\\n| 2023 | 1,515 |\\n| 2024 | 459 |\\n| 2025 and thereafter | — |\\n| Total minimum lease payments | $ | 8,153 |\\n\\nDuring the year ended December 31, 2020, the Company entered into leasing arrangements for certain data center equipment under non-cancelable capital leases. The leasing arrangements have terms of 36 months beginning on the date the Company accepts the installation of the equipment subject to the lease. As of December 31, 2020, the equipment had not been installed and the Company had not accepted the equipment under these leases, and as such the lease commencement date had not begun. During the three months ended March 31, 2021, a portion of the equipment was installed and the related lease commenced. The Company is required to make total payments of $ 6,045 over the term of the leases which is excluded from the table above. The Company recorded $ 1,024 in capital leases to property and equipment, net, as of March 31, 2021 (see Note 3), which is being depreciated over the lease term of 36 months. The $ 1,024 of capital leases represents the total balance of other-long term liabilities on the unaudited condensed consolidated balance sheet as of March 31, 2021.\\nIn addition to the lease commitments above, the Company also has multi-year commitments with certain data providers. The Company is committed to spend approximately $ 4,124 , $ 6,776 , and $ 1,933 for the remainder of the year ending December 31, 2021, and for the years ending December 31, 2022, and 2023, respectively, for data services.\\n22\\nLitigation\\nThe Company, from time to time, may be party to litigation arising in the ordinary course of its business. The Company was not subject to any material legal proceedings during the three months ended March 31, 2021, and, to the best of its knowledge, no material legal proceedings are currently pending or threatened.\\nIndemnification\\nThe Company typically enters into indemnification agreements with customers in the ordinary course of business. Pursuant to these agreements, the Company indemnifies and agrees to reimburse the indemnified party for losses suffered or incurred as a result of claims of intellectual property infringement. These indemnification agreements are provisions of the applicable customer agreement. Based on when clients first sign an agreement for the Company’s service, the maximum potential amount of future payments the Company could be required to make under certain of these indemnification agreements is unlimited. Based on historical experience and information known as of March 31, 2021, the Company has not incurred any costs for the above guarantees and indemnities.\\nIn certain circumstances, the Company warrants that its services will perform in all material respects in accordance with its standard published specification documentation in effect at the time of delivery of the services to the customer for the term of the agreement. To date, the Company has not incurred significant expense under its warranties and, as a result, the Company believes the estimated fair value of these agreements is immaterial.\\n12. Components of Other Income, Net\\nThe components of other income, net, are as follows:\\n| For the Three Months EndedMarch 31, |\\n| 2021 | 2020 |\\n| Foreign currency exchange gain (loss) | 44 | ( 107 ) |\\n| Other, net | 7 | 163 |\\n| Other income, net | $ | 51 | $ | 56 |\\n\\n13. Employee Benefit Plan\\nThe Company maintains a defined contribution savings plan under Section 401(k) of the Internal Revenue Code (the “401(k) Plan”) covering all U.S. employees who satisfy certain eligibility requirements. The 401(k) Plan allows each participant to defer a percentage of their eligible compensation subject to applicable annual limits pursuant to the limits established by the Internal Revenue Service. The Company may, at the discretion of the Board, make contributions in the form of matching contributions or profit-sharing contributions. For the three months ended March 31, 2021 and 2020, the Company made matching contributions of $ 90 and $ 34 , respectively, to the 401(k) Plan.\\n14. Segment and Geographic Information\\nDisclosure requirements about segments of an enterprise and related information establishes standards for reporting information regarding operating segments in annual financial statements and requires selected information of those segments to be presented in interim financial reports issued to shareholders. Operating segments are defined as components of an enterprise about which separate discrete financial information is available that is evaluated regularly by the chief operating decision maker,\\n23\\nor decision-making group, in deciding how to allocate resources and in assessing performance. The Company’s chief operating decision maker is the chief executive officer. The Company and the chief executive officer view the Company’s operations and manage its business as one operating segment.\\nGeographic Data\\nThe Company allocates, for the purpose of geographic data reporting, its revenue based upon the location of the customer. Total revenue by geographic area was as follows:\\n| For the Three Months EndedMarch 31, |\\n| 2021 | 2020 |\\n| Revenue: |\\n| United States | $ | 18,132 | $ | 12,886 |\\n| United Kingdom | 4,195 | 2,994 |\\n| Other | 17,671 | 11,907 |\\n| Total revenue | $ | 39,998 | $ | 27,787 |\\n\\nProperty and equipment, net by geographic location consists of the following:\\n| As of |\\n| March 31,2021 | December 31,2020 |\\n| Property and equipment, net: |\\n| United States | $ | 2,020 | $ | 1,023 |\\n| Russia | 1,360 | 1,450 |\\n| Czech Republic | 440 | 439 |\\n| Other | 56 | 56 |\\n| Total assets | $ | 3,876 | $ | 2,968 |\\n\\n15. Subsequent Events\\nThe Company has completed an evaluation of all subsequent events after the balance sheet date of March 31, 2021 through the date this Quarterly Report on Form 10-Q was filed with the SEC, to ensure that this filing includes appropriate disclosure of events both recognized in the financial statements as of March 31, 2021, and events which occurred subsequently but were not recognized in the financial statements. The Company has concluded that no subsequent events have occurred that require disclosure, except as disclosed within these financial statements and except as disclosed below.\\nExercise of Overallotment Option\\nOn April 20, 2021, the underwriters of the Company’s IPO partially exercised their option to purchase additional shares of Class A common stock. In connection with the closing of the partial exercise on April 23, 2021, the underwriters purchased 719,266 shares of the Company’s Class A common stock for net proceeds to the Company of $ 9.4 million.\\n24\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\\nYou should read the following discussion and analysis of our financial condition and results of operations together with the unaudited condensed consolidated financial statements, and related notes that are included elsewhere in this Quarterly Report on Form 10-Q, along with the financial information included in our prospectus dated March 24, 2021 (the “Prospectus”) as filed with the Securities Exchange Commission (the “SEC”) on March 25, 2021 pursuant to Rule 424(b) under the Securities Act of 1933, as amended (the “Securities Act”). Some of the information contained in this discussion and analysis, including information with respect to our planned investments in our research and development, sales and marketing, and general and administrative functions, contains forward-looking statements based upon current plans, beliefs, and expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under the sections titled “Special Note Regarding Forward-Looking Statements” and “Risk Factors” included elsewhere in this Quarterly Report on Form 10-Q.\\nSPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS\\nThis Quarterly Report on Form 10-Q contains forward-looking statements about Semrush Holdings, Inc. (“Semrush Holdings”) and our subsidiaries (collectively, the “Group”, the “Company”, “Semrush”, “we”, “us”, or “our”) and our industry that involve substantial risks and uncertainties. All statements other than statements of historical facts contained in this Quarterly Report on Form 10-Q, including statements regarding our future results of operations, financial condition, business strategy and plans and objectives of management for future operations, are forward-looking statements. In some cases, you can identify forward-looking statements because they contain words such as “anticipate,” “believe,” “contemplate,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “predict,” “project,” “should,” “target,” “will,” or “would,” or the negative of these words or other similar terms or expressions. Forward-looking statements contained in this Quarterly Report on Form 10-Q include, but are not limited to, statements about:\\n•our future financial performance, including our revenue, annual recurring revenue (“ARR”), costs of revenue, gross profit or gross margin and operating expenses;\\n•the sufficiency of our cash and cash equivalents to meet our liquidity needs;\\n•anticipated trends and growth rates in our business and in the markets in which we operate;\\n•our ability to maintain the security and availability of our internal networks and platform;\\n•our ability to attract new paying customers and convert free customers into paying customers;\\n•our ability to retain and expand sales to our existing paying customers, including upgrades to premium subscriptions, purchases of add-on offerings, and increasing the number of authorized users per paying customer;\\n•our ability to access, collect, and analyze data;\\n•our ability to successfully expand in our existing markets and into new markets;\\n•our ability to effectively manage our growth and future expenses;\\n•our ability to continue to innovate and develop new products and features, improve our data assets, and enhance our technological capabilities;\\n•our estimated total addressable market;\\n25\\n•our ability to maintain, protect, and enhance our intellectual property;\\n•our ability to comply with modified or new laws and regulations applying to our business;\\n•the attraction and retention of qualified employees and key personnel;\\n•our anticipated investments in sales and marketing, and research and development;\\n•our ability to successfully defend litigation brought against us;\\n•our ability to successfully acquire and integrate companies and assets;\\n•the increased expenses associated with being a public company;\\n•our use of the net proceeds from our initial public offering (“IPO”); and\\n•the impact of the novel strain of coronavirus (“COVID-19”) on our business and industry.\\nYou should not rely upon forward-looking statements as predictions of future events. We have based the forward-looking statements contained in this Quarterly Report on Form 10-Q primarily on our current expectations and projections about future events and trends that we believe may affect our business, financial condition, results of operations and prospects. The outcome of the events described in these forward-looking statements is subject to risks, uncertainties, and other factors described in the section titled “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q. Moreover, we operate in a very competitive and rapidly changing environment. New risks and uncertainties emerge from time to time, and it is not possible for us to predict all risks and uncertainties that could have an impact on the forward-looking statements contained in this Quarterly Report on Form 10-Q. The results, events, and circumstances reflected in the forward-looking statements may not be achieved or occur, and actual results, events, or circumstances could differ materially from those described in the forward-looking statements.\\nThe forward-looking statements made in this Quarterly Report on Form 10-Q relate only to events as of the date on which the statements are made. We undertake no obligation to update any forward-looking statements made in this Quarterly Report on Form 10-Q to reflect events or circumstances after the date of this Quarterly Report on Form 10-Q or to reflect new information or the occurrence of unanticipated events, except as required by law. We may not actually achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. Our forward-looking statements do not reflect the potential impact of any future acquisitions, mergers, dispositions, joint ventures or investments we may make.\\nIn addition, statements that “we believe” and similar statements reflect our beliefs and opinions on the relevant subject. These statements are based upon information available to us as of the date of this Quarterly Report on Form 10-Q, and while we believe such information forms a reasonable basis for such statements, such information may be limited or incomplete, and our statements should not be read to indicate that we have conducted an exhaustive inquiry into, or review of, all potentially available relevant information. These statements are inherently uncertain and you are cautioned not to unduly rely upon these statements.\\nCompany Overview\\nWe are a leading online visibility management software-as-a-service (“SaaS”) platform, enabling companies globally to identify and reach the right audience in the right context and through the right channels. Online visibility represents how effectively companies connect with consumers across a variety of digital channels, including search, social and digital media, digital public relations, and review websites.\\n26\\nOur proprietary SaaS platform enables us to aggregate and enrich trillions of data points collected from hundreds of millions of unique domains, social media platforms, online ads, and web traffic. This allows our customers to understand trends, derive unique and actionable insights to improve their websites and social media pages, and distribute highly relevant content to their targeted customers across channels to drive high-quality traffic.\\nOn March 29, 2021, we completed our IPO in which we issued and sold 10,000,000 shares of our Class A common stock at a public offering price of $14.00 per share for aggregate gross proceeds of $140.0 million. We received approximately $126.6 million in net proceeds after deducting $9.8 million of underwriting discounts and commissions and approximately $3.6 million in offering costs. In connection with the closing of the IPO, all of the outstanding shares of our Preferred Stock and Common Stock automatically converted into 124,905,954 shares of Class B common stock.\\nWe generate substantially all of our revenue from monthly and annual subscriptions to our online visibility management platform under a SaaS model. Subscription revenue is recognized ratably over the contract term beginning on the date the product is made available to customers.\\nWe have one reportable segment. See Note 14 of our Unaudited Condensed Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q for more information.\\nKey Factors Affecting Our Performance\\nWe regularly review a number of factors that have impacted, and we believe will continue to impact, our results of operations and growth. These factors include:\\nAcquiring New Paying Customers\\nWe expect increasing demand for third-party online visibility software to accelerate adoption of our platform. Our recurring subscription model provides significant visibility into our future results and we believe ARR is the best indicator of the scale of our platform, while mitigating fluctuations due to seasonality and contract term. We define ARR as the daily revenue of all paid subscription agreements that are actively generating revenue as of the last day of the reporting period multiplied by 365. We include both monthly recurring paid subscriptions, which renew automatically unless cancelled, as well as the annual recurring paid subscriptions so long as we do not have any indication that a customer has cancelled or intends to cancel its subscription and we continue to generate revenue from them. As of March 31, 2021 and 2020, we had more than 72,000 paying customers and 56,000 paying customers, respectively, accounting for $167.6 million and $109.5 million in ARR, respectively.\\nRetaining and Expanding Sales to Our Existing Customers\\nWe serve a diverse customer base across a variety of sizes and industries that is focused on maximizing their online visibility. We believe there is a significant opportunity to expand within our existing customer base as customers often initially purchase our entry-level subscription, which offers lower usage limits and limited user licenses, as well as fewer features. We have demonstrated the ability to expand contract values with our existing customers as they use our products and recognize the critical nature of our platform and often seek premium offerings through incremental usage, features, add-ons, and additional user licenses.\\nWe have successfully increased ARR per paying customer over time and believe this metric is an indicator of our ability to grow the long-term value of our platform. We expect ARR per paying customer to continue to increase as customers adopt our premium offerings and we continue to introduce new products and functionality. Our ARR per paying customer as of March 31, 2021 and 2020 was $2,274 and $1,942, respectively. We define ARR per paying customer during a given period as ARR from our paying customers at the end of the period divided by the number of paying customers as of the end of the same\\n27\\nperiod. We define the number of paying customers as the number of unique business and individual customers at the end of a particular period. We define a business customer as all accounts that contain a common non-individual business email domain (e.g., all subscriptions with an email domain of @XYZ.com will be considered to be one customer), and an individual customer as an account that uses an individual non-business email domain.\\nSustaining Product and Technology Innovation\\nWe have a strong track record of developing new products that have high adoption rates among our paying customers. Our product development organization plays a critical role in continuing to enhance the effectiveness and differentiation of our technology in an evolving landscape and maximizing retention of our existing customers. We intend to continue investing in product development to improve our data assets, expand our products and enhance our technological capabilities.\\nNon-GAAP Financial Measures\\nIn addition to our financial results determined in accordance with U.S. generally accepted accounting principles (“GAAP”), we believe that free cash flow and free cash flow margin, each a non-GAAP financial measure, are useful in evaluating the performance of our business.\\nFree cash flow and free cash flow margin\\nWe define free cash flow, a non-GAAP financial measure, as net cash provided by operating activities less purchases of property and equipment and capitalized software development costs. We define free cash flow margin as free cash flow divided by total revenue. We monitor free cash flow and free cash flow margin as two measures of our overall business performance, which enables us to analyze our future performance without the effects of non-cash items and allow us to better understand the cash needs of our business. While we believe that free cash flow and free cash flow margin are useful in evaluating our business, free cash flow and free cash flow margin are each a non-GAAP financial measure that have limitations as an analytical tool, and free cash flow and free cash flow margin should not be considered as an alternative to, or substitute for, net cash used in operating activities in accordance with GAAP. The utility of each of free cash flow and free cash flow margin as a measure of our liquidity is further limited as each measure does not represent the total increase or decrease in our cash balance for any given period. In addition, other companies, including companies in our industry, may calculate free cash flow and free cash flow margin differently or not at all, which reduces the usefulness of free cash flow and free cash flow margin as tool for comparison. A summary of our cash flows from operating, investing and financing activities is provided below. We recommend that you review the reconciliation of free cash flow to net cash used in operating activities, the most directly comparable GAAP financial measure, and the reconciliation of free cash flow margin to net cash used in operating activities (as a percentage of revenue), the most directly comparable GAAP financial measure, provided below, and that you not rely on free cash flow, free cash flow margin or any single financial measure to evaluate our business.\\n| Three Months Ended March 31,(in thousands) |\\n| 2021 | 2020 |\\n| Net cash provided by operating activities | $ | 9,007 | $ | 561 |\\n| Net cash used in investing activities | (1,139) | (1,381) |\\n| Net cash provided by (used in) financing activities | 128,468 | (16) |\\n| Net increase (decrease) in cash, cash equivalents and restricted cash | $ | 136,336 | (836) |\\n\\n28\\n| Three Months Ended March 31,(in thousands) |\\n| 2021 | 2020 |\\n| Net cash provided by operating activities | $ | 9,007 | $ | 561 |\\n| Purchases of property and equipment | (166) | (1,084) |\\n| Capitalization of internal-use software costs | (123) | (297) |\\n| Free cash flow | $ | 8,718 | $ | (820) |\\n\\n| Three Months Ended March 31,(in thousands) |\\n| 2021 | 2020 |\\n| Net cash provided by operating activities (as a percentage of revenue) | 22.5 | % | 2.0 | % |\\n| Purchases of property and equipment (as a percentage of revenue) | (0.4) | % | (3.9) | % |\\n| Capitalization of internal-use software costs (as a percentage of revenue) | (0.3) | % | (1.1) | % |\\n| Free cash flow margin | 21.8 | % | (3.0) | % |\\n\\nComponents of our Results of Operations\\nRevenue\\nWe generate nearly all of our revenue from subscriptions to our online visibility management platform under a SaaS model. Subscription revenue is recognized ratably over the contract term beginning on the date on which we provide the customer access to our platform. Our customers do not have the right to take possession of our software. Our subscriptions are generally non-cancellable during the contractual subscription term, however our subscription contracts contain a right to a refund if requested within seven days of purchase.\\nWe offer our paid products to customers via monthly or annual subscription plans, as well as one-time and ongoing add-ons. As of March 31, 2021 and 2020, approximately 77% and 76%, respectively, of our paying customers purchased monthly subscription plans. Our subscription-based model enables customers to select a plan based on their needs and license our platform on a per user per month basis.\\nAs of March 31, 2021, we served approximately 72,000 paying customers in various industries, and our revenue is not concentrated with any single customer or industry. For the three months ended March 31, 2021 and 2020, no single customer accounted for more than 1% of our revenue.\\nCost of Revenue\\nCost of revenue primarily consists of expenses related to hosting our platform, acquiring data, and providing support to our customers. These expenses are comprised of personnel and related costs, including salaries, benefits, incentive compensation, and stock-based compensation expense related to the management of our data centers, our customer support team and our customer success team, and data acquisition costs. In addition to these expenses, we incur third-party service provider costs, such as data center and networking expenses, allocated overhead costs, depreciation expense and amortization associated with the Company’s property and equipment, and amortization of capitalized software development costs and other intangible assets. We allocate overhead costs, such as rent and facility costs, information technology costs, and employee benefit costs to all departments based on headcount. As such, general overhead expenses are reflected in cost of revenue and each operating expense category.\\n29\\nWe expect our cost of revenue to increase in absolute dollars due to expenditures related to the purchase of hardware, data, expansion, and support of our data center operations and customer support teams. We also expect that cost of revenue as a percentage of revenue will decrease over time as we are able to achieve economies of scale in our business, although it may fluctuate from period to period depending on the timing of significant expenditures. To the extent that our customer base grows, we intend to continue to invest additional resources in expanding the delivery capability of our products and other services. The timing of these additional expenses could affect our cost of revenue, both in terms of absolute dollars and as a percentage of revenue in any particular quarterly or annual period.\\nOperating Expenses\\nResearch and Development\\nResearch and development expenses primarily consist of personnel and related costs, including salaries, benefits, incentive compensation, stock-based compensation, and allocated overhead costs. Research and development expenses also include depreciation expense and other expenses associated with product development. Other than internal-use software costs that qualify for capitalization, research and development costs are expensed as incurred. We plan to increase the dollar amount of our investment in research and development for the foreseeable future as we focus on developing new products, features, and enhancements to our platform. We believe that investing in the development of new products, features, and enhancements improves customer experience, makes our platform more attractive to new paying customers and provides us with opportunities to expand sales to existing paying customers and convert free customers to paying customers. However, we expect our research and development expenses to decrease as a percentage of our revenue over time.\\nSales and Marketing\\nSales and marketing expenses primarily consist of personnel and related costs directly associated with our sales and marketing department, including salaries, benefits, incentive compensation, and stock-based compensation, online advertising expenses, and marketing and promotional expenses, as well as allocated overhead costs. We expense all costs as they are incurred, excluding sales commissions identified as incremental costs to obtain a contract, which are capitalized and amortized on a straight-line basis over the average period of benefit, which we estimate to be two years. We expect that our sales and marketing expenses will continue to increase in absolute dollars in the year ending December 31, 2021. New sales personnel require training and may take several months or more to achieve productivity; as such, the costs we incur in connection with the hiring of new sales personnel in a given period are not typically offset by increased revenue in that period and may not result in new revenue if these sales personnel fail to become productive. We expect to increase our investment in sales and marketing as we add new services, which will increase these expenses in absolute dollars. Over the long term, we believe that sales and marketing expenses as a percentage of revenue will vary depending upon the mix of revenue from new and existing customers, as well as changes in the productivity of our sales and marketing programs.\\nGeneral and Administrative\\nGeneral and administrative expenses primarily consist of personnel and related expenses, including salaries, benefits, incentive compensation, and stock-based compensation, associated with our finance, legal, human resources, and other administrative employees. Our general and administrative expenses also include professional fees for external legal, accounting, and other consulting services, insurance, depreciation and amortization expense, as well as allocated overhead. We expect to increase the size of our general and administrative functions to support the growth of our business. We expect to continue to incur additional expenses as a result of operating as a public company, including costs to comply with rules and regulations applicable to companies listed on a U.S. securities exchange, costs related to compliance and reporting obligations pursuant to the rules and regulations of the SEC, increases in\\n30\\ninsurance premiums, investor relations and professional services. We expect the dollar amount of our general and administrative expenses to increase for the foreseeable future. However, we expect our general and administrative expenses to decrease as a percentage of revenue over time.\\nOther Income, Net\\nIncluded in other income, net are foreign currency transaction gains and losses. The functional currency of our international operations is the U.S. dollar except for Prowly, which is Polish Zloty. Any differences resulting from the re-measurement of assets and liabilities denominated in a currency other than the functional currency are recorded within other income, net. We expect our foreign currency exchange gains and losses to continue to fluctuate in the future as foreign currency exchange rates change.\\nOther income, net also includes amounts for other miscellaneous income and expense unrelated to our core operations.\\nIncome Tax Provision\\nWe operate in several tax jurisdictions and are subject to taxes in each country or jurisdiction in which we conduct business. We account for income taxes in accordance with the asset and liability method. Under this method, deferred tax assets and liabilities are recognized based on temporary differences between the financial reporting and income tax bases of assets and liabilities using statutory rates. In addition, this method requires a valuation allowance against net deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. To date, we have incurred cumulative net losses and maintain a full valuation allowance on our net deferred tax assets. We expect this trend to continue for the foreseeable future. Our tax expense for the three months ended March 31, 2021 and 2020 primarily relates to income earned in certain foreign jurisdictions.\\nResults of Operations\\nThe following tables set forth information comparing our results of operations in dollars and as a percentage of total revenue for the periods presented. The period-to-period comparison of results is not necessarily indicative of results for future periods.\\n31\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| (in thousands) |\\n| Revenue | $ | 39,998 | $ | 27,787 |\\n| Cost of revenue (1) | 8,773 | 6,611 |\\n| Gross profit | 31,225 | 21,176 |\\n| Operating expenses |\\n| Sales and marketing (1) | 16,457 | 12,877 |\\n| Research and development (1) | 5,358 | 4,237 |\\n| General and administrative (1) | 7,904 | 5,933 |\\n| Total operating expenses | 29,719 | 23,047 |\\n| Income (loss) from operations | 1,506 | (1,871) |\\n| Other income, net | 51 | 56 |\\n| Income (loss) before income taxes | 1,557 | (1,815) |\\n| Provision for income taxes | 86 | 116 |\\n| Net income (loss) | $ | 1,471 | $ | (1,931) |\\n\\n__________________\\n(1)Includes stock-based compensation expense as follows:\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| (in thousands) |\\n| Cost of revenue | $ | 7 | $ | 5 |\\n| Sales and marketing | 190 | 27 |\\n| Research and development | 67 | 29 |\\n| General and administrative | 329 | 144 |\\n| Total stock-based compensation | $ | 593 | $ | 205 |\\n\\n32\\nThe following table sets forth our unaudited condensed consolidated statements of operations data expressed as a percentage of revenue for the periods indicated:\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| (as a percentage of total revenue) |\\n| Revenue | 100 | % | 100 | % |\\n| Cost of revenue | 22 | % | 24 | % |\\n| Gross profit | 78 | % | 76 | % |\\n| Operating expenses |\\n| Sales and marketing | 41 | % | 46 | % |\\n| Research and development | 13 | % | 15 | % |\\n| General and administrative | 20 | % | 22 | % |\\n| Total operating expenses | 74 | % | 83 | % |\\n| Income (loss) from operations | 4 | % | (6) | % |\\n| Other income, net | — | % | — | % |\\n| Income (loss) before income taxes | 4 | % | (6) | % |\\n| Provision for income taxes | — | % | — | % |\\n| Net income (loss) | 4 | % | (6) | % |\\n\\nComparison of the Three Months Ended March 31, 2021 and 2020\\nRevenue\\nOur revenue during the three months ended March 31, 2021 and 2020 was as follows:\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | Amount | % |\\n| (dollars in thousands) |\\n| Revenue | $ | 39,998 | 27,787 | $ | 12,211 | 44 | % |\\n\\nRevenue increased in all regions and was most pronounced in the United States. The majority of this increase was driven by an increase in the number of paying customers from 56,000 as of March 31, 2020 to 72,000 as of March 31, 2021. The net income for the three months ended March 31, 2021 was partially driven by an increase in the subscription price of our core product.\\n33\\nThe locations of our paying customers during the three months ended March 31, 2021 and 2020 were as follows:\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| (in thousands) |\\n| Revenue: |\\n| United States | $ | 18,132 | $ | 12,886 |\\n| United Kingdom | 4,195 | 2,994 |\\n| Other | 17,671 | 11,907 |\\n| Total revenue | $ | 39,998 | $ | 27,787 |\\n\\nCost of Revenue, Gross Profit and Gross Margin\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | Amount | % |\\n| (dollars in thousands) |\\n| Cost of revenue | $ | 8,773 | $ | 6,611 | $ | 2,162 | 33 | % |\\n| Gross profit | $ | 31,225 | $ | 21,176 | $ | 10,049 | 47 | % |\\n| Gross margin | 78.1 | % | 76.2 | % |\\n\\nThe increase in cost of revenue for the three months ended March 31, 2021 compared to the three months ended March 31, 2020 was primarily due to the following changes:\\n| Change |\\n| (in thousands) |\\n| Hosting fees | $ | 446 |\\n| Integration and data costs | 787 |\\n| Merchant fees | 309 |\\n| Other | 620 |\\n| Cost of revenue | $ | 2,162 |\\n\\nHosting fees increased, driven by the additional costs associated with our growth in subscription revenue and the additional costs associated with expanding our relationships with our current paying subscribers. Integration and data costs increased primarily as a result of increasing costs incurred related to new products and customer growth. Merchant fees increased commensurate with sales growth. Other costs increased primarily as a result of a 95% increase in headcount as we continue to grow our customer support and customer success teams to support our customer growth.\\n34\\nOperating Expenses\\nSales and Marketing\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | Amount | % |\\n| (dollars in thousands) |\\n| Sales and marketing | $ | 16,457 | $ | 12,877 | $ | 3,580 | 28 | % |\\n| Percentage of total revenue | 41 | % | 46 | % |\\n\\nThe increase in sales and marketing expense for the three months ended March 31, 2021 compared to the three months ended March 31, 2020 was primarily due to the following:\\n| Change |\\n| (in thousands) |\\n| Personnel costs | $ | 2,156 |\\n| Advertising expense | 1,503 |\\n| Other | (79) |\\n| Sales and marketing | $ | 3,580 |\\n\\nPersonnel costs increased primarily as a result of a 24% increase in headcount as we continue to expand our sales teams to grow our customer base. Personnel costs include the amortization of capitalized commission costs, which increased quarter over quarter partially due to the amortization of commissions paid in prior periods, as well as expense associated with the amortization of commissions paid and capitalized during the three months ended March 31, 2021, which increased compared to the three months ended March 31, 2020 due to the overall growth in sales. Advertising expense increased primarily as a result of increasing expenses to acquire new paying customers.\\nResearch and Development\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | Amount | % |\\n| (dollars in thousands) |\\n| Research and development | $ | 5,358 | $ | 4,237 | $ | 1,121 | 26 | % |\\n| Percentage of total revenue | 13 | % | 15 | % |\\n\\nResearch and development costs increased primarily as a result of a 31% increase in headcount as we continue to expand our product development teams.\\nGeneral and administrative\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | Amount | % |\\n| (dollars in thousands) |\\n| General and administrative | $ | 7,904 | $ | 5,933 | $ | 1,971 | 33 | % |\\n| Percentage of total revenue | 20 | % | 21 | % |\\n\\n35\\nThe increase in general and administrative expense was primarily driven by a 47% increase in headcount as we continue to expand our accounting and reporting, legal and compliance, and internal support teams. It was also driven by a 167% increase in stock-based compensation applicable to these teams.\\nOther Income, Net\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | Amount | % |\\n| (dollars in thousands) |\\n| Other income, net | $ | 51 | $ | 56 | $ | (5) | (9) | % |\\n| Percentage of total revenue | — | % | — | % |\\n\\nThe relatively small decrease in other income was partially driven by changes in the foreign exchange gains or losses from foreign currency translation adjustments associated with our international activities.\\nProvision for Income Taxes\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | Amount | % |\\n| (dollars in thousands) |\\n| Provision for income taxes | $ | 86 | $ | 116 | $ | (30) | (26) | % |\\n| Percentage of total revenue | — | % | — | % |\\n\\nThe provision for income taxes is primarily attributable to estimated taxes related to our foreign jurisdictions.\\nLiquidity and Capital Resources\\nTo date, our principal sources of liquidity have been the net proceeds of $126.6 million, after deducting underwriting discounts and offering expenses paid or payable by us, from our IPO in March 2021, the net proceeds we received through private sales of equity securities, as well as sales of premium subscriptions to our platform.\\nAs of March 31, 2021, our principal sources of liquidity were cash and cash equivalents of $171.9 million and accounts receivable of $2.4 million. With the exception of this three month period ended March 31, 2021, we have generated losses from operations since inception. With the exception of this three month period ended March 31, 2021, we expect to continue to incur operating losses and negative cash flows for the foreseeable future due to the investments in our business we intend to make as described above.\\nOur principal uses of cash in recent periods have been to fund operations and invest in capital expenditures, and are held in cash deposits and money market funds.\\nWe believe our existing cash will be sufficient to meet our operating and capital needs for at least the next 12 months. Our future capital requirements will depend on many factors, including our subscription growth rate, subscription renewal activity, billing frequency, the timing and extent of spending to support our research and development efforts, the expansion of sales and marketing activities, the introduction of new and enhanced product offerings, and the continuing market acceptance of our platform and products. In the future, we may enter into arrangements to acquire or invest in complementary companies,\\n36\\nproducts, and technologies, including intellectual property rights. We may be required to seek additional equity or debt financing. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us, or at all. If we are unable to raise additional capital or generate cash flows necessary to expand our operations, our business, results of operations, and financial condition could be adversely affected.\\nOur Credit Facility\\nPursuant to the Credit Agreement among us and Semrush Inc., a Delaware corporation (“Semrush US Sub”), each as a borrower, the lenders party thereto from time to time and JPMorgan Chase Bank, N.A., as the administrative agent, as amended from time to time, we have a senior secured credit facility that consists of a $45.0 million revolving credit facility and a letter of credit sub-facility with an aggregate limit equal to the lesser of $5.0 million and the aggregate unused amount of the revolving commitments then in effect. The availability of the credit facility is subject to the borrowing base based on an advance rate of 400% multiplied by annualized retention applied to monthly recurring revenue. The credit facility has a maturity of three years and will mature on January 12, 2024.\\nBorrowings under our credit facility bear interest at our option at (i) LIBOR, subject to a 0.50% floor, plus a margin, or (ii) the alternate base rate, subject to a 3.25% floor (or 1.50% prior to positive consolidated adjusted earnings before interest, taxes, depreciation, and amortization (“adjusted EBITDA”) for the twelve months most recently ended), plus a margin. For LIBOR borrowings, the applicable rate margin is 2.75% (or 3.50% prior to positive consolidated adjusted EBITDA as of the twelve months most recently ended). For base rate borrowings, the applicable margin is 0.00% (or 2.50% prior to positive consolidated adjusted EBITDA as of the twelve months most recently ended). We are also required to pay a 0.25% per annum fee on undrawn amounts under our revolving credit facility, payable quarterly in arrears.\\nOperating Activities\\nOur largest source of operating cash is cash collections from our customers for subscription services. Our primary uses of cash from operating activities are for online advertising, personnel costs across the sales and marketing and product and development departments, and hosting costs.\\nNet cash provided by operating activities during the three months ended March 31, 2021 was $9.0 million, which resulted from a net income of $1.5 million adjusted for non-cash charges of $2.3 million and a net cash inflow of $5.2 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of $0.5 million of depreciation and amortization expense, $1.3 million for amortization of deferred contract acquisition costs related to capitalized commissions, and $0.6 million of stock-based compensation expense. The changes in operating assets and liabilities was primarily the result of a $5.6 million increase in deferred revenue due to the addition of new customers and expansion of the business, a $2.4 million increase in accrued expenses, and a $1.6 million increase in accounts payable. These inflows were partially offset by a $2.4 million increase in deferred contract costs, a $1.0 million increase in prepaid expenses and other current assets, and a $1.0 million increase in accounts receivable.\\nNet cash provided by operating activities during the three months ended March 31, 2020 was $0.6 million, which resulted from a net loss of $1.9 million adjusted for non-cash charges of $1.5 million and net cash inflow of $1.0 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of $1.1 million for amortization of deferred contract acquisition costs related to capitalized commissions, $0.2 million of stock-based compensation expense, and $0.2 million of depreciation and amortization expense. The changes in operating assets and liabilities was primarily the result of a $1.7 million increase in deferred revenue due to the addition of new customers and expansion of the business, a $1.0 million increase in accrued expenses, a $0.7 million decrease in accounts receivable, and a $0.1 million increase in accounts payable. These inflows were partially offset by\\n37\\na $1.7 million increase in deferred contract costs and a $0.7 million increase in prepaid expenses and other current assets.\\nInvesting Activities\\nNet cash used in investing activities for the three months ended March 31, 2021 and 2020 was $1.1 million and $1.4 million, respectively. The decrease of $0.2 million of cash used in investing activities was primarily due to the reduced purchases of computer equipment and hardware, as well as a decrease in capitalized costs associated with internal use software. During the three months ended March 31, 2021, cash used in investing activities also included $500 paid for two convertible debt securities.\\nFinancing Activities\\nNet cash provided by financing activities for the three months ended March 31, 2021 was $128.5 million, primarily consisting of the net proceeds from the IPO. Net cash used in financing activities for the three months ended March 31, 2020 was insignificant and consisted entirely of payments of deferred offering costs.\\nContractual Obligations\\nAs of March 31, 2021, there were no material changes in our contractual obligations and commitments from those disclosed in the Prospectus, other than those appearing in the notes to the Unaudited Condensed Consolidated Financial Statements appearing elsewhere in this Quarterly Report on Form 10-Q.\\nOff-Balance Sheet Arrangements\\nAs of March 31, 2021, we did not have any relationships with any entities or financial partnerships, such as structured finance or special purpose entities, that would have been established for the purpose of facilitating off-balance sheet arrangements or other purposes. As a result, we are not exposed to related financing, liquidity, market or credit risks that could arise if we had engaged in those types of arrangements.\\nRecent Accounting Pronouncements\\nRefer to the section titled “Recent Accounting Pronouncements” in Note 2 of the notes to our Unaudited Condensed Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q for more information.\\nCritical Accounting Policies and Estimates\\nOur Unaudited Condensed Consolidated Financial Statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these Unaudited Condensed Consolidated Financial Statements in conformity with GAAP requires management to make estimates, judgments, and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may differ from these estimates.\\nOur critical accounting policies are described under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations— Critical Accounting Policies and Estimates” in the Prospectus and in Note 2 of the notes to our Unaudited Condensed Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q.\\n38\\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\\nWe are exposed to market risk in the ordinary course of our business. Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in foreign currency exchange rates, interest rates and inflation. We do not hold or issue financial instruments for trading purposes.\\nInterest Rate Risk\\nWe had cash and cash equivalents of $171.9 million and $35.5 million as of March 31, 2021 and December 31, 2020, respectively. Our cash and cash equivalents are held in cash deposits and money market funds. Due to the short-term nature of these instruments, we do not believe that we have any material exposure to changes in the fair value of our investment portfolio as a result of changes in interest rates.\\nAs of March 31, 2021, we had $45.0 million available under the revolving credit facility, with $5.0 million of such revolving commitments available under the letter of credit sub-facility. Borrowings under our credit facility bear interest at our option at (i) LIBOR, subject to a 0.50% floor, plus a margin, or (ii) the base rate, subject to a 3.25% floor (or 1.50% prior to an IPO or positive consolidated adjusted EBITDA as of the twelve months most recently ended), plus a margin. For LIBOR borrowings, the applicable rate margin is 2.75% (or 3.50% prior to an IPO or positive consolidated adjusted EBITDA as of the twelve months most recently ended). For base rate borrowings, the applicable margin is 0.00% (or 2.50% prior to an IPO or positive consolidated adjusted EBITDA as of the twelve months most recently ended). We are also required to pay a 0.25% per annum fee on undrawn amounts under our revolving credit facility, payable quarterly in arrears.\\nWe did not have any current investments in marketable securities as of March 31, 2021 and 2020.\\nForeign Currency Exchange Risk\\nWe are not currently subject to significant foreign currency exchange risk with respect to revenue as our U.S. and international sales are predominantly denominated in U.S. dollars. However, we have some foreign currency risk related to a small amount of sales denominated in euros, and expenses denominated in euros, rubles, korunas, and zloty. Sales denominated in euros reflect the prevailing U.S. dollar exchange rate on the date of invoice for such sales. Increases in the relative value of the U.S. dollar to the euro may negatively affect revenue and other operating results as expressed in U.S. dollars. We incur significant expenses outside the United States denominated in these foreign currencies, primarily the ruble. If the average exchange rates of any of these foreign currencies strengthen against the dollar, the dollar value of our expenses outside the United States will increase. For example, an immediate 10% decrease or increase in the relative value of the U.S. dollar to the ruble would result in a $3.4 million loss or gain on our unaudited condensed consolidated statements of operations and cash flows.\\nWe have not engaged in the hedging of foreign currency transactions to date. However, as our international operations expand, our foreign currency exchange risk may increase. If our foreign currency exchange risk increases in the future, we may evaluate the costs and benefits of initiating a foreign currency hedge program in connection with non-U.S. dollar denominated transactions.\\n39\\nItem 4. Controls and Procedures\\nEvaluation of Disclosure Controls and Procedures\\nOur management, including our Chief Executive Officer and Chief Financial Officer, have evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on management’s review, with participation of our Chief Executive Officer and Chief Financial Officer, the Chief Executive Officer and Chief Financial Officer have concluded that, as of the quarter ended March 31, 2021, the Company’s disclosure controls and procedures were not effective.\\nAs previously disclosed under the section titled “Risk Factors” of the Prospectus, in connection with the audit of our consolidated financial statements for the year ended December 31, 2019, we and our independent registered public accounting firm identified a material weakness in our internal control over financial reporting related to deficiencies in our controls over the financial statement close process. Specifically, there were deficiencies in the design and operation of internal controls over the identification and review of complex accounting issues involving significant judgment or estimates with respect to certain prior period transactions.\\nNotwithstanding the identified material weakness, our management believes the Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q fairly present, in all material respects, our financial condition, results of operations and cash flows as of and for the periods presented in accordance with U.S. generally accepted accounting principles.\\nRemediation Plan for Material Weakness\\nRemediation generally requires making changes to how controls are designed and implemented and then adhering to those changes for a sufficient period of time such that the effectiveness of those changes is demonstrated with an appropriate amount of consistency. In response to the material weakness, we implemented, and are continuing to implement, measures designed to improve our internal control over financial reporting. These measures include formalizing our processes and internal control documentation, strengthening supervisory reviews by our financial management, hiring additional qualified accounting and finance personnel, and engaging financial consultants to enable the implementation of internal control over financial reporting. Further, changes and improvements in our internal control over financial reporting environment will be implemented based on ongoing management reviews and the continued implementation of the remediation plan.\\nChanges in Internal Control Over Financial Reporting\\nExcept for the remediation measures in connection with the material weakness described above, there were no other changes to our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended March 31, 2021, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\nInherent Limitations on Effectiveness of Controls\\nOur management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitation in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of\\n40\\nfraud, if any, within our company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the controls. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with policies or procedures may deteriorate. Due to inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.\\n41\\nPART II — OTHER INFORMATION\\nItem 1. Legal Proceedings\\nFrom time to time we may become in involved in legal proceedings or be subject to claims arising in the ordinary course of our business. We are not presently a party to any legal proceedings that, if determined adversely to us, would individually or taken together have a material adverse effect on our business, operating results, financial condition or cash flows. Regardless of the outcome, litigation can have an adverse impact on us because of defense and settlement costs, diversion of management resources and other factors.\\nItem 1A. Risk Factors\\nInvesting in our Class A common stock involves a high degree of risk. You should carefully consider the risks and uncertainties described below, together with all of the other information in this Quarterly Report on Form 10-Q, before making a decision to invest in our Class A common stock. If any of the risks actually occur, our business, results of operations, financial condition, and prospects could be harmed. In that event, the trading price of our Class A common stock could decline, and you could lose part or all of your investment.\\nSummary of the Material Risks Associated with Our Business\\nOur business is subject to numerous risks and uncertainties that you should be aware of in evaluating our business. These risks and uncertainties include, but are not limited to, the following:\\n• We derive, and expect to continue to derive, substantially all of our revenue and cash flows from our paying customers with premium subscriptions, and our business and operating results will be harmed if our paying customers do not renew their premium subscriptions.\\n• Our business and operating results will be harmed if our paying customers do not upgrade their premium subscriptions or if they fail to purchase additional products.\\n• If we fail to attract new potential customers through unpaid and paid marketing efforts, register them for trials, and convert them into paying customers, our operating results would be harmed.\\n• The market in which we operate is intensely competitive, and if we do not compete effectively, our ability to attract and retain free and paying customers could be harmed, which would negatively impact our business and operating results.\\n• Our products depend on publicly available and paid third-party data sources, and, if we lose access to data provided by such data sources or the terms and conditions on which we obtain such access become less favorable, our business could suffer.\\n• Our ability to introduce new products and add-ons is dependent on adequate research and development resources. If we do not adequately fund our research and development efforts or use product and development teams effectively, our business and operating results may be harmed.\\n• If we are unable to maintain and enhance our brand, or if events occur that damage our reputation and brand, our ability to maintain and expand our customer base may be impaired, and our business and financial results may be harmed.\\n42\\n• We depend on our executive officers and other key employees, and the loss of one or more of these employees could harm our business.\\n• An inability to attract and retain other highly skilled employees could harm our business.\\n• Changes by search engines, social networking sites, and other third-party services to their underlying technology configurations or policies regarding the use of their platforms and/or technologies for commercial purposes, including anti-spam policies, may limit the efficacy of certain of our products, tools, and add-ons and as a result, our business may suffer.\\n• If the security of the confidential information or personal information of any customers of our platform is breached or otherwise subjected to unauthorized access or disclosure, our reputation may be harmed and we may be exposed to liability.\\n• The effects of the COVID-19 pandemic are uncertain and may materially affect our customers or potential customers and how we operate our business, and the duration and extent to which the pandemic continues to threaten our future operating results remains uncertain.\\n• If the use of cookies or other tracking technologies becomes subject to unfavorable legislation or regulation, is restricted by internet users or other third parties or is blocked or limited by users or by technical changes on end users’ devices, our ability to attract new customers and to develop and provide certain products could be diminished or eliminated.\\n• We may not be able to adequately protect our proprietary and intellectual property rights in our data or technology.\\nMost Material Risks to Us\\nWe derive, and expect to continue to derive, substantially all of our revenue and cash flows from our paying customers with premium subscriptions, and our business and operating results will be harmed if our paying customers do not renew their premium subscriptions.\\nWe derive, and expect to continue to derive, substantially all of our revenue and cash flows from our paying customers with premium subscriptions. Our business and financial results depend on our paying customers renewing their subscriptions for our products when existing contract terms expire. Although our customer agreements provide for auto-renewal of subscriptions, our paying customers have no obligation to renew their premium subscriptions if they provide proper notice of their desire not to renew, and we cannot guarantee that they will renew their premium subscriptions for the same or longer terms, the same or a greater number of user licenses or products and add-ons, or at all. We offer premium subscriptions on a monthly or annual basis with our annual subscriptions receiving a discount for the longer-term commitment. Our paying customers predominantly choose monthly subscription terms, which allow them to terminate or adjust their premium subscriptions with us on a monthly basis as external factors change and could cause our results of operations to fluctuate significantly from quarter to quarter. Our renewal rates, including our dollar-based net revenue retention rate, may decline or fluctuate as a result of a number of factors, including customer satisfaction with our platform and products, reliability of our products, our customer success and support experience, the price and functionality of our platform, products, and add-ons relative to those of our competitors, mergers and acquisitions affecting our customer base, the effects of global economic conditions and other external factors, or reductions in our customers’ spending levels. Our business and operating results will be adversely affected if our paying customers do not renew their premium subscriptions.\\n43\\nOur business and operating results will be harmed if our paying customers do not upgrade their premium subscriptions or if they fail to purchase additional products.\\nOur future financial performance also depends in part on our ability to continue to upgrade paying customers to higher-price point subscriptions and sell additional user licenses, and products and add-ons such as Prowly, Sellerly, and Competitive Intelligence. Conversely, our paying customers may convert to lower-cost or free subscriptions if they do not perceive value in paying for our higher-price point subscriptions, thereby impacting our ability to increase revenue. For example, a paying customer subscribing to our core product through a “Business” subscription may downgrade to the “Guru” subscription if they do not deem the additional features and functionality worth the incremental costs. To expand our relationships with our customers, we must demonstrate to existing paying and free customers that the additional functionality associated with an upgraded subscription outweighs the incremental costs. Our customers’ decisions as to whether to upgrade their subscriptions or not is driven by a number of factors, including customer satisfaction with the security, performance, and reliability of our platform and products, general economic conditions, the price and functionality of our platform and products relative to those of our competitors, and customer reaction to the price for additional products. If our efforts to expand our relationships with our existing paying and free customers are not successful, our revenue growth rate may decline and our business and operating results will be adversely affected.\\nIf we fail to attract new potential customers through unpaid and paid marketing efforts, register them for trials, and convert them into paying customers, our operating results would be harmed.\\nThe number of new customers we attract, whether as free or paying customers, is a key factor in growing our customer and premium subscription base which drive our revenues and collections. We utilize various unpaid content marketing strategies, including blogs, webinars, thought leadership, and social media engagement, as well as paid advertising, to attract visitors to our websites. We cannot guarantee that these unpaid or paid marketing efforts will continue to attract the same volume and quality of traffic to our websites or will continue to result in the same level of registrations for premium subscriptions as they have in the past. In the future, we may be required to increase our marketing spend to maintain the same volume and quality of traffic. Moreover, we cannot be certain that increased sales and marketing spend will generate more paying customers without increasing our customer acquisition costs on a per paying customer basis. We offer potential customers several tiered subscription options for our online visibility management platform, including free subscriptions of a limited-functionality product and premium subscriptions of our “Pro”, “Guru” or “Business” offerings for our core product, depending on the level of functionality they seek. We have materially grown our number of paying customers through the provision of free subscriptions and through trials of a premium version of our online visibility and marketing insight products. Trial subscriptions automatically become premium subscriptions if the customer does not opt out of the trial subscription after the trial period is over, and such trial subscriptions can be upgraded to obtain additional features, functionality, and varying levels of access and report generating capabilities. In the future, we may be required to provide additional functionality to our free subscriptions to attract visitors to our websites and incent visitors to sign up for free subscriptions. In addition, we encourage our free customers to upgrade to premium subscriptions through in-product prompts and notifications, by recommending additional features and functionality, and by providing customer support to explain such additional features and functionality. Our failure to attract new free customers and convert them into paying customers could have a material adverse effect on our operating results as our business may be adversely affected by the costs of, and sales lost from, making certain of our products available on a free basis. While we do not receive any revenue from our customers who use our platform on a free basis, we bear incremental expenses as a result of their continuing free access to our platform and certain of our products.\\n44\\nThe market in which we operate is intensely competitive, and if we do not compete effectively, our ability to attract and retain free and paying customers could be harmed, which would negatively impact our business and operating results.\\nThe market for our products is fragmented, rapidly evolving, and highly competitive, with relatively low barriers to entry. Our all-in-one SaaS platform competes with software products and solutions that are focused on a particular customer need, or point solutions. For example, we compete with point solutions for search advertising and search engine optimization, marketing analytics and social media management, market intelligence, and web analytics services. Our ability to attract and retain free and paying customers depends in part on the actual and perceived quality and design of our platform, products, and add-ons compared to competitive point solutions and continued market acceptance of our platform, products, and add-ons for existing and new use-cases. To remain competitive and to acquire new customers, we must deliver features and functionality that enhance the utility and perceived value of our platform, products, and add-ons to our prospective and existing customers. Our platform, products, and add-ons must (i) operate without the presence of material software defects, whether actual or perceived, (ii) maintain deep and rich data sources, (iii) adapt to the changing needs of our current and prospective customers including by developing new technology, (iv) adapt to changing functionality and provide interoperability with third-party application programming interfaces (“APIs”), (v) maintain and develop integrations with complementary third-party services that provide value to our customers, (vi) be easy to use and visually pleasing, (vii) deliver rapid return on investment to our customers across multiple functions within their organizations, and (viii) be delivered with a superior customer support experience. We may not be successful in delivering on some or all of the foregoing or in doing so while maintaining competitive pricing, which could result in customer dissatisfaction leading to termination or downgrades of premium subscriptions, fewer new free customers, fewer subscription upgrades or lower dollar-based net revenue retention rates, prospective customers’ selection of our competitors’ products over our own, and other adverse effects on our business.\\nMany of our current and future competitors benefit from competitive advantages over us, such as greater name recognition, longer operating histories, more targeted products for specific use cases, larger sales and more established relationships or integrations with third-party data providers, search engines, online retail platforms, and social media networking sites, and more established relationships with customers in the market. Additionally, many of our competitors may expend a considerably greater amount of funds on their research and development efforts, and those that do not, may be acquired by larger companies that would allocate greater resources to our competitors’ research and development programs. Specifically, our competitors focusing on point solutions may have the ability to expend greater funds in a more targeted manner to develop superior solutions that address a specific need, as compared to our research and development expenditures which are allocated across our platform. In addition, some of our competitors may enter into strategic relationships or consummate strategic acquisitions to offer a broader range of functionality than we do, a more competitive multi-point solution, or to address needs that our platform does not. These types of business combinations may make it more difficult for us to acquire new free customers or maintain or upgrade our free and paying customers, any of which could ultimately impact our ability to compete effectively. We expect these competitive pressures to continue as competitors attempt to strengthen or preserve their market positions and as new competitors enter the market.\\nDemand for our platform is also price sensitive. Many factors, including our marketing, sales and technology costs, and the pricing and marketing strategies of our competitors, can significantly affect our pricing strategies. Certain competitors offer, or may in the future offer, lower-priced or free products that compete with our platform, products, and/or add-ons, or may bundle their solutions with other companies’ offerings to provide a broader range of functionality at reduced volume pricing. Similarly, certain competitors may use marketing strategies that enable them to acquire customers at a lower cost than we do. Even if such competitive products do not include all the features and functionality that our platform provides, we could face pricing pressure to the extent that customers find such alternative products to be sufficient to meet their needs or do not perceive a material return on investment from the additional\\n45\\nfeatures and functionality they would obtain by purchasing our platform relative to the competitive point solutions. Additionally, our competitors may further drive down the price through strategic business combinations. We may be forced to engage in price-cutting initiatives, offer other discounts, or increase our sales and marketing and other expenses to attract and retain free and paying customers in response to competitive pressures, any of which would harm our business and operating results.\\nWe have incurred losses in the past and may not consistently achieve profitability in the future.\\nWe have a history of incurring net losses and although we have achieved profitability in certain periods we expect to continue to incur net losses in the future. We incurred net losses of $10.2 million and $7.0 million for the years ended December 31, 2019 and 2020, respectively. As of March 31, 2021, we had an accumulated deficit of $34.3 million. We do not know if we will be able to achieve or sustain profitability in the future. We plan to continue to invest in our research and development, and sales and marketing efforts, and we anticipate that our operating expenses will continue to increase as we scale our business and expand our operations. We also expect our general and administrative expenses to increase as a result of our growth and operating as a public company. Our ability to achieve and sustain profitability is based on numerous factors, many of which are beyond our control.\\nOur products depend on publicly available and paid third-party data sources, and, if we lose access to data provided by such data sources or the terms and conditions on which we obtain such access become less favorable, our business could suffer.\\nWe have developed our platform, products, and add-ons to rely in part on access to data from third-party sources. The primary sources of third-party data include data collected from third-party websites algorithmically through our proprietary data collection techniques, including web crawling of third-party websites, data purchased from independent third-party data providers, which includes clickstream data, search engine data, online advertising data, and data from social media sources, and reference data that our customers grant us access to, which includes our customers’ website and social media data. We obtain social media data through APIs that connect to social media platform operators, including Facebook, Twitter, Instagram, Pinterest, and LinkedIn. We also collect data from our customers in connection with their use of our platform.\\nTo date, our relationships with most data providers (including social media platforms) are governed by such data providers’ respective standard terms and conditions, which govern the availability and access to, and permitted uses of such data (including via APIs), and which are subject to change by such providers from time to time, with little or no notice and with little or no right of redress. Similarly, our access to publicly available data may depend on restrictions that website owners may impose through technical measures or otherwise, including restrictions on automated data collection. We cannot accurately predict the impact of changes in the terms of data providers that may impede our access to the data. If these data providers or websites choose not to make their data available on the same terms, or at all, we would have to seek alternative sources, which could prove expensive and time-consuming, and may be less efficient or effective. Such changes could impact our ability to provide our services in a timely manner, if at all, and could negatively impact the perceived value of our platform and our business. There can be no assurance that following any such modification of terms or termination we would be able to maintain the current level of functionality of our platform in such circumstances, which could adversely affect our results of operations.\\nWe also rely on negotiated agreements with other data providers from whom we purchase independently sourced data, including clickstream data, search engine data, online advertising data, data from social media, and other sources. These negotiated agreements provide access to additional data that allow us to provide a more comprehensive solution for our customers. These agreements are subject to termination in certain circumstances, and there can be no assurance that we will be able to renew those agreements or that the terms of any such renewal, including pricing and levels of service, will be favorable. In addition, there can be no assurance that we will not be required to enter into new negotiated\\n46\\nagreements with data providers in the future to maintain or enhance the level of functionality of our platform, or that the terms and conditions of such agreements, including pricing and levels of service, will not be less favorable, which could adversely affect our results of operations. Further, third-party data providers have previously, and may again, cease operations or a specific business line or cease providing products or data to their customers, including us. If we are not able to obtain third-party data on commercially reasonable terms, if these data providers stop making their data available to us, or if our competitors are able to purchase such data on better terms, the functionality of our platform and our ability to compete could be harmed.\\nTo the extent that we license or obtain data from third parties, we may be subject to contractual obligations to satisfy certain requirements under applicable laws including, but not limited to, providing public notice of our data processing activities and obtaining appropriate consents where required. If one or more of those third-party data providers considers that we have failed to satisfy these requirements, such third-party data provider may bring claims against us seeking damages, and/or seeking to prevent our future use of any data already provided. Such claims could potentially adversely affect our ability to provide our services and the current level of functionality of our platform in such circumstances, which could adversely affect our results of operations.\\nOur business may be harmed if any of our data sources:\\n•changes, limits or discontinues our access to their data;\\n•modifies its terms of service or other policies, including imposing prohibitive fees or restrictions on our use of their data or our ability to access it;\\n•changes or limits how customer information is accessed by us or our customers and their users;\\n•changes or limits how we can use such data;\\n•establishes more favorable relationships with one or more of our competitors; or\\n•experiences disruptions of its technology, services or business generally.\\nRisks Related to our Business\\nOur ability to introduce new products and add-ons is dependent on adequate research and development resources. If we do not adequately fund our research and development efforts or use product and development teams effectively, our business and operating results may be harmed.\\nTo remain competitive, we must continue to develop new product offerings, as well as features and enhancements to our existing platform and products. Maintaining adequate research and development personnel and resources to meet the demands of the market is essential. If we experience high turnover of our product and development personnel, a lack of management ability to guide our research and development, or a lack of other research and development resources, we may miss or fail to execute on new product development and strategic opportunities and consequently lose potential and actual market share. The success of our business is dependent on our product and development teams developing and executing on a product roadmap that allows us to retain and increase the spending of our existing customers, attract new customers and upgrade our free customers to premium subscriptions. Our failure to maintain adequate research and development resources, to use our research and development resources efficiently, and to address the demands of our prospective and actual customers could materially adversely affect our business.\\n47\\nIf we are unable to maintain and enhance our brand, or if events occur that damage our reputation and brand, our ability to maintain and expand our customer base may be impaired, and our business and financial results may be harmed.\\nMaintaining, promoting, and enhancing our brand is critical to maintaining and expanding our customer base. We seek to build our brand through a mix of free and paid initiatives. We market our platform and products through free information resources on our website, including our blog and online digital marketing courses (including through our Semrush Academy), pay-per-click advertisements on search engines and social networking sites, participation in social networking sites, and free and paid banner advertisements on other websites. The strength of our brand further drives free traffic sources, including customer referrals, word-of-mouth, and direct searches for our “Semrush” name, or web presence solutions, in search engines. In addition, we maintain relationships with agencies and affiliates to further increase brand awareness and generate customer demand. To the extent that new customers are increasingly derived from paid as opposed to free marketing initiatives, our customer acquisition cost will increase.\\nBeyond direct sales and marketing efforts, maintaining and enhancing our brand will depend largely on our ability to continue to provide a well-designed, useful, reliable, and innovative platform, efficient sales process, and high-quality customer service, which we may not do successfully. For a discussion of other factors that will impact our brand recognition see the risk factors described elsewhere in this section, including without limitation, those risk factors entitled “The market in which we operate is intensely competitive, and if we do not compete effectively, our ability to attract and retain free customers and paying customers could be harmed, which would negatively impact our business and operating results.”; “If we fail to offer high-quality customer service and provide a positive customer experience, it may be more difficult to add and retain paying customers and increase the number of user licenses per paying customer, especially from large enterprises.”; “If third-party applications change such that we do not or cannot maintain the compatibility of our platform with these applications or if we fail to integrate with or provide third-party applications that our customers desire to use with our products, demand for our solutions and platform could decline.”; “We rely on search engines and social networking sites to attract a meaningful portion of our customers, and if those search engines or social networking sites change their listings or policies regarding advertising, or increase their pricing or suffer problems, it may limit our ability to attract new customers.”; and “If we fail to anticipate and adapt to new and increasingly prevalent social media platforms, other competing products and services that do so more effectively could surpass us and lead to decreased demand for our platform and products.”\\nWe depend on our executive officers and other key employees, and the loss of one or more of these employees could harm our business.\\nOur success depends largely upon the continued services of our executive officers and other key employees. We rely on our leadership team in the areas of research and development, operations, security, marketing, sales, customer service, and general and administrative functions, and on individual contributors and team leaders in our research and development and operations. From time to time, there may be changes in our executive management team resulting from the hiring or departure of executives, which could disrupt our business. The loss of one or more of our executive officers or key employees could harm our business. Changes in our executive management team may also cause disruptions in, and harm to, our business.\\nWe are led by our CEO and co-founder, Oleg Shchegolev, our COO and co-founder, Dmitry Melnikov, and our Chief Product Officer, Vitalii Obishchenko, each of whom plays an important role in driving our culture, determining our strategy, and executing against that strategy companywide. If the services of Mr. Shchegolev, Mr. Melnikov, and/or Mr. Obishchenko become unavailable to us for any reason, it may be difficult or impossible for us to find an adequate and timely replacement, which could cause us to be less successful in maintaining our culture, and developing and effectively executing on our strategies and initiatives.\\n48\\nAn inability to attract and retain other highly skilled employees could harm our business.\\nTo execute our growth plan, we must attract and retain highly qualified personnel. Competition for highly qualified personnel in Boston, Massachusetts, where our headquarters is located, and Trevose, Pennsylvania, Dallas, Texas, Prague, Czech Republic, Limassol, Cyprus, St. Petersburg, Russia, and Warsaw, Poland where we have offices. Competition in these locations is intense, especially for software engineers experienced in designing and developing software and SaaS applications, and experienced sales professionals who understand our products and the market in which we operate. We have from time to time experienced, and we expect to continue to experience, difficulty in hiring and retaining employees with appropriate qualifications. In addition, immigration laws in the locations in which we have offices and operations restrict or limit our ability to recruit internationally. Any changes to the immigration policies applicable to locations in which we have offices and operations that restrain the flow of technical and professional talent may inhibit our ability to recruit and retain highly qualified employees. Many of the companies with which we compete for experienced personnel may be able to offer more attractive terms of employment to potential candidates. If we hire employees from competitors or other companies, their former employers may attempt to assert that these employees have breached their legal obligations to such former employers, resulting in a diversion of our time and resources.\\nIn addition, job candidates and existing employees often consider the value of the equity awards they receive in connection with their employment as part of their overall compensation package. If the perceived value of our equity awards declines or does not compare favorably to the value of equity offered by other companies competing for the same personnel resources, it may harm our ability to recruit and retain highly skilled employees. In addition, we invest significant time and expense in training our employees, which increases their value to competitors who may seek to recruit them. For example, our software developers gain deep and direct experience in data analytics, machine learning, and search optimization, making them increasingly attractive to our competitors and other similar businesses. If we fail to attract new personnel or fail to retain and motivate our current personnel, our business and future growth prospects could be harmed.\\nChanges by search engines, social networking sites, and other third-party services to their underlying technology configurations or policies regarding the use of their platforms and/or technologies for commercial purposes, including anti-spam policies, may limit the efficacy of certain of our products, tools, and add-ons and as a result, our business may suffer.\\nOur online visibility platform is designed to help our customers connect with consumers across a variety of digital channels, search engines, social networking sites, and other third-party services. These services may adapt and change their strategies and policies over time. Search engines typically provide two types of search results, organic (i.e., non-paid) and purchased listings. Organic search results are determined and organized solely by automated criteria set by the search engine, and a ranking level cannot be purchased. Search engines revise their algorithms from time to time in an attempt to optimize their search result listings. Changes to search engine algorithms may diminish the efficacy of certain of our products, tools, and add-ons, and potentially render them obsolete. For example, if a given search engine stopped using backlinks in its ranking algorithm, our customers’ perception of our backlink analytics tool, which enables customers to analyze and monitor the backlink profile of their own and other websites, may be adversely impacted. Similarly, if a search engine ceases to manually penalize or take action against web pages for unnatural backlinks, then our customers may determine that auditing their backlinks is unnecessary which could cause them to devalue our backlink audit tool, which enables companies to check whether malicious websites have links to their sites, or cease using it altogether. In response to these types of changes we may be required to recalibrate our product offerings by reducing prices, discontinuing the affected product, or otherwise. These responses may be costly, may not be effective, and our business may suffer.\\nAdditionally, search engines, social networking sites, and other third-party services typically have terms of service, guidelines, and other policies to which its users are contractually obligated to adhere.\\n49\\nFor example, Google’s Gmail offering has a spam and abuse policy that prohibits sending spam, distributing viruses, or otherwise abusing the service. Prowly and our link building tool enable our customers to send emails to their desired recipients, such as marketing and affiliate partners, social media influencers, journalists, and bloggers. Our link building tool relies on a direct Gmail integration through which our customers are able to send emails using our platform as if they were sending emails directly from their Gmail account, and our Prowly product involves emails initiated by customers over Prowly servers. Our customers’ actions using either the link building tool or Prowly could be flagged under Google’s spam and abuse policy or in the future such actions may be prohibited by subsequent changes to Google’s policies. Any change to the policies of the third-party services with which our products, tools, and add-ons integrate or interact, or with which our products are intended to be used, including any anti-spam policies, or any actions taken by these third-party service providers under their policies could adversely impact the efficacy and perceived value of our products, tools, and add-ons, and as a result, our business may be harmed.\\nIf third-party applications change such that we do not or cannot maintain the compatibility of our platform with these applications or if we fail to integrate with or provide third-party applications that our customers desire to use with our products, demand for our solutions and platform could decline.\\nThe attractiveness of our platform depends, in part, on our ability to integrate via APIs with third-party applications that our customers desire to use with our products, such as Google, Facebook, Instagram, Twitter, YouTube, LinkedIn, Pinterest, Majestic, and others. Third-party application providers may change the features of their applications and platforms, including their APIs, or alter the terms governing use of their applications and platforms in an adverse manner. Further, third-party application providers may refuse to partner with us, or limit or restrict our access to their applications and platforms. Such changes could functionally limit or terminate our ability to use these third-party applications with our platform, which could negatively impact our offerings and the customer experience, and ultimately harm our business. If we fail to integrate our platform with new third-party applications that our customers desire, or to adapt to the data transfer requirements of such third-party applications and platforms, we may not be able to offer the functionality that our customers expect, which would negatively impact our offerings and, as a result, harm our business. Additionally, our business could be harmed if our customers have negative experiences in using the third-party integrations that we offer.\\nIf we fail to maintain and improve our methods and technologies, or fail to anticipate new methods or technologies for data collection and analysis, hardware, software, and software related technologies, competing products and services could surpass ours in depth, breadth, or accuracy of our data, the insights that we offer or in other respects.\\nWe expect continuous development in the market with respect to data matching, data filtering, data predicting, algorithms, machine learning, and other related technologies and methods for gathering, cataloging, updating, processing, analyzing, and communicating data and other information about how consumers find, interact with, and digest digital content. Similarly, we expect continuous changes in computer hardware, network operating systems, programming tools, programming languages, operating systems, the use of the internet, and the variety of network, hardware, browser, mobile, and browser-side platforms, and related technologies with which our platform and products must integrate. Further, changes in customer preferences or regulatory requirements may require changes in the technology used to gather and process the data necessary to deliver our customers the insights that they expect. Any of these developments and changes could create opportunities for a competitor to create products or a platform comparable or superior to ours, or that takes material market share from us in one or more product categories, and create challenges and risks for us if we are unable to successfully modify and enhance our products to adapt accordingly.\\n50\\nIf we fail to anticipate and adapt to new and increasingly prevalent social media platforms, other competing products and services that do so more effectively could surpass us and lead to decreased demand for our platform and products.\\nThe use of social media throughout the world is pervasive and growing. According to a survey by GlobalWebIndex of individuals ages 16 to 64, 97% of digital consumers have used social media during the first quarter of 2020, with digital consumers spending an average of 2 hours and 22 minutes per day on social networks and messaging apps between January and March 2020. The social media industry has experienced, and is likely to continue to experience, rapid change due to the evolving trends, tastes and preferences of users. If consumers widely adopt new social media networks and platforms, we will need to develop integrations and functionality related to these new networks and platforms. This development effort may require significant research and development and sales and marketing resources, as well as licensing fees, all of which could adversely affect our business and operating results. In addition, new social media networks and platforms may not provide us with sufficient access to data from their platforms, preventing us from building effective integrations with our platform and products. Changing consumer tastes may also render our current integrations or functionality obsolete and the financial terms, if any, under which we would obtain integrations or functionality, unfavorable. Any failure of our products to operate effectively with the social media networks used most frequently by consumers could reduce the demand for our products. If we are unable to respond to these changes in a cost-effective manner, our products and aspects of our platform may become less marketable and less competitive or obsolete, and our operating results may be negatively affected.\\nIf we fail to offer high-quality customer service and provide a positive customer experience, it may be more difficult to add and retain paying customers, secure upgrades, sell add-ons, and increase the number of user licenses per paying customer.\\nOur ability to add and retain paying customers, secure subscription upgrades, and sell add-ons depends in part on our customer service. Our sales and customer success team engages with customers to onboard them onto our platform, responds to support requests and other general inquiries, and assists with other account management matters. The perceived quality of customer service is one of the key facets potential customers evaluate when deciding between competing products and if our customer service is not viewed favorably, potential customers may choose our competitors’ products over our own. Additionally, our large enterprise customers from time to time demand custom solutions, such as custom APIs and custom reporting, and customer support that do not fit within one of our pre-packaged premium subscriptions, and addressing such demands often requires additional one-on-one engagement with our sales and customer success team members in order to finalize and service the commercial relationship. As we add more large enterprise customers and increase the number of user licenses per paying customer, we may need to devote more resources to customer service, and we may find it difficult and costly to effectively scale. If we do not adequately scale our customer success teams to meet the demands of new and existing customers, or if we otherwise fail to provide high-quality customer service during onboarding or at any other stage of the customer relationship, or a positive customer experience, we may lose such customers to our competition and fewer customers could renew or upgrade their subscriptions and purchase add-ons, which would harm our business, results of operations, and financial condition.\\nFailures or loss of, or material changes with respect to, the third-party hardware, software, and infrastructure on which we rely, including third-party data center hosting facilities and third-party distribution channels to support our operations, could adversely affect our business.\\nWe rely on leased and third-party owned hardware, software and infrastructure, including third-party data center hosting facilities and third-party distribution channels to support our operations. We primarily use three data centers in the United States, two located in Virginia and one in Georgia, as well as two Google Cloud locations in Virginia and South Carolina. We host each of our products and the data processed through such products in a combination of two of the foregoing locations for redundancy. If any\\n51\\nof our data center suppliers experience disruptions or failures, it would take time for the applicable backup data center to become fully functioning, and we would likely experience delays in delivering the affected products and segments of our platform, which may involve incurring significant additional expenses.\\nFurthermore, the owners and operators of our data center facilities do not guarantee that access to our platform will be uninterrupted or error-free. We do not control the operation of these third-party providers’ facilities, which could be subject to break-ins, computer viruses, sabotage, intentional acts of vandalism and other misconduct. Further, our leased servers and data centers are vulnerable to damage or interruption from natural disasters, terrorist attacks, power loss, telecommunications failures or similar catastrophic events. The COVID-19 pandemic could cause our third-party data center hosting facilities and cloud computing platform providers, which are critical to our infrastructure, to shut down their operations, experience technical or security incidents that delay or disrupt performance or delivery of services to us, or experience interference with the supply chain of hardware required by their systems and services, any of which could materially adversely affect our business. For example, we have experienced delays in migrating to our new data center in Virginia, due to the limited availability of certain required hardware components resulting from supply chain delays caused by the COVID-19 pandemic. If there were to be a significant outage or disaster that rendered one of our servers or data centers inoperable for any length of time, we would have to undertake recovery operations for the impacted products, which could interrupt the availability of our platform. If we were unable to restore the availability of our platform and products within a reasonable period of time, our customer satisfaction could suffer, damaging our reputation as a result, and we could lose customers to our competition, which would materially and adversely affect our business and results of operations.\\nIn addition, third-party data hosting and transmission services comprise a significant portion of our operating costs. If the costs for such services increase due to vendor consolidation, regulation, contract renegotiation, or otherwise, we may not be able to increase the fees for our platform or products to cover the changes, which would have a negative impact on our results of operations.\\nIf the security of the confidential information or personal information of any customers of our platform is breached or otherwise subjected to unauthorized access or disclosure, our reputation may be harmed and we may be exposed to liability.\\nWith consent from our customers, we obtain confidential and other customer data from our customers’ websites, social media accounts, and Google Analytics’ accounts to operate certain functionality on our platform. We rely on credit card purchases as the primary means of collecting our premium subscription fees. In addition, with consent from our customers, we collect and store certain personally identifiable information (“personal data”), credit card information, and other data needed to create, support, and administer the customer account, conduct our business, and comply with legal obligations, including rules imposed by the Payment Card Industry networks.\\nWe believe that we take reasonable steps to protect the security, integrity, availability, and confidentiality of the information we and our third-party service providers hold, but there is no guarantee that despite our efforts, inadvertent disclosure (such as may arise from software bugs or other technical malfunctions, employee error or malfeasance, or other factors) or unauthorized disclosure or loss of personal or other confidential information will not occur or that third parties will not gain unauthorized access to this information. We have experienced, and may experience in the future, breaches of our security due to human error, malfeasance, system errors or vulnerabilities, or other irregularities. For example, we have been the target of attempts to identify and exploit system vulnerabilities and/or penetrate or bypass our security measures to gain unauthorized access to our systems, including a brute force attack that resulted in access to our affiliate program partner contact information. Since techniques used to obtain unauthorized access change frequently, we and our third-party service providers may be unable to anticipate these techniques or to implement adequate preventative measures. If our security measures or the security measures of our third-party service providers are breached because of third-party action, employee error, malfeasance or otherwise, or if design flaws in our software are exposed\\n52\\nand exploited, and, as a result, a third-party obtains unauthorized access to any customers’ data, our relationships with our customers may be damaged, and we could incur liability. Further, our customers with annual subscription terms may have the right to terminate their subscriptions before the end of the subscription term due to our uncured material breach of agreement, including with respect to our data security obligations. It is also possible that unauthorized access to customer data may be obtained through inadequate use of security controls by customers, suppliers or other vendors. While we are not currently aware of any impact that the SolarWinds supply chain attack had on our business, this is a recent event, and the scope of the attack is yet unknown. Therefore, there is residual risk that we may experience a security breach arising from the SolarWinds supply chain attack. We may also be subject to additional liability risks for failing to disclose data breaches or other security incidents under state data breach notification laws or under the private right of action granted to individuals under certain data privacy laws for actions arising from certain data security incidents, such as the California Consumer Privacy Act (“CCPA”) (which is further discussed below in this “Risk Factors” section). In addition, some regions, such as the EU, the United Kingdom (“UK”), and the United States, have enacted mandatory data breach notification requirements for companies to notify data protection authorities, state and federal agencies, or individuals of data security incidents or personal data breaches. We may also be contractually required to notify certain customers in the event of a security incident pursuant to the applicable customer agreement. These mandatory disclosures regarding a security breach may lead to negative publicity and may cause our customers to lose confidence in the effectiveness of our data security measures. Any security breach, whether actual or perceived, may harm our reputation, and we could lose customers or fail to acquire new customers.\\nFederal, state, and provincial regulators and industry groups may also consider and implement from time to time new privacy and security requirements that apply to our business, such as the long established Massachusetts data security law and the recently enacted New York Stop Hacks and Improve Electronic Data Act, both of which establish prescriptive administrative, technical, and physical data security requirements on companies, and permits civil penalties for each violation. Compliance with evolving privacy and security laws, requirements, and regulations may result in cost increases due to necessary systems changes, new limitations or constraints on our business models and the development of new administrative processes. They also may impose further restrictions on our collection, disclosure, and use of personally identifiable information kept in our databases or those of our vendors. If our security measures fail to protect credit card information adequately, we could be liable to both our customers and their users for their losses, as well as the vendors under our agreements with them such that we could be subject to fines and higher transaction fees, we could face regulatory action, and our customers and vendors could end their relationships with us, any of which could harm our business, results of operations or financial condition. Any willful or accidental security breaches or other unauthorized access to or disclosure of personal data could expose us to enforcement actions, regulatory or governmental audits, investigations, litigation, fines, penalties, adverse publicity, downtime of our systems, and other possible liabilities. There can be no assurance that the limitations of liability in our contracts would be enforceable or adequate or would otherwise protect us from any such liabilities or damages with respect to any particular claim. In addition, our cybersecurity insurance coverage may be inadequate to cover all costs and expenses associated with a security breach that may occur in the future.\\nIn recent periods, we have experienced, and expect to continue to experience, rapid growth and organizational change. If we fail to manage our growth effectively, we may be unable to execute our business plan, maintain high levels of service and customer satisfaction or attract new employees and customers.\\nWe have experienced, and expect to continue to experience, rapid growth in our number of customers, sales, revenues, locations, and headcount, which has placed, and may continue to place, significant demands on our management, and our operational and financial resources. We have paying customers in over 142 countries, and the number of our paying customers has grown from over 56,000 as of March 31, 2020 to over 72,000 as of March 31, 2021. We have seven offices across the globe with salespeople dispersed in various other locations, and the continued domestic and international growth\\n53\\nthat we anticipate will require us to continue to expand our global employee headcount. It may be difficult for us to identify, recruit, train, and manage enough personnel to efficiently scale our operations, manage our product development effectively and to match the growth of our customer base. As we continue to grow, we face challenges of integrating, developing, training, and motivating a rapidly growing and dispersed employee base. We are facing novel challenges with respect to integrating new employees and managing multi-geographic teams as COVID-19 prevents certain of our onboarding personnel from travelling between our offices to assist with such integration and training. Certain members of our executive management team have not previously worked together for an extended period of time, which may affect how they manage our growth. If we fail to manage our anticipated growth effectively, our brand and reputation could be negatively affected, which could harm our ability to attract employees and customers.\\nTo manage growth in our operations and personnel, we will need to continue to scale and improve our operational, financial, and management controls, and our reporting systems and procedures, which will require significant capital expenditures increasing our cost of operations and the reallocation of valuable management resources. As we scale, it may become more difficult and will require additional capital expenditures to maintain and increase the productivity of our employees, to address the needs of our actual and prospective customers, and provide high-quality customer service, to further develop and enhance our products, and remain competitive against our competitors’ products. Additionally, our expansion has placed, and our expected future growth will continue to place, a significant strain on our management, customer service teams, product and development, sales and marketing, administrative, financial, and other resources.\\nTechnical problems or disruptions that affect either our customers’ (and their users’) ability to access our platform and products, or the software, internal applications, database, and network systems underlying our platform and products, could damage our reputation and brands, lead to reduced demand for our platform and products, lower revenues, and increased costs.\\nOur business, brands, reputation, and ability to attract and retain customers depend upon the satisfactory performance, reliability, and availability of our platform, which in turn depend upon the availability of the internet and our third-party service providers. Interruptions in these systems, whether due to system failures, computer viruses, software errors, physical or electronic break-ins, malicious hacks or attacks on our systems (such as denial of service attacks), or force majeure events, could affect the security and availability of our products and prevent or inhibit the ability of customers to access our platform. In addition, the software, internal applications, and systems underlying our products and platform are complex and may not be error-free. We may encounter technical problems when we attempt to perform routine maintenance or enhance our software, internal applications, and systems. In addition, our platform may be negatively impacted by technical issues experienced by our third-party service providers. Any inefficiencies, errors, or technical problems with our software, internal applications, and systems could reduce the quality of our platform and products or interfere with our customers’ (and their users’) use of our platform and products, which could negatively impact our brand, reduce demand, lower our revenues, and increase our costs.\\nWe are exposed to risks associated with premium subscription and payment processing and any disruption to such processing systems could adversely affect our business and results of operations.\\nWe primarily rely on our own billing systems to manage our subscriptions and billing frequencies, and we use third-party subscription management and payment processing platforms for some of our products. If we or any of our third-party vendors were to experience an interruption, delay, or outage in service and availability, we may be unable to process new and renewals of subscriptions and our ability to process such subscription and credit card payments would be delayed while we activate an alternative billing platform. Although alternative third-party providers may be available to us, we may incur significant expenses and research and development efforts to deploy any alternative providers. To the extent there\\n54\\nare disruptions in our billing systems or third-party subscription and payment processing systems, we could experience revenue loss, accounting issues, and harm to our reputation and customer relationships, which would adversely affect our business and results of operations.\\nWe are subject to a number of risks related to credit and debit card payments, including:\\n•we pay interchange and other fees, which may increase over time and could require us to either increase the prices we charge for our products or experience an increase in our operating expenses;\\n•if our billing systems fail to work properly and the failure has an adverse effect on our customer satisfaction, causes credit and debit card issuers to disallow our continued use of their payment products, or, does not permit us to automatically charge our paying customers’ credit and debit cards on a timely basis or at all, we could lose or experience a delay in collection of customer payments;\\n•if we are unable to maintain our chargeback rate at acceptable levels, we may face civil liability, diminished public perception of our security measures and our credit card fees for chargeback transactions, or our fees for other credit and debit card transactions or issuers, may increase, or issuers may terminate their relationship with us; and\\n•we could be significantly impaired in our ability to operate our business if we lose our ability to process payments on any major credit or debit card.\\nA significant portion of our operations is located outside of the United States, which subjects us to additional risks, including increased complexity, the costs of managing international operations, geopolitical instability, and fluctuations in currency exchange rates.\\nThe design and development of our products is primarily conducted by our subsidiaries in Russia, the Czech Republic, Cyprus, and Poland. We also have marketing and administrative operations in the same jurisdictions. In addition, members of our sales force are located in Russia, Europe, the United Kingdom and Australia. Approximately 55% of our revenue for the three months ended March 31, 2021 was generated from sales to paying customers located outside the United States, including indirect sales through our resellers outside of the United States. As a result of our international operations and sales efforts, we face numerous challenges and risks that could harm our international operations, delay new product releases, increase our operating costs, and hinder our ability to grow and detect underlying trends in our operations and business, and consequently adversely impact our business, financial condition, and results of operations. Such risks include but are not limited to the following:\\n•geopolitical and economic instability in and impacting the localities where we have foreign operations, such as Russia;\\n•military conflicts impacting the localities where we have foreign operations;\\n•limited protection for, and vulnerability to theft of, our intellectual property rights, including our trade secrets;\\n•compliance with local laws and regulations, and unanticipated changes in local laws and regulations, including tax laws and regulations;\\n•trade and foreign exchange restrictions and higher tariffs;\\n•the complexity of managing international trade sanctions and export restrictions from the jurisdictions in which we have foreign operations;\\n55\\n•fluctuations in foreign currency exchange rates which may make our premium subscriptions more expensive for international paying customers and which may increase our expenses for employee compensation and other operating expenses that are paid in currencies other than U.S. dollars;\\n•restrictions imposed by the United States government against other countries, or foreign governments restrictions imposed on the United States, impacting our ability to do business with certain companies or in certain countries and the complexity of complying with those restrictions;\\n•power outages, natural disasters, and other local events that could affect the availability of the internet and the consequences of disruptions, such as large-scale outages or interruptions of service from utilities or telecommunications providers;\\n•difficulties in staffing international operations;\\n•changes in immigration policies which may impact our ability to hire personnel;\\n•differing employment practices, laws, and labor relations;\\n•regional health issues and the impact of public health epidemics and pandemics on employees and the global economy, such as the COVID-19 pandemic; and\\n•travel, work-from-home or other restrictions or work stoppages, like those currently imposed by governments around the world as a result of the COVID-19 pandemic.\\nFurther, it is possible that governments of one or more foreign countries may seek to limit access to the internet or our platform, products or certain features in their countries, or impose other restrictions that may affect the availability of our platform, products, or certain features in their countries for an extended period of time or indefinitely. For example, Russia and China are among a number of countries that have recently blocked certain online services, including Amazon Web Services, making it difficult for such services to access those markets. In addition, governments in certain countries may seek to restrict or prohibit access to our platform if they consider us to be in violation of their laws (including privacy laws) and may require us to disclose or provide access to information in our possession. If we fail to anticipate developments in the law or fail for any reason to comply with relevant laws, our platforms could be further blocked or restricted and we could be exposed to significant liability that could harm our business. In the event that access to our platform is restricted, in whole or in part, in one or more countries or our competitors are able to successfully penetrate geographic markets that we cannot access, our ability to acquire new customers or renew or grow the premium subscriptions of existing paying customers may be adversely affected, we may not be able to maintain or grow our revenue as anticipated and our business, results of operations, and financial condition could be adversely affected.\\nThe effects of the COVID-19 pandemic are uncertain and may materially affect our customers or potential customers and how we operate our business, and the duration and extent to which the pandemic continues to threaten our future operating results remains uncertain.\\nThe global COVID-19 pandemic has disrupted the economy and put unprecedented strains on governments, health care systems, educational institutions, companies, and individuals around the world. The impact and duration of the COVID-19 pandemic are difficult to assess or predict and will depend in part upon the actions taken by governments, companies, and other enterprises in response to the pandemic. The pandemic has already caused, and is likely to result in further, significant disruption of global financial markets and economic uncertainty. Adverse market conditions resulting from the COVID-19 pandemic could materially adversely affect our revenues, business and the value of our Class A common stock.\\n56\\nOur customers, particularly small-to-medium sized businesses (“SMBs”) and marketing agencies focused on SMBs, which have been particularly impacted by the COVID-19 pandemic, have reduced and may further reduce their technology or sales and marketing spending or delay purchasing decisions, which could result in slowed growth, reduced demand from new and existing SMB customers, and/or lower dollar-based net revenue retention rates, which could materially and adversely impact our business. In March 2020, our paying customer growth rate was relatively flat compared to our paying customer growth rate in February 2020. However, in April 2020 our paying customer growth rate declined, which we believe was primarily a result of the COVID-19 pandemic and the related socioeconomic impacts. In response, we offered free or discounted pricing to certain paying customers contemplating canceling their premium subscriptions as a remedial measure to retain them. Our paying customer growth rate started to increase again by May 2020. Depending on the duration of the COVID-19 pandemic, we may in the future be required to take further remedial measures, including changing our terms or offering further discounts, which may materially adversely impact our revenues and business in future periods.\\nIn response to the COVID-19 pandemic, we temporarily closed all of our offices (including our headquarters in Boston, Massachusetts, and offices in Trevose, Pennsylvania, Dallas, Texas, Prague, Czech Republic, Limassol, Cyprus, and St. Petersburg, Russia), subsequently reopened certain offices at reduced capacity, enabled our employees to work remotely, implemented temporary travel restrictions for all non-essential business, and shifted company events to virtual-only experiences. We may deem it advisable to similarly alter, postpone, or cancel additional events in the future. If the COVID-19 pandemic worsens, especially in regions where we have offices, our business activities conducted from those offices could be adversely affected and we may have to invest additional capital into improving our technology and remote working capabilities and in relocating those activities to alternate locations from which we operate. We may take further actions that alter our business operations as may be required by local, state, or federal authorities or that we determine are in the best interests of our employees. Such measures could negatively affect our sales and marketing efforts, sales cycles, employee productivity, or customer retention, any of which could harm our financial condition and business operations.\\nFurther, the COVID-19 pandemic has resulted in our employees and the employees of many of our customers and vendors working remotely. If the network and infrastructure of internet providers becomes overburdened by increased usage or is otherwise unreliable or unavailable, our employees’, and our customers’ and vendors’ employees’ access to the internet and ability to conduct business could be negatively impacted. We and our vendors may experience an increase in attempted cyber-attacks, targeted intrusion, ransomware, and phishing campaigns seeking to take advantage of shifts to employees working remotely using their household or personal internet networks. Any of these factors could interrupt our ability to provide our platform, decrease the productivity of our workforce, and significantly harm our business operations, financial condition, and results of operations.\\nTo the extent the COVID-19 pandemic adversely affects our business and financial results, it may also have the effect of heightening many of the other risks described in this ‘‘Risk Factors’’ section.\\nAdverse or weakened general economic and market conditions may reduce spending on sales and marketing technology and information, which could harm our revenue, results of operations, and cash flows.\\nOur revenue, results of operations, and cash flows depend on the overall demand for and use of technology and information for sales and marketing, which depends in part on the amount of spending allocated by our paying customers or potential paying customers on sales and marketing technology and information. In addition to the internal strategy of our paying customers, which is not predictable and is subject to change, this spending depends on worldwide economic and geopolitical conditions. The United States, EU, and other key international economies have experienced cyclical downturns from time to time in which economic activity was impacted by falling demand for a variety of goods and services, restricted credit, poor liquidity, reduced corporate profitability, volatility in credit, equity, and foreign exchange markets, bankruptcies, public health crises, and pandemics such as COVID-19, and overall economic\\n57\\nuncertainty. These economic conditions can arise suddenly, may disproportionately impact SMBs that make up an important segment of our paying customer base, and the full impact of such conditions often remains uncertain for extended periods of time. Further actions or inactions of the United States or other major national governments, including the UK’s 2016 vote in favor of the UK’s exit from the EU, may also impact economic conditions, which could result in financial market disruptions or an economic downturn.\\nConcerns about the systemic impact of an economic recession, energy costs, geopolitical issues, or the availability and cost of credit could lead to increased market volatility, decreased consumer confidence, and diminished growth expectations in the U.S. economy and abroad, which could affect the rate of information technology spending and adversely affect our paying customers’ ability or willingness to purchase our products, delay prospective paying customers’ purchasing decisions, reduce the value or duration of their premium subscription contracts, or affect retention rates. Any of these conditions or occurrences could adversely affect our future sales and operating results because most of our paying customers are on month-to-month premium subscriptions that can be cancelled at any time. Further, some of our paying customers may view a premium subscription to our platform as a discretionary purchase, and our paying customers may reduce their discretionary spending on our platform during an economic downturn and consequently reduce or terminate their premium subscription or decide not to upgrade another premium subscription. In particular, spending patterns of the SMBs that make up a large portion of our paying customer base are difficult to predict and are sensitive to the general economic climate, the economic outlook specific to small businesses, the then-current level of profitability experienced by SMBs and overall consumer confidence. In addition, weak economic conditions can result in paying customers seeking to utilize free or lower-cost solutions from alternative sources. Prolonged economic slowdowns may result in requests to renegotiate existing contracts on less advantageous terms to us than those currently in place, payment defaults on existing contracts, or non-renewal at the end of a contract term.\\nFailure of our commercial liability insurance policy to cover claims and any changes to the availability or coverage amounts in our existing policy could have a material adverse effect on our business, financial condition, and results of operations.\\nWe cannot assure you that our existing general liability insurance coverage and coverage for errors and omissions in our products will be fully covered by our existing policies and will continue to be available on acceptable terms, or will be available in sufficient amounts to cover one or more large claims, or that the insurer will not deny coverage as to any future claim. The successful assertion of one or more large claims against us that exceeds available insurance coverage, or the occurrence of changes in our insurance policies, including premium increases or the imposition of large deductible or co-insurance requirements, could have a material adverse effect on our business, financial condition, and results of operations.\\nAs we acquire and invest in companies or technologies, we may not realize expected business or financial benefits and the acquisitions or investments could prove difficult to integrate, disrupt our business, dilute stockholder value and adversely affect our business, results of operations, and financial condition.\\nAs part of our business strategy, we evaluate and may make investments in, or acquisitions of, complementary companies, services, databases, and technologies, and we expect that we will continue to evaluate and pursue such investments and acquisitions in the future to further grow and augment our business, our platform, and product offerings. For example, in August 2020, we acquired Prowly, an advertising and public relations technology company based in Poland. We have incurred and will continue to incur costs to integrate Prowly’s business and selling process into our business and to integrate Prowly’s products into our platform, such as software integration expenses and costs related to the renegotiation of redundant vendor agreements, and we expect to incur similar costs to integrate future acquisitions. We may have difficulty effectively integrating the personnel, businesses, and technologies of these acquisitions into our company and platform, and achieving the strategic goals of those acquisitions.\\n58\\nOur strategy to make selective acquisitions to complement our platform depends in part on the availability of, our ability to identify, and our ability to engage and pursue suitable acquisition candidates. We may not be able to find suitable acquisition candidates, and we may not be able to complete acquisitions on favorable terms, if at all. Acquired assets, data, or companies may not be successfully integrated into our operations, costs in connection with acquisitions and integrations may be higher than expected, and we may also incur unanticipated acquisition-related costs. These costs could adversely affect our financial condition, results of operations, or prospects. Any acquisition we complete could be viewed negatively by customers, users, developers, and other employees, partners, or investors, and could have adverse effects on our existing business relationships and company culture.\\nAcquisitions and other transactions, arrangements, and investments involve numerous risks and could create unforeseen operating difficulties and expenditures, including:\\n•difficulties in, and the cost of, integrating personnel and cultures, operations, technologies, products, services, and platforms which may lead to failure to achieve the expected benefits on a timely basis or at all;\\n•diversion of financial and managerial resources from existing operations;\\n•the potential entry into new markets in which we have little or no experience or where competitors may have stronger market positions;\\n•potential write-offs of acquired assets or investments, and potential financial and credit risks associated with acquired customers;\\n•additional stock-based compensation and difficulties in, and financial costs of, addressing acquired compensation structures inconsistent with our compensation structure;\\n•inability to generate sufficient revenue to offset acquisition and/or investment costs;\\n•inability to maintain, or changes in, relationships with customers and partners of the acquired business;\\n•challenges converting the revenue recognition policies of companies we may acquire and forecasting the recognition of their revenue, including subscription-based revenue and revenue based on the transfer of control, as well as appropriate allocation of the customer consideration to the individual deliverables;\\n•difficulty with, and costs related to, transitioning the acquired technology onto our existing platform, augmenting the acquired technologies and platforms to the levels that are consistent with our brand and reputation, augmenting or maintaining the security standards for acquired technology consistent with our platform and other products, and customer acceptance of multiple platforms on a temporary or permanent basis;\\n•potential unknown liabilities associated with the acquired companies, including risks associated with acquired intellectual property and/or technologies;\\n•challenges relating to the structure of an investment, such as governance, accountability, and decision-making conflicts;\\n•negative impact to our results of operations because of the depreciation and amortization of amounts related to acquired intangible assets, fixed assets, and deferred compensation;\\n•the loss of acquired unearned revenue and unbilled unearned revenue;\\n59\\n•delays in customer purchases due to uncertainty related to any acquisition;\\n•ineffective or inadequate controls, procedures, and policies at the acquired company;\\n•challenges caused by integrating operations over distance, and across different languages, cultures, and political environments;\\n•currency and regulatory risks associated with conducting operations in foreign countries and potential additional cybersecurity and compliance risks resulting from entry into new markets;\\n•tax effects and costs of any such acquisitions, including the related integration into our tax structure and assessment of the impact on the realizability of our future tax assets or liabilities; and\\n•potential challenges by governmental authorities for anti-competitive or other reasons.\\nAny of these risks could harm our business. In addition, to facilitate these acquisitions or investments, we may seek additional equity or debt financing, which may not be available on terms favorable to us or at all, may affect our ability to complete subsequent acquisitions or investments and may affect the risks of owning our Class A common stock. For example, if we finance acquisitions by issuing equity or convertible debt securities or loans, our existing stockholders may be diluted, or we could face constraints related to the terms of, and repayment obligations related to, the incurrence of indebtedness that could affect the market price of our Class A common stock.\\nOur debt obligations contain restrictions that impact our business and expose us to risks that could adversely affect our liquidity and financial condition.\\nOn January 12, 2021, we executed a credit agreement with JPMorgan Chase Bank, N.A., in the form of a revolving credit facility, that consists of a $45.0 million revolving credit facility and a letter of credit sub-facility with an aggregate limit equal to the lesser of $5.0 million and the aggregate unused amount of the revolving commitments then in effect. The amount of borrowings permitted at any one time under the revolving credit facility is subject to a borrowing base based on an advance rate of 400% multiplied by annualized retention applied to monthly recurring revenue. As a result, our access to the revolving credit facility is potentially subject to significant fluctuations depending on the value of the borrowing base as of any measurement date.\\nThe credit agreement (as amended, restated, amended and restated, supplemented or otherwise modified from time to time, the “Credit Agreement”) governing our revolving credit facility (collectively, our “credit facility”) contains various covenants that are operative so long as our credit facility remains outstanding. The covenants, among other things, limit our and certain of our subsidiaries’ abilities to:\\n•incur additional indebtedness or guarantee indebtedness of others;\\n•create additional liens on our assets;\\n•pay dividends and make other distributions on our capital stock, and redeem and repurchase our capital stock;\\n•make investments, including acquisitions;\\n•make capital expenditures;\\n•enter into mergers or consolidations or sell assets;\\n•sell our subsidiaries; or\\n60\\n•enter into transactions with affiliates.\\nOur credit facility also contains numerous affirmative covenants and a financial covenant of either minimum liquidity or a maximum leverage ratio.\\nIf we experience a decline in cash flow due to any of the factors described in this “Risk Factors” section or otherwise, we could have difficulty paying interest due on our indebtedness and meeting the financial covenants set forth in our credit facility. If we fail to comply with the various requirements of our indebtedness, we could default under our credit facility. Any such default that is not cured or waived could result in an acceleration of indebtedness then outstanding under our credit facility, an increase in the applicable interest rates under our credit facility, and a requirement that Semrush US Sub, which is a co-borrower under the facility, pay the obligations in full, and would permit the lenders to exercise remedies with respect to all of the collateral that is securing our credit facility, including substantially all of our and Semrush US Sub’s assets. Thus, any such default could have a material adverse effect on our liquidity and financial condition.\\nIf we cannot maintain our company culture as we grow, we could lose the innovation, teamwork, passion, and focus on execution that we believe contribute to our success and our business may be harmed.\\nWe believe that a critical component to our success has been our company culture, which is based on transparency, innovation, creativity, and personal autonomy to take on challenges and initiatives. We have invested substantial time and resources in building our team within this company culture across our offices. Any failure to preserve our culture could negatively affect our ability to retain and recruit personnel and to effectively focus on and pursue our corporate objectives. As we grow and develop the infrastructure of a public company, we may find it difficult to maintain these foundational aspects of our company culture. If we fail to maintain our company culture, we may fail to recruit qualified employees, our existing employees may terminate their employment, our ability to execute on marketing, sales, product and development, and other initiatives may suffer, and our business may be adversely impacted in other ways.\\nChanges in the sizes or types of paying customers that purchase premium subscriptions to our platform or products could affect our business, and our financial results may fluctuate due to increasing variability in our sales cycles.\\nOur strategy is to sell premium subscriptions of our platform to paying customers of all sizes, from sole proprietors, to SMBs, to large enterprise customers. Selling monthly premium subscriptions to SMBs generally involves lower or plateauing premium subscription upgrade potential, lower retention rates (especially in times of economic uncertainty where marketing and sales budgets are subject to increased scrutiny and reduction), and more limited interaction with our sales and other personnel than sales to large enterprises. Conversely, sales to large enterprises generally entail longer sales cycles, more significant and costly selling and support efforts, and greater uncertainty of completing the sale than sales to SMBs. We plan our expenses based on certain assumptions about the length and variability of our sales cycle based upon historical trends for sales and conversion rates associated with our existing paying customers. If and as our paying customer base expands to include more large enterprise customers, our sales expenses may increase, sales cycles may lengthen and become less predictable, and we may see a greater number of paying customers with longer terms and extended payment terms which, in turn, may increase our paying customer acquisition costs, increase our credit risk, and may in other ways adversely affect our financial results. Additional factors that may influence the length and variability of our sales cycle include:\\n•the need to educate prospective customers about the different products available on our platform, and their uses and benefits;\\n61\\n•the discretionary nature of purchase and budget cycles and decisions;\\n•the competitive nature of evaluation and purchasing processes;\\n•economic and political stability and other external factors;\\n•evolving functionality demands;\\n•announcements of planned introductions of new products, features or functionality by us or our competitors; and\\n•lengthy and multi-faceted purchasing approval processes required by our customers, especially large enterprise customers.\\nIf there are changes in, or we fail to adequately predict, the mix of paying customers that purchase premium subscriptions to our platform, our gross margins and operating results could be adversely affected, and fluctuations increasing the variability in our sales cycles could negatively affect our financial results.\\nForecasts of our market and market growth may prove to be inaccurate, and even if the markets in which we compete achieve the forecasted growth, there can be no assurance that our business will grow at similar rates, or at all.\\nGrowth forecasts that we have provided and may provide, including those in the Prospectus and in this Quarterly Report on Form 10-Q, relating to our market opportunities and the expected growth thereof are subject to significant uncertainty and are based on assumptions and estimates which may prove to be inaccurate. Even if these markets grow at the forecasted rates, we may not grow our business at a similar rate, or at all. Our growth is subject to many factors, including our success in implementing our business strategy, which is subject to many risks and uncertainties. Accordingly, the forecasts of market growth that we have provided and may in the future provide should not be taken as indicative of our future growth.\\nOur management has broad discretion over the use of the proceeds from the IPO, and might not use the net proceeds effectively.\\nOur management has broad discretion to use the net proceeds from the IPO, including for any of the purposes described in the section titled “Use of Proceeds” included in the Prospectus, and you will be relying on the judgment of our management regarding the application of these proceeds. Our management might not apply the net proceeds in ways that increase the value of your investment. Until we use the net proceeds from the IPO, we plan to invest them, and these investments may not yield a favorable rate of return. If we do not invest or apply the net proceeds from the IPO in ways that enhance stockholder value, we may fail to achieve expected financial results, which could cause our stock price to decline.\\nWe may be subject to litigation for any of a variety of claims, which could harm our reputation and adversely affect our business, results of operations, and financial condition.\\nIn the ordinary course of business, we may be involved in and subject to litigation for a variety of claims or disputes and receive regulatory inquiries. These claims, lawsuits, and proceedings could include labor and employment, wage and hour, income tax, commercial, data privacy, antitrust, alleged securities law violations or other investor claims, and other matters. The number and significance of these potential claims and disputes may increase as our business expands. Any claim against us, regardless of its merit, could be costly, divert management’s attention and operational resources, and harm our reputation. As litigation is inherently unpredictable, we cannot assure you that any potential claims or disputes will not\\n62\\nhave a material adverse effect on our business, results of operations, and financial condition. Any claims or litigation, even if fully indemnified or insured, could make it more difficult to compete effectively or to obtain adequate insurance in the future.\\nIn addition, we may be required to spend significant resources to monitor and protect our contractual, intellectual property, and other rights, including collection of payments and fees. Litigation has been and may be necessary in the future to enforce such rights. Such litigation could be costly, time consuming, and distracting to management and could result in the impairment or loss of our rights. Furthermore, our efforts to enforce our rights may be met with defenses, counterclaims, and countersuits attacking the validity and enforceability of such rights. Our inability to protect our rights, as well as any costly litigation or diversion of our management’s attention and resources, could have an adverse effect on our business, results of operations, and financial condition or harm our reputation.\\nOur failure to raise additional capital or generate cash flows necessary to expand our operations and invest in new technologies in the future could reduce our ability to compete successfully and harm our results of operations.\\nWe may require additional financing, and we may not be able to obtain debt or equity financing on favorable terms, if at all. Any debt financing obtained by us could involve restrictive covenants relating to financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities, including potential acquisitions. If we raise additional funds through further issuances of equity, convertible debt securities or other securities convertible into equity, our existing stockholders could experience significant dilution, and any new equity securities we issue could have rights, preferences, and privileges senior to those of holders of our Class A common stock. The terms of any debt financing may include liquidity requirements, restrict our ability to pay dividends, and require us to comply with other covenants restrictions. If we need additional capital and cannot raise it on acceptable terms, or at all, we may not be able to, among other things:\\n•develop new features, integrations, capabilities, and enhancements;\\n•continue to expand our product and development, and sales and marketing teams;\\n•hire, train, and retain employees;\\n•respond to competitive pressures or unanticipated working capital requirements; or\\n•pursue acquisition opportunities.\\nOur referral partners and resellers provide revenue to our business, and we benefit from our association with them. Our failure to maintain successful relationships with these partners could adversely affect our business.\\nOur referral partners and resellers drive revenue to our business and our agreements with these partners and resellers are non-exclusive, with the exception of one exclusive reseller agreement in Japan. While most of these partners and resellers offer products or services that are complementary to our platform and products, some offer point solutions that compete with certain functionalities of our platform. These referral partners and resellers may decide in the future to terminate their agreements with us and/or to market and sell a competitor’s or their own products or services rather than ours, which could cause our revenue to decline. Our competitors may in some cases be effective in causing our referral partners and resellers, or potential referrals and resellers, to favor their products and services or to prevent or reduce sales of our platform and products. Also, we derive tangible and intangible benefits from our association with some of our referral partners and members of our affiliate networking programs, particularly high-profile partners that reach a large number of companies through the internet. If a\\n63\\nsubstantial number of these partners or networking affiliates reduce or cease their relationships with us, our business, financial condition, and results of operations could be adversely affected.\\nWe expect that we will need to continue to expand and maintain a network of referral partners and resellers in order to expand into certain international markets. A loss of or reduction in sales through these third parties could reduce our revenue. Recruiting and retaining qualified resellers in our network and training them in our technology and product offerings requires significant time and resources. If we decide to further develop and expand our indirect sales channels, we must continue to scale and improve our processes and procedures to support these channels, including investment in systems and training. Many resellers may not be willing to invest the time and resources required to train their staff to effectively sell our platform. If we fail to maintain relationships with our referral partners and resellers, fail to develop relationships with new referral partners and resellers in new markets or expand the same in existing markets, or fail to manage, train, or provide appropriate incentives to our existing referral partners and resellers, our ability to increase the number of new paying customers and increase sales to existing paying customers could be adversely impacted, which would harm our business.\\nOur ability to utilize our net operating loss carryforwards may be limited.\\nAs of December 31, 2020, we had U.S. federal and state net operating loss carryforwards of approximately $28.0 million and $14.1 million, respectively. Our ability to utilize our federal net operating loss carryforwards may be limited under Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”). The limitations apply if we experience an “ownership change,” which is generally defined as a greater than 50 percentage point change (by value) in the ownership of our equity by certain stockholders over a rolling three-year period. Similar provisions of state tax law may also apply to limit the use of our state net operating loss carryforwards. Future changes in our stock ownership, which may be outside of our control, may trigger an ownership change and, consequently, the limitations under Section 382 of the Code. As a result, if or when we earn net taxable income, our ability to use our pre-change net operating loss carryforwards to offset such taxable income may be subject to limitations, which could adversely affect our future cash flows.\\nWe could be required to collect additional sales and other similar taxes or be subject to other tax liabilities that may increase the costs our customers would have to pay for our subscriptions and adversely affect our operating results.\\nSales and use, value-added, goods and services, and similar tax laws and rates are complicated and vary greatly by jurisdiction. There is significant uncertainty as to what constitutes sufficient nexus for a national, state or local jurisdiction to levy taxes, fees, and surcharges for sales made over the internet, as well as whether our subscriptions are subject to tax in various jurisdictions. Certain countries and the vast majority of states have considered or adopted laws that impose tax collection obligations on out-of-state companies. Additionally, in the United States, the Supreme Court of the United States recently ruled in South Dakota v. Wayfair, Inc. et. al. (“Wayfair”) that online sellers can be required to collect sales and use tax despite not having a physical presence in the buyer’s state. In response to the Wayfair case, or otherwise, national, states or local governments may enforce laws requiring us to calculate, collect, and remit taxes on sales in their jurisdictions. We have not always collected sales and other similar taxes in all jurisdictions in which we are required to. We may be obligated to collect and remit sales tax in jurisdictions in which we have not previously collected and remitted sales tax. We could also be subject to audits in states and non-U.S. jurisdictions for which we have not accrued tax liabilities. A successful assertion by one or more countries or states requiring us to collect taxes where we historically have not or presently do not do so could result in substantial tax liabilities, including taxes on past sales, as well as penalties and interest. The imposition by national, state or local governments of sales tax collection obligations on out-of-state sellers could also create additional administrative burdens for us and decrease our future sales, which could adversely affect our business and operating results.\\nRisks Related to the Regulatory Framework that Governs Us\\n64\\nIf the use of cookies or other tracking technologies becomes subject to unfavorable legislation or regulation, is restricted by internet users or other third parties or is blocked or limited by users or by technical changes on end users’ devices, our ability to attract new customers and to develop and provide certain products could be diminished or eliminated.\\nWe rely on small text files and other technologies, such as web beacons (collectively, “cookies”) which are placed on internet browsers to gather data regarding the content of a user’s web browsing activity. We use cookies to store users’ settings between sessions and to enable visitors to our website to use certain features, such as gaining access to secure areas of the website. We also use cookies, including cookies placed by third-party services with which we integrate, to enable us to gather statistics about our visitors’ use of our website and to allow our website visitors to connect our platform to their social networking sites, which enables us to advertise our products to them using retargeting methods. The availability of this data may be limited by numerous potential factors, including government legislation or regulation restricting the use of cookies for certain purposes, such as retargeting, browser limitations on the collection or use of cookies, or internet users deleting or blocking cookies on their web browsers or on our website.\\nOur ability, like those of other technology companies, to collect, augment, analyze, use, and share information collected through the use of third-party cookies for online behavioral advertising is governed by U.S. and foreign laws and regulations which change from time to time, such as those regulating the level of consumer notice and consent required before a company can employ cookies to collect data about interactions with users online. In the United States, both state and federal legislation govern activities such as the collection and use of data, and privacy in the advertising technology industry has frequently been subject to review, and occasional enforcement, by the Federal Trade Commission, or the FTC, U.S. Congress, and individual states.\\nAs our business is global, our activities are also subject to foreign legislation and regulation. In the EU, the EU Directive 2002/58/EC (as amended by Directive 2009/136/EC), commonly referred to as the e-Privacy Directive, and related implementing legislation in the EU and the UK requires that accessing or storing information on an internet user’s device, such as through a cookie, is allowed only if the internet user has been informed thereof, and provided prior unambiguous, specific, and informed consent for the placement of a cookie on a user’s device. A new e-Privacy Regulation is currently under discussion by EU member states to replace the e-Privacy Directive. Although it remains under debate, the proposed e-Privacy Regulation would amend rules on third-party cookies and significantly increase penalties for non-compliance. We cannot yet determine the impact such future laws, regulations, and standards may have on our use of third-party cookies. Additionally, the use of third-party cookies in the digital advertising ecosystem, particularly in the context of real-time bidding advertising auctions, is subject to increased regulatory scrutiny in the EU. Several European data protection authorities (including in Belgium, Ireland, UK, Poland, Spain, Luxembourg, and the Netherlands) have launched investigations or inquiries over Google’s and other AdTech companies’ practices concerning the collection and sharing of consumer data through cookies, the outcome of which is still uncertain. These investigations or inquiries could result in the imposition of more stringent standards around consent to place cookies or otherwise restrict the use of third-party cookies for online behavioral advertising. We have also received inquiries from, and engaged in correspondence with, European data protection authorities regarding our practices regarding cookies used on our websites, and the outcome of these inquiries is still uncertain.\\nAdditionally, new and expanding “Do Not Track” regulations have recently been enacted or proposed that protect users’ right to choose whether or not to be tracked online. These regulations seek, among other things, to allow end users to have greater control over the use of private information collected online, to forbid the collection or use of online information, to demand a business to comply with their choice to opt out of such collection or use, and to place limits upon the disclosure of information to third-party websites.\\n65\\nContinued regulation of cookies, and changes in the interpretation and enforcement of existing laws, regulations, standards, and other obligations, as well as increased enforcement by industry groups or data protection authorities, could restrict our activities, such as efforts to understand users’ internet usage and engage in marketing activities, or require changes to our practices. Any inability to obtain information through cookies or to obtain it on the terms we anticipate, could cause a significant impact on the operation of our platform, impair our ability to target and attract new customers, and reduce our ability to predict our customers’ interests in or need for one or more of our products, any of which may cause a reduction in revenue or a reduction in revenue growth, negatively impact our ability to obtain new subscriptions and retain or grow the subscriptions of existing customers.\\nAdditionally, cookies may easily be deleted or blocked by internet users. All of the most commonly used internet browsers (including Chrome, Firefox, Internet Explorer, and Safari) allow internet users to prevent cookies from being accepted by their browsers. Internet users can also delete cookies from their computers at any time. Some internet users also download “ad blocking” software that prevents cookies from being stored on a user’s device. If more internet users adopt these settings or delete their cookies more frequently than they currently do, our business could be harmed. In addition, the Safari and Firefox browsers block third-party cookies by default, and other browsers may do so in the future. Unless such default settings in browsers were altered by internet users to permit the placement of third-party cookies, fewer cookies would be available, which could adversely affect our business. In addition, companies such as Google LLC have publicly disclosed their intention to move away from cookies to another form of persistent unique identifier, or ID, to identify individual internet users or internet-connected devices in the bidding process on advertising exchanges. If companies do not use shared IDs across the entire ecosystem, this could have a negative impact on our ability obtain content consumption data.\\nChanges in laws, regulations, and public perception concerning data protection and privacy, or changes in the interpretation or patterns of enforcement of existing laws and regulations, could impair our efforts to maintain and expand our customer base or the ability of our customers and users to use our platform and some or all of our products. Breaches of laws and regulations concerning data protection and privacy could expose us to significant fines and other penalties.\\nWe hold personal data about a variety of individuals, such as our customers, users, employees, contractors, and business partners, and we use such personal data as needed to collect payment from our customers, communicate with and recommend products to our customers and prospective customers through our marketing and advertising efforts, and comply with legal obligations. Processing of personal data is increasingly subject to legislation and regulation in numerous jurisdictions around the world.\\nFor example, relevant applicable laws and regulations governing the collection, use, disclosure or other processing of personal information include, in the United States, rules and regulations promulgated under the authority of the Federal Trade Commission, the California Consumer Privacy Act of 2018 (the “CCPA”), and state breach notification laws. In particular, in California, the CCPA was enacted in June 2018, became effective back on January 1, 2020 and became subject to enforcement by the California Attorney General’s office on July 1, 2020. The CCPA broadly defines personal information and provides an expansive meaning to activity considered to be a sale of personal information, and gives California residents expanded privacy rights and protections, including the right to opt out of the sale of personal information. The CCPA also provides for civil penalties for violations and a private right of action for data breaches. Moreover, a new privacy law that amends and expands the CCPA, the California Privacy Rights Act, or CPRA, was passed on November 3, 2020. The CPRA creates additional obligations relating to personal information that take effect on January 1, 2023 (with certain provisions having retroactive effect to January 1, 2022). The CPRA also establishes a new enforcement agency dedicated to consumer privacy. The CPRA’s implementing regulations are expected on or before July 1, 2022, and enforcement is scheduled to begin July 1, 2023. We will continue to monitor developments related to the CPRA and anticipate additional costs and expenses associated with CPRA compliance. In addition, since the enactment of CCPA, new privacy and data security laws have been proposed in more than half of the states in the United States and in the U.S. Congress, reflecting a trend toward more stringent privacy\\n66\\nlegislation in the United States, which trend may accelerate depending on the results of the 2020 U.S. presidential election. The effects of the CCPA, CPRA, and other similar state or federal laws, are potentially significant and may require us to modify our data processing practices and policies, and to incur substantial costs and potential liability in an effort to comply with such legislation.\\nWe maintain offices in the EU (including Poland, the Czech Republic, and Cyprus) and we have customers in the EU and the UK. Accordingly, we are subject to the General Data Protection Regulation (EU) 2016/679 (the “GDPR”), and related member state implementing legislation, and to the UK’s Data Protection Act 2018 (collectively, “European Data Protection Law”). European Data Protection Law places obligations on controllers and processors of personal data, while establishing rights for individuals with respect to their personal data, including rights of access and deletion in certain circumstances. European Data Protection Law is also explicitly extraterritorial in its application, and could affect our business activities in jurisdictions outside the EU and the UK.\\nWe have implemented measures designed to comply with the requirements of European Data Protection Law. In respect of these measures, we rely on positions and interpretations of the law (including European Data Protection Law) that have yet to be fully tested before the relevant courts and regulators. If a regulator or court of competent jurisdiction determined that one or more of our compliance efforts does not satisfy the applicable requirements of the law (including European Data Protection Law), or if any party brought a claim in this regard, we could be subject to governmental or regulatory investigations, enforcement actions, regulatory fines, compliance orders, litigation or public statements against us by consumer advocacy groups or others, any of which could cause customers to lose trust in us or otherwise damage our reputation. Likewise, a change in guidance could be costly and have an adverse effect on our business.\\nThe requirements of European Data Protection Law pertaining to the licensing of data or obtaining such data from third parties are not entirely clear in all cases. It is possible that third parties may bring claims against us, alleging non-compliance with such requirements, and seeking damages, seeking to prevent us from using certain data, or seeking to prevent us from using data in particular ways. Such claims could potentially adversely affect our ability to provide our services and the current level of functionality of our platform in such circumstances, which could adversely affect our results of operations.\\nEuropean Data Protection Law also imposes strict rules on the transfer of personal data out of the EU/UK to third countries deemed to lack adequate privacy protections (including the United States), unless an appropriate safeguard specified by the GDPR is implemented, such as the Standard Contractual Clauses (“SCCs”), approved by the European Commission, or a derogation applies. The Court of Justice of the EU (the “CJEU”), recently deemed that the SCCs are valid. However, the CJEU ruled that transfers made pursuant to the SCCs and other alternative transfer mechanisms need to be analyzed on a case-by-case basis to ensure EU standards of data protection are met in the jurisdiction where the data importer is based, and there continue to be concerns about whether the SCCs and other mechanisms will face additional challenges. EU regulators have announced that there will be further guidance issued on these topics, but such guidance has yet to be finalized. We rely on SCCs and certain derogations to transfer personal data from the EU and the UK to the United States and Russia. Until the remaining legal uncertainties regarding how to legally continue transfers pursuant to the SCCs and other mechanisms are settled, we will continue to face uncertainty as to whether our efforts to comply with our obligations under European Data Protection Law are sufficient. European or multi-national customers may refuse or be reluctant to use or continue to use our platform or products as a result of such developments until law makers and regulators in the EU and the United States have resolved the issues that instigated the decision of the CJEU noted above. This and other future developments regarding the flow of data across borders could increase the cost and complexity of delivering our platform and products in some markets and may lead to governmental enforcement actions, litigation, fines, and penalties or adverse publicity, which could have an adverse effect on our reputation and business.\\n67\\nThe relationship between the UK and the EU in relation to certain aspects of data protection law remains unclear. In addition, it is likely that documentation will need to be put in place between UK entities and entities in EU member states to ensure adequate safeguards are in place for data transfers, which may result in us incurring additional costs with respect to transfers of personal data between the EU and the UK. We may find it necessary or advantageous to join industry bodies, or self-regulatory organizations, that impose stricter compliance requirements than those set out in applicable laws, including European Data Protection Laws. We may also be bound by contractual restrictions that prevent us from participating in data processing activities that would otherwise be permissible under applicable laws, including European Data Protection Laws. Such strategic choices may impact our ability to exploit data and may have an adverse impact on our business.\\nAs we maintain offices in Russia, we face particular privacy, data security, and data protection risks in connection with requirements of Russia’s data protection and security laws, including Federal Law of 21 July 2014 No. 242-FZ, which entered into effect September 1, 2015, Federal Law of 27 July 2006 No. 152-FZ (as amended) and Federal Law of 27 July 2006 No. 149-FZ (as amended). Among other stringent requirements, these laws require ensuring that certain operations on personal data of Russian citizens are conducted in database(s) located in Russia.\\nWe expect that there will continue to be new proposed laws, regulations, and industry standards concerning privacy, data protection, and information security in the United States, the EU, and other jurisdictions, and we cannot yet determine the impact such future laws, regulations, and standards may have on our business.\\nThese and other legal requirements could require us to make additional changes to our platform or products in order for us or our customers to comply with such legal requirements or reduce our ability to lawfully collect personal data used in our platform and products. These changes could reduce demand for our platform or products, require us to take on more onerous obligations in our contracts, restrict our ability to store, transfer, and process personal data or, in some cases, impact our ability or our customers’ ability to offer our products in certain locations, to deploy our solutions, to reach current and prospective customers, or to derive insights from data globally.\\nThe costs of complying with existing or new data privacy or data protection laws and regulations, regulatory guidance, our privacy policies and contractual obligations to customers, users, or other third parties, may limit the use and adoption of our platform and products, reduce overall demand for our products, make it more difficult for us to meet expectations from or commitments to customers and users, lead to significant fines, penalties, or liabilities for noncompliance, impact our reputation, or slow the pace at which we close sales transactions, any of which could harm our business.\\nFurthermore, the uncertain and shifting regulatory environment and trust climate may cause concerns regarding data privacy and may cause our vendors, customers and users to resist providing the data necessary to allow us to offer our platform and products to our customers and users effectively, or could prompt individuals to opt out of our collection of their personal data. Even the perception that the privacy of personal data is not satisfactorily protected or does not meet regulatory requirements could discourage prospective customers from subscribing to our products or discourage current customers from renewing their subscriptions.\\nCompliance with any of the foregoing laws and regulations can be costly and can delay or impede the development of new products. We may incur substantial fines if we violate any laws or regulations relating to the collection or use of personal data. For example, the GDPR imposes sanctions for violations up to the greater of €20 million and 4% of worldwide gross annual revenue, enables individuals to claim damages resulting from infringement of the GDPR and introduces the right for non-profit organizations to bring claims on behalf of data subjects. CCPA allows for fines of up to $7,500 for each violation (affected individual) that a business does not cure within 30 days of receiving notice of the violation. Non-compliance with Russian data localization rules may result in imposition of an administrative fine of up to\\n68\\nRUB 18 million, or approximately $240,000, for each violation. Our actual or alleged failure to comply with applicable privacy or data security laws, regulations, and policies, or to protect personal data, could result in enforcement actions and significant penalties against us, which could result in negative publicity or costs, subject us to claims or other remedies, and have a material adverse effect on our business, financial condition, and results of operations.\\nMany aspects of data protection and privacy laws are relatively new and their scope has not been tested in the courts. As a result, these laws and regulations are subject to differing interpretations and may be inconsistent among jurisdictions. It is possible that these laws and regulations may be interpreted and applied in a manner that is inconsistent with our interpretations and existing data management practices or the features of our products. Certain of our activities could be found by a court, government or regulatory authority to be noncompliant or become noncompliant in the future with one or more data protection or data privacy laws, even if we have implemented and maintained a strategy that we believe to be compliant. Further, we may be subject to additional risks associated with data security breaches or other incidents, in particular because certain data privacy laws, including the GDPR and CCPA, grant individuals a private right of action arising from certain data security incidents. If so, in addition to the possibility of fines, lawsuits, and other claims and penalties, we could be required to fundamentally change our business activities and practices or modify our products, which could harm our business.\\nWe also receive personal data from third-party vendors (e.g., data brokers). We may not be able to verify with complete certainty the source of such data, how it was collected, and that such data was collected and is being shared with us in compliance with all applicable data protection and privacy laws. Our use of personal data obtained from third-party vendors could result in potential regulatory investigations, fines, penalties, compliance orders, liability, litigation, and remediation costs, as well as reputational harm, any of which could materially adversely affect our business and financial results. The requirements of European Data Protection Law pertaining to the licensing of data or obtaining such data from third parties are not entirely clear in all cases. It is possible that third parties may bring claims against us, alleging non-compliance with such requirements, and seeking damages, seeking to prevent us from using certain data, or seeking to prevent us from using data in particular ways. Such claims could potentially adversely affect our ability to provide our services and the current level of functionality of our platform in such circumstances, which could adversely affect our results of operations.\\nChanges in legislation or requirements related to automatically renewing subscription plans, or our failure to comply with existing or future regulations, may adversely impact our business.\\nOur business relies heavily on the fact that customers enter subscription contracts where they agree that the subscription will automatically renew for a new term, and their credit or debit cards will automatically be charged on an ongoing basis, unless the subscription is canceled by the customer. Some states have passed or considered legislation limiting the duration for which subscriptions can automatically renew, if at all.\\nAlthough this enacted and proposed legislation generally would not affect companies that sell subscriptions to other companies, like ours does, there could be variances and inconsistencies in these rules or requirements among jurisdictions that expose us to compliance risks that would have a material adverse effect on our business operations and financial condition, and could result in fines, penalties, damages, civil liability, and higher transaction fees. In addition, any costs that result from future legislation and regulations, or from changes in the interpretation of existing legislation and regulations, could individually or in the aggregate cause us to change or limit our business practices, which may make our subscription business model less attractive.\\nChanges in laws and regulations related to the internet or changes in the internet infrastructure itself may diminish the demand for our platform and could harm our business.\\n69\\nThe future success of our business depends upon the continued use of the internet as a primary medium for commerce, communication, and business applications. Federal, state, or foreign governmental bodies or agencies have in the past adopted, and may in the future adopt, laws or regulations affecting the use of the internet as a commercial medium. The adoption of any laws or regulations that could reduce the growth or use of the internet, including laws or practices limiting internet neutrality, could decrease the demand for, or the usage of, our platform and products, increase our cost of doing business, require us to modify our platform or financial systems, and may harm our results of operations. In addition, government agencies or private organizations have imposed and may impose additional taxes, fees, or other charges for accessing the internet or commerce conducted via the internet, which could limit the growth of internet-related commerce or communications generally, result in higher prices for our products and platform, or result in reduced demand for internet-based products such as ours.\\nAs the internet continues to experience growth in the number of users, frequency of use, and amount of data transmitted, the internet infrastructure that we and our customers rely on may be unable to support the demands placed upon it. In addition, there could be adverse effects from delays in the development or adoption of new standards and protocols to handle increased demands of internet activity, security, reliability, cost, ease-of-use, accessibility, and quality of service. Further, our platform depends on the quality of our customers’ access to the internet. The failure of the internet infrastructure that we or our customers rely on, even for a short period of time, could undermine our operations and harm our results of operations.\\nInternet access is frequently provided by companies that have significant market power that could take actions that degrade, disrupt, or increase the cost of customer access to our platform, any of which would negatively impact our business. On June 11, 2018, the repeal of the Federal Communications Commission’s, or the FCC, “net neutrality” rules took effect and returned to a “light-touch” regulatory framework. The prior rules were designed to ensure that all online content is treated the same by internet service providers and other companies that provide broadband services. Additionally, on September 30, 2018, California enacted the California internet Consumer Protection and Net Neutrality Act of 2018, making California the fourth state to enact a state-level net neutrality law since the FCC repealed its nationwide regulations, mandating that all broadband services in California must be provided in accordance with state net neutrality requirements. The U.S. Department of Justice has sued to block the law going into effect, and California has agreed to delay enforcement until the resolution of the FCC’s repeal of the federal rules. A number of other states are considering legislation or executive actions that would regulate the conduct of broadband providers. We cannot predict whether the FCC order or state initiatives will be modified, overturned, or vacated by legal action of the court, federal legislation or the FCC. With the repeal of net neutrality rules, network operators may choose to implement usage-based pricing, discount pricing charged to providers of competitive products, otherwise materially change their pricing rates or schemes, charge us to deliver our traffic or throttle its delivery, implement bandwidth caps or other usage restrictions or otherwise try to monetize or control access to their networks, any of which could increase our costs, or those of our customers in accessing our platform, and negatively impact our business and results of operations.\\nFederal, state, and foreign laws regulate internet tracking software, the sending of commercial emails and text messages, and other activities, which could impact the use of our platform and products, and potentially subject us to regulatory enforcement or private litigation.\\nWe are subject to laws and regulations that govern sending marketing and advertising by electronic means, such email and telephone. For example, in the United States, the Controlling the Assault of Non-Solicited Pornography and Marketing Act of 2003, or the CAN-SPAM Act, among other things, obligates the sender of commercial emails to provide recipients with the ability to opt out of receiving future commercial emails from the sender. In addition, the Telephone Consumer Protection Act imposes certain notice, consent, and opt-out obligations on companies that send telephone or text communications using auto dialers to consumers, and provides consumers with private rights of action for violations. Further,\\n70\\ncertain states and foreign jurisdictions, such as Australia, Canada, and the EU, have enacted laws that prohibit sending unsolicited marketing emails unless the recipient has provided its prior consent to receipt of such email, or in other words has “opted-in” to receiving it. A requirement that recipients opt into, or the ability of recipients to opt out of, receiving commercial emails may minimize the effectiveness of our marketing, which could adversely affect our ability to attract new customers or entice existing customers to upgrade their subscriptions.\\nWe are subject to U.S. economic sanctions, export control and anti-corruption laws, and regulations that could impair our ability to compete in international markets or subject us to liability if we violate such laws and regulations.\\nWe are subject to U.S. economic sanctions, export control and anti-corruption laws, and regulations that prohibit the provision of certain products and services to certain countries, governments, and persons targeted by U.S. sanctions. We are in the process of implementing certain precautions to prevent our platform and products from being exported or accessed in violation of U.S. export controls or U.S. sanctions laws and regulations. However, we cannot be certain that the precautions we take will prevent all violations of these laws.\\nWe have previously identified, and may continue to identify, customer accounts for our platform and products that may originate from, or are intended to benefit, persons in countries that are subject to U.S. embargoes, including transactions or events in or relating to Cuba, Iran, North Korea, Syria, and the Crimea region of Ukraine. We have recently submitted a voluntary self-disclosure to the U.S. Department of the Treasury’s Office of Foreign Assets Control, or OFAC, regarding potential violations of OFAC regulations that may have involved the provision of services to customers in sanctioned countries. We have not yet obtained a determination from OFAC.\\nIf we are found to be in violation of U.S. sanctions or export control laws, we may be fined or other penalties could be imposed. Furthermore, changes in export control or economic sanctions laws and enforcement could also result in increased compliance requirements and related costs, which could materially adversely affect our business, results of operations, financial condition and/or cash flows.\\nWe are also subject to various U.S. and international anti-corruption laws, such as the U.S. Foreign Corrupt Practices Act and the UK Bribery Act, as well as other similar anti-bribery and anti-kickback laws and regulations. These laws and regulations generally prohibit companies and their employees and intermediaries from authorizing, offering, or providing improper payments or benefits to government officials and other recipients for improper purposes. Our exposure for violating these laws may increase as we continue to expand our international presence, and any failure to comply with such laws could harm our business.\\nOur internal controls over financial reporting currently do not meet all of the standards contemplated by Section 404 of the Sarbanes-Oxley Act of 2002, as amended (“SOX”), and failure to achieve and maintain effective internal controls over financial reporting in accordance with Section 404 of SOX could impair our ability to produce timely and accurate financial statements or comply with applicable regulations and have a material adverse effect on our business. In the future, our disclosure controls and procedures may not prevent or detect all errors or acts of fraud.\\nAs a public company, we are subject to certain reporting requirements of the Exchange Act and have significant requirements for enhanced financial reporting and internal controls. Our disclosure controls and procedures are designed to reasonably assure that information required to be disclosed by us in reports we file or submit under the Exchange Act is accumulated and communicated to management, recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the SEC. The process of designing and implementing effective internal controls is a continuous effort that requires us to anticipate and react to changes in our business and the economic and regulatory environments, and to expend significant resources to maintain a system of internal controls that is\\n71\\nadequate to satisfy our reporting obligations as a public company. If we are unable to establish or maintain appropriate internal financial reporting controls and procedures, it could cause us to fail to meet our reporting obligations on a timely basis, result in material misstatements in our consolidated financial statements, and harm our operating results. We believe that any disclosure controls and procedures or internal controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by an unauthorized override of the controls. Accordingly, because of the inherent limitations in our control system, misstatements or insufficient disclosures due to error or fraud may occur and not be detected.\\nIn addition, we are required pursuant to Section 404 of SOX, to furnish a report by management on, among other things, the effectiveness of our internal control over financial reporting in the Annual Report on Form 10-K for the year ended December 31, 2022. This assessment will need to include disclosure of any material weaknesses identified by our management in our internal control over financial reporting. The rules governing the standards that must be met for our management to assess our internal control over financial reporting are complex and require significant documentation, testing, and possible remediation. Testing and maintaining internal controls may divert management’s attention from other matters that are important to our business. Beginning with our Annual Report on Form 10-K for the year ended December 31, 2022, our independent registered public accounting firm may be required to attest to the effectiveness of our internal control over financial reporting on an annual basis. However, while we remain an emerging growth company, our independent registered public accounting firm will not be required to attest to the effectiveness of our internal control over financial reporting. If we are not able to complete our initial assessment of our internal controls and otherwise implement the requirements of Section 404 of SOX in a timely manner or with adequate compliance, our independent registered public accounting firm may not be able to certify as to the adequacy of our internal controls over financial reporting. Additionally, when required, an independent assessment of the effectiveness of our internal controls over financial reporting could detect problems that our management’s assessment might not. Undetected material weaknesses in our internal controls over financial reporting could lead to financial statement restatements and require us to incur the expense of remediation.\\nMatters impacting our internal controls may cause us to be unable to report our financial information on a timely basis and thereby subject us to adverse regulatory consequences, including sanctions by the SEC or violations of applicable stock exchange listing rules, which may result in a breach of the covenants under existing or future financing arrangements. There also could be a negative reaction in the financial markets due to a loss of investor confidence in us and the reliability of our financial statements. Confidence in the reliability of our financial statements also could suffer if we or our independent registered public accounting firm report a material weakness in our internal controls over financial reporting. This could materially adversely affect us and lead to a decline in the market price of our Class A common stock.\\nIn connection with the audit of our consolidated financial statements for the year ended December 31, 2019, we and our independent registered public accounting firm identified a material weakness in our internal control over financial reporting related to deficiencies in our controls over the financial statement close process. Specifically, there were deficiencies in the design and operations of internal controls over the identification and review of complex accounting issues involving significant judgment or estimates with respect to certain prior period transactions.\\nWe have implemented, and are continuing to implement, measures designed to improve our internal control over financial reporting to remediate this material weakness. These measures include formalizing our processes and internal control documentation, strengthening supervisory reviews by our financial management, hiring additional qualified accounting and finance personnel, and engaging financial consultants to enable the implementation of internal control over financial reporting.\\n72\\nWe expect to incur additional costs to remediate the control deficiencies identified, though there can be no assurance that our efforts will be successful or avoid potential future material weaknesses. If we are unable to successfully remediate our existing or any future material weaknesses in our internal control over financial reporting, or if we identify any additional material weaknesses, the accuracy and timing of our financial reporting may be adversely affected, we may be unable to maintain compliance with securities law requirements regarding timely filing of periodic reports in addition to applicable stock exchange listing requirements, investors may lose confidence in our financial reporting, and our stock price may decline as a result. We also could become subject to investigations by the New York Stock Exchange (“NYSE”), the SEC or other regulatory authorities.\\nOur internal resources and personnel may in the future be insufficient to avoid accounting errors and there can be no assurance that we will not have additional material weaknesses in the future. Any failure to develop or maintain effective controls or any difficulties encountered implementing required new or improved controls could harm our operating results or cause us to fail to meet our reporting obligations and may result in a restatement of our financial statements for prior periods. Any failure to implement and maintain effective internal control over financial reporting also could adversely affect the results of periodic management evaluations and annual independent registered public accounting firm attestation reports regarding the effectiveness of our internal control over financial reporting that we will eventually be required to include in our periodic reports that will be filed with the SEC. Ineffective disclosure controls, procedures, and internal control over financial reporting could also cause investors to lose confidence in our reported financial and other information, which would likely have a negative effect on the trading price of our common stock. In addition, if we are unable to continue to meet these requirements, we may not be able to remain listed on the NYSE.\\nUnanticipated changes in our effective tax rate and additional tax liabilities may impact our financial results.\\nWe are subject to income taxes in the United States and various jurisdictions outside of the United States. Our income tax obligations are generally determined based on our business operations in these jurisdictions. Significant judgment is often required in the determination of our worldwide provision for income taxes. Our effective tax rate could be impacted by changes in the earnings and losses in countries with differing statutory tax rates, changes in non-deductible expenses, changes in excess tax benefits of stock-based compensation, changes in the valuation of deferred tax assets and liabilities and our ability to utilize them, the applicability of withholding taxes, effects from acquisitions, changes in accounting principles and tax laws in jurisdictions where we operate. Any changes, ambiguity, or uncertainty in taxing jurisdictions’ administrative interpretations, decisions, policies, and positions could also materially impact our income tax liabilities.\\nAs our business continues to grow and if we become more profitable, we anticipate that our income tax obligations could significantly increase. If our existing tax credits and net operating loss carry-forwards become fully utilized, we may be unable to offset or otherwise mitigate our tax obligations to the same extent as in prior years. This could have a material impact to our future cash flows or operating results.\\nIn addition, recent global tax developments applicable to multinational companies, including certain approaches of addressing taxation of digital economy recently proposed or enacted by the Organisation for Economic Co-operation and Development, the European Commission or certain major jurisdictions where we operate or might in the future operate, might have a material impact to our business and future cash flow from operating activities, or future financial results. We are also subject to tax examinations in multiple jurisdictions. While we regularly evaluate new information that may change our judgment resulting in recognition, derecognition, or changes in measurement of a tax position taken, there can be no assurance that the final determination of any examinations will not have an adverse effect on our operating results and financial position. In addition, our operations may change, which may impact our tax liabilities. As our brand becomes increasingly recognizable both domestically and internationally, our tax\\n73\\nplanning structure and corresponding profile may be subject to increased scrutiny, and if we are perceived negatively, we may experience brand or reputational harm.\\nWe may also be subject to additional tax liabilities and penalties due to changes in non-income based taxes resulting from changes in federal, state, or international tax laws, changes in taxing jurisdictions’ administrative interpretations, decisions, policies and positions, results of tax examinations, settlements or judicial decisions, changes in accounting principles, and changes to the business operations, including acquisitions, as well as the evaluation of new information that results in a change to a tax position taken in a prior period. Any resulting increase in our tax obligation or cash taxes paid could adversely affect our cash flows and financial results.\\nOur international operations may subject us to greater than anticipated tax liabilities.\\nWe are expanding our international operations to better support our growth into international markets. Our corporate structure and associated transfer pricing policies contemplate future growth in international markets, and consider the functions, risks, and assets of the various entities involved in intercompany transactions. The amount of taxes we pay in different jurisdictions may depend on the application of the tax laws of various jurisdictions, including the United States, to our international business activities, changes in tax rates, new or revised tax laws or interpretations of existing tax laws and policies, and our ability to operate our business in a manner consistent with our corporate structure and intercompany arrangements. The taxing authorities of the jurisdictions in which we operate may challenge our methodologies for pricing intercompany transactions pursuant to our intercompany arrangements or disagree with our determinations as to the income and expenses attributable to specific jurisdictions. If such a challenge or disagreement were to occur, and our position was not sustained, we could be required to pay additional taxes, interest, and penalties, which could result in one-time tax charges, higher effective tax rates, reduced cash flows, and lower overall profitability of our operations and we may be required to revise our intercompany agreements. Our financial statements could fail to reflect adequate reserves to cover such a contingency.\\nRisks Related to Our Intellectual Property\\nWe may not be able to adequately protect our proprietary and intellectual property rights in our data or technology.\\nOur success is dependent, in part, upon protecting our proprietary information and technology. Our intellectual property portfolio primarily consists of registered and unregistered trademarks, unregistered copyrights, domain names, know-how, and trade secrets. We may be unsuccessful in adequately protecting our intellectual property. No assurance can be given that confidentiality, non-disclosure, or invention or copyright assignment agreements with employees, consultants, partners or other parties have been entered into, will not be breached, or will otherwise be effective in establishing our rights in intellectual property and in controlling access to and distribution of our platform, or certain aspects of our platform, and proprietary information. Further, these agreements do not prevent our competitors from independently developing technologies that are substantially equivalent or superior to our platform. Additionally, certain unauthorized use of our intellectual property may go undetected, or we may face legal or practical barriers to enforcing our legal rights even where unauthorized use is detected.\\nCurrent laws may not provide for adequate protection of our platform or data, especially in foreign jurisdictions which may have laws that provide insufficient protections to companies. In addition, legal standards relating to the validity, enforceability, and scope of protection of proprietary rights in internet-related businesses are uncertain and evolving, and changes in these standards may adversely impact the viability or value of our proprietary rights. Some license provisions protecting against unauthorized use, copying, transfer, and disclosure of our products, or certain aspects of our platform, or our data may be unenforceable under the laws of certain jurisdictions. Further, the laws of some countries do not protect\\n74\\nproprietary rights to the same extent as the laws of the United States, and the laws and mechanisms for protection and enforcement of intellectual property rights in some foreign countries may be inadequate. As we continue to operate in foreign countries and expand our international activities, we have encountered and may in the future encounter challenges in navigating the laws of foreign countries, which may adversely affect our ability to protect our proprietary rights and subject us to claims from current or former personnel and other third parties. Moreover, our exposure to unauthorized copying of certain aspects of our platform, or our data may increase. Further, competitors, foreign governments, foreign government-backed actors, criminals, or other third parties may gain unauthorized access to our proprietary information and technology. Accordingly, despite our efforts, we may be unable to prevent third parties from infringing upon or misappropriating our technology and intellectual property or claiming that we infringe upon or misappropriate their technology and intellectual property.\\nTo protect our intellectual property rights, we may be required to spend significant resources to monitor, protect, and defend these rights, and we may or may not be able to detect infringement by our customers or third parties. Litigation has been and may be necessary in the future to enforce our intellectual property rights and to protect our trade secrets. Such litigation could be costly, time consuming, and distracting to management and could result in the impairment or loss of portions of our intellectual property. Furthermore, our efforts to enforce our intellectual property rights may be met with defenses, counterclaims, and countersuits attacking the validity and enforceability of our intellectual property rights. Our inability to protect our proprietary technology against unauthorized copying or use, as well as any costly litigation or diversion of our management’s attention and resources, could delay further sales or the implementation of our platform, impair the functionality of our platform, delay introductions of new features, integrations, and capabilities, result in our substituting inferior or more costly technologies into our platform, or injure our reputation. In addition, we may be required to license additional technology from third parties to develop and market new features, integrations, and capabilities, and we cannot be certain that we could license that technology on commercially reasonable terms or at all, and our inability to license this technology could harm our ability to compete.\\nIf third parties claim that we infringe upon or otherwise violate their intellectual property rights, our business could be adversely affected.\\nWe have in the past and may in the future be subject to claims that we have infringed or otherwise violated third parties’ intellectual property rights. There is patent, copyright, and other intellectual property development and enforcement activity in our industry and relating to the technology we use in our business. Our future success depends in part on not infringing upon or otherwise violating the intellectual property rights of others. From time to time, our competitors or other third parties (including non-practicing entities and patent holding companies) may claim that we are infringing upon or otherwise violating their intellectual property rights, and we may be found to be infringing upon or otherwise violating such rights. In addition, we do not own any issued, nor do we have any pending patents, which limits our ability to deter patent infringement claims by competitors and other third parties who hold patents. We may be unaware of the intellectual property rights of others that may cover some or all of our current or future technology or conflict with our rights, and the patent, copyright, and other intellectual property rights of others may limit our ability to improve our technology and compete effectively. Any claims of intellectual property infringement or other intellectual property violations, even those without merit, could:\\n•be expensive and time consuming to defend;\\n•cause us to cease making, licensing or using our platform or products that incorporate the challenged intellectual property;\\n•require us to modify, redesign, reengineer or rebrand our platform or products, if feasible;\\n•divert management’s attention and resources; or\\n75\\n•require us to enter into royalty or licensing agreements to obtain the right to use a third-party’s intellectual property.\\nAny royalty or licensing agreements, if required, may not be available to us on acceptable terms or at all. A successful claim of infringement against us could result in our being required to pay significant damages, enter into costly settlement agreements, or prevent us from offering our platform or products, any of which could have a negative impact on our operating profits and harm our future prospects. We may also be obligated to indemnify our customers or business partners in connection with any such litigation and to obtain licenses, modify our platform or products, or refund premium subscription fees, which could further exhaust our resources. Such disputes could also disrupt our platform or products, adversely affecting our customer satisfaction and ability to attract customers.\\nOur use of “open source” software could negatively affect our ability to offer and sell access to our platform and products, and subject us to possible litigation.\\nWe use open source software in our platform and products, and expect to continue to use open source software in the future. There are uncertainties regarding the proper interpretation of and compliance with open source licenses, and there is a risk that such licenses could be construed in a manner that imposes unanticipated conditions or restrictions on our ability to use such open source software, and consequently to provide or distribute our platform and products. Although use of open source software has historically been free, recently several open source providers have begun to charge license fees for use of their software. If our current open source providers were to begin to charge for these licenses or increase their license fees significantly, we would have to choose between paying such license fees or incurring the expense to replace the open source software with other software or with our own software, which would increase our research and development costs, and have a negative impact on our results of operations and financial condition.\\nAdditionally, we may from time to time face claims from third parties claiming ownership of, or seeking to enforce the terms of, an open source license, including by demanding release of source code for the open source software, derivative works or our proprietary source code that was developed using or that is distributed with such open source software. These claims could also result in litigation and could require us to make our proprietary software source code freely available, require us to devote additional research and development resources to change our platform or incur additional costs and expenses, any of which could result in reputational harm and would have a negative effect on our business and operating results. In addition, if the license terms for the open source software we utilize change, we may be forced to reengineer our platform or incur additional costs to comply with the changed license terms or to replace the affected open source software. Further, use of certain open source software can lead to greater risks than use of third-party commercial software, as open source licensors generally do not provide warranties or controls on the origin of software or indemnification for third-party infringement claims. Although we have implemented policies to regulate the use and incorporation of open source software into our platform and products, we cannot be certain that we have not incorporated open source software in our platform and products in a manner that is inconsistent with such policies.\\nIndemnity provisions in various agreements potentially expose us to substantial liability for intellectual property infringement and other losses.\\nOur agreements with resellers and other third parties may include indemnification or other provisions under which we agree to indemnify or otherwise be liable to them for losses suffered or incurred as a result of claims of intellectual property infringement, damages caused by us to property or persons, or other liabilities relating to or arising from our platform, products or other acts or omissions. For some of our larger customers, we sometimes negotiate similar indemnification provisions or indemnification for breaches of our obligations, representations or warranties in the subscription agreement, gross negligence or willful misconduct, breaches of confidentiality, losses related to security incidents, breach of the data processing addendum or violations of applicable law. In some instances, the term of these\\n76\\ncontractual provisions survives the termination or expiration of the applicable agreement. Large indemnity payments or damage claims from contractual breach could harm our business, operating results, and financial condition.\\nFrom time to time, third parties may assert infringement claims against our customers or resellers. These claims may require us to initiate or defend protracted and costly litigation on behalf of customers and resellers, regardless of the merits of these claims. If any of these claims succeed, we may be forced to pay damages on behalf of our customers and resellers or may be required to obtain licenses for the platform or products they use or resell or modify our platform or products. We may not be able to obtain all necessary licenses on commercially reasonable terms, or at all, or to make such modifications to avoid a claim, in which case our customers and resellers may be required to stop using or reselling our platform or products. Further, customers may require us to indemnify or otherwise be liable to them for breach of confidentiality or failure to implement adequate security measures with respect to their data stored, transmitted or processed by our employees or platform. Although we normally contractually limit our liability with respect to such obligations, we may still incur substantial liability related to them. Any dispute with a customer with respect to such obligations could have adverse effects on our relationship with that customer and other current and prospective customers, reduce demand for our platform or products, and harm our revenue, business, and operating results.\\nRisks Related to Ownership of Our Class A Common Stock\\nWe are an emerging growth company and we cannot be certain that the reduced disclosure requirements applicable to emerging growth companies will not make our Class A common stock less attractive to investors.\\nWe are an “emerging growth company” as defined in the Jumpstart Our Business Startups Act, or the JOBS Act. Under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards until such time as those standards apply to private companies. We have elected to use this extended transition period for complying with new or revised accounting standards that have different effective dates for public and private companies until the earlier of the date we (i) are no longer an emerging growth company or (ii) affirmatively and irrevocably opt out of the extended transition period provided in the JOBS Act. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates.\\nFor as long as we continue to be an emerging growth company, we also intend to take advantage of certain other exemptions from various reporting requirements that are applicable to other public companies including, but not limited to, reduced disclosure obligations regarding executive compensation in our periodic reports, proxy statements, and registration statements, and exemptions from the requirements of holding a non-binding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. We cannot predict if investors will find our Class A common stock less attractive because we will rely on these exemptions. If some investors find our Class A common stock less attractive as a result, there may be a less active trading market for our Class A common stock and our stock price may be more volatile.\\nWe will remain an emerging growth company until the earliest of (i) the last day of the year in which we have total annual gross revenue of $1.07 billion or more, (ii) December 31, 2026, (iii) the date on which we have issued more than $1.0 billion in nonconvertible debt during the previous three years, or (iv) the date on which we are deemed to be a large accelerated filer under the rules of the SEC.\\n77\\nWe are subject to costs, regulations and requirements as a result of being a public company, which could impair our profitability, make it more difficult to run our business, or divert management’s attention from our business.\\nAs a public company, and particularly after we are no longer an emerging growth company, we are required to commit significant resources, management time, and attention to the requirements of being a public company, which causes us to incur significant legal, accounting, and other expenses, including costs associated with public company reporting requirements, and recruiting and retaining independent directors. We also have incurred and will continue to incur costs associated with SOX and the Dodd-Frank Wall Street Reform and Consumer Protection Act and related rules implemented by the SEC and the NYSE, and compliance with these requirements will place significant demands on our legal, accounting, and finance staff and on our accounting, financial, and information systems. The expenses incurred by public companies generally for reporting and corporate governance purposes have been increasing. These rules and regulations may increase our legal and financial compliance costs and to make some activities more time-consuming and costly, although we are currently unable to estimate these costs with any degree of certainty. In addition, we might not be successful in implementing these requirements. These laws and regulations also could make it more difficult or costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. These laws and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors (the “Board”) or Board committees or as our executive officers. Furthermore, if we are unable to continue to satisfy our obligations as a public company, we could be subject to delisting of our Class A common stock, fines, sanctions, and other regulatory action and potentially civil litigation.\\nAn active public market for our Class A common stock may not be sustained and could be highly volatile, and you may not be able to resell your shares at or above your original purchase price, if at all.\\nWe have a limited trading history. The market price of our Class A common stock could be highly volatile and may fluctuate substantially as a result of many factors, including:\\n•actual or anticipated fluctuations in our results of operations;\\n•variance in our results of operation from the expectations of market analysts;\\n•announcements by us or our competitors of significant business developments, changes in service provider relationships, acquisitions or expansion plans;\\n•changes in the prices of our products;\\n•our involvement in litigation;\\n•our sale of Class A common stock or other securities in the future;\\n•market conditions in our industry;\\n•changes in key personnel;\\n•the trading volume of our Class A common stock;\\n•changes in the estimation of the future size and growth rate of our markets; and\\n•general economic and market conditions.\\n78\\nIn addition, the stock markets have experienced extreme price and volume fluctuations. Broad market and industry factors may materially harm the market price of our Class A common stock, regardless of our results of operation. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted against that company. If we were involved in any similar litigation we could incur substantial costs, and our management’s attention and resources could be diverted.\\nIf you purchase shares of our Class A common stock, you may not be able to resell those shares at or above the price you originally paid. An active or liquid market in our Class A common stock may not be sustainable, which could adversely affect your ability to sell your shares and could depress the market price of our Class A common stock.\\nThe issuance of additional stock in connection with financings, acquisitions, investments, our stock incentive plans or otherwise will dilute all other stockholders.\\nOur amended and restated certificate of incorporation authorizes us to issue up to 1,000,000,000 shares of Class A common stock and up to 100,000,000 shares of preferred stock with such rights and preferences as may be determined by our Board. Subject to compliance with applicable rules and regulations, we may issue our shares of Class A common stock or securities convertible into our Class A common stock from time to time in connection with a financing, acquisition, investment, our stock incentive plans or otherwise. Any such issuance could result in substantial dilution to our existing stockholders and cause the trading price of our Class A common stock to decline.\\nA total of 124,905,954, or approximately 93%, of the outstanding shares of our Class A and Class B common stock are restricted from immediate resale, but may be sold on a stock exchange in the near future. The large number of shares eligible for public sale or subject to rights requiring us to register them for public sale could depress the market price of our Class A common stock.\\nThe market price of our Class A common stock could decline as a result of sales of a large number of shares of our Class A common stock in the market, and the perception that these sales could occur may also depress the market price of our Class A common stock. We, our executive officers, directors, and the holders of substantially all of our capital stock and securities convertible into or exchangeable for our capital stock outstanding prior to our IPO have entered into lock-up agreements with the underwriters under which they have agreed, subject to specific exceptions and early release triggers, not to sell any of our stock for 180 days following March 24, 2021. Following the expiration of this period and subject to applicable securities laws, such shares may be sold on the public market.\\nStockholders owning an aggregate of up to 36,750,000 shares of our Class B common stock are entitled, under contracts providing for registration rights, to require us to register shares owned by them for public sale in the United States. In addition, we filed a registration statement on Form S-8 on March 25, 2021, to register 24,114,926 shares of our Class A common stock under our equity compensation plans.\\nSales of our shares as restrictions end or pursuant to registration rights may make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate. These sales also could cause the trading price of our Class A common stock to fall and make it more difficult for you to sell shares of our Class A common stock.\\nIf we do not meet the expectations of equity research analysts, if they do not publish research or reports about our business or if they issue unfavorable commentary or downgrade our Class A common stock, the price of our Class A common stock could decline.\\nThe trading market for our Class A common stock will depend in part on the research and reports that equity research analysts publish about us and our business. The analysts’ estimates are based upon their\\n79\\nown opinions and are often different from our estimates or expectations. If our results of operations are below the estimates or expectations of public market analysts and investors, our stock price could decline. Moreover, the price of our Class A common stock could decline if one or more securities analysts downgrade our Class A common stock or if those analysts issue other unfavorable commentary or cease publishing reports about us or our business.\\nWe cannot predict the impact our dual structure may have on the market price of our Class A common stock.\\nWe cannot predict whether our dual class structure, combined with the concentrated control of our stockholders who held our capital stock prior to the completion of our IPO, including our executive officers, employees, and directors and their affiliates, will result in a lower or more volatile market price of our Class A common stock or in adverse publicity or other adverse consequences. For example, certain index providers have announced restrictions on including companies with multiple class share structures in certain of their indices. In July 2017, FTSE Russell and Standard & Poor’s announced that they would cease to allow most newly public companies utilizing dual or multi-class capital structures to be included in their indices. Under the announced policies, our dual class capital structure would make us ineligible for inclusion in any of these indices. Given the sustained flow of investment funds into passive strategies that seek to track certain indexes, exclusion from stock indexes would likely preclude investment by many of these funds and could make our Class A common stock less attractive to other investors. As a result, the market price of our Class A common stock could be adversely affected.\\nThe dual class structure of our common stock has the effect of concentrating voting control with those stockholders who held our capital stock prior to the completion of our IPO, including our directors, executive officers, and their affiliates, who as of March 31, 2021 held in aggregate 93% of the voting power of our capital stock, which will limit or preclude your ability to influence corporate matters.\\nOur Class B common stock has ten votes per share, and our Class A common stock has one vote per share. As of March 31, 2021, our directors, executive officers, and their affiliates, held in the aggregate 93% of the voting power of our capital stock. Because of the ten-to-one voting ratio between our Class B common stock and Class A common stock, the holders of our Class B common stock collectively will continue to control a majority of the combined voting power of our common stock and therefore will be able to control all matters submitted to our stockholders for approval until the earlier of (a) the seven year anniversary of the closing of our IPO (b) such time as the outstanding shares of Class B common stock represent less than ten percent of the aggregate number of shares of our outstanding common stock and (c) the date the holders of two-thirds of our Class B common stock elect to convert the Class B common stock to Class A common stock. This concentrated control may limit or preclude your ability to influence corporate matters for the foreseeable future, including the election of directors, amendments of our organizational documents, and any merger, consolidation, sale of all or substantially all of our assets, or other major corporate transaction requiring stockholder approval. In addition, this may prevent or discourage unsolicited acquisition proposals or offers for our capital stock that you may feel are in your best interest as one of our stockholders.\\nFuture transfers by holders of Class B common stock will generally result in those shares converting to Class A common stock, subject to limited exceptions, such as certain transfers effected for estate planning purposes. The conversion of Class B common stock to Class A common stock will have the effect, over time, of increasing the relative voting power of those holders of Class B common stock who retain their shares in the long term.\\nWe do not expect to declare any dividends in the foreseeable future.\\nWe do not anticipate declaring any cash dividends to holders of our common stock in the foreseeable future. In addition, our credit facility places restrictions on our ability to pay cash dividends. Consequently,\\n80\\ninvestors may need to rely on sales of their Class A common stock after price appreciation, which may never occur, as the only way to realize any future gains on their investment. Investors seeking cash dividends should not purchase our Class A common stock.\\nProvisions in our charter documents and under Delaware law could make an acquisition of our company more difficult, limit attempts by our stockholders to replace or remove our current Board, and limit the market price of our Class A common stock.\\nProvisions in our amended and restated certificate of incorporation and amended and restated bylaws may have the effect of delaying or preventing a change of control or changes in our management. Our amended and restated certificate of incorporation and amended and restated bylaws, include provisions that:\\n•provide that the authorized but unissued shares of our common stock and our preferred stock are available for future issuance without stockholder approval;\\n•provide that our Board is classified into three classes of directors with staggered three-year terms;\\n•permit the Board to establish the number of directors and fill any vacancies and newly created directorships;\\n•require super-majority voting to amend some provisions in our amended and restated certificate of incorporation and amended and restated bylaws;\\n•authorize the issuance of “blank check” preferred stock that our Board could use to implement a stockholder rights plan;\\n•provide that only the Chairperson of our Board, our Chief Executive Officer, or a majority of our Board will be authorized to call a special meeting of stockholders;\\n•provide for a dual class common stock structure in which holders of our Class B common stock have the ability to control the outcome of matters requiring stockholder approval, even if they own significantly less than a majority of the outstanding shares of our Class A and Class B common stock, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or its assets;\\n•prohibit stockholder action by written consent, which requires all stockholder actions to be taken at a meeting of our stockholders;\\n•provide that the Board is expressly authorized to make, alter or repeal our bylaws; and\\n•advance notice requirements for nominations for election to our Board or for proposing matters that can be acted upon by stockholders at annual stockholder meetings.\\nMoreover, Section 203 of the Delaware General Corporation Law may discourage, delay, or prevent a change in control of our company. Section 203 imposes certain restrictions on mergers, business combinations, and other transactions between us and holders of 15% or more of our common stock.\\nOur bylaws designate certain courts as the sole and exclusive forum for certain types of actions and proceedings that may be initiated by our stockholders, which could limit our stockholders’\\n81\\nability to obtain a favorable judicial forum for disputes with us or our directors, officers, or employees.\\nOur bylaws provide that, unless we consent in writing to an alternative forum, the Court of Chancery of the State of Delaware will be the sole and exclusive forum for any state law claim for (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of or based on a fiduciary duty owed by any of our current or former directors, officers, or employees to us or our stockholders, (iii) any action asserting a claim arising pursuant to any provision of the Delaware General Corporation Law, our amended and restated certificate of incorporation or our amended and restated bylaws (including the interpretation, validity or enforceability thereof) or (iv) any action asserting a claim that is governed by the internal affairs doctrine, in each case subject to the Court of Chancery having personal jurisdiction over the indispensable parties named as defendants therein, or the Delaware Forum Provision. The Delaware Forum Provision will not apply to any causes of action arising under the Securities Act or the Exchange Act. Our amended and restated bylaws further provide that, unless we consent in writing to the selection of an alternative forum, the federal district courts of the United States shall be the sole and exclusive forum for resolving any complaint asserting a cause of action arising under the Securities Act, or the Federal Forum Provision. In addition, our amended and restated bylaws provide that any person or entity purchasing or otherwise acquiring any interest in shares of our common stock is deemed to have notice of and consented to the foregoing provisions; provided, however, that stockholders cannot and will not be deemed to have waived our compliance with the federal securities laws and the rules and regulations thereunder.\\nThe Delaware Forum Provision and the Federal Forum Provision in our amended and restated bylaws may impose additional litigation costs on stockholders in pursuing any such claims, particularly if the stockholders do not reside in or near the State of Delaware. Additionally, the forum selection clauses in our amended and restated bylaws may limit our stockholders’ ability to bring a claim in a forum that they find favorable for disputes with us or our directors, officers or employees, which may discourage such lawsuits against us and our directors, officers and employees even though an action, if successful, might benefit our stockholders. In addition, while the Delaware Supreme Court ruled in March 2020 that federal forum selection provisions purporting to require claims under the Securities Act be brought in federal court were “facially valid” under Delaware law, there is uncertainty as to whether other courts will enforce our Federal Forum Provision. If the Federal Forum Provision is found to be unenforceable, we may incur additional costs associated with resolving such matters. The Federal Forum Provision may also impose additional litigation costs on stockholders who assert that the provision is not enforceable or invalid. The Court of Chancery of the State of Delaware and the federal district courts of the United States may also reach different judgments or results than would other courts, including courts where a stockholder considering an action may be located or would otherwise choose to bring the action, and such judgments may be more or less favorable to us than our stockholders.\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\\nUnregistered Sales of Equity Securities\\nFrom January 1, 2021 through March 31, 2021, pursuant to our Amended and Restated 2019 Stock Option and Grant Plan (the “2019 Plan”) we issued and sold to our employees, consultants and other service providers an aggregate of 3,861 shares of common stock upon the exercise of options under our 2019 Plan at exercise prices ranging from $1.23 to $1.68 per share, for an aggregate exercise price of $5,207. These 3,861 shares of common stock were exchanged for an equal number of shares of our Class B common stock in connection with our IPO.\\nFrom January 1, 2021 through March 31, 2021, pursuant to our 2021 Stock Option and Grant Plan we granted one employee an aggregate of 19,500 restricted stock units, with a grant date fair value $14 per restricted stock unit.\\n82\\nNone of the foregoing transactions involved any underwriters, underwriting discounts or commissions, or any public offering. The sales of the above securities were deemed to be exempt from registration under the Securities Act in reliance on Section 4(a)(2) of the Securities Act or Rule 701 promulgated under Section 3(b) of the Securities Act as transactions by an issuer not involving any public offering or pursuant to benefit plans and contracts relating to compensation as provided under Rule 701. The recipients of the securities in each of these transactions represented their intentions to acquire the securities for investment only and not with a view to or for sale in connection with any distribution thereof, and appropriate legends were affixed to the securities issued in these transactions. All recipients had adequate access, through their relationships with us, to information about us. The sales of these securities were made without any general solicitation or advertising.\\nUse of Proceeds From the IPO\\nOn March 29, 2021, we closed the IPO, in which we issued 10,000,000 shares of Class A common stock, and on April 23, 2021 we closed the partial exercise of the underwriter’s option to purchase additional shares of our Class A common stock, in which we issued an additional 719,266 shares of Class A common stock, at a price to the public of $14.00 for aggregate net proceeds of $135,987 after deducting underwriting discounts and commissions of $10,505 and expenses payable by us of $3,578. The offer and sale of all of the shares in the IPO were registered under the Securities Act pursuant to the Prospectus. No payments were made by us to directors, officers or persons owning ten percent or more of our common stock or to their associates, or to our affiliates, other than payments in the ordinary course of business to officers for salaries and to non-employee directors pursuant to our director compensation policy. There has been no material change in the planned use of proceeds from the IPO as described in the Prospectus. We invested the funds received in accordance with our Board approved investment policy, which provides for investments in obligations of the U.S. and foreign governments, money market instruments, registered money market funds, corporate and municipal bonds. Goldman, Sachs & Co. LLC, J.P. Morgan Securities LLC and Jefferies LLC acted as joint lead bookrunning managers of the IPO.\\nItem 3. Defaults Upon Senior Securities\\nNone.\\nItem 4. Mine Safety Disclosures\\nNot applicable.\\nItem 5. Other Information\\nNone.\\nItem 6. Exhibits\\nThe exhibits listed below are filed or incorporated by reference in this Quarterly Report on Form 10-Q.\\n| Exhibit Number | Exhibit Title |\\n| 3.1(1) | Amended and Restated Certificate of Incorporation of the Registrant |\\n| 3.2(2) | Amended and Restated Bylaws of the Registrant |\\n| 4.1(3) | Form of Common Stock certificate of the Registrant |\\n\\n83\\n| 31.1* | Certification of Principal Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended |\\n| 31.2* | Certification of Principal Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended |\\n| 32.1+ | Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act |\\n| 101.INS* | XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document |\\n| 101.SCH* | XBRL Taxonomy Extension Schema Document |\\n| 101.CAL* | XBRL Taxonomy Extension Calculation Linkbase Document |\\n| 101.DEF* | XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101.LAB* | XBRL Taxonomy Extension Label Linkbase Document |\\n| 101.PRE* | XBRL Taxonomy Extension Presentation Linkbase Document |\\n| 104 | Cover Page with Interactive Data File (formatted as Inline XBRL with applicable taxonomy extension information contained in Exhibits 101) |\\n\\n(1) File as Exhibit 3.2 to Registrant’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on March 16, 2021, and incorporated herein by reference.\\n(2) Filed as Exhibit 3.4 to Registrant’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on March 16, 2021, and incorporated herein by reference.\\n(3) Filed as Exhibit 4.1 to Registrant’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on March 16, 2021, and incorporated herein by reference.\\n* Filed herewith.\\n+ The certifications furnished in Exhibit 32.1 hereto are deemed to accompany this Quarterly Report on Form 10-Q and will not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, except to the extent that the Registrant specifically incorporates it by reference. Such certifications will not be deemed to be incorporated by reference into any filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, except to the extent that the Registrant specifically incorporates it by reference.\\n84\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n| SEMRUSH HOLDINGS, INC. |\\n| May 11, 2021 | By: | /s/ Oleg Shchegolev |\\n| Oleg Shchegolev |\\n| Chief Executive Officer |\\n| (Principal Executive Officer) |\\n| May 11, 2021 | By: | /s/ Evgeny Fetisov |\\n| Evgeny Fetisov |\\n| Chief Financial Officer |\\n| (Principal Financial Officer and Principal Accounting Officer) |\\n\\n85\\n \\n\\nIf the company plans to maintain an equal distribution of total assets and total liabilities and stockholders' equity by the end of 2021, along with a 10% increase in \\\"Deferred contract costs, net of current portion\\\" and \\\"Other long-term assets\\\" from March 2021 levels, what should be the new total of current assets in dollars?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 190736.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 50,\n \"input_length\": 62594\n}"}}},{"rowIdx":51,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nITEM 1 —\nBusiness\nIn this annual report on Form 10-K, “the Company,” “we” or “our” refer to A. M. Castle & Co., a Maryland corporation, and its subsidiaries included in the consolidated financial statements, except as otherwise indicated or as the context otherwise requires.\nBusiness and Markets\nCompany Overview\nThe Company is a specialty metals (90% of net sales) and plastics (10% of net sales) distribution company serving customers on a global basis. The Company provides a broad range of products and value-added processing and supply chain services to a wide array of customers, principally within the producer durable equipment, oil and gas, aerospace, heavy industrial equipment, industrial goods, construction equipment, retail, marine and automotive sectors of the global economy. Particular focus is placed on the aerospace and defense, oil and gas, power generation, mining, heavy industrial equipment manufacturing, marine, office furniture and fixtures, safety products, life sciences applications, transportation and general manufacturing industries.\nThe Company’s corporate headquarters are currently located in Oak Brook, Illinois. The Company operates out of 49 service centers located throughout North America (44), Europe (4) and Asia (1). The Company’s service centers hold inventory and process and distribute products to both local and export markets.\nIndustry and Markets\nService centers act as supply chain intermediaries between primary producers, which deal in bulk quantities in order to achieve economies of scale, and end-users in a variety of industries that require specialized products in significantly smaller quantities and forms. Service centers also manage the differences in lead times that exist in the supply chain. While original equipment manufacturers (“OEM”) and other customers often demand delivery within hours, the lead time required by primary producers can be as long as several months. Service centers also provide value to customers by aggregating purchasing, providing warehousing and distribution services to meet specific customer needs, including demanding delivery times and precise metal specifications.\nThe principal markets served by the Company are highly competitive. Competition is based on service, quality, processing capabilities, inventory availability, timely delivery, ability to provide supply chain solutions and price. The\n3\nCompany competes in a highly fragmented industry. Competition in the various markets in which the Company participates comes from a large number of value-added metals processors and service centers on a regional and local basis, some of which have greater financial resources and some of which have more established brand names in the local markets served by the Company.\nThe Company also competes to a lesser extent with primary metals producers who typically sell to larger customers requiring shipments of large volumes of metal.\nIn order to capture scale efficiencies and remain competitive, many primary metal producers are consolidating their operations and focusing on their core production activities. These producers have increasingly outsourced metals distribution and inventory management to metals service centers. This process of outsourcing allows them to work with a relatively small number of intermediaries rather than many end customers. As a result, metals service centers, including the Company, are now providing a range of services for their customers, including metal purchasing, processing and supply chain solutions.\nRecent Acquisitions\nDuring December 2011, the Company completed its acquisition (the “Acquisition”) of Tube Supply, Inc. (“Tube Supply”), which has expanded the Company’s product offerings in the oil and gas industry. Subsequent to the acquisition, Tube Supply operated as a Limited Liability Corporation until it was merged with A. M. Castle & Co. in September of 2012. The results of Tube Supply are included in the Company’s Metals segment.\nProcurement\nThe Company purchases metals and plastics from many producers. Material is purchased in large lots and stocked at its service centers until sold, usually in smaller quantities and typically with some value-added processing services performed. The Company’s ability to provide quick delivery of a wide variety of specialty metals and plastic products, along with its processing capabilities and supply chain management solutions, allows customers to lower their own inventory investment by reducing their need to order the large quantities required by producers and their need to perform additional material processing services. Some of the Company’s purchases are covered by long-term contracts and commitments, which generally have corresponding customer sales agreements.\nOrders are primarily filled with materials shipped from Company stock. The materials required to fill the balance of sales are obtained from other sources, such as direct mill shipments to customers or purchases from other distributors. Deliveries are made principally by the Company’s fleet contracted through third party logistics providers. Common carrier delivery is used in areas not serviced directly by the Company’s fleet.\nAt December 31, 2012, the Company had 1,701 full-time employees. Of these, approximately 250 are represented by collective bargaining units, principally the United Steelworkers of America and International Brotherhood of Teamsters.\nBusiness Segments\nThe Company distributes and performs processing on both metals and plastics. Although the distribution processes are similar, the customer markets, supplier bases and types of products are different. Additionally, the Company’s Chief Executive Officer, the chief operating decision-maker, reviews and manages these two businesses separately. As such, these businesses are considered reportable segments and are reported accordingly in the Company’s various public filings. Neither of the Company’s reportable segments has any unusual working capital requirements.\nIn the last three years, the percentages of total sales of the two segments were as follows:\n| 2012 | 2011 | 2010 |\n| Metals | 90 | % | 90 | % | 89 | % |\n| Plastics | 10 | % | 10 | % | 11 | % |\n| 100 | % | 100 | % | 100 | % |\n\nMetals Segment\nIn its Metals segment, the Company’s marketing strategy focuses on distributing highly engineered specialty grades and alloys of metals as well as providing specialized processing services designed to meet very precise specifications. Core products include alloy, aluminum, nickel, stainless steel, carbon and titanium. Inventories of\n4\nthese products assume many forms such as plate, sheet, extrusions, round bar, hexagon bar, square and flat bar, tubing and coil. Depending on the size of the facility and the nature of the markets it serves, a service center is equipped as needed with bar saws, plate saws, oxygen and plasma arc flame cutting machinery, trepanning machinery, boring machinery, honing equipment, water-jet cutting equipment, stress relieving and annealing furnaces, surface grinding equipment, and sheet shearing equipment.\nThe Company’s customer base is well diversified and therefore, the Company does not have dependence upon any single customer, or a few customers. Our customer base includes many Fortune 500 companies as well as thousands of medium and smaller sized firms.\nThe Company’s broad network of locations provides same or next-day delivery to most of the segment’s markets, and two-day delivery to substantially all of the remaining markets.\nPlastics Segment\nThe Company’s Plastics segment consists exclusively of a wholly-owned subsidiary that operates as Total Plastics, Inc. (“TPI”), headquartered in Kalamazoo, Michigan, and its wholly-owned subsidiaries. The Plastics segment stocks and distributes a wide variety of plastics in forms that include plate, rod, tube, clear sheet, tape, gaskets and fittings. Processing activities within this segment include cut-to-length, cut-to-shape, bending and forming according to customer specifications.\nThe Plastics segment’s diverse customer base consists of companies in the retail (point-of-purchase), automotive, marine, office furniture and fixtures, safety products, life sciences applications, and general manufacturing industries. TPI has locations throughout the upper northeast and midwest regions of the U.S. and one facility in Florida from which it services a wide variety of users of industrial plastics.\nJoint Venture\nThe Company holds a 50% joint venture interest in Kreher Steel Co. (“Kreher”), a metals distributor of bulk quantities of alloy, special bar quality and stainless steel bars, headquartered in Melrose Park, Illinois. The Company’s equity in the earnings of this joint venture is reported separately in the Company’s consolidated statements of operations. Kreher is considered a significant subsidiary under Rule 3-09 of Regulation S-X. Therefore, its stand-alone financial statements are included in this filing.\nAccess to SEC Filings\nThe Company makes available free of charge on or through its Web site at www.amcastle.com the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the U.S. Securities and Exchange Commission (the “SEC”). Information on our website does not constitute part of this annual report on Form 10-K.\nITEM 1A —\nRisk Factors\nOur business, financial condition, results of operations, and cash flows are subject to various risks, many of which are not exclusively within our control that may cause actual performance to differ materially from historical or projected future performance. The risks described below are not the only risks we face. Any of the following risks, as well as other risks and uncertainties not currently known to us or that we currently consider to be immaterial, could materially and adversely affect our business, financial condition, results of operations, or cash flows.\nWe may not achieve all of the expected benefits from our restructuring and performance enhancement initiatives.\nWe have recently begun implementing restructuring actions in our metals business, including organizational restructuring, warehouse realignments and performance improvement programs. We expect these measures will result in improvements to annualized operating profits of approximately $33.0 million once fully implemented in 2013. In addition, we continue to evaluate additional options to improve efficiency and performance of our operations. We have made certain assumptions in estimating the anticipated impact of our restructuring and performance enhancement initiatives. These assumptions may turn out to be incorrect due to a variety of factors. In addition, our ability to realize the expected benefits from these initiatives is subject to significant business, economic, and competitive uncertainties and contingencies, many of which are beyond our control. Some of our cost saving measures may not have the impact on our operating profitability that we currently project. If we are unsuccessful in implementing these initiatives or if we do not achieve our expected results, our results of operations and cash flows could be materially adversely affected.\n5\nOur substantial level of indebtedness could adversely affect our financial condition and prevent us from fulfilling our obligations under our debt instruments.\nWe have substantial debt service obligations. As of December 31, 2012, we had approximately $322.5 million of total debt outstanding, excluding capital lease obligations of $1.4 million, of which $264.5 million is secured. As of December 31, 2012, the Company had approximately $50.5 million of availability under our revolving credit facility. Subject to restrictions contained in the debt instruments, we may incur additional indebtedness.\nOur substantial level of indebtedness could have significant effects on our business, including the following:\n\n| • | it may be more difficult for us to satisfy our financial obligations; |\n\n| • | our ability to obtain additional financing for working capital, capital expenditures, strategic acquisitions or general corporate purposes may be impaired; |\n\n| • | we must use a substantial portion of our cash flow from operations to pay interest on our indebtedness, which will reduce the funds available to use for operations and other purposes; |\n\n| • | our ability to fund a change of control offer under our debt instruments may be limited; |\n\n| • | our substantial level of indebtedness could place us at a competitive disadvantage compared to our competitors that may have proportionately less debt; |\n\n| • | our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate may be limited; and |\n\n| • | our substantial level of indebtedness may make us more vulnerable to economic downturns and adverse developments in our business. |\n\nWe expect to obtain the funds to pay our expenses and to repay our indebtedness primarily from our operations and, in the case of our indebtedness, from the refinancing thereof. Our ability to meet our expenses and make these payments therefore depends on our future performance, which will be affected by financial, business, economic and other factors, many of which we cannot control. Our business may not generate sufficient cash flow from operations in the future, and our currently anticipated growth in revenue and cash flow may not be realized, either or both of which could result in our being unable to repay indebtedness or to fund other liquidity needs. If we do not have enough funds, we may be required to refinance all or part of our then existing debt, sell assets or borrow more funds, which we may not be able to accomplish on terms acceptable to us, or at all. In addition, the terms of existing or future debt agreements may restrict us from pursuing any of these alternatives.\nOur debt instruments impose significant operating and financial restrictions, which may prevent us from pursuing certain business opportunities and taking certain actions and our failure to comply with the covenants contained in our debt instruments could result in an event of default that could adversely affect our operating results.\nOur debt agreements impose, and future debt agreements may impose, operating and financial restrictions on us. These restrictions limit or prohibit, among other things, our ability to:\n\n| • | incur additional indebtedness unless certain financial tests are satisfied or issue disqualified capital stock; |\n\n| • | pay dividends, redeem subordinated debt or make other restricted payments; |\n\n| • | make certain investments or acquisitions; |\n\n| • | issue stock of subsidiaries; |\n\n| • | grant or permit certain liens on our assets; |\n\n| • | enter into certain transactions with affiliates; |\n\n| • | merge, consolidate or transfer substantially all of our assets; |\n\n| • | incur dividend or other payment restrictions affecting certain of our subsidiaries; |\n\n| • | transfer, sell or acquire assets, including capital stock of our subsidiaries; and |\n\n| • | change the business we conduct. |\n\nThese covenants could adversely affect our ability to finance our future operations or capital needs, withstand a future downturn in our business or the economy in general, engage in business activities, including future opportunities that may be in our interest, and plan for or react to market conditions or otherwise execute our business strategies. A breach of any of these covenants could result in a default in respect of the related indebtedness. If a default occurs, the relevant lenders or holders of such indebtedness could elect to declare the indebtedness, together with accrued interest and other fees, to be immediately due and payable and proceed against any collateral securing that indebtedness. If the maturity of our indebtedness is accelerated, we may not have sufficient cash resources to satisfy our debt obligations and may not be able to continue our operations as planned.\n6\nWe may not be able to generate sufficient cash to service all of our existing debt service obligations, and may be forced to take other actions to satisfy our obligations under our debt agreements, which may not be successful.\nOur annual debt service obligations until December 2015, when our revolving credit facility is scheduled to mature, will be primarily limited to interest payments on our outstanding debt securities, with an aggregate principal amount of $282.5 million, and on borrowings under our $100.0 million revolving credit facility of $39.5 million as of December 31, 2012. Our ability to make scheduled payments on or to refinance our debt obligations depends on our future financial condition and operating performance, which are subject to prevailing economic and competitive conditions and to certain financial, business and other factors beyond our control. Our business may not generate sufficient cash flow from operations in the future and our currently anticipated levels of revenue and cash flow may not be realized, either or both of which could result in our being unable to repay indebtedness or to fund other liquidity needs. Therefore, we may not be able to maintain or realize a level of cash flows from operating activities sufficient to permit us to pay the principal, premium, if any, and interest on our indebtedness.\nIf our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay investments and capital expenditures, sell assets, seek additional capital or restructure or refinance our indebtedness. Our ability to restructure or refinance our debt will depend on the condition of the capital markets and our financial condition at such time. Any refinancing of our debt could be at higher interest rates and may require us to comply with more onerous borrowing covenants, which could further restrict our business operations. The terms of existing or future debt instruments may restrict us from adopting some of these alternatives. In addition, any failure to make payments of principal and interest on our outstanding indebtedness on a timely basis would likely result in a reduction of our credit rating, which could harm our ability to incur additional indebtedness. These alternative measures may not be successful and may not permit us to meet our scheduled debt service obligations.\nOur future operating results depend on the volatility of the prices of metals and plastics, which could cause our results to be adversely affected.\nThe prices we pay for raw materials, both metals and plastics, and the prices we charge for products may fluctuate depending on many factors, including general economic conditions (both domestic and international), competition, production levels, import duties and other trade restrictions and currency fluctuations. To the extent metals and plastics prices decline, we would generally expect lower sales and possibly lower net income, depending on the timing of the price changes and the ability to pass price changes on to our customers. To the extent we are not able to pass on to our customers any increases in our raw materials prices, our operating results may be adversely affected. In addition, because we maintain substantial inventories of metals and plastics in order to meet short lead-times and the just-in-time delivery requirements of our customers, a reduction in our selling prices could result in lower profitability or, in some cases, losses, either of which could adversely impact our ability to remain in compliance with certain financial covenants contained in our debt instruments, as well as result in us incurring impairment charges.\nDisruptions or shortages in the supply of raw materials could adversely affect our operating results and our ability to meet our customers’ demands.\nOur business requires materials that are sourced from third party suppliers. If for any reason our primary suppliers of metals should curtail or discontinue their delivery of raw materials to us at competitive prices and in a timely manner, our operating results could suffer. Unforeseen disruptions in our supply bases could materially impact our ability to deliver products to customers. The number of available suppliers could be reduced by factors such as industry consolidation and bankruptcies affecting metals and plastics producers, or suppliers may be unwilling or unable to meet our demand due to industry supply conditions generally. If we are unable to obtain sufficient amounts of raw materials from our traditional suppliers, we may not be able to obtain such raw materials from alternative sources at competitive prices to meet our delivery schedules, which could have an adverse impact on our operating results. To the extent we have quoted prices to customers and accepted orders for products prior to purchasing necessary raw materials, or have existing contracts, we may be unable to raise the price of products to cover all or part of the increased cost of the raw materials to our customers.\nIn some cases the availability of raw materials requires long lead times. As a result, we may experience delays or shortages in the supply of raw materials. If unable to obtain adequate and timely deliveries of required raw materials, we may be unable to timely supply customers with sufficient quantities of products. This could cause us to lose sales, incur additional costs, or suffer harm to our reputation.\n7\nIncreases in freight and energy prices would increase our operating costs and we may be unable to pass these increases on to our customers in the form of higher prices, which may adversely affect our operating results.\nWe use energy to process and transport our products. The prices for and availability of energy resources are subject to volatile market conditions, which are affected by political, economic and regulatory factors beyond our control. Our operating costs increase if energy costs, including electricity, diesel fuel and natural gas, rise. During periods of higher freight and energy costs, we may not be able to recover our operating cost increases through price increases without reducing demand for our products. In addition, we typically do not hedge our exposure to higher freight or energy prices.\nWe service industries that are highly cyclical, and any downturn in our customers’ industries could reduce our revenue and profitability.\nMany of our products are sold to customers in industries that experience significant fluctuations in demand based on economic conditions, energy prices, consumer demand, availability of adequate credit and financing, customer inventory levels, changes in governmental policies and other factors beyond our control. As a result of this volatility in the industries we serve, when one or more of our customers' industries experiences a decline, we may have difficulty increasing or maintaining our level of sales or profitability if we are not able to divert sales of our products to customers in other industries. We have made a strategic decision to focus sales resources on certain industries, specifically the aerospace, oil and gas and heavy equipment, machine tools and general industrial equipment industries. A downturn in these industries has had, and may in the future continue to have, an adverse effect on our operating results. We are also particularly sensitive to market trends in the manufacturing sector of the North American economy.\nA portion of our sales, particularly in the aerospace industry, are related to contracts awarded to our customers under various U.S. Government defense-related programs. Significant changes in defense spending, or in government priorities and requirements could impact the funding, or the timing of funding, of those defense programs, which could negatively impact our results of operations and financial condition.\nOur industry is highly competitive, which may force us to lower our prices and may have an adverse effect on our operating results.\nThe principal markets that we serve are highly competitive. Competition is based principally on price, service, quality, processing capabilities, inventory availability and timely delivery. We compete in a highly fragmented industry. Competition in the various markets in which we participate comes from a large number of value-added metals processors and service centers on a regional and local basis, some of which have greater financial resources than we do and some of which have more established brand names in the local markets we serve. We also compete to a lesser extent with primary metals producers who typically sell to very large customers requiring shipments of large volumes of metal. Increased competition could force us to lower our prices or to offer increased services at a higher cost to us, which could have an adverse effect on our operating results.\nOur operating results are subject to the seasonal nature of our customers’ businesses.\nA portion of our customers experience seasonal slowdowns. Historically, our revenues in the months of July, November and December have been lower than in other months because of a reduced number of shipping days and holiday or vacation closures for some customers. Consequently, our sales in the first two quarters of the year are usually higher than in the third and fourth quarters. As a result, analysts and investors may inaccurately estimate the effects of seasonality on our operating results in one or more future quarters and, consequently, our operating results may fall below expectations.\nWe rely upon our suppliers as to the specifications of the metals we purchase from them.\nWe rely on mill certifications that attest to the physical and chemical specifications of the metal received from our suppliers for resale and generally, consistent with industry practice, do not undertake independent testing of such metals. We rely on our customers to notify us of any metal that does not conform to the specifications certified by the supplying mill. Although our primary sources of products have been domestic mills, we have and will continue to purchase product from foreign suppliers when we believe it is appropriate. In the event that metal purchased from domestic suppliers is deemed to not meet quality specifications as set forth in the mill certifications or customer specifications, we generally have recourse against these suppliers for both the cost of the products purchased and possible claims from our customers. However, such recourse will not compensate us for the damage to our reputation that may arise from sub-standard products and possible losses of customers. Moreover, there is a greater level of risk that similar recourse will not be available to us in the event of claims by our customers related to products from foreign\n8\nsuppliers that do not meet the specifications set forth in the mill certifications. In such circumstances, we may be at greater risk of loss for claims for which we do not carry, or do not carry sufficient, insurance.\nWe are vulnerable to interest rate fluctuations on our indebtedness, which could hurt our operating results.\nWe are exposed to various interest rate risks that arise in the normal course of business. We finance our operations with fixed and variable rate borrowings. Market risk arises from changes in variable interest rates. Under our revolving credit facility, our interest rate on borrowings is subject to changes based on fluctuations in the LIBOR and prime rates of interest. If interest rates significantly increase, we could be unable to service our debt which could have an adverse effect on our operating results.\nWe operate in international markets, which expose us to a number of risks.\nAlthough a substantial majority of our business activity takes place in the United States, we serve and operate in certain international markets, which expose us to political, economic and currency related risks, including the following:\n| • | potential for adverse change in the local political or social climate or in government policies, laws and regulations; |\n\n| • | difficulty staffing and managing geographically diverse operations and the application of foreign labor regulations; |\n\n| • | restrictions on imports and exports or sources of supply; |\n\n| • | currency exchange rate risk; and |\n\n| • | change in duties and taxes. |\n\nWe operate in Canada, Mexico, France, and the United Kingdom, with limited operations in Singapore and China. An act of war or terrorism or major pandemic event could disrupt international shipping schedules, cause additional delays in importing our products into the United States or increase the costs required to do so. In addition, acts of crime or violence in these international markets (for example, in Mexico) could adversely affect our operating results. Fluctuations in the value of the U.S. dollar versus foreign currencies could reduce the value of these assets as reported in our financial statements, which could reduce our stockholders' equity. If we do not adequately anticipate and respond to these risks and the other risks inherent in international operations, it could have a material adverse effect on our operating results.\nWe may not be able to realize the benefits we anticipate from our acquisitions, including the Tube Supply acquisition.\nIn December 2011 we acquired Tube Supply, Inc. We intend to continue to seek attractive opportunities to acquire other businesses in the future. Achieving the benefits of these acquisitions depends on the timely, efficient and successful execution of a number of post-acquisition events, including our integration of the acquired businesses. Factors that could affect our ability to achieve the benefits we anticipate from our acquisition include:\n| • | difficulties in integrating and managing personnel, financial reporting and other systems used by the acquired businesses; |\n\n| • | the failure of the acquired businesses to perform in accordance with our expectations; |\n\n| • | failure to achieve anticipated synergies between our business units and the acquired businesses; |\n\n| • | the loss of the acquired businesses' customers; and |\n\n| • | cyclicality of business. |\n\nThe presence of any of the above factors individually or in combination could result in future impairment charges against the assets of the acquired businesses. If the acquired businesses do not operate as we anticipate, it could adversely affect our operating results and financial condition. As a result, there can be no assurance that the acquisitions, including the Tube Supply acquisition, will be successful or will not, in fact, adversely affect our business.\nOur business could be adversely affected by a disruption to our primary distribution hub.\nOur largest facility, in Franklin Park, Illinois, serves as a primary distribution center that ships product to our other facilities as well as external customers. Our business could be adversely impacted by a major disruption at this facility due to unforeseen developments occurring in or around the facility, such as:\n| • | damage to or inoperability of our warehouse or related systems; |\n\n| • | a prolonged power or telecommunication failure; |\n\n| • | a natural disaster, environmental or public health issue; or |\n\n| • | an airplane crash or act of war or terrorism on-site or nearby as the facility is located within seven miles of O'Hare International Airport (a major U.S. airport) and lies below certain take-off and landing flight patterns. |\n\n9\nA prolonged disruption of the services and capabilities of our Franklin Park facility and operation could adversely impact our operating results.\nDamage to or a disruption in our information technology systems could impact our ability to conduct business and/or report our financial performance.\nOver the last several years we have been implementing a new enterprise-wide resources planning (''ERP'') system. While we have completed the conversions of substantially all of our North American and European locations onto the new ERP system, we can provide no assurance that the continued phased-implementation at our remaining facilities, including Tube Supply, will be successful or will occur as planned. Difficulties associated with the design and implementation of the new ERP system could adversely affect our business, our customer service and our operating results.\nWe rely on information technology systems to provide inventory availability to our sales and operating personnel, improve customer service through better order and product reference data and monitor operating results. Difficulties associated with upgrades or integration with new systems could lead to business interruption that could harm our reputation, increase our operating costs and decrease profitability. In addition, any significant disruption relating to our current or new information technology systems, whether due from such things as fire, flood, tornado and other natural disasters, power loss, network failures, loss of data, security breaches and computer viruses, or otherwise, may have an adverse effect on our business, our operating results and our ability to report our financial performance in a timely manner.\nA portion of our workforce is represented by collective bargaining units, which may lead to work stoppages.\nAs of December 31, 2012, approximately 15% of our U.S. employees were represented by unions under collective bargaining agreements, including hourly warehouse employees at our primary distribution center in Franklin Park, Illinois. As these agreements expire, there can be no assurance that we will succeed in concluding collective bargaining agreements with the union to replace those that expire. Although we believe that our labor relations have generally been satisfactory, we cannot predict how stable our relationships with these labor organizations will be or whether we will be able to meet union requirements without impacting our operating results and financial condition. The unions may also limit our flexibility in dealing with our workforce. Work stoppages and instability in our union relationships could negatively impact the timely processing and shipment of our products, which could strain relationships with customers and adversely affect our operating results.\nAn impairment or restructuring charge could have an adverse effect on our operating results.\nWe continue to evaluate opportunities to reduce costs and improve operating performance. These actions could result in restructuring and related charges, including but not limited to asset impairments, employee termination costs, charges for pension benefits, and pension curtailments that could be significant, which could adversely affect our financial condition and results of operations.\nWe have a significant amount of long-lived assets, including goodwill and intangible assets. We review the recoverability of goodwill annually or whenever significant events or changes occur which might impair the recovery of recorded costs, making certain assumptions regarding future operating performance. We review the recoverability of definite lived intangible assets and other long-lived assets whenever significant events or changes occur which might impair the recovery of recorded costs, making certain assumptions regarding future operating performance. The results of these calculations may be affected by the current or further declines in the market conditions for our products, as well as interest rates and general economic conditions. If impairment is determined to exist, we will incur impairment losses, which will have an adverse effect on our operating results and our ability to remain in compliance with certain financial covenants contained in our debt instruments.\nWe could incur substantial costs in order to comply with, or to address any violations under, environmental and employee health and safety laws, which could adversely affect our operating results.\nOur operations are subject to various environmental statutes and regulations, including laws and regulations governing materials we use. In addition, certain of our operations are subject to international, federal, state and local environmental laws and regulations that impose limitations on the discharge of pollutants into the air and water and establish standards for the treatment, storage and disposal of solid and hazardous wastes. Our operations are also subject to various employee safety and health laws and regulations, including those concerning occupational injury and illness, employee exposure to hazardous materials and employee complaints. Certain of our facilities are located in industrial areas, have a history of heavy industrial use and have been in operation for many years and, over time, we and other\n10\npredecessor operators of these facilities have generated, used, handled and disposed of hazardous and other regulated wastes. Currently unknown cleanup obligations at these facilities, or at off-site locations at which materials from our operations were disposed, could result in future expenditures that cannot be currently quantified but which could have an adverse effect on our operating results.\nWe may face risks associated with current or future litigation and claims.\nFrom time to time, we are involved in a variety of lawsuits, claims and other proceedings relating to the conduct of our business. These suits concern issues including contract disputes, employment actions, employee benefits, taxes, environmental, health and safety, personal injury and product liability matters. Due to the uncertainties of litigation, we can give no assurance that we will prevail on all claims made against us in the lawsuits that we currently face or that additional claims will not be made against us in the future. While it is not feasible to predict the outcome of all pending lawsuits and claims, we do not believe that the disposition of any such pending matters is likely to have an adverse effect on our financial condition or liquidity, although the resolution in any reporting period of one of more of these matters could have an adverse effect on our operating results for that period. Also, we can give no assurance that any other lawsuits or claims brought in the future will not have an adverse effect on our financial condition, liquidity or operating results.\nPotential environmental legislative and regulatory actions could impose significant costs on the operations of our customers and suppliers, which could have a material adverse impact on our results of operations, financial condition and cash flows.\nClimate change regulation or some form of legislation aimed at reducing greenhouse gas (''GHG'') emissions is currently being considered in the United States as well as globally. As a metals and plastics distributor, our operations do not emit significant amounts of GHG. However, the manufacturing processes of many of our suppliers and customers are energy intensive and generate carbon dioxide and other GHG emissions. Any adopted future climate change and GHG regulations may impose significant costs on the operations of our customers and suppliers and indirectly impact our operations.\nThe Tube Supply acquisition significantly extends our exposure in the oil and gas sector to customers who utilize non-traditional drilling techniques, including hydraulic fracturing. Hydraulic fracturing is an important and commonly used process for the completion of natural gas, and to a lesser extent, oil wells in shale formations. Certain environmental and other groups have asserted that chemicals used in the fracturing process could adversely affect drinking water supplies. The U.S. Congress and various state and local governments are considering increased regulatory oversight of the hydraulic fracturing process, including through additional permit requirements, operational restrictions, reporting obligations and temporary or permanent bans on hydraulic fracturing in certain environmentally sensitive areas such as watersheds. We cannot predict whether such laws or regulations will be enacted and, if so, what actions any such laws or regulations would require or prohibit. Additional levels of regulatory oversight on, or otherwise limiting, the hydraulic fracturing process could subject the business and operations of our oil and gas customers to delays, increased operating costs and process prohibitions, and indirectly impact our oil and gas business through reduced demand for our products.\nUntil the timing, scope and extent of any future regulation becomes known, we cannot predict the effect on our results of operations, financial condition and cash flows.\nCommodity hedging transactions may expose us to loss or limit our potential gains.\nWe have entered into certain fixed price sales contracts with customers which expose us to risks associated with fluctuations in commodity prices. As part of our risk management program, we may use financial instruments from time-to-time to mitigate all or portions of these risks, including commodity futures, forwards or other derivative instruments. While intended to reduce the effects of the commodity price fluctuations, these transactions may limit our potential gains or expose us to losses. Also, should our counterparties to such transactions fail to honor their obligations due to financial distress we would be exposed to potential losses or the inability to recover anticipated gains from these transactions.\nOwnership of our stock is concentrated, which may limit stockholders’ ability to influence corporate matters.\nAs of December 31, 2012, based on filings made with the SEC and other information made available to us as of that date, we believe Patrick J. Herbert, III, one of our directors, may be deemed to beneficially own approximately 22.8% of our common stock. Accordingly, Mr. Herbert and his affiliates may have the voting power to substantially control the outcome of matters requiring a stockholder vote including the election of directors and the approval of significant\n11\ncorporate matters. Such a concentration of control could adversely affect the market price of our common stock or prevent a change in control or other business combinations that might be beneficial to us.\nWe have various mechanisms in place that may prevent a change in control that stockholders may otherwise consider favorable.\nOn August 31, 2012, our Board of Directors adopted a shareholder rights plan pursuant to which one purchase right was distributed as a dividend on each share of our common stock held of record as of the close of business on September 11, 2012. Upon becoming exercisable, each right will entitle its holder to purchase from the Company one one-hundredth of a share of our Series B Junior Preferred Stock for the purchase price of $54.00. Generally, the rights will become exercisable ten days after the date on which any person or group becomes the beneficial owner of 10% or more of our common stock or has commenced a tender or exchange offer which, if consummated, would result in any person or group becoming the beneficial owner of 10% or more of our common stock, subject to the terms and conditions set forth in the shareholder rights plan. The rights are attached to the certificates representing outstanding shares of common stock until the rights become exercisable, at which point separate certificates will be distributed to the record holders of our common stock. If a person or group becomes the beneficial owner of 10% or more of our common stock, which we refer to as an “acquiring person,” each right will entitle its holder, other than the acquiring person, to receive upon exercise a number of shares of our common stock having a market value of two times the purchase price of the right.\nThe shareholder rights plan is designed to deter coercive takeover tactics and to prevent an acquirer from gaining control of the Company without offering a fair price to all of our stockholders. The existence of the shareholder rights plan, however, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding common stock, and thereby adversely affect the market price of our common stock.\nIn addition, our charter and by-laws and the Maryland General Corporation Law, or the MGCL, include provisions that may be deemed to have antitakeover effects and may delay, defer or prevent a takeover attempt that stockholders might consider to be in their best interests. For example, the MGCL, our charter and bylaws require the approval of the holders of two-thirds of the votes entitled to be cast on the matter to amend our charter (unless our Board of Directors has unanimously approved the amendment, in which case the approval of the holders of a majority of such votes is required), contain certain advance notice procedures for nominating candidates for election to our Board of Directors, and permit our Board of Directors to issue up to 9.988 million shares of preferred stock.\nFurthermore, we are subject to the anti-takeover provisions of the MGCL that prohibit us from engaging in a “business combination” with an “interested stockholder” for a period of five years after the date of the transaction in which the person first becomes an “interested stockholder,” unless the business combination or stockholder interest is approved in a prescribed manner. The application of these and certain other provisions of our charter could have the effect of delaying or preventing a change of control, which could adversely affect the market price of our common stock.\nThe provisions of our debt instruments also contain limitations on our ability to enter into change of control transactions. In addition, the repurchase rights in our 7.0% convertible senior notes due 2017 (“Convertible Notes”) triggered by the occurrence of a “fundamental change” (as defined in the indenture for the Convertible Notes), and the additional shares of our common stock by which the conversion rate is increased in connection with certain fundamental change transactions, as described in the indenture for the Convertible Notes, could discourage a potential acquirer.\nWe may not have the cash necessary to satisfy our cash obligations under our Convertible Notes.\nAs of December 31, 2012, we had approximately $57.5 million of aggregate principal amount outstanding under the Convertible Notes. The Convertible Notes bear cash interest semiannually at a rate of 7.0% per year, and mature on December 15, 2017. Upon the occurrence of a fundamental change (as defined in the indenture for the Convertible Notes), we may be required to repurchase some or all of the Convertible Notes for cash at a repurchase price equal to 100% of the principal amount of the Convertible Notes being repurchased, plus any accrued and unpaid interest up to but excluding the relevant fundamental change repurchase date. We may not have sufficient funds to satisfy such cash obligations and, in such circumstances, may not be able to arrange the necessary financing on favorable terms or at all. In addition, our ability to satisfy such cash obligations will be restricted pursuant to covenants contained in the indenture for the Convertible Notes and will be permitted to be paid only in limited circumstances. We may also be limited in our ability to satisfy such cash obligations by applicable law or the terms of other instruments governing our indebtedness. Our inability to make cash payments to satisfy our obligations described above would trigger an event of default under the Convertible Notes, which in turn could constitute an event of default under any of our outstanding indebtedness, thereby resulting in the acceleration of such indebtedness, the prepayment of which could further restrict our ability to satisfy such cash obligations.\n12\nThe conditional conversion features of our Convertible Notes, if triggered, may adversely affect our financial condition and operating results.\nIn the event the conditional conversion features of the Convertible Notes are triggered, holders of the Convertible Notes will be entitled to convert the Convertible Notes at any time during specified periods at their option. If one or more holders elect to convert their Convertible Notes, and we elect or are deemed to have elected cash settlement or combination settlement, we would be required to pay cash to satisfy all or a portion of our conversion obligation for such Convertible Notes, which could adversely affect our liquidity. In addition, even if holders do not elect to convert their Convertible Notes, we could be required under applicable accounting rules to reclassify all or a portion of the outstanding principal of the Convertible Notes as a current rather than long-term liability, which would result in a material reduction of our net working capital.\nITEM 1B —\nUnresolved Staff Comments\nNone.\nITEM 2 —\nProperties\nThe Company’s corporate headquarters are located in Oak Brook, Illinois. All properties and equipment are sufficient for the Company’s current level of activities. Distribution centers and sales offices are maintained at each of the following locations, most of which are leased, except as indicated:\n| Locations | ApproximateFloor Area inSquare Feet |\n| Metals Segment |\n| North America |\n| Bedford Heights, Ohio | 374,400 | (1) |\n| Birmingham, Alabama | 76,000 | (1) |\n| Blaine, Minnesota | 65,200 | (1) |\n| Charlotte, North Carolina | 116,500 | (1) |\n| Edmonton, Alberta | 87,103 |\n| Fairless Hills, Pennsylvania | 71,600 | (1) |\n| Franklin Park, Illinois | 522,600 | (1) |\n| Gardena, California | 117,000 |\n| Grand Prairie, Texas | 78,000 | (1) |\n| Hammond, Indiana (H-A Industries) | 243,000 |\n| Houston, Texas | 383,100 | (3) |\n| Kansas City, Missouri | 118,000 |\n| Kennesaw, Georgia | 87,500 |\n| Kent, Washington | 53,000 |\n| Lafayette, Louisiana | 5,000 |\n| Mississauga, Ontario | 57,000 |\n| Orange, Connecticut | 57,389 |\n| Paramount, California | 155,500 |\n| Point Claire, Quebec | 38,760 |\n| Santa Cantarina, Nuevo Leon, Mexico | 112,000 |\n| Saskatoon, Saskatchewan | 15,000 |\n| Selkirk, Manitoba | 50,000 | (1) |\n| Stockton, California | 60,000 |\n| Twinsburg, Ohio | 120,000 |\n| Wichita, Kansas | 95,000 |\n\n13\n| Locations | ApproximateFloor Area inSquare Feet |\n| Worcester, Massachusetts | 53,500 | (1) |\n| Europe |\n| Blackburn, England | 62,139 |\n| Letchworth, England | 40,000 |\n| Trafford Park, England | 30,000 |\n| Montoir de Bretagne, France | 38,944 |\n| Asia |\n| Shanghai, China | 45,700 |\n| Sales Offices |\n| Bilbao, Spain | (Intentionally left blank) |\n| Fairfield, Ohio |\n| Milwaukee, Wisconsin |\n| Phoenix, Arizona |\n| Singapore |\n| Tulsa, Oklahoma |\n| Total Metals Segment | 3,428,935 |\n| Plastics Segment |\n| Baltimore, Maryland | 24,000 |\n| Cleveland, Ohio | 8,600 |\n| Cranston, Rhode Island | 14,990 |\n| Detroit, Michigan | 22,000 |\n| Elk Grove Village, Illinois | 22,500 |\n| Fort Wayne, Indiana | 17,600 |\n| Grand Rapids, Michigan | 42,500 | (1) |\n| Harrisburg, Pennsylvania | 13,900 |\n| Indianapolis, Indiana | 13,500 |\n| Kalamazoo, Michigan | 81,000 |\n| Knoxville, Tennessee | 16,530 |\n| Maple Shade, New Jersey | 12,480 |\n| Mt. Vernon, New York | 30,000 |\n| New Philadelphia, Ohio | 15,700 |\n| Pittsburgh, Pennsylvania | 12,800 |\n| Rockford, Michigan | 53,600 |\n| Tampa, Florida | 17,700 |\n| Worcester, Massachusetts | 2,500 | (1) |\n| Total Plastics Segment | 421,900 |\n| Headquarters |\n| Oak Brook, Illinois | 39,360 | (2) |\n| GRAND TOTAL | 3,890,195 |\n\n| (1) | Represents owned facility. |\n\n| (2) | The Company’s principal executive offices do not include a distribution or sales office. |\n\n| (3) | Represents two leased facilities (274,000 square feet) and one owned facility (109,100 square feet). |\n\n14\nITEM 3 —\nLegal Proceedings\n(Amounts in thousands)\nThe Company is party to a variety of legal proceedings and other claims, including proceedings by government authorities, which arise from the operation of its business. These proceedings are incidental and occur in the normal course of the Company's business affairs. The majority of these claims and proceedings relate to commercial disputes with customers, suppliers, and others; employment, including benefit matters; product quality; and environmental, health and safety claims. It is the opinion of management that the currently expected outcome of these proceedings and claims, after taking into account recorded accruals and the availability and limits of our insurance coverage, will not have a material adverse effect on the consolidated results of operations, financial condition or cash flows of the Company.\nGovernment Proceeding\nIn 2011, the Company determined that it inadvertently exported certain aluminum alloy bar that are listed on the U.S. Bureau of Industry and Security's (BIS) Commerce Control List to countries where there is an export license requirement if an exception is not otherwise available. The exports, which occurred in 2011, had a total transaction value of approximately $13 and were made without export licenses. The exports involved five shipments to the Company's wholly-owned subsidiary in China and to a customer in the Philippines. In response thereto, the Company submitted a voluntary self-disclosure describing the nature of these shipments to the Office of Export Enforcement of the Department of Commerce (OEE) in accordance with applicable Export Administration Regulations. If it is determined that the Company failed to comply with the applicable U.S. export regulations, the OEE could assess civil penalties of up to $1,250, restrict export privileges or provide an administrative warning. While the ultimate disposition of this matter cannot be predicted with certainty, it is the opinion of management, based on the information available at this time, that the outcome of this matter will not have a material effect on the Company's financial position, results of operations or cash flows.\nITEM 4 —\nMine Safety Disclosures\nNot applicable.\nExecutive Officers of The Registrant\nThe following selected information for each of our current executive officers (as defined by regulations of the SEC) was prepared as of March 4, 2013.\n| Name and Title | Age | Business Experience |\n| Patrick R. AndersonVice President, CorporateController and Chief Accounting Officer | 41 | Mr. Anderson began his employment with the registrant in 2007 and was elected to the position of Vice President, Corporate Controller and Chief Accounting Officer. Prior to joining the registrant, he was employed as a Senior Manager with Deloitte & Touche LLP (a global accounting firm) where he was employed from 1994 to 2007. |\n| Scott J. DolanPresident and Chief Executive Officer | 42 | Mr. Dolan most recently served as Senior Vice President, Airport Operations and Cargo, of United Continental Holdings, Inc. (a $37 billion publicly traded provider of passenger and cargo air transportation services), and its principal wholly-owned subsidiaries, United Airlines and Continental Airlines, from 2010 to 2011. From 2004 until 2010, Mr. Dolan served as Senior Vice President, Airport Operations and President, United Cargo (2006-2010) and as Senior Vice President and President, United Cargo (2004-2006) for UAL Corporation and its principal subsidiary, United Airlines. Mr. Dolan worked at Atlas Air Worldwide Holdings, Inc. (a global airfreight company) from 2002 to 2004, where he served as Senior Vice President and Chief Operating Officer from 2003-2004 and as Vice President, Business Integration from 2002 to 2003. Prior to joining Atlas Air, Mr. Dolan spent five years at General Electric Company, where he served in a variety of positions including Vice President, Operational Performance, Polar Air Cargo, a subsidiary of GE Capital Aviation Services. |\n\n15\n| Name and Title | Age | Business Experience |\n| Thomas L. GarrettVice President andPresident, Total Plastics, Inc. | 50 | Mr. Garrett began his employment with Total Plastics, Inc., a wholly owned subsidiary of the registrant, in 1988 and was appointed to the position of Controller. In 1996, he was elected to the position of Vice President and in 2001 was appointed to the position of Vice President of the registrant and President of Total Plastics, Inc. |\n| Kevin H. GlynnVice Presidentand Chief Information Officer | 49 | Mr. Glynn began his employment with the registrant in October 2010 as the Interim Chief Information Officer. In January 2011 he was appointed Vice President and Chief Information Officer. Prior to joining the registrant, he was employed as a Managing Principal at Laminar Group LLC (a management consulting company) from 2009 to 2010, Chief Operating Officer at IRON Solutions, Inc. (an information technology company specializing in data, software and media services for the agriculture equipment market) from 2008 to 2009 and as Senior Vice President and Chief Information Officer at CNH America, LLC (a manufacturer of agricultural and construction equipment) from 2006 to 2007. |\n| Robert J. PernaVice President,General Counsel and Secretary | 49 | Mr. Perna began his employment with the registrant in 2008 and was elected to the position of Vice President-General Counsel and Secretary. Prior to joining the registrant he was General Counsel, North America, CNH America, LLC (a manufacturer of agricultural and construction equipment) since 2007, and he also served as Associate General Counsel and Corporate Secretary for Navistar International Corporation (a manufacturer of commercial trucks and diesel engines) since 2001. |\n| Anne D. ScharmVice President, Human Resources | 36 | Ms. Scharm began her employment with the registrant in 2011 as the Director of Organizational Development. In December 2011, she was appointed as the Interim Vice President, Human Resources. In March 2012, she was appointed Vice President, Human Resources. Prior to joining the registrant, she was employed as Director of Human Resources and Organizational Development with Delnor Health System, (now known as Cadence Health - a healthcare organization) from 2006 to 2011. |\n| Scott F. StephensVice President,Chief Financial Officer and Treasurer | 43 | Mr. Stephens began his employment with the registrant in 2008 and was elected to the position of Vice President, Chief Financial Officer, and Treasurer. From February 2010 to December 2010, he was also appointed to the position of Interim President, Castle Metals Oil & Gas. In May 2012, Mr. Stephens was elected to serve as Interim Chief Executive Officer until October 2012. Formerly, he served as the CFO of Lawson Products, Inc. (a distributor of services, systems and products to the MRO and OEM marketplace) from 2004 to 2008, and CFO of The Wormser Company from 2001 to 2004. |\n| Blain A. TiffanyChief Commercial Officer | 54 | Mr. Tiffany began his employment with the registrant in 2000 and was appointed to the position of District Manager. He was appointed Eastern Region Manager in 2003, Vice President – Regional Manager in 2005 and in 2006 was appointed to the position of Vice President – Sales. In 2007, Mr. Tiffany was appointed to the position of Vice President, President of Castle Metals Plate. In 2009, Mr. Tiffany served as Vice President, President of Castle Metals Aerospace through 2011. In 2012, Mr. Tiffany served as Vice President, Castle Metals and in January 2013 was appointed to the position of Chief Commercial Officer. |\n\n16\nPART II\n\nITEM 5 —\nMarket for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities\nThe Company’s common stock trades on the New York Stock Exchange under the ticker symbol “CAS”. As of March 1, 2013 there were approximately 880 shareholders of record. Payment of cash dividends and repurchase of common stock are currently limited due to restrictions contained in the Company’s debt agreements. No cash dividends were paid on the Company’s common stock in 2012 and 2011. We may consider paying cash dividends on the Company common stock at some point in the future, subject to the limitations described above. Any future payment of cash dividends, if any, is at the discretion of the Board of Directors and will depend on the Company’s earnings, capital requirements and financial condition, restrictions under the Company’s debt instruments, and such other factors as the Board of Directors may consider.\nSee Part III, Item 12, “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters”, for information regarding common stock authorized for issuance under equity compensation plans.\nThe table below presents shares of the Company’s common stock which were acquired by the Company during the quarter ended December 31, 2012:\n| Period | TotalNumber ofSharesPurchased(1) | AveragePricePaid perShare | Total numberof SharesPurchased asPart ofPubliclyAnnouncedPlans orPrograms | MaximumNumber (orApproximateDollar Value) of Shares that May Yet Be Purchased under the Plans or Programs |\n| October 1 through October 31 | — | — | — | — |\n| November 1 through November 30 | — | — | — | — |\n| December 1 through December 31 | 24,469 | $ | 14.77 | — | — |\n| Total | 24,469 | $ | 14.77 | — | — |\n\n| (1) | The total number of shares purchased represents shares surrendered to the Company by employees to satisfy tax withholding obligations upon vesting of restricted stock units awarded pursuant to the Company’s 2010 - 2012 Long-Term Compensation Plan. |\n\nOn October 15, 2012 the Company granted 78,492 restricted stock units to Scott J. Dolan, President and Chief Executive Officer, as an equity inducement award. The restricted stock units subject to the inducement award will vest in four equal annual installments, subject to Mr. Dolan's continued employment by the Company. At the time of vesting, the Company will issue to Mr. Dolan in cancellation of the restricted stock units, the number of shares of common stock of the Company equal to the number of restricted stock units. The inducement award was granted outside of the Company's 2008 Omnibus Incentive Plan, authorized by the independent members of the Human Resources Committee of the Company's Board of Directors and granted as an inducement material to Mr. Dolan's employment with the Company in accordance with Section 303A.08 of the New York Stock Exchange Listed Company Manual. The issuance of these shares of restricted stock units was made in reliance upon the exemptions form registration provided by Section 4(2) under the Securities Act of 1933, as amended.\nThe following table sets forth the range of the high and low sales prices of shares of the Company’s common stock for the periods indicated:\n| 2012 | 2011 |\n| Low | High | Low | High |\n| First Quarter | $ | 9.59 | $ | 12.90 | $ | 15.14 | $ | 19.29 |\n| Second Quarter | $ | 9.65 | $ | 14.20 | $ | 15.25 | $ | 19.24 |\n| Third Quarter | $ | 6.99 | $ | 13.54 | $ | 10.37 | $ | 18.46 |\n| Fourth Quarter | $ | 10.83 | $ | 14.97 | $ | 7.85 | $ | 14.91 |\n\n17\nThe following graph compares the cumulative total stockholder return on our common stock for the five-year period ended December 31, 2012, with the cumulative total return of the Standard and Poor’s 500 Index and to a peer group index. The comparison in the graph assumes the investment of $100 on December 31, 2007. Cumulative total stockholder return means share price increases or decreases plus dividends paid, with the dividends reinvested, and reflect market capitalization weighting. The graph does not forecast future performance of our common stock. The Company moved to a new peer group index during 2010 in conjunction with the establishment of a relative total shareholder return performance measure under the Company’s long term compensation plan. The Company believes this new peer group provides a more meaningful comparison of our stock performance. The new peer group index is made up of companies in the metals industry or in the industrial products distribution business, although not all of the companies included in the new peer group index participate in all of the lines of business in which the Company is engaged and some of the companies included in the peer group index also engage in lines of business in which the Company does not participate. Additionally, the market capitalizations of many of the companies in the peer group are quite different from that of the Company.\nCOMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*\nAmong A.M. Castle & Co., the S&P 500 Index, and a Peer Group\n*$100 invested on 12/31/07 in stock or index, including reinvestment of dividends.\nFiscal year ending December 31.\nCopyright© 2013 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved.\n| 12/07 | 12/08 | 12/09 | 12/10 | 12/11 | 12/12 |\n| A. M. Castle & Co. | $ | 100.00 | $ | 40.32 | $ | 51.30 | $ | 68.99 | $ | 35.45 | $ | 55.35 |\n| S&P 500 | 100.00 | 63.00 | 79.67 | 91.67 | 93.61 | 108.59 |\n| Peer Group (a) | 100.00 | 51.46 | 69.81 | 84.89 | 76.47 | 78.43 |\n\n\n| (a) | The Peer Group Index consists of the following companies: AEP Industries Inc.; AK Steel Holding Corp.; Allegheny Technologies Inc.; Amcol International Corp.; Applied Industrial Technologies Inc.; Carpenter Technology Corp.; Cliffs Natural Resources Inc.; Commercial Metals Company; Fastenal Company; Gibraltar Industries Inc.; Haynes International Inc.; Kaman Corp.; Lawson Products Inc.; MSC Industrial Direct Company Inc.; Nucor Corp.; Olin Corp.; Olympic Steel, Inc.; Quanex Building Products Corp.; Reliance Steel & Aluminum Co.; RTI International Metals Inc.; Schnitzer Steel Industries Inc.; Steel Dynamics Inc.; Stillwater Mining Company; Texas Industries Inc.; United States Steel Corp.; and Worthington Industries Inc. |\n\n18\nITEM 6 —\nSelected Financial Data\nThe Selected Financial Data in the table below includes the results of the December 2011 and January 2008 acquisitions of Tube Supply and Metals U.K., respectively, from the date of acquisition.\n| (dollars in millions, except per share data) | 2012 | 2011 | 2010 | 2009 | 2008 |\n| For the year ended December 31: |\n| Net sales | $ | 1,270.4 | $ | 1,132.4 | $ | 943.7 | $ | 812.6 | $ | 1,501.0 |\n| Equity in earnings of joint venture | 7.2 | 11.7 | 5.6 | 0.4 | 8.8 |\n| Net loss from continuing operations | (9.7 | ) | (1.8 | ) | (5.6 | ) | (26.9 | ) | (17.1 | ) |\n| Basic (loss) earnings per common share from continuing operations | (0.42 | ) | (0.08 | ) | (0.25 | ) | (1.18 | ) | (0.76 | ) |\n| Diluted (loss) earnings per common share from continuing operations | (0.42 | ) | (0.08 | ) | (0.25 | ) | (1.18 | ) | (0.76 | ) |\n| Cash dividends declared per common share | — | — | — | 0.06 | 0.24 |\n| As of December 31: |\n| Total assets | 788.8 | 822.3 | 529.4 | 558.0 | 679.0 |\n| Long-term debt, less current portion | 296.2 | 314.2 | 61.1 | 67.7 | 75.0 |\n| Total debt | 297.1 | 314.9 | 69.1 | 89.2 | 117.1 |\n| Total stockholders’ equity | 337.3 | 312.3 | 313.5 | 318.2 | 347.3 |\n\nITEM 7 —\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations\nAmounts in millions except per share data\nInformation regarding the business and markets of A.M. Castle & Co. and its subsidiaries (the “Company”), including its reportable segments, is included in Item 1 “Business” of this annual report on Form 10-K.\nThe following discussion should be read in conjunction with Item 6 “Selected Financial Data” and the Company’s consolidated financial statements and related notes thereto in Item 8 “Financial Statements and Supplementary Data”.\nEXECUTIVE OVERVIEW\nThe Company’s strategy is to become the foremost global provider of specialty metals products and services and specialized supply chain solutions to targeted global industries.\nDuring 2012, the following significant events occurred which impacted the Company’s operations and/or financial results:\n\n| • | Lower LIFO charges and the inclusion of Tube Supply's activity in 2012 resulted in decreased cost of materials as a percentage of sales to 73.0% in 2012 compared to 74.7% in 2011; |\n\n| • | Increased operating income as a percentage of sales to 3.2%, up from 0.5% in 2011; |\n\n| • | Expanded operations in the United Kingdom to support the continued increase in aerospace defense program business; and |\n\n| • | In the first four months of 2012, the Company recognized $15.6 million of interest expense related to the mark-to-market adjustment on the conversion option associated with the convertible debt. In April, the Company reclassified the cumulative value of the conversion option associated with the convertible debt to additional paid-in capital as a result of the authorization of additional shares of common stock and the conversion option is no longer required to be marked-to-market through earnings. |\n\nRecent Market and Pricing Trends\nThe Company experienced decreased demand from its customer base during the second half of 2012 in the Metals segment as customer buying patterns slowed to reflect a more cautious outlook. Industry data indicates that U.S. service center steel shipments were higher than 2011 levels by approximately 1%, while U.S. service center aluminum shipments were approximately 1% lower in 2012 compared to 2011 levels. Virtually all key end-use\n19\nmarkets experienced decreases in demand in the Company’s Metals segment during 2012. The Plastics segment experienced an increase in demand for its products in 2012 compared to 2011, reflecting continued strength in the automotive sector. Due to the late-cycle nature of the Company’s targeted customers, results typically lag the general economic cycle by twelve months.\nPricing across the majority of the Company’s markets started strong during 2012 and then softened for the majority of the year. The combination of factors above negatively impacted the Company’s operating results during the last three quarters of 2012.\nChanges in pricing can have a more direct impact on the Company’s operating results than changes in volume due to certain factors including but not limited to:\n\n| • | Changes in volume typically result in corresponding changes to the Company’s variable costs. However, as pricing changes occur, variable expenses are not directly impacted. |\n\n| • | If surcharges are not passed through to the customer or are passed through without a mark-up, the Company’s profitability will be adversely impacted. |\n\nCurrent Business Outlook\nManagement uses the Purchasing Managers Index (‘PMI’) provided by the Institute for Supply Management (website is www.ism.ws) as an external indicator for tracking the demand outlook and possible trends in its general manufacturing markets. The table below shows PMI trends from the first quarter of 2010 through the fourth quarter of 2012. Generally speaking, according to the ISM, an index above 50.0 indicates growth in the manufacturing sector of the U.S. economy, while readings under 50.0 indicate contraction.\n| YEAR | Qtr 1 | Qtr 2 | Qtr 3 | Qtr 4 |\n| 2010 | 58.2 | 58.8 | 55.4 | 56.8 |\n| 2011 | 61.1 | 56.4 | 51.0 | 52.4 |\n| 2012 | 53.3 | 52.7 | 50.3 | 50.6 |\n\nMaterial pricing and demand in both the Metals and Plastics segments of the Company’s business have historically proven to be difficult to predict with any degree of accuracy. A favorable PMI trend suggests that demand for some of the Company’s products and services, in particular those that are sold to the general manufacturing customer base in the U.S., could potentially be at a higher level in the near-term. The PMI trended upward from late 2012 levels in the first two months of 2013 to 53.1 in January and 54.2 in February. The Company believes that its revenue trends typically correlate to the changes in PMI on a six to twelve month lag basis.\nRESULTS OF OPERATIONS: YEAR-TO-YEAR COMPARISONS AND COMMENTARY\nOur discussion of comparative period results is based upon the following components of the Company’s consolidated statements of operations.\nNet Sales —The Company derives its sales from the processing and delivery of metals and plastics. Pricing is established with each customer order and includes charges for the material, processing activities and delivery. The pricing varies by product line and type of processing. From time to time the Company may enter into fixed price arrangements with customers while simultaneously obtaining similar agreements with its suppliers.\nCost of Materials — Cost of materials consists of the costs that the Company pays suppliers for metals, plastics and related inbound freight charges, excluding depreciation and amortization which are included in operating costs and expenses discussed below. The Company accounts for inventory primarily on a last-in-first-out (“LIFO”) basis. LIFO adjustments are calculated as of December 31 of each year. The Company may enter into hedges to mitigate the risk associated with commodity price fluctuations. Gains and losses which result from marking the hedge contracts to market are recorded in cost of materials.\nOperating Costs and Expenses — Operating costs and expenses primarily consist of:\n\n| • | Warehouse, processing and delivery expenses, including occupancy costs, compensation and employee benefits for warehouse personnel, processing, shipping and handling costs; |\n\n| • | Sales expenses, including compensation and employee benefits for sales personnel; |\n\n20\n| • | General and administrative expenses, including compensation for executive officers and general management, expenses for professional services primarily related to accounting and legal advisory services, bad debt expense, data communication, computer hardware and maintenance and foreign currency gain or loss; and |\n\n| • | Depreciation and amortization expenses, including depreciation for all owned property and equipment, and amortization of various intangible assets. |\n\n2012 Results Compared to 2011\nAs a result of the acquisition of Tube Supply in December 2011, the full year results were included in the Company's Metals segment during 2012.\nConsolidated results by business segment are summarized in the following table for years 2012 and 2011.\nOperating Results by Segment\n| Year Ended December 31, | Fav / (Unfav) |\n| 2012 | 2011 | $ Change | % Change |\n| Net Sales |\n| Metals | $ | 1,143.9 | $ | 1,014.2 | $ | 129.7 | 12.8 | % |\n| Plastics | 126.5 | 118.2 | 8.3 | 7.0 | % |\n| Total Net Sales | $ | 1,270.4 | $ | 1,132.4 | $ | 138.0 | 12.2 | % |\n| Cost of Materials |\n| Metals | $ | 836.3 | $ | 763.0 | $ | (73.3 | ) | (9.6 | )% |\n| % of Metals Sales | 73.1 | % | 75.2 | % |\n| Plastics | 91.0 | 82.6 | (8.4 | ) | (10.2 | )% |\n| % of Plastics Sales | 71.9 | % | 69.9 | % |\n| Total Cost of Materials | $ | 927.3 | $ | 845.6 | $ | (81.7 | ) | (9.7 | )% |\n| % of Total Sales | 73.0 | % | 74.7 | % |\n| Operating Costs and Expenses |\n| Metals | $ | 257.8 | $ | 237.7 | $ | (20.1 | ) | (8.5 | )% |\n| Plastics | 32.3 | 32.7 | 0.4 | 1.2 | % |\n| Other | 11.9 | 11.2 | (0.7 | ) | (6.3 | )% |\n| Total Operating Costs & Expenses | $ | 302.0 | $ | 281.6 | $ | (20.4 | ) | (7.2 | )% |\n| % of Total Sales | 23.8 | % | 24.9 | % |\n| Operating Income (Loss) |\n| Metals | $ | 49.8 | $ | 13.5 | $ | 36.3 | 268.9 | % |\n| % of Metals Sales | 4.4 | % | 1.3 | % |\n| Plastics | 3.2 | 2.9 | 0.3 | 10.3 | % |\n| % of Plastics Sales | 2.5 | % | 2.5 | % |\n| Other | (11.9 | ) | (11.2 | ) | (0.7 | ) | (6.3 | )% |\n| Total Operating Income | $ | 41.1 | $ | 5.2 | $ | 35.9 | 690.4 | % |\n| % of Total Sales | 3.2 | % | 0.5 | % |\n\n“Other” includes costs of executive, legal and finance departments which are shared by both segments of the Company.\nNet Sales:\nConsolidated net sales were $1,270.4 million in 2012, an increase of $138.0 million, or 12.2%, versus 2011. Metals segment net sales during 2012 of $1,143.9 million were $129.7 million, or 12.8%, higher than 2011. Tube Supply contributed net sales of $178.5 million in 2012 compared to $7.6 million for the two-week period ended December 31, 2011. Excluding Tube Supply results, net sales for the Metals segment were $41.2 million lower in\n21\n2012 compared to 2011. Lower net sales were primarily the result of lower shipping volumes. Average tons sold per day, excluding Tube Supply, decreased 3.9% compared to the prior year. The decrease in demand experienced in 2012 was driven primarily by SBQ bar, carbon bar and aluminum products. Excluding Tube Supply, gains in the oil and gas business were offset by weakness in the industrial business in 2012 compared to 2011.\nPlastics segment net sales during 2012 of $126.5 million were $8.3 million, or 7.0%, higher than 2011 primarily due to increased sales volume, reflecting continued strength in the automotive sector.\nCost of Materials:\nCost of materials (exclusive of depreciation and amortization) were $927.3 million, an increase of $81.7 million, or 9.7%, compared to 2011. Material costs for the Metals segment were $836.3 million or 73.1% as a percent of net sales compared to $763.0 million or 75.2% as a percent of net sales in 2011. Tube Supply cost of materials were $118.7 million in 2012 compared to $5.3 million for the two-week period ended December 31, 2011. During 2011, the Company implemented a commodity hedging program to mitigate the risks associated with certain commodity price fluctuations. The 2012 results include a $0.4 million charge associated with the realized and unrealized losses for forward contracts related to the commodity hedging program compared to a $2.4 million charge in 2011. Cost of materials for the Metals segment include a LIFO charge of $1.1 million in 2012 compared to $15.1 million in 2011. The remaining increase in cost of materials for the Metals segment is consistent with the sales volume increase year-over-year.\nMaterial costs for the Plastics segment were 71.9% as a percent of net sales in 2012 as compared to 69.9% for the same period last year due to higher costs experienced in the automotive sector of the business.\nOperating Expenses and Operating Income (Loss):\nOperating costs and expenses increased $20.4 million, or 7.2%, compared to last year. Operating costs and expenses for 2012 were $302.0 million, or 23.8% as a percent of net sales, compared to $281.6 million million, or 24.9% as a percent of net sales last year. Operating costs related to Tube Supply were $32.9 million in 2012 compared to $0.9 million in 2011.\nDuring the second quarter of 2012, the Company incurred costs associated with executive employment transition in the amount of $1.6 million. As a result of the transition, share-based awards were forfeited, which resulted in a significant increase in the Company’s forfeiture rate. The increase in the forfeiture rate estimate associated with the active Long-term Compensation Plans resulted in a decrease in sales, general and administrative cost of approximately $1.0 million. The net impact of the employment transition costs on sales, general and administrative expense was approximately $0.6 million.\nThe increase in operating expenses for 2012 compared to 2011 primarily relates to the following:\n\n| • | Warehouse, processing and delivery costs increased by $13.4 million of which a $15.6 million increase is associated with the increase for Tube Supply for the period. The Tube Supply impact was offset by a $2.2 million decrease primarily attributed to a decline in workers’ compensation, overtime wage, temporary employee and utilities costs, partially offset by an increase in compensation and benefits expense as a result of headcount, merit and healthcare cost increases and rent expense due to a full year of expense for the expanded facility in Mexico, which was substantially completed in 2011 and rent expense for the new facility in Trafford Park, United Kingdom during 2012; |\n\n| • | Sales, general and administrative costs increased by $1.6 million of which a $9.8 million increase is associated with the increase for Tube Supply for the period. The net impact of the CEO transition costs of $0.6 million and an increase to bad debt reserves for customer bankruptcies of $0.8 million were included in the 2012 results. The 2011 results include a $0.9 million charge for export penalties related to product shipments that occurred from 2005 to 2008 and $4.3 million for charges related to the acquisition of Tube Supply. The remaining decrease of $4.6 million is primarily attributed to a decline incentive compensation and other compensation and benefits costs, partially offset by an increase in workers' compensation and outside services costs; and |\n\n| • | Depreciation and amortization expense was $5.4 million higher than 2011 primarily due to the depreciation and amortization of Tube Supply’s fixed and intangible assets acquired in December 2011. |\n\nConsolidated operating income for 2012 was $41.1 million compared to $5.2 million in 2011.\n22\nOther Income and Expense, Income Taxes and Net Loss:\nInterest expense was $56.7 million in 2012, an increase of $36.9 million versus 2011 as a result of interest charges on the Company’s new senior secured and convertible notes, as well as the unrealized loss for the mark-to-market adjustment on the conversion option associated with the convertible notes.\nThe increase in interest expense for 2012 compared to the prior year is a result of the following:\n\n| • | Increase for the non-cash interest charge of $11.6 million associated with the mark-to-market adjustment on the conversion option associated with the convertible notes, which is not deductible for federal income tax purposes; |\n\n| • | Increase for interest on senior secured and convertible notes of $31.0 million; and |\n\n| • | Increase for amortization of deferred financing fees and debt discount of $1.1 million. |\n\nIn addition to items above, there was a loss on extinguishment of the Company’s existing long-term notes of $6.2 million and a charge for underwriting fees associated with the debt financing of $3.4 million recorded in 2011.\nThe Company recorded income tax expense of $1.4 million in 2012 compared to a tax benefit of $1.1 million in 2011. The Company’s effective tax rate is expressed as ‘Income tax benefit’ (which includes tax expense on the Company’s share of joint venture earnings) as a percentage of ‘Loss before income taxes and equity in earnings of joint venture.’ This calculation includes taxes on the joint venture income but excludes joint venture income. The effective tax rate for 2012 and 2011 was 9.2% and 7.7%, respectively. The change in the effective tax rate for 2012 compared to 2011 was primarily the result of the non-deductibility of the change in the mark-to-market adjustment on the conversion option associated with the convertible notes in the amount of $11.6 million.\nEquity in earnings of the Company’s joint venture was $7.2 million in 2012 compared to $11.7 million in 2011. The decrease is a result of lower demand in virtually all of the joint venture’s end-use markets compared to last year.\nConsolidated net loss for 2012 was $9.7 million, or $0.42 per diluted share, compared to net loss of $1.8 million, or $0.08 per diluted share, for 2011.\n23\n2011 Results Compared to 2010\nConsolidated results by business segment are summarized in the following table for years 2011 and 2010.\nOperating Results by Segment\n| Year Ended December 31, | Fav / (Unfav) |\n| 2011 | 2010 | $ Change | % Change |\n| Net Sales |\n| Metals | $ | 1,014.2 | $ | 841.1 | $ | 173.1 | 20.6 | % |\n| Plastics | 118.2 | 102.6 | 15.6 | 15.2 | % |\n| Total Net Sales | $ | 1,132.4 | $ | 943.7 | $ | 188.7 | 20.0 | % |\n| Cost of Materials |\n| Metals | $ | 763.0 | $ | 631.1 | $ | (131.9 | ) | (20.9 | )% |\n| % of Metals Sales | 75.2 | % | 75.0 | % |\n| Plastics | 82.6 | 69.8 | (12.8 | ) | (18.3 | )% |\n| % of Plastics Sales | 69.9 | % | 68.0 | % |\n| Total Cost of Materials | $ | 845.6 | $ | 700.9 | $ | (144.7 | ) | (20.6 | )% |\n| % of Total Sales | 74.7 | % | 74.3 | % |\n| Operating Costs and Expenses |\n| Metals | $ | 237.7 | $ | 215.5 | $ | (22.2 | ) | (10.3 | )% |\n| Plastics | 32.7 | 29.3 | (3.4 | ) | (11.6 | )% |\n| Other | 11.2 | 7.4 | (3.8 | ) | (51.4 | )% |\n| Total Operating Costs & Expenses | $ | 281.6 | $ | 252.2 | $ | (29.4 | ) | (11.7 | )% |\n| % of Total Sales | 24.9 | % | 26.7 | % |\n| Operating (Loss) Income |\n| Metals | $ | 13.5 | $ | (5.5 | ) | $ | 19.0 | 345.5 | % |\n| % of Metals Sales | 1.3 | % | (0.7 | )% |\n| Plastics | 2.9 | 3.6 | (0.7 | ) | (19.4 | )% |\n| % of Plastics Sales | 2.5 | % | 3.5 | % |\n| Other | (11.2 | ) | (7.4 | ) | (3.8 | ) | (51.4 | )% |\n| Total Operating (Loss) | $ | 5.2 | $ | (9.3 | ) | $ | 14.5 | 155.9 | % |\n| % of Total Sales | 0.5 | % | (1.0 | )% |\n\n“Other” includes costs of executive, legal and finance departments which are shared by both segments of the Company.\nNet Sales:\nConsolidated net sales were $1,132.4 million in 2011, an increase of $188.7 million, or 20.0%, versus 2010. Metals segment net sales during 2011 of $1,014.2 million were $173.1 million, or 20.6%, higher than 2010. Tube Supply contributed net sales of $7.6 million for the two-week period ended December 31, 2011. Higher net sales were primarily the result of higher shipping volumes. Average tons sold per day, excluding Tube Supply, increased 18.1% compared to the prior year. The increase in demand experienced in 2011 was driven primarily by SBQ bar, alloy bar, carbon and alloy plate, stainless and tubing products. Key end-use markets that experienced increased demand in 2011 compared to 2010 include oil and gas, mining and heavy equipment and general industrial markets.\nPlastics segment net sales during 2011 of $118.2 million were $15.6 million, or 15.2%, higher than 2010 primarily due to higher overall pricing and, to a lesser extent, increased sales volume. The Plastics business experienced increased sales volume during 2011 reflecting strength in the automotive and office furniture end-use markets compared to 2010.\n24\nCost of Materials:\nCost of materials (exclusive of depreciation and amortization) were $845.6 million, an increase of $144.7 million, or 20.6%, compared to 2010. Material costs for the Metals segment were $763.0 million or 75.2% as a percent of net sales compared to $631.1 million or 75.0% as a percent of net sales in 2010. Tube Supply cost of materials were $5.3 million for the two-week period ended December 31, 2011. During 2011, the Company implemented a commodity hedging program to mitigate the risks associated with certain commodity price fluctuations. The 2011 results include a $2.4 million charge associated with the mark-to-market adjustment for forward contracts related to the commodity hedging program compared to no charge in 2010. The Metals segment recorded LIFO expense of $15.1 million in 2011 compared to $7.7 million in 2010. The remaining increase in cost of materials for the Metals segment is consistent with the sales volume increase year-over-year.\nMaterial costs for the Plastics segment were 69.9% as a percent of net sales in 2011 as compared to 68.0% for the same period last year. The Plastics segment recorded LIFO expense of $0.9 million in 2011 compared to $0.3 million in 2010.\nDuring 2010, a reduction in inventories resulted in a liquidation of applicable LIFO inventory quantities carried at lower costs in prior years. On a consolidated basis, cost of materials for 2010 were lower by $12.5 million as a result of the liquidations.\nOperating Expenses and Operating Income (Loss):\nOperating costs and expenses increased $29.4 million, or 11.7%, compared to last year. Operating costs and expenses for 2011 were $281.6 million, or 24.9% as a percent of net sales, compared to $252.2 million, or 26.7% as a percent of net sales last year. Operating costs and expenses in 2011 include a $0.9 million charge for export penalties related to product shipments that occurred from 2005 to 2008 and in 2011 compared to no charge in 2010. Additionally, there were no facility consolidation charges during 2011 compared to $2.4 million in 2010.\nFull workweeks and 401(k) matching contributions were reinstated in January and April 2010, respectively, resulting in overall increases in payroll related costs in 2011 compared to 2010. Additionally, effective July 1, 2011, the Company’s 401(k) matching contribution was increased to 100% of each dollar on eligible employee contributions up to the first 6% of the employee’s pre-tax compensation. Effective July 1, 2011, the Company’s fixed contribution of 4% of eligible earnings for all employees was eliminated. Other factors that contributed to increased payroll related costs in 2011 compared to 2010 included merit increases and headcount increases.\nIn addition to payroll related costs, there were costs associated with the acquisition of Tube Supply in December 2011 of $4.3 million, as well as Tube Supply activity for the two-week period ended December 31, 2011 that contributed $0.9 million to the overall increase.\nThe $29.4 million increase in operating expenses in 2011 compared to 2010 primarily relates to the following:\n\n| • | Warehouse, processing and delivery costs increased by $11.6 million of which $4.1 million is due to increased compensation and benefits expenses as a result of headcount, merit and healthcare cost increases and $7.2 million is the result of increases in charges associated with higher sales volumes, such as warehouse, packing and shipping supplies, repairs and maintenance, utilities, outside services, overtime wages and temporary help. The warehouse, processing and delivery cost increase associated with Tube Supply for the two-week period ended December 31, 2011 amounted to $0.3 million; |\n\n| • | Sales, general and administrative costs increased by $17.9 million. The increase is primarily comprised of $4.3 million of direct acquisition-related costs, $7.1 million as a result of headcount, merit and healthcare cost increases and a $0.9 million charge for export penalties related to product shipments that occurred from 2005 to 2008 and in 2011. The sales, general and administrative cost increase associated with Tube Supply for the two-week period ended December 31, 2011 amounted to $0.3 million. The balance of the difference relates other administrative expenses including training, travel and insurance; and |\n\n| • | Depreciation and amortization expense decreased $0.1 million in 2011 compared to 2010. The depreciation and amortization expense for Tube Supply for the two-week period ended December 31, 2011 amounted to $0.3 million. |\n\nConsolidated operating income for 2011 was $5.2 million compared to operating loss of $9.3 million in 2010.\n25\nOther Income and Expense, Income Taxes and Net Loss:\nInterest expense was $13.7 million in 2011, an increase of $8.7 million versus 2010 as a result of charges associated with refinancing the Company’s debt in conjunction with the Tube Supply acquisition. The Company issued $225.0 million of senior secured notes and $57.5 million of convertible senior notes and entered into a $100.0 million senior secured asset based revolving credit facility.\nInterest expense for 2011 includes the following charges:\n\n| • | Non-cash interest charge of $4.0 million associated with the mark-to-market adjustment for the derivative liability component of the convertible notes, which is not deductible for federal income tax purposes; |\n\n| • | Non-cash interest charge of $0.2 million for the amortization of new debt origination fees; |\n\n| • | Interest on new debt of $1.6 million; and |\n\n| • | Underwriting fees of $3.4 million associated with the debt financing. |\n\nIn addition to increased interest expense, there was a loss on extinguishment of the Company’s existing long-term notes of $6.2 million, which is comprised of a non-cash charge of $0.9 million for the write-off of existing debt issuance costs and $5.2 million for the fees associated with the prepayment of the notes.\nThe Company recorded a tax benefit of $1.1 million in 2011 compared to a tax benefit of $3.1 million in 2010. The Company’s effective tax rate is expressed as ‘Income tax benefit’ (which includes tax expense on the Company’s share of joint venture earnings) as a percentage of ‘Loss before income taxes and equity in earnings of joint venture.’ This calculation includes taxes on the joint venture income but excludes joint venture income. The effective tax rate for 2011 and 2010 was 7.7% and 21.7%, respectively. The change in the tax rate was due primarily to the additional income tax on joint venture income compared to 2010 and the non-deductibility of the mark-to-market charge on the derivative liability component of the convertible notes.\nEquity in earnings of the Company’s joint venture was $11.7 million in 2011 compared to $5.6 million in 2010. The increase is a result of higher demand in virtually all of the joint venture’s end-use markets, most notably the oil and gas and automotive sectors, and higher pricing compared to last year.\nConsolidated net loss for 2011 was $1.8 million, or $0.08 per diluted share, compared to net loss of $5.6 million, or $0.25 per diluted share, for 2010.\nLiquidity and Capital Resources\nCash and cash equivalents decreased by $8.9 million and $6.2 million for the years ended December 31, 2012 and 2011, respectively, and increased by $8.4 million for the year ended December 31, 2010.\nThe Company’s principal sources of liquidity are cash provided by operations and available borrowing capacity to fund working capital needs and growth initiatives. Cash provided by operations for the year-ended December 31, 2012 was $5.4 million compared to cash used in operations of $46.3 million for the year-ended December 31, 2011 and cash provided by operations of $34.4 million for the year-ended December 31, 2010. Specific components of the change in working capital are highlighted below:\n\n| • | During 2012, cash receipts from customers exceeded net sales resulting in a $44.6 million cash flow source due to a decrease in accounts receivable compared to a $26.4 million cash flow use due to an increase in accounts receivable for 2011. Net sales increased 12.2% from 2011. Average receivable days outstanding was 49.0 days for 2012 and 50.3 for 2011. |\n\n| • | During 2012, inventory purchases exceeded sales of inventory resulting in a $29.3 million cash flow use due to an increase in inventory compared to a $39.4 million cash flow use due to an increase in inventory in 2011. Average days sales in inventory was 187.0 days for 2012 verses 128.5 days for 2011. |\n\n| • | During 2012, cash paid for inventories and other goods and services exceeded purchases resulting in a $38.0 million cash flow use due to a net decrease in accounts payable and accrued liabilities compared to a $9.7 million cash flow source due to a net increase in accounts payable and accrued liabilities for 2011. |\n\n| • | The Company received its 2010 federal income tax refund of approximately $2.0 million during February 2012 and its 2009 federal income tax refund of approximately $6.3 million during January 2011. |\n\n26\nIn December 2011, in conjunction with the acquisition of Tube Supply, the Company issued $225.0 million aggregate principal amount of 12.75% Senior Secured Notes due 2016, $57.5 million aggregate principal amount of 7.0% Convertible Senior Notes due 2017 and entered into a $100.0 million senior secured asset based revolving credit facility (the “New Revolving Credit Facility”). Net proceeds of $304.6 million were used to complete the Acquisition, pay-off amounts outstanding under our previous credit agreement and for general corporate purposes.\nHistorically, the Company’s primary uses of liquidity and capital resources have been capital expenditures, payments on debt (including interest payments), acquisitions and dividend payments. Management believes the Company will be able to generate sufficient cash from operations and planned working capital improvements to fund its ongoing capital expenditure programs and meet its debt obligations for at least the next twelve months. Furthermore, the Company does have available borrowing capacity under the New Revolving Credit Agreement. The new debt agreements impose significant operating and financial restrictions which may prevent the Company from certain business opportunities such as, making acquisitions or paying dividends among other things. The New Revolving Credit facility contains a springing financial maintenance covenant requiring the Company to maintain the ratio of EBITDA (as defined in the agreement) to fixed charges of 1.1 to 1.0 when excess availability is less than the greater of 10% of the calculated borrowing base (as defined in the agreement) or $10 million. In addition, if excess availability is less than the greater of 12.5% of the calculated borrowing base (as defined in the agreement) or $12.5 million, the lender has the right to take full dominion of the Company’s cash collections and apply these proceeds to outstanding loans under the New Revolving Credit Agreement (“cash dominion”). Based on the Company’s cash projections, it does not anticipate a scenario whereby cash dominion would occur during the next twelve months.\nThe Company is committed to maintaining a strong financial position through maintaining sufficient levels of available liquidity, managing working capital and monitoring the Company’s overall capitalization. Cash and cash equivalents at December 31, 2012 were $21.6 million and the Company had $50.5 million of available borrowing capacity under its New Revolving Credit Facility. Approximately 23% of the Company’s consolidated cash and cash equivalents balance resides in the United States. As foreign earnings are permanently reinvested, availability under the Company’s New Revolving Credit Facility would be used to fund operations in the United States should the need arise in the future.\nWorking capital at December 31, 2012 was $379.3 million compared to $349.0 million at December 31, 2011. The increase in working capital is primarily due to higher inventory of $31.7 million, prepaid expenses and other current assets of $4.7 million and lower accounts payable of $48.9 million, offset by lower accounts receivable of $42.7 million and lower cash of $8.9 million, from December 31, 2011 to 2012.\nThe Company monitors its overall capitalization by evaluating total debt to total capitalization. Total debt to total capitalization is defined as the sum of short- and long-term debt, divided by the sum of total debt and stockholders’ equity. Total debt to total capitalization was 46.8% at December 31, 2012 and 50.2% at December 31, 2011. As of April 26, 2012, the conversion option value of $42.0 million associated with the convertible debt, which was issued in December 2011, was reclassified from long-term debt to additional paid-in capital, resulting in a decrease to the debt to total capitalization at December 31, 2012. The deferred tax benefit of $8.3 million associated with the temporary difference between the financial reporting basis of the derivative liability and its tax basis at the date of issuance (December 15, 2011) was also reclassified to additional paid-in capital. Over the long-term, the Company plans to continue to improve its total debt to total capitalization by improving operating results, managing working capital and using cash generated from operations to repay outstanding debt. Going forward, as and when permitted by term of agreements noted above, depending on market conditions, the Company may decide in the future to refinance, redeem or repurchase its debt and take other steps to reduce its debt or lease obligations or otherwise improve its overall financial position and balance sheet.\nCapital Expenditures\nCash paid for capital expenditures for 2012 was $11.1 million compared to $11.7 million in 2011. The expenditures during 2012 were comprised of approximately $1.1 million of ERP and other information technology enhancements and $1.3 million related to existing and new facility expansions for additional automotive business in the Plastics segment and for additional aerospace defense business in the United Kingdom. The balance of the capital expenditures in 2012 are the result of normal equipment, building improvement and furniture and fixture upgrades throughout the year. Management believes that capital expenditures will approximate $14 million in 2013.\n27\nContractual Obligations and Other Commitments\nThe following table includes information about the Company’s contractual obligations that impact its short-term and long-term liquidity and capital needs. The table includes information about payments due under specified contractual obligations and is aggregated by type of contractual obligation. It includes the maturity profile of the Company’s consolidated long-term debt, operating leases and other long-term liabilities.\nAt December 31, 2012, the Company’s contractual obligations, including estimated payments by period, were as follows:\n| Payments Due In | Total | Less Than One Year | One toThree Years | Three toFive Years | More Than Five Years |\n| Long-term debt obligations (excluding capital lease obligations) | $ | 322.0 | $ | — | $ | 39.5 | $ | 282.5 | $ | — |\n| Interest payments on debt obligations (a) | 137.4 | 33.6 | 67.1 | 36.7 | — |\n| Capital lease obligations | 1.4 | 0.4 | 0.8 | 0.2 | — |\n| Operating lease obligations | 76.7 | 14.4 | 21.5 | 16.7 | 24.1 |\n| Purchase obligations (b) | 333.5 | 222.6 | 110.9 | — | — |\n| Other (c) | 8.1 | 8.1 | — | — | — |\n| Total | $ | 879.1 | $ | 279.1 | $ | 239.8 | $ | 336.1 | $ | 24.1 |\n\n| a) | Interest payments on debt obligations represent interest on all Company debt outstanding as of December 31, 2012. The interest payment amounts related to the variable rate component of the Company’s debt assume that interest will be paid at the rates prevailing at December 31, 2012. Future interest rates may change, and therefore, actual interest payments could differ from those disclosed in the table above. |\n\n| b) | Purchase obligations consist of raw material purchases made in the normal course of business. The Company has contracts to purchase minimum quantities of material with certain suppliers. For each contractual purchase obligation, the Company generally has a purchase agreement from its customer for the same amount of material over the same time period. |\n\n| c) | ‘Other’ is comprised of deferred revenues that represent commitments to deliver products and obligations related to recognizing and measuring tax positions taken or expected to be taken in a tax return that directly or indirectly affect amounts reported in financial statements. The uncertain tax positions included in the Company’s obligations are related to temporary differences and uncertain tax positions where the Company anticipates a high probability of settlement within a given timeframe. The years for which the temporary differences related to the uncertain tax positions will reverse have been estimated in scheduling the obligations within the table. |\n\nThe table and corresponding footnotes above do not include $10.7 million of other non-current liabilities recorded on the consolidated balance sheets. These non-current liabilities consist of liabilities related to the Company’s non-funded supplemental pension plan and postretirement benefit plans for which payment periods cannot be determined. Non-current liabilities also include $37.5 million of deferred income taxes, deferred gain on the sale of certain assets, derivative liability associated with commodity hedges and unfavorable lease liability for a lease entered into in conjunction with the Tube Supply acquisition, which was excluded from the table as the amounts due and timing of payments (or receipts) at future contract settlement dates cannot be determined.\nPension Funding\nThe Company’s funding policy on its defined benefit pension plans is to satisfy the minimum funding requirements of the Employee Retirement Income Security Act (“ERISA”). Future funding requirements are dependent upon various factors outside the Company’s control including, but not limited to, fund asset performance and changes in regulatory or accounting requirements. Based upon factors known and considered as of December 31, 2012, the Company does not anticipate making significant cash contributions to the pension plans in 2013.\nThe investment target portfolio allocation for the Company-sponsored pension plans and supplemental pension plan focuses primarily on corporate fixed income securities that match the overall duration and term of the Company’s pension liability structure. Refer to “Retirement Plans” within Critical Accounting Policies and Note 5 to the consolidated financial statements for additional details regarding other plan assumptions.\nOff-Balance Sheet Arrangements\n28\nWith the exception of letters of credit and operating lease financing on certain equipment used in the operation of the business, it is not the Company’s general practice to use off-balance sheet arrangements, such as third-party special-purpose entities or guarantees of third parties.\nAs of December 31, 2012, the Company had $6.8 million of irrevocable letters of credit outstanding which primarily consisted of $4.0 million for collateral associated with commodity hedges and $2.0 million for compliance with the insurance reserve requirements of its workers’ compensation insurance carriers.\nThe Company is party to certain multi-employer pension plans. The overall cost of such plans to the Company is insignificant. If the Company withdraws from a multi-employer pension plan in the future, it could potentially incur a withdrawal liability at that time.\nObligations of the Company associated with its leased equipment are disclosed under the “Contractual Obligations and Other Commitments” section above.\nCritical Accounting Policies\nThe consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America, and include amounts that are based on management’s estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. The following is a description of the Company’s accounting policies that management believes require the most significant judgments and estimates when preparing the Company’s consolidated financial statements:\nRevenue Recognition — Revenue from the sales of products is recognized when the earnings process is complete and when the title and risk and rewards of ownership have passed to the customer, which is primarily at the time of shipment. Revenue recognized other than at time of shipment represents less than 3% of the Company’s consolidated net sales. Revenue from shipping and handling charges is recorded in net sales. Provisions for allowances related to sales discounts and rebates are recorded based on terms of the sale in the period that the sale is recorded. Management utilizes historical information and the current sales trends of the business to estimate such provisions. Actual results could differ from these estimates. The provisions related to discounts and rebates due to customers are recorded as a reduction within net sales in the Company’s consolidated statements of operations and comprehensive loss.\nThe Company maintains an allowance for doubtful accounts resulting from the inability of our customers to make required payments. The allowance for doubtful accounts is maintained at a level considered appropriate based on historical experience and specific identification of customer receivable balances for which collection is unlikely. The provisions for doubtful accounts is recorded in sales, general and administrative expense in the Company’s consolidated statements of operations and comprehensive loss. Estimates of doubtful accounts are based upon historical write-off experience as a percentage of net sales and judgments about the probable effects of economic conditions on certain customers, which can fluctuate significantly from year to year. The Company cannot be certain that the rate of future credit losses will be similar to past experience.\nThe Company also maintains an allowance for credit memos for estimated credit memos to be issued against current sales. Estimates of allowance for credit memos are based upon the application of a historical issuance lag period to the average credit memos issued each month. If actual results differ significantly from historical experience, there could be a negative impact on the Company’s operating results.\nIncome Taxes — The Company’s income tax expense, deferred tax assets and liabilities and reserve for uncertain tax positions reflect management’s best estimate of taxes to be paid. The Company is subject to income taxes in the U.S. and several foreign jurisdictions. The determination of the consolidated income tax expense requires judgment and estimation by management. It is possible that actual results could differ from the estimates that management has used to determine its consolidated income tax expense.\nThe Company accounts for deferred income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statement and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.\n29\nValuation allowances are recorded against deferred tax assets when it is more likely than not that the amounts will not be realized, which will increase the provision for income taxes in the period in which that determination is made.\nThe Company has undistributed earnings of foreign subsidiaries of approximately $83.4 million at December 31, 2012, for which deferred taxes have not been provided. Such earnings are considered indefinitely invested in the foreign subsidiaries. If such earnings were repatriated, additional tax expense may result, although due to the potential availability of foreign tax credits and other items, the calculation of such additional taxes is not practicable.\nThe Company’s investment in the joint venture is through a 50% interest in a limited liability corporation (LLC) taxed as a partnership. The joint venture has two subsidiaries organized as individually taxed C-Corporations. The Company includes in its income tax provision the income tax liability on its share of the income of the joint venture and its subsidiaries. The income tax liability of the joint venture itself is generally treated as a current income tax expense and the income tax liability associated with the profits of the two subsidiaries of the joint venture is treated as deferred income tax expense. The Company can not independently cause a dividend to be declared by one of the subsidiaries of the joint venture, therefore no benefit of a dividend received deduction can be recognized in the Company's tax provision until a dividend is declared. If one of the C-Corporation subsidiaries of the joint venture declares a dividend payable to the joint venture, the Company recognizes a benefit for the 80% dividends received deduction on its 50% share of the dividend.\nThe Company’s income tax provisions are based on calculations and assumptions that are subject to examination by the IRS and other tax authorities. Although the Company believes that the positions taken on previously filed tax returns are reasonable, it has established tax and interest reserves in recognition that various taxing authorities may challenge the positions taken, which could result in additional liabilities for taxes and interest. The Company regularly reviews its deferred tax assets for recoverability considering historical profitability, projected future taxable income, the expected timing of the reversals of existing temporary differences and tax planning strategies.\nFor uncertain tax positions, the Company applies the provisions of relevant authoritative guidance, which requires application of a “more likely than not” threshold to the recognition and derecognition of tax positions. The Company’s ongoing assessments of the more likely than not outcomes of tax authority examinations and related tax positions require significant judgment and can increase or decrease the Company’s effective tax rate as well as impact operating results.\nRetirement Plans — The Company values retirement plan liabilities based on assumptions and valuations established by management. Future valuations are subject to market changes, which are not in the control of the Company and could differ materially from the amounts currently reported. The Company evaluates the discount rate and expected return on assets at least annually and evaluates other assumptions involving demographic factors, such as retirement age, mortality and turnover periodically, and updates them to reflect actual experience and expectations for the future. Actual results in any given year will often differ from actuarial assumptions because of economic and other factors.\nAccumulated and projected benefit obligations are expressed as the present value of future cash payments which are discounted using the weighted average of market-observed yields for high quality fixed income securities with maturities that correspond to the payment of benefits. Lower discount rates increase present values and subsequent-year pension expense; higher discount rates decrease present values and subsequent-year pension expense. Discount rates used for determining the Company’s projected benefit obligation for retirement plans were 3.50 - 3.75% and 4.25% at December 31, 2012 and 2011, respectively.\nThe Company’s pension plan asset portfolio as of December 31, 2012 is primarily invested in fixed income securities with a duration of approximately 12 years. The assets generally fall within Level 2 of the fair value hierarchy. Assets in the Company’s pension plans have earned approximately 12% since 2008 when the Company changed its target investment allocation to focus primarily on fixed income securities. The target investment asset allocation for the pension plans’ funds focuses primarily on corporate fixed income securities that match the overall duration and term of the Company’s pension liability structure. As of December 31, 2012 and 2011, the funding surplus was approximately 3% and 6%, respectively. To determine the expected long-term rate of return on the pension plans’ assets, current and expected asset allocations are considered, as well as historical and expected returns on various categories of plan assets.\n30\nThe Company used the following weighted-average discount rates and expected return on plan assets to determine the net periodic pension credit:\n| 2012 | 2011 |\n| Discount rate | 4.25 | % | 5.25 | % |\n| Expected long-term rate of return on plan assets | 5.75 | % | 6.50 | % |\n\nHolding all other assumptions constant, the following table illustrates the sensitivity of changes to the discount rate and long-term rate of return assumptions on the Company’s net periodic pension credit (amounts in millions):\n| Impact on 2012Expenses - increase (decrease) |\n| 50 basis point decrease in discount rate | $(1.1) |\n| 50 basis point increase in discount rate | $1.1 |\n| 50 basis point decrease in expected return on assets | $0.9 |\n\nGoodwill and Other Intangible Assets Impairment — The carrying value of the Company’s goodwill is evaluated annually on January 1st of each fiscal year or when certain triggering events occur which require a more current valuation. The Company assesses, at least quarterly, whether any triggering events have occurred.\nA two-step method is used for determining goodwill impairment. The first step is performed to identify whether a potential impairment exists by comparing each reporting unit’s fair value to its carrying value. If the carrying value of a reporting unit exceeds its fair value, the next step it to measure the amount of impairment loss, if any.\nThe determination of the fair value of the reporting units requires significant estimates and assumptions to be made by management. The fair value of each reporting unit is estimated using a combination of an income approach, which estimates fair value based on a discounted cash flow analysis using historical data, estimates of future cash flows and discount rates based on the view of a market participant, and a market approach, which estimates fair value using market multiples of various financial measures of comparable public companies. In selecting the appropriate assumptions the Company considers: the selection of appropriate peer group companies; control premiums appropriate for acquisitions in the industry in which the Company competes; discount rates; terminal growth rates; long-term projections of future financial performance; and relative weighting of income and market approaches. The long-term projections used in the valuation are developed as part of the Company’s annual budgeting and strategic planning process. The discount rates used to determine the fair values of the reporting units are those of a hypothetical market participant which are developed based upon an analysis of comparable companies and include adjustments made to account for any individual reporting unit specific attributes such as, size and industry.\nBased on the impairment test performed on January 1, 2012 (the Company's annual measurement date), the Company concluded that the fair values for each reporting unit exceeded the carrying values. Except for Aerospace and Oil & Gas, all other reporting units' fair values exceeded their carrying values by more than 10% as of January 1, 2012.\nThe Company has completed its January 1, 2013 annual goodwill impairment test. As of January 1, 2013, the Aerospace and Oil & Gas reporting units had goodwill balances of approximately $21 million and $20 million, respectively, and $0 of indefinite lived intangible assets. A combination of the income approach and the market approach was utilized to estimate the reporting units' fair values. The Aerospace and Oil & Gas reporting units both had estimated fair values that exceeded carry value by less than 10%. Under the income approach, the following key assumptions were used in the Company's discounted cash flow analysis:\n| Aerospace | Oil & Gas |\n| Discount rate | 15.0 | % | 14.0 | % |\n| 5-year CAGR | 4.2 | % | 1.5 | % |\n| Terminal growth rate | 3.0 | % | 3.0 | % |\n\n31\nUnder the market approach, the Company used a multiple of earnings before interest, taxes, depreciation and amortization (“EBITDA”) of 6.5 and 6.0 for Aerospace and Oil & Gas, respectively. The EBITDA multiple observed in the marketplace for recent transactions ranged from 6.0 to 8.7 with a median of 6.9 as of January 1, 2013. The Company considers several factors in estimating the EBITDA multiple including a reporting unit's market position, gross and operating margins and prospects for growth, among other factors.\nHolding all other assumptions in the model constant, the Company has summarized what the discount rate and EBITDA multiple would have to be (holding the other variable constant) in order for the fair value of Aerospace and Oil & Gas reporting units to fall below their respective carrying value:\n| Aerospace | Oil & Gas |\n| Discount rate | 16.5 | % | 14.8 | % |\n| EBITDA multiple | 5.8 | 5.6 |\n\nIf either reporting unit's carrying value exceeded its fair value, additional valuation procedures would have been required to determine whether the reporting unit's goodwill was impaired, and to the extent goodwill was impaired, the magnitude of the impairment charge.\nAlthough the Company believes its estimates of fair value are reasonable, actual financial results could differ from those estimates due to the inherent uncertainty involved in making such estimates. Changes in assumptions concerning future financial results or other underlying assumptions could have a significant impact on either the fair value of the reporting units, the amount of the goodwill impairment charge, or both. Future declines in the overall market value of the Company’s equity may also result in a conclusion that the fair value of one or more reporting units has declined below its carrying value.\nThe majority of the Company’s recorded intangible assets were acquired as part of the Transtar and Tube Supply acquisitions in September 2006 and December 2011, respectively, and consist of customer relationships, non-compete agreements, trade names and developed technology. The initial values of the intangible assets were based on a discounted cash flow valuation using assumptions made by management as to future revenues from select customers, the level and pace of attrition in such revenues over time and assumed operating income amounts generated from such revenues. The intangible assets are amortized over their useful lives, which are 4 to 12 years for customer relationships, 3 years for non-compete agreements, 1 to 10 years for trade names and 3 years for developed technology. Useful lives are estimated by management and determined based on the timeframe over which a significant portion of the estimated future cash flows are expected to be realized from the respective intangible assets. Furthermore, when certain conditions or certain triggering events occur, a separate test of impairment, similar to the impairment test for long-lived assets discussed below, is performed. If the intangible asset is deemed to be impaired, such asset will be written down to its fair value.\nSee Note 8 to the consolidated financial statements for detailed information on goodwill and intangible assets.\nLong-Lived Assets — The Company’s long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows (undiscounted and without interest charges) expected to be generated by the asset. If such assets are impaired, the impairment charge is calculated as the amount by which the carrying amount of the assets exceeds the fair value of the assets. Determining whether impairment has occurred typically requires various estimates and assumptions, including determining which undiscounted cash flows are directly related to the potentially impaired asset, the useful life over which cash flows will occur, their amount, and the asset’s residual value, if any. The Company derives the required undiscounted cash flow estimates from historical experience and internal business plans. Measurement of an impairment loss requires a determination of fair value. The Company uses an income approach, which estimates fair value based on estimates of future cash flows discounted at an appropriate interest rate.\nShare-Based Compensation — The Company offers share-based compensation to executive and other key employees, as well as its directors. Share-based compensation expense is recorded over the vesting period based on the grant date fair value of the stock award. Stock options have an exercise price equal to the market price of the Company’s stock on the grant date (options granted prior to 2010) or the average closing price of the Company’s stock for the ten trading days preceding the grant date (options granted in 2010) and have a contractual life of eight to ten years. Options and restricted stock generally vest in one to five years for executives and employees and three years for directors. The Company may either issue shares from treasury or new shares upon share option exercise.\n32\nStock options are valued based on the market price of the Company’s stock on the grant date, using a Black-Scholes option-pricing model. The expense associated with stock option awards is recorded on a straight-line basis over the vesting period, net of estimated forfeitures.\nThe grant date fair value for stock options granted during 2010 was estimated using the Black-Scholes option-pricing model with the following assumptions:\n| 2010 |\n| Expected volatility | 58.5 | % |\n| Risk-free interest rate | 2.3 | % |\n| Expected life (in years) | 5.5 |\n| Expected dividend yield | 1.2 | % |\n\nShare-based compensation expense for non-vested shares and restricted share units in the long-term compensation plans (“LTC Plans”) is established using the market price of the Company’s common stock on the date of grant.\nThe grant date fair value of performance shares containing a market-based performance condition awarded under the LTC Plans were estimated using a Monte Carlo simulation with the following assumptions:\n| 2012 | 2011 | 2010 |\n| Expected volatility | 85.0 | % | 62.0 | % | 61.6 | % |\n| Risk-free interest rate | 0.40 | % | 1.10 | % | 1.45 | % |\n| Expected life (in years) | 2.81 | 2.84 | 2.80 |\n| Expected dividend yield | — | — | — |\n\nPerformance awards under the active LTC Plans were granted to the Company's new CEO in October 2012. The grant date fair values of performance shares awarded to the CEO containing the RTSR market-based performance condition was estimated using a Monte Carlo simulation with the following assumptions:\n| 2012 | 2011 | 2010 |\n| Expected volatility | 60.7 | % | 60.7 | % | 60.7 | % |\n| Risk-free interest rate | 0.34 | % | 0.34 | % | 0.34 | % |\n| Expected life (in years) | 2.21 | 1.21 | 0.21 |\n| Expected dividend yield | — | — | — |\n\nManagement estimates the probable number of shares which will ultimately vest when calculating the share-based compensation expense for the LTC Plans. As of December 31, 2012, the Company’s weighted average forfeiture rate is approximately 33%. The actual number of shares that vest may differ from management’s estimate. Final award vesting and distribution of performance awards granted under the LTC Plans are determined based on the Company’s actual performance versus the target goals for a three-year consecutive period as defined in each plan. Partial awards can be earned for performance less than the target goal, but in excess of minimum goals; and award distributions above the target can be achieved if the maximum goals are met or exceeded.\nUnder the 2012, 2011 and 2010 LTC Plans, the potential award for the performance shares granted is partially dependent on the Company’s relative total shareholder return (“RTSR”), which represents a market condition. RTSR is measured against a group of peer companies either in the metals industry or in the industrial products distribution industry. Compensation expense for performance awards containing a market condition is recognized regardless of whether the market condition is achieved to the extent the requisite service period condition is met.\nUnder the 2012 and 2011 LTC Plans, the potential award for performance shares containing a non-market-based performance condition is determined based on the Company’s actual performance versus Company-specific target goals for Return on Invested Capital (“ROIC”) (as defined in the 2012 and 2011 LTC Plans). Under the 2012 LTC Plan, the non-market based performance condition is determined based on the Company's average actual performance versus Company-specific goals for ROIC for the three-year performance period beginning on January 1st of the year of grant. Under the 2011 LTC Plan, the non-market-based performance condition is determined for\n33\nany one or more fiscal years during the three-year performance period beginning on January 1st of the year of grant. Partial performance awards can be earned for performance less than the target goal, but in excess of minimum goals and award distributions twice the target can be achieved if the maximum goals are met or exceeded. The number of performance shares, if any, that vest based on the performance achieved during the three-year performance period, will vest at the end of the three-year performance period. Compensation expense recognized is based on management’s expectation of future performance compared to the pre-established performance goals. If the performance goals are not expected to be met, no compensation expense is recognized and any previously recognized compensation expense is reversed.\nUnless covered by a specific change-in-control or severance arrangement, participants to whom restricted stock units, performance shares and other non-vested shares have been granted must be employed by the Company on the vesting date or at the end of the performance period, or the award will be forfeited.\nFair Value of Financial Instruments — The three-tier value hierarchy the Company utilizes, which prioritizes the inputs used in the valuation methodologies, is:\nLevel 1—Valuations based on quoted prices for identical assets and liabilities in active markets.\nLevel 2—Valuations based on observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data.\nLevel 3—Valuations based on unobservable inputs reflecting our own assumptions, consistent with reasonably available assumptions made by other market participants.\nThe fair value of cash, accounts receivable and accounts payable approximate their carrying values. The fair value of cash equivalents are determined using the fair value hierarchy described above. Cash equivalents consisting of money market funds are valued based on quoted prices in active markets and as a result are classified as Level 1.\nThe Company’s pension plan asset portfolio as of December 31, 2012 and 2011 is primarily invested in fixed income securities, which generally fall within Level 2 of the fair value hierarchy. Fixed income securities are valued based on evaluated prices provided to the trustee by independent pricing services. Such prices may be determined by factors which include, but are not limited to, market quotations, yields, maturities, call features, ratings, institutional size trading in similar groups of securities and developments related to specific securities.\nFair value disclosures for the Senior Secured Notes are determined based on recent trades of the bonds and fall within level 2 of the fair value hierarchy. The fair value of the Convertible Notes, which fall within level 3 of the fair value hierarchy, is determined based on similar debt instruments that do not contain a conversion feature, as well as other factors related to the callable nature of the notes. The estimated fair value of the derivative liability for the conversion feature, which falls within level 3 of the fair value hierarchy, is computed using a binomial lattice model using the Company’s historical volatility over the term corresponding to the remaining contractual term of the Convertible Notes and observed spreads of similar debt instruments that do not include a conversion feature. The estimated fair value of the Company’s debt outstanding under its revolving credit facilities, which fall within level 3 of the fair value hierarchy, assumes the current amount of debt outstanding at the end of the year was outstanding until the maturity of the Company’s facility in December 2015.\nFair value of commodity hedges is based on information which is representative of readily observable market data. Derivative liabilities associated with commodity hedges are classified as Level 2 in the fair value hierarchy.\nRecent Accounting Pronouncements\nEffective January 1, 2012, the Company adopted new guidance that applies to the presentation of other comprehensive (loss) income, the testing of goodwill for impairment and the measurement and disclosure of fair value of assets, liabilities and instruments classified in a reporting entity’s shareholders’ equity in the financial statements.\nSee Note 1 to the consolidated financial statements for detailed information on recent accounting pronouncements.\n34\nITEM 7a —\nQuantitative and Qualitative Disclosures about Market Risk\nThe Company is exposed to interest rate, commodity price, and foreign exchange rate risks that arise in the normal course of business.\nInterest Rate Risk — The Company is exposed to market risk related to its fixed rate and variable rate long-term debt. We do not utilize derivative instruments to manage exposure to interest rate changes. The market value of the Company’s $282.5 million of fixed rate long-term debt may be impacted by changes in interest rates. The Company does not expect to repay its fixed rate debt prior to its scheduled maturities.\nThe Company’s interest rates on borrowings under its $100 million four-year revolving credit facility are subject to changes in the LIBOR and prime interest rates. Borrowings under the Company’s revolving credit agreement were approximately $39.5 million as of December 31, 2012. A hypothetical 100 basis point increase on the Company’s variable rate debt would result in $0.4 million of additional interest expense on an annual basis.\nCommodity Price Risk — The Company’s raw material costs are comprised primarily of engineered metals and plastics. Market risk arises from changes in the price of steel, other metals and plastics. Although average selling prices generally increase or decrease as material costs increase or decrease, the impact of a change in the purchase price of materials is more immediately reflected in the Company’s cost of materials than in its selling prices. The ability to pass surcharges on to customers immediately can be limited due to contractual provisions with those customers. Therefore, a lag may exist between when the surcharge impacts net sales and cost of materials, respectively, which could result in a higher or lower operating profit.\nThe Company has a commodity hedging program to mitigate risks associated with certain commodity price fluctuations. If the commodity prices hedged were to decrease hypothetically by 100 basis points, the 2012 unrealized loss recorded in cost of materials would have increased by approximately $0.1 million.\nForeign Currency Risk — The Company conducts the majority of its business in the United States but also has operations in Canada, Mexico, France, the United Kingdom, Spain, China and Singapore. The Company’s results of operations historically have not been materially affected by foreign currency transaction gains and losses and, therefore, the Company has no financial instruments in place for managing the exposure to foreign currency exchange rates.\nAs a result of the new debt financing arrangements entered into during December 2011, the Company has certain outstanding intercompany borrowings denominated in the U.S. dollar at its Canadian and United Kingdom subsidiaries. These intercompany borrowings are not hedged and may cause foreign currency exposure, which could be significant, in future periods if they remain unhedged.\n35\nITEM 8 — Financial Statements and Supplementary Data\nAmounts in thousands, except par value and per share data\n| Consolidated Statements of Operations and Comprehensive Loss |\n| Year Ended December 31, |\n| 2012 | 2011 | 2010 |\n| Net sales | $ | 1,270,368 | $ | 1,132,366 | $ | 943,706 |\n| Costs and expenses: |\n| Cost of materials (exclusive of depreciation and amortization) | 927,287 | 845,609 | 700,854 |\n| Warehouse, processing and delivery expense | 148,256 | 134,898 | 123,318 |\n| Sales, general and administrative expense | 127,813 | 126,193 | 108,223 |\n| Depreciation and amortization expense | 25,867 | 20,472 | 20,649 |\n| Operating income (loss) | 41,145 | 5,194 | (9,338 | ) |\n| Interest expense, net | (41,090 | ) | (9,663 | ) | (4,988 | ) |\n| Interest expense - unrealized loss on debt conversion option | (15,597 | ) | (3,991 | ) | — |\n| Loss on extinguishment of debt | — | (6,153 | ) | — |\n| Loss before income taxes and equity in earnings of joint venture | (15,542 | ) | (14,613 | ) | (14,326 | ) |\n| Income taxes | (1,430 | ) | 1,126 | 3,101 |\n| Loss before equity in earnings of joint venture | (16,972 | ) | (13,487 | ) | (11,225 | ) |\n| Equity in earnings of joint venture | 7,224 | 11,727 | 5,585 |\n| Net loss | (9,748 | ) | (1,760 | ) | (5,640 | ) |\n| Basic loss per share | $ | (0.42 | ) | $ | (0.08 | ) | $ | (0.25 | ) |\n| Diluted loss per share | $ | (0.42 | ) | $ | (0.08 | ) | $ | (0.25 | ) |\n| Dividends per common share | $ | — | $ | — | $ | — |\n| Comprehensive loss: |\n| Foreign currency translation gains (losses) | $ | 2,369 | $ | (941 | ) | $ | (536 | ) |\n| Unrecognized pension and postretirement benefit costs, net of tax benefit of $2,312, $1,965 and $1,116 | (3,616 | ) | (3,071 | ) | (1,748 | ) |\n| Other comprehensive loss | (1,247 | ) | (4,012 | ) | (2,284 | ) |\n| Net loss | (9,748 | ) | (1,760 | ) | (5,640 | ) |\n| Comprehensive loss | $ | (10,995 | ) | $ | (5,772 | ) | $ | (7,924 | ) |\n\nThe accompanying notes to consolidated financial statements are an integral part of these statements.\n36\n| Consolidated Balance Sheets |\n| December 31, |\n| 2012 | 2011 |\n| Assets |\n| Current assets |\n| Cash and cash equivalents | $ | 21,607 | $ | 30,524 |\n| Accounts receivable, less allowances of $3,529 and $3,584 | 138,311 | 181,036 |\n| Inventories, principally on last-in first-out basis (replacement cost higher by $139,940 and $138,882) | 303,772 | 272,039 |\n| Prepaid expenses and other current assets | 15,092 | 10,382 |\n| Income tax receivable | 7,596 | 8,287 |\n| Total current assets | 486,378 | 502,268 |\n| Investment in joint venture | 38,854 | 36,460 |\n| Goodwill | 70,300 | 69,901 |\n| Intangible assets | 82,477 | 93,813 |\n| Prepaid pension cost | 12,891 | 15,956 |\n| Other assets | 18,266 | 21,784 |\n| Property, plant and equipment, at cost |\n| Land | 5,195 | 5,194 |\n| Building | 52,884 | 52,434 |\n| Machinery and equipment | 178,664 | 172,833 |\n| Property, plant and equipment, at cost | 236,743 | 230,461 |\n| Less—accumulated depreciation | (157,103 | ) | (148,320 | ) |\n| Property, plant and equipment, net | 79,640 | 82,141 |\n| Total assets | $ | 788,806 | $ | 822,323 |\n| Liabilities and Stockholders’ Equity |\n| Current liabilities |\n| Accounts payable | $ | 67,990 | $ | 116,874 |\n| Accrued payroll and employee benefits | 11,749 | 14,792 |\n| Accrued liabilities | 24,815 | 19,036 |\n| Income taxes payable | 1,563 | 1,884 |\n| Current portion of long-term debt | 415 | 192 |\n| Short term debt | 500 | 500 |\n| Total current liabilities | 107,032 | 153,278 |\n| Long-term debt, less current portion | 296,154 | 314,240 |\n| Deferred income taxes | 32,350 | 25,650 |\n| Other non-current liabilities | 5,279 | 7,252 |\n| Pension and post retirement benefit obligations | 10,651 | 9,624 |\n| Commitments and contingencies |\n| Stockholders’ equity |\n| Preferred stock, $0.01 par value—9,988 shares authorized (including 400 Series B Junior Preferred $0.00 par value shares); no shares issued and outstanding at December 31, 2012 and December 31, 2011 | — | — |\n| Common stock, $0.01 par value—60,000 shares authorized and 23,211 shares issued and 23,152 outstanding at December 31, 2012; 30,000 shares authorized and 23,159 shares issued and 23,010 outstanding at December 31, 2011 | 232 | 232 |\n| Additional paid-in capital | 219,619 | 184,596 |\n| Retained earnings | 139,239 | 148,987 |\n| Accumulated other comprehensive loss | (21,071 | ) | (19,824 | ) |\n| Treasury stock, at cost—59 shares at December 31, 2012 and 149 shares at December 31, 2011 | (679 | ) | (1,712 | ) |\n| Total stockholders’ equity | 337,340 | 312,279 |\n| Total liabilities and stockholders’ equity | $ | 788,806 | $ | 822,323 |\n\nThe accompanying notes to consolidated financial statements are an integral part of these statements.\n37\n| Consolidated Statements of Cash Flows |\n| Years Ended December 31, |\n| 2012 | 2011 | 2010 |\n| Operating activities: |\n| Net loss | $ | (9,748 | ) | $ | (1,760 | ) | $ | (5,640 | ) |\n| Adjustments to reconcile net loss to net cash from (used in) operating activities: |\n| Depreciation and amortization | 25,867 | 20,472 | 20,649 |\n| Amortization of deferred gain | (1,619 | ) | (503 | ) | (890 | ) |\n| Amortization of deferred financing costs and debt discount | 6,232 | 1,662 | 685 |\n| Loss on sale of fixed assets | 354 | 120 | 391 |\n| Unrealized loss on debt conversion option | 15,597 | 3,991 | — |\n| Unrealized losses on commodity hedges | 163 | 2,331 | — |\n| Equity in earnings of joint venture | (7,224 | ) | (11,727 | ) | (5,585 | ) |\n| Dividends from joint venture | 4,729 | 3,117 | 1,260 |\n| Deferred tax (benefit) provision | (1,284 | ) | (3,333 | ) | (11,386 | ) |\n| Share-based compensation expense | 2,277 | 4,349 | 2,411 |\n| Excess tax benefits from share-based payment arrangements | (90 | ) | (301 | ) | (219 | ) |\n| Increase (decrease) from changes in, net of acquisition: |\n| Accounts receivable | 44,570 | (26,446 | ) | (22,521 | ) |\n| Inventories | (29,340 | ) | (39,435 | ) | 39,686 |\n| Prepaid expenses and other current assets | (2,397 | ) | (3,408 | ) | (1,718 | ) |\n| Other assets | (480 | ) | 188 | 399 |\n| Prepaid pension costs | (2,863 | ) | (2,412 | ) | (1,530 | ) |\n| Accounts payable | (42,560 | ) | 9,910 | (1,866 | ) |\n| Accrued payroll and employee benefits | (2,974 | ) | (2,470 | ) | 5,827 |\n| Income taxes payable and receivable | 454 | (820 | ) | 11,536 |\n| Accrued liabilities | 4,514 | (184 | ) | 1,586 |\n| Postretirement benefit obligations and other liabilities | 1,173 | 371 | 1,287 |\n| Net cash from (used in) operating activities | 5,351 | (46,288 | ) | 34,362 |\n| Investing activities: |\n| Acquisition/Investment of businesses, net of cash acquired | (6,472 | ) | (174,244 | ) | — |\n| Capital expenditures | (11,121 | ) | (11,744 | ) | (7,572 | ) |\n| Proceeds from sale of fixed assets | 153 | 226 | 4 |\n| Insurance proceeds | — | 573 | 125 |\n| Net cash used in investing activities | (17,440 | ) | (185,189 | ) | (7,443 | ) |\n| Financing activities: |\n| Short-term (repayments) borrowings, net | (27 | ) | 653 | (13,720 | ) |\n| Net (repayments) borrowings on previously existing revolving lines of credit | — | (26,403 | ) | 2,324 |\n| Proceeds from long-term debt, including new revolving credit facility | 767,090 | 320,476 | — |\n| Repayments of long-term debt, including new revolving credit facility | (762,887 | ) | (53,212 | ) | (7,754 | ) |\n| Payment of debt issue costs | (1,503 | ) | (16,633 | ) | — |\n| Exercise of stock options | 146 | 356 | 566 |\n| Excess tax benefits from share-based payment arrangements | 90 | 301 | 219 |\n| Net cash from (used in) financing activities | 2,909 | 225,538 | (18,365 | ) |\n| Effect of exchange rate changes on cash and cash equivalents | 263 | (253 | ) | (149 | ) |\n| Net (decrease) increase in cash and cash equivalents | (8,917 | ) | (6,192 | ) | 8,405 |\n| Cash and cash equivalents—beginning of year | 30,524 | 36,716 | 28,311 |\n| Cash and cash equivalents—end of year | $ | 21,607 | $ | 30,524 | $ | 36,716 |\n\nSee Note 1 to the consolidated financial statements for supplemental cash flow disclosures.\nThe accompanying notes to consolidated financial statements are an integral part of these statements.\n38\n| Consolidated Statements of Stockholders' Equity |\n| CommonShares | TreasuryShares | PreferredStock | CommonStock | TreasuryStock | AdditionalPaid-inCapital | RetainedEarnings | Accumulated OtherComprehensiveIncome | Total |\n| Balance at January 1, 2010 | 23,115 | (209 | ) | $ | — | $ | 230 | $ | (3,010 | ) | $ | 178,129 | $ | 156,387 | $ | (13,528 | ) | $ | 318,208 |\n| Net loss | (5,640 | ) | (5,640 | ) |\n| Foreign currency translation | (536 | ) | (536 | ) |\n| Defined benefit pension liability adjustments, net of tax benefit of $1,116 | (1,748 | ) | (1,748 | ) |\n| Long-term incentive plan | 1,278 | 1,278 |\n| Exercise of stock options and other | 34 | 46 | 1 | 784 | 1,112 | 1,897 |\n| Balance at December 31, 2010 | 23,149 | (163 | ) | $ | — | $ | 231 | $ | (2,226 | ) | $ | 180,519 | $ | 150,747 | $ | (15,812 | ) | $ | 313,459 |\n| Net loss | (1,760 | ) | (1,760 | ) |\n| Foreign currency translation | (941 | ) | (941 | ) |\n| Defined benefit pension liability adjustments, net of tax benefit of $1,965 | (3,071 | ) | (3,071 | ) |\n| Long-term incentive plan | 3,260 | 3,260 |\n| Exercise of stock options and other | 10 | 14 | 1 | 514 | 817 | 1,332 |\n| Balance at December 31, 2011 | 23,159 | (149 | ) | $ | — | $ | 232 | $ | (1,712 | ) | $ | 184,596 | $ | 148,987 | $ | (19,824 | ) | $ | 312,279 |\n| Net loss | (9,748 | ) | — | (9,748 | ) |\n| Foreign currency translation | 2,369 | 2,369 |\n| Defined benefit pension liability adjustments, net of tax benefit of $2,312 | (3,616 | ) | (3,616 | ) |\n| Embedded conversion option, net of tax benefit of $8,285 | 33,752 | 33,752 |\n| Long-term incentive plan | 1,592 | 1,592 |\n| Exercise of stock options and other | 52 | 90 | 1,033 | (321 | ) | 712 |\n| Balance at December 31, 2012 | 23,211 | (59 | ) | $ | — | $ | 232 | $ | (679 | ) | $ | 219,619 | $ | 139,239 | $ | (21,071 | ) | $ | 337,340 |\n\nThe accompanying notes to consolidated financial statements are an integral part of these statements.\n39\nA. M. Castle & Co.\nNotes to Consolidated Financial Statements\nAmounts in thousands except per share data and percentages\n(1) Basis of Presentation and Significant Accounting Policies\nNature of operations — A.M. Castle & Co. and its subsidiaries (the “Company”) is a specialty metals and plastics distribution company serving principally the North American market, but with a growing global presence. The Company has operations in the United States, Canada, Mexico, France, the United Kingdom, Spain, China and Singapore. The Company provides a broad range of product inventories as well as value-added processing and supply chain services to a wide array of customers, principally within the producer durable equipment, oil and gas, aerospace, heavy industrial equipment, industrial goods, construction equipment, retail, marine and automotive sectors of the global economy. Particular focus is placed on the aerospace and defense, oil and gas, power generation, mining, heavy industrial equipment, marine, office furniture and fixtures, safety products, life science applications, automotive and general manufacturing industries as well as general engineering applications.\nThe Company’s corporate headquarters are located in Oak Brook, Illinois. The Company has 49 operational service centers located throughout North America (44), Europe (4) and Asia (1).\nThe Company purchases metals and plastics from many producers. Purchases are made in large lots and held in distribution centers until sold, usually in smaller quantities and often with value-added processing services performed. Orders are primarily filled with materials shipped from Company stock. The materials required to fill the balance of sales are obtained from other sources, such as direct mill shipments to customers or purchases from other distributors. Thousands of customers from a wide array of industries are serviced primarily through the Company’s own sales organization.\nBasis of presentation — The consolidated financial statements include the accounts of A. M. Castle & Co. and its subsidiaries over which the Company exhibits a controlling interest. The equity method of accounting is used for the Company’s 50% owned joint venture, Kreher Steel Company, LLC (“Kreher”). All inter-company accounts and transactions have been eliminated.\nReclassification — For comparability, certain 2011 amounts have been reclassified to conform to presentation adopted in 2012.\nUse of estimates — The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. The principal areas of estimation reflected in the consolidated financial statements are accounts receivable allowances, inventory reserves, goodwill and intangible assets, income taxes, pension and other post-employment benefits and share-based compensation and convertible debt feature mark-to-mark adjustments.\nRevenue recognition — Revenue from the sales of products is recognized when the earnings process is complete and when the title and risk and rewards of ownership have passed to the customer, which is primarily at the time of shipment. Revenue recognized other than at the time of shipment represents less than 3% of the Company’s consolidated net sales for the years ended December 31, 2012, 2011 and 2010. Provisions for allowances related to sales discounts and rebates are recorded based on terms of the sale in the period that the sale is recorded. Management utilizes historical information and the current sales trends of the business to estimate such provisions. The provisions related to discounts and rebates due to customers are recorded as a reduction within net sales in the Company’s consolidated statements of operations and comprehensive loss.\nThe Company maintains an allowance for doubtful accounts resulting from the inability of customers to make required payments. The allowance for doubtful accounts is maintained at a level considered appropriate based on historical experience and specific identification of customer receivable balances for which collection is unlikely. The provisions for doubtful accounts is recorded in sales, general and administrative expense in the Company’s consolidated statements of operations and comprehensive loss. Estimates of doubtful accounts are based upon historical write-off experience as a percentage of net sales and judgments about the probable effects of economic conditions on certain customers.\n40\nThe Company also maintains an allowance for credit memos for estimated credit memos to be issued against current sales. Estimates of allowance for credit memos are based upon the application of a historical issuance lag period to the average credit memos issued each month.\nAccounts receivable allowance activity is presented in the table below:\n| 2012 | 2011 | 2010 |\n| Balance, beginning of year | $ | 3,584 | $ | 3,848 | $ | 4,195 |\n| Add Provision charged to expense | 1,420 | 523 | 777 |\n| Recoveries | 90 | 140 | 186 |\n| Other | — | 157 | — |\n| Less Charges against allowance | (1,565 | ) | (1,084 | ) | (1,310 | ) |\n| Balance, end of year | $ | 3,529 | $ | 3,584 | $ | 3,848 |\n\nRevenue from shipping and handling charges is recorded in net sales. Costs incurred in connection with shipping and handling the Company’s products, which are related to third-party carriers or performed by Company personnel are included in warehouse, processing and delivery expenses. For the years ended December 31, 2012, 2011 and 2010, shipping and handling costs included in warehouse, processing and delivery expenses were $36,585, $35,214, and $31,067, respectively.\nCost of materials — Cost of materials consists of the costs the Company pays for metals, plastics and related inbound freight charges. It excludes depreciation and amortization which are discussed below. The Company accounts for the majority of its inventory on a last-in, first-out (“LIFO”) basis and LIFO adjustments are recorded in cost of materials.\nOperating expenses — Operating costs and expenses primarily consist of:\n\n| • | Warehouse, processing and delivery expenses, including occupancy costs, compensation and employee benefits for warehouse personnel, processing, shipping and handling costs; |\n\n| • | Sales expenses, including compensation and employee benefits for sales personnel; |\n\n| • | General and administrative expenses, including compensation for executive officers and general management, expenses for professional services primarily attributable to accounting and legal advisory services, bad debt expenses, data communication, computer hardware and maintenance and foreign currency gain or loss; and |\n\n| • | Depreciation and amortization expenses, including depreciation for all owned property and equipment, and amortization of various intangible assets. |\n\nCash equivalents — Cash equivalents are highly liquid, short-term investments that have an original maturity of 90 days or less.\nStatement of cash flows — Non-cash investing and financing activities and supplemental disclosures of consolidated cash flow information are as follows:\n| Year Ended December 31, |\n| 2012 | 2011 | 2010 |\n| Non-cash investing and financing activities: |\n| Capital expenditures financed by accounts payable | $ | 479 | $ | 1,123 | $ | 100 |\n| Capital lease obligations | 1,009 | — | — |\n| Deferred debt origination fees | — | 886 | — |\n| Additional purchase price paid in 2012 for Tube Supply acquisition | — | 6,472 | — |\n| Cash paid during the year for: |\n| Interest | 34,051 | 7,234 | 4,392 |\n| Income taxes | 5,557 | 9,555 | 1,631 |\n| Cash received during the year for: |\n| Income tax refunds | 3,184 | 6,724 | 4,430 |\n\n41\nInventories — Inventories consist of finished goods. Approximately eighty percent of the Company’s inventories are valued at the lower of LIFO cost or market at December 31, 2012 and 2011. Final inventory determination under the LIFO costing method is made at the end of each fiscal year based on the actual inventory levels and costs at that time. The Company values its LIFO increments using the cost of its latest purchases during the years reported. Current replacement cost of inventories exceeded book value by $139,940 and $138,882 at December 31, 2012 and 2011, respectively. Income taxes would become payable on any realization of this excess from reductions in the level of inventories.\nDuring 2010, a reduction in inventories resulted in a liquidation of applicable LIFO inventory quantities carried at lower costs in prior years. Cost of materials for 2010 were lower by $12,500, as a result of the liquidations.\nThe Company maintains allowances for excess and obsolete inventory and physical inventory losses. The excess and obsolete inventory allowance is determined based on specific identification of material, adjusted for expected scrap value to be received. The allowance for physical inventory losses is determined based on historical physical inventory experience.\nInsurance plans — In August 2009, the Company became a member of a group captive insurance company (the “Captive”) domiciled in Grand Cayman Island. The Captive reinsures losses related to certain of the Company’s workers’ compensation, automobile and general liability risks that occur subsequent to August 2009. Premiums are based on the Company’s loss experience and are accrued as expenses for the period to which the premium relates. Premiums are credited to the Company’s “loss fund” and earn investment income until claims are actually paid. For workers’ compensation, automobile and general liability claims that were incurred prior to August 2009, the Company is self-insured. Self-insurance amounts are capped, for individual claims and in the aggregate, for each policy year by an insurance company. Self-insurance reserves are based on unpaid, known claims (including related administrative fees assessed by the insurance company for claims processing) and a reserve for incurred but not reported claims based on the Company’s historical claims experience and development.\nThe Company is self-insured for medical insurance for its domestic operations. Self-insurance reserves are maintained based on incurred but not paid claims based on a historical lag.\nProperty, plant and equipment — Property, plant and equipment are stated at cost and include assets held under capital leases. Expenditures for major additions and improvements are capitalized, while maintenance and repair costs that do not substantially improve or extend the useful lives of the respective assets are expensed in the period in which they are incurred. When items are disposed, the related costs and accumulated depreciation are removed from the accounts and any gain or loss is reflected in income.\nThe Company provides for depreciation of plant and equipment sufficient to amortize the cost over their estimated useful lives as follows:\n| Buildings and building improvements | 3 – 40 years |\n| Plant equipment | 3 – 25 years |\n| Furniture and fixtures | 2 – 10 years |\n| Vehicles and office equipment | 3 – 7 years |\n\nLeasehold improvements are depreciated over the shorter of their useful lives or the remaining term of the lease. Depreciation is calculated using the straight-line method and depreciation expense for 2012, 2011 and 2010 was $14,024, $13,605 and $13,578, respectively.\nLong-lived assets — The Company’s long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset or asset group to future net cash flows (undiscounted and without interest charges) expected to be generated by the asset or asset group. If future net cash flows are less than the carrying value, the asset or asset group may be impaired. If such assets are impaired, the impairment charge is calculated as the amount by which the carrying amount of the assets exceeds the fair value of the assets. Determining whether impairment has occurred typically requires various estimates and assumptions, including determining which undiscounted cash flows are directly related to the potentially impaired asset, the useful life over which cash flows will occur, their amount, and the asset’s residual value, if any. The Company derives the required undiscounted cash flow estimates from historical experience and internal business plans.\n42\nGoodwill and intangible assets — The carrying value of the Company’s goodwill is evaluated annually on January 1st of each fiscal year or when certain triggering events occur which require a more current valuation. The Company assesses, at least quarterly, whether any triggering events have occurred.\nA two-step method is used for determining goodwill impairment. The first step is performed to identify whether a potential impairment exists by comparing each reporting unit’s fair value to its carrying value. If the carrying value of a reporting unit exceeds its fair value, the next step is to measure the amount of impairment loss, if any.\nThe majority of the Company’s recorded intangible assets were acquired as part of the Transtar and Tube Supply, Inc. (“Tube Supply”) acquisitions in September 2006 and December 2011, respectively, and consist of customer relationships, non-compete agreements, trade names and developed technology. The initial values of the intangible assets were based on a discounted cash flow valuation using assumptions made by management as to future revenues from select customers, the level and pace of attrition in such revenues over time and assumed operating income amounts generated from such revenues. These intangible assets are amortized over their useful lives, which are 4 to 12 years for customer relationships, 3 years for non-compete agreements, 1 to 10 years for trade names, and 3 years for developed technology. Useful lives are estimated by management and determined based on the timeframe over which a significant portion of the estimated future cash flows are expected to be realized from the respective intangible assets. Furthermore, when certain conditions or certain triggering events occur, a separate test of impairment, similar to the impairment test for long-lived assets, is performed. If the intangible asset is deemed to be impaired, such asset will be written down to its fair value.\nIncome taxes — The Company accounts for income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statement and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.\nThe Company records valuation allowances against its deferred tax assets when it is more likely than not that the amounts will not be realized, which will increase the provision for income taxes in the period in which that determination is made.\nThe Company has undistributed earnings of foreign subsidiaries of approximately $83,352 at December 31, 2012, for which deferred taxes have not been provided. Such earnings are considered indefinitely invested in the foreign subsidiaries. If such earnings were repatriated, additional tax expense may result, although due to the potential availability of foreign tax credits and other items, the calculation of such additional taxes is not practicable.\nThe Company's 50% ownership interest in Kreher (see Note 6) is through a 50% interest in a limited liability corporation (LLC) taxed as a partnership. Kreher has two subsidiaries organized as individually taxed C-Corporations. The Company includes in its income tax provision the income tax liability on its share of Kreher income. The income tax liability of Kreher itself is generally treated as a current income tax expense and the income tax liability associated with the profits of the two subsidiaries of Kreher is treated as a deferred income tax expense. The Company can not independently cause a dividend to be declared by one of Kreher's subsidiaries, therefore no benefit of a dividend received deduction can be recognized in the Company's tax provision until a dividend is declared. If one of Kreher's C-Corporation subsidiaries declares a dividend payable to Kreher, the Company recognizes a benefit for the 80% dividends received deduction on its 50% share of the dividend.\nThe Company recognizes the tax benefits of uncertain tax positions only if those benefits will more likely than not be sustained upon examination by the relevant tax authorities. Unrecognized tax benefits are subsequently recognized at the time the recognition threshold is met, the tax matter is effectively settled or the statute of limitations expires for the return containing the tax position, whichever is earlier. Due to the complexity of some of these uncertainties, the ultimate resolution may result in a payment that differs from the current estimate.\nThe Company recognizes interest and penalties related to unrecognized tax benefits within income tax expense. Accrued interest and penalties are included within other long-term liabilities in the consolidated balance sheets.\nForeign currency — For the majority of the Company’s non-U.S. operations, the functional currency is the local currency. Assets and liabilities of those operations are translated into U.S. dollars using year-end exchange rates, and income and expenses are translated using the average exchange rates for the reporting period. The currency effects of translating financial statements of the Company’s non-U.S. operations which operate in local currency environments are recorded in accumulated other comprehensive income (loss), a separate component of\n43\nstockholders’ equity. Transaction gains or losses resulting from foreign currency transactions were not material for any of the years presented.\nEarnings per share — Diluted earnings per share is computed by dividing net income by the weighted average number of shares of common stock plus common stock equivalents. Common stock equivalents consist of employee and director stock options, restricted stock awards, other share-based payment awards, and contingently issuable shares related to the Company’s convertible debt which are included in the calculation of weighted average shares outstanding using the treasury stock method, if dilutive.\nThe following table is a reconciliation of the basic and diluted earnings per share calculations:\n| 2012 | 2011 | 2010 |\n| Numerator: |\n| Net loss | $ | (9,748 | ) | $ | (1,760 | ) | $ | (5,640 | ) |\n| Denominator: |\n| Denominator for basic loss per share: |\n| Weighted average common shares outstanding | 22,993 | 22,983 | 22,708 |\n| Effect of dilutive securities: |\n| Outstanding common stock equivalents | — | — | — |\n| Denominator for diluted loss per share | 22,993 | 22,983 | 22,708 |\n| Basic loss per share | $ | (0.42 | ) | $ | (0.08 | ) | $ | (0.25 | ) |\n| Diluted loss per share | $ | (0.42 | ) | $ | (0.08 | ) | $ | (0.25 | ) |\n| Excluded outstanding share-based awards having an anti-dilutive effect | 994 | 757 | 471 |\n\nThe Convertible Notes are dilutive to the extent the Company generates net income and the average stock price during the period is greater than $10.28, the conversion price of the Convertible Notes. The Convertible Notes are only dilutive for the “in the money” portion of the Convertible Notes that could be settled with the Company’s stock. In future periods, absent a fundamental change, (as defined in the Convertible Notes agreement), the outstanding Convertible Notes could increase diluted average shares outstanding by a maximum of approximately 5,600 shares. As of December 31, 2012 and 2011, 1,416 and 1,734 shares, respectively, were excluded from diluted average shares outstanding as there would have been an anti-dilutive effect.\nFor the years ended December 31, 2012, 2011 and 2010, the participating securities, which represent certain non-vested shares granted by the Company, were less than one percent of total securities. These securities do not participate in the Company’s net losses.\nConcentrations — The Company serves a wide range of customers within the producer durable equipment, oil and gas, aerospace, heavy industrial equipment, industrial goods, construction equipment, retail, marine and automotive sectors of the economy from locations throughout the United States, Canada, Mexico, France, the United Kingdom, Spain, China and Singapore. Its customer base includes many Fortune 500 companies as well as thousands of medium and smaller sized firms spread across the entire spectrum of metals and plastics using industries. The Company’s customer base is well diversified and, therefore, the Company does not have dependence upon any single customer or a few customers. No single customer represents more than 3% of the Company’s total net sales. Approximately 78% of the Company’s business is conducted from locations in the United States.\nShare-based compensation — The Company offers share-based compensation to executive and other key employees, as well as its directors. Share-based compensation expense is recorded over the vesting period based on the grant date fair value of the stock award. Stock options have an exercise price equal to the market price of the Company’s stock on the grant date (options granted prior to 2010) or the average closing price of the Company’s stock for the 10 trading days preceding the grant date (options granted in 2010) and have a contractual life of eight to ten years. Options and restricted stock generally vest in one to five years for executives and employees and three years for directors. The Company may either issue shares from treasury or new shares upon share option exercise. Management estimates the probable number of shares which will ultimately vest when calculating the share-based compensation expense for the long-term compensation plans (\"LTC Plans\"). As of December 31, 2012, the Company’s weighted average forfeiture rate is approximately 33%. The actual number of shares that vest may differ from management’s estimate.\n44\nStock options are valued based on the market price of the Company’s stock on the grant date, using a Black-Scholes option-pricing model. The expense associated with stock option awards is recorded on a straight-line basis over the vesting period, net of estimated forfeitures.\nShare-based compensation expense for restricted share units and non-vested shares in the LTC Plans is established using the market price of the Company’s common stock on the date of grant.\nFinal award vesting and distribution of performance awards granted under the LTC Plans are determined based on the Company’s actual performance versus the target goals for a three-year consecutive period as defined in each plan. Partial awards can be earned for performance less than the target goal, but in excess of minimum goals; and award distributions above the target can be achieved if the maximum goals are met or exceeded.\nUnder the 2012, 2011, and 2010 LTC Plans, the potential award for the performance shares granted is partially dependent on the Company’s relative total shareholder return (“RTSR”), which represents a market condition. RTSR is measured against a group of peer companies either in the metals industry or in the industrial products distribution industry. Compensation expense for performance awards containing a market condition is recognized regardless of whether the market condition is achieved to the extent the requisite service period condition is met. The grant date fair value of performance shares containing a market-based performance condition awarded under the LTC Plans was estimated using a Monte Carlo simulation.\nUnder the 2012 and 2011 LTC Plans, the potential award for performance share units containing a non-market-based performance condition is determined based on the Company's actual performance versus Company-specific target goals for Return on Invested Capital (“ROIC”), as defined in the 2012 and 2011 LTC Plans. Under the 2012 LTC Plan, the non-market-based performance condition is determined based on the Company's average actual performance versus Company-specific goals for ROIC for the three-year performance period beginning on January 1st of the year of grant. Under the 2011 LTC Plan, the non-market-based performance condition is determined for any one or more fiscal years during the three-year performance period beginning on January 1st of the year of grant. Partial performance awards can be earned for performance less than the target goal, but in excess of minimum goals and award distributions twice the target can be achieved if the maximum goals are met or exceeded. The number of performance shares, if any, that vest based on the performance achieved during the three-year performance period, will vest at the end of the three-year performance period. Compensation expense recognized is based on management's expectation of future performance compared to the pre-established performance goals. If the performance goals are not expected to be met, no compensation expense is recognized and any previously recognized compensation expense is reversed.\nUnless covered by a specific change-in-control or severance arrangement, participants to whom restricted stock units, performance shares and other non-vested shares have been granted must be employed by the Company on the vesting date or at the end of the performance period, respectively, or the award will be forfeited.\nNew Accounting Standards Updates\nStandards Updates Adopted\nEffective January 1, 2012, the Company adopted ASU No. 2011-08, “Intangibles – Goodwill and Other.” The objective of this ASU is to simplify how entities test goodwill for impairment. The amendments allow entities to assess qualitative factors to determine whether it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test per Topic 350, “Intangibles – Goodwill and Other.” The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent. The adoption of this ASU impacts the way the Company tests goodwill for impairment. As allowed by this ASU for its January 1, 2012 annual impairment test, the Company did not elect the option to perform a qualitative evaluation about the likelihood of goodwill impairment to determine whether it should calculate the fair value of a reporting unit. Instead the Company followed the two-step method. Refer to Note 8 for the results of the annual goodwill impairment test.\nEffective January 1, 2012, the Company adopted ASU No. 2011-05, “Presentation of Comprehensive Income.” The amendments in this ASU impact all entities that report items of other comprehensive (loss) income and are effective retrospectively for public entities. The amendments in this ASU eliminate the option to present the components of other comprehensive (loss) income as part of the statement of changes in stockholders’ equity. The amendments provide the entity with the option to present the total of comprehensive (loss) income, the components of net (loss) income and the components of other comprehensive (loss) income either in a single continuous statement of comprehensive (loss) income or in two separate but consecutive statements. Both options require an entity to present each component of net (loss) income along with total net (loss) income, each component of other\n45\ncomprehensive (loss) income along with total other comprehensive (loss) income and a total amount for comprehensive (loss) income. The subsequent issuance of ASU 2011-12, “Comprehensive Income” in December 2011 deferred the changes in ASU 2011-05 that relate to the presentation of reclassification adjustments out of accumulated other comprehensive (loss) income. All other provisions in ASU 2011-05 were effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The presentation requirements associated with the adoption of ASU 2011-05 are reflected in the consolidated statements of operations and comprehensive loss herein.\nEffective January 1, 2012, the Company adopted ASU No. 2011-04, “Fair Value Measurement.” The amendments in this ASU apply to all reporting entities that are required or permitted to measure or disclose the fair value of an asset, a liability, or an instrument classified in a reporting entity’s shareholders’ equity in the financial statements. The amendments in this ASU clarify the requirements of the existing standard and include some changes to principles or requirements for measuring or disclosing information about fair value measurements. The adoption of this ASU did not have an impact on the Company's financial condition, liquidity or operating results. The disclosure requirements associated with the adoption of ASU 2011-04 are reflected in Note 10.\nStandards Updates Issued Not Yet Effective\nDuring December 2011, the FASB issued ASU No. 2011-11, “Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities.” The amendments in this ASU require an entity to disclose information to enable users of its financial statements to evaluate the effect or potential effect of netting arrangements on its financial position, including the effect or potential effect of rights of set off associated with an entity’s recognized assets and recognized liabilities within the scope of Topic 210. The ASU is effective for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. The adoption of this ASU may impact the Company’s disclosures in future interim and annual financial statements issued.\n(2) Acquisition\nOn December 15, 2011, the Company acquired 100 percent of the outstanding common shares of Tube Supply (the “Acquisition”). The Acquisition was accounted for using the acquisition method. Accordingly, the purchase price has been allocated to the assets acquired and liabilities assumed based on estimated fair values at date of acquisition. The nonrecurring fair value measurements are classified as Level 3 in the fair value hierarchy (see Note 10 for the definition of Level 3 inputs).\nThe results and the assets of Tube Supply are included in the Company’s Metals segment.\nTube Supply, based in Houston, Texas, is a leading value-added distributor of specialty tubular and bar products for the oil and gas industry. Tube Supply provides high quality products and services primarily to the North American oilfield equipment manufacturing industry. Tube Supply operates two service centers, which are located in Houston, Texas and Edmonton, Alberta. The Acquisition will allow the Company to capitalize on the growing demand and opportunities in the oil and gas sector through new product offerings to an expanded customer base.\nThe aggregate purchase price was $184,385 and represents the aggregate cash purchase price, including a working capital adjustment. The premium paid in excess of the fair value of the net assets acquired was primarily for the ability to expand the Company’s oil and gas product offerings, as well as to obtain Tube Supply’s skilled, established workforce.\nDuring 2011, the Company incurred $4,260 of direct acquisition-related costs, which are recorded in Sales, general and administrative expense.\n46\nAn allocation of the purchase price to the fair value of the assets acquired and liabilities assumed, which was finalized as of December 2012, is as follows:\nPurchase Price Allocation\n| Current assets | $ | 134,817 |\n| Property, plant and equipment, net | 6,767 |\n| Other assets | 346 |\n| Trade name | 7,700 |\n| Customer relationships | 48,800 |\n| Non-compete agreements | 1,000 |\n| Developed technology | 1,400 |\n| Goodwill | 19,637 |\n| Total assets acquired | 220,467 |\n| Current liabilities | 33,211 |\n| Long-term liabilities | 2,871 |\n| Total liabilities assumed | 36,082 |\n| Total purchase price | $ | 184,385 |\n\nThe acquired intangible assets have a weighted average useful life of approximately 11.4 years. Useful lives by intangible asset category are as follows: trade name - 10 years, customer relationships - 12 years, non-compete agreements - 3 years and developed technology - 3 years.\nAt closing, the Company entered into a lease agreement with the former owners of Tube Supply. At December 31, 2012 and 2011, an unfavorable lease liability associated with the lease for a newly constructed distribution center used by Tube Supply of $2,168 and $2,871, respectively, is recorded in other non-current liabilities. The current portion of the unfavorable lease liability in the amount of $645 is included in accrued liabilities in the consolidated balance sheets at December 31, 2012 and 2011. The unfavorable lease liability resulted from the present value of the difference between the estimated fair market value and the executed contract price the Company will pay to lease the property. The unfavorable lease liability will be amortized over the remaining life of the lease.\nThe goodwill and intangible assets are deductible for tax purposes.\nThe results of operations of Tube Supply have been included in the Company's consolidated statements of operations and comprehensive loss since December 15, 2011. The net sales and net income for Tube Supply during the period from December 15, 2011 through December 31, 2011 were $7,648 and $901, respectively.\nThe following unaudited pro forma summary presents the effect of the Acquisition during the years ended December 31, 2011 and 2010 as though the business had been acquired as of January 1, 2010:\n| Year ended December 31,(Unaudited) |\n| 2011 | 2010 |\n| Pro forma net sales | $ | 1,332,176 | $ | 1,069,564 |\n| Pro forma net income (loss) | 7,033 | (24,268 | ) |\n| Pro forma basic net income (loss) per share | $ | 0.31 | $ | (1.06 | ) |\n| Pro forma diluted net income (loss) per share | 0.28 | (1.06 | ) |\n\nUnaudited pro forma supplemental information is based upon management estimates and judgments. The unaudited pro forma supplemental information also includes purchase accounting and interest expense adjustments and the related tax effects. The unaudited pro forma supplemental information for the year ended December 31, 2011 excludes direct acquisition-related costs of $4,260 and includes loss on extinguishment of debt of $6,153 and interest costs of $7,366 associated with the underwriting fee for debt financing and the mark-to-market adjustment for the conversion option on the convertible bonds. The unaudited pro forma supplemental information for the year ended December 31, 2010 includes direct acquisition-related costs of $4,260. These pro forma results are not necessarily indicative of what would have occurred if the acquisition had been in effect for the periods presented or of future results. Pro forma financial information is not provided for the year ended December 31, 2012 as a full\n47\nyear of post-acquisition results of operations for Tube Supply were included in the Company's consolidated statements of operations and comprehensive loss.\nSee Note 9 for detailed discussion on the Company’s debt financing structure used to finance the Acquisition.\n(3) Segment Reporting\nThe Company distributes and performs processing on both metals and plastics. Although the distribution processes are similar, the customer markets, supplier bases and types of products are different. Additionally, the Company’s Chief Executive Officer, the chief operating decision-maker, reviews and manages these two businesses separately. As such, these businesses are considered reportable segments and are reported accordingly. Neither of the Company’s reportable segments has any unusual working capital requirements.\nIn its Metals segment, the Company’s marketing strategy focuses on distributing highly engineered specialty grades and alloys of metals as well as providing specialized processing services designed to meet very precise specifications. Core products include alloy, aluminum, stainless, nickel, titanium and carbon. Inventories of these products assume many forms such as plate, sheet, extrusions, round bar, hexagon bar, square and flat bar, tubing and coil. Depending on the size of the facility and the nature of the markets it serves, service centers are equipped as needed with bar saws, plate saws, oxygen and plasma arc flame cutting machinery, trepanning machinery, boring machinery, honing equipment, water-jet cutting, stress relieving and annealing furnaces, surface grinding equipment and sheet shearing equipment. This segment also performs various specialized fabrications for its customers through pre-qualified subcontractors that thermally process, turn, polish and straighten alloy and carbon bar.\nThe Company’s Plastics segment consists exclusively of a wholly-owned subsidiary that operates as Total Plastics, Inc. (“TPI”), headquartered in Kalamazoo, Michigan, and its wholly-owned subsidiaries. The Plastics segment stocks and distributes a wide variety of plastics in forms that include plate, rod, tube, clear sheet, tape, gaskets and fittings. Processing activities within this segment include cut-to-length, cut-to-shape, bending and forming according to customer specifications. The Plastics segment’s diverse customer base consists of companies in the retail (point-of-purchase), automotive, marine, office furniture and fixtures, safety products, life sciences applications, and general manufacturing industries. TPI has locations throughout the upper northeast and midwest regions of the U.S. and one facility in Florida from which it services a wide variety of users of industrial plastics.\nThe accounting policies of all segments are the same as described in Note 1. Management evaluates the performance of its business segments based on operating income.\nThe Company operates locations in the United States, Canada, Mexico, France, the United Kingdom, China and Singapore. No activity from any individual country outside the United States is material, and therefore, foreign activity is reported on an aggregate basis. Net sales are attributed to countries based on the location of the Company’s subsidiary that is selling direct to the customer. Company-wide geographic data as of and for the years ended December 31, 2012, 2011 and 2010 are as follows:\n| 2012 | 2011 | 2010 |\n| Net sales |\n| United States | $ | 988,161 | $ | 895,165 | $ | 757,052 |\n| All other countries | 282,207 | 237,201 | 186,654 |\n| Total | $ | 1,270,368 | $ | 1,132,366 | $ | 943,706 |\n| Long-lived assets |\n| United States | $ | 68,253 | $ | 72,138 |\n| All other countries | 11,387 | 10,003 |\n| Total | $ | 79,640 | $ | 82,141 |\n\n48\nSegment information as of and for the years ended December 31, 2012, 2011 and 2010 is as follows:\n| NetSales | OperatingIncome(Loss) | TotalAssets | CapitalExpenditures | Depreciation &Amortization |\n| 2012 |\n| Metals segment (a) | $ | 1,143,884 | $ | 49,822 | $ | 693,803 | $ | 9,819 | $ | 24,480 |\n| Plastics segment | 126,484 | 3,188 | 56,149 | 1,831 | 1,387 |\n| Other (b) | — | (11,865 | ) | 38,854 | — | — |\n| Consolidated | $ | 1,270,368 | $ | 41,145 | $ | 788,806 | $ | 11,650 | $ | 25,867 |\n| 2011 |\n| Metals segment (a) | $ | 1,014,130 | $ | 13,524 | $ | 729,692 | $ | 10,639 | $ | 19,329 |\n| Plastics segment | 118,236 | 2,860 | 56,171 | 2,228 | 1,143 |\n| Other (b) | — | (11,190 | ) | 36,460 | — | — |\n| Consolidated | $ | 1,132,366 | $ | 5,194 | $ | 822,323 | $ | 12,867 | $ | 20,472 |\n| 2010 |\n| Metals segment | $ | 841,067 | $ | (5,478 | ) | $ | 454,345 | $ | 6,815 | $ | 19,392 |\n| Plastics segment | 102,639 | 3,559 | 47,128 | 757 | 1,257 |\n| Other (b) | — | (7,419 | ) | 27,879 | — | — |\n| Consolidated | $ | 943,706 | $ | (9,338 | ) | $ | 529,352 | $ | 7,572 | $ | 20,649 |\n\n(a) The results of Tube Supply, acquired on December 15, 2011, are included in the Company's Metals segment.\n(b) “Other” – Operating loss includes the costs of executive, legal and finance departments, which are shared by both the Metals and Plastics segments. The “Other” category’s total assets consist of the Company’s investment in joint venture.\nBelow are reconciliations of segment data to the consolidated loss before income taxes:\n| 2012 | 2011 | 2010 |\n| Operating income (loss) | $ | 41,145 | $ | 5,194 | $ | (9,338 | ) |\n| Interest expense, net | (41,090 | ) | (9,663 | ) | (4,988 | ) |\n| Interest expense - unrealized loss on debt conversion option | (15,597 | ) | (3,991 | ) | — |\n| Loss on extinguishment of debt | — | (6,153 | ) | — |\n| Loss before income taxes and equity in earnings of joint venture | (15,542 | ) | (14,613 | ) | (14,326 | ) |\n| Equity in earnings of joint venture | 7,224 | 11,727 | 5,585 |\n| Consolidated loss before income taxes | $ | (8,318 | ) | $ | (2,886 | ) | $ | (8,741 | ) |\n\n(4) Lease Agreements\nThe Company has operating and capital leases covering certain warehouse facilities, equipment, automobiles and trucks, with the lapse of time as the basis for all rental payments.\nFuture minimum rental payments under operating and capital leases that have initial or remaining non-cancelable lease terms in excess of one year as of December 31, 2012, are as follows:\n| Capital | Operating |\n| 2013 | $ | 415 | $ | 14,401 |\n| 2014 | 396 | 11,375 |\n| 2015 | 392 | 10,091 |\n| 2016 | 197 | 8,702 |\n| 2017 | — | 8,007 |\n| Later years | — | 24,130 |\n| Total future minimum rental payments | $ | 1,400 | $ | 76,706 |\n\n49\nTotal rental payments charged to expense were $15,579 in 2012, $12,362 in 2011, and $13,712 in 2010. Lease extrication charges of $1,215 associated with the consolidation of two of the Company’s facilities in the Metals segment were included in total rental payments charged to expense in 2010 within Warehouse, processing and delivery expense in the consolidated statements of operations and comprehensive loss. There were no lease extrication charges in 2012 and 2011. Total gross value of property, plant and equipment under capital leases was $1,895 and $2,698 in 2012 and 2011, respectively.\n(5) Employee Benefit Plans\nPension Plans\nSubstantially all employees who meet certain requirements of age, length of service and hours worked per year are covered by Company-sponsored pension plans and supplemental pension plan (collectively, the “pension plans”). These pension plans are defined benefit, noncontributory plans. Benefits paid to retirees are based upon age at retirement, years of credited service and average earnings. The Company also has a supplemental pension plan, which is a non-qualified, unfunded plan. The Company uses a December 31 measurement date for the pension plans.\nThe Company-sponsored pension plans are frozen for all employees except for employees of certain subsidiaries and employees represented by the United Steelworkers of America. The assets of the Company-sponsored pension plans are maintained in a single trust account.\nThe Company’s funding policy is to satisfy the minimum funding requirements of the Employee Retirement Income Security Act of 1974, commonly called ERISA.\nComponents of net periodic pension credit are as follows:\n| 2012 | 2011 | 2010 |\n| Service cost | $ | 608 | $ | 539 | $ | 623 |\n| Interest cost | 6,832 | 7,393 | 7,456 |\n| Expected return on assets | (9,855 | ) | (10,054 | ) | (9,342 | ) |\n| Amortization of prior service cost | 324 | 324 | 231 |\n| Amortization of actuarial loss | 594 | 229 | 237 |\n| Net periodic pension credit | $ | (1,497 | ) | $ | (1,569 | ) | $ | (795 | ) |\n\nThe expected 2013 amortization of pension prior service cost and actuarial loss is $323 and $1,942, respectively.\n50\nThe status of the plans at December 31, 2012 and 2011 are as follows:\n| 2012 | 2011 |\n| Change in projected benefit obligation: |\n| Projected benefit obligation at beginning of year | $ | 164,407 | $ | 144,235 |\n| Service cost | 608 | 539 |\n| Interest cost | 6,832 | 7,393 |\n| Benefit payments | (6,558 | ) | (6,151 | ) |\n| Actuarial loss | 15,848 | 18,391 |\n| Projected benefit obligation at end of year | $ | 181,137 | $ | 164,407 |\n| Change in plan assets: |\n| Fair value of plan assets at beginning of year | $ | 174,938 | $ | 157,996 |\n| Actual return on assets | 18,463 | 22,867 |\n| Employer contributions | 307 | 226 |\n| Benefit payments | (6,558 | ) | (6,151 | ) |\n| Fair value of plan assets at end of year | $ | 187,150 | $ | 174,938 |\n| Funded status – net prepaid | $ | 6,013 | $ | 10,531 |\n| Amounts recognized in the consolidated balance sheets consist of: |\n| Prepaid pension cost | $ | 12,891 | $ | 15,956 |\n| Accrued liabilities | (309 | ) | (219 | ) |\n| Pension benefit obligations | (6,569 | ) | (5,206 | ) |\n| Net amount recognized | $ | 6,013 | $ | 10,531 |\n| Pre-tax components of accumulated other comprehensive income (loss): |\n| Unrecognized actuarial loss | $ | (29,778 | ) | $ | (23,131 | ) |\n| Unrecognized prior service cost | (1,617 | ) | (1,942 | ) |\n| Total | $ | (31,395 | ) | $ | (25,073 | ) |\n| Accumulated benefit obligation | $ | 180,551 | $ | 163,874 |\n\nFor the plan with an accumulated benefit obligation in excess of plan assets, the projected benefit obligation, accumulated benefit obligation and fair value of plan assets were $5,893, $5,893 and $0, respectively, at December 31, 2012; and $5,425, $5,425 and $0, respectively, at December 31, 2011.\nThe assumptions used to measure the projected benefit obligations for the Company’s defined benefit pension plans are as follows:\n| 2012 | 2011 |\n| Discount rate | 3.50 - 3.75% | 4.25 | % |\n| Projected annual salary increases | 0 - 3.00% | 0 - 3.00% |\n\nThe assumptions used to determine net periodic pension credit are as follows:\n| 2012 | 2011 | 2010 |\n| Discount rate | 4.25 | % | 5.25 | % | 5.75 | % |\n| Expected long-term rate of return on plan assets | 5.75 | % | 6.50 | % | 6.50 | % |\n| Projected annual salary increases | 0 - 3.00% | 0 - 3.00% | 0 - 3.00% |\n\nThe Company’s expected return on plan assets is derived from reviews of asset allocation strategies and historical and anticipated future long-term performance of individual asset classes. The Company’s analysis gives consideration to historical returns and long-term, prospective rates of return.\n51\nThe Company’s pension plan assets are allocated entirely to fixed income securities at December 31, 2012 and 2011.\nThe Company’s pension plans’ funds are managed in accordance with investment policies recommended by its investment advisor and approved by the Human Resources Committee of the Board of Directors. The overall target portfolio allocation is 100% fixed income securities. These funds’ conformance with style profiles and performance is monitored regularly by management, with the assistance of the Company’s investment advisor. Adjustments are typically made in the subsequent quarters when investment allocations deviate from the target range. The investment advisor provides quarterly reports to management and the Human Resources Committee of the Board of Directors.\nThe fair values of the Company’s pension plan assets fall within the following levels of the fair value hierarchy as of December 31, 2012:\n| Level 1 | Level 2 | Level 3 | Total |\n| Fixed income securities (1) | $ | 10,562 | $ | 176,610 | $ | — | $ | 187,172 |\n| Accounts payable – pending trades | (22 | ) |\n| Total | $ | 187,150 |\n\n\n| (1) | Fixed income securities are comprised of corporate bonds (75%), government bonds (16%), government agencies securities (6%) and other fixed income securities (3%). |\n\nThe fair values of the Company’s pension plan assets fall within the following levels of the fair value hierarchy as of December 31, 2011:\n| Level 1 | Level 2 | Level 3 | Total |\n| Fixed income securities (2) | $ | 9,949 | $ | 172,694 | $ | — | $ | 182,643 |\n| Accounts payable – pending trades | (7,705 | ) |\n| Total | $ | 174,938 |\n\n\n| (2) | Fixed income securities are comprised of corporate bonds (74%), government bonds (16%), government agencies securities (7%) and other fixed income securities (3%). |\n\nThe estimated future pension benefit payments are:\n| 2013 | $ | 7,974 |\n| 2014 | 8,213 |\n| 2015 | 8,828 |\n| 2016 | 9,115 |\n| 2017 | 9,607 |\n| 2018 — 2022 | 51,839 |\n\nThe Company is also party to certain multi-employer pension plans. The overall cost of such plans to the Company is insignificant. If the Company withdraws from a multi-employer pension plan in the future, it could potentially incur a withdrawal liability at that time.\nPostretirement Plan\nThe Company also provides declining value life insurance to its retirees and a maximum of three years of medical coverage to qualified individuals who retire between the ages of 62 and 65. The Company does not fund these benefits in advance, and uses a December 31 measurement date.\n52\nComponents of net periodic postretirement benefit cost for 2012, 2011 and 2010 were as follows:\n| 2012 | 2011 | 2010 |\n| Service cost | $ | 161 | $ | 164 | $ | 177 |\n| Interest cost | 170 | 222 | 219 |\n| Amortization of prior service cost | — | — | 29 |\n| Amortization of actuarial gain | — | — | (16 | ) |\n| Net periodic postretirement benefit cost | $ | 331 | $ | 386 | $ | 409 |\n\nThe expected 2012, amortization of postretirement prior service cost and actuarial gain are insignificant.\nThe status of the postretirement benefit plans at December 31, 2012 and 2011 were as follows:\n| 2012 | 2011 |\n| Change in accumulated postretirement benefit obligations: |\n| Accumulated postretirement benefit obligation at beginning of year | $ | 4,635 | $ | 4,339 |\n| Service cost | 161 | 164 |\n| Interest cost | 170 | 222 |\n| Benefit payments | (193 | ) | (100 | ) |\n| Actuarial (gain) loss | (394 | ) | 10 |\n| Accumulated postretirement benefit obligation at end of year | $ | 4,379 | $ | 4,635 |\n| Funded status – net liability | $ | 4,379 | $ | 4,635 |\n| Amounts recognized in the consolidated balance sheets consist of: |\n| Accrued liabilities | $ | (296 | ) | $ | (218 | ) |\n| Postretirement benefit obligations | (4,083 | ) | (4,417 | ) |\n| Net amount recognized | $ | (4,379 | ) | $ | (4,635 | ) |\n| Pre-tax components of accumulated other comprehensive income (loss): |\n| Unrecognized actuarial gain | $ | 661 | $ | 266 |\n| Total | $ | 661 | $ | 266 |\n\nThe assumed health care cost trend rates for medical plans at December 31 were as follows:\n| 2012 | 2011 | 2010 |\n| Medical cost trend rate | 8.00 | % | 8.50 | % | 8.00 | % |\n| Ultimate medical cost trend rate | 5.00 | % | 5.00 | % | 5.00 | % |\n| Year ultimate medical cost trend rate will be reached | 2019 | 2018 | 2013 |\n\nA 1% increase in the health care cost trend rate assumptions would have increased the accumulated postretirement benefit obligation at December 31, 2012 by $259 with no significant impact on the annual periodic postretirement benefit cost. A 1% decrease in the health care cost trend rate assumptions would have decreased the accumulated postretirement benefit obligation at December 31, 2012 by $235 with no significant impact on the annual periodic postretirement benefit cost.\n53\nThe weighted average discount rate used to determine the net periodic postretirement benefit costs and the accumulated postretirement benefit obligations were as follows:\n| 2012 | 2011 | 2010 |\n| Net periodic postretirement benefit costs | 3.75 | % | 5.25 | % | 5.75 | % |\n| Accumulated postretirement benefit obligations | 3.50 | % | 3.75 | % | 5.25 | % |\n\nRetirement Savings Plan\nThe Company’s retirement savings plan includes features under Section 401(k) of the Internal Revenue Code. Effective July 1, 2011, the Company’s 401(k) matching contribution was increased to 100% of each dollar on eligible employee contributions up to the first 6% of the employee’s pre-tax compensation and the Company’s fixed contribution of 4% of eligible earnings for all employees was eliminated. Company contributions cliff vest after two years of employment.\nEffective July 1, 2012, the Company's 401(k) plan was amended to include the U.S. employees of Tube Supply. Employees were eligible to participate in the Company's 401(k) plan immediately. Tube Supply's existing plan assets were rolled over into the Company's 401(k) plan during 2012 as a result of this amendment.\nThe amounts expensed are summarized below:\n| 2012 | 2011 | 2010 |\n| Supplemental contributions and 401(k) match | $ | 5,260 | $ | 4,414 | $ | 1,634 |\n\n(6) Joint Venture\nKreher Steel Co., LLC is a 50% owned joint venture of the Company. It is a metals distributor of bulk quantities of alloy, special bar quality and stainless steel bars, headquartered in Melrose Park, Illinois.\nThe following information summarizes the Company’s participation in the joint venture as of and for the year ended December 31:\n| 2012 | 2011 | 2010 |\n| Equity in earnings of joint venture | $ | 7,224 | $ | 11,727 | $ | 5,585 |\n| Investment in joint venture | 38,854 | 36,460 | 27,879 |\n| Sales to joint venture | 455 | 362 | 973 |\n| Purchases from joint venture | 695 | 884 | 223 |\n\nThe following information summarizes financial data for this joint venture as of and for the year ended December 31:\n| 2012 | 2011 | 2010 |\n| Revenues | $ | 257,776 | $ | 269,657 | $ | 188,107 |\n| Net income | 14,603 | 23,643 | 11,035 |\n| Current assets | 92,421 | 111,263 | 71,611 |\n| Non-current assets | 26,099 | 22,979 | 17,880 |\n| Current liabilities | 14,315 | 59,952 | 32,828 |\n| Non-current liabilities | 27,845 | 3,089 | 2,872 |\n| Members’ equity | 76,360 | 71,199 | 53,791 |\n| Capital expenditures | 5,259 | 6,736 | 2,271 |\n| Depreciation and amortization | 2,034 | 1,603 | 1,720 |\n\n54\n(7) Income Taxes\n(Loss) Income before income taxes and equity in earnings of joint venture generated by the Company’s U.S. and non-U.S. operations were as follows:\n| 2012 | 2011 | 2010 |\n| U.S | $ | (28,398 | ) | $ | (26,321 | ) | $ | (19,420 | ) |\n| Non-U.S. | 12,856 | 11,708 | 5,094 |\n\nThe Company’s income tax expense (benefit) is comprised of the following:\n| 2012 | 2011 | 2010 |\n| Federal |\n| current | $ | (842 | ) | $ | (1,204 | ) | $ | 6,823 |\n| deferred | (1,542 | ) | (2,041 | ) | (11,270 | ) |\n| State |\n| current | 629 | 461 | 17 |\n| deferred | 401 | (1,218 | ) | (186 | ) |\n| Foreign |\n| current | 2,927 | 2,970 | 1,464 |\n| deferred | (143 | ) | (94 | ) | 51 |\n| $ | 1,430 | $ | (1,126 | ) | $ | (3,101 | ) |\n\nThe reconciliation between the Company’s effective tax rate on income or loss and the U.S. federal income tax rate of 35% is as follows:\n| 2012 | 2011 | 2010 |\n| Federal income tax at statutory rates | $ | (5,439 | ) | $ | (5,115 | ) | $ | (5,014 | ) |\n| State income taxes, net of federal income tax benefits | 22 | (1,007 | ) | (313 | ) |\n| Permanent items: |\n| Dividends received deductions | (766 | ) | — | — |\n| Convertible debt mark-to-market - non-deductible | 6,206 | 1,551 |\n| Other permanent differences | 480 | 662 | 326 |\n| Federal and state income tax on joint venture | 2,766 | 4,478 | 2,158 |\n| Rate differential on foreign income | (1,680 | ) | (726 | ) | (755 | ) |\n| Unrecognized tax benefits | (557 | ) | (576 | ) | 424 |\n| Audit settlements | 218 | — | — |\n| State rate changes | (68 | ) | (478 | ) | — |\n| Other | 248 | 85 | 73 |\n| Income tax expense (benefit) | $ | 1,430 | $ | (1,126 | ) | $ | (3,101 | ) |\n| Effective income tax expense rate | 9.2 | % | 7.7 | % | 21.7 | % |\n\n55\nSignificant components of the Company’s deferred tax assets and liabilities are as follows:\n| 2012 | 2011 |\n| Deferred tax assets: |\n| Postretirement benefits | $ | 3,830 | $ | 3,675 |\n| Deferred compensation | 1,940 | 1,916 |\n| Deferred gain | — | 271 |\n| Impairments | 1,452 | 1,311 |\n| Alternative minimum tax and net operating loss carryforward | 3,487 | 2,635 |\n| Total deferred tax assets | $ | 10,709 | $ | 9,808 |\n| Deferred tax liabilities: |\n| Depreciation | $ | 8,032 | $ | 8,307 |\n| Inventory | 1,146 | 1,695 |\n| Pension | 4,240 | 5,742 |\n| Intangible assets and goodwill | 24,224 | 16,486 |\n| Other, net | 1,665 | 1,475 |\n| Total deferred tax liabilities | 39,307 | 33,705 |\n| Net deferred tax liabilities | $ | 28,598 | $ | 23,897 |\n\nAs of December 31, 2012, the Company has federal, state and foreign net operating losses (\"NOLs\") as follows:\n| Amount | Expiration Period |\n| Federal | $ | — |\n| State | 19,499 | 2015 to 2032 |\n| Foreign | 2,473 | (a) |\n\n(a) Foreign NOLs of $369 expire in 2014 and $2,104 do not expire.\nBased on all available evidence, including historical and forecasted financial results, the Company determined that it is more likely than not that the federal, state and foreign NOLs that have expiration dates will be realized due to the fact that the Company anticipates it will be able to have sufficient earnings in future years to use the NOL carryforwards prior to expiration. To the extent that the Company does not generate sufficient state or foreign taxable income within the statutory carryforward periods to utilize the NOL carryforwards in the respective jurisdictions, they will expire unused. However, based upon all available evidence, the Company has concluded that it will utilize these NOL carryforwards prior to the expiration period.\nThe following table shows the net change in the Company’s unrecognized tax benefits:\n| 2012 | 2011 | 2010 |\n| Balance as of January 1 | $ | 861 | $ | 1,465 | $ | 726 |\n| Increases (decreases) in unrecognized tax benefits: |\n| Due to tax positions taken in prior years | — | 91 | 729 |\n| Due to tax positions taken during the current year | 45 | 60 | 44 |\n| Due to settlement with tax authorities | (757 | ) | — | (34 | ) |\n| Due to expiration of statute | (44 | ) | (755 | ) | — |\n| Balance as of December 31 | $ | 105 | $ | 861 | $ | 1,465 |\n\nUnrecognized tax benefits of $105, $861 and $950 would impact the effective tax rate if recognized as of December 31, 2012, 2011 and 2010, respectively. The accrued interest and penalties related to unrecognized tax benefits were insignificant at December 31, 2012 and 2011. The interest and penalties recorded by the Company were insignificant for the years ended December 31, 2012, 2011 and 2010.\n56\nDuring 2012 and 2011, statutes expired on certain unrecognized tax benefits of the Company. The reversal of the reserve of these unrecognized tax benefits was recorded as a component of overall income tax benefit for the years ended December 31, 2012 and 2011, respectively.\nThe Company or its subsidiaries files income tax returns in the United States federal jurisdiction, 29 states, and 7 foreign jurisdictions.\nThe following tax years remain open to examination by the major taxing jurisdictions to which the Company is subject:\n| U.S. Federal | 2010 to 2011 |\n| U.S. States | 2008 to 2011 |\n| Foreign | 2007 to 2011 |\n\nDuring the second quarter of 2012, audits of the Company’s 2008 and 2009 U.S. federal income tax returns were concluded with no significant assessment. During 2011, the Company recognized $423 of tax benefits, excluding interest, due to the expiration of the statute of limitations for uncertain tax positions taken in prior years. Due to the potential for resolution of the examination or expiration of statutes of limitations, it is reasonably possible that the Company’s gross unrecognized tax benefits may change within the next 12 months by a range of zero to $60.\nThe Company received its 2010 federal tax refund of $2,025 during February 2012 and its 2009 federal income tax refund of $6,344 during January 2011.\n(8) Goodwill and Intangible Assets\nThe changes in carrying amounts of goodwill during the years ended December 31, 2012 and 2011 were as follows:\n| 2012 | 2011 |\n| MetalsSegment | PlasticsSegment | Total | MetalsSegment | PlasticsSegment | Total |\n| Balance as of January 1 |\n| Goodwill | $ | 117,145 | $ | 12,973 | $ | 130,118 | $ | 97,354 | $ | 12,973 | $ | 110,327 |\n| Accumulated impairment losses | (60,217 | ) | — | (60,217 | ) | (60,217 | ) | — | (60,217 | ) |\n| 56,928 | 12,973 | 69,901 | 37,137 | 12,973 | 50,110 |\n| Acquisition of Tube Supply | — | — | — | 19,637 | — | 19,637 |\n| Currency valuation | 399 | — | 399 | 154 | — | 154 |\n| Balance as of December 31 |\n| Goodwill | 117,544 | 12,973 | 130,517 | 117,145 | 12,973 | 130,118 |\n| Accumulated impairment losses | (60,217 | ) | — | (60,217 | ) | (60,217 | ) | — | (60,217 | ) |\n| $ | 57,327 | $ | 12,973 | $ | 70,300 | $ | 56,928 | $ | 12,973 | $ | 69,901 |\n\nThe Company’s annual test for goodwill impairment is completed as of January 1st each year. Based on its January 1, 2012 test, the Company determined that there was no impairment of goodwill. The Company's year-to-date operating results, among other factors, are considered in determining whether it is more likely than not that the fair value for any reporting unit has declined below its carrying value, which would require the Company to perform an interim goodwill impairment test. Another recession or economic declines in specific industries could change management's expectations of future financial results and/or key valuation assumptions used in determining the fair-value of its reporting units, which could result in a goodwill impairment.\n57\nThe following summarizes the components of intangible assets at December 31, 2012 and 2011 :\n| 2012 | 2011 |\n| Gross CarryingAmount | AccumulatedAmortization | Gross CarryingAmount | AccumulatedAmortization |\n| Customer relationships | $ | 119,118 | $ | 45,317 | $ | 118,567 | $ | 34,960 |\n| Non-compete agreements | 3,888 | 3,235 | 3,888 | 2,902 |\n| Trade names | 8,297 | 1,188 | 8,249 | 410 |\n| Developed technology | 1,400 | 486 | 1,400 | 19 |\n| Total | $ | 132,703 | $ | 50,226 | $ | 132,104 | $ | 38,291 |\n\nThe weighted-average amortization period for the intangible assets is 10.8 years, 11.3 years for customer relationships, 9.4 years for trade names, 3 years for non-compete agreements and 3 years for developed technology. Substantially all of the Company’s intangible assets were acquired as part of the acquisitions of Transtar on September 5, 2006 and Tube Supply on December 15, 2011.\nFor the years ended December 31, 2012, 2011, and 2010, the aggregate amortization expense was $11,843, $6,867 and $7,071, respectively.\nThe following is a summary of the estimated annual amortization expense for each of the next 5 years:\n| 2013 | $ | 11,775 |\n| 2014 | 11,742 |\n| 2015 | 10,975 |\n| 2016 | 10,975 |\n| 2017 | 8,951 |\n\n(9) Debt\nShort-term and long-term debt consisted of the following at December 31, 2012 and 2011:\n| 2012 | 2011 |\n| SHORT-TERM DEBT |\n| Foreign | $ | 500 | $ | 500 |\n| Total short-term debt | 500 | 500 |\n| LONG-TERM DEBT |\n| 12.75% Senior Secured Notes due December 15, 2016 | 225,000 | 225,000 |\n| 7.0% Convertible Notes due December 15, 2017 | 57,500 | 57,500 |\n| New Revolving Credit Facility due December 15, 2015 | 39,500 | 35,500 |\n| Other, primarily capital leases | 1,400 | 244 |\n| Total long-term debt | 323,400 | 318,244 |\n| Plus: derivative liability for conversion feature associated with convertible debt | — | 26,440 |\n| Less: unamortized discount | (26,831 | ) | (30,252 | ) |\n| Less: current portion | (415 | ) | (192 | ) |\n| Total long-term portion | 296,154 | 314,240 |\n| TOTAL SHORT-TERM AND LONG-TERM DEBT | $ | 297,069 | $ | 314,932 |\n\nDuring December of 2011, in conjunction with the completion of the Acquisition (see Note 2), the Company issued $225,000 aggregate principal amount of 12.75% Senior Secured Notes due 2016 (the “Secured Notes”), $57,500 aggregate principal amount of 7.0% Convertible Senior Notes due 2017 (the “Convertible Notes”) and entered into a $100,000 senior secured asset based revolving credit facility (the “New Revolving Credit Facility”). Net proceeds from these transactions (collectively referred to as the “Debt Transactions”) were used to complete the Acquisition, repay existing debt and for general corporate purposes. The Company incurred debt origination fees of $18,136\n58\nassociated with the Debt Transactions which are primarily being amortized using the effective interest method and recognized interest expense of $3,375 for underwriting fees associated with the debt financing. The Company recognized a loss of $6,153 on the extinguishment of its previously existing debt which included prepayment fees and the write-off of previously existing deferred financing costs.\nSecured Notes\nThe Company filed a registration statement with the Securities and Exchange Commission on Form S-4 on April 11, 2012. The registration statement was declared effective on June 12, 2012.\nOn June 12, 2012, the Company commenced an offer to exchange $225,000 principal amount of 12.75% Secured Notes due 2016, which are registered under the Securities Act of 1933 (the “New Secured Notes”), for $225,000 principal amount of outstanding 12.75% Senior Secured Notes due 2016, which had not been registered under the Securities Act of 1933 (the “Old Secured Notes”). The terms of the New Secured Notes issued are identical in all material respects to the Old Secured Notes, except that the New Secured Notes are registered under the Securities Act of 1933, do not have any of the transfer restrictions, registration rights and additional interest provisions relating to the Old Secured Notes and bear a different CUSIP number from the Old Secured Notes. The Company did not receive any proceeds from the exchange offer.\nThe New Secured Notes will mature on December 15, 2016. The Company will pay interest on the New Secured Notes at a rate of 12.75% per annum in cash semi-annually. During 2012, interest payments totaling $28,688 were made on June 15, 2012 and December 14, 2012. The New Secured Notes are fully and unconditionally guaranteed, jointly and severally, by certain 100% owned domestic subsidiaries of the Company (the “Note Guarantors”). The New Secured Notes and the related guarantees are secured by a lien on substantially all of the Company's and the Note Guarantors' assets, subject to certain exceptions and permitted liens pursuant to a pledge and security agreement. The terms of the New Secured Notes contain numerous covenants imposing financial and operating restrictions on the Company's business. These covenants place restrictions on the Company's ability and the ability of its subsidiaries to, among other things, pay dividends, redeem stock or make other distributions or restricted payments; incur indebtedness or issue common stock; make certain investments; create liens; agree to payment restrictions affecting certain subsidiaries; consolidate or merge; sell or otherwise transfer or dispose of assets, including equity interests of certain subsidiaries; enter into transactions with affiliates, enter into sale and leaseback transactions; and use the proceeds of permitted sales of the Company's assets. Refer to Note 14 for Guarantor Financial Information disclosure.\nOn or after December 15, 2014, the Company may redeem some or all of the New Secured Notes at a redemption premium of 106.375% of the principal amount for the 12-month period beginning December 15, 2014 and 100% thereafter, plus accrued and unpaid interest. Prior to December 15, 2014, the Company may redeem up to 35% of the aggregate principal amount of the New Secured Notes at a redemption price of 112.75% of the principal amount, plus accrued and unpaid interest, with the net cash proceeds of certain equity offerings. In addition, the Company may, at its option, redeem some or all of the New Secured Notes at any time prior to December 15, 2014, by paying a “make-whole” premium, plus accrued and unpaid interest.\nThe New Secured Notes also contain a provision that allows holders of the New Secured Notes to require the Company to repurchase all or any part of the Secured Notes if a change of control triggering event occurs. Under this provision, the repurchase of the New Secured Notes will occur at a purchase price of 101% of the outstanding principal amount, plus accrued and unpaid interest, if any, on such New Secured Notes to the date of repurchase. In addition, upon certain asset sales, the Company may be required to offer to use the net proceeds thereof to purchase some of the New Secured Notes at 100% of the principal amount thereof, plus accrued and unpaid interest.\nSubject to certain conditions, within 95 days after the end of each fiscal year, the Company must make an offer to purchase New Secured Notes with certain of its excess cash flow for such fiscal year (as defined in the indenture) for such fiscal year, commencing with the fiscal year ending December 31, 2012, at 103% of the principal amount thereof, plus accrued and unpaid interest. For the fiscal year ended December 31, 2012, the Company estimated excess cash flow (as defined in the indenture) to be approximately $17,000 and therefore, an offer to purchase New Secured Notes is required to be made within 95 days of year end.\nAlthough redemption of the New Secured Notes is outside of the control of the Company, the New Secured Notes in the amount of $17,000 are reported as long-term debt as availability under the Company's revolving credit facility, which is long-term in nature, would be used if redemption occurred.\n59\nConvertible Notes\nThe $50,000 Convertible Notes were issued pursuant to an indenture, dated as of December 15, 2011, among the Company, the Note Guarantors and U.S. Bank National Association, as trustee. The Convertible Notes were issued by the Company at an initial offering price equal to 100% of the principal amount. The Company granted the initial purchaser in the Convertible Notes offering an option, exercisable within 30 days, to purchase up to an additional $7,500 aggregate principal amount of Convertible Notes. The initial purchaser exercised their option in full and, on December 20, 2011, the Company issued an additional $7,500 aggregate principal amount of Convertible Notes.\nThe Convertible Notes will mature on December 15, 2017. The Company will pay interest on the Convertible Notes at a rate of 7.0% in cash semi-annually. During 2012, interest payments totaling $4,025 were made on June 15, 2012 and December 14, 2012. The Convertible Notes will be fully and unconditionally guaranteed, jointly and severally, on a senior unsecured basis by the Note Guarantors. The initial conversion rate for the Convertible Notes will be 97.2384 shares of the Company’s common stock per $1 principal amount of Convertible Notes, equivalent to an initial conversion price of approximately $10.28 per share of common stock. The conversion rate will be subject to adjustment, but will not be adjusted for accrued and unpaid interest, if any. In addition, if an event constituting a fundamental change occurs, the Company will in some cases increase the conversion rate for a holder that elects to convert its Convertible Notes in connection with such fundamental change. Upon conversion, the Company will pay and/or deliver, as the case may be, cash, shares of common stock or a combination of cash and shares of common stock, at the Company’s election, together with cash in lieu of fractional shares.\nHolders may convert their Convertible Notes at their option on any day prior to the close of business on the scheduled trading day immediately preceding June 15, 2017 only under the following circumstances: (1) during the five business-day period after any five consecutive trading-day period (the “measurement period”) in which the trading price per note for each day of that measurement period was less than 98% of the product of the last reported sale price of the Company’s common stock and the applicable conversion rate on each such day; (2) during any calendar quarter (and only during such calendar quarter) after the calendar quarter ended December 31, 2011, if the last reported sale price of the Company’s common stock for 20 or more trading days (whether or not consecutive) during the period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is equal to or greater than 130% of the applicable conversion price in effect for each applicable trading day; (3) upon the occurrence of specified corporate events, including certain dividends and distributions; or (4) if the Company calls the Convertible Notes for redemption on or after December 20, 2015. The Convertible Notes will be convertible, regardless of the foregoing circumstances, at any time from, and including, June 15, 2017 through the second scheduled trading day immediately preceding the maturity date.\nPrior to April 26, 2012, the Company had the option to elect not to issue shares of common stock upon conversion of the Convertible Notes to the extent such election would result in the issuance of more than 19.99% of the common stock outstanding immediately before the issuance of the Convertible Notes until the Company receives shareholder approval for such issuance and shareholder approval of the increase in the number of shares of common stock authorized and available for issuance upon conversion of the Convertible Notes. Since the Company did not have sufficient authorized shares available to share-settle the conversion option in full, the embedded conversion option did not qualify for equity classification and instead was separately valued and accounted for as a derivative liability as of December 31, 2011. The initial value allocated to the derivative liability was $22,330 of the $57,500 principal amount of the Convertible Notes, which represents a discount to the debt to be amortized through interest expense using the effective interest method through the maturity of the Convertible Notes. Accordingly, the effective interest rate used to amortize the debt discount on the Convertible Notes was determined to be 17.78%. During each reporting period prior to April 26, 2012, the derivative liability was marked to fair value through earnings. As of December 31, 2011, the derivative liability, which is classified in long-term debt, had a fair value of $26,440. There was no derivative liability as of December 31, 2012.\nOn April 26, 2012, at the Company's Annual Meeting of Stockholders, shareholder approval was obtained for the issuance of shares in excess of 20% of the Company's outstanding common stock to satisfy any conversions of the Convertible Notes. Additionally, shareholder approval was obtained to amend the Company's charter to authorize additional shares of common stock from 30,000 to 60,000. With these approvals, the Company now has the ability to share-settle the conversion option in full and therefore, the embedded conversion option is no longer required to be separately valued and accounted for as a derivative liability. As of April 26, 2012, the conversion option's cumulative value of $42,037 was reclassified to additional paid-in capital and will no longer be marked-to-market through earnings. The deferred tax benefit of $8,285 associated with the temporary difference between the financial reporting basis of the derivative liability and its tax basis at the date of issuance (December 15, 2011) was also reclassified to additional paid-in capital.\n60\nUpon a fundamental change, subject to certain exceptions, holders may require the Company to repurchase some or all of their Convertible Notes for cash at a repurchase price equal to 100% of the principal amount of the Convertible Notes being repurchased, plus any accrued and unpaid interest.\nThe Company may not redeem the Convertible Notes prior to December 20, 2015. On or after December 20, 2015, the Company may redeem all or part of the Convertible Notes (except for the Convertible Notes that we are required to repurchase as described above) if the last reported sale price of the Company’s common stock exceeds 135% of the applicable conversion price for 20 or more trading days in a period of 30 consecutive trading days ending on the trading day immediately prior to the date of the redemption notice. The redemption price will equal the sum of 100% of the principal amount of the Convertible Notes to be redeemed, plus accrued and unpaid interest, plus a “make-whole premium” payment. The Company must make the \"make-whole\" premium payments on all Convertible Notes called for redemption including Convertible Notes converted after the date we delivered the notice of redemption. The Company will pay the redemption price in cash except for any non-cash portion of the \"make-whole\" premium.\nNew Revolving Credit Facility\nThe New Revolving Credit Facility consists of a $100,000 senior secured asset-based revolving credit facility (subject to adjustment pursuant to a borrowing base described below), of which (a) up to an aggregate principal amount of $20,000 will be available for a Canadian subfacility, (b) up to an aggregate principal amount of $20,000 will be available for letters of credit and (c) up to an aggregate principal amount of $10,000 will be available for swingline loans. Loans under the New Revolving Credit Facility will be made available to the Company and certain domestic subsidiaries (the “U.S. Borrowers”) in U.S. dollars and the Canadian Borrowers in U.S. dollars and Canadian dollars. The New Revolving Credit Facility will mature on December 15, 2015.\nAll obligations of the U.S. Borrowers under the New Revolving Credit Facility are guaranteed on a senior secured basis by each direct and indirect, existing and future, domestic subsidiary of the U.S. Borrowers (the “U.S. Subsidiary Guarantors” and together with the U.S. Borrowers, the “U.S. Credit Parties”), subject to certain exceptions for immaterial subsidiaries. All obligations of the Canadian Borrowers under the New Revolving Credit Facility are guaranteed on a senior secured basis by (a) each U.S. Credit Party and (b) each direct and indirect, existing and future, Canadian subsidiary of the Company (the “Canadian Subsidiary Guarantors” and together with the Canadian Borrowers, the “Canadian Credit Parties”; and the U.S. Credit Parties together with the Canadian Credit Parties, the “Credit Parties”), subject to certain exceptions.\nAll obligations under the New Revolving Credit Facility are secured on a first-priority basis by a perfected security interest in substantially all assets of the Credit Parties (subject to certain exceptions for permitted liens). The New Revolving Credit Facility will rank pari passu in right of payment with the Secured Notes, but, pursuant to the intercreditor agreement, the Secured Notes will be effectively subordinated to the indebtedness under the New Revolving Credit Facility with respect to the collateral.\nAt the Company’s election, borrowings under the New Revolving Credit Facility will bear interest at variable rates based on (a) a customary base rate plus an applicable margin of between 0.50% and 1.00% (depending on quarterly average undrawn availability under the New Revolving Credit Facility) or (b) an adjusted LIBOR rate plus an applicable margin of between 1.50% and 2.00% (depending on quarterly average undrawn availability under the New Revolving Credit Facility). The weighted average interest rate on borrowings under the revolving credit facilities were 2.71% and 1.63% for the year ended December 31, 2012 and 2011, respectively. The Company will pay certain customary recurring fees with respect to the New Revolving Credit Facility.\nThe New Revolving Credit Facility permits the Company to increase the aggregate amount of the commitments under the New Revolving Credit Facility from time to time in an aggregate amount for all such increases not to exceed $50,000, subject to certain conditions. The existing lenders under the New Revolving Credit Facility are not obligated to provide the incremental commitments.\nThe New Revolving Credit facility contains a springing financial maintenance covenant requiring the Company to maintain the ratio of EBITDA (as defined in the agreement) to fixed charges of 1.1 to 1.0 when excess availability is less than the greater of 10% of the calculated borrowing base (as defined in the agreement) or $10,000. In addition, if excess availability is less than the greater of 12.5% of the calculated borrowing base (as defined in the agreement) or $12,500, the lender has the right to take full dominion of the Company’s cash collections and apply these proceeds to outstanding loans under the New Revolving Credit Agreement. As of December 31, 2012, the Company’s excess availability of $50,543 was above such thresholds.\n61\nNet interest expense reported on the consolidated statements of operations was reduced by interest income from investment of excess cash balances of $222 in 2012, $254 in 2011 and $201 in 2010.\n(10) Fair Value Measurements\nThe three-tier value hierarchy the Company utilizes, which prioritizes the inputs used in the valuation methodologies, is:\nLevel 1—Valuations based on quoted prices for identical assets and liabilities in active markets.\nLevel 2—Valuations based on observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data.\nLevel 3—Valuations based on unobservable inputs reflecting our own assumptions, consistent with reasonably available assumptions made by other market participants.\nThe fair value of cash, accounts receivable and accounts payable approximate their carrying values. The fair value of cash equivalents are determined using the fair value hierarchy described above. Cash equivalents consisting of money market funds are valued based on quoted prices in active markets and as a result are classified as Level 1.\nThe Company’s pension plan asset portfolio as of December 31, 2012 and 2011 is primarily invested in fixed income securities, which generally fall within Level 2 of the fair value hierarchy. Fixed income securities in the are valued based on evaluated prices provided to the trustee by independent pricing services. Such prices may be determined by factors which include, but are not limited to, market quotations, yields, maturities, call features, ratings, institutional size trading in similar groups of securities and developments related to specific securities. Refer to Note 5 for pension fair value disclosures.\nFair Value Measurements of Debt\nThe fair value of the Company’s Senior Secured Notes as of December 31, 2012 was estimated to be $263,813 compared to a carrying value of $218,335, net of unamortized discount. The fair value for the Senior Secured Notes is determined based on recent trades of the bonds and fall within level 2 of the fair value hierarchy.\nThe fair value of the Convertible Notes, as of December 31, 2012 was estimated to be approximately $95,000 compared to a carrying value of $37,334, net of unamortized discount. The fair value for the Convertible Notes, which fall within level 3 of the fair value hierarchy, is determined based on similar debt instruments that do not contain a conversion feature, as well as other factors related to the callable nature of the notes.\nThe main inputs and assumptions into the fair value model for the Convertible Notes at December 31, 2012 were as follows:\n| Company's stock price at the end of the period | $ | 14.77 |\n| Expected volatility | 22.3 | % |\n| Credit spreads | 8.22 | % |\n| Risk-free interest rate | 0.36 | % |\n\nThe estimated fair value of the derivative liability for the conversion feature (refer to table below), which falls within level 3 of the fair value hierarchy, as of December 31, 2011 was computed using a binomial lattice model using the Company’s historical volatility over the term corresponding to the remaining contractual term of the Convertible Notes and observed spreads of similar debt instruments that do not include a conversion feature.\nAs of December 31, 2012, the estimated fair value of the Company’s debt outstanding under its revolving credit facilities, which falls within level 3 of the fair value hierarchy, is $37,775 compared to its carrying value of $40,000, assuming the current amount of debt outstanding at the end of the year was outstanding until the maturity of the Company’s facility in December 2015. Although borrowings could be materially greater or less than the current amount of borrowings outstanding at the end of the year, it is not practical to estimate the amounts that may be outstanding during the future periods since there is no predetermined borrowing or repayment schedule.\n62\nFair Value Measurements of Commodity Hedges\nThe Company has a commodity hedging program to mitigate risks associated with certain commodity price fluctuations. At December 31, 2012, the Company had executed forward contracts that extend through 2016. The counterparty to these contracts is not considered a credit risk by the Company. At December 31, 2012 and 2011, the notional value associated with forward contracts was $17,191 and $15,486, respectively. The Company recorded, through cost of materials, realized and unrealized losses of $430 and $2,377 during the years ended December 31, 2012 and 2011, respectively, as a result of the decline in the fair value of the contracts. There were no gains or losses recorded for commodity hedges during 2010. Refer to Note 13 for letters of credit outstanding for collateral associated with commodity hedges.\nThe Company uses information which is representative of readily observable market data when valuing derivative liabilities associated with commodity hedges. The derivative liabilities are classified as Level 2 in the table below.\nThe liabilities measured at fair value on a recurring basis were as follows:\n| Level 1 | Level 2 | Level 3 | Total |\n| As of December 31, 2012: |\n| Derivative liability for commodity hedges | $ | — | $ | 2,494 | $ | — | $ | 2,494 |\n| As of December 31, 2011: |\n| Derivative liability for commodity hedges | $ | — | $ | 2,331 | $ | — | $ | 2,331 |\n| Derivative liability for conversion feature associated with convertible debt | — | — | 26,440 | 26,440 |\n\nThe following reconciliation represents the change in fair value of Level 3 liabilities between January 1, 2012 and December 31, 2012:\n| Derivative liability forconversion featureassociated withconvertible debt |\n| Fair value as of January 1 | $ | 26,440 |\n| Mark-to-market adjustment on conversion feature | 15,597 |\n| Reclassification from long-term debt to additional paid-in capital | (42,037 | ) |\n| Fair value as of December 31 | $ | — |\n\n(11) Share-based Compensation\nThe Company accounts for its share-based compensation arrangements by recognizing compensation expense for the fair value of the share awards ratably over their vesting period or a shorter period, as applicable. The consolidated compensation cost recorded for the Company’s share-based compensation arrangements was $2,277, $4,349 and $2,411 for 2012, 2011 and 2010, respectively. The total income tax benefit recognized in the consolidated statements of operations for share-based compensation arrangements was $872, $1,534 and $831 in 2012, 2011 and 2010, respectively. All compensation expense related to share-based compensation arrangements is recorded in sales, general and administrative expense. The unrecognized compensation cost as of December 31, 2012 associated with all share-based payment arrangements is $4,973 and the weighted average period over which it is to be expensed is 1.4 years.\n| Plan Description | Authorized Shares |\n| 1995 Directors Stock Option Plan | 188 |\n| 1996 Restricted Stock and Stock Option Plan | 938 |\n| 2000 Restricted Stock and Stock Option Plan | 1,200 |\n| 2004 Restricted Stock, Stock Option and Equity Compensation Plan | 1,350 |\n| 2008 A. M. Castle & Co. Omnibus Incentive Plan (amended and restated as of April 28, 2011) | 2,750 |\n\n63\nLong-Term Compensation and Incentive Plans\nOn March 7, 2012, the Human Resources Committee (the “Committee”) of the Board of Directors of the Company approved equity awards under the Company’s 2012 Long-Term Compensation Plan (\"2012 LTC Plan\") for executive officers and other select personnel. The 2012 LTC Plan awards included restricted stock units (\"RSUs\") and performance share units (\"PSUs\"). All 2012 LTC Plan awards are subject to the terms of the Company's 2008 A.M. Castle & Co. Omnibus Incentive Plan.\nOn March 2, 2011, the Committee approved equity awards under the Company's 2011 Long-Term Compensation Plan (\"2011 LTC Plan\") for executive officers and other select personnel. The 2011 LTC Plan awards included RSUs and PSUs. All 2011 LTC Plan awards are subject to the terms of the Company's 2008 A.M. Castle Omnibus Incentive Plan.\nOn March 18, 2010, the Committee approved equity awards under the Company’s 2010 Long-Term Compensation Plan (“2010 LTC Plan”) for executive officers and other select personnel. The 2010 LTC Plan awards included RSUs, PSUs, and stock options. All 2010 LTC Plan awards are subject to the terms of the Company’s 2008 Restricted Stock, Stock Option and Equity Compensation Plan, amended and restated as of December 9, 2010.\nUnless covered by a specific change-in-control or severance agreement, participants to whom RSUs, performance shares and other non-vested shares have been granted must be employed by the Company on the vesting date or at the end of the performance period, respectively, or the award will be forfeited. However, for stock option awards, unless a participant is covered by a specific change-in-control or severance agreement, options are forfeited in the event of the termination of employment other than by reason of disability or a retirement.\nCompensation expense is recognized based on management’s estimate of the total number of share-based awards expected to vest at the end of the service period.\nRestricted Share Units and Non-Vested Shares\nThe RSUs granted under the 2012 and 2011 LTC Plans will cliff vest on December 31, 2014 and December 31, 2013, respectively. Approximately 78 RSUs granted under the 2010 LTC Plan cliff vested on December 31, 2012. Each RSU that becomes vested entitles the participant to receive one share of the Company’s common stock. The number of shares delivered may be reduced by the number of shares required to be withheld for federal and state withholding tax requirements (determined at the market price of Company shares at the time of payout).\nThe outstanding non-vested share balance consists of shares issued to the Board of Directors during the second quarter of 2012 and shares issued for retention incentive purposes. The Director shares vest during the second quarter of 2015 and the balance of the shares vest on December 31, 2014. The RSU share balance consists of units granted to employees for incentive purposes.\nThe fair value of the RSUs and non-vested shares is established using the market price of the Company’s stock on the date of grant.\nA summary of the non-vested share and RSU activity is as follows:\n| Shares | Units |\n| Shares | Weighted-Average GrantDate Fair Value | Units | Weighted-Average GrantDate Fair Value |\n| Outstanding at January 1, 2012 | 38 | $ | 18.74 | 232 | $ | 14.39 |\n| Granted | 73 | $ | 12.22 | 309 | $ | 10.60 |\n| Forfeited | (5 | ) | $ | 17.02 | (158 | ) | $ | 12.44 |\n| Vested | (33 | ) | $ | 18.95 | (85 | ) | $ | 12.45 |\n| Outstanding at December 31, 2012 | 73 | $ | 12.22 | 298 | $ | 12.05 |\n| Expected to vest at December 31, 2012 | 73 | $ | 12.22 | 256 | $ | 12.36 |\n\nThe unrecognized compensation cost as of December 31, 2012 associated with RSU and non-vested share awards is $2,758. The total fair value of shares vested during the years ended December 31, 2012, 2011 and 2010 was $1,685, $2,166 and $600, respectively.\n64\nPerformance Shares\nUnder the 2012, 2011 and 2010 LTC Plans, the potential award for the performance shares granted is dependent on the Company’s relative total shareholder return (“RTSR”), which represents a market condition, over a three-year performance period, beginning January 1, 2012, January 1, 2011 and January 1, 2010 and ending December 31, 2014, December 31, 2013 and December 31, 2012, respectively. RTSR is measured against a group of peer companies either in the metals industry or in the industrial products distribution industry (the “RTSR Peer Group”). The 2012, 2011 and 2010 LTC Plans provide with respect to performance shares for (1) a threshold level up to which the threshold level of performance shares will vest, a target performance level at which the target number of performance shares will vest, a maximum performance level at or above which the maximum number of performance shares will vest, and pro rata vesting between the threshold and maximum performance levels and (2) minimum and maximum vesting opportunities ranging from one-half up to two times the target number. The threshold, target and maximum performance levels for RTSR are the 25th, 50th and 75th percentile, respectively, relative to RTSR Peer Group performance. The number of performance shares, if any, that vest based on the performance achieved during the three-year performance period, will vest at the end of the three-year performance period. Compensation expense for performance awards containing a market condition is recognized regardless of whether the market condition is achieved to the extent the requisite service period condition is met. Each performance share that becomes vested entitles the participant to receive one share of the Company’s common stock. The number of shares delivered may be reduced by the number of shares required to be withheld for federal and state withholding tax requirements (determined at the market price of Company shares at the time of payout).\nUnder the 2012 and 2011 LTC Plans, the potential award for performance shares containing a non-market-based performance condition is determined based on the Company's actual performance versus Company-specific target goals for Return on Invested Capital (“ROIC”), as defined in the 2012 and 2011 LTC Plans. Under the 2012 LTC Plan, the non-market-based performance condition is determined based on the Company's average actual performance versus Company-specific goals for ROIC for the three-year performance period beginning on January 1st of the year of grant. Under the 2011 LTC Plan, the non-market-based performance condition is determined for any one or more fiscal years during the three-year performance period beginning on January 1st of the year of grant. Partial performance awards can be earned for performance less than the target goal, but in excess of minimum goals and award distributions twice the target can be achieved if the maximum goals are met or exceeded. The number of performance shares, if any, that vest based on the performance achieved during the three-year performance period, will vest at the end of the three-year performance period. Compensation expense recognized is based on management’s expectation of future performance compared to the pre-established performance goals. If the performance goals are not expected to be met, no compensation expense is recognized and any previously recognized compensation expense is reversed.\nThe grant date fair values of performance shares awarded containing the RTSR market-based performance condition was estimated using a Monte Carlo simulation with the following assumptions:\n| 2012 | 2011 | 2010 |\n| Grant Date Fair Value per Share | $ | 13.78 | $ | 23.89 | $ | 12.26 |\n| Expected volatility | 85.0 | % | 62.0 | % | 61.6 | % |\n| Risk-free interest rate | 0.40 | % | 1.10 | % | 1.45 | % |\n| Expected life (in years) | 2.81 | 2.84 | 2.80 |\n| Expected dividend yield | — | — | — |\n\nPerformance awards under the active LTC Plans were granted to the Company's new CEO in October 2012. The grant date fair values of performance shares awarded to the CEO containing the RTSR market-based performance condition was estimated using a Monte Carlo simulation with the following assumptions:\n| 2012 | 2011 | 2010 |\n| Grant Date Fair Value per Share | $ | 16.65 | $ | 10.61 | $ | 5.57 |\n| Expected volatility | 60.7 | % | 60.7 | % | 60.7 | % |\n| Risk-free interest rate | 0.34 | % | 0.34 | % | 0.34 | % |\n| Expected life (in years) | 2.21 | 1.21 | 0.21 |\n| Expected dividend yield | — | — | — |\n\n65\nFinal award vesting and distribution of performance awards granted under the 2010 LTC Plan was determined based on the Company’s actual performance versus the target goals for a three-year consecutive period (as defined in the 2010 Plan). Refer to the table below for the number of shares expected to be issued under 2010 LTC Plan.\n| Plan Year | Grant Date Fair Value | Estimated Number ofPerformance Shares to be Issued | Maximum Number ofPerformance Shares thatcould Potentially be Issued |\n| 2012 LTC Plan |\n| Market-based performance condition | $ | 13.78 | 172 | 244 |\n| Market-based performance condition (1) | $ | 16.65 | 41 | 58 |\n| Non-market-based performance condition | $ | 10.02 | — | 244 |\n| Non-market-based performance condition (1) | $ | 12.74 | — | 58 |\n| 2011 LTC Plan |\n| Market-based performance condition | $ | 23.89 | 39 | 131 |\n| Market-based performance condition (1) | $ | 10.61 | 9 | 32 |\n| Non-market-based performance condition | $ | 17.13 | — | 131 |\n| Non-market-based performance condition (1) | $ | 12.74 | — | 32 |\n| 2010 LTC Plan |\n| Market-based performance condition | $ | 12.26 | 83 | 237 |\n| Market-based performance condition (1) | $ | 5.57 | 2 | 5 |\n\n(1) Represents the status of performance awards granted under the active LTC Plans in October 2012.\nThe unrecognized compensation cost as of December 31, 2012 associated with the 2012 and 2011 LTC Plans performance shares is $2,145.\nStock Options\nThere were no stock options issued under the 2012 or 2011 LTC Plans. The stock options issued under the 2010 LTC Plan vest and become exercisable three years from the date of the grant. The term of the options is eight years. The exercise price of the options is $12.79 per share. The grant date fair value of $5.71 per share was estimated using the Black-Scholes option-pricing model with the following assumptions:\n| 2010 |\n| Expected volatility | 58.5 | % |\n| Risk-free interest rate | 2.3 | % |\n| Expected life (in years) | 5.5 |\n| Expected dividend yield | 1.2 | % |\n\n| Shares | WeightedAverageExercise Price | IntrinsicValue | Weighted AverageRemainingContractual Life |\n| Stock options outstanding at January 1, 2012 | 418 | $ | 12.44 |\n| Exercised | (16 | ) | $ | 9.11 |\n| Forfeited | (113 | ) | $ | 15.56 |\n| Expired | (19 | ) | $ | 12.60 |\n| Stock options outstanding at December 31, 2012 | 270 | $ | 11.34 | $ | 937 | 3.8 |\n| Stock options exercisable at December 31, 2012 | 111 | $ | 9.25 | $ | 621 | 1.5 |\n| Stock options vested or expected to vest as of December 31, 2012 | 259 | $ | 11.28 | $ | 915 | 3.7 |\n\n66\nThe total intrinsic value of options exercised during the years ended December 31, 2012, 2011 and 2010, was $36, $194 and $219, respectively. The unrecognized compensation cost as of December 31, 2012 associated with stock options is $70.\n(12) Stockholders' Equity\nShareholder Rights Plan\nIn August 2012, the Company's Board of Directors adopted a Shareholder Rights Plan (the “Rights Plan”) and declared a dividend of one right for each outstanding share of the Company's common stock outstanding at the close of business on September 11, 2012. Pursuant to the Rights Plan, the Company is issuing one preferred stock purchase right (a “Right”) for each share of common stock outstanding on September 11, 2012. Each Right, once exercisable, represents the right to purchase one one-hundredth of a share (a “Unit”) of Series B Junior Preferred Stock of the Company, without par value, for $54.00, subject to adjustment. The Rights become exercisable in the event any individual person or entity, without Board approval, acquires 10% or more of the Company's common stock, subject to certain exceptions. In these circumstances, each holder of a Right (other than rights held by the acquirer) will be entitled to purchase, at the then-current exercise price of the Right, additional shares of the Company's common stock having a value of twice the exercise price of the Right. Additionally, if the Company is involved in a merger or other business combination transaction with another person after which its common stock does not remain outstanding, each Right will entitle its holder to purchase, at the then-current exercise price of the Right, shares of common stock of the ultimate parent of such other person having a market value of twice the exercise price of the Right. The Rights may be redeemed by the Company for $0.001 per Right at any time until the tenth business day following the first public announcement of an acquisition of beneficial ownership of 10% of the Company's common stock. The Rights Plan will expire on August 30, 2013.\nAccumulated Other Comprehensive Loss\nAccumulated other comprehensive loss as reported in the consolidated balance sheets as of December 31, 2012 and 2011 was comprised of the following:\n| 2012 | 2011 |\n| Foreign currency translation losses | $ | (2,322 | ) | $ | (4,691 | ) |\n| Unrecognized pension and postretirement benefit costs, net of tax | (18,749 | ) | (15,133 | ) |\n| Total accumulated other comprehensive loss | $ | (21,071 | ) | $ | (19,824 | ) |\n\n(13) Commitments and Contingent Liabilities\nAs of December 31, 2012, the Company had $6,794 of irrevocable letters of credit outstanding which primarily consisted of $4,000 for collateral associated with commodity hedges and $1,994 for compliance with the insurance reserve requirements of its workers’ compensation insurance carriers.\nThe Company is party to a variety of legal proceedings and other claims, including proceedings by government authorities, which arise from the operation of its business. These proceedings are incidental and occur in the normal course of the Company's business affairs. The majority of these claims and proceedings relate to commercial disputes with customers, suppliers, and others; employment, including benefit matters; product quality; and environmental, health and safety claims. It is the opinion of management that the currently expected outcome of these proceedings and claims, after taking into account recorded accruals and the availability and limits of our insurance coverage, will not have a material adverse effect on the consolidated results of operations, financial condition or cash flows of the Company.\nIn 2011, the Company determined that it inadvertently exported certain aluminum alloy bar that are listed on the U.S. Bureau of Industry and Security's (BIS) Commerce Control List to countries where there is an export license requirement if an exception is not otherwise available. The exports, which occurred in 2011, had a total transaction value of approximately $13 and were made without export licenses. The exports involved five shipments to the Company's wholly-owned subsidiary in China and to a customer in the Philippines. In response thereto, the Company submitted a voluntary self-disclosure describing the nature of these shipments to the Office of Export Enforcement of the Department of Commerce (OEE) in accordance with applicable Export Administration Regulations. The Company previously disclosed similar incidents to BIS in 2008, which were resolved in September 2011 through the payment of a $775 civil penalty and a commitment to satisfy certain compliance and reporting obligations. If it is determined that the Company failed to comply with the applicable U.S. export regulations, the OEE could assess civil penalties of up to $1,250, restrict export privileges or provide an administrative warning.\n67\nWhile the ultimate disposition of this matter cannot be predicted with certainty, it is the opinion of management, based on the information available at this time, that the outcome of this matter will not have a material effect on the Company's financial position, results of operations or cash flows.\n(14) Guarantor Financial Information\nThe accompanying consolidating financial information has been prepared and presented pursuant to Rule 3-10 of SEC Regulation S-X “Financial Statements of Guarantors and Issuers of Guaranteed Securities Registered or Being Registered.” The consolidating financial information presents A. M. Castle & Co. (Parent) and subsidiaries. The consolidating financial information has been prepared on the same basis as the consolidated statements of the Parent. The equity method of accounting is followed within this financial information.\nIn September 2012, the Company merged Tube Supply, LLC, a guarantor, with the Parent. The Company has reflected this change in its accompanying consolidating financial statements of guarantors and non-guarantors.\n68\n| Condensed Consolidating Balance SheetAs of December 31, 2012 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Assets |\n| Current assets |\n| Cash and cash equivalents | $ | 3,332 | $ | 1,677 | $ | 16,598 | $ | — | $ | 21,607 |\n| Accounts receivable, less allowance for doubtful accounts | 60,293 | 34,037 | 43,981 | — | 138,311 |\n| Receivables from affiliates | 95 | 1,118 | 668 | (1,881 | ) | — |\n| Inventories | 183,189 | 44,874 | 75,777 | (68 | ) | 303,772 |\n| Prepaid expenses and other current assets | 16,141 | (1,490 | ) | 8,239 | (202 | ) | 22,688 |\n| Total current assets | 263,050 | 80,216 | 145,263 | (2,151 | ) | 486,378 |\n| Investment in joint venture | 38,854 | — | — | — | 38,854 |\n| Goodwill | 12,921 | 41,556 | 15,823 | — | 70,300 |\n| Intangible assets | 34,343 | 28,325 | 19,809 | — | 82,477 |\n| Other assets | 28,142 | (98 | ) | 3,113 | — | 31,157 |\n| Investment in subsidiaries | 245,798 | 11,526 | — | (257,324 | ) | — |\n| Receivables from affiliates | 62,696 | 83,891 | 3,280 | (149,867 | ) | — |\n| Property, plant and equipment, net | 52,424 | 15,403 | 11,813 | — | 79,640 |\n| Total assets | $ | 738,228 | $ | 260,819 | $ | 199,101 | $ | (409,342 | ) | $ | 788,806 |\n| Liabilities and Stockholders’ Equity |\n| Current liabilities |\n| Accounts payable | $ | 40,510 | $ | 13,434 | $ | 14,046 | $ | — | $ | 67,990 |\n| Payables due to affiliates | 742 | 95 | 1,044 | (1,881 | ) | — |\n| Other current liabilities | 26,566 | 3,478 | 8,083 | — | 38,127 |\n| Current portion of long-term debt and short-term debt | 386 | 1 | 528 | — | 915 |\n| Total current liabilities | 68,204 | 17,008 | 23,701 | (1,881 | ) | 107,032 |\n| Long-term debt, less current portion | 292,086 | — | 4,068 | — | 296,154 |\n| Payables due to affiliates | 12,114 | 11,994 | 125,759 | (149,867 | ) | — |\n| Deferred income taxes | 14,209 | 18,614 | (473 | ) | — | 32,350 |\n| Other non-current liabilities | 14,275 | 1,339 | 316 | — | 15,930 |\n| Stockholders’ equity | 337,340 | 211,864 | 45,730 | (257,594 | ) | 337,340 |\n| Total liabilities and stockholders’ equity | $ | 738,228 | $ | 260,819 | $ | 199,101 | $ | (409,342 | ) | $ | 788,806 |\n\n69\n| Condensed Consolidating Balance SheetAs of December 31, 2011 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Assets |\n| Current assets |\n| Cash and cash equivalents | $ | 11,534 | $ | 582 | $ | 18,408 | $ | — | $ | 30,524 |\n| Accounts receivable, less allowance for doubtful accounts | 88,434 | 37,487 | 55,115 | — | 181,036 |\n| Receivables from affiliates | 273 | 3,495 | 146 | (3,914 | ) | — |\n| Inventories | 163,776 | 48,980 | 59,547 | (264 | ) | 272,039 |\n| Prepaid expenses and other current assets | 18,517 | (3,331 | ) | 3,483 | — | 18,669 |\n| Total current assets | 282,534 | 87,213 | 136,699 | (4,178 | ) | 502,268 |\n| Investment in joint venture | 36,460 | — | — | — | 36,460 |\n| Goodwill | 12,921 | 41,556 | 15,424 | — | 69,901 |\n| Intangible assets | 38,238 | 34,395 | 21,180 | — | 93,813 |\n| Other assets | 34,691 | 237 | 2,812 | — | 37,740 |\n| Investment in subsidiaries | 243,823 | 12,151 | — | (255,974 | ) | — |\n| Receivables from affiliates | 66,878 | 71,041 | 7,292 | (145,211 | ) | — |\n| Property, plant and equipment, net | 56,266 | 15,416 | 10,459 | — | 82,141 |\n| Total assets | $ | 771,811 | $ | 262,009 | $ | 193,866 | $ | (405,363 | ) | $ | 822,323 |\n| Liabilities and Stockholders’ Equity |\n| Current liabilities |\n| Accounts payable | $ | 84,437 | $ | 14,826 | $ | 17,611 | $ | — | $ | 116,874 |\n| Payables due to affiliates | 1,387 | 76 | 2,451 | (3,914 | ) | — |\n| Other current liabilities | 25,895 | 4,459 | 5,358 | — | 35,712 |\n| Current portion of long-term debt and short-term debt | 82 | 50 | 560 | — | 692 |\n| Total current liabilities | 111,801 | 19,411 | 25,980 | (3,914 | ) | 153,278 |\n| Long-term debt, less current portion | 303,739 | 1 | 10,500 | — | 314,240 |\n| Payables due to affiliates | 23,727 | 8,572 | 112,912 | (145,211 | ) | — |\n| Deferred income taxes | 6,280 | 19,647 | (277 | ) | — | 25,650 |\n| Other non-current liabilities | 13,985 | 2,324 | 567 | — | 16,876 |\n| Stockholders’ equity | 312,279 | 212,054 | 44,184 | (256,238 | ) | 312,279 |\n| Total liabilities and stockholders’ equity | $ | 771,811 | $ | 262,009 | $ | 193,866 | $ | (405,363 | ) | $ | 822,323 |\n\n70\n| Condensed Consolidating Statement of Operations and Comprehensive (Loss) IncomeFor the year ended December 31, 2012 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Net Sales | $ | 755,642 | $ | 270,644 | $ | 282,274 | $ | (38,192 | ) | $ | 1,270,368 |\n| Costs and expenses: |\n| Cost of materials (exclusive of depreciation and amortization) | 548,659 | 199,004 | 217,749 | (38,125 | ) | 927,287 |\n| Warehouse, processing and delivery expense | 91,628 | 32,459 | 24,169 | — | 148,256 |\n| Sales, general and administrative expense | 75,497 | 30,351 | 21,965 | — | 127,813 |\n| Depreciation and amortization expense | 12,955 | 8,888 | 4,024 | — | 25,867 |\n| Operating income (loss) | 26,903 | (58 | ) | 14,367 | (67 | ) | 41,145 |\n| Interest expense, net | (25,820 | ) | — | (15,270 | ) | — | (41,090 | ) |\n| Interest expense - unrealized loss on debt conversion option | (15,597 | ) | — | — | — | (15,597 | ) |\n| Loss before income taxes and equity in earnings of subsidiaries and joint venture | (14,514 | ) | (58 | ) | (903 | ) | (67 | ) | (15,542 | ) |\n| Income taxes | (1,805 | ) | 475 | 102 | (202 | ) | (1,430 | ) |\n| Equity in (losses) earnings of subsidiaries | (653 | ) | (1,203 | ) | — | 1,856 | — |\n| Equity in earnings of joint venture | 7,224 | — | — | — | 7,224 |\n| Net (loss) income | (9,748 | ) | (786 | ) | (801 | ) | 1,587 | (9,748 | ) |\n| Comprehensive (loss) income: |\n| Foreign currency translation gains (losses) | 2,369 | 578 | 2,369 | (2,947 | ) | 2,369 |\n| Unrecognized pension and postretirement benefit costs, net of tax | (3,616 | ) | — | — | — | (3,616 | ) |\n| Other comprehensive (loss) income | (1,247 | ) | 578 | 2,369 | (2,947 | ) | (1,247 | ) |\n| Net loss | (9,748 | ) | (786 | ) | (801 | ) | 1,587 | (9,748 | ) |\n| Comprehensive (loss) income | $ | (10,995 | ) | $ | (208 | ) | $ | 1,568 | $ | (1,360 | ) | $ | (10,995 | ) |\n\n71\n| Condensed Consolidating Statement of Operations Comprehensive (Loss) IncomeFor the year ended December 31, 2011 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Net Sales | $ | 621,036 | $ | 283,290 | $ | 237,201 | $ | (9,161 | ) | $ | 1,132,366 |\n| Costs and expenses: |\n| Cost of materials (exclusive of depreciation and amortization) | 466,133 | 207,269 | 181,104 | (8,897 | ) | 845,609 |\n| Warehouse, processing and delivery expense | 80,543 | 33,828 | 20,527 | — | 134,898 |\n| Sales, general and administrative expense | 74,154 | 31,807 | 20,232 | — | 126,193 |\n| Depreciation and amortization expense | 8,874 | 8,910 | 2,688 | — | 20,472 |\n| Operating (loss) income | (8,668 | ) | 1,476 | 12,650 | (264 | ) | 5,194 |\n| Interest expense, net | (4,982 | ) | — | (4,681 | ) | — | (9,663 | ) |\n| Interest expense - unrealized loss on debt conversion option | (3,991 | ) | (3,991 | ) |\n| Loss on extinguishment of debt | (6,153 | ) | — | — | — | (6,153 | ) |\n| (Loss) income before income taxes and equity in earnings of subsidiaries and joint venture | (23,794 | ) | 1,476 | 7,969 | (264 | ) | (14,613 | ) |\n| Income taxes | 3,267 | (433 | ) | (1,708 | ) | — | 1,126 |\n| Equity in earnings of subsidiaries | 7,040 | (209 | ) | — | (6,831 | ) | — |\n| Equity in earnings of joint venture | 11,727 | — | — | — | 11,727 |\n| Net (loss) income | (1,760 | ) | 834 | 6,261 | (7,095 | ) | (1,760 | ) |\n| Comprehensive (loss) income: |\n| Foreign currency translation (losses) gains | (941 | ) | 1,180 | (941 | ) | (239 | ) | (941 | ) |\n| Unrecognized pension and postretirement benefit costs, net of tax | (3,071 | ) | — | — | — | (3,071 | ) |\n| Other comprehensive (loss) income | (4,012 | ) | 1,180 | (941 | ) | (239 | ) | (4,012 | ) |\n| Net (loss) income | (1,760 | ) | 834 | 6,261 | (7,095 | ) | (1,760 | ) |\n| Comprehensive (loss) income | $ | (5,772 | ) | $ | 2,014 | $ | 5,320 | $ | (7,334 | ) | $ | (5,772 | ) |\n\n72\n| Condensed Consolidating Statement of Operations Comprehensive (Loss) IncomeFor the year ended December 31, 2010 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Net Sales | $ | 498,848 | $ | 266,491 | $ | 186,654 | $ | (8,287 | ) | $ | 943,706 |\n| Costs and expenses: |\n| Cost of materials (exclusive of depreciation and amortization) | 369,865 | 195,184 | 144,092 | (8,287 | ) | 700,854 |\n| Warehouse, processing and delivery expense | 72,234 | 33,250 | 17,834 | — | 123,318 |\n| Sales, general and administrative expense | 61,751 | 29,684 | 16,788 | — | 108,223 |\n| Depreciation and amortization expense | 8,665 | 9,114 | 2,870 | — | 20,649 |\n| Operating (loss) income | (13,667 | ) | (741 | ) | 5,070 | — | (9,338 | ) |\n| Interest expense, net | (1,008 | ) | — | (3,980 | ) | — | (4,988 | ) |\n| (Loss) income before income taxes and equity in earnings of subsidiaries and joint venture | (14,675 | ) | (741 | ) | 1,090 | — | (14,326 | ) |\n| Income taxes | 3,106 | 420 | (425 | ) | — | 3,101 |\n| Equity in earnings of subsidiaries | 344 | 110 | — | (454 | ) | — |\n| Equity in earnings of joint venture | 5,585 | — | — | — | 5,585 |\n| Net (loss) income | (5,640 | ) | (211 | ) | 665 | (454 | ) | (5,640 | ) |\n| Comprehensive (loss) income: |\n| Foreign currency translation (losses) gains | (536 | ) | (2,337 | ) | (536 | ) | 2,873 | (536 | ) |\n| Unrecognized pension and postretirement benefit costs, net of tax | (1,748 | ) | — | — | — | (1,748 | ) |\n| Other comprehensive (loss) income | (2,284 | ) | (2,337 | ) | (536 | ) | 2,873 | (2,284 | ) |\n| Net (loss) income | (5,640 | ) | (211 | ) | 665 | (454 | ) | (5,640 | ) |\n| Comprehensive (loss) income | $ | (7,924 | ) | $ | (2,548 | ) | $ | 129 | $ | 2,419 | $ | (7,924 | ) |\n\n73\n| Condensed Consolidating Statement of Cash FlowsFor the year ended December 31, 2012 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Operating activities: |\n| Net (loss) income | $ | (9,748 | ) | $ | (786 | ) | $ | (801 | ) | $ | 1,587 | $ | (9,748 | ) |\n| Equity in losses of subsidiaries | 653 | 1,203 | — | (1,856 | ) | — |\n| Adjustments to reconcile net (loss) income to cash provided by operating activities | 10,688 | 12,951 | (8,809 | ) | 269 | 15,099 |\n| Net cash from (used in) operating activities | 1,593 | 13,368 | (9,610 | ) | — | 5,351 |\n| Investing activities: |\n| Acquisition/Investment of businesses, net of cash acquired | (6,472 | ) | — | — | — | (6,472 | ) |\n| Capital expenditures | (5,336 | ) | (2,802 | ) | (2,983 | ) | — | (11,121 | ) |\n| Other investing activities, net | — | 6 | 147 | — | 153 |\n| Net cash used in investing activities | (11,808 | ) | (2,796 | ) | (2,836 | ) | — | (17,440 | ) |\n| Financing activities: |\n| Proceeds from long-term debt, including new revolving credit facility | 756,550 | — | 10,540 | — | 767,090 |\n| Repayments of long-term debt, including new revolving credit facility | (745,839 | ) | (49 | ) | (16,999 | ) | — | (762,887 | ) |\n| Payment of debt issue costs | (1,503 | ) | — | — | — | (1,503 | ) |\n| Net intercompany (repayments) borrowings | (7,431 | ) | (9,428 | ) | 16,859 | — | — |\n| Other financing | 236 | — | (27 | ) | — | 209 |\n| Net cash from (used in) financing activities | 2,013 | (9,477 | ) | 10,373 | — | 2,909 |\n| Effect of exchange rate changes on cash and cash equivalents | — | — | 263 | — | 263 |\n| (Decrease) increase in cash and cash equivalents | (8,202 | ) | 1,095 | (1,810 | ) | — | (8,917 | ) |\n| Cash and cash equivalents - beginning of year | 11,534 | 582 | 18,408 | — | 30,524 |\n| Cash and cash equivalents - end of period | $ | 3,332 | $ | 1,677 | $ | 16,598 | $ | — | $ | 21,607 |\n\n74\n| Condensed Consolidating Statement of Cash FlowsFor the year ended December 31, 2011 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Operating activities: |\n| Net (loss) income | $ | (1,760 | ) | $ | 834 | $ | 6,261 | $ | (7,095 | ) | $ | (1,760 | ) |\n| Equity in earnings of subsidiaries | (7,040 | ) | 209 | — | 6,831 | — |\n| Adjustments to reconcile net (loss) income to cash provided by operating activities | 10,232 | 15,095 | (70,119 | ) | 264 | (44,528 | ) |\n| Net cash from (used in) operating activities | 1,432 | 16,138 | (63,858 | ) | — | (46,288 | ) |\n| Investing activities: |\n| Acquisition/Investment of businesses, net of cash acquired | (175,836 | ) | — | 1,592 | (174,244 | ) |\n| Capital expenditures | (6,077 | ) | (2,783 | ) | (2,884 | ) | — | (11,744 | ) |\n| Other investing activities, net | 605 | 136 | 58 | — | 799 |\n| Net cash used in investing activities | (181,308 | ) | (2,647 | ) | (1,234 | ) | — | (185,189 | ) |\n| Financing activities: |\n| Net borrowings (repayments) of debt | 82 | 8 | (25,840 | ) | — | (25,750 | ) |\n| Proceeds from long-term debt, including new revolving credit facility | 309,625 | — | 10,851 | — | 320,476 |\n| Repayments of long-term debt, including new revolving credit facility | (52,896 | ) | (55 | ) | (261 | ) | — | (53,212 | ) |\n| Payment of debt issue costs | (16,380 | ) | — | (253 | ) | — | (16,633 | ) |\n| Net intercompany (repayments) borrowings | (57,307 | ) | (13,930 | ) | 71,237 | — | — |\n| Other financing activities, net | 657 | — | — | — | 657 |\n| Net cash from (used in) financing activities | 183,781 | (13,977 | ) | 55,734 | — | 225,538 |\n| Effect of exchange rate changes on cash and cash equivalents | — | — | (253 | ) | — | (253 | ) |\n| Increase (decrease) in cash and cash equivalents | 3,905 | (486 | ) | (9,611 | ) | — | (6,192 | ) |\n| Cash and cash equivalents - beginning of year | 7,629 | 1,068 | 28,019 | — | 36,716 |\n| Cash and cash equivalents - end of period | $ | 11,534 | $ | 582 | $ | 18,408 | $ | — | $ | 30,524 |\n\n75\n| Condensed Consolidating Statement of Cash FlowsFor the year ended December 31, 2010 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Operating activities: |\n| Net (loss) income | $ | (5,640 | ) | $ | (211 | ) | $ | 665 | $ | (454 | ) | $ | (5,640 | ) |\n| Equity in earnings of subsidiaries | (344 | ) | (110 | ) | — | 454 | — |\n| Adjustments to reconcile net (loss) income to cash provided by operating activities | 12,721 | 29,562 | 500 | (2,781 | ) | 40,002 |\n| Net cash from (used in) operating activities | 6,737 | 29,241 | 1,165 | (2,781 | ) | 34,362 |\n| Investing activities: |\n| Capital expenditures | (4,244 | ) | (1,267 | ) | (2,061 | ) | — | (7,572 | ) |\n| Other investing activities, net | 125 | 4 | — | — | 129 |\n| Net cash used in investing activities | (4,119 | ) | (1,263 | ) | (2,061 | ) | — | (7,443 | ) |\n| Financing activities: |\n| Net (repayments) borrowings of debt | (13,720 | ) | — | 2,324 | — | (11,396 | ) |\n| Repayments of long-term debt | (7,007 | ) | (343 | ) | (404 | ) | — | (7,754 | ) |\n| Net intercompany borrowings (repayments) | 15,794 | (27,350 | ) | 8,775 | 2,781 | — |\n| Other financing activities, net | 785 | — | — | — | 785 |\n| Net cash (used in) from financing activities | (4,148 | ) | (27,693 | ) | 10,695 | 2,781 | (18,365 | ) |\n| Effect of exchange rate changes on cash and cash equivalents | — | — | (149 | ) | — | (149 | ) |\n| (Decrease) increase in cash and cash equivalents | (1,530 | ) | 285 | 9,650 | — | 8,405 |\n| Cash and cash equivalents - beginning of year | 9,159 | 783 | 18,369 | — | 28,311 |\n| Cash and cash equivalents - end of period | $ | 7,629 | $ | 1,068 | $ | 28,019 | $ | — | $ | 36,716 |\n\n76\n(15) Selected Quarterly Data (Unaudited)\nThe results of Tube Supply, acquired during December 2011, were included in the 2012 selected quarterly data in the table below.\n| FirstQuarter | SecondQuarter | ThirdQuarter | FourthQuarter |\n| 2012 |\n| Net sales | $ | 362,916 | $ | 329,392 | $ | 304,039 | $ | 274,021 |\n| Gross profit (a) | 53,810 | 43,763 | 42,867 | 28,518 |\n| Net (loss) income (c) | (4,300 | ) | (2,978 | ) | 3,173 | (5,643 | ) |\n| Basic (loss) earnings per share | $ | (0.19 | ) | $ | (0.13 | ) | $ | 0.14 | $ | (0.24 | ) |\n| Diluted (loss) earnings per share | $ | (0.19 | ) | $ | (0.13 | ) | $ | 0.13 | $ | (0.24 | ) |\n| Common stock dividends declared | $ | — | $ | — | $ | — | $ | — |\n| 2011 |\n| Net sales | $ | 272,788 | $ | 282,568 | $ | 294,860 | $ | 282,150 |\n| Gross profit (a) | 33,219 | 35,165 | 33,233 | 29,770 |\n| Net income (loss) (b) | 2,703 | 3,697 | 3,803 | (11,963 | ) |\n| Basic earnings (loss) per share | $ | 0.12 | $ | 0.16 | $ | 0.17 | $ | (0.52 | ) |\n| Diluted earnings (loss) per share | $ | 0.12 | $ | 0.16 | $ | 0.16 | $ | (0.52 | ) |\n| Common stock dividends declared | $ | — | $ | — | $ | — | $ | — |\n\n| (a) | Gross profit equals net sales minus cost of materials, warehouse, processing, and delivery costs and less depreciation and amortization expense. |\n\n| (b) | Fourth quarter results include fees incurred as a result of the acquisition of Tube Supply and the related debt refinancing in December 2011. The results of Tube Supply are included in the fourth quarter results for the two-week period ended December 31, 2011 and for the entire fiscal year ended December 31, 2012. In addition, a mark-to-market adjustment related to the conversion option associated with the convertible debt in the amount of $3,991 was included in interest expense during the fourth quarter. |\n\n| (c) | First and second quarter results include a mark-to-market adjustment related to the conversion option associated with the convertible debt in the amount of $11,340 and $4,257, respectively. Amounts were included in interest expense during the respective quarters. |\n\n(16) Subsequent Events\nOn January 16, 2013, the Company announced restructuring actions, including an organizational restructuring, warehouse realignments and performance improvement programs. The total pre-tax charge associated with these actions is estimated to be approximately $10,000, which is expected to be incurred in the first half of 2013. Of this amount, approximately $3,500 is attributable to employee severance and other employment related benefits, $2,500 is attributable to lease termination costs, $1,600 is attributable to moving costs in conjunction with the warehouse realignments and $2,400 relates to other costs. The Company may identify additional opportunities as it implements the restructuring actions that could impact its overall estimate. In addition, the Company expects to incur capital expenditures of approximately $1,400 in 2013 that are directly associated with the restructuring actions.\n77\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\nTo the Board of Directors and Stockholders of A.M. Castle & Co.\nOak Brook, Illinois\nWe have audited the accompanying consolidated balance sheets of A.M. Castle & Co. and subsidiaries (the \"Company\") as of December 31, 2012 and 2011, and the related consolidated statements of operations and comprehensive income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2012. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the consolidated financial statements based on our audits. We did not audit the financial statements of Kreher Steel Company, LLC, a 50% owned joint venture, the Company's investment in which is accounted for by use of the equity method. The Company's equity of $38,854 and $36,460 in Kreher Steel Company, LLC's net assets at December 31, 2012 and 2011, respectively, and of $7,224 and $11,727 in that company's net income for the years then ended are included in the accompanying financial statements. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Kreher Steel Company, LLC, is based solely on the report of the other auditors.\nWe conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.\nIn our opinion, based on our audits and the report of other auditors, such consolidated financial statements present fairly, in all material respects, the financial position of A.M. Castle & Co. and subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America.\nWe have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of December 31, 2012, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 11, 2013 expressed an unqualified opinion on the Company's internal control over financial reporting.\n/s/ DELOITTE & TOUCHE LLP\nDELOITTE & TOUCHE LLP\nChicago, Illinois\nMarch 11, 2013\n78\n| Kreher Steel Company, LLC and SubsidiariesCONSOLIDATED BALANCE SHEETSDecember 31, |\n| 2012 | 2011 |\n| ASSETS |\n| Current assets |\n| Cash and cash equivalents | $ | 3,373,355 | $ | 8,743,820 |\n| Accounts receivable (net of allowance for doubtful accounts of approximately $1,435,000 in 2012 and $1,335,000 in 2011) | 19,736,301 | 32,461,983 |\n| Inventory, net | 66,958,361 | 69,297,422 |\n| Deferred taxes | 271,553 | 29,699 |\n| Prepaid income taxes | 1,424,064 | 186,889 |\n| Prepaid expenses and other current assets | 657,039 | 542,689 |\n| Total current assets | 92,420,673 | 111,262,502 |\n| Property and equipment |\n| Land and building | 14,485,343 | 14,334,997 |\n| Machinery and equipment | 16,533,990 | 11,923,342 |\n| Furniture, fixtures and office equipment | 2,155,447 | 1,952,447 |\n| Automobiles and trucks | 990,508 | 871,929 |\n| Leasehold improvements | 2,334,855 | 1,872,955 |\n| Construction in progress | 266,129 | 753,234 |\n| 36,766,272 | 31,708,904 |\n| Less accumulated depreciation and amortization | 14,719,685 | 12,856,503 |\n| Property and equipment, net | 22,046,587 | 18,852,401 |\n| Deferred financing costs, net of amortization | 104,616 | 121,263 |\n| Goodwill | 3,525,247 | 3,525,247 |\n| Intangible assets, net of amortization | 275,616 | 398,112 |\n| Other assets | 146,785 | 81,543 |\n| $ | 118,519,524 | $ | 134,241,068 |\n| LIABILITIES AND MEMBER'S CAPITAL |\n| Current liabilities |\n| Revolving line of credit | $ | — | $ | 35,000,000 |\n| Current portion of long-term debt | 211,894 | 215,918 |\n| Accounts payable | 11,536,613 | 21,094,460 |\n| Accrued expenses | 2,565,966 | 3,641,502 |\n| Total current liabilities | 14,314,473 | 59,951,880 |\n| Revolving line of credit | 24,000,000 | — |\n| Deferred taxes, non-current | 1,977,273 | 1,008,748 |\n| Long-term debt, less current portion | 1,867,707 | 2,080,993 |\n| Commitments and contingencies |\n| Member's capital | 76,360,071 | 71,199,447 |\n| $ | 118,519,524 | $ | 134,241,068 |\n\n79\n| Kreher Steel Company, LLC and SubsidiariesCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOMEYears ended December 31, |\n| 2012 | 2011 | 2010 |\n| Net revenues | $ | 257,776,157 | $ | 269,657,054 | $ | 188,107,237 |\n| Cost of sales | 213,490,152 | 219,478,535 | 156,801,397 |\n| Gross profit | 44,286,005 | 50,178,519 | 31,305,840 |\n| Operating expenses |\n| Selling | 12,970,475 | 12,761,204 | 9,729,856 |\n| General and administrative | 12,657,611 | 9,970,335 | 8,283,347 |\n| Total operating expenses | 25,628,086 | 22,731,539 | 18,013,203 |\n| Earnings from operations | 18,657,919 | 27,446,980 | 13,292,637 |\n| Other expense (income) |\n| Interest expense | 519,416 | 432,990 | 259,558 |\n| Interest income | (3,263 | ) | (1,994 | ) | (5,035 | ) |\n| Other income, net | (169,015 | ) | (180,807 | ) | (152,887 | ) |\n| Net earnings before taxes | 18,310,781 | 27,196,791 | 13,191,001 |\n| Income tax provision (benefit) | 3,708,101 | 3,553,382 | 2,155,950 |\n| NET EARNINGS | 14,602,680 | 23,643,409 | 11,035,051 |\n| Other comprehensive income |\n| Foreign currency translation adjustment | 15,554 | — | — |\n| COMPREHENSIVE INCOME | $ | 14,618,234 | $ | 23,643,409 | $ | 11,035,051 |\n\n80\n| Kreher Steel Company, LLC and SubsidiariesCONSOLIDATED STATEMENTS OF MEMBERS’ CAPITALThree years ended December 31, 2012 |\n| Accumulated |\n| other | Total |\n| Member's | Retained | Accumulated | Treasury | comprehensive | member's |\n| contribution | earnings | distributions | stock | income | capital |\n| Balance at January 1, 2010, 400 units | 7,042,411 | 67,379,821 | (23,906,770 | ) | (5,240,092 | ) | — | 45,275,370 |\n| Net earnings | — | 11,035,051 | — | — | — | 11,035,051 |\n| Distributions | — | — | (2,519,593 | ) | — | — | (2,519,593 | ) |\n| Balance at December 31, 2010, 400 units | 7,042,411 | 78,414,872 | (26,426,363 | ) | (5,240,092 | ) | — | 53,790,828 |\n| Net earnings | — | 23,643,409 | — | — | — | 23,643,409 |\n| Distributions | — | — | (6,234,790 | ) | — | — | (6,234,790 | ) |\n| Balance at December 31, 2011, 400 units | 7,042,411 | 102,058,281 | (32,661,153 | ) | (5,240,092 | ) | — | 71,199,447 |\n| Net earnings | — | 14,602,680 | — | — | — | 14,602,680 |\n| Distributions | — | — | (9,457,600 | ) | — | — | (9,457,600 | ) |\n| Foreign currency translation adjustment | — | — | — | — | 15,544 | 15,544 |\n| Balance at December 31, 2012, 400 units | $ | 7,042,411 | $ | 116,660,961 | $ | (42,118,753 | ) | $ | (5,240,092 | ) | $ | 15,544 | $ | 76,360,071 |\n\n81\n| Kreher Steel Company, LLC and SubsidiariesCONSOLIDATED STATEMENTS OF CASH FLOWSYears ended December 31, |\n| 2012 | 2011 | 2010 |\n| Cash flows from operating activities |\n| Net earnings | $ | 14,602,680 | $ | 23,643,409 | $ | 11,035,051 |\n| Adjustments to reconcile net earnings to net cash provided by (used in) operating activities |\n| Depreciation and amortization | 2,033,956 | 1,602,925 | 1,720,133 |\n| Deferred taxes | 726,671 | 390,341 | 84,362 |\n| Bad debt expense | 2,595,710 | 34,779 | 178,911 |\n| (Gain) loss on sale of property and equipment | (4,851 | ) | 9,790 | 59,676 |\n| Changes in assets and liabilities |\n| Accounts receivable | 10,129,971 | (8,508,956 | ) | (8,488,036 | ) |\n| Inventory | 2,339,061 | (27,383,374 | ) | (11,823,574 | ) |\n| Prepaid expenses and other assets | (1,400,121 | ) | (58,839 | ) | 182,962 |\n| Accounts payable | (9,557,992 | ) | 3,900,243 | 1,739,501 |\n| Accrued expenses | (1,075,536 | ) | 1,215,113 | 388,680 |\n| Net cash provided by (used in) operating activities | 20,389,549 | (5,154,569 | ) | (4,922,334 | ) |\n| Cash flows from investing activities |\n| Purchases of property and equipment | (5,258,846 | ) | (6,735,595 | ) | (2,271,435 | ) |\n| Proceeds from sale of property and equipment | 145,605 | 19,843 | 256,132 |\n| Net cash used in investing activities | (5,113,241 | ) | (6,715,752 | ) | (2,015,303 | ) |\n| Cash flows from financing activities |\n| Net (decrease) increase in line of credit | (11,000,000 | ) | 22,163,000 | 10,837,000 |\n| Repayment of long-term debt | (217,310 | ) | (268,089 | ) | (360,000 | ) |\n| Distributions to member | (9,457,600 | ) | (6,234,790 | ) | (2,519,593 | ) |\n| Net cash (used in) provided by financing activities | (20,674,910 | ) | 15,660,121 | 7,957,407 |\n| Effect of exchange rate changes on cash and cash equivalents | 28,137 | — | — |\n| Net (decrease) increase in cash and cash equivalents | (5,370,465 | ) | 3,789,800 | 1,019,770 |\n| Cash and cash equivalents at beginning of year | 8,743,820 | 4,954,020 | 3,934,250 |\n| Cash and cash equivalents at end of year | $ | 3,373,355 | $ | 8,743,820 | $ | 4,954,020 |\n| Supplemental disclosures of cash flow information |\n| Cash paid during the year for |\n| Interest | $ | 422,074 | $ | 350,341 | $ | 171,525 |\n| Income taxes, net of refunds | 4,855,764 | 2,910,000 | 1,097,409 |\n| Supplemental disclosures of non-cash investing and financing activities |\n| Acquisition of machinery and equipment through capital leases | $ | — | $ | — | $ | 150,019 |\n\n82\nNOTE A - NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nDescription of Company\nKreher Steel Company, LLC and Subsidiaries (the Company) was formed as a limited liability company (LLC) on January 11, 1996, and commenced business on May 1, 1996. The LLC member's initial contribution consisted of the net assets of Kreher Steel Co., Inc.\nThe Company is a national distributor and processor of carbon and alloy steel bar products. The Company has locations throughout the United States and in Edmonton, Canada, and primarily sells in the vicinity of these locations.\nPrinciples of Consolidation\nThe Company's financial statements are presented on a consolidated basis and include its wholly owned subsidiaries, Kreher Wire Processing, Inc. and Special Metals, Inc., as well as a branch of Kreher Steel Company, LLC located in Edmonton, Canada. All intercompany transactions and balances have been eliminated.\nUse of Estimates\nThe preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from these estimates.\nCash and Cash Equivalents\nThe Company considers all highly liquid investments with maturities of three months or less to be cash equivalents. The Company maintains cash balances at financial institutions in the United States of America that are insured by the Federal Deposit Insurance Corporation (FDIC). At December 31, 2012 and 2011, the Company had approximately $2,113,000 and $7,975,000, respectively, in excess of FDIC insured limits. The Company has not experienced any losses related to these balances, and management believes its credit risk to be minimal.\nShipping and Handling Fees\nFor the years ended December 31, 2012, 2011 and 2010, shipping and handling costs billed to customers amounted to approximately $1,548,000, $1,431,230 and $899,000, respectively, and were included in selling expenses.\nFinancial Instruments and Risk Management\nConcentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company's customer base and their dispersion across different businesses and geographic areas. At December 31, 2012, 2011 and 2010, there were no individual customers that made up more than 10% of consolidated sales.\nThe Company's financial instruments include cash equivalents, accounts receivable, accounts payable and notes payable. The carrying amounts of cash equivalents, accounts receivable, accounts payable and notes payable approximate fair value due to their short-term nature and variable interest rates paid.\nPrices for steel fluctuate based on worldwide production and, as a result, the Company is subject to the risk of future changing market prices. Furthermore, the Company purchased approximately 6%, 9% and 7% of its inventory from foreign suppliers for the years ended December 31, 2012, 2011 and 2010, respectively.\nInventory\nInventory is valued at the lower of cost or market. Cost is determined by the specific identification method. The Company provides a reserve for obsolete and slow-moving inventory. As of December 31, 2012 and 2011, the reserve for obsolete and slow-moving inventory was approximately $810,000 and $583,000, respectively.\n83\nChanges in the Company's inventory reserve are as follows at December 31:\n| 2012 | 2011 |\n| Beginning balance | $ | 583,346 | $ | 1,778,365 |\n| Provision (release of provision) | 307,440 | (1,140,966 | ) |\n| Write-offs | (81,119 | ) | (54,053 | ) |\n| Total inventory reserve | $ | 809,667 | $ | 583,346 |\n\nProperty and Equipment\nProperty and equipment are stated at cost less accumulated depreciation. Depreciation is based on the straight-line method and the estimated useful lives of the property and equipment. Depreciation of leasehold improvements is based on the estimated useful life or the term of the lease, whichever is shorter. The Company uses an accelerated method of depreciation for tax purposes. Depreciation expense for December 31, 2012, 2011 and 2010, was approximately $1,911,000, $1,467,000 and $1,543,000, respectively.\nDepreciable lives by asset classification are as follows:\n| Asset description | Life |\n| Furniture and fixtures | 5 - 7 years |\n| Office equipment | 5 - 7 years |\n| Machinery and equipment | 7 - 10 years |\n| Automobiles and trucks | 3 - 5 years |\n| Building and leasehold improvements | 7 - 40 years |\n\nRepairs and maintenance are charged to expense when incurred. Expenditures for improvements are capitalized. Upon sale or retirement, the related cost and accumulated depreciation or amortization are removed from the respective accounts, and any resulting gain or loss is included in operations.\nLong-Lived Assets\nThe Company reviews the carrying values of its long-lived assets for possible impairment whenever events or changes in circumstances indicate that the carrying amounts of the assets may not be recoverable. Any long-lived assets held for disposal are reported at the lower of their carrying amounts or fair value less cost to sell. No triggering events were identified during each year presented that would require an impairment analysis. Additionally, no assets were held for disposal as of December 31, 2012 or 2011.\nGoodwill and Intangible Assets\nGoodwill represents the excess of purchase price paid over the fair values of net assets acquired and liabilities assumed in the Company's acquisitions.\nIntangible assets include non-competition agreements and non-contractual customer relationships. The fair value of identifiable intangible assets was estimated based on discounted future cash flow projections. Intangible assets are amortized on a straight-line basis over their estimated economic lives. The weighted-average useful life of intangible assets was five years as of December 31, 2012.\nThe Company evaluates the recoverability of identifiable intangible assets whenever events or changes in circumstances indicate that an intangible asset's carrying amount may not be recoverable. Such circumstances could include, but are not limited to, a significant decrease in the market value of the asset, a significant adverse change in the extent or manner in which an asset is used, or an accumulation of costs significantly in excess of the amount originally expected for the acquisition of an asset. No events or changes in circumstances were identified during the year that required an impairment analysis.\n84\nManagement is required to evaluate goodwill for impairment on an annual basis. The Company tests for impairment using a two-step process that involves (1) comparing the estimated fair value of the reporting unit to its net book value and (2) comparing the estimated implied fair value of goodwill and intangible assets to its carrying value. Goodwill and intangible assets were valued on the date of the acquisition. As of December 31, 2012 and 2011, there was no impairment of the goodwill or intangible assets acquired based on the analysis performed as of December 31, 2012.\nRevenue Recognition\nRevenue from the sale of goods is recognized at the time of shipment, except for revenue from sales of products to certain customers whose contractual terms specify FOB destination. Revenue from sales of products to these customers is recognized at the time of receipt by the customer when title and risk of loss pass to the customer.\nAccounts Receivable\nCredit is extended based on an evaluation of a customer's financial condition and, generally, collateral is not required. Accounts receivable are generally due within 30 days of the negotiated terms and are stated at amounts due from customers net of an allowance for doubtful accounts. Accounts outstanding longer than the contractual payment terms are considered past due. The Company maintains reserves for potential losses on receivables and credits from its customers, and these losses have not exceeded management's expectations. The Company determines its allowance for doubtful accounts by considering a number of factors, including the length of time trade accounts receivable are past due, the Company's previous loss history, the customer's current ability to pay its obligation to the Company, and the condition of the general economy and the industry as a whole. The Company writes off accounts receivable when they become uncollectible, and payments subsequently received on such receivables are credited to the allowance for doubtful accounts.\nEconomic Dependency - Major Suppliers\nDuring the years ended December 31, 2012, 2011 and 2010, the Company purchased approximately 44%, 45% and 49%, respectively, of its materials from five suppliers.\nDeferred Financing Costs\nDeferred financing costs are amortized over the life of the underlying credit agreement or the expected remaining life of the underlying credit agreement.\nIncome Taxes\nAs an LLC, the Company is not subject to federal and state income taxes, and its income or loss is allocated to and reported in the tax returns of its member. Accordingly, no liability or provision for federal and state income taxes attributable to the LLC's operations is included in the accompanying financial statements. The Company provides for income taxes for its wholly owned subsidiaries, Kreher Wire Processing, Inc. and Special Metals, Inc., which are subject to federal and state income taxes as they are structured as C Corporations. Special Metals Canada, which is structured as a foreign branch of a domestic company, will pay federal and provincial taxes in Canada. The taxes paid will be reported to the member in order to claim foreign tax credits.\nThe Company applies a comprehensive model for the financial statement recognition, measurement, classification and disclosure of uncertain tax positions. In the first step of the two-step process, the Company evaluates the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. In the second step, the Company measures the tax benefit as the largest amount that is more than 50% likely of being realized upon settlement. As of December 31, 2012 and 2011, the Company determined that there are no uncertain tax positions with a more than 50% likelihood of being realized upon settlement.\nAdvertising Costs\nAdvertising costs are charged to expense when the advertisement is first run. The Company expensed advertising costs of approximately $102,000, $80,000 and $62,000 in 2012, 2011 and 2010, respectively.\n85\nReclassifications\nCertain reclassifications of prior-year presentations have been made to conform to the 2012 presentation.\nNOTE B - INTANGIBLE ASSETS\nIntangible assets are amortized using the straight-line method, using the remaining useful life, and are as follows at December 31, 2012:\n| Remaining |\n| Asset description | useful life |\n| Non-contractual customer relationships | 2.25 years |\n\nThe following is a summary of intangible assets at December 31:\n| 2012 | 2011 |\n| Intangible assets |\n| Finite life |\n| Non-compete agreements | $ | 220,000 | $ | 220,000 |\n| Non-contractual customer relationships | 980,000 | 980,000 |\n| 1,200,000 | 1,200,000 |\n| Less accumulated amortization | 924,384 | 801,888 |\n| Net intangible assets | $ | 275,616 | $ | 398,112 |\n\nAmortization expense related to identifiable intangible assets was $122,496, $136,245 and $177,492 for the years ended December 31, 2012, 2011 and 2010, respectively. The intangible assets related to the non-compete agreements became fully amortized during 2011. Estimated annual amortization expense as of December 31, 2012, is a follows:\n| Years ending December 31, |\n| 2013 | $ | 122,496 |\n| 2014 | 122,496 |\n| 2015 | 30,624 |\n\nNOTE C - TRANSACTIONS WITH AFFILIATES\nIncluded in accounts receivable at December 31, 2012, was approximately $3,000 due from companies related through common ownership. There was no amount included in accounts receivable at December 31, 2011, due from companies related through common ownership.\nIncluded in accounts payable at December 31, 2012 and 2011, was approximately $21,000 and $79,000, respectively, due to companies related through common ownership.\nSales to and purchases from companies related through common ownership for the year ended December 31, 2012, were approximately $695,000 and $809,000, respectively, for the year ended December 31, 2011, were approximately $851,000 and $2,294,000, respectively, and for the year ended December 31, 2010, were approximately $351,000 and $2,118,000, respectively.\nNOTE D - ALLOWANCE FOR DOUBTFUL ACCOUNTS\nChanges in the Company's allowance for doubtful accounts are as follows at December 31:\n86\n| 2012 | 2011 |\n| Beginning balance | $ | 1,335,000 | $ | 1,340,000 |\n| Bad debt expense | 2,595,710 | 34,779 |\n| Recoveries | 20,125 | 536 |\n| Accounts written off | (2,515,835 | ) | (40,315 | ) |\n| Total allowance for doubtful accounts | $ | 1,435,000 | $ | 1,335,000 |\n\nNOTE E - DEBT\nDebt as of December 31, 2012 and 2011, is as follows:\n| 2012 | 2011 |\n| Revolving lines of credit | $ | 24,000,000 | $ | 35,000,000 |\n| Notes payable |\n| Michigan Strategic Fund Limited Obligation Revenue Bonds (2000) | $ | 875,000 | $ | 950,000 |\n| Michigan Strategic Fund Limited Obligation Revenue Bonds (2006) | 1,150,000 | 1,245,000 |\n| Capitalized leases | 54,601 | 101,911 |\n| Total notes payable | 2,079,601 | 2,296,911 |\n| Current portion of long-term debt | 211,894 | 215,918 |\n| Long-term debt | $ | 1,867,707 | $ | 2,080,993 |\n\nIn April 2004, the Company entered into a loan agreement. The loan consists of advances on a revolving line of credit, with maximum availability of $25,000,000, with the option of extending the credit to $40,000,000, through April 2009. In May 2007, the Company took that option and refinanced its $25,000,000 secured revolving credit agreement from an asset-based loan to a commercial-based loan, which can be increased to $40,000,000 in $5,000,000 increments. In April 2008, the Company increased the revolving credit to $30,000,000. The Company decreased the revolving credit to $20,000,000 in September 2009. In August 2011, the Company increased the revolving credit to $25,000,000. The interest charged on the loan is divided into the LIBOR portion and the prime rate portion. The outstanding balance on the LIBOR portion at a rate of 1.22% was $21,000,000 at December 31, 2011. There was a balance of $2,000,000 outstanding on the prime rate portion at a rate of 2.625% (prime minus 0.625%) at December 31, 2011.\nIn May 2007, the Company's subsidiary, Special Metals, Inc., also entered into a commercial-based loan for $5,000,000, which can be increased to $10,000,000 in $1,000,000 increments. In October 2011, the Company amended the loan agreement and increased the revolving credit to $15,000,000 based on the consolidated availability of the Company. The interest charged on the loan is divided into the LIBOR portion and the prime rate portion. The outstanding balance on the LIBOR portion at a rate of 1.22% was $12,000,000 at December 31, 2011. There was no outstanding balance on the LIBOR portion of the loan at December 31, 2011.\nIn April 2012, the Company entered into a new loan agreement. The loan named both the Company and its subsidiary, Special Metals, Inc., as co-borrowers. The loan is for $50,000,000, which can be increased to $65,000,000 in $5,000,000 increments. The interest charged on the loan is divided into the LIBOR portion and the prime rate portion. The outstanding balance on the LIBOR portion at a rate of 1.21% was $22,000,000 at December 31, 2012. The outstanding balance on the prime rate portion at a rate of 2.75% was $2,000,000 at December 31, 2012. The loan is secured by the Company's receivables, inventory and fixed assets, and expires in April 2017.\nThe Company is in compliance with all covenants related to the revolving credit agreements and all other notes payable.\nIn 2000, the Company's subsidiary, Kreher Wire Processing, Inc., obtained a Michigan Strategic Fund Limited Obligation Revenue Bond for $4,900,000. Interest is charged at a variable rate as defined in the agreement. The interest rate as of December 31, 2012 and 2011, was 0.23% and 0.20%, respectively. The Company makes monthly interest payments and annual principal and debt service payments. The Company is also required to make annual payments for the letter of credit fee. The bonds mature on May 1, 2016.\n87\nIn 2006, Kreher Wire Processing, Inc. obtained a Michigan Strategic Fund Limited Obligation Revenue Bond for $2,695,000. Interest is charged at a variable rate as defined in the agreement. The interest rate as of December 31, 2012 and 2011, was 0.23% and 0.20%, respectively. The Company makes monthly interest payments and annual principal and debt service payments. The Company is also required to make quarterly payments for the letter of credit fee. The bonds mature on October 1, 2021.\nIn 2010, Special Metals, Inc. entered into several lease agreements that met the criteria for capitalization. At December 31, 2012 and 2011, the gross amount of cost related to capital leases included in machinery and equipment was approximately $150,000. Related accumulated amortization at December 31, 2012 and 2011, was approximately $110,000 and $65,000, respectively. The total rental payments incurred for the years ended December 31, 2012, 2011 and 2010, was approximately $73,000, $73,000 and $33,000, respectively.\nThe carrying value of debt approximates fair value given the variable nature of the interest rates. Maturities of debt at December 31, 2012, are as follows:\n| Years ending December 31, |\n| 2013 | $ | 211,894 |\n| 2014 | 205,778 |\n| 2015 | 226,929 |\n| 2016 | 725,000 |\n| 2017 | 24,125,000 |\n| Thereafter | 585,000 |\n| Total | $ | 26,079,601 |\n\nNOTE F - INCOME TAXES\nAs an LLC, the Company is not subject to federal and state income taxes, and its income or loss is allocated to and reported in the tax returns of its member. The Company provides for income taxes for its wholly owned subsidiaries, Kreher Wire Processing, Inc. and Special Metals, Inc., which are subject to federal and state income taxes. The Company also provides for federal and provincial taxes at Special Metals Canada, which is structured as a foreign branch of a domestic company. The taxes paid will be reported to the member in order to claim foreign tax credits.\nThe tax effect of temporary differences that give rise to deferred tax assets and liabilities as of December 31, 2012 and 2011, are as follows:\n| 2012 | 2011 |\n| Deferred tax assets |\n| Accounts receivable and inventory reserves | $ | 271,553 | $ | 29,699 |\n| Deferred tax liabilities |\n| Amortization of intangibles | (110,246 | ) | (159,245 | ) |\n| Depreciation and other | (1,867,027 | ) | (849,503 | ) |\n| Total deferred tax liabilities | (1,977,273 | ) | (1,008,748 | ) |\n| Net deferred tax liabilities | $ | (1,705,720 | ) | $ | (979,049 | ) |\n\n88\nThe net current and non-current components of the deferred income taxes recognized in the balance sheets at December 31, 2012 and 2011, are as follows:\n| 2012 | 2011 |\n| Net current assets | $ | 271,553 | $ | 29,699 |\n| Net long-term liabilities | (1,977,273 | ) | (1,008,748 | ) |\n| Total net deferred tax liabilities | $ | (1,705,720 | ) | $ | (979,049 | ) |\n\nIncome tax expense consists of the following components as of December 31:\n| 2012 | 2011 | 2010 |\n| Current |\n| Federal | $ | 2,673,070 | $ | 2,667,703 | $ | 1,845,850 |\n| State | 398,649 | 495,338 | 225,738 |\n| Foreign | (90,289 | ) | — | — |\n| Deferred | 726,671 | 390,341 | 84,362 |\n| Total income tax expense | $ | 3,708,101 | $ | 3,553,382 | $ | 2,155,950 |\n\nThe differences between the federal statutory rate of 34% and the effective rate are due to state income taxes, permanent deductions, settlement of prior returns related to the acquisition and the fact that no tax provisions are recorded for operations attributable to Kreher Steel Company, LLC in the accompanying financial statements. Tax years dated back to December 31, 2009, are open for federal and state tax audit purposes. The total effective rate of the subsidiaries at December 31, 2012, 2011 and 2010, was 20.2%, 13.1% and 16.3%, respectively.\nA reconciliation of the effective income tax rate to the U.S. statutory tax rate is as follows:\n| 2012 | 2011 | 2010 |\n| U.S. statutory tax rate | 34 | % | 34 | % | 34 | % |\n| Non-taxable LLC income | (16.2 | ) | (21.1 | ) | (20.4 | ) |\n| State and local taxes - net of federal tax expense | 2.2 | 0.5 | 2.1 |\n| Foreign taxes | (0.2 | ) | 0.0 | 0.0 |\n| Other, net | 0.4 | (0.3 | ) | 0.6 |\n| Effective tax rate | 20.2 | % | 13.1 | % | 16.3 | % |\n\n89\nNOTE G - COMMITMENTS\nOperating Lease Commitments\nThe Company leases certain equipment and warehouse space under operating lease obligations with rent escalation clauses for the warehouse space only. Accordingly, the Company has recorded these lease obligations on a straight-line basis and recorded a deferred rent liability of approximately $53,000 and $94,000 for the years ended December 31, 2012 and 2011, respectively. Rent expense, net of sublease income for the years ended December 31, 2012, 2011 and 2010, was approximately $1,339,000, $1,081,000 and $687,000, respectively. The following shows minimum future rental payments for the next five years under these obligations:\n| Years ending December 31, |\n| 2,013 | $ | 1,001,042 |\n| 2,014 | 629,844 |\n| 2,015 | 596,404 |\n| 2,016 | 538,668 |\n| 2017 and thereafter | 421,401 |\n\nHealth Insurance\nThe Company maintains a fully self-insured health insurance plan. Approximately $1,105,000, $1,021,000 and $904,000 were expensed in 2012, 2011 and 2010, respectively, under this plan. The Company also maintains a fully self-insured health insurance plan at one of its wholly owned subsidiaries. Approximately $850,000, $562,000 and $346,000 were expensed for this plan during 2012, 2011 and 2010, respectively.\nNOTE H - EMPLOYEE BENEFIT PLAN\nThe Company maintains a qualified plan under Section 401(k) of the Internal Revenue Code. This plan is available for all employees who have completed one year or more of continuous service. The plan allows employees to contribute an annual limit of the lesser of 60% of eligible compensation or $17,500 (the federal limit for 2012). The Company will match contributions at the discretion of management. The Company has a non-discretionary match of 100%, up to 4% of what employees elect. The Company also has a profit-sharing match of $500 per participant, which is discretionary. This discretionary match was paid in 2012, 2011 and 2010. Participants are fully vested at all times in their contributions and become fully vested in the Company's contributions over a defined period. The plan is responsible for costs associated with its administration. Approximately $280,000, $200,000 and $153,000 was charged to expense for the years ended December 31, 2012, 2011 and 2010, respectively.\nThe Company also maintains a qualified plan under Section 401(k) of the Internal Revenue Code at a wholly owned subsidiary. This plan is available for all employees who have completed one year or more of continuous service. The plan allows employees to contribute an annual limit of $17,500 (the federal limit for 2012). The Company will match contributions at the discretion of management. The Company also has a discretionary profit-sharing contribution. Participants are fully vested in all contributions. The plan is responsible for costs associated with its administration. During 2012, 2011 and 2010, approximately $320,000, $240,000 and $210,000, respectively, was charged to expense.\nNOTE I - CONTINGENCIES\nThe Company is subject to various legal proceedings that have arisen in the normal course of business. In the opinion of management, these actions, when concluded and determined, will not have a material adverse effect on the financial position or operations of the Company.\nNOTE J - MEMBER'S CAPITAL\nThe Company is a single-member LLC and shall continue until December 31, 2045.\n90\nNOTE K - SUBSEQUENT EVENTS\nThe Company evaluated its December 31, 2012, financial statements for subsequent events through February 18, 2013, the date the financial statements were available to be issued. The Company is not aware of any subsequent events that would require recognition or disclosure in the financial statements.\n91\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\nBoard of Directors\nKreher Steel Company, LLC\nWe have audited the accompanying consolidated balance sheets of Kreher Steel Company, LLC (a Delaware limited liability company) and Subsidiaries (the Company) as of December 31, 2012 and 2011, and the related consolidated statements of comprehensive income, member's capital and cash flows for each of the three years ended December 31, 2012. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.\nWe conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.\nIn our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kreher Steel Company, LLC and Subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America.\n/s/ Grant Thornton LLP\nGrant Thornton LLP\nChicago, Illinois\nFebruary 18, 2013\n92\nITEM 9 —\nChanges In and Disagreements With Accountants on Accounting and Financial Disclosure\nNone.\nITEM 9A —\nControls & Procedures\nDisclosure Controls and Procedures\nA review and evaluation was performed by the Company’s management, including the Chief Executive Officer (CEO) and Chief Financial Officer (CFO), of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) of the Security Exchange Act of 1934). Based upon that review and evaluation, the CEO and CFO have concluded that the Company’s disclosure controls and procedures were effective as of December 31, 2012.\n(a) Management’s Annual Report on Internal Control Over Financial Reporting\nThe Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in the Securities Exchange Act of 1934 rule 240.13a-15(f). The Company’s internal control over financial reporting is a process designed under the supervision of the Company’s Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles.\nInternal control over financial reporting, no matter how well designed, has inherent limitations and may not prevent or detect misstatements. Therefore, even effective internal control over financial reporting can only provide reasonable assurance with respect to the financial statement preparation and presentation. Also, projections of any evaluation of effectiveness to future periods are subject to risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.\nThe Company, under the direction of its Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of its internal control over financial reporting as of December 31, 2012 based upon the framework published by the Committee of Sponsoring Organizations of the Treadway Commission, referred to as the Internal Control—Integrated Framework.\nBased on our evaluation under the framework in Internal Control — Integrated Framework, the Company’s management has concluded that our internal control over financial reporting was effective as of December 31, 2012.\nThe effectiveness of the Company’s internal control over financial reporting as of December 31, 2012 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their attestation report included in Item 9A of this annual report.\n(b) Report of Independent Registered Public Accounting Firm\nTo the Board of Directors and Stockholders of\nA.M. Castle & Co.\nOak Brook, Illinois\nWe have audited the internal control over financial reporting of A.M. Castle & Co. and subsidiaries (the \"Company\") as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit.\nWe conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.\n93\nA company's internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.\nBecause of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.\nIn our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.\nWe have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2012 of the Company and our report dated March 11, 2013 expressed an unqualified opinion on those financial statements.\n/s/ DELOITTE & TOUCHE LLP\nDELOITTE & TOUCHE LLP\nChicago, Illinois\nMarch 11, 2013\n(c) Change in Internal Control Over Financial Reporting\nAn evaluation was performed by the Company’s management, including the CEO and CFO, of any changes in internal controls over financial reporting that occurred during the last fiscal quarter and that materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting. The evaluation did not identify any change in the Company’s internal control over financial reporting that occurred during the latest fiscal quarter and that has materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting.\nItem 9B —\nOther Information\nNone.\n94\nPART III\nITEM 10 —\nDirectors, Executive Officers and Corporate Governance\nInformation regarding our executive officers is included under the heading “Executive Officers of the Registrant” in Part I of this Annual Report on Form 10-K. All additional information required to be filed in Part III, Item 10, Form 10-K, has been included in the sections of the Company's Definitive Proxy Statement for its 2013 annual meeting of shareholders (fiscal 2012 Proxy Statement) dated and to be filed with the Securities and Exchange Commission on or about March 12, 2013 entitled “Proposal 1- Election of Directors,” “Certain Governance Matters,” and “Section 16(A) Beneficial Ownership Reporting Compliance,” and is hereby incorporated by this specific reference.\nITEM 11 —\nExecutive Compensation\nAll information required to be filed in Part III, Item 11, Form 10-K, has been included in the sections of the fiscal 2012 Proxy Statement entitled “Compensation Discussion and Analysis,” “Report of the Human Resources Committee,” “Compensation Committee Interlocks and Insider Participation”, “Compensation Risk”, “Non-Employee Director Compensation,” and “Executive Compensation and Other Information” and is hereby incorporated by this specific reference.\nITEM 12 —\nSecurity Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters\nThe information required to be filed in Part III, Item 12, Form 10-K, has been included in the sections of the fiscal 2012 Proxy Statement entitled “Stock Ownership of Directors, Management and Principal Stockholders” and “Equity Compensation Plan Information” and is hereby incorporated by this specific reference.\nITEM 13 —\nCertain Relationships and Related Transactions, and Director Independence\nAll information required to be filed in Part III, Item 13, Form 10-K, has been included in the sections of the fiscal 2012 Proxy Statement entitled “Related Party Transactions” and “Director Independence; Financial Experts” and is hereby incorporated by this specific reference.\nITEM 14 —\nPrincipal Accountant Fees and Services\nAll information required to be filed in Part III, Item 14, Form 10-K, has been included in the sections of the fiscal 2012 Proxy Statement entitled “Audit and Non-Audit Fees” and “Pre-Approval Policy for Audit and Non-Audit Services” and is hereby incorporated by this specific reference.\n95\nPART IV\nITEM 15 —\nExhibits\nA. M. Castle & Co.\nIndex To Financial Statements\n\n| Page |\n| Consolidated Statements of Operations and Comprehensive Loss—For the years ended December 31, 2012, 2011 and 2010 | 36 |\n| Consolidated Balance Sheets—December 31, 2012 and 2011 | 37 |\n| Consolidated Statements of Cash Flows—For the years ended December 31, 2012, 2011 and 2010 | 38 |\n| Consolidated Statements of Stockholders’ Equity – For the years ended December 31, 2012, 2011 and 2010 | 39 |\n| Notes to Consolidated Financial Statements | 40 |\n| Report of Independent Registered Public Accounting Firm | 77 |\n| Kreher Steel Co., LLC Financial Statements | 79 |\n| Exhibit Index |\n\n96\nThe following exhibits are filed herewith or incorporated by reference.\n| ExhibitNumber | Description of Exhibit |\n| 2.1 | Stock Purchase Agreement dated as of August 12, 2006 by and among A. M. Castle & Co. and Transtar Holdings #2, LLC. Filed as Exhibit 2.1 to Form 8-K filed August 17, 2006. Commission File No. 1-5415. |\n| 2.2 | Stock Purchase Agreement, dated November 9, 2011, by and among A.M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, Inc. Filed as Exhibit 2.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 2.3 | Agreement and Amendment, dated December 15, 2011, by and among A.M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, Tube Supply, Inc. and A.M. Castle & Co. (Canada) Inc. Filed as Exhibit 2.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 2.4 | Second Amendment to the Stock Purchase Agreement, dated January 13, 2012, by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). Incorporated by reference to Exhibit 2.3 to the Company's Form S-4/A filed with the SEC on May 25, 2012. Commission File No. 333-180662. |\n| 2.5 | Third Amendment to the Stock Purchase Agreement, dated May 11, 2012, by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). Incorporated by reference to Exhibit 2.4 to the Company's Form S-4/A filed with the SEC on May 25, 2012. Commission File No. 333-180662. |\n| 2.6 | Fourth Amendment to the Stock Purchase Agreement, dated September 13, 2012 by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). |\n| 2.7 | Fifth Amendment to the Stock Purchase Agreement, dated November 14, 2012 by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). |\n| 3.1 | Articles of Restatement of the Charter of the Company filed with the State Department of Assessments and Taxation of Maryland on April 27, 2012. Filed as Exhibit 3.1 to Quarterly Report on Form 10-Q for the period ended March 31, 2012, which was filed on May 3, 2012. Commission File No. 1-5415. |\n| 3.2 | By-Laws of the Company as amended on October 28, 2010. Filed as Exhibit 3.2 to Quarterly Report on Form 10-Q for the period ended September 30, 2010, which was filed on November 5, 2010. Commission File No. 1-5415. |\n| 3.3 | Articles Supplementary of the Company. Filed as Exhibit 3.1 to Form 8-A filed on September 6, 2012. Commission File No. 1-5415. |\n| 4.1 | Indenture, dated as of December 15, 2011, among A.M. Castle & Co., the Guarantors, U.S. Bank National Association, as trustee and U.S. Bank National Association, as collateral agent. Filed as Exhibit 4.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 4.2 | Indenture, dated as of December 15, 2011, between A.M. Castle & Co., the Guarantors and U.S. Bank National Association, as trustee. Filed as Exhibit 4.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 4.3 | Rights Agreement, dated as of August 31, 2012, by and between A.M. Castle & Co. and American Stock Transfer & Trust Company, LLC, as Rights Agent. Filed as Exhibit 4.1 to Form 8-K filed on August 31, 2012. Commission File No. 1-05415. |\n| 10.1* | A. M. Castle & Co. 1995 Director Stock Option Plan. Filed as Exhibit A to Proxy Statement filed March 7, 1995. Commission File No. 1-5415. |\n| 10.2* | A. M. Castle & Co. 1996 Restricted Stock and Stock Option Plan. Filed as Exhibit A to Proxy Statement filed March 8, 2006. Commission File No. 1-5415. |\n| 10.3* | A. M. Castle & Co. 2000 Restricted Stock and Stock Option Plan. Filed as Appendix B to Proxy Statement filed March 23, 2001. Commission File No. 1-5415. |\n\n97\n| ExhibitNumber | Description of Exhibit |\n| 10.4* | A. M. Castle & Co. 2004 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit D to Proxy Statement filed March 12, 2004. Commission File No. 1-5415. |\n| 10.5* | A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan, as amended and restated as of December 9, 2010. Filed as Exhibit 10.25 to Annual Report on Form 8-K filed on December 15, 2010. Commission File No. 1-5415. |\n| 10.6* | Form of Restricted Stock Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.11 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\n| 10.7* | Form of Performance Share Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.12 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\n| 10.8* | A. M. Castle & Co. Directors Deferred Compensation Plan, as amended and restated as of October 22, 2008. Filed as Exhibit 10.13 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\n| 10.9* | A. M. Castle & Co. Supplemental 401(k) Savings and Retirement Plan, as amended and restated, effective as of January 1, 2009. Filed as Exhibit 10.14 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\n| 10.10* | A. M. Castle & Co. Supplemental Pension Plan, as amended and restated, effective as of January 1, 2009. Filed as Exhibit 10.15 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\n| 10.11* | First Amendment to the A. M. Castle & Co. Supplemental 401(k) Savings and Retirement Plan, executed April 15, 2009 (as effective April 27, 2009). Filed as Exhibit 10.1 to Form 8-K filed on April 16, 2009. Commission File No. 1-5415. |\n| 10.12* | Form of A.M. Castle & Co. Indemnification Agreement to be executed with all directors and executive officers. Filed as Exhibit 10.16 to Form 8-K filed on July 29, 2009. Commission File No. 1-5415. |\n| 10.13* | Form of Restricted Stock Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.20 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. |\n| 10.14* | Form of Performance Share Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.21 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. |\n| 10.15* | Form of Incentive Stock Option Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.22 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. |\n| 10.16* | Form of Non-Qualified Stock Option Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.23 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. |\n| 10.17* | Form of Non-Employee Director Restricted Stock Award Agreement. Filed as Exhibit 10.1 to Form 8-K filed on April 27, 2010. Commission File No. 1-5415. |\n| 10.18* | Form of Amended and Restated Change of Control Agreement for all executive officers other than the CEO. Filed as Exhibit 10.24 to Form 8-K filed on September 21, 2010. Commission File No. 1-5415. |\n| 10.19* | Form of Amended and Restated Severance Agreement for executive officers other than the CEO. Filed as Exhibit 10.26 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. |\n| 10.20* | CEO Change in Control Agreement, as amended and restated December 22, 2010. Filed as Exhibit 10.27 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. |\n\n98\n| ExhibitNumber | Description of Exhibit |\n| 10.21* | CEO Employment/Non-Competition Agreement, as amended and restated December 22, 2010. Filed as Exhibit 10.28 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. |\n| 10.22* | Form of Performance Share Award Agreement, adopted March 2, 2011, under A.M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.29 to Form 8-K filed March 8, 2011. Commission File No. 1-5415. |\n| 10.23* | 2008 A. M. Castle & Co. Omnibus Incentive Plan, as amended and restated as of April 28, 2011. Filed as Exhibit 10.30 to Form 8-K filed May 3, 2011. Commission File No. 1-5415. |\n| 10.24* | Stephen V. Hooks Executive Retention and Severance Agreement, dated October 27, 2011. Filed as Exhibit 10.31 to Form 8-K filed November 1, 2011. Commission File No. 1-5415. |\n| 10.25 | Pledge and Security Agreement, dated as of December 15, 2011, by A.M. Castle & Co., and its subsidiaries that are party thereto, in favor of U.S. Bank National Association, as collateral agent, for the benefit of the Secured Parties. Filed as Exhibit 10.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 10.26 | Intercreditor Agreement, dated as of December 15, 2011, among Wells Fargo Bank, National Association, in its capacity as administrative and collateral agent for the First Lien Secured Parties and U.S. Bank National Association, a national banking association, in its capacity as trustee and collateral agend for the Second Lien Secured Parties. Filed as Exhibit 10.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 10.27 | Registration Rights Agreement, dated as of December 15, 2011, between A.M. Castle & Co., the Guarantors and Jefferies & Company, Inc., as initial purchaser, for the benefit of the Holders of the Notes. Filed as Exhibit 10.3 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 10.28 | Loan and Security Agreement, dated December 15, 2011, by and among A.M. Castle & Co., Transtar Metals Corp., Advanced Fabricating Technology, LLC, Oliver Steel Plate Co., Paramont Machine Company, LLC, Total Plastics, Inc., Tube Supply, LLC, A.M. Castle & Co. (Canada) Inc., Tube Supply Canada ULC, the other Loan Parties party thereto, the lenders which are now or which hereafter become a party thereto, and Wells Fargo Bank, National Association, a national banking association, in its capacity as administrative agent and collateral agent for Secured Parties. Filed as Exhibit 10.4 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 10.29* | Employment Agreement, dated November 9, 2011, by and between A. M. Castle & Co. and Mr. Paul Sorensen. Filed as Exhibit 10.29 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. |\n| 10.30* | Form of Retention Bonus Agreement for certain executive officers in connection with CEO leadership transition, dated May 14, 2012. Filed as Exhibit 10.30 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. |\n| 10.31* | Amendment to Employment Agreement, dated May 30, 2012, by and between A. M. Castle & Co. and Mr. Paul Sorensen. Filed as Exhibit 10.31 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. |\n| 10.32* | Employment Offer Letter dated October 10, 2012, between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.32 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. |\n| 10.33* | Form of Restricted Stock Unit Award Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.33 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. |\n| 10.34* | Form of Severance Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.34 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. |\n| 10.35* | Form of Change of Control Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.35 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. |\n\n99\n| ExhibitNumber | Description of Exhibit |\n| 10.36* | Offer of Chief Commercial Officer dated December 28, 2012, between A.M. Castle & Co. and Mr. Blain Tiffany. Filed as Exhibit 10.36 to Form 8-K filed January 22, 2013. Commission File No. 1-5415. |\n| 21.1 | Subsidiaries of Registrant |\n| 23.1 | Consent of Deloitte & Touche LLP |\n| 23.2 | Consent of Grant Thornton LLP |\n| 31.1 | CEO Certification Pursuant to Section 302 of the Sarbanes Oxley Act of 2002. |\n| 31.2 | CFO Certification Pursuant to Section 302 of the Sarbanes Oxley Act of 2002. |\n| 32.1 | CEO and CFO Certification Pursuant to Section 906 of the Sarbanes Oxley Act of 2002. |\n| 101.INS | XBRL Instance Document (1) |\n| 101.SCH | XBRL Taxonomy Extension Schema Document (1) |\n| 101.CAL | XBRL Taxonomy Calculation Linkbase Document (1) |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document(1) |\n| 101.LAB | XBRL Taxonomy Label Linkbase Document (1) |\n| 101.PRE | XBRL Taxonomy Presentation Linkbase Document (1) |\n\n| (1) | Furnished with this report. In accordance with Rule 406T of Regulation S-T, the information in these exhibits shall not be deemed to be “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to liability under that section, and shall not be incorporated by reference into any registration statement or other document filed under the Securities Act of 1933, as amended, except as expressly set forth by specific reference in such filing. |\n| * | These agreements are considered a compensatory plan or arrangement. |\n\n100\nSIGNATURES\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n| A. M. Castle & Co. |\n| (Registrant) |\n\n| By: | /s/ Patrick R. Anderson |\n| Patrick R. Anderson, Vice President—Controller and Chief Accounting Officer |\n| (Principal Accounting Officer) |\n| Date: | March 11, 2013 |\n\nPursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities as shown following their name on this 11th day of March, 2013.\n| /s/ Brian P. Anderson | /s/ Gary A. Masse | /s/ Ann M. Drake |\n| Brian P. Anderson, Chairman of the Board | Gary A. Masse, Director | Ann M. Drake, Director |\n| /s/ Scott J. Dolan | /s/ Scott F. Stephens | /s/ Reuben S. Donnelley |\n| Scott J. Dolan, President, | Scott F. Stephens, Vice President | Reuben S. Donnelley, Director |\n| Chief Executive Officer and | and Chief Financial Officer |\n| Director | (Principal Financial Officer) |\n| (Principal Executive Officer) |\n| /s/ Patrick J. Herbert, III | /s/ Terrence J. Keating | /s/ James D. Kelly |\n| Patrick J. Herbert, III, Director | Terrence J. Keating, Director | James D. Kelly, Director |\n| /s/ Pamela Forbes Lieberman |\n| Pamela Forbes Lieberman, Director | John McCartney, Director |\n\n101\nExhibit Index\nThe following exhibits are filed herewith or incorporated herein by reference:\n\n| Exhibit No. | Description | Page |\n| 2.1 | Stock Purchase Agreement dated as of August 12, 2006 by and among A. M. Castle & Co. and Transtar Holdings #2, LLC. Filed as Exhibit 2.1 to Form 8-K filed August 17, 2006. Commission File No. 1-5415. | — |\n| 2.2 | Stock Purchase Agreement, dated November 9, 2011, by and among A.M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, Inc. Filed as Exhibit 2.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 2.3 | Agreement and Amendment, dated December 15, 2011, by and among A.M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, Tube Supply, Inc. and A.M. Castle & Co. (Canada) Inc. Filed as Exhibit 2.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 2.4 | Second Amendment to the Stock Purchase Agreement, dated January 13, 2012, by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). Incorporated by reference to Exhibit 2.3 to the Company's Form S-4/A filed with the SEC on May 25, 2012. Commission File No. 333-180662. | — |\n| 2.5 | Third Amendment to the Stock Purchase Agreement, dated May 11, 2012, by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). Incorporated by reference to Exhibit 2.4 to the Company's Form S-4/A filed with the SEC on May 25, 2012. Commission File No. 333-180662. | — |\n| 2.6 | Fourth Amendment to the Stock Purchase Agreement, dated September 13, 2012 by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). | E-1 |\n| 2.7 | Fifth Amendment to the Stock Purchase Agreement, dated November 14, 2012 by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). | E-3 |\n| 3.1 | Articles of Restatement of the Charter of the Company filed with the State Department of Assessments and Taxation of Maryland on April 27, 2012. Filed as Exhibit 3.1 to Quarterly Report on Form 10-Q for the period ended March 31, 2012, which was filed on May 3, 2012. Commission File No. 1-5415. | — |\n| 3.2 | By-Laws of the Company as amended on October 28, 2010. Filed as Exhibit 3.2 to Quarterly Report on Form 10-Q for the period ended September 30, 2010, which was filed on November 5, 2010. Commission File No. 1-5415. | — |\n| 3.3 | Articles Supplementary of the Company. Filed as Exhibit 3.1 to Form 8-A filed on September 6, 2012. Commission File No. 1-5415. | — |\n| 4.1 | Indenture, dated as of December 15, 2011, among A.M. Castle & Co., the Guarantors, U.S. Bank National Association, as trustee and U.S. Bank National Association, as collateral agent. Filed as Exhibit 4.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 4.2 | Indenture, dated as of December 15, 2011, between A.M. Castle & Co., the Guarantors and U.S. Bank National Association, as trustee. Filed as Exhibit 4.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 4.3 | Rights Agreement, dated as of August 31, 2012, by and between A.M. Castle & Co. and American Stock Transfer & Trust Company, LLC, as Rights Agent. Filed as Exhibit 4.1 to Form 8-K filed on August 31, 2012. Commission File No. 1-05415. | — |\n| 10.1* | A. M. Castle & Co. 1995 Director Stock Option Plan. Filed as Exhibit A to Proxy Statement filed March 7, 1995. Commission File No. 1-5415. | — |\n| 10.2* | A. M. Castle & Co. 1996 Restricted Stock and Stock Option Plan. Filed as Exhibit A to Proxy Statement filed March 8, 2006. Commission File No. 1-5415. | — |\n\n102\n| Exhibit No. | Description | Page |\n| 10.3* | A. M. Castle & Co. 2000 Restricted Stock and Stock Option Plan. Filed as Appendix B to Proxy Statement filed March 23, 2001. Commission File No. 1-5415. | — |\n| 10.4* | A. M. Castle & Co. 2004 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit D to Proxy Statement filed March 12, 2004. Commission File No. 1-5415. | — |\n| 10.5* | A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan, as amended and restated as of December 9, 2010. Filed as Exhibit 10.25 to Annual Report on Form 8-K filed on December 15, 2010. Commission File No. 1-5415. | — |\n| 10.6* | Form of Restricted Stock Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.11 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\n| 10.7* | Form of Performance Share Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.12 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\n| 10.8* | A. M. Castle & Co. Directors Deferred Compensation Plan, as amended and restated as of October 22, 2008. Filed as Exhibit 10.13 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\n| 10.9* | A. M. Castle & Co. Supplemental 401(k) Savings and Retirement Plan, as amended and restated, effective as of January 1, 2009. Filed as Exhibit 10.14 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\n| 10.10* | A. M. Castle & Co. Supplemental Pension Plan, as amended and restated, effective as of January 1, 2009. Filed as Exhibit 10.15 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\n| 10.11* | First Amendment to the A. M. Castle & Co. Supplemental 401(k) Savings and Retirement Plan, executed April 15, 2009 (as effective April 27, 2009). Filed as Exhibit 10.1 to Form 8-K filed on April 16, 2009. Commission File No. 1-5415. | — |\n| 10.12* | Form of A.M. Castle & Co. Indemnification Agreement to be executed with all directors and executive officers. Filed as Exhibit 10.16 to Form 8-K filed on July 29, 2009. Commission File No. 1-5415. | — |\n| 10.13* | Form of Restricted Stock Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.20 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. | — |\n| 10.14* | Form of Performance Share Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.21 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. | — |\n| 10.15* | Form of Incentive Stock Option Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.22 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. | — |\n| 10.16* | Form of Non-Qualified Stock Option Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.23 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. | — |\n| 10.17* | Form of Non-Employee Director Restricted Stock Award Agreement. Filed as Exhibit 10.1 to Form 8-K filed on April 27, 2010. Commission File No. 1-5415. | — |\n| 10.18* | Form of Amended and Restated Change of Control Agreement for all executive officers other than the CEO. Filed as Exhibit 10.24 to Form 8-K filed on September 21, 2010. Commission File No. 1-5415. | — |\n\n103\n| Exhibit No. | Description | Page |\n| 10.19* | Form of Amended and Restated Severance Agreement for executive officers other than the CEO. Filed as Exhibit 10.26 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. | — |\n| 10.20* | CEO Change in Control Agreement, as amended and restated December 22, 2010. Filed as Exhibit 10.27 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. | — |\n| 10.21* | CEO Employment/Non-Competition Agreement, as amended and restated December 22, 2010. Filed as Exhibit 10.28 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. | — |\n| 10.22* | Form of Performance Share Award Agreement, adopted March 2, 2011, under A.M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.29 to Form 8-K filed March 8, 2011. Commission File No. 1-5415. | — |\n| 10.23* | 2008 A. M. Castle & Co. Omnibus Incentive Plan, as amended and restated as of April 28, 2011. Filed as Exhibit 10.30 to Form 8-K filed May 3, 2011. Commission File No. 1-5415. | — |\n| 10.24* | Stephen V. Hooks Executive Retention and Severance Agreement, dated October 27, 2011. Filed as Exhibit 10.31 to Form 8-K filed November 1, 2011. Commission File No. 1-5415. | — |\n| 10.25 | Pledge and Security Agreement, dated as of December 15, 2011, by A.M. Castle & Co., and its subsidiaries that are party thereto, in favor of U.S. Bank National Association, as collateral agent, for the benefit of the Secured Parties. Filed as Exhibit 10.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 10.26 | Intercreditor Agreement, dated as of December 15, 2011, among Wells Fargo Bank, National Association, in its capacity as administrative and collateral agent for the First Lien Secured Parties and U.S. Bank National Association, a national banking association, in its capacity as trustee and collateral agend for the Second Lien Secured Parties. Filed as Exhibit 10.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 10.27 | Registration Rights Agreement, dated as of December 15, 2011, between A.M. Castle & Co., the Guarantors and Jefferies & Company, Inc., as initial purchaser, for the benefit of the Holders of the Notes. Filed as Exhibit 10.3 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 10.28 | Loan and Security Agreement, dated December 15, 2011, by and among A.M. Castle & Co., Transtar Metals Corp., Advanced Fabricating Technology, LLC, Oliver Steel Plate Co., Paramont Machine Company, LLC, Total Plastics, Inc., Tube Supply, LLC, A.M. Castle & Co. (Canada) Inc., Tube Supply Canada ULC, the other Loan Parties party thereto, the lenders which are now or which hereafter become a party thereto, and Wells Fargo Bank, National Association, a national banking association, in its capacity as administrative agent and collateral agent for Secured Parties. Filed as Exhibit 10.4 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 10.29* | Employment Agreement, dated November 9, 2011, by and between A. M. Castle & Co. and Mr. Paul Sorensen. Filed as Exhibit 10.29 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. | — |\n| 10.30* | Form of Retention Bonus Agreement for certain executive officers in connection with CEO leadership transition, dated May 14, 2012. Filed as Exhibit 10.30 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. | — |\n| 10.31* | Amendment to Employment Agreement, dated May 30, 2012, by and between A. M. Castle & Co. and Mr. Paul Sorensen. Filed as Exhibit 10.31 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. | — |\n| 10.32* | Employment Offer Letter dated October 10, 2012, between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.32 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. | — |\n\n104\n| Exhibit No. | Description | Page |\n| 10.33* | Form of Restricted Stock Unit Award Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.33 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. | — |\n| 10.34* | Form of Severance Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.34 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. | — |\n| 10.35* | Form of Change of Control Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.35 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. | — |\n| 10.36* | Offer of Chief Commercial Officer dated December 28, 2012, between A.M. Castle & Co. and Mr. Blain Tiffany. Filed as Exhibit 10.36 to Form 8-K filed January 22, 2013. Commission File No. 1-5415. | — |\n| 21.1 | Subsidiaries of Registrant | E-5 |\n| 23.1 | Consent of Deloitte & Touche LLP | E-6 |\n| 23.2 | Consent of Grant Thornton LLP | E-7 |\n| 31.1 | CEO Certification Pursuant to Section 302 of the Sarbanes Oxley Act of 2002. | E-8 |\n| 31.2 | CFO Certification Pursuant to Section 302 of the Sarbanes Oxley Act of 2002. | E-9 |\n| 32.1 | CEO and CFO Certification Pursuant to Section 906 of the Sarbanes Oxley Act of 2002. | E-10 |\n| 101.INS | XBRL Instance Document (1) | — |\n| 101.SCH | XBRL Taxonomy Extension Schema Document (1) | — |\n| 101.CAL | XBRL Taxonomy Calculation Linkbase Document (1) | — |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document(1) | — |\n| 101.LAB | XBRL Taxonomy Label Linkbase Document (1) | — |\n| 101.PRE | XBRL Taxonomy Presentation Linkbase Document (1) | — |\n\n| (1) | Furnished with this report. In accordance with Rule 406T of Regulation S-T, the information in these exhibits shall not be deemed to be “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to liability under that section, and shall not be incorporated by reference into any registration statement or other document filed under the Securities Act of 1933, as amended, except as expressly set forth by specific reference in such filing. |\n| * | These agreements are considered a compensatory plan or arrangement. |\n\n105\n \n\nWhat is the total cost incurred by the company for the acquisition of Tube Supply, inclusive of direct acquisition-related costs, CEO transition costs, bad debt reserves for customer bankruptcies, charges for export penalties related to product shipments and underwriting fees associated with debt financing in $ million?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nITEM 1 —\\nBusiness\\nIn this annual report on Form 10-K, “the Company,” “we” or “our” refer to A. M. Castle & Co., a Maryland corporation, and its subsidiaries included in the consolidated financial statements, except as otherwise indicated or as the context otherwise requires.\\nBusiness and Markets\\nCompany Overview\\nThe Company is a specialty metals (90% of net sales) and plastics (10% of net sales) distribution company serving customers on a global basis. The Company provides a broad range of products and value-added processing and supply chain services to a wide array of customers, principally within the producer durable equipment, oil and gas, aerospace, heavy industrial equipment, industrial goods, construction equipment, retail, marine and automotive sectors of the global economy. Particular focus is placed on the aerospace and defense, oil and gas, power generation, mining, heavy industrial equipment manufacturing, marine, office furniture and fixtures, safety products, life sciences applications, transportation and general manufacturing industries.\\nThe Company’s corporate headquarters are currently located in Oak Brook, Illinois. The Company operates out of 49 service centers located throughout North America (44), Europe (4) and Asia (1). The Company’s service centers hold inventory and process and distribute products to both local and export markets.\\nIndustry and Markets\\nService centers act as supply chain intermediaries between primary producers, which deal in bulk quantities in order to achieve economies of scale, and end-users in a variety of industries that require specialized products in significantly smaller quantities and forms. Service centers also manage the differences in lead times that exist in the supply chain. While original equipment manufacturers (“OEM”) and other customers often demand delivery within hours, the lead time required by primary producers can be as long as several months. Service centers also provide value to customers by aggregating purchasing, providing warehousing and distribution services to meet specific customer needs, including demanding delivery times and precise metal specifications.\\nThe principal markets served by the Company are highly competitive. Competition is based on service, quality, processing capabilities, inventory availability, timely delivery, ability to provide supply chain solutions and price. The\\n3\\nCompany competes in a highly fragmented industry. Competition in the various markets in which the Company participates comes from a large number of value-added metals processors and service centers on a regional and local basis, some of which have greater financial resources and some of which have more established brand names in the local markets served by the Company.\\nThe Company also competes to a lesser extent with primary metals producers who typically sell to larger customers requiring shipments of large volumes of metal.\\nIn order to capture scale efficiencies and remain competitive, many primary metal producers are consolidating their operations and focusing on their core production activities. These producers have increasingly outsourced metals distribution and inventory management to metals service centers. This process of outsourcing allows them to work with a relatively small number of intermediaries rather than many end customers. As a result, metals service centers, including the Company, are now providing a range of services for their customers, including metal purchasing, processing and supply chain solutions.\\nRecent Acquisitions\\nDuring December 2011, the Company completed its acquisition (the “Acquisition”) of Tube Supply, Inc. (“Tube Supply”), which has expanded the Company’s product offerings in the oil and gas industry. Subsequent to the acquisition, Tube Supply operated as a Limited Liability Corporation until it was merged with A. M. Castle & Co. in September of 2012. The results of Tube Supply are included in the Company’s Metals segment.\\nProcurement\\nThe Company purchases metals and plastics from many producers. Material is purchased in large lots and stocked at its service centers until sold, usually in smaller quantities and typically with some value-added processing services performed. The Company’s ability to provide quick delivery of a wide variety of specialty metals and plastic products, along with its processing capabilities and supply chain management solutions, allows customers to lower their own inventory investment by reducing their need to order the large quantities required by producers and their need to perform additional material processing services. Some of the Company’s purchases are covered by long-term contracts and commitments, which generally have corresponding customer sales agreements.\\nOrders are primarily filled with materials shipped from Company stock. The materials required to fill the balance of sales are obtained from other sources, such as direct mill shipments to customers or purchases from other distributors. Deliveries are made principally by the Company’s fleet contracted through third party logistics providers. Common carrier delivery is used in areas not serviced directly by the Company’s fleet.\\nAt December 31, 2012, the Company had 1,701 full-time employees. Of these, approximately 250 are represented by collective bargaining units, principally the United Steelworkers of America and International Brotherhood of Teamsters.\\nBusiness Segments\\nThe Company distributes and performs processing on both metals and plastics. Although the distribution processes are similar, the customer markets, supplier bases and types of products are different. Additionally, the Company’s Chief Executive Officer, the chief operating decision-maker, reviews and manages these two businesses separately. As such, these businesses are considered reportable segments and are reported accordingly in the Company’s various public filings. Neither of the Company’s reportable segments has any unusual working capital requirements.\\nIn the last three years, the percentages of total sales of the two segments were as follows:\\n| 2012 | 2011 | 2010 |\\n| Metals | 90 | % | 90 | % | 89 | % |\\n| Plastics | 10 | % | 10 | % | 11 | % |\\n| 100 | % | 100 | % | 100 | % |\\n\\nMetals Segment\\nIn its Metals segment, the Company’s marketing strategy focuses on distributing highly engineered specialty grades and alloys of metals as well as providing specialized processing services designed to meet very precise specifications. Core products include alloy, aluminum, nickel, stainless steel, carbon and titanium. Inventories of\\n4\\nthese products assume many forms such as plate, sheet, extrusions, round bar, hexagon bar, square and flat bar, tubing and coil. Depending on the size of the facility and the nature of the markets it serves, a service center is equipped as needed with bar saws, plate saws, oxygen and plasma arc flame cutting machinery, trepanning machinery, boring machinery, honing equipment, water-jet cutting equipment, stress relieving and annealing furnaces, surface grinding equipment, and sheet shearing equipment.\\nThe Company’s customer base is well diversified and therefore, the Company does not have dependence upon any single customer, or a few customers. Our customer base includes many Fortune 500 companies as well as thousands of medium and smaller sized firms.\\nThe Company’s broad network of locations provides same or next-day delivery to most of the segment’s markets, and two-day delivery to substantially all of the remaining markets.\\nPlastics Segment\\nThe Company’s Plastics segment consists exclusively of a wholly-owned subsidiary that operates as Total Plastics, Inc. (“TPI”), headquartered in Kalamazoo, Michigan, and its wholly-owned subsidiaries. The Plastics segment stocks and distributes a wide variety of plastics in forms that include plate, rod, tube, clear sheet, tape, gaskets and fittings. Processing activities within this segment include cut-to-length, cut-to-shape, bending and forming according to customer specifications.\\nThe Plastics segment’s diverse customer base consists of companies in the retail (point-of-purchase), automotive, marine, office furniture and fixtures, safety products, life sciences applications, and general manufacturing industries. TPI has locations throughout the upper northeast and midwest regions of the U.S. and one facility in Florida from which it services a wide variety of users of industrial plastics.\\nJoint Venture\\nThe Company holds a 50% joint venture interest in Kreher Steel Co. (“Kreher”), a metals distributor of bulk quantities of alloy, special bar quality and stainless steel bars, headquartered in Melrose Park, Illinois. The Company’s equity in the earnings of this joint venture is reported separately in the Company’s consolidated statements of operations. Kreher is considered a significant subsidiary under Rule 3-09 of Regulation S-X. Therefore, its stand-alone financial statements are included in this filing.\\nAccess to SEC Filings\\nThe Company makes available free of charge on or through its Web site at www.amcastle.com the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the U.S. Securities and Exchange Commission (the “SEC”). Information on our website does not constitute part of this annual report on Form 10-K.\\nITEM 1A —\\nRisk Factors\\nOur business, financial condition, results of operations, and cash flows are subject to various risks, many of which are not exclusively within our control that may cause actual performance to differ materially from historical or projected future performance. The risks described below are not the only risks we face. Any of the following risks, as well as other risks and uncertainties not currently known to us or that we currently consider to be immaterial, could materially and adversely affect our business, financial condition, results of operations, or cash flows.\\nWe may not achieve all of the expected benefits from our restructuring and performance enhancement initiatives.\\nWe have recently begun implementing restructuring actions in our metals business, including organizational restructuring, warehouse realignments and performance improvement programs. We expect these measures will result in improvements to annualized operating profits of approximately $33.0 million once fully implemented in 2013. In addition, we continue to evaluate additional options to improve efficiency and performance of our operations. We have made certain assumptions in estimating the anticipated impact of our restructuring and performance enhancement initiatives. These assumptions may turn out to be incorrect due to a variety of factors. In addition, our ability to realize the expected benefits from these initiatives is subject to significant business, economic, and competitive uncertainties and contingencies, many of which are beyond our control. Some of our cost saving measures may not have the impact on our operating profitability that we currently project. If we are unsuccessful in implementing these initiatives or if we do not achieve our expected results, our results of operations and cash flows could be materially adversely affected.\\n5\\nOur substantial level of indebtedness could adversely affect our financial condition and prevent us from fulfilling our obligations under our debt instruments.\\nWe have substantial debt service obligations. As of December 31, 2012, we had approximately $322.5 million of total debt outstanding, excluding capital lease obligations of $1.4 million, of which $264.5 million is secured. As of December 31, 2012, the Company had approximately $50.5 million of availability under our revolving credit facility. Subject to restrictions contained in the debt instruments, we may incur additional indebtedness.\\nOur substantial level of indebtedness could have significant effects on our business, including the following:\\n\\n| • | it may be more difficult for us to satisfy our financial obligations; |\\n\\n| • | our ability to obtain additional financing for working capital, capital expenditures, strategic acquisitions or general corporate purposes may be impaired; |\\n\\n| • | we must use a substantial portion of our cash flow from operations to pay interest on our indebtedness, which will reduce the funds available to use for operations and other purposes; |\\n\\n| • | our ability to fund a change of control offer under our debt instruments may be limited; |\\n\\n| • | our substantial level of indebtedness could place us at a competitive disadvantage compared to our competitors that may have proportionately less debt; |\\n\\n| • | our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate may be limited; and |\\n\\n| • | our substantial level of indebtedness may make us more vulnerable to economic downturns and adverse developments in our business. |\\n\\nWe expect to obtain the funds to pay our expenses and to repay our indebtedness primarily from our operations and, in the case of our indebtedness, from the refinancing thereof. Our ability to meet our expenses and make these payments therefore depends on our future performance, which will be affected by financial, business, economic and other factors, many of which we cannot control. Our business may not generate sufficient cash flow from operations in the future, and our currently anticipated growth in revenue and cash flow may not be realized, either or both of which could result in our being unable to repay indebtedness or to fund other liquidity needs. If we do not have enough funds, we may be required to refinance all or part of our then existing debt, sell assets or borrow more funds, which we may not be able to accomplish on terms acceptable to us, or at all. In addition, the terms of existing or future debt agreements may restrict us from pursuing any of these alternatives.\\nOur debt instruments impose significant operating and financial restrictions, which may prevent us from pursuing certain business opportunities and taking certain actions and our failure to comply with the covenants contained in our debt instruments could result in an event of default that could adversely affect our operating results.\\nOur debt agreements impose, and future debt agreements may impose, operating and financial restrictions on us. These restrictions limit or prohibit, among other things, our ability to:\\n\\n| • | incur additional indebtedness unless certain financial tests are satisfied or issue disqualified capital stock; |\\n\\n| • | pay dividends, redeem subordinated debt or make other restricted payments; |\\n\\n| • | make certain investments or acquisitions; |\\n\\n| • | issue stock of subsidiaries; |\\n\\n| • | grant or permit certain liens on our assets; |\\n\\n| • | enter into certain transactions with affiliates; |\\n\\n| • | merge, consolidate or transfer substantially all of our assets; |\\n\\n| • | incur dividend or other payment restrictions affecting certain of our subsidiaries; |\\n\\n| • | transfer, sell or acquire assets, including capital stock of our subsidiaries; and |\\n\\n| • | change the business we conduct. |\\n\\nThese covenants could adversely affect our ability to finance our future operations or capital needs, withstand a future downturn in our business or the economy in general, engage in business activities, including future opportunities that may be in our interest, and plan for or react to market conditions or otherwise execute our business strategies. A breach of any of these covenants could result in a default in respect of the related indebtedness. If a default occurs, the relevant lenders or holders of such indebtedness could elect to declare the indebtedness, together with accrued interest and other fees, to be immediately due and payable and proceed against any collateral securing that indebtedness. If the maturity of our indebtedness is accelerated, we may not have sufficient cash resources to satisfy our debt obligations and may not be able to continue our operations as planned.\\n6\\nWe may not be able to generate sufficient cash to service all of our existing debt service obligations, and may be forced to take other actions to satisfy our obligations under our debt agreements, which may not be successful.\\nOur annual debt service obligations until December 2015, when our revolving credit facility is scheduled to mature, will be primarily limited to interest payments on our outstanding debt securities, with an aggregate principal amount of $282.5 million, and on borrowings under our $100.0 million revolving credit facility of $39.5 million as of December 31, 2012. Our ability to make scheduled payments on or to refinance our debt obligations depends on our future financial condition and operating performance, which are subject to prevailing economic and competitive conditions and to certain financial, business and other factors beyond our control. Our business may not generate sufficient cash flow from operations in the future and our currently anticipated levels of revenue and cash flow may not be realized, either or both of which could result in our being unable to repay indebtedness or to fund other liquidity needs. Therefore, we may not be able to maintain or realize a level of cash flows from operating activities sufficient to permit us to pay the principal, premium, if any, and interest on our indebtedness.\\nIf our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay investments and capital expenditures, sell assets, seek additional capital or restructure or refinance our indebtedness. Our ability to restructure or refinance our debt will depend on the condition of the capital markets and our financial condition at such time. Any refinancing of our debt could be at higher interest rates and may require us to comply with more onerous borrowing covenants, which could further restrict our business operations. The terms of existing or future debt instruments may restrict us from adopting some of these alternatives. In addition, any failure to make payments of principal and interest on our outstanding indebtedness on a timely basis would likely result in a reduction of our credit rating, which could harm our ability to incur additional indebtedness. These alternative measures may not be successful and may not permit us to meet our scheduled debt service obligations.\\nOur future operating results depend on the volatility of the prices of metals and plastics, which could cause our results to be adversely affected.\\nThe prices we pay for raw materials, both metals and plastics, and the prices we charge for products may fluctuate depending on many factors, including general economic conditions (both domestic and international), competition, production levels, import duties and other trade restrictions and currency fluctuations. To the extent metals and plastics prices decline, we would generally expect lower sales and possibly lower net income, depending on the timing of the price changes and the ability to pass price changes on to our customers. To the extent we are not able to pass on to our customers any increases in our raw materials prices, our operating results may be adversely affected. In addition, because we maintain substantial inventories of metals and plastics in order to meet short lead-times and the just-in-time delivery requirements of our customers, a reduction in our selling prices could result in lower profitability or, in some cases, losses, either of which could adversely impact our ability to remain in compliance with certain financial covenants contained in our debt instruments, as well as result in us incurring impairment charges.\\nDisruptions or shortages in the supply of raw materials could adversely affect our operating results and our ability to meet our customers’ demands.\\nOur business requires materials that are sourced from third party suppliers. If for any reason our primary suppliers of metals should curtail or discontinue their delivery of raw materials to us at competitive prices and in a timely manner, our operating results could suffer. Unforeseen disruptions in our supply bases could materially impact our ability to deliver products to customers. The number of available suppliers could be reduced by factors such as industry consolidation and bankruptcies affecting metals and plastics producers, or suppliers may be unwilling or unable to meet our demand due to industry supply conditions generally. If we are unable to obtain sufficient amounts of raw materials from our traditional suppliers, we may not be able to obtain such raw materials from alternative sources at competitive prices to meet our delivery schedules, which could have an adverse impact on our operating results. To the extent we have quoted prices to customers and accepted orders for products prior to purchasing necessary raw materials, or have existing contracts, we may be unable to raise the price of products to cover all or part of the increased cost of the raw materials to our customers.\\nIn some cases the availability of raw materials requires long lead times. As a result, we may experience delays or shortages in the supply of raw materials. If unable to obtain adequate and timely deliveries of required raw materials, we may be unable to timely supply customers with sufficient quantities of products. This could cause us to lose sales, incur additional costs, or suffer harm to our reputation.\\n7\\nIncreases in freight and energy prices would increase our operating costs and we may be unable to pass these increases on to our customers in the form of higher prices, which may adversely affect our operating results.\\nWe use energy to process and transport our products. The prices for and availability of energy resources are subject to volatile market conditions, which are affected by political, economic and regulatory factors beyond our control. Our operating costs increase if energy costs, including electricity, diesel fuel and natural gas, rise. During periods of higher freight and energy costs, we may not be able to recover our operating cost increases through price increases without reducing demand for our products. In addition, we typically do not hedge our exposure to higher freight or energy prices.\\nWe service industries that are highly cyclical, and any downturn in our customers’ industries could reduce our revenue and profitability.\\nMany of our products are sold to customers in industries that experience significant fluctuations in demand based on economic conditions, energy prices, consumer demand, availability of adequate credit and financing, customer inventory levels, changes in governmental policies and other factors beyond our control. As a result of this volatility in the industries we serve, when one or more of our customers' industries experiences a decline, we may have difficulty increasing or maintaining our level of sales or profitability if we are not able to divert sales of our products to customers in other industries. We have made a strategic decision to focus sales resources on certain industries, specifically the aerospace, oil and gas and heavy equipment, machine tools and general industrial equipment industries. A downturn in these industries has had, and may in the future continue to have, an adverse effect on our operating results. We are also particularly sensitive to market trends in the manufacturing sector of the North American economy.\\nA portion of our sales, particularly in the aerospace industry, are related to contracts awarded to our customers under various U.S. Government defense-related programs. Significant changes in defense spending, or in government priorities and requirements could impact the funding, or the timing of funding, of those defense programs, which could negatively impact our results of operations and financial condition.\\nOur industry is highly competitive, which may force us to lower our prices and may have an adverse effect on our operating results.\\nThe principal markets that we serve are highly competitive. Competition is based principally on price, service, quality, processing capabilities, inventory availability and timely delivery. We compete in a highly fragmented industry. Competition in the various markets in which we participate comes from a large number of value-added metals processors and service centers on a regional and local basis, some of which have greater financial resources than we do and some of which have more established brand names in the local markets we serve. We also compete to a lesser extent with primary metals producers who typically sell to very large customers requiring shipments of large volumes of metal. Increased competition could force us to lower our prices or to offer increased services at a higher cost to us, which could have an adverse effect on our operating results.\\nOur operating results are subject to the seasonal nature of our customers’ businesses.\\nA portion of our customers experience seasonal slowdowns. Historically, our revenues in the months of July, November and December have been lower than in other months because of a reduced number of shipping days and holiday or vacation closures for some customers. Consequently, our sales in the first two quarters of the year are usually higher than in the third and fourth quarters. As a result, analysts and investors may inaccurately estimate the effects of seasonality on our operating results in one or more future quarters and, consequently, our operating results may fall below expectations.\\nWe rely upon our suppliers as to the specifications of the metals we purchase from them.\\nWe rely on mill certifications that attest to the physical and chemical specifications of the metal received from our suppliers for resale and generally, consistent with industry practice, do not undertake independent testing of such metals. We rely on our customers to notify us of any metal that does not conform to the specifications certified by the supplying mill. Although our primary sources of products have been domestic mills, we have and will continue to purchase product from foreign suppliers when we believe it is appropriate. In the event that metal purchased from domestic suppliers is deemed to not meet quality specifications as set forth in the mill certifications or customer specifications, we generally have recourse against these suppliers for both the cost of the products purchased and possible claims from our customers. However, such recourse will not compensate us for the damage to our reputation that may arise from sub-standard products and possible losses of customers. Moreover, there is a greater level of risk that similar recourse will not be available to us in the event of claims by our customers related to products from foreign\\n8\\nsuppliers that do not meet the specifications set forth in the mill certifications. In such circumstances, we may be at greater risk of loss for claims for which we do not carry, or do not carry sufficient, insurance.\\nWe are vulnerable to interest rate fluctuations on our indebtedness, which could hurt our operating results.\\nWe are exposed to various interest rate risks that arise in the normal course of business. We finance our operations with fixed and variable rate borrowings. Market risk arises from changes in variable interest rates. Under our revolving credit facility, our interest rate on borrowings is subject to changes based on fluctuations in the LIBOR and prime rates of interest. If interest rates significantly increase, we could be unable to service our debt which could have an adverse effect on our operating results.\\nWe operate in international markets, which expose us to a number of risks.\\nAlthough a substantial majority of our business activity takes place in the United States, we serve and operate in certain international markets, which expose us to political, economic and currency related risks, including the following:\\n| • | potential for adverse change in the local political or social climate or in government policies, laws and regulations; |\\n\\n| • | difficulty staffing and managing geographically diverse operations and the application of foreign labor regulations; |\\n\\n| • | restrictions on imports and exports or sources of supply; |\\n\\n| • | currency exchange rate risk; and |\\n\\n| • | change in duties and taxes. |\\n\\nWe operate in Canada, Mexico, France, and the United Kingdom, with limited operations in Singapore and China. An act of war or terrorism or major pandemic event could disrupt international shipping schedules, cause additional delays in importing our products into the United States or increase the costs required to do so. In addition, acts of crime or violence in these international markets (for example, in Mexico) could adversely affect our operating results. Fluctuations in the value of the U.S. dollar versus foreign currencies could reduce the value of these assets as reported in our financial statements, which could reduce our stockholders' equity. If we do not adequately anticipate and respond to these risks and the other risks inherent in international operations, it could have a material adverse effect on our operating results.\\nWe may not be able to realize the benefits we anticipate from our acquisitions, including the Tube Supply acquisition.\\nIn December 2011 we acquired Tube Supply, Inc. We intend to continue to seek attractive opportunities to acquire other businesses in the future. Achieving the benefits of these acquisitions depends on the timely, efficient and successful execution of a number of post-acquisition events, including our integration of the acquired businesses. Factors that could affect our ability to achieve the benefits we anticipate from our acquisition include:\\n| • | difficulties in integrating and managing personnel, financial reporting and other systems used by the acquired businesses; |\\n\\n| • | the failure of the acquired businesses to perform in accordance with our expectations; |\\n\\n| • | failure to achieve anticipated synergies between our business units and the acquired businesses; |\\n\\n| • | the loss of the acquired businesses' customers; and |\\n\\n| • | cyclicality of business. |\\n\\nThe presence of any of the above factors individually or in combination could result in future impairment charges against the assets of the acquired businesses. If the acquired businesses do not operate as we anticipate, it could adversely affect our operating results and financial condition. As a result, there can be no assurance that the acquisitions, including the Tube Supply acquisition, will be successful or will not, in fact, adversely affect our business.\\nOur business could be adversely affected by a disruption to our primary distribution hub.\\nOur largest facility, in Franklin Park, Illinois, serves as a primary distribution center that ships product to our other facilities as well as external customers. Our business could be adversely impacted by a major disruption at this facility due to unforeseen developments occurring in or around the facility, such as:\\n| • | damage to or inoperability of our warehouse or related systems; |\\n\\n| • | a prolonged power or telecommunication failure; |\\n\\n| • | a natural disaster, environmental or public health issue; or |\\n\\n| • | an airplane crash or act of war or terrorism on-site or nearby as the facility is located within seven miles of O'Hare International Airport (a major U.S. airport) and lies below certain take-off and landing flight patterns. |\\n\\n9\\nA prolonged disruption of the services and capabilities of our Franklin Park facility and operation could adversely impact our operating results.\\nDamage to or a disruption in our information technology systems could impact our ability to conduct business and/or report our financial performance.\\nOver the last several years we have been implementing a new enterprise-wide resources planning (''ERP'') system. While we have completed the conversions of substantially all of our North American and European locations onto the new ERP system, we can provide no assurance that the continued phased-implementation at our remaining facilities, including Tube Supply, will be successful or will occur as planned. Difficulties associated with the design and implementation of the new ERP system could adversely affect our business, our customer service and our operating results.\\nWe rely on information technology systems to provide inventory availability to our sales and operating personnel, improve customer service through better order and product reference data and monitor operating results. Difficulties associated with upgrades or integration with new systems could lead to business interruption that could harm our reputation, increase our operating costs and decrease profitability. In addition, any significant disruption relating to our current or new information technology systems, whether due from such things as fire, flood, tornado and other natural disasters, power loss, network failures, loss of data, security breaches and computer viruses, or otherwise, may have an adverse effect on our business, our operating results and our ability to report our financial performance in a timely manner.\\nA portion of our workforce is represented by collective bargaining units, which may lead to work stoppages.\\nAs of December 31, 2012, approximately 15% of our U.S. employees were represented by unions under collective bargaining agreements, including hourly warehouse employees at our primary distribution center in Franklin Park, Illinois. As these agreements expire, there can be no assurance that we will succeed in concluding collective bargaining agreements with the union to replace those that expire. Although we believe that our labor relations have generally been satisfactory, we cannot predict how stable our relationships with these labor organizations will be or whether we will be able to meet union requirements without impacting our operating results and financial condition. The unions may also limit our flexibility in dealing with our workforce. Work stoppages and instability in our union relationships could negatively impact the timely processing and shipment of our products, which could strain relationships with customers and adversely affect our operating results.\\nAn impairment or restructuring charge could have an adverse effect on our operating results.\\nWe continue to evaluate opportunities to reduce costs and improve operating performance. These actions could result in restructuring and related charges, including but not limited to asset impairments, employee termination costs, charges for pension benefits, and pension curtailments that could be significant, which could adversely affect our financial condition and results of operations.\\nWe have a significant amount of long-lived assets, including goodwill and intangible assets. We review the recoverability of goodwill annually or whenever significant events or changes occur which might impair the recovery of recorded costs, making certain assumptions regarding future operating performance. We review the recoverability of definite lived intangible assets and other long-lived assets whenever significant events or changes occur which might impair the recovery of recorded costs, making certain assumptions regarding future operating performance. The results of these calculations may be affected by the current or further declines in the market conditions for our products, as well as interest rates and general economic conditions. If impairment is determined to exist, we will incur impairment losses, which will have an adverse effect on our operating results and our ability to remain in compliance with certain financial covenants contained in our debt instruments.\\nWe could incur substantial costs in order to comply with, or to address any violations under, environmental and employee health and safety laws, which could adversely affect our operating results.\\nOur operations are subject to various environmental statutes and regulations, including laws and regulations governing materials we use. In addition, certain of our operations are subject to international, federal, state and local environmental laws and regulations that impose limitations on the discharge of pollutants into the air and water and establish standards for the treatment, storage and disposal of solid and hazardous wastes. Our operations are also subject to various employee safety and health laws and regulations, including those concerning occupational injury and illness, employee exposure to hazardous materials and employee complaints. Certain of our facilities are located in industrial areas, have a history of heavy industrial use and have been in operation for many years and, over time, we and other\\n10\\npredecessor operators of these facilities have generated, used, handled and disposed of hazardous and other regulated wastes. Currently unknown cleanup obligations at these facilities, or at off-site locations at which materials from our operations were disposed, could result in future expenditures that cannot be currently quantified but which could have an adverse effect on our operating results.\\nWe may face risks associated with current or future litigation and claims.\\nFrom time to time, we are involved in a variety of lawsuits, claims and other proceedings relating to the conduct of our business. These suits concern issues including contract disputes, employment actions, employee benefits, taxes, environmental, health and safety, personal injury and product liability matters. Due to the uncertainties of litigation, we can give no assurance that we will prevail on all claims made against us in the lawsuits that we currently face or that additional claims will not be made against us in the future. While it is not feasible to predict the outcome of all pending lawsuits and claims, we do not believe that the disposition of any such pending matters is likely to have an adverse effect on our financial condition or liquidity, although the resolution in any reporting period of one of more of these matters could have an adverse effect on our operating results for that period. Also, we can give no assurance that any other lawsuits or claims brought in the future will not have an adverse effect on our financial condition, liquidity or operating results.\\nPotential environmental legislative and regulatory actions could impose significant costs on the operations of our customers and suppliers, which could have a material adverse impact on our results of operations, financial condition and cash flows.\\nClimate change regulation or some form of legislation aimed at reducing greenhouse gas (''GHG'') emissions is currently being considered in the United States as well as globally. As a metals and plastics distributor, our operations do not emit significant amounts of GHG. However, the manufacturing processes of many of our suppliers and customers are energy intensive and generate carbon dioxide and other GHG emissions. Any adopted future climate change and GHG regulations may impose significant costs on the operations of our customers and suppliers and indirectly impact our operations.\\nThe Tube Supply acquisition significantly extends our exposure in the oil and gas sector to customers who utilize non-traditional drilling techniques, including hydraulic fracturing. Hydraulic fracturing is an important and commonly used process for the completion of natural gas, and to a lesser extent, oil wells in shale formations. Certain environmental and other groups have asserted that chemicals used in the fracturing process could adversely affect drinking water supplies. The U.S. Congress and various state and local governments are considering increased regulatory oversight of the hydraulic fracturing process, including through additional permit requirements, operational restrictions, reporting obligations and temporary or permanent bans on hydraulic fracturing in certain environmentally sensitive areas such as watersheds. We cannot predict whether such laws or regulations will be enacted and, if so, what actions any such laws or regulations would require or prohibit. Additional levels of regulatory oversight on, or otherwise limiting, the hydraulic fracturing process could subject the business and operations of our oil and gas customers to delays, increased operating costs and process prohibitions, and indirectly impact our oil and gas business through reduced demand for our products.\\nUntil the timing, scope and extent of any future regulation becomes known, we cannot predict the effect on our results of operations, financial condition and cash flows.\\nCommodity hedging transactions may expose us to loss or limit our potential gains.\\nWe have entered into certain fixed price sales contracts with customers which expose us to risks associated with fluctuations in commodity prices. As part of our risk management program, we may use financial instruments from time-to-time to mitigate all or portions of these risks, including commodity futures, forwards or other derivative instruments. While intended to reduce the effects of the commodity price fluctuations, these transactions may limit our potential gains or expose us to losses. Also, should our counterparties to such transactions fail to honor their obligations due to financial distress we would be exposed to potential losses or the inability to recover anticipated gains from these transactions.\\nOwnership of our stock is concentrated, which may limit stockholders’ ability to influence corporate matters.\\nAs of December 31, 2012, based on filings made with the SEC and other information made available to us as of that date, we believe Patrick J. Herbert, III, one of our directors, may be deemed to beneficially own approximately 22.8% of our common stock. Accordingly, Mr. Herbert and his affiliates may have the voting power to substantially control the outcome of matters requiring a stockholder vote including the election of directors and the approval of significant\\n11\\ncorporate matters. Such a concentration of control could adversely affect the market price of our common stock or prevent a change in control or other business combinations that might be beneficial to us.\\nWe have various mechanisms in place that may prevent a change in control that stockholders may otherwise consider favorable.\\nOn August 31, 2012, our Board of Directors adopted a shareholder rights plan pursuant to which one purchase right was distributed as a dividend on each share of our common stock held of record as of the close of business on September 11, 2012. Upon becoming exercisable, each right will entitle its holder to purchase from the Company one one-hundredth of a share of our Series B Junior Preferred Stock for the purchase price of $54.00. Generally, the rights will become exercisable ten days after the date on which any person or group becomes the beneficial owner of 10% or more of our common stock or has commenced a tender or exchange offer which, if consummated, would result in any person or group becoming the beneficial owner of 10% or more of our common stock, subject to the terms and conditions set forth in the shareholder rights plan. The rights are attached to the certificates representing outstanding shares of common stock until the rights become exercisable, at which point separate certificates will be distributed to the record holders of our common stock. If a person or group becomes the beneficial owner of 10% or more of our common stock, which we refer to as an “acquiring person,” each right will entitle its holder, other than the acquiring person, to receive upon exercise a number of shares of our common stock having a market value of two times the purchase price of the right.\\nThe shareholder rights plan is designed to deter coercive takeover tactics and to prevent an acquirer from gaining control of the Company without offering a fair price to all of our stockholders. The existence of the shareholder rights plan, however, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding common stock, and thereby adversely affect the market price of our common stock.\\nIn addition, our charter and by-laws and the Maryland General Corporation Law, or the MGCL, include provisions that may be deemed to have antitakeover effects and may delay, defer or prevent a takeover attempt that stockholders might consider to be in their best interests. For example, the MGCL, our charter and bylaws require the approval of the holders of two-thirds of the votes entitled to be cast on the matter to amend our charter (unless our Board of Directors has unanimously approved the amendment, in which case the approval of the holders of a majority of such votes is required), contain certain advance notice procedures for nominating candidates for election to our Board of Directors, and permit our Board of Directors to issue up to 9.988 million shares of preferred stock.\\nFurthermore, we are subject to the anti-takeover provisions of the MGCL that prohibit us from engaging in a “business combination” with an “interested stockholder” for a period of five years after the date of the transaction in which the person first becomes an “interested stockholder,” unless the business combination or stockholder interest is approved in a prescribed manner. The application of these and certain other provisions of our charter could have the effect of delaying or preventing a change of control, which could adversely affect the market price of our common stock.\\nThe provisions of our debt instruments also contain limitations on our ability to enter into change of control transactions. In addition, the repurchase rights in our 7.0% convertible senior notes due 2017 (“Convertible Notes”) triggered by the occurrence of a “fundamental change” (as defined in the indenture for the Convertible Notes), and the additional shares of our common stock by which the conversion rate is increased in connection with certain fundamental change transactions, as described in the indenture for the Convertible Notes, could discourage a potential acquirer.\\nWe may not have the cash necessary to satisfy our cash obligations under our Convertible Notes.\\nAs of December 31, 2012, we had approximately $57.5 million of aggregate principal amount outstanding under the Convertible Notes. The Convertible Notes bear cash interest semiannually at a rate of 7.0% per year, and mature on December 15, 2017. Upon the occurrence of a fundamental change (as defined in the indenture for the Convertible Notes), we may be required to repurchase some or all of the Convertible Notes for cash at a repurchase price equal to 100% of the principal amount of the Convertible Notes being repurchased, plus any accrued and unpaid interest up to but excluding the relevant fundamental change repurchase date. We may not have sufficient funds to satisfy such cash obligations and, in such circumstances, may not be able to arrange the necessary financing on favorable terms or at all. In addition, our ability to satisfy such cash obligations will be restricted pursuant to covenants contained in the indenture for the Convertible Notes and will be permitted to be paid only in limited circumstances. We may also be limited in our ability to satisfy such cash obligations by applicable law or the terms of other instruments governing our indebtedness. Our inability to make cash payments to satisfy our obligations described above would trigger an event of default under the Convertible Notes, which in turn could constitute an event of default under any of our outstanding indebtedness, thereby resulting in the acceleration of such indebtedness, the prepayment of which could further restrict our ability to satisfy such cash obligations.\\n12\\nThe conditional conversion features of our Convertible Notes, if triggered, may adversely affect our financial condition and operating results.\\nIn the event the conditional conversion features of the Convertible Notes are triggered, holders of the Convertible Notes will be entitled to convert the Convertible Notes at any time during specified periods at their option. If one or more holders elect to convert their Convertible Notes, and we elect or are deemed to have elected cash settlement or combination settlement, we would be required to pay cash to satisfy all or a portion of our conversion obligation for such Convertible Notes, which could adversely affect our liquidity. In addition, even if holders do not elect to convert their Convertible Notes, we could be required under applicable accounting rules to reclassify all or a portion of the outstanding principal of the Convertible Notes as a current rather than long-term liability, which would result in a material reduction of our net working capital.\\nITEM 1B —\\nUnresolved Staff Comments\\nNone.\\nITEM 2 —\\nProperties\\nThe Company’s corporate headquarters are located in Oak Brook, Illinois. All properties and equipment are sufficient for the Company’s current level of activities. Distribution centers and sales offices are maintained at each of the following locations, most of which are leased, except as indicated:\\n| Locations | ApproximateFloor Area inSquare Feet |\\n| Metals Segment |\\n| North America |\\n| Bedford Heights, Ohio | 374,400 | (1) |\\n| Birmingham, Alabama | 76,000 | (1) |\\n| Blaine, Minnesota | 65,200 | (1) |\\n| Charlotte, North Carolina | 116,500 | (1) |\\n| Edmonton, Alberta | 87,103 |\\n| Fairless Hills, Pennsylvania | 71,600 | (1) |\\n| Franklin Park, Illinois | 522,600 | (1) |\\n| Gardena, California | 117,000 |\\n| Grand Prairie, Texas | 78,000 | (1) |\\n| Hammond, Indiana (H-A Industries) | 243,000 |\\n| Houston, Texas | 383,100 | (3) |\\n| Kansas City, Missouri | 118,000 |\\n| Kennesaw, Georgia | 87,500 |\\n| Kent, Washington | 53,000 |\\n| Lafayette, Louisiana | 5,000 |\\n| Mississauga, Ontario | 57,000 |\\n| Orange, Connecticut | 57,389 |\\n| Paramount, California | 155,500 |\\n| Point Claire, Quebec | 38,760 |\\n| Santa Cantarina, Nuevo Leon, Mexico | 112,000 |\\n| Saskatoon, Saskatchewan | 15,000 |\\n| Selkirk, Manitoba | 50,000 | (1) |\\n| Stockton, California | 60,000 |\\n| Twinsburg, Ohio | 120,000 |\\n| Wichita, Kansas | 95,000 |\\n\\n13\\n| Locations | ApproximateFloor Area inSquare Feet |\\n| Worcester, Massachusetts | 53,500 | (1) |\\n| Europe |\\n| Blackburn, England | 62,139 |\\n| Letchworth, England | 40,000 |\\n| Trafford Park, England | 30,000 |\\n| Montoir de Bretagne, France | 38,944 |\\n| Asia |\\n| Shanghai, China | 45,700 |\\n| Sales Offices |\\n| Bilbao, Spain | (Intentionally left blank) |\\n| Fairfield, Ohio |\\n| Milwaukee, Wisconsin |\\n| Phoenix, Arizona |\\n| Singapore |\\n| Tulsa, Oklahoma |\\n| Total Metals Segment | 3,428,935 |\\n| Plastics Segment |\\n| Baltimore, Maryland | 24,000 |\\n| Cleveland, Ohio | 8,600 |\\n| Cranston, Rhode Island | 14,990 |\\n| Detroit, Michigan | 22,000 |\\n| Elk Grove Village, Illinois | 22,500 |\\n| Fort Wayne, Indiana | 17,600 |\\n| Grand Rapids, Michigan | 42,500 | (1) |\\n| Harrisburg, Pennsylvania | 13,900 |\\n| Indianapolis, Indiana | 13,500 |\\n| Kalamazoo, Michigan | 81,000 |\\n| Knoxville, Tennessee | 16,530 |\\n| Maple Shade, New Jersey | 12,480 |\\n| Mt. Vernon, New York | 30,000 |\\n| New Philadelphia, Ohio | 15,700 |\\n| Pittsburgh, Pennsylvania | 12,800 |\\n| Rockford, Michigan | 53,600 |\\n| Tampa, Florida | 17,700 |\\n| Worcester, Massachusetts | 2,500 | (1) |\\n| Total Plastics Segment | 421,900 |\\n| Headquarters |\\n| Oak Brook, Illinois | 39,360 | (2) |\\n| GRAND TOTAL | 3,890,195 |\\n\\n| (1) | Represents owned facility. |\\n\\n| (2) | The Company’s principal executive offices do not include a distribution or sales office. |\\n\\n| (3) | Represents two leased facilities (274,000 square feet) and one owned facility (109,100 square feet). |\\n\\n14\\nITEM 3 —\\nLegal Proceedings\\n(Amounts in thousands)\\nThe Company is party to a variety of legal proceedings and other claims, including proceedings by government authorities, which arise from the operation of its business. These proceedings are incidental and occur in the normal course of the Company's business affairs. The majority of these claims and proceedings relate to commercial disputes with customers, suppliers, and others; employment, including benefit matters; product quality; and environmental, health and safety claims. It is the opinion of management that the currently expected outcome of these proceedings and claims, after taking into account recorded accruals and the availability and limits of our insurance coverage, will not have a material adverse effect on the consolidated results of operations, financial condition or cash flows of the Company.\\nGovernment Proceeding\\nIn 2011, the Company determined that it inadvertently exported certain aluminum alloy bar that are listed on the U.S. Bureau of Industry and Security's (BIS) Commerce Control List to countries where there is an export license requirement if an exception is not otherwise available. The exports, which occurred in 2011, had a total transaction value of approximately $13 and were made without export licenses. The exports involved five shipments to the Company's wholly-owned subsidiary in China and to a customer in the Philippines. In response thereto, the Company submitted a voluntary self-disclosure describing the nature of these shipments to the Office of Export Enforcement of the Department of Commerce (OEE) in accordance with applicable Export Administration Regulations. If it is determined that the Company failed to comply with the applicable U.S. export regulations, the OEE could assess civil penalties of up to $1,250, restrict export privileges or provide an administrative warning. While the ultimate disposition of this matter cannot be predicted with certainty, it is the opinion of management, based on the information available at this time, that the outcome of this matter will not have a material effect on the Company's financial position, results of operations or cash flows.\\nITEM 4 —\\nMine Safety Disclosures\\nNot applicable.\\nExecutive Officers of The Registrant\\nThe following selected information for each of our current executive officers (as defined by regulations of the SEC) was prepared as of March 4, 2013.\\n| Name and Title | Age | Business Experience |\\n| Patrick R. AndersonVice President, CorporateController and Chief Accounting Officer | 41 | Mr. Anderson began his employment with the registrant in 2007 and was elected to the position of Vice President, Corporate Controller and Chief Accounting Officer. Prior to joining the registrant, he was employed as a Senior Manager with Deloitte & Touche LLP (a global accounting firm) where he was employed from 1994 to 2007. |\\n| Scott J. DolanPresident and Chief Executive Officer | 42 | Mr. Dolan most recently served as Senior Vice President, Airport Operations and Cargo, of United Continental Holdings, Inc. (a $37 billion publicly traded provider of passenger and cargo air transportation services), and its principal wholly-owned subsidiaries, United Airlines and Continental Airlines, from 2010 to 2011. From 2004 until 2010, Mr. Dolan served as Senior Vice President, Airport Operations and President, United Cargo (2006-2010) and as Senior Vice President and President, United Cargo (2004-2006) for UAL Corporation and its principal subsidiary, United Airlines. Mr. Dolan worked at Atlas Air Worldwide Holdings, Inc. (a global airfreight company) from 2002 to 2004, where he served as Senior Vice President and Chief Operating Officer from 2003-2004 and as Vice President, Business Integration from 2002 to 2003. Prior to joining Atlas Air, Mr. Dolan spent five years at General Electric Company, where he served in a variety of positions including Vice President, Operational Performance, Polar Air Cargo, a subsidiary of GE Capital Aviation Services. |\\n\\n15\\n| Name and Title | Age | Business Experience |\\n| Thomas L. GarrettVice President andPresident, Total Plastics, Inc. | 50 | Mr. Garrett began his employment with Total Plastics, Inc., a wholly owned subsidiary of the registrant, in 1988 and was appointed to the position of Controller. In 1996, he was elected to the position of Vice President and in 2001 was appointed to the position of Vice President of the registrant and President of Total Plastics, Inc. |\\n| Kevin H. GlynnVice Presidentand Chief Information Officer | 49 | Mr. Glynn began his employment with the registrant in October 2010 as the Interim Chief Information Officer. In January 2011 he was appointed Vice President and Chief Information Officer. Prior to joining the registrant, he was employed as a Managing Principal at Laminar Group LLC (a management consulting company) from 2009 to 2010, Chief Operating Officer at IRON Solutions, Inc. (an information technology company specializing in data, software and media services for the agriculture equipment market) from 2008 to 2009 and as Senior Vice President and Chief Information Officer at CNH America, LLC (a manufacturer of agricultural and construction equipment) from 2006 to 2007. |\\n| Robert J. PernaVice President,General Counsel and Secretary | 49 | Mr. Perna began his employment with the registrant in 2008 and was elected to the position of Vice President-General Counsel and Secretary. Prior to joining the registrant he was General Counsel, North America, CNH America, LLC (a manufacturer of agricultural and construction equipment) since 2007, and he also served as Associate General Counsel and Corporate Secretary for Navistar International Corporation (a manufacturer of commercial trucks and diesel engines) since 2001. |\\n| Anne D. ScharmVice President, Human Resources | 36 | Ms. Scharm began her employment with the registrant in 2011 as the Director of Organizational Development. In December 2011, she was appointed as the Interim Vice President, Human Resources. In March 2012, she was appointed Vice President, Human Resources. Prior to joining the registrant, she was employed as Director of Human Resources and Organizational Development with Delnor Health System, (now known as Cadence Health - a healthcare organization) from 2006 to 2011. |\\n| Scott F. StephensVice President,Chief Financial Officer and Treasurer | 43 | Mr. Stephens began his employment with the registrant in 2008 and was elected to the position of Vice President, Chief Financial Officer, and Treasurer. From February 2010 to December 2010, he was also appointed to the position of Interim President, Castle Metals Oil & Gas. In May 2012, Mr. Stephens was elected to serve as Interim Chief Executive Officer until October 2012. Formerly, he served as the CFO of Lawson Products, Inc. (a distributor of services, systems and products to the MRO and OEM marketplace) from 2004 to 2008, and CFO of The Wormser Company from 2001 to 2004. |\\n| Blain A. TiffanyChief Commercial Officer | 54 | Mr. Tiffany began his employment with the registrant in 2000 and was appointed to the position of District Manager. He was appointed Eastern Region Manager in 2003, Vice President – Regional Manager in 2005 and in 2006 was appointed to the position of Vice President – Sales. In 2007, Mr. Tiffany was appointed to the position of Vice President, President of Castle Metals Plate. In 2009, Mr. Tiffany served as Vice President, President of Castle Metals Aerospace through 2011. In 2012, Mr. Tiffany served as Vice President, Castle Metals and in January 2013 was appointed to the position of Chief Commercial Officer. |\\n\\n16\\nPART II\\n\\nITEM 5 —\\nMarket for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities\\nThe Company’s common stock trades on the New York Stock Exchange under the ticker symbol “CAS”. As of March 1, 2013 there were approximately 880 shareholders of record. Payment of cash dividends and repurchase of common stock are currently limited due to restrictions contained in the Company’s debt agreements. No cash dividends were paid on the Company’s common stock in 2012 and 2011. We may consider paying cash dividends on the Company common stock at some point in the future, subject to the limitations described above. Any future payment of cash dividends, if any, is at the discretion of the Board of Directors and will depend on the Company’s earnings, capital requirements and financial condition, restrictions under the Company’s debt instruments, and such other factors as the Board of Directors may consider.\\nSee Part III, Item 12, “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters”, for information regarding common stock authorized for issuance under equity compensation plans.\\nThe table below presents shares of the Company’s common stock which were acquired by the Company during the quarter ended December 31, 2012:\\n| Period | TotalNumber ofSharesPurchased(1) | AveragePricePaid perShare | Total numberof SharesPurchased asPart ofPubliclyAnnouncedPlans orPrograms | MaximumNumber (orApproximateDollar Value) of Shares that May Yet Be Purchased under the Plans or Programs |\\n| October 1 through October 31 | — | — | — | — |\\n| November 1 through November 30 | — | — | — | — |\\n| December 1 through December 31 | 24,469 | $ | 14.77 | — | — |\\n| Total | 24,469 | $ | 14.77 | — | — |\\n\\n| (1) | The total number of shares purchased represents shares surrendered to the Company by employees to satisfy tax withholding obligations upon vesting of restricted stock units awarded pursuant to the Company’s 2010 - 2012 Long-Term Compensation Plan. |\\n\\nOn October 15, 2012 the Company granted 78,492 restricted stock units to Scott J. Dolan, President and Chief Executive Officer, as an equity inducement award. The restricted stock units subject to the inducement award will vest in four equal annual installments, subject to Mr. Dolan's continued employment by the Company. At the time of vesting, the Company will issue to Mr. Dolan in cancellation of the restricted stock units, the number of shares of common stock of the Company equal to the number of restricted stock units. The inducement award was granted outside of the Company's 2008 Omnibus Incentive Plan, authorized by the independent members of the Human Resources Committee of the Company's Board of Directors and granted as an inducement material to Mr. Dolan's employment with the Company in accordance with Section 303A.08 of the New York Stock Exchange Listed Company Manual. The issuance of these shares of restricted stock units was made in reliance upon the exemptions form registration provided by Section 4(2) under the Securities Act of 1933, as amended.\\nThe following table sets forth the range of the high and low sales prices of shares of the Company’s common stock for the periods indicated:\\n| 2012 | 2011 |\\n| Low | High | Low | High |\\n| First Quarter | $ | 9.59 | $ | 12.90 | $ | 15.14 | $ | 19.29 |\\n| Second Quarter | $ | 9.65 | $ | 14.20 | $ | 15.25 | $ | 19.24 |\\n| Third Quarter | $ | 6.99 | $ | 13.54 | $ | 10.37 | $ | 18.46 |\\n| Fourth Quarter | $ | 10.83 | $ | 14.97 | $ | 7.85 | $ | 14.91 |\\n\\n17\\nThe following graph compares the cumulative total stockholder return on our common stock for the five-year period ended December 31, 2012, with the cumulative total return of the Standard and Poor’s 500 Index and to a peer group index. The comparison in the graph assumes the investment of $100 on December 31, 2007. Cumulative total stockholder return means share price increases or decreases plus dividends paid, with the dividends reinvested, and reflect market capitalization weighting. The graph does not forecast future performance of our common stock. The Company moved to a new peer group index during 2010 in conjunction with the establishment of a relative total shareholder return performance measure under the Company’s long term compensation plan. The Company believes this new peer group provides a more meaningful comparison of our stock performance. The new peer group index is made up of companies in the metals industry or in the industrial products distribution business, although not all of the companies included in the new peer group index participate in all of the lines of business in which the Company is engaged and some of the companies included in the peer group index also engage in lines of business in which the Company does not participate. Additionally, the market capitalizations of many of the companies in the peer group are quite different from that of the Company.\\nCOMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*\\nAmong A.M. Castle & Co., the S&P 500 Index, and a Peer Group\\n*$100 invested on 12/31/07 in stock or index, including reinvestment of dividends.\\nFiscal year ending December 31.\\nCopyright© 2013 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved.\\n| 12/07 | 12/08 | 12/09 | 12/10 | 12/11 | 12/12 |\\n| A. M. Castle & Co. | $ | 100.00 | $ | 40.32 | $ | 51.30 | $ | 68.99 | $ | 35.45 | $ | 55.35 |\\n| S&P 500 | 100.00 | 63.00 | 79.67 | 91.67 | 93.61 | 108.59 |\\n| Peer Group (a) | 100.00 | 51.46 | 69.81 | 84.89 | 76.47 | 78.43 |\\n\\n\\n| (a) | The Peer Group Index consists of the following companies: AEP Industries Inc.; AK Steel Holding Corp.; Allegheny Technologies Inc.; Amcol International Corp.; Applied Industrial Technologies Inc.; Carpenter Technology Corp.; Cliffs Natural Resources Inc.; Commercial Metals Company; Fastenal Company; Gibraltar Industries Inc.; Haynes International Inc.; Kaman Corp.; Lawson Products Inc.; MSC Industrial Direct Company Inc.; Nucor Corp.; Olin Corp.; Olympic Steel, Inc.; Quanex Building Products Corp.; Reliance Steel & Aluminum Co.; RTI International Metals Inc.; Schnitzer Steel Industries Inc.; Steel Dynamics Inc.; Stillwater Mining Company; Texas Industries Inc.; United States Steel Corp.; and Worthington Industries Inc. |\\n\\n18\\nITEM 6 —\\nSelected Financial Data\\nThe Selected Financial Data in the table below includes the results of the December 2011 and January 2008 acquisitions of Tube Supply and Metals U.K., respectively, from the date of acquisition.\\n| (dollars in millions, except per share data) | 2012 | 2011 | 2010 | 2009 | 2008 |\\n| For the year ended December 31: |\\n| Net sales | $ | 1,270.4 | $ | 1,132.4 | $ | 943.7 | $ | 812.6 | $ | 1,501.0 |\\n| Equity in earnings of joint venture | 7.2 | 11.7 | 5.6 | 0.4 | 8.8 |\\n| Net loss from continuing operations | (9.7 | ) | (1.8 | ) | (5.6 | ) | (26.9 | ) | (17.1 | ) |\\n| Basic (loss) earnings per common share from continuing operations | (0.42 | ) | (0.08 | ) | (0.25 | ) | (1.18 | ) | (0.76 | ) |\\n| Diluted (loss) earnings per common share from continuing operations | (0.42 | ) | (0.08 | ) | (0.25 | ) | (1.18 | ) | (0.76 | ) |\\n| Cash dividends declared per common share | — | — | — | 0.06 | 0.24 |\\n| As of December 31: |\\n| Total assets | 788.8 | 822.3 | 529.4 | 558.0 | 679.0 |\\n| Long-term debt, less current portion | 296.2 | 314.2 | 61.1 | 67.7 | 75.0 |\\n| Total debt | 297.1 | 314.9 | 69.1 | 89.2 | 117.1 |\\n| Total stockholders’ equity | 337.3 | 312.3 | 313.5 | 318.2 | 347.3 |\\n\\nITEM 7 —\\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations\\nAmounts in millions except per share data\\nInformation regarding the business and markets of A.M. Castle & Co. and its subsidiaries (the “Company”), including its reportable segments, is included in Item 1 “Business” of this annual report on Form 10-K.\\nThe following discussion should be read in conjunction with Item 6 “Selected Financial Data” and the Company’s consolidated financial statements and related notes thereto in Item 8 “Financial Statements and Supplementary Data”.\\nEXECUTIVE OVERVIEW\\nThe Company’s strategy is to become the foremost global provider of specialty metals products and services and specialized supply chain solutions to targeted global industries.\\nDuring 2012, the following significant events occurred which impacted the Company’s operations and/or financial results:\\n\\n| • | Lower LIFO charges and the inclusion of Tube Supply's activity in 2012 resulted in decreased cost of materials as a percentage of sales to 73.0% in 2012 compared to 74.7% in 2011; |\\n\\n| • | Increased operating income as a percentage of sales to 3.2%, up from 0.5% in 2011; |\\n\\n| • | Expanded operations in the United Kingdom to support the continued increase in aerospace defense program business; and |\\n\\n| • | In the first four months of 2012, the Company recognized $15.6 million of interest expense related to the mark-to-market adjustment on the conversion option associated with the convertible debt. In April, the Company reclassified the cumulative value of the conversion option associated with the convertible debt to additional paid-in capital as a result of the authorization of additional shares of common stock and the conversion option is no longer required to be marked-to-market through earnings. |\\n\\nRecent Market and Pricing Trends\\nThe Company experienced decreased demand from its customer base during the second half of 2012 in the Metals segment as customer buying patterns slowed to reflect a more cautious outlook. Industry data indicates that U.S. service center steel shipments were higher than 2011 levels by approximately 1%, while U.S. service center aluminum shipments were approximately 1% lower in 2012 compared to 2011 levels. Virtually all key end-use\\n19\\nmarkets experienced decreases in demand in the Company’s Metals segment during 2012. The Plastics segment experienced an increase in demand for its products in 2012 compared to 2011, reflecting continued strength in the automotive sector. Due to the late-cycle nature of the Company’s targeted customers, results typically lag the general economic cycle by twelve months.\\nPricing across the majority of the Company’s markets started strong during 2012 and then softened for the majority of the year. The combination of factors above negatively impacted the Company’s operating results during the last three quarters of 2012.\\nChanges in pricing can have a more direct impact on the Company’s operating results than changes in volume due to certain factors including but not limited to:\\n\\n| • | Changes in volume typically result in corresponding changes to the Company’s variable costs. However, as pricing changes occur, variable expenses are not directly impacted. |\\n\\n| • | If surcharges are not passed through to the customer or are passed through without a mark-up, the Company’s profitability will be adversely impacted. |\\n\\nCurrent Business Outlook\\nManagement uses the Purchasing Managers Index (‘PMI’) provided by the Institute for Supply Management (website is www.ism.ws) as an external indicator for tracking the demand outlook and possible trends in its general manufacturing markets. The table below shows PMI trends from the first quarter of 2010 through the fourth quarter of 2012. Generally speaking, according to the ISM, an index above 50.0 indicates growth in the manufacturing sector of the U.S. economy, while readings under 50.0 indicate contraction.\\n| YEAR | Qtr 1 | Qtr 2 | Qtr 3 | Qtr 4 |\\n| 2010 | 58.2 | 58.8 | 55.4 | 56.8 |\\n| 2011 | 61.1 | 56.4 | 51.0 | 52.4 |\\n| 2012 | 53.3 | 52.7 | 50.3 | 50.6 |\\n\\nMaterial pricing and demand in both the Metals and Plastics segments of the Company’s business have historically proven to be difficult to predict with any degree of accuracy. A favorable PMI trend suggests that demand for some of the Company’s products and services, in particular those that are sold to the general manufacturing customer base in the U.S., could potentially be at a higher level in the near-term. The PMI trended upward from late 2012 levels in the first two months of 2013 to 53.1 in January and 54.2 in February. The Company believes that its revenue trends typically correlate to the changes in PMI on a six to twelve month lag basis.\\nRESULTS OF OPERATIONS: YEAR-TO-YEAR COMPARISONS AND COMMENTARY\\nOur discussion of comparative period results is based upon the following components of the Company’s consolidated statements of operations.\\nNet Sales —The Company derives its sales from the processing and delivery of metals and plastics. Pricing is established with each customer order and includes charges for the material, processing activities and delivery. The pricing varies by product line and type of processing. From time to time the Company may enter into fixed price arrangements with customers while simultaneously obtaining similar agreements with its suppliers.\\nCost of Materials — Cost of materials consists of the costs that the Company pays suppliers for metals, plastics and related inbound freight charges, excluding depreciation and amortization which are included in operating costs and expenses discussed below. The Company accounts for inventory primarily on a last-in-first-out (“LIFO”) basis. LIFO adjustments are calculated as of December 31 of each year. The Company may enter into hedges to mitigate the risk associated with commodity price fluctuations. Gains and losses which result from marking the hedge contracts to market are recorded in cost of materials.\\nOperating Costs and Expenses — Operating costs and expenses primarily consist of:\\n\\n| • | Warehouse, processing and delivery expenses, including occupancy costs, compensation and employee benefits for warehouse personnel, processing, shipping and handling costs; |\\n\\n| • | Sales expenses, including compensation and employee benefits for sales personnel; |\\n\\n20\\n| • | General and administrative expenses, including compensation for executive officers and general management, expenses for professional services primarily related to accounting and legal advisory services, bad debt expense, data communication, computer hardware and maintenance and foreign currency gain or loss; and |\\n\\n| • | Depreciation and amortization expenses, including depreciation for all owned property and equipment, and amortization of various intangible assets. |\\n\\n2012 Results Compared to 2011\\nAs a result of the acquisition of Tube Supply in December 2011, the full year results were included in the Company's Metals segment during 2012.\\nConsolidated results by business segment are summarized in the following table for years 2012 and 2011.\\nOperating Results by Segment\\n| Year Ended December 31, | Fav / (Unfav) |\\n| 2012 | 2011 | $ Change | % Change |\\n| Net Sales |\\n| Metals | $ | 1,143.9 | $ | 1,014.2 | $ | 129.7 | 12.8 | % |\\n| Plastics | 126.5 | 118.2 | 8.3 | 7.0 | % |\\n| Total Net Sales | $ | 1,270.4 | $ | 1,132.4 | $ | 138.0 | 12.2 | % |\\n| Cost of Materials |\\n| Metals | $ | 836.3 | $ | 763.0 | $ | (73.3 | ) | (9.6 | )% |\\n| % of Metals Sales | 73.1 | % | 75.2 | % |\\n| Plastics | 91.0 | 82.6 | (8.4 | ) | (10.2 | )% |\\n| % of Plastics Sales | 71.9 | % | 69.9 | % |\\n| Total Cost of Materials | $ | 927.3 | $ | 845.6 | $ | (81.7 | ) | (9.7 | )% |\\n| % of Total Sales | 73.0 | % | 74.7 | % |\\n| Operating Costs and Expenses |\\n| Metals | $ | 257.8 | $ | 237.7 | $ | (20.1 | ) | (8.5 | )% |\\n| Plastics | 32.3 | 32.7 | 0.4 | 1.2 | % |\\n| Other | 11.9 | 11.2 | (0.7 | ) | (6.3 | )% |\\n| Total Operating Costs & Expenses | $ | 302.0 | $ | 281.6 | $ | (20.4 | ) | (7.2 | )% |\\n| % of Total Sales | 23.8 | % | 24.9 | % |\\n| Operating Income (Loss) |\\n| Metals | $ | 49.8 | $ | 13.5 | $ | 36.3 | 268.9 | % |\\n| % of Metals Sales | 4.4 | % | 1.3 | % |\\n| Plastics | 3.2 | 2.9 | 0.3 | 10.3 | % |\\n| % of Plastics Sales | 2.5 | % | 2.5 | % |\\n| Other | (11.9 | ) | (11.2 | ) | (0.7 | ) | (6.3 | )% |\\n| Total Operating Income | $ | 41.1 | $ | 5.2 | $ | 35.9 | 690.4 | % |\\n| % of Total Sales | 3.2 | % | 0.5 | % |\\n\\n“Other” includes costs of executive, legal and finance departments which are shared by both segments of the Company.\\nNet Sales:\\nConsolidated net sales were $1,270.4 million in 2012, an increase of $138.0 million, or 12.2%, versus 2011. Metals segment net sales during 2012 of $1,143.9 million were $129.7 million, or 12.8%, higher than 2011. Tube Supply contributed net sales of $178.5 million in 2012 compared to $7.6 million for the two-week period ended December 31, 2011. Excluding Tube Supply results, net sales for the Metals segment were $41.2 million lower in\\n21\\n2012 compared to 2011. Lower net sales were primarily the result of lower shipping volumes. Average tons sold per day, excluding Tube Supply, decreased 3.9% compared to the prior year. The decrease in demand experienced in 2012 was driven primarily by SBQ bar, carbon bar and aluminum products. Excluding Tube Supply, gains in the oil and gas business were offset by weakness in the industrial business in 2012 compared to 2011.\\nPlastics segment net sales during 2012 of $126.5 million were $8.3 million, or 7.0%, higher than 2011 primarily due to increased sales volume, reflecting continued strength in the automotive sector.\\nCost of Materials:\\nCost of materials (exclusive of depreciation and amortization) were $927.3 million, an increase of $81.7 million, or 9.7%, compared to 2011. Material costs for the Metals segment were $836.3 million or 73.1% as a percent of net sales compared to $763.0 million or 75.2% as a percent of net sales in 2011. Tube Supply cost of materials were $118.7 million in 2012 compared to $5.3 million for the two-week period ended December 31, 2011. During 2011, the Company implemented a commodity hedging program to mitigate the risks associated with certain commodity price fluctuations. The 2012 results include a $0.4 million charge associated with the realized and unrealized losses for forward contracts related to the commodity hedging program compared to a $2.4 million charge in 2011. Cost of materials for the Metals segment include a LIFO charge of $1.1 million in 2012 compared to $15.1 million in 2011. The remaining increase in cost of materials for the Metals segment is consistent with the sales volume increase year-over-year.\\nMaterial costs for the Plastics segment were 71.9% as a percent of net sales in 2012 as compared to 69.9% for the same period last year due to higher costs experienced in the automotive sector of the business.\\nOperating Expenses and Operating Income (Loss):\\nOperating costs and expenses increased $20.4 million, or 7.2%, compared to last year. Operating costs and expenses for 2012 were $302.0 million, or 23.8% as a percent of net sales, compared to $281.6 million million, or 24.9% as a percent of net sales last year. Operating costs related to Tube Supply were $32.9 million in 2012 compared to $0.9 million in 2011.\\nDuring the second quarter of 2012, the Company incurred costs associated with executive employment transition in the amount of $1.6 million. As a result of the transition, share-based awards were forfeited, which resulted in a significant increase in the Company’s forfeiture rate. The increase in the forfeiture rate estimate associated with the active Long-term Compensation Plans resulted in a decrease in sales, general and administrative cost of approximately $1.0 million. The net impact of the employment transition costs on sales, general and administrative expense was approximately $0.6 million.\\nThe increase in operating expenses for 2012 compared to 2011 primarily relates to the following:\\n\\n| • | Warehouse, processing and delivery costs increased by $13.4 million of which a $15.6 million increase is associated with the increase for Tube Supply for the period. The Tube Supply impact was offset by a $2.2 million decrease primarily attributed to a decline in workers’ compensation, overtime wage, temporary employee and utilities costs, partially offset by an increase in compensation and benefits expense as a result of headcount, merit and healthcare cost increases and rent expense due to a full year of expense for the expanded facility in Mexico, which was substantially completed in 2011 and rent expense for the new facility in Trafford Park, United Kingdom during 2012; |\\n\\n| • | Sales, general and administrative costs increased by $1.6 million of which a $9.8 million increase is associated with the increase for Tube Supply for the period. The net impact of the CEO transition costs of $0.6 million and an increase to bad debt reserves for customer bankruptcies of $0.8 million were included in the 2012 results. The 2011 results include a $0.9 million charge for export penalties related to product shipments that occurred from 2005 to 2008 and $4.3 million for charges related to the acquisition of Tube Supply. The remaining decrease of $4.6 million is primarily attributed to a decline incentive compensation and other compensation and benefits costs, partially offset by an increase in workers' compensation and outside services costs; and |\\n\\n| • | Depreciation and amortization expense was $5.4 million higher than 2011 primarily due to the depreciation and amortization of Tube Supply’s fixed and intangible assets acquired in December 2011. |\\n\\nConsolidated operating income for 2012 was $41.1 million compared to $5.2 million in 2011.\\n22\\nOther Income and Expense, Income Taxes and Net Loss:\\nInterest expense was $56.7 million in 2012, an increase of $36.9 million versus 2011 as a result of interest charges on the Company’s new senior secured and convertible notes, as well as the unrealized loss for the mark-to-market adjustment on the conversion option associated with the convertible notes.\\nThe increase in interest expense for 2012 compared to the prior year is a result of the following:\\n\\n| • | Increase for the non-cash interest charge of $11.6 million associated with the mark-to-market adjustment on the conversion option associated with the convertible notes, which is not deductible for federal income tax purposes; |\\n\\n| • | Increase for interest on senior secured and convertible notes of $31.0 million; and |\\n\\n| • | Increase for amortization of deferred financing fees and debt discount of $1.1 million. |\\n\\nIn addition to items above, there was a loss on extinguishment of the Company’s existing long-term notes of $6.2 million and a charge for underwriting fees associated with the debt financing of $3.4 million recorded in 2011.\\nThe Company recorded income tax expense of $1.4 million in 2012 compared to a tax benefit of $1.1 million in 2011. The Company’s effective tax rate is expressed as ‘Income tax benefit’ (which includes tax expense on the Company’s share of joint venture earnings) as a percentage of ‘Loss before income taxes and equity in earnings of joint venture.’ This calculation includes taxes on the joint venture income but excludes joint venture income. The effective tax rate for 2012 and 2011 was 9.2% and 7.7%, respectively. The change in the effective tax rate for 2012 compared to 2011 was primarily the result of the non-deductibility of the change in the mark-to-market adjustment on the conversion option associated with the convertible notes in the amount of $11.6 million.\\nEquity in earnings of the Company’s joint venture was $7.2 million in 2012 compared to $11.7 million in 2011. The decrease is a result of lower demand in virtually all of the joint venture’s end-use markets compared to last year.\\nConsolidated net loss for 2012 was $9.7 million, or $0.42 per diluted share, compared to net loss of $1.8 million, or $0.08 per diluted share, for 2011.\\n23\\n2011 Results Compared to 2010\\nConsolidated results by business segment are summarized in the following table for years 2011 and 2010.\\nOperating Results by Segment\\n| Year Ended December 31, | Fav / (Unfav) |\\n| 2011 | 2010 | $ Change | % Change |\\n| Net Sales |\\n| Metals | $ | 1,014.2 | $ | 841.1 | $ | 173.1 | 20.6 | % |\\n| Plastics | 118.2 | 102.6 | 15.6 | 15.2 | % |\\n| Total Net Sales | $ | 1,132.4 | $ | 943.7 | $ | 188.7 | 20.0 | % |\\n| Cost of Materials |\\n| Metals | $ | 763.0 | $ | 631.1 | $ | (131.9 | ) | (20.9 | )% |\\n| % of Metals Sales | 75.2 | % | 75.0 | % |\\n| Plastics | 82.6 | 69.8 | (12.8 | ) | (18.3 | )% |\\n| % of Plastics Sales | 69.9 | % | 68.0 | % |\\n| Total Cost of Materials | $ | 845.6 | $ | 700.9 | $ | (144.7 | ) | (20.6 | )% |\\n| % of Total Sales | 74.7 | % | 74.3 | % |\\n| Operating Costs and Expenses |\\n| Metals | $ | 237.7 | $ | 215.5 | $ | (22.2 | ) | (10.3 | )% |\\n| Plastics | 32.7 | 29.3 | (3.4 | ) | (11.6 | )% |\\n| Other | 11.2 | 7.4 | (3.8 | ) | (51.4 | )% |\\n| Total Operating Costs & Expenses | $ | 281.6 | $ | 252.2 | $ | (29.4 | ) | (11.7 | )% |\\n| % of Total Sales | 24.9 | % | 26.7 | % |\\n| Operating (Loss) Income |\\n| Metals | $ | 13.5 | $ | (5.5 | ) | $ | 19.0 | 345.5 | % |\\n| % of Metals Sales | 1.3 | % | (0.7 | )% |\\n| Plastics | 2.9 | 3.6 | (0.7 | ) | (19.4 | )% |\\n| % of Plastics Sales | 2.5 | % | 3.5 | % |\\n| Other | (11.2 | ) | (7.4 | ) | (3.8 | ) | (51.4 | )% |\\n| Total Operating (Loss) | $ | 5.2 | $ | (9.3 | ) | $ | 14.5 | 155.9 | % |\\n| % of Total Sales | 0.5 | % | (1.0 | )% |\\n\\n“Other” includes costs of executive, legal and finance departments which are shared by both segments of the Company.\\nNet Sales:\\nConsolidated net sales were $1,132.4 million in 2011, an increase of $188.7 million, or 20.0%, versus 2010. Metals segment net sales during 2011 of $1,014.2 million were $173.1 million, or 20.6%, higher than 2010. Tube Supply contributed net sales of $7.6 million for the two-week period ended December 31, 2011. Higher net sales were primarily the result of higher shipping volumes. Average tons sold per day, excluding Tube Supply, increased 18.1% compared to the prior year. The increase in demand experienced in 2011 was driven primarily by SBQ bar, alloy bar, carbon and alloy plate, stainless and tubing products. Key end-use markets that experienced increased demand in 2011 compared to 2010 include oil and gas, mining and heavy equipment and general industrial markets.\\nPlastics segment net sales during 2011 of $118.2 million were $15.6 million, or 15.2%, higher than 2010 primarily due to higher overall pricing and, to a lesser extent, increased sales volume. The Plastics business experienced increased sales volume during 2011 reflecting strength in the automotive and office furniture end-use markets compared to 2010.\\n24\\nCost of Materials:\\nCost of materials (exclusive of depreciation and amortization) were $845.6 million, an increase of $144.7 million, or 20.6%, compared to 2010. Material costs for the Metals segment were $763.0 million or 75.2% as a percent of net sales compared to $631.1 million or 75.0% as a percent of net sales in 2010. Tube Supply cost of materials were $5.3 million for the two-week period ended December 31, 2011. During 2011, the Company implemented a commodity hedging program to mitigate the risks associated with certain commodity price fluctuations. The 2011 results include a $2.4 million charge associated with the mark-to-market adjustment for forward contracts related to the commodity hedging program compared to no charge in 2010. The Metals segment recorded LIFO expense of $15.1 million in 2011 compared to $7.7 million in 2010. The remaining increase in cost of materials for the Metals segment is consistent with the sales volume increase year-over-year.\\nMaterial costs for the Plastics segment were 69.9% as a percent of net sales in 2011 as compared to 68.0% for the same period last year. The Plastics segment recorded LIFO expense of $0.9 million in 2011 compared to $0.3 million in 2010.\\nDuring 2010, a reduction in inventories resulted in a liquidation of applicable LIFO inventory quantities carried at lower costs in prior years. On a consolidated basis, cost of materials for 2010 were lower by $12.5 million as a result of the liquidations.\\nOperating Expenses and Operating Income (Loss):\\nOperating costs and expenses increased $29.4 million, or 11.7%, compared to last year. Operating costs and expenses for 2011 were $281.6 million, or 24.9% as a percent of net sales, compared to $252.2 million, or 26.7% as a percent of net sales last year. Operating costs and expenses in 2011 include a $0.9 million charge for export penalties related to product shipments that occurred from 2005 to 2008 and in 2011 compared to no charge in 2010. Additionally, there were no facility consolidation charges during 2011 compared to $2.4 million in 2010.\\nFull workweeks and 401(k) matching contributions were reinstated in January and April 2010, respectively, resulting in overall increases in payroll related costs in 2011 compared to 2010. Additionally, effective July 1, 2011, the Company’s 401(k) matching contribution was increased to 100% of each dollar on eligible employee contributions up to the first 6% of the employee’s pre-tax compensation. Effective July 1, 2011, the Company’s fixed contribution of 4% of eligible earnings for all employees was eliminated. Other factors that contributed to increased payroll related costs in 2011 compared to 2010 included merit increases and headcount increases.\\nIn addition to payroll related costs, there were costs associated with the acquisition of Tube Supply in December 2011 of $4.3 million, as well as Tube Supply activity for the two-week period ended December 31, 2011 that contributed $0.9 million to the overall increase.\\nThe $29.4 million increase in operating expenses in 2011 compared to 2010 primarily relates to the following:\\n\\n| • | Warehouse, processing and delivery costs increased by $11.6 million of which $4.1 million is due to increased compensation and benefits expenses as a result of headcount, merit and healthcare cost increases and $7.2 million is the result of increases in charges associated with higher sales volumes, such as warehouse, packing and shipping supplies, repairs and maintenance, utilities, outside services, overtime wages and temporary help. The warehouse, processing and delivery cost increase associated with Tube Supply for the two-week period ended December 31, 2011 amounted to $0.3 million; |\\n\\n| • | Sales, general and administrative costs increased by $17.9 million. The increase is primarily comprised of $4.3 million of direct acquisition-related costs, $7.1 million as a result of headcount, merit and healthcare cost increases and a $0.9 million charge for export penalties related to product shipments that occurred from 2005 to 2008 and in 2011. The sales, general and administrative cost increase associated with Tube Supply for the two-week period ended December 31, 2011 amounted to $0.3 million. The balance of the difference relates other administrative expenses including training, travel and insurance; and |\\n\\n| • | Depreciation and amortization expense decreased $0.1 million in 2011 compared to 2010. The depreciation and amortization expense for Tube Supply for the two-week period ended December 31, 2011 amounted to $0.3 million. |\\n\\nConsolidated operating income for 2011 was $5.2 million compared to operating loss of $9.3 million in 2010.\\n25\\nOther Income and Expense, Income Taxes and Net Loss:\\nInterest expense was $13.7 million in 2011, an increase of $8.7 million versus 2010 as a result of charges associated with refinancing the Company’s debt in conjunction with the Tube Supply acquisition. The Company issued $225.0 million of senior secured notes and $57.5 million of convertible senior notes and entered into a $100.0 million senior secured asset based revolving credit facility.\\nInterest expense for 2011 includes the following charges:\\n\\n| • | Non-cash interest charge of $4.0 million associated with the mark-to-market adjustment for the derivative liability component of the convertible notes, which is not deductible for federal income tax purposes; |\\n\\n| • | Non-cash interest charge of $0.2 million for the amortization of new debt origination fees; |\\n\\n| • | Interest on new debt of $1.6 million; and |\\n\\n| • | Underwriting fees of $3.4 million associated with the debt financing. |\\n\\nIn addition to increased interest expense, there was a loss on extinguishment of the Company’s existing long-term notes of $6.2 million, which is comprised of a non-cash charge of $0.9 million for the write-off of existing debt issuance costs and $5.2 million for the fees associated with the prepayment of the notes.\\nThe Company recorded a tax benefit of $1.1 million in 2011 compared to a tax benefit of $3.1 million in 2010. The Company’s effective tax rate is expressed as ‘Income tax benefit’ (which includes tax expense on the Company’s share of joint venture earnings) as a percentage of ‘Loss before income taxes and equity in earnings of joint venture.’ This calculation includes taxes on the joint venture income but excludes joint venture income. The effective tax rate for 2011 and 2010 was 7.7% and 21.7%, respectively. The change in the tax rate was due primarily to the additional income tax on joint venture income compared to 2010 and the non-deductibility of the mark-to-market charge on the derivative liability component of the convertible notes.\\nEquity in earnings of the Company’s joint venture was $11.7 million in 2011 compared to $5.6 million in 2010. The increase is a result of higher demand in virtually all of the joint venture’s end-use markets, most notably the oil and gas and automotive sectors, and higher pricing compared to last year.\\nConsolidated net loss for 2011 was $1.8 million, or $0.08 per diluted share, compared to net loss of $5.6 million, or $0.25 per diluted share, for 2010.\\nLiquidity and Capital Resources\\nCash and cash equivalents decreased by $8.9 million and $6.2 million for the years ended December 31, 2012 and 2011, respectively, and increased by $8.4 million for the year ended December 31, 2010.\\nThe Company’s principal sources of liquidity are cash provided by operations and available borrowing capacity to fund working capital needs and growth initiatives. Cash provided by operations for the year-ended December 31, 2012 was $5.4 million compared to cash used in operations of $46.3 million for the year-ended December 31, 2011 and cash provided by operations of $34.4 million for the year-ended December 31, 2010. Specific components of the change in working capital are highlighted below:\\n\\n| • | During 2012, cash receipts from customers exceeded net sales resulting in a $44.6 million cash flow source due to a decrease in accounts receivable compared to a $26.4 million cash flow use due to an increase in accounts receivable for 2011. Net sales increased 12.2% from 2011. Average receivable days outstanding was 49.0 days for 2012 and 50.3 for 2011. |\\n\\n| • | During 2012, inventory purchases exceeded sales of inventory resulting in a $29.3 million cash flow use due to an increase in inventory compared to a $39.4 million cash flow use due to an increase in inventory in 2011. Average days sales in inventory was 187.0 days for 2012 verses 128.5 days for 2011. |\\n\\n| • | During 2012, cash paid for inventories and other goods and services exceeded purchases resulting in a $38.0 million cash flow use due to a net decrease in accounts payable and accrued liabilities compared to a $9.7 million cash flow source due to a net increase in accounts payable and accrued liabilities for 2011. |\\n\\n| • | The Company received its 2010 federal income tax refund of approximately $2.0 million during February 2012 and its 2009 federal income tax refund of approximately $6.3 million during January 2011. |\\n\\n26\\nIn December 2011, in conjunction with the acquisition of Tube Supply, the Company issued $225.0 million aggregate principal amount of 12.75% Senior Secured Notes due 2016, $57.5 million aggregate principal amount of 7.0% Convertible Senior Notes due 2017 and entered into a $100.0 million senior secured asset based revolving credit facility (the “New Revolving Credit Facility”). Net proceeds of $304.6 million were used to complete the Acquisition, pay-off amounts outstanding under our previous credit agreement and for general corporate purposes.\\nHistorically, the Company’s primary uses of liquidity and capital resources have been capital expenditures, payments on debt (including interest payments), acquisitions and dividend payments. Management believes the Company will be able to generate sufficient cash from operations and planned working capital improvements to fund its ongoing capital expenditure programs and meet its debt obligations for at least the next twelve months. Furthermore, the Company does have available borrowing capacity under the New Revolving Credit Agreement. The new debt agreements impose significant operating and financial restrictions which may prevent the Company from certain business opportunities such as, making acquisitions or paying dividends among other things. The New Revolving Credit facility contains a springing financial maintenance covenant requiring the Company to maintain the ratio of EBITDA (as defined in the agreement) to fixed charges of 1.1 to 1.0 when excess availability is less than the greater of 10% of the calculated borrowing base (as defined in the agreement) or $10 million. In addition, if excess availability is less than the greater of 12.5% of the calculated borrowing base (as defined in the agreement) or $12.5 million, the lender has the right to take full dominion of the Company’s cash collections and apply these proceeds to outstanding loans under the New Revolving Credit Agreement (“cash dominion”). Based on the Company’s cash projections, it does not anticipate a scenario whereby cash dominion would occur during the next twelve months.\\nThe Company is committed to maintaining a strong financial position through maintaining sufficient levels of available liquidity, managing working capital and monitoring the Company’s overall capitalization. Cash and cash equivalents at December 31, 2012 were $21.6 million and the Company had $50.5 million of available borrowing capacity under its New Revolving Credit Facility. Approximately 23% of the Company’s consolidated cash and cash equivalents balance resides in the United States. As foreign earnings are permanently reinvested, availability under the Company’s New Revolving Credit Facility would be used to fund operations in the United States should the need arise in the future.\\nWorking capital at December 31, 2012 was $379.3 million compared to $349.0 million at December 31, 2011. The increase in working capital is primarily due to higher inventory of $31.7 million, prepaid expenses and other current assets of $4.7 million and lower accounts payable of $48.9 million, offset by lower accounts receivable of $42.7 million and lower cash of $8.9 million, from December 31, 2011 to 2012.\\nThe Company monitors its overall capitalization by evaluating total debt to total capitalization. Total debt to total capitalization is defined as the sum of short- and long-term debt, divided by the sum of total debt and stockholders’ equity. Total debt to total capitalization was 46.8% at December 31, 2012 and 50.2% at December 31, 2011. As of April 26, 2012, the conversion option value of $42.0 million associated with the convertible debt, which was issued in December 2011, was reclassified from long-term debt to additional paid-in capital, resulting in a decrease to the debt to total capitalization at December 31, 2012. The deferred tax benefit of $8.3 million associated with the temporary difference between the financial reporting basis of the derivative liability and its tax basis at the date of issuance (December 15, 2011) was also reclassified to additional paid-in capital. Over the long-term, the Company plans to continue to improve its total debt to total capitalization by improving operating results, managing working capital and using cash generated from operations to repay outstanding debt. Going forward, as and when permitted by term of agreements noted above, depending on market conditions, the Company may decide in the future to refinance, redeem or repurchase its debt and take other steps to reduce its debt or lease obligations or otherwise improve its overall financial position and balance sheet.\\nCapital Expenditures\\nCash paid for capital expenditures for 2012 was $11.1 million compared to $11.7 million in 2011. The expenditures during 2012 were comprised of approximately $1.1 million of ERP and other information technology enhancements and $1.3 million related to existing and new facility expansions for additional automotive business in the Plastics segment and for additional aerospace defense business in the United Kingdom. The balance of the capital expenditures in 2012 are the result of normal equipment, building improvement and furniture and fixture upgrades throughout the year. Management believes that capital expenditures will approximate $14 million in 2013.\\n27\\nContractual Obligations and Other Commitments\\nThe following table includes information about the Company’s contractual obligations that impact its short-term and long-term liquidity and capital needs. The table includes information about payments due under specified contractual obligations and is aggregated by type of contractual obligation. It includes the maturity profile of the Company’s consolidated long-term debt, operating leases and other long-term liabilities.\\nAt December 31, 2012, the Company’s contractual obligations, including estimated payments by period, were as follows:\\n| Payments Due In | Total | Less Than One Year | One toThree Years | Three toFive Years | More Than Five Years |\\n| Long-term debt obligations (excluding capital lease obligations) | $ | 322.0 | $ | — | $ | 39.5 | $ | 282.5 | $ | — |\\n| Interest payments on debt obligations (a) | 137.4 | 33.6 | 67.1 | 36.7 | — |\\n| Capital lease obligations | 1.4 | 0.4 | 0.8 | 0.2 | — |\\n| Operating lease obligations | 76.7 | 14.4 | 21.5 | 16.7 | 24.1 |\\n| Purchase obligations (b) | 333.5 | 222.6 | 110.9 | — | — |\\n| Other (c) | 8.1 | 8.1 | — | — | — |\\n| Total | $ | 879.1 | $ | 279.1 | $ | 239.8 | $ | 336.1 | $ | 24.1 |\\n\\n| a) | Interest payments on debt obligations represent interest on all Company debt outstanding as of December 31, 2012. The interest payment amounts related to the variable rate component of the Company’s debt assume that interest will be paid at the rates prevailing at December 31, 2012. Future interest rates may change, and therefore, actual interest payments could differ from those disclosed in the table above. |\\n\\n| b) | Purchase obligations consist of raw material purchases made in the normal course of business. The Company has contracts to purchase minimum quantities of material with certain suppliers. For each contractual purchase obligation, the Company generally has a purchase agreement from its customer for the same amount of material over the same time period. |\\n\\n| c) | ‘Other’ is comprised of deferred revenues that represent commitments to deliver products and obligations related to recognizing and measuring tax positions taken or expected to be taken in a tax return that directly or indirectly affect amounts reported in financial statements. The uncertain tax positions included in the Company’s obligations are related to temporary differences and uncertain tax positions where the Company anticipates a high probability of settlement within a given timeframe. The years for which the temporary differences related to the uncertain tax positions will reverse have been estimated in scheduling the obligations within the table. |\\n\\nThe table and corresponding footnotes above do not include $10.7 million of other non-current liabilities recorded on the consolidated balance sheets. These non-current liabilities consist of liabilities related to the Company’s non-funded supplemental pension plan and postretirement benefit plans for which payment periods cannot be determined. Non-current liabilities also include $37.5 million of deferred income taxes, deferred gain on the sale of certain assets, derivative liability associated with commodity hedges and unfavorable lease liability for a lease entered into in conjunction with the Tube Supply acquisition, which was excluded from the table as the amounts due and timing of payments (or receipts) at future contract settlement dates cannot be determined.\\nPension Funding\\nThe Company’s funding policy on its defined benefit pension plans is to satisfy the minimum funding requirements of the Employee Retirement Income Security Act (“ERISA”). Future funding requirements are dependent upon various factors outside the Company’s control including, but not limited to, fund asset performance and changes in regulatory or accounting requirements. Based upon factors known and considered as of December 31, 2012, the Company does not anticipate making significant cash contributions to the pension plans in 2013.\\nThe investment target portfolio allocation for the Company-sponsored pension plans and supplemental pension plan focuses primarily on corporate fixed income securities that match the overall duration and term of the Company’s pension liability structure. Refer to “Retirement Plans” within Critical Accounting Policies and Note 5 to the consolidated financial statements for additional details regarding other plan assumptions.\\nOff-Balance Sheet Arrangements\\n28\\nWith the exception of letters of credit and operating lease financing on certain equipment used in the operation of the business, it is not the Company’s general practice to use off-balance sheet arrangements, such as third-party special-purpose entities or guarantees of third parties.\\nAs of December 31, 2012, the Company had $6.8 million of irrevocable letters of credit outstanding which primarily consisted of $4.0 million for collateral associated with commodity hedges and $2.0 million for compliance with the insurance reserve requirements of its workers’ compensation insurance carriers.\\nThe Company is party to certain multi-employer pension plans. The overall cost of such plans to the Company is insignificant. If the Company withdraws from a multi-employer pension plan in the future, it could potentially incur a withdrawal liability at that time.\\nObligations of the Company associated with its leased equipment are disclosed under the “Contractual Obligations and Other Commitments” section above.\\nCritical Accounting Policies\\nThe consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America, and include amounts that are based on management’s estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. The following is a description of the Company’s accounting policies that management believes require the most significant judgments and estimates when preparing the Company’s consolidated financial statements:\\nRevenue Recognition — Revenue from the sales of products is recognized when the earnings process is complete and when the title and risk and rewards of ownership have passed to the customer, which is primarily at the time of shipment. Revenue recognized other than at time of shipment represents less than 3% of the Company’s consolidated net sales. Revenue from shipping and handling charges is recorded in net sales. Provisions for allowances related to sales discounts and rebates are recorded based on terms of the sale in the period that the sale is recorded. Management utilizes historical information and the current sales trends of the business to estimate such provisions. Actual results could differ from these estimates. The provisions related to discounts and rebates due to customers are recorded as a reduction within net sales in the Company’s consolidated statements of operations and comprehensive loss.\\nThe Company maintains an allowance for doubtful accounts resulting from the inability of our customers to make required payments. The allowance for doubtful accounts is maintained at a level considered appropriate based on historical experience and specific identification of customer receivable balances for which collection is unlikely. The provisions for doubtful accounts is recorded in sales, general and administrative expense in the Company’s consolidated statements of operations and comprehensive loss. Estimates of doubtful accounts are based upon historical write-off experience as a percentage of net sales and judgments about the probable effects of economic conditions on certain customers, which can fluctuate significantly from year to year. The Company cannot be certain that the rate of future credit losses will be similar to past experience.\\nThe Company also maintains an allowance for credit memos for estimated credit memos to be issued against current sales. Estimates of allowance for credit memos are based upon the application of a historical issuance lag period to the average credit memos issued each month. If actual results differ significantly from historical experience, there could be a negative impact on the Company’s operating results.\\nIncome Taxes — The Company’s income tax expense, deferred tax assets and liabilities and reserve for uncertain tax positions reflect management’s best estimate of taxes to be paid. The Company is subject to income taxes in the U.S. and several foreign jurisdictions. The determination of the consolidated income tax expense requires judgment and estimation by management. It is possible that actual results could differ from the estimates that management has used to determine its consolidated income tax expense.\\nThe Company accounts for deferred income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statement and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.\\n29\\nValuation allowances are recorded against deferred tax assets when it is more likely than not that the amounts will not be realized, which will increase the provision for income taxes in the period in which that determination is made.\\nThe Company has undistributed earnings of foreign subsidiaries of approximately $83.4 million at December 31, 2012, for which deferred taxes have not been provided. Such earnings are considered indefinitely invested in the foreign subsidiaries. If such earnings were repatriated, additional tax expense may result, although due to the potential availability of foreign tax credits and other items, the calculation of such additional taxes is not practicable.\\nThe Company’s investment in the joint venture is through a 50% interest in a limited liability corporation (LLC) taxed as a partnership. The joint venture has two subsidiaries organized as individually taxed C-Corporations. The Company includes in its income tax provision the income tax liability on its share of the income of the joint venture and its subsidiaries. The income tax liability of the joint venture itself is generally treated as a current income tax expense and the income tax liability associated with the profits of the two subsidiaries of the joint venture is treated as deferred income tax expense. The Company can not independently cause a dividend to be declared by one of the subsidiaries of the joint venture, therefore no benefit of a dividend received deduction can be recognized in the Company's tax provision until a dividend is declared. If one of the C-Corporation subsidiaries of the joint venture declares a dividend payable to the joint venture, the Company recognizes a benefit for the 80% dividends received deduction on its 50% share of the dividend.\\nThe Company’s income tax provisions are based on calculations and assumptions that are subject to examination by the IRS and other tax authorities. Although the Company believes that the positions taken on previously filed tax returns are reasonable, it has established tax and interest reserves in recognition that various taxing authorities may challenge the positions taken, which could result in additional liabilities for taxes and interest. The Company regularly reviews its deferred tax assets for recoverability considering historical profitability, projected future taxable income, the expected timing of the reversals of existing temporary differences and tax planning strategies.\\nFor uncertain tax positions, the Company applies the provisions of relevant authoritative guidance, which requires application of a “more likely than not” threshold to the recognition and derecognition of tax positions. The Company’s ongoing assessments of the more likely than not outcomes of tax authority examinations and related tax positions require significant judgment and can increase or decrease the Company’s effective tax rate as well as impact operating results.\\nRetirement Plans — The Company values retirement plan liabilities based on assumptions and valuations established by management. Future valuations are subject to market changes, which are not in the control of the Company and could differ materially from the amounts currently reported. The Company evaluates the discount rate and expected return on assets at least annually and evaluates other assumptions involving demographic factors, such as retirement age, mortality and turnover periodically, and updates them to reflect actual experience and expectations for the future. Actual results in any given year will often differ from actuarial assumptions because of economic and other factors.\\nAccumulated and projected benefit obligations are expressed as the present value of future cash payments which are discounted using the weighted average of market-observed yields for high quality fixed income securities with maturities that correspond to the payment of benefits. Lower discount rates increase present values and subsequent-year pension expense; higher discount rates decrease present values and subsequent-year pension expense. Discount rates used for determining the Company’s projected benefit obligation for retirement plans were 3.50 - 3.75% and 4.25% at December 31, 2012 and 2011, respectively.\\nThe Company’s pension plan asset portfolio as of December 31, 2012 is primarily invested in fixed income securities with a duration of approximately 12 years. The assets generally fall within Level 2 of the fair value hierarchy. Assets in the Company’s pension plans have earned approximately 12% since 2008 when the Company changed its target investment allocation to focus primarily on fixed income securities. The target investment asset allocation for the pension plans’ funds focuses primarily on corporate fixed income securities that match the overall duration and term of the Company’s pension liability structure. As of December 31, 2012 and 2011, the funding surplus was approximately 3% and 6%, respectively. To determine the expected long-term rate of return on the pension plans’ assets, current and expected asset allocations are considered, as well as historical and expected returns on various categories of plan assets.\\n30\\nThe Company used the following weighted-average discount rates and expected return on plan assets to determine the net periodic pension credit:\\n| 2012 | 2011 |\\n| Discount rate | 4.25 | % | 5.25 | % |\\n| Expected long-term rate of return on plan assets | 5.75 | % | 6.50 | % |\\n\\nHolding all other assumptions constant, the following table illustrates the sensitivity of changes to the discount rate and long-term rate of return assumptions on the Company’s net periodic pension credit (amounts in millions):\\n| Impact on 2012Expenses - increase (decrease) |\\n| 50 basis point decrease in discount rate | $(1.1) |\\n| 50 basis point increase in discount rate | $1.1 |\\n| 50 basis point decrease in expected return on assets | $0.9 |\\n\\nGoodwill and Other Intangible Assets Impairment — The carrying value of the Company’s goodwill is evaluated annually on January 1st of each fiscal year or when certain triggering events occur which require a more current valuation. The Company assesses, at least quarterly, whether any triggering events have occurred.\\nA two-step method is used for determining goodwill impairment. The first step is performed to identify whether a potential impairment exists by comparing each reporting unit’s fair value to its carrying value. If the carrying value of a reporting unit exceeds its fair value, the next step it to measure the amount of impairment loss, if any.\\nThe determination of the fair value of the reporting units requires significant estimates and assumptions to be made by management. The fair value of each reporting unit is estimated using a combination of an income approach, which estimates fair value based on a discounted cash flow analysis using historical data, estimates of future cash flows and discount rates based on the view of a market participant, and a market approach, which estimates fair value using market multiples of various financial measures of comparable public companies. In selecting the appropriate assumptions the Company considers: the selection of appropriate peer group companies; control premiums appropriate for acquisitions in the industry in which the Company competes; discount rates; terminal growth rates; long-term projections of future financial performance; and relative weighting of income and market approaches. The long-term projections used in the valuation are developed as part of the Company’s annual budgeting and strategic planning process. The discount rates used to determine the fair values of the reporting units are those of a hypothetical market participant which are developed based upon an analysis of comparable companies and include adjustments made to account for any individual reporting unit specific attributes such as, size and industry.\\nBased on the impairment test performed on January 1, 2012 (the Company's annual measurement date), the Company concluded that the fair values for each reporting unit exceeded the carrying values. Except for Aerospace and Oil & Gas, all other reporting units' fair values exceeded their carrying values by more than 10% as of January 1, 2012.\\nThe Company has completed its January 1, 2013 annual goodwill impairment test. As of January 1, 2013, the Aerospace and Oil & Gas reporting units had goodwill balances of approximately $21 million and $20 million, respectively, and $0 of indefinite lived intangible assets. A combination of the income approach and the market approach was utilized to estimate the reporting units' fair values. The Aerospace and Oil & Gas reporting units both had estimated fair values that exceeded carry value by less than 10%. Under the income approach, the following key assumptions were used in the Company's discounted cash flow analysis:\\n| Aerospace | Oil & Gas |\\n| Discount rate | 15.0 | % | 14.0 | % |\\n| 5-year CAGR | 4.2 | % | 1.5 | % |\\n| Terminal growth rate | 3.0 | % | 3.0 | % |\\n\\n31\\nUnder the market approach, the Company used a multiple of earnings before interest, taxes, depreciation and amortization (“EBITDA”) of 6.5 and 6.0 for Aerospace and Oil & Gas, respectively. The EBITDA multiple observed in the marketplace for recent transactions ranged from 6.0 to 8.7 with a median of 6.9 as of January 1, 2013. The Company considers several factors in estimating the EBITDA multiple including a reporting unit's market position, gross and operating margins and prospects for growth, among other factors.\\nHolding all other assumptions in the model constant, the Company has summarized what the discount rate and EBITDA multiple would have to be (holding the other variable constant) in order for the fair value of Aerospace and Oil & Gas reporting units to fall below their respective carrying value:\\n| Aerospace | Oil & Gas |\\n| Discount rate | 16.5 | % | 14.8 | % |\\n| EBITDA multiple | 5.8 | 5.6 |\\n\\nIf either reporting unit's carrying value exceeded its fair value, additional valuation procedures would have been required to determine whether the reporting unit's goodwill was impaired, and to the extent goodwill was impaired, the magnitude of the impairment charge.\\nAlthough the Company believes its estimates of fair value are reasonable, actual financial results could differ from those estimates due to the inherent uncertainty involved in making such estimates. Changes in assumptions concerning future financial results or other underlying assumptions could have a significant impact on either the fair value of the reporting units, the amount of the goodwill impairment charge, or both. Future declines in the overall market value of the Company’s equity may also result in a conclusion that the fair value of one or more reporting units has declined below its carrying value.\\nThe majority of the Company’s recorded intangible assets were acquired as part of the Transtar and Tube Supply acquisitions in September 2006 and December 2011, respectively, and consist of customer relationships, non-compete agreements, trade names and developed technology. The initial values of the intangible assets were based on a discounted cash flow valuation using assumptions made by management as to future revenues from select customers, the level and pace of attrition in such revenues over time and assumed operating income amounts generated from such revenues. The intangible assets are amortized over their useful lives, which are 4 to 12 years for customer relationships, 3 years for non-compete agreements, 1 to 10 years for trade names and 3 years for developed technology. Useful lives are estimated by management and determined based on the timeframe over which a significant portion of the estimated future cash flows are expected to be realized from the respective intangible assets. Furthermore, when certain conditions or certain triggering events occur, a separate test of impairment, similar to the impairment test for long-lived assets discussed below, is performed. If the intangible asset is deemed to be impaired, such asset will be written down to its fair value.\\nSee Note 8 to the consolidated financial statements for detailed information on goodwill and intangible assets.\\nLong-Lived Assets — The Company’s long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows (undiscounted and without interest charges) expected to be generated by the asset. If such assets are impaired, the impairment charge is calculated as the amount by which the carrying amount of the assets exceeds the fair value of the assets. Determining whether impairment has occurred typically requires various estimates and assumptions, including determining which undiscounted cash flows are directly related to the potentially impaired asset, the useful life over which cash flows will occur, their amount, and the asset’s residual value, if any. The Company derives the required undiscounted cash flow estimates from historical experience and internal business plans. Measurement of an impairment loss requires a determination of fair value. The Company uses an income approach, which estimates fair value based on estimates of future cash flows discounted at an appropriate interest rate.\\nShare-Based Compensation — The Company offers share-based compensation to executive and other key employees, as well as its directors. Share-based compensation expense is recorded over the vesting period based on the grant date fair value of the stock award. Stock options have an exercise price equal to the market price of the Company’s stock on the grant date (options granted prior to 2010) or the average closing price of the Company’s stock for the ten trading days preceding the grant date (options granted in 2010) and have a contractual life of eight to ten years. Options and restricted stock generally vest in one to five years for executives and employees and three years for directors. The Company may either issue shares from treasury or new shares upon share option exercise.\\n32\\nStock options are valued based on the market price of the Company’s stock on the grant date, using a Black-Scholes option-pricing model. The expense associated with stock option awards is recorded on a straight-line basis over the vesting period, net of estimated forfeitures.\\nThe grant date fair value for stock options granted during 2010 was estimated using the Black-Scholes option-pricing model with the following assumptions:\\n| 2010 |\\n| Expected volatility | 58.5 | % |\\n| Risk-free interest rate | 2.3 | % |\\n| Expected life (in years) | 5.5 |\\n| Expected dividend yield | 1.2 | % |\\n\\nShare-based compensation expense for non-vested shares and restricted share units in the long-term compensation plans (“LTC Plans”) is established using the market price of the Company’s common stock on the date of grant.\\nThe grant date fair value of performance shares containing a market-based performance condition awarded under the LTC Plans were estimated using a Monte Carlo simulation with the following assumptions:\\n| 2012 | 2011 | 2010 |\\n| Expected volatility | 85.0 | % | 62.0 | % | 61.6 | % |\\n| Risk-free interest rate | 0.40 | % | 1.10 | % | 1.45 | % |\\n| Expected life (in years) | 2.81 | 2.84 | 2.80 |\\n| Expected dividend yield | — | — | — |\\n\\nPerformance awards under the active LTC Plans were granted to the Company's new CEO in October 2012. The grant date fair values of performance shares awarded to the CEO containing the RTSR market-based performance condition was estimated using a Monte Carlo simulation with the following assumptions:\\n| 2012 | 2011 | 2010 |\\n| Expected volatility | 60.7 | % | 60.7 | % | 60.7 | % |\\n| Risk-free interest rate | 0.34 | % | 0.34 | % | 0.34 | % |\\n| Expected life (in years) | 2.21 | 1.21 | 0.21 |\\n| Expected dividend yield | — | — | — |\\n\\nManagement estimates the probable number of shares which will ultimately vest when calculating the share-based compensation expense for the LTC Plans. As of December 31, 2012, the Company’s weighted average forfeiture rate is approximately 33%. The actual number of shares that vest may differ from management’s estimate. Final award vesting and distribution of performance awards granted under the LTC Plans are determined based on the Company’s actual performance versus the target goals for a three-year consecutive period as defined in each plan. Partial awards can be earned for performance less than the target goal, but in excess of minimum goals; and award distributions above the target can be achieved if the maximum goals are met or exceeded.\\nUnder the 2012, 2011 and 2010 LTC Plans, the potential award for the performance shares granted is partially dependent on the Company’s relative total shareholder return (“RTSR”), which represents a market condition. RTSR is measured against a group of peer companies either in the metals industry or in the industrial products distribution industry. Compensation expense for performance awards containing a market condition is recognized regardless of whether the market condition is achieved to the extent the requisite service period condition is met.\\nUnder the 2012 and 2011 LTC Plans, the potential award for performance shares containing a non-market-based performance condition is determined based on the Company’s actual performance versus Company-specific target goals for Return on Invested Capital (“ROIC”) (as defined in the 2012 and 2011 LTC Plans). Under the 2012 LTC Plan, the non-market based performance condition is determined based on the Company's average actual performance versus Company-specific goals for ROIC for the three-year performance period beginning on January 1st of the year of grant. Under the 2011 LTC Plan, the non-market-based performance condition is determined for\\n33\\nany one or more fiscal years during the three-year performance period beginning on January 1st of the year of grant. Partial performance awards can be earned for performance less than the target goal, but in excess of minimum goals and award distributions twice the target can be achieved if the maximum goals are met or exceeded. The number of performance shares, if any, that vest based on the performance achieved during the three-year performance period, will vest at the end of the three-year performance period. Compensation expense recognized is based on management’s expectation of future performance compared to the pre-established performance goals. If the performance goals are not expected to be met, no compensation expense is recognized and any previously recognized compensation expense is reversed.\\nUnless covered by a specific change-in-control or severance arrangement, participants to whom restricted stock units, performance shares and other non-vested shares have been granted must be employed by the Company on the vesting date or at the end of the performance period, or the award will be forfeited.\\nFair Value of Financial Instruments — The three-tier value hierarchy the Company utilizes, which prioritizes the inputs used in the valuation methodologies, is:\\nLevel 1—Valuations based on quoted prices for identical assets and liabilities in active markets.\\nLevel 2—Valuations based on observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data.\\nLevel 3—Valuations based on unobservable inputs reflecting our own assumptions, consistent with reasonably available assumptions made by other market participants.\\nThe fair value of cash, accounts receivable and accounts payable approximate their carrying values. The fair value of cash equivalents are determined using the fair value hierarchy described above. Cash equivalents consisting of money market funds are valued based on quoted prices in active markets and as a result are classified as Level 1.\\nThe Company’s pension plan asset portfolio as of December 31, 2012 and 2011 is primarily invested in fixed income securities, which generally fall within Level 2 of the fair value hierarchy. Fixed income securities are valued based on evaluated prices provided to the trustee by independent pricing services. Such prices may be determined by factors which include, but are not limited to, market quotations, yields, maturities, call features, ratings, institutional size trading in similar groups of securities and developments related to specific securities.\\nFair value disclosures for the Senior Secured Notes are determined based on recent trades of the bonds and fall within level 2 of the fair value hierarchy. The fair value of the Convertible Notes, which fall within level 3 of the fair value hierarchy, is determined based on similar debt instruments that do not contain a conversion feature, as well as other factors related to the callable nature of the notes. The estimated fair value of the derivative liability for the conversion feature, which falls within level 3 of the fair value hierarchy, is computed using a binomial lattice model using the Company’s historical volatility over the term corresponding to the remaining contractual term of the Convertible Notes and observed spreads of similar debt instruments that do not include a conversion feature. The estimated fair value of the Company’s debt outstanding under its revolving credit facilities, which fall within level 3 of the fair value hierarchy, assumes the current amount of debt outstanding at the end of the year was outstanding until the maturity of the Company’s facility in December 2015.\\nFair value of commodity hedges is based on information which is representative of readily observable market data. Derivative liabilities associated with commodity hedges are classified as Level 2 in the fair value hierarchy.\\nRecent Accounting Pronouncements\\nEffective January 1, 2012, the Company adopted new guidance that applies to the presentation of other comprehensive (loss) income, the testing of goodwill for impairment and the measurement and disclosure of fair value of assets, liabilities and instruments classified in a reporting entity’s shareholders’ equity in the financial statements.\\nSee Note 1 to the consolidated financial statements for detailed information on recent accounting pronouncements.\\n34\\nITEM 7a —\\nQuantitative and Qualitative Disclosures about Market Risk\\nThe Company is exposed to interest rate, commodity price, and foreign exchange rate risks that arise in the normal course of business.\\nInterest Rate Risk — The Company is exposed to market risk related to its fixed rate and variable rate long-term debt. We do not utilize derivative instruments to manage exposure to interest rate changes. The market value of the Company’s $282.5 million of fixed rate long-term debt may be impacted by changes in interest rates. The Company does not expect to repay its fixed rate debt prior to its scheduled maturities.\\nThe Company’s interest rates on borrowings under its $100 million four-year revolving credit facility are subject to changes in the LIBOR and prime interest rates. Borrowings under the Company’s revolving credit agreement were approximately $39.5 million as of December 31, 2012. A hypothetical 100 basis point increase on the Company’s variable rate debt would result in $0.4 million of additional interest expense on an annual basis.\\nCommodity Price Risk — The Company’s raw material costs are comprised primarily of engineered metals and plastics. Market risk arises from changes in the price of steel, other metals and plastics. Although average selling prices generally increase or decrease as material costs increase or decrease, the impact of a change in the purchase price of materials is more immediately reflected in the Company’s cost of materials than in its selling prices. The ability to pass surcharges on to customers immediately can be limited due to contractual provisions with those customers. Therefore, a lag may exist between when the surcharge impacts net sales and cost of materials, respectively, which could result in a higher or lower operating profit.\\nThe Company has a commodity hedging program to mitigate risks associated with certain commodity price fluctuations. If the commodity prices hedged were to decrease hypothetically by 100 basis points, the 2012 unrealized loss recorded in cost of materials would have increased by approximately $0.1 million.\\nForeign Currency Risk — The Company conducts the majority of its business in the United States but also has operations in Canada, Mexico, France, the United Kingdom, Spain, China and Singapore. The Company’s results of operations historically have not been materially affected by foreign currency transaction gains and losses and, therefore, the Company has no financial instruments in place for managing the exposure to foreign currency exchange rates.\\nAs a result of the new debt financing arrangements entered into during December 2011, the Company has certain outstanding intercompany borrowings denominated in the U.S. dollar at its Canadian and United Kingdom subsidiaries. These intercompany borrowings are not hedged and may cause foreign currency exposure, which could be significant, in future periods if they remain unhedged.\\n35\\nITEM 8 — Financial Statements and Supplementary Data\\nAmounts in thousands, except par value and per share data\\n| Consolidated Statements of Operations and Comprehensive Loss |\\n| Year Ended December 31, |\\n| 2012 | 2011 | 2010 |\\n| Net sales | $ | 1,270,368 | $ | 1,132,366 | $ | 943,706 |\\n| Costs and expenses: |\\n| Cost of materials (exclusive of depreciation and amortization) | 927,287 | 845,609 | 700,854 |\\n| Warehouse, processing and delivery expense | 148,256 | 134,898 | 123,318 |\\n| Sales, general and administrative expense | 127,813 | 126,193 | 108,223 |\\n| Depreciation and amortization expense | 25,867 | 20,472 | 20,649 |\\n| Operating income (loss) | 41,145 | 5,194 | (9,338 | ) |\\n| Interest expense, net | (41,090 | ) | (9,663 | ) | (4,988 | ) |\\n| Interest expense - unrealized loss on debt conversion option | (15,597 | ) | (3,991 | ) | — |\\n| Loss on extinguishment of debt | — | (6,153 | ) | — |\\n| Loss before income taxes and equity in earnings of joint venture | (15,542 | ) | (14,613 | ) | (14,326 | ) |\\n| Income taxes | (1,430 | ) | 1,126 | 3,101 |\\n| Loss before equity in earnings of joint venture | (16,972 | ) | (13,487 | ) | (11,225 | ) |\\n| Equity in earnings of joint venture | 7,224 | 11,727 | 5,585 |\\n| Net loss | (9,748 | ) | (1,760 | ) | (5,640 | ) |\\n| Basic loss per share | $ | (0.42 | ) | $ | (0.08 | ) | $ | (0.25 | ) |\\n| Diluted loss per share | $ | (0.42 | ) | $ | (0.08 | ) | $ | (0.25 | ) |\\n| Dividends per common share | $ | — | $ | — | $ | — |\\n| Comprehensive loss: |\\n| Foreign currency translation gains (losses) | $ | 2,369 | $ | (941 | ) | $ | (536 | ) |\\n| Unrecognized pension and postretirement benefit costs, net of tax benefit of $2,312, $1,965 and $1,116 | (3,616 | ) | (3,071 | ) | (1,748 | ) |\\n| Other comprehensive loss | (1,247 | ) | (4,012 | ) | (2,284 | ) |\\n| Net loss | (9,748 | ) | (1,760 | ) | (5,640 | ) |\\n| Comprehensive loss | $ | (10,995 | ) | $ | (5,772 | ) | $ | (7,924 | ) |\\n\\nThe accompanying notes to consolidated financial statements are an integral part of these statements.\\n36\\n| Consolidated Balance Sheets |\\n| December 31, |\\n| 2012 | 2011 |\\n| Assets |\\n| Current assets |\\n| Cash and cash equivalents | $ | 21,607 | $ | 30,524 |\\n| Accounts receivable, less allowances of $3,529 and $3,584 | 138,311 | 181,036 |\\n| Inventories, principally on last-in first-out basis (replacement cost higher by $139,940 and $138,882) | 303,772 | 272,039 |\\n| Prepaid expenses and other current assets | 15,092 | 10,382 |\\n| Income tax receivable | 7,596 | 8,287 |\\n| Total current assets | 486,378 | 502,268 |\\n| Investment in joint venture | 38,854 | 36,460 |\\n| Goodwill | 70,300 | 69,901 |\\n| Intangible assets | 82,477 | 93,813 |\\n| Prepaid pension cost | 12,891 | 15,956 |\\n| Other assets | 18,266 | 21,784 |\\n| Property, plant and equipment, at cost |\\n| Land | 5,195 | 5,194 |\\n| Building | 52,884 | 52,434 |\\n| Machinery and equipment | 178,664 | 172,833 |\\n| Property, plant and equipment, at cost | 236,743 | 230,461 |\\n| Less—accumulated depreciation | (157,103 | ) | (148,320 | ) |\\n| Property, plant and equipment, net | 79,640 | 82,141 |\\n| Total assets | $ | 788,806 | $ | 822,323 |\\n| Liabilities and Stockholders’ Equity |\\n| Current liabilities |\\n| Accounts payable | $ | 67,990 | $ | 116,874 |\\n| Accrued payroll and employee benefits | 11,749 | 14,792 |\\n| Accrued liabilities | 24,815 | 19,036 |\\n| Income taxes payable | 1,563 | 1,884 |\\n| Current portion of long-term debt | 415 | 192 |\\n| Short term debt | 500 | 500 |\\n| Total current liabilities | 107,032 | 153,278 |\\n| Long-term debt, less current portion | 296,154 | 314,240 |\\n| Deferred income taxes | 32,350 | 25,650 |\\n| Other non-current liabilities | 5,279 | 7,252 |\\n| Pension and post retirement benefit obligations | 10,651 | 9,624 |\\n| Commitments and contingencies |\\n| Stockholders’ equity |\\n| Preferred stock, $0.01 par value—9,988 shares authorized (including 400 Series B Junior Preferred $0.00 par value shares); no shares issued and outstanding at December 31, 2012 and December 31, 2011 | — | — |\\n| Common stock, $0.01 par value—60,000 shares authorized and 23,211 shares issued and 23,152 outstanding at December 31, 2012; 30,000 shares authorized and 23,159 shares issued and 23,010 outstanding at December 31, 2011 | 232 | 232 |\\n| Additional paid-in capital | 219,619 | 184,596 |\\n| Retained earnings | 139,239 | 148,987 |\\n| Accumulated other comprehensive loss | (21,071 | ) | (19,824 | ) |\\n| Treasury stock, at cost—59 shares at December 31, 2012 and 149 shares at December 31, 2011 | (679 | ) | (1,712 | ) |\\n| Total stockholders’ equity | 337,340 | 312,279 |\\n| Total liabilities and stockholders’ equity | $ | 788,806 | $ | 822,323 |\\n\\nThe accompanying notes to consolidated financial statements are an integral part of these statements.\\n37\\n| Consolidated Statements of Cash Flows |\\n| Years Ended December 31, |\\n| 2012 | 2011 | 2010 |\\n| Operating activities: |\\n| Net loss | $ | (9,748 | ) | $ | (1,760 | ) | $ | (5,640 | ) |\\n| Adjustments to reconcile net loss to net cash from (used in) operating activities: |\\n| Depreciation and amortization | 25,867 | 20,472 | 20,649 |\\n| Amortization of deferred gain | (1,619 | ) | (503 | ) | (890 | ) |\\n| Amortization of deferred financing costs and debt discount | 6,232 | 1,662 | 685 |\\n| Loss on sale of fixed assets | 354 | 120 | 391 |\\n| Unrealized loss on debt conversion option | 15,597 | 3,991 | — |\\n| Unrealized losses on commodity hedges | 163 | 2,331 | — |\\n| Equity in earnings of joint venture | (7,224 | ) | (11,727 | ) | (5,585 | ) |\\n| Dividends from joint venture | 4,729 | 3,117 | 1,260 |\\n| Deferred tax (benefit) provision | (1,284 | ) | (3,333 | ) | (11,386 | ) |\\n| Share-based compensation expense | 2,277 | 4,349 | 2,411 |\\n| Excess tax benefits from share-based payment arrangements | (90 | ) | (301 | ) | (219 | ) |\\n| Increase (decrease) from changes in, net of acquisition: |\\n| Accounts receivable | 44,570 | (26,446 | ) | (22,521 | ) |\\n| Inventories | (29,340 | ) | (39,435 | ) | 39,686 |\\n| Prepaid expenses and other current assets | (2,397 | ) | (3,408 | ) | (1,718 | ) |\\n| Other assets | (480 | ) | 188 | 399 |\\n| Prepaid pension costs | (2,863 | ) | (2,412 | ) | (1,530 | ) |\\n| Accounts payable | (42,560 | ) | 9,910 | (1,866 | ) |\\n| Accrued payroll and employee benefits | (2,974 | ) | (2,470 | ) | 5,827 |\\n| Income taxes payable and receivable | 454 | (820 | ) | 11,536 |\\n| Accrued liabilities | 4,514 | (184 | ) | 1,586 |\\n| Postretirement benefit obligations and other liabilities | 1,173 | 371 | 1,287 |\\n| Net cash from (used in) operating activities | 5,351 | (46,288 | ) | 34,362 |\\n| Investing activities: |\\n| Acquisition/Investment of businesses, net of cash acquired | (6,472 | ) | (174,244 | ) | — |\\n| Capital expenditures | (11,121 | ) | (11,744 | ) | (7,572 | ) |\\n| Proceeds from sale of fixed assets | 153 | 226 | 4 |\\n| Insurance proceeds | — | 573 | 125 |\\n| Net cash used in investing activities | (17,440 | ) | (185,189 | ) | (7,443 | ) |\\n| Financing activities: |\\n| Short-term (repayments) borrowings, net | (27 | ) | 653 | (13,720 | ) |\\n| Net (repayments) borrowings on previously existing revolving lines of credit | — | (26,403 | ) | 2,324 |\\n| Proceeds from long-term debt, including new revolving credit facility | 767,090 | 320,476 | — |\\n| Repayments of long-term debt, including new revolving credit facility | (762,887 | ) | (53,212 | ) | (7,754 | ) |\\n| Payment of debt issue costs | (1,503 | ) | (16,633 | ) | — |\\n| Exercise of stock options | 146 | 356 | 566 |\\n| Excess tax benefits from share-based payment arrangements | 90 | 301 | 219 |\\n| Net cash from (used in) financing activities | 2,909 | 225,538 | (18,365 | ) |\\n| Effect of exchange rate changes on cash and cash equivalents | 263 | (253 | ) | (149 | ) |\\n| Net (decrease) increase in cash and cash equivalents | (8,917 | ) | (6,192 | ) | 8,405 |\\n| Cash and cash equivalents—beginning of year | 30,524 | 36,716 | 28,311 |\\n| Cash and cash equivalents—end of year | $ | 21,607 | $ | 30,524 | $ | 36,716 |\\n\\nSee Note 1 to the consolidated financial statements for supplemental cash flow disclosures.\\nThe accompanying notes to consolidated financial statements are an integral part of these statements.\\n38\\n| Consolidated Statements of Stockholders' Equity |\\n| CommonShares | TreasuryShares | PreferredStock | CommonStock | TreasuryStock | AdditionalPaid-inCapital | RetainedEarnings | Accumulated OtherComprehensiveIncome | Total |\\n| Balance at January 1, 2010 | 23,115 | (209 | ) | $ | — | $ | 230 | $ | (3,010 | ) | $ | 178,129 | $ | 156,387 | $ | (13,528 | ) | $ | 318,208 |\\n| Net loss | (5,640 | ) | (5,640 | ) |\\n| Foreign currency translation | (536 | ) | (536 | ) |\\n| Defined benefit pension liability adjustments, net of tax benefit of $1,116 | (1,748 | ) | (1,748 | ) |\\n| Long-term incentive plan | 1,278 | 1,278 |\\n| Exercise of stock options and other | 34 | 46 | 1 | 784 | 1,112 | 1,897 |\\n| Balance at December 31, 2010 | 23,149 | (163 | ) | $ | — | $ | 231 | $ | (2,226 | ) | $ | 180,519 | $ | 150,747 | $ | (15,812 | ) | $ | 313,459 |\\n| Net loss | (1,760 | ) | (1,760 | ) |\\n| Foreign currency translation | (941 | ) | (941 | ) |\\n| Defined benefit pension liability adjustments, net of tax benefit of $1,965 | (3,071 | ) | (3,071 | ) |\\n| Long-term incentive plan | 3,260 | 3,260 |\\n| Exercise of stock options and other | 10 | 14 | 1 | 514 | 817 | 1,332 |\\n| Balance at December 31, 2011 | 23,159 | (149 | ) | $ | — | $ | 232 | $ | (1,712 | ) | $ | 184,596 | $ | 148,987 | $ | (19,824 | ) | $ | 312,279 |\\n| Net loss | (9,748 | ) | — | (9,748 | ) |\\n| Foreign currency translation | 2,369 | 2,369 |\\n| Defined benefit pension liability adjustments, net of tax benefit of $2,312 | (3,616 | ) | (3,616 | ) |\\n| Embedded conversion option, net of tax benefit of $8,285 | 33,752 | 33,752 |\\n| Long-term incentive plan | 1,592 | 1,592 |\\n| Exercise of stock options and other | 52 | 90 | 1,033 | (321 | ) | 712 |\\n| Balance at December 31, 2012 | 23,211 | (59 | ) | $ | — | $ | 232 | $ | (679 | ) | $ | 219,619 | $ | 139,239 | $ | (21,071 | ) | $ | 337,340 |\\n\\nThe accompanying notes to consolidated financial statements are an integral part of these statements.\\n39\\nA. M. Castle & Co.\\nNotes to Consolidated Financial Statements\\nAmounts in thousands except per share data and percentages\\n(1) Basis of Presentation and Significant Accounting Policies\\nNature of operations — A.M. Castle & Co. and its subsidiaries (the “Company”) is a specialty metals and plastics distribution company serving principally the North American market, but with a growing global presence. The Company has operations in the United States, Canada, Mexico, France, the United Kingdom, Spain, China and Singapore. The Company provides a broad range of product inventories as well as value-added processing and supply chain services to a wide array of customers, principally within the producer durable equipment, oil and gas, aerospace, heavy industrial equipment, industrial goods, construction equipment, retail, marine and automotive sectors of the global economy. Particular focus is placed on the aerospace and defense, oil and gas, power generation, mining, heavy industrial equipment, marine, office furniture and fixtures, safety products, life science applications, automotive and general manufacturing industries as well as general engineering applications.\\nThe Company’s corporate headquarters are located in Oak Brook, Illinois. The Company has 49 operational service centers located throughout North America (44), Europe (4) and Asia (1).\\nThe Company purchases metals and plastics from many producers. Purchases are made in large lots and held in distribution centers until sold, usually in smaller quantities and often with value-added processing services performed. Orders are primarily filled with materials shipped from Company stock. The materials required to fill the balance of sales are obtained from other sources, such as direct mill shipments to customers or purchases from other distributors. Thousands of customers from a wide array of industries are serviced primarily through the Company’s own sales organization.\\nBasis of presentation — The consolidated financial statements include the accounts of A. M. Castle & Co. and its subsidiaries over which the Company exhibits a controlling interest. The equity method of accounting is used for the Company’s 50% owned joint venture, Kreher Steel Company, LLC (“Kreher”). All inter-company accounts and transactions have been eliminated.\\nReclassification — For comparability, certain 2011 amounts have been reclassified to conform to presentation adopted in 2012.\\nUse of estimates — The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. The principal areas of estimation reflected in the consolidated financial statements are accounts receivable allowances, inventory reserves, goodwill and intangible assets, income taxes, pension and other post-employment benefits and share-based compensation and convertible debt feature mark-to-mark adjustments.\\nRevenue recognition — Revenue from the sales of products is recognized when the earnings process is complete and when the title and risk and rewards of ownership have passed to the customer, which is primarily at the time of shipment. Revenue recognized other than at the time of shipment represents less than 3% of the Company’s consolidated net sales for the years ended December 31, 2012, 2011 and 2010. Provisions for allowances related to sales discounts and rebates are recorded based on terms of the sale in the period that the sale is recorded. Management utilizes historical information and the current sales trends of the business to estimate such provisions. The provisions related to discounts and rebates due to customers are recorded as a reduction within net sales in the Company’s consolidated statements of operations and comprehensive loss.\\nThe Company maintains an allowance for doubtful accounts resulting from the inability of customers to make required payments. The allowance for doubtful accounts is maintained at a level considered appropriate based on historical experience and specific identification of customer receivable balances for which collection is unlikely. The provisions for doubtful accounts is recorded in sales, general and administrative expense in the Company’s consolidated statements of operations and comprehensive loss. Estimates of doubtful accounts are based upon historical write-off experience as a percentage of net sales and judgments about the probable effects of economic conditions on certain customers.\\n40\\nThe Company also maintains an allowance for credit memos for estimated credit memos to be issued against current sales. Estimates of allowance for credit memos are based upon the application of a historical issuance lag period to the average credit memos issued each month.\\nAccounts receivable allowance activity is presented in the table below:\\n| 2012 | 2011 | 2010 |\\n| Balance, beginning of year | $ | 3,584 | $ | 3,848 | $ | 4,195 |\\n| Add Provision charged to expense | 1,420 | 523 | 777 |\\n| Recoveries | 90 | 140 | 186 |\\n| Other | — | 157 | — |\\n| Less Charges against allowance | (1,565 | ) | (1,084 | ) | (1,310 | ) |\\n| Balance, end of year | $ | 3,529 | $ | 3,584 | $ | 3,848 |\\n\\nRevenue from shipping and handling charges is recorded in net sales. Costs incurred in connection with shipping and handling the Company’s products, which are related to third-party carriers or performed by Company personnel are included in warehouse, processing and delivery expenses. For the years ended December 31, 2012, 2011 and 2010, shipping and handling costs included in warehouse, processing and delivery expenses were $36,585, $35,214, and $31,067, respectively.\\nCost of materials — Cost of materials consists of the costs the Company pays for metals, plastics and related inbound freight charges. It excludes depreciation and amortization which are discussed below. The Company accounts for the majority of its inventory on a last-in, first-out (“LIFO”) basis and LIFO adjustments are recorded in cost of materials.\\nOperating expenses — Operating costs and expenses primarily consist of:\\n\\n| • | Warehouse, processing and delivery expenses, including occupancy costs, compensation and employee benefits for warehouse personnel, processing, shipping and handling costs; |\\n\\n| • | Sales expenses, including compensation and employee benefits for sales personnel; |\\n\\n| • | General and administrative expenses, including compensation for executive officers and general management, expenses for professional services primarily attributable to accounting and legal advisory services, bad debt expenses, data communication, computer hardware and maintenance and foreign currency gain or loss; and |\\n\\n| • | Depreciation and amortization expenses, including depreciation for all owned property and equipment, and amortization of various intangible assets. |\\n\\nCash equivalents — Cash equivalents are highly liquid, short-term investments that have an original maturity of 90 days or less.\\nStatement of cash flows — Non-cash investing and financing activities and supplemental disclosures of consolidated cash flow information are as follows:\\n| Year Ended December 31, |\\n| 2012 | 2011 | 2010 |\\n| Non-cash investing and financing activities: |\\n| Capital expenditures financed by accounts payable | $ | 479 | $ | 1,123 | $ | 100 |\\n| Capital lease obligations | 1,009 | — | — |\\n| Deferred debt origination fees | — | 886 | — |\\n| Additional purchase price paid in 2012 for Tube Supply acquisition | — | 6,472 | — |\\n| Cash paid during the year for: |\\n| Interest | 34,051 | 7,234 | 4,392 |\\n| Income taxes | 5,557 | 9,555 | 1,631 |\\n| Cash received during the year for: |\\n| Income tax refunds | 3,184 | 6,724 | 4,430 |\\n\\n41\\nInventories — Inventories consist of finished goods. Approximately eighty percent of the Company’s inventories are valued at the lower of LIFO cost or market at December 31, 2012 and 2011. Final inventory determination under the LIFO costing method is made at the end of each fiscal year based on the actual inventory levels and costs at that time. The Company values its LIFO increments using the cost of its latest purchases during the years reported. Current replacement cost of inventories exceeded book value by $139,940 and $138,882 at December 31, 2012 and 2011, respectively. Income taxes would become payable on any realization of this excess from reductions in the level of inventories.\\nDuring 2010, a reduction in inventories resulted in a liquidation of applicable LIFO inventory quantities carried at lower costs in prior years. Cost of materials for 2010 were lower by $12,500, as a result of the liquidations.\\nThe Company maintains allowances for excess and obsolete inventory and physical inventory losses. The excess and obsolete inventory allowance is determined based on specific identification of material, adjusted for expected scrap value to be received. The allowance for physical inventory losses is determined based on historical physical inventory experience.\\nInsurance plans — In August 2009, the Company became a member of a group captive insurance company (the “Captive”) domiciled in Grand Cayman Island. The Captive reinsures losses related to certain of the Company’s workers’ compensation, automobile and general liability risks that occur subsequent to August 2009. Premiums are based on the Company’s loss experience and are accrued as expenses for the period to which the premium relates. Premiums are credited to the Company’s “loss fund” and earn investment income until claims are actually paid. For workers’ compensation, automobile and general liability claims that were incurred prior to August 2009, the Company is self-insured. Self-insurance amounts are capped, for individual claims and in the aggregate, for each policy year by an insurance company. Self-insurance reserves are based on unpaid, known claims (including related administrative fees assessed by the insurance company for claims processing) and a reserve for incurred but not reported claims based on the Company’s historical claims experience and development.\\nThe Company is self-insured for medical insurance for its domestic operations. Self-insurance reserves are maintained based on incurred but not paid claims based on a historical lag.\\nProperty, plant and equipment — Property, plant and equipment are stated at cost and include assets held under capital leases. Expenditures for major additions and improvements are capitalized, while maintenance and repair costs that do not substantially improve or extend the useful lives of the respective assets are expensed in the period in which they are incurred. When items are disposed, the related costs and accumulated depreciation are removed from the accounts and any gain or loss is reflected in income.\\nThe Company provides for depreciation of plant and equipment sufficient to amortize the cost over their estimated useful lives as follows:\\n| Buildings and building improvements | 3 – 40 years |\\n| Plant equipment | 3 – 25 years |\\n| Furniture and fixtures | 2 – 10 years |\\n| Vehicles and office equipment | 3 – 7 years |\\n\\nLeasehold improvements are depreciated over the shorter of their useful lives or the remaining term of the lease. Depreciation is calculated using the straight-line method and depreciation expense for 2012, 2011 and 2010 was $14,024, $13,605 and $13,578, respectively.\\nLong-lived assets — The Company’s long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset or asset group to future net cash flows (undiscounted and without interest charges) expected to be generated by the asset or asset group. If future net cash flows are less than the carrying value, the asset or asset group may be impaired. If such assets are impaired, the impairment charge is calculated as the amount by which the carrying amount of the assets exceeds the fair value of the assets. Determining whether impairment has occurred typically requires various estimates and assumptions, including determining which undiscounted cash flows are directly related to the potentially impaired asset, the useful life over which cash flows will occur, their amount, and the asset’s residual value, if any. The Company derives the required undiscounted cash flow estimates from historical experience and internal business plans.\\n42\\nGoodwill and intangible assets — The carrying value of the Company’s goodwill is evaluated annually on January 1st of each fiscal year or when certain triggering events occur which require a more current valuation. The Company assesses, at least quarterly, whether any triggering events have occurred.\\nA two-step method is used for determining goodwill impairment. The first step is performed to identify whether a potential impairment exists by comparing each reporting unit’s fair value to its carrying value. If the carrying value of a reporting unit exceeds its fair value, the next step is to measure the amount of impairment loss, if any.\\nThe majority of the Company’s recorded intangible assets were acquired as part of the Transtar and Tube Supply, Inc. (“Tube Supply”) acquisitions in September 2006 and December 2011, respectively, and consist of customer relationships, non-compete agreements, trade names and developed technology. The initial values of the intangible assets were based on a discounted cash flow valuation using assumptions made by management as to future revenues from select customers, the level and pace of attrition in such revenues over time and assumed operating income amounts generated from such revenues. These intangible assets are amortized over their useful lives, which are 4 to 12 years for customer relationships, 3 years for non-compete agreements, 1 to 10 years for trade names, and 3 years for developed technology. Useful lives are estimated by management and determined based on the timeframe over which a significant portion of the estimated future cash flows are expected to be realized from the respective intangible assets. Furthermore, when certain conditions or certain triggering events occur, a separate test of impairment, similar to the impairment test for long-lived assets, is performed. If the intangible asset is deemed to be impaired, such asset will be written down to its fair value.\\nIncome taxes — The Company accounts for income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statement and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.\\nThe Company records valuation allowances against its deferred tax assets when it is more likely than not that the amounts will not be realized, which will increase the provision for income taxes in the period in which that determination is made.\\nThe Company has undistributed earnings of foreign subsidiaries of approximately $83,352 at December 31, 2012, for which deferred taxes have not been provided. Such earnings are considered indefinitely invested in the foreign subsidiaries. If such earnings were repatriated, additional tax expense may result, although due to the potential availability of foreign tax credits and other items, the calculation of such additional taxes is not practicable.\\nThe Company's 50% ownership interest in Kreher (see Note 6) is through a 50% interest in a limited liability corporation (LLC) taxed as a partnership. Kreher has two subsidiaries organized as individually taxed C-Corporations. The Company includes in its income tax provision the income tax liability on its share of Kreher income. The income tax liability of Kreher itself is generally treated as a current income tax expense and the income tax liability associated with the profits of the two subsidiaries of Kreher is treated as a deferred income tax expense. The Company can not independently cause a dividend to be declared by one of Kreher's subsidiaries, therefore no benefit of a dividend received deduction can be recognized in the Company's tax provision until a dividend is declared. If one of Kreher's C-Corporation subsidiaries declares a dividend payable to Kreher, the Company recognizes a benefit for the 80% dividends received deduction on its 50% share of the dividend.\\nThe Company recognizes the tax benefits of uncertain tax positions only if those benefits will more likely than not be sustained upon examination by the relevant tax authorities. Unrecognized tax benefits are subsequently recognized at the time the recognition threshold is met, the tax matter is effectively settled or the statute of limitations expires for the return containing the tax position, whichever is earlier. Due to the complexity of some of these uncertainties, the ultimate resolution may result in a payment that differs from the current estimate.\\nThe Company recognizes interest and penalties related to unrecognized tax benefits within income tax expense. Accrued interest and penalties are included within other long-term liabilities in the consolidated balance sheets.\\nForeign currency — For the majority of the Company’s non-U.S. operations, the functional currency is the local currency. Assets and liabilities of those operations are translated into U.S. dollars using year-end exchange rates, and income and expenses are translated using the average exchange rates for the reporting period. The currency effects of translating financial statements of the Company’s non-U.S. operations which operate in local currency environments are recorded in accumulated other comprehensive income (loss), a separate component of\\n43\\nstockholders’ equity. Transaction gains or losses resulting from foreign currency transactions were not material for any of the years presented.\\nEarnings per share — Diluted earnings per share is computed by dividing net income by the weighted average number of shares of common stock plus common stock equivalents. Common stock equivalents consist of employee and director stock options, restricted stock awards, other share-based payment awards, and contingently issuable shares related to the Company’s convertible debt which are included in the calculation of weighted average shares outstanding using the treasury stock method, if dilutive.\\nThe following table is a reconciliation of the basic and diluted earnings per share calculations:\\n| 2012 | 2011 | 2010 |\\n| Numerator: |\\n| Net loss | $ | (9,748 | ) | $ | (1,760 | ) | $ | (5,640 | ) |\\n| Denominator: |\\n| Denominator for basic loss per share: |\\n| Weighted average common shares outstanding | 22,993 | 22,983 | 22,708 |\\n| Effect of dilutive securities: |\\n| Outstanding common stock equivalents | — | — | — |\\n| Denominator for diluted loss per share | 22,993 | 22,983 | 22,708 |\\n| Basic loss per share | $ | (0.42 | ) | $ | (0.08 | ) | $ | (0.25 | ) |\\n| Diluted loss per share | $ | (0.42 | ) | $ | (0.08 | ) | $ | (0.25 | ) |\\n| Excluded outstanding share-based awards having an anti-dilutive effect | 994 | 757 | 471 |\\n\\nThe Convertible Notes are dilutive to the extent the Company generates net income and the average stock price during the period is greater than $10.28, the conversion price of the Convertible Notes. The Convertible Notes are only dilutive for the “in the money” portion of the Convertible Notes that could be settled with the Company’s stock. In future periods, absent a fundamental change, (as defined in the Convertible Notes agreement), the outstanding Convertible Notes could increase diluted average shares outstanding by a maximum of approximately 5,600 shares. As of December 31, 2012 and 2011, 1,416 and 1,734 shares, respectively, were excluded from diluted average shares outstanding as there would have been an anti-dilutive effect.\\nFor the years ended December 31, 2012, 2011 and 2010, the participating securities, which represent certain non-vested shares granted by the Company, were less than one percent of total securities. These securities do not participate in the Company’s net losses.\\nConcentrations — The Company serves a wide range of customers within the producer durable equipment, oil and gas, aerospace, heavy industrial equipment, industrial goods, construction equipment, retail, marine and automotive sectors of the economy from locations throughout the United States, Canada, Mexico, France, the United Kingdom, Spain, China and Singapore. Its customer base includes many Fortune 500 companies as well as thousands of medium and smaller sized firms spread across the entire spectrum of metals and plastics using industries. The Company’s customer base is well diversified and, therefore, the Company does not have dependence upon any single customer or a few customers. No single customer represents more than 3% of the Company’s total net sales. Approximately 78% of the Company’s business is conducted from locations in the United States.\\nShare-based compensation — The Company offers share-based compensation to executive and other key employees, as well as its directors. Share-based compensation expense is recorded over the vesting period based on the grant date fair value of the stock award. Stock options have an exercise price equal to the market price of the Company’s stock on the grant date (options granted prior to 2010) or the average closing price of the Company’s stock for the 10 trading days preceding the grant date (options granted in 2010) and have a contractual life of eight to ten years. Options and restricted stock generally vest in one to five years for executives and employees and three years for directors. The Company may either issue shares from treasury or new shares upon share option exercise. Management estimates the probable number of shares which will ultimately vest when calculating the share-based compensation expense for the long-term compensation plans (\\\"LTC Plans\\\"). As of December 31, 2012, the Company’s weighted average forfeiture rate is approximately 33%. The actual number of shares that vest may differ from management’s estimate.\\n44\\nStock options are valued based on the market price of the Company’s stock on the grant date, using a Black-Scholes option-pricing model. The expense associated with stock option awards is recorded on a straight-line basis over the vesting period, net of estimated forfeitures.\\nShare-based compensation expense for restricted share units and non-vested shares in the LTC Plans is established using the market price of the Company’s common stock on the date of grant.\\nFinal award vesting and distribution of performance awards granted under the LTC Plans are determined based on the Company’s actual performance versus the target goals for a three-year consecutive period as defined in each plan. Partial awards can be earned for performance less than the target goal, but in excess of minimum goals; and award distributions above the target can be achieved if the maximum goals are met or exceeded.\\nUnder the 2012, 2011, and 2010 LTC Plans, the potential award for the performance shares granted is partially dependent on the Company’s relative total shareholder return (“RTSR”), which represents a market condition. RTSR is measured against a group of peer companies either in the metals industry or in the industrial products distribution industry. Compensation expense for performance awards containing a market condition is recognized regardless of whether the market condition is achieved to the extent the requisite service period condition is met. The grant date fair value of performance shares containing a market-based performance condition awarded under the LTC Plans was estimated using a Monte Carlo simulation.\\nUnder the 2012 and 2011 LTC Plans, the potential award for performance share units containing a non-market-based performance condition is determined based on the Company's actual performance versus Company-specific target goals for Return on Invested Capital (“ROIC”), as defined in the 2012 and 2011 LTC Plans. Under the 2012 LTC Plan, the non-market-based performance condition is determined based on the Company's average actual performance versus Company-specific goals for ROIC for the three-year performance period beginning on January 1st of the year of grant. Under the 2011 LTC Plan, the non-market-based performance condition is determined for any one or more fiscal years during the three-year performance period beginning on January 1st of the year of grant. Partial performance awards can be earned for performance less than the target goal, but in excess of minimum goals and award distributions twice the target can be achieved if the maximum goals are met or exceeded. The number of performance shares, if any, that vest based on the performance achieved during the three-year performance period, will vest at the end of the three-year performance period. Compensation expense recognized is based on management's expectation of future performance compared to the pre-established performance goals. If the performance goals are not expected to be met, no compensation expense is recognized and any previously recognized compensation expense is reversed.\\nUnless covered by a specific change-in-control or severance arrangement, participants to whom restricted stock units, performance shares and other non-vested shares have been granted must be employed by the Company on the vesting date or at the end of the performance period, respectively, or the award will be forfeited.\\nNew Accounting Standards Updates\\nStandards Updates Adopted\\nEffective January 1, 2012, the Company adopted ASU No. 2011-08, “Intangibles – Goodwill and Other.” The objective of this ASU is to simplify how entities test goodwill for impairment. The amendments allow entities to assess qualitative factors to determine whether it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test per Topic 350, “Intangibles – Goodwill and Other.” The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent. The adoption of this ASU impacts the way the Company tests goodwill for impairment. As allowed by this ASU for its January 1, 2012 annual impairment test, the Company did not elect the option to perform a qualitative evaluation about the likelihood of goodwill impairment to determine whether it should calculate the fair value of a reporting unit. Instead the Company followed the two-step method. Refer to Note 8 for the results of the annual goodwill impairment test.\\nEffective January 1, 2012, the Company adopted ASU No. 2011-05, “Presentation of Comprehensive Income.” The amendments in this ASU impact all entities that report items of other comprehensive (loss) income and are effective retrospectively for public entities. The amendments in this ASU eliminate the option to present the components of other comprehensive (loss) income as part of the statement of changes in stockholders’ equity. The amendments provide the entity with the option to present the total of comprehensive (loss) income, the components of net (loss) income and the components of other comprehensive (loss) income either in a single continuous statement of comprehensive (loss) income or in two separate but consecutive statements. Both options require an entity to present each component of net (loss) income along with total net (loss) income, each component of other\\n45\\ncomprehensive (loss) income along with total other comprehensive (loss) income and a total amount for comprehensive (loss) income. The subsequent issuance of ASU 2011-12, “Comprehensive Income” in December 2011 deferred the changes in ASU 2011-05 that relate to the presentation of reclassification adjustments out of accumulated other comprehensive (loss) income. All other provisions in ASU 2011-05 were effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The presentation requirements associated with the adoption of ASU 2011-05 are reflected in the consolidated statements of operations and comprehensive loss herein.\\nEffective January 1, 2012, the Company adopted ASU No. 2011-04, “Fair Value Measurement.” The amendments in this ASU apply to all reporting entities that are required or permitted to measure or disclose the fair value of an asset, a liability, or an instrument classified in a reporting entity’s shareholders’ equity in the financial statements. The amendments in this ASU clarify the requirements of the existing standard and include some changes to principles or requirements for measuring or disclosing information about fair value measurements. The adoption of this ASU did not have an impact on the Company's financial condition, liquidity or operating results. The disclosure requirements associated with the adoption of ASU 2011-04 are reflected in Note 10.\\nStandards Updates Issued Not Yet Effective\\nDuring December 2011, the FASB issued ASU No. 2011-11, “Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities.” The amendments in this ASU require an entity to disclose information to enable users of its financial statements to evaluate the effect or potential effect of netting arrangements on its financial position, including the effect or potential effect of rights of set off associated with an entity’s recognized assets and recognized liabilities within the scope of Topic 210. The ASU is effective for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. The adoption of this ASU may impact the Company’s disclosures in future interim and annual financial statements issued.\\n(2) Acquisition\\nOn December 15, 2011, the Company acquired 100 percent of the outstanding common shares of Tube Supply (the “Acquisition”). The Acquisition was accounted for using the acquisition method. Accordingly, the purchase price has been allocated to the assets acquired and liabilities assumed based on estimated fair values at date of acquisition. The nonrecurring fair value measurements are classified as Level 3 in the fair value hierarchy (see Note 10 for the definition of Level 3 inputs).\\nThe results and the assets of Tube Supply are included in the Company’s Metals segment.\\nTube Supply, based in Houston, Texas, is a leading value-added distributor of specialty tubular and bar products for the oil and gas industry. Tube Supply provides high quality products and services primarily to the North American oilfield equipment manufacturing industry. Tube Supply operates two service centers, which are located in Houston, Texas and Edmonton, Alberta. The Acquisition will allow the Company to capitalize on the growing demand and opportunities in the oil and gas sector through new product offerings to an expanded customer base.\\nThe aggregate purchase price was $184,385 and represents the aggregate cash purchase price, including a working capital adjustment. The premium paid in excess of the fair value of the net assets acquired was primarily for the ability to expand the Company’s oil and gas product offerings, as well as to obtain Tube Supply’s skilled, established workforce.\\nDuring 2011, the Company incurred $4,260 of direct acquisition-related costs, which are recorded in Sales, general and administrative expense.\\n46\\nAn allocation of the purchase price to the fair value of the assets acquired and liabilities assumed, which was finalized as of December 2012, is as follows:\\nPurchase Price Allocation\\n| Current assets | $ | 134,817 |\\n| Property, plant and equipment, net | 6,767 |\\n| Other assets | 346 |\\n| Trade name | 7,700 |\\n| Customer relationships | 48,800 |\\n| Non-compete agreements | 1,000 |\\n| Developed technology | 1,400 |\\n| Goodwill | 19,637 |\\n| Total assets acquired | 220,467 |\\n| Current liabilities | 33,211 |\\n| Long-term liabilities | 2,871 |\\n| Total liabilities assumed | 36,082 |\\n| Total purchase price | $ | 184,385 |\\n\\nThe acquired intangible assets have a weighted average useful life of approximately 11.4 years. Useful lives by intangible asset category are as follows: trade name - 10 years, customer relationships - 12 years, non-compete agreements - 3 years and developed technology - 3 years.\\nAt closing, the Company entered into a lease agreement with the former owners of Tube Supply. At December 31, 2012 and 2011, an unfavorable lease liability associated with the lease for a newly constructed distribution center used by Tube Supply of $2,168 and $2,871, respectively, is recorded in other non-current liabilities. The current portion of the unfavorable lease liability in the amount of $645 is included in accrued liabilities in the consolidated balance sheets at December 31, 2012 and 2011. The unfavorable lease liability resulted from the present value of the difference between the estimated fair market value and the executed contract price the Company will pay to lease the property. The unfavorable lease liability will be amortized over the remaining life of the lease.\\nThe goodwill and intangible assets are deductible for tax purposes.\\nThe results of operations of Tube Supply have been included in the Company's consolidated statements of operations and comprehensive loss since December 15, 2011. The net sales and net income for Tube Supply during the period from December 15, 2011 through December 31, 2011 were $7,648 and $901, respectively.\\nThe following unaudited pro forma summary presents the effect of the Acquisition during the years ended December 31, 2011 and 2010 as though the business had been acquired as of January 1, 2010:\\n| Year ended December 31,(Unaudited) |\\n| 2011 | 2010 |\\n| Pro forma net sales | $ | 1,332,176 | $ | 1,069,564 |\\n| Pro forma net income (loss) | 7,033 | (24,268 | ) |\\n| Pro forma basic net income (loss) per share | $ | 0.31 | $ | (1.06 | ) |\\n| Pro forma diluted net income (loss) per share | 0.28 | (1.06 | ) |\\n\\nUnaudited pro forma supplemental information is based upon management estimates and judgments. The unaudited pro forma supplemental information also includes purchase accounting and interest expense adjustments and the related tax effects. The unaudited pro forma supplemental information for the year ended December 31, 2011 excludes direct acquisition-related costs of $4,260 and includes loss on extinguishment of debt of $6,153 and interest costs of $7,366 associated with the underwriting fee for debt financing and the mark-to-market adjustment for the conversion option on the convertible bonds. The unaudited pro forma supplemental information for the year ended December 31, 2010 includes direct acquisition-related costs of $4,260. These pro forma results are not necessarily indicative of what would have occurred if the acquisition had been in effect for the periods presented or of future results. Pro forma financial information is not provided for the year ended December 31, 2012 as a full\\n47\\nyear of post-acquisition results of operations for Tube Supply were included in the Company's consolidated statements of operations and comprehensive loss.\\nSee Note 9 for detailed discussion on the Company’s debt financing structure used to finance the Acquisition.\\n(3) Segment Reporting\\nThe Company distributes and performs processing on both metals and plastics. Although the distribution processes are similar, the customer markets, supplier bases and types of products are different. Additionally, the Company’s Chief Executive Officer, the chief operating decision-maker, reviews and manages these two businesses separately. As such, these businesses are considered reportable segments and are reported accordingly. Neither of the Company’s reportable segments has any unusual working capital requirements.\\nIn its Metals segment, the Company’s marketing strategy focuses on distributing highly engineered specialty grades and alloys of metals as well as providing specialized processing services designed to meet very precise specifications. Core products include alloy, aluminum, stainless, nickel, titanium and carbon. Inventories of these products assume many forms such as plate, sheet, extrusions, round bar, hexagon bar, square and flat bar, tubing and coil. Depending on the size of the facility and the nature of the markets it serves, service centers are equipped as needed with bar saws, plate saws, oxygen and plasma arc flame cutting machinery, trepanning machinery, boring machinery, honing equipment, water-jet cutting, stress relieving and annealing furnaces, surface grinding equipment and sheet shearing equipment. This segment also performs various specialized fabrications for its customers through pre-qualified subcontractors that thermally process, turn, polish and straighten alloy and carbon bar.\\nThe Company’s Plastics segment consists exclusively of a wholly-owned subsidiary that operates as Total Plastics, Inc. (“TPI”), headquartered in Kalamazoo, Michigan, and its wholly-owned subsidiaries. The Plastics segment stocks and distributes a wide variety of plastics in forms that include plate, rod, tube, clear sheet, tape, gaskets and fittings. Processing activities within this segment include cut-to-length, cut-to-shape, bending and forming according to customer specifications. The Plastics segment’s diverse customer base consists of companies in the retail (point-of-purchase), automotive, marine, office furniture and fixtures, safety products, life sciences applications, and general manufacturing industries. TPI has locations throughout the upper northeast and midwest regions of the U.S. and one facility in Florida from which it services a wide variety of users of industrial plastics.\\nThe accounting policies of all segments are the same as described in Note 1. Management evaluates the performance of its business segments based on operating income.\\nThe Company operates locations in the United States, Canada, Mexico, France, the United Kingdom, China and Singapore. No activity from any individual country outside the United States is material, and therefore, foreign activity is reported on an aggregate basis. Net sales are attributed to countries based on the location of the Company’s subsidiary that is selling direct to the customer. Company-wide geographic data as of and for the years ended December 31, 2012, 2011 and 2010 are as follows:\\n| 2012 | 2011 | 2010 |\\n| Net sales |\\n| United States | $ | 988,161 | $ | 895,165 | $ | 757,052 |\\n| All other countries | 282,207 | 237,201 | 186,654 |\\n| Total | $ | 1,270,368 | $ | 1,132,366 | $ | 943,706 |\\n| Long-lived assets |\\n| United States | $ | 68,253 | $ | 72,138 |\\n| All other countries | 11,387 | 10,003 |\\n| Total | $ | 79,640 | $ | 82,141 |\\n\\n48\\nSegment information as of and for the years ended December 31, 2012, 2011 and 2010 is as follows:\\n| NetSales | OperatingIncome(Loss) | TotalAssets | CapitalExpenditures | Depreciation &Amortization |\\n| 2012 |\\n| Metals segment (a) | $ | 1,143,884 | $ | 49,822 | $ | 693,803 | $ | 9,819 | $ | 24,480 |\\n| Plastics segment | 126,484 | 3,188 | 56,149 | 1,831 | 1,387 |\\n| Other (b) | — | (11,865 | ) | 38,854 | — | — |\\n| Consolidated | $ | 1,270,368 | $ | 41,145 | $ | 788,806 | $ | 11,650 | $ | 25,867 |\\n| 2011 |\\n| Metals segment (a) | $ | 1,014,130 | $ | 13,524 | $ | 729,692 | $ | 10,639 | $ | 19,329 |\\n| Plastics segment | 118,236 | 2,860 | 56,171 | 2,228 | 1,143 |\\n| Other (b) | — | (11,190 | ) | 36,460 | — | — |\\n| Consolidated | $ | 1,132,366 | $ | 5,194 | $ | 822,323 | $ | 12,867 | $ | 20,472 |\\n| 2010 |\\n| Metals segment | $ | 841,067 | $ | (5,478 | ) | $ | 454,345 | $ | 6,815 | $ | 19,392 |\\n| Plastics segment | 102,639 | 3,559 | 47,128 | 757 | 1,257 |\\n| Other (b) | — | (7,419 | ) | 27,879 | — | — |\\n| Consolidated | $ | 943,706 | $ | (9,338 | ) | $ | 529,352 | $ | 7,572 | $ | 20,649 |\\n\\n(a) The results of Tube Supply, acquired on December 15, 2011, are included in the Company's Metals segment.\\n(b) “Other” – Operating loss includes the costs of executive, legal and finance departments, which are shared by both the Metals and Plastics segments. The “Other” category’s total assets consist of the Company’s investment in joint venture.\\nBelow are reconciliations of segment data to the consolidated loss before income taxes:\\n| 2012 | 2011 | 2010 |\\n| Operating income (loss) | $ | 41,145 | $ | 5,194 | $ | (9,338 | ) |\\n| Interest expense, net | (41,090 | ) | (9,663 | ) | (4,988 | ) |\\n| Interest expense - unrealized loss on debt conversion option | (15,597 | ) | (3,991 | ) | — |\\n| Loss on extinguishment of debt | — | (6,153 | ) | — |\\n| Loss before income taxes and equity in earnings of joint venture | (15,542 | ) | (14,613 | ) | (14,326 | ) |\\n| Equity in earnings of joint venture | 7,224 | 11,727 | 5,585 |\\n| Consolidated loss before income taxes | $ | (8,318 | ) | $ | (2,886 | ) | $ | (8,741 | ) |\\n\\n(4) Lease Agreements\\nThe Company has operating and capital leases covering certain warehouse facilities, equipment, automobiles and trucks, with the lapse of time as the basis for all rental payments.\\nFuture minimum rental payments under operating and capital leases that have initial or remaining non-cancelable lease terms in excess of one year as of December 31, 2012, are as follows:\\n| Capital | Operating |\\n| 2013 | $ | 415 | $ | 14,401 |\\n| 2014 | 396 | 11,375 |\\n| 2015 | 392 | 10,091 |\\n| 2016 | 197 | 8,702 |\\n| 2017 | — | 8,007 |\\n| Later years | — | 24,130 |\\n| Total future minimum rental payments | $ | 1,400 | $ | 76,706 |\\n\\n49\\nTotal rental payments charged to expense were $15,579 in 2012, $12,362 in 2011, and $13,712 in 2010. Lease extrication charges of $1,215 associated with the consolidation of two of the Company’s facilities in the Metals segment were included in total rental payments charged to expense in 2010 within Warehouse, processing and delivery expense in the consolidated statements of operations and comprehensive loss. There were no lease extrication charges in 2012 and 2011. Total gross value of property, plant and equipment under capital leases was $1,895 and $2,698 in 2012 and 2011, respectively.\\n(5) Employee Benefit Plans\\nPension Plans\\nSubstantially all employees who meet certain requirements of age, length of service and hours worked per year are covered by Company-sponsored pension plans and supplemental pension plan (collectively, the “pension plans”). These pension plans are defined benefit, noncontributory plans. Benefits paid to retirees are based upon age at retirement, years of credited service and average earnings. The Company also has a supplemental pension plan, which is a non-qualified, unfunded plan. The Company uses a December 31 measurement date for the pension plans.\\nThe Company-sponsored pension plans are frozen for all employees except for employees of certain subsidiaries and employees represented by the United Steelworkers of America. The assets of the Company-sponsored pension plans are maintained in a single trust account.\\nThe Company’s funding policy is to satisfy the minimum funding requirements of the Employee Retirement Income Security Act of 1974, commonly called ERISA.\\nComponents of net periodic pension credit are as follows:\\n| 2012 | 2011 | 2010 |\\n| Service cost | $ | 608 | $ | 539 | $ | 623 |\\n| Interest cost | 6,832 | 7,393 | 7,456 |\\n| Expected return on assets | (9,855 | ) | (10,054 | ) | (9,342 | ) |\\n| Amortization of prior service cost | 324 | 324 | 231 |\\n| Amortization of actuarial loss | 594 | 229 | 237 |\\n| Net periodic pension credit | $ | (1,497 | ) | $ | (1,569 | ) | $ | (795 | ) |\\n\\nThe expected 2013 amortization of pension prior service cost and actuarial loss is $323 and $1,942, respectively.\\n50\\nThe status of the plans at December 31, 2012 and 2011 are as follows:\\n| 2012 | 2011 |\\n| Change in projected benefit obligation: |\\n| Projected benefit obligation at beginning of year | $ | 164,407 | $ | 144,235 |\\n| Service cost | 608 | 539 |\\n| Interest cost | 6,832 | 7,393 |\\n| Benefit payments | (6,558 | ) | (6,151 | ) |\\n| Actuarial loss | 15,848 | 18,391 |\\n| Projected benefit obligation at end of year | $ | 181,137 | $ | 164,407 |\\n| Change in plan assets: |\\n| Fair value of plan assets at beginning of year | $ | 174,938 | $ | 157,996 |\\n| Actual return on assets | 18,463 | 22,867 |\\n| Employer contributions | 307 | 226 |\\n| Benefit payments | (6,558 | ) | (6,151 | ) |\\n| Fair value of plan assets at end of year | $ | 187,150 | $ | 174,938 |\\n| Funded status – net prepaid | $ | 6,013 | $ | 10,531 |\\n| Amounts recognized in the consolidated balance sheets consist of: |\\n| Prepaid pension cost | $ | 12,891 | $ | 15,956 |\\n| Accrued liabilities | (309 | ) | (219 | ) |\\n| Pension benefit obligations | (6,569 | ) | (5,206 | ) |\\n| Net amount recognized | $ | 6,013 | $ | 10,531 |\\n| Pre-tax components of accumulated other comprehensive income (loss): |\\n| Unrecognized actuarial loss | $ | (29,778 | ) | $ | (23,131 | ) |\\n| Unrecognized prior service cost | (1,617 | ) | (1,942 | ) |\\n| Total | $ | (31,395 | ) | $ | (25,073 | ) |\\n| Accumulated benefit obligation | $ | 180,551 | $ | 163,874 |\\n\\nFor the plan with an accumulated benefit obligation in excess of plan assets, the projected benefit obligation, accumulated benefit obligation and fair value of plan assets were $5,893, $5,893 and $0, respectively, at December 31, 2012; and $5,425, $5,425 and $0, respectively, at December 31, 2011.\\nThe assumptions used to measure the projected benefit obligations for the Company’s defined benefit pension plans are as follows:\\n| 2012 | 2011 |\\n| Discount rate | 3.50 - 3.75% | 4.25 | % |\\n| Projected annual salary increases | 0 - 3.00% | 0 - 3.00% |\\n\\nThe assumptions used to determine net periodic pension credit are as follows:\\n| 2012 | 2011 | 2010 |\\n| Discount rate | 4.25 | % | 5.25 | % | 5.75 | % |\\n| Expected long-term rate of return on plan assets | 5.75 | % | 6.50 | % | 6.50 | % |\\n| Projected annual salary increases | 0 - 3.00% | 0 - 3.00% | 0 - 3.00% |\\n\\nThe Company’s expected return on plan assets is derived from reviews of asset allocation strategies and historical and anticipated future long-term performance of individual asset classes. The Company’s analysis gives consideration to historical returns and long-term, prospective rates of return.\\n51\\nThe Company’s pension plan assets are allocated entirely to fixed income securities at December 31, 2012 and 2011.\\nThe Company’s pension plans’ funds are managed in accordance with investment policies recommended by its investment advisor and approved by the Human Resources Committee of the Board of Directors. The overall target portfolio allocation is 100% fixed income securities. These funds’ conformance with style profiles and performance is monitored regularly by management, with the assistance of the Company’s investment advisor. Adjustments are typically made in the subsequent quarters when investment allocations deviate from the target range. The investment advisor provides quarterly reports to management and the Human Resources Committee of the Board of Directors.\\nThe fair values of the Company’s pension plan assets fall within the following levels of the fair value hierarchy as of December 31, 2012:\\n| Level 1 | Level 2 | Level 3 | Total |\\n| Fixed income securities (1) | $ | 10,562 | $ | 176,610 | $ | — | $ | 187,172 |\\n| Accounts payable – pending trades | (22 | ) |\\n| Total | $ | 187,150 |\\n\\n\\n| (1) | Fixed income securities are comprised of corporate bonds (75%), government bonds (16%), government agencies securities (6%) and other fixed income securities (3%). |\\n\\nThe fair values of the Company’s pension plan assets fall within the following levels of the fair value hierarchy as of December 31, 2011:\\n| Level 1 | Level 2 | Level 3 | Total |\\n| Fixed income securities (2) | $ | 9,949 | $ | 172,694 | $ | — | $ | 182,643 |\\n| Accounts payable – pending trades | (7,705 | ) |\\n| Total | $ | 174,938 |\\n\\n\\n| (2) | Fixed income securities are comprised of corporate bonds (74%), government bonds (16%), government agencies securities (7%) and other fixed income securities (3%). |\\n\\nThe estimated future pension benefit payments are:\\n| 2013 | $ | 7,974 |\\n| 2014 | 8,213 |\\n| 2015 | 8,828 |\\n| 2016 | 9,115 |\\n| 2017 | 9,607 |\\n| 2018 — 2022 | 51,839 |\\n\\nThe Company is also party to certain multi-employer pension plans. The overall cost of such plans to the Company is insignificant. If the Company withdraws from a multi-employer pension plan in the future, it could potentially incur a withdrawal liability at that time.\\nPostretirement Plan\\nThe Company also provides declining value life insurance to its retirees and a maximum of three years of medical coverage to qualified individuals who retire between the ages of 62 and 65. The Company does not fund these benefits in advance, and uses a December 31 measurement date.\\n52\\nComponents of net periodic postretirement benefit cost for 2012, 2011 and 2010 were as follows:\\n| 2012 | 2011 | 2010 |\\n| Service cost | $ | 161 | $ | 164 | $ | 177 |\\n| Interest cost | 170 | 222 | 219 |\\n| Amortization of prior service cost | — | — | 29 |\\n| Amortization of actuarial gain | — | — | (16 | ) |\\n| Net periodic postretirement benefit cost | $ | 331 | $ | 386 | $ | 409 |\\n\\nThe expected 2012, amortization of postretirement prior service cost and actuarial gain are insignificant.\\nThe status of the postretirement benefit plans at December 31, 2012 and 2011 were as follows:\\n| 2012 | 2011 |\\n| Change in accumulated postretirement benefit obligations: |\\n| Accumulated postretirement benefit obligation at beginning of year | $ | 4,635 | $ | 4,339 |\\n| Service cost | 161 | 164 |\\n| Interest cost | 170 | 222 |\\n| Benefit payments | (193 | ) | (100 | ) |\\n| Actuarial (gain) loss | (394 | ) | 10 |\\n| Accumulated postretirement benefit obligation at end of year | $ | 4,379 | $ | 4,635 |\\n| Funded status – net liability | $ | 4,379 | $ | 4,635 |\\n| Amounts recognized in the consolidated balance sheets consist of: |\\n| Accrued liabilities | $ | (296 | ) | $ | (218 | ) |\\n| Postretirement benefit obligations | (4,083 | ) | (4,417 | ) |\\n| Net amount recognized | $ | (4,379 | ) | $ | (4,635 | ) |\\n| Pre-tax components of accumulated other comprehensive income (loss): |\\n| Unrecognized actuarial gain | $ | 661 | $ | 266 |\\n| Total | $ | 661 | $ | 266 |\\n\\nThe assumed health care cost trend rates for medical plans at December 31 were as follows:\\n| 2012 | 2011 | 2010 |\\n| Medical cost trend rate | 8.00 | % | 8.50 | % | 8.00 | % |\\n| Ultimate medical cost trend rate | 5.00 | % | 5.00 | % | 5.00 | % |\\n| Year ultimate medical cost trend rate will be reached | 2019 | 2018 | 2013 |\\n\\nA 1% increase in the health care cost trend rate assumptions would have increased the accumulated postretirement benefit obligation at December 31, 2012 by $259 with no significant impact on the annual periodic postretirement benefit cost. A 1% decrease in the health care cost trend rate assumptions would have decreased the accumulated postretirement benefit obligation at December 31, 2012 by $235 with no significant impact on the annual periodic postretirement benefit cost.\\n53\\nThe weighted average discount rate used to determine the net periodic postretirement benefit costs and the accumulated postretirement benefit obligations were as follows:\\n| 2012 | 2011 | 2010 |\\n| Net periodic postretirement benefit costs | 3.75 | % | 5.25 | % | 5.75 | % |\\n| Accumulated postretirement benefit obligations | 3.50 | % | 3.75 | % | 5.25 | % |\\n\\nRetirement Savings Plan\\nThe Company’s retirement savings plan includes features under Section 401(k) of the Internal Revenue Code. Effective July 1, 2011, the Company’s 401(k) matching contribution was increased to 100% of each dollar on eligible employee contributions up to the first 6% of the employee’s pre-tax compensation and the Company’s fixed contribution of 4% of eligible earnings for all employees was eliminated. Company contributions cliff vest after two years of employment.\\nEffective July 1, 2012, the Company's 401(k) plan was amended to include the U.S. employees of Tube Supply. Employees were eligible to participate in the Company's 401(k) plan immediately. Tube Supply's existing plan assets were rolled over into the Company's 401(k) plan during 2012 as a result of this amendment.\\nThe amounts expensed are summarized below:\\n| 2012 | 2011 | 2010 |\\n| Supplemental contributions and 401(k) match | $ | 5,260 | $ | 4,414 | $ | 1,634 |\\n\\n(6) Joint Venture\\nKreher Steel Co., LLC is a 50% owned joint venture of the Company. It is a metals distributor of bulk quantities of alloy, special bar quality and stainless steel bars, headquartered in Melrose Park, Illinois.\\nThe following information summarizes the Company’s participation in the joint venture as of and for the year ended December 31:\\n| 2012 | 2011 | 2010 |\\n| Equity in earnings of joint venture | $ | 7,224 | $ | 11,727 | $ | 5,585 |\\n| Investment in joint venture | 38,854 | 36,460 | 27,879 |\\n| Sales to joint venture | 455 | 362 | 973 |\\n| Purchases from joint venture | 695 | 884 | 223 |\\n\\nThe following information summarizes financial data for this joint venture as of and for the year ended December 31:\\n| 2012 | 2011 | 2010 |\\n| Revenues | $ | 257,776 | $ | 269,657 | $ | 188,107 |\\n| Net income | 14,603 | 23,643 | 11,035 |\\n| Current assets | 92,421 | 111,263 | 71,611 |\\n| Non-current assets | 26,099 | 22,979 | 17,880 |\\n| Current liabilities | 14,315 | 59,952 | 32,828 |\\n| Non-current liabilities | 27,845 | 3,089 | 2,872 |\\n| Members’ equity | 76,360 | 71,199 | 53,791 |\\n| Capital expenditures | 5,259 | 6,736 | 2,271 |\\n| Depreciation and amortization | 2,034 | 1,603 | 1,720 |\\n\\n54\\n(7) Income Taxes\\n(Loss) Income before income taxes and equity in earnings of joint venture generated by the Company’s U.S. and non-U.S. operations were as follows:\\n| 2012 | 2011 | 2010 |\\n| U.S | $ | (28,398 | ) | $ | (26,321 | ) | $ | (19,420 | ) |\\n| Non-U.S. | 12,856 | 11,708 | 5,094 |\\n\\nThe Company’s income tax expense (benefit) is comprised of the following:\\n| 2012 | 2011 | 2010 |\\n| Federal |\\n| current | $ | (842 | ) | $ | (1,204 | ) | $ | 6,823 |\\n| deferred | (1,542 | ) | (2,041 | ) | (11,270 | ) |\\n| State |\\n| current | 629 | 461 | 17 |\\n| deferred | 401 | (1,218 | ) | (186 | ) |\\n| Foreign |\\n| current | 2,927 | 2,970 | 1,464 |\\n| deferred | (143 | ) | (94 | ) | 51 |\\n| $ | 1,430 | $ | (1,126 | ) | $ | (3,101 | ) |\\n\\nThe reconciliation between the Company’s effective tax rate on income or loss and the U.S. federal income tax rate of 35% is as follows:\\n| 2012 | 2011 | 2010 |\\n| Federal income tax at statutory rates | $ | (5,439 | ) | $ | (5,115 | ) | $ | (5,014 | ) |\\n| State income taxes, net of federal income tax benefits | 22 | (1,007 | ) | (313 | ) |\\n| Permanent items: |\\n| Dividends received deductions | (766 | ) | — | — |\\n| Convertible debt mark-to-market - non-deductible | 6,206 | 1,551 |\\n| Other permanent differences | 480 | 662 | 326 |\\n| Federal and state income tax on joint venture | 2,766 | 4,478 | 2,158 |\\n| Rate differential on foreign income | (1,680 | ) | (726 | ) | (755 | ) |\\n| Unrecognized tax benefits | (557 | ) | (576 | ) | 424 |\\n| Audit settlements | 218 | — | — |\\n| State rate changes | (68 | ) | (478 | ) | — |\\n| Other | 248 | 85 | 73 |\\n| Income tax expense (benefit) | $ | 1,430 | $ | (1,126 | ) | $ | (3,101 | ) |\\n| Effective income tax expense rate | 9.2 | % | 7.7 | % | 21.7 | % |\\n\\n55\\nSignificant components of the Company’s deferred tax assets and liabilities are as follows:\\n| 2012 | 2011 |\\n| Deferred tax assets: |\\n| Postretirement benefits | $ | 3,830 | $ | 3,675 |\\n| Deferred compensation | 1,940 | 1,916 |\\n| Deferred gain | — | 271 |\\n| Impairments | 1,452 | 1,311 |\\n| Alternative minimum tax and net operating loss carryforward | 3,487 | 2,635 |\\n| Total deferred tax assets | $ | 10,709 | $ | 9,808 |\\n| Deferred tax liabilities: |\\n| Depreciation | $ | 8,032 | $ | 8,307 |\\n| Inventory | 1,146 | 1,695 |\\n| Pension | 4,240 | 5,742 |\\n| Intangible assets and goodwill | 24,224 | 16,486 |\\n| Other, net | 1,665 | 1,475 |\\n| Total deferred tax liabilities | 39,307 | 33,705 |\\n| Net deferred tax liabilities | $ | 28,598 | $ | 23,897 |\\n\\nAs of December 31, 2012, the Company has federal, state and foreign net operating losses (\\\"NOLs\\\") as follows:\\n| Amount | Expiration Period |\\n| Federal | $ | — |\\n| State | 19,499 | 2015 to 2032 |\\n| Foreign | 2,473 | (a) |\\n\\n(a) Foreign NOLs of $369 expire in 2014 and $2,104 do not expire.\\nBased on all available evidence, including historical and forecasted financial results, the Company determined that it is more likely than not that the federal, state and foreign NOLs that have expiration dates will be realized due to the fact that the Company anticipates it will be able to have sufficient earnings in future years to use the NOL carryforwards prior to expiration. To the extent that the Company does not generate sufficient state or foreign taxable income within the statutory carryforward periods to utilize the NOL carryforwards in the respective jurisdictions, they will expire unused. However, based upon all available evidence, the Company has concluded that it will utilize these NOL carryforwards prior to the expiration period.\\nThe following table shows the net change in the Company’s unrecognized tax benefits:\\n| 2012 | 2011 | 2010 |\\n| Balance as of January 1 | $ | 861 | $ | 1,465 | $ | 726 |\\n| Increases (decreases) in unrecognized tax benefits: |\\n| Due to tax positions taken in prior years | — | 91 | 729 |\\n| Due to tax positions taken during the current year | 45 | 60 | 44 |\\n| Due to settlement with tax authorities | (757 | ) | — | (34 | ) |\\n| Due to expiration of statute | (44 | ) | (755 | ) | — |\\n| Balance as of December 31 | $ | 105 | $ | 861 | $ | 1,465 |\\n\\nUnrecognized tax benefits of $105, $861 and $950 would impact the effective tax rate if recognized as of December 31, 2012, 2011 and 2010, respectively. The accrued interest and penalties related to unrecognized tax benefits were insignificant at December 31, 2012 and 2011. The interest and penalties recorded by the Company were insignificant for the years ended December 31, 2012, 2011 and 2010.\\n56\\nDuring 2012 and 2011, statutes expired on certain unrecognized tax benefits of the Company. The reversal of the reserve of these unrecognized tax benefits was recorded as a component of overall income tax benefit for the years ended December 31, 2012 and 2011, respectively.\\nThe Company or its subsidiaries files income tax returns in the United States federal jurisdiction, 29 states, and 7 foreign jurisdictions.\\nThe following tax years remain open to examination by the major taxing jurisdictions to which the Company is subject:\\n| U.S. Federal | 2010 to 2011 |\\n| U.S. States | 2008 to 2011 |\\n| Foreign | 2007 to 2011 |\\n\\nDuring the second quarter of 2012, audits of the Company’s 2008 and 2009 U.S. federal income tax returns were concluded with no significant assessment. During 2011, the Company recognized $423 of tax benefits, excluding interest, due to the expiration of the statute of limitations for uncertain tax positions taken in prior years. Due to the potential for resolution of the examination or expiration of statutes of limitations, it is reasonably possible that the Company’s gross unrecognized tax benefits may change within the next 12 months by a range of zero to $60.\\nThe Company received its 2010 federal tax refund of $2,025 during February 2012 and its 2009 federal income tax refund of $6,344 during January 2011.\\n(8) Goodwill and Intangible Assets\\nThe changes in carrying amounts of goodwill during the years ended December 31, 2012 and 2011 were as follows:\\n| 2012 | 2011 |\\n| MetalsSegment | PlasticsSegment | Total | MetalsSegment | PlasticsSegment | Total |\\n| Balance as of January 1 |\\n| Goodwill | $ | 117,145 | $ | 12,973 | $ | 130,118 | $ | 97,354 | $ | 12,973 | $ | 110,327 |\\n| Accumulated impairment losses | (60,217 | ) | — | (60,217 | ) | (60,217 | ) | — | (60,217 | ) |\\n| 56,928 | 12,973 | 69,901 | 37,137 | 12,973 | 50,110 |\\n| Acquisition of Tube Supply | — | — | — | 19,637 | — | 19,637 |\\n| Currency valuation | 399 | — | 399 | 154 | — | 154 |\\n| Balance as of December 31 |\\n| Goodwill | 117,544 | 12,973 | 130,517 | 117,145 | 12,973 | 130,118 |\\n| Accumulated impairment losses | (60,217 | ) | — | (60,217 | ) | (60,217 | ) | — | (60,217 | ) |\\n| $ | 57,327 | $ | 12,973 | $ | 70,300 | $ | 56,928 | $ | 12,973 | $ | 69,901 |\\n\\nThe Company’s annual test for goodwill impairment is completed as of January 1st each year. Based on its January 1, 2012 test, the Company determined that there was no impairment of goodwill. The Company's year-to-date operating results, among other factors, are considered in determining whether it is more likely than not that the fair value for any reporting unit has declined below its carrying value, which would require the Company to perform an interim goodwill impairment test. Another recession or economic declines in specific industries could change management's expectations of future financial results and/or key valuation assumptions used in determining the fair-value of its reporting units, which could result in a goodwill impairment.\\n57\\nThe following summarizes the components of intangible assets at December 31, 2012 and 2011 :\\n| 2012 | 2011 |\\n| Gross CarryingAmount | AccumulatedAmortization | Gross CarryingAmount | AccumulatedAmortization |\\n| Customer relationships | $ | 119,118 | $ | 45,317 | $ | 118,567 | $ | 34,960 |\\n| Non-compete agreements | 3,888 | 3,235 | 3,888 | 2,902 |\\n| Trade names | 8,297 | 1,188 | 8,249 | 410 |\\n| Developed technology | 1,400 | 486 | 1,400 | 19 |\\n| Total | $ | 132,703 | $ | 50,226 | $ | 132,104 | $ | 38,291 |\\n\\nThe weighted-average amortization period for the intangible assets is 10.8 years, 11.3 years for customer relationships, 9.4 years for trade names, 3 years for non-compete agreements and 3 years for developed technology. Substantially all of the Company’s intangible assets were acquired as part of the acquisitions of Transtar on September 5, 2006 and Tube Supply on December 15, 2011.\\nFor the years ended December 31, 2012, 2011, and 2010, the aggregate amortization expense was $11,843, $6,867 and $7,071, respectively.\\nThe following is a summary of the estimated annual amortization expense for each of the next 5 years:\\n| 2013 | $ | 11,775 |\\n| 2014 | 11,742 |\\n| 2015 | 10,975 |\\n| 2016 | 10,975 |\\n| 2017 | 8,951 |\\n\\n(9) Debt\\nShort-term and long-term debt consisted of the following at December 31, 2012 and 2011:\\n| 2012 | 2011 |\\n| SHORT-TERM DEBT |\\n| Foreign | $ | 500 | $ | 500 |\\n| Total short-term debt | 500 | 500 |\\n| LONG-TERM DEBT |\\n| 12.75% Senior Secured Notes due December 15, 2016 | 225,000 | 225,000 |\\n| 7.0% Convertible Notes due December 15, 2017 | 57,500 | 57,500 |\\n| New Revolving Credit Facility due December 15, 2015 | 39,500 | 35,500 |\\n| Other, primarily capital leases | 1,400 | 244 |\\n| Total long-term debt | 323,400 | 318,244 |\\n| Plus: derivative liability for conversion feature associated with convertible debt | — | 26,440 |\\n| Less: unamortized discount | (26,831 | ) | (30,252 | ) |\\n| Less: current portion | (415 | ) | (192 | ) |\\n| Total long-term portion | 296,154 | 314,240 |\\n| TOTAL SHORT-TERM AND LONG-TERM DEBT | $ | 297,069 | $ | 314,932 |\\n\\nDuring December of 2011, in conjunction with the completion of the Acquisition (see Note 2), the Company issued $225,000 aggregate principal amount of 12.75% Senior Secured Notes due 2016 (the “Secured Notes”), $57,500 aggregate principal amount of 7.0% Convertible Senior Notes due 2017 (the “Convertible Notes”) and entered into a $100,000 senior secured asset based revolving credit facility (the “New Revolving Credit Facility”). Net proceeds from these transactions (collectively referred to as the “Debt Transactions”) were used to complete the Acquisition, repay existing debt and for general corporate purposes. The Company incurred debt origination fees of $18,136\\n58\\nassociated with the Debt Transactions which are primarily being amortized using the effective interest method and recognized interest expense of $3,375 for underwriting fees associated with the debt financing. The Company recognized a loss of $6,153 on the extinguishment of its previously existing debt which included prepayment fees and the write-off of previously existing deferred financing costs.\\nSecured Notes\\nThe Company filed a registration statement with the Securities and Exchange Commission on Form S-4 on April 11, 2012. The registration statement was declared effective on June 12, 2012.\\nOn June 12, 2012, the Company commenced an offer to exchange $225,000 principal amount of 12.75% Secured Notes due 2016, which are registered under the Securities Act of 1933 (the “New Secured Notes”), for $225,000 principal amount of outstanding 12.75% Senior Secured Notes due 2016, which had not been registered under the Securities Act of 1933 (the “Old Secured Notes”). The terms of the New Secured Notes issued are identical in all material respects to the Old Secured Notes, except that the New Secured Notes are registered under the Securities Act of 1933, do not have any of the transfer restrictions, registration rights and additional interest provisions relating to the Old Secured Notes and bear a different CUSIP number from the Old Secured Notes. The Company did not receive any proceeds from the exchange offer.\\nThe New Secured Notes will mature on December 15, 2016. The Company will pay interest on the New Secured Notes at a rate of 12.75% per annum in cash semi-annually. During 2012, interest payments totaling $28,688 were made on June 15, 2012 and December 14, 2012. The New Secured Notes are fully and unconditionally guaranteed, jointly and severally, by certain 100% owned domestic subsidiaries of the Company (the “Note Guarantors”). The New Secured Notes and the related guarantees are secured by a lien on substantially all of the Company's and the Note Guarantors' assets, subject to certain exceptions and permitted liens pursuant to a pledge and security agreement. The terms of the New Secured Notes contain numerous covenants imposing financial and operating restrictions on the Company's business. These covenants place restrictions on the Company's ability and the ability of its subsidiaries to, among other things, pay dividends, redeem stock or make other distributions or restricted payments; incur indebtedness or issue common stock; make certain investments; create liens; agree to payment restrictions affecting certain subsidiaries; consolidate or merge; sell or otherwise transfer or dispose of assets, including equity interests of certain subsidiaries; enter into transactions with affiliates, enter into sale and leaseback transactions; and use the proceeds of permitted sales of the Company's assets. Refer to Note 14 for Guarantor Financial Information disclosure.\\nOn or after December 15, 2014, the Company may redeem some or all of the New Secured Notes at a redemption premium of 106.375% of the principal amount for the 12-month period beginning December 15, 2014 and 100% thereafter, plus accrued and unpaid interest. Prior to December 15, 2014, the Company may redeem up to 35% of the aggregate principal amount of the New Secured Notes at a redemption price of 112.75% of the principal amount, plus accrued and unpaid interest, with the net cash proceeds of certain equity offerings. In addition, the Company may, at its option, redeem some or all of the New Secured Notes at any time prior to December 15, 2014, by paying a “make-whole” premium, plus accrued and unpaid interest.\\nThe New Secured Notes also contain a provision that allows holders of the New Secured Notes to require the Company to repurchase all or any part of the Secured Notes if a change of control triggering event occurs. Under this provision, the repurchase of the New Secured Notes will occur at a purchase price of 101% of the outstanding principal amount, plus accrued and unpaid interest, if any, on such New Secured Notes to the date of repurchase. In addition, upon certain asset sales, the Company may be required to offer to use the net proceeds thereof to purchase some of the New Secured Notes at 100% of the principal amount thereof, plus accrued and unpaid interest.\\nSubject to certain conditions, within 95 days after the end of each fiscal year, the Company must make an offer to purchase New Secured Notes with certain of its excess cash flow for such fiscal year (as defined in the indenture) for such fiscal year, commencing with the fiscal year ending December 31, 2012, at 103% of the principal amount thereof, plus accrued and unpaid interest. For the fiscal year ended December 31, 2012, the Company estimated excess cash flow (as defined in the indenture) to be approximately $17,000 and therefore, an offer to purchase New Secured Notes is required to be made within 95 days of year end.\\nAlthough redemption of the New Secured Notes is outside of the control of the Company, the New Secured Notes in the amount of $17,000 are reported as long-term debt as availability under the Company's revolving credit facility, which is long-term in nature, would be used if redemption occurred.\\n59\\nConvertible Notes\\nThe $50,000 Convertible Notes were issued pursuant to an indenture, dated as of December 15, 2011, among the Company, the Note Guarantors and U.S. Bank National Association, as trustee. The Convertible Notes were issued by the Company at an initial offering price equal to 100% of the principal amount. The Company granted the initial purchaser in the Convertible Notes offering an option, exercisable within 30 days, to purchase up to an additional $7,500 aggregate principal amount of Convertible Notes. The initial purchaser exercised their option in full and, on December 20, 2011, the Company issued an additional $7,500 aggregate principal amount of Convertible Notes.\\nThe Convertible Notes will mature on December 15, 2017. The Company will pay interest on the Convertible Notes at a rate of 7.0% in cash semi-annually. During 2012, interest payments totaling $4,025 were made on June 15, 2012 and December 14, 2012. The Convertible Notes will be fully and unconditionally guaranteed, jointly and severally, on a senior unsecured basis by the Note Guarantors. The initial conversion rate for the Convertible Notes will be 97.2384 shares of the Company’s common stock per $1 principal amount of Convertible Notes, equivalent to an initial conversion price of approximately $10.28 per share of common stock. The conversion rate will be subject to adjustment, but will not be adjusted for accrued and unpaid interest, if any. In addition, if an event constituting a fundamental change occurs, the Company will in some cases increase the conversion rate for a holder that elects to convert its Convertible Notes in connection with such fundamental change. Upon conversion, the Company will pay and/or deliver, as the case may be, cash, shares of common stock or a combination of cash and shares of common stock, at the Company’s election, together with cash in lieu of fractional shares.\\nHolders may convert their Convertible Notes at their option on any day prior to the close of business on the scheduled trading day immediately preceding June 15, 2017 only under the following circumstances: (1) during the five business-day period after any five consecutive trading-day period (the “measurement period”) in which the trading price per note for each day of that measurement period was less than 98% of the product of the last reported sale price of the Company’s common stock and the applicable conversion rate on each such day; (2) during any calendar quarter (and only during such calendar quarter) after the calendar quarter ended December 31, 2011, if the last reported sale price of the Company’s common stock for 20 or more trading days (whether or not consecutive) during the period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is equal to or greater than 130% of the applicable conversion price in effect for each applicable trading day; (3) upon the occurrence of specified corporate events, including certain dividends and distributions; or (4) if the Company calls the Convertible Notes for redemption on or after December 20, 2015. The Convertible Notes will be convertible, regardless of the foregoing circumstances, at any time from, and including, June 15, 2017 through the second scheduled trading day immediately preceding the maturity date.\\nPrior to April 26, 2012, the Company had the option to elect not to issue shares of common stock upon conversion of the Convertible Notes to the extent such election would result in the issuance of more than 19.99% of the common stock outstanding immediately before the issuance of the Convertible Notes until the Company receives shareholder approval for such issuance and shareholder approval of the increase in the number of shares of common stock authorized and available for issuance upon conversion of the Convertible Notes. Since the Company did not have sufficient authorized shares available to share-settle the conversion option in full, the embedded conversion option did not qualify for equity classification and instead was separately valued and accounted for as a derivative liability as of December 31, 2011. The initial value allocated to the derivative liability was $22,330 of the $57,500 principal amount of the Convertible Notes, which represents a discount to the debt to be amortized through interest expense using the effective interest method through the maturity of the Convertible Notes. Accordingly, the effective interest rate used to amortize the debt discount on the Convertible Notes was determined to be 17.78%. During each reporting period prior to April 26, 2012, the derivative liability was marked to fair value through earnings. As of December 31, 2011, the derivative liability, which is classified in long-term debt, had a fair value of $26,440. There was no derivative liability as of December 31, 2012.\\nOn April 26, 2012, at the Company's Annual Meeting of Stockholders, shareholder approval was obtained for the issuance of shares in excess of 20% of the Company's outstanding common stock to satisfy any conversions of the Convertible Notes. Additionally, shareholder approval was obtained to amend the Company's charter to authorize additional shares of common stock from 30,000 to 60,000. With these approvals, the Company now has the ability to share-settle the conversion option in full and therefore, the embedded conversion option is no longer required to be separately valued and accounted for as a derivative liability. As of April 26, 2012, the conversion option's cumulative value of $42,037 was reclassified to additional paid-in capital and will no longer be marked-to-market through earnings. The deferred tax benefit of $8,285 associated with the temporary difference between the financial reporting basis of the derivative liability and its tax basis at the date of issuance (December 15, 2011) was also reclassified to additional paid-in capital.\\n60\\nUpon a fundamental change, subject to certain exceptions, holders may require the Company to repurchase some or all of their Convertible Notes for cash at a repurchase price equal to 100% of the principal amount of the Convertible Notes being repurchased, plus any accrued and unpaid interest.\\nThe Company may not redeem the Convertible Notes prior to December 20, 2015. On or after December 20, 2015, the Company may redeem all or part of the Convertible Notes (except for the Convertible Notes that we are required to repurchase as described above) if the last reported sale price of the Company’s common stock exceeds 135% of the applicable conversion price for 20 or more trading days in a period of 30 consecutive trading days ending on the trading day immediately prior to the date of the redemption notice. The redemption price will equal the sum of 100% of the principal amount of the Convertible Notes to be redeemed, plus accrued and unpaid interest, plus a “make-whole premium” payment. The Company must make the \\\"make-whole\\\" premium payments on all Convertible Notes called for redemption including Convertible Notes converted after the date we delivered the notice of redemption. The Company will pay the redemption price in cash except for any non-cash portion of the \\\"make-whole\\\" premium.\\nNew Revolving Credit Facility\\nThe New Revolving Credit Facility consists of a $100,000 senior secured asset-based revolving credit facility (subject to adjustment pursuant to a borrowing base described below), of which (a) up to an aggregate principal amount of $20,000 will be available for a Canadian subfacility, (b) up to an aggregate principal amount of $20,000 will be available for letters of credit and (c) up to an aggregate principal amount of $10,000 will be available for swingline loans. Loans under the New Revolving Credit Facility will be made available to the Company and certain domestic subsidiaries (the “U.S. Borrowers”) in U.S. dollars and the Canadian Borrowers in U.S. dollars and Canadian dollars. The New Revolving Credit Facility will mature on December 15, 2015.\\nAll obligations of the U.S. Borrowers under the New Revolving Credit Facility are guaranteed on a senior secured basis by each direct and indirect, existing and future, domestic subsidiary of the U.S. Borrowers (the “U.S. Subsidiary Guarantors” and together with the U.S. Borrowers, the “U.S. Credit Parties”), subject to certain exceptions for immaterial subsidiaries. All obligations of the Canadian Borrowers under the New Revolving Credit Facility are guaranteed on a senior secured basis by (a) each U.S. Credit Party and (b) each direct and indirect, existing and future, Canadian subsidiary of the Company (the “Canadian Subsidiary Guarantors” and together with the Canadian Borrowers, the “Canadian Credit Parties”; and the U.S. Credit Parties together with the Canadian Credit Parties, the “Credit Parties”), subject to certain exceptions.\\nAll obligations under the New Revolving Credit Facility are secured on a first-priority basis by a perfected security interest in substantially all assets of the Credit Parties (subject to certain exceptions for permitted liens). The New Revolving Credit Facility will rank pari passu in right of payment with the Secured Notes, but, pursuant to the intercreditor agreement, the Secured Notes will be effectively subordinated to the indebtedness under the New Revolving Credit Facility with respect to the collateral.\\nAt the Company’s election, borrowings under the New Revolving Credit Facility will bear interest at variable rates based on (a) a customary base rate plus an applicable margin of between 0.50% and 1.00% (depending on quarterly average undrawn availability under the New Revolving Credit Facility) or (b) an adjusted LIBOR rate plus an applicable margin of between 1.50% and 2.00% (depending on quarterly average undrawn availability under the New Revolving Credit Facility). The weighted average interest rate on borrowings under the revolving credit facilities were 2.71% and 1.63% for the year ended December 31, 2012 and 2011, respectively. The Company will pay certain customary recurring fees with respect to the New Revolving Credit Facility.\\nThe New Revolving Credit Facility permits the Company to increase the aggregate amount of the commitments under the New Revolving Credit Facility from time to time in an aggregate amount for all such increases not to exceed $50,000, subject to certain conditions. The existing lenders under the New Revolving Credit Facility are not obligated to provide the incremental commitments.\\nThe New Revolving Credit facility contains a springing financial maintenance covenant requiring the Company to maintain the ratio of EBITDA (as defined in the agreement) to fixed charges of 1.1 to 1.0 when excess availability is less than the greater of 10% of the calculated borrowing base (as defined in the agreement) or $10,000. In addition, if excess availability is less than the greater of 12.5% of the calculated borrowing base (as defined in the agreement) or $12,500, the lender has the right to take full dominion of the Company’s cash collections and apply these proceeds to outstanding loans under the New Revolving Credit Agreement. As of December 31, 2012, the Company’s excess availability of $50,543 was above such thresholds.\\n61\\nNet interest expense reported on the consolidated statements of operations was reduced by interest income from investment of excess cash balances of $222 in 2012, $254 in 2011 and $201 in 2010.\\n(10) Fair Value Measurements\\nThe three-tier value hierarchy the Company utilizes, which prioritizes the inputs used in the valuation methodologies, is:\\nLevel 1—Valuations based on quoted prices for identical assets and liabilities in active markets.\\nLevel 2—Valuations based on observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data.\\nLevel 3—Valuations based on unobservable inputs reflecting our own assumptions, consistent with reasonably available assumptions made by other market participants.\\nThe fair value of cash, accounts receivable and accounts payable approximate their carrying values. The fair value of cash equivalents are determined using the fair value hierarchy described above. Cash equivalents consisting of money market funds are valued based on quoted prices in active markets and as a result are classified as Level 1.\\nThe Company’s pension plan asset portfolio as of December 31, 2012 and 2011 is primarily invested in fixed income securities, which generally fall within Level 2 of the fair value hierarchy. Fixed income securities in the are valued based on evaluated prices provided to the trustee by independent pricing services. Such prices may be determined by factors which include, but are not limited to, market quotations, yields, maturities, call features, ratings, institutional size trading in similar groups of securities and developments related to specific securities. Refer to Note 5 for pension fair value disclosures.\\nFair Value Measurements of Debt\\nThe fair value of the Company’s Senior Secured Notes as of December 31, 2012 was estimated to be $263,813 compared to a carrying value of $218,335, net of unamortized discount. The fair value for the Senior Secured Notes is determined based on recent trades of the bonds and fall within level 2 of the fair value hierarchy.\\nThe fair value of the Convertible Notes, as of December 31, 2012 was estimated to be approximately $95,000 compared to a carrying value of $37,334, net of unamortized discount. The fair value for the Convertible Notes, which fall within level 3 of the fair value hierarchy, is determined based on similar debt instruments that do not contain a conversion feature, as well as other factors related to the callable nature of the notes.\\nThe main inputs and assumptions into the fair value model for the Convertible Notes at December 31, 2012 were as follows:\\n| Company's stock price at the end of the period | $ | 14.77 |\\n| Expected volatility | 22.3 | % |\\n| Credit spreads | 8.22 | % |\\n| Risk-free interest rate | 0.36 | % |\\n\\nThe estimated fair value of the derivative liability for the conversion feature (refer to table below), which falls within level 3 of the fair value hierarchy, as of December 31, 2011 was computed using a binomial lattice model using the Company’s historical volatility over the term corresponding to the remaining contractual term of the Convertible Notes and observed spreads of similar debt instruments that do not include a conversion feature.\\nAs of December 31, 2012, the estimated fair value of the Company’s debt outstanding under its revolving credit facilities, which falls within level 3 of the fair value hierarchy, is $37,775 compared to its carrying value of $40,000, assuming the current amount of debt outstanding at the end of the year was outstanding until the maturity of the Company’s facility in December 2015. Although borrowings could be materially greater or less than the current amount of borrowings outstanding at the end of the year, it is not practical to estimate the amounts that may be outstanding during the future periods since there is no predetermined borrowing or repayment schedule.\\n62\\nFair Value Measurements of Commodity Hedges\\nThe Company has a commodity hedging program to mitigate risks associated with certain commodity price fluctuations. At December 31, 2012, the Company had executed forward contracts that extend through 2016. The counterparty to these contracts is not considered a credit risk by the Company. At December 31, 2012 and 2011, the notional value associated with forward contracts was $17,191 and $15,486, respectively. The Company recorded, through cost of materials, realized and unrealized losses of $430 and $2,377 during the years ended December 31, 2012 and 2011, respectively, as a result of the decline in the fair value of the contracts. There were no gains or losses recorded for commodity hedges during 2010. Refer to Note 13 for letters of credit outstanding for collateral associated with commodity hedges.\\nThe Company uses information which is representative of readily observable market data when valuing derivative liabilities associated with commodity hedges. The derivative liabilities are classified as Level 2 in the table below.\\nThe liabilities measured at fair value on a recurring basis were as follows:\\n| Level 1 | Level 2 | Level 3 | Total |\\n| As of December 31, 2012: |\\n| Derivative liability for commodity hedges | $ | — | $ | 2,494 | $ | — | $ | 2,494 |\\n| As of December 31, 2011: |\\n| Derivative liability for commodity hedges | $ | — | $ | 2,331 | $ | — | $ | 2,331 |\\n| Derivative liability for conversion feature associated with convertible debt | — | — | 26,440 | 26,440 |\\n\\nThe following reconciliation represents the change in fair value of Level 3 liabilities between January 1, 2012 and December 31, 2012:\\n| Derivative liability forconversion featureassociated withconvertible debt |\\n| Fair value as of January 1 | $ | 26,440 |\\n| Mark-to-market adjustment on conversion feature | 15,597 |\\n| Reclassification from long-term debt to additional paid-in capital | (42,037 | ) |\\n| Fair value as of December 31 | $ | — |\\n\\n(11) Share-based Compensation\\nThe Company accounts for its share-based compensation arrangements by recognizing compensation expense for the fair value of the share awards ratably over their vesting period or a shorter period, as applicable. The consolidated compensation cost recorded for the Company’s share-based compensation arrangements was $2,277, $4,349 and $2,411 for 2012, 2011 and 2010, respectively. The total income tax benefit recognized in the consolidated statements of operations for share-based compensation arrangements was $872, $1,534 and $831 in 2012, 2011 and 2010, respectively. All compensation expense related to share-based compensation arrangements is recorded in sales, general and administrative expense. The unrecognized compensation cost as of December 31, 2012 associated with all share-based payment arrangements is $4,973 and the weighted average period over which it is to be expensed is 1.4 years.\\n| Plan Description | Authorized Shares |\\n| 1995 Directors Stock Option Plan | 188 |\\n| 1996 Restricted Stock and Stock Option Plan | 938 |\\n| 2000 Restricted Stock and Stock Option Plan | 1,200 |\\n| 2004 Restricted Stock, Stock Option and Equity Compensation Plan | 1,350 |\\n| 2008 A. M. Castle & Co. Omnibus Incentive Plan (amended and restated as of April 28, 2011) | 2,750 |\\n\\n63\\nLong-Term Compensation and Incentive Plans\\nOn March 7, 2012, the Human Resources Committee (the “Committee”) of the Board of Directors of the Company approved equity awards under the Company’s 2012 Long-Term Compensation Plan (\\\"2012 LTC Plan\\\") for executive officers and other select personnel. The 2012 LTC Plan awards included restricted stock units (\\\"RSUs\\\") and performance share units (\\\"PSUs\\\"). All 2012 LTC Plan awards are subject to the terms of the Company's 2008 A.M. Castle & Co. Omnibus Incentive Plan.\\nOn March 2, 2011, the Committee approved equity awards under the Company's 2011 Long-Term Compensation Plan (\\\"2011 LTC Plan\\\") for executive officers and other select personnel. The 2011 LTC Plan awards included RSUs and PSUs. All 2011 LTC Plan awards are subject to the terms of the Company's 2008 A.M. Castle Omnibus Incentive Plan.\\nOn March 18, 2010, the Committee approved equity awards under the Company’s 2010 Long-Term Compensation Plan (“2010 LTC Plan”) for executive officers and other select personnel. The 2010 LTC Plan awards included RSUs, PSUs, and stock options. All 2010 LTC Plan awards are subject to the terms of the Company’s 2008 Restricted Stock, Stock Option and Equity Compensation Plan, amended and restated as of December 9, 2010.\\nUnless covered by a specific change-in-control or severance agreement, participants to whom RSUs, performance shares and other non-vested shares have been granted must be employed by the Company on the vesting date or at the end of the performance period, respectively, or the award will be forfeited. However, for stock option awards, unless a participant is covered by a specific change-in-control or severance agreement, options are forfeited in the event of the termination of employment other than by reason of disability or a retirement.\\nCompensation expense is recognized based on management’s estimate of the total number of share-based awards expected to vest at the end of the service period.\\nRestricted Share Units and Non-Vested Shares\\nThe RSUs granted under the 2012 and 2011 LTC Plans will cliff vest on December 31, 2014 and December 31, 2013, respectively. Approximately 78 RSUs granted under the 2010 LTC Plan cliff vested on December 31, 2012. Each RSU that becomes vested entitles the participant to receive one share of the Company’s common stock. The number of shares delivered may be reduced by the number of shares required to be withheld for federal and state withholding tax requirements (determined at the market price of Company shares at the time of payout).\\nThe outstanding non-vested share balance consists of shares issued to the Board of Directors during the second quarter of 2012 and shares issued for retention incentive purposes. The Director shares vest during the second quarter of 2015 and the balance of the shares vest on December 31, 2014. The RSU share balance consists of units granted to employees for incentive purposes.\\nThe fair value of the RSUs and non-vested shares is established using the market price of the Company’s stock on the date of grant.\\nA summary of the non-vested share and RSU activity is as follows:\\n| Shares | Units |\\n| Shares | Weighted-Average GrantDate Fair Value | Units | Weighted-Average GrantDate Fair Value |\\n| Outstanding at January 1, 2012 | 38 | $ | 18.74 | 232 | $ | 14.39 |\\n| Granted | 73 | $ | 12.22 | 309 | $ | 10.60 |\\n| Forfeited | (5 | ) | $ | 17.02 | (158 | ) | $ | 12.44 |\\n| Vested | (33 | ) | $ | 18.95 | (85 | ) | $ | 12.45 |\\n| Outstanding at December 31, 2012 | 73 | $ | 12.22 | 298 | $ | 12.05 |\\n| Expected to vest at December 31, 2012 | 73 | $ | 12.22 | 256 | $ | 12.36 |\\n\\nThe unrecognized compensation cost as of December 31, 2012 associated with RSU and non-vested share awards is $2,758. The total fair value of shares vested during the years ended December 31, 2012, 2011 and 2010 was $1,685, $2,166 and $600, respectively.\\n64\\nPerformance Shares\\nUnder the 2012, 2011 and 2010 LTC Plans, the potential award for the performance shares granted is dependent on the Company’s relative total shareholder return (“RTSR”), which represents a market condition, over a three-year performance period, beginning January 1, 2012, January 1, 2011 and January 1, 2010 and ending December 31, 2014, December 31, 2013 and December 31, 2012, respectively. RTSR is measured against a group of peer companies either in the metals industry or in the industrial products distribution industry (the “RTSR Peer Group”). The 2012, 2011 and 2010 LTC Plans provide with respect to performance shares for (1) a threshold level up to which the threshold level of performance shares will vest, a target performance level at which the target number of performance shares will vest, a maximum performance level at or above which the maximum number of performance shares will vest, and pro rata vesting between the threshold and maximum performance levels and (2) minimum and maximum vesting opportunities ranging from one-half up to two times the target number. The threshold, target and maximum performance levels for RTSR are the 25th, 50th and 75th percentile, respectively, relative to RTSR Peer Group performance. The number of performance shares, if any, that vest based on the performance achieved during the three-year performance period, will vest at the end of the three-year performance period. Compensation expense for performance awards containing a market condition is recognized regardless of whether the market condition is achieved to the extent the requisite service period condition is met. Each performance share that becomes vested entitles the participant to receive one share of the Company’s common stock. The number of shares delivered may be reduced by the number of shares required to be withheld for federal and state withholding tax requirements (determined at the market price of Company shares at the time of payout).\\nUnder the 2012 and 2011 LTC Plans, the potential award for performance shares containing a non-market-based performance condition is determined based on the Company's actual performance versus Company-specific target goals for Return on Invested Capital (“ROIC”), as defined in the 2012 and 2011 LTC Plans. Under the 2012 LTC Plan, the non-market-based performance condition is determined based on the Company's average actual performance versus Company-specific goals for ROIC for the three-year performance period beginning on January 1st of the year of grant. Under the 2011 LTC Plan, the non-market-based performance condition is determined for any one or more fiscal years during the three-year performance period beginning on January 1st of the year of grant. Partial performance awards can be earned for performance less than the target goal, but in excess of minimum goals and award distributions twice the target can be achieved if the maximum goals are met or exceeded. The number of performance shares, if any, that vest based on the performance achieved during the three-year performance period, will vest at the end of the three-year performance period. Compensation expense recognized is based on management’s expectation of future performance compared to the pre-established performance goals. If the performance goals are not expected to be met, no compensation expense is recognized and any previously recognized compensation expense is reversed.\\nThe grant date fair values of performance shares awarded containing the RTSR market-based performance condition was estimated using a Monte Carlo simulation with the following assumptions:\\n| 2012 | 2011 | 2010 |\\n| Grant Date Fair Value per Share | $ | 13.78 | $ | 23.89 | $ | 12.26 |\\n| Expected volatility | 85.0 | % | 62.0 | % | 61.6 | % |\\n| Risk-free interest rate | 0.40 | % | 1.10 | % | 1.45 | % |\\n| Expected life (in years) | 2.81 | 2.84 | 2.80 |\\n| Expected dividend yield | — | — | — |\\n\\nPerformance awards under the active LTC Plans were granted to the Company's new CEO in October 2012. The grant date fair values of performance shares awarded to the CEO containing the RTSR market-based performance condition was estimated using a Monte Carlo simulation with the following assumptions:\\n| 2012 | 2011 | 2010 |\\n| Grant Date Fair Value per Share | $ | 16.65 | $ | 10.61 | $ | 5.57 |\\n| Expected volatility | 60.7 | % | 60.7 | % | 60.7 | % |\\n| Risk-free interest rate | 0.34 | % | 0.34 | % | 0.34 | % |\\n| Expected life (in years) | 2.21 | 1.21 | 0.21 |\\n| Expected dividend yield | — | — | — |\\n\\n65\\nFinal award vesting and distribution of performance awards granted under the 2010 LTC Plan was determined based on the Company’s actual performance versus the target goals for a three-year consecutive period (as defined in the 2010 Plan). Refer to the table below for the number of shares expected to be issued under 2010 LTC Plan.\\n| Plan Year | Grant Date Fair Value | Estimated Number ofPerformance Shares to be Issued | Maximum Number ofPerformance Shares thatcould Potentially be Issued |\\n| 2012 LTC Plan |\\n| Market-based performance condition | $ | 13.78 | 172 | 244 |\\n| Market-based performance condition (1) | $ | 16.65 | 41 | 58 |\\n| Non-market-based performance condition | $ | 10.02 | — | 244 |\\n| Non-market-based performance condition (1) | $ | 12.74 | — | 58 |\\n| 2011 LTC Plan |\\n| Market-based performance condition | $ | 23.89 | 39 | 131 |\\n| Market-based performance condition (1) | $ | 10.61 | 9 | 32 |\\n| Non-market-based performance condition | $ | 17.13 | — | 131 |\\n| Non-market-based performance condition (1) | $ | 12.74 | — | 32 |\\n| 2010 LTC Plan |\\n| Market-based performance condition | $ | 12.26 | 83 | 237 |\\n| Market-based performance condition (1) | $ | 5.57 | 2 | 5 |\\n\\n(1) Represents the status of performance awards granted under the active LTC Plans in October 2012.\\nThe unrecognized compensation cost as of December 31, 2012 associated with the 2012 and 2011 LTC Plans performance shares is $2,145.\\nStock Options\\nThere were no stock options issued under the 2012 or 2011 LTC Plans. The stock options issued under the 2010 LTC Plan vest and become exercisable three years from the date of the grant. The term of the options is eight years. The exercise price of the options is $12.79 per share. The grant date fair value of $5.71 per share was estimated using the Black-Scholes option-pricing model with the following assumptions:\\n| 2010 |\\n| Expected volatility | 58.5 | % |\\n| Risk-free interest rate | 2.3 | % |\\n| Expected life (in years) | 5.5 |\\n| Expected dividend yield | 1.2 | % |\\n\\n| Shares | WeightedAverageExercise Price | IntrinsicValue | Weighted AverageRemainingContractual Life |\\n| Stock options outstanding at January 1, 2012 | 418 | $ | 12.44 |\\n| Exercised | (16 | ) | $ | 9.11 |\\n| Forfeited | (113 | ) | $ | 15.56 |\\n| Expired | (19 | ) | $ | 12.60 |\\n| Stock options outstanding at December 31, 2012 | 270 | $ | 11.34 | $ | 937 | 3.8 |\\n| Stock options exercisable at December 31, 2012 | 111 | $ | 9.25 | $ | 621 | 1.5 |\\n| Stock options vested or expected to vest as of December 31, 2012 | 259 | $ | 11.28 | $ | 915 | 3.7 |\\n\\n66\\nThe total intrinsic value of options exercised during the years ended December 31, 2012, 2011 and 2010, was $36, $194 and $219, respectively. The unrecognized compensation cost as of December 31, 2012 associated with stock options is $70.\\n(12) Stockholders' Equity\\nShareholder Rights Plan\\nIn August 2012, the Company's Board of Directors adopted a Shareholder Rights Plan (the “Rights Plan”) and declared a dividend of one right for each outstanding share of the Company's common stock outstanding at the close of business on September 11, 2012. Pursuant to the Rights Plan, the Company is issuing one preferred stock purchase right (a “Right”) for each share of common stock outstanding on September 11, 2012. Each Right, once exercisable, represents the right to purchase one one-hundredth of a share (a “Unit”) of Series B Junior Preferred Stock of the Company, without par value, for $54.00, subject to adjustment. The Rights become exercisable in the event any individual person or entity, without Board approval, acquires 10% or more of the Company's common stock, subject to certain exceptions. In these circumstances, each holder of a Right (other than rights held by the acquirer) will be entitled to purchase, at the then-current exercise price of the Right, additional shares of the Company's common stock having a value of twice the exercise price of the Right. Additionally, if the Company is involved in a merger or other business combination transaction with another person after which its common stock does not remain outstanding, each Right will entitle its holder to purchase, at the then-current exercise price of the Right, shares of common stock of the ultimate parent of such other person having a market value of twice the exercise price of the Right. The Rights may be redeemed by the Company for $0.001 per Right at any time until the tenth business day following the first public announcement of an acquisition of beneficial ownership of 10% of the Company's common stock. The Rights Plan will expire on August 30, 2013.\\nAccumulated Other Comprehensive Loss\\nAccumulated other comprehensive loss as reported in the consolidated balance sheets as of December 31, 2012 and 2011 was comprised of the following:\\n| 2012 | 2011 |\\n| Foreign currency translation losses | $ | (2,322 | ) | $ | (4,691 | ) |\\n| Unrecognized pension and postretirement benefit costs, net of tax | (18,749 | ) | (15,133 | ) |\\n| Total accumulated other comprehensive loss | $ | (21,071 | ) | $ | (19,824 | ) |\\n\\n(13) Commitments and Contingent Liabilities\\nAs of December 31, 2012, the Company had $6,794 of irrevocable letters of credit outstanding which primarily consisted of $4,000 for collateral associated with commodity hedges and $1,994 for compliance with the insurance reserve requirements of its workers’ compensation insurance carriers.\\nThe Company is party to a variety of legal proceedings and other claims, including proceedings by government authorities, which arise from the operation of its business. These proceedings are incidental and occur in the normal course of the Company's business affairs. The majority of these claims and proceedings relate to commercial disputes with customers, suppliers, and others; employment, including benefit matters; product quality; and environmental, health and safety claims. It is the opinion of management that the currently expected outcome of these proceedings and claims, after taking into account recorded accruals and the availability and limits of our insurance coverage, will not have a material adverse effect on the consolidated results of operations, financial condition or cash flows of the Company.\\nIn 2011, the Company determined that it inadvertently exported certain aluminum alloy bar that are listed on the U.S. Bureau of Industry and Security's (BIS) Commerce Control List to countries where there is an export license requirement if an exception is not otherwise available. The exports, which occurred in 2011, had a total transaction value of approximately $13 and were made without export licenses. The exports involved five shipments to the Company's wholly-owned subsidiary in China and to a customer in the Philippines. In response thereto, the Company submitted a voluntary self-disclosure describing the nature of these shipments to the Office of Export Enforcement of the Department of Commerce (OEE) in accordance with applicable Export Administration Regulations. The Company previously disclosed similar incidents to BIS in 2008, which were resolved in September 2011 through the payment of a $775 civil penalty and a commitment to satisfy certain compliance and reporting obligations. If it is determined that the Company failed to comply with the applicable U.S. export regulations, the OEE could assess civil penalties of up to $1,250, restrict export privileges or provide an administrative warning.\\n67\\nWhile the ultimate disposition of this matter cannot be predicted with certainty, it is the opinion of management, based on the information available at this time, that the outcome of this matter will not have a material effect on the Company's financial position, results of operations or cash flows.\\n(14) Guarantor Financial Information\\nThe accompanying consolidating financial information has been prepared and presented pursuant to Rule 3-10 of SEC Regulation S-X “Financial Statements of Guarantors and Issuers of Guaranteed Securities Registered or Being Registered.” The consolidating financial information presents A. M. Castle & Co. (Parent) and subsidiaries. The consolidating financial information has been prepared on the same basis as the consolidated statements of the Parent. The equity method of accounting is followed within this financial information.\\nIn September 2012, the Company merged Tube Supply, LLC, a guarantor, with the Parent. The Company has reflected this change in its accompanying consolidating financial statements of guarantors and non-guarantors.\\n68\\n| Condensed Consolidating Balance SheetAs of December 31, 2012 |\\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\\n| Assets |\\n| Current assets |\\n| Cash and cash equivalents | $ | 3,332 | $ | 1,677 | $ | 16,598 | $ | — | $ | 21,607 |\\n| Accounts receivable, less allowance for doubtful accounts | 60,293 | 34,037 | 43,981 | — | 138,311 |\\n| Receivables from affiliates | 95 | 1,118 | 668 | (1,881 | ) | — |\\n| Inventories | 183,189 | 44,874 | 75,777 | (68 | ) | 303,772 |\\n| Prepaid expenses and other current assets | 16,141 | (1,490 | ) | 8,239 | (202 | ) | 22,688 |\\n| Total current assets | 263,050 | 80,216 | 145,263 | (2,151 | ) | 486,378 |\\n| Investment in joint venture | 38,854 | — | — | — | 38,854 |\\n| Goodwill | 12,921 | 41,556 | 15,823 | — | 70,300 |\\n| Intangible assets | 34,343 | 28,325 | 19,809 | — | 82,477 |\\n| Other assets | 28,142 | (98 | ) | 3,113 | — | 31,157 |\\n| Investment in subsidiaries | 245,798 | 11,526 | — | (257,324 | ) | — |\\n| Receivables from affiliates | 62,696 | 83,891 | 3,280 | (149,867 | ) | — |\\n| Property, plant and equipment, net | 52,424 | 15,403 | 11,813 | — | 79,640 |\\n| Total assets | $ | 738,228 | $ | 260,819 | $ | 199,101 | $ | (409,342 | ) | $ | 788,806 |\\n| Liabilities and Stockholders’ Equity |\\n| Current liabilities |\\n| Accounts payable | $ | 40,510 | $ | 13,434 | $ | 14,046 | $ | — | $ | 67,990 |\\n| Payables due to affiliates | 742 | 95 | 1,044 | (1,881 | ) | — |\\n| Other current liabilities | 26,566 | 3,478 | 8,083 | — | 38,127 |\\n| Current portion of long-term debt and short-term debt | 386 | 1 | 528 | — | 915 |\\n| Total current liabilities | 68,204 | 17,008 | 23,701 | (1,881 | ) | 107,032 |\\n| Long-term debt, less current portion | 292,086 | — | 4,068 | — | 296,154 |\\n| Payables due to affiliates | 12,114 | 11,994 | 125,759 | (149,867 | ) | — |\\n| Deferred income taxes | 14,209 | 18,614 | (473 | ) | — | 32,350 |\\n| Other non-current liabilities | 14,275 | 1,339 | 316 | — | 15,930 |\\n| Stockholders’ equity | 337,340 | 211,864 | 45,730 | (257,594 | ) | 337,340 |\\n| Total liabilities and stockholders’ equity | $ | 738,228 | $ | 260,819 | $ | 199,101 | $ | (409,342 | ) | $ | 788,806 |\\n\\n69\\n| Condensed Consolidating Balance SheetAs of December 31, 2011 |\\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\\n| Assets |\\n| Current assets |\\n| Cash and cash equivalents | $ | 11,534 | $ | 582 | $ | 18,408 | $ | — | $ | 30,524 |\\n| Accounts receivable, less allowance for doubtful accounts | 88,434 | 37,487 | 55,115 | — | 181,036 |\\n| Receivables from affiliates | 273 | 3,495 | 146 | (3,914 | ) | — |\\n| Inventories | 163,776 | 48,980 | 59,547 | (264 | ) | 272,039 |\\n| Prepaid expenses and other current assets | 18,517 | (3,331 | ) | 3,483 | — | 18,669 |\\n| Total current assets | 282,534 | 87,213 | 136,699 | (4,178 | ) | 502,268 |\\n| Investment in joint venture | 36,460 | — | — | — | 36,460 |\\n| Goodwill | 12,921 | 41,556 | 15,424 | — | 69,901 |\\n| Intangible assets | 38,238 | 34,395 | 21,180 | — | 93,813 |\\n| Other assets | 34,691 | 237 | 2,812 | — | 37,740 |\\n| Investment in subsidiaries | 243,823 | 12,151 | — | (255,974 | ) | — |\\n| Receivables from affiliates | 66,878 | 71,041 | 7,292 | (145,211 | ) | — |\\n| Property, plant and equipment, net | 56,266 | 15,416 | 10,459 | — | 82,141 |\\n| Total assets | $ | 771,811 | $ | 262,009 | $ | 193,866 | $ | (405,363 | ) | $ | 822,323 |\\n| Liabilities and Stockholders’ Equity |\\n| Current liabilities |\\n| Accounts payable | $ | 84,437 | $ | 14,826 | $ | 17,611 | $ | — | $ | 116,874 |\\n| Payables due to affiliates | 1,387 | 76 | 2,451 | (3,914 | ) | — |\\n| Other current liabilities | 25,895 | 4,459 | 5,358 | — | 35,712 |\\n| Current portion of long-term debt and short-term debt | 82 | 50 | 560 | — | 692 |\\n| Total current liabilities | 111,801 | 19,411 | 25,980 | (3,914 | ) | 153,278 |\\n| Long-term debt, less current portion | 303,739 | 1 | 10,500 | — | 314,240 |\\n| Payables due to affiliates | 23,727 | 8,572 | 112,912 | (145,211 | ) | — |\\n| Deferred income taxes | 6,280 | 19,647 | (277 | ) | — | 25,650 |\\n| Other non-current liabilities | 13,985 | 2,324 | 567 | — | 16,876 |\\n| Stockholders’ equity | 312,279 | 212,054 | 44,184 | (256,238 | ) | 312,279 |\\n| Total liabilities and stockholders’ equity | $ | 771,811 | $ | 262,009 | $ | 193,866 | $ | (405,363 | ) | $ | 822,323 |\\n\\n70\\n| Condensed Consolidating Statement of Operations and Comprehensive (Loss) IncomeFor the year ended December 31, 2012 |\\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\\n| Net Sales | $ | 755,642 | $ | 270,644 | $ | 282,274 | $ | (38,192 | ) | $ | 1,270,368 |\\n| Costs and expenses: |\\n| Cost of materials (exclusive of depreciation and amortization) | 548,659 | 199,004 | 217,749 | (38,125 | ) | 927,287 |\\n| Warehouse, processing and delivery expense | 91,628 | 32,459 | 24,169 | — | 148,256 |\\n| Sales, general and administrative expense | 75,497 | 30,351 | 21,965 | — | 127,813 |\\n| Depreciation and amortization expense | 12,955 | 8,888 | 4,024 | — | 25,867 |\\n| Operating income (loss) | 26,903 | (58 | ) | 14,367 | (67 | ) | 41,145 |\\n| Interest expense, net | (25,820 | ) | — | (15,270 | ) | — | (41,090 | ) |\\n| Interest expense - unrealized loss on debt conversion option | (15,597 | ) | — | — | — | (15,597 | ) |\\n| Loss before income taxes and equity in earnings of subsidiaries and joint venture | (14,514 | ) | (58 | ) | (903 | ) | (67 | ) | (15,542 | ) |\\n| Income taxes | (1,805 | ) | 475 | 102 | (202 | ) | (1,430 | ) |\\n| Equity in (losses) earnings of subsidiaries | (653 | ) | (1,203 | ) | — | 1,856 | — |\\n| Equity in earnings of joint venture | 7,224 | — | — | — | 7,224 |\\n| Net (loss) income | (9,748 | ) | (786 | ) | (801 | ) | 1,587 | (9,748 | ) |\\n| Comprehensive (loss) income: |\\n| Foreign currency translation gains (losses) | 2,369 | 578 | 2,369 | (2,947 | ) | 2,369 |\\n| Unrecognized pension and postretirement benefit costs, net of tax | (3,616 | ) | — | — | — | (3,616 | ) |\\n| Other comprehensive (loss) income | (1,247 | ) | 578 | 2,369 | (2,947 | ) | (1,247 | ) |\\n| Net loss | (9,748 | ) | (786 | ) | (801 | ) | 1,587 | (9,748 | ) |\\n| Comprehensive (loss) income | $ | (10,995 | ) | $ | (208 | ) | $ | 1,568 | $ | (1,360 | ) | $ | (10,995 | ) |\\n\\n71\\n| Condensed Consolidating Statement of Operations Comprehensive (Loss) IncomeFor the year ended December 31, 2011 |\\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\\n| Net Sales | $ | 621,036 | $ | 283,290 | $ | 237,201 | $ | (9,161 | ) | $ | 1,132,366 |\\n| Costs and expenses: |\\n| Cost of materials (exclusive of depreciation and amortization) | 466,133 | 207,269 | 181,104 | (8,897 | ) | 845,609 |\\n| Warehouse, processing and delivery expense | 80,543 | 33,828 | 20,527 | — | 134,898 |\\n| Sales, general and administrative expense | 74,154 | 31,807 | 20,232 | — | 126,193 |\\n| Depreciation and amortization expense | 8,874 | 8,910 | 2,688 | — | 20,472 |\\n| Operating (loss) income | (8,668 | ) | 1,476 | 12,650 | (264 | ) | 5,194 |\\n| Interest expense, net | (4,982 | ) | — | (4,681 | ) | — | (9,663 | ) |\\n| Interest expense - unrealized loss on debt conversion option | (3,991 | ) | (3,991 | ) |\\n| Loss on extinguishment of debt | (6,153 | ) | — | — | — | (6,153 | ) |\\n| (Loss) income before income taxes and equity in earnings of subsidiaries and joint venture | (23,794 | ) | 1,476 | 7,969 | (264 | ) | (14,613 | ) |\\n| Income taxes | 3,267 | (433 | ) | (1,708 | ) | — | 1,126 |\\n| Equity in earnings of subsidiaries | 7,040 | (209 | ) | — | (6,831 | ) | — |\\n| Equity in earnings of joint venture | 11,727 | — | — | — | 11,727 |\\n| Net (loss) income | (1,760 | ) | 834 | 6,261 | (7,095 | ) | (1,760 | ) |\\n| Comprehensive (loss) income: |\\n| Foreign currency translation (losses) gains | (941 | ) | 1,180 | (941 | ) | (239 | ) | (941 | ) |\\n| Unrecognized pension and postretirement benefit costs, net of tax | (3,071 | ) | — | — | — | (3,071 | ) |\\n| Other comprehensive (loss) income | (4,012 | ) | 1,180 | (941 | ) | (239 | ) | (4,012 | ) |\\n| Net (loss) income | (1,760 | ) | 834 | 6,261 | (7,095 | ) | (1,760 | ) |\\n| Comprehensive (loss) income | $ | (5,772 | ) | $ | 2,014 | $ | 5,320 | $ | (7,334 | ) | $ | (5,772 | ) |\\n\\n72\\n| Condensed Consolidating Statement of Operations Comprehensive (Loss) IncomeFor the year ended December 31, 2010 |\\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\\n| Net Sales | $ | 498,848 | $ | 266,491 | $ | 186,654 | $ | (8,287 | ) | $ | 943,706 |\\n| Costs and expenses: |\\n| Cost of materials (exclusive of depreciation and amortization) | 369,865 | 195,184 | 144,092 | (8,287 | ) | 700,854 |\\n| Warehouse, processing and delivery expense | 72,234 | 33,250 | 17,834 | — | 123,318 |\\n| Sales, general and administrative expense | 61,751 | 29,684 | 16,788 | — | 108,223 |\\n| Depreciation and amortization expense | 8,665 | 9,114 | 2,870 | — | 20,649 |\\n| Operating (loss) income | (13,667 | ) | (741 | ) | 5,070 | — | (9,338 | ) |\\n| Interest expense, net | (1,008 | ) | — | (3,980 | ) | — | (4,988 | ) |\\n| (Loss) income before income taxes and equity in earnings of subsidiaries and joint venture | (14,675 | ) | (741 | ) | 1,090 | — | (14,326 | ) |\\n| Income taxes | 3,106 | 420 | (425 | ) | — | 3,101 |\\n| Equity in earnings of subsidiaries | 344 | 110 | — | (454 | ) | — |\\n| Equity in earnings of joint venture | 5,585 | — | — | — | 5,585 |\\n| Net (loss) income | (5,640 | ) | (211 | ) | 665 | (454 | ) | (5,640 | ) |\\n| Comprehensive (loss) income: |\\n| Foreign currency translation (losses) gains | (536 | ) | (2,337 | ) | (536 | ) | 2,873 | (536 | ) |\\n| Unrecognized pension and postretirement benefit costs, net of tax | (1,748 | ) | — | — | — | (1,748 | ) |\\n| Other comprehensive (loss) income | (2,284 | ) | (2,337 | ) | (536 | ) | 2,873 | (2,284 | ) |\\n| Net (loss) income | (5,640 | ) | (211 | ) | 665 | (454 | ) | (5,640 | ) |\\n| Comprehensive (loss) income | $ | (7,924 | ) | $ | (2,548 | ) | $ | 129 | $ | 2,419 | $ | (7,924 | ) |\\n\\n73\\n| Condensed Consolidating Statement of Cash FlowsFor the year ended December 31, 2012 |\\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\\n| Operating activities: |\\n| Net (loss) income | $ | (9,748 | ) | $ | (786 | ) | $ | (801 | ) | $ | 1,587 | $ | (9,748 | ) |\\n| Equity in losses of subsidiaries | 653 | 1,203 | — | (1,856 | ) | — |\\n| Adjustments to reconcile net (loss) income to cash provided by operating activities | 10,688 | 12,951 | (8,809 | ) | 269 | 15,099 |\\n| Net cash from (used in) operating activities | 1,593 | 13,368 | (9,610 | ) | — | 5,351 |\\n| Investing activities: |\\n| Acquisition/Investment of businesses, net of cash acquired | (6,472 | ) | — | — | — | (6,472 | ) |\\n| Capital expenditures | (5,336 | ) | (2,802 | ) | (2,983 | ) | — | (11,121 | ) |\\n| Other investing activities, net | — | 6 | 147 | — | 153 |\\n| Net cash used in investing activities | (11,808 | ) | (2,796 | ) | (2,836 | ) | — | (17,440 | ) |\\n| Financing activities: |\\n| Proceeds from long-term debt, including new revolving credit facility | 756,550 | — | 10,540 | — | 767,090 |\\n| Repayments of long-term debt, including new revolving credit facility | (745,839 | ) | (49 | ) | (16,999 | ) | — | (762,887 | ) |\\n| Payment of debt issue costs | (1,503 | ) | — | — | — | (1,503 | ) |\\n| Net intercompany (repayments) borrowings | (7,431 | ) | (9,428 | ) | 16,859 | — | — |\\n| Other financing | 236 | — | (27 | ) | — | 209 |\\n| Net cash from (used in) financing activities | 2,013 | (9,477 | ) | 10,373 | — | 2,909 |\\n| Effect of exchange rate changes on cash and cash equivalents | — | — | 263 | — | 263 |\\n| (Decrease) increase in cash and cash equivalents | (8,202 | ) | 1,095 | (1,810 | ) | — | (8,917 | ) |\\n| Cash and cash equivalents - beginning of year | 11,534 | 582 | 18,408 | — | 30,524 |\\n| Cash and cash equivalents - end of period | $ | 3,332 | $ | 1,677 | $ | 16,598 | $ | — | $ | 21,607 |\\n\\n74\\n| Condensed Consolidating Statement of Cash FlowsFor the year ended December 31, 2011 |\\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\\n| Operating activities: |\\n| Net (loss) income | $ | (1,760 | ) | $ | 834 | $ | 6,261 | $ | (7,095 | ) | $ | (1,760 | ) |\\n| Equity in earnings of subsidiaries | (7,040 | ) | 209 | — | 6,831 | — |\\n| Adjustments to reconcile net (loss) income to cash provided by operating activities | 10,232 | 15,095 | (70,119 | ) | 264 | (44,528 | ) |\\n| Net cash from (used in) operating activities | 1,432 | 16,138 | (63,858 | ) | — | (46,288 | ) |\\n| Investing activities: |\\n| Acquisition/Investment of businesses, net of cash acquired | (175,836 | ) | — | 1,592 | (174,244 | ) |\\n| Capital expenditures | (6,077 | ) | (2,783 | ) | (2,884 | ) | — | (11,744 | ) |\\n| Other investing activities, net | 605 | 136 | 58 | — | 799 |\\n| Net cash used in investing activities | (181,308 | ) | (2,647 | ) | (1,234 | ) | — | (185,189 | ) |\\n| Financing activities: |\\n| Net borrowings (repayments) of debt | 82 | 8 | (25,840 | ) | — | (25,750 | ) |\\n| Proceeds from long-term debt, including new revolving credit facility | 309,625 | — | 10,851 | — | 320,476 |\\n| Repayments of long-term debt, including new revolving credit facility | (52,896 | ) | (55 | ) | (261 | ) | — | (53,212 | ) |\\n| Payment of debt issue costs | (16,380 | ) | — | (253 | ) | — | (16,633 | ) |\\n| Net intercompany (repayments) borrowings | (57,307 | ) | (13,930 | ) | 71,237 | — | — |\\n| Other financing activities, net | 657 | — | — | — | 657 |\\n| Net cash from (used in) financing activities | 183,781 | (13,977 | ) | 55,734 | — | 225,538 |\\n| Effect of exchange rate changes on cash and cash equivalents | — | — | (253 | ) | — | (253 | ) |\\n| Increase (decrease) in cash and cash equivalents | 3,905 | (486 | ) | (9,611 | ) | — | (6,192 | ) |\\n| Cash and cash equivalents - beginning of year | 7,629 | 1,068 | 28,019 | — | 36,716 |\\n| Cash and cash equivalents - end of period | $ | 11,534 | $ | 582 | $ | 18,408 | $ | — | $ | 30,524 |\\n\\n75\\n| Condensed Consolidating Statement of Cash FlowsFor the year ended December 31, 2010 |\\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\\n| Operating activities: |\\n| Net (loss) income | $ | (5,640 | ) | $ | (211 | ) | $ | 665 | $ | (454 | ) | $ | (5,640 | ) |\\n| Equity in earnings of subsidiaries | (344 | ) | (110 | ) | — | 454 | — |\\n| Adjustments to reconcile net (loss) income to cash provided by operating activities | 12,721 | 29,562 | 500 | (2,781 | ) | 40,002 |\\n| Net cash from (used in) operating activities | 6,737 | 29,241 | 1,165 | (2,781 | ) | 34,362 |\\n| Investing activities: |\\n| Capital expenditures | (4,244 | ) | (1,267 | ) | (2,061 | ) | — | (7,572 | ) |\\n| Other investing activities, net | 125 | 4 | — | — | 129 |\\n| Net cash used in investing activities | (4,119 | ) | (1,263 | ) | (2,061 | ) | — | (7,443 | ) |\\n| Financing activities: |\\n| Net (repayments) borrowings of debt | (13,720 | ) | — | 2,324 | — | (11,396 | ) |\\n| Repayments of long-term debt | (7,007 | ) | (343 | ) | (404 | ) | — | (7,754 | ) |\\n| Net intercompany borrowings (repayments) | 15,794 | (27,350 | ) | 8,775 | 2,781 | — |\\n| Other financing activities, net | 785 | — | — | — | 785 |\\n| Net cash (used in) from financing activities | (4,148 | ) | (27,693 | ) | 10,695 | 2,781 | (18,365 | ) |\\n| Effect of exchange rate changes on cash and cash equivalents | — | — | (149 | ) | — | (149 | ) |\\n| (Decrease) increase in cash and cash equivalents | (1,530 | ) | 285 | 9,650 | — | 8,405 |\\n| Cash and cash equivalents - beginning of year | 9,159 | 783 | 18,369 | — | 28,311 |\\n| Cash and cash equivalents - end of period | $ | 7,629 | $ | 1,068 | $ | 28,019 | $ | — | $ | 36,716 |\\n\\n76\\n(15) Selected Quarterly Data (Unaudited)\\nThe results of Tube Supply, acquired during December 2011, were included in the 2012 selected quarterly data in the table below.\\n| FirstQuarter | SecondQuarter | ThirdQuarter | FourthQuarter |\\n| 2012 |\\n| Net sales | $ | 362,916 | $ | 329,392 | $ | 304,039 | $ | 274,021 |\\n| Gross profit (a) | 53,810 | 43,763 | 42,867 | 28,518 |\\n| Net (loss) income (c) | (4,300 | ) | (2,978 | ) | 3,173 | (5,643 | ) |\\n| Basic (loss) earnings per share | $ | (0.19 | ) | $ | (0.13 | ) | $ | 0.14 | $ | (0.24 | ) |\\n| Diluted (loss) earnings per share | $ | (0.19 | ) | $ | (0.13 | ) | $ | 0.13 | $ | (0.24 | ) |\\n| Common stock dividends declared | $ | — | $ | — | $ | — | $ | — |\\n| 2011 |\\n| Net sales | $ | 272,788 | $ | 282,568 | $ | 294,860 | $ | 282,150 |\\n| Gross profit (a) | 33,219 | 35,165 | 33,233 | 29,770 |\\n| Net income (loss) (b) | 2,703 | 3,697 | 3,803 | (11,963 | ) |\\n| Basic earnings (loss) per share | $ | 0.12 | $ | 0.16 | $ | 0.17 | $ | (0.52 | ) |\\n| Diluted earnings (loss) per share | $ | 0.12 | $ | 0.16 | $ | 0.16 | $ | (0.52 | ) |\\n| Common stock dividends declared | $ | — | $ | — | $ | — | $ | — |\\n\\n| (a) | Gross profit equals net sales minus cost of materials, warehouse, processing, and delivery costs and less depreciation and amortization expense. |\\n\\n| (b) | Fourth quarter results include fees incurred as a result of the acquisition of Tube Supply and the related debt refinancing in December 2011. The results of Tube Supply are included in the fourth quarter results for the two-week period ended December 31, 2011 and for the entire fiscal year ended December 31, 2012. In addition, a mark-to-market adjustment related to the conversion option associated with the convertible debt in the amount of $3,991 was included in interest expense during the fourth quarter. |\\n\\n| (c) | First and second quarter results include a mark-to-market adjustment related to the conversion option associated with the convertible debt in the amount of $11,340 and $4,257, respectively. Amounts were included in interest expense during the respective quarters. |\\n\\n(16) Subsequent Events\\nOn January 16, 2013, the Company announced restructuring actions, including an organizational restructuring, warehouse realignments and performance improvement programs. The total pre-tax charge associated with these actions is estimated to be approximately $10,000, which is expected to be incurred in the first half of 2013. Of this amount, approximately $3,500 is attributable to employee severance and other employment related benefits, $2,500 is attributable to lease termination costs, $1,600 is attributable to moving costs in conjunction with the warehouse realignments and $2,400 relates to other costs. The Company may identify additional opportunities as it implements the restructuring actions that could impact its overall estimate. In addition, the Company expects to incur capital expenditures of approximately $1,400 in 2013 that are directly associated with the restructuring actions.\\n77\\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\\nTo the Board of Directors and Stockholders of A.M. Castle & Co.\\nOak Brook, Illinois\\nWe have audited the accompanying consolidated balance sheets of A.M. Castle & Co. and subsidiaries (the \\\"Company\\\") as of December 31, 2012 and 2011, and the related consolidated statements of operations and comprehensive income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2012. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the consolidated financial statements based on our audits. We did not audit the financial statements of Kreher Steel Company, LLC, a 50% owned joint venture, the Company's investment in which is accounted for by use of the equity method. The Company's equity of $38,854 and $36,460 in Kreher Steel Company, LLC's net assets at December 31, 2012 and 2011, respectively, and of $7,224 and $11,727 in that company's net income for the years then ended are included in the accompanying financial statements. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Kreher Steel Company, LLC, is based solely on the report of the other auditors.\\nWe conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.\\nIn our opinion, based on our audits and the report of other auditors, such consolidated financial statements present fairly, in all material respects, the financial position of A.M. Castle & Co. and subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America.\\nWe have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of December 31, 2012, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 11, 2013 expressed an unqualified opinion on the Company's internal control over financial reporting.\\n/s/ DELOITTE & TOUCHE LLP\\nDELOITTE & TOUCHE LLP\\nChicago, Illinois\\nMarch 11, 2013\\n78\\n| Kreher Steel Company, LLC and SubsidiariesCONSOLIDATED BALANCE SHEETSDecember 31, |\\n| 2012 | 2011 |\\n| ASSETS |\\n| Current assets |\\n| Cash and cash equivalents | $ | 3,373,355 | $ | 8,743,820 |\\n| Accounts receivable (net of allowance for doubtful accounts of approximately $1,435,000 in 2012 and $1,335,000 in 2011) | 19,736,301 | 32,461,983 |\\n| Inventory, net | 66,958,361 | 69,297,422 |\\n| Deferred taxes | 271,553 | 29,699 |\\n| Prepaid income taxes | 1,424,064 | 186,889 |\\n| Prepaid expenses and other current assets | 657,039 | 542,689 |\\n| Total current assets | 92,420,673 | 111,262,502 |\\n| Property and equipment |\\n| Land and building | 14,485,343 | 14,334,997 |\\n| Machinery and equipment | 16,533,990 | 11,923,342 |\\n| Furniture, fixtures and office equipment | 2,155,447 | 1,952,447 |\\n| Automobiles and trucks | 990,508 | 871,929 |\\n| Leasehold improvements | 2,334,855 | 1,872,955 |\\n| Construction in progress | 266,129 | 753,234 |\\n| 36,766,272 | 31,708,904 |\\n| Less accumulated depreciation and amortization | 14,719,685 | 12,856,503 |\\n| Property and equipment, net | 22,046,587 | 18,852,401 |\\n| Deferred financing costs, net of amortization | 104,616 | 121,263 |\\n| Goodwill | 3,525,247 | 3,525,247 |\\n| Intangible assets, net of amortization | 275,616 | 398,112 |\\n| Other assets | 146,785 | 81,543 |\\n| $ | 118,519,524 | $ | 134,241,068 |\\n| LIABILITIES AND MEMBER'S CAPITAL |\\n| Current liabilities |\\n| Revolving line of credit | $ | — | $ | 35,000,000 |\\n| Current portion of long-term debt | 211,894 | 215,918 |\\n| Accounts payable | 11,536,613 | 21,094,460 |\\n| Accrued expenses | 2,565,966 | 3,641,502 |\\n| Total current liabilities | 14,314,473 | 59,951,880 |\\n| Revolving line of credit | 24,000,000 | — |\\n| Deferred taxes, non-current | 1,977,273 | 1,008,748 |\\n| Long-term debt, less current portion | 1,867,707 | 2,080,993 |\\n| Commitments and contingencies |\\n| Member's capital | 76,360,071 | 71,199,447 |\\n| $ | 118,519,524 | $ | 134,241,068 |\\n\\n79\\n| Kreher Steel Company, LLC and SubsidiariesCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOMEYears ended December 31, |\\n| 2012 | 2011 | 2010 |\\n| Net revenues | $ | 257,776,157 | $ | 269,657,054 | $ | 188,107,237 |\\n| Cost of sales | 213,490,152 | 219,478,535 | 156,801,397 |\\n| Gross profit | 44,286,005 | 50,178,519 | 31,305,840 |\\n| Operating expenses |\\n| Selling | 12,970,475 | 12,761,204 | 9,729,856 |\\n| General and administrative | 12,657,611 | 9,970,335 | 8,283,347 |\\n| Total operating expenses | 25,628,086 | 22,731,539 | 18,013,203 |\\n| Earnings from operations | 18,657,919 | 27,446,980 | 13,292,637 |\\n| Other expense (income) |\\n| Interest expense | 519,416 | 432,990 | 259,558 |\\n| Interest income | (3,263 | ) | (1,994 | ) | (5,035 | ) |\\n| Other income, net | (169,015 | ) | (180,807 | ) | (152,887 | ) |\\n| Net earnings before taxes | 18,310,781 | 27,196,791 | 13,191,001 |\\n| Income tax provision (benefit) | 3,708,101 | 3,553,382 | 2,155,950 |\\n| NET EARNINGS | 14,602,680 | 23,643,409 | 11,035,051 |\\n| Other comprehensive income |\\n| Foreign currency translation adjustment | 15,554 | — | — |\\n| COMPREHENSIVE INCOME | $ | 14,618,234 | $ | 23,643,409 | $ | 11,035,051 |\\n\\n80\\n| Kreher Steel Company, LLC and SubsidiariesCONSOLIDATED STATEMENTS OF MEMBERS’ CAPITALThree years ended December 31, 2012 |\\n| Accumulated |\\n| other | Total |\\n| Member's | Retained | Accumulated | Treasury | comprehensive | member's |\\n| contribution | earnings | distributions | stock | income | capital |\\n| Balance at January 1, 2010, 400 units | 7,042,411 | 67,379,821 | (23,906,770 | ) | (5,240,092 | ) | — | 45,275,370 |\\n| Net earnings | — | 11,035,051 | — | — | — | 11,035,051 |\\n| Distributions | — | — | (2,519,593 | ) | — | — | (2,519,593 | ) |\\n| Balance at December 31, 2010, 400 units | 7,042,411 | 78,414,872 | (26,426,363 | ) | (5,240,092 | ) | — | 53,790,828 |\\n| Net earnings | — | 23,643,409 | — | — | — | 23,643,409 |\\n| Distributions | — | — | (6,234,790 | ) | — | — | (6,234,790 | ) |\\n| Balance at December 31, 2011, 400 units | 7,042,411 | 102,058,281 | (32,661,153 | ) | (5,240,092 | ) | — | 71,199,447 |\\n| Net earnings | — | 14,602,680 | — | — | — | 14,602,680 |\\n| Distributions | — | — | (9,457,600 | ) | — | — | (9,457,600 | ) |\\n| Foreign currency translation adjustment | — | — | — | — | 15,544 | 15,544 |\\n| Balance at December 31, 2012, 400 units | $ | 7,042,411 | $ | 116,660,961 | $ | (42,118,753 | ) | $ | (5,240,092 | ) | $ | 15,544 | $ | 76,360,071 |\\n\\n81\\n| Kreher Steel Company, LLC and SubsidiariesCONSOLIDATED STATEMENTS OF CASH FLOWSYears ended December 31, |\\n| 2012 | 2011 | 2010 |\\n| Cash flows from operating activities |\\n| Net earnings | $ | 14,602,680 | $ | 23,643,409 | $ | 11,035,051 |\\n| Adjustments to reconcile net earnings to net cash provided by (used in) operating activities |\\n| Depreciation and amortization | 2,033,956 | 1,602,925 | 1,720,133 |\\n| Deferred taxes | 726,671 | 390,341 | 84,362 |\\n| Bad debt expense | 2,595,710 | 34,779 | 178,911 |\\n| (Gain) loss on sale of property and equipment | (4,851 | ) | 9,790 | 59,676 |\\n| Changes in assets and liabilities |\\n| Accounts receivable | 10,129,971 | (8,508,956 | ) | (8,488,036 | ) |\\n| Inventory | 2,339,061 | (27,383,374 | ) | (11,823,574 | ) |\\n| Prepaid expenses and other assets | (1,400,121 | ) | (58,839 | ) | 182,962 |\\n| Accounts payable | (9,557,992 | ) | 3,900,243 | 1,739,501 |\\n| Accrued expenses | (1,075,536 | ) | 1,215,113 | 388,680 |\\n| Net cash provided by (used in) operating activities | 20,389,549 | (5,154,569 | ) | (4,922,334 | ) |\\n| Cash flows from investing activities |\\n| Purchases of property and equipment | (5,258,846 | ) | (6,735,595 | ) | (2,271,435 | ) |\\n| Proceeds from sale of property and equipment | 145,605 | 19,843 | 256,132 |\\n| Net cash used in investing activities | (5,113,241 | ) | (6,715,752 | ) | (2,015,303 | ) |\\n| Cash flows from financing activities |\\n| Net (decrease) increase in line of credit | (11,000,000 | ) | 22,163,000 | 10,837,000 |\\n| Repayment of long-term debt | (217,310 | ) | (268,089 | ) | (360,000 | ) |\\n| Distributions to member | (9,457,600 | ) | (6,234,790 | ) | (2,519,593 | ) |\\n| Net cash (used in) provided by financing activities | (20,674,910 | ) | 15,660,121 | 7,957,407 |\\n| Effect of exchange rate changes on cash and cash equivalents | 28,137 | — | — |\\n| Net (decrease) increase in cash and cash equivalents | (5,370,465 | ) | 3,789,800 | 1,019,770 |\\n| Cash and cash equivalents at beginning of year | 8,743,820 | 4,954,020 | 3,934,250 |\\n| Cash and cash equivalents at end of year | $ | 3,373,355 | $ | 8,743,820 | $ | 4,954,020 |\\n| Supplemental disclosures of cash flow information |\\n| Cash paid during the year for |\\n| Interest | $ | 422,074 | $ | 350,341 | $ | 171,525 |\\n| Income taxes, net of refunds | 4,855,764 | 2,910,000 | 1,097,409 |\\n| Supplemental disclosures of non-cash investing and financing activities |\\n| Acquisition of machinery and equipment through capital leases | $ | — | $ | — | $ | 150,019 |\\n\\n82\\nNOTE A - NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\\nDescription of Company\\nKreher Steel Company, LLC and Subsidiaries (the Company) was formed as a limited liability company (LLC) on January 11, 1996, and commenced business on May 1, 1996. The LLC member's initial contribution consisted of the net assets of Kreher Steel Co., Inc.\\nThe Company is a national distributor and processor of carbon and alloy steel bar products. The Company has locations throughout the United States and in Edmonton, Canada, and primarily sells in the vicinity of these locations.\\nPrinciples of Consolidation\\nThe Company's financial statements are presented on a consolidated basis and include its wholly owned subsidiaries, Kreher Wire Processing, Inc. and Special Metals, Inc., as well as a branch of Kreher Steel Company, LLC located in Edmonton, Canada. All intercompany transactions and balances have been eliminated.\\nUse of Estimates\\nThe preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from these estimates.\\nCash and Cash Equivalents\\nThe Company considers all highly liquid investments with maturities of three months or less to be cash equivalents. The Company maintains cash balances at financial institutions in the United States of America that are insured by the Federal Deposit Insurance Corporation (FDIC). At December 31, 2012 and 2011, the Company had approximately $2,113,000 and $7,975,000, respectively, in excess of FDIC insured limits. The Company has not experienced any losses related to these balances, and management believes its credit risk to be minimal.\\nShipping and Handling Fees\\nFor the years ended December 31, 2012, 2011 and 2010, shipping and handling costs billed to customers amounted to approximately $1,548,000, $1,431,230 and $899,000, respectively, and were included in selling expenses.\\nFinancial Instruments and Risk Management\\nConcentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company's customer base and their dispersion across different businesses and geographic areas. At December 31, 2012, 2011 and 2010, there were no individual customers that made up more than 10% of consolidated sales.\\nThe Company's financial instruments include cash equivalents, accounts receivable, accounts payable and notes payable. The carrying amounts of cash equivalents, accounts receivable, accounts payable and notes payable approximate fair value due to their short-term nature and variable interest rates paid.\\nPrices for steel fluctuate based on worldwide production and, as a result, the Company is subject to the risk of future changing market prices. Furthermore, the Company purchased approximately 6%, 9% and 7% of its inventory from foreign suppliers for the years ended December 31, 2012, 2011 and 2010, respectively.\\nInventory\\nInventory is valued at the lower of cost or market. Cost is determined by the specific identification method. The Company provides a reserve for obsolete and slow-moving inventory. As of December 31, 2012 and 2011, the reserve for obsolete and slow-moving inventory was approximately $810,000 and $583,000, respectively.\\n83\\nChanges in the Company's inventory reserve are as follows at December 31:\\n| 2012 | 2011 |\\n| Beginning balance | $ | 583,346 | $ | 1,778,365 |\\n| Provision (release of provision) | 307,440 | (1,140,966 | ) |\\n| Write-offs | (81,119 | ) | (54,053 | ) |\\n| Total inventory reserve | $ | 809,667 | $ | 583,346 |\\n\\nProperty and Equipment\\nProperty and equipment are stated at cost less accumulated depreciation. Depreciation is based on the straight-line method and the estimated useful lives of the property and equipment. Depreciation of leasehold improvements is based on the estimated useful life or the term of the lease, whichever is shorter. The Company uses an accelerated method of depreciation for tax purposes. Depreciation expense for December 31, 2012, 2011 and 2010, was approximately $1,911,000, $1,467,000 and $1,543,000, respectively.\\nDepreciable lives by asset classification are as follows:\\n| Asset description | Life |\\n| Furniture and fixtures | 5 - 7 years |\\n| Office equipment | 5 - 7 years |\\n| Machinery and equipment | 7 - 10 years |\\n| Automobiles and trucks | 3 - 5 years |\\n| Building and leasehold improvements | 7 - 40 years |\\n\\nRepairs and maintenance are charged to expense when incurred. Expenditures for improvements are capitalized. Upon sale or retirement, the related cost and accumulated depreciation or amortization are removed from the respective accounts, and any resulting gain or loss is included in operations.\\nLong-Lived Assets\\nThe Company reviews the carrying values of its long-lived assets for possible impairment whenever events or changes in circumstances indicate that the carrying amounts of the assets may not be recoverable. Any long-lived assets held for disposal are reported at the lower of their carrying amounts or fair value less cost to sell. No triggering events were identified during each year presented that would require an impairment analysis. Additionally, no assets were held for disposal as of December 31, 2012 or 2011.\\nGoodwill and Intangible Assets\\nGoodwill represents the excess of purchase price paid over the fair values of net assets acquired and liabilities assumed in the Company's acquisitions.\\nIntangible assets include non-competition agreements and non-contractual customer relationships. The fair value of identifiable intangible assets was estimated based on discounted future cash flow projections. Intangible assets are amortized on a straight-line basis over their estimated economic lives. The weighted-average useful life of intangible assets was five years as of December 31, 2012.\\nThe Company evaluates the recoverability of identifiable intangible assets whenever events or changes in circumstances indicate that an intangible asset's carrying amount may not be recoverable. Such circumstances could include, but are not limited to, a significant decrease in the market value of the asset, a significant adverse change in the extent or manner in which an asset is used, or an accumulation of costs significantly in excess of the amount originally expected for the acquisition of an asset. No events or changes in circumstances were identified during the year that required an impairment analysis.\\n84\\nManagement is required to evaluate goodwill for impairment on an annual basis. The Company tests for impairment using a two-step process that involves (1) comparing the estimated fair value of the reporting unit to its net book value and (2) comparing the estimated implied fair value of goodwill and intangible assets to its carrying value. Goodwill and intangible assets were valued on the date of the acquisition. As of December 31, 2012 and 2011, there was no impairment of the goodwill or intangible assets acquired based on the analysis performed as of December 31, 2012.\\nRevenue Recognition\\nRevenue from the sale of goods is recognized at the time of shipment, except for revenue from sales of products to certain customers whose contractual terms specify FOB destination. Revenue from sales of products to these customers is recognized at the time of receipt by the customer when title and risk of loss pass to the customer.\\nAccounts Receivable\\nCredit is extended based on an evaluation of a customer's financial condition and, generally, collateral is not required. Accounts receivable are generally due within 30 days of the negotiated terms and are stated at amounts due from customers net of an allowance for doubtful accounts. Accounts outstanding longer than the contractual payment terms are considered past due. The Company maintains reserves for potential losses on receivables and credits from its customers, and these losses have not exceeded management's expectations. The Company determines its allowance for doubtful accounts by considering a number of factors, including the length of time trade accounts receivable are past due, the Company's previous loss history, the customer's current ability to pay its obligation to the Company, and the condition of the general economy and the industry as a whole. The Company writes off accounts receivable when they become uncollectible, and payments subsequently received on such receivables are credited to the allowance for doubtful accounts.\\nEconomic Dependency - Major Suppliers\\nDuring the years ended December 31, 2012, 2011 and 2010, the Company purchased approximately 44%, 45% and 49%, respectively, of its materials from five suppliers.\\nDeferred Financing Costs\\nDeferred financing costs are amortized over the life of the underlying credit agreement or the expected remaining life of the underlying credit agreement.\\nIncome Taxes\\nAs an LLC, the Company is not subject to federal and state income taxes, and its income or loss is allocated to and reported in the tax returns of its member. Accordingly, no liability or provision for federal and state income taxes attributable to the LLC's operations is included in the accompanying financial statements. The Company provides for income taxes for its wholly owned subsidiaries, Kreher Wire Processing, Inc. and Special Metals, Inc., which are subject to federal and state income taxes as they are structured as C Corporations. Special Metals Canada, which is structured as a foreign branch of a domestic company, will pay federal and provincial taxes in Canada. The taxes paid will be reported to the member in order to claim foreign tax credits.\\nThe Company applies a comprehensive model for the financial statement recognition, measurement, classification and disclosure of uncertain tax positions. In the first step of the two-step process, the Company evaluates the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. In the second step, the Company measures the tax benefit as the largest amount that is more than 50% likely of being realized upon settlement. As of December 31, 2012 and 2011, the Company determined that there are no uncertain tax positions with a more than 50% likelihood of being realized upon settlement.\\nAdvertising Costs\\nAdvertising costs are charged to expense when the advertisement is first run. The Company expensed advertising costs of approximately $102,000, $80,000 and $62,000 in 2012, 2011 and 2010, respectively.\\n85\\nReclassifications\\nCertain reclassifications of prior-year presentations have been made to conform to the 2012 presentation.\\nNOTE B - INTANGIBLE ASSETS\\nIntangible assets are amortized using the straight-line method, using the remaining useful life, and are as follows at December 31, 2012:\\n| Remaining |\\n| Asset description | useful life |\\n| Non-contractual customer relationships | 2.25 years |\\n\\nThe following is a summary of intangible assets at December 31:\\n| 2012 | 2011 |\\n| Intangible assets |\\n| Finite life |\\n| Non-compete agreements | $ | 220,000 | $ | 220,000 |\\n| Non-contractual customer relationships | 980,000 | 980,000 |\\n| 1,200,000 | 1,200,000 |\\n| Less accumulated amortization | 924,384 | 801,888 |\\n| Net intangible assets | $ | 275,616 | $ | 398,112 |\\n\\nAmortization expense related to identifiable intangible assets was $122,496, $136,245 and $177,492 for the years ended December 31, 2012, 2011 and 2010, respectively. The intangible assets related to the non-compete agreements became fully amortized during 2011. Estimated annual amortization expense as of December 31, 2012, is a follows:\\n| Years ending December 31, |\\n| 2013 | $ | 122,496 |\\n| 2014 | 122,496 |\\n| 2015 | 30,624 |\\n\\nNOTE C - TRANSACTIONS WITH AFFILIATES\\nIncluded in accounts receivable at December 31, 2012, was approximately $3,000 due from companies related through common ownership. There was no amount included in accounts receivable at December 31, 2011, due from companies related through common ownership.\\nIncluded in accounts payable at December 31, 2012 and 2011, was approximately $21,000 and $79,000, respectively, due to companies related through common ownership.\\nSales to and purchases from companies related through common ownership for the year ended December 31, 2012, were approximately $695,000 and $809,000, respectively, for the year ended December 31, 2011, were approximately $851,000 and $2,294,000, respectively, and for the year ended December 31, 2010, were approximately $351,000 and $2,118,000, respectively.\\nNOTE D - ALLOWANCE FOR DOUBTFUL ACCOUNTS\\nChanges in the Company's allowance for doubtful accounts are as follows at December 31:\\n86\\n| 2012 | 2011 |\\n| Beginning balance | $ | 1,335,000 | $ | 1,340,000 |\\n| Bad debt expense | 2,595,710 | 34,779 |\\n| Recoveries | 20,125 | 536 |\\n| Accounts written off | (2,515,835 | ) | (40,315 | ) |\\n| Total allowance for doubtful accounts | $ | 1,435,000 | $ | 1,335,000 |\\n\\nNOTE E - DEBT\\nDebt as of December 31, 2012 and 2011, is as follows:\\n| 2012 | 2011 |\\n| Revolving lines of credit | $ | 24,000,000 | $ | 35,000,000 |\\n| Notes payable |\\n| Michigan Strategic Fund Limited Obligation Revenue Bonds (2000) | $ | 875,000 | $ | 950,000 |\\n| Michigan Strategic Fund Limited Obligation Revenue Bonds (2006) | 1,150,000 | 1,245,000 |\\n| Capitalized leases | 54,601 | 101,911 |\\n| Total notes payable | 2,079,601 | 2,296,911 |\\n| Current portion of long-term debt | 211,894 | 215,918 |\\n| Long-term debt | $ | 1,867,707 | $ | 2,080,993 |\\n\\nIn April 2004, the Company entered into a loan agreement. The loan consists of advances on a revolving line of credit, with maximum availability of $25,000,000, with the option of extending the credit to $40,000,000, through April 2009. In May 2007, the Company took that option and refinanced its $25,000,000 secured revolving credit agreement from an asset-based loan to a commercial-based loan, which can be increased to $40,000,000 in $5,000,000 increments. In April 2008, the Company increased the revolving credit to $30,000,000. The Company decreased the revolving credit to $20,000,000 in September 2009. In August 2011, the Company increased the revolving credit to $25,000,000. The interest charged on the loan is divided into the LIBOR portion and the prime rate portion. The outstanding balance on the LIBOR portion at a rate of 1.22% was $21,000,000 at December 31, 2011. There was a balance of $2,000,000 outstanding on the prime rate portion at a rate of 2.625% (prime minus 0.625%) at December 31, 2011.\\nIn May 2007, the Company's subsidiary, Special Metals, Inc., also entered into a commercial-based loan for $5,000,000, which can be increased to $10,000,000 in $1,000,000 increments. In October 2011, the Company amended the loan agreement and increased the revolving credit to $15,000,000 based on the consolidated availability of the Company. The interest charged on the loan is divided into the LIBOR portion and the prime rate portion. The outstanding balance on the LIBOR portion at a rate of 1.22% was $12,000,000 at December 31, 2011. There was no outstanding balance on the LIBOR portion of the loan at December 31, 2011.\\nIn April 2012, the Company entered into a new loan agreement. The loan named both the Company and its subsidiary, Special Metals, Inc., as co-borrowers. The loan is for $50,000,000, which can be increased to $65,000,000 in $5,000,000 increments. The interest charged on the loan is divided into the LIBOR portion and the prime rate portion. The outstanding balance on the LIBOR portion at a rate of 1.21% was $22,000,000 at December 31, 2012. The outstanding balance on the prime rate portion at a rate of 2.75% was $2,000,000 at December 31, 2012. The loan is secured by the Company's receivables, inventory and fixed assets, and expires in April 2017.\\nThe Company is in compliance with all covenants related to the revolving credit agreements and all other notes payable.\\nIn 2000, the Company's subsidiary, Kreher Wire Processing, Inc., obtained a Michigan Strategic Fund Limited Obligation Revenue Bond for $4,900,000. Interest is charged at a variable rate as defined in the agreement. The interest rate as of December 31, 2012 and 2011, was 0.23% and 0.20%, respectively. The Company makes monthly interest payments and annual principal and debt service payments. The Company is also required to make annual payments for the letter of credit fee. The bonds mature on May 1, 2016.\\n87\\nIn 2006, Kreher Wire Processing, Inc. obtained a Michigan Strategic Fund Limited Obligation Revenue Bond for $2,695,000. Interest is charged at a variable rate as defined in the agreement. The interest rate as of December 31, 2012 and 2011, was 0.23% and 0.20%, respectively. The Company makes monthly interest payments and annual principal and debt service payments. The Company is also required to make quarterly payments for the letter of credit fee. The bonds mature on October 1, 2021.\\nIn 2010, Special Metals, Inc. entered into several lease agreements that met the criteria for capitalization. At December 31, 2012 and 2011, the gross amount of cost related to capital leases included in machinery and equipment was approximately $150,000. Related accumulated amortization at December 31, 2012 and 2011, was approximately $110,000 and $65,000, respectively. The total rental payments incurred for the years ended December 31, 2012, 2011 and 2010, was approximately $73,000, $73,000 and $33,000, respectively.\\nThe carrying value of debt approximates fair value given the variable nature of the interest rates. Maturities of debt at December 31, 2012, are as follows:\\n| Years ending December 31, |\\n| 2013 | $ | 211,894 |\\n| 2014 | 205,778 |\\n| 2015 | 226,929 |\\n| 2016 | 725,000 |\\n| 2017 | 24,125,000 |\\n| Thereafter | 585,000 |\\n| Total | $ | 26,079,601 |\\n\\nNOTE F - INCOME TAXES\\nAs an LLC, the Company is not subject to federal and state income taxes, and its income or loss is allocated to and reported in the tax returns of its member. The Company provides for income taxes for its wholly owned subsidiaries, Kreher Wire Processing, Inc. and Special Metals, Inc., which are subject to federal and state income taxes. The Company also provides for federal and provincial taxes at Special Metals Canada, which is structured as a foreign branch of a domestic company. The taxes paid will be reported to the member in order to claim foreign tax credits.\\nThe tax effect of temporary differences that give rise to deferred tax assets and liabilities as of December 31, 2012 and 2011, are as follows:\\n| 2012 | 2011 |\\n| Deferred tax assets |\\n| Accounts receivable and inventory reserves | $ | 271,553 | $ | 29,699 |\\n| Deferred tax liabilities |\\n| Amortization of intangibles | (110,246 | ) | (159,245 | ) |\\n| Depreciation and other | (1,867,027 | ) | (849,503 | ) |\\n| Total deferred tax liabilities | (1,977,273 | ) | (1,008,748 | ) |\\n| Net deferred tax liabilities | $ | (1,705,720 | ) | $ | (979,049 | ) |\\n\\n88\\nThe net current and non-current components of the deferred income taxes recognized in the balance sheets at December 31, 2012 and 2011, are as follows:\\n| 2012 | 2011 |\\n| Net current assets | $ | 271,553 | $ | 29,699 |\\n| Net long-term liabilities | (1,977,273 | ) | (1,008,748 | ) |\\n| Total net deferred tax liabilities | $ | (1,705,720 | ) | $ | (979,049 | ) |\\n\\nIncome tax expense consists of the following components as of December 31:\\n| 2012 | 2011 | 2010 |\\n| Current |\\n| Federal | $ | 2,673,070 | $ | 2,667,703 | $ | 1,845,850 |\\n| State | 398,649 | 495,338 | 225,738 |\\n| Foreign | (90,289 | ) | — | — |\\n| Deferred | 726,671 | 390,341 | 84,362 |\\n| Total income tax expense | $ | 3,708,101 | $ | 3,553,382 | $ | 2,155,950 |\\n\\nThe differences between the federal statutory rate of 34% and the effective rate are due to state income taxes, permanent deductions, settlement of prior returns related to the acquisition and the fact that no tax provisions are recorded for operations attributable to Kreher Steel Company, LLC in the accompanying financial statements. Tax years dated back to December 31, 2009, are open for federal and state tax audit purposes. The total effective rate of the subsidiaries at December 31, 2012, 2011 and 2010, was 20.2%, 13.1% and 16.3%, respectively.\\nA reconciliation of the effective income tax rate to the U.S. statutory tax rate is as follows:\\n| 2012 | 2011 | 2010 |\\n| U.S. statutory tax rate | 34 | % | 34 | % | 34 | % |\\n| Non-taxable LLC income | (16.2 | ) | (21.1 | ) | (20.4 | ) |\\n| State and local taxes - net of federal tax expense | 2.2 | 0.5 | 2.1 |\\n| Foreign taxes | (0.2 | ) | 0.0 | 0.0 |\\n| Other, net | 0.4 | (0.3 | ) | 0.6 |\\n| Effective tax rate | 20.2 | % | 13.1 | % | 16.3 | % |\\n\\n89\\nNOTE G - COMMITMENTS\\nOperating Lease Commitments\\nThe Company leases certain equipment and warehouse space under operating lease obligations with rent escalation clauses for the warehouse space only. Accordingly, the Company has recorded these lease obligations on a straight-line basis and recorded a deferred rent liability of approximately $53,000 and $94,000 for the years ended December 31, 2012 and 2011, respectively. Rent expense, net of sublease income for the years ended December 31, 2012, 2011 and 2010, was approximately $1,339,000, $1,081,000 and $687,000, respectively. The following shows minimum future rental payments for the next five years under these obligations:\\n| Years ending December 31, |\\n| 2,013 | $ | 1,001,042 |\\n| 2,014 | 629,844 |\\n| 2,015 | 596,404 |\\n| 2,016 | 538,668 |\\n| 2017 and thereafter | 421,401 |\\n\\nHealth Insurance\\nThe Company maintains a fully self-insured health insurance plan. Approximately $1,105,000, $1,021,000 and $904,000 were expensed in 2012, 2011 and 2010, respectively, under this plan. The Company also maintains a fully self-insured health insurance plan at one of its wholly owned subsidiaries. Approximately $850,000, $562,000 and $346,000 were expensed for this plan during 2012, 2011 and 2010, respectively.\\nNOTE H - EMPLOYEE BENEFIT PLAN\\nThe Company maintains a qualified plan under Section 401(k) of the Internal Revenue Code. This plan is available for all employees who have completed one year or more of continuous service. The plan allows employees to contribute an annual limit of the lesser of 60% of eligible compensation or $17,500 (the federal limit for 2012). The Company will match contributions at the discretion of management. The Company has a non-discretionary match of 100%, up to 4% of what employees elect. The Company also has a profit-sharing match of $500 per participant, which is discretionary. This discretionary match was paid in 2012, 2011 and 2010. Participants are fully vested at all times in their contributions and become fully vested in the Company's contributions over a defined period. The plan is responsible for costs associated with its administration. Approximately $280,000, $200,000 and $153,000 was charged to expense for the years ended December 31, 2012, 2011 and 2010, respectively.\\nThe Company also maintains a qualified plan under Section 401(k) of the Internal Revenue Code at a wholly owned subsidiary. This plan is available for all employees who have completed one year or more of continuous service. The plan allows employees to contribute an annual limit of $17,500 (the federal limit for 2012). The Company will match contributions at the discretion of management. The Company also has a discretionary profit-sharing contribution. Participants are fully vested in all contributions. The plan is responsible for costs associated with its administration. During 2012, 2011 and 2010, approximately $320,000, $240,000 and $210,000, respectively, was charged to expense.\\nNOTE I - CONTINGENCIES\\nThe Company is subject to various legal proceedings that have arisen in the normal course of business. In the opinion of management, these actions, when concluded and determined, will not have a material adverse effect on the financial position or operations of the Company.\\nNOTE J - MEMBER'S CAPITAL\\nThe Company is a single-member LLC and shall continue until December 31, 2045.\\n90\\nNOTE K - SUBSEQUENT EVENTS\\nThe Company evaluated its December 31, 2012, financial statements for subsequent events through February 18, 2013, the date the financial statements were available to be issued. The Company is not aware of any subsequent events that would require recognition or disclosure in the financial statements.\\n91\\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\\nBoard of Directors\\nKreher Steel Company, LLC\\nWe have audited the accompanying consolidated balance sheets of Kreher Steel Company, LLC (a Delaware limited liability company) and Subsidiaries (the Company) as of December 31, 2012 and 2011, and the related consolidated statements of comprehensive income, member's capital and cash flows for each of the three years ended December 31, 2012. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.\\nWe conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.\\nIn our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kreher Steel Company, LLC and Subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America.\\n/s/ Grant Thornton LLP\\nGrant Thornton LLP\\nChicago, Illinois\\nFebruary 18, 2013\\n92\\nITEM 9 —\\nChanges In and Disagreements With Accountants on Accounting and Financial Disclosure\\nNone.\\nITEM 9A —\\nControls & Procedures\\nDisclosure Controls and Procedures\\nA review and evaluation was performed by the Company’s management, including the Chief Executive Officer (CEO) and Chief Financial Officer (CFO), of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) of the Security Exchange Act of 1934). Based upon that review and evaluation, the CEO and CFO have concluded that the Company’s disclosure controls and procedures were effective as of December 31, 2012.\\n(a) Management’s Annual Report on Internal Control Over Financial Reporting\\nThe Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in the Securities Exchange Act of 1934 rule 240.13a-15(f). The Company’s internal control over financial reporting is a process designed under the supervision of the Company’s Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles.\\nInternal control over financial reporting, no matter how well designed, has inherent limitations and may not prevent or detect misstatements. Therefore, even effective internal control over financial reporting can only provide reasonable assurance with respect to the financial statement preparation and presentation. Also, projections of any evaluation of effectiveness to future periods are subject to risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.\\nThe Company, under the direction of its Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of its internal control over financial reporting as of December 31, 2012 based upon the framework published by the Committee of Sponsoring Organizations of the Treadway Commission, referred to as the Internal Control—Integrated Framework.\\nBased on our evaluation under the framework in Internal Control — Integrated Framework, the Company’s management has concluded that our internal control over financial reporting was effective as of December 31, 2012.\\nThe effectiveness of the Company’s internal control over financial reporting as of December 31, 2012 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their attestation report included in Item 9A of this annual report.\\n(b) Report of Independent Registered Public Accounting Firm\\nTo the Board of Directors and Stockholders of\\nA.M. Castle & Co.\\nOak Brook, Illinois\\nWe have audited the internal control over financial reporting of A.M. Castle & Co. and subsidiaries (the \\\"Company\\\") as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit.\\nWe conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.\\n93\\nA company's internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.\\nBecause of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.\\nIn our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.\\nWe have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2012 of the Company and our report dated March 11, 2013 expressed an unqualified opinion on those financial statements.\\n/s/ DELOITTE & TOUCHE LLP\\nDELOITTE & TOUCHE LLP\\nChicago, Illinois\\nMarch 11, 2013\\n(c) Change in Internal Control Over Financial Reporting\\nAn evaluation was performed by the Company’s management, including the CEO and CFO, of any changes in internal controls over financial reporting that occurred during the last fiscal quarter and that materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting. The evaluation did not identify any change in the Company’s internal control over financial reporting that occurred during the latest fiscal quarter and that has materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting.\\nItem 9B —\\nOther Information\\nNone.\\n94\\nPART III\\nITEM 10 —\\nDirectors, Executive Officers and Corporate Governance\\nInformation regarding our executive officers is included under the heading “Executive Officers of the Registrant” in Part I of this Annual Report on Form 10-K. All additional information required to be filed in Part III, Item 10, Form 10-K, has been included in the sections of the Company's Definitive Proxy Statement for its 2013 annual meeting of shareholders (fiscal 2012 Proxy Statement) dated and to be filed with the Securities and Exchange Commission on or about March 12, 2013 entitled “Proposal 1- Election of Directors,” “Certain Governance Matters,” and “Section 16(A) Beneficial Ownership Reporting Compliance,” and is hereby incorporated by this specific reference.\\nITEM 11 —\\nExecutive Compensation\\nAll information required to be filed in Part III, Item 11, Form 10-K, has been included in the sections of the fiscal 2012 Proxy Statement entitled “Compensation Discussion and Analysis,” “Report of the Human Resources Committee,” “Compensation Committee Interlocks and Insider Participation”, “Compensation Risk”, “Non-Employee Director Compensation,” and “Executive Compensation and Other Information” and is hereby incorporated by this specific reference.\\nITEM 12 —\\nSecurity Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters\\nThe information required to be filed in Part III, Item 12, Form 10-K, has been included in the sections of the fiscal 2012 Proxy Statement entitled “Stock Ownership of Directors, Management and Principal Stockholders” and “Equity Compensation Plan Information” and is hereby incorporated by this specific reference.\\nITEM 13 —\\nCertain Relationships and Related Transactions, and Director Independence\\nAll information required to be filed in Part III, Item 13, Form 10-K, has been included in the sections of the fiscal 2012 Proxy Statement entitled “Related Party Transactions” and “Director Independence; Financial Experts” and is hereby incorporated by this specific reference.\\nITEM 14 —\\nPrincipal Accountant Fees and Services\\nAll information required to be filed in Part III, Item 14, Form 10-K, has been included in the sections of the fiscal 2012 Proxy Statement entitled “Audit and Non-Audit Fees” and “Pre-Approval Policy for Audit and Non-Audit Services” and is hereby incorporated by this specific reference.\\n95\\nPART IV\\nITEM 15 —\\nExhibits\\nA. M. Castle & Co.\\nIndex To Financial Statements\\n\\n| Page |\\n| Consolidated Statements of Operations and Comprehensive Loss—For the years ended December 31, 2012, 2011 and 2010 | 36 |\\n| Consolidated Balance Sheets—December 31, 2012 and 2011 | 37 |\\n| Consolidated Statements of Cash Flows—For the years ended December 31, 2012, 2011 and 2010 | 38 |\\n| Consolidated Statements of Stockholders’ Equity – For the years ended December 31, 2012, 2011 and 2010 | 39 |\\n| Notes to Consolidated Financial Statements | 40 |\\n| Report of Independent Registered Public Accounting Firm | 77 |\\n| Kreher Steel Co., LLC Financial Statements | 79 |\\n| Exhibit Index |\\n\\n96\\nThe following exhibits are filed herewith or incorporated by reference.\\n| ExhibitNumber | Description of Exhibit |\\n| 2.1 | Stock Purchase Agreement dated as of August 12, 2006 by and among A. M. Castle & Co. and Transtar Holdings #2, LLC. Filed as Exhibit 2.1 to Form 8-K filed August 17, 2006. Commission File No. 1-5415. |\\n| 2.2 | Stock Purchase Agreement, dated November 9, 2011, by and among A.M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, Inc. Filed as Exhibit 2.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\\n| 2.3 | Agreement and Amendment, dated December 15, 2011, by and among A.M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, Tube Supply, Inc. and A.M. Castle & Co. (Canada) Inc. Filed as Exhibit 2.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\\n| 2.4 | Second Amendment to the Stock Purchase Agreement, dated January 13, 2012, by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). Incorporated by reference to Exhibit 2.3 to the Company's Form S-4/A filed with the SEC on May 25, 2012. Commission File No. 333-180662. |\\n| 2.5 | Third Amendment to the Stock Purchase Agreement, dated May 11, 2012, by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). Incorporated by reference to Exhibit 2.4 to the Company's Form S-4/A filed with the SEC on May 25, 2012. Commission File No. 333-180662. |\\n| 2.6 | Fourth Amendment to the Stock Purchase Agreement, dated September 13, 2012 by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). |\\n| 2.7 | Fifth Amendment to the Stock Purchase Agreement, dated November 14, 2012 by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). |\\n| 3.1 | Articles of Restatement of the Charter of the Company filed with the State Department of Assessments and Taxation of Maryland on April 27, 2012. Filed as Exhibit 3.1 to Quarterly Report on Form 10-Q for the period ended March 31, 2012, which was filed on May 3, 2012. Commission File No. 1-5415. |\\n| 3.2 | By-Laws of the Company as amended on October 28, 2010. Filed as Exhibit 3.2 to Quarterly Report on Form 10-Q for the period ended September 30, 2010, which was filed on November 5, 2010. Commission File No. 1-5415. |\\n| 3.3 | Articles Supplementary of the Company. Filed as Exhibit 3.1 to Form 8-A filed on September 6, 2012. Commission File No. 1-5415. |\\n| 4.1 | Indenture, dated as of December 15, 2011, among A.M. Castle & Co., the Guarantors, U.S. Bank National Association, as trustee and U.S. Bank National Association, as collateral agent. Filed as Exhibit 4.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\\n| 4.2 | Indenture, dated as of December 15, 2011, between A.M. Castle & Co., the Guarantors and U.S. Bank National Association, as trustee. Filed as Exhibit 4.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\\n| 4.3 | Rights Agreement, dated as of August 31, 2012, by and between A.M. Castle & Co. and American Stock Transfer & Trust Company, LLC, as Rights Agent. Filed as Exhibit 4.1 to Form 8-K filed on August 31, 2012. Commission File No. 1-05415. |\\n| 10.1* | A. M. Castle & Co. 1995 Director Stock Option Plan. Filed as Exhibit A to Proxy Statement filed March 7, 1995. Commission File No. 1-5415. |\\n| 10.2* | A. M. Castle & Co. 1996 Restricted Stock and Stock Option Plan. Filed as Exhibit A to Proxy Statement filed March 8, 2006. Commission File No. 1-5415. |\\n| 10.3* | A. M. Castle & Co. 2000 Restricted Stock and Stock Option Plan. Filed as Appendix B to Proxy Statement filed March 23, 2001. Commission File No. 1-5415. |\\n\\n97\\n| ExhibitNumber | Description of Exhibit |\\n| 10.4* | A. M. Castle & Co. 2004 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit D to Proxy Statement filed March 12, 2004. Commission File No. 1-5415. |\\n| 10.5* | A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan, as amended and restated as of December 9, 2010. Filed as Exhibit 10.25 to Annual Report on Form 8-K filed on December 15, 2010. Commission File No. 1-5415. |\\n| 10.6* | Form of Restricted Stock Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.11 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\\n| 10.7* | Form of Performance Share Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.12 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\\n| 10.8* | A. M. Castle & Co. Directors Deferred Compensation Plan, as amended and restated as of October 22, 2008. Filed as Exhibit 10.13 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\\n| 10.9* | A. M. Castle & Co. Supplemental 401(k) Savings and Retirement Plan, as amended and restated, effective as of January 1, 2009. Filed as Exhibit 10.14 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\\n| 10.10* | A. M. Castle & Co. Supplemental Pension Plan, as amended and restated, effective as of January 1, 2009. Filed as Exhibit 10.15 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\\n| 10.11* | First Amendment to the A. M. Castle & Co. Supplemental 401(k) Savings and Retirement Plan, executed April 15, 2009 (as effective April 27, 2009). Filed as Exhibit 10.1 to Form 8-K filed on April 16, 2009. Commission File No. 1-5415. |\\n| 10.12* | Form of A.M. Castle & Co. Indemnification Agreement to be executed with all directors and executive officers. Filed as Exhibit 10.16 to Form 8-K filed on July 29, 2009. Commission File No. 1-5415. |\\n| 10.13* | Form of Restricted Stock Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.20 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. |\\n| 10.14* | Form of Performance Share Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.21 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. |\\n| 10.15* | Form of Incentive Stock Option Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.22 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. |\\n| 10.16* | Form of Non-Qualified Stock Option Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.23 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. |\\n| 10.17* | Form of Non-Employee Director Restricted Stock Award Agreement. Filed as Exhibit 10.1 to Form 8-K filed on April 27, 2010. Commission File No. 1-5415. |\\n| 10.18* | Form of Amended and Restated Change of Control Agreement for all executive officers other than the CEO. Filed as Exhibit 10.24 to Form 8-K filed on September 21, 2010. Commission File No. 1-5415. |\\n| 10.19* | Form of Amended and Restated Severance Agreement for executive officers other than the CEO. Filed as Exhibit 10.26 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. |\\n| 10.20* | CEO Change in Control Agreement, as amended and restated December 22, 2010. Filed as Exhibit 10.27 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. |\\n\\n98\\n| ExhibitNumber | Description of Exhibit |\\n| 10.21* | CEO Employment/Non-Competition Agreement, as amended and restated December 22, 2010. Filed as Exhibit 10.28 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. |\\n| 10.22* | Form of Performance Share Award Agreement, adopted March 2, 2011, under A.M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.29 to Form 8-K filed March 8, 2011. Commission File No. 1-5415. |\\n| 10.23* | 2008 A. M. Castle & Co. Omnibus Incentive Plan, as amended and restated as of April 28, 2011. Filed as Exhibit 10.30 to Form 8-K filed May 3, 2011. Commission File No. 1-5415. |\\n| 10.24* | Stephen V. Hooks Executive Retention and Severance Agreement, dated October 27, 2011. Filed as Exhibit 10.31 to Form 8-K filed November 1, 2011. Commission File No. 1-5415. |\\n| 10.25 | Pledge and Security Agreement, dated as of December 15, 2011, by A.M. Castle & Co., and its subsidiaries that are party thereto, in favor of U.S. Bank National Association, as collateral agent, for the benefit of the Secured Parties. Filed as Exhibit 10.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\\n| 10.26 | Intercreditor Agreement, dated as of December 15, 2011, among Wells Fargo Bank, National Association, in its capacity as administrative and collateral agent for the First Lien Secured Parties and U.S. Bank National Association, a national banking association, in its capacity as trustee and collateral agend for the Second Lien Secured Parties. Filed as Exhibit 10.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\\n| 10.27 | Registration Rights Agreement, dated as of December 15, 2011, between A.M. Castle & Co., the Guarantors and Jefferies & Company, Inc., as initial purchaser, for the benefit of the Holders of the Notes. Filed as Exhibit 10.3 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\\n| 10.28 | Loan and Security Agreement, dated December 15, 2011, by and among A.M. Castle & Co., Transtar Metals Corp., Advanced Fabricating Technology, LLC, Oliver Steel Plate Co., Paramont Machine Company, LLC, Total Plastics, Inc., Tube Supply, LLC, A.M. Castle & Co. (Canada) Inc., Tube Supply Canada ULC, the other Loan Parties party thereto, the lenders which are now or which hereafter become a party thereto, and Wells Fargo Bank, National Association, a national banking association, in its capacity as administrative agent and collateral agent for Secured Parties. Filed as Exhibit 10.4 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\\n| 10.29* | Employment Agreement, dated November 9, 2011, by and between A. M. Castle & Co. and Mr. Paul Sorensen. Filed as Exhibit 10.29 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. |\\n| 10.30* | Form of Retention Bonus Agreement for certain executive officers in connection with CEO leadership transition, dated May 14, 2012. Filed as Exhibit 10.30 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. |\\n| 10.31* | Amendment to Employment Agreement, dated May 30, 2012, by and between A. M. Castle & Co. and Mr. Paul Sorensen. Filed as Exhibit 10.31 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. |\\n| 10.32* | Employment Offer Letter dated October 10, 2012, between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.32 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. |\\n| 10.33* | Form of Restricted Stock Unit Award Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.33 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. |\\n| 10.34* | Form of Severance Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.34 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. |\\n| 10.35* | Form of Change of Control Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.35 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. |\\n\\n99\\n| ExhibitNumber | Description of Exhibit |\\n| 10.36* | Offer of Chief Commercial Officer dated December 28, 2012, between A.M. Castle & Co. and Mr. Blain Tiffany. Filed as Exhibit 10.36 to Form 8-K filed January 22, 2013. Commission File No. 1-5415. |\\n| 21.1 | Subsidiaries of Registrant |\\n| 23.1 | Consent of Deloitte & Touche LLP |\\n| 23.2 | Consent of Grant Thornton LLP |\\n| 31.1 | CEO Certification Pursuant to Section 302 of the Sarbanes Oxley Act of 2002. |\\n| 31.2 | CFO Certification Pursuant to Section 302 of the Sarbanes Oxley Act of 2002. |\\n| 32.1 | CEO and CFO Certification Pursuant to Section 906 of the Sarbanes Oxley Act of 2002. |\\n| 101.INS | XBRL Instance Document (1) |\\n| 101.SCH | XBRL Taxonomy Extension Schema Document (1) |\\n| 101.CAL | XBRL Taxonomy Calculation Linkbase Document (1) |\\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document(1) |\\n| 101.LAB | XBRL Taxonomy Label Linkbase Document (1) |\\n| 101.PRE | XBRL Taxonomy Presentation Linkbase Document (1) |\\n\\n| (1) | Furnished with this report. In accordance with Rule 406T of Regulation S-T, the information in these exhibits shall not be deemed to be “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to liability under that section, and shall not be incorporated by reference into any registration statement or other document filed under the Securities Act of 1933, as amended, except as expressly set forth by specific reference in such filing. |\\n| * | These agreements are considered a compensatory plan or arrangement. |\\n\\n100\\nSIGNATURES\\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\n| A. M. Castle & Co. |\\n| (Registrant) |\\n\\n| By: | /s/ Patrick R. Anderson |\\n| Patrick R. Anderson, Vice President—Controller and Chief Accounting Officer |\\n| (Principal Accounting Officer) |\\n| Date: | March 11, 2013 |\\n\\nPursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities as shown following their name on this 11th day of March, 2013.\\n| /s/ Brian P. Anderson | /s/ Gary A. Masse | /s/ Ann M. Drake |\\n| Brian P. Anderson, Chairman of the Board | Gary A. Masse, Director | Ann M. Drake, Director |\\n| /s/ Scott J. Dolan | /s/ Scott F. Stephens | /s/ Reuben S. Donnelley |\\n| Scott J. Dolan, President, | Scott F. Stephens, Vice President | Reuben S. Donnelley, Director |\\n| Chief Executive Officer and | and Chief Financial Officer |\\n| Director | (Principal Financial Officer) |\\n| (Principal Executive Officer) |\\n| /s/ Patrick J. Herbert, III | /s/ Terrence J. Keating | /s/ James D. Kelly |\\n| Patrick J. Herbert, III, Director | Terrence J. Keating, Director | James D. Kelly, Director |\\n| /s/ Pamela Forbes Lieberman |\\n| Pamela Forbes Lieberman, Director | John McCartney, Director |\\n\\n101\\nExhibit Index\\nThe following exhibits are filed herewith or incorporated herein by reference:\\n\\n| Exhibit No. | Description | Page |\\n| 2.1 | Stock Purchase Agreement dated as of August 12, 2006 by and among A. M. Castle & Co. and Transtar Holdings #2, LLC. Filed as Exhibit 2.1 to Form 8-K filed August 17, 2006. Commission File No. 1-5415. | — |\\n| 2.2 | Stock Purchase Agreement, dated November 9, 2011, by and among A.M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, Inc. Filed as Exhibit 2.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\\n| 2.3 | Agreement and Amendment, dated December 15, 2011, by and among A.M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, Tube Supply, Inc. and A.M. Castle & Co. (Canada) Inc. Filed as Exhibit 2.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\\n| 2.4 | Second Amendment to the Stock Purchase Agreement, dated January 13, 2012, by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). Incorporated by reference to Exhibit 2.3 to the Company's Form S-4/A filed with the SEC on May 25, 2012. Commission File No. 333-180662. | — |\\n| 2.5 | Third Amendment to the Stock Purchase Agreement, dated May 11, 2012, by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). Incorporated by reference to Exhibit 2.4 to the Company's Form S-4/A filed with the SEC on May 25, 2012. Commission File No. 333-180662. | — |\\n| 2.6 | Fourth Amendment to the Stock Purchase Agreement, dated September 13, 2012 by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). | E-1 |\\n| 2.7 | Fifth Amendment to the Stock Purchase Agreement, dated November 14, 2012 by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). | E-3 |\\n| 3.1 | Articles of Restatement of the Charter of the Company filed with the State Department of Assessments and Taxation of Maryland on April 27, 2012. Filed as Exhibit 3.1 to Quarterly Report on Form 10-Q for the period ended March 31, 2012, which was filed on May 3, 2012. Commission File No. 1-5415. | — |\\n| 3.2 | By-Laws of the Company as amended on October 28, 2010. Filed as Exhibit 3.2 to Quarterly Report on Form 10-Q for the period ended September 30, 2010, which was filed on November 5, 2010. Commission File No. 1-5415. | — |\\n| 3.3 | Articles Supplementary of the Company. Filed as Exhibit 3.1 to Form 8-A filed on September 6, 2012. Commission File No. 1-5415. | — |\\n| 4.1 | Indenture, dated as of December 15, 2011, among A.M. Castle & Co., the Guarantors, U.S. Bank National Association, as trustee and U.S. Bank National Association, as collateral agent. Filed as Exhibit 4.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\\n| 4.2 | Indenture, dated as of December 15, 2011, between A.M. Castle & Co., the Guarantors and U.S. Bank National Association, as trustee. Filed as Exhibit 4.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\\n| 4.3 | Rights Agreement, dated as of August 31, 2012, by and between A.M. Castle & Co. and American Stock Transfer & Trust Company, LLC, as Rights Agent. Filed as Exhibit 4.1 to Form 8-K filed on August 31, 2012. Commission File No. 1-05415. | — |\\n| 10.1* | A. M. Castle & Co. 1995 Director Stock Option Plan. Filed as Exhibit A to Proxy Statement filed March 7, 1995. Commission File No. 1-5415. | — |\\n| 10.2* | A. M. Castle & Co. 1996 Restricted Stock and Stock Option Plan. Filed as Exhibit A to Proxy Statement filed March 8, 2006. Commission File No. 1-5415. | — |\\n\\n102\\n| Exhibit No. | Description | Page |\\n| 10.3* | A. M. Castle & Co. 2000 Restricted Stock and Stock Option Plan. Filed as Appendix B to Proxy Statement filed March 23, 2001. Commission File No. 1-5415. | — |\\n| 10.4* | A. M. Castle & Co. 2004 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit D to Proxy Statement filed March 12, 2004. Commission File No. 1-5415. | — |\\n| 10.5* | A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan, as amended and restated as of December 9, 2010. Filed as Exhibit 10.25 to Annual Report on Form 8-K filed on December 15, 2010. Commission File No. 1-5415. | — |\\n| 10.6* | Form of Restricted Stock Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.11 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\\n| 10.7* | Form of Performance Share Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.12 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\\n| 10.8* | A. M. Castle & Co. Directors Deferred Compensation Plan, as amended and restated as of October 22, 2008. Filed as Exhibit 10.13 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\\n| 10.9* | A. M. Castle & Co. Supplemental 401(k) Savings and Retirement Plan, as amended and restated, effective as of January 1, 2009. Filed as Exhibit 10.14 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\\n| 10.10* | A. M. Castle & Co. Supplemental Pension Plan, as amended and restated, effective as of January 1, 2009. Filed as Exhibit 10.15 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\\n| 10.11* | First Amendment to the A. M. Castle & Co. Supplemental 401(k) Savings and Retirement Plan, executed April 15, 2009 (as effective April 27, 2009). Filed as Exhibit 10.1 to Form 8-K filed on April 16, 2009. Commission File No. 1-5415. | — |\\n| 10.12* | Form of A.M. Castle & Co. Indemnification Agreement to be executed with all directors and executive officers. Filed as Exhibit 10.16 to Form 8-K filed on July 29, 2009. Commission File No. 1-5415. | — |\\n| 10.13* | Form of Restricted Stock Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.20 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. | — |\\n| 10.14* | Form of Performance Share Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.21 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. | — |\\n| 10.15* | Form of Incentive Stock Option Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.22 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. | — |\\n| 10.16* | Form of Non-Qualified Stock Option Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.23 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. | — |\\n| 10.17* | Form of Non-Employee Director Restricted Stock Award Agreement. Filed as Exhibit 10.1 to Form 8-K filed on April 27, 2010. Commission File No. 1-5415. | — |\\n| 10.18* | Form of Amended and Restated Change of Control Agreement for all executive officers other than the CEO. Filed as Exhibit 10.24 to Form 8-K filed on September 21, 2010. Commission File No. 1-5415. | — |\\n\\n103\\n| Exhibit No. | Description | Page |\\n| 10.19* | Form of Amended and Restated Severance Agreement for executive officers other than the CEO. Filed as Exhibit 10.26 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. | — |\\n| 10.20* | CEO Change in Control Agreement, as amended and restated December 22, 2010. Filed as Exhibit 10.27 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. | — |\\n| 10.21* | CEO Employment/Non-Competition Agreement, as amended and restated December 22, 2010. Filed as Exhibit 10.28 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. | — |\\n| 10.22* | Form of Performance Share Award Agreement, adopted March 2, 2011, under A.M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.29 to Form 8-K filed March 8, 2011. Commission File No. 1-5415. | — |\\n| 10.23* | 2008 A. M. Castle & Co. Omnibus Incentive Plan, as amended and restated as of April 28, 2011. Filed as Exhibit 10.30 to Form 8-K filed May 3, 2011. Commission File No. 1-5415. | — |\\n| 10.24* | Stephen V. Hooks Executive Retention and Severance Agreement, dated October 27, 2011. Filed as Exhibit 10.31 to Form 8-K filed November 1, 2011. Commission File No. 1-5415. | — |\\n| 10.25 | Pledge and Security Agreement, dated as of December 15, 2011, by A.M. Castle & Co., and its subsidiaries that are party thereto, in favor of U.S. Bank National Association, as collateral agent, for the benefit of the Secured Parties. Filed as Exhibit 10.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\\n| 10.26 | Intercreditor Agreement, dated as of December 15, 2011, among Wells Fargo Bank, National Association, in its capacity as administrative and collateral agent for the First Lien Secured Parties and U.S. Bank National Association, a national banking association, in its capacity as trustee and collateral agend for the Second Lien Secured Parties. Filed as Exhibit 10.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\\n| 10.27 | Registration Rights Agreement, dated as of December 15, 2011, between A.M. Castle & Co., the Guarantors and Jefferies & Company, Inc., as initial purchaser, for the benefit of the Holders of the Notes. Filed as Exhibit 10.3 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\\n| 10.28 | Loan and Security Agreement, dated December 15, 2011, by and among A.M. Castle & Co., Transtar Metals Corp., Advanced Fabricating Technology, LLC, Oliver Steel Plate Co., Paramont Machine Company, LLC, Total Plastics, Inc., Tube Supply, LLC, A.M. Castle & Co. (Canada) Inc., Tube Supply Canada ULC, the other Loan Parties party thereto, the lenders which are now or which hereafter become a party thereto, and Wells Fargo Bank, National Association, a national banking association, in its capacity as administrative agent and collateral agent for Secured Parties. Filed as Exhibit 10.4 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\\n| 10.29* | Employment Agreement, dated November 9, 2011, by and between A. M. Castle & Co. and Mr. Paul Sorensen. Filed as Exhibit 10.29 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. | — |\\n| 10.30* | Form of Retention Bonus Agreement for certain executive officers in connection with CEO leadership transition, dated May 14, 2012. Filed as Exhibit 10.30 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. | — |\\n| 10.31* | Amendment to Employment Agreement, dated May 30, 2012, by and between A. M. Castle & Co. and Mr. Paul Sorensen. Filed as Exhibit 10.31 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. | — |\\n| 10.32* | Employment Offer Letter dated October 10, 2012, between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.32 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. | — |\\n\\n104\\n| Exhibit No. | Description | Page |\\n| 10.33* | Form of Restricted Stock Unit Award Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.33 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. | — |\\n| 10.34* | Form of Severance Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.34 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. | — |\\n| 10.35* | Form of Change of Control Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.35 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. | — |\\n| 10.36* | Offer of Chief Commercial Officer dated December 28, 2012, between A.M. Castle & Co. and Mr. Blain Tiffany. Filed as Exhibit 10.36 to Form 8-K filed January 22, 2013. Commission File No. 1-5415. | — |\\n| 21.1 | Subsidiaries of Registrant | E-5 |\\n| 23.1 | Consent of Deloitte & Touche LLP | E-6 |\\n| 23.2 | Consent of Grant Thornton LLP | E-7 |\\n| 31.1 | CEO Certification Pursuant to Section 302 of the Sarbanes Oxley Act of 2002. | E-8 |\\n| 31.2 | CFO Certification Pursuant to Section 302 of the Sarbanes Oxley Act of 2002. | E-9 |\\n| 32.1 | CEO and CFO Certification Pursuant to Section 906 of the Sarbanes Oxley Act of 2002. | E-10 |\\n| 101.INS | XBRL Instance Document (1) | — |\\n| 101.SCH | XBRL Taxonomy Extension Schema Document (1) | — |\\n| 101.CAL | XBRL Taxonomy Calculation Linkbase Document (1) | — |\\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document(1) | — |\\n| 101.LAB | XBRL Taxonomy Label Linkbase Document (1) | — |\\n| 101.PRE | XBRL Taxonomy Presentation Linkbase Document (1) | — |\\n\\n| (1) | Furnished with this report. In accordance with Rule 406T of Regulation S-T, the information in these exhibits shall not be deemed to be “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to liability under that section, and shall not be incorporated by reference into any registration statement or other document filed under the Securities Act of 1933, as amended, except as expressly set forth by specific reference in such filing. |\\n| * | These agreements are considered a compensatory plan or arrangement. |\\n\\n105\\n \\n\\nWhat is the total cost incurred by the company for the acquisition of Tube Supply, inclusive of direct acquisition-related costs, CEO transition costs, bad debt reserves for customer bankruptcies, charges for export penalties related to product shipments and underwriting fees associated with debt financing in $ million?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 10.9.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 51,\n \"input_length\": 92719\n}"}}},{"rowIdx":52,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nItem 1. Financial statements\nSOCIETY PASS INCORPORATED\nCONDENSED CONSOLIDATED BALANCE SHEETS\nAS OF SEPTEMBER 30, 2021 AND DECEMBER 31, 2020\n(Currency expressed in United States Dollars (“US$”))\n\n| September 30, 2021 | December 31, 2020 |\n| (Unaudited) |\n| ASSETS |\n| Current assets: |\n| Cash and cash equivalents | $ | 5,722,450 | $ | 506,666 |\n| Due from related parties | 97,500 | — |\n| Accounts receivable, net | 87,803 | 1,897 |\n| Deposits, prepayments and other receivables | 69,623 | 60,532 |\n| Total current assets | 5,977,376 | 569,095 |\n| Non-current assets: |\n| Intangible assets, net | 4,800,000 | 7,200,000 |\n| Property, plant and equipment, net | 11,080 | 18,069 |\n| Right of use assets, net | 529,782 | 79,109 |\n| Total non-current assets | 5,340,862 | 7,297,178 |\n| TOTAL ASSETS | $ | 11,318,238 | $ | 7,866,273 |\n| LIABILITIES AND SHAREHOLDERS’ DEFICIT |\n| Current liabilities: |\n| Accounts payables | $ | 104,680 | $ | 54,256 |\n| Contract liabilities | 35,582 | 18,646 |\n| Accrued liabilities and other payables | 752,640 | 677,572 |\n| Contingent service payable | — | 633,000 |\n| Due to related parties | 24,763 | 1,571,737 |\n| Operating lease liabilities | 167,773 | 36,752 |\n| Total current liabilities | 1,085,438 | 2,991,963 |\n| Non-current liabilities |\n| Operating lease liabilities | 365,539 | 46,453 |\n| TOTAL LIABILITIES | 1,450,977 | 3,038,416 |\n| COMMITMENTS AND CONTINGENCIES |\n| Convertible preferred shares; $ 0.0001 par value, 5,000,000 shares authorized, 4,916,500 and 4,920,000 shares undesignated as of September 30, 2021 and December 31, 2020, respectively |\n| Series A shares: 10,000 shares designated; 8,000 and 8,000 Series A shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | 8,000,000 | 8,000,000 |\n| Series B shares: 10,000 shares designated; 2,548 and 2,548 Series B shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | 3,412,503 | 3,412,503 |\n| Series B-1 shares: 15,000 shares designated; 160 and 160 Series B-1 shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | 466,720 | 466,720 |\n| Series C shares: 15,000 shares designated; 1,552 and 362 Series C shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively, net of issuance cost | 8,353,373 | 2,151,706 |\n| Series C-1 shares: 30,000 shares designated; 13,984 and 2,885 Series C-1 shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively, net of issuance cost and stock subscription receivable | 5,057,192 | 1,211,700 |\n| SHAREHOLDERS’ DEFICIT |\n| Series X Super Voting Preferred Stock, $ 0.0001 par value, 3,500 shares designated; 3,500 and 0 Series X shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | — | — |\n| Common shares; $ 0.0001 par value, 95,000,000 shares authorized; 9,695,480 and 7,413,600 shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | 970 | 742 |\n| Additional paid-in capital | 12,712,290 | 2,227,033 |\n| Accumulated other comprehensive loss | ( 19,478 | ) | ( 55,236 | ) |\n| Accumulated deficit | ( 28,116,309 | ) | ( 12,587,311 | ) |\n| Total shareholders’ deficit | ( 15,422,527 | ) | ( 10,414,772 | ) |\n| TOTAL LIABILITIES AND SHAREHOLDERS’ DEFICIT | $ | 11,318,238 | $ | 7,866,273 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n\n| 3 |\n\nSOCIETY PASS INCORPORATED\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND\nOTHER COMPREHENSIVE LOSS\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2021 AND 2020\n(Currency expressed in United States Dollars (“US$”))\n(Unaudited)\n\n| Three months ended | Nine months ended |\n| September 30, | September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Revenue, net |\n| Hardware sales | $ | — | $ | 585 | $ | 335 | $ | 3,510 |\n| Software subscription | 10,016 | 11,044 | 26,970 | 37,752 |\n| Sales – online ordering | 73,518 | — | 73,518 | — |\n| Total revenue | 83,534 | 11,629 | 100,823 | 41,262 |\n| Cost of sales: |\n| Hardware sales | — | ( 585 | ) | ( 165 | ) | ( 2,982 | ) |\n| Software subscription | ( 101,695 | ) | ( 19,731 | ) | ( 206,387 | ) | ( 56,127 | ) |\n| Cost of online ordering | ( 57,741 | ) | — | ( 57,741 | ) | — |\n| Total cost of revenue | ( 159,436 | ) | ( 20,316 | ) | ( 264,293 | ) | ( 59,109 | ) |\n| Gross loss | ( 75,902 | ) | ( 8,687 | ) | ( 163,470 | ) | ( 17,847 | ) |\n| Operating expenses: |\n| Sales and marketing expenses | ( 42,843 | ) | — | ( 85,027 | ) | ( 3,125 | ) |\n| Software development costs | ( 9,709 | ) | ( 33,658 | ) | ( 76,698 | ) | ( 139,151 | ) |\n| Impairment loss | — | 4,164 | ( 200,000 | ) | ( 8,778 | ) |\n| General and administrative expenses | ( 8,292,463 | ) | ( 1,580,287 | ) | ( 14,414,362 | ) | ( 2,311,266 | ) |\n| Total operating expenses | ( 8,345,015 | ) | ( 1,609,781 | ) | ( 14,776,087 | ) | ( 2,462,320 | ) |\n| Loss from operations | ( 8,420,917 | ) | ( 1,618,468 | ) | ( 14,939,557 | ) | ( 2,480,167 | ) |\n| Other income (expense): |\n| Interest income | 55 | 3 | 71 | 11 |\n| Interest expense | ( 12,272 | ) | ( 12,261 | ) | ( 36,486 | ) | ( 36,381 | ) |\n| Loss on settlement of litigation | — | — | ( 550,000 | ) | — |\n| Other income | 5,170 | 3,737 | 6,917 | 9,495 |\n| Total other expense | ( 7,047 | ) | ( 8,521 | ) | ( 579,498 | ) | ( 26,875 | ) |\n| Loss before income taxes | ( 8,427,964 | ) | ( 1,626,989 | ) | ( 15,519,055 | ) | ( 2,507,042 | ) |\n| Income taxes | ( 1,303 | ) | ( 4 | ) | ( 9,943 | ) | ( 15,069 | ) |\n| NET LOSS | $ | ( 8,429,267 | ) | $ | ( 1,626,993 | ) | $ | ( 15,528,998 | ) | $ | ( 2,522,111 | ) |\n| Other comprehensive loss: |\n| Foreign currency translation income | 8,859 | 51,183 | 35,758 | 15,249 |\n| COMPREHENSIVE LOSS | $ | ( 8,420,408 | ) | $ | ( 1,575,810 | ) | $ | ( 15,493,240 | ) | $ | ( 2,506,862 | ) |\n| Net loss per share – Basic and Diluted | $ | ( 1 | ) | $ | ( 0 | ) | $ | ( 2 | ) | $ | ( 0 | ) |\n| Weighted average common shares outstanding – Basic and Diluted | 7,823,818 | 6,848,700 | 7,551,842 | 6,847,945 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n\n| 4 |\n\nSOCIETY PASS INCORPORATED\nCONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ DEFICIT\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2021 AND 2020\n(Currency expressed in United States Dollars (“US$”))\n(Unaudited)\n\n| Three months ended September 30, 2021 |\n| Common stock | Additional paid-in capital | Accumulated other comprehensive (loss) income | Accumulated deficit | Total shareholders’ deficit |\n| Shares | Amount |\n| Balance as of July 1, 2021 | 7,413,600 | $ | 742 | $ | 5,145,228 | $ | ( 28,337 | ) | $ | ( 19,687,042 | ) | $ | ( 14,569,409 | ) |\n| Imputed Interest | — | — | 12,260 | — | — | 12,260 |\n| Shares issued for services | 1,274,250 | 127 | 5,149,929 | — | — | 5,150,056 |\n| Shares issued for accrued salaries | 1,157,630 | 116 | 960,718 | — | — | 960,834 |\n| Share cancellation | ( 150,000 | ) | ( 15 | ) | 15 | — | — | — |\n| Waiver of related parties debts | — | — | 1,444,140 | — | — | 1,444,140 |\n| Net loss for the period | — | — | — | — | ( 8,429,267 | ) | ( 8,429,267 | ) |\n| Foreign currency translation adjustment | — | — | — | 8,859 | — | 8,859 |\n| Balance as of September 30, 2021 | 9,695,480 | $ | 970 | $ | 12,712,290 | $ | ( 19,478 | ) | $ | ( 28,116,309 | ) | $ | ( 15,422,527 | ) |\n\n\n| Three months ended September 30, 2020 |\n| Common stock | Additional paid-in capital | Accumulated other comprehensive (loss) income | Accumulated deficit | Total shareholder’ deficit |\n| Shares | Amount |\n| Balance as of July 1, 2020 | 6,847,200 | $ | 685 | $ | 1,729,064 | $ | ( 31,946 | ) | $ | ( 9,654,441 | ) | $ | ( 7,956,638 | ) |\n| Issuance of common stock for services | 1,016,400 | — | 848,505 | — | — | 848,505 |\n| Imputed interest | — | — | 12,261 | — | — | 12,261 |\n| Net loss for the period | — | — | — | — | ( 1,626,993 | ) | ( 1,626,993 | ) |\n| Foreign currency translation adjustment | — | — | — | 51,183 | — | 51,183 |\n| Balance as of September 30, 2020 | 7,863,600 | $ | 685 | $ | 2,589,830 | $ | 19,237 | $ | ( 11,281,434 | ) | $ | ( 8,671,682 | ) |\n\n\n| 5 |\n\n\n| Nine months ended September 30, 2021 |\n| Common stock | Additional paid-in capital | Accumulated other comprehensive (loss) income | Accumulated deficit | Total shareholder’ deficit |\n| Shares | Amount |\n| Balance as of January 1, 2021 | 7,413,600 | $ | 742 | $ | 2,227,033 | $ | ( 55,236 | ) | $ | ( 12,587,311 | ) | $ | ( 10,414,772 | ) |\n| Imputed Interest | — | — | 36,380 | — | — | 36,380 |\n| Shares issued for services | 1,274,250 | 127 | 5,149,929 | — | — | 5,150,056 |\n| Shares issued for accrued salaries | 1,157,630 | 116 | 960,718 | — | — | 960,834 |\n| Loss on fair value of shares issued for accrued salaries | — | — | 2,894,075 | — | — | 2,894,075 |\n| Share cancellation | ( 150,000 | ) | ( 15 | ) | 15 | — | — | — |\n| Waiver of related parties debts | — | — | 1,444,140 | — | — | 1,444,140 |\n| Net loss for the period | — | — | — | — | ( 15,528,998 | ) | ( 15,528,998 | ) |\n| Foreign currency translation adjustment | — | — | — | 35,758 | — | 35,758 |\n| Balance as of September 30, 2021 | 9,695,480 | $ | 970 | $ | 12,712,290 | $ | ( 19,478 | ) | $ | ( 28,116,309 | ) | $ | ( 15,422,527 | ) |\n\n\n| Nine months ended September 30, 2020 |\n| Common stock | Additional paid-in capital | Accumulated other comprehensive (loss) income | Accumulated deficit | Total shareholders’ deficit |\n| Shares | Amount |\n| Balance as of January 1, 2020 | 6,847,200 | $ | 685 | $ | 1,704,944 | $ | 3,988 | $ | ( 8,759,323 | ) | $ | ( 7,049,706 | ) |\n| Issuance of common stock for services | 1,016,400 | — | 848,505 | — | — | 848,505 |\n| Imputed interest | — | — | 36,381 | — | — | 36,381 |\n| Net loss for the period | — | — | — | — | ( 2,522,111 | ) | ( 2,522,111 | ) |\n| Foreign currency translation adjustment | — | — | — | 15,249 | — | 15,249 |\n| Balance as of September 30, 2020 | 7,863,600 | $ | 685 | $ | 2,589,830 | $ | 19,237 | $ | ( 11,281,434 | ) | $ | ( 8,671,682 | ) |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n\n| 6 |\n\nSOCIETY PASS INCORPORATED\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\nFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2021 AND 2020\n(Currency expressed in United States Dollars (“US$”))\n(Unaudited)\n\n| Nine months ended September 30, |\n| 2021 | 2020 |\n| Cash flows from operating activities: |\n| Net loss | $ | ( 15,528,998 | ) | $ | ( 2,522,111 | ) |\n| Adjustments to reconcile net loss to net cash used in operating activities |\n| Depreciation and amortization | 2,406,648 | 4,447 |\n| Impairment loss | 200,000 | 8,778 |\n| Imputed interest | 36,380 | 36,381 |\n| Loss on settlement of litigation | 550,000 | — |\n| Stock based compensation for services | 10,071,830 | 1,641,877 |\n| Change in operating assets and liabilities: |\n| Accounts receivable | ( 85,906 | ) | ( 19,900 | ) |\n| Inventories | — | ( 7,212 | ) |\n| Deposits, prepayments and other receivables | ( 9,091 | ) | ( 7,005 | ) |\n| Contract liabilities | 16,936 | 8,275 |\n| Accounts payables | 50,424 | 61 |\n| Accrued liabilities and other payables | ( 474,932 | ) | ( 37,960 | ) |\n| Advances to related parties | 127,500 | ( 76,278 | ) |\n| Right of use assets | 28,498 | — |\n| Operating lease liabilities | ( 29,064 | ) | — |\n| Net cash used in operating activities | ( 2,639,775 | ) | ( 970,647 | ) |\n| Cash flows from investing activities: |\n| Purchase of investment assets | ( 200,000 | ) | — |\n| Net cash used in investing activities | ( 200,000 | ) | — |\n| Cash flows from financing activities: |\n| Proceed from the issuance of Series C preferred stock and exercise of warrants | 8,019,461 | 708,960 |\n| Net cash provided by financing activities | 8,019,461 | 708,960 |\n| Effect on exchange rate change on cash and cash equivalents | 36,098 | 16,689 |\n| NET CHANGE IN CASH AND CASH EQUIVALENTS | 5,215,784 | ( 244,998 | ) |\n| CASH AND CASH EQUIVALENT AT BEGINNING OF PERIOD | 506,666 | 606,491 |\n| CASH AND CASH EQUIVALENT AT END OF PERIOD | $ | 5,722,450 | $ | 361,493 |\n| Supplemental disclosure of cash flow information: |\n| Cash paid for interest | $ | 106 | $ | — |\n| Cash paid for income tax | $ | — | $ | — |\n| NON-CASH INVESTING AND FINANCING ACTIVITIES |\n| Impact of adoption of ASC 842 - lease obligation and ROU asset | $ | 479,171 | $ | — |\n| Waiver of related party debt accounted as capital transaction | $ | 1,444,140 | $ | — |\n| Fair value of preferred stock issued for services | $ | 2,948,982 | $ | 793,372 |\n| Fair value of preferred stock accounted and included for issuance cost | $ | 441,642 | $ | — |\n| Common stock issued for accrued salaries | $ | 960,835 | $ | — |\n| Shares cancellation | $ | 15 | $ | — |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n\n| 7 |\n\nNOTE－1 DESCRIPTION OF BUSINESS AND ORGANIZATION\nSociety Pass Incorporated (the “Company”) is incorporated in State of Nevada on June 22, 2018 under the name of Food Society Inc. On October 3, 2018, the Company changed its corporate name to Society Pass Incorporated. The Company through its subsidiaries, mainly sells and distributes the hardware and software of Point of Sales (POS) application in Vietnam.\nDescription of subsidiaries incorporated by the Company\n\n| Schedule of Description of subsidiaries |\n| Name | Place and date of incorporation | Principal activities | Particulars of registered/ paid up share Capital | Effective interest held |\n| Society Technology LLC | State of Nevada , January 24, 2019 | IP Licensing | US$1 | 100 % |\n| SOPA Cognitive Analytics Private Limited | India , February 5, 2019 | Computer sciences consultancy and data analytics | INR1,238,470 | 100 % |\n| SOPA Technology Pte. Ltd . | Singapore , June 4, 2019 | Investment holding | SG$1,250,000 | 100 % |\n| SOPA Technology Company Limited | Vietnam , October 1, 2019 | Software production | Registered: VND 2,307,300,000; Paid up: VND 1,034,029,911 | 100 % |\n| Hottab Pte Ltd. (HPL) | Singapore , January 17, 2015 | Software development and marketing for the F&B industry | SG$620,287.75 | 100 % |\n| Hottab Vietnam Co. Ltd | Vietnam , April 17, 2015 | Sale of POS hardware and software | VND 1,000,000,000 | 100 % |\n| Hottab Asset Company Limited | Vietnam , July 25, 2019 | Sale of POS hardware and software | VND 5,000,000,000 | 100 % |\n\nThe Company and its subsidiaries are hereinafter referred to as (the “Company”).\nOn October 29, 2019 with the revised provision dated November 11, 2019, the Company acquired Hottab Pte Ltd and its subsidiaries, at the consideration of $ 1,050,000 consisted of Series C preference shares valued at $ 900,000 and the cash consideration of $ 150,000 . The value of the $900,000 Series C preference shares issued was determined based on the stated value per share of the Company’s shares at the acquisition date. Also, the Company shall pay to the Company additional Series C preference shares with an aggregate value of $ 558,000 (the “Equity Incentive”) in the event the Company able to fulfilled the other terms per their arrangement with in five months from the completion date.\nOn February 10, 2021, the Company effected a 750 for 1 stock split of the issued and outstanding shares of the Company’s common stock. The number of authorized shares and par value remain unchanged. All share and per share information in this financial statements and footnotes have been retroactively adjusted for the period and years presented, unless otherwise indicated, to give effect to the forward stock split.\nOn September 21, 2021, the Company effected a 1 for 2.5 stock split of the issued and outstanding shares of the Company’s common stock. The number of authorized shares and par value remain unchanged. All share and per share information in this financial statements and footnotes have been retroactively adjusted for the period and years presented, unless otherwise indicated, to give effect to the reverse stock split.\nAn additional result of the stock split was that the stated value of preferred stock, the number of designated shares and outstanding shares of each series of preferred stock was unchanged in accordance to the respective certificate of designations. The number of authorized shares of preferred stock remained unchanged.\n\n| 8 |\n\nSpun Out\nOn December 31, 2019, the Company recently spun out Food Society Group Limited (Food Business), which aims to develop and commercialize chain of restaurants in Vietnam.\nIn connection with the presentation of the Company’s consolidated financial statements, the Company considered the guidance described in the SEC’s codified Staff Accounting Bulletins, Topic 5, Section Z, paragraph 7, “Accounting for the Spin-off of a subsidiary”.\nThe Company’s initial registration of its securities under the 1933 Securities Act and the spin off transaction of the Food Society Group Limited occurred prior to the effectiveness of the Company’s registration statement.\nThe Company considered the following facts and circumstances in concluding omitting the Food Society Group Limited results of operations and financial position in the consolidated financial statements presented in the registration statement:\n• The Company’s operations as a developer of an e-commerce platform and the Food Society Group Limited operations as a two(2) retail restaurants are in dissimilar business that would ordinarily be distinguished as reportable segments as defined by FASB ASC 280-10-50-10.\n• The Company and the subsidiary have been managed and financed historically as if autonomous\n• The Company and the subsidiary have no common facilities or costs\n• The Company and the subsidiary are operated and financed autonomously after the spinoff, and\n• There are no material financial commitments , guarantees or contingent liabilities to each other after the spin off\nAccordingly, the Company has elected to characterize the spin-off of the Food Society Group Limited as a change in the Company’s reporting and present its historical financial statements as if the Company never had an investment in the subsidiary.\nThis spun off our subsidiary Food Society Group Limited which owns 100% of Vietnam Eats (Hong Kong) Limited which owns 100% of Loft Restaurant Service Trading Company Limited that operates 2 restaurants in Vietnam.\nThomas O’Connor, our former Chief Marketing Officer, serves as the legal representative of Loft Restaurant Service Trading Company Limited. Our Chief Executive Officer and Chairman of our board of directors, Dennis Nguyen., is the Chairman of Food Society Group Limited’s board of directors.\nThe two restaurants were making losses for the financial year of 2019. The Company wanted to focus on building our loyalty technology platform. On December 20, 2019’s Board of Directors meeting the CFO presented the case for the spun off. The board voted on the February 18, 2020 to spin out the Food Society Group Limited via a proportionate distribution of shareholding percentage to the existing shareholders as at December 31, 2019.\nNOTE－2 LIQUIDITY AND CAPITAL RESOURCES\nThe accompanying unaudited condensed consolidated financial statements have been prepared using the going concern basis of accounting, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.\nThe Company suffered from an accumulated deficit of 28,116,309 at September 30, 2021. The Company incurred continuous net loss of $ 15,528,998 during the nine months ended September 30, 2021. The continuation of the Company as a going concern is dependent upon the continued financial support from its shareholders. Management believes the Company is currently pursuing additional financing for its operations. However, there is no assurance that the Company will be successful in securing sufficient funds to sustain the operations.\n\n| 9 |\n\nThe registration statement for the Company’s Initial Public Offering became effective on November 8, 2021. On November 8, 2021, the Company entered into an underwriting agreement with Maxim Group LLC, related to the offering of 2,888,889 shares of the Company’s common stock (the “Firm Share”), at a public offering price of $ 9.00 per share. Under the terms of the Underwriting Agreement, the Company has granted the Underwriters an option, exercisable for 45 days, to purchase an additional 236,111 shares of common stock (the “Option Shares”) to cover over-allotments. The Company has raised funding from Initial Public Offering and Option shares of $ 26,000,001 and 2,124,999 . In addition, the Company has raised $ 8,019,461 , net of issuance cost in the form of equity subsequent to issuance of the audit report on the Company’s December 31, 2020 financial statements respectively in the form of equity subsequent to issuance of the audit report on the Company’s December 31, 2020 financial statements and based upon the capital raised, the Company believes it has sufficient liquidity to meet its working capital requirements for the next 12 months. As a result the Company has mitigated any doubts about its ability to continue as a going concern\nThe recent outbreak of COVID-19, which has been declared by the World Health Organization to be a pandemic, has spread across the globe and is impacting worldwide economic activity.. The COVID-19 pandemic has significantly impacted health and economic conditions throughout Vietnam, Singapore and Southeast Asia. National, regional and local governments took a variety of actions to contain the spread of COVID-19, including office and store closures, quarantining suspected COVID-19 patients, and capacity limitations. These developments have significantly impacted the results of operations, financial condition and cash flows of the Company included in this reporting. The impact included the difficulties of working remotely from home including slow Internet connection, the inability of our accounting and financial officers to collaborate as effectively as they would otherwise have in an office environment and issues arising from mandatory state quarantines.\nWhile it is not possible at this time to estimate with sufficient certainty the impact that COVID-19 could have on the Company’s business, the continued spread of COVID-19 and the measures taken by federal, state, local and foreign governments could disrupt the operation of the Company’s business. The COVID-19 outbreak and mitigation measures have also had and may continue to have an adverse impact on global and domestic economic conditions, which could have an adverse effect on the Company’s business and financial condition, including on its potential to conduct financings on terms acceptable to the Company, if at all. In addition, the Company has taken temporary precautionary measures intended to help minimize the risk of the virus to its employees, including temporarily requiring employees to work remotely, and discouraging employee attendance at in-person work-related meetings, which could negatively affect the Company’s business. These measures are continuing. The extent to which the COVID-19 outbreak impacts the Company’s results will depend on future developments that are highly uncertain and cannot be predicted, including new information that may emerge concerning the severity of the virus and the actions to contain its impact.\nNOTE－3 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nThe accompanying unaudited condensed consolidated financial statements reflect the application of certain significant accounting policies as described in this note and elsewhere in the accompanying condensed consolidated financial statements and notes.\n• Basis of presentation\nThe accompanying unaudited interim consolidated condensed financial statements of Society Pass Incorporated have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with Article 8-03 of Regulation S-X. Accordingly, they do not include all the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments, consisting only of normal recurring accruals necessary for a fair statement of financial position, results of operations and cash flows, have been included. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the financial statements and the accompanying notes included in the Company’s registration statement on Form S-1 for the year ended December 31, 2020. The year-end balance sheet data presented for comparative purposes was derived from audited financial statements, but does not include all disclosures required by GAAP. The results of operations for the three and nine months ended September 30, 2021 are not necessarily indicative of the operating results for the year ending December 31, 2021 or for any other subsequent interim period.\n\n| 10 |\n\n• Use of estimates and assumptions\nIn preparing these condensed consolidated financial statements, management makes estimates and assumptions that affect the reported amounts of assets and liabilities in the balance sheet and revenues and expenses during the years reported. Actual results may differ from these estimates. If actual results significantly differ from the Company’s estimates, the Company’s financial condition and results of operations could be materially impacted. Significant estimates in the period include the allowance for doubtful accounts on accounts and other receivables, assumptions used in assessing right of use assets, imputed interest on due to related parties, and impairment of long-term assets, business acquisition allocation of purchase consideration, and deferred tax valuation allowance.\n• Basis of consolidation\nThe condensed consolidated financial statements include the financial statements of the Company and its subsidiaries. All significant inter-company balances and transactions within the Company have been eliminated upon consolidation. In addition, certain amounts in the prior periods’ consolidated financial statements have been reclassified to conform to the current period presentation.\n• Cash and cash equivalents\nCash and cash equivalents are carried at cost and represent cash on hand, demand deposits placed with banks or other financial institutions and all highly liquid investments with an original maturity of three months or less as of the purchase date of such investments. As of September 30, 2021 and December 31, 2020, the cash and cash equivalent was amounted to $ 5,722,450 and $ 506,666 , respectively.\nThe Company currently has bank deposits with financial institutions in the U.S. which does not exceed FDIC insurance limits. FDIC insurance provides protection for bank deposits up to $ 250,000 , so there were uninsured balance of $ 4,895,306 and $ 208,635 in parent entity as of September 30, 2021 and December 31, 2020, respectively. In addition, the Company has uninsured bank deposits with a financial institution outside the U.S. All uninsured bank deposits are held at high quality credit institutions.\n• Accounts receivable\nAccounts receivable are recorded at the invoiced amount and do not bear interest, which are due within contractual payment terms, generally 30 to 90 days from completion of service. Credit is extended based on evaluation of a customer's financial condition, the customer credit-worthiness and their payment history. Accounts receivable outstanding longer than the contractual payment terms are considered past due. Past due balances over 90 days and over a specified amount are reviewed individually for collectibility. At the end of fiscal year, the Company specifically evaluates individual customer’s financial condition, credit history, and the current economic conditions to monitor the progress of the collection of accounts receivables. The Company considers the allowance for doubtful accounts for any estimated losses resulting from the inability of its customers to make required payments. For the receivables that are past due or not being paid according to payment terms, the appropriate actions are taken to exhaust all means of collection, including seeking legal resolution in a court of law. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. The Company does not have any off-balance-sheet credit exposure related to its customers. As of September 30, 2021 and December 31, 2020, the allowance for doubtful accounts amounted to $ 0 and $ 0 , respectively.\n• Inventories\nInventories are stated at the lower of cost or net realizable value, cost being determined on a first-in-first-out method. Costs include hardware equipment and peripheral costs which are purchased from the Company’s suppliers as merchandized goods. The Company provides inventory allowances based on excess and obsolete inventories determined principally by customer demand. During the nine months ended September 30, 2021 and 2020, the Company recorded an allowance for obsolete inventories of $ 0 and $ 0 , respectively. During the three months ended September 30, 2021 and 2020, the Company recorded an allowance for obsolete inventories of $ 0 and $ 0 , respectively. The inventories were amounted to $ 0 and $ 0 at September 30, 2021 and December 31, 2020, respectively.\n\n| 11 |\n\n• Property, plant and equipment\nPlant and equipment are stated at cost less accumulated depreciation and accumulated impairment losses, if any. Depreciation is calculated on the straight-line basis over the following expected useful lives from the date on which they become fully operational and after taking into account their estimated residual values:\n\n| Schedule of Expected useful life |\n| Expected useful lives |\n| Computer equipment | 3 years |\n| Office equipment | 5 years |\n\nExpenditures for repairs and maintenance are expensed as incurred. When assets have been retired or sold, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is recognized in the results of operations.\n• Impairment of long-lived assets\nIn accordance with the provisions of ASC Topic 360, “Impairment or Disposal of Long-Lived Assets”, all long-lived assets such as plant and equipment and intangible assets held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is evaluated by a comparison of the carrying amount of an asset to its estimated future undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amounts of the assets exceed the fair value of the assets. There has been no impairment charge for the periods presented.\n• Revenue recognition\nThe Company adopted Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”). Under ASU 2014-09, the Company applies the following five steps in order to determine the appropriate amount of revenue to be recognized as it fulfills its obligations under each of its agreements:\n\n| • | identify the contract with a customer; |\n| • | identify the performance obligations in the contract; |\n| • | determine the transaction price; |\n| • | allocate the transaction price to performance obligations in the contract; and |\n| • | recognize revenue as the performance obligation is satisfied. |\n\nThe revenues are generated from a diversified a mix of marketplace activities and the services of the Company provide merchants to help them grow their businesses. The revenue streams consist of Consumer Facing revenues and Merchant Facing revenues.\nConsumer Facing Business\nThe Company’s performance obligation includes providing connectivity between merchant and consumer, generally through an online ordering platform. The platform allows merchants to create account, place menu and track their sale reports on the merchant facing application. The platform also allows the consumers to create account and make orders from merchants on the consumer facing application. The platform allows delivering company to accept online delivery request and ship order from merchant to consumer.\nThe Company also has online lifestyle platform allow customers to purchase high-end brands of all catergories: Under the Company’s smart search engine, consumers search or review their favorite brands among hundreds of choices in Apparel, Bags & Shoes, Accessory, Health & Beauty, Home & Lifestyle, International, Women, Men and Kids & Babies categories. The platform also allow consumers order from hundreds of vendor choices with personalized promotions based on purchase history and location. The platform has also partnered up with a Vietnam-based delivery company, Tikinow, to offer seamless delivery of product from merchant to consumer’s home or office at the touch of a button. Consumers place orders for delivery or pickup at the Company’s logistics center.\n| 12 |\n\nRevenue streams for consumer facing business:\nF&B sector\n\n| 1) | Ordering fees comprise the fees that the different types of merchants pay for every completed transaction on the Platform, exclusive of delivery fees charged. Monthly/annual subscription fees or 10% commission on order value on each successful order will be charged. |\n\n\n| 2) | Delivery fees include an upfront fixed fee and additional variable fees based on the distance. Various percentage of commission will be charged as delivery fee on each successful order received and delivered. |\n\nThe Company recognizes revenues from consumer facing business upon the completion of delivery and services rendered.\nDuring the period ended September 30, 2021 and 2020, the Company have not generated any revenue from this stream.\nLifestyle sector\n\n| 1) | Customer placed orders on the website / app, sales orders report will be generated in the system. The Company will start to proceed to packaging and delivering customer. The sales recognised. |\n\nDuring the nine months ended September 30, 2021 and 2020, the Company have generated $ 73,518 and $ 0 , respectively revenue from this stream. During the three months ended September 30, 2021 and 2020, the Company have generated $ 73,518 and $ 0 , respectively revenue from this stream.\nMerchant Facing Business\nRevenue streams for merchant facing business include:\n\n| 1) | Subscription fees consist of the fees that the Company charge merchants to get on the Merchant Marketing Program; |\n| 2) | The Company provides optional add-on software services which includes Analytics and Chatbox capabilities at a fixed fee per month. |\n| 3) | The Company collects commissions when they sell third party hardware and equipment (cashier stations, waiter tablets and printers) to merchants. |\n| 4) | Vendor Financing. The Company collects brokerage fees whenever the Company facilitates financing transactions between merchants and one of the Company’s partner financial institutions. |\n\nDuring the nine months ended September 30, 2021 and 2020, the Company have generated $26,970 and $37,752, respectively revenue from this stream. During the three months ended September 30, 2021 and 2020, the Company have generated $10,016 and $11,044, respectively revenue from this stream.\nHardware Product Revenues — the Company generally is involved with the sale of on-premise appliances and end-point devices. The single performance obligation is to transfer the hardware product (which is to be installed with its licensed software integral to the functionality of the hardware product). The entire transaction price is allocated to the hardware product and is generally recognized as revenue at the time of delivery because the customer obtains control of the product at that point in time. It is concluded that control generally transfers at that point in time because the customer has title to the hardware, physical possession, and a present obligation to pay for the hardware. Payments for hardware contracts are generally due 30 to 90 days after shipment of the hardware product.\n\n| 13 |\n\nThe Company records revenues from the sales of third-party products on a “gross” basis pursuant to ASC 606-10 Revenue Recognition – Revenue from Contracts with Customers, when the Company controls the specified good before it is transferred to the end customer and have the risks and rewards as principal in the transaction, such as responsibility for fulfillment, retaining the risk for collection, and establishing the price of the products. If these indicators have not been met, or if indicators of net revenue reporting specified in ASC 606-10 are present in the arrangement, revenue is recognized net of related direct costs.\nSoftware License Revenues — The Company’s performance obligation includes providing connectivity to software, generally through a monthly subscription, where the Company typically satisfies its performance obligations prior to the submission of invoices to the customer for such services. The Company’s software sale arrangements grant customers the right to access and use the software products which are to be installed with the relevant hardware for connectivity at the outset of an arrangement, and to be entitled to both technical support and software upgrades and enhancements during the term of the agreement. The term of the subscription period is generally 12 months, with the automatic renewal of another one year, and the subscription license service is billed monthly, quarterly or annually. Sales are generally recorded in the month the service is provided. For clients who are billed on an annual basis, deferred revenue is recorded and amortized over the life of the contract. Payments are generally due 30 to 90 days after delivery of the software licenses.\nThe Company records its revenues on hardware product and software license, net of value added taxes (“VAT”) upon the services are rendered and the title and risk of loss of hardware products are fully transferred to the customers. The Company is subject to VAT which is levied on the majority of the hardware products at the rate of 10% on the invoiced value of sales.\nContract assets\nIn accordance with ASC 606-10-45-3, contract asset is when the Company’s right to payment for goods and services already transferred to a customer if that right to payment is conditional on something other than the passage of time. The Company will recognize a contract asset when it has fulfilled a contract obligation but must perform other obligations before being entitled to payment.\nThere were no contract assets at September 30, 2021 and December 31, 2020.\nContract liabilities\nIn accordance with ASC 606-10-45-2, a contract liability is Company’s obligation to transfer goods or services to a customer when the customer prepays consideration or when the customer’s consideration is due for goods and services that the Company will yet provide whichever happens earlier.\nContract liabilities represent amounts collected from, or invoiced to, customers in excess of revenues recognized, primarily from the billing of annual subscription agreements. The value of contract liabilities will increase or decrease based on the timing of invoices and recognition of revenue. The Company’s contract liability balance was $ 35,582 and $ 18,646 as of September 30, 2021 and December 31, 2020, respectively.\nContract costs\nUnder ASC-606, the Company applies the following three steps in order to evaluate the costs to be capitalized as it fulfills following three criteria:\n• Incremental costs directly related to a specific contract;\n• Costs that generate or enhance resources of the company that will be used to satisfy performance of the terms of the contract; and\n• Costs that are expected to be recovered from the customer.\nNo contract costs are capitalized for the nine months ended September 30, 2021 and 2020.\nNo contract costs are capitalized for the three months ended September 30, 2021 and 2020.\n\n| 14 |\n\n• Software development costs\nIn accordance with the relevant FASB accounting guidance regarding the development of software to be sold, leased, or marketed, the Company expenses such costs as they are incurred until technological feasibility has been established, at and after which time these costs are capitalized until the product is available for general release to customers. Once the technological feasibility is established per ASC 985-20, the Company capitalizes costs associated with the acquisition or development of major software for internal and external use in the balance sheet. Costs incurred to enhance the Company’s software products, after general market release of the services using the products, is expensed in the period they are incurred. The Company only capitalizes subsequent additions, modifications or upgrades to internally developed software to the extent that such changes allow the software to perform a task it previously did not perform. The Company also expenses website costs as incurred.\nResearch and development expenditures in the development of its own software are charged to operations as incurred. Based on the software development process, technological feasibility is established upon completion of a working model, which also requires certification and extensive testing. Costs incurred by the Company between completion of the working model and the point at which the product is ready for general release are immaterial. For the nine months ended September 30, 2021 and 2020, the software development costs were $ 76,698 and $ 139,151 , respectively. For three months ended September 30, 2021 and 2020, the software development costs were $ 9,709 and $ 33,658 , respectively.\n• Product warranties\nThe Company’s provision for estimated future warranty costs is based upon historical relationship of warranty claims to sales. Based upon historical sales trends and warranties provided by the Company’s suppliers, the Company has concluded that no warranty liability is required as of September 30, 2021 and December 31, 2020. To date, product allowance and returns have been minimal and, based on its experience, the Company believes that returns of its products will continue to be minimal.\n• Shipping and handling costs\nNo shipping and handling costs are associated with the distribution of the products to the customers which are borne by the Company’s suppliers or distributors.\n• Sales and marketing\nSales and marketing expenses include payroll, employee benefits and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $ 85,027 and $ 3,125 for the nine months ended September 30, 2021 and 2020, respectively. For three months ended September 30, 2021 and 2020, the Advertising expense were $ 42,843 and $ 0 , respectively.\n• Income tax\nThe Company adopted the ASC 740 Income Tax provisions of paragraph 740-10-25-13, which addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the condensed consolidated financial statements. Under paragraph 740-10-25-13, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the condensed consolidated financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent (50%) likelihood of being realized upon ultimate settlement. Paragraph 740-10-25-13 also provides guidance on de-recognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures. The Company had no material adjustments to its liabilities for unrecognized income tax benefits according to the provisions of paragraph 740-10-25-13.\n\n| 15 |\n\nThe estimated future tax effects of temporary differences between the tax basis of assets and liabilities are reported in the accompanying balance sheets, as well as tax credit carry-backs and carry-forwards. The Company periodically reviews the recoverability of deferred tax assets recorded on its balance sheets and provides valuation allowances as management deems necessary.\nThe Company and its wholly-owned foreign subsidiary, is subject to income taxes in the jurisdictions in which it operates. Significant judgment is required in determining the provision for income tax. There are many transactions and calculations undertaken during the ordinary course of business for which the ultimate tax determination is uncertain. The company recognizes liabilities for anticipated tax audit issues based on the Company’s current understanding of the tax law. Where the final tax outcome of these matters is different from the carrying amounts, such differences will impact the current and deferred tax provisions in the period in which such determination is made.\n• Uncertain tax positions\nThe Company did not take any uncertain tax positions and had no adjustments to its income tax liabilities or benefits pursuant to the ASC 740 provisions of Section 740-10-25 for the three and nine months ended September 30, 2021 and 2020.\n• Foreign currencies translation and transactions\nThe reporting currency of the Company is United States Dollar (\"US$\") and the accompanying condensed consolidated financial statements have been expressed in US$. In addition, the Company’s subsidiary is operating in the Republic of Vietnam and India and maintains its books and record in its local currency, Vietnam Dong (“VND”) and Indian Rupee (“INR), respectively, which are the functional currency as being the primary currency of the economic environment in which their operations are conducted. In general, for consolidation purposes, assets and liabilities of its subsidiaries whose functional currency is not US$ are translated into US$, in accordance with ASC Topic 830-30, “Translation of Financial Statement”, using the exchange rate on the balance sheet date. Shareholders’ equity is translated using the historical rates. Revenues and expenses are translated at average rates prevailing during the year. The gains and losses resulting from translation of financial statements of foreign subsidiary are recorded as a separate component of accumulated other comprehensive income within the statements of changes in shareholder’s equity.\nTranslation of amounts from SGD$ into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\n\n| Schedule of Foreign currencies translation and transactions |\n| September 30, 2021 | September 30, 2020 |\n| Period-end SGD$:US$ exchange rate | $ | 0.73534 | $ | 0.73118 |\n| Period average SGD$:US$ exchange rate | $ | 0.74658 | $ | 0.71922 |\n\nTranslation of amounts from VND into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\n\n| September 30, 2021 | September 30, 2020 |\n| Period-end VND$:US$ exchange rate | $ | 0.000044 | $ | 0.000043 |\n| Period average VND$:US$ exchange rate | $ | 0.000043 | $ | 0.000043 |\n\nTranslation of amounts from INR into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\n\n| September 30, 2021 | September 30, 2020 |\n| Period-end INR$:US$ exchange rate | $ | 0.013463 | $ | 0.013570 |\n| Period average INR$:US$ exchange rate | $ | 0.013576 | $ | 0.013490 |\n\nTranslation gains and losses that arise from exchange rate fluctuations from transactions denominated in a currency other than the functional currency are translated, as the case may be, at the rate on the date of the transaction and included in the results of operations as incurred.\n\n| 16 |\n\nForeign Exchange Loss (Gain). We recorded a foreign exchange gain of $ 8,859 for the three months ended September 30, 2021 as compared to a gain of $ 51,183 for the same period in 2020. Foreign exchange gains and losses are primarily unrealized (non-cash) in nature and results from the re-measuring of specific transactions and monetary accounts in a currency other than the functional currency. For example, a U.S. Dollar transaction which occurs in Singapore is re-measured at the period-end to Singapore dollar amount if it has not been settled previously. The foreign exchange gain for the three months ended September 30, 2021 was due to an increase in the value of the Singapore Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the Singapore dollar to the U.S. Dollar increased 0.56%. At September 30, 2021, the exchange rate was 0.73534 as compared to 0.73118 at September 30, 2020. In addition, a U.S. Dollar transaction which occurs in India is re-measured at the period-end to India dollar amount if it has not been settled previously. The foreign exchange loss for the three months ended September 30, 2021 was due to an increase in the value of the India Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the India dollar to the U.S. Dollar increased 0.79%. At September 30, 2021, the exchange rate was 0.013463 as compared to 0.013570 at September 30, 2020. A U.S. Dollar transaction which occurs in Vietnam is re-measured at the period-end to Vietnameses dollar amount if it has not been settled previously. The foreign exchange gain for the three months ended September 30, 2021 was due to an increase in the value of the Vietnamese Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the Vietnamese dollar to the U.S. Dollar increased 2.32%. At September 30, 2021, the exchange rate was 0.000044 as compared to 0.000043 at September 30, 2020.\n• Comprehensive income\nASC Topic 220, “Comprehensive Income”, establishes standards for reporting and display of comprehensive income, its components and accumulated balances. Comprehensive income as defined includes all changes in equity during a period from non-owner sources. Accumulated other comprehensive income, as presented in the accompanying condensed consolidated statements of changes in shareholders’ equity, consists of changes in unrealized gains and losses on foreign currency translation. This comprehensive income is not included in the computation of income tax expense or benefit.\n• Leases\nThe Company adopted Topic 842, Leases (“ASC 842”) to determine if an arrangement is a lease at inception. Operating leases are included in operating lease right-of-use (“ROU”) assets and operating lease liabilities in the condensed consolidated balance sheets. Finance leases are included in property and equipment, other current liabilities, and other long-term liabilities in the condensed consolidated balance sheets.\nROU assets represent the right to use an underlying asset for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As most of the Company’s leases do not provide an implicit rate, the Company generally use the incremental borrowing rate based on the estimated rate of interest for collateralized borrowing over a similar term of the lease payments at commencement date. The operating lease ROU asset also includes any lease payments made and excludes lease incentives. The lease terms may include options to extend or terminate the lease when it is reasonably certain that the Company will exercise that option. Lease expense for lease payments is recognized on a straight-line basis over the lease term.\n\n| 17 |\n\nIn accordance with the guidance in ASC 842, components of a lease should be split into three categories: lease components (e.g. land, building, etc.), non-lease components (e.g. common area maintenance, consumables, etc.), and non-components (e.g. property taxes, insurance, etc.). Subsequently, the fixed and in-substance fixed contract consideration (including any related to non-components) must be allocated based on the respective relative fair values to the lease components and non-lease components.\nAs of September 30, 2021 and December 31, 2020, the Company recorded the right of use asset of $ 529,782 and $ 79,109 respectively.\n• Related parties\nThe Company follows the ASC 850-10, Related Party for the identification of related parties and disclosure of related party transactions.\nPursuant to section 850-10-20 the related parties include a) affiliates of the Company; b) entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of section 825–10–15, to be accounted for by the equity method by the investing entity; c) trusts for the benefit of employees, such as pension and Income-sharing trusts that are managed by or under the trusteeship of management; d) principal owners of the Company; e) management of the Company; f) other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests; and g) other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.\nThe condensed consolidated financial statements shall include disclosures of material related party transactions, other than compensation arrangements, expense allowances, and other similar items in the ordinary course of business. However, disclosure of transactions that are eliminated in the preparation of consolidated or combined financial statements is not required in those statements. The disclosures shall include: a) the nature of the relationship(s) involved; b) a description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the financial statements; c) the dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period; and d) amount due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement.\n• Commitments and contingencies\nThe Company follows the ASC 450-20, Commitments to report accounting for contingencies. Certain conditions may exist as of the date the financial statements are issued, which may result in a loss to the Company but which will only be resolved when one or more future events occur or fail to occur. The Company assesses such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or un-asserted claims that may result in such proceedings, the Company evaluates the perceived merits of any legal proceedings or un-asserted claims as well as the perceived merits of the amount of relief sought or expected to be sought therein.\nIf the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s consolidated financial statements. If the assessment indicates that a potentially material loss contingency is not probable but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, and an estimate of the range of possible losses, if determinable and material, would be disclosed.\nLoss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the guarantees would be disclosed. Management does not believe, based upon information available at this time that these matters will have a material adverse effect on the Company’s financial position, results of operations or cash flows. However, there is no assurance that such matters will not materially and adversely affect the Company’s business, financial position, and results of operations or cash flows.\n\n| 18 |\n\n• Fair value of financial instruments\nThe Company follows paragraph 825-10-50-10 of the FASB Accounting Standards Codification for disclosures about fair value of its financial instruments and has adopted paragraph 820-10-35-37 of the FASB Accounting Standards Codification (“Paragraph 820-10-35-37”) to measure the fair value of its financial instruments. Paragraph 820-10-35-37 of the FASB Accounting Standards Codification establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. To increase consistency and comparability in fair value measurements and related disclosures, paragraph 820-10-35-37 of the FASB Accounting Standards Codification establishes a fair value hierarchy which prioritizes the inputs to valuation techniques used to measure fair value into three (3) broad levels. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The three (3) levels of fair value hierarchy defined by paragraph 820-10-35-37 of the FASB Accounting Standards Codification are described below:\n\n| Level 1 | Quoted market prices available in active markets for identical assets or liabilities as of the reporting date. |\n| Level 2 | Pricing inputs other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable as of the reporting date. |\n| Level 3 | Pricing inputs that are generally observable inputs and not corroborated by market data. |\n\nFinancial assets are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable.\nThe fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.\nThe carrying amounts of the Company’s financial assets and liabilities, such as cash and cash equivalents, accounts receivable, deposits, prepayments and other receivables, contract liabilities, accrued liabilities and other payables, amounts due to related parties and operating lease liabilities, approximate their fair values because of the short maturity of these instruments.\n• Cost of goods sold\nCost of goods sold consists of the cost of hardware, software and payroll, which are directly attributable to the sales of products. The cost also consists of costs of materials which has been sold attributable to the sales of high-end products. Additional costs may include freight paid to acquire the goods, custom duties, sales or use taxes not recoverable paid on materials used, and any fee for purchase.\n• Share-based compensation\nPursuant to ASU 2018-07, the Company follows ASC 718, Compensation—Stock Compensation (“ASC 718”), which requires the measurement and recognition of compensation expense for all share-based payment awards (employee or non employee), are measured at grant-date fair value of the equity instruments that an entity is obligated to issue. Restricted stock units are valued using the market price of the Company’s common shares on the date of grant. As of September 30, 2021, those shares issued for service compensations were immediately vested, and therefore this amount is thus recognized as expense with an offset to preferred or September 30, 2021 and 2020, the stock-based compensations are recorded in the General and administrative expenses within the Condensed Consolidated Statements of Operations and Other Comprehensive Loss.”\n\n| 19 |\n\n• Business combinations\nThe Company follows ASC 805, Business Combinations (“ASC 805”) and ASC 810-10-65, Consolidation. ASC 805 requires most identifiable assets, liabilities, non-controlling interests, and goodwill acquired in a business combination to be recorded at “fair value.” The statement applies to all business combinations, including combinations among mutual entities and combinations by contract alone. Under ASC 805, all business combinations are accounted for by applying the acquisition method. Accounting for goodwill requires significant management estimates and judgment. Management performs periodic reviews of the carrying value of goodwill to determine whether events and circumstances indicate that an impairment in value may have occurred. A variety of factors could cause the carrying value of goodwill to become impaired. A write-down of the carrying value of goodwill could result in a non-cash charge, which could have an adverse effect on the Company’s results of operations.\n• Earnings per share\nBasic per share amounts are calculated using the weighted average shares outstanding during the year, excluding unvested restricted stock units. The Company uses the treasury stock method to determine the dilutive effect of stock options and other dilutive instruments. Under the treasury stock method, only “in the money” dilutive instruments impact the diluted calculations in computing diluted earnings per share. Diluted calculations reflect the weighted average incremental common shares that would be issued upon exercise of dilutive options assuming the proceeds would be used to repurchase shares at average market prices for the period.\nAs of September 30, 2021 and December 31, 2020, the Company has the number of shares of common stock to be issued upon conversion of below:\n\n| Schedule of Common stock issued |\n| As of September 30, | As of December 31, |\n| 2021 | 2020 |\n| Series A Convertible Preferred Stock (a) | 8,000 | 8,000 |\n| Series B Convertible Preferred Stock | 764,400 | 764,400 |\n| Series B-1 Convertible Preferred Stock | 48,000 | 48,000 |\n| Series C Convertible Preferred Stock | 465,600 | 108,600 |\n| Series C-1 Convertible Preferred Stock | 4,195,200 | 865,500 |\n| Warrants granted | — | — |\n| Warrants granted with Series C-1 Convertible Preferred Stock | 1,178,700 | 614,100 |\n| Total: | 6,659,900 | 2,408,600 |\n\n\n| (a) | The Series A the conversion formula is aggregate Stated Value divided by IPO price (Stated Value for each Series A preferred share is $1,000). There are 8,000 shares of Series A Preferred Stock issued and outstanding (10,000 shares are designated Series A). The conversion formula would be $8 million (the aggregate stated value) divided by IPO price. |\n\n• Segment Reporting\nASC Topic 280, “Segment Reporting” establishes standards for reporting information about operating segments on a basis consistent with the Company’s internal organization structure as well as information about geographical areas, business segments and major customers in condensed consolidated financial statements. For the nine months ended September 30, 2021 and 2020, the Company operates in two reportable operating segment.\n• Emerging Growth Company\nWe are an “emerging growth company” under the JOBS Act. For as long as we are an “emerging growth company,” we are not required to: (i) comply with any new or revised financial accounting standards that have different effective dates for public and private companies until those standards would otherwise apply to private companies, (ii) provide an auditor’s attestation report on management’s assessment of the effectiveness of internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act, (iii) comply with any new requirements adopted by the Public Company Accounting Oversight Board (“PCAOB”) requiring mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor would be required to provide additional information about the audit and the financial statements of the issuer or (iv) comply with any new audit rules adopted by the PCAOB after April 5, 2012, unless the SEC determines otherwise. However, we have elected to “opt out” of the extended transition period discussed in (i) and will therefore comply with new or revised accounting standards on the applicable dates on which the adoption of such standards are required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to opt out of such extended transition period for compliance with new or revised accounting standards is irrevocable.\n\n| 20 |\n\n• Recent Accounting Pronouncements\nFrom time to time, new accounting pronouncements are issued by the Financial Accounting Standard Board (“FASB”) or other standard setting bodies and adopted by the Company as of the specified effective date. Unless otherwise discussed, the Company believes that the impact of recently issued standards that are not yet effective will not have a material impact on its financial position or results of operations upon adoption.\nAccounting Standards Adopted\nIn August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (“ASU 2018-13”), which eliminates, adds and modifies certain disclosure requirements for fair value measurements. The amendment is effective for interim and annual reporting periods beginning after December 15, 2019. The Company has evaluated and the adoption of this does not have any impact on the financial statements.\nIn November 2018, the FASB issued ASU No. 2018-18, Collaborative Arrangements (“ASU 2018-18”), which clarifies the interaction between ASC 808, Collaborative Arrangements and ASC 606, Revenue from Contracts with Customers. Certain transactions between participants in a collaborative arrangement should be accounted for under ASC 606 when the counterparty is a customer. In addition, ASU 2018-18 precludes an entity from presenting consideration from a transaction in a collaborative arrangement as revenue if the counterparty is not a customer for that transaction. ASU 2018-18 should be applied retrospectively to the date of initial application of ASC 606. This guidance is effective for interim and fiscal periods beginning after December 15, 2019. The Company has evaluated and the adoption of this does not have an any impact on the financial statements.\nAccounting Standards Issued, Not Adopted\nIn June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). This ASU requires measurement and recognition of expected credit losses for financial assets. ASU 2016-13 also requires new disclosures for financial assets measured at amortized cost, loans and available-for-sale debt securities. ASU 2016-13 is effective for the Company beginning January 1, 2023. Entities will apply the standard's provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. The Company is currently evaluating the potential effect of this standard on its financial statements. The Company does not expect this standard to have a material impact on its financial statements.\nIn December 2019, the FASB issued ASU No. 2019-12, Income Taxes: Simplifying the Accounting for Income Taxes (“ASU 2019-12”), which eliminates certain exceptions related to the approach for intraperiod tax allocation, the methodology for calculating income taxes in an interim period and the recognition of deferred tax liabilities for outside basis differences. The new guidance also simplifies aspects of the accounting for franchise taxes and enacted changes in tax laws or rates and clarifies the accounting for transactions that result in a step-up in the tax basis of goodwill. The standard is effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2020, with early adoption permitted. Adoption of the standard requires certain changes to be made prospectively, with some changes to be made retrospectively. The Company does not expect the adoption of this standard to have a material impact on its financial position, results of operations or cash flows.\n\n| 21 |\n\nIn March 2020, the FASB issued ASU 2020-03, “Codification Improvements to Financial Instruments”: The amendments in this update are to clarify, correct errors in, or make minor improvements to a variety of ASC topics. The changes in ASU 2020-03 are not expected to have a significant effect on current accounting practices. The ASU improves various financial instrument topics in the Codification to increase stakeholder awareness of the amendments and to expedite the improvement process by making the Codification easier to understand and easier to apply by eliminating inconsistencies and providing clarifications. The ASU is effective for smaller reporting companies for fiscal years beginning after December 15, 2022 with early application permitted. The Company is currently evaluating the impact the adoption of this guidance may have on its consolidated financial statements.\nIn August 2020, the FASB issued ASU 2020-06 Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40) related to the measurement and disclosure requirements for convertible instruments and contracts in an entity's own equity. The pronouncement simplifies and adds disclosure requirements for the accounting and measurement of convertible instruments and the settlement assessment for contracts in an entity's own equity. This pronouncement is effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2021 and early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. The Company is currently evaluating the impact that this standard will have on its consolidated financial statements.\nNo other new accounting pronouncements were issued or became effective in the period that had, or are expected to have, a material impact on our condensed consolidated Financial Statements.\nNOTE－4 BUSINESS COMBINATION\nOn November 11, 2019, the Company completed the acquisition of 100 % equity interest of Hottab Pte Limited (the “Acquisition”). The total consideration of the acquisition is 156 shares of series C convertible preferred stock, approximately $ 900,000 , cash consideration $ 150,000 and additional series C convertible preferred stock approximately $ 558,000 . The Company accounted for the transaction as an acquisition of a business pursuant to ASC 805, “Business Combinations” (“ASC 805”).\n\n| Schedule of Purchase price allocation |\n| Purchase price allocation: |\n| Fair value of stock at closing | $ | 900,000 |\n| Cash paid | 75,000 |\n| Deferred payments- Cash | 71,422 |\n| Deferred payment- shares | 531,380 |\n| Less cash received | ( 15,337 | ) |\n| Purchase price | $ | 1,562,465 |\n\nThe transaction was accounted for using the acquisition method. Accordingly, goodwill has been measured as the excess of the total consideration over the amounts assigned to the identifiable assets acquired and liabilities assumed based on their preliminary estimated fair values.\nThe deferred payments of $ 633,000 were discounted using the yield on a CCC rated corporate debt for 3-month, 6-month and 9-month maturities, respectively. The implied discount is approximately $ 30,198 , which will be amortized over the term on the payments.\nThe purchase price allocation resulted in $2,766,000 of goodwill, as below:\n\n| Schedule of Acquisition of assets and liability |\n| Acquired assets: |\n| Trade receivables | $ | 6,906 |\n| Other receivables | 1,857 |\n| Total acquired assets | 8,763 |\n| Less: Assumed liabilities |\n| Trade payables | 39,147 |\n| Accrued liabilities and other payable | 68,458 |\n| Amounts due to related parties | 1,080,904 |\n| Deferred revenue | 23,789 |\n| Total Assumed liabilities | 1,212,298 |\n| Fair value of net liabilities assumed | ( 1,203,535 | ) |\n| Goodwill recorded | 2,766,000 |\n| Cash consideration allocated | $ | 1,562,465 |\n\n\n| 22 |\n\nUnder the acquisition method of accounting, the total acquisition consideration price was allocated to the assets acquired and liabilities assumed based on their preliminary estimated fair values. The fair value measurements utilize estimates based on key assumptions of the Acquisition, and historical and current market data. The preliminary allocation of the purchase price is based on the best information available and is pending, amongst other things: (i) the finalization of the valuation of the fair values and useful lives of tangible assets acquired; (ii) the finalization of the valuations and useful lives for the intangible assets acquired; (iii) finalization of the valuation of accounts payable and accrued expenses; and (iv) finalization of the fair value of non-cash consideration.\nThe Acquisition was accounted for as a business combination in accordance with ASC 805 “Business Combinations”. The Company has allocated the purchase price consideration based upon the fair value of the identifiable assets acquired and liabilities assumed on the acquisition date. Management of the Company is responsible for determining the fair value of assets acquired, liabilities assumed and intangible assets identified as of the acquisition date and considered a number of factors including valuations from management estimation. Acquisition-related costs incurred for the acquisitions are not material and have been expensed as incurred in general and administrative expense.\nThe goodwill is not expected to be deductible for tax purposes. The goodwill is fully impaired during the year ended December 31, 2019, because there were continuous operating losses and negative cash flows incurred subsequently. Under ASC 350-20-50, the Company recognized the goodwill impairment loss by comparing the actual operating results of Hottab to the profit forecast and a negative performance is resulted.\nDuring the measurement period (which is the period required to obtain all necessary information that existed at the acquisition date, or to conclude that such information is unavailable, not to exceed one year), additional assets or liabilities may be recognized, or there could be changes to the amounts of assets or liabilities previously recognized on a preliminary basis, if new information is obtained about facts and circumstances that existed as of the acquisition date that, if known, would have resulted in the recognition of these assets or liabilities as of that date. No additional assets or liabilities were recognized during the measurement period, or the changes to the amounts of assets or liabilities previously recognized.\nOn September 30, 2021, the Company served the notification to a related party that certain terms under call option agreement and side letter were no longer effective, in case of non-fulfillment with the milestone conditions as set out in the agreements amounts of $75,000 cash consideration and $558,000 equity incentive. The said amount was written off and accounted as capital transaction and therefore credited the additional paid in capital account as of September 30, 2021.\nNOTE－5 REVENUE\nRevenue consisted of the following deliverables:\n\n| Schedule of Revenue |\n| Three months ended September 30, | Nine months ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Hardware sales | $ | — | $ | 585 | $ | 335 | $ | 3,510 |\n| Software subscription | 10,016 | 11,044 | 26,970 | 37,752 |\n| Sales – online ordering | 73,518 | — | 73,518 | — |\n| $ | 83,534 | $ | 11,629 | $ | 100,823 | $ | 41,262 |\n\n\n| 23 |\n\nIn accordance with ASC 280, Segment Reporting (“ASC 280”), we have two reportable geographic segments:\nSoftware License Revenues. Sales are based on the countries in which the customer is located. Summarized financial information concerning our geographic segments is shown in the following tables:\n\n| Schedule of geographic segments |\n| Three months ended September 30, | Nine months ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Indonesia | $ | 10,016 | $ | 9,788 | $ | 24,813 | $ | 31,604 |\n| Vietnam | — | 1,841 | 2,492 | 9,658 |\n| $ | 10,016 | $ | 11,629 | $ | 27,305 | $ | 41,262 |\n\nOnline Ordering Revenues. Sales are based on the countries in which the customer is located. Summarized financial information concerning our geographic segments is shown in the following tables:\n\n| Three months ended September 30, | Nine months ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Indonesia | $— | $— | $— | $— |\n| Vietnam | 73,518 | — | 73,518 | — |\n| $ | 73,518 | $ | — | $ | 73,518 | $ | — |\n\nContract liabilities recognized was related to software sales only and the following is reconciliation for the periods:\n\n| Schedule of Contract liabilities |\n| Period ended September 30, 2021 | Year ended December 31, 2020 |\n| (Unaudited) |\n| Contract liabilities, brought forward | $ | 18,646 | $ | 19,843 |\n| Add: recognized as deferred revenue | 35,582 | 47,090 |\n| Less: recognized as current period/year revenue | ( 18,646 | ) | ( 48,287 | ) |\n| Contract liabilities, carried forward | $ | 35,582 | $ | 18,646 |\n\nNOTE－6 INTANGIBLE ASSETS\nAs of September 30, 2021 and December 31, 2020, intangible assets consisted of the following:\n\n| Schedule of intangible assets |\n| Useful life | September 30, 2021 | December 31, 2020 |\n| (Unaudited) |\n| At cost: |\n| Software platform | 2.5 years | $ | 8,000,000 | $ | 8,000,000 |\n| Other intangible assets | 3 – 5 years | 1,725 | 1,725 |\n| 8,001,725 | 8,001,725 |\n| Less: accumulated amortization | ( 3,201,725 | ) | ( 801,725 | ) |\n| $ | 4,800,000 | $ | 7,200,000 |\n\n\n| 24 |\n\nOn November 1 2018, the Company entered software development agreement with CVO Advisors Pte Ltd (CVO) 2018 to design and build App and Web-based platform for the total consideration of $8,000,000. CVO who is a third party vendor in the business of designing, developing, operating computer software applications including mobile and web application for social media, big data, point of sales, loyalty rewards, food delivery and technology platforms in Asia. The CVO developer performed and accepted technical work, of software development phase, which was materially completed by December 23, 2018. The Company obtained a third party license (Wallet Factory International Ltd) for their technology build up by CVO.\nThe delivered platform was further developed by the Company’s in-house technology team (based in Noida that Sopa is currently using for the loyalty platform. The platform can be downloaded from Apple store or Googleplay store (i.e. SoPaApp) and the Company’s web version is on www.sopa.asia. The platform was completed developed on September 30, 2020 and has estimated life of 2.5 years. The platform started to be amortized from October 1, 2020.\nFurther, the Company entered subscription agreement with CVO to issued 8,000 shares of preferred stocks for the software development, equal to the aggregate of $ 8,000,000 or at the stated value of $ 1,000 per share.\nPursuant to the subscription agreement entered with CVO, the Company issued 8,000 shares of Series A convertible preferred stock for the purchase of software development at the stated value of $ 1,000 per share, totaling $8,000,000. CVO performed and accepted the technical work such as designing, developing, operating computer software applications including mobile and web application for social media, big data, point of sales, loyalty rewards, food delivery and technology platforms. The holder of this series A provided their consent to waive the warrant provision available with them and accordingly the preferred series A accounted in 2018.\nAlso, owner of CVO entered into call option agreement with the CEO of the Company to sale all the shares of CVO for the sum of $10 per share, as of date, these options were exercised by the CEO of the Company, but the equity holders of CVO Advisors Pte. Ltd. have not honored the exercise of the call. The parties are currently in litigation (refer Note 19). As a result of this option exercise, there was no accounting effect on the Company’s financial statement during the period ended September 30, 2021.\nAmortization of intangible assets attributable to future periods is as follows:\n\n| Schedule of Amortization of intangible assets |\n| Year ending December 31: | Amount |\n| 2021 (remaining period) | $ | 800,000 |\n| 2022 | 3,200,000 |\n| 2023 | 800,000 |\n| Total | $ | 4,800,000 |\n\nAmortization of intangible assets was $ 2,400,000 and $ 1,479 for the nine months ended September 30, 2021 and 2020, respectively.\nAmortization of intangible assets was $ 800,000 and $ 0 for the three months ended September 30, 2021 and 2020, respectively.\nNOTE－ 7 PROPERTY, PLANT AND EQUIPMENT\nProperty, plant and equipment consisted of the following:\n\n| Schedule of Property plant and equipment |\n| September 30, 2021 | December 31, 2020 |\n| (Unaudited) |\n| At cost: |\n| Computer | $ | 29,206 | $ | 29,206 |\n| Office equipment | 1,721 | 1,721 |\n| 30,927 | 30,927 |\n| Less: accumulated depreciation | ( 19,403 | ) | ( 12,755 | ) |\n| Less: exchange difference | ( 444 | ) | ( 103 | ) |\n| $ | 11,080 | $ | 18,069 |\n\nDepreciation expense for the nine months ended September 30, 2021 and 2020 were $ 6,648 and $ 2,968 , respectively.\nDepreciation expense for the three months ended September 30, 2021 and 2020 were $ 2,197 and $ 714 , respectively.\n\n| 25 |\n\nNOTE— 8 ASSET PURCHASE AGREEMENT\nOn February 16, 2021, the Company subsidiary SoPa Technology Pte Ltd (“SoPa Pte Ltd”) acquired certain e-commerce assets from Goodventures Sea Limited (“Goodventures”) pursuant to an Asset Purchase Agreement dated February 16, 2021 (the “Leflair Purchase Agreement”). The acquired assets consisted of intellectual property for it lifestyle e-commerce retail business.\nAs consideration for entering into the Asset Purchase Agreement, the Company agreed to pay Goodventure a total of $ 200,000 in cash payable in installments until April 16, 2021 and 1,500 ordinary shares of SoPa Pte Ltd by April 16, 2021, which represent 15% of the outstanding share capital of SoPa Technology Pte Ltd.\nThe assets acquired by SoPa Pte Ltd under the Leflair Purchase Agreement were substantially all of the assets of an online retail platform that carried the “Leflair” brand name and included a Leflair e-commrce website, Leflair iOs and Android Apps, and backend end infrastructure as well as marketing properties including a customer list and social media pages. In addition, SoPa Technology Ptd Ltd acquired intellectual property such as Leflair logos, trademarks and brands.\nThe Company accounted for this acquisition as an asset acquisition under ASC 805 and that the Company has early adopted the amendments of Regulation S-X dated May 21, 2020 and has concluded that this acquisition was not significant. Accordingly, the presentation of the assets acquired, historical financial statements under Rule 3-05 and related pro forma information under Article 11 of Regulation S-X, respectively, are not required to be presented.\n\n| Schedule of Asset acquisition |\n| Acquired assets: |\n| Intellectual property | $ | 200,000 |\n| Less: Assumed liabilities |\n| Accrued liabilities and other payable | — |\n| Fair value of net assets acquired | 200,000 |\n| Impairment loss recorded | ( 200,000 | ) |\n| Net asset value | $ | — |\n\nThe purchase price of $200,000 shall be allocated amongst the intangible assets acquired, further, these intangible have a short term life as well as the quantum of the value, the company decided to expense it and accounted $ 0 - and $ 200,000 as impairment loss during the three and nine months ended September 30, 2021.\nThe shares issued as part of this transaction do not give the holders the right to influence or control SoPa Pte Ltd. The holders do not have any special voting rights or the right to appoint any board members. SoPa Pte Ltd has not yet issued the shares to the future holders. Since the shares of SoPa Pte Ltd have not yet been issue, no minority interest needs to be recorded as of September 30, 2021.\n\n| 26 |\n\nSoPa Pte Ltd is a private company that was incorporated under the laws of Singapore on June 6, 2019. SoPa Pte Ltd manages Society Pass Incorporated’s operating activities in SEA countries and South Asia. As a pass-through holding company, the value of the 15% interest in the SoPa Pte Ltd to be issued to LeFlair owners has an indeterminate value and no real current value. Society Pass Incorporated plans to record the issuance of the shares at the nominal par value of the shares to be issued to the holders. The value of the assets acquired shall be the value of the cash paid and to be paid to the sellers.\nThe Company has paid $ 200,000 during the period ended September 30, 2021.\nNOTE－9 AMOUNTS DUE FROM (TO) RELATED PARTIES\nAmounts due to related parties consisted of the following:\n\n| Schedule of Amount due to related parties |\n| September 30, 2021 | December 31, 2020 |\n| (Unaudited) |\n| Amounts due to related parties (a) | $ | 24,763 | $ | 96,940 |\n| Amounts due to shareholders (b) | — | 738,964 |\n| Amount due to a director (c) | — | 735,833 |\n| $ | 24,763 | $ | 1,571,737 |\n\n(a) The amounts represented temporary advances to the Company including related parties (two officers), which were unsecured, interest-free and had no fixed terms of repayments. On September 30, 2021, the Company received the notifications that the outstanding amounts of $ 72,176 were forgiven by the related parties, the said amount was written off and accounted as capital transaction and therefore credited the additional paid in capital account as of September 30, 2021. The Company’s due to related parties balance was $ 24,763 and $ 96,940 as of September 30, 2021 and December 31, 2020, respectively.\n(b) In February 2018, the Company entered into MOU with Connect Investment Pte Ltd (Enter Asia) for capital alliance for approximately 27% of shareholdings in the Company. Further, in August 2018, the said MOU was modified and shareholding was revised from 27% to 10% in the Company. However, subsequently in October 2020, it was agreed between both the parties to cease the said MOU with the understanding that there is no current and future obligation with either of them i.e. neither EnterAsia to make investment in the Company nor the Company to issue shares to EnterAsia. Further, the EnterAsia is going to get the shares of the Hottab Holdings Ltd (HHL) for the amount so far invested in the Company and therefore the amount due to EnterAsia is reclassified into the amount due to shareholder “Hottab Holdings Ltd”.\nThis amounts represented temporary advances to the Company by shareholder, which were unsecured, interest-free and had no fixed terms of repayments. On September 30, 2021, the Company received the notifications that the outstanding amounts of $ 738,964 were forgiven by the related parties, the said amount was written off and accounted as capital transaction and therefore credited the additional paid in capital account as of September 30, 2021. The Company’s due to a shareholder balance was $ 0 and $ 738,964 as of September 30, 2021 and December 31, 2020, respectively. Imputed interest is charged at 4.5 % per annum, which was amounted to $ 36,380 and $ 36,381 for the nine months ended September 30, 2021 and 2020, respectively.\n(c) The amount represented paid salaries and bonus to the Director which was unsecured, interest-free and had no fixed terms of repayments. As of June 30, 2021, the Director had $ 960,833 in accrued, but unpaid compensation which could be converted to shares by dividing that amount by the employment agreement conversion price of $ 0.83 to produce 1,157,630 shares. During the period ended September 30, 2021, the Company issued those shares at the fair value of $ 3,854,908 , results into the additional compensation expenses of $ 2,894,075 accounted under stock based compensation account. The Company’s due to a director balance was $- 0 and $ 735,833 as of September 30, 2021 and December 31, 2020, respectively.\n\n| 27 |\n\nAmounts due from related parties\nThe director has advance $ 97,500 during the period ended September 30, 2021, subsequently as of date, the same was recovered by the Company.\nNOTE－10 ACCOUNTS PAYABLE AND ACCRUED LIABILITIES\nAccounts payable consisted of the following:\n\n| Schedule of Accounts payable |\n| September 30, 2021 | December 31, 2020 |\n| (Unaudited) |\n| Accounts payable | $ | 104,680 | $ | 54,256 |\n| Accrued liabilities and other payables- Related Party (a) | 224,669 | 197,548 |\n| Accrued liabilities and other payables (b) | 527,971 | 480,024 |\n| Total Accounts payable | $ | 857,320 | $ | 731,828 |\n\n(a) The amount represented due to three related parties in respect to unpaid salaries, unpaid legal fees and unpaid consulting fees amounted to $ 21,701 , $ 70,104 and $ 132,864 , respectively as of September 30, 2021.\nThe amount represented due to three related parties in respect to unpaid salaries, unpaid legal fees and unpaid consulting fees amounted to $ 5,000 , $ 112,692 and $ 79,856 , respectively as of December 31, 2020.\n(b) Accrued liabilities and other payables consisted of the following:\n\n| Schedule of Accrued liabilities |\n| September 30, 2021 | December 31, 2020 |\n| (Unaudited) |\n| Accrued payroll | $ | 54,528 | $ | 58,092 |\n| Other accrual | 154,325 | 146,826 |\n| Other payables (c) | 245,000 | 245,000 |\n| Accrued vat expenses | 19,932 | 1,788 |\n| Accrued taxes | 54,186 | 28,318 |\n| Total Accrued liabilities | $ | 527,971 | $ | 480,024 |\n\n(c) This included $75,000 related to SOSV. In January 2019, the HPL entered into stock purchase agreement and accelerator contract for equity (ACE) with SOSV IV LLC (SOSV) whereby the HPL will issue shares representing 5% of their capital stock for the amounts of $ 168,000 in three tranche (a) SOSV to pay to the HPL $ 75,000 for integration of Mobile Only Accelerator (MOX) software development kit, (b) SOSV to pay on behalf of the HPL $ 48,000 upon MOX successful application and setting up subsidiary, and (c) SOSV to pay on behalf of the HPL $ 45,000 for setting program for services. The Company received first tranche of $ 75,000 only and thereafter no other two tranche received by the HPL, however, the outcome of the deal did not results success and so later the HPL have not issued any shares to the SOSV, therefore the arrangement amount of $ 75,000 accounted as loan from SOSV. The Company sent the legal letter to the SOSV intimating that the Company acquired HPL by issuing 156 shares of preferred stock series C to Hottab Holding Limited for the 100% acquisition of HPL. As of September 30, 2021 and December 31, 2020, the Company had a total of $ 75,000 and $ 75,000 outstanding on this account, respectively. (refer footnote#19 for legal update).\n\n| 28 |\n\nNOTE－11 LEASES\nWe adopted ASU No. 2016-02, Leases, on January 1, 2019, the beginning of our fiscal 2019, using the modified retrospective approach. We determine whether an arrangement is a lease at inception. This determination generally depends on whether the arrangement conveys the right to control the use of an identified fixed asset explicitly or implicitly for a period of time in exchange for consideration. Control of an underlying asset is conveyed if we obtain the rights to direct the use of and to obtain substantially all of the economic benefit from the use of the underlying asset. Some of our leases include both lease and non-lease components which are accounted for as a single lease component as we have elected the practical expedient. Some of our operating lease agreements include variable lease costs, primarily taxes, insurance, common area maintenance or increases in rental costs related to inflation. Substantially all of our equipment leases and some of our real estate leases have terms of less than one year and, as such, are accounted for as short-term leases as we have elected the practical expedient.\nOperating leases are included in the right-of-use lease assets, other current liabilities and long-term lease liabilities on the Consolidated Balance Sheet. Right-of-use assets and lease liabilities are recognized at each lease’s commencement date based on the present values of its lease payments over its respective lease term. When a borrowing rate is not explicitly available for a lease, our incremental borrowing rate is used based on information available at the lease’s commencement date to determine the present value of its lease payments. Operating lease payments are recognized on a straight-line basis over the lease term. We had no financing leases as of September 30, 2021 and December 31, 2020.\nThe Company adopts a 5.26 % as weighted average incremental borrowing rate to determine the present value of the lease payments. The weighted average remaining life of the lease was 3.48 year.\nDuring the period ended September 30, 2021, the Company enter into new lease arrangements, and accounted as per ASC 842, the ROU asset and lease obligation of $ 479,171 .\nThe Company excludes short-term leases (those with lease terms of less than one year at inception) from the measurement of lease liabilities or right-of-use assets. The following tables summarize the lease expense for the period ended September 30:\n\n| Schedule of Lease expenses |\n| Three months ended September 30, | Nine months ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Operating lease expense (per ASC 842) | $ | 13,554 | $ | 6,076 | $ | 31,975 | $ | 21,802 |\n| Short-term lease expense (other than ASC 842) | 63,363 | 4,627 | 66,420 | 31,258 |\n| Total lease expense | $ | 76,917 | $ | 10,703 | $ | 98,395 | $ | 53,060 |\n\nAs of September 30, 2021, right-of-use assets were $ 529,782 and lease liabilities were $ 533,312 .\nAs of December 31, 2020, right-of-use assets were $ 79,109 and lease liabilities were $ 83,205 .\nComponents of Lease Expense\nWe recognize lease expense on a straight-line basis over the term of our operating leases, as reported within “general and administrative” expense on the accompanying consolidated statement of operations.\nFuture Contractual Lease Payments as of September 30, 2021\nThe below table summarizes our (i) minimum lease payments over the next five years, (ii) lease arrangement implied interest, and (iii) present value of future lease payments for the next three years ending September 30:\n\n| Schedule of Future Contractual Lease Payments |\n| Years ended September 30, | Operating lease amount |\n| 2022 | $ | 190,025 |\n| 2023 | 166,530 |\n| 2024 | 147,813 |\n| 2025 | 77,997 |\n| Total | 582,365 |\n| Less: interest | ( 49,053 | ) |\n| Present value of lease liabilities | $ | 533,312 |\n| Less: non-current portion | ( 365,539 | ) |\n| Present value of lease liabilities – current liability | $ | 167,773 |\n\n\n| 29 |\n\nNOTE－12 SHAREHOLDERS’ DEFICIT\nAuthorized stock\nThe Company is authorized to issue two classes of stock. The total number of shares of stock which the Company is authorized to issue is 100,000,000 shares of capital stock, consisting of 95,000,000 shares of common stock, $ 0.0001 par value per share, and 5,000,000 shares of preferred stock, $ 0.0001 par value per share.\nThe holders of the Company’s common stock are entitled to the following rights:\nVoting Rights: Each share of the Company’s common stock entitles its holder to one vote per share on all matters to be voted or consented upon by the stockholders. Holders of the Company’s common stock are not entitled to cumulative voting rights with respect to the election of directors.\nDividend Right: Subject to limitations under Nevada law and preferences that may apply to any shares of preferred stock that the Company may decide to issue in the future, holders of the Company’s common stock are entitled to receive ratably such dividends or other distributions, if any, as may be declared by the Board of the Company out of funds legally available therefor.\nLiquidation Right:. In the event of the liquidation, dissolution or winding up of our business, the holders of the Company’s common stock are entitled to share ratably in the assets available for distribution after the payment of all of the debts and other liabilities of the Company, subject to the prior rights of the holders of the Company’s preferred stock.\nOther Matters: The holders of the Company’s common stock have no subscription, redemption or conversion privileges. The Company’s common stock does not entitle its holders to preemptive rights. All of the outstanding shares of the Company’s common stock are fully paid and non-assessable. The rights, preferences and privileges of the holders of the Company’s common stock are subject to the rights of the holders of shares of any series of preferred stock which the Company may issue in the future.\nCommon stock outstanding\nAs of September 30, 2021 and December 31, 2020, the Company had a total of 9,695,480 and 7,413,600 shares of its common stock issued and outstanding, respectively.\nOn February 10, 2021, the Company effected a 750 for 1 stock split of the issued and outstanding shares of the Company’s common stock. The number of authorized shares and par value remain unchanged. All share and per share information in this financial statements and footnotes have been retroactively adjusted for the periods presented, unless otherwise indicated, to give effect to the forward stock split.\nOn September 21, 2021, the Company effected a 1 for 2.5 stock split of the issued and outstanding shares of the Company’s common stock. The number of authorized shares and par value remain unchanged. All share and per share information in this financial statements and footnotes have been retroactively adjusted for the periods presented, unless otherwise indicated, to give effect to the reverse stock split.\n\n| 30 |\n\nAn additional result of the stock split was that the stated value of preferred stock, the number of designated shares and outstanding shares of each series of preferred stock was unchanged in accordance to the respective certificate of designations. The number of authorized shares of preferred stock remained unchanged.\nDuring the period ended September 30, 2021 and 2020, the Company issued 824,250 and 1,014,900 shares of common stock for employee services for the value of $ 1,707,557 and $ 1,023,494 , respectively.\nDuring the period ended September 30, 2021 and 2020, the Company issued 1,157,630 and 0 shares of common stock for director’s accrued salaries for the value of $ 960,834 and $ 0 , respectively. The Company accounted $ 2,894,075 additional cost on these share issuance as loss on fair value of shares issued in 2021.\nDuring the period ended September 30, 2021 and 2020, the Company issued 450,000 and 0 shares of common stock for director’s bonus for the value of $ 3,442,499 and $ 0 , respectively.\nDuring the period ended September 30, 2021 and 2020, the Company cancelled 150,000 and 0 shares of common stock at par value.\nWarrants\nIn August 2019, the Company issued 21,000 shares of warrants to one employee for compensation of his service to purchase 21,000 shares of its common stock for the fair value of $17,500. Each share of warrant is converted to one share of common stock at an exercise price of $0.0001. The warrants will expire on the second (2nd) anniversary of the initial date of issuance. As at December 31, 2019, none of the warrants have been exercised. 21,000 shares fully exercised during the year ended December 31, 2020.\nIn December 2020, the Company issued certain numbers of warrants pursuant to the Series C-1 Subscription Agreement. Each redeemable warrant is entitled the holder to purchase one C-1 preferred share at a price of $ 420 per share. The warrants shall be exercisable on or before December 31, 2020 and September 30, 2021. During the nine months ended September 30, 2021, the Company issued 2,120 warrants. During the nine months ended September 30, 2020, the Company issued 1,824 warrants.\nIn December 2020, a total of 838 warrants are exercised in exchanged to 838 Series C-1 preferred shares. (refer note 13 for details).\nOn April 19, 2021, the Company extended the termination date of the Warrant issued to Preferred series C-1 holder by nine months from the expiration date of September 30, 2021 to December 31, 2021. The Company considers this warrant as permanent equity per ASC 815-40-35-2. As such, there is no value assigned to this extension.\nThe Company determined the fair value using the Black-Scholes option pricing model with the following assumptions for the period ended September 30, 2021 and year ended December 31, 2020:\n\n| Schedule of Stock option assumptions |\n| September 30, 2021 | December 31, 2020 |\n| Dividend rate | 0 | % | 0 | % |\n| Risk-free rate | 2 | % | 2 | % |\n| Weighted average expected life (years) | 9 months | 9 months |\n| Expected volatility | 0 | % | 0 | %(a) |\n| Share price | $ | 0.22 | $ | 0.22 |\n\n\n| (a) | The Company considered no volatility as from inception through the date there is very minimal transaction of the Company common stock. |\n\n\n| 31 |\n\nBelow is a summary of the Company’s issued and outstanding warrants as of September 30, 2021 and December 31, 2020:\n| Schedule of warrants issued and outstanding |\n| Warrants | Weighted average exercise price | Weighted average remaining contractual life (in years) |\n| Outstanding as of December 31, 2019 (a) | 21,000 | $ | 0.0001 | 1.3 |\n| Issued (b) | 4,094 | $ | 420 | 0.9 |\n| Exercised | ( 21,838 | ) | $ | ( 6.34 | ) | 1 |\n| Expired | ( 1,209 | ) | $ | ( 420 | ) | ( 0.6 | ) |\n| Outstanding as of December 31, 2020 | 2,047 | $ | 420 | 0.6 |\n| Issued (b) | 2,120 | $ | 420 | 0.5 |\n| Exercised | ( 238 | ) | $ | ( 420 | ) | — |\n| Expired | — | — | — |\n| Outstanding as of September 30, 2021 (b) | 3,929 | $ | 420 | 0.5 |\n\nThere is no intrinsic value for warrants as of September 30, 2021 and December 31, 2020.\n\n| (a) | Common stock will be issued if those warrants exercise. |\n\n\n| (b) | Preferred stock series C-1 will be issued if those warrants exercise. |\n\nNOTE－13 PREFERRED STOCKS AND WARRANTS\nAs of September 30, 2021 and December 31, 2020, the Company’s preferred stocks have been designated as follow:\n\n| Schedule of Preferred stocks |\n| No. of shares | Stated Value |\n| Series A Convertible Preferred Stock | 10,000 | $ | 1,000 |\n| Series B Convertible Preferred Stock | 10,000 | $ | 1,336 |\n| Series B-1 Convertible Preferred Stock | 15,000 | $ | 2,917 |\n| Series C Convertible Preferred Stock | 15,000 | $ | 5,763 |\n| Series C-1 Convertible Preferred Stock | 30,000 | $ | 420 |\n| Series X Super Voting Preferred Stock | 3,500 | $ | 0.0001 |\n\nAll of the Series A, B, B-1, C, and C-1 Preferred Shares were issued at a value of respective stated value per share. These all Series of Preferred Shares contain a conversion option, are convert into a fixed number of common shares or redeemable with the cash repayment at the liquidation, so as a result of this liquidation preference, under U.S GAAP, the Company has classified the all these Series of Preferred Shares within mezzanine equity in the condensed consolidated balance sheet.\nSeries X Super Voting Preferred Stock was issued a par value per share. This Series of Preferred Shares does not contain a conversion option, so as a result of this liquidation preference, under U.S GAAP, the Company has classified the this Series of Preferred Shares within permanent equity in the condensed consolidated balance sheet.\nVoting Rights: (1) The affirmative vote of at least a majority of the holders of each series of preferred stock shall be necessary to:\n\n| (a) | increase or decrease the par value of the shares of the Series A Preferred Stock, alter or change the powers, preferences or rights of the shares of Series A Preferred Stock or create, alter or change the powers, preferences or rights of any other capital stock of the Company if after such alteration or change such capital stock would be senior to or pari passu with Series A Preferred Stock; and |\n\n\n| (a) | adversely affect the shares of Series A Preferred Stock, including in connection with a merger, recapitalization, reorganization or otherwise. |\n\n\n| 32 |\n\n(2) The affirmative vote of at least a majority of the holders of the shares of the Series A Preferred Stock shall be necessary to:\n\n| (a) | enter into a transaction or series of related transactions deemed to be a liquidation, dissolution or winding up of the Corporation, or voluntarily liquidate or dissolve; |\n\n\n| (b) | authorize a merger, acquisition or sale of substantially all of the assets of the Company or any of its subsidiaries (other than a merger exclusively to effect a change of domicile of the Company to another state of the United States); |\n\n\n| (c) | increase or decrease (other than decreases resulting from conversion of the Series A Preferred Stock) the authorized number of shares of the Company’s preferred stock or any series thereof, the number of shares of the Company’s common stock or any series thereof or the number of shares of any other class or series of capital stock of the Company; and |\n\n\n| (d) | any repurchase or redemption of capital stock of the Company except any repurchase or redemption at cost upon the termination of services of a service provider to the Company or the exercise by the Company of contractual rights of first refusal as applied to such capital stock. |\n\nDividend Rights: The holders of the Company’s preferred stock are not entitled to any dividend rights.\nConversion Rights (Series A Preferred Stock): Upon the consummation of this offering, the issued and outstanding shares of Series A Preferred Stock automatically convert into a number of shares of the Company’s common stock equal to the quotient obtained by dividing (x) the aggregate Stated Value of the issued and outstanding Series A Preferred Stock plus any other amounts due to the holders thereof divided by (y) the offering price of the Company’s common stock. If 90 days after conversion, the closing market price of the Company’s common stock as quoted on Nasdaq (the “Market Value”) has decreased below the initial public offering price, each holder of the Series A Preferred Stock shall be issued a warrant to purchase a number of shares of the Company’s common stock equal to 40% of the quotient of the (a) aggregate Stated Value held by such holder before conversion at the initial public offering price and the Market Value of the shares of common stock that were issuable upon conversion divided by (b) the Market Value. The warrants shall have a term of five years and shall be exercisable at the Market Value.\nConversion Rights (Preferred Stock other than Series A and Series X Super Voting Preferred Stock): Upon the consummation of this offering, each issued and outstanding share of Series B Preferred Stock, Series B-1 Preferred Stock, Series C Preferred Stock and Series C-1 Preferred Stock will automatically convert into 750 shares of the Company’s common stock. Series X Super Voting Preferred stock shall not have any rights to convert into the Company’s common stock.\nLiquidation Rights: In the event of any liquidation, dissolution or winding up of the Company, either voluntary or involuntary (a \"Liquidation Event\"), the holders of each series of preferred stock shall be entitled to receive, prior and in preference to any distribution of any of the assets or surplus funds of the Company to the holders of the Company’s common stock by reason of their ownership thereof, an amount per share in cash equal to the greater of (x) the aggregate Stated Value for all shares of such series of Preferred Stock then held by then or (y) the amount payable per share of the Company’s common stock which such holder of preferred stock would have received if such holder had converted to common stock immediately prior to the Liquidation Event all of such series of preferred stock then held by such holder (the \"Series Stock Liquidation Preference\"). If, upon the occurrence of a Liquidation Event, the funds thus distributed among the holders of the preferred stock shall be insufficient to permit the payment to the holders of the preferred stock the full Series Stock Liquidation Preference for all series, then the entire assets and funds of the Company legally available for distribution shall be distributed ratably among the holders of the preferred stock in proportion to the aggregate Series Liquidation Preferences that would otherwise be payable to each of the holders of preferred stock. Such payment shall constitute payment in full to the holders of the preferred stock upon the Liquidation Event. After such payment shall have been made in full, or funds necessary for such payment shall have been set aside by the Company in trust for the account of the holders of preferred stock, so as to be immediately available for such payment, such holders of preferred stock shall be entitled to no further participation in the distribution of the assets of the Company. The sale of all or substantially all of the assets of the Company, or merger, tender offer or other business combination to which the Company is a party in which the voting stockholders of the Company prior to such transaction do not own a majority of the voting securities of the resulting entity or by which any person or group acquires beneficial ownership of 50% or more of the voting securities of the Company or resulting entity shall be deemed to be a Liquidation Event.\n\n| 33 |\n\nOther Matters: The holders of the Company’s preferred stock have no subscription or redemption privileges and are not subject to redemption. The Company’s Series Preferred Stock does not entitle its holders to preemptive rights. All of the outstanding shares of the Company’s preferred stock are fully paid and non-assessable.\nSeries A Preferred Shares\nDuring the year ended December 31, 2018, the Company issued 8,000 shares of Series A convertible preferred stock for the purchase of software at the stated value of $ 1,000 per share, totaling $ 8,000,000 . The holder of this series A provided their consent to waive the warrant provision available with them and accordingly the preferred series A accounted in 2018.\nThere was no Series A Preferred Shares issued during the nine months ended September 30, 2021 and 2020.\nAs of September 30, 2021 and December 31, 2020, there were 8,000 and 8,000 shares of Series A Preferred Shares issued and outstanding, respectively.\nSeries B Preferred Shares\nThere was no Series B Preferred Shares issued during the nine months ended September 30, 2021 and 2020.\nAs of September 30, 2021 and December 31, 2020, there were 2,548 and 2,548 shares of Series B Preferred Shares issued and outstanding, respectively.\nSeries B-1 Preferred Shares\nThere was no Series B-1 Preferred Shares issued during the nine months ended September 30, 2021 and 2020.\nAs of September 30, 2021 and December 31, 2020, there were 160 and 160 shares of Series B-1 Preferred Shares issued and outstanding, respectively.\nSeries C Preferred Shares\nDuring the nine months ended September 30, 2021, the Company issued 1,116 and 74 shares of Series C preferred stock for cash in private placement and consulting services for the value of $ 6,431,508 and $ 426,462 , respectively.\nDuring the nine months ended September 30, 2021, the Company incurred the issuance cost on above Series C private placement accounted $ 195,942 in shares and $ 460,361 in cash.\nThere was no Series C Preferred Shares issued during the nine months ended September 30, 2020.\nAs of September 30, 2021 and December 31, 2020, there were 1,552 and 362 shares of Series C Preferred Shares issued and outstanding, respectively.\nSeries C-1 Preferred Shares\nThe Company accounts for warrants issued in accordance with the guidance on “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity” in Topic 480. These warrants did not meet the criteria to be classified as a liability award and therefore were treated as an equity award and classified the Series C-1 Preferred Shares within mezzanine equity in the condensed consolidated balance sheet.\n\n| 34 |\n\nDuring the period ended September 30, 2021, the Company issued 6,235 and 4,864 shares of Series C-1 preferred stock for cash in private placement and consulting services for the value of $ 2,618,700 (out of which $479,640 is received subsequent to September 30, 2021) and $ 2,042,880 , respectively.\nDuring the nine months ended September 30, 2021, the Company incurred the issuance cost on above series C-1 private placement accounted $ 245,700 in shares and $ 90,748 in cash. There is no issuance cost incurred in 2020.\nDuring the period ended September 30, 2020, the Company issued 1,688 and 571 shares of Series C-1 preferred stock for cash in private placement and consulting services for the value of $ 708,960 and $ 239,820 , respectively.\nAs of September 30, 2021 and December 31, 2020, there were 13,984 and 2,885 shares of Series C-1 Preferred Shares issued and outstanding, respectively.\nSeries X Super Voting Preferred Shares\nIn August 2021, the Company created a new series of preferred stock to be titled “Series X Super Voting Preferred Stock,” consisting of 2,000 shares and to provide to such preferred stock certain rights and privileges including but not limited to the right to 10,000 votes per share (post reverse split: 4,000 votes per share) to vote on all matters that may come before the stockholders of the Corporation, voting together with the common stock as a single class on all matters to be voted or consented upon by the stockholders but is not entitled to any dividends, liquidation preference or conversion or redemption rights, so accordingly it is accounted as an equity classification. In September 2021, the Company increased the number of shares designated as Series X Super Voting Preferred to 3,500.\nDuring the period ended September 30, 2021 and 2020, the Company issued 3,500 and 0 shares of Series C-preferred stock at par value, respectively.\nAs of September 30, 2021 and December 31, 2020, there were 3,500 and 0 shares of Series C Preferred Shares issued and outstanding, respectively.\nNOTE－ 14 INCOME TAXES\nFor the nine months ended September 30, 2021 and 2020, the local (“Nevada”) and foreign components of loss before income taxes were comprised of the following:\n\n| Schedule of Loss before income tax |\n| Nine months ended September 30, |\n| 2021 | 2020 |\n| Tax jurisdiction from: |\n| - Local | $ | 14,272,684 | $ | — |\n| - Foreign | 1,246,371 | 2,507,042 |\n| Loss before income taxes | $ | 15,519,055 | $ | 2,507,042 |\n\nThe provision for income taxes consisted of the following:\n\n| Schedule of provision for income taxes |\n| Nine months ended September 30, |\n| 2021 | 2020 |\n| Current: |\n| - United States | $ | — | $ | — |\n| - Singapore | — | — |\n| - Vietnam | — | — |\n| - India | 9,943 | 15,069 |\n| Deferred: |\n| - United States | — | — |\n| - Singapore | — | — |\n| - Vietnam | — | — |\n| - India | — | — |\n| Income tax expense | $ | 9,943 | $ | 15,069 |\n\n\n| 35 |\n\nThe effective tax rate in the years presented is the result of the mix of income earned in various tax jurisdictions that apply a broad range of income tax rate. The Company operates in various countries: Singapore and Vietnam that are subject to taxes in the jurisdictions in which they operate, as follows:\nUnited States\nThe Company is registered in the Nevada and is subject to the tax laws of United States.\nAs of September 30, 2021, the operation in the United states incurred $ 25,094,900 of cumulative net operating losses which can be carried forward to offset future taxable income. The net operating loss carryforwards has no expiration. The Company has provided for a full valuation allowance against the deferred tax assets of $ 5,269,929 on the expected future tax benefits from the net operating loss carryforwards as the management believes it is more likely than not that these assets will not be realized in the future.\nSingapore\nThe Company’s subsidiary is registered in the Republic of Singapore and is subject to the tax laws of Singapore.\nAs of September 30, 2021, the operation in the Singapore incurred $ 1,437,668 of cumulative net operating losses which can be carried forward to offset future taxable income. The net operating loss carryforwards has no expiration. The Company has provided for a full valuation allowance against the deferred tax assets of $ 230,027 on the expected future tax benefits from the net operating loss carryforwards as the management believes it is more likely than not that these assets will not be realized in the future.\nVietnam\nThe Company’s subsidiary operating in Vietnam is subject to the Vietnam Income Tax at a standard income tax rate of 20 % during its tax year. The reconciliation of income tax rate to the effective income tax rate for the nine months ended September 30, 2021 and 2020 is as follows:\n\n| Schedule of Effective Income Tax Rate Reconciliation |\n| Nine months ended September 30, |\n| 2021 | 2020 |\n| Loss before income taxes | $ | ( 450,407 | ) | $ | ( 233,689 | ) |\n| Statutory income tax rate | 20 | % | 20 | % |\n| Income tax expense at statutory rate | ( 90,081 | ) | ( 46,738 | ) |\n| Tax effect of allowance | 90,081 | 46,738 |\n| Income tax expense | $ | — | $ | — |\n\nAs of September 30, 2021, the operation in the Vietnam incurred $ 859,275 of cumulative net operating losses which can be carried forward to offset future taxable income. The net operating loss carryforwards begin to expire in 2026, if unutilized. The Company has provided for a full valuation allowance against the deferred tax assets of $ 171,855 on the expected future tax benefits from the net operating loss carryforwards as the management believes it is more likely than not that these assets will not be realized in the future.\nIndia\nThe Company’s subsidiary operating in India is subject to the India Income Tax at a standard income tax rate of 25 % during its tax year. The reconciliation of income tax rate to the effective income tax rate for the nine months ended September 30, 2021 and 2020 is as follows:\n\n| Nine months ended September 30, |\n| 2021 | 2020 |\n| Income before income taxes | $ | 17,716 | $ | ( 182,363 | ) |\n| Statutory income tax rate | 25 | % | 15 | % |\n| Income tax expense at statutory rate | 4,429 | ( 27,354 | ) |\n| Tax effect of allowance | 5,514 | 42,423 |\n| Income tax expense | $ | 9,943 | $ | 15,069 |\n\n\n| 36 |\n\nAs of September 30, 2021, the operation in the India incurred $ 17,716 of net operating gain. The Company has provided for a full tax effect allowance against the current and deferred tax expenses of $ 9,943 .\nThe following table sets forth the significant components of the deferred tax assets and liabilities of the Company as of September 30, 2021 and December 31, 2020:\n\n| Schedule of Deferred Tax Assets and Liabilities |\n| September 30, 2021 | December 31, 2020 |\n| (Unaudited) |\n| Deferred tax assets: |\n| Net operating loss carryforwards |\n| - United States | $ | 5,269,929 | $ | 2,171,941 |\n| - Singapore | 230,027 | 131,985 |\n| - Vietnam | 171,855 | 81,774 |\n| - India | — | — |\n| 5,671,811 | 2,385,700 |\n| Less: valuation allowance | ( 5,671,811 | ) | ( 2,385,700 | ) |\n| Deferred tax assets, net | $ | — | $ | — |\n\nNOTE－ 15 PENSION COSTS\nThe Company is required to make contribution to their employees under a government-mandated defined contribution pension scheme for its eligible full-times employees in all countries operating in the Company. The Company is required to contribute a specified percentage of the participants’ relevant income based on their ages and wages level. During the nine months ended September 30, 2021 and 2020, $ 9,655 and $ 5,199 contributions were made accordingly. During the three months ended September 30, 2021 and 2020, $ 5,669 and $ 3,463 contributions were made accordingly.\nNOTE－ 16 RELATED PARTY TRANSACTIONS\nFrom time to time, the shareholder and director of the Company advanced funds to the Company for working capital purpose. Those advances are unsecured, non-interest bearing and due on demand.\nDuring the three month ended September 30, 2021 and 2020, the Company rendered the consultancy service with related parties for the issuance of 2,854 and 571 shares of Series C-1 preferred stock, at the price of $ 1,198,680 and $ 239,820 , respectively.\nDuring the nine month ended September 30, 2021 and 2020, the Company rendered the consultancy service with related parties for the issuance of 4,314 and 571 shares of Series C-1 preferred stock, at the price of $ 1,811,880 and $ 239,820 , respectively.\nThe Company paid and accrued to the directors, the total salaries of $ 196,108 and $ 22,529 and 201,588 and $ 0 during the three months ended September 30, 2021 and 2020, respectively.\nThe Company paid and accrued to the directors, the total salaries of $ 611,193 and $ 22,529 and $ 604,378 and $ 0 during the nine months ended September 30, 2021 and 2020, respectively.\n\n| 37 |\n\nDuring the three months ended September 30, 2021 and 2020, the Company issued 2,134,042 and 3000 shares of Common stock, at the price of $12,570,943 and $ 810,000 for the stock based compensation to director and employee, respectively.\nDuring the nine months ended September 30, 2021 and 2020, the Company issued 2,134,042 and 3000 shares of Common stock, at the price of $ 12,570,943 and 810,000 for the stock based compensation to director and employee, respectively.\nThe company subsidiaries paid and accrued their two officers, total professional fee of $ 5,785 and $ 1,259 and $ 8,310 and $ 1,300 during the three months ended September 30, 2021 and 2020, respectively.\nThe company subsidiaries paid and accrued their two officers, total professional fee of $ 10,307 and $ 1,259 and $ 35,898 and $ 1,300 during the nine months ended September 30, 2021 and 2020, respectively.\nThe Company paid and accrued its shareholders, total professional fee of $ 151,342 and $ 102,412 and $ 31,341 and $ 21,000 during the three months ended September 30, 2021 and 2020, respectively.\nThe Company paid and accrued its shareholders, total professional fee of $ 378,785 and $ 123,412 and $ 102,979 and $ 56,0000 during the nine months ended September 30, 2021 and 2020, respectively.\nDuring August and September 2021, the Company issued 3,300 shares of its Series X Super Voting Preferred Stock (the “Super Voting Preferred Stock”) to the founder and Chief Executive Officer, Mr. Dennis Nguyen and 200 shares of the Super Voting Preferred Stock to Chief Financial Officer, Mr. Raynauld Liang.\nIn August 2021, the Company approved the conversion of Inter-Company loan of $1,249,999 due and owing by Sopa Technology PTE. LTD. (“STPL”), by exchange of 8,500 shares of STPL which represents 85% of the total issued and paid-up capital of STPL on a fully diluted basis.\nOn September 30, 2021, the Company received the notifications that the outstanding amounts of $ 72,176 and $ 738,964 were forgiven by the related parties. Also, the Company served the notification to a related party that certain terms under call option agreement and side letter were no longer effective, in case of non-fulfillment with the milestone conditions as set out in the agreements amounts of $ 75,000 cash consideration and $ 558,000 equity incentive.\nAs of June 30, 2021, Mr. Nguyen had $ 960,833 in accrued, but unpaid compensation which could be converted to shares by dividing that amount by the employment agreement conversion price of $ 0.83 to produce 1,157,630 shares.\nHOTTAB Asset Vietnam Co Ltd, a company limited by shares incorporated under the laws of Vietnam on July 25, 2019, is currently wholly-owned by Ngo Cham, an employee of HOTTAB Vietnam Co Ltd. HOTTAB Asset Vietnam Co Ltd manages the Group’s website and apps in Vietnam via a contractual relationship. All profits accrued by HOTTAB Asset Vietnam Co Ltd are paid as management fees to HOTTAB Vietnam Co Ltd. HOTTAB Vietnam Co Ltd has an irrevocable call option to acquire 100% of the equity of HOTTAB Asset Vietnam Co Ltd.\nApart from the transactions and balances detailed elsewhere in these accompanying condensed consolidated financial statements, the Company has no other significant or material related party transactions during the periods presented.\nNOTE－17 CONCENTRATIONS OF RISK\nThe Company is exposed to the following concentrations of risk:\n(a) Major customers\nFor the nine months ended September 30, 2021 and 2020, the customers who accounted for 10% or more of the Company’s revenues and its outstanding receivable balances at year-end dates, are presented as follows:\n\n| Schedule of concentrations of risk |\n| Nine months ended September 30, 2021 | September 30, 2021 |\n| Customer | Revenues | Percentage of revenues | Accounts receivable |\n| Customer A | $ | 24,813 | 25 | % | $ | 19,308 |\n| Customer B | $ | 12,615 | 13 | % | $ | — |\n| Customer C | $ | 58,300 | 58 | % | $ | 68,285 | * |\n\n\n| * | - This included value added taxes (“VAT”) |\n\n\n| 38 |\n\n\n| Nine months ended September 30, 2020 | September 30, 2020 |\n| Customer | Revenues | Percentage of revenues | Accounts receivable |\n| Customer A | $ | 31,604 | 76 | % | $ | — |\n\nFor the three months ended September 30, 2021 and 2020, the customers who accounted for 10% or more of the Company’s revenues and its outstanding receivable balances at year-end dates, are presented as follows:\n\n| Three months ended September 30, 2021 |\n| Customer | Revenues | Percentage of revenues |\n| Customer A | $ | 10,016 | 12 | % |\n| Customer B | $ | 12,615 | 13 | % |\n| Customer C | $ | 58,300 | 58 | % |\n\n\n| Three months ended September 30, 2020 |\n| Customer | Revenues | Percentage of revenues |\n| Customer A | $ | 9,789 | 84 | % |\n\nAll customers are located in Vietnam except one located in Indonesia.\n(b) Major vendors\nFor the nine months ended September 30, 2021 and 2020, the vendors who accounts for 10% or more of the Company’s hardware purchases and software cost its outstanding payable balances as at year-end dates, are presented as follows:\n\n| Nine months ended September 30, 2021 | September 30, 2021 |\n| Vendors | Purchases | Percentage of purchases | Accounts payable |\n| Vendor A | $ | 30,577 | 27 % | $ | 44,867 |\n| Vendor B | $ | 17,827 | 16 % |\n\n\n| Nine months ended September 30, 2020 | September 30, 2020 |\n| Vendors | Purchases | Percentage of purchases | Accounts payable |\n| Vendor A | $ | 46,863 | 72 % | $ | — |\n| Vendor B | — | — | — |\n\n\n| 39 |\n\nFor the three months ended September 30, 2021 and 2020, the vendors who accounts for 10% or more of the Company’s hardware purchases and software cost its outstanding payable balances as at year-end dates, are presented as follows:\n\n| Three months ended September 30, 2021 |\n| Purchases | Percentage of purchases |\n| Vendors |\n| Vendor A | $ | — | — |\n\n\n| Three months ended September 30, 2020 |\n| Vendors | Purchases | Percentage of purchases |\n| Vendor A | $ | 24,401 | 90 % |\n| Vendor B | — | — |\n\nAll vendors are located in Vietnam.\n(c) Credit risk\nFinancial instruments that are potentially subject to credit risk consist principally of trade receivables. The Company believes the concentration of credit risk in its trade receivables is substantially mitigated by its ongoing credit evaluation process and relatively short collection terms. The Company does not generally require collateral from customers. The Company evaluates the need for an allowance for doubtful accounts based upon factors surrounding the credit risk of specific customers, historical trends and other information.\n(d) Exchange rate risk\nThe reporting currency of the Company is US$, to date the majority of the revenues and costs are denominated in VND, SGD and INR and a significant portion of the assets and liabilities are denominated in VND, SGD and INR. As a result, the Company is exposed to foreign exchange risk as its revenues and results of operations may be affected by fluctuations in the exchange rate between US$ and VND, SGD and INR. If VND, SGD and INR depreciates against US$, the value of VND, SGD and INR revenues and assets as expressed in US$ financial statements will decline. The Company does not hold any derivative or other financial instruments that expose to substantial market risk.\n(e) Economic and political risks\nThe Company's operations are conducted in the Republic of Vietnam. Accordingly, the Company's business, financial condition and results of operations may be influenced by the political, economic and legal environment in the Vietnam, and by the general state of the Vietnam economy.\nThe Company's operations in the Vietnam and India are subject to special considerations and significant risks not typically associated with companies in North America and Western Europe. These include risks associated with, among others, the political, economic and legal environment and foreign currency exchange. The Company's results may be adversely affected by changes in the political and social conditions in the Vietnam and India, and by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion, remittances abroad, and rates and methods of taxation.\nNOTE－18 COMMITMENTS AND CONTINGENCIES\nAs of September 30, 2021, the Company has no material commitments or contingencies.\nRight issues under Series C-1 preferred stock\nThe Company has issued warrant pursuant to the Series C-1 Subscription Agreement. Each redeemable warrant entitles the holder to purchase two (2) common shares at a price of $168 per share. The warrants shall be exercisable on or before December 31, 2020 and June 30, 2021, respectively. On April 19, 2021, the Company extended the termination date of the Warrant issued to Preferred series C-1 holder by six months from the expiration date of June 30, 2021 to December 31, 2021. The Company considers this warrant as permanent equity per ASC 815-40-35-2. As such, there is no value assigned to this extension.\n\n| 40 |\n\nFinancing arrangement (due to a shareholder)\nIn February 2018, the Company entered into MOU with Connect Investment Pte Ltd (Enter Asia) for capital alliance for approximately 27% of shareholdings in the Company. Further, in August 2018, the said MOU was modified and shareholding was revised from 27% to 10% in the Company. However, subsequently in October 2020, it was agreed between both the parties to cease the said MOU with the understanding that there is no current and future obligation with either of them i.e. neither EnterAsia to make investment in the Company nor the Company to issue shares to EnterAsia. Further, the EnterAsia is going to get the shares of the Hottab Holdings Ltd (HHL) for the amount so far invested in the Company and therefore the amount due to EnterAsia is reclassified into the amount due to shareholder “Hottab Holdings Ltd”.\nSOSV\nIn January 2019, the HPL entered into stock purchase agreement and accelerator contract for equity (ACE) with SOSV IV LLC (SOSV) whereby the HPL will issue shares representing 5% of their capital stock for the amounts of $ 168,000 in three tranche (a) SOSV to pay to the HPL $ 75,000 for integration of Mobile Only Accelerator (MOX) software development kit, (b) SOSV to pay on behalf of the HPL $ 48,000 upon MOX successful application and setting up subsidiary, and (c) SOSV to pay on behalf of the HPL $ 45,000 for setting program for services. The Company received first tranche of $ 75,000 only and thereafter no other two tranche received by the HPL, however, the outcome of the deal did not results success and so later the HPL have not issued any shares to the SOSV, therefore the arrangement amount of $ 75,000 accounted as loan from SOSV. On February 2, 2021, the Company sent the legal letter to the SOSV intimating that the Company acquired HPL by issuing 117,000 preferred stock series C to Hottab Holding Limited for the 100 % acquisition of HPL. As of September 30, 2021 and December 31, 2020, the Company had a total of $ 75,000 and $ 75,000 , outstanding on this account, respectively. (see below for legal update)\nService contracts\nThe Company carries various service contracts on its vendors for repairs, maintenance and inspections. All contracts are short term and can be cancelled.\nMaterial contracts\nOn 28 May 2021, the Company entered into a business cooperation agreement with Paytech Company Limited (“Strategic Partners”) to provide payment integration and loyalty services to the platform that allows merchants to process transactions with consumers. As of date, this program have not started and expected to commence in next year 2022.\nOn 15 August 2021, the Company entered into a business cooperation agreement with Rainbow Loyalty Company Limited (“Strategic Partners”) to provide loyalty services for merchants on the platform. As of date, this program have not started and expected to commence in next year 2022.\nExecutive service agreements\nOn April 1, 2017 the Company entered into an at-will Employment Agreement with Dennis Nguyen, its Chairman and Chief Executive Officer. The Employment Agreement provides for a monthly salary of $ 40,000 ; provided that until the Company has adequate reserves to pay Mr. Nguyen’s salary, he may convert any unpaid salary into common stock of the Company at a share price equal to $ 250 per share. Mr. Nguyen is also entitled to an annual cash bonus of $ 250,000 ; provided that until the Company has adequate reserves to pay Mr. Nguyen’s annual bonus, he may convert any unpaid bonus into common stock of the Company as described above. This provision was inserted into the employment agreement to compensate Mr. Nguyen in stock, at his option, and was to remain operable only until the Company has sufficient cash to pay him his salary in cash. From July 2021 until now, the Company’s cash balance has been at least $ 4 million and the Company has paid Mr. Nguyen his salary in full in every month from July 2021 until now. As a result of these facts, the conversion feature in Mr. Nguyen’s contract became inoperable as of July 1, 2021 and Mr. Nguyen no longer has the option to convert unpaid salary into the Company’s shares. On October 25, 2021, the Company has also amended Mr. Nguyen’s contract to delete the conversion feature to make clear the conversion feature will not be operable in the future. Therefore, the Company will not accrue any expense. Mr. Nguyen is also entitled to participate in all of the other benefits of the Company which are generally available to office employees and other employees of the Company. Mr. Nguyen is not entitled to any severance pay.\nOn September 1, 2021 the Company entered into a 5-year Employment Agreement with Raynauld Liang, its Chief Financial Officer and Singapore Country General Manager. The employment agreement provides Mr. Liang with compensation of (i) an annual base salary of $ 240,000 ; (ii) an annual discretionary incentive cash bonus with a minimum target of 25% of base salary; (iii) 814,950 shares of the Company’s common stock (taking into account the Company’s stock split 1:750 and reverse stock split 1:2.5), of which 651,960 shares are subject to vesting over a two-year period; and (iv) all other executive benefits sponsored by the Company. If a change of control of the Company occurs and if at the time of such change of control the Company’s common stock is trading at a price that is double the initial public offering price, then Mr. Liang will be entitled to a cash bonus equal to three (3) times his base salary. If Mr. Liang is terminated other than for cause or resigns for good reason, he will be entitled to receive continued base salary until the earlier of (x) the anniversary date of such termination and (y) the end of the 5-year term of the employment agreement; provided, however, if the termination is after September 1, 2022, then the period set forth in clause (x) shall be 18 months from the date of the employment agreement. Mr. Liang may terminate the employment agreement at any time other than for good reason with 30 days’ notice to the Company.\n\n| 41 |\n\nLitigation\nFrom time to time, the Company may become involved in various lawsuits and legal proceedings, which arise, in the ordinary course of business. However, litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm the Company’s business. The Company is not aware of any such legal proceedings that will have, individually or in the aggregate, a material adverse effect on its business, financial condition or operating results.\nTwo cases are employment actions filed by former employees who seek compensation alleged to be due pursuant to agreements with the Company. Both of the employees are represented by the same counsel and filed their cases in the Supreme Court of the State of New York, County of New York, in December 2019.\nIn one of those actions, a former employee claims entitlement to compensation and a bonus totaling $566,000 and 39,000-58,500 shares of Company common stock, together with costs. The Company responded to the complaint and also asserted counterclaims in the proceeding for $1,500,000 to $4,000,000 plus punitive damages, together with interest and costs, arising from, inter alia, the former employee’s breach of contract, unfair competition, misappropriation of trade secrets and breach of fiduciary duty. The former employee has responded to the Company’s counterclaims and this action is in the discovery phase of the litigation.\nIn the other employment action, another former employee claims entitlement to salary payments and expense reimbursement in the amount of $ 122,042 .60, plus liquidated damages, together with costs. This former employee also claims entitlement to 516,300 to 760,800 shares of the Company’s common stock. In addition, this action also includes claims by a plaintiff-entity alleging entitlement to $8 million in shares of the Company’s Series A Preferred stock. The Company responded to the complaint and also asserted counterclaims against the former employee in the proceeding for $1,500,000 to $2,000,000 plus punitive damages, together with costs, arising from, inter alia, the former employee’s breach of contract, breach of fiduciary duty, tortious interference and fraud. The former employee has responded to the Company’s counterclaims and this action is still in the discovery phase of litigation.\nThe third case also involves one of those former employees; therein, a Company affiliate filed suit in February 2020 seeking enforcement, by way of specific performance, of an agreement which entitles the affiliate to purchase all of the 99 percent of the shares of the plaintiff-entity which alleges entitlement to $8 million in shares of the Company’s Series A Preferred Stock in one of the employment actions described above. The former employee has responded to the Company’s complaint in this action with a motion to dismiss, which was later withdrawn by same, and then by way of an answer without counterclaims. The judge assigned to this action has announced his retirement and the case has not yet been reassigned.\nThe Company was in an AAA arbitration defending allegations of breach of an agreement. The Demand for Arbitration therein, dated August 25, 2020, asserted that the Petitioner, an LLC, had an agreement with the Company and its CEO granting the Petitioner the right to require the Company to redeem certain common stock in the Company for a cash payment.\nThe Demand alleged that the Petitioner submitted a Redemption Notice, as required under the alleged agreement, obligating the Company to redeem the shares. The Demand alleged that the failure of the Company to redeem the shares and pay Petitioner further obligated the Company to provide additional common stock to the Petitioner. The amount alleged to be due to the Petitioner as of July 31, 2020 was said to be $590,461.94 and growing daily while the number of additional common stock shares alleged to be due to Petitioner as of July 31, 2020 was said to be 708,542,582 and growing, daily.\nIn order to avoid an adverse award, the Company agreed to settle the matter for the sum of $550,000. No additional shares were included in the settlement agreement. The settlement sum was required to be paid in two tranches, with $250,000 to have been paid on or before May 28, 2021 and the remaining $300,000 to be paid on or before June 30, 2021. The Company made the required settlement payments and the matter is now considered closed.\n\n| 42 |\n\nOn or about March 5, 2021, SOSV IV LLC (“SOSV”) sent a demand letter to the Company in regard to its investment in Hottab Pte. Ltd. (“Hottab”).\nIn this letter, and the subsequently filed lawsuits, SOSV alleges that it entered into an investment arrangement with Hottab in which SOSV was to receive five percent (5%) of the common stock of Hottab and entered into an Accelerator Contract for Equity (the “ACE”) pursuant to which it alleges to have invested a sum of $168,000 with Hottab. These events are alleged to have taken place prior to the Company’s acquisition of Hottab. SOSV alleges that the Company subsequently acquired all of the outstanding shares of Hottab, which it alleges triggered a liquidity event clause under the ACE requiring the Company, by way of its ownership of Hottab, to pay SOSV twice its investment, or $336,000.\nSOSV further alleges that subsequent to a term sheet between the Company and Hottab being executed, the Company entered into an agreement to purchase one hundred percent (100%) of the issued and outstanding shares of Hottab from Hottab Holdings Limited (“Hottab Holdings”). As SOSV does not have any interest in Hottab Holdings, it did not receive any consideration as allegedly provided under the ACE.\nUpon these allegations, SOSV asserts causes of action sounding in fraudulent misrepresentation/concealment, breach of contract, breach of the covenant of good faith and fair dealing, quantum meruit and/or unjust enrichment, promissory estoppel, oppression of minority shareholder, and breach of fiduciary duties. SOSV seeks damages in the amount of $336,000.00 in addition damages equal to the value of SOSV’s alleged equity in Hottab or in the alternative shares of the Company in an amount equal to SOSV’s ownership interest in Hottab at the time of the purchase of Hottab’s shares from Hottab Holdings.\nInitially, SOSV filed suit in the District Court for New Jersey on June 10, 2021. SOSV voluntarily dismissed its New Jersey lawsuit and on October 29, 2021, re-filed the action in the Southern District of New York. The New York lawsuit was also voluntarily dismissed by SOSV. However, SOSV may choose to re-file its lawsuit.\nThe Company denies the accusations of SOSV and intends to vigorously defend this matter if the action is re-filed. As the lawsuit has been voluntarily dismissed, there have been no proceedings and we are unable to prognosticate a likelihood of success, or whether SOSV will re-file the action.\nAs of September 30, 2021 and December 31, 2020, the Company had a total of $75,000 and $75,000 outstanding on this account, respectively.\nAs of September 30, 2021, the Company expects no possible loss from these legal proceedings and no provision is accrued accordingly.\n\n| 43 |\n\nNOTE－19 SEGMENT REPORTING\nWe have two reportable segments: (i) e-commerce and (ii) Merchant POS. The e-commerce segment includes the operations of Sopa Technology Company Ltd. Additionally, the Merchant POS segment comprises the operations of Hottab group and SOPA entities except SOPA Technology Company Ltd. Lastly, reported under Merchant POS included acquired operating segment, Hottab group and all SOPA entities except SOPA Technology Company Ltd . Merchant POS includes Hardware sales, subscription sales and e-Commerce includes online ordering such as Fashion & Accessories, Beauty & Personal Care, and Home & Lifestyle.\nOur Chief Operating Decision Maker (CODM) evaluate operating segments using the following table presents revenues and gross profits by reportable segment and asset except liability information.\n| Schedule of Segment Reporting |\n| Nine Months Ended September 30, 2021 |\n| e-Commerce | Merchant POS | Total |\n| Revenue |\n| Hardware sales | $ | — | $ | 335 | $ | 335 |\n| Software subscription | — | 26,970 | 26,970 |\n| Sales – online ordering | 73,518 | — | 73,518 |\n| Total revenue | 73,518 | 27,305 | 100,823 |\n| Cost of sales: |\n| Hardware sales | — | ( 165 | ) | ( 165 | ) |\n| Software subscription | ( 166,761 | ) | ( 39,626 | ) | ( 206,387 | ) |\n| Cost of online ordering | ( 57,741 | ) | — | ( 57,741 | ) |\n| Total cost of revenue | ( 224,502 | ) | ( 39,791 | ) | ( 264,293 | ) |\n| Operating Expenses |\n| Sales and marketing expenses | ( 78,808 | ) | ( 6,219 | ) | ( 85,027 | ) |\n| Software development costs | — | ( 76,698 | ) | ( 76,698 | ) |\n| Impairment loss | ( 200,000 | ) | — | ( 200,000 | ) |\n| General and administrative expenses | ( 73,285 | ) | ( 14,341,077 | ) | ( 14,414,362 | ) |\n| Total operating expenses | ( 352,093 | ) | ( 14,423,994 | ) | ( 14,776,087 | ) |\n| Loss from operations | ( 503,077 | ) | ( 14,436,180 | ) | ( 14,939,557 | ) |\n\n\n| Three Months Ended September 30, 2021 |\n| e-Commerce | Merchant POS | Total |\n| Revenue |\n| Hardware sales | $ | — | $ | — | $ | — |\n| Software subscription | — | 10,016 | 10,016 |\n| Sales – online ordering | 73,518 | — | 73,518 |\n| Total revenue | 73,518 | 10,016 | 83,534 |\n| Cost of sales: |\n| Hardware sales | — | — | — |\n| Software subscription | ( 80,557 | ) | ( 21,138 | ) | ( 101,695 | ) |\n| Cost of online ordering | ( 57,741 | ) | — | ( 57,741 | ) |\n| Total cost of revenue | ( 138,298 | ) | ( 21,138 | ) | ( 159,436 | ) |\n| Operating Expenses |\n| Sales and marketing expenses | ( 40,744 | ) | ( 2,099 | ) | ( 42,843 | ) |\n| Software development costs | — | ( 9,709 | ) | ( 9,709 | ) |\n| Impairment loss | — | — | — |\n| General and administrative expenses | ( 48,658 | ) | ( 8,243,805 | ) | ( 8,292,463 | ) |\n| Total operating expenses | ( 89,402 | ) | ( 8,255,613 | ) | ( 8,345,015 | ) |\n| Loss from operations | ( 154,182 | ) | ( 8,266,735 | ) | ( 8,420,917 | ) |\n\n| 44 |\n\n\n| September 30, 2021 |\n| e-Commerce | Merchant POS | Total |\n| Identifiable assets | $ | 147,950 | $ | 11,170,288 | $ | 11,318,238 |\n\n\n| December 31, 2020 |\n| e-Commerce | Merchant POS | Total |\n| Identifiable assets | $ | — | $ | 7,866,273 | $ | 7,866,273 |\n\n\n| Nine Months Ended September 30, 2020 |\n| e-Commerce | Merchant POS | Total |\n| Revenue |\n| Hardware sales | $ | — | $ | 3,510 | $ | 3,510 |\n| Software subscription | — | 37,752 | 37,752 |\n| Sales – online ordering | — | — | — |\n| Total revenue | — | 41,262 | 41,262 |\n| Cost of sales: |\n| Hardware sales | — | ( 2,982 | ) | ( 2,982 | ) |\n| Software subscription | — | ( 56,127 | ) | ( 56,127 | ) |\n| Cost of online ordering | — | — | — |\n| Total cost of revenue | — | ( 59,109 | ) | ( 59,109 | ) |\n| Operating Expenses |\n| Sales and marketing expenses | — | ( 3,125 | ) | ( 3,125 | ) |\n| Software development costs | — | ( 139,151 | ) | ( 139,151 | ) |\n| Impairment loss | — | ( 8,778 | ) | ( 8,778 | ) |\n| General and administrative expenses | — | ( 2,311,266 | ) | ( 2,311,266 | ) |\n| Total operating expenses | — | ( 2,462,320 | ) | ( 2,462,320 | ) |\n| Loss from operations | — | ( 2,480,167 | ) | ( 2,480,167 | ) |\n\n\n| Three Months Ended September 30, 2020 |\n| e-Commerce | Merchant POS | Total |\n| Revenue |\n| Hardware sales | $ | — | $ | 585 | $ | 585 |\n| Software subscription | — | 11,044 | 11,044 |\n| Sales – online ordering | — | — | — |\n| Total revenue | — | 11,629 | 11,629 |\n| Cost of sales: |\n| Hardware sales | — | ( 585 | ) | ( 585 | ) |\n| Software subscription | — | ( 19,731 | ) | ( 19,731 | ) |\n| Cost of online ordering | — | — | — |\n| Total cost of revenue | — | ( 20,316 | ) | ( 20,316 | ) |\n| Operating Expenses |\n| Sales and marketing expenses | — | — | — |\n| Software development costs | — | ( 33,658 | ) | ( 33,658 | ) |\n| Impairment loss | — | 4,164 | 4,164 |\n| General and administrative expenses | — | ( 1,580,287 | ) | ( 1,580,287 | ) |\n| Total operating expenses | — | ( 1,609,781 | ) | ( 1,609,781 | ) |\n| Loss from operations | — | ( 1,618,468 | ) | ( 1,618,468 | ) |\n\n\n| 45 |\n\nNOTE－20 SUBSEQUENT EVENTS\nIn accordance with ASC Topic 855, “Subsequent Events”, which establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued, the Company has evaluated all events or transactions that occurred after September 30, 2021, up through the date the Company issued the unaudited condensed consolidated financial statements.\nOn November 8, 2021, the Company entered into an underwriting agreement (the “Underwriting Agreement”) with Maxim Group LLC, acting as representative to the underwriters (the “Representative”), related to the initial public offering of 2,888,889 shares of the Company’s common stock, par value $ 0.0001 per share (the “Firm Shares”), at a public offering price of $ 9.00 per share. Under the terms of the Underwriting Agreement, the Company has granted the Underwriters an option, exercisable for 45 days, to purchase up to an additional 433,334 shares of common stock (the “Option Shares”) at a public offering price of $ 9.00 , less discounts and commissions, to cover over-allotments, if any. The Company’s common stock was listed on the Nasdaq Capital Market on November 9, 2021 and began trading on such date. The closings (the “IPO Closings”) of the offering and sale of the Firm Shares and the sale of 236,111 Option Shares occurred on November 12, 2021. Aggregate gross proceeds from the closings related to the Firm Shares and the Option Shares was $ 26,000,001 and $ 2,124,999 , respectively.\nOn December 1, 2021, Leflair Incorporated under the laws of the State of Navada and subsequently share issued to the Company on December 7, 2021 as wholly-owned subsidiary.\nOn December 6, 2021, the Company entered into two consulting agreements with China-America Culture Media Inc. and New Continental Technology Inc., acting as Consultanct to assist the Company in completing certain Business Opportunities with potential partners until February 28, 2023. The consideration of the service are $ 3,250,000 and $ 3,190,000 .\nUpon the IPO Closings, all outstanding shares of preferred stock series A, B, B-1, C and C-1 automatically converted into 888,889 shares, 764,400 shares, 48,000 shares, 465,600 shares and 4,195,200 shares of the Company’s common stock, respectively.\n\n| 46 |\n\n\nItem 2. Management’s discussion and analysis of financial condition and results of operations.\nThe following discussion summarizes the significant factors affecting the operating results, financial condition, liquidity, and cash flows of our Company as of and for the periods presented below. The following discussion and analysis should be read in conjunction with “Selected Consolidated Financial Data,” the condensed consolidated financial statements and the related notes thereto, and the consolidated financial statements and the related notes thereto all included elsewhere in this report. The statements in this discussion regarding industry outlook, our expectations regarding our future performance, liquidity, and capital resources, and all other non-historical statements in this discussion are forward-looking statements and are based on the beliefs of our management, as well as assumptions made by, and information currently available to, our management. Actual results could differ materially from those discussed in or implied by forward-looking statements as a result of various factors, including those discussed in the Company’s final prospectus for its initial public offering on file with the Secuties and Exchange Commision (the “SEC”), particularly in the sections entitled “Special Note Regarding Forward-Looking Statements” and “Risk Factors.”\nOverview\nWe acquire and operate e-commerce platforms through our direct and indirect wholly-owned subsidiaries, including but not limited to Society Technology LLC, SoPa Technology Pte Ltd, SoPa Cognitive Analytics Pte Ltd, Sopa Technology Co Ltd, HOTTAB Pte Ltd and HOTTAB Vietnam Co Ltd. Along with HOTTAB Asset Vietnam Co Ltd (currently wholly-owned by one employee of HOTTAB Vietnam Co Ltd and contractually operated by HOTTAB Vietnam Co Ltd), these eight companies form the Society Pass Group (the “Group”). The Group currently markets to both consumers and merchants in Vietnam while maintaining an administrative headquarters in Singapore. In Feb 2021,we have acquired an online lifestyle platform of Leflair branded assets (the “Leflair Assets”) as more fully described in “Business – Leflair” and are in the process of integrating the Leflair assets with the SoPa and #HOTTAB platform. On 9 November 2021, the Group have been approved for listing on Nasdaq Capital Market (“Nasdaq”) and will trade under the ticker symbol “SOPA”. The Group is a leading Southeast Asian data-driven loyalty platform with its initial offering of 2,888,889 shares of common stock at a price of US$9.00 per share. After the completion of our initial public offering (“IPO”), we intend to expand our e-commerce ecosystem throughout the rest of SEA and South Asia with particular focuses on Philippines, India and Bangladesh.\nOur ecosystem currently comprises of seven e-commerce interfaces targeting consumers and merchants: SoPa food & beverage (“F&B”) App, SoPa.asia F&B Marketplace website, #HOTTAB Biz App, #HOTTAB POS App, Hottab.net admin website, Leflair App, and Leflair Lifetyle Marketplace website (the “Platform”). Our loyalty-focused and data-driven e-commerce marketing platform interfaces connect consumers with merchants in the F&B and lifestyle sectors, assisting local brick-and-mortar businesses to access new customers and markets to thrive in an increasingly convenience-driven economy. Our Platform integrates with both global and country-specific search engines and applications and accepts international address and phone number data, providing a consumer experience that respects local languages, address formats and customs. Our strategic partners work with us to penetrate local markets, while our Platform allows effortless integration with existing technological applications and websites.\nOur consumer facing business consists of our “SoPa” and “Leflair” brands. Through our SoPa F&B App, and SoPa.asia F&B Marketplace website, we provide frictionless online ordering and delivery experience for consumers in the F&B sector. Our Leflair lifestyle e-commerce platform markets and sells products in three verticals: Fashion & Accessories, Beauty & Personal Care, and Home & Lifestyle. Our consumer facing platforms feature an easy-to-navigate, multi-lingual user interface with multiple integrated payment and delivery options\nBranded as “#HOTTAB”, our merchant facing business helps merchants increase revenues and streamline costs with an online and multilingual store front, fully integrated POS software solution, joint marketing program, payment infrastructure, loyalty administration, customer profile analytics, and SME financing packages. Through #HOTTAB Biz App, #HOTTAB POS and Hottab.net merchant administration website interfaces, #HOTTAB functions both online and offline and facilitates transactions, orders, voucher redemption, and rewards. Merchants only need a smart device in order to quickly access our #HOTTAB product ecosystem. In addition, our Customer Care department provides attentive after-sales service.\n\n| 47 |\n\nUpon the expected launch of Society Points in the second half of 2021, consumers will be able to use our Society Points at merchant locations initially throughout Vietnam and then we expect to expand availability of Society Points throughout SEA and South Asia See “Business —Loyalty Points —Society Points.”\nAs of December 6, 2021 we have onboarded over 1.5 million registered consumers and over 5,500 registered merchants on our Platform.\nImpact of the COVID-19 Pandemic\nThe current outbreak of COVID-19 has globally resulted in loss of life, business shutdowns, restrictions on travel, and widespread cancellation of social gatherings. The extent to which the COVID-19 pandemic impacts our business will depend on future developments, which are highly uncertain and cannot be predicted at this time, including:\n\n| • | new information which may emerge concerning the severity of the disease in Vietnam and SEA; |\n\n| • | the duration and spread of the outbreak; |\n\n| • | the severity of travel restrictions imposed by geographic areas in which we operate, mandatory or voluntary business closures; |\n\n| • | regulatory actions taken in response to the pandemic, which may impact merchant operations, consumer and merchant pricing, and our product offerings; |\n\n| • | other business disruptions that affect our workforce; |\n\n| • | the impact on capital and financial markets; and |\n\n| • | action taken throughout the world, including in markets in which we operate, to contain the COVID-19 outbreak or treat its impact. |\n\nIn addition, the current outbreak of COVID-19 has resulted in a widespread global health crisis and adversely affected global economies and financial markets, and similar public health threats could do so in the future. Such events have impacted, and could in the future impact, demand for merchants and consumer purchase patterns, which in turn, could adversely affect our revenue and results of operations.\nSince the onset of the COVID-19 pandemic in March and April 2020, all our POS merchant clients are affected by COVID-19 measures for F&B to temporary stop restaurant dine ins.\n\n| • | Some of our restaurant clients ceased operations permanently and many were closed since June 2020 without any notice of reopening their business to date. |\n\n| • | Our largest POS client, a hotel chain for which we provide POS services to their F&B business in their hotels, ceased operations in two out of nine hotels since April 2020. |\n\n| • | The Company faces challenges to onboard new clients but at the same time losing many existing ones. |\n\nWith the ongoing pandemic, Company faces challenges in our operation as follows;\n\n| • | Disruption of operation in Vietnam, India, Singapore and US where staffs have to work from home. |\n\n| • | The coordination of rebooting of company’s recent asset acquisition of Leflair an ecommerce platform. |\n\n| • | Application of licenses are delayed as government agencies take longer time to review and process time. |\n\n| • | HR process to hire personnel are generally slow due to people not willing to leave their current job, company have to spend more time and resources. |\n\n\n| 48 |\n\nThe spread of COVID-19 has caused us to modify our business practices, including employee travel, employee work locations in certain cases, and cancellation of physical participation in certain meetings, events and conferences and further actions may be taken as required or recommended by government authorities or as we determine are in the best interests of our employees, customers, and other business partners. We are monitoring the global outbreak of the pandemic, in SEA, especially Vietnam and are taking steps in an effort to identify and mitigate the adverse impacts on, and risks to, our business posed by its spread and the governmental and community reactions thereto. See “Risk Factors--Our business may be materially adversely affected by the recent coronavirus (COVID-19) outbreak.\nFinancial Condition\nResults of Operations\nThe following table sets forth certain operational data for the three and nine months ended September 30, 2021 and 2020:\n\n| Three months ended September 30, | Nine months ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Revenue,net | 83,534 | 11,629 | 100,823 | 41,262 |\n| Cost of revenue | (159,436 | ) | (20,316 | ) | (264,293 | ) | (59,109 | ) |\n| Gross loss | (75,902 | ) | (8,687 | ) | (163,470 | ) | (17,847 | ) |\n| Less operating expenses: |\n| Sales and marketing expenses | (42,843 | ) | — | (85,027 | ) | (3,125 | ) |\n| Software development costs | (9,709 | ) | (33,658 | ) | (76,698 | ) | (139,151 | ) |\n| Impairment loss | — | 4,164 | (200,000 | ) | (8,778 | ) |\n| General and administrative expenses | (8,292,463 | ) | (1,580,287 | ) | (14,414,362 | ) | (2,311,266 | ) |\n| Total operating expenses | (8,345,015 | ) | (1,609,781 | ) | (14,776,087 | ) | (2,462,320 | ) |\n| Loss from operations | (8,420,917 | ) | (1,618,468 | ) | (14,939,557 | ) | (2,480,167 | ) |\n| Other income (expense): |\n| Interest income | 55 | 3 | 71 | 11 |\n| Interest expense | (12,272 | ) | (12,261 | ) | (36,486 | ) | (36,381 | ) |\n| Loss on settlement of litigation | — | — | (550,000 | ) | — |\n| Other income | 5,170 | 3,737 | 6,917 | 9,495 |\n| Total other expense | (7,047 | ) | (8,521 | ) | (579,498 | ) | (26,875 | ) |\n| Loss before income taxes | (8,427,964 | ) | (1,626,989 | ) | (15,519,055 | ) | (2,507,042 | ) |\n| Income taxes | (1,303 | ) | (4 | ) | (9,943 | ) | (15,069 | ) |\n| NET LOSS | $ | (8,429,267 | ) | $ | (1,626,993 | ) | $ | (15,528,998 | ) | $ | (2,522,111 | ) |\n\nRevenue. We generated revenues of $83,534 and $ 11,629 for the three months ended September 30, 2021 and 2020 respectively. During the nine month ended September 30, 2021 and 2020 we generated revenue of $100,823 and $41,262 respectively. The significant increase in revenue for three months and nine months was due to more merchants were joining our platform to operate their business.\n\n| 49 |\n\nDuring the nine months ended September 30, 2021 and 2020, the following customer exceeded 10% of the Company’s revenues:\n\n| Nine months ended September 30, 2021 | September 30, 2021 |\n| Customer | Revenues | Percentage of revenues | Accounts receivable |\n| Aryaduta Hospitality & Leisure Group | $ | 24,813 | 25 | % | $ | 19,308 |\n| PayDollars-Payment Gateway | $ | 12,615 | 13 | % | $ | — |\n| Tiki Smart Logistic | $ | 58,300 | 58 | % | $ | 68,285 | * |\n\n* - This included value added taxes (“VAT”)\n\n| Nine months ended September 30, 2020 | September 30, 2020 |\n| Customer | Revenues | Percentage of revenues | Accounts receivable |\n| Aryaduta Hospitality & Leisure Group | $ | 31,604 | 76 | % | $ | — |\n\nFor the three months ended September 30, 2021 and 2020, the customers who accounted for 10% or more of the Company’s revenues and its outstanding receivable balances at year-end dates, are presented as follows:\n\n| Three months ended September 30, 2021 |\n| Customer | Revenues | Percentage of revenues |\n| Aryaduta Hospitality & Leisure Group | $ | 10,016 | 12 | % |\n| PayDollars-Payment Gateway | $ | 12,615 | 13 | % |\n| Tiki Smart Logistic | $ | 58,300 | 58 | % |\n\n\n| Three months ended September 30, 2020 |\n| Customer | Revenues | Percentage of revenues |\n| Aryaduta Hospitality & Leisure Group | $ | 9,789 | 84 | % |\n\nAll of our customers are located in Vietnam except one above significant customer located in Indonesia.\nCost of Revenue. We incurred cost of revenue of $159,436 and $20,316 for three months ended September 30, 2021, and 2020 respectively. During the period of nine months ended September 30,2021 and 2020, we incurred cost of revenue of $264,293 and $59,109 respectively. Cost of revenue increased primarily as a result of the fixed subscription cost and the increased in number of headcounts arising from the acquisition of e-commerce assets from Goodventures Sea Limited.\nMajor vendors\nFor the nine months ended September 30, 2021 and 2020, the vendors who accounts for 10% or more of the Company’s hardware purchases and software cost its outstanding payable balances as at year-end dates, are presented as follows:\n\n| Nine months ended September 30, 2021 | September 30, 2021 |\n| Vendors | Purchases | Percentage of purchases | Accounts payable |\n| Vendor A | $ | 30,577 | 27% | $ | 44,867 |\n| Vendor B | 17,827 | 16% |\n\n\n| Nine months ended September 30, 2020 | September 30, 2020 |\n| Vendors | Purchases | Percentage of purchases | Accounts payable |\n| Vendor A | $ | 46,863 | 72% | $ | — |\n| Vendor B | — | — | — |\n\n\n| 50 |\n\nFor the three months ended September 30, 2021 and 2020, the vendors who accounts for 10% or more of the Company’s hardware purchases and software cost its outstanding payable balances as at year-end dates, are presented as follows:\n\n| Three months ended September 30, 2021 |\n| Vendors | Purchases | Percentage of purchases |\n| Vendor A | $ | — | — |\n\n\n| Three months ended September 30, 2020 |\n| Vendors | Purchases | Percentage of purchases |\n| Vendor A | $ | 24,201 | 90 | % |\n| Vendor B | — | — |\n\nAll vendors are located in Vietnam.\nGross Loss. We recorded a gross loss of $75,902 and $8,687 for three months ended September,30 2021 and 2020 respectively. During the nine months ended September 30,2021 and 2020, we recorded a gross loss of $163,470 and $17,847 respectively. The increase in gross loss is primarily attributable to fixed subscription cost and the number of headcounts arising from the acquisition of e-commerce assets from Goodventures Sea Limited.\nSales and Marketing Expenses (“S&M”). We incurred S&M expenses of $42,843 and $0 for three months ended September 30, 2021 and 2020 respectively. During nine months ended September 30,2021 and 2020, we have incurred S&M expenses of $85,027 and $3,125 respectively. The increase in S&M is primarily attributable to the increased in sales and promotion expenses related to get more merchants joining our e-commerce platform to operate their business. Also, increase marketing cost to attract attention of customer to our e-commerce platform.\nSoftware Development Cost (“SDC”). We incurred SDC expenses of $9,709 and 33,658 for three months ended September 30, 2021 and 2020 respectively. During the nine months ended September 30, 2021 and 2020, we incurred SDC exepenses of $76,698 and $139,151 respectively. The decrease in SDC is primarily attributable to the restructuring of our technology development team.\nImpairment Charge (“IC”). We incurred impairment charge of $200,000 and $8,778 for the nine months ended September 30, 2021, and 2020, respectively. No impairment charge imcurred for the three months ended September 30, 2021 and 2020. The increase is primarily attributable to the acquisition of Leflair ecommerce asset which was expensed in the same period due to the short life term of the asset and the quantum of consideration.\nGeneral and Administrative Expenses (“G&A”). We incurred G&A expenses of $8,292,463 and $1,580,287 for three months ended September 30, 2021 and 2020 respectively. During the nine months ended September 30, 2021 and 2020, we incurred G&A expenses of $14,414,362 and $2,311,266 respectively. The increase in G&A is primarily attributable to the professional cost associated with cost related to company filing for listing on Nasdaq, amortization of intangible assets and Stock based compensation for services.\nLoss on settlement of litigation. On May 21, 2021, the Company has agreed to settle the matter for the sum of $550,000. No additional shares were included in the settlement agreement. The settlement sum is required to be paid in two tranches, with $250,000 to have been paid on or before May 28, 2021 and the remaining $300,000 to be paid on or before June 30, 2021. The Company made the first payment of $250,000 on May 25, 2021 and complete the settlement sum as provided under the settlement agreement by paying the remaining $300,000 on June 29, 2021. In connection with the settlement, the Company recognized litigation settlement expense and a related accrued liability of $550,000 in the period ended September 30, 2021. There is no such expenses incurred in the comparative period ended September 30, 2020.\n\n| 51 |\n\nIncome Tax Expense. Our income tax expenses for the three months ended September 30,2021 and 2020 was $1,303 and $4 and for nine months ended September 30, 2021 and 2020 was $9,943 and $15,069, respectively.\nNet Loss. As a result for the three months ended September 30, 2021, we incurred a net loss of $8,429,267 as compare to the same period ended September 30,2020 of $1,626,993. During nine month ended September 30, 2021 the Group having loss of $15,528,998, as compared to $2,522,111 for the same period ended September 30, 2020. The increase in net loss is primarily attributable to the professional cost associated with cost related to company filing for listing on Nasdaq and amortization of intangible assets.\nLiquidity and Capital Resources\nAs of September 30, 2021, we had cash and cash equivalents of $5,722,450, accounts receivable of $87,803, deposits, prepayments and other receivables of $69,623 and due from related parties of $97,500.\nAs of December 31, 2020, we had cash and cash equivalents of $506,666, accounts receivable of $1,897, deposits, prepayments and other receivables of $60,532.\nThe accompanying consolidated financial statements have been prepared using the going concern basis of accounting, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.\nThe Company suffered from an accumulated deficit of $28,116,309 at September 30, 2021. The Company incurred net loss of $15,528,998 during the nine months ended September 30, 2021. These factors raise substantial doubt about the Company’s ability to continue as a going concern for a period of twelve months from the date of issuance of this financial statement, without additional debt or equity financing. The continuation of the Company as a going concern is dependent upon the continued financial support from its shareholders. Management believes the Company is currently pursuing additional financing for its operations. However, there is no assurance that the Company will be successful in securing sufficient funds to sustain the operations.\nThe registration statement for the Company’s Initial Public Offering became effective on November 8, 2021. On November 8, 2021, the Company entered into an underwriting agreement with Maxim Group LLC, related to the offering of 2,888,889 shares of the Company’s common stock (the “Firm Share”), at a public offering price of $9.00 per share. Under the terms of the Underwriting Agreement, the Company has granted the Underwriters an option, exercisable for 45 days, to purchase an additional 236,111 shares of common stock (the “Option Shares”) to cover over-allotments. The Company has raised funding from Initial Public Offering and Option shares of $26,000,001 and 2,124,999. In addition, the Company has raised $8,019,461, net of issuance cost in the form of equity subsequent to issuance of the audit report on the Company’s December 31, 2020 financial statements respectively in the form of equity subsequent to issuance of the audit report on the Company’s December 31, 2020 financial statements and based upon the capital raised, the Company believes it has sufficient liquidity to meet its working capital requirements for the next 12 months. As a result the Company has mitigated any doubts about its ability to continue as a going concern\nThese consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets and liabilities that may result in the Company not being able to continue as a going concern.\n\n| Nine Months Ended September 30, |\n| 2021 | 2020 |\n| Net cash (used in) operating activities | $ | (2,639,775 | ) | $ | (970,647 | ) |\n| Net cash (used in) investing activities | (200,000 | ) | — |\n| Net cash provided by financing activities | 8,019,461 | 708,960 |\n| Effect on exchange rate change | 36,098 | 16,689 |\n| Net change in cash and cash equivalents | 5,215,784 | (244,998 | ) |\n| Cash and cash equivalent at beginning of period | 506,666 | 606,491 |\n| Cash and cash equivalent at end of period | 5,722,450 | 361,493 |\n\n| 52 |\n\nNet Cash Used In Operating Activities.\nFor the nine months ended September 30, 2021, net cash used in operating activities was $2,639,775, which consisted primarily of a net loss of $15,528,998, offset by increase in stock based compensation for services of $10,071,830, increase in accounts receivables of $85,906, increase in deposits, prepayments and other receivables of $9,091, increase in contract liabilities $16,936, increase in accounts payables of $50,424, decrease in accrued liabilities and other payable of $474,932, increase in advance to related parties of $127,500, decrease in operating lease liabilities of $29,064, increase in depreciation and amortization of $2,406,648, increase in impairment loss of $200,000, increase in loss on settlement of litigation of 550,000.\nFor the nine months ended September 30, 2020, net cash used in operating activities was $970,647, which consisted primarily of net loss of $2,522,111, offset by increase in impairment loss of $8,778, increase in account receivable of $19,900, increase in inventories of $7,212, increase in deposits, prepayment and other receivables of $7005, increase in contract liabilities of $8,275, increase in accounts payable of $61, decrease in accrued liabilities and other payables of $37,960 and decrease in advance to related parties of $76,278.\nWe expect to continue to rely on cash generated through financing from our existing shareholders and private placements of our securities, however, to finance our operations and future acquisitions.\nNet Cash (Used In) Investing Activities.\nFor the nine months ended September 30, 2021, there is net cash of 200,000 being deposit paid for Leflair asset acquisition investing activities.\nFor the nine months ended September 30, 2020, there is no net cash impact on investing activities\nNet Cash Provided By Financing Activities.\nFor the nine months ended September 30, 2021, net cash provided by financing activities was $8,109,461, consisting primarily of funds raised from shareholders for Series C, Series C1 and warrant exercised.\nFor the nine months ended September 30, 2020, net cash provided by financing activities was $708,960, consisting primarily of funds raised from shareholders for Series C and warrant exercised.\nCritical Accounting Policies and Estimate\n• Basis of presentation\nThe accompanying unaudited interim consolidated condensed financial statements of Society Pass Incorporated have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with Article 8-03 of Regulation S-X. Accordingly, they do not include all the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments, consisting only of normal recurring accruals necessary for a fair statement of financial position, results of operations and cash flows, have been included. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the financial statements and the accompanying notes included in the Company’s registration statement on Form S-1 for the year ended December 31, 2020. The year-end balance sheet data presented for comparative purposes was derived from audited financial statements, but does not include all disclosures required by GAAP. The results of operations for the three and nine months ended September 30, 2021 are not necessarily indicative of the operating results for the year ending December 31, 2021 or for any other subsequent interim period.\n\n| 53 |\n\n• Use of estimates and assumptions\nIn preparing these consolidated financial statements, management makes estimates and assumptions that affect the reported amounts of assets and liabilities in the balance sheet and revenues and expenses during the years reported. Actual results may differ from these estimates. If actual results significantly differ from the Company’s estimates, the Company’s financial condition and results of operations could be materially impacted. Significant estimates in the period include the allowance for doubtful accounts on accounts and other receivables, assumptions used in assessing right of use assets, imputed interest on due to related parties, and impairment of long-term assets, business acquisition allocation of purchase consideration, and deferred tax valuation allowance.\n• Basis of consolidation\nThe condensed consolidated financial statements include the financial statements of the Company and its subsidiaries. All significant inter-company balances and transactions within the Company have been eliminated upon consolidation. In addition, certain amounts in the prior periods’ consolidated financial statements have been reclassified to conform to the current period presentation.\n• Cash and cash equivalents\nCash and cash equivalents are carried at cost and represent cash on hand, demand deposits placed with banks or other financial institutions and all highly liquid investments with an original maturity of three months or less as of the purchase date of such investments. As of September 30, 2021 and December 31, 2020, the cash and cash equivalent was amounted to $5,722,450 and $506,666, respectively.\nThe Company currently has bank deposits with financial institutions in the U.S. which does not exceed FDIC insurance limits. FDIC insurance provides protection for bank deposits up to $250,000, so there were uninsured balance of $4,895,306 and $208,635 in parent entity as of September 30, 2021 and December 31, 2020, respectively. In addition, the Company has uninsured bank deposits with a financial institution outside the U.S. All uninsured bank deposits are held at high quality credit institutions.\n• Accounts receivable\nAccounts receivable are recorded at the invoiced amount and do not bear interest, which are due within contractual payment terms, generally 30 to 90 days from completion of service. Credit is extended based on evaluation of a customer's financial condition, the customer credit-worthiness and their payment history. Accounts receivable outstanding longer than the contractual payment terms are considered past due. Past due balances over 90 days and over a specified amount are reviewed individually for collectibility. At the end of fiscal year, the Company specifically evaluates individual customer’s financial condition, credit history, and the current economic conditions to monitor the progress of the collection of accounts receivables. The Company considers the allowance for doubtful accounts for any estimated losses resulting from the inability of its customers to make required payments. For the receivables that are past due or not being paid according to payment terms, the appropriate actions are taken to exhaust all means of collection, including seeking legal resolution in a court of law. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. The Company does not have any off-balance-sheet credit exposure related to its customers. As of September 30, 2021 and December 31, 2020, the allowance for doubtful accounts amounted to $0 and $0, respectively.\n• Inventories\nInventories are stated at the lower of cost or net realizable value, cost being determined on a first-in-first-out method. Costs include hardware equipment and peripheral costs which are purchased from the Company’s suppliers as merchanized goods. The Company provides inventory allowances based on excess and obsolete inventories determined principally by customer demand. During the nine months ended September 30, 2021 and 2020, the Company recorded an allowance for obsolete inventories of $0 and $0, respectively. During the three months ended September 30, 2021 and 2020, the Company recorded an allowance for obsolete inventories of $0 and $0, respectively. The inventories were amounted to $0 and $0 at September 30, 2021 and December 31, 2020, respectively.\n\n| 54 |\n\n• Property, plant and equipment\nPlant and equipment are stated at cost less accumulated depreciation and accumulated impairment losses, if any. Depreciation is calculated on the straight-line basis over the following expected useful lives from the date on which they become fully operational and after taking into account their estimated residual values:\n\n| Expected useful lives |\n| Computer equipment | 3 years |\n| Office equipment | 5 years |\n\nExpenditures for repairs and maintenance are expensed as incurred. When assets have been retired or sold, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is recognized in the results of operations.\n• Impairment of long-lived assets\nIn accordance with the provisions of ASC Topic 360, “Impairment or Disposal of Long-Lived Assets”, all long-lived assets such as plant and equipment and intangible assets held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is evaluated by a comparison of the carrying amount of an asset to its estimated future undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amounts of the assets exceed the fair value of the assets. There has been no impairment charge for the periods presented.\n• Revenue recognition\nThe Company adopted Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”). Under ASU 2014-09, the Company applies the following five steps in order to determine the appropriate amount of revenue to be recognized as it fulfills its obligations under each of its agreements:\n\n| • | identify the contract with a customer; |\n| • | identify the performance obligations in the contract; |\n| • | determine the transaction price; |\n| • | allocate the transaction price to performance obligations in the contract; and |\n| • | recognize revenue as the performance obligation is satisfied. |\n\nThe revenues are generated from a diversified a mix of marketplace activities and the services of the Company provide merchants to help them grow their businesses. The revenue streams consist of Consumer Facing revenues and Merchant Facing revenues.\nConsumer Facing Business\nThe Company’s performance obligation includes providing connectivity between merchant and consumer, generally through an online ordering platform. The platform allows merchants to create account, place menu and track their sale reports on the merchant facing application. The platform also allows the consumers to create account and make orders from merchants on the consumer facing application. The platform allows delivering company to accept online delivery request and ship order from merchant to consumer.\nThe Company also has online lifestyle platform allow customers to purchase high-end brands of all catergories: Under the Company’s smart search engine, consumers search or review their favorite brands among hundreds of choices in Apparel, Bags & Shoes, Accessory, Health & Beauty, Home & Lifestyle, International, Women, Men and Kids & Babies categories. The platform also allow consumers order from hundreds of vendor choices with personalized promotions based on purchase history and location. The platform has also partnered up with a Vietnam-based delivery company, Tikinow, to offer seamless delivery of product from merchant to consumer’s home or office at the touch of a button. Consumers place orders for delivery or pickup at the Company’s logistics center\n| 55 |\n\nRevenue streams for consumer facing business:\nF&B sector\n\n| 1) | Ordering fees comprise the fees that the different types of merchants pay for every completed transaction on the Platform, exclusive of delivery fees charged. Monthly/annual subscription fees or 10% commission on order value on each successful order will be charged. |\n\n\n| 2) | Delivery fees include an upfront fixed fee and additional variable fees based on the distance. Various percentage of commission will be charged as delivery fee on each successful order received and delivered. |\n\nThe Company recognizes revenues from consumer facing business upon the completion of delivery and services rendered.\nDuring the period ended September 30, 2021 and 2020, the Company have not generated any revenue from this stream.\nLifestyle sector\n\n| 1) | Customer placed orders on the website / app, sales orders report will be generated in the system. The Company will start to proceed to packaging and delivering customer. The sales recognised. |\n\nDuring the nine months ended September 30, 2021 and 2020, the Company have generated $73,518 and $0, respectively revenue from this stream. During the three months ended September 30, 2021 and 2020, the Company have generated $73,518 and $0, respectively revenue from this stream.\nMerchant Facing Business\nRevenue streams for merchant facing business include:\n\n| 1) | Subscription fees consist of the fees that the Company charge merchants to get on the Merchant Marketing Program; |\n\n| 2) | The Company provides optional add-on software services which includes Analytics and Chatbox capabilities at a fixed fee per month. |\n\n| 3) | The Company collects commissions when they sell third party hardware and equipment (cashier stations, waiter tablets and printers) to merchants. |\n\n| 4) | Vendor Financing. The Company collects brokerage fees whenever the Company facilitates financing transactions between merchants and one of the Company’s partner financial institutions. |\n\nDuring the nine months ended September 30, 2021 and 2020, the Company have generated $26,970 and $37,752, respectively revenue from this stream. During the three months ended September 30, 2021 and 2020, the Company have generated $10,016 and $11,044, respectively revenue from this stream\nHardware Product Revenues — the Company generally is involved with the sale of on-premise appliances and end-point devices. The single performance obligation is to transfer the hardware product (which is to be installed with its licensed software integral to the functionality of the hardware product). The entire transaction price is allocated to the hardware product and is generally recognized as revenue at the time of delivery because the customer obtains control of the product at that point in time. It is concluded that control generally transfers at that point in time because the customer has title to the hardware, physical possession, and a present obligation to pay for the hardware. Payments for hardware contracts are generally due 30 to 90 days after shipment of the hardware product.\n\n| 56 |\n\nThe Company records revenues from the sales of third-party products on a “gross” basis pursuant to ASC 606-10 Revenue Recognition – Revenue from Contracts with Customers, when the Company controls the specified good before it is transferred to the end customer and have the risks and rewards as principal in the transaction, such as responsibility for fulfillment, retaining the risk for collection, and establishing the price of the products. If these indicators have not been met, or if indicators of net revenue reporting specified in ASC 606-10 are present in the arrangement, revenue is recognized net of related direct costs.\nSoftware License Revenues — The Company’s performance obligation includes providing connectivity to software, generally through a monthly subscription, where the Company typically satisfies its performance obligations prior to the submission of invoices to the customer for such services. The Company’s software sale arrangements grant customers the right to access and use the software products which are to be installed with the relevant hardware for connectivity at the outset of an arrangement, and to be entitled to both technical support and software upgrades and enhancements during the term of the agreement. The term of the subscription period is generally 12 months, with the automatic renewal of another one year, and the subscription license service is billed monthly, quarterly or annually. Sales are generally recorded in the month the service is provided. For clients who are billed on an annual basis, deferred revenue is recorded and amortized over the life of the contract. Payments are generally due 30 to 90 days after delivery of the software licenses.\nThe Company records its revenues on hardware product and software license, net of value added taxes (“VAT”) upon the services are rendered and the title and risk of loss of hardware products are fully transferred to the customers. The Company is subject to VAT which is levied on the majority of the hardware products at the rate of 10% on the invoiced value of sales.\nContract assets\nIn accordance with ASC 606-10-45-3, contract asset is when the Company’s right to payment for goods and services already transferred to a customer if that right to payment is conditional on something other than the passage of time. The Company will recognize a contract asset when it has fulfilled a contract obligation but must perform other obligations before being entitled to payment.\nThere were no contract assets at September 30, 2021 and December 31, 2020.\nContract liabilities\nIn accordance with ASC 606-10-45-2, A contract liability is Company’s obligation to transfer goods or services to a customer when the customer prepays consideration or when the customer’s consideration is due for goods and services that the Company will yet provide whichever happens earlier.\nContract liabilities represent amounts collected from, or invoiced to, customers in excess of revenues recognized, primarily from the billing of annual subscription agreements. The value of contract liabilities will increase or decrease based on the timing of invoices and recognition of revenue. The Company’s contract liability balance was $35,582 and $18,646 as of September 30, 2021 and December 31, 2020, respectively.\nContract costs\nUnder ASC-606, the Company applies the following three steps in order to evaluate the costs to be capitalized as it fulfills following three criteria:\n• Incremental costs directly related to a specific contract;\n• Costs that generate or enhance resources of the company that will be used to satisfy performance of the terms of the contract; and\n• Costs that are expected to be recovered from the customer.\nNo contract costs are capitalized for the three and nine months ended September 30, 2021 and 2020.\n\n| 57 |\n\n• Software development costs\nIn accordance with the relevant FASB accounting guidance regarding the development of software to be sold, leased, or marketed, the Company expenses such costs as they are incurred until technological feasibility has been established, at and after which time these costs are capitalized until the product is available for general release to customers. Once the technological feasibility is established per ASC 985-20, the Company capitalizes costs associated with the acquisition or development of major software for internal and external use in the balance sheet. Costs incurred to enhance the Company’s software products, after general market release of the services using the products, is expensed in the period they are incurred. The Company only capitalizes subsequent additions, modifications or upgrades to internally developed software to the extent that such changes allow the software to perform a task it previously did not perform. The Company also expenses website costs as incurred.\nResearch and development expenditures in the development of its own software are charged to operations as incurred. Based on the software development process, technological feasibility is established upon completion of a working model, which also requires certification and extensive testing. Costs incurred by the Company between completion of the working model and the point at which the product is ready for general release are immaterial. For the nine months ended September 30, 2021 and 2020, the software development costs were $76,698 and $139,151, respectively. For three months ended September 30, 2021 and 2020, the software development costs were $9,709 and $33,658, respectively.\n• Product warranties\nThe Company’s provision for estimated future warranty costs is based upon historical relationship of warranty claims to sales. Based upon historical sales trends and warranties provided by the Company’s suppliers, the Company has concluded that no warranty liability is required as of June 30, 2021 and 2020. To date, product allowance and returns have been minimal and, based on its experience, the Company believes that returns of its products will continue to be minimal.\n• Shipping and handling costs\nNo shipping and handling costs are associated with the distribution of the products to the customers which are borne by the Company’s suppliers or distributors.\n• Sales and marketing\nSales and marketing expenses include payroll, employee benefits and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $85,027 and $3,125 for the nine months ended September 30, 2021 and 2020, respectively. For three months ended September 30, 2021 and 2020, the Advertising expense were $42,843 and $0, respectively.\n• Income tax\nThe Company adopted the ASC 740 Income Tax provisions of paragraph 740-10-25-13, which addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the consolidated financial statements. Under paragraph 740-10-25-13, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent (50%) likelihood of being realized upon ultimate settlement. Paragraph 740-10-25-13 also provides guidance on de-recognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures. The Company had no material adjustments to its liabilities for unrecognized income tax benefits according to the provisions of paragraph 740-10-25-13.\n\n| 58 |\n\nThe estimated future tax effects of temporary differences between the tax basis of assets and liabilities are reported in the accompanying balance sheets, as well as tax credit carry-backs and carry-forwards. The Company periodically reviews the recoverability of deferred tax assets recorded on its balance sheets and provides valuation allowances as management deems necessary.\nThe Company and its wholly-owned foreign subsidiary, is subject to income taxes in the jurisdictions in which it operates. Significant judgment is required in determining the provision for income tax. There are many transactions and calculations undertaken during the ordinary course of business for which the ultimate tax determination is uncertain. The company recognizes liabilities for anticipated tax audit issues based on the Company’s current understanding of the tax law. Where the final tax outcome of these matters is different from the carrying amounts, such differences will impact the current and deferred tax provisions in the period in which such determination is made.\n• Uncertain tax positions\nThe Company did not take any uncertain tax positions and had no adjustments to its income tax liabilities or benefits pursuant to the ASC 740 provisions of Section 740-10-25 for the three and nine months ended September 30, 2021 and 2020.\n• Foreign currencies translation and transactions\nThe reporting currency of the Company is United States Dollar (\"US$\") and the accompanying consolidated financial statements have been expressed in US$. In addition, the Company’s subsidiary is operating in the Republic of Vietnam and India and maintains its books and record in its local currency, Vietnam Dong (“VND”) and Indian Rupee (“INR), respectively, which are the functional currency as being the primary currency of the economic environment in which their operations are conducted. In general, for consolidation purposes, assets and liabilities of its subsidiaries whose functional currency is not US$ are translated into US$, in accordance with ASC Topic 830-30, “Translation of Financial Statement”, using the exchange rate on the balance sheet date. Shareholders’ equity is translated using the historical rates. Revenues and expenses are translated at average rates prevailing during the year. The gains and losses resulting from translation of financial statements of foreign subsidiary are recorded as a separate component of accumulated other comprehensive income within the statements of changes in shareholder’s equity.\nTranslation of amounts from SGD$ into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\n\n| September 30, 2021 | September 30, 2020 |\n| Period-end SGD$:US$ exchange rate | $ | 0.73534 | $ | 0.73118 |\n| Period average SGD$:US$ exchange rate | $ | 0.74658 | $ | 0.71922 |\n\nTranslation of amounts from VND into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\n\n| September 30, 2021 | September 30, 2020 |\n| Period-end VND$:US$ exchange rate | $ | 0.000044 | $ | 0.000043 |\n| Period average VND$:US$ exchange rate | $ | 0.000043 | $ | 0.000043 |\n\nTranslation of amounts from INR into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\n\n| September 30, 2021 | September 30, 2020 |\n| Period-end INR$:US$ exchange rate | $ | 0.013463 | $ | 0.013570 |\n| Period average INR$:US$ exchange rate | $ | 0.013576 | $ | 0.013490 |\n\n\n| 59 |\n\nTranslation gains and losses that arise from exchange rate fluctuations from transactions denominated in a currency other than the functional currency are translated, as the case may be, at the rate on the date of the transaction and included in the results of operations as incurred.\nForeign Exchange Loss (Gain). We recorded a foreign exchange gain of $8,859 for the three months ended September 30, 2021 as compared to a gain of $51,183 for the same period in 2020. Foreign exchange gains and losses are primarily unrealized (non-cash) in nature and results from the re-measuring of specific transactions and monetary accounts in a currency other than the functional currency. For example, a U.S. Dollar transaction which occurs in Singapore is re-measured at the period-end to Singapore dollar amount if it has not been settled previously. The foreign exchange loss or gain for the three months ended September 30, 2021 was due to an increase in the value of the Singapore Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the Singapore dollar to the U.S. Dollar increased 0.56%. At September 30, 2021, the exchange rate was 0.73534 as compared to 0.73118 at September 30, 2020. In addition, a U.S. Dollar transaction which occurs in India is re-measured at the period-end to India dollar amount if it has not been settled previously. The foreign exchange loss for the three months ended September 30, 2021 was due to an increase in the value of the India Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the India dollar to the U.S. Dollar increased 0.79%. At September 30, 2021, the exchange rate was 0.013463 as compared to 0.013570 at September 30, 2020. A U.S. Dollar transaction which occurs in Vietnam is re-measured at the period-end to Vietnameses dollar amount if it has not been settled previously. The foreign exchange gain for the three months ended September 30, 2021 was due to an increase in the value of the Vietnamese Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the Vietnamese dollar to the U.S. Dollar increased 2.32%. At September 30, 2021, the exchange rate was 0.000044 as compared to 0.000043 at September 30, 2020.\n• Comprehensive income\nASC 220, “Comprehensive Income”, establishes standards for reporting and display of comprehensive income, its components and accumulated balances. Comprehensive income as defined includes all changes in equity during a period from non-owner sources. Accumulated other comprehensive income, as presented in the accompanying consolidated statements of changes in shareholders’ equity, consists of changes in unrealized gains and losses on foreign currency translation. This comprehensive income is not included in the computation of income tax expense or benefit.\n• Leases\nThe Company adopted ASC 842, Leases (“ASC 842”) to determines if an arrangement is a lease at inception. Operating leases are included in operating lease right-of-use (“ROU”) assets and operating lease liabilities in the consolidated balance sheets. Finance leases are included in property and equipment, other current liabilities, and other long-term liabilities in the condensed consolidated balance sheets.\nROU assets represent the right to use an underlying asset for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As most of the Company’s leases do not provide an implicit rate, the Company generally use the incremental borrowing rate based on the estimated rate of interest for collateralized borrowing over a similar term of the lease payments at commencement date. The operating lease ROU asset also includes any lease payments made and excludes lease incentives. The lease terms may include options to extend or terminate the lease when it is reasonably certain that the Company will exercise that option. Lease expense for lease payments is recognized on a straight-line basis over the lease term.\nIn accordance with the guidance in ASC 842, components of a lease should be split into three categories: lease components (e.g. land, building, etc.), non-lease components (e.g. common area maintenance, consumables, etc.), and non-components (e.g. property taxes, insurance, etc.). Subsequently, the fixed and in-substance fixed contract consideration (including any related to non-components) must be allocated based on the respective relative fair values to the lease components and non-lease components.\n• Related parties\nThe Company follows the ASC 850-10, Related Party for the identification of related parties and disclosure of related party transactions.\nPursuant to section 850-10-20 the related parties include a) affiliates of the Company; b) entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of section 825–10–15, to be accounted for by the equity method by the investing entity; c) trusts for the benefit of employees, such as pension and Income-sharing trusts that are managed by or under the trusteeship of management; d) principal owners of the Company; e) management of the Company; f) other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests; and g) other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting ;parties might be prevented from fully pursuing its own separate interests.\n\n| 60 |\n\nThe condnensed consolidated financial statements shall include disclosures of material related party transactions, other than compensation arrangements, expense allowances, and other similar items in the ordinary course of business. However, disclosure of transactions that are eliminated in the preparation of consolidated or combined financial statements is not required in those statements. The disclosures shall include: a) the nature of the relationship(s) involved; b) a description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the financial statements; c) the dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period; and d) amount due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement.\n• Commitments and contingencies\nThe Company follows the ASC 450-20, Commitments to report accounting for contingencies. Certain conditions may exist as of the date the financial statements are issued, which may result in a loss to the Company but which will only be resolved when one or more future events occur or fail to occur. The Company assesses such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or un-asserted claims that may result in such proceedings, the Company evaluates the perceived merits of any legal proceedings or un-asserted claims as well as the perceived merits of the amount of relief sought or expected to be sought therein.\nIf the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s consolidated financial statements. If the assessment indicates that a potentially material loss contingency is not probable but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, and an estimate of the range of possible losses, if determinable and material, would be disclosed.\nLoss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the guarantees would be disclosed. Management does not believe, based upon information available at this time that these matters will have a material adverse effect on the Company’s financial position, results of operations or cash flows. However, there is no assurance that such matters will not materially and adversely affect the Company’s business, financial position, and results of operations or cash flows.\n• Fair value of financial instruments\nThe Company follows paragraph 825-10-50-10 of the FASB Accounting Standards Codification for disclosures about fair value of its financial instruments and has adopted paragraph 820-10-35-37 of the FASB Accounting Standards Codification (“Paragraph 820-10-35-37”) to measure the fair value of its financial instruments. Paragraph 820-10-35-37 of the FASB Accounting Standards Codification establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. To increase consistency and comparability in fair value measurements and related disclosures, paragraph 820-10-35-37 of the FASB Accounting Standards Codification establishes a fair value hierarchy which prioritizes the inputs to valuation techniques used to measure fair value into three (3) broad levels. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The three (3) levels of fair value hierarchy defined by paragraph 820-10-35-37 of the FASB Accounting Standards Codification are described below:\n\n| Level 1 | Quoted market prices available in active markets for identical assets or liabilities as of the reporting date. |\n| Level 2 | Pricing inputs other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable as of the reporting date. |\n| Level 3 | Pricing inputs that are generally observable inputs and not corroborated by market data. |\n\n\n| 61 |\n\nFinancial assets are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable.\nThe fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.\nThe carrying amounts of the Company’s financial assets and liabilities, such as cash and cash equivalents, accounts receivable, deposits, prepayments and other receivables, contract liabilities, accrued liabilities and other payables, amounts due to related parties and operating lease liabilities, approximate their fair values because of the short maturity of these instruments.\n• Cost of goods sold\nCost of goods sold consists of the cost of hardware, software and payroll, which are directly attributable to the sales of products. The cost also consists of costs of materials which has been sold attributable to the sales of high-end products. Additional costs may include freight paid to acquire the goods, custom duties, sales or use taxes not recoverable paid on materials used, and any fee for purchase\n• Share-based compensation\nPursuant to ASU 2018-07, the Company follows ASC 718, Compensation—Stock Compensation (“ASC 718”), which requires the measurement and recognition of compensation expense for all share-based payment awards (employee or non employee), are measured at grant-date fair value of the equity instruments that an entity is obligated to issue. Restricted stock units are valued using the market price of the Company’s common shares on the date of grant. As of September 30, 2021, those shares issued for service compensations were immediately vested, and therefore this amount is thus recognized as expense with an offset to preferred or September 30, 2021 and 2020, the stock-based compensations are recorded in the General and administrative expenses within the Condensed Consolidated Statements of Operations and Other Comprehensive Loss.”\n• Business combinations\nThe Company follows ASC 805, Business Combinations (“ASC 805”) and ASC 810-10-65, Consolidation. ASC 805 requires most identifiable assets, liabilities, non-controlling interests, and goodwill acquired in a business combination to be recorded at “fair value.” The statement applies to all business combinations, including combinations among mutual entities and combinations by contract alone. Under ASC 805, all business combinations are accounted for by applying the acquisition method. Accounting for goodwill requires significant management estimates and judgment. Management performs periodic reviews of the carrying value of goodwill to determine whether events and circumstances indicate that an impairment in value may have occurred. A variety of factors could cause the carrying value of goodwill to become impaired. A write-down of the carrying value of goodwill could result in a non-cash charge, which could have an adverse effect on the Company’s results of operations.\n• Earnings per share\nBasic per share amounts are calculated using the weighted average shares outstanding during the year, excluding unvested restricted stock units. The Company uses the treasury stock method to determine the dilutive effect of stock options and other dilutive instruments. Under the treasury stock method, only “in the money” dilutive instruments impact the diluted calculations in computing diluted earnings per share. Diluted calculations reflect the weighted average incremental common shares that would be issued upon exercise of dilutive options assuming the proceeds would be used to repurchase shares at average market prices for the period.\n\n| 62 |\n\nAs of September 30, 2021 and December 31, 2020, the Company has the number of shares of common stock to be issued upon conversion of below:\n\n| As of September 30, | As of December 31, |\n| 2021 | 2020 |\n| Series A Convertible Preferred Stock (a) | 8,000 | 8,000 |\n| Series B Convertible Preferred Stock | 764,400 | 764,400 |\n| Series B-1 Convertible Preferred Stock | 48,000 | 48,000 |\n| Series C Convertible Preferred Stock | 465,600 | 108,600 |\n| Series C-1 Convertible Preferred Stock | 4,195,200 | 865,500 |\n| Warrants granted | — | — |\n| Warrants granted with Series C-1 Convertible Preferred Stock | 1,178,700 | 614,100 |\n| Total: | 6,659,900 | 2,408,600 |\n\n\n| (a) | The Series A the conversion formula is aggregate Stated Value divided by IPO price (Stated Value for each Series A preferred share is $1,000). There are 8,000 shares of Series A Preferred Stock issued and outstanding (10,000 shares are designated Series A). The conversion formula would be $8 million (the aggregate stated value) divided by IPO price. |\n\n• Segment Reporting\nASC Topic 280, “Segment Reporting” establishes standards for reporting information about operating segments on a basis consistent with the Company’s internal organization structure as well as information about geographical areas, business segments and major customers in condensed consolidated financial statements. For the nine months ended September 30, 2021 and 2020, the Company operates in two reportable operating segment.\nEmerging Growth Company\nWe are an “emerging growth company” under the JOBS Act. For as long as we are an “emerging growth company,” we are not required to: (i) comply with any new or revised financial accounting standards that have different effective dates for public and private companies until those standards would otherwise apply to private companies, (ii) provide an auditor’s attestation report on management’s assessment of the effectiveness of internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act, (iii) comply with any new requirements adopted by the Public Company Accounting Oversight Board (“PCAOB”) requiring mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor would be required to provide additional information about the audit and the financial statements of the issuer or (iv) comply with any new audit rules adopted by the PCAOB after April 5, 2012, unless the SEC determines otherwise. However, we have elected to “opt out” of the extended transition period discussed in (i) and will therefore comply with new or revised accounting standards on the applicable dates on which the adoption of such standards are required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to opt out of such extended transition period for compliance with new or revised accounting standards is irrevocable.\nCritical Accounting Policies and Estimate\n• Recent accounting pronouncements\nFrom time to time, new accounting pronouncements are issued by the Financial Accounting Standard Board (“FASB”) or other standard setting bodies and adopted by the Company as of the specified effective date. Unless otherwise discussed, the Company believes that the impact of recently issued standards that are not yet effective will not have a material impact on its financial position or results of operations upon adoption.\n\n| 63 |\n\nAccounting Standards Adopted\nIn August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (“ASU 2018-13”), which eliminates, adds and modifies certain disclosure requirements for fair value measurements. The amendment is effective for interim and annual reporting periods beginning after December 15, 2019. The Company has evaluated and the adoption of this does not have an any impact on the financial statements.\nIn November 2018, the FASB issued ASU No. 2018-18, Collaborative Arrangements (“ASU 2018-18”), which clarifies the interaction between ASC 808, Collaborative Arrangements and ASC 606, Revenue from Contracts with Customers. Certain transactions between participants in a collaborative arrangement should be accounted for under ASC 606 when the counterparty is a customer. In addition, ASU 2018-18 precludes an entity from presenting consideration from a transaction in a collaborative arrangement as revenue if the counterparty is not a customer for that transaction. ASU 2018-18 should be applied retrospectively to the date of initial application of ASC 606. This guidance is effective for interim and fiscal periods beginning after December 15, 2019. The Company has evaluated and the adoption of this does not have an any impact on the financial statements.\nAccounting Standards Issued, Not Adopted\nIn June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). This ASU requires measurement and recognition of expected credit losses for financial assets. ASU 2016-13 also requires new disclosures for financial assets measured at amortized cost, loans and available-for-sale debt securities. ASU 2016-13 is effective for the Company beginning January 1, 2023. Entities will apply the standard's provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. The Company is currently evaluating the potential effect of this standard on its financial statements. The Company does not expect this standard to have a material impact on its financial statements.\nIn December 2019, the FASB issued ASU No. 2019-12, Income Taxes: Simplifying the Accounting for Income Taxes (“ASU 2019-12”), which eliminates certain exceptions related to the approach for intraperiod tax allocation, the methodology for calculating income taxes in an interim period and the recognition of deferred tax liabilities for outside basis differences. The new guidance also simplifies aspects of the accounting for franchise taxes and enacted changes in tax laws or rates and clarifies the accounting for transactions that result in a step-up in the tax basis of goodwill. The standard is effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2020, with early adoption permitted. Adoption of the standard requires certain changes to be made prospectively, with some changes to be made retrospectively. The Company does not expect the adoption of this standard to have a material impact on its financial position, results of operations or cash flows.\nIn March 2020, the FASB issued ASU 2020-03, “Codification Improvements to Financial Instruments”: The amendments in this update are to clarify, correct errors in, or make minor improvements to a variety of ASC topics. The changes in ASU 2020-03 are not expected to have a significant effect on current accounting practices. The ASU improves various financial instrument topics in the Codification to increase stakeholder awareness of the amendments and to expedite the improvement process by making the Codification easier to understand and easier to apply by eliminating inconsistencies and providing clarifications. The ASU is effective for smaller reporting companies for fiscal years beginning after December 15, 2022 with early application permitted. The Company is currently evaluating the impact the adoption of this guidance may have on its consolidated financial statements.\nIn August 2020, the FASB issued ASU 2020-06 Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40) related to the measurement and disclosure requirements for convertible instruments and contracts in an entity's own equity. The pronouncement simplifies and adds disclosure requirements for the accounting and measurement of convertible instruments and the settlement assessment for contracts in an entity's own equity. This pronouncement is effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2021 and early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. The Company is currently evaluating the impact that this standard will have on its consolidated financial statements.\n\n| 64 |\n\n\nItem 3. Quantitative and Qualitative Disclosures about Market Risk.\nWe did not have investments and do not utilize derivative financial instruments to manage our interest rate risks.\nItem 4. Controls and Procedures.\nEvaluation of Disclosure Controls and Procedures\nWe maintain disclosure controls and procedures that are designed to provide reasonable assurance that the information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934, as amended (the \"Exchange Act\"), is recorded, processed, summarized and reported within the time periods specified in the rules and forms promulgated by the Securities and Exchange Commission, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Because of the inherent limitations to the effectiveness of any system of disclosure controls and procedures, no evaluation of disclosure controls and procedures can provide absolute assurance that all control issues and instances of fraud, if any, with a company have been prevented or detected on a timely basis. Even disclosure controls and procedures determined to be effective can only provide reasonable assurance that their objectives are achieved.\nAs of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) pursuant to Rule 13a-15 of the Exchange Act. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are not effective at the reasonable assurance level.\nOur size has prevented us from being able to employ sufficient resources to enable us to have an adequate level of supervision and segregation of duties. Therefore, it is difficult to effectively segregate accounting duties which comprises a material weakness in internal controls. This lack of segregation of duties leads management to conclude that the Company’s disclosure controls and procedures are not effective to give reasonable assurance that the information required to be disclosed in reports that the Company files under the Exchange Act is recorded, processed, summarized and reported as and when required.\nTo the extent reasonably possible given our limited resources, we intend to take measures to cure the aforementioned weaknesses, including, but not limited to, increasing the capacity of our qualified financial personnel to ensure that accounting policies and procedures are consistent across the organization and that we have adequate control over our Exchange Act reporting disclosures.\nChanges in Internal Control over Financial Reporting\nThere were no changes in the Company’s internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)) during the quarter ended September 30, 2021 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\n| 65 |\n\nPART II\nOTHER INFORMATION\n\nItem 1. Legal Proceedings.\nThe Company is currently litigating three cases pending in the Supreme Court of the State of New York and one case pending in the United States District Court for the District of New Jersey.\nTwo cases are employment actions filed by former employees who seek compensation alleged to be due pursuant to agreements with the Company. Both of the employees are represented by the same counsel and filed their cases in the Supreme Court of the State of New York, County of New York, in December 2019.\nIn one of those actions, a former employee claims entitlement to compensation and a bonus totaling $566,000 and 39,000-58,500 shares of Company common stock, together with costs. The Company responded to the complaint and also asserted counterclaims in the proceeding for $1,500,000 to $4,000,000 plus punitive damages, together with interest and costs, arising from, inter alia, the former employee’s breach of contract, unfair competition, misappropriation of trade secrets and breach of fiduciary duty. The former employee has responded to the Company’s counterclaims and this action is in the discovery phase of the litigation.\nIn the other employment action, another former employee claims entitlement to salary payments and expense reimbursement in the amount of $122,042.60, plus liquidated damages, together with costs. This former employee also claims entitlement to 516,300 to 760,800 shares of the Company’s common stock. In addition, this action also includes claims by a plaintiff-entity alleging entitlement to $8 million in shares of the Company’s Series A Preferred stock. The Company responded to the complaint and also asserted counterclaims against the former employee in the proceeding for $1,500,000 to $2,000,000 plus punitive damages, together with costs, arising from, inter alia, the former employee’s breach of contract, breach of fiduciary duty, tortious interference and fraud. The former employee has responded to the Company’s counterclaims. The judge assigned to this action retired at the end of 2020. A new judge has been assigned and this action is progressing through the discovery phase of litigation.\nThe third case also involves one of those former employees; therein, a Company affiliate filed suit in February 2020 seeking enforcement, by way of specific performance, of an agreement which entitles the affiliate to purchase all of the 99 percent of the shares of the plaintiff-entity which alleges entitlement to $8 million in shares of the Company’s Series A Preferred Stock in one of the employment actions described above. The former employee has responded to the Company’s complaint in this action with a motion to dismiss, which was later withdrawn by same, and then by way of an answer without counterclaims. The judge assigned to this action has announced his retirement and the case has not yet been reassigned.\nThe Company was in an AAA arbitration defending allegations of breach of an agreement. The Demand for Arbitration therein, dated August 25, 2020, asserted that the Petitioner, an LLC, had an agreement with the Company and its CEO granting the Petitioner the right to require the Company to redeem certain common stock in the Company for a cash payment.\nThe Demand alleged that the Petitioner submitted a Redemption Notice, as required under the alleged agreement, obligating the Company to redeem the shares. The Demand alleged that the failure of the Company to redeem the shares and pay Petitioner further obligated the Company to provide additional common stock to the Petitioner. The amount alleged to be due to the Petitioner as of July 31, 2020 was said to be $590,461.94 and growing daily while the number of additional common stock shares alleged to be due to Petitioner as of July 31, 2020 was said to be 708,542,582 and growing, daily.\nIn order to avoid an adverse award, the Company agreed to settle the matter for the sum of $550,000. No additional shares were included in the settlement agreement. The settlement sum was required to be paid in two tranches, with $250,000 to have been paid on or before May 28, 2021 and the remaining $300,000 to be paid on or before June 30, 2021. The Company made the required settlement payments and the matter is now considered closed.\n\n| 66 |\n\nOn or about March 5, 2021, SOSV IV LLC (“SOSV”) sent a demand letter to the Company in regard to its investment in Hottab Pte. Ltd. (“Hottab”).\nIn this letter, and the subsequently filed lawsuits, SOSV alleges that it entered into an investment arrangement with Hottab in which SOSV was to receive five percent (5%) of the common stock of Hottab and entered into an Accelerator Contract for Equity (the “ACE”) pursuant to which it alleges to have invested a sum of $168,000 with Hottab. These events are alleged to have taken place prior to the Company’s acquisition of Hottab. SOSV alleges that the Company subsequently acquired all of the outstanding shares of Hottab, which it alleges triggered a liquidity event clause under the ACE requiring the Company, by way of its ownership of Hottab, to pay SOSV twice its investment, or $336,000.\nSOSV further alleges that subsequent to a term sheet between the Company and Hottab being executed, the Company entered into an agreement to purchase one hundred percent (100%) of the issued and outstanding shares of Hottab from Hottab Holdings Limited (“Hottab Holdings”). As SOSV does not have any interest in Hottab Holdings, it did not receive any consideration as allegedly provided under the ACE.\nUpon these allegations, SOSV asserts causes of action sounding in fraudulent misrepresentation/concealment, breach of contract, breach of the covenant of good faith and fair dealing, quantum meruit and/or unjust enrichment, promissory estoppel, oppression of minority shareholder, and breach of fiduciary duties. SOSV seeks damages in the amount of $336,000.00 in addition damages equal to the value of SOSV’s alleged equity in Hottab or in the alternative shares of the Company in an amount equal to SOSV’s ownership interest in Hottab at the time of the purchase of Hottab’s shares from Hottab Holdings.\nInitially, SOSV filed suit in the District Court for New Jersey on June 10, 2021. SOSV voluntarily dismissed its New Jersey lawsuit and on October 29, 2021, re-filed the action in the Southern District of New York. The New York lawsuit was also voluntarily dismissed by SOSV. However, SOSV may choose to re-file its lawsuit.\nThe Company denies the accusations of SOSV and intends to vigorously defend this matter if the action is re-filed. As the lawsuit has been voluntarily dismissed, there have been no proceedings and we are unable to prognosticate a likelihood of success, or whether SOSV will re-file the action.\nAs of September 30, 2021 and December 31, 2020, the Company had a total of $75,000 and $75,000 outstanding on this account, respectively.\nAs of September 30, 2021, the Company does not expect any losses from these legal proceedings and accordingly has not accrued any provisions for them.\nItem 1A. Risk Factors.\nAs of the date of this Quarterly Report on Form 10-Q, there have been no material changes to the risk factors disclosed in our Prospectus, filed with the SEC on November 10, 2021, pursuant to Rule 424(b)(4) under the Securities Act of 1933, as amended. We may disclose changes to such factors or disclose additional factors from time to time in our future filings with the SEC.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\nNot Applicable\nItem 3. Defaults Upon Senior Securities.\nNot Applicable\nItem 4. Mine Safety Disclosures.\nNot Applicable\nItem 5. Other Information\nNone\n| 67 |\n\n\nItem 6. Exhibits\nEXHIBIT INDEX\n| Exhibit No. | Description |\n| 3.1 | Articles of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.2 | Amended Bylaws of The Registrant (incorporated by reference to Exhibit 3.2 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.3 | Certificate of Designation of Series A Convertible Preferred Stock incorporated by reference to Exhibit 3.3 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.4 | Certificate of Correction of Series A Certificate of Designation filed May 2019 incorporated by reference to Exhibit 3.4 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3. | Certificate of Correction to Series A Certificate of Designation filed December 2020 (incorporated by reference to Exhibit 3.5 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.6 | Certificate of Designation of Series B Convertible Preferred Stock (incorporated by reference to Exhibit 3.6 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.7 | Certificate of Correction of Series B Certificate of Designation (incorporated by reference to Exhibit 3.7 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.8 | Certificate of Designation of Series B-1 Convertible Preferred Stock (incorporated by reference to Exhibit 3.8 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.9 | Certificate of Correction of Series B-1 Certificate of Designation (incorporated by reference to Exhibit 3.9 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 20210. |\n| 3.10 | Certificate of Designation of Series C Convertible Preferred Stock (incorporated by reference to Exhibit 3.10 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.11 | Certificate of Correction of Series C Certificate of Designation (incorporated by reference to Exhibit 3.11 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.12 | Certificate of Designation of Series C-1 Convertible Preferred Stock (incorporated by reference to Exhibit 3.12 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.13 | Certificate of Designation for Series X Super Voting Preferred Stock ((incorporated by reference to Exhibit 3.13 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 20210. |\n| 3.14 | Certificate of Amendment to Articles of Incorporation to change the authorized capital of the Registrant, filed December 4, 2018 (incorporated by reference to Exhibit 3.14 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.15 | Certificate of Amendment to Articles of Incorporation to change the name of Registrant, filed October 2, 2018 (incorporated by reference to Exhibit 3.15 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.16 | Certificate of Amendment to Articles of Incorporation to effect reverse stock split (incorporated by reference to Exhibit 3.16 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.17 | Certificate of Amendment to Series X Super Voting Preferred Certificate of Designation (incorporated by reference to Exhibit 3.17 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 4.1 | Form of Series C-1 Warrant (incorporated by reference to Exhibit 4.1 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 4.2 | Form of Underwriter Warrant (incorporated by reference to Exhibit 4.2 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.1 | Software Set Up, Development and Use License Agreement dated November 15, 2018 between Society Pass Incorporated and Wallet Factory International Limited (incorporated by reference to Exhibit 10.1 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.2 | Stock Purchase Agreement dated January 10 2019 between HOTTAB PTE. LTD., SOSV IV LLC, General Mobile Corporation and Sanjeev Sapkota (incorporated by reference to Exhibit 10.2 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.3 | Accelerator Contract for Equity dated January 10, 2019 by and between HOTTAB PTE. LTD., SOV IV LLC and Sanjeev Sapkota (incorporated by reference to Exhibit 10.3 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.4 | Employment Agreement dated as of April 1, 2017 between Society Pass Incorporated and Dennis Luan Thuc Nguyen (incorporated by reference to Exhibit 10.4 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.5 | Employment Agreement dated as of September 1, 2020 between Society Pass Incorporated and Liang Wee Leong Raynauld (incorporated by reference to Exhibit 10.5 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.6 | Asset Purchase Agreement dated February 16, 2021 between Goodventures Sea Limited and Sopa Technology PTE. LTD. (incorporated by reference to Exhibit 10.6 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.7 | Shareholders Agreement dated February 16, 2021 between Goodventures Sea Limited and Sopa Technology PTE. LTD (incorporated by reference to Exhibit 10.7 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.8 | Food Delivery Partnership Agreement dated as of April 22, 2021 between Hottab Asset Vietnam Co. Ltd and Dream Space Trading Co. Ltd (incorporated by reference to Exhibit 10.8 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.9 | Food Delivery Partnership Agreement dated as of July 29, 2020 between Hottab Asset Vietnam Co. Ltd and Lala Move Vietnam Co. Ltd (incorporated by reference to Exhibit 10.9 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.10 | Payment Gateway Agreement dated February 25, 2020 between Hottab Asset Vietnam Co. Ltd and VTC Technology and Digital Content Company (incorporated by reference to Exhibit 10.10 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.11 | Payment Gateway Agreement dated April 20, 2020 between Hottab Asset Vietnam Co. Ltd and Media Corporation (Vietnam Post Telecommunication Media) (incorporated by reference to Exhibit 10.11 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.12 | Payment Gateway Agreement dated August 31, 2020 between Hottab Asset Vietnam Co. Ltd and Zion Joint Stock Company (incorporated by reference to Exhibit 10.12 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.13 | Payment Gateway Agreement dated August 31, 2020 between Hottab Asset Vietnam Co. Ltd and Online Mobile Service Joint Stock Co (incorporated by reference to Exhibit 10.13 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.14 | Vendor Finance Partnership Agreement, dated as of October 22, 2019 between Hottab Asset Vietnam Co. Ltd and SHBank Finance Co. Ltd (incorporated by reference to Exhibit 10.14 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.15 | Business Cooperation Agreement dated March 6, 2020 between Hottab Asset Vietnam Co. and Triip Pte. Ltd ((incorporated by reference to Exhibit 10.15 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.16 | The Registrant’s 2021 Equity Incentive Plan (incorporated by reference to Exhibit 10.16 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.17 | Business Cooperation Contract dated May 28, 2021 between Paytech, JSC and the Registrant (incorporated by reference to Exhibit 10.17 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.18 | Business Cooperation Agreement dated August 15, 2021 between Hottab Vietnam Company Limited and Rainbow Loyalty Company Limited (incorporated by reference to Exhibit 10.18 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.19 | Amendment to Employment Agreement dated October 25, 2021 between Dennis Nguyen and the Registrant (incorporated by reference to Exhibit 10.19 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 31.1 | Certification of principal executive officer pursuant to Rule 13a-14(A) promulgated under the Securities Exchange Act of 1934 |\n| 31.2 | Certification of principal financial officer pursuant to Rule 13a-14(A) promulgated under the Securities Exchange Act of 1934 |\n| 32.1* | Certification of principal executive officer and principal financial officer pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(B) promulgated under the Securities Exchange Act of 1934 |\n\n* The certifications furnished in Exhibit 32.1 hereto are deemed to accompany this Form 10-Q and are not deemed “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to the liability of that section, nor shall they be deemed incorporated by reference into any filing under the Securities Act or the Exchange Act.\n| 68 |\n\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n| SOCIETY PASS INCORPORATED |\n| (Registrant) |\n| Date: December 9, 2021 | By: | /s/ Dennis Nguyen |\n| Dennis Nuguyen |\n| Chief Executive Officer |\n| Date: December 9, 2021 | By: | /s/ Ranauld Liang |\n| Raynauld Liang |\n| Chief Financial Officer |\n\n\n| 69 |\n\n\n \n\nWhat would be the total number of common stock to be issued in 2021 if the IPO price is $10 per share, if the conversion for Series A preferred stocks is its aggregate Stated Value divided by IPO price?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nItem 1. Financial statements\\nSOCIETY PASS INCORPORATED\\nCONDENSED CONSOLIDATED BALANCE SHEETS\\nAS OF SEPTEMBER 30, 2021 AND DECEMBER 31, 2020\\n(Currency expressed in United States Dollars (“US$”))\\n\\n| September 30, 2021 | December 31, 2020 |\\n| (Unaudited) |\\n| ASSETS |\\n| Current assets: |\\n| Cash and cash equivalents | $ | 5,722,450 | $ | 506,666 |\\n| Due from related parties | 97,500 | — |\\n| Accounts receivable, net | 87,803 | 1,897 |\\n| Deposits, prepayments and other receivables | 69,623 | 60,532 |\\n| Total current assets | 5,977,376 | 569,095 |\\n| Non-current assets: |\\n| Intangible assets, net | 4,800,000 | 7,200,000 |\\n| Property, plant and equipment, net | 11,080 | 18,069 |\\n| Right of use assets, net | 529,782 | 79,109 |\\n| Total non-current assets | 5,340,862 | 7,297,178 |\\n| TOTAL ASSETS | $ | 11,318,238 | $ | 7,866,273 |\\n| LIABILITIES AND SHAREHOLDERS’ DEFICIT |\\n| Current liabilities: |\\n| Accounts payables | $ | 104,680 | $ | 54,256 |\\n| Contract liabilities | 35,582 | 18,646 |\\n| Accrued liabilities and other payables | 752,640 | 677,572 |\\n| Contingent service payable | — | 633,000 |\\n| Due to related parties | 24,763 | 1,571,737 |\\n| Operating lease liabilities | 167,773 | 36,752 |\\n| Total current liabilities | 1,085,438 | 2,991,963 |\\n| Non-current liabilities |\\n| Operating lease liabilities | 365,539 | 46,453 |\\n| TOTAL LIABILITIES | 1,450,977 | 3,038,416 |\\n| COMMITMENTS AND CONTINGENCIES |\\n| Convertible preferred shares; $ 0.0001 par value, 5,000,000 shares authorized, 4,916,500 and 4,920,000 shares undesignated as of September 30, 2021 and December 31, 2020, respectively |\\n| Series A shares: 10,000 shares designated; 8,000 and 8,000 Series A shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | 8,000,000 | 8,000,000 |\\n| Series B shares: 10,000 shares designated; 2,548 and 2,548 Series B shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | 3,412,503 | 3,412,503 |\\n| Series B-1 shares: 15,000 shares designated; 160 and 160 Series B-1 shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | 466,720 | 466,720 |\\n| Series C shares: 15,000 shares designated; 1,552 and 362 Series C shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively, net of issuance cost | 8,353,373 | 2,151,706 |\\n| Series C-1 shares: 30,000 shares designated; 13,984 and 2,885 Series C-1 shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively, net of issuance cost and stock subscription receivable | 5,057,192 | 1,211,700 |\\n| SHAREHOLDERS’ DEFICIT |\\n| Series X Super Voting Preferred Stock, $ 0.0001 par value, 3,500 shares designated; 3,500 and 0 Series X shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | — | — |\\n| Common shares; $ 0.0001 par value, 95,000,000 shares authorized; 9,695,480 and 7,413,600 shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | 970 | 742 |\\n| Additional paid-in capital | 12,712,290 | 2,227,033 |\\n| Accumulated other comprehensive loss | ( 19,478 | ) | ( 55,236 | ) |\\n| Accumulated deficit | ( 28,116,309 | ) | ( 12,587,311 | ) |\\n| Total shareholders’ deficit | ( 15,422,527 | ) | ( 10,414,772 | ) |\\n| TOTAL LIABILITIES AND SHAREHOLDERS’ DEFICIT | $ | 11,318,238 | $ | 7,866,273 |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n\\n| 3 |\\n\\nSOCIETY PASS INCORPORATED\\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND\\nOTHER COMPREHENSIVE LOSS\\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2021 AND 2020\\n(Currency expressed in United States Dollars (“US$”))\\n(Unaudited)\\n\\n| Three months ended | Nine months ended |\\n| September 30, | September 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Revenue, net |\\n| Hardware sales | $ | — | $ | 585 | $ | 335 | $ | 3,510 |\\n| Software subscription | 10,016 | 11,044 | 26,970 | 37,752 |\\n| Sales – online ordering | 73,518 | — | 73,518 | — |\\n| Total revenue | 83,534 | 11,629 | 100,823 | 41,262 |\\n| Cost of sales: |\\n| Hardware sales | — | ( 585 | ) | ( 165 | ) | ( 2,982 | ) |\\n| Software subscription | ( 101,695 | ) | ( 19,731 | ) | ( 206,387 | ) | ( 56,127 | ) |\\n| Cost of online ordering | ( 57,741 | ) | — | ( 57,741 | ) | — |\\n| Total cost of revenue | ( 159,436 | ) | ( 20,316 | ) | ( 264,293 | ) | ( 59,109 | ) |\\n| Gross loss | ( 75,902 | ) | ( 8,687 | ) | ( 163,470 | ) | ( 17,847 | ) |\\n| Operating expenses: |\\n| Sales and marketing expenses | ( 42,843 | ) | — | ( 85,027 | ) | ( 3,125 | ) |\\n| Software development costs | ( 9,709 | ) | ( 33,658 | ) | ( 76,698 | ) | ( 139,151 | ) |\\n| Impairment loss | — | 4,164 | ( 200,000 | ) | ( 8,778 | ) |\\n| General and administrative expenses | ( 8,292,463 | ) | ( 1,580,287 | ) | ( 14,414,362 | ) | ( 2,311,266 | ) |\\n| Total operating expenses | ( 8,345,015 | ) | ( 1,609,781 | ) | ( 14,776,087 | ) | ( 2,462,320 | ) |\\n| Loss from operations | ( 8,420,917 | ) | ( 1,618,468 | ) | ( 14,939,557 | ) | ( 2,480,167 | ) |\\n| Other income (expense): |\\n| Interest income | 55 | 3 | 71 | 11 |\\n| Interest expense | ( 12,272 | ) | ( 12,261 | ) | ( 36,486 | ) | ( 36,381 | ) |\\n| Loss on settlement of litigation | — | — | ( 550,000 | ) | — |\\n| Other income | 5,170 | 3,737 | 6,917 | 9,495 |\\n| Total other expense | ( 7,047 | ) | ( 8,521 | ) | ( 579,498 | ) | ( 26,875 | ) |\\n| Loss before income taxes | ( 8,427,964 | ) | ( 1,626,989 | ) | ( 15,519,055 | ) | ( 2,507,042 | ) |\\n| Income taxes | ( 1,303 | ) | ( 4 | ) | ( 9,943 | ) | ( 15,069 | ) |\\n| NET LOSS | $ | ( 8,429,267 | ) | $ | ( 1,626,993 | ) | $ | ( 15,528,998 | ) | $ | ( 2,522,111 | ) |\\n| Other comprehensive loss: |\\n| Foreign currency translation income | 8,859 | 51,183 | 35,758 | 15,249 |\\n| COMPREHENSIVE LOSS | $ | ( 8,420,408 | ) | $ | ( 1,575,810 | ) | $ | ( 15,493,240 | ) | $ | ( 2,506,862 | ) |\\n| Net loss per share – Basic and Diluted | $ | ( 1 | ) | $ | ( 0 | ) | $ | ( 2 | ) | $ | ( 0 | ) |\\n| Weighted average common shares outstanding – Basic and Diluted | 7,823,818 | 6,848,700 | 7,551,842 | 6,847,945 |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n\\n| 4 |\\n\\nSOCIETY PASS INCORPORATED\\nCONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ DEFICIT\\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2021 AND 2020\\n(Currency expressed in United States Dollars (“US$”))\\n(Unaudited)\\n\\n| Three months ended September 30, 2021 |\\n| Common stock | Additional paid-in capital | Accumulated other comprehensive (loss) income | Accumulated deficit | Total shareholders’ deficit |\\n| Shares | Amount |\\n| Balance as of July 1, 2021 | 7,413,600 | $ | 742 | $ | 5,145,228 | $ | ( 28,337 | ) | $ | ( 19,687,042 | ) | $ | ( 14,569,409 | ) |\\n| Imputed Interest | — | — | 12,260 | — | — | 12,260 |\\n| Shares issued for services | 1,274,250 | 127 | 5,149,929 | — | — | 5,150,056 |\\n| Shares issued for accrued salaries | 1,157,630 | 116 | 960,718 | — | — | 960,834 |\\n| Share cancellation | ( 150,000 | ) | ( 15 | ) | 15 | — | — | — |\\n| Waiver of related parties debts | — | — | 1,444,140 | — | — | 1,444,140 |\\n| Net loss for the period | — | — | — | — | ( 8,429,267 | ) | ( 8,429,267 | ) |\\n| Foreign currency translation adjustment | — | — | — | 8,859 | — | 8,859 |\\n| Balance as of September 30, 2021 | 9,695,480 | $ | 970 | $ | 12,712,290 | $ | ( 19,478 | ) | $ | ( 28,116,309 | ) | $ | ( 15,422,527 | ) |\\n\\n\\n| Three months ended September 30, 2020 |\\n| Common stock | Additional paid-in capital | Accumulated other comprehensive (loss) income | Accumulated deficit | Total shareholder’ deficit |\\n| Shares | Amount |\\n| Balance as of July 1, 2020 | 6,847,200 | $ | 685 | $ | 1,729,064 | $ | ( 31,946 | ) | $ | ( 9,654,441 | ) | $ | ( 7,956,638 | ) |\\n| Issuance of common stock for services | 1,016,400 | — | 848,505 | — | — | 848,505 |\\n| Imputed interest | — | — | 12,261 | — | — | 12,261 |\\n| Net loss for the period | — | — | — | — | ( 1,626,993 | ) | ( 1,626,993 | ) |\\n| Foreign currency translation adjustment | — | — | — | 51,183 | — | 51,183 |\\n| Balance as of September 30, 2020 | 7,863,600 | $ | 685 | $ | 2,589,830 | $ | 19,237 | $ | ( 11,281,434 | ) | $ | ( 8,671,682 | ) |\\n\\n\\n| 5 |\\n\\n\\n| Nine months ended September 30, 2021 |\\n| Common stock | Additional paid-in capital | Accumulated other comprehensive (loss) income | Accumulated deficit | Total shareholder’ deficit |\\n| Shares | Amount |\\n| Balance as of January 1, 2021 | 7,413,600 | $ | 742 | $ | 2,227,033 | $ | ( 55,236 | ) | $ | ( 12,587,311 | ) | $ | ( 10,414,772 | ) |\\n| Imputed Interest | — | — | 36,380 | — | — | 36,380 |\\n| Shares issued for services | 1,274,250 | 127 | 5,149,929 | — | — | 5,150,056 |\\n| Shares issued for accrued salaries | 1,157,630 | 116 | 960,718 | — | — | 960,834 |\\n| Loss on fair value of shares issued for accrued salaries | — | — | 2,894,075 | — | — | 2,894,075 |\\n| Share cancellation | ( 150,000 | ) | ( 15 | ) | 15 | — | — | — |\\n| Waiver of related parties debts | — | — | 1,444,140 | — | — | 1,444,140 |\\n| Net loss for the period | — | — | — | — | ( 15,528,998 | ) | ( 15,528,998 | ) |\\n| Foreign currency translation adjustment | — | — | — | 35,758 | — | 35,758 |\\n| Balance as of September 30, 2021 | 9,695,480 | $ | 970 | $ | 12,712,290 | $ | ( 19,478 | ) | $ | ( 28,116,309 | ) | $ | ( 15,422,527 | ) |\\n\\n\\n| Nine months ended September 30, 2020 |\\n| Common stock | Additional paid-in capital | Accumulated other comprehensive (loss) income | Accumulated deficit | Total shareholders’ deficit |\\n| Shares | Amount |\\n| Balance as of January 1, 2020 | 6,847,200 | $ | 685 | $ | 1,704,944 | $ | 3,988 | $ | ( 8,759,323 | ) | $ | ( 7,049,706 | ) |\\n| Issuance of common stock for services | 1,016,400 | — | 848,505 | — | — | 848,505 |\\n| Imputed interest | — | — | 36,381 | — | — | 36,381 |\\n| Net loss for the period | — | — | — | — | ( 2,522,111 | ) | ( 2,522,111 | ) |\\n| Foreign currency translation adjustment | — | — | — | 15,249 | — | 15,249 |\\n| Balance as of September 30, 2020 | 7,863,600 | $ | 685 | $ | 2,589,830 | $ | 19,237 | $ | ( 11,281,434 | ) | $ | ( 8,671,682 | ) |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n\\n| 6 |\\n\\nSOCIETY PASS INCORPORATED\\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\\nFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2021 AND 2020\\n(Currency expressed in United States Dollars (“US$”))\\n(Unaudited)\\n\\n| Nine months ended September 30, |\\n| 2021 | 2020 |\\n| Cash flows from operating activities: |\\n| Net loss | $ | ( 15,528,998 | ) | $ | ( 2,522,111 | ) |\\n| Adjustments to reconcile net loss to net cash used in operating activities |\\n| Depreciation and amortization | 2,406,648 | 4,447 |\\n| Impairment loss | 200,000 | 8,778 |\\n| Imputed interest | 36,380 | 36,381 |\\n| Loss on settlement of litigation | 550,000 | — |\\n| Stock based compensation for services | 10,071,830 | 1,641,877 |\\n| Change in operating assets and liabilities: |\\n| Accounts receivable | ( 85,906 | ) | ( 19,900 | ) |\\n| Inventories | — | ( 7,212 | ) |\\n| Deposits, prepayments and other receivables | ( 9,091 | ) | ( 7,005 | ) |\\n| Contract liabilities | 16,936 | 8,275 |\\n| Accounts payables | 50,424 | 61 |\\n| Accrued liabilities and other payables | ( 474,932 | ) | ( 37,960 | ) |\\n| Advances to related parties | 127,500 | ( 76,278 | ) |\\n| Right of use assets | 28,498 | — |\\n| Operating lease liabilities | ( 29,064 | ) | — |\\n| Net cash used in operating activities | ( 2,639,775 | ) | ( 970,647 | ) |\\n| Cash flows from investing activities: |\\n| Purchase of investment assets | ( 200,000 | ) | — |\\n| Net cash used in investing activities | ( 200,000 | ) | — |\\n| Cash flows from financing activities: |\\n| Proceed from the issuance of Series C preferred stock and exercise of warrants | 8,019,461 | 708,960 |\\n| Net cash provided by financing activities | 8,019,461 | 708,960 |\\n| Effect on exchange rate change on cash and cash equivalents | 36,098 | 16,689 |\\n| NET CHANGE IN CASH AND CASH EQUIVALENTS | 5,215,784 | ( 244,998 | ) |\\n| CASH AND CASH EQUIVALENT AT BEGINNING OF PERIOD | 506,666 | 606,491 |\\n| CASH AND CASH EQUIVALENT AT END OF PERIOD | $ | 5,722,450 | $ | 361,493 |\\n| Supplemental disclosure of cash flow information: |\\n| Cash paid for interest | $ | 106 | $ | — |\\n| Cash paid for income tax | $ | — | $ | — |\\n| NON-CASH INVESTING AND FINANCING ACTIVITIES |\\n| Impact of adoption of ASC 842 - lease obligation and ROU asset | $ | 479,171 | $ | — |\\n| Waiver of related party debt accounted as capital transaction | $ | 1,444,140 | $ | — |\\n| Fair value of preferred stock issued for services | $ | 2,948,982 | $ | 793,372 |\\n| Fair value of preferred stock accounted and included for issuance cost | $ | 441,642 | $ | — |\\n| Common stock issued for accrued salaries | $ | 960,835 | $ | — |\\n| Shares cancellation | $ | 15 | $ | — |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n\\n| 7 |\\n\\nNOTE－1 DESCRIPTION OF BUSINESS AND ORGANIZATION\\nSociety Pass Incorporated (the “Company”) is incorporated in State of Nevada on June 22, 2018 under the name of Food Society Inc. On October 3, 2018, the Company changed its corporate name to Society Pass Incorporated. The Company through its subsidiaries, mainly sells and distributes the hardware and software of Point of Sales (POS) application in Vietnam.\\nDescription of subsidiaries incorporated by the Company\\n\\n| Schedule of Description of subsidiaries |\\n| Name | Place and date of incorporation | Principal activities | Particulars of registered/ paid up share Capital | Effective interest held |\\n| Society Technology LLC | State of Nevada , January 24, 2019 | IP Licensing | US$1 | 100 % |\\n| SOPA Cognitive Analytics Private Limited | India , February 5, 2019 | Computer sciences consultancy and data analytics | INR1,238,470 | 100 % |\\n| SOPA Technology Pte. Ltd . | Singapore , June 4, 2019 | Investment holding | SG$1,250,000 | 100 % |\\n| SOPA Technology Company Limited | Vietnam , October 1, 2019 | Software production | Registered: VND 2,307,300,000; Paid up: VND 1,034,029,911 | 100 % |\\n| Hottab Pte Ltd. (HPL) | Singapore , January 17, 2015 | Software development and marketing for the F&B industry | SG$620,287.75 | 100 % |\\n| Hottab Vietnam Co. Ltd | Vietnam , April 17, 2015 | Sale of POS hardware and software | VND 1,000,000,000 | 100 % |\\n| Hottab Asset Company Limited | Vietnam , July 25, 2019 | Sale of POS hardware and software | VND 5,000,000,000 | 100 % |\\n\\nThe Company and its subsidiaries are hereinafter referred to as (the “Company”).\\nOn October 29, 2019 with the revised provision dated November 11, 2019, the Company acquired Hottab Pte Ltd and its subsidiaries, at the consideration of $ 1,050,000 consisted of Series C preference shares valued at $ 900,000 and the cash consideration of $ 150,000 . The value of the $900,000 Series C preference shares issued was determined based on the stated value per share of the Company’s shares at the acquisition date. Also, the Company shall pay to the Company additional Series C preference shares with an aggregate value of $ 558,000 (the “Equity Incentive”) in the event the Company able to fulfilled the other terms per their arrangement with in five months from the completion date.\\nOn February 10, 2021, the Company effected a 750 for 1 stock split of the issued and outstanding shares of the Company’s common stock. The number of authorized shares and par value remain unchanged. All share and per share information in this financial statements and footnotes have been retroactively adjusted for the period and years presented, unless otherwise indicated, to give effect to the forward stock split.\\nOn September 21, 2021, the Company effected a 1 for 2.5 stock split of the issued and outstanding shares of the Company’s common stock. The number of authorized shares and par value remain unchanged. All share and per share information in this financial statements and footnotes have been retroactively adjusted for the period and years presented, unless otherwise indicated, to give effect to the reverse stock split.\\nAn additional result of the stock split was that the stated value of preferred stock, the number of designated shares and outstanding shares of each series of preferred stock was unchanged in accordance to the respective certificate of designations. The number of authorized shares of preferred stock remained unchanged.\\n\\n| 8 |\\n\\nSpun Out\\nOn December 31, 2019, the Company recently spun out Food Society Group Limited (Food Business), which aims to develop and commercialize chain of restaurants in Vietnam.\\nIn connection with the presentation of the Company’s consolidated financial statements, the Company considered the guidance described in the SEC’s codified Staff Accounting Bulletins, Topic 5, Section Z, paragraph 7, “Accounting for the Spin-off of a subsidiary”.\\nThe Company’s initial registration of its securities under the 1933 Securities Act and the spin off transaction of the Food Society Group Limited occurred prior to the effectiveness of the Company’s registration statement.\\nThe Company considered the following facts and circumstances in concluding omitting the Food Society Group Limited results of operations and financial position in the consolidated financial statements presented in the registration statement:\\n• The Company’s operations as a developer of an e-commerce platform and the Food Society Group Limited operations as a two(2) retail restaurants are in dissimilar business that would ordinarily be distinguished as reportable segments as defined by FASB ASC 280-10-50-10.\\n• The Company and the subsidiary have been managed and financed historically as if autonomous\\n• The Company and the subsidiary have no common facilities or costs\\n• The Company and the subsidiary are operated and financed autonomously after the spinoff, and\\n• There are no material financial commitments , guarantees or contingent liabilities to each other after the spin off\\nAccordingly, the Company has elected to characterize the spin-off of the Food Society Group Limited as a change in the Company’s reporting and present its historical financial statements as if the Company never had an investment in the subsidiary.\\nThis spun off our subsidiary Food Society Group Limited which owns 100% of Vietnam Eats (Hong Kong) Limited which owns 100% of Loft Restaurant Service Trading Company Limited that operates 2 restaurants in Vietnam.\\nThomas O’Connor, our former Chief Marketing Officer, serves as the legal representative of Loft Restaurant Service Trading Company Limited. Our Chief Executive Officer and Chairman of our board of directors, Dennis Nguyen., is the Chairman of Food Society Group Limited’s board of directors.\\nThe two restaurants were making losses for the financial year of 2019. The Company wanted to focus on building our loyalty technology platform. On December 20, 2019’s Board of Directors meeting the CFO presented the case for the spun off. The board voted on the February 18, 2020 to spin out the Food Society Group Limited via a proportionate distribution of shareholding percentage to the existing shareholders as at December 31, 2019.\\nNOTE－2 LIQUIDITY AND CAPITAL RESOURCES\\nThe accompanying unaudited condensed consolidated financial statements have been prepared using the going concern basis of accounting, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.\\nThe Company suffered from an accumulated deficit of 28,116,309 at September 30, 2021. The Company incurred continuous net loss of $ 15,528,998 during the nine months ended September 30, 2021. The continuation of the Company as a going concern is dependent upon the continued financial support from its shareholders. Management believes the Company is currently pursuing additional financing for its operations. However, there is no assurance that the Company will be successful in securing sufficient funds to sustain the operations.\\n\\n| 9 |\\n\\nThe registration statement for the Company’s Initial Public Offering became effective on November 8, 2021. On November 8, 2021, the Company entered into an underwriting agreement with Maxim Group LLC, related to the offering of 2,888,889 shares of the Company’s common stock (the “Firm Share”), at a public offering price of $ 9.00 per share. Under the terms of the Underwriting Agreement, the Company has granted the Underwriters an option, exercisable for 45 days, to purchase an additional 236,111 shares of common stock (the “Option Shares”) to cover over-allotments. The Company has raised funding from Initial Public Offering and Option shares of $ 26,000,001 and 2,124,999 . In addition, the Company has raised $ 8,019,461 , net of issuance cost in the form of equity subsequent to issuance of the audit report on the Company’s December 31, 2020 financial statements respectively in the form of equity subsequent to issuance of the audit report on the Company’s December 31, 2020 financial statements and based upon the capital raised, the Company believes it has sufficient liquidity to meet its working capital requirements for the next 12 months. As a result the Company has mitigated any doubts about its ability to continue as a going concern\\nThe recent outbreak of COVID-19, which has been declared by the World Health Organization to be a pandemic, has spread across the globe and is impacting worldwide economic activity.. The COVID-19 pandemic has significantly impacted health and economic conditions throughout Vietnam, Singapore and Southeast Asia. National, regional and local governments took a variety of actions to contain the spread of COVID-19, including office and store closures, quarantining suspected COVID-19 patients, and capacity limitations. These developments have significantly impacted the results of operations, financial condition and cash flows of the Company included in this reporting. The impact included the difficulties of working remotely from home including slow Internet connection, the inability of our accounting and financial officers to collaborate as effectively as they would otherwise have in an office environment and issues arising from mandatory state quarantines.\\nWhile it is not possible at this time to estimate with sufficient certainty the impact that COVID-19 could have on the Company’s business, the continued spread of COVID-19 and the measures taken by federal, state, local and foreign governments could disrupt the operation of the Company’s business. The COVID-19 outbreak and mitigation measures have also had and may continue to have an adverse impact on global and domestic economic conditions, which could have an adverse effect on the Company’s business and financial condition, including on its potential to conduct financings on terms acceptable to the Company, if at all. In addition, the Company has taken temporary precautionary measures intended to help minimize the risk of the virus to its employees, including temporarily requiring employees to work remotely, and discouraging employee attendance at in-person work-related meetings, which could negatively affect the Company’s business. These measures are continuing. The extent to which the COVID-19 outbreak impacts the Company’s results will depend on future developments that are highly uncertain and cannot be predicted, including new information that may emerge concerning the severity of the virus and the actions to contain its impact.\\nNOTE－3 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\\nThe accompanying unaudited condensed consolidated financial statements reflect the application of certain significant accounting policies as described in this note and elsewhere in the accompanying condensed consolidated financial statements and notes.\\n• Basis of presentation\\nThe accompanying unaudited interim consolidated condensed financial statements of Society Pass Incorporated have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with Article 8-03 of Regulation S-X. Accordingly, they do not include all the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments, consisting only of normal recurring accruals necessary for a fair statement of financial position, results of operations and cash flows, have been included. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the financial statements and the accompanying notes included in the Company’s registration statement on Form S-1 for the year ended December 31, 2020. The year-end balance sheet data presented for comparative purposes was derived from audited financial statements, but does not include all disclosures required by GAAP. The results of operations for the three and nine months ended September 30, 2021 are not necessarily indicative of the operating results for the year ending December 31, 2021 or for any other subsequent interim period.\\n\\n| 10 |\\n\\n• Use of estimates and assumptions\\nIn preparing these condensed consolidated financial statements, management makes estimates and assumptions that affect the reported amounts of assets and liabilities in the balance sheet and revenues and expenses during the years reported. Actual results may differ from these estimates. If actual results significantly differ from the Company’s estimates, the Company’s financial condition and results of operations could be materially impacted. Significant estimates in the period include the allowance for doubtful accounts on accounts and other receivables, assumptions used in assessing right of use assets, imputed interest on due to related parties, and impairment of long-term assets, business acquisition allocation of purchase consideration, and deferred tax valuation allowance.\\n• Basis of consolidation\\nThe condensed consolidated financial statements include the financial statements of the Company and its subsidiaries. All significant inter-company balances and transactions within the Company have been eliminated upon consolidation. In addition, certain amounts in the prior periods’ consolidated financial statements have been reclassified to conform to the current period presentation.\\n• Cash and cash equivalents\\nCash and cash equivalents are carried at cost and represent cash on hand, demand deposits placed with banks or other financial institutions and all highly liquid investments with an original maturity of three months or less as of the purchase date of such investments. As of September 30, 2021 and December 31, 2020, the cash and cash equivalent was amounted to $ 5,722,450 and $ 506,666 , respectively.\\nThe Company currently has bank deposits with financial institutions in the U.S. which does not exceed FDIC insurance limits. FDIC insurance provides protection for bank deposits up to $ 250,000 , so there were uninsured balance of $ 4,895,306 and $ 208,635 in parent entity as of September 30, 2021 and December 31, 2020, respectively. In addition, the Company has uninsured bank deposits with a financial institution outside the U.S. All uninsured bank deposits are held at high quality credit institutions.\\n• Accounts receivable\\nAccounts receivable are recorded at the invoiced amount and do not bear interest, which are due within contractual payment terms, generally 30 to 90 days from completion of service. Credit is extended based on evaluation of a customer's financial condition, the customer credit-worthiness and their payment history. Accounts receivable outstanding longer than the contractual payment terms are considered past due. Past due balances over 90 days and over a specified amount are reviewed individually for collectibility. At the end of fiscal year, the Company specifically evaluates individual customer’s financial condition, credit history, and the current economic conditions to monitor the progress of the collection of accounts receivables. The Company considers the allowance for doubtful accounts for any estimated losses resulting from the inability of its customers to make required payments. For the receivables that are past due or not being paid according to payment terms, the appropriate actions are taken to exhaust all means of collection, including seeking legal resolution in a court of law. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. The Company does not have any off-balance-sheet credit exposure related to its customers. As of September 30, 2021 and December 31, 2020, the allowance for doubtful accounts amounted to $ 0 and $ 0 , respectively.\\n• Inventories\\nInventories are stated at the lower of cost or net realizable value, cost being determined on a first-in-first-out method. Costs include hardware equipment and peripheral costs which are purchased from the Company’s suppliers as merchandized goods. The Company provides inventory allowances based on excess and obsolete inventories determined principally by customer demand. During the nine months ended September 30, 2021 and 2020, the Company recorded an allowance for obsolete inventories of $ 0 and $ 0 , respectively. During the three months ended September 30, 2021 and 2020, the Company recorded an allowance for obsolete inventories of $ 0 and $ 0 , respectively. The inventories were amounted to $ 0 and $ 0 at September 30, 2021 and December 31, 2020, respectively.\\n\\n| 11 |\\n\\n• Property, plant and equipment\\nPlant and equipment are stated at cost less accumulated depreciation and accumulated impairment losses, if any. Depreciation is calculated on the straight-line basis over the following expected useful lives from the date on which they become fully operational and after taking into account their estimated residual values:\\n\\n| Schedule of Expected useful life |\\n| Expected useful lives |\\n| Computer equipment | 3 years |\\n| Office equipment | 5 years |\\n\\nExpenditures for repairs and maintenance are expensed as incurred. When assets have been retired or sold, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is recognized in the results of operations.\\n• Impairment of long-lived assets\\nIn accordance with the provisions of ASC Topic 360, “Impairment or Disposal of Long-Lived Assets”, all long-lived assets such as plant and equipment and intangible assets held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is evaluated by a comparison of the carrying amount of an asset to its estimated future undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amounts of the assets exceed the fair value of the assets. There has been no impairment charge for the periods presented.\\n• Revenue recognition\\nThe Company adopted Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”). Under ASU 2014-09, the Company applies the following five steps in order to determine the appropriate amount of revenue to be recognized as it fulfills its obligations under each of its agreements:\\n\\n| • | identify the contract with a customer; |\\n| • | identify the performance obligations in the contract; |\\n| • | determine the transaction price; |\\n| • | allocate the transaction price to performance obligations in the contract; and |\\n| • | recognize revenue as the performance obligation is satisfied. |\\n\\nThe revenues are generated from a diversified a mix of marketplace activities and the services of the Company provide merchants to help them grow their businesses. The revenue streams consist of Consumer Facing revenues and Merchant Facing revenues.\\nConsumer Facing Business\\nThe Company’s performance obligation includes providing connectivity between merchant and consumer, generally through an online ordering platform. The platform allows merchants to create account, place menu and track their sale reports on the merchant facing application. The platform also allows the consumers to create account and make orders from merchants on the consumer facing application. The platform allows delivering company to accept online delivery request and ship order from merchant to consumer.\\nThe Company also has online lifestyle platform allow customers to purchase high-end brands of all catergories: Under the Company’s smart search engine, consumers search or review their favorite brands among hundreds of choices in Apparel, Bags & Shoes, Accessory, Health & Beauty, Home & Lifestyle, International, Women, Men and Kids & Babies categories. The platform also allow consumers order from hundreds of vendor choices with personalized promotions based on purchase history and location. The platform has also partnered up with a Vietnam-based delivery company, Tikinow, to offer seamless delivery of product from merchant to consumer’s home or office at the touch of a button. Consumers place orders for delivery or pickup at the Company’s logistics center.\\n| 12 |\\n\\nRevenue streams for consumer facing business:\\nF&B sector\\n\\n| 1) | Ordering fees comprise the fees that the different types of merchants pay for every completed transaction on the Platform, exclusive of delivery fees charged. Monthly/annual subscription fees or 10% commission on order value on each successful order will be charged. |\\n\\n\\n| 2) | Delivery fees include an upfront fixed fee and additional variable fees based on the distance. Various percentage of commission will be charged as delivery fee on each successful order received and delivered. |\\n\\nThe Company recognizes revenues from consumer facing business upon the completion of delivery and services rendered.\\nDuring the period ended September 30, 2021 and 2020, the Company have not generated any revenue from this stream.\\nLifestyle sector\\n\\n| 1) | Customer placed orders on the website / app, sales orders report will be generated in the system. The Company will start to proceed to packaging and delivering customer. The sales recognised. |\\n\\nDuring the nine months ended September 30, 2021 and 2020, the Company have generated $ 73,518 and $ 0 , respectively revenue from this stream. During the three months ended September 30, 2021 and 2020, the Company have generated $ 73,518 and $ 0 , respectively revenue from this stream.\\nMerchant Facing Business\\nRevenue streams for merchant facing business include:\\n\\n| 1) | Subscription fees consist of the fees that the Company charge merchants to get on the Merchant Marketing Program; |\\n| 2) | The Company provides optional add-on software services which includes Analytics and Chatbox capabilities at a fixed fee per month. |\\n| 3) | The Company collects commissions when they sell third party hardware and equipment (cashier stations, waiter tablets and printers) to merchants. |\\n| 4) | Vendor Financing. The Company collects brokerage fees whenever the Company facilitates financing transactions between merchants and one of the Company’s partner financial institutions. |\\n\\nDuring the nine months ended September 30, 2021 and 2020, the Company have generated $26,970 and $37,752, respectively revenue from this stream. During the three months ended September 30, 2021 and 2020, the Company have generated $10,016 and $11,044, respectively revenue from this stream.\\nHardware Product Revenues — the Company generally is involved with the sale of on-premise appliances and end-point devices. The single performance obligation is to transfer the hardware product (which is to be installed with its licensed software integral to the functionality of the hardware product). The entire transaction price is allocated to the hardware product and is generally recognized as revenue at the time of delivery because the customer obtains control of the product at that point in time. It is concluded that control generally transfers at that point in time because the customer has title to the hardware, physical possession, and a present obligation to pay for the hardware. Payments for hardware contracts are generally due 30 to 90 days after shipment of the hardware product.\\n\\n| 13 |\\n\\nThe Company records revenues from the sales of third-party products on a “gross” basis pursuant to ASC 606-10 Revenue Recognition – Revenue from Contracts with Customers, when the Company controls the specified good before it is transferred to the end customer and have the risks and rewards as principal in the transaction, such as responsibility for fulfillment, retaining the risk for collection, and establishing the price of the products. If these indicators have not been met, or if indicators of net revenue reporting specified in ASC 606-10 are present in the arrangement, revenue is recognized net of related direct costs.\\nSoftware License Revenues — The Company’s performance obligation includes providing connectivity to software, generally through a monthly subscription, where the Company typically satisfies its performance obligations prior to the submission of invoices to the customer for such services. The Company’s software sale arrangements grant customers the right to access and use the software products which are to be installed with the relevant hardware for connectivity at the outset of an arrangement, and to be entitled to both technical support and software upgrades and enhancements during the term of the agreement. The term of the subscription period is generally 12 months, with the automatic renewal of another one year, and the subscription license service is billed monthly, quarterly or annually. Sales are generally recorded in the month the service is provided. For clients who are billed on an annual basis, deferred revenue is recorded and amortized over the life of the contract. Payments are generally due 30 to 90 days after delivery of the software licenses.\\nThe Company records its revenues on hardware product and software license, net of value added taxes (“VAT”) upon the services are rendered and the title and risk of loss of hardware products are fully transferred to the customers. The Company is subject to VAT which is levied on the majority of the hardware products at the rate of 10% on the invoiced value of sales.\\nContract assets\\nIn accordance with ASC 606-10-45-3, contract asset is when the Company’s right to payment for goods and services already transferred to a customer if that right to payment is conditional on something other than the passage of time. The Company will recognize a contract asset when it has fulfilled a contract obligation but must perform other obligations before being entitled to payment.\\nThere were no contract assets at September 30, 2021 and December 31, 2020.\\nContract liabilities\\nIn accordance with ASC 606-10-45-2, a contract liability is Company’s obligation to transfer goods or services to a customer when the customer prepays consideration or when the customer’s consideration is due for goods and services that the Company will yet provide whichever happens earlier.\\nContract liabilities represent amounts collected from, or invoiced to, customers in excess of revenues recognized, primarily from the billing of annual subscription agreements. The value of contract liabilities will increase or decrease based on the timing of invoices and recognition of revenue. The Company’s contract liability balance was $ 35,582 and $ 18,646 as of September 30, 2021 and December 31, 2020, respectively.\\nContract costs\\nUnder ASC-606, the Company applies the following three steps in order to evaluate the costs to be capitalized as it fulfills following three criteria:\\n• Incremental costs directly related to a specific contract;\\n• Costs that generate or enhance resources of the company that will be used to satisfy performance of the terms of the contract; and\\n• Costs that are expected to be recovered from the customer.\\nNo contract costs are capitalized for the nine months ended September 30, 2021 and 2020.\\nNo contract costs are capitalized for the three months ended September 30, 2021 and 2020.\\n\\n| 14 |\\n\\n• Software development costs\\nIn accordance with the relevant FASB accounting guidance regarding the development of software to be sold, leased, or marketed, the Company expenses such costs as they are incurred until technological feasibility has been established, at and after which time these costs are capitalized until the product is available for general release to customers. Once the technological feasibility is established per ASC 985-20, the Company capitalizes costs associated with the acquisition or development of major software for internal and external use in the balance sheet. Costs incurred to enhance the Company’s software products, after general market release of the services using the products, is expensed in the period they are incurred. The Company only capitalizes subsequent additions, modifications or upgrades to internally developed software to the extent that such changes allow the software to perform a task it previously did not perform. The Company also expenses website costs as incurred.\\nResearch and development expenditures in the development of its own software are charged to operations as incurred. Based on the software development process, technological feasibility is established upon completion of a working model, which also requires certification and extensive testing. Costs incurred by the Company between completion of the working model and the point at which the product is ready for general release are immaterial. For the nine months ended September 30, 2021 and 2020, the software development costs were $ 76,698 and $ 139,151 , respectively. For three months ended September 30, 2021 and 2020, the software development costs were $ 9,709 and $ 33,658 , respectively.\\n• Product warranties\\nThe Company’s provision for estimated future warranty costs is based upon historical relationship of warranty claims to sales. Based upon historical sales trends and warranties provided by the Company’s suppliers, the Company has concluded that no warranty liability is required as of September 30, 2021 and December 31, 2020. To date, product allowance and returns have been minimal and, based on its experience, the Company believes that returns of its products will continue to be minimal.\\n• Shipping and handling costs\\nNo shipping and handling costs are associated with the distribution of the products to the customers which are borne by the Company’s suppliers or distributors.\\n• Sales and marketing\\nSales and marketing expenses include payroll, employee benefits and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $ 85,027 and $ 3,125 for the nine months ended September 30, 2021 and 2020, respectively. For three months ended September 30, 2021 and 2020, the Advertising expense were $ 42,843 and $ 0 , respectively.\\n• Income tax\\nThe Company adopted the ASC 740 Income Tax provisions of paragraph 740-10-25-13, which addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the condensed consolidated financial statements. Under paragraph 740-10-25-13, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the condensed consolidated financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent (50%) likelihood of being realized upon ultimate settlement. Paragraph 740-10-25-13 also provides guidance on de-recognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures. The Company had no material adjustments to its liabilities for unrecognized income tax benefits according to the provisions of paragraph 740-10-25-13.\\n\\n| 15 |\\n\\nThe estimated future tax effects of temporary differences between the tax basis of assets and liabilities are reported in the accompanying balance sheets, as well as tax credit carry-backs and carry-forwards. The Company periodically reviews the recoverability of deferred tax assets recorded on its balance sheets and provides valuation allowances as management deems necessary.\\nThe Company and its wholly-owned foreign subsidiary, is subject to income taxes in the jurisdictions in which it operates. Significant judgment is required in determining the provision for income tax. There are many transactions and calculations undertaken during the ordinary course of business for which the ultimate tax determination is uncertain. The company recognizes liabilities for anticipated tax audit issues based on the Company’s current understanding of the tax law. Where the final tax outcome of these matters is different from the carrying amounts, such differences will impact the current and deferred tax provisions in the period in which such determination is made.\\n• Uncertain tax positions\\nThe Company did not take any uncertain tax positions and had no adjustments to its income tax liabilities or benefits pursuant to the ASC 740 provisions of Section 740-10-25 for the three and nine months ended September 30, 2021 and 2020.\\n• Foreign currencies translation and transactions\\nThe reporting currency of the Company is United States Dollar (\\\"US$\\\") and the accompanying condensed consolidated financial statements have been expressed in US$. In addition, the Company’s subsidiary is operating in the Republic of Vietnam and India and maintains its books and record in its local currency, Vietnam Dong (“VND”) and Indian Rupee (“INR), respectively, which are the functional currency as being the primary currency of the economic environment in which their operations are conducted. In general, for consolidation purposes, assets and liabilities of its subsidiaries whose functional currency is not US$ are translated into US$, in accordance with ASC Topic 830-30, “Translation of Financial Statement”, using the exchange rate on the balance sheet date. Shareholders’ equity is translated using the historical rates. Revenues and expenses are translated at average rates prevailing during the year. The gains and losses resulting from translation of financial statements of foreign subsidiary are recorded as a separate component of accumulated other comprehensive income within the statements of changes in shareholder’s equity.\\nTranslation of amounts from SGD$ into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\\n\\n| Schedule of Foreign currencies translation and transactions |\\n| September 30, 2021 | September 30, 2020 |\\n| Period-end SGD$:US$ exchange rate | $ | 0.73534 | $ | 0.73118 |\\n| Period average SGD$:US$ exchange rate | $ | 0.74658 | $ | 0.71922 |\\n\\nTranslation of amounts from VND into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\\n\\n| September 30, 2021 | September 30, 2020 |\\n| Period-end VND$:US$ exchange rate | $ | 0.000044 | $ | 0.000043 |\\n| Period average VND$:US$ exchange rate | $ | 0.000043 | $ | 0.000043 |\\n\\nTranslation of amounts from INR into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\\n\\n| September 30, 2021 | September 30, 2020 |\\n| Period-end INR$:US$ exchange rate | $ | 0.013463 | $ | 0.013570 |\\n| Period average INR$:US$ exchange rate | $ | 0.013576 | $ | 0.013490 |\\n\\nTranslation gains and losses that arise from exchange rate fluctuations from transactions denominated in a currency other than the functional currency are translated, as the case may be, at the rate on the date of the transaction and included in the results of operations as incurred.\\n\\n| 16 |\\n\\nForeign Exchange Loss (Gain). We recorded a foreign exchange gain of $ 8,859 for the three months ended September 30, 2021 as compared to a gain of $ 51,183 for the same period in 2020. Foreign exchange gains and losses are primarily unrealized (non-cash) in nature and results from the re-measuring of specific transactions and monetary accounts in a currency other than the functional currency. For example, a U.S. Dollar transaction which occurs in Singapore is re-measured at the period-end to Singapore dollar amount if it has not been settled previously. The foreign exchange gain for the three months ended September 30, 2021 was due to an increase in the value of the Singapore Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the Singapore dollar to the U.S. Dollar increased 0.56%. At September 30, 2021, the exchange rate was 0.73534 as compared to 0.73118 at September 30, 2020. In addition, a U.S. Dollar transaction which occurs in India is re-measured at the period-end to India dollar amount if it has not been settled previously. The foreign exchange loss for the three months ended September 30, 2021 was due to an increase in the value of the India Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the India dollar to the U.S. Dollar increased 0.79%. At September 30, 2021, the exchange rate was 0.013463 as compared to 0.013570 at September 30, 2020. A U.S. Dollar transaction which occurs in Vietnam is re-measured at the period-end to Vietnameses dollar amount if it has not been settled previously. The foreign exchange gain for the three months ended September 30, 2021 was due to an increase in the value of the Vietnamese Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the Vietnamese dollar to the U.S. Dollar increased 2.32%. At September 30, 2021, the exchange rate was 0.000044 as compared to 0.000043 at September 30, 2020.\\n• Comprehensive income\\nASC Topic 220, “Comprehensive Income”, establishes standards for reporting and display of comprehensive income, its components and accumulated balances. Comprehensive income as defined includes all changes in equity during a period from non-owner sources. Accumulated other comprehensive income, as presented in the accompanying condensed consolidated statements of changes in shareholders’ equity, consists of changes in unrealized gains and losses on foreign currency translation. This comprehensive income is not included in the computation of income tax expense or benefit.\\n• Leases\\nThe Company adopted Topic 842, Leases (“ASC 842”) to determine if an arrangement is a lease at inception. Operating leases are included in operating lease right-of-use (“ROU”) assets and operating lease liabilities in the condensed consolidated balance sheets. Finance leases are included in property and equipment, other current liabilities, and other long-term liabilities in the condensed consolidated balance sheets.\\nROU assets represent the right to use an underlying asset for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As most of the Company’s leases do not provide an implicit rate, the Company generally use the incremental borrowing rate based on the estimated rate of interest for collateralized borrowing over a similar term of the lease payments at commencement date. The operating lease ROU asset also includes any lease payments made and excludes lease incentives. The lease terms may include options to extend or terminate the lease when it is reasonably certain that the Company will exercise that option. Lease expense for lease payments is recognized on a straight-line basis over the lease term.\\n\\n| 17 |\\n\\nIn accordance with the guidance in ASC 842, components of a lease should be split into three categories: lease components (e.g. land, building, etc.), non-lease components (e.g. common area maintenance, consumables, etc.), and non-components (e.g. property taxes, insurance, etc.). Subsequently, the fixed and in-substance fixed contract consideration (including any related to non-components) must be allocated based on the respective relative fair values to the lease components and non-lease components.\\nAs of September 30, 2021 and December 31, 2020, the Company recorded the right of use asset of $ 529,782 and $ 79,109 respectively.\\n• Related parties\\nThe Company follows the ASC 850-10, Related Party for the identification of related parties and disclosure of related party transactions.\\nPursuant to section 850-10-20 the related parties include a) affiliates of the Company; b) entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of section 825–10–15, to be accounted for by the equity method by the investing entity; c) trusts for the benefit of employees, such as pension and Income-sharing trusts that are managed by or under the trusteeship of management; d) principal owners of the Company; e) management of the Company; f) other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests; and g) other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.\\nThe condensed consolidated financial statements shall include disclosures of material related party transactions, other than compensation arrangements, expense allowances, and other similar items in the ordinary course of business. However, disclosure of transactions that are eliminated in the preparation of consolidated or combined financial statements is not required in those statements. The disclosures shall include: a) the nature of the relationship(s) involved; b) a description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the financial statements; c) the dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period; and d) amount due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement.\\n• Commitments and contingencies\\nThe Company follows the ASC 450-20, Commitments to report accounting for contingencies. Certain conditions may exist as of the date the financial statements are issued, which may result in a loss to the Company but which will only be resolved when one or more future events occur or fail to occur. The Company assesses such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or un-asserted claims that may result in such proceedings, the Company evaluates the perceived merits of any legal proceedings or un-asserted claims as well as the perceived merits of the amount of relief sought or expected to be sought therein.\\nIf the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s consolidated financial statements. If the assessment indicates that a potentially material loss contingency is not probable but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, and an estimate of the range of possible losses, if determinable and material, would be disclosed.\\nLoss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the guarantees would be disclosed. Management does not believe, based upon information available at this time that these matters will have a material adverse effect on the Company’s financial position, results of operations or cash flows. However, there is no assurance that such matters will not materially and adversely affect the Company’s business, financial position, and results of operations or cash flows.\\n\\n| 18 |\\n\\n• Fair value of financial instruments\\nThe Company follows paragraph 825-10-50-10 of the FASB Accounting Standards Codification for disclosures about fair value of its financial instruments and has adopted paragraph 820-10-35-37 of the FASB Accounting Standards Codification (“Paragraph 820-10-35-37”) to measure the fair value of its financial instruments. Paragraph 820-10-35-37 of the FASB Accounting Standards Codification establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. To increase consistency and comparability in fair value measurements and related disclosures, paragraph 820-10-35-37 of the FASB Accounting Standards Codification establishes a fair value hierarchy which prioritizes the inputs to valuation techniques used to measure fair value into three (3) broad levels. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The three (3) levels of fair value hierarchy defined by paragraph 820-10-35-37 of the FASB Accounting Standards Codification are described below:\\n\\n| Level 1 | Quoted market prices available in active markets for identical assets or liabilities as of the reporting date. |\\n| Level 2 | Pricing inputs other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable as of the reporting date. |\\n| Level 3 | Pricing inputs that are generally observable inputs and not corroborated by market data. |\\n\\nFinancial assets are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable.\\nThe fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.\\nThe carrying amounts of the Company’s financial assets and liabilities, such as cash and cash equivalents, accounts receivable, deposits, prepayments and other receivables, contract liabilities, accrued liabilities and other payables, amounts due to related parties and operating lease liabilities, approximate their fair values because of the short maturity of these instruments.\\n• Cost of goods sold\\nCost of goods sold consists of the cost of hardware, software and payroll, which are directly attributable to the sales of products. The cost also consists of costs of materials which has been sold attributable to the sales of high-end products. Additional costs may include freight paid to acquire the goods, custom duties, sales or use taxes not recoverable paid on materials used, and any fee for purchase.\\n• Share-based compensation\\nPursuant to ASU 2018-07, the Company follows ASC 718, Compensation—Stock Compensation (“ASC 718”), which requires the measurement and recognition of compensation expense for all share-based payment awards (employee or non employee), are measured at grant-date fair value of the equity instruments that an entity is obligated to issue. Restricted stock units are valued using the market price of the Company’s common shares on the date of grant. As of September 30, 2021, those shares issued for service compensations were immediately vested, and therefore this amount is thus recognized as expense with an offset to preferred or September 30, 2021 and 2020, the stock-based compensations are recorded in the General and administrative expenses within the Condensed Consolidated Statements of Operations and Other Comprehensive Loss.”\\n\\n| 19 |\\n\\n• Business combinations\\nThe Company follows ASC 805, Business Combinations (“ASC 805”) and ASC 810-10-65, Consolidation. ASC 805 requires most identifiable assets, liabilities, non-controlling interests, and goodwill acquired in a business combination to be recorded at “fair value.” The statement applies to all business combinations, including combinations among mutual entities and combinations by contract alone. Under ASC 805, all business combinations are accounted for by applying the acquisition method. Accounting for goodwill requires significant management estimates and judgment. Management performs periodic reviews of the carrying value of goodwill to determine whether events and circumstances indicate that an impairment in value may have occurred. A variety of factors could cause the carrying value of goodwill to become impaired. A write-down of the carrying value of goodwill could result in a non-cash charge, which could have an adverse effect on the Company’s results of operations.\\n• Earnings per share\\nBasic per share amounts are calculated using the weighted average shares outstanding during the year, excluding unvested restricted stock units. The Company uses the treasury stock method to determine the dilutive effect of stock options and other dilutive instruments. Under the treasury stock method, only “in the money” dilutive instruments impact the diluted calculations in computing diluted earnings per share. Diluted calculations reflect the weighted average incremental common shares that would be issued upon exercise of dilutive options assuming the proceeds would be used to repurchase shares at average market prices for the period.\\nAs of September 30, 2021 and December 31, 2020, the Company has the number of shares of common stock to be issued upon conversion of below:\\n\\n| Schedule of Common stock issued |\\n| As of September 30, | As of December 31, |\\n| 2021 | 2020 |\\n| Series A Convertible Preferred Stock (a) | 8,000 | 8,000 |\\n| Series B Convertible Preferred Stock | 764,400 | 764,400 |\\n| Series B-1 Convertible Preferred Stock | 48,000 | 48,000 |\\n| Series C Convertible Preferred Stock | 465,600 | 108,600 |\\n| Series C-1 Convertible Preferred Stock | 4,195,200 | 865,500 |\\n| Warrants granted | — | — |\\n| Warrants granted with Series C-1 Convertible Preferred Stock | 1,178,700 | 614,100 |\\n| Total: | 6,659,900 | 2,408,600 |\\n\\n\\n| (a) | The Series A the conversion formula is aggregate Stated Value divided by IPO price (Stated Value for each Series A preferred share is $1,000). There are 8,000 shares of Series A Preferred Stock issued and outstanding (10,000 shares are designated Series A). The conversion formula would be $8 million (the aggregate stated value) divided by IPO price. |\\n\\n• Segment Reporting\\nASC Topic 280, “Segment Reporting” establishes standards for reporting information about operating segments on a basis consistent with the Company’s internal organization structure as well as information about geographical areas, business segments and major customers in condensed consolidated financial statements. For the nine months ended September 30, 2021 and 2020, the Company operates in two reportable operating segment.\\n• Emerging Growth Company\\nWe are an “emerging growth company” under the JOBS Act. For as long as we are an “emerging growth company,” we are not required to: (i) comply with any new or revised financial accounting standards that have different effective dates for public and private companies until those standards would otherwise apply to private companies, (ii) provide an auditor’s attestation report on management’s assessment of the effectiveness of internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act, (iii) comply with any new requirements adopted by the Public Company Accounting Oversight Board (“PCAOB”) requiring mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor would be required to provide additional information about the audit and the financial statements of the issuer or (iv) comply with any new audit rules adopted by the PCAOB after April 5, 2012, unless the SEC determines otherwise. However, we have elected to “opt out” of the extended transition period discussed in (i) and will therefore comply with new or revised accounting standards on the applicable dates on which the adoption of such standards are required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to opt out of such extended transition period for compliance with new or revised accounting standards is irrevocable.\\n\\n| 20 |\\n\\n• Recent Accounting Pronouncements\\nFrom time to time, new accounting pronouncements are issued by the Financial Accounting Standard Board (“FASB”) or other standard setting bodies and adopted by the Company as of the specified effective date. Unless otherwise discussed, the Company believes that the impact of recently issued standards that are not yet effective will not have a material impact on its financial position or results of operations upon adoption.\\nAccounting Standards Adopted\\nIn August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (“ASU 2018-13”), which eliminates, adds and modifies certain disclosure requirements for fair value measurements. The amendment is effective for interim and annual reporting periods beginning after December 15, 2019. The Company has evaluated and the adoption of this does not have any impact on the financial statements.\\nIn November 2018, the FASB issued ASU No. 2018-18, Collaborative Arrangements (“ASU 2018-18”), which clarifies the interaction between ASC 808, Collaborative Arrangements and ASC 606, Revenue from Contracts with Customers. Certain transactions between participants in a collaborative arrangement should be accounted for under ASC 606 when the counterparty is a customer. In addition, ASU 2018-18 precludes an entity from presenting consideration from a transaction in a collaborative arrangement as revenue if the counterparty is not a customer for that transaction. ASU 2018-18 should be applied retrospectively to the date of initial application of ASC 606. This guidance is effective for interim and fiscal periods beginning after December 15, 2019. The Company has evaluated and the adoption of this does not have an any impact on the financial statements.\\nAccounting Standards Issued, Not Adopted\\nIn June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). This ASU requires measurement and recognition of expected credit losses for financial assets. ASU 2016-13 also requires new disclosures for financial assets measured at amortized cost, loans and available-for-sale debt securities. ASU 2016-13 is effective for the Company beginning January 1, 2023. Entities will apply the standard's provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. The Company is currently evaluating the potential effect of this standard on its financial statements. The Company does not expect this standard to have a material impact on its financial statements.\\nIn December 2019, the FASB issued ASU No. 2019-12, Income Taxes: Simplifying the Accounting for Income Taxes (“ASU 2019-12”), which eliminates certain exceptions related to the approach for intraperiod tax allocation, the methodology for calculating income taxes in an interim period and the recognition of deferred tax liabilities for outside basis differences. The new guidance also simplifies aspects of the accounting for franchise taxes and enacted changes in tax laws or rates and clarifies the accounting for transactions that result in a step-up in the tax basis of goodwill. The standard is effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2020, with early adoption permitted. Adoption of the standard requires certain changes to be made prospectively, with some changes to be made retrospectively. The Company does not expect the adoption of this standard to have a material impact on its financial position, results of operations or cash flows.\\n\\n| 21 |\\n\\nIn March 2020, the FASB issued ASU 2020-03, “Codification Improvements to Financial Instruments”: The amendments in this update are to clarify, correct errors in, or make minor improvements to a variety of ASC topics. The changes in ASU 2020-03 are not expected to have a significant effect on current accounting practices. The ASU improves various financial instrument topics in the Codification to increase stakeholder awareness of the amendments and to expedite the improvement process by making the Codification easier to understand and easier to apply by eliminating inconsistencies and providing clarifications. The ASU is effective for smaller reporting companies for fiscal years beginning after December 15, 2022 with early application permitted. The Company is currently evaluating the impact the adoption of this guidance may have on its consolidated financial statements.\\nIn August 2020, the FASB issued ASU 2020-06 Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40) related to the measurement and disclosure requirements for convertible instruments and contracts in an entity's own equity. The pronouncement simplifies and adds disclosure requirements for the accounting and measurement of convertible instruments and the settlement assessment for contracts in an entity's own equity. This pronouncement is effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2021 and early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. The Company is currently evaluating the impact that this standard will have on its consolidated financial statements.\\nNo other new accounting pronouncements were issued or became effective in the period that had, or are expected to have, a material impact on our condensed consolidated Financial Statements.\\nNOTE－4 BUSINESS COMBINATION\\nOn November 11, 2019, the Company completed the acquisition of 100 % equity interest of Hottab Pte Limited (the “Acquisition”). The total consideration of the acquisition is 156 shares of series C convertible preferred stock, approximately $ 900,000 , cash consideration $ 150,000 and additional series C convertible preferred stock approximately $ 558,000 . The Company accounted for the transaction as an acquisition of a business pursuant to ASC 805, “Business Combinations” (“ASC 805”).\\n\\n| Schedule of Purchase price allocation |\\n| Purchase price allocation: |\\n| Fair value of stock at closing | $ | 900,000 |\\n| Cash paid | 75,000 |\\n| Deferred payments- Cash | 71,422 |\\n| Deferred payment- shares | 531,380 |\\n| Less cash received | ( 15,337 | ) |\\n| Purchase price | $ | 1,562,465 |\\n\\nThe transaction was accounted for using the acquisition method. Accordingly, goodwill has been measured as the excess of the total consideration over the amounts assigned to the identifiable assets acquired and liabilities assumed based on their preliminary estimated fair values.\\nThe deferred payments of $ 633,000 were discounted using the yield on a CCC rated corporate debt for 3-month, 6-month and 9-month maturities, respectively. The implied discount is approximately $ 30,198 , which will be amortized over the term on the payments.\\nThe purchase price allocation resulted in $2,766,000 of goodwill, as below:\\n\\n| Schedule of Acquisition of assets and liability |\\n| Acquired assets: |\\n| Trade receivables | $ | 6,906 |\\n| Other receivables | 1,857 |\\n| Total acquired assets | 8,763 |\\n| Less: Assumed liabilities |\\n| Trade payables | 39,147 |\\n| Accrued liabilities and other payable | 68,458 |\\n| Amounts due to related parties | 1,080,904 |\\n| Deferred revenue | 23,789 |\\n| Total Assumed liabilities | 1,212,298 |\\n| Fair value of net liabilities assumed | ( 1,203,535 | ) |\\n| Goodwill recorded | 2,766,000 |\\n| Cash consideration allocated | $ | 1,562,465 |\\n\\n\\n| 22 |\\n\\nUnder the acquisition method of accounting, the total acquisition consideration price was allocated to the assets acquired and liabilities assumed based on their preliminary estimated fair values. The fair value measurements utilize estimates based on key assumptions of the Acquisition, and historical and current market data. The preliminary allocation of the purchase price is based on the best information available and is pending, amongst other things: (i) the finalization of the valuation of the fair values and useful lives of tangible assets acquired; (ii) the finalization of the valuations and useful lives for the intangible assets acquired; (iii) finalization of the valuation of accounts payable and accrued expenses; and (iv) finalization of the fair value of non-cash consideration.\\nThe Acquisition was accounted for as a business combination in accordance with ASC 805 “Business Combinations”. The Company has allocated the purchase price consideration based upon the fair value of the identifiable assets acquired and liabilities assumed on the acquisition date. Management of the Company is responsible for determining the fair value of assets acquired, liabilities assumed and intangible assets identified as of the acquisition date and considered a number of factors including valuations from management estimation. Acquisition-related costs incurred for the acquisitions are not material and have been expensed as incurred in general and administrative expense.\\nThe goodwill is not expected to be deductible for tax purposes. The goodwill is fully impaired during the year ended December 31, 2019, because there were continuous operating losses and negative cash flows incurred subsequently. Under ASC 350-20-50, the Company recognized the goodwill impairment loss by comparing the actual operating results of Hottab to the profit forecast and a negative performance is resulted.\\nDuring the measurement period (which is the period required to obtain all necessary information that existed at the acquisition date, or to conclude that such information is unavailable, not to exceed one year), additional assets or liabilities may be recognized, or there could be changes to the amounts of assets or liabilities previously recognized on a preliminary basis, if new information is obtained about facts and circumstances that existed as of the acquisition date that, if known, would have resulted in the recognition of these assets or liabilities as of that date. No additional assets or liabilities were recognized during the measurement period, or the changes to the amounts of assets or liabilities previously recognized.\\nOn September 30, 2021, the Company served the notification to a related party that certain terms under call option agreement and side letter were no longer effective, in case of non-fulfillment with the milestone conditions as set out in the agreements amounts of $75,000 cash consideration and $558,000 equity incentive. The said amount was written off and accounted as capital transaction and therefore credited the additional paid in capital account as of September 30, 2021.\\nNOTE－5 REVENUE\\nRevenue consisted of the following deliverables:\\n\\n| Schedule of Revenue |\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Hardware sales | $ | — | $ | 585 | $ | 335 | $ | 3,510 |\\n| Software subscription | 10,016 | 11,044 | 26,970 | 37,752 |\\n| Sales – online ordering | 73,518 | — | 73,518 | — |\\n| $ | 83,534 | $ | 11,629 | $ | 100,823 | $ | 41,262 |\\n\\n\\n| 23 |\\n\\nIn accordance with ASC 280, Segment Reporting (“ASC 280”), we have two reportable geographic segments:\\nSoftware License Revenues. Sales are based on the countries in which the customer is located. Summarized financial information concerning our geographic segments is shown in the following tables:\\n\\n| Schedule of geographic segments |\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Indonesia | $ | 10,016 | $ | 9,788 | $ | 24,813 | $ | 31,604 |\\n| Vietnam | — | 1,841 | 2,492 | 9,658 |\\n| $ | 10,016 | $ | 11,629 | $ | 27,305 | $ | 41,262 |\\n\\nOnline Ordering Revenues. Sales are based on the countries in which the customer is located. Summarized financial information concerning our geographic segments is shown in the following tables:\\n\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Indonesia | $— | $— | $— | $— |\\n| Vietnam | 73,518 | — | 73,518 | — |\\n| $ | 73,518 | $ | — | $ | 73,518 | $ | — |\\n\\nContract liabilities recognized was related to software sales only and the following is reconciliation for the periods:\\n\\n| Schedule of Contract liabilities |\\n| Period ended September 30, 2021 | Year ended December 31, 2020 |\\n| (Unaudited) |\\n| Contract liabilities, brought forward | $ | 18,646 | $ | 19,843 |\\n| Add: recognized as deferred revenue | 35,582 | 47,090 |\\n| Less: recognized as current period/year revenue | ( 18,646 | ) | ( 48,287 | ) |\\n| Contract liabilities, carried forward | $ | 35,582 | $ | 18,646 |\\n\\nNOTE－6 INTANGIBLE ASSETS\\nAs of September 30, 2021 and December 31, 2020, intangible assets consisted of the following:\\n\\n| Schedule of intangible assets |\\n| Useful life | September 30, 2021 | December 31, 2020 |\\n| (Unaudited) |\\n| At cost: |\\n| Software platform | 2.5 years | $ | 8,000,000 | $ | 8,000,000 |\\n| Other intangible assets | 3 – 5 years | 1,725 | 1,725 |\\n| 8,001,725 | 8,001,725 |\\n| Less: accumulated amortization | ( 3,201,725 | ) | ( 801,725 | ) |\\n| $ | 4,800,000 | $ | 7,200,000 |\\n\\n\\n| 24 |\\n\\nOn November 1 2018, the Company entered software development agreement with CVO Advisors Pte Ltd (CVO) 2018 to design and build App and Web-based platform for the total consideration of $8,000,000. CVO who is a third party vendor in the business of designing, developing, operating computer software applications including mobile and web application for social media, big data, point of sales, loyalty rewards, food delivery and technology platforms in Asia. The CVO developer performed and accepted technical work, of software development phase, which was materially completed by December 23, 2018. The Company obtained a third party license (Wallet Factory International Ltd) for their technology build up by CVO.\\nThe delivered platform was further developed by the Company’s in-house technology team (based in Noida that Sopa is currently using for the loyalty platform. The platform can be downloaded from Apple store or Googleplay store (i.e. SoPaApp) and the Company’s web version is on www.sopa.asia. The platform was completed developed on September 30, 2020 and has estimated life of 2.5 years. The platform started to be amortized from October 1, 2020.\\nFurther, the Company entered subscription agreement with CVO to issued 8,000 shares of preferred stocks for the software development, equal to the aggregate of $ 8,000,000 or at the stated value of $ 1,000 per share.\\nPursuant to the subscription agreement entered with CVO, the Company issued 8,000 shares of Series A convertible preferred stock for the purchase of software development at the stated value of $ 1,000 per share, totaling $8,000,000. CVO performed and accepted the technical work such as designing, developing, operating computer software applications including mobile and web application for social media, big data, point of sales, loyalty rewards, food delivery and technology platforms. The holder of this series A provided their consent to waive the warrant provision available with them and accordingly the preferred series A accounted in 2018.\\nAlso, owner of CVO entered into call option agreement with the CEO of the Company to sale all the shares of CVO for the sum of $10 per share, as of date, these options were exercised by the CEO of the Company, but the equity holders of CVO Advisors Pte. Ltd. have not honored the exercise of the call. The parties are currently in litigation (refer Note 19). As a result of this option exercise, there was no accounting effect on the Company’s financial statement during the period ended September 30, 2021.\\nAmortization of intangible assets attributable to future periods is as follows:\\n\\n| Schedule of Amortization of intangible assets |\\n| Year ending December 31: | Amount |\\n| 2021 (remaining period) | $ | 800,000 |\\n| 2022 | 3,200,000 |\\n| 2023 | 800,000 |\\n| Total | $ | 4,800,000 |\\n\\nAmortization of intangible assets was $ 2,400,000 and $ 1,479 for the nine months ended September 30, 2021 and 2020, respectively.\\nAmortization of intangible assets was $ 800,000 and $ 0 for the three months ended September 30, 2021 and 2020, respectively.\\nNOTE－ 7 PROPERTY, PLANT AND EQUIPMENT\\nProperty, plant and equipment consisted of the following:\\n\\n| Schedule of Property plant and equipment |\\n| September 30, 2021 | December 31, 2020 |\\n| (Unaudited) |\\n| At cost: |\\n| Computer | $ | 29,206 | $ | 29,206 |\\n| Office equipment | 1,721 | 1,721 |\\n| 30,927 | 30,927 |\\n| Less: accumulated depreciation | ( 19,403 | ) | ( 12,755 | ) |\\n| Less: exchange difference | ( 444 | ) | ( 103 | ) |\\n| $ | 11,080 | $ | 18,069 |\\n\\nDepreciation expense for the nine months ended September 30, 2021 and 2020 were $ 6,648 and $ 2,968 , respectively.\\nDepreciation expense for the three months ended September 30, 2021 and 2020 were $ 2,197 and $ 714 , respectively.\\n\\n| 25 |\\n\\nNOTE— 8 ASSET PURCHASE AGREEMENT\\nOn February 16, 2021, the Company subsidiary SoPa Technology Pte Ltd (“SoPa Pte Ltd”) acquired certain e-commerce assets from Goodventures Sea Limited (“Goodventures”) pursuant to an Asset Purchase Agreement dated February 16, 2021 (the “Leflair Purchase Agreement”). The acquired assets consisted of intellectual property for it lifestyle e-commerce retail business.\\nAs consideration for entering into the Asset Purchase Agreement, the Company agreed to pay Goodventure a total of $ 200,000 in cash payable in installments until April 16, 2021 and 1,500 ordinary shares of SoPa Pte Ltd by April 16, 2021, which represent 15% of the outstanding share capital of SoPa Technology Pte Ltd.\\nThe assets acquired by SoPa Pte Ltd under the Leflair Purchase Agreement were substantially all of the assets of an online retail platform that carried the “Leflair” brand name and included a Leflair e-commrce website, Leflair iOs and Android Apps, and backend end infrastructure as well as marketing properties including a customer list and social media pages. In addition, SoPa Technology Ptd Ltd acquired intellectual property such as Leflair logos, trademarks and brands.\\nThe Company accounted for this acquisition as an asset acquisition under ASC 805 and that the Company has early adopted the amendments of Regulation S-X dated May 21, 2020 and has concluded that this acquisition was not significant. Accordingly, the presentation of the assets acquired, historical financial statements under Rule 3-05 and related pro forma information under Article 11 of Regulation S-X, respectively, are not required to be presented.\\n\\n| Schedule of Asset acquisition |\\n| Acquired assets: |\\n| Intellectual property | $ | 200,000 |\\n| Less: Assumed liabilities |\\n| Accrued liabilities and other payable | — |\\n| Fair value of net assets acquired | 200,000 |\\n| Impairment loss recorded | ( 200,000 | ) |\\n| Net asset value | $ | — |\\n\\nThe purchase price of $200,000 shall be allocated amongst the intangible assets acquired, further, these intangible have a short term life as well as the quantum of the value, the company decided to expense it and accounted $ 0 - and $ 200,000 as impairment loss during the three and nine months ended September 30, 2021.\\nThe shares issued as part of this transaction do not give the holders the right to influence or control SoPa Pte Ltd. The holders do not have any special voting rights or the right to appoint any board members. SoPa Pte Ltd has not yet issued the shares to the future holders. Since the shares of SoPa Pte Ltd have not yet been issue, no minority interest needs to be recorded as of September 30, 2021.\\n\\n| 26 |\\n\\nSoPa Pte Ltd is a private company that was incorporated under the laws of Singapore on June 6, 2019. SoPa Pte Ltd manages Society Pass Incorporated’s operating activities in SEA countries and South Asia. As a pass-through holding company, the value of the 15% interest in the SoPa Pte Ltd to be issued to LeFlair owners has an indeterminate value and no real current value. Society Pass Incorporated plans to record the issuance of the shares at the nominal par value of the shares to be issued to the holders. The value of the assets acquired shall be the value of the cash paid and to be paid to the sellers.\\nThe Company has paid $ 200,000 during the period ended September 30, 2021.\\nNOTE－9 AMOUNTS DUE FROM (TO) RELATED PARTIES\\nAmounts due to related parties consisted of the following:\\n\\n| Schedule of Amount due to related parties |\\n| September 30, 2021 | December 31, 2020 |\\n| (Unaudited) |\\n| Amounts due to related parties (a) | $ | 24,763 | $ | 96,940 |\\n| Amounts due to shareholders (b) | — | 738,964 |\\n| Amount due to a director (c) | — | 735,833 |\\n| $ | 24,763 | $ | 1,571,737 |\\n\\n(a) The amounts represented temporary advances to the Company including related parties (two officers), which were unsecured, interest-free and had no fixed terms of repayments. On September 30, 2021, the Company received the notifications that the outstanding amounts of $ 72,176 were forgiven by the related parties, the said amount was written off and accounted as capital transaction and therefore credited the additional paid in capital account as of September 30, 2021. The Company’s due to related parties balance was $ 24,763 and $ 96,940 as of September 30, 2021 and December 31, 2020, respectively.\\n(b) In February 2018, the Company entered into MOU with Connect Investment Pte Ltd (Enter Asia) for capital alliance for approximately 27% of shareholdings in the Company. Further, in August 2018, the said MOU was modified and shareholding was revised from 27% to 10% in the Company. However, subsequently in October 2020, it was agreed between both the parties to cease the said MOU with the understanding that there is no current and future obligation with either of them i.e. neither EnterAsia to make investment in the Company nor the Company to issue shares to EnterAsia. Further, the EnterAsia is going to get the shares of the Hottab Holdings Ltd (HHL) for the amount so far invested in the Company and therefore the amount due to EnterAsia is reclassified into the amount due to shareholder “Hottab Holdings Ltd”.\\nThis amounts represented temporary advances to the Company by shareholder, which were unsecured, interest-free and had no fixed terms of repayments. On September 30, 2021, the Company received the notifications that the outstanding amounts of $ 738,964 were forgiven by the related parties, the said amount was written off and accounted as capital transaction and therefore credited the additional paid in capital account as of September 30, 2021. The Company’s due to a shareholder balance was $ 0 and $ 738,964 as of September 30, 2021 and December 31, 2020, respectively. Imputed interest is charged at 4.5 % per annum, which was amounted to $ 36,380 and $ 36,381 for the nine months ended September 30, 2021 and 2020, respectively.\\n(c) The amount represented paid salaries and bonus to the Director which was unsecured, interest-free and had no fixed terms of repayments. As of June 30, 2021, the Director had $ 960,833 in accrued, but unpaid compensation which could be converted to shares by dividing that amount by the employment agreement conversion price of $ 0.83 to produce 1,157,630 shares. During the period ended September 30, 2021, the Company issued those shares at the fair value of $ 3,854,908 , results into the additional compensation expenses of $ 2,894,075 accounted under stock based compensation account. The Company’s due to a director balance was $- 0 and $ 735,833 as of September 30, 2021 and December 31, 2020, respectively.\\n\\n| 27 |\\n\\nAmounts due from related parties\\nThe director has advance $ 97,500 during the period ended September 30, 2021, subsequently as of date, the same was recovered by the Company.\\nNOTE－10 ACCOUNTS PAYABLE AND ACCRUED LIABILITIES\\nAccounts payable consisted of the following:\\n\\n| Schedule of Accounts payable |\\n| September 30, 2021 | December 31, 2020 |\\n| (Unaudited) |\\n| Accounts payable | $ | 104,680 | $ | 54,256 |\\n| Accrued liabilities and other payables- Related Party (a) | 224,669 | 197,548 |\\n| Accrued liabilities and other payables (b) | 527,971 | 480,024 |\\n| Total Accounts payable | $ | 857,320 | $ | 731,828 |\\n\\n(a) The amount represented due to three related parties in respect to unpaid salaries, unpaid legal fees and unpaid consulting fees amounted to $ 21,701 , $ 70,104 and $ 132,864 , respectively as of September 30, 2021.\\nThe amount represented due to three related parties in respect to unpaid salaries, unpaid legal fees and unpaid consulting fees amounted to $ 5,000 , $ 112,692 and $ 79,856 , respectively as of December 31, 2020.\\n(b) Accrued liabilities and other payables consisted of the following:\\n\\n| Schedule of Accrued liabilities |\\n| September 30, 2021 | December 31, 2020 |\\n| (Unaudited) |\\n| Accrued payroll | $ | 54,528 | $ | 58,092 |\\n| Other accrual | 154,325 | 146,826 |\\n| Other payables (c) | 245,000 | 245,000 |\\n| Accrued vat expenses | 19,932 | 1,788 |\\n| Accrued taxes | 54,186 | 28,318 |\\n| Total Accrued liabilities | $ | 527,971 | $ | 480,024 |\\n\\n(c) This included $75,000 related to SOSV. In January 2019, the HPL entered into stock purchase agreement and accelerator contract for equity (ACE) with SOSV IV LLC (SOSV) whereby the HPL will issue shares representing 5% of their capital stock for the amounts of $ 168,000 in three tranche (a) SOSV to pay to the HPL $ 75,000 for integration of Mobile Only Accelerator (MOX) software development kit, (b) SOSV to pay on behalf of the HPL $ 48,000 upon MOX successful application and setting up subsidiary, and (c) SOSV to pay on behalf of the HPL $ 45,000 for setting program for services. The Company received first tranche of $ 75,000 only and thereafter no other two tranche received by the HPL, however, the outcome of the deal did not results success and so later the HPL have not issued any shares to the SOSV, therefore the arrangement amount of $ 75,000 accounted as loan from SOSV. The Company sent the legal letter to the SOSV intimating that the Company acquired HPL by issuing 156 shares of preferred stock series C to Hottab Holding Limited for the 100% acquisition of HPL. As of September 30, 2021 and December 31, 2020, the Company had a total of $ 75,000 and $ 75,000 outstanding on this account, respectively. (refer footnote#19 for legal update).\\n\\n| 28 |\\n\\nNOTE－11 LEASES\\nWe adopted ASU No. 2016-02, Leases, on January 1, 2019, the beginning of our fiscal 2019, using the modified retrospective approach. We determine whether an arrangement is a lease at inception. This determination generally depends on whether the arrangement conveys the right to control the use of an identified fixed asset explicitly or implicitly for a period of time in exchange for consideration. Control of an underlying asset is conveyed if we obtain the rights to direct the use of and to obtain substantially all of the economic benefit from the use of the underlying asset. Some of our leases include both lease and non-lease components which are accounted for as a single lease component as we have elected the practical expedient. Some of our operating lease agreements include variable lease costs, primarily taxes, insurance, common area maintenance or increases in rental costs related to inflation. Substantially all of our equipment leases and some of our real estate leases have terms of less than one year and, as such, are accounted for as short-term leases as we have elected the practical expedient.\\nOperating leases are included in the right-of-use lease assets, other current liabilities and long-term lease liabilities on the Consolidated Balance Sheet. Right-of-use assets and lease liabilities are recognized at each lease’s commencement date based on the present values of its lease payments over its respective lease term. When a borrowing rate is not explicitly available for a lease, our incremental borrowing rate is used based on information available at the lease’s commencement date to determine the present value of its lease payments. Operating lease payments are recognized on a straight-line basis over the lease term. We had no financing leases as of September 30, 2021 and December 31, 2020.\\nThe Company adopts a 5.26 % as weighted average incremental borrowing rate to determine the present value of the lease payments. The weighted average remaining life of the lease was 3.48 year.\\nDuring the period ended September 30, 2021, the Company enter into new lease arrangements, and accounted as per ASC 842, the ROU asset and lease obligation of $ 479,171 .\\nThe Company excludes short-term leases (those with lease terms of less than one year at inception) from the measurement of lease liabilities or right-of-use assets. The following tables summarize the lease expense for the period ended September 30:\\n\\n| Schedule of Lease expenses |\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Operating lease expense (per ASC 842) | $ | 13,554 | $ | 6,076 | $ | 31,975 | $ | 21,802 |\\n| Short-term lease expense (other than ASC 842) | 63,363 | 4,627 | 66,420 | 31,258 |\\n| Total lease expense | $ | 76,917 | $ | 10,703 | $ | 98,395 | $ | 53,060 |\\n\\nAs of September 30, 2021, right-of-use assets were $ 529,782 and lease liabilities were $ 533,312 .\\nAs of December 31, 2020, right-of-use assets were $ 79,109 and lease liabilities were $ 83,205 .\\nComponents of Lease Expense\\nWe recognize lease expense on a straight-line basis over the term of our operating leases, as reported within “general and administrative” expense on the accompanying consolidated statement of operations.\\nFuture Contractual Lease Payments as of September 30, 2021\\nThe below table summarizes our (i) minimum lease payments over the next five years, (ii) lease arrangement implied interest, and (iii) present value of future lease payments for the next three years ending September 30:\\n\\n| Schedule of Future Contractual Lease Payments |\\n| Years ended September 30, | Operating lease amount |\\n| 2022 | $ | 190,025 |\\n| 2023 | 166,530 |\\n| 2024 | 147,813 |\\n| 2025 | 77,997 |\\n| Total | 582,365 |\\n| Less: interest | ( 49,053 | ) |\\n| Present value of lease liabilities | $ | 533,312 |\\n| Less: non-current portion | ( 365,539 | ) |\\n| Present value of lease liabilities – current liability | $ | 167,773 |\\n\\n\\n| 29 |\\n\\nNOTE－12 SHAREHOLDERS’ DEFICIT\\nAuthorized stock\\nThe Company is authorized to issue two classes of stock. The total number of shares of stock which the Company is authorized to issue is 100,000,000 shares of capital stock, consisting of 95,000,000 shares of common stock, $ 0.0001 par value per share, and 5,000,000 shares of preferred stock, $ 0.0001 par value per share.\\nThe holders of the Company’s common stock are entitled to the following rights:\\nVoting Rights: Each share of the Company’s common stock entitles its holder to one vote per share on all matters to be voted or consented upon by the stockholders. Holders of the Company’s common stock are not entitled to cumulative voting rights with respect to the election of directors.\\nDividend Right: Subject to limitations under Nevada law and preferences that may apply to any shares of preferred stock that the Company may decide to issue in the future, holders of the Company’s common stock are entitled to receive ratably such dividends or other distributions, if any, as may be declared by the Board of the Company out of funds legally available therefor.\\nLiquidation Right:. In the event of the liquidation, dissolution or winding up of our business, the holders of the Company’s common stock are entitled to share ratably in the assets available for distribution after the payment of all of the debts and other liabilities of the Company, subject to the prior rights of the holders of the Company’s preferred stock.\\nOther Matters: The holders of the Company’s common stock have no subscription, redemption or conversion privileges. The Company’s common stock does not entitle its holders to preemptive rights. All of the outstanding shares of the Company’s common stock are fully paid and non-assessable. The rights, preferences and privileges of the holders of the Company’s common stock are subject to the rights of the holders of shares of any series of preferred stock which the Company may issue in the future.\\nCommon stock outstanding\\nAs of September 30, 2021 and December 31, 2020, the Company had a total of 9,695,480 and 7,413,600 shares of its common stock issued and outstanding, respectively.\\nOn February 10, 2021, the Company effected a 750 for 1 stock split of the issued and outstanding shares of the Company’s common stock. The number of authorized shares and par value remain unchanged. All share and per share information in this financial statements and footnotes have been retroactively adjusted for the periods presented, unless otherwise indicated, to give effect to the forward stock split.\\nOn September 21, 2021, the Company effected a 1 for 2.5 stock split of the issued and outstanding shares of the Company’s common stock. The number of authorized shares and par value remain unchanged. All share and per share information in this financial statements and footnotes have been retroactively adjusted for the periods presented, unless otherwise indicated, to give effect to the reverse stock split.\\n\\n| 30 |\\n\\nAn additional result of the stock split was that the stated value of preferred stock, the number of designated shares and outstanding shares of each series of preferred stock was unchanged in accordance to the respective certificate of designations. The number of authorized shares of preferred stock remained unchanged.\\nDuring the period ended September 30, 2021 and 2020, the Company issued 824,250 and 1,014,900 shares of common stock for employee services for the value of $ 1,707,557 and $ 1,023,494 , respectively.\\nDuring the period ended September 30, 2021 and 2020, the Company issued 1,157,630 and 0 shares of common stock for director’s accrued salaries for the value of $ 960,834 and $ 0 , respectively. The Company accounted $ 2,894,075 additional cost on these share issuance as loss on fair value of shares issued in 2021.\\nDuring the period ended September 30, 2021 and 2020, the Company issued 450,000 and 0 shares of common stock for director’s bonus for the value of $ 3,442,499 and $ 0 , respectively.\\nDuring the period ended September 30, 2021 and 2020, the Company cancelled 150,000 and 0 shares of common stock at par value.\\nWarrants\\nIn August 2019, the Company issued 21,000 shares of warrants to one employee for compensation of his service to purchase 21,000 shares of its common stock for the fair value of $17,500. Each share of warrant is converted to one share of common stock at an exercise price of $0.0001. The warrants will expire on the second (2nd) anniversary of the initial date of issuance. As at December 31, 2019, none of the warrants have been exercised. 21,000 shares fully exercised during the year ended December 31, 2020.\\nIn December 2020, the Company issued certain numbers of warrants pursuant to the Series C-1 Subscription Agreement. Each redeemable warrant is entitled the holder to purchase one C-1 preferred share at a price of $ 420 per share. The warrants shall be exercisable on or before December 31, 2020 and September 30, 2021. During the nine months ended September 30, 2021, the Company issued 2,120 warrants. During the nine months ended September 30, 2020, the Company issued 1,824 warrants.\\nIn December 2020, a total of 838 warrants are exercised in exchanged to 838 Series C-1 preferred shares. (refer note 13 for details).\\nOn April 19, 2021, the Company extended the termination date of the Warrant issued to Preferred series C-1 holder by nine months from the expiration date of September 30, 2021 to December 31, 2021. The Company considers this warrant as permanent equity per ASC 815-40-35-2. As such, there is no value assigned to this extension.\\nThe Company determined the fair value using the Black-Scholes option pricing model with the following assumptions for the period ended September 30, 2021 and year ended December 31, 2020:\\n\\n| Schedule of Stock option assumptions |\\n| September 30, 2021 | December 31, 2020 |\\n| Dividend rate | 0 | % | 0 | % |\\n| Risk-free rate | 2 | % | 2 | % |\\n| Weighted average expected life (years) | 9 months | 9 months |\\n| Expected volatility | 0 | % | 0 | %(a) |\\n| Share price | $ | 0.22 | $ | 0.22 |\\n\\n\\n| (a) | The Company considered no volatility as from inception through the date there is very minimal transaction of the Company common stock. |\\n\\n\\n| 31 |\\n\\nBelow is a summary of the Company’s issued and outstanding warrants as of September 30, 2021 and December 31, 2020:\\n| Schedule of warrants issued and outstanding |\\n| Warrants | Weighted average exercise price | Weighted average remaining contractual life (in years) |\\n| Outstanding as of December 31, 2019 (a) | 21,000 | $ | 0.0001 | 1.3 |\\n| Issued (b) | 4,094 | $ | 420 | 0.9 |\\n| Exercised | ( 21,838 | ) | $ | ( 6.34 | ) | 1 |\\n| Expired | ( 1,209 | ) | $ | ( 420 | ) | ( 0.6 | ) |\\n| Outstanding as of December 31, 2020 | 2,047 | $ | 420 | 0.6 |\\n| Issued (b) | 2,120 | $ | 420 | 0.5 |\\n| Exercised | ( 238 | ) | $ | ( 420 | ) | — |\\n| Expired | — | — | — |\\n| Outstanding as of September 30, 2021 (b) | 3,929 | $ | 420 | 0.5 |\\n\\nThere is no intrinsic value for warrants as of September 30, 2021 and December 31, 2020.\\n\\n| (a) | Common stock will be issued if those warrants exercise. |\\n\\n\\n| (b) | Preferred stock series C-1 will be issued if those warrants exercise. |\\n\\nNOTE－13 PREFERRED STOCKS AND WARRANTS\\nAs of September 30, 2021 and December 31, 2020, the Company’s preferred stocks have been designated as follow:\\n\\n| Schedule of Preferred stocks |\\n| No. of shares | Stated Value |\\n| Series A Convertible Preferred Stock | 10,000 | $ | 1,000 |\\n| Series B Convertible Preferred Stock | 10,000 | $ | 1,336 |\\n| Series B-1 Convertible Preferred Stock | 15,000 | $ | 2,917 |\\n| Series C Convertible Preferred Stock | 15,000 | $ | 5,763 |\\n| Series C-1 Convertible Preferred Stock | 30,000 | $ | 420 |\\n| Series X Super Voting Preferred Stock | 3,500 | $ | 0.0001 |\\n\\nAll of the Series A, B, B-1, C, and C-1 Preferred Shares were issued at a value of respective stated value per share. These all Series of Preferred Shares contain a conversion option, are convert into a fixed number of common shares or redeemable with the cash repayment at the liquidation, so as a result of this liquidation preference, under U.S GAAP, the Company has classified the all these Series of Preferred Shares within mezzanine equity in the condensed consolidated balance sheet.\\nSeries X Super Voting Preferred Stock was issued a par value per share. This Series of Preferred Shares does not contain a conversion option, so as a result of this liquidation preference, under U.S GAAP, the Company has classified the this Series of Preferred Shares within permanent equity in the condensed consolidated balance sheet.\\nVoting Rights: (1) The affirmative vote of at least a majority of the holders of each series of preferred stock shall be necessary to:\\n\\n| (a) | increase or decrease the par value of the shares of the Series A Preferred Stock, alter or change the powers, preferences or rights of the shares of Series A Preferred Stock or create, alter or change the powers, preferences or rights of any other capital stock of the Company if after such alteration or change such capital stock would be senior to or pari passu with Series A Preferred Stock; and |\\n\\n\\n| (a) | adversely affect the shares of Series A Preferred Stock, including in connection with a merger, recapitalization, reorganization or otherwise. |\\n\\n\\n| 32 |\\n\\n(2) The affirmative vote of at least a majority of the holders of the shares of the Series A Preferred Stock shall be necessary to:\\n\\n| (a) | enter into a transaction or series of related transactions deemed to be a liquidation, dissolution or winding up of the Corporation, or voluntarily liquidate or dissolve; |\\n\\n\\n| (b) | authorize a merger, acquisition or sale of substantially all of the assets of the Company or any of its subsidiaries (other than a merger exclusively to effect a change of domicile of the Company to another state of the United States); |\\n\\n\\n| (c) | increase or decrease (other than decreases resulting from conversion of the Series A Preferred Stock) the authorized number of shares of the Company’s preferred stock or any series thereof, the number of shares of the Company’s common stock or any series thereof or the number of shares of any other class or series of capital stock of the Company; and |\\n\\n\\n| (d) | any repurchase or redemption of capital stock of the Company except any repurchase or redemption at cost upon the termination of services of a service provider to the Company or the exercise by the Company of contractual rights of first refusal as applied to such capital stock. |\\n\\nDividend Rights: The holders of the Company’s preferred stock are not entitled to any dividend rights.\\nConversion Rights (Series A Preferred Stock): Upon the consummation of this offering, the issued and outstanding shares of Series A Preferred Stock automatically convert into a number of shares of the Company’s common stock equal to the quotient obtained by dividing (x) the aggregate Stated Value of the issued and outstanding Series A Preferred Stock plus any other amounts due to the holders thereof divided by (y) the offering price of the Company’s common stock. If 90 days after conversion, the closing market price of the Company’s common stock as quoted on Nasdaq (the “Market Value”) has decreased below the initial public offering price, each holder of the Series A Preferred Stock shall be issued a warrant to purchase a number of shares of the Company’s common stock equal to 40% of the quotient of the (a) aggregate Stated Value held by such holder before conversion at the initial public offering price and the Market Value of the shares of common stock that were issuable upon conversion divided by (b) the Market Value. The warrants shall have a term of five years and shall be exercisable at the Market Value.\\nConversion Rights (Preferred Stock other than Series A and Series X Super Voting Preferred Stock): Upon the consummation of this offering, each issued and outstanding share of Series B Preferred Stock, Series B-1 Preferred Stock, Series C Preferred Stock and Series C-1 Preferred Stock will automatically convert into 750 shares of the Company’s common stock. Series X Super Voting Preferred stock shall not have any rights to convert into the Company’s common stock.\\nLiquidation Rights: In the event of any liquidation, dissolution or winding up of the Company, either voluntary or involuntary (a \\\"Liquidation Event\\\"), the holders of each series of preferred stock shall be entitled to receive, prior and in preference to any distribution of any of the assets or surplus funds of the Company to the holders of the Company’s common stock by reason of their ownership thereof, an amount per share in cash equal to the greater of (x) the aggregate Stated Value for all shares of such series of Preferred Stock then held by then or (y) the amount payable per share of the Company’s common stock which such holder of preferred stock would have received if such holder had converted to common stock immediately prior to the Liquidation Event all of such series of preferred stock then held by such holder (the \\\"Series Stock Liquidation Preference\\\"). If, upon the occurrence of a Liquidation Event, the funds thus distributed among the holders of the preferred stock shall be insufficient to permit the payment to the holders of the preferred stock the full Series Stock Liquidation Preference for all series, then the entire assets and funds of the Company legally available for distribution shall be distributed ratably among the holders of the preferred stock in proportion to the aggregate Series Liquidation Preferences that would otherwise be payable to each of the holders of preferred stock. Such payment shall constitute payment in full to the holders of the preferred stock upon the Liquidation Event. After such payment shall have been made in full, or funds necessary for such payment shall have been set aside by the Company in trust for the account of the holders of preferred stock, so as to be immediately available for such payment, such holders of preferred stock shall be entitled to no further participation in the distribution of the assets of the Company. The sale of all or substantially all of the assets of the Company, or merger, tender offer or other business combination to which the Company is a party in which the voting stockholders of the Company prior to such transaction do not own a majority of the voting securities of the resulting entity or by which any person or group acquires beneficial ownership of 50% or more of the voting securities of the Company or resulting entity shall be deemed to be a Liquidation Event.\\n\\n| 33 |\\n\\nOther Matters: The holders of the Company’s preferred stock have no subscription or redemption privileges and are not subject to redemption. The Company’s Series Preferred Stock does not entitle its holders to preemptive rights. All of the outstanding shares of the Company’s preferred stock are fully paid and non-assessable.\\nSeries A Preferred Shares\\nDuring the year ended December 31, 2018, the Company issued 8,000 shares of Series A convertible preferred stock for the purchase of software at the stated value of $ 1,000 per share, totaling $ 8,000,000 . The holder of this series A provided their consent to waive the warrant provision available with them and accordingly the preferred series A accounted in 2018.\\nThere was no Series A Preferred Shares issued during the nine months ended September 30, 2021 and 2020.\\nAs of September 30, 2021 and December 31, 2020, there were 8,000 and 8,000 shares of Series A Preferred Shares issued and outstanding, respectively.\\nSeries B Preferred Shares\\nThere was no Series B Preferred Shares issued during the nine months ended September 30, 2021 and 2020.\\nAs of September 30, 2021 and December 31, 2020, there were 2,548 and 2,548 shares of Series B Preferred Shares issued and outstanding, respectively.\\nSeries B-1 Preferred Shares\\nThere was no Series B-1 Preferred Shares issued during the nine months ended September 30, 2021 and 2020.\\nAs of September 30, 2021 and December 31, 2020, there were 160 and 160 shares of Series B-1 Preferred Shares issued and outstanding, respectively.\\nSeries C Preferred Shares\\nDuring the nine months ended September 30, 2021, the Company issued 1,116 and 74 shares of Series C preferred stock for cash in private placement and consulting services for the value of $ 6,431,508 and $ 426,462 , respectively.\\nDuring the nine months ended September 30, 2021, the Company incurred the issuance cost on above Series C private placement accounted $ 195,942 in shares and $ 460,361 in cash.\\nThere was no Series C Preferred Shares issued during the nine months ended September 30, 2020.\\nAs of September 30, 2021 and December 31, 2020, there were 1,552 and 362 shares of Series C Preferred Shares issued and outstanding, respectively.\\nSeries C-1 Preferred Shares\\nThe Company accounts for warrants issued in accordance with the guidance on “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity” in Topic 480. These warrants did not meet the criteria to be classified as a liability award and therefore were treated as an equity award and classified the Series C-1 Preferred Shares within mezzanine equity in the condensed consolidated balance sheet.\\n\\n| 34 |\\n\\nDuring the period ended September 30, 2021, the Company issued 6,235 and 4,864 shares of Series C-1 preferred stock for cash in private placement and consulting services for the value of $ 2,618,700 (out of which $479,640 is received subsequent to September 30, 2021) and $ 2,042,880 , respectively.\\nDuring the nine months ended September 30, 2021, the Company incurred the issuance cost on above series C-1 private placement accounted $ 245,700 in shares and $ 90,748 in cash. There is no issuance cost incurred in 2020.\\nDuring the period ended September 30, 2020, the Company issued 1,688 and 571 shares of Series C-1 preferred stock for cash in private placement and consulting services for the value of $ 708,960 and $ 239,820 , respectively.\\nAs of September 30, 2021 and December 31, 2020, there were 13,984 and 2,885 shares of Series C-1 Preferred Shares issued and outstanding, respectively.\\nSeries X Super Voting Preferred Shares\\nIn August 2021, the Company created a new series of preferred stock to be titled “Series X Super Voting Preferred Stock,” consisting of 2,000 shares and to provide to such preferred stock certain rights and privileges including but not limited to the right to 10,000 votes per share (post reverse split: 4,000 votes per share) to vote on all matters that may come before the stockholders of the Corporation, voting together with the common stock as a single class on all matters to be voted or consented upon by the stockholders but is not entitled to any dividends, liquidation preference or conversion or redemption rights, so accordingly it is accounted as an equity classification. In September 2021, the Company increased the number of shares designated as Series X Super Voting Preferred to 3,500.\\nDuring the period ended September 30, 2021 and 2020, the Company issued 3,500 and 0 shares of Series C-preferred stock at par value, respectively.\\nAs of September 30, 2021 and December 31, 2020, there were 3,500 and 0 shares of Series C Preferred Shares issued and outstanding, respectively.\\nNOTE－ 14 INCOME TAXES\\nFor the nine months ended September 30, 2021 and 2020, the local (“Nevada”) and foreign components of loss before income taxes were comprised of the following:\\n\\n| Schedule of Loss before income tax |\\n| Nine months ended September 30, |\\n| 2021 | 2020 |\\n| Tax jurisdiction from: |\\n| - Local | $ | 14,272,684 | $ | — |\\n| - Foreign | 1,246,371 | 2,507,042 |\\n| Loss before income taxes | $ | 15,519,055 | $ | 2,507,042 |\\n\\nThe provision for income taxes consisted of the following:\\n\\n| Schedule of provision for income taxes |\\n| Nine months ended September 30, |\\n| 2021 | 2020 |\\n| Current: |\\n| - United States | $ | — | $ | — |\\n| - Singapore | — | — |\\n| - Vietnam | — | — |\\n| - India | 9,943 | 15,069 |\\n| Deferred: |\\n| - United States | — | — |\\n| - Singapore | — | — |\\n| - Vietnam | — | — |\\n| - India | — | — |\\n| Income tax expense | $ | 9,943 | $ | 15,069 |\\n\\n\\n| 35 |\\n\\nThe effective tax rate in the years presented is the result of the mix of income earned in various tax jurisdictions that apply a broad range of income tax rate. The Company operates in various countries: Singapore and Vietnam that are subject to taxes in the jurisdictions in which they operate, as follows:\\nUnited States\\nThe Company is registered in the Nevada and is subject to the tax laws of United States.\\nAs of September 30, 2021, the operation in the United states incurred $ 25,094,900 of cumulative net operating losses which can be carried forward to offset future taxable income. The net operating loss carryforwards has no expiration. The Company has provided for a full valuation allowance against the deferred tax assets of $ 5,269,929 on the expected future tax benefits from the net operating loss carryforwards as the management believes it is more likely than not that these assets will not be realized in the future.\\nSingapore\\nThe Company’s subsidiary is registered in the Republic of Singapore and is subject to the tax laws of Singapore.\\nAs of September 30, 2021, the operation in the Singapore incurred $ 1,437,668 of cumulative net operating losses which can be carried forward to offset future taxable income. The net operating loss carryforwards has no expiration. The Company has provided for a full valuation allowance against the deferred tax assets of $ 230,027 on the expected future tax benefits from the net operating loss carryforwards as the management believes it is more likely than not that these assets will not be realized in the future.\\nVietnam\\nThe Company’s subsidiary operating in Vietnam is subject to the Vietnam Income Tax at a standard income tax rate of 20 % during its tax year. The reconciliation of income tax rate to the effective income tax rate for the nine months ended September 30, 2021 and 2020 is as follows:\\n\\n| Schedule of Effective Income Tax Rate Reconciliation |\\n| Nine months ended September 30, |\\n| 2021 | 2020 |\\n| Loss before income taxes | $ | ( 450,407 | ) | $ | ( 233,689 | ) |\\n| Statutory income tax rate | 20 | % | 20 | % |\\n| Income tax expense at statutory rate | ( 90,081 | ) | ( 46,738 | ) |\\n| Tax effect of allowance | 90,081 | 46,738 |\\n| Income tax expense | $ | — | $ | — |\\n\\nAs of September 30, 2021, the operation in the Vietnam incurred $ 859,275 of cumulative net operating losses which can be carried forward to offset future taxable income. The net operating loss carryforwards begin to expire in 2026, if unutilized. The Company has provided for a full valuation allowance against the deferred tax assets of $ 171,855 on the expected future tax benefits from the net operating loss carryforwards as the management believes it is more likely than not that these assets will not be realized in the future.\\nIndia\\nThe Company’s subsidiary operating in India is subject to the India Income Tax at a standard income tax rate of 25 % during its tax year. The reconciliation of income tax rate to the effective income tax rate for the nine months ended September 30, 2021 and 2020 is as follows:\\n\\n| Nine months ended September 30, |\\n| 2021 | 2020 |\\n| Income before income taxes | $ | 17,716 | $ | ( 182,363 | ) |\\n| Statutory income tax rate | 25 | % | 15 | % |\\n| Income tax expense at statutory rate | 4,429 | ( 27,354 | ) |\\n| Tax effect of allowance | 5,514 | 42,423 |\\n| Income tax expense | $ | 9,943 | $ | 15,069 |\\n\\n\\n| 36 |\\n\\nAs of September 30, 2021, the operation in the India incurred $ 17,716 of net operating gain. The Company has provided for a full tax effect allowance against the current and deferred tax expenses of $ 9,943 .\\nThe following table sets forth the significant components of the deferred tax assets and liabilities of the Company as of September 30, 2021 and December 31, 2020:\\n\\n| Schedule of Deferred Tax Assets and Liabilities |\\n| September 30, 2021 | December 31, 2020 |\\n| (Unaudited) |\\n| Deferred tax assets: |\\n| Net operating loss carryforwards |\\n| - United States | $ | 5,269,929 | $ | 2,171,941 |\\n| - Singapore | 230,027 | 131,985 |\\n| - Vietnam | 171,855 | 81,774 |\\n| - India | — | — |\\n| 5,671,811 | 2,385,700 |\\n| Less: valuation allowance | ( 5,671,811 | ) | ( 2,385,700 | ) |\\n| Deferred tax assets, net | $ | — | $ | — |\\n\\nNOTE－ 15 PENSION COSTS\\nThe Company is required to make contribution to their employees under a government-mandated defined contribution pension scheme for its eligible full-times employees in all countries operating in the Company. The Company is required to contribute a specified percentage of the participants’ relevant income based on their ages and wages level. During the nine months ended September 30, 2021 and 2020, $ 9,655 and $ 5,199 contributions were made accordingly. During the three months ended September 30, 2021 and 2020, $ 5,669 and $ 3,463 contributions were made accordingly.\\nNOTE－ 16 RELATED PARTY TRANSACTIONS\\nFrom time to time, the shareholder and director of the Company advanced funds to the Company for working capital purpose. Those advances are unsecured, non-interest bearing and due on demand.\\nDuring the three month ended September 30, 2021 and 2020, the Company rendered the consultancy service with related parties for the issuance of 2,854 and 571 shares of Series C-1 preferred stock, at the price of $ 1,198,680 and $ 239,820 , respectively.\\nDuring the nine month ended September 30, 2021 and 2020, the Company rendered the consultancy service with related parties for the issuance of 4,314 and 571 shares of Series C-1 preferred stock, at the price of $ 1,811,880 and $ 239,820 , respectively.\\nThe Company paid and accrued to the directors, the total salaries of $ 196,108 and $ 22,529 and 201,588 and $ 0 during the three months ended September 30, 2021 and 2020, respectively.\\nThe Company paid and accrued to the directors, the total salaries of $ 611,193 and $ 22,529 and $ 604,378 and $ 0 during the nine months ended September 30, 2021 and 2020, respectively.\\n\\n| 37 |\\n\\nDuring the three months ended September 30, 2021 and 2020, the Company issued 2,134,042 and 3000 shares of Common stock, at the price of $12,570,943 and $ 810,000 for the stock based compensation to director and employee, respectively.\\nDuring the nine months ended September 30, 2021 and 2020, the Company issued 2,134,042 and 3000 shares of Common stock, at the price of $ 12,570,943 and 810,000 for the stock based compensation to director and employee, respectively.\\nThe company subsidiaries paid and accrued their two officers, total professional fee of $ 5,785 and $ 1,259 and $ 8,310 and $ 1,300 during the three months ended September 30, 2021 and 2020, respectively.\\nThe company subsidiaries paid and accrued their two officers, total professional fee of $ 10,307 and $ 1,259 and $ 35,898 and $ 1,300 during the nine months ended September 30, 2021 and 2020, respectively.\\nThe Company paid and accrued its shareholders, total professional fee of $ 151,342 and $ 102,412 and $ 31,341 and $ 21,000 during the three months ended September 30, 2021 and 2020, respectively.\\nThe Company paid and accrued its shareholders, total professional fee of $ 378,785 and $ 123,412 and $ 102,979 and $ 56,0000 during the nine months ended September 30, 2021 and 2020, respectively.\\nDuring August and September 2021, the Company issued 3,300 shares of its Series X Super Voting Preferred Stock (the “Super Voting Preferred Stock”) to the founder and Chief Executive Officer, Mr. Dennis Nguyen and 200 shares of the Super Voting Preferred Stock to Chief Financial Officer, Mr. Raynauld Liang.\\nIn August 2021, the Company approved the conversion of Inter-Company loan of $1,249,999 due and owing by Sopa Technology PTE. LTD. (“STPL”), by exchange of 8,500 shares of STPL which represents 85% of the total issued and paid-up capital of STPL on a fully diluted basis.\\nOn September 30, 2021, the Company received the notifications that the outstanding amounts of $ 72,176 and $ 738,964 were forgiven by the related parties. Also, the Company served the notification to a related party that certain terms under call option agreement and side letter were no longer effective, in case of non-fulfillment with the milestone conditions as set out in the agreements amounts of $ 75,000 cash consideration and $ 558,000 equity incentive.\\nAs of June 30, 2021, Mr. Nguyen had $ 960,833 in accrued, but unpaid compensation which could be converted to shares by dividing that amount by the employment agreement conversion price of $ 0.83 to produce 1,157,630 shares.\\nHOTTAB Asset Vietnam Co Ltd, a company limited by shares incorporated under the laws of Vietnam on July 25, 2019, is currently wholly-owned by Ngo Cham, an employee of HOTTAB Vietnam Co Ltd. HOTTAB Asset Vietnam Co Ltd manages the Group’s website and apps in Vietnam via a contractual relationship. All profits accrued by HOTTAB Asset Vietnam Co Ltd are paid as management fees to HOTTAB Vietnam Co Ltd. HOTTAB Vietnam Co Ltd has an irrevocable call option to acquire 100% of the equity of HOTTAB Asset Vietnam Co Ltd.\\nApart from the transactions and balances detailed elsewhere in these accompanying condensed consolidated financial statements, the Company has no other significant or material related party transactions during the periods presented.\\nNOTE－17 CONCENTRATIONS OF RISK\\nThe Company is exposed to the following concentrations of risk:\\n(a) Major customers\\nFor the nine months ended September 30, 2021 and 2020, the customers who accounted for 10% or more of the Company’s revenues and its outstanding receivable balances at year-end dates, are presented as follows:\\n\\n| Schedule of concentrations of risk |\\n| Nine months ended September 30, 2021 | September 30, 2021 |\\n| Customer | Revenues | Percentage of revenues | Accounts receivable |\\n| Customer A | $ | 24,813 | 25 | % | $ | 19,308 |\\n| Customer B | $ | 12,615 | 13 | % | $ | — |\\n| Customer C | $ | 58,300 | 58 | % | $ | 68,285 | * |\\n\\n\\n| * | - This included value added taxes (“VAT”) |\\n\\n\\n| 38 |\\n\\n\\n| Nine months ended September 30, 2020 | September 30, 2020 |\\n| Customer | Revenues | Percentage of revenues | Accounts receivable |\\n| Customer A | $ | 31,604 | 76 | % | $ | — |\\n\\nFor the three months ended September 30, 2021 and 2020, the customers who accounted for 10% or more of the Company’s revenues and its outstanding receivable balances at year-end dates, are presented as follows:\\n\\n| Three months ended September 30, 2021 |\\n| Customer | Revenues | Percentage of revenues |\\n| Customer A | $ | 10,016 | 12 | % |\\n| Customer B | $ | 12,615 | 13 | % |\\n| Customer C | $ | 58,300 | 58 | % |\\n\\n\\n| Three months ended September 30, 2020 |\\n| Customer | Revenues | Percentage of revenues |\\n| Customer A | $ | 9,789 | 84 | % |\\n\\nAll customers are located in Vietnam except one located in Indonesia.\\n(b) Major vendors\\nFor the nine months ended September 30, 2021 and 2020, the vendors who accounts for 10% or more of the Company’s hardware purchases and software cost its outstanding payable balances as at year-end dates, are presented as follows:\\n\\n| Nine months ended September 30, 2021 | September 30, 2021 |\\n| Vendors | Purchases | Percentage of purchases | Accounts payable |\\n| Vendor A | $ | 30,577 | 27 % | $ | 44,867 |\\n| Vendor B | $ | 17,827 | 16 % |\\n\\n\\n| Nine months ended September 30, 2020 | September 30, 2020 |\\n| Vendors | Purchases | Percentage of purchases | Accounts payable |\\n| Vendor A | $ | 46,863 | 72 % | $ | — |\\n| Vendor B | — | — | — |\\n\\n\\n| 39 |\\n\\nFor the three months ended September 30, 2021 and 2020, the vendors who accounts for 10% or more of the Company’s hardware purchases and software cost its outstanding payable balances as at year-end dates, are presented as follows:\\n\\n| Three months ended September 30, 2021 |\\n| Purchases | Percentage of purchases |\\n| Vendors |\\n| Vendor A | $ | — | — |\\n\\n\\n| Three months ended September 30, 2020 |\\n| Vendors | Purchases | Percentage of purchases |\\n| Vendor A | $ | 24,401 | 90 % |\\n| Vendor B | — | — |\\n\\nAll vendors are located in Vietnam.\\n(c) Credit risk\\nFinancial instruments that are potentially subject to credit risk consist principally of trade receivables. The Company believes the concentration of credit risk in its trade receivables is substantially mitigated by its ongoing credit evaluation process and relatively short collection terms. The Company does not generally require collateral from customers. The Company evaluates the need for an allowance for doubtful accounts based upon factors surrounding the credit risk of specific customers, historical trends and other information.\\n(d) Exchange rate risk\\nThe reporting currency of the Company is US$, to date the majority of the revenues and costs are denominated in VND, SGD and INR and a significant portion of the assets and liabilities are denominated in VND, SGD and INR. As a result, the Company is exposed to foreign exchange risk as its revenues and results of operations may be affected by fluctuations in the exchange rate between US$ and VND, SGD and INR. If VND, SGD and INR depreciates against US$, the value of VND, SGD and INR revenues and assets as expressed in US$ financial statements will decline. The Company does not hold any derivative or other financial instruments that expose to substantial market risk.\\n(e) Economic and political risks\\nThe Company's operations are conducted in the Republic of Vietnam. Accordingly, the Company's business, financial condition and results of operations may be influenced by the political, economic and legal environment in the Vietnam, and by the general state of the Vietnam economy.\\nThe Company's operations in the Vietnam and India are subject to special considerations and significant risks not typically associated with companies in North America and Western Europe. These include risks associated with, among others, the political, economic and legal environment and foreign currency exchange. The Company's results may be adversely affected by changes in the political and social conditions in the Vietnam and India, and by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion, remittances abroad, and rates and methods of taxation.\\nNOTE－18 COMMITMENTS AND CONTINGENCIES\\nAs of September 30, 2021, the Company has no material commitments or contingencies.\\nRight issues under Series C-1 preferred stock\\nThe Company has issued warrant pursuant to the Series C-1 Subscription Agreement. Each redeemable warrant entitles the holder to purchase two (2) common shares at a price of $168 per share. The warrants shall be exercisable on or before December 31, 2020 and June 30, 2021, respectively. On April 19, 2021, the Company extended the termination date of the Warrant issued to Preferred series C-1 holder by six months from the expiration date of June 30, 2021 to December 31, 2021. The Company considers this warrant as permanent equity per ASC 815-40-35-2. As such, there is no value assigned to this extension.\\n\\n| 40 |\\n\\nFinancing arrangement (due to a shareholder)\\nIn February 2018, the Company entered into MOU with Connect Investment Pte Ltd (Enter Asia) for capital alliance for approximately 27% of shareholdings in the Company. Further, in August 2018, the said MOU was modified and shareholding was revised from 27% to 10% in the Company. However, subsequently in October 2020, it was agreed between both the parties to cease the said MOU with the understanding that there is no current and future obligation with either of them i.e. neither EnterAsia to make investment in the Company nor the Company to issue shares to EnterAsia. Further, the EnterAsia is going to get the shares of the Hottab Holdings Ltd (HHL) for the amount so far invested in the Company and therefore the amount due to EnterAsia is reclassified into the amount due to shareholder “Hottab Holdings Ltd”.\\nSOSV\\nIn January 2019, the HPL entered into stock purchase agreement and accelerator contract for equity (ACE) with SOSV IV LLC (SOSV) whereby the HPL will issue shares representing 5% of their capital stock for the amounts of $ 168,000 in three tranche (a) SOSV to pay to the HPL $ 75,000 for integration of Mobile Only Accelerator (MOX) software development kit, (b) SOSV to pay on behalf of the HPL $ 48,000 upon MOX successful application and setting up subsidiary, and (c) SOSV to pay on behalf of the HPL $ 45,000 for setting program for services. The Company received first tranche of $ 75,000 only and thereafter no other two tranche received by the HPL, however, the outcome of the deal did not results success and so later the HPL have not issued any shares to the SOSV, therefore the arrangement amount of $ 75,000 accounted as loan from SOSV. On February 2, 2021, the Company sent the legal letter to the SOSV intimating that the Company acquired HPL by issuing 117,000 preferred stock series C to Hottab Holding Limited for the 100 % acquisition of HPL. As of September 30, 2021 and December 31, 2020, the Company had a total of $ 75,000 and $ 75,000 , outstanding on this account, respectively. (see below for legal update)\\nService contracts\\nThe Company carries various service contracts on its vendors for repairs, maintenance and inspections. All contracts are short term and can be cancelled.\\nMaterial contracts\\nOn 28 May 2021, the Company entered into a business cooperation agreement with Paytech Company Limited (“Strategic Partners”) to provide payment integration and loyalty services to the platform that allows merchants to process transactions with consumers. As of date, this program have not started and expected to commence in next year 2022.\\nOn 15 August 2021, the Company entered into a business cooperation agreement with Rainbow Loyalty Company Limited (“Strategic Partners”) to provide loyalty services for merchants on the platform. As of date, this program have not started and expected to commence in next year 2022.\\nExecutive service agreements\\nOn April 1, 2017 the Company entered into an at-will Employment Agreement with Dennis Nguyen, its Chairman and Chief Executive Officer. The Employment Agreement provides for a monthly salary of $ 40,000 ; provided that until the Company has adequate reserves to pay Mr. Nguyen’s salary, he may convert any unpaid salary into common stock of the Company at a share price equal to $ 250 per share. Mr. Nguyen is also entitled to an annual cash bonus of $ 250,000 ; provided that until the Company has adequate reserves to pay Mr. Nguyen’s annual bonus, he may convert any unpaid bonus into common stock of the Company as described above. This provision was inserted into the employment agreement to compensate Mr. Nguyen in stock, at his option, and was to remain operable only until the Company has sufficient cash to pay him his salary in cash. From July 2021 until now, the Company’s cash balance has been at least $ 4 million and the Company has paid Mr. Nguyen his salary in full in every month from July 2021 until now. As a result of these facts, the conversion feature in Mr. Nguyen’s contract became inoperable as of July 1, 2021 and Mr. Nguyen no longer has the option to convert unpaid salary into the Company’s shares. On October 25, 2021, the Company has also amended Mr. Nguyen’s contract to delete the conversion feature to make clear the conversion feature will not be operable in the future. Therefore, the Company will not accrue any expense. Mr. Nguyen is also entitled to participate in all of the other benefits of the Company which are generally available to office employees and other employees of the Company. Mr. Nguyen is not entitled to any severance pay.\\nOn September 1, 2021 the Company entered into a 5-year Employment Agreement with Raynauld Liang, its Chief Financial Officer and Singapore Country General Manager. The employment agreement provides Mr. Liang with compensation of (i) an annual base salary of $ 240,000 ; (ii) an annual discretionary incentive cash bonus with a minimum target of 25% of base salary; (iii) 814,950 shares of the Company’s common stock (taking into account the Company’s stock split 1:750 and reverse stock split 1:2.5), of which 651,960 shares are subject to vesting over a two-year period; and (iv) all other executive benefits sponsored by the Company. If a change of control of the Company occurs and if at the time of such change of control the Company’s common stock is trading at a price that is double the initial public offering price, then Mr. Liang will be entitled to a cash bonus equal to three (3) times his base salary. If Mr. Liang is terminated other than for cause or resigns for good reason, he will be entitled to receive continued base salary until the earlier of (x) the anniversary date of such termination and (y) the end of the 5-year term of the employment agreement; provided, however, if the termination is after September 1, 2022, then the period set forth in clause (x) shall be 18 months from the date of the employment agreement. Mr. Liang may terminate the employment agreement at any time other than for good reason with 30 days’ notice to the Company.\\n\\n| 41 |\\n\\nLitigation\\nFrom time to time, the Company may become involved in various lawsuits and legal proceedings, which arise, in the ordinary course of business. However, litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm the Company’s business. The Company is not aware of any such legal proceedings that will have, individually or in the aggregate, a material adverse effect on its business, financial condition or operating results.\\nTwo cases are employment actions filed by former employees who seek compensation alleged to be due pursuant to agreements with the Company. Both of the employees are represented by the same counsel and filed their cases in the Supreme Court of the State of New York, County of New York, in December 2019.\\nIn one of those actions, a former employee claims entitlement to compensation and a bonus totaling $566,000 and 39,000-58,500 shares of Company common stock, together with costs. The Company responded to the complaint and also asserted counterclaims in the proceeding for $1,500,000 to $4,000,000 plus punitive damages, together with interest and costs, arising from, inter alia, the former employee’s breach of contract, unfair competition, misappropriation of trade secrets and breach of fiduciary duty. The former employee has responded to the Company’s counterclaims and this action is in the discovery phase of the litigation.\\nIn the other employment action, another former employee claims entitlement to salary payments and expense reimbursement in the amount of $ 122,042 .60, plus liquidated damages, together with costs. This former employee also claims entitlement to 516,300 to 760,800 shares of the Company’s common stock. In addition, this action also includes claims by a plaintiff-entity alleging entitlement to $8 million in shares of the Company’s Series A Preferred stock. The Company responded to the complaint and also asserted counterclaims against the former employee in the proceeding for $1,500,000 to $2,000,000 plus punitive damages, together with costs, arising from, inter alia, the former employee’s breach of contract, breach of fiduciary duty, tortious interference and fraud. The former employee has responded to the Company’s counterclaims and this action is still in the discovery phase of litigation.\\nThe third case also involves one of those former employees; therein, a Company affiliate filed suit in February 2020 seeking enforcement, by way of specific performance, of an agreement which entitles the affiliate to purchase all of the 99 percent of the shares of the plaintiff-entity which alleges entitlement to $8 million in shares of the Company’s Series A Preferred Stock in one of the employment actions described above. The former employee has responded to the Company’s complaint in this action with a motion to dismiss, which was later withdrawn by same, and then by way of an answer without counterclaims. The judge assigned to this action has announced his retirement and the case has not yet been reassigned.\\nThe Company was in an AAA arbitration defending allegations of breach of an agreement. The Demand for Arbitration therein, dated August 25, 2020, asserted that the Petitioner, an LLC, had an agreement with the Company and its CEO granting the Petitioner the right to require the Company to redeem certain common stock in the Company for a cash payment.\\nThe Demand alleged that the Petitioner submitted a Redemption Notice, as required under the alleged agreement, obligating the Company to redeem the shares. The Demand alleged that the failure of the Company to redeem the shares and pay Petitioner further obligated the Company to provide additional common stock to the Petitioner. The amount alleged to be due to the Petitioner as of July 31, 2020 was said to be $590,461.94 and growing daily while the number of additional common stock shares alleged to be due to Petitioner as of July 31, 2020 was said to be 708,542,582 and growing, daily.\\nIn order to avoid an adverse award, the Company agreed to settle the matter for the sum of $550,000. No additional shares were included in the settlement agreement. The settlement sum was required to be paid in two tranches, with $250,000 to have been paid on or before May 28, 2021 and the remaining $300,000 to be paid on or before June 30, 2021. The Company made the required settlement payments and the matter is now considered closed.\\n\\n| 42 |\\n\\nOn or about March 5, 2021, SOSV IV LLC (“SOSV”) sent a demand letter to the Company in regard to its investment in Hottab Pte. Ltd. (“Hottab”).\\nIn this letter, and the subsequently filed lawsuits, SOSV alleges that it entered into an investment arrangement with Hottab in which SOSV was to receive five percent (5%) of the common stock of Hottab and entered into an Accelerator Contract for Equity (the “ACE”) pursuant to which it alleges to have invested a sum of $168,000 with Hottab. These events are alleged to have taken place prior to the Company’s acquisition of Hottab. SOSV alleges that the Company subsequently acquired all of the outstanding shares of Hottab, which it alleges triggered a liquidity event clause under the ACE requiring the Company, by way of its ownership of Hottab, to pay SOSV twice its investment, or $336,000.\\nSOSV further alleges that subsequent to a term sheet between the Company and Hottab being executed, the Company entered into an agreement to purchase one hundred percent (100%) of the issued and outstanding shares of Hottab from Hottab Holdings Limited (“Hottab Holdings”). As SOSV does not have any interest in Hottab Holdings, it did not receive any consideration as allegedly provided under the ACE.\\nUpon these allegations, SOSV asserts causes of action sounding in fraudulent misrepresentation/concealment, breach of contract, breach of the covenant of good faith and fair dealing, quantum meruit and/or unjust enrichment, promissory estoppel, oppression of minority shareholder, and breach of fiduciary duties. SOSV seeks damages in the amount of $336,000.00 in addition damages equal to the value of SOSV’s alleged equity in Hottab or in the alternative shares of the Company in an amount equal to SOSV’s ownership interest in Hottab at the time of the purchase of Hottab’s shares from Hottab Holdings.\\nInitially, SOSV filed suit in the District Court for New Jersey on June 10, 2021. SOSV voluntarily dismissed its New Jersey lawsuit and on October 29, 2021, re-filed the action in the Southern District of New York. The New York lawsuit was also voluntarily dismissed by SOSV. However, SOSV may choose to re-file its lawsuit.\\nThe Company denies the accusations of SOSV and intends to vigorously defend this matter if the action is re-filed. As the lawsuit has been voluntarily dismissed, there have been no proceedings and we are unable to prognosticate a likelihood of success, or whether SOSV will re-file the action.\\nAs of September 30, 2021 and December 31, 2020, the Company had a total of $75,000 and $75,000 outstanding on this account, respectively.\\nAs of September 30, 2021, the Company expects no possible loss from these legal proceedings and no provision is accrued accordingly.\\n\\n| 43 |\\n\\nNOTE－19 SEGMENT REPORTING\\nWe have two reportable segments: (i) e-commerce and (ii) Merchant POS. The e-commerce segment includes the operations of Sopa Technology Company Ltd. Additionally, the Merchant POS segment comprises the operations of Hottab group and SOPA entities except SOPA Technology Company Ltd. Lastly, reported under Merchant POS included acquired operating segment, Hottab group and all SOPA entities except SOPA Technology Company Ltd . Merchant POS includes Hardware sales, subscription sales and e-Commerce includes online ordering such as Fashion & Accessories, Beauty & Personal Care, and Home & Lifestyle.\\nOur Chief Operating Decision Maker (CODM) evaluate operating segments using the following table presents revenues and gross profits by reportable segment and asset except liability information.\\n| Schedule of Segment Reporting |\\n| Nine Months Ended September 30, 2021 |\\n| e-Commerce | Merchant POS | Total |\\n| Revenue |\\n| Hardware sales | $ | — | $ | 335 | $ | 335 |\\n| Software subscription | — | 26,970 | 26,970 |\\n| Sales – online ordering | 73,518 | — | 73,518 |\\n| Total revenue | 73,518 | 27,305 | 100,823 |\\n| Cost of sales: |\\n| Hardware sales | — | ( 165 | ) | ( 165 | ) |\\n| Software subscription | ( 166,761 | ) | ( 39,626 | ) | ( 206,387 | ) |\\n| Cost of online ordering | ( 57,741 | ) | — | ( 57,741 | ) |\\n| Total cost of revenue | ( 224,502 | ) | ( 39,791 | ) | ( 264,293 | ) |\\n| Operating Expenses |\\n| Sales and marketing expenses | ( 78,808 | ) | ( 6,219 | ) | ( 85,027 | ) |\\n| Software development costs | — | ( 76,698 | ) | ( 76,698 | ) |\\n| Impairment loss | ( 200,000 | ) | — | ( 200,000 | ) |\\n| General and administrative expenses | ( 73,285 | ) | ( 14,341,077 | ) | ( 14,414,362 | ) |\\n| Total operating expenses | ( 352,093 | ) | ( 14,423,994 | ) | ( 14,776,087 | ) |\\n| Loss from operations | ( 503,077 | ) | ( 14,436,180 | ) | ( 14,939,557 | ) |\\n\\n\\n| Three Months Ended September 30, 2021 |\\n| e-Commerce | Merchant POS | Total |\\n| Revenue |\\n| Hardware sales | $ | — | $ | — | $ | — |\\n| Software subscription | — | 10,016 | 10,016 |\\n| Sales – online ordering | 73,518 | — | 73,518 |\\n| Total revenue | 73,518 | 10,016 | 83,534 |\\n| Cost of sales: |\\n| Hardware sales | — | — | — |\\n| Software subscription | ( 80,557 | ) | ( 21,138 | ) | ( 101,695 | ) |\\n| Cost of online ordering | ( 57,741 | ) | — | ( 57,741 | ) |\\n| Total cost of revenue | ( 138,298 | ) | ( 21,138 | ) | ( 159,436 | ) |\\n| Operating Expenses |\\n| Sales and marketing expenses | ( 40,744 | ) | ( 2,099 | ) | ( 42,843 | ) |\\n| Software development costs | — | ( 9,709 | ) | ( 9,709 | ) |\\n| Impairment loss | — | — | — |\\n| General and administrative expenses | ( 48,658 | ) | ( 8,243,805 | ) | ( 8,292,463 | ) |\\n| Total operating expenses | ( 89,402 | ) | ( 8,255,613 | ) | ( 8,345,015 | ) |\\n| Loss from operations | ( 154,182 | ) | ( 8,266,735 | ) | ( 8,420,917 | ) |\\n\\n| 44 |\\n\\n\\n| September 30, 2021 |\\n| e-Commerce | Merchant POS | Total |\\n| Identifiable assets | $ | 147,950 | $ | 11,170,288 | $ | 11,318,238 |\\n\\n\\n| December 31, 2020 |\\n| e-Commerce | Merchant POS | Total |\\n| Identifiable assets | $ | — | $ | 7,866,273 | $ | 7,866,273 |\\n\\n\\n| Nine Months Ended September 30, 2020 |\\n| e-Commerce | Merchant POS | Total |\\n| Revenue |\\n| Hardware sales | $ | — | $ | 3,510 | $ | 3,510 |\\n| Software subscription | — | 37,752 | 37,752 |\\n| Sales – online ordering | — | — | — |\\n| Total revenue | — | 41,262 | 41,262 |\\n| Cost of sales: |\\n| Hardware sales | — | ( 2,982 | ) | ( 2,982 | ) |\\n| Software subscription | — | ( 56,127 | ) | ( 56,127 | ) |\\n| Cost of online ordering | — | — | — |\\n| Total cost of revenue | — | ( 59,109 | ) | ( 59,109 | ) |\\n| Operating Expenses |\\n| Sales and marketing expenses | — | ( 3,125 | ) | ( 3,125 | ) |\\n| Software development costs | — | ( 139,151 | ) | ( 139,151 | ) |\\n| Impairment loss | — | ( 8,778 | ) | ( 8,778 | ) |\\n| General and administrative expenses | — | ( 2,311,266 | ) | ( 2,311,266 | ) |\\n| Total operating expenses | — | ( 2,462,320 | ) | ( 2,462,320 | ) |\\n| Loss from operations | — | ( 2,480,167 | ) | ( 2,480,167 | ) |\\n\\n\\n| Three Months Ended September 30, 2020 |\\n| e-Commerce | Merchant POS | Total |\\n| Revenue |\\n| Hardware sales | $ | — | $ | 585 | $ | 585 |\\n| Software subscription | — | 11,044 | 11,044 |\\n| Sales – online ordering | — | — | — |\\n| Total revenue | — | 11,629 | 11,629 |\\n| Cost of sales: |\\n| Hardware sales | — | ( 585 | ) | ( 585 | ) |\\n| Software subscription | — | ( 19,731 | ) | ( 19,731 | ) |\\n| Cost of online ordering | — | — | — |\\n| Total cost of revenue | — | ( 20,316 | ) | ( 20,316 | ) |\\n| Operating Expenses |\\n| Sales and marketing expenses | — | — | — |\\n| Software development costs | — | ( 33,658 | ) | ( 33,658 | ) |\\n| Impairment loss | — | 4,164 | 4,164 |\\n| General and administrative expenses | — | ( 1,580,287 | ) | ( 1,580,287 | ) |\\n| Total operating expenses | — | ( 1,609,781 | ) | ( 1,609,781 | ) |\\n| Loss from operations | — | ( 1,618,468 | ) | ( 1,618,468 | ) |\\n\\n\\n| 45 |\\n\\nNOTE－20 SUBSEQUENT EVENTS\\nIn accordance with ASC Topic 855, “Subsequent Events”, which establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued, the Company has evaluated all events or transactions that occurred after September 30, 2021, up through the date the Company issued the unaudited condensed consolidated financial statements.\\nOn November 8, 2021, the Company entered into an underwriting agreement (the “Underwriting Agreement”) with Maxim Group LLC, acting as representative to the underwriters (the “Representative”), related to the initial public offering of 2,888,889 shares of the Company’s common stock, par value $ 0.0001 per share (the “Firm Shares”), at a public offering price of $ 9.00 per share. Under the terms of the Underwriting Agreement, the Company has granted the Underwriters an option, exercisable for 45 days, to purchase up to an additional 433,334 shares of common stock (the “Option Shares”) at a public offering price of $ 9.00 , less discounts and commissions, to cover over-allotments, if any. The Company’s common stock was listed on the Nasdaq Capital Market on November 9, 2021 and began trading on such date. The closings (the “IPO Closings”) of the offering and sale of the Firm Shares and the sale of 236,111 Option Shares occurred on November 12, 2021. Aggregate gross proceeds from the closings related to the Firm Shares and the Option Shares was $ 26,000,001 and $ 2,124,999 , respectively.\\nOn December 1, 2021, Leflair Incorporated under the laws of the State of Navada and subsequently share issued to the Company on December 7, 2021 as wholly-owned subsidiary.\\nOn December 6, 2021, the Company entered into two consulting agreements with China-America Culture Media Inc. and New Continental Technology Inc., acting as Consultanct to assist the Company in completing certain Business Opportunities with potential partners until February 28, 2023. The consideration of the service are $ 3,250,000 and $ 3,190,000 .\\nUpon the IPO Closings, all outstanding shares of preferred stock series A, B, B-1, C and C-1 automatically converted into 888,889 shares, 764,400 shares, 48,000 shares, 465,600 shares and 4,195,200 shares of the Company’s common stock, respectively.\\n\\n| 46 |\\n\\n\\nItem 2. Management’s discussion and analysis of financial condition and results of operations.\\nThe following discussion summarizes the significant factors affecting the operating results, financial condition, liquidity, and cash flows of our Company as of and for the periods presented below. The following discussion and analysis should be read in conjunction with “Selected Consolidated Financial Data,” the condensed consolidated financial statements and the related notes thereto, and the consolidated financial statements and the related notes thereto all included elsewhere in this report. The statements in this discussion regarding industry outlook, our expectations regarding our future performance, liquidity, and capital resources, and all other non-historical statements in this discussion are forward-looking statements and are based on the beliefs of our management, as well as assumptions made by, and information currently available to, our management. Actual results could differ materially from those discussed in or implied by forward-looking statements as a result of various factors, including those discussed in the Company’s final prospectus for its initial public offering on file with the Secuties and Exchange Commision (the “SEC”), particularly in the sections entitled “Special Note Regarding Forward-Looking Statements” and “Risk Factors.”\\nOverview\\nWe acquire and operate e-commerce platforms through our direct and indirect wholly-owned subsidiaries, including but not limited to Society Technology LLC, SoPa Technology Pte Ltd, SoPa Cognitive Analytics Pte Ltd, Sopa Technology Co Ltd, HOTTAB Pte Ltd and HOTTAB Vietnam Co Ltd. Along with HOTTAB Asset Vietnam Co Ltd (currently wholly-owned by one employee of HOTTAB Vietnam Co Ltd and contractually operated by HOTTAB Vietnam Co Ltd), these eight companies form the Society Pass Group (the “Group”). The Group currently markets to both consumers and merchants in Vietnam while maintaining an administrative headquarters in Singapore. In Feb 2021,we have acquired an online lifestyle platform of Leflair branded assets (the “Leflair Assets”) as more fully described in “Business – Leflair” and are in the process of integrating the Leflair assets with the SoPa and #HOTTAB platform. On 9 November 2021, the Group have been approved for listing on Nasdaq Capital Market (“Nasdaq”) and will trade under the ticker symbol “SOPA”. The Group is a leading Southeast Asian data-driven loyalty platform with its initial offering of 2,888,889 shares of common stock at a price of US$9.00 per share. After the completion of our initial public offering (“IPO”), we intend to expand our e-commerce ecosystem throughout the rest of SEA and South Asia with particular focuses on Philippines, India and Bangladesh.\\nOur ecosystem currently comprises of seven e-commerce interfaces targeting consumers and merchants: SoPa food & beverage (“F&B”) App, SoPa.asia F&B Marketplace website, #HOTTAB Biz App, #HOTTAB POS App, Hottab.net admin website, Leflair App, and Leflair Lifetyle Marketplace website (the “Platform”). Our loyalty-focused and data-driven e-commerce marketing platform interfaces connect consumers with merchants in the F&B and lifestyle sectors, assisting local brick-and-mortar businesses to access new customers and markets to thrive in an increasingly convenience-driven economy. Our Platform integrates with both global and country-specific search engines and applications and accepts international address and phone number data, providing a consumer experience that respects local languages, address formats and customs. Our strategic partners work with us to penetrate local markets, while our Platform allows effortless integration with existing technological applications and websites.\\nOur consumer facing business consists of our “SoPa” and “Leflair” brands. Through our SoPa F&B App, and SoPa.asia F&B Marketplace website, we provide frictionless online ordering and delivery experience for consumers in the F&B sector. Our Leflair lifestyle e-commerce platform markets and sells products in three verticals: Fashion & Accessories, Beauty & Personal Care, and Home & Lifestyle. Our consumer facing platforms feature an easy-to-navigate, multi-lingual user interface with multiple integrated payment and delivery options\\nBranded as “#HOTTAB”, our merchant facing business helps merchants increase revenues and streamline costs with an online and multilingual store front, fully integrated POS software solution, joint marketing program, payment infrastructure, loyalty administration, customer profile analytics, and SME financing packages. Through #HOTTAB Biz App, #HOTTAB POS and Hottab.net merchant administration website interfaces, #HOTTAB functions both online and offline and facilitates transactions, orders, voucher redemption, and rewards. Merchants only need a smart device in order to quickly access our #HOTTAB product ecosystem. In addition, our Customer Care department provides attentive after-sales service.\\n\\n| 47 |\\n\\nUpon the expected launch of Society Points in the second half of 2021, consumers will be able to use our Society Points at merchant locations initially throughout Vietnam and then we expect to expand availability of Society Points throughout SEA and South Asia See “Business —Loyalty Points —Society Points.”\\nAs of December 6, 2021 we have onboarded over 1.5 million registered consumers and over 5,500 registered merchants on our Platform.\\nImpact of the COVID-19 Pandemic\\nThe current outbreak of COVID-19 has globally resulted in loss of life, business shutdowns, restrictions on travel, and widespread cancellation of social gatherings. The extent to which the COVID-19 pandemic impacts our business will depend on future developments, which are highly uncertain and cannot be predicted at this time, including:\\n\\n| • | new information which may emerge concerning the severity of the disease in Vietnam and SEA; |\\n\\n| • | the duration and spread of the outbreak; |\\n\\n| • | the severity of travel restrictions imposed by geographic areas in which we operate, mandatory or voluntary business closures; |\\n\\n| • | regulatory actions taken in response to the pandemic, which may impact merchant operations, consumer and merchant pricing, and our product offerings; |\\n\\n| • | other business disruptions that affect our workforce; |\\n\\n| • | the impact on capital and financial markets; and |\\n\\n| • | action taken throughout the world, including in markets in which we operate, to contain the COVID-19 outbreak or treat its impact. |\\n\\nIn addition, the current outbreak of COVID-19 has resulted in a widespread global health crisis and adversely affected global economies and financial markets, and similar public health threats could do so in the future. Such events have impacted, and could in the future impact, demand for merchants and consumer purchase patterns, which in turn, could adversely affect our revenue and results of operations.\\nSince the onset of the COVID-19 pandemic in March and April 2020, all our POS merchant clients are affected by COVID-19 measures for F&B to temporary stop restaurant dine ins.\\n\\n| • | Some of our restaurant clients ceased operations permanently and many were closed since June 2020 without any notice of reopening their business to date. |\\n\\n| • | Our largest POS client, a hotel chain for which we provide POS services to their F&B business in their hotels, ceased operations in two out of nine hotels since April 2020. |\\n\\n| • | The Company faces challenges to onboard new clients but at the same time losing many existing ones. |\\n\\nWith the ongoing pandemic, Company faces challenges in our operation as follows;\\n\\n| • | Disruption of operation in Vietnam, India, Singapore and US where staffs have to work from home. |\\n\\n| • | The coordination of rebooting of company’s recent asset acquisition of Leflair an ecommerce platform. |\\n\\n| • | Application of licenses are delayed as government agencies take longer time to review and process time. |\\n\\n| • | HR process to hire personnel are generally slow due to people not willing to leave their current job, company have to spend more time and resources. |\\n\\n\\n| 48 |\\n\\nThe spread of COVID-19 has caused us to modify our business practices, including employee travel, employee work locations in certain cases, and cancellation of physical participation in certain meetings, events and conferences and further actions may be taken as required or recommended by government authorities or as we determine are in the best interests of our employees, customers, and other business partners. We are monitoring the global outbreak of the pandemic, in SEA, especially Vietnam and are taking steps in an effort to identify and mitigate the adverse impacts on, and risks to, our business posed by its spread and the governmental and community reactions thereto. See “Risk Factors--Our business may be materially adversely affected by the recent coronavirus (COVID-19) outbreak.\\nFinancial Condition\\nResults of Operations\\nThe following table sets forth certain operational data for the three and nine months ended September 30, 2021 and 2020:\\n\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Revenue,net | 83,534 | 11,629 | 100,823 | 41,262 |\\n| Cost of revenue | (159,436 | ) | (20,316 | ) | (264,293 | ) | (59,109 | ) |\\n| Gross loss | (75,902 | ) | (8,687 | ) | (163,470 | ) | (17,847 | ) |\\n| Less operating expenses: |\\n| Sales and marketing expenses | (42,843 | ) | — | (85,027 | ) | (3,125 | ) |\\n| Software development costs | (9,709 | ) | (33,658 | ) | (76,698 | ) | (139,151 | ) |\\n| Impairment loss | — | 4,164 | (200,000 | ) | (8,778 | ) |\\n| General and administrative expenses | (8,292,463 | ) | (1,580,287 | ) | (14,414,362 | ) | (2,311,266 | ) |\\n| Total operating expenses | (8,345,015 | ) | (1,609,781 | ) | (14,776,087 | ) | (2,462,320 | ) |\\n| Loss from operations | (8,420,917 | ) | (1,618,468 | ) | (14,939,557 | ) | (2,480,167 | ) |\\n| Other income (expense): |\\n| Interest income | 55 | 3 | 71 | 11 |\\n| Interest expense | (12,272 | ) | (12,261 | ) | (36,486 | ) | (36,381 | ) |\\n| Loss on settlement of litigation | — | — | (550,000 | ) | — |\\n| Other income | 5,170 | 3,737 | 6,917 | 9,495 |\\n| Total other expense | (7,047 | ) | (8,521 | ) | (579,498 | ) | (26,875 | ) |\\n| Loss before income taxes | (8,427,964 | ) | (1,626,989 | ) | (15,519,055 | ) | (2,507,042 | ) |\\n| Income taxes | (1,303 | ) | (4 | ) | (9,943 | ) | (15,069 | ) |\\n| NET LOSS | $ | (8,429,267 | ) | $ | (1,626,993 | ) | $ | (15,528,998 | ) | $ | (2,522,111 | ) |\\n\\nRevenue. We generated revenues of $83,534 and $ 11,629 for the three months ended September 30, 2021 and 2020 respectively. During the nine month ended September 30, 2021 and 2020 we generated revenue of $100,823 and $41,262 respectively. The significant increase in revenue for three months and nine months was due to more merchants were joining our platform to operate their business.\\n\\n| 49 |\\n\\nDuring the nine months ended September 30, 2021 and 2020, the following customer exceeded 10% of the Company’s revenues:\\n\\n| Nine months ended September 30, 2021 | September 30, 2021 |\\n| Customer | Revenues | Percentage of revenues | Accounts receivable |\\n| Aryaduta Hospitality & Leisure Group | $ | 24,813 | 25 | % | $ | 19,308 |\\n| PayDollars-Payment Gateway | $ | 12,615 | 13 | % | $ | — |\\n| Tiki Smart Logistic | $ | 58,300 | 58 | % | $ | 68,285 | * |\\n\\n* - This included value added taxes (“VAT”)\\n\\n| Nine months ended September 30, 2020 | September 30, 2020 |\\n| Customer | Revenues | Percentage of revenues | Accounts receivable |\\n| Aryaduta Hospitality & Leisure Group | $ | 31,604 | 76 | % | $ | — |\\n\\nFor the three months ended September 30, 2021 and 2020, the customers who accounted for 10% or more of the Company’s revenues and its outstanding receivable balances at year-end dates, are presented as follows:\\n\\n| Three months ended September 30, 2021 |\\n| Customer | Revenues | Percentage of revenues |\\n| Aryaduta Hospitality & Leisure Group | $ | 10,016 | 12 | % |\\n| PayDollars-Payment Gateway | $ | 12,615 | 13 | % |\\n| Tiki Smart Logistic | $ | 58,300 | 58 | % |\\n\\n\\n| Three months ended September 30, 2020 |\\n| Customer | Revenues | Percentage of revenues |\\n| Aryaduta Hospitality & Leisure Group | $ | 9,789 | 84 | % |\\n\\nAll of our customers are located in Vietnam except one above significant customer located in Indonesia.\\nCost of Revenue. We incurred cost of revenue of $159,436 and $20,316 for three months ended September 30, 2021, and 2020 respectively. During the period of nine months ended September 30,2021 and 2020, we incurred cost of revenue of $264,293 and $59,109 respectively. Cost of revenue increased primarily as a result of the fixed subscription cost and the increased in number of headcounts arising from the acquisition of e-commerce assets from Goodventures Sea Limited.\\nMajor vendors\\nFor the nine months ended September 30, 2021 and 2020, the vendors who accounts for 10% or more of the Company’s hardware purchases and software cost its outstanding payable balances as at year-end dates, are presented as follows:\\n\\n| Nine months ended September 30, 2021 | September 30, 2021 |\\n| Vendors | Purchases | Percentage of purchases | Accounts payable |\\n| Vendor A | $ | 30,577 | 27% | $ | 44,867 |\\n| Vendor B | 17,827 | 16% |\\n\\n\\n| Nine months ended September 30, 2020 | September 30, 2020 |\\n| Vendors | Purchases | Percentage of purchases | Accounts payable |\\n| Vendor A | $ | 46,863 | 72% | $ | — |\\n| Vendor B | — | — | — |\\n\\n\\n| 50 |\\n\\nFor the three months ended September 30, 2021 and 2020, the vendors who accounts for 10% or more of the Company’s hardware purchases and software cost its outstanding payable balances as at year-end dates, are presented as follows:\\n\\n| Three months ended September 30, 2021 |\\n| Vendors | Purchases | Percentage of purchases |\\n| Vendor A | $ | — | — |\\n\\n\\n| Three months ended September 30, 2020 |\\n| Vendors | Purchases | Percentage of purchases |\\n| Vendor A | $ | 24,201 | 90 | % |\\n| Vendor B | — | — |\\n\\nAll vendors are located in Vietnam.\\nGross Loss. We recorded a gross loss of $75,902 and $8,687 for three months ended September,30 2021 and 2020 respectively. During the nine months ended September 30,2021 and 2020, we recorded a gross loss of $163,470 and $17,847 respectively. The increase in gross loss is primarily attributable to fixed subscription cost and the number of headcounts arising from the acquisition of e-commerce assets from Goodventures Sea Limited.\\nSales and Marketing Expenses (“S&M”). We incurred S&M expenses of $42,843 and $0 for three months ended September 30, 2021 and 2020 respectively. During nine months ended September 30,2021 and 2020, we have incurred S&M expenses of $85,027 and $3,125 respectively. The increase in S&M is primarily attributable to the increased in sales and promotion expenses related to get more merchants joining our e-commerce platform to operate their business. Also, increase marketing cost to attract attention of customer to our e-commerce platform.\\nSoftware Development Cost (“SDC”). We incurred SDC expenses of $9,709 and 33,658 for three months ended September 30, 2021 and 2020 respectively. During the nine months ended September 30, 2021 and 2020, we incurred SDC exepenses of $76,698 and $139,151 respectively. The decrease in SDC is primarily attributable to the restructuring of our technology development team.\\nImpairment Charge (“IC”). We incurred impairment charge of $200,000 and $8,778 for the nine months ended September 30, 2021, and 2020, respectively. No impairment charge imcurred for the three months ended September 30, 2021 and 2020. The increase is primarily attributable to the acquisition of Leflair ecommerce asset which was expensed in the same period due to the short life term of the asset and the quantum of consideration.\\nGeneral and Administrative Expenses (“G&A”). We incurred G&A expenses of $8,292,463 and $1,580,287 for three months ended September 30, 2021 and 2020 respectively. During the nine months ended September 30, 2021 and 2020, we incurred G&A expenses of $14,414,362 and $2,311,266 respectively. The increase in G&A is primarily attributable to the professional cost associated with cost related to company filing for listing on Nasdaq, amortization of intangible assets and Stock based compensation for services.\\nLoss on settlement of litigation. On May 21, 2021, the Company has agreed to settle the matter for the sum of $550,000. No additional shares were included in the settlement agreement. The settlement sum is required to be paid in two tranches, with $250,000 to have been paid on or before May 28, 2021 and the remaining $300,000 to be paid on or before June 30, 2021. The Company made the first payment of $250,000 on May 25, 2021 and complete the settlement sum as provided under the settlement agreement by paying the remaining $300,000 on June 29, 2021. In connection with the settlement, the Company recognized litigation settlement expense and a related accrued liability of $550,000 in the period ended September 30, 2021. There is no such expenses incurred in the comparative period ended September 30, 2020.\\n\\n| 51 |\\n\\nIncome Tax Expense. Our income tax expenses for the three months ended September 30,2021 and 2020 was $1,303 and $4 and for nine months ended September 30, 2021 and 2020 was $9,943 and $15,069, respectively.\\nNet Loss. As a result for the three months ended September 30, 2021, we incurred a net loss of $8,429,267 as compare to the same period ended September 30,2020 of $1,626,993. During nine month ended September 30, 2021 the Group having loss of $15,528,998, as compared to $2,522,111 for the same period ended September 30, 2020. The increase in net loss is primarily attributable to the professional cost associated with cost related to company filing for listing on Nasdaq and amortization of intangible assets.\\nLiquidity and Capital Resources\\nAs of September 30, 2021, we had cash and cash equivalents of $5,722,450, accounts receivable of $87,803, deposits, prepayments and other receivables of $69,623 and due from related parties of $97,500.\\nAs of December 31, 2020, we had cash and cash equivalents of $506,666, accounts receivable of $1,897, deposits, prepayments and other receivables of $60,532.\\nThe accompanying consolidated financial statements have been prepared using the going concern basis of accounting, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.\\nThe Company suffered from an accumulated deficit of $28,116,309 at September 30, 2021. The Company incurred net loss of $15,528,998 during the nine months ended September 30, 2021. These factors raise substantial doubt about the Company’s ability to continue as a going concern for a period of twelve months from the date of issuance of this financial statement, without additional debt or equity financing. The continuation of the Company as a going concern is dependent upon the continued financial support from its shareholders. Management believes the Company is currently pursuing additional financing for its operations. However, there is no assurance that the Company will be successful in securing sufficient funds to sustain the operations.\\nThe registration statement for the Company’s Initial Public Offering became effective on November 8, 2021. On November 8, 2021, the Company entered into an underwriting agreement with Maxim Group LLC, related to the offering of 2,888,889 shares of the Company’s common stock (the “Firm Share”), at a public offering price of $9.00 per share. Under the terms of the Underwriting Agreement, the Company has granted the Underwriters an option, exercisable for 45 days, to purchase an additional 236,111 shares of common stock (the “Option Shares”) to cover over-allotments. The Company has raised funding from Initial Public Offering and Option shares of $26,000,001 and 2,124,999. In addition, the Company has raised $8,019,461, net of issuance cost in the form of equity subsequent to issuance of the audit report on the Company’s December 31, 2020 financial statements respectively in the form of equity subsequent to issuance of the audit report on the Company’s December 31, 2020 financial statements and based upon the capital raised, the Company believes it has sufficient liquidity to meet its working capital requirements for the next 12 months. As a result the Company has mitigated any doubts about its ability to continue as a going concern\\nThese consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets and liabilities that may result in the Company not being able to continue as a going concern.\\n\\n| Nine Months Ended September 30, |\\n| 2021 | 2020 |\\n| Net cash (used in) operating activities | $ | (2,639,775 | ) | $ | (970,647 | ) |\\n| Net cash (used in) investing activities | (200,000 | ) | — |\\n| Net cash provided by financing activities | 8,019,461 | 708,960 |\\n| Effect on exchange rate change | 36,098 | 16,689 |\\n| Net change in cash and cash equivalents | 5,215,784 | (244,998 | ) |\\n| Cash and cash equivalent at beginning of period | 506,666 | 606,491 |\\n| Cash and cash equivalent at end of period | 5,722,450 | 361,493 |\\n\\n| 52 |\\n\\nNet Cash Used In Operating Activities.\\nFor the nine months ended September 30, 2021, net cash used in operating activities was $2,639,775, which consisted primarily of a net loss of $15,528,998, offset by increase in stock based compensation for services of $10,071,830, increase in accounts receivables of $85,906, increase in deposits, prepayments and other receivables of $9,091, increase in contract liabilities $16,936, increase in accounts payables of $50,424, decrease in accrued liabilities and other payable of $474,932, increase in advance to related parties of $127,500, decrease in operating lease liabilities of $29,064, increase in depreciation and amortization of $2,406,648, increase in impairment loss of $200,000, increase in loss on settlement of litigation of 550,000.\\nFor the nine months ended September 30, 2020, net cash used in operating activities was $970,647, which consisted primarily of net loss of $2,522,111, offset by increase in impairment loss of $8,778, increase in account receivable of $19,900, increase in inventories of $7,212, increase in deposits, prepayment and other receivables of $7005, increase in contract liabilities of $8,275, increase in accounts payable of $61, decrease in accrued liabilities and other payables of $37,960 and decrease in advance to related parties of $76,278.\\nWe expect to continue to rely on cash generated through financing from our existing shareholders and private placements of our securities, however, to finance our operations and future acquisitions.\\nNet Cash (Used In) Investing Activities.\\nFor the nine months ended September 30, 2021, there is net cash of 200,000 being deposit paid for Leflair asset acquisition investing activities.\\nFor the nine months ended September 30, 2020, there is no net cash impact on investing activities\\nNet Cash Provided By Financing Activities.\\nFor the nine months ended September 30, 2021, net cash provided by financing activities was $8,109,461, consisting primarily of funds raised from shareholders for Series C, Series C1 and warrant exercised.\\nFor the nine months ended September 30, 2020, net cash provided by financing activities was $708,960, consisting primarily of funds raised from shareholders for Series C and warrant exercised.\\nCritical Accounting Policies and Estimate\\n• Basis of presentation\\nThe accompanying unaudited interim consolidated condensed financial statements of Society Pass Incorporated have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with Article 8-03 of Regulation S-X. Accordingly, they do not include all the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments, consisting only of normal recurring accruals necessary for a fair statement of financial position, results of operations and cash flows, have been included. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the financial statements and the accompanying notes included in the Company’s registration statement on Form S-1 for the year ended December 31, 2020. The year-end balance sheet data presented for comparative purposes was derived from audited financial statements, but does not include all disclosures required by GAAP. The results of operations for the three and nine months ended September 30, 2021 are not necessarily indicative of the operating results for the year ending December 31, 2021 or for any other subsequent interim period.\\n\\n| 53 |\\n\\n• Use of estimates and assumptions\\nIn preparing these consolidated financial statements, management makes estimates and assumptions that affect the reported amounts of assets and liabilities in the balance sheet and revenues and expenses during the years reported. Actual results may differ from these estimates. If actual results significantly differ from the Company’s estimates, the Company’s financial condition and results of operations could be materially impacted. Significant estimates in the period include the allowance for doubtful accounts on accounts and other receivables, assumptions used in assessing right of use assets, imputed interest on due to related parties, and impairment of long-term assets, business acquisition allocation of purchase consideration, and deferred tax valuation allowance.\\n• Basis of consolidation\\nThe condensed consolidated financial statements include the financial statements of the Company and its subsidiaries. All significant inter-company balances and transactions within the Company have been eliminated upon consolidation. In addition, certain amounts in the prior periods’ consolidated financial statements have been reclassified to conform to the current period presentation.\\n• Cash and cash equivalents\\nCash and cash equivalents are carried at cost and represent cash on hand, demand deposits placed with banks or other financial institutions and all highly liquid investments with an original maturity of three months or less as of the purchase date of such investments. As of September 30, 2021 and December 31, 2020, the cash and cash equivalent was amounted to $5,722,450 and $506,666, respectively.\\nThe Company currently has bank deposits with financial institutions in the U.S. which does not exceed FDIC insurance limits. FDIC insurance provides protection for bank deposits up to $250,000, so there were uninsured balance of $4,895,306 and $208,635 in parent entity as of September 30, 2021 and December 31, 2020, respectively. In addition, the Company has uninsured bank deposits with a financial institution outside the U.S. All uninsured bank deposits are held at high quality credit institutions.\\n• Accounts receivable\\nAccounts receivable are recorded at the invoiced amount and do not bear interest, which are due within contractual payment terms, generally 30 to 90 days from completion of service. Credit is extended based on evaluation of a customer's financial condition, the customer credit-worthiness and their payment history. Accounts receivable outstanding longer than the contractual payment terms are considered past due. Past due balances over 90 days and over a specified amount are reviewed individually for collectibility. At the end of fiscal year, the Company specifically evaluates individual customer’s financial condition, credit history, and the current economic conditions to monitor the progress of the collection of accounts receivables. The Company considers the allowance for doubtful accounts for any estimated losses resulting from the inability of its customers to make required payments. For the receivables that are past due or not being paid according to payment terms, the appropriate actions are taken to exhaust all means of collection, including seeking legal resolution in a court of law. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. The Company does not have any off-balance-sheet credit exposure related to its customers. As of September 30, 2021 and December 31, 2020, the allowance for doubtful accounts amounted to $0 and $0, respectively.\\n• Inventories\\nInventories are stated at the lower of cost or net realizable value, cost being determined on a first-in-first-out method. Costs include hardware equipment and peripheral costs which are purchased from the Company’s suppliers as merchanized goods. The Company provides inventory allowances based on excess and obsolete inventories determined principally by customer demand. During the nine months ended September 30, 2021 and 2020, the Company recorded an allowance for obsolete inventories of $0 and $0, respectively. During the three months ended September 30, 2021 and 2020, the Company recorded an allowance for obsolete inventories of $0 and $0, respectively. The inventories were amounted to $0 and $0 at September 30, 2021 and December 31, 2020, respectively.\\n\\n| 54 |\\n\\n• Property, plant and equipment\\nPlant and equipment are stated at cost less accumulated depreciation and accumulated impairment losses, if any. Depreciation is calculated on the straight-line basis over the following expected useful lives from the date on which they become fully operational and after taking into account their estimated residual values:\\n\\n| Expected useful lives |\\n| Computer equipment | 3 years |\\n| Office equipment | 5 years |\\n\\nExpenditures for repairs and maintenance are expensed as incurred. When assets have been retired or sold, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is recognized in the results of operations.\\n• Impairment of long-lived assets\\nIn accordance with the provisions of ASC Topic 360, “Impairment or Disposal of Long-Lived Assets”, all long-lived assets such as plant and equipment and intangible assets held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is evaluated by a comparison of the carrying amount of an asset to its estimated future undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amounts of the assets exceed the fair value of the assets. There has been no impairment charge for the periods presented.\\n• Revenue recognition\\nThe Company adopted Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”). Under ASU 2014-09, the Company applies the following five steps in order to determine the appropriate amount of revenue to be recognized as it fulfills its obligations under each of its agreements:\\n\\n| • | identify the contract with a customer; |\\n| • | identify the performance obligations in the contract; |\\n| • | determine the transaction price; |\\n| • | allocate the transaction price to performance obligations in the contract; and |\\n| • | recognize revenue as the performance obligation is satisfied. |\\n\\nThe revenues are generated from a diversified a mix of marketplace activities and the services of the Company provide merchants to help them grow their businesses. The revenue streams consist of Consumer Facing revenues and Merchant Facing revenues.\\nConsumer Facing Business\\nThe Company’s performance obligation includes providing connectivity between merchant and consumer, generally through an online ordering platform. The platform allows merchants to create account, place menu and track their sale reports on the merchant facing application. The platform also allows the consumers to create account and make orders from merchants on the consumer facing application. The platform allows delivering company to accept online delivery request and ship order from merchant to consumer.\\nThe Company also has online lifestyle platform allow customers to purchase high-end brands of all catergories: Under the Company’s smart search engine, consumers search or review their favorite brands among hundreds of choices in Apparel, Bags & Shoes, Accessory, Health & Beauty, Home & Lifestyle, International, Women, Men and Kids & Babies categories. The platform also allow consumers order from hundreds of vendor choices with personalized promotions based on purchase history and location. The platform has also partnered up with a Vietnam-based delivery company, Tikinow, to offer seamless delivery of product from merchant to consumer’s home or office at the touch of a button. Consumers place orders for delivery or pickup at the Company’s logistics center\\n| 55 |\\n\\nRevenue streams for consumer facing business:\\nF&B sector\\n\\n| 1) | Ordering fees comprise the fees that the different types of merchants pay for every completed transaction on the Platform, exclusive of delivery fees charged. Monthly/annual subscription fees or 10% commission on order value on each successful order will be charged. |\\n\\n\\n| 2) | Delivery fees include an upfront fixed fee and additional variable fees based on the distance. Various percentage of commission will be charged as delivery fee on each successful order received and delivered. |\\n\\nThe Company recognizes revenues from consumer facing business upon the completion of delivery and services rendered.\\nDuring the period ended September 30, 2021 and 2020, the Company have not generated any revenue from this stream.\\nLifestyle sector\\n\\n| 1) | Customer placed orders on the website / app, sales orders report will be generated in the system. The Company will start to proceed to packaging and delivering customer. The sales recognised. |\\n\\nDuring the nine months ended September 30, 2021 and 2020, the Company have generated $73,518 and $0, respectively revenue from this stream. During the three months ended September 30, 2021 and 2020, the Company have generated $73,518 and $0, respectively revenue from this stream.\\nMerchant Facing Business\\nRevenue streams for merchant facing business include:\\n\\n| 1) | Subscription fees consist of the fees that the Company charge merchants to get on the Merchant Marketing Program; |\\n\\n| 2) | The Company provides optional add-on software services which includes Analytics and Chatbox capabilities at a fixed fee per month. |\\n\\n| 3) | The Company collects commissions when they sell third party hardware and equipment (cashier stations, waiter tablets and printers) to merchants. |\\n\\n| 4) | Vendor Financing. The Company collects brokerage fees whenever the Company facilitates financing transactions between merchants and one of the Company’s partner financial institutions. |\\n\\nDuring the nine months ended September 30, 2021 and 2020, the Company have generated $26,970 and $37,752, respectively revenue from this stream. During the three months ended September 30, 2021 and 2020, the Company have generated $10,016 and $11,044, respectively revenue from this stream\\nHardware Product Revenues — the Company generally is involved with the sale of on-premise appliances and end-point devices. The single performance obligation is to transfer the hardware product (which is to be installed with its licensed software integral to the functionality of the hardware product). The entire transaction price is allocated to the hardware product and is generally recognized as revenue at the time of delivery because the customer obtains control of the product at that point in time. It is concluded that control generally transfers at that point in time because the customer has title to the hardware, physical possession, and a present obligation to pay for the hardware. Payments for hardware contracts are generally due 30 to 90 days after shipment of the hardware product.\\n\\n| 56 |\\n\\nThe Company records revenues from the sales of third-party products on a “gross” basis pursuant to ASC 606-10 Revenue Recognition – Revenue from Contracts with Customers, when the Company controls the specified good before it is transferred to the end customer and have the risks and rewards as principal in the transaction, such as responsibility for fulfillment, retaining the risk for collection, and establishing the price of the products. If these indicators have not been met, or if indicators of net revenue reporting specified in ASC 606-10 are present in the arrangement, revenue is recognized net of related direct costs.\\nSoftware License Revenues — The Company’s performance obligation includes providing connectivity to software, generally through a monthly subscription, where the Company typically satisfies its performance obligations prior to the submission of invoices to the customer for such services. The Company’s software sale arrangements grant customers the right to access and use the software products which are to be installed with the relevant hardware for connectivity at the outset of an arrangement, and to be entitled to both technical support and software upgrades and enhancements during the term of the agreement. The term of the subscription period is generally 12 months, with the automatic renewal of another one year, and the subscription license service is billed monthly, quarterly or annually. Sales are generally recorded in the month the service is provided. For clients who are billed on an annual basis, deferred revenue is recorded and amortized over the life of the contract. Payments are generally due 30 to 90 days after delivery of the software licenses.\\nThe Company records its revenues on hardware product and software license, net of value added taxes (“VAT”) upon the services are rendered and the title and risk of loss of hardware products are fully transferred to the customers. The Company is subject to VAT which is levied on the majority of the hardware products at the rate of 10% on the invoiced value of sales.\\nContract assets\\nIn accordance with ASC 606-10-45-3, contract asset is when the Company’s right to payment for goods and services already transferred to a customer if that right to payment is conditional on something other than the passage of time. The Company will recognize a contract asset when it has fulfilled a contract obligation but must perform other obligations before being entitled to payment.\\nThere were no contract assets at September 30, 2021 and December 31, 2020.\\nContract liabilities\\nIn accordance with ASC 606-10-45-2, A contract liability is Company’s obligation to transfer goods or services to a customer when the customer prepays consideration or when the customer’s consideration is due for goods and services that the Company will yet provide whichever happens earlier.\\nContract liabilities represent amounts collected from, or invoiced to, customers in excess of revenues recognized, primarily from the billing of annual subscription agreements. The value of contract liabilities will increase or decrease based on the timing of invoices and recognition of revenue. The Company’s contract liability balance was $35,582 and $18,646 as of September 30, 2021 and December 31, 2020, respectively.\\nContract costs\\nUnder ASC-606, the Company applies the following three steps in order to evaluate the costs to be capitalized as it fulfills following three criteria:\\n• Incremental costs directly related to a specific contract;\\n• Costs that generate or enhance resources of the company that will be used to satisfy performance of the terms of the contract; and\\n• Costs that are expected to be recovered from the customer.\\nNo contract costs are capitalized for the three and nine months ended September 30, 2021 and 2020.\\n\\n| 57 |\\n\\n• Software development costs\\nIn accordance with the relevant FASB accounting guidance regarding the development of software to be sold, leased, or marketed, the Company expenses such costs as they are incurred until technological feasibility has been established, at and after which time these costs are capitalized until the product is available for general release to customers. Once the technological feasibility is established per ASC 985-20, the Company capitalizes costs associated with the acquisition or development of major software for internal and external use in the balance sheet. Costs incurred to enhance the Company’s software products, after general market release of the services using the products, is expensed in the period they are incurred. The Company only capitalizes subsequent additions, modifications or upgrades to internally developed software to the extent that such changes allow the software to perform a task it previously did not perform. The Company also expenses website costs as incurred.\\nResearch and development expenditures in the development of its own software are charged to operations as incurred. Based on the software development process, technological feasibility is established upon completion of a working model, which also requires certification and extensive testing. Costs incurred by the Company between completion of the working model and the point at which the product is ready for general release are immaterial. For the nine months ended September 30, 2021 and 2020, the software development costs were $76,698 and $139,151, respectively. For three months ended September 30, 2021 and 2020, the software development costs were $9,709 and $33,658, respectively.\\n• Product warranties\\nThe Company’s provision for estimated future warranty costs is based upon historical relationship of warranty claims to sales. Based upon historical sales trends and warranties provided by the Company’s suppliers, the Company has concluded that no warranty liability is required as of June 30, 2021 and 2020. To date, product allowance and returns have been minimal and, based on its experience, the Company believes that returns of its products will continue to be minimal.\\n• Shipping and handling costs\\nNo shipping and handling costs are associated with the distribution of the products to the customers which are borne by the Company’s suppliers or distributors.\\n• Sales and marketing\\nSales and marketing expenses include payroll, employee benefits and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $85,027 and $3,125 for the nine months ended September 30, 2021 and 2020, respectively. For three months ended September 30, 2021 and 2020, the Advertising expense were $42,843 and $0, respectively.\\n• Income tax\\nThe Company adopted the ASC 740 Income Tax provisions of paragraph 740-10-25-13, which addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the consolidated financial statements. Under paragraph 740-10-25-13, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent (50%) likelihood of being realized upon ultimate settlement. Paragraph 740-10-25-13 also provides guidance on de-recognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures. The Company had no material adjustments to its liabilities for unrecognized income tax benefits according to the provisions of paragraph 740-10-25-13.\\n\\n| 58 |\\n\\nThe estimated future tax effects of temporary differences between the tax basis of assets and liabilities are reported in the accompanying balance sheets, as well as tax credit carry-backs and carry-forwards. The Company periodically reviews the recoverability of deferred tax assets recorded on its balance sheets and provides valuation allowances as management deems necessary.\\nThe Company and its wholly-owned foreign subsidiary, is subject to income taxes in the jurisdictions in which it operates. Significant judgment is required in determining the provision for income tax. There are many transactions and calculations undertaken during the ordinary course of business for which the ultimate tax determination is uncertain. The company recognizes liabilities for anticipated tax audit issues based on the Company’s current understanding of the tax law. Where the final tax outcome of these matters is different from the carrying amounts, such differences will impact the current and deferred tax provisions in the period in which such determination is made.\\n• Uncertain tax positions\\nThe Company did not take any uncertain tax positions and had no adjustments to its income tax liabilities or benefits pursuant to the ASC 740 provisions of Section 740-10-25 for the three and nine months ended September 30, 2021 and 2020.\\n• Foreign currencies translation and transactions\\nThe reporting currency of the Company is United States Dollar (\\\"US$\\\") and the accompanying consolidated financial statements have been expressed in US$. In addition, the Company’s subsidiary is operating in the Republic of Vietnam and India and maintains its books and record in its local currency, Vietnam Dong (“VND”) and Indian Rupee (“INR), respectively, which are the functional currency as being the primary currency of the economic environment in which their operations are conducted. In general, for consolidation purposes, assets and liabilities of its subsidiaries whose functional currency is not US$ are translated into US$, in accordance with ASC Topic 830-30, “Translation of Financial Statement”, using the exchange rate on the balance sheet date. Shareholders’ equity is translated using the historical rates. Revenues and expenses are translated at average rates prevailing during the year. The gains and losses resulting from translation of financial statements of foreign subsidiary are recorded as a separate component of accumulated other comprehensive income within the statements of changes in shareholder’s equity.\\nTranslation of amounts from SGD$ into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\\n\\n| September 30, 2021 | September 30, 2020 |\\n| Period-end SGD$:US$ exchange rate | $ | 0.73534 | $ | 0.73118 |\\n| Period average SGD$:US$ exchange rate | $ | 0.74658 | $ | 0.71922 |\\n\\nTranslation of amounts from VND into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\\n\\n| September 30, 2021 | September 30, 2020 |\\n| Period-end VND$:US$ exchange rate | $ | 0.000044 | $ | 0.000043 |\\n| Period average VND$:US$ exchange rate | $ | 0.000043 | $ | 0.000043 |\\n\\nTranslation of amounts from INR into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\\n\\n| September 30, 2021 | September 30, 2020 |\\n| Period-end INR$:US$ exchange rate | $ | 0.013463 | $ | 0.013570 |\\n| Period average INR$:US$ exchange rate | $ | 0.013576 | $ | 0.013490 |\\n\\n\\n| 59 |\\n\\nTranslation gains and losses that arise from exchange rate fluctuations from transactions denominated in a currency other than the functional currency are translated, as the case may be, at the rate on the date of the transaction and included in the results of operations as incurred.\\nForeign Exchange Loss (Gain). We recorded a foreign exchange gain of $8,859 for the three months ended September 30, 2021 as compared to a gain of $51,183 for the same period in 2020. Foreign exchange gains and losses are primarily unrealized (non-cash) in nature and results from the re-measuring of specific transactions and monetary accounts in a currency other than the functional currency. For example, a U.S. Dollar transaction which occurs in Singapore is re-measured at the period-end to Singapore dollar amount if it has not been settled previously. The foreign exchange loss or gain for the three months ended September 30, 2021 was due to an increase in the value of the Singapore Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the Singapore dollar to the U.S. Dollar increased 0.56%. At September 30, 2021, the exchange rate was 0.73534 as compared to 0.73118 at September 30, 2020. In addition, a U.S. Dollar transaction which occurs in India is re-measured at the period-end to India dollar amount if it has not been settled previously. The foreign exchange loss for the three months ended September 30, 2021 was due to an increase in the value of the India Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the India dollar to the U.S. Dollar increased 0.79%. At September 30, 2021, the exchange rate was 0.013463 as compared to 0.013570 at September 30, 2020. A U.S. Dollar transaction which occurs in Vietnam is re-measured at the period-end to Vietnameses dollar amount if it has not been settled previously. The foreign exchange gain for the three months ended September 30, 2021 was due to an increase in the value of the Vietnamese Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the Vietnamese dollar to the U.S. Dollar increased 2.32%. At September 30, 2021, the exchange rate was 0.000044 as compared to 0.000043 at September 30, 2020.\\n• Comprehensive income\\nASC 220, “Comprehensive Income”, establishes standards for reporting and display of comprehensive income, its components and accumulated balances. Comprehensive income as defined includes all changes in equity during a period from non-owner sources. Accumulated other comprehensive income, as presented in the accompanying consolidated statements of changes in shareholders’ equity, consists of changes in unrealized gains and losses on foreign currency translation. This comprehensive income is not included in the computation of income tax expense or benefit.\\n• Leases\\nThe Company adopted ASC 842, Leases (“ASC 842”) to determines if an arrangement is a lease at inception. Operating leases are included in operating lease right-of-use (“ROU”) assets and operating lease liabilities in the consolidated balance sheets. Finance leases are included in property and equipment, other current liabilities, and other long-term liabilities in the condensed consolidated balance sheets.\\nROU assets represent the right to use an underlying asset for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As most of the Company’s leases do not provide an implicit rate, the Company generally use the incremental borrowing rate based on the estimated rate of interest for collateralized borrowing over a similar term of the lease payments at commencement date. The operating lease ROU asset also includes any lease payments made and excludes lease incentives. The lease terms may include options to extend or terminate the lease when it is reasonably certain that the Company will exercise that option. Lease expense for lease payments is recognized on a straight-line basis over the lease term.\\nIn accordance with the guidance in ASC 842, components of a lease should be split into three categories: lease components (e.g. land, building, etc.), non-lease components (e.g. common area maintenance, consumables, etc.), and non-components (e.g. property taxes, insurance, etc.). Subsequently, the fixed and in-substance fixed contract consideration (including any related to non-components) must be allocated based on the respective relative fair values to the lease components and non-lease components.\\n• Related parties\\nThe Company follows the ASC 850-10, Related Party for the identification of related parties and disclosure of related party transactions.\\nPursuant to section 850-10-20 the related parties include a) affiliates of the Company; b) entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of section 825–10–15, to be accounted for by the equity method by the investing entity; c) trusts for the benefit of employees, such as pension and Income-sharing trusts that are managed by or under the trusteeship of management; d) principal owners of the Company; e) management of the Company; f) other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests; and g) other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting ;parties might be prevented from fully pursuing its own separate interests.\\n\\n| 60 |\\n\\nThe condnensed consolidated financial statements shall include disclosures of material related party transactions, other than compensation arrangements, expense allowances, and other similar items in the ordinary course of business. However, disclosure of transactions that are eliminated in the preparation of consolidated or combined financial statements is not required in those statements. The disclosures shall include: a) the nature of the relationship(s) involved; b) a description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the financial statements; c) the dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period; and d) amount due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement.\\n• Commitments and contingencies\\nThe Company follows the ASC 450-20, Commitments to report accounting for contingencies. Certain conditions may exist as of the date the financial statements are issued, which may result in a loss to the Company but which will only be resolved when one or more future events occur or fail to occur. The Company assesses such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or un-asserted claims that may result in such proceedings, the Company evaluates the perceived merits of any legal proceedings or un-asserted claims as well as the perceived merits of the amount of relief sought or expected to be sought therein.\\nIf the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s consolidated financial statements. If the assessment indicates that a potentially material loss contingency is not probable but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, and an estimate of the range of possible losses, if determinable and material, would be disclosed.\\nLoss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the guarantees would be disclosed. Management does not believe, based upon information available at this time that these matters will have a material adverse effect on the Company’s financial position, results of operations or cash flows. However, there is no assurance that such matters will not materially and adversely affect the Company’s business, financial position, and results of operations or cash flows.\\n• Fair value of financial instruments\\nThe Company follows paragraph 825-10-50-10 of the FASB Accounting Standards Codification for disclosures about fair value of its financial instruments and has adopted paragraph 820-10-35-37 of the FASB Accounting Standards Codification (“Paragraph 820-10-35-37”) to measure the fair value of its financial instruments. Paragraph 820-10-35-37 of the FASB Accounting Standards Codification establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. To increase consistency and comparability in fair value measurements and related disclosures, paragraph 820-10-35-37 of the FASB Accounting Standards Codification establishes a fair value hierarchy which prioritizes the inputs to valuation techniques used to measure fair value into three (3) broad levels. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The three (3) levels of fair value hierarchy defined by paragraph 820-10-35-37 of the FASB Accounting Standards Codification are described below:\\n\\n| Level 1 | Quoted market prices available in active markets for identical assets or liabilities as of the reporting date. |\\n| Level 2 | Pricing inputs other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable as of the reporting date. |\\n| Level 3 | Pricing inputs that are generally observable inputs and not corroborated by market data. |\\n\\n\\n| 61 |\\n\\nFinancial assets are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable.\\nThe fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.\\nThe carrying amounts of the Company’s financial assets and liabilities, such as cash and cash equivalents, accounts receivable, deposits, prepayments and other receivables, contract liabilities, accrued liabilities and other payables, amounts due to related parties and operating lease liabilities, approximate their fair values because of the short maturity of these instruments.\\n• Cost of goods sold\\nCost of goods sold consists of the cost of hardware, software and payroll, which are directly attributable to the sales of products. The cost also consists of costs of materials which has been sold attributable to the sales of high-end products. Additional costs may include freight paid to acquire the goods, custom duties, sales or use taxes not recoverable paid on materials used, and any fee for purchase\\n• Share-based compensation\\nPursuant to ASU 2018-07, the Company follows ASC 718, Compensation—Stock Compensation (“ASC 718”), which requires the measurement and recognition of compensation expense for all share-based payment awards (employee or non employee), are measured at grant-date fair value of the equity instruments that an entity is obligated to issue. Restricted stock units are valued using the market price of the Company’s common shares on the date of grant. As of September 30, 2021, those shares issued for service compensations were immediately vested, and therefore this amount is thus recognized as expense with an offset to preferred or September 30, 2021 and 2020, the stock-based compensations are recorded in the General and administrative expenses within the Condensed Consolidated Statements of Operations and Other Comprehensive Loss.”\\n• Business combinations\\nThe Company follows ASC 805, Business Combinations (“ASC 805”) and ASC 810-10-65, Consolidation. ASC 805 requires most identifiable assets, liabilities, non-controlling interests, and goodwill acquired in a business combination to be recorded at “fair value.” The statement applies to all business combinations, including combinations among mutual entities and combinations by contract alone. Under ASC 805, all business combinations are accounted for by applying the acquisition method. Accounting for goodwill requires significant management estimates and judgment. Management performs periodic reviews of the carrying value of goodwill to determine whether events and circumstances indicate that an impairment in value may have occurred. A variety of factors could cause the carrying value of goodwill to become impaired. A write-down of the carrying value of goodwill could result in a non-cash charge, which could have an adverse effect on the Company’s results of operations.\\n• Earnings per share\\nBasic per share amounts are calculated using the weighted average shares outstanding during the year, excluding unvested restricted stock units. The Company uses the treasury stock method to determine the dilutive effect of stock options and other dilutive instruments. Under the treasury stock method, only “in the money” dilutive instruments impact the diluted calculations in computing diluted earnings per share. Diluted calculations reflect the weighted average incremental common shares that would be issued upon exercise of dilutive options assuming the proceeds would be used to repurchase shares at average market prices for the period.\\n\\n| 62 |\\n\\nAs of September 30, 2021 and December 31, 2020, the Company has the number of shares of common stock to be issued upon conversion of below:\\n\\n| As of September 30, | As of December 31, |\\n| 2021 | 2020 |\\n| Series A Convertible Preferred Stock (a) | 8,000 | 8,000 |\\n| Series B Convertible Preferred Stock | 764,400 | 764,400 |\\n| Series B-1 Convertible Preferred Stock | 48,000 | 48,000 |\\n| Series C Convertible Preferred Stock | 465,600 | 108,600 |\\n| Series C-1 Convertible Preferred Stock | 4,195,200 | 865,500 |\\n| Warrants granted | — | — |\\n| Warrants granted with Series C-1 Convertible Preferred Stock | 1,178,700 | 614,100 |\\n| Total: | 6,659,900 | 2,408,600 |\\n\\n\\n| (a) | The Series A the conversion formula is aggregate Stated Value divided by IPO price (Stated Value for each Series A preferred share is $1,000). There are 8,000 shares of Series A Preferred Stock issued and outstanding (10,000 shares are designated Series A). The conversion formula would be $8 million (the aggregate stated value) divided by IPO price. |\\n\\n• Segment Reporting\\nASC Topic 280, “Segment Reporting” establishes standards for reporting information about operating segments on a basis consistent with the Company’s internal organization structure as well as information about geographical areas, business segments and major customers in condensed consolidated financial statements. For the nine months ended September 30, 2021 and 2020, the Company operates in two reportable operating segment.\\nEmerging Growth Company\\nWe are an “emerging growth company” under the JOBS Act. For as long as we are an “emerging growth company,” we are not required to: (i) comply with any new or revised financial accounting standards that have different effective dates for public and private companies until those standards would otherwise apply to private companies, (ii) provide an auditor’s attestation report on management’s assessment of the effectiveness of internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act, (iii) comply with any new requirements adopted by the Public Company Accounting Oversight Board (“PCAOB”) requiring mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor would be required to provide additional information about the audit and the financial statements of the issuer or (iv) comply with any new audit rules adopted by the PCAOB after April 5, 2012, unless the SEC determines otherwise. However, we have elected to “opt out” of the extended transition period discussed in (i) and will therefore comply with new or revised accounting standards on the applicable dates on which the adoption of such standards are required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to opt out of such extended transition period for compliance with new or revised accounting standards is irrevocable.\\nCritical Accounting Policies and Estimate\\n• Recent accounting pronouncements\\nFrom time to time, new accounting pronouncements are issued by the Financial Accounting Standard Board (“FASB”) or other standard setting bodies and adopted by the Company as of the specified effective date. Unless otherwise discussed, the Company believes that the impact of recently issued standards that are not yet effective will not have a material impact on its financial position or results of operations upon adoption.\\n\\n| 63 |\\n\\nAccounting Standards Adopted\\nIn August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (“ASU 2018-13”), which eliminates, adds and modifies certain disclosure requirements for fair value measurements. The amendment is effective for interim and annual reporting periods beginning after December 15, 2019. The Company has evaluated and the adoption of this does not have an any impact on the financial statements.\\nIn November 2018, the FASB issued ASU No. 2018-18, Collaborative Arrangements (“ASU 2018-18”), which clarifies the interaction between ASC 808, Collaborative Arrangements and ASC 606, Revenue from Contracts with Customers. Certain transactions between participants in a collaborative arrangement should be accounted for under ASC 606 when the counterparty is a customer. In addition, ASU 2018-18 precludes an entity from presenting consideration from a transaction in a collaborative arrangement as revenue if the counterparty is not a customer for that transaction. ASU 2018-18 should be applied retrospectively to the date of initial application of ASC 606. This guidance is effective for interim and fiscal periods beginning after December 15, 2019. The Company has evaluated and the adoption of this does not have an any impact on the financial statements.\\nAccounting Standards Issued, Not Adopted\\nIn June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). This ASU requires measurement and recognition of expected credit losses for financial assets. ASU 2016-13 also requires new disclosures for financial assets measured at amortized cost, loans and available-for-sale debt securities. ASU 2016-13 is effective for the Company beginning January 1, 2023. Entities will apply the standard's provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. The Company is currently evaluating the potential effect of this standard on its financial statements. The Company does not expect this standard to have a material impact on its financial statements.\\nIn December 2019, the FASB issued ASU No. 2019-12, Income Taxes: Simplifying the Accounting for Income Taxes (“ASU 2019-12”), which eliminates certain exceptions related to the approach for intraperiod tax allocation, the methodology for calculating income taxes in an interim period and the recognition of deferred tax liabilities for outside basis differences. The new guidance also simplifies aspects of the accounting for franchise taxes and enacted changes in tax laws or rates and clarifies the accounting for transactions that result in a step-up in the tax basis of goodwill. The standard is effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2020, with early adoption permitted. Adoption of the standard requires certain changes to be made prospectively, with some changes to be made retrospectively. The Company does not expect the adoption of this standard to have a material impact on its financial position, results of operations or cash flows.\\nIn March 2020, the FASB issued ASU 2020-03, “Codification Improvements to Financial Instruments”: The amendments in this update are to clarify, correct errors in, or make minor improvements to a variety of ASC topics. The changes in ASU 2020-03 are not expected to have a significant effect on current accounting practices. The ASU improves various financial instrument topics in the Codification to increase stakeholder awareness of the amendments and to expedite the improvement process by making the Codification easier to understand and easier to apply by eliminating inconsistencies and providing clarifications. The ASU is effective for smaller reporting companies for fiscal years beginning after December 15, 2022 with early application permitted. The Company is currently evaluating the impact the adoption of this guidance may have on its consolidated financial statements.\\nIn August 2020, the FASB issued ASU 2020-06 Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40) related to the measurement and disclosure requirements for convertible instruments and contracts in an entity's own equity. The pronouncement simplifies and adds disclosure requirements for the accounting and measurement of convertible instruments and the settlement assessment for contracts in an entity's own equity. This pronouncement is effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2021 and early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. The Company is currently evaluating the impact that this standard will have on its consolidated financial statements.\\n\\n| 64 |\\n\\n\\nItem 3. Quantitative and Qualitative Disclosures about Market Risk.\\nWe did not have investments and do not utilize derivative financial instruments to manage our interest rate risks.\\nItem 4. Controls and Procedures.\\nEvaluation of Disclosure Controls and Procedures\\nWe maintain disclosure controls and procedures that are designed to provide reasonable assurance that the information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934, as amended (the \\\"Exchange Act\\\"), is recorded, processed, summarized and reported within the time periods specified in the rules and forms promulgated by the Securities and Exchange Commission, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Because of the inherent limitations to the effectiveness of any system of disclosure controls and procedures, no evaluation of disclosure controls and procedures can provide absolute assurance that all control issues and instances of fraud, if any, with a company have been prevented or detected on a timely basis. Even disclosure controls and procedures determined to be effective can only provide reasonable assurance that their objectives are achieved.\\nAs of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) pursuant to Rule 13a-15 of the Exchange Act. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are not effective at the reasonable assurance level.\\nOur size has prevented us from being able to employ sufficient resources to enable us to have an adequate level of supervision and segregation of duties. Therefore, it is difficult to effectively segregate accounting duties which comprises a material weakness in internal controls. This lack of segregation of duties leads management to conclude that the Company’s disclosure controls and procedures are not effective to give reasonable assurance that the information required to be disclosed in reports that the Company files under the Exchange Act is recorded, processed, summarized and reported as and when required.\\nTo the extent reasonably possible given our limited resources, we intend to take measures to cure the aforementioned weaknesses, including, but not limited to, increasing the capacity of our qualified financial personnel to ensure that accounting policies and procedures are consistent across the organization and that we have adequate control over our Exchange Act reporting disclosures.\\nChanges in Internal Control over Financial Reporting\\nThere were no changes in the Company’s internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)) during the quarter ended September 30, 2021 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\\n| 65 |\\n\\nPART II\\nOTHER INFORMATION\\n\\nItem 1. Legal Proceedings.\\nThe Company is currently litigating three cases pending in the Supreme Court of the State of New York and one case pending in the United States District Court for the District of New Jersey.\\nTwo cases are employment actions filed by former employees who seek compensation alleged to be due pursuant to agreements with the Company. Both of the employees are represented by the same counsel and filed their cases in the Supreme Court of the State of New York, County of New York, in December 2019.\\nIn one of those actions, a former employee claims entitlement to compensation and a bonus totaling $566,000 and 39,000-58,500 shares of Company common stock, together with costs. The Company responded to the complaint and also asserted counterclaims in the proceeding for $1,500,000 to $4,000,000 plus punitive damages, together with interest and costs, arising from, inter alia, the former employee’s breach of contract, unfair competition, misappropriation of trade secrets and breach of fiduciary duty. The former employee has responded to the Company’s counterclaims and this action is in the discovery phase of the litigation.\\nIn the other employment action, another former employee claims entitlement to salary payments and expense reimbursement in the amount of $122,042.60, plus liquidated damages, together with costs. This former employee also claims entitlement to 516,300 to 760,800 shares of the Company’s common stock. In addition, this action also includes claims by a plaintiff-entity alleging entitlement to $8 million in shares of the Company’s Series A Preferred stock. The Company responded to the complaint and also asserted counterclaims against the former employee in the proceeding for $1,500,000 to $2,000,000 plus punitive damages, together with costs, arising from, inter alia, the former employee’s breach of contract, breach of fiduciary duty, tortious interference and fraud. The former employee has responded to the Company’s counterclaims. The judge assigned to this action retired at the end of 2020. A new judge has been assigned and this action is progressing through the discovery phase of litigation.\\nThe third case also involves one of those former employees; therein, a Company affiliate filed suit in February 2020 seeking enforcement, by way of specific performance, of an agreement which entitles the affiliate to purchase all of the 99 percent of the shares of the plaintiff-entity which alleges entitlement to $8 million in shares of the Company’s Series A Preferred Stock in one of the employment actions described above. The former employee has responded to the Company’s complaint in this action with a motion to dismiss, which was later withdrawn by same, and then by way of an answer without counterclaims. The judge assigned to this action has announced his retirement and the case has not yet been reassigned.\\nThe Company was in an AAA arbitration defending allegations of breach of an agreement. The Demand for Arbitration therein, dated August 25, 2020, asserted that the Petitioner, an LLC, had an agreement with the Company and its CEO granting the Petitioner the right to require the Company to redeem certain common stock in the Company for a cash payment.\\nThe Demand alleged that the Petitioner submitted a Redemption Notice, as required under the alleged agreement, obligating the Company to redeem the shares. The Demand alleged that the failure of the Company to redeem the shares and pay Petitioner further obligated the Company to provide additional common stock to the Petitioner. The amount alleged to be due to the Petitioner as of July 31, 2020 was said to be $590,461.94 and growing daily while the number of additional common stock shares alleged to be due to Petitioner as of July 31, 2020 was said to be 708,542,582 and growing, daily.\\nIn order to avoid an adverse award, the Company agreed to settle the matter for the sum of $550,000. No additional shares were included in the settlement agreement. The settlement sum was required to be paid in two tranches, with $250,000 to have been paid on or before May 28, 2021 and the remaining $300,000 to be paid on or before June 30, 2021. The Company made the required settlement payments and the matter is now considered closed.\\n\\n| 66 |\\n\\nOn or about March 5, 2021, SOSV IV LLC (“SOSV”) sent a demand letter to the Company in regard to its investment in Hottab Pte. Ltd. (“Hottab”).\\nIn this letter, and the subsequently filed lawsuits, SOSV alleges that it entered into an investment arrangement with Hottab in which SOSV was to receive five percent (5%) of the common stock of Hottab and entered into an Accelerator Contract for Equity (the “ACE”) pursuant to which it alleges to have invested a sum of $168,000 with Hottab. These events are alleged to have taken place prior to the Company’s acquisition of Hottab. SOSV alleges that the Company subsequently acquired all of the outstanding shares of Hottab, which it alleges triggered a liquidity event clause under the ACE requiring the Company, by way of its ownership of Hottab, to pay SOSV twice its investment, or $336,000.\\nSOSV further alleges that subsequent to a term sheet between the Company and Hottab being executed, the Company entered into an agreement to purchase one hundred percent (100%) of the issued and outstanding shares of Hottab from Hottab Holdings Limited (“Hottab Holdings”). As SOSV does not have any interest in Hottab Holdings, it did not receive any consideration as allegedly provided under the ACE.\\nUpon these allegations, SOSV asserts causes of action sounding in fraudulent misrepresentation/concealment, breach of contract, breach of the covenant of good faith and fair dealing, quantum meruit and/or unjust enrichment, promissory estoppel, oppression of minority shareholder, and breach of fiduciary duties. SOSV seeks damages in the amount of $336,000.00 in addition damages equal to the value of SOSV’s alleged equity in Hottab or in the alternative shares of the Company in an amount equal to SOSV’s ownership interest in Hottab at the time of the purchase of Hottab’s shares from Hottab Holdings.\\nInitially, SOSV filed suit in the District Court for New Jersey on June 10, 2021. SOSV voluntarily dismissed its New Jersey lawsuit and on October 29, 2021, re-filed the action in the Southern District of New York. The New York lawsuit was also voluntarily dismissed by SOSV. However, SOSV may choose to re-file its lawsuit.\\nThe Company denies the accusations of SOSV and intends to vigorously defend this matter if the action is re-filed. As the lawsuit has been voluntarily dismissed, there have been no proceedings and we are unable to prognosticate a likelihood of success, or whether SOSV will re-file the action.\\nAs of September 30, 2021 and December 31, 2020, the Company had a total of $75,000 and $75,000 outstanding on this account, respectively.\\nAs of September 30, 2021, the Company does not expect any losses from these legal proceedings and accordingly has not accrued any provisions for them.\\nItem 1A. Risk Factors.\\nAs of the date of this Quarterly Report on Form 10-Q, there have been no material changes to the risk factors disclosed in our Prospectus, filed with the SEC on November 10, 2021, pursuant to Rule 424(b)(4) under the Securities Act of 1933, as amended. We may disclose changes to such factors or disclose additional factors from time to time in our future filings with the SEC.\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\\nNot Applicable\\nItem 3. Defaults Upon Senior Securities.\\nNot Applicable\\nItem 4. Mine Safety Disclosures.\\nNot Applicable\\nItem 5. Other Information\\nNone\\n| 67 |\\n\\n\\nItem 6. Exhibits\\nEXHIBIT INDEX\\n| Exhibit No. | Description |\\n| 3.1 | Articles of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.2 | Amended Bylaws of The Registrant (incorporated by reference to Exhibit 3.2 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.3 | Certificate of Designation of Series A Convertible Preferred Stock incorporated by reference to Exhibit 3.3 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.4 | Certificate of Correction of Series A Certificate of Designation filed May 2019 incorporated by reference to Exhibit 3.4 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3. | Certificate of Correction to Series A Certificate of Designation filed December 2020 (incorporated by reference to Exhibit 3.5 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.6 | Certificate of Designation of Series B Convertible Preferred Stock (incorporated by reference to Exhibit 3.6 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.7 | Certificate of Correction of Series B Certificate of Designation (incorporated by reference to Exhibit 3.7 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.8 | Certificate of Designation of Series B-1 Convertible Preferred Stock (incorporated by reference to Exhibit 3.8 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.9 | Certificate of Correction of Series B-1 Certificate of Designation (incorporated by reference to Exhibit 3.9 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 20210. |\\n| 3.10 | Certificate of Designation of Series C Convertible Preferred Stock (incorporated by reference to Exhibit 3.10 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.11 | Certificate of Correction of Series C Certificate of Designation (incorporated by reference to Exhibit 3.11 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.12 | Certificate of Designation of Series C-1 Convertible Preferred Stock (incorporated by reference to Exhibit 3.12 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.13 | Certificate of Designation for Series X Super Voting Preferred Stock ((incorporated by reference to Exhibit 3.13 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 20210. |\\n| 3.14 | Certificate of Amendment to Articles of Incorporation to change the authorized capital of the Registrant, filed December 4, 2018 (incorporated by reference to Exhibit 3.14 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.15 | Certificate of Amendment to Articles of Incorporation to change the name of Registrant, filed October 2, 2018 (incorporated by reference to Exhibit 3.15 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.16 | Certificate of Amendment to Articles of Incorporation to effect reverse stock split (incorporated by reference to Exhibit 3.16 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.17 | Certificate of Amendment to Series X Super Voting Preferred Certificate of Designation (incorporated by reference to Exhibit 3.17 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 4.1 | Form of Series C-1 Warrant (incorporated by reference to Exhibit 4.1 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 4.2 | Form of Underwriter Warrant (incorporated by reference to Exhibit 4.2 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.1 | Software Set Up, Development and Use License Agreement dated November 15, 2018 between Society Pass Incorporated and Wallet Factory International Limited (incorporated by reference to Exhibit 10.1 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.2 | Stock Purchase Agreement dated January 10 2019 between HOTTAB PTE. LTD., SOSV IV LLC, General Mobile Corporation and Sanjeev Sapkota (incorporated by reference to Exhibit 10.2 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.3 | Accelerator Contract for Equity dated January 10, 2019 by and between HOTTAB PTE. LTD., SOV IV LLC and Sanjeev Sapkota (incorporated by reference to Exhibit 10.3 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.4 | Employment Agreement dated as of April 1, 2017 between Society Pass Incorporated and Dennis Luan Thuc Nguyen (incorporated by reference to Exhibit 10.4 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.5 | Employment Agreement dated as of September 1, 2020 between Society Pass Incorporated and Liang Wee Leong Raynauld (incorporated by reference to Exhibit 10.5 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.6 | Asset Purchase Agreement dated February 16, 2021 between Goodventures Sea Limited and Sopa Technology PTE. LTD. (incorporated by reference to Exhibit 10.6 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.7 | Shareholders Agreement dated February 16, 2021 between Goodventures Sea Limited and Sopa Technology PTE. LTD (incorporated by reference to Exhibit 10.7 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.8 | Food Delivery Partnership Agreement dated as of April 22, 2021 between Hottab Asset Vietnam Co. Ltd and Dream Space Trading Co. Ltd (incorporated by reference to Exhibit 10.8 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.9 | Food Delivery Partnership Agreement dated as of July 29, 2020 between Hottab Asset Vietnam Co. Ltd and Lala Move Vietnam Co. Ltd (incorporated by reference to Exhibit 10.9 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.10 | Payment Gateway Agreement dated February 25, 2020 between Hottab Asset Vietnam Co. Ltd and VTC Technology and Digital Content Company (incorporated by reference to Exhibit 10.10 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.11 | Payment Gateway Agreement dated April 20, 2020 between Hottab Asset Vietnam Co. Ltd and Media Corporation (Vietnam Post Telecommunication Media) (incorporated by reference to Exhibit 10.11 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.12 | Payment Gateway Agreement dated August 31, 2020 between Hottab Asset Vietnam Co. Ltd and Zion Joint Stock Company (incorporated by reference to Exhibit 10.12 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.13 | Payment Gateway Agreement dated August 31, 2020 between Hottab Asset Vietnam Co. Ltd and Online Mobile Service Joint Stock Co (incorporated by reference to Exhibit 10.13 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.14 | Vendor Finance Partnership Agreement, dated as of October 22, 2019 between Hottab Asset Vietnam Co. Ltd and SHBank Finance Co. Ltd (incorporated by reference to Exhibit 10.14 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.15 | Business Cooperation Agreement dated March 6, 2020 between Hottab Asset Vietnam Co. and Triip Pte. Ltd ((incorporated by reference to Exhibit 10.15 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.16 | The Registrant’s 2021 Equity Incentive Plan (incorporated by reference to Exhibit 10.16 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.17 | Business Cooperation Contract dated May 28, 2021 between Paytech, JSC and the Registrant (incorporated by reference to Exhibit 10.17 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.18 | Business Cooperation Agreement dated August 15, 2021 between Hottab Vietnam Company Limited and Rainbow Loyalty Company Limited (incorporated by reference to Exhibit 10.18 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.19 | Amendment to Employment Agreement dated October 25, 2021 between Dennis Nguyen and the Registrant (incorporated by reference to Exhibit 10.19 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 31.1 | Certification of principal executive officer pursuant to Rule 13a-14(A) promulgated under the Securities Exchange Act of 1934 |\\n| 31.2 | Certification of principal financial officer pursuant to Rule 13a-14(A) promulgated under the Securities Exchange Act of 1934 |\\n| 32.1* | Certification of principal executive officer and principal financial officer pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(B) promulgated under the Securities Exchange Act of 1934 |\\n\\n* The certifications furnished in Exhibit 32.1 hereto are deemed to accompany this Form 10-Q and are not deemed “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to the liability of that section, nor shall they be deemed incorporated by reference into any filing under the Securities Act or the Exchange Act.\\n| 68 |\\n\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n| SOCIETY PASS INCORPORATED |\\n| (Registrant) |\\n| Date: December 9, 2021 | By: | /s/ Dennis Nguyen |\\n| Dennis Nuguyen |\\n| Chief Executive Officer |\\n| Date: December 9, 2021 | By: | /s/ Ranauld Liang |\\n| Raynauld Liang |\\n| Chief Financial Officer |\\n\\n\\n| 69 |\\n\\n\\n \\n\\nWhat would be the total number of common stock to be issued in 2021 if the IPO price is $10 per share, if the conversion for Series A preferred stocks is its aggregate Stated Value divided by IPO price?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 7459900.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 52,\n \"input_length\": 62394\n}"}}},{"rowIdx":53,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nPART I—FINANCIAL INFORMATION\nITEM 1. FINANCIAL STATEMENTS\nBoise Cascade Company\nConsolidated Statements of Operations\n(unaudited)\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands, except per-share data) |\n| Sales | $ | 1,544,329 | $ | 2,326,282 |\n| Costs and expenses |\n| Materials, labor, and other operating expenses (excluding depreciation) | 1,230,635 | 1,729,896 |\n| Depreciation and amortization | 31,186 | 20,543 |\n| Selling and distribution expenses | 128,788 | 146,651 |\n| General and administrative expenses | 26,463 | 26,052 |\n| Other (income) expense, net | ( 345 ) | ( 2,488 ) |\n| 1,416,727 | 1,920,654 |\n| Income from operations | 127,602 | 405,628 |\n| Foreign currency exchange gain (loss) | ( 73 ) | 132 |\n| Pension expense (excluding service costs) | ( 41 ) | ( 171 ) |\n| Interest expense | ( 6,361 ) | ( 6,254 ) |\n| Interest income | 9,685 | 65 |\n| Change in fair value of interest rate swaps | ( 804 ) | 2,066 |\n| 2,406 | ( 4,162 ) |\n| Income before income taxes | 130,008 | 401,466 |\n| Income tax provision | ( 33,275 ) | ( 98,866 ) |\n| Net income | $ | 96,733 | $ | 302,600 |\n| Weighted average common shares outstanding: |\n| Basic | 39,593 | 39,474 |\n| Diluted | 39,838 | 39,768 |\n| Net income per common share: |\n| Basic | $ | 2.44 | $ | 7.67 |\n| Diluted | $ | 2.43 | $ | 7.61 |\n| Dividends declared per common share | $ | 0.15 | $ | 0.12 |\n\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\n1\nBoise Cascade Company\nConsolidated Statements of Comprehensive Income\n(unaudited)\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| Net income | $ | 96,733 | $ | 302,600 |\n| Other comprehensive income, net of tax |\n| Defined benefit pension plans |\n| Amortization of actuarial loss, net of tax of $ 2 and $ 5 , respectively | 6 | 16 |\n| Effect of settlements, net of tax of $ — and $ 32 , respectively | — | 98 |\n| Other comprehensive income, net of tax | 6 | 114 |\n| Comprehensive income | $ | 96,739 | $ | 302,714 |\n\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\n2\nBoise Cascade Company\nConsolidated Balance Sheets\n(unaudited)\n| March 31,2023 | December 31,2022 |\n| (thousands) |\n| ASSETS |\n| Current |\n| Cash and cash equivalents | $ | 1,000,721 | $ | 998,344 |\n| Receivables |\n| Trade, less allowances of $ 4,341 and $ 3,264 | 417,515 | 297,237 |\n| Related parties | 196 | 19 |\n| Other | 13,821 | 23,023 |\n| Inventories | 738,798 | 697,551 |\n| Prepaid expenses and other | 20,666 | 47,878 |\n| Total current assets | 2,191,717 | 2,064,052 |\n| Property and equipment, net | 772,734 | 770,023 |\n| Operating lease right-of-use assets | 52,441 | 55,582 |\n| Finance lease right-of-use assets | 25,883 | 26,501 |\n| Timber deposits | 8,299 | 7,519 |\n| Goodwill | 137,958 | 137,958 |\n| Intangible assets, net | 157,133 | 161,433 |\n| Deferred income taxes | 6,135 | 6,116 |\n| Other assets | 9,887 | 11,330 |\n| Total assets | $ | 3,362,187 | $ | 3,240,514 |\n\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\n3\nBoise Cascade Company\nConsolidated Balance Sheets (continued)\n(unaudited)\n| March 31,2023 | December 31,2022 |\n| (thousands, except per-share data) |\n| LIABILITIES AND STOCKHOLDERS' EQUITY |\n| Current |\n| Accounts payable |\n| Trade | $ | 400,455 | $ | 269,785 |\n| Related parties | 1,420 | 1,019 |\n| Accrued liabilities |\n| Compensation and benefits | 79,606 | 142,463 |\n| Interest payable | 5,088 | 9,955 |\n| Other | 93,579 | 122,606 |\n| Total current liabilities | 580,148 | 545,828 |\n| Debt |\n| Long-term debt | 444,614 | 444,392 |\n| Other |\n| Compensation and benefits | 33,280 | 33,226 |\n| Operating lease liabilities, net of current portion | 45,681 | 48,668 |\n| Finance lease liabilities, net of current portion | 29,549 | 30,022 |\n| Deferred income taxes | 66,855 | 63,454 |\n| Other long-term liabilities | 17,540 | 16,949 |\n| 192,905 | 192,319 |\n| Commitments and contingent liabilities |\n| Stockholders' equity |\n| Preferred stock, $ 0.01 par value per share; 50,000 shares authorized, no shares issued and outstanding | — | — |\n| Common stock, $ 0.01 par value per share; 300,000 shares authorized, 44,983 and 44,827 shares issued, respectively | 450 | 448 |\n| Treasury stock, 5,392 and 5,367 shares at cost, respectively | ( 140,391 ) | ( 138,909 ) |\n| Additional paid-in capital | 548,611 | 551,215 |\n| Accumulated other comprehensive loss | ( 514 ) | ( 520 ) |\n| Retained earnings | 1,736,364 | 1,645,741 |\n| Total stockholders' equity | 2,144,520 | 2,057,975 |\n| Total liabilities and stockholders' equity | $ | 3,362,187 | $ | 3,240,514 |\n\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\n4\nBoise Cascade Company\nConsolidated Statements of Cash Flows\n(unaudited)\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| Cash provided by (used for) operations |\n| Net income | $ | 96,733 | $ | 302,600 |\n| Items in net income not using (providing) cash |\n| Depreciation and amortization, including deferred financing costs and other | 31,853 | 20,993 |\n| Stock-based compensation | 3,324 | 2,392 |\n| Pension expense | 41 | 171 |\n| Deferred income taxes | 3,393 | ( 729 ) |\n| Change in fair value of interest rate swaps | 804 | ( 2,066 ) |\n| Other | ( 518 ) | ( 2,412 ) |\n| Decrease (increase) in working capital |\n| Receivables | ( 111,253 ) | ( 218,018 ) |\n| Inventories | ( 41,247 ) | ( 143,997 ) |\n| Prepaid expenses and other | ( 1,428 ) | ( 3,227 ) |\n| Accounts payable and accrued liabilities | 36,181 | 147,425 |\n| Pension contributions | ( 136 ) | ( 655 ) |\n| Income taxes payable | 28,631 | 95,352 |\n| Other | 1,614 | 1,116 |\n| Net cash provided by operations | 47,992 | 198,945 |\n| Cash provided by (used for) investment |\n| Expenditures for property and equipment | ( 30,063 ) | ( 17,448 ) |\n| Proceeds from sales of assets and other | 565 | 2,581 |\n| Net cash used for investment | ( 29,498 ) | ( 14,867 ) |\n| Cash provided by (used for) financing |\n| Dividends paid on common stock | ( 8,258 ) | ( 5,939 ) |\n| Tax withholding payments on stock-based awards | ( 5,926 ) | ( 3,930 ) |\n| Treasury stock purchased | ( 1,482 ) | — |\n| Other | ( 451 ) | ( 395 ) |\n| Net cash used for financing | ( 16,117 ) | ( 10,264 ) |\n| Net increase in cash and cash equivalents | 2,377 | 173,814 |\n| Balance at beginning of the period | 998,344 | 748,907 |\n| Balance at end of the period | $ | 1,000,721 | $ | 922,721 |\n\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\n5\nBoise Cascade Company\nConsolidated Statements of Stockholders' Equity\n(unaudited)\n| Common Stock | Treasury Stock | Additional Paid-In Capital | Accumulated Other Comprehensive Loss | Retained Earnings | Total |\n| Shares | Amount | Shares | Amount |\n| (thousands) |\n| Balance at December 31, 2022 | 44,827 | $ | 448 | 5,367 | $ | ( 138,909 ) | $ | 551,215 | $ | ( 520 ) | $ | 1,645,741 | $ | 2,057,975 |\n| Net income | 96,733 | 96,733 |\n| Other comprehensive income | 6 | 6 |\n| Common stock issued | 156 | 2 | 2 |\n| Treasury stock purchased | 25 | ( 1,482 ) | ( 1,482 ) |\n| Stock-based compensation | 3,324 | 3,324 |\n| Common stock dividends ($ 0.15 per share) | ( 6,110 ) | ( 6,110 ) |\n| Tax withholding payments on stock-based awards | ( 5,926 ) | ( 5,926 ) |\n| Other | ( 2 ) | ( 2 ) |\n| Balance at March 31, 2023 | 44,983 | $ | 450 | 5,392 | $ | ( 140,391 ) | $ | 548,611 | $ | ( 514 ) | $ | 1,736,364 | $ | 2,144,520 |\n\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\n6\nBoise Cascade Company\nConsolidated Statements of Stockholders' Equity (continued)\n(unaudited)\n| Common Stock | Treasury Stock | Additional Paid-In Capital | Accumulated Other Comprehensive Loss | Retained Earnings | Total |\n| Shares | Amount | Shares | Amount |\n| (thousands) |\n| Balance at December 31, 2021 | 44,698 | $ | 447 | 5,367 | $ | ( 138,909 ) | $ | 543,249 | $ | ( 1,047 ) | $ | 948,879 | $ | 1,352,619 |\n| Net income | 302,600 | 302,600 |\n| Other comprehensive income | 114 | 114 |\n| Common stock issued | 117 | 1 | 1 |\n| Stock-based compensation | 2,392 | 2,392 |\n| Common stock dividends ($ 0.12 per share) | ( 5,133 ) | ( 5,133 ) |\n| Tax withholding payments on stock-based awards | ( 3,930 ) | ( 3,930 ) |\n| Proceeds from exercise of stock options | 27 | 27 |\n| Other | ( 1 ) | ( 1 ) |\n| Balance at March 31, 2022 | 44,815 | $ | 448 | 5,367 | $ | ( 138,909 ) | $ | 541,737 | $ | ( 933 ) | $ | 1,246,346 | $ | 1,648,689 |\n\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\n7\nCondensed Notes to Unaudited Quarterly Consolidated Financial Statements\n1. Nature of Operations and Consolidation\nNature of Operations\nBoise Cascade Company is a building products company headquartered in Boise, Idaho. As used in this Form 10-Q, the terms \"Boise Cascade,\" \"we,\" and \"our\" refer to Boise Cascade Company and its consolidated subsidiaries. We are one of the largest producers of engineered wood products (EWP) and plywood in North America and a leading United States wholesale distributor of building products.\nWe operate our business using two reportable segments: (1) Wood Products, which primarily manufactures EWP and plywood, and (2) Building Materials Distribution (BMD), which is a wholesale distributor of building materials. For more information, see Note 12, Segment Information.\nConsolidation\nThe accompanying quarterly consolidated financial statements have not been audited by an independent registered public accounting firm but, in the opinion of management, include all adjustments necessary to present fairly the financial position, results of operations, cash flows, and stockholders' equity for the interim periods presented. Except as disclosed within these condensed notes to unaudited quarterly consolidated financial statements, the adjustments made were of a normal, recurring nature. Certain information and footnote disclosures normally included in our annual consolidated financial statements have been condensed or omitted. The quarterly consolidated financial statements include the accounts of Boise Cascade and its subsidiaries after elimination of intercompany balances and transactions. Quarterly results are not necessarily indicative of results that may be expected for the full year. These condensed notes to unaudited quarterly consolidated financial statements should be read in conjunction with our 2022 Form 10-K and the other reports we file with the Securities and Exchange Commission.\n2. Summary of Significant Accounting Policies\nAccounting Policies\nThe complete summary of significant accounting policies is included in Note 2, Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements in \"Item 8. Financial Statements and Supplementary Data\" in our 2022 Form 10-K.\nUse of Estimates\nThe preparation of financial statements in conformity with generally accepted accounting principles (GAAP) requires management to make estimates and assumptions about future events. These estimates and the underlying assumptions affect the amounts of assets and liabilities reported, disclosures about contingent assets and liabilities, and reported amounts of revenues and expenses. Such estimates include the valuation of accounts receivable, inventories, goodwill, intangible assets, and other long-lived assets; legal contingencies; guarantee obligations; indemnifications; assumptions used in retirement, medical, and workers' compensation benefits; assumptions used in the determination of right-of-use (ROU) assets and related lease liabilities; stock-based compensation; fair value measurements; income taxes; and vendor and customer rebates, among others. These estimates and assumptions are based on management's best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors, including the current economic environment, which management believes to be reasonable under the circumstances. We adjust such estimates and assumptions when facts and circumstances dictate. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in these estimates resulting from continuing changes in the economic environment will be reflected in the consolidated financial statements in future periods.\n8\nRevenue Recognition\nRevenues are recognized when control of the promised goods or services is transferred to our customers, in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services. For revenue disaggregated by major product line for each reportable segment, see Note 12, Segment Information.\nFees for shipping and handling charged to customers for sales transactions are included in \"Sales\" in our Consolidated Statements of Operations. When control over products has transferred to the customer, we have elected to recognize costs related to shipping and handling as fulfillment costs. For our Wood Products segment, costs related to shipping and handling are included in \"Materials, labor, and other operating expenses (excluding depreciation)\" in our Consolidated Statements of Operations. In our Wood Products segment, we view our shipping and handling costs as a cost of the manufacturing process and the movement of product to our end customers. For our BMD segment, costs related to shipping and handling of $ 53.5 million and $ 56.3 million for the three months ended March 31, 2023 and 2022, respectively, are included in \"Selling and distribution expenses\" in our Consolidated Statements of Operations. In our BMD segment, our activities relate to the purchase and resale of finished products, and excluding shipping and handling costs from \"Materials, labor, and other operating expenses (excluding depreciation)\" provides us a clearer view of our operating performance and the effectiveness of our sales and purchasing functions.\nCustomer Rebates and Allowances\nRebates are provided to our customers and our customers' customers based on the volume of their purchases, among other factors such as customer loyalty, conversion, and commitment, as well as temporary protection from price increases. We provide the rebates to increase the sell-through of our products. Rebates are generally estimated based on the expected amount to be paid and recorded as a decrease in \"Sales.\" At March 31, 2023 and December 31, 2022, we had $ 58.7 million and $ 92.9 million, respectively, of rebates payable to our customers recorded in \"Accrued liabilities, Other\" on our Consolidated Balance Sheets. We adjust our estimate of revenue at the earlier of when the probability of rebates paid changes or when the amounts become fixed. There have not been significant changes to our estimates of rebates, although it is reasonably possible that a change in the estimate may occur.\nVendor Rebates and Allowances\nWe receive rebates and allowances from our vendors under a number of different programs, including vendor marketing programs. At March 31, 2023 and December 31, 2022, we had $ 9.0 million and $ 17.8 million, respectively, of vendor rebates and allowances recorded in \"Receivables, Other\" on our Consolidated Balance Sheets. Rebates and allowances received from our vendors are recognized as a reduction of \"Materials, labor, and other operating expenses (excluding depreciation)\" when the product is sold, unless the rebates and allowances are linked to a specific incremental cost to sell a vendor's product. Amounts received from vendors that are linked to specific selling and distribution expenses are recognized as a reduction of \"Selling and distribution expenses\" in the period the expense is incurred.\nLeases\nWe primarily lease land, building, and equipment under operating and finance leases. We determine if an arrangement is a lease at inception and assess lease classification as either operating or finance at lease inception or upon modification. Substantially all of our leases with initial terms greater than one year are for real estate, including distribution centers, corporate headquarters, land, and other office space. Substantially all of these lease agreements have fixed payment terms based on the passage of time and are recorded in our BMD segment. Many of our leases include fixed escalation clauses, renewal options and/or termination options that are factored into our determination of lease term and lease payments when appropriate. Renewal options generally range from one to ten years with fixed payment terms similar to those in the original lease agreements. Some lease agreements provide us with the option to purchase the leased property at market value. Our lease agreements do not contain any residual value guarantees.\nROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. ROU assets and lease liabilities are recognized at the lease commencement date based on the estimated present value of fixed lease payments over the lease term. The current portion of our operating and finance lease liabilities are recorded in \"Accrued liabilities, Other\" on our Consolidated Balance Sheets.\nWe use our estimated incremental borrowing rate, which is derived from information available at the lease commencement date, in determining the present value of lease payments. In determining our incremental borrowing rates, we\n9\ngive consideration to publicly available interest rates for instruments with similar characteristics, including credit rating, term, and collateralization.\nFor purposes of determining straight-line rent expense, the lease term is calculated from the date we first take possession of the facility, including any periods of free rent and any renewal option periods we are reasonably certain of exercising. Variable lease expense generally includes reimbursement of actual costs for common area maintenance, property taxes, and insurance on leased real estate and are recorded as incurred. Most of our operating lease expense was recorded in \"Selling and distribution expenses\" in our Consolidated Statements of Operations. In addition, we do not separate lease and non-lease components for all of our leases.\nOur short-term leases primarily include equipment rentals with lease terms on a month-to-month basis, which provide for our seasonal needs and flexibility in the use of equipment. Our short-term leases also include certain real estate for which either party has the right to cancel upon providing notice of 30 to 90 days. We do not recognize ROU assets or lease liabilities for short-term leases.\nInventories\nInventories included the following (work in process is not material):\n\n| March 31,2023 | December 31,2022 |\n| (thousands) |\n| Finished goods and work in process | $ | 640,858 | $ | 596,328 |\n| Logs | 50,154 | 54,921 |\n| Other raw materials and supplies | 47,786 | 46,302 |\n| $ | 738,798 | $ | 697,551 |\n\nProperty and Equipment\nProperty and equipment consisted of the following asset classes:\n\n| March 31,2023 | December 31,2022 |\n| (thousands) |\n| Land | $ | 61,806 | $ | 60,211 |\n| Buildings | 242,484 | 231,087 |\n| Improvements | 70,419 | 69,832 |\n| Mobile equipment, information technology, and office furniture | 215,460 | 210,666 |\n| Machinery and equipment | 993,900 | 989,338 |\n| Construction in progress | 45,348 | 41,899 |\n| 1,629,417 | 1,603,033 |\n| Less: accumulated depreciation | ( 856,683 ) | ( 833,010 ) |\n| $ | 772,734 | $ | 770,023 |\n\n10\nFair Value\nFair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value hierarchy under GAAP gives the highest priority to quoted market prices (Level 1) and the lowest priority to unobservable inputs (Level 3). In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine fair value (Level 1). If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, we use quoted prices for similar assets and liabilities or inputs that are observable either directly or indirectly (Level 2). If quoted prices for identical or similar assets are not available or are unobservable, we may use internally developed valuation models, whose inputs include bid prices, and third-party valuations utilizing underlying asset assumptions (Level 3).\nFinancial Instruments\nOur financial instruments are cash and cash equivalents, accounts receivable, accounts payable, long-term debt, and an interest rate swap. Our cash is recorded at cost, which approximates fair value, and our cash equivalents are money market funds. As of March 31, 2023 and December 31, 2022, we held $ 981.1 million and $ 954.4 million, respectively, in money market funds that are measured at fair value on a recurring basis using Level 1 inputs. The recorded values of accounts receivable and accounts payable approximate fair values based on their short-term nature. At March 31, 2023 and December 31, 2022, the book value of our fixed-rate debt for each period was $ 400.0 million, and the fair value was estimated to be $ 348.0 million and $ 348.5 million, respectively. The difference between the book value and the fair value is derived from the difference between the period-end market interest rate and the stated rate of our fixed-rate, long-term debt. We estimated the fair value of our fixed-rate debt using quoted market prices of our debt in inactive markets (Level 2 inputs). The interest rate on our variable-rate debt is based on market conditions such as the Secured Overnight Financing Rate (SOFR) or a base rate. Because the interest rate on the variable-rate debt is based on current market conditions, we believe that the estimated fair value of the outstanding balance on our variable-rate debt approximates book value. As discussed below, we also have an interest rate swap to mitigate our variable interest rate exposure, the fair value of which is measured based on Level 2 inputs.\nInterest Rate Risk and Interest Rate Swap\nWe are exposed to interest rate risk arising from fluctuations in variable-rate SOFR on our term loan and when we have loan amounts outstanding on our Revolving Credit Facility. At March 31, 2023, we had $ 50.0 million of variable-rate debt outstanding based on one-month term SOFR . Our objective is to limit the variability of interest payments on our debt. To meet this objective, we enter into receive-variable, pay-fixed interest rate swaps to mitigate the variable-rate cash flow exposure with fixed-rate cash flows. In accordance with our risk management strategy, we actively monitor our interest rate exposure and use derivative instruments from time to time to manage the related risk. We do not speculate using derivative instruments.\nAt March 31, 2023, we had one interest rate swap agreement, which we entered into in 2020 and commenced in February 2022. Under the interest rate swap, we receive one-month SOFR plus a spread adjustment of 0.10 % variable interest rate payments and make fixed interest rate payments, thereby fixing the interest rate on $ 50.0 million of variable rate debt exposure. Payments on this interest rate swap, with a notional principal amount of $ 50.0 million, are due on a monthly basis at an annual fixed rate of 0.41 %, and this swap expires in June 2025.\nThe interest rate swap agreement was not designated as a cash flow hedge, and as a result, all changes in the fair value are recognized in \"Change in fair value of interest rate swaps\" in our Consolidated Statements of Operations rather than through other comprehensive income. At March 31, 2023 and December 31, 2022, we recorded long-term assets of $ 4.0 million and $ 4.8 million, respectively, in \"Other assets\" on our Consolidated Balance Sheets, representing the fair value of the interest rate swap agreement. The swap was valued based on observable inputs for similar assets and liabilities and other observable inputs for interest rates and yield curves (Level 2 inputs).\nConcentration of Credit Risk\nWe are exposed to credit risk related to customer accounts receivable. In order to manage credit risk, we consider customer concentrations and current economic trends and monitor the creditworthiness of significant customers based on ongoing credit evaluations. At March 31, 2023, receivables from two customers accounted for approximately 19 % and 12 % of total receivables. At December 31, 2022, receivables from these two customers accounted for approximately 17 % and 14 % of total receivables. No other customer accounted for 10% or more of total receivables.\n11\nNew and Recently Adopted Accounting Standards\nThere were no accounting standards recently issued that had or are expected to have a material impact on our consolidated financial statements and associated disclosures.\n3. Income Taxes\nFor the three months ended March 31, 2023 and 2022, we recorded $ 33.3 million and $ 98.9 million, respectively, of income tax expense and had an effective rate of 25.6 % and 24.6 %, respectively. For both periods, the primary reason for the difference between the federal statutory income tax rate of 21 % and the effective tax rate was the effect of state taxes.\nDuring the three months ended March 31, 2023 and 2022, cash paid for taxes, net of refunds received, were $ 1.2 million and $ 4.2 million, respectively.\n4. Net Income Per Common Share\nBasic net income per common share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Weighted average common shares outstanding for the basic net income per common share calculation includes certain vested restricted stock units (RSUs) and performance stock units (PSUs) as there are no conditions under which those shares will not be issued. Diluted net income per common share is computed by dividing net income by the combination of the weighted average number of common shares outstanding during the period and other potentially dilutive weighted average common shares. Other potentially dilutive weighted average common shares include the dilutive effect of stock options, RSUs, and PSUs for each period using the treasury stock method. Under the treasury stock method, the exercise price of a share and the amount of compensation expense, if any, for future service that has not yet been recognized are assumed to be used to repurchase shares in the current period.\nThe following table sets forth the computation of basic and diluted net income per common share:\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands, except per-share data) |\n| Net income | $ | 96,733 | $ | 302,600 |\n| Weighted average common shares outstanding during the period (for basic calculation) | 39,593 | 39,474 |\n| Dilutive effect of other potential common shares | 245 | 294 |\n| Weighted average common shares and potential common shares (for diluted calculation) | 39,838 | 39,768 |\n| Net income per common share - Basic | $ | 2.44 | $ | 7.67 |\n| Net income per common share - Diluted | $ | 2.43 | $ | 7.61 |\n\nThe computation of the dilutive effect of other potential common shares excludes stock awards representing an insignificant number of shares of common stock in both the three months ended March 31, 2023 and 2022. Under the treasury stock method, the inclusion of these stock awards would have been antidilutive.\n12\n5. Acquisition\nWe account for acquisition transactions in accordance with ASC 805, Business Combinations. Accordingly, the results of operations of the acquiree are included in our consolidated financial statements from the acquisition date. The consideration transferred is allocated to the identifiable assets acquired and liabilities assumed based on estimated fair values at the acquisition date, with any excess recorded as goodwill. Transaction-related costs are expensed in the period the costs are incurred. During the measurement period, which may be up to one year from the acquisition date, we may record adjustments to the assets acquired and liabilities assumed with the corresponding adjustment to goodwill.\nOn July 25, 2022, our wholly-owned subsidiary, Boise Cascade Wood Products, L.L.C., completed the acquisition of 100 % of the equity interest in Coastal Plywood, and its plywood manufacturing operations located in Havana, Florida, and Chapman, Alabama, for a purchase price of $ 515.2 million, including a post-closing adjustment of $ 1.6 million based upon a working capital target (the Acquisition).\nThe following table summarizes the final allocations of the purchase price to the assets acquired and liabilities assumed, based on our estimates of the fair value at the date of the Acquisition:\n| Acquisition Date Fair Value |\n| (thousands) |\n| Accounts receivable | $ | 16,123 |\n| Inventories | 22,977 |\n| Property and equipment | 251,329 |\n| Other assets | 1,809 |\n| Intangible assets: |\n| Trade name | 700 |\n| Customer relationships | 153,600 |\n| Goodwill | 77,576 |\n| Assets acquired | 524,114 |\n| Accounts payable and accrued liabilities | 6,299 |\n| Other long-term liabilities | 2,578 |\n| Liabilities assumed | 8,877 |\n| Net assets acquired | $ | 515,237 |\n\n13\n6. Goodwill and Intangible Assets\nGoodwill represents the excess of the purchase price and related costs over the fair value of the net tangible and intangible assets of businesses acquired.\nThe carrying amount of our goodwill by segment is as follows:\n| BuildingMaterialsDistribution | Wood Products | Total |\n| (thousands) |\n| Balance at December 31, 2022 and March 31, 2023 | $ | 11,792 | $ | 126,166 | $ | 137,958 |\n\nAt March 31, 2023 and December 31, 2022, intangible assets represented the values assigned to trade names and trademarks and customer relationships. We maintain trademarks for our manufactured wood products, particularly EWP. Our key registered trademarks are perpetual in duration as long as we continue to timely file all post registration maintenance documents related thereto. These trade names and trademarks have indefinite lives, are not amortized, and have a carrying amount of $ 8.9 million. In 2022, we acquired a trade name and customer relationships as discussed in Note 5, Acquisition. The acquired trade name has a useful life of one year . The weighted-average useful life for customer relationships from the date of purchase is approximately 10 years. For the three months ended March 31, 2023 and 2022 we recognized $ 4.3 million and $ 0.3 million, respectively, of amortization expense for intangible assets.\nIntangible assets consisted of the following:\n| March 31, 2023 |\n| Gross CarryingAmount | AccumulatedAmortization | Net CarryingAmount |\n| (thousands) |\n| Trade names and trademarks | $ | 9,600 | $ | ( 467 ) | $ | 9,133 |\n| Customer relationships | 166,050 | ( 18,050 ) | 148,000 |\n| $ | 175,650 | $ | ( 18,517 ) | $ | 157,133 |\n\n| December 31, 2022 |\n| Gross CarryingAmount | AccumulatedAmortization | Net CarryingAmount |\n| (thousands) |\n| Trade names and trademarks | $ | 9,600 | $ | ( 292 ) | $ | 9,308 |\n| Customer relationships | 166,050 | ( 13,925 ) | 152,125 |\n| $ | 175,650 | $ | ( 14,217 ) | $ | 161,433 |\n\n7. Debt\nLong-term debt consisted of the following:\n| March 31,2023 | December 31,2022 |\n| (thousands) |\n| Asset-based revolving credit facility due 2027 | $ | — | $ | — |\n| Asset-based credit facility term loan due 2027 | 50,000 | 50,000 |\n| 4.875% senior notes due 2030 | 400,000 | 400,000 |\n| Deferred financing costs | ( 5,386 ) | ( 5,608 ) |\n| Long-term debt | $ | 444,614 | $ | 444,392 |\n\n14\nAsset-Based Credit Facility\nOn May 15, 2015, Boise Cascade and its principal operating subsidiaries, Boise Cascade Wood Products, L.L.C., and Boise Cascade Building Materials Distribution, L.L.C., as borrowers, and Boise Cascade Wood Products Holdings Corp., as guarantor, entered into an Amended and Restated Credit Agreement, as amended, (the Amended Agreement) with Wells Fargo Capital Finance, LLC, as administrative agent, and the banks named therein as lenders. The Amended Agreement includes a $ 400 million senior secured asset-based revolving credit facility (Revolving Credit Facility) and a $ 50.0 million term loan (ABL Term Loan) maturing on the earlier of (a) September 9, 2027 and (b) 90 days prior to the maturity of our $ 400 million of 4.875 % senior notes due July 1, 2030 (or the maturity date of any permitted refinancing indebtedness or permitted upsized refinancing indebtedness in respect thereof). Interest on borrowings under our Revolving Credit Facility and ABL Term Loan are payable monthly. Borrowings under the Amended Agreement are constrained by a borrowing base formula dependent upon levels of eligible receivables and inventory reduced by outstanding borrowings and letters of credit (Availability).\nThe Amended Agreement is secured by a first-priority security interest in substantially all of our assets, except for property and equipment. The proceeds of borrowings under the agreement are available for working capital and other general corporate purposes.\nThe Amended Agreement contains customary nonfinancial covenants, including a negative pledge covenant and restrictions on new indebtedness, investments, distributions to equity holders, asset sales, and affiliate transactions, the scope of which are dependent on the Availability existing from time to time. The Amended Agreement also contains a requirement that we meet a 1 :1 fixed-charge coverage ratio (FCCR), applicable only if Availability falls below the greater of (a) 10 % of the Line Cap (as defined in the Amended Agreement) and (b) $ 35 million. Availability exceeded the minimum threshold amounts required for testing of the FCCR at all times since entering into the Amended Agreement, and Availability at March 31, 2023 was $ 395.9 million.\nThe Amended Agreement permits us to pay dividends only if at the time of payment (a) no default has occurred or is continuing (or would result from such payment) under the Amended Agreement, and (b) either (i) pro forma Excess Availability (as defined in the Amended Agreement) is equal to or exceeds the greater of (x) 20 % of the Line Cap and (y) $ 75 million or (ii) (x) pro forma Excess Availability is equal to or exceeds the greater of (1) 15 % of Line Cap and (2) $ 55 million and (y) our fixed-charge coverage ratio is greater than or equal to 1 :1 on a pro forma basis.\nRevolving Credit Facility\nInterest rates under the Revolving Credit Facility are based, at our election, on either Daily Simple SOFR, Term SOFR, or a base rate, as defined in the Amended Agreement, plus a spread over the index elected that ranges from 1.25 % to 1.50 % for loans based on SOFR and from 0.25 % to 0.50 % for loans based on the base rate. The spread is determined on the basis of a pricing grid that results in a higher spread as average quarterly Availability declines. Both SOFR options include an additional credit spread adjustment of 0.10 %. Letters of credit are subject to a fronting fee payable to the issuing bank and a fee payable to the lenders equal to the Term SOFR margin rate. In addition, we are required to pay an unused commitment fee at a rate of 0.20 % per annum of the average unused portion of the lending commitments.\nAt both March 31, 2023 and December 31, 2022, we had no borrowings outstanding under the Revolving Credit Facility and $ 4.1 million and $ 3.8 million, respectively, of letters of credit outstanding. These letters of credit and borrowings, if any, reduce availability under the Revolving Credit Facility by an equivalent amount.\nABL Term Loan\nThe ABL Term Loan was provided by institutions within the Farm Credit system. Borrowings under the ABL Term Loan may be repaid from time to time at the discretion of the borrowers without premium or penalty. However, any principal amount of ABL Term Loan repaid may not be subsequently re-borrowed.\nInterest rates under the ABL Term Loan are based, at our election, on either Daily Simple SOFR, Term SOFR, or a base rate, as defined in the Amended Agreement, plus a spread over the index elected that ranges from 1.75 % to 2.00 % for SOFR rate loans and from 0.75 % to 1.00 % for base rate loans, both dependent on the amount of Average Excess Availability (as defined in the Amended Agreement). Both SOFR options include an additional credit spread adjustment of 0.10 %. During the three months ended March 31, 2023, the average interest rate on the ABL Term Loan was approximately 6.36 %.\nWe have received and expect to continue receiving patronage credits under the ABL Term Loan. Patronage credits are distributions of profits from banks in the Farm Credit system, which are cooperatives that are required to distribute profits to\n15\ntheir members. Patronage distributions, which are generally made in cash, are received in the year after they are earned. Patronage credits are recorded as a reduction to interest expense in the year earned. After giving effect to expected patronage distributions, the effective average net interest rate on the ABL Term Loan was approximately 5.4 % during the three months ended March 31, 2023.\n2030 Notes\nOn July 27, 2020, we issued $ 400 million of 4.875 % senior notes due July 1, 2030 (2030 Notes) through a private placement that was exempt from the registration requirements of the Securities Act. Interest on our 2030 Notes is payable semiannually in arrears on January 1 and July 1. The 2030 Notes are guaranteed by each of our existing and future direct or indirect domestic subsidiaries that is a guarantor under our Amended Agreement.\nThe 2030 Notes are senior unsecured obligations and rank equally with all of the existing and future senior indebtedness of Boise Cascade Company and of the guarantors, senior to all of their existing and future subordinated indebtedness, effectively subordinated to all of their present and future senior secured indebtedness (including all borrowings with respect to our Amended Agreement to the extent of the value of the assets securing such indebtedness), and structurally subordinated to the indebtedness of any subsidiaries that do not guarantee the 2030 Notes.\nThe terms of the indenture governing the 2030 Notes, among other things, limit the ability of Boise Cascade and our restricted subsidiaries to: incur additional debt; declare or pay dividends; redeem stock or make other distributions to stockholders; make investments; create liens on assets; consolidate, merge or transfer substantially all of their assets; enter into transactions with affiliates; and sell or transfer certain assets. The indenture governing the 2030 Notes permits us to pay dividends only if at the time of payment (i) no default has occurred or is continuing (or would result from such payment) under the indenture, and (ii) our consolidated leverage ratio is no greater than 3.5 :1, or (iii) the dividend, together with other dividends since the issue date, would not exceed our \"builder\" basket under the indenture. In addition, the indenture includes certain specific baskets for the payment of dividends.\nThe indenture governing the 2030 Notes provides for customary events of default and remedies.\nInterest Rate Swap\nFor information on interest rate swap, see Interest Rate Risk and Interest Rate Swap of Note 2, Summary of Significant Accounting Policies.\nCash Paid for Interest\nFor the three months ended March 31, 2023 and 2022, cash payments for interest were $ 10.4 million and $ 10.6 million, respectively.\n16\n8. Leases\nLease Costs\nThe components of lease expense were as follows:\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| Operating lease cost | $ | 3,317 | $ | 3,561 |\n| Finance lease cost |\n| Amortization of right-of-use assets | 618 | 626 |\n| Interest on lease liabilities | 560 | 587 |\n| Variable lease cost | 1,385 | 1,034 |\n| Short-term lease cost | 1,551 | 1,312 |\n| Sublease income | ( 53 ) | ( 112 ) |\n| Total lease cost | $ | 7,378 | $ | 7,008 |\n\nOther Information\nSupplemental cash flow information related to leases was as follows:\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| Cash paid for amounts included in the measurement of lease liabilities |\n| Operating cash flows from operating leases | $ | 3,366 | $ | 3,440 |\n| Operating cash flows from finance leases | 560 | 587 |\n| Financing cash flows from finance leases | 451 | 422 |\n| Right-of-use assets obtained in exchange for lease obligations |\n| Operating leases | 92 | — |\n| Finance leases | — | — |\n\n17\nOther information related to leases was as follows:\n| March 31, 2023 | December 31, 2022 |\n| Weighted-average remaining lease term (years) |\n| Operating leases | 7 | 7 |\n| Finance leases | 14 | 14 |\n| Weighted-average discount rate |\n| Operating leases | 6.0 | % | 6.0 | % |\n| Finance leases | 7.6 | % | 7.6 | % |\n\nAs of March 31, 2023, our minimum lease payment requirements for noncancelable operating and finance leases are as follows:\n| Operating Leases | Finance Leases |\n| (thousands) |\n| Remainder of 2023 | $ | 10,162 | $ | 3,046 |\n| 2024 | 12,104 | 4,052 |\n| 2025 | 10,385 | 3,735 |\n| 2026 | 7,200 | 3,581 |\n| 2027 | 6,497 | 3,649 |\n| Thereafter | 23,633 | 33,086 |\n| Total future minimum lease payments | 69,981 | 51,149 |\n| Less: interest | ( 14,015 ) | ( 19,746 ) |\n| Total lease obligations | 55,966 | 31,403 |\n| Less: current obligations | ( 10,285 ) | ( 1,854 ) |\n| Long-term lease obligations | $ | 45,681 | $ | 29,549 |\n\n9. Stock-Based Compensation\nIn first quarter 2023 and 2022, we granted two types of stock-based awards under our incentive plan: performance stock units (PSUs) and restricted stock units (RSUs).\nPSU and RSU Awards\nDuring the three months ended March 31, 2023, we granted 93,282 PSUs to our officers and other employees, subject to performance and service conditions. For the officers, the number of shares actually awarded will range from 0 % to 200 % of the target amount, depending upon Boise Cascade's 2023 return on invested capital (ROIC), as approved by our compensation committee in accordance with the related grant agreement. We define ROIC as net operating profit after taxes (NOPAT) divided by average invested capital (based on a rolling thirteen-month average). We define NOPAT as net income plus after-tax financing expense. Invested capital is defined as total assets plus capitalized lease expense, less cash, cash equivalents, and current liabilities, excluding short-term debt. For the other employees, the number of shares actually awarded will range from 0 % to 200 % of the target amount, depending upon Boise Cascade’s 2023 EBITDA, defined as income before interest (interest expense and interest income), income taxes, and depreciation and amortization, as approved by executive management, determined in accordance with the related grant agreement. Because the PSUs contain a performance condition, we record compensation expense over the requisite service period based on the most probable number of shares expected to vest.\nDuring the three months ended March 31, 2022, we granted 66,180 PSUs to our officers and other employees, subject to performance and service conditions. During the 2022 performance period, officers and other employees earned 152 % and 200 %, respectively, of the target based on Boise Cascade's 2022 ROIC and EBITDA, as applicable, determined by our compensation committee and executive management, as applicable, in accordance with the related grant agreements.\nThe PSUs granted to officers generally vest in a single installment three years from the date of grant, while the PSUs granted to other employees vest in three equal tranches each year after the grant date.\n18\nDuring the three months ended March 31, 2023 and 2022, we granted an aggregate of 115,060 and 81,523 RSUs, respectively, to our officers, other employees, and nonemployee directors with only service conditions. The RSUs granted to officers and other employees vest in three equal tranches each year after the grant date. The RSUs granted to nonemployee directors vest in a single installment after a one year period.\nWe based the fair value of PSU and RSU awards on the closing market price of our common stock on the grant date. During the three months ended March 31, 2023 and 2022, the total fair value of PSUs and RSUs vested was $ 16.8 million and $ 12.0 million, respectively.\nThe following summarizes the activity of our PSUs and RSUs awarded under our incentive plan for the three months ended March 31, 2023:\n| PSUs | RSUs |\n| Number of shares | Weighted Average Grant-Date Fair Value | Number of shares | Weighted Average Grant-Date Fair Value |\n| Outstanding, December 31, 2022 | 317,854 | $ | 51.46 | 155,339 | $ | 65.17 |\n| Granted | 93,282 | 69.33 | 115,060 | 69.33 |\n| Performance condition adjustment (a) | 39,873 | 79.80 | — | — |\n| Vested | ( 154,794 ) | 40.61 | ( 87,632 ) | 60.64 |\n| Forfeited | ( 5,399 ) | 68.55 | ( 3,200 ) | 70.32 |\n| Outstanding, March 31, 2023 | 290,816 | $ | 66.54 | 179,567 | $ | 69.96 |\n\n_______________________________\n(a) Represents additional PSUs granted during the three months ended March 31, 2023, related to above-target achievement of the 2022 performance condition described above.\nCompensation Expense\nWe record compensation expense over the awards' vesting period and account for share-based award forfeitures as they occur, rather than making estimates of future forfeitures. Any shares not vested are forfeited. We recognize compensation expense for stock awards with only service conditions on a straight-line basis over the requisite service period. Most of our stock-based compensation expense was recorded in \"General and administrative expenses\" in our Consolidated Statements of Operations. Total stock-based compensation recognized from PSUs and RSUs, net of forfeitures, was as follows:\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| PSUs | $ | 1,814 | $ | 1,306 |\n| RSUs | 1,510 | 1,086 |\n| Total | $ | 3,324 | $ | 2,392 |\n\nThe related tax benefit for the three months ended March 31, 2023 and 2022, was $ 0.9 million and $ 0.6 million respectively. As of March 31, 2023, total unrecognized compensation expense related to nonvested share-based compensation arrangements was $ 23.7 million. This expense is expected to be recognized over a weighted-average period of 2.2 years.\n19\n10. Stockholders' Equity\nDividends\nOn November 14, 2017, we announced that our board of directors approved a dividend policy to pay quarterly cash dividends to holders of our common stock. For more information regarding our dividend declarations and payments made during each of the three months ended March 31, 2023 and 2022, see \"Common stock dividends\" on our Consolidated Statements of Stockholders' Equity.\nOn May 4, 2023 , our board of directors declared a quarterly dividend of $ 0.15 per share on our common stock, as well as a special dividend of $ 3.00 per share on our common stock, both payable on June 15, 2023 , to stockholders of record on June 1, 2023 . For a description of the restrictions in our asset-based credit facility and the indenture governing our senior notes on our ability to pay dividends, see Note 7, Debt.\nFuture dividend declarations, including amount per share, record date and payment date, will be made at the discretion of our board of directors and will depend upon, among other things, legal capital requirements and surplus, our future operations and earnings, general financial condition, material cash requirements, restrictions imposed by our asset-based credit facility and the indenture governing our senior notes, applicable laws, and other factors that our board of directors may deem relevant.\nStock Repurchase\nOn July 28, 2022, our board of directors authorized the repurchase of an additional 1.5 million shares of our common stock. This increase was in addition to the remaining authorized shares under our prior common stock repurchase program that was authorized on February 25, 2015 (the Program). Share repurchases may be made on an opportunistic basis, through open market transactions, privately negotiated transactions, or by other means in accordance with applicable federal securities laws. We are not obligated to purchase any shares and there is no set date that the Program will expire. Our board of directors may increase or decrease the number of shares under the Program or terminate the Program in its discretion at any time. During the three months ended March 31, 2023, we repurchased 24,727 shares under the Program at a cost of $ 1.5 million, or an average of $ 59.91 per share. The shares were purchased with cash on hand and are recorded as \"Treasury stock\" on our Consolidated Balance Sheet. As of March 31, 2023, there were 1,972,262 shares of common stock that may yet be purchased under the Program.\n11. Transactions With Related Party\nLouisiana Timber Procurement Company, L.L.C. (LTP) is an unconsolidated variable-interest entity that is 50 % owned by us and 50 % owned by Packaging Corporation of America (PCA). LTP procures sawtimber, pulpwood, residual chips, and other residual wood fiber to meet the wood and fiber requirements of us and PCA in Louisiana. We are not the primary beneficiary of LTP as we do not have power to direct the activities that most significantly affect the economic performance of LTP. Accordingly, we do not consolidate LTP's results in our financial statements.\nSales\nRelated-party sales to LTP from our Wood Products segment in our Consolidated Statements of Operations were $ 3.0 million and $ 3.7 million, respectively, during the three months ended March 31, 2023 and 2022. These sales are recorded in \"Sales\" in our Consolidated Statements of Operations.\nCosts and Expenses\nRelated-party wood fiber purchases from LTP were $ 20.1 million and $ 20.8 million, respectively, during the three months ended March 31, 2023 and 2022. These costs are recorded in \"Materials, labor, and other operating expenses (excluding depreciation)\" in our Consolidated Statements of Operations.\n20\n12. Segment Information\nWe operate our business using two reportable segments: Wood Products and BMD. We measure and evaluate our reportable segments based on net sales and segment operating income (loss). Accordingly, our chief operating decision maker reviews the performance of the company and allocates resources based primarily on net sales and segment operating income (loss) for our business segments. Unallocated corporate costs are presented as reconciling items to arrive at operating income. There are no differences in our basis of measurement of segment profit or loss from those disclosed in Note 16, Segment Information, of the Notes to Consolidated Financial Statements in \"Item 8. Financial Statements and Supplementary Data\" in our 2022 Form 10-K.\nWood Products and BMD segment sales to external customers, including related parties, by product line, are as follows:\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (millions) |\n| Wood Products (a) |\n| LVL (b) | $ | 7.4 | $ | 1.7 |\n| I-joists (b) | 4.7 | ( 2.2 ) |\n| Other engineered wood products (b) | 7.4 | 11.8 |\n| Plywood and veneer | 91.3 | 161.2 |\n| Lumber | 23.6 | 17.7 |\n| Byproducts | 24.3 | 19.1 |\n| Other | 6.5 | 5.2 |\n| 165.1 | 214.5 |\n| Building Materials Distribution |\n| Commodity | 547.5 | 1,102.0 |\n| General line | 533.6 | 615.1 |\n| Engineered wood products | 298.1 | 394.7 |\n| 1,379.2 | 2,111.8 |\n| $ | 1,544.3 | $ | 2,326.3 |\n\n___________________________________\n(a) Amounts represent sales to external customers. Sales are calculated after intersegment sales eliminations to our BMD segment.\n(b) Sales of EWP to external customers are net of the cost of all EWP rebates and sales allowances provided at various stages of the supply chain (including distributors, dealers, and homebuilders). For both the three months ended March 31, 2023 and 2022, approximately 79 % of Wood Products' EWP sales volumes were to our BMD segment.\n21\nAn analysis of our operations by segment is as follows:\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| Net sales by segment |\n| Wood Products | $ | 437,428 | $ | 558,944 |\n| Building Materials Distribution | 1,379,242 | 2,111,833 |\n| Intersegment eliminations (a) | ( 272,341 ) | ( 344,495 ) |\n| Total net sales | $ | 1,544,329 | $ | 2,326,282 |\n| Segment operating income |\n| Wood Products | $ | 69,395 | $ | 190,116 |\n| Building Materials Distribution | 69,685 | 225,892 |\n| Total segment operating income | 139,080 | 416,008 |\n| Unallocated corporate costs | ( 11,478 ) | ( 10,380 ) |\n| Income from operations | $ | 127,602 | $ | 405,628 |\n\n___________________________________\n(a) Primarily represents intersegment sales from our Wood Products segment to our BMD segment.\n13. Commitments, Legal Proceedings and Contingencies, and Guarantees\nCommitments\nWe are a party to a number of long-term log supply agreements that are discussed in Note 17, Commitments, Legal Proceedings and Contingencies, and Guarantees, of the Notes to Consolidated Financial Statements in \"Item 8. Financial Statements and Supplementary Data\" in our 2022 Form 10-K. In addition, we have purchase obligations for goods and services, capital expenditures, and raw materials entered into in the normal course of business. As of March 31, 2023, there have been no material changes to the above commitments disclosed in the 2022 Form 10-K.\nLegal Proceedings and Contingencies\nWe are a party to legal proceedings that arise in the ordinary course of our business, including commercial liability claims, premises claims, environmental claims, and employment-related claims, among others. As of the date of this filing, we do not believe that we are party to any legal action that could reasonably be expected to have, individually or in the aggregate, a material adverse effect on our financial position, results of operations, or cash flows.\nGuarantees\nWe provide guarantees, indemnifications, and assurances to others. Note 17, Commitments, Legal Proceedings and Contingencies, and Guarantees, of the Notes to Consolidated Financial Statements in \"Item 8. Financial Statements and Supplementary Data\" in our 2022 Form 10-K describes the nature of our guarantees, including the approximate terms of the guarantees, how the guarantees arose, the events or circumstances that would require us to perform under the guarantees, and the maximum potential undiscounted amounts of future payments we could be required to make. As of March 31, 2023, there have been no material changes to the guarantees disclosed in the 2022 Form 10-K.\n22\n\nITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nUnderstanding Our Financial Information\nThis Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and related notes in \"Item 1. Financial Statements\" of this Form 10-Q, as well as our 2022 Form 10-K. The following discussion includes statements regarding our expectations with respect to our future performance, liquidity, and capital resources. Such statements, along with any other nonhistorical statements in the discussion, are forward-looking. These forward-looking statements include, without limitation, any statement that may predict, indicate, or imply future results, performance, or achievements and may contain the words \"may,\" \"will,\" \"expect,\" \"believe,\" \"should,\" \"plan,\" \"anticipate,\" and other similar expressions. All of these forward-looking statements are based on estimates and assumptions made by our management that, although believed by us to be reasonable, are inherently uncertain. These forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in \"Item 1A. Risk Factors\" in our 2022 Form 10-K, as well as those factors listed in other documents we file with the Securities and Exchange Commission (the SEC). We do not assume an obligation to update any forward-looking statement. Our future actual results may differ materially from those contained in or implied by any of the forward-looking statements in this Form 10-Q.\nBackground\nBoise Cascade Company is a building products company headquartered in Boise, Idaho. As used in this Form 10-Q, the terms \"Boise Cascade,\" \"we,\" and \"our\" refer to Boise Cascade Company and its consolidated subsidiaries. Boise Cascade is a large, vertically-integrated wood products manufacturer and building materials distributor. We have two reportable segments: (i) Wood Products, which primarily manufactures engineered wood products (EWP) and plywood; and (ii) Building Materials Distribution (BMD), which is a wholesale distributor of building materials. Our products are used in the construction of new residential housing, including single-family, multi-family, and manufactured homes, the repair-and-remodeling of existing housing, the construction of light industrial and commercial buildings, and industrial applications. For more information, see Note 12, Segment Information, of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in \"Item 1. Financial Statements\" of this Form 10-Q.\nExecutive Overview\nWe recorded income from operations of $127.6 million during the three months ended March 31, 2023, compared with income from operations of $405.6 million during the three months ended March 31, 2022. In our Wood Products segment, income decreased $120.7 million to $69.4 million for the three months ended March 31, 2023, from $190.1 million for the three months ended March 31, 2022, due primarily to lower plywood sales prices, lower EWP sales volumes, higher per-unit conversion costs, and an increase in depreciation and amortization expense due to the acquisition of two plywood facilities located in Havana, Florida, and Chapman, Alabama, on July 25, 2022 (the Acquisition). These decreases were offset partially by higher EWP sales prices and higher plywood sales volumes, as well as lower OSB costs (used in the manufacture of I-joists). In our BMD segment, income decreased $156.2 million to $69.7 million for the three months ended March 31, 2023, from $225.9 million for the three months ended March 31, 2022, driven by a gross margin decrease of $177.3 million, resulting primarily from lower margins on commodity products and lower sales volumes, offset partially by decreased selling and distribution expenses of $20.3 million. These changes are discussed further in \"Our Operating Results\" below.\nWe ended first quarter 2023 with $1,000.7 million of cash and cash equivalents and $395.9 million of undrawn committed bank line availability, for total available liquidity of $1,396.7 million. We had $444.6 million of outstanding debt at March 31, 2023. We generated $2.4 million of cash during the three months ended March 31, 2023, as cash provided by operations was offset partially by capital spending, dividends paid on our common stock, and tax withholding payments on stock-based awards. A further description of our cash sources and uses for the three-month comparative periods are discussed in \"Liquidity and Capital Resources\" below.\nDemand for the products we manufacture, as well as the products we purchase and distribute, is correlated with new residential construction, residential repair-and-remodeling activity and light commercial construction. U.S. housing starts in March 2023 were approximately 1.42 million on a seasonally adjusted annual rate basis, as reported by the U.S. Census Bureau. In addition, mortgage rates have declined from peak levels in late 2022, and measures of builder sentiment have improved from fourth quarter 2022 levels. However, home affordability remains a challenge for consumers, and the Federal Reserve's ongoing actions in response to inflationary data and what impacts these actions have on future mortgage rates and the broader economy\n23\nwill influence the near-term demand environment. As such, the full year outlook for 2023 is uncertain and is reflected in various industry forecasts for 2023 U.S. housing starts that generally range from 1.2 million to 1.4 million units, compared with actual housing starts of 1.55 million in 2022, as reported by the U.S. Census Bureau. Regarding home improvement spending, the age of U.S. housing stock and elevated levels of homeowner equity have provided a favorable backdrop for repair-and-remodel spending. However, industry forecasts project continued moderation of year-over-year growth in renovation spending, and economic uncertainty may also negatively impact homeowners' further investment in their residences.\nAs a manufacturer of certain commodity products, we have sales and profitability exposure to declines in commodity product prices and rising input costs. Our distribution business purchases and resells a broad mix of commodity products with periods of increasing prices providing the opportunity for higher sales and increased margins, while declining price environments expose us to declines in sales and profitability. Future commodity product pricing and commodity input costs may be volatile in response to economic uncertainties, industry operating rates, transportation constraints or disruptions, net import and export activity, inventory levels in various distribution channels, and seasonal demand patterns. In addition, EWP volumes will continue to be influenced by demand for new residential construction, particularly single-family housing starts and we expect further EWP price erosion in the second quarter.\nFactors That Affect Our Operating Results and Trends\nOur results of operations and financial performance are influenced by a variety of factors, including the following:\n•the commodity nature of a portion of our products and their price movements, which are driven largely by industry capacity and operating rates, industry cycles that affect supply and demand, and net import and export activity;\n•general economic conditions, including but not limited to housing starts, repair-and-remodeling activity, light commercial construction, inventory levels of new and existing homes for sale, foreclosure rates, interest rates, inflation, unemployment rates, household formation rates, prospective home buyers' access to and cost of financing, and housing affordability, that ultimately affect demand for our products;\n•the highly competitive nature of our industry;\n•declines in demand for our products due to competing technologies or materials, as well as changes in building code provisions;\n•disruptions to information systems used to process and store customer, employee, and vendor information, as well as the technology that manages our operations and other business processes;\n•material disruptions and/or major equipment failure at our manufacturing facilities;\n•labor disruptions, shortages of skilled and technical labor, or increased labor costs;\n•the need to successfully formulate and implement succession plans for key members of our management team;\n•product shortages, loss of key suppliers, and our dependence on third-party suppliers and manufacturers;\n•the cost and availability of third-party transportation services used to deliver the goods we manufacture and distribute, as well as our raw materials;\n•cost and availability of raw materials, including wood fiber and glues and resins;\n•our ability to successfully and efficiently complete and integrate acquisitions;\n•the concentration of our sales among a relatively small group of customers, as well as the financial condition and creditworthiness of our customers;\n•impairment of our long-lived assets, goodwill, and/or intangible assets;\n•substantial ongoing capital investment costs, including those associated with acquisitions, and the difficulty in offsetting fixed costs related to those investments;\n24\n•our indebtedness, including the possibility that we may not generate sufficient cash flows from operations or that future borrowings may not be available in amounts sufficient to fulfill our debt obligations and fund other liquidity needs;\n•restrictive covenants contained in our debt agreements;\n•compliance with data privacy and security laws and regulations;\n•the impacts of climate change and related legislative and regulatory responses intended to reduce climate change;\n•cost of compliance with government regulations, in particular, environmental regulations;\n•the enactment of tax reform legislation;\n•exposure to product liability, product warranty, casualty, construction defect, and other claims;\n•fluctuations in the market for our equity; and\n•the other factors described in \"Item 1A. Risk Factors\" in our 2022 Form 10-K.\n25\nOur Operating Results\nThe following tables set forth our operating results in dollars and as a percentage of sales for the three months ended March 31, 2023 and 2022:\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (millions) |\n| Sales | $ | 1,544.3 | $ | 2,326.3 |\n| Costs and expenses |\n| Materials, labor, and other operating expenses (excluding depreciation) | 1,230.6 | 1,729.9 |\n| Depreciation and amortization | 31.2 | 20.5 |\n| Selling and distribution expenses | 128.8 | 146.7 |\n| General and administrative expenses | 26.5 | 26.1 |\n| Other (income) expense, net | (0.3) | (2.5) |\n| 1,416.7 | 1,920.7 |\n| Income from operations | $ | 127.6 | $ | 405.6 |\n| (percentage of sales) |\n| Sales | 100.0 | % | 100.0 | % |\n| Costs and expenses |\n| Materials, labor, and other operating expenses (excluding depreciation) | 79.7 | % | 74.4 | % |\n| Depreciation and amortization | 2.0 | 0.9 |\n| Selling and distribution expenses | 8.3 | 6.3 |\n| General and administrative expenses | 1.7 | 1.1 |\n| Other (income) expense, net | — | (0.1) |\n| 91.7 | % | 82.6 | % |\n| Income from operations | 8.3 | % | 17.4 | % |\n\n26\nSales Volumes and Prices\nSet forth below are historical U.S. housing starts data, segment sales volumes and average net selling prices for the principal products sold by our Wood Products segment, and sales mix and gross margin information for our BMD segment for the three months ended March 31, 2023 and 2022.\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| U.S. Housing Starts (a) |\n| Single-family | 190.5 | 266.8 |\n| Multi-family | 129.4 | 122.9 |\n| 319.9 | 389.7 |\n| (thousands) |\n| Segment Sales |\n| Wood Products | $ | 437,428 | $ | 558,944 |\n| Building Materials Distribution | 1,379,242 | 2,111,833 |\n| Intersegment eliminations | (272,341) | (344,495) |\n| Total sales | $ | 1,544,329 | $ | 2,326,282 |\n| Wood Products | (millions) |\n| Sales Volumes |\n| Laminated veneer lumber (LVL) (cubic feet) | 3.6 | 4.6 |\n| I-joists (equivalent lineal feet) | 39 | 65 |\n| Plywood (sq. ft.) (3/8\" basis) | 406 | 317 |\n| Wood Products | (dollars per unit) |\n| Average Net Selling Prices |\n| Laminated veneer lumber (LVL) (cubic foot) | $ | 31.17 | $ | 26.40 |\n| I-joists (1,000 equivalent lineal feet) | 2,168 | 1,877 |\n| Plywood (1,000 sq. ft.) (3/8\" basis) | 367 | 689 |\n| (percentage of Building Materials Distribution sales) |\n| Building Materials Distribution |\n| Product Line Sales |\n| Commodity | 39.7 | % | 52.2 | % |\n| General line | 38.7 | % | 29.1 | % |\n| Engineered wood products | 21.6 | % | 18.7 | % |\n| Gross margin percentage (b) | 14.8 | % | 18.0 | % |\n\n_______________________________________\n(a) Actual U.S. housing starts data reported by the U.S. Census Bureau.\n(b) We define gross margin as \"Sales\" less \"Materials, labor, and other operating expenses (excluding depreciation).\" Substantially all costs included in \"Materials, labor, and other operating expenses (excluding depreciation)\" for our BMD segment are for inventory purchased for resale. Gross margin percentage is gross margin as a percentage of segment sales.\n27\nSales\nFor the three months ended March 31, 2023, total sales decreased $782.0 million, or 34%, to $1,544.3 million from $2,326.3 million during the three months ended March 31, 2022. As described below, the decrease in sales was driven by the changes in sales prices and volumes for the products we manufacture and distribute with single-family residential construction activity being the key demand driver of our sales. In first quarter 2023, total U.S. housing starts decreased 18%, driven by a decrease in single-family housing starts of 29% compared with the same period in 2022. Average composite lumber and average composite panel prices for the three months ended March 31, 2023 were 67% and 59% lower, respectively, than in the same period in the prior year, as reflected by Random Lengths composite lumber and panel pricing.\nWood Products. Sales, including sales to our BMD segment, decreased $121.5 million, or 22%, to $437.4 million for the three months ended March 31, 2023, from $558.9 million for the three months ended March 31, 2022. The decrease in sales was driven by lower plywood sales prices of 47%, resulting in decreased sales of $130.6 million. In addition, lower sales volumes of I-joists and LVL (collectively referred to as EWP) of 41% and 22%, respectively, resulted in decreased sales of $50.0 million and $26.4 million, respectively. EWP sales volumes decreased due to a decline in housing starts. I-joist volumes were also impacted by the availability of product substitutes and construction methods in certain geographies that reduce the wood floor opportunity. These decreases were offset partially by higher sales volumes for plywood of 28%, resulting in increased sales of $61.3 million. In addition, higher sales prices for LVL and I-joists of 18% and 16%, respectively, resulted in increased sales of $17.4 million and $11.3 million, respectively. The increase in EWP pricing was due to realizations of previously announced price increases and the expiration of certain temporary price protection arrangements.\nBuilding Materials Distribution. Sales decreased $732.6 million, or 35%, to $1,379.2 million for the three months ended March 31, 2023, from $2,111.8 million for the three months ended March 31, 2022. Compared with the same quarter in the prior year, the overall decrease in sales was driven by sales price and sales volume decreases of 20% and 15%, respectively. By product line, commodity sales decreased 50%, or $554.5 million; general line product sales decreased 13%, or $81.6 million; and sales of EWP (substantially all of which are sourced through our Wood Products segment) decreased 24%, or $96.5 million.\nCosts and Expenses\nMaterials, labor, and other operating expenses (excluding depreciation) decreased $499.3 million, or 29%, to $1,230.6 million for the three months ended March 31, 2023, compared with $1,729.9 million during the same period in the prior year. In our Wood Products segment, materials, labor, and other operating expenses decreased due to lower EWP sales volumes, as well as lower per-unit costs of OSB (used in the manufacture of I-joists) of approximately 19%, compared with first quarter 2022, as well as decreased other manufacturing costs, offset partially by increased labor costs. However, materials, labor, and other operating expenses as a percentage of sales (MLO rate) in our Wood Products segment increased by 1,340 basis points. The increase in the MLO rate was primarily the result of lower plywood sales prices, resulting in decreased leveraging of labor, wood fiber, and other manufacturing costs. In BMD, the decrease in materials, labor, and other operating expenses was driven by lower purchased materials costs as a result of lower sales volumes and lower commodity prices, compared with first quarter 2022. However, the BMD segment MLO rate increased by 330 basis points compared with first quarter 2022, driven primarily by lower margin percentages on our commodity product sales. In our BMD Segment, periods of increasing prices provide the opportunity for higher sales and increased margins, while declining price environments generally result in declines in sales and profitability.\nDepreciation and amortization expenses increased $10.7 million, or 52%, to $31.2 million for the three months ended March 31, 2023, compared with $20.5 million during the same period in the prior year. The increase was due primarily to the Acquisition on July 25, 2022, and other capital expenditures.\nSelling and distribution expenses decreased $17.9 million, or 12%, to $128.8 million for the three months ended March 31, 2023, compared with $146.7 million during the same period in the prior year, primarily as a result of lower incentive compensation expenses of $20.0 million, offset partially by an increase in shipping and handling costs and discretionary expenses during the three months ended March 31, 2023 compared with the same period in the prior year.\nGeneral and administrative expenses increased $0.4 million, or 2%, to $26.5 million for the three months ended March 31, 2023, compared with $26.1 million for the same period in the prior year, primarily due to an increase in professional fees and employee-related expenses, offset partially by lower incentive compensation expenses during the three months ended March 31, 2023 compared with the same period in the prior year.\n28\nFor the three months ended March 31, 2023, other income (expense), net, was $0.3 million of income, compared with $2.5 million of income for the three months ended March 31, 2022. Other income for the three months ended March 31, 2022 primarily included earn-out income related to a previous asset sale in our Wood Products segment.\nIncome From Operations\nIncome from operations decreased $278.0 million to $127.6 million for the three months ended March 31, 2023, compared with $405.6 million for the three months ended March 31, 2022.\nWood Products. Segment income decreased $120.7 million to $69.4 million for the three months ended March 31, 2023, compared with $190.1 million for the three months ended March 31, 2022. The decrease in segment income was due primarily to lower plywood sales prices and lower EWP sales volumes. In addition, segment income was negatively impacted by higher per-unit conversion costs and an increase in depreciation and amortization expense of $10.7 million related to the Acquisition. These decreases in segment income were offset partially by higher EWP sales prices and higher plywood sales volumes, as well as lower OSB costs (used in the manufacture of I-joists).\nBuilding Materials Distribution. Segment income decreased $156.2 million to $69.7 million for the three months ended March 31, 2023, from $225.9 million for the three months ended March 31, 2022. The decline in segment income was driven by a gross margin decrease of $177.3 million, resulting primarily from lower margins on commodity products and lower sales volumes, offset partially by decreased selling and distribution expenses of $20.3 million.\nCorporate. Unallocated corporate expenses increased $1.1 million to $11.5 million for the three months ended March 31, 2023, from $10.4 million for the same period in the prior year. The increase was due primarily to an increase in professional fees.\nOther\nInterest Income. Interest income increased $9.6 million to $9.7 million for the three months ended March 31, 2023, from $0.1 million for the three months ended March 31, 2022. The increase was due primarily to higher interest rates on cash equivalents and increases in the average balances of cash equivalents.\nChange in fair value of interest rate swaps. For information related to our interest rate swap, see the discussion under \"Interest Rate Risk and Interest Rate Swap\" of Note 2, Summary of Significant Accounting Policies, of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in \"Item 1. Financial Statements\" of this Form 10-Q.\nIncome Tax Provision\nFor the three months ended March 31, 2023 and 2022, we recorded $33.3 million and $98.9 million, respectively, of income tax expense and had an effective rate of 25.6% and 24.6%, respectively. For both periods, the primary reason for the difference between the federal statutory income tax rate of 21% and the effective tax rate was the effect of state taxes.\nLiquidity and Capital Resources\nWe ended first quarter 2023 with $1,000.7 million of cash and cash equivalents and $444.6 million of debt. At March 31, 2023, we had $1,396.7 million of available liquidity (cash and cash equivalents and undrawn committed bank line availability). We generated $2.4 million of cash during the three months ended March 31, 2023, as cash provided by operations was offset partially by capital spending, dividends paid on our common stock, and tax withholding payments on stock-based awards. Further descriptions of our cash sources and uses for the three month comparative periods are noted below.\nWe believe that our cash flows from operations, combined with our current cash levels and available borrowing capacity, will be adequate to fund debt service requirements and provide cash, as required, to support our ongoing operations, capital expenditures, lease obligations, working capital, income tax payments, and to pay cash dividends to holders of our common stock over the next 12 months. We expect to fund our seasonal and intra-month working capital requirements in 2023 from cash on hand and, if necessary, borrowings under our revolving credit facility.\n29\nSources and Uses of Cash\nWe generate cash primarily from sales of our products, as well as short-term and long-term borrowings. Our primary uses of cash are for expenses related to the manufacture and distribution of building products, including inventory purchased for resale, wood fiber, labor, energy, and glues and resins. In addition to paying for ongoing operating costs, we use cash to invest in our business, service our debt and lease obligations, and return cash to our shareholders through dividends or common stock repurchases. Below is a discussion of our sources and uses of cash for operating activities, investing activities, and financing activities.\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| Net cash provided by operations | $ | 47,992 | $ | 198,945 |\n| Net cash used for investment | (29,498) | (14,867) |\n| Net cash used for financing | (16,117) | (10,264) |\n\nOperating Activities\nFor the three months ended March 31, 2023, our operating activities generated $48.0 million of cash, compared with $198.9 million of cash generated in the same period in 2022. The $150.9 million decrease in cash provided by operations was due primarily to a decrease in income from operations, offset partially by a lesser year-over-year increase in working capital and a decrease in cash paid for taxes, net of refunds, of $2.9 million. Working capital increased $117.7 million during the three months ended March 31, 2023, compared with a $217.8 million increase for the same period in the prior year. See \"Our Operating Results\" in this Management's Discussion and Analysis of Financial Condition and Results of Operations for more information related to factors affecting our operating results.\nThe increase in working capital during both periods was primarily attributable to higher receivables and inventories, offset by an increase in accounts payable and accrued liabilities. The increases in receivables in both periods primarily reflect increased sales of approximately 26% and 49%, comparing sales for the months of March 2023 and 2022 with sales for the months of December 2022 and 2021, respectively. Inventories increased during the three months ended March 31, 2023 in preparation for the spring building season. During the three months ended March 31, 2022 inventories increased primarily due to increased cost of inventory purchased for resale and higher production costs for our manufactured products. The increase in accounts payable and accrued liabilities as of March 31, 2023 was related to the increase in inventories, offset partially by employee incentive compensation payouts made during the quarter and lower accrued rebates. The increase in accounts payable and accrued liabilities as of March 31, 2022 was related to the increase in inventories and higher accrued rebates, offset partially by employee incentive compensation payouts made during first quarter 2022.\nInvestment Activities\nDuring the three months ended March 31, 2023 and 2022, we used $30.1 million and $17.4 million, respectively, of cash for purchases of property and equipment, including business improvement and quality/efficiency projects, replacement and expansion projects, and ongoing environmental compliance. During the three months ended March 31, 2022, we received $2.5 million of earn-out income related to a previous asset sale in our Wood Products segment.\nWe expect capital expenditures in 2023 to total approximately $120 million to $140 million. We expect our capital spending in 2023 will be for business improvement and quality/efficiency projects, replacement and expansion projects, and ongoing environmental compliance. Our 2023 capital expenditures range includes funding for greenfield distribution centers in South Carolina and Texas, projects at our mills in the southeast to expand our EWP capacity, and the purchase of property to house an additional door shop assembly operation in Kansas City, Missouri. This level of capital expenditures could increase or decrease as a result of several factors, including acquisitions, efforts to further accelerate organic growth, exercise of lease purchase options, our financial results, future economic conditions, availability of engineering and construction resources, and timing and availability of equipment purchases.\nFinancing Activities\nDuring the three months ended March 31, 2023, our financing activities used $16.1 million of cash, including $8.3 million for common stock dividend payments, $5.9 million of tax withholding payments on stock-based awards, and $1.5\n30\nmillion for the repurchase of 24,727 shares of our common stock. During the three months ended March 31, 2023, we did not borrow under our revolving credit facility, and therefore have no borrowings outstanding on the facility as of March 31, 2023.\nDuring the three months ended March 31, 2022, our financing activities used $10.3 million of cash, including $5.9 million for common stock dividend payments and $3.9 million of tax withholding payments on stock-based awards. During the three months ended March 31, 2022, we did not borrow under our revolving credit facility.\nFuture dividend declarations, including amount per share, record date and payment date, will be made at the discretion of our board of directors and will depend upon, among other things, legal capital requirements and surplus, our future operations and earnings, general financial condition, material cash requirements, restrictions imposed by our asset-based credit facility and the indenture governing our senior notes, applicable laws, and other factors that our board of directors may deem relevant.\nFor more information related to our debt transactions and structure, our dividend policy, and our stock repurchase program, see the discussion in Note 7, Debt, and Note 10, Stockholders' Equity, respectively, of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in \"Item 1. Financial Statements\" of this Form 10-Q.\nOther Material Cash Requirements\nFor information about other material cash requirements, see Liquidity and Capital Resources in \"Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations\" in our 2022 Form 10-K. As of March 31, 2023, there have been no material changes in other material cash requirements outside the ordinary course of business since December 31, 2022.\nGuarantees\nNote 9, Debt, and Note 17, Commitments, Legal Proceedings and Contingencies, and Guarantees, of the Notes to Consolidated Financial Statements in \"Item 8. Financial Statements and Supplementary Data\" in our 2022 Form 10-K describe the nature of our guarantees, including the approximate terms of the guarantees, how the guarantees arose, the events or circumstances that would require us to perform under the guarantees, and the maximum potential undiscounted amounts of future payments we could be required to make. As of March 31, 2023, there have been no material changes to the guarantees disclosed in our 2022 Form 10-K.\nSeasonal Influences\nWe are exposed to fluctuations in quarterly sales volumes and expenses due to seasonal factors. These seasonal factors are common in the building products industry. Seasonal changes in levels of building activity affect our building products businesses, which are dependent on housing starts, repair-and-remodeling activities, and light commercial construction activities. We typically report lower sales volumes in the first and fourth quarters due to the impact of poor weather on the construction market, and we generally have higher sales volumes in the second and third quarters, reflecting an increase in construction due to more favorable weather conditions. We typically have higher working capital in the first and second quarters in preparation and response to the building season. Seasonally cold weather increases costs, especially energy consumption costs, at most of our manufacturing facilities.\nEmployees\nAs of April 30, 2023, we had approximately 6,660 employees. Approximately 19% of these employees work pursuant to collective bargaining agreements. As of April 30, 2023, we had ten collective bargaining agreements. One agreement covering approximately 80 employees at our Canadian EWP facility expired on December 31, 2022, but the terms and conditions of this agreement remain in effect pending negotiation of a new agreement. We may not be able to renew this agreement or may renew it on terms that are less favorable to us than the current agreement. If any of these agreements are not renewed or extended upon their termination, we could experience a material labor disruption, strike, or significantly increased labor costs at one or more of our facilities, either in the course of negotiations of a labor agreement or otherwise. Labor disruptions or shortages could prevent us from meeting customer demands or result in increased costs, thereby reducing our sales and profitability.\n31\nDisclosures of Financial Market Risks\nIn the normal course of business, we are exposed to financial risks such as changes in commodity prices, interest rates, and foreign currency exchange rates. As of March 31, 2023, there have been no material changes to financial market risks disclosed in our 2022 Form 10-K.\nEnvironmental\nAs of March 31, 2023, there have been no material changes to environmental issues disclosed in our 2022 Form 10-K. For additional information, see Environmental in \"Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations\" in our 2022 Form 10-K.\nCritical Accounting Estimates\nCritical accounting estimates are those that are most important to the portrayal of our financial condition and results. These estimates require management's most difficult, subjective, or complex judgments, often as a result of the need to estimate matters that are inherently uncertain. We review the development, selection, and disclosure of our critical accounting estimates with the Audit Committee of our board of directors. For information about critical accounting estimates, see Critical Accounting Estimates in \"Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations\" in our 2022 Form 10-K. At March 31, 2023, there have been no material changes to our critical accounting estimates from those disclosed in our 2022 Form 10-K.\nNew and Recently Adopted Accounting Standards\nFor information related to new and recently adopted accounting standards, see \"New and Recently Adopted Accounting Standards\" in Note 2, Summary of Significant Accounting Policies, of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in \"Item 1. Financial Statements\" in this Form 10-Q.\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nFor information relating to quantitative and qualitative disclosures about market risk, see the discussion under \"Item 7A. Quantitative and Qualitative Disclosures About Market Risk\" and under the headings \"Disclosures of Financial Market Risks\" and \"Financial Instruments\" in \"Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations\" in our 2022 Form 10-K. As of March 31, 2023, there have been no material changes in our exposure to market risk from those disclosed in our 2022 Form 10-K.\n\nITEM 4. CONTROLS AND PROCEDURES\nEvaluation of Disclosure Controls and Procedures\nWe maintain \"disclosure controls and procedures,\" as defined in Rule 13a-15(e) under the Exchange Act. We have designed these controls and procedures to reasonably assure that information required to be disclosed in our reports filed or submitted under the Exchange Act, such as this Form 10-Q, is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. We have also designed our disclosure controls to provide reasonable assurance that such information is accumulated and communicated to our senior management, including our chief executive officer (CEO) and our chief financial officer (CFO), as appropriate, to allow them to make timely decisions regarding our required disclosures. Based on their evaluation, our CEO and CFO have concluded that as of March 31, 2023, our disclosure controls and procedures were effective.\nChanges in Internal Control Over Financial Reporting\nThere were no changes in our internal control over financial reporting that occurred during the three months ended March 31, 2023, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n32\nPART II—OTHER INFORMATION\nITEM 1. LEGAL PROCEEDINGS\nWe are a party to legal proceedings that arise in the ordinary course of our business, including commercial liability claims, premises claims, environmental claims, and employment-related claims, among others. As of the date of this filing, we do not believe that we are party to any legal action that could reasonably be expected to have, individually or in the aggregate, a material adverse effect on our financial position, results of operations, or cash flows.\nSEC regulations require us to disclose certain information about proceedings arising under federal, state or local environmental provisions if we reasonably believe that such proceedings may result in monetary sanctions above a stated threshold. Pursuant to the SEC regulations, we use a threshold of $1 million or more for purposes of determining whether disclosure of any such proceedings is required.\nITEM 1A. RISK FACTORS\nThis report on Form 10-Q contains forward-looking statements. Statements that are not historical or current facts, including statements about our expectations, anticipated financial results, projected capital expenditures, and future business prospects, are forward-looking statements. You can identify these statements by our use of words such as \"may,\" \"will,\" \"expect,\" \"believe,\" \"should,\" \"plan,\" \"anticipate,\" and other similar expressions. You can find examples of these statements throughout this report, including \"Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.\" We cannot guarantee that our actual results will be consistent with the forward-looking statements we make in this report. You should review carefully the risk factors listed in \"Item 1A. Risk Factors\" in our 2022 Form 10-K, as well as those factors listed in other documents we file with the Securities and Exchange Commission. We do not assume an obligation to update any forward-looking statement.\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nPurchase of Equity Securities by the Issuer and Affiliated Purchasers\nOn July 28, 2022, our board of directors authorized the repurchase of an additional 1.5 million shares of our common stock. This increase was in addition to the remaining authorized shares under our prior common stock repurchase program that was authorized on February 25, 2015 (the Program). Share repurchases may be made on an opportunistic basis, through open market transactions, privately negotiated transactions, or by other means in accordance with applicable federal securities laws. We are not obligated to purchase any shares and there is no set date that the Program will expire. Our board of directors may increase or decrease the number of shares under the Program or terminate the Program in its discretion at any time. During first quarter 2023, we repurchased 24,727 shares under the Program at a cost of $1.5 million, or an average of $59.91 per share. Set forth below is information regarding the Company's share repurchases during the first quarter ended March 31, 2023.\n| Total Number of Shares Purchased | Average Price Paid per Share | Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs | The Maximum Number of Shares That May Yet Be Purchased Under the Plans or Programs |\n| January 1, 2023 - January 31, 2023 | — | $ | — | — | 1,996,989 |\n| February 1, 2023 - February 28, 2023 | — | — | — | 1,996,989 |\n| March 1, 2023 - March 31, 2023 | 24,727 | 59.91 | 24,727 | 1,972,262 |\n| Total | 24,727 | $ | 59.91 | 24,727 | 1,972,262 |\n\nITEM 3. DEFAULTS UPON SENIOR SECURITIES\nNone.\nITEM 4. MINE SAFETY DISCLOSURES\nNot applicable.\n33\n\nITEM 5. OTHER INFORMATION\nNone.\nITEM 6. EXHIBITS\n| Number | Description |\n| 10.1 | Form of 2023 Restricted Stock Unit Agreement |\n| 10.2 | Form of 2023 Performance Stock Unit Agreement |\n| 10.3 | Form of 2023 Director Restricted Stock Unit Agreement |\n| 10.4 | Ninth Amendment to Amended and Restated Credit Agreement, dated March 31, 2023, by and among the Lenders identified on the signature pages thereof, Wells Fargo Capital Finance, LLC, as administrative agent, Boise Cascade Company, and the other Borrowers identified on the signature pages thereof |\n| 31.1 | CEO Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2 | CFO Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1 | CEO Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2 | CFO Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS | Inline XBRL Instance Document |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\n\n34\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| BOISE CASCADE COMPANY |\n| /s/ Kelly E. Hibbs |\n| Kelly E. HibbsSenior Vice President, Chief Financial Officer and Treasurer |\n\nDate: May 4, 2023\n35\n \n\nWhat is the percentage increase in finance cost from the year 2022 to 2023 in relation to the net income for each year in percentage?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nPART I—FINANCIAL INFORMATION\\nITEM 1. FINANCIAL STATEMENTS\\nBoise Cascade Company\\nConsolidated Statements of Operations\\n(unaudited)\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (thousands, except per-share data) |\\n| Sales | $ | 1,544,329 | $ | 2,326,282 |\\n| Costs and expenses |\\n| Materials, labor, and other operating expenses (excluding depreciation) | 1,230,635 | 1,729,896 |\\n| Depreciation and amortization | 31,186 | 20,543 |\\n| Selling and distribution expenses | 128,788 | 146,651 |\\n| General and administrative expenses | 26,463 | 26,052 |\\n| Other (income) expense, net | ( 345 ) | ( 2,488 ) |\\n| 1,416,727 | 1,920,654 |\\n| Income from operations | 127,602 | 405,628 |\\n| Foreign currency exchange gain (loss) | ( 73 ) | 132 |\\n| Pension expense (excluding service costs) | ( 41 ) | ( 171 ) |\\n| Interest expense | ( 6,361 ) | ( 6,254 ) |\\n| Interest income | 9,685 | 65 |\\n| Change in fair value of interest rate swaps | ( 804 ) | 2,066 |\\n| 2,406 | ( 4,162 ) |\\n| Income before income taxes | 130,008 | 401,466 |\\n| Income tax provision | ( 33,275 ) | ( 98,866 ) |\\n| Net income | $ | 96,733 | $ | 302,600 |\\n| Weighted average common shares outstanding: |\\n| Basic | 39,593 | 39,474 |\\n| Diluted | 39,838 | 39,768 |\\n| Net income per common share: |\\n| Basic | $ | 2.44 | $ | 7.67 |\\n| Diluted | $ | 2.43 | $ | 7.61 |\\n| Dividends declared per common share | $ | 0.15 | $ | 0.12 |\\n\\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\\n1\\nBoise Cascade Company\\nConsolidated Statements of Comprehensive Income\\n(unaudited)\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (thousands) |\\n| Net income | $ | 96,733 | $ | 302,600 |\\n| Other comprehensive income, net of tax |\\n| Defined benefit pension plans |\\n| Amortization of actuarial loss, net of tax of $ 2 and $ 5 , respectively | 6 | 16 |\\n| Effect of settlements, net of tax of $ — and $ 32 , respectively | — | 98 |\\n| Other comprehensive income, net of tax | 6 | 114 |\\n| Comprehensive income | $ | 96,739 | $ | 302,714 |\\n\\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\\n2\\nBoise Cascade Company\\nConsolidated Balance Sheets\\n(unaudited)\\n| March 31,2023 | December 31,2022 |\\n| (thousands) |\\n| ASSETS |\\n| Current |\\n| Cash and cash equivalents | $ | 1,000,721 | $ | 998,344 |\\n| Receivables |\\n| Trade, less allowances of $ 4,341 and $ 3,264 | 417,515 | 297,237 |\\n| Related parties | 196 | 19 |\\n| Other | 13,821 | 23,023 |\\n| Inventories | 738,798 | 697,551 |\\n| Prepaid expenses and other | 20,666 | 47,878 |\\n| Total current assets | 2,191,717 | 2,064,052 |\\n| Property and equipment, net | 772,734 | 770,023 |\\n| Operating lease right-of-use assets | 52,441 | 55,582 |\\n| Finance lease right-of-use assets | 25,883 | 26,501 |\\n| Timber deposits | 8,299 | 7,519 |\\n| Goodwill | 137,958 | 137,958 |\\n| Intangible assets, net | 157,133 | 161,433 |\\n| Deferred income taxes | 6,135 | 6,116 |\\n| Other assets | 9,887 | 11,330 |\\n| Total assets | $ | 3,362,187 | $ | 3,240,514 |\\n\\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\\n3\\nBoise Cascade Company\\nConsolidated Balance Sheets (continued)\\n(unaudited)\\n| March 31,2023 | December 31,2022 |\\n| (thousands, except per-share data) |\\n| LIABILITIES AND STOCKHOLDERS' EQUITY |\\n| Current |\\n| Accounts payable |\\n| Trade | $ | 400,455 | $ | 269,785 |\\n| Related parties | 1,420 | 1,019 |\\n| Accrued liabilities |\\n| Compensation and benefits | 79,606 | 142,463 |\\n| Interest payable | 5,088 | 9,955 |\\n| Other | 93,579 | 122,606 |\\n| Total current liabilities | 580,148 | 545,828 |\\n| Debt |\\n| Long-term debt | 444,614 | 444,392 |\\n| Other |\\n| Compensation and benefits | 33,280 | 33,226 |\\n| Operating lease liabilities, net of current portion | 45,681 | 48,668 |\\n| Finance lease liabilities, net of current portion | 29,549 | 30,022 |\\n| Deferred income taxes | 66,855 | 63,454 |\\n| Other long-term liabilities | 17,540 | 16,949 |\\n| 192,905 | 192,319 |\\n| Commitments and contingent liabilities |\\n| Stockholders' equity |\\n| Preferred stock, $ 0.01 par value per share; 50,000 shares authorized, no shares issued and outstanding | — | — |\\n| Common stock, $ 0.01 par value per share; 300,000 shares authorized, 44,983 and 44,827 shares issued, respectively | 450 | 448 |\\n| Treasury stock, 5,392 and 5,367 shares at cost, respectively | ( 140,391 ) | ( 138,909 ) |\\n| Additional paid-in capital | 548,611 | 551,215 |\\n| Accumulated other comprehensive loss | ( 514 ) | ( 520 ) |\\n| Retained earnings | 1,736,364 | 1,645,741 |\\n| Total stockholders' equity | 2,144,520 | 2,057,975 |\\n| Total liabilities and stockholders' equity | $ | 3,362,187 | $ | 3,240,514 |\\n\\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\\n4\\nBoise Cascade Company\\nConsolidated Statements of Cash Flows\\n(unaudited)\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (thousands) |\\n| Cash provided by (used for) operations |\\n| Net income | $ | 96,733 | $ | 302,600 |\\n| Items in net income not using (providing) cash |\\n| Depreciation and amortization, including deferred financing costs and other | 31,853 | 20,993 |\\n| Stock-based compensation | 3,324 | 2,392 |\\n| Pension expense | 41 | 171 |\\n| Deferred income taxes | 3,393 | ( 729 ) |\\n| Change in fair value of interest rate swaps | 804 | ( 2,066 ) |\\n| Other | ( 518 ) | ( 2,412 ) |\\n| Decrease (increase) in working capital |\\n| Receivables | ( 111,253 ) | ( 218,018 ) |\\n| Inventories | ( 41,247 ) | ( 143,997 ) |\\n| Prepaid expenses and other | ( 1,428 ) | ( 3,227 ) |\\n| Accounts payable and accrued liabilities | 36,181 | 147,425 |\\n| Pension contributions | ( 136 ) | ( 655 ) |\\n| Income taxes payable | 28,631 | 95,352 |\\n| Other | 1,614 | 1,116 |\\n| Net cash provided by operations | 47,992 | 198,945 |\\n| Cash provided by (used for) investment |\\n| Expenditures for property and equipment | ( 30,063 ) | ( 17,448 ) |\\n| Proceeds from sales of assets and other | 565 | 2,581 |\\n| Net cash used for investment | ( 29,498 ) | ( 14,867 ) |\\n| Cash provided by (used for) financing |\\n| Dividends paid on common stock | ( 8,258 ) | ( 5,939 ) |\\n| Tax withholding payments on stock-based awards | ( 5,926 ) | ( 3,930 ) |\\n| Treasury stock purchased | ( 1,482 ) | — |\\n| Other | ( 451 ) | ( 395 ) |\\n| Net cash used for financing | ( 16,117 ) | ( 10,264 ) |\\n| Net increase in cash and cash equivalents | 2,377 | 173,814 |\\n| Balance at beginning of the period | 998,344 | 748,907 |\\n| Balance at end of the period | $ | 1,000,721 | $ | 922,721 |\\n\\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\\n5\\nBoise Cascade Company\\nConsolidated Statements of Stockholders' Equity\\n(unaudited)\\n| Common Stock | Treasury Stock | Additional Paid-In Capital | Accumulated Other Comprehensive Loss | Retained Earnings | Total |\\n| Shares | Amount | Shares | Amount |\\n| (thousands) |\\n| Balance at December 31, 2022 | 44,827 | $ | 448 | 5,367 | $ | ( 138,909 ) | $ | 551,215 | $ | ( 520 ) | $ | 1,645,741 | $ | 2,057,975 |\\n| Net income | 96,733 | 96,733 |\\n| Other comprehensive income | 6 | 6 |\\n| Common stock issued | 156 | 2 | 2 |\\n| Treasury stock purchased | 25 | ( 1,482 ) | ( 1,482 ) |\\n| Stock-based compensation | 3,324 | 3,324 |\\n| Common stock dividends ($ 0.15 per share) | ( 6,110 ) | ( 6,110 ) |\\n| Tax withholding payments on stock-based awards | ( 5,926 ) | ( 5,926 ) |\\n| Other | ( 2 ) | ( 2 ) |\\n| Balance at March 31, 2023 | 44,983 | $ | 450 | 5,392 | $ | ( 140,391 ) | $ | 548,611 | $ | ( 514 ) | $ | 1,736,364 | $ | 2,144,520 |\\n\\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\\n6\\nBoise Cascade Company\\nConsolidated Statements of Stockholders' Equity (continued)\\n(unaudited)\\n| Common Stock | Treasury Stock | Additional Paid-In Capital | Accumulated Other Comprehensive Loss | Retained Earnings | Total |\\n| Shares | Amount | Shares | Amount |\\n| (thousands) |\\n| Balance at December 31, 2021 | 44,698 | $ | 447 | 5,367 | $ | ( 138,909 ) | $ | 543,249 | $ | ( 1,047 ) | $ | 948,879 | $ | 1,352,619 |\\n| Net income | 302,600 | 302,600 |\\n| Other comprehensive income | 114 | 114 |\\n| Common stock issued | 117 | 1 | 1 |\\n| Stock-based compensation | 2,392 | 2,392 |\\n| Common stock dividends ($ 0.12 per share) | ( 5,133 ) | ( 5,133 ) |\\n| Tax withholding payments on stock-based awards | ( 3,930 ) | ( 3,930 ) |\\n| Proceeds from exercise of stock options | 27 | 27 |\\n| Other | ( 1 ) | ( 1 ) |\\n| Balance at March 31, 2022 | 44,815 | $ | 448 | 5,367 | $ | ( 138,909 ) | $ | 541,737 | $ | ( 933 ) | $ | 1,246,346 | $ | 1,648,689 |\\n\\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\\n7\\nCondensed Notes to Unaudited Quarterly Consolidated Financial Statements\\n1. Nature of Operations and Consolidation\\nNature of Operations\\nBoise Cascade Company is a building products company headquartered in Boise, Idaho. As used in this Form 10-Q, the terms \\\"Boise Cascade,\\\" \\\"we,\\\" and \\\"our\\\" refer to Boise Cascade Company and its consolidated subsidiaries. We are one of the largest producers of engineered wood products (EWP) and plywood in North America and a leading United States wholesale distributor of building products.\\nWe operate our business using two reportable segments: (1) Wood Products, which primarily manufactures EWP and plywood, and (2) Building Materials Distribution (BMD), which is a wholesale distributor of building materials. For more information, see Note 12, Segment Information.\\nConsolidation\\nThe accompanying quarterly consolidated financial statements have not been audited by an independent registered public accounting firm but, in the opinion of management, include all adjustments necessary to present fairly the financial position, results of operations, cash flows, and stockholders' equity for the interim periods presented. Except as disclosed within these condensed notes to unaudited quarterly consolidated financial statements, the adjustments made were of a normal, recurring nature. Certain information and footnote disclosures normally included in our annual consolidated financial statements have been condensed or omitted. The quarterly consolidated financial statements include the accounts of Boise Cascade and its subsidiaries after elimination of intercompany balances and transactions. Quarterly results are not necessarily indicative of results that may be expected for the full year. These condensed notes to unaudited quarterly consolidated financial statements should be read in conjunction with our 2022 Form 10-K and the other reports we file with the Securities and Exchange Commission.\\n2. Summary of Significant Accounting Policies\\nAccounting Policies\\nThe complete summary of significant accounting policies is included in Note 2, Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements in \\\"Item 8. Financial Statements and Supplementary Data\\\" in our 2022 Form 10-K.\\nUse of Estimates\\nThe preparation of financial statements in conformity with generally accepted accounting principles (GAAP) requires management to make estimates and assumptions about future events. These estimates and the underlying assumptions affect the amounts of assets and liabilities reported, disclosures about contingent assets and liabilities, and reported amounts of revenues and expenses. Such estimates include the valuation of accounts receivable, inventories, goodwill, intangible assets, and other long-lived assets; legal contingencies; guarantee obligations; indemnifications; assumptions used in retirement, medical, and workers' compensation benefits; assumptions used in the determination of right-of-use (ROU) assets and related lease liabilities; stock-based compensation; fair value measurements; income taxes; and vendor and customer rebates, among others. These estimates and assumptions are based on management's best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors, including the current economic environment, which management believes to be reasonable under the circumstances. We adjust such estimates and assumptions when facts and circumstances dictate. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in these estimates resulting from continuing changes in the economic environment will be reflected in the consolidated financial statements in future periods.\\n8\\nRevenue Recognition\\nRevenues are recognized when control of the promised goods or services is transferred to our customers, in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services. For revenue disaggregated by major product line for each reportable segment, see Note 12, Segment Information.\\nFees for shipping and handling charged to customers for sales transactions are included in \\\"Sales\\\" in our Consolidated Statements of Operations. When control over products has transferred to the customer, we have elected to recognize costs related to shipping and handling as fulfillment costs. For our Wood Products segment, costs related to shipping and handling are included in \\\"Materials, labor, and other operating expenses (excluding depreciation)\\\" in our Consolidated Statements of Operations. In our Wood Products segment, we view our shipping and handling costs as a cost of the manufacturing process and the movement of product to our end customers. For our BMD segment, costs related to shipping and handling of $ 53.5 million and $ 56.3 million for the three months ended March 31, 2023 and 2022, respectively, are included in \\\"Selling and distribution expenses\\\" in our Consolidated Statements of Operations. In our BMD segment, our activities relate to the purchase and resale of finished products, and excluding shipping and handling costs from \\\"Materials, labor, and other operating expenses (excluding depreciation)\\\" provides us a clearer view of our operating performance and the effectiveness of our sales and purchasing functions.\\nCustomer Rebates and Allowances\\nRebates are provided to our customers and our customers' customers based on the volume of their purchases, among other factors such as customer loyalty, conversion, and commitment, as well as temporary protection from price increases. We provide the rebates to increase the sell-through of our products. Rebates are generally estimated based on the expected amount to be paid and recorded as a decrease in \\\"Sales.\\\" At March 31, 2023 and December 31, 2022, we had $ 58.7 million and $ 92.9 million, respectively, of rebates payable to our customers recorded in \\\"Accrued liabilities, Other\\\" on our Consolidated Balance Sheets. We adjust our estimate of revenue at the earlier of when the probability of rebates paid changes or when the amounts become fixed. There have not been significant changes to our estimates of rebates, although it is reasonably possible that a change in the estimate may occur.\\nVendor Rebates and Allowances\\nWe receive rebates and allowances from our vendors under a number of different programs, including vendor marketing programs. At March 31, 2023 and December 31, 2022, we had $ 9.0 million and $ 17.8 million, respectively, of vendor rebates and allowances recorded in \\\"Receivables, Other\\\" on our Consolidated Balance Sheets. Rebates and allowances received from our vendors are recognized as a reduction of \\\"Materials, labor, and other operating expenses (excluding depreciation)\\\" when the product is sold, unless the rebates and allowances are linked to a specific incremental cost to sell a vendor's product. Amounts received from vendors that are linked to specific selling and distribution expenses are recognized as a reduction of \\\"Selling and distribution expenses\\\" in the period the expense is incurred.\\nLeases\\nWe primarily lease land, building, and equipment under operating and finance leases. We determine if an arrangement is a lease at inception and assess lease classification as either operating or finance at lease inception or upon modification. Substantially all of our leases with initial terms greater than one year are for real estate, including distribution centers, corporate headquarters, land, and other office space. Substantially all of these lease agreements have fixed payment terms based on the passage of time and are recorded in our BMD segment. Many of our leases include fixed escalation clauses, renewal options and/or termination options that are factored into our determination of lease term and lease payments when appropriate. Renewal options generally range from one to ten years with fixed payment terms similar to those in the original lease agreements. Some lease agreements provide us with the option to purchase the leased property at market value. Our lease agreements do not contain any residual value guarantees.\\nROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. ROU assets and lease liabilities are recognized at the lease commencement date based on the estimated present value of fixed lease payments over the lease term. The current portion of our operating and finance lease liabilities are recorded in \\\"Accrued liabilities, Other\\\" on our Consolidated Balance Sheets.\\nWe use our estimated incremental borrowing rate, which is derived from information available at the lease commencement date, in determining the present value of lease payments. In determining our incremental borrowing rates, we\\n9\\ngive consideration to publicly available interest rates for instruments with similar characteristics, including credit rating, term, and collateralization.\\nFor purposes of determining straight-line rent expense, the lease term is calculated from the date we first take possession of the facility, including any periods of free rent and any renewal option periods we are reasonably certain of exercising. Variable lease expense generally includes reimbursement of actual costs for common area maintenance, property taxes, and insurance on leased real estate and are recorded as incurred. Most of our operating lease expense was recorded in \\\"Selling and distribution expenses\\\" in our Consolidated Statements of Operations. In addition, we do not separate lease and non-lease components for all of our leases.\\nOur short-term leases primarily include equipment rentals with lease terms on a month-to-month basis, which provide for our seasonal needs and flexibility in the use of equipment. Our short-term leases also include certain real estate for which either party has the right to cancel upon providing notice of 30 to 90 days. We do not recognize ROU assets or lease liabilities for short-term leases.\\nInventories\\nInventories included the following (work in process is not material):\\n\\n| March 31,2023 | December 31,2022 |\\n| (thousands) |\\n| Finished goods and work in process | $ | 640,858 | $ | 596,328 |\\n| Logs | 50,154 | 54,921 |\\n| Other raw materials and supplies | 47,786 | 46,302 |\\n| $ | 738,798 | $ | 697,551 |\\n\\nProperty and Equipment\\nProperty and equipment consisted of the following asset classes:\\n\\n| March 31,2023 | December 31,2022 |\\n| (thousands) |\\n| Land | $ | 61,806 | $ | 60,211 |\\n| Buildings | 242,484 | 231,087 |\\n| Improvements | 70,419 | 69,832 |\\n| Mobile equipment, information technology, and office furniture | 215,460 | 210,666 |\\n| Machinery and equipment | 993,900 | 989,338 |\\n| Construction in progress | 45,348 | 41,899 |\\n| 1,629,417 | 1,603,033 |\\n| Less: accumulated depreciation | ( 856,683 ) | ( 833,010 ) |\\n| $ | 772,734 | $ | 770,023 |\\n\\n10\\nFair Value\\nFair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value hierarchy under GAAP gives the highest priority to quoted market prices (Level 1) and the lowest priority to unobservable inputs (Level 3). In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine fair value (Level 1). If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, we use quoted prices for similar assets and liabilities or inputs that are observable either directly or indirectly (Level 2). If quoted prices for identical or similar assets are not available or are unobservable, we may use internally developed valuation models, whose inputs include bid prices, and third-party valuations utilizing underlying asset assumptions (Level 3).\\nFinancial Instruments\\nOur financial instruments are cash and cash equivalents, accounts receivable, accounts payable, long-term debt, and an interest rate swap. Our cash is recorded at cost, which approximates fair value, and our cash equivalents are money market funds. As of March 31, 2023 and December 31, 2022, we held $ 981.1 million and $ 954.4 million, respectively, in money market funds that are measured at fair value on a recurring basis using Level 1 inputs. The recorded values of accounts receivable and accounts payable approximate fair values based on their short-term nature. At March 31, 2023 and December 31, 2022, the book value of our fixed-rate debt for each period was $ 400.0 million, and the fair value was estimated to be $ 348.0 million and $ 348.5 million, respectively. The difference between the book value and the fair value is derived from the difference between the period-end market interest rate and the stated rate of our fixed-rate, long-term debt. We estimated the fair value of our fixed-rate debt using quoted market prices of our debt in inactive markets (Level 2 inputs). The interest rate on our variable-rate debt is based on market conditions such as the Secured Overnight Financing Rate (SOFR) or a base rate. Because the interest rate on the variable-rate debt is based on current market conditions, we believe that the estimated fair value of the outstanding balance on our variable-rate debt approximates book value. As discussed below, we also have an interest rate swap to mitigate our variable interest rate exposure, the fair value of which is measured based on Level 2 inputs.\\nInterest Rate Risk and Interest Rate Swap\\nWe are exposed to interest rate risk arising from fluctuations in variable-rate SOFR on our term loan and when we have loan amounts outstanding on our Revolving Credit Facility. At March 31, 2023, we had $ 50.0 million of variable-rate debt outstanding based on one-month term SOFR . Our objective is to limit the variability of interest payments on our debt. To meet this objective, we enter into receive-variable, pay-fixed interest rate swaps to mitigate the variable-rate cash flow exposure with fixed-rate cash flows. In accordance with our risk management strategy, we actively monitor our interest rate exposure and use derivative instruments from time to time to manage the related risk. We do not speculate using derivative instruments.\\nAt March 31, 2023, we had one interest rate swap agreement, which we entered into in 2020 and commenced in February 2022. Under the interest rate swap, we receive one-month SOFR plus a spread adjustment of 0.10 % variable interest rate payments and make fixed interest rate payments, thereby fixing the interest rate on $ 50.0 million of variable rate debt exposure. Payments on this interest rate swap, with a notional principal amount of $ 50.0 million, are due on a monthly basis at an annual fixed rate of 0.41 %, and this swap expires in June 2025.\\nThe interest rate swap agreement was not designated as a cash flow hedge, and as a result, all changes in the fair value are recognized in \\\"Change in fair value of interest rate swaps\\\" in our Consolidated Statements of Operations rather than through other comprehensive income. At March 31, 2023 and December 31, 2022, we recorded long-term assets of $ 4.0 million and $ 4.8 million, respectively, in \\\"Other assets\\\" on our Consolidated Balance Sheets, representing the fair value of the interest rate swap agreement. The swap was valued based on observable inputs for similar assets and liabilities and other observable inputs for interest rates and yield curves (Level 2 inputs).\\nConcentration of Credit Risk\\nWe are exposed to credit risk related to customer accounts receivable. In order to manage credit risk, we consider customer concentrations and current economic trends and monitor the creditworthiness of significant customers based on ongoing credit evaluations. At March 31, 2023, receivables from two customers accounted for approximately 19 % and 12 % of total receivables. At December 31, 2022, receivables from these two customers accounted for approximately 17 % and 14 % of total receivables. No other customer accounted for 10% or more of total receivables.\\n11\\nNew and Recently Adopted Accounting Standards\\nThere were no accounting standards recently issued that had or are expected to have a material impact on our consolidated financial statements and associated disclosures.\\n3. Income Taxes\\nFor the three months ended March 31, 2023 and 2022, we recorded $ 33.3 million and $ 98.9 million, respectively, of income tax expense and had an effective rate of 25.6 % and 24.6 %, respectively. For both periods, the primary reason for the difference between the federal statutory income tax rate of 21 % and the effective tax rate was the effect of state taxes.\\nDuring the three months ended March 31, 2023 and 2022, cash paid for taxes, net of refunds received, were $ 1.2 million and $ 4.2 million, respectively.\\n4. Net Income Per Common Share\\nBasic net income per common share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Weighted average common shares outstanding for the basic net income per common share calculation includes certain vested restricted stock units (RSUs) and performance stock units (PSUs) as there are no conditions under which those shares will not be issued. Diluted net income per common share is computed by dividing net income by the combination of the weighted average number of common shares outstanding during the period and other potentially dilutive weighted average common shares. Other potentially dilutive weighted average common shares include the dilutive effect of stock options, RSUs, and PSUs for each period using the treasury stock method. Under the treasury stock method, the exercise price of a share and the amount of compensation expense, if any, for future service that has not yet been recognized are assumed to be used to repurchase shares in the current period.\\nThe following table sets forth the computation of basic and diluted net income per common share:\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (thousands, except per-share data) |\\n| Net income | $ | 96,733 | $ | 302,600 |\\n| Weighted average common shares outstanding during the period (for basic calculation) | 39,593 | 39,474 |\\n| Dilutive effect of other potential common shares | 245 | 294 |\\n| Weighted average common shares and potential common shares (for diluted calculation) | 39,838 | 39,768 |\\n| Net income per common share - Basic | $ | 2.44 | $ | 7.67 |\\n| Net income per common share - Diluted | $ | 2.43 | $ | 7.61 |\\n\\nThe computation of the dilutive effect of other potential common shares excludes stock awards representing an insignificant number of shares of common stock in both the three months ended March 31, 2023 and 2022. Under the treasury stock method, the inclusion of these stock awards would have been antidilutive.\\n12\\n5. Acquisition\\nWe account for acquisition transactions in accordance with ASC 805, Business Combinations. Accordingly, the results of operations of the acquiree are included in our consolidated financial statements from the acquisition date. The consideration transferred is allocated to the identifiable assets acquired and liabilities assumed based on estimated fair values at the acquisition date, with any excess recorded as goodwill. Transaction-related costs are expensed in the period the costs are incurred. During the measurement period, which may be up to one year from the acquisition date, we may record adjustments to the assets acquired and liabilities assumed with the corresponding adjustment to goodwill.\\nOn July 25, 2022, our wholly-owned subsidiary, Boise Cascade Wood Products, L.L.C., completed the acquisition of 100 % of the equity interest in Coastal Plywood, and its plywood manufacturing operations located in Havana, Florida, and Chapman, Alabama, for a purchase price of $ 515.2 million, including a post-closing adjustment of $ 1.6 million based upon a working capital target (the Acquisition).\\nThe following table summarizes the final allocations of the purchase price to the assets acquired and liabilities assumed, based on our estimates of the fair value at the date of the Acquisition:\\n| Acquisition Date Fair Value |\\n| (thousands) |\\n| Accounts receivable | $ | 16,123 |\\n| Inventories | 22,977 |\\n| Property and equipment | 251,329 |\\n| Other assets | 1,809 |\\n| Intangible assets: |\\n| Trade name | 700 |\\n| Customer relationships | 153,600 |\\n| Goodwill | 77,576 |\\n| Assets acquired | 524,114 |\\n| Accounts payable and accrued liabilities | 6,299 |\\n| Other long-term liabilities | 2,578 |\\n| Liabilities assumed | 8,877 |\\n| Net assets acquired | $ | 515,237 |\\n\\n13\\n6. Goodwill and Intangible Assets\\nGoodwill represents the excess of the purchase price and related costs over the fair value of the net tangible and intangible assets of businesses acquired.\\nThe carrying amount of our goodwill by segment is as follows:\\n| BuildingMaterialsDistribution | Wood Products | Total |\\n| (thousands) |\\n| Balance at December 31, 2022 and March 31, 2023 | $ | 11,792 | $ | 126,166 | $ | 137,958 |\\n\\nAt March 31, 2023 and December 31, 2022, intangible assets represented the values assigned to trade names and trademarks and customer relationships. We maintain trademarks for our manufactured wood products, particularly EWP. Our key registered trademarks are perpetual in duration as long as we continue to timely file all post registration maintenance documents related thereto. These trade names and trademarks have indefinite lives, are not amortized, and have a carrying amount of $ 8.9 million. In 2022, we acquired a trade name and customer relationships as discussed in Note 5, Acquisition. The acquired trade name has a useful life of one year . The weighted-average useful life for customer relationships from the date of purchase is approximately 10 years. For the three months ended March 31, 2023 and 2022 we recognized $ 4.3 million and $ 0.3 million, respectively, of amortization expense for intangible assets.\\nIntangible assets consisted of the following:\\n| March 31, 2023 |\\n| Gross CarryingAmount | AccumulatedAmortization | Net CarryingAmount |\\n| (thousands) |\\n| Trade names and trademarks | $ | 9,600 | $ | ( 467 ) | $ | 9,133 |\\n| Customer relationships | 166,050 | ( 18,050 ) | 148,000 |\\n| $ | 175,650 | $ | ( 18,517 ) | $ | 157,133 |\\n\\n| December 31, 2022 |\\n| Gross CarryingAmount | AccumulatedAmortization | Net CarryingAmount |\\n| (thousands) |\\n| Trade names and trademarks | $ | 9,600 | $ | ( 292 ) | $ | 9,308 |\\n| Customer relationships | 166,050 | ( 13,925 ) | 152,125 |\\n| $ | 175,650 | $ | ( 14,217 ) | $ | 161,433 |\\n\\n7. Debt\\nLong-term debt consisted of the following:\\n| March 31,2023 | December 31,2022 |\\n| (thousands) |\\n| Asset-based revolving credit facility due 2027 | $ | — | $ | — |\\n| Asset-based credit facility term loan due 2027 | 50,000 | 50,000 |\\n| 4.875% senior notes due 2030 | 400,000 | 400,000 |\\n| Deferred financing costs | ( 5,386 ) | ( 5,608 ) |\\n| Long-term debt | $ | 444,614 | $ | 444,392 |\\n\\n14\\nAsset-Based Credit Facility\\nOn May 15, 2015, Boise Cascade and its principal operating subsidiaries, Boise Cascade Wood Products, L.L.C., and Boise Cascade Building Materials Distribution, L.L.C., as borrowers, and Boise Cascade Wood Products Holdings Corp., as guarantor, entered into an Amended and Restated Credit Agreement, as amended, (the Amended Agreement) with Wells Fargo Capital Finance, LLC, as administrative agent, and the banks named therein as lenders. The Amended Agreement includes a $ 400 million senior secured asset-based revolving credit facility (Revolving Credit Facility) and a $ 50.0 million term loan (ABL Term Loan) maturing on the earlier of (a) September 9, 2027 and (b) 90 days prior to the maturity of our $ 400 million of 4.875 % senior notes due July 1, 2030 (or the maturity date of any permitted refinancing indebtedness or permitted upsized refinancing indebtedness in respect thereof). Interest on borrowings under our Revolving Credit Facility and ABL Term Loan are payable monthly. Borrowings under the Amended Agreement are constrained by a borrowing base formula dependent upon levels of eligible receivables and inventory reduced by outstanding borrowings and letters of credit (Availability).\\nThe Amended Agreement is secured by a first-priority security interest in substantially all of our assets, except for property and equipment. The proceeds of borrowings under the agreement are available for working capital and other general corporate purposes.\\nThe Amended Agreement contains customary nonfinancial covenants, including a negative pledge covenant and restrictions on new indebtedness, investments, distributions to equity holders, asset sales, and affiliate transactions, the scope of which are dependent on the Availability existing from time to time. The Amended Agreement also contains a requirement that we meet a 1 :1 fixed-charge coverage ratio (FCCR), applicable only if Availability falls below the greater of (a) 10 % of the Line Cap (as defined in the Amended Agreement) and (b) $ 35 million. Availability exceeded the minimum threshold amounts required for testing of the FCCR at all times since entering into the Amended Agreement, and Availability at March 31, 2023 was $ 395.9 million.\\nThe Amended Agreement permits us to pay dividends only if at the time of payment (a) no default has occurred or is continuing (or would result from such payment) under the Amended Agreement, and (b) either (i) pro forma Excess Availability (as defined in the Amended Agreement) is equal to or exceeds the greater of (x) 20 % of the Line Cap and (y) $ 75 million or (ii) (x) pro forma Excess Availability is equal to or exceeds the greater of (1) 15 % of Line Cap and (2) $ 55 million and (y) our fixed-charge coverage ratio is greater than or equal to 1 :1 on a pro forma basis.\\nRevolving Credit Facility\\nInterest rates under the Revolving Credit Facility are based, at our election, on either Daily Simple SOFR, Term SOFR, or a base rate, as defined in the Amended Agreement, plus a spread over the index elected that ranges from 1.25 % to 1.50 % for loans based on SOFR and from 0.25 % to 0.50 % for loans based on the base rate. The spread is determined on the basis of a pricing grid that results in a higher spread as average quarterly Availability declines. Both SOFR options include an additional credit spread adjustment of 0.10 %. Letters of credit are subject to a fronting fee payable to the issuing bank and a fee payable to the lenders equal to the Term SOFR margin rate. In addition, we are required to pay an unused commitment fee at a rate of 0.20 % per annum of the average unused portion of the lending commitments.\\nAt both March 31, 2023 and December 31, 2022, we had no borrowings outstanding under the Revolving Credit Facility and $ 4.1 million and $ 3.8 million, respectively, of letters of credit outstanding. These letters of credit and borrowings, if any, reduce availability under the Revolving Credit Facility by an equivalent amount.\\nABL Term Loan\\nThe ABL Term Loan was provided by institutions within the Farm Credit system. Borrowings under the ABL Term Loan may be repaid from time to time at the discretion of the borrowers without premium or penalty. However, any principal amount of ABL Term Loan repaid may not be subsequently re-borrowed.\\nInterest rates under the ABL Term Loan are based, at our election, on either Daily Simple SOFR, Term SOFR, or a base rate, as defined in the Amended Agreement, plus a spread over the index elected that ranges from 1.75 % to 2.00 % for SOFR rate loans and from 0.75 % to 1.00 % for base rate loans, both dependent on the amount of Average Excess Availability (as defined in the Amended Agreement). Both SOFR options include an additional credit spread adjustment of 0.10 %. During the three months ended March 31, 2023, the average interest rate on the ABL Term Loan was approximately 6.36 %.\\nWe have received and expect to continue receiving patronage credits under the ABL Term Loan. Patronage credits are distributions of profits from banks in the Farm Credit system, which are cooperatives that are required to distribute profits to\\n15\\ntheir members. Patronage distributions, which are generally made in cash, are received in the year after they are earned. Patronage credits are recorded as a reduction to interest expense in the year earned. After giving effect to expected patronage distributions, the effective average net interest rate on the ABL Term Loan was approximately 5.4 % during the three months ended March 31, 2023.\\n2030 Notes\\nOn July 27, 2020, we issued $ 400 million of 4.875 % senior notes due July 1, 2030 (2030 Notes) through a private placement that was exempt from the registration requirements of the Securities Act. Interest on our 2030 Notes is payable semiannually in arrears on January 1 and July 1. The 2030 Notes are guaranteed by each of our existing and future direct or indirect domestic subsidiaries that is a guarantor under our Amended Agreement.\\nThe 2030 Notes are senior unsecured obligations and rank equally with all of the existing and future senior indebtedness of Boise Cascade Company and of the guarantors, senior to all of their existing and future subordinated indebtedness, effectively subordinated to all of their present and future senior secured indebtedness (including all borrowings with respect to our Amended Agreement to the extent of the value of the assets securing such indebtedness), and structurally subordinated to the indebtedness of any subsidiaries that do not guarantee the 2030 Notes.\\nThe terms of the indenture governing the 2030 Notes, among other things, limit the ability of Boise Cascade and our restricted subsidiaries to: incur additional debt; declare or pay dividends; redeem stock or make other distributions to stockholders; make investments; create liens on assets; consolidate, merge or transfer substantially all of their assets; enter into transactions with affiliates; and sell or transfer certain assets. The indenture governing the 2030 Notes permits us to pay dividends only if at the time of payment (i) no default has occurred or is continuing (or would result from such payment) under the indenture, and (ii) our consolidated leverage ratio is no greater than 3.5 :1, or (iii) the dividend, together with other dividends since the issue date, would not exceed our \\\"builder\\\" basket under the indenture. In addition, the indenture includes certain specific baskets for the payment of dividends.\\nThe indenture governing the 2030 Notes provides for customary events of default and remedies.\\nInterest Rate Swap\\nFor information on interest rate swap, see Interest Rate Risk and Interest Rate Swap of Note 2, Summary of Significant Accounting Policies.\\nCash Paid for Interest\\nFor the three months ended March 31, 2023 and 2022, cash payments for interest were $ 10.4 million and $ 10.6 million, respectively.\\n16\\n8. Leases\\nLease Costs\\nThe components of lease expense were as follows:\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (thousands) |\\n| Operating lease cost | $ | 3,317 | $ | 3,561 |\\n| Finance lease cost |\\n| Amortization of right-of-use assets | 618 | 626 |\\n| Interest on lease liabilities | 560 | 587 |\\n| Variable lease cost | 1,385 | 1,034 |\\n| Short-term lease cost | 1,551 | 1,312 |\\n| Sublease income | ( 53 ) | ( 112 ) |\\n| Total lease cost | $ | 7,378 | $ | 7,008 |\\n\\nOther Information\\nSupplemental cash flow information related to leases was as follows:\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (thousands) |\\n| Cash paid for amounts included in the measurement of lease liabilities |\\n| Operating cash flows from operating leases | $ | 3,366 | $ | 3,440 |\\n| Operating cash flows from finance leases | 560 | 587 |\\n| Financing cash flows from finance leases | 451 | 422 |\\n| Right-of-use assets obtained in exchange for lease obligations |\\n| Operating leases | 92 | — |\\n| Finance leases | — | — |\\n\\n17\\nOther information related to leases was as follows:\\n| March 31, 2023 | December 31, 2022 |\\n| Weighted-average remaining lease term (years) |\\n| Operating leases | 7 | 7 |\\n| Finance leases | 14 | 14 |\\n| Weighted-average discount rate |\\n| Operating leases | 6.0 | % | 6.0 | % |\\n| Finance leases | 7.6 | % | 7.6 | % |\\n\\nAs of March 31, 2023, our minimum lease payment requirements for noncancelable operating and finance leases are as follows:\\n| Operating Leases | Finance Leases |\\n| (thousands) |\\n| Remainder of 2023 | $ | 10,162 | $ | 3,046 |\\n| 2024 | 12,104 | 4,052 |\\n| 2025 | 10,385 | 3,735 |\\n| 2026 | 7,200 | 3,581 |\\n| 2027 | 6,497 | 3,649 |\\n| Thereafter | 23,633 | 33,086 |\\n| Total future minimum lease payments | 69,981 | 51,149 |\\n| Less: interest | ( 14,015 ) | ( 19,746 ) |\\n| Total lease obligations | 55,966 | 31,403 |\\n| Less: current obligations | ( 10,285 ) | ( 1,854 ) |\\n| Long-term lease obligations | $ | 45,681 | $ | 29,549 |\\n\\n9. Stock-Based Compensation\\nIn first quarter 2023 and 2022, we granted two types of stock-based awards under our incentive plan: performance stock units (PSUs) and restricted stock units (RSUs).\\nPSU and RSU Awards\\nDuring the three months ended March 31, 2023, we granted 93,282 PSUs to our officers and other employees, subject to performance and service conditions. For the officers, the number of shares actually awarded will range from 0 % to 200 % of the target amount, depending upon Boise Cascade's 2023 return on invested capital (ROIC), as approved by our compensation committee in accordance with the related grant agreement. We define ROIC as net operating profit after taxes (NOPAT) divided by average invested capital (based on a rolling thirteen-month average). We define NOPAT as net income plus after-tax financing expense. Invested capital is defined as total assets plus capitalized lease expense, less cash, cash equivalents, and current liabilities, excluding short-term debt. For the other employees, the number of shares actually awarded will range from 0 % to 200 % of the target amount, depending upon Boise Cascade’s 2023 EBITDA, defined as income before interest (interest expense and interest income), income taxes, and depreciation and amortization, as approved by executive management, determined in accordance with the related grant agreement. Because the PSUs contain a performance condition, we record compensation expense over the requisite service period based on the most probable number of shares expected to vest.\\nDuring the three months ended March 31, 2022, we granted 66,180 PSUs to our officers and other employees, subject to performance and service conditions. During the 2022 performance period, officers and other employees earned 152 % and 200 %, respectively, of the target based on Boise Cascade's 2022 ROIC and EBITDA, as applicable, determined by our compensation committee and executive management, as applicable, in accordance with the related grant agreements.\\nThe PSUs granted to officers generally vest in a single installment three years from the date of grant, while the PSUs granted to other employees vest in three equal tranches each year after the grant date.\\n18\\nDuring the three months ended March 31, 2023 and 2022, we granted an aggregate of 115,060 and 81,523 RSUs, respectively, to our officers, other employees, and nonemployee directors with only service conditions. The RSUs granted to officers and other employees vest in three equal tranches each year after the grant date. The RSUs granted to nonemployee directors vest in a single installment after a one year period.\\nWe based the fair value of PSU and RSU awards on the closing market price of our common stock on the grant date. During the three months ended March 31, 2023 and 2022, the total fair value of PSUs and RSUs vested was $ 16.8 million and $ 12.0 million, respectively.\\nThe following summarizes the activity of our PSUs and RSUs awarded under our incentive plan for the three months ended March 31, 2023:\\n| PSUs | RSUs |\\n| Number of shares | Weighted Average Grant-Date Fair Value | Number of shares | Weighted Average Grant-Date Fair Value |\\n| Outstanding, December 31, 2022 | 317,854 | $ | 51.46 | 155,339 | $ | 65.17 |\\n| Granted | 93,282 | 69.33 | 115,060 | 69.33 |\\n| Performance condition adjustment (a) | 39,873 | 79.80 | — | — |\\n| Vested | ( 154,794 ) | 40.61 | ( 87,632 ) | 60.64 |\\n| Forfeited | ( 5,399 ) | 68.55 | ( 3,200 ) | 70.32 |\\n| Outstanding, March 31, 2023 | 290,816 | $ | 66.54 | 179,567 | $ | 69.96 |\\n\\n_______________________________\\n(a) Represents additional PSUs granted during the three months ended March 31, 2023, related to above-target achievement of the 2022 performance condition described above.\\nCompensation Expense\\nWe record compensation expense over the awards' vesting period and account for share-based award forfeitures as they occur, rather than making estimates of future forfeitures. Any shares not vested are forfeited. We recognize compensation expense for stock awards with only service conditions on a straight-line basis over the requisite service period. Most of our stock-based compensation expense was recorded in \\\"General and administrative expenses\\\" in our Consolidated Statements of Operations. Total stock-based compensation recognized from PSUs and RSUs, net of forfeitures, was as follows:\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (thousands) |\\n| PSUs | $ | 1,814 | $ | 1,306 |\\n| RSUs | 1,510 | 1,086 |\\n| Total | $ | 3,324 | $ | 2,392 |\\n\\nThe related tax benefit for the three months ended March 31, 2023 and 2022, was $ 0.9 million and $ 0.6 million respectively. As of March 31, 2023, total unrecognized compensation expense related to nonvested share-based compensation arrangements was $ 23.7 million. This expense is expected to be recognized over a weighted-average period of 2.2 years.\\n19\\n10. Stockholders' Equity\\nDividends\\nOn November 14, 2017, we announced that our board of directors approved a dividend policy to pay quarterly cash dividends to holders of our common stock. For more information regarding our dividend declarations and payments made during each of the three months ended March 31, 2023 and 2022, see \\\"Common stock dividends\\\" on our Consolidated Statements of Stockholders' Equity.\\nOn May 4, 2023 , our board of directors declared a quarterly dividend of $ 0.15 per share on our common stock, as well as a special dividend of $ 3.00 per share on our common stock, both payable on June 15, 2023 , to stockholders of record on June 1, 2023 . For a description of the restrictions in our asset-based credit facility and the indenture governing our senior notes on our ability to pay dividends, see Note 7, Debt.\\nFuture dividend declarations, including amount per share, record date and payment date, will be made at the discretion of our board of directors and will depend upon, among other things, legal capital requirements and surplus, our future operations and earnings, general financial condition, material cash requirements, restrictions imposed by our asset-based credit facility and the indenture governing our senior notes, applicable laws, and other factors that our board of directors may deem relevant.\\nStock Repurchase\\nOn July 28, 2022, our board of directors authorized the repurchase of an additional 1.5 million shares of our common stock. This increase was in addition to the remaining authorized shares under our prior common stock repurchase program that was authorized on February 25, 2015 (the Program). Share repurchases may be made on an opportunistic basis, through open market transactions, privately negotiated transactions, or by other means in accordance with applicable federal securities laws. We are not obligated to purchase any shares and there is no set date that the Program will expire. Our board of directors may increase or decrease the number of shares under the Program or terminate the Program in its discretion at any time. During the three months ended March 31, 2023, we repurchased 24,727 shares under the Program at a cost of $ 1.5 million, or an average of $ 59.91 per share. The shares were purchased with cash on hand and are recorded as \\\"Treasury stock\\\" on our Consolidated Balance Sheet. As of March 31, 2023, there were 1,972,262 shares of common stock that may yet be purchased under the Program.\\n11. Transactions With Related Party\\nLouisiana Timber Procurement Company, L.L.C. (LTP) is an unconsolidated variable-interest entity that is 50 % owned by us and 50 % owned by Packaging Corporation of America (PCA). LTP procures sawtimber, pulpwood, residual chips, and other residual wood fiber to meet the wood and fiber requirements of us and PCA in Louisiana. We are not the primary beneficiary of LTP as we do not have power to direct the activities that most significantly affect the economic performance of LTP. Accordingly, we do not consolidate LTP's results in our financial statements.\\nSales\\nRelated-party sales to LTP from our Wood Products segment in our Consolidated Statements of Operations were $ 3.0 million and $ 3.7 million, respectively, during the three months ended March 31, 2023 and 2022. These sales are recorded in \\\"Sales\\\" in our Consolidated Statements of Operations.\\nCosts and Expenses\\nRelated-party wood fiber purchases from LTP were $ 20.1 million and $ 20.8 million, respectively, during the three months ended March 31, 2023 and 2022. These costs are recorded in \\\"Materials, labor, and other operating expenses (excluding depreciation)\\\" in our Consolidated Statements of Operations.\\n20\\n12. Segment Information\\nWe operate our business using two reportable segments: Wood Products and BMD. We measure and evaluate our reportable segments based on net sales and segment operating income (loss). Accordingly, our chief operating decision maker reviews the performance of the company and allocates resources based primarily on net sales and segment operating income (loss) for our business segments. Unallocated corporate costs are presented as reconciling items to arrive at operating income. There are no differences in our basis of measurement of segment profit or loss from those disclosed in Note 16, Segment Information, of the Notes to Consolidated Financial Statements in \\\"Item 8. Financial Statements and Supplementary Data\\\" in our 2022 Form 10-K.\\nWood Products and BMD segment sales to external customers, including related parties, by product line, are as follows:\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (millions) |\\n| Wood Products (a) |\\n| LVL (b) | $ | 7.4 | $ | 1.7 |\\n| I-joists (b) | 4.7 | ( 2.2 ) |\\n| Other engineered wood products (b) | 7.4 | 11.8 |\\n| Plywood and veneer | 91.3 | 161.2 |\\n| Lumber | 23.6 | 17.7 |\\n| Byproducts | 24.3 | 19.1 |\\n| Other | 6.5 | 5.2 |\\n| 165.1 | 214.5 |\\n| Building Materials Distribution |\\n| Commodity | 547.5 | 1,102.0 |\\n| General line | 533.6 | 615.1 |\\n| Engineered wood products | 298.1 | 394.7 |\\n| 1,379.2 | 2,111.8 |\\n| $ | 1,544.3 | $ | 2,326.3 |\\n\\n___________________________________\\n(a) Amounts represent sales to external customers. Sales are calculated after intersegment sales eliminations to our BMD segment.\\n(b) Sales of EWP to external customers are net of the cost of all EWP rebates and sales allowances provided at various stages of the supply chain (including distributors, dealers, and homebuilders). For both the three months ended March 31, 2023 and 2022, approximately 79 % of Wood Products' EWP sales volumes were to our BMD segment.\\n21\\nAn analysis of our operations by segment is as follows:\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (thousands) |\\n| Net sales by segment |\\n| Wood Products | $ | 437,428 | $ | 558,944 |\\n| Building Materials Distribution | 1,379,242 | 2,111,833 |\\n| Intersegment eliminations (a) | ( 272,341 ) | ( 344,495 ) |\\n| Total net sales | $ | 1,544,329 | $ | 2,326,282 |\\n| Segment operating income |\\n| Wood Products | $ | 69,395 | $ | 190,116 |\\n| Building Materials Distribution | 69,685 | 225,892 |\\n| Total segment operating income | 139,080 | 416,008 |\\n| Unallocated corporate costs | ( 11,478 ) | ( 10,380 ) |\\n| Income from operations | $ | 127,602 | $ | 405,628 |\\n\\n___________________________________\\n(a) Primarily represents intersegment sales from our Wood Products segment to our BMD segment.\\n13. Commitments, Legal Proceedings and Contingencies, and Guarantees\\nCommitments\\nWe are a party to a number of long-term log supply agreements that are discussed in Note 17, Commitments, Legal Proceedings and Contingencies, and Guarantees, of the Notes to Consolidated Financial Statements in \\\"Item 8. Financial Statements and Supplementary Data\\\" in our 2022 Form 10-K. In addition, we have purchase obligations for goods and services, capital expenditures, and raw materials entered into in the normal course of business. As of March 31, 2023, there have been no material changes to the above commitments disclosed in the 2022 Form 10-K.\\nLegal Proceedings and Contingencies\\nWe are a party to legal proceedings that arise in the ordinary course of our business, including commercial liability claims, premises claims, environmental claims, and employment-related claims, among others. As of the date of this filing, we do not believe that we are party to any legal action that could reasonably be expected to have, individually or in the aggregate, a material adverse effect on our financial position, results of operations, or cash flows.\\nGuarantees\\nWe provide guarantees, indemnifications, and assurances to others. Note 17, Commitments, Legal Proceedings and Contingencies, and Guarantees, of the Notes to Consolidated Financial Statements in \\\"Item 8. Financial Statements and Supplementary Data\\\" in our 2022 Form 10-K describes the nature of our guarantees, including the approximate terms of the guarantees, how the guarantees arose, the events or circumstances that would require us to perform under the guarantees, and the maximum potential undiscounted amounts of future payments we could be required to make. As of March 31, 2023, there have been no material changes to the guarantees disclosed in the 2022 Form 10-K.\\n22\\n\\nITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\\nUnderstanding Our Financial Information\\nThis Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and related notes in \\\"Item 1. Financial Statements\\\" of this Form 10-Q, as well as our 2022 Form 10-K. The following discussion includes statements regarding our expectations with respect to our future performance, liquidity, and capital resources. Such statements, along with any other nonhistorical statements in the discussion, are forward-looking. These forward-looking statements include, without limitation, any statement that may predict, indicate, or imply future results, performance, or achievements and may contain the words \\\"may,\\\" \\\"will,\\\" \\\"expect,\\\" \\\"believe,\\\" \\\"should,\\\" \\\"plan,\\\" \\\"anticipate,\\\" and other similar expressions. All of these forward-looking statements are based on estimates and assumptions made by our management that, although believed by us to be reasonable, are inherently uncertain. These forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in \\\"Item 1A. Risk Factors\\\" in our 2022 Form 10-K, as well as those factors listed in other documents we file with the Securities and Exchange Commission (the SEC). We do not assume an obligation to update any forward-looking statement. Our future actual results may differ materially from those contained in or implied by any of the forward-looking statements in this Form 10-Q.\\nBackground\\nBoise Cascade Company is a building products company headquartered in Boise, Idaho. As used in this Form 10-Q, the terms \\\"Boise Cascade,\\\" \\\"we,\\\" and \\\"our\\\" refer to Boise Cascade Company and its consolidated subsidiaries. Boise Cascade is a large, vertically-integrated wood products manufacturer and building materials distributor. We have two reportable segments: (i) Wood Products, which primarily manufactures engineered wood products (EWP) and plywood; and (ii) Building Materials Distribution (BMD), which is a wholesale distributor of building materials. Our products are used in the construction of new residential housing, including single-family, multi-family, and manufactured homes, the repair-and-remodeling of existing housing, the construction of light industrial and commercial buildings, and industrial applications. For more information, see Note 12, Segment Information, of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in \\\"Item 1. Financial Statements\\\" of this Form 10-Q.\\nExecutive Overview\\nWe recorded income from operations of $127.6 million during the three months ended March 31, 2023, compared with income from operations of $405.6 million during the three months ended March 31, 2022. In our Wood Products segment, income decreased $120.7 million to $69.4 million for the three months ended March 31, 2023, from $190.1 million for the three months ended March 31, 2022, due primarily to lower plywood sales prices, lower EWP sales volumes, higher per-unit conversion costs, and an increase in depreciation and amortization expense due to the acquisition of two plywood facilities located in Havana, Florida, and Chapman, Alabama, on July 25, 2022 (the Acquisition). These decreases were offset partially by higher EWP sales prices and higher plywood sales volumes, as well as lower OSB costs (used in the manufacture of I-joists). In our BMD segment, income decreased $156.2 million to $69.7 million for the three months ended March 31, 2023, from $225.9 million for the three months ended March 31, 2022, driven by a gross margin decrease of $177.3 million, resulting primarily from lower margins on commodity products and lower sales volumes, offset partially by decreased selling and distribution expenses of $20.3 million. These changes are discussed further in \\\"Our Operating Results\\\" below.\\nWe ended first quarter 2023 with $1,000.7 million of cash and cash equivalents and $395.9 million of undrawn committed bank line availability, for total available liquidity of $1,396.7 million. We had $444.6 million of outstanding debt at March 31, 2023. We generated $2.4 million of cash during the three months ended March 31, 2023, as cash provided by operations was offset partially by capital spending, dividends paid on our common stock, and tax withholding payments on stock-based awards. A further description of our cash sources and uses for the three-month comparative periods are discussed in \\\"Liquidity and Capital Resources\\\" below.\\nDemand for the products we manufacture, as well as the products we purchase and distribute, is correlated with new residential construction, residential repair-and-remodeling activity and light commercial construction. U.S. housing starts in March 2023 were approximately 1.42 million on a seasonally adjusted annual rate basis, as reported by the U.S. Census Bureau. In addition, mortgage rates have declined from peak levels in late 2022, and measures of builder sentiment have improved from fourth quarter 2022 levels. However, home affordability remains a challenge for consumers, and the Federal Reserve's ongoing actions in response to inflationary data and what impacts these actions have on future mortgage rates and the broader economy\\n23\\nwill influence the near-term demand environment. As such, the full year outlook for 2023 is uncertain and is reflected in various industry forecasts for 2023 U.S. housing starts that generally range from 1.2 million to 1.4 million units, compared with actual housing starts of 1.55 million in 2022, as reported by the U.S. Census Bureau. Regarding home improvement spending, the age of U.S. housing stock and elevated levels of homeowner equity have provided a favorable backdrop for repair-and-remodel spending. However, industry forecasts project continued moderation of year-over-year growth in renovation spending, and economic uncertainty may also negatively impact homeowners' further investment in their residences.\\nAs a manufacturer of certain commodity products, we have sales and profitability exposure to declines in commodity product prices and rising input costs. Our distribution business purchases and resells a broad mix of commodity products with periods of increasing prices providing the opportunity for higher sales and increased margins, while declining price environments expose us to declines in sales and profitability. Future commodity product pricing and commodity input costs may be volatile in response to economic uncertainties, industry operating rates, transportation constraints or disruptions, net import and export activity, inventory levels in various distribution channels, and seasonal demand patterns. In addition, EWP volumes will continue to be influenced by demand for new residential construction, particularly single-family housing starts and we expect further EWP price erosion in the second quarter.\\nFactors That Affect Our Operating Results and Trends\\nOur results of operations and financial performance are influenced by a variety of factors, including the following:\\n•the commodity nature of a portion of our products and their price movements, which are driven largely by industry capacity and operating rates, industry cycles that affect supply and demand, and net import and export activity;\\n•general economic conditions, including but not limited to housing starts, repair-and-remodeling activity, light commercial construction, inventory levels of new and existing homes for sale, foreclosure rates, interest rates, inflation, unemployment rates, household formation rates, prospective home buyers' access to and cost of financing, and housing affordability, that ultimately affect demand for our products;\\n•the highly competitive nature of our industry;\\n•declines in demand for our products due to competing technologies or materials, as well as changes in building code provisions;\\n•disruptions to information systems used to process and store customer, employee, and vendor information, as well as the technology that manages our operations and other business processes;\\n•material disruptions and/or major equipment failure at our manufacturing facilities;\\n•labor disruptions, shortages of skilled and technical labor, or increased labor costs;\\n•the need to successfully formulate and implement succession plans for key members of our management team;\\n•product shortages, loss of key suppliers, and our dependence on third-party suppliers and manufacturers;\\n•the cost and availability of third-party transportation services used to deliver the goods we manufacture and distribute, as well as our raw materials;\\n•cost and availability of raw materials, including wood fiber and glues and resins;\\n•our ability to successfully and efficiently complete and integrate acquisitions;\\n•the concentration of our sales among a relatively small group of customers, as well as the financial condition and creditworthiness of our customers;\\n•impairment of our long-lived assets, goodwill, and/or intangible assets;\\n•substantial ongoing capital investment costs, including those associated with acquisitions, and the difficulty in offsetting fixed costs related to those investments;\\n24\\n•our indebtedness, including the possibility that we may not generate sufficient cash flows from operations or that future borrowings may not be available in amounts sufficient to fulfill our debt obligations and fund other liquidity needs;\\n•restrictive covenants contained in our debt agreements;\\n•compliance with data privacy and security laws and regulations;\\n•the impacts of climate change and related legislative and regulatory responses intended to reduce climate change;\\n•cost of compliance with government regulations, in particular, environmental regulations;\\n•the enactment of tax reform legislation;\\n•exposure to product liability, product warranty, casualty, construction defect, and other claims;\\n•fluctuations in the market for our equity; and\\n•the other factors described in \\\"Item 1A. Risk Factors\\\" in our 2022 Form 10-K.\\n25\\nOur Operating Results\\nThe following tables set forth our operating results in dollars and as a percentage of sales for the three months ended March 31, 2023 and 2022:\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (millions) |\\n| Sales | $ | 1,544.3 | $ | 2,326.3 |\\n| Costs and expenses |\\n| Materials, labor, and other operating expenses (excluding depreciation) | 1,230.6 | 1,729.9 |\\n| Depreciation and amortization | 31.2 | 20.5 |\\n| Selling and distribution expenses | 128.8 | 146.7 |\\n| General and administrative expenses | 26.5 | 26.1 |\\n| Other (income) expense, net | (0.3) | (2.5) |\\n| 1,416.7 | 1,920.7 |\\n| Income from operations | $ | 127.6 | $ | 405.6 |\\n| (percentage of sales) |\\n| Sales | 100.0 | % | 100.0 | % |\\n| Costs and expenses |\\n| Materials, labor, and other operating expenses (excluding depreciation) | 79.7 | % | 74.4 | % |\\n| Depreciation and amortization | 2.0 | 0.9 |\\n| Selling and distribution expenses | 8.3 | 6.3 |\\n| General and administrative expenses | 1.7 | 1.1 |\\n| Other (income) expense, net | — | (0.1) |\\n| 91.7 | % | 82.6 | % |\\n| Income from operations | 8.3 | % | 17.4 | % |\\n\\n26\\nSales Volumes and Prices\\nSet forth below are historical U.S. housing starts data, segment sales volumes and average net selling prices for the principal products sold by our Wood Products segment, and sales mix and gross margin information for our BMD segment for the three months ended March 31, 2023 and 2022.\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (thousands) |\\n| U.S. Housing Starts (a) |\\n| Single-family | 190.5 | 266.8 |\\n| Multi-family | 129.4 | 122.9 |\\n| 319.9 | 389.7 |\\n| (thousands) |\\n| Segment Sales |\\n| Wood Products | $ | 437,428 | $ | 558,944 |\\n| Building Materials Distribution | 1,379,242 | 2,111,833 |\\n| Intersegment eliminations | (272,341) | (344,495) |\\n| Total sales | $ | 1,544,329 | $ | 2,326,282 |\\n| Wood Products | (millions) |\\n| Sales Volumes |\\n| Laminated veneer lumber (LVL) (cubic feet) | 3.6 | 4.6 |\\n| I-joists (equivalent lineal feet) | 39 | 65 |\\n| Plywood (sq. ft.) (3/8\\\" basis) | 406 | 317 |\\n| Wood Products | (dollars per unit) |\\n| Average Net Selling Prices |\\n| Laminated veneer lumber (LVL) (cubic foot) | $ | 31.17 | $ | 26.40 |\\n| I-joists (1,000 equivalent lineal feet) | 2,168 | 1,877 |\\n| Plywood (1,000 sq. ft.) (3/8\\\" basis) | 367 | 689 |\\n| (percentage of Building Materials Distribution sales) |\\n| Building Materials Distribution |\\n| Product Line Sales |\\n| Commodity | 39.7 | % | 52.2 | % |\\n| General line | 38.7 | % | 29.1 | % |\\n| Engineered wood products | 21.6 | % | 18.7 | % |\\n| Gross margin percentage (b) | 14.8 | % | 18.0 | % |\\n\\n_______________________________________\\n(a) Actual U.S. housing starts data reported by the U.S. Census Bureau.\\n(b) We define gross margin as \\\"Sales\\\" less \\\"Materials, labor, and other operating expenses (excluding depreciation).\\\" Substantially all costs included in \\\"Materials, labor, and other operating expenses (excluding depreciation)\\\" for our BMD segment are for inventory purchased for resale. Gross margin percentage is gross margin as a percentage of segment sales.\\n27\\nSales\\nFor the three months ended March 31, 2023, total sales decreased $782.0 million, or 34%, to $1,544.3 million from $2,326.3 million during the three months ended March 31, 2022. As described below, the decrease in sales was driven by the changes in sales prices and volumes for the products we manufacture and distribute with single-family residential construction activity being the key demand driver of our sales. In first quarter 2023, total U.S. housing starts decreased 18%, driven by a decrease in single-family housing starts of 29% compared with the same period in 2022. Average composite lumber and average composite panel prices for the three months ended March 31, 2023 were 67% and 59% lower, respectively, than in the same period in the prior year, as reflected by Random Lengths composite lumber and panel pricing.\\nWood Products. Sales, including sales to our BMD segment, decreased $121.5 million, or 22%, to $437.4 million for the three months ended March 31, 2023, from $558.9 million for the three months ended March 31, 2022. The decrease in sales was driven by lower plywood sales prices of 47%, resulting in decreased sales of $130.6 million. In addition, lower sales volumes of I-joists and LVL (collectively referred to as EWP) of 41% and 22%, respectively, resulted in decreased sales of $50.0 million and $26.4 million, respectively. EWP sales volumes decreased due to a decline in housing starts. I-joist volumes were also impacted by the availability of product substitutes and construction methods in certain geographies that reduce the wood floor opportunity. These decreases were offset partially by higher sales volumes for plywood of 28%, resulting in increased sales of $61.3 million. In addition, higher sales prices for LVL and I-joists of 18% and 16%, respectively, resulted in increased sales of $17.4 million and $11.3 million, respectively. The increase in EWP pricing was due to realizations of previously announced price increases and the expiration of certain temporary price protection arrangements.\\nBuilding Materials Distribution. Sales decreased $732.6 million, or 35%, to $1,379.2 million for the three months ended March 31, 2023, from $2,111.8 million for the three months ended March 31, 2022. Compared with the same quarter in the prior year, the overall decrease in sales was driven by sales price and sales volume decreases of 20% and 15%, respectively. By product line, commodity sales decreased 50%, or $554.5 million; general line product sales decreased 13%, or $81.6 million; and sales of EWP (substantially all of which are sourced through our Wood Products segment) decreased 24%, or $96.5 million.\\nCosts and Expenses\\nMaterials, labor, and other operating expenses (excluding depreciation) decreased $499.3 million, or 29%, to $1,230.6 million for the three months ended March 31, 2023, compared with $1,729.9 million during the same period in the prior year. In our Wood Products segment, materials, labor, and other operating expenses decreased due to lower EWP sales volumes, as well as lower per-unit costs of OSB (used in the manufacture of I-joists) of approximately 19%, compared with first quarter 2022, as well as decreased other manufacturing costs, offset partially by increased labor costs. However, materials, labor, and other operating expenses as a percentage of sales (MLO rate) in our Wood Products segment increased by 1,340 basis points. The increase in the MLO rate was primarily the result of lower plywood sales prices, resulting in decreased leveraging of labor, wood fiber, and other manufacturing costs. In BMD, the decrease in materials, labor, and other operating expenses was driven by lower purchased materials costs as a result of lower sales volumes and lower commodity prices, compared with first quarter 2022. However, the BMD segment MLO rate increased by 330 basis points compared with first quarter 2022, driven primarily by lower margin percentages on our commodity product sales. In our BMD Segment, periods of increasing prices provide the opportunity for higher sales and increased margins, while declining price environments generally result in declines in sales and profitability.\\nDepreciation and amortization expenses increased $10.7 million, or 52%, to $31.2 million for the three months ended March 31, 2023, compared with $20.5 million during the same period in the prior year. The increase was due primarily to the Acquisition on July 25, 2022, and other capital expenditures.\\nSelling and distribution expenses decreased $17.9 million, or 12%, to $128.8 million for the three months ended March 31, 2023, compared with $146.7 million during the same period in the prior year, primarily as a result of lower incentive compensation expenses of $20.0 million, offset partially by an increase in shipping and handling costs and discretionary expenses during the three months ended March 31, 2023 compared with the same period in the prior year.\\nGeneral and administrative expenses increased $0.4 million, or 2%, to $26.5 million for the three months ended March 31, 2023, compared with $26.1 million for the same period in the prior year, primarily due to an increase in professional fees and employee-related expenses, offset partially by lower incentive compensation expenses during the three months ended March 31, 2023 compared with the same period in the prior year.\\n28\\nFor the three months ended March 31, 2023, other income (expense), net, was $0.3 million of income, compared with $2.5 million of income for the three months ended March 31, 2022. Other income for the three months ended March 31, 2022 primarily included earn-out income related to a previous asset sale in our Wood Products segment.\\nIncome From Operations\\nIncome from operations decreased $278.0 million to $127.6 million for the three months ended March 31, 2023, compared with $405.6 million for the three months ended March 31, 2022.\\nWood Products. Segment income decreased $120.7 million to $69.4 million for the three months ended March 31, 2023, compared with $190.1 million for the three months ended March 31, 2022. The decrease in segment income was due primarily to lower plywood sales prices and lower EWP sales volumes. In addition, segment income was negatively impacted by higher per-unit conversion costs and an increase in depreciation and amortization expense of $10.7 million related to the Acquisition. These decreases in segment income were offset partially by higher EWP sales prices and higher plywood sales volumes, as well as lower OSB costs (used in the manufacture of I-joists).\\nBuilding Materials Distribution. Segment income decreased $156.2 million to $69.7 million for the three months ended March 31, 2023, from $225.9 million for the three months ended March 31, 2022. The decline in segment income was driven by a gross margin decrease of $177.3 million, resulting primarily from lower margins on commodity products and lower sales volumes, offset partially by decreased selling and distribution expenses of $20.3 million.\\nCorporate. Unallocated corporate expenses increased $1.1 million to $11.5 million for the three months ended March 31, 2023, from $10.4 million for the same period in the prior year. The increase was due primarily to an increase in professional fees.\\nOther\\nInterest Income. Interest income increased $9.6 million to $9.7 million for the three months ended March 31, 2023, from $0.1 million for the three months ended March 31, 2022. The increase was due primarily to higher interest rates on cash equivalents and increases in the average balances of cash equivalents.\\nChange in fair value of interest rate swaps. For information related to our interest rate swap, see the discussion under \\\"Interest Rate Risk and Interest Rate Swap\\\" of Note 2, Summary of Significant Accounting Policies, of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in \\\"Item 1. Financial Statements\\\" of this Form 10-Q.\\nIncome Tax Provision\\nFor the three months ended March 31, 2023 and 2022, we recorded $33.3 million and $98.9 million, respectively, of income tax expense and had an effective rate of 25.6% and 24.6%, respectively. For both periods, the primary reason for the difference between the federal statutory income tax rate of 21% and the effective tax rate was the effect of state taxes.\\nLiquidity and Capital Resources\\nWe ended first quarter 2023 with $1,000.7 million of cash and cash equivalents and $444.6 million of debt. At March 31, 2023, we had $1,396.7 million of available liquidity (cash and cash equivalents and undrawn committed bank line availability). We generated $2.4 million of cash during the three months ended March 31, 2023, as cash provided by operations was offset partially by capital spending, dividends paid on our common stock, and tax withholding payments on stock-based awards. Further descriptions of our cash sources and uses for the three month comparative periods are noted below.\\nWe believe that our cash flows from operations, combined with our current cash levels and available borrowing capacity, will be adequate to fund debt service requirements and provide cash, as required, to support our ongoing operations, capital expenditures, lease obligations, working capital, income tax payments, and to pay cash dividends to holders of our common stock over the next 12 months. We expect to fund our seasonal and intra-month working capital requirements in 2023 from cash on hand and, if necessary, borrowings under our revolving credit facility.\\n29\\nSources and Uses of Cash\\nWe generate cash primarily from sales of our products, as well as short-term and long-term borrowings. Our primary uses of cash are for expenses related to the manufacture and distribution of building products, including inventory purchased for resale, wood fiber, labor, energy, and glues and resins. In addition to paying for ongoing operating costs, we use cash to invest in our business, service our debt and lease obligations, and return cash to our shareholders through dividends or common stock repurchases. Below is a discussion of our sources and uses of cash for operating activities, investing activities, and financing activities.\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (thousands) |\\n| Net cash provided by operations | $ | 47,992 | $ | 198,945 |\\n| Net cash used for investment | (29,498) | (14,867) |\\n| Net cash used for financing | (16,117) | (10,264) |\\n\\nOperating Activities\\nFor the three months ended March 31, 2023, our operating activities generated $48.0 million of cash, compared with $198.9 million of cash generated in the same period in 2022. The $150.9 million decrease in cash provided by operations was due primarily to a decrease in income from operations, offset partially by a lesser year-over-year increase in working capital and a decrease in cash paid for taxes, net of refunds, of $2.9 million. Working capital increased $117.7 million during the three months ended March 31, 2023, compared with a $217.8 million increase for the same period in the prior year. See \\\"Our Operating Results\\\" in this Management's Discussion and Analysis of Financial Condition and Results of Operations for more information related to factors affecting our operating results.\\nThe increase in working capital during both periods was primarily attributable to higher receivables and inventories, offset by an increase in accounts payable and accrued liabilities. The increases in receivables in both periods primarily reflect increased sales of approximately 26% and 49%, comparing sales for the months of March 2023 and 2022 with sales for the months of December 2022 and 2021, respectively. Inventories increased during the three months ended March 31, 2023 in preparation for the spring building season. During the three months ended March 31, 2022 inventories increased primarily due to increased cost of inventory purchased for resale and higher production costs for our manufactured products. The increase in accounts payable and accrued liabilities as of March 31, 2023 was related to the increase in inventories, offset partially by employee incentive compensation payouts made during the quarter and lower accrued rebates. The increase in accounts payable and accrued liabilities as of March 31, 2022 was related to the increase in inventories and higher accrued rebates, offset partially by employee incentive compensation payouts made during first quarter 2022.\\nInvestment Activities\\nDuring the three months ended March 31, 2023 and 2022, we used $30.1 million and $17.4 million, respectively, of cash for purchases of property and equipment, including business improvement and quality/efficiency projects, replacement and expansion projects, and ongoing environmental compliance. During the three months ended March 31, 2022, we received $2.5 million of earn-out income related to a previous asset sale in our Wood Products segment.\\nWe expect capital expenditures in 2023 to total approximately $120 million to $140 million. We expect our capital spending in 2023 will be for business improvement and quality/efficiency projects, replacement and expansion projects, and ongoing environmental compliance. Our 2023 capital expenditures range includes funding for greenfield distribution centers in South Carolina and Texas, projects at our mills in the southeast to expand our EWP capacity, and the purchase of property to house an additional door shop assembly operation in Kansas City, Missouri. This level of capital expenditures could increase or decrease as a result of several factors, including acquisitions, efforts to further accelerate organic growth, exercise of lease purchase options, our financial results, future economic conditions, availability of engineering and construction resources, and timing and availability of equipment purchases.\\nFinancing Activities\\nDuring the three months ended March 31, 2023, our financing activities used $16.1 million of cash, including $8.3 million for common stock dividend payments, $5.9 million of tax withholding payments on stock-based awards, and $1.5\\n30\\nmillion for the repurchase of 24,727 shares of our common stock. During the three months ended March 31, 2023, we did not borrow under our revolving credit facility, and therefore have no borrowings outstanding on the facility as of March 31, 2023.\\nDuring the three months ended March 31, 2022, our financing activities used $10.3 million of cash, including $5.9 million for common stock dividend payments and $3.9 million of tax withholding payments on stock-based awards. During the three months ended March 31, 2022, we did not borrow under our revolving credit facility.\\nFuture dividend declarations, including amount per share, record date and payment date, will be made at the discretion of our board of directors and will depend upon, among other things, legal capital requirements and surplus, our future operations and earnings, general financial condition, material cash requirements, restrictions imposed by our asset-based credit facility and the indenture governing our senior notes, applicable laws, and other factors that our board of directors may deem relevant.\\nFor more information related to our debt transactions and structure, our dividend policy, and our stock repurchase program, see the discussion in Note 7, Debt, and Note 10, Stockholders' Equity, respectively, of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in \\\"Item 1. Financial Statements\\\" of this Form 10-Q.\\nOther Material Cash Requirements\\nFor information about other material cash requirements, see Liquidity and Capital Resources in \\\"Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations\\\" in our 2022 Form 10-K. As of March 31, 2023, there have been no material changes in other material cash requirements outside the ordinary course of business since December 31, 2022.\\nGuarantees\\nNote 9, Debt, and Note 17, Commitments, Legal Proceedings and Contingencies, and Guarantees, of the Notes to Consolidated Financial Statements in \\\"Item 8. Financial Statements and Supplementary Data\\\" in our 2022 Form 10-K describe the nature of our guarantees, including the approximate terms of the guarantees, how the guarantees arose, the events or circumstances that would require us to perform under the guarantees, and the maximum potential undiscounted amounts of future payments we could be required to make. As of March 31, 2023, there have been no material changes to the guarantees disclosed in our 2022 Form 10-K.\\nSeasonal Influences\\nWe are exposed to fluctuations in quarterly sales volumes and expenses due to seasonal factors. These seasonal factors are common in the building products industry. Seasonal changes in levels of building activity affect our building products businesses, which are dependent on housing starts, repair-and-remodeling activities, and light commercial construction activities. We typically report lower sales volumes in the first and fourth quarters due to the impact of poor weather on the construction market, and we generally have higher sales volumes in the second and third quarters, reflecting an increase in construction due to more favorable weather conditions. We typically have higher working capital in the first and second quarters in preparation and response to the building season. Seasonally cold weather increases costs, especially energy consumption costs, at most of our manufacturing facilities.\\nEmployees\\nAs of April 30, 2023, we had approximately 6,660 employees. Approximately 19% of these employees work pursuant to collective bargaining agreements. As of April 30, 2023, we had ten collective bargaining agreements. One agreement covering approximately 80 employees at our Canadian EWP facility expired on December 31, 2022, but the terms and conditions of this agreement remain in effect pending negotiation of a new agreement. We may not be able to renew this agreement or may renew it on terms that are less favorable to us than the current agreement. If any of these agreements are not renewed or extended upon their termination, we could experience a material labor disruption, strike, or significantly increased labor costs at one or more of our facilities, either in the course of negotiations of a labor agreement or otherwise. Labor disruptions or shortages could prevent us from meeting customer demands or result in increased costs, thereby reducing our sales and profitability.\\n31\\nDisclosures of Financial Market Risks\\nIn the normal course of business, we are exposed to financial risks such as changes in commodity prices, interest rates, and foreign currency exchange rates. As of March 31, 2023, there have been no material changes to financial market risks disclosed in our 2022 Form 10-K.\\nEnvironmental\\nAs of March 31, 2023, there have been no material changes to environmental issues disclosed in our 2022 Form 10-K. For additional information, see Environmental in \\\"Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations\\\" in our 2022 Form 10-K.\\nCritical Accounting Estimates\\nCritical accounting estimates are those that are most important to the portrayal of our financial condition and results. These estimates require management's most difficult, subjective, or complex judgments, often as a result of the need to estimate matters that are inherently uncertain. We review the development, selection, and disclosure of our critical accounting estimates with the Audit Committee of our board of directors. For information about critical accounting estimates, see Critical Accounting Estimates in \\\"Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations\\\" in our 2022 Form 10-K. At March 31, 2023, there have been no material changes to our critical accounting estimates from those disclosed in our 2022 Form 10-K.\\nNew and Recently Adopted Accounting Standards\\nFor information related to new and recently adopted accounting standards, see \\\"New and Recently Adopted Accounting Standards\\\" in Note 2, Summary of Significant Accounting Policies, of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in \\\"Item 1. Financial Statements\\\" in this Form 10-Q.\\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nFor information relating to quantitative and qualitative disclosures about market risk, see the discussion under \\\"Item 7A. Quantitative and Qualitative Disclosures About Market Risk\\\" and under the headings \\\"Disclosures of Financial Market Risks\\\" and \\\"Financial Instruments\\\" in \\\"Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations\\\" in our 2022 Form 10-K. As of March 31, 2023, there have been no material changes in our exposure to market risk from those disclosed in our 2022 Form 10-K.\\n\\nITEM 4. CONTROLS AND PROCEDURES\\nEvaluation of Disclosure Controls and Procedures\\nWe maintain \\\"disclosure controls and procedures,\\\" as defined in Rule 13a-15(e) under the Exchange Act. We have designed these controls and procedures to reasonably assure that information required to be disclosed in our reports filed or submitted under the Exchange Act, such as this Form 10-Q, is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. We have also designed our disclosure controls to provide reasonable assurance that such information is accumulated and communicated to our senior management, including our chief executive officer (CEO) and our chief financial officer (CFO), as appropriate, to allow them to make timely decisions regarding our required disclosures. Based on their evaluation, our CEO and CFO have concluded that as of March 31, 2023, our disclosure controls and procedures were effective.\\nChanges in Internal Control Over Financial Reporting\\nThere were no changes in our internal control over financial reporting that occurred during the three months ended March 31, 2023, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\n32\\nPART II—OTHER INFORMATION\\nITEM 1. LEGAL PROCEEDINGS\\nWe are a party to legal proceedings that arise in the ordinary course of our business, including commercial liability claims, premises claims, environmental claims, and employment-related claims, among others. As of the date of this filing, we do not believe that we are party to any legal action that could reasonably be expected to have, individually or in the aggregate, a material adverse effect on our financial position, results of operations, or cash flows.\\nSEC regulations require us to disclose certain information about proceedings arising under federal, state or local environmental provisions if we reasonably believe that such proceedings may result in monetary sanctions above a stated threshold. Pursuant to the SEC regulations, we use a threshold of $1 million or more for purposes of determining whether disclosure of any such proceedings is required.\\nITEM 1A. RISK FACTORS\\nThis report on Form 10-Q contains forward-looking statements. Statements that are not historical or current facts, including statements about our expectations, anticipated financial results, projected capital expenditures, and future business prospects, are forward-looking statements. You can identify these statements by our use of words such as \\\"may,\\\" \\\"will,\\\" \\\"expect,\\\" \\\"believe,\\\" \\\"should,\\\" \\\"plan,\\\" \\\"anticipate,\\\" and other similar expressions. You can find examples of these statements throughout this report, including \\\"Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.\\\" We cannot guarantee that our actual results will be consistent with the forward-looking statements we make in this report. You should review carefully the risk factors listed in \\\"Item 1A. Risk Factors\\\" in our 2022 Form 10-K, as well as those factors listed in other documents we file with the Securities and Exchange Commission. We do not assume an obligation to update any forward-looking statement.\\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\\nPurchase of Equity Securities by the Issuer and Affiliated Purchasers\\nOn July 28, 2022, our board of directors authorized the repurchase of an additional 1.5 million shares of our common stock. This increase was in addition to the remaining authorized shares under our prior common stock repurchase program that was authorized on February 25, 2015 (the Program). Share repurchases may be made on an opportunistic basis, through open market transactions, privately negotiated transactions, or by other means in accordance with applicable federal securities laws. We are not obligated to purchase any shares and there is no set date that the Program will expire. Our board of directors may increase or decrease the number of shares under the Program or terminate the Program in its discretion at any time. During first quarter 2023, we repurchased 24,727 shares under the Program at a cost of $1.5 million, or an average of $59.91 per share. Set forth below is information regarding the Company's share repurchases during the first quarter ended March 31, 2023.\\n| Total Number of Shares Purchased | Average Price Paid per Share | Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs | The Maximum Number of Shares That May Yet Be Purchased Under the Plans or Programs |\\n| January 1, 2023 - January 31, 2023 | — | $ | — | — | 1,996,989 |\\n| February 1, 2023 - February 28, 2023 | — | — | — | 1,996,989 |\\n| March 1, 2023 - March 31, 2023 | 24,727 | 59.91 | 24,727 | 1,972,262 |\\n| Total | 24,727 | $ | 59.91 | 24,727 | 1,972,262 |\\n\\nITEM 3. DEFAULTS UPON SENIOR SECURITIES\\nNone.\\nITEM 4. MINE SAFETY DISCLOSURES\\nNot applicable.\\n33\\n\\nITEM 5. OTHER INFORMATION\\nNone.\\nITEM 6. EXHIBITS\\n| Number | Description |\\n| 10.1 | Form of 2023 Restricted Stock Unit Agreement |\\n| 10.2 | Form of 2023 Performance Stock Unit Agreement |\\n| 10.3 | Form of 2023 Director Restricted Stock Unit Agreement |\\n| 10.4 | Ninth Amendment to Amended and Restated Credit Agreement, dated March 31, 2023, by and among the Lenders identified on the signature pages thereof, Wells Fargo Capital Finance, LLC, as administrative agent, Boise Cascade Company, and the other Borrowers identified on the signature pages thereof |\\n| 31.1 | CEO Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 31.2 | CFO Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 32.1 | CEO Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 32.2 | CFO Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 101.INS | Inline XBRL Instance Document |\\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document |\\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document |\\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\\n\\n34\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n\\n| BOISE CASCADE COMPANY |\\n| /s/ Kelly E. Hibbs |\\n| Kelly E. HibbsSenior Vice President, Chief Financial Officer and Treasurer |\\n\\nDate: May 4, 2023\\n35\\n \\n\\nWhat is the percentage increase in finance cost from the year 2022 to 2023 in relation to the net income for each year in percentage?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 391.2.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 53,\n \"input_length\": 24586\n}"}}},{"rowIdx":54,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nITEM 1.\nFINANCIAL STATEMENTS\nARDELYX, INC.\nCondensed Balance Sheets\n(In thousands, except share and per share amounts)\n\n| June 30,2014 | December 31,2013 |\n| (Unaudited) |\n| Assets |\n| Current assets: |\n| Cash and cash equivalents | $ | 117,814 | $ | 34,435 |\n| Accounts receivable | 3,025 | 6,436 |\n| Prepaid expenses and other current assets | 1,308 | 965 |\n| Total current assets | 122,147 | 41,836 |\n| Property and equipment, net | 1,138 | 530 |\n| Other assets | 13 | 358 |\n| Restricted cash | 180 | 180 |\n| Total assets | $ | 123,478 | $ | 42,904 |\n| Liabilities, convertible preferred stock, and stockholders’ equity (deficit) |\n| Current liabilities: |\n| Accounts payable | $ | 2,308 | $ | 2,284 |\n| Accrued compensation and benefits | 802 | 927 |\n| Other accrued liabilities | 1,003 | 95 |\n| Deferred rent | — | 5 |\n| Deferred revenue, current portion | 23,221 | 13,828 |\n| Total current liabilities | 27,334 | 17,139 |\n| Deferred revenue, non-current | 33,170 | 26,470 |\n| Convertible preferred stock warrant liability | — | 6,456 |\n| Liabilities related to early exercise of options | 107 | 163 |\n| Total liabilities | 60,611 | 50,228 |\n| Commitments and contingencies |\n| Convertible preferred stock, $0.0001 par value per share — no shares and 108,829,748 shares authorized as of June 30, 2014 and December 31, 2013, respectively; no shares and 11,517,222 shares issued and outstanding as of June 30, 2014 and December 31, 2013, respectively | — | 56,155 |\n| Stockholders’ equity (deficit): |\n| Preferred stock, $0.0001 par value; 5,000,000 shares and no shares authorized as of June 30, 2014 and December 31, 2013, respectively; no shares issued and outstanding as of June 30, 2014 and December 31, 2013, respectively | — | — |\n| Common stock, $0.0001 par value — 300,000,000 and 130,360,121 shares authorized as of June 30, 2014 and December 31, 2013, respectively; 18,335,620 and 1,225,481 shares issued and outstanding as of June 30, 2014 and December 31, 2013, respectively | 2 | — |\n| Additional paid-in capital | 130,836 | 5,174 |\n| Accumulated deficit | (67,971 | ) | (68,653 | ) |\n| Total stockholders’ equity (deficit) | 62,867 | (63,479 | ) |\n| Total liabilities, convertible preferred stock, and stockholders’ equity (deficit) | $ | 123,478 | $ | 42,904 |\n\nSee accompanying notes.\n2\nARDELYX, INC.\nCondensed Statements of Operations and Comprehensive Income (Loss)\n(Unaudited)\n(In thousands, except share and per share amounts)\n\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Revenue: |\n| Licensing revenue | $ | 6,507 | $ | 1,989 | $ | 9,743 | $ | 3,978 |\n| Collaborative development revenue | 2,630 | 5,302 | 7,944 | 9,869 |\n| Total revenue | 9,137 | 7,291 | 17,687 | 13,847 |\n| Operating expenses: |\n| Research and development | 5,183 | 7,234 | 12,820 | 13,173 |\n| General and administrative | 1,203 | 908 | 2,580 | 1,935 |\n| Total operating expenses | 6,386 | 8,142 | 15,400 | 15,108 |\n| Income (loss) from operations | 2,751 | (851 | ) | 2,287 | (1,261 | ) |\n| Other expense, net | (8 | ) | (4 | ) | (12 | ) | (29 | ) |\n| Change in fair value of preferred stock warrant liability | 1,010 | — | (1,593 | ) | — |\n| Income (loss) before provision for income taxes | 3,753 | (855 | ) | 682 | (1,290 | ) |\n| Provision for income taxes | — | 36 | — | 71 |\n| Net income (loss) and comprehensive income (loss) | $ | 3,753 | $ | (891 | ) | $ | 682 | $ | (1,361 | ) |\n| Net income (loss) attributable to common stockholders: |\n| Basic | $ | 515 | $ | (891 | ) | $ | — | $ | (1,361 | ) |\n| Diluted | $ | 703 | $ | (891 | ) | $ | — | $ | (1,361 | ) |\n| Shares used to compute net income (loss) per share attributable to common stockholders: |\n| Basic | 2,611,259 | 1,102,093 | 1,937,509 | 1,072,583 |\n| Diluted | 3,904,136 | 1,102,093 | 1,937,509 | 1,072,583 |\n| Net income (loss) per share attributable to common stockholders: |\n| Basic | $ | 0.20 | $ | (0.81 | ) | $ | — | $ | (1.27 | ) |\n| Diluted | $ | 0.18 | $ | (0.81 | ) | $ | — | $ | (1.27 | ) |\n\nSee accompanying notes.\n3\nARDELYX, INC.\nCondensed Statements of Cash Flows\n(Unaudited)\n(In thousands)\n\n| Six Months Ended June 30, |\n| 2014 | 2013 |\n| Operating activities |\n| Net income (loss) | $ | 682 | $ | (1,361 | ) |\n| Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |\n| Depreciation and amortization expense | 128 | 356 |\n| Stock-based compensation | 163 | 190 |\n| Change in fair value of preferred stock warrant liability | 1,593 | — |\n| Changes in operating assets and liabilities: |\n| Accounts receivable | 3,411 | (3,912 | ) |\n| Prepaid and other current assets | (343 | ) | (496 | ) |\n| Other assets | 345 | (731 | ) |\n| Accounts payable | 24 | 1,131 |\n| Accrued compensation and benefits | (125 | ) | (377 | ) |\n| Other accrued liabilities | 908 | (572 | ) |\n| Deferred revenue | 16,093 | (2,863 | ) |\n| Deferred rent | (5 | ) | (262 | ) |\n| Net cash provided by (used in) operating activities | 22,874 | (8,897 | ) |\n| Investing activities |\n| Purchases of property and equipment | (736 | ) | (257 | ) |\n| Net cash used in investing activities | (736 | ) | (257 | ) |\n| Financing activities |\n| Proceeds from issuance of common stock | 61,241 | 2 |\n| Repurchase of unvested common stock | — | (2 | ) |\n| Net cash provided by financing activities | 61,241 | — |\n| Net increase (decrease) in cash and cash equivalents | 83,379 | (9,154 | ) |\n| Cash and cash equivalents at beginning of period | 34,435 | 32,903 |\n| Cash and cash equivalents at end of period | $ | 117,814 | $ | 23,749 |\n\nSee accompanying notes.\n4\nARDELYX, INC.\nNotes to the Unaudited Interim Condensed Financial Statements\n1. Organization and Basis of Presentation\nArdelyx, Inc. (the “Company”) is a clinical stage biopharmaceutical company focused on the discovery, development and commercialization of innovative, non-systemic, small molecule therapeutics that work exclusively in the gastrointestinal tract to treat cardio-renal, gastrointestinal and metabolic diseases. The Company has developed a drug discovery and design platform enabling it, in a rapid and cost-efficient manner, to discover and design novel drug candidates. The Company was incorporated in Delaware on October 17, 2007, under the name Nteryx and changed its name to Ardelyx, Inc. in June 2008.\nThe Company operates in only one business segment, which is the development of biopharmaceutical products.\nBasis of Presentation\nThe accompanying unaudited condensed financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) and following the requirements of the Securities and Exchange Commission (the “SEC”) for interim reporting. As permitted under those rules, certain footnotes or other financial information that are normally required by U.S. GAAP can be condensed or omitted. These financial statements have been prepared on the same basis as the Company’s annual financial statements and, in the opinion of management, reflect all adjustments, consisting only of normal recurring adjustments that are necessary for a fair statement of the Company’s financial information. The results of operations for the three and six months ended June 30, 2014 are not necessarily indicative of the results to be expected for the year ending December 31, 2014 or for any other interim period or for any other future year. The balance sheet as of December 31, 2013 has been derived from audited financial statements at that date but does not include all of the information required by U.S. GAAP for complete financial statements.\nThe accompanying condensed financial statements and related financial information should be read in conjunction with the audited financial statements and the related notes thereto for the year ended December 31, 2013 included in the Company’s Prospectus filed pursuant to Rule 424(b)(4) on June 19, 2014 with the SEC (the “Prospectus”).\nReverse Stock Split\nOn June 18, 2014, the Company’s Amended and Restated Certificate of Incorporation became effective resulting in a reverse split of the Company’s common stock and convertible preferred stock at a 1-for-9 ratio (the “Reverse Stock Split”). The par value and the authorized shares of the common stock and convertible preferred stock were not adjusted as a result of the Reverse Stock Split. All issued and outstanding common stock, convertible preferred stock, warrants for preferred stock, options for common stock and per share amounts contained in the financial statements have been retroactively adjusted to reflect this Reverse Stock Split for all periods presented.\nInitial Public Offering\nOn June 18, 2014, the Company’s registration statement on Form S-1 (File No. 333-196090) relating to the initial public offering (the “IPO”) of its common stock was declared effective by the SEC. The IPO closed on June 24, 2014 at which time the Company sold 4,928,900 shares of its common stock, which included the exercise in full by the underwriters of the IPO of their option to purchase 642,900 additional shares of the Company’s common stock. The Company received cash proceeds of $61.2 million from the IPO, net of underwriting discounts and commissions and expenses paid by the Company.\nOn June 24, 2014, prior to the closing of the IPO, all outstanding shares of convertible preferred stock converted into 11,517,222 shares of common stock with the related carrying value of $56.2 million reclassified to common stock and additional paid-in capital. In addition, all convertible preferred stock warrants were net exercised and converted into common stock and the related convertible preferred stock warrant liability was reclassified to additional paid-in capital.\nOn June 24, 2014, the Company’s Amended and Restated Certificate of Incorporation became effective and the number of shares of capital stock the Company is authorized to issue was increased to 305,000,000 shares, of which 300,000,000 shares may be common stock and 5,000,000 shares may be preferred stock. Both the common stock and preferred stock have a par value of $0.0001 per share. There are no shares of preferred stock outstanding at June 30, 2014.\n5\n2. Summary of Significant Accounting Policies\nUse of Estimates\nThe preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and judgments that affect the amounts reported in the financial statements and accompanying notes. On an ongoing basis, management evaluates its estimates, including those related to revenue recognition, clinical trial accruals, income taxes, and stock-based compensation. Management bases its estimates on historical experience and on various other market-specific and relevant assumptions that management believes to be reasonable under the circumstances. Actual results may differ from those estimates.\nCash and Cash Equivalents\nThe Company considers all highly liquid investments purchased with an original maturity date of 90 days or less on the date of purchase to be cash equivalents. The Company invests its cash in bank deposits and money market accounts.\nRestricted Cash\nThe Company is required to guarantee the credit limit on its corporate credit card with a certificate of deposit of $100,000. The collateral will be released upon the cancellation of the corporate credit card.\nThe Company is required under its facility lease agreement to maintain a line of credit with a bank in the amount of $80,000 for the benefit of the lessor. The line of credit is secured by a cash deposit with the bank. The cash deposit will be released upon expiration of the line of credit.\nComprehensive Income (Loss)\nComprehensive income (loss) is composed of two components: net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) refers to gains and losses that under GAAP are recorded as an element of stockholders’ equity (deficit), but are excluded from net income (loss). The Company did not record any transactions within other comprehensive income (loss) in the periods presented and, therefore, the net income (loss) and comprehensive income (loss) were the same for all periods presented.\nRevenue Recognition\nRevenue from research activities made under collaboration partnership agreements are recognized as the services are provided and when there is persuasive evidence that an arrangement exists, delivery has occurred, the price is fixed or determinable, and collectability is reasonably assured. Revenue generated from research and licensing agreements typically includes up-front signing or license fees, cost reimbursements, research services, minimum sublicense fees, milestone payments, and royalties on future licensees’ product sales.\nFor revenue agreements with multiple-element arrangements, such as license and development agreements, the Company allocates revenue to each non-contingent deliverable based on the relative selling price of each deliverable. When applying the relative selling price method, the Company determines the selling price for each deliverable using vendor-specific objective evidence or third-party evidence. If neither exists, the Company uses its best estimate of selling price for that deliverable. Revenue allocated is then recognized when the four basic revenue recognition criteria are met for each deliverable.\nThe Company recognizes revenue from upfront payments ratably over the term of its estimated period of performance under the agreement which is recorded as licensing revenue. Reimbursements for development costs incurred under the Company’s license agreement with AstraZeneca are classified as collaborative development revenue. The Company recognizes cost reimbursement revenue under collaboration partnership agreements as the related research and development costs for services are rendered. Deferred revenue represents the portion of research or license payments received which has not been earned.\nRevenues from milestones, if they are nonrefundable and deemed substantive, are recognized upon successful accomplishment of the milestones. To the extent that non-substantive milestones are achieved and the Company has remaining performance obligations, milestones are deferred and recognized as revenue over the estimated remaining period of performance. The Company will recognize revenue associated with the non-substantive milestones upon achievement of the milestone if there are no undelivered elements and it has no remaining performance obligations. The Company will account for sales-based milestones as royalties that will be recognized as revenue upon achievement of the milestone.\n6\nNet Income (Loss) per Share Attributable to Common Stockholders\nBasic net income (loss) per share attributable to common stockholders is calculated by dividing the net income (loss) attributable to common stockholders by the weighted-average number of shares of common stock outstanding for the period. Prior to the Company’s IPO of its common stock, the Company’s Series A and Series B convertible preferred stock was entitled to receive dividends of up to $0.8181 and $0.2781 per share, respectively, prior and in preference to any declaration or payment of any dividend on common stock and thereafter participate pro rata on an as converted basis with the common stock holders on any distributions to common stockholders. The convertible preferred shares were therefore considered to be participating securities. As a result, the Company calculated the net income (loss) per share using the two-class method. Accordingly, the net income (loss) attributable to common stockholders is derived from the net income (loss) for the period and, in periods in which the Company has net income attributable to common stockholders, an adjustment is made for the noncumulative dividends and allocations of earnings to participating securities based on their outstanding shareholder rights. Under the two-class method, the net loss attributable to common stockholders is not allocated to the convertible preferred stock as the convertible preferred stock did not have a contractual obligation to share in the Company’s losses. The diluted net income per share attributable to common stockholders is computed by giving effect to all potential dilutive common stock equivalents outstanding for the period. In periods when we have incurred a net loss, convertible preferred stock, options to purchase common stock and convertible preferred stock warrants are considered common stock equivalents but have been excluded from the calculation of diluted net loss per share attributable to common stockholders as their effect is antidilutive.\nRecent Accounting Pronouncement\nIn July 2013, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update (“ASU”) 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. The ASU concludes an unrecognized tax benefit should be presented as a reduction of a deferred tax asset when settlement in this manner is available under the law. The Company adopted this amendment as of January 1, 2014, which did not have a significant impact on the balance sheet.\nIn May 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”), which converges the FASB and the International Accounting Standards Board standards on revenue recognition. Areas of revenue recognition that will be affected include, but are not limited to, transfer of control, variable consideration, allocation of transfer pricing, licenses, time value of money, contract costs and disclosures. This guidance is effective for the fiscal years and interim reporting periods beginning after December 15, 2016, at which time the Company may adopt the new standard under the full retrospective method or the modified retrospective method. Early adoption is not permitted. The Company has not yet selected a transition method nor has the Company determined the impact of the new standard on its financial statements and related disclosures.\n3. Fair Value Measurements\nFinancial assets and liabilities are recorded at fair value. The carrying amounts of certain of the Company’s financial instruments, including cash equivalents, accounts receivable and accounts payable, are valued at cost, which approximates fair value due to their short maturities. The accounting guidance for fair value provides a framework for measuring fair value, and requires certain new disclosures about how fair value is determined. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the reporting date. The accounting guidance also establishes a three-level valuation hierarchy that prioritizes the inputs to valuation techniques used to measure fair value based upon whether such inputs are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect market assumptions made by the reporting entity.\nThe three-level hierarchy for the inputs to valuation techniques is briefly summarized as follows:\n\n| Level 1 | – | Observable inputs such as quoted prices (unadjusted) for identical instruments in active markets. |\n| Level 2 | – | Observable inputs such as quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, or model-derived valuations whose significant inputs are observable. |\n| Level 3 | – | Unobservable inputs that reflect the reporting entity’s own assumptions. |\n\n7\nThe following table sets forth the fair value of the Company’s financial assets and liabilities measured on a recurring basis by level within the fair value hierarchy:\n\n| June 30, 2014 |\n| Total | Level 1 | Level 2 | Level 3 |\n| (In thousands) |\n| Assets: |\n| Money market funds | $ | 116,653 | $ | 116,653 | $ | — | $ | — |\n| Certificates of deposit | 180 | — | 180 | — |\n| Total | $ | 116,833 | $ | 116,653 | $ | 180 | $ | — |\n\n\n| December 31, 2013 |\n| Total | Level 1 | Level 2 | Level 3 |\n| (In thousands) |\n| Assets: |\n| Money market funds | $ | 32,472 | $ | 32,472 | $ | — | $ | — |\n| Certificates of deposit | 180 | — | 180 | — |\n| Total | $ | 32,652 | $ | 32,472 | $ | 180 | $ | — |\n| Liabilities: |\n| Convertible preferred stock warrant liability | $ | 6,456 | $ | — | $ | — | $ | 6,456 |\n| Total | $ | 6,456 | $ | — | $ | — | $ | 6,456 |\n\nWhere quoted prices are available in an active market, securities are classified as Level 1. The Company classifies money market funds as Level 1. When quoted market prices are not available for the specific security, then the Company estimates fair value by using benchmark yields, reported trades, broker/dealer quotes, and issuer spreads. The Company classifies certificates of deposit as Level 2. In certain cases where there is limited activity or less transparency around inputs to valuation, securities are classified as Level 3. There were no transfers between Level 1 and Level 2 during the periods presented.\nLevel 3 liabilities that are measured at fair value on a recurring basis consist of the preferred stock warrant liability, which was measured using the probability weighted expected return method that calculated the probability of the Company going public or being acquired, and the option-pricing method for remaining private in the near to mid-term. The fair value of the preferred stock warrant liability as of December 31, 2013 was estimated using such scenarios that were weighted based on the Company’s estimate of the probability of each scenario: 20% for IPO; 10% for merger and 70% for stay private as of December 31, 2013. The preferred stock warrant liability was remeasured prior to the net exercise of the warrants using the IPO price. At the end of each reporting period, the change in estimated fair value during the period is recorded in change in fair value of convertible preferred stock warrant liability in the statements of operations and comprehensive income (loss). Generally, increases or decreases in the fair value of the underlying convertible preferred stock would result in a directionally similar impact in the fair value measurement of the warrant liability. The preferred stock warrants were net exercised and converted to common stock upon the completion of the IPO and are no longer subject to remeasurement.\nThe following table sets forth a summary of the changes in the estimated fair value of the Company’s preferred stock warrants which were measured at fair value on a recurring basis (in thousands):\n\n| ConvertiblePreferred StockWarrant Liability |\n| Balance at December 31, 2013 | $ | 6,456 |\n| Net increase in fair value of warrant liabilities upon revaluation | 1,593 |\n| Reclassification of warrant liability to additional paid-in capital | (8,049 | ) |\n| Balance at June 30, 2014 | $ | — |\n\n8\n4. Collaboration and Licensing agreements\nAstraZeneca AB (“AstraZeneca”)\nUnder the terms of the AstraZeneca collaboration partnership agreement, the Company received an up-front license fee of $35.0 million in October 2012 and a $15.0 million payment in December 2013, which are both being recognized as revenue on a straight-line basis over the estimated period of performance, which is currently estimated to be December 2016. AstraZeneca reimburses the Company for its internal and external development-related costs. These reimbursements are recognized as collaborative development revenue when the development-related costs are incurred.\nIn May 2014, the Company received from AstraZeneca a $25.0 million payment as a result of the dosing of the first patient in the Phase 2b clinical trial in hyperphosphatemia. As the $25.0 million did not meet the criteria to be considered the achievement of a substantive milestone for accounting purposes, the amount was recorded as deferred revenue when received and is being recognized as revenue on a straight-line basis over the remaining estimated period of performance under the AstraZeneca collaboration partnership agreement, which is currently estimated to be December 2016.\nAs of June 30, 2014, the Company was eligible to receive future contingent payments up to a total of $795.0 million, which is comprised of future development milestones up to an additional $197.5 million and launch, commercialization, and sales milestones up to an additional $597.5 million. The contingent payments are triggered upon the activities expected to be undertaken by AstraZeneca. Revenue from milestones, if they are nonrefundable and deemed substantive, are recognized upon successful accomplishment of the milestone. The Company will recognize revenue associated with non-substantive milestones upon achievement of the milestones if there are no undelivered elements and it has no remaining performance obligation. To the extent that non-substantive milestones are achieved and the Company has remaining performance obligations, milestones are deferred and recognized as revenue over the estimated remaining period of performance.\nFor the three months ended June 30, 2014 and 2013, the Company recognized revenue of $6.5 million and $2.0 million, respectively, related to amortization of the up-front and other license fees, and $2.6 million and $5.3 million for collaborative development services. For the six months ended June 30, 2014 and 2013, the Company recognized revenues of $9.7 million and $4.0 million, respectively, related to amortization of the up-front and other license fees, and $7.9 million and $9.9 million for collaborative development services. As of June 30, 2014 and December 31, 2013, the Company had total deferred revenue of $56.4 million and $40.3 million related to the AstraZeneca license agreement.\nSanofi SA (“Sanofi”)\nIn February 2014, the Company entered into a License Option and License Agreement with Sanofi (“Option and License Agreement”) for its NaP2b phosphate transport inhibitor program. NaP2b is an intestinal phosphate transporter whose activity accounts for a significant portion of dietary phosphate absorption in humans. The inhibition of NaP2b is believed to have utility for the treatment of hyperphosphatemia (elevated serum phosphate) in patients with end stage renal disease (ESRD) and other forms of chronic kidney disease (CKD). Under the Option and License Agreement, the Company granted Sanofi an exclusive worldwide license to conduct research utilizing the Company’s small molecule NaP2b inhibitors. In addition, Sanofi has the option to obtain an exclusive license to develop, manufacture and commercialize the Company’s NaP2b inhibitors. Sanofi is advancing this program towards first-in-human clinical trials. Under the Option and License Agreement, Sanofi is responsible for all of the costs and expenses for research and preclinical activities and, should it exercise its option, for the development and commercialization efforts under the program. Under the Option and License Agreement, the Company received a payment of $1.25 million, which was recognized as revenue after the Company provided to Sanofi the background know-how, listed patents, and materials (together, the “Technology Transfer Deliverables”) in May 2014 pursuant to the Option and License Agreement.\nThe Company has the potential to earn future development, regulatory and commercial milestone payments of up to $196.8 million if Sanofi continues to advance the program into development and through commercialization. If a NaP2b inhibitor is commercialized by Sanofi as a result of this program, the Company will receive tiered royalties ranging from mid-single digits into the low double digits. As part of the arrangement with Sanofi, the Company retains an option to participate in co-promotional activities in the United States. Future potential milestone payments do not meet the criteria to be considered substantive milestones, and therefore will be treated as other contingent consideration and recognized as revenue as they are achieved as the Company has no performance obligations under the Option and License Agreement. No milestones have been received since the inception of the agreement.\n9\n5. Stock Incentive Plan\nAs of June 30, 2014, a total of 2,149,021 shares of common stock had been reserved for issuance under the 2008 Plan, and no shares are available for future grant. The 2014 Equity Incentive Award Plan (“2014 Plan”) became effective on June 18, 2014, immediately prior to the time the Company’s Registration Statement on Form S-1 became effective. Under the 2014 Plan, 1,419,328 shares of common stock were initially reserved for issuance pursuant to a variety of stock-based compensation awards, including stock options, stock appreciation rights, or SARs, restricted stock awards, restricted stock unit awards, deferred stock awards, deferred stock unit awards, dividend equivalent awards, stock payment awards and performance awards. In addition, 35,221 shares that had been available for future awards under the 2008 Plan as of June 18, 2014, were added to the initial reserve available under the 2014 Plan, bringing the total reserve upon the effective date of the 2014 Plan to 1,454,549. The number of shares initially reserved for issuance or transfer pursuant to awards under the 2014 Plan will be increased by (i) the number of shares represented by awards outstanding under 2008 Plan on June 18, 2014, that are forfeited or lapse unexercised (ii) if approved by the Administrator of the 2014 Plan, an annual increase on the first day of each fiscal year beginning in 2015 and ending in 2024, equal to the lesser of (A) four percent (4.0%) of the shares of stock outstanding (on an as converted basis) on the last day of the immediately preceding fiscal year and (B) such smaller number of shares of stock as determined by our board of directors; provided, however, that no more than 10,683,053 shares of stock may be issued upon the exercise of incentive stock options. The Company also adopted the 2014 Employee Stock Purchase Plan (ESPP) and initially reserved 202,762 shares of common stock as of its effective date of June 18, 2014. If approved by the Administrator of the ESPP, on the first day of each calendar year, beginning in 2015 and ending in 2024, the number of shares in the reserve will increase by at least an amount equal to the lesser of (i) one percent (1.0%) of the shares of common stock outstanding on the last day of the immediately preceding fiscal year and (ii) such number of shares of common stock as determined by the board of directors; provided, however, no more than 2,230,374 shares of our common stock may be issued under the ESPP.\nThe following table summarizes activity under the 2008 Plan and the 2014 Plan, including grants to nonemployees and restricted stock issued:\n\n| Shares Availablefor Grant | OptionsOutstanding | WeightedAverageExercise Priceper Share | AggregateIntrinsicValue(in thousands) |\n| Balances at December 31, 2013 | 3,914 | 1,162,829 | $ | 1.03 |\n| Options authorized under the 2008 Plan | 33,333 | — |\n| Options authorized under the 2014 Plan | 1,419,328 | — |\n| Options granted | (63,888 | ) | 63,888 | 13.95 |\n| Options cancelled | 1,862 | (1,862 | ) | 0.77 |\n| Options exercised | — | (92,781 | ) | 0.60 |\n| Balances at June 30, 2014 | 1,394,549 | 1,132,074 | $ | 1.79 | $ | 16,050 |\n| Vested at June 30, 2014 | 576,049 | $ | 0.91 | $ | 8,678 |\n| Expected to vest at June 30, 2014 | 1,132,074 | $ | 1.79 | $ | 16,050 |\n\nThe weighted-average grant-date estimated fair value of options granted during the three and six months ended June 30, 2014 was $10.98 and $10.96, respectively, and during the three and six months ended June 30, 2013 was $0 and $2.65 per share, respectively. The aggregate intrinsic value was calculated as the difference between the exercise price of the options and the estimated fair value of the Company’s common stock of $15.97 per share as of June 30, 2014.\nLiability for Early Exercise of Stock Options\nAs of June 30, 2014 and December 31, 2013, there were 193,447 and 286,217 shares of common stock outstanding, respectively, subject to the Company’s right of repurchase at prices ranging from $0.27 to $1.08 per share. As of June 30, 2014 and December 31, 2013, the Company recorded $107,000 and $163,000, respectively, as liabilities associated with shares issued with repurchase rights.\n10\nStock-based Compensation\nTotal stock-based compensation recognized was as follows (in thousands):\n\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Research and development | $ | 38 | $ | 50 | $ | 75 | $ | 99 |\n| General and administrative | 61 | 32 | 88 | 91 |\n| Total | $ | 99 | $ | 82 | $ | 163 | $ | 190 |\n\nAs of June 30, 2014 and December 31, 2013, there was $1.1 million and $549,000, respectively, of unrecognized stock-based compensation expense, net of estimated forfeitures, related to unvested share options with a weighted-average remaining recognition period of 1.6 and 1.8 years.\nThe fair value of stock option awards to employees was estimated at the date of grant using a Black-Scholes option-pricing model with the following weighted-average assumptions:\n\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Expected term (years) | 5.77 | — | 5.79 | 6.08 |\n| Volatility | 101 | % | — | 101 | % | 97 | % |\n| Risk-free interest rate | 1.76 | % | — | 1.77 | % | 1.05 | % |\n| Dividend yield | — | % | — | — | % | — | % |\n\nFor the three months ended June 30, 2013, there were no stock options granted.\n6. Net Income (Loss) per Share Attributable to Common Stockholders\nThe following table sets forth the computation of the unaudited basic and diluted net income (loss) per share attributable to common stockholders (in thousands, except share and per share data):\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Net income (loss) | $ | 3,753 | $ | (891 | ) | $ | 682 | $ | (1,361 | ) |\n| Noncumulative dividends on convertible preferred stock | (1,099 | ) | — | (682 | ) | — |\n| Undistributed earnings allocated to participating securities | (2,139 | ) | — | — | — |\n| Net income (loss) attributable to common stockholders, basic | $ | 515 | $ | (891 | ) | $ | — | $ | (1,361 | ) |\n| Adjustment to undistributed earnings allocated to participating securities | 188 | — | — | — |\n| Net income (loss) attributable to common stockholders, diluted | $ | 703 | $ | (891 | ) | $ | — | $ | (1,361 | ) |\n| Basic shares: |\n| Weighted average common shares outstanding | 2,611,259 | 1,102,093 | 1,937,509 | 1,072,583 |\n| Diluted shares: |\n| Weighted average effect of dilutive stock options | 765,672 | — | — | — |\n| Weighted average convertible preferred stock warrants outstanding | 527,205 | — | — | — |\n| 3,904,136 | 1,102,093 | 1,937,509 | 1,072,583 |\n| Net income (loss) per share attributable to common stockholders: |\n| Basic | $ | 0.20 | $ | (0.81 | ) | $ | — | $ | (1.27 | ) |\n| Diluted | $ | 0.18 | $ | (0.81 | ) | $ | — | $ | (1.27 | ) |\n\n11\nThe following outstanding shares of common stock equivalents were excluded from the computation of diluted net income (loss) per share attributable to common stockholders for the periods presented because including them would have been antidilutive:\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Convertible preferred stock | — | 11,517,222 | — | 11,517,222 |\n| Options to purchase common stock | 12,459 | 1,215,262 | 1,132,074 | 1,215,262 |\n| Warrants to purchase convertible preferred stock | — | 574,953 | — | 574,953 |\n| Total | 12,459 | 13,307,437 | 1,132,074 | 13,307,437 |\n\n7. Related Party Transactions\nAs part of the consulting arrangement with the spouse of an executive of the Company to provide research and development services related to clinical operations, the Company incurred expenses of $60,000 and $64,000 for services rendered during the three months ended June 30, 2014 and 2013, respectively and $120,000 and $126,000 for services rendered during the six months ended June 30, 2014 and 2013, respectively. As of June 30, 2014 and December 31, 2013, the Company owed $20,000 and $18,000, respectively, to the individual, which is recorded in accounts payable.\n12\n\n\nITEM 2.\nMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.\nYou should read the following discussion in conjunction with our condensed financial statements (unaudited) and related notes included elsewhere in this report. This Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. All statements other than statements of historical facts contained in this report are forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “could,” “will,” “would,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “intend,” “predict,” “seek,” “contemplate,” “potential” or “continue” or the negative of these terms or other comparable terminology. These forward-looking statements, include, but are not limited to, the initiation, timing, progress and results of our preclinical studies and clinical trials, and our research and development programs; our ability to advance product candidates into, and successfully complete, clinical trials; our receipt of future milestone payments and/or royalties, and the expected timing of such payments; our collaborators’ exercise of their license options; the commercialization of our product candidates; the implementation of our business model, strategic plans for our business, product candidates and technology; the scope of protection we are able to establish and maintain for intellectual property rights covering our product candidates and technology; estimates of our expenses, future revenues, capital requirements and our needs for additional financing; the timing or likelihood of regulatory filings and approvals; our ability to maintain and establish collaborations or obtain additional government grant funding; our use of proceeds from our IPO; our financial performance; and developments relating to our competitors and our industry. These statements reflect our current views with respect to future events or our future financial performance, are based on assumptions, and involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Given these uncertainties, you should not place undue reliance on these forward-looking statements. Factors that may cause actual results to differ materially from current expectations include, among other things, those listed under “Risk Factors” in the Prospectus or described elsewhere in this Quarterly Report on Form 10-Q. These forward-looking statements speak only as of the date hereof. Except as required by law, we assume no obligation to update or revise these forward-looking statements for any reason, even if new information becomes available in the future. Unless the context requires otherwise, in this Quarterly Report on Form 10-Q, the terms “Ardelyx,” “Company,” “we,” “us” and “our” refer to Ardelyx, Inc., a Delaware corporation.\nOverview\nWe are a clinical-stage biopharmaceutical company focused on the discovery, development and commercialization of innovative, non-systemic, small molecule therapeutics that work exclusively in the gastrointestinal, or GI, tract to treat cardio-renal, GI and metabolic diseases. We have developed a proprietary drug discovery and design platform enabling us, in a rapid and cost-efficient manner, to discover and design novel drug candidates. Utilizing our platform, we discovered and designed our lead product candidate, tenapanor, which in preclinical and clinical studies has consistently demonstrated the ability to reduce the absorption of dietary sodium and phosphorus. To enhance our proprietary drug discovery and design platform, we have developed a cell-culture system to simulate gut tissues called the Ardelyx Primary Enterocyte and Colonocyte Culture System, or APECCS. We have also identified over 3,800 proteins on the inner surface of the gut, many of which we believe may be drug targets. In addition to tenapanor, we have discovered small molecule NaP2b inhibitors for the treatment of hyperphosphatemia in end stage renal disease, or ESRD, a program we have licensed to Sanofi S.A., or Sanofi. We are also independently advancing three other discovery and lead development programs focused in cardio-renal, GI and metabolic diseases.\nIn October 2012, we entered into a collaboration partnership with AstraZeneca AB, or AstraZeneca, for the worldwide development and commercialization of tenapanor. AstraZeneca is responsible for all of the development and commercialization costs for tenapanor, and we have retained an option to co-promote in the United States. Together with AstraZeneca, we are evaluating tenapanor in three Phase 2 clinical trials in patients with ESRD, late-stage CKD, and constipation-predominant irritable bowel syndrome, or IBS-C. If we exercise our right to co-fund the first Phase 3 clinical development program for tenapanor, we may invest $20.0 million, $30.0 million or $40.0 million to acquire an increase of 1%, 2% or 3%, respectively, in the royalties payable to us by AstraZeneca on net sales of tenapanor. In December 2013, we entered into an amendment to the license agreement to acknowledge the intention of AstraZeneca to commence development of tenapanor for the treatment of hyperphosphatemia in ESRD patients and to provide additional clarification for certain payments. There was no change in the total consideration that we could receive under the agreement.\nThrough our participation with AstraZeneca on a development collaboration committee, we are involved in the management and oversight of the development of tenapanor and participation will continue until all of Phase 2 clinical trials with tenapanor have been completed. In addition, we are directly responsible for the conduct of certain specified clinical trials being conducted with tenapanor. AstraZeneca reimburses us for our internal and external costs related to those development efforts, and any other development efforts that may be assigned to us by the development collaboration committee. We were initially responsible for supplying tenapanor for use in development. The agreement also obligates us to transfer the technology and other necessary information such that AstraZeneca will be able to assume the responsibility for the supply of the drug product for use in later-stage clinical trials.\n13\nUnder the terms of the agreement with AstraZeneca, we received a $35.0 million upfront payment and we are eligible to receive up to $237.5 million in development milestones, of which we have received $40.0 million as of June 30, 2014. The $40.0 million in development milestones consists of a payment of $15.0 million that we received in December 2013 and a payment of $25.0 million that we received in May 2014 as a result of the dosing of the first patient in the Phase 2b ESRD clinical trial in hyperphosphatemia in April 2014. In addition to the $237.5 million in total development milestones, we are also eligible to receive up to $597.5 million in sales and launch milestones. Through June 30, 2014, we also received $29.1 million in reimbursement for our development efforts provided under the agreement. We are also eligible to receive incremental tiered royalties based on aggregate annual net sales of each licensed product starting in the high single digits and increasing to high teen percentages as annual net sales increase, subject to an increase related to our co-fund election, if we decide to make such an election.\nWe have identified the deliverables within the arrangement as a license to the technology, the initial supply of the compound of the licensed product for use in development, and ongoing development activities through completion of all Phase 2 clinical trials to be conducted with tenapanor, which are accounted for as a single unit of accounting. We have concluded that the license is not a separate unit of accounting. It does not have stand-alone value to AstraZeneca, separable from the development services to be performed pursuant to the agreement, as AstraZeneca is unable to use the license for its intended purpose without our performance of the development services, which includes the initial supply of the compound of the licensed product. As a result, we recognize revenue from the $35.0 million up-front payment on a straight-line basis over the period from the effective date of the agreement through the completion of all Phase 2 clinical trials to be conducted with tenapanor, which we currently estimate to be December 2016, and we recognize revenue from the $15.0 million and the $25.0 million development milestone payments on a straight-line basis over the same estimated completion date.\nIn 2014, we entered into an option and license agreement with Sanofi under which we granted Sanofi an exclusive worldwide license to conduct research utilizing our small molecule NaP2b inhibitors. In addition, Sanofi has the option to obtain an exclusive license to develop, manufacture and commercialize our NaP2b inhibitors. Sanofi is advancing this program towards first-in-human clinical trials. Under our arrangement, Sanofi is responsible for all of the costs and expenses for research and preclinical activities and, should it exercise its option, for the development and commercialization efforts under the program. Under the license option and license agreement, we received an upfront payment of $1.25 million and are responsible for up to $0.2 million of patent costs, at which point any additional patent costs will be fully reimbursed to us by Sanofi. We have the potential to earn future development, regulatory and commercial milestone payments of up to $196.75 million if Sanofi continues to advance the program into development and through commercialization. If a NaP2b inhibitor is commercialized by Sanofi as a result of this program, we will receive tiered royalties ranging from the mid-single digits into the low double digits. As part of our agreement with Sanofi, we retain an option to co-promote licensed products in the United States. We recognized the $1.25 million to revenue after we completed the Technology Transfer Deliverables in May 2014 pursuant to the Option and License Agreement.\nOur revenue to date has been generated from collaboration and license revenue pursuant to our license agreements with AstraZeneca, and Sanofi. We have not generated any commercial product revenue. As of June 30, 2014, we had accumulated deficit of $68.0 million. We have incurred significant losses in the past and may continue to incur significant losses in the future as we advance our unpartnered preclinical programs. The significance of future losses will be dependent in part on whether AstraZeneca continues to develop and advance tenapanor, and whether Sanofi exercises its option to obtain an exclusive license to develop, manufacture and commercialize our NaP2b inhibitors, which in either case would result in milestone payments to us. There can be no assurance that we will receive additional collaboration revenue in the future.\nInitial Public Offering\nOn June 18, 2014, our registration statement on Form S-1 (File No. 333-196090) relating to the IPO of our common stock was declared effective by the SEC. The IPO closed on June 24, 2014 at which time we sold 4,928,900 shares of our common stock, which included 642,900 shares of common stock purchased by the underwriters upon the full exercise of their option to purchase additional shares of common stock. We received cash proceeds of $61.2 million from the IPO, net of underwriting discounts and commissions and expenses paid by us.\n14\nFinancial Operations Overview\nRevenue\nOur revenue to date has been generated from non-refundable license payments and reimbursements for research and development expenses under our license agreements. We recognize revenue from upfront payments ratably over the term of our estimated period of performance under the agreement which we consider to be licensing revenue. In addition to receiving upfront payments, we may also be entitled to milestone and other contingent payments upon achieving predefined objectives. Such payments are recorded as revenue when we achieve the underlying milestone if it is deemed to be a substantive milestone at the date the arrangement is entered into. To the extent that non-substantive milestones are achieved and we have remaining performance obligations, milestones are deferred and recognized as revenue over the estimated remaining period of performance. Reimbursements from AstraZeneca for development costs incurred under our license and collaboration agreement with them are classified as collaborative development revenue.\nResearch and Development Expenses\nResearch and development expenses represent costs incurred to conduct research, such as the discovery and development of our unpartnered product candidates, as well as the development of product candidates pursuant to our license agreement with AstraZeneca. We recognize all research and development costs as they are incurred.\nResearch and development expenses consist of the following:\n| | external research and development expenses incurred under agreements with consultants, third-party contract research organizations, or CROs, and investigative sites where a substantial portion of our clinical studies are conducted, and with contract manufacturing organizations, or CMOs, where our clinical supplies are produced; |\n\n| | employee-related expenses, which include salaries, benefits and stock-based compensation; and |\n\n| | facilities and other allocated expenses, which include direct and allocated expenses for rent and maintenance of facilities, depreciation and amortization expense and other supplies. |\n\nPrior to the execution of our license agreement with AstraZeneca in October 2012, we incurred $18.0 million in research and development expenses related to tenapanor. Following the execution of the license agreement and through June 30, 2014, we incurred $30.2 million in research and development expenses related to tenapanor, all of which are reimbursed by AstraZeneca under the license agreement. The reimbursements are recognized in collaborative development revenue in the Statement of Operations and Comprehensive Income (Loss).\nThe following table summarizes our research and development expenses during the three and six months ended June 30, 2014 and 2013 (in thousands):\n\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Discovery research expense | $ | 2,562 | $ | 2,052 | $ | 4,922 | $ | 3,761 |\n| AstraZeneca collaboration development expense | 2,621 | 5,182 | 7,898 | 9,412 |\n| Total research and development expenses | $ | 5,183 | $ | 7,234 | $ | 12,820 | $ | 13,173 |\n\nWe expect our unpartnered research and development expenses will increase in the future as we progress our internal product candidates, advance our discovery research projects into the preclinical stage and continue our early stage research including further development of our APECCS cell-culture system. The process of conducting preclinical studies and clinical trials necessary to obtain regulatory approval is costly and time consuming. We or our collaboration partners may never succeed in achieving marketing approval for any of our product candidates. The probability of success of each of the product candidates may be affected by numerous factors, including preclinical data, clinical data, competition, manufacturing capability and commercial viability.\nMost of our product development programs are at an early stage; therefore, the successful development of our product candidates is highly uncertain and may not result in approved products. Completion dates and completion costs can vary significantly for each product candidate and are difficult to predict. Given the uncertainty associated with clinical trial enrollment and the risks inherent in the development process, we are unable to determine the duration and completion costs of current or future clinical trials of our product candidates or if and to what extent we will generate revenues from the commercialization and sale of any of our product candidates. We anticipate that we and our collaboration partners will make determinations as to which programs to pursue and how much funding to direct to each program on an ongoing basis in response to the scientific and clinical success of each product candidate, as well as an ongoing assessment as to each product candidate’s commercial potential. We will need to raise additional\n15\ncapital or may seek additional collaboration partnerships in the future in order to complete the development and commercialization of our product candidates.\nGeneral and Administrative\nGeneral and administrative expenses includes personnel costs, travel expenses and other expenses for outside professional services, including legal, human resources, audit and accounting services. Personnel costs includes salaries, bonus, benefits and stock-based compensation. We expect to incur additional expenses as a result of being a public company following the completion of our IPO in June 2014, including expenses to comply with the rules and regulations applicable to companies listed on a national securities exchange and costs related to compliance and reporting obligations pursuant to the rules and regulations of the SEC, as well as increases in expenses for additional insurance, investor relations activities and other administration and professional services.\nChange in Fair Value of Convertible Preferred Stock Warrant Liability\nChange in fair value of convertible preferred stock warrant liability was the fair value remeasurement of our liability related to our convertible preferred stock warrants. We recorded adjustments to the estimated fair value of the convertible preferred stock warrants until they were net exercised prior to the completion of our IPO and then converted into common stock. At that time, the convertible preferred stock warrant liability was reclassified to additional paid-in capital and we no longer record any related periodic fair value adjustments.\nProvision for Income Taxes\nWe did not record a provision for income taxes for the three and six months ended June 30, 2014 because we expect to generate a net operating loss for the year ending December 31, 2014. Our deferred tax assets continue to be fully offset by a valuation allowance.\nProvision for income taxes for the 2013 periods consists of California state income taxes as we were required to pay the Alternative Minimum Tax for the $35.0 million upfront payment received from AstraZeneca in 2012.\nCritical Accounting Polices and Estimates\nThe discussion and analysis of our financial condition and results of operations are based upon our unaudited condensed financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our critical accounting policies and estimates. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. There have been no significant and material changes in our critical accounting policies during the three and six months ended June 30, 2014, as compared to those disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates” in the Prospectus filed with the SEC on June 19, 2014.\n16\nResults of Operations\nComparison of the Three Months Ended June 30, 2014 and 2013\n\n| Three Months Ended June 30, | Dollar Change |\n| 2014 | 2013 |\n| (In thousands) |\n| Revenue: |\n| Licensing revenue | $ | 6,507 | $ | 1,989 | $ | 4,518 |\n| Collaborative development revenue | 2,630 | 5,302 | (2,672 | ) |\n| Total revenue | 9,137 | 7,291 | 1,846 |\n| Operating expenses: |\n| Research and development | 5,183 | 7,234 | (2,051 | ) |\n| General and administrative | 1,203 | 908 | 295 |\n| Total operating expenses | 6,386 | 8,142 | (1,756 | ) |\n| Income (loss) from operations | 2,751 | (851 | ) | 3,602 |\n| Other expense, net | (8 | ) | (4 | ) | (4 | ) |\n| Change in fair value of preferred stock warrant liability | 1,010 | — | 1,010 |\n| Income (loss) before provision for income taxes | 3,753 | (855 | ) | 4,608 |\n| Provision for income taxes | — | 36 | (36 | ) |\n| Net income (loss) | $ | 3,753 | $ | (891 | ) | $ | 4,644 |\n\nRevenue\nLicensing revenue for the three months ended June 30, 2014 was $6.5 million, an increase of $4.5 million, or 227%, compared to licensing revenue of $2.0 million for the three months ended June 30, 2013. The increase was primarily due to the increased amounts recognized from the $15.0 million development milestone payment we received in December 2013 related to the amendment to the AstraZeneca agreement and the $25.0 million development milestone payment we received in May 2014 related to the dosing of the first patient in the Phase 2b ESRD clinical trial in hyperphosphatemia in April 2014, which are both being recognized ratably over our expected period of performance under the agreement. The estimated period of performance is based on the completion of all of the Phase 2 clinical trials for tenapanor. We estimate that the end of all Phase 2 clinical trials will be December 2016. The expected period of performance is reviewed quarterly and adjusted, as needed, to reflect the progress of clinical studies. The remaining increase was due to the $1.25 million we recognized pursuant to the Option and License Agreement with Sanofi.\nCollaborative development revenue consists of our development expenses that are reimbursable to us by AstraZeneca as part of our license agreement. Collaborative development revenue for the three months ended June 30, 2014 was $2.6 million, a decrease of $2.7 million, or 50%, compared to $5.3 million for the three months ended June 30, 2013. The decrease was primarily because of a decrease in our development activities related to the clinical trials that are a part of the AstraZeneca agreement.\nResearch and Development\nResearch and development expenses were $5.2 million for the three months ended June 30, 2014, a decrease of $2.1 million, or 28%, compared to $7.2 million for the three months ended June 30, 2013. The decrease was primarily driven by a $2.6 million decrease in development activities related to tenapanor conducted by Ardelyx in accordance with the AstraZeneca agreement. Discovery research expenses increased by $0.5 million due to an increase in our research activities for non-partnered programs.\nGeneral and Administrative\nGeneral and administrative expenses were $1.2 million for the three months ended June 30, 2014, an increase of $0.3 million, or 32%, compared to $0.9 million for the three months ended June 30, 2013. The increase was primarily due to an increase in professional services fees of $0.1 million and an increase of $0.1 million in personnel related expenses.\nChange in Fair Value of Preferred Stock Warrant Liability\nChange in fair value of preferred stock warrant liability was $1.0 million of income for the three months ended June 30, 2014 compared to zero for the three months ended June 30, 2013. The change was due to a decrease in the fair value of our convertible preferred stock over the three month period.\n17\nComparison of the Six Months Ended June 30, 2014 and 2013\n| Six Months Ended June 30, | Dollar Change |\n| 2014 | 2013 |\n| (In thousands) |\n| Revenue: |\n| Licensing revenue | $ | 9,743 | $ | 3,978 | $ | 5,765 |\n| Collaborative development revenue | 7,944 | 9,869 | (1,925 | ) |\n| Total revenue | 17,687 | 13,847 | 3,840 |\n| Operating expenses: |\n| Research and development | 12,820 | 13,173 | (353 | ) |\n| General and administrative | 2,580 | 1,935 | 645 |\n| Total operating expenses | 15,400 | 15,108 | 292 |\n| Income (loss) from operations | 2,287 | (1,261 | ) | 3,548 |\n| Other expense, net | (12 | ) | (29 | ) | 17 |\n| Change in fair value of preferred stock warrant liability | (1,593 | ) | — | (1,593 | ) |\n| Income (loss) before provision for income taxes | 682 | (1,290 | ) | 1,972 |\n| Provision for income taxes | — | 71 | (71 | ) |\n| Net income (loss) | $ | 682 | $ | (1,361 | ) | $ | 2,043 |\n\nRevenue\nLicensing revenue for the six months ended June 30, 2014 was $9.7 million, an increase of $5.8 million, or 145%, compared to total licensing revenue of $4.0 million for the six months ended June 30, 2013. The increase was primarily due to the increased amounts recognized from the $15.0 million development milestone payment we received in December 2013 related to the amendment to the AstraZeneca agreement and the $25.0 million development milestone payment we received in May 2014 related to the dosing of the first patient in the Phase 2b ESRD clinical trial in hyperphosphatemia in April 2014, which are both being recognized ratably over our expected period of performance under the agreement. The estimated period of performance is based on the completion of all of the Phase 2 clinical trials for tenapanor. We estimate that the end of all Phase 2 clinical trials will be December 2016. The expected period of performance is reviewed quarterly and adjusted, as needed, to reflect the progress of clinical studies. The remaining increase was due to the $1.25 million we recognized in May 2014 pursuant to the Option and License Agreement with Sanofi.\nCollaborative development revenue consists of our development expenses that are reimbursable to us by AstraZeneca as part of our license agreement. Collaborative development revenue for the six months ended June 30, 2014 was $7.9 million, a decrease of $1.9 million, or 20%, compared to $9.9 million for the six months ended June 30, 2013. The decrease was due to a decrease in our development activities primarily related to the clinical trials that are a part of the AstraZeneca agreement.\nResearch and Development\nResearch and development expenses were $12.8 million for the six months ended June 30, 2014, a decrease of $0.4 million, or 3%, compared to $13.2 million for the six months ended June 30, 2013. The decrease in AstraZeneca collaboration development expense of $1.5 million was primarily driven by the decrease in development activities related to tenapanor conducted by Ardelyx under the license agreement with AstraZeneca. Discovery research expenses increased by $1.2 million due to an increase in our research activities for non-partnered programs.\nGeneral and Administrative\nGeneral and administrative expenses were $2.6 million for the six months ended June 30, 2014, an increase of $0.6 million, or 33%, compared to $1.9 million for the six months ended June 30, 2013. The increase was primarily due to an increase in professional services fees of $0.4 million and an increase of $0.2 million personnel related expenses.\nChange in Fair Value of Preferred Stock Warrant Liability\nChange in fair value of preferred stock warrant liability was $1.6 million for the six months ended June 30, 2014, an increase of $1.6 million compared to zero for the six months ended June 30, 2013. The increase was due to an increase in the fair value of our convertible preferred stock over the six month period.\n18\nLiquidity and Capital Resources\nAs of June 30, 2014, we had cash and cash equivalents totaling $117.8 million. In connection with our IPO, we received cash proceeds of $61.2 million, net of underwriters’ discounts and commissions and expenses paid by the Company in June 2014. Prior to the IPO, we funded our operations primarily with cash flows from the sales of our convertible preferred stock in private placements and from the upfront payments and other collaboration related payments received from our collaboration partners AstraZeneca and Sanofi.\nOur primary uses of cash are to fund operating expenses, primarily research and development expenditures. Cash used to fund operating expenses is impacted by the timing of when we pay these expenses, as reflected in the change in our outstanding accounts payable and accrued expenses.\nWe believe that our existing capital resources as of June 30, 2014 will be sufficient to meet our projected operating requirements for at least the next 12 months. We have based this estimate on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we currently expect. Further, our operating plan may change, and we may need additional funds to meet operational needs and capital requirements for clinical trials and other research and development expenditures. We currently have no credit facility or committed sources of capital other than potential milestones receivable under our current collaboration partnerships. Because of the numerous risks and uncertainties associated with the development and commercialization of our product candidates and the extent to which we may enter into additional collaboration partnerships with third parties to participate in their development and commercialization, we are unable to estimate the amounts of increased capital outlays and operating expenditures associated with our current and anticipated clinical studies. Our future funding requirements will depend on many factors, including the following:\n| | our decision whether or not to exercise our right to co-fund the first Phase 3 clinical development program for tenapanor, in which we may invest $20.0 million, $30.0 million or $40.0 million to acquire an increase of 1%, 2% or 3%, respectively, in the royalties payable to us by AstraZeneca on net sales of tenapanor; |\n\n| | the achievement of development and regulatory milestones resulting in the payment to us from our collaboration partners of contractual milestone payments and the timing of the receipt of such payments, if any; |\n\n| | the progress, timing, scope, results and costs of our preclinical studies and clinical trials for our product candidates that have not been licensed, including the ability to enroll patients in a timely manner for clinical trials; |\n\n| | the time and cost necessary to obtain regulatory approvals for our product candidates that have not been licensed and the costs of post-marketing studies that could be required by regulatory authorities; |\n\n| | our ability and the ability of our collaboration partners to successfully commercialize and/or co-promote our product candidates; |\n\n| | the manufacturing, selling and marketing costs associated with product candidates, including the cost and timing of building our sales and marketing capabilities; |\n\n| | our ability to establish and maintain collaboration partnerships, in-license/out-license or other similar arrangements and the financial terms of such agreements; |\n\n| | the timing, receipt, and amount of sales of, or royalties on, our future products, if any; |\n\n| | the sales price and the availability of adequate third-party reimbursement for our product candidates; |\n\n| | the cash requirements of any future acquisitions or discovery of product candidates; |\n\n| | the number and scope of preclinical and discovery programs that we decide to pursue or initiate; |\n\n| | the time and cost necessary to respond to technological and market developments; and |\n\n| | the costs of filing, prosecuting, maintaining, defending and enforcing any patent claims and other intellectual property rights, including litigation costs and the outcome of such litigation, including costs of defending any claims of infringement brought by others in connection with the development, manufacture or commercialization of our product candidates. |\n\n19\nThe following table summarizes our cash flows for the periods indicated (in thousands):\n\n| Six MonthsEnded June 30, |\n| 2014 | 2013 |\n| Cash provided by (used in) operating activities | $ | 22,874 | $ | (8,897 | ) |\n| Cash used in investing activities | (736 | ) | (257 | ) |\n| Cash provided by financing activities | 61,241 | — |\n| Net increase (decrease) in cash and cash equivalents | $ | 83,379 | $ | (9,154 | ) |\n\nCash Flows from Operating Activities\nCash provided by operating activities for the six months ended June 30, 2014 was $22.9 million, consisting of net income of $0.7 million, non-cash charges of $0.1 million for depreciation and amortization expense, $0.2 million for stock-based compensation, $1.6 million for the change in the fair value remeasurement of our convertible preferred stock warrant liability and a net increase of $20.3 million in our net operating assets and liabilities. The changes in our net operating assets and liabilities was primarily due to a $16.1 million increase in deferred revenue which was mainly driven by the $25.0 million payment received in May 2014 in connection with our agreement with AstraZeneca, a $3.4 million decrease in our accounts receivable due to the timing of payments received from AstraZeneca for reimbursable costs incurred under our licensing agreement and a $0.9 million increase in our other accrued liabilities due to the timing of payments.\nCash used in operating activities for the six months ended June 30, 2013 was $8.9 million, consisting of a net loss of $1.4 million, which was partially offset by non-cash charges of $0.4 million for depreciation and amortization, $0.2 million for stock-based compensation and a net decrease of $8.1 million in our net operating assets and liabilities. The cash used as a result of the changes in our net operating assets and liabilities was due primarily to a $2.9 million decrease in deferred revenue which was mainly driven by the amortization of the $35.0 million up-front payment received in connection with our agreement with AstraZeneca and a $3.9 million increase in our accounts receivable due to the timing of payments received from AstraZeneca for reimbursable costs incurred under our licensing agreement and a $1.2 million increase in prepaid expenses and other assets related to advance payments made to vendors for clinical development activities. These changes were partially offset by a $1.1 million increase in our accounts payable due to the timing of payments.\nCash Flows from Investing Activities\nCash used in investing activities for the six months ended June 30, 2014 and 2013 of $0.7 million and $0.3 million was related to our acquisition of property and equipment related to the expansion of our laboratory and related equipment.\nCash Flows from Financing Activities\nCash provided by financing activities for the six months ended June 30, 2014 was due to the IPO proceeds of $61.2 million.\nOff-Balance Sheet Arrangements\nAs of June 30, 2014, we did not have any off-balance sheet arrangements or any holdings in variable interest entities.\nRecent Accounting Pronouncement\nIn July 2013, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update, or ASU 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. The ASU concludes an unrecognized tax benefit should be presented as a reduction of a deferred tax asset when settlement in this manner is available under the law. We adopted this amendment as of January 1, 2014, which did not have a significant impact on the balance sheet.\nIn May 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers, or ASU 2014-09, which converges the FASB and the International Accounting Standards Board standards on revenue recognition. Areas of revenue recognition that will be affected include, but are not limited to, transfer of control, variable consideration, allocation of transfer pricing, licenses, time value of money, contract costs and disclosures. This guidance is effective for the fiscal years and interim reporting periods beginning after December 15, 2016, at which time we may adopt the new standard under the full retrospective method or the modified retrospective method. Early adoption is not permitted. We have not yet selected a transition method nor have we determined the impact of the new standard on our financial statements and related disclosures\n20\n\n\nITEM 3.\nQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nWe are exposed to market risks in the ordinary course of our business. These risks primarily include risk related to interest rate sensitivities. We had cash and cash equivalents of $117.8 million as of June 30, 2014, which consist of bank deposits and money market funds. Such interest-earning instruments carry a degree of interest rate risk; however, historical fluctuations in interest income have not been significant. We had no outstanding debt as of June 30, 2014.\n\n\nITEM 4.\nCONTROLS AND PROCEDURES\nEvaluation of Disclosure Controls and Procedures\nAs required by Rule 13a-15(b) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), our management, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2014. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate, to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of June 30, 2014, our Chief Executive Officer and Chief Financial Officer have concluded that, as of June 30, 2014, our disclosure controls and procedures were effective at the reasonable assurance level.\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15(d) and 15d-15(d) of the Exchange Act that occurred during the quarter ended June 30, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\nPART II. OTHER INFORMATION\n\n\nITEM 1.\nLEGAL PROCEEDINGS\nWe are not currently a party to any material litigation or other material legal proceedings.\n\n\nITEM 1A.\nRISK FACTORS\nOur business involves significant risks, some of which are described below. You should carefully consider these risks, as well as other information in this Quarterly Report on Form 10-Q, including our financial statements and the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The occurrence of any of the events or developments described below could harm our business, financial condition, results of operations, cash flows, the trading price of our common stock and our growth prospects. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations.\nRisks Related to Our Limited Operating History, Financial Condition and Capital Requirements\nWe have a limited operating history, have incurred significant losses since our inception and we will incur losses in the future. We have only one product candidate in clinical trials and no product sales, which, together with our limited operating history, makes it difficult to assess our future viability.\nWe are a clinical-stage biopharmaceutical company with a limited operating history. Biopharmaceutical product development is a highly speculative undertaking and involves a substantial degree of risk. To date, we have focused substantially all of our efforts on our research and development activities, including developing our lead product candidate, tenapanor, and developing our proprietary drug discovery and design platform. To date, we have not commercialized any products or generated any revenue from the sale of products. We are not profitable and have incurred losses in each year since our inception in October 2007, and we do not know whether or when we will become profitable. We have only a limited operating history upon which to evaluate our business and prospects. We continue to incur significant research, development and other expenses related to our ongoing operations. Our net loss\n21\nfor the years ended December 31, 2012 and 2013 was $9.8 million and $6.6 million, respectively. While we had a net income of $3.8 million and $0.7 million, respectively, for the three and six months ended June 30, 2014, this performance may not be indicative of future performance. As of June 30, 2014, we had an accumulated deficit of $68.0 million.\nIf we do not receive anticipated milestone payments from our collaboration partners, AstraZeneca AB, or AstraZeneca and Sanofi S.A., or Sanofi, our operating losses will substantially increase for the foreseeable future as we continue our discovery, research, development, manufacturing and commercialization activities. There can be no assurance that we will receive any potential milestones under our agreements with AstraZeneca and/or Sanofi. For a discussion of the risks associated with our preclinical and clinical development programs with, and potential for milestone payments from, AstraZeneca and Sanofi, see below under “—Risks Related to Our Business.”\nEven if we receive the anticipated milestone payments or receive royalty payments from our collaboration partners, we may not be able to achieve or sustain profitability. For example, we may choose to exercise our right to co-fund a portion of the first Phase 3 clinical development program for tenapanor, incurring expenses of up to $40.0 million, and we would likely incur continued operating losses during the period we are co-funding the program. In addition, our receipt of milestone payments from our collaboration partners may not result in the recognition of revenue in the period received, as we may be required to amortize the milestone payment over a period of time. Depending upon such requirement and the period of amortization, we may continue to incur losses even after the receipt of such milestone payments. Therefore, there can be no assurance that our losses will not increase into the future. Our prior losses, combined with possible future losses, have had and will continue to have an adverse effect on our stockholders’ equity and working capital. Further, the net losses we incur may fluctuate significantly from quarter to quarter and year to year, such that a period-to-period comparison of our results of operations may not be a good indication of our future performance.\nWe have never generated any revenue from product sales and may never be profitable.\nWe have no products approved for sale and have never generated any revenue from product sales. Our ability to generate revenue from product sales and achieve profitability depends on our ability, and the ability of our collaboration partners, to successfully complete the development of and obtain the regulatory and marketing approvals necessary to commercialize one or more of our product candidates. We do not anticipate generating revenue from product sales for the foreseeable future. Our ability to generate future revenue from product sales or pursuant to milestone payments depends heavily on many factors, including but not limited to:\n| • | the completion of research and preclinical and clinical development of our product candidates; |\n\n| • | together with our collaboration partners, obtaining regulatory approvals for our product candidates; |\n\n| • | the ability of our collaboration partners to successfully commercialize and/or our ability to commercialize or co-promote, if we so choose, our product candidates; |\n\n| • | developing a sustainable and scalable manufacturing process for any approved product candidates and establishing and maintaining supply and manufacturing relationships with third parties that can provide adequate (in amount and quality) products to support clinical development and the market demand for our product candidates, if approved; |\n\n| • | obtaining market acceptance of our product candidates, if approved, as viable treatment options; |\n\n| • | addressing any competing technological and market developments; |\n\n| • | identifying, assessing, acquiring, in-licensing and/or developing new product candidates; |\n\n| • | negotiating favorable terms in any collaboration partnership, licensing or other arrangements into which we may enter; |\n\n| • | maintaining, protecting, and expanding our portfolio of intellectual property rights, including patents, trade secrets, and know-how, and our ability to develop, manufacture and commercialize our product candidates and products without infringing intellectual property rights of others; and |\n\n| • | attracting, hiring, and retaining qualified personnel. |\n\nIn cases where we, or our collaboration partners, are successful in obtaining regulatory approvals to market one or more of our product candidates, our revenue will be dependent, in part, upon the size of the markets in the territories for which regulatory approval is granted, the accepted price for the product, the ability to get reimbursement at any price and whether we have royalty and/or co-promotion rights for that territory. If the number of patients suitable for our product candidates is not as significant as we estimate, the indication approved by regulatory authorities is narrower than we expect, or the reasonably accepted population for treatment is narrowed by competition, physician choice or treatment guidelines, we may not generate significant revenue from the sale of such products, even if approved. Even if we achieve profitability in the future, we may not be able to sustain profitability in subsequent periods. Our failure to generate revenue from product sales would likely depress our market value and could impair our ability to raise capital, expand our business, discover or develop other product candidates or continue our operations. A decline in the value of our common stock could cause our stockholders to lose all or part of their investment.\n22\nWe may require substantial additional financing to achieve our goals, and a failure to obtain this necessary capital when needed on acceptable terms, or at all, could force us to delay, limit, reduce or terminate our product development or other operations.\nSince our inception, most of our resources have been dedicated to our research and development activities, including developing our lead product candidate, tenapanor, and developing our proprietary drug discovery and design platform. As of June 30, 2014, we had working capital of $94.8 million, including capital resources consisting of cash and cash equivalents of $117.8 million. We believe that we will continue to expend substantial resources for the foreseeable future, including costs associated with research and development, conducting preclinical studies and clinical trials, obtaining regulatory approvals and sales and marketing. Because the outcome of any clinical trial and/or regulatory approval process is highly uncertain, we cannot reasonably estimate the actual amounts necessary to successfully complete the development, regulatory approval process and commercialization or co-promotion of any of our product candidates.\nBased on our current operating plan, we believe that our existing capital resources will allow us to fund our operating plan through at least the next 12 months. However, our operating plan may change as a result of many factors currently unknown to us, and we may need to seek additional funds sooner than planned. Our future funding requirements will depend on many factors, including, but not limited to:\n| • | our decision whether or not to exercise our right to co-fund the first Phase 3 clinical development program for tenapanor, in which case we may invest $20.0 million, $30.0 million or $40.0 million to acquire an increase of 1%, 2% or 3%, respectively, in the royalties payable to us by AstraZeneca on net sales of tenapanor; |\n\n| • | the achievement of development and regulatory milestones resulting in the payment to us from our collaboration partners of contractual milestone payments and the timing of receipt of such payments, if any; |\n\n| • | the progress, timing, scope, results and costs of our preclinical studies and clinical trials for our product candidates that have not been licensed, including the ability to enroll patients in a timely manner for clinical trials; |\n\n| • | the time and cost necessary to obtain regulatory approvals for our product candidates that have not been licensed and the costs of post-marketing studies that could be required by regulatory authorities; |\n\n| • | our ability and the ability of our collaboration partners to successfully commercialize and/or co-promote our product candidates; |\n\n| • | the manufacturing, selling and marketing costs associated with product candidates, including the cost and timing of building our sales and marketing capabilities; |\n\n| • | our ability to establish and maintain collaboration partnerships, in-license/out-license or other similar arrangements and the financial terms of such agreements; |\n\n| • | the timing, receipt, and amount of sales of, or royalties on, our future products, if any; |\n\n| • | the sales price and the availability of adequate third-party reimbursement for our product candidates; |\n\n| • | the cash requirements of any future acquisitions or discovery of product candidates; |\n\n| • | the number and scope of preclinical and discovery programs that we decide to pursue or initiate; |\n\n| • | the time and cost necessary to respond to technological and market developments; and |\n\n| • | the costs of filing, prosecuting, maintaining, defending and enforcing any patent claims and other intellectual property rights, including litigation costs and the outcome of such litigation, including costs of defending any claims of infringement brought by others in connection with the development, manufacture or commercialization of our product candidates. |\n\nAdditional funds may not be available when we need them on terms that are acceptable to us, or at all. If adequate funds are not available to us on a timely basis, we may be required to delay, limit, reduce or terminate our research and development activities, preclinical and clinical trials for our product candidates for which we retain such responsibility and our establishment and maintenance of sales and marketing capabilities or other activities that may be necessary to commercialize or co-promote our product candidates.\n23\nRisks Related to Our Business\nWe are substantially dependent on the success of our lead product candidate, tenapanor, which may not be successful in nonclinical studies or clinical trials, receive regulatory approval or be successfully commercialized.\nTo date, we have invested a significant amount of our efforts and financial resources in the research and development of tenapanor, which is currently our lead product candidate and only product candidate in clinical trials. In particular, together with AstraZeneca, our collaboration partner for tenapanor, we have completed six Phase 1 and two Phase 2 trials and are currently conducting three Phase 2 trials and one Phase 1 study. Our near-term prospects, including our ability to finance our operations through the receipt of milestone payments and generate revenue from product sales, will depend heavily on the successful development and AstraZeneca’s commercialization of tenapanor, if approved. The clinical and commercial success of tenapanor will depend on a number of factors, including the following:\n| • | the timely completion of the ongoing clinical trials of tenapanor, which will depend substantially upon the satisfactory performance of third-party contractors; |\n\n| • | whether tenapanor’s safety and efficacy profile is satisfactory to the U.S. Food and Drug Administration, or FDA, and foreign regulatory authorities to warrant marketing approval; |\n\n| • | the timely completion of the ongoing chronic kidney disease, or CKD, Phase 2a clinical trial, which will depend substantially upon our ability to identify principal investigators with patient populations suitable for study, and the ability of those principal investigators to successfully enroll those patients into the trial; |\n\n| • | the results of a long-term rat carcinogenicity study required for approval of tenapanor, which will not be known for at least two and half years, and which may be delayed for a significant period of time for reasons outside of the control of AstraZeneca, particularly if AstraZeneca is required to restart or modify the study for any reason; |\n\n| • | whether FDA or foreign regulatory authorities require additional clinical trials prior to approval to market tenapanor; |\n\n| • | the prevalence and severity of adverse side effects of tenapanor; |\n\n| • | the timely receipt of necessary marketing approvals from the FDA and foreign regulatory authorities; |\n\n| • | the ability of AstraZeneca and us through our co-promotion rights, if we choose to exercise such rights and are not precluded from doing so under the terms of our agreement with AstraZeneca or any subsequent co-promotion agreements, to successfully commercialize tenapanor, if approved for marketing and sale by the FDA or foreign regulatory authorities, including educating physicians and patients about the benefits, administration and use of tenapanor; |\n\n| • | achieving and maintaining compliance with all regulatory requirements applicable to tenapanor; |\n\n| • | acceptance of tenapanor as safe and effective by patients and the medical community; |\n\n| • | the availability, perceived advantages, relative cost, relative safety and relative efficacy of alternative and competing treatments; |\n\n| • | obtaining and sustaining an adequate level of coverage and reimbursement for tenapanor by third-party payors; |\n\n| • | the effectiveness of AstraZeneca’s marketing, sales and distribution strategy and operations; |\n\n| • | the ability of AstraZeneca, or any third-party manufacturer it contracts with, to successfully scale up the manufacturing process for tenapanor, which has not yet been demonstrated, and to manufacture supplies of tenapanor and to develop, validate and maintain a commercially viable manufacturing process that is compliant with current good manufacturing practice, or cGMP, requirements; |\n\n| • | enforcing intellectual property rights in and to tenapanor; |\n\n| • | avoiding third-party interference, opposition, derivation or similar proceedings with respect to our patent rights, and avoiding other challenges to our patent rights and patent infringement claims; and |\n\n| • | a continued acceptable safety profile of tenapanor following approval. |\n\nMost of these factors are beyond our control, including clinical development, the regulatory submission process, manufacturing, marketing and sales efforts of AstraZeneca.\nAs a first-in-class drug, tenapanor, has not been extensively studied in humans and the nonclinical and clinical data on its effect in the human body is limited to the trials and studies that we and AstraZeneca have completed. As a first-in-class drug, there is a higher likelihood that approval may not be attained as compared to a class of drugs with approved products. We cannot be certain that tenapanor will be successful in preclinical studies, clinical trials or receive regulatory approval. For example, like phosphate binders, treatment with tenapanor in patients with end stage renal disease, or ESRD, may be significantly impacted by such patient’s adherence to a restrictive low phosphorus diet, and as such, adherence may be a factor in demonstrating the efficacy of tenapanor in clinical trials for this patient population. Further, it may not be possible or practicable to demonstrate, or if approved, to market on the basis of,\n24\ncertain of the benefits we believe tenapanor possesses, including the reduction of sodium absorption in patients with CKD, which is unlikely to be an endpoint to be considered for approval in CKD patients. Additionally, the reduction of serum phosphorus is currently an approvable endpoint in ESRD, but not in the broader CKD patient population in the United States. If the number of patients in the market for tenapanor or the price that the market can bear is not as significant as we estimate, we may not generate significant revenue from sales of tenapanor, if approved. Accordingly, there can be no assurance that tenapanor will ever be successfully commercialized or that we will ever generate revenue from sales of tenapanor. If we and AstraZeneca are not successful in completing the development of, obtaining approval for, and commercializing tenapanor, or are significantly delayed in doing so, our business will be materially harmed.\nWe are dependent on AstraZeneca for the development, regulatory approval, manufacture and commercialization of our small molecule NHE3 inhibitor program, which includes tenapanor, and if AstraZeneca fails to perform as expected, or is unable to obtain the required regulatory approvals for tenapanor, the potential for us to generate future revenue from milestone and royalty payments from tenapanor would be significantly reduced and our business would be materially and adversely harmed.\nIn October 2012, we entered into a license agreement with AstraZeneca granting it an exclusive worldwide license to our small molecule NHE3 inhibitor program, which includes our lead product candidate, tenapanor, for all indications. Under this agreement, AstraZeneca has responsibility for completing all nonclinical and clinical development and obtaining and maintaining regulatory approval for tenapanor from the FDA and regulatory agencies outside of the United States. Ultimately, if tenapanor is advanced through clinical trials and receives marketing approval from the FDA or comparable foreign regulatory agencies, AstraZeneca will be responsible for the commercialization of tenapanor, subject to our right to elect to participate in certain co-promotion activities in the United States. The potential for us to obtain future development milestone payments and, ultimately, generate revenue from royalties from tenapanor depends entirely on the successful development, regulatory approval, marketing and commercialization of tenapanor by AstraZeneca. In addition to the risks inherent in the development of a drug product candidate, our collaboration partnership with AstraZeneca may not be successful due to a number of important factors, including the following:\n| • | prior to the 175th day after the database lock for the ongoing Phase 2b clinical trial in hyperphosphatemic ESRD patients, AstraZeneca may terminate the license for any reason with 30 -days’ prior written notice and thereafter AstraZeneca may terminate the license with 120- days’ prior written notice; |\n\n| • | AstraZeneca has the unilateral ability to choose not to develop tenapanor for one or more indications for which it has been or is currently being evaluated, provided it pursues at least one indication, and AstraZeneca may choose to pursue an indication that is not in our strategic best interest or to delay the pursuit of, or forego an indication, even if clinical data is supportive of further development for such indication; |\n\n| • | AstraZeneca may choose not to develop and commercialize tenapanor in all relevant markets; |\n\n| • | AstraZeneca may take considerably more time advancing tenapanor through the clinical and regulatory process than we currently anticipate, which could materially delay the achievement of milestones and, consequently the receipt of milestone payments from AstraZeneca; |\n\n\n| • | AstraZeneca’s obligation to use “commercially reasonable efforts” with regard to the development, regulatory approval, manufacture and commercialization of tenapanor under our agreement leaves AstraZeneca with discretion in determining the efforts and resources that it will apply to the development, regulatory approval, manufacture and commercialization of tenapanor; |\n\n| • | subject to our right to elect to participate in co-promotion activities in the United States, AstraZeneca controls all aspects of the commercialization of tenapanor; |\n\n| • | AstraZeneca is obligated to reimburse a specified amount for the current constipation-predominant irritable bowel syndrome, or IBS-C, Phase 2b clinical trial, and despite our efforts to keep costs below that amount, we may be required to spend more than that to complete the trial, and if we do so, we will not be reimbursed for those excess amounts by AstraZeneca; |\n\n| • | AstraZeneca’s recent strategic withdrawal from selling gastrointestinal, or GI, products and the differing treatment of the IBS-C indication in our agreement implies that AstraZeneca may choose not to develop the IBS-C indication, even if our current Phase 2b clinical trial were successful; |\n\n| • | AstraZeneca may change the focus of its development and commercialization efforts or pursue higher-priority programs and, accordingly, reduce the efforts and resources allocated to tenapanor, which will have the direct effect of reducing our co-promotion activities as our level of co-promotion is limited to a percentage of the overall commercialization activities; |\n\n| • | AstraZeneca may fail to develop a commercially viable formulation or manufacturing process for tenapanor, and may fail to manufacture or supply sufficient drug substance of tenapanor for commercial use, if approved, which could result in lost revenue; |\n\n25\n\n| • | AstraZeneca may not comply with all applicable regulatory requirements or may fail to report safety data in accordance with all applicable regulatory requirements; |\n\n| • | AstraZeneca may sublicense its rights with respect to tenapanor to one or more third parties without our consent; |\n\n| • | AstraZeneca may not dedicate the resources that would be necessary to carry tenapanor through clinical development or may not obtain the necessary regulatory approvals; |\n\n| • | if AstraZeneca is acquired during the term of our collaboration partnership, the acquiror may have different strategic priorities that could cause it to terminate our agreement or reduce its commitment to our collaboration partnership; and |\n\n| • | if our agreement with AstraZeneca terminates, we will no longer have rights to receive potential revenue under the agreement with AstraZeneca for future milestones or royalties, in which case we would need to identify alternative means to continue the development, manufacture and commercialization of tenapanor, alone or with others. |\n\nThe timing and amount of any milestone and royalty payments we may receive under our agreement will depend on, among other things, the efforts, allocation of resources, and successful development and commercialization of tenapanor by AstraZeneca under our agreement. There can be no assurance that any of the development and regulatory milestones will be achieved or that we will receive any future milestone payments under the agreement. In addition, in certain circumstances we may believe that we have achieved a particular milestone and AstraZeneca may disagree with our belief. In that case, receipt of that milestone payment may be delayed or may never be received, which may require us to adjust our operating plans.\nIf AstraZeneca does not perform in the manner we expect or fulfill its responsibilities in a timely manner, or at all, the clinical development, regulatory approval and commercialization efforts related to tenapanor could be delayed or terminated and it could become necessary for us to assume the responsibility at our own expense for the clinical development of tenapanor. In that event, we would likely be required to substantially limit the size and scope of the development and commercialization of tenapanor or seek additional financing to fund further development, or to identify alternative collaboration partners for tenapanor, and our potential to generate future revenue from royalties and milestone payments from tenapanor would be significantly reduced or delayed and our business would be materially and adversely harmed.\nOur election to co-fund the first Phase 3 clinical development program for tenapanor must be made in a limited time period prior to the initiation of the first pivotal clinical trial for tenapanor and, as a result, we may make a substantial capital investment for a product candidate based on limited clinical data.\nUnder our agreement with AstraZeneca, we may elect to participate in the funding of the first Phase 3 clinical development program for the first indication of tenapanor by investing a co-funding amount of $20.0 million, $30.0 million or $40.0 million to acquire an increase of 1%, 2% or 3%, respectively, in the royalties payable to us by AstraZeneca on net sales of tenapanor. We may exercise this right only for a limited period of 60 days following AstraZeneca’s determination to proceed to the first Phase 3 clinical development program for tenapanor for a specific indication. An election to participate in the co-fund will be based, in part, on our analysis as to the likelihood of success of the Phase 3 clinical development program and the potential for regulatory approval to commercialize tenapanor. As a result, we will be required to make a substantial capital investment in tenapanor prior to the initiation of the first pivotal clinical trial and if tenapanor is unsuccessful in its pivotal trial or if it never receives regulatory approval, we will not receive any financial return on this capital investment.\nWe have not yet negotiated our agreement with AstraZeneca specifying all of the terms of our co-promotion right.\nPursuant to our license agreement with AstraZeneca, we have retained a co-promotion right with respect to tenapanor in the United States. While the license agreement includes the material terms of our co-promotion right, we and AstraZeneca mutually agreed to negotiate a separate agreement specifying the detailed activities and responsibilities in respect of the marketing and co-promotion of tenapanor following our election to exercise our co-promotion rights. If we elect to exercise our co-promotion rights, the separate agreement we negotiated with AstraZeneca may place restrictions or additional obligations on us, including financial obligations. Any restrictions or additional obligations may restrict our co-promotion activities or involve more significant financial obligations than we currently anticipate.\nExercising our co-promotion right under our license agreement with AstraZeneca may restrict our future commercialization and/or co-promotion activities.\nOur agreement with AstraZeneca prohibits us from using the same sales force to co-promote tenapanor as we do to promote other products that compete with tenapanor or with any other products that are then being actively promoted by AstraZeneca or its affiliates. If we elect to co-promote tenapanor, we may therefore be required to have a separate sales forces to promote other products we may elect to co-promote under our agreement with Sanofi, or other products we develop and commercialize on our own, should any of such products be competitive with tenapanor or with any other products promoted by AstraZeneca or its affiliates. The exercise of the co-promotion right under our agreement with AstraZeneca, could adversely affect the efficiency and cost of our promotion efforts for\n26\nour products and, effectively, may prohibit us from exercising our co-promotion rights under our agreement with Sanofi or with respect to other co-promotion rights with future collaboration partners.\nIf Sanofi does not exercise its option to obtain an exclusive license to develop, manufacture and commercialize our NaP2b inhibitors or if it exercises the option and subsequently terminates any development program under its collaboration partnership with us, any potential milestone payments or revenue from product sales under this collaboration partnership will be significantly reduced or non-existent, and our results of operations and financial condition will be materially and adversely affected.\nIn February 2014, we entered into a license option and license agreement with Sanofi under which we granted Sanofi an exclusive worldwide license to conduct research utilizing our small molecule NaP2b inhibitors, which we refer to as our RDX002 program, solely for the purpose of completing activities under a preclinical development plan. We believe the inhibition of NaP2b, an intestinal phosphate transporter, would provide utility for the treatment of hyperphosphatemia in ESRD patients, which is also the lead indication for which we and AstraZeneca are developing tenapanor.\nUnder the terms of this agreement, Sanofi has the option to obtain an exclusive license to develop, manufacture and commercialize our NaP2b inhibitors. Sanofi may exercise this option at any time following the effective date of the agreement and ending 45 days after the filing of an investigational new drug application, or IND, subject to certain exceptions, and if Sanofi does not file an IND on or before the 40th month anniversary of the completion of the technology transfer phase, the agreement will terminate.\nIf Sanofi does not exercise its option under its agreement with us, or terminates its rights and obligations with respect to the development program or the entire agreement, then depending on the timing of such event:\n| • | the development of our NaP2b inhibitor program may be terminated or significantly delayed; |\n\n| • | we would bear all of the risks and costs related to the further development and commercialization of product candidates that were previously the subject of the agreement if we decided to continue work under the NaP2b inhibitor program independently; |\n\n| • | we would not be eligible to receive any of the remaining development or regulatory milestone payments or royalties on product sales; |\n\n| • | in order to fund further development and commercialization of the NaP2b program, we may need to raise additional capital if we choose to internally pursue the development of the program, or we may need to seek out and establish alternative collaboration partnerships with third-party collaboration partners for the program, which may not be possible, or we may not be able to do so on terms which are acceptable to us, in which case it may be necessary for us to limit the size or scope of the programs or increase our expenditures and seek additional funding by other means; and |\n\n| • | our cash expenditures could increase significantly if it is necessary for us to hire additional employees and allocate scarce resources to the development and commercialization of the NaP2b program. |\n\nAny of these events would have a material adverse effect on our results of operations and financial condition.\nIn addition, we may be effectively prohibited from co-promoting any product candidates arising from the NaP2b program if we have previously exercised our co-promotion right under our agreement with AstraZeneca. For additional information regarding the effect of exercising our co-promotion right with AstraZeneca, see the risk factor above titled “Exercising our co-promotion right under our license agreement with AstraZeneca may restrict our future commercialization and/or co-promotion activities.”\nClinical drug development involves a lengthy and expensive process with an uncertain outcome, and we may encounter substantial delays in our clinical studies. Furthermore, results of earlier studies and trials may not be predictive of future trial results.\nBefore obtaining marketing approval from regulatory authorities for the sale of our product candidates, we, or our collaboration partners, must conduct extensive clinical studies to demonstrate the safety and efficacy of the product candidates in humans. Clinical testing is expensive and can take many years to complete, and its outcome is inherently uncertain. Failure can occur at any time during the clinical trial process. For example, in a Phase 2a study evaluating tenapanor in ESRD patients with fluid overload, while pharmacological activity of tenapanor was confirmed, the study failed to meet the primary endpoint of a statistically significant difference between tenapanor and placebo in change in interdialytic weight gain from baseline to week 4. The results of preclinical and clinical studies of our product candidates may not be predictive of the results of later-stage clinical trials. For example, the positive results generated to date in preclinical and clinical studies for tenapanor do not ensure that the ongoing Phase 2a and Phase 2b clinical trials, or future clinical trials, will demonstrate similar results. Product candidates in later stages of clinical trials may fail to show the desired safety and efficacy despite having progressed through preclinical studies and initial clinical trials. A number of companies in the pharmaceutical, biopharmaceutical and biotechnology industries have suffered significant setbacks in advanced clinical trials for similar indications that we are pursuing due to lack of efficacy or adverse safety profiles, notwithstanding promising\n27\nresults in earlier studies, and we cannot be certain that we will not face similar setbacks. Even if our clinical trials are completed, the results may not be sufficient to obtain regulatory approval for our product candidates.\nWe may experience delays in our ongoing or future trials, and we do not know whether future clinical trials will begin on time, need to be redesigned, enroll an adequate number of patients on time or be completed on schedule, if at all. Clinical trials can be delayed or terminated for a variety of reasons, including delay or failure to:\n| • | obtain regulatory approval to commence a trial, if applicable; |\n\n| • | reach agreement on acceptable terms with prospective contract research organizations, or CROs, and clinical trial sites, the terms of which can be subject to extensive negotiation and may vary significantly among different CROs and trial sites; |\n\n| • | obtain institutional review board, or IRB, approval at each site; |\n\n| • | recruit suitable patients in a timely manner to participate in our trials; |\n\n| • | have patients complete a trial or return for post-treatment follow-up; |\n\n| • | ensure that clinical sites observe trial protocol, comply with good clinical practices, or GCPs, or continue to participate in a trial; |\n\n| • | address any patient safety concerns that arise during the course of a trial; |\n\n| • | address any conflicts with new or existing laws or regulations; |\n\n| • | initiate or add a sufficient number of clinical trial sites; or |\n\n| • | manufacture sufficient quantities of product candidate for use in clinical trials. |\n\nPatient enrollment is a significant factor in the timing of clinical trials and is affected by many factors, including the size and nature of the patient population, the proximity of patients to clinical sites, the eligibility criteria for the trial, the design of the clinical trial, competing clinical trials and clinicians’ and patients’ perceptions as to the potential advantages of the drug being studied in relation to other available therapies, including any new drugs or treatments that may be approved for the indications we are investigating. We and AstraZeneca have experienced a delay in the enrollment of the ongoing Phase 2a clinical trial in CKD patients due to the restrictive eligibility criteria, and, although we have initiated efforts to increase enrollment by initiating new sites and amending the protocol, there can be no assurances that our efforts will be successful in increasing the rate of enrollment to complete this study on time, if at all.\nWe could also encounter delays if a clinical trial is suspended or terminated by us, our collaboration partner for the product candidate, by the IRBs of the institutions in which such trials are being conducted, by an independent data safety monitoring board, or DSMB, for such trial or by the FDA or other regulatory authorities. Such authorities may suspend or terminate a clinical trial due to a number of factors, including failure to conduct the clinical trial in accordance with regulatory requirements or our clinical protocols, inspection of the clinical trial operations or trial site by the FDA or other regulatory authorities resulting in the imposition of a clinical hold, unforeseen safety issues or adverse side effects, failure to demonstrate a benefit from using a drug, changes in governmental regulations or administrative actions or lack of adequate funding to continue the clinical trial.\nFurther, conducting clinical trials in foreign countries presents additional risks that may delay completion of clinical trials. These risks include the failure of physicians or enrolled patients in foreign countries to adhere to clinical protocol as a result of differences in healthcare services or cultural customs, managing additional administrative burdens associated with foreign regulatory schemes and political and economic risks relevant to such foreign countries. In addition, the FDA may determine that the clinical trial results obtained in foreign subjects do not represent the safety and efficacy of a product candidate when administered in U.S. patients and are thus not supportive of an NDA approval in the United States. As part of our effort to increase the rate of enrollment in the ongoing Phase 2a clinical trial in CKD patients, we and AstraZeneca have initiated sites in Germany. For the reasons stated above, these efforts may not improve the rate of enrollment in this study, or generate results that can be used to support the development of tenapanor.\nIf there are delays in the completion of, or termination of, any clinical trial of our product candidates, the commercial prospects of our product candidates may be harmed, and our ability to generate revenue from product sales from any of these product candidates will be delayed. In addition, any delays in completing the clinical trials will increase costs, slow down our product candidate development and approval process and jeopardize the ability to commence product sales and generate revenue from product sales. Any of these occurrences may significantly harm our business, financial condition and prospects. In addition, many of the factors that cause, or lead to, a delay in the commencement or completion of clinical trials may also ultimately lead to the denial of regulatory approval of our product candidates.\n28\nOur unlicensed product candidates are at an early stage of development and we may not be successful in our efforts to develop these products or expand our pipeline of product candidates.\nA key element of our strategy is to expand our pipeline of products candidates utilizing our proprietary drug discovery and design platform and to advance such product candidates through clinical development. Our current unlicensed product candidates are in the discovery and lead identification stages of preclinical development and will require substantial preclinical and clinical development, testing and regulatory approval prior to commercialization. In particular, tenapanor is our only product candidate in clinical trials and our other product candidates are in the preclinical stage with significant research and development required before we could file an IND with regulatory authorities to begin clinical studies. Of the large number of drugs in development, only a small percentage of such drugs successfully complete the FDA regulatory approval process and are commercialized. Accordingly, even if we are able to continue to fund our development programs, there can be no assurance that any product candidates will reach the clinic or be successfully developed or commercialized.\nResearch programs to identify product candidates require substantial technical, financial and human resources, whether or not any product candidates are ultimately identified. Although our research and development efforts to date have resulted in several development programs, we may not be able to develop product candidates that are safe and effective. Our research programs may initially show promise in identifying potential product candidates, yet fail to yield product candidates for clinical development or commercialization for many reasons, including the following:\n| • | the research methodology used and our drug discovery and design platform may not be successful in identifying potential product candidates; |\n\n| • | competitors may develop alternatives that render our product candidates obsolete or less attractive; |\n\n| • | product candidates we develop may nevertheless be covered by third parties’ patents or other exclusive rights; |\n\n| • | the market for a product candidate may change during our program so that the continued development of that product candidate is no longer reasonable; |\n\n| • | a product candidate may on further study be shown to have harmful side effects or other characteristics that indicate it is unlikely to be effective or otherwise does not meet applicable regulatory criteria; |\n\n| • | a product candidate may not be capable of being produced in commercial quantities at an acceptable cost, or at all; and |\n\n| • | a product candidate may not be accepted as safe and effective by patients, the medical community or third-party payors, if applicable. |\n\nEven if we are successful in continuing to expand our pipeline, through our own research and development efforts or by pursuing in-licensing or acquisition of product candidates, the potential product candidates for which we identify or acquire rights may not be suitable for clinical development, including as a result of being shown to have harmful side effects or other characteristics that indicate that they are unlikely to receive marketing approval and achieve market acceptance. If we do not successfully develop and commercialize a product pipeline, we may not be able to generate revenue from product sales in future periods or ever achieve profitability.\nOur proprietary drug discovery and design platform, and, in particular, APECCS, is a new approach to the discovery, design and development of new product candidates and may not result in any products of commercial value.\nWe have developed a proprietary drug discovery and design platform to enable the identification, screening, testing, design and development of new product candidates, and we recently we enhanced this platform with the addition of APECCS. We plan to utilize APECCS to identify new and potentially novel targets in the GI tract. We have also identified over 3,800 proteins on the inner surface of the gut, many of which we believe may be drug targets. However, there can be no assurance that APECCS will work or that any of these potential targets or other aspects of our proprietary drug discovery and design platform will yield product candidates that could enter clinical development and, ultimately, be commercially valuable.\nAlthough we expect to continue to enhance the capabilities of our APECCS system by advancing the cell culture and screening process and/or acquiring new technologies to broaden the scope of APECCS, we may not be successful in any of our enhancement and development efforts. For example, we may not be able to enter into agreements on suitable terms to obtain technologies required to develop certain capabilities of APECCS. In addition, we may not be successful in developing the conditions necessary to grow multiple segments of intestine or from multiple species, or otherwise develop assays or cell cultures necessary to expand these capabilities. If our enhancement or development efforts are unsuccessful, we may not be able to advance our drug discovery capabilities as quickly as we expect or identify as many potential drugable targets as we desire.\n29\nWe may expend our limited resources to pursue a particular product candidate or indication and fail to capitalize on product candidates or indications that may be more profitable or for which there is a greater likelihood of success.\nBecause we have limited financial and managerial resources, we have focused on research programs and product candidates that relate to discovery and development of non-systemic drugs that work in the GI tract. As a result, we may forego or delay pursuit of opportunities with other product candidates or for other indications that later prove to have greater commercial potential. Our resource allocation decisions may cause us to fail to capitalize on viable commercial products or profitable market opportunities. Our spending on current and future research and development programs and product candidates for specific indications may not yield any commercially viable products. If we do not accurately evaluate the commercial potential or target market for a particular product candidate, we may relinquish valuable rights to that product candidate through collaboration partnerships, licensing or other royalty arrangements in cases in which it would have been more advantageous for us to retain sole development and commercialization rights to such product candidate.\nWe rely on third parties to conduct some of our preclinical and nonclinical studies and all of our clinical trials. If these third parties do not successfully carry out their contractual duties or meet expected deadlines, we may be unable to obtain regulatory approval for or commercialize our product candidates.\nWe do not have the ability to independently conduct clinical trials and, in some cases, preclinical or nonclinical studies. We rely on medical institutions, clinical investigators, contract laboratories, collaboration partners and other third parties, such as CROs, to conduct clinical trials on our product candidates. The third parties with whom we contract for execution of the clinical trials we are conducting with AstraZeneca, as well as those third parties with whom we will contract for execution of clinical trials for our internal programs, play a significant role in the conduct of these trials and the subsequent collection and analysis of data. However, these third parties are not our employees, and except for contractual duties and obligations, we control only certain aspects of their activities and have limited ability to control the amount or timing of resources that they devote to our programs. Although we rely, and will continue to rely, on these third parties to conduct some of our preclinical and nonclinical studies and all of our clinical trials, we remain responsible for ensuring that each of our studies and clinical trials is conducted in accordance with the applicable protocol, legal, regulatory and scientific standards and our reliance on third parties does not relieve us of our regulatory responsibilities. We and these third parties are required to comply with current good laboratory practices, or GLPs, for preclinical and nonclinical studies, and good clinical practices, or GCPs, for clinical studies. GLPs and GCPs are regulations and guidelines enforced by the FDA, the Competent Authorities of the Member States of the European Economic Area, or EEA, and comparable foreign regulatory authorities for all of our products in preclinical and clinical development, respectively. Regulatory authorities enforce GCPs through periodic inspections of trial sponsors, principal investigators and trial sites. If we or any of our third party contractors fail to comply with applicable regulatory requirements, including GCPs, the clinical data generated in our clinical trials may be deemed unreliable and the FDA, the European Medicines Agency, or EMA, or comparable foreign regulatory authorities may require us to perform additional clinical trials before approving our marketing applications. There can be no assurance that upon inspection by a given regulatory authority, such regulatory authority will determine that any of our clinical trials comply with GCP regulations. In addition, our clinical trials must be conducted with product produced under cGMP regulations. Our failure to comply with these regulations may require us to repeat clinical trials, which would delay the regulatory approval process.\nEven if our product candidates obtain regulatory approval, they may never achieve market acceptance or commercial success, which will depend, in part, upon the degree of acceptance among physicians, patients, patient advocacy groups, health care payors and the medical community.\nEven if our product candidates obtain FDA or other regulatory approvals, and are ultimately commercialized, our product candidates may not achieve market acceptance among physicians, patients, third-party payors, patient advocacy groups, health care payors and the medical community. Market acceptance of our product candidates for which marketing approval is obtained depends on a number of factors, including:\n| • | the efficacy of the products as demonstrated in clinical trials; |\n\n| • | the prevalence and severity of any side effects and overall safety profile of the product; |\n\n| • | the clinical indications for which the product is approved; |\n\n| • | advantages over existing therapies; |\n\n| • | acceptance by physicians, major operators of clinics and patients of the product as a safe and effective treatment; |\n\n| • | relative convenience and ease of administration of our products; |\n\n| • | the potential and perceived advantages of our product candidates over current treatment options or alternative treatments, including future alternative treatments; |\n\n| • | the cost of treatment in relation to alternative treatments and willingness to pay for our products, if approved, on the part of physicians and patients; |\n\n30\n\n| • | the availability of alternative products and their ability to meet market demand; |\n\n| • | the strength of our or our collaboration partners’ marketing and distribution organizations; |\n\n| • | the quality of our relationships with patient advocacy groups; and |\n\n| • | sufficient third-party coverage or reimbursement. |\n\nAny failure by our product candidates that obtain regulatory approval to achieve market acceptance or commercial success would adversely affect our results of operations.\nOur product candidates may cause undesirable side effects or have other properties that could delay our clinical trials, or delay or prevent regulatory approval, limit the commercial profile of an approved label, or result in significant negative consequences following regulatory approval, if any. If any of our product candidates receives marketing approval and we or others later identify undesirable side effects caused by the product candidate, the ability to market the product candidates could be compromised.\nUndesirable side effects caused by our product candidates could cause us, our collaboration partners, or regulatory authorities to interrupt, delay or halt clinical trials, result in the delay or denial of regulatory approval by the FDA or other comparable foreign regulatory authorities or limit the commercial profile of an approved label. To date, patients treated with tenapanor have experienced drug-related side effects including diarrhea, nausea, flatulence, abdominal discomfort, abdominal pain, abdominal distention and changes in electrolytes. In the event that trials conducted by us or AstraZeneca with tenapanor, or trials we conduct with our other product candidates, reveal an unacceptable severity and prevalence of these or other side effects, such trials could be suspended or terminated and the FDA or comparable foreign regulatory authorities could order AstraZeneca or us to cease further development of or deny approval of tenapanor, or any such other product candidate, for any or all targeted indications. The drug-related side effects could affect patient recruitment or the ability of enrolled patients to complete the trial or result in potential product liability claims. Any of these occurrences may harm our business, financial condition and prospects significantly.\nIn addition, in the event that any of our product candidates receives regulatory approval and we or others later identify undesirable side effects caused by one of our products, a number of potentially significant negative consequences could occur, including:\n| • | regulatory authorities may withdraw their approval of the product or seize the product; |\n\n| • | we, or our collaboration partners, may be required to recall the product; |\n\n| • | additional restrictions may be imposed on the marketing of the particular product or the manufacturing processes for the product or any component thereof, including the imposition of a Risk Evaluation and Mitigation Strategies, or REMS, plan that may require creation of a Medication Guide outlining the risks of such side effects for distribution to patients, as well as elements to assure safe use of the product, such as a patient registry and training and certification of prescribers; |\n\n| • | we, or our collaboration partners, may be subject to fines, injunctions or the imposition of civil or criminal penalties; |\n\n| • | regulatory authorities may require the addition of labeling statements, such as a “black box” warning or a contraindication; |\n\n| • | we could be sued and held liable for harm caused to patients; |\n\n| • | the product may become less competitive; and |\n\n| • | our reputation may suffer |\n\nAny of the foregoing events could prevent us, or our collaboration partners, from achieving or maintaining market acceptance of a particular product candidate, if approved, and could result in the loss of significant revenue to us, which would materially and adversely affect our results of operations and business.\nWe face substantial competition and our competitors may discover, develop or commercialize products faster or more successfully than us.\nThe biotechnology and pharmaceutical industries are highly competitive, and we face significant competition from companies in the biotechnology, pharmaceutical and other related markets that are researching and marketing products designed to address diseases that we are currently developing products to treat. If approved for marketing by the FDA or other regulatory agencies, tenapanor, or our other product candidates, would compete against existing treatments. For example, tenapanor will, if approved, compete directly with phosphate binders for the treatment of hyperphosphatemia in patients with ESRD, including sevelamer hydrochloride (Renagel) and sevelamer carbonate (Renvela), which were launched by Genzyme. Impax Laboratories, Inc. launched an authorized generic version of sevelamer carbonate in April 2014 and is expected to launch a generic version of sevelamer hydrochloride in September 2014. In addition to the currently marketed phosphate binders, we are aware of several other binders in development such as ferric citrate (Zerenex), an iron-based binder in Phase 3 being developed in the United States by Keryx and approved in Japan, and fermagate (Alpharen), an iron-based binder in Phase 2 being developed by Opko Health.\n31\nWhile there are no treatments for CKD that have been proven to reverse the disease, we are aware of one agent, CLP-1001, being developed by Sorbent Therapeutics, which is an orally administered, non-systemic exchange resin that binds both sodium and potassium as well as protons that showed positive effects in CKD patients with heart failure in a Phase 2a clinical trial and which showed the ability to increase fecal sodium. We believe this agent, if approved, may be competitive with tenapanor to treat CKD and ESRD patients. We are aware of certain investigational drugs that were being developed for delaying kidney decline as measured by estimated glomerular filtration rate, or eGFR. Among other products, Concert Pharmaceuticals is developing CTP-499 which showed protective effects on kidney function at 48 weeks in a Phase 2 clinical trial in patients with CKD and type 2 diabetes.\nNumerous treatments exist for constipation and the constipation component of IBS-C, many of which are over-the-counter. These include psyllium husk (such as Metamucil), methylcellulose (such as Citrucel), calcium polycarbophil (such as FiberCon), lactulose (such as Cephulac), polyethylene glycol (such as MiraLax), sennosides (such as Exlax), bisacodyl (such as Ducolax), docusate sodium (such as Colace), magnesium hydroxide (such as Milk of Magnesia), saline enemas (such as Fleet) and sorbitol. These agents are generally inexpensive and work well to relieve temporary constipation. We are also aware of two prescription drugs currently on the U.S. market that are approved to treat IBS-C, Linzess (linaclotide), which was developed by Ironwood Pharmaceuticals and was approved in 2012 and 2013 for IBS-C and chronic constipation in both the United States and in Europe, and Amitiza (lubiprostone), which was first approved in the United States in 2006 and is currently marketed by Sucampo and Takeda for treatment of chronic idiopathic constipation, or CIC, IBS-C and opioid induced constipation, or OIC.\nIt is possible that our competitors will develop and market drugs or other treatments that are less expensive and more effective than our product candidates, or that will render our product candidates obsolete. It is also possible that our competitors will commercialize competing drugs or treatments before we, or our collaboration partners, can launch any products developed from our product candidates. We also anticipate that we will face increased competition in the future as new companies enter into our target markets.\nMany of our competitors have materially greater name recognition and financial, manufacturing, marketing, research and drug development resources than we do. Additional mergers and acquisitions in the biotechnology and pharmaceutical industries may result in even more resources being concentrated in our competitors. Large pharmaceutical companies in particular have extensive expertise in preclinical and clinical testing and in obtaining regulatory approvals for drugs. In addition, academic institutions, government agencies, and other public and private organizations conducting research may seek patent protection with respect to potentially competitive products or technologies. These organizations may also establish exclusive collaboration partnerships or licensing relationships with our competitors.\nWe currently have no sales organization. If we are unable to establish sales capabilities on our own or through third parties, we may not be able to co-promote tenapanor, if approved, or commercialize or co-promote any of our other product candidates.\nWe currently do not have a sales organization. In order to co-promote tenapanor or commercialize or co-promote any of our other product candidates, we must build our marketing, sales, distribution, managerial and other non-technical capabilities or make arrangements with third parties to perform these services, and we may not be successful in doing so. If one or more of our product candidates receives regulatory approval, we expect to establish a specialty sales organization with technical expertise and supporting distribution capabilities to co-promote and/or commercialize our product candidates, which will be expensive and time consuming. As a company, we have no prior experience in the marketing, sale and distribution of pharmaceutical products and there are significant risks involved in building and managing a sales organization, including our ability to hire, retain, and incentivize qualified individuals, generate sufficient sales leads, provide adequate training to sales and marketing personnel, comply with regulatory requirements applicable to the marketing and sale of drug products and effectively manage a geographically dispersed sales and marketing team. Any failure or delay in the development of our internal sales, marketing and distribution capabilities would adversely impact the commercialization of these products.\nWe may choose to collaborate with third parties that have direct sales forces and established distribution systems, either to augment our own sales force and distribution systems or in lieu of our own sales force and distribution systems. If we are unable to enter into such arrangements on acceptable terms or at all, we may not be able to successfully commercialize our product candidates.\n32\nWe rely completely on third parties to manufacture our preclinical and clinical drug supplies, and we intend to rely on third parties to produce commercial supplies of any approved product candidate. Our business would be harmed if those third parties fail to obtain approval of the FDA, Competent Authorities of the Member States of the EEA or comparable regulatory authorities, fail to provide us with sufficient quantities of drug product, or fail to do so at acceptable quality levels or prices.\nWe do not currently have, nor do we plan to acquire, the infrastructure or capability internally to manufacture our preclinical and clinical drug supplies for use in the conduct of our preclinical and clinical studies, and we lack the resources and the capability to manufacture any of our product candidates on a clinical or commercial scale. The facilities used by our contract manufacturers to manufacture any drug products must be approved by the FDA pursuant to inspections that will be conducted after an NDA is submitted to the FDA. We do not control the manufacturing process of our product candidates, and, other than with respect to tenapanor, we are completely dependent on our contract manufacturing partners for compliance with the regulatory requirements, known as cGMPs, for manufacture of both active drug substances and finished drug products. Under our agreement with AstraZeneca, the manufacturing of tenapanor is the responsibility of AstraZeneca. We are entirely dependent on AstraZeneca for all aspects of the manufacturing and validation process, as well as providing all commercial supply of tenapanor. For additional information regarding the risks of our dependence on AstraZeneca, see the risk factors above titled “We are substantially dependent on the success of our lead product candidate, tenapanor, which may not be successful in nonclinical studies or clinical trials, receive regulatory approval or be successfully commercialized” and “We are dependent on AstraZeneca for the development, regulatory approval, manufacture and commercialization of our small molecule NHE3 inhibitor program, which includes tenapanor, and if AstraZeneca fails to perform as expected, or is unable to obtain the required regulatory approvals for tenapanor, the potential for us to generate future revenue from milestone and royalty payments from tenapanor would be significantly reduced and our business would be materially and adversely harmed.”\nIf our contract manufacturers cannot successfully manufacture material that conforms to our specifications and the strict regulatory requirements of the FDA or others, they will not be able to secure and/or maintain regulatory approval for their manufacturing facilities. In addition, we have no control over the ability of our contract manufacturers to maintain adequate quality control, quality assurance and qualified personnel. If the FDA or a comparable foreign regulatory authority does not approve these facilities for the manufacture of our product candidates or if it withdraws any such approval in the future, we may need to find alternative manufacturing facilities, which would significantly impact our ability to develop, obtain regulatory approval for or market our product candidates, if approved.\nWe rely on our manufacturers to purchase from third-party suppliers the materials necessary to produce our product candidates for our clinical studies. There are a limited number of suppliers for raw materials that we use to manufacture our drugs, and there may be a need to identify alternate suppliers to prevent a possible disruption of the manufacture of the materials necessary to produce our product candidates for our clinical studies, and, if approved, ultimately for commercial sale. We do not have any control over the process or timing of the acquisition of these raw materials by our manufacturers. Although we generally do not begin a clinical study unless we believe we have on hand, or will be able to manufacture a sufficient supply of a product candidate to complete such study, any significant delay or discontinuity in the supply of a product candidate, or the raw material components thereof, for an ongoing clinical study due to the need to replace a third-party manufacturer could considerably delay completion of our clinical studies, product testing, and potential regulatory approval of our product candidates, which could harm our business and results of operations.\nThird-party payor coverage and reimbursement status of newly-approved products is uncertain. Failure to obtain or maintain adequate coverage and reimbursement for our products, if approved, could limit our ability to market those products and decrease our ability to generate revenue.\nThe pricing, coverage and reimbursement of our product candidates, if approved, must be adequate to support a commercial infrastructure. The availability and adequacy of coverage and reimbursement by governmental and private payors are essential for most patients to be able to afford treatments such as ours, assuming approval. Sales of our product candidates will depend substantially, both domestically and abroad, on the extent to which the costs of our product candidates will be paid for by health maintenance, managed care, pharmacy benefit, and similar healthcare management organizations, or reimbursed by government authorities, private health insurers, and other third-party payors. If coverage and reimbursement are not available, or are available only to limited levels, we may not be able to successfully commercialize our product candidates. Even if coverage is provided, the approved reimbursement amount may not be high enough to allow us to establish or maintain pricing sufficient to realize a return on our investment.\nThere is significant uncertainty related to the insurance coverage and reimbursement of newly approved products. In the United States, the principal decisions about coverage and reimbursement for new drugs are typically made by the Centers for Medicare & Medicaid Services, or CMS, an agency within the U.S. Department of Health and Human Services responsible for administering the Medicare program, as CMS decides whether and to what extent a new drug will be covered and reimbursed under Medicare. Private payors tend to follow the coverage reimbursement policies established by CMS to a substantial degree. It is difficult to predict what CMS will decide with respect to reimbursement for products such as ours.\n33\nIn July 2010, CMS released its final rule to implement a bundled prospective payment system for the treatment of ESRD patients as required by the Medicare Improvements for Patients and Providers Act, or MIPPA. The bundled payment covers a bundle of items and services routinely required for dialysis treatments furnished to Medicare beneficiaries in Medicare-certified ESRD facilities or at their home, including the cost of certain routine drugs. The final rule delayed the inclusion of oral medications without intravenous equivalents in the bundled payment until January 1, 2014 and in April 2014, President Obama signed the Protecting Access to Medicare Act of 2014, which further extends this implementation date to January 1, 2024. As a result of the recent legislation, beginning in 2024, ESRD-related drugs will be included in the bundle and separate Medicare reimbursement will no longer be available for such drugs, as it is today under Medicare Part D. While it is too early to project the full impact bundling may have on the industry, the impact could potentially cause dramatic price reductions for tenapanor, if approved. We and AstraZeneca may be unable to sell tenapanor, if approved, to dialysis providers on a profitable basis if third-party payors reduce their current levels of payment, or if our costs of production increase faster than increases in reimbursement levels.\nOutside the United States, international operations are generally subject to extensive governmental price controls and other market regulations, and we believe the increasing emphasis on cost-containment initiatives in Europe, Canada, China and other countries has and will continue to put pressure on the pricing and usage of our product candidates. In many countries, the prices of medical products are subject to varying price control mechanisms as part of national health systems. Other countries allow companies to fix their own prices for medicinal products, but monitor and control company profits. Additional foreign price controls or other changes in pricing regulation could restrict the amount that we are able to charge for our product candidates. Accordingly, in markets outside the United States, the reimbursement for our products may be reduced compared with the United States and may be insufficient to generate commercially reasonable revenue and profits.\nMoreover, increasing efforts by governmental and third-party payors in the United States and abroad to cap or reduce healthcare costs may cause such organizations to limit both coverage and the level of reimbursement for new products approved and, as a result, these caps may not cover or provide adequate payment for our product candidates. We expect to experience pricing pressures in connection with the sale of any of our product candidates due to the trend toward managed healthcare, the increasing influence of health maintenance organizations, and additional legislative changes. The downward pressure on healthcare costs in general, particularly prescription drugs and surgical procedures and other treatments, has become very intense. As a result, increasingly high barriers are being erected to the entry of new products.\nIf product liability lawsuits are brought against us, we may incur substantial liabilities and may be required to limit commercialization of our product candidates.\nWe face an inherent risk of product liability as a result of the clinical testing of our product candidates and will face an even greater risk if we commercialize any products. For example, we may be sued if any product we develop allegedly causes injury or is found to be otherwise unsuitable during product testing, manufacturing, marketing or sale. Any such product liability claims may include allegations of defects in manufacturing, defects in design, a failure to warn of dangers inherent in the product, negligence, strict liability, and a breach of warranties. Claims could also be asserted under state consumer protection acts. If we cannot successfully defend ourselves against product liability claims, we may incur substantial liabilities or be required to limit commercialization of our product candidates. Even successful defense would require significant financial and management resources. Regardless of the merits or eventual outcome, liability claims may result in:\n| • | decreased demand for our product candidates; |\n\n| • | injury to our reputation; |\n\n| • | withdrawal of clinical trial participants; |\n\n| • | costs to defend the related litigation; |\n\n| • | a diversion of management’s time and our resources; |\n\n| • | substantial monetary awards to trial participants or patients; |\n\n| • | regulatory investigations, product recalls or withdrawals, or labeling, marketing or promotional restrictions; |\n\n| • | loss of revenue; and |\n\n| • | the inability to commercialize or co-promote our product candidates. |\n\nOur inability to obtain and maintain sufficient product liability insurance at an acceptable cost and scope of coverage to protect against potential product liability claims could prevent or inhibit the commercialization of any products we develop. We currently carry product liability insurance covering use in our clinical trials in the amount of $10.0 million in the aggregate. Although we maintain such insurance, any claim that may be brought against us could result in a court judgment or settlement in an amount that is not covered, in whole or in part, by our insurance or that is in excess of the limits of our insurance coverage. Our insurance policies also have various exclusions and deductibles, and we may be subject to a product liability claim for which we have no coverage. We will\n34\nhave to pay any amounts awarded by a court or negotiated in a settlement that exceed our coverage limitations or that are not covered by our insurance, and we may not have, or be able to obtain, sufficient capital to pay such amounts. Moreover, in the future, we may not be able to maintain insurance coverage at a reasonable cost or in sufficient amounts to protect us against losses.\nWe are highly dependent on the services of our President and Chief Executive Officer, Michael Raab, our Chief Scientific Officer, Dominique Charmot, Ph.D., and our Vice President of Drug Development, David Rosenbaum, Ph.D., and if we are not able to retain these members of our management or recruit additional management, clinical and scientific personnel, our business will suffer.\nOur success depends in part on our continued ability to attract, retain and motivate highly qualified personnel. In particular, we are highly dependent upon Michael Raab, our President and Chief Executive Officer, Dominique Charmot, Ph.D., our Chief Scientific Officer, and David Rosenbaum, Ph.D., our Vice President of Drug Development. The loss of services of any of these individuals could delay or prevent the successful development of our product pipeline, completion of our planned clinical trials or the commercialization of our product candidates. Although we have entered into employment agreements with our senior management team, including Mr. Raab and Drs. Charmot and Rosenbaum, these agreements are terminable at will with or without notice and, therefore, we may not be able to retain their services as expected. Although we have not historically experienced unique difficulties attracting and retaining qualified employees, we could experience such problems in the future. For example, competition for qualified personnel in the biotechnology and pharmaceuticals field is intense due to the limited number of individuals who possess the skills and experience required by our industry. In addition to the competition for personnel, the San Francisco Bay area in particular is characterized by a high cost of living. As such, we could have difficulty attracting experienced personnel to our company and may be required to expend significant financial resources in our employee recruitment and retention efforts.\nWe will need to significantly increase the size of our organization, and we may experience difficulties in managing growth.\nAs of June 30, 2014, we had 36 full-time employees. We will need to continue to expand our managerial, operational, finance and other resources in order to manage our operations, preclinical and clinical trials, research and development activities, regulatory filings, manufacturing and supply activities, and any marketing and commercialization activities, including co-promotion activities. Our management, personnel, systems and facilities currently in place may not be adequate to support this future growth. Our need to effectively execute our growth strategy requires that we:\n| • | expand our general and administrative functions; |\n\n| • | establish and build a marketing and commercial organization; |\n\n| • | identify, recruit, retain, incentivize and integrate additional employees; |\n\n| • | manage our internal development efforts effectively while carrying out our contractual obligations to third parties; and |\n\n| • | continue to improve our operational, legal, financial and management controls, reporting systems and procedures. |\n\nIf we are not able to attract, retain and motivate necessary personnel to accomplish our business objectives, we may experience constraints that will significantly impede the achievement of our development objectives, our ability to raise additional capital and our ability to implement our business strategy.\nWe incur significant costs as a result of operating as a public company, and our management will devote substantial time to new compliance initiatives. We may fail to comply with the rules that apply to public companies, including Section 404 of the Sarbanes-Oxley Act of 2002, which could result in sanctions or other penalties that would harm our business.\nWe incur significant legal, accounting and other expenses as a public company, including costs resulting from public company reporting obligations under the Securities Exchange Act of 1934, as amended, or the Exchange Act, and regulations regarding corporate governance practices. The listing requirements of The NASDAQ Global Market require that we satisfy certain corporate governance requirements relating to director independence, distributing annual and interim reports, stockholder meetings, approvals and voting, soliciting proxies, conflicts of interest and a code of conduct. Our management and other personnel will need to devote a substantial amount of time to ensure that we comply with all of these requirements, and we will need to hire additional accounting and financial staff with appropriate public company reporting experience and technical accounting knowledge. Moreover, the reporting requirements, rules and regulations will increase our legal and financial compliance costs and will make some activities more time consuming and costly. Any changes we make to comply with these obligations may not be sufficient to allow us to satisfy our obligations as a public company on a timely basis, or at all. These reporting requirements, rules and regulations, coupled with the increase in potential litigation exposure associated with being a public company, could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors or board committees or to serve as executive officers, or to obtain certain types of insurance, including directors’ and officers’ insurance, on acceptable terms.\n35\nIn addition, we expect to implement an enterprise resource planning, or ERP, system for our company in connection with becoming a public reporting company. An ERP system is intended to combine and streamline the management of our financial, accounting, human resources, sales and marketing and other functions, enabling us to manage operations and track performance more effectively. However, an ERP system will require us to complete many processes and procedures for the effective use of the system or to run our business using the system, which may result in substantial costs. Additionally, during the conversion process, we may be limited in our ability to convert any business that we acquire to the ERP. Any disruptions or difficulties in implementing or using an ERP system could adversely affect our controls and harm our business, including our ability to forecast or make sales and collect our receivables. Moreover, such disruption or difficulties could result in unanticipated costs and diversion of management attention.\nWe are subject to Section 404 of The Sarbanes-Oxley Act of 2002, or Section 404, and the related rules of the Securities and Exchange Commission, or SEC, which generally require our management and independent registered public accounting firm to report on the effectiveness of our internal control over financial reporting. Beginning with the second annual report that we will be required to file with the SEC, Section 404 requires an annual management assessment of the effectiveness of our internal control over financial reporting. However, for so long as we remain an emerging growth company as defined in the Jumpstart Our Business Startups Act of 2012, or JOBS Act, we intend to take advantage of certain exemptions from various reporting requirements that are applicable to public companies that are not emerging growth companies, including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404. Once we are no longer an emerging growth company or, if prior to such date, we opt to no longer take advantage of the applicable exemption, we will be required to include an opinion from our independent registered public accounting firm on the effectiveness of our internal controls over financial reporting. We will remain an emerging growth company until the earlier of (1) the last day of the fiscal year following the fifth anniversary of the completion of our IPO (December 31, 2019), (2) the last day of the fiscal year in which we have total annual gross revenue of at least $1.0 billion, or (3) the last day of the fiscal year in which we are deemed to be a large accelerated filer, which means the market value of our common stock that is held by non-affiliates exceeds $700 million as of the prior June 30th, and (4) the date on which we have issued more than $1.0 billion in non-convertible debt during the prior three-year period.\nTo date, we have not conducted any other review of our internal control for the purpose of providing the reports required by Section 404 and the related SEC rules. During the course of our review and testing, we may identify deficiencies and be unable to remediate them before we must provide the required reports. Furthermore, if we have a material weakness in our internal controls over financial reporting, we may not detect errors on a timely basis and our financial statements may be materially misstated. We or our independent registered public accounting firm may not be able to conclude on an ongoing basis that we have effective internal control over financial reporting, which could harm our operating results, cause investors to lose confidence in our reported financial information and cause the trading price of our stock to fall. In addition, as a public company we are required to file accurate and timely quarterly and annual reports with the SEC under the Exchange Act. Any failure to report our financial results on an accurate and timely basis could result in sanctions, lawsuits, delisting of our shares from The NASDAQ Global Market or other adverse consequences that would materially harm our business.\nWe may form additional collaboration partnerships in the future with respect to our independent programs, and we may not realize the benefits of such collaborations.\nWe may form collaboration partnerships, create joint ventures or enter into licensing arrangements with third parties with respect to our independent programs that we believe will complement or augment our existing business. We have historically engaged, and intend to continue to engage, in partnering discussions with a range of pharmaceutical and biotechnology companies and could enter into new collaboration partnerships at any time. We face significant competition in seeking appropriate collaboration partners, and the negotiation process to secure appropriate terms is time-consuming and complex. Any delays in identifying suitable collaboration partners and entering into agreements to develop our product candidates could also delay the commercialization of our product candidates, which may reduce their competitiveness even if they reach the market. Moreover, we may not be successful in our efforts to establish such a collaboration partnership for any future product candidates and programs on terms that are acceptable to us, or at all. This may be because our product candidates and programs may be deemed to be at too early of a stage of development for collaborative effort, our research and development pipeline may be viewed as insufficient, and/or third parties may not view our product candidates and programs as having sufficient potential for commercialization, including the likelihood of an adequate safety and efficacy profile. Even if we are successful in entering into a collaboration partnership or license arrangement, there is no guarantee that the collaboration partnership will be successful, or that any future collaboration partner will commit sufficient resources to the development, regulatory approval, and commercialization effort for such products, or that such alliances will result in us achieving revenues that justify such transactions.\n36\nWe may engage in strategic transactions that could impact our liquidity, increase our expenses and present significant distractions to our management.\nWe intend to consider strategic transactions, such as acquisitions of companies, asset purchases, and or in-licensing of products, product candidates or technologies. Additional potential transactions that we may consider include a variety of different business arrangements, including spin-offs, collaboration partnerships, joint ventures, restructurings, divestitures, business combinations and investments. Any such transaction may require us to incur non-recurring or other charges, may increase our near- and long-term expenditures and may pose significant integration challenges or disrupt our management or business, which could adversely affect our operations and financial results. For example, these transactions may entail numerous operational and financial risks, including:\n| • | up-front, milestone and royalty payments, equity investments and financial support of new research and development candidates including increase of personnel, all of which may be substantial; |\n\n| • | exposure to unknown liabilities; |\n\n| • | disruption of our business and diversion of our management’s time and attention in order to develop acquired products, product candidates or technologies; |\n\n| • | incurrence of substantial debt or dilutive issuances of equity securities to pay for acquisitions; |\n\n\n| • | higher-than-expected acquisition and integration costs; |\n\n| • | write-downs of assets or goodwill or impairment charges; |\n\n| • | increased amortization expenses; |\n\n| • | difficulty and cost in combining the operations and personnel of any acquired businesses with our operations and personnel; |\n\n| • | impairment of relationships with key suppliers or customers of any acquired businesses due to changes in management and ownership; and |\n\n| • | inability to retain key employees of any acquired businesses. |\n\nAccordingly, although there can be no assurance that we will undertake or successfully complete any transactions of the nature described above, any transactions that we do complete may be subject to the foregoing or other risks and could have a material adverse effect on our business, results of operations, financial condition and prospects.\nIf we seek and obtain approval to commercialize our product candidates outside of the United States, or otherwise engage in business outside of the United States, a variety of risks associated with international operations could materially adversely affect our business.\nWe may decide to seek marketing approval for certain of our product candidates outside the United States or otherwise engage in business outside the United States, including entering into contractual agreements with third-parties. We expect that we will be subject to additional risks related to entering into these international business markets and relationships, including:\n| • | different regulatory requirements for drug approvals in foreign countries; |\n\n| • | differing United States and foreign drug import and export rules; |\n\n| • | reduced protection for intellectual property rights in foreign countries; |\n\n| • | unexpected changes in tariffs, trade barriers and regulatory requirements; |\n\n| • | different reimbursement systems, and different competitive drugs; |\n\n| • | economic weakness, including inflation, or political instability in particular foreign economies and markets; |\n\n| • | compliance with tax, employment, immigration and labor laws for employees living or traveling abroad; |\n\n| • | foreign taxes, including withholding of payroll taxes; |\n\n| • | foreign currency fluctuations, which could result in increased operating expenses and reduced revenues, and other obligations incident to doing business in another country; |\n\n| • | workforce uncertainty in countries where labor unrest is more common than in the United States; |\n\n| • | production shortages resulting from any events affecting raw material supply or manufacturing capabilities abroad; |\n\n| • | potential liability resulting from development work conducted by these distributors; and |\n\n| • | business interruptions resulting from geopolitical actions, including war and terrorism, or natural disasters. |\n\n37\nOur business involves the use of hazardous materials and we and third-parties with whom we contract must comply with environmental laws and regulations, which can be expensive and restrict how we do business.\nOur research and development activities involve the controlled storage, use and disposal of hazardous materials, including the components of our product candidates and other hazardous compounds. We and manufacturers and suppliers with whom we may contract are subject to laws and regulations governing the use, manufacture, storage, handling and disposal of these hazardous materials. In some cases, these hazardous materials and various wastes resulting from their use are stored at our and our manufacturers’ facilities pending their use and disposal. We cannot eliminate the risk of contamination, which could cause an interruption of our commercialization efforts, research and development efforts and business operations, environmental damage resulting in costly clean-up and liabilities under applicable laws and regulations governing the use, storage, handling and disposal of these materials and specified waste products. We cannot guarantee that that the safety procedures utilized by third-party manufacturers and suppliers with whom we may contract will comply with the standards prescribed by laws and regulations or will eliminate the risk of accidental contamination or injury from these materials. In such an event, we may be held liable for any resulting damages and such liability could exceed our resources and state or federal or other applicable authorities may curtail our use of certain materials and/or interrupt our business operations. Furthermore, environmental laws and regulations are complex, change frequently and have tended to become more stringent. We cannot predict the impact of such changes and cannot be certain of our future compliance. We do not currently carry biological or hazardous waste insurance coverage.\nOur internal computer systems, or those of our CROs or other contractors or consultants, may fail or suffer security breaches, which could result in a material disruption of our product development programs.\nDespite the implementation of security measures, our internal computer systems and those of our CROs and other contractors and consultants are vulnerable to damage from computer viruses, unauthorized access, natural disasters, terrorism, war and telecommunication and electrical failures. While we have not experienced any such system failure, accident or security breach to date, if such an event were to occur and cause interruptions in our operations, it could result in a material disruption of our programs. For example, the loss of clinical trial data from completed or ongoing clinical trials for any of our product candidates could result in delays in our regulatory approval efforts and significantly increase our costs to recover or reproduce the data. To the extent that any disruption or security breach results in a loss of or damage to our data or applications, or inappropriate disclosure of confidential or proprietary information, we could incur liability and the further development of our product candidates could be delayed.\nWe may be adversely affected by the current global economic environment.\nOur ability to attract and retain collaboration partners or customers, invest in and grow our business and meet our financial obligations depends on our operating and financial performance, which, in turn, is subject to numerous factors, including the prevailing economic conditions and financial, business and other factors beyond our control, such as the rate of unemployment, the number of uninsured persons in the United States and inflationary pressures. Our results of operations could be adversely affected by general conditions in the global economy and in the global financial markets. The recent global financial crisis caused extreme volatility and disruptions in the capital and credit markets. We cannot anticipate all the ways in which the current global economic climate and global financial market conditions could adversely impact our business.\nWe are exposed to risks associated with reduced profitability and the potential financial instability of our collaboration partners or customers, many of which may be adversely affected by volatile conditions in the financial markets. For example, unemployment and underemployment, and the resultant loss of insurance, may decrease the demand for healthcare services and pharmaceuticals. If fewer patients are seeking medical care because they do not have insurance coverage, our collaboration partners or customers may experience reductions in revenues, profitability and/or cash flow that could lead them to reduce their support of our programs or financing activities. If collaboration partners or customers are not successful in generating sufficient revenue or are precluded from securing financing, they may not be able to pay, or may delay payment of, accounts receivable that are owed to us. In addition, the volatility in the financial markets could cause significant fluctuations in the interest rate and currency markets. We currently do not hedge for these risks. The foregoing events, in turn, could adversely affect our financial condition and liquidity. In addition, if economic challenges in the United States result in widespread and prolonged unemployment, either regionally or on a national basis, prior to the effectiveness of certain provisions of the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act, collectively known as the Affordable Care Act, a substantial number of people may become uninsured or underinsured. To the extent economic challenges result in fewer individuals pursuing or being able to afford our product candidates once commercialized, our business, results of operations, financial condition and cash flows could be adversely affected.\nWe may be adversely affected by earthquakes or other natural disasters and our business continuity and disaster recovery plans may not adequately protect us from a serious disaster.\nOur corporate headquarters and other facilities are located in the San Francisco Bay Area, which in the past has experienced severe earthquakes. We do not carry earthquake insurance. Earthquakes or other natural disasters could severely disrupt our operations, and have a material adverse effect on our business, results of operations, financial condition and prospects.\n38\nIf a natural disaster, power outage or other event occurred that prevented us from using all or a significant portion of our headquarters, that damaged critical infrastructure, such as our enterprise financial systems or manufacturing resource planning and enterprise quality systems, or that otherwise disrupted operations, it may be difficult or, in certain cases, impossible for us to continue our business for a substantial period of time. The disaster recovery and business continuity plans we have in place currently are limited and are unlikely to prove adequate in the event of a serious disaster or similar event. We may incur substantial expenses as a result of the limited nature of our disaster recovery and business continuity plans, which, particularly when taken together with our lack of earthquake insurance, could have a material adverse effect on our business.\nRisks Related to Government Regulation\nThe regulatory approval processes of the FDA and comparable foreign authorities are lengthy, time consuming and inherently unpredictable. If we are ultimately unable to obtain regulatory approval for our product candidates, our business will be substantially harmed.\nThe research, testing, manufacturing, labeling, approval, selling, import, export, marketing and distribution of drug products are subject to extensive regulation by the FDA and other regulatory authorities in the United States and other countries, which regulations differ from country to country. Neither we nor any of our collaboration partners is permitted to market any drug product in the United States until we receive marketing approval from the FDA. We have not submitted an application or obtained marketing approval for any of our product candidates anywhere in the world. Obtaining regulatory approval of a new drug application, or NDA, can be a lengthy, expensive and uncertain process. In addition, failure to comply with FDA and other applicable United States and foreign regulatory requirements may subject us to administrative or judicially imposed sanctions or other actions, including:\n| • | warning letters; |\n\n| • | civil and criminal penalties; |\n\n| • | injunctions; |\n\n| • | withdrawal of regulatory approval of products; |\n\n| • | product seizure or detention; |\n\n| • | product recalls; |\n\n| • | total or partial suspension of production; and |\n\n| • | refusal to approve pending NDAs or supplements to approved NDAs. |\n\nPrior to obtaining approval to commercialize a drug candidate in the United States or abroad, we or our collaboration partners must demonstrate with substantial evidence from well-controlled clinical trials, and to the satisfaction of the FDA or other foreign regulatory agencies, that such drug candidates are safe and effective for their intended uses. The number of nonclinical studies and clinical trials that will be required for FDA approval varies depending on the drug candidate, the disease or condition that the drug candidate is designed to address, and the regulations applicable to any particular drug candidate. Results from nonclinical studies and clinical trials can be interpreted in different ways. Even if we believe the nonclinical or clinical data for our drug candidates are promising, such data may not be sufficient to support approval by the FDA and other regulatory authorities. Administering drug candidates to humans may produce undesirable side effects, which could interrupt, delay or halt clinical trials and result in the FDA or other regulatory authorities denying approval of a drug candidate for any or all targeted indications.\nThe time required to obtain approval by the FDA and comparable foreign authorities is unpredictable, typically takes many years following the commencement of clinical studies, and depends upon numerous factors. The FDA and comparable foreign authorities have substantial discretion in the approval process and we may encounter matters with the FDA or such comparable authorities that requires us to expend additional time and resources and delay or prevent the approval of our product candidates. For example, the FDA may require us to conduct additional studies or trials for drug product either prior to or post-approval, such as additional drug-drug interaction studies or safety or efficacy studies or trials, or it may object to elements of our clinical development program such as the number of subjects in our current clinical trials from the United States. In addition, approval policies, regulations or the type and amount of clinical data necessary to gain approval may change during the course of a product candidate’s clinical development and may vary among jurisdictions, which may cause delays in the approval or result in a decision not to approve an application for regulatory approval. Despite the time and expense exerted, failure can occur at any stage. Applications for our product candidates could fail to receive regulatory approval for many reasons, including but not limited to the following:\n| • | the FDA or comparable foreign regulatory authorities may disagree with the design or implementation of our, or our collaboration partners’, clinical studies; |\n\n| • | the population studied in the clinical program may not be sufficiently broad or representative to assure safety in the full population for which approval is sought; |\n\n39\n\n| • | the FDA or comparable foreign regulatory authorities may disagree with the interpretation of data from preclinical studies or clinical studies; |\n\n| • | the data collected from clinical studies of our product candidates may not be sufficient to support the submission of a NDA or other submission or to obtain regulatory approval in the United States or elsewhere; |\n\n| • | we or our collaboration partners may be unable to demonstrate to the FDA or comparable foreign regulatory authorities that a product candidate’s risk-benefit ratio for its proposed indication is acceptable; |\n\n| • | the FDA or comparable foreign regulatory authorities may fail to approve the manufacturing processes, test procedures and specifications, or facilities of third-party manufacturers responsible for clinical and commercial supplies; and |\n\n| • | the approval policies or regulations of the FDA or comparable foreign regulatory authorities may significantly change in a manner rendering our clinical data insufficient for approval. |\n\nThis lengthy approval process, as well as the unpredictability of the results of clinical studies, may result in our failure and/or that of our collaboration partners to obtain regulatory approval to market any of our product candidates, which would significantly harm our business, results of operations, and prospects. Additionally, if the FDA requires that we conduct additional clinical studies, places limitations in our label, delays approval to market our product candidates or limits the use of our products, our business and results of operations may be harmed.\nIn addition, even if we were to obtain approval, regulatory authorities may approve any of our product candidates for fewer or more limited indications than we request, may not approve the price we intend to charge for our products, may grant approval contingent on the performance of costly post-marketing clinical trials, or may approve a product candidate with a label that does not include the labeling claims necessary or desirable for the successful commercialization of that product candidate. Any of the foregoing scenarios could materially harm the commercial prospects for our product candidates.\nEven if we receive regulatory approval for a product candidate, we will be subject to ongoing regulatory obligations and continued regulatory review, which may result in significant additional expense. Additionally, any product candidates, if approved, could be subject to labeling and other restrictions and market withdrawal, and we may be subject to penalties if we fail to comply with regulatory requirements or experience unanticipated problems with our products.\nEven if a drug is approved by the FDA or foreign regulatory authorities, the manufacturing processes, labeling, packaging, distribution, adverse event reporting, storage, advertising, promotion and recordkeeping for the product will be subject to extensive and ongoing regulatory requirements. These requirements include submissions of safety and other post-marketing information and reports, registration, as well as continued compliance with cGMPs and GCPs for any clinical trials that we conduct post-approval. As such, we and our third party contract manufacturers will be subject to continual review and periodic inspections to assess compliance with regulatory requirements. Accordingly, we and others with whom we work must continue to expend time, money, and effort in all areas of regulatory compliance, including manufacturing, production, and quality control. Regulatory authorities may also impose significant restrictions on a product’s indicated uses or marketing or impose ongoing requirements for potentially costly post-marketing studies. Furthermore, any new legislation addressing drug safety issues could result in delays or increased costs to assure compliance.\nWe will also be required to report certain adverse reactions and production problems, if any, to the FDA, and to comply with requirements concerning advertising and promotion for our products. Promotional communications with respect to prescription drugs are subject to a variety of legal and regulatory restrictions and must be consistent with the information in the product’s approved label. As such, we may not promote our products for indications or uses for which they do not have FDA approval.\nLater discovery of previously unknown problems with a product, including adverse events of unanticipated severity or frequency, or with our third-party manufacturers or manufacturing processes, or failure to comply with regulatory requirements, may result in, among other things:\n| • | warning letters, fines or holds on clinical trials; |\n\n| • | restrictions on the marketing or manufacturing of the product, withdrawal of the product from the market or voluntary or mandatory product recalls; |\n\n| • | injunctions or the imposition of civil or criminal penalties; |\n\n| • | suspension or revocation of existing regulatory approvals; |\n\n| • | suspension of any of our ongoing clinical trials; |\n\n| • | refusal to approve pending applications or supplements to approved applications submitted by us; |\n\n| • | restrictions on our or our contract manufacturers’ operations; or |\n\n40\n\n| • | product seizure or detention, or refusal to permit the import or export of products. |\n\nAny government investigation of alleged violations of law could require us to expend significant time and resources in response, and could generate negative publicity. Any failure to comply with ongoing regulatory requirements may significantly and adversely affect our ability to commercialize our product candidates. If regulatory sanctions are applied or if regulatory approval is withdrawn, the value of our company and our operating results will be adversely affected.\nIn addition, the FDA’s policies may change and additional government regulations may be enacted that could prevent, limit or delay regulatory approval of our product candidates. If we are slow or unable to adapt to changes in existing requirements or the adoption of new requirements or policies, or if we are not able to maintain regulatory compliance, we may lose any marketing approval that we may have obtained, which would adversely affect our business, prospects and ability to achieve or sustain profitability.\nWe and our collaboration partners and contract manufacturers are subject to significant regulation with respect to manufacturing our product candidates. The manufacturing facilities on which we rely may not continue to meet regulatory requirements or may not be able to meet supply demands.\nAll entities involved in the preparation of product candidates for clinical studies or commercial sale, including our existing contract manufacturers for our product candidates and AstraZeneca, and those contract manufacturers it may rely upon with respect to the manufacture of tenapanor, are subject to extensive regulation. Components of a finished therapeutic product approved for commercial sale or used in late-stage clinical studies must be manufactured in accordance with cGMP. These regulations govern manufacturing processes and procedures (including record keeping) and the implementation and operation of quality systems to control and assure the quality of investigational products and products approved for sale. Poor control of production processes can lead to the introduction of contaminants or to inadvertent changes in the properties or stability of our product candidates that may not be detectable in final product testing. We, our collaboration partners, or our contract manufacturers must supply all necessary documentation in support of an NDA or comparable regulatory filing on a timely basis and must adhere to cGMP regulations enforced by the FDA and other regulatory agencies through their facilities inspection programs. Some of our contract manufacturers have never produced a commercially approved pharmaceutical product and therefore have not obtained the requisite regulatory authority approvals to do so. The facilities and quality systems of some or all of our collaboration partners and third-party contractors must pass a pre-approval inspection for compliance with the applicable regulations as a condition of regulatory approval of our product candidates. In addition, the regulatory authorities may, at any time, audit or inspect a manufacturing facility involved with the preparation of our product candidates or our other potential products or the associated quality systems for compliance with the regulations applicable to the activities being conducted. Although we oversee the contract manufacturers, we cannot control the manufacturing process of, and are completely dependent on, other than with respect to tenapanor, our contract manufacturing partners for compliance with the regulatory requirements. AstraZeneca is fully responsible for the manufacture of tenapanor, and we are entirely dependent upon AstraZeneca for compliance with the regulatory requirements. If these facilities do not pass a pre-approval plant inspection, regulatory approval of the products may not be granted or may be substantially delayed until any violations are corrected to the satisfaction of the regulatory authority, if ever. In addition, we have no control over the ability of our contract manufacturers to maintain adequate quality control, quality assurance and qualified personnel.\nThe regulatory authorities also may, at any time following approval of a product for sale, audit the manufacturing facilities of our collaboration partners and third-party contractors. If any such inspection or audit identifies a failure to comply with applicable regulations or if a violation of our product specifications or applicable regulations occurs independent of such an inspection or audit, we or the relevant regulatory authority may require remedial measures that may be costly and/or time consuming for us or a third party to implement, and that may include the temporary or permanent suspension of a clinical study or commercial sales or the temporary or permanent suspension of production or closure of a facility. Any such remedial measures imposed upon us or third parties with whom we contract could materially harm our business.\nIf we, our collaboration partners, or any of our third-party manufacturers fail to maintain regulatory compliance, the FDA or other applicable regulatory authority can impose regulatory sanctions including, among other things, refusal to approve a pending application for a new drug product, withdrawal of an approval, or suspension of production. As a result, our business, financial condition, and results of operations may be materially harmed.\nAdditionally, if supply from one approved manufacturer is interrupted, an alternative manufacturer would need to be qualified through an NDA, a supplemental NDA or equivalent foreign regulatory filing, which could result in further delay. The regulatory agencies may also require additional studies if a new manufacturer is relied upon for commercial production. Switching manufacturers may involve substantial costs and is likely to result in a delay in our desired clinical and commercial timelines.\n41\nThese factors could cause us to incur higher costs and could cause the delay or termination of clinical studies, regulatory submissions, required approvals, or commercialization of our product candidates. Furthermore, if our suppliers fail to meet contractual requirements and we are unable to secure one or more replacement suppliers capable of production at a substantially equivalent cost, our clinical studies may be delayed or we could lose potential revenue.\nIf we fail to comply or are found to have failed to comply with FDA and other regulations related to the promotion of our products for unapproved uses, we could be subject to criminal penalties, substantial fines or other sanctions and damage awards.\nThe regulations relating to the promotion of products for unapproved uses are complex and subject to substantial interpretation by the FDA and other government agencies. If tenapanor, or our other product candidates, receives marketing approval, we and our collaborating partners will be restricted from marketing the product outside of its approved labeling, also referred to as off-label promotion. However, physicians may nevertheless prescribe an approved product to their patients in a manner that is inconsistent with the approved label, which is an off-label use. We intend to implement compliance and training programs designed to ensure that our sales and marketing practices comply with applicable regulations regarding off-label promotion. Notwithstanding these programs, the FDA or other government agencies may allege or find that our practices constitute prohibited promotion of our product candidates for unapproved uses. We also cannot be sure that our employees will comply with company policies and applicable regulations regarding the promotion of products for unapproved uses.\nOver the past several years, a significant number of pharmaceutical and biotechnology companies have been the target of inquiries and investigations by various federal and state regulatory, investigative, prosecutorial and administrative entities in connection with the promotion of products for unapproved uses and other sales practices, including the Department of Justice and various U.S. Attorneys’ Offices, the Office of Inspector General of the Department of Health and Human Services, the FDA, the Federal Trade Commission and various state Attorneys General offices. These investigations have alleged violations of various federal and state laws and regulations, including claims asserting antitrust violations, violations of the Food, Drug and Cosmetic Act, the False Claims Act, the Prescription Drug Marketing Act, anti-kickback laws, and other alleged violations in connection with the promotion of products for unapproved uses, pricing and Medicare and/or Medicaid reimbursement. Many of these investigations originate as “qui tam” actions under the False Claims Act. Under the False Claims Act, any individual can bring a claim on behalf of the government alleging that a person or entity has presented a false claim, or caused a false claim to be submitted, to the government for payment. The person bringing a qui tam suit is entitled to a share of any recovery or settlement. Qui tam suits, also commonly referred to as “whistleblower suits,” are often brought by current or former employees. In a qui tam suit, the government must decide whether to intervene and prosecute the case. If it declines, the individual may pursue the case alone.\nIf the FDA or any other governmental agency initiates an enforcement action against us or if we are the subject of a qui tam suit and it is determined that we violated prohibitions relating to the promotion of products for unapproved uses, we could be subject to substantial civil or criminal fines or damage awards and other sanctions such as consent decrees and corporate integrity agreements pursuant to which our activities would be subject to ongoing scrutiny and monitoring to ensure compliance with applicable laws and regulations. Any such fines, awards or other sanctions would have an adverse effect on our revenue, business, financial prospects and reputation.\nIf approved, tenapanor and our other product candidates may cause or contribute to adverse medical events that we are required to report to regulatory agencies and if we fail to do so we could be subject to sanctions that would materially harm our business.\nSome participants in clinical studies of tenapanor have reported adverse effects after being treated with tenapanor, including diarrhea, nausea, flatulence, abdominal discomfort, abdominal pain, abdominal distention and changes in electrolytes. If we are successful in commercializing any products, FDA and foreign regulatory agency regulations require that we report certain information about adverse medical events if those products may have caused or contributed to those adverse events. The timing of our obligation to report would be triggered by the date we become aware of the adverse event as well as the nature of the event. We may fail to report adverse events we become aware of within the prescribed timeframe. We may also fail to appreciate that we have become aware of a reportable adverse event, especially if it is not reported to us as an adverse event or if it is an adverse event that is unexpected or removed in time from the use of our products. If we fail to comply with our reporting obligations, the FDA or a foreign regulatory agency could take action, including criminal prosecution, the imposition of civil monetary penalties, seizure of our products or delay in approval or clearance of future products.\n42\nOur employees, independent contractors, principal investigators, CROs, collaboration partners, consultants and vendors may engage in misconduct or other improper activities, including noncompliance with regulatory standards and requirements.\nWe are exposed to the risk that our employees, independent contractors, principal investigators, CROs, collaboration partners, consultants and vendors may engage in fraudulent conduct or other illegal activity. Misconduct by these parties could include intentional, reckless and/or negligent conduct or unauthorized activities that violate: (1) FDA regulations, including those laws that require the reporting of true, complete and accurate information to the FDA; (2) manufacturing standards; (3) federal and state healthcare fraud and abuse laws and regulations; or (4) laws that require the reporting of true and accurate financial information and data. Specifically, sales, marketing and business arrangements in the healthcare industry are subject to extensive laws and regulations intended to prevent fraud, kickbacks, self-dealing and other abusive practices. These laws and regulations may restrict or prohibit a wide range of pricing, discounting, marketing and promotion, sales commission, customer incentive programs and other business arrangements. These activities also include the improper use of information obtained in the course of clinical trials, which could result in regulatory sanctions and serious harm to our reputation. It is not always possible to identify and deter misconduct by employees and other third parties, and the precautions we take to detect and prevent this activity may not be effective in controlling unknown or unmanaged risks or losses or in protecting us from governmental investigations or other actions or lawsuits stemming from a failure to be in compliance with such laws or regulations. If any such actions are instituted against us, and we are not successful in defending ourselves or asserting our rights, those actions could have a significant impact on our business, including the imposition of significant civil, criminal and administrative penalties, damages, monetary fines, possible exclusion from participation in Medicare, Medicaid and other federal healthcare programs, contractual damages, reputational harm, diminished profits and future earnings, and curtailment of our operations, any of which could adversely affect our ability to operate our business and our results of operations.\nFailure to obtain regulatory approvals in foreign jurisdictions would prevent us from marketing our products internationally.\nIn order to market any product in the EEA (which is composed of the 28 Member States of the European Union plus Norway, Iceland and Liechtenstein), and many other foreign jurisdictions, separate regulatory approvals are required. In the EEA, medicinal products can only be commercialized after obtaining a Marketing Authorization, or MA. Before granting the MA, the EMA or the competent authorities of the Member States of the EEA make an assessment of the risk-benefit balance of the product on the basis of scientific criteria concerning its quality, safety and efficacy.\nThe approval procedures vary among countries and can involve additional clinical testing, and the time required to obtain approval may differ from that required to obtain FDA approval. Clinical trials conducted in one country may not be accepted by regulatory authorities in other countries. Approval by the FDA does not ensure approval by regulatory authorities in other countries, and approval by one or more foreign regulatory authorities does not ensure approval by regulatory authorities in other foreign countries or by the FDA. However, a failure or delay in obtaining regulatory approval in one country may have a negative effect on the regulatory process in others. The foreign regulatory approval process may include all of the risks associated with obtaining FDA approval. We may not be able to file for regulatory approvals or to do so on a timely basis, and even if we do file we may not receive necessary approvals to commercialize our products in any market.\nWe and our collaboration partners may be subject to healthcare laws, regulation and enforcement; our failure or the failure of our collaboration partners to comply with these laws could have a material adverse effect on our results of operations and financial conditions.\nAlthough we do not currently have any products on the market, once we begin commercializing our products, we and our collaboration partners may be subject to additional healthcare statutory and regulatory requirements and enforcement by the federal government and the states and foreign governments in which we conduct our business. The laws that may affect our ability to operate as a commercial organization include:\n| • | the federal Anti-Kickback Statute, which prohibits, among other things, persons from knowingly and willfully soliciting, receiving, offering or paying remuneration, directly or indirectly, in exchange for or to induce either the referral of an individual for, or the purchase, order or recommendation of, any good or service for which payment may be made under federal healthcare programs such as the Medicare and Medicaid programs; |\n\n| • | federal false claims laws which prohibit, among other things, individuals or entities from knowingly presenting, or causing to be presented, claims for payment from Medicare, Medicaid, or other third-party payors that are false or fraudulent; |\n\n| • | federal criminal laws that prohibit executing a scheme to defraud any healthcare benefit program or making false statements relating to healthcare matters; |\n\n| • | the federal Health Insurance Portability and Accountability Act of 1996, as amended by the Health Information Technology for Economic and Clinical Health Act, which governs the conduct of certain electronic healthcare transactions and protects the security and privacy of protected health information; |\n\n43\n\n| • | the federal physician sunshine requirements under the Affordable Care Act, which requires manufacturers of drugs, devices, biologics, and medical supplies to report annually to the CMS information related to payments and other transfers of value to physicians, other healthcare providers, and teaching hospitals, and ownership and investment interests held by physicians and other healthcare providers and their immediate family members; |\n\n| • | state law equivalents of each of the above federal laws, such as anti-kickback and false claims laws which may apply to items or services reimbursed by any third-party payor, including commercial insurers; |\n\n| • | state laws that require pharmaceutical companies to comply with the pharmaceutical industry’s voluntary compliance guidelines and the applicable compliance guidance promulgated by the federal government, or otherwise restrict payments that may be made to healthcare providers and other potential referral sources; |\n\n| • | state laws that require drug manufacturers to report information related to payments and other transfers of value to physicians and other healthcare providers or marketing expenditures; and state laws governing the privacy and security of health information in certain circumstances, many of which differ from each other in significant ways, thus complicating compliance efforts; and |\n\n| • | European and other foreign law equivalents of each of the laws, including reporting requirements detailing interactions with and payments to healthcare providers. |\n\nBecause of the breadth of these laws and the narrowness of the statutory exceptions and safe harbors available, it is possible that some of our business activities could be subject to challenge under one or more of such laws. The risk of our being found in violation of these laws is increased by the fact that many of them have not been fully interpreted by the regulatory authorities or the courts, and their provisions are open to a variety of interpretations. Further, the Affordable Care Act, among other things, amends the intent requirement of the federal anti-kickback and criminal health care fraud statutes. A person or entity no longer needs to have actual knowledge of this statute or specific intent to violate it. In addition, the Affordable Care Act provides that the government may assert that a claim including items or services resulting from a violation of the federal anti-kickback statute constitutes a false or fraudulent claim for purposes of the false claims statutes. Any action against us for violation of these laws, even if we successfully defend against it, could cause us to incur significant legal expenses and divert our management’s attention from the operation of our business. If our operations are found to be in violation of any of the laws described above or any other governmental laws and regulations that apply to us, we may be subject to penalties, including civil and criminal penalties, damages, fines, the curtailment or restructuring of our operations, the exclusion from participation in federal and state healthcare programs and imprisonment, any of which could adversely affect our ability to market our products and adversely impact our financial results.\nLegislative or regulatory healthcare reforms in the United States may make it more difficult and costly for us to obtain regulatory clearance or approval of our product candidates and to produce, market and distribute our products after clearance or approval is obtained.\nFrom time to time, legislation is drafted and introduced in Congress that could significantly change the statutory provisions governing the regulatory clearance or approval, manufacture, and marketing of regulated products or the reimbursement thereof. In addition, FDA regulations and guidance are often revised or reinterpreted by the FDA in ways that may significantly affect our business and our products. Any new regulations or revisions or reinterpretations of existing regulations may impose additional costs or lengthen review times of our product candidates. We cannot determine what effect changes in regulations, statutes, legal interpretation or policies, when and if promulgated, enacted or adopted may have on our business in the future. Such changes could, among other things, require:\n| • | additional clinical trials to be conducted prior to obtaining approval; |\n\n| • | changes to manufacturing methods; |\n\n| • | recall, replacement, or discontinuance of one or more of our products; and |\n\n| • | additional record keeping. |\n\nEach of these would likely entail substantial time and cost and could materially harm our business and our financial results. In addition, delays in receipt of or failure to receive regulatory clearances or approvals for any future products would harm our business, financial condition and results of operations.\nIn addition, the full impact of recent healthcare reform and other changes in the healthcare industry and in healthcare spending is currently unknown, and may adversely affect our business model. In the United States, the Affordable Care Act was enacted in 2010 with a goal of reducing the cost of healthcare and substantially changing the way healthcare is financed by both government and private insurers. The Affordable Care Act, among other things, increased the minimum Medicaid rebates owed by manufacturers under the Medicaid Drug Rebate Program and extended the rebate program to individuals enrolled in Medicaid managed care organizations, established annual fees and taxes on manufacturers of certain branded prescription drugs, and created a new Medicare\n44\nPart D coverage gap discount program, in which manufacturers must agree to offer 50% point-of-sale discounts off negotiated prices of applicable brand drugs to eligible beneficiaries during their coverage gap period as a condition for the manufacturer’s outpatient drugs to be covered under Medicare Part D.\nIn addition, other legislative changes have been proposed and adopted in the United States since the Affordable Care Act was enacted. On August 2, 2011, the Budget Control Act of 2011 created measures for spending reductions by Congress. A Joint Select Committee on Deficit Reduction, tasked with recommending a targeted deficit reduction of at least $1.2 trillion for the years 2013 through 2021, was unable to reach required goals, thereby triggering the legislation’s automatic reduction to several government programs. This included aggregate reductions of Medicare payments to providers of 2% per fiscal year, which went into effect on April 1, 2013. On January 2, 2013, the ATRA was signed into law, which, among other things, further reduced Medicare payments to several providers, including hospitals.\nIt is likely that federal and state legislatures within the United States and foreign governments will continue to consider changes to existing healthcare legislation. We cannot predict the reform initiatives that may be adopted in the future or whether initiatives that have been adopted will be repealed or modified. The continuing efforts of the government, insurance companies, managed care organizations and other payors of healthcare services to contain or reduce costs of healthcare may adversely affect the demand for any drug products for which we may obtain regulatory approval, our ability to set a price that we believe is fair for our products, our ability to obtain coverage and reimbursement approval for a product, our ability to generate revenues and achieve or maintain profitability, and the level of taxes that we are required to pay.\nRisks Related to Intellectual Property\nWe may become subject to claims alleging infringement of third parties’ patents or proprietary rights and/or claims seeking to invalidate our patents, which would be costly, time consuming and, if successfully asserted against us, delay or prevent the development and commercialization of tenapanor or any other product candidates.\nThere have been many lawsuits and other proceedings asserting infringement or misappropriation of patents and other intellectual property rights in the pharmaceutical and biotechnology industries. There can be no assurances that we will not be subject to claims alleging that the manufacture, use or sale of tenapanor or any other product candidates nor that any activities conducted by us, infringes existing or future third-party patents, or that such claims, if any, will not be successful. Because patent applications can take many years to issue and may be confidential for 18 months or more after filing, and because pending patent claims can be revised before issuance, there may be applications now pending which may later result in issued patents that may be infringed by the manufacture, use or sale of tenapanor or other product candidates or by the operation of our business. Moreover, we may face patent infringement claims from non-practicing entities that have no relevant product revenue and against whom our own patent portfolio may thus have no deterrent effect. We may be unaware of one or more issued patents that would be infringed by the manufacture, sale or use of tenapanor or our other product candidates.\nWe may be subject to third-party patent infringement claims in the future against us or our collaboration partners that would cause us to incur substantial expenses and, if successful against us, could cause us to pay substantial damages, including treble damages and attorney’s fees if we are found to be willfully infringing a third party’s patents. We may be required to indemnify future collaboration partners against such claims. We are not aware of any threatened or pending claims related to these matters, but in the future litigation may be necessary to defend against such claims. If a patent infringement suit were brought against us or our collaboration partners, we or they could be forced to stop or delay research, development, manufacturing or sales of the product or product candidate that is the subject of the suit. As a result of patent infringement claims, or in order to avoid potential claims, we or our collaboration partners may choose to seek, or be required to seek, a license from the third party and would most likely be required to pay license fees or royalties or both. These licenses may not be available on acceptable terms, or at all. Even if we or our collaboration partners were able to obtain a license, the rights may be nonexclusive, which would give our competitors access to the same intellectual property. Ultimately, we could be prevented from commercializing a product, or forced to redesign it, or to cease some aspect of our business operations if, as a result of actual or threatened patent infringement claims, we or our collaboration partners are unable to enter into licenses on acceptable terms. Even if we are successful in defending against such claims, such litigation can be expensive and time consuming to litigate and would divert management’s attention from our core business. Any of these events could harm our business significantly.\nIn addition to infringement claims against us, if third parties prepare and file patent applications in the United States that also claim technology similar or identical to ours, we may have to participate in interference or derivation proceedings in the United States Patent and Trademark Office, or the USPTO, to determine which party is entitled to a patent on the disputed invention. We may also become involved in similar opposition proceedings in the European Patent Office or similar offices in other jurisdictions regarding our intellectual property rights with respect to our products and technology. Since patent applications are confidential for a period of time after filing, we cannot be certain that we were the first to file any patent application related to our product candidates.\n45\nIf our intellectual property related to our product candidates is not adequate or if we are not able to protect our trade secrets or our confidential information, we may not be able to compete effectively in our market.\nWe rely upon a combination of patents, trade secret protection and confidentiality agreements to protect the intellectual property related to our product candidates, our drug discovery and development platform and our development programs. Any disclosure to or misappropriation by third parties of our confidential or proprietary information could enable competitors to quickly duplicate or surpass our technological achievements, thus eroding our competitive position in our market.\nThe strength of patents in the biotechnology and pharmaceutical field involves complex legal and scientific questions and can be uncertain. The patent applications that we own or license may fail to result in issued patents in the United States or in foreign countries. Additionally, our research and development efforts may result in product candidates for which patent protection is limited or not available. Even if patents do successfully issue, third parties may challenge the validity, enforceability or scope thereof, which may result in such patents being narrowed, invalidated or held unenforceable. For example, U.S. patents can be challenged by any person before the new USPTO Patent Trial and Appeals Board at any time before one year after that person is served an infringement complaint based on the patents. Patents granted by the European Patent Office may be similarly opposed by any person within nine months from the publication of the grant. Similar proceedings are available in other jurisdictions, and in the United States, Europe and other jurisdictions third parties can raise questions of validity with a patent office even before a patent has granted. Furthermore, even if they are unchallenged, our patents and patent applications may not adequately protect our intellectual property or prevent others from designing around our claims. For example, a third party may develop a competitive product that provides therapeutic benefits similar to one or more of our product candidates but has a sufficiently different composition to fall outside the scope of our patent protection. If the breadth or strength of protection provided by the patents and patent applications we hold or pursue with respect to our product candidates is successfully challenged, then our ability to commercialize such product candidates could be negatively affected, and we may face unexpected competition that could have a material adverse impact on our business. Further, if we encounter delays in our clinical trials, the period of time during which we or our collaboration partners could market tenapanor or other product candidates under patent protection would be reduced.\nEven where laws provide protection, costly and time-consuming litigation could be necessary to enforce and determine the scope of our proprietary rights, and the outcome of such litigation would be uncertain. If we or one of our collaboration partners were to initiate legal proceedings against a third party to enforce a patent covering the product candidate, the defendant could counterclaim that our patent is invalid and/or unenforceable. In patent litigation in the United States, defendant counterclaims alleging invalidity and/or unenforceability are commonplace. Grounds for a validity challenge could be an alleged failure to meet any of several statutory requirements, including lack of novelty, obviousness or non-enablement. Grounds for an unenforceability assertion could be an allegation that someone connected with prosecution of the patent withheld relevant information from the USPTO, or made a misleading statement, during prosecution. The outcome following legal assertions of invalidity and unenforceability is unpredictable. With respect to validity, for example, we cannot be certain that there is no invalidating prior art, of which we and the patent examiner were unaware during prosecution. If a defendant were to prevail on a legal assertion of invalidity and/or unenforceability against our intellectual property related to a product candidate, we would lose at least part, and perhaps all, of the patent protection on such product candidate. Such a loss of patent protection would have a material adverse impact on our business. Moreover, our competitors could counterclaim that we infringe their intellectual property, and some of our competitors have substantially greater intellectual property portfolios than we do.\nWe also rely on trade secret protection and confidentiality agreements to protect proprietary know-how that may not be patentable, processes for which patents may be difficult to obtain and/or enforce and any other elements of our drug discovery and development processes that involve proprietary know-how, information or technology that is not covered by patents. Although we require all of our employees, consultants, advisors and any third parties who have access to our proprietary know-how, information or technology, to assign their inventions to us, and endeavor to execute confidentiality agreements with all such parties, we cannot be certain that we have executed such agreements with all parties who may have helped to develop our intellectual property or who had access to our proprietary information, nor can we be certain that our agreements will not be breached by such consultants, advisors or third parties, or by our former employees. The breach of such agreements by individuals or entities who are actively involved in the discovery and design of our potential drug candidates, or in the development of our discovery and design platform, including APECCS, could require us to pursue legal action to protect our trade secrets and confidential information, which would be expensive, and the outcome of which would be unpredictable. If we are not successful in prohibiting the continued breach of such agreements, our business could be negatively impacted. We cannot guarantee that our trade secrets and other confidential proprietary information will not be disclosed or that competitors will not otherwise gain access to our trade secrets or independently develop substantially equivalent information and techniques.\n46\nFurther, the laws of some foreign countries do not protect proprietary rights to the same extent or in the same manner as the laws of the United States. As a result, we may encounter significant problems in protecting and defending our intellectual property both in the United States and abroad. If we are unable to prevent material disclosure of the intellectual property related to our technologies to third parties, we will not be able to establish or maintain a competitive advantage in our market, which could materially adversely affect our business, results of operations and financial condition.\nIf we or our collaboration partners do not obtain patent term extension in the United States under the Hatch-Waxman Act and in foreign countries under similar legislation, thereby potentially extending the term of marketing exclusivity for our product candidates, our business may be materially harmed.\nDepending upon the timing, duration and specifics of FDA marketing approval of our product candidates, if any, one of the U.S. patents covering each of such approved product(s) or the use thereof may be eligible for up to five years of patent term restoration under the Hatch-Waxman Act. The Hatch-Waxman Act allows a maximum of one patent to be extended per FDA approved product. Patent term extension also may be available in certain foreign countries upon regulatory approval of our product candidates. Nevertheless, we or our collaboration partners may not be granted patent term extension either in the United States or in any foreign country because of, for example, failing to apply within applicable deadlines, failing to apply prior to expiration of relevant patents or otherwise failing to satisfy applicable requirements. Moreover, the term of extension, as well as the scope of patent protection during any such extension, afforded by the governmental authority could be less than we request.\nIf we are unable to obtain patent term extension or restoration, or the term of any such extension is less than we or our collaboration partners request, the period during which we or our collaboration partners will have the right to exclusively market our product will be shortened and our competitors may obtain approval of competing products following our patent expiration, and our revenue could be reduced, possibly materially.\nChanges in U.S. patent law could diminish the value of patents in general, thereby impairing our ability to protect our products.\nAs is the case with other biopharmaceutical companies, our success is heavily dependent on intellectual property, particularly patents. Obtaining and enforcing patents in the biopharmaceutical industry involve both technological and legal complexity. Therefore, obtaining and enforcing biopharmaceutical patents is costly, time consuming and inherently uncertain. In addition, the United States has recently enacted and is currently implementing wide-ranging patent reform legislation, including the Leahy-Smith America Invents Act signed into law on September 16, 2011. That Act includes a number of significant changes to U.S. patent law. These include provisions that affect the way patent applications are prosecuted and new venues and opportunities for competitors to challenge patent portfolios. Because of that Act, the U.S. patent system is now a “first to file” system, which may make it more difficult to obtain patent protection for inventions and increase the uncertainties and costs surrounding the prosecution of our or our collaboration partners’ patent applications and the enforcement or defense of our or our collaboration partners’ issued patents, all of which could materially adversely affect our business, results of operations and financial condition.\nThe United States Supreme Court has ruled on several patent cases in recent years, either narrowing the scope of patent protection available in certain circumstances or weakening the rights of patent owners in certain situations. In addition to increasing uncertainty with regard to our ability to obtain patents in the future, this combination of events has created uncertainty with respect to the value of patents once obtained. Depending on future actions by the U.S. Congress, the federal courts, and the USPTO, the laws and regulations governing patents could change in unpredictable ways that would weaken our ability to obtain new patents or to enforce our existing patents and patents that we might obtain in the future.\nObtaining and maintaining our patent protection depends on compliance with various procedural, document submission, fee payment and other requirements imposed by governmental patent agencies, and our patent protection could be reduced or eliminated for non-compliance with these requirements.\nThe USPTO and various foreign patent agencies require compliance with a number of procedural, documentary, fee payment and other provisions to maintain patent applications and issued patents. Noncompliance with these requirements can result in abandonment or lapse of a patent or patent application, resulting in partial or complete loss of patent rights in the relevant jurisdiction. In such an event, competitors might be able to enter the market earlier than would otherwise have been the case.\nWe may not be able to enforce our intellectual property rights throughout the world.\nThe laws of some foreign countries do not protect intellectual property rights to the same extent as the laws of the United States. Many companies have encountered significant problems in protecting and defending intellectual property rights in certain foreign jurisdictions. The legal systems of some countries, particularly developing countries, do not favor the enforcement of patents and other intellectual property protection, especially those relating to life sciences. This could make it difficult for us to stop the infringement of our patents or the misappropriation of our other intellectual property rights. For example, many foreign countries have compulsory licensing laws under which a patent owner must grant licenses to third parties.\n47\nProceedings to enforce our patent rights in foreign jurisdictions, whether or not successful, could result in substantial costs and divert our efforts and attention from other aspects of our business. Furthermore, while we intend to protect our intellectual property rights in our expected significant markets, we cannot ensure that we will be able to initiate or maintain similar efforts in all jurisdictions in which we may wish to market our products. Accordingly, our efforts to protect our intellectual property rights in such countries may be inadequate. In addition, changes in the law and legal decisions by courts in the United States and foreign countries may affect our ability to obtain and enforce adequate intellectual property protection for our technology.\nWe may be subject to claims that we or our employees have misappropriated the intellectual property, including know-how or trade secrets, of a third party, or claiming ownership of what we regard as our own intellectual property.\nMany of our employees, consultants and contractors were previously employed at or engaged by other biotechnology or pharmaceutical companies, including our competitors or potential competitors. Some of these employees, consultants and contractors, executed proprietary rights, non-disclosure and non-competition agreements in connection with such previous employment. Although we try to ensure that our employees, consultants and contractors do not use the intellectual property and other proprietary information or know-how or trade secrets of others in their work for us, and do not perform work for us that is in conflict with their obligations to another employer or any other entity, we may be subject to claims that we or these employees, consultants and contractors have used or disclosed such intellectual property, including know-how, trade secrets or other proprietary information. In addition, an employee, advisor or consultant who performs work for us may have obligations to a third party that are in conflict with their obligations to us, and as a result such third party may claim an ownership interest in the intellectual property arising out of work performed for us. We are not aware of any threatened or pending claims related to these matters, but in the future litigation may be necessary to defend against such claims. If we fail in defending any such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights or personnel, or access to consultants and contractors. Even if we are successful in defending against such claims, litigation could result in substantial costs and be a distraction to management.\nIn addition, while we typically require our employees, consultants and contractors who may be involved in the development of intellectual property to execute agreements assigning such intellectual property to us, we may be unsuccessful in executing such an agreement with each party who in fact develops intellectual property that we regard as our own, which may result in claims by or against us related to the ownership of such intellectual property. If we fail in prosecuting or defending any such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights. Even if we are successful in prosecuting or defending against such claims, litigation could result in substantial costs and be a distraction to our management and scientific personnel.\nRisks Related to Our Common Stock\nOur stock price may be volatile and our stockholders may not be able to resell shares of our common stock at or above the price they paid.\nThe trading price of our common stock is highly volatile and could be subject to wide fluctuations in response to various factors, some of which are beyond our control. These factors include those discussed in this “Risk Factors” section of this Quarterly Report on Form 10Q and others such as:\n| • | results from, or any delays in, clinical trial programs relating to our product candidates, including the ongoing and planned clinical trials for tenapanor; |\n\n| • | ability to commercialize or obtain regulatory approval for our product candidates, or delays in commercializing or obtaining regulatory approval; |\n\n| • | announcements of regulatory approval or a complete response letter to tenapanor, or specific label indications or patient populations for its use, or changes or delays in the regulatory review process; |\n\n| • | announcements relating to future collaboration partnerships or our existing collaboration partnerships with AstraZeneca and/or Sanofi, including decisions regarding the exercise by AstraZeneca or Sanofi of their options or any termination by them of any development program under their collaboration partnerships with us; |\n\n| • | our election, and the related announcement, to exercise our co-fund right with respect to the first Phase 3 clinical development program for tenapanor; |\n\n| • | announcements of therapeutic innovations or new products by us or our competitors; |\n\n| • | adverse actions taken by regulatory agencies with respect to our clinical trials, manufacturing supply chain or sales and marketing activities; |\n\n| • | changes or developments in laws or regulations applicable to our product candidates; |\n\n| • | any adverse changes to our relationship with any manufacturers or suppliers; |\n\n\n| • | the success of our testing and clinical trials; |\n\n48\n\n| • | the success of our efforts to acquire or license or discover additional product candidates; |\n\n| • | any intellectual property infringement actions in which we may become involved; |\n\n| • | announcements concerning our competitors or the pharmaceutical industry in general; |\n\n| • | achievement of expected product sales and profitability; |\n\n| • | manufacture, supply or distribution shortages; |\n\n| • | actual or anticipated fluctuations in our operating results; |\n\n| • | FDA or other U.S. or foreign regulatory actions affecting us or our industry or other healthcare reform measures in the United States; |\n\n| • | changes in financial estimates or recommendations by securities analysts; |\n\n| • | trading volume of our common stock; |\n\n| • | sales of our common stock by us, our executive officers and directors or our stockholders in the future; |\n\n| • | general economic and market conditions and overall fluctuations in the United States equity markets; and |\n\n| • | the loss of any of our key scientific or management personnel. |\n\nIn addition, the stock markets in general, and the markets for pharmaceutical, biopharmaceutical and biotechnology stocks in particular, have experienced extreme volatility that may have been unrelated to the operating performance of the issuer. These broad market fluctuations may adversely affect the trading price or liquidity of our common stock. In the past, when the market price of a stock has been volatile, holders of that stock have sometimes instituted securities class action litigation against the issuer. If any of our stockholders were to bring such a lawsuit against us, we could incur substantial costs defending the lawsuit and the attention of our management would be diverted from the operation of our business, which could seriously harm our financial position. Any adverse determination in litigation could also subject us to significant liabilities.\nAn active, liquid and orderly market for our common stock may not develop or be sustained\nWe completed our IPO in June 2014. Prior to that, there had been no public market for shares of our common stock. Following our IPO, the trading volume of our common stock on The NASDAQ Global Market has been limited, and an active public market for our shares may not develop or, if it develops, be sustained.\nWe cannot predict the extent in which investor interest in our company will lead to the development of, or sustain an active trading market on The NASDAQ Global Market or otherwise or how liquid that market might become. The lack of an active market may impair our stockholders’ ability to sell their shares at the time they wish to sell them or at a price that they consider reasonable. An inactive market may also impair our ability to raise capital by selling shares and may impair our ability to acquire other businesses or technologies or in-license new product candidates using our shares as consideration.\nIf securities or industry analysts do not continue to publish research or reports about our business, or if they issue an adverse or misleading opinion regarding our stock, our stock price and trading volume could decline.\nThe trading market for our common stock is influenced by the research and reports that industry or securities analysts publish about us or our business. If any of the analysts who cover us issue an adverse or misleading opinion regarding us, our business model, our intellectual property or our stock performance, or if our clinical trials and operating results fail to meet the expectations of analysts, our stock price would likely decline. If one or more of these analysts cease coverage of us or fail to publish reports on us regularly, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline.\nWe are an “emerging growth company” and as a result of the reduced disclosure and governance requirements applicable to emerging growth companies, our common stock may be less attractive to investors.\nWe are an “emerging growth company,” as defined in the JOBS Act, and we intend to take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. If some investors find our common stock less attractive as a result of our reliance on the JOBS Act exemption, there may be a less active trading market for our common stock and our stock price may be more volatile. We may take advantage of these reporting exemptions until we are no longer an emerging growth company. We will remain an emerging growth company until the earlier of (1) the last day of the fiscal year following the fifth anniversary of the completion of our IPO (December 31, 2019), (2) the last day of the fiscal year in which we have total annual gross revenue of at least $1.0 billion, or (3) the last day of the fiscal year in\n49\nwhich we are deemed to be a large accelerated filer, which means the market value of our common stock that is held by non-affiliates exceeds $700 million as of the prior June 30th, and (4) the date on which we have issued more than $1.0 billion in non-convertible debt during the prior three-year period.\nIf we sell shares of our common stock in future financings, stockholders may experience immediate dilution and, as a result, our stock price may decline.\nWe may from time to time issue additional shares of common stock at a discount from the current trading price of our common stock. As a result, our stockholders would experience immediate dilution upon the purchase of any shares of our common stock sold at such discount. In addition, as opportunities present themselves, we may enter into financing or similar arrangements in the future, including the issuance of debt securities, preferred stock or common stock. If we issue common stock or securities convertible into common stock, our common stockholders would experience additional dilution and, as a result, our stock price may decline.\nSales of a substantial number of shares of our common stock in the public market could cause our stock price to fall.\nIf our existing stockholders sell, or indicate an intention to sell, substantial amounts of our common stock in the public market after the lock-up and other legal restrictions on resale in connection with our IPO lapse, the trading price of our common stock could decline. As of June 30, 2014, we had 18,529,067 shares of common stock outstanding. Of those shares, the 4,101,632 shares sold in our IPO are freely tradable, without restriction (except as otherwise applicable), in the public market. The remaining 827,268 shares sold in our IPO are subject to the lock-up agreements pertaining to our IPO.\nThe lock-up agreements pertaining to our IPO will expire on December 15, 2014. After the lock-up agreements expire, as of June 30, 2014, up to an additional 14,427,435 shares of common stock will be eligible for sale in the public market, 12,826,261 of which are held by current directors, executive officers and other affiliates and may be subject to Rule 144 under the Securities Act of 1933, or the Securities Act.\nIn addition, as of June 30, 2014, 1.1 million shares of common stock that are subject to outstanding options, will become eligible for sale in the public market to the extent permitted by the provisions of various vesting schedules, the lock-up agreements and Rule 144 and Rule 701 under the Securities Act. If these additional shares of common stock are sold, or if it is perceived that they will be sold, in the public market, the trading price of our common stock could decline.\nThe holders of approximately 12.4 million shares of our outstanding common stock as of June 30, 2014, are entitled to rights with respect to the registration of their shares under the Securities Act, subject to vesting schedules and to the lock-up agreements described above. Registration of these shares under the Securities Act would result in the shares becoming freely tradable without restriction under the Securities Act, except for shares purchased by affiliates. Any sales of securities by these stockholders could have a material adverse effect on the trading price of our common stock.\nOur principal stockholders and management own a significant percentage of our stock and will be able to exert significant control over matters subject to stockholder approval.\nAs of June 30, 2014, our executive officers, directors, holders of 5% or more of our capital stock and their respective affiliates beneficially owned approximately two-thirds of our outstanding voting stock. Therefore, these stockholders will have the ability to influence us through this ownership position. These stockholders may be able to determine all matters requiring stockholder approval. For example, these stockholders may be able to control elections of directors, amendments of our organizational documents, or approval of any merger, sale of assets, or other major corporate transaction. This may prevent or discourage unsolicited acquisition proposals or offers for our common stock that certain stockholders may feel are in their best interest as one of our stockholders.\nWe have broad discretion to determine how to use the funds raised in our IPO, and may use them in ways that may not enhance our operating results or the price of our common stock.\nOur management has broad discretion over the use of proceeds from our IPO, and we could spend the proceeds from this offering in ways our stockholders may not agree with or that do not yield a favorable return, if at all. We currently intend to use substantially all of the net proceeds of this offering to fund continued discovery and development efforts for our preclinical product candidates, the exercise of our right to co-fund the first Phase 3 clinical development program for tenapanor, if we decide to exercise such right, expenses related to the development of APECCS, and the balance for working capital and general corporate purposes, which will include facilities expansion and the pursuit of other research and discovery efforts and could also include the acquisition or in-license of other products, product candidates or technologies. However, our use of these proceeds may differ substantially from our current plans. If we do not invest or apply the proceeds of this offering in ways that improve our operating results, we may fail to achieve expected financial results, which could cause our stock price to decline.\n50\nProvisions in our charter documents and under Delaware law could discourage a takeover that stockholders may consider favorable and may lead to entrenchment of management.\nOur amended and restated certificate of incorporation and amended and restated bylaws contain provisions that could significantly reduce the value of our shares to a potential acquirer or delay or prevent changes in control or changes in our management without the consent of our board of directors. The provisions in our charter documents include the following:\n| • | a classified board of directors with three-year staggered terms, which may delay the ability of stockholders to change the membership of a majority of our board of directors; |\n\n| • | no cumulative voting in the election of directors, which limits the ability of minority stockholders to elect director candidates; |\n\n| • | the exclusive right of our board of directors to elect a director to fill a vacancy created by the expansion of the board of directors or the resignation, death or removal of a director, which prevents stockholders from being able to fill vacancies on our board of directors; |\n\n| • | the required approval of at least 66 2/3% of the shares entitled to vote to remove a director for cause, and the prohibition on removal of directors without cause; |\n\n| • | the ability of our board of directors to authorize the issuance of shares of preferred stock and to determine the price and other terms of those shares, including preferences and voting rights, without stockholder approval, which could be used to significantly dilute the ownership of a hostile acquiror; |\n\n| • | the ability of our board of directors to alter our bylaws without obtaining stockholder approval; |\n\n| • | the required approval of at least 66 2/3% of the shares entitled to vote at an election of directors to adopt, amend or repeal our bylaws or repeal the provisions of our amended and restated certificate of incorporation regarding the election and removal of directors; |\n\n| • | a prohibition on stockholder action by written consent, which forces stockholder action to be taken at an annual or special meeting of our stockholders; |\n\n| • | the requirement that a special meeting of stockholders may be called only by the chairman of the board of directors, the chief executive officer, the president or the board of directors, which may delay the ability of our stockholders to force consideration of a proposal or to take action, including the removal of directors; and |\n\n| • | advance notice procedures that stockholders must comply with in order to nominate candidates to our board of directors or to propose matters to be acted upon at a stockholders’ meeting, which may discourage or deter a potential acquiror from conducting a solicitation of proxies to elect the acquiror’s own slate of directors or otherwise attempting to obtain control of us. |\n\nIn addition, these provisions would apply even if we were to receive an offer that some stockholders may consider beneficial.\nWe are also subject to the anti-takeover provisions contained in Section 203 of the Delaware General Corporation Law. Under Section 203, a corporation may not, in general, engage in a business combination with any holder of 15% or more of its capital stock unless the holder has held the stock for three years or, among other exceptions, the board of directors has approved the transaction.\nClaims for indemnification by our directors and officers may reduce our available funds to satisfy successful third-party claims against us and may reduce the amount of money available to us.\nOur amended and restated certificate of incorporation and amended and restated bylaws provide that we will indemnify our directors and officers, in each case to the fullest extent permitted by Delaware law.\nIn addition, as permitted by Section 145 of the Delaware General Corporation Law, our amended and restated bylaws and our indemnification agreements that we have entered into with our directors and officers provide that:\n| • | We will indemnify our directors and officers for serving us in those capacities or for serving other business enterprises at our request, to the fullest extent permitted by Delaware law. Delaware law provides that a corporation may indemnify such person if such person acted in good faith and in a manner such person reasonably believed to be in or not opposed to the best interests of the registrant and, with respect to any criminal proceeding, had no reasonable cause to believe such person’s conduct was unlawful. |\n\n| • | We may, in our discretion, indemnify employees and agents in those circumstances where indemnification is permitted by applicable law. |\n\n51\n\n| • | We are required to advance expenses, as incurred, to our directors and officers in connection with defending a proceeding, except that such directors or officers shall undertake to repay such advances if it is ultimately determined that such person is not entitled to indemnification. |\n\n| • | We will not be obligated pursuant to our amended and restated bylaws to indemnify a person with respect to proceedings initiated by that person against us or our other indemnitees, except with respect to proceedings authorized by our board of directors or brought to enforce a right to indemnification. |\n\n| • | The rights conferred in our amended and restated bylaws are not exclusive, and we are authorized to enter into indemnification agreements with our directors, officers, employees and agents and to obtain insurance to indemnify such persons. |\n\n| • | We may not retroactively amend our amended and restated bylaw provisions to reduce our indemnification obligations to directors, officers, employees and agents. |\n\nWe do not currently intend to pay dividends on our common stock, and, consequently, our stockholders’ ability to achieve a return on their investment will depend on appreciation in the price of our common stock.\nWe do not currently intend to pay any cash dividends on our common stock for the foreseeable future. We currently intend to invest our future earnings, if any, to fund our growth. Additionally, the terms of our loan and security agreements could restrict our ability to pay dividends. Therefore, our stockholders are not likely to receive any dividends on our common stock for the foreseeable future. Since we do not intend to pay dividends, our stockholders’ ability to receive a return on their investment will depend on any future appreciation in the market value of our common stock. There is no guarantee that our common stock will appreciate or even maintain the price at which our holders have purchased it.\n\n\nITEM 2.\nUNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nUnregistered Sales of Equity Securities\nFrom April 1, 2014 through June 30, 2014, we sold and issued the following unregistered securities:\n1. In June 2014, upon the closing of our IPO, all of our then-outstanding shares of convertible preferred stock automatically converted into 11,517,222 shares of common stock, and all of our then-outstanding Series B warrants were net exercised into 571,244 shares of our common stock at an exercise price of $0.09 per share. The issuance of such shares of common stock was exempt from the registration requirements of the Securities Act pursuant to Section 3(a)(9) and Section 4(a)(2) of the Securities Act of 1933, as amended.\n2. We granted stock option to employees and directors under our 2008 Stock Incentive Plan and our 2014 Equity Incentive Plan covering an aggregate of 63,888 shares of common stock at a weighted average exercise price of $13.95 per share.\nUse of Proceeds\nOn June 18, 2014, the U.S. Securities and Exchange Commission declared effective our registration statement on Form S-1 (File No. 333-196090), as amended, filed in connection with our IPO. Pursuant to the registration statement, we registered the offer and sale of 4,286,000 shares of our common stock with an aggregate offering price of $60.0 million. With the full exercise of the underwriters’ over-allotment option, we sold and issued 4,928,900 shares of our common stock at a price to the public of $14.00 per share for an aggregate offering price of approximately $69.0 million. The managing underwriters of the offering were Citigroup Global Markets Inc., Leerink Partners LLC, JMP Securities LLC and Wedbush Securities Inc. After deducting underwriting discounts, commissions and offering expenses paid or payable by us of $7.8 million, the net proceeds from the offering were $61.2 million. No offering expenses were paid or are payable, directly or indirectly, to our directors or officers, to persons owning 10% or more of any class of our equity securities or to any of our affiliates.\nThe net proceeds from the IPO have been invested in money market funds.\nThere has been no material change in the expected use of the net proceeds from our IPO as described in our prospectus relating to our IPO.\n\n\nITEM 3.\nDefaults upon Senior Securities\nNot applicable.\n52\n\n\nITEM 4.\nMine Safety Disclosures\nNot applicable\n\n\nITEM 5.\nOther Information\nNone.\n\n\nITEM 6.\nExhibits\n\n| Incorporated by Reference |\n| ExhibitNumber | Exhibit Description | Form | Date | Number | FiledHerewith |\n| 3.1 | Amended and Restated Certificate of Incorporation. | 8-K | 6/24/2014 | 3.1 |\n| 3.2 | Amended and Restated Bylaws. | 8-K | 6/24/2014 | 3.2 |\n| 4.1 | Reference is made to exhibits 3.1 and 3.2. |\n| 4.2 | Form of Common Stock Certificate. | S-1/A | 6/18/2014 | 4.2 |\n| 10.1(a)# | Ardelyx, Inc. 2014 Equity Incentive Award Plan. | S-8 | 7/14/2014 | 99.3 |\n| 10.1(b)# | Form of Stock Option Grant Notice and Stock Option Agreement under the 2014 Equity Incentive Award Plan. | S-1/A | 6/18/2014 | 10.6(b) |\n| 10.1(c)# | Form of Restricted Stock Award Agreement and Restricted Stock Unit Award Grant Notice under the 2014 Equity Incentive Award Plan. | S-1/A | 6/18/2014 | 10.6.(c) |\n| 10.2# | Form of Indemnification Agreement for directors and officers. | S-1/A | 6/9/2014 | 10.7 |\n| 10.3# | Amended and Restated Executive Employment Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Michael Raab | S-1/A | 6/9/2014 | 10.8 |\n| 10.4# | Change in Control Severance Agreement, dated as of June 6, 2014, by and between Ardelyx, Inc. and Dominique Charmot, Ph.D | S-1/A | 6/9/2014 | 10.9 |\n| 10.5# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Mark Kaufmann | S-1/A | 6/9/2014 | 10.15 |\n| 10.6# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Elizabeth Grammer, Esq | S-1/A | 6/9/2014 | 10.16 |\n| 10.7# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Jeffrey Jacobs, Ph.D | S-1/A | 6/9/2014 | 10.16 |\n| 10.8# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and George Jue. | S-1/A | 6/9/2014 | 10.18 |\n| 10.9# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and David Rosenbaum, Ph.D | S-1/A | 6/9/2014 | 10.19 |\n\n53\n\n| Incorporated by Reference |\n| ExhibitNumber | Exhibit Description | Form | Date | Number | FiledHerewith |\n| 10.10# | Ardelyx, Inc. 2014 Employee Stock Purchase Plan. | S-8 | 7/14/2014 | 99.6 |\n| 10.11# | Non-Employee Director Compensation Program. | S-1/A | 6/9/2014 | 10.21 |\n| 31.1 | Certification of Principal Executive Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended. | X |\n| 31.2 | Certification of Principal Financial Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended. | X |\n| 32.1 | Certification of Principal Executive Officer and Principal Financial Officer Required Under Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C §1350. | X |\n| 101.INS* | XBRL Instance Document | X |\n| 101.SCH* | XBRL Taxonomy Extension Schema Document | X |\n| 101.CAL* | XBRL Taxonomy Extension Calculation Linkbase Document | X |\n| 101.DEF* | XBRL Taxonomy Extension Definition Linkbase Document | X |\n| 101.LAB* | XBRL Taxonomy Extension Label Linkbase Document | X |\n| 101.PRE* | XBRL Taxonomy Extension Presentation Linkbase Document | X |\n\n\n| # | Indicates management contract or compensatory plan. |\n\n\n| * | In accordance with Rule 406T of Regulation S-T, the Interactive Data Files in Exhibits 101.INS; 101.SCH; 101.CAL; 101.DEF; 101.LAB and 101.PRE are deemed not filed or a part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, and are deemed not filed for purposes of Section 18 of the Securities Act of 1934, as amended, and otherwise are not subject to liability under those sections. |\n\n54\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| Ardelyx, Inc. |\n| Date: August 8, 2014 | By: | /s/ Michael Raab |\n| Michael Raab President Chief Executive Officer and Director (Principal Executive Officer) |\n\n55\nEXHIBIT INDEX\nExhibit Index\n\n| Incorporated by Reference |\n| ExhibitNumber | Exhibit Description | Form | Date | Number | FiledHerewith |\n| 3.1 | Amended and Restated Certificate of Incorporation. | 8-K | 6/24/2014 | 3.1 |\n| 3.2 | Amended and Restated Bylaws. | 8-K | 6/24/2014 | 3.2 |\n| 4.1 | Reference is made to exhibits 3.1 and 3.2. |\n| 4.2 | Form of Common Stock Certificate. | S-1/A | 6/18/2014 | 4.2 |\n| 10.1(a)# | Ardelyx, Inc. 2014 Equity Incentive Award Plan. | S-8 | 7/14/2014 | 99.3 |\n| 10.1(b)# | Form of Stock Option Grant Notice and Stock Option Agreement under the 2014 Equity Incentive Award Plan. | S-1/A | 6/18/204 | 10.6(b) |\n| 10.1(c)# | Form of Restricted Stock Award Agreement and Restricted Stock Unit Award Grant Notice under the 2014 Equity Incentive Award Plan. | S-1/A | 6/18/2014 | 10.6(c) |\n| 10.2# | Form of Indemnification Agreement for directors and officers. | S-1/A | 6/9/2014 | 10.7 |\n| 10.3# | Amended and Restated Executive Employment Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Michael Raab | S-1/A | 6/9/2014 | 10.8 |\n| 10.4# | Change in Control Severance Agreement, dated as of June 6, 2014, by and between Ardelyx, Inc. and Dominique Charmot, Ph.D | S-1/A | 6/9/2014 | 10.9 |\n| 10.5# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Mark Kaufmann | S-1/A | 6/9/2014 | 10.15 |\n| 10.6# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Elizabeth Grammer, Esq | S-1/A | 6/9/2014 | 10.16 |\n| 10.7# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Jeffrey Jacobs, Ph.D | S-1/A | 6/9/2014 | 10.17 |\n| 10.8# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and George Jue. | S-1/A | 6/9/2014 | 10.18 |\n| 10.9# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and David Rosenbaum, Ph.D | S-1/A | 6/9/2014 | 10.19 |\n| 10.10# | Ardelyx, Inc. 2014 Employee Stock Purchase Plan. | S-8 | 7/14/2014 | 99.6 |\n| 10.11# | Non-Employee Director Compensation Program. | S-1/A | 6/9/2014 | 10.21 |\n| 31.1 | Certification of Principal Executive Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended. | X |\n| 31.2 | Certification of Principal Financial Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended. | X |\n\n56\n\n| Incorporated by Reference |\n| ExhibitNumber | Exhibit Description | Form | Date | Number | FiledHerewith |\n| 32.1 | Certification of Principal Executive Officer and Principal Financial Officer Required Under Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C §1350. | X |\n| 101.INS* | XBRL Instance Document | X |\n| 101.SCH* | XBRL Taxonomy Extension Schema Document | X |\n| 101.CAL* | XBRL Taxonomy Extension Calculation Linkbase Document | X |\n| 101.DEF* | XBRL Taxonomy Extension Definition Linkbase Document | X |\n| 101.LAB* | XBRL Taxonomy Extension Label Linkbase Document | X |\n| 101.PRE* | XBRL Taxonomy Extension Presentation Linkbase Document | X |\n\n\n| # | Indicates management contract or compensatory plan. |\n\n\n| * | In accordance with Rule 406T of Regulation S-T, the Interactive Data Files in Exhibits 101.INS; 101.SCH; 101.CAL; 101.DEF; 101.LAB and 101.PRE are deemed not filed or a part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, and are deemed not filed for purposes of Section 18 of the Securities Act of 1934, as amended, and otherwise are not subject to liability under those sections. |\n\n57\n\n \n\nWhat is the increase in the overall exercise value of the options from December 31, 2013 to June 30, 2014, considering the balances at these dates and their respective weighted average exercise price per share (in thousands of dollars)?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nITEM 1.\\nFINANCIAL STATEMENTS\\nARDELYX, INC.\\nCondensed Balance Sheets\\n(In thousands, except share and per share amounts)\\n\\n| June 30,2014 | December 31,2013 |\\n| (Unaudited) |\\n| Assets |\\n| Current assets: |\\n| Cash and cash equivalents | $ | 117,814 | $ | 34,435 |\\n| Accounts receivable | 3,025 | 6,436 |\\n| Prepaid expenses and other current assets | 1,308 | 965 |\\n| Total current assets | 122,147 | 41,836 |\\n| Property and equipment, net | 1,138 | 530 |\\n| Other assets | 13 | 358 |\\n| Restricted cash | 180 | 180 |\\n| Total assets | $ | 123,478 | $ | 42,904 |\\n| Liabilities, convertible preferred stock, and stockholders’ equity (deficit) |\\n| Current liabilities: |\\n| Accounts payable | $ | 2,308 | $ | 2,284 |\\n| Accrued compensation and benefits | 802 | 927 |\\n| Other accrued liabilities | 1,003 | 95 |\\n| Deferred rent | — | 5 |\\n| Deferred revenue, current portion | 23,221 | 13,828 |\\n| Total current liabilities | 27,334 | 17,139 |\\n| Deferred revenue, non-current | 33,170 | 26,470 |\\n| Convertible preferred stock warrant liability | — | 6,456 |\\n| Liabilities related to early exercise of options | 107 | 163 |\\n| Total liabilities | 60,611 | 50,228 |\\n| Commitments and contingencies |\\n| Convertible preferred stock, $0.0001 par value per share — no shares and 108,829,748 shares authorized as of June 30, 2014 and December 31, 2013, respectively; no shares and 11,517,222 shares issued and outstanding as of June 30, 2014 and December 31, 2013, respectively | — | 56,155 |\\n| Stockholders’ equity (deficit): |\\n| Preferred stock, $0.0001 par value; 5,000,000 shares and no shares authorized as of June 30, 2014 and December 31, 2013, respectively; no shares issued and outstanding as of June 30, 2014 and December 31, 2013, respectively | — | — |\\n| Common stock, $0.0001 par value — 300,000,000 and 130,360,121 shares authorized as of June 30, 2014 and December 31, 2013, respectively; 18,335,620 and 1,225,481 shares issued and outstanding as of June 30, 2014 and December 31, 2013, respectively | 2 | — |\\n| Additional paid-in capital | 130,836 | 5,174 |\\n| Accumulated deficit | (67,971 | ) | (68,653 | ) |\\n| Total stockholders’ equity (deficit) | 62,867 | (63,479 | ) |\\n| Total liabilities, convertible preferred stock, and stockholders’ equity (deficit) | $ | 123,478 | $ | 42,904 |\\n\\nSee accompanying notes.\\n2\\nARDELYX, INC.\\nCondensed Statements of Operations and Comprehensive Income (Loss)\\n(Unaudited)\\n(In thousands, except share and per share amounts)\\n\\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\\n| 2014 | 2013 | 2014 | 2013 |\\n| Revenue: |\\n| Licensing revenue | $ | 6,507 | $ | 1,989 | $ | 9,743 | $ | 3,978 |\\n| Collaborative development revenue | 2,630 | 5,302 | 7,944 | 9,869 |\\n| Total revenue | 9,137 | 7,291 | 17,687 | 13,847 |\\n| Operating expenses: |\\n| Research and development | 5,183 | 7,234 | 12,820 | 13,173 |\\n| General and administrative | 1,203 | 908 | 2,580 | 1,935 |\\n| Total operating expenses | 6,386 | 8,142 | 15,400 | 15,108 |\\n| Income (loss) from operations | 2,751 | (851 | ) | 2,287 | (1,261 | ) |\\n| Other expense, net | (8 | ) | (4 | ) | (12 | ) | (29 | ) |\\n| Change in fair value of preferred stock warrant liability | 1,010 | — | (1,593 | ) | — |\\n| Income (loss) before provision for income taxes | 3,753 | (855 | ) | 682 | (1,290 | ) |\\n| Provision for income taxes | — | 36 | — | 71 |\\n| Net income (loss) and comprehensive income (loss) | $ | 3,753 | $ | (891 | ) | $ | 682 | $ | (1,361 | ) |\\n| Net income (loss) attributable to common stockholders: |\\n| Basic | $ | 515 | $ | (891 | ) | $ | — | $ | (1,361 | ) |\\n| Diluted | $ | 703 | $ | (891 | ) | $ | — | $ | (1,361 | ) |\\n| Shares used to compute net income (loss) per share attributable to common stockholders: |\\n| Basic | 2,611,259 | 1,102,093 | 1,937,509 | 1,072,583 |\\n| Diluted | 3,904,136 | 1,102,093 | 1,937,509 | 1,072,583 |\\n| Net income (loss) per share attributable to common stockholders: |\\n| Basic | $ | 0.20 | $ | (0.81 | ) | $ | — | $ | (1.27 | ) |\\n| Diluted | $ | 0.18 | $ | (0.81 | ) | $ | — | $ | (1.27 | ) |\\n\\nSee accompanying notes.\\n3\\nARDELYX, INC.\\nCondensed Statements of Cash Flows\\n(Unaudited)\\n(In thousands)\\n\\n| Six Months Ended June 30, |\\n| 2014 | 2013 |\\n| Operating activities |\\n| Net income (loss) | $ | 682 | $ | (1,361 | ) |\\n| Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |\\n| Depreciation and amortization expense | 128 | 356 |\\n| Stock-based compensation | 163 | 190 |\\n| Change in fair value of preferred stock warrant liability | 1,593 | — |\\n| Changes in operating assets and liabilities: |\\n| Accounts receivable | 3,411 | (3,912 | ) |\\n| Prepaid and other current assets | (343 | ) | (496 | ) |\\n| Other assets | 345 | (731 | ) |\\n| Accounts payable | 24 | 1,131 |\\n| Accrued compensation and benefits | (125 | ) | (377 | ) |\\n| Other accrued liabilities | 908 | (572 | ) |\\n| Deferred revenue | 16,093 | (2,863 | ) |\\n| Deferred rent | (5 | ) | (262 | ) |\\n| Net cash provided by (used in) operating activities | 22,874 | (8,897 | ) |\\n| Investing activities |\\n| Purchases of property and equipment | (736 | ) | (257 | ) |\\n| Net cash used in investing activities | (736 | ) | (257 | ) |\\n| Financing activities |\\n| Proceeds from issuance of common stock | 61,241 | 2 |\\n| Repurchase of unvested common stock | — | (2 | ) |\\n| Net cash provided by financing activities | 61,241 | — |\\n| Net increase (decrease) in cash and cash equivalents | 83,379 | (9,154 | ) |\\n| Cash and cash equivalents at beginning of period | 34,435 | 32,903 |\\n| Cash and cash equivalents at end of period | $ | 117,814 | $ | 23,749 |\\n\\nSee accompanying notes.\\n4\\nARDELYX, INC.\\nNotes to the Unaudited Interim Condensed Financial Statements\\n1. Organization and Basis of Presentation\\nArdelyx, Inc. (the “Company”) is a clinical stage biopharmaceutical company focused on the discovery, development and commercialization of innovative, non-systemic, small molecule therapeutics that work exclusively in the gastrointestinal tract to treat cardio-renal, gastrointestinal and metabolic diseases. The Company has developed a drug discovery and design platform enabling it, in a rapid and cost-efficient manner, to discover and design novel drug candidates. The Company was incorporated in Delaware on October 17, 2007, under the name Nteryx and changed its name to Ardelyx, Inc. in June 2008.\\nThe Company operates in only one business segment, which is the development of biopharmaceutical products.\\nBasis of Presentation\\nThe accompanying unaudited condensed financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) and following the requirements of the Securities and Exchange Commission (the “SEC”) for interim reporting. As permitted under those rules, certain footnotes or other financial information that are normally required by U.S. GAAP can be condensed or omitted. These financial statements have been prepared on the same basis as the Company’s annual financial statements and, in the opinion of management, reflect all adjustments, consisting only of normal recurring adjustments that are necessary for a fair statement of the Company’s financial information. The results of operations for the three and six months ended June 30, 2014 are not necessarily indicative of the results to be expected for the year ending December 31, 2014 or for any other interim period or for any other future year. The balance sheet as of December 31, 2013 has been derived from audited financial statements at that date but does not include all of the information required by U.S. GAAP for complete financial statements.\\nThe accompanying condensed financial statements and related financial information should be read in conjunction with the audited financial statements and the related notes thereto for the year ended December 31, 2013 included in the Company’s Prospectus filed pursuant to Rule 424(b)(4) on June 19, 2014 with the SEC (the “Prospectus”).\\nReverse Stock Split\\nOn June 18, 2014, the Company’s Amended and Restated Certificate of Incorporation became effective resulting in a reverse split of the Company’s common stock and convertible preferred stock at a 1-for-9 ratio (the “Reverse Stock Split”). The par value and the authorized shares of the common stock and convertible preferred stock were not adjusted as a result of the Reverse Stock Split. All issued and outstanding common stock, convertible preferred stock, warrants for preferred stock, options for common stock and per share amounts contained in the financial statements have been retroactively adjusted to reflect this Reverse Stock Split for all periods presented.\\nInitial Public Offering\\nOn June 18, 2014, the Company’s registration statement on Form S-1 (File No. 333-196090) relating to the initial public offering (the “IPO”) of its common stock was declared effective by the SEC. The IPO closed on June 24, 2014 at which time the Company sold 4,928,900 shares of its common stock, which included the exercise in full by the underwriters of the IPO of their option to purchase 642,900 additional shares of the Company’s common stock. The Company received cash proceeds of $61.2 million from the IPO, net of underwriting discounts and commissions and expenses paid by the Company.\\nOn June 24, 2014, prior to the closing of the IPO, all outstanding shares of convertible preferred stock converted into 11,517,222 shares of common stock with the related carrying value of $56.2 million reclassified to common stock and additional paid-in capital. In addition, all convertible preferred stock warrants were net exercised and converted into common stock and the related convertible preferred stock warrant liability was reclassified to additional paid-in capital.\\nOn June 24, 2014, the Company’s Amended and Restated Certificate of Incorporation became effective and the number of shares of capital stock the Company is authorized to issue was increased to 305,000,000 shares, of which 300,000,000 shares may be common stock and 5,000,000 shares may be preferred stock. Both the common stock and preferred stock have a par value of $0.0001 per share. There are no shares of preferred stock outstanding at June 30, 2014.\\n5\\n2. Summary of Significant Accounting Policies\\nUse of Estimates\\nThe preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and judgments that affect the amounts reported in the financial statements and accompanying notes. On an ongoing basis, management evaluates its estimates, including those related to revenue recognition, clinical trial accruals, income taxes, and stock-based compensation. Management bases its estimates on historical experience and on various other market-specific and relevant assumptions that management believes to be reasonable under the circumstances. Actual results may differ from those estimates.\\nCash and Cash Equivalents\\nThe Company considers all highly liquid investments purchased with an original maturity date of 90 days or less on the date of purchase to be cash equivalents. The Company invests its cash in bank deposits and money market accounts.\\nRestricted Cash\\nThe Company is required to guarantee the credit limit on its corporate credit card with a certificate of deposit of $100,000. The collateral will be released upon the cancellation of the corporate credit card.\\nThe Company is required under its facility lease agreement to maintain a line of credit with a bank in the amount of $80,000 for the benefit of the lessor. The line of credit is secured by a cash deposit with the bank. The cash deposit will be released upon expiration of the line of credit.\\nComprehensive Income (Loss)\\nComprehensive income (loss) is composed of two components: net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) refers to gains and losses that under GAAP are recorded as an element of stockholders’ equity (deficit), but are excluded from net income (loss). The Company did not record any transactions within other comprehensive income (loss) in the periods presented and, therefore, the net income (loss) and comprehensive income (loss) were the same for all periods presented.\\nRevenue Recognition\\nRevenue from research activities made under collaboration partnership agreements are recognized as the services are provided and when there is persuasive evidence that an arrangement exists, delivery has occurred, the price is fixed or determinable, and collectability is reasonably assured. Revenue generated from research and licensing agreements typically includes up-front signing or license fees, cost reimbursements, research services, minimum sublicense fees, milestone payments, and royalties on future licensees’ product sales.\\nFor revenue agreements with multiple-element arrangements, such as license and development agreements, the Company allocates revenue to each non-contingent deliverable based on the relative selling price of each deliverable. When applying the relative selling price method, the Company determines the selling price for each deliverable using vendor-specific objective evidence or third-party evidence. If neither exists, the Company uses its best estimate of selling price for that deliverable. Revenue allocated is then recognized when the four basic revenue recognition criteria are met for each deliverable.\\nThe Company recognizes revenue from upfront payments ratably over the term of its estimated period of performance under the agreement which is recorded as licensing revenue. Reimbursements for development costs incurred under the Company’s license agreement with AstraZeneca are classified as collaborative development revenue. The Company recognizes cost reimbursement revenue under collaboration partnership agreements as the related research and development costs for services are rendered. Deferred revenue represents the portion of research or license payments received which has not been earned.\\nRevenues from milestones, if they are nonrefundable and deemed substantive, are recognized upon successful accomplishment of the milestones. To the extent that non-substantive milestones are achieved and the Company has remaining performance obligations, milestones are deferred and recognized as revenue over the estimated remaining period of performance. The Company will recognize revenue associated with the non-substantive milestones upon achievement of the milestone if there are no undelivered elements and it has no remaining performance obligations. The Company will account for sales-based milestones as royalties that will be recognized as revenue upon achievement of the milestone.\\n6\\nNet Income (Loss) per Share Attributable to Common Stockholders\\nBasic net income (loss) per share attributable to common stockholders is calculated by dividing the net income (loss) attributable to common stockholders by the weighted-average number of shares of common stock outstanding for the period. Prior to the Company’s IPO of its common stock, the Company’s Series A and Series B convertible preferred stock was entitled to receive dividends of up to $0.8181 and $0.2781 per share, respectively, prior and in preference to any declaration or payment of any dividend on common stock and thereafter participate pro rata on an as converted basis with the common stock holders on any distributions to common stockholders. The convertible preferred shares were therefore considered to be participating securities. As a result, the Company calculated the net income (loss) per share using the two-class method. Accordingly, the net income (loss) attributable to common stockholders is derived from the net income (loss) for the period and, in periods in which the Company has net income attributable to common stockholders, an adjustment is made for the noncumulative dividends and allocations of earnings to participating securities based on their outstanding shareholder rights. Under the two-class method, the net loss attributable to common stockholders is not allocated to the convertible preferred stock as the convertible preferred stock did not have a contractual obligation to share in the Company’s losses. The diluted net income per share attributable to common stockholders is computed by giving effect to all potential dilutive common stock equivalents outstanding for the period. In periods when we have incurred a net loss, convertible preferred stock, options to purchase common stock and convertible preferred stock warrants are considered common stock equivalents but have been excluded from the calculation of diluted net loss per share attributable to common stockholders as their effect is antidilutive.\\nRecent Accounting Pronouncement\\nIn July 2013, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update (“ASU”) 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. The ASU concludes an unrecognized tax benefit should be presented as a reduction of a deferred tax asset when settlement in this manner is available under the law. The Company adopted this amendment as of January 1, 2014, which did not have a significant impact on the balance sheet.\\nIn May 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”), which converges the FASB and the International Accounting Standards Board standards on revenue recognition. Areas of revenue recognition that will be affected include, but are not limited to, transfer of control, variable consideration, allocation of transfer pricing, licenses, time value of money, contract costs and disclosures. This guidance is effective for the fiscal years and interim reporting periods beginning after December 15, 2016, at which time the Company may adopt the new standard under the full retrospective method or the modified retrospective method. Early adoption is not permitted. The Company has not yet selected a transition method nor has the Company determined the impact of the new standard on its financial statements and related disclosures.\\n3. Fair Value Measurements\\nFinancial assets and liabilities are recorded at fair value. The carrying amounts of certain of the Company’s financial instruments, including cash equivalents, accounts receivable and accounts payable, are valued at cost, which approximates fair value due to their short maturities. The accounting guidance for fair value provides a framework for measuring fair value, and requires certain new disclosures about how fair value is determined. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the reporting date. The accounting guidance also establishes a three-level valuation hierarchy that prioritizes the inputs to valuation techniques used to measure fair value based upon whether such inputs are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect market assumptions made by the reporting entity.\\nThe three-level hierarchy for the inputs to valuation techniques is briefly summarized as follows:\\n\\n| Level 1 | – | Observable inputs such as quoted prices (unadjusted) for identical instruments in active markets. |\\n| Level 2 | – | Observable inputs such as quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, or model-derived valuations whose significant inputs are observable. |\\n| Level 3 | – | Unobservable inputs that reflect the reporting entity’s own assumptions. |\\n\\n7\\nThe following table sets forth the fair value of the Company’s financial assets and liabilities measured on a recurring basis by level within the fair value hierarchy:\\n\\n| June 30, 2014 |\\n| Total | Level 1 | Level 2 | Level 3 |\\n| (In thousands) |\\n| Assets: |\\n| Money market funds | $ | 116,653 | $ | 116,653 | $ | — | $ | — |\\n| Certificates of deposit | 180 | — | 180 | — |\\n| Total | $ | 116,833 | $ | 116,653 | $ | 180 | $ | — |\\n\\n\\n| December 31, 2013 |\\n| Total | Level 1 | Level 2 | Level 3 |\\n| (In thousands) |\\n| Assets: |\\n| Money market funds | $ | 32,472 | $ | 32,472 | $ | — | $ | — |\\n| Certificates of deposit | 180 | — | 180 | — |\\n| Total | $ | 32,652 | $ | 32,472 | $ | 180 | $ | — |\\n| Liabilities: |\\n| Convertible preferred stock warrant liability | $ | 6,456 | $ | — | $ | — | $ | 6,456 |\\n| Total | $ | 6,456 | $ | — | $ | — | $ | 6,456 |\\n\\nWhere quoted prices are available in an active market, securities are classified as Level 1. The Company classifies money market funds as Level 1. When quoted market prices are not available for the specific security, then the Company estimates fair value by using benchmark yields, reported trades, broker/dealer quotes, and issuer spreads. The Company classifies certificates of deposit as Level 2. In certain cases where there is limited activity or less transparency around inputs to valuation, securities are classified as Level 3. There were no transfers between Level 1 and Level 2 during the periods presented.\\nLevel 3 liabilities that are measured at fair value on a recurring basis consist of the preferred stock warrant liability, which was measured using the probability weighted expected return method that calculated the probability of the Company going public or being acquired, and the option-pricing method for remaining private in the near to mid-term. The fair value of the preferred stock warrant liability as of December 31, 2013 was estimated using such scenarios that were weighted based on the Company’s estimate of the probability of each scenario: 20% for IPO; 10% for merger and 70% for stay private as of December 31, 2013. The preferred stock warrant liability was remeasured prior to the net exercise of the warrants using the IPO price. At the end of each reporting period, the change in estimated fair value during the period is recorded in change in fair value of convertible preferred stock warrant liability in the statements of operations and comprehensive income (loss). Generally, increases or decreases in the fair value of the underlying convertible preferred stock would result in a directionally similar impact in the fair value measurement of the warrant liability. The preferred stock warrants were net exercised and converted to common stock upon the completion of the IPO and are no longer subject to remeasurement.\\nThe following table sets forth a summary of the changes in the estimated fair value of the Company’s preferred stock warrants which were measured at fair value on a recurring basis (in thousands):\\n\\n| ConvertiblePreferred StockWarrant Liability |\\n| Balance at December 31, 2013 | $ | 6,456 |\\n| Net increase in fair value of warrant liabilities upon revaluation | 1,593 |\\n| Reclassification of warrant liability to additional paid-in capital | (8,049 | ) |\\n| Balance at June 30, 2014 | $ | — |\\n\\n8\\n4. Collaboration and Licensing agreements\\nAstraZeneca AB (“AstraZeneca”)\\nUnder the terms of the AstraZeneca collaboration partnership agreement, the Company received an up-front license fee of $35.0 million in October 2012 and a $15.0 million payment in December 2013, which are both being recognized as revenue on a straight-line basis over the estimated period of performance, which is currently estimated to be December 2016. AstraZeneca reimburses the Company for its internal and external development-related costs. These reimbursements are recognized as collaborative development revenue when the development-related costs are incurred.\\nIn May 2014, the Company received from AstraZeneca a $25.0 million payment as a result of the dosing of the first patient in the Phase 2b clinical trial in hyperphosphatemia. As the $25.0 million did not meet the criteria to be considered the achievement of a substantive milestone for accounting purposes, the amount was recorded as deferred revenue when received and is being recognized as revenue on a straight-line basis over the remaining estimated period of performance under the AstraZeneca collaboration partnership agreement, which is currently estimated to be December 2016.\\nAs of June 30, 2014, the Company was eligible to receive future contingent payments up to a total of $795.0 million, which is comprised of future development milestones up to an additional $197.5 million and launch, commercialization, and sales milestones up to an additional $597.5 million. The contingent payments are triggered upon the activities expected to be undertaken by AstraZeneca. Revenue from milestones, if they are nonrefundable and deemed substantive, are recognized upon successful accomplishment of the milestone. The Company will recognize revenue associated with non-substantive milestones upon achievement of the milestones if there are no undelivered elements and it has no remaining performance obligation. To the extent that non-substantive milestones are achieved and the Company has remaining performance obligations, milestones are deferred and recognized as revenue over the estimated remaining period of performance.\\nFor the three months ended June 30, 2014 and 2013, the Company recognized revenue of $6.5 million and $2.0 million, respectively, related to amortization of the up-front and other license fees, and $2.6 million and $5.3 million for collaborative development services. For the six months ended June 30, 2014 and 2013, the Company recognized revenues of $9.7 million and $4.0 million, respectively, related to amortization of the up-front and other license fees, and $7.9 million and $9.9 million for collaborative development services. As of June 30, 2014 and December 31, 2013, the Company had total deferred revenue of $56.4 million and $40.3 million related to the AstraZeneca license agreement.\\nSanofi SA (“Sanofi”)\\nIn February 2014, the Company entered into a License Option and License Agreement with Sanofi (“Option and License Agreement”) for its NaP2b phosphate transport inhibitor program. NaP2b is an intestinal phosphate transporter whose activity accounts for a significant portion of dietary phosphate absorption in humans. The inhibition of NaP2b is believed to have utility for the treatment of hyperphosphatemia (elevated serum phosphate) in patients with end stage renal disease (ESRD) and other forms of chronic kidney disease (CKD). Under the Option and License Agreement, the Company granted Sanofi an exclusive worldwide license to conduct research utilizing the Company’s small molecule NaP2b inhibitors. In addition, Sanofi has the option to obtain an exclusive license to develop, manufacture and commercialize the Company’s NaP2b inhibitors. Sanofi is advancing this program towards first-in-human clinical trials. Under the Option and License Agreement, Sanofi is responsible for all of the costs and expenses for research and preclinical activities and, should it exercise its option, for the development and commercialization efforts under the program. Under the Option and License Agreement, the Company received a payment of $1.25 million, which was recognized as revenue after the Company provided to Sanofi the background know-how, listed patents, and materials (together, the “Technology Transfer Deliverables”) in May 2014 pursuant to the Option and License Agreement.\\nThe Company has the potential to earn future development, regulatory and commercial milestone payments of up to $196.8 million if Sanofi continues to advance the program into development and through commercialization. If a NaP2b inhibitor is commercialized by Sanofi as a result of this program, the Company will receive tiered royalties ranging from mid-single digits into the low double digits. As part of the arrangement with Sanofi, the Company retains an option to participate in co-promotional activities in the United States. Future potential milestone payments do not meet the criteria to be considered substantive milestones, and therefore will be treated as other contingent consideration and recognized as revenue as they are achieved as the Company has no performance obligations under the Option and License Agreement. No milestones have been received since the inception of the agreement.\\n9\\n5. Stock Incentive Plan\\nAs of June 30, 2014, a total of 2,149,021 shares of common stock had been reserved for issuance under the 2008 Plan, and no shares are available for future grant. The 2014 Equity Incentive Award Plan (“2014 Plan”) became effective on June 18, 2014, immediately prior to the time the Company’s Registration Statement on Form S-1 became effective. Under the 2014 Plan, 1,419,328 shares of common stock were initially reserved for issuance pursuant to a variety of stock-based compensation awards, including stock options, stock appreciation rights, or SARs, restricted stock awards, restricted stock unit awards, deferred stock awards, deferred stock unit awards, dividend equivalent awards, stock payment awards and performance awards. In addition, 35,221 shares that had been available for future awards under the 2008 Plan as of June 18, 2014, were added to the initial reserve available under the 2014 Plan, bringing the total reserve upon the effective date of the 2014 Plan to 1,454,549. The number of shares initially reserved for issuance or transfer pursuant to awards under the 2014 Plan will be increased by (i) the number of shares represented by awards outstanding under 2008 Plan on June 18, 2014, that are forfeited or lapse unexercised (ii) if approved by the Administrator of the 2014 Plan, an annual increase on the first day of each fiscal year beginning in 2015 and ending in 2024, equal to the lesser of (A) four percent (4.0%) of the shares of stock outstanding (on an as converted basis) on the last day of the immediately preceding fiscal year and (B) such smaller number of shares of stock as determined by our board of directors; provided, however, that no more than 10,683,053 shares of stock may be issued upon the exercise of incentive stock options. The Company also adopted the 2014 Employee Stock Purchase Plan (ESPP) and initially reserved 202,762 shares of common stock as of its effective date of June 18, 2014. If approved by the Administrator of the ESPP, on the first day of each calendar year, beginning in 2015 and ending in 2024, the number of shares in the reserve will increase by at least an amount equal to the lesser of (i) one percent (1.0%) of the shares of common stock outstanding on the last day of the immediately preceding fiscal year and (ii) such number of shares of common stock as determined by the board of directors; provided, however, no more than 2,230,374 shares of our common stock may be issued under the ESPP.\\nThe following table summarizes activity under the 2008 Plan and the 2014 Plan, including grants to nonemployees and restricted stock issued:\\n\\n| Shares Availablefor Grant | OptionsOutstanding | WeightedAverageExercise Priceper Share | AggregateIntrinsicValue(in thousands) |\\n| Balances at December 31, 2013 | 3,914 | 1,162,829 | $ | 1.03 |\\n| Options authorized under the 2008 Plan | 33,333 | — |\\n| Options authorized under the 2014 Plan | 1,419,328 | — |\\n| Options granted | (63,888 | ) | 63,888 | 13.95 |\\n| Options cancelled | 1,862 | (1,862 | ) | 0.77 |\\n| Options exercised | — | (92,781 | ) | 0.60 |\\n| Balances at June 30, 2014 | 1,394,549 | 1,132,074 | $ | 1.79 | $ | 16,050 |\\n| Vested at June 30, 2014 | 576,049 | $ | 0.91 | $ | 8,678 |\\n| Expected to vest at June 30, 2014 | 1,132,074 | $ | 1.79 | $ | 16,050 |\\n\\nThe weighted-average grant-date estimated fair value of options granted during the three and six months ended June 30, 2014 was $10.98 and $10.96, respectively, and during the three and six months ended June 30, 2013 was $0 and $2.65 per share, respectively. The aggregate intrinsic value was calculated as the difference between the exercise price of the options and the estimated fair value of the Company’s common stock of $15.97 per share as of June 30, 2014.\\nLiability for Early Exercise of Stock Options\\nAs of June 30, 2014 and December 31, 2013, there were 193,447 and 286,217 shares of common stock outstanding, respectively, subject to the Company’s right of repurchase at prices ranging from $0.27 to $1.08 per share. As of June 30, 2014 and December 31, 2013, the Company recorded $107,000 and $163,000, respectively, as liabilities associated with shares issued with repurchase rights.\\n10\\nStock-based Compensation\\nTotal stock-based compensation recognized was as follows (in thousands):\\n\\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\\n| 2014 | 2013 | 2014 | 2013 |\\n| Research and development | $ | 38 | $ | 50 | $ | 75 | $ | 99 |\\n| General and administrative | 61 | 32 | 88 | 91 |\\n| Total | $ | 99 | $ | 82 | $ | 163 | $ | 190 |\\n\\nAs of June 30, 2014 and December 31, 2013, there was $1.1 million and $549,000, respectively, of unrecognized stock-based compensation expense, net of estimated forfeitures, related to unvested share options with a weighted-average remaining recognition period of 1.6 and 1.8 years.\\nThe fair value of stock option awards to employees was estimated at the date of grant using a Black-Scholes option-pricing model with the following weighted-average assumptions:\\n\\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\\n| 2014 | 2013 | 2014 | 2013 |\\n| Expected term (years) | 5.77 | — | 5.79 | 6.08 |\\n| Volatility | 101 | % | — | 101 | % | 97 | % |\\n| Risk-free interest rate | 1.76 | % | — | 1.77 | % | 1.05 | % |\\n| Dividend yield | — | % | — | — | % | — | % |\\n\\nFor the three months ended June 30, 2013, there were no stock options granted.\\n6. Net Income (Loss) per Share Attributable to Common Stockholders\\nThe following table sets forth the computation of the unaudited basic and diluted net income (loss) per share attributable to common stockholders (in thousands, except share and per share data):\\n\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2014 | 2013 | 2014 | 2013 |\\n| Net income (loss) | $ | 3,753 | $ | (891 | ) | $ | 682 | $ | (1,361 | ) |\\n| Noncumulative dividends on convertible preferred stock | (1,099 | ) | — | (682 | ) | — |\\n| Undistributed earnings allocated to participating securities | (2,139 | ) | — | — | — |\\n| Net income (loss) attributable to common stockholders, basic | $ | 515 | $ | (891 | ) | $ | — | $ | (1,361 | ) |\\n| Adjustment to undistributed earnings allocated to participating securities | 188 | — | — | — |\\n| Net income (loss) attributable to common stockholders, diluted | $ | 703 | $ | (891 | ) | $ | — | $ | (1,361 | ) |\\n| Basic shares: |\\n| Weighted average common shares outstanding | 2,611,259 | 1,102,093 | 1,937,509 | 1,072,583 |\\n| Diluted shares: |\\n| Weighted average effect of dilutive stock options | 765,672 | — | — | — |\\n| Weighted average convertible preferred stock warrants outstanding | 527,205 | — | — | — |\\n| 3,904,136 | 1,102,093 | 1,937,509 | 1,072,583 |\\n| Net income (loss) per share attributable to common stockholders: |\\n| Basic | $ | 0.20 | $ | (0.81 | ) | $ | — | $ | (1.27 | ) |\\n| Diluted | $ | 0.18 | $ | (0.81 | ) | $ | — | $ | (1.27 | ) |\\n\\n11\\nThe following outstanding shares of common stock equivalents were excluded from the computation of diluted net income (loss) per share attributable to common stockholders for the periods presented because including them would have been antidilutive:\\n\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2014 | 2013 | 2014 | 2013 |\\n| Convertible preferred stock | — | 11,517,222 | — | 11,517,222 |\\n| Options to purchase common stock | 12,459 | 1,215,262 | 1,132,074 | 1,215,262 |\\n| Warrants to purchase convertible preferred stock | — | 574,953 | — | 574,953 |\\n| Total | 12,459 | 13,307,437 | 1,132,074 | 13,307,437 |\\n\\n7. Related Party Transactions\\nAs part of the consulting arrangement with the spouse of an executive of the Company to provide research and development services related to clinical operations, the Company incurred expenses of $60,000 and $64,000 for services rendered during the three months ended June 30, 2014 and 2013, respectively and $120,000 and $126,000 for services rendered during the six months ended June 30, 2014 and 2013, respectively. As of June 30, 2014 and December 31, 2013, the Company owed $20,000 and $18,000, respectively, to the individual, which is recorded in accounts payable.\\n12\\n\\n\\nITEM 2.\\nMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.\\nYou should read the following discussion in conjunction with our condensed financial statements (unaudited) and related notes included elsewhere in this report. This Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. All statements other than statements of historical facts contained in this report are forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “could,” “will,” “would,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “intend,” “predict,” “seek,” “contemplate,” “potential” or “continue” or the negative of these terms or other comparable terminology. These forward-looking statements, include, but are not limited to, the initiation, timing, progress and results of our preclinical studies and clinical trials, and our research and development programs; our ability to advance product candidates into, and successfully complete, clinical trials; our receipt of future milestone payments and/or royalties, and the expected timing of such payments; our collaborators’ exercise of their license options; the commercialization of our product candidates; the implementation of our business model, strategic plans for our business, product candidates and technology; the scope of protection we are able to establish and maintain for intellectual property rights covering our product candidates and technology; estimates of our expenses, future revenues, capital requirements and our needs for additional financing; the timing or likelihood of regulatory filings and approvals; our ability to maintain and establish collaborations or obtain additional government grant funding; our use of proceeds from our IPO; our financial performance; and developments relating to our competitors and our industry. These statements reflect our current views with respect to future events or our future financial performance, are based on assumptions, and involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Given these uncertainties, you should not place undue reliance on these forward-looking statements. Factors that may cause actual results to differ materially from current expectations include, among other things, those listed under “Risk Factors” in the Prospectus or described elsewhere in this Quarterly Report on Form 10-Q. These forward-looking statements speak only as of the date hereof. Except as required by law, we assume no obligation to update or revise these forward-looking statements for any reason, even if new information becomes available in the future. Unless the context requires otherwise, in this Quarterly Report on Form 10-Q, the terms “Ardelyx,” “Company,” “we,” “us” and “our” refer to Ardelyx, Inc., a Delaware corporation.\\nOverview\\nWe are a clinical-stage biopharmaceutical company focused on the discovery, development and commercialization of innovative, non-systemic, small molecule therapeutics that work exclusively in the gastrointestinal, or GI, tract to treat cardio-renal, GI and metabolic diseases. We have developed a proprietary drug discovery and design platform enabling us, in a rapid and cost-efficient manner, to discover and design novel drug candidates. Utilizing our platform, we discovered and designed our lead product candidate, tenapanor, which in preclinical and clinical studies has consistently demonstrated the ability to reduce the absorption of dietary sodium and phosphorus. To enhance our proprietary drug discovery and design platform, we have developed a cell-culture system to simulate gut tissues called the Ardelyx Primary Enterocyte and Colonocyte Culture System, or APECCS. We have also identified over 3,800 proteins on the inner surface of the gut, many of which we believe may be drug targets. In addition to tenapanor, we have discovered small molecule NaP2b inhibitors for the treatment of hyperphosphatemia in end stage renal disease, or ESRD, a program we have licensed to Sanofi S.A., or Sanofi. We are also independently advancing three other discovery and lead development programs focused in cardio-renal, GI and metabolic diseases.\\nIn October 2012, we entered into a collaboration partnership with AstraZeneca AB, or AstraZeneca, for the worldwide development and commercialization of tenapanor. AstraZeneca is responsible for all of the development and commercialization costs for tenapanor, and we have retained an option to co-promote in the United States. Together with AstraZeneca, we are evaluating tenapanor in three Phase 2 clinical trials in patients with ESRD, late-stage CKD, and constipation-predominant irritable bowel syndrome, or IBS-C. If we exercise our right to co-fund the first Phase 3 clinical development program for tenapanor, we may invest $20.0 million, $30.0 million or $40.0 million to acquire an increase of 1%, 2% or 3%, respectively, in the royalties payable to us by AstraZeneca on net sales of tenapanor. In December 2013, we entered into an amendment to the license agreement to acknowledge the intention of AstraZeneca to commence development of tenapanor for the treatment of hyperphosphatemia in ESRD patients and to provide additional clarification for certain payments. There was no change in the total consideration that we could receive under the agreement.\\nThrough our participation with AstraZeneca on a development collaboration committee, we are involved in the management and oversight of the development of tenapanor and participation will continue until all of Phase 2 clinical trials with tenapanor have been completed. In addition, we are directly responsible for the conduct of certain specified clinical trials being conducted with tenapanor. AstraZeneca reimburses us for our internal and external costs related to those development efforts, and any other development efforts that may be assigned to us by the development collaboration committee. We were initially responsible for supplying tenapanor for use in development. The agreement also obligates us to transfer the technology and other necessary information such that AstraZeneca will be able to assume the responsibility for the supply of the drug product for use in later-stage clinical trials.\\n13\\nUnder the terms of the agreement with AstraZeneca, we received a $35.0 million upfront payment and we are eligible to receive up to $237.5 million in development milestones, of which we have received $40.0 million as of June 30, 2014. The $40.0 million in development milestones consists of a payment of $15.0 million that we received in December 2013 and a payment of $25.0 million that we received in May 2014 as a result of the dosing of the first patient in the Phase 2b ESRD clinical trial in hyperphosphatemia in April 2014. In addition to the $237.5 million in total development milestones, we are also eligible to receive up to $597.5 million in sales and launch milestones. Through June 30, 2014, we also received $29.1 million in reimbursement for our development efforts provided under the agreement. We are also eligible to receive incremental tiered royalties based on aggregate annual net sales of each licensed product starting in the high single digits and increasing to high teen percentages as annual net sales increase, subject to an increase related to our co-fund election, if we decide to make such an election.\\nWe have identified the deliverables within the arrangement as a license to the technology, the initial supply of the compound of the licensed product for use in development, and ongoing development activities through completion of all Phase 2 clinical trials to be conducted with tenapanor, which are accounted for as a single unit of accounting. We have concluded that the license is not a separate unit of accounting. It does not have stand-alone value to AstraZeneca, separable from the development services to be performed pursuant to the agreement, as AstraZeneca is unable to use the license for its intended purpose without our performance of the development services, which includes the initial supply of the compound of the licensed product. As a result, we recognize revenue from the $35.0 million up-front payment on a straight-line basis over the period from the effective date of the agreement through the completion of all Phase 2 clinical trials to be conducted with tenapanor, which we currently estimate to be December 2016, and we recognize revenue from the $15.0 million and the $25.0 million development milestone payments on a straight-line basis over the same estimated completion date.\\nIn 2014, we entered into an option and license agreement with Sanofi under which we granted Sanofi an exclusive worldwide license to conduct research utilizing our small molecule NaP2b inhibitors. In addition, Sanofi has the option to obtain an exclusive license to develop, manufacture and commercialize our NaP2b inhibitors. Sanofi is advancing this program towards first-in-human clinical trials. Under our arrangement, Sanofi is responsible for all of the costs and expenses for research and preclinical activities and, should it exercise its option, for the development and commercialization efforts under the program. Under the license option and license agreement, we received an upfront payment of $1.25 million and are responsible for up to $0.2 million of patent costs, at which point any additional patent costs will be fully reimbursed to us by Sanofi. We have the potential to earn future development, regulatory and commercial milestone payments of up to $196.75 million if Sanofi continues to advance the program into development and through commercialization. If a NaP2b inhibitor is commercialized by Sanofi as a result of this program, we will receive tiered royalties ranging from the mid-single digits into the low double digits. As part of our agreement with Sanofi, we retain an option to co-promote licensed products in the United States. We recognized the $1.25 million to revenue after we completed the Technology Transfer Deliverables in May 2014 pursuant to the Option and License Agreement.\\nOur revenue to date has been generated from collaboration and license revenue pursuant to our license agreements with AstraZeneca, and Sanofi. We have not generated any commercial product revenue. As of June 30, 2014, we had accumulated deficit of $68.0 million. We have incurred significant losses in the past and may continue to incur significant losses in the future as we advance our unpartnered preclinical programs. The significance of future losses will be dependent in part on whether AstraZeneca continues to develop and advance tenapanor, and whether Sanofi exercises its option to obtain an exclusive license to develop, manufacture and commercialize our NaP2b inhibitors, which in either case would result in milestone payments to us. There can be no assurance that we will receive additional collaboration revenue in the future.\\nInitial Public Offering\\nOn June 18, 2014, our registration statement on Form S-1 (File No. 333-196090) relating to the IPO of our common stock was declared effective by the SEC. The IPO closed on June 24, 2014 at which time we sold 4,928,900 shares of our common stock, which included 642,900 shares of common stock purchased by the underwriters upon the full exercise of their option to purchase additional shares of common stock. We received cash proceeds of $61.2 million from the IPO, net of underwriting discounts and commissions and expenses paid by us.\\n14\\nFinancial Operations Overview\\nRevenue\\nOur revenue to date has been generated from non-refundable license payments and reimbursements for research and development expenses under our license agreements. We recognize revenue from upfront payments ratably over the term of our estimated period of performance under the agreement which we consider to be licensing revenue. In addition to receiving upfront payments, we may also be entitled to milestone and other contingent payments upon achieving predefined objectives. Such payments are recorded as revenue when we achieve the underlying milestone if it is deemed to be a substantive milestone at the date the arrangement is entered into. To the extent that non-substantive milestones are achieved and we have remaining performance obligations, milestones are deferred and recognized as revenue over the estimated remaining period of performance. Reimbursements from AstraZeneca for development costs incurred under our license and collaboration agreement with them are classified as collaborative development revenue.\\nResearch and Development Expenses\\nResearch and development expenses represent costs incurred to conduct research, such as the discovery and development of our unpartnered product candidates, as well as the development of product candidates pursuant to our license agreement with AstraZeneca. We recognize all research and development costs as they are incurred.\\nResearch and development expenses consist of the following:\\n| | external research and development expenses incurred under agreements with consultants, third-party contract research organizations, or CROs, and investigative sites where a substantial portion of our clinical studies are conducted, and with contract manufacturing organizations, or CMOs, where our clinical supplies are produced; |\\n\\n| | employee-related expenses, which include salaries, benefits and stock-based compensation; and |\\n\\n| | facilities and other allocated expenses, which include direct and allocated expenses for rent and maintenance of facilities, depreciation and amortization expense and other supplies. |\\n\\nPrior to the execution of our license agreement with AstraZeneca in October 2012, we incurred $18.0 million in research and development expenses related to tenapanor. Following the execution of the license agreement and through June 30, 2014, we incurred $30.2 million in research and development expenses related to tenapanor, all of which are reimbursed by AstraZeneca under the license agreement. The reimbursements are recognized in collaborative development revenue in the Statement of Operations and Comprehensive Income (Loss).\\nThe following table summarizes our research and development expenses during the three and six months ended June 30, 2014 and 2013 (in thousands):\\n\\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\\n| 2014 | 2013 | 2014 | 2013 |\\n| Discovery research expense | $ | 2,562 | $ | 2,052 | $ | 4,922 | $ | 3,761 |\\n| AstraZeneca collaboration development expense | 2,621 | 5,182 | 7,898 | 9,412 |\\n| Total research and development expenses | $ | 5,183 | $ | 7,234 | $ | 12,820 | $ | 13,173 |\\n\\nWe expect our unpartnered research and development expenses will increase in the future as we progress our internal product candidates, advance our discovery research projects into the preclinical stage and continue our early stage research including further development of our APECCS cell-culture system. The process of conducting preclinical studies and clinical trials necessary to obtain regulatory approval is costly and time consuming. We or our collaboration partners may never succeed in achieving marketing approval for any of our product candidates. The probability of success of each of the product candidates may be affected by numerous factors, including preclinical data, clinical data, competition, manufacturing capability and commercial viability.\\nMost of our product development programs are at an early stage; therefore, the successful development of our product candidates is highly uncertain and may not result in approved products. Completion dates and completion costs can vary significantly for each product candidate and are difficult to predict. Given the uncertainty associated with clinical trial enrollment and the risks inherent in the development process, we are unable to determine the duration and completion costs of current or future clinical trials of our product candidates or if and to what extent we will generate revenues from the commercialization and sale of any of our product candidates. We anticipate that we and our collaboration partners will make determinations as to which programs to pursue and how much funding to direct to each program on an ongoing basis in response to the scientific and clinical success of each product candidate, as well as an ongoing assessment as to each product candidate’s commercial potential. We will need to raise additional\\n15\\ncapital or may seek additional collaboration partnerships in the future in order to complete the development and commercialization of our product candidates.\\nGeneral and Administrative\\nGeneral and administrative expenses includes personnel costs, travel expenses and other expenses for outside professional services, including legal, human resources, audit and accounting services. Personnel costs includes salaries, bonus, benefits and stock-based compensation. We expect to incur additional expenses as a result of being a public company following the completion of our IPO in June 2014, including expenses to comply with the rules and regulations applicable to companies listed on a national securities exchange and costs related to compliance and reporting obligations pursuant to the rules and regulations of the SEC, as well as increases in expenses for additional insurance, investor relations activities and other administration and professional services.\\nChange in Fair Value of Convertible Preferred Stock Warrant Liability\\nChange in fair value of convertible preferred stock warrant liability was the fair value remeasurement of our liability related to our convertible preferred stock warrants. We recorded adjustments to the estimated fair value of the convertible preferred stock warrants until they were net exercised prior to the completion of our IPO and then converted into common stock. At that time, the convertible preferred stock warrant liability was reclassified to additional paid-in capital and we no longer record any related periodic fair value adjustments.\\nProvision for Income Taxes\\nWe did not record a provision for income taxes for the three and six months ended June 30, 2014 because we expect to generate a net operating loss for the year ending December 31, 2014. Our deferred tax assets continue to be fully offset by a valuation allowance.\\nProvision for income taxes for the 2013 periods consists of California state income taxes as we were required to pay the Alternative Minimum Tax for the $35.0 million upfront payment received from AstraZeneca in 2012.\\nCritical Accounting Polices and Estimates\\nThe discussion and analysis of our financial condition and results of operations are based upon our unaudited condensed financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our critical accounting policies and estimates. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. There have been no significant and material changes in our critical accounting policies during the three and six months ended June 30, 2014, as compared to those disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates” in the Prospectus filed with the SEC on June 19, 2014.\\n16\\nResults of Operations\\nComparison of the Three Months Ended June 30, 2014 and 2013\\n\\n| Three Months Ended June 30, | Dollar Change |\\n| 2014 | 2013 |\\n| (In thousands) |\\n| Revenue: |\\n| Licensing revenue | $ | 6,507 | $ | 1,989 | $ | 4,518 |\\n| Collaborative development revenue | 2,630 | 5,302 | (2,672 | ) |\\n| Total revenue | 9,137 | 7,291 | 1,846 |\\n| Operating expenses: |\\n| Research and development | 5,183 | 7,234 | (2,051 | ) |\\n| General and administrative | 1,203 | 908 | 295 |\\n| Total operating expenses | 6,386 | 8,142 | (1,756 | ) |\\n| Income (loss) from operations | 2,751 | (851 | ) | 3,602 |\\n| Other expense, net | (8 | ) | (4 | ) | (4 | ) |\\n| Change in fair value of preferred stock warrant liability | 1,010 | — | 1,010 |\\n| Income (loss) before provision for income taxes | 3,753 | (855 | ) | 4,608 |\\n| Provision for income taxes | — | 36 | (36 | ) |\\n| Net income (loss) | $ | 3,753 | $ | (891 | ) | $ | 4,644 |\\n\\nRevenue\\nLicensing revenue for the three months ended June 30, 2014 was $6.5 million, an increase of $4.5 million, or 227%, compared to licensing revenue of $2.0 million for the three months ended June 30, 2013. The increase was primarily due to the increased amounts recognized from the $15.0 million development milestone payment we received in December 2013 related to the amendment to the AstraZeneca agreement and the $25.0 million development milestone payment we received in May 2014 related to the dosing of the first patient in the Phase 2b ESRD clinical trial in hyperphosphatemia in April 2014, which are both being recognized ratably over our expected period of performance under the agreement. The estimated period of performance is based on the completion of all of the Phase 2 clinical trials for tenapanor. We estimate that the end of all Phase 2 clinical trials will be December 2016. The expected period of performance is reviewed quarterly and adjusted, as needed, to reflect the progress of clinical studies. The remaining increase was due to the $1.25 million we recognized pursuant to the Option and License Agreement with Sanofi.\\nCollaborative development revenue consists of our development expenses that are reimbursable to us by AstraZeneca as part of our license agreement. Collaborative development revenue for the three months ended June 30, 2014 was $2.6 million, a decrease of $2.7 million, or 50%, compared to $5.3 million for the three months ended June 30, 2013. The decrease was primarily because of a decrease in our development activities related to the clinical trials that are a part of the AstraZeneca agreement.\\nResearch and Development\\nResearch and development expenses were $5.2 million for the three months ended June 30, 2014, a decrease of $2.1 million, or 28%, compared to $7.2 million for the three months ended June 30, 2013. The decrease was primarily driven by a $2.6 million decrease in development activities related to tenapanor conducted by Ardelyx in accordance with the AstraZeneca agreement. Discovery research expenses increased by $0.5 million due to an increase in our research activities for non-partnered programs.\\nGeneral and Administrative\\nGeneral and administrative expenses were $1.2 million for the three months ended June 30, 2014, an increase of $0.3 million, or 32%, compared to $0.9 million for the three months ended June 30, 2013. The increase was primarily due to an increase in professional services fees of $0.1 million and an increase of $0.1 million in personnel related expenses.\\nChange in Fair Value of Preferred Stock Warrant Liability\\nChange in fair value of preferred stock warrant liability was $1.0 million of income for the three months ended June 30, 2014 compared to zero for the three months ended June 30, 2013. The change was due to a decrease in the fair value of our convertible preferred stock over the three month period.\\n17\\nComparison of the Six Months Ended June 30, 2014 and 2013\\n| Six Months Ended June 30, | Dollar Change |\\n| 2014 | 2013 |\\n| (In thousands) |\\n| Revenue: |\\n| Licensing revenue | $ | 9,743 | $ | 3,978 | $ | 5,765 |\\n| Collaborative development revenue | 7,944 | 9,869 | (1,925 | ) |\\n| Total revenue | 17,687 | 13,847 | 3,840 |\\n| Operating expenses: |\\n| Research and development | 12,820 | 13,173 | (353 | ) |\\n| General and administrative | 2,580 | 1,935 | 645 |\\n| Total operating expenses | 15,400 | 15,108 | 292 |\\n| Income (loss) from operations | 2,287 | (1,261 | ) | 3,548 |\\n| Other expense, net | (12 | ) | (29 | ) | 17 |\\n| Change in fair value of preferred stock warrant liability | (1,593 | ) | — | (1,593 | ) |\\n| Income (loss) before provision for income taxes | 682 | (1,290 | ) | 1,972 |\\n| Provision for income taxes | — | 71 | (71 | ) |\\n| Net income (loss) | $ | 682 | $ | (1,361 | ) | $ | 2,043 |\\n\\nRevenue\\nLicensing revenue for the six months ended June 30, 2014 was $9.7 million, an increase of $5.8 million, or 145%, compared to total licensing revenue of $4.0 million for the six months ended June 30, 2013. The increase was primarily due to the increased amounts recognized from the $15.0 million development milestone payment we received in December 2013 related to the amendment to the AstraZeneca agreement and the $25.0 million development milestone payment we received in May 2014 related to the dosing of the first patient in the Phase 2b ESRD clinical trial in hyperphosphatemia in April 2014, which are both being recognized ratably over our expected period of performance under the agreement. The estimated period of performance is based on the completion of all of the Phase 2 clinical trials for tenapanor. We estimate that the end of all Phase 2 clinical trials will be December 2016. The expected period of performance is reviewed quarterly and adjusted, as needed, to reflect the progress of clinical studies. The remaining increase was due to the $1.25 million we recognized in May 2014 pursuant to the Option and License Agreement with Sanofi.\\nCollaborative development revenue consists of our development expenses that are reimbursable to us by AstraZeneca as part of our license agreement. Collaborative development revenue for the six months ended June 30, 2014 was $7.9 million, a decrease of $1.9 million, or 20%, compared to $9.9 million for the six months ended June 30, 2013. The decrease was due to a decrease in our development activities primarily related to the clinical trials that are a part of the AstraZeneca agreement.\\nResearch and Development\\nResearch and development expenses were $12.8 million for the six months ended June 30, 2014, a decrease of $0.4 million, or 3%, compared to $13.2 million for the six months ended June 30, 2013. The decrease in AstraZeneca collaboration development expense of $1.5 million was primarily driven by the decrease in development activities related to tenapanor conducted by Ardelyx under the license agreement with AstraZeneca. Discovery research expenses increased by $1.2 million due to an increase in our research activities for non-partnered programs.\\nGeneral and Administrative\\nGeneral and administrative expenses were $2.6 million for the six months ended June 30, 2014, an increase of $0.6 million, or 33%, compared to $1.9 million for the six months ended June 30, 2013. The increase was primarily due to an increase in professional services fees of $0.4 million and an increase of $0.2 million personnel related expenses.\\nChange in Fair Value of Preferred Stock Warrant Liability\\nChange in fair value of preferred stock warrant liability was $1.6 million for the six months ended June 30, 2014, an increase of $1.6 million compared to zero for the six months ended June 30, 2013. The increase was due to an increase in the fair value of our convertible preferred stock over the six month period.\\n18\\nLiquidity and Capital Resources\\nAs of June 30, 2014, we had cash and cash equivalents totaling $117.8 million. In connection with our IPO, we received cash proceeds of $61.2 million, net of underwriters’ discounts and commissions and expenses paid by the Company in June 2014. Prior to the IPO, we funded our operations primarily with cash flows from the sales of our convertible preferred stock in private placements and from the upfront payments and other collaboration related payments received from our collaboration partners AstraZeneca and Sanofi.\\nOur primary uses of cash are to fund operating expenses, primarily research and development expenditures. Cash used to fund operating expenses is impacted by the timing of when we pay these expenses, as reflected in the change in our outstanding accounts payable and accrued expenses.\\nWe believe that our existing capital resources as of June 30, 2014 will be sufficient to meet our projected operating requirements for at least the next 12 months. We have based this estimate on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we currently expect. Further, our operating plan may change, and we may need additional funds to meet operational needs and capital requirements for clinical trials and other research and development expenditures. We currently have no credit facility or committed sources of capital other than potential milestones receivable under our current collaboration partnerships. Because of the numerous risks and uncertainties associated with the development and commercialization of our product candidates and the extent to which we may enter into additional collaboration partnerships with third parties to participate in their development and commercialization, we are unable to estimate the amounts of increased capital outlays and operating expenditures associated with our current and anticipated clinical studies. Our future funding requirements will depend on many factors, including the following:\\n| | our decision whether or not to exercise our right to co-fund the first Phase 3 clinical development program for tenapanor, in which we may invest $20.0 million, $30.0 million or $40.0 million to acquire an increase of 1%, 2% or 3%, respectively, in the royalties payable to us by AstraZeneca on net sales of tenapanor; |\\n\\n| | the achievement of development and regulatory milestones resulting in the payment to us from our collaboration partners of contractual milestone payments and the timing of the receipt of such payments, if any; |\\n\\n| | the progress, timing, scope, results and costs of our preclinical studies and clinical trials for our product candidates that have not been licensed, including the ability to enroll patients in a timely manner for clinical trials; |\\n\\n| | the time and cost necessary to obtain regulatory approvals for our product candidates that have not been licensed and the costs of post-marketing studies that could be required by regulatory authorities; |\\n\\n| | our ability and the ability of our collaboration partners to successfully commercialize and/or co-promote our product candidates; |\\n\\n| | the manufacturing, selling and marketing costs associated with product candidates, including the cost and timing of building our sales and marketing capabilities; |\\n\\n| | our ability to establish and maintain collaboration partnerships, in-license/out-license or other similar arrangements and the financial terms of such agreements; |\\n\\n| | the timing, receipt, and amount of sales of, or royalties on, our future products, if any; |\\n\\n| | the sales price and the availability of adequate third-party reimbursement for our product candidates; |\\n\\n| | the cash requirements of any future acquisitions or discovery of product candidates; |\\n\\n| | the number and scope of preclinical and discovery programs that we decide to pursue or initiate; |\\n\\n| | the time and cost necessary to respond to technological and market developments; and |\\n\\n| | the costs of filing, prosecuting, maintaining, defending and enforcing any patent claims and other intellectual property rights, including litigation costs and the outcome of such litigation, including costs of defending any claims of infringement brought by others in connection with the development, manufacture or commercialization of our product candidates. |\\n\\n19\\nThe following table summarizes our cash flows for the periods indicated (in thousands):\\n\\n| Six MonthsEnded June 30, |\\n| 2014 | 2013 |\\n| Cash provided by (used in) operating activities | $ | 22,874 | $ | (8,897 | ) |\\n| Cash used in investing activities | (736 | ) | (257 | ) |\\n| Cash provided by financing activities | 61,241 | — |\\n| Net increase (decrease) in cash and cash equivalents | $ | 83,379 | $ | (9,154 | ) |\\n\\nCash Flows from Operating Activities\\nCash provided by operating activities for the six months ended June 30, 2014 was $22.9 million, consisting of net income of $0.7 million, non-cash charges of $0.1 million for depreciation and amortization expense, $0.2 million for stock-based compensation, $1.6 million for the change in the fair value remeasurement of our convertible preferred stock warrant liability and a net increase of $20.3 million in our net operating assets and liabilities. The changes in our net operating assets and liabilities was primarily due to a $16.1 million increase in deferred revenue which was mainly driven by the $25.0 million payment received in May 2014 in connection with our agreement with AstraZeneca, a $3.4 million decrease in our accounts receivable due to the timing of payments received from AstraZeneca for reimbursable costs incurred under our licensing agreement and a $0.9 million increase in our other accrued liabilities due to the timing of payments.\\nCash used in operating activities for the six months ended June 30, 2013 was $8.9 million, consisting of a net loss of $1.4 million, which was partially offset by non-cash charges of $0.4 million for depreciation and amortization, $0.2 million for stock-based compensation and a net decrease of $8.1 million in our net operating assets and liabilities. The cash used as a result of the changes in our net operating assets and liabilities was due primarily to a $2.9 million decrease in deferred revenue which was mainly driven by the amortization of the $35.0 million up-front payment received in connection with our agreement with AstraZeneca and a $3.9 million increase in our accounts receivable due to the timing of payments received from AstraZeneca for reimbursable costs incurred under our licensing agreement and a $1.2 million increase in prepaid expenses and other assets related to advance payments made to vendors for clinical development activities. These changes were partially offset by a $1.1 million increase in our accounts payable due to the timing of payments.\\nCash Flows from Investing Activities\\nCash used in investing activities for the six months ended June 30, 2014 and 2013 of $0.7 million and $0.3 million was related to our acquisition of property and equipment related to the expansion of our laboratory and related equipment.\\nCash Flows from Financing Activities\\nCash provided by financing activities for the six months ended June 30, 2014 was due to the IPO proceeds of $61.2 million.\\nOff-Balance Sheet Arrangements\\nAs of June 30, 2014, we did not have any off-balance sheet arrangements or any holdings in variable interest entities.\\nRecent Accounting Pronouncement\\nIn July 2013, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update, or ASU 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. The ASU concludes an unrecognized tax benefit should be presented as a reduction of a deferred tax asset when settlement in this manner is available under the law. We adopted this amendment as of January 1, 2014, which did not have a significant impact on the balance sheet.\\nIn May 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers, or ASU 2014-09, which converges the FASB and the International Accounting Standards Board standards on revenue recognition. Areas of revenue recognition that will be affected include, but are not limited to, transfer of control, variable consideration, allocation of transfer pricing, licenses, time value of money, contract costs and disclosures. This guidance is effective for the fiscal years and interim reporting periods beginning after December 15, 2016, at which time we may adopt the new standard under the full retrospective method or the modified retrospective method. Early adoption is not permitted. We have not yet selected a transition method nor have we determined the impact of the new standard on our financial statements and related disclosures\\n20\\n\\n\\nITEM 3.\\nQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nWe are exposed to market risks in the ordinary course of our business. These risks primarily include risk related to interest rate sensitivities. We had cash and cash equivalents of $117.8 million as of June 30, 2014, which consist of bank deposits and money market funds. Such interest-earning instruments carry a degree of interest rate risk; however, historical fluctuations in interest income have not been significant. We had no outstanding debt as of June 30, 2014.\\n\\n\\nITEM 4.\\nCONTROLS AND PROCEDURES\\nEvaluation of Disclosure Controls and Procedures\\nAs required by Rule 13a-15(b) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), our management, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2014. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate, to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of June 30, 2014, our Chief Executive Officer and Chief Financial Officer have concluded that, as of June 30, 2014, our disclosure controls and procedures were effective at the reasonable assurance level.\\nChanges in Internal Control over Financial Reporting\\nThere were no changes in our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15(d) and 15d-15(d) of the Exchange Act that occurred during the quarter ended June 30, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\nPART II. OTHER INFORMATION\\n\\n\\nITEM 1.\\nLEGAL PROCEEDINGS\\nWe are not currently a party to any material litigation or other material legal proceedings.\\n\\n\\nITEM 1A.\\nRISK FACTORS\\nOur business involves significant risks, some of which are described below. You should carefully consider these risks, as well as other information in this Quarterly Report on Form 10-Q, including our financial statements and the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The occurrence of any of the events or developments described below could harm our business, financial condition, results of operations, cash flows, the trading price of our common stock and our growth prospects. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations.\\nRisks Related to Our Limited Operating History, Financial Condition and Capital Requirements\\nWe have a limited operating history, have incurred significant losses since our inception and we will incur losses in the future. We have only one product candidate in clinical trials and no product sales, which, together with our limited operating history, makes it difficult to assess our future viability.\\nWe are a clinical-stage biopharmaceutical company with a limited operating history. Biopharmaceutical product development is a highly speculative undertaking and involves a substantial degree of risk. To date, we have focused substantially all of our efforts on our research and development activities, including developing our lead product candidate, tenapanor, and developing our proprietary drug discovery and design platform. To date, we have not commercialized any products or generated any revenue from the sale of products. We are not profitable and have incurred losses in each year since our inception in October 2007, and we do not know whether or when we will become profitable. We have only a limited operating history upon which to evaluate our business and prospects. We continue to incur significant research, development and other expenses related to our ongoing operations. Our net loss\\n21\\nfor the years ended December 31, 2012 and 2013 was $9.8 million and $6.6 million, respectively. While we had a net income of $3.8 million and $0.7 million, respectively, for the three and six months ended June 30, 2014, this performance may not be indicative of future performance. As of June 30, 2014, we had an accumulated deficit of $68.0 million.\\nIf we do not receive anticipated milestone payments from our collaboration partners, AstraZeneca AB, or AstraZeneca and Sanofi S.A., or Sanofi, our operating losses will substantially increase for the foreseeable future as we continue our discovery, research, development, manufacturing and commercialization activities. There can be no assurance that we will receive any potential milestones under our agreements with AstraZeneca and/or Sanofi. For a discussion of the risks associated with our preclinical and clinical development programs with, and potential for milestone payments from, AstraZeneca and Sanofi, see below under “—Risks Related to Our Business.”\\nEven if we receive the anticipated milestone payments or receive royalty payments from our collaboration partners, we may not be able to achieve or sustain profitability. For example, we may choose to exercise our right to co-fund a portion of the first Phase 3 clinical development program for tenapanor, incurring expenses of up to $40.0 million, and we would likely incur continued operating losses during the period we are co-funding the program. In addition, our receipt of milestone payments from our collaboration partners may not result in the recognition of revenue in the period received, as we may be required to amortize the milestone payment over a period of time. Depending upon such requirement and the period of amortization, we may continue to incur losses even after the receipt of such milestone payments. Therefore, there can be no assurance that our losses will not increase into the future. Our prior losses, combined with possible future losses, have had and will continue to have an adverse effect on our stockholders’ equity and working capital. Further, the net losses we incur may fluctuate significantly from quarter to quarter and year to year, such that a period-to-period comparison of our results of operations may not be a good indication of our future performance.\\nWe have never generated any revenue from product sales and may never be profitable.\\nWe have no products approved for sale and have never generated any revenue from product sales. Our ability to generate revenue from product sales and achieve profitability depends on our ability, and the ability of our collaboration partners, to successfully complete the development of and obtain the regulatory and marketing approvals necessary to commercialize one or more of our product candidates. We do not anticipate generating revenue from product sales for the foreseeable future. Our ability to generate future revenue from product sales or pursuant to milestone payments depends heavily on many factors, including but not limited to:\\n| • | the completion of research and preclinical and clinical development of our product candidates; |\\n\\n| • | together with our collaboration partners, obtaining regulatory approvals for our product candidates; |\\n\\n| • | the ability of our collaboration partners to successfully commercialize and/or our ability to commercialize or co-promote, if we so choose, our product candidates; |\\n\\n| • | developing a sustainable and scalable manufacturing process for any approved product candidates and establishing and maintaining supply and manufacturing relationships with third parties that can provide adequate (in amount and quality) products to support clinical development and the market demand for our product candidates, if approved; |\\n\\n| • | obtaining market acceptance of our product candidates, if approved, as viable treatment options; |\\n\\n| • | addressing any competing technological and market developments; |\\n\\n| • | identifying, assessing, acquiring, in-licensing and/or developing new product candidates; |\\n\\n| • | negotiating favorable terms in any collaboration partnership, licensing or other arrangements into which we may enter; |\\n\\n| • | maintaining, protecting, and expanding our portfolio of intellectual property rights, including patents, trade secrets, and know-how, and our ability to develop, manufacture and commercialize our product candidates and products without infringing intellectual property rights of others; and |\\n\\n| • | attracting, hiring, and retaining qualified personnel. |\\n\\nIn cases where we, or our collaboration partners, are successful in obtaining regulatory approvals to market one or more of our product candidates, our revenue will be dependent, in part, upon the size of the markets in the territories for which regulatory approval is granted, the accepted price for the product, the ability to get reimbursement at any price and whether we have royalty and/or co-promotion rights for that territory. If the number of patients suitable for our product candidates is not as significant as we estimate, the indication approved by regulatory authorities is narrower than we expect, or the reasonably accepted population for treatment is narrowed by competition, physician choice or treatment guidelines, we may not generate significant revenue from the sale of such products, even if approved. Even if we achieve profitability in the future, we may not be able to sustain profitability in subsequent periods. Our failure to generate revenue from product sales would likely depress our market value and could impair our ability to raise capital, expand our business, discover or develop other product candidates or continue our operations. A decline in the value of our common stock could cause our stockholders to lose all or part of their investment.\\n22\\nWe may require substantial additional financing to achieve our goals, and a failure to obtain this necessary capital when needed on acceptable terms, or at all, could force us to delay, limit, reduce or terminate our product development or other operations.\\nSince our inception, most of our resources have been dedicated to our research and development activities, including developing our lead product candidate, tenapanor, and developing our proprietary drug discovery and design platform. As of June 30, 2014, we had working capital of $94.8 million, including capital resources consisting of cash and cash equivalents of $117.8 million. We believe that we will continue to expend substantial resources for the foreseeable future, including costs associated with research and development, conducting preclinical studies and clinical trials, obtaining regulatory approvals and sales and marketing. Because the outcome of any clinical trial and/or regulatory approval process is highly uncertain, we cannot reasonably estimate the actual amounts necessary to successfully complete the development, regulatory approval process and commercialization or co-promotion of any of our product candidates.\\nBased on our current operating plan, we believe that our existing capital resources will allow us to fund our operating plan through at least the next 12 months. However, our operating plan may change as a result of many factors currently unknown to us, and we may need to seek additional funds sooner than planned. Our future funding requirements will depend on many factors, including, but not limited to:\\n| • | our decision whether or not to exercise our right to co-fund the first Phase 3 clinical development program for tenapanor, in which case we may invest $20.0 million, $30.0 million or $40.0 million to acquire an increase of 1%, 2% or 3%, respectively, in the royalties payable to us by AstraZeneca on net sales of tenapanor; |\\n\\n| • | the achievement of development and regulatory milestones resulting in the payment to us from our collaboration partners of contractual milestone payments and the timing of receipt of such payments, if any; |\\n\\n| • | the progress, timing, scope, results and costs of our preclinical studies and clinical trials for our product candidates that have not been licensed, including the ability to enroll patients in a timely manner for clinical trials; |\\n\\n| • | the time and cost necessary to obtain regulatory approvals for our product candidates that have not been licensed and the costs of post-marketing studies that could be required by regulatory authorities; |\\n\\n| • | our ability and the ability of our collaboration partners to successfully commercialize and/or co-promote our product candidates; |\\n\\n| • | the manufacturing, selling and marketing costs associated with product candidates, including the cost and timing of building our sales and marketing capabilities; |\\n\\n| • | our ability to establish and maintain collaboration partnerships, in-license/out-license or other similar arrangements and the financial terms of such agreements; |\\n\\n| • | the timing, receipt, and amount of sales of, or royalties on, our future products, if any; |\\n\\n| • | the sales price and the availability of adequate third-party reimbursement for our product candidates; |\\n\\n| • | the cash requirements of any future acquisitions or discovery of product candidates; |\\n\\n| • | the number and scope of preclinical and discovery programs that we decide to pursue or initiate; |\\n\\n| • | the time and cost necessary to respond to technological and market developments; and |\\n\\n| • | the costs of filing, prosecuting, maintaining, defending and enforcing any patent claims and other intellectual property rights, including litigation costs and the outcome of such litigation, including costs of defending any claims of infringement brought by others in connection with the development, manufacture or commercialization of our product candidates. |\\n\\nAdditional funds may not be available when we need them on terms that are acceptable to us, or at all. If adequate funds are not available to us on a timely basis, we may be required to delay, limit, reduce or terminate our research and development activities, preclinical and clinical trials for our product candidates for which we retain such responsibility and our establishment and maintenance of sales and marketing capabilities or other activities that may be necessary to commercialize or co-promote our product candidates.\\n23\\nRisks Related to Our Business\\nWe are substantially dependent on the success of our lead product candidate, tenapanor, which may not be successful in nonclinical studies or clinical trials, receive regulatory approval or be successfully commercialized.\\nTo date, we have invested a significant amount of our efforts and financial resources in the research and development of tenapanor, which is currently our lead product candidate and only product candidate in clinical trials. In particular, together with AstraZeneca, our collaboration partner for tenapanor, we have completed six Phase 1 and two Phase 2 trials and are currently conducting three Phase 2 trials and one Phase 1 study. Our near-term prospects, including our ability to finance our operations through the receipt of milestone payments and generate revenue from product sales, will depend heavily on the successful development and AstraZeneca’s commercialization of tenapanor, if approved. The clinical and commercial success of tenapanor will depend on a number of factors, including the following:\\n| • | the timely completion of the ongoing clinical trials of tenapanor, which will depend substantially upon the satisfactory performance of third-party contractors; |\\n\\n| • | whether tenapanor’s safety and efficacy profile is satisfactory to the U.S. Food and Drug Administration, or FDA, and foreign regulatory authorities to warrant marketing approval; |\\n\\n| • | the timely completion of the ongoing chronic kidney disease, or CKD, Phase 2a clinical trial, which will depend substantially upon our ability to identify principal investigators with patient populations suitable for study, and the ability of those principal investigators to successfully enroll those patients into the trial; |\\n\\n| • | the results of a long-term rat carcinogenicity study required for approval of tenapanor, which will not be known for at least two and half years, and which may be delayed for a significant period of time for reasons outside of the control of AstraZeneca, particularly if AstraZeneca is required to restart or modify the study for any reason; |\\n\\n| • | whether FDA or foreign regulatory authorities require additional clinical trials prior to approval to market tenapanor; |\\n\\n| • | the prevalence and severity of adverse side effects of tenapanor; |\\n\\n| • | the timely receipt of necessary marketing approvals from the FDA and foreign regulatory authorities; |\\n\\n| • | the ability of AstraZeneca and us through our co-promotion rights, if we choose to exercise such rights and are not precluded from doing so under the terms of our agreement with AstraZeneca or any subsequent co-promotion agreements, to successfully commercialize tenapanor, if approved for marketing and sale by the FDA or foreign regulatory authorities, including educating physicians and patients about the benefits, administration and use of tenapanor; |\\n\\n| • | achieving and maintaining compliance with all regulatory requirements applicable to tenapanor; |\\n\\n| • | acceptance of tenapanor as safe and effective by patients and the medical community; |\\n\\n| • | the availability, perceived advantages, relative cost, relative safety and relative efficacy of alternative and competing treatments; |\\n\\n| • | obtaining and sustaining an adequate level of coverage and reimbursement for tenapanor by third-party payors; |\\n\\n| • | the effectiveness of AstraZeneca’s marketing, sales and distribution strategy and operations; |\\n\\n| • | the ability of AstraZeneca, or any third-party manufacturer it contracts with, to successfully scale up the manufacturing process for tenapanor, which has not yet been demonstrated, and to manufacture supplies of tenapanor and to develop, validate and maintain a commercially viable manufacturing process that is compliant with current good manufacturing practice, or cGMP, requirements; |\\n\\n| • | enforcing intellectual property rights in and to tenapanor; |\\n\\n| • | avoiding third-party interference, opposition, derivation or similar proceedings with respect to our patent rights, and avoiding other challenges to our patent rights and patent infringement claims; and |\\n\\n| • | a continued acceptable safety profile of tenapanor following approval. |\\n\\nMost of these factors are beyond our control, including clinical development, the regulatory submission process, manufacturing, marketing and sales efforts of AstraZeneca.\\nAs a first-in-class drug, tenapanor, has not been extensively studied in humans and the nonclinical and clinical data on its effect in the human body is limited to the trials and studies that we and AstraZeneca have completed. As a first-in-class drug, there is a higher likelihood that approval may not be attained as compared to a class of drugs with approved products. We cannot be certain that tenapanor will be successful in preclinical studies, clinical trials or receive regulatory approval. For example, like phosphate binders, treatment with tenapanor in patients with end stage renal disease, or ESRD, may be significantly impacted by such patient’s adherence to a restrictive low phosphorus diet, and as such, adherence may be a factor in demonstrating the efficacy of tenapanor in clinical trials for this patient population. Further, it may not be possible or practicable to demonstrate, or if approved, to market on the basis of,\\n24\\ncertain of the benefits we believe tenapanor possesses, including the reduction of sodium absorption in patients with CKD, which is unlikely to be an endpoint to be considered for approval in CKD patients. Additionally, the reduction of serum phosphorus is currently an approvable endpoint in ESRD, but not in the broader CKD patient population in the United States. If the number of patients in the market for tenapanor or the price that the market can bear is not as significant as we estimate, we may not generate significant revenue from sales of tenapanor, if approved. Accordingly, there can be no assurance that tenapanor will ever be successfully commercialized or that we will ever generate revenue from sales of tenapanor. If we and AstraZeneca are not successful in completing the development of, obtaining approval for, and commercializing tenapanor, or are significantly delayed in doing so, our business will be materially harmed.\\nWe are dependent on AstraZeneca for the development, regulatory approval, manufacture and commercialization of our small molecule NHE3 inhibitor program, which includes tenapanor, and if AstraZeneca fails to perform as expected, or is unable to obtain the required regulatory approvals for tenapanor, the potential for us to generate future revenue from milestone and royalty payments from tenapanor would be significantly reduced and our business would be materially and adversely harmed.\\nIn October 2012, we entered into a license agreement with AstraZeneca granting it an exclusive worldwide license to our small molecule NHE3 inhibitor program, which includes our lead product candidate, tenapanor, for all indications. Under this agreement, AstraZeneca has responsibility for completing all nonclinical and clinical development and obtaining and maintaining regulatory approval for tenapanor from the FDA and regulatory agencies outside of the United States. Ultimately, if tenapanor is advanced through clinical trials and receives marketing approval from the FDA or comparable foreign regulatory agencies, AstraZeneca will be responsible for the commercialization of tenapanor, subject to our right to elect to participate in certain co-promotion activities in the United States. The potential for us to obtain future development milestone payments and, ultimately, generate revenue from royalties from tenapanor depends entirely on the successful development, regulatory approval, marketing and commercialization of tenapanor by AstraZeneca. In addition to the risks inherent in the development of a drug product candidate, our collaboration partnership with AstraZeneca may not be successful due to a number of important factors, including the following:\\n| • | prior to the 175th day after the database lock for the ongoing Phase 2b clinical trial in hyperphosphatemic ESRD patients, AstraZeneca may terminate the license for any reason with 30 -days’ prior written notice and thereafter AstraZeneca may terminate the license with 120- days’ prior written notice; |\\n\\n| • | AstraZeneca has the unilateral ability to choose not to develop tenapanor for one or more indications for which it has been or is currently being evaluated, provided it pursues at least one indication, and AstraZeneca may choose to pursue an indication that is not in our strategic best interest or to delay the pursuit of, or forego an indication, even if clinical data is supportive of further development for such indication; |\\n\\n| • | AstraZeneca may choose not to develop and commercialize tenapanor in all relevant markets; |\\n\\n| • | AstraZeneca may take considerably more time advancing tenapanor through the clinical and regulatory process than we currently anticipate, which could materially delay the achievement of milestones and, consequently the receipt of milestone payments from AstraZeneca; |\\n\\n\\n| • | AstraZeneca’s obligation to use “commercially reasonable efforts” with regard to the development, regulatory approval, manufacture and commercialization of tenapanor under our agreement leaves AstraZeneca with discretion in determining the efforts and resources that it will apply to the development, regulatory approval, manufacture and commercialization of tenapanor; |\\n\\n| • | subject to our right to elect to participate in co-promotion activities in the United States, AstraZeneca controls all aspects of the commercialization of tenapanor; |\\n\\n| • | AstraZeneca is obligated to reimburse a specified amount for the current constipation-predominant irritable bowel syndrome, or IBS-C, Phase 2b clinical trial, and despite our efforts to keep costs below that amount, we may be required to spend more than that to complete the trial, and if we do so, we will not be reimbursed for those excess amounts by AstraZeneca; |\\n\\n| • | AstraZeneca’s recent strategic withdrawal from selling gastrointestinal, or GI, products and the differing treatment of the IBS-C indication in our agreement implies that AstraZeneca may choose not to develop the IBS-C indication, even if our current Phase 2b clinical trial were successful; |\\n\\n| • | AstraZeneca may change the focus of its development and commercialization efforts or pursue higher-priority programs and, accordingly, reduce the efforts and resources allocated to tenapanor, which will have the direct effect of reducing our co-promotion activities as our level of co-promotion is limited to a percentage of the overall commercialization activities; |\\n\\n| • | AstraZeneca may fail to develop a commercially viable formulation or manufacturing process for tenapanor, and may fail to manufacture or supply sufficient drug substance of tenapanor for commercial use, if approved, which could result in lost revenue; |\\n\\n25\\n\\n| • | AstraZeneca may not comply with all applicable regulatory requirements or may fail to report safety data in accordance with all applicable regulatory requirements; |\\n\\n| • | AstraZeneca may sublicense its rights with respect to tenapanor to one or more third parties without our consent; |\\n\\n| • | AstraZeneca may not dedicate the resources that would be necessary to carry tenapanor through clinical development or may not obtain the necessary regulatory approvals; |\\n\\n| • | if AstraZeneca is acquired during the term of our collaboration partnership, the acquiror may have different strategic priorities that could cause it to terminate our agreement or reduce its commitment to our collaboration partnership; and |\\n\\n| • | if our agreement with AstraZeneca terminates, we will no longer have rights to receive potential revenue under the agreement with AstraZeneca for future milestones or royalties, in which case we would need to identify alternative means to continue the development, manufacture and commercialization of tenapanor, alone or with others. |\\n\\nThe timing and amount of any milestone and royalty payments we may receive under our agreement will depend on, among other things, the efforts, allocation of resources, and successful development and commercialization of tenapanor by AstraZeneca under our agreement. There can be no assurance that any of the development and regulatory milestones will be achieved or that we will receive any future milestone payments under the agreement. In addition, in certain circumstances we may believe that we have achieved a particular milestone and AstraZeneca may disagree with our belief. In that case, receipt of that milestone payment may be delayed or may never be received, which may require us to adjust our operating plans.\\nIf AstraZeneca does not perform in the manner we expect or fulfill its responsibilities in a timely manner, or at all, the clinical development, regulatory approval and commercialization efforts related to tenapanor could be delayed or terminated and it could become necessary for us to assume the responsibility at our own expense for the clinical development of tenapanor. In that event, we would likely be required to substantially limit the size and scope of the development and commercialization of tenapanor or seek additional financing to fund further development, or to identify alternative collaboration partners for tenapanor, and our potential to generate future revenue from royalties and milestone payments from tenapanor would be significantly reduced or delayed and our business would be materially and adversely harmed.\\nOur election to co-fund the first Phase 3 clinical development program for tenapanor must be made in a limited time period prior to the initiation of the first pivotal clinical trial for tenapanor and, as a result, we may make a substantial capital investment for a product candidate based on limited clinical data.\\nUnder our agreement with AstraZeneca, we may elect to participate in the funding of the first Phase 3 clinical development program for the first indication of tenapanor by investing a co-funding amount of $20.0 million, $30.0 million or $40.0 million to acquire an increase of 1%, 2% or 3%, respectively, in the royalties payable to us by AstraZeneca on net sales of tenapanor. We may exercise this right only for a limited period of 60 days following AstraZeneca’s determination to proceed to the first Phase 3 clinical development program for tenapanor for a specific indication. An election to participate in the co-fund will be based, in part, on our analysis as to the likelihood of success of the Phase 3 clinical development program and the potential for regulatory approval to commercialize tenapanor. As a result, we will be required to make a substantial capital investment in tenapanor prior to the initiation of the first pivotal clinical trial and if tenapanor is unsuccessful in its pivotal trial or if it never receives regulatory approval, we will not receive any financial return on this capital investment.\\nWe have not yet negotiated our agreement with AstraZeneca specifying all of the terms of our co-promotion right.\\nPursuant to our license agreement with AstraZeneca, we have retained a co-promotion right with respect to tenapanor in the United States. While the license agreement includes the material terms of our co-promotion right, we and AstraZeneca mutually agreed to negotiate a separate agreement specifying the detailed activities and responsibilities in respect of the marketing and co-promotion of tenapanor following our election to exercise our co-promotion rights. If we elect to exercise our co-promotion rights, the separate agreement we negotiated with AstraZeneca may place restrictions or additional obligations on us, including financial obligations. Any restrictions or additional obligations may restrict our co-promotion activities or involve more significant financial obligations than we currently anticipate.\\nExercising our co-promotion right under our license agreement with AstraZeneca may restrict our future commercialization and/or co-promotion activities.\\nOur agreement with AstraZeneca prohibits us from using the same sales force to co-promote tenapanor as we do to promote other products that compete with tenapanor or with any other products that are then being actively promoted by AstraZeneca or its affiliates. If we elect to co-promote tenapanor, we may therefore be required to have a separate sales forces to promote other products we may elect to co-promote under our agreement with Sanofi, or other products we develop and commercialize on our own, should any of such products be competitive with tenapanor or with any other products promoted by AstraZeneca or its affiliates. The exercise of the co-promotion right under our agreement with AstraZeneca, could adversely affect the efficiency and cost of our promotion efforts for\\n26\\nour products and, effectively, may prohibit us from exercising our co-promotion rights under our agreement with Sanofi or with respect to other co-promotion rights with future collaboration partners.\\nIf Sanofi does not exercise its option to obtain an exclusive license to develop, manufacture and commercialize our NaP2b inhibitors or if it exercises the option and subsequently terminates any development program under its collaboration partnership with us, any potential milestone payments or revenue from product sales under this collaboration partnership will be significantly reduced or non-existent, and our results of operations and financial condition will be materially and adversely affected.\\nIn February 2014, we entered into a license option and license agreement with Sanofi under which we granted Sanofi an exclusive worldwide license to conduct research utilizing our small molecule NaP2b inhibitors, which we refer to as our RDX002 program, solely for the purpose of completing activities under a preclinical development plan. We believe the inhibition of NaP2b, an intestinal phosphate transporter, would provide utility for the treatment of hyperphosphatemia in ESRD patients, which is also the lead indication for which we and AstraZeneca are developing tenapanor.\\nUnder the terms of this agreement, Sanofi has the option to obtain an exclusive license to develop, manufacture and commercialize our NaP2b inhibitors. Sanofi may exercise this option at any time following the effective date of the agreement and ending 45 days after the filing of an investigational new drug application, or IND, subject to certain exceptions, and if Sanofi does not file an IND on or before the 40th month anniversary of the completion of the technology transfer phase, the agreement will terminate.\\nIf Sanofi does not exercise its option under its agreement with us, or terminates its rights and obligations with respect to the development program or the entire agreement, then depending on the timing of such event:\\n| • | the development of our NaP2b inhibitor program may be terminated or significantly delayed; |\\n\\n| • | we would bear all of the risks and costs related to the further development and commercialization of product candidates that were previously the subject of the agreement if we decided to continue work under the NaP2b inhibitor program independently; |\\n\\n| • | we would not be eligible to receive any of the remaining development or regulatory milestone payments or royalties on product sales; |\\n\\n| • | in order to fund further development and commercialization of the NaP2b program, we may need to raise additional capital if we choose to internally pursue the development of the program, or we may need to seek out and establish alternative collaboration partnerships with third-party collaboration partners for the program, which may not be possible, or we may not be able to do so on terms which are acceptable to us, in which case it may be necessary for us to limit the size or scope of the programs or increase our expenditures and seek additional funding by other means; and |\\n\\n| • | our cash expenditures could increase significantly if it is necessary for us to hire additional employees and allocate scarce resources to the development and commercialization of the NaP2b program. |\\n\\nAny of these events would have a material adverse effect on our results of operations and financial condition.\\nIn addition, we may be effectively prohibited from co-promoting any product candidates arising from the NaP2b program if we have previously exercised our co-promotion right under our agreement with AstraZeneca. For additional information regarding the effect of exercising our co-promotion right with AstraZeneca, see the risk factor above titled “Exercising our co-promotion right under our license agreement with AstraZeneca may restrict our future commercialization and/or co-promotion activities.”\\nClinical drug development involves a lengthy and expensive process with an uncertain outcome, and we may encounter substantial delays in our clinical studies. Furthermore, results of earlier studies and trials may not be predictive of future trial results.\\nBefore obtaining marketing approval from regulatory authorities for the sale of our product candidates, we, or our collaboration partners, must conduct extensive clinical studies to demonstrate the safety and efficacy of the product candidates in humans. Clinical testing is expensive and can take many years to complete, and its outcome is inherently uncertain. Failure can occur at any time during the clinical trial process. For example, in a Phase 2a study evaluating tenapanor in ESRD patients with fluid overload, while pharmacological activity of tenapanor was confirmed, the study failed to meet the primary endpoint of a statistically significant difference between tenapanor and placebo in change in interdialytic weight gain from baseline to week 4. The results of preclinical and clinical studies of our product candidates may not be predictive of the results of later-stage clinical trials. For example, the positive results generated to date in preclinical and clinical studies for tenapanor do not ensure that the ongoing Phase 2a and Phase 2b clinical trials, or future clinical trials, will demonstrate similar results. Product candidates in later stages of clinical trials may fail to show the desired safety and efficacy despite having progressed through preclinical studies and initial clinical trials. A number of companies in the pharmaceutical, biopharmaceutical and biotechnology industries have suffered significant setbacks in advanced clinical trials for similar indications that we are pursuing due to lack of efficacy or adverse safety profiles, notwithstanding promising\\n27\\nresults in earlier studies, and we cannot be certain that we will not face similar setbacks. Even if our clinical trials are completed, the results may not be sufficient to obtain regulatory approval for our product candidates.\\nWe may experience delays in our ongoing or future trials, and we do not know whether future clinical trials will begin on time, need to be redesigned, enroll an adequate number of patients on time or be completed on schedule, if at all. Clinical trials can be delayed or terminated for a variety of reasons, including delay or failure to:\\n| • | obtain regulatory approval to commence a trial, if applicable; |\\n\\n| • | reach agreement on acceptable terms with prospective contract research organizations, or CROs, and clinical trial sites, the terms of which can be subject to extensive negotiation and may vary significantly among different CROs and trial sites; |\\n\\n| • | obtain institutional review board, or IRB, approval at each site; |\\n\\n| • | recruit suitable patients in a timely manner to participate in our trials; |\\n\\n| • | have patients complete a trial or return for post-treatment follow-up; |\\n\\n| • | ensure that clinical sites observe trial protocol, comply with good clinical practices, or GCPs, or continue to participate in a trial; |\\n\\n| • | address any patient safety concerns that arise during the course of a trial; |\\n\\n| • | address any conflicts with new or existing laws or regulations; |\\n\\n| • | initiate or add a sufficient number of clinical trial sites; or |\\n\\n| • | manufacture sufficient quantities of product candidate for use in clinical trials. |\\n\\nPatient enrollment is a significant factor in the timing of clinical trials and is affected by many factors, including the size and nature of the patient population, the proximity of patients to clinical sites, the eligibility criteria for the trial, the design of the clinical trial, competing clinical trials and clinicians’ and patients’ perceptions as to the potential advantages of the drug being studied in relation to other available therapies, including any new drugs or treatments that may be approved for the indications we are investigating. We and AstraZeneca have experienced a delay in the enrollment of the ongoing Phase 2a clinical trial in CKD patients due to the restrictive eligibility criteria, and, although we have initiated efforts to increase enrollment by initiating new sites and amending the protocol, there can be no assurances that our efforts will be successful in increasing the rate of enrollment to complete this study on time, if at all.\\nWe could also encounter delays if a clinical trial is suspended or terminated by us, our collaboration partner for the product candidate, by the IRBs of the institutions in which such trials are being conducted, by an independent data safety monitoring board, or DSMB, for such trial or by the FDA or other regulatory authorities. Such authorities may suspend or terminate a clinical trial due to a number of factors, including failure to conduct the clinical trial in accordance with regulatory requirements or our clinical protocols, inspection of the clinical trial operations or trial site by the FDA or other regulatory authorities resulting in the imposition of a clinical hold, unforeseen safety issues or adverse side effects, failure to demonstrate a benefit from using a drug, changes in governmental regulations or administrative actions or lack of adequate funding to continue the clinical trial.\\nFurther, conducting clinical trials in foreign countries presents additional risks that may delay completion of clinical trials. These risks include the failure of physicians or enrolled patients in foreign countries to adhere to clinical protocol as a result of differences in healthcare services or cultural customs, managing additional administrative burdens associated with foreign regulatory schemes and political and economic risks relevant to such foreign countries. In addition, the FDA may determine that the clinical trial results obtained in foreign subjects do not represent the safety and efficacy of a product candidate when administered in U.S. patients and are thus not supportive of an NDA approval in the United States. As part of our effort to increase the rate of enrollment in the ongoing Phase 2a clinical trial in CKD patients, we and AstraZeneca have initiated sites in Germany. For the reasons stated above, these efforts may not improve the rate of enrollment in this study, or generate results that can be used to support the development of tenapanor.\\nIf there are delays in the completion of, or termination of, any clinical trial of our product candidates, the commercial prospects of our product candidates may be harmed, and our ability to generate revenue from product sales from any of these product candidates will be delayed. In addition, any delays in completing the clinical trials will increase costs, slow down our product candidate development and approval process and jeopardize the ability to commence product sales and generate revenue from product sales. Any of these occurrences may significantly harm our business, financial condition and prospects. In addition, many of the factors that cause, or lead to, a delay in the commencement or completion of clinical trials may also ultimately lead to the denial of regulatory approval of our product candidates.\\n28\\nOur unlicensed product candidates are at an early stage of development and we may not be successful in our efforts to develop these products or expand our pipeline of product candidates.\\nA key element of our strategy is to expand our pipeline of products candidates utilizing our proprietary drug discovery and design platform and to advance such product candidates through clinical development. Our current unlicensed product candidates are in the discovery and lead identification stages of preclinical development and will require substantial preclinical and clinical development, testing and regulatory approval prior to commercialization. In particular, tenapanor is our only product candidate in clinical trials and our other product candidates are in the preclinical stage with significant research and development required before we could file an IND with regulatory authorities to begin clinical studies. Of the large number of drugs in development, only a small percentage of such drugs successfully complete the FDA regulatory approval process and are commercialized. Accordingly, even if we are able to continue to fund our development programs, there can be no assurance that any product candidates will reach the clinic or be successfully developed or commercialized.\\nResearch programs to identify product candidates require substantial technical, financial and human resources, whether or not any product candidates are ultimately identified. Although our research and development efforts to date have resulted in several development programs, we may not be able to develop product candidates that are safe and effective. Our research programs may initially show promise in identifying potential product candidates, yet fail to yield product candidates for clinical development or commercialization for many reasons, including the following:\\n| • | the research methodology used and our drug discovery and design platform may not be successful in identifying potential product candidates; |\\n\\n| • | competitors may develop alternatives that render our product candidates obsolete or less attractive; |\\n\\n| • | product candidates we develop may nevertheless be covered by third parties’ patents or other exclusive rights; |\\n\\n| • | the market for a product candidate may change during our program so that the continued development of that product candidate is no longer reasonable; |\\n\\n| • | a product candidate may on further study be shown to have harmful side effects or other characteristics that indicate it is unlikely to be effective or otherwise does not meet applicable regulatory criteria; |\\n\\n| • | a product candidate may not be capable of being produced in commercial quantities at an acceptable cost, or at all; and |\\n\\n| • | a product candidate may not be accepted as safe and effective by patients, the medical community or third-party payors, if applicable. |\\n\\nEven if we are successful in continuing to expand our pipeline, through our own research and development efforts or by pursuing in-licensing or acquisition of product candidates, the potential product candidates for which we identify or acquire rights may not be suitable for clinical development, including as a result of being shown to have harmful side effects or other characteristics that indicate that they are unlikely to receive marketing approval and achieve market acceptance. If we do not successfully develop and commercialize a product pipeline, we may not be able to generate revenue from product sales in future periods or ever achieve profitability.\\nOur proprietary drug discovery and design platform, and, in particular, APECCS, is a new approach to the discovery, design and development of new product candidates and may not result in any products of commercial value.\\nWe have developed a proprietary drug discovery and design platform to enable the identification, screening, testing, design and development of new product candidates, and we recently we enhanced this platform with the addition of APECCS. We plan to utilize APECCS to identify new and potentially novel targets in the GI tract. We have also identified over 3,800 proteins on the inner surface of the gut, many of which we believe may be drug targets. However, there can be no assurance that APECCS will work or that any of these potential targets or other aspects of our proprietary drug discovery and design platform will yield product candidates that could enter clinical development and, ultimately, be commercially valuable.\\nAlthough we expect to continue to enhance the capabilities of our APECCS system by advancing the cell culture and screening process and/or acquiring new technologies to broaden the scope of APECCS, we may not be successful in any of our enhancement and development efforts. For example, we may not be able to enter into agreements on suitable terms to obtain technologies required to develop certain capabilities of APECCS. In addition, we may not be successful in developing the conditions necessary to grow multiple segments of intestine or from multiple species, or otherwise develop assays or cell cultures necessary to expand these capabilities. If our enhancement or development efforts are unsuccessful, we may not be able to advance our drug discovery capabilities as quickly as we expect or identify as many potential drugable targets as we desire.\\n29\\nWe may expend our limited resources to pursue a particular product candidate or indication and fail to capitalize on product candidates or indications that may be more profitable or for which there is a greater likelihood of success.\\nBecause we have limited financial and managerial resources, we have focused on research programs and product candidates that relate to discovery and development of non-systemic drugs that work in the GI tract. As a result, we may forego or delay pursuit of opportunities with other product candidates or for other indications that later prove to have greater commercial potential. Our resource allocation decisions may cause us to fail to capitalize on viable commercial products or profitable market opportunities. Our spending on current and future research and development programs and product candidates for specific indications may not yield any commercially viable products. If we do not accurately evaluate the commercial potential or target market for a particular product candidate, we may relinquish valuable rights to that product candidate through collaboration partnerships, licensing or other royalty arrangements in cases in which it would have been more advantageous for us to retain sole development and commercialization rights to such product candidate.\\nWe rely on third parties to conduct some of our preclinical and nonclinical studies and all of our clinical trials. If these third parties do not successfully carry out their contractual duties or meet expected deadlines, we may be unable to obtain regulatory approval for or commercialize our product candidates.\\nWe do not have the ability to independently conduct clinical trials and, in some cases, preclinical or nonclinical studies. We rely on medical institutions, clinical investigators, contract laboratories, collaboration partners and other third parties, such as CROs, to conduct clinical trials on our product candidates. The third parties with whom we contract for execution of the clinical trials we are conducting with AstraZeneca, as well as those third parties with whom we will contract for execution of clinical trials for our internal programs, play a significant role in the conduct of these trials and the subsequent collection and analysis of data. However, these third parties are not our employees, and except for contractual duties and obligations, we control only certain aspects of their activities and have limited ability to control the amount or timing of resources that they devote to our programs. Although we rely, and will continue to rely, on these third parties to conduct some of our preclinical and nonclinical studies and all of our clinical trials, we remain responsible for ensuring that each of our studies and clinical trials is conducted in accordance with the applicable protocol, legal, regulatory and scientific standards and our reliance on third parties does not relieve us of our regulatory responsibilities. We and these third parties are required to comply with current good laboratory practices, or GLPs, for preclinical and nonclinical studies, and good clinical practices, or GCPs, for clinical studies. GLPs and GCPs are regulations and guidelines enforced by the FDA, the Competent Authorities of the Member States of the European Economic Area, or EEA, and comparable foreign regulatory authorities for all of our products in preclinical and clinical development, respectively. Regulatory authorities enforce GCPs through periodic inspections of trial sponsors, principal investigators and trial sites. If we or any of our third party contractors fail to comply with applicable regulatory requirements, including GCPs, the clinical data generated in our clinical trials may be deemed unreliable and the FDA, the European Medicines Agency, or EMA, or comparable foreign regulatory authorities may require us to perform additional clinical trials before approving our marketing applications. There can be no assurance that upon inspection by a given regulatory authority, such regulatory authority will determine that any of our clinical trials comply with GCP regulations. In addition, our clinical trials must be conducted with product produced under cGMP regulations. Our failure to comply with these regulations may require us to repeat clinical trials, which would delay the regulatory approval process.\\nEven if our product candidates obtain regulatory approval, they may never achieve market acceptance or commercial success, which will depend, in part, upon the degree of acceptance among physicians, patients, patient advocacy groups, health care payors and the medical community.\\nEven if our product candidates obtain FDA or other regulatory approvals, and are ultimately commercialized, our product candidates may not achieve market acceptance among physicians, patients, third-party payors, patient advocacy groups, health care payors and the medical community. Market acceptance of our product candidates for which marketing approval is obtained depends on a number of factors, including:\\n| • | the efficacy of the products as demonstrated in clinical trials; |\\n\\n| • | the prevalence and severity of any side effects and overall safety profile of the product; |\\n\\n| • | the clinical indications for which the product is approved; |\\n\\n| • | advantages over existing therapies; |\\n\\n| • | acceptance by physicians, major operators of clinics and patients of the product as a safe and effective treatment; |\\n\\n| • | relative convenience and ease of administration of our products; |\\n\\n| • | the potential and perceived advantages of our product candidates over current treatment options or alternative treatments, including future alternative treatments; |\\n\\n| • | the cost of treatment in relation to alternative treatments and willingness to pay for our products, if approved, on the part of physicians and patients; |\\n\\n30\\n\\n| • | the availability of alternative products and their ability to meet market demand; |\\n\\n| • | the strength of our or our collaboration partners’ marketing and distribution organizations; |\\n\\n| • | the quality of our relationships with patient advocacy groups; and |\\n\\n| • | sufficient third-party coverage or reimbursement. |\\n\\nAny failure by our product candidates that obtain regulatory approval to achieve market acceptance or commercial success would adversely affect our results of operations.\\nOur product candidates may cause undesirable side effects or have other properties that could delay our clinical trials, or delay or prevent regulatory approval, limit the commercial profile of an approved label, or result in significant negative consequences following regulatory approval, if any. If any of our product candidates receives marketing approval and we or others later identify undesirable side effects caused by the product candidate, the ability to market the product candidates could be compromised.\\nUndesirable side effects caused by our product candidates could cause us, our collaboration partners, or regulatory authorities to interrupt, delay or halt clinical trials, result in the delay or denial of regulatory approval by the FDA or other comparable foreign regulatory authorities or limit the commercial profile of an approved label. To date, patients treated with tenapanor have experienced drug-related side effects including diarrhea, nausea, flatulence, abdominal discomfort, abdominal pain, abdominal distention and changes in electrolytes. In the event that trials conducted by us or AstraZeneca with tenapanor, or trials we conduct with our other product candidates, reveal an unacceptable severity and prevalence of these or other side effects, such trials could be suspended or terminated and the FDA or comparable foreign regulatory authorities could order AstraZeneca or us to cease further development of or deny approval of tenapanor, or any such other product candidate, for any or all targeted indications. The drug-related side effects could affect patient recruitment or the ability of enrolled patients to complete the trial or result in potential product liability claims. Any of these occurrences may harm our business, financial condition and prospects significantly.\\nIn addition, in the event that any of our product candidates receives regulatory approval and we or others later identify undesirable side effects caused by one of our products, a number of potentially significant negative consequences could occur, including:\\n| • | regulatory authorities may withdraw their approval of the product or seize the product; |\\n\\n| • | we, or our collaboration partners, may be required to recall the product; |\\n\\n| • | additional restrictions may be imposed on the marketing of the particular product or the manufacturing processes for the product or any component thereof, including the imposition of a Risk Evaluation and Mitigation Strategies, or REMS, plan that may require creation of a Medication Guide outlining the risks of such side effects for distribution to patients, as well as elements to assure safe use of the product, such as a patient registry and training and certification of prescribers; |\\n\\n| • | we, or our collaboration partners, may be subject to fines, injunctions or the imposition of civil or criminal penalties; |\\n\\n| • | regulatory authorities may require the addition of labeling statements, such as a “black box” warning or a contraindication; |\\n\\n| • | we could be sued and held liable for harm caused to patients; |\\n\\n| • | the product may become less competitive; and |\\n\\n| • | our reputation may suffer |\\n\\nAny of the foregoing events could prevent us, or our collaboration partners, from achieving or maintaining market acceptance of a particular product candidate, if approved, and could result in the loss of significant revenue to us, which would materially and adversely affect our results of operations and business.\\nWe face substantial competition and our competitors may discover, develop or commercialize products faster or more successfully than us.\\nThe biotechnology and pharmaceutical industries are highly competitive, and we face significant competition from companies in the biotechnology, pharmaceutical and other related markets that are researching and marketing products designed to address diseases that we are currently developing products to treat. If approved for marketing by the FDA or other regulatory agencies, tenapanor, or our other product candidates, would compete against existing treatments. For example, tenapanor will, if approved, compete directly with phosphate binders for the treatment of hyperphosphatemia in patients with ESRD, including sevelamer hydrochloride (Renagel) and sevelamer carbonate (Renvela), which were launched by Genzyme. Impax Laboratories, Inc. launched an authorized generic version of sevelamer carbonate in April 2014 and is expected to launch a generic version of sevelamer hydrochloride in September 2014. In addition to the currently marketed phosphate binders, we are aware of several other binders in development such as ferric citrate (Zerenex), an iron-based binder in Phase 3 being developed in the United States by Keryx and approved in Japan, and fermagate (Alpharen), an iron-based binder in Phase 2 being developed by Opko Health.\\n31\\nWhile there are no treatments for CKD that have been proven to reverse the disease, we are aware of one agent, CLP-1001, being developed by Sorbent Therapeutics, which is an orally administered, non-systemic exchange resin that binds both sodium and potassium as well as protons that showed positive effects in CKD patients with heart failure in a Phase 2a clinical trial and which showed the ability to increase fecal sodium. We believe this agent, if approved, may be competitive with tenapanor to treat CKD and ESRD patients. We are aware of certain investigational drugs that were being developed for delaying kidney decline as measured by estimated glomerular filtration rate, or eGFR. Among other products, Concert Pharmaceuticals is developing CTP-499 which showed protective effects on kidney function at 48 weeks in a Phase 2 clinical trial in patients with CKD and type 2 diabetes.\\nNumerous treatments exist for constipation and the constipation component of IBS-C, many of which are over-the-counter. These include psyllium husk (such as Metamucil), methylcellulose (such as Citrucel), calcium polycarbophil (such as FiberCon), lactulose (such as Cephulac), polyethylene glycol (such as MiraLax), sennosides (such as Exlax), bisacodyl (such as Ducolax), docusate sodium (such as Colace), magnesium hydroxide (such as Milk of Magnesia), saline enemas (such as Fleet) and sorbitol. These agents are generally inexpensive and work well to relieve temporary constipation. We are also aware of two prescription drugs currently on the U.S. market that are approved to treat IBS-C, Linzess (linaclotide), which was developed by Ironwood Pharmaceuticals and was approved in 2012 and 2013 for IBS-C and chronic constipation in both the United States and in Europe, and Amitiza (lubiprostone), which was first approved in the United States in 2006 and is currently marketed by Sucampo and Takeda for treatment of chronic idiopathic constipation, or CIC, IBS-C and opioid induced constipation, or OIC.\\nIt is possible that our competitors will develop and market drugs or other treatments that are less expensive and more effective than our product candidates, or that will render our product candidates obsolete. It is also possible that our competitors will commercialize competing drugs or treatments before we, or our collaboration partners, can launch any products developed from our product candidates. We also anticipate that we will face increased competition in the future as new companies enter into our target markets.\\nMany of our competitors have materially greater name recognition and financial, manufacturing, marketing, research and drug development resources than we do. Additional mergers and acquisitions in the biotechnology and pharmaceutical industries may result in even more resources being concentrated in our competitors. Large pharmaceutical companies in particular have extensive expertise in preclinical and clinical testing and in obtaining regulatory approvals for drugs. In addition, academic institutions, government agencies, and other public and private organizations conducting research may seek patent protection with respect to potentially competitive products or technologies. These organizations may also establish exclusive collaboration partnerships or licensing relationships with our competitors.\\nWe currently have no sales organization. If we are unable to establish sales capabilities on our own or through third parties, we may not be able to co-promote tenapanor, if approved, or commercialize or co-promote any of our other product candidates.\\nWe currently do not have a sales organization. In order to co-promote tenapanor or commercialize or co-promote any of our other product candidates, we must build our marketing, sales, distribution, managerial and other non-technical capabilities or make arrangements with third parties to perform these services, and we may not be successful in doing so. If one or more of our product candidates receives regulatory approval, we expect to establish a specialty sales organization with technical expertise and supporting distribution capabilities to co-promote and/or commercialize our product candidates, which will be expensive and time consuming. As a company, we have no prior experience in the marketing, sale and distribution of pharmaceutical products and there are significant risks involved in building and managing a sales organization, including our ability to hire, retain, and incentivize qualified individuals, generate sufficient sales leads, provide adequate training to sales and marketing personnel, comply with regulatory requirements applicable to the marketing and sale of drug products and effectively manage a geographically dispersed sales and marketing team. Any failure or delay in the development of our internal sales, marketing and distribution capabilities would adversely impact the commercialization of these products.\\nWe may choose to collaborate with third parties that have direct sales forces and established distribution systems, either to augment our own sales force and distribution systems or in lieu of our own sales force and distribution systems. If we are unable to enter into such arrangements on acceptable terms or at all, we may not be able to successfully commercialize our product candidates.\\n32\\nWe rely completely on third parties to manufacture our preclinical and clinical drug supplies, and we intend to rely on third parties to produce commercial supplies of any approved product candidate. Our business would be harmed if those third parties fail to obtain approval of the FDA, Competent Authorities of the Member States of the EEA or comparable regulatory authorities, fail to provide us with sufficient quantities of drug product, or fail to do so at acceptable quality levels or prices.\\nWe do not currently have, nor do we plan to acquire, the infrastructure or capability internally to manufacture our preclinical and clinical drug supplies for use in the conduct of our preclinical and clinical studies, and we lack the resources and the capability to manufacture any of our product candidates on a clinical or commercial scale. The facilities used by our contract manufacturers to manufacture any drug products must be approved by the FDA pursuant to inspections that will be conducted after an NDA is submitted to the FDA. We do not control the manufacturing process of our product candidates, and, other than with respect to tenapanor, we are completely dependent on our contract manufacturing partners for compliance with the regulatory requirements, known as cGMPs, for manufacture of both active drug substances and finished drug products. Under our agreement with AstraZeneca, the manufacturing of tenapanor is the responsibility of AstraZeneca. We are entirely dependent on AstraZeneca for all aspects of the manufacturing and validation process, as well as providing all commercial supply of tenapanor. For additional information regarding the risks of our dependence on AstraZeneca, see the risk factors above titled “We are substantially dependent on the success of our lead product candidate, tenapanor, which may not be successful in nonclinical studies or clinical trials, receive regulatory approval or be successfully commercialized” and “We are dependent on AstraZeneca for the development, regulatory approval, manufacture and commercialization of our small molecule NHE3 inhibitor program, which includes tenapanor, and if AstraZeneca fails to perform as expected, or is unable to obtain the required regulatory approvals for tenapanor, the potential for us to generate future revenue from milestone and royalty payments from tenapanor would be significantly reduced and our business would be materially and adversely harmed.”\\nIf our contract manufacturers cannot successfully manufacture material that conforms to our specifications and the strict regulatory requirements of the FDA or others, they will not be able to secure and/or maintain regulatory approval for their manufacturing facilities. In addition, we have no control over the ability of our contract manufacturers to maintain adequate quality control, quality assurance and qualified personnel. If the FDA or a comparable foreign regulatory authority does not approve these facilities for the manufacture of our product candidates or if it withdraws any such approval in the future, we may need to find alternative manufacturing facilities, which would significantly impact our ability to develop, obtain regulatory approval for or market our product candidates, if approved.\\nWe rely on our manufacturers to purchase from third-party suppliers the materials necessary to produce our product candidates for our clinical studies. There are a limited number of suppliers for raw materials that we use to manufacture our drugs, and there may be a need to identify alternate suppliers to prevent a possible disruption of the manufacture of the materials necessary to produce our product candidates for our clinical studies, and, if approved, ultimately for commercial sale. We do not have any control over the process or timing of the acquisition of these raw materials by our manufacturers. Although we generally do not begin a clinical study unless we believe we have on hand, or will be able to manufacture a sufficient supply of a product candidate to complete such study, any significant delay or discontinuity in the supply of a product candidate, or the raw material components thereof, for an ongoing clinical study due to the need to replace a third-party manufacturer could considerably delay completion of our clinical studies, product testing, and potential regulatory approval of our product candidates, which could harm our business and results of operations.\\nThird-party payor coverage and reimbursement status of newly-approved products is uncertain. Failure to obtain or maintain adequate coverage and reimbursement for our products, if approved, could limit our ability to market those products and decrease our ability to generate revenue.\\nThe pricing, coverage and reimbursement of our product candidates, if approved, must be adequate to support a commercial infrastructure. The availability and adequacy of coverage and reimbursement by governmental and private payors are essential for most patients to be able to afford treatments such as ours, assuming approval. Sales of our product candidates will depend substantially, both domestically and abroad, on the extent to which the costs of our product candidates will be paid for by health maintenance, managed care, pharmacy benefit, and similar healthcare management organizations, or reimbursed by government authorities, private health insurers, and other third-party payors. If coverage and reimbursement are not available, or are available only to limited levels, we may not be able to successfully commercialize our product candidates. Even if coverage is provided, the approved reimbursement amount may not be high enough to allow us to establish or maintain pricing sufficient to realize a return on our investment.\\nThere is significant uncertainty related to the insurance coverage and reimbursement of newly approved products. In the United States, the principal decisions about coverage and reimbursement for new drugs are typically made by the Centers for Medicare & Medicaid Services, or CMS, an agency within the U.S. Department of Health and Human Services responsible for administering the Medicare program, as CMS decides whether and to what extent a new drug will be covered and reimbursed under Medicare. Private payors tend to follow the coverage reimbursement policies established by CMS to a substantial degree. It is difficult to predict what CMS will decide with respect to reimbursement for products such as ours.\\n33\\nIn July 2010, CMS released its final rule to implement a bundled prospective payment system for the treatment of ESRD patients as required by the Medicare Improvements for Patients and Providers Act, or MIPPA. The bundled payment covers a bundle of items and services routinely required for dialysis treatments furnished to Medicare beneficiaries in Medicare-certified ESRD facilities or at their home, including the cost of certain routine drugs. The final rule delayed the inclusion of oral medications without intravenous equivalents in the bundled payment until January 1, 2014 and in April 2014, President Obama signed the Protecting Access to Medicare Act of 2014, which further extends this implementation date to January 1, 2024. As a result of the recent legislation, beginning in 2024, ESRD-related drugs will be included in the bundle and separate Medicare reimbursement will no longer be available for such drugs, as it is today under Medicare Part D. While it is too early to project the full impact bundling may have on the industry, the impact could potentially cause dramatic price reductions for tenapanor, if approved. We and AstraZeneca may be unable to sell tenapanor, if approved, to dialysis providers on a profitable basis if third-party payors reduce their current levels of payment, or if our costs of production increase faster than increases in reimbursement levels.\\nOutside the United States, international operations are generally subject to extensive governmental price controls and other market regulations, and we believe the increasing emphasis on cost-containment initiatives in Europe, Canada, China and other countries has and will continue to put pressure on the pricing and usage of our product candidates. In many countries, the prices of medical products are subject to varying price control mechanisms as part of national health systems. Other countries allow companies to fix their own prices for medicinal products, but monitor and control company profits. Additional foreign price controls or other changes in pricing regulation could restrict the amount that we are able to charge for our product candidates. Accordingly, in markets outside the United States, the reimbursement for our products may be reduced compared with the United States and may be insufficient to generate commercially reasonable revenue and profits.\\nMoreover, increasing efforts by governmental and third-party payors in the United States and abroad to cap or reduce healthcare costs may cause such organizations to limit both coverage and the level of reimbursement for new products approved and, as a result, these caps may not cover or provide adequate payment for our product candidates. We expect to experience pricing pressures in connection with the sale of any of our product candidates due to the trend toward managed healthcare, the increasing influence of health maintenance organizations, and additional legislative changes. The downward pressure on healthcare costs in general, particularly prescription drugs and surgical procedures and other treatments, has become very intense. As a result, increasingly high barriers are being erected to the entry of new products.\\nIf product liability lawsuits are brought against us, we may incur substantial liabilities and may be required to limit commercialization of our product candidates.\\nWe face an inherent risk of product liability as a result of the clinical testing of our product candidates and will face an even greater risk if we commercialize any products. For example, we may be sued if any product we develop allegedly causes injury or is found to be otherwise unsuitable during product testing, manufacturing, marketing or sale. Any such product liability claims may include allegations of defects in manufacturing, defects in design, a failure to warn of dangers inherent in the product, negligence, strict liability, and a breach of warranties. Claims could also be asserted under state consumer protection acts. If we cannot successfully defend ourselves against product liability claims, we may incur substantial liabilities or be required to limit commercialization of our product candidates. Even successful defense would require significant financial and management resources. Regardless of the merits or eventual outcome, liability claims may result in:\\n| • | decreased demand for our product candidates; |\\n\\n| • | injury to our reputation; |\\n\\n| • | withdrawal of clinical trial participants; |\\n\\n| • | costs to defend the related litigation; |\\n\\n| • | a diversion of management’s time and our resources; |\\n\\n| • | substantial monetary awards to trial participants or patients; |\\n\\n| • | regulatory investigations, product recalls or withdrawals, or labeling, marketing or promotional restrictions; |\\n\\n| • | loss of revenue; and |\\n\\n| • | the inability to commercialize or co-promote our product candidates. |\\n\\nOur inability to obtain and maintain sufficient product liability insurance at an acceptable cost and scope of coverage to protect against potential product liability claims could prevent or inhibit the commercialization of any products we develop. We currently carry product liability insurance covering use in our clinical trials in the amount of $10.0 million in the aggregate. Although we maintain such insurance, any claim that may be brought against us could result in a court judgment or settlement in an amount that is not covered, in whole or in part, by our insurance or that is in excess of the limits of our insurance coverage. Our insurance policies also have various exclusions and deductibles, and we may be subject to a product liability claim for which we have no coverage. We will\\n34\\nhave to pay any amounts awarded by a court or negotiated in a settlement that exceed our coverage limitations or that are not covered by our insurance, and we may not have, or be able to obtain, sufficient capital to pay such amounts. Moreover, in the future, we may not be able to maintain insurance coverage at a reasonable cost or in sufficient amounts to protect us against losses.\\nWe are highly dependent on the services of our President and Chief Executive Officer, Michael Raab, our Chief Scientific Officer, Dominique Charmot, Ph.D., and our Vice President of Drug Development, David Rosenbaum, Ph.D., and if we are not able to retain these members of our management or recruit additional management, clinical and scientific personnel, our business will suffer.\\nOur success depends in part on our continued ability to attract, retain and motivate highly qualified personnel. In particular, we are highly dependent upon Michael Raab, our President and Chief Executive Officer, Dominique Charmot, Ph.D., our Chief Scientific Officer, and David Rosenbaum, Ph.D., our Vice President of Drug Development. The loss of services of any of these individuals could delay or prevent the successful development of our product pipeline, completion of our planned clinical trials or the commercialization of our product candidates. Although we have entered into employment agreements with our senior management team, including Mr. Raab and Drs. Charmot and Rosenbaum, these agreements are terminable at will with or without notice and, therefore, we may not be able to retain their services as expected. Although we have not historically experienced unique difficulties attracting and retaining qualified employees, we could experience such problems in the future. For example, competition for qualified personnel in the biotechnology and pharmaceuticals field is intense due to the limited number of individuals who possess the skills and experience required by our industry. In addition to the competition for personnel, the San Francisco Bay area in particular is characterized by a high cost of living. As such, we could have difficulty attracting experienced personnel to our company and may be required to expend significant financial resources in our employee recruitment and retention efforts.\\nWe will need to significantly increase the size of our organization, and we may experience difficulties in managing growth.\\nAs of June 30, 2014, we had 36 full-time employees. We will need to continue to expand our managerial, operational, finance and other resources in order to manage our operations, preclinical and clinical trials, research and development activities, regulatory filings, manufacturing and supply activities, and any marketing and commercialization activities, including co-promotion activities. Our management, personnel, systems and facilities currently in place may not be adequate to support this future growth. Our need to effectively execute our growth strategy requires that we:\\n| • | expand our general and administrative functions; |\\n\\n| • | establish and build a marketing and commercial organization; |\\n\\n| • | identify, recruit, retain, incentivize and integrate additional employees; |\\n\\n| • | manage our internal development efforts effectively while carrying out our contractual obligations to third parties; and |\\n\\n| • | continue to improve our operational, legal, financial and management controls, reporting systems and procedures. |\\n\\nIf we are not able to attract, retain and motivate necessary personnel to accomplish our business objectives, we may experience constraints that will significantly impede the achievement of our development objectives, our ability to raise additional capital and our ability to implement our business strategy.\\nWe incur significant costs as a result of operating as a public company, and our management will devote substantial time to new compliance initiatives. We may fail to comply with the rules that apply to public companies, including Section 404 of the Sarbanes-Oxley Act of 2002, which could result in sanctions or other penalties that would harm our business.\\nWe incur significant legal, accounting and other expenses as a public company, including costs resulting from public company reporting obligations under the Securities Exchange Act of 1934, as amended, or the Exchange Act, and regulations regarding corporate governance practices. The listing requirements of The NASDAQ Global Market require that we satisfy certain corporate governance requirements relating to director independence, distributing annual and interim reports, stockholder meetings, approvals and voting, soliciting proxies, conflicts of interest and a code of conduct. Our management and other personnel will need to devote a substantial amount of time to ensure that we comply with all of these requirements, and we will need to hire additional accounting and financial staff with appropriate public company reporting experience and technical accounting knowledge. Moreover, the reporting requirements, rules and regulations will increase our legal and financial compliance costs and will make some activities more time consuming and costly. Any changes we make to comply with these obligations may not be sufficient to allow us to satisfy our obligations as a public company on a timely basis, or at all. These reporting requirements, rules and regulations, coupled with the increase in potential litigation exposure associated with being a public company, could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors or board committees or to serve as executive officers, or to obtain certain types of insurance, including directors’ and officers’ insurance, on acceptable terms.\\n35\\nIn addition, we expect to implement an enterprise resource planning, or ERP, system for our company in connection with becoming a public reporting company. An ERP system is intended to combine and streamline the management of our financial, accounting, human resources, sales and marketing and other functions, enabling us to manage operations and track performance more effectively. However, an ERP system will require us to complete many processes and procedures for the effective use of the system or to run our business using the system, which may result in substantial costs. Additionally, during the conversion process, we may be limited in our ability to convert any business that we acquire to the ERP. Any disruptions or difficulties in implementing or using an ERP system could adversely affect our controls and harm our business, including our ability to forecast or make sales and collect our receivables. Moreover, such disruption or difficulties could result in unanticipated costs and diversion of management attention.\\nWe are subject to Section 404 of The Sarbanes-Oxley Act of 2002, or Section 404, and the related rules of the Securities and Exchange Commission, or SEC, which generally require our management and independent registered public accounting firm to report on the effectiveness of our internal control over financial reporting. Beginning with the second annual report that we will be required to file with the SEC, Section 404 requires an annual management assessment of the effectiveness of our internal control over financial reporting. However, for so long as we remain an emerging growth company as defined in the Jumpstart Our Business Startups Act of 2012, or JOBS Act, we intend to take advantage of certain exemptions from various reporting requirements that are applicable to public companies that are not emerging growth companies, including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404. Once we are no longer an emerging growth company or, if prior to such date, we opt to no longer take advantage of the applicable exemption, we will be required to include an opinion from our independent registered public accounting firm on the effectiveness of our internal controls over financial reporting. We will remain an emerging growth company until the earlier of (1) the last day of the fiscal year following the fifth anniversary of the completion of our IPO (December 31, 2019), (2) the last day of the fiscal year in which we have total annual gross revenue of at least $1.0 billion, or (3) the last day of the fiscal year in which we are deemed to be a large accelerated filer, which means the market value of our common stock that is held by non-affiliates exceeds $700 million as of the prior June 30th, and (4) the date on which we have issued more than $1.0 billion in non-convertible debt during the prior three-year period.\\nTo date, we have not conducted any other review of our internal control for the purpose of providing the reports required by Section 404 and the related SEC rules. During the course of our review and testing, we may identify deficiencies and be unable to remediate them before we must provide the required reports. Furthermore, if we have a material weakness in our internal controls over financial reporting, we may not detect errors on a timely basis and our financial statements may be materially misstated. We or our independent registered public accounting firm may not be able to conclude on an ongoing basis that we have effective internal control over financial reporting, which could harm our operating results, cause investors to lose confidence in our reported financial information and cause the trading price of our stock to fall. In addition, as a public company we are required to file accurate and timely quarterly and annual reports with the SEC under the Exchange Act. Any failure to report our financial results on an accurate and timely basis could result in sanctions, lawsuits, delisting of our shares from The NASDAQ Global Market or other adverse consequences that would materially harm our business.\\nWe may form additional collaboration partnerships in the future with respect to our independent programs, and we may not realize the benefits of such collaborations.\\nWe may form collaboration partnerships, create joint ventures or enter into licensing arrangements with third parties with respect to our independent programs that we believe will complement or augment our existing business. We have historically engaged, and intend to continue to engage, in partnering discussions with a range of pharmaceutical and biotechnology companies and could enter into new collaboration partnerships at any time. We face significant competition in seeking appropriate collaboration partners, and the negotiation process to secure appropriate terms is time-consuming and complex. Any delays in identifying suitable collaboration partners and entering into agreements to develop our product candidates could also delay the commercialization of our product candidates, which may reduce their competitiveness even if they reach the market. Moreover, we may not be successful in our efforts to establish such a collaboration partnership for any future product candidates and programs on terms that are acceptable to us, or at all. This may be because our product candidates and programs may be deemed to be at too early of a stage of development for collaborative effort, our research and development pipeline may be viewed as insufficient, and/or third parties may not view our product candidates and programs as having sufficient potential for commercialization, including the likelihood of an adequate safety and efficacy profile. Even if we are successful in entering into a collaboration partnership or license arrangement, there is no guarantee that the collaboration partnership will be successful, or that any future collaboration partner will commit sufficient resources to the development, regulatory approval, and commercialization effort for such products, or that such alliances will result in us achieving revenues that justify such transactions.\\n36\\nWe may engage in strategic transactions that could impact our liquidity, increase our expenses and present significant distractions to our management.\\nWe intend to consider strategic transactions, such as acquisitions of companies, asset purchases, and or in-licensing of products, product candidates or technologies. Additional potential transactions that we may consider include a variety of different business arrangements, including spin-offs, collaboration partnerships, joint ventures, restructurings, divestitures, business combinations and investments. Any such transaction may require us to incur non-recurring or other charges, may increase our near- and long-term expenditures and may pose significant integration challenges or disrupt our management or business, which could adversely affect our operations and financial results. For example, these transactions may entail numerous operational and financial risks, including:\\n| • | up-front, milestone and royalty payments, equity investments and financial support of new research and development candidates including increase of personnel, all of which may be substantial; |\\n\\n| • | exposure to unknown liabilities; |\\n\\n| • | disruption of our business and diversion of our management’s time and attention in order to develop acquired products, product candidates or technologies; |\\n\\n| • | incurrence of substantial debt or dilutive issuances of equity securities to pay for acquisitions; |\\n\\n\\n| • | higher-than-expected acquisition and integration costs; |\\n\\n| • | write-downs of assets or goodwill or impairment charges; |\\n\\n| • | increased amortization expenses; |\\n\\n| • | difficulty and cost in combining the operations and personnel of any acquired businesses with our operations and personnel; |\\n\\n| • | impairment of relationships with key suppliers or customers of any acquired businesses due to changes in management and ownership; and |\\n\\n| • | inability to retain key employees of any acquired businesses. |\\n\\nAccordingly, although there can be no assurance that we will undertake or successfully complete any transactions of the nature described above, any transactions that we do complete may be subject to the foregoing or other risks and could have a material adverse effect on our business, results of operations, financial condition and prospects.\\nIf we seek and obtain approval to commercialize our product candidates outside of the United States, or otherwise engage in business outside of the United States, a variety of risks associated with international operations could materially adversely affect our business.\\nWe may decide to seek marketing approval for certain of our product candidates outside the United States or otherwise engage in business outside the United States, including entering into contractual agreements with third-parties. We expect that we will be subject to additional risks related to entering into these international business markets and relationships, including:\\n| • | different regulatory requirements for drug approvals in foreign countries; |\\n\\n| • | differing United States and foreign drug import and export rules; |\\n\\n| • | reduced protection for intellectual property rights in foreign countries; |\\n\\n| • | unexpected changes in tariffs, trade barriers and regulatory requirements; |\\n\\n| • | different reimbursement systems, and different competitive drugs; |\\n\\n| • | economic weakness, including inflation, or political instability in particular foreign economies and markets; |\\n\\n| • | compliance with tax, employment, immigration and labor laws for employees living or traveling abroad; |\\n\\n| • | foreign taxes, including withholding of payroll taxes; |\\n\\n| • | foreign currency fluctuations, which could result in increased operating expenses and reduced revenues, and other obligations incident to doing business in another country; |\\n\\n| • | workforce uncertainty in countries where labor unrest is more common than in the United States; |\\n\\n| • | production shortages resulting from any events affecting raw material supply or manufacturing capabilities abroad; |\\n\\n| • | potential liability resulting from development work conducted by these distributors; and |\\n\\n| • | business interruptions resulting from geopolitical actions, including war and terrorism, or natural disasters. |\\n\\n37\\nOur business involves the use of hazardous materials and we and third-parties with whom we contract must comply with environmental laws and regulations, which can be expensive and restrict how we do business.\\nOur research and development activities involve the controlled storage, use and disposal of hazardous materials, including the components of our product candidates and other hazardous compounds. We and manufacturers and suppliers with whom we may contract are subject to laws and regulations governing the use, manufacture, storage, handling and disposal of these hazardous materials. In some cases, these hazardous materials and various wastes resulting from their use are stored at our and our manufacturers’ facilities pending their use and disposal. We cannot eliminate the risk of contamination, which could cause an interruption of our commercialization efforts, research and development efforts and business operations, environmental damage resulting in costly clean-up and liabilities under applicable laws and regulations governing the use, storage, handling and disposal of these materials and specified waste products. We cannot guarantee that that the safety procedures utilized by third-party manufacturers and suppliers with whom we may contract will comply with the standards prescribed by laws and regulations or will eliminate the risk of accidental contamination or injury from these materials. In such an event, we may be held liable for any resulting damages and such liability could exceed our resources and state or federal or other applicable authorities may curtail our use of certain materials and/or interrupt our business operations. Furthermore, environmental laws and regulations are complex, change frequently and have tended to become more stringent. We cannot predict the impact of such changes and cannot be certain of our future compliance. We do not currently carry biological or hazardous waste insurance coverage.\\nOur internal computer systems, or those of our CROs or other contractors or consultants, may fail or suffer security breaches, which could result in a material disruption of our product development programs.\\nDespite the implementation of security measures, our internal computer systems and those of our CROs and other contractors and consultants are vulnerable to damage from computer viruses, unauthorized access, natural disasters, terrorism, war and telecommunication and electrical failures. While we have not experienced any such system failure, accident or security breach to date, if such an event were to occur and cause interruptions in our operations, it could result in a material disruption of our programs. For example, the loss of clinical trial data from completed or ongoing clinical trials for any of our product candidates could result in delays in our regulatory approval efforts and significantly increase our costs to recover or reproduce the data. To the extent that any disruption or security breach results in a loss of or damage to our data or applications, or inappropriate disclosure of confidential or proprietary information, we could incur liability and the further development of our product candidates could be delayed.\\nWe may be adversely affected by the current global economic environment.\\nOur ability to attract and retain collaboration partners or customers, invest in and grow our business and meet our financial obligations depends on our operating and financial performance, which, in turn, is subject to numerous factors, including the prevailing economic conditions and financial, business and other factors beyond our control, such as the rate of unemployment, the number of uninsured persons in the United States and inflationary pressures. Our results of operations could be adversely affected by general conditions in the global economy and in the global financial markets. The recent global financial crisis caused extreme volatility and disruptions in the capital and credit markets. We cannot anticipate all the ways in which the current global economic climate and global financial market conditions could adversely impact our business.\\nWe are exposed to risks associated with reduced profitability and the potential financial instability of our collaboration partners or customers, many of which may be adversely affected by volatile conditions in the financial markets. For example, unemployment and underemployment, and the resultant loss of insurance, may decrease the demand for healthcare services and pharmaceuticals. If fewer patients are seeking medical care because they do not have insurance coverage, our collaboration partners or customers may experience reductions in revenues, profitability and/or cash flow that could lead them to reduce their support of our programs or financing activities. If collaboration partners or customers are not successful in generating sufficient revenue or are precluded from securing financing, they may not be able to pay, or may delay payment of, accounts receivable that are owed to us. In addition, the volatility in the financial markets could cause significant fluctuations in the interest rate and currency markets. We currently do not hedge for these risks. The foregoing events, in turn, could adversely affect our financial condition and liquidity. In addition, if economic challenges in the United States result in widespread and prolonged unemployment, either regionally or on a national basis, prior to the effectiveness of certain provisions of the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act, collectively known as the Affordable Care Act, a substantial number of people may become uninsured or underinsured. To the extent economic challenges result in fewer individuals pursuing or being able to afford our product candidates once commercialized, our business, results of operations, financial condition and cash flows could be adversely affected.\\nWe may be adversely affected by earthquakes or other natural disasters and our business continuity and disaster recovery plans may not adequately protect us from a serious disaster.\\nOur corporate headquarters and other facilities are located in the San Francisco Bay Area, which in the past has experienced severe earthquakes. We do not carry earthquake insurance. Earthquakes or other natural disasters could severely disrupt our operations, and have a material adverse effect on our business, results of operations, financial condition and prospects.\\n38\\nIf a natural disaster, power outage or other event occurred that prevented us from using all or a significant portion of our headquarters, that damaged critical infrastructure, such as our enterprise financial systems or manufacturing resource planning and enterprise quality systems, or that otherwise disrupted operations, it may be difficult or, in certain cases, impossible for us to continue our business for a substantial period of time. The disaster recovery and business continuity plans we have in place currently are limited and are unlikely to prove adequate in the event of a serious disaster or similar event. We may incur substantial expenses as a result of the limited nature of our disaster recovery and business continuity plans, which, particularly when taken together with our lack of earthquake insurance, could have a material adverse effect on our business.\\nRisks Related to Government Regulation\\nThe regulatory approval processes of the FDA and comparable foreign authorities are lengthy, time consuming and inherently unpredictable. If we are ultimately unable to obtain regulatory approval for our product candidates, our business will be substantially harmed.\\nThe research, testing, manufacturing, labeling, approval, selling, import, export, marketing and distribution of drug products are subject to extensive regulation by the FDA and other regulatory authorities in the United States and other countries, which regulations differ from country to country. Neither we nor any of our collaboration partners is permitted to market any drug product in the United States until we receive marketing approval from the FDA. We have not submitted an application or obtained marketing approval for any of our product candidates anywhere in the world. Obtaining regulatory approval of a new drug application, or NDA, can be a lengthy, expensive and uncertain process. In addition, failure to comply with FDA and other applicable United States and foreign regulatory requirements may subject us to administrative or judicially imposed sanctions or other actions, including:\\n| • | warning letters; |\\n\\n| • | civil and criminal penalties; |\\n\\n| • | injunctions; |\\n\\n| • | withdrawal of regulatory approval of products; |\\n\\n| • | product seizure or detention; |\\n\\n| • | product recalls; |\\n\\n| • | total or partial suspension of production; and |\\n\\n| • | refusal to approve pending NDAs or supplements to approved NDAs. |\\n\\nPrior to obtaining approval to commercialize a drug candidate in the United States or abroad, we or our collaboration partners must demonstrate with substantial evidence from well-controlled clinical trials, and to the satisfaction of the FDA or other foreign regulatory agencies, that such drug candidates are safe and effective for their intended uses. The number of nonclinical studies and clinical trials that will be required for FDA approval varies depending on the drug candidate, the disease or condition that the drug candidate is designed to address, and the regulations applicable to any particular drug candidate. Results from nonclinical studies and clinical trials can be interpreted in different ways. Even if we believe the nonclinical or clinical data for our drug candidates are promising, such data may not be sufficient to support approval by the FDA and other regulatory authorities. Administering drug candidates to humans may produce undesirable side effects, which could interrupt, delay or halt clinical trials and result in the FDA or other regulatory authorities denying approval of a drug candidate for any or all targeted indications.\\nThe time required to obtain approval by the FDA and comparable foreign authorities is unpredictable, typically takes many years following the commencement of clinical studies, and depends upon numerous factors. The FDA and comparable foreign authorities have substantial discretion in the approval process and we may encounter matters with the FDA or such comparable authorities that requires us to expend additional time and resources and delay or prevent the approval of our product candidates. For example, the FDA may require us to conduct additional studies or trials for drug product either prior to or post-approval, such as additional drug-drug interaction studies or safety or efficacy studies or trials, or it may object to elements of our clinical development program such as the number of subjects in our current clinical trials from the United States. In addition, approval policies, regulations or the type and amount of clinical data necessary to gain approval may change during the course of a product candidate’s clinical development and may vary among jurisdictions, which may cause delays in the approval or result in a decision not to approve an application for regulatory approval. Despite the time and expense exerted, failure can occur at any stage. Applications for our product candidates could fail to receive regulatory approval for many reasons, including but not limited to the following:\\n| • | the FDA or comparable foreign regulatory authorities may disagree with the design or implementation of our, or our collaboration partners’, clinical studies; |\\n\\n| • | the population studied in the clinical program may not be sufficiently broad or representative to assure safety in the full population for which approval is sought; |\\n\\n39\\n\\n| • | the FDA or comparable foreign regulatory authorities may disagree with the interpretation of data from preclinical studies or clinical studies; |\\n\\n| • | the data collected from clinical studies of our product candidates may not be sufficient to support the submission of a NDA or other submission or to obtain regulatory approval in the United States or elsewhere; |\\n\\n| • | we or our collaboration partners may be unable to demonstrate to the FDA or comparable foreign regulatory authorities that a product candidate’s risk-benefit ratio for its proposed indication is acceptable; |\\n\\n| • | the FDA or comparable foreign regulatory authorities may fail to approve the manufacturing processes, test procedures and specifications, or facilities of third-party manufacturers responsible for clinical and commercial supplies; and |\\n\\n| • | the approval policies or regulations of the FDA or comparable foreign regulatory authorities may significantly change in a manner rendering our clinical data insufficient for approval. |\\n\\nThis lengthy approval process, as well as the unpredictability of the results of clinical studies, may result in our failure and/or that of our collaboration partners to obtain regulatory approval to market any of our product candidates, which would significantly harm our business, results of operations, and prospects. Additionally, if the FDA requires that we conduct additional clinical studies, places limitations in our label, delays approval to market our product candidates or limits the use of our products, our business and results of operations may be harmed.\\nIn addition, even if we were to obtain approval, regulatory authorities may approve any of our product candidates for fewer or more limited indications than we request, may not approve the price we intend to charge for our products, may grant approval contingent on the performance of costly post-marketing clinical trials, or may approve a product candidate with a label that does not include the labeling claims necessary or desirable for the successful commercialization of that product candidate. Any of the foregoing scenarios could materially harm the commercial prospects for our product candidates.\\nEven if we receive regulatory approval for a product candidate, we will be subject to ongoing regulatory obligations and continued regulatory review, which may result in significant additional expense. Additionally, any product candidates, if approved, could be subject to labeling and other restrictions and market withdrawal, and we may be subject to penalties if we fail to comply with regulatory requirements or experience unanticipated problems with our products.\\nEven if a drug is approved by the FDA or foreign regulatory authorities, the manufacturing processes, labeling, packaging, distribution, adverse event reporting, storage, advertising, promotion and recordkeeping for the product will be subject to extensive and ongoing regulatory requirements. These requirements include submissions of safety and other post-marketing information and reports, registration, as well as continued compliance with cGMPs and GCPs for any clinical trials that we conduct post-approval. As such, we and our third party contract manufacturers will be subject to continual review and periodic inspections to assess compliance with regulatory requirements. Accordingly, we and others with whom we work must continue to expend time, money, and effort in all areas of regulatory compliance, including manufacturing, production, and quality control. Regulatory authorities may also impose significant restrictions on a product’s indicated uses or marketing or impose ongoing requirements for potentially costly post-marketing studies. Furthermore, any new legislation addressing drug safety issues could result in delays or increased costs to assure compliance.\\nWe will also be required to report certain adverse reactions and production problems, if any, to the FDA, and to comply with requirements concerning advertising and promotion for our products. Promotional communications with respect to prescription drugs are subject to a variety of legal and regulatory restrictions and must be consistent with the information in the product’s approved label. As such, we may not promote our products for indications or uses for which they do not have FDA approval.\\nLater discovery of previously unknown problems with a product, including adverse events of unanticipated severity or frequency, or with our third-party manufacturers or manufacturing processes, or failure to comply with regulatory requirements, may result in, among other things:\\n| • | warning letters, fines or holds on clinical trials; |\\n\\n| • | restrictions on the marketing or manufacturing of the product, withdrawal of the product from the market or voluntary or mandatory product recalls; |\\n\\n| • | injunctions or the imposition of civil or criminal penalties; |\\n\\n| • | suspension or revocation of existing regulatory approvals; |\\n\\n| • | suspension of any of our ongoing clinical trials; |\\n\\n| • | refusal to approve pending applications or supplements to approved applications submitted by us; |\\n\\n| • | restrictions on our or our contract manufacturers’ operations; or |\\n\\n40\\n\\n| • | product seizure or detention, or refusal to permit the import or export of products. |\\n\\nAny government investigation of alleged violations of law could require us to expend significant time and resources in response, and could generate negative publicity. Any failure to comply with ongoing regulatory requirements may significantly and adversely affect our ability to commercialize our product candidates. If regulatory sanctions are applied or if regulatory approval is withdrawn, the value of our company and our operating results will be adversely affected.\\nIn addition, the FDA’s policies may change and additional government regulations may be enacted that could prevent, limit or delay regulatory approval of our product candidates. If we are slow or unable to adapt to changes in existing requirements or the adoption of new requirements or policies, or if we are not able to maintain regulatory compliance, we may lose any marketing approval that we may have obtained, which would adversely affect our business, prospects and ability to achieve or sustain profitability.\\nWe and our collaboration partners and contract manufacturers are subject to significant regulation with respect to manufacturing our product candidates. The manufacturing facilities on which we rely may not continue to meet regulatory requirements or may not be able to meet supply demands.\\nAll entities involved in the preparation of product candidates for clinical studies or commercial sale, including our existing contract manufacturers for our product candidates and AstraZeneca, and those contract manufacturers it may rely upon with respect to the manufacture of tenapanor, are subject to extensive regulation. Components of a finished therapeutic product approved for commercial sale or used in late-stage clinical studies must be manufactured in accordance with cGMP. These regulations govern manufacturing processes and procedures (including record keeping) and the implementation and operation of quality systems to control and assure the quality of investigational products and products approved for sale. Poor control of production processes can lead to the introduction of contaminants or to inadvertent changes in the properties or stability of our product candidates that may not be detectable in final product testing. We, our collaboration partners, or our contract manufacturers must supply all necessary documentation in support of an NDA or comparable regulatory filing on a timely basis and must adhere to cGMP regulations enforced by the FDA and other regulatory agencies through their facilities inspection programs. Some of our contract manufacturers have never produced a commercially approved pharmaceutical product and therefore have not obtained the requisite regulatory authority approvals to do so. The facilities and quality systems of some or all of our collaboration partners and third-party contractors must pass a pre-approval inspection for compliance with the applicable regulations as a condition of regulatory approval of our product candidates. In addition, the regulatory authorities may, at any time, audit or inspect a manufacturing facility involved with the preparation of our product candidates or our other potential products or the associated quality systems for compliance with the regulations applicable to the activities being conducted. Although we oversee the contract manufacturers, we cannot control the manufacturing process of, and are completely dependent on, other than with respect to tenapanor, our contract manufacturing partners for compliance with the regulatory requirements. AstraZeneca is fully responsible for the manufacture of tenapanor, and we are entirely dependent upon AstraZeneca for compliance with the regulatory requirements. If these facilities do not pass a pre-approval plant inspection, regulatory approval of the products may not be granted or may be substantially delayed until any violations are corrected to the satisfaction of the regulatory authority, if ever. In addition, we have no control over the ability of our contract manufacturers to maintain adequate quality control, quality assurance and qualified personnel.\\nThe regulatory authorities also may, at any time following approval of a product for sale, audit the manufacturing facilities of our collaboration partners and third-party contractors. If any such inspection or audit identifies a failure to comply with applicable regulations or if a violation of our product specifications or applicable regulations occurs independent of such an inspection or audit, we or the relevant regulatory authority may require remedial measures that may be costly and/or time consuming for us or a third party to implement, and that may include the temporary or permanent suspension of a clinical study or commercial sales or the temporary or permanent suspension of production or closure of a facility. Any such remedial measures imposed upon us or third parties with whom we contract could materially harm our business.\\nIf we, our collaboration partners, or any of our third-party manufacturers fail to maintain regulatory compliance, the FDA or other applicable regulatory authority can impose regulatory sanctions including, among other things, refusal to approve a pending application for a new drug product, withdrawal of an approval, or suspension of production. As a result, our business, financial condition, and results of operations may be materially harmed.\\nAdditionally, if supply from one approved manufacturer is interrupted, an alternative manufacturer would need to be qualified through an NDA, a supplemental NDA or equivalent foreign regulatory filing, which could result in further delay. The regulatory agencies may also require additional studies if a new manufacturer is relied upon for commercial production. Switching manufacturers may involve substantial costs and is likely to result in a delay in our desired clinical and commercial timelines.\\n41\\nThese factors could cause us to incur higher costs and could cause the delay or termination of clinical studies, regulatory submissions, required approvals, or commercialization of our product candidates. Furthermore, if our suppliers fail to meet contractual requirements and we are unable to secure one or more replacement suppliers capable of production at a substantially equivalent cost, our clinical studies may be delayed or we could lose potential revenue.\\nIf we fail to comply or are found to have failed to comply with FDA and other regulations related to the promotion of our products for unapproved uses, we could be subject to criminal penalties, substantial fines or other sanctions and damage awards.\\nThe regulations relating to the promotion of products for unapproved uses are complex and subject to substantial interpretation by the FDA and other government agencies. If tenapanor, or our other product candidates, receives marketing approval, we and our collaborating partners will be restricted from marketing the product outside of its approved labeling, also referred to as off-label promotion. However, physicians may nevertheless prescribe an approved product to their patients in a manner that is inconsistent with the approved label, which is an off-label use. We intend to implement compliance and training programs designed to ensure that our sales and marketing practices comply with applicable regulations regarding off-label promotion. Notwithstanding these programs, the FDA or other government agencies may allege or find that our practices constitute prohibited promotion of our product candidates for unapproved uses. We also cannot be sure that our employees will comply with company policies and applicable regulations regarding the promotion of products for unapproved uses.\\nOver the past several years, a significant number of pharmaceutical and biotechnology companies have been the target of inquiries and investigations by various federal and state regulatory, investigative, prosecutorial and administrative entities in connection with the promotion of products for unapproved uses and other sales practices, including the Department of Justice and various U.S. Attorneys’ Offices, the Office of Inspector General of the Department of Health and Human Services, the FDA, the Federal Trade Commission and various state Attorneys General offices. These investigations have alleged violations of various federal and state laws and regulations, including claims asserting antitrust violations, violations of the Food, Drug and Cosmetic Act, the False Claims Act, the Prescription Drug Marketing Act, anti-kickback laws, and other alleged violations in connection with the promotion of products for unapproved uses, pricing and Medicare and/or Medicaid reimbursement. Many of these investigations originate as “qui tam” actions under the False Claims Act. Under the False Claims Act, any individual can bring a claim on behalf of the government alleging that a person or entity has presented a false claim, or caused a false claim to be submitted, to the government for payment. The person bringing a qui tam suit is entitled to a share of any recovery or settlement. Qui tam suits, also commonly referred to as “whistleblower suits,” are often brought by current or former employees. In a qui tam suit, the government must decide whether to intervene and prosecute the case. If it declines, the individual may pursue the case alone.\\nIf the FDA or any other governmental agency initiates an enforcement action against us or if we are the subject of a qui tam suit and it is determined that we violated prohibitions relating to the promotion of products for unapproved uses, we could be subject to substantial civil or criminal fines or damage awards and other sanctions such as consent decrees and corporate integrity agreements pursuant to which our activities would be subject to ongoing scrutiny and monitoring to ensure compliance with applicable laws and regulations. Any such fines, awards or other sanctions would have an adverse effect on our revenue, business, financial prospects and reputation.\\nIf approved, tenapanor and our other product candidates may cause or contribute to adverse medical events that we are required to report to regulatory agencies and if we fail to do so we could be subject to sanctions that would materially harm our business.\\nSome participants in clinical studies of tenapanor have reported adverse effects after being treated with tenapanor, including diarrhea, nausea, flatulence, abdominal discomfort, abdominal pain, abdominal distention and changes in electrolytes. If we are successful in commercializing any products, FDA and foreign regulatory agency regulations require that we report certain information about adverse medical events if those products may have caused or contributed to those adverse events. The timing of our obligation to report would be triggered by the date we become aware of the adverse event as well as the nature of the event. We may fail to report adverse events we become aware of within the prescribed timeframe. We may also fail to appreciate that we have become aware of a reportable adverse event, especially if it is not reported to us as an adverse event or if it is an adverse event that is unexpected or removed in time from the use of our products. If we fail to comply with our reporting obligations, the FDA or a foreign regulatory agency could take action, including criminal prosecution, the imposition of civil monetary penalties, seizure of our products or delay in approval or clearance of future products.\\n42\\nOur employees, independent contractors, principal investigators, CROs, collaboration partners, consultants and vendors may engage in misconduct or other improper activities, including noncompliance with regulatory standards and requirements.\\nWe are exposed to the risk that our employees, independent contractors, principal investigators, CROs, collaboration partners, consultants and vendors may engage in fraudulent conduct or other illegal activity. Misconduct by these parties could include intentional, reckless and/or negligent conduct or unauthorized activities that violate: (1) FDA regulations, including those laws that require the reporting of true, complete and accurate information to the FDA; (2) manufacturing standards; (3) federal and state healthcare fraud and abuse laws and regulations; or (4) laws that require the reporting of true and accurate financial information and data. Specifically, sales, marketing and business arrangements in the healthcare industry are subject to extensive laws and regulations intended to prevent fraud, kickbacks, self-dealing and other abusive practices. These laws and regulations may restrict or prohibit a wide range of pricing, discounting, marketing and promotion, sales commission, customer incentive programs and other business arrangements. These activities also include the improper use of information obtained in the course of clinical trials, which could result in regulatory sanctions and serious harm to our reputation. It is not always possible to identify and deter misconduct by employees and other third parties, and the precautions we take to detect and prevent this activity may not be effective in controlling unknown or unmanaged risks or losses or in protecting us from governmental investigations or other actions or lawsuits stemming from a failure to be in compliance with such laws or regulations. If any such actions are instituted against us, and we are not successful in defending ourselves or asserting our rights, those actions could have a significant impact on our business, including the imposition of significant civil, criminal and administrative penalties, damages, monetary fines, possible exclusion from participation in Medicare, Medicaid and other federal healthcare programs, contractual damages, reputational harm, diminished profits and future earnings, and curtailment of our operations, any of which could adversely affect our ability to operate our business and our results of operations.\\nFailure to obtain regulatory approvals in foreign jurisdictions would prevent us from marketing our products internationally.\\nIn order to market any product in the EEA (which is composed of the 28 Member States of the European Union plus Norway, Iceland and Liechtenstein), and many other foreign jurisdictions, separate regulatory approvals are required. In the EEA, medicinal products can only be commercialized after obtaining a Marketing Authorization, or MA. Before granting the MA, the EMA or the competent authorities of the Member States of the EEA make an assessment of the risk-benefit balance of the product on the basis of scientific criteria concerning its quality, safety and efficacy.\\nThe approval procedures vary among countries and can involve additional clinical testing, and the time required to obtain approval may differ from that required to obtain FDA approval. Clinical trials conducted in one country may not be accepted by regulatory authorities in other countries. Approval by the FDA does not ensure approval by regulatory authorities in other countries, and approval by one or more foreign regulatory authorities does not ensure approval by regulatory authorities in other foreign countries or by the FDA. However, a failure or delay in obtaining regulatory approval in one country may have a negative effect on the regulatory process in others. The foreign regulatory approval process may include all of the risks associated with obtaining FDA approval. We may not be able to file for regulatory approvals or to do so on a timely basis, and even if we do file we may not receive necessary approvals to commercialize our products in any market.\\nWe and our collaboration partners may be subject to healthcare laws, regulation and enforcement; our failure or the failure of our collaboration partners to comply with these laws could have a material adverse effect on our results of operations and financial conditions.\\nAlthough we do not currently have any products on the market, once we begin commercializing our products, we and our collaboration partners may be subject to additional healthcare statutory and regulatory requirements and enforcement by the federal government and the states and foreign governments in which we conduct our business. The laws that may affect our ability to operate as a commercial organization include:\\n| • | the federal Anti-Kickback Statute, which prohibits, among other things, persons from knowingly and willfully soliciting, receiving, offering or paying remuneration, directly or indirectly, in exchange for or to induce either the referral of an individual for, or the purchase, order or recommendation of, any good or service for which payment may be made under federal healthcare programs such as the Medicare and Medicaid programs; |\\n\\n| • | federal false claims laws which prohibit, among other things, individuals or entities from knowingly presenting, or causing to be presented, claims for payment from Medicare, Medicaid, or other third-party payors that are false or fraudulent; |\\n\\n| • | federal criminal laws that prohibit executing a scheme to defraud any healthcare benefit program or making false statements relating to healthcare matters; |\\n\\n| • | the federal Health Insurance Portability and Accountability Act of 1996, as amended by the Health Information Technology for Economic and Clinical Health Act, which governs the conduct of certain electronic healthcare transactions and protects the security and privacy of protected health information; |\\n\\n43\\n\\n| • | the federal physician sunshine requirements under the Affordable Care Act, which requires manufacturers of drugs, devices, biologics, and medical supplies to report annually to the CMS information related to payments and other transfers of value to physicians, other healthcare providers, and teaching hospitals, and ownership and investment interests held by physicians and other healthcare providers and their immediate family members; |\\n\\n| • | state law equivalents of each of the above federal laws, such as anti-kickback and false claims laws which may apply to items or services reimbursed by any third-party payor, including commercial insurers; |\\n\\n| • | state laws that require pharmaceutical companies to comply with the pharmaceutical industry’s voluntary compliance guidelines and the applicable compliance guidance promulgated by the federal government, or otherwise restrict payments that may be made to healthcare providers and other potential referral sources; |\\n\\n| • | state laws that require drug manufacturers to report information related to payments and other transfers of value to physicians and other healthcare providers or marketing expenditures; and state laws governing the privacy and security of health information in certain circumstances, many of which differ from each other in significant ways, thus complicating compliance efforts; and |\\n\\n| • | European and other foreign law equivalents of each of the laws, including reporting requirements detailing interactions with and payments to healthcare providers. |\\n\\nBecause of the breadth of these laws and the narrowness of the statutory exceptions and safe harbors available, it is possible that some of our business activities could be subject to challenge under one or more of such laws. The risk of our being found in violation of these laws is increased by the fact that many of them have not been fully interpreted by the regulatory authorities or the courts, and their provisions are open to a variety of interpretations. Further, the Affordable Care Act, among other things, amends the intent requirement of the federal anti-kickback and criminal health care fraud statutes. A person or entity no longer needs to have actual knowledge of this statute or specific intent to violate it. In addition, the Affordable Care Act provides that the government may assert that a claim including items or services resulting from a violation of the federal anti-kickback statute constitutes a false or fraudulent claim for purposes of the false claims statutes. Any action against us for violation of these laws, even if we successfully defend against it, could cause us to incur significant legal expenses and divert our management’s attention from the operation of our business. If our operations are found to be in violation of any of the laws described above or any other governmental laws and regulations that apply to us, we may be subject to penalties, including civil and criminal penalties, damages, fines, the curtailment or restructuring of our operations, the exclusion from participation in federal and state healthcare programs and imprisonment, any of which could adversely affect our ability to market our products and adversely impact our financial results.\\nLegislative or regulatory healthcare reforms in the United States may make it more difficult and costly for us to obtain regulatory clearance or approval of our product candidates and to produce, market and distribute our products after clearance or approval is obtained.\\nFrom time to time, legislation is drafted and introduced in Congress that could significantly change the statutory provisions governing the regulatory clearance or approval, manufacture, and marketing of regulated products or the reimbursement thereof. In addition, FDA regulations and guidance are often revised or reinterpreted by the FDA in ways that may significantly affect our business and our products. Any new regulations or revisions or reinterpretations of existing regulations may impose additional costs or lengthen review times of our product candidates. We cannot determine what effect changes in regulations, statutes, legal interpretation or policies, when and if promulgated, enacted or adopted may have on our business in the future. Such changes could, among other things, require:\\n| • | additional clinical trials to be conducted prior to obtaining approval; |\\n\\n| • | changes to manufacturing methods; |\\n\\n| • | recall, replacement, or discontinuance of one or more of our products; and |\\n\\n| • | additional record keeping. |\\n\\nEach of these would likely entail substantial time and cost and could materially harm our business and our financial results. In addition, delays in receipt of or failure to receive regulatory clearances or approvals for any future products would harm our business, financial condition and results of operations.\\nIn addition, the full impact of recent healthcare reform and other changes in the healthcare industry and in healthcare spending is currently unknown, and may adversely affect our business model. In the United States, the Affordable Care Act was enacted in 2010 with a goal of reducing the cost of healthcare and substantially changing the way healthcare is financed by both government and private insurers. The Affordable Care Act, among other things, increased the minimum Medicaid rebates owed by manufacturers under the Medicaid Drug Rebate Program and extended the rebate program to individuals enrolled in Medicaid managed care organizations, established annual fees and taxes on manufacturers of certain branded prescription drugs, and created a new Medicare\\n44\\nPart D coverage gap discount program, in which manufacturers must agree to offer 50% point-of-sale discounts off negotiated prices of applicable brand drugs to eligible beneficiaries during their coverage gap period as a condition for the manufacturer’s outpatient drugs to be covered under Medicare Part D.\\nIn addition, other legislative changes have been proposed and adopted in the United States since the Affordable Care Act was enacted. On August 2, 2011, the Budget Control Act of 2011 created measures for spending reductions by Congress. A Joint Select Committee on Deficit Reduction, tasked with recommending a targeted deficit reduction of at least $1.2 trillion for the years 2013 through 2021, was unable to reach required goals, thereby triggering the legislation’s automatic reduction to several government programs. This included aggregate reductions of Medicare payments to providers of 2% per fiscal year, which went into effect on April 1, 2013. On January 2, 2013, the ATRA was signed into law, which, among other things, further reduced Medicare payments to several providers, including hospitals.\\nIt is likely that federal and state legislatures within the United States and foreign governments will continue to consider changes to existing healthcare legislation. We cannot predict the reform initiatives that may be adopted in the future or whether initiatives that have been adopted will be repealed or modified. The continuing efforts of the government, insurance companies, managed care organizations and other payors of healthcare services to contain or reduce costs of healthcare may adversely affect the demand for any drug products for which we may obtain regulatory approval, our ability to set a price that we believe is fair for our products, our ability to obtain coverage and reimbursement approval for a product, our ability to generate revenues and achieve or maintain profitability, and the level of taxes that we are required to pay.\\nRisks Related to Intellectual Property\\nWe may become subject to claims alleging infringement of third parties’ patents or proprietary rights and/or claims seeking to invalidate our patents, which would be costly, time consuming and, if successfully asserted against us, delay or prevent the development and commercialization of tenapanor or any other product candidates.\\nThere have been many lawsuits and other proceedings asserting infringement or misappropriation of patents and other intellectual property rights in the pharmaceutical and biotechnology industries. There can be no assurances that we will not be subject to claims alleging that the manufacture, use or sale of tenapanor or any other product candidates nor that any activities conducted by us, infringes existing or future third-party patents, or that such claims, if any, will not be successful. Because patent applications can take many years to issue and may be confidential for 18 months or more after filing, and because pending patent claims can be revised before issuance, there may be applications now pending which may later result in issued patents that may be infringed by the manufacture, use or sale of tenapanor or other product candidates or by the operation of our business. Moreover, we may face patent infringement claims from non-practicing entities that have no relevant product revenue and against whom our own patent portfolio may thus have no deterrent effect. We may be unaware of one or more issued patents that would be infringed by the manufacture, sale or use of tenapanor or our other product candidates.\\nWe may be subject to third-party patent infringement claims in the future against us or our collaboration partners that would cause us to incur substantial expenses and, if successful against us, could cause us to pay substantial damages, including treble damages and attorney’s fees if we are found to be willfully infringing a third party’s patents. We may be required to indemnify future collaboration partners against such claims. We are not aware of any threatened or pending claims related to these matters, but in the future litigation may be necessary to defend against such claims. If a patent infringement suit were brought against us or our collaboration partners, we or they could be forced to stop or delay research, development, manufacturing or sales of the product or product candidate that is the subject of the suit. As a result of patent infringement claims, or in order to avoid potential claims, we or our collaboration partners may choose to seek, or be required to seek, a license from the third party and would most likely be required to pay license fees or royalties or both. These licenses may not be available on acceptable terms, or at all. Even if we or our collaboration partners were able to obtain a license, the rights may be nonexclusive, which would give our competitors access to the same intellectual property. Ultimately, we could be prevented from commercializing a product, or forced to redesign it, or to cease some aspect of our business operations if, as a result of actual or threatened patent infringement claims, we or our collaboration partners are unable to enter into licenses on acceptable terms. Even if we are successful in defending against such claims, such litigation can be expensive and time consuming to litigate and would divert management’s attention from our core business. Any of these events could harm our business significantly.\\nIn addition to infringement claims against us, if third parties prepare and file patent applications in the United States that also claim technology similar or identical to ours, we may have to participate in interference or derivation proceedings in the United States Patent and Trademark Office, or the USPTO, to determine which party is entitled to a patent on the disputed invention. We may also become involved in similar opposition proceedings in the European Patent Office or similar offices in other jurisdictions regarding our intellectual property rights with respect to our products and technology. Since patent applications are confidential for a period of time after filing, we cannot be certain that we were the first to file any patent application related to our product candidates.\\n45\\nIf our intellectual property related to our product candidates is not adequate or if we are not able to protect our trade secrets or our confidential information, we may not be able to compete effectively in our market.\\nWe rely upon a combination of patents, trade secret protection and confidentiality agreements to protect the intellectual property related to our product candidates, our drug discovery and development platform and our development programs. Any disclosure to or misappropriation by third parties of our confidential or proprietary information could enable competitors to quickly duplicate or surpass our technological achievements, thus eroding our competitive position in our market.\\nThe strength of patents in the biotechnology and pharmaceutical field involves complex legal and scientific questions and can be uncertain. The patent applications that we own or license may fail to result in issued patents in the United States or in foreign countries. Additionally, our research and development efforts may result in product candidates for which patent protection is limited or not available. Even if patents do successfully issue, third parties may challenge the validity, enforceability or scope thereof, which may result in such patents being narrowed, invalidated or held unenforceable. For example, U.S. patents can be challenged by any person before the new USPTO Patent Trial and Appeals Board at any time before one year after that person is served an infringement complaint based on the patents. Patents granted by the European Patent Office may be similarly opposed by any person within nine months from the publication of the grant. Similar proceedings are available in other jurisdictions, and in the United States, Europe and other jurisdictions third parties can raise questions of validity with a patent office even before a patent has granted. Furthermore, even if they are unchallenged, our patents and patent applications may not adequately protect our intellectual property or prevent others from designing around our claims. For example, a third party may develop a competitive product that provides therapeutic benefits similar to one or more of our product candidates but has a sufficiently different composition to fall outside the scope of our patent protection. If the breadth or strength of protection provided by the patents and patent applications we hold or pursue with respect to our product candidates is successfully challenged, then our ability to commercialize such product candidates could be negatively affected, and we may face unexpected competition that could have a material adverse impact on our business. Further, if we encounter delays in our clinical trials, the period of time during which we or our collaboration partners could market tenapanor or other product candidates under patent protection would be reduced.\\nEven where laws provide protection, costly and time-consuming litigation could be necessary to enforce and determine the scope of our proprietary rights, and the outcome of such litigation would be uncertain. If we or one of our collaboration partners were to initiate legal proceedings against a third party to enforce a patent covering the product candidate, the defendant could counterclaim that our patent is invalid and/or unenforceable. In patent litigation in the United States, defendant counterclaims alleging invalidity and/or unenforceability are commonplace. Grounds for a validity challenge could be an alleged failure to meet any of several statutory requirements, including lack of novelty, obviousness or non-enablement. Grounds for an unenforceability assertion could be an allegation that someone connected with prosecution of the patent withheld relevant information from the USPTO, or made a misleading statement, during prosecution. The outcome following legal assertions of invalidity and unenforceability is unpredictable. With respect to validity, for example, we cannot be certain that there is no invalidating prior art, of which we and the patent examiner were unaware during prosecution. If a defendant were to prevail on a legal assertion of invalidity and/or unenforceability against our intellectual property related to a product candidate, we would lose at least part, and perhaps all, of the patent protection on such product candidate. Such a loss of patent protection would have a material adverse impact on our business. Moreover, our competitors could counterclaim that we infringe their intellectual property, and some of our competitors have substantially greater intellectual property portfolios than we do.\\nWe also rely on trade secret protection and confidentiality agreements to protect proprietary know-how that may not be patentable, processes for which patents may be difficult to obtain and/or enforce and any other elements of our drug discovery and development processes that involve proprietary know-how, information or technology that is not covered by patents. Although we require all of our employees, consultants, advisors and any third parties who have access to our proprietary know-how, information or technology, to assign their inventions to us, and endeavor to execute confidentiality agreements with all such parties, we cannot be certain that we have executed such agreements with all parties who may have helped to develop our intellectual property or who had access to our proprietary information, nor can we be certain that our agreements will not be breached by such consultants, advisors or third parties, or by our former employees. The breach of such agreements by individuals or entities who are actively involved in the discovery and design of our potential drug candidates, or in the development of our discovery and design platform, including APECCS, could require us to pursue legal action to protect our trade secrets and confidential information, which would be expensive, and the outcome of which would be unpredictable. If we are not successful in prohibiting the continued breach of such agreements, our business could be negatively impacted. We cannot guarantee that our trade secrets and other confidential proprietary information will not be disclosed or that competitors will not otherwise gain access to our trade secrets or independently develop substantially equivalent information and techniques.\\n46\\nFurther, the laws of some foreign countries do not protect proprietary rights to the same extent or in the same manner as the laws of the United States. As a result, we may encounter significant problems in protecting and defending our intellectual property both in the United States and abroad. If we are unable to prevent material disclosure of the intellectual property related to our technologies to third parties, we will not be able to establish or maintain a competitive advantage in our market, which could materially adversely affect our business, results of operations and financial condition.\\nIf we or our collaboration partners do not obtain patent term extension in the United States under the Hatch-Waxman Act and in foreign countries under similar legislation, thereby potentially extending the term of marketing exclusivity for our product candidates, our business may be materially harmed.\\nDepending upon the timing, duration and specifics of FDA marketing approval of our product candidates, if any, one of the U.S. patents covering each of such approved product(s) or the use thereof may be eligible for up to five years of patent term restoration under the Hatch-Waxman Act. The Hatch-Waxman Act allows a maximum of one patent to be extended per FDA approved product. Patent term extension also may be available in certain foreign countries upon regulatory approval of our product candidates. Nevertheless, we or our collaboration partners may not be granted patent term extension either in the United States or in any foreign country because of, for example, failing to apply within applicable deadlines, failing to apply prior to expiration of relevant patents or otherwise failing to satisfy applicable requirements. Moreover, the term of extension, as well as the scope of patent protection during any such extension, afforded by the governmental authority could be less than we request.\\nIf we are unable to obtain patent term extension or restoration, or the term of any such extension is less than we or our collaboration partners request, the period during which we or our collaboration partners will have the right to exclusively market our product will be shortened and our competitors may obtain approval of competing products following our patent expiration, and our revenue could be reduced, possibly materially.\\nChanges in U.S. patent law could diminish the value of patents in general, thereby impairing our ability to protect our products.\\nAs is the case with other biopharmaceutical companies, our success is heavily dependent on intellectual property, particularly patents. Obtaining and enforcing patents in the biopharmaceutical industry involve both technological and legal complexity. Therefore, obtaining and enforcing biopharmaceutical patents is costly, time consuming and inherently uncertain. In addition, the United States has recently enacted and is currently implementing wide-ranging patent reform legislation, including the Leahy-Smith America Invents Act signed into law on September 16, 2011. That Act includes a number of significant changes to U.S. patent law. These include provisions that affect the way patent applications are prosecuted and new venues and opportunities for competitors to challenge patent portfolios. Because of that Act, the U.S. patent system is now a “first to file” system, which may make it more difficult to obtain patent protection for inventions and increase the uncertainties and costs surrounding the prosecution of our or our collaboration partners’ patent applications and the enforcement or defense of our or our collaboration partners’ issued patents, all of which could materially adversely affect our business, results of operations and financial condition.\\nThe United States Supreme Court has ruled on several patent cases in recent years, either narrowing the scope of patent protection available in certain circumstances or weakening the rights of patent owners in certain situations. In addition to increasing uncertainty with regard to our ability to obtain patents in the future, this combination of events has created uncertainty with respect to the value of patents once obtained. Depending on future actions by the U.S. Congress, the federal courts, and the USPTO, the laws and regulations governing patents could change in unpredictable ways that would weaken our ability to obtain new patents or to enforce our existing patents and patents that we might obtain in the future.\\nObtaining and maintaining our patent protection depends on compliance with various procedural, document submission, fee payment and other requirements imposed by governmental patent agencies, and our patent protection could be reduced or eliminated for non-compliance with these requirements.\\nThe USPTO and various foreign patent agencies require compliance with a number of procedural, documentary, fee payment and other provisions to maintain patent applications and issued patents. Noncompliance with these requirements can result in abandonment or lapse of a patent or patent application, resulting in partial or complete loss of patent rights in the relevant jurisdiction. In such an event, competitors might be able to enter the market earlier than would otherwise have been the case.\\nWe may not be able to enforce our intellectual property rights throughout the world.\\nThe laws of some foreign countries do not protect intellectual property rights to the same extent as the laws of the United States. Many companies have encountered significant problems in protecting and defending intellectual property rights in certain foreign jurisdictions. The legal systems of some countries, particularly developing countries, do not favor the enforcement of patents and other intellectual property protection, especially those relating to life sciences. This could make it difficult for us to stop the infringement of our patents or the misappropriation of our other intellectual property rights. For example, many foreign countries have compulsory licensing laws under which a patent owner must grant licenses to third parties.\\n47\\nProceedings to enforce our patent rights in foreign jurisdictions, whether or not successful, could result in substantial costs and divert our efforts and attention from other aspects of our business. Furthermore, while we intend to protect our intellectual property rights in our expected significant markets, we cannot ensure that we will be able to initiate or maintain similar efforts in all jurisdictions in which we may wish to market our products. Accordingly, our efforts to protect our intellectual property rights in such countries may be inadequate. In addition, changes in the law and legal decisions by courts in the United States and foreign countries may affect our ability to obtain and enforce adequate intellectual property protection for our technology.\\nWe may be subject to claims that we or our employees have misappropriated the intellectual property, including know-how or trade secrets, of a third party, or claiming ownership of what we regard as our own intellectual property.\\nMany of our employees, consultants and contractors were previously employed at or engaged by other biotechnology or pharmaceutical companies, including our competitors or potential competitors. Some of these employees, consultants and contractors, executed proprietary rights, non-disclosure and non-competition agreements in connection with such previous employment. Although we try to ensure that our employees, consultants and contractors do not use the intellectual property and other proprietary information or know-how or trade secrets of others in their work for us, and do not perform work for us that is in conflict with their obligations to another employer or any other entity, we may be subject to claims that we or these employees, consultants and contractors have used or disclosed such intellectual property, including know-how, trade secrets or other proprietary information. In addition, an employee, advisor or consultant who performs work for us may have obligations to a third party that are in conflict with their obligations to us, and as a result such third party may claim an ownership interest in the intellectual property arising out of work performed for us. We are not aware of any threatened or pending claims related to these matters, but in the future litigation may be necessary to defend against such claims. If we fail in defending any such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights or personnel, or access to consultants and contractors. Even if we are successful in defending against such claims, litigation could result in substantial costs and be a distraction to management.\\nIn addition, while we typically require our employees, consultants and contractors who may be involved in the development of intellectual property to execute agreements assigning such intellectual property to us, we may be unsuccessful in executing such an agreement with each party who in fact develops intellectual property that we regard as our own, which may result in claims by or against us related to the ownership of such intellectual property. If we fail in prosecuting or defending any such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights. Even if we are successful in prosecuting or defending against such claims, litigation could result in substantial costs and be a distraction to our management and scientific personnel.\\nRisks Related to Our Common Stock\\nOur stock price may be volatile and our stockholders may not be able to resell shares of our common stock at or above the price they paid.\\nThe trading price of our common stock is highly volatile and could be subject to wide fluctuations in response to various factors, some of which are beyond our control. These factors include those discussed in this “Risk Factors” section of this Quarterly Report on Form 10Q and others such as:\\n| • | results from, or any delays in, clinical trial programs relating to our product candidates, including the ongoing and planned clinical trials for tenapanor; |\\n\\n| • | ability to commercialize or obtain regulatory approval for our product candidates, or delays in commercializing or obtaining regulatory approval; |\\n\\n| • | announcements of regulatory approval or a complete response letter to tenapanor, or specific label indications or patient populations for its use, or changes or delays in the regulatory review process; |\\n\\n| • | announcements relating to future collaboration partnerships or our existing collaboration partnerships with AstraZeneca and/or Sanofi, including decisions regarding the exercise by AstraZeneca or Sanofi of their options or any termination by them of any development program under their collaboration partnerships with us; |\\n\\n| • | our election, and the related announcement, to exercise our co-fund right with respect to the first Phase 3 clinical development program for tenapanor; |\\n\\n| • | announcements of therapeutic innovations or new products by us or our competitors; |\\n\\n| • | adverse actions taken by regulatory agencies with respect to our clinical trials, manufacturing supply chain or sales and marketing activities; |\\n\\n| • | changes or developments in laws or regulations applicable to our product candidates; |\\n\\n| • | any adverse changes to our relationship with any manufacturers or suppliers; |\\n\\n\\n| • | the success of our testing and clinical trials; |\\n\\n48\\n\\n| • | the success of our efforts to acquire or license or discover additional product candidates; |\\n\\n| • | any intellectual property infringement actions in which we may become involved; |\\n\\n| • | announcements concerning our competitors or the pharmaceutical industry in general; |\\n\\n| • | achievement of expected product sales and profitability; |\\n\\n| • | manufacture, supply or distribution shortages; |\\n\\n| • | actual or anticipated fluctuations in our operating results; |\\n\\n| • | FDA or other U.S. or foreign regulatory actions affecting us or our industry or other healthcare reform measures in the United States; |\\n\\n| • | changes in financial estimates or recommendations by securities analysts; |\\n\\n| • | trading volume of our common stock; |\\n\\n| • | sales of our common stock by us, our executive officers and directors or our stockholders in the future; |\\n\\n| • | general economic and market conditions and overall fluctuations in the United States equity markets; and |\\n\\n| • | the loss of any of our key scientific or management personnel. |\\n\\nIn addition, the stock markets in general, and the markets for pharmaceutical, biopharmaceutical and biotechnology stocks in particular, have experienced extreme volatility that may have been unrelated to the operating performance of the issuer. These broad market fluctuations may adversely affect the trading price or liquidity of our common stock. In the past, when the market price of a stock has been volatile, holders of that stock have sometimes instituted securities class action litigation against the issuer. If any of our stockholders were to bring such a lawsuit against us, we could incur substantial costs defending the lawsuit and the attention of our management would be diverted from the operation of our business, which could seriously harm our financial position. Any adverse determination in litigation could also subject us to significant liabilities.\\nAn active, liquid and orderly market for our common stock may not develop or be sustained\\nWe completed our IPO in June 2014. Prior to that, there had been no public market for shares of our common stock. Following our IPO, the trading volume of our common stock on The NASDAQ Global Market has been limited, and an active public market for our shares may not develop or, if it develops, be sustained.\\nWe cannot predict the extent in which investor interest in our company will lead to the development of, or sustain an active trading market on The NASDAQ Global Market or otherwise or how liquid that market might become. The lack of an active market may impair our stockholders’ ability to sell their shares at the time they wish to sell them or at a price that they consider reasonable. An inactive market may also impair our ability to raise capital by selling shares and may impair our ability to acquire other businesses or technologies or in-license new product candidates using our shares as consideration.\\nIf securities or industry analysts do not continue to publish research or reports about our business, or if they issue an adverse or misleading opinion regarding our stock, our stock price and trading volume could decline.\\nThe trading market for our common stock is influenced by the research and reports that industry or securities analysts publish about us or our business. If any of the analysts who cover us issue an adverse or misleading opinion regarding us, our business model, our intellectual property or our stock performance, or if our clinical trials and operating results fail to meet the expectations of analysts, our stock price would likely decline. If one or more of these analysts cease coverage of us or fail to publish reports on us regularly, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline.\\nWe are an “emerging growth company” and as a result of the reduced disclosure and governance requirements applicable to emerging growth companies, our common stock may be less attractive to investors.\\nWe are an “emerging growth company,” as defined in the JOBS Act, and we intend to take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. If some investors find our common stock less attractive as a result of our reliance on the JOBS Act exemption, there may be a less active trading market for our common stock and our stock price may be more volatile. We may take advantage of these reporting exemptions until we are no longer an emerging growth company. We will remain an emerging growth company until the earlier of (1) the last day of the fiscal year following the fifth anniversary of the completion of our IPO (December 31, 2019), (2) the last day of the fiscal year in which we have total annual gross revenue of at least $1.0 billion, or (3) the last day of the fiscal year in\\n49\\nwhich we are deemed to be a large accelerated filer, which means the market value of our common stock that is held by non-affiliates exceeds $700 million as of the prior June 30th, and (4) the date on which we have issued more than $1.0 billion in non-convertible debt during the prior three-year period.\\nIf we sell shares of our common stock in future financings, stockholders may experience immediate dilution and, as a result, our stock price may decline.\\nWe may from time to time issue additional shares of common stock at a discount from the current trading price of our common stock. As a result, our stockholders would experience immediate dilution upon the purchase of any shares of our common stock sold at such discount. In addition, as opportunities present themselves, we may enter into financing or similar arrangements in the future, including the issuance of debt securities, preferred stock or common stock. If we issue common stock or securities convertible into common stock, our common stockholders would experience additional dilution and, as a result, our stock price may decline.\\nSales of a substantial number of shares of our common stock in the public market could cause our stock price to fall.\\nIf our existing stockholders sell, or indicate an intention to sell, substantial amounts of our common stock in the public market after the lock-up and other legal restrictions on resale in connection with our IPO lapse, the trading price of our common stock could decline. As of June 30, 2014, we had 18,529,067 shares of common stock outstanding. Of those shares, the 4,101,632 shares sold in our IPO are freely tradable, without restriction (except as otherwise applicable), in the public market. The remaining 827,268 shares sold in our IPO are subject to the lock-up agreements pertaining to our IPO.\\nThe lock-up agreements pertaining to our IPO will expire on December 15, 2014. After the lock-up agreements expire, as of June 30, 2014, up to an additional 14,427,435 shares of common stock will be eligible for sale in the public market, 12,826,261 of which are held by current directors, executive officers and other affiliates and may be subject to Rule 144 under the Securities Act of 1933, or the Securities Act.\\nIn addition, as of June 30, 2014, 1.1 million shares of common stock that are subject to outstanding options, will become eligible for sale in the public market to the extent permitted by the provisions of various vesting schedules, the lock-up agreements and Rule 144 and Rule 701 under the Securities Act. If these additional shares of common stock are sold, or if it is perceived that they will be sold, in the public market, the trading price of our common stock could decline.\\nThe holders of approximately 12.4 million shares of our outstanding common stock as of June 30, 2014, are entitled to rights with respect to the registration of their shares under the Securities Act, subject to vesting schedules and to the lock-up agreements described above. Registration of these shares under the Securities Act would result in the shares becoming freely tradable without restriction under the Securities Act, except for shares purchased by affiliates. Any sales of securities by these stockholders could have a material adverse effect on the trading price of our common stock.\\nOur principal stockholders and management own a significant percentage of our stock and will be able to exert significant control over matters subject to stockholder approval.\\nAs of June 30, 2014, our executive officers, directors, holders of 5% or more of our capital stock and their respective affiliates beneficially owned approximately two-thirds of our outstanding voting stock. Therefore, these stockholders will have the ability to influence us through this ownership position. These stockholders may be able to determine all matters requiring stockholder approval. For example, these stockholders may be able to control elections of directors, amendments of our organizational documents, or approval of any merger, sale of assets, or other major corporate transaction. This may prevent or discourage unsolicited acquisition proposals or offers for our common stock that certain stockholders may feel are in their best interest as one of our stockholders.\\nWe have broad discretion to determine how to use the funds raised in our IPO, and may use them in ways that may not enhance our operating results or the price of our common stock.\\nOur management has broad discretion over the use of proceeds from our IPO, and we could spend the proceeds from this offering in ways our stockholders may not agree with or that do not yield a favorable return, if at all. We currently intend to use substantially all of the net proceeds of this offering to fund continued discovery and development efforts for our preclinical product candidates, the exercise of our right to co-fund the first Phase 3 clinical development program for tenapanor, if we decide to exercise such right, expenses related to the development of APECCS, and the balance for working capital and general corporate purposes, which will include facilities expansion and the pursuit of other research and discovery efforts and could also include the acquisition or in-license of other products, product candidates or technologies. However, our use of these proceeds may differ substantially from our current plans. If we do not invest or apply the proceeds of this offering in ways that improve our operating results, we may fail to achieve expected financial results, which could cause our stock price to decline.\\n50\\nProvisions in our charter documents and under Delaware law could discourage a takeover that stockholders may consider favorable and may lead to entrenchment of management.\\nOur amended and restated certificate of incorporation and amended and restated bylaws contain provisions that could significantly reduce the value of our shares to a potential acquirer or delay or prevent changes in control or changes in our management without the consent of our board of directors. The provisions in our charter documents include the following:\\n| • | a classified board of directors with three-year staggered terms, which may delay the ability of stockholders to change the membership of a majority of our board of directors; |\\n\\n| • | no cumulative voting in the election of directors, which limits the ability of minority stockholders to elect director candidates; |\\n\\n| • | the exclusive right of our board of directors to elect a director to fill a vacancy created by the expansion of the board of directors or the resignation, death or removal of a director, which prevents stockholders from being able to fill vacancies on our board of directors; |\\n\\n| • | the required approval of at least 66 2/3% of the shares entitled to vote to remove a director for cause, and the prohibition on removal of directors without cause; |\\n\\n| • | the ability of our board of directors to authorize the issuance of shares of preferred stock and to determine the price and other terms of those shares, including preferences and voting rights, without stockholder approval, which could be used to significantly dilute the ownership of a hostile acquiror; |\\n\\n| • | the ability of our board of directors to alter our bylaws without obtaining stockholder approval; |\\n\\n| • | the required approval of at least 66 2/3% of the shares entitled to vote at an election of directors to adopt, amend or repeal our bylaws or repeal the provisions of our amended and restated certificate of incorporation regarding the election and removal of directors; |\\n\\n| • | a prohibition on stockholder action by written consent, which forces stockholder action to be taken at an annual or special meeting of our stockholders; |\\n\\n| • | the requirement that a special meeting of stockholders may be called only by the chairman of the board of directors, the chief executive officer, the president or the board of directors, which may delay the ability of our stockholders to force consideration of a proposal or to take action, including the removal of directors; and |\\n\\n| • | advance notice procedures that stockholders must comply with in order to nominate candidates to our board of directors or to propose matters to be acted upon at a stockholders’ meeting, which may discourage or deter a potential acquiror from conducting a solicitation of proxies to elect the acquiror’s own slate of directors or otherwise attempting to obtain control of us. |\\n\\nIn addition, these provisions would apply even if we were to receive an offer that some stockholders may consider beneficial.\\nWe are also subject to the anti-takeover provisions contained in Section 203 of the Delaware General Corporation Law. Under Section 203, a corporation may not, in general, engage in a business combination with any holder of 15% or more of its capital stock unless the holder has held the stock for three years or, among other exceptions, the board of directors has approved the transaction.\\nClaims for indemnification by our directors and officers may reduce our available funds to satisfy successful third-party claims against us and may reduce the amount of money available to us.\\nOur amended and restated certificate of incorporation and amended and restated bylaws provide that we will indemnify our directors and officers, in each case to the fullest extent permitted by Delaware law.\\nIn addition, as permitted by Section 145 of the Delaware General Corporation Law, our amended and restated bylaws and our indemnification agreements that we have entered into with our directors and officers provide that:\\n| • | We will indemnify our directors and officers for serving us in those capacities or for serving other business enterprises at our request, to the fullest extent permitted by Delaware law. Delaware law provides that a corporation may indemnify such person if such person acted in good faith and in a manner such person reasonably believed to be in or not opposed to the best interests of the registrant and, with respect to any criminal proceeding, had no reasonable cause to believe such person’s conduct was unlawful. |\\n\\n| • | We may, in our discretion, indemnify employees and agents in those circumstances where indemnification is permitted by applicable law. |\\n\\n51\\n\\n| • | We are required to advance expenses, as incurred, to our directors and officers in connection with defending a proceeding, except that such directors or officers shall undertake to repay such advances if it is ultimately determined that such person is not entitled to indemnification. |\\n\\n| • | We will not be obligated pursuant to our amended and restated bylaws to indemnify a person with respect to proceedings initiated by that person against us or our other indemnitees, except with respect to proceedings authorized by our board of directors or brought to enforce a right to indemnification. |\\n\\n| • | The rights conferred in our amended and restated bylaws are not exclusive, and we are authorized to enter into indemnification agreements with our directors, officers, employees and agents and to obtain insurance to indemnify such persons. |\\n\\n| • | We may not retroactively amend our amended and restated bylaw provisions to reduce our indemnification obligations to directors, officers, employees and agents. |\\n\\nWe do not currently intend to pay dividends on our common stock, and, consequently, our stockholders’ ability to achieve a return on their investment will depend on appreciation in the price of our common stock.\\nWe do not currently intend to pay any cash dividends on our common stock for the foreseeable future. We currently intend to invest our future earnings, if any, to fund our growth. Additionally, the terms of our loan and security agreements could restrict our ability to pay dividends. Therefore, our stockholders are not likely to receive any dividends on our common stock for the foreseeable future. Since we do not intend to pay dividends, our stockholders’ ability to receive a return on their investment will depend on any future appreciation in the market value of our common stock. There is no guarantee that our common stock will appreciate or even maintain the price at which our holders have purchased it.\\n\\n\\nITEM 2.\\nUNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\\nUnregistered Sales of Equity Securities\\nFrom April 1, 2014 through June 30, 2014, we sold and issued the following unregistered securities:\\n1. In June 2014, upon the closing of our IPO, all of our then-outstanding shares of convertible preferred stock automatically converted into 11,517,222 shares of common stock, and all of our then-outstanding Series B warrants were net exercised into 571,244 shares of our common stock at an exercise price of $0.09 per share. The issuance of such shares of common stock was exempt from the registration requirements of the Securities Act pursuant to Section 3(a)(9) and Section 4(a)(2) of the Securities Act of 1933, as amended.\\n2. We granted stock option to employees and directors under our 2008 Stock Incentive Plan and our 2014 Equity Incentive Plan covering an aggregate of 63,888 shares of common stock at a weighted average exercise price of $13.95 per share.\\nUse of Proceeds\\nOn June 18, 2014, the U.S. Securities and Exchange Commission declared effective our registration statement on Form S-1 (File No. 333-196090), as amended, filed in connection with our IPO. Pursuant to the registration statement, we registered the offer and sale of 4,286,000 shares of our common stock with an aggregate offering price of $60.0 million. With the full exercise of the underwriters’ over-allotment option, we sold and issued 4,928,900 shares of our common stock at a price to the public of $14.00 per share for an aggregate offering price of approximately $69.0 million. The managing underwriters of the offering were Citigroup Global Markets Inc., Leerink Partners LLC, JMP Securities LLC and Wedbush Securities Inc. After deducting underwriting discounts, commissions and offering expenses paid or payable by us of $7.8 million, the net proceeds from the offering were $61.2 million. No offering expenses were paid or are payable, directly or indirectly, to our directors or officers, to persons owning 10% or more of any class of our equity securities or to any of our affiliates.\\nThe net proceeds from the IPO have been invested in money market funds.\\nThere has been no material change in the expected use of the net proceeds from our IPO as described in our prospectus relating to our IPO.\\n\\n\\nITEM 3.\\nDefaults upon Senior Securities\\nNot applicable.\\n52\\n\\n\\nITEM 4.\\nMine Safety Disclosures\\nNot applicable\\n\\n\\nITEM 5.\\nOther Information\\nNone.\\n\\n\\nITEM 6.\\nExhibits\\n\\n| Incorporated by Reference |\\n| ExhibitNumber | Exhibit Description | Form | Date | Number | FiledHerewith |\\n| 3.1 | Amended and Restated Certificate of Incorporation. | 8-K | 6/24/2014 | 3.1 |\\n| 3.2 | Amended and Restated Bylaws. | 8-K | 6/24/2014 | 3.2 |\\n| 4.1 | Reference is made to exhibits 3.1 and 3.2. |\\n| 4.2 | Form of Common Stock Certificate. | S-1/A | 6/18/2014 | 4.2 |\\n| 10.1(a)# | Ardelyx, Inc. 2014 Equity Incentive Award Plan. | S-8 | 7/14/2014 | 99.3 |\\n| 10.1(b)# | Form of Stock Option Grant Notice and Stock Option Agreement under the 2014 Equity Incentive Award Plan. | S-1/A | 6/18/2014 | 10.6(b) |\\n| 10.1(c)# | Form of Restricted Stock Award Agreement and Restricted Stock Unit Award Grant Notice under the 2014 Equity Incentive Award Plan. | S-1/A | 6/18/2014 | 10.6.(c) |\\n| 10.2# | Form of Indemnification Agreement for directors and officers. | S-1/A | 6/9/2014 | 10.7 |\\n| 10.3# | Amended and Restated Executive Employment Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Michael Raab | S-1/A | 6/9/2014 | 10.8 |\\n| 10.4# | Change in Control Severance Agreement, dated as of June 6, 2014, by and between Ardelyx, Inc. and Dominique Charmot, Ph.D | S-1/A | 6/9/2014 | 10.9 |\\n| 10.5# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Mark Kaufmann | S-1/A | 6/9/2014 | 10.15 |\\n| 10.6# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Elizabeth Grammer, Esq | S-1/A | 6/9/2014 | 10.16 |\\n| 10.7# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Jeffrey Jacobs, Ph.D | S-1/A | 6/9/2014 | 10.16 |\\n| 10.8# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and George Jue. | S-1/A | 6/9/2014 | 10.18 |\\n| 10.9# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and David Rosenbaum, Ph.D | S-1/A | 6/9/2014 | 10.19 |\\n\\n53\\n\\n| Incorporated by Reference |\\n| ExhibitNumber | Exhibit Description | Form | Date | Number | FiledHerewith |\\n| 10.10# | Ardelyx, Inc. 2014 Employee Stock Purchase Plan. | S-8 | 7/14/2014 | 99.6 |\\n| 10.11# | Non-Employee Director Compensation Program. | S-1/A | 6/9/2014 | 10.21 |\\n| 31.1 | Certification of Principal Executive Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended. | X |\\n| 31.2 | Certification of Principal Financial Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended. | X |\\n| 32.1 | Certification of Principal Executive Officer and Principal Financial Officer Required Under Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C §1350. | X |\\n| 101.INS* | XBRL Instance Document | X |\\n| 101.SCH* | XBRL Taxonomy Extension Schema Document | X |\\n| 101.CAL* | XBRL Taxonomy Extension Calculation Linkbase Document | X |\\n| 101.DEF* | XBRL Taxonomy Extension Definition Linkbase Document | X |\\n| 101.LAB* | XBRL Taxonomy Extension Label Linkbase Document | X |\\n| 101.PRE* | XBRL Taxonomy Extension Presentation Linkbase Document | X |\\n\\n\\n| # | Indicates management contract or compensatory plan. |\\n\\n\\n| * | In accordance with Rule 406T of Regulation S-T, the Interactive Data Files in Exhibits 101.INS; 101.SCH; 101.CAL; 101.DEF; 101.LAB and 101.PRE are deemed not filed or a part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, and are deemed not filed for purposes of Section 18 of the Securities Act of 1934, as amended, and otherwise are not subject to liability under those sections. |\\n\\n54\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\n\\n| Ardelyx, Inc. |\\n| Date: August 8, 2014 | By: | /s/ Michael Raab |\\n| Michael Raab President Chief Executive Officer and Director (Principal Executive Officer) |\\n\\n55\\nEXHIBIT INDEX\\nExhibit Index\\n\\n| Incorporated by Reference |\\n| ExhibitNumber | Exhibit Description | Form | Date | Number | FiledHerewith |\\n| 3.1 | Amended and Restated Certificate of Incorporation. | 8-K | 6/24/2014 | 3.1 |\\n| 3.2 | Amended and Restated Bylaws. | 8-K | 6/24/2014 | 3.2 |\\n| 4.1 | Reference is made to exhibits 3.1 and 3.2. |\\n| 4.2 | Form of Common Stock Certificate. | S-1/A | 6/18/2014 | 4.2 |\\n| 10.1(a)# | Ardelyx, Inc. 2014 Equity Incentive Award Plan. | S-8 | 7/14/2014 | 99.3 |\\n| 10.1(b)# | Form of Stock Option Grant Notice and Stock Option Agreement under the 2014 Equity Incentive Award Plan. | S-1/A | 6/18/204 | 10.6(b) |\\n| 10.1(c)# | Form of Restricted Stock Award Agreement and Restricted Stock Unit Award Grant Notice under the 2014 Equity Incentive Award Plan. | S-1/A | 6/18/2014 | 10.6(c) |\\n| 10.2# | Form of Indemnification Agreement for directors and officers. | S-1/A | 6/9/2014 | 10.7 |\\n| 10.3# | Amended and Restated Executive Employment Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Michael Raab | S-1/A | 6/9/2014 | 10.8 |\\n| 10.4# | Change in Control Severance Agreement, dated as of June 6, 2014, by and between Ardelyx, Inc. and Dominique Charmot, Ph.D | S-1/A | 6/9/2014 | 10.9 |\\n| 10.5# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Mark Kaufmann | S-1/A | 6/9/2014 | 10.15 |\\n| 10.6# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Elizabeth Grammer, Esq | S-1/A | 6/9/2014 | 10.16 |\\n| 10.7# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Jeffrey Jacobs, Ph.D | S-1/A | 6/9/2014 | 10.17 |\\n| 10.8# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and George Jue. | S-1/A | 6/9/2014 | 10.18 |\\n| 10.9# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and David Rosenbaum, Ph.D | S-1/A | 6/9/2014 | 10.19 |\\n| 10.10# | Ardelyx, Inc. 2014 Employee Stock Purchase Plan. | S-8 | 7/14/2014 | 99.6 |\\n| 10.11# | Non-Employee Director Compensation Program. | S-1/A | 6/9/2014 | 10.21 |\\n| 31.1 | Certification of Principal Executive Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended. | X |\\n| 31.2 | Certification of Principal Financial Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended. | X |\\n\\n56\\n\\n| Incorporated by Reference |\\n| ExhibitNumber | Exhibit Description | Form | Date | Number | FiledHerewith |\\n| 32.1 | Certification of Principal Executive Officer and Principal Financial Officer Required Under Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C §1350. | X |\\n| 101.INS* | XBRL Instance Document | X |\\n| 101.SCH* | XBRL Taxonomy Extension Schema Document | X |\\n| 101.CAL* | XBRL Taxonomy Extension Calculation Linkbase Document | X |\\n| 101.DEF* | XBRL Taxonomy Extension Definition Linkbase Document | X |\\n| 101.LAB* | XBRL Taxonomy Extension Label Linkbase Document | X |\\n| 101.PRE* | XBRL Taxonomy Extension Presentation Linkbase Document | X |\\n\\n\\n| # | Indicates management contract or compensatory plan. |\\n\\n\\n| * | In accordance with Rule 406T of Regulation S-T, the Interactive Data Files in Exhibits 101.INS; 101.SCH; 101.CAL; 101.DEF; 101.LAB and 101.PRE are deemed not filed or a part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, and are deemed not filed for purposes of Section 18 of the Securities Act of 1934, as amended, and otherwise are not subject to liability under those sections. |\\n\\n57\\n\\n \\n\\nWhat is the increase in the overall exercise value of the options from December 31, 2013 to June 30, 2014, considering the balances at these dates and their respective weighted average exercise price per share (in thousands of dollars)?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 828.6985899999999.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 54,\n \"input_length\": 53707\n}"}}},{"rowIdx":55,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nITEM 1. Business\nThe Company\n1. Organizational History\nWe are the result of a share exchange transaction completed in March 2004 between the shareholders of Tintic Gold Mining Company (“Tintic”), a corporation originally incorporated in the state of Utah on June 14, 1933 to perform mining operations in Utah, and the shareholders of Kiwa Bio-Tech Products Group Ltd. (“Kiwa BVI”), a company originally organized under the laws of the British Virgin Islands on June 5, 2002. The share exchange resulted in a change of control of Tintic, with former Kiwa BVI stockholders owning approximately 89% of Tintic on a fully diluted basis and Kiwa BVI surviving as a wholly-owned subsidiary of Tintic. Subsequent to the share exchange transaction, Tintic changed its name to Kiwa Bio-Tech Products Group Corporation. On July 21, 2004, we completed our reincorporation in the State of Delaware. On March 8, 2017, we completed our reincorporation in the State of Nevada.\nThe Company operates through a series of subsidiaries in the Peoples Republic of China as detailed in the following Organizational Chart. The Company had previously operated its business through its subsidiaries Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Kiwa Shandong”) and Tianjin Kiwa Feed Co., Ltd. (“Kiwa Tianjin”). Kiwa Tianjin has been dissolved since July 11, 2012. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\n\n| 3 |\n\n\n2. Overview of Business\nWe develop, manufacture, distribute and market innovative, cost-effective and environmentally safe bio-technological products for agriculture. Our products are designed to enhance the quality of human life by increasing the value, quality and productivity of crops and decreasing the negative environmental impact of chemicals and other wastes.\n\n| 4 |\n\n\nBio-fertilizers\nWe have developed six bio-fertilizer products with bacillus species (“bacillus spp”) and/or photosynthetic bacteria as core ingredients. Some of our products contain ingredients of both photosynthesis and bacillus bacteria. Bacillus spp is a species of bacteria that interacts with plants and promotes biological processes. It is highly effective for promoting plant growth, enhancing yield, improving quality and elevating resistances. Photosynthetic bacteria are a group of green and purple bacteria. Bacterial photosynthesis differs from green plant photosynthesis in that bacterial photosynthesis occurs in an anaerobic environment and does not produce oxygen. Photosynthetic bacteria can enhance the photosynthetic capacity of green plants by increasing the utilization of sunlight, which helps keep the photosynthetic process at a vigorous level, enhances the capacity of plants to transform inorganic materials to organic products, and boosts overall plant health and productivity.\nOur bacillus bacteria based fertilizers are protected by patents. In 2004, we acquired patent no. ZL 93101635.5 entitled “Highly Effective Composite Bacteria for Enhancing Yield and the Related Methodology for Manufacturing” from China Agricultural University (“CAU”) for the aggregate purchase of $480,411, consisting of $60,411 in cash and 5,000 shares of our common stock, valued at $84.00 per share (aggregate value of $420,000). Our photosynthetic bacteria based fertilizers are also protected by trade secret laws.\nThe patent acquired from CAU covers six different species of bacillus which have been tested as bio-fertilizers to enhance yield and plant health. The production methods of the six species are also patented. The patent has expired on February 19, 2013.There are no limitations under this agreement on our exclusive use of the patent. Pursuant to our agreement with CAU, the University agreed to provide research and technology support services at no additional cost to us in the event we decide to use the patent to produce commercial products. These research and technology support services include: (1) furnishing faculty or graduate-level researchers to help bacteria culturing, sampling, testing, trial production and production formula adjustment; (2) providing production technology and procedures to turn the products into powder form while keeping live required bacteria in the products; (3) establishing quality standards and quality control systems; (4) providing testing and research support for us to obtain necessary sale permits from the Chinese government; and (5) cooperation in developing derivative products.\nOn January 5, 2011, the State Intellectual Property Office of the PRC (“Intellectual Property Office”) granted Kiwa two Certificates of Patent of Invention for (1) “A cucumber dedicated composite anti-continuous cropping effect probiotics and their specific strains with related application” with patent number of “ZL 2008 1 0144492.6”; and (2) “Cotton dedicated composite anti-continuous cropping effect probiotics and their special strains with related application” with patent number of “ZL 2008 1 0144491.1” These two patents have been developed by Kiwa-CAU R&D Center. These two patents will expire on August 5, 2028. These two patents can be used to develop specific environment-friendly bio-fertilizer.\nWe have obtained five fertilizer registration certificates from the Chinese government - four covering our bacillus bacteria fertilizer and one covering our photosynthetic bacteria fertilizer. The five registration certificates are: (1) Microorganism Microbial Inoculum Fertilizer Registration Certificate issued by the PRC Ministry of Agriculture; (2) Photosynthetic Bacteria Fertilizer Registration Certificate issued by the PRC Ministry of Agriculture; (3) Amino Acid Foliar Fomular Fertilizer Registration Certificate issued by the PRC Ministry of Agriculture; (4) Organic Fertilizer Registration Certificate issued by Agriculture Department of Shandong Province; and (5) Organic Matter-Decomposing Inoculants Registration Certificate issued by the PRC Ministry of Agriculture on February 16, 2008. Protected by these five fertilizer registration certificates and five trademarks under the names of “KANGTAN” (Chinese translation name for Kiwa), “ZHIGUANGYOU,” “PUGUANGFU,” “JINWA” and “KANGGUAN,” we have developed six series of bio-fertilizer products with bacillus spp and/or photosynthetic bacteria as core ingredients. Valid period of fertilizer registration certificates is five years and may be extended for another five years upon application from the owner of fertilizer registration certificates. The Company has determined to re-apply the Fertilizer Registration Certificate issued by the PRC Ministry of Agriculture.\n\n| 5 |\n\n\nKiwa-CAU Research and Development Center\nIn July 2006, we established a new research center with CAU which is known as Kiwa-CAU Bio-Tech Research & Development Center (the “Kiwa-CAU R&D Center”). Pursuant to an agreement between CAU and Kiwa Shandong dated November 14, 2006, Kiwa agreed to contribute RMB 1 million (approximately $160,000) each year to fund research at Kiwa-CAU R&D Center. Under the above agreement, the Kiwa-CAU R&D Center is responsible for fulfilling the overall research-and-development functions of Kiwa Shandong, including: (1) development of new technologies and new products (which will be shared by Kiwa and CAU); (2) subsequent perfection of existing product-related technologies; and (3) training quality-control personnel and technicians and technical support for marketing activities. The Company has spent $224,704 and $178,388 for its research and development activities during the years ended December 31, 2016 and 2015, respectively. The costs incurred by Company’s research and development activities are not borne directly by customers.\nDuring fiscal 2014, Kiwa-CAU R&D Center had successfully isolated several strains of endophytic bacillus from plants. A number of strains had been observed to have the capability of boosting crop yield and dispelling chemical pesticide residual from soil. These strains could be used for developing not only new biological preparation but also environmental protection preparation.\nPursuant to the agreement on joint incorporation of the research and development center between CAU and Kiwa dated November 14, 2006, Kiwa agreed to invest RMB 1 million (approximately $160,000) each year to fund research at the R&D Center. The term of this agreement was ten years starting from July 1, 2006. Prof. Qi Wang, who became one of our directors in July 2007, has acted as the Director of Kiwa-CAU R&D Center since July 2006. The Company has negotiated a follow-up Cooperation Agreement for the technologies with China Agricultural University.\nOn November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). Pursuant to the Agreement, the Company will form a strategic partnership with the two institutes and establish an “International Cooperation Platform for Internet and Safe Agricultural Products”. To fund the cooperation platform’s R&D activities, the Company will provide RMB 1 million (approximately $160,000) per year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. The term of the Agreement is for three years beginning November 20, 2015. Prof. Yong Chang Wu, the authorized representative of IARRP, CAAS, is also one of the Company’s directors effective since November 20, 2015 until March 13, 2017.\nOn February 23, 2017, the Company agreed to a strategic relationship with ETS (Tianjin) Biological Science and Technology Development Co., Ltd. (“ETS”). The partnership will include the deployment and strategic use of ETS biotechnology to produce of bio-fertilizers for use in both China and internationally. Kiwa and ETS, together with the certain Chinese government departments, will work together to enhance China’s microbial fertilizer industry standards and China’s food safety industry chain standards. The parties will work together on the development of microbial technology and products in agriculture, environmental protection, soil management and other fields. Relying on the Chinese Academy of Sciences, ETS Environmental and Agricultural Microbial Technology Research Center and biotechnology project research results, Kiwa has introduced the ETS core technology to complete bio-fertilizer upgrading, transformation and to develop new product lines. In order to meet the growing global consumer demand to increase food supply and develop sustainable farming we are applying sustainable use of biotechnology and the use of biotechnology products to replace chemical products, which will strengthen environmental protection and promote international cooperation. As a result of strict management of many agricultural chemicals, such chemicals will continue to be abandoned, resulting is a growing demand for bio-fertilizers. It has been widely accepted that the application of ETS biotechnology facilitates agricultural sustainability and helps to protect the soil and improve grain output. The technology focuses on keeping soil healthy by restoring healthy microbes that are naturally present in healthy soils. As the technology gains worldwide recognition, it is imperative to popularize bio-fertilizer in developing countries to fulfill the needs of growing populations and promote environmentally friendly agriculture. Through the cooperation of Kiwa and ETS, the parties aim to enhance the usage of the bio-fertilizers in China. The cooperation will bring technological transformation and support for Kiwa to improve its existing manufacturing techniques. Kiwa and ETS will also collaborate to establish a comprehensive platform for producing, supplying, and marketing in China. Ultimately, Kiwa would look to introduce these products to the international market, including the United States.\n\n| 6 |\n\n\nOther\nOn November 30, 2015, we entered into an acquisition agreement (the “Agreement”) with the shareholders of Caber Holdings LTD, whose Chinese name is Hong Kong Baina Group Co., Ltd, located in Hong Kong (“Baina Hong Kong”), and Oriental Baina Co. Ltd. (hereinafter referred to as “Baina Beijing”), Baina Hong Kong’s wholly-owned subsidiary in Beijing, China. As a result of this Agreement, Kiwa renamed Baina Beijing to Kiwa Baiao Bio-Tech (Beijing) Co., Ltd., which replaced Kiwa Bio-Tech (Shandong) Co., Ltd (“Kiwa Shandong”) to operate Kiwa’s bio-fertilizer market expansion and become Kiwa’s platform for future acquisitions of new agricultural-related projects in China. In accordance with the terms of the Agreement, Kiwa agreed to pay US$30,000 to the Baina Hong Kong Shareholders for the acquisition of 100% of the equity of Baina Hong Kong. The Company paid RMB 220,000 (approximately $34,000) for the acquisition. The acquisition was completed on January 7, 2016. Both Baina Hong Kong and Baina Beijing had no activities before the acquisition date and had no assets and liabilities.\nThereafter, Baina Beijing formed two new subsidiaries—Kiwa Bio-Tech (Shenzhen) Co., Ltd (Registered in Shenzhen on November 2016); Kangdu Bio-Tech Hebei Co., Ltd. (Registered in Hebei on December 2106) to operate in specific markets in China.\nOn December 17, 2015, we entered into a distribution agreement (the “Agreement”) with Kangtan Gerui (Beijing) Bio-Tech Co., Ltd. (“Gerui”) and formally awarded Gerui a right to sell and distribute the Company’s fertilizer products in 3 major agricultural regions of China— Hainan Province, Hunan Province and Xinjiang Autonomous Region. The Company’s Research and Development department has been conducting application experiments in Hainan and Hunan Provinces since August 2015, in accordance with the market requirements. The experiment data indicates that the Company’s fertilizer products have fulfilled the requirements of reduction of content of heavy metals in soil and improved crop yield. Gerui was founded in Beijing in April 2015 and relies on the sales network of China’s Supply and Marketing Cooperatives system. Currently, the Company and Gerui do not hold any interest in each other; however, a collaboration and integration may take place in the future. The term of the Agreement is for a period of three years commencing December 17, 2015. In September 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd obtained a fertilizer sales permit from the Chinese government and began to sale the products directly to customers in those 3 major agricultural regions. In September 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd obtained a fertilizer sales permit from the Chinese government and began to sale the products directly to customers in those 3 major agricultural regions.\n\n| 7 |\n\n\nOn February 27, 2017, the Company signed a strategic cooperation agreement with the Beijing Zhongpin Agricultural Science and Technology Development Center (“Zhongpin Center”). Zhongpin Center is the Chinese Agricultural Science and Technology Innovation and Development Committee’s executive implementation agency (referred to as the Agricultural Science and Technology Commission). The Agricultural Science and Technology Commission is set up by the Chinese Central Government for the construction of the National Ecological Security Agriculture Industrial Chain standardization system. This includes the establishment of National Ecology Safe Agricultural Industrial Parks to build China’s Ecological Security and Agricultural Industrial in an orderly business environment, including completion of the National Soil Remediation Program and governance of the various government functions of the institutions. Through the guidance and support by the Zhongpin Center, Kiwa will participate and be involved in China’s National Soil Remediation Program and construction of the National Ecological Security Agriculture Industrial Chain Standardization System’s operation and process.\n\nITEM 1A. Risk Factors\nSmaller reporting companies are not required to provide the information required by this item.\n\n| 8 |\n\n\n\nITEM 1B. Unresolved Staff Comments\nNone.\n\nITEM 2. Properties\nIn June 2002, Kiwa Shandong entered into an agreement with Zoucheng Municipal Government granting us the use of at least 15.7 acres in Shandong Province, China at no cost for 10 years to construct a manufacturing facility. Under the agreement, we have the option to pay a fee of approximately RMB 480,000 (approximately $78,155) per acre for the land use right at the expiration of the 10-year period. We may not transfer or pledge the temporary land use right. In the same agreement, we have also committed to invest approximately $18 million to $24 million for developing the manufacturing and research facilities in Zoucheng, Shandong Province. On February 11, 2017 Kiwa Bio-Tech Products (Shandong) entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\n\nITEM 3. Legal Proceedings\nNone.\n\nITEM 4. Mine Safety Disclosures\nNot applicable.\nPart II\n\nITEM 5. Market for Registrants’ Common Equity, Related Stockholder Matters and Issuer Purchasers of Equity Securities\nMarket Information\nThe Company’s common stock has been quoted on the OTCQB under the symbol “KWBT” since March 30, 2004.\nThe following table sets forth the high and low bid quotations per share of our common stock as reported on the OTCQB for the periods indicated. The high and low bid quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. All prices are adjusted to reflect the Company’s one for 200 reverse split which went effective January 28, 2016.\n\n| Fiscal Year 2016 | High | Low |\n| First Quarter | $ | 2.24 | $ | 0.20 |\n| Second Quarter | $ | 1.98 | $ | 1.30 |\n| Third Quarter | $ | 1.65 | $ | 0.62 |\n| Fourth Quarter | $ | 1.43 | $ | 0.80 |\n\n\n| Fiscal Year 2015 | High | Low |\n| First Quarter | $ | 1.47 | $ | 0.12 |\n| Second Quarter | $ | 0.44 | $ | 0.02 |\n| Third Quarter | $ | 0.32 | $ | 0.12 |\n| Fourth Quarter | $ | 0.70 | $ | 0.12 |\n\nHolders\nAs of December 31, 2016, there were approximately 461 shareholders of record of our common shares.\nDividend Policy\nWe have not paid any dividends on our common shares since our inception and do not anticipate that dividends will be paid at any time in the immediate future.\nEquity Compensation Plan Information\nThe information required by Item 5 regarding securities authorized for issuance under equity compensation plans is included in Item 12 of this report.\n\n| 9 |\n\n\nRecent Sales of Unregistered Securities\nThe following is a list of securities issued for cash or converted with debentures or as stock compensation to consultants during the period from January 1, 2016 through April 14, 2017, which were not registered under the Securities Act:\n\n| Name of Purchaser | Issue Date | Security | Shares | Consideration |\n| YVONNE WANG | 3/24/16 | Common | 240,000 | Debenture Conversion |\n| WEI LI | 3/24/16 | Common | 2,900,000 | Debenture Conversion |\n| MARK E. CRONE | 3/25/16 | Common | 1,000 | Legal Fees |\n| ZENG MIN QING | 5/24/16 | Common | 125,000 | Stock Purchase |\n| CHENG TZU-YUN | 5/24/16 | Common | 50,000 | Stock Purchase |\n| ZHIMING ZHU | 5/24/16 | Common | 45,000 | Stock Purchase |\n| HANG ZHAO | 7/20/16 | Common | 20,000 | Stock Purchase |\n| SHIWEI XIE | 7/20/16 | Common | 10,000 | Stock Purchase |\n| XIAOQIANG YU | 7/20/16 | Common | 30,000 | Stock Purchase |\n| HANG ZHAO | 8/10/16 | Common | 20,000 | Stock Purchase |\n| XIAOQIANG YU | 8/10/16 | Common | 10,000 | Stock Purchase |\n| XIANGRON CHEN | 8/10/16 | Common | 40,000 | Stock Purchase |\n| JIMMY ZHOU | 8/24/16 | Common | 101,947 | Consultant Fees |\n| WEIHONG SHAN | 10/6/16 | Common | 150,000 | Stock Purchase |\n| LIFENG LIU | 10/6/16 | Common | 100,000 | Stock Purchase |\n| ZHENPING LI | 10/6/16 | Common | 100,000 | Stock Purchase |\n| QI JIANG | 10/6/16 | Common | 550,000 | Stock Purchase |\n| LEI HOU | 10/6/16 | Common | 100,000 | Stock Purchase |\n| BING ZHANG | 10/6/16 | Common | 150,000 | Stock Purchase |\n| DEMEI YANG | 10/6/16 | Common | 150,000 | Stock Purchase |\n| WSMG ADVISORS, INC. | 10/6/16 | Common | 100,000 | Consultant Fees |\n| EQUITIES.COM, INC | 10/6/16 | Common | 30,808 | Consultant Fees |\n| GENG LIU | 10/19/16 | Common | 500,000 | Consultant Fees |\n| LIXIN TIAN | 10/19/16 | Common | 500,000 | Consultant Fees |\n| XU LIU | 10/19/16 | Common | 500,000 | Consultant Fees |\n| QINGKE XING | 10/19/16 | Common | 60,000 | Consultant Fees |\n| GROWTH CIRCLE INC. | 10/19/16 | Common | 20,000 | Consultant Fees |\n| WILLIAM FARRANCE | 11/29/16 | Common | 125,000 | Stock Purchase |\n| JUNWEI ZHENG | 3/3/17 | Common | 920,000 | Stock Purchase |\n| YUAN WANG | 3/3/17 | Common | 80,000 | Stock Purchase |\n| YUAN WANG | 3/3/17 | Common | 70,000 | Consultant Fees |\n\n\nITEM 6. Selected Financial Data\nNot required.\n\nITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nThis Annual Report on Form 10-K for the fiscal year ended December 31, 2016 contains “forward-looking” statements within the meaning of Section 21E of the Securities and Exchange Act of 1934, as amended, including statements that include the words “believes,” “expects,” “anticipates,” or similar expressions. These forward-looking statements include, among others, statements concerning our expectations regarding our working capital requirements, financing requirements, business, growth prospects, competition and results of operations, and other statements of expectations, beliefs, future plans and strategies, anticipated events or trends, and similar expressions concerning matters that are not historical facts. The forward-looking statements in this Annual Report on Form 10-K for the fiscal year ended December 31, 2016 involve known and unknown risks, uncertainties and other factors (described in “Business-Risk Factors” under Item 1) that could cause our actual results, performance or achievements to differ materially from those expressed in or implied by the forward-looking statements contained herein.\nOverview\nThe Company took its present corporate form in March 2004 when the shareholders of Tintic Gold Mining Company, a Utah public corporation (“Tintic”), entered into a share exchange transaction with the shareholders of Kiwa BVI, a privately-held British Virgin Islands corporation that left the shareholders of Kiwa BVI owning a majority of Tintic and Kiwa BVI a wholly-owned subsidiary of Tintic, see “Business - The Company” under Item 1. For accounting purposes this transaction was treated as an acquisition of Tintic Gold Mining Company by Kiwa BVI in the form of a reverse triangular merger and a recapitalization of Kiwa BVI and its wholly owned subsidiary, Kiwa Shandong. On July 21, 2004, we completed our reincorporation in the State of Delaware. On March 8, 2017, we completed our reincorporation in the State of Nevada.\nThe Company operates through a series of subsidiaries in the Peoples Republic of China as detailed in the Organizational Chart on page 4, above. The Company had previously operated its business through its subsidiaries Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Kiwa Shandong”) and Tianjin Kiwa Feed Co., Ltd. (“Kiwa Tianjin”). Kiwa Tianjin has been dissolved since July 11, 2012. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\n\n| 10 |\n\n\nWe generated revenue in fiscal year 2016. We incurred a net income of $963,296 and a net loss $677,358 during fiscal 2016 and 2015, respectively.\nDue to our limited revenues, we have relied on the proceeds from loans from both unrelated and related parties to provide the resources necessary to fund the development of our business plan and operations. Our financing activities generated $1,053,358 and $148,009 during fiscal 2016 and 2015, respectively. These funds are insufficient to execute our business plan as currently contemplated, which may result in the risks described in “Risk Factors” under Item 1 - Business.\nGoing Concern\nThe consolidated financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.\nAs of December 31, 2016, the Company’s current liabilities substantially exceeded its current assets by $5,729,622. Although the company’s operations for the year ended December 31, 2016 resulted net income of $963,296, it had an accumulated deficit of $19,489,400 and stockholders’ deficiency of $5,601,213 at December 31, 2016. These circumstances, among others, raise substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. The financial statements also do not include any adjustments relating to the recoverability and classification of recorded asset amounts, or amounts and classifications of liabilities that might be necessary should the Company be unable to continue as a going concern.\nThe Company already raised additional fund through equity financing and plans to raise additional funds from domestic and foreign banks and/or financial institutions to increase working capital in order to meet capital demands. Please refer to Note 15 (Subsequent Evens) for additional information.\nTrends and Uncertainties in Regulation and Government Policy in China\nForeign Exchange Policy Changes\nChina is considering allowing its currency to be freely exchangeable for other major currencies. This change will result in greater liquidity for revenues generated in Renminbi (“RMB”). We would benefit by having easier access to and greater flexibility with capital generated in and held in the form of RMB. The majority of our assets are located in China and most of our earnings are currently generated in China, and are therefore denominated in RMB. Changes in the RMB-U.S. Dollar exchange rate will impact our reported results of operations and financial condition. In the event that RMB appreciates over the next year as compared to the U.S. Dollar, our earnings will benefit from the appreciation of the RMB. However, if we have to use U.S. Dollars to invest in our Chinese operations, we will suffer from the depreciation of U.S. Dollars against the RMB. On the other hand, if the value of the RMB were to depreciate compared to the U.S. Dollar, then our reported earnings and financial condition would be adversely affected when converted to U.S. Dollars.\nOn July 21, 2005, the People’s Bank of China announced it would appreciate the RMB, increasing the RMB-U.S. Dollar exchange rate from approximately US$1.00 = RMB 8.28 to approximately US$1.00 = RMB 8.11. So far the trend of such appreciation continues. The exchange rate of U.S. Dollar against RMB on December 31, 2016 was US$1.00 = RMB 6.945.\nCritical Accounting Policies and Estimates\nWe prepared our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Management periodically evaluates the estimates and judgments made. Management bases its estimates and judgments on historical experience and on various factors that are believed to be reasonable under current circumstances. Actual results may differ from these estimates as a result of different assumptions or conditions.\nThe following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements. In addition, you should refer to our accompanying audited balance sheets as of December 31, 2016 and 2015, and the audited statements of comprehensive loss, equity movement and cash flows for the fiscal years ended December 31, 2016 and 2015, and the related notes thereto, for further discussion of our accounting policies.\nFair value of warrants and options\nWe have adopted ASC Topic 815, “Accounting for Derivative Instruments and Hedging Activities” to recognize warrants relating to loans and warrants issued to consultants as compensation as derivative instruments in our consolidated financial statements.\n\n| 11 |\n\n\nWe also adopted ASC Topic 718, “Share Based Payment” to recognize options granted to employees as derivative instruments in our consolidated financial statements.\nWe calculate the fair value of the warrants and options using the Black-Scholes Model.\nIncome Taxes\nThe Company accounts for income taxes under the provisions of FASB ASC Topic 740, “Income Tax,” which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Deferred tax assets and liabilities are recognized for the future tax consequence attributable to the difference between the tax bases of assets and liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are measured using the enacted tax rate expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company establishes a valuation when it is more likely than not that the assets will not be recovered.\nASC Topic 740.10.30 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC Topic 740.10.40 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. We have no material uncertain tax positions for any of the reporting periods presented.\nMajor Customers and Suppliers.\nBio-fertilizer products\nDuring 2016, the following were Kiwa’s major customers:\n1. Qingzhou City Agricultural Production Materials Co., Ltd. second wholesale department (11.3% of sales)\n2. Huarong County Yinfeng fertilizer industry LTD. (81% of sales)\nDuring 2016, the following were Kiwa’s major suppliers:\n1. Weifang Druek Fertilizer Co., Ltd (92% of Subcontractor Production)\n2 Lianyungang Chuangyi Logistics Co., Ltd (Logistics provider)\n3. Linshu Shangrun Color Printing Co., Ltd (Packing provider)\nResults of Operations\nNet Sales\nNet sales were $9,617,845 and $0 for the years ended December 31, 2016 and 2015, respectively.\nCost of Sales\nCost of sales was $7,672,451 and $0 for the years ended December 31, 2016 and 2015, respectively.\nGross Profit/Loss\nGross profit for fiscal 2016 was $1,945,394 compared to $0 for fiscal 2015.\nLicensing Revenue\nLicensing revenue totaled $786,329 for the year ended December 31, 2016.\nGeneral and Administrative\nGeneral and administrative expenses were $874,097 and $313,589 for the years ended December 31, 2016 and 2015, respectively, an increase of $560,508 or 178%. General and administrative expenses include professional fees, officers’ compensation, depreciation and amortization, salaries, travel and entertainment, rent, office expense and telephone expense etc.\n\n| 12 |\n\n\nResearch and Development\nResearch and development expenses increased significantly by $45,445 or 25% to $224,433 for the year ended December 31, 2016, compared to $178,988 for the prior comparable period. Research and development expense mainly consists of the expenses of maintaining Kiwa-CAU R&D Center, which began operation in July 2006 (see “Business-Intellectual Property and Product Lines- Kiwa-CAU R&D Center” under Item 1 in Part I). On November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). Pursuant to the Agreement, the Company will form a strategic partnership with the two institutes and establish an “International Cooperation Platform for Internet and Safe Agricultural Products”. To fund the cooperation platform’s R&D activities, the Company will provide RMB 1 million (approximately $160,000) per year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. During the years ended December 31, 2016 and 2015, the Company accrued $224,433 and $178,988 for research and development respectively.\nPenalty Expense\nWe charged $77,575 and $72,512 of liquidated damages in connection with the 6% Notes to penalty expenses during the years ended December 31, 2016 and 2015, respectively. The increase of penalty expense was mainly due to accrued and unpaid interest on the 6% Notes.\nInterest Expenses\nNet interest expense was $112,977 and $112,629 in the fiscal years of 2016 and 2015, respectively, representing a increase of $348 or 0.3%.\nNet Income & (Loss)\nDuring the fiscal year 2016, net income was $963,296, comparing with net loss $677,358 for the same period of 2015, representing an increase of $1,640,654.\nComprehensive Gain & (Loss)\nComprehensive income increased by $1,446,652 from $(253,293) for fiscal 2015, as compared to $1,193,359 for the comparable year of 2016.\nLiquidity and Capital Resources\nSince inception of our ag-biotech business in 2002, we have relied on the proceeds from the sale of our equity securities and loans from both unrelated and related parties to provide the resources necessary to fund our operations and the execution of our business plan. During fiscal 2016 and 2015, we raised $1,053,358 and $148,009 in total from stock purchase agreements and related party loans. To some extent, these advances improved our short-term liquidity. However, as of December 31, 2016, our current liabilities substantially exceeded current assets by $5,729,622, reflecting a current ratio of 0.4451, whereas current liabilities exceeded current assets by $11,103.261, reflecting a current ratio of 0.0043 as of December 31, 2015. During the years ended December 31, 2016 and 2015, we did not issue any shares resulting from the conversion of principal of the 6% Notes into our common stock.\n\n| 13 |\n\n\nAs of December 31, 2016 and 2015, we had cash of $13,469 and $721, respectively. The change is outlined as follows:\nDuring the fiscal year of 2016, net cash used in our operating activities was $1,142,9741, compared to $150,208 for the comparable period of 2015. Such cash was mainly used for maintaining operations of a public company and working capital for our bio-fertilizer business.\nDuring the fiscal year of 2016, we incurred approximately $79,083 in investment activity, including $34,112 in acquiring a subsidiary.\nDuring the year ended December 31, 2016, we generated cash inflow for $1,053,358 from financing activities, compared to $148,009 of cash inflow during the year ended December 31, 2015, from financing activities.\nAs of December 31, 2016, we had an accumulated deficit of $19,489,400, down from $20,324,812 deficit at December 31, 2015, as a result of a net income of $967,296 including $127,884 for statutory reserve for the year ended December 31, 2016 and compared to a net loss of $677,358 for 2015.\nWe still require additional working capital to accomplish our business objectives and to sustain our operations. Continuously, we intend to raise additional capital through the issuance of debt or equity securities to fund the development of our planned business operations, although there can be no assurance that we will be successful in obtaining this financing. The following factors, among others, may significantly harm our ability to obtain required additional financing.\nGiven the facts that:\n\n| (1) | Outstanding 6% Notes. As of December 31, 2016, the amount of outstanding 6% Notes was $150,250. The 6% Notes have been in default since June 2009. |\n| (2) | Outstanding note payable of $360,000 as of December 31, 2016. This note has been in default since July 2007. |\n\nContractual Obligations\n(1) Operation of Kiwa-CAU R&D Center\nPursuant to the agreement on joint incorporation of the research and development center between CAU and Kiwa Shandong dated November 14, 2006, Kiwa Shandong agrees to invest RMB 1 million (approximately $160,000) each year to fund research at the R&D Center. The term of this agreement is ten years starting from July 1, 2006. Prof. Qi Wang, who became one of our directors in July 2007, has acted as the Director of Kiwa-CAU R&D Center since July 2006.\n(2) Investment in manufacturing and research facilities in Zoucheng, Shandong Province in China\nAccording to the Project Agreement with Zoucheng Municipal Government in 2002, we have committed to investing approximately $18 million to $24 million for developing the manufacturing and research facilities in Zoucheng, Shandong Province. As of December 31, 2016, we had invested approximately $1.91 million for the project. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\n\n| 14 |\n\n\n(3) Strategic cooperation with two institutes in China\nOn November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). Pursuant to the Agreement, the Company will form a strategic partnership with the two institutes and establish an “International Cooperation Platform for Internet and Safe Agricultural Products”. To fund the cooperation platform’s R&D activities, the Company will provide RMB 1 million (approximately $160,000) per year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. The term of the Agreement is for three years beginning November 20, 2015.\n(4) Acquisition of Caber Holdings LTD (Hong Kong Baina Group Co. LTD) in China\nOn November 30, 2015, we entered into an acquisition agreement (the “Agreement”) with the shareholders of Caber Holdings LTD, whose Chinese name is Hong Kong Baina Group Co., Ltd, located in Hong Kong (“Baina Hong Kong”), and Oriental Baina Co. Ltd. (hereinafter referred to as “Baina Beijing”), Baina Hong Kong’s wholly-owned subsidiary in Beijing, China. When this acquisition is completed, Kiwa will rename Baina Beijing to Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. Kiwa Baiao Co. Ltd will replace Kiwa’s current subsidiary in China - Kiwa Bio-Tech (Shandong) Co., Ltd (“Kiwa Shandong”) - to operate Kiwa’s bio-fertilizer market expansion and become Kiwa’s platform for future acquisitions of new agricultural-related projects in China. In accordance with the terms of the Agreement, Kiwa agreed to pay US$30,000 to the Baina Hong Kong Shareholders for the acquisition of 100% of the equity of Baina Hong Kong. As of December 31, 2015, the Company has paid RMB 220,000 (approximately $34,000) for the acquisition. The acquisition was completed on January 7, 2016. Both Baina Hong Kong and Baina Beijing had no activities before the acquisition date and had no assets and liabilities. Thereafter, Baina Beijing formed two new subsidiaries—Kiwa Bio-Tech (Shenzhen) Co., Ltd (Registered in Shenzhen on November 2016); Kangdu Bio-Tech Hebei Co., Ltd. (Registered in Hebei on December 2106) to operate in specific markets in China.\n(5) Distribution agreement with Kangtan Gerui Bio-Tech in China\nOn December 17, 2015, Kiwa Bio-Tech Products Group Corporation (the “Company”) entered into a distribution agreement (the “Agreement”) with Kangtan Gerui (Beijing) Bio-Tech Co., Ltd. (“Gerui”) and formally awarded Gerui a right to sell and distribute the Company’s fertilizer products in 3 major agricultural regions of China— Hainan Province, Hunan Province and Xinjiang Autonomous Region. The Company’s Research and Development department has been conducting application experiments in Hainan and Hunan Provinces since August 2015, in accordance with the market requirements. The experiment data indicates that the Company’s fertilizer products have fulfill the requirements of reduction of content of heavy metals in soil and improve crop yield. Gerui was founded in Beijing in April 2015 and relies on the sales network of China’s Supply and Marketing Cooperatives system. Currently, the Company and Gerui do not hold any interest in each other; however, a collaboration and integration may take place in the future. The term of the Agreement is for a period of three years commencing December 17, 2015. In September 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd obtained a fertilizer sales permit from the Chinese government and began to sale the products directly to customers in those 3 major agricultural regions.\n(6) Lease payments\n(1) On April 29, 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. entered an office lease agreement with two-year team. Monthly lease payment and building management fee totaled RMB 77,867 or approximately USD $11,622.\n(2) On November 11, 2017, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. entered an apartment lease agreement for its employees. The lease term is one year with monthly lease payment of RMB 6,000 or approximately USD $896.\n(3) In March 1, 2017, Kiwa Bio-Tech (Shenzhen) Co., Ltd, a newly established subsidiary entered an office lease agreement with one-year term. Monthly lease payment is RMB 29,000 or approximately of USD $4,320.\nOff-Balance Sheet Arrangements\nAt December 31, 2016, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise had we engaged in such relationships.\nRecent Accounting Pronouncements\nSee Note 2 to the Consolidated Financial Statements under Item 8, Part II.\n\n| 15 |\n\n\n\nITEM 7A. Quantitative and Qualitative Disclosures about Market Risk\nNot required.\n\nITEM 8. Financial Statements and Supplementary Data\nThe full text of our audited consolidated financial statements as of December 31, 2016 and 2015 begins on page F-1 of this annual report.\n\nITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure\nOn February 15, 2017, the Board of Directors of Kiwa Bio-Tech Products Group Corporation (“Kiwa” or “Company”) decided to engage DYH & Co. as independent principal accountant and auditor to report on the Company’s financial statements for the fiscal year ended December 31, 2016, including performing the required quarterly reviews.\nIn conjunction with the new engagement, the Company has dismissed its former accountant, Paritz & Co., P.A., Hackensack, NJ (“Paritz”), as the Company’s principal accountant effective February 22, 2016. Paritz has served the Company well since 2013. Under Item 304 of Regulation S-K, the reason for the auditor change is dismissal, not resignation nor declining to stand for re-election.\nDuring the two most recent fiscal years and the interim period through the date of the dismissal, there were no disagreements with Paritz on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which disagreements, if not resolved to Paritz’s satisfaction, would have caused Paritz to make reference to the subject matter of the disagreements in connection with its reports.\n\nITEM 9A. Controls and Procedures\nDisclosure Controls and Procedures\nOur management, under the supervision and with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), has evaluated the effectiveness of our disclosure controls and procedures as defined in SEC Rules 13a-15(e) and 15d-15(e) as of the end of the period covered by this Annual Report. Our disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports we file or submit under the Securities Exchange Act of 1934 (“Exchange Act”) is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management including our CEO and CFO, to allow timely decisions regarding required disclosures. Based on their evaluation, our CEO and CFO have concluded that, as of December 31, 2016, our disclosure controls and procedures were ineffective.\nManagement Report on Internal Control over Financial Reporting\nOur management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Our internal control over financial reporting was designed to provide reasonable assurance to the Company’s management and board of directors regarding the preparation and fair presentation of published consolidated financial statements. Internal control over financial reporting is promulgated under the Exchange Act as a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and effected by the Company’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting, no matter how well designed, has inherent limitations and may not prevent or detect misstatements. Therefore, even effective internal control over financial reporting can only provide reasonable assurance with respect to the financial statement preparation and presentation.\nOur management has conducted, with the participation of our CEO and CFO, an assessment, including testing of the effectiveness, of our internal control over financial reporting as of December 31, 2016. Management’s assessment of internal control over financial reporting was conducted using the criteria in Internal Control over Financial Reporting - Guidance for Smaller Public Companies issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on such evaluation, management identified deficiencies that were determined to be a material weakness.\nA material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. Because of the material weakness described below, management concluded that our internal control over financial reporting was ineffective as of December 31, 2016.\n\n| 16 |\n\n\nThe specific material weakness identified by the Company’s management as of December 31, 2016 is described as follows:\n\n| ● | The Company did not have sufficient and skilled accounting personnel with an appropriate level of technical accounting knowledge and experience in the application of accounting principles generally accepted in the United States of America commensurate with the Company’s financial reporting requirements, which resulted in a number of internal control deficiencies that were identified as being significant. The Company’s management determined that the number and nature of these significant deficiencies, when aggregated, constituted a material weakness. |\n| ● | The Company lacks qualified resources to perform the internal audit functions properly. In addition, the scope and effectiveness of the Company’s internal audit function are yet to be developed. |\n| ● | We currently do not have an audit committee. |\n\nRemediation Initiative\n\n| ● | We are committed to establishing the internal audit functions but due to limited qualified resources in the region, we were not able to hire sufficient internal audit resources before the end of 2016. However, internally we established a central management center to recruit more senior qualified people in order to improve our internal control procedures. Externally, we are looking forward to engaging an accounting firm to assist the Company in improving the Company’s internal control system based on COSO Framework. |\n| ● | We intend to establish an audit committee of the board of directors as soon as practicable. We envision that the audit committee will be primarily responsible for reviewing the services performed by our independent auditors, evaluating our accounting policies and our system of internal controls. |\n\nConclusion\nDespite the material weakness and deficiencies reported above, the Company’s management believes that its consolidated financial statements included in this report fairly present in all material respects the Company’s financial condition, results of operations and cash flows for the periods presented and that this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report.\nThis Annual Report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the SEC that permit the Company to provide only management’s report in this Annual Report.\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting during the fiscal year ended December 31, 2016 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n\nITEM 9B. Other Information\nNone.\n\n| 17 |\n\n\nPart III\n\nITEM 10. Directors, Executive Officers and Corporate Governance\nDirectors and Executive Officers\nSet forth below are the names of our directors and executive officers, their ages, their offices with us, if any, their principal occupations or employment for the past five years. The directors listed below will serve until the Company’s next annual meeting of the stockholders:\n\n| Name | Age | Position | Director Since |\n| Yvonne Wang | 39 | Acting President, CEO and CFO and Director | 2015 |\n| Feng Li | 28 | Secretary and Director | 2015 |\n| Qi Wang | 49 | Vice President of Technology, Director | 2007 |\n| Yong Lin Song Xiao Qiang Yu | 50 39 | CTO, Director of Technology and Director Sales and Marketing Director | 2017 2016 |\n\nYvonne Wang Ms. Wang became our Chairman in November 2015. She served as corporate Secretary from 2005 to 2015. Prior to 2005, she served as an executive assistant and a manager of the Company’s U.S. office between April 2003 and September 2005. She obtained her B.S. degree of Business Administration from University of Phoenix.\nOn August 11, 2106 became Company’s acting president, CEO and CFO.\nFeng Li became our Secretary and a Director in 2015. From 2011- 2012, Ms. Li has served as an assistant project manager for SCHSAsia, a boutique business consulting firm specializing in events and project management for overseas company wishing to expand into the Asia Pacific arena. From 2012 until 2014, Ms. Li served as a campaigner for WildAid China Office, a non-profit organization with focus on raising public awareness on wildlife and climate change related issues.\nQi Wang became our Vice President - Technical on July 19, 2005 and was elected as one of our directors of the Company on July 18, 2007. Prof. Wang has also acted as Director of Kiwa-CAU R&D Center since July 2006. Prof. Wang served as a Professor and Advisor for Ph.D. students in the Department of Plant Pathology, China Agricultural University (“CAU”) since January 2005. Prior to that, he served as an assistant professor and lecturer of CAU since June 1997. He obtained his master degree and Ph.D. in agricultural science from CAU in July 1994 and July 1997, respectively. Prof. Wang received his bachelor’s degree of science from Inner Mongolia Agricultural University in July 1989. He is a committee member of various scientific institutes in China, including the National Research and Application Center for Increasing-Yield Bacteria, Chinese Society of Plant Pathology, Chinese Association of Animal Science and Veterinary Medicine. Prof. Wang’s unique expertise in the field of agriculture offers significant knowledge and experience to the Board of Directors when making critical operational decisions.\nYong Lin Song became our CTO and Director of Technology responsible for the Company’s R&D operations on March 2016 and as one of our directors of the Company on March 2017. Mr. Song is a senior agronomist at the Institute of Agricultural Resources and Regional Planning, Chinese Academy of Agricultural Sciences. He has 29 years of experience in microbial R&D and technology promotion and has led many national agricultural projects. In 2001, he was responsible for technological achievement transformation and technology promotion of Agricultural Resources and Regional Planning, Chinese Academy of Agricultural Sciences. In 2009, he served as deputy secretary general of the Chinese Society of Plant Nutrition and Fertilizer Science.\nXiao Qiang Yu became our Sales and Marketing Director on June 2016 and is responsible for managing the overall marketing strategy of Kiwa, which includes brand expansion, sale targets, strategic planning and corporate communications. Mr. Yu participated in Chinese fertilizer market since 1999. Mr. Yu has over 15 years of marketing, management and strategy experience from two major fertilizer companies in China.\n\n| 18 |\n\n\nFamily Relationships\nThere are no family relationships among our directors or executive officers.\nInvolvement in Certain Legal Proceedings\nNone of our directors or executive officers has, during the past ten years:\n\n| (a) | Had any bankruptcy petition filed by or against any business of which such person was a general partner or executive officer either at the time of the bankruptcy or within two years prior to that time; |\n| (b) | Been convicted in a criminal proceeding or subject to a pending criminal proceeding; |\n| (c) | Been subject to any order, judgment, or decree, not subsequently reversed, suspended or vacated, of any court of competent jurisdiction or any federal or state authority, permanently or temporarily enjoining, barring, suspending or otherwise limiting his involvement in any type of business, securities, futures, commodities or banking activities; and |\n| (d) | Been found by a court of competent jurisdiction (in a civil action), the Securities and Exchange Commission or the Commodity Futures Trading Commission to have violated a federal or state securities or commodities law, and the judgment has not been reversed, suspended, or vacated. |\n\nSection 16(a) Beneficial Ownership Compliance\nSection 16(a) of the Securities Exchange Act of 1934 requires our officers, directors and certain persons holding more than 10 percent of a registered class of our common stock to file with the SEC initial reports of ownership and reports of changes in ownership of our common stock. Officers, directors and certain other shareholders are required by the SEC to furnish the Company with copies of all Section 16(a) forms they file. To the best of the Company’s knowledge, based solely upon a review of the copies of such reports, the Company believes that all Section 16(a) filing requirements applicable to its officers, directors and certain other shareholders were complied with during the fiscal year ended December 31, 2016.\nCode of Ethics\nWe have adopted a Code of Business Conduct and Ethics (the “Code”) that is applicable to all employees, consultants and members of the Board of Directors, including the Chief Executive Officer, Chief Financial Officer and Secretary. This Code embodies our commitment to conduct business in accordance with the highest ethical standards and applicable laws, rules and regulations. We will provide any person a copy of the Code, without charge, upon written request to the Company’s Secretary. Requests should be addressed in writing to Ms. Yvonne Wang; 310 N. Indian Hill Blvd., #702 Claremont, California 91711.\nBoard Composition; Audit Committee and Financial Expert\nOur Board of Directors is currently composed of four members: Yvonne Wang, Feng Li, Qi Wang and Yong Lin Song. All board actions require the approval of a majority of the directors in attendance at a meeting at which a quorum is present.\n\n| 19 |\n\n\nWe currently do not have an audit committee. We intend, however, to establish an audit committee of the board of directors as soon as practicable. We envision that the audit committee will be primarily responsible for reviewing the services performed by our independent auditors, evaluating our accounting policies and our system of internal controls. Currently such functions are performed by our Board of Directors.\nThe Board does not have a “financial expert” as defined by SEC rules implementing Section 407 of the Sarbanes-Oxley Act.\nBoard meetings and committees; annual meeting attendance.\nDuring fiscal year 2016, the Board of Directors did not have any meetings.\n\nITEM 11. Executive Compensation\nWe currently have no Compensation Committee. The Board of Directors is currently performing the duties and responsibilities of Compensation Committee. In addition, we have no formal compensation policy. We decide on our executives’ compensation based on average compensation levels of similar companies in the U.S. or China, depending on consideration of many factors such as where the executive works. Our Chief Executive Officer’s compensation is approved by the Board of Directors. Other named executive officers’ compensation are proposed by our Chief Executive Officer and approved by the Board of Directors.\nOur Stock Incentive Plan is administered by the Board of Directors. Any amendment to our Stock Incentive Plan requires majority approval of the stockholders of the Company.\nThe Company had no officers or directors whose total compensation during either 2016 or 2015 exceeded $100,000.\nCurrently, the main forms of compensation provided to each of our executive officers are: (1) annual salary; (2) non-equity Incentive Plan; and (3) the granting of incentive stock options subject to approval by our Board of Directors.\nSummary Compensation Table\nSummary Compensation Table\n\n| Name and principal position | Year | Salary ($) | Bonus ($) | Stock Awards ($) | Option Awards ($) | Non-Equity Incentive Plan Compensation ($) | Nonqualified Deferred Compensation Earnings ($) | All Other Compensation ($) | Total ($) |\n| (a) | (b) | (c) | (d) | (e) | (f) | (g) | (h) | (i) | (j) |\n| Yvonne Wang, | 2016 | 84,000 | Nil | Nil | Nil | Nil | Nil | Nil | 84,000 |\n| Acting President, CEO and CFO | 2015 | 51,000 | Nil | Nil | Nil | Nil | Nil | Nil | 51,000 |\n| Yong Lin Song, | 2016 | 29,828 | Nil | Nil | Nil | Nil | Nil | Nil | 29,828 |\n| CTO, Director of Technology | 2015 | Nil | Nil | Nil | Nil | Nil | Nil | Nil | Nil |\n| Xiao Qiang Yu, | 2016 | 30,259 | Nil | Nil | Nil | Nil | Nil | Nil | 30,259 |\n| Sales and Marketing Director | 2015 | Nil | Nil | Nil | Nil | Nil | Nil | Nil | Nil |\n\nEmployment Contracts and Termination of Employment and Change of Control Arrangements\nThere are no compensatory plans or arrangements with respect to a named executive officer that would result in payments or installments in excess of $100,000 upon the resignation, retirement or other termination of such executive officer’s employment with us or from a change-in-control.\n\n| 20 |\n\n\nStock Incentive Plan and Option Grants\n2016 Stock Incentive Plan\nOn March 8, 2017, pursuant to the consent of the holders of a majority of the votes entitled to be cast on the matter, were approved of the Kiwa Bio-Tech Products Group Corporation 2016 Employee, Director and Consultant Stock Plan. The Plan is a key aspect of our compensation program, designed to attract, retain, and motivate the highly qualified individuals required for our long-term success.\nNo options were granted under the Plan during 2016.\nOption Exercises and Stock Vested\nNo stock options were exercised by any officers or directors during 2016 and 2015. We did not adjust or amend the exercise price of any stock options previously awarded to any named executive officers during 2016 and 2015.\n\n| 21 |\n\n\nDirector Compensation for 2016\nWe currently have no policy in effect for providing compensation to our directors for their services on our Board of Directors, and did not compensate our directors in 2016 for services performed as directors.\n\nITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters\nThe following table sets forth as of April 7, 2017 certain information with respect to the beneficial ownership of our common stock by (i) each of our executive officers, (ii) each person who is known by us to beneficially own more than 5% of our outstanding common stock, and (iii) all of our directors and executive officers as a group. Percentage ownership is calculated based on 9,798,981 shares of our common stock and 500,000 shares of our Series A Preferred Stock outstanding as of April 7, 2017. None of the shares listed below are issuable pursuant to stock options or warrants of the Company.\n\n| Title of class | Name and Address of Beneficial Ownership(1) | Amount and Nature of Beneficial Owner (2) | Percentage of class |\n| Common Stock | Yvonne Wang | 240,000 | 2.45 | % |\n| Common Stock | Feng Li (3) | 1,965,326 | 20.06 | % |\n| Common Stock | Qi Wang | - | - |\n| Common Stock | Yong Lin Song | - | - |\n| Common Stock | All officers and directors as a group | 2,205,326 | 22.51 | % |\n| Ser. A Pref. Stock | Yvonne Wang | 250,000 | 50.00 | % |\n| Ser. A Pref. Stock | Feng Li | 250,000 | 50.00 | % |\n| Ser. A Pref. Stock | All officers and directors as a group | 500,000 | 100.00 | % |\n| 5% Holders: |\n| Common Stock | Troniya Industrial Incubator, Inc. | 1,000,000 | 10.21 | % |\n| Common Stock | Liu Geng | 500,000 | 5.10 | % |\n| Common Stock | Liu Xu | 500,000 | 5.10 | % |\n| Common Stock | Tian Lixin | 500,000 | 5.10 | % |\n| Common Stock | Zheng JunWei | 920,000 | 9.39 | % |\n| Common Stock | Wei Li (3) | 1,965,326 | 20.06 | % |\n\n\n| (1) | The address for all holders is 310 N. Indian Hill Blvd, #702, Claremont, CA 91711. |\n| (2) | In determining beneficial ownership of our Common Stock and Series A Preferred Stock, the number of shares shown includes shares which the beneficial owner may acquire upon exercise of debentures, warrants and options which may be acquired within 60 days. Unless otherwise stated, each beneficial owner has sole power to vote and dispose of its shares. |\n| (3) | Includes 61,784 shares of common stock held by All Star Technology, Inc., a British Virgin Islands international business company. Feng Li’s father, Wei Li, exercises voting and investment control over the shares held by All Star Technology, Inc. Wei Li is a principal stockholder of All Star Technology, Inc. and may be deemed to beneficially own such shares, but disclaims beneficial ownership in such shares held by All Star Technology, Inc. except to the extent of his pecuniary interest therein. Mr. Li has pledged all of his common stock of the Company as collateral security for the Company’s obligations under certain 6% Convertible Notes owed by the Company. |\n\n\n| 22 |\n\n\nChange in Control\nNone.\n\nITEM 13. Certain Relationships and Related Transactions, and Director Independence\nFor description of transactions with related parties, see Note 6 to Consolidated Financial Statements under Item 8 in Part II.\nUnder the independence standard set forth in Rule 4200(a) (15) of the Market Place Rules of the Nasdaq Stock Market, which is the independence standard that we have chosen to report under.\n\nITEM 14. Principal Accountant Fees and Services\nFees Paid to Independent Public Accountants for 2016 and 2015.\nAudit Fees\nAll of the services described below were approved by our board of directors prior to performance of such services. The board of directors has determined that the payments made to its independent accountants for these services are compatible with maintaining such auditor’s independence.\nThe aggregate audit fees for 2016 and 2015 paid and payable to DYH & Company and Paritz & Company, P.A. were approximately $38,000 and $30,500, respectively. The amounts include: (1) fees for professional services rendered by DYH & Company and Paritz & Company, P.A. in connection with the audit of our consolidated financial statements; (2) reviews of our quarterly reports on the Form 10-Q.\n\n| 23 |\n\n\nAudit-Related Fees\nAudit-related fees for 2016 and 2015 were $nil.\nTax Fees\nTax service fees billed by Paritz & Co., P.A. as tax consultant for 2016 and 2015 were $3,400 and $2,750, respectively.\nAll Other Fees\nNone.\nPolicy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditors\nSince we did not have a formal audit committee, our board of directors served as our audit committee. We have not adopted pre-approval policies and procedures with respect to our accountants in 2016. All of the services provided and fees charged by our independent registered accounting firms in 2016 were approved by the board of directors.\n\n| 24 |\n\n\nPart IV\n\nITEM 15. Exhibits and Financial Statement Schedules\n\n| Exhibit No. | Description |\n| 31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934 |\n| 31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934 |\n| 32.1 | Certification of Chief Executive Officer, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2 | Certification of Chief Financial Officer, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS | XBRL Instance Document |\n| 101.SCH | XBRL Taxonomy Extension Schema Document |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document |\n\n\n| 25 |\n\n\nKiwa Bio-Tech Products Group Corporation\nSignatures\nPursuant to the requirements of Section 13 or 15(d) of the Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\nDate: April 17, 2017\n\n| KIWA BIO-TECH PRODUCTS GROUP CORPORATION. |\n| By: | /s/ Yvonne Wang |\n| Yvonne Wang Chief Executive Officer (Principal Executive Officer) |\n| By: | /s/ Yvonne Wang |\n| Yvonne Wang Chief Financial Officer (Principal Financial and Accounting Officer) |\n\nPursuant to the requirements of Section 13 or 15(d) of the Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf of the registrant and in the capacities and on the dates indicated.\n\n| /s/ Yvonne Wang | Chief Executive Officer and Director | April 17, 2017 |\n| Yvonne Wang | (Principal Executive Officer) |\n| /s/ Yvonne Wang | Chief Financial Officer | April 17, 2017 |\n| Yvonne Wang | (Principal Financial and Accounting Officer) |\n| /s/ Feng Li | Secretary and Director | April 17, 2017 |\n| Feng Li |\n| /s/ Qi Wang | Vice President of Technology and Director | April 17, 2017 |\n| Qi Wang |\n| /s/ Yong Lin Song | CTO, Director of Technology and Director | April 17, 2017 |\n| Yong Lin Song |\n\n\n| 26 |\n\n\nKiwa Bio-Tech Products Group Corporation\nIndex to Consolidated Financial Statements\n\n| Page |\n| Reports of Independent Registered Public Accounting Firms | F-1 |\n| Consolidated Balance Sheets | F-3 |\n| Consolidated Statements of Comprehensive Income (Loss) | F-4 |\n| Consolidated Statements of Stockholders’ Deficiency | F-5 |\n| Consolidated Statements of Cash Flows | F-6 |\n| Notes to Consolidated Financial Statements | F-7 |\n\n\n| 27 |\n\n\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\nTo Board of Directors and the Stockholders of\nKiwa Bio-Tech Products Group Corporation\nWe have audited the accompanying consolidated balance sheet of Kiwa Bio-Tech Products Group Corporations as of December 31, 2015 and the related consolidated statement of comprehensive loss, changes in stockholders’ deficiency and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.\nWe conducted our audit in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.\nIn our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kiwa Bio-Tech Products Group Corporation as of December 31, 2015, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.\n/s/ Paritz & Company, P.A.\nHackensack, New Jersey\nApril 14, 2016\n\n| F-1 |\n\n\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\nTo the Board of Directors and Stockholders of Kiwa Bio-Tech Products Group Corporation\nWe have audited the accompanying consolidated balance sheet of Kiwa Bio-Tech Products Group Corporation as of December 31, 2016, and the related statements of income, comprehensive income, stockholders’ equity, and cash flows for the year ended December 31, 2016. Kiwa Bio-Tech Products Group Corporation’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits.\nWe conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.\nIn our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Kiwa Bio-Tech Products Group Corporation as of December 31, 2016, and the results of its operations and its cash flows for the year ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America.\nThe accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 3 to the consolidated financial statements, the Company’s current liabilities substantially exceeded its current assets by $5,729,622 at December 31, 2016. Although the Company reported net income approximately $963,296 for its fiscal year ended December 31, 2016, it had an accumulated deficit of $19,489,400 as of December 31, 2016. These circumstances, among others, raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regarding to these matters are described in Note 3, which include raising additional equity financing. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.\n/s/ DYH & Company\nIrvine, California\nApril 17, 2017\n\n| F-2 |\n\n\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\nCONSOLIDATED BALANCE SHEETS\n\n| December 31, 2016 | December 31, 2015 |\n| ASSETS |\n| Current assets |\n| Cash and cash equivalents | $ | 13,469 | $ | 721 |\n| Accounts receivable | 1,122,754 | - |\n| Prepaid expenses | 92,504 | - |\n| Other receivable | 1,561,331 | 47,453 |\n| Advance to suppliers | 1,805,044 | - |\n| Total current assets | 4,595,102 | 48,174 |\n| Property, plant and equipment - net | 59,778 | 2,807 |\n| Deposit | 34,519 | - |\n| Goodwill | 34,112 | - |\n| Total non-current assets | 128,409 | 2,807 |\n| Total assets | $ | 4,723,511 | $ | 50,981 |\n| LIABILITIES AND STOCKHOLDERS’ DEFICIENCY |\n| Current liabilities |\n| Accounts payable | $ | 1,318,802 | $ | 269,360 |\n| Accrued expenses | 35,715 | 30,887 |\n| Advances from customers | 12,883 | 13,800 |\n| Construction costs payable | 255,539 | 273,722 |\n| Due to related parties - trade | 1,283,215 | 1,143,978 |\n| Due to related parties - non-trade | 100,798 | 3,166,198 |\n| Convertible notes payable | 150,250 | 150,250 |\n| Notes payable | 360,000 | 360,000 |\n| Unsecured loans payable | 1,655,343 | 1,773,131 |\n| Salary payable | 1,688,353 | 1,632,881 |\n| Taxes payable | 919,255 | 478,209 |\n| Penalty payable | 482,327 | 404,752 |\n| Interest payable | 1,042,661 | 930,062 |\n| Other payables | 1,019,583 | 524,205 |\n| Total current liabilities | 10,324,724 | 11,151,435 |\n| SHAREHOLDER’S EQUITY |\n| Preferred stock - $0.001 par value, Authorized 20,000,000 shares. Issued and outstanding 500,000 and 500,000 shares at December 31, 2016 and 2015, respectively. | 500 | 500 |\n| Common stock - $0.001 per value. Authorized 100,000,000 shares. Issued and outstanding $8,728,981 and 2,000,000 shares at December 31, 2016 and 2015 | 8,729 | 2,000 |\n| Additional paid-in capital | 13,789,990 | 9,490,837 |\n| Statutory Reserve | 127,884 | - |\n| Accumulated deficit | (19,489,400 | ) | (20,324,812 | ) |\n| Accumulated other comprehensive loss | (38,916 | ) | (268,979 | ) |\n| Total stockholders’ deficiency | (5,601,213 | ) | (11,100,454 | ) |\n| Total liabilities and shareholder’s equity | $ | 4,723,511 | $ | 50,981 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n\n| F-3 |\n\n\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)\n\n| Years Ended December 31, |\n| 2016 | 2015 |\n| Revenue | $ | 9,617,845 | $ | - |\n| Cost of goods sold | 7,672,451 | - |\n| Gross profit | 1,945,394 | - |\n| Operating expenses |\n| Research and development | 224,433 | 178,988 |\n| Selling expenses | 49,295 | - |\n| General and administrative | 874,097 | 313,589 |\n| Total operating expenses | 1,147,825 | 492,577 |\n| Operating income (loss) | 797,569 | (492,577 | ) |\n| Other income |\n| License revenue | 786,329 | - |\n| Other expense |\n| Penalty expense | (77,575 | ) | (72,152 | ) |\n| Interest expense | (112,977 | ) | (112,629 | ) |\n| Other expense | (3,770 | ) | - |\n| Total other expense | (194,322 | ) | (184,781 | ) |\n| Net income (loss) before income tax | 1,389,576 | (677,358 | ) |\n| Income tax provision | (426,280 | ) | - |\n| Net income (loss) | 963,296 | (677,358 | ) |\n| Other comprehensive income |\n| Foreign currency translation adjustment | 230,063 | 424,065 |\n| Total comprehensive income (loss) | $ | 1,193,359 | $ | (253,293 | ) |\n| Net income (loss) per common share - basic | $ | 0.17 | $ | (0.34 | ) |\n| Net income (loss) per common share - diluted | $ | 0.11 | $ | (0.34 | ) |\n| Weighted average number of common shares outstanding - basic | 5,645,263 | 2,000,000 |\n| Weighted average number of common shares outstanding - diluted | 8,872,655 | 2,000,000 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n\n| F-4 |\n\n\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\nCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ DEFICIENCY\n\n| Common Stock | Preferred Stock | Additional Paid-in | Statutory | Accumulated | Accumulated Other Comprehensive | Total Stockholders’ |\n| Shares | Amount | Shares | Amount | Capital | Reserve | Deficit | Loss | Deficiency |\n| Balance, December 31, 2014 (Restated) | 2,000,000 | $ | 2,000 | - | $ | - | $ | 8,491,337 | $ | - | $ | (19,647,454 | ) | $ | (693,044 | ) | $ | (11,847,161 | ) |\n| Issuance of 500,000 shares of preferred stock as debt cancellation on December 14, 2015 | - | - | 500,000 | 500 | 999,500 | - | - | 1,000,000 |\n| Net loss | - | - | - | - | - | (677,358 | ) | - | (677,358 | ) |\n| Foreign currency translation adjustment | - | - | - | - | - | - | - | 424,065 | 424,065 |\n| Balance, December 31, 2015 | 2,000,000 | 2,000 | 500,000 | 500 | 9,490,837 | - | (20,324,812 | ) | (268,979 | ) | (11,100,454 | ) |\n| Issuance of common shares for cash | 1,775,000 | 1,775 | - | - | 857,884 | - | 859,659 |\n| Issuance of common shares for Liabilities settlement | 3,243,173 | 3,243 | - | - | 3,188,731 | - | 3,191,974 |\n| Issuance of common shares for consulting service | 1,710,808 | 1,711 | - | - | 252,539 | - | 254,250 |\n| Net income | - | - | - | - | - | 127,884 | 835,412 | 963,296 |\n| Foreign currency translation adjustments | 230,063 | 230,063 |\n| Balance, December 31, 2016 | 8,728,981 | $ | 8,729 | 500,000 | $ | 500 | $ | 13,789,991 | $ | 127,884 | $ | (19,489,400 | ) | $ | (38,916 | ) | $ | (5,601,212 | ) |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n\n| F-5 |\n\n\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\nCONSOLIDATED STATEMENTS OF CASH FLOWS\n\n| Years Ended December 31, |\n| 2016 | 2015 |\n| Cash flows from operating activities: |\n| Net income (loss) | $ | 963,296 | $ | (677,358 | ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: |\n| Depreciation | 23,980 | 4,352 |\n| Bad debt | 55,240 | - |\n| Provision for penalty payable | 77,575 | 72,152 |\n| Accrued interest on convertible notes and note payable | 112,599 | 112,538 |\n| Changes in operating assets and liabilities: | - | - |\n| Accounts receivable | (1,229,249 | ) | - |\n| Other receivable | (1,619,623 | ) | - |\n| Advance to supplier | (1,887,446 | ) | - |\n| Prepaid expense | (59,154 | ) | - |\n| Deposit | (36,095 | ) | (33,921 | ) |\n| Account payable | 1,116,061 | - |\n| Accrued expense | 7,117 | - |\n| Salary payable | 93,860 | 125,924 |\n| Taxes payable | 494,397 | 62,915 |\n| Due to related parties - trade | 217,293 | 178,988 |\n| Other payables | 527,175 | 4,202 |\n| Net cash used in operating activities | (1,142,974 | ) | (150,208 | ) |\n| Cash flows from investing activities: |\n| Purchase of property, plant and equipment | (79,083 | ) | - |\n| Net cash used in investing activities | (79,083 | ) | - |\n| Cash flows from financing activities: |\n| Proceeds from related parties, net of payments to related parties | 139,085 | 148,009 |\n| Proceeds from sale of common stock | 914,273 | - |\n| Net cash provided by financing activities | 1,053,358 | 148,009 |\n| Effect of exchange rate change | 181,447 | (43 | ) |\n| Cash and cash equivalents: |\n| Net increase (decrease) | 12,748 | (2,242 | ) |\n| Balance at beginning of year | 721 | 2,963 |\n| Balance at end of year | $ | 13,469 | $ | 721 |\n| Non-cash financing activities: |\n| Issuance of common stock for debts settlement | $ | 3,137,359 | $ | 1,000,000 |\n| Issuance of common stock for consulting service | 254,250 |\n| Supplemental Disclosures of Cash flow Information: |\n| Cash paid for interest | $ | $ | - |\n| Cash paid for income taxes | $ | $ | - |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n\n| F-6 |\n\n\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\nNOTES TO CONSOLIDATED FINANCIAL STATEMENTS\nDECEMBER 31, 2016\n1. Description of Business and Organization\nOrganization – Kiwa Bio-Tech Products Group Corporation (“the Company”) is the result of a share exchange transaction accomplished on March 12, 2004 between the shareholders of Kiwa Bio-Tech Products Group Ltd. (“Kiwa BVI”), a company originally organized under the laws of the British Virgin Islands on June 5, 2002 and Tintic Gold Mining Company (“Tintic”), a corporation originally incorporated in the state of Utah on June 14, 1933 to perform mining operations in Utah. The share exchange resulted in a change of control of Tintic, with former Kiwa BVI stockholders owning approximately 89% of Tintic on a fully diluted basis and Kiwa BVI surviving as a wholly-owned subsidiary of Tintic. Subsequent to the share exchange transaction, Tintic changed its name to Kiwa Bio-Tech Products Group Corporation. On July 21, 2004, the Company completed its reincorporation in the State of Delaware. On March 8, 2017, we completed our reincorporation in the State of Nevada.\nThe Company operates through a series of subsidiaries in the Peoples Republic of China as detailed in the following Organizational Chart. The Company had previously operated its business through its subsidiaries Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Kiwa Shandong”) and Tianjin Kiwa Feed Co., Ltd. (“Kiwa Tianjin ”). Kiwa Tianjin has been dissolved since July, 11, 2012. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\nBusiness – The Company’s business plan is to develop and market innovative, manufacture, distribute cost-effective and environmentally safe bio-technological products for agriculture markets primarily in China. The Company has acquired technologies to produce and market bio-fertilizer.\n2. Summary of Significant Accounting Policies\nPrinciple of Consolidation - These consolidated financial statements include the financial statements of the Company and its wholly-owned subsidiaries, Kiwa BVI, Hong Kong Baina Group Holding Company, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd, Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Kiwa Shandong”). All significant inter-company balances or transactions are eliminated on consolidation.\nReverse Split - On January 14, 2016, the Company filed a Certificate of Amendment of its Certificate of Incorporation with the State of Delaware with reference to a 1-for-200 reverse stock split with respect to its Common Stock with effective date of January 28, 2016. In connection with the reverse split, the Company’s authorized capital was amended to be 120,000,000 shares, comprising 100,000,000 shares of Common Stock par value $0.001 and 20,000,000 shares of Preferred Stock par value $0.001. All relevant information relating to numbers of shares, options and per share information have been retrospectively adjusted to reflect the reverse stock split for all periods presented.\nUse of Estimates - The preparation of financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant accounting estimates include the valuation of securities issued, deferred tax assets and related valuation allowance.\n\n| F-7 |\n\n\nCertain of our estimates, including evaluating the collectability of accounts receivable and the fair market value of long-lived assets, could be affected by external conditions, including those unique to our industry, and general economic conditions. It is possible that these external factors could have an effect on our estimates that could cause actual results to differ from our estimates. We re-evaluate all of our accounting estimates annually based on these conditions and record adjustments when necessary.\nCash and Cash Equivalents\nThe Company considers all highly liquid investments with a maturity of three months or less to be cash and cash equivalents. At times, such investments may be in excess of Federal Deposit Insurance Corporation (FDIC) insurance limit.\nAccounts Receivables - Accounts receivables represent customer accounts receivables. The allowance for doubtful accounts is based on a combination of current sales, historical charge offs and specific accounts identified as high risk. Uncollectible accounts receivable are charged against the allowance for doubtful accounts when all reasonable efforts to collect the amounts due have been exhausted. Such allowances, if any, would be recorded in the period the impairment is identified.\nAllowance for doubtful accounts\nThe Company provides an allowance for doubtful accounts equal to the estimated uncollectible amounts. The Company’s estimate is based on historical collection experience and a review of the current status of trade accounts receivable. It is reasonably possible that the Company’s estimate of the allowance for doubtful accounts will change. There was no allowance for doubtful accounts at December 31, 2016 and December 31, 2015.\nInventories - Inventories are stated at the lower of cost, determined on the weighted average method, and net realizable value. Work in progress and finished goods are composed of direct material, direct labor and a portion of manufacturing overhead. Net realizable value is the estimated selling price in the ordinary course of business, less estimated costs to complete and dispose.\nProperty, plant and equipment - Property, plant and equipment are stated at cost less accumulated depreciation and accumulated impairment losses, if any. Gains or losses on disposals are reflected as gain or loss in the year of disposal. The cost of improvements that extend the life of property, plant and equipment are capitalized. These capitalized costs may include structural improvements, equipment and fixtures. All ordinary repair and maintenance costs are expensed as incurred. Depreciation for financial reporting purposes is provided using the straight-line method over the estimated useful lives of the assets as follows:\n\n| Useful Life |\n| (In years) |\n| Buildings | 30 - 35 |\n| Machinery and equipment | 5 - 10 |\n| Automobiles | 8 |\n| Office equipment | 2 - 5 |\n| Computer software | 3 |\n\nImpairment of Long-Lived Assets - The Company’s long-lived assets consist of property, equipment and intangible assets. The Company evaluates its investment in long-lived assets, including property and equipment, for recoverability whenever events or changes in circumstances indicate the net carrying amount may not be recoverable. Judgments regarding potential impairment are based on legal factors, market conditions and operational performance indicators, among others. In assessing the impairment of property and equipment, the Company makes assumptions regarding the estimated future cash flows and other factors to determine the fair value of the respective assets.\nFair value of warrants and options - The Company adopted ASC Topic 815, “Accounting for Derivative Instruments and Hedging Activities” to recognize warrants relating to loans and warrants issued to consultants as compensation as derivative instruments in our consolidated financial statements. The Company also adopted ASC Topic 718, “Share Based Payment” to recognize options granted to employees as derivative instruments in our consolidated financial statements. The Company calculates the fair value of the warrants and options using the Black-Scholes Model.\n\n| F-8 |\n\n\nRevenue Recognition – The Company applies paragraph 605-10-S99-1 of the FASB Accounting Standards Codification for revenue recognition. The Company recognizes revenue when it is realized or realizable and earned. The Company considers revenue realized or realizable and earned when all of the following criteria are met: (i) persuasive evidence of an arrangement exists, (ii) the product has been shipped or the services have been rendered to the customer, (iii) the sales price is fixed or determinable, and (iv) collectability is reasonably assured.\nThe Company derives its revenues from sales contracts with its customer with revenues being generated upon delivery of products. Persuasive evidence of an arrangement is demonstrated via invoice; and the sales price to the customer is fixed upon acceptance of the purchase order and there is no separate sales rebate, discount, or volume incentive.\nShipping and Handling Costs - Substantially all costs of shipping and handling of products to customers are included in selling. Shipping and handling costs for the years ended December 31, 2016 and 2015 were $480,892 and $ nil, respectively.\nIncome Taxes - The Company accounts for income taxes under the provisions of FASB ASC Topic 740, “Income Tax,” which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Deferred tax assets and liabilities are recognized for the future tax consequence attributable to the difference between the tax bases of assets and liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are measured using the enacted tax rate expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company establishes a valuation when it is more likely than not that the assets will not be recovered.\nASC Topic 740.10.30 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC Topic 740.10.40 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. We have no material uncertain tax positions for any of the reporting periods presented.\nForeign Currency Translation and Other Comprehensive Income - The Company uses United States dollars (“US Dollar” or “US$” or “$”) for financial reporting purposes. However, the Company maintains the books and records in its functional currency, Chinese Renminbi (“RMB”), being the primary currency of the economic environment in which its operations are conducted. In general, the Company translates its assets and liabilities into U.S. dollars using the applicable exchange rates prevailing at the balance sheet date, and the statement of comprehensive loss and the statement of cash flow are translated at average exchange rates during the reporting period. Equity accounts are translated at historical rates. Adjustments resulting from the translation of the Company’s financial statements are recorded as accumulated other comprehensive income.\nOther comprehensive income for the years ended December 31, 2016 and 2015 represented foreign currency translation adjustments and were included in the consolidated statements of comprehensive loss.\nThe exchange rates used to translate amounts in RMB into U.S. Dollars for the purposes of preparing the consolidated financial statements were as follows:\n\n| As of December 31, |\n| 2016 | 2015 |\n| Balance sheet items, except for equity accounts | 6.94 | 6.4857 |\n\n\n| Years ended December 31, |\n| 2016 | 2015 |\n| Items in the statements of comprehensive loss | 6.62 | 6.2281 |\n\nAdvertising Costs - The Company charges all advertising costs to expense as incurred. The total amounts of advertising costs charged to selling, general and administrative expense were $nil for the years ended December 31, 2016 and 2015, respectively.\nResearch and Development Costs - Research and development costs are charged to expense as incurred. During the years ended December 31, 2016 and 2015, research and development costs were $224,433 and $178,988, respectively.\n\n| F-9 |\n\n\nNet Loss Per Common Share - Basic loss per common share is calculated by dividing net loss attributable to Kiwa stockholders by the weighted-average number of shares of common stock outstanding during the period. Diluted loss per common share includes dilutive effect of dilutive securities (stock options, warrants, convertible debt, stock subscription and other stock commitments issuable). These potentially dilutive securities were not included in the calculation of loss per share for the periods presented because the Company incurred a loss during such periods and thus the effect would have been anti-dilutive. Accordingly, basic and diluted loss per common share is the same for all periods presented. As of December 31, 2016 and 2015, potentially dilutive securities aggregated 8,872,655 (632,204 post-reverse split shares) and 126,440,833 (632,204 post-reverse split shares) shares of common stock, respectively.\nFair Value of Financial Instruments\nThe Company follows paragraph 825-10-50-10 of the FASB Accounting Standards Codification for disclosures about fair value of its financial instruments and paragraph 820- 10-35-37 of the FASB Accounting Standards Codification (“Paragraph 820-10-35-37”) to measure the fair value of its financial instruments. Paragraph 820-10-35-37 establishes a framework for measuring fair value with U.S. GAAP, and expands disclosures about fair value measurements.\nTo increase consistency and comparability in fair value measurements and related disclosures, Paragraph 820-10-35-37 establishes a fair value hierarchy which prioritizes the inputs to valuation techniques used to measure fair value into three (3) broad levels. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The three (3) levels of fair value hierarchy defined by Paragraph 820-10-35-37 are described below:\n\n| ● | Level 1: quoted market prices available in active markets for identical assets or liabilities as of the reporting date. |\n| ● | Level 2: pricing inputs other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable as of the reporting date. |\n| ● | Level 3: Pricing inputs that are generally observable inputs and not corroborated by market data. |\n\nFinancial assets are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable.\nThe fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.\nThe fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.\nThe carrying amount of the Company’s financial assets and liabilities, such as cash and cash equivalent, prepaid expenses, accounts payable and accrued expenses, approximate their fair value because of the short maturity of those instruments.\nTransactions involving related parties cannot be presumed to be carried out on an arm’s-length basis, as the requisite conditions of competitive, free-market dealings may not exist. Representations about transactions with related parties, if made, shall not imply that the related party transactions were consummated on terms equivalent to those that prevail in arm’s-length transactions unless such representations can be substantiated.\nIt is not however practical to determine the fair value of advances from stockholders, if any, due to their related party nature.\n\n| F-10 |\n\n\nRelated Parties\nThe Company follows subtopic 850-10 of the FASB Accounting Standards Codification for the identification of related parties and disclosure of related party transactions. Pursuant to Section 850-10-20 the related parties include: a) affiliates of the Company; b) entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of Section 825–10–15, to be accounted for by the equity method by the investing entity; c) trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of management; d) principal owners of the Company; e) management of the Company; f) other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests; and g) other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly Influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.\nThe consolidated financial statements shall include disclosures of material related party transactions, other than compensation arrangements, expense allowances, and other similar items in the ordinary course of business. However, disclosure of transactions that are eliminated in the preparation of consolidated financial statements is not required in those statements. The disclosures shall include: a. the nature of the relationship(s) involved; b. a description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the consolidated financial statements; c. the dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period; and d. amounts due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement.\nCommitments and Contingencies\nThe Company follows subtopic 450-20 of the FASB Accounting Standards Codification to report accounting for contingencies. Certain conditions may exist as of the date the consolidated financial statements are issued, which may result in a loss to the Company but which will only be resolved when one or more future events occur or fail to occur. The Company assesses such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or unasserted claims that may result in such proceedings, the Company evaluates the perceived merits of any legal proceedings or unasserted claims as well as the perceived merits of the amount of relief sought or expected to be sought therein.\n\n| F-11 |\n\n\nIf the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s consolidated financial statements. If the assessment indicates that a potential material loss contingency is not probable but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, and an estimate of the range of possible losses, if determinable and material, would be disclosed.\nLoss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the guarantees would be disclosed. Management does not believe, based upon information available at this time that these matters will have a material adverse effect on the Company’s financial position, results of operations or cash flows. However, there is no assurance that such matters will not materially and adversely\nStock Based Compensation\nThe Company accounts for employee and non-employee stock awards under ASC 718, whereby equity instruments issued to employees for services are recorded based on the fair value of the instrument issued and those issued to non-employees are recorded based on the fair value of the consideration received or the fair value of the equity instrument, whichever is more reliably measurable.\nNo stock based compensation was issued or outstanding as of December 31, 2016 and 2015.\nIncome Tax Provision\nIncome taxes are accounted for using the asset and liability method. Deferred income taxes are provided for temporary differences in recognizing certain income, expense and credit items for financial reporting purposes and tax reporting purposes. Such deferred income taxes primarily relate to the difference between the tax basis of assets and liabilities and their financial reporting amounts. Deferred tax assets and liabilities are measured by applying enacted statutory tax rates applicable to the future years in which deferred tax assets or liabilities are expected to be settled or realized. There were no material deferred tax assets or liabilities as of December 31, 2016 and December 31, 2015.\nAs of December 31, 2016, and 2015, the Company did not identify any material uncertain tax positions. As of December 31, 2016, the Company’s returns are subject to examination by federal and state taxing authorities, generally for three years and four years, respectively, after they are filed.\nNet Income (Loss) Per Common Share\nNet income (loss) per common share is computed pursuant to section 260-10-45 of the FASB Accounting Standards Codification. Basic net income (loss) per common share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period.\n\n| F-12 |\n\n\nDiluted net income (loss) per common share is computed by dividing net income (loss) by the weighted average number of shares of common stock and potentially outstanding shares of common stock during the period to reflect the potential dilution that could occur from common shares issuable through contingent shares issuance arrangement, stock options or warrants.\nThere were no potentially dilutive debt or equity instruments issued and outstanding at any time during the twelve-month periods ended December 31, 2016 and 2015.\nCash Flows Reporting\nThe Company adopted paragraph 230-10-45-24 of the FASB Accounting Standards Codification for cash flows reporting, classifies cash receipts and payments according to whether they stem from operating, investing, or financing activities and provides definitions of each category, and uses the indirect or reconciliation method (“Indirect method”) as defined by paragraph 230-10-45-25 of the FASB Accounting Standards Codification to report net cash flow from operating activities by adjusting net income to reconcile it to net cash flow from operating activities by removing the effects of (a) all deferrals of past operating cash receipts and payments and all accruals of expected future operating cash receipts and payments and (b) all items that are included in net income that do not affect operating cash receipts and payments. The Company reports the reporting currency equivalent of foreign currency cash flows, using the current exchange rate at the time of the cash flows and the effect of exchange rate changes on cash held in foreign currencies is reported as a separate item in the reconciliation of beginning and ending balances of cash and cash equivalents and separately provides information about investing and financing activities not resulting in cash receipts or payments in the period pursuant to paragraph 830-230-45-1 of the FASB Accounting Standards Codification.\nSubsequent Events\nThe Company follows the guidance in Section 855-10-50 of the FASB Accounting Standards Codification for the disclosure of subsequent events. The Company will evaluate subsequent events through the date when the financial statements were issued. Pursuant to ASU 2010-09 of the FASB Accounting Standards Codification, the Company as an SEC filer considers its financial statements issued when they are widely distributed to users, such as through filing them on EDGAR.\nRecent accounting pronouncements\nIn November 2015, FASB issued ASU 2015-17, “Balance Sheet Classification of Deferred Taxes.” ASU 2015-17 requires that deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial position. ASU 2015-17 is effective for financial statements issued for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. The Company does not expect these changes to have a material impact on the Company’s consolidated financial statements.\nIn January 2016, Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-01, “Recognition and Measurement of Financial Assets and Financial Liabilities.” ASU 2016-01 requires equity investments to be measured at fair value with changes in fair value recognized in net income; simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; Eliminates the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet; requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; requires an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments; requires separate presentation of financial assets and financial liabilities by measurement category and form of financial assets on the balance sheet or the accompanying notes to the financial statements and clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets. ASU 2016-01 is effective for financial statements issued for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. The Company does not expect these changes to have a material impact on the Company’s consolidated financial statements.\n\n| F-13 |\n\n\nIn March 2016, the FASB issued ASU 2016-09—Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. The amendments in this guidance are relating to employee share-based compensation. Under the new guidance, we are required to recognize the tax effects of stock compensation as income tax expense or benefit in the income statement and treat the tax effects of exercised or vested awards as discrete items in the reporting period in which they occur. Excess tax benefits are required to be classified as operating activities, and shares we withhold on behalf of employees for tax purposes are required to be classified as financing activities. We may make an accounting policy election to continue to estimate the number of awards that are expected to vest or account for forfeitures when they occur. The threshold to qualify for equity classification permits withholding up to the maximum statutory tax rates. This guidance is required to be adopted in the first quarter of 2017. We are currently evaluating the impact this guidance will have on our consolidated financial statements.\nIn August 2016, the FASB issued ASU 2016-15—Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (a consensus of the Emerging Issues Task Force). The amendments in this guidance on eight specific cash flow issues with regard to how cash receipts and cash payments are presented and classified in the statement of cash flows in order to clarify existing guidance and reduce diversity in practice. The guidance is required to be adopted in the first quarter of 2018 on a retrospective basis, unless it is impracticable to apply, in which case it should be applied prospectively as of the earliest date practicable. Early adoption is permitted. We are currently evaluating the impact this guidance will have on our consolidated statement of cash flows.\nIn January 2017, the FASB issued ASU 2017-01, “Business Combinations (Topic 805): Clarifying the Definition of a Business.” The amendments in this guidance are clarifying the definition of a business to assist entities when determining whether an integrated set of assets and activities meets the definition of a business. The update provides that when substantially all the fair value of the assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets, the set is not a business. The guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The adoption of this new guidance is not expected to have a material impact on our consolidated financial statements.\nIn January 2017, the FASB issued ASU 2017-04—Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. The amendments in this guidance to eliminate the requirement to calculate the implied fair value of goodwill to measure goodwill impairment charge (Step 2). As a result, an impairment charge will equal the amount by which a reporting unit’s carrying amount exceeds its fair value, not to exceed the amount of goodwill allocated to the reporting unit. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. The amendment should be applied on a prospective basis. The guidance is effective for goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for goodwill impairment tests performed after January 1, 2017. The impact of this guidance for the Company will depend on the outcomes of future goodwill impairment tests.\nThere were other updates recently issued. The Company does not believe that other than disclosed above, the recently issued, but not yet adopted, accounting pronouncements will have a material impact on its financial position, results of operations or cash flows.\nGoodwill and Other Intangibles\nIn accordance with Accounting Standards Update (ASU) No. 2014-02, management evaluates goodwill on an annual basis in the fourth quarter of more frequently if management believes indicators of impairment exist. Such indicators could, but are not limited to (1) a significant adverse change in legal factors or in business climate, (2) unanticipated competition, or (3) an adverse action or assessment by a regulator. The Company first assesses qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, including goodwill. If management concludes that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, management conducts a two-step quantitative goodwill impairment test. The first step of the impairment test involves comparing the fair value of the applicable reporting unit with its carrying value. The Company estimates the fair value of its reporting units using a combination of the income, or discounted cash flows, approach and the market approach, with utilizes comparable companies’ data. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, management performs the second step of the goodwill impairment test. The second step of the goodwill impairment test involves comparing the implied fair value of the affected reporting unit’s goodwill with the carrying value of that goodwill. The amount, by which the carrying value of the goodwill exceeds its implied fair value, if any, is recognized as an impairment loss. The Company’s evaluation of goodwill completed during the year resulted in no impairment losses.\n3. Going Concern\nThe consolidated financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.\nAs of December 31, 2016, the Company’s current liabilities substantially exceeded its current assets by $5,729,622, had an accumulated deficit of $19,489,400, and stockholders’ deficiency of $5,601,213. These circumstances, among others, raise substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. The financial statements also do not include any adjustments relating to the recoverability and classification of recorded asset amounts, or amounts and classifications of liabilities that might be necessary should the Company be unable to continue as a going concern.\nThe management of the Company already raised additional equity during the first quarter of 2017 for approximately $1,000,000. (Please refer to Note 14 for additional information) The Company is generating additional revenue while seeking additional equity financing. Management is very optimistic about the Company’s continue profitability for the coming years.\n4. Property, Plant and Equipment\nProperty, plant and equipment, net consisted of the following:\n\n| December 31, 2016 | December 31, 2015 |\n| Property, Plant and Equipment |\n| Buildings | $ | - | $ | 1,308,785 |\n| Machinery and equipment | - | 595,623 |\n| Automobiles | - | 85,769 |\n| Office equipment | 942 | 104,843 |\n| Furniture | 8,276 | - |\n| Leasehold improvement | 70,871 | - |\n| Computer software | - | 22,304 |\n| Property, plant and equipment - total | $ | 80,089 | $ | 2,117,324 |\n| Less: accumulated depreciation | (20,311 | ) | (762,791 | ) |\n| Less: impairment on long-lived assets | - | (1,351,726 | ) |\n| Property, plant and equipment - net | $ | 59,778 | $ | 2,807 |\n\nThe building is on a piece of land the use right of which was granted to Kiwa Bio-Tech Products (Shandong) Co., Ltd. by local government free for 10 years and then for another 20 years on a fee calculated according to Kiwa Shandong’s net profit. Since Kiwa Shandong did not generate any net profit, no fee is payable.\nDepreciation expense was $22,340 and $4,352 for the years ended December 31, 2016 and 2015, respectively.\nImpairment on long-lived assets was $nil for the years ended December 31, 2016 and 2015, respectively.\nAll of our property, plant and equipment have been held as collateral to secure the 6% Notes (see Note 8).\n5. Goodwill\nOn November 30, 2015, Kiwa Bio-tech Products Group Ltd in BVI (\"Kiwa BVI\") entered an acquisition agreement with shareholders of Caber Holdings Ltd. (“Acquiree”) in Hong Kong to acquire 100 percent entity interest of the acquiree, including a wholly owned subsidiary, Oriental Baina Co., Ltd. in Beijing for US$30,000. The acquisition was completed in January, 2016. On the acquisition date, there was no any asset or liability acquired, and thus no fair value was allocated to asset and liability. Including legal fee and government fees, the total payment of approximately $34,112 ($30,000 plus legal fee and government fees totaled $4,112) was recorded as goodwill. The fair value of the goodwill is tested prior to the year-end 2016, and management determined there is no impairment to the goodwill as of December 31, 2016.\n6. Construction Costs Payable\nConstruction costs payable represents remaining amounts to be paid for the first phase of construction of bio-fertilizer facility in Shandong. The balance of construction costs payable as of December 31, 2016 and 2015 was $255,539 and $273,722, respectively.\n\n| F-14 |\n\n\n7. Related Party Transactions\nAmounts due to related parties consisted of the following as of December 31, 2016 and 2015:\n\n| Item | Nature | Notes | December 31, 2016 | December 31, 2015 |\n| Mr. Wei Li (“Mr. Li”) | Non-trade | (1 | ) | $ | - | $ | 2,879,307 |\n| Kangtai Xinnong Agriculture Tech (Beijing) Co., Ltd. (“Kangtai”) | Non-trade | (2 | ) | - | (12,173 | ) |\n| Ms. Yvonne Wang (“Ms. Wang”) | Non-trade | (3 | ) | 100,798 | 299,064 |\n| Subtotal | 100,798 | 3,166,198 |\n| Kiwa-CAU R&D Center | Trade | (4 | ) | 1,122,754 | 1,125,553 |\n| CAAS IARRP and IAED Institutes | Trade | (5 | ) | 160,461 | 18,425 |\n| Subtotal | 1,283,215 | 1,143,978 |\n| Total | $ | 1,384,013 | $ | 4,310,176 |\n\n(1) Mr. Li\nMr. Li was the Chairman of the Board until November 20, 2015 and was the Chief Executive Officer of the Company until July 1, 2015.\nAdvances and Loans\nOn December 14, 2015, Mr. Li assigned $500,000 of obligation owed by the Company to his daughter, Feng Li. On the same day, Feng Li subscribed for the purchase of 250,000 shares of preferred stock for the aggregate amount of $500,000, and agreed to the concurrent cancellation of debt owed by the Company.\nOn March 24, 2016, the Company issued 2,900,000 shares of common stock to Mr. Li to settle down entire outstanding balance of $2,879,307. Subsequently in June 2016, Mr. Li transferred 1,000,000 shares to Troniya Industria Incubator Co., Ltd as a personal collateral for RMB 3.2 million received in Kiwa Baiao Bio-Tech (Beijing) Co., Ltd.’s account.\nGuarantees for the Company\nMr. Li has pledged without any compensation from the Company all of his common stock of the Company as collateral for the Company’s obligations under the 6% Notes (see Note 9).\n(2) Kangtai\nKangtai is a private company and is 64% owned by Mr. Li. Mr. Li is the Chairman of Kangtai.\n(3) Ms. Wang\nMs. Wang is the Secretary of the Company until November 20, 2015. Effective as of November 20, 2015, the Company appointed Ms. Wang as the Chairman of the Board. Effective August 11, 2016, the Company’s Board of Directors has assigned Ms. Wang the additional titles of Acting President, Acting Chief Executive Officer and Acting Chief Financial Officer.\nOn December 14, 2015, Ms. Wang subscribed for the purchase of 250,000 shares of preferred stock for the aggregate amount of $500,000, and agrees to the concurrent cancellation of debt owed by the Company.\nOn March 24, 2016, the Company issued 240,000 shares of common stock to Ms. Wang to pay off the loan balance of $240,000. During the year ended December 31, 2016, Ms. Wang paid various expenses on behalf of the Company. As of December 31, 2016, the amount due to Ms. Wang was $100,798.\n\n| F-15 |\n\n\n(4) Kiwa-CAU R&D Center\nIn November 2006, Kiwa and China Agricultural University (the “CAU”) agreed to jointly establish a new research and development center, named Kiwa-CAU R&D Center. The term of the agreement was ten years commencing July 1, 2006.\n\n| ● | Pursuant to the agreement, Kiwa agree to invest RMB 1 million (approximately $160,000) each year to fund research at Kiwa-CAU R&D Center. Prof. Qi Wang, a director of the Company, is also the director of Kiwa-CAU R&D Center. The Company recorded $75,528 and $160,563 research and development expenses related to this R&D Center for the years ended December 31, 2016 and 2015, respectively. |\n\n(5) CAAS IARRP and IAED Institutes\nOn November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). The term of the Agreement was three years commencing November 20, 2015.\n\n| ● | Pursuant to the agreement, Kiwa agree to invest RMB 1 million (approximately $160,000) each year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. Prof. Yong Chang Wu, the authorized representative of IARRP, CAAS, is also one of the Company's directors effective since November 20, 2015 until March 13, 2017. The Company recorded $149,176 and $18,425 research and development expenses related to the institutes, for the years ended December 31, 2016 and 2015, respectively, |\n\nResearch and Development expenses for the years ended December 31, 2016 and 2015, totaled $224,704 and $178,988, respectively.\n8. Unsecured Loans Payable\nUnsecured loans payable consisted of the following:\n\n| Item | December 31, 2016 | December 31, 2015 |\n| Unsecured loan payable to Zoucheng Municipal Government, non-interest bearing, becoming due within three years from Kiwa Shandong’s first profitable year on a formula basis, interest has not been imputed due to the undeterminable repayment date | $ | 1,269,880 | $ | 1,387,668 |\n| Unsecured loan payable to Zoucheng Science & Technology Bureau, non-interest bearing, it is due in Kiwa Shandong’s first profitable year, interest has not been imputed due to the undeterminable repayment date | 385,463 | 385,463 |\n| Total | $ | 1,655,343 | $ | 1,773,131 |\n\nThe Company qualifies for non-interest bearing loans under a Chinese government sponsored program to encourage economic development in certain industries and locations in China. To qualify for the favorable loan terms, a company must meet the following criteria: (1) be a technology company with innovative technology or product (as determined by the Science Bureau of the central Chinese government); (2) operate in specific industries that the Chinese government has determined are important to encourage development, such as agriculture, environmental, education, and others; and (3) be located in an undeveloped area such as Zoucheng, Shandong Province, where the manufacturing facility of the Company is located.\nAccording to the Company’s project agreement, Zoucheng Municipal Government granted the Company use of at least 15.7 acres in Shandong Province, China at no cost for 10 years to construct a manufacturing facility. Under the agreement, the Company has the option to pay a fee of RMB 480,000 ($77,100) per acre for the land use right after the 10-year period until May 2012. The Company may not transfer or pledge the temporary land use right. The Company also committed to invest approximately $18 million to $24 million for developing the manufacturing and research facilities in Zoucheng, Shandong Province. As of December 31, 2016, the Company invested approximately $2 million for the property, plant and equipment of the project and these assets were impaired as of December 31, 2016.\n\n| F-16 |\n\n\n9. Convertible Notes Payable\nConvertible notes payable consists of 6% secured convertible notes issued to FirsTrust Group Inc. on June 29, 2006. The notes beard interest at 6% and were due on June 29, 2009. Once the note is pass due, the interest rate increased to 15% per annum. The Company accrued $22,977 and $22,538 interest expense on convertible notes for the years ended December 31, 2016 and 2015, respectively. Interest payable to FirstTrust Group Inc. totaled $183,361 and $160,762 at December 31, 2016 and 2015, respectively.\nThe conversion price of the 6% Notes is based on a 40% discount to the average of the trading price of the Company’s common stock on the OTC Bulletin Board over a 20-day trading period. The conversion price is also adjusted for certain subsequent issuances of equity securities of the Company at prices below the conversion price then in effect. The 6% Notes contain a volume limitation that prohibits the holder from further converting the 6% Notes if doing so would cause the holder and its affiliates to hold more than 4.99% of the Company’s outstanding common stock. In addition, the holder of the 6% Notes agrees that they may not convert more than their pro-rata share (based on original principal amount) of the greater of $120,000 principal amount of the 6% Notes per calendar month or the average daily dollar volume calculated during the 10 business days prior to a conversion, per conversion. This conversion limit has since been eliminated pursuant to an agreement by the Company and the Purchasers.\nThe Company incurs a financial penalty in cash or shares at the option of the Company (equal to 2% of the outstanding amount of the Notes per month plus accrued and unpaid interest on the Notes, prorated for partial months) if it breaches this or other affirmative covenants in the Purchase Agreement, including a covenant to maintain a sufficient number of authorized shares under its Certificate of Incorporation to cover at least 110% of the stock issuable upon full conversion of the Notes. Pursuant to the relevant provisions for liquidated damages in the Purchase Agreement, the Company has accrued the penalty of $77,575 and $72,152 for the years ended December 31, 2016 and 2015, respectively.\nThe 6% Notes require the Company to procure the Purchaser’s consent prior to taking certain actions including the payment of dividends, repurchasing stock, incurring debt, guaranteeing obligations, merging or restructuring the Company, or selling significant assets.\nThe Company’s obligations under the 6% Notes are secured by a first priority security interest in the Company’s intellectual property pursuant to an Intellectual Property Security Agreement with the Purchasers, and by a first priority security interest in all of the Company’s other assets pursuant to a Security Agreement with the Purchasers. In addition, Mr. Li, the Company’s former Chief Executive Officer until July 1, 2015, has pledged all of his common stock of the Company as collateral for the Company’s obligations under the 6% Notes. The intellectual property pledged had a cost of $592,901 which carrying value of $179,897 was fully impaired during the year ended December 31, 2009.\n\n| F-17 |\n\n\n10. Note payable\nOn May 29, 2007, the Company issued a $360,000 promissory note to an unrelated individual. This note bears interest at 18% per annum and due on July 27, 2007. This note is currently in default and bears interest of 25% per annum (the “Default rate”) until paid in full. This note is secured by a pledge of 6,178,336 (post-reverse split 30,892) shares of the Company’s common stock owned by Investlink (China) Limited, a British Virgin Island corporation. The Company accrued $90,000 and $90,000 interest expense on note payable for the years ended December 31, 2016 and 2015, respectively.\n11.Stockholders’ Deficiency\nOn December 14, 2015, the Company issued 500,000 shares of preferred stock for the aggregate amount of $1,000,000 as debt cancellation owed to two related party individuals (see Note 7).\nIn March, 2016, the Company issued 3,140,000 shares of common stock to Mr. Li and Ms. Wang for debt and salary payable settlement for an aggregate amount of $3,141,000 (See Note 7). In addition, the Company issued 101,947 common shares to Jimmy Zhou, former CEO in August 2016, to settle payable to him for $50,974. All of issuances of common shares for settlement of debts were based the stock price on the transaction dates.\nDuring the year, the Company issued 1,775,000 common shares for cash at $0.8 per share for an aggregate subscribe price equivalent to $1,420,000, of which $859,659 has received while approximately $560,341 remaining subscribe receivable at December 31, 2016.\nDuring the year ended December 31, 2016, the Company issued 1,711,808 common shares to four consulting companies as compensation for their consulting service received, totaled $254,250 approximately for the year ended December 31, 2016.\n12. Stock-based Compensation\nOn December 12, 2006, the Company granted options for 2,000,000 shares (10,000 post-reverse split shares) of its common stock under its 2004 Stock Incentive Plan. Summary of options issued and outstanding at December 31, 2016 and 2015 and the movements during the years then ended are as follows:\n\n| F-18 |\n\n\n\n| Number of underlying shares | Weighted- Average Exercise Price Per Share | Aggregate Intrinsic Value | Weighted- Average Contractual Life Remaining in Years |\n| Outstanding at December 31, 2014 | 6,163 | $ | 35 | $ | - | 2 |\n| Exercised | - | - | - |\n| Expired | - | - | - |\n| Forfeited | - | - | - |\n| Outstanding at December 31, 2015 | 6,163 | $ | 35 | $ | - | 1 |\n| Exercised | - | - | - |\n| Expired | 6,163 | $ | 35 | - |\n| Forfeited | - | - | - |\n| Outstanding at December 31, 2016 | - | - | $ | - | - |\n| Exercisable at December 31, 2016 | - | - | $ | - | - |\n\nAs of December 31, 2016, no stock options or other stock-based compensation was outstanding and all prior grants of stock options had expired as of that date.\n13. Income Tax\nIn accordance with the current tax laws in China, Kiwa Shandong is subject to a corporate income tax rate of 25% on its taxable income. However, Kiwa Shandong has not provided for any corporate income taxes since it had no taxable income for the years ended December 31, 2016 and 2015.\nNo provision for taxes is made for U.S. income tax as the Company has no taxable income in the U.S. In accordance with the relevant tax laws in the British Virgin Islands, Kiwa BVI, as an International Business Company, is exempt from income taxes.\nA reconciliation of the provision for income taxes determined at the local income tax rate to the Company’s effective income tax rate is as follows:\n\n| Years ended December 31, |\n| 2016 | 2015 |\n| Pre-tax income (loss) | $ | 1,389,576 | $ | (677,358 | ) |\n| U.S. federal corporate income tax rate | 34 | % | 34 | % |\n| Income tax computed at U.S. federal corporate income tax rate | 472,456 | (230,302 | ) |\n| Reconciling items: |\n| Rate differential for PRC earnings | (139,923 | ) | 22,439 |\n| Change of valuation allowance | 301,813 | 171,993 |\n| Non-deductible expenses | (208,066 | ) | 35,870 |\n| Effective tax expense | $ | 426,280 | $ | - |\n\n\n| F-19 |\n\n\nThe Company had deferred tax assets as follows:\n\n| December 31, 2016 | December 31, 2015 |\n| Net operating losses carried forward | $ | 3,475,563 | $ | 3,398,402 |\n| Less: Valuation allowance | (3,475,563 | ) | (3,398,402 | ) |\n| Net deferred tax assets | $ | - | $ | - |\n\nAs of December 31, 2016 and 2015, the Company had approximately $3.5 million and $8 million net operating loss carryforwards available to reduce future taxable income. Net operating loss of the Company could be carried forward and taken against any taxable income for a period of not more than twenty years from the year of the initial loss pursuant to Section 172 of the Internal Revenue Code of 1986, as amended. The net operating loss of Kiwa Shandong could be carried forward for a period of not more than five years from the year of the initial loss pursuant to relevant PRC tax laws and regulations. It is more likely than not that the deferred tax assets cannot be utilized in the future because there will not be significant future earnings from the entity which generated the net operating loss. Therefore, the Company recorded a full valuation allowance on its deferred tax assets.\nAs of December 31, 2016 and 2015, the Company has no material unrecognized tax benefits which would favorably affect the effective income tax rate in future periods and does not believe that there will be any significant increases or decreases of unrecognized tax benefits within the next twelve months. No interest or penalties relating to income tax matters have been imposed on the Company during the two years ended December 31, 2016 and 2015, and no provision for interest and penalties is deemed necessary as of December 31, 2016 and 2015.\nAccording to the PRC Tax Administration and Collection Law, the statute of limitations is three years if the underpayment of taxes is due to computational errors made by the taxpayer or its withholding agent. The statute of limitations extends to five years under special circumstances, which are not clearly defined. In the case of a related party transaction, the statute of limitation is ten years. There is no statute of limitation in the case of tax evasion.\n14. Commitments and Contingencies\nThe Company has the following material contractual obligations:\n(1) Investment in manufacturing and research facilities in Zoucheng, Shandong Province in China\nAccording to the Project Agreement with Zoucheng Municipal Government in 2002, we have committed to investing approximately $18 million to $24 million for developing the manufacturing and research facilities in Zoucheng, Shandong Province. As of December 31, 2016, we had invested approximately $1.91 million for the project. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\n(2) Strategic cooperation with two institutes in China\nOn November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). Pursuant to the Agreement, the Company will form a strategic partnership with the two institutes and establish an “International Cooperation Platform for Internet and Safe Agricultural Products”. To fund the cooperation platform’s R&D activities, the Company will provide RMB 1 million (approximately $160,000) per year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. The term of the Agreement is for three years beginning November 20, 2015. Prof. Yong Chang Wu, the authorized representative of IARRP, CAAS, is also one of the Company’s directors effective since November 20, 2015 until March 13, 2017.\n\n| F-20 |\n\n\n(3) Distribution agreement with Kangtan Gerui Bio-Tech in China\nOn December 17, 2015, Kiwa Bio-Tech Products Group Corporation (the “Company”) entered into a distribution agreement (the “Agreement”) with Kangtan Gerui (Beijing) Bio-Tech Co., Ltd. (“Gerui”) and formally awarded Gerui a right to sell and distribute the Company’s fertilizer products in 3 major agricultural regions of China— Hainan Province, Hunan Province and Xinjiang Autonomous Region. The Company’s Research and Development department has been conducting application experiments in Hainan and Hunan Provinces since August 2015, in accordance with the market requirements. The experiment data indicates that the Company’s fertilizer products have fulfill the requirements of reduction of content of heavy metals in soil and improve crop yield. Gerui was founded in Beijing in April 2015 and relies on the sales network of China’s Supply and Marketing Cooperatives system. Currently, the Company and Gerui do not hold any interest in each other; however, a collaboration and integration may take place in the future. The term of the Agreement is for a period of three years commencing December 17, 2015. In September 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd obtained a fertilizer sales permit from the Chinese government and began to sale the products directly to customers in those 3 major agricultural regions.\n(4) Lease payments\n(1) On April 29, 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. entered an office lease agreement with two-year team. Monthly lease payment and building management fee totaled RMB 77,867 or approximately USD $11,622.\n(2) On November 11, 2017, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. entered an apartment lease agreement for its employees. The lease term is one year with monthly lease payment of RMB 6,000 or approximately USD $896.\n(3) In March 1, 2017, Kiwa Bio-Tech (Shenzhen) Co., Ltd, a newly established subsidiary entered an office lease agreement with one-year term. Monthly lease payment is RMB 29,000 or approximately of USD $4,320.\nThe future lease payments at December 31, 2016 are summarized below.\n\n| Beijing Office | Beijing Apartment | Shenzhen Office | Total |\n| 2017 | $ | 139,462 | $ | 3,632 | $ | 4,328 | $ | 147,422 |\n| 2018 | $ | 44,555 | - | - | $ | 44,555 |\n| Thereafter | - | - | - | - |\n\n15. Subsequent Events\nThe Company has evaluated the existence of significant events subsequent to the balance sheet date through the date these financial statements were issued and has determined that there were no subsequent events or transactions which would require recognition or disclosure in the financial statements, other than noted herein.\nOn February 11, 2017, the Company executed an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) whereby the Company transferred all of its right, title and interest in Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Shandong”) to the Transferee for the RMB equivalent of US$1.00. In connection with the transaction, the Transferee received all assets of Shandong which are estimated to be approximately RMB 14,057,713 at the effective date and assumed all liabilities of Shandong which are estimated to be approximately RMB 59,446,513 at the effective date. In connection with this transaction, Transferee agreed to indemnify the Company for any liability or claims of any third party(ies) against Shandong or the Company for five (5) years. The transaction is subject to obtaining Chinese government approval for the transaction, which the parties agrees to use their best efforts to obtain prior to December 31, 2017. The completion of transfer is under government processing.\n\n| F-21 |\n\n\nOn February 15, 2017, the Company completed the sale of 1,000,000 shares of Kiwa Common Stock (each a “Share”) at a price of $1.00 per share (total sale proceeds were $1,000,000) to Junwei Zheng in a private transaction which was exempt from registration under Section 4(a)(2) of the Securities Act of 1933, as amended (the “Act”) and Regulation S promulgated under the Act since, among other things, the transaction did not involve a public offering and the securities were acquired for investment purposes only and not with a view to or for sale in connection with any distribution thereof and were purchased by an investor who is not a resident of the United States. The net proceeds will be used for the further development of Kiwa products and distribution, as well as for general working capital.\nOn February 23, 2017, the Company has agreed to a strategic relationship with ETS (Tianjin) Biological Science and Technology Development Co., Ltd. (“ETS”). The partnership will include the deployment and strategic use of ETS biotechnology to produce of bio-fertilizers for use in both China and internationally. Kiwa and ETS, together with the certain Chinese government departments, will work together to enhance China’s microbial fertilizer industry standards and China’s food safety industry chain standards. The parties will work together on the development of microbial technology and products in agriculture, environmental protection, soil management and other fields. Relying on the Chinese Academy of Sciences, ETS Environmental and Agricultural Microbial Technology Research Center and biotechnology project research results, Kiwa has introduced the ETS core technology to complete bio-fertilizer upgrading, transformation and to develop new product lines. In order to meet the growing global consumer demand to increase food supply and develop sustainable farming we are applying sustainable use of biotechnology and the use of biotechnology products to replace chemical products, which will strengthen environmental protection and promote international cooperation. As a result of strict management of many agricultural chemicals, such chemicals will continue to be abandoned, resulting is a growing demand for bio-fertilizers. It has been widely accepted that the application of ETS biotechnology facilitates agricultural sustainability and helps to protect the soil and improve grain output. The technology focuses on keeping soil healthy by restoring healthy microbes that are naturally present in healthy soils. As the technology gains worldwide recognition, it is imperative to popularize bio-fertilizer in developing countries to fulfill the needs of growing populations and promote environmentally friendly agriculture. Through the cooperation of Kiwa and ETS, the parties aim to enhance the usage of the bio-fertilizers in China. The cooperation will bring technological transformation and support for Kiwa to improve its existing manufacturing techniques. Kiwa and ETS will also collaborate to establish a comprehensive platform for producing, supplying, and marketing in China. Ultimately, Kiwa would look to introduce these products to the international market, including the United States.\nOn February 27, 2017, the Company has signed a strategic cooperation agreement with the Beijing Zhongpin Agricultural Science and Technology Development Center (“Zhongpin Center”). Zhongpin Center is the Chinese Agricultural Science and Technology Innovation and Development Committee’s executive implementation agency (referred to as the Agricultural Science and Technology Commission). The Agricultural Science and Technology Commission is set up by the Chinese Central Government for the construction of the National Ecological Security Agriculture Industrial Chain standardization system. This includes the establishment of National Ecology Safe Agricultural Industrial Parks to build China’s Ecological Security and Agricultural Industrial in an orderly business environment, including completion of the National Soil Remediation Program and governance of the various government functions of the institutions. Through the guidance and support by the Zhongpin Center, Kiwa will participate and be involved in China’s National Soil Remediation Program and construction of the National Ecological Security Agriculture Industrial Chain Standardization System’s operation and process.\nOn March 8, 2017, pursuant to the consent of the holders of a majority of the votes entitled to be cast on the matter and the approval of the majority of the directors of the Company, the Company was converted from a Delaware corporation to a Nevada corporation by filing of Articles of Conversion and Articles of Incorporation in the State of Nevada and filing a Certificate of Dissolution in the State of Delaware.\nOn March 8, 2017, pursuant to the consent of the holders of a majority of the votes entitled to be cast on the matter and the approval of the Kiwa Bio-Tech Products Group Corporation 2016 Employee, Director and Consultant Stock Plan.\nOn March 13, 2017, Yong Change Wu was removed as a director of the Company by the consent of the holders of a majority of the votes entitled to be cast on the matter and the approval of the majority of the directors of the Company. Immediately thereafter, the Board appointed Yong Lin Song as a director of the Company to be effective immediately.\n\n| F-22 |\n\n\n\n \n\nWhat is the total amount spent by the company on research and development, and acquisitions from 2004 to 2016 in US dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nITEM 1. Business\\nThe Company\\n1. Organizational History\\nWe are the result of a share exchange transaction completed in March 2004 between the shareholders of Tintic Gold Mining Company (“Tintic”), a corporation originally incorporated in the state of Utah on June 14, 1933 to perform mining operations in Utah, and the shareholders of Kiwa Bio-Tech Products Group Ltd. (“Kiwa BVI”), a company originally organized under the laws of the British Virgin Islands on June 5, 2002. The share exchange resulted in a change of control of Tintic, with former Kiwa BVI stockholders owning approximately 89% of Tintic on a fully diluted basis and Kiwa BVI surviving as a wholly-owned subsidiary of Tintic. Subsequent to the share exchange transaction, Tintic changed its name to Kiwa Bio-Tech Products Group Corporation. On July 21, 2004, we completed our reincorporation in the State of Delaware. On March 8, 2017, we completed our reincorporation in the State of Nevada.\\nThe Company operates through a series of subsidiaries in the Peoples Republic of China as detailed in the following Organizational Chart. The Company had previously operated its business through its subsidiaries Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Kiwa Shandong”) and Tianjin Kiwa Feed Co., Ltd. (“Kiwa Tianjin”). Kiwa Tianjin has been dissolved since July 11, 2012. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\\n\\n| 3 |\\n\\n\\n2. Overview of Business\\nWe develop, manufacture, distribute and market innovative, cost-effective and environmentally safe bio-technological products for agriculture. Our products are designed to enhance the quality of human life by increasing the value, quality and productivity of crops and decreasing the negative environmental impact of chemicals and other wastes.\\n\\n| 4 |\\n\\n\\nBio-fertilizers\\nWe have developed six bio-fertilizer products with bacillus species (“bacillus spp”) and/or photosynthetic bacteria as core ingredients. Some of our products contain ingredients of both photosynthesis and bacillus bacteria. Bacillus spp is a species of bacteria that interacts with plants and promotes biological processes. It is highly effective for promoting plant growth, enhancing yield, improving quality and elevating resistances. Photosynthetic bacteria are a group of green and purple bacteria. Bacterial photosynthesis differs from green plant photosynthesis in that bacterial photosynthesis occurs in an anaerobic environment and does not produce oxygen. Photosynthetic bacteria can enhance the photosynthetic capacity of green plants by increasing the utilization of sunlight, which helps keep the photosynthetic process at a vigorous level, enhances the capacity of plants to transform inorganic materials to organic products, and boosts overall plant health and productivity.\\nOur bacillus bacteria based fertilizers are protected by patents. In 2004, we acquired patent no. ZL 93101635.5 entitled “Highly Effective Composite Bacteria for Enhancing Yield and the Related Methodology for Manufacturing” from China Agricultural University (“CAU”) for the aggregate purchase of $480,411, consisting of $60,411 in cash and 5,000 shares of our common stock, valued at $84.00 per share (aggregate value of $420,000). Our photosynthetic bacteria based fertilizers are also protected by trade secret laws.\\nThe patent acquired from CAU covers six different species of bacillus which have been tested as bio-fertilizers to enhance yield and plant health. The production methods of the six species are also patented. The patent has expired on February 19, 2013.There are no limitations under this agreement on our exclusive use of the patent. Pursuant to our agreement with CAU, the University agreed to provide research and technology support services at no additional cost to us in the event we decide to use the patent to produce commercial products. These research and technology support services include: (1) furnishing faculty or graduate-level researchers to help bacteria culturing, sampling, testing, trial production and production formula adjustment; (2) providing production technology and procedures to turn the products into powder form while keeping live required bacteria in the products; (3) establishing quality standards and quality control systems; (4) providing testing and research support for us to obtain necessary sale permits from the Chinese government; and (5) cooperation in developing derivative products.\\nOn January 5, 2011, the State Intellectual Property Office of the PRC (“Intellectual Property Office”) granted Kiwa two Certificates of Patent of Invention for (1) “A cucumber dedicated composite anti-continuous cropping effect probiotics and their specific strains with related application” with patent number of “ZL 2008 1 0144492.6”; and (2) “Cotton dedicated composite anti-continuous cropping effect probiotics and their special strains with related application” with patent number of “ZL 2008 1 0144491.1” These two patents have been developed by Kiwa-CAU R&D Center. These two patents will expire on August 5, 2028. These two patents can be used to develop specific environment-friendly bio-fertilizer.\\nWe have obtained five fertilizer registration certificates from the Chinese government - four covering our bacillus bacteria fertilizer and one covering our photosynthetic bacteria fertilizer. The five registration certificates are: (1) Microorganism Microbial Inoculum Fertilizer Registration Certificate issued by the PRC Ministry of Agriculture; (2) Photosynthetic Bacteria Fertilizer Registration Certificate issued by the PRC Ministry of Agriculture; (3) Amino Acid Foliar Fomular Fertilizer Registration Certificate issued by the PRC Ministry of Agriculture; (4) Organic Fertilizer Registration Certificate issued by Agriculture Department of Shandong Province; and (5) Organic Matter-Decomposing Inoculants Registration Certificate issued by the PRC Ministry of Agriculture on February 16, 2008. Protected by these five fertilizer registration certificates and five trademarks under the names of “KANGTAN” (Chinese translation name for Kiwa), “ZHIGUANGYOU,” “PUGUANGFU,” “JINWA” and “KANGGUAN,” we have developed six series of bio-fertilizer products with bacillus spp and/or photosynthetic bacteria as core ingredients. Valid period of fertilizer registration certificates is five years and may be extended for another five years upon application from the owner of fertilizer registration certificates. The Company has determined to re-apply the Fertilizer Registration Certificate issued by the PRC Ministry of Agriculture.\\n\\n| 5 |\\n\\n\\nKiwa-CAU Research and Development Center\\nIn July 2006, we established a new research center with CAU which is known as Kiwa-CAU Bio-Tech Research & Development Center (the “Kiwa-CAU R&D Center”). Pursuant to an agreement between CAU and Kiwa Shandong dated November 14, 2006, Kiwa agreed to contribute RMB 1 million (approximately $160,000) each year to fund research at Kiwa-CAU R&D Center. Under the above agreement, the Kiwa-CAU R&D Center is responsible for fulfilling the overall research-and-development functions of Kiwa Shandong, including: (1) development of new technologies and new products (which will be shared by Kiwa and CAU); (2) subsequent perfection of existing product-related technologies; and (3) training quality-control personnel and technicians and technical support for marketing activities. The Company has spent $224,704 and $178,388 for its research and development activities during the years ended December 31, 2016 and 2015, respectively. The costs incurred by Company’s research and development activities are not borne directly by customers.\\nDuring fiscal 2014, Kiwa-CAU R&D Center had successfully isolated several strains of endophytic bacillus from plants. A number of strains had been observed to have the capability of boosting crop yield and dispelling chemical pesticide residual from soil. These strains could be used for developing not only new biological preparation but also environmental protection preparation.\\nPursuant to the agreement on joint incorporation of the research and development center between CAU and Kiwa dated November 14, 2006, Kiwa agreed to invest RMB 1 million (approximately $160,000) each year to fund research at the R&D Center. The term of this agreement was ten years starting from July 1, 2006. Prof. Qi Wang, who became one of our directors in July 2007, has acted as the Director of Kiwa-CAU R&D Center since July 2006. The Company has negotiated a follow-up Cooperation Agreement for the technologies with China Agricultural University.\\nOn November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). Pursuant to the Agreement, the Company will form a strategic partnership with the two institutes and establish an “International Cooperation Platform for Internet and Safe Agricultural Products”. To fund the cooperation platform’s R&D activities, the Company will provide RMB 1 million (approximately $160,000) per year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. The term of the Agreement is for three years beginning November 20, 2015. Prof. Yong Chang Wu, the authorized representative of IARRP, CAAS, is also one of the Company’s directors effective since November 20, 2015 until March 13, 2017.\\nOn February 23, 2017, the Company agreed to a strategic relationship with ETS (Tianjin) Biological Science and Technology Development Co., Ltd. (“ETS”). The partnership will include the deployment and strategic use of ETS biotechnology to produce of bio-fertilizers for use in both China and internationally. Kiwa and ETS, together with the certain Chinese government departments, will work together to enhance China’s microbial fertilizer industry standards and China’s food safety industry chain standards. The parties will work together on the development of microbial technology and products in agriculture, environmental protection, soil management and other fields. Relying on the Chinese Academy of Sciences, ETS Environmental and Agricultural Microbial Technology Research Center and biotechnology project research results, Kiwa has introduced the ETS core technology to complete bio-fertilizer upgrading, transformation and to develop new product lines. In order to meet the growing global consumer demand to increase food supply and develop sustainable farming we are applying sustainable use of biotechnology and the use of biotechnology products to replace chemical products, which will strengthen environmental protection and promote international cooperation. As a result of strict management of many agricultural chemicals, such chemicals will continue to be abandoned, resulting is a growing demand for bio-fertilizers. It has been widely accepted that the application of ETS biotechnology facilitates agricultural sustainability and helps to protect the soil and improve grain output. The technology focuses on keeping soil healthy by restoring healthy microbes that are naturally present in healthy soils. As the technology gains worldwide recognition, it is imperative to popularize bio-fertilizer in developing countries to fulfill the needs of growing populations and promote environmentally friendly agriculture. Through the cooperation of Kiwa and ETS, the parties aim to enhance the usage of the bio-fertilizers in China. The cooperation will bring technological transformation and support for Kiwa to improve its existing manufacturing techniques. Kiwa and ETS will also collaborate to establish a comprehensive platform for producing, supplying, and marketing in China. Ultimately, Kiwa would look to introduce these products to the international market, including the United States.\\n\\n| 6 |\\n\\n\\nOther\\nOn November 30, 2015, we entered into an acquisition agreement (the “Agreement”) with the shareholders of Caber Holdings LTD, whose Chinese name is Hong Kong Baina Group Co., Ltd, located in Hong Kong (“Baina Hong Kong”), and Oriental Baina Co. Ltd. (hereinafter referred to as “Baina Beijing”), Baina Hong Kong’s wholly-owned subsidiary in Beijing, China. As a result of this Agreement, Kiwa renamed Baina Beijing to Kiwa Baiao Bio-Tech (Beijing) Co., Ltd., which replaced Kiwa Bio-Tech (Shandong) Co., Ltd (“Kiwa Shandong”) to operate Kiwa’s bio-fertilizer market expansion and become Kiwa’s platform for future acquisitions of new agricultural-related projects in China. In accordance with the terms of the Agreement, Kiwa agreed to pay US$30,000 to the Baina Hong Kong Shareholders for the acquisition of 100% of the equity of Baina Hong Kong. The Company paid RMB 220,000 (approximately $34,000) for the acquisition. The acquisition was completed on January 7, 2016. Both Baina Hong Kong and Baina Beijing had no activities before the acquisition date and had no assets and liabilities.\\nThereafter, Baina Beijing formed two new subsidiaries—Kiwa Bio-Tech (Shenzhen) Co., Ltd (Registered in Shenzhen on November 2016); Kangdu Bio-Tech Hebei Co., Ltd. (Registered in Hebei on December 2106) to operate in specific markets in China.\\nOn December 17, 2015, we entered into a distribution agreement (the “Agreement”) with Kangtan Gerui (Beijing) Bio-Tech Co., Ltd. (“Gerui”) and formally awarded Gerui a right to sell and distribute the Company’s fertilizer products in 3 major agricultural regions of China— Hainan Province, Hunan Province and Xinjiang Autonomous Region. The Company’s Research and Development department has been conducting application experiments in Hainan and Hunan Provinces since August 2015, in accordance with the market requirements. The experiment data indicates that the Company’s fertilizer products have fulfilled the requirements of reduction of content of heavy metals in soil and improved crop yield. Gerui was founded in Beijing in April 2015 and relies on the sales network of China’s Supply and Marketing Cooperatives system. Currently, the Company and Gerui do not hold any interest in each other; however, a collaboration and integration may take place in the future. The term of the Agreement is for a period of three years commencing December 17, 2015. In September 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd obtained a fertilizer sales permit from the Chinese government and began to sale the products directly to customers in those 3 major agricultural regions. In September 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd obtained a fertilizer sales permit from the Chinese government and began to sale the products directly to customers in those 3 major agricultural regions.\\n\\n| 7 |\\n\\n\\nOn February 27, 2017, the Company signed a strategic cooperation agreement with the Beijing Zhongpin Agricultural Science and Technology Development Center (“Zhongpin Center”). Zhongpin Center is the Chinese Agricultural Science and Technology Innovation and Development Committee’s executive implementation agency (referred to as the Agricultural Science and Technology Commission). The Agricultural Science and Technology Commission is set up by the Chinese Central Government for the construction of the National Ecological Security Agriculture Industrial Chain standardization system. This includes the establishment of National Ecology Safe Agricultural Industrial Parks to build China’s Ecological Security and Agricultural Industrial in an orderly business environment, including completion of the National Soil Remediation Program and governance of the various government functions of the institutions. Through the guidance and support by the Zhongpin Center, Kiwa will participate and be involved in China’s National Soil Remediation Program and construction of the National Ecological Security Agriculture Industrial Chain Standardization System’s operation and process.\\n\\nITEM 1A. Risk Factors\\nSmaller reporting companies are not required to provide the information required by this item.\\n\\n| 8 |\\n\\n\\n\\nITEM 1B. Unresolved Staff Comments\\nNone.\\n\\nITEM 2. Properties\\nIn June 2002, Kiwa Shandong entered into an agreement with Zoucheng Municipal Government granting us the use of at least 15.7 acres in Shandong Province, China at no cost for 10 years to construct a manufacturing facility. Under the agreement, we have the option to pay a fee of approximately RMB 480,000 (approximately $78,155) per acre for the land use right at the expiration of the 10-year period. We may not transfer or pledge the temporary land use right. In the same agreement, we have also committed to invest approximately $18 million to $24 million for developing the manufacturing and research facilities in Zoucheng, Shandong Province. On February 11, 2017 Kiwa Bio-Tech Products (Shandong) entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\\n\\nITEM 3. Legal Proceedings\\nNone.\\n\\nITEM 4. Mine Safety Disclosures\\nNot applicable.\\nPart II\\n\\nITEM 5. Market for Registrants’ Common Equity, Related Stockholder Matters and Issuer Purchasers of Equity Securities\\nMarket Information\\nThe Company’s common stock has been quoted on the OTCQB under the symbol “KWBT” since March 30, 2004.\\nThe following table sets forth the high and low bid quotations per share of our common stock as reported on the OTCQB for the periods indicated. The high and low bid quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. All prices are adjusted to reflect the Company’s one for 200 reverse split which went effective January 28, 2016.\\n\\n| Fiscal Year 2016 | High | Low |\\n| First Quarter | $ | 2.24 | $ | 0.20 |\\n| Second Quarter | $ | 1.98 | $ | 1.30 |\\n| Third Quarter | $ | 1.65 | $ | 0.62 |\\n| Fourth Quarter | $ | 1.43 | $ | 0.80 |\\n\\n\\n| Fiscal Year 2015 | High | Low |\\n| First Quarter | $ | 1.47 | $ | 0.12 |\\n| Second Quarter | $ | 0.44 | $ | 0.02 |\\n| Third Quarter | $ | 0.32 | $ | 0.12 |\\n| Fourth Quarter | $ | 0.70 | $ | 0.12 |\\n\\nHolders\\nAs of December 31, 2016, there were approximately 461 shareholders of record of our common shares.\\nDividend Policy\\nWe have not paid any dividends on our common shares since our inception and do not anticipate that dividends will be paid at any time in the immediate future.\\nEquity Compensation Plan Information\\nThe information required by Item 5 regarding securities authorized for issuance under equity compensation plans is included in Item 12 of this report.\\n\\n| 9 |\\n\\n\\nRecent Sales of Unregistered Securities\\nThe following is a list of securities issued for cash or converted with debentures or as stock compensation to consultants during the period from January 1, 2016 through April 14, 2017, which were not registered under the Securities Act:\\n\\n| Name of Purchaser | Issue Date | Security | Shares | Consideration |\\n| YVONNE WANG | 3/24/16 | Common | 240,000 | Debenture Conversion |\\n| WEI LI | 3/24/16 | Common | 2,900,000 | Debenture Conversion |\\n| MARK E. CRONE | 3/25/16 | Common | 1,000 | Legal Fees |\\n| ZENG MIN QING | 5/24/16 | Common | 125,000 | Stock Purchase |\\n| CHENG TZU-YUN | 5/24/16 | Common | 50,000 | Stock Purchase |\\n| ZHIMING ZHU | 5/24/16 | Common | 45,000 | Stock Purchase |\\n| HANG ZHAO | 7/20/16 | Common | 20,000 | Stock Purchase |\\n| SHIWEI XIE | 7/20/16 | Common | 10,000 | Stock Purchase |\\n| XIAOQIANG YU | 7/20/16 | Common | 30,000 | Stock Purchase |\\n| HANG ZHAO | 8/10/16 | Common | 20,000 | Stock Purchase |\\n| XIAOQIANG YU | 8/10/16 | Common | 10,000 | Stock Purchase |\\n| XIANGRON CHEN | 8/10/16 | Common | 40,000 | Stock Purchase |\\n| JIMMY ZHOU | 8/24/16 | Common | 101,947 | Consultant Fees |\\n| WEIHONG SHAN | 10/6/16 | Common | 150,000 | Stock Purchase |\\n| LIFENG LIU | 10/6/16 | Common | 100,000 | Stock Purchase |\\n| ZHENPING LI | 10/6/16 | Common | 100,000 | Stock Purchase |\\n| QI JIANG | 10/6/16 | Common | 550,000 | Stock Purchase |\\n| LEI HOU | 10/6/16 | Common | 100,000 | Stock Purchase |\\n| BING ZHANG | 10/6/16 | Common | 150,000 | Stock Purchase |\\n| DEMEI YANG | 10/6/16 | Common | 150,000 | Stock Purchase |\\n| WSMG ADVISORS, INC. | 10/6/16 | Common | 100,000 | Consultant Fees |\\n| EQUITIES.COM, INC | 10/6/16 | Common | 30,808 | Consultant Fees |\\n| GENG LIU | 10/19/16 | Common | 500,000 | Consultant Fees |\\n| LIXIN TIAN | 10/19/16 | Common | 500,000 | Consultant Fees |\\n| XU LIU | 10/19/16 | Common | 500,000 | Consultant Fees |\\n| QINGKE XING | 10/19/16 | Common | 60,000 | Consultant Fees |\\n| GROWTH CIRCLE INC. | 10/19/16 | Common | 20,000 | Consultant Fees |\\n| WILLIAM FARRANCE | 11/29/16 | Common | 125,000 | Stock Purchase |\\n| JUNWEI ZHENG | 3/3/17 | Common | 920,000 | Stock Purchase |\\n| YUAN WANG | 3/3/17 | Common | 80,000 | Stock Purchase |\\n| YUAN WANG | 3/3/17 | Common | 70,000 | Consultant Fees |\\n\\n\\nITEM 6. Selected Financial Data\\nNot required.\\n\\nITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations\\nThis Annual Report on Form 10-K for the fiscal year ended December 31, 2016 contains “forward-looking” statements within the meaning of Section 21E of the Securities and Exchange Act of 1934, as amended, including statements that include the words “believes,” “expects,” “anticipates,” or similar expressions. These forward-looking statements include, among others, statements concerning our expectations regarding our working capital requirements, financing requirements, business, growth prospects, competition and results of operations, and other statements of expectations, beliefs, future plans and strategies, anticipated events or trends, and similar expressions concerning matters that are not historical facts. The forward-looking statements in this Annual Report on Form 10-K for the fiscal year ended December 31, 2016 involve known and unknown risks, uncertainties and other factors (described in “Business-Risk Factors” under Item 1) that could cause our actual results, performance or achievements to differ materially from those expressed in or implied by the forward-looking statements contained herein.\\nOverview\\nThe Company took its present corporate form in March 2004 when the shareholders of Tintic Gold Mining Company, a Utah public corporation (“Tintic”), entered into a share exchange transaction with the shareholders of Kiwa BVI, a privately-held British Virgin Islands corporation that left the shareholders of Kiwa BVI owning a majority of Tintic and Kiwa BVI a wholly-owned subsidiary of Tintic, see “Business - The Company” under Item 1. For accounting purposes this transaction was treated as an acquisition of Tintic Gold Mining Company by Kiwa BVI in the form of a reverse triangular merger and a recapitalization of Kiwa BVI and its wholly owned subsidiary, Kiwa Shandong. On July 21, 2004, we completed our reincorporation in the State of Delaware. On March 8, 2017, we completed our reincorporation in the State of Nevada.\\nThe Company operates through a series of subsidiaries in the Peoples Republic of China as detailed in the Organizational Chart on page 4, above. The Company had previously operated its business through its subsidiaries Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Kiwa Shandong”) and Tianjin Kiwa Feed Co., Ltd. (“Kiwa Tianjin”). Kiwa Tianjin has been dissolved since July 11, 2012. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\\n\\n| 10 |\\n\\n\\nWe generated revenue in fiscal year 2016. We incurred a net income of $963,296 and a net loss $677,358 during fiscal 2016 and 2015, respectively.\\nDue to our limited revenues, we have relied on the proceeds from loans from both unrelated and related parties to provide the resources necessary to fund the development of our business plan and operations. Our financing activities generated $1,053,358 and $148,009 during fiscal 2016 and 2015, respectively. These funds are insufficient to execute our business plan as currently contemplated, which may result in the risks described in “Risk Factors” under Item 1 - Business.\\nGoing Concern\\nThe consolidated financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.\\nAs of December 31, 2016, the Company’s current liabilities substantially exceeded its current assets by $5,729,622. Although the company’s operations for the year ended December 31, 2016 resulted net income of $963,296, it had an accumulated deficit of $19,489,400 and stockholders’ deficiency of $5,601,213 at December 31, 2016. These circumstances, among others, raise substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. The financial statements also do not include any adjustments relating to the recoverability and classification of recorded asset amounts, or amounts and classifications of liabilities that might be necessary should the Company be unable to continue as a going concern.\\nThe Company already raised additional fund through equity financing and plans to raise additional funds from domestic and foreign banks and/or financial institutions to increase working capital in order to meet capital demands. Please refer to Note 15 (Subsequent Evens) for additional information.\\nTrends and Uncertainties in Regulation and Government Policy in China\\nForeign Exchange Policy Changes\\nChina is considering allowing its currency to be freely exchangeable for other major currencies. This change will result in greater liquidity for revenues generated in Renminbi (“RMB”). We would benefit by having easier access to and greater flexibility with capital generated in and held in the form of RMB. The majority of our assets are located in China and most of our earnings are currently generated in China, and are therefore denominated in RMB. Changes in the RMB-U.S. Dollar exchange rate will impact our reported results of operations and financial condition. In the event that RMB appreciates over the next year as compared to the U.S. Dollar, our earnings will benefit from the appreciation of the RMB. However, if we have to use U.S. Dollars to invest in our Chinese operations, we will suffer from the depreciation of U.S. Dollars against the RMB. On the other hand, if the value of the RMB were to depreciate compared to the U.S. Dollar, then our reported earnings and financial condition would be adversely affected when converted to U.S. Dollars.\\nOn July 21, 2005, the People’s Bank of China announced it would appreciate the RMB, increasing the RMB-U.S. Dollar exchange rate from approximately US$1.00 = RMB 8.28 to approximately US$1.00 = RMB 8.11. So far the trend of such appreciation continues. The exchange rate of U.S. Dollar against RMB on December 31, 2016 was US$1.00 = RMB 6.945.\\nCritical Accounting Policies and Estimates\\nWe prepared our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Management periodically evaluates the estimates and judgments made. Management bases its estimates and judgments on historical experience and on various factors that are believed to be reasonable under current circumstances. Actual results may differ from these estimates as a result of different assumptions or conditions.\\nThe following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements. In addition, you should refer to our accompanying audited balance sheets as of December 31, 2016 and 2015, and the audited statements of comprehensive loss, equity movement and cash flows for the fiscal years ended December 31, 2016 and 2015, and the related notes thereto, for further discussion of our accounting policies.\\nFair value of warrants and options\\nWe have adopted ASC Topic 815, “Accounting for Derivative Instruments and Hedging Activities” to recognize warrants relating to loans and warrants issued to consultants as compensation as derivative instruments in our consolidated financial statements.\\n\\n| 11 |\\n\\n\\nWe also adopted ASC Topic 718, “Share Based Payment” to recognize options granted to employees as derivative instruments in our consolidated financial statements.\\nWe calculate the fair value of the warrants and options using the Black-Scholes Model.\\nIncome Taxes\\nThe Company accounts for income taxes under the provisions of FASB ASC Topic 740, “Income Tax,” which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Deferred tax assets and liabilities are recognized for the future tax consequence attributable to the difference between the tax bases of assets and liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are measured using the enacted tax rate expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company establishes a valuation when it is more likely than not that the assets will not be recovered.\\nASC Topic 740.10.30 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC Topic 740.10.40 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. We have no material uncertain tax positions for any of the reporting periods presented.\\nMajor Customers and Suppliers.\\nBio-fertilizer products\\nDuring 2016, the following were Kiwa’s major customers:\\n1. Qingzhou City Agricultural Production Materials Co., Ltd. second wholesale department (11.3% of sales)\\n2. Huarong County Yinfeng fertilizer industry LTD. (81% of sales)\\nDuring 2016, the following were Kiwa’s major suppliers:\\n1. Weifang Druek Fertilizer Co., Ltd (92% of Subcontractor Production)\\n2 Lianyungang Chuangyi Logistics Co., Ltd (Logistics provider)\\n3. Linshu Shangrun Color Printing Co., Ltd (Packing provider)\\nResults of Operations\\nNet Sales\\nNet sales were $9,617,845 and $0 for the years ended December 31, 2016 and 2015, respectively.\\nCost of Sales\\nCost of sales was $7,672,451 and $0 for the years ended December 31, 2016 and 2015, respectively.\\nGross Profit/Loss\\nGross profit for fiscal 2016 was $1,945,394 compared to $0 for fiscal 2015.\\nLicensing Revenue\\nLicensing revenue totaled $786,329 for the year ended December 31, 2016.\\nGeneral and Administrative\\nGeneral and administrative expenses were $874,097 and $313,589 for the years ended December 31, 2016 and 2015, respectively, an increase of $560,508 or 178%. General and administrative expenses include professional fees, officers’ compensation, depreciation and amortization, salaries, travel and entertainment, rent, office expense and telephone expense etc.\\n\\n| 12 |\\n\\n\\nResearch and Development\\nResearch and development expenses increased significantly by $45,445 or 25% to $224,433 for the year ended December 31, 2016, compared to $178,988 for the prior comparable period. Research and development expense mainly consists of the expenses of maintaining Kiwa-CAU R&D Center, which began operation in July 2006 (see “Business-Intellectual Property and Product Lines- Kiwa-CAU R&D Center” under Item 1 in Part I). On November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). Pursuant to the Agreement, the Company will form a strategic partnership with the two institutes and establish an “International Cooperation Platform for Internet and Safe Agricultural Products”. To fund the cooperation platform’s R&D activities, the Company will provide RMB 1 million (approximately $160,000) per year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. During the years ended December 31, 2016 and 2015, the Company accrued $224,433 and $178,988 for research and development respectively.\\nPenalty Expense\\nWe charged $77,575 and $72,512 of liquidated damages in connection with the 6% Notes to penalty expenses during the years ended December 31, 2016 and 2015, respectively. The increase of penalty expense was mainly due to accrued and unpaid interest on the 6% Notes.\\nInterest Expenses\\nNet interest expense was $112,977 and $112,629 in the fiscal years of 2016 and 2015, respectively, representing a increase of $348 or 0.3%.\\nNet Income & (Loss)\\nDuring the fiscal year 2016, net income was $963,296, comparing with net loss $677,358 for the same period of 2015, representing an increase of $1,640,654.\\nComprehensive Gain & (Loss)\\nComprehensive income increased by $1,446,652 from $(253,293) for fiscal 2015, as compared to $1,193,359 for the comparable year of 2016.\\nLiquidity and Capital Resources\\nSince inception of our ag-biotech business in 2002, we have relied on the proceeds from the sale of our equity securities and loans from both unrelated and related parties to provide the resources necessary to fund our operations and the execution of our business plan. During fiscal 2016 and 2015, we raised $1,053,358 and $148,009 in total from stock purchase agreements and related party loans. To some extent, these advances improved our short-term liquidity. However, as of December 31, 2016, our current liabilities substantially exceeded current assets by $5,729,622, reflecting a current ratio of 0.4451, whereas current liabilities exceeded current assets by $11,103.261, reflecting a current ratio of 0.0043 as of December 31, 2015. During the years ended December 31, 2016 and 2015, we did not issue any shares resulting from the conversion of principal of the 6% Notes into our common stock.\\n\\n| 13 |\\n\\n\\nAs of December 31, 2016 and 2015, we had cash of $13,469 and $721, respectively. The change is outlined as follows:\\nDuring the fiscal year of 2016, net cash used in our operating activities was $1,142,9741, compared to $150,208 for the comparable period of 2015. Such cash was mainly used for maintaining operations of a public company and working capital for our bio-fertilizer business.\\nDuring the fiscal year of 2016, we incurred approximately $79,083 in investment activity, including $34,112 in acquiring a subsidiary.\\nDuring the year ended December 31, 2016, we generated cash inflow for $1,053,358 from financing activities, compared to $148,009 of cash inflow during the year ended December 31, 2015, from financing activities.\\nAs of December 31, 2016, we had an accumulated deficit of $19,489,400, down from $20,324,812 deficit at December 31, 2015, as a result of a net income of $967,296 including $127,884 for statutory reserve for the year ended December 31, 2016 and compared to a net loss of $677,358 for 2015.\\nWe still require additional working capital to accomplish our business objectives and to sustain our operations. Continuously, we intend to raise additional capital through the issuance of debt or equity securities to fund the development of our planned business operations, although there can be no assurance that we will be successful in obtaining this financing. The following factors, among others, may significantly harm our ability to obtain required additional financing.\\nGiven the facts that:\\n\\n| (1) | Outstanding 6% Notes. As of December 31, 2016, the amount of outstanding 6% Notes was $150,250. The 6% Notes have been in default since June 2009. |\\n| (2) | Outstanding note payable of $360,000 as of December 31, 2016. This note has been in default since July 2007. |\\n\\nContractual Obligations\\n(1) Operation of Kiwa-CAU R&D Center\\nPursuant to the agreement on joint incorporation of the research and development center between CAU and Kiwa Shandong dated November 14, 2006, Kiwa Shandong agrees to invest RMB 1 million (approximately $160,000) each year to fund research at the R&D Center. The term of this agreement is ten years starting from July 1, 2006. Prof. Qi Wang, who became one of our directors in July 2007, has acted as the Director of Kiwa-CAU R&D Center since July 2006.\\n(2) Investment in manufacturing and research facilities in Zoucheng, Shandong Province in China\\nAccording to the Project Agreement with Zoucheng Municipal Government in 2002, we have committed to investing approximately $18 million to $24 million for developing the manufacturing and research facilities in Zoucheng, Shandong Province. As of December 31, 2016, we had invested approximately $1.91 million for the project. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\\n\\n| 14 |\\n\\n\\n(3) Strategic cooperation with two institutes in China\\nOn November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). Pursuant to the Agreement, the Company will form a strategic partnership with the two institutes and establish an “International Cooperation Platform for Internet and Safe Agricultural Products”. To fund the cooperation platform’s R&D activities, the Company will provide RMB 1 million (approximately $160,000) per year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. The term of the Agreement is for three years beginning November 20, 2015.\\n(4) Acquisition of Caber Holdings LTD (Hong Kong Baina Group Co. LTD) in China\\nOn November 30, 2015, we entered into an acquisition agreement (the “Agreement”) with the shareholders of Caber Holdings LTD, whose Chinese name is Hong Kong Baina Group Co., Ltd, located in Hong Kong (“Baina Hong Kong”), and Oriental Baina Co. Ltd. (hereinafter referred to as “Baina Beijing”), Baina Hong Kong’s wholly-owned subsidiary in Beijing, China. When this acquisition is completed, Kiwa will rename Baina Beijing to Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. Kiwa Baiao Co. Ltd will replace Kiwa’s current subsidiary in China - Kiwa Bio-Tech (Shandong) Co., Ltd (“Kiwa Shandong”) - to operate Kiwa’s bio-fertilizer market expansion and become Kiwa’s platform for future acquisitions of new agricultural-related projects in China. In accordance with the terms of the Agreement, Kiwa agreed to pay US$30,000 to the Baina Hong Kong Shareholders for the acquisition of 100% of the equity of Baina Hong Kong. As of December 31, 2015, the Company has paid RMB 220,000 (approximately $34,000) for the acquisition. The acquisition was completed on January 7, 2016. Both Baina Hong Kong and Baina Beijing had no activities before the acquisition date and had no assets and liabilities. Thereafter, Baina Beijing formed two new subsidiaries—Kiwa Bio-Tech (Shenzhen) Co., Ltd (Registered in Shenzhen on November 2016); Kangdu Bio-Tech Hebei Co., Ltd. (Registered in Hebei on December 2106) to operate in specific markets in China.\\n(5) Distribution agreement with Kangtan Gerui Bio-Tech in China\\nOn December 17, 2015, Kiwa Bio-Tech Products Group Corporation (the “Company”) entered into a distribution agreement (the “Agreement”) with Kangtan Gerui (Beijing) Bio-Tech Co., Ltd. (“Gerui”) and formally awarded Gerui a right to sell and distribute the Company’s fertilizer products in 3 major agricultural regions of China— Hainan Province, Hunan Province and Xinjiang Autonomous Region. The Company’s Research and Development department has been conducting application experiments in Hainan and Hunan Provinces since August 2015, in accordance with the market requirements. The experiment data indicates that the Company’s fertilizer products have fulfill the requirements of reduction of content of heavy metals in soil and improve crop yield. Gerui was founded in Beijing in April 2015 and relies on the sales network of China’s Supply and Marketing Cooperatives system. Currently, the Company and Gerui do not hold any interest in each other; however, a collaboration and integration may take place in the future. The term of the Agreement is for a period of three years commencing December 17, 2015. In September 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd obtained a fertilizer sales permit from the Chinese government and began to sale the products directly to customers in those 3 major agricultural regions.\\n(6) Lease payments\\n(1) On April 29, 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. entered an office lease agreement with two-year team. Monthly lease payment and building management fee totaled RMB 77,867 or approximately USD $11,622.\\n(2) On November 11, 2017, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. entered an apartment lease agreement for its employees. The lease term is one year with monthly lease payment of RMB 6,000 or approximately USD $896.\\n(3) In March 1, 2017, Kiwa Bio-Tech (Shenzhen) Co., Ltd, a newly established subsidiary entered an office lease agreement with one-year term. Monthly lease payment is RMB 29,000 or approximately of USD $4,320.\\nOff-Balance Sheet Arrangements\\nAt December 31, 2016, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise had we engaged in such relationships.\\nRecent Accounting Pronouncements\\nSee Note 2 to the Consolidated Financial Statements under Item 8, Part II.\\n\\n| 15 |\\n\\n\\n\\nITEM 7A. Quantitative and Qualitative Disclosures about Market Risk\\nNot required.\\n\\nITEM 8. Financial Statements and Supplementary Data\\nThe full text of our audited consolidated financial statements as of December 31, 2016 and 2015 begins on page F-1 of this annual report.\\n\\nITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure\\nOn February 15, 2017, the Board of Directors of Kiwa Bio-Tech Products Group Corporation (“Kiwa” or “Company”) decided to engage DYH & Co. as independent principal accountant and auditor to report on the Company’s financial statements for the fiscal year ended December 31, 2016, including performing the required quarterly reviews.\\nIn conjunction with the new engagement, the Company has dismissed its former accountant, Paritz & Co., P.A., Hackensack, NJ (“Paritz”), as the Company’s principal accountant effective February 22, 2016. Paritz has served the Company well since 2013. Under Item 304 of Regulation S-K, the reason for the auditor change is dismissal, not resignation nor declining to stand for re-election.\\nDuring the two most recent fiscal years and the interim period through the date of the dismissal, there were no disagreements with Paritz on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which disagreements, if not resolved to Paritz’s satisfaction, would have caused Paritz to make reference to the subject matter of the disagreements in connection with its reports.\\n\\nITEM 9A. Controls and Procedures\\nDisclosure Controls and Procedures\\nOur management, under the supervision and with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), has evaluated the effectiveness of our disclosure controls and procedures as defined in SEC Rules 13a-15(e) and 15d-15(e) as of the end of the period covered by this Annual Report. Our disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports we file or submit under the Securities Exchange Act of 1934 (“Exchange Act”) is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management including our CEO and CFO, to allow timely decisions regarding required disclosures. Based on their evaluation, our CEO and CFO have concluded that, as of December 31, 2016, our disclosure controls and procedures were ineffective.\\nManagement Report on Internal Control over Financial Reporting\\nOur management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Our internal control over financial reporting was designed to provide reasonable assurance to the Company’s management and board of directors regarding the preparation and fair presentation of published consolidated financial statements. Internal control over financial reporting is promulgated under the Exchange Act as a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and effected by the Company’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting, no matter how well designed, has inherent limitations and may not prevent or detect misstatements. Therefore, even effective internal control over financial reporting can only provide reasonable assurance with respect to the financial statement preparation and presentation.\\nOur management has conducted, with the participation of our CEO and CFO, an assessment, including testing of the effectiveness, of our internal control over financial reporting as of December 31, 2016. Management’s assessment of internal control over financial reporting was conducted using the criteria in Internal Control over Financial Reporting - Guidance for Smaller Public Companies issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on such evaluation, management identified deficiencies that were determined to be a material weakness.\\nA material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. Because of the material weakness described below, management concluded that our internal control over financial reporting was ineffective as of December 31, 2016.\\n\\n| 16 |\\n\\n\\nThe specific material weakness identified by the Company’s management as of December 31, 2016 is described as follows:\\n\\n| ● | The Company did not have sufficient and skilled accounting personnel with an appropriate level of technical accounting knowledge and experience in the application of accounting principles generally accepted in the United States of America commensurate with the Company’s financial reporting requirements, which resulted in a number of internal control deficiencies that were identified as being significant. The Company’s management determined that the number and nature of these significant deficiencies, when aggregated, constituted a material weakness. |\\n| ● | The Company lacks qualified resources to perform the internal audit functions properly. In addition, the scope and effectiveness of the Company’s internal audit function are yet to be developed. |\\n| ● | We currently do not have an audit committee. |\\n\\nRemediation Initiative\\n\\n| ● | We are committed to establishing the internal audit functions but due to limited qualified resources in the region, we were not able to hire sufficient internal audit resources before the end of 2016. However, internally we established a central management center to recruit more senior qualified people in order to improve our internal control procedures. Externally, we are looking forward to engaging an accounting firm to assist the Company in improving the Company’s internal control system based on COSO Framework. |\\n| ● | We intend to establish an audit committee of the board of directors as soon as practicable. We envision that the audit committee will be primarily responsible for reviewing the services performed by our independent auditors, evaluating our accounting policies and our system of internal controls. |\\n\\nConclusion\\nDespite the material weakness and deficiencies reported above, the Company’s management believes that its consolidated financial statements included in this report fairly present in all material respects the Company’s financial condition, results of operations and cash flows for the periods presented and that this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report.\\nThis Annual Report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the SEC that permit the Company to provide only management’s report in this Annual Report.\\nChanges in Internal Control over Financial Reporting\\nThere were no changes in our internal control over financial reporting during the fiscal year ended December 31, 2016 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\n\\nITEM 9B. Other Information\\nNone.\\n\\n| 17 |\\n\\n\\nPart III\\n\\nITEM 10. Directors, Executive Officers and Corporate Governance\\nDirectors and Executive Officers\\nSet forth below are the names of our directors and executive officers, their ages, their offices with us, if any, their principal occupations or employment for the past five years. The directors listed below will serve until the Company’s next annual meeting of the stockholders:\\n\\n| Name | Age | Position | Director Since |\\n| Yvonne Wang | 39 | Acting President, CEO and CFO and Director | 2015 |\\n| Feng Li | 28 | Secretary and Director | 2015 |\\n| Qi Wang | 49 | Vice President of Technology, Director | 2007 |\\n| Yong Lin Song Xiao Qiang Yu | 50 39 | CTO, Director of Technology and Director Sales and Marketing Director | 2017 2016 |\\n\\nYvonne Wang Ms. Wang became our Chairman in November 2015. She served as corporate Secretary from 2005 to 2015. Prior to 2005, she served as an executive assistant and a manager of the Company’s U.S. office between April 2003 and September 2005. She obtained her B.S. degree of Business Administration from University of Phoenix.\\nOn August 11, 2106 became Company’s acting president, CEO and CFO.\\nFeng Li became our Secretary and a Director in 2015. From 2011- 2012, Ms. Li has served as an assistant project manager for SCHSAsia, a boutique business consulting firm specializing in events and project management for overseas company wishing to expand into the Asia Pacific arena. From 2012 until 2014, Ms. Li served as a campaigner for WildAid China Office, a non-profit organization with focus on raising public awareness on wildlife and climate change related issues.\\nQi Wang became our Vice President - Technical on July 19, 2005 and was elected as one of our directors of the Company on July 18, 2007. Prof. Wang has also acted as Director of Kiwa-CAU R&D Center since July 2006. Prof. Wang served as a Professor and Advisor for Ph.D. students in the Department of Plant Pathology, China Agricultural University (“CAU”) since January 2005. Prior to that, he served as an assistant professor and lecturer of CAU since June 1997. He obtained his master degree and Ph.D. in agricultural science from CAU in July 1994 and July 1997, respectively. Prof. Wang received his bachelor’s degree of science from Inner Mongolia Agricultural University in July 1989. He is a committee member of various scientific institutes in China, including the National Research and Application Center for Increasing-Yield Bacteria, Chinese Society of Plant Pathology, Chinese Association of Animal Science and Veterinary Medicine. Prof. Wang’s unique expertise in the field of agriculture offers significant knowledge and experience to the Board of Directors when making critical operational decisions.\\nYong Lin Song became our CTO and Director of Technology responsible for the Company’s R&D operations on March 2016 and as one of our directors of the Company on March 2017. Mr. Song is a senior agronomist at the Institute of Agricultural Resources and Regional Planning, Chinese Academy of Agricultural Sciences. He has 29 years of experience in microbial R&D and technology promotion and has led many national agricultural projects. In 2001, he was responsible for technological achievement transformation and technology promotion of Agricultural Resources and Regional Planning, Chinese Academy of Agricultural Sciences. In 2009, he served as deputy secretary general of the Chinese Society of Plant Nutrition and Fertilizer Science.\\nXiao Qiang Yu became our Sales and Marketing Director on June 2016 and is responsible for managing the overall marketing strategy of Kiwa, which includes brand expansion, sale targets, strategic planning and corporate communications. Mr. Yu participated in Chinese fertilizer market since 1999. Mr. Yu has over 15 years of marketing, management and strategy experience from two major fertilizer companies in China.\\n\\n| 18 |\\n\\n\\nFamily Relationships\\nThere are no family relationships among our directors or executive officers.\\nInvolvement in Certain Legal Proceedings\\nNone of our directors or executive officers has, during the past ten years:\\n\\n| (a) | Had any bankruptcy petition filed by or against any business of which such person was a general partner or executive officer either at the time of the bankruptcy or within two years prior to that time; |\\n| (b) | Been convicted in a criminal proceeding or subject to a pending criminal proceeding; |\\n| (c) | Been subject to any order, judgment, or decree, not subsequently reversed, suspended or vacated, of any court of competent jurisdiction or any federal or state authority, permanently or temporarily enjoining, barring, suspending or otherwise limiting his involvement in any type of business, securities, futures, commodities or banking activities; and |\\n| (d) | Been found by a court of competent jurisdiction (in a civil action), the Securities and Exchange Commission or the Commodity Futures Trading Commission to have violated a federal or state securities or commodities law, and the judgment has not been reversed, suspended, or vacated. |\\n\\nSection 16(a) Beneficial Ownership Compliance\\nSection 16(a) of the Securities Exchange Act of 1934 requires our officers, directors and certain persons holding more than 10 percent of a registered class of our common stock to file with the SEC initial reports of ownership and reports of changes in ownership of our common stock. Officers, directors and certain other shareholders are required by the SEC to furnish the Company with copies of all Section 16(a) forms they file. To the best of the Company’s knowledge, based solely upon a review of the copies of such reports, the Company believes that all Section 16(a) filing requirements applicable to its officers, directors and certain other shareholders were complied with during the fiscal year ended December 31, 2016.\\nCode of Ethics\\nWe have adopted a Code of Business Conduct and Ethics (the “Code”) that is applicable to all employees, consultants and members of the Board of Directors, including the Chief Executive Officer, Chief Financial Officer and Secretary. This Code embodies our commitment to conduct business in accordance with the highest ethical standards and applicable laws, rules and regulations. We will provide any person a copy of the Code, without charge, upon written request to the Company’s Secretary. Requests should be addressed in writing to Ms. Yvonne Wang; 310 N. Indian Hill Blvd., #702 Claremont, California 91711.\\nBoard Composition; Audit Committee and Financial Expert\\nOur Board of Directors is currently composed of four members: Yvonne Wang, Feng Li, Qi Wang and Yong Lin Song. All board actions require the approval of a majority of the directors in attendance at a meeting at which a quorum is present.\\n\\n| 19 |\\n\\n\\nWe currently do not have an audit committee. We intend, however, to establish an audit committee of the board of directors as soon as practicable. We envision that the audit committee will be primarily responsible for reviewing the services performed by our independent auditors, evaluating our accounting policies and our system of internal controls. Currently such functions are performed by our Board of Directors.\\nThe Board does not have a “financial expert” as defined by SEC rules implementing Section 407 of the Sarbanes-Oxley Act.\\nBoard meetings and committees; annual meeting attendance.\\nDuring fiscal year 2016, the Board of Directors did not have any meetings.\\n\\nITEM 11. Executive Compensation\\nWe currently have no Compensation Committee. The Board of Directors is currently performing the duties and responsibilities of Compensation Committee. In addition, we have no formal compensation policy. We decide on our executives’ compensation based on average compensation levels of similar companies in the U.S. or China, depending on consideration of many factors such as where the executive works. Our Chief Executive Officer’s compensation is approved by the Board of Directors. Other named executive officers’ compensation are proposed by our Chief Executive Officer and approved by the Board of Directors.\\nOur Stock Incentive Plan is administered by the Board of Directors. Any amendment to our Stock Incentive Plan requires majority approval of the stockholders of the Company.\\nThe Company had no officers or directors whose total compensation during either 2016 or 2015 exceeded $100,000.\\nCurrently, the main forms of compensation provided to each of our executive officers are: (1) annual salary; (2) non-equity Incentive Plan; and (3) the granting of incentive stock options subject to approval by our Board of Directors.\\nSummary Compensation Table\\nSummary Compensation Table\\n\\n| Name and principal position | Year | Salary ($) | Bonus ($) | Stock Awards ($) | Option Awards ($) | Non-Equity Incentive Plan Compensation ($) | Nonqualified Deferred Compensation Earnings ($) | All Other Compensation ($) | Total ($) |\\n| (a) | (b) | (c) | (d) | (e) | (f) | (g) | (h) | (i) | (j) |\\n| Yvonne Wang, | 2016 | 84,000 | Nil | Nil | Nil | Nil | Nil | Nil | 84,000 |\\n| Acting President, CEO and CFO | 2015 | 51,000 | Nil | Nil | Nil | Nil | Nil | Nil | 51,000 |\\n| Yong Lin Song, | 2016 | 29,828 | Nil | Nil | Nil | Nil | Nil | Nil | 29,828 |\\n| CTO, Director of Technology | 2015 | Nil | Nil | Nil | Nil | Nil | Nil | Nil | Nil |\\n| Xiao Qiang Yu, | 2016 | 30,259 | Nil | Nil | Nil | Nil | Nil | Nil | 30,259 |\\n| Sales and Marketing Director | 2015 | Nil | Nil | Nil | Nil | Nil | Nil | Nil | Nil |\\n\\nEmployment Contracts and Termination of Employment and Change of Control Arrangements\\nThere are no compensatory plans or arrangements with respect to a named executive officer that would result in payments or installments in excess of $100,000 upon the resignation, retirement or other termination of such executive officer’s employment with us or from a change-in-control.\\n\\n| 20 |\\n\\n\\nStock Incentive Plan and Option Grants\\n2016 Stock Incentive Plan\\nOn March 8, 2017, pursuant to the consent of the holders of a majority of the votes entitled to be cast on the matter, were approved of the Kiwa Bio-Tech Products Group Corporation 2016 Employee, Director and Consultant Stock Plan. The Plan is a key aspect of our compensation program, designed to attract, retain, and motivate the highly qualified individuals required for our long-term success.\\nNo options were granted under the Plan during 2016.\\nOption Exercises and Stock Vested\\nNo stock options were exercised by any officers or directors during 2016 and 2015. We did not adjust or amend the exercise price of any stock options previously awarded to any named executive officers during 2016 and 2015.\\n\\n| 21 |\\n\\n\\nDirector Compensation for 2016\\nWe currently have no policy in effect for providing compensation to our directors for their services on our Board of Directors, and did not compensate our directors in 2016 for services performed as directors.\\n\\nITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters\\nThe following table sets forth as of April 7, 2017 certain information with respect to the beneficial ownership of our common stock by (i) each of our executive officers, (ii) each person who is known by us to beneficially own more than 5% of our outstanding common stock, and (iii) all of our directors and executive officers as a group. Percentage ownership is calculated based on 9,798,981 shares of our common stock and 500,000 shares of our Series A Preferred Stock outstanding as of April 7, 2017. None of the shares listed below are issuable pursuant to stock options or warrants of the Company.\\n\\n| Title of class | Name and Address of Beneficial Ownership(1) | Amount and Nature of Beneficial Owner (2) | Percentage of class |\\n| Common Stock | Yvonne Wang | 240,000 | 2.45 | % |\\n| Common Stock | Feng Li (3) | 1,965,326 | 20.06 | % |\\n| Common Stock | Qi Wang | - | - |\\n| Common Stock | Yong Lin Song | - | - |\\n| Common Stock | All officers and directors as a group | 2,205,326 | 22.51 | % |\\n| Ser. A Pref. Stock | Yvonne Wang | 250,000 | 50.00 | % |\\n| Ser. A Pref. Stock | Feng Li | 250,000 | 50.00 | % |\\n| Ser. A Pref. Stock | All officers and directors as a group | 500,000 | 100.00 | % |\\n| 5% Holders: |\\n| Common Stock | Troniya Industrial Incubator, Inc. | 1,000,000 | 10.21 | % |\\n| Common Stock | Liu Geng | 500,000 | 5.10 | % |\\n| Common Stock | Liu Xu | 500,000 | 5.10 | % |\\n| Common Stock | Tian Lixin | 500,000 | 5.10 | % |\\n| Common Stock | Zheng JunWei | 920,000 | 9.39 | % |\\n| Common Stock | Wei Li (3) | 1,965,326 | 20.06 | % |\\n\\n\\n| (1) | The address for all holders is 310 N. Indian Hill Blvd, #702, Claremont, CA 91711. |\\n| (2) | In determining beneficial ownership of our Common Stock and Series A Preferred Stock, the number of shares shown includes shares which the beneficial owner may acquire upon exercise of debentures, warrants and options which may be acquired within 60 days. Unless otherwise stated, each beneficial owner has sole power to vote and dispose of its shares. |\\n| (3) | Includes 61,784 shares of common stock held by All Star Technology, Inc., a British Virgin Islands international business company. Feng Li’s father, Wei Li, exercises voting and investment control over the shares held by All Star Technology, Inc. Wei Li is a principal stockholder of All Star Technology, Inc. and may be deemed to beneficially own such shares, but disclaims beneficial ownership in such shares held by All Star Technology, Inc. except to the extent of his pecuniary interest therein. Mr. Li has pledged all of his common stock of the Company as collateral security for the Company’s obligations under certain 6% Convertible Notes owed by the Company. |\\n\\n\\n| 22 |\\n\\n\\nChange in Control\\nNone.\\n\\nITEM 13. Certain Relationships and Related Transactions, and Director Independence\\nFor description of transactions with related parties, see Note 6 to Consolidated Financial Statements under Item 8 in Part II.\\nUnder the independence standard set forth in Rule 4200(a) (15) of the Market Place Rules of the Nasdaq Stock Market, which is the independence standard that we have chosen to report under.\\n\\nITEM 14. Principal Accountant Fees and Services\\nFees Paid to Independent Public Accountants for 2016 and 2015.\\nAudit Fees\\nAll of the services described below were approved by our board of directors prior to performance of such services. The board of directors has determined that the payments made to its independent accountants for these services are compatible with maintaining such auditor’s independence.\\nThe aggregate audit fees for 2016 and 2015 paid and payable to DYH & Company and Paritz & Company, P.A. were approximately $38,000 and $30,500, respectively. The amounts include: (1) fees for professional services rendered by DYH & Company and Paritz & Company, P.A. in connection with the audit of our consolidated financial statements; (2) reviews of our quarterly reports on the Form 10-Q.\\n\\n| 23 |\\n\\n\\nAudit-Related Fees\\nAudit-related fees for 2016 and 2015 were $nil.\\nTax Fees\\nTax service fees billed by Paritz & Co., P.A. as tax consultant for 2016 and 2015 were $3,400 and $2,750, respectively.\\nAll Other Fees\\nNone.\\nPolicy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditors\\nSince we did not have a formal audit committee, our board of directors served as our audit committee. We have not adopted pre-approval policies and procedures with respect to our accountants in 2016. All of the services provided and fees charged by our independent registered accounting firms in 2016 were approved by the board of directors.\\n\\n| 24 |\\n\\n\\nPart IV\\n\\nITEM 15. Exhibits and Financial Statement Schedules\\n\\n| Exhibit No. | Description |\\n| 31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934 |\\n| 31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934 |\\n| 32.1 | Certification of Chief Executive Officer, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 32.2 | Certification of Chief Financial Officer, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 101.INS | XBRL Instance Document |\\n| 101.SCH | XBRL Taxonomy Extension Schema Document |\\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document |\\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document |\\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document |\\n\\n\\n| 25 |\\n\\n\\nKiwa Bio-Tech Products Group Corporation\\nSignatures\\nPursuant to the requirements of Section 13 or 15(d) of the Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\nDate: April 17, 2017\\n\\n| KIWA BIO-TECH PRODUCTS GROUP CORPORATION. |\\n| By: | /s/ Yvonne Wang |\\n| Yvonne Wang Chief Executive Officer (Principal Executive Officer) |\\n| By: | /s/ Yvonne Wang |\\n| Yvonne Wang Chief Financial Officer (Principal Financial and Accounting Officer) |\\n\\nPursuant to the requirements of Section 13 or 15(d) of the Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf of the registrant and in the capacities and on the dates indicated.\\n\\n| /s/ Yvonne Wang | Chief Executive Officer and Director | April 17, 2017 |\\n| Yvonne Wang | (Principal Executive Officer) |\\n| /s/ Yvonne Wang | Chief Financial Officer | April 17, 2017 |\\n| Yvonne Wang | (Principal Financial and Accounting Officer) |\\n| /s/ Feng Li | Secretary and Director | April 17, 2017 |\\n| Feng Li |\\n| /s/ Qi Wang | Vice President of Technology and Director | April 17, 2017 |\\n| Qi Wang |\\n| /s/ Yong Lin Song | CTO, Director of Technology and Director | April 17, 2017 |\\n| Yong Lin Song |\\n\\n\\n| 26 |\\n\\n\\nKiwa Bio-Tech Products Group Corporation\\nIndex to Consolidated Financial Statements\\n\\n| Page |\\n| Reports of Independent Registered Public Accounting Firms | F-1 |\\n| Consolidated Balance Sheets | F-3 |\\n| Consolidated Statements of Comprehensive Income (Loss) | F-4 |\\n| Consolidated Statements of Stockholders’ Deficiency | F-5 |\\n| Consolidated Statements of Cash Flows | F-6 |\\n| Notes to Consolidated Financial Statements | F-7 |\\n\\n\\n| 27 |\\n\\n\\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\\nTo Board of Directors and the Stockholders of\\nKiwa Bio-Tech Products Group Corporation\\nWe have audited the accompanying consolidated balance sheet of Kiwa Bio-Tech Products Group Corporations as of December 31, 2015 and the related consolidated statement of comprehensive loss, changes in stockholders’ deficiency and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.\\nWe conducted our audit in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.\\nIn our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kiwa Bio-Tech Products Group Corporation as of December 31, 2015, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.\\n/s/ Paritz & Company, P.A.\\nHackensack, New Jersey\\nApril 14, 2016\\n\\n| F-1 |\\n\\n\\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\\nTo the Board of Directors and Stockholders of Kiwa Bio-Tech Products Group Corporation\\nWe have audited the accompanying consolidated balance sheet of Kiwa Bio-Tech Products Group Corporation as of December 31, 2016, and the related statements of income, comprehensive income, stockholders’ equity, and cash flows for the year ended December 31, 2016. Kiwa Bio-Tech Products Group Corporation’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits.\\nWe conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.\\nIn our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Kiwa Bio-Tech Products Group Corporation as of December 31, 2016, and the results of its operations and its cash flows for the year ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America.\\nThe accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 3 to the consolidated financial statements, the Company’s current liabilities substantially exceeded its current assets by $5,729,622 at December 31, 2016. Although the Company reported net income approximately $963,296 for its fiscal year ended December 31, 2016, it had an accumulated deficit of $19,489,400 as of December 31, 2016. These circumstances, among others, raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regarding to these matters are described in Note 3, which include raising additional equity financing. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.\\n/s/ DYH & Company\\nIrvine, California\\nApril 17, 2017\\n\\n| F-2 |\\n\\n\\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\\nCONSOLIDATED BALANCE SHEETS\\n\\n| December 31, 2016 | December 31, 2015 |\\n| ASSETS |\\n| Current assets |\\n| Cash and cash equivalents | $ | 13,469 | $ | 721 |\\n| Accounts receivable | 1,122,754 | - |\\n| Prepaid expenses | 92,504 | - |\\n| Other receivable | 1,561,331 | 47,453 |\\n| Advance to suppliers | 1,805,044 | - |\\n| Total current assets | 4,595,102 | 48,174 |\\n| Property, plant and equipment - net | 59,778 | 2,807 |\\n| Deposit | 34,519 | - |\\n| Goodwill | 34,112 | - |\\n| Total non-current assets | 128,409 | 2,807 |\\n| Total assets | $ | 4,723,511 | $ | 50,981 |\\n| LIABILITIES AND STOCKHOLDERS’ DEFICIENCY |\\n| Current liabilities |\\n| Accounts payable | $ | 1,318,802 | $ | 269,360 |\\n| Accrued expenses | 35,715 | 30,887 |\\n| Advances from customers | 12,883 | 13,800 |\\n| Construction costs payable | 255,539 | 273,722 |\\n| Due to related parties - trade | 1,283,215 | 1,143,978 |\\n| Due to related parties - non-trade | 100,798 | 3,166,198 |\\n| Convertible notes payable | 150,250 | 150,250 |\\n| Notes payable | 360,000 | 360,000 |\\n| Unsecured loans payable | 1,655,343 | 1,773,131 |\\n| Salary payable | 1,688,353 | 1,632,881 |\\n| Taxes payable | 919,255 | 478,209 |\\n| Penalty payable | 482,327 | 404,752 |\\n| Interest payable | 1,042,661 | 930,062 |\\n| Other payables | 1,019,583 | 524,205 |\\n| Total current liabilities | 10,324,724 | 11,151,435 |\\n| SHAREHOLDER’S EQUITY |\\n| Preferred stock - $0.001 par value, Authorized 20,000,000 shares. Issued and outstanding 500,000 and 500,000 shares at December 31, 2016 and 2015, respectively. | 500 | 500 |\\n| Common stock - $0.001 per value. Authorized 100,000,000 shares. Issued and outstanding $8,728,981 and 2,000,000 shares at December 31, 2016 and 2015 | 8,729 | 2,000 |\\n| Additional paid-in capital | 13,789,990 | 9,490,837 |\\n| Statutory Reserve | 127,884 | - |\\n| Accumulated deficit | (19,489,400 | ) | (20,324,812 | ) |\\n| Accumulated other comprehensive loss | (38,916 | ) | (268,979 | ) |\\n| Total stockholders’ deficiency | (5,601,213 | ) | (11,100,454 | ) |\\n| Total liabilities and shareholder’s equity | $ | 4,723,511 | $ | 50,981 |\\n\\nThe accompanying notes are an integral part of these consolidated financial statements.\\n\\n| F-3 |\\n\\n\\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)\\n\\n| Years Ended December 31, |\\n| 2016 | 2015 |\\n| Revenue | $ | 9,617,845 | $ | - |\\n| Cost of goods sold | 7,672,451 | - |\\n| Gross profit | 1,945,394 | - |\\n| Operating expenses |\\n| Research and development | 224,433 | 178,988 |\\n| Selling expenses | 49,295 | - |\\n| General and administrative | 874,097 | 313,589 |\\n| Total operating expenses | 1,147,825 | 492,577 |\\n| Operating income (loss) | 797,569 | (492,577 | ) |\\n| Other income |\\n| License revenue | 786,329 | - |\\n| Other expense |\\n| Penalty expense | (77,575 | ) | (72,152 | ) |\\n| Interest expense | (112,977 | ) | (112,629 | ) |\\n| Other expense | (3,770 | ) | - |\\n| Total other expense | (194,322 | ) | (184,781 | ) |\\n| Net income (loss) before income tax | 1,389,576 | (677,358 | ) |\\n| Income tax provision | (426,280 | ) | - |\\n| Net income (loss) | 963,296 | (677,358 | ) |\\n| Other comprehensive income |\\n| Foreign currency translation adjustment | 230,063 | 424,065 |\\n| Total comprehensive income (loss) | $ | 1,193,359 | $ | (253,293 | ) |\\n| Net income (loss) per common share - basic | $ | 0.17 | $ | (0.34 | ) |\\n| Net income (loss) per common share - diluted | $ | 0.11 | $ | (0.34 | ) |\\n| Weighted average number of common shares outstanding - basic | 5,645,263 | 2,000,000 |\\n| Weighted average number of common shares outstanding - diluted | 8,872,655 | 2,000,000 |\\n\\nThe accompanying notes are an integral part of these consolidated financial statements.\\n\\n| F-4 |\\n\\n\\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\\nCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ DEFICIENCY\\n\\n| Common Stock | Preferred Stock | Additional Paid-in | Statutory | Accumulated | Accumulated Other Comprehensive | Total Stockholders’ |\\n| Shares | Amount | Shares | Amount | Capital | Reserve | Deficit | Loss | Deficiency |\\n| Balance, December 31, 2014 (Restated) | 2,000,000 | $ | 2,000 | - | $ | - | $ | 8,491,337 | $ | - | $ | (19,647,454 | ) | $ | (693,044 | ) | $ | (11,847,161 | ) |\\n| Issuance of 500,000 shares of preferred stock as debt cancellation on December 14, 2015 | - | - | 500,000 | 500 | 999,500 | - | - | 1,000,000 |\\n| Net loss | - | - | - | - | - | (677,358 | ) | - | (677,358 | ) |\\n| Foreign currency translation adjustment | - | - | - | - | - | - | - | 424,065 | 424,065 |\\n| Balance, December 31, 2015 | 2,000,000 | 2,000 | 500,000 | 500 | 9,490,837 | - | (20,324,812 | ) | (268,979 | ) | (11,100,454 | ) |\\n| Issuance of common shares for cash | 1,775,000 | 1,775 | - | - | 857,884 | - | 859,659 |\\n| Issuance of common shares for Liabilities settlement | 3,243,173 | 3,243 | - | - | 3,188,731 | - | 3,191,974 |\\n| Issuance of common shares for consulting service | 1,710,808 | 1,711 | - | - | 252,539 | - | 254,250 |\\n| Net income | - | - | - | - | - | 127,884 | 835,412 | 963,296 |\\n| Foreign currency translation adjustments | 230,063 | 230,063 |\\n| Balance, December 31, 2016 | 8,728,981 | $ | 8,729 | 500,000 | $ | 500 | $ | 13,789,991 | $ | 127,884 | $ | (19,489,400 | ) | $ | (38,916 | ) | $ | (5,601,212 | ) |\\n\\nThe accompanying notes are an integral part of these consolidated financial statements.\\n\\n| F-5 |\\n\\n\\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\\nCONSOLIDATED STATEMENTS OF CASH FLOWS\\n\\n| Years Ended December 31, |\\n| 2016 | 2015 |\\n| Cash flows from operating activities: |\\n| Net income (loss) | $ | 963,296 | $ | (677,358 | ) |\\n| Adjustments to reconcile net loss to net cash used in operating activities: |\\n| Depreciation | 23,980 | 4,352 |\\n| Bad debt | 55,240 | - |\\n| Provision for penalty payable | 77,575 | 72,152 |\\n| Accrued interest on convertible notes and note payable | 112,599 | 112,538 |\\n| Changes in operating assets and liabilities: | - | - |\\n| Accounts receivable | (1,229,249 | ) | - |\\n| Other receivable | (1,619,623 | ) | - |\\n| Advance to supplier | (1,887,446 | ) | - |\\n| Prepaid expense | (59,154 | ) | - |\\n| Deposit | (36,095 | ) | (33,921 | ) |\\n| Account payable | 1,116,061 | - |\\n| Accrued expense | 7,117 | - |\\n| Salary payable | 93,860 | 125,924 |\\n| Taxes payable | 494,397 | 62,915 |\\n| Due to related parties - trade | 217,293 | 178,988 |\\n| Other payables | 527,175 | 4,202 |\\n| Net cash used in operating activities | (1,142,974 | ) | (150,208 | ) |\\n| Cash flows from investing activities: |\\n| Purchase of property, plant and equipment | (79,083 | ) | - |\\n| Net cash used in investing activities | (79,083 | ) | - |\\n| Cash flows from financing activities: |\\n| Proceeds from related parties, net of payments to related parties | 139,085 | 148,009 |\\n| Proceeds from sale of common stock | 914,273 | - |\\n| Net cash provided by financing activities | 1,053,358 | 148,009 |\\n| Effect of exchange rate change | 181,447 | (43 | ) |\\n| Cash and cash equivalents: |\\n| Net increase (decrease) | 12,748 | (2,242 | ) |\\n| Balance at beginning of year | 721 | 2,963 |\\n| Balance at end of year | $ | 13,469 | $ | 721 |\\n| Non-cash financing activities: |\\n| Issuance of common stock for debts settlement | $ | 3,137,359 | $ | 1,000,000 |\\n| Issuance of common stock for consulting service | 254,250 |\\n| Supplemental Disclosures of Cash flow Information: |\\n| Cash paid for interest | $ | $ | - |\\n| Cash paid for income taxes | $ | $ | - |\\n\\nThe accompanying notes are an integral part of these consolidated financial statements.\\n\\n| F-6 |\\n\\n\\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\\nNOTES TO CONSOLIDATED FINANCIAL STATEMENTS\\nDECEMBER 31, 2016\\n1. Description of Business and Organization\\nOrganization – Kiwa Bio-Tech Products Group Corporation (“the Company”) is the result of a share exchange transaction accomplished on March 12, 2004 between the shareholders of Kiwa Bio-Tech Products Group Ltd. (“Kiwa BVI”), a company originally organized under the laws of the British Virgin Islands on June 5, 2002 and Tintic Gold Mining Company (“Tintic”), a corporation originally incorporated in the state of Utah on June 14, 1933 to perform mining operations in Utah. The share exchange resulted in a change of control of Tintic, with former Kiwa BVI stockholders owning approximately 89% of Tintic on a fully diluted basis and Kiwa BVI surviving as a wholly-owned subsidiary of Tintic. Subsequent to the share exchange transaction, Tintic changed its name to Kiwa Bio-Tech Products Group Corporation. On July 21, 2004, the Company completed its reincorporation in the State of Delaware. On March 8, 2017, we completed our reincorporation in the State of Nevada.\\nThe Company operates through a series of subsidiaries in the Peoples Republic of China as detailed in the following Organizational Chart. The Company had previously operated its business through its subsidiaries Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Kiwa Shandong”) and Tianjin Kiwa Feed Co., Ltd. (“Kiwa Tianjin ”). Kiwa Tianjin has been dissolved since July, 11, 2012. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\\nBusiness – The Company’s business plan is to develop and market innovative, manufacture, distribute cost-effective and environmentally safe bio-technological products for agriculture markets primarily in China. The Company has acquired technologies to produce and market bio-fertilizer.\\n2. Summary of Significant Accounting Policies\\nPrinciple of Consolidation - These consolidated financial statements include the financial statements of the Company and its wholly-owned subsidiaries, Kiwa BVI, Hong Kong Baina Group Holding Company, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd, Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Kiwa Shandong”). All significant inter-company balances or transactions are eliminated on consolidation.\\nReverse Split - On January 14, 2016, the Company filed a Certificate of Amendment of its Certificate of Incorporation with the State of Delaware with reference to a 1-for-200 reverse stock split with respect to its Common Stock with effective date of January 28, 2016. In connection with the reverse split, the Company’s authorized capital was amended to be 120,000,000 shares, comprising 100,000,000 shares of Common Stock par value $0.001 and 20,000,000 shares of Preferred Stock par value $0.001. All relevant information relating to numbers of shares, options and per share information have been retrospectively adjusted to reflect the reverse stock split for all periods presented.\\nUse of Estimates - The preparation of financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant accounting estimates include the valuation of securities issued, deferred tax assets and related valuation allowance.\\n\\n| F-7 |\\n\\n\\nCertain of our estimates, including evaluating the collectability of accounts receivable and the fair market value of long-lived assets, could be affected by external conditions, including those unique to our industry, and general economic conditions. It is possible that these external factors could have an effect on our estimates that could cause actual results to differ from our estimates. We re-evaluate all of our accounting estimates annually based on these conditions and record adjustments when necessary.\\nCash and Cash Equivalents\\nThe Company considers all highly liquid investments with a maturity of three months or less to be cash and cash equivalents. At times, such investments may be in excess of Federal Deposit Insurance Corporation (FDIC) insurance limit.\\nAccounts Receivables - Accounts receivables represent customer accounts receivables. The allowance for doubtful accounts is based on a combination of current sales, historical charge offs and specific accounts identified as high risk. Uncollectible accounts receivable are charged against the allowance for doubtful accounts when all reasonable efforts to collect the amounts due have been exhausted. Such allowances, if any, would be recorded in the period the impairment is identified.\\nAllowance for doubtful accounts\\nThe Company provides an allowance for doubtful accounts equal to the estimated uncollectible amounts. The Company’s estimate is based on historical collection experience and a review of the current status of trade accounts receivable. It is reasonably possible that the Company’s estimate of the allowance for doubtful accounts will change. There was no allowance for doubtful accounts at December 31, 2016 and December 31, 2015.\\nInventories - Inventories are stated at the lower of cost, determined on the weighted average method, and net realizable value. Work in progress and finished goods are composed of direct material, direct labor and a portion of manufacturing overhead. Net realizable value is the estimated selling price in the ordinary course of business, less estimated costs to complete and dispose.\\nProperty, plant and equipment - Property, plant and equipment are stated at cost less accumulated depreciation and accumulated impairment losses, if any. Gains or losses on disposals are reflected as gain or loss in the year of disposal. The cost of improvements that extend the life of property, plant and equipment are capitalized. These capitalized costs may include structural improvements, equipment and fixtures. All ordinary repair and maintenance costs are expensed as incurred. Depreciation for financial reporting purposes is provided using the straight-line method over the estimated useful lives of the assets as follows:\\n\\n| Useful Life |\\n| (In years) |\\n| Buildings | 30 - 35 |\\n| Machinery and equipment | 5 - 10 |\\n| Automobiles | 8 |\\n| Office equipment | 2 - 5 |\\n| Computer software | 3 |\\n\\nImpairment of Long-Lived Assets - The Company’s long-lived assets consist of property, equipment and intangible assets. The Company evaluates its investment in long-lived assets, including property and equipment, for recoverability whenever events or changes in circumstances indicate the net carrying amount may not be recoverable. Judgments regarding potential impairment are based on legal factors, market conditions and operational performance indicators, among others. In assessing the impairment of property and equipment, the Company makes assumptions regarding the estimated future cash flows and other factors to determine the fair value of the respective assets.\\nFair value of warrants and options - The Company adopted ASC Topic 815, “Accounting for Derivative Instruments and Hedging Activities” to recognize warrants relating to loans and warrants issued to consultants as compensation as derivative instruments in our consolidated financial statements. The Company also adopted ASC Topic 718, “Share Based Payment” to recognize options granted to employees as derivative instruments in our consolidated financial statements. The Company calculates the fair value of the warrants and options using the Black-Scholes Model.\\n\\n| F-8 |\\n\\n\\nRevenue Recognition – The Company applies paragraph 605-10-S99-1 of the FASB Accounting Standards Codification for revenue recognition. The Company recognizes revenue when it is realized or realizable and earned. The Company considers revenue realized or realizable and earned when all of the following criteria are met: (i) persuasive evidence of an arrangement exists, (ii) the product has been shipped or the services have been rendered to the customer, (iii) the sales price is fixed or determinable, and (iv) collectability is reasonably assured.\\nThe Company derives its revenues from sales contracts with its customer with revenues being generated upon delivery of products. Persuasive evidence of an arrangement is demonstrated via invoice; and the sales price to the customer is fixed upon acceptance of the purchase order and there is no separate sales rebate, discount, or volume incentive.\\nShipping and Handling Costs - Substantially all costs of shipping and handling of products to customers are included in selling. Shipping and handling costs for the years ended December 31, 2016 and 2015 were $480,892 and $ nil, respectively.\\nIncome Taxes - The Company accounts for income taxes under the provisions of FASB ASC Topic 740, “Income Tax,” which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Deferred tax assets and liabilities are recognized for the future tax consequence attributable to the difference between the tax bases of assets and liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are measured using the enacted tax rate expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company establishes a valuation when it is more likely than not that the assets will not be recovered.\\nASC Topic 740.10.30 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC Topic 740.10.40 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. We have no material uncertain tax positions for any of the reporting periods presented.\\nForeign Currency Translation and Other Comprehensive Income - The Company uses United States dollars (“US Dollar” or “US$” or “$”) for financial reporting purposes. However, the Company maintains the books and records in its functional currency, Chinese Renminbi (“RMB”), being the primary currency of the economic environment in which its operations are conducted. In general, the Company translates its assets and liabilities into U.S. dollars using the applicable exchange rates prevailing at the balance sheet date, and the statement of comprehensive loss and the statement of cash flow are translated at average exchange rates during the reporting period. Equity accounts are translated at historical rates. Adjustments resulting from the translation of the Company’s financial statements are recorded as accumulated other comprehensive income.\\nOther comprehensive income for the years ended December 31, 2016 and 2015 represented foreign currency translation adjustments and were included in the consolidated statements of comprehensive loss.\\nThe exchange rates used to translate amounts in RMB into U.S. Dollars for the purposes of preparing the consolidated financial statements were as follows:\\n\\n| As of December 31, |\\n| 2016 | 2015 |\\n| Balance sheet items, except for equity accounts | 6.94 | 6.4857 |\\n\\n\\n| Years ended December 31, |\\n| 2016 | 2015 |\\n| Items in the statements of comprehensive loss | 6.62 | 6.2281 |\\n\\nAdvertising Costs - The Company charges all advertising costs to expense as incurred. The total amounts of advertising costs charged to selling, general and administrative expense were $nil for the years ended December 31, 2016 and 2015, respectively.\\nResearch and Development Costs - Research and development costs are charged to expense as incurred. During the years ended December 31, 2016 and 2015, research and development costs were $224,433 and $178,988, respectively.\\n\\n| F-9 |\\n\\n\\nNet Loss Per Common Share - Basic loss per common share is calculated by dividing net loss attributable to Kiwa stockholders by the weighted-average number of shares of common stock outstanding during the period. Diluted loss per common share includes dilutive effect of dilutive securities (stock options, warrants, convertible debt, stock subscription and other stock commitments issuable). These potentially dilutive securities were not included in the calculation of loss per share for the periods presented because the Company incurred a loss during such periods and thus the effect would have been anti-dilutive. Accordingly, basic and diluted loss per common share is the same for all periods presented. As of December 31, 2016 and 2015, potentially dilutive securities aggregated 8,872,655 (632,204 post-reverse split shares) and 126,440,833 (632,204 post-reverse split shares) shares of common stock, respectively.\\nFair Value of Financial Instruments\\nThe Company follows paragraph 825-10-50-10 of the FASB Accounting Standards Codification for disclosures about fair value of its financial instruments and paragraph 820- 10-35-37 of the FASB Accounting Standards Codification (“Paragraph 820-10-35-37”) to measure the fair value of its financial instruments. Paragraph 820-10-35-37 establishes a framework for measuring fair value with U.S. GAAP, and expands disclosures about fair value measurements.\\nTo increase consistency and comparability in fair value measurements and related disclosures, Paragraph 820-10-35-37 establishes a fair value hierarchy which prioritizes the inputs to valuation techniques used to measure fair value into three (3) broad levels. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The three (3) levels of fair value hierarchy defined by Paragraph 820-10-35-37 are described below:\\n\\n| ● | Level 1: quoted market prices available in active markets for identical assets or liabilities as of the reporting date. |\\n| ● | Level 2: pricing inputs other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable as of the reporting date. |\\n| ● | Level 3: Pricing inputs that are generally observable inputs and not corroborated by market data. |\\n\\nFinancial assets are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable.\\nThe fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.\\nThe fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.\\nThe carrying amount of the Company’s financial assets and liabilities, such as cash and cash equivalent, prepaid expenses, accounts payable and accrued expenses, approximate their fair value because of the short maturity of those instruments.\\nTransactions involving related parties cannot be presumed to be carried out on an arm’s-length basis, as the requisite conditions of competitive, free-market dealings may not exist. Representations about transactions with related parties, if made, shall not imply that the related party transactions were consummated on terms equivalent to those that prevail in arm’s-length transactions unless such representations can be substantiated.\\nIt is not however practical to determine the fair value of advances from stockholders, if any, due to their related party nature.\\n\\n| F-10 |\\n\\n\\nRelated Parties\\nThe Company follows subtopic 850-10 of the FASB Accounting Standards Codification for the identification of related parties and disclosure of related party transactions. Pursuant to Section 850-10-20 the related parties include: a) affiliates of the Company; b) entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of Section 825–10–15, to be accounted for by the equity method by the investing entity; c) trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of management; d) principal owners of the Company; e) management of the Company; f) other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests; and g) other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly Influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.\\nThe consolidated financial statements shall include disclosures of material related party transactions, other than compensation arrangements, expense allowances, and other similar items in the ordinary course of business. However, disclosure of transactions that are eliminated in the preparation of consolidated financial statements is not required in those statements. The disclosures shall include: a. the nature of the relationship(s) involved; b. a description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the consolidated financial statements; c. the dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period; and d. amounts due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement.\\nCommitments and Contingencies\\nThe Company follows subtopic 450-20 of the FASB Accounting Standards Codification to report accounting for contingencies. Certain conditions may exist as of the date the consolidated financial statements are issued, which may result in a loss to the Company but which will only be resolved when one or more future events occur or fail to occur. The Company assesses such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or unasserted claims that may result in such proceedings, the Company evaluates the perceived merits of any legal proceedings or unasserted claims as well as the perceived merits of the amount of relief sought or expected to be sought therein.\\n\\n| F-11 |\\n\\n\\nIf the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s consolidated financial statements. If the assessment indicates that a potential material loss contingency is not probable but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, and an estimate of the range of possible losses, if determinable and material, would be disclosed.\\nLoss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the guarantees would be disclosed. Management does not believe, based upon information available at this time that these matters will have a material adverse effect on the Company’s financial position, results of operations or cash flows. However, there is no assurance that such matters will not materially and adversely\\nStock Based Compensation\\nThe Company accounts for employee and non-employee stock awards under ASC 718, whereby equity instruments issued to employees for services are recorded based on the fair value of the instrument issued and those issued to non-employees are recorded based on the fair value of the consideration received or the fair value of the equity instrument, whichever is more reliably measurable.\\nNo stock based compensation was issued or outstanding as of December 31, 2016 and 2015.\\nIncome Tax Provision\\nIncome taxes are accounted for using the asset and liability method. Deferred income taxes are provided for temporary differences in recognizing certain income, expense and credit items for financial reporting purposes and tax reporting purposes. Such deferred income taxes primarily relate to the difference between the tax basis of assets and liabilities and their financial reporting amounts. Deferred tax assets and liabilities are measured by applying enacted statutory tax rates applicable to the future years in which deferred tax assets or liabilities are expected to be settled or realized. There were no material deferred tax assets or liabilities as of December 31, 2016 and December 31, 2015.\\nAs of December 31, 2016, and 2015, the Company did not identify any material uncertain tax positions. As of December 31, 2016, the Company’s returns are subject to examination by federal and state taxing authorities, generally for three years and four years, respectively, after they are filed.\\nNet Income (Loss) Per Common Share\\nNet income (loss) per common share is computed pursuant to section 260-10-45 of the FASB Accounting Standards Codification. Basic net income (loss) per common share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period.\\n\\n| F-12 |\\n\\n\\nDiluted net income (loss) per common share is computed by dividing net income (loss) by the weighted average number of shares of common stock and potentially outstanding shares of common stock during the period to reflect the potential dilution that could occur from common shares issuable through contingent shares issuance arrangement, stock options or warrants.\\nThere were no potentially dilutive debt or equity instruments issued and outstanding at any time during the twelve-month periods ended December 31, 2016 and 2015.\\nCash Flows Reporting\\nThe Company adopted paragraph 230-10-45-24 of the FASB Accounting Standards Codification for cash flows reporting, classifies cash receipts and payments according to whether they stem from operating, investing, or financing activities and provides definitions of each category, and uses the indirect or reconciliation method (“Indirect method”) as defined by paragraph 230-10-45-25 of the FASB Accounting Standards Codification to report net cash flow from operating activities by adjusting net income to reconcile it to net cash flow from operating activities by removing the effects of (a) all deferrals of past operating cash receipts and payments and all accruals of expected future operating cash receipts and payments and (b) all items that are included in net income that do not affect operating cash receipts and payments. The Company reports the reporting currency equivalent of foreign currency cash flows, using the current exchange rate at the time of the cash flows and the effect of exchange rate changes on cash held in foreign currencies is reported as a separate item in the reconciliation of beginning and ending balances of cash and cash equivalents and separately provides information about investing and financing activities not resulting in cash receipts or payments in the period pursuant to paragraph 830-230-45-1 of the FASB Accounting Standards Codification.\\nSubsequent Events\\nThe Company follows the guidance in Section 855-10-50 of the FASB Accounting Standards Codification for the disclosure of subsequent events. The Company will evaluate subsequent events through the date when the financial statements were issued. Pursuant to ASU 2010-09 of the FASB Accounting Standards Codification, the Company as an SEC filer considers its financial statements issued when they are widely distributed to users, such as through filing them on EDGAR.\\nRecent accounting pronouncements\\nIn November 2015, FASB issued ASU 2015-17, “Balance Sheet Classification of Deferred Taxes.” ASU 2015-17 requires that deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial position. ASU 2015-17 is effective for financial statements issued for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. The Company does not expect these changes to have a material impact on the Company’s consolidated financial statements.\\nIn January 2016, Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-01, “Recognition and Measurement of Financial Assets and Financial Liabilities.” ASU 2016-01 requires equity investments to be measured at fair value with changes in fair value recognized in net income; simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; Eliminates the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet; requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; requires an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments; requires separate presentation of financial assets and financial liabilities by measurement category and form of financial assets on the balance sheet or the accompanying notes to the financial statements and clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets. ASU 2016-01 is effective for financial statements issued for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. The Company does not expect these changes to have a material impact on the Company’s consolidated financial statements.\\n\\n| F-13 |\\n\\n\\nIn March 2016, the FASB issued ASU 2016-09—Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. The amendments in this guidance are relating to employee share-based compensation. Under the new guidance, we are required to recognize the tax effects of stock compensation as income tax expense or benefit in the income statement and treat the tax effects of exercised or vested awards as discrete items in the reporting period in which they occur. Excess tax benefits are required to be classified as operating activities, and shares we withhold on behalf of employees for tax purposes are required to be classified as financing activities. We may make an accounting policy election to continue to estimate the number of awards that are expected to vest or account for forfeitures when they occur. The threshold to qualify for equity classification permits withholding up to the maximum statutory tax rates. This guidance is required to be adopted in the first quarter of 2017. We are currently evaluating the impact this guidance will have on our consolidated financial statements.\\nIn August 2016, the FASB issued ASU 2016-15—Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (a consensus of the Emerging Issues Task Force). The amendments in this guidance on eight specific cash flow issues with regard to how cash receipts and cash payments are presented and classified in the statement of cash flows in order to clarify existing guidance and reduce diversity in practice. The guidance is required to be adopted in the first quarter of 2018 on a retrospective basis, unless it is impracticable to apply, in which case it should be applied prospectively as of the earliest date practicable. Early adoption is permitted. We are currently evaluating the impact this guidance will have on our consolidated statement of cash flows.\\nIn January 2017, the FASB issued ASU 2017-01, “Business Combinations (Topic 805): Clarifying the Definition of a Business.” The amendments in this guidance are clarifying the definition of a business to assist entities when determining whether an integrated set of assets and activities meets the definition of a business. The update provides that when substantially all the fair value of the assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets, the set is not a business. The guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The adoption of this new guidance is not expected to have a material impact on our consolidated financial statements.\\nIn January 2017, the FASB issued ASU 2017-04—Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. The amendments in this guidance to eliminate the requirement to calculate the implied fair value of goodwill to measure goodwill impairment charge (Step 2). As a result, an impairment charge will equal the amount by which a reporting unit’s carrying amount exceeds its fair value, not to exceed the amount of goodwill allocated to the reporting unit. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. The amendment should be applied on a prospective basis. The guidance is effective for goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for goodwill impairment tests performed after January 1, 2017. The impact of this guidance for the Company will depend on the outcomes of future goodwill impairment tests.\\nThere were other updates recently issued. The Company does not believe that other than disclosed above, the recently issued, but not yet adopted, accounting pronouncements will have a material impact on its financial position, results of operations or cash flows.\\nGoodwill and Other Intangibles\\nIn accordance with Accounting Standards Update (ASU) No. 2014-02, management evaluates goodwill on an annual basis in the fourth quarter of more frequently if management believes indicators of impairment exist. Such indicators could, but are not limited to (1) a significant adverse change in legal factors or in business climate, (2) unanticipated competition, or (3) an adverse action or assessment by a regulator. The Company first assesses qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, including goodwill. If management concludes that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, management conducts a two-step quantitative goodwill impairment test. The first step of the impairment test involves comparing the fair value of the applicable reporting unit with its carrying value. The Company estimates the fair value of its reporting units using a combination of the income, or discounted cash flows, approach and the market approach, with utilizes comparable companies’ data. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, management performs the second step of the goodwill impairment test. The second step of the goodwill impairment test involves comparing the implied fair value of the affected reporting unit’s goodwill with the carrying value of that goodwill. The amount, by which the carrying value of the goodwill exceeds its implied fair value, if any, is recognized as an impairment loss. The Company’s evaluation of goodwill completed during the year resulted in no impairment losses.\\n3. Going Concern\\nThe consolidated financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.\\nAs of December 31, 2016, the Company’s current liabilities substantially exceeded its current assets by $5,729,622, had an accumulated deficit of $19,489,400, and stockholders’ deficiency of $5,601,213. These circumstances, among others, raise substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. The financial statements also do not include any adjustments relating to the recoverability and classification of recorded asset amounts, or amounts and classifications of liabilities that might be necessary should the Company be unable to continue as a going concern.\\nThe management of the Company already raised additional equity during the first quarter of 2017 for approximately $1,000,000. (Please refer to Note 14 for additional information) The Company is generating additional revenue while seeking additional equity financing. Management is very optimistic about the Company’s continue profitability for the coming years.\\n4. Property, Plant and Equipment\\nProperty, plant and equipment, net consisted of the following:\\n\\n| December 31, 2016 | December 31, 2015 |\\n| Property, Plant and Equipment |\\n| Buildings | $ | - | $ | 1,308,785 |\\n| Machinery and equipment | - | 595,623 |\\n| Automobiles | - | 85,769 |\\n| Office equipment | 942 | 104,843 |\\n| Furniture | 8,276 | - |\\n| Leasehold improvement | 70,871 | - |\\n| Computer software | - | 22,304 |\\n| Property, plant and equipment - total | $ | 80,089 | $ | 2,117,324 |\\n| Less: accumulated depreciation | (20,311 | ) | (762,791 | ) |\\n| Less: impairment on long-lived assets | - | (1,351,726 | ) |\\n| Property, plant and equipment - net | $ | 59,778 | $ | 2,807 |\\n\\nThe building is on a piece of land the use right of which was granted to Kiwa Bio-Tech Products (Shandong) Co., Ltd. by local government free for 10 years and then for another 20 years on a fee calculated according to Kiwa Shandong’s net profit. Since Kiwa Shandong did not generate any net profit, no fee is payable.\\nDepreciation expense was $22,340 and $4,352 for the years ended December 31, 2016 and 2015, respectively.\\nImpairment on long-lived assets was $nil for the years ended December 31, 2016 and 2015, respectively.\\nAll of our property, plant and equipment have been held as collateral to secure the 6% Notes (see Note 8).\\n5. Goodwill\\nOn November 30, 2015, Kiwa Bio-tech Products Group Ltd in BVI (\\\"Kiwa BVI\\\") entered an acquisition agreement with shareholders of Caber Holdings Ltd. (“Acquiree”) in Hong Kong to acquire 100 percent entity interest of the acquiree, including a wholly owned subsidiary, Oriental Baina Co., Ltd. in Beijing for US$30,000. The acquisition was completed in January, 2016. On the acquisition date, there was no any asset or liability acquired, and thus no fair value was allocated to asset and liability. Including legal fee and government fees, the total payment of approximately $34,112 ($30,000 plus legal fee and government fees totaled $4,112) was recorded as goodwill. The fair value of the goodwill is tested prior to the year-end 2016, and management determined there is no impairment to the goodwill as of December 31, 2016.\\n6. Construction Costs Payable\\nConstruction costs payable represents remaining amounts to be paid for the first phase of construction of bio-fertilizer facility in Shandong. The balance of construction costs payable as of December 31, 2016 and 2015 was $255,539 and $273,722, respectively.\\n\\n| F-14 |\\n\\n\\n7. Related Party Transactions\\nAmounts due to related parties consisted of the following as of December 31, 2016 and 2015:\\n\\n| Item | Nature | Notes | December 31, 2016 | December 31, 2015 |\\n| Mr. Wei Li (“Mr. Li”) | Non-trade | (1 | ) | $ | - | $ | 2,879,307 |\\n| Kangtai Xinnong Agriculture Tech (Beijing) Co., Ltd. (“Kangtai”) | Non-trade | (2 | ) | - | (12,173 | ) |\\n| Ms. Yvonne Wang (“Ms. Wang”) | Non-trade | (3 | ) | 100,798 | 299,064 |\\n| Subtotal | 100,798 | 3,166,198 |\\n| Kiwa-CAU R&D Center | Trade | (4 | ) | 1,122,754 | 1,125,553 |\\n| CAAS IARRP and IAED Institutes | Trade | (5 | ) | 160,461 | 18,425 |\\n| Subtotal | 1,283,215 | 1,143,978 |\\n| Total | $ | 1,384,013 | $ | 4,310,176 |\\n\\n(1) Mr. Li\\nMr. Li was the Chairman of the Board until November 20, 2015 and was the Chief Executive Officer of the Company until July 1, 2015.\\nAdvances and Loans\\nOn December 14, 2015, Mr. Li assigned $500,000 of obligation owed by the Company to his daughter, Feng Li. On the same day, Feng Li subscribed for the purchase of 250,000 shares of preferred stock for the aggregate amount of $500,000, and agreed to the concurrent cancellation of debt owed by the Company.\\nOn March 24, 2016, the Company issued 2,900,000 shares of common stock to Mr. Li to settle down entire outstanding balance of $2,879,307. Subsequently in June 2016, Mr. Li transferred 1,000,000 shares to Troniya Industria Incubator Co., Ltd as a personal collateral for RMB 3.2 million received in Kiwa Baiao Bio-Tech (Beijing) Co., Ltd.’s account.\\nGuarantees for the Company\\nMr. Li has pledged without any compensation from the Company all of his common stock of the Company as collateral for the Company’s obligations under the 6% Notes (see Note 9).\\n(2) Kangtai\\nKangtai is a private company and is 64% owned by Mr. Li. Mr. Li is the Chairman of Kangtai.\\n(3) Ms. Wang\\nMs. Wang is the Secretary of the Company until November 20, 2015. Effective as of November 20, 2015, the Company appointed Ms. Wang as the Chairman of the Board. Effective August 11, 2016, the Company’s Board of Directors has assigned Ms. Wang the additional titles of Acting President, Acting Chief Executive Officer and Acting Chief Financial Officer.\\nOn December 14, 2015, Ms. Wang subscribed for the purchase of 250,000 shares of preferred stock for the aggregate amount of $500,000, and agrees to the concurrent cancellation of debt owed by the Company.\\nOn March 24, 2016, the Company issued 240,000 shares of common stock to Ms. Wang to pay off the loan balance of $240,000. During the year ended December 31, 2016, Ms. Wang paid various expenses on behalf of the Company. As of December 31, 2016, the amount due to Ms. Wang was $100,798.\\n\\n| F-15 |\\n\\n\\n(4) Kiwa-CAU R&D Center\\nIn November 2006, Kiwa and China Agricultural University (the “CAU”) agreed to jointly establish a new research and development center, named Kiwa-CAU R&D Center. The term of the agreement was ten years commencing July 1, 2006.\\n\\n| ● | Pursuant to the agreement, Kiwa agree to invest RMB 1 million (approximately $160,000) each year to fund research at Kiwa-CAU R&D Center. Prof. Qi Wang, a director of the Company, is also the director of Kiwa-CAU R&D Center. The Company recorded $75,528 and $160,563 research and development expenses related to this R&D Center for the years ended December 31, 2016 and 2015, respectively. |\\n\\n(5) CAAS IARRP and IAED Institutes\\nOn November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). The term of the Agreement was three years commencing November 20, 2015.\\n\\n| ● | Pursuant to the agreement, Kiwa agree to invest RMB 1 million (approximately $160,000) each year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. Prof. Yong Chang Wu, the authorized representative of IARRP, CAAS, is also one of the Company's directors effective since November 20, 2015 until March 13, 2017. The Company recorded $149,176 and $18,425 research and development expenses related to the institutes, for the years ended December 31, 2016 and 2015, respectively, |\\n\\nResearch and Development expenses for the years ended December 31, 2016 and 2015, totaled $224,704 and $178,988, respectively.\\n8. Unsecured Loans Payable\\nUnsecured loans payable consisted of the following:\\n\\n| Item | December 31, 2016 | December 31, 2015 |\\n| Unsecured loan payable to Zoucheng Municipal Government, non-interest bearing, becoming due within three years from Kiwa Shandong’s first profitable year on a formula basis, interest has not been imputed due to the undeterminable repayment date | $ | 1,269,880 | $ | 1,387,668 |\\n| Unsecured loan payable to Zoucheng Science & Technology Bureau, non-interest bearing, it is due in Kiwa Shandong’s first profitable year, interest has not been imputed due to the undeterminable repayment date | 385,463 | 385,463 |\\n| Total | $ | 1,655,343 | $ | 1,773,131 |\\n\\nThe Company qualifies for non-interest bearing loans under a Chinese government sponsored program to encourage economic development in certain industries and locations in China. To qualify for the favorable loan terms, a company must meet the following criteria: (1) be a technology company with innovative technology or product (as determined by the Science Bureau of the central Chinese government); (2) operate in specific industries that the Chinese government has determined are important to encourage development, such as agriculture, environmental, education, and others; and (3) be located in an undeveloped area such as Zoucheng, Shandong Province, where the manufacturing facility of the Company is located.\\nAccording to the Company’s project agreement, Zoucheng Municipal Government granted the Company use of at least 15.7 acres in Shandong Province, China at no cost for 10 years to construct a manufacturing facility. Under the agreement, the Company has the option to pay a fee of RMB 480,000 ($77,100) per acre for the land use right after the 10-year period until May 2012. The Company may not transfer or pledge the temporary land use right. The Company also committed to invest approximately $18 million to $24 million for developing the manufacturing and research facilities in Zoucheng, Shandong Province. As of December 31, 2016, the Company invested approximately $2 million for the property, plant and equipment of the project and these assets were impaired as of December 31, 2016.\\n\\n| F-16 |\\n\\n\\n9. Convertible Notes Payable\\nConvertible notes payable consists of 6% secured convertible notes issued to FirsTrust Group Inc. on June 29, 2006. The notes beard interest at 6% and were due on June 29, 2009. Once the note is pass due, the interest rate increased to 15% per annum. The Company accrued $22,977 and $22,538 interest expense on convertible notes for the years ended December 31, 2016 and 2015, respectively. Interest payable to FirstTrust Group Inc. totaled $183,361 and $160,762 at December 31, 2016 and 2015, respectively.\\nThe conversion price of the 6% Notes is based on a 40% discount to the average of the trading price of the Company’s common stock on the OTC Bulletin Board over a 20-day trading period. The conversion price is also adjusted for certain subsequent issuances of equity securities of the Company at prices below the conversion price then in effect. The 6% Notes contain a volume limitation that prohibits the holder from further converting the 6% Notes if doing so would cause the holder and its affiliates to hold more than 4.99% of the Company’s outstanding common stock. In addition, the holder of the 6% Notes agrees that they may not convert more than their pro-rata share (based on original principal amount) of the greater of $120,000 principal amount of the 6% Notes per calendar month or the average daily dollar volume calculated during the 10 business days prior to a conversion, per conversion. This conversion limit has since been eliminated pursuant to an agreement by the Company and the Purchasers.\\nThe Company incurs a financial penalty in cash or shares at the option of the Company (equal to 2% of the outstanding amount of the Notes per month plus accrued and unpaid interest on the Notes, prorated for partial months) if it breaches this or other affirmative covenants in the Purchase Agreement, including a covenant to maintain a sufficient number of authorized shares under its Certificate of Incorporation to cover at least 110% of the stock issuable upon full conversion of the Notes. Pursuant to the relevant provisions for liquidated damages in the Purchase Agreement, the Company has accrued the penalty of $77,575 and $72,152 for the years ended December 31, 2016 and 2015, respectively.\\nThe 6% Notes require the Company to procure the Purchaser’s consent prior to taking certain actions including the payment of dividends, repurchasing stock, incurring debt, guaranteeing obligations, merging or restructuring the Company, or selling significant assets.\\nThe Company’s obligations under the 6% Notes are secured by a first priority security interest in the Company’s intellectual property pursuant to an Intellectual Property Security Agreement with the Purchasers, and by a first priority security interest in all of the Company’s other assets pursuant to a Security Agreement with the Purchasers. In addition, Mr. Li, the Company’s former Chief Executive Officer until July 1, 2015, has pledged all of his common stock of the Company as collateral for the Company’s obligations under the 6% Notes. The intellectual property pledged had a cost of $592,901 which carrying value of $179,897 was fully impaired during the year ended December 31, 2009.\\n\\n| F-17 |\\n\\n\\n10. Note payable\\nOn May 29, 2007, the Company issued a $360,000 promissory note to an unrelated individual. This note bears interest at 18% per annum and due on July 27, 2007. This note is currently in default and bears interest of 25% per annum (the “Default rate”) until paid in full. This note is secured by a pledge of 6,178,336 (post-reverse split 30,892) shares of the Company’s common stock owned by Investlink (China) Limited, a British Virgin Island corporation. The Company accrued $90,000 and $90,000 interest expense on note payable for the years ended December 31, 2016 and 2015, respectively.\\n11.Stockholders’ Deficiency\\nOn December 14, 2015, the Company issued 500,000 shares of preferred stock for the aggregate amount of $1,000,000 as debt cancellation owed to two related party individuals (see Note 7).\\nIn March, 2016, the Company issued 3,140,000 shares of common stock to Mr. Li and Ms. Wang for debt and salary payable settlement for an aggregate amount of $3,141,000 (See Note 7). In addition, the Company issued 101,947 common shares to Jimmy Zhou, former CEO in August 2016, to settle payable to him for $50,974. All of issuances of common shares for settlement of debts were based the stock price on the transaction dates.\\nDuring the year, the Company issued 1,775,000 common shares for cash at $0.8 per share for an aggregate subscribe price equivalent to $1,420,000, of which $859,659 has received while approximately $560,341 remaining subscribe receivable at December 31, 2016.\\nDuring the year ended December 31, 2016, the Company issued 1,711,808 common shares to four consulting companies as compensation for their consulting service received, totaled $254,250 approximately for the year ended December 31, 2016.\\n12. Stock-based Compensation\\nOn December 12, 2006, the Company granted options for 2,000,000 shares (10,000 post-reverse split shares) of its common stock under its 2004 Stock Incentive Plan. Summary of options issued and outstanding at December 31, 2016 and 2015 and the movements during the years then ended are as follows:\\n\\n| F-18 |\\n\\n\\n\\n| Number of underlying shares | Weighted- Average Exercise Price Per Share | Aggregate Intrinsic Value | Weighted- Average Contractual Life Remaining in Years |\\n| Outstanding at December 31, 2014 | 6,163 | $ | 35 | $ | - | 2 |\\n| Exercised | - | - | - |\\n| Expired | - | - | - |\\n| Forfeited | - | - | - |\\n| Outstanding at December 31, 2015 | 6,163 | $ | 35 | $ | - | 1 |\\n| Exercised | - | - | - |\\n| Expired | 6,163 | $ | 35 | - |\\n| Forfeited | - | - | - |\\n| Outstanding at December 31, 2016 | - | - | $ | - | - |\\n| Exercisable at December 31, 2016 | - | - | $ | - | - |\\n\\nAs of December 31, 2016, no stock options or other stock-based compensation was outstanding and all prior grants of stock options had expired as of that date.\\n13. Income Tax\\nIn accordance with the current tax laws in China, Kiwa Shandong is subject to a corporate income tax rate of 25% on its taxable income. However, Kiwa Shandong has not provided for any corporate income taxes since it had no taxable income for the years ended December 31, 2016 and 2015.\\nNo provision for taxes is made for U.S. income tax as the Company has no taxable income in the U.S. In accordance with the relevant tax laws in the British Virgin Islands, Kiwa BVI, as an International Business Company, is exempt from income taxes.\\nA reconciliation of the provision for income taxes determined at the local income tax rate to the Company’s effective income tax rate is as follows:\\n\\n| Years ended December 31, |\\n| 2016 | 2015 |\\n| Pre-tax income (loss) | $ | 1,389,576 | $ | (677,358 | ) |\\n| U.S. federal corporate income tax rate | 34 | % | 34 | % |\\n| Income tax computed at U.S. federal corporate income tax rate | 472,456 | (230,302 | ) |\\n| Reconciling items: |\\n| Rate differential for PRC earnings | (139,923 | ) | 22,439 |\\n| Change of valuation allowance | 301,813 | 171,993 |\\n| Non-deductible expenses | (208,066 | ) | 35,870 |\\n| Effective tax expense | $ | 426,280 | $ | - |\\n\\n\\n| F-19 |\\n\\n\\nThe Company had deferred tax assets as follows:\\n\\n| December 31, 2016 | December 31, 2015 |\\n| Net operating losses carried forward | $ | 3,475,563 | $ | 3,398,402 |\\n| Less: Valuation allowance | (3,475,563 | ) | (3,398,402 | ) |\\n| Net deferred tax assets | $ | - | $ | - |\\n\\nAs of December 31, 2016 and 2015, the Company had approximately $3.5 million and $8 million net operating loss carryforwards available to reduce future taxable income. Net operating loss of the Company could be carried forward and taken against any taxable income for a period of not more than twenty years from the year of the initial loss pursuant to Section 172 of the Internal Revenue Code of 1986, as amended. The net operating loss of Kiwa Shandong could be carried forward for a period of not more than five years from the year of the initial loss pursuant to relevant PRC tax laws and regulations. It is more likely than not that the deferred tax assets cannot be utilized in the future because there will not be significant future earnings from the entity which generated the net operating loss. Therefore, the Company recorded a full valuation allowance on its deferred tax assets.\\nAs of December 31, 2016 and 2015, the Company has no material unrecognized tax benefits which would favorably affect the effective income tax rate in future periods and does not believe that there will be any significant increases or decreases of unrecognized tax benefits within the next twelve months. No interest or penalties relating to income tax matters have been imposed on the Company during the two years ended December 31, 2016 and 2015, and no provision for interest and penalties is deemed necessary as of December 31, 2016 and 2015.\\nAccording to the PRC Tax Administration and Collection Law, the statute of limitations is three years if the underpayment of taxes is due to computational errors made by the taxpayer or its withholding agent. The statute of limitations extends to five years under special circumstances, which are not clearly defined. In the case of a related party transaction, the statute of limitation is ten years. There is no statute of limitation in the case of tax evasion.\\n14. Commitments and Contingencies\\nThe Company has the following material contractual obligations:\\n(1) Investment in manufacturing and research facilities in Zoucheng, Shandong Province in China\\nAccording to the Project Agreement with Zoucheng Municipal Government in 2002, we have committed to investing approximately $18 million to $24 million for developing the manufacturing and research facilities in Zoucheng, Shandong Province. As of December 31, 2016, we had invested approximately $1.91 million for the project. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\\n(2) Strategic cooperation with two institutes in China\\nOn November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). Pursuant to the Agreement, the Company will form a strategic partnership with the two institutes and establish an “International Cooperation Platform for Internet and Safe Agricultural Products”. To fund the cooperation platform’s R&D activities, the Company will provide RMB 1 million (approximately $160,000) per year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. The term of the Agreement is for three years beginning November 20, 2015. Prof. Yong Chang Wu, the authorized representative of IARRP, CAAS, is also one of the Company’s directors effective since November 20, 2015 until March 13, 2017.\\n\\n| F-20 |\\n\\n\\n(3) Distribution agreement with Kangtan Gerui Bio-Tech in China\\nOn December 17, 2015, Kiwa Bio-Tech Products Group Corporation (the “Company”) entered into a distribution agreement (the “Agreement”) with Kangtan Gerui (Beijing) Bio-Tech Co., Ltd. (“Gerui”) and formally awarded Gerui a right to sell and distribute the Company’s fertilizer products in 3 major agricultural regions of China— Hainan Province, Hunan Province and Xinjiang Autonomous Region. The Company’s Research and Development department has been conducting application experiments in Hainan and Hunan Provinces since August 2015, in accordance with the market requirements. The experiment data indicates that the Company’s fertilizer products have fulfill the requirements of reduction of content of heavy metals in soil and improve crop yield. Gerui was founded in Beijing in April 2015 and relies on the sales network of China’s Supply and Marketing Cooperatives system. Currently, the Company and Gerui do not hold any interest in each other; however, a collaboration and integration may take place in the future. The term of the Agreement is for a period of three years commencing December 17, 2015. In September 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd obtained a fertilizer sales permit from the Chinese government and began to sale the products directly to customers in those 3 major agricultural regions.\\n(4) Lease payments\\n(1) On April 29, 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. entered an office lease agreement with two-year team. Monthly lease payment and building management fee totaled RMB 77,867 or approximately USD $11,622.\\n(2) On November 11, 2017, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. entered an apartment lease agreement for its employees. The lease term is one year with monthly lease payment of RMB 6,000 or approximately USD $896.\\n(3) In March 1, 2017, Kiwa Bio-Tech (Shenzhen) Co., Ltd, a newly established subsidiary entered an office lease agreement with one-year term. Monthly lease payment is RMB 29,000 or approximately of USD $4,320.\\nThe future lease payments at December 31, 2016 are summarized below.\\n\\n| Beijing Office | Beijing Apartment | Shenzhen Office | Total |\\n| 2017 | $ | 139,462 | $ | 3,632 | $ | 4,328 | $ | 147,422 |\\n| 2018 | $ | 44,555 | - | - | $ | 44,555 |\\n| Thereafter | - | - | - | - |\\n\\n15. Subsequent Events\\nThe Company has evaluated the existence of significant events subsequent to the balance sheet date through the date these financial statements were issued and has determined that there were no subsequent events or transactions which would require recognition or disclosure in the financial statements, other than noted herein.\\nOn February 11, 2017, the Company executed an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) whereby the Company transferred all of its right, title and interest in Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Shandong”) to the Transferee for the RMB equivalent of US$1.00. In connection with the transaction, the Transferee received all assets of Shandong which are estimated to be approximately RMB 14,057,713 at the effective date and assumed all liabilities of Shandong which are estimated to be approximately RMB 59,446,513 at the effective date. In connection with this transaction, Transferee agreed to indemnify the Company for any liability or claims of any third party(ies) against Shandong or the Company for five (5) years. The transaction is subject to obtaining Chinese government approval for the transaction, which the parties agrees to use their best efforts to obtain prior to December 31, 2017. The completion of transfer is under government processing.\\n\\n| F-21 |\\n\\n\\nOn February 15, 2017, the Company completed the sale of 1,000,000 shares of Kiwa Common Stock (each a “Share”) at a price of $1.00 per share (total sale proceeds were $1,000,000) to Junwei Zheng in a private transaction which was exempt from registration under Section 4(a)(2) of the Securities Act of 1933, as amended (the “Act”) and Regulation S promulgated under the Act since, among other things, the transaction did not involve a public offering and the securities were acquired for investment purposes only and not with a view to or for sale in connection with any distribution thereof and were purchased by an investor who is not a resident of the United States. The net proceeds will be used for the further development of Kiwa products and distribution, as well as for general working capital.\\nOn February 23, 2017, the Company has agreed to a strategic relationship with ETS (Tianjin) Biological Science and Technology Development Co., Ltd. (“ETS”). The partnership will include the deployment and strategic use of ETS biotechnology to produce of bio-fertilizers for use in both China and internationally. Kiwa and ETS, together with the certain Chinese government departments, will work together to enhance China’s microbial fertilizer industry standards and China’s food safety industry chain standards. The parties will work together on the development of microbial technology and products in agriculture, environmental protection, soil management and other fields. Relying on the Chinese Academy of Sciences, ETS Environmental and Agricultural Microbial Technology Research Center and biotechnology project research results, Kiwa has introduced the ETS core technology to complete bio-fertilizer upgrading, transformation and to develop new product lines. In order to meet the growing global consumer demand to increase food supply and develop sustainable farming we are applying sustainable use of biotechnology and the use of biotechnology products to replace chemical products, which will strengthen environmental protection and promote international cooperation. As a result of strict management of many agricultural chemicals, such chemicals will continue to be abandoned, resulting is a growing demand for bio-fertilizers. It has been widely accepted that the application of ETS biotechnology facilitates agricultural sustainability and helps to protect the soil and improve grain output. The technology focuses on keeping soil healthy by restoring healthy microbes that are naturally present in healthy soils. As the technology gains worldwide recognition, it is imperative to popularize bio-fertilizer in developing countries to fulfill the needs of growing populations and promote environmentally friendly agriculture. Through the cooperation of Kiwa and ETS, the parties aim to enhance the usage of the bio-fertilizers in China. The cooperation will bring technological transformation and support for Kiwa to improve its existing manufacturing techniques. Kiwa and ETS will also collaborate to establish a comprehensive platform for producing, supplying, and marketing in China. Ultimately, Kiwa would look to introduce these products to the international market, including the United States.\\nOn February 27, 2017, the Company has signed a strategic cooperation agreement with the Beijing Zhongpin Agricultural Science and Technology Development Center (“Zhongpin Center”). Zhongpin Center is the Chinese Agricultural Science and Technology Innovation and Development Committee’s executive implementation agency (referred to as the Agricultural Science and Technology Commission). The Agricultural Science and Technology Commission is set up by the Chinese Central Government for the construction of the National Ecological Security Agriculture Industrial Chain standardization system. This includes the establishment of National Ecology Safe Agricultural Industrial Parks to build China’s Ecological Security and Agricultural Industrial in an orderly business environment, including completion of the National Soil Remediation Program and governance of the various government functions of the institutions. Through the guidance and support by the Zhongpin Center, Kiwa will participate and be involved in China’s National Soil Remediation Program and construction of the National Ecological Security Agriculture Industrial Chain Standardization System’s operation and process.\\nOn March 8, 2017, pursuant to the consent of the holders of a majority of the votes entitled to be cast on the matter and the approval of the majority of the directors of the Company, the Company was converted from a Delaware corporation to a Nevada corporation by filing of Articles of Conversion and Articles of Incorporation in the State of Nevada and filing a Certificate of Dissolution in the State of Delaware.\\nOn March 8, 2017, pursuant to the consent of the holders of a majority of the votes entitled to be cast on the matter and the approval of the Kiwa Bio-Tech Products Group Corporation 2016 Employee, Director and Consultant Stock Plan.\\nOn March 13, 2017, Yong Change Wu was removed as a director of the Company by the consent of the holders of a majority of the votes entitled to be cast on the matter and the approval of the majority of the directors of the Company. Immediately thereafter, the Board appointed Yong Lin Song as a director of the Company to be effective immediately.\\n\\n| F-22 |\\n\\n\\n\\n \\n\\nWhat is the total amount spent by the company on research and development, and acquisitions from 2004 to 2016 in US dollars?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 2517503.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 55,\n \"input_length\": 35732\n}"}}},{"rowIdx":56,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nITEM 1. FINANCIAL STATEMENTS\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED BALANCE SHEETS\n(UNAUDITED)\n\n| September 30, | December 31, |\n| (in thousands, except share data) | 2022 | 2021 |\n| ASSETS |\n| Current assets |\n| Cash and cash equivalents | $ | 96,215 | $ | 164,622 |\n| Restricted cash | 18,079 | 16,015 |\n| Accounts receivable, net of allowance for expected credit losses of $ 13,648 and $ 15,916 , respectively | 833,432 | 797,677 |\n| Prepaid expenses and other current assets | 155,429 | 126,000 |\n| Total current assets | 1,103,155 | 1,104,314 |\n| Property and equipment, net | 69,084 | 63,696 |\n| Goodwill | 2,246,053 | 2,206,004 |\n| Other intangible assets, net | 2,150,075 | 2,287,514 |\n| Investments in unconsolidated affiliates | 124,815 | 125,158 |\n| Other assets | 120,644 | 67,582 |\n| Total assets | $ | 5,813,826 | $ | 5,854,268 |\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\n| Current liabilities |\n| Current portion of long-term debt | $ | 14,704 | $ | 14,397 |\n| Accounts payable | 267,684 | 277,366 |\n| Accrued compensation and benefits | 109,935 | 139,157 |\n| Other accrued expenses | 161,246 | 164,133 |\n| Deferred revenues | 47,441 | 50,467 |\n| Total current liabilities | 601,010 | 645,520 |\n| Long-term debt, net of current portion | 2,024,591 | 2,028,882 |\n| Deferred income tax liabilities | 456,755 | 483,165 |\n| Warrant liability | 733 | 22,189 |\n| Other long-term liabilities | 109,421 | 92,218 |\n| Total liabilities | 3,192,510 | 3,271,974 |\n| Commitments and contingencies (Note 10) |\n| Redeemable noncontrolling interest | 3,353 | 1,893 |\n| Equity attributable to stockholders of Advantage Solutions Inc. |\n| Common stock, $ 0.0001 par value, 3,290,000,000 shares authorized; 319,675,888 and 316,963,552 shares issued and outstanding as of September 30, 2022 and December 31, 2021, respectively | 32 | 32 |\n| Additional paid in capital | 3,398,477 | 3,373,278 |\n| Accumulated deficit | ( 823,212 | ) | ( 866,607 | ) |\n| Loans to Karman Topco L.P. | ( 6,357 | ) | ( 6,340 | ) |\n| Accumulated other comprehensive loss | ( 29,978 | ) | ( 4,479 | ) |\n| Treasury stock, at cost; 1,610,014 shares as of September 30, 2022 and December 31, 2021 | ( 12,567 | ) | ( 12,567 | ) |\n| Total equity attributable to stockholders of Advantage Solutions Inc. | 2,526,395 | 2,483,317 |\n| Nonredeemable noncontrolling interest | 91,568 | 97,084 |\n| Total stockholders’ equity | 2,617,963 | 2,580,401 |\n| Total liabilities, redeemable noncontrolling interest, and stockholders’ equity | $ | 5,813,826 | $ | 5,854,268 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n3\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME\n(UNAUDITED)\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (in thousands, except share and per share data) | 2022 | 2021 | 2022 | 2021 |\n| Revenues | $ | 1,051,095 | $ | 928,760 | $ | 2,946,979 | $ | 2,569,735 |\n| Cost of revenues (exclusive of depreciation and amortization shown separately below) | 908,523 | 766,253 | 2,536,256 | 2,117,818 |\n| Selling, general, and administrative expenses | 37,945 | 37,742 | 138,594 | 124,830 |\n| Depreciation and amortization | 57,785 | 59,163 | 173,997 | 181,450 |\n| Total operating expenses | 1,004,253 | 863,158 | 2,848,847 | 2,424,098 |\n| Operating income | 46,842 | 65,602 | 98,132 | 145,637 |\n| Other (income) expenses: |\n| Change in fair value of warrant liability | ( 1,100 | ) | ( 3,491 | ) | ( 21,456 | ) | ( 5,024 | ) |\n| Interest expense, net | 23,557 | 36,490 | 63,628 | 104,544 |\n| Total other expenses | 22,457 | 32,999 | 42,172 | 99,520 |\n| Income before income taxes | 24,385 | 32,603 | 55,960 | 46,117 |\n| Provision for income taxes | 1,158 | 8,276 | 11,523 | 16,582 |\n| Net income | 23,227 | 24,327 | 44,437 | 29,535 |\n| Less: net income attributable to noncontrolling interest | 2,168 | 1,016 | 1,042 | 219 |\n| Net income attributable to stockholders of Advantage Solutions Inc. | 21,059 | 23,311 | 43,395 | 29,316 |\n| Other comprehensive loss, net of tax: |\n| Foreign currency translation adjustments | ( 13,616 | ) | ( 2,443 | ) | ( 25,499 | ) | ( 4,239 | ) |\n| Total comprehensive income attributable to stockholders of Advantage Solutions Inc. | $ | 7,443 | $ | 20,868 | $ | 17,896 | $ | 25,077 |\n| Net income per common share: |\n| Basic | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n| Diluted | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n| Weighted-average number of common shares: |\n| Basic | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\n| Diluted | 319,725,065 | 320,120,634 | 319,190,804 | 319,654,817 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n4\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\n(UNAUDITED)\n\n| Accumulated | Advantage |\n| Common Stock | Treasury Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at July 1, 2022 | 318,465,449 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,390,899 | $ | ( 844,271 | ) | $ | ( 6,351 | ) | $ | ( 16,362 | ) | $ | 2,511,380 | $ | 90,109 | $ | 2,601,489 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | — | — | 21,059 | — | — | 21,059 | 2,092 | 23,151 |\n| Foreign currency translation adjustments | — | — | — | — | — | — | — | ( 13,616 | ) | ( 13,616 | ) | ( 6,824 | ) | ( 20,440 | ) |\n| Total comprehensive income (loss) | 7,443 | ( 4,732 | ) | 2,711 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | — | — | ( 6 | ) | — | ( 6 | ) | — | ( 6 | ) |\n| Increase in noncontrolling interest | — | — | — | — | — | — | — | — | — | 6,191 | 6,191 |\n| Equity-based compensation of Karman Topco L.P. | — | — | — | — | ( 828 | ) | — | — | — | ( 828 | ) | — | ( 828 | ) |\n| Shares issued under 2020 Employee Stock Purchase Plan | 470,786 | — | — | — | 1,667 | — | — | — | 1,667 | — | 1,667 |\n| Shares issued under 2020 Incentive Award Plan | 739,653 | — | — | — | — | — | — | — | — | — | — |\n| Stock-based compensation expense | — | — | — | — | 6,739 | — | — | — | 6,739 | — | 6,739 |\n| Balance at September 30, 2022 | 319,675,888 | $ | 32 | $ | 1,610,014 | $ | ( 12,567 | ) | $ | 3,398,477 | $ | ( 823,212 | ) | $ | ( 6,357 | ) | $ | ( 29,978 | ) | $ | 2,526,395 | $ | 91,568 | $ | 2,617,963 |\n\n\n| Accumulated | Advantage |\n| Common Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at July 1, 2021 | 318,496,390 | $ | 32 | $ | 3,361,262 | $ | ( 915,096 | ) | $ | ( 6,328 | ) | $ | ( 1,122 | ) | $ | 2,438,748 | $ | 95,916 | $ | 2,534,664 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | 23,311 | — | — | 23,311 | 973 | 24,284 |\n| Foreign currency translation adjustments | — | — | — | — | — | ( 2,443 | ) | ( 2,443 | ) | ( 2,305 | ) | ( 4,748 | ) |\n| Total comprehensive income (loss) | 20,868 | ( 1,332 | ) | 19,536 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | ( 6 | ) | — | ( 6 | ) | — | ( 6 | ) |\n| Redemption of noncontrolling interest | — | — | ( 16 | ) | — | — | — | ( 16 | ) | — | ( 16 | ) |\n| Equity-based compensation of Karman Topco L.P. | — | — | ( 6,030 | ) | — | — | — | ( 6,030 | ) | — | ( 6,030 | ) |\n| Shares issued upon exercise of warrants | 1 | — | — | — | — | — | — | — | — |\n| Shares issued under 2020 Employee Stock Purchase Plan | 77,172 | — | 736 | — | — | — | 736 | — | 736 |\n| Stock-based compensation expense | — | — | 8,413 | — | — | — | 8,413 | — | 8,413 |\n| Balance at September 30, 2021 | 318,573,563 | $ | 32 | $ | 3,364,365 | $ | ( 891,785 | ) | $ | ( 6,334 | ) | $ | ( 3,565 | ) | $ | 2,462,713 | $ | 94,584 | $ | 2,557,297 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n5\n\n| Accumulated | Advantage |\n| Common Stock | Treasury Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at January 1, 2022 | 316,963,552 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,373,278 | $ | ( 866,607 | ) | $ | ( 6,340 | ) | $ | ( 4,479 | ) | $ | 2,483,317 | $ | 97,084 | $ | 2,580,401 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | — | — | 43,395 | — | — | 43,395 | 918 | 44,313 |\n| Foreign currency translation adjustments | — | — | — | — | — | — | — | ( 25,499 | ) | ( 25,499 | ) | ( 12,625 | ) | ( 38,124 | ) |\n| Total comprehensive income (loss) | — | — | — | — | — | — | — | — | 17,896 | ( 11,707 | ) | 6,189 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | — | — | ( 17 | ) | — | ( 17 | ) | — | ( 17 | ) |\n| Increase in noncontrolling interest | — | — | — | — | — | — | — | — | — | 6,191 | 6,191 |\n| Equity-based compensation of Karman Topco L.P. | — | — | — | — | ( 7,142 | ) | — | — | — | ( 7,142 | ) | — | ( 7,142 | ) |\n| Shares issued under 2020 Employee Stock Purchase Plan | 713,213 | — | — | — | 3,320 | — | — | — | 3,320 | — | 3,320 |\n| Shares issued under 2020 Incentive Award Plan | 1,999,123 | — | — | — | — | — | — | — | — | — | — |\n| Stock-based compensation expense | — | — | — | — | 29,021 | — | — | — | 29,021 | — | 29,021 |\n| Balance at September 30, 2022 | 319,675,888 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,398,477 | $ | ( 823,212 | ) | $ | ( 6,357 | ) | $ | ( 29,978 | ) | $ | 2,526,395 | $ | 91,568 | $ | 2,617,963 |\n\n\n| Accumulated | Advantage |\n| Common Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at January 1, 2021 | 318,425,182 | $ | 32 | $ | 3,348,546 | $ | ( 921,101 | ) | $ | ( 6,316 | ) | $ | 674 | $ | 2,421,835 | $ | 96,954 | $ | 2,518,789 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | 29,316 | — | — | 29,316 | 190 | 29,506 |\n| Foreign currency translation adjustments | — | — | — | — | — | ( 4,239 | ) | ( 4,239 | ) | ( 2,796 | ) | ( 7,035 | ) |\n| Total comprehensive income (loss) | 25,077 | ( 2,606 | ) | 22,471 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | ( 18 | ) | — | ( 18 | ) | — | ( 18 | ) |\n| Redemption of noncontrolling interest | — | — | ( 452 | ) | — | — | — | ( 452 | ) | 236 | ( 216 | ) |\n| Equity-based compensation of Karman Topco L.P. | — | — | ( 13,140 | ) | — | — | — | ( 13,140 | ) | — | ( 13,140 | ) |\n| Shares issued under 2020 Incentive Award Plan | 24,784 | — | — | — | — | — | — | — | — |\n| Shares issued upon vesting of restricted stock units | 41,424 | — | — | — | — | — | — | — | — |\n| Shares issued under 2020 Employee Stock Purchase Plan | 77,172 | — | 736 | — | — | — | 736 | — | 736 |\n| Shares issued upon exercise of warrants | 5,001 | — | 58 | — | — | — | 58 | — | 58 |\n| Stock-based compensation expense | — | — | 28,617 | — | — | — | 28,617 | — | 28,617 |\n| Balance at September 30, 2021 | 318,573,563 | $ | 32 | $ | 3,364,365 | $ | ( 891,785 | ) | $ | ( 6,334 | ) | $ | ( 3,565 | ) | $ | 2,462,713 | $ | 94,584 | $ | 2,557,297 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n6\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(UNAUDITED)\n\n| Nine Months Ended September 30, |\n| (in thousands) | 2022 | 2021 |\n| CASH FLOWS FROM OPERATING ACTIVITIES |\n| Net income | $ | 44,437 | $ | 29,535 |\n| Adjustments to reconcile net income to net cash provided by operating activities |\n| Noncash interest (income) expense, net | ( 34,419 | ) | 2,893 |\n| Depreciation and amortization | 173,997 | 181,450 |\n| Change in fair value of warrant liability | ( 21,456 | ) | ( 5,024 | ) |\n| Fair value adjustments related to contingent consideration | 5,448 | 6,977 |\n| Deferred income taxes | ( 28,561 | ) | ( 17,468 | ) |\n| Equity-based compensation of Karman Topco L.P. | ( 7,142 | ) | ( 13,140 | ) |\n| Stock-based compensation | 29,906 | 28,617 |\n| Equity in earnings of unconsolidated affiliates | ( 6,480 | ) | ( 6,222 | ) |\n| Distribution received from unconsolidated affiliates | 1,339 | 1,154 |\n| Loss on disposal of property and equipment | 608 | 6,327 |\n| Loss on divestiture | 2,953 | — |\n| Changes in operating assets and liabilities, net of effects from purchases of businesses: |\n| Accounts receivable, net | ( 45,383 | ) | ( 121,036 | ) |\n| Prepaid expenses and other assets | ( 45,087 | ) | ( 64,716 | ) |\n| Accounts payable | ( 7,914 | ) | 37,294 |\n| Accrued compensation and benefits | ( 26,316 | ) | 16,684 |\n| Deferred revenues | ( 156 | ) | 2,869 |\n| Other accrued expenses and other liabilities | 46,176 | 14,874 |\n| Net cash provided by operating activities | 81,950 | 101,068 |\n| CASH FLOWS FROM INVESTING ACTIVITIES |\n| Purchase of businesses, net of cash acquired | ( 74,146 | ) | ( 40,046 | ) |\n| Purchase of investment in unconsolidated affiliates | ( 775 | ) | ( 2,000 | ) |\n| Purchase of property and equipment | ( 30,037 | ) | ( 24,106 | ) |\n| Proceeds from divestiture | 1,896 | — |\n| Net cash used in investing activities | ( 103,062 | ) | ( 66,152 | ) |\n| CASH FLOWS FROM FINANCING ACTIVITIES |\n| Borrowings under lines of credit | 140,333 | 51,685 |\n| Payments on lines of credit | ( 139,684 | ) | ( 102,493 | ) |\n| Proceeds from issuance of long-term debt | 266 | — |\n| Principal payments on long-term debt | ( 10,427 | ) | ( 10,133 | ) |\n| Proceeds from issuance of common stock | 3,320 | 794 |\n| Contingent consideration payments | ( 23,164 | ) | ( 6,247 | ) |\n| Holdback payments | ( 8,557 | ) | ( 2,389 | ) |\n| Contribution from noncontrolling interest | 5,217 | — |\n| Redemption of noncontrolling interest | ( 224 | ) | ( 216 | ) |\n| Net cash used in financing activities | ( 32,920 | ) | ( 68,999 | ) |\n| Net effect of foreign currency changes on cash | ( 12,311 | ) | ( 1,476 | ) |\n| Net change in cash, cash equivalents and restricted cash | ( 66,343 | ) | ( 35,559 | ) |\n| Cash, cash equivalents and restricted cash, beginning of period | 180,637 | 219,966 |\n| Cash, cash equivalents and restricted cash, end of period | $ | 114,294 | $ | 184,407 |\n| SUPPLEMENTAL CASH FLOW INFORMATION |\n| Purchase of property and equipment recorded in accounts payable and accrued expenses | $ | 1,409 | $ | 322 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n7\nADVANTAGE SOLUTIONS INC.\nNOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(UNAUDITED)\n1. Organization and Significant Accounting Policies Advantage Solutions Inc. (the “Company”) is a provider of outsourced solutions to consumer goods companies and retailers. The Company’s Class A common stock is listed on the Nasdaq Global Select Market under the symbol “ADV” and warrants to purchase the Class A common stock at an exercise price of $ 11.50 per share are listed on the Nasdaq Global Select Market under the symbol “ADVWW”. Basis of Presentation The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its subsidiaries. The unaudited condensed consolidated financial statements do not include all of the information required by accounting principles generally accepted in the United States (“GAAP”). The Condensed Consolidated Balance Sheet at December 31, 2021 was derived from the audited Consolidated Balance Sheet at that date and does not include all the disclosures required by GAAP. In the opinion of management, all adjustments which are of a normal recurring nature and necessary for a fair statement of the results as of September 30, 2022 and for the three and nine months ended September 30, 2022 and 2021 have been reflected in the condensed consolidated financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements as of and for the year ended December 31, 2021 and the related footnotes thereto. Operating results for the three and nine months ended September 30, 2022 are not necessarily indicative of the results to be expected during the remainder of the current year or for any future period. COVID-19 Pandemic Beginning in March 2020 and continuing through the first quarter of 2021, the Company’s services experienced the most severe effects from reductions in client spending due to the economic impact related to the COVID-19 pandemic. While mixed by services and geography, the spending reductions impacted all of the Company’s services and markets. Globally, the most impacted services were the Company's experiential services. Most services began to recover in April 2021, and the recovery has continued through the third quarter of 2022. Impact of the War in Ukraine The Company has a minority interest in a European company that has majority-ownership interests in local agencies in Russia. During the first quarter of 2022, the war in Ukraine resulted in the imposition of sanctions by the United States, the United Kingdom, and the European Union, that affected, and continues to affect, the cross-border operations of businesses operating in Russia. In addition, Russian regulators have imposed currency restrictions and regulations that created uncertainty regarding the Company's ability to recover its investment in operations in Russia, as well as the Company's ability to exercise control or influence over operations by the local agencies in Russia. As a result, the Company intends to use its influence to cause the European company to dispose of its ownership interests in the local agencies in Russia. Accordingly, the Company recorded pretax charges of $ 2.8 million in the first quarter of 2022, primarily consisting of its proportionate share of the net investment in its Russian interest in “Selling, general, and administrative expenses” in the Condensed Consolidated Statements of Operations and Comprehensive Income. Recent Accounting StandardsAccounting Standards Recently Adopted by the CompanyIn March 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on 8 Financial Reporting. This guidance provides optional expedients and exceptions for GAAP to contracts, hedging relationships, and other transactions that reference the London Interbank Offered Rate (“LIBOR”) or another reference rate if certain criteria are met. The amendments in this update are effective for reporting periods that include or are subsequent to March 12, 2020 and must be applied prospectively to contract modifications and hedging relationships through December 31, 2022. On April 1, 2022, the Company adopted the standard prospectively and determined that the adoption of this accounting guidance did not have a material impact on its condensed consolidated financial statements.On January 1, 2022, the Company adopted ASU No. 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity (“ASU 2020-06”), which simplifies accounting for convertible instruments by removing major separation models required under current GAAP, simplifies the contract settlement assessment for equity classification, requires the use of the if-converted method for all convertible instruments in the diluted earnings per share calculation and expands disclosure requirements. The adoption of this accounting standard, under the full retrospective method, did not have a material impact on the Company's condensed consolidated financial statements and use of the if-converted method did not have an impact on the Company's overall earnings per share calculation.On January 1, 2022, the Company adopted ASU 2021-04, Earnings Per Share (Topic 260), Debt—Modifications and Extinguishments (Subtopic 470-50), Compensation—Stock Compensation (Topic 718), and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Issuer’s Accounting for Certain Modifications or Exchanges of Freestanding Equity-Classified Written Call Options (a consensus of the FASB Emerging Issues Task Force). The guidance clarifies certain aspects of the current guidance to promote consistency among reporting of an issuer’s accounting for modifications or exchanges of freestanding equity-classified written call options (for example, warrants) that remain equity-classified after modification or exchange. The guidance is applied prospectively to all modifications or exchanges that occur on or after the date of adoption and the adoption of this accounting standard did not have a material impact on the Company’s condensed consolidated financial statements.On January 1, 2022, the Company adopted ASU 2021-10, Government Assistance (Topic 832): Disclosures by Business Entities about Government Assistance. This update requires annual disclosures about transactions with a government that are accounted for by applying a grant or contribution accounting model by analogy. The guidance is applied prospectively to all transactions within the scope of the amendments that are reflected in financial statements at the date of initial application and new transactions that are entered into after the date of initial application. The adoption of this accounting standard did not have a material impact on the Company’s condensed consolidated financial statements. Accounting Standards Recently Issued but Not Yet Adopted by the CompanyIn October 2021, the FASB issued ASU 2021-08, Business Combinations (Topic 606): Accounting for Contract Assets and Contract Liabilities from Contracts with Customers, which requires that an entity recognize and measure contract assets and contract liabilities acquired in a business combination in accordance with Topic 606 as if it had originated the contracts. Generally, this should result in an acquirer recognizing and measuring the acquired contract assets and contract liabilities consistent with how they were recognized and measured in the acquiree’s financial statements, if the acquiree prepared financial statements in accordance with GAAP. The amendment in this update is effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. The guidance should be applied prospectively to business combinations occurring on or after the effective date of the amendment in this update. The Company is evaluating the potential impact of this adoption on its consolidated financial statements. All other new accounting pronouncements issued, but not yet effective or adopted have been deemed to be not relevant to the Company and, accordingly, are not expected to have a material impact once adopted.\n9\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Sales brand-centric services | $ | 343,478 | $ | 330,740 | $ | 1,005,707 | $ | 946,147 |\n| Sales retail-centric services | 302,768 | 266,399 | 836,640 | 746,960 |\n| Total sales revenues | 646,246 | 597,139 | 1,842,347 | 1,693,107 |\n| Marketing brand-centric services | 143,241 | 142,554 | 393,155 | 381,358 |\n| Marketing retail-centric services | 261,608 | 189,067 | 711,477 | 495,270 |\n| Total marketing revenues | 404,849 | 331,621 | 1,104,632 | 876,628 |\n| Total revenues | $ | 1,051,095 | $ | 928,760 | $ | 2,946,979 | $ | 2,569,735 |\n\n| (in thousands) |\n| Consideration: |\n| Cash | $ | 74,146 |\n| Holdback | 810 |\n| Fair value of contingent consideration | 510 |\n| Total consideration | $ | 75,466 |\n| Recognized amounts of identifiable assets acquired and liabilities assumed: |\n| Assets |\n| Accounts receivable | $ | 9,409 |\n| Other assets | 3,446 |\n| Identifiable intangible assets | 25,546 |\n| Total assets | 38,401 |\n| Liabilities |\n| Accounts payable | 7,363 |\n| Deferred tax liabilities and other | 8,744 |\n| Total liabilities | 16,107 |\n| Redeemable noncontrolling interest | 1,987 |\n| Noncontrolling interest | 974 |\n| Total identifiable net assets | 19,333 |\n| Goodwill arising from acquisitions | $ | 56,133 |\n| (in thousands) | Amount | WeightedAverageUseful Life |\n| Client relationships | $ | 24,413 | 6 years |\n| Trade names | 1,133 | 10 years |\n| Total identifiable intangible assets | $ | 25,546 |\n| (in thousands) |\n| Consideration |\n| Cash | $ | 40,046 |\n| Holdbacks | 13,599 |\n| Fair value of contingent consideration | 19,883 |\n| Total consideration | $ | 73,528 |\n| Recognized amounts of identifiable assets acquired and liabilities assumed: |\n| Assets |\n| Accounts receivable | $ | 12,834 |\n| Other assets | 4,400 |\n| Property and equipment | 1,001 |\n| Identifiable intangible assets | 36,210 |\n| Total assets | 54,445 |\n| Liabilities |\n| Total liabilities | 21,758 |\n| Redeemable noncontrolling interest | 1,804 |\n| Total identifiable net assets | 30,883 |\n| Goodwill arising from acquisitions | $ | 42,645 |\n| (in thousands) | Amount | WeightedAverageUseful Life |\n| Client relationships | $ | 27,860 | 7 years |\n| Trade Names | 5,250 | 5 years |\n| Developed technology | 3,100 | 7 years |\n| Total identifiable intangible assets | $ | 36,210 |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Revenues | $ | 1,052,274 | $ | 963,576 | $ | 2,962,479 | $ | 2,719,111 |\n| Net income | $ | 21,467 | $ | 23,896 | $ | 46,461 | $ | 32,590 |\n\n\n| Sales | Marketing | Total |\n| (in thousands) |\n| Balance at January 1, 2021 | $ | 1,462,378 | $ | 700,961 | $ | 2,163,339 |\n| Acquisitions | 32,087 | 13,315 | 45,402 |\n| Measurement period adjustments | 179 | ( 1,043 | ) | ( 864 | ) |\n| Foreign exchange translation effects | ( 1,873 | ) | — | ( 1,873 | ) |\n| Balance at December 31, 2021 | $ | 1,492,771 | $ | 713,233 | $ | 2,206,004 |\n| Acquisitions | 5,672 | 50,461 | 56,133 |\n| Measurement period adjustments | ( 446 | ) | — | ( 446 | ) |\n| Foreign exchange translation effects | ( 15,638 | ) | — | ( 15,638 | ) |\n| Balance at September 30, 2022 | $ | 1,482,359 | $ | 763,694 | $ | 2,246,053 |\n| September 30, 2022 |\n| (amounts in thousands) | Weighted Average Useful Life | Gross CarryingValue | AccumulatedAmortization | Net Carrying Value |\n| Finite-lived intangible assets: |\n| Client relationships | 14 years | $ | 2,486,064 | $ | 1,290,842 | $ | 1,195,222 |\n| Trade names | 8 years | 135,271 | 84,067 | 51,204 |\n| Developed technology | 5 years | 13,260 | 9,870 | 3,390 |\n| Covenant not to compete | 5 years | 6,100 | 5,841 | 259 |\n| Total finite-lived intangible assets | 2,640,695 | 1,390,620 | 1,250,075 |\n| Indefinite-lived intangible assets: |\n| Trade names | 900,000 | — | 900,000 |\n| Total other intangible assets | $ | 3,540,695 | $ | 1,390,620 | $ | 2,150,075 |\n| December 31, 2021 |\n| (amounts in thousands) | Weighted Average Useful Life | Gross CarryingValue | AccumulatedAmortization | Net Carrying Value |\n| Finite-lived intangible assets: |\n| Client relationships | 14 years | $ | 2,480,167 | $ | 1,158,732 | $ | 1,321,435 |\n| Trade names | 8 years | 138,206 | 78,355 | 59,851 |\n| Developed technology | 5 years | 13,260 | 8,206 | 5,054 |\n| Covenant not to compete | 5 years | 6,100 | 4,926 | 1,174 |\n| Total finite-lived intangible assets | 2,637,733 | 1,250,219 | 1,387,514 |\n| Indefinite-lived intangible assets: |\n| Trade names | 900,000 | — | 900,000 |\n| Total other intangible assets | $ | 3,537,733 | $ | 1,250,219 | $ | 2,287,514 |\n| (in thousands) |\n| Remainder of 2022 | $ | 49,782 |\n| 2023 | 197,530 |\n| 2024 | 196,181 |\n| 2025 | 190,153 |\n| 2026 | 186,203 |\n| Thereafter | 430,226 |\n| Total amortization expense | $ | 1,250,075 |\n\n\n| September 30, | December 31, |\n| (in thousands) | 2022 | 2021 |\n| Term Loan Facility | $ | 1,301,813 | $ | 1,311,750 |\n| Notes | 775,000 | 775,000 |\n| Government loans for COVID-19 relief | 4,113 | 5,212 |\n| Other | 1,492 | 1,113 |\n| Total long-term debt | 2,082,418 | 2,093,075 |\n| Less: current portion | 14,704 | 14,397 |\n| Less: debt issuance costs | 43,123 | 49,796 |\n| Long-term debt, net of current portion | $ | 2,024,591 | $ | 2,028,882 |\n\n| September 30, 2022 |\n| (in thousands) | Fair Value | Level 1 | Level 2 | Level 3 |\n| Assets measured at fair value |\n| Derivative financial instruments | $ | 49,149 | $ | — | $ | 49,149 | $ | — |\n| Total assets measured at fair value | $ | 49,149 | $ | — | $ | 49,149 | $ | — |\n| Liabilities measured at fair value |\n| Warrant liability | $ | 733 | $ | — | $ | 733 | $ | — |\n| Contingent consideration liabilities | 40,431 | — | — | 40,431 |\n| Total liabilities measured at fair value | $ | 41,164 | $ | — | $ | 733 | $ | 40,431 |\n| December 31, 2021 |\n| (in thousands) | Fair Value | Level 1 | Level 2 | Level 3 |\n| Assets measured at fair value |\n| Derivative financial instruments | $ | 10,164 | $ | — | $ | 10,164 | $ | — |\n| Total assets measured at fair value | $ | 10,164 | $ | — | $ | 10,164 | $ | — |\n| Liabilities measured at fair value |\n| Derivative financial instruments | $ | 385 | $ | — | $ | 385 | $ | — |\n| Warrant liability | 22,189 | — | — | 22,189 |\n| Contingent consideration liabilities | 58,366 | — | — | 58,366 |\n| Total liabilities measured at fair value | $ | 80,940 | $ | — | $ | 385 | $ | 80,555 |\n| September 30, |\n| (in thousands) | 2022 | 2021 |\n| Beginning of the period | $ | 58,366 | $ | 45,901 |\n| Fair value of acquisitions | 510 | 19,883 |\n| Changes in fair value | 5,448 | 6,977 |\n| Payments | ( 23,164 | ) | ( 6,399 | ) |\n| Measurement period adjustments | — | ( 1,181 | ) |\n| Foreign exchange translation effects | ( 729 | ) | ( 69 | ) |\n| End of the period | $ | 40,431 | $ | 65,112 |\n| (in thousands) | Carrying Value | Fair Value(Level 2) |\n| Balance at September 30, 2022 |\n| Term Loan Facility | $ | 1,301,813 | $ | 1,329,741 |\n| Notes | 775,000 | 723,486 |\n| Government loans for COVID-19 relief | 4,113 | 4,306 |\n| Other | 1,492 | 1,492 |\n| Total long-term debt | $ | 2,082,418 | $ | 2,059,025 |\n| (in thousands) | Carrying Value | Fair Value(Level 2) |\n| Balance at December 31, 2021 |\n| Term Loan Facility | $ | 1,311,750 | $ | 1,406,552 |\n| Notes | 775,000 | 894,611 |\n| Government loans for COVID-19 relief | 5,212 | 5,615 |\n| Other | 1,113 | 1,113 |\n| Total long-term debt | $ | 2,093,075 | $ | 2,307,891 |\n\n\n| Revenues | Accounts Receivable |\n| Three Months Ended September 30, | Nine Months Ended September 30, | As of September 30, | As of December 31, |\n| (in thousands) | 2022 | 2021 | 2022 | 2021 | 2022 | 2021 |\n| Client 1 | $ | 450 | $ | — | $ | 1,275 | $ | — | $ | 301 | $ | 176 |\n| Client 2 | 136 | 42 | 668 | 75 | 289 | 160 |\n| Client 3 | 147 | 124 | 455 | 457 | 129 | 190 |\n| All other clients | 30 | 1,452 | 152 | 6,694 | 16 | 10 |\n| Total | $ | 763 | $ | 1,618 | $ | 2,550 | $ | 7,226 | $ | 735 | $ | 536 |\n\n8. Income TaxesThe Company’s effective tax rates were 4.7 % and 25.4 % for the three months ended September 30, 2022 and 2021, respectively. The effective tax rate is based upon the estimated income or loss before taxes for the year, by jurisdiction, and adjusted for estimated permanent tax adjustments. The fluctuation in the Company’s effective tax rate was primarily due to the three months pretax book income differences and the discrete impact of $ 5.0 million to remeasure the deferred tax liability as a result of a reduction in the Company's blended state tax rate driven primarily by a Pennsylvania statutory tax rate change for the three months ended September 30, 2022, no t included in the three months ended September 30, 2021.The Company’s effective tax rates were 20.6 % and 36.0 % for the nine months ended September 30, 2022 and 2021, respectively. The effective tax rate is based upon the estimated income or loss before taxes for the year, by jurisdiction, and adjusted for estimated permanent tax adjustments. The fluctuation in the Company’s effective tax rate was primarily due to the nine months pretax book income differences, the discrete impact of $ 5.0 million to remeasure the deferred tax liability as a result of a reduction in the Company's blended state tax rate driven primarily by a Pennsylvania statutory tax rate change for the nine months ended September 30, 2022, offset by a shortfall adjustment of $ 2.4 million of stock based compensation for the nine months ended September 30, 2022. On August 16, 2022, the U.S. government enacted the Inflation Reduction Act (“IRA”), which imposes a new corporate alternative minimum tax (“CAMT”), an excise tax on stock buybacks, and significant tax incentives for energy and climate initiatives, among other provisions. The Company does not expect the CAMT to have a material impact on its consolidated financial statements.\n| (in thousands) | Sales | Marketing | Total |\n| Three Months Ended September 30, 2022 |\n| Revenues | $ | 646,246 | $ | 404,849 | $ | 1,051,095 |\n| Depreciation and amortization | $ | 39,798 | $ | 17,987 | $ | 57,785 |\n| Operating income | $ | 31,765 | $ | 15,077 | $ | 46,842 |\n| Three Months Ended September 30, 2021 |\n| Revenues | $ | 597,139 | $ | 331,621 | $ | 928,760 |\n| Depreciation and amortization | $ | 41,515 | $ | 17,648 | $ | 59,163 |\n| Operating income | $ | 51,906 | $ | 13,696 | $ | 65,602 |\n| (in thousands) | Sales | Marketing | Total |\n| Nine Months Ended September 30, 2022 |\n| Revenues | $ | 1,842,347 | $ | 1,104,632 | $ | 2,946,979 |\n| Depreciation and amortization | $ | 121,310 | $ | 52,687 | $ | 173,997 |\n| Operating income | $ | 65,915 | $ | 32,217 | $ | 98,132 |\n| Nine Months Ended September 30, 2021 |\n| Revenues | $ | 1,693,107 | $ | 876,628 | $ | 2,569,735 |\n| Depreciation and amortization | $ | 128,789 | $ | 52,661 | $ | 181,450 |\n| Operating income | $ | 131,727 | $ | 13,910 | $ | 145,637 |\n\n10. Commitments and ContingenciesLitigationThe Company is involved in various legal matters that arise in the ordinary course of its business. Some of these legal matters purport or may be determined to be class and/or representative actions, or seek substantial damages, or penalties. The Company has accrued amounts in connection with certain legal matters, including with respect to certain of the matters described below. There can be no assurance, however, that these accruals will be sufficient to cover such matters or other legal matters or that such matters or other legal matters will not materially or adversely affect the Company’s financial position, liquidity, or results of operations.Employment MattersThe Company has also been involved in various litigation, including purported class or representative actions with respect to matters arising under the California Labor Code and Private Attorneys General Act. The Company has retained outside counsel to represent it in these matters and is vigorously defending its interests. Legal Matters Related to Take 5On April 1, 2018, the Company acquired certain assets and assumed liabilities of Take 5 Media Group (“Take 5”). In June 2019, as a result of a review of internal allegations related to inconsistency of data provided by Take 5 to its clients, the Company commenced an investigation into Take 5’s operations. In July 2019, as a result of the Company’s investigation, the Company determined that revenue during the fiscal year ended December 31, 2018 attributable to the Take 5 business had been recognized for services that were not performed on behalf of clients of Take 5 and that inaccurate reports were made to Take 5 clients about those services (referred to as the “Take 5 Matter”). As a result of these findings, in July 2019, the Company terminated all operations of Take 5, including the use of its associated trade names and the offering of its services to its clients and offered refunds to Take 5 clients of collected revenues attributable to Take 5 since the Company’s acquisition of Take 5. 20 USAO and FBI Voluntary Disclosure and Investigation Related to Take 5The Company voluntarily disclosed to the United States Attorney’s Office and the Federal Bureau of Investigation certain misconduct occurring at Take 5, a line of business that the Company closed in July 2019. The Company intends to cooperate in this and any other governmental investigations that may arise in connection with the Take 5 Matter. At this time, the Company cannot predict the ultimate outcome of any investigation related to the Take 5 Matter and is unable to estimate the potential impact such an investigation may have on the Company. Arbitration Proceedings Related to Take 5In August 2019, as a result of the Take 5 Matter, the Company provided a written indemnification claim notice to the sellers of Take 5 (the “Take 5 Sellers”) seeking monetary damages (including interest, fees and costs) based on allegations of breach of the asset purchase agreement (the “Take 5 APA”), as well as fraud. In September 2019, the Take 5 Sellers initiated arbitration proceedings against the Company, alleging breach of the Take 5 APA as a result of the Company’s decision to terminate the operations of the Take 5 business, and seeking monetary damages equal to all unpaid earn-out payments under the Take 5 APA (plus interest, fees and costs). In 2020, the Take 5 sellers amended their statement of claim to allege defamation, relating to statements the Company made to customers in connection with terminating the operations of the Take 5 business, and seeking monetary damages for the alleged injury to their reputation. The Company filed its response to the Take 5 Sellers’ claims, and asserted indemnification, fraud and other claims against the Take 5 Sellers as counterclaims and cross-claims in the arbitration proceedings. In October 2022, the arbitrator made a final award in favor of the Company. The Company is currently unable to estimate if or when it will be able to collect any amounts associated with this arbitration. Other Legal Matters Related to Take 5The Take 5 Matter may result in additional litigation against the Company, including lawsuits from clients, or governmental investigations, which may expose the Company to potential liability in excess of the amounts being offered by the Company as refunds to Take 5 clients. The Company is currently unable to determine the amount of any potential liability, costs or expenses (above the amounts already being offered as refunds) that may result from any lawsuits or investigations associated with the Take 5 Matter or determine whether any such issues will have any future material adverse effect on the Company’s financial position, liquidity, or results of operations. Although the Company has insurance covering certain liabilities, the insurance may not be sufficient to cover any potential liability or expenses associated with the Take 5 Matter.\n| (in thousands, except share and per share data) Performance Period | Number ofSharesThreshold | Number ofSharesTarget | Number ofSharesMaximum | WeightedAverage FairValue perShare | Maximum Remaining Unrecognized Compensation Expense | Weighted-average remaining requisite service periods |\n| January 1, 2022— December 31, 2022 | 2,479,997 | 4,959,993 | 7,439,990 | $ | 5.63 | $ | 80,689 | 1.5 years |\n| January 1, 2021— December 31, 2021 | 1,121,698 | 1,121,698 | 1,319,458 | $ | 13.17 | $ | 4,982 | 1.1 years |\n| Performance Share Units | Weighted Average GrantDate Fair Value |\n| Outstanding at January 1, 2022 | 2,609,079 | $ | 13.07 |\n| Granted | 5,393,085 | $ | 5.66 |\n| Distributed | 660,880 | $ | 13.09 |\n| Forfeited | 684,261 | $ | 8.19 |\n| PSU performance adjustment | ( 377,572 | ) | $ | 11.19 |\n| Outstanding at September 30, 2022 | 6,279,451 | $ | 7.22 |\n| Number of RSUs | Weighted Average GrantDate Fair Value |\n| Outstanding at January 1, 2022 | 3,660,553 | $ | 10.64 |\n| Granted | 6,302,801 | $ | 5.74 |\n| Distributed | 1,338,213 | $ | 10.61 |\n| Forfeited | 869,955 | $ | 8.02 |\n| Outstanding at September 30, 2022 | 7,755,186 | $ | 6.96 |\n| September 30, |\n| 2022 |\n| Share Price | $ | 5.99 |\n| Dividend yield | 0.0 | % |\n| Expected volatility | 30.0 | % |\n| Risk-free interest rate | 2.0 | % |\n| Expected term (years) | 6.5 |\n\n\n| (in thousands) |\n| Balance at January 1, 2022 | $ | 1,893 |\n| Fair value at acquisition | 1,987 |\n| Net income attributable to redeemable noncontrolling interests | 124 |\n| Dividend distribution | ( 223 | ) |\n| Foreign currency translation adjustment | ( 428 | ) |\n| Balance at September 30, 2022 | $ | 3,353 |\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (in thousands, except share and earnings per share data) | 2022 | 2021 | 2022 | 2021 |\n| Basic earnings per share computation: |\n| Numerator: |\n| Net income attributable to stockholders of Advantage Solutions Inc. | $ | 21,059 | $ | 23,311 | $ | 43,395 | $ | 29,316 |\n| Denominator: |\n| Weighted average common shares - basic | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\n| Basic earnings per common share | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n| Diluted earnings per share computation: |\n| Numerator: |\n| Net income attributable to stockholders of Advantage Solutions Inc. | $ | 21,059 | $ | 23,311 | $ | 43,395 | $ | 29,316 |\n| Denominator: |\n| Weighted average common shares outstanding | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\n| Performance and Restricted Stock Units | 602,566 | 1,450,668 | 496,968 | 1,335,011 |\n| Employee stock purchase plan and stock options | 300,604 | 106,469 | 348,271 | 106,469 |\n| Weighted average common shares - diluted | 319,725,065 | 320,120,634 | 319,190,804 | 319,654,817 |\n| Diluted earnings per common share | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n\n24\n14. Subsequent EventsIn October 2022, the Company granted 2,153,900 RSUs and 1,170,000 stock options, with an estimated aggregate grant date fair value of $ 4.8 million and $ 1.2 million, respectively.\n25\n\nITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nForward-Looking Statements\nThis Quarterly Report on Form 10-Q (this “Quarterly Report”), including the section titled “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements that are based on current expectations, estimates, forecasts and projections about us, our future performance, our business, our beliefs and our management’s assumptions. Such words as “expect,” “anticipate,” “outlook,” “could,” “target,” “project,” “intend,” “plan,” “believe,” “seek,” “estimate,” “should,” “may,” “assume” and “continue” as well as variations of such words and similar expressions are intended to identify such forward-looking statements, although not all forward-looking statements contain such terms. These statements are not guarantees of future performance and they involve certain risks, uncertainties and assumptions that are difficult to predict. We have based our forward-looking statements on our management’s beliefs and assumptions based on information available to our management at the time the statements are made. We caution you that actual outcomes and results may differ materially from what is expressed, implied or forecasted by our forward-looking statements. More information regarding these risks and uncertainties and other important factors that could cause actual results to differ materially from those in the forward-looking statements is set forth in Part II, Item 1A “Risk Factors” of this report. Investors are cautioned not to place undue reliance on any such forward-looking statements, which speak only as of the date they are made. Except as required under the federal securities laws and the rules and regulations of the Securities and Exchange Commission, we do not have any intention or obligation to update publicly any forward-looking statements after the distribution of this report, whether as a result of new information, future events, changes in assumptions or otherwise.\nExecutive Overview\nWe are a leading business solutions provider to consumer goods manufacturers and retailers. We have a strong platform of competitively advantaged sales and marketing services built over multiple decades – essential, business critical services like headquarter sales, retail merchandising, in-store sampling, digital commerce and shopper marketing. For brands and retailers of all sizes, we help get the right products on the shelf (whether physical or digital) and into the hands of consumers (however they shop). We use a scaled platform to innovate as a trusted partner with our clients, solving problems to increase their efficiency and effectiveness across a broad range of channels.\nWe have two reportable segments: sales and marketing.\nThrough our sales segment, which generated approximately 62.5% and 65.9% of our total revenues in the nine months ended September 30, 2022 and 2021, respectively, we offer headquarter sales representation services to consumer goods manufacturers, for whom we prepare and present to retailers a business case to increase distribution of manufacturers’ products and optimize how they are displayed, priced and promoted. We also make in-store merchandising visits for both manufacturer and retailer clients to ensure the products we represent are adequately stocked and properly displayed.\nThrough our marketing segment, which generated approximately 37.5% and 34.1% of our total revenues in the nine months ended September 30, 2022 and 2021, respectively, we help brands and retailers reach consumers through two main categories within the marketing segment. The first and largest category is our retail experiential business, also known as in-store sampling or demonstrations, where we manage highly customized large-scale sampling programs (both in-store and online) for leading retailers. The second category is our collection of specialized agency services, in which we provide private label services to retailers and develop granular marketing programs for brands and retailers through our shopper, consumer and digital marketing agencies.\n26\nBusiness Combination with Conyers Park\nOn October 28, 2020, Conyers Park II Acquisition Corp. (“Conyers Park”), a Delaware corporation, consummated a merger with ASI Intermediate Corp. (“ASI”), formerly known as Advantage Solutions Inc., with ASI surviving the merger as a wholly owned subsidiary of Conyers Park (the “Merger” and, together with the other transactions contemplated by the merger agreement, the “Transactions”). On October 28, 2020, and in connection with the closing of the Transactions, Conyers Park changed its name to Advantage Solutions Inc.\nImpacts of the COVID-19 Pandemic\nBeginning in March 2020 and continuing through the first quarter of 2021, our services experienced the effects from reductions in client spending due to the economic impact related to the COVID-19 pandemic. While mixed by services and geography, the spending reductions impacted all of our services and markets. Globally, the most impacted services were our experiential services. Most services began to improve in April 2021, and the improvement has continued through the third quarter of 2022.\nSummary\nOur financial performance for the three months ended September 30, 2022 as compared to the three months ended September 30, 2021 includes:\n•Revenues increased by $122.3 million, or 13.2%, to $1,051.1 million;\n•Operating income decreased by $18.8 million, or 28.6%, to $46.8 million;\n•Net income decreased by $1.1 million, or 4.5% to $23.2 million;\n•Adjusted Net Income increased by $3.6 million, or 6.1%, to $62.7 million; and\n•Adjusted EBITDA decreased by $15.5 million, or 11.6%, to $118.3 million.\nOur financial performance for the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021 includes:\n•Revenues increased by $377.2 million, or 14.7% to $2,947.0 million;\n•Operating income decreased by $47.5 million, or 32.6% to $98.1 million;\n•Net income increased by $14.9 million, or 50.5% to $44.4 million;\n•Adjusted Net Income increased by $5.8 million, or 3.9% to $152.5 million; and\n•Adjusted EBITDA decreased by $43.8 million, or 11.9% to $323.3 million.\nDuring the nine months ended September 30, 2022, we acquired four businesses. The aggregate purchase price was $75.5 million, of which $74.1 million was paid in cash, $0.5 million in contingent consideration and $0.8 million in holdback.\nFactors Affecting Our Business and Financial Reporting\nThere are a number of factors, in addition to the impact of the COVID-19 pandemic and inflation, that affect the performance of our business and the comparability of our results from period to period including:\n•Organic Growth. Part of our strategy is to generate organic growth by expanding our existing client relationships, continuing to win new clients, pursuing channel expansion and new industry opportunities, enhancing our digital technology solutions, developing our international platform, delivering operational efficiencies and expanding into logical adjacencies. We believe that by pursuing\n27\nthese organic growth opportunities we will be able to continue to enhance our value proposition to our clients and thereby grow our business.\n•Acquisitions. We have grown and expect to continue to grow our business in part by acquiring quality businesses, both domestic and international. Excluding the 2017 acquisition of Daymon Worldwide Inc., we have completed 73 acquisitions from January 2014 to November 9, 2022, ranging in purchase prices from approximately $0.3 million to $98.5 million. Many of our acquisition agreements include contingent consideration arrangements, which are described below. We have completed acquisitions at what we believe are attractive purchase prices and have regularly structured our agreements to result in the generation of long-lived tax assets, which have in turn reduced our effective purchase prices when incorporating the value of those tax assets. We continue to look for strategic acquisitions that can be completed at attractive purchase prices.\n•Contingent Consideration. Many of our acquisition agreements include contingent consideration arrangements, which are generally based on the achievement of financial performance thresholds by the operations attributable to the acquired businesses. The contingent consideration arrangements are based upon our valuations of the acquired businesses and are intended to share the investment risk with the sellers of such businesses if projected financial results are not achieved. The fair values of these contingent consideration arrangements are included as part of the purchase price of the acquired companies on their respective acquisition dates. For each transaction, we estimate the fair value of contingent consideration payments as part of the initial purchase price. We review and assess the estimated fair value of contingent consideration on a quarterly basis, and the updated fair value could differ materially from our initial estimates. Adjustments to the estimated fair value related to changes in all other unobservable inputs are reported in “Selling, general and administrative expenses” in our Condensed Consolidated Statements of Operations and Comprehensive Income.\n•Depreciation and Amortization. As a result of the acquisition of our business by Karman Topco L.P. (“Topco”) on July 25, 2014 (the “2014 Topco Acquisition”), we acquired significant intangible assets, the value of which is amortized, on a straight-line basis, over 15 years from the date of the 2014 Topco Acquisition, unless determined to be indefinite-lived. The amortization of such intangible assets recorded in our consolidated financial statements has a significant impact on our operating income (loss) and net income (loss). Our historical acquisitions have increased, and future acquisitions likely will increase, our intangible assets. We do not believe the amortization expense associated with the intangibles created from our purchase accounting adjustments reflect a material economic cost to our business. Unlike depreciation expense which has an economic cost reflected by the fact that we must re-invest in property and equipment to maintain the asset base delivering our results of operations, we do not have any capital re-investment requirements associated with the acquired intangibles, such as client relationships and trade names, that comprise the majority of the finite-lived intangibles that create our amortization expense.\n•Foreign Exchange Fluctuations. Our financial results are affected by fluctuations in the exchange rate between the U.S. dollar and other currencies, primarily Canadian dollars, British pounds and euros, due to our operations in such foreign jurisdictions. See also “ —Quantitative and Qualitative Disclosure of Market Risk—Foreign Currency Risk.”\n•Seasonality. Our quarterly results are seasonal in nature, with the fourth fiscal quarter typically generating a higher proportion of our revenues than other fiscal quarters, as a result of higher consumer spending. We generally record slightly lower revenues in the first fiscal quarter of each year, as our clients begin to roll out new programs for the year, and consumer spending generally is less in the first fiscal quarter than other quarters. Timing of our clients’ marketing expenses, associated with marketing campaigns and new product launches, can also result in fluctuations from one quarter to another.\n28\nHow We Assess the Performance of Our Business\nRevenues\nRevenues related to our sales segment are primarily comprised of commissions, fee-for-service and cost-plus fees for providing retail merchandising services, category and space management, headquarter relationship management, technology solutions and administrative services. A small portion of our arrangements include performance incentive provisions, which allow us to earn additional revenues on our performance relative to specified quantitative or qualitative goals. We recognize the incentive portion of revenues under these arrangements when the related services are transferred to the customer.\nMarketing segment revenues are primarily recognized in the form of a fee-for-service (including retainer fees, fees charged to clients based on hours incurred, project-based fees or fees for executing in-person consumer engagements or experiences, which engagements or experiences we refer to as events), commissions or on a cost-plus basis, in each case, related to services including experiential marketing, shopper and consumer marketing services, private label development or our digital, social and media services.\nGiven our acquisition strategy, we analyze our financial performance, in part, by measuring revenue growth in two ways—revenue growth attributable to organic activities and revenue growth attributable to acquisitions, which we refer to as organic revenues and acquired revenues, respectively.\nWe define organic revenues as any revenues that are not acquired revenues. Our organic revenues exclude the impacts of acquisitions and divestitures, when applicable, which improves comparability of our results from period to period.\nIn general, when we acquire a business, the acquisition includes a contingent consideration arrangement (e.g., an earn-out provision) and, accordingly, we separately track the relevant metrics associated with the earnout agreement of the acquired business. In such cases, we consider revenues generated by such a business during the 12 months following its acquisition to be acquired revenues. For example, if we completed an acquisition on July 1, 2021 for a business that included a contingent consideration arrangement, we would consider revenues from the acquired business from July 1, 2021 to June 30, 2022 to be acquired revenues. We generally consider growth attributable to the financial performance of an acquired business after the 12-month anniversary of the date of acquisition to be organic.\nIn limited cases, when the acquisition of an acquired business does not include a contingent consideration arrangement, or we otherwise do not separately track the financial performance of the acquired business due to operational integration, we consider the revenues that the business generated in the 12 months prior to its acquisition to be our acquired revenues for the 12 months following its acquisition, and any differences in revenues actually generated during the 12 months after its acquisition to be organic. For example, if we completed an acquisition on July 1, 2021 for a business that did not include a contingent consideration arrangement, we would consider the amount of revenues from the acquired business from July 1, 2020 to June 30, 2021 to be acquired revenues during the period from July 1, 2021 to June 30, 2022, with any differences from that amount actually generated during the latter period to be organic revenues.\nAll revenues generated by our acquired businesses are considered to be organic revenues after the 12-month anniversary of the date of acquisition.\nWhen we divest a business, we consider the revenues that the divested business generated in the 12 months prior to its divestiture to be subtracted from acquired revenues for the 12 months following its divestiture. For example, if we completed a divestiture on July 1, 2021 for a business, we would consider the amount of revenues from the divested business from July 1, 2020 to June 30, 2021 to be subtracted from acquired revenues during the period from July 1, 2021 to June 30, 2022.\nWe measure organic revenue growth and acquired revenue growth by comparing the organic revenues or acquired revenues, respectively, period over period, net of any divestitures.\n29\nCost of Revenues\nOur cost of revenues consists of both fixed and variable expenses primarily attributable to the hiring, training, compensation and benefits provided to both full-time and part-time associates, as well as other project-related expenses. A number of costs associated with our associates are subject to external factors, including inflation, increases in market specific wages and minimum wage rates at federal, state and municipal levels and minimum pay levels for exempt roles. Additionally, when we enter into certain new client relationships, we may experience an initial increase in expenses associated with hiring, training and other items needed to launch the new relationship.\nSelling, General and Administrative Expenses\nSelling, general and administrative expenses consist primarily of salaries, payroll taxes and benefits for corporate personnel. Other overhead costs include information technology, occupancy costs for corporate personnel, professional services fees, including accounting and legal services, and other general corporate expenses. Additionally, included in selling, general and administrative expenses are costs associated with the changes in fair value of the contingent consideration of acquisitions and other acquisition-related costs. Acquisition-related costs are comprised of fees related to change of equity ownership, transaction costs, professional fees, due diligence and integration activities.\nOther (Income) Expenses\nChange in Fair Value of Warrant Liability\nChange in fair value of warrant liability represents a non-cash (income) expense resulting from a fair value adjustment to warrant liability with respect to the private placement warrants. Based on the period of time the public warrants have now been trading, we determined the fair value of the liability classified private placement warrants by approximating the value with the share price of the public warrants at the respective period end, which is inherently less subjective and judgmental given it is based on observable inputs. Previously, the fair value of the warrant liability was based on the input assumptions used in the Black-Scholes option pricing model, including our stock price at the end of the reporting period, the implied volatility or other inputs to the model and the number of private placement warrants outstanding, which may vary from period to period. We believe these amounts are not correlated to future business operations.\nInterest Expense\nInterest expense relates primarily to borrowings under the Senior Secured Credit Facilities as described below. See “ —Liquidity and Capital Resources.”\nDepreciation and Amortization\nAmortization Expense\nIncluded in our depreciation and amortization expense is amortization of acquired intangible assets. We have ascribed value to identifiable intangible assets other than goodwill in our purchase price allocations for companies we have acquired. These assets include, but are not limited to, client relationships and trade names. To the extent we ascribe value to identifiable intangible assets that have finite lives, we amortize those values over the estimated useful lives of the assets. Such amortization expense, although non-cash in the period expensed, directly impacts our results of operations. It is difficult to predict with any precision the amount of expense we may record relating to future acquired intangible assets.\n30\nAs a result of the 2014 Topco Acquisition, we acquired significant intangible assets, the value of which is amortized, on a straight-line basis, over 15 years from the date of the 2014 Topco Acquisition, unless determined to be indefinite-lived.\nDepreciation Expense\nDepreciation expense relates to the property and equipment that we own, which represented less than 1% of our total assets at September 30, 2022 and 2021, respectively.\nIncome Taxes\nIncome tax expense and our effective tax rates can be affected by many factors, including state apportionment factors, our acquisition strategy, tax incentives and credits available to us, changes in judgment regarding our ability to realize our deferred tax assets, changes in our worldwide mix of pre-tax losses or earnings, changes in existing tax laws and our assessment of uncertain tax positions.\nCash Flows\nWe have positive cash flow characteristics, as described below, due to the limited required capital investment in the fixed assets and working capital needs to operate our business in the normal course. See “ —Liquidity and Capital Resources.”\nOur principal sources of liquidity are cash flows from operations, borrowings under the Revolving Credit Facility, and other debt. Our principal uses of cash are operating expenses, working capital requirements, acquisitions and repayment of debt.\nAdjusted Net Income\nAdjusted Net Income is a non-GAAP financial measure. Adjusted Net Income means Net income before (i) impairment of goodwill and indefinite-lived assets, (ii) amortization of intangible assets, (iii) equity-based compensation of Topco, (iv) changes in fair value of warrant liability, (v) fair value adjustments of contingent consideration related to acquisitions, (vi) acquisition-related expenses, (vii) costs associated with COVID-19, net of benefits received, (viii) EBITDA for economic interests in investments, (ix) restructuring expenses, (x) litigation expenses (recovery), (xi) costs associated with the Take 5 Matter, (xii) related tax adjustments and (xiii) other adjustments that management believes are helpful in evaluating our operating performance.\nWe present Adjusted Net Income because we use it as a supplemental measure to evaluate the performance of our business in a way that also considers our ability to generate profit without the impact of items that we do not believe are indicative of our operating performance or are unusual or infrequent in nature and aid in the comparability of our performance from period to period. Adjusted Net Income should not be considered as an alternative for Net income, our most directly comparable measure presented on a GAAP basis.\nAdjusted EBITDA and Adjusted EBITDA by Segment\nAdjusted EBITDA and Adjusted EBITDA by segment are supplemental non-GAAP financial measures of our operating performance. Adjusted EBITDA means Net income before (i) interest expense, net, (ii) provision for income taxes, (iii) depreciation, (iv) impairment of goodwill and indefinite-lived assets, (v) amortization of intangible assets, (vi) equity-based compensation of Topco, (vii) changes in fair value of warrant liability, (viii) stock-based compensation expense, (ix) fair value adjustments of contingent consideration related to acquisitions, (x) acquisition-related expenses, (xi) costs associated with COVID-19, net of benefits received, (xii) EBITDA for economic interests in investments, (xiii) restructuring expenses, (xiv) litigation expenses (recovery), (xv) costs associated with the Take 5 Matter and (xvi) other adjustments that management believes are helpful in evaluating our operating performance.\n31\nWe present Adjusted EBITDA and Adjusted EBITDA by segment because they are key operating measures used by us to assess our financial performance. These measures adjust for items that we believe do not reflect the ongoing operating performance of our business, such as certain noncash items, unusual or infrequent items or items that change from period to period without any material relevance to our operating performance. We evaluate these measures in conjunction with our results according to GAAP because we believe they provide a more complete understanding of factors and trends affecting our business than GAAP measures alone. Furthermore, the agreements governing our indebtedness contain covenants and other tests based on measures substantially similar to Adjusted EBITDA. Neither Adjusted EBITDA nor Adjusted EBITDA by segment should be considered as an alternative for Net income, our most directly comparable measure presented on a GAAP basis.\nResults of Operations for the Three and Nine Months Ended September 30, 2022 and 2021\nThe following table sets forth items derived from the Company’s consolidated statements of operations for the three and nine months ended September 30, 2022 and 2021 in dollars and as a percentage of total revenues.\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (amounts in thousands) | 2022 | 2021 | 2022 | 2021 |\n| Revenues | $ | 1,051,095 | 100.0 | % | $ | 928,760 | 100.0 | % | $ | 2,946,979 | 100.0 | % | $ | 2,569,735 | 100.0 | % |\n| Cost of revenues | 908,523 | 86.4 | % | 766,253 | 82.5 | % | 2,536,256 | 86.1 | % | 2,117,818 | 82.4 | % |\n| Selling, general, and administrative expenses | 37,945 | 3.6 | % | 37,742 | 4.1 | % | 138,594 | 4.7 | % | 124,830 | 4.9 | % |\n| Depreciation and amortization | 57,785 | 5.5 | % | 59,163 | 6.4 | % | 173,997 | 5.9 | % | 181,450 | 7.1 | % |\n| Total expenses | 1,004,253 | 95.5 | % | 863,158 | 92.9 | % | 2,848,847 | 96.7 | % | 2,424,098 | 94.3 | % |\n| Operating income | 46,842 | 4.5 | % | 65,602 | 7.1 | % | 98,132 | 3.3 | % | 145,637 | 5.7 | % |\n| Other (income) expenses: |\n| Change in fair value of warrant liability | (1,100 | ) | (0.1 | )% | (3,491 | ) | (0.4 | )% | (21,456 | ) | (0.7 | )% | (5,024 | ) | (0.2 | )% |\n| Interest expense, net | 23,557 | 2.2 | % | 36,490 | 3.9 | % | 63,628 | 2.2 | % | 104,544 | 4.1 | % |\n| Total other expenses | 22,457 | 2.1 | % | 32,999 | 3.6 | % | 42,172 | 1.4 | % | 99,520 | 3.9 | % |\n| Income before income taxes | 24,385 | 2.3 | % | 32,603 | 3.5 | % | 55,960 | 1.9 | % | 46,117 | 1.8 | % |\n| Provision for income taxes | 1,158 | 0.1 | % | 8,276 | 0.9 | % | 11,523 | 0.4 | % | 16,582 | 0.6 | % |\n| Net income | $ | 23,227 | 2.2 | % | $ | 24,327 | 2.6 | % | $ | 44,437 | 1.5 | % | $ | 29,535 | 1.1 | % |\n| Other Financial Data |\n| Adjusted Net Income(1) | $ | 62,682 | 6.0 | % | $ | 59,101 | 6.4 | % | $ | 152,541 | 5.2 | % | $ | 146,762 | 5.7 | % |\n| Adjusted EBITDA(1) | $ | 118,268 | 11.3 | % | $ | 133,756 | 14.4 | % | $ | 323,329 | 11.0 | % | $ | 367,155 | 14.3 | % |\n\n(1)Adjusted Net Income and Adjusted EBITDA are financial measures that are not calculated in accordance with GAAP. For a discussion of our presentation of Adjusted Net Income and Adjusted EBITDA and reconciliations of Net income to Adjusted Net Income and Adjusted EBITDA, see “—Non-GAAP Financial Measures.”\nComparison of the Three Months Ended September 30, 2022 and 2021\nRevenues\n\n| Three Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 646,246 | $ | 597,139 | $ | 49,107 | 8.2 | % |\n| Marketing | 404,849 | 331,621 | 73,228 | 22.1 | % |\n| Total revenues | $ | 1,051,095 | $ | 928,760 | $ | 122,335 | 13.2 | % |\n\nTotal revenues increased by $122.3 million, or 13.2%, during the three months ended September 30, 2022, as compared to the three months ended September 30, 2021.\nThe sales segment revenues increased $49.1 million during the three months ended September 30, 2022 as compared to the three months ended September 30, 2021, of which $23.6 million were revenues from acquired\n32\nbusinesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $17.0 million, the segment experienced an increase of $42.5 million in organic revenues primarily due to growth in our retail merchandising services and international businesses, partially offset by a decrease in our third party selling and retailing services.\nThe marketing segment revenues increased $73.2 million during the three months ended September 30, 2022 as compared to the three months ended September 30, 2021, of which $11.0 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $5.7 million, the segment experienced an increase of $67.9 million in organic revenues. The increase in revenues was primarily due to an increase in our in-store product demonstration and sampling services which continue to recover from the temporary suspensions as a result of the COVID-19 pandemic, partially offset by a decrease in certain of our client media spend.\nCost of Revenues\nCost of revenues as a percentage of revenues for the three months ended September 30, 2022 was 86.4%, as compared to 82.5% for the three months ended September 30, 2021. The increase as a percentage of revenues was largely attributable to the change in the revenue mix of our services as a result of recoveries from the COVID-19 pandemic and acquired businesses, and the ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\nSelling, General and Administrative Expenses\nSelling, general and administrative expenses as a percentage of revenues for the three months ended September 30, 2022 was 3.6%, compared to 4.1% for the three months ended September 30, 2021, primarily due to the change in fair value adjustments related to contingent consideration and a decrease in legal fees associated with the Take 5 Matter.\nDepreciation and Amortization Expense\nDepreciation and amortization expense decreased by $1.4 million, or 2.3%, to $57.8 million for the three months ended September 30, 2022 compared to $59.2 million for the three months ended September 30, 2021, which stayed relatively consistent year over year.\nOperating Income\n\n| Three Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 31,765 | $ | 51,906 | $ | (20,141 | ) | (38.8 | )% |\n| Marketing | 15,077 | 13,696 | 1,381 | 10.1 | % |\n| Total operating income | $ | 46,842 | $ | 65,602 | $ | (18,760 | ) | (28.6 | )% |\n\nIn the sales segment, the decrease in operating income during the three months ended September 30, 2022 was due to a shift in revenue mix and ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\nIn the marketing segment, the increase in operating income during the three months ended September 30, 2022 was due to the growth in revenues, partially offset by the increase in cost of revenues as described above.\nChange in Fair Value of Warrant Liability\nChange in fair value of warrant liability represents $1.1 million of non-cash gain resulting from a fair value adjustment to warrant liability with respect to the private placement warrants for the three months ended September 30, 2022, approximating the fair value with the warrant price of the public warrants.\n33\nInterest Expense, net\nInterest expense, net decreased $12.9 million, or 35.4%, to $23.6 million for the three months ended September 30, 2022, from $36.5 million for the three months ended September 30, 2021. The decrease in interest expense, net was primarily due to the increase in fair value changes in derivatives instruments.\nProvision for Income Taxes\nProvision for income taxes was $1.2 million for the three months ended September 30, 2022 as compared to $8.3 million of provision for income taxes for the three months ended September 30, 2021. The fluctuation was primarily attributable to the decrease in pre-tax income during the three months ended September 30, 2022 and decrease of $4.3 million of discrete items for the three months ended September 30, 2022.\nNet Income\nNet income was $23.2 million for the three months ended September 30, 2022, compared to net income of $24.3 million for the three months ended September 30, 2021. The decrease in net income was primarily driven by the decrease in operating income as described above, offset by the decrease in interest expense, net and provision for income taxes.\nAdjusted Net Income\nThe increase in Adjusted Net Income for the three months ended September 30, 2022 was attributable to the decrease in interest expense, net as described above. For a reconciliation of Adjusted Net Income to Net income, see “ —Non-GAAP Financial Measures.”\nAdjusted EBITDA and Adjusted EBITDA by Segment\n\n| Three Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 76,172 | $ | 95,199 | $ | (19,027 | ) | (20.0 | )% |\n| Marketing | 42,096 | 38,557 | 3,539 | 9.2 | % |\n| Total Adjusted EBITDA | $ | 118,268 | $ | 133,756 | $ | (15,488 | ) | (11.6 | )% |\n\nAdjusted EBITDA decreased by $15.5 million, or 11.6%, to $118.3 million for the three months ended September 30, 2022, from $133.8 million for the three months ended September 30, 2021. In the sales segment, the decrease in Adjusted EBITDA was primarily attributable to the increase in cost of revenues as described above. In the marketing segment, the increase in the Adjusted EBITDA was primarily attributable to the growth in revenues as described above. For a reconciliation of Adjusted EBITDA to Net income, see “—Non-GAAP Financial Measures.”\nComparison of the Nine Months Ended September 30, 2022 and 2021\nRevenues\n\n| Nine Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 1,842,347 | $ | 1,693,107 | $ | 149,240 | 8.8 | % |\n| Marketing | 1,104,632 | 876,628 | 228,004 | 26.0 | % |\n| Total revenues | $ | 2,946,979 | $ | 2,569,735 | $ | 377,244 | 14.7 | % |\n\n34\nTotal revenues increased by $377.2 million, or 14.7%, during the nine months ended September 30, 2022, as compared to the nine months ended September 30, 2021.\nThe sales segment revenues increased $149.2 million during the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021, of which $114.2 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $33.9 million, the segment experienced an increase of $68.9 million in organic revenues primarily due to our European joint venture which experienced continued recoveries from temporary reduction in services as a result of the COVID-19 pandemic and growth in our retail merchandising services partially offset by a decrease in our foodservice and third party selling and retailing services.\nThe marketing segment revenues increased $228.0 million during the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021, of which $23.1 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $11.6 million, the segment experienced an increase of $216.5 million in organic revenues. The increase in revenues was primarily due to an increase in our in-store product demonstration and sampling services which continue to recover from the temporary suspensions as a result of the COVID-19 pandemic, partially offset by a decrease in certain of our client media spend.\nCost of Revenues\nCost of revenues as a percentage of revenues for the nine months ended September 30, 2022 was 86.1%, as compared to 82.4% for the nine months ended September 30, 2021. The increase as a percentage of revenues was largely attributable to the change in the revenue mix of our services as a result of recoveries from the COVID-19 pandemic and acquired businesses, and the ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\nSelling, General and Administrative Expenses\nSelling, general and administrative expenses as a percentage of revenues for the nine months ended September 30, 2022 was 4.7%, compared to 4.9% for the nine months ended September 30, 2021.\nDepreciation and Amortization Expense\nDepreciation and amortization expense decreased by $7.5 million or 4.1% to $174.0 million for the nine months ended September 30, 2022 compared to $181.5 million for the nine months ended September 30, 2021. The decrease was primarily due to a decrease in depreciation expenses from our internally developed software.\nOperating Income\n\n| Nine Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 65,915 | $ | 131,727 | $ | (65,812 | ) | (50.0 | %) |\n| Marketing | 32,217 | 13,910 | 18,307 | 131.6 | % |\n| Total operating income | $ | 98,132 | $ | 145,637 | $ | (47,505 | ) | (32.6 | %) |\n\nIn the sales segment, the decrease in operating income during the nine months ended September 30, 2022 was primarily attributable to a shift in revenue mix, ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses, the change in fair value adjustments related to contingent consideration, and an increase in stock-based compensation expense, partially offset by a decrease in depreciation expense.\n35\nIn the marketing segment, the increase in operating income during the nine months ended September 30, 2022 was primarily attributable to the growth in revenues, partially offset by the increase in cost of revenues as described above and the change in fair value adjustments related to contingent consideration.\nChange in Fair Value of Warrant Liability\nChange in fair value of warrant liability represents $21.5 million of non-cash gain resulting from a fair value adjustment to warrant liability with respect to the private placement warrants for the nine months ended September 30, 2022, approximating the fair value with the warrant price of the public warrants.\nInterest Expense, net\nInterest expense, net decreased $40.9 million, or 39.1%, to $63.6 million for the nine months ended September 30, 2022, from $104.5 million for the nine months ended September 30, 2021. The decrease in interest expense, net was primarily due to the increase in fair value changes in derivatives instruments.\nProvision for Income Taxes\nProvision for income taxes was $11.5 million for the nine months ended September 30, 2022 as compared to $16.6 million for the nine months ended September 30, 2021. The fluctuation was primarily attributable to the increase in pre-tax income during the nine months ended September 30, 2022, partially offset by a decrease of $7.4 million of discrete items.\nNet Income\nNet income was $44.4 million for the nine months ended September 30, 2022, compared to net income of $29.5 million for the nine months ended September 30, 2021. The increase in net income was primarily driven by the decrease in change in fair value of warrant liability, interest expense, net, and provision for income taxes, partially offset by the decrease in operating income as described above.\nAdjusted Net Income\nThe increase in Adjusted Net Income for the nine months ended September 30, 2022 was attributable to the decrease in change in fair value of warrant liability, and interest expense, net as described above. For a reconciliation of Adjusted Net Income to Net income, see “ —Non-GAAP Financial Measures.”\nAdjusted EBITDA and Adjusted EBITDA by Segment\n\n| Nine Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 216,158 | $ | 268,798 | $ | (52,640 | ) | (19.6 | )% |\n| Marketing | 107,171 | 98,357 | 8,814 | 9.0 | % |\n| Total Adjusted EBITDA | $ | 323,329 | $ | 367,155 | $ | (43,826 | ) | (11.9 | )% |\n\nAdjusted EBITDA decreased by $43.8 million, or 11.9%, to $323.3 million for the nine months ended September 30, 2022, from $367.2 million for the nine months ended September 30, 2021. In the sales segment, the decrease in Adjusted EBITDA was primarily attributable to the increase in cost of revenues as described above. In the marketing segment, the increase in the Adjusted EBITDA was primarily attributable to the growth in revenues as described above. For a reconciliation of Adjusted EBITDA to Net income, see “—Non-GAAP Financial Measures.”\n36\nNon-GAAP Financial Measures\nAdjusted Net Income is a non-GAAP financial measure. Adjusted Net Income means Net income before (i) impairment of goodwill and indefinite-lived assets, (ii) amortization of intangible assets, (iii) equity-based compensation of Topco, (iv) change in fair value of warrant liability, (v) fair value adjustments of contingent consideration related to acquisitions, (vi) acquisition-related expenses, (vii) costs associated with COVID-19, net of benefits received, (viii) EBITDA for economic interests in investments, (ix) restructuring expenses, (x) litigation expenses (recovery), (xi) costs associated with the Take 5 Matter, (xii) related tax adjustments and (xiii)other adjustments that management believes are helpful in evaluating our operating performance.\nWe present Adjusted Net Income because we use it as a supplemental measure to evaluate the performance of our business in a way that also considers our ability to generate profit without the impact of items that we do not believe are indicative of our operating performance or are unusual or infrequent in nature and aid in the comparability of our performance from period to period. Adjusted Net Income should not be considered as an alternative for our Net income, our most directly comparable measure presented on a GAAP basis.\nA reconciliation of Adjusted Net Income to Net income is provided in the following table:\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Net income | $ | 23,227 | $ | 24,327 | $ | 44,437 | $ | 29,535 |\n| Less: Net income attributable to noncontrolling interest | 2,168 | 1,016 | 1,042 | 219 |\n| Add: |\n| Equity -based compensation of Karman Topco L.P.(a) | (828 | ) | (5,575 | ) | (7,142 | ) | (10,031 | ) |\n| Change in fair value of warrant liability | (1,100 | ) | (3,491 | ) | (21,456 | ) | (5,024 | ) |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (340 | ) | 3,221 | 5,448 | 5,776 |\n| Acquisition-related expenses(d) | 4,260 | 5,110 | 19,843 | 13,053 |\n| Restructuring expenses(e) | 3,562 | (394 | ) | 4,458 | 10,636 |\n| Litigation(f) | — | (92 | ) | (800 | ) | (910 | ) |\n| Amortization of intangible assets(g) | 49,997 | 49,786 | 150,930 | 148,396 |\n| Costs associated with COVID-19, net of benefits received(h) | 2,009 | 1,087 | 4,945 | (948 | ) |\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\n| Tax adjustments related to non-GAAP adjustments(j) | (16,215 | ) | (15,262 | ) | (49,168 | ) | (47,113 | ) |\n| Adjusted Net Income | $ | 62,682 | $ | 59,101 | $ | 152,541 | $ | 146,762 |\n\nAdjusted EBITDA and Adjusted EBITDA by segment are supplemental non-GAAP financial measures of our operating performance. Adjusted EBITDA means Net income before (i) interest expense, net, (ii) provision for income taxes, (iii) depreciation, (iv) impairment of goodwill and indefinite-lived assets, (v) amortization of intangible assets, (vi) equity-based compensation of Topco, (vii) change in fair value of warrant liability, (viii) stock-based compensation expense, (ix) fair value adjustments of contingent consideration related to acquisitions, (x) acquisition-related expenses, (xi) costs associated with COVID-19, net of benefits received, (xii) EBITDA for economic interests in investments, (xiii) restructuring expenses, (xiv) litigation expenses (recovery), (xv) costs associated with the Take 5 Matter and (xvi) other adjustments that management believes are helpful in evaluating our operating performance.\nWe present Adjusted EBITDA and Adjusted EBITDA by segment because they are key operating measures used by us to assess our financial performance. These measures adjust for items that we believe do not reflect the ongoing operating performance of our business, such as certain noncash items, unusual or infrequent items or items that change from period to period without any material relevance to our operating performance. We evaluate these measures in conjunction with our results according to GAAP because we believe they provide a more complete understanding of factors and trends affecting our business than GAAP measures alone. Furthermore, the agreements governing our indebtedness contain covenants and other tests based on measures substantially similar to\n37\nAdjusted EBITDA. Neither Adjusted EBITDA nor Adjusted EBITDA by segment should be considered as an alternative for our Net income, our most directly comparable measure presented on a GAAP basis.\nA reconciliation of Adjusted EBITDA to Net income is provided in the following table:\n\n| Consolidated | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Net income | $ | 23,227 | $ | 24,327 | $ | 44,437 | $ | 29,535 |\n| Add: |\n| Interest expense, net | 23,557 | 36,490 | 63,628 | 104,544 |\n| Provision for income taxes | 1,158 | 8,276 | 11,523 | 16,582 |\n| Depreciation and amortization | 57,785 | 59,163 | 173,997 | 181,450 |\n| Equity-based compensation of Karman Topco L.P.(a) | (828 | ) | (5,575 | ) | (7,142 | ) | (10,031 | ) |\n| Change in fair value of warrant liability | (1,100 | ) | (3,491 | ) | (21,456 | ) | (5,024 | ) |\n| Stock-based compensation expense(b) | 7,174 | 7,854 | 29,906 | 25,497 |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (340 | ) | 3,221 | 5,448 | 5,776 |\n| Acquisition-related expenses(d) | 4,260 | 5,110 | 19,843 | 13,053 |\n| EBITDA for economic interests in investments(k) | (2,474 | ) | (3,620 | ) | (7,546 | ) | (6,616 | ) |\n| Restructuring expenses(e) | 3,562 | (394 | ) | 4,458 | 10,636 |\n| Litigation(f) | — | (92 | ) | (800 | ) | (910 | ) |\n| Costs associated with COVID-19, net of benefits received(h) | 2,009 | 1,087 | 4,945 | (948 | ) |\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\n| Adjusted EBITDA | $ | 118,268 | $ | 133,756 | $ | 323,329 | $ | 367,155 |\n\nFinancial information by segment, including a reconciliation of Adjusted EBITDA by segment to operating income, the closest GAAP financial measure, is provided in the following table:\n\n| Sales Segment | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Operating income | $ | 31,765 | $ | 51,906 | $ | 65,915 | $ | 131,727 |\n| Add: |\n| Depreciation and amortization | 39,798 | 41,515 | 121,310 | 128,789 |\n| Equity-based compensation of Karman Topco L.P.(a) | (320 | ) | (4,844 | ) | (4,004 | ) | (7,360 | ) |\n| Stock-based compensation expense(b) | 4,080 | 4,371 | 18,009 | 13,795 |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (1,901 | ) | 192 | 4,992 | (4,057 | ) |\n| Acquisition-related expenses(d) | 2,880 | 3,899 | 13,734 | 9,499 |\n| EBITDA for economic interests in investments(k) | (2,656 | ) | (3,832 | ) | (8,018 | ) | (7,429 | ) |\n| Restructuring expenses(e) | 2,360 | 1,273 | 3,519 | 3,229 |\n| Litigation(f) | — | (68 | ) | (100 | ) | (584 | ) |\n| Costs associated with COVID-19, net of benefits received(h) | 166 | 787 | 801 | 1,189 |\n| Sales Segment Adjusted EBITDA | $ | 76,172 | $ | 95,199 | $ | 216,158 | $ | 268,798 |\n\n38\n\n| Marketing Segment | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Operating income | $ | 15,077 | $ | 13,696 | $ | 32,217 | $ | 13,910 |\n| Add: |\n| Depreciation and amortization | 17,987 | 17,648 | 52,687 | 52,661 |\n| Equity-based compensation of Karman Topco L.P.(a) | (508 | ) | (731 | ) | (3,138 | ) | (2,671 | ) |\n| Stock-based compensation expense(b) | 3,094 | 3,483 | 11,897 | 11,702 |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | 1,561 | 3,029 | 456 | 9,833 |\n| Acquisition-related expenses(d) | 1,380 | 1,211 | 6,109 | 3,554 |\n| EBITDA for economic interests in investments(k) | 182 | 212 | 472 | 813 |\n| Restructuring expenses(e) | 1,202 | (1,667 | ) | 939 | 7,407 |\n| Litigation(f) | — | (24 | ) | (700 | ) | (326 | ) |\n| Costs associated with COVID-19, net of benefits received(h) | 1,843 | 300 | 4,144 | (2,137 | ) |\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\n| Marketing Segment Adjusted EBITDA | $ | 42,096 | $ | 38,557 | $ | 107,171 | $ | 98,357 |\n\n\n\n\n| (a) | Represents expenses related to (i) equity-based compensation expense associated with grants of Common Series D Units of Topco made to one of the Advantage Sponsors (as defined below) and (ii) equity-based compensation expense associated with the Common Series C Units of Topco. |\n| (b) | Represents non-cash compensation expense related to the 2020 Incentive Award Plan and the 2020 Employee Stock Purchase Plan. |\n| (c) | Represents adjustments to the estimated fair value of our contingent consideration liabilities related to our acquisitions. See Note 6—Fair Value of Financial Instruments to our unaudited condensed financial statements for the three and nine months ended September 30, 2022 and 2021. |\n| (d) | Represents fees and costs associated with activities related to our acquisitions and restructuring activities, including professional fees, due diligence, and integration activities. |\n| (e) | Represents fees and costs associated with various internal reorganization activities among our consolidated entities. |\n| (f) | Represents legal settlements that are unusual or infrequent costs associated with our operating activities. |\n| (g) | Represents the amortization of intangible assets recorded in connection with the 2014 Topco Acquisition and our other acquisitions. |\n| (h) | Represents (i) costs related to implementation of strategies for workplace safety in response to COVID-19, including employee-relief fund, additional sick pay for front-line associates, medical benefit payments for furloughed associates, and personal protective equipment; and (ii) benefits received from government grants for COVID-19 relief. |\n| (i) | Represents costs associated with the Take 5 Matter, primarily, professional fees and other related costs, for the three and nine months ended September 30, 2022 and 2021, respectively. |\n| (j) | Represents the tax provision or benefit associated with the adjustments above, taking into account the Company’s applicable tax rates, after excluding adjustments related to items that do not have a related tax impact. |\n| (k) | Represents additions to reflect our proportional share of Adjusted EBITDA related to our equity method investments and reductions to remove the Adjusted EBITDA related to the minority ownership percentage of the entities that we fully consolidate in our financial statements. |\n\n39\nLiquidity and Capital Resources\nOur principal sources of liquidity were cash flows from operations, borrowings under the Revolving Credit Facility, and other debt. Our principal uses of cash are operating expenses, working capital requirements, acquisitions, interest on debt and repayment of debt.\nCash Flows\nA summary of our cash operating, investing and financing activities are shown in the following table:\n\n| Nine Months Ended September 30, |\n| (in thousands) | 2022 | 2021 |\n| Net cash provided by operating activities | $ | 81,950 | $ | 101,068 |\n| Net cash used in investing activities | (103,062 | ) | (66,152 | ) |\n| Net cash used in financing activities | (32,920 | ) | (68,999 | ) |\n| Net effect of foreign currency fluctuations on cash | (12,311 | ) | (1,476 | ) |\n| Net change in cash, cash equivalents and restricted cash | $ | (66,343 | ) | $ | (35,559 | ) |\n\nNet Cash Provided by Operating Activities\nNet cash used in operating activities during the nine months ended September 30, 2022 consisted of net income of $44.4 million adjusted for certain non-cash items, including depreciation and amortization of $174.0 million and effects of changes in working capital. Net cash provided by operating activities during the nine months ended September 30, 2021 consisted of net income of $29.5 million adjusted for certain non-cash items, including depreciation and amortization of $181.5 million and effects of changes in working capital. The decrease in cash provided by operating activities during the nine months ended September 30, 2022 relative to the same period in 2021 was primarily due to ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses during the nine months ended September 30, 2022.\nNet Cash Used in Investing Activities\nNet cash used in investing activities during the nine months ended September 30, 2022 primarily consisted of the purchase of businesses, net of cash acquired of $74.4 million and purchase of property and equipment of $30.0 million. Net cash used in investing activities during the nine months ended September 30, 2021 primarily consisted of the purchase of businesses, net of cash acquired of $40.0 million and purchase of property and equipment of $24.1 million.\nNet Cash Used in Financing Activities\nWe primarily finance our growth through cash flows from operations, however, we also incur long-term debt or borrow under lines of credit when necessary to execute acquisitions. Additionally, many of our acquisition agreements include contingent consideration arrangements, which are generally based on the achievement of future financial performance by the operations attributable to the acquired companies. The portion of the cash payment up to the acquisition date fair value of the contingent consideration liability are classified as financing outflows, and amounts paid in excess of the acquisition date fair value of that liability are classified as operating outflows.\nCash flows used in financing activities during the nine months ended September 30, 2022 were primarily related to payments of contingent consideration and holdback payments of $31.7 million, repayment of principal on our Term Loan Facility of $9.9 million, partially offset by $3.3 million related to proceeds from the issuance of Class A common stock and $5.2 million of contribution from noncontrolling interest. Cash flows related to financing activities during the nine months ended September 30, 2021 were primarily related to borrowings of $51.7 million and repayment of $102.7 million on the Revolving Credit Facility and our lines of credit and $8.6 million related to payments of contingent consideration and holdback payments.\n40\nDescription of Credit Facilities\nSenior Secured Credit Facilities\nIn connection with the consummation of the Transactions, Advantage Sales & Marketing Inc. (the “Borrower”), an indirect wholly-owned subsidiary of the Company, entered into (i) a senior secured asset-based revolving credit facility in an aggregate principal amount of up to $400.0 million, subject to borrowing base capacity (as may be amended from time to time, the “Revolving Credit Facility”) and (ii) a secured first lien term loan credit facility in an aggregate principal amount of $1.325 billion (as may be amended from time to time, the “Term Loan Facility” and together with the Revolving Credit Facility, the “Senior Secured Credit Facilities”).\nRevolving Credit Facility\nOur Revolving Credit Facility provides for revolving loans and letters of credit in an aggregate amount of up to $400.0 million, subject to borrowing base capacity. Letters of credit are limited to the lesser of (a) $150.0 million and (b) the aggregate unused amount of commitments under our Revolving Credit Facility then in effect. Loans under the Revolving Credit Facility may be denominated in either U.S. dollars or Canadian dollars. Bank of America, N.A., is administrative agent and ABL Collateral Agent. The Revolving Credit Facility is scheduled to mature in October 2025. We may use borrowings under the Revolving Credit Facility to fund working capital and for other general corporate purposes, including permitted acquisitions and other investments. As of September 30, 2022, we had unused capacity under our Revolving Credit Facility available to us of $400.0 million, subject to borrowing base limitations (without giving effect to approximately $54.5 million of outstanding letters of credit and the borrowing base limitations for additional borrowings).\nBorrowings under the Revolving Credit Facility are limited by borrowing base calculations based on the sum of specified percentages of eligible accounts receivable plus specified percentages of qualified cash, minus the amount of any applicable reserves. Borrowings will bear interest at a floating rate, which can be either an adjusted Eurodollar rate plus an applicable margin or, at the Borrower’s option, a base rate plus an applicable margin. The applicable margins for the Revolving Credit Facility are 2.00%, 2.25% or 2.50%, with respect to Eurodollar rate borrowings and 1.00%, 1.25% or 1.50%, with respect to base rate borrowings, in each case depending on average excess availability under the Revolving Credit Facility. The Borrower’s ability to draw under the Revolving Credit Facility or issue letters of credit thereunder will be conditioned upon, among other things, the Borrower’s delivery of prior written notice of a borrowing or issuance, as applicable, the Borrower’s ability to reaffirm the representations and warranties contained in the credit agreement governing the Revolving Credit Facility and the absence of any default or event of default thereunder.\nThe Borrower’s obligations under the Revolving Credit Facility are guaranteed by Karman Intermediate Corp. (“Holdings”) and all of the Borrower’s direct and indirect wholly owned material U.S. subsidiaries (subject to certain permitted exceptions) and Canadian subsidiaries (subject to certain permitted exceptions, including exceptions based on immateriality thresholders of aggregate assets and revenues of Canadian subsidiaries) (the “Guarantors”). The Revolving Credit Facility is secured by a lien on substantially all of Holdings’, the Borrower’s and the Guarantors’ assets (subject to certain permitted exceptions). The Borrower’s Revolving Credit Facility has a first-priority lien on the current asset collateral and a second-priority lien on security interests in the fixed asset collateral (second in priority to the liens securing the Notes and the Term Loan Facility discussed below), in each case, subject to other permitted liens.\nThe Revolving Credit Facility has the following fees: (i) an unused line fee of 0.375% or 0.250% per annum of the unused portion of the Revolving Credit Facility, depending on average excess availability under the Revolving Credit Facility; (ii) a letter of credit participation fee on the aggregate stated amount of each letter of credit equal to the applicable margin for adjusted Eurodollar rate loans, as applicable; and (iii) certain other customary fees and expenses of the lenders and agents thereunder.\nThe Revolving Credit Facility contains customary covenants, including, but not limited to, restrictions on the Borrower’s ability and that of our subsidiaries to merge and consolidate with other companies, incur indebtedness, grant liens or security interests on assets, make acquisitions, loans, advances or investments, pay dividends, sell or\n41\notherwise transfer assets, optionally prepay or modify terms of any junior indebtedness, enter into transactions with affiliates or change our line of business. The Revolving Credit Facility will require the maintenance of a fixed charge coverage ratio (as set forth in the credit agreement governing the Revolving Credit Facility) of 1.00 to 1.00 at the end of each fiscal quarter when excess availability is less than the greater of $25 million and 10% of the lesser of the borrowing base and maximum borrowing capacity. Such fixed charge coverage ratio will be tested at the end of each quarter until such time as excess availability exceeds the level set forth above.\nThe Revolving Credit Facility provides that, upon the occurrence of certain events of default, the Borrower’s obligations thereunder may be accelerated and the lending commitments terminated. Such events of default include payment defaults to the lenders thereunder, material inaccuracies of representations and warranties, covenant defaults, cross-defaults to other material indebtedness, voluntary and involuntary bankruptcy, insolvency, corporate arrangement, winding-up, liquidation or similar proceedings, material money judgments, material pension-plan events, certain change of control events and other customary events of default.\nOn October 28, 2021, the Borrower and Holdings entered into the First Amendment to ABL Revolving Credit Agreement (the “ABL Amendment”), which amended the ABL Revolving Credit Agreement, dated October 28, 2020, by and among the Borrower, Holdings, the lenders from time to time party thereto and Bank of America, as administrative agent. The ABL Amendment was entered into by the Borrower to amend certain terms and provisions, including (i) reducing the interest rate floor for Eurocurrency rate loans from 0.50% to 0.00% and base rate loans from 1.50% to 1.00%, and (ii) updating the provisions by which U.S. Dollar LIBOR will eventually be replaced with the Secured Oversight Financing Rate (“SOFR”) or another interest rate benchmark to reflect the most recent standards and practices used in the industry.\nTerm Loan Facility\nThe Term Loan Facility is a term loan facility denominated in U.S. dollars in an aggregate principal amount of $1.325 billion. Borrowings under the Term Loan Facility amortize in equal quarterly installments in an amount equal to 1.00% per annum of the principal amount. Borrowings will bear interest at a floating rate, which can be either an adjusted Eurodollar rate plus an applicable margin or, at the Borrower’s option, a base rate plus an applicable margin. The applicable margins for the Term Loan Facility are 4.50% with respect to Eurodollar rate borrowings and 3.50% with respect to base rate borrowings.\nThe Borrower may voluntarily prepay loans or reduce commitments under the Term Loan Facility, in whole or in part, subject to minimum amounts, with prior notice but without premium or penalty (other than a 1.00% premium on any prepayment in connection with a repricing transaction prior to the date that is six months after the effective date of the First Lien Amendment).\nThe Borrower will be required to prepay the Term Loan Facility with 100% of the net cash proceeds of certain asset sales (such percentage subject to reduction based on the achievement of specific first lien net leverage ratios) and subject to certain reinvestment rights, 100% of the net cash proceeds of certain debt issuances and 50% of excess cash flow (such percentage subject to reduction based on the achievement of specific first lien net leverage ratios).\nThe Borrower’s obligations under the Term Loan Facility are guaranteed by Holdings and the Guarantors. Our Term Loan Facility is secured by a lien on substantially all of Holdings’, the Borrower’s and the Guarantors’ assets (subject to certain permitted exceptions). The Term Loan Facility has a first-priority lien on the fixed asset collateral (equal in priority with the liens securing the Notes) and a second-priority lien on security interests in the current asset collateral (second in priority to the liens securing the Revolving Credit Facility), in each case, subject to other permitted liens.\nThe Term Loan Facility contains certain customary negative covenants, including, but not limited to, restrictions on the Borrower’s ability and that of our restricted subsidiaries to merge and consolidate with other companies, incur indebtedness, grant liens or security interests on assets, pay dividends or make other restricted payments, sell or otherwise transfer assets or enter into transactions with affiliates.\n42\nThe Term Loan Facility provides that, upon the occurrence of certain events of default, the Borrower’s obligations thereunder may be accelerated. Such events of default will include payment defaults to the lenders thereunder, material inaccuracies of representations and warranties, covenant defaults, cross-defaults to other material indebtedness, voluntary and involuntary bankruptcy, insolvency, corporate arrangement, winding-up, liquidation or similar proceedings, material money judgments, change of control and other customary events of default.\nOn October 28, 2021 (the “First Lien Amendment Effective Date”), the Borrower, Holdings, and certain of the Borrower’s subsidiaries, entered into Amendment No. 1 to the First Lien Credit Agreement (the “First Lien Amendment”), which amended the First Lien Credit Agreement, dated October 28, 2020, by and among the Borrower, Holdings, Bank of America, as administrative agent and collateral agent, each lender party from time to time thereto, and the other parties thereto. The First Lien Amendment was entered into by the Borrower to reduce the applicable interest rate on the term loan to 5.25% per annum, resulting in estimated interest savings of approximately $9.9 million or $7.3 million, net of tax, per annum. Additional terms and provisions amended include (i) resetting the period for six months following the First Lien Amendment Effective Date in which a 1.00% prepayment premium shall apply to any prepayment of the term loan in connection with certain repricing events, and (ii) updating the provisions by which U.S. Dollar LIBOR will eventually be replaced with SOFR or another interest rate benchmark to reflect the most recent standards and practices used in the industry and by Bank of America.\nSenior Secured Notes\nIn connection with the Transactions, Advantage Solutions FinCo LLC (“Finco”) issued $775.0 million aggregate principal amount of 6.50% Senior Secured Notes due 2028 (the “Notes”). Substantially concurrently with the Transactions, Finco merged with and into Advantage Sales & Marketing Inc. (in its capacity as the issuer of the Notes, the “Issuer”), with the Issuer continuing as the surviving entity and assuming the obligations of Finco. The Notes were sold to BofA Securities, Inc., Deutsche Bank Securities Inc., Morgan Stanley & Co. LLC and Apollo Global Securities, LLC. The Notes were resold to certain non-U.S. persons pursuant to Regulation S under the Securities Act of 1933, as amended (the “Securities Act”), and to persons reasonably believed to be qualified institutional buyers pursuant to Rule 144A under the Securities Act at a purchase price equal to 100% of their principal amount. The terms of the Notes are governed by an Indenture, dated as of October 28, 2020 (the “Indenture”), among Finco, the Issuer, the guarantors named therein (the “Notes Guarantors”) and Wilmington Trust, National Association, as trustee and collateral agent.\nInterest and maturity\nInterest on the Notes is payable semi-annually in arrears on May 15 and November 15 at a rate of 6.50% per annum, commencing on May 15, 2021. The Notes will mature on November 15, 2028.\nGuarantees\nThe Notes are guaranteed by Holdings and each of the Issuer’s direct and indirect wholly owned material U.S. subsidiaries (subject to certain permitted exceptions) and Canadian subsidiaries (subject to certain permitted exceptions, including exceptions based on immateriality thresholders of aggregate assets and revenues of Canadian subsidiaries) that is a borrower or guarantor under the Term Loan Facility.\nSecurity and Ranking\nThe Notes and the related guarantees are the general, senior secured obligations of the Issuer and the Notes Guarantors, are secured on a first-priority pari passu basis by security interests on the fixed asset collateral (equal in priority with liens securing the Term Loan Facility), and are secured on a second-priority basis by security interests on the current asset collateral (second in priority to the liens securing the Revolving Credit Facility and equal in priority with liens securing the Term Loan Facility), in each case, subject to certain limitations and exceptions and permitted liens.\n43\nThe Notes and related guarantees rank (i) equally in right of payment with all of the Issuer’s and the Guarantors’ senior indebtedness, without giving effect to collateral arrangements (including the Senior Secured Credit Facilities) and effectively equal to all of the Issuer’s and the Guarantors’ senior indebtedness secured on the same priority basis as the Notes, including the Term Loan Facility, (ii) effectively subordinated to any of the Issuer’s and the Guarantors’ indebtedness that is secured by assets that do not constitute collateral for the Notes to the extent of the value of the assets securing such indebtedness and to indebtedness that is secured by a senior-priority lien, including the Revolving Credit Facility to the extent of the value of the current asset collateral and (iii) structurally subordinated to the liabilities of the Issuer’s non-Guarantor subsidiaries.\nOptional redemption for the Notes\nThe Notes are redeemable on or after November 15, 2023 at the applicable redemption prices specified in the Indenture plus accrued and unpaid interest. The Notes may also be redeemed at any time prior to November 15, 2023 at a redemption price equal to 100% of the aggregate principal amount of such Notes to be redeemed plus a “make-whole” premium, plus accrued and unpaid interest. In addition, the Issuer may redeem up to 40% of the original aggregate principal amount of Notes before November 15, 2023 with the net cash proceeds of certain equity offerings at a redemption price equal to 106.5% of the aggregate principal amount of such Notes to be redeemed, plus accrued and unpaid interest. Furthermore, prior to November 15, 2023 the Issuer may redeem during each calendar year up to 10% of the original aggregate principal amount of the Notes at a redemption price equal to 103% of the aggregate principal amount of such Notes to be redeemed, plus accrued and unpaid interest. If the Issuer or its restricted subsidiaries sell certain of their respective assets or experience specific kinds of changes of control, subject to certain exceptions, the Issuer must offer to purchase the Notes at par. In connection with any offer to purchase all Notes, if holders of no less than 90% of the aggregate principal amount of Notes validly tender their Notes, the Issuer is entitled to redeem any remaining Notes at the price offered to each holder.\nRestrictive covenants\nThe Notes are subject to covenants that, among other things limit the Issuer’s ability and its restricted subsidiaries’ ability to: incur additional indebtedness or guarantee indebtedness; pay dividends or make other distributions in respect of, or repurchase or redeem, the Issuer’s or a parent entity’s capital stock; prepay, redeem or repurchase certain indebtedness; issue certain preferred stock or similar equity securities; make loans and investments; sell or otherwise dispose of assets; incur liens; enter into transactions with affiliates; enter into agreements restricting the Issuer’s subsidiaries’ ability to pay dividends; and consolidate, merge or sell all or substantially all of the Issuer’s assets. Most of these covenants will be suspended on the Notes so long as they have investment grade ratings from both Moody’s Investors Service, Inc. and S&P Global Ratings and so long as no default or event of default under the Indenture has occurred and is continuing.\nEvents of default\nThe following constitute events of default under the Notes, among others: default in the payment of interest; default in the payment of principal; failure to comply with covenants; failure to pay other indebtedness after final maturity or acceleration of other indebtedness exceeding a specified amount; certain events of bankruptcy; failure to pay a judgment for payment of money exceeding a specified aggregate amount; voidance of subsidiary guarantees; failure of any material provision of any security document or intercreditor agreement to be in full force and effect; and lack of perfection of liens on a material portion of the collateral, in each case subject to applicable grace periods.\nFuture Cash Requirement\nThere were no material changes to our contractual future cash requirements from those disclosed in our 2021 Annual Report.\n44\nCash and Cash Equivalents Held Outside the United States\nAs of September 30, 2022 and December 31, 2021, $71.6 million and $86.2 million, respectively, of our cash and cash equivalents were held by foreign subsidiaries. As of September 30, 2022, and December 31, 2021, $21.6 million and $40.0 million, respectively, of our cash and cash equivalents were held by foreign branches.\nWe assessed our determination as to our indefinite reinvestment intent for certain of our foreign subsidiaries and recorded a deferred tax liability of approximately $2.5 million of withholding tax as of December 31, 2021 for unremitted earnings in Canada with respect to which the Company does not have an indefinite reinvestment assertion. We will continue to evaluate our cash needs, however we currently do not intend, nor do we foresee a need, to repatriate funds from the foreign subsidiaries except for Canada. We have continued to assert indefinite reinvestment on all other earnings as it is necessary for continuing operations and to grow the business. If at a point in the future our assertion changes, we will evaluate tax-efficient means to repatriate the income. In addition, we expect existing domestic cash and cash flows from operations to continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, such as debt repayment and capital expenditures, for at least the next 12 months and thereafter for the foreseeable future.\nIf we should require more capital in the United States than is generated by our domestic operations, for example, to fund significant discretionary activities such as business acquisitions, we could elect to repatriate future earnings from foreign jurisdictions. These alternatives could result in higher tax expense or increased interest expense. We consider the majority of the undistributed earnings of our foreign subsidiaries, as of December 31, 2021, to be indefinitely reinvested and, accordingly, no provision has been made for taxes in excess of the $2.5 million noted above.\nOff-Balance Sheet Arrangements\nWe do not have any off-balance sheet financing arrangements or liabilities, guarantee contracts, retained or contingent interests in transferred assets or any obligation arising out of a material variable interest in an unconsolidated entity. We do not have any majority-owned subsidiaries that are not included in our consolidated financial statements. Additionally, we do not have an interest in, or relationships with, any special-purpose entities.\nCritical Accounting Policies and Estimates\nOur critical accounting policies and estimates are included in our 2021 Annual Report and did not materially change during the nine months ended September 30, 2022.\nRecently Issued Accounting Pronouncements\nSee the information set forth in Note 1, Organization and Significant Accounting Policies – Recent Accounting Standards, to our unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2022 and 2021 included in “Part I, Financial Information—Item 1. Financial Statements” in this Quarterly Report.\n45\n\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nForeign Currency Risk\nOur exposure to foreign currency exchange rate fluctuations is primarily the result of foreign subsidiaries and foreign branches primarily domiciled in Europe and Canada. We use financial derivative instruments to hedge foreign currency exchange rate risks associated with our Canadian subsidiary.\nThe assets and liabilities of our foreign subsidiaries and foreign branches, whose functional currencies are primarily Canadian dollars, British pounds and euros, respectively, are translated into U.S. dollars at exchange rates in effect at the balance sheet date. Income and expense items are translated at the average exchange rates prevailing during the period. The cumulative translation effects for subsidiaries using a functional currency other than the U.S. dollar are included in accumulated other comprehensive loss as a separate component of stockholders’ equity. We estimate that had the exchange rate in each country unfavorably changed by ten percent relative to the U.S. dollar, our consolidated income before taxes would have decreased by approximately $2.5 million for the nine months ended September 30, 2022.\nInterest Rate Risk\nInterest rate exposure relates primarily to the effect of interest rate changes on borrowings outstanding under the Term Loan Facility, Revolving Credit Facility and Notes.\nWe manage our interest rate risk through the use of derivative financial instruments. Specifically, we have entered into interest rate cap agreements to manage our exposure to potential interest rate increases that may result from fluctuations in LIBOR. We do not designate these derivatives as hedges for accounting purposes, and as a result, all changes in the fair value of derivatives, used to hedge interest rates, are recorded in “Interest expense, net” in our Condensed Consolidated Statements of Operations and Comprehensive Income.\nAs of September 30, 2022, we had interest rate cap contracts on an additional $650.0 million of notional value of principal from other financial institutions, with a maturity date of December 16, 2024 to manage our exposure to interest rate movements on variable rate credit facilities when one-month LIBOR on term loans exceeding a cap of 0.75%. The aggregate fair value of our interest rate caps represented an outstanding net asset of $49.1 million as of September 30, 2022.\nHolding other variables constant, a change of one-eighth percentage point in the weighted average interest rate above the floor of 0.75% on the Term Loan Facility and Revolving Credit Facility would have resulted in an increase of $0.7 million in interest expense, net of gains from interest rate caps, for the nine months ended September 30, 2022.\nIn the future, in order to manage our interest rate risk, we may refinance our existing debt, enter into additional interest rate cap agreements or modify our existing interest rate cap agreement. However, we do not intend or expect to enter into derivative or interest rate cap transactions for speculative purposes.\n46\n\nITEM 4. CONTROLS AND PROCEDURES\nOur management, with the participation of our chief executive officer and chief financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Quarterly Report. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of September 30, 2022, our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in reports we file or submit under the Exchange Act is (1) recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and (2) accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.\nThere were no changes in internal control over financial reporting that occurred during the quarter ended September 30, 2022, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\nIn designing and evaluating our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints, and that management is required to apply judgment in evaluating the benefits of possible controls and procedures relative to their costs.\n47\nPART II - OTHER INFORMATION\n\nITEM 1. LEGAL PROCEEDINGS\nWe are involved in various legal matters that arise in the ordinary course of our business. Some of these legal matters purport or may be determined to be class and/or representative actions, or seek substantial damages or penalties. Some of these legal matters relate to disputes regarding acquisitions. In connection with certain of the below matters and other legal matters, we have accrued amounts that we believe are appropriate. There can be no assurance, however, that the above matters and other legal matters will not result in us having to make payments in excess of such accruals or that the above matters or other legal matters will not materially or adversely affect our business, financial position or results of operations.\nEmployment-Related Matters\nWe have also been involved in various litigation, including purported class or representative actions with respect to matters arising under the U.S. Fair Labor Standards Act, California’s Labor Code (the “Labor Code”) and California’s Labor Code Private Attorneys General Act (“PAGA”). Many involve allegations for allegedly failing to pay wages and/or overtime, failing to provide meal and rest breaks and failing to pay reporting time pay, waiting time penalties and other penalties.\nA former employee filed a complaint in California Superior Court, Santa Clara County in July 2017, which seeks civil damages and penalties on behalf of the plaintiff and similarly situated persons for various alleged wage and hour violations under the Labor Code, including failure to pay wages and/or overtime, failure to provide meal and rest breaks, failure to pay reporting time pay, waiting time penalties and penalties pursuant to PAGA. We filed a motion for summary judgment. The court granted our motion for summary judgment in March 2020, and the plaintiff filed an appeal of the court’s ruling in May 2020. We have retained outside counsel to represent us and intend to vigorously defend our interests in this matter.\nProceedings Relating to Take 5\nThe following proceedings relate to the Take 5 Matter, which is discussed in greater detail in “PART I, Financial Information —Item 1. Financial Statements—Note 10. Commitments and Contingencies” and “Risk Factors — Risks Related to the Company’s Business and Industry” in this Quarterly Report.\nUSAO and FBI Voluntary Disclosure and Investigation Related to Take 5\nIn connection with the Take 5 Matter, we voluntarily disclosed to the United States Attorney’s Office and the Federal Bureau of Investigation certain misconduct occurring at Take 5. We intend to cooperate in this and any other governmental investigation that may arise in connection with the Take 5 Matter. At this time, we cannot predict the ultimate outcome of any investigation related to the Take 5 Matter and are unable to estimate the potential impact such an investigation may have on us.\nArbitration Proceedings Related to Take 5\nIn August 2019, as a result of the Take 5 Matter, we provided a written indemnification claim notice to the sellers of Take 5, or the Take 5 Sellers, seeking monetary damages (including interest, fees and costs) based on allegations of breach of the asset purchase agreement, or Take 5 APA, as well as fraud. In September 2019, the Take 5 Sellers initiated arbitration proceedings in the state of Delaware against us, alleging breach of the Take 5 APA as a result of our decision to terminate the operations of the Take 5 business and seeking monetary damages equal to all unpaid earn-out payments under the Take 5 APA (plus interest fees and costs). In 2020, the Take 5 Sellers amended their statement of claim to allege defamation, relating to statements we made to customers in connection with terminating the operations of the Take 5 business, and seeking monetary damages for the alleged injury to their reputation. We have filed our response to the Take 5 Sellers’ claims and asserted indemnification, fraud and other claims against the Take 5 Sellers as counterclaims and cross-claims in the arbitration proceedings.\n48\nIn October 2022, the arbitrator made a final award in our favor. We are currently unable to estimate if or when we will be able to collect any amounts associated with this arbitration.\nOther Legal Matters Related to Take 5\nThe Take 5 Matter may result in additional litigation against us, including lawsuits from clients, or governmental investigations, which may expose us to potential liability in excess of the amounts being offered by us as refunds to Take 5 clients. We are currently unable to determine the amount of any potential liability, costs or expenses (above the amounts already being offered as refunds) that may result from any lawsuits or investigations associated with the Take 5 Matter or determine whether any such issues will have any future material adverse effect on our financial position, liquidity or results of operations. Although we have insurance covering certain liabilities, we cannot assure that the insurance will be sufficient to cover any potential liability or expenses associated with the Take 5 Matter.\n\nITEM 1A. RISK FACTORS\nInvesting in our securities involves risks. Before you make a decision regarding our securities, in addition to the risks and uncertainties discussed above under “Forward-Looking Statements,” you should carefully consider the specific risks set forth herein. If any of these risks actually occur, it may materially harm our business, financial condition, liquidity and results of operations. As a result, the market price of our securities could decline, and you could lose all or part of your investment. Additionally, the risks and uncertainties described in this Quarterly Report are not the only risks and uncertainties that we face. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may become material and adversely affect our business. The following discussion should be read in conjunction with the financial statements and notes to the financial statements included herein.\nSummary of Principal Risks Associated with Our Business\nSet forth below is a summary of some of the principal risks we face:\n•the COVID-19 pandemic and the measures taken to mitigate its spread including its adverse effects on our business, results of operations, financial condition and liquidity;\n•market-driven wage changes or changes to labor laws or wage or job classification regulations, including minimum wage;\n•our ability to hire, timely train, and retain talented individuals for our workforce, and to maintain our corporate culture as we grow;\n•developments with respect to retailers that are out of our control;\n•our ability to continue to generate significant operating cash flow;\n•consolidation within the industry of our clients creating pressure on the nature and pricing of our services;\n•our reliance on continued access to retailers’ platforms;\n•consumer goods manufacturers and retailers reviewing and changing their sales, retail, marketing, and technology programs and relationships;\n•our ability to successfully develop and maintain relevant omni-channel services for our clients in an evolving industry and to otherwise adapt to significant technological change;\n•client procurement strategies putting additional operational and financial pressure on our services;\n•our ability to maintain proper and effective internal control over financial reporting in the future;\n•potential and actual harms to our business arising from the matter related to the 2018 acquisition of Take 5 Media Group (the “Take 5 Matter”);\n•our ability to identify attractive acquisition targets, acquire them at attractive prices, and successfully integrate the acquired businesses;\n•our ability to avoid or manage business conflicts among competing brands;\n49\n•difficulties in integrating acquired businesses;\n•our substantial indebtedness and our ability to refinance at favorable rates;\n•limitations, restrictions, and business decisions involving our joint ventures and minority investments;\n•our ability to respond to changes in digital practices and policies;\n•exposure to foreign currency exchange rate fluctuations and risks related to our international operations;\n•disruptions in global financial markets relating to terrorist attacks or geopolitical risk and the recent conflict between Russia and Ukraine;\n•the ability to maintain applicable listing standards;\n•changes in applicable laws or regulations; and\n•the possibility that we may be adversely affected by other political, economic, business, and/or competitive factors.\nRisks Related to the Company’s Business and Industry\nThe COVID-19 pandemic and the measures taken to mitigate its spread have had, and are likely to continue to have, an adverse effect on our business, results of operations, financial condition and liquidity.\nThe COVID-19 pandemic, including the measures taken to mitigate its spread, have had, and are likely to continue to have, adverse effects on our business and operations. There are many uncertainties regarding the current COVID-19 pandemic, including the scope of potential public health issues, the anticipated duration of the pandemic and the extent of local and worldwide social, political and economic disruption it has caused and may cause in the future. To date, the COVID-19 pandemic and measures taken to mitigate the spread of COVID-19, including restrictions on large gatherings, closures of face-to-face events and indoor dining facilities, “shelter in place” health orders and travel restrictions, have had far-reaching direct and indirect impacts on many aspects of our operations, including temporary termination of certain in-store demonstration services and other services, as well as on consumer behavior and purchasing patterns, in particular with respect to the foodservice industries, and declines in consumer demand for restaurant, school and hotel dining, where we promote our clients’ products. Since March 2020, our marketing segment has experienced a significant decline in revenues, primarily due to the temporary suspension or reduction of certain in-store demonstration services and decreased demand in our digital marketing services, both of which we believe were caused by the COVID-19 pandemic and the various governmental and private responses to the pandemic, and which may continue in the future. In our sales segment, we have experienced significant shifts in consumer spending preferences and habits. We can provide no assurances that the strength of that segment will continue or that we will be able to continue to evolve our business in the future as the COVID-19 pandemic continues to impact our clients’ businesses.\nWe have taken several actions in response to these business disruptions, including reducing certain of our discretionary expenditures, reducing our real estate foot print, through lease terminations and amendments (including abandoning several office leases prior to reaching termination agreements with its landlords), eliminating non-essential travel and terminating, furloughing or instituting pay reductions and deferrals for some of our associates. However, the pandemic has had, and may continue to have, an adverse effect on our results of operations, including our revenues, our financial condition and liquidity.\nThe COVID-19 pandemic also may have the effect of heightening many of the other risks described in these “Risk Factors”, including:\n•potential changes in the policies of retailers in response to the COVID-19 pandemic, including changes to or restrictions on their outsourcing of sales and marketing functions and restrictions on the performance of in-store demonstration services, if permitted at all;\n•potential changes in the demand for services by our clients in response to the COVID-19 pandemic;\n•our ability to hire, timely train and retain talented individuals for our workforce;\n•disruptions, delays and strains in certain domestic and internal supply changes that have had, and may continue to have, a negative effect on the flow or availability of certain products;\n50\n•the need for us to adapt to technological change and otherwise develop and maintain omni-channel solutions;\n•our ability to generate sufficient cash to service our substantial indebtedness;\n•our ability to maintain our credit rating;\n•our ability to offer high-quality customer support and maintain our reputation;\n•our ability to identify, perform adequate diligence on and consummate acquisitions of attractive business targets, and then subsequently integrate such acquired businesses;\n•our ability to maintain our corporate culture;\n•severe disruption and instability in the U.S. and global financial markets or deteriorations in credit and financing conditions, which could make it difficult for us to access debt and equity capital on attractive terms, or at all;\n•our ability to effectively manage our operations while a significant amount of our associates continue to work remotely due to the COVID-19 pandemic;\n•deteriorating economic conditions, declines in labor force participation rates, public transportation disruptions or other disruptions as a result of the COVID-19 pandemic;\n•potential cost-saving strategies implemented by clients that reduce fees paid to third-party service providers such as ourselves; and\n•our ability to implement additional internal control measures to improve our internal control over financial reporting.\nWe cannot predict the full extent to which the COVID-19 pandemic may affect our business, financial condition, results of operations and liquidity as such effects will depend on how the COVID-19 pandemic and the measures taken in response to the COVID-19 pandemic continue to develop. However, these effects may continue, evolve or increase in severity, each of which could further negatively impact our business, financial condition, results of operations and liquidity.\nMarket-driven wage increases and changes to wage or job classification regulations, including minimum wages could adversely affect our business, financial condition or results of operations.\nMarket competition has and may continue to cause us to increase the salaries or wages paid to our associates or the benefits packages that they receive. If we experience further market-driven increases in salaries, wage rates or benefits or if we fail to increase our offered salaries, wages or benefits packages competitively, the quality of our workforce could decline, causing our client service to suffer. Low unemployment rates or lower levels of labor force participation rates may increase the likelihood or impact of such market pressures. Any of these changes affecting wages or benefits for our associates could adversely affect our business, financial condition or results of operations.\nChanges in labor laws related to employee hours, wages, job classification and benefits, including health care benefits, could adversely affect our business, financial condition or results of operations. As of September 30, 2022, we employed approximately 75,000 associates, many of whom are paid above, but near, applicable minimum wages, and their wages may be affected by changes in minimum wage laws.\nAdditionally, many of our salaried associates are paid at rates that could be impacted by changes to minimum pay levels for exempt roles. Certain state or municipal jurisdictions in which we operate have recently increased their minimum wage by a significant amount, and other jurisdictions are considering or plan to implement similar actions, which may increase our labor costs. Any increases at the federal, state or municipal level to the minimum pay rate required to remain exempt from overtime pay may adversely affect our business, financial condition or results of operations.\nAn inability to hire, timely train and retain talented individuals for our workforce could slow our growth and adversely impact our ability to operate our business.\nOur ability to meet our workforce needs, while controlling associate-related costs, including salaries, wages and benefits, is subject to numerous external factors, including the availability of talented persons in the workforce in the local markets in which we operate, prevailing unemployment rates and competitive wage rates in such\n51\nmarkets. We may find that there is an insufficient number of qualified individuals to fill our associate positions with the qualifications we seek. Competition in these communities for qualified staff could require us to pay higher wages and provide greater benefits, especially if there is significant improvement in regional or national economic conditions. We must also train and, in some circumstances, certify these associates under our policies and practices and any applicable legal requirements. If we are unable to hire, timely train or retain talented individuals may result in higher turnover and increased labor costs, and could compromise the quality of our service, all of which could adversely affect our business.\nInflation may adversely affect our operating results.\nInflationary factors such as increases in the labor costs, material costs and overhead costs may adversely affect our operating results. A high rate of inflation, including a continuation of inflation at the current rate, has had and may continue to have an adverse effect on our ability to maintain attractive levels of gross margin and general and administrative expenses as a percentage of total revenue, if we are unable to pass on these costs through increased prices, revised budget estimates, or offset them in other ways.\nOur business and results of operations are affected by developments with and policies of retailers that are out of our control.\nA limited number of national retailers account for a large percentage of sales for our consumer goods manufacturer clients. We expect that a significant portion of these clients’ sales will continue to be made through a relatively small number of retailers and that this percentage may increase if the growth of mass retailers and the trend of retailer consolidation continues. As a result, changes in the strategies of large retailers, including a reduction in the number of brands that these retailers carry or an increase in shelf space that they dedicate to private label products, could materially reduce the value of our services to these clients or these clients’ use of our services and, in turn, our revenues and profitability. Many retailers have critically analyzed the number and variety of brands they sell, and have reduced or discontinued the sale of certain of our clients’ product lines at their stores, and more retailers may continue to do so. If this continues to occur and these clients are unable to improve distribution for their products at other retailers, our business or results of operations could be adversely affected. These trends may be accelerated as a result of the COVID-19 pandemic.\nAdditionally, many retailers, including several of the largest retailers in North America, which own and operate a significant number of the locations at which we provide our services, have implemented or may implement in the future, policies that designate certain service providers to be the exclusive provider or one of their preferred providers for specified services, including many of the services that we provide to such retailers or our clients.\nSome of these designations apply across all of such retailers’ stores, while other designations are limited to specific regions. If we are unable to respond effectively to the expectations and demands of such retailers or if retailers do not designate us as their exclusive provider or one of their preferred providers for any reason, they could reduce or restrict the services that we are permitted to perform for our clients at their facilities or require our clients to purchase services from other designated services providers, which include our competitors, either of which could adversely affect our business or results of operations.\nConsolidation in the industries we serve could put pressure on the pricing of our services, which could adversely affect our business, financial condition or results of operations.\nConsolidation in the consumer goods and retail industries we serve could reduce aggregate demand for our services in the future and could adversely affect our business or our results of operations. In October 2022, The Kroger Co. and Albertsons Companies, Inc., two large retailers, announced an agreement to merge their businesses together with an anticipated closing in 2024. When companies consolidate, the services they previously purchased separately are often purchased by the combined entity, leading to the termination of relationships with certain service providers or demands for reduced fees and commissions. The combined company may also choose to insource certain functions that were historically outsourced, resulting in the termination of existing relationships with third-party service providers. While we attempt to mitigate the revenue impact of any consolidation by maintaining existing or winning new service arrangements with the combined companies, there can be no assurance as to the degree to which we will be able to do so as consolidation continues in the industries we serve, and our business, financial condition or results of operations may be adversely affected.\n52\nConsumer goods manufacturers and retailers may periodically review and change their sales, retail, marketing and technology programs and relationships to our detriment.\nThe consumer goods manufacturers and retailers to whom we provide our business solutions operate in highly competitive and rapidly changing environments. From time to time these parties may put their sales, retail, marketing and technology programs and relationships up for competitive review, which may increase in frequency as a result of the COVID-19 pandemic and its impacts on the consumer goods manufacturers and retailer industries. We have occasionally lost accounts with significant clients as a result of these reviews in the past, and our clients are typically able to reduce or cancel current or future spending on our services on short notice for any reason. We believe that key competitive considerations for retaining existing and winning new accounts include our ability to develop solutions that meet the needs of these manufacturers and retailers in this environment, the quality and effectiveness of our services and our ability to operate efficiently. To the extent that we are not able to develop these solutions, maintain the quality and effectiveness of our services or operate efficiently, we may not be able to retain key clients, and our business, financial condition or results of operations may be adversely affected.\nOur largest clients generate a significant portion of our revenues.\nOur three largest clients generated approximately 11% of our revenues in the fiscal year ended December 31, 2021. These clients are generally able to reduce or cancel spending on our services on short notice for any reason. A significant reduction in spending on our services by our largest clients, or the loss of one or more of our largest clients, if not replaced by new clients or an increase in business from existing clients, would adversely affect our business and results of operations. In addition, when large retailers suspend or reduce in-store demonstration services, such as in response to the COVID-19 pandemic, our business and results of operations can be adversely affected.\nWe are reliant on continued access to retailer platforms on commercially reasonable terms for the provision of certain of our e-commerce services in which our clients’ products are resold by us, as the vendor of record, directly to the consumer.\nA portion of the e-commerce services we provide involve the purchase and resale by us, as the vendor of record, of our clients’ products through retailer platforms. The control that retailers such as Amazon have over the access and fee structures and/or pricing for products on their platforms could impact the volume of purchases of these products made on their platform and our revenues from the provision of such e-commerce services. If such retailers establish terms that restrict the offering of these products on their platform, significantly impact the financial terms on which such products are offered, or do not approve the inclusion of such products on their platform, our business could be negatively impacted. Additionally, we also generally rely on a retailer’s payment processing services for purchases made on its platform by consumers. To the extent such payment processing services are offered to us on less favorable terms, or become unavailable to us for any reason, our costs of revenue with respect to this aspect of our business could increase, and our margins could be materially adversely impacted. We cannot assure you that we will be successful in maintaining access to these retailer platforms on commercially reasonable terms, or at all.\nThe retail industry is evolving, and if we do not successfully develop and maintain relevant omni-channel services for our clients, our business, financial condition or results of operations could be adversely impacted.\nHistorically, substantially all of our sales segment revenues were generated by sales and services that ultimately occurred in traditional retail stores. The retail industry is evolving, as demonstrated by the number of retailers that offer both traditional retail stores and e-commerce platforms or exclusively e-commerce platforms. In addition, the COVID-19 pandemic has placed pressure on the traditional retail store model, including store closures, changes in consumer spending, and extensive health and safety risks and compliance requirements. Consumers are increasingly using computers, tablets, mobile phones and other devices to comparison shop, determine product availability and complete purchases online, a trend that has accelerated during the COVID-19 pandemic, and which may continue thereafter. If consumers continue to purchase more products online and e-commerce continues to displace brick-and-mortar retail sales, there may be a decrease in the demand for certain of our services. Omni-channel retailing is rapidly evolving and we believe we will need to keep pace with the changing consumer expectations and new developments by our competitors.\n53\nWhile we continue to seek to develop effective omni-channel solutions for our clients that support both their e-commerce and traditional retail needs, there can be no assurances that these efforts will result in revenue gains sufficient to offset potential decreases associated with a decline in traditional retail sales or that we will be able to maintain our position as a leader in our industry. If we are unable to provide, improve or develop innovative digital services and solutions in a timely manner or at all, our business, financial condition or results of operations could be adversely impacted.\nWe may be unable to adapt to significant technological change, which could adversely affect our business, financial condition or results of operations.\nWe operate businesses that require sophisticated data collection, processing and software for analysis and insights. Some of the technologies supporting the industries we serve are changing rapidly, particularly as a result of the COVID-19 pandemic. We will be required to continue to adapt to changing technologies, either by developing and marketing new services or by enhancing our existing services, to meet client demand.\nMoreover, the introduction of new services embodying new technologies, including automation of certain of our in-store services, and the emergence of new industry standards could render existing services obsolete. Our continued success will depend on our ability to adapt to changing technologies, manage and process increasing amounts of data and information and improve the performance, features and reliability of our existing services in response to changing client and industry demands. We may experience difficulties that could delay or prevent the successful design, development, testing, introduction or marketing of our services. New services or enhancements to existing services may not adequately meet the requirements of current and prospective clients or achieve market acceptance.\nOur ability to maintain our competitive position depends on our ability to attract and retain talented executives.\nWe believe that our continued success depends to a significant extent upon the efforts, abilities and relationships of our senior executives and the strength of our middle management team. Although we have entered into employment agreements with certain of our senior executives, each of them may terminate their employment with us at any time. The replacement of any of our senior executives likely would involve significant time and costs and may significantly delay or prevent the achievement of our business objectives and could therefore have an adverse impact on our business. In addition, we do not carry any “key person” insurance policies that could offset potential loss of service under applicable circumstances. Furthermore, if we are unable to attract and retain a talented team of middle management executives, it may be difficult to maintain the expertise and industry relationships that our clients value, and they may terminate or reduce their relationship with us.\nClient procurement and fee reduction strategies could put additional operational and financial pressure on our services or negatively impact our relationships, business, financial condition or results of operations.\nMany of our clients seek opportunities to reduce their costs through procurement strategies that reduce fees paid to third-party service providers. As a result, certain of our clients have sought, and may continue to seek, more aggressive terms from us, including with respect to pricing and payment terms. Such activities put operational and financial pressure on our business, which could limit the amounts we earn or delay the timing of our cash receipts. Such activities may also cause disputes with our clients or negatively impact our relationships or financial results. Our clients have experienced, and may continue to experience, increases in their expenses associated with materials and logistics, which may cause them to reduce expenses elsewhere. While we attempt to mitigate negative implications to client relationships and the revenue impact of any pricing pressure by aligning our revenues opportunity with satisfactory client outcomes, there can be no assurance as to the degree to which we will be able to do so successfully. Additionally, price concessions can lead to margin compression, which in turn could adversely affect our business, financial condition or results of operations.\nIf we fail to offer high-quality customer support, our business and reputation may suffer.\nHigh-quality education, training and customer support are important for successful marketing and sales and for the renewal of existing customers. Providing this education, training and support requires that our personnel who manage our online training resource or provide customer support have specific inbound experience domain knowledge and expertise, making it more difficult for us to hire qualified personnel and to scale up our support operations. The importance of high-quality customer support will increase as we expand our business and pursue\n54\nnew customers. If we do not help our customers use multiple applications and provide effective ongoing support, our ability to sell additional functionality and services to, or to retain, existing customers may suffer and our reputation with existing or potential customers may be harmed.\nWe may be adversely affected if clients reduce their outsourcing of sales and marketing functions.\nOur business and growth strategies depend in large part on companies continuing to elect to outsource sales and marketing functions. Our clients and potential clients will outsource if they perceive that outsourcing may provide quality services at a lower overall cost and permit them to focus on their core business activities and have done so in the past. We cannot be certain that the industry trend to outsource will continue or not be reversed or that clients that have historically outsourced functions will not decide to perform these functions themselves. Unfavorable developments with respect to outsourcing could adversely affect our business, financial conditions and results of operations.\nWe previously identified material weaknesses in our internal control over financial reporting. If we fail to maintain proper and effective internal control over financial reporting in the future, our ability to produce accurate and timely financial statements could be impaired, investors’ views of us could be harmed, and we could be subject to enforcement actions by the SEC.\nDuring 2021, we completed the remediation measures related to the material weaknesses previously identified and concluded that our internal control over financial reporting was effective as of December 31, 2021. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim consolidated financial statements will not be prevented or detected on a timely basis. If we are unable to maintain effective internal control over financial reporting or disclosure controls and procedures, our ability to record, process and report financial information accurately, and to prepare financial statements within required time periods could be adversely affected, which could subject us to litigation or investigations requiring management resources and payment of legal and other expenses, negatively affect investor confidence in our financial statements and adversely impact our stock price.\nIf we are unable to identify attractive acquisition targets, acquire them at attractive prices or successfully integrate the acquired businesses, we may be unsuccessful in growing our business.\nA significant portion of our growth has been as a result of our acquisition of complementary businesses that grow our service offerings, expand our geographic reach and strengthen valuable relationships with clients. However, there can be no assurance that we will find attractive acquisition targets, that we will acquire them at attractive prices, that we will succeed at effectively managing the integration of acquired businesses into our existing operations or that such acquired businesses or technologies will be well received by our clients, potential clients or our investors. We could also encounter higher-than-expected earn-out payments, unforeseen transaction- and integration-related costs or delays or other circumstances such as disputes with or the loss of key or other personnel from acquired businesses, challenges or delays in integrating systems or technology of acquired businesses, a deterioration in our associate and client relationships, harm to our reputation with clients, interruptions in our business activities or unforeseen or higher-than-expected inherited liabilities. Many of these potential circumstances are outside of our control and any of them could result in increased costs, decreased revenue, decreased synergies or the diversion of management time and attention.\nIn order for us to continue to grow our business through acquisitions we will need to identify appropriate acquisition opportunities and acquire them at attractive prices. We may choose to pay cash, incur debt or issue equity securities to pay for any such acquisition. The incurrence of indebtedness would result in increased fixed obligations and could also include covenants or other restrictions that would impede our ability to manage our operations. The sale of equity to finance any such acquisition could result in dilution to our stockholders.\nWe may encounter significant difficulties integrating acquired businesses.\nThe integration of any businesses is a complex, costly and time-consuming process. As a result, we have devoted, and will continue to devote, significant management attention and resources to integrating acquired businesses. The failure to meet the challenges involved in integrating businesses and to realize the anticipated benefits of any acquisition could cause an interruption of, or a loss of momentum in, the activities of our combined\n55\nbusiness and could adversely affect our results of operations. The difficulties of combining acquired businesses with our own include, among others:\n•the diversion of management attention to integration matters;\n•difficulties in integrating functional roles, processes and systems, including accounting systems;\n•challenges in conforming standards, controls, procedures and accounting and other policies, business cultures and compensation structures between the two companies;\n•difficulties in assimilating, attracting and retaining key personnel;\n•challenges in keeping existing clients and obtaining new clients;\n•difficulties in achieving anticipated cost savings, synergies, business opportunities and growth prospects from an acquisition;\n•difficulties in managing the expanded operations of a significantly larger and more complex business;\n•contingent liabilities, including contingent tax liabilities or litigation, that may be larger than expected; and\n•potential unknown liabilities, adverse consequences or unforeseen increased expenses associated with an acquisition, including possible adverse tax consequences to the combined business pursuant to changes in applicable tax laws or regulations.\nMany of these factors are outside of our control, and any one of them could result in increased costs, decreased expected revenues and diversion of management time and energy, all of which could adversely impact our business and results of operations. These difficulties have been enhanced further during the COVID-19 pandemic as a result of our office closures and work-from home policies, which may hinder assimilation of key personnel.\nIf we are not able to successfully integrate an acquisition, if we incur significantly greater costs to achieve the expected synergies than we anticipate or if activities related to the expected synergies have unintended consequences, our business, financial condition or results of operations could be adversely affected.\nOur corporate culture has contributed to our success and, if we are unable to maintain it as we evolve, our business, operating results and financial condition could be harmed.\nWe believe our corporate culture has been a significant factor in our success. However, as our company evolves, including through acquisitions and the impacts of the COVID-19 pandemic, such as working remotely and reductions in workforce, it may be difficult to maintain our culture, which could reduce our ability to innovate and operate effectively. The failure to maintain the key aspects of our culture as our organization evolves could result in decreased employee satisfaction, increased difficulty in attracting top talent, increased turnover and compromised the quality of our client service, all of which are important to our success and to the effective execution of our business strategy. If we are unable to maintain our corporate culture as we evolve and execute our growth strategies, our business, operating results and financial condition could be harmed.\nAcquiring new clients and retaining existing clients depends on our ability to avoid or manage business conflicts among competing brands.\nOur ability to acquire new clients and to retain existing clients, whether by expansion of our own operations or through an acquired business may in some cases be limited by the other parties’ perceptions of, or policies concerning, perceived competitive conflicts arising from our other relationships. Some of our contracts expressly restrict our ability to represent competitors of the counterparty. These perceived competitive conflicts may also become more challenging to avoid or manage as a result of continued consolidation in the consumer goods and retail industries and our own acquisitions. If we are unable to avoid or manage business conflicts among competing manufacturers and retailers, we may be unable to acquire new clients or be forced to terminate existing client relationships, and in either case, our business and results of operations may be adversely affected.\nLimitations, restrictions and business decisions involving our joint ventures and minority investments may adversely affect our growth and results of operations.\n56\nWe have made substantial investments in joint ventures and minority investments and may use these and other similar methods to expand our service offerings and geographical coverage in the future. These arrangements typically involve other business services companies as partners that may be competitors of ours in certain markets. Joint venture agreements may place limitations or restrictions on our services. As part of our joint venture with, and investments in Smollan, we are restricted under certain circumstances from making direct acquisitions and otherwise expanding our service offerings into markets outside of North America and Europe. As a result of our acquisition of Daymon Worldwide Inc. pursuant to the terms of our arrangements with Smollan and our joint venture, Smollan and our joint venture may elect to purchase from us, and have purchased, certain Daymon business units that operate outside of North America. If Smollan or our joint venture do not elect to purchase those business units, we may, under certain circumstances, elect to retain, sell or discontinue those business units. The limitations and restrictions tied to our joint venture and minority investments limit our potential business opportunities and reduce the economic opportunity for certain prospective international investments and operations. Additionally, though we control our joint ventures, we may rely upon our equity partners or local management for operational and compliance matters associated with our joint ventures or minority investments. Moreover, our other equity partners and minority investments may have business interests, strategies or goals that are inconsistent with ours. Business decisions, including actions or omissions, of a joint venture or other equity partner or management for a business unit may adversely affect the value of our investment, result in litigation or regulatory action against us or adversely affect our growth and results of operations.\nOur international operations expose us to risks that could impede growth in the future, and our attempts to grow our business internationally may not be successful.\nWe continue to explore opportunities in major international markets. International operations expose us to various additional risks that could adversely affect our business, including:\n•costs of customizing services for clients outside of the United States;\n•the burdens of complying with a wide variety of foreign laws;\n•potential difficulty in enforcing contracts;\n•being subject to U.S. laws and regulations governing international operations, including the U.S. Foreign Corrupt Practices Act and sanctions regimes;\n•being subject to foreign anti-bribery laws in the jurisdictions in which we operate, such as the UK Bribery Act;\n•reduced protection for intellectual property rights;\n•increased financial accounting and reporting complexity;\n•additional legal compliance requirements, including custom and import requirements with respect to products imported to and exported across international borders;\n•exposure to foreign currency exchange rate fluctuations;\n•exposure to local economic conditions;\n•limitations on the repatriation of funds or profits from foreign operations;\n•exposure to local or regional political conditions, including adverse tax policies and civil unrest;\n•the risks of a natural disaster, public health crisis (including the occurrence of a contagious disease or illness, such as the coronavirus), an outbreak of war (such as Russia's invasion of Ukraine), the escalation of hostilities and acts of terrorism in the jurisdictions in which we operate; and\n•the disparate impact of the COVID-19 pandemic, including the measures taken to mitigate its spread, across various jurisdictions.\nAdditionally, the withdrawal of the United Kingdom from the European Union, or “Brexit,” has created economic and political uncertainty, including volatility in global financial markets and the value of foreign currencies. The impact of Brexit may not be fully realized for several years. Additionally, in many countries outside of the United States, there has not been a historical practice of using third parties to provide sales and marketing services. Accordingly, while it is part of our strategy to expand into international markets, it may be difficult for us to grow our international business units on a timely basis, or at all.\nThe ongoing conflict between Russia and Ukraine may adversely affect our business and results of operations.\n57\nGiven the nature of our business and our international operations, political, economic, and other conditions in foreign countries and regions, including geopolitical risks such as those arising from the current conflict between Russia and Ukraine, may adversely affect our business and results of operations. The broader consequences of this conflict, which may include further sanctions, embargoes, regional instability, and geopolitical shifts; disruptions to transportation and distribution routes, or strategic decisions to alter certain routes; potential retaliatory action by the Russian government against companies, including us, including nationalization of foreign businesses and/or assets in Russia; increased tensions between the United States and countries in which we operate; and the extent of the conflict’s effect on our business and results of operations as well as the global economy, cannot be predicted.\nAdditionally, we have a minority interest in a European company that owns majority interests in local agencies in Russia. In addition to the imposition of sanctions by the United States, the United Kingdom, and the European Union that affect the cross-border operations of businesses operating in Russia, Russian regulators have imposed currency restrictions and regulations that created uncertainty regarding our ability to recover our investment in operations in Russia, as well as our ability to exercise control or influence involving operations by the local agencies in Russia. As a result, we intend to use our influence to cause the European company to dispose of our ownership interests in the local agencies in Russia. Accordingly, we recorded pretax charges of $2.8 million in the first quarter of 2022, primarily consisting of our proportionate share of the net investment in our Russian interest in “Selling, general, and administrative expenses” in the Condensed Consolidated Statements of Operations and Comprehensive Income.\nTo the extent the current conflict between Russia and Ukraine adversely affects our business, particularly in Russia, it may also have the effect of heightening many other risks disclosed in our 2021 Annual Report and this Quarterly Report, any of which could materially and adversely affect our business and results of operations. Such risks include, but are not limited to, adverse effects on macroeconomic conditions, including inflation and business spending; disruptions to our information technology infrastructure, including through cyberattack, ransom attack, or cyber-intrusion; adverse changes in international trade policies and relations; our ability to maintain or increase our prices, our ability to implement and execute our business strategy, disruptions in global supply chains, our exposure to foreign currency fluctuations, and constraints, volatility, or disruption in the capital markets, difficulty staffing and managing impacted operations, and the recoverability of assets in the region.\nWe may be subject to unionization, work stoppages, slowdowns or increased labor costs.\nCurrently, none of our associates in the United States are represented by a union. However, our associates have the right under the National Labor Relations Act to choose union representation. If all or a significant number of our associates become unionized and the terms of any collective bargaining agreement were significantly different from our current compensation arrangements, it could increase our costs and adversely impact our profitability. Moreover, if a significant number of our associates participate in labor unions, it could put us at increased risk of labor strikes and disruption of our operations or adversely affect our growth and results of operations. In December 2019, a union which commonly represents employees in the supermarket industry filed a petition with the National Labor Relations Board to represent approximately 120 of our associates who work in and around Boston. An election was held, and based on certified results of the election we prevailed in this election. Notwithstanding this successful election, we could face future union organization efforts or elections, which could lead to additional costs, distract management or otherwise harm our business.\nIf goodwill or other intangible assets in connection with our acquisitions become impaired, we could take significant non-cash charges against earnings.\nWe have made acquisitions to complement and expand the services we offer and intend to continue to do so when attractive acquisition opportunities exist in the market. As a result of prior acquisitions, including the acquisition of our business in 2014 by our current parent entity, Topco, we have goodwill and intangible assets recorded on our balance sheet of $2.2 billion and $2.2 billion, respectively, as of September 30, 2022, as further described in Note 4 to our condensed consolidated financial statements for the three and nine months ended September 30, 2022.\nUnder accounting guidelines, we must assess, at least annually, whether the value of goodwill and other intangible assets has been impaired. We have recognized non-cash goodwill and non-cash intangible asset impairment charges, and we can make no assurances that we will not record any additional impairment charges in\n58\nthe future. Any future reduction or impairment of the value of goodwill or other intangible assets will similarly result in charges against earnings, which could adversely affect our reported financial results in future periods.\nFailures in, or incidents involving, our technology infrastructure could damage our business, reputation and brand and substantially harm our business and results of operations.\nOur business is highly dependent on our ability to manage operations and process a large number of transactions on a daily basis. We rely heavily on our operating, payroll, financial, accounting and other data processing systems which require substantial support and maintenance, and may be subject to disabilities, errors, or other harms. If our data and network infrastructure were to fail, or if we were to suffer a data security breach, or an interruption or degradation of services in our data center, third-party cloud, and other infrastructure environments, we could lose important data, which could harm our business and reputation, and cause us to incur significant liabilities. Our facilities, as well as the facilities of third-parties that provide or maintain, or have access to our data or network infrastructure, are vulnerable to damage or interruption from earthquakes, hurricanes, floods, fires, cyber security attacks, terrorist attacks, power losses, telecommunications failures and similar events. In the event that our or any third-party provider’s systems or service abilities are hindered by any of the events discussed above, our ability to operate may be impaired. Our information technology systems, and the information technology systems of our current or future third-party vendors, collaborators, consultants and service providers, could be penetrated by internal or external parties intent on extracting information, corrupting information, stealing intellectual property or trade secrets, or disrupting business processes. A third party’s decision to close facilities or terminate services without adequate notice, or other unanticipated problems, could adversely impact our operations. Any of the aforementioned risks may be augmented if our or any third-party provider’s business continuity and disaster recovery plans prove to be inadequate in preventing the loss of data, service interruptions, disruptions to our operations or damages to important systems or facilities. Our data center, third-party cloud, and managed service provider infrastructure also could be subject to break-ins, cyber-attacks (including through the use of malware, software bugs, computer viruses, ransomware, social engineering, and denial of service), sabotage, intentional acts of vandalism and other misconduct, from a spectrum of actors ranging in sophistication from threats common to most industries to more advanced and persistent, highly organized adversaries. Any security breach or incident, including personal data breaches, that we experience could result in unauthorized access to, or misuse, modification, destruction or unauthorized acquisition of, our internal sensitive corporate data, such as personal data, financial data, trade secrets, intellectual property, or other competitively sensitive or confidential data. Such unauthorized access, misuse, acquisition, or modification of sensitive data may result in data loss, corruption or alteration, interruptions in our operations or damage to our computer hardware or systems or those of our employees or customers. Our systems have been the target of cyber-attacks. Although we have taken and continue to take steps to enhance our cybersecurity posture, we cannot assure that future cyber incidents will not occur or that our systems will not be targeted or breached in the future. Any such breach or unauthorized access could result in a disruption of the Company’s operations, the theft, unauthorized use or publication of the Company’s intellectual property, other proprietary information or the personal information of customers, employees, licensees or suppliers, a reduction of the revenues the Company is able to generate from its operations, damage to the Company’s brand and reputation, a loss of confidence in the security of the Company’s business and products, and significant legal and financial exposure. If any such incident results in litigation, we may be required to make significant expenditures in the course of such litigation and may be required to pay significant amounts in damages. We may not carry sufficient business interruption insurance to compensate us for losses that may occur as a result of any events that cause interruptions in our service. Significant unavailability of our services due to attacks could cause us to incur significant liability, could cause users to cease using our services and materially and adversely affect our business, prospects, financial condition and results of operations.\nWe use complex software in our technology infrastructure, which we seek to continually update and improve. Replacing such systems is often time-consuming and expensive and can also be intrusive to daily business operations. Further, we may not always be successful in executing these upgrades and improvements, which may result in a failure of our systems. We may experience periodic system interruptions from time to time. Any slowdown or failure of our underlying technology infrastructure could harm our business and reputation, which could materially adversely affect our results of operations. Our disaster recovery plan or those of our third-party providers may be inadequate, and our business interruption insurance may not be sufficient to compensate us for the losses that could occur.\n59\nFailure to comply with federal, state and foreign laws and regulations relating to privacy, data protection and consumer protection, or the expansion of current or the enactment of new laws or regulations relating to privacy, data protection and consumer protection, could adversely affect our business and our financial condition.\nA variety of federal, state and foreign laws and regulations govern the collection, use, retention, sharing and security of personal information. The information, security and privacy requirements imposed by such governmental laws and regulations relating to privacy, data protection and consumer protection are increasingly demanding, quickly evolving and may be subject to differing interpretations or legal theories among regulators, enforcers, and civil litigants. These requirements may not be harmonized, may be interpreted and applied in a manner that is inconsistent from one jurisdiction to another or may conflict with other rules or our practices. As a result, our practices may not have complied or may not comply in the future with all such laws, regulations, requirements and obligations. Our actual or perceived failure to comply with such laws and regulations could result in fines, investigations, enforcement actions, penalties, sanctions, claims for damages by affected individuals, and damage to our reputation, among other negative consequences, any of which could have a material adverse effect on its financial performance.\nCertain aspects of our business and/or the data it collects is subject to the California Consumer Protection Act of 2018 (“CCPA”), which became effective in 2020 and regulates the collection, use and processing of personal information relating to California residents, and which grants certain privacy rights to California residents, including rights to request access to and to request deletion of personal information relating to such individuals under certain circumstances. Compliance with the new obligations imposed by the CCPA depends in part on how its requirements are interpreted and applied by the California attorney general and courts. Alleged violations of the CCPA may result in substantial civil penalties or statutory damages when applied at scale, up to $2,500 per violation or $7,500 per intentional violation of any CCPA requirement, which may be applied on a per-person or per-record basis. The CCPA also establishes a private right of action if certain personal information of individuals is subject to an unauthorized access and exfiltration, theft, or disclosure as a result of a business’s violation of the duty to implement and maintain reasonable security procedures and practices, which authorizes statutory damages $100 to $750 per person per incident even if there is no actual harm or damage to plaintiffs. This private right of action may increase the likelihood of, and risks associated with, data breach litigation. Further, in November 2020, the State of California adopted the California Privacy Rights Act of 2020 (“CPRA”) which goes into effect January 1, 2023 and is enforceable starting on July 1, 2023. The CPRA expands and amends the CCPA, including additional and strengthened privacy rights for California residents, new requirements regarding sensitive data and data sharing for digital advertising, and tripled damages for violations involving children’s data. Also on January 1, 2023, the CCPA – as amended by the CPRA – will be newly applicable to personal information collected for employment-related purposes as well as from business-to-business contacts, creating new regulatory obligations as to datasets that until then had been largely exempt from the CCPA. The CPRA includes a 12-month “look-back” provision that requires businesses to map out all information retained since January 1, 2022. The CPRA also establishes a dedicated privacy regulator under California law, with rulemaking and enforcement responsibilities. Certain regulations implementing the CPRA are expected in draft and final form by the end of 2022, with potentially additional regulations to be proposed following the CPRA’s January 1, 2023 effective date.\nFour other states – Virginia, Colorado, Connecticut, and Utah – have passed their own comprehensive privacy laws to go into effect in 2023. Like the CCPA and CPRA, these laws regulate the collection, use, processing, and sharing of personal information relating to residents of each state respectively, and grants certain privacy rights to those residents. The new state laws also have key differences from the CCPA and CPRA, such as requiring affirmative consent before businesses may process sensitive personal information, requiring data protection assessments, and requiring contracts between data controllers and data processors that direct data processors to assist data controllers in performing their obligations, as well as other differences among them. Each law is enforceable by its own state’s attorney general – for example, violation of the Virginia or Utah laws will cost up to $7,500 per violation – and none include an explicit private right of action. Other states are expected to consider and potentially pass similar privacy laws in 2023.\nCertain aspects of our business and/or the data it collects is may also be subject to international privacy laws and regulations, many of which, such as the General Data Privacy Regulation (“GDPR”) and national laws implementing or supplementing the GDPR, such as the United Kingdom Data Protection Law 2018 (which retains\n60\nkey features of GDPR post-Brexit), as well as the EU’s Privacy and Electronic Communications Directive (“ePrivacy Directive”), are significantly more stringent than those currently enforced in the United States. The GDPR requires companies to meet requirements regarding the handling of personal data of individuals located in the European Economic Area (the “EEA”). The GDPR imposes mandatory data breach notification requirements subject to a 72-hour notification deadline. The GDPR also includes significant penalties for noncompliance, which may result in monetary penalties of up to the higher of €20.0 million or 4% of a group’s worldwide turnover for the preceding financial year for the most serious violations. The GDPR and other similar regulations such as the ePrivacy Directive and related member state regulations and directives require companies to give specific types of notice and informed consent is in many cases required for the placement of a cookie or similar technologies on a user’s device for online tracking for behavioral advertising and other purposes and for direct electronic marketing, and the GDPR also imposes additional conditions in order to satisfy such consent, such as a prohibition on pre-checked tick boxes and bundled consents. Enforcement of the GDPR and related regulations varies by each EU Member State and is ongoing. Further laws and regulations on these topics are forthcoming, including the ePrivacy Directive’s proposed successor, the Regulation on Privacy and Electronic Communications (“ePrivacy Regulation”), as well as the Digital Services Act (“DSA”) and Digital Markets Act (“DMA”). The GDPR may increase our responsibility and liability in relation to personal data that we process where that processing is subject to the GDPR. In addition, we may be required to put in place additional mechanisms to ensure compliance with the GDPR, including GDPR requirements as implemented by individual countries. Compliance with the GDPR will be a rigorous and time-intensive process that may increase our cost of doing business or require us to change our business practices.\nIn addition, under GDPR, transfers of personal data are prohibited to countries outside of the EEA that have not been determined by the European Commission to provide adequate protections for personal data, including the United States. There are mechanisms to permit the transfer of personal data from the EEA to the United States, but there is also uncertainty as to the future of such mechanisms, which have been under consistent scrutiny and challenge. In July 2020, decision of the Court of Justice of the European Union invalidated the EU-U.S. Privacy Shield Framework, a means that previously permitted transfers of personal data from the EEA to companies in the United States that certified adherence to the Privacy Shield Framework. While the Biden Administration issued an executive order in October 2022 mandating new legal safeguards over U.S. national security agencies’ access and use of EU and U.S. personal data, it is currently unclear what, if any, formal arrangement may replace the Privacy Shield Framework. Standard contractual clauses approved by the European Commission to permit transfers from the EU to third countries currently remain as a basis on which to transfer personal data from the EEA to other countries. Standard contractual clauses are also subject to legal challenge, and in November 2020, the European Commission published a draft of updated standard contractual clauses. In January 2022, for example, Austria’s data protection authority determined that the use of Google Analytics violated the GDPR and the Court of Justice of the European Union’s “Schrems II” decision on international data transfers. We presently rely on standard contractual clauses to transfer personal data from EEA member countries, and we may be impacted by changes in law as a result of future review or invalidation of, or changes to, this mechanism by European courts or regulators. While we will continue to undertake efforts to conform to current regulatory obligations and evolving best practices, we may be unsuccessful in conforming to permitted means of transferring personal data from the European Economic Area. We may also experience hesitancy, reluctance, or refusal by European or multi-national customers to continue to use some of our services due to the potential risk exposure of personal data transfers and the current data protection obligations imposed on them by certain data protection authorities. Such customers may also view any alternative approaches to the transfer of any personal data as being too costly, too burdensome, or otherwise objectionable, and therefore may decide not to do business with us if the transfer of personal data is a necessary requirement.\nAlthough we take reasonable efforts to comply with all applicable laws and regulations and have invested and continue to invest human and technology resources into data privacy compliance efforts, there can be no assurance that we will not be subject to regulatory action, including fines, in the event of an incident or other claim. Data protection laws and requirements may also be enacted, interpreted or applied in a manner that creates inconsistent or contradictory requirements on companies that operate across jurisdictions. We or our third-party service providers could be adversely affected if legislation or regulations are expanded to require changes in our or our third-party service providers’ business practices or if governing jurisdictions interpret or implement their legislation or regulations in ways that negatively affect our or our third-party service providers’ business, results of operations or financial condition. For example, we may find it necessary to establish alternative systems to maintain personal data in the EEA, which may involve substantial expense and may cause us to divert resources from other aspects of\n61\nour business, all of which may adversely affect our results from operations. Further, any inability to adequately address privacy concerns in connection with our solutions, or comply with applicable privacy or data protection laws, regulations and policies, could result in additional cost and liability to us, and adversely affect our ability to offer our solutions. GDPR, CCPA, CPRA and other similar laws and regulations, as well as any associated inquiries or investigations or any other government actions, may be costly to comply with, result in negative publicity, increase our operating costs, require significant management time and attention and subject us to remedies that may harm our business, including fines or demands or orders that we modify or cease existing business practices. Our systems may not be able to satisfy these changing requirements and manufacturer, retailer and associate expectations, or may require significant additional investments or time in order to do so.\nWe expect that new industry standards, laws and regulations will continue to be proposed regarding privacy, data protection and information security in many jurisdictions, including the European e-Privacy Regulation, which is currently in draft form, as well as at the U.S. federal and state levels. In addition, new data processes and datasets associated with emerging technologies are coming under increased regulatory scrutiny, such as biometrics and automated decision-making. We cannot yet determine the impact such future laws, regulations and standards may have on our business. Complying with these evolving obligations is challenging, time consuming and expensive, and federal regulators, state attorneys general and plaintiff’s attorneys have been, and will likely continue to be, active in this space. Expanding definitions and interpretations of what constitutes “personal data” (or the equivalent) within the United States, the EEA and elsewhere may increase our compliance costs and legal liability. For example, various state privacy proposals have included a private right of action for basic privacy violations which, if passed, would dramatically increase both the legal costs of defending frivolous lawsuits and the penalties and costs associated with alleged violations.\nA data breach or any failure, or perceived failure, by us to comply with any federal, state or foreign privacy or consumer protection-related laws, regulations or other principles or orders to which we may be subject or other legal obligations relating to privacy or consumer protection could adversely affect our reputation, brand and business, and may result in fines, enforcement actions, sanctions, claims (including claims for damages by affected individuals), investigations, proceedings or actions against us by governmental entities or others, or other penalties or liabilities or require us to change our operations and/or cease using certain data sets, among other negative consequences, any of which could have a material adverse effect on our business. Moreover, the proliferation of supply chain-based cyberattacks and vendor security incidents increases these potential risks and costs even in cases where the attack did not target us, occur on our systems, or result from any action or inaction by us. Depending on the nature of the information compromised, we may also have obligations to notify users, law enforcement, regulators, business partners or payment companies about the incident and provide some form of remedy, such as refunds or identity theft monitoring services, for the individuals affected by the incident.\nThe Take 5 Matter may lead to additional harms, risks and uncertainties for us, including litigation and governmental investigations, a reduction in revenue, a potential deterioration in our relationships or reputation and a loss in investor confidence.\nOn April 1, 2018, we acquired certain assets and assumed certain liabilities of Take 5 Media Group. In June 2019, as a result of a review of internal allegations related to inconsistency of data provided by Take 5 to its clients, we commenced an investigation into Take 5’s operations. In July 2019, as a result of our investigation, we terminated all operations of Take 5, including the use of its associated trade names and the offering of its services to its clients and offered refunds to Take 5 clients of collected revenues attributable to Take 5 since our acquisition of Take 5.\nAs a result of these matters, we may be subject to a number of additional harms, risks and uncertainties, including substantial costs for professional services fee, potential lawsuits by clients or other interested parties who claim to have been harmed by the misconduct at Take 5, other costs and fees related to the Take 5 Matter (in excess of the amounts already offered as refunds), potential governmental investigations arising from the Take 5 Matter, a reduction in our current and anticipated revenue and a potential deterioration in our associate and client relationships or our reputation. In addition, if we do not prevail in any litigation or governmental investigation related to these matters, we could be subject to costs related to such litigation or governmental investigation, including equitable relief, civil monetary damages, treble damages, repayment or criminal penalties, which may not be covered by insurance or may materially increase our insurance costs. We have incurred and will continue to incur additional substantial professional fees regardless of the outcome of any such litigation or governmental\n62\ninvestigation. In addition, there can be no assurance to what degree, if any, we will be able to recover any such costs or damages from the former owners of Take 5 or whether such former owners of Take 5 engaged in further unknown improper activities that may subject us to further costs or damages, including potential reputational harm. Likewise, such events have caused and may cause further diversion of our management’s time and attention. Any adverse outcome related to these matters cannot be predicted at this time, and may materially harm our business, reputation, financial condition and/or results of operations, or the trading price of our securities.\nOur business is seasonal in nature and quarterly operating results can fluctuate.\nOur services are seasonal in nature, with the fourth fiscal quarter typically generating a higher proportion of our revenues than other fiscal quarters. Adverse events, such as deteriorating economic conditions, higher unemployment, higher gas prices, public transportation disruptions, public health crises (including the COVID-19 pandemic) or unanticipated adverse weather, could result in lower-than-planned sales during key revenue-producing seasons. For example, frequent or unusually heavy snowfall, ice storms, rainstorms, windstorms or other extreme weather conditions over a prolonged period could make it difficult for consumers to travel to retail stores or foodservice locations. Such events could lead to lower revenues, negatively impacting our financial condition and results of operations.\nOur business is competitive, and increased competition could adversely affect our business and results of operations.\nThe sales, marketing and merchandising services industry is competitive. We face competition from a few other large, national or super-regional agencies as well as many niche and regional agencies. Remaining competitive in this industry requires that we closely monitor and respond to trends in all industry sectors. We cannot assure you that we will be able to anticipate and respond successfully to such trends in a timely manner. Moreover, some of our competitors may choose to sell services competitive to ours at lower prices by accepting lower margins and profitability or may be able to sell services competitive to ours at lower prices due to proprietary ownership of data or technical superiority, which could negatively impact the rates that we can charge. If we are unable to compete successfully, it could have a material adverse effect on our business, financial condition and our results of operations. If certain competitors were to combine into integrated sales, marketing and merchandising services companies, additional sales, marketing and merchandising service companies were to enter the market or existing participants in this industry were to become more competitive, including through technological innovation such as social media and crowdsourcing, it could have a material adverse effect on our business, financial condition or results of operations.\nDamage to our reputation could negatively impact our business, financial condition and results of operations.\nOur reputation and the quality of our brand are critical to our business and success in existing markets and will be critical to our success as we enter new markets. We believe that we have built our reputation on the high quality of our sales and marketing services, our commitment to our clients and our performance-based culture, and we must protect and grow the value of our brand in order for us to continue to be successful. Any incident that erodes client loyalty to our brand could significantly reduce its value and damage our business. Also, there has been a marked increase in the use of social media platforms and similar devices, including blogs, social media websites, Twitter and other forms of internet-based communications that provide individuals with access to a broad audience of consumers and other interested persons. Many social media platforms immediately publish the content their subscribers and participants post, often without filters or checks on accuracy of the content posted. Information concerning us may be posted on such platforms at any time. Information posted may be adverse to our interests or may be inaccurate, each of which may harm our performance, prospects or business. The harm may be immediate without affording us an opportunity for redress or correction.\nWe rely on third parties to provide certain data and services in connection with the provision of our services.\nWe rely on third parties to provide certain data and services for use in connection with the provision of our services. For example, we contract with third parties to obtain the raw data on retail product sales and inventories. These suppliers of data may impose restrictions on our use of such data, fail to adhere to our quality control standards, increase the price they charge us for this data or refuse altogether to license the data to us. If we are unable to use such third-party data and services or if we are unable to contract with third parties, when necessary,\n63\nour business, financial condition or our results of operations could be adversely affected. In the event that such data and services are unavailable for our use or the cost of acquiring such data and services increases, our business could be adversely affected.\nWe may be unable to timely and effectively respond to changes in digital practices and policies, which could adversely affect our business, financial condition or results of operations.\nChanges to practices and policies of operating systems, websites and other digital platforms, including, without limitation, Apple’s or Android’s transparency policies, may reduce the quantity and quality of the data and metrics that can be collected or used by us and our clients or reduce the value of our digital services. These limitations may adversely affect both our and our clients’ ability to effectively target and measure the performance of our digital services. In addition, our clients and third party vendors routinely evaluate their digital practices and policies, and if in the future they determine to modify such practices and policies for any reasons, including, without limitation, privacy, targeting, age or content concerns, this could decrease the desire for our digital services as compared to other alternatives. If we are unable to timely or effectively respond to changes in digital practices and policies, or if our clients do not believe that our digital services will generate a competitive return on investment relative to alternatives, then our business, financial condition or results of operations could be adversely affected.\nWe may not be able to adequately protect our intellectual property, which, in turn, could harm the value of our brands and adversely affect our business.\nOur ability to implement our business plan successfully depends in part on our ability to further build brand recognition using our trade names, service marks, trademarks, proprietary products and other intellectual property, including our name and logos. We rely on U.S. and foreign trademark, copyright and trade secret laws, as well as license agreements, nondisclosure agreements and confidentiality and other contractual provisions to protect our intellectual property. Nevertheless, these laws and procedures may not be adequate to prevent unauthorized parties from attempting to copy or otherwise obtain our processes and technology or deter our competitors from developing similar business solutions and concepts, and adequate remedies may not be available in the event of an unauthorized use or disclosure of our trade secrets and other intellectual property.\nThe success of our business depends on our continued ability to use our existing trademarks and service marks to increase brand awareness and further develop our brand in both domestic and international markets. We have registered and applied to register our trade names, service marks and trademarks in the United States and foreign jurisdictions. However, the steps we have taken to protect our intellectual property in the United States and in foreign countries may not be adequate, and third parties may misappropriate, dilute, infringe upon or otherwise harm the value of our intellectual property. If any of our registered or unregistered trademarks, trade names or service marks is challenged, infringed, circumvented or declared generic or determined to be infringing on other marks, it could have an adverse effect on our sales or market position. In addition, the laws of some foreign countries do not protect intellectual property to the same extent as the laws of the United States. Many companies have encountered significant problems in protecting and defending intellectual property rights in certain jurisdictions. This could make it difficult to stop the infringement or misappropriation of our intellectual property rights in foreign jurisdictions.\nWe rely upon trade secrets and other confidential and proprietary know‑how to develop and maintain our competitive position. While it is our policy to enter into agreements imposing nondisclosure and confidentiality obligations upon our employees and third parties to protect our intellectual property, these obligations may be breached, may not provide meaningful protection for our trade secrets or proprietary know‑how, or adequate remedies may not be available in the event of an unauthorized access, use or disclosure of our trade secrets and know‑how. Furthermore, despite the existence of such nondisclosure and confidentiality agreements, or other contractual restrictions, we may not be able to prevent the unauthorized disclosure or use of our confidential proprietary information or trade secrets by consultants, vendors and employees. In addition, others could obtain knowledge of our trade secrets through independent development or other legal means.\nAny claims or litigation initiated by us to protect our proprietary technology could be time consuming, costly and divert the attention of our technical and management resources. If we choose to go to court to stop a third party from infringing our intellectual property, that third party may ask the court to rule that our intellectual property rights are invalid and/or should not be enforced against that third party. Even if the action that we take to protect\n64\nour intellectual property rights is successful, any infringement may still have a material adverse effect on our business, financial condition and results of operations.\nWe may be subject to claims of infringement of third-party intellectual property rights that are costly to defend, result in the diversion of management’s time and efforts, require the payment of damages, limit our ability to use particular technologies in the future or prevent us from marketing our existing or future products and services.\nThird parties may assert that we infringe, misappropriate or otherwise violate their intellectual property, including with respect to our digital solutions and other technologies that are important to our business, and may sue us for intellectual property infringement. We may not be aware of whether our products or services do or will infringe existing or future patents or the intellectual property rights of others. In addition, there can be no assurance that one or more of our competitors who have developed competing technologies or our other competitors will not be granted patents for their technology and allege that we have infringed on such patents.\nAny claims that our business infringes the intellectual property rights of others, regardless of the merit or resolution of such claims, could incur substantial costs, and the time and attention of our management and other personnel may be diverted in pursuing these proceedings. An adverse determination in any intellectual property claim could require us to pay damages, be subject to an injunction, and/or stop using our technologies, trademarks, copyrighted works and other material found to be in violation of another party’s rights, and could prevent us from licensing our technologies to others unless we enter into royalty or licensing arrangements with the prevailing party or are able to redesign our products and services to avoid infringement. With respect to any third-party intellectual property that we use or wish to use in our business (whether or not asserted against us in litigation), we may not be able to enter into licensing or other arrangements with the owner of such intellectual property at a reasonable cost or on reasonable terms. Any of the foregoing could harm our commercial success.\nWe are dependent on proprietary technology licensed from others. If we lose our licenses, we may not be able to continue developing our products.\nWe have obtained licenses that give us rights to third party intellectual property that is necessary or useful to our business. These license agreements may impose various royalty and other obligations on us. One or more of our licensors may allege that we have breached our license agreement with them, and could seek to terminate our license, which could adversely affect our competitive business position and harm our business prospects. In addition, any claims brought against us by our licensors could be costly, time-consuming and divert the attention of our management and key personnel from our business operations.\nConsumer goods manufacturers and retailers, including some of our clients, are subject to extensive governmental regulation and we and they may be subject to enforcement in the event of noncompliance with applicable requirements.\nConsumer goods manufacturers and retailers, including some of our clients, are subject to a broad range of federal, state, local and international laws and regulations governing, among other things, the research, development, manufacture, distribution, marketing and post-market reporting of consumer products. These include laws administered by the U.S. Food and Drug Administration (the “FDA”), the U.S. Drug Enforcement Administration, the U.S. Federal Trade Commission, the U.S. Department of Agriculture and other federal, state, local and international regulatory authorities. For example, certain of our clients market and sell products containing cannabidiol (“CBD”). CBD products are subject to a number of federal, state, local and international laws and regulations restricting their use in certain categories of products and in certain jurisdictions. In particular, the FDA has publicly stated it is prohibited to sell into interstate commerce food, beverages or dietary supplements that contain CBD. These laws are broad in scope and subject to evolving interpretations, which could require us to incur costs associated with new or modified compliance requirements or require us or our clients to alter or limit our activities, including marketing and promotion, of such products, or to remove them from the market altogether.\nIf a regulatory authority determines that we or our current or future clients have not complied with the applicable regulatory requirements, our business may be materially impacted and we or our clients could be subject to enforcement actions or loss of business. We cannot predict the nature of any future laws, regulations, interpretations or applications of the laws, nor can we determine what effect additional laws, regulations or administrative policies and procedures, if and when enacted, promulgated and implemented, could have on our business.\n65\nWe may be subject to claims for products for which we are the vendor of record or may otherwise be in the chain of title.\nFor certain of our clients’ products, we become the vendor of record or otherwise may be in the chain of title. For these products, we could be subject to potential claims for misbranded, adulterated, contaminated, damaged or spoiled products, or could be subject to liability in connection with claims related to infringement of intellectual property, product liability, product recalls or other liabilities arising in connection with the sale or marketing of these products. As a result, we could be subject to claims or lawsuits (including potential class action lawsuits), and we could incur liabilities that are not insured or exceed our insurance coverage or for which the manufacturer of the product does not indemnify us. Even if product claims against us are not successful or fully pursued, these claims could be costly and time consuming and may require our management to spend time defending the claims rather than operating our business.\nA product that has been actually or allegedly misbranded, adulterated or damaged or is actually or allegedly defective could result in product withdrawals or recalls, destruction of product inventory, negative publicity and substantial costs of compliance or remediation. Any of these events, including a significant product liability judgment against us, could result in monetary damages and/or a loss of demand for our products, both of which could have an adverse effect on our business or results of operations.\nWe generate revenues and incur expenses throughout the world that are subject to exchange rate fluctuations, and our results of operations may suffer due to currency translations.\nOur U.S. operations earn revenues and incur expenses primarily in U.S. dollars, while our international operations earn revenues and incur expenses primarily in Canadian dollars, British pounds or euros. Because of currency exchange rate fluctuations, including possible devaluations, we are subject to currency translation exposure on the results of our operations, in addition to economic exposure. There has been, and may continue to be, volatility in currency exchange rates as a result of the United Kingdom’s withdrawal from the European Union, especially between the U.S. dollar and the British pound. These risks could adversely impact our business or results of operations.\nFluctuations in our tax obligations and effective tax rate and realization of our deferred tax assets may result in volatility of our operating results.\nWe are subject to taxes by the U.S. federal, state, local and foreign tax authorities, and our tax liabilities will be affected by the allocation of expenses to differing jurisdictions. We record tax expense based on our estimates of future payments, which may include reserves for uncertain tax positions in multiple tax jurisdictions, and valuation allowances related to certain net deferred tax assets. At any one time, many tax years may be subject to audit by various taxing jurisdictions. The results of these audits and negotiations with taxing authorities may affect the ultimate settlement of these matters. We expect that throughout the year there could be ongoing variability in our quarterly tax rates as events occur and exposures are evaluated. Our future effective tax rates could be subject to volatility or adversely affected by a number of factors, including:\n•changes in the valuation of our deferred tax assets and liabilities;\n•expected timing and amount of the release of any tax valuation allowance;\n•tax effects of equity-based compensation;\n•changes in tax laws, regulations or interpretations thereof; or\n•future earnings being lower than anticipated in jurisdictions where we have lower statutory tax rates and higher than anticipated earnings in jurisdictions where we have higher statutory tax rates.\nIn addition, our effective tax rate in a given financial statement period may be materially impacted by a variety of factors including but not limited to changes in the mix and level of earnings, varying tax rates in the different jurisdictions in which we operate, fluctuations in the valuation allowance, deductibility of certain items or changes to existing accounting rules or regulations. Further, tax legislation may be enacted in the future which could negatively impact our current or future tax structure and effective tax rates. We may be subject to audits of\n66\nour income, sales and other transaction taxes by U.S. federal, state, local and foreign taxing authorities. Outcomes from these audits could have an adverse effect on our operating results and financial condition.\nRisks Related to Ownership of Our Common Stock\nWe are controlled by Topco, the Advantage Sponsors, and the CP Sponsor, whose economic and other interests in our business may be different from yours.\nOur authorized capital stock consists of 3,290,000,000 shares of Class A common stock, and as of November 8, 2022, certain equityholders of Topco (the “Advantage Sponsors”), Topco and Conyers Park II Sponsor LLC, an affiliate of Centerview Capital Management, LLC, which was Conyers Park’s sponsor prior to the Merger (the “CP Sponsor”), collectively own 254,310,000 shares, or 79.55% (including 65.30% held by Topco), of our outstanding Class A common stock. Subject to applicable law, the Advantage Sponsors, through their direct ownership of our common stock and their ownership of equity interests of Topco, and the CP Sponsor are able to exert significant influence in the election of our directors and control actions to be taken by our stockholders, including amendments to our third amended and restated certificate of incorporation and approval of mergers, sales of substantially all of our assets, and other significant corporate transactions. It is possible that the interests of Topco, the Advantage Sponsors and the CP Sponsor may in some circumstances conflict with our interests and the interests of our other stockholders, including you.\nWe are a controlled company within the meaning of the Nasdaq Stock Market LLC listing requirements and as a result, may rely on exemptions from certain corporate governance requirements. To the extent we rely on such exemptions, you will not have the same protections afforded to stockholders of companies that are subject to such corporate governance requirements.\nBecause of the voting power over our company held by Topco, the Advantage Sponsors, and the CP Sponsor and the voting arrangement between such parties, we are considered a controlled company for the purposes of the Nasdaq Stock Market LLC (“Nasdaq”) listing requirements. As such, we are exempt from the corporate governance requirements that our board of directors, compensation committee, and nominating and corporate governance committee meet the standard of independence established by those corporate governance requirements. The independence standards are intended to ensure that directors who meet the independence standards are free of any conflicting interest that could influence their actions as directors.\nWe do not currently utilize the exemptions afforded to a controlled company, though we are entitled to do so. To the extent we utilize these exemptions, you will not have the same protections afforded to stockholders of companies that are subject to all of the corporate governance requirements of Nasdaq.\nThe anti-takeover provisions of our certificate of incorporation and bylaws could prevent or delay a change in control of us, even if such change in control would be beneficial to our stockholders.\nProvisions of our certificate of incorporation and bylaws, as well as provisions of Delaware law, could discourage, delay, or prevent a merger, acquisition, or other change in control of us, even if such change in control would be beneficial to our stockholders. These include:\n•authorizing the issuance of “blank check” preferred stock that could be issued by our board of directors to increase the number of outstanding shares and thwart a takeover attempt;\n•provision for a classified board of directors so that not all members of our board of directors are elected at one time;\n•not permitting the use of cumulative voting for the election of directors;\n•permitting the removal of directors only for cause;\n•limiting the ability of stockholders to call special meetings; •requiring all stockholder actions to be taken at a meeting of our stockholders;\n•requiring approval of the holders of at least two-thirds of the shares entitled to vote at an election of directors to adopt, amend, or repeal the proposed bylaws or repeal the provisions of the third amended and restated certificate of incorporation regarding the election and removal of directors; and\n67\n•establishing advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings.\nIn addition, although we have opted out of Section 203 of the Delaware General Corporation Law (“DGCL”), our certificate of incorporation contain similar provisions providing that we may not engage in certain “business combinations” with any “interested stockholder” for a three-year period following the time that the stockholder became an interested stockholder, subject to certain exceptions. Generally, a “business combination” includes a merger, asset, or stock sale or other transaction resulting in a financial benefit to the interested stockholder.\nSubject to certain exceptions, an “interested stockholder” is a person who, together with that person’s affiliates and associates, owns, or within the previous three years owned, 15% or more of our outstanding voting stock.\nUnder certain circumstances, this provision will make it more difficult for a person who would be an “interested stockholder” to effect various business combinations with us for a three-year period. These provisions also may have the effect of preventing changes in our board of directors and may make it more difficult to accomplish transactions which stockholders may otherwise deem to be in their best interests.\nMoreover, our certificate of incorporation provides that Topco and its affiliates do not constitute “interested stockholders” for purposes of this provision, and thus any business combination transaction between us and Topco and its affiliates would not be subject to the protections otherwise provided by this provision. Topco and its affiliates are not prohibited from selling a controlling interest in us to a third party and may do so without your approval and without providing for a purchase of your shares of common stock, subject to the lock-up restrictions applicable to Topco. Accordingly, your shares of common stock may be worth less than they would be if Topco and its affiliates did not maintain voting control over us.\nThe provisions of our certificate of incorporation and bylaws requiring exclusive venue in the Court of Chancery in the State of Delaware or the federal district courts of the United States of America for certain types of lawsuits may have the effect of discouraging lawsuits against our directors and officers.\nOur certificate of incorporation and bylaws require, to the fullest extent permitted by law, that (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of a fiduciary duty owed by any of our directors, officers, or other employees to us or our stockholders, (iii) any action asserting a claim against us arising pursuant to any provision of the DGCL or our certificate of incorporation or bylaws, or (iv) any action asserting a claim against us governed by the internal affairs doctrine will have to be brought only in the Court of Chancery in the State of Delaware (or the federal district court for the District of Delaware or other state courts of the State of Delaware if the Court of Chancery in the State of Delaware does not have jurisdiction).\nOur certificate of incorporation and bylaws also require that the federal district courts of the United States of America will be the exclusive forum for the resolution of any complaint asserting a cause of action arising under the Securities Act; however, there is uncertainty as to whether a court would enforce such provision, and investors cannot waive compliance with federal securities laws and the rules and regulations thereunder. Although we believe these provisions benefit us by providing increased consistency in the application of applicable law in the types of lawsuits to which they apply, the provisions may have the effect of discouraging lawsuits against our directors and officers. These provisions do not apply to any suits brought to enforce any liability or duty created by the Exchange Act or any other claim for which the federal courts of the United States have exclusive jurisdiction.\nBecause we have no current plans to pay cash dividends on our Class A common stock, you may not receive any return on investment unless you sell your Class A common stock for a price greater than that which you paid for it.\nWe have no current plans to pay cash dividends on our Class A common stock. The declaration, amount and payment of any future dividends on our Class A common stock will be at the discretion of our board of directors and will depend upon our results of operations, financial condition, capital requirements, and other factors that our board of directors deems relevant. The payment of cash dividends is also restricted under the terms of the agreements governing our debt and our ability to pay dividend may also be restricted by the terms of any future credit agreement or any securities we or our subsidiaries may issue.\n68\nAn active, liquid trading market for our Class A common stock may not be available.\nWe cannot predict the extent to which investor interest in our company will lead to availability of a trading market on Nasdaq or otherwise in the future or how active and liquid that market may be for our Class A common stock. If an active and liquid trading market is not available, you may have difficulty selling any of our Class A common stock. Among other things, in the absence of a liquid public trading market:\n•you may not be able to liquidate your investment in shares of Class A common stock;\n•you may not be able to resell your shares of Class A common stock at or above the price attributed to them in the Transactions;\n•the market price of shares of Class A common stock may experience significant price volatility; and\n•there may be less efficiency in carrying out your purchase and sale orders.\nThe trading price of our Class A common stock may be volatile or may decline regardless of our operating performance.\nThe market prices for our Class A common stock are likely to be volatile and may fluctuate significantly in response to a number of factors, most of which we cannot control, including:\n•quarterly variations in our operating results compared to market expectations;\n•changes in preferences of our clients;\n•announcements of new products or services or significant price reductions;\n•the size of our public float;\n•fluctuations in stock market prices and volumes;\n•defaults on our indebtedness;\n•changes in senior management or key personnel;\n•the granting, vesting, or exercise of employee stock options, restricted stock, or other equity rights;\n•the payment of any dividends thereon in shares of our common stock;\n•changes in financial estimates or recommendations by securities analysts;\n•negative earnings or other announcements by us;\n•downgrades in our credit ratings;\n•material litigation or governmental investigations;\n•issuances of capital stock;\n•global economic, legal, and regulatory factors unrelated to our performance, including the COVID-19 pandemic; or\n•the realization of any risks described in this Quarterly Report under “Risk Factors.”\nIn addition, in the past, stockholders have instituted securities class action litigation against companies following periods of market volatility. If we were involved in securities litigation, we could incur substantial costs and our resources and the attention of management could be diverted from our business.\nWe cannot provide any guaranty that we will continue to repurchase our common stock pursuant to our stock repurchase program.\nIn November 2021, our board of directors authorized a share repurchase program, under which we may repurchase up to $100 million of our outstanding Class A common stock (the “2021 Share Repurchase Program”). As of September 30, 2022, the remaining amount available for repurchase pursuant to the 2021 Share Repurchase Program is $87.4 million. However, we are not obligated to make any further purchases under the 2021 Share Repurchase Program and we may suspend or permanently discontinue this program at any time or significantly reduce the amount of repurchases under the program. Any announcement of a suspension, discontinuance or reduction of this program may negatively impact our reputation and investor confidence.\n69\nThe valuation of our private placement warrants could increase the volatility in our net income (loss) in our consolidated statements of earnings (loss).\nThe change in fair value of our private placement warrants is determined using the fair value of the liability classified private placement warrants by approximating the value with the share price of the public warrants. The change in fair value of warrant liability represents the mark-to-market fair value adjustments to the outstanding private placement warrants issued in connection with the initial public offering of Conyers Park. Significant changes in share price of the public warrants may adversely affect the volatility in our net income (loss) in our Condensed Consolidated Statements of Operations and Comprehensive Income.\nRisks Related to Indebtedness\nWe need to continue to generate significant operating cash flow in order to fund acquisitions and to service our debt.\nOur business currently generates operating cash flow, which we use to fund acquisitions to grow our business and to service our substantial indebtedness. If, because of loss of revenue, pressure on pricing from customers, increases in our costs (including increases in costs related to servicing our indebtedness or labor costs), general economic, financial, competitive, legislative, regulatory conditions or other factors, including any acceleration of the foregoing as a result of the COVID-19 pandemic, many of which are outside of our control our business generates less operating cash flow, we may not have sufficient funds to grow our business or to service our indebtedness.\nIf we are unable to generate sufficient cash flow or are otherwise unable to obtain funds necessary to meet required payments of principal, premium, if any, and interest on our indebtedness, or if we otherwise fail to comply with the various covenants in the agreements governing our indebtedness, we could be in default under the terms of the agreements governing such indebtedness. In the event of such default, the lenders under our credit facilities could elect to terminate their commitments thereunder, cease making further loans and institute foreclosure proceedings against our assets, and we could be forced into bankruptcy or liquidation. If our operating performance declines, we may in the future need to obtain waivers from the required lenders under our credit agreements to avoid being in default. If we or any of our subsidiaries breach the covenants under our credit agreements and seek a waiver, we may not be able to obtain a waiver from the required lenders. If this occurs, we would be in default under our credit agreements, the lenders could exercise their rights as described above, and we could be forced into bankruptcy or liquidation.\nOur substantial indebtedness could adversely affect our financial health, restrict our activities, and affect our ability to meet our obligations.\nWe have a significant amount of indebtedness. As of September 30, 2022, we had total indebtedness of $2.1 billion, excluding debt issuance costs, with an additional $54.5 million of letters of credit outstanding under our revolving credit facility. The agreements governing our indebtedness contain customary covenants that restrict us from taking certain actions, such as incurring additional debt, permitting liens on pledged assets, making investments, paying dividends or making distributions to equity holders, prepaying junior debt, engaging in mergers or restructurings, and selling assets, among other things, which may restrict our ability to successfully execute on our business plan. For a more detailed description of the covenants and material terms of our material indebtedness, please see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” in this Quarterly Report.\nDespite current indebtedness levels, we and our subsidiaries may still be able to incur additional indebtedness, which could increase the risks associated with our indebtedness.\nWe and our subsidiaries may be able to incur additional indebtedness in the future because the terms of our indebtedness do not fully prohibit us or our subsidiaries from doing so. Subject to covenant compliance and certain conditions, as of September 30, 2022, the agreements governing our indebtedness would have permitted us to borrow up to an additional $345.5 million under our revolving credit facility. In addition, we and our subsidiaries have, and will have, the ability to incur additional indebtedness as incremental facilities under our credit agreement\n70\nand we or our subsidiaries may issue additional notes in the future. If additional debt is added to our current debt levels and our subsidiaries’ current debt levels, the related risks that we and they now face could increase.\nFailure to maintain our credit ratings could adversely affect our liquidity, capital position, ability to hedge certain financial risks, borrowing costs, and access to capital markets.\nOur credit risk is evaluated by the major independent rating agencies, and such agencies have in the past downgraded, and could in the future downgrade, our ratings. Our credit rating may impact the interest rates on any future indebtedness as well as the applicability of certain covenants in the agreements governing our indebtedness. We cannot assure you that we will be able to maintain our current credit ratings, and any additional, actual or anticipated changes or downgrades in our credit ratings, including any announcement that our ratings are under further review for a downgrade, may have a negative impact on our liquidity, capital position, ability to hedge certain financial risks, and access to capital markets.\nOur variable rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase significantly.\nBorrowings under our credit facilities are at variable rates of interest and expose us to interest rate risk. If interest rates were to increase, our debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same, and our net income and cash flows, including cash available for servicing our indebtedness, will correspondingly decrease. On a pro forma basis, assuming no other prepayments of the credit facility and that our revolving credit facility is fully drawn (and to the extent that LIBOR is in excess of the 0.00% and 0.75% floors applicable to our revolving credit facility and our term loan credit facility, respectively), each one-eighth percentage point change in interest rates would result in an approximately $1.0 million change in interest expense, net of gains from interest rate caps, for the nine months ended September 30, 2022. In the future, we may enter into interest rate swaps that involve the exchange of floating- for fixed-rate interest payments in order to reduce interest rate volatility or risk. However, we may not maintain interest rate swaps with respect to any of our variable rate indebtedness, and any swaps we enter into may not fully or effectively mitigate our interest rate risk.\nThe elimination of LIBOR after June 2023 may affect our financial results\nCertain of our financial arrangements, including the Senior Secured Credit Facilities, were made at variable rates that use the London Interbank Offered Rate, or LIBOR (or metrics derived from or related to LIBOR), as a benchmark for establishing the interest rate. All LIBOR tenors relevant to us will cease to be published or will no longer be representative after June 30, 2023. This means that any of our LIBOR-based borrowings that extend beyond June 30, 2023 will need to be converted to a replacement rate. In the U.S., the Alternative Reference Rates Committee (the “ARRC”) convened by the Federal Reserve Board and the Federal Reserve Bank of New York has recommended the Secured Overnight Financing Rate (“SOFR”) plus a recommended spread adjustment as LIBOR’s replacement. There are significant differences between LIBOR and SOFR, such as LIBOR being an unsecured lending rate while SOFR is a secured lending rate, and SOFR being an overnight rate while LIBOR reflects term rates at different maturities. If our LIBOR-based financing arrangements are converted to SOFR, the differences between LIBOR and SOFR, plus the recommended spread adjustment, could result in interest costs that are higher than if LIBOR remained available, which could adversely impact our operating results. Although SOFR is the ARRC’s recommended replacement rate, it is also possible that lenders and other counterparties may instead choose alternative replacement rates that may differ from LIBOR in ways similar to SOFR or in other ways that would result in higher interest costs for us. There is no assurance that any alternative reference rate, including SOFR, will be similar to, or produce the same value or economic equivalence as, LIBOR, and there continues to be uncertainty regarding the nature of potential changes to and future utilization of specific LIBOR tenors, the development and acceptance of SOFR or alternative reference rates, and other reforms. These consequences cannot be entirely predicted and could have an adverse impact on the market value for or value of LIBOR-linked securities, loans and other financial obligations or extensions of credit held by or due to us. Changes in market interest rates may influence our financing costs, returns on financial investments and the valuation of derivative contracts and could reduce our earnings and cash flows.\n71\nGeneral Risk Factors\nOur business and financial results may be affected by various litigation and regulatory proceedings.\nWe are subject to litigation and regulatory proceedings in the normal course of business and could become subject to additional claims in the future. These proceedings have included, and in the future may include, matters involving personnel and employment issues, workers’ compensation, personal and property injury, disputes relating to acquisitions (including contingent consideration), governmental investigations and other proceedings. Some historical and current legal proceedings and future legal proceedings may purport to be brought as class actions or representative basis on behalf of similarly situated parties including with respect to employment-related matters. We cannot be certain of the ultimate outcomes of any such claims, and resolution of these types of matters against us may result in significant fines, judgments or settlements, which, if uninsured, or if the fines, judgments and settlements exceed insured levels, could adversely affect our business or financial results. See “Legal Proceedings.”\nWe are subject to many federal, state, local and international laws with which compliance is both costly and complex.\nOur business is subject to various, and sometimes complex, laws and regulations, including those that have been or may be implemented in response to the COVID-19 pandemic. In order to conduct our operations in compliance with these laws and regulations, we must obtain and maintain numerous permits, approvals and certificates from various federal, state, local and international governmental authorities. We may incur substantial costs in order to maintain compliance with these existing laws and regulations. In addition, our costs of compliance may increase if existing laws and regulations are revised or reinterpreted or if new laws and regulations become applicable to our operations. These costs could have an adverse impact on our business or results of operations. Moreover, our failure to comply with these laws and regulations, as interpreted and enforced, could lead to fines, penalties or management distraction or otherwise harm our business.\nOur insurance may not provide adequate levels of coverage against claims.\nWe believe that we maintain insurance customary for businesses of our size and type. However, there are types of losses we may incur that cannot be insured against or that we believe are not economically reasonable to insure. Further, insurance may not continue to be available to us on acceptable terms, if at all, and, if available, coverage may not be adequate. If we are unable to obtain insurance at an acceptable cost or on acceptable terms, we could be exposed to significant losses.\nWe have incurred and will continue to incur increased costs as a public company.\nAs a public company, we have incurred and will continue to incur significant legal, accounting, insurance, and other expenses that we did not incur as a private company, including costs associated with public company reporting requirements. We also have incurred and will incur costs associated with the Sarbanes-Oxley Act and related rules implemented by the SEC. The expenses incurred by public companies for reporting and corporate governance purposes generally have been increasing. We expect these rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly, although we are currently unable to estimate these costs with any degree of certainty. In estimating these costs, we took into account expenses related to insurance, legal, accounting, and compliance activities, as well as other expenses not currently incurred. These laws and regulations could also make it more difficult or costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. These laws and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, on our board committees, or as our executive officers. Furthermore, if we are unable to satisfy our obligations as a public company, we could be subject to delisting of our Class A common stock, fines, sanctions, and other regulatory action and potentially civil litigation.\nOur management has limited experience in operating a public company.\nOur executive officers have limited experience in the management of a publicly traded company. Our management team may not successfully or effectively manage our transition to a public company that will be\n72\nsubject to significant regulatory oversight and reporting obligations under federal securities laws. Their limited experience in dealing with the increasingly complex laws pertaining to public companies could be a significant disadvantage in that it is likely that an increasing amount of their time may be devoted to these activities which will result in less time being devoted to the management and growth of the Company. We may not have adequate personnel with the appropriate level of knowledge, experience, and training in the accounting policies, practices or internal control over financial reporting required of public companies in the United States. The development and implementation of the standards and controls necessary for the Company to achieve the level of accounting standards required of a public company in the United States may require costs greater than expected. It is possible that we will be required to expand our employee base and hire additional employees to support our operations as a public company which will increase our operating costs in future periods.\nIf securities analysts do not publish research or reports about our business or if they publish negative evaluations of our common stock, the price of our Class A common stock could decline.\nThe trading market for our Class A common stock will rely in part on the research and reports that industry or financial analysts publish about us or our business. If few analysts commence coverage of us, the trading price of our stock could be negatively affected. Even with analyst coverage, if one or more of the analysts covering our business downgrade their evaluations of our stock, the price of our Class A common stock could decline. If one or more of these analysts cease to cover our common stock, we could lose visibility in the market for our Class A common stock, which in turn could cause our Class A common stock price to decline.\nSubstantial future sales of our Class A common stock, or the perception in the public markets that these sales may occur, may depress our stock price.\nSales of substantial amounts of our common stock in the public market, or the perception that these sales could occur, could adversely affect the price of our common stock and could impair our ability to raise capital through the sale of additional shares. Certain shares of our common stock are freely tradable without restriction under the Securities Act, except for any shares of our common stock that may be held or acquired by our directors, executive officers, and other affiliates, as that term is defined in the Securities Act, which are to be restricted securities under the Securities Act. Restricted securities may not be sold in the public market unless the sale is registered under the Securities Act or an exemption from registration is available. Topco, the Advantage Sponsors, the CP Sponsor and members of our management have rights, subject to certain conditions, to require us to file registration statements covering Topco’s shares of our common stock or to include shares in registration statements that we may file for ourselves or other stockholders. In each of November 2020 and March 2021, we filed a registration statement on Form S-1 under which certain of our shareholders may sell, from time to time, 50,000,000 shares and 255,465,000 shares of our Class A common stock, respectively, that, if sold, will be freely tradable without restriction under the Securities Act. In the event a large number of shares of Class A common stock are sold in the public market, such sales could reduce the market price of our Class A common stock.\nWe may also issue shares of our common stock or securities convertible into our common stock from time to time in connection with financings, acquisitions, investments, or otherwise. Any such issuance could result in ownership dilution to you as a stockholder and cause the trading price of our common stock to decline.\n\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nNone\n\nItem 3. Defaults Upon Senior Securities\nNone\n\nItem 4. Mine Safety Disclosures\nNone\n73\n\nItem 5. Other Information\nNone\n\nItem 6. Exhibits\n74\nSignatures 75\n2\nPART I - FINANCIAL INFORMATION\nITEM 1. FINANCIAL STATEMENTS\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED BALANCE SHEETS\n(UNAUDITED)\n\n| September 30, | December 31, |\n| (in thousands, except share data) | 2022 | 2021 |\n| ASSETS |\n| Current assets |\n| Cash and cash equivalents | $ | 96,215 | $ | 164,622 |\n| Restricted cash | 18,079 | 16,015 |\n| Accounts receivable, net of allowance for expected credit losses of $ 13,648 and $ 15,916 , respectively | 833,432 | 797,677 |\n| Prepaid expenses and other current assets | 155,429 | 126,000 |\n| Total current assets | 1,103,155 | 1,104,314 |\n| Property and equipment, net | 69,084 | 63,696 |\n| Goodwill | 2,246,053 | 2,206,004 |\n| Other intangible assets, net | 2,150,075 | 2,287,514 |\n| Investments in unconsolidated affiliates | 124,815 | 125,158 |\n| Other assets | 120,644 | 67,582 |\n| Total assets | $ | 5,813,826 | $ | 5,854,268 |\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\n| Current liabilities |\n| Current portion of long-term debt | $ | 14,704 | $ | 14,397 |\n| Accounts payable | 267,684 | 277,366 |\n| Accrued compensation and benefits | 109,935 | 139,157 |\n| Other accrued expenses | 161,246 | 164,133 |\n| Deferred revenues | 47,441 | 50,467 |\n| Total current liabilities | 601,010 | 645,520 |\n| Long-term debt, net of current portion | 2,024,591 | 2,028,882 |\n| Deferred income tax liabilities | 456,755 | 483,165 |\n| Warrant liability | 733 | 22,189 |\n| Other long-term liabilities | 109,421 | 92,218 |\n| Total liabilities | 3,192,510 | 3,271,974 |\n| Commitments and contingencies (Note 10) |\n| Redeemable noncontrolling interest | 3,353 | 1,893 |\n| Equity attributable to stockholders of Advantage Solutions Inc. |\n| Common stock, $ 0.0001 par value, 3,290,000,000 shares authorized; 319,675,888 and 316,963,552 shares issued and outstanding as of September 30, 2022 and December 31, 2021, respectively | 32 | 32 |\n| Additional paid in capital | 3,398,477 | 3,373,278 |\n| Accumulated deficit | ( 823,212 | ) | ( 866,607 | ) |\n| Loans to Karman Topco L.P. | ( 6,357 | ) | ( 6,340 | ) |\n| Accumulated other comprehensive loss | ( 29,978 | ) | ( 4,479 | ) |\n| Treasury stock, at cost; 1,610,014 shares as of September 30, 2022 and December 31, 2021 | ( 12,567 | ) | ( 12,567 | ) |\n| Total equity attributable to stockholders of Advantage Solutions Inc. | 2,526,395 | 2,483,317 |\n| Nonredeemable noncontrolling interest | 91,568 | 97,084 |\n| Total stockholders’ equity | 2,617,963 | 2,580,401 |\n| Total liabilities, redeemable noncontrolling interest, and stockholders’ equity | $ | 5,813,826 | $ | 5,854,268 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n3\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME\n(UNAUDITED)\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (in thousands, except share and per share data) | 2022 | 2021 | 2022 | 2021 |\n| Revenues | $ | 1,051,095 | $ | 928,760 | $ | 2,946,979 | $ | 2,569,735 |\n| Cost of revenues (exclusive of depreciation and amortization shown separately below) | 908,523 | 766,253 | 2,536,256 | 2,117,818 |\n| Selling, general, and administrative expenses | 37,945 | 37,742 | 138,594 | 124,830 |\n| Depreciation and amortization | 57,785 | 59,163 | 173,997 | 181,450 |\n| Total operating expenses | 1,004,253 | 863,158 | 2,848,847 | 2,424,098 |\n| Operating income | 46,842 | 65,602 | 98,132 | 145,637 |\n| Other (income) expenses: |\n| Change in fair value of warrant liability | ( 1,100 | ) | ( 3,491 | ) | ( 21,456 | ) | ( 5,024 | ) |\n| Interest expense, net | 23,557 | 36,490 | 63,628 | 104,544 |\n| Total other expenses | 22,457 | 32,999 | 42,172 | 99,520 |\n| Income before income taxes | 24,385 | 32,603 | 55,960 | 46,117 |\n| Provision for income taxes | 1,158 | 8,276 | 11,523 | 16,582 |\n| Net income | 23,227 | 24,327 | 44,437 | 29,535 |\n| Less: net income attributable to noncontrolling interest | 2,168 | 1,016 | 1,042 | 219 |\n| Net income attributable to stockholders of Advantage Solutions Inc. | 21,059 | 23,311 | 43,395 | 29,316 |\n| Other comprehensive loss, net of tax: |\n| Foreign currency translation adjustments | ( 13,616 | ) | ( 2,443 | ) | ( 25,499 | ) | ( 4,239 | ) |\n| Total comprehensive income attributable to stockholders of Advantage Solutions Inc. | $ | 7,443 | $ | 20,868 | $ | 17,896 | $ | 25,077 |\n| Net income per common share: |\n| Basic | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n| Diluted | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n| Weighted-average number of common shares: |\n| Basic | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\n| Diluted | 319,725,065 | 320,120,634 | 319,190,804 | 319,654,817 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n4\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\n(UNAUDITED)\n\n| Accumulated | Advantage |\n| Common Stock | Treasury Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at July 1, 2022 | 318,465,449 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,390,899 | $ | ( 844,271 | ) | $ | ( 6,351 | ) | $ | ( 16,362 | ) | $ | 2,511,380 | $ | 90,109 | $ | 2,601,489 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | — | — | 21,059 | — | — | 21,059 | 2,092 | 23,151 |\n| Foreign currency translation adjustments | — | — | — | — | — | — | — | ( 13,616 | ) | ( 13,616 | ) | ( 6,824 | ) | ( 20,440 | ) |\n| Total comprehensive income (loss) | 7,443 | ( 4,732 | ) | 2,711 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | — | — | ( 6 | ) | — | ( 6 | ) | — | ( 6 | ) |\n| Increase in noncontrolling interest | — | — | — | — | — | — | — | — | — | 6,191 | 6,191 |\n| Equity-based compensation of Karman Topco L.P. | — | — | — | — | ( 828 | ) | — | — | — | ( 828 | ) | — | ( 828 | ) |\n| Shares issued under 2020 Employee Stock Purchase Plan | 470,786 | — | — | — | 1,667 | — | — | — | 1,667 | — | 1,667 |\n| Shares issued under 2020 Incentive Award Plan | 739,653 | — | — | — | — | — | — | — | — | — | — |\n| Stock-based compensation expense | — | — | — | — | 6,739 | — | — | — | 6,739 | — | 6,739 |\n| Balance at September 30, 2022 | 319,675,888 | $ | 32 | $ | 1,610,014 | $ | ( 12,567 | ) | $ | 3,398,477 | $ | ( 823,212 | ) | $ | ( 6,357 | ) | $ | ( 29,978 | ) | $ | 2,526,395 | $ | 91,568 | $ | 2,617,963 |\n\n\n| Accumulated | Advantage |\n| Common Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at July 1, 2021 | 318,496,390 | $ | 32 | $ | 3,361,262 | $ | ( 915,096 | ) | $ | ( 6,328 | ) | $ | ( 1,122 | ) | $ | 2,438,748 | $ | 95,916 | $ | 2,534,664 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | 23,311 | — | — | 23,311 | 973 | 24,284 |\n| Foreign currency translation adjustments | — | — | — | — | — | ( 2,443 | ) | ( 2,443 | ) | ( 2,305 | ) | ( 4,748 | ) |\n| Total comprehensive income (loss) | 20,868 | ( 1,332 | ) | 19,536 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | ( 6 | ) | — | ( 6 | ) | — | ( 6 | ) |\n| Redemption of noncontrolling interest | — | — | ( 16 | ) | — | — | — | ( 16 | ) | — | ( 16 | ) |\n| Equity-based compensation of Karman Topco L.P. | — | — | ( 6,030 | ) | — | — | — | ( 6,030 | ) | — | ( 6,030 | ) |\n| Shares issued upon exercise of warrants | 1 | — | — | — | — | — | — | — | — |\n| Shares issued under 2020 Employee Stock Purchase Plan | 77,172 | — | 736 | — | — | — | 736 | — | 736 |\n| Stock-based compensation expense | — | — | 8,413 | — | — | — | 8,413 | — | 8,413 |\n| Balance at September 30, 2021 | 318,573,563 | $ | 32 | $ | 3,364,365 | $ | ( 891,785 | ) | $ | ( 6,334 | ) | $ | ( 3,565 | ) | $ | 2,462,713 | $ | 94,584 | $ | 2,557,297 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n5\n\n| Accumulated | Advantage |\n| Common Stock | Treasury Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at January 1, 2022 | 316,963,552 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,373,278 | $ | ( 866,607 | ) | $ | ( 6,340 | ) | $ | ( 4,479 | ) | $ | 2,483,317 | $ | 97,084 | $ | 2,580,401 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | — | — | 43,395 | — | — | 43,395 | 918 | 44,313 |\n| Foreign currency translation adjustments | — | — | — | — | — | — | — | ( 25,499 | ) | ( 25,499 | ) | ( 12,625 | ) | ( 38,124 | ) |\n| Total comprehensive income (loss) | — | — | — | — | — | — | — | — | 17,896 | ( 11,707 | ) | 6,189 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | — | — | ( 17 | ) | — | ( 17 | ) | — | ( 17 | ) |\n| Increase in noncontrolling interest | — | — | — | — | — | — | — | — | — | 6,191 | 6,191 |\n| Equity-based compensation of Karman Topco L.P. | — | — | — | — | ( 7,142 | ) | — | — | — | ( 7,142 | ) | — | ( 7,142 | ) |\n| Shares issued under 2020 Employee Stock Purchase Plan | 713,213 | — | — | — | 3,320 | — | — | — | 3,320 | — | 3,320 |\n| Shares issued under 2020 Incentive Award Plan | 1,999,123 | — | — | — | — | — | — | — | — | — | — |\n| Stock-based compensation expense | — | — | — | — | 29,021 | — | — | — | 29,021 | — | 29,021 |\n| Balance at September 30, 2022 | 319,675,888 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,398,477 | $ | ( 823,212 | ) | $ | ( 6,357 | ) | $ | ( 29,978 | ) | $ | 2,526,395 | $ | 91,568 | $ | 2,617,963 |\n\n\n| Accumulated | Advantage |\n| Common Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at January 1, 2021 | 318,425,182 | $ | 32 | $ | 3,348,546 | $ | ( 921,101 | ) | $ | ( 6,316 | ) | $ | 674 | $ | 2,421,835 | $ | 96,954 | $ | 2,518,789 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | 29,316 | — | — | 29,316 | 190 | 29,506 |\n| Foreign currency translation adjustments | — | — | — | — | — | ( 4,239 | ) | ( 4,239 | ) | ( 2,796 | ) | ( 7,035 | ) |\n| Total comprehensive income (loss) | 25,077 | ( 2,606 | ) | 22,471 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | ( 18 | ) | — | ( 18 | ) | — | ( 18 | ) |\n| Redemption of noncontrolling interest | — | — | ( 452 | ) | — | — | — | ( 452 | ) | 236 | ( 216 | ) |\n| Equity-based compensation of Karman Topco L.P. | — | — | ( 13,140 | ) | — | — | — | ( 13,140 | ) | — | ( 13,140 | ) |\n| Shares issued under 2020 Incentive Award Plan | 24,784 | — | — | — | — | — | — | — | — |\n| Shares issued upon vesting of restricted stock units | 41,424 | — | — | — | — | — | — | — | — |\n| Shares issued under 2020 Employee Stock Purchase Plan | 77,172 | — | 736 | — | — | — | 736 | — | 736 |\n| Shares issued upon exercise of warrants | 5,001 | — | 58 | — | — | — | 58 | — | 58 |\n| Stock-based compensation expense | — | — | 28,617 | — | — | — | 28,617 | — | 28,617 |\n| Balance at September 30, 2021 | 318,573,563 | $ | 32 | $ | 3,364,365 | $ | ( 891,785 | ) | $ | ( 6,334 | ) | $ | ( 3,565 | ) | $ | 2,462,713 | $ | 94,584 | $ | 2,557,297 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n6\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(UNAUDITED)\n\n| Nine Months Ended September 30, |\n| (in thousands) | 2022 | 2021 |\n| CASH FLOWS FROM OPERATING ACTIVITIES |\n| Net income | $ | 44,437 | $ | 29,535 |\n| Adjustments to reconcile net income to net cash provided by operating activities |\n| Noncash interest (income) expense, net | ( 34,419 | ) | 2,893 |\n| Depreciation and amortization | 173,997 | 181,450 |\n| Change in fair value of warrant liability | ( 21,456 | ) | ( 5,024 | ) |\n| Fair value adjustments related to contingent consideration | 5,448 | 6,977 |\n| Deferred income taxes | ( 28,561 | ) | ( 17,468 | ) |\n| Equity-based compensation of Karman Topco L.P. | ( 7,142 | ) | ( 13,140 | ) |\n| Stock-based compensation | 29,906 | 28,617 |\n| Equity in earnings of unconsolidated affiliates | ( 6,480 | ) | ( 6,222 | ) |\n| Distribution received from unconsolidated affiliates | 1,339 | 1,154 |\n| Loss on disposal of property and equipment | 608 | 6,327 |\n| Loss on divestiture | 2,953 | — |\n| Changes in operating assets and liabilities, net of effects from purchases of businesses: |\n| Accounts receivable, net | ( 45,383 | ) | ( 121,036 | ) |\n| Prepaid expenses and other assets | ( 45,087 | ) | ( 64,716 | ) |\n| Accounts payable | ( 7,914 | ) | 37,294 |\n| Accrued compensation and benefits | ( 26,316 | ) | 16,684 |\n| Deferred revenues | ( 156 | ) | 2,869 |\n| Other accrued expenses and other liabilities | 46,176 | 14,874 |\n| Net cash provided by operating activities | 81,950 | 101,068 |\n| CASH FLOWS FROM INVESTING ACTIVITIES |\n| Purchase of businesses, net of cash acquired | ( 74,146 | ) | ( 40,046 | ) |\n| Purchase of investment in unconsolidated affiliates | ( 775 | ) | ( 2,000 | ) |\n| Purchase of property and equipment | ( 30,037 | ) | ( 24,106 | ) |\n| Proceeds from divestiture | 1,896 | — |\n| Net cash used in investing activities | ( 103,062 | ) | ( 66,152 | ) |\n| CASH FLOWS FROM FINANCING ACTIVITIES |\n| Borrowings under lines of credit | 140,333 | 51,685 |\n| Payments on lines of credit | ( 139,684 | ) | ( 102,493 | ) |\n| Proceeds from issuance of long-term debt | 266 | — |\n| Principal payments on long-term debt | ( 10,427 | ) | ( 10,133 | ) |\n| Proceeds from issuance of common stock | 3,320 | 794 |\n| Contingent consideration payments | ( 23,164 | ) | ( 6,247 | ) |\n| Holdback payments | ( 8,557 | ) | ( 2,389 | ) |\n| Contribution from noncontrolling interest | 5,217 | — |\n| Redemption of noncontrolling interest | ( 224 | ) | ( 216 | ) |\n| Net cash used in financing activities | ( 32,920 | ) | ( 68,999 | ) |\n| Net effect of foreign currency changes on cash | ( 12,311 | ) | ( 1,476 | ) |\n| Net change in cash, cash equivalents and restricted cash | ( 66,343 | ) | ( 35,559 | ) |\n| Cash, cash equivalents and restricted cash, beginning of period | 180,637 | 219,966 |\n| Cash, cash equivalents and restricted cash, end of period | $ | 114,294 | $ | 184,407 |\n| SUPPLEMENTAL CASH FLOW INFORMATION |\n| Purchase of property and equipment recorded in accounts payable and accrued expenses | $ | 1,409 | $ | 322 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n7\nADVANTAGE SOLUTIONS INC.\nNOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(UNAUDITED)\n1. Organization and Significant Accounting Policies Advantage Solutions Inc. (the “Company”) is a provider of outsourced solutions to consumer goods companies and retailers. The Company’s Class A common stock is listed on the Nasdaq Global Select Market under the symbol “ADV” and warrants to purchase the Class A common stock at an exercise price of $ 11.50 per share are listed on the Nasdaq Global Select Market under the symbol “ADVWW”. Basis of Presentation The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its subsidiaries. The unaudited condensed consolidated financial statements do not include all of the information required by accounting principles generally accepted in the United States (“GAAP”). The Condensed Consolidated Balance Sheet at December 31, 2021 was derived from the audited Consolidated Balance Sheet at that date and does not include all the disclosures required by GAAP. In the opinion of management, all adjustments which are of a normal recurring nature and necessary for a fair statement of the results as of September 30, 2022 and for the three and nine months ended September 30, 2022 and 2021 have been reflected in the condensed consolidated financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements as of and for the year ended December 31, 2021 and the related footnotes thereto. Operating results for the three and nine months ended September 30, 2022 are not necessarily indicative of the results to be expected during the remainder of the current year or for any future period. COVID-19 Pandemic Beginning in March 2020 and continuing through the first quarter of 2021, the Company’s services experienced the most severe effects from reductions in client spending due to the economic impact related to the COVID-19 pandemic. While mixed by services and geography, the spending reductions impacted all of the Company’s services and markets. Globally, the most impacted services were the Company's experiential services. Most services began to recover in April 2021, and the recovery has continued through the third quarter of 2022. Impact of the War in Ukraine The Company has a minority interest in a European company that has majority-ownership interests in local agencies in Russia. During the first quarter of 2022, the war in Ukraine resulted in the imposition of sanctions by the United States, the United Kingdom, and the European Union, that affected, and continues to affect, the cross-border operations of businesses operating in Russia. In addition, Russian regulators have imposed currency restrictions and regulations that created uncertainty regarding the Company's ability to recover its investment in operations in Russia, as well as the Company's ability to exercise control or influence over operations by the local agencies in Russia. As a result, the Company intends to use its influence to cause the European company to dispose of its ownership interests in the local agencies in Russia. Accordingly, the Company recorded pretax charges of $ 2.8 million in the first quarter of 2022, primarily consisting of its proportionate share of the net investment in its Russian interest in “Selling, general, and administrative expenses” in the Condensed Consolidated Statements of Operations and Comprehensive Income. Recent Accounting StandardsAccounting Standards Recently Adopted by the CompanyIn March 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on 8 Financial Reporting. This guidance provides optional expedients and exceptions for GAAP to contracts, hedging relationships, and other transactions that reference the London Interbank Offered Rate (“LIBOR”) or another reference rate if certain criteria are met. The amendments in this update are effective for reporting periods that include or are subsequent to March 12, 2020 and must be applied prospectively to contract modifications and hedging relationships through December 31, 2022. On April 1, 2022, the Company adopted the standard prospectively and determined that the adoption of this accounting guidance did not have a material impact on its condensed consolidated financial statements.On January 1, 2022, the Company adopted ASU No. 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity (“ASU 2020-06”), which simplifies accounting for convertible instruments by removing major separation models required under current GAAP, simplifies the contract settlement assessment for equity classification, requires the use of the if-converted method for all convertible instruments in the diluted earnings per share calculation and expands disclosure requirements. The adoption of this accounting standard, under the full retrospective method, did not have a material impact on the Company's condensed consolidated financial statements and use of the if-converted method did not have an impact on the Company's overall earnings per share calculation.On January 1, 2022, the Company adopted ASU 2021-04, Earnings Per Share (Topic 260), Debt—Modifications and Extinguishments (Subtopic 470-50), Compensation—Stock Compensation (Topic 718), and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Issuer’s Accounting for Certain Modifications or Exchanges of Freestanding Equity-Classified Written Call Options (a consensus of the FASB Emerging Issues Task Force). The guidance clarifies certain aspects of the current guidance to promote consistency among reporting of an issuer’s accounting for modifications or exchanges of freestanding equity-classified written call options (for example, warrants) that remain equity-classified after modification or exchange. The guidance is applied prospectively to all modifications or exchanges that occur on or after the date of adoption and the adoption of this accounting standard did not have a material impact on the Company’s condensed consolidated financial statements.On January 1, 2022, the Company adopted ASU 2021-10, Government Assistance (Topic 832): Disclosures by Business Entities about Government Assistance. This update requires annual disclosures about transactions with a government that are accounted for by applying a grant or contribution accounting model by analogy. The guidance is applied prospectively to all transactions within the scope of the amendments that are reflected in financial statements at the date of initial application and new transactions that are entered into after the date of initial application. The adoption of this accounting standard did not have a material impact on the Company’s condensed consolidated financial statements. Accounting Standards Recently Issued but Not Yet Adopted by the CompanyIn October 2021, the FASB issued ASU 2021-08, Business Combinations (Topic 606): Accounting for Contract Assets and Contract Liabilities from Contracts with Customers, which requires that an entity recognize and measure contract assets and contract liabilities acquired in a business combination in accordance with Topic 606 as if it had originated the contracts. Generally, this should result in an acquirer recognizing and measuring the acquired contract assets and contract liabilities consistent with how they were recognized and measured in the acquiree’s financial statements, if the acquiree prepared financial statements in accordance with GAAP. The amendment in this update is effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. The guidance should be applied prospectively to business combinations occurring on or after the effective date of the amendment in this update. The Company is evaluating the potential impact of this adoption on its consolidated financial statements. All other new accounting pronouncements issued, but not yet effective or adopted have been deemed to be not relevant to the Company and, accordingly, are not expected to have a material impact once adopted.\n9\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Sales brand-centric services | $ | 343,478 | $ | 330,740 | $ | 1,005,707 | $ | 946,147 |\n| Sales retail-centric services | 302,768 | 266,399 | 836,640 | 746,960 |\n| Total sales revenues | 646,246 | 597,139 | 1,842,347 | 1,693,107 |\n| Marketing brand-centric services | 143,241 | 142,554 | 393,155 | 381,358 |\n| Marketing retail-centric services | 261,608 | 189,067 | 711,477 | 495,270 |\n| Total marketing revenues | 404,849 | 331,621 | 1,104,632 | 876,628 |\n| Total revenues | $ | 1,051,095 | $ | 928,760 | $ | 2,946,979 | $ | 2,569,735 |\n\n| (in thousands) |\n| Consideration: |\n| Cash | $ | 74,146 |\n| Holdback | 810 |\n| Fair value of contingent consideration | 510 |\n| Total consideration | $ | 75,466 |\n| Recognized amounts of identifiable assets acquired and liabilities assumed: |\n| Assets |\n| Accounts receivable | $ | 9,409 |\n| Other assets | 3,446 |\n| Identifiable intangible assets | 25,546 |\n| Total assets | 38,401 |\n| Liabilities |\n| Accounts payable | 7,363 |\n| Deferred tax liabilities and other | 8,744 |\n| Total liabilities | 16,107 |\n| Redeemable noncontrolling interest | 1,987 |\n| Noncontrolling interest | 974 |\n| Total identifiable net assets | 19,333 |\n| Goodwill arising from acquisitions | $ | 56,133 |\n| (in thousands) | Amount | WeightedAverageUseful Life |\n| Client relationships | $ | 24,413 | 6 years |\n| Trade names | 1,133 | 10 years |\n| Total identifiable intangible assets | $ | 25,546 |\n| (in thousands) |\n| Consideration |\n| Cash | $ | 40,046 |\n| Holdbacks | 13,599 |\n| Fair value of contingent consideration | 19,883 |\n| Total consideration | $ | 73,528 |\n| Recognized amounts of identifiable assets acquired and liabilities assumed: |\n| Assets |\n| Accounts receivable | $ | 12,834 |\n| Other assets | 4,400 |\n| Property and equipment | 1,001 |\n| Identifiable intangible assets | 36,210 |\n| Total assets | 54,445 |\n| Liabilities |\n| Total liabilities | 21,758 |\n| Redeemable noncontrolling interest | 1,804 |\n| Total identifiable net assets | 30,883 |\n| Goodwill arising from acquisitions | $ | 42,645 |\n| (in thousands) | Amount | WeightedAverageUseful Life |\n| Client relationships | $ | 27,860 | 7 years |\n| Trade Names | 5,250 | 5 years |\n| Developed technology | 3,100 | 7 years |\n| Total identifiable intangible assets | $ | 36,210 |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Revenues | $ | 1,052,274 | $ | 963,576 | $ | 2,962,479 | $ | 2,719,111 |\n| Net income | $ | 21,467 | $ | 23,896 | $ | 46,461 | $ | 32,590 |\n\n\n| Sales | Marketing | Total |\n| (in thousands) |\n| Balance at January 1, 2021 | $ | 1,462,378 | $ | 700,961 | $ | 2,163,339 |\n| Acquisitions | 32,087 | 13,315 | 45,402 |\n| Measurement period adjustments | 179 | ( 1,043 | ) | ( 864 | ) |\n| Foreign exchange translation effects | ( 1,873 | ) | — | ( 1,873 | ) |\n| Balance at December 31, 2021 | $ | 1,492,771 | $ | 713,233 | $ | 2,206,004 |\n| Acquisitions | 5,672 | 50,461 | 56,133 |\n| Measurement period adjustments | ( 446 | ) | — | ( 446 | ) |\n| Foreign exchange translation effects | ( 15,638 | ) | — | ( 15,638 | ) |\n| Balance at September 30, 2022 | $ | 1,482,359 | $ | 763,694 | $ | 2,246,053 |\n| September 30, 2022 |\n| (amounts in thousands) | Weighted Average Useful Life | Gross CarryingValue | AccumulatedAmortization | Net Carrying Value |\n| Finite-lived intangible assets: |\n| Client relationships | 14 years | $ | 2,486,064 | $ | 1,290,842 | $ | 1,195,222 |\n| Trade names | 8 years | 135,271 | 84,067 | 51,204 |\n| Developed technology | 5 years | 13,260 | 9,870 | 3,390 |\n| Covenant not to compete | 5 years | 6,100 | 5,841 | 259 |\n| Total finite-lived intangible assets | 2,640,695 | 1,390,620 | 1,250,075 |\n| Indefinite-lived intangible assets: |\n| Trade names | 900,000 | — | 900,000 |\n| Total other intangible assets | $ | 3,540,695 | $ | 1,390,620 | $ | 2,150,075 |\n| December 31, 2021 |\n| (amounts in thousands) | Weighted Average Useful Life | Gross CarryingValue | AccumulatedAmortization | Net Carrying Value |\n| Finite-lived intangible assets: |\n| Client relationships | 14 years | $ | 2,480,167 | $ | 1,158,732 | $ | 1,321,435 |\n| Trade names | 8 years | 138,206 | 78,355 | 59,851 |\n| Developed technology | 5 years | 13,260 | 8,206 | 5,054 |\n| Covenant not to compete | 5 years | 6,100 | 4,926 | 1,174 |\n| Total finite-lived intangible assets | 2,637,733 | 1,250,219 | 1,387,514 |\n| Indefinite-lived intangible assets: |\n| Trade names | 900,000 | — | 900,000 |\n| Total other intangible assets | $ | 3,537,733 | $ | 1,250,219 | $ | 2,287,514 |\n| (in thousands) |\n| Remainder of 2022 | $ | 49,782 |\n| 2023 | 197,530 |\n| 2024 | 196,181 |\n| 2025 | 190,153 |\n| 2026 | 186,203 |\n| Thereafter | 430,226 |\n| Total amortization expense | $ | 1,250,075 |\n\n\n| September 30, | December 31, |\n| (in thousands) | 2022 | 2021 |\n| Term Loan Facility | $ | 1,301,813 | $ | 1,311,750 |\n| Notes | 775,000 | 775,000 |\n| Government loans for COVID-19 relief | 4,113 | 5,212 |\n| Other | 1,492 | 1,113 |\n| Total long-term debt | 2,082,418 | 2,093,075 |\n| Less: current portion | 14,704 | 14,397 |\n| Less: debt issuance costs | 43,123 | 49,796 |\n| Long-term debt, net of current portion | $ | 2,024,591 | $ | 2,028,882 |\n\n| September 30, 2022 |\n| (in thousands) | Fair Value | Level 1 | Level 2 | Level 3 |\n| Assets measured at fair value |\n| Derivative financial instruments | $ | 49,149 | $ | — | $ | 49,149 | $ | — |\n| Total assets measured at fair value | $ | 49,149 | $ | — | $ | 49,149 | $ | — |\n| Liabilities measured at fair value |\n| Warrant liability | $ | 733 | $ | — | $ | 733 | $ | — |\n| Contingent consideration liabilities | 40,431 | — | — | 40,431 |\n| Total liabilities measured at fair value | $ | 41,164 | $ | — | $ | 733 | $ | 40,431 |\n| December 31, 2021 |\n| (in thousands) | Fair Value | Level 1 | Level 2 | Level 3 |\n| Assets measured at fair value |\n| Derivative financial instruments | $ | 10,164 | $ | — | $ | 10,164 | $ | — |\n| Total assets measured at fair value | $ | 10,164 | $ | — | $ | 10,164 | $ | — |\n| Liabilities measured at fair value |\n| Derivative financial instruments | $ | 385 | $ | — | $ | 385 | $ | — |\n| Warrant liability | 22,189 | — | — | 22,189 |\n| Contingent consideration liabilities | 58,366 | — | — | 58,366 |\n| Total liabilities measured at fair value | $ | 80,940 | $ | — | $ | 385 | $ | 80,555 |\n| September 30, |\n| (in thousands) | 2022 | 2021 |\n| Beginning of the period | $ | 58,366 | $ | 45,901 |\n| Fair value of acquisitions | 510 | 19,883 |\n| Changes in fair value | 5,448 | 6,977 |\n| Payments | ( 23,164 | ) | ( 6,399 | ) |\n| Measurement period adjustments | — | ( 1,181 | ) |\n| Foreign exchange translation effects | ( 729 | ) | ( 69 | ) |\n| End of the period | $ | 40,431 | $ | 65,112 |\n| (in thousands) | Carrying Value | Fair Value(Level 2) |\n| Balance at September 30, 2022 |\n| Term Loan Facility | $ | 1,301,813 | $ | 1,329,741 |\n| Notes | 775,000 | 723,486 |\n| Government loans for COVID-19 relief | 4,113 | 4,306 |\n| Other | 1,492 | 1,492 |\n| Total long-term debt | $ | 2,082,418 | $ | 2,059,025 |\n| (in thousands) | Carrying Value | Fair Value(Level 2) |\n| Balance at December 31, 2021 |\n| Term Loan Facility | $ | 1,311,750 | $ | 1,406,552 |\n| Notes | 775,000 | 894,611 |\n| Government loans for COVID-19 relief | 5,212 | 5,615 |\n| Other | 1,113 | 1,113 |\n| Total long-term debt | $ | 2,093,075 | $ | 2,307,891 |\n\n\n| Revenues | Accounts Receivable |\n| Three Months Ended September 30, | Nine Months Ended September 30, | As of September 30, | As of December 31, |\n| (in thousands) | 2022 | 2021 | 2022 | 2021 | 2022 | 2021 |\n| Client 1 | $ | 450 | $ | — | $ | 1,275 | $ | — | $ | 301 | $ | 176 |\n| Client 2 | 136 | 42 | 668 | 75 | 289 | 160 |\n| Client 3 | 147 | 124 | 455 | 457 | 129 | 190 |\n| All other clients | 30 | 1,452 | 152 | 6,694 | 16 | 10 |\n| Total | $ | 763 | $ | 1,618 | $ | 2,550 | $ | 7,226 | $ | 735 | $ | 536 |\n\n8. Income TaxesThe Company’s effective tax rates were 4.7 % and 25.4 % for the three months ended September 30, 2022 and 2021, respectively. The effective tax rate is based upon the estimated income or loss before taxes for the year, by jurisdiction, and adjusted for estimated permanent tax adjustments. The fluctuation in the Company’s effective tax rate was primarily due to the three months pretax book income differences and the discrete impact of $ 5.0 million to remeasure the deferred tax liability as a result of a reduction in the Company's blended state tax rate driven primarily by a Pennsylvania statutory tax rate change for the three months ended September 30, 2022, no t included in the three months ended September 30, 2021.The Company’s effective tax rates were 20.6 % and 36.0 % for the nine months ended September 30, 2022 and 2021, respectively. The effective tax rate is based upon the estimated income or loss before taxes for the year, by jurisdiction, and adjusted for estimated permanent tax adjustments. The fluctuation in the Company’s effective tax rate was primarily due to the nine months pretax book income differences, the discrete impact of $ 5.0 million to remeasure the deferred tax liability as a result of a reduction in the Company's blended state tax rate driven primarily by a Pennsylvania statutory tax rate change for the nine months ended September 30, 2022, offset by a shortfall adjustment of $ 2.4 million of stock based compensation for the nine months ended September 30, 2022. On August 16, 2022, the U.S. government enacted the Inflation Reduction Act (“IRA”), which imposes a new corporate alternative minimum tax (“CAMT”), an excise tax on stock buybacks, and significant tax incentives for energy and climate initiatives, among other provisions. The Company does not expect the CAMT to have a material impact on its consolidated financial statements.\n| (in thousands) | Sales | Marketing | Total |\n| Three Months Ended September 30, 2022 |\n| Revenues | $ | 646,246 | $ | 404,849 | $ | 1,051,095 |\n| Depreciation and amortization | $ | 39,798 | $ | 17,987 | $ | 57,785 |\n| Operating income | $ | 31,765 | $ | 15,077 | $ | 46,842 |\n| Three Months Ended September 30, 2021 |\n| Revenues | $ | 597,139 | $ | 331,621 | $ | 928,760 |\n| Depreciation and amortization | $ | 41,515 | $ | 17,648 | $ | 59,163 |\n| Operating income | $ | 51,906 | $ | 13,696 | $ | 65,602 |\n| (in thousands) | Sales | Marketing | Total |\n| Nine Months Ended September 30, 2022 |\n| Revenues | $ | 1,842,347 | $ | 1,104,632 | $ | 2,946,979 |\n| Depreciation and amortization | $ | 121,310 | $ | 52,687 | $ | 173,997 |\n| Operating income | $ | 65,915 | $ | 32,217 | $ | 98,132 |\n| Nine Months Ended September 30, 2021 |\n| Revenues | $ | 1,693,107 | $ | 876,628 | $ | 2,569,735 |\n| Depreciation and amortization | $ | 128,789 | $ | 52,661 | $ | 181,450 |\n| Operating income | $ | 131,727 | $ | 13,910 | $ | 145,637 |\n\n10. Commitments and ContingenciesLitigationThe Company is involved in various legal matters that arise in the ordinary course of its business. Some of these legal matters purport or may be determined to be class and/or representative actions, or seek substantial damages, or penalties. The Company has accrued amounts in connection with certain legal matters, including with respect to certain of the matters described below. There can be no assurance, however, that these accruals will be sufficient to cover such matters or other legal matters or that such matters or other legal matters will not materially or adversely affect the Company’s financial position, liquidity, or results of operations.Employment MattersThe Company has also been involved in various litigation, including purported class or representative actions with respect to matters arising under the California Labor Code and Private Attorneys General Act. The Company has retained outside counsel to represent it in these matters and is vigorously defending its interests. Legal Matters Related to Take 5On April 1, 2018, the Company acquired certain assets and assumed liabilities of Take 5 Media Group (“Take 5”). In June 2019, as a result of a review of internal allegations related to inconsistency of data provided by Take 5 to its clients, the Company commenced an investigation into Take 5’s operations. In July 2019, as a result of the Company’s investigation, the Company determined that revenue during the fiscal year ended December 31, 2018 attributable to the Take 5 business had been recognized for services that were not performed on behalf of clients of Take 5 and that inaccurate reports were made to Take 5 clients about those services (referred to as the “Take 5 Matter”). As a result of these findings, in July 2019, the Company terminated all operations of Take 5, including the use of its associated trade names and the offering of its services to its clients and offered refunds to Take 5 clients of collected revenues attributable to Take 5 since the Company’s acquisition of Take 5. 20 USAO and FBI Voluntary Disclosure and Investigation Related to Take 5The Company voluntarily disclosed to the United States Attorney’s Office and the Federal Bureau of Investigation certain misconduct occurring at Take 5, a line of business that the Company closed in July 2019. The Company intends to cooperate in this and any other governmental investigations that may arise in connection with the Take 5 Matter. At this time, the Company cannot predict the ultimate outcome of any investigation related to the Take 5 Matter and is unable to estimate the potential impact such an investigation may have on the Company. Arbitration Proceedings Related to Take 5In August 2019, as a result of the Take 5 Matter, the Company provided a written indemnification claim notice to the sellers of Take 5 (the “Take 5 Sellers”) seeking monetary damages (including interest, fees and costs) based on allegations of breach of the asset purchase agreement (the “Take 5 APA”), as well as fraud. In September 2019, the Take 5 Sellers initiated arbitration proceedings against the Company, alleging breach of the Take 5 APA as a result of the Company’s decision to terminate the operations of the Take 5 business, and seeking monetary damages equal to all unpaid earn-out payments under the Take 5 APA (plus interest, fees and costs). In 2020, the Take 5 sellers amended their statement of claim to allege defamation, relating to statements the Company made to customers in connection with terminating the operations of the Take 5 business, and seeking monetary damages for the alleged injury to their reputation. The Company filed its response to the Take 5 Sellers’ claims, and asserted indemnification, fraud and other claims against the Take 5 Sellers as counterclaims and cross-claims in the arbitration proceedings. In October 2022, the arbitrator made a final award in favor of the Company. The Company is currently unable to estimate if or when it will be able to collect any amounts associated with this arbitration. Other Legal Matters Related to Take 5The Take 5 Matter may result in additional litigation against the Company, including lawsuits from clients, or governmental investigations, which may expose the Company to potential liability in excess of the amounts being offered by the Company as refunds to Take 5 clients. The Company is currently unable to determine the amount of any potential liability, costs or expenses (above the amounts already being offered as refunds) that may result from any lawsuits or investigations associated with the Take 5 Matter or determine whether any such issues will have any future material adverse effect on the Company’s financial position, liquidity, or results of operations. Although the Company has insurance covering certain liabilities, the insurance may not be sufficient to cover any potential liability or expenses associated with the Take 5 Matter.\n| (in thousands, except share and per share data) Performance Period | Number ofSharesThreshold | Number ofSharesTarget | Number ofSharesMaximum | WeightedAverage FairValue perShare | Maximum Remaining Unrecognized Compensation Expense | Weighted-average remaining requisite service periods |\n| January 1, 2022— December 31, 2022 | 2,479,997 | 4,959,993 | 7,439,990 | $ | 5.63 | $ | 80,689 | 1.5 years |\n| January 1, 2021— December 31, 2021 | 1,121,698 | 1,121,698 | 1,319,458 | $ | 13.17 | $ | 4,982 | 1.1 years |\n| Performance Share Units | Weighted Average GrantDate Fair Value |\n| Outstanding at January 1, 2022 | 2,609,079 | $ | 13.07 |\n| Granted | 5,393,085 | $ | 5.66 |\n| Distributed | 660,880 | $ | 13.09 |\n| Forfeited | 684,261 | $ | 8.19 |\n| PSU performance adjustment | ( 377,572 | ) | $ | 11.19 |\n| Outstanding at September 30, 2022 | 6,279,451 | $ | 7.22 |\n| Number of RSUs | Weighted Average GrantDate Fair Value |\n| Outstanding at January 1, 2022 | 3,660,553 | $ | 10.64 |\n| Granted | 6,302,801 | $ | 5.74 |\n| Distributed | 1,338,213 | $ | 10.61 |\n| Forfeited | 869,955 | $ | 8.02 |\n| Outstanding at September 30, 2022 | 7,755,186 | $ | 6.96 |\n| September 30, |\n| 2022 |\n| Share Price | $ | 5.99 |\n| Dividend yield | 0.0 | % |\n| Expected volatility | 30.0 | % |\n| Risk-free interest rate | 2.0 | % |\n| Expected term (years) | 6.5 |\n\n\n| (in thousands) |\n| Balance at January 1, 2022 | $ | 1,893 |\n| Fair value at acquisition | 1,987 |\n| Net income attributable to redeemable noncontrolling interests | 124 |\n| Dividend distribution | ( 223 | ) |\n| Foreign currency translation adjustment | ( 428 | ) |\n| Balance at September 30, 2022 | $ | 3,353 |\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (in thousands, except share and earnings per share data) | 2022 | 2021 | 2022 | 2021 |\n| Basic earnings per share computation: |\n| Numerator: |\n| Net income attributable to stockholders of Advantage Solutions Inc. | $ | 21,059 | $ | 23,311 | $ | 43,395 | $ | 29,316 |\n| Denominator: |\n| Weighted average common shares - basic | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\n| Basic earnings per common share | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n| Diluted earnings per share computation: |\n| Numerator: |\n| Net income attributable to stockholders of Advantage Solutions Inc. | $ | 21,059 | $ | 23,311 | $ | 43,395 | $ | 29,316 |\n| Denominator: |\n| Weighted average common shares outstanding | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\n| Performance and Restricted Stock Units | 602,566 | 1,450,668 | 496,968 | 1,335,011 |\n| Employee stock purchase plan and stock options | 300,604 | 106,469 | 348,271 | 106,469 |\n| Weighted average common shares - diluted | 319,725,065 | 320,120,634 | 319,190,804 | 319,654,817 |\n| Diluted earnings per common share | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n\n24\n14. Subsequent EventsIn October 2022, the Company granted 2,153,900 RSUs and 1,170,000 stock options, with an estimated aggregate grant date fair value of $ 4.8 million and $ 1.2 million, respectively.\n25\nITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nForward-Looking Statements\nThis Quarterly Report on Form 10-Q (this “Quarterly Report”), including the section titled “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements that are based on current expectations, estimates, forecasts and projections about us, our future performance, our business, our beliefs and our management’s assumptions. Such words as “expect,” “anticipate,” “outlook,” “could,” “target,” “project,” “intend,” “plan,” “believe,” “seek,” “estimate,” “should,” “may,” “assume” and “continue” as well as variations of such words and similar expressions are intended to identify such forward-looking statements, although not all forward-looking statements contain such terms. These statements are not guarantees of future performance and they involve certain risks, uncertainties and assumptions that are difficult to predict. We have based our forward-looking statements on our management’s beliefs and assumptions based on information available to our management at the time the statements are made. We caution you that actual outcomes and results may differ materially from what is expressed, implied or forecasted by our forward-looking statements. More information regarding these risks and uncertainties and other important factors that could cause actual results to differ materially from those in the forward-looking statements is set forth in Part II, Item 1A “Risk Factors” of this report. Investors are cautioned not to place undue reliance on any such forward-looking statements, which speak only as of the date they are made. Except as required under the federal securities laws and the rules and regulations of the Securities and Exchange Commission, we do not have any intention or obligation to update publicly any forward-looking statements after the distribution of this report, whether as a result of new information, future events, changes in assumptions or otherwise.\nExecutive Overview\nWe are a leading business solutions provider to consumer goods manufacturers and retailers. We have a strong platform of competitively advantaged sales and marketing services built over multiple decades – essential, business critical services like headquarter sales, retail merchandising, in-store sampling, digital commerce and shopper marketing. For brands and retailers of all sizes, we help get the right products on the shelf (whether physical or digital) and into the hands of consumers (however they shop). We use a scaled platform to innovate as a trusted partner with our clients, solving problems to increase their efficiency and effectiveness across a broad range of channels.\nWe have two reportable segments: sales and marketing.\nThrough our sales segment, which generated approximately 62.5% and 65.9% of our total revenues in the nine months ended September 30, 2022 and 2021, respectively, we offer headquarter sales representation services to consumer goods manufacturers, for whom we prepare and present to retailers a business case to increase distribution of manufacturers’ products and optimize how they are displayed, priced and promoted. We also make in-store merchandising visits for both manufacturer and retailer clients to ensure the products we represent are adequately stocked and properly displayed.\nThrough our marketing segment, which generated approximately 37.5% and 34.1% of our total revenues in the nine months ended September 30, 2022 and 2021, respectively, we help brands and retailers reach consumers through two main categories within the marketing segment. The first and largest category is our retail experiential business, also known as in-store sampling or demonstrations, where we manage highly customized large-scale sampling programs (both in-store and online) for leading retailers. The second category is our collection of specialized agency services, in which we provide private label services to retailers and develop granular marketing programs for brands and retailers through our shopper, consumer and digital marketing agencies.\n26\nBusiness Combination with Conyers Park\nOn October 28, 2020, Conyers Park II Acquisition Corp. (“Conyers Park”), a Delaware corporation, consummated a merger with ASI Intermediate Corp. (“ASI”), formerly known as Advantage Solutions Inc., with ASI surviving the merger as a wholly owned subsidiary of Conyers Park (the “Merger” and, together with the other transactions contemplated by the merger agreement, the “Transactions”). On October 28, 2020, and in connection with the closing of the Transactions, Conyers Park changed its name to Advantage Solutions Inc.\nImpacts of the COVID-19 Pandemic\nBeginning in March 2020 and continuing through the first quarter of 2021, our services experienced the effects from reductions in client spending due to the economic impact related to the COVID-19 pandemic. While mixed by services and geography, the spending reductions impacted all of our services and markets. Globally, the most impacted services were our experiential services. Most services began to improve in April 2021, and the improvement has continued through the third quarter of 2022.\nSummary\nOur financial performance for the three months ended September 30, 2022 as compared to the three months ended September 30, 2021 includes:\n•Revenues increased by $122.3 million, or 13.2%, to $1,051.1 million;\n•Operating income decreased by $18.8 million, or 28.6%, to $46.8 million;\n•Net income decreased by $1.1 million, or 4.5% to $23.2 million;\n•Adjusted Net Income increased by $3.6 million, or 6.1%, to $62.7 million; and\n•Adjusted EBITDA decreased by $15.5 million, or 11.6%, to $118.3 million.\nOur financial performance for the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021 includes:\n•Revenues increased by $377.2 million, or 14.7% to $2,947.0 million;\n•Operating income decreased by $47.5 million, or 32.6% to $98.1 million;\n•Net income increased by $14.9 million, or 50.5% to $44.4 million;\n•Adjusted Net Income increased by $5.8 million, or 3.9% to $152.5 million; and\n•Adjusted EBITDA decreased by $43.8 million, or 11.9% to $323.3 million.\nDuring the nine months ended September 30, 2022, we acquired four businesses. The aggregate purchase price was $75.5 million, of which $74.1 million was paid in cash, $0.5 million in contingent consideration and $0.8 million in holdback.\nFactors Affecting Our Business and Financial Reporting\nThere are a number of factors, in addition to the impact of the COVID-19 pandemic and inflation, that affect the performance of our business and the comparability of our results from period to period including:\n•Organic Growth. Part of our strategy is to generate organic growth by expanding our existing client relationships, continuing to win new clients, pursuing channel expansion and new industry opportunities, enhancing our digital technology solutions, developing our international platform, delivering operational efficiencies and expanding into logical adjacencies. We believe that by pursuing\n27\nthese organic growth opportunities we will be able to continue to enhance our value proposition to our clients and thereby grow our business.\n•Acquisitions. We have grown and expect to continue to grow our business in part by acquiring quality businesses, both domestic and international. Excluding the 2017 acquisition of Daymon Worldwide Inc., we have completed 73 acquisitions from January 2014 to November 9, 2022, ranging in purchase prices from approximately $0.3 million to $98.5 million. Many of our acquisition agreements include contingent consideration arrangements, which are described below. We have completed acquisitions at what we believe are attractive purchase prices and have regularly structured our agreements to result in the generation of long-lived tax assets, which have in turn reduced our effective purchase prices when incorporating the value of those tax assets. We continue to look for strategic acquisitions that can be completed at attractive purchase prices.\n•Contingent Consideration. Many of our acquisition agreements include contingent consideration arrangements, which are generally based on the achievement of financial performance thresholds by the operations attributable to the acquired businesses. The contingent consideration arrangements are based upon our valuations of the acquired businesses and are intended to share the investment risk with the sellers of such businesses if projected financial results are not achieved. The fair values of these contingent consideration arrangements are included as part of the purchase price of the acquired companies on their respective acquisition dates. For each transaction, we estimate the fair value of contingent consideration payments as part of the initial purchase price. We review and assess the estimated fair value of contingent consideration on a quarterly basis, and the updated fair value could differ materially from our initial estimates. Adjustments to the estimated fair value related to changes in all other unobservable inputs are reported in “Selling, general and administrative expenses” in our Condensed Consolidated Statements of Operations and Comprehensive Income.\n•Depreciation and Amortization. As a result of the acquisition of our business by Karman Topco L.P. (“Topco”) on July 25, 2014 (the “2014 Topco Acquisition”), we acquired significant intangible assets, the value of which is amortized, on a straight-line basis, over 15 years from the date of the 2014 Topco Acquisition, unless determined to be indefinite-lived. The amortization of such intangible assets recorded in our consolidated financial statements has a significant impact on our operating income (loss) and net income (loss). Our historical acquisitions have increased, and future acquisitions likely will increase, our intangible assets. We do not believe the amortization expense associated with the intangibles created from our purchase accounting adjustments reflect a material economic cost to our business. Unlike depreciation expense which has an economic cost reflected by the fact that we must re-invest in property and equipment to maintain the asset base delivering our results of operations, we do not have any capital re-investment requirements associated with the acquired intangibles, such as client relationships and trade names, that comprise the majority of the finite-lived intangibles that create our amortization expense.\n•Foreign Exchange Fluctuations. Our financial results are affected by fluctuations in the exchange rate between the U.S. dollar and other currencies, primarily Canadian dollars, British pounds and euros, due to our operations in such foreign jurisdictions. See also “ —Quantitative and Qualitative Disclosure of Market Risk—Foreign Currency Risk.”\n•Seasonality. Our quarterly results are seasonal in nature, with the fourth fiscal quarter typically generating a higher proportion of our revenues than other fiscal quarters, as a result of higher consumer spending. We generally record slightly lower revenues in the first fiscal quarter of each year, as our clients begin to roll out new programs for the year, and consumer spending generally is less in the first fiscal quarter than other quarters. Timing of our clients’ marketing expenses, associated with marketing campaigns and new product launches, can also result in fluctuations from one quarter to another.\n28\nHow We Assess the Performance of Our Business\nRevenues\nRevenues related to our sales segment are primarily comprised of commissions, fee-for-service and cost-plus fees for providing retail merchandising services, category and space management, headquarter relationship management, technology solutions and administrative services. A small portion of our arrangements include performance incentive provisions, which allow us to earn additional revenues on our performance relative to specified quantitative or qualitative goals. We recognize the incentive portion of revenues under these arrangements when the related services are transferred to the customer.\nMarketing segment revenues are primarily recognized in the form of a fee-for-service (including retainer fees, fees charged to clients based on hours incurred, project-based fees or fees for executing in-person consumer engagements or experiences, which engagements or experiences we refer to as events), commissions or on a cost-plus basis, in each case, related to services including experiential marketing, shopper and consumer marketing services, private label development or our digital, social and media services.\nGiven our acquisition strategy, we analyze our financial performance, in part, by measuring revenue growth in two ways—revenue growth attributable to organic activities and revenue growth attributable to acquisitions, which we refer to as organic revenues and acquired revenues, respectively.\nWe define organic revenues as any revenues that are not acquired revenues. Our organic revenues exclude the impacts of acquisitions and divestitures, when applicable, which improves comparability of our results from period to period.\nIn general, when we acquire a business, the acquisition includes a contingent consideration arrangement (e.g., an earn-out provision) and, accordingly, we separately track the relevant metrics associated with the earnout agreement of the acquired business. In such cases, we consider revenues generated by such a business during the 12 months following its acquisition to be acquired revenues. For example, if we completed an acquisition on July 1, 2021 for a business that included a contingent consideration arrangement, we would consider revenues from the acquired business from July 1, 2021 to June 30, 2022 to be acquired revenues. We generally consider growth attributable to the financial performance of an acquired business after the 12-month anniversary of the date of acquisition to be organic.\nIn limited cases, when the acquisition of an acquired business does not include a contingent consideration arrangement, or we otherwise do not separately track the financial performance of the acquired business due to operational integration, we consider the revenues that the business generated in the 12 months prior to its acquisition to be our acquired revenues for the 12 months following its acquisition, and any differences in revenues actually generated during the 12 months after its acquisition to be organic. For example, if we completed an acquisition on July 1, 2021 for a business that did not include a contingent consideration arrangement, we would consider the amount of revenues from the acquired business from July 1, 2020 to June 30, 2021 to be acquired revenues during the period from July 1, 2021 to June 30, 2022, with any differences from that amount actually generated during the latter period to be organic revenues.\nAll revenues generated by our acquired businesses are considered to be organic revenues after the 12-month anniversary of the date of acquisition.\nWhen we divest a business, we consider the revenues that the divested business generated in the 12 months prior to its divestiture to be subtracted from acquired revenues for the 12 months following its divestiture. For example, if we completed a divestiture on July 1, 2021 for a business, we would consider the amount of revenues from the divested business from July 1, 2020 to June 30, 2021 to be subtracted from acquired revenues during the period from July 1, 2021 to June 30, 2022.\nWe measure organic revenue growth and acquired revenue growth by comparing the organic revenues or acquired revenues, respectively, period over period, net of any divestitures.\n29\nCost of Revenues\nOur cost of revenues consists of both fixed and variable expenses primarily attributable to the hiring, training, compensation and benefits provided to both full-time and part-time associates, as well as other project-related expenses. A number of costs associated with our associates are subject to external factors, including inflation, increases in market specific wages and minimum wage rates at federal, state and municipal levels and minimum pay levels for exempt roles. Additionally, when we enter into certain new client relationships, we may experience an initial increase in expenses associated with hiring, training and other items needed to launch the new relationship.\nSelling, General and Administrative Expenses\nSelling, general and administrative expenses consist primarily of salaries, payroll taxes and benefits for corporate personnel. Other overhead costs include information technology, occupancy costs for corporate personnel, professional services fees, including accounting and legal services, and other general corporate expenses. Additionally, included in selling, general and administrative expenses are costs associated with the changes in fair value of the contingent consideration of acquisitions and other acquisition-related costs. Acquisition-related costs are comprised of fees related to change of equity ownership, transaction costs, professional fees, due diligence and integration activities.\nOther (Income) Expenses\nChange in Fair Value of Warrant Liability\nChange in fair value of warrant liability represents a non-cash (income) expense resulting from a fair value adjustment to warrant liability with respect to the private placement warrants. Based on the period of time the public warrants have now been trading, we determined the fair value of the liability classified private placement warrants by approximating the value with the share price of the public warrants at the respective period end, which is inherently less subjective and judgmental given it is based on observable inputs. Previously, the fair value of the warrant liability was based on the input assumptions used in the Black-Scholes option pricing model, including our stock price at the end of the reporting period, the implied volatility or other inputs to the model and the number of private placement warrants outstanding, which may vary from period to period. We believe these amounts are not correlated to future business operations.\nInterest Expense\nInterest expense relates primarily to borrowings under the Senior Secured Credit Facilities as described below. See “ —Liquidity and Capital Resources.”\nDepreciation and Amortization\nAmortization Expense\nIncluded in our depreciation and amortization expense is amortization of acquired intangible assets. We have ascribed value to identifiable intangible assets other than goodwill in our purchase price allocations for companies we have acquired. These assets include, but are not limited to, client relationships and trade names. To the extent we ascribe value to identifiable intangible assets that have finite lives, we amortize those values over the estimated useful lives of the assets. Such amortization expense, although non-cash in the period expensed, directly impacts our results of operations. It is difficult to predict with any precision the amount of expense we may record relating to future acquired intangible assets.\n30\nAs a result of the 2014 Topco Acquisition, we acquired significant intangible assets, the value of which is amortized, on a straight-line basis, over 15 years from the date of the 2014 Topco Acquisition, unless determined to be indefinite-lived.\nDepreciation Expense\nDepreciation expense relates to the property and equipment that we own, which represented less than 1% of our total assets at September 30, 2022 and 2021, respectively.\nIncome Taxes\nIncome tax expense and our effective tax rates can be affected by many factors, including state apportionment factors, our acquisition strategy, tax incentives and credits available to us, changes in judgment regarding our ability to realize our deferred tax assets, changes in our worldwide mix of pre-tax losses or earnings, changes in existing tax laws and our assessment of uncertain tax positions.\nCash Flows\nWe have positive cash flow characteristics, as described below, due to the limited required capital investment in the fixed assets and working capital needs to operate our business in the normal course. See “ —Liquidity and Capital Resources.”\nOur principal sources of liquidity are cash flows from operations, borrowings under the Revolving Credit Facility, and other debt. Our principal uses of cash are operating expenses, working capital requirements, acquisitions and repayment of debt.\nAdjusted Net Income\nAdjusted Net Income is a non-GAAP financial measure. Adjusted Net Income means Net income before (i) impairment of goodwill and indefinite-lived assets, (ii) amortization of intangible assets, (iii) equity-based compensation of Topco, (iv) changes in fair value of warrant liability, (v) fair value adjustments of contingent consideration related to acquisitions, (vi) acquisition-related expenses, (vii) costs associated with COVID-19, net of benefits received, (viii) EBITDA for economic interests in investments, (ix) restructuring expenses, (x) litigation expenses (recovery), (xi) costs associated with the Take 5 Matter, (xii) related tax adjustments and (xiii) other adjustments that management believes are helpful in evaluating our operating performance.\nWe present Adjusted Net Income because we use it as a supplemental measure to evaluate the performance of our business in a way that also considers our ability to generate profit without the impact of items that we do not believe are indicative of our operating performance or are unusual or infrequent in nature and aid in the comparability of our performance from period to period. Adjusted Net Income should not be considered as an alternative for Net income, our most directly comparable measure presented on a GAAP basis.\nAdjusted EBITDA and Adjusted EBITDA by Segment\nAdjusted EBITDA and Adjusted EBITDA by segment are supplemental non-GAAP financial measures of our operating performance. Adjusted EBITDA means Net income before (i) interest expense, net, (ii) provision for income taxes, (iii) depreciation, (iv) impairment of goodwill and indefinite-lived assets, (v) amortization of intangible assets, (vi) equity-based compensation of Topco, (vii) changes in fair value of warrant liability, (viii) stock-based compensation expense, (ix) fair value adjustments of contingent consideration related to acquisitions, (x) acquisition-related expenses, (xi) costs associated with COVID-19, net of benefits received, (xii) EBITDA for economic interests in investments, (xiii) restructuring expenses, (xiv) litigation expenses (recovery), (xv) costs associated with the Take 5 Matter and (xvi) other adjustments that management believes are helpful in evaluating our operating performance.\n31\nWe present Adjusted EBITDA and Adjusted EBITDA by segment because they are key operating measures used by us to assess our financial performance. These measures adjust for items that we believe do not reflect the ongoing operating performance of our business, such as certain noncash items, unusual or infrequent items or items that change from period to period without any material relevance to our operating performance. We evaluate these measures in conjunction with our results according to GAAP because we believe they provide a more complete understanding of factors and trends affecting our business than GAAP measures alone. Furthermore, the agreements governing our indebtedness contain covenants and other tests based on measures substantially similar to Adjusted EBITDA. Neither Adjusted EBITDA nor Adjusted EBITDA by segment should be considered as an alternative for Net income, our most directly comparable measure presented on a GAAP basis.\nResults of Operations for the Three and Nine Months Ended September 30, 2022 and 2021\nThe following table sets forth items derived from the Company’s consolidated statements of operations for the three and nine months ended September 30, 2022 and 2021 in dollars and as a percentage of total revenues.\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (amounts in thousands) | 2022 | 2021 | 2022 | 2021 |\n| Revenues | $ | 1,051,095 | 100.0 | % | $ | 928,760 | 100.0 | % | $ | 2,946,979 | 100.0 | % | $ | 2,569,735 | 100.0 | % |\n| Cost of revenues | 908,523 | 86.4 | % | 766,253 | 82.5 | % | 2,536,256 | 86.1 | % | 2,117,818 | 82.4 | % |\n| Selling, general, and administrative expenses | 37,945 | 3.6 | % | 37,742 | 4.1 | % | 138,594 | 4.7 | % | 124,830 | 4.9 | % |\n| Depreciation and amortization | 57,785 | 5.5 | % | 59,163 | 6.4 | % | 173,997 | 5.9 | % | 181,450 | 7.1 | % |\n| Total expenses | 1,004,253 | 95.5 | % | 863,158 | 92.9 | % | 2,848,847 | 96.7 | % | 2,424,098 | 94.3 | % |\n| Operating income | 46,842 | 4.5 | % | 65,602 | 7.1 | % | 98,132 | 3.3 | % | 145,637 | 5.7 | % |\n| Other (income) expenses: |\n| Change in fair value of warrant liability | (1,100 | ) | (0.1 | )% | (3,491 | ) | (0.4 | )% | (21,456 | ) | (0.7 | )% | (5,024 | ) | (0.2 | )% |\n| Interest expense, net | 23,557 | 2.2 | % | 36,490 | 3.9 | % | 63,628 | 2.2 | % | 104,544 | 4.1 | % |\n| Total other expenses | 22,457 | 2.1 | % | 32,999 | 3.6 | % | 42,172 | 1.4 | % | 99,520 | 3.9 | % |\n| Income before income taxes | 24,385 | 2.3 | % | 32,603 | 3.5 | % | 55,960 | 1.9 | % | 46,117 | 1.8 | % |\n| Provision for income taxes | 1,158 | 0.1 | % | 8,276 | 0.9 | % | 11,523 | 0.4 | % | 16,582 | 0.6 | % |\n| Net income | $ | 23,227 | 2.2 | % | $ | 24,327 | 2.6 | % | $ | 44,437 | 1.5 | % | $ | 29,535 | 1.1 | % |\n| Other Financial Data |\n| Adjusted Net Income(1) | $ | 62,682 | 6.0 | % | $ | 59,101 | 6.4 | % | $ | 152,541 | 5.2 | % | $ | 146,762 | 5.7 | % |\n| Adjusted EBITDA(1) | $ | 118,268 | 11.3 | % | $ | 133,756 | 14.4 | % | $ | 323,329 | 11.0 | % | $ | 367,155 | 14.3 | % |\n\n(1)Adjusted Net Income and Adjusted EBITDA are financial measures that are not calculated in accordance with GAAP. For a discussion of our presentation of Adjusted Net Income and Adjusted EBITDA and reconciliations of Net income to Adjusted Net Income and Adjusted EBITDA, see “—Non-GAAP Financial Measures.”\nComparison of the Three Months Ended September 30, 2022 and 2021\nRevenues\n\n| Three Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 646,246 | $ | 597,139 | $ | 49,107 | 8.2 | % |\n| Marketing | 404,849 | 331,621 | 73,228 | 22.1 | % |\n| Total revenues | $ | 1,051,095 | $ | 928,760 | $ | 122,335 | 13.2 | % |\n\nTotal revenues increased by $122.3 million, or 13.2%, during the three months ended September 30, 2022, as compared to the three months ended September 30, 2021.\nThe sales segment revenues increased $49.1 million during the three months ended September 30, 2022 as compared to the three months ended September 30, 2021, of which $23.6 million were revenues from acquired\n32\nbusinesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $17.0 million, the segment experienced an increase of $42.5 million in organic revenues primarily due to growth in our retail merchandising services and international businesses, partially offset by a decrease in our third party selling and retailing services.\nThe marketing segment revenues increased $73.2 million during the three months ended September 30, 2022 as compared to the three months ended September 30, 2021, of which $11.0 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $5.7 million, the segment experienced an increase of $67.9 million in organic revenues. The increase in revenues was primarily due to an increase in our in-store product demonstration and sampling services which continue to recover from the temporary suspensions as a result of the COVID-19 pandemic, partially offset by a decrease in certain of our client media spend.\nCost of Revenues\nCost of revenues as a percentage of revenues for the three months ended September 30, 2022 was 86.4%, as compared to 82.5% for the three months ended September 30, 2021. The increase as a percentage of revenues was largely attributable to the change in the revenue mix of our services as a result of recoveries from the COVID-19 pandemic and acquired businesses, and the ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\nSelling, General and Administrative Expenses\nSelling, general and administrative expenses as a percentage of revenues for the three months ended September 30, 2022 was 3.6%, compared to 4.1% for the three months ended September 30, 2021, primarily due to the change in fair value adjustments related to contingent consideration and a decrease in legal fees associated with the Take 5 Matter.\nDepreciation and Amortization Expense\nDepreciation and amortization expense decreased by $1.4 million, or 2.3%, to $57.8 million for the three months ended September 30, 2022 compared to $59.2 million for the three months ended September 30, 2021, which stayed relatively consistent year over year.\nOperating Income\n\n| Three Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 31,765 | $ | 51,906 | $ | (20,141 | ) | (38.8 | )% |\n| Marketing | 15,077 | 13,696 | 1,381 | 10.1 | % |\n| Total operating income | $ | 46,842 | $ | 65,602 | $ | (18,760 | ) | (28.6 | )% |\n\nIn the sales segment, the decrease in operating income during the three months ended September 30, 2022 was due to a shift in revenue mix and ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\nIn the marketing segment, the increase in operating income during the three months ended September 30, 2022 was due to the growth in revenues, partially offset by the increase in cost of revenues as described above.\nChange in Fair Value of Warrant Liability\nChange in fair value of warrant liability represents $1.1 million of non-cash gain resulting from a fair value adjustment to warrant liability with respect to the private placement warrants for the three months ended September 30, 2022, approximating the fair value with the warrant price of the public warrants.\n33\nInterest Expense, net\nInterest expense, net decreased $12.9 million, or 35.4%, to $23.6 million for the three months ended September 30, 2022, from $36.5 million for the three months ended September 30, 2021. The decrease in interest expense, net was primarily due to the increase in fair value changes in derivatives instruments.\nProvision for Income Taxes\nProvision for income taxes was $1.2 million for the three months ended September 30, 2022 as compared to $8.3 million of provision for income taxes for the three months ended September 30, 2021. The fluctuation was primarily attributable to the decrease in pre-tax income during the three months ended September 30, 2022 and decrease of $4.3 million of discrete items for the three months ended September 30, 2022.\nNet Income\nNet income was $23.2 million for the three months ended September 30, 2022, compared to net income of $24.3 million for the three months ended September 30, 2021. The decrease in net income was primarily driven by the decrease in operating income as described above, offset by the decrease in interest expense, net and provision for income taxes.\nAdjusted Net Income\nThe increase in Adjusted Net Income for the three months ended September 30, 2022 was attributable to the decrease in interest expense, net as described above. For a reconciliation of Adjusted Net Income to Net income, see “ —Non-GAAP Financial Measures.”\nAdjusted EBITDA and Adjusted EBITDA by Segment\n\n| Three Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 76,172 | $ | 95,199 | $ | (19,027 | ) | (20.0 | )% |\n| Marketing | 42,096 | 38,557 | 3,539 | 9.2 | % |\n| Total Adjusted EBITDA | $ | 118,268 | $ | 133,756 | $ | (15,488 | ) | (11.6 | )% |\n\nAdjusted EBITDA decreased by $15.5 million, or 11.6%, to $118.3 million for the three months ended September 30, 2022, from $133.8 million for the three months ended September 30, 2021. In the sales segment, the decrease in Adjusted EBITDA was primarily attributable to the increase in cost of revenues as described above. In the marketing segment, the increase in the Adjusted EBITDA was primarily attributable to the growth in revenues as described above. For a reconciliation of Adjusted EBITDA to Net income, see “—Non-GAAP Financial Measures.”\nComparison of the Nine Months Ended September 30, 2022 and 2021\nRevenues\n\n| Nine Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 1,842,347 | $ | 1,693,107 | $ | 149,240 | 8.8 | % |\n| Marketing | 1,104,632 | 876,628 | 228,004 | 26.0 | % |\n| Total revenues | $ | 2,946,979 | $ | 2,569,735 | $ | 377,244 | 14.7 | % |\n\n34\nTotal revenues increased by $377.2 million, or 14.7%, during the nine months ended September 30, 2022, as compared to the nine months ended September 30, 2021.\nThe sales segment revenues increased $149.2 million during the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021, of which $114.2 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $33.9 million, the segment experienced an increase of $68.9 million in organic revenues primarily due to our European joint venture which experienced continued recoveries from temporary reduction in services as a result of the COVID-19 pandemic and growth in our retail merchandising services partially offset by a decrease in our foodservice and third party selling and retailing services.\nThe marketing segment revenues increased $228.0 million during the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021, of which $23.1 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $11.6 million, the segment experienced an increase of $216.5 million in organic revenues. The increase in revenues was primarily due to an increase in our in-store product demonstration and sampling services which continue to recover from the temporary suspensions as a result of the COVID-19 pandemic, partially offset by a decrease in certain of our client media spend.\nCost of Revenues\nCost of revenues as a percentage of revenues for the nine months ended September 30, 2022 was 86.1%, as compared to 82.4% for the nine months ended September 30, 2021. The increase as a percentage of revenues was largely attributable to the change in the revenue mix of our services as a result of recoveries from the COVID-19 pandemic and acquired businesses, and the ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\nSelling, General and Administrative Expenses\nSelling, general and administrative expenses as a percentage of revenues for the nine months ended September 30, 2022 was 4.7%, compared to 4.9% for the nine months ended September 30, 2021.\nDepreciation and Amortization Expense\nDepreciation and amortization expense decreased by $7.5 million or 4.1% to $174.0 million for the nine months ended September 30, 2022 compared to $181.5 million for the nine months ended September 30, 2021. The decrease was primarily due to a decrease in depreciation expenses from our internally developed software.\nOperating Income\n\n| Nine Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 65,915 | $ | 131,727 | $ | (65,812 | ) | (50.0 | %) |\n| Marketing | 32,217 | 13,910 | 18,307 | 131.6 | % |\n| Total operating income | $ | 98,132 | $ | 145,637 | $ | (47,505 | ) | (32.6 | %) |\n\nIn the sales segment, the decrease in operating income during the nine months ended September 30, 2022 was primarily attributable to a shift in revenue mix, ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses, the change in fair value adjustments related to contingent consideration, and an increase in stock-based compensation expense, partially offset by a decrease in depreciation expense.\n35\nIn the marketing segment, the increase in operating income during the nine months ended September 30, 2022 was primarily attributable to the growth in revenues, partially offset by the increase in cost of revenues as described above and the change in fair value adjustments related to contingent consideration.\nChange in Fair Value of Warrant Liability\nChange in fair value of warrant liability represents $21.5 million of non-cash gain resulting from a fair value adjustment to warrant liability with respect to the private placement warrants for the nine months ended September 30, 2022, approximating the fair value with the warrant price of the public warrants.\nInterest Expense, net\nInterest expense, net decreased $40.9 million, or 39.1%, to $63.6 million for the nine months ended September 30, 2022, from $104.5 million for the nine months ended September 30, 2021. The decrease in interest expense, net was primarily due to the increase in fair value changes in derivatives instruments.\nProvision for Income Taxes\nProvision for income taxes was $11.5 million for the nine months ended September 30, 2022 as compared to $16.6 million for the nine months ended September 30, 2021. The fluctuation was primarily attributable to the increase in pre-tax income during the nine months ended September 30, 2022, partially offset by a decrease of $7.4 million of discrete items.\nNet Income\nNet income was $44.4 million for the nine months ended September 30, 2022, compared to net income of $29.5 million for the nine months ended September 30, 2021. The increase in net income was primarily driven by the decrease in change in fair value of warrant liability, interest expense, net, and provision for income taxes, partially offset by the decrease in operating income as described above.\nAdjusted Net Income\nThe increase in Adjusted Net Income for the nine months ended September 30, 2022 was attributable to the decrease in change in fair value of warrant liability, and interest expense, net as described above. For a reconciliation of Adjusted Net Income to Net income, see “ —Non-GAAP Financial Measures.”\nAdjusted EBITDA and Adjusted EBITDA by Segment\n\n| Nine Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 216,158 | $ | 268,798 | $ | (52,640 | ) | (19.6 | )% |\n| Marketing | 107,171 | 98,357 | 8,814 | 9.0 | % |\n| Total Adjusted EBITDA | $ | 323,329 | $ | 367,155 | $ | (43,826 | ) | (11.9 | )% |\n\nAdjusted EBITDA decreased by $43.8 million, or 11.9%, to $323.3 million for the nine months ended September 30, 2022, from $367.2 million for the nine months ended September 30, 2021. In the sales segment, the decrease in Adjusted EBITDA was primarily attributable to the increase in cost of revenues as described above. In the marketing segment, the increase in the Adjusted EBITDA was primarily attributable to the growth in revenues as described above. For a reconciliation of Adjusted EBITDA to Net income, see “—Non-GAAP Financial Measures.”\n36\nNon-GAAP Financial Measures\nAdjusted Net Income is a non-GAAP financial measure. Adjusted Net Income means Net income before (i) impairment of goodwill and indefinite-lived assets, (ii) amortization of intangible assets, (iii) equity-based compensation of Topco, (iv) change in fair value of warrant liability, (v) fair value adjustments of contingent consideration related to acquisitions, (vi) acquisition-related expenses, (vii) costs associated with COVID-19, net of benefits received, (viii) EBITDA for economic interests in investments, (ix) restructuring expenses, (x) litigation expenses (recovery), (xi) costs associated with the Take 5 Matter, (xii) related tax adjustments and (xiii)other adjustments that management believes are helpful in evaluating our operating performance.\nWe present Adjusted Net Income because we use it as a supplemental measure to evaluate the performance of our business in a way that also considers our ability to generate profit without the impact of items that we do not believe are indicative of our operating performance or are unusual or infrequent in nature and aid in the comparability of our performance from period to period. Adjusted Net Income should not be considered as an alternative for our Net income, our most directly comparable measure presented on a GAAP basis.\nA reconciliation of Adjusted Net Income to Net income is provided in the following table:\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Net income | $ | 23,227 | $ | 24,327 | $ | 44,437 | $ | 29,535 |\n| Less: Net income attributable to noncontrolling interest | 2,168 | 1,016 | 1,042 | 219 |\n| Add: |\n| Equity -based compensation of Karman Topco L.P.(a) | (828 | ) | (5,575 | ) | (7,142 | ) | (10,031 | ) |\n| Change in fair value of warrant liability | (1,100 | ) | (3,491 | ) | (21,456 | ) | (5,024 | ) |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (340 | ) | 3,221 | 5,448 | 5,776 |\n| Acquisition-related expenses(d) | 4,260 | 5,110 | 19,843 | 13,053 |\n| Restructuring expenses(e) | 3,562 | (394 | ) | 4,458 | 10,636 |\n| Litigation(f) | — | (92 | ) | (800 | ) | (910 | ) |\n| Amortization of intangible assets(g) | 49,997 | 49,786 | 150,930 | 148,396 |\n| Costs associated with COVID-19, net of benefits received(h) | 2,009 | 1,087 | 4,945 | (948 | ) |\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\n| Tax adjustments related to non-GAAP adjustments(j) | (16,215 | ) | (15,262 | ) | (49,168 | ) | (47,113 | ) |\n| Adjusted Net Income | $ | 62,682 | $ | 59,101 | $ | 152,541 | $ | 146,762 |\n\nAdjusted EBITDA and Adjusted EBITDA by segment are supplemental non-GAAP financial measures of our operating performance. Adjusted EBITDA means Net income before (i) interest expense, net, (ii) provision for income taxes, (iii) depreciation, (iv) impairment of goodwill and indefinite-lived assets, (v) amortization of intangible assets, (vi) equity-based compensation of Topco, (vii) change in fair value of warrant liability, (viii) stock-based compensation expense, (ix) fair value adjustments of contingent consideration related to acquisitions, (x) acquisition-related expenses, (xi) costs associated with COVID-19, net of benefits received, (xii) EBITDA for economic interests in investments, (xiii) restructuring expenses, (xiv) litigation expenses (recovery), (xv) costs associated with the Take 5 Matter and (xvi) other adjustments that management believes are helpful in evaluating our operating performance.\nWe present Adjusted EBITDA and Adjusted EBITDA by segment because they are key operating measures used by us to assess our financial performance. These measures adjust for items that we believe do not reflect the ongoing operating performance of our business, such as certain noncash items, unusual or infrequent items or items that change from period to period without any material relevance to our operating performance. We evaluate these measures in conjunction with our results according to GAAP because we believe they provide a more complete understanding of factors and trends affecting our business than GAAP measures alone. Furthermore, the agreements governing our indebtedness contain covenants and other tests based on measures substantially similar to\n37\nAdjusted EBITDA. Neither Adjusted EBITDA nor Adjusted EBITDA by segment should be considered as an alternative for our Net income, our most directly comparable measure presented on a GAAP basis.\nA reconciliation of Adjusted EBITDA to Net income is provided in the following table:\n\n| Consolidated | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Net income | $ | 23,227 | $ | 24,327 | $ | 44,437 | $ | 29,535 |\n| Add: |\n| Interest expense, net | 23,557 | 36,490 | 63,628 | 104,544 |\n| Provision for income taxes | 1,158 | 8,276 | 11,523 | 16,582 |\n| Depreciation and amortization | 57,785 | 59,163 | 173,997 | 181,450 |\n| Equity-based compensation of Karman Topco L.P.(a) | (828 | ) | (5,575 | ) | (7,142 | ) | (10,031 | ) |\n| Change in fair value of warrant liability | (1,100 | ) | (3,491 | ) | (21,456 | ) | (5,024 | ) |\n| Stock-based compensation expense(b) | 7,174 | 7,854 | 29,906 | 25,497 |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (340 | ) | 3,221 | 5,448 | 5,776 |\n| Acquisition-related expenses(d) | 4,260 | 5,110 | 19,843 | 13,053 |\n| EBITDA for economic interests in investments(k) | (2,474 | ) | (3,620 | ) | (7,546 | ) | (6,616 | ) |\n| Restructuring expenses(e) | 3,562 | (394 | ) | 4,458 | 10,636 |\n| Litigation(f) | — | (92 | ) | (800 | ) | (910 | ) |\n| Costs associated with COVID-19, net of benefits received(h) | 2,009 | 1,087 | 4,945 | (948 | ) |\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\n| Adjusted EBITDA | $ | 118,268 | $ | 133,756 | $ | 323,329 | $ | 367,155 |\n\nFinancial information by segment, including a reconciliation of Adjusted EBITDA by segment to operating income, the closest GAAP financial measure, is provided in the following table:\n\n| Sales Segment | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Operating income | $ | 31,765 | $ | 51,906 | $ | 65,915 | $ | 131,727 |\n| Add: |\n| Depreciation and amortization | 39,798 | 41,515 | 121,310 | 128,789 |\n| Equity-based compensation of Karman Topco L.P.(a) | (320 | ) | (4,844 | ) | (4,004 | ) | (7,360 | ) |\n| Stock-based compensation expense(b) | 4,080 | 4,371 | 18,009 | 13,795 |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (1,901 | ) | 192 | 4,992 | (4,057 | ) |\n| Acquisition-related expenses(d) | 2,880 | 3,899 | 13,734 | 9,499 |\n| EBITDA for economic interests in investments(k) | (2,656 | ) | (3,832 | ) | (8,018 | ) | (7,429 | ) |\n| Restructuring expenses(e) | 2,360 | 1,273 | 3,519 | 3,229 |\n| Litigation(f) | — | (68 | ) | (100 | ) | (584 | ) |\n| Costs associated with COVID-19, net of benefits received(h) | 166 | 787 | 801 | 1,189 |\n| Sales Segment Adjusted EBITDA | $ | 76,172 | $ | 95,199 | $ | 216,158 | $ | 268,798 |\n\n38\n\n| Marketing Segment | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Operating income | $ | 15,077 | $ | 13,696 | $ | 32,217 | $ | 13,910 |\n| Add: |\n| Depreciation and amortization | 17,987 | 17,648 | 52,687 | 52,661 |\n| Equity-based compensation of Karman Topco L.P.(a) | (508 | ) | (731 | ) | (3,138 | ) | (2,671 | ) |\n| Stock-based compensation expense(b) | 3,094 | 3,483 | 11,897 | 11,702 |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | 1,561 | 3,029 | 456 | 9,833 |\n| Acquisition-related expenses(d) | 1,380 | 1,211 | 6,109 | 3,554 |\n| EBITDA for economic interests in investments(k) | 182 | 212 | 472 | 813 |\n| Restructuring expenses(e) | 1,202 | (1,667 | ) | 939 | 7,407 |\n| Litigation(f) | — | (24 | ) | (700 | ) | (326 | ) |\n| Costs associated with COVID-19, net of benefits received(h) | 1,843 | 300 | 4,144 | (2,137 | ) |\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\n| Marketing Segment Adjusted EBITDA | $ | 42,096 | $ | 38,557 | $ | 107,171 | $ | 98,357 |\n\n\n\n\n| (a) | Represents expenses related to (i) equity-based compensation expense associated with grants of Common Series D Units of Topco made to one of the Advantage Sponsors (as defined below) and (ii) equity-based compensation expense associated with the Common Series C Units of Topco. |\n| (b) | Represents non-cash compensation expense related to the 2020 Incentive Award Plan and the 2020 Employee Stock Purchase Plan. |\n| (c) | Represents adjustments to the estimated fair value of our contingent consideration liabilities related to our acquisitions. See Note 6—Fair Value of Financial Instruments to our unaudited condensed financial statements for the three and nine months ended September 30, 2022 and 2021. |\n| (d) | Represents fees and costs associated with activities related to our acquisitions and restructuring activities, including professional fees, due diligence, and integration activities. |\n| (e) | Represents fees and costs associated with various internal reorganization activities among our consolidated entities. |\n| (f) | Represents legal settlements that are unusual or infrequent costs associated with our operating activities. |\n| (g) | Represents the amortization of intangible assets recorded in connection with the 2014 Topco Acquisition and our other acquisitions. |\n| (h) | Represents (i) costs related to implementation of strategies for workplace safety in response to COVID-19, including employee-relief fund, additional sick pay for front-line associates, medical benefit payments for furloughed associates, and personal protective equipment; and (ii) benefits received from government grants for COVID-19 relief. |\n| (i) | Represents costs associated with the Take 5 Matter, primarily, professional fees and other related costs, for the three and nine months ended September 30, 2022 and 2021, respectively. |\n| (j) | Represents the tax provision or benefit associated with the adjustments above, taking into account the Company’s applicable tax rates, after excluding adjustments related to items that do not have a related tax impact. |\n| (k) | Represents additions to reflect our proportional share of Adjusted EBITDA related to our equity method investments and reductions to remove the Adjusted EBITDA related to the minority ownership percentage of the entities that we fully consolidate in our financial statements. |\n\n39\nLiquidity and Capital Resources\nOur principal sources of liquidity were cash flows from operations, borrowings under the Revolving Credit Facility, and other debt. Our principal uses of cash are operating expenses, working capital requirements, acquisitions, interest on debt and repayment of debt.\nCash Flows\nA summary of our cash operating, investing and financing activities are shown in the following table:\n\n| Nine Months Ended September 30, |\n| (in thousands) | 2022 | 2021 |\n| Net cash provided by operating activities | $ | 81,950 | $ | 101,068 |\n| Net cash used in investing activities | (103,062 | ) | (66,152 | ) |\n| Net cash used in financing activities | (32,920 | ) | (68,999 | ) |\n| Net effect of foreign currency fluctuations on cash | (12,311 | ) | (1,476 | ) |\n| Net change in cash, cash equivalents and restricted cash | $ | (66,343 | ) | $ | (35,559 | ) |\n\nNet Cash Provided by Operating Activities\nNet cash used in operating activities during the nine months ended September 30, 2022 consisted of net income of $44.4 million adjusted for certain non-cash items, including depreciation and amortization of $174.0 million and effects of changes in working capital. Net cash provided by operating activities during the nine months ended September 30, 2021 consisted of net income of $29.5 million adjusted for certain non-cash items, including depreciation and amortization of $181.5 million and effects of changes in working capital. The decrease in cash provided by operating activities during the nine months ended September 30, 2022 relative to the same period in 2021 was primarily due to ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses during the nine months ended September 30, 2022.\nNet Cash Used in Investing Activities\nNet cash used in investing activities during the nine months ended September 30, 2022 primarily consisted of the purchase of businesses, net of cash acquired of $74.4 million and purchase of property and equipment of $30.0 million. Net cash used in investing activities during the nine months ended September 30, 2021 primarily consisted of the purchase of businesses, net of cash acquired of $40.0 million and purchase of property and equipment of $24.1 million.\nNet Cash Used in Financing Activities\nWe primarily finance our growth through cash flows from operations, however, we also incur long-term debt or borrow under lines of credit when necessary to execute acquisitions. Additionally, many of our acquisition agreements include contingent consideration arrangements, which are generally based on the achievement of future financial performance by the operations attributable to the acquired companies. The portion of the cash payment up to the acquisition date fair value of the contingent consideration liability are classified as financing outflows, and amounts paid in excess of the acquisition date fair value of that liability are classified as operating outflows.\nCash flows used in financing activities during the nine months ended September 30, 2022 were primarily related to payments of contingent consideration and holdback payments of $31.7 million, repayment of principal on our Term Loan Facility of $9.9 million, partially offset by $3.3 million related to proceeds from the issuance of Class A common stock and $5.2 million of contribution from noncontrolling interest. Cash flows related to financing activities during the nine months ended September 30, 2021 were primarily related to borrowings of $51.7 million and repayment of $102.7 million on the Revolving Credit Facility and our lines of credit and $8.6 million related to payments of contingent consideration and holdback payments.\n40\nDescription of Credit Facilities\nSenior Secured Credit Facilities\nIn connection with the consummation of the Transactions, Advantage Sales & Marketing Inc. (the “Borrower”), an indirect wholly-owned subsidiary of the Company, entered into (i) a senior secured asset-based revolving credit facility in an aggregate principal amount of up to $400.0 million, subject to borrowing base capacity (as may be amended from time to time, the “Revolving Credit Facility”) and (ii) a secured first lien term loan credit facility in an aggregate principal amount of $1.325 billion (as may be amended from time to time, the “Term Loan Facility” and together with the Revolving Credit Facility, the “Senior Secured Credit Facilities”).\nRevolving Credit Facility\nOur Revolving Credit Facility provides for revolving loans and letters of credit in an aggregate amount of up to $400.0 million, subject to borrowing base capacity. Letters of credit are limited to the lesser of (a) $150.0 million and (b) the aggregate unused amount of commitments under our Revolving Credit Facility then in effect. Loans under the Revolving Credit Facility may be denominated in either U.S. dollars or Canadian dollars. Bank of America, N.A., is administrative agent and ABL Collateral Agent. The Revolving Credit Facility is scheduled to mature in October 2025. We may use borrowings under the Revolving Credit Facility to fund working capital and for other general corporate purposes, including permitted acquisitions and other investments. As of September 30, 2022, we had unused capacity under our Revolving Credit Facility available to us of $400.0 million, subject to borrowing base limitations (without giving effect to approximately $54.5 million of outstanding letters of credit and the borrowing base limitations for additional borrowings).\nBorrowings under the Revolving Credit Facility are limited by borrowing base calculations based on the sum of specified percentages of eligible accounts receivable plus specified percentages of qualified cash, minus the amount of any applicable reserves. Borrowings will bear interest at a floating rate, which can be either an adjusted Eurodollar rate plus an applicable margin or, at the Borrower’s option, a base rate plus an applicable margin. The applicable margins for the Revolving Credit Facility are 2.00%, 2.25% or 2.50%, with respect to Eurodollar rate borrowings and 1.00%, 1.25% or 1.50%, with respect to base rate borrowings, in each case depending on average excess availability under the Revolving Credit Facility. The Borrower’s ability to draw under the Revolving Credit Facility or issue letters of credit thereunder will be conditioned upon, among other things, the Borrower’s delivery of prior written notice of a borrowing or issuance, as applicable, the Borrower’s ability to reaffirm the representations and warranties contained in the credit agreement governing the Revolving Credit Facility and the absence of any default or event of default thereunder.\nThe Borrower’s obligations under the Revolving Credit Facility are guaranteed by Karman Intermediate Corp. (“Holdings”) and all of the Borrower’s direct and indirect wholly owned material U.S. subsidiaries (subject to certain permitted exceptions) and Canadian subsidiaries (subject to certain permitted exceptions, including exceptions based on immateriality thresholders of aggregate assets and revenues of Canadian subsidiaries) (the “Guarantors”). The Revolving Credit Facility is secured by a lien on substantially all of Holdings’, the Borrower’s and the Guarantors’ assets (subject to certain permitted exceptions). The Borrower’s Revolving Credit Facility has a first-priority lien on the current asset collateral and a second-priority lien on security interests in the fixed asset collateral (second in priority to the liens securing the Notes and the Term Loan Facility discussed below), in each case, subject to other permitted liens.\nThe Revolving Credit Facility has the following fees: (i) an unused line fee of 0.375% or 0.250% per annum of the unused portion of the Revolving Credit Facility, depending on average excess availability under the Revolving Credit Facility; (ii) a letter of credit participation fee on the aggregate stated amount of each letter of credit equal to the applicable margin for adjusted Eurodollar rate loans, as applicable; and (iii) certain other customary fees and expenses of the lenders and agents thereunder.\nThe Revolving Credit Facility contains customary covenants, including, but not limited to, restrictions on the Borrower’s ability and that of our subsidiaries to merge and consolidate with other companies, incur indebtedness, grant liens or security interests on assets, make acquisitions, loans, advances or investments, pay dividends, sell or\n41\notherwise transfer assets, optionally prepay or modify terms of any junior indebtedness, enter into transactions with affiliates or change our line of business. The Revolving Credit Facility will require the maintenance of a fixed charge coverage ratio (as set forth in the credit agreement governing the Revolving Credit Facility) of 1.00 to 1.00 at the end of each fiscal quarter when excess availability is less than the greater of $25 million and 10% of the lesser of the borrowing base and maximum borrowing capacity. Such fixed charge coverage ratio will be tested at the end of each quarter until such time as excess availability exceeds the level set forth above.\nThe Revolving Credit Facility provides that, upon the occurrence of certain events of default, the Borrower’s obligations thereunder may be accelerated and the lending commitments terminated. Such events of default include payment defaults to the lenders thereunder, material inaccuracies of representations and warranties, covenant defaults, cross-defaults to other material indebtedness, voluntary and involuntary bankruptcy, insolvency, corporate arrangement, winding-up, liquidation or similar proceedings, material money judgments, material pension-plan events, certain change of control events and other customary events of default.\nOn October 28, 2021, the Borrower and Holdings entered into the First Amendment to ABL Revolving Credit Agreement (the “ABL Amendment”), which amended the ABL Revolving Credit Agreement, dated October 28, 2020, by and among the Borrower, Holdings, the lenders from time to time party thereto and Bank of America, as administrative agent. The ABL Amendment was entered into by the Borrower to amend certain terms and provisions, including (i) reducing the interest rate floor for Eurocurrency rate loans from 0.50% to 0.00% and base rate loans from 1.50% to 1.00%, and (ii) updating the provisions by which U.S. Dollar LIBOR will eventually be replaced with the Secured Oversight Financing Rate (“SOFR”) or another interest rate benchmark to reflect the most recent standards and practices used in the industry.\nTerm Loan Facility\nThe Term Loan Facility is a term loan facility denominated in U.S. dollars in an aggregate principal amount of $1.325 billion. Borrowings under the Term Loan Facility amortize in equal quarterly installments in an amount equal to 1.00% per annum of the principal amount. Borrowings will bear interest at a floating rate, which can be either an adjusted Eurodollar rate plus an applicable margin or, at the Borrower’s option, a base rate plus an applicable margin. The applicable margins for the Term Loan Facility are 4.50% with respect to Eurodollar rate borrowings and 3.50% with respect to base rate borrowings.\nThe Borrower may voluntarily prepay loans or reduce commitments under the Term Loan Facility, in whole or in part, subject to minimum amounts, with prior notice but without premium or penalty (other than a 1.00% premium on any prepayment in connection with a repricing transaction prior to the date that is six months after the effective date of the First Lien Amendment).\nThe Borrower will be required to prepay the Term Loan Facility with 100% of the net cash proceeds of certain asset sales (such percentage subject to reduction based on the achievement of specific first lien net leverage ratios) and subject to certain reinvestment rights, 100% of the net cash proceeds of certain debt issuances and 50% of excess cash flow (such percentage subject to reduction based on the achievement of specific first lien net leverage ratios).\nThe Borrower’s obligations under the Term Loan Facility are guaranteed by Holdings and the Guarantors. Our Term Loan Facility is secured by a lien on substantially all of Holdings’, the Borrower’s and the Guarantors’ assets (subject to certain permitted exceptions). The Term Loan Facility has a first-priority lien on the fixed asset collateral (equal in priority with the liens securing the Notes) and a second-priority lien on security interests in the current asset collateral (second in priority to the liens securing the Revolving Credit Facility), in each case, subject to other permitted liens.\nThe Term Loan Facility contains certain customary negative covenants, including, but not limited to, restrictions on the Borrower’s ability and that of our restricted subsidiaries to merge and consolidate with other companies, incur indebtedness, grant liens or security interests on assets, pay dividends or make other restricted payments, sell or otherwise transfer assets or enter into transactions with affiliates.\n42\nThe Term Loan Facility provides that, upon the occurrence of certain events of default, the Borrower’s obligations thereunder may be accelerated. Such events of default will include payment defaults to the lenders thereunder, material inaccuracies of representations and warranties, covenant defaults, cross-defaults to other material indebtedness, voluntary and involuntary bankruptcy, insolvency, corporate arrangement, winding-up, liquidation or similar proceedings, material money judgments, change of control and other customary events of default.\nOn October 28, 2021 (the “First Lien Amendment Effective Date”), the Borrower, Holdings, and certain of the Borrower’s subsidiaries, entered into Amendment No. 1 to the First Lien Credit Agreement (the “First Lien Amendment”), which amended the First Lien Credit Agreement, dated October 28, 2020, by and among the Borrower, Holdings, Bank of America, as administrative agent and collateral agent, each lender party from time to time thereto, and the other parties thereto. The First Lien Amendment was entered into by the Borrower to reduce the applicable interest rate on the term loan to 5.25% per annum, resulting in estimated interest savings of approximately $9.9 million or $7.3 million, net of tax, per annum. Additional terms and provisions amended include (i) resetting the period for six months following the First Lien Amendment Effective Date in which a 1.00% prepayment premium shall apply to any prepayment of the term loan in connection with certain repricing events, and (ii) updating the provisions by which U.S. Dollar LIBOR will eventually be replaced with SOFR or another interest rate benchmark to reflect the most recent standards and practices used in the industry and by Bank of America.\nSenior Secured Notes\nIn connection with the Transactions, Advantage Solutions FinCo LLC (“Finco”) issued $775.0 million aggregate principal amount of 6.50% Senior Secured Notes due 2028 (the “Notes”). Substantially concurrently with the Transactions, Finco merged with and into Advantage Sales & Marketing Inc. (in its capacity as the issuer of the Notes, the “Issuer”), with the Issuer continuing as the surviving entity and assuming the obligations of Finco. The Notes were sold to BofA Securities, Inc., Deutsche Bank Securities Inc., Morgan Stanley & Co. LLC and Apollo Global Securities, LLC. The Notes were resold to certain non-U.S. persons pursuant to Regulation S under the Securities Act of 1933, as amended (the “Securities Act”), and to persons reasonably believed to be qualified institutional buyers pursuant to Rule 144A under the Securities Act at a purchase price equal to 100% of their principal amount. The terms of the Notes are governed by an Indenture, dated as of October 28, 2020 (the “Indenture”), among Finco, the Issuer, the guarantors named therein (the “Notes Guarantors”) and Wilmington Trust, National Association, as trustee and collateral agent.\nInterest and maturity\nInterest on the Notes is payable semi-annually in arrears on May 15 and November 15 at a rate of 6.50% per annum, commencing on May 15, 2021. The Notes will mature on November 15, 2028.\nGuarantees\nThe Notes are guaranteed by Holdings and each of the Issuer’s direct and indirect wholly owned material U.S. subsidiaries (subject to certain permitted exceptions) and Canadian subsidiaries (subject to certain permitted exceptions, including exceptions based on immateriality thresholders of aggregate assets and revenues of Canadian subsidiaries) that is a borrower or guarantor under the Term Loan Facility.\nSecurity and Ranking\nThe Notes and the related guarantees are the general, senior secured obligations of the Issuer and the Notes Guarantors, are secured on a first-priority pari passu basis by security interests on the fixed asset collateral (equal in priority with liens securing the Term Loan Facility), and are secured on a second-priority basis by security interests on the current asset collateral (second in priority to the liens securing the Revolving Credit Facility and equal in priority with liens securing the Term Loan Facility), in each case, subject to certain limitations and exceptions and permitted liens.\n43\nThe Notes and related guarantees rank (i) equally in right of payment with all of the Issuer’s and the Guarantors’ senior indebtedness, without giving effect to collateral arrangements (including the Senior Secured Credit Facilities) and effectively equal to all of the Issuer’s and the Guarantors’ senior indebtedness secured on the same priority basis as the Notes, including the Term Loan Facility, (ii) effectively subordinated to any of the Issuer’s and the Guarantors’ indebtedness that is secured by assets that do not constitute collateral for the Notes to the extent of the value of the assets securing such indebtedness and to indebtedness that is secured by a senior-priority lien, including the Revolving Credit Facility to the extent of the value of the current asset collateral and (iii) structurally subordinated to the liabilities of the Issuer’s non-Guarantor subsidiaries.\nOptional redemption for the Notes\nThe Notes are redeemable on or after November 15, 2023 at the applicable redemption prices specified in the Indenture plus accrued and unpaid interest. The Notes may also be redeemed at any time prior to November 15, 2023 at a redemption price equal to 100% of the aggregate principal amount of such Notes to be redeemed plus a “make-whole” premium, plus accrued and unpaid interest. In addition, the Issuer may redeem up to 40% of the original aggregate principal amount of Notes before November 15, 2023 with the net cash proceeds of certain equity offerings at a redemption price equal to 106.5% of the aggregate principal amount of such Notes to be redeemed, plus accrued and unpaid interest. Furthermore, prior to November 15, 2023 the Issuer may redeem during each calendar year up to 10% of the original aggregate principal amount of the Notes at a redemption price equal to 103% of the aggregate principal amount of such Notes to be redeemed, plus accrued and unpaid interest. If the Issuer or its restricted subsidiaries sell certain of their respective assets or experience specific kinds of changes of control, subject to certain exceptions, the Issuer must offer to purchase the Notes at par. In connection with any offer to purchase all Notes, if holders of no less than 90% of the aggregate principal amount of Notes validly tender their Notes, the Issuer is entitled to redeem any remaining Notes at the price offered to each holder.\nRestrictive covenants\nThe Notes are subject to covenants that, among other things limit the Issuer’s ability and its restricted subsidiaries’ ability to: incur additional indebtedness or guarantee indebtedness; pay dividends or make other distributions in respect of, or repurchase or redeem, the Issuer’s or a parent entity’s capital stock; prepay, redeem or repurchase certain indebtedness; issue certain preferred stock or similar equity securities; make loans and investments; sell or otherwise dispose of assets; incur liens; enter into transactions with affiliates; enter into agreements restricting the Issuer’s subsidiaries’ ability to pay dividends; and consolidate, merge or sell all or substantially all of the Issuer’s assets. Most of these covenants will be suspended on the Notes so long as they have investment grade ratings from both Moody’s Investors Service, Inc. and S&P Global Ratings and so long as no default or event of default under the Indenture has occurred and is continuing.\nEvents of default\nThe following constitute events of default under the Notes, among others: default in the payment of interest; default in the payment of principal; failure to comply with covenants; failure to pay other indebtedness after final maturity or acceleration of other indebtedness exceeding a specified amount; certain events of bankruptcy; failure to pay a judgment for payment of money exceeding a specified aggregate amount; voidance of subsidiary guarantees; failure of any material provision of any security document or intercreditor agreement to be in full force and effect; and lack of perfection of liens on a material portion of the collateral, in each case subject to applicable grace periods.\nFuture Cash Requirement\nThere were no material changes to our contractual future cash requirements from those disclosed in our 2021 Annual Report.\n44\nCash and Cash Equivalents Held Outside the United States\nAs of September 30, 2022 and December 31, 2021, $71.6 million and $86.2 million, respectively, of our cash and cash equivalents were held by foreign subsidiaries. As of September 30, 2022, and December 31, 2021, $21.6 million and $40.0 million, respectively, of our cash and cash equivalents were held by foreign branches.\nWe assessed our determination as to our indefinite reinvestment intent for certain of our foreign subsidiaries and recorded a deferred tax liability of approximately $2.5 million of withholding tax as of December 31, 2021 for unremitted earnings in Canada with respect to which the Company does not have an indefinite reinvestment assertion. We will continue to evaluate our cash needs, however we currently do not intend, nor do we foresee a need, to repatriate funds from the foreign subsidiaries except for Canada. We have continued to assert indefinite reinvestment on all other earnings as it is necessary for continuing operations and to grow the business. If at a point in the future our assertion changes, we will evaluate tax-efficient means to repatriate the income. In addition, we expect existing domestic cash and cash flows from operations to continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, such as debt repayment and capital expenditures, for at least the next 12 months and thereafter for the foreseeable future.\nIf we should require more capital in the United States than is generated by our domestic operations, for example, to fund significant discretionary activities such as business acquisitions, we could elect to repatriate future earnings from foreign jurisdictions. These alternatives could result in higher tax expense or increased interest expense. We consider the majority of the undistributed earnings of our foreign subsidiaries, as of December 31, 2021, to be indefinitely reinvested and, accordingly, no provision has been made for taxes in excess of the $2.5 million noted above.\nOff-Balance Sheet Arrangements\nWe do not have any off-balance sheet financing arrangements or liabilities, guarantee contracts, retained or contingent interests in transferred assets or any obligation arising out of a material variable interest in an unconsolidated entity. We do not have any majority-owned subsidiaries that are not included in our consolidated financial statements. Additionally, we do not have an interest in, or relationships with, any special-purpose entities.\nCritical Accounting Policies and Estimates\nOur critical accounting policies and estimates are included in our 2021 Annual Report and did not materially change during the nine months ended September 30, 2022.\nRecently Issued Accounting Pronouncements\nSee the information set forth in Note 1, Organization and Significant Accounting Policies – Recent Accounting Standards, to our unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2022 and 2021 included in “Part I, Financial Information—Item 1. Financial Statements” in this Quarterly Report.\n45\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nForeign Currency Risk\nOur exposure to foreign currency exchange rate fluctuations is primarily the result of foreign subsidiaries and foreign branches primarily domiciled in Europe and Canada. We use financial derivative instruments to hedge foreign currency exchange rate risks associated with our Canadian subsidiary.\nThe assets and liabilities of our foreign subsidiaries and foreign branches, whose functional currencies are primarily Canadian dollars, British pounds and euros, respectively, are translated into U.S. dollars at exchange rates in effect at the balance sheet date. Income and expense items are translated at the average exchange rates prevailing during the period. The cumulative translation effects for subsidiaries using a functional currency other than the U.S. dollar are included in accumulated other comprehensive loss as a separate component of stockholders’ equity. We estimate that had the exchange rate in each country unfavorably changed by ten percent relative to the U.S. dollar, our consolidated income before taxes would have decreased by approximately $2.5 million for the nine months ended September 30, 2022.\nInterest Rate Risk\nInterest rate exposure relates primarily to the effect of interest rate changes on borrowings outstanding under the Term Loan Facility, Revolving Credit Facility and Notes.\nWe manage our interest rate risk through the use of derivative financial instruments. Specifically, we have entered into interest rate cap agreements to manage our exposure to potential interest rate increases that may result from fluctuations in LIBOR. We do not designate these derivatives as hedges for accounting purposes, and as a result, all changes in the fair value of derivatives, used to hedge interest rates, are recorded in “Interest expense, net” in our Condensed Consolidated Statements of Operations and Comprehensive Income.\nAs of September 30, 2022, we had interest rate cap contracts on an additional $650.0 million of notional value of principal from other financial institutions, with a maturity date of December 16, 2024 to manage our exposure to interest rate movements on variable rate credit facilities when one-month LIBOR on term loans exceeding a cap of 0.75%. The aggregate fair value of our interest rate caps represented an outstanding net asset of $49.1 million as of September 30, 2022.\nHolding other variables constant, a change of one-eighth percentage point in the weighted average interest rate above the floor of 0.75% on the Term Loan Facility and Revolving Credit Facility would have resulted in an increase of $0.7 million in interest expense, net of gains from interest rate caps, for the nine months ended September 30, 2022.\nIn the future, in order to manage our interest rate risk, we may refinance our existing debt, enter into additional interest rate cap agreements or modify our existing interest rate cap agreement. However, we do not intend or expect to enter into derivative or interest rate cap transactions for speculative purposes.\n46\nITEM 4. CONTROLS AND PROCEDURES\nOur management, with the participation of our chief executive officer and chief financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Quarterly Report. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of September 30, 2022, our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in reports we file or submit under the Exchange Act is (1) recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and (2) accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.\nThere were no changes in internal control over financial reporting that occurred during the quarter ended September 30, 2022, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\nIn designing and evaluating our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints, and that management is required to apply judgment in evaluating the benefits of possible controls and procedures relative to their costs.\n47\nPART II - OTHER INFORMATION\nITEM 1. LEGAL PROCEEDINGS\nWe are involved in various legal matters that arise in the ordinary course of our business. Some of these legal matters purport or may be determined to be class and/or representative actions, or seek substantial damages or penalties. Some of these legal matters relate to disputes regarding acquisitions. In connection with certain of the below matters and other legal matters, we have accrued amounts that we believe are appropriate. There can be no assurance, however, that the above matters and other legal matters will not result in us having to make payments in excess of such accruals or that the above matters or other legal matters will not materially or adversely affect our business, financial position or results of operations.\nEmployment-Related Matters\nWe have also been involved in various litigation, including purported class or representative actions with respect to matters arising under the U.S. Fair Labor Standards Act, California’s Labor Code (the “Labor Code”) and California’s Labor Code Private Attorneys General Act (“PAGA”). Many involve allegations for allegedly failing to pay wages and/or overtime, failing to provide meal and rest breaks and failing to pay reporting time pay, waiting time penalties and other penalties.\nA former employee filed a complaint in California Superior Court, Santa Clara County in July 2017, which seeks civil damages and penalties on behalf of the plaintiff and similarly situated persons for various alleged wage and hour violations under the Labor Code, including failure to pay wages and/or overtime, failure to provide meal and rest breaks, failure to pay reporting time pay, waiting time penalties and penalties pursuant to PAGA. We filed a motion for summary judgment. The court granted our motion for summary judgment in March 2020, and the plaintiff filed an appeal of the court’s ruling in May 2020. We have retained outside counsel to represent us and intend to vigorously defend our interests in this matter.\nProceedings Relating to Take 5\nThe following proceedings relate to the Take 5 Matter, which is discussed in greater detail in “PART I, Financial Information —Item 1. Financial Statements—Note 10. Commitments and Contingencies” and “Risk Factors — Risks Related to the Company’s Business and Industry” in this Quarterly Report.\nUSAO and FBI Voluntary Disclosure and Investigation Related to Take 5\nIn connection with the Take 5 Matter, we voluntarily disclosed to the United States Attorney’s Office and the Federal Bureau of Investigation certain misconduct occurring at Take 5. We intend to cooperate in this and any other governmental investigation that may arise in connection with the Take 5 Matter. At this time, we cannot predict the ultimate outcome of any investigation related to the Take 5 Matter and are unable to estimate the potential impact such an investigation may have on us.\nArbitration Proceedings Related to Take 5\nIn August 2019, as a result of the Take 5 Matter, we provided a written indemnification claim notice to the sellers of Take 5, or the Take 5 Sellers, seeking monetary damages (including interest, fees and costs) based on allegations of breach of the asset purchase agreement, or Take 5 APA, as well as fraud. In September 2019, the Take 5 Sellers initiated arbitration proceedings in the state of Delaware against us, alleging breach of the Take 5 APA as a result of our decision to terminate the operations of the Take 5 business and seeking monetary damages equal to all unpaid earn-out payments under the Take 5 APA (plus interest fees and costs). In 2020, the Take 5 Sellers amended their statement of claim to allege defamation, relating to statements we made to customers in connection with terminating the operations of the Take 5 business, and seeking monetary damages for the alleged injury to their reputation. We have filed our response to the Take 5 Sellers’ claims and asserted indemnification, fraud and other claims against the Take 5 Sellers as counterclaims and cross-claims in the arbitration proceedings.\n48\nIn October 2022, the arbitrator made a final award in our favor. We are currently unable to estimate if or when we will be able to collect any amounts associated with this arbitration.\nOther Legal Matters Related to Take 5\nThe Take 5 Matter may result in additional litigation against us, including lawsuits from clients, or governmental investigations, which may expose us to potential liability in excess of the amounts being offered by us as refunds to Take 5 clients. We are currently unable to determine the amount of any potential liability, costs or expenses (above the amounts already being offered as refunds) that may result from any lawsuits or investigations associated with the Take 5 Matter or determine whether any such issues will have any future material adverse effect on our financial position, liquidity or results of operations. Although we have insurance covering certain liabilities, we cannot assure that the insurance will be sufficient to cover any potential liability or expenses associated with the Take 5 Matter.\nITEM 1A. RISK FACTORS\nInvesting in our securities involves risks. Before you make a decision regarding our securities, in addition to the risks and uncertainties discussed above under “Forward-Looking Statements,” you should carefully consider the specific risks set forth herein. If any of these risks actually occur, it may materially harm our business, financial condition, liquidity and results of operations. As a result, the market price of our securities could decline, and you could lose all or part of your investment. Additionally, the risks and uncertainties described in this Quarterly Report are not the only risks and uncertainties that we face. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may become material and adversely affect our business. The following discussion should be read in conjunction with the financial statements and notes to the financial statements included herein.\nSummary of Principal Risks Associated with Our Business\nSet forth below is a summary of some of the principal risks we face:\n•the COVID-19 pandemic and the measures taken to mitigate its spread including its adverse effects on our business, results of operations, financial condition and liquidity;\n•market-driven wage changes or changes to labor laws or wage or job classification regulations, including minimum wage;\n•our ability to hire, timely train, and retain talented individuals for our workforce, and to maintain our corporate culture as we grow;\n•developments with respect to retailers that are out of our control;\n•our ability to continue to generate significant operating cash flow;\n•consolidation within the industry of our clients creating pressure on the nature and pricing of our services;\n•our reliance on continued access to retailers’ platforms;\n•consumer goods manufacturers and retailers reviewing and changing their sales, retail, marketing, and technology programs and relationships;\n•our ability to successfully develop and maintain relevant omni-channel services for our clients in an evolving industry and to otherwise adapt to significant technological change;\n•client procurement strategies putting additional operational and financial pressure on our services;\n•our ability to maintain proper and effective internal control over financial reporting in the future;\n•potential and actual harms to our business arising from the matter related to the 2018 acquisition of Take 5 Media Group (the “Take 5 Matter”);\n•our ability to identify attractive acquisition targets, acquire them at attractive prices, and successfully integrate the acquired businesses;\n•our ability to avoid or manage business conflicts among competing brands;\n49\n•difficulties in integrating acquired businesses;\n•our substantial indebtedness and our ability to refinance at favorable rates;\n•limitations, restrictions, and business decisions involving our joint ventures and minority investments;\n•our ability to respond to changes in digital practices and policies;\n•exposure to foreign currency exchange rate fluctuations and risks related to our international operations;\n•disruptions in global financial markets relating to terrorist attacks or geopolitical risk and the recent conflict between Russia and Ukraine;\n•the ability to maintain applicable listing standards;\n•changes in applicable laws or regulations; and\n•the possibility that we may be adversely affected by other political, economic, business, and/or competitive factors.\nRisks Related to the Company’s Business and Industry\nThe COVID-19 pandemic and the measures taken to mitigate its spread have had, and are likely to continue to have, an adverse effect on our business, results of operations, financial condition and liquidity.\nThe COVID-19 pandemic, including the measures taken to mitigate its spread, have had, and are likely to continue to have, adverse effects on our business and operations. There are many uncertainties regarding the current COVID-19 pandemic, including the scope of potential public health issues, the anticipated duration of the pandemic and the extent of local and worldwide social, political and economic disruption it has caused and may cause in the future. To date, the COVID-19 pandemic and measures taken to mitigate the spread of COVID-19, including restrictions on large gatherings, closures of face-to-face events and indoor dining facilities, “shelter in place” health orders and travel restrictions, have had far-reaching direct and indirect impacts on many aspects of our operations, including temporary termination of certain in-store demonstration services and other services, as well as on consumer behavior and purchasing patterns, in particular with respect to the foodservice industries, and declines in consumer demand for restaurant, school and hotel dining, where we promote our clients’ products. Since March 2020, our marketing segment has experienced a significant decline in revenues, primarily due to the temporary suspension or reduction of certain in-store demonstration services and decreased demand in our digital marketing services, both of which we believe were caused by the COVID-19 pandemic and the various governmental and private responses to the pandemic, and which may continue in the future. In our sales segment, we have experienced significant shifts in consumer spending preferences and habits. We can provide no assurances that the strength of that segment will continue or that we will be able to continue to evolve our business in the future as the COVID-19 pandemic continues to impact our clients’ businesses.\nWe have taken several actions in response to these business disruptions, including reducing certain of our discretionary expenditures, reducing our real estate foot print, through lease terminations and amendments (including abandoning several office leases prior to reaching termination agreements with its landlords), eliminating non-essential travel and terminating, furloughing or instituting pay reductions and deferrals for some of our associates. However, the pandemic has had, and may continue to have, an adverse effect on our results of operations, including our revenues, our financial condition and liquidity.\nThe COVID-19 pandemic also may have the effect of heightening many of the other risks described in these “Risk Factors”, including:\n•potential changes in the policies of retailers in response to the COVID-19 pandemic, including changes to or restrictions on their outsourcing of sales and marketing functions and restrictions on the performance of in-store demonstration services, if permitted at all;\n•potential changes in the demand for services by our clients in response to the COVID-19 pandemic;\n•our ability to hire, timely train and retain talented individuals for our workforce;\n•disruptions, delays and strains in certain domestic and internal supply changes that have had, and may continue to have, a negative effect on the flow or availability of certain products;\n50\n•the need for us to adapt to technological change and otherwise develop and maintain omni-channel solutions;\n•our ability to generate sufficient cash to service our substantial indebtedness;\n•our ability to maintain our credit rating;\n•our ability to offer high-quality customer support and maintain our reputation;\n•our ability to identify, perform adequate diligence on and consummate acquisitions of attractive business targets, and then subsequently integrate such acquired businesses;\n•our ability to maintain our corporate culture;\n•severe disruption and instability in the U.S. and global financial markets or deteriorations in credit and financing conditions, which could make it difficult for us to access debt and equity capital on attractive terms, or at all;\n•our ability to effectively manage our operations while a significant amount of our associates continue to work remotely due to the COVID-19 pandemic;\n•deteriorating economic conditions, declines in labor force participation rates, public transportation disruptions or other disruptions as a result of the COVID-19 pandemic;\n•potential cost-saving strategies implemented by clients that reduce fees paid to third-party service providers such as ourselves; and\n•our ability to implement additional internal control measures to improve our internal control over financial reporting.\nWe cannot predict the full extent to which the COVID-19 pandemic may affect our business, financial condition, results of operations and liquidity as such effects will depend on how the COVID-19 pandemic and the measures taken in response to the COVID-19 pandemic continue to develop. However, these effects may continue, evolve or increase in severity, each of which could further negatively impact our business, financial condition, results of operations and liquidity.\nMarket-driven wage increases and changes to wage or job classification regulations, including minimum wages could adversely affect our business, financial condition or results of operations.\nMarket competition has and may continue to cause us to increase the salaries or wages paid to our associates or the benefits packages that they receive. If we experience further market-driven increases in salaries, wage rates or benefits or if we fail to increase our offered salaries, wages or benefits packages competitively, the quality of our workforce could decline, causing our client service to suffer. Low unemployment rates or lower levels of labor force participation rates may increase the likelihood or impact of such market pressures. Any of these changes affecting wages or benefits for our associates could adversely affect our business, financial condition or results of operations.\nChanges in labor laws related to employee hours, wages, job classification and benefits, including health care benefits, could adversely affect our business, financial condition or results of operations. As of September 30, 2022, we employed approximately 75,000 associates, many of whom are paid above, but near, applicable minimum wages, and their wages may be affected by changes in minimum wage laws.\nAdditionally, many of our salaried associates are paid at rates that could be impacted by changes to minimum pay levels for exempt roles. Certain state or municipal jurisdictions in which we operate have recently increased their minimum wage by a significant amount, and other jurisdictions are considering or plan to implement similar actions, which may increase our labor costs. Any increases at the federal, state or municipal level to the minimum pay rate required to remain exempt from overtime pay may adversely affect our business, financial condition or results of operations.\nAn inability to hire, timely train and retain talented individuals for our workforce could slow our growth and adversely impact our ability to operate our business.\nOur ability to meet our workforce needs, while controlling associate-related costs, including salaries, wages and benefits, is subject to numerous external factors, including the availability of talented persons in the workforce in the local markets in which we operate, prevailing unemployment rates and competitive wage rates in such\n51\nmarkets. We may find that there is an insufficient number of qualified individuals to fill our associate positions with the qualifications we seek. Competition in these communities for qualified staff could require us to pay higher wages and provide greater benefits, especially if there is significant improvement in regional or national economic conditions. We must also train and, in some circumstances, certify these associates under our policies and practices and any applicable legal requirements. If we are unable to hire, timely train or retain talented individuals may result in higher turnover and increased labor costs, and could compromise the quality of our service, all of which could adversely affect our business.\nInflation may adversely affect our operating results.\nInflationary factors such as increases in the labor costs, material costs and overhead costs may adversely affect our operating results. A high rate of inflation, including a continuation of inflation at the current rate, has had and may continue to have an adverse effect on our ability to maintain attractive levels of gross margin and general and administrative expenses as a percentage of total revenue, if we are unable to pass on these costs through increased prices, revised budget estimates, or offset them in other ways.\nOur business and results of operations are affected by developments with and policies of retailers that are out of our control.\nA limited number of national retailers account for a large percentage of sales for our consumer goods manufacturer clients. We expect that a significant portion of these clients’ sales will continue to be made through a relatively small number of retailers and that this percentage may increase if the growth of mass retailers and the trend of retailer consolidation continues. As a result, changes in the strategies of large retailers, including a reduction in the number of brands that these retailers carry or an increase in shelf space that they dedicate to private label products, could materially reduce the value of our services to these clients or these clients’ use of our services and, in turn, our revenues and profitability. Many retailers have critically analyzed the number and variety of brands they sell, and have reduced or discontinued the sale of certain of our clients’ product lines at their stores, and more retailers may continue to do so. If this continues to occur and these clients are unable to improve distribution for their products at other retailers, our business or results of operations could be adversely affected. These trends may be accelerated as a result of the COVID-19 pandemic.\nAdditionally, many retailers, including several of the largest retailers in North America, which own and operate a significant number of the locations at which we provide our services, have implemented or may implement in the future, policies that designate certain service providers to be the exclusive provider or one of their preferred providers for specified services, including many of the services that we provide to such retailers or our clients.\nSome of these designations apply across all of such retailers’ stores, while other designations are limited to specific regions. If we are unable to respond effectively to the expectations and demands of such retailers or if retailers do not designate us as their exclusive provider or one of their preferred providers for any reason, they could reduce or restrict the services that we are permitted to perform for our clients at their facilities or require our clients to purchase services from other designated services providers, which include our competitors, either of which could adversely affect our business or results of operations.\nConsolidation in the industries we serve could put pressure on the pricing of our services, which could adversely affect our business, financial condition or results of operations.\nConsolidation in the consumer goods and retail industries we serve could reduce aggregate demand for our services in the future and could adversely affect our business or our results of operations. In October 2022, The Kroger Co. and Albertsons Companies, Inc., two large retailers, announced an agreement to merge their businesses together with an anticipated closing in 2024. When companies consolidate, the services they previously purchased separately are often purchased by the combined entity, leading to the termination of relationships with certain service providers or demands for reduced fees and commissions. The combined company may also choose to insource certain functions that were historically outsourced, resulting in the termination of existing relationships with third-party service providers. While we attempt to mitigate the revenue impact of any consolidation by maintaining existing or winning new service arrangements with the combined companies, there can be no assurance as to the degree to which we will be able to do so as consolidation continues in the industries we serve, and our business, financial condition or results of operations may be adversely affected.\n52\nConsumer goods manufacturers and retailers may periodically review and change their sales, retail, marketing and technology programs and relationships to our detriment.\nThe consumer goods manufacturers and retailers to whom we provide our business solutions operate in highly competitive and rapidly changing environments. From time to time these parties may put their sales, retail, marketing and technology programs and relationships up for competitive review, which may increase in frequency as a result of the COVID-19 pandemic and its impacts on the consumer goods manufacturers and retailer industries. We have occasionally lost accounts with significant clients as a result of these reviews in the past, and our clients are typically able to reduce or cancel current or future spending on our services on short notice for any reason. We believe that key competitive considerations for retaining existing and winning new accounts include our ability to develop solutions that meet the needs of these manufacturers and retailers in this environment, the quality and effectiveness of our services and our ability to operate efficiently. To the extent that we are not able to develop these solutions, maintain the quality and effectiveness of our services or operate efficiently, we may not be able to retain key clients, and our business, financial condition or results of operations may be adversely affected.\nOur largest clients generate a significant portion of our revenues.\nOur three largest clients generated approximately 11% of our revenues in the fiscal year ended December 31, 2021. These clients are generally able to reduce or cancel spending on our services on short notice for any reason. A significant reduction in spending on our services by our largest clients, or the loss of one or more of our largest clients, if not replaced by new clients or an increase in business from existing clients, would adversely affect our business and results of operations. In addition, when large retailers suspend or reduce in-store demonstration services, such as in response to the COVID-19 pandemic, our business and results of operations can be adversely affected.\nWe are reliant on continued access to retailer platforms on commercially reasonable terms for the provision of certain of our e-commerce services in which our clients’ products are resold by us, as the vendor of record, directly to the consumer.\nA portion of the e-commerce services we provide involve the purchase and resale by us, as the vendor of record, of our clients’ products through retailer platforms. The control that retailers such as Amazon have over the access and fee structures and/or pricing for products on their platforms could impact the volume of purchases of these products made on their platform and our revenues from the provision of such e-commerce services. If such retailers establish terms that restrict the offering of these products on their platform, significantly impact the financial terms on which such products are offered, or do not approve the inclusion of such products on their platform, our business could be negatively impacted. Additionally, we also generally rely on a retailer’s payment processing services for purchases made on its platform by consumers. To the extent such payment processing services are offered to us on less favorable terms, or become unavailable to us for any reason, our costs of revenue with respect to this aspect of our business could increase, and our margins could be materially adversely impacted. We cannot assure you that we will be successful in maintaining access to these retailer platforms on commercially reasonable terms, or at all.\nThe retail industry is evolving, and if we do not successfully develop and maintain relevant omni-channel services for our clients, our business, financial condition or results of operations could be adversely impacted.\nHistorically, substantially all of our sales segment revenues were generated by sales and services that ultimately occurred in traditional retail stores. The retail industry is evolving, as demonstrated by the number of retailers that offer both traditional retail stores and e-commerce platforms or exclusively e-commerce platforms. In addition, the COVID-19 pandemic has placed pressure on the traditional retail store model, including store closures, changes in consumer spending, and extensive health and safety risks and compliance requirements. Consumers are increasingly using computers, tablets, mobile phones and other devices to comparison shop, determine product availability and complete purchases online, a trend that has accelerated during the COVID-19 pandemic, and which may continue thereafter. If consumers continue to purchase more products online and e-commerce continues to displace brick-and-mortar retail sales, there may be a decrease in the demand for certain of our services. Omni-channel retailing is rapidly evolving and we believe we will need to keep pace with the changing consumer expectations and new developments by our competitors.\n53\nWhile we continue to seek to develop effective omni-channel solutions for our clients that support both their e-commerce and traditional retail needs, there can be no assurances that these efforts will result in revenue gains sufficient to offset potential decreases associated with a decline in traditional retail sales or that we will be able to maintain our position as a leader in our industry. If we are unable to provide, improve or develop innovative digital services and solutions in a timely manner or at all, our business, financial condition or results of operations could be adversely impacted.\nWe may be unable to adapt to significant technological change, which could adversely affect our business, financial condition or results of operations.\nWe operate businesses that require sophisticated data collection, processing and software for analysis and insights. Some of the technologies supporting the industries we serve are changing rapidly, particularly as a result of the COVID-19 pandemic. We will be required to continue to adapt to changing technologies, either by developing and marketing new services or by enhancing our existing services, to meet client demand.\nMoreover, the introduction of new services embodying new technologies, including automation of certain of our in-store services, and the emergence of new industry standards could render existing services obsolete. Our continued success will depend on our ability to adapt to changing technologies, manage and process increasing amounts of data and information and improve the performance, features and reliability of our existing services in response to changing client and industry demands. We may experience difficulties that could delay or prevent the successful design, development, testing, introduction or marketing of our services. New services or enhancements to existing services may not adequately meet the requirements of current and prospective clients or achieve market acceptance.\nOur ability to maintain our competitive position depends on our ability to attract and retain talented executives.\nWe believe that our continued success depends to a significant extent upon the efforts, abilities and relationships of our senior executives and the strength of our middle management team. Although we have entered into employment agreements with certain of our senior executives, each of them may terminate their employment with us at any time. The replacement of any of our senior executives likely would involve significant time and costs and may significantly delay or prevent the achievement of our business objectives and could therefore have an adverse impact on our business. In addition, we do not carry any “key person” insurance policies that could offset potential loss of service under applicable circumstances. Furthermore, if we are unable to attract and retain a talented team of middle management executives, it may be difficult to maintain the expertise and industry relationships that our clients value, and they may terminate or reduce their relationship with us.\nClient procurement and fee reduction strategies could put additional operational and financial pressure on our services or negatively impact our relationships, business, financial condition or results of operations.\nMany of our clients seek opportunities to reduce their costs through procurement strategies that reduce fees paid to third-party service providers. As a result, certain of our clients have sought, and may continue to seek, more aggressive terms from us, including with respect to pricing and payment terms. Such activities put operational and financial pressure on our business, which could limit the amounts we earn or delay the timing of our cash receipts. Such activities may also cause disputes with our clients or negatively impact our relationships or financial results. Our clients have experienced, and may continue to experience, increases in their expenses associated with materials and logistics, which may cause them to reduce expenses elsewhere. While we attempt to mitigate negative implications to client relationships and the revenue impact of any pricing pressure by aligning our revenues opportunity with satisfactory client outcomes, there can be no assurance as to the degree to which we will be able to do so successfully. Additionally, price concessions can lead to margin compression, which in turn could adversely affect our business, financial condition or results of operations.\nIf we fail to offer high-quality customer support, our business and reputation may suffer.\nHigh-quality education, training and customer support are important for successful marketing and sales and for the renewal of existing customers. Providing this education, training and support requires that our personnel who manage our online training resource or provide customer support have specific inbound experience domain knowledge and expertise, making it more difficult for us to hire qualified personnel and to scale up our support operations. The importance of high-quality customer support will increase as we expand our business and pursue\n54\nnew customers. If we do not help our customers use multiple applications and provide effective ongoing support, our ability to sell additional functionality and services to, or to retain, existing customers may suffer and our reputation with existing or potential customers may be harmed.\nWe may be adversely affected if clients reduce their outsourcing of sales and marketing functions.\nOur business and growth strategies depend in large part on companies continuing to elect to outsource sales and marketing functions. Our clients and potential clients will outsource if they perceive that outsourcing may provide quality services at a lower overall cost and permit them to focus on their core business activities and have done so in the past. We cannot be certain that the industry trend to outsource will continue or not be reversed or that clients that have historically outsourced functions will not decide to perform these functions themselves. Unfavorable developments with respect to outsourcing could adversely affect our business, financial conditions and results of operations.\nWe previously identified material weaknesses in our internal control over financial reporting. If we fail to maintain proper and effective internal control over financial reporting in the future, our ability to produce accurate and timely financial statements could be impaired, investors’ views of us could be harmed, and we could be subject to enforcement actions by the SEC.\nDuring 2021, we completed the remediation measures related to the material weaknesses previously identified and concluded that our internal control over financial reporting was effective as of December 31, 2021. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim consolidated financial statements will not be prevented or detected on a timely basis. If we are unable to maintain effective internal control over financial reporting or disclosure controls and procedures, our ability to record, process and report financial information accurately, and to prepare financial statements within required time periods could be adversely affected, which could subject us to litigation or investigations requiring management resources and payment of legal and other expenses, negatively affect investor confidence in our financial statements and adversely impact our stock price.\nIf we are unable to identify attractive acquisition targets, acquire them at attractive prices or successfully integrate the acquired businesses, we may be unsuccessful in growing our business.\nA significant portion of our growth has been as a result of our acquisition of complementary businesses that grow our service offerings, expand our geographic reach and strengthen valuable relationships with clients. However, there can be no assurance that we will find attractive acquisition targets, that we will acquire them at attractive prices, that we will succeed at effectively managing the integration of acquired businesses into our existing operations or that such acquired businesses or technologies will be well received by our clients, potential clients or our investors. We could also encounter higher-than-expected earn-out payments, unforeseen transaction- and integration-related costs or delays or other circumstances such as disputes with or the loss of key or other personnel from acquired businesses, challenges or delays in integrating systems or technology of acquired businesses, a deterioration in our associate and client relationships, harm to our reputation with clients, interruptions in our business activities or unforeseen or higher-than-expected inherited liabilities. Many of these potential circumstances are outside of our control and any of them could result in increased costs, decreased revenue, decreased synergies or the diversion of management time and attention.\nIn order for us to continue to grow our business through acquisitions we will need to identify appropriate acquisition opportunities and acquire them at attractive prices. We may choose to pay cash, incur debt or issue equity securities to pay for any such acquisition. The incurrence of indebtedness would result in increased fixed obligations and could also include covenants or other restrictions that would impede our ability to manage our operations. The sale of equity to finance any such acquisition could result in dilution to our stockholders.\nWe may encounter significant difficulties integrating acquired businesses.\nThe integration of any businesses is a complex, costly and time-consuming process. As a result, we have devoted, and will continue to devote, significant management attention and resources to integrating acquired businesses. The failure to meet the challenges involved in integrating businesses and to realize the anticipated benefits of any acquisition could cause an interruption of, or a loss of momentum in, the activities of our combined\n55\nbusiness and could adversely affect our results of operations. The difficulties of combining acquired businesses with our own include, among others:\n•the diversion of management attention to integration matters;\n•difficulties in integrating functional roles, processes and systems, including accounting systems;\n•challenges in conforming standards, controls, procedures and accounting and other policies, business cultures and compensation structures between the two companies;\n•difficulties in assimilating, attracting and retaining key personnel;\n•challenges in keeping existing clients and obtaining new clients;\n•difficulties in achieving anticipated cost savings, synergies, business opportunities and growth prospects from an acquisition;\n•difficulties in managing the expanded operations of a significantly larger and more complex business;\n•contingent liabilities, including contingent tax liabilities or litigation, that may be larger than expected; and\n•potential unknown liabilities, adverse consequences or unforeseen increased expenses associated with an acquisition, including possible adverse tax consequences to the combined business pursuant to changes in applicable tax laws or regulations.\nMany of these factors are outside of our control, and any one of them could result in increased costs, decreased expected revenues and diversion of management time and energy, all of which could adversely impact our business and results of operations. These difficulties have been enhanced further during the COVID-19 pandemic as a result of our office closures and work-from home policies, which may hinder assimilation of key personnel.\nIf we are not able to successfully integrate an acquisition, if we incur significantly greater costs to achieve the expected synergies than we anticipate or if activities related to the expected synergies have unintended consequences, our business, financial condition or results of operations could be adversely affected.\nOur corporate culture has contributed to our success and, if we are unable to maintain it as we evolve, our business, operating results and financial condition could be harmed.\nWe believe our corporate culture has been a significant factor in our success. However, as our company evolves, including through acquisitions and the impacts of the COVID-19 pandemic, such as working remotely and reductions in workforce, it may be difficult to maintain our culture, which could reduce our ability to innovate and operate effectively. The failure to maintain the key aspects of our culture as our organization evolves could result in decreased employee satisfaction, increased difficulty in attracting top talent, increased turnover and compromised the quality of our client service, all of which are important to our success and to the effective execution of our business strategy. If we are unable to maintain our corporate culture as we evolve and execute our growth strategies, our business, operating results and financial condition could be harmed.\nAcquiring new clients and retaining existing clients depends on our ability to avoid or manage business conflicts among competing brands.\nOur ability to acquire new clients and to retain existing clients, whether by expansion of our own operations or through an acquired business may in some cases be limited by the other parties’ perceptions of, or policies concerning, perceived competitive conflicts arising from our other relationships. Some of our contracts expressly restrict our ability to represent competitors of the counterparty. These perceived competitive conflicts may also become more challenging to avoid or manage as a result of continued consolidation in the consumer goods and retail industries and our own acquisitions. If we are unable to avoid or manage business conflicts among competing manufacturers and retailers, we may be unable to acquire new clients or be forced to terminate existing client relationships, and in either case, our business and results of operations may be adversely affected.\nLimitations, restrictions and business decisions involving our joint ventures and minority investments may adversely affect our growth and results of operations.\n56\nWe have made substantial investments in joint ventures and minority investments and may use these and other similar methods to expand our service offerings and geographical coverage in the future. These arrangements typically involve other business services companies as partners that may be competitors of ours in certain markets. Joint venture agreements may place limitations or restrictions on our services. As part of our joint venture with, and investments in Smollan, we are restricted under certain circumstances from making direct acquisitions and otherwise expanding our service offerings into markets outside of North America and Europe. As a result of our acquisition of Daymon Worldwide Inc. pursuant to the terms of our arrangements with Smollan and our joint venture, Smollan and our joint venture may elect to purchase from us, and have purchased, certain Daymon business units that operate outside of North America. If Smollan or our joint venture do not elect to purchase those business units, we may, under certain circumstances, elect to retain, sell or discontinue those business units. The limitations and restrictions tied to our joint venture and minority investments limit our potential business opportunities and reduce the economic opportunity for certain prospective international investments and operations. Additionally, though we control our joint ventures, we may rely upon our equity partners or local management for operational and compliance matters associated with our joint ventures or minority investments. Moreover, our other equity partners and minority investments may have business interests, strategies or goals that are inconsistent with ours. Business decisions, including actions or omissions, of a joint venture or other equity partner or management for a business unit may adversely affect the value of our investment, result in litigation or regulatory action against us or adversely affect our growth and results of operations.\nOur international operations expose us to risks that could impede growth in the future, and our attempts to grow our business internationally may not be successful.\nWe continue to explore opportunities in major international markets. International operations expose us to various additional risks that could adversely affect our business, including:\n•costs of customizing services for clients outside of the United States;\n•the burdens of complying with a wide variety of foreign laws;\n•potential difficulty in enforcing contracts;\n•being subject to U.S. laws and regulations governing international operations, including the U.S. Foreign Corrupt Practices Act and sanctions regimes;\n•being subject to foreign anti-bribery laws in the jurisdictions in which we operate, such as the UK Bribery Act;\n•reduced protection for intellectual property rights;\n•increased financial accounting and reporting complexity;\n•additional legal compliance requirements, including custom and import requirements with respect to products imported to and exported across international borders;\n•exposure to foreign currency exchange rate fluctuations;\n•exposure to local economic conditions;\n•limitations on the repatriation of funds or profits from foreign operations;\n•exposure to local or regional political conditions, including adverse tax policies and civil unrest;\n•the risks of a natural disaster, public health crisis (including the occurrence of a contagious disease or illness, such as the coronavirus), an outbreak of war (such as Russia's invasion of Ukraine), the escalation of hostilities and acts of terrorism in the jurisdictions in which we operate; and\n•the disparate impact of the COVID-19 pandemic, including the measures taken to mitigate its spread, across various jurisdictions.\nAdditionally, the withdrawal of the United Kingdom from the European Union, or “Brexit,” has created economic and political uncertainty, including volatility in global financial markets and the value of foreign currencies. The impact of Brexit may not be fully realized for several years. Additionally, in many countries outside of the United States, there has not been a historical practice of using third parties to provide sales and marketing services. Accordingly, while it is part of our strategy to expand into international markets, it may be difficult for us to grow our international business units on a timely basis, or at all.\nThe ongoing conflict between Russia and Ukraine may adversely affect our business and results of operations.\n57\nGiven the nature of our business and our international operations, political, economic, and other conditions in foreign countries and regions, including geopolitical risks such as those arising from the current conflict between Russia and Ukraine, may adversely affect our business and results of operations. The broader consequences of this conflict, which may include further sanctions, embargoes, regional instability, and geopolitical shifts; disruptions to transportation and distribution routes, or strategic decisions to alter certain routes; potential retaliatory action by the Russian government against companies, including us, including nationalization of foreign businesses and/or assets in Russia; increased tensions between the United States and countries in which we operate; and the extent of the conflict’s effect on our business and results of operations as well as the global economy, cannot be predicted.\nAdditionally, we have a minority interest in a European company that owns majority interests in local agencies in Russia. In addition to the imposition of sanctions by the United States, the United Kingdom, and the European Union that affect the cross-border operations of businesses operating in Russia, Russian regulators have imposed currency restrictions and regulations that created uncertainty regarding our ability to recover our investment in operations in Russia, as well as our ability to exercise control or influence involving operations by the local agencies in Russia. As a result, we intend to use our influence to cause the European company to dispose of our ownership interests in the local agencies in Russia. Accordingly, we recorded pretax charges of $2.8 million in the first quarter of 2022, primarily consisting of our proportionate share of the net investment in our Russian interest in “Selling, general, and administrative expenses” in the Condensed Consolidated Statements of Operations and Comprehensive Income.\nTo the extent the current conflict between Russia and Ukraine adversely affects our business, particularly in Russia, it may also have the effect of heightening many other risks disclosed in our 2021 Annual Report and this Quarterly Report, any of which could materially and adversely affect our business and results of operations. Such risks include, but are not limited to, adverse effects on macroeconomic conditions, including inflation and business spending; disruptions to our information technology infrastructure, including through cyberattack, ransom attack, or cyber-intrusion; adverse changes in international trade policies and relations; our ability to maintain or increase our prices, our ability to implement and execute our business strategy, disruptions in global supply chains, our exposure to foreign currency fluctuations, and constraints, volatility, or disruption in the capital markets, difficulty staffing and managing impacted operations, and the recoverability of assets in the region.\nWe may be subject to unionization, work stoppages, slowdowns or increased labor costs.\nCurrently, none of our associates in the United States are represented by a union. However, our associates have the right under the National Labor Relations Act to choose union representation. If all or a significant number of our associates become unionized and the terms of any collective bargaining agreement were significantly different from our current compensation arrangements, it could increase our costs and adversely impact our profitability. Moreover, if a significant number of our associates participate in labor unions, it could put us at increased risk of labor strikes and disruption of our operations or adversely affect our growth and results of operations. In December 2019, a union which commonly represents employees in the supermarket industry filed a petition with the National Labor Relations Board to represent approximately 120 of our associates who work in and around Boston. An election was held, and based on certified results of the election we prevailed in this election. Notwithstanding this successful election, we could face future union organization efforts or elections, which could lead to additional costs, distract management or otherwise harm our business.\nIf goodwill or other intangible assets in connection with our acquisitions become impaired, we could take significant non-cash charges against earnings.\nWe have made acquisitions to complement and expand the services we offer and intend to continue to do so when attractive acquisition opportunities exist in the market. As a result of prior acquisitions, including the acquisition of our business in 2014 by our current parent entity, Topco, we have goodwill and intangible assets recorded on our balance sheet of $2.2 billion and $2.2 billion, respectively, as of September 30, 2022, as further described in Note 4 to our condensed consolidated financial statements for the three and nine months ended September 30, 2022.\nUnder accounting guidelines, we must assess, at least annually, whether the value of goodwill and other intangible assets has been impaired. We have recognized non-cash goodwill and non-cash intangible asset impairment charges, and we can make no assurances that we will not record any additional impairment charges in\n58\nthe future. Any future reduction or impairment of the value of goodwill or other intangible assets will similarly result in charges against earnings, which could adversely affect our reported financial results in future periods.\nFailures in, or incidents involving, our technology infrastructure could damage our business, reputation and brand and substantially harm our business and results of operations.\nOur business is highly dependent on our ability to manage operations and process a large number of transactions on a daily basis. We rely heavily on our operating, payroll, financial, accounting and other data processing systems which require substantial support and maintenance, and may be subject to disabilities, errors, or other harms. If our data and network infrastructure were to fail, or if we were to suffer a data security breach, or an interruption or degradation of services in our data center, third-party cloud, and other infrastructure environments, we could lose important data, which could harm our business and reputation, and cause us to incur significant liabilities. Our facilities, as well as the facilities of third-parties that provide or maintain, or have access to our data or network infrastructure, are vulnerable to damage or interruption from earthquakes, hurricanes, floods, fires, cyber security attacks, terrorist attacks, power losses, telecommunications failures and similar events. In the event that our or any third-party provider’s systems or service abilities are hindered by any of the events discussed above, our ability to operate may be impaired. Our information technology systems, and the information technology systems of our current or future third-party vendors, collaborators, consultants and service providers, could be penetrated by internal or external parties intent on extracting information, corrupting information, stealing intellectual property or trade secrets, or disrupting business processes. A third party’s decision to close facilities or terminate services without adequate notice, or other unanticipated problems, could adversely impact our operations. Any of the aforementioned risks may be augmented if our or any third-party provider’s business continuity and disaster recovery plans prove to be inadequate in preventing the loss of data, service interruptions, disruptions to our operations or damages to important systems or facilities. Our data center, third-party cloud, and managed service provider infrastructure also could be subject to break-ins, cyber-attacks (including through the use of malware, software bugs, computer viruses, ransomware, social engineering, and denial of service), sabotage, intentional acts of vandalism and other misconduct, from a spectrum of actors ranging in sophistication from threats common to most industries to more advanced and persistent, highly organized adversaries. Any security breach or incident, including personal data breaches, that we experience could result in unauthorized access to, or misuse, modification, destruction or unauthorized acquisition of, our internal sensitive corporate data, such as personal data, financial data, trade secrets, intellectual property, or other competitively sensitive or confidential data. Such unauthorized access, misuse, acquisition, or modification of sensitive data may result in data loss, corruption or alteration, interruptions in our operations or damage to our computer hardware or systems or those of our employees or customers. Our systems have been the target of cyber-attacks. Although we have taken and continue to take steps to enhance our cybersecurity posture, we cannot assure that future cyber incidents will not occur or that our systems will not be targeted or breached in the future. Any such breach or unauthorized access could result in a disruption of the Company’s operations, the theft, unauthorized use or publication of the Company’s intellectual property, other proprietary information or the personal information of customers, employees, licensees or suppliers, a reduction of the revenues the Company is able to generate from its operations, damage to the Company’s brand and reputation, a loss of confidence in the security of the Company’s business and products, and significant legal and financial exposure. If any such incident results in litigation, we may be required to make significant expenditures in the course of such litigation and may be required to pay significant amounts in damages. We may not carry sufficient business interruption insurance to compensate us for losses that may occur as a result of any events that cause interruptions in our service. Significant unavailability of our services due to attacks could cause us to incur significant liability, could cause users to cease using our services and materially and adversely affect our business, prospects, financial condition and results of operations.\nWe use complex software in our technology infrastructure, which we seek to continually update and improve. Replacing such systems is often time-consuming and expensive and can also be intrusive to daily business operations. Further, we may not always be successful in executing these upgrades and improvements, which may result in a failure of our systems. We may experience periodic system interruptions from time to time. Any slowdown or failure of our underlying technology infrastructure could harm our business and reputation, which could materially adversely affect our results of operations. Our disaster recovery plan or those of our third-party providers may be inadequate, and our business interruption insurance may not be sufficient to compensate us for the losses that could occur.\n59\nFailure to comply with federal, state and foreign laws and regulations relating to privacy, data protection and consumer protection, or the expansion of current or the enactment of new laws or regulations relating to privacy, data protection and consumer protection, could adversely affect our business and our financial condition.\nA variety of federal, state and foreign laws and regulations govern the collection, use, retention, sharing and security of personal information. The information, security and privacy requirements imposed by such governmental laws and regulations relating to privacy, data protection and consumer protection are increasingly demanding, quickly evolving and may be subject to differing interpretations or legal theories among regulators, enforcers, and civil litigants. These requirements may not be harmonized, may be interpreted and applied in a manner that is inconsistent from one jurisdiction to another or may conflict with other rules or our practices. As a result, our practices may not have complied or may not comply in the future with all such laws, regulations, requirements and obligations. Our actual or perceived failure to comply with such laws and regulations could result in fines, investigations, enforcement actions, penalties, sanctions, claims for damages by affected individuals, and damage to our reputation, among other negative consequences, any of which could have a material adverse effect on its financial performance.\nCertain aspects of our business and/or the data it collects is subject to the California Consumer Protection Act of 2018 (“CCPA”), which became effective in 2020 and regulates the collection, use and processing of personal information relating to California residents, and which grants certain privacy rights to California residents, including rights to request access to and to request deletion of personal information relating to such individuals under certain circumstances. Compliance with the new obligations imposed by the CCPA depends in part on how its requirements are interpreted and applied by the California attorney general and courts. Alleged violations of the CCPA may result in substantial civil penalties or statutory damages when applied at scale, up to $2,500 per violation or $7,500 per intentional violation of any CCPA requirement, which may be applied on a per-person or per-record basis. The CCPA also establishes a private right of action if certain personal information of individuals is subject to an unauthorized access and exfiltration, theft, or disclosure as a result of a business’s violation of the duty to implement and maintain reasonable security procedures and practices, which authorizes statutory damages $100 to $750 per person per incident even if there is no actual harm or damage to plaintiffs. This private right of action may increase the likelihood of, and risks associated with, data breach litigation. Further, in November 2020, the State of California adopted the California Privacy Rights Act of 2020 (“CPRA”) which goes into effect January 1, 2023 and is enforceable starting on July 1, 2023. The CPRA expands and amends the CCPA, including additional and strengthened privacy rights for California residents, new requirements regarding sensitive data and data sharing for digital advertising, and tripled damages for violations involving children’s data. Also on January 1, 2023, the CCPA – as amended by the CPRA – will be newly applicable to personal information collected for employment-related purposes as well as from business-to-business contacts, creating new regulatory obligations as to datasets that until then had been largely exempt from the CCPA. The CPRA includes a 12-month “look-back” provision that requires businesses to map out all information retained since January 1, 2022. The CPRA also establishes a dedicated privacy regulator under California law, with rulemaking and enforcement responsibilities. Certain regulations implementing the CPRA are expected in draft and final form by the end of 2022, with potentially additional regulations to be proposed following the CPRA’s January 1, 2023 effective date.\nFour other states – Virginia, Colorado, Connecticut, and Utah – have passed their own comprehensive privacy laws to go into effect in 2023. Like the CCPA and CPRA, these laws regulate the collection, use, processing, and sharing of personal information relating to residents of each state respectively, and grants certain privacy rights to those residents. The new state laws also have key differences from the CCPA and CPRA, such as requiring affirmative consent before businesses may process sensitive personal information, requiring data protection assessments, and requiring contracts between data controllers and data processors that direct data processors to assist data controllers in performing their obligations, as well as other differences among them. Each law is enforceable by its own state’s attorney general – for example, violation of the Virginia or Utah laws will cost up to $7,500 per violation – and none include an explicit private right of action. Other states are expected to consider and potentially pass similar privacy laws in 2023.\nCertain aspects of our business and/or the data it collects is may also be subject to international privacy laws and regulations, many of which, such as the General Data Privacy Regulation (“GDPR”) and national laws implementing or supplementing the GDPR, such as the United Kingdom Data Protection Law 2018 (which retains\n60\nkey features of GDPR post-Brexit), as well as the EU’s Privacy and Electronic Communications Directive (“ePrivacy Directive”), are significantly more stringent than those currently enforced in the United States. The GDPR requires companies to meet requirements regarding the handling of personal data of individuals located in the European Economic Area (the “EEA”). The GDPR imposes mandatory data breach notification requirements subject to a 72-hour notification deadline. The GDPR also includes significant penalties for noncompliance, which may result in monetary penalties of up to the higher of €20.0 million or 4% of a group’s worldwide turnover for the preceding financial year for the most serious violations. The GDPR and other similar regulations such as the ePrivacy Directive and related member state regulations and directives require companies to give specific types of notice and informed consent is in many cases required for the placement of a cookie or similar technologies on a user’s device for online tracking for behavioral advertising and other purposes and for direct electronic marketing, and the GDPR also imposes additional conditions in order to satisfy such consent, such as a prohibition on pre-checked tick boxes and bundled consents. Enforcement of the GDPR and related regulations varies by each EU Member State and is ongoing. Further laws and regulations on these topics are forthcoming, including the ePrivacy Directive’s proposed successor, the Regulation on Privacy and Electronic Communications (“ePrivacy Regulation”), as well as the Digital Services Act (“DSA”) and Digital Markets Act (“DMA”). The GDPR may increase our responsibility and liability in relation to personal data that we process where that processing is subject to the GDPR. In addition, we may be required to put in place additional mechanisms to ensure compliance with the GDPR, including GDPR requirements as implemented by individual countries. Compliance with the GDPR will be a rigorous and time-intensive process that may increase our cost of doing business or require us to change our business practices.\nIn addition, under GDPR, transfers of personal data are prohibited to countries outside of the EEA that have not been determined by the European Commission to provide adequate protections for personal data, including the United States. There are mechanisms to permit the transfer of personal data from the EEA to the United States, but there is also uncertainty as to the future of such mechanisms, which have been under consistent scrutiny and challenge. In July 2020, decision of the Court of Justice of the European Union invalidated the EU-U.S. Privacy Shield Framework, a means that previously permitted transfers of personal data from the EEA to companies in the United States that certified adherence to the Privacy Shield Framework. While the Biden Administration issued an executive order in October 2022 mandating new legal safeguards over U.S. national security agencies’ access and use of EU and U.S. personal data, it is currently unclear what, if any, formal arrangement may replace the Privacy Shield Framework. Standard contractual clauses approved by the European Commission to permit transfers from the EU to third countries currently remain as a basis on which to transfer personal data from the EEA to other countries. Standard contractual clauses are also subject to legal challenge, and in November 2020, the European Commission published a draft of updated standard contractual clauses. In January 2022, for example, Austria’s data protection authority determined that the use of Google Analytics violated the GDPR and the Court of Justice of the European Union’s “Schrems II” decision on international data transfers. We presently rely on standard contractual clauses to transfer personal data from EEA member countries, and we may be impacted by changes in law as a result of future review or invalidation of, or changes to, this mechanism by European courts or regulators. While we will continue to undertake efforts to conform to current regulatory obligations and evolving best practices, we may be unsuccessful in conforming to permitted means of transferring personal data from the European Economic Area. We may also experience hesitancy, reluctance, or refusal by European or multi-national customers to continue to use some of our services due to the potential risk exposure of personal data transfers and the current data protection obligations imposed on them by certain data protection authorities. Such customers may also view any alternative approaches to the transfer of any personal data as being too costly, too burdensome, or otherwise objectionable, and therefore may decide not to do business with us if the transfer of personal data is a necessary requirement.\nAlthough we take reasonable efforts to comply with all applicable laws and regulations and have invested and continue to invest human and technology resources into data privacy compliance efforts, there can be no assurance that we will not be subject to regulatory action, including fines, in the event of an incident or other claim. Data protection laws and requirements may also be enacted, interpreted or applied in a manner that creates inconsistent or contradictory requirements on companies that operate across jurisdictions. We or our third-party service providers could be adversely affected if legislation or regulations are expanded to require changes in our or our third-party service providers’ business practices or if governing jurisdictions interpret or implement their legislation or regulations in ways that negatively affect our or our third-party service providers’ business, results of operations or financial condition. For example, we may find it necessary to establish alternative systems to maintain personal data in the EEA, which may involve substantial expense and may cause us to divert resources from other aspects of\n61\nour business, all of which may adversely affect our results from operations. Further, any inability to adequately address privacy concerns in connection with our solutions, or comply with applicable privacy or data protection laws, regulations and policies, could result in additional cost and liability to us, and adversely affect our ability to offer our solutions. GDPR, CCPA, CPRA and other similar laws and regulations, as well as any associated inquiries or investigations or any other government actions, may be costly to comply with, result in negative publicity, increase our operating costs, require significant management time and attention and subject us to remedies that may harm our business, including fines or demands or orders that we modify or cease existing business practices. Our systems may not be able to satisfy these changing requirements and manufacturer, retailer and associate expectations, or may require significant additional investments or time in order to do so.\nWe expect that new industry standards, laws and regulations will continue to be proposed regarding privacy, data protection and information security in many jurisdictions, including the European e-Privacy Regulation, which is currently in draft form, as well as at the U.S. federal and state levels. In addition, new data processes and datasets associated with emerging technologies are coming under increased regulatory scrutiny, such as biometrics and automated decision-making. We cannot yet determine the impact such future laws, regulations and standards may have on our business. Complying with these evolving obligations is challenging, time consuming and expensive, and federal regulators, state attorneys general and plaintiff’s attorneys have been, and will likely continue to be, active in this space. Expanding definitions and interpretations of what constitutes “personal data” (or the equivalent) within the United States, the EEA and elsewhere may increase our compliance costs and legal liability. For example, various state privacy proposals have included a private right of action for basic privacy violations which, if passed, would dramatically increase both the legal costs of defending frivolous lawsuits and the penalties and costs associated with alleged violations.\nA data breach or any failure, or perceived failure, by us to comply with any federal, state or foreign privacy or consumer protection-related laws, regulations or other principles or orders to which we may be subject or other legal obligations relating to privacy or consumer protection could adversely affect our reputation, brand and business, and may result in fines, enforcement actions, sanctions, claims (including claims for damages by affected individuals), investigations, proceedings or actions against us by governmental entities or others, or other penalties or liabilities or require us to change our operations and/or cease using certain data sets, among other negative consequences, any of which could have a material adverse effect on our business. Moreover, the proliferation of supply chain-based cyberattacks and vendor security incidents increases these potential risks and costs even in cases where the attack did not target us, occur on our systems, or result from any action or inaction by us. Depending on the nature of the information compromised, we may also have obligations to notify users, law enforcement, regulators, business partners or payment companies about the incident and provide some form of remedy, such as refunds or identity theft monitoring services, for the individuals affected by the incident.\nThe Take 5 Matter may lead to additional harms, risks and uncertainties for us, including litigation and governmental investigations, a reduction in revenue, a potential deterioration in our relationships or reputation and a loss in investor confidence.\nOn April 1, 2018, we acquired certain assets and assumed certain liabilities of Take 5 Media Group. In June 2019, as a result of a review of internal allegations related to inconsistency of data provided by Take 5 to its clients, we commenced an investigation into Take 5’s operations. In July 2019, as a result of our investigation, we terminated all operations of Take 5, including the use of its associated trade names and the offering of its services to its clients and offered refunds to Take 5 clients of collected revenues attributable to Take 5 since our acquisition of Take 5.\nAs a result of these matters, we may be subject to a number of additional harms, risks and uncertainties, including substantial costs for professional services fee, potential lawsuits by clients or other interested parties who claim to have been harmed by the misconduct at Take 5, other costs and fees related to the Take 5 Matter (in excess of the amounts already offered as refunds), potential governmental investigations arising from the Take 5 Matter, a reduction in our current and anticipated revenue and a potential deterioration in our associate and client relationships or our reputation. In addition, if we do not prevail in any litigation or governmental investigation related to these matters, we could be subject to costs related to such litigation or governmental investigation, including equitable relief, civil monetary damages, treble damages, repayment or criminal penalties, which may not be covered by insurance or may materially increase our insurance costs. We have incurred and will continue to incur additional substantial professional fees regardless of the outcome of any such litigation or governmental\n62\ninvestigation. In addition, there can be no assurance to what degree, if any, we will be able to recover any such costs or damages from the former owners of Take 5 or whether such former owners of Take 5 engaged in further unknown improper activities that may subject us to further costs or damages, including potential reputational harm. Likewise, such events have caused and may cause further diversion of our management’s time and attention. Any adverse outcome related to these matters cannot be predicted at this time, and may materially harm our business, reputation, financial condition and/or results of operations, or the trading price of our securities.\nOur business is seasonal in nature and quarterly operating results can fluctuate.\nOur services are seasonal in nature, with the fourth fiscal quarter typically generating a higher proportion of our revenues than other fiscal quarters. Adverse events, such as deteriorating economic conditions, higher unemployment, higher gas prices, public transportation disruptions, public health crises (including the COVID-19 pandemic) or unanticipated adverse weather, could result in lower-than-planned sales during key revenue-producing seasons. For example, frequent or unusually heavy snowfall, ice storms, rainstorms, windstorms or other extreme weather conditions over a prolonged period could make it difficult for consumers to travel to retail stores or foodservice locations. Such events could lead to lower revenues, negatively impacting our financial condition and results of operations.\nOur business is competitive, and increased competition could adversely affect our business and results of operations.\nThe sales, marketing and merchandising services industry is competitive. We face competition from a few other large, national or super-regional agencies as well as many niche and regional agencies. Remaining competitive in this industry requires that we closely monitor and respond to trends in all industry sectors. We cannot assure you that we will be able to anticipate and respond successfully to such trends in a timely manner. Moreover, some of our competitors may choose to sell services competitive to ours at lower prices by accepting lower margins and profitability or may be able to sell services competitive to ours at lower prices due to proprietary ownership of data or technical superiority, which could negatively impact the rates that we can charge. If we are unable to compete successfully, it could have a material adverse effect on our business, financial condition and our results of operations. If certain competitors were to combine into integrated sales, marketing and merchandising services companies, additional sales, marketing and merchandising service companies were to enter the market or existing participants in this industry were to become more competitive, including through technological innovation such as social media and crowdsourcing, it could have a material adverse effect on our business, financial condition or results of operations.\nDamage to our reputation could negatively impact our business, financial condition and results of operations.\nOur reputation and the quality of our brand are critical to our business and success in existing markets and will be critical to our success as we enter new markets. We believe that we have built our reputation on the high quality of our sales and marketing services, our commitment to our clients and our performance-based culture, and we must protect and grow the value of our brand in order for us to continue to be successful. Any incident that erodes client loyalty to our brand could significantly reduce its value and damage our business. Also, there has been a marked increase in the use of social media platforms and similar devices, including blogs, social media websites, Twitter and other forms of internet-based communications that provide individuals with access to a broad audience of consumers and other interested persons. Many social media platforms immediately publish the content their subscribers and participants post, often without filters or checks on accuracy of the content posted. Information concerning us may be posted on such platforms at any time. Information posted may be adverse to our interests or may be inaccurate, each of which may harm our performance, prospects or business. The harm may be immediate without affording us an opportunity for redress or correction.\nWe rely on third parties to provide certain data and services in connection with the provision of our services.\nWe rely on third parties to provide certain data and services for use in connection with the provision of our services. For example, we contract with third parties to obtain the raw data on retail product sales and inventories. These suppliers of data may impose restrictions on our use of such data, fail to adhere to our quality control standards, increase the price they charge us for this data or refuse altogether to license the data to us. If we are unable to use such third-party data and services or if we are unable to contract with third parties, when necessary,\n63\nour business, financial condition or our results of operations could be adversely affected. In the event that such data and services are unavailable for our use or the cost of acquiring such data and services increases, our business could be adversely affected.\nWe may be unable to timely and effectively respond to changes in digital practices and policies, which could adversely affect our business, financial condition or results of operations.\nChanges to practices and policies of operating systems, websites and other digital platforms, including, without limitation, Apple’s or Android’s transparency policies, may reduce the quantity and quality of the data and metrics that can be collected or used by us and our clients or reduce the value of our digital services. These limitations may adversely affect both our and our clients’ ability to effectively target and measure the performance of our digital services. In addition, our clients and third party vendors routinely evaluate their digital practices and policies, and if in the future they determine to modify such practices and policies for any reasons, including, without limitation, privacy, targeting, age or content concerns, this could decrease the desire for our digital services as compared to other alternatives. If we are unable to timely or effectively respond to changes in digital practices and policies, or if our clients do not believe that our digital services will generate a competitive return on investment relative to alternatives, then our business, financial condition or results of operations could be adversely affected.\nWe may not be able to adequately protect our intellectual property, which, in turn, could harm the value of our brands and adversely affect our business.\nOur ability to implement our business plan successfully depends in part on our ability to further build brand recognition using our trade names, service marks, trademarks, proprietary products and other intellectual property, including our name and logos. We rely on U.S. and foreign trademark, copyright and trade secret laws, as well as license agreements, nondisclosure agreements and confidentiality and other contractual provisions to protect our intellectual property. Nevertheless, these laws and procedures may not be adequate to prevent unauthorized parties from attempting to copy or otherwise obtain our processes and technology or deter our competitors from developing similar business solutions and concepts, and adequate remedies may not be available in the event of an unauthorized use or disclosure of our trade secrets and other intellectual property.\nThe success of our business depends on our continued ability to use our existing trademarks and service marks to increase brand awareness and further develop our brand in both domestic and international markets. We have registered and applied to register our trade names, service marks and trademarks in the United States and foreign jurisdictions. However, the steps we have taken to protect our intellectual property in the United States and in foreign countries may not be adequate, and third parties may misappropriate, dilute, infringe upon or otherwise harm the value of our intellectual property. If any of our registered or unregistered trademarks, trade names or service marks is challenged, infringed, circumvented or declared generic or determined to be infringing on other marks, it could have an adverse effect on our sales or market position. In addition, the laws of some foreign countries do not protect intellectual property to the same extent as the laws of the United States. Many companies have encountered significant problems in protecting and defending intellectual property rights in certain jurisdictions. This could make it difficult to stop the infringement or misappropriation of our intellectual property rights in foreign jurisdictions.\nWe rely upon trade secrets and other confidential and proprietary know‑how to develop and maintain our competitive position. While it is our policy to enter into agreements imposing nondisclosure and confidentiality obligations upon our employees and third parties to protect our intellectual property, these obligations may be breached, may not provide meaningful protection for our trade secrets or proprietary know‑how, or adequate remedies may not be available in the event of an unauthorized access, use or disclosure of our trade secrets and know‑how. Furthermore, despite the existence of such nondisclosure and confidentiality agreements, or other contractual restrictions, we may not be able to prevent the unauthorized disclosure or use of our confidential proprietary information or trade secrets by consultants, vendors and employees. In addition, others could obtain knowledge of our trade secrets through independent development or other legal means.\nAny claims or litigation initiated by us to protect our proprietary technology could be time consuming, costly and divert the attention of our technical and management resources. If we choose to go to court to stop a third party from infringing our intellectual property, that third party may ask the court to rule that our intellectual property rights are invalid and/or should not be enforced against that third party. Even if the action that we take to protect\n64\nour intellectual property rights is successful, any infringement may still have a material adverse effect on our business, financial condition and results of operations.\nWe may be subject to claims of infringement of third-party intellectual property rights that are costly to defend, result in the diversion of management’s time and efforts, require the payment of damages, limit our ability to use particular technologies in the future or prevent us from marketing our existing or future products and services.\nThird parties may assert that we infringe, misappropriate or otherwise violate their intellectual property, including with respect to our digital solutions and other technologies that are important to our business, and may sue us for intellectual property infringement. We may not be aware of whether our products or services do or will infringe existing or future patents or the intellectual property rights of others. In addition, there can be no assurance that one or more of our competitors who have developed competing technologies or our other competitors will not be granted patents for their technology and allege that we have infringed on such patents.\nAny claims that our business infringes the intellectual property rights of others, regardless of the merit or resolution of such claims, could incur substantial costs, and the time and attention of our management and other personnel may be diverted in pursuing these proceedings. An adverse determination in any intellectual property claim could require us to pay damages, be subject to an injunction, and/or stop using our technologies, trademarks, copyrighted works and other material found to be in violation of another party’s rights, and could prevent us from licensing our technologies to others unless we enter into royalty or licensing arrangements with the prevailing party or are able to redesign our products and services to avoid infringement. With respect to any third-party intellectual property that we use or wish to use in our business (whether or not asserted against us in litigation), we may not be able to enter into licensing or other arrangements with the owner of such intellectual property at a reasonable cost or on reasonable terms. Any of the foregoing could harm our commercial success.\nWe are dependent on proprietary technology licensed from others. If we lose our licenses, we may not be able to continue developing our products.\nWe have obtained licenses that give us rights to third party intellectual property that is necessary or useful to our business. These license agreements may impose various royalty and other obligations on us. One or more of our licensors may allege that we have breached our license agreement with them, and could seek to terminate our license, which could adversely affect our competitive business position and harm our business prospects. In addition, any claims brought against us by our licensors could be costly, time-consuming and divert the attention of our management and key personnel from our business operations.\nConsumer goods manufacturers and retailers, including some of our clients, are subject to extensive governmental regulation and we and they may be subject to enforcement in the event of noncompliance with applicable requirements.\nConsumer goods manufacturers and retailers, including some of our clients, are subject to a broad range of federal, state, local and international laws and regulations governing, among other things, the research, development, manufacture, distribution, marketing and post-market reporting of consumer products. These include laws administered by the U.S. Food and Drug Administration (the “FDA”), the U.S. Drug Enforcement Administration, the U.S. Federal Trade Commission, the U.S. Department of Agriculture and other federal, state, local and international regulatory authorities. For example, certain of our clients market and sell products containing cannabidiol (“CBD”). CBD products are subject to a number of federal, state, local and international laws and regulations restricting their use in certain categories of products and in certain jurisdictions. In particular, the FDA has publicly stated it is prohibited to sell into interstate commerce food, beverages or dietary supplements that contain CBD. These laws are broad in scope and subject to evolving interpretations, which could require us to incur costs associated with new or modified compliance requirements or require us or our clients to alter or limit our activities, including marketing and promotion, of such products, or to remove them from the market altogether.\nIf a regulatory authority determines that we or our current or future clients have not complied with the applicable regulatory requirements, our business may be materially impacted and we or our clients could be subject to enforcement actions or loss of business. We cannot predict the nature of any future laws, regulations, interpretations or applications of the laws, nor can we determine what effect additional laws, regulations or administrative policies and procedures, if and when enacted, promulgated and implemented, could have on our business.\n65\nWe may be subject to claims for products for which we are the vendor of record or may otherwise be in the chain of title.\nFor certain of our clients’ products, we become the vendor of record or otherwise may be in the chain of title. For these products, we could be subject to potential claims for misbranded, adulterated, contaminated, damaged or spoiled products, or could be subject to liability in connection with claims related to infringement of intellectual property, product liability, product recalls or other liabilities arising in connection with the sale or marketing of these products. As a result, we could be subject to claims or lawsuits (including potential class action lawsuits), and we could incur liabilities that are not insured or exceed our insurance coverage or for which the manufacturer of the product does not indemnify us. Even if product claims against us are not successful or fully pursued, these claims could be costly and time consuming and may require our management to spend time defending the claims rather than operating our business.\nA product that has been actually or allegedly misbranded, adulterated or damaged or is actually or allegedly defective could result in product withdrawals or recalls, destruction of product inventory, negative publicity and substantial costs of compliance or remediation. Any of these events, including a significant product liability judgment against us, could result in monetary damages and/or a loss of demand for our products, both of which could have an adverse effect on our business or results of operations.\nWe generate revenues and incur expenses throughout the world that are subject to exchange rate fluctuations, and our results of operations may suffer due to currency translations.\nOur U.S. operations earn revenues and incur expenses primarily in U.S. dollars, while our international operations earn revenues and incur expenses primarily in Canadian dollars, British pounds or euros. Because of currency exchange rate fluctuations, including possible devaluations, we are subject to currency translation exposure on the results of our operations, in addition to economic exposure. There has been, and may continue to be, volatility in currency exchange rates as a result of the United Kingdom’s withdrawal from the European Union, especially between the U.S. dollar and the British pound. These risks could adversely impact our business or results of operations.\nFluctuations in our tax obligations and effective tax rate and realization of our deferred tax assets may result in volatility of our operating results.\nWe are subject to taxes by the U.S. federal, state, local and foreign tax authorities, and our tax liabilities will be affected by the allocation of expenses to differing jurisdictions. We record tax expense based on our estimates of future payments, which may include reserves for uncertain tax positions in multiple tax jurisdictions, and valuation allowances related to certain net deferred tax assets. At any one time, many tax years may be subject to audit by various taxing jurisdictions. The results of these audits and negotiations with taxing authorities may affect the ultimate settlement of these matters. We expect that throughout the year there could be ongoing variability in our quarterly tax rates as events occur and exposures are evaluated. Our future effective tax rates could be subject to volatility or adversely affected by a number of factors, including:\n•changes in the valuation of our deferred tax assets and liabilities;\n•expected timing and amount of the release of any tax valuation allowance;\n•tax effects of equity-based compensation;\n•changes in tax laws, regulations or interpretations thereof; or\n•future earnings being lower than anticipated in jurisdictions where we have lower statutory tax rates and higher than anticipated earnings in jurisdictions where we have higher statutory tax rates.\nIn addition, our effective tax rate in a given financial statement period may be materially impacted by a variety of factors including but not limited to changes in the mix and level of earnings, varying tax rates in the different jurisdictions in which we operate, fluctuations in the valuation allowance, deductibility of certain items or changes to existing accounting rules or regulations. Further, tax legislation may be enacted in the future which could negatively impact our current or future tax structure and effective tax rates. We may be subject to audits of\n66\nour income, sales and other transaction taxes by U.S. federal, state, local and foreign taxing authorities. Outcomes from these audits could have an adverse effect on our operating results and financial condition.\nRisks Related to Ownership of Our Common Stock\nWe are controlled by Topco, the Advantage Sponsors, and the CP Sponsor, whose economic and other interests in our business may be different from yours.\nOur authorized capital stock consists of 3,290,000,000 shares of Class A common stock, and as of November 8, 2022, certain equityholders of Topco (the “Advantage Sponsors”), Topco and Conyers Park II Sponsor LLC, an affiliate of Centerview Capital Management, LLC, which was Conyers Park’s sponsor prior to the Merger (the “CP Sponsor”), collectively own 254,310,000 shares, or 79.55% (including 65.30% held by Topco), of our outstanding Class A common stock. Subject to applicable law, the Advantage Sponsors, through their direct ownership of our common stock and their ownership of equity interests of Topco, and the CP Sponsor are able to exert significant influence in the election of our directors and control actions to be taken by our stockholders, including amendments to our third amended and restated certificate of incorporation and approval of mergers, sales of substantially all of our assets, and other significant corporate transactions. It is possible that the interests of Topco, the Advantage Sponsors and the CP Sponsor may in some circumstances conflict with our interests and the interests of our other stockholders, including you.\nWe are a controlled company within the meaning of the Nasdaq Stock Market LLC listing requirements and as a result, may rely on exemptions from certain corporate governance requirements. To the extent we rely on such exemptions, you will not have the same protections afforded to stockholders of companies that are subject to such corporate governance requirements.\nBecause of the voting power over our company held by Topco, the Advantage Sponsors, and the CP Sponsor and the voting arrangement between such parties, we are considered a controlled company for the purposes of the Nasdaq Stock Market LLC (“Nasdaq”) listing requirements. As such, we are exempt from the corporate governance requirements that our board of directors, compensation committee, and nominating and corporate governance committee meet the standard of independence established by those corporate governance requirements. The independence standards are intended to ensure that directors who meet the independence standards are free of any conflicting interest that could influence their actions as directors.\nWe do not currently utilize the exemptions afforded to a controlled company, though we are entitled to do so. To the extent we utilize these exemptions, you will not have the same protections afforded to stockholders of companies that are subject to all of the corporate governance requirements of Nasdaq.\nThe anti-takeover provisions of our certificate of incorporation and bylaws could prevent or delay a change in control of us, even if such change in control would be beneficial to our stockholders.\nProvisions of our certificate of incorporation and bylaws, as well as provisions of Delaware law, could discourage, delay, or prevent a merger, acquisition, or other change in control of us, even if such change in control would be beneficial to our stockholders. These include:\n•authorizing the issuance of “blank check” preferred stock that could be issued by our board of directors to increase the number of outstanding shares and thwart a takeover attempt;\n•provision for a classified board of directors so that not all members of our board of directors are elected at one time;\n•not permitting the use of cumulative voting for the election of directors;\n•permitting the removal of directors only for cause;\n•limiting the ability of stockholders to call special meetings; •requiring all stockholder actions to be taken at a meeting of our stockholders;\n•requiring approval of the holders of at least two-thirds of the shares entitled to vote at an election of directors to adopt, amend, or repeal the proposed bylaws or repeal the provisions of the third amended and restated certificate of incorporation regarding the election and removal of directors; and\n67\n•establishing advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings.\nIn addition, although we have opted out of Section 203 of the Delaware General Corporation Law (“DGCL”), our certificate of incorporation contain similar provisions providing that we may not engage in certain “business combinations” with any “interested stockholder” for a three-year period following the time that the stockholder became an interested stockholder, subject to certain exceptions. Generally, a “business combination” includes a merger, asset, or stock sale or other transaction resulting in a financial benefit to the interested stockholder.\nSubject to certain exceptions, an “interested stockholder” is a person who, together with that person’s affiliates and associates, owns, or within the previous three years owned, 15% or more of our outstanding voting stock.\nUnder certain circumstances, this provision will make it more difficult for a person who would be an “interested stockholder” to effect various business combinations with us for a three-year period. These provisions also may have the effect of preventing changes in our board of directors and may make it more difficult to accomplish transactions which stockholders may otherwise deem to be in their best interests.\nMoreover, our certificate of incorporation provides that Topco and its affiliates do not constitute “interested stockholders” for purposes of this provision, and thus any business combination transaction between us and Topco and its affiliates would not be subject to the protections otherwise provided by this provision. Topco and its affiliates are not prohibited from selling a controlling interest in us to a third party and may do so without your approval and without providing for a purchase of your shares of common stock, subject to the lock-up restrictions applicable to Topco. Accordingly, your shares of common stock may be worth less than they would be if Topco and its affiliates did not maintain voting control over us.\nThe provisions of our certificate of incorporation and bylaws requiring exclusive venue in the Court of Chancery in the State of Delaware or the federal district courts of the United States of America for certain types of lawsuits may have the effect of discouraging lawsuits against our directors and officers.\nOur certificate of incorporation and bylaws require, to the fullest extent permitted by law, that (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of a fiduciary duty owed by any of our directors, officers, or other employees to us or our stockholders, (iii) any action asserting a claim against us arising pursuant to any provision of the DGCL or our certificate of incorporation or bylaws, or (iv) any action asserting a claim against us governed by the internal affairs doctrine will have to be brought only in the Court of Chancery in the State of Delaware (or the federal district court for the District of Delaware or other state courts of the State of Delaware if the Court of Chancery in the State of Delaware does not have jurisdiction).\nOur certificate of incorporation and bylaws also require that the federal district courts of the United States of America will be the exclusive forum for the resolution of any complaint asserting a cause of action arising under the Securities Act; however, there is uncertainty as to whether a court would enforce such provision, and investors cannot waive compliance with federal securities laws and the rules and regulations thereunder. Although we believe these provisions benefit us by providing increased consistency in the application of applicable law in the types of lawsuits to which they apply, the provisions may have the effect of discouraging lawsuits against our directors and officers. These provisions do not apply to any suits brought to enforce any liability or duty created by the Exchange Act or any other claim for which the federal courts of the United States have exclusive jurisdiction.\nBecause we have no current plans to pay cash dividends on our Class A common stock, you may not receive any return on investment unless you sell your Class A common stock for a price greater than that which you paid for it.\nWe have no current plans to pay cash dividends on our Class A common stock. The declaration, amount and payment of any future dividends on our Class A common stock will be at the discretion of our board of directors and will depend upon our results of operations, financial condition, capital requirements, and other factors that our board of directors deems relevant. The payment of cash dividends is also restricted under the terms of the agreements governing our debt and our ability to pay dividend may also be restricted by the terms of any future credit agreement or any securities we or our subsidiaries may issue.\n68\nAn active, liquid trading market for our Class A common stock may not be available.\nWe cannot predict the extent to which investor interest in our company will lead to availability of a trading market on Nasdaq or otherwise in the future or how active and liquid that market may be for our Class A common stock. If an active and liquid trading market is not available, you may have difficulty selling any of our Class A common stock. Among other things, in the absence of a liquid public trading market:\n•you may not be able to liquidate your investment in shares of Class A common stock;\n•you may not be able to resell your shares of Class A common stock at or above the price attributed to them in the Transactions;\n•the market price of shares of Class A common stock may experience significant price volatility; and\n•there may be less efficiency in carrying out your purchase and sale orders.\nThe trading price of our Class A common stock may be volatile or may decline regardless of our operating performance.\nThe market prices for our Class A common stock are likely to be volatile and may fluctuate significantly in response to a number of factors, most of which we cannot control, including:\n•quarterly variations in our operating results compared to market expectations;\n•changes in preferences of our clients;\n•announcements of new products or services or significant price reductions;\n•the size of our public float;\n•fluctuations in stock market prices and volumes;\n•defaults on our indebtedness;\n•changes in senior management or key personnel;\n•the granting, vesting, or exercise of employee stock options, restricted stock, or other equity rights;\n•the payment of any dividends thereon in shares of our common stock;\n•changes in financial estimates or recommendations by securities analysts;\n•negative earnings or other announcements by us;\n•downgrades in our credit ratings;\n•material litigation or governmental investigations;\n•issuances of capital stock;\n•global economic, legal, and regulatory factors unrelated to our performance, including the COVID-19 pandemic; or\n•the realization of any risks described in this Quarterly Report under “Risk Factors.”\nIn addition, in the past, stockholders have instituted securities class action litigation against companies following periods of market volatility. If we were involved in securities litigation, we could incur substantial costs and our resources and the attention of management could be diverted from our business.\nWe cannot provide any guaranty that we will continue to repurchase our common stock pursuant to our stock repurchase program.\nIn November 2021, our board of directors authorized a share repurchase program, under which we may repurchase up to $100 million of our outstanding Class A common stock (the “2021 Share Repurchase Program”). As of September 30, 2022, the remaining amount available for repurchase pursuant to the 2021 Share Repurchase Program is $87.4 million. However, we are not obligated to make any further purchases under the 2021 Share Repurchase Program and we may suspend or permanently discontinue this program at any time or significantly reduce the amount of repurchases under the program. Any announcement of a suspension, discontinuance or reduction of this program may negatively impact our reputation and investor confidence.\n69\nThe valuation of our private placement warrants could increase the volatility in our net income (loss) in our consolidated statements of earnings (loss).\nThe change in fair value of our private placement warrants is determined using the fair value of the liability classified private placement warrants by approximating the value with the share price of the public warrants. The change in fair value of warrant liability represents the mark-to-market fair value adjustments to the outstanding private placement warrants issued in connection with the initial public offering of Conyers Park. Significant changes in share price of the public warrants may adversely affect the volatility in our net income (loss) in our Condensed Consolidated Statements of Operations and Comprehensive Income.\nRisks Related to Indebtedness\nWe need to continue to generate significant operating cash flow in order to fund acquisitions and to service our debt.\nOur business currently generates operating cash flow, which we use to fund acquisitions to grow our business and to service our substantial indebtedness. If, because of loss of revenue, pressure on pricing from customers, increases in our costs (including increases in costs related to servicing our indebtedness or labor costs), general economic, financial, competitive, legislative, regulatory conditions or other factors, including any acceleration of the foregoing as a result of the COVID-19 pandemic, many of which are outside of our control our business generates less operating cash flow, we may not have sufficient funds to grow our business or to service our indebtedness.\nIf we are unable to generate sufficient cash flow or are otherwise unable to obtain funds necessary to meet required payments of principal, premium, if any, and interest on our indebtedness, or if we otherwise fail to comply with the various covenants in the agreements governing our indebtedness, we could be in default under the terms of the agreements governing such indebtedness. In the event of such default, the lenders under our credit facilities could elect to terminate their commitments thereunder, cease making further loans and institute foreclosure proceedings against our assets, and we could be forced into bankruptcy or liquidation. If our operating performance declines, we may in the future need to obtain waivers from the required lenders under our credit agreements to avoid being in default. If we or any of our subsidiaries breach the covenants under our credit agreements and seek a waiver, we may not be able to obtain a waiver from the required lenders. If this occurs, we would be in default under our credit agreements, the lenders could exercise their rights as described above, and we could be forced into bankruptcy or liquidation.\nOur substantial indebtedness could adversely affect our financial health, restrict our activities, and affect our ability to meet our obligations.\nWe have a significant amount of indebtedness. As of September 30, 2022, we had total indebtedness of $2.1 billion, excluding debt issuance costs, with an additional $54.5 million of letters of credit outstanding under our revolving credit facility. The agreements governing our indebtedness contain customary covenants that restrict us from taking certain actions, such as incurring additional debt, permitting liens on pledged assets, making investments, paying dividends or making distributions to equity holders, prepaying junior debt, engaging in mergers or restructurings, and selling assets, among other things, which may restrict our ability to successfully execute on our business plan. For a more detailed description of the covenants and material terms of our material indebtedness, please see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” in this Quarterly Report.\nDespite current indebtedness levels, we and our subsidiaries may still be able to incur additional indebtedness, which could increase the risks associated with our indebtedness.\nWe and our subsidiaries may be able to incur additional indebtedness in the future because the terms of our indebtedness do not fully prohibit us or our subsidiaries from doing so. Subject to covenant compliance and certain conditions, as of September 30, 2022, the agreements governing our indebtedness would have permitted us to borrow up to an additional $345.5 million under our revolving credit facility. In addition, we and our subsidiaries have, and will have, the ability to incur additional indebtedness as incremental facilities under our credit agreement\n70\nand we or our subsidiaries may issue additional notes in the future. If additional debt is added to our current debt levels and our subsidiaries’ current debt levels, the related risks that we and they now face could increase.\nFailure to maintain our credit ratings could adversely affect our liquidity, capital position, ability to hedge certain financial risks, borrowing costs, and access to capital markets.\nOur credit risk is evaluated by the major independent rating agencies, and such agencies have in the past downgraded, and could in the future downgrade, our ratings. Our credit rating may impact the interest rates on any future indebtedness as well as the applicability of certain covenants in the agreements governing our indebtedness. We cannot assure you that we will be able to maintain our current credit ratings, and any additional, actual or anticipated changes or downgrades in our credit ratings, including any announcement that our ratings are under further review for a downgrade, may have a negative impact on our liquidity, capital position, ability to hedge certain financial risks, and access to capital markets.\nOur variable rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase significantly.\nBorrowings under our credit facilities are at variable rates of interest and expose us to interest rate risk. If interest rates were to increase, our debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same, and our net income and cash flows, including cash available for servicing our indebtedness, will correspondingly decrease. On a pro forma basis, assuming no other prepayments of the credit facility and that our revolving credit facility is fully drawn (and to the extent that LIBOR is in excess of the 0.00% and 0.75% floors applicable to our revolving credit facility and our term loan credit facility, respectively), each one-eighth percentage point change in interest rates would result in an approximately $1.0 million change in interest expense, net of gains from interest rate caps, for the nine months ended September 30, 2022. In the future, we may enter into interest rate swaps that involve the exchange of floating- for fixed-rate interest payments in order to reduce interest rate volatility or risk. However, we may not maintain interest rate swaps with respect to any of our variable rate indebtedness, and any swaps we enter into may not fully or effectively mitigate our interest rate risk.\nThe elimination of LIBOR after June 2023 may affect our financial results\nCertain of our financial arrangements, including the Senior Secured Credit Facilities, were made at variable rates that use the London Interbank Offered Rate, or LIBOR (or metrics derived from or related to LIBOR), as a benchmark for establishing the interest rate. All LIBOR tenors relevant to us will cease to be published or will no longer be representative after June 30, 2023. This means that any of our LIBOR-based borrowings that extend beyond June 30, 2023 will need to be converted to a replacement rate. In the U.S., the Alternative Reference Rates Committee (the “ARRC”) convened by the Federal Reserve Board and the Federal Reserve Bank of New York has recommended the Secured Overnight Financing Rate (“SOFR”) plus a recommended spread adjustment as LIBOR’s replacement. There are significant differences between LIBOR and SOFR, such as LIBOR being an unsecured lending rate while SOFR is a secured lending rate, and SOFR being an overnight rate while LIBOR reflects term rates at different maturities. If our LIBOR-based financing arrangements are converted to SOFR, the differences between LIBOR and SOFR, plus the recommended spread adjustment, could result in interest costs that are higher than if LIBOR remained available, which could adversely impact our operating results. Although SOFR is the ARRC’s recommended replacement rate, it is also possible that lenders and other counterparties may instead choose alternative replacement rates that may differ from LIBOR in ways similar to SOFR or in other ways that would result in higher interest costs for us. There is no assurance that any alternative reference rate, including SOFR, will be similar to, or produce the same value or economic equivalence as, LIBOR, and there continues to be uncertainty regarding the nature of potential changes to and future utilization of specific LIBOR tenors, the development and acceptance of SOFR or alternative reference rates, and other reforms. These consequences cannot be entirely predicted and could have an adverse impact on the market value for or value of LIBOR-linked securities, loans and other financial obligations or extensions of credit held by or due to us. Changes in market interest rates may influence our financing costs, returns on financial investments and the valuation of derivative contracts and could reduce our earnings and cash flows.\n71\nGeneral Risk Factors\nOur business and financial results may be affected by various litigation and regulatory proceedings.\nWe are subject to litigation and regulatory proceedings in the normal course of business and could become subject to additional claims in the future. These proceedings have included, and in the future may include, matters involving personnel and employment issues, workers’ compensation, personal and property injury, disputes relating to acquisitions (including contingent consideration), governmental investigations and other proceedings. Some historical and current legal proceedings and future legal proceedings may purport to be brought as class actions or representative basis on behalf of similarly situated parties including with respect to employment-related matters. We cannot be certain of the ultimate outcomes of any such claims, and resolution of these types of matters against us may result in significant fines, judgments or settlements, which, if uninsured, or if the fines, judgments and settlements exceed insured levels, could adversely affect our business or financial results. See “Legal Proceedings.”\nWe are subject to many federal, state, local and international laws with which compliance is both costly and complex.\nOur business is subject to various, and sometimes complex, laws and regulations, including those that have been or may be implemented in response to the COVID-19 pandemic. In order to conduct our operations in compliance with these laws and regulations, we must obtain and maintain numerous permits, approvals and certificates from various federal, state, local and international governmental authorities. We may incur substantial costs in order to maintain compliance with these existing laws and regulations. In addition, our costs of compliance may increase if existing laws and regulations are revised or reinterpreted or if new laws and regulations become applicable to our operations. These costs could have an adverse impact on our business or results of operations. Moreover, our failure to comply with these laws and regulations, as interpreted and enforced, could lead to fines, penalties or management distraction or otherwise harm our business.\nOur insurance may not provide adequate levels of coverage against claims.\nWe believe that we maintain insurance customary for businesses of our size and type. However, there are types of losses we may incur that cannot be insured against or that we believe are not economically reasonable to insure. Further, insurance may not continue to be available to us on acceptable terms, if at all, and, if available, coverage may not be adequate. If we are unable to obtain insurance at an acceptable cost or on acceptable terms, we could be exposed to significant losses.\nWe have incurred and will continue to incur increased costs as a public company.\nAs a public company, we have incurred and will continue to incur significant legal, accounting, insurance, and other expenses that we did not incur as a private company, including costs associated with public company reporting requirements. We also have incurred and will incur costs associated with the Sarbanes-Oxley Act and related rules implemented by the SEC. The expenses incurred by public companies for reporting and corporate governance purposes generally have been increasing. We expect these rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly, although we are currently unable to estimate these costs with any degree of certainty. In estimating these costs, we took into account expenses related to insurance, legal, accounting, and compliance activities, as well as other expenses not currently incurred. These laws and regulations could also make it more difficult or costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. These laws and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, on our board committees, or as our executive officers. Furthermore, if we are unable to satisfy our obligations as a public company, we could be subject to delisting of our Class A common stock, fines, sanctions, and other regulatory action and potentially civil litigation.\nOur management has limited experience in operating a public company.\nOur executive officers have limited experience in the management of a publicly traded company. Our management team may not successfully or effectively manage our transition to a public company that will be\n72\nsubject to significant regulatory oversight and reporting obligations under federal securities laws. Their limited experience in dealing with the increasingly complex laws pertaining to public companies could be a significant disadvantage in that it is likely that an increasing amount of their time may be devoted to these activities which will result in less time being devoted to the management and growth of the Company. We may not have adequate personnel with the appropriate level of knowledge, experience, and training in the accounting policies, practices or internal control over financial reporting required of public companies in the United States. The development and implementation of the standards and controls necessary for the Company to achieve the level of accounting standards required of a public company in the United States may require costs greater than expected. It is possible that we will be required to expand our employee base and hire additional employees to support our operations as a public company which will increase our operating costs in future periods.\nIf securities analysts do not publish research or reports about our business or if they publish negative evaluations of our common stock, the price of our Class A common stock could decline.\nThe trading market for our Class A common stock will rely in part on the research and reports that industry or financial analysts publish about us or our business. If few analysts commence coverage of us, the trading price of our stock could be negatively affected. Even with analyst coverage, if one or more of the analysts covering our business downgrade their evaluations of our stock, the price of our Class A common stock could decline. If one or more of these analysts cease to cover our common stock, we could lose visibility in the market for our Class A common stock, which in turn could cause our Class A common stock price to decline.\nSubstantial future sales of our Class A common stock, or the perception in the public markets that these sales may occur, may depress our stock price.\nSales of substantial amounts of our common stock in the public market, or the perception that these sales could occur, could adversely affect the price of our common stock and could impair our ability to raise capital through the sale of additional shares. Certain shares of our common stock are freely tradable without restriction under the Securities Act, except for any shares of our common stock that may be held or acquired by our directors, executive officers, and other affiliates, as that term is defined in the Securities Act, which are to be restricted securities under the Securities Act. Restricted securities may not be sold in the public market unless the sale is registered under the Securities Act or an exemption from registration is available. Topco, the Advantage Sponsors, the CP Sponsor and members of our management have rights, subject to certain conditions, to require us to file registration statements covering Topco’s shares of our common stock or to include shares in registration statements that we may file for ourselves or other stockholders. In each of November 2020 and March 2021, we filed a registration statement on Form S-1 under which certain of our shareholders may sell, from time to time, 50,000,000 shares and 255,465,000 shares of our Class A common stock, respectively, that, if sold, will be freely tradable without restriction under the Securities Act. In the event a large number of shares of Class A common stock are sold in the public market, such sales could reduce the market price of our Class A common stock.\nWe may also issue shares of our common stock or securities convertible into our common stock from time to time in connection with financings, acquisitions, investments, or otherwise. Any such issuance could result in ownership dilution to you as a stockholder and cause the trading price of our common stock to decline.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nNone\nItem 3. Defaults Upon Senior Securities\nNone\nItem 4. Mine Safety Disclosures\nNone\n73\nItem 5. Other Information\nNone\nITEM 6. Exhibits\nThe following exhibits are filed with this Report:\n\n| ExhibitNumber | Description |\n| 31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934 |\n| 31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934 |\n| 32.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350 |\n| 32.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350 |\n| 101.INS | Inline XBRL Instance Document – the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\n\n***\n74\nSIGNATURES\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| ADVANTAGE SOLUTIONS INC. |\n| By: | /s/ Jill Griffin |\n| Jill Griffin |\n| Chief Executive Officer (Principal Executive Officer) |\n| Date: | November 9, 2022 |\n| By: | /s/ Brian Stevens |\n| Brian Stevens |\n| Chief Financial Officer and Chief Operating |\n| Officer (Principal Financial Officer) |\n| Date: | November 9, 2022 |\n\n75\n \n\nWhat is the percentage change in the company's total net worth between July 1, 2021 and September 30, 2021?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nITEM 1. FINANCIAL STATEMENTS\\nADVANTAGE SOLUTIONS INC.\\nCONDENSED CONSOLIDATED BALANCE SHEETS\\n(UNAUDITED)\\n\\n| September 30, | December 31, |\\n| (in thousands, except share data) | 2022 | 2021 |\\n| ASSETS |\\n| Current assets |\\n| Cash and cash equivalents | $ | 96,215 | $ | 164,622 |\\n| Restricted cash | 18,079 | 16,015 |\\n| Accounts receivable, net of allowance for expected credit losses of $ 13,648 and $ 15,916 , respectively | 833,432 | 797,677 |\\n| Prepaid expenses and other current assets | 155,429 | 126,000 |\\n| Total current assets | 1,103,155 | 1,104,314 |\\n| Property and equipment, net | 69,084 | 63,696 |\\n| Goodwill | 2,246,053 | 2,206,004 |\\n| Other intangible assets, net | 2,150,075 | 2,287,514 |\\n| Investments in unconsolidated affiliates | 124,815 | 125,158 |\\n| Other assets | 120,644 | 67,582 |\\n| Total assets | $ | 5,813,826 | $ | 5,854,268 |\\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\\n| Current liabilities |\\n| Current portion of long-term debt | $ | 14,704 | $ | 14,397 |\\n| Accounts payable | 267,684 | 277,366 |\\n| Accrued compensation and benefits | 109,935 | 139,157 |\\n| Other accrued expenses | 161,246 | 164,133 |\\n| Deferred revenues | 47,441 | 50,467 |\\n| Total current liabilities | 601,010 | 645,520 |\\n| Long-term debt, net of current portion | 2,024,591 | 2,028,882 |\\n| Deferred income tax liabilities | 456,755 | 483,165 |\\n| Warrant liability | 733 | 22,189 |\\n| Other long-term liabilities | 109,421 | 92,218 |\\n| Total liabilities | 3,192,510 | 3,271,974 |\\n| Commitments and contingencies (Note 10) |\\n| Redeemable noncontrolling interest | 3,353 | 1,893 |\\n| Equity attributable to stockholders of Advantage Solutions Inc. |\\n| Common stock, $ 0.0001 par value, 3,290,000,000 shares authorized; 319,675,888 and 316,963,552 shares issued and outstanding as of September 30, 2022 and December 31, 2021, respectively | 32 | 32 |\\n| Additional paid in capital | 3,398,477 | 3,373,278 |\\n| Accumulated deficit | ( 823,212 | ) | ( 866,607 | ) |\\n| Loans to Karman Topco L.P. | ( 6,357 | ) | ( 6,340 | ) |\\n| Accumulated other comprehensive loss | ( 29,978 | ) | ( 4,479 | ) |\\n| Treasury stock, at cost; 1,610,014 shares as of September 30, 2022 and December 31, 2021 | ( 12,567 | ) | ( 12,567 | ) |\\n| Total equity attributable to stockholders of Advantage Solutions Inc. | 2,526,395 | 2,483,317 |\\n| Nonredeemable noncontrolling interest | 91,568 | 97,084 |\\n| Total stockholders’ equity | 2,617,963 | 2,580,401 |\\n| Total liabilities, redeemable noncontrolling interest, and stockholders’ equity | $ | 5,813,826 | $ | 5,854,268 |\\n\\nSee Notes to the Condensed Consolidated Financial Statements.\\n3\\nADVANTAGE SOLUTIONS INC.\\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME\\n(UNAUDITED)\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (in thousands, except share and per share data) | 2022 | 2021 | 2022 | 2021 |\\n| Revenues | $ | 1,051,095 | $ | 928,760 | $ | 2,946,979 | $ | 2,569,735 |\\n| Cost of revenues (exclusive of depreciation and amortization shown separately below) | 908,523 | 766,253 | 2,536,256 | 2,117,818 |\\n| Selling, general, and administrative expenses | 37,945 | 37,742 | 138,594 | 124,830 |\\n| Depreciation and amortization | 57,785 | 59,163 | 173,997 | 181,450 |\\n| Total operating expenses | 1,004,253 | 863,158 | 2,848,847 | 2,424,098 |\\n| Operating income | 46,842 | 65,602 | 98,132 | 145,637 |\\n| Other (income) expenses: |\\n| Change in fair value of warrant liability | ( 1,100 | ) | ( 3,491 | ) | ( 21,456 | ) | ( 5,024 | ) |\\n| Interest expense, net | 23,557 | 36,490 | 63,628 | 104,544 |\\n| Total other expenses | 22,457 | 32,999 | 42,172 | 99,520 |\\n| Income before income taxes | 24,385 | 32,603 | 55,960 | 46,117 |\\n| Provision for income taxes | 1,158 | 8,276 | 11,523 | 16,582 |\\n| Net income | 23,227 | 24,327 | 44,437 | 29,535 |\\n| Less: net income attributable to noncontrolling interest | 2,168 | 1,016 | 1,042 | 219 |\\n| Net income attributable to stockholders of Advantage Solutions Inc. | 21,059 | 23,311 | 43,395 | 29,316 |\\n| Other comprehensive loss, net of tax: |\\n| Foreign currency translation adjustments | ( 13,616 | ) | ( 2,443 | ) | ( 25,499 | ) | ( 4,239 | ) |\\n| Total comprehensive income attributable to stockholders of Advantage Solutions Inc. | $ | 7,443 | $ | 20,868 | $ | 17,896 | $ | 25,077 |\\n| Net income per common share: |\\n| Basic | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\\n| Diluted | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\\n| Weighted-average number of common shares: |\\n| Basic | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\\n| Diluted | 319,725,065 | 320,120,634 | 319,190,804 | 319,654,817 |\\n\\nSee Notes to the Condensed Consolidated Financial Statements.\\n4\\nADVANTAGE SOLUTIONS INC.\\nCONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\\n(UNAUDITED)\\n\\n| Accumulated | Advantage |\\n| Common Stock | Treasury Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\\n| Shares | Amount | Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\\n| (in thousands, except share data) |\\n| Balance at July 1, 2022 | 318,465,449 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,390,899 | $ | ( 844,271 | ) | $ | ( 6,351 | ) | $ | ( 16,362 | ) | $ | 2,511,380 | $ | 90,109 | $ | 2,601,489 |\\n| Comprehensive income (loss) |\\n| Net income | — | — | — | — | — | 21,059 | — | — | 21,059 | 2,092 | 23,151 |\\n| Foreign currency translation adjustments | — | — | — | — | — | — | — | ( 13,616 | ) | ( 13,616 | ) | ( 6,824 | ) | ( 20,440 | ) |\\n| Total comprehensive income (loss) | 7,443 | ( 4,732 | ) | 2,711 |\\n| Interest on loans to Karman Topco L.P. | — | — | — | — | — | — | ( 6 | ) | — | ( 6 | ) | — | ( 6 | ) |\\n| Increase in noncontrolling interest | — | — | — | — | — | — | — | — | — | 6,191 | 6,191 |\\n| Equity-based compensation of Karman Topco L.P. | — | — | — | — | ( 828 | ) | — | — | — | ( 828 | ) | — | ( 828 | ) |\\n| Shares issued under 2020 Employee Stock Purchase Plan | 470,786 | — | — | — | 1,667 | — | — | — | 1,667 | — | 1,667 |\\n| Shares issued under 2020 Incentive Award Plan | 739,653 | — | — | — | — | — | — | — | — | — | — |\\n| Stock-based compensation expense | — | — | — | — | 6,739 | — | — | — | 6,739 | — | 6,739 |\\n| Balance at September 30, 2022 | 319,675,888 | $ | 32 | $ | 1,610,014 | $ | ( 12,567 | ) | $ | 3,398,477 | $ | ( 823,212 | ) | $ | ( 6,357 | ) | $ | ( 29,978 | ) | $ | 2,526,395 | $ | 91,568 | $ | 2,617,963 |\\n\\n\\n| Accumulated | Advantage |\\n| Common Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\\n| Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\\n| (in thousands, except share data) |\\n| Balance at July 1, 2021 | 318,496,390 | $ | 32 | $ | 3,361,262 | $ | ( 915,096 | ) | $ | ( 6,328 | ) | $ | ( 1,122 | ) | $ | 2,438,748 | $ | 95,916 | $ | 2,534,664 |\\n| Comprehensive income (loss) |\\n| Net income | — | — | — | 23,311 | — | — | 23,311 | 973 | 24,284 |\\n| Foreign currency translation adjustments | — | — | — | — | — | ( 2,443 | ) | ( 2,443 | ) | ( 2,305 | ) | ( 4,748 | ) |\\n| Total comprehensive income (loss) | 20,868 | ( 1,332 | ) | 19,536 |\\n| Interest on loans to Karman Topco L.P. | — | — | — | — | ( 6 | ) | — | ( 6 | ) | — | ( 6 | ) |\\n| Redemption of noncontrolling interest | — | — | ( 16 | ) | — | — | — | ( 16 | ) | — | ( 16 | ) |\\n| Equity-based compensation of Karman Topco L.P. | — | — | ( 6,030 | ) | — | — | — | ( 6,030 | ) | — | ( 6,030 | ) |\\n| Shares issued upon exercise of warrants | 1 | — | — | — | — | — | — | — | — |\\n| Shares issued under 2020 Employee Stock Purchase Plan | 77,172 | — | 736 | — | — | — | 736 | — | 736 |\\n| Stock-based compensation expense | — | — | 8,413 | — | — | — | 8,413 | — | 8,413 |\\n| Balance at September 30, 2021 | 318,573,563 | $ | 32 | $ | 3,364,365 | $ | ( 891,785 | ) | $ | ( 6,334 | ) | $ | ( 3,565 | ) | $ | 2,462,713 | $ | 94,584 | $ | 2,557,297 |\\n\\nSee Notes to the Condensed Consolidated Financial Statements.\\n5\\n\\n| Accumulated | Advantage |\\n| Common Stock | Treasury Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\\n| Shares | Amount | Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\\n| (in thousands, except share data) |\\n| Balance at January 1, 2022 | 316,963,552 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,373,278 | $ | ( 866,607 | ) | $ | ( 6,340 | ) | $ | ( 4,479 | ) | $ | 2,483,317 | $ | 97,084 | $ | 2,580,401 |\\n| Comprehensive income (loss) |\\n| Net income | — | — | — | — | — | 43,395 | — | — | 43,395 | 918 | 44,313 |\\n| Foreign currency translation adjustments | — | — | — | — | — | — | — | ( 25,499 | ) | ( 25,499 | ) | ( 12,625 | ) | ( 38,124 | ) |\\n| Total comprehensive income (loss) | — | — | — | — | — | — | — | — | 17,896 | ( 11,707 | ) | 6,189 |\\n| Interest on loans to Karman Topco L.P. | — | — | — | — | — | — | ( 17 | ) | — | ( 17 | ) | — | ( 17 | ) |\\n| Increase in noncontrolling interest | — | — | — | — | — | — | — | — | — | 6,191 | 6,191 |\\n| Equity-based compensation of Karman Topco L.P. | — | — | — | — | ( 7,142 | ) | — | — | — | ( 7,142 | ) | — | ( 7,142 | ) |\\n| Shares issued under 2020 Employee Stock Purchase Plan | 713,213 | — | — | — | 3,320 | — | — | — | 3,320 | — | 3,320 |\\n| Shares issued under 2020 Incentive Award Plan | 1,999,123 | — | — | — | — | — | — | — | — | — | — |\\n| Stock-based compensation expense | — | — | — | — | 29,021 | — | — | — | 29,021 | — | 29,021 |\\n| Balance at September 30, 2022 | 319,675,888 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,398,477 | $ | ( 823,212 | ) | $ | ( 6,357 | ) | $ | ( 29,978 | ) | $ | 2,526,395 | $ | 91,568 | $ | 2,617,963 |\\n\\n\\n| Accumulated | Advantage |\\n| Common Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\\n| Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\\n| (in thousands, except share data) |\\n| Balance at January 1, 2021 | 318,425,182 | $ | 32 | $ | 3,348,546 | $ | ( 921,101 | ) | $ | ( 6,316 | ) | $ | 674 | $ | 2,421,835 | $ | 96,954 | $ | 2,518,789 |\\n| Comprehensive income (loss) |\\n| Net income | — | — | — | 29,316 | — | — | 29,316 | 190 | 29,506 |\\n| Foreign currency translation adjustments | — | — | — | — | — | ( 4,239 | ) | ( 4,239 | ) | ( 2,796 | ) | ( 7,035 | ) |\\n| Total comprehensive income (loss) | 25,077 | ( 2,606 | ) | 22,471 |\\n| Interest on loans to Karman Topco L.P. | — | — | — | — | ( 18 | ) | — | ( 18 | ) | — | ( 18 | ) |\\n| Redemption of noncontrolling interest | — | — | ( 452 | ) | — | — | — | ( 452 | ) | 236 | ( 216 | ) |\\n| Equity-based compensation of Karman Topco L.P. | — | — | ( 13,140 | ) | — | — | — | ( 13,140 | ) | — | ( 13,140 | ) |\\n| Shares issued under 2020 Incentive Award Plan | 24,784 | — | — | — | — | — | — | — | — |\\n| Shares issued upon vesting of restricted stock units | 41,424 | — | — | — | — | — | — | — | — |\\n| Shares issued under 2020 Employee Stock Purchase Plan | 77,172 | — | 736 | — | — | — | 736 | — | 736 |\\n| Shares issued upon exercise of warrants | 5,001 | — | 58 | — | — | — | 58 | — | 58 |\\n| Stock-based compensation expense | — | — | 28,617 | — | — | — | 28,617 | — | 28,617 |\\n| Balance at September 30, 2021 | 318,573,563 | $ | 32 | $ | 3,364,365 | $ | ( 891,785 | ) | $ | ( 6,334 | ) | $ | ( 3,565 | ) | $ | 2,462,713 | $ | 94,584 | $ | 2,557,297 |\\n\\nSee Notes to the Condensed Consolidated Financial Statements.\\n6\\nADVANTAGE SOLUTIONS INC.\\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\\n(UNAUDITED)\\n\\n| Nine Months Ended September 30, |\\n| (in thousands) | 2022 | 2021 |\\n| CASH FLOWS FROM OPERATING ACTIVITIES |\\n| Net income | $ | 44,437 | $ | 29,535 |\\n| Adjustments to reconcile net income to net cash provided by operating activities |\\n| Noncash interest (income) expense, net | ( 34,419 | ) | 2,893 |\\n| Depreciation and amortization | 173,997 | 181,450 |\\n| Change in fair value of warrant liability | ( 21,456 | ) | ( 5,024 | ) |\\n| Fair value adjustments related to contingent consideration | 5,448 | 6,977 |\\n| Deferred income taxes | ( 28,561 | ) | ( 17,468 | ) |\\n| Equity-based compensation of Karman Topco L.P. | ( 7,142 | ) | ( 13,140 | ) |\\n| Stock-based compensation | 29,906 | 28,617 |\\n| Equity in earnings of unconsolidated affiliates | ( 6,480 | ) | ( 6,222 | ) |\\n| Distribution received from unconsolidated affiliates | 1,339 | 1,154 |\\n| Loss on disposal of property and equipment | 608 | 6,327 |\\n| Loss on divestiture | 2,953 | — |\\n| Changes in operating assets and liabilities, net of effects from purchases of businesses: |\\n| Accounts receivable, net | ( 45,383 | ) | ( 121,036 | ) |\\n| Prepaid expenses and other assets | ( 45,087 | ) | ( 64,716 | ) |\\n| Accounts payable | ( 7,914 | ) | 37,294 |\\n| Accrued compensation and benefits | ( 26,316 | ) | 16,684 |\\n| Deferred revenues | ( 156 | ) | 2,869 |\\n| Other accrued expenses and other liabilities | 46,176 | 14,874 |\\n| Net cash provided by operating activities | 81,950 | 101,068 |\\n| CASH FLOWS FROM INVESTING ACTIVITIES |\\n| Purchase of businesses, net of cash acquired | ( 74,146 | ) | ( 40,046 | ) |\\n| Purchase of investment in unconsolidated affiliates | ( 775 | ) | ( 2,000 | ) |\\n| Purchase of property and equipment | ( 30,037 | ) | ( 24,106 | ) |\\n| Proceeds from divestiture | 1,896 | — |\\n| Net cash used in investing activities | ( 103,062 | ) | ( 66,152 | ) |\\n| CASH FLOWS FROM FINANCING ACTIVITIES |\\n| Borrowings under lines of credit | 140,333 | 51,685 |\\n| Payments on lines of credit | ( 139,684 | ) | ( 102,493 | ) |\\n| Proceeds from issuance of long-term debt | 266 | — |\\n| Principal payments on long-term debt | ( 10,427 | ) | ( 10,133 | ) |\\n| Proceeds from issuance of common stock | 3,320 | 794 |\\n| Contingent consideration payments | ( 23,164 | ) | ( 6,247 | ) |\\n| Holdback payments | ( 8,557 | ) | ( 2,389 | ) |\\n| Contribution from noncontrolling interest | 5,217 | — |\\n| Redemption of noncontrolling interest | ( 224 | ) | ( 216 | ) |\\n| Net cash used in financing activities | ( 32,920 | ) | ( 68,999 | ) |\\n| Net effect of foreign currency changes on cash | ( 12,311 | ) | ( 1,476 | ) |\\n| Net change in cash, cash equivalents and restricted cash | ( 66,343 | ) | ( 35,559 | ) |\\n| Cash, cash equivalents and restricted cash, beginning of period | 180,637 | 219,966 |\\n| Cash, cash equivalents and restricted cash, end of period | $ | 114,294 | $ | 184,407 |\\n| SUPPLEMENTAL CASH FLOW INFORMATION |\\n| Purchase of property and equipment recorded in accounts payable and accrued expenses | $ | 1,409 | $ | 322 |\\n\\nSee Notes to the Condensed Consolidated Financial Statements.\\n7\\nADVANTAGE SOLUTIONS INC.\\nNOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(UNAUDITED)\\n1. Organization and Significant Accounting Policies Advantage Solutions Inc. (the “Company”) is a provider of outsourced solutions to consumer goods companies and retailers. The Company’s Class A common stock is listed on the Nasdaq Global Select Market under the symbol “ADV” and warrants to purchase the Class A common stock at an exercise price of $ 11.50 per share are listed on the Nasdaq Global Select Market under the symbol “ADVWW”. Basis of Presentation The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its subsidiaries. The unaudited condensed consolidated financial statements do not include all of the information required by accounting principles generally accepted in the United States (“GAAP”). The Condensed Consolidated Balance Sheet at December 31, 2021 was derived from the audited Consolidated Balance Sheet at that date and does not include all the disclosures required by GAAP. In the opinion of management, all adjustments which are of a normal recurring nature and necessary for a fair statement of the results as of September 30, 2022 and for the three and nine months ended September 30, 2022 and 2021 have been reflected in the condensed consolidated financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements as of and for the year ended December 31, 2021 and the related footnotes thereto. Operating results for the three and nine months ended September 30, 2022 are not necessarily indicative of the results to be expected during the remainder of the current year or for any future period. COVID-19 Pandemic Beginning in March 2020 and continuing through the first quarter of 2021, the Company’s services experienced the most severe effects from reductions in client spending due to the economic impact related to the COVID-19 pandemic. While mixed by services and geography, the spending reductions impacted all of the Company’s services and markets. Globally, the most impacted services were the Company's experiential services. Most services began to recover in April 2021, and the recovery has continued through the third quarter of 2022. Impact of the War in Ukraine The Company has a minority interest in a European company that has majority-ownership interests in local agencies in Russia. During the first quarter of 2022, the war in Ukraine resulted in the imposition of sanctions by the United States, the United Kingdom, and the European Union, that affected, and continues to affect, the cross-border operations of businesses operating in Russia. In addition, Russian regulators have imposed currency restrictions and regulations that created uncertainty regarding the Company's ability to recover its investment in operations in Russia, as well as the Company's ability to exercise control or influence over operations by the local agencies in Russia. As a result, the Company intends to use its influence to cause the European company to dispose of its ownership interests in the local agencies in Russia. Accordingly, the Company recorded pretax charges of $ 2.8 million in the first quarter of 2022, primarily consisting of its proportionate share of the net investment in its Russian interest in “Selling, general, and administrative expenses” in the Condensed Consolidated Statements of Operations and Comprehensive Income. Recent Accounting StandardsAccounting Standards Recently Adopted by the CompanyIn March 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on 8 Financial Reporting. This guidance provides optional expedients and exceptions for GAAP to contracts, hedging relationships, and other transactions that reference the London Interbank Offered Rate (“LIBOR”) or another reference rate if certain criteria are met. The amendments in this update are effective for reporting periods that include or are subsequent to March 12, 2020 and must be applied prospectively to contract modifications and hedging relationships through December 31, 2022. On April 1, 2022, the Company adopted the standard prospectively and determined that the adoption of this accounting guidance did not have a material impact on its condensed consolidated financial statements.On January 1, 2022, the Company adopted ASU No. 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity (“ASU 2020-06”), which simplifies accounting for convertible instruments by removing major separation models required under current GAAP, simplifies the contract settlement assessment for equity classification, requires the use of the if-converted method for all convertible instruments in the diluted earnings per share calculation and expands disclosure requirements. The adoption of this accounting standard, under the full retrospective method, did not have a material impact on the Company's condensed consolidated financial statements and use of the if-converted method did not have an impact on the Company's overall earnings per share calculation.On January 1, 2022, the Company adopted ASU 2021-04, Earnings Per Share (Topic 260), Debt—Modifications and Extinguishments (Subtopic 470-50), Compensation—Stock Compensation (Topic 718), and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Issuer’s Accounting for Certain Modifications or Exchanges of Freestanding Equity-Classified Written Call Options (a consensus of the FASB Emerging Issues Task Force). The guidance clarifies certain aspects of the current guidance to promote consistency among reporting of an issuer’s accounting for modifications or exchanges of freestanding equity-classified written call options (for example, warrants) that remain equity-classified after modification or exchange. The guidance is applied prospectively to all modifications or exchanges that occur on or after the date of adoption and the adoption of this accounting standard did not have a material impact on the Company’s condensed consolidated financial statements.On January 1, 2022, the Company adopted ASU 2021-10, Government Assistance (Topic 832): Disclosures by Business Entities about Government Assistance. This update requires annual disclosures about transactions with a government that are accounted for by applying a grant or contribution accounting model by analogy. The guidance is applied prospectively to all transactions within the scope of the amendments that are reflected in financial statements at the date of initial application and new transactions that are entered into after the date of initial application. The adoption of this accounting standard did not have a material impact on the Company’s condensed consolidated financial statements. Accounting Standards Recently Issued but Not Yet Adopted by the CompanyIn October 2021, the FASB issued ASU 2021-08, Business Combinations (Topic 606): Accounting for Contract Assets and Contract Liabilities from Contracts with Customers, which requires that an entity recognize and measure contract assets and contract liabilities acquired in a business combination in accordance with Topic 606 as if it had originated the contracts. Generally, this should result in an acquirer recognizing and measuring the acquired contract assets and contract liabilities consistent with how they were recognized and measured in the acquiree’s financial statements, if the acquiree prepared financial statements in accordance with GAAP. The amendment in this update is effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. The guidance should be applied prospectively to business combinations occurring on or after the effective date of the amendment in this update. The Company is evaluating the potential impact of this adoption on its consolidated financial statements. All other new accounting pronouncements issued, but not yet effective or adopted have been deemed to be not relevant to the Company and, accordingly, are not expected to have a material impact once adopted.\\n9\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Sales brand-centric services | $ | 343,478 | $ | 330,740 | $ | 1,005,707 | $ | 946,147 |\\n| Sales retail-centric services | 302,768 | 266,399 | 836,640 | 746,960 |\\n| Total sales revenues | 646,246 | 597,139 | 1,842,347 | 1,693,107 |\\n| Marketing brand-centric services | 143,241 | 142,554 | 393,155 | 381,358 |\\n| Marketing retail-centric services | 261,608 | 189,067 | 711,477 | 495,270 |\\n| Total marketing revenues | 404,849 | 331,621 | 1,104,632 | 876,628 |\\n| Total revenues | $ | 1,051,095 | $ | 928,760 | $ | 2,946,979 | $ | 2,569,735 |\\n\\n| (in thousands) |\\n| Consideration: |\\n| Cash | $ | 74,146 |\\n| Holdback | 810 |\\n| Fair value of contingent consideration | 510 |\\n| Total consideration | $ | 75,466 |\\n| Recognized amounts of identifiable assets acquired and liabilities assumed: |\\n| Assets |\\n| Accounts receivable | $ | 9,409 |\\n| Other assets | 3,446 |\\n| Identifiable intangible assets | 25,546 |\\n| Total assets | 38,401 |\\n| Liabilities |\\n| Accounts payable | 7,363 |\\n| Deferred tax liabilities and other | 8,744 |\\n| Total liabilities | 16,107 |\\n| Redeemable noncontrolling interest | 1,987 |\\n| Noncontrolling interest | 974 |\\n| Total identifiable net assets | 19,333 |\\n| Goodwill arising from acquisitions | $ | 56,133 |\\n| (in thousands) | Amount | WeightedAverageUseful Life |\\n| Client relationships | $ | 24,413 | 6 years |\\n| Trade names | 1,133 | 10 years |\\n| Total identifiable intangible assets | $ | 25,546 |\\n| (in thousands) |\\n| Consideration |\\n| Cash | $ | 40,046 |\\n| Holdbacks | 13,599 |\\n| Fair value of contingent consideration | 19,883 |\\n| Total consideration | $ | 73,528 |\\n| Recognized amounts of identifiable assets acquired and liabilities assumed: |\\n| Assets |\\n| Accounts receivable | $ | 12,834 |\\n| Other assets | 4,400 |\\n| Property and equipment | 1,001 |\\n| Identifiable intangible assets | 36,210 |\\n| Total assets | 54,445 |\\n| Liabilities |\\n| Total liabilities | 21,758 |\\n| Redeemable noncontrolling interest | 1,804 |\\n| Total identifiable net assets | 30,883 |\\n| Goodwill arising from acquisitions | $ | 42,645 |\\n| (in thousands) | Amount | WeightedAverageUseful Life |\\n| Client relationships | $ | 27,860 | 7 years |\\n| Trade Names | 5,250 | 5 years |\\n| Developed technology | 3,100 | 7 years |\\n| Total identifiable intangible assets | $ | 36,210 |\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Revenues | $ | 1,052,274 | $ | 963,576 | $ | 2,962,479 | $ | 2,719,111 |\\n| Net income | $ | 21,467 | $ | 23,896 | $ | 46,461 | $ | 32,590 |\\n\\n\\n| Sales | Marketing | Total |\\n| (in thousands) |\\n| Balance at January 1, 2021 | $ | 1,462,378 | $ | 700,961 | $ | 2,163,339 |\\n| Acquisitions | 32,087 | 13,315 | 45,402 |\\n| Measurement period adjustments | 179 | ( 1,043 | ) | ( 864 | ) |\\n| Foreign exchange translation effects | ( 1,873 | ) | — | ( 1,873 | ) |\\n| Balance at December 31, 2021 | $ | 1,492,771 | $ | 713,233 | $ | 2,206,004 |\\n| Acquisitions | 5,672 | 50,461 | 56,133 |\\n| Measurement period adjustments | ( 446 | ) | — | ( 446 | ) |\\n| Foreign exchange translation effects | ( 15,638 | ) | — | ( 15,638 | ) |\\n| Balance at September 30, 2022 | $ | 1,482,359 | $ | 763,694 | $ | 2,246,053 |\\n| September 30, 2022 |\\n| (amounts in thousands) | Weighted Average Useful Life | Gross CarryingValue | AccumulatedAmortization | Net Carrying Value |\\n| Finite-lived intangible assets: |\\n| Client relationships | 14 years | $ | 2,486,064 | $ | 1,290,842 | $ | 1,195,222 |\\n| Trade names | 8 years | 135,271 | 84,067 | 51,204 |\\n| Developed technology | 5 years | 13,260 | 9,870 | 3,390 |\\n| Covenant not to compete | 5 years | 6,100 | 5,841 | 259 |\\n| Total finite-lived intangible assets | 2,640,695 | 1,390,620 | 1,250,075 |\\n| Indefinite-lived intangible assets: |\\n| Trade names | 900,000 | — | 900,000 |\\n| Total other intangible assets | $ | 3,540,695 | $ | 1,390,620 | $ | 2,150,075 |\\n| December 31, 2021 |\\n| (amounts in thousands) | Weighted Average Useful Life | Gross CarryingValue | AccumulatedAmortization | Net Carrying Value |\\n| Finite-lived intangible assets: |\\n| Client relationships | 14 years | $ | 2,480,167 | $ | 1,158,732 | $ | 1,321,435 |\\n| Trade names | 8 years | 138,206 | 78,355 | 59,851 |\\n| Developed technology | 5 years | 13,260 | 8,206 | 5,054 |\\n| Covenant not to compete | 5 years | 6,100 | 4,926 | 1,174 |\\n| Total finite-lived intangible assets | 2,637,733 | 1,250,219 | 1,387,514 |\\n| Indefinite-lived intangible assets: |\\n| Trade names | 900,000 | — | 900,000 |\\n| Total other intangible assets | $ | 3,537,733 | $ | 1,250,219 | $ | 2,287,514 |\\n| (in thousands) |\\n| Remainder of 2022 | $ | 49,782 |\\n| 2023 | 197,530 |\\n| 2024 | 196,181 |\\n| 2025 | 190,153 |\\n| 2026 | 186,203 |\\n| Thereafter | 430,226 |\\n| Total amortization expense | $ | 1,250,075 |\\n\\n\\n| September 30, | December 31, |\\n| (in thousands) | 2022 | 2021 |\\n| Term Loan Facility | $ | 1,301,813 | $ | 1,311,750 |\\n| Notes | 775,000 | 775,000 |\\n| Government loans for COVID-19 relief | 4,113 | 5,212 |\\n| Other | 1,492 | 1,113 |\\n| Total long-term debt | 2,082,418 | 2,093,075 |\\n| Less: current portion | 14,704 | 14,397 |\\n| Less: debt issuance costs | 43,123 | 49,796 |\\n| Long-term debt, net of current portion | $ | 2,024,591 | $ | 2,028,882 |\\n\\n| September 30, 2022 |\\n| (in thousands) | Fair Value | Level 1 | Level 2 | Level 3 |\\n| Assets measured at fair value |\\n| Derivative financial instruments | $ | 49,149 | $ | — | $ | 49,149 | $ | — |\\n| Total assets measured at fair value | $ | 49,149 | $ | — | $ | 49,149 | $ | — |\\n| Liabilities measured at fair value |\\n| Warrant liability | $ | 733 | $ | — | $ | 733 | $ | — |\\n| Contingent consideration liabilities | 40,431 | — | — | 40,431 |\\n| Total liabilities measured at fair value | $ | 41,164 | $ | — | $ | 733 | $ | 40,431 |\\n| December 31, 2021 |\\n| (in thousands) | Fair Value | Level 1 | Level 2 | Level 3 |\\n| Assets measured at fair value |\\n| Derivative financial instruments | $ | 10,164 | $ | — | $ | 10,164 | $ | — |\\n| Total assets measured at fair value | $ | 10,164 | $ | — | $ | 10,164 | $ | — |\\n| Liabilities measured at fair value |\\n| Derivative financial instruments | $ | 385 | $ | — | $ | 385 | $ | — |\\n| Warrant liability | 22,189 | — | — | 22,189 |\\n| Contingent consideration liabilities | 58,366 | — | — | 58,366 |\\n| Total liabilities measured at fair value | $ | 80,940 | $ | — | $ | 385 | $ | 80,555 |\\n| September 30, |\\n| (in thousands) | 2022 | 2021 |\\n| Beginning of the period | $ | 58,366 | $ | 45,901 |\\n| Fair value of acquisitions | 510 | 19,883 |\\n| Changes in fair value | 5,448 | 6,977 |\\n| Payments | ( 23,164 | ) | ( 6,399 | ) |\\n| Measurement period adjustments | — | ( 1,181 | ) |\\n| Foreign exchange translation effects | ( 729 | ) | ( 69 | ) |\\n| End of the period | $ | 40,431 | $ | 65,112 |\\n| (in thousands) | Carrying Value | Fair Value(Level 2) |\\n| Balance at September 30, 2022 |\\n| Term Loan Facility | $ | 1,301,813 | $ | 1,329,741 |\\n| Notes | 775,000 | 723,486 |\\n| Government loans for COVID-19 relief | 4,113 | 4,306 |\\n| Other | 1,492 | 1,492 |\\n| Total long-term debt | $ | 2,082,418 | $ | 2,059,025 |\\n| (in thousands) | Carrying Value | Fair Value(Level 2) |\\n| Balance at December 31, 2021 |\\n| Term Loan Facility | $ | 1,311,750 | $ | 1,406,552 |\\n| Notes | 775,000 | 894,611 |\\n| Government loans for COVID-19 relief | 5,212 | 5,615 |\\n| Other | 1,113 | 1,113 |\\n| Total long-term debt | $ | 2,093,075 | $ | 2,307,891 |\\n\\n\\n| Revenues | Accounts Receivable |\\n| Three Months Ended September 30, | Nine Months Ended September 30, | As of September 30, | As of December 31, |\\n| (in thousands) | 2022 | 2021 | 2022 | 2021 | 2022 | 2021 |\\n| Client 1 | $ | 450 | $ | — | $ | 1,275 | $ | — | $ | 301 | $ | 176 |\\n| Client 2 | 136 | 42 | 668 | 75 | 289 | 160 |\\n| Client 3 | 147 | 124 | 455 | 457 | 129 | 190 |\\n| All other clients | 30 | 1,452 | 152 | 6,694 | 16 | 10 |\\n| Total | $ | 763 | $ | 1,618 | $ | 2,550 | $ | 7,226 | $ | 735 | $ | 536 |\\n\\n8. Income TaxesThe Company’s effective tax rates were 4.7 % and 25.4 % for the three months ended September 30, 2022 and 2021, respectively. The effective tax rate is based upon the estimated income or loss before taxes for the year, by jurisdiction, and adjusted for estimated permanent tax adjustments. The fluctuation in the Company’s effective tax rate was primarily due to the three months pretax book income differences and the discrete impact of $ 5.0 million to remeasure the deferred tax liability as a result of a reduction in the Company's blended state tax rate driven primarily by a Pennsylvania statutory tax rate change for the three months ended September 30, 2022, no t included in the three months ended September 30, 2021.The Company’s effective tax rates were 20.6 % and 36.0 % for the nine months ended September 30, 2022 and 2021, respectively. The effective tax rate is based upon the estimated income or loss before taxes for the year, by jurisdiction, and adjusted for estimated permanent tax adjustments. The fluctuation in the Company’s effective tax rate was primarily due to the nine months pretax book income differences, the discrete impact of $ 5.0 million to remeasure the deferred tax liability as a result of a reduction in the Company's blended state tax rate driven primarily by a Pennsylvania statutory tax rate change for the nine months ended September 30, 2022, offset by a shortfall adjustment of $ 2.4 million of stock based compensation for the nine months ended September 30, 2022. On August 16, 2022, the U.S. government enacted the Inflation Reduction Act (“IRA”), which imposes a new corporate alternative minimum tax (“CAMT”), an excise tax on stock buybacks, and significant tax incentives for energy and climate initiatives, among other provisions. The Company does not expect the CAMT to have a material impact on its consolidated financial statements.\\n| (in thousands) | Sales | Marketing | Total |\\n| Three Months Ended September 30, 2022 |\\n| Revenues | $ | 646,246 | $ | 404,849 | $ | 1,051,095 |\\n| Depreciation and amortization | $ | 39,798 | $ | 17,987 | $ | 57,785 |\\n| Operating income | $ | 31,765 | $ | 15,077 | $ | 46,842 |\\n| Three Months Ended September 30, 2021 |\\n| Revenues | $ | 597,139 | $ | 331,621 | $ | 928,760 |\\n| Depreciation and amortization | $ | 41,515 | $ | 17,648 | $ | 59,163 |\\n| Operating income | $ | 51,906 | $ | 13,696 | $ | 65,602 |\\n| (in thousands) | Sales | Marketing | Total |\\n| Nine Months Ended September 30, 2022 |\\n| Revenues | $ | 1,842,347 | $ | 1,104,632 | $ | 2,946,979 |\\n| Depreciation and amortization | $ | 121,310 | $ | 52,687 | $ | 173,997 |\\n| Operating income | $ | 65,915 | $ | 32,217 | $ | 98,132 |\\n| Nine Months Ended September 30, 2021 |\\n| Revenues | $ | 1,693,107 | $ | 876,628 | $ | 2,569,735 |\\n| Depreciation and amortization | $ | 128,789 | $ | 52,661 | $ | 181,450 |\\n| Operating income | $ | 131,727 | $ | 13,910 | $ | 145,637 |\\n\\n10. Commitments and ContingenciesLitigationThe Company is involved in various legal matters that arise in the ordinary course of its business. Some of these legal matters purport or may be determined to be class and/or representative actions, or seek substantial damages, or penalties. The Company has accrued amounts in connection with certain legal matters, including with respect to certain of the matters described below. There can be no assurance, however, that these accruals will be sufficient to cover such matters or other legal matters or that such matters or other legal matters will not materially or adversely affect the Company’s financial position, liquidity, or results of operations.Employment MattersThe Company has also been involved in various litigation, including purported class or representative actions with respect to matters arising under the California Labor Code and Private Attorneys General Act. The Company has retained outside counsel to represent it in these matters and is vigorously defending its interests. Legal Matters Related to Take 5On April 1, 2018, the Company acquired certain assets and assumed liabilities of Take 5 Media Group (“Take 5”). In June 2019, as a result of a review of internal allegations related to inconsistency of data provided by Take 5 to its clients, the Company commenced an investigation into Take 5’s operations. In July 2019, as a result of the Company’s investigation, the Company determined that revenue during the fiscal year ended December 31, 2018 attributable to the Take 5 business had been recognized for services that were not performed on behalf of clients of Take 5 and that inaccurate reports were made to Take 5 clients about those services (referred to as the “Take 5 Matter”). As a result of these findings, in July 2019, the Company terminated all operations of Take 5, including the use of its associated trade names and the offering of its services to its clients and offered refunds to Take 5 clients of collected revenues attributable to Take 5 since the Company’s acquisition of Take 5. 20 USAO and FBI Voluntary Disclosure and Investigation Related to Take 5The Company voluntarily disclosed to the United States Attorney’s Office and the Federal Bureau of Investigation certain misconduct occurring at Take 5, a line of business that the Company closed in July 2019. The Company intends to cooperate in this and any other governmental investigations that may arise in connection with the Take 5 Matter. At this time, the Company cannot predict the ultimate outcome of any investigation related to the Take 5 Matter and is unable to estimate the potential impact such an investigation may have on the Company. Arbitration Proceedings Related to Take 5In August 2019, as a result of the Take 5 Matter, the Company provided a written indemnification claim notice to the sellers of Take 5 (the “Take 5 Sellers”) seeking monetary damages (including interest, fees and costs) based on allegations of breach of the asset purchase agreement (the “Take 5 APA”), as well as fraud. In September 2019, the Take 5 Sellers initiated arbitration proceedings against the Company, alleging breach of the Take 5 APA as a result of the Company’s decision to terminate the operations of the Take 5 business, and seeking monetary damages equal to all unpaid earn-out payments under the Take 5 APA (plus interest, fees and costs). In 2020, the Take 5 sellers amended their statement of claim to allege defamation, relating to statements the Company made to customers in connection with terminating the operations of the Take 5 business, and seeking monetary damages for the alleged injury to their reputation. The Company filed its response to the Take 5 Sellers’ claims, and asserted indemnification, fraud and other claims against the Take 5 Sellers as counterclaims and cross-claims in the arbitration proceedings. In October 2022, the arbitrator made a final award in favor of the Company. The Company is currently unable to estimate if or when it will be able to collect any amounts associated with this arbitration. Other Legal Matters Related to Take 5The Take 5 Matter may result in additional litigation against the Company, including lawsuits from clients, or governmental investigations, which may expose the Company to potential liability in excess of the amounts being offered by the Company as refunds to Take 5 clients. The Company is currently unable to determine the amount of any potential liability, costs or expenses (above the amounts already being offered as refunds) that may result from any lawsuits or investigations associated with the Take 5 Matter or determine whether any such issues will have any future material adverse effect on the Company’s financial position, liquidity, or results of operations. Although the Company has insurance covering certain liabilities, the insurance may not be sufficient to cover any potential liability or expenses associated with the Take 5 Matter.\\n| (in thousands, except share and per share data) Performance Period | Number ofSharesThreshold | Number ofSharesTarget | Number ofSharesMaximum | WeightedAverage FairValue perShare | Maximum Remaining Unrecognized Compensation Expense | Weighted-average remaining requisite service periods |\\n| January 1, 2022— December 31, 2022 | 2,479,997 | 4,959,993 | 7,439,990 | $ | 5.63 | $ | 80,689 | 1.5 years |\\n| January 1, 2021— December 31, 2021 | 1,121,698 | 1,121,698 | 1,319,458 | $ | 13.17 | $ | 4,982 | 1.1 years |\\n| Performance Share Units | Weighted Average GrantDate Fair Value |\\n| Outstanding at January 1, 2022 | 2,609,079 | $ | 13.07 |\\n| Granted | 5,393,085 | $ | 5.66 |\\n| Distributed | 660,880 | $ | 13.09 |\\n| Forfeited | 684,261 | $ | 8.19 |\\n| PSU performance adjustment | ( 377,572 | ) | $ | 11.19 |\\n| Outstanding at September 30, 2022 | 6,279,451 | $ | 7.22 |\\n| Number of RSUs | Weighted Average GrantDate Fair Value |\\n| Outstanding at January 1, 2022 | 3,660,553 | $ | 10.64 |\\n| Granted | 6,302,801 | $ | 5.74 |\\n| Distributed | 1,338,213 | $ | 10.61 |\\n| Forfeited | 869,955 | $ | 8.02 |\\n| Outstanding at September 30, 2022 | 7,755,186 | $ | 6.96 |\\n| September 30, |\\n| 2022 |\\n| Share Price | $ | 5.99 |\\n| Dividend yield | 0.0 | % |\\n| Expected volatility | 30.0 | % |\\n| Risk-free interest rate | 2.0 | % |\\n| Expected term (years) | 6.5 |\\n\\n\\n| (in thousands) |\\n| Balance at January 1, 2022 | $ | 1,893 |\\n| Fair value at acquisition | 1,987 |\\n| Net income attributable to redeemable noncontrolling interests | 124 |\\n| Dividend distribution | ( 223 | ) |\\n| Foreign currency translation adjustment | ( 428 | ) |\\n| Balance at September 30, 2022 | $ | 3,353 |\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (in thousands, except share and earnings per share data) | 2022 | 2021 | 2022 | 2021 |\\n| Basic earnings per share computation: |\\n| Numerator: |\\n| Net income attributable to stockholders of Advantage Solutions Inc. | $ | 21,059 | $ | 23,311 | $ | 43,395 | $ | 29,316 |\\n| Denominator: |\\n| Weighted average common shares - basic | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\\n| Basic earnings per common share | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\\n| Diluted earnings per share computation: |\\n| Numerator: |\\n| Net income attributable to stockholders of Advantage Solutions Inc. | $ | 21,059 | $ | 23,311 | $ | 43,395 | $ | 29,316 |\\n| Denominator: |\\n| Weighted average common shares outstanding | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\\n| Performance and Restricted Stock Units | 602,566 | 1,450,668 | 496,968 | 1,335,011 |\\n| Employee stock purchase plan and stock options | 300,604 | 106,469 | 348,271 | 106,469 |\\n| Weighted average common shares - diluted | 319,725,065 | 320,120,634 | 319,190,804 | 319,654,817 |\\n| Diluted earnings per common share | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\\n\\n24\\n14. Subsequent EventsIn October 2022, the Company granted 2,153,900 RSUs and 1,170,000 stock options, with an estimated aggregate grant date fair value of $ 4.8 million and $ 1.2 million, respectively.\\n25\\n\\nITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\\nForward-Looking Statements\\nThis Quarterly Report on Form 10-Q (this “Quarterly Report”), including the section titled “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements that are based on current expectations, estimates, forecasts and projections about us, our future performance, our business, our beliefs and our management’s assumptions. Such words as “expect,” “anticipate,” “outlook,” “could,” “target,” “project,” “intend,” “plan,” “believe,” “seek,” “estimate,” “should,” “may,” “assume” and “continue” as well as variations of such words and similar expressions are intended to identify such forward-looking statements, although not all forward-looking statements contain such terms. These statements are not guarantees of future performance and they involve certain risks, uncertainties and assumptions that are difficult to predict. We have based our forward-looking statements on our management’s beliefs and assumptions based on information available to our management at the time the statements are made. We caution you that actual outcomes and results may differ materially from what is expressed, implied or forecasted by our forward-looking statements. More information regarding these risks and uncertainties and other important factors that could cause actual results to differ materially from those in the forward-looking statements is set forth in Part II, Item 1A “Risk Factors” of this report. Investors are cautioned not to place undue reliance on any such forward-looking statements, which speak only as of the date they are made. Except as required under the federal securities laws and the rules and regulations of the Securities and Exchange Commission, we do not have any intention or obligation to update publicly any forward-looking statements after the distribution of this report, whether as a result of new information, future events, changes in assumptions or otherwise.\\nExecutive Overview\\nWe are a leading business solutions provider to consumer goods manufacturers and retailers. We have a strong platform of competitively advantaged sales and marketing services built over multiple decades – essential, business critical services like headquarter sales, retail merchandising, in-store sampling, digital commerce and shopper marketing. For brands and retailers of all sizes, we help get the right products on the shelf (whether physical or digital) and into the hands of consumers (however they shop). We use a scaled platform to innovate as a trusted partner with our clients, solving problems to increase their efficiency and effectiveness across a broad range of channels.\\nWe have two reportable segments: sales and marketing.\\nThrough our sales segment, which generated approximately 62.5% and 65.9% of our total revenues in the nine months ended September 30, 2022 and 2021, respectively, we offer headquarter sales representation services to consumer goods manufacturers, for whom we prepare and present to retailers a business case to increase distribution of manufacturers’ products and optimize how they are displayed, priced and promoted. We also make in-store merchandising visits for both manufacturer and retailer clients to ensure the products we represent are adequately stocked and properly displayed.\\nThrough our marketing segment, which generated approximately 37.5% and 34.1% of our total revenues in the nine months ended September 30, 2022 and 2021, respectively, we help brands and retailers reach consumers through two main categories within the marketing segment. The first and largest category is our retail experiential business, also known as in-store sampling or demonstrations, where we manage highly customized large-scale sampling programs (both in-store and online) for leading retailers. The second category is our collection of specialized agency services, in which we provide private label services to retailers and develop granular marketing programs for brands and retailers through our shopper, consumer and digital marketing agencies.\\n26\\nBusiness Combination with Conyers Park\\nOn October 28, 2020, Conyers Park II Acquisition Corp. (“Conyers Park”), a Delaware corporation, consummated a merger with ASI Intermediate Corp. (“ASI”), formerly known as Advantage Solutions Inc., with ASI surviving the merger as a wholly owned subsidiary of Conyers Park (the “Merger” and, together with the other transactions contemplated by the merger agreement, the “Transactions”). On October 28, 2020, and in connection with the closing of the Transactions, Conyers Park changed its name to Advantage Solutions Inc.\\nImpacts of the COVID-19 Pandemic\\nBeginning in March 2020 and continuing through the first quarter of 2021, our services experienced the effects from reductions in client spending due to the economic impact related to the COVID-19 pandemic. While mixed by services and geography, the spending reductions impacted all of our services and markets. Globally, the most impacted services were our experiential services. Most services began to improve in April 2021, and the improvement has continued through the third quarter of 2022.\\nSummary\\nOur financial performance for the three months ended September 30, 2022 as compared to the three months ended September 30, 2021 includes:\\n•Revenues increased by $122.3 million, or 13.2%, to $1,051.1 million;\\n•Operating income decreased by $18.8 million, or 28.6%, to $46.8 million;\\n•Net income decreased by $1.1 million, or 4.5% to $23.2 million;\\n•Adjusted Net Income increased by $3.6 million, or 6.1%, to $62.7 million; and\\n•Adjusted EBITDA decreased by $15.5 million, or 11.6%, to $118.3 million.\\nOur financial performance for the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021 includes:\\n•Revenues increased by $377.2 million, or 14.7% to $2,947.0 million;\\n•Operating income decreased by $47.5 million, or 32.6% to $98.1 million;\\n•Net income increased by $14.9 million, or 50.5% to $44.4 million;\\n•Adjusted Net Income increased by $5.8 million, or 3.9% to $152.5 million; and\\n•Adjusted EBITDA decreased by $43.8 million, or 11.9% to $323.3 million.\\nDuring the nine months ended September 30, 2022, we acquired four businesses. The aggregate purchase price was $75.5 million, of which $74.1 million was paid in cash, $0.5 million in contingent consideration and $0.8 million in holdback.\\nFactors Affecting Our Business and Financial Reporting\\nThere are a number of factors, in addition to the impact of the COVID-19 pandemic and inflation, that affect the performance of our business and the comparability of our results from period to period including:\\n•Organic Growth. Part of our strategy is to generate organic growth by expanding our existing client relationships, continuing to win new clients, pursuing channel expansion and new industry opportunities, enhancing our digital technology solutions, developing our international platform, delivering operational efficiencies and expanding into logical adjacencies. We believe that by pursuing\\n27\\nthese organic growth opportunities we will be able to continue to enhance our value proposition to our clients and thereby grow our business.\\n•Acquisitions. We have grown and expect to continue to grow our business in part by acquiring quality businesses, both domestic and international. Excluding the 2017 acquisition of Daymon Worldwide Inc., we have completed 73 acquisitions from January 2014 to November 9, 2022, ranging in purchase prices from approximately $0.3 million to $98.5 million. Many of our acquisition agreements include contingent consideration arrangements, which are described below. We have completed acquisitions at what we believe are attractive purchase prices and have regularly structured our agreements to result in the generation of long-lived tax assets, which have in turn reduced our effective purchase prices when incorporating the value of those tax assets. We continue to look for strategic acquisitions that can be completed at attractive purchase prices.\\n•Contingent Consideration. Many of our acquisition agreements include contingent consideration arrangements, which are generally based on the achievement of financial performance thresholds by the operations attributable to the acquired businesses. The contingent consideration arrangements are based upon our valuations of the acquired businesses and are intended to share the investment risk with the sellers of such businesses if projected financial results are not achieved. The fair values of these contingent consideration arrangements are included as part of the purchase price of the acquired companies on their respective acquisition dates. For each transaction, we estimate the fair value of contingent consideration payments as part of the initial purchase price. We review and assess the estimated fair value of contingent consideration on a quarterly basis, and the updated fair value could differ materially from our initial estimates. Adjustments to the estimated fair value related to changes in all other unobservable inputs are reported in “Selling, general and administrative expenses” in our Condensed Consolidated Statements of Operations and Comprehensive Income.\\n•Depreciation and Amortization. As a result of the acquisition of our business by Karman Topco L.P. (“Topco”) on July 25, 2014 (the “2014 Topco Acquisition”), we acquired significant intangible assets, the value of which is amortized, on a straight-line basis, over 15 years from the date of the 2014 Topco Acquisition, unless determined to be indefinite-lived. The amortization of such intangible assets recorded in our consolidated financial statements has a significant impact on our operating income (loss) and net income (loss). Our historical acquisitions have increased, and future acquisitions likely will increase, our intangible assets. We do not believe the amortization expense associated with the intangibles created from our purchase accounting adjustments reflect a material economic cost to our business. Unlike depreciation expense which has an economic cost reflected by the fact that we must re-invest in property and equipment to maintain the asset base delivering our results of operations, we do not have any capital re-investment requirements associated with the acquired intangibles, such as client relationships and trade names, that comprise the majority of the finite-lived intangibles that create our amortization expense.\\n•Foreign Exchange Fluctuations. Our financial results are affected by fluctuations in the exchange rate between the U.S. dollar and other currencies, primarily Canadian dollars, British pounds and euros, due to our operations in such foreign jurisdictions. See also “ —Quantitative and Qualitative Disclosure of Market Risk—Foreign Currency Risk.”\\n•Seasonality. Our quarterly results are seasonal in nature, with the fourth fiscal quarter typically generating a higher proportion of our revenues than other fiscal quarters, as a result of higher consumer spending. We generally record slightly lower revenues in the first fiscal quarter of each year, as our clients begin to roll out new programs for the year, and consumer spending generally is less in the first fiscal quarter than other quarters. Timing of our clients’ marketing expenses, associated with marketing campaigns and new product launches, can also result in fluctuations from one quarter to another.\\n28\\nHow We Assess the Performance of Our Business\\nRevenues\\nRevenues related to our sales segment are primarily comprised of commissions, fee-for-service and cost-plus fees for providing retail merchandising services, category and space management, headquarter relationship management, technology solutions and administrative services. A small portion of our arrangements include performance incentive provisions, which allow us to earn additional revenues on our performance relative to specified quantitative or qualitative goals. We recognize the incentive portion of revenues under these arrangements when the related services are transferred to the customer.\\nMarketing segment revenues are primarily recognized in the form of a fee-for-service (including retainer fees, fees charged to clients based on hours incurred, project-based fees or fees for executing in-person consumer engagements or experiences, which engagements or experiences we refer to as events), commissions or on a cost-plus basis, in each case, related to services including experiential marketing, shopper and consumer marketing services, private label development or our digital, social and media services.\\nGiven our acquisition strategy, we analyze our financial performance, in part, by measuring revenue growth in two ways—revenue growth attributable to organic activities and revenue growth attributable to acquisitions, which we refer to as organic revenues and acquired revenues, respectively.\\nWe define organic revenues as any revenues that are not acquired revenues. Our organic revenues exclude the impacts of acquisitions and divestitures, when applicable, which improves comparability of our results from period to period.\\nIn general, when we acquire a business, the acquisition includes a contingent consideration arrangement (e.g., an earn-out provision) and, accordingly, we separately track the relevant metrics associated with the earnout agreement of the acquired business. In such cases, we consider revenues generated by such a business during the 12 months following its acquisition to be acquired revenues. For example, if we completed an acquisition on July 1, 2021 for a business that included a contingent consideration arrangement, we would consider revenues from the acquired business from July 1, 2021 to June 30, 2022 to be acquired revenues. We generally consider growth attributable to the financial performance of an acquired business after the 12-month anniversary of the date of acquisition to be organic.\\nIn limited cases, when the acquisition of an acquired business does not include a contingent consideration arrangement, or we otherwise do not separately track the financial performance of the acquired business due to operational integration, we consider the revenues that the business generated in the 12 months prior to its acquisition to be our acquired revenues for the 12 months following its acquisition, and any differences in revenues actually generated during the 12 months after its acquisition to be organic. For example, if we completed an acquisition on July 1, 2021 for a business that did not include a contingent consideration arrangement, we would consider the amount of revenues from the acquired business from July 1, 2020 to June 30, 2021 to be acquired revenues during the period from July 1, 2021 to June 30, 2022, with any differences from that amount actually generated during the latter period to be organic revenues.\\nAll revenues generated by our acquired businesses are considered to be organic revenues after the 12-month anniversary of the date of acquisition.\\nWhen we divest a business, we consider the revenues that the divested business generated in the 12 months prior to its divestiture to be subtracted from acquired revenues for the 12 months following its divestiture. For example, if we completed a divestiture on July 1, 2021 for a business, we would consider the amount of revenues from the divested business from July 1, 2020 to June 30, 2021 to be subtracted from acquired revenues during the period from July 1, 2021 to June 30, 2022.\\nWe measure organic revenue growth and acquired revenue growth by comparing the organic revenues or acquired revenues, respectively, period over period, net of any divestitures.\\n29\\nCost of Revenues\\nOur cost of revenues consists of both fixed and variable expenses primarily attributable to the hiring, training, compensation and benefits provided to both full-time and part-time associates, as well as other project-related expenses. A number of costs associated with our associates are subject to external factors, including inflation, increases in market specific wages and minimum wage rates at federal, state and municipal levels and minimum pay levels for exempt roles. Additionally, when we enter into certain new client relationships, we may experience an initial increase in expenses associated with hiring, training and other items needed to launch the new relationship.\\nSelling, General and Administrative Expenses\\nSelling, general and administrative expenses consist primarily of salaries, payroll taxes and benefits for corporate personnel. Other overhead costs include information technology, occupancy costs for corporate personnel, professional services fees, including accounting and legal services, and other general corporate expenses. Additionally, included in selling, general and administrative expenses are costs associated with the changes in fair value of the contingent consideration of acquisitions and other acquisition-related costs. Acquisition-related costs are comprised of fees related to change of equity ownership, transaction costs, professional fees, due diligence and integration activities.\\nOther (Income) Expenses\\nChange in Fair Value of Warrant Liability\\nChange in fair value of warrant liability represents a non-cash (income) expense resulting from a fair value adjustment to warrant liability with respect to the private placement warrants. Based on the period of time the public warrants have now been trading, we determined the fair value of the liability classified private placement warrants by approximating the value with the share price of the public warrants at the respective period end, which is inherently less subjective and judgmental given it is based on observable inputs. Previously, the fair value of the warrant liability was based on the input assumptions used in the Black-Scholes option pricing model, including our stock price at the end of the reporting period, the implied volatility or other inputs to the model and the number of private placement warrants outstanding, which may vary from period to period. We believe these amounts are not correlated to future business operations.\\nInterest Expense\\nInterest expense relates primarily to borrowings under the Senior Secured Credit Facilities as described below. See “ —Liquidity and Capital Resources.”\\nDepreciation and Amortization\\nAmortization Expense\\nIncluded in our depreciation and amortization expense is amortization of acquired intangible assets. We have ascribed value to identifiable intangible assets other than goodwill in our purchase price allocations for companies we have acquired. These assets include, but are not limited to, client relationships and trade names. To the extent we ascribe value to identifiable intangible assets that have finite lives, we amortize those values over the estimated useful lives of the assets. Such amortization expense, although non-cash in the period expensed, directly impacts our results of operations. It is difficult to predict with any precision the amount of expense we may record relating to future acquired intangible assets.\\n30\\nAs a result of the 2014 Topco Acquisition, we acquired significant intangible assets, the value of which is amortized, on a straight-line basis, over 15 years from the date of the 2014 Topco Acquisition, unless determined to be indefinite-lived.\\nDepreciation Expense\\nDepreciation expense relates to the property and equipment that we own, which represented less than 1% of our total assets at September 30, 2022 and 2021, respectively.\\nIncome Taxes\\nIncome tax expense and our effective tax rates can be affected by many factors, including state apportionment factors, our acquisition strategy, tax incentives and credits available to us, changes in judgment regarding our ability to realize our deferred tax assets, changes in our worldwide mix of pre-tax losses or earnings, changes in existing tax laws and our assessment of uncertain tax positions.\\nCash Flows\\nWe have positive cash flow characteristics, as described below, due to the limited required capital investment in the fixed assets and working capital needs to operate our business in the normal course. See “ —Liquidity and Capital Resources.”\\nOur principal sources of liquidity are cash flows from operations, borrowings under the Revolving Credit Facility, and other debt. Our principal uses of cash are operating expenses, working capital requirements, acquisitions and repayment of debt.\\nAdjusted Net Income\\nAdjusted Net Income is a non-GAAP financial measure. Adjusted Net Income means Net income before (i) impairment of goodwill and indefinite-lived assets, (ii) amortization of intangible assets, (iii) equity-based compensation of Topco, (iv) changes in fair value of warrant liability, (v) fair value adjustments of contingent consideration related to acquisitions, (vi) acquisition-related expenses, (vii) costs associated with COVID-19, net of benefits received, (viii) EBITDA for economic interests in investments, (ix) restructuring expenses, (x) litigation expenses (recovery), (xi) costs associated with the Take 5 Matter, (xii) related tax adjustments and (xiii) other adjustments that management believes are helpful in evaluating our operating performance.\\nWe present Adjusted Net Income because we use it as a supplemental measure to evaluate the performance of our business in a way that also considers our ability to generate profit without the impact of items that we do not believe are indicative of our operating performance or are unusual or infrequent in nature and aid in the comparability of our performance from period to period. Adjusted Net Income should not be considered as an alternative for Net income, our most directly comparable measure presented on a GAAP basis.\\nAdjusted EBITDA and Adjusted EBITDA by Segment\\nAdjusted EBITDA and Adjusted EBITDA by segment are supplemental non-GAAP financial measures of our operating performance. Adjusted EBITDA means Net income before (i) interest expense, net, (ii) provision for income taxes, (iii) depreciation, (iv) impairment of goodwill and indefinite-lived assets, (v) amortization of intangible assets, (vi) equity-based compensation of Topco, (vii) changes in fair value of warrant liability, (viii) stock-based compensation expense, (ix) fair value adjustments of contingent consideration related to acquisitions, (x) acquisition-related expenses, (xi) costs associated with COVID-19, net of benefits received, (xii) EBITDA for economic interests in investments, (xiii) restructuring expenses, (xiv) litigation expenses (recovery), (xv) costs associated with the Take 5 Matter and (xvi) other adjustments that management believes are helpful in evaluating our operating performance.\\n31\\nWe present Adjusted EBITDA and Adjusted EBITDA by segment because they are key operating measures used by us to assess our financial performance. These measures adjust for items that we believe do not reflect the ongoing operating performance of our business, such as certain noncash items, unusual or infrequent items or items that change from period to period without any material relevance to our operating performance. We evaluate these measures in conjunction with our results according to GAAP because we believe they provide a more complete understanding of factors and trends affecting our business than GAAP measures alone. Furthermore, the agreements governing our indebtedness contain covenants and other tests based on measures substantially similar to Adjusted EBITDA. Neither Adjusted EBITDA nor Adjusted EBITDA by segment should be considered as an alternative for Net income, our most directly comparable measure presented on a GAAP basis.\\nResults of Operations for the Three and Nine Months Ended September 30, 2022 and 2021\\nThe following table sets forth items derived from the Company’s consolidated statements of operations for the three and nine months ended September 30, 2022 and 2021 in dollars and as a percentage of total revenues.\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (amounts in thousands) | 2022 | 2021 | 2022 | 2021 |\\n| Revenues | $ | 1,051,095 | 100.0 | % | $ | 928,760 | 100.0 | % | $ | 2,946,979 | 100.0 | % | $ | 2,569,735 | 100.0 | % |\\n| Cost of revenues | 908,523 | 86.4 | % | 766,253 | 82.5 | % | 2,536,256 | 86.1 | % | 2,117,818 | 82.4 | % |\\n| Selling, general, and administrative expenses | 37,945 | 3.6 | % | 37,742 | 4.1 | % | 138,594 | 4.7 | % | 124,830 | 4.9 | % |\\n| Depreciation and amortization | 57,785 | 5.5 | % | 59,163 | 6.4 | % | 173,997 | 5.9 | % | 181,450 | 7.1 | % |\\n| Total expenses | 1,004,253 | 95.5 | % | 863,158 | 92.9 | % | 2,848,847 | 96.7 | % | 2,424,098 | 94.3 | % |\\n| Operating income | 46,842 | 4.5 | % | 65,602 | 7.1 | % | 98,132 | 3.3 | % | 145,637 | 5.7 | % |\\n| Other (income) expenses: |\\n| Change in fair value of warrant liability | (1,100 | ) | (0.1 | )% | (3,491 | ) | (0.4 | )% | (21,456 | ) | (0.7 | )% | (5,024 | ) | (0.2 | )% |\\n| Interest expense, net | 23,557 | 2.2 | % | 36,490 | 3.9 | % | 63,628 | 2.2 | % | 104,544 | 4.1 | % |\\n| Total other expenses | 22,457 | 2.1 | % | 32,999 | 3.6 | % | 42,172 | 1.4 | % | 99,520 | 3.9 | % |\\n| Income before income taxes | 24,385 | 2.3 | % | 32,603 | 3.5 | % | 55,960 | 1.9 | % | 46,117 | 1.8 | % |\\n| Provision for income taxes | 1,158 | 0.1 | % | 8,276 | 0.9 | % | 11,523 | 0.4 | % | 16,582 | 0.6 | % |\\n| Net income | $ | 23,227 | 2.2 | % | $ | 24,327 | 2.6 | % | $ | 44,437 | 1.5 | % | $ | 29,535 | 1.1 | % |\\n| Other Financial Data |\\n| Adjusted Net Income(1) | $ | 62,682 | 6.0 | % | $ | 59,101 | 6.4 | % | $ | 152,541 | 5.2 | % | $ | 146,762 | 5.7 | % |\\n| Adjusted EBITDA(1) | $ | 118,268 | 11.3 | % | $ | 133,756 | 14.4 | % | $ | 323,329 | 11.0 | % | $ | 367,155 | 14.3 | % |\\n\\n(1)Adjusted Net Income and Adjusted EBITDA are financial measures that are not calculated in accordance with GAAP. For a discussion of our presentation of Adjusted Net Income and Adjusted EBITDA and reconciliations of Net income to Adjusted Net Income and Adjusted EBITDA, see “—Non-GAAP Financial Measures.”\\nComparison of the Three Months Ended September 30, 2022 and 2021\\nRevenues\\n\\n| Three Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 646,246 | $ | 597,139 | $ | 49,107 | 8.2 | % |\\n| Marketing | 404,849 | 331,621 | 73,228 | 22.1 | % |\\n| Total revenues | $ | 1,051,095 | $ | 928,760 | $ | 122,335 | 13.2 | % |\\n\\nTotal revenues increased by $122.3 million, or 13.2%, during the three months ended September 30, 2022, as compared to the three months ended September 30, 2021.\\nThe sales segment revenues increased $49.1 million during the three months ended September 30, 2022 as compared to the three months ended September 30, 2021, of which $23.6 million were revenues from acquired\\n32\\nbusinesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $17.0 million, the segment experienced an increase of $42.5 million in organic revenues primarily due to growth in our retail merchandising services and international businesses, partially offset by a decrease in our third party selling and retailing services.\\nThe marketing segment revenues increased $73.2 million during the three months ended September 30, 2022 as compared to the three months ended September 30, 2021, of which $11.0 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $5.7 million, the segment experienced an increase of $67.9 million in organic revenues. The increase in revenues was primarily due to an increase in our in-store product demonstration and sampling services which continue to recover from the temporary suspensions as a result of the COVID-19 pandemic, partially offset by a decrease in certain of our client media spend.\\nCost of Revenues\\nCost of revenues as a percentage of revenues for the three months ended September 30, 2022 was 86.4%, as compared to 82.5% for the three months ended September 30, 2021. The increase as a percentage of revenues was largely attributable to the change in the revenue mix of our services as a result of recoveries from the COVID-19 pandemic and acquired businesses, and the ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\\nSelling, General and Administrative Expenses\\nSelling, general and administrative expenses as a percentage of revenues for the three months ended September 30, 2022 was 3.6%, compared to 4.1% for the three months ended September 30, 2021, primarily due to the change in fair value adjustments related to contingent consideration and a decrease in legal fees associated with the Take 5 Matter.\\nDepreciation and Amortization Expense\\nDepreciation and amortization expense decreased by $1.4 million, or 2.3%, to $57.8 million for the three months ended September 30, 2022 compared to $59.2 million for the three months ended September 30, 2021, which stayed relatively consistent year over year.\\nOperating Income\\n\\n| Three Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 31,765 | $ | 51,906 | $ | (20,141 | ) | (38.8 | )% |\\n| Marketing | 15,077 | 13,696 | 1,381 | 10.1 | % |\\n| Total operating income | $ | 46,842 | $ | 65,602 | $ | (18,760 | ) | (28.6 | )% |\\n\\nIn the sales segment, the decrease in operating income during the three months ended September 30, 2022 was due to a shift in revenue mix and ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\\nIn the marketing segment, the increase in operating income during the three months ended September 30, 2022 was due to the growth in revenues, partially offset by the increase in cost of revenues as described above.\\nChange in Fair Value of Warrant Liability\\nChange in fair value of warrant liability represents $1.1 million of non-cash gain resulting from a fair value adjustment to warrant liability with respect to the private placement warrants for the three months ended September 30, 2022, approximating the fair value with the warrant price of the public warrants.\\n33\\nInterest Expense, net\\nInterest expense, net decreased $12.9 million, or 35.4%, to $23.6 million for the three months ended September 30, 2022, from $36.5 million for the three months ended September 30, 2021. The decrease in interest expense, net was primarily due to the increase in fair value changes in derivatives instruments.\\nProvision for Income Taxes\\nProvision for income taxes was $1.2 million for the three months ended September 30, 2022 as compared to $8.3 million of provision for income taxes for the three months ended September 30, 2021. The fluctuation was primarily attributable to the decrease in pre-tax income during the three months ended September 30, 2022 and decrease of $4.3 million of discrete items for the three months ended September 30, 2022.\\nNet Income\\nNet income was $23.2 million for the three months ended September 30, 2022, compared to net income of $24.3 million for the three months ended September 30, 2021. The decrease in net income was primarily driven by the decrease in operating income as described above, offset by the decrease in interest expense, net and provision for income taxes.\\nAdjusted Net Income\\nThe increase in Adjusted Net Income for the three months ended September 30, 2022 was attributable to the decrease in interest expense, net as described above. For a reconciliation of Adjusted Net Income to Net income, see “ —Non-GAAP Financial Measures.”\\nAdjusted EBITDA and Adjusted EBITDA by Segment\\n\\n| Three Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 76,172 | $ | 95,199 | $ | (19,027 | ) | (20.0 | )% |\\n| Marketing | 42,096 | 38,557 | 3,539 | 9.2 | % |\\n| Total Adjusted EBITDA | $ | 118,268 | $ | 133,756 | $ | (15,488 | ) | (11.6 | )% |\\n\\nAdjusted EBITDA decreased by $15.5 million, or 11.6%, to $118.3 million for the three months ended September 30, 2022, from $133.8 million for the three months ended September 30, 2021. In the sales segment, the decrease in Adjusted EBITDA was primarily attributable to the increase in cost of revenues as described above. In the marketing segment, the increase in the Adjusted EBITDA was primarily attributable to the growth in revenues as described above. For a reconciliation of Adjusted EBITDA to Net income, see “—Non-GAAP Financial Measures.”\\nComparison of the Nine Months Ended September 30, 2022 and 2021\\nRevenues\\n\\n| Nine Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 1,842,347 | $ | 1,693,107 | $ | 149,240 | 8.8 | % |\\n| Marketing | 1,104,632 | 876,628 | 228,004 | 26.0 | % |\\n| Total revenues | $ | 2,946,979 | $ | 2,569,735 | $ | 377,244 | 14.7 | % |\\n\\n34\\nTotal revenues increased by $377.2 million, or 14.7%, during the nine months ended September 30, 2022, as compared to the nine months ended September 30, 2021.\\nThe sales segment revenues increased $149.2 million during the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021, of which $114.2 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $33.9 million, the segment experienced an increase of $68.9 million in organic revenues primarily due to our European joint venture which experienced continued recoveries from temporary reduction in services as a result of the COVID-19 pandemic and growth in our retail merchandising services partially offset by a decrease in our foodservice and third party selling and retailing services.\\nThe marketing segment revenues increased $228.0 million during the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021, of which $23.1 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $11.6 million, the segment experienced an increase of $216.5 million in organic revenues. The increase in revenues was primarily due to an increase in our in-store product demonstration and sampling services which continue to recover from the temporary suspensions as a result of the COVID-19 pandemic, partially offset by a decrease in certain of our client media spend.\\nCost of Revenues\\nCost of revenues as a percentage of revenues for the nine months ended September 30, 2022 was 86.1%, as compared to 82.4% for the nine months ended September 30, 2021. The increase as a percentage of revenues was largely attributable to the change in the revenue mix of our services as a result of recoveries from the COVID-19 pandemic and acquired businesses, and the ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\\nSelling, General and Administrative Expenses\\nSelling, general and administrative expenses as a percentage of revenues for the nine months ended September 30, 2022 was 4.7%, compared to 4.9% for the nine months ended September 30, 2021.\\nDepreciation and Amortization Expense\\nDepreciation and amortization expense decreased by $7.5 million or 4.1% to $174.0 million for the nine months ended September 30, 2022 compared to $181.5 million for the nine months ended September 30, 2021. The decrease was primarily due to a decrease in depreciation expenses from our internally developed software.\\nOperating Income\\n\\n| Nine Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 65,915 | $ | 131,727 | $ | (65,812 | ) | (50.0 | %) |\\n| Marketing | 32,217 | 13,910 | 18,307 | 131.6 | % |\\n| Total operating income | $ | 98,132 | $ | 145,637 | $ | (47,505 | ) | (32.6 | %) |\\n\\nIn the sales segment, the decrease in operating income during the nine months ended September 30, 2022 was primarily attributable to a shift in revenue mix, ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses, the change in fair value adjustments related to contingent consideration, and an increase in stock-based compensation expense, partially offset by a decrease in depreciation expense.\\n35\\nIn the marketing segment, the increase in operating income during the nine months ended September 30, 2022 was primarily attributable to the growth in revenues, partially offset by the increase in cost of revenues as described above and the change in fair value adjustments related to contingent consideration.\\nChange in Fair Value of Warrant Liability\\nChange in fair value of warrant liability represents $21.5 million of non-cash gain resulting from a fair value adjustment to warrant liability with respect to the private placement warrants for the nine months ended September 30, 2022, approximating the fair value with the warrant price of the public warrants.\\nInterest Expense, net\\nInterest expense, net decreased $40.9 million, or 39.1%, to $63.6 million for the nine months ended September 30, 2022, from $104.5 million for the nine months ended September 30, 2021. The decrease in interest expense, net was primarily due to the increase in fair value changes in derivatives instruments.\\nProvision for Income Taxes\\nProvision for income taxes was $11.5 million for the nine months ended September 30, 2022 as compared to $16.6 million for the nine months ended September 30, 2021. The fluctuation was primarily attributable to the increase in pre-tax income during the nine months ended September 30, 2022, partially offset by a decrease of $7.4 million of discrete items.\\nNet Income\\nNet income was $44.4 million for the nine months ended September 30, 2022, compared to net income of $29.5 million for the nine months ended September 30, 2021. The increase in net income was primarily driven by the decrease in change in fair value of warrant liability, interest expense, net, and provision for income taxes, partially offset by the decrease in operating income as described above.\\nAdjusted Net Income\\nThe increase in Adjusted Net Income for the nine months ended September 30, 2022 was attributable to the decrease in change in fair value of warrant liability, and interest expense, net as described above. For a reconciliation of Adjusted Net Income to Net income, see “ —Non-GAAP Financial Measures.”\\nAdjusted EBITDA and Adjusted EBITDA by Segment\\n\\n| Nine Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 216,158 | $ | 268,798 | $ | (52,640 | ) | (19.6 | )% |\\n| Marketing | 107,171 | 98,357 | 8,814 | 9.0 | % |\\n| Total Adjusted EBITDA | $ | 323,329 | $ | 367,155 | $ | (43,826 | ) | (11.9 | )% |\\n\\nAdjusted EBITDA decreased by $43.8 million, or 11.9%, to $323.3 million for the nine months ended September 30, 2022, from $367.2 million for the nine months ended September 30, 2021. In the sales segment, the decrease in Adjusted EBITDA was primarily attributable to the increase in cost of revenues as described above. In the marketing segment, the increase in the Adjusted EBITDA was primarily attributable to the growth in revenues as described above. For a reconciliation of Adjusted EBITDA to Net income, see “—Non-GAAP Financial Measures.”\\n36\\nNon-GAAP Financial Measures\\nAdjusted Net Income is a non-GAAP financial measure. Adjusted Net Income means Net income before (i) impairment of goodwill and indefinite-lived assets, (ii) amortization of intangible assets, (iii) equity-based compensation of Topco, (iv) change in fair value of warrant liability, (v) fair value adjustments of contingent consideration related to acquisitions, (vi) acquisition-related expenses, (vii) costs associated with COVID-19, net of benefits received, (viii) EBITDA for economic interests in investments, (ix) restructuring expenses, (x) litigation expenses (recovery), (xi) costs associated with the Take 5 Matter, (xii) related tax adjustments and (xiii)other adjustments that management believes are helpful in evaluating our operating performance.\\nWe present Adjusted Net Income because we use it as a supplemental measure to evaluate the performance of our business in a way that also considers our ability to generate profit without the impact of items that we do not believe are indicative of our operating performance or are unusual or infrequent in nature and aid in the comparability of our performance from period to period. Adjusted Net Income should not be considered as an alternative for our Net income, our most directly comparable measure presented on a GAAP basis.\\nA reconciliation of Adjusted Net Income to Net income is provided in the following table:\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Net income | $ | 23,227 | $ | 24,327 | $ | 44,437 | $ | 29,535 |\\n| Less: Net income attributable to noncontrolling interest | 2,168 | 1,016 | 1,042 | 219 |\\n| Add: |\\n| Equity -based compensation of Karman Topco L.P.(a) | (828 | ) | (5,575 | ) | (7,142 | ) | (10,031 | ) |\\n| Change in fair value of warrant liability | (1,100 | ) | (3,491 | ) | (21,456 | ) | (5,024 | ) |\\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (340 | ) | 3,221 | 5,448 | 5,776 |\\n| Acquisition-related expenses(d) | 4,260 | 5,110 | 19,843 | 13,053 |\\n| Restructuring expenses(e) | 3,562 | (394 | ) | 4,458 | 10,636 |\\n| Litigation(f) | — | (92 | ) | (800 | ) | (910 | ) |\\n| Amortization of intangible assets(g) | 49,997 | 49,786 | 150,930 | 148,396 |\\n| Costs associated with COVID-19, net of benefits received(h) | 2,009 | 1,087 | 4,945 | (948 | ) |\\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\\n| Tax adjustments related to non-GAAP adjustments(j) | (16,215 | ) | (15,262 | ) | (49,168 | ) | (47,113 | ) |\\n| Adjusted Net Income | $ | 62,682 | $ | 59,101 | $ | 152,541 | $ | 146,762 |\\n\\nAdjusted EBITDA and Adjusted EBITDA by segment are supplemental non-GAAP financial measures of our operating performance. Adjusted EBITDA means Net income before (i) interest expense, net, (ii) provision for income taxes, (iii) depreciation, (iv) impairment of goodwill and indefinite-lived assets, (v) amortization of intangible assets, (vi) equity-based compensation of Topco, (vii) change in fair value of warrant liability, (viii) stock-based compensation expense, (ix) fair value adjustments of contingent consideration related to acquisitions, (x) acquisition-related expenses, (xi) costs associated with COVID-19, net of benefits received, (xii) EBITDA for economic interests in investments, (xiii) restructuring expenses, (xiv) litigation expenses (recovery), (xv) costs associated with the Take 5 Matter and (xvi) other adjustments that management believes are helpful in evaluating our operating performance.\\nWe present Adjusted EBITDA and Adjusted EBITDA by segment because they are key operating measures used by us to assess our financial performance. These measures adjust for items that we believe do not reflect the ongoing operating performance of our business, such as certain noncash items, unusual or infrequent items or items that change from period to period without any material relevance to our operating performance. We evaluate these measures in conjunction with our results according to GAAP because we believe they provide a more complete understanding of factors and trends affecting our business than GAAP measures alone. Furthermore, the agreements governing our indebtedness contain covenants and other tests based on measures substantially similar to\\n37\\nAdjusted EBITDA. Neither Adjusted EBITDA nor Adjusted EBITDA by segment should be considered as an alternative for our Net income, our most directly comparable measure presented on a GAAP basis.\\nA reconciliation of Adjusted EBITDA to Net income is provided in the following table:\\n\\n| Consolidated | Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Net income | $ | 23,227 | $ | 24,327 | $ | 44,437 | $ | 29,535 |\\n| Add: |\\n| Interest expense, net | 23,557 | 36,490 | 63,628 | 104,544 |\\n| Provision for income taxes | 1,158 | 8,276 | 11,523 | 16,582 |\\n| Depreciation and amortization | 57,785 | 59,163 | 173,997 | 181,450 |\\n| Equity-based compensation of Karman Topco L.P.(a) | (828 | ) | (5,575 | ) | (7,142 | ) | (10,031 | ) |\\n| Change in fair value of warrant liability | (1,100 | ) | (3,491 | ) | (21,456 | ) | (5,024 | ) |\\n| Stock-based compensation expense(b) | 7,174 | 7,854 | 29,906 | 25,497 |\\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (340 | ) | 3,221 | 5,448 | 5,776 |\\n| Acquisition-related expenses(d) | 4,260 | 5,110 | 19,843 | 13,053 |\\n| EBITDA for economic interests in investments(k) | (2,474 | ) | (3,620 | ) | (7,546 | ) | (6,616 | ) |\\n| Restructuring expenses(e) | 3,562 | (394 | ) | 4,458 | 10,636 |\\n| Litigation(f) | — | (92 | ) | (800 | ) | (910 | ) |\\n| Costs associated with COVID-19, net of benefits received(h) | 2,009 | 1,087 | 4,945 | (948 | ) |\\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\\n| Adjusted EBITDA | $ | 118,268 | $ | 133,756 | $ | 323,329 | $ | 367,155 |\\n\\nFinancial information by segment, including a reconciliation of Adjusted EBITDA by segment to operating income, the closest GAAP financial measure, is provided in the following table:\\n\\n| Sales Segment | Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Operating income | $ | 31,765 | $ | 51,906 | $ | 65,915 | $ | 131,727 |\\n| Add: |\\n| Depreciation and amortization | 39,798 | 41,515 | 121,310 | 128,789 |\\n| Equity-based compensation of Karman Topco L.P.(a) | (320 | ) | (4,844 | ) | (4,004 | ) | (7,360 | ) |\\n| Stock-based compensation expense(b) | 4,080 | 4,371 | 18,009 | 13,795 |\\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (1,901 | ) | 192 | 4,992 | (4,057 | ) |\\n| Acquisition-related expenses(d) | 2,880 | 3,899 | 13,734 | 9,499 |\\n| EBITDA for economic interests in investments(k) | (2,656 | ) | (3,832 | ) | (8,018 | ) | (7,429 | ) |\\n| Restructuring expenses(e) | 2,360 | 1,273 | 3,519 | 3,229 |\\n| Litigation(f) | — | (68 | ) | (100 | ) | (584 | ) |\\n| Costs associated with COVID-19, net of benefits received(h) | 166 | 787 | 801 | 1,189 |\\n| Sales Segment Adjusted EBITDA | $ | 76,172 | $ | 95,199 | $ | 216,158 | $ | 268,798 |\\n\\n38\\n\\n| Marketing Segment | Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Operating income | $ | 15,077 | $ | 13,696 | $ | 32,217 | $ | 13,910 |\\n| Add: |\\n| Depreciation and amortization | 17,987 | 17,648 | 52,687 | 52,661 |\\n| Equity-based compensation of Karman Topco L.P.(a) | (508 | ) | (731 | ) | (3,138 | ) | (2,671 | ) |\\n| Stock-based compensation expense(b) | 3,094 | 3,483 | 11,897 | 11,702 |\\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | 1,561 | 3,029 | 456 | 9,833 |\\n| Acquisition-related expenses(d) | 1,380 | 1,211 | 6,109 | 3,554 |\\n| EBITDA for economic interests in investments(k) | 182 | 212 | 472 | 813 |\\n| Restructuring expenses(e) | 1,202 | (1,667 | ) | 939 | 7,407 |\\n| Litigation(f) | — | (24 | ) | (700 | ) | (326 | ) |\\n| Costs associated with COVID-19, net of benefits received(h) | 1,843 | 300 | 4,144 | (2,137 | ) |\\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\\n| Marketing Segment Adjusted EBITDA | $ | 42,096 | $ | 38,557 | $ | 107,171 | $ | 98,357 |\\n\\n\\n\\n\\n| (a) | Represents expenses related to (i) equity-based compensation expense associated with grants of Common Series D Units of Topco made to one of the Advantage Sponsors (as defined below) and (ii) equity-based compensation expense associated with the Common Series C Units of Topco. |\\n| (b) | Represents non-cash compensation expense related to the 2020 Incentive Award Plan and the 2020 Employee Stock Purchase Plan. |\\n| (c) | Represents adjustments to the estimated fair value of our contingent consideration liabilities related to our acquisitions. See Note 6—Fair Value of Financial Instruments to our unaudited condensed financial statements for the three and nine months ended September 30, 2022 and 2021. |\\n| (d) | Represents fees and costs associated with activities related to our acquisitions and restructuring activities, including professional fees, due diligence, and integration activities. |\\n| (e) | Represents fees and costs associated with various internal reorganization activities among our consolidated entities. |\\n| (f) | Represents legal settlements that are unusual or infrequent costs associated with our operating activities. |\\n| (g) | Represents the amortization of intangible assets recorded in connection with the 2014 Topco Acquisition and our other acquisitions. |\\n| (h) | Represents (i) costs related to implementation of strategies for workplace safety in response to COVID-19, including employee-relief fund, additional sick pay for front-line associates, medical benefit payments for furloughed associates, and personal protective equipment; and (ii) benefits received from government grants for COVID-19 relief. |\\n| (i) | Represents costs associated with the Take 5 Matter, primarily, professional fees and other related costs, for the three and nine months ended September 30, 2022 and 2021, respectively. |\\n| (j) | Represents the tax provision or benefit associated with the adjustments above, taking into account the Company’s applicable tax rates, after excluding adjustments related to items that do not have a related tax impact. |\\n| (k) | Represents additions to reflect our proportional share of Adjusted EBITDA related to our equity method investments and reductions to remove the Adjusted EBITDA related to the minority ownership percentage of the entities that we fully consolidate in our financial statements. |\\n\\n39\\nLiquidity and Capital Resources\\nOur principal sources of liquidity were cash flows from operations, borrowings under the Revolving Credit Facility, and other debt. Our principal uses of cash are operating expenses, working capital requirements, acquisitions, interest on debt and repayment of debt.\\nCash Flows\\nA summary of our cash operating, investing and financing activities are shown in the following table:\\n\\n| Nine Months Ended September 30, |\\n| (in thousands) | 2022 | 2021 |\\n| Net cash provided by operating activities | $ | 81,950 | $ | 101,068 |\\n| Net cash used in investing activities | (103,062 | ) | (66,152 | ) |\\n| Net cash used in financing activities | (32,920 | ) | (68,999 | ) |\\n| Net effect of foreign currency fluctuations on cash | (12,311 | ) | (1,476 | ) |\\n| Net change in cash, cash equivalents and restricted cash | $ | (66,343 | ) | $ | (35,559 | ) |\\n\\nNet Cash Provided by Operating Activities\\nNet cash used in operating activities during the nine months ended September 30, 2022 consisted of net income of $44.4 million adjusted for certain non-cash items, including depreciation and amortization of $174.0 million and effects of changes in working capital. Net cash provided by operating activities during the nine months ended September 30, 2021 consisted of net income of $29.5 million adjusted for certain non-cash items, including depreciation and amortization of $181.5 million and effects of changes in working capital. The decrease in cash provided by operating activities during the nine months ended September 30, 2022 relative to the same period in 2021 was primarily due to ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses during the nine months ended September 30, 2022.\\nNet Cash Used in Investing Activities\\nNet cash used in investing activities during the nine months ended September 30, 2022 primarily consisted of the purchase of businesses, net of cash acquired of $74.4 million and purchase of property and equipment of $30.0 million. Net cash used in investing activities during the nine months ended September 30, 2021 primarily consisted of the purchase of businesses, net of cash acquired of $40.0 million and purchase of property and equipment of $24.1 million.\\nNet Cash Used in Financing Activities\\nWe primarily finance our growth through cash flows from operations, however, we also incur long-term debt or borrow under lines of credit when necessary to execute acquisitions. Additionally, many of our acquisition agreements include contingent consideration arrangements, which are generally based on the achievement of future financial performance by the operations attributable to the acquired companies. The portion of the cash payment up to the acquisition date fair value of the contingent consideration liability are classified as financing outflows, and amounts paid in excess of the acquisition date fair value of that liability are classified as operating outflows.\\nCash flows used in financing activities during the nine months ended September 30, 2022 were primarily related to payments of contingent consideration and holdback payments of $31.7 million, repayment of principal on our Term Loan Facility of $9.9 million, partially offset by $3.3 million related to proceeds from the issuance of Class A common stock and $5.2 million of contribution from noncontrolling interest. Cash flows related to financing activities during the nine months ended September 30, 2021 were primarily related to borrowings of $51.7 million and repayment of $102.7 million on the Revolving Credit Facility and our lines of credit and $8.6 million related to payments of contingent consideration and holdback payments.\\n40\\nDescription of Credit Facilities\\nSenior Secured Credit Facilities\\nIn connection with the consummation of the Transactions, Advantage Sales & Marketing Inc. (the “Borrower”), an indirect wholly-owned subsidiary of the Company, entered into (i) a senior secured asset-based revolving credit facility in an aggregate principal amount of up to $400.0 million, subject to borrowing base capacity (as may be amended from time to time, the “Revolving Credit Facility”) and (ii) a secured first lien term loan credit facility in an aggregate principal amount of $1.325 billion (as may be amended from time to time, the “Term Loan Facility” and together with the Revolving Credit Facility, the “Senior Secured Credit Facilities”).\\nRevolving Credit Facility\\nOur Revolving Credit Facility provides for revolving loans and letters of credit in an aggregate amount of up to $400.0 million, subject to borrowing base capacity. Letters of credit are limited to the lesser of (a) $150.0 million and (b) the aggregate unused amount of commitments under our Revolving Credit Facility then in effect. Loans under the Revolving Credit Facility may be denominated in either U.S. dollars or Canadian dollars. Bank of America, N.A., is administrative agent and ABL Collateral Agent. The Revolving Credit Facility is scheduled to mature in October 2025. We may use borrowings under the Revolving Credit Facility to fund working capital and for other general corporate purposes, including permitted acquisitions and other investments. As of September 30, 2022, we had unused capacity under our Revolving Credit Facility available to us of $400.0 million, subject to borrowing base limitations (without giving effect to approximately $54.5 million of outstanding letters of credit and the borrowing base limitations for additional borrowings).\\nBorrowings under the Revolving Credit Facility are limited by borrowing base calculations based on the sum of specified percentages of eligible accounts receivable plus specified percentages of qualified cash, minus the amount of any applicable reserves. Borrowings will bear interest at a floating rate, which can be either an adjusted Eurodollar rate plus an applicable margin or, at the Borrower’s option, a base rate plus an applicable margin. The applicable margins for the Revolving Credit Facility are 2.00%, 2.25% or 2.50%, with respect to Eurodollar rate borrowings and 1.00%, 1.25% or 1.50%, with respect to base rate borrowings, in each case depending on average excess availability under the Revolving Credit Facility. The Borrower’s ability to draw under the Revolving Credit Facility or issue letters of credit thereunder will be conditioned upon, among other things, the Borrower’s delivery of prior written notice of a borrowing or issuance, as applicable, the Borrower’s ability to reaffirm the representations and warranties contained in the credit agreement governing the Revolving Credit Facility and the absence of any default or event of default thereunder.\\nThe Borrower’s obligations under the Revolving Credit Facility are guaranteed by Karman Intermediate Corp. (“Holdings”) and all of the Borrower’s direct and indirect wholly owned material U.S. subsidiaries (subject to certain permitted exceptions) and Canadian subsidiaries (subject to certain permitted exceptions, including exceptions based on immateriality thresholders of aggregate assets and revenues of Canadian subsidiaries) (the “Guarantors”). The Revolving Credit Facility is secured by a lien on substantially all of Holdings’, the Borrower’s and the Guarantors’ assets (subject to certain permitted exceptions). The Borrower’s Revolving Credit Facility has a first-priority lien on the current asset collateral and a second-priority lien on security interests in the fixed asset collateral (second in priority to the liens securing the Notes and the Term Loan Facility discussed below), in each case, subject to other permitted liens.\\nThe Revolving Credit Facility has the following fees: (i) an unused line fee of 0.375% or 0.250% per annum of the unused portion of the Revolving Credit Facility, depending on average excess availability under the Revolving Credit Facility; (ii) a letter of credit participation fee on the aggregate stated amount of each letter of credit equal to the applicable margin for adjusted Eurodollar rate loans, as applicable; and (iii) certain other customary fees and expenses of the lenders and agents thereunder.\\nThe Revolving Credit Facility contains customary covenants, including, but not limited to, restrictions on the Borrower’s ability and that of our subsidiaries to merge and consolidate with other companies, incur indebtedness, grant liens or security interests on assets, make acquisitions, loans, advances or investments, pay dividends, sell or\\n41\\notherwise transfer assets, optionally prepay or modify terms of any junior indebtedness, enter into transactions with affiliates or change our line of business. The Revolving Credit Facility will require the maintenance of a fixed charge coverage ratio (as set forth in the credit agreement governing the Revolving Credit Facility) of 1.00 to 1.00 at the end of each fiscal quarter when excess availability is less than the greater of $25 million and 10% of the lesser of the borrowing base and maximum borrowing capacity. Such fixed charge coverage ratio will be tested at the end of each quarter until such time as excess availability exceeds the level set forth above.\\nThe Revolving Credit Facility provides that, upon the occurrence of certain events of default, the Borrower’s obligations thereunder may be accelerated and the lending commitments terminated. Such events of default include payment defaults to the lenders thereunder, material inaccuracies of representations and warranties, covenant defaults, cross-defaults to other material indebtedness, voluntary and involuntary bankruptcy, insolvency, corporate arrangement, winding-up, liquidation or similar proceedings, material money judgments, material pension-plan events, certain change of control events and other customary events of default.\\nOn October 28, 2021, the Borrower and Holdings entered into the First Amendment to ABL Revolving Credit Agreement (the “ABL Amendment”), which amended the ABL Revolving Credit Agreement, dated October 28, 2020, by and among the Borrower, Holdings, the lenders from time to time party thereto and Bank of America, as administrative agent. The ABL Amendment was entered into by the Borrower to amend certain terms and provisions, including (i) reducing the interest rate floor for Eurocurrency rate loans from 0.50% to 0.00% and base rate loans from 1.50% to 1.00%, and (ii) updating the provisions by which U.S. Dollar LIBOR will eventually be replaced with the Secured Oversight Financing Rate (“SOFR”) or another interest rate benchmark to reflect the most recent standards and practices used in the industry.\\nTerm Loan Facility\\nThe Term Loan Facility is a term loan facility denominated in U.S. dollars in an aggregate principal amount of $1.325 billion. Borrowings under the Term Loan Facility amortize in equal quarterly installments in an amount equal to 1.00% per annum of the principal amount. Borrowings will bear interest at a floating rate, which can be either an adjusted Eurodollar rate plus an applicable margin or, at the Borrower’s option, a base rate plus an applicable margin. The applicable margins for the Term Loan Facility are 4.50% with respect to Eurodollar rate borrowings and 3.50% with respect to base rate borrowings.\\nThe Borrower may voluntarily prepay loans or reduce commitments under the Term Loan Facility, in whole or in part, subject to minimum amounts, with prior notice but without premium or penalty (other than a 1.00% premium on any prepayment in connection with a repricing transaction prior to the date that is six months after the effective date of the First Lien Amendment).\\nThe Borrower will be required to prepay the Term Loan Facility with 100% of the net cash proceeds of certain asset sales (such percentage subject to reduction based on the achievement of specific first lien net leverage ratios) and subject to certain reinvestment rights, 100% of the net cash proceeds of certain debt issuances and 50% of excess cash flow (such percentage subject to reduction based on the achievement of specific first lien net leverage ratios).\\nThe Borrower’s obligations under the Term Loan Facility are guaranteed by Holdings and the Guarantors. Our Term Loan Facility is secured by a lien on substantially all of Holdings’, the Borrower’s and the Guarantors’ assets (subject to certain permitted exceptions). The Term Loan Facility has a first-priority lien on the fixed asset collateral (equal in priority with the liens securing the Notes) and a second-priority lien on security interests in the current asset collateral (second in priority to the liens securing the Revolving Credit Facility), in each case, subject to other permitted liens.\\nThe Term Loan Facility contains certain customary negative covenants, including, but not limited to, restrictions on the Borrower’s ability and that of our restricted subsidiaries to merge and consolidate with other companies, incur indebtedness, grant liens or security interests on assets, pay dividends or make other restricted payments, sell or otherwise transfer assets or enter into transactions with affiliates.\\n42\\nThe Term Loan Facility provides that, upon the occurrence of certain events of default, the Borrower’s obligations thereunder may be accelerated. Such events of default will include payment defaults to the lenders thereunder, material inaccuracies of representations and warranties, covenant defaults, cross-defaults to other material indebtedness, voluntary and involuntary bankruptcy, insolvency, corporate arrangement, winding-up, liquidation or similar proceedings, material money judgments, change of control and other customary events of default.\\nOn October 28, 2021 (the “First Lien Amendment Effective Date”), the Borrower, Holdings, and certain of the Borrower’s subsidiaries, entered into Amendment No. 1 to the First Lien Credit Agreement (the “First Lien Amendment”), which amended the First Lien Credit Agreement, dated October 28, 2020, by and among the Borrower, Holdings, Bank of America, as administrative agent and collateral agent, each lender party from time to time thereto, and the other parties thereto. The First Lien Amendment was entered into by the Borrower to reduce the applicable interest rate on the term loan to 5.25% per annum, resulting in estimated interest savings of approximately $9.9 million or $7.3 million, net of tax, per annum. Additional terms and provisions amended include (i) resetting the period for six months following the First Lien Amendment Effective Date in which a 1.00% prepayment premium shall apply to any prepayment of the term loan in connection with certain repricing events, and (ii) updating the provisions by which U.S. Dollar LIBOR will eventually be replaced with SOFR or another interest rate benchmark to reflect the most recent standards and practices used in the industry and by Bank of America.\\nSenior Secured Notes\\nIn connection with the Transactions, Advantage Solutions FinCo LLC (“Finco”) issued $775.0 million aggregate principal amount of 6.50% Senior Secured Notes due 2028 (the “Notes”). Substantially concurrently with the Transactions, Finco merged with and into Advantage Sales & Marketing Inc. (in its capacity as the issuer of the Notes, the “Issuer”), with the Issuer continuing as the surviving entity and assuming the obligations of Finco. The Notes were sold to BofA Securities, Inc., Deutsche Bank Securities Inc., Morgan Stanley & Co. LLC and Apollo Global Securities, LLC. The Notes were resold to certain non-U.S. persons pursuant to Regulation S under the Securities Act of 1933, as amended (the “Securities Act”), and to persons reasonably believed to be qualified institutional buyers pursuant to Rule 144A under the Securities Act at a purchase price equal to 100% of their principal amount. The terms of the Notes are governed by an Indenture, dated as of October 28, 2020 (the “Indenture”), among Finco, the Issuer, the guarantors named therein (the “Notes Guarantors”) and Wilmington Trust, National Association, as trustee and collateral agent.\\nInterest and maturity\\nInterest on the Notes is payable semi-annually in arrears on May 15 and November 15 at a rate of 6.50% per annum, commencing on May 15, 2021. The Notes will mature on November 15, 2028.\\nGuarantees\\nThe Notes are guaranteed by Holdings and each of the Issuer’s direct and indirect wholly owned material U.S. subsidiaries (subject to certain permitted exceptions) and Canadian subsidiaries (subject to certain permitted exceptions, including exceptions based on immateriality thresholders of aggregate assets and revenues of Canadian subsidiaries) that is a borrower or guarantor under the Term Loan Facility.\\nSecurity and Ranking\\nThe Notes and the related guarantees are the general, senior secured obligations of the Issuer and the Notes Guarantors, are secured on a first-priority pari passu basis by security interests on the fixed asset collateral (equal in priority with liens securing the Term Loan Facility), and are secured on a second-priority basis by security interests on the current asset collateral (second in priority to the liens securing the Revolving Credit Facility and equal in priority with liens securing the Term Loan Facility), in each case, subject to certain limitations and exceptions and permitted liens.\\n43\\nThe Notes and related guarantees rank (i) equally in right of payment with all of the Issuer’s and the Guarantors’ senior indebtedness, without giving effect to collateral arrangements (including the Senior Secured Credit Facilities) and effectively equal to all of the Issuer’s and the Guarantors’ senior indebtedness secured on the same priority basis as the Notes, including the Term Loan Facility, (ii) effectively subordinated to any of the Issuer’s and the Guarantors’ indebtedness that is secured by assets that do not constitute collateral for the Notes to the extent of the value of the assets securing such indebtedness and to indebtedness that is secured by a senior-priority lien, including the Revolving Credit Facility to the extent of the value of the current asset collateral and (iii) structurally subordinated to the liabilities of the Issuer’s non-Guarantor subsidiaries.\\nOptional redemption for the Notes\\nThe Notes are redeemable on or after November 15, 2023 at the applicable redemption prices specified in the Indenture plus accrued and unpaid interest. The Notes may also be redeemed at any time prior to November 15, 2023 at a redemption price equal to 100% of the aggregate principal amount of such Notes to be redeemed plus a “make-whole” premium, plus accrued and unpaid interest. In addition, the Issuer may redeem up to 40% of the original aggregate principal amount of Notes before November 15, 2023 with the net cash proceeds of certain equity offerings at a redemption price equal to 106.5% of the aggregate principal amount of such Notes to be redeemed, plus accrued and unpaid interest. Furthermore, prior to November 15, 2023 the Issuer may redeem during each calendar year up to 10% of the original aggregate principal amount of the Notes at a redemption price equal to 103% of the aggregate principal amount of such Notes to be redeemed, plus accrued and unpaid interest. If the Issuer or its restricted subsidiaries sell certain of their respective assets or experience specific kinds of changes of control, subject to certain exceptions, the Issuer must offer to purchase the Notes at par. In connection with any offer to purchase all Notes, if holders of no less than 90% of the aggregate principal amount of Notes validly tender their Notes, the Issuer is entitled to redeem any remaining Notes at the price offered to each holder.\\nRestrictive covenants\\nThe Notes are subject to covenants that, among other things limit the Issuer’s ability and its restricted subsidiaries’ ability to: incur additional indebtedness or guarantee indebtedness; pay dividends or make other distributions in respect of, or repurchase or redeem, the Issuer’s or a parent entity’s capital stock; prepay, redeem or repurchase certain indebtedness; issue certain preferred stock or similar equity securities; make loans and investments; sell or otherwise dispose of assets; incur liens; enter into transactions with affiliates; enter into agreements restricting the Issuer’s subsidiaries’ ability to pay dividends; and consolidate, merge or sell all or substantially all of the Issuer’s assets. Most of these covenants will be suspended on the Notes so long as they have investment grade ratings from both Moody’s Investors Service, Inc. and S&P Global Ratings and so long as no default or event of default under the Indenture has occurred and is continuing.\\nEvents of default\\nThe following constitute events of default under the Notes, among others: default in the payment of interest; default in the payment of principal; failure to comply with covenants; failure to pay other indebtedness after final maturity or acceleration of other indebtedness exceeding a specified amount; certain events of bankruptcy; failure to pay a judgment for payment of money exceeding a specified aggregate amount; voidance of subsidiary guarantees; failure of any material provision of any security document or intercreditor agreement to be in full force and effect; and lack of perfection of liens on a material portion of the collateral, in each case subject to applicable grace periods.\\nFuture Cash Requirement\\nThere were no material changes to our contractual future cash requirements from those disclosed in our 2021 Annual Report.\\n44\\nCash and Cash Equivalents Held Outside the United States\\nAs of September 30, 2022 and December 31, 2021, $71.6 million and $86.2 million, respectively, of our cash and cash equivalents were held by foreign subsidiaries. As of September 30, 2022, and December 31, 2021, $21.6 million and $40.0 million, respectively, of our cash and cash equivalents were held by foreign branches.\\nWe assessed our determination as to our indefinite reinvestment intent for certain of our foreign subsidiaries and recorded a deferred tax liability of approximately $2.5 million of withholding tax as of December 31, 2021 for unremitted earnings in Canada with respect to which the Company does not have an indefinite reinvestment assertion. We will continue to evaluate our cash needs, however we currently do not intend, nor do we foresee a need, to repatriate funds from the foreign subsidiaries except for Canada. We have continued to assert indefinite reinvestment on all other earnings as it is necessary for continuing operations and to grow the business. If at a point in the future our assertion changes, we will evaluate tax-efficient means to repatriate the income. In addition, we expect existing domestic cash and cash flows from operations to continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, such as debt repayment and capital expenditures, for at least the next 12 months and thereafter for the foreseeable future.\\nIf we should require more capital in the United States than is generated by our domestic operations, for example, to fund significant discretionary activities such as business acquisitions, we could elect to repatriate future earnings from foreign jurisdictions. These alternatives could result in higher tax expense or increased interest expense. We consider the majority of the undistributed earnings of our foreign subsidiaries, as of December 31, 2021, to be indefinitely reinvested and, accordingly, no provision has been made for taxes in excess of the $2.5 million noted above.\\nOff-Balance Sheet Arrangements\\nWe do not have any off-balance sheet financing arrangements or liabilities, guarantee contracts, retained or contingent interests in transferred assets or any obligation arising out of a material variable interest in an unconsolidated entity. We do not have any majority-owned subsidiaries that are not included in our consolidated financial statements. Additionally, we do not have an interest in, or relationships with, any special-purpose entities.\\nCritical Accounting Policies and Estimates\\nOur critical accounting policies and estimates are included in our 2021 Annual Report and did not materially change during the nine months ended September 30, 2022.\\nRecently Issued Accounting Pronouncements\\nSee the information set forth in Note 1, Organization and Significant Accounting Policies – Recent Accounting Standards, to our unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2022 and 2021 included in “Part I, Financial Information—Item 1. Financial Statements” in this Quarterly Report.\\n45\\n\\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nForeign Currency Risk\\nOur exposure to foreign currency exchange rate fluctuations is primarily the result of foreign subsidiaries and foreign branches primarily domiciled in Europe and Canada. We use financial derivative instruments to hedge foreign currency exchange rate risks associated with our Canadian subsidiary.\\nThe assets and liabilities of our foreign subsidiaries and foreign branches, whose functional currencies are primarily Canadian dollars, British pounds and euros, respectively, are translated into U.S. dollars at exchange rates in effect at the balance sheet date. Income and expense items are translated at the average exchange rates prevailing during the period. The cumulative translation effects for subsidiaries using a functional currency other than the U.S. dollar are included in accumulated other comprehensive loss as a separate component of stockholders’ equity. We estimate that had the exchange rate in each country unfavorably changed by ten percent relative to the U.S. dollar, our consolidated income before taxes would have decreased by approximately $2.5 million for the nine months ended September 30, 2022.\\nInterest Rate Risk\\nInterest rate exposure relates primarily to the effect of interest rate changes on borrowings outstanding under the Term Loan Facility, Revolving Credit Facility and Notes.\\nWe manage our interest rate risk through the use of derivative financial instruments. Specifically, we have entered into interest rate cap agreements to manage our exposure to potential interest rate increases that may result from fluctuations in LIBOR. We do not designate these derivatives as hedges for accounting purposes, and as a result, all changes in the fair value of derivatives, used to hedge interest rates, are recorded in “Interest expense, net” in our Condensed Consolidated Statements of Operations and Comprehensive Income.\\nAs of September 30, 2022, we had interest rate cap contracts on an additional $650.0 million of notional value of principal from other financial institutions, with a maturity date of December 16, 2024 to manage our exposure to interest rate movements on variable rate credit facilities when one-month LIBOR on term loans exceeding a cap of 0.75%. The aggregate fair value of our interest rate caps represented an outstanding net asset of $49.1 million as of September 30, 2022.\\nHolding other variables constant, a change of one-eighth percentage point in the weighted average interest rate above the floor of 0.75% on the Term Loan Facility and Revolving Credit Facility would have resulted in an increase of $0.7 million in interest expense, net of gains from interest rate caps, for the nine months ended September 30, 2022.\\nIn the future, in order to manage our interest rate risk, we may refinance our existing debt, enter into additional interest rate cap agreements or modify our existing interest rate cap agreement. However, we do not intend or expect to enter into derivative or interest rate cap transactions for speculative purposes.\\n46\\n\\nITEM 4. CONTROLS AND PROCEDURES\\nOur management, with the participation of our chief executive officer and chief financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Quarterly Report. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of September 30, 2022, our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in reports we file or submit under the Exchange Act is (1) recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and (2) accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.\\nThere were no changes in internal control over financial reporting that occurred during the quarter ended September 30, 2022, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\\nIn designing and evaluating our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints, and that management is required to apply judgment in evaluating the benefits of possible controls and procedures relative to their costs.\\n47\\nPART II - OTHER INFORMATION\\n\\nITEM 1. LEGAL PROCEEDINGS\\nWe are involved in various legal matters that arise in the ordinary course of our business. Some of these legal matters purport or may be determined to be class and/or representative actions, or seek substantial damages or penalties. Some of these legal matters relate to disputes regarding acquisitions. In connection with certain of the below matters and other legal matters, we have accrued amounts that we believe are appropriate. There can be no assurance, however, that the above matters and other legal matters will not result in us having to make payments in excess of such accruals or that the above matters or other legal matters will not materially or adversely affect our business, financial position or results of operations.\\nEmployment-Related Matters\\nWe have also been involved in various litigation, including purported class or representative actions with respect to matters arising under the U.S. Fair Labor Standards Act, California’s Labor Code (the “Labor Code”) and California’s Labor Code Private Attorneys General Act (“PAGA”). Many involve allegations for allegedly failing to pay wages and/or overtime, failing to provide meal and rest breaks and failing to pay reporting time pay, waiting time penalties and other penalties.\\nA former employee filed a complaint in California Superior Court, Santa Clara County in July 2017, which seeks civil damages and penalties on behalf of the plaintiff and similarly situated persons for various alleged wage and hour violations under the Labor Code, including failure to pay wages and/or overtime, failure to provide meal and rest breaks, failure to pay reporting time pay, waiting time penalties and penalties pursuant to PAGA. We filed a motion for summary judgment. The court granted our motion for summary judgment in March 2020, and the plaintiff filed an appeal of the court’s ruling in May 2020. We have retained outside counsel to represent us and intend to vigorously defend our interests in this matter.\\nProceedings Relating to Take 5\\nThe following proceedings relate to the Take 5 Matter, which is discussed in greater detail in “PART I, Financial Information —Item 1. Financial Statements—Note 10. Commitments and Contingencies” and “Risk Factors — Risks Related to the Company’s Business and Industry” in this Quarterly Report.\\nUSAO and FBI Voluntary Disclosure and Investigation Related to Take 5\\nIn connection with the Take 5 Matter, we voluntarily disclosed to the United States Attorney’s Office and the Federal Bureau of Investigation certain misconduct occurring at Take 5. We intend to cooperate in this and any other governmental investigation that may arise in connection with the Take 5 Matter. At this time, we cannot predict the ultimate outcome of any investigation related to the Take 5 Matter and are unable to estimate the potential impact such an investigation may have on us.\\nArbitration Proceedings Related to Take 5\\nIn August 2019, as a result of the Take 5 Matter, we provided a written indemnification claim notice to the sellers of Take 5, or the Take 5 Sellers, seeking monetary damages (including interest, fees and costs) based on allegations of breach of the asset purchase agreement, or Take 5 APA, as well as fraud. In September 2019, the Take 5 Sellers initiated arbitration proceedings in the state of Delaware against us, alleging breach of the Take 5 APA as a result of our decision to terminate the operations of the Take 5 business and seeking monetary damages equal to all unpaid earn-out payments under the Take 5 APA (plus interest fees and costs). In 2020, the Take 5 Sellers amended their statement of claim to allege defamation, relating to statements we made to customers in connection with terminating the operations of the Take 5 business, and seeking monetary damages for the alleged injury to their reputation. We have filed our response to the Take 5 Sellers’ claims and asserted indemnification, fraud and other claims against the Take 5 Sellers as counterclaims and cross-claims in the arbitration proceedings.\\n48\\nIn October 2022, the arbitrator made a final award in our favor. We are currently unable to estimate if or when we will be able to collect any amounts associated with this arbitration.\\nOther Legal Matters Related to Take 5\\nThe Take 5 Matter may result in additional litigation against us, including lawsuits from clients, or governmental investigations, which may expose us to potential liability in excess of the amounts being offered by us as refunds to Take 5 clients. We are currently unable to determine the amount of any potential liability, costs or expenses (above the amounts already being offered as refunds) that may result from any lawsuits or investigations associated with the Take 5 Matter or determine whether any such issues will have any future material adverse effect on our financial position, liquidity or results of operations. Although we have insurance covering certain liabilities, we cannot assure that the insurance will be sufficient to cover any potential liability or expenses associated with the Take 5 Matter.\\n\\nITEM 1A. RISK FACTORS\\nInvesting in our securities involves risks. Before you make a decision regarding our securities, in addition to the risks and uncertainties discussed above under “Forward-Looking Statements,” you should carefully consider the specific risks set forth herein. If any of these risks actually occur, it may materially harm our business, financial condition, liquidity and results of operations. As a result, the market price of our securities could decline, and you could lose all or part of your investment. Additionally, the risks and uncertainties described in this Quarterly Report are not the only risks and uncertainties that we face. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may become material and adversely affect our business. The following discussion should be read in conjunction with the financial statements and notes to the financial statements included herein.\\nSummary of Principal Risks Associated with Our Business\\nSet forth below is a summary of some of the principal risks we face:\\n•the COVID-19 pandemic and the measures taken to mitigate its spread including its adverse effects on our business, results of operations, financial condition and liquidity;\\n•market-driven wage changes or changes to labor laws or wage or job classification regulations, including minimum wage;\\n•our ability to hire, timely train, and retain talented individuals for our workforce, and to maintain our corporate culture as we grow;\\n•developments with respect to retailers that are out of our control;\\n•our ability to continue to generate significant operating cash flow;\\n•consolidation within the industry of our clients creating pressure on the nature and pricing of our services;\\n•our reliance on continued access to retailers’ platforms;\\n•consumer goods manufacturers and retailers reviewing and changing their sales, retail, marketing, and technology programs and relationships;\\n•our ability to successfully develop and maintain relevant omni-channel services for our clients in an evolving industry and to otherwise adapt to significant technological change;\\n•client procurement strategies putting additional operational and financial pressure on our services;\\n•our ability to maintain proper and effective internal control over financial reporting in the future;\\n•potential and actual harms to our business arising from the matter related to the 2018 acquisition of Take 5 Media Group (the “Take 5 Matter”);\\n•our ability to identify attractive acquisition targets, acquire them at attractive prices, and successfully integrate the acquired businesses;\\n•our ability to avoid or manage business conflicts among competing brands;\\n49\\n•difficulties in integrating acquired businesses;\\n•our substantial indebtedness and our ability to refinance at favorable rates;\\n•limitations, restrictions, and business decisions involving our joint ventures and minority investments;\\n•our ability to respond to changes in digital practices and policies;\\n•exposure to foreign currency exchange rate fluctuations and risks related to our international operations;\\n•disruptions in global financial markets relating to terrorist attacks or geopolitical risk and the recent conflict between Russia and Ukraine;\\n•the ability to maintain applicable listing standards;\\n•changes in applicable laws or regulations; and\\n•the possibility that we may be adversely affected by other political, economic, business, and/or competitive factors.\\nRisks Related to the Company’s Business and Industry\\nThe COVID-19 pandemic and the measures taken to mitigate its spread have had, and are likely to continue to have, an adverse effect on our business, results of operations, financial condition and liquidity.\\nThe COVID-19 pandemic, including the measures taken to mitigate its spread, have had, and are likely to continue to have, adverse effects on our business and operations. There are many uncertainties regarding the current COVID-19 pandemic, including the scope of potential public health issues, the anticipated duration of the pandemic and the extent of local and worldwide social, political and economic disruption it has caused and may cause in the future. To date, the COVID-19 pandemic and measures taken to mitigate the spread of COVID-19, including restrictions on large gatherings, closures of face-to-face events and indoor dining facilities, “shelter in place” health orders and travel restrictions, have had far-reaching direct and indirect impacts on many aspects of our operations, including temporary termination of certain in-store demonstration services and other services, as well as on consumer behavior and purchasing patterns, in particular with respect to the foodservice industries, and declines in consumer demand for restaurant, school and hotel dining, where we promote our clients’ products. Since March 2020, our marketing segment has experienced a significant decline in revenues, primarily due to the temporary suspension or reduction of certain in-store demonstration services and decreased demand in our digital marketing services, both of which we believe were caused by the COVID-19 pandemic and the various governmental and private responses to the pandemic, and which may continue in the future. In our sales segment, we have experienced significant shifts in consumer spending preferences and habits. We can provide no assurances that the strength of that segment will continue or that we will be able to continue to evolve our business in the future as the COVID-19 pandemic continues to impact our clients’ businesses.\\nWe have taken several actions in response to these business disruptions, including reducing certain of our discretionary expenditures, reducing our real estate foot print, through lease terminations and amendments (including abandoning several office leases prior to reaching termination agreements with its landlords), eliminating non-essential travel and terminating, furloughing or instituting pay reductions and deferrals for some of our associates. However, the pandemic has had, and may continue to have, an adverse effect on our results of operations, including our revenues, our financial condition and liquidity.\\nThe COVID-19 pandemic also may have the effect of heightening many of the other risks described in these “Risk Factors”, including:\\n•potential changes in the policies of retailers in response to the COVID-19 pandemic, including changes to or restrictions on their outsourcing of sales and marketing functions and restrictions on the performance of in-store demonstration services, if permitted at all;\\n•potential changes in the demand for services by our clients in response to the COVID-19 pandemic;\\n•our ability to hire, timely train and retain talented individuals for our workforce;\\n•disruptions, delays and strains in certain domestic and internal supply changes that have had, and may continue to have, a negative effect on the flow or availability of certain products;\\n50\\n•the need for us to adapt to technological change and otherwise develop and maintain omni-channel solutions;\\n•our ability to generate sufficient cash to service our substantial indebtedness;\\n•our ability to maintain our credit rating;\\n•our ability to offer high-quality customer support and maintain our reputation;\\n•our ability to identify, perform adequate diligence on and consummate acquisitions of attractive business targets, and then subsequently integrate such acquired businesses;\\n•our ability to maintain our corporate culture;\\n•severe disruption and instability in the U.S. and global financial markets or deteriorations in credit and financing conditions, which could make it difficult for us to access debt and equity capital on attractive terms, or at all;\\n•our ability to effectively manage our operations while a significant amount of our associates continue to work remotely due to the COVID-19 pandemic;\\n•deteriorating economic conditions, declines in labor force participation rates, public transportation disruptions or other disruptions as a result of the COVID-19 pandemic;\\n•potential cost-saving strategies implemented by clients that reduce fees paid to third-party service providers such as ourselves; and\\n•our ability to implement additional internal control measures to improve our internal control over financial reporting.\\nWe cannot predict the full extent to which the COVID-19 pandemic may affect our business, financial condition, results of operations and liquidity as such effects will depend on how the COVID-19 pandemic and the measures taken in response to the COVID-19 pandemic continue to develop. However, these effects may continue, evolve or increase in severity, each of which could further negatively impact our business, financial condition, results of operations and liquidity.\\nMarket-driven wage increases and changes to wage or job classification regulations, including minimum wages could adversely affect our business, financial condition or results of operations.\\nMarket competition has and may continue to cause us to increase the salaries or wages paid to our associates or the benefits packages that they receive. If we experience further market-driven increases in salaries, wage rates or benefits or if we fail to increase our offered salaries, wages or benefits packages competitively, the quality of our workforce could decline, causing our client service to suffer. Low unemployment rates or lower levels of labor force participation rates may increase the likelihood or impact of such market pressures. Any of these changes affecting wages or benefits for our associates could adversely affect our business, financial condition or results of operations.\\nChanges in labor laws related to employee hours, wages, job classification and benefits, including health care benefits, could adversely affect our business, financial condition or results of operations. As of September 30, 2022, we employed approximately 75,000 associates, many of whom are paid above, but near, applicable minimum wages, and their wages may be affected by changes in minimum wage laws.\\nAdditionally, many of our salaried associates are paid at rates that could be impacted by changes to minimum pay levels for exempt roles. Certain state or municipal jurisdictions in which we operate have recently increased their minimum wage by a significant amount, and other jurisdictions are considering or plan to implement similar actions, which may increase our labor costs. Any increases at the federal, state or municipal level to the minimum pay rate required to remain exempt from overtime pay may adversely affect our business, financial condition or results of operations.\\nAn inability to hire, timely train and retain talented individuals for our workforce could slow our growth and adversely impact our ability to operate our business.\\nOur ability to meet our workforce needs, while controlling associate-related costs, including salaries, wages and benefits, is subject to numerous external factors, including the availability of talented persons in the workforce in the local markets in which we operate, prevailing unemployment rates and competitive wage rates in such\\n51\\nmarkets. We may find that there is an insufficient number of qualified individuals to fill our associate positions with the qualifications we seek. Competition in these communities for qualified staff could require us to pay higher wages and provide greater benefits, especially if there is significant improvement in regional or national economic conditions. We must also train and, in some circumstances, certify these associates under our policies and practices and any applicable legal requirements. If we are unable to hire, timely train or retain talented individuals may result in higher turnover and increased labor costs, and could compromise the quality of our service, all of which could adversely affect our business.\\nInflation may adversely affect our operating results.\\nInflationary factors such as increases in the labor costs, material costs and overhead costs may adversely affect our operating results. A high rate of inflation, including a continuation of inflation at the current rate, has had and may continue to have an adverse effect on our ability to maintain attractive levels of gross margin and general and administrative expenses as a percentage of total revenue, if we are unable to pass on these costs through increased prices, revised budget estimates, or offset them in other ways.\\nOur business and results of operations are affected by developments with and policies of retailers that are out of our control.\\nA limited number of national retailers account for a large percentage of sales for our consumer goods manufacturer clients. We expect that a significant portion of these clients’ sales will continue to be made through a relatively small number of retailers and that this percentage may increase if the growth of mass retailers and the trend of retailer consolidation continues. As a result, changes in the strategies of large retailers, including a reduction in the number of brands that these retailers carry or an increase in shelf space that they dedicate to private label products, could materially reduce the value of our services to these clients or these clients’ use of our services and, in turn, our revenues and profitability. Many retailers have critically analyzed the number and variety of brands they sell, and have reduced or discontinued the sale of certain of our clients’ product lines at their stores, and more retailers may continue to do so. If this continues to occur and these clients are unable to improve distribution for their products at other retailers, our business or results of operations could be adversely affected. These trends may be accelerated as a result of the COVID-19 pandemic.\\nAdditionally, many retailers, including several of the largest retailers in North America, which own and operate a significant number of the locations at which we provide our services, have implemented or may implement in the future, policies that designate certain service providers to be the exclusive provider or one of their preferred providers for specified services, including many of the services that we provide to such retailers or our clients.\\nSome of these designations apply across all of such retailers’ stores, while other designations are limited to specific regions. If we are unable to respond effectively to the expectations and demands of such retailers or if retailers do not designate us as their exclusive provider or one of their preferred providers for any reason, they could reduce or restrict the services that we are permitted to perform for our clients at their facilities or require our clients to purchase services from other designated services providers, which include our competitors, either of which could adversely affect our business or results of operations.\\nConsolidation in the industries we serve could put pressure on the pricing of our services, which could adversely affect our business, financial condition or results of operations.\\nConsolidation in the consumer goods and retail industries we serve could reduce aggregate demand for our services in the future and could adversely affect our business or our results of operations. In October 2022, The Kroger Co. and Albertsons Companies, Inc., two large retailers, announced an agreement to merge their businesses together with an anticipated closing in 2024. When companies consolidate, the services they previously purchased separately are often purchased by the combined entity, leading to the termination of relationships with certain service providers or demands for reduced fees and commissions. The combined company may also choose to insource certain functions that were historically outsourced, resulting in the termination of existing relationships with third-party service providers. While we attempt to mitigate the revenue impact of any consolidation by maintaining existing or winning new service arrangements with the combined companies, there can be no assurance as to the degree to which we will be able to do so as consolidation continues in the industries we serve, and our business, financial condition or results of operations may be adversely affected.\\n52\\nConsumer goods manufacturers and retailers may periodically review and change their sales, retail, marketing and technology programs and relationships to our detriment.\\nThe consumer goods manufacturers and retailers to whom we provide our business solutions operate in highly competitive and rapidly changing environments. From time to time these parties may put their sales, retail, marketing and technology programs and relationships up for competitive review, which may increase in frequency as a result of the COVID-19 pandemic and its impacts on the consumer goods manufacturers and retailer industries. We have occasionally lost accounts with significant clients as a result of these reviews in the past, and our clients are typically able to reduce or cancel current or future spending on our services on short notice for any reason. We believe that key competitive considerations for retaining existing and winning new accounts include our ability to develop solutions that meet the needs of these manufacturers and retailers in this environment, the quality and effectiveness of our services and our ability to operate efficiently. To the extent that we are not able to develop these solutions, maintain the quality and effectiveness of our services or operate efficiently, we may not be able to retain key clients, and our business, financial condition or results of operations may be adversely affected.\\nOur largest clients generate a significant portion of our revenues.\\nOur three largest clients generated approximately 11% of our revenues in the fiscal year ended December 31, 2021. These clients are generally able to reduce or cancel spending on our services on short notice for any reason. A significant reduction in spending on our services by our largest clients, or the loss of one or more of our largest clients, if not replaced by new clients or an increase in business from existing clients, would adversely affect our business and results of operations. In addition, when large retailers suspend or reduce in-store demonstration services, such as in response to the COVID-19 pandemic, our business and results of operations can be adversely affected.\\nWe are reliant on continued access to retailer platforms on commercially reasonable terms for the provision of certain of our e-commerce services in which our clients’ products are resold by us, as the vendor of record, directly to the consumer.\\nA portion of the e-commerce services we provide involve the purchase and resale by us, as the vendor of record, of our clients’ products through retailer platforms. The control that retailers such as Amazon have over the access and fee structures and/or pricing for products on their platforms could impact the volume of purchases of these products made on their platform and our revenues from the provision of such e-commerce services. If such retailers establish terms that restrict the offering of these products on their platform, significantly impact the financial terms on which such products are offered, or do not approve the inclusion of such products on their platform, our business could be negatively impacted. Additionally, we also generally rely on a retailer’s payment processing services for purchases made on its platform by consumers. To the extent such payment processing services are offered to us on less favorable terms, or become unavailable to us for any reason, our costs of revenue with respect to this aspect of our business could increase, and our margins could be materially adversely impacted. We cannot assure you that we will be successful in maintaining access to these retailer platforms on commercially reasonable terms, or at all.\\nThe retail industry is evolving, and if we do not successfully develop and maintain relevant omni-channel services for our clients, our business, financial condition or results of operations could be adversely impacted.\\nHistorically, substantially all of our sales segment revenues were generated by sales and services that ultimately occurred in traditional retail stores. The retail industry is evolving, as demonstrated by the number of retailers that offer both traditional retail stores and e-commerce platforms or exclusively e-commerce platforms. In addition, the COVID-19 pandemic has placed pressure on the traditional retail store model, including store closures, changes in consumer spending, and extensive health and safety risks and compliance requirements. Consumers are increasingly using computers, tablets, mobile phones and other devices to comparison shop, determine product availability and complete purchases online, a trend that has accelerated during the COVID-19 pandemic, and which may continue thereafter. If consumers continue to purchase more products online and e-commerce continues to displace brick-and-mortar retail sales, there may be a decrease in the demand for certain of our services. Omni-channel retailing is rapidly evolving and we believe we will need to keep pace with the changing consumer expectations and new developments by our competitors.\\n53\\nWhile we continue to seek to develop effective omni-channel solutions for our clients that support both their e-commerce and traditional retail needs, there can be no assurances that these efforts will result in revenue gains sufficient to offset potential decreases associated with a decline in traditional retail sales or that we will be able to maintain our position as a leader in our industry. If we are unable to provide, improve or develop innovative digital services and solutions in a timely manner or at all, our business, financial condition or results of operations could be adversely impacted.\\nWe may be unable to adapt to significant technological change, which could adversely affect our business, financial condition or results of operations.\\nWe operate businesses that require sophisticated data collection, processing and software for analysis and insights. Some of the technologies supporting the industries we serve are changing rapidly, particularly as a result of the COVID-19 pandemic. We will be required to continue to adapt to changing technologies, either by developing and marketing new services or by enhancing our existing services, to meet client demand.\\nMoreover, the introduction of new services embodying new technologies, including automation of certain of our in-store services, and the emergence of new industry standards could render existing services obsolete. Our continued success will depend on our ability to adapt to changing technologies, manage and process increasing amounts of data and information and improve the performance, features and reliability of our existing services in response to changing client and industry demands. We may experience difficulties that could delay or prevent the successful design, development, testing, introduction or marketing of our services. New services or enhancements to existing services may not adequately meet the requirements of current and prospective clients or achieve market acceptance.\\nOur ability to maintain our competitive position depends on our ability to attract and retain talented executives.\\nWe believe that our continued success depends to a significant extent upon the efforts, abilities and relationships of our senior executives and the strength of our middle management team. Although we have entered into employment agreements with certain of our senior executives, each of them may terminate their employment with us at any time. The replacement of any of our senior executives likely would involve significant time and costs and may significantly delay or prevent the achievement of our business objectives and could therefore have an adverse impact on our business. In addition, we do not carry any “key person” insurance policies that could offset potential loss of service under applicable circumstances. Furthermore, if we are unable to attract and retain a talented team of middle management executives, it may be difficult to maintain the expertise and industry relationships that our clients value, and they may terminate or reduce their relationship with us.\\nClient procurement and fee reduction strategies could put additional operational and financial pressure on our services or negatively impact our relationships, business, financial condition or results of operations.\\nMany of our clients seek opportunities to reduce their costs through procurement strategies that reduce fees paid to third-party service providers. As a result, certain of our clients have sought, and may continue to seek, more aggressive terms from us, including with respect to pricing and payment terms. Such activities put operational and financial pressure on our business, which could limit the amounts we earn or delay the timing of our cash receipts. Such activities may also cause disputes with our clients or negatively impact our relationships or financial results. Our clients have experienced, and may continue to experience, increases in their expenses associated with materials and logistics, which may cause them to reduce expenses elsewhere. While we attempt to mitigate negative implications to client relationships and the revenue impact of any pricing pressure by aligning our revenues opportunity with satisfactory client outcomes, there can be no assurance as to the degree to which we will be able to do so successfully. Additionally, price concessions can lead to margin compression, which in turn could adversely affect our business, financial condition or results of operations.\\nIf we fail to offer high-quality customer support, our business and reputation may suffer.\\nHigh-quality education, training and customer support are important for successful marketing and sales and for the renewal of existing customers. Providing this education, training and support requires that our personnel who manage our online training resource or provide customer support have specific inbound experience domain knowledge and expertise, making it more difficult for us to hire qualified personnel and to scale up our support operations. The importance of high-quality customer support will increase as we expand our business and pursue\\n54\\nnew customers. If we do not help our customers use multiple applications and provide effective ongoing support, our ability to sell additional functionality and services to, or to retain, existing customers may suffer and our reputation with existing or potential customers may be harmed.\\nWe may be adversely affected if clients reduce their outsourcing of sales and marketing functions.\\nOur business and growth strategies depend in large part on companies continuing to elect to outsource sales and marketing functions. Our clients and potential clients will outsource if they perceive that outsourcing may provide quality services at a lower overall cost and permit them to focus on their core business activities and have done so in the past. We cannot be certain that the industry trend to outsource will continue or not be reversed or that clients that have historically outsourced functions will not decide to perform these functions themselves. Unfavorable developments with respect to outsourcing could adversely affect our business, financial conditions and results of operations.\\nWe previously identified material weaknesses in our internal control over financial reporting. If we fail to maintain proper and effective internal control over financial reporting in the future, our ability to produce accurate and timely financial statements could be impaired, investors’ views of us could be harmed, and we could be subject to enforcement actions by the SEC.\\nDuring 2021, we completed the remediation measures related to the material weaknesses previously identified and concluded that our internal control over financial reporting was effective as of December 31, 2021. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim consolidated financial statements will not be prevented or detected on a timely basis. If we are unable to maintain effective internal control over financial reporting or disclosure controls and procedures, our ability to record, process and report financial information accurately, and to prepare financial statements within required time periods could be adversely affected, which could subject us to litigation or investigations requiring management resources and payment of legal and other expenses, negatively affect investor confidence in our financial statements and adversely impact our stock price.\\nIf we are unable to identify attractive acquisition targets, acquire them at attractive prices or successfully integrate the acquired businesses, we may be unsuccessful in growing our business.\\nA significant portion of our growth has been as a result of our acquisition of complementary businesses that grow our service offerings, expand our geographic reach and strengthen valuable relationships with clients. However, there can be no assurance that we will find attractive acquisition targets, that we will acquire them at attractive prices, that we will succeed at effectively managing the integration of acquired businesses into our existing operations or that such acquired businesses or technologies will be well received by our clients, potential clients or our investors. We could also encounter higher-than-expected earn-out payments, unforeseen transaction- and integration-related costs or delays or other circumstances such as disputes with or the loss of key or other personnel from acquired businesses, challenges or delays in integrating systems or technology of acquired businesses, a deterioration in our associate and client relationships, harm to our reputation with clients, interruptions in our business activities or unforeseen or higher-than-expected inherited liabilities. Many of these potential circumstances are outside of our control and any of them could result in increased costs, decreased revenue, decreased synergies or the diversion of management time and attention.\\nIn order for us to continue to grow our business through acquisitions we will need to identify appropriate acquisition opportunities and acquire them at attractive prices. We may choose to pay cash, incur debt or issue equity securities to pay for any such acquisition. The incurrence of indebtedness would result in increased fixed obligations and could also include covenants or other restrictions that would impede our ability to manage our operations. The sale of equity to finance any such acquisition could result in dilution to our stockholders.\\nWe may encounter significant difficulties integrating acquired businesses.\\nThe integration of any businesses is a complex, costly and time-consuming process. As a result, we have devoted, and will continue to devote, significant management attention and resources to integrating acquired businesses. The failure to meet the challenges involved in integrating businesses and to realize the anticipated benefits of any acquisition could cause an interruption of, or a loss of momentum in, the activities of our combined\\n55\\nbusiness and could adversely affect our results of operations. The difficulties of combining acquired businesses with our own include, among others:\\n•the diversion of management attention to integration matters;\\n•difficulties in integrating functional roles, processes and systems, including accounting systems;\\n•challenges in conforming standards, controls, procedures and accounting and other policies, business cultures and compensation structures between the two companies;\\n•difficulties in assimilating, attracting and retaining key personnel;\\n•challenges in keeping existing clients and obtaining new clients;\\n•difficulties in achieving anticipated cost savings, synergies, business opportunities and growth prospects from an acquisition;\\n•difficulties in managing the expanded operations of a significantly larger and more complex business;\\n•contingent liabilities, including contingent tax liabilities or litigation, that may be larger than expected; and\\n•potential unknown liabilities, adverse consequences or unforeseen increased expenses associated with an acquisition, including possible adverse tax consequences to the combined business pursuant to changes in applicable tax laws or regulations.\\nMany of these factors are outside of our control, and any one of them could result in increased costs, decreased expected revenues and diversion of management time and energy, all of which could adversely impact our business and results of operations. These difficulties have been enhanced further during the COVID-19 pandemic as a result of our office closures and work-from home policies, which may hinder assimilation of key personnel.\\nIf we are not able to successfully integrate an acquisition, if we incur significantly greater costs to achieve the expected synergies than we anticipate or if activities related to the expected synergies have unintended consequences, our business, financial condition or results of operations could be adversely affected.\\nOur corporate culture has contributed to our success and, if we are unable to maintain it as we evolve, our business, operating results and financial condition could be harmed.\\nWe believe our corporate culture has been a significant factor in our success. However, as our company evolves, including through acquisitions and the impacts of the COVID-19 pandemic, such as working remotely and reductions in workforce, it may be difficult to maintain our culture, which could reduce our ability to innovate and operate effectively. The failure to maintain the key aspects of our culture as our organization evolves could result in decreased employee satisfaction, increased difficulty in attracting top talent, increased turnover and compromised the quality of our client service, all of which are important to our success and to the effective execution of our business strategy. If we are unable to maintain our corporate culture as we evolve and execute our growth strategies, our business, operating results and financial condition could be harmed.\\nAcquiring new clients and retaining existing clients depends on our ability to avoid or manage business conflicts among competing brands.\\nOur ability to acquire new clients and to retain existing clients, whether by expansion of our own operations or through an acquired business may in some cases be limited by the other parties’ perceptions of, or policies concerning, perceived competitive conflicts arising from our other relationships. Some of our contracts expressly restrict our ability to represent competitors of the counterparty. These perceived competitive conflicts may also become more challenging to avoid or manage as a result of continued consolidation in the consumer goods and retail industries and our own acquisitions. If we are unable to avoid or manage business conflicts among competing manufacturers and retailers, we may be unable to acquire new clients or be forced to terminate existing client relationships, and in either case, our business and results of operations may be adversely affected.\\nLimitations, restrictions and business decisions involving our joint ventures and minority investments may adversely affect our growth and results of operations.\\n56\\nWe have made substantial investments in joint ventures and minority investments and may use these and other similar methods to expand our service offerings and geographical coverage in the future. These arrangements typically involve other business services companies as partners that may be competitors of ours in certain markets. Joint venture agreements may place limitations or restrictions on our services. As part of our joint venture with, and investments in Smollan, we are restricted under certain circumstances from making direct acquisitions and otherwise expanding our service offerings into markets outside of North America and Europe. As a result of our acquisition of Daymon Worldwide Inc. pursuant to the terms of our arrangements with Smollan and our joint venture, Smollan and our joint venture may elect to purchase from us, and have purchased, certain Daymon business units that operate outside of North America. If Smollan or our joint venture do not elect to purchase those business units, we may, under certain circumstances, elect to retain, sell or discontinue those business units. The limitations and restrictions tied to our joint venture and minority investments limit our potential business opportunities and reduce the economic opportunity for certain prospective international investments and operations. Additionally, though we control our joint ventures, we may rely upon our equity partners or local management for operational and compliance matters associated with our joint ventures or minority investments. Moreover, our other equity partners and minority investments may have business interests, strategies or goals that are inconsistent with ours. Business decisions, including actions or omissions, of a joint venture or other equity partner or management for a business unit may adversely affect the value of our investment, result in litigation or regulatory action against us or adversely affect our growth and results of operations.\\nOur international operations expose us to risks that could impede growth in the future, and our attempts to grow our business internationally may not be successful.\\nWe continue to explore opportunities in major international markets. International operations expose us to various additional risks that could adversely affect our business, including:\\n•costs of customizing services for clients outside of the United States;\\n•the burdens of complying with a wide variety of foreign laws;\\n•potential difficulty in enforcing contracts;\\n•being subject to U.S. laws and regulations governing international operations, including the U.S. Foreign Corrupt Practices Act and sanctions regimes;\\n•being subject to foreign anti-bribery laws in the jurisdictions in which we operate, such as the UK Bribery Act;\\n•reduced protection for intellectual property rights;\\n•increased financial accounting and reporting complexity;\\n•additional legal compliance requirements, including custom and import requirements with respect to products imported to and exported across international borders;\\n•exposure to foreign currency exchange rate fluctuations;\\n•exposure to local economic conditions;\\n•limitations on the repatriation of funds or profits from foreign operations;\\n•exposure to local or regional political conditions, including adverse tax policies and civil unrest;\\n•the risks of a natural disaster, public health crisis (including the occurrence of a contagious disease or illness, such as the coronavirus), an outbreak of war (such as Russia's invasion of Ukraine), the escalation of hostilities and acts of terrorism in the jurisdictions in which we operate; and\\n•the disparate impact of the COVID-19 pandemic, including the measures taken to mitigate its spread, across various jurisdictions.\\nAdditionally, the withdrawal of the United Kingdom from the European Union, or “Brexit,” has created economic and political uncertainty, including volatility in global financial markets and the value of foreign currencies. The impact of Brexit may not be fully realized for several years. Additionally, in many countries outside of the United States, there has not been a historical practice of using third parties to provide sales and marketing services. Accordingly, while it is part of our strategy to expand into international markets, it may be difficult for us to grow our international business units on a timely basis, or at all.\\nThe ongoing conflict between Russia and Ukraine may adversely affect our business and results of operations.\\n57\\nGiven the nature of our business and our international operations, political, economic, and other conditions in foreign countries and regions, including geopolitical risks such as those arising from the current conflict between Russia and Ukraine, may adversely affect our business and results of operations. The broader consequences of this conflict, which may include further sanctions, embargoes, regional instability, and geopolitical shifts; disruptions to transportation and distribution routes, or strategic decisions to alter certain routes; potential retaliatory action by the Russian government against companies, including us, including nationalization of foreign businesses and/or assets in Russia; increased tensions between the United States and countries in which we operate; and the extent of the conflict’s effect on our business and results of operations as well as the global economy, cannot be predicted.\\nAdditionally, we have a minority interest in a European company that owns majority interests in local agencies in Russia. In addition to the imposition of sanctions by the United States, the United Kingdom, and the European Union that affect the cross-border operations of businesses operating in Russia, Russian regulators have imposed currency restrictions and regulations that created uncertainty regarding our ability to recover our investment in operations in Russia, as well as our ability to exercise control or influence involving operations by the local agencies in Russia. As a result, we intend to use our influence to cause the European company to dispose of our ownership interests in the local agencies in Russia. Accordingly, we recorded pretax charges of $2.8 million in the first quarter of 2022, primarily consisting of our proportionate share of the net investment in our Russian interest in “Selling, general, and administrative expenses” in the Condensed Consolidated Statements of Operations and Comprehensive Income.\\nTo the extent the current conflict between Russia and Ukraine adversely affects our business, particularly in Russia, it may also have the effect of heightening many other risks disclosed in our 2021 Annual Report and this Quarterly Report, any of which could materially and adversely affect our business and results of operations. Such risks include, but are not limited to, adverse effects on macroeconomic conditions, including inflation and business spending; disruptions to our information technology infrastructure, including through cyberattack, ransom attack, or cyber-intrusion; adverse changes in international trade policies and relations; our ability to maintain or increase our prices, our ability to implement and execute our business strategy, disruptions in global supply chains, our exposure to foreign currency fluctuations, and constraints, volatility, or disruption in the capital markets, difficulty staffing and managing impacted operations, and the recoverability of assets in the region.\\nWe may be subject to unionization, work stoppages, slowdowns or increased labor costs.\\nCurrently, none of our associates in the United States are represented by a union. However, our associates have the right under the National Labor Relations Act to choose union representation. If all or a significant number of our associates become unionized and the terms of any collective bargaining agreement were significantly different from our current compensation arrangements, it could increase our costs and adversely impact our profitability. Moreover, if a significant number of our associates participate in labor unions, it could put us at increased risk of labor strikes and disruption of our operations or adversely affect our growth and results of operations. In December 2019, a union which commonly represents employees in the supermarket industry filed a petition with the National Labor Relations Board to represent approximately 120 of our associates who work in and around Boston. An election was held, and based on certified results of the election we prevailed in this election. Notwithstanding this successful election, we could face future union organization efforts or elections, which could lead to additional costs, distract management or otherwise harm our business.\\nIf goodwill or other intangible assets in connection with our acquisitions become impaired, we could take significant non-cash charges against earnings.\\nWe have made acquisitions to complement and expand the services we offer and intend to continue to do so when attractive acquisition opportunities exist in the market. As a result of prior acquisitions, including the acquisition of our business in 2014 by our current parent entity, Topco, we have goodwill and intangible assets recorded on our balance sheet of $2.2 billion and $2.2 billion, respectively, as of September 30, 2022, as further described in Note 4 to our condensed consolidated financial statements for the three and nine months ended September 30, 2022.\\nUnder accounting guidelines, we must assess, at least annually, whether the value of goodwill and other intangible assets has been impaired. We have recognized non-cash goodwill and non-cash intangible asset impairment charges, and we can make no assurances that we will not record any additional impairment charges in\\n58\\nthe future. Any future reduction or impairment of the value of goodwill or other intangible assets will similarly result in charges against earnings, which could adversely affect our reported financial results in future periods.\\nFailures in, or incidents involving, our technology infrastructure could damage our business, reputation and brand and substantially harm our business and results of operations.\\nOur business is highly dependent on our ability to manage operations and process a large number of transactions on a daily basis. We rely heavily on our operating, payroll, financial, accounting and other data processing systems which require substantial support and maintenance, and may be subject to disabilities, errors, or other harms. If our data and network infrastructure were to fail, or if we were to suffer a data security breach, or an interruption or degradation of services in our data center, third-party cloud, and other infrastructure environments, we could lose important data, which could harm our business and reputation, and cause us to incur significant liabilities. Our facilities, as well as the facilities of third-parties that provide or maintain, or have access to our data or network infrastructure, are vulnerable to damage or interruption from earthquakes, hurricanes, floods, fires, cyber security attacks, terrorist attacks, power losses, telecommunications failures and similar events. In the event that our or any third-party provider’s systems or service abilities are hindered by any of the events discussed above, our ability to operate may be impaired. Our information technology systems, and the information technology systems of our current or future third-party vendors, collaborators, consultants and service providers, could be penetrated by internal or external parties intent on extracting information, corrupting information, stealing intellectual property or trade secrets, or disrupting business processes. A third party’s decision to close facilities or terminate services without adequate notice, or other unanticipated problems, could adversely impact our operations. Any of the aforementioned risks may be augmented if our or any third-party provider’s business continuity and disaster recovery plans prove to be inadequate in preventing the loss of data, service interruptions, disruptions to our operations or damages to important systems or facilities. Our data center, third-party cloud, and managed service provider infrastructure also could be subject to break-ins, cyber-attacks (including through the use of malware, software bugs, computer viruses, ransomware, social engineering, and denial of service), sabotage, intentional acts of vandalism and other misconduct, from a spectrum of actors ranging in sophistication from threats common to most industries to more advanced and persistent, highly organized adversaries. Any security breach or incident, including personal data breaches, that we experience could result in unauthorized access to, or misuse, modification, destruction or unauthorized acquisition of, our internal sensitive corporate data, such as personal data, financial data, trade secrets, intellectual property, or other competitively sensitive or confidential data. Such unauthorized access, misuse, acquisition, or modification of sensitive data may result in data loss, corruption or alteration, interruptions in our operations or damage to our computer hardware or systems or those of our employees or customers. Our systems have been the target of cyber-attacks. Although we have taken and continue to take steps to enhance our cybersecurity posture, we cannot assure that future cyber incidents will not occur or that our systems will not be targeted or breached in the future. Any such breach or unauthorized access could result in a disruption of the Company’s operations, the theft, unauthorized use or publication of the Company’s intellectual property, other proprietary information or the personal information of customers, employees, licensees or suppliers, a reduction of the revenues the Company is able to generate from its operations, damage to the Company’s brand and reputation, a loss of confidence in the security of the Company’s business and products, and significant legal and financial exposure. If any such incident results in litigation, we may be required to make significant expenditures in the course of such litigation and may be required to pay significant amounts in damages. We may not carry sufficient business interruption insurance to compensate us for losses that may occur as a result of any events that cause interruptions in our service. Significant unavailability of our services due to attacks could cause us to incur significant liability, could cause users to cease using our services and materially and adversely affect our business, prospects, financial condition and results of operations.\\nWe use complex software in our technology infrastructure, which we seek to continually update and improve. Replacing such systems is often time-consuming and expensive and can also be intrusive to daily business operations. Further, we may not always be successful in executing these upgrades and improvements, which may result in a failure of our systems. We may experience periodic system interruptions from time to time. Any slowdown or failure of our underlying technology infrastructure could harm our business and reputation, which could materially adversely affect our results of operations. Our disaster recovery plan or those of our third-party providers may be inadequate, and our business interruption insurance may not be sufficient to compensate us for the losses that could occur.\\n59\\nFailure to comply with federal, state and foreign laws and regulations relating to privacy, data protection and consumer protection, or the expansion of current or the enactment of new laws or regulations relating to privacy, data protection and consumer protection, could adversely affect our business and our financial condition.\\nA variety of federal, state and foreign laws and regulations govern the collection, use, retention, sharing and security of personal information. The information, security and privacy requirements imposed by such governmental laws and regulations relating to privacy, data protection and consumer protection are increasingly demanding, quickly evolving and may be subject to differing interpretations or legal theories among regulators, enforcers, and civil litigants. These requirements may not be harmonized, may be interpreted and applied in a manner that is inconsistent from one jurisdiction to another or may conflict with other rules or our practices. As a result, our practices may not have complied or may not comply in the future with all such laws, regulations, requirements and obligations. Our actual or perceived failure to comply with such laws and regulations could result in fines, investigations, enforcement actions, penalties, sanctions, claims for damages by affected individuals, and damage to our reputation, among other negative consequences, any of which could have a material adverse effect on its financial performance.\\nCertain aspects of our business and/or the data it collects is subject to the California Consumer Protection Act of 2018 (“CCPA”), which became effective in 2020 and regulates the collection, use and processing of personal information relating to California residents, and which grants certain privacy rights to California residents, including rights to request access to and to request deletion of personal information relating to such individuals under certain circumstances. Compliance with the new obligations imposed by the CCPA depends in part on how its requirements are interpreted and applied by the California attorney general and courts. Alleged violations of the CCPA may result in substantial civil penalties or statutory damages when applied at scale, up to $2,500 per violation or $7,500 per intentional violation of any CCPA requirement, which may be applied on a per-person or per-record basis. The CCPA also establishes a private right of action if certain personal information of individuals is subject to an unauthorized access and exfiltration, theft, or disclosure as a result of a business’s violation of the duty to implement and maintain reasonable security procedures and practices, which authorizes statutory damages $100 to $750 per person per incident even if there is no actual harm or damage to plaintiffs. This private right of action may increase the likelihood of, and risks associated with, data breach litigation. Further, in November 2020, the State of California adopted the California Privacy Rights Act of 2020 (“CPRA”) which goes into effect January 1, 2023 and is enforceable starting on July 1, 2023. The CPRA expands and amends the CCPA, including additional and strengthened privacy rights for California residents, new requirements regarding sensitive data and data sharing for digital advertising, and tripled damages for violations involving children’s data. Also on January 1, 2023, the CCPA – as amended by the CPRA – will be newly applicable to personal information collected for employment-related purposes as well as from business-to-business contacts, creating new regulatory obligations as to datasets that until then had been largely exempt from the CCPA. The CPRA includes a 12-month “look-back” provision that requires businesses to map out all information retained since January 1, 2022. The CPRA also establishes a dedicated privacy regulator under California law, with rulemaking and enforcement responsibilities. Certain regulations implementing the CPRA are expected in draft and final form by the end of 2022, with potentially additional regulations to be proposed following the CPRA’s January 1, 2023 effective date.\\nFour other states – Virginia, Colorado, Connecticut, and Utah – have passed their own comprehensive privacy laws to go into effect in 2023. Like the CCPA and CPRA, these laws regulate the collection, use, processing, and sharing of personal information relating to residents of each state respectively, and grants certain privacy rights to those residents. The new state laws also have key differences from the CCPA and CPRA, such as requiring affirmative consent before businesses may process sensitive personal information, requiring data protection assessments, and requiring contracts between data controllers and data processors that direct data processors to assist data controllers in performing their obligations, as well as other differences among them. Each law is enforceable by its own state’s attorney general – for example, violation of the Virginia or Utah laws will cost up to $7,500 per violation – and none include an explicit private right of action. Other states are expected to consider and potentially pass similar privacy laws in 2023.\\nCertain aspects of our business and/or the data it collects is may also be subject to international privacy laws and regulations, many of which, such as the General Data Privacy Regulation (“GDPR”) and national laws implementing or supplementing the GDPR, such as the United Kingdom Data Protection Law 2018 (which retains\\n60\\nkey features of GDPR post-Brexit), as well as the EU’s Privacy and Electronic Communications Directive (“ePrivacy Directive”), are significantly more stringent than those currently enforced in the United States. The GDPR requires companies to meet requirements regarding the handling of personal data of individuals located in the European Economic Area (the “EEA”). The GDPR imposes mandatory data breach notification requirements subject to a 72-hour notification deadline. The GDPR also includes significant penalties for noncompliance, which may result in monetary penalties of up to the higher of €20.0 million or 4% of a group’s worldwide turnover for the preceding financial year for the most serious violations. The GDPR and other similar regulations such as the ePrivacy Directive and related member state regulations and directives require companies to give specific types of notice and informed consent is in many cases required for the placement of a cookie or similar technologies on a user’s device for online tracking for behavioral advertising and other purposes and for direct electronic marketing, and the GDPR also imposes additional conditions in order to satisfy such consent, such as a prohibition on pre-checked tick boxes and bundled consents. Enforcement of the GDPR and related regulations varies by each EU Member State and is ongoing. Further laws and regulations on these topics are forthcoming, including the ePrivacy Directive’s proposed successor, the Regulation on Privacy and Electronic Communications (“ePrivacy Regulation”), as well as the Digital Services Act (“DSA”) and Digital Markets Act (“DMA”). The GDPR may increase our responsibility and liability in relation to personal data that we process where that processing is subject to the GDPR. In addition, we may be required to put in place additional mechanisms to ensure compliance with the GDPR, including GDPR requirements as implemented by individual countries. Compliance with the GDPR will be a rigorous and time-intensive process that may increase our cost of doing business or require us to change our business practices.\\nIn addition, under GDPR, transfers of personal data are prohibited to countries outside of the EEA that have not been determined by the European Commission to provide adequate protections for personal data, including the United States. There are mechanisms to permit the transfer of personal data from the EEA to the United States, but there is also uncertainty as to the future of such mechanisms, which have been under consistent scrutiny and challenge. In July 2020, decision of the Court of Justice of the European Union invalidated the EU-U.S. Privacy Shield Framework, a means that previously permitted transfers of personal data from the EEA to companies in the United States that certified adherence to the Privacy Shield Framework. While the Biden Administration issued an executive order in October 2022 mandating new legal safeguards over U.S. national security agencies’ access and use of EU and U.S. personal data, it is currently unclear what, if any, formal arrangement may replace the Privacy Shield Framework. Standard contractual clauses approved by the European Commission to permit transfers from the EU to third countries currently remain as a basis on which to transfer personal data from the EEA to other countries. Standard contractual clauses are also subject to legal challenge, and in November 2020, the European Commission published a draft of updated standard contractual clauses. In January 2022, for example, Austria’s data protection authority determined that the use of Google Analytics violated the GDPR and the Court of Justice of the European Union’s “Schrems II” decision on international data transfers. We presently rely on standard contractual clauses to transfer personal data from EEA member countries, and we may be impacted by changes in law as a result of future review or invalidation of, or changes to, this mechanism by European courts or regulators. While we will continue to undertake efforts to conform to current regulatory obligations and evolving best practices, we may be unsuccessful in conforming to permitted means of transferring personal data from the European Economic Area. We may also experience hesitancy, reluctance, or refusal by European or multi-national customers to continue to use some of our services due to the potential risk exposure of personal data transfers and the current data protection obligations imposed on them by certain data protection authorities. Such customers may also view any alternative approaches to the transfer of any personal data as being too costly, too burdensome, or otherwise objectionable, and therefore may decide not to do business with us if the transfer of personal data is a necessary requirement.\\nAlthough we take reasonable efforts to comply with all applicable laws and regulations and have invested and continue to invest human and technology resources into data privacy compliance efforts, there can be no assurance that we will not be subject to regulatory action, including fines, in the event of an incident or other claim. Data protection laws and requirements may also be enacted, interpreted or applied in a manner that creates inconsistent or contradictory requirements on companies that operate across jurisdictions. We or our third-party service providers could be adversely affected if legislation or regulations are expanded to require changes in our or our third-party service providers’ business practices or if governing jurisdictions interpret or implement their legislation or regulations in ways that negatively affect our or our third-party service providers’ business, results of operations or financial condition. For example, we may find it necessary to establish alternative systems to maintain personal data in the EEA, which may involve substantial expense and may cause us to divert resources from other aspects of\\n61\\nour business, all of which may adversely affect our results from operations. Further, any inability to adequately address privacy concerns in connection with our solutions, or comply with applicable privacy or data protection laws, regulations and policies, could result in additional cost and liability to us, and adversely affect our ability to offer our solutions. GDPR, CCPA, CPRA and other similar laws and regulations, as well as any associated inquiries or investigations or any other government actions, may be costly to comply with, result in negative publicity, increase our operating costs, require significant management time and attention and subject us to remedies that may harm our business, including fines or demands or orders that we modify or cease existing business practices. Our systems may not be able to satisfy these changing requirements and manufacturer, retailer and associate expectations, or may require significant additional investments or time in order to do so.\\nWe expect that new industry standards, laws and regulations will continue to be proposed regarding privacy, data protection and information security in many jurisdictions, including the European e-Privacy Regulation, which is currently in draft form, as well as at the U.S. federal and state levels. In addition, new data processes and datasets associated with emerging technologies are coming under increased regulatory scrutiny, such as biometrics and automated decision-making. We cannot yet determine the impact such future laws, regulations and standards may have on our business. Complying with these evolving obligations is challenging, time consuming and expensive, and federal regulators, state attorneys general and plaintiff’s attorneys have been, and will likely continue to be, active in this space. Expanding definitions and interpretations of what constitutes “personal data” (or the equivalent) within the United States, the EEA and elsewhere may increase our compliance costs and legal liability. For example, various state privacy proposals have included a private right of action for basic privacy violations which, if passed, would dramatically increase both the legal costs of defending frivolous lawsuits and the penalties and costs associated with alleged violations.\\nA data breach or any failure, or perceived failure, by us to comply with any federal, state or foreign privacy or consumer protection-related laws, regulations or other principles or orders to which we may be subject or other legal obligations relating to privacy or consumer protection could adversely affect our reputation, brand and business, and may result in fines, enforcement actions, sanctions, claims (including claims for damages by affected individuals), investigations, proceedings or actions against us by governmental entities or others, or other penalties or liabilities or require us to change our operations and/or cease using certain data sets, among other negative consequences, any of which could have a material adverse effect on our business. Moreover, the proliferation of supply chain-based cyberattacks and vendor security incidents increases these potential risks and costs even in cases where the attack did not target us, occur on our systems, or result from any action or inaction by us. Depending on the nature of the information compromised, we may also have obligations to notify users, law enforcement, regulators, business partners or payment companies about the incident and provide some form of remedy, such as refunds or identity theft monitoring services, for the individuals affected by the incident.\\nThe Take 5 Matter may lead to additional harms, risks and uncertainties for us, including litigation and governmental investigations, a reduction in revenue, a potential deterioration in our relationships or reputation and a loss in investor confidence.\\nOn April 1, 2018, we acquired certain assets and assumed certain liabilities of Take 5 Media Group. In June 2019, as a result of a review of internal allegations related to inconsistency of data provided by Take 5 to its clients, we commenced an investigation into Take 5’s operations. In July 2019, as a result of our investigation, we terminated all operations of Take 5, including the use of its associated trade names and the offering of its services to its clients and offered refunds to Take 5 clients of collected revenues attributable to Take 5 since our acquisition of Take 5.\\nAs a result of these matters, we may be subject to a number of additional harms, risks and uncertainties, including substantial costs for professional services fee, potential lawsuits by clients or other interested parties who claim to have been harmed by the misconduct at Take 5, other costs and fees related to the Take 5 Matter (in excess of the amounts already offered as refunds), potential governmental investigations arising from the Take 5 Matter, a reduction in our current and anticipated revenue and a potential deterioration in our associate and client relationships or our reputation. In addition, if we do not prevail in any litigation or governmental investigation related to these matters, we could be subject to costs related to such litigation or governmental investigation, including equitable relief, civil monetary damages, treble damages, repayment or criminal penalties, which may not be covered by insurance or may materially increase our insurance costs. We have incurred and will continue to incur additional substantial professional fees regardless of the outcome of any such litigation or governmental\\n62\\ninvestigation. In addition, there can be no assurance to what degree, if any, we will be able to recover any such costs or damages from the former owners of Take 5 or whether such former owners of Take 5 engaged in further unknown improper activities that may subject us to further costs or damages, including potential reputational harm. Likewise, such events have caused and may cause further diversion of our management’s time and attention. Any adverse outcome related to these matters cannot be predicted at this time, and may materially harm our business, reputation, financial condition and/or results of operations, or the trading price of our securities.\\nOur business is seasonal in nature and quarterly operating results can fluctuate.\\nOur services are seasonal in nature, with the fourth fiscal quarter typically generating a higher proportion of our revenues than other fiscal quarters. Adverse events, such as deteriorating economic conditions, higher unemployment, higher gas prices, public transportation disruptions, public health crises (including the COVID-19 pandemic) or unanticipated adverse weather, could result in lower-than-planned sales during key revenue-producing seasons. For example, frequent or unusually heavy snowfall, ice storms, rainstorms, windstorms or other extreme weather conditions over a prolonged period could make it difficult for consumers to travel to retail stores or foodservice locations. Such events could lead to lower revenues, negatively impacting our financial condition and results of operations.\\nOur business is competitive, and increased competition could adversely affect our business and results of operations.\\nThe sales, marketing and merchandising services industry is competitive. We face competition from a few other large, national or super-regional agencies as well as many niche and regional agencies. Remaining competitive in this industry requires that we closely monitor and respond to trends in all industry sectors. We cannot assure you that we will be able to anticipate and respond successfully to such trends in a timely manner. Moreover, some of our competitors may choose to sell services competitive to ours at lower prices by accepting lower margins and profitability or may be able to sell services competitive to ours at lower prices due to proprietary ownership of data or technical superiority, which could negatively impact the rates that we can charge. If we are unable to compete successfully, it could have a material adverse effect on our business, financial condition and our results of operations. If certain competitors were to combine into integrated sales, marketing and merchandising services companies, additional sales, marketing and merchandising service companies were to enter the market or existing participants in this industry were to become more competitive, including through technological innovation such as social media and crowdsourcing, it could have a material adverse effect on our business, financial condition or results of operations.\\nDamage to our reputation could negatively impact our business, financial condition and results of operations.\\nOur reputation and the quality of our brand are critical to our business and success in existing markets and will be critical to our success as we enter new markets. We believe that we have built our reputation on the high quality of our sales and marketing services, our commitment to our clients and our performance-based culture, and we must protect and grow the value of our brand in order for us to continue to be successful. Any incident that erodes client loyalty to our brand could significantly reduce its value and damage our business. Also, there has been a marked increase in the use of social media platforms and similar devices, including blogs, social media websites, Twitter and other forms of internet-based communications that provide individuals with access to a broad audience of consumers and other interested persons. Many social media platforms immediately publish the content their subscribers and participants post, often without filters or checks on accuracy of the content posted. Information concerning us may be posted on such platforms at any time. Information posted may be adverse to our interests or may be inaccurate, each of which may harm our performance, prospects or business. The harm may be immediate without affording us an opportunity for redress or correction.\\nWe rely on third parties to provide certain data and services in connection with the provision of our services.\\nWe rely on third parties to provide certain data and services for use in connection with the provision of our services. For example, we contract with third parties to obtain the raw data on retail product sales and inventories. These suppliers of data may impose restrictions on our use of such data, fail to adhere to our quality control standards, increase the price they charge us for this data or refuse altogether to license the data to us. If we are unable to use such third-party data and services or if we are unable to contract with third parties, when necessary,\\n63\\nour business, financial condition or our results of operations could be adversely affected. In the event that such data and services are unavailable for our use or the cost of acquiring such data and services increases, our business could be adversely affected.\\nWe may be unable to timely and effectively respond to changes in digital practices and policies, which could adversely affect our business, financial condition or results of operations.\\nChanges to practices and policies of operating systems, websites and other digital platforms, including, without limitation, Apple’s or Android’s transparency policies, may reduce the quantity and quality of the data and metrics that can be collected or used by us and our clients or reduce the value of our digital services. These limitations may adversely affect both our and our clients’ ability to effectively target and measure the performance of our digital services. In addition, our clients and third party vendors routinely evaluate their digital practices and policies, and if in the future they determine to modify such practices and policies for any reasons, including, without limitation, privacy, targeting, age or content concerns, this could decrease the desire for our digital services as compared to other alternatives. If we are unable to timely or effectively respond to changes in digital practices and policies, or if our clients do not believe that our digital services will generate a competitive return on investment relative to alternatives, then our business, financial condition or results of operations could be adversely affected.\\nWe may not be able to adequately protect our intellectual property, which, in turn, could harm the value of our brands and adversely affect our business.\\nOur ability to implement our business plan successfully depends in part on our ability to further build brand recognition using our trade names, service marks, trademarks, proprietary products and other intellectual property, including our name and logos. We rely on U.S. and foreign trademark, copyright and trade secret laws, as well as license agreements, nondisclosure agreements and confidentiality and other contractual provisions to protect our intellectual property. Nevertheless, these laws and procedures may not be adequate to prevent unauthorized parties from attempting to copy or otherwise obtain our processes and technology or deter our competitors from developing similar business solutions and concepts, and adequate remedies may not be available in the event of an unauthorized use or disclosure of our trade secrets and other intellectual property.\\nThe success of our business depends on our continued ability to use our existing trademarks and service marks to increase brand awareness and further develop our brand in both domestic and international markets. We have registered and applied to register our trade names, service marks and trademarks in the United States and foreign jurisdictions. However, the steps we have taken to protect our intellectual property in the United States and in foreign countries may not be adequate, and third parties may misappropriate, dilute, infringe upon or otherwise harm the value of our intellectual property. If any of our registered or unregistered trademarks, trade names or service marks is challenged, infringed, circumvented or declared generic or determined to be infringing on other marks, it could have an adverse effect on our sales or market position. In addition, the laws of some foreign countries do not protect intellectual property to the same extent as the laws of the United States. Many companies have encountered significant problems in protecting and defending intellectual property rights in certain jurisdictions. This could make it difficult to stop the infringement or misappropriation of our intellectual property rights in foreign jurisdictions.\\nWe rely upon trade secrets and other confidential and proprietary know‑how to develop and maintain our competitive position. While it is our policy to enter into agreements imposing nondisclosure and confidentiality obligations upon our employees and third parties to protect our intellectual property, these obligations may be breached, may not provide meaningful protection for our trade secrets or proprietary know‑how, or adequate remedies may not be available in the event of an unauthorized access, use or disclosure of our trade secrets and know‑how. Furthermore, despite the existence of such nondisclosure and confidentiality agreements, or other contractual restrictions, we may not be able to prevent the unauthorized disclosure or use of our confidential proprietary information or trade secrets by consultants, vendors and employees. In addition, others could obtain knowledge of our trade secrets through independent development or other legal means.\\nAny claims or litigation initiated by us to protect our proprietary technology could be time consuming, costly and divert the attention of our technical and management resources. If we choose to go to court to stop a third party from infringing our intellectual property, that third party may ask the court to rule that our intellectual property rights are invalid and/or should not be enforced against that third party. Even if the action that we take to protect\\n64\\nour intellectual property rights is successful, any infringement may still have a material adverse effect on our business, financial condition and results of operations.\\nWe may be subject to claims of infringement of third-party intellectual property rights that are costly to defend, result in the diversion of management’s time and efforts, require the payment of damages, limit our ability to use particular technologies in the future or prevent us from marketing our existing or future products and services.\\nThird parties may assert that we infringe, misappropriate or otherwise violate their intellectual property, including with respect to our digital solutions and other technologies that are important to our business, and may sue us for intellectual property infringement. We may not be aware of whether our products or services do or will infringe existing or future patents or the intellectual property rights of others. In addition, there can be no assurance that one or more of our competitors who have developed competing technologies or our other competitors will not be granted patents for their technology and allege that we have infringed on such patents.\\nAny claims that our business infringes the intellectual property rights of others, regardless of the merit or resolution of such claims, could incur substantial costs, and the time and attention of our management and other personnel may be diverted in pursuing these proceedings. An adverse determination in any intellectual property claim could require us to pay damages, be subject to an injunction, and/or stop using our technologies, trademarks, copyrighted works and other material found to be in violation of another party’s rights, and could prevent us from licensing our technologies to others unless we enter into royalty or licensing arrangements with the prevailing party or are able to redesign our products and services to avoid infringement. With respect to any third-party intellectual property that we use or wish to use in our business (whether or not asserted against us in litigation), we may not be able to enter into licensing or other arrangements with the owner of such intellectual property at a reasonable cost or on reasonable terms. Any of the foregoing could harm our commercial success.\\nWe are dependent on proprietary technology licensed from others. If we lose our licenses, we may not be able to continue developing our products.\\nWe have obtained licenses that give us rights to third party intellectual property that is necessary or useful to our business. These license agreements may impose various royalty and other obligations on us. One or more of our licensors may allege that we have breached our license agreement with them, and could seek to terminate our license, which could adversely affect our competitive business position and harm our business prospects. In addition, any claims brought against us by our licensors could be costly, time-consuming and divert the attention of our management and key personnel from our business operations.\\nConsumer goods manufacturers and retailers, including some of our clients, are subject to extensive governmental regulation and we and they may be subject to enforcement in the event of noncompliance with applicable requirements.\\nConsumer goods manufacturers and retailers, including some of our clients, are subject to a broad range of federal, state, local and international laws and regulations governing, among other things, the research, development, manufacture, distribution, marketing and post-market reporting of consumer products. These include laws administered by the U.S. Food and Drug Administration (the “FDA”), the U.S. Drug Enforcement Administration, the U.S. Federal Trade Commission, the U.S. Department of Agriculture and other federal, state, local and international regulatory authorities. For example, certain of our clients market and sell products containing cannabidiol (“CBD”). CBD products are subject to a number of federal, state, local and international laws and regulations restricting their use in certain categories of products and in certain jurisdictions. In particular, the FDA has publicly stated it is prohibited to sell into interstate commerce food, beverages or dietary supplements that contain CBD. These laws are broad in scope and subject to evolving interpretations, which could require us to incur costs associated with new or modified compliance requirements or require us or our clients to alter or limit our activities, including marketing and promotion, of such products, or to remove them from the market altogether.\\nIf a regulatory authority determines that we or our current or future clients have not complied with the applicable regulatory requirements, our business may be materially impacted and we or our clients could be subject to enforcement actions or loss of business. We cannot predict the nature of any future laws, regulations, interpretations or applications of the laws, nor can we determine what effect additional laws, regulations or administrative policies and procedures, if and when enacted, promulgated and implemented, could have on our business.\\n65\\nWe may be subject to claims for products for which we are the vendor of record or may otherwise be in the chain of title.\\nFor certain of our clients’ products, we become the vendor of record or otherwise may be in the chain of title. For these products, we could be subject to potential claims for misbranded, adulterated, contaminated, damaged or spoiled products, or could be subject to liability in connection with claims related to infringement of intellectual property, product liability, product recalls or other liabilities arising in connection with the sale or marketing of these products. As a result, we could be subject to claims or lawsuits (including potential class action lawsuits), and we could incur liabilities that are not insured or exceed our insurance coverage or for which the manufacturer of the product does not indemnify us. Even if product claims against us are not successful or fully pursued, these claims could be costly and time consuming and may require our management to spend time defending the claims rather than operating our business.\\nA product that has been actually or allegedly misbranded, adulterated or damaged or is actually or allegedly defective could result in product withdrawals or recalls, destruction of product inventory, negative publicity and substantial costs of compliance or remediation. Any of these events, including a significant product liability judgment against us, could result in monetary damages and/or a loss of demand for our products, both of which could have an adverse effect on our business or results of operations.\\nWe generate revenues and incur expenses throughout the world that are subject to exchange rate fluctuations, and our results of operations may suffer due to currency translations.\\nOur U.S. operations earn revenues and incur expenses primarily in U.S. dollars, while our international operations earn revenues and incur expenses primarily in Canadian dollars, British pounds or euros. Because of currency exchange rate fluctuations, including possible devaluations, we are subject to currency translation exposure on the results of our operations, in addition to economic exposure. There has been, and may continue to be, volatility in currency exchange rates as a result of the United Kingdom’s withdrawal from the European Union, especially between the U.S. dollar and the British pound. These risks could adversely impact our business or results of operations.\\nFluctuations in our tax obligations and effective tax rate and realization of our deferred tax assets may result in volatility of our operating results.\\nWe are subject to taxes by the U.S. federal, state, local and foreign tax authorities, and our tax liabilities will be affected by the allocation of expenses to differing jurisdictions. We record tax expense based on our estimates of future payments, which may include reserves for uncertain tax positions in multiple tax jurisdictions, and valuation allowances related to certain net deferred tax assets. At any one time, many tax years may be subject to audit by various taxing jurisdictions. The results of these audits and negotiations with taxing authorities may affect the ultimate settlement of these matters. We expect that throughout the year there could be ongoing variability in our quarterly tax rates as events occur and exposures are evaluated. Our future effective tax rates could be subject to volatility or adversely affected by a number of factors, including:\\n•changes in the valuation of our deferred tax assets and liabilities;\\n•expected timing and amount of the release of any tax valuation allowance;\\n•tax effects of equity-based compensation;\\n•changes in tax laws, regulations or interpretations thereof; or\\n•future earnings being lower than anticipated in jurisdictions where we have lower statutory tax rates and higher than anticipated earnings in jurisdictions where we have higher statutory tax rates.\\nIn addition, our effective tax rate in a given financial statement period may be materially impacted by a variety of factors including but not limited to changes in the mix and level of earnings, varying tax rates in the different jurisdictions in which we operate, fluctuations in the valuation allowance, deductibility of certain items or changes to existing accounting rules or regulations. Further, tax legislation may be enacted in the future which could negatively impact our current or future tax structure and effective tax rates. We may be subject to audits of\\n66\\nour income, sales and other transaction taxes by U.S. federal, state, local and foreign taxing authorities. Outcomes from these audits could have an adverse effect on our operating results and financial condition.\\nRisks Related to Ownership of Our Common Stock\\nWe are controlled by Topco, the Advantage Sponsors, and the CP Sponsor, whose economic and other interests in our business may be different from yours.\\nOur authorized capital stock consists of 3,290,000,000 shares of Class A common stock, and as of November 8, 2022, certain equityholders of Topco (the “Advantage Sponsors”), Topco and Conyers Park II Sponsor LLC, an affiliate of Centerview Capital Management, LLC, which was Conyers Park’s sponsor prior to the Merger (the “CP Sponsor”), collectively own 254,310,000 shares, or 79.55% (including 65.30% held by Topco), of our outstanding Class A common stock. Subject to applicable law, the Advantage Sponsors, through their direct ownership of our common stock and their ownership of equity interests of Topco, and the CP Sponsor are able to exert significant influence in the election of our directors and control actions to be taken by our stockholders, including amendments to our third amended and restated certificate of incorporation and approval of mergers, sales of substantially all of our assets, and other significant corporate transactions. It is possible that the interests of Topco, the Advantage Sponsors and the CP Sponsor may in some circumstances conflict with our interests and the interests of our other stockholders, including you.\\nWe are a controlled company within the meaning of the Nasdaq Stock Market LLC listing requirements and as a result, may rely on exemptions from certain corporate governance requirements. To the extent we rely on such exemptions, you will not have the same protections afforded to stockholders of companies that are subject to such corporate governance requirements.\\nBecause of the voting power over our company held by Topco, the Advantage Sponsors, and the CP Sponsor and the voting arrangement between such parties, we are considered a controlled company for the purposes of the Nasdaq Stock Market LLC (“Nasdaq”) listing requirements. As such, we are exempt from the corporate governance requirements that our board of directors, compensation committee, and nominating and corporate governance committee meet the standard of independence established by those corporate governance requirements. The independence standards are intended to ensure that directors who meet the independence standards are free of any conflicting interest that could influence their actions as directors.\\nWe do not currently utilize the exemptions afforded to a controlled company, though we are entitled to do so. To the extent we utilize these exemptions, you will not have the same protections afforded to stockholders of companies that are subject to all of the corporate governance requirements of Nasdaq.\\nThe anti-takeover provisions of our certificate of incorporation and bylaws could prevent or delay a change in control of us, even if such change in control would be beneficial to our stockholders.\\nProvisions of our certificate of incorporation and bylaws, as well as provisions of Delaware law, could discourage, delay, or prevent a merger, acquisition, or other change in control of us, even if such change in control would be beneficial to our stockholders. These include:\\n•authorizing the issuance of “blank check” preferred stock that could be issued by our board of directors to increase the number of outstanding shares and thwart a takeover attempt;\\n•provision for a classified board of directors so that not all members of our board of directors are elected at one time;\\n•not permitting the use of cumulative voting for the election of directors;\\n•permitting the removal of directors only for cause;\\n•limiting the ability of stockholders to call special meetings; •requiring all stockholder actions to be taken at a meeting of our stockholders;\\n•requiring approval of the holders of at least two-thirds of the shares entitled to vote at an election of directors to adopt, amend, or repeal the proposed bylaws or repeal the provisions of the third amended and restated certificate of incorporation regarding the election and removal of directors; and\\n67\\n•establishing advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings.\\nIn addition, although we have opted out of Section 203 of the Delaware General Corporation Law (“DGCL”), our certificate of incorporation contain similar provisions providing that we may not engage in certain “business combinations” with any “interested stockholder” for a three-year period following the time that the stockholder became an interested stockholder, subject to certain exceptions. Generally, a “business combination” includes a merger, asset, or stock sale or other transaction resulting in a financial benefit to the interested stockholder.\\nSubject to certain exceptions, an “interested stockholder” is a person who, together with that person’s affiliates and associates, owns, or within the previous three years owned, 15% or more of our outstanding voting stock.\\nUnder certain circumstances, this provision will make it more difficult for a person who would be an “interested stockholder” to effect various business combinations with us for a three-year period. These provisions also may have the effect of preventing changes in our board of directors and may make it more difficult to accomplish transactions which stockholders may otherwise deem to be in their best interests.\\nMoreover, our certificate of incorporation provides that Topco and its affiliates do not constitute “interested stockholders” for purposes of this provision, and thus any business combination transaction between us and Topco and its affiliates would not be subject to the protections otherwise provided by this provision. Topco and its affiliates are not prohibited from selling a controlling interest in us to a third party and may do so without your approval and without providing for a purchase of your shares of common stock, subject to the lock-up restrictions applicable to Topco. Accordingly, your shares of common stock may be worth less than they would be if Topco and its affiliates did not maintain voting control over us.\\nThe provisions of our certificate of incorporation and bylaws requiring exclusive venue in the Court of Chancery in the State of Delaware or the federal district courts of the United States of America for certain types of lawsuits may have the effect of discouraging lawsuits against our directors and officers.\\nOur certificate of incorporation and bylaws require, to the fullest extent permitted by law, that (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of a fiduciary duty owed by any of our directors, officers, or other employees to us or our stockholders, (iii) any action asserting a claim against us arising pursuant to any provision of the DGCL or our certificate of incorporation or bylaws, or (iv) any action asserting a claim against us governed by the internal affairs doctrine will have to be brought only in the Court of Chancery in the State of Delaware (or the federal district court for the District of Delaware or other state courts of the State of Delaware if the Court of Chancery in the State of Delaware does not have jurisdiction).\\nOur certificate of incorporation and bylaws also require that the federal district courts of the United States of America will be the exclusive forum for the resolution of any complaint asserting a cause of action arising under the Securities Act; however, there is uncertainty as to whether a court would enforce such provision, and investors cannot waive compliance with federal securities laws and the rules and regulations thereunder. Although we believe these provisions benefit us by providing increased consistency in the application of applicable law in the types of lawsuits to which they apply, the provisions may have the effect of discouraging lawsuits against our directors and officers. These provisions do not apply to any suits brought to enforce any liability or duty created by the Exchange Act or any other claim for which the federal courts of the United States have exclusive jurisdiction.\\nBecause we have no current plans to pay cash dividends on our Class A common stock, you may not receive any return on investment unless you sell your Class A common stock for a price greater than that which you paid for it.\\nWe have no current plans to pay cash dividends on our Class A common stock. The declaration, amount and payment of any future dividends on our Class A common stock will be at the discretion of our board of directors and will depend upon our results of operations, financial condition, capital requirements, and other factors that our board of directors deems relevant. The payment of cash dividends is also restricted under the terms of the agreements governing our debt and our ability to pay dividend may also be restricted by the terms of any future credit agreement or any securities we or our subsidiaries may issue.\\n68\\nAn active, liquid trading market for our Class A common stock may not be available.\\nWe cannot predict the extent to which investor interest in our company will lead to availability of a trading market on Nasdaq or otherwise in the future or how active and liquid that market may be for our Class A common stock. If an active and liquid trading market is not available, you may have difficulty selling any of our Class A common stock. Among other things, in the absence of a liquid public trading market:\\n•you may not be able to liquidate your investment in shares of Class A common stock;\\n•you may not be able to resell your shares of Class A common stock at or above the price attributed to them in the Transactions;\\n•the market price of shares of Class A common stock may experience significant price volatility; and\\n•there may be less efficiency in carrying out your purchase and sale orders.\\nThe trading price of our Class A common stock may be volatile or may decline regardless of our operating performance.\\nThe market prices for our Class A common stock are likely to be volatile and may fluctuate significantly in response to a number of factors, most of which we cannot control, including:\\n•quarterly variations in our operating results compared to market expectations;\\n•changes in preferences of our clients;\\n•announcements of new products or services or significant price reductions;\\n•the size of our public float;\\n•fluctuations in stock market prices and volumes;\\n•defaults on our indebtedness;\\n•changes in senior management or key personnel;\\n•the granting, vesting, or exercise of employee stock options, restricted stock, or other equity rights;\\n•the payment of any dividends thereon in shares of our common stock;\\n•changes in financial estimates or recommendations by securities analysts;\\n•negative earnings or other announcements by us;\\n•downgrades in our credit ratings;\\n•material litigation or governmental investigations;\\n•issuances of capital stock;\\n•global economic, legal, and regulatory factors unrelated to our performance, including the COVID-19 pandemic; or\\n•the realization of any risks described in this Quarterly Report under “Risk Factors.”\\nIn addition, in the past, stockholders have instituted securities class action litigation against companies following periods of market volatility. If we were involved in securities litigation, we could incur substantial costs and our resources and the attention of management could be diverted from our business.\\nWe cannot provide any guaranty that we will continue to repurchase our common stock pursuant to our stock repurchase program.\\nIn November 2021, our board of directors authorized a share repurchase program, under which we may repurchase up to $100 million of our outstanding Class A common stock (the “2021 Share Repurchase Program”). As of September 30, 2022, the remaining amount available for repurchase pursuant to the 2021 Share Repurchase Program is $87.4 million. However, we are not obligated to make any further purchases under the 2021 Share Repurchase Program and we may suspend or permanently discontinue this program at any time or significantly reduce the amount of repurchases under the program. Any announcement of a suspension, discontinuance or reduction of this program may negatively impact our reputation and investor confidence.\\n69\\nThe valuation of our private placement warrants could increase the volatility in our net income (loss) in our consolidated statements of earnings (loss).\\nThe change in fair value of our private placement warrants is determined using the fair value of the liability classified private placement warrants by approximating the value with the share price of the public warrants. The change in fair value of warrant liability represents the mark-to-market fair value adjustments to the outstanding private placement warrants issued in connection with the initial public offering of Conyers Park. Significant changes in share price of the public warrants may adversely affect the volatility in our net income (loss) in our Condensed Consolidated Statements of Operations and Comprehensive Income.\\nRisks Related to Indebtedness\\nWe need to continue to generate significant operating cash flow in order to fund acquisitions and to service our debt.\\nOur business currently generates operating cash flow, which we use to fund acquisitions to grow our business and to service our substantial indebtedness. If, because of loss of revenue, pressure on pricing from customers, increases in our costs (including increases in costs related to servicing our indebtedness or labor costs), general economic, financial, competitive, legislative, regulatory conditions or other factors, including any acceleration of the foregoing as a result of the COVID-19 pandemic, many of which are outside of our control our business generates less operating cash flow, we may not have sufficient funds to grow our business or to service our indebtedness.\\nIf we are unable to generate sufficient cash flow or are otherwise unable to obtain funds necessary to meet required payments of principal, premium, if any, and interest on our indebtedness, or if we otherwise fail to comply with the various covenants in the agreements governing our indebtedness, we could be in default under the terms of the agreements governing such indebtedness. In the event of such default, the lenders under our credit facilities could elect to terminate their commitments thereunder, cease making further loans and institute foreclosure proceedings against our assets, and we could be forced into bankruptcy or liquidation. If our operating performance declines, we may in the future need to obtain waivers from the required lenders under our credit agreements to avoid being in default. If we or any of our subsidiaries breach the covenants under our credit agreements and seek a waiver, we may not be able to obtain a waiver from the required lenders. If this occurs, we would be in default under our credit agreements, the lenders could exercise their rights as described above, and we could be forced into bankruptcy or liquidation.\\nOur substantial indebtedness could adversely affect our financial health, restrict our activities, and affect our ability to meet our obligations.\\nWe have a significant amount of indebtedness. As of September 30, 2022, we had total indebtedness of $2.1 billion, excluding debt issuance costs, with an additional $54.5 million of letters of credit outstanding under our revolving credit facility. The agreements governing our indebtedness contain customary covenants that restrict us from taking certain actions, such as incurring additional debt, permitting liens on pledged assets, making investments, paying dividends or making distributions to equity holders, prepaying junior debt, engaging in mergers or restructurings, and selling assets, among other things, which may restrict our ability to successfully execute on our business plan. For a more detailed description of the covenants and material terms of our material indebtedness, please see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” in this Quarterly Report.\\nDespite current indebtedness levels, we and our subsidiaries may still be able to incur additional indebtedness, which could increase the risks associated with our indebtedness.\\nWe and our subsidiaries may be able to incur additional indebtedness in the future because the terms of our indebtedness do not fully prohibit us or our subsidiaries from doing so. Subject to covenant compliance and certain conditions, as of September 30, 2022, the agreements governing our indebtedness would have permitted us to borrow up to an additional $345.5 million under our revolving credit facility. In addition, we and our subsidiaries have, and will have, the ability to incur additional indebtedness as incremental facilities under our credit agreement\\n70\\nand we or our subsidiaries may issue additional notes in the future. If additional debt is added to our current debt levels and our subsidiaries’ current debt levels, the related risks that we and they now face could increase.\\nFailure to maintain our credit ratings could adversely affect our liquidity, capital position, ability to hedge certain financial risks, borrowing costs, and access to capital markets.\\nOur credit risk is evaluated by the major independent rating agencies, and such agencies have in the past downgraded, and could in the future downgrade, our ratings. Our credit rating may impact the interest rates on any future indebtedness as well as the applicability of certain covenants in the agreements governing our indebtedness. We cannot assure you that we will be able to maintain our current credit ratings, and any additional, actual or anticipated changes or downgrades in our credit ratings, including any announcement that our ratings are under further review for a downgrade, may have a negative impact on our liquidity, capital position, ability to hedge certain financial risks, and access to capital markets.\\nOur variable rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase significantly.\\nBorrowings under our credit facilities are at variable rates of interest and expose us to interest rate risk. If interest rates were to increase, our debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same, and our net income and cash flows, including cash available for servicing our indebtedness, will correspondingly decrease. On a pro forma basis, assuming no other prepayments of the credit facility and that our revolving credit facility is fully drawn (and to the extent that LIBOR is in excess of the 0.00% and 0.75% floors applicable to our revolving credit facility and our term loan credit facility, respectively), each one-eighth percentage point change in interest rates would result in an approximately $1.0 million change in interest expense, net of gains from interest rate caps, for the nine months ended September 30, 2022. In the future, we may enter into interest rate swaps that involve the exchange of floating- for fixed-rate interest payments in order to reduce interest rate volatility or risk. However, we may not maintain interest rate swaps with respect to any of our variable rate indebtedness, and any swaps we enter into may not fully or effectively mitigate our interest rate risk.\\nThe elimination of LIBOR after June 2023 may affect our financial results\\nCertain of our financial arrangements, including the Senior Secured Credit Facilities, were made at variable rates that use the London Interbank Offered Rate, or LIBOR (or metrics derived from or related to LIBOR), as a benchmark for establishing the interest rate. All LIBOR tenors relevant to us will cease to be published or will no longer be representative after June 30, 2023. This means that any of our LIBOR-based borrowings that extend beyond June 30, 2023 will need to be converted to a replacement rate. In the U.S., the Alternative Reference Rates Committee (the “ARRC”) convened by the Federal Reserve Board and the Federal Reserve Bank of New York has recommended the Secured Overnight Financing Rate (“SOFR”) plus a recommended spread adjustment as LIBOR’s replacement. There are significant differences between LIBOR and SOFR, such as LIBOR being an unsecured lending rate while SOFR is a secured lending rate, and SOFR being an overnight rate while LIBOR reflects term rates at different maturities. If our LIBOR-based financing arrangements are converted to SOFR, the differences between LIBOR and SOFR, plus the recommended spread adjustment, could result in interest costs that are higher than if LIBOR remained available, which could adversely impact our operating results. Although SOFR is the ARRC’s recommended replacement rate, it is also possible that lenders and other counterparties may instead choose alternative replacement rates that may differ from LIBOR in ways similar to SOFR or in other ways that would result in higher interest costs for us. There is no assurance that any alternative reference rate, including SOFR, will be similar to, or produce the same value or economic equivalence as, LIBOR, and there continues to be uncertainty regarding the nature of potential changes to and future utilization of specific LIBOR tenors, the development and acceptance of SOFR or alternative reference rates, and other reforms. These consequences cannot be entirely predicted and could have an adverse impact on the market value for or value of LIBOR-linked securities, loans and other financial obligations or extensions of credit held by or due to us. Changes in market interest rates may influence our financing costs, returns on financial investments and the valuation of derivative contracts and could reduce our earnings and cash flows.\\n71\\nGeneral Risk Factors\\nOur business and financial results may be affected by various litigation and regulatory proceedings.\\nWe are subject to litigation and regulatory proceedings in the normal course of business and could become subject to additional claims in the future. These proceedings have included, and in the future may include, matters involving personnel and employment issues, workers’ compensation, personal and property injury, disputes relating to acquisitions (including contingent consideration), governmental investigations and other proceedings. Some historical and current legal proceedings and future legal proceedings may purport to be brought as class actions or representative basis on behalf of similarly situated parties including with respect to employment-related matters. We cannot be certain of the ultimate outcomes of any such claims, and resolution of these types of matters against us may result in significant fines, judgments or settlements, which, if uninsured, or if the fines, judgments and settlements exceed insured levels, could adversely affect our business or financial results. See “Legal Proceedings.”\\nWe are subject to many federal, state, local and international laws with which compliance is both costly and complex.\\nOur business is subject to various, and sometimes complex, laws and regulations, including those that have been or may be implemented in response to the COVID-19 pandemic. In order to conduct our operations in compliance with these laws and regulations, we must obtain and maintain numerous permits, approvals and certificates from various federal, state, local and international governmental authorities. We may incur substantial costs in order to maintain compliance with these existing laws and regulations. In addition, our costs of compliance may increase if existing laws and regulations are revised or reinterpreted or if new laws and regulations become applicable to our operations. These costs could have an adverse impact on our business or results of operations. Moreover, our failure to comply with these laws and regulations, as interpreted and enforced, could lead to fines, penalties or management distraction or otherwise harm our business.\\nOur insurance may not provide adequate levels of coverage against claims.\\nWe believe that we maintain insurance customary for businesses of our size and type. However, there are types of losses we may incur that cannot be insured against or that we believe are not economically reasonable to insure. Further, insurance may not continue to be available to us on acceptable terms, if at all, and, if available, coverage may not be adequate. If we are unable to obtain insurance at an acceptable cost or on acceptable terms, we could be exposed to significant losses.\\nWe have incurred and will continue to incur increased costs as a public company.\\nAs a public company, we have incurred and will continue to incur significant legal, accounting, insurance, and other expenses that we did not incur as a private company, including costs associated with public company reporting requirements. We also have incurred and will incur costs associated with the Sarbanes-Oxley Act and related rules implemented by the SEC. The expenses incurred by public companies for reporting and corporate governance purposes generally have been increasing. We expect these rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly, although we are currently unable to estimate these costs with any degree of certainty. In estimating these costs, we took into account expenses related to insurance, legal, accounting, and compliance activities, as well as other expenses not currently incurred. These laws and regulations could also make it more difficult or costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. These laws and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, on our board committees, or as our executive officers. Furthermore, if we are unable to satisfy our obligations as a public company, we could be subject to delisting of our Class A common stock, fines, sanctions, and other regulatory action and potentially civil litigation.\\nOur management has limited experience in operating a public company.\\nOur executive officers have limited experience in the management of a publicly traded company. Our management team may not successfully or effectively manage our transition to a public company that will be\\n72\\nsubject to significant regulatory oversight and reporting obligations under federal securities laws. Their limited experience in dealing with the increasingly complex laws pertaining to public companies could be a significant disadvantage in that it is likely that an increasing amount of their time may be devoted to these activities which will result in less time being devoted to the management and growth of the Company. We may not have adequate personnel with the appropriate level of knowledge, experience, and training in the accounting policies, practices or internal control over financial reporting required of public companies in the United States. The development and implementation of the standards and controls necessary for the Company to achieve the level of accounting standards required of a public company in the United States may require costs greater than expected. It is possible that we will be required to expand our employee base and hire additional employees to support our operations as a public company which will increase our operating costs in future periods.\\nIf securities analysts do not publish research or reports about our business or if they publish negative evaluations of our common stock, the price of our Class A common stock could decline.\\nThe trading market for our Class A common stock will rely in part on the research and reports that industry or financial analysts publish about us or our business. If few analysts commence coverage of us, the trading price of our stock could be negatively affected. Even with analyst coverage, if one or more of the analysts covering our business downgrade their evaluations of our stock, the price of our Class A common stock could decline. If one or more of these analysts cease to cover our common stock, we could lose visibility in the market for our Class A common stock, which in turn could cause our Class A common stock price to decline.\\nSubstantial future sales of our Class A common stock, or the perception in the public markets that these sales may occur, may depress our stock price.\\nSales of substantial amounts of our common stock in the public market, or the perception that these sales could occur, could adversely affect the price of our common stock and could impair our ability to raise capital through the sale of additional shares. Certain shares of our common stock are freely tradable without restriction under the Securities Act, except for any shares of our common stock that may be held or acquired by our directors, executive officers, and other affiliates, as that term is defined in the Securities Act, which are to be restricted securities under the Securities Act. Restricted securities may not be sold in the public market unless the sale is registered under the Securities Act or an exemption from registration is available. Topco, the Advantage Sponsors, the CP Sponsor and members of our management have rights, subject to certain conditions, to require us to file registration statements covering Topco’s shares of our common stock or to include shares in registration statements that we may file for ourselves or other stockholders. In each of November 2020 and March 2021, we filed a registration statement on Form S-1 under which certain of our shareholders may sell, from time to time, 50,000,000 shares and 255,465,000 shares of our Class A common stock, respectively, that, if sold, will be freely tradable without restriction under the Securities Act. In the event a large number of shares of Class A common stock are sold in the public market, such sales could reduce the market price of our Class A common stock.\\nWe may also issue shares of our common stock or securities convertible into our common stock from time to time in connection with financings, acquisitions, investments, or otherwise. Any such issuance could result in ownership dilution to you as a stockholder and cause the trading price of our common stock to decline.\\n\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\\nNone\\n\\nItem 3. Defaults Upon Senior Securities\\nNone\\n\\nItem 4. Mine Safety Disclosures\\nNone\\n73\\n\\nItem 5. Other Information\\nNone\\n\\nItem 6. Exhibits\\n74\\nSignatures 75\\n2\\nPART I - FINANCIAL INFORMATION\\nITEM 1. FINANCIAL STATEMENTS\\nADVANTAGE SOLUTIONS INC.\\nCONDENSED CONSOLIDATED BALANCE SHEETS\\n(UNAUDITED)\\n\\n| September 30, | December 31, |\\n| (in thousands, except share data) | 2022 | 2021 |\\n| ASSETS |\\n| Current assets |\\n| Cash and cash equivalents | $ | 96,215 | $ | 164,622 |\\n| Restricted cash | 18,079 | 16,015 |\\n| Accounts receivable, net of allowance for expected credit losses of $ 13,648 and $ 15,916 , respectively | 833,432 | 797,677 |\\n| Prepaid expenses and other current assets | 155,429 | 126,000 |\\n| Total current assets | 1,103,155 | 1,104,314 |\\n| Property and equipment, net | 69,084 | 63,696 |\\n| Goodwill | 2,246,053 | 2,206,004 |\\n| Other intangible assets, net | 2,150,075 | 2,287,514 |\\n| Investments in unconsolidated affiliates | 124,815 | 125,158 |\\n| Other assets | 120,644 | 67,582 |\\n| Total assets | $ | 5,813,826 | $ | 5,854,268 |\\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\\n| Current liabilities |\\n| Current portion of long-term debt | $ | 14,704 | $ | 14,397 |\\n| Accounts payable | 267,684 | 277,366 |\\n| Accrued compensation and benefits | 109,935 | 139,157 |\\n| Other accrued expenses | 161,246 | 164,133 |\\n| Deferred revenues | 47,441 | 50,467 |\\n| Total current liabilities | 601,010 | 645,520 |\\n| Long-term debt, net of current portion | 2,024,591 | 2,028,882 |\\n| Deferred income tax liabilities | 456,755 | 483,165 |\\n| Warrant liability | 733 | 22,189 |\\n| Other long-term liabilities | 109,421 | 92,218 |\\n| Total liabilities | 3,192,510 | 3,271,974 |\\n| Commitments and contingencies (Note 10) |\\n| Redeemable noncontrolling interest | 3,353 | 1,893 |\\n| Equity attributable to stockholders of Advantage Solutions Inc. |\\n| Common stock, $ 0.0001 par value, 3,290,000,000 shares authorized; 319,675,888 and 316,963,552 shares issued and outstanding as of September 30, 2022 and December 31, 2021, respectively | 32 | 32 |\\n| Additional paid in capital | 3,398,477 | 3,373,278 |\\n| Accumulated deficit | ( 823,212 | ) | ( 866,607 | ) |\\n| Loans to Karman Topco L.P. | ( 6,357 | ) | ( 6,340 | ) |\\n| Accumulated other comprehensive loss | ( 29,978 | ) | ( 4,479 | ) |\\n| Treasury stock, at cost; 1,610,014 shares as of September 30, 2022 and December 31, 2021 | ( 12,567 | ) | ( 12,567 | ) |\\n| Total equity attributable to stockholders of Advantage Solutions Inc. | 2,526,395 | 2,483,317 |\\n| Nonredeemable noncontrolling interest | 91,568 | 97,084 |\\n| Total stockholders’ equity | 2,617,963 | 2,580,401 |\\n| Total liabilities, redeemable noncontrolling interest, and stockholders’ equity | $ | 5,813,826 | $ | 5,854,268 |\\n\\nSee Notes to the Condensed Consolidated Financial Statements.\\n3\\nADVANTAGE SOLUTIONS INC.\\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME\\n(UNAUDITED)\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (in thousands, except share and per share data) | 2022 | 2021 | 2022 | 2021 |\\n| Revenues | $ | 1,051,095 | $ | 928,760 | $ | 2,946,979 | $ | 2,569,735 |\\n| Cost of revenues (exclusive of depreciation and amortization shown separately below) | 908,523 | 766,253 | 2,536,256 | 2,117,818 |\\n| Selling, general, and administrative expenses | 37,945 | 37,742 | 138,594 | 124,830 |\\n| Depreciation and amortization | 57,785 | 59,163 | 173,997 | 181,450 |\\n| Total operating expenses | 1,004,253 | 863,158 | 2,848,847 | 2,424,098 |\\n| Operating income | 46,842 | 65,602 | 98,132 | 145,637 |\\n| Other (income) expenses: |\\n| Change in fair value of warrant liability | ( 1,100 | ) | ( 3,491 | ) | ( 21,456 | ) | ( 5,024 | ) |\\n| Interest expense, net | 23,557 | 36,490 | 63,628 | 104,544 |\\n| Total other expenses | 22,457 | 32,999 | 42,172 | 99,520 |\\n| Income before income taxes | 24,385 | 32,603 | 55,960 | 46,117 |\\n| Provision for income taxes | 1,158 | 8,276 | 11,523 | 16,582 |\\n| Net income | 23,227 | 24,327 | 44,437 | 29,535 |\\n| Less: net income attributable to noncontrolling interest | 2,168 | 1,016 | 1,042 | 219 |\\n| Net income attributable to stockholders of Advantage Solutions Inc. | 21,059 | 23,311 | 43,395 | 29,316 |\\n| Other comprehensive loss, net of tax: |\\n| Foreign currency translation adjustments | ( 13,616 | ) | ( 2,443 | ) | ( 25,499 | ) | ( 4,239 | ) |\\n| Total comprehensive income attributable to stockholders of Advantage Solutions Inc. | $ | 7,443 | $ | 20,868 | $ | 17,896 | $ | 25,077 |\\n| Net income per common share: |\\n| Basic | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\\n| Diluted | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\\n| Weighted-average number of common shares: |\\n| Basic | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\\n| Diluted | 319,725,065 | 320,120,634 | 319,190,804 | 319,654,817 |\\n\\nSee Notes to the Condensed Consolidated Financial Statements.\\n4\\nADVANTAGE SOLUTIONS INC.\\nCONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\\n(UNAUDITED)\\n\\n| Accumulated | Advantage |\\n| Common Stock | Treasury Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\\n| Shares | Amount | Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\\n| (in thousands, except share data) |\\n| Balance at July 1, 2022 | 318,465,449 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,390,899 | $ | ( 844,271 | ) | $ | ( 6,351 | ) | $ | ( 16,362 | ) | $ | 2,511,380 | $ | 90,109 | $ | 2,601,489 |\\n| Comprehensive income (loss) |\\n| Net income | — | — | — | — | — | 21,059 | — | — | 21,059 | 2,092 | 23,151 |\\n| Foreign currency translation adjustments | — | — | — | — | — | — | — | ( 13,616 | ) | ( 13,616 | ) | ( 6,824 | ) | ( 20,440 | ) |\\n| Total comprehensive income (loss) | 7,443 | ( 4,732 | ) | 2,711 |\\n| Interest on loans to Karman Topco L.P. | — | — | — | — | — | — | ( 6 | ) | — | ( 6 | ) | — | ( 6 | ) |\\n| Increase in noncontrolling interest | — | — | — | — | — | — | — | — | — | 6,191 | 6,191 |\\n| Equity-based compensation of Karman Topco L.P. | — | — | — | — | ( 828 | ) | — | — | — | ( 828 | ) | — | ( 828 | ) |\\n| Shares issued under 2020 Employee Stock Purchase Plan | 470,786 | — | — | — | 1,667 | — | — | — | 1,667 | — | 1,667 |\\n| Shares issued under 2020 Incentive Award Plan | 739,653 | — | — | — | — | — | — | — | — | — | — |\\n| Stock-based compensation expense | — | — | — | — | 6,739 | — | — | — | 6,739 | — | 6,739 |\\n| Balance at September 30, 2022 | 319,675,888 | $ | 32 | $ | 1,610,014 | $ | ( 12,567 | ) | $ | 3,398,477 | $ | ( 823,212 | ) | $ | ( 6,357 | ) | $ | ( 29,978 | ) | $ | 2,526,395 | $ | 91,568 | $ | 2,617,963 |\\n\\n\\n| Accumulated | Advantage |\\n| Common Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\\n| Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\\n| (in thousands, except share data) |\\n| Balance at July 1, 2021 | 318,496,390 | $ | 32 | $ | 3,361,262 | $ | ( 915,096 | ) | $ | ( 6,328 | ) | $ | ( 1,122 | ) | $ | 2,438,748 | $ | 95,916 | $ | 2,534,664 |\\n| Comprehensive income (loss) |\\n| Net income | — | — | — | 23,311 | — | — | 23,311 | 973 | 24,284 |\\n| Foreign currency translation adjustments | — | — | — | — | — | ( 2,443 | ) | ( 2,443 | ) | ( 2,305 | ) | ( 4,748 | ) |\\n| Total comprehensive income (loss) | 20,868 | ( 1,332 | ) | 19,536 |\\n| Interest on loans to Karman Topco L.P. | — | — | — | — | ( 6 | ) | — | ( 6 | ) | — | ( 6 | ) |\\n| Redemption of noncontrolling interest | — | — | ( 16 | ) | — | — | — | ( 16 | ) | — | ( 16 | ) |\\n| Equity-based compensation of Karman Topco L.P. | — | — | ( 6,030 | ) | — | — | — | ( 6,030 | ) | — | ( 6,030 | ) |\\n| Shares issued upon exercise of warrants | 1 | — | — | — | — | — | — | — | — |\\n| Shares issued under 2020 Employee Stock Purchase Plan | 77,172 | — | 736 | — | — | — | 736 | — | 736 |\\n| Stock-based compensation expense | — | — | 8,413 | — | — | — | 8,413 | — | 8,413 |\\n| Balance at September 30, 2021 | 318,573,563 | $ | 32 | $ | 3,364,365 | $ | ( 891,785 | ) | $ | ( 6,334 | ) | $ | ( 3,565 | ) | $ | 2,462,713 | $ | 94,584 | $ | 2,557,297 |\\n\\nSee Notes to the Condensed Consolidated Financial Statements.\\n5\\n\\n| Accumulated | Advantage |\\n| Common Stock | Treasury Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\\n| Shares | Amount | Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\\n| (in thousands, except share data) |\\n| Balance at January 1, 2022 | 316,963,552 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,373,278 | $ | ( 866,607 | ) | $ | ( 6,340 | ) | $ | ( 4,479 | ) | $ | 2,483,317 | $ | 97,084 | $ | 2,580,401 |\\n| Comprehensive income (loss) |\\n| Net income | — | — | — | — | — | 43,395 | — | — | 43,395 | 918 | 44,313 |\\n| Foreign currency translation adjustments | — | — | — | — | — | — | — | ( 25,499 | ) | ( 25,499 | ) | ( 12,625 | ) | ( 38,124 | ) |\\n| Total comprehensive income (loss) | — | — | — | — | — | — | — | — | 17,896 | ( 11,707 | ) | 6,189 |\\n| Interest on loans to Karman Topco L.P. | — | — | — | — | — | — | ( 17 | ) | — | ( 17 | ) | — | ( 17 | ) |\\n| Increase in noncontrolling interest | — | — | — | — | — | — | — | — | — | 6,191 | 6,191 |\\n| Equity-based compensation of Karman Topco L.P. | — | — | — | — | ( 7,142 | ) | — | — | — | ( 7,142 | ) | — | ( 7,142 | ) |\\n| Shares issued under 2020 Employee Stock Purchase Plan | 713,213 | — | — | — | 3,320 | — | — | — | 3,320 | — | 3,320 |\\n| Shares issued under 2020 Incentive Award Plan | 1,999,123 | — | — | — | — | — | — | — | — | — | — |\\n| Stock-based compensation expense | — | — | — | — | 29,021 | — | — | — | 29,021 | — | 29,021 |\\n| Balance at September 30, 2022 | 319,675,888 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,398,477 | $ | ( 823,212 | ) | $ | ( 6,357 | ) | $ | ( 29,978 | ) | $ | 2,526,395 | $ | 91,568 | $ | 2,617,963 |\\n\\n\\n| Accumulated | Advantage |\\n| Common Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\\n| Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\\n| (in thousands, except share data) |\\n| Balance at January 1, 2021 | 318,425,182 | $ | 32 | $ | 3,348,546 | $ | ( 921,101 | ) | $ | ( 6,316 | ) | $ | 674 | $ | 2,421,835 | $ | 96,954 | $ | 2,518,789 |\\n| Comprehensive income (loss) |\\n| Net income | — | — | — | 29,316 | — | — | 29,316 | 190 | 29,506 |\\n| Foreign currency translation adjustments | — | — | — | — | — | ( 4,239 | ) | ( 4,239 | ) | ( 2,796 | ) | ( 7,035 | ) |\\n| Total comprehensive income (loss) | 25,077 | ( 2,606 | ) | 22,471 |\\n| Interest on loans to Karman Topco L.P. | — | — | — | — | ( 18 | ) | — | ( 18 | ) | — | ( 18 | ) |\\n| Redemption of noncontrolling interest | — | — | ( 452 | ) | — | — | — | ( 452 | ) | 236 | ( 216 | ) |\\n| Equity-based compensation of Karman Topco L.P. | — | — | ( 13,140 | ) | — | — | — | ( 13,140 | ) | — | ( 13,140 | ) |\\n| Shares issued under 2020 Incentive Award Plan | 24,784 | — | — | — | — | — | — | — | — |\\n| Shares issued upon vesting of restricted stock units | 41,424 | — | — | — | — | — | — | — | — |\\n| Shares issued under 2020 Employee Stock Purchase Plan | 77,172 | — | 736 | — | — | — | 736 | — | 736 |\\n| Shares issued upon exercise of warrants | 5,001 | — | 58 | — | — | — | 58 | — | 58 |\\n| Stock-based compensation expense | — | — | 28,617 | — | — | — | 28,617 | — | 28,617 |\\n| Balance at September 30, 2021 | 318,573,563 | $ | 32 | $ | 3,364,365 | $ | ( 891,785 | ) | $ | ( 6,334 | ) | $ | ( 3,565 | ) | $ | 2,462,713 | $ | 94,584 | $ | 2,557,297 |\\n\\nSee Notes to the Condensed Consolidated Financial Statements.\\n6\\nADVANTAGE SOLUTIONS INC.\\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\\n(UNAUDITED)\\n\\n| Nine Months Ended September 30, |\\n| (in thousands) | 2022 | 2021 |\\n| CASH FLOWS FROM OPERATING ACTIVITIES |\\n| Net income | $ | 44,437 | $ | 29,535 |\\n| Adjustments to reconcile net income to net cash provided by operating activities |\\n| Noncash interest (income) expense, net | ( 34,419 | ) | 2,893 |\\n| Depreciation and amortization | 173,997 | 181,450 |\\n| Change in fair value of warrant liability | ( 21,456 | ) | ( 5,024 | ) |\\n| Fair value adjustments related to contingent consideration | 5,448 | 6,977 |\\n| Deferred income taxes | ( 28,561 | ) | ( 17,468 | ) |\\n| Equity-based compensation of Karman Topco L.P. | ( 7,142 | ) | ( 13,140 | ) |\\n| Stock-based compensation | 29,906 | 28,617 |\\n| Equity in earnings of unconsolidated affiliates | ( 6,480 | ) | ( 6,222 | ) |\\n| Distribution received from unconsolidated affiliates | 1,339 | 1,154 |\\n| Loss on disposal of property and equipment | 608 | 6,327 |\\n| Loss on divestiture | 2,953 | — |\\n| Changes in operating assets and liabilities, net of effects from purchases of businesses: |\\n| Accounts receivable, net | ( 45,383 | ) | ( 121,036 | ) |\\n| Prepaid expenses and other assets | ( 45,087 | ) | ( 64,716 | ) |\\n| Accounts payable | ( 7,914 | ) | 37,294 |\\n| Accrued compensation and benefits | ( 26,316 | ) | 16,684 |\\n| Deferred revenues | ( 156 | ) | 2,869 |\\n| Other accrued expenses and other liabilities | 46,176 | 14,874 |\\n| Net cash provided by operating activities | 81,950 | 101,068 |\\n| CASH FLOWS FROM INVESTING ACTIVITIES |\\n| Purchase of businesses, net of cash acquired | ( 74,146 | ) | ( 40,046 | ) |\\n| Purchase of investment in unconsolidated affiliates | ( 775 | ) | ( 2,000 | ) |\\n| Purchase of property and equipment | ( 30,037 | ) | ( 24,106 | ) |\\n| Proceeds from divestiture | 1,896 | — |\\n| Net cash used in investing activities | ( 103,062 | ) | ( 66,152 | ) |\\n| CASH FLOWS FROM FINANCING ACTIVITIES |\\n| Borrowings under lines of credit | 140,333 | 51,685 |\\n| Payments on lines of credit | ( 139,684 | ) | ( 102,493 | ) |\\n| Proceeds from issuance of long-term debt | 266 | — |\\n| Principal payments on long-term debt | ( 10,427 | ) | ( 10,133 | ) |\\n| Proceeds from issuance of common stock | 3,320 | 794 |\\n| Contingent consideration payments | ( 23,164 | ) | ( 6,247 | ) |\\n| Holdback payments | ( 8,557 | ) | ( 2,389 | ) |\\n| Contribution from noncontrolling interest | 5,217 | — |\\n| Redemption of noncontrolling interest | ( 224 | ) | ( 216 | ) |\\n| Net cash used in financing activities | ( 32,920 | ) | ( 68,999 | ) |\\n| Net effect of foreign currency changes on cash | ( 12,311 | ) | ( 1,476 | ) |\\n| Net change in cash, cash equivalents and restricted cash | ( 66,343 | ) | ( 35,559 | ) |\\n| Cash, cash equivalents and restricted cash, beginning of period | 180,637 | 219,966 |\\n| Cash, cash equivalents and restricted cash, end of period | $ | 114,294 | $ | 184,407 |\\n| SUPPLEMENTAL CASH FLOW INFORMATION |\\n| Purchase of property and equipment recorded in accounts payable and accrued expenses | $ | 1,409 | $ | 322 |\\n\\nSee Notes to the Condensed Consolidated Financial Statements.\\n7\\nADVANTAGE SOLUTIONS INC.\\nNOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(UNAUDITED)\\n1. Organization and Significant Accounting Policies Advantage Solutions Inc. (the “Company”) is a provider of outsourced solutions to consumer goods companies and retailers. The Company’s Class A common stock is listed on the Nasdaq Global Select Market under the symbol “ADV” and warrants to purchase the Class A common stock at an exercise price of $ 11.50 per share are listed on the Nasdaq Global Select Market under the symbol “ADVWW”. Basis of Presentation The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its subsidiaries. The unaudited condensed consolidated financial statements do not include all of the information required by accounting principles generally accepted in the United States (“GAAP”). The Condensed Consolidated Balance Sheet at December 31, 2021 was derived from the audited Consolidated Balance Sheet at that date and does not include all the disclosures required by GAAP. In the opinion of management, all adjustments which are of a normal recurring nature and necessary for a fair statement of the results as of September 30, 2022 and for the three and nine months ended September 30, 2022 and 2021 have been reflected in the condensed consolidated financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements as of and for the year ended December 31, 2021 and the related footnotes thereto. Operating results for the three and nine months ended September 30, 2022 are not necessarily indicative of the results to be expected during the remainder of the current year or for any future period. COVID-19 Pandemic Beginning in March 2020 and continuing through the first quarter of 2021, the Company’s services experienced the most severe effects from reductions in client spending due to the economic impact related to the COVID-19 pandemic. While mixed by services and geography, the spending reductions impacted all of the Company’s services and markets. Globally, the most impacted services were the Company's experiential services. Most services began to recover in April 2021, and the recovery has continued through the third quarter of 2022. Impact of the War in Ukraine The Company has a minority interest in a European company that has majority-ownership interests in local agencies in Russia. During the first quarter of 2022, the war in Ukraine resulted in the imposition of sanctions by the United States, the United Kingdom, and the European Union, that affected, and continues to affect, the cross-border operations of businesses operating in Russia. In addition, Russian regulators have imposed currency restrictions and regulations that created uncertainty regarding the Company's ability to recover its investment in operations in Russia, as well as the Company's ability to exercise control or influence over operations by the local agencies in Russia. As a result, the Company intends to use its influence to cause the European company to dispose of its ownership interests in the local agencies in Russia. Accordingly, the Company recorded pretax charges of $ 2.8 million in the first quarter of 2022, primarily consisting of its proportionate share of the net investment in its Russian interest in “Selling, general, and administrative expenses” in the Condensed Consolidated Statements of Operations and Comprehensive Income. Recent Accounting StandardsAccounting Standards Recently Adopted by the CompanyIn March 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on 8 Financial Reporting. This guidance provides optional expedients and exceptions for GAAP to contracts, hedging relationships, and other transactions that reference the London Interbank Offered Rate (“LIBOR”) or another reference rate if certain criteria are met. The amendments in this update are effective for reporting periods that include or are subsequent to March 12, 2020 and must be applied prospectively to contract modifications and hedging relationships through December 31, 2022. On April 1, 2022, the Company adopted the standard prospectively and determined that the adoption of this accounting guidance did not have a material impact on its condensed consolidated financial statements.On January 1, 2022, the Company adopted ASU No. 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity (“ASU 2020-06”), which simplifies accounting for convertible instruments by removing major separation models required under current GAAP, simplifies the contract settlement assessment for equity classification, requires the use of the if-converted method for all convertible instruments in the diluted earnings per share calculation and expands disclosure requirements. The adoption of this accounting standard, under the full retrospective method, did not have a material impact on the Company's condensed consolidated financial statements and use of the if-converted method did not have an impact on the Company's overall earnings per share calculation.On January 1, 2022, the Company adopted ASU 2021-04, Earnings Per Share (Topic 260), Debt—Modifications and Extinguishments (Subtopic 470-50), Compensation—Stock Compensation (Topic 718), and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Issuer’s Accounting for Certain Modifications or Exchanges of Freestanding Equity-Classified Written Call Options (a consensus of the FASB Emerging Issues Task Force). The guidance clarifies certain aspects of the current guidance to promote consistency among reporting of an issuer’s accounting for modifications or exchanges of freestanding equity-classified written call options (for example, warrants) that remain equity-classified after modification or exchange. The guidance is applied prospectively to all modifications or exchanges that occur on or after the date of adoption and the adoption of this accounting standard did not have a material impact on the Company’s condensed consolidated financial statements.On January 1, 2022, the Company adopted ASU 2021-10, Government Assistance (Topic 832): Disclosures by Business Entities about Government Assistance. This update requires annual disclosures about transactions with a government that are accounted for by applying a grant or contribution accounting model by analogy. The guidance is applied prospectively to all transactions within the scope of the amendments that are reflected in financial statements at the date of initial application and new transactions that are entered into after the date of initial application. The adoption of this accounting standard did not have a material impact on the Company’s condensed consolidated financial statements. Accounting Standards Recently Issued but Not Yet Adopted by the CompanyIn October 2021, the FASB issued ASU 2021-08, Business Combinations (Topic 606): Accounting for Contract Assets and Contract Liabilities from Contracts with Customers, which requires that an entity recognize and measure contract assets and contract liabilities acquired in a business combination in accordance with Topic 606 as if it had originated the contracts. Generally, this should result in an acquirer recognizing and measuring the acquired contract assets and contract liabilities consistent with how they were recognized and measured in the acquiree’s financial statements, if the acquiree prepared financial statements in accordance with GAAP. The amendment in this update is effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. The guidance should be applied prospectively to business combinations occurring on or after the effective date of the amendment in this update. The Company is evaluating the potential impact of this adoption on its consolidated financial statements. All other new accounting pronouncements issued, but not yet effective or adopted have been deemed to be not relevant to the Company and, accordingly, are not expected to have a material impact once adopted.\\n9\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Sales brand-centric services | $ | 343,478 | $ | 330,740 | $ | 1,005,707 | $ | 946,147 |\\n| Sales retail-centric services | 302,768 | 266,399 | 836,640 | 746,960 |\\n| Total sales revenues | 646,246 | 597,139 | 1,842,347 | 1,693,107 |\\n| Marketing brand-centric services | 143,241 | 142,554 | 393,155 | 381,358 |\\n| Marketing retail-centric services | 261,608 | 189,067 | 711,477 | 495,270 |\\n| Total marketing revenues | 404,849 | 331,621 | 1,104,632 | 876,628 |\\n| Total revenues | $ | 1,051,095 | $ | 928,760 | $ | 2,946,979 | $ | 2,569,735 |\\n\\n| (in thousands) |\\n| Consideration: |\\n| Cash | $ | 74,146 |\\n| Holdback | 810 |\\n| Fair value of contingent consideration | 510 |\\n| Total consideration | $ | 75,466 |\\n| Recognized amounts of identifiable assets acquired and liabilities assumed: |\\n| Assets |\\n| Accounts receivable | $ | 9,409 |\\n| Other assets | 3,446 |\\n| Identifiable intangible assets | 25,546 |\\n| Total assets | 38,401 |\\n| Liabilities |\\n| Accounts payable | 7,363 |\\n| Deferred tax liabilities and other | 8,744 |\\n| Total liabilities | 16,107 |\\n| Redeemable noncontrolling interest | 1,987 |\\n| Noncontrolling interest | 974 |\\n| Total identifiable net assets | 19,333 |\\n| Goodwill arising from acquisitions | $ | 56,133 |\\n| (in thousands) | Amount | WeightedAverageUseful Life |\\n| Client relationships | $ | 24,413 | 6 years |\\n| Trade names | 1,133 | 10 years |\\n| Total identifiable intangible assets | $ | 25,546 |\\n| (in thousands) |\\n| Consideration |\\n| Cash | $ | 40,046 |\\n| Holdbacks | 13,599 |\\n| Fair value of contingent consideration | 19,883 |\\n| Total consideration | $ | 73,528 |\\n| Recognized amounts of identifiable assets acquired and liabilities assumed: |\\n| Assets |\\n| Accounts receivable | $ | 12,834 |\\n| Other assets | 4,400 |\\n| Property and equipment | 1,001 |\\n| Identifiable intangible assets | 36,210 |\\n| Total assets | 54,445 |\\n| Liabilities |\\n| Total liabilities | 21,758 |\\n| Redeemable noncontrolling interest | 1,804 |\\n| Total identifiable net assets | 30,883 |\\n| Goodwill arising from acquisitions | $ | 42,645 |\\n| (in thousands) | Amount | WeightedAverageUseful Life |\\n| Client relationships | $ | 27,860 | 7 years |\\n| Trade Names | 5,250 | 5 years |\\n| Developed technology | 3,100 | 7 years |\\n| Total identifiable intangible assets | $ | 36,210 |\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Revenues | $ | 1,052,274 | $ | 963,576 | $ | 2,962,479 | $ | 2,719,111 |\\n| Net income | $ | 21,467 | $ | 23,896 | $ | 46,461 | $ | 32,590 |\\n\\n\\n| Sales | Marketing | Total |\\n| (in thousands) |\\n| Balance at January 1, 2021 | $ | 1,462,378 | $ | 700,961 | $ | 2,163,339 |\\n| Acquisitions | 32,087 | 13,315 | 45,402 |\\n| Measurement period adjustments | 179 | ( 1,043 | ) | ( 864 | ) |\\n| Foreign exchange translation effects | ( 1,873 | ) | — | ( 1,873 | ) |\\n| Balance at December 31, 2021 | $ | 1,492,771 | $ | 713,233 | $ | 2,206,004 |\\n| Acquisitions | 5,672 | 50,461 | 56,133 |\\n| Measurement period adjustments | ( 446 | ) | — | ( 446 | ) |\\n| Foreign exchange translation effects | ( 15,638 | ) | — | ( 15,638 | ) |\\n| Balance at September 30, 2022 | $ | 1,482,359 | $ | 763,694 | $ | 2,246,053 |\\n| September 30, 2022 |\\n| (amounts in thousands) | Weighted Average Useful Life | Gross CarryingValue | AccumulatedAmortization | Net Carrying Value |\\n| Finite-lived intangible assets: |\\n| Client relationships | 14 years | $ | 2,486,064 | $ | 1,290,842 | $ | 1,195,222 |\\n| Trade names | 8 years | 135,271 | 84,067 | 51,204 |\\n| Developed technology | 5 years | 13,260 | 9,870 | 3,390 |\\n| Covenant not to compete | 5 years | 6,100 | 5,841 | 259 |\\n| Total finite-lived intangible assets | 2,640,695 | 1,390,620 | 1,250,075 |\\n| Indefinite-lived intangible assets: |\\n| Trade names | 900,000 | — | 900,000 |\\n| Total other intangible assets | $ | 3,540,695 | $ | 1,390,620 | $ | 2,150,075 |\\n| December 31, 2021 |\\n| (amounts in thousands) | Weighted Average Useful Life | Gross CarryingValue | AccumulatedAmortization | Net Carrying Value |\\n| Finite-lived intangible assets: |\\n| Client relationships | 14 years | $ | 2,480,167 | $ | 1,158,732 | $ | 1,321,435 |\\n| Trade names | 8 years | 138,206 | 78,355 | 59,851 |\\n| Developed technology | 5 years | 13,260 | 8,206 | 5,054 |\\n| Covenant not to compete | 5 years | 6,100 | 4,926 | 1,174 |\\n| Total finite-lived intangible assets | 2,637,733 | 1,250,219 | 1,387,514 |\\n| Indefinite-lived intangible assets: |\\n| Trade names | 900,000 | — | 900,000 |\\n| Total other intangible assets | $ | 3,537,733 | $ | 1,250,219 | $ | 2,287,514 |\\n| (in thousands) |\\n| Remainder of 2022 | $ | 49,782 |\\n| 2023 | 197,530 |\\n| 2024 | 196,181 |\\n| 2025 | 190,153 |\\n| 2026 | 186,203 |\\n| Thereafter | 430,226 |\\n| Total amortization expense | $ | 1,250,075 |\\n\\n\\n| September 30, | December 31, |\\n| (in thousands) | 2022 | 2021 |\\n| Term Loan Facility | $ | 1,301,813 | $ | 1,311,750 |\\n| Notes | 775,000 | 775,000 |\\n| Government loans for COVID-19 relief | 4,113 | 5,212 |\\n| Other | 1,492 | 1,113 |\\n| Total long-term debt | 2,082,418 | 2,093,075 |\\n| Less: current portion | 14,704 | 14,397 |\\n| Less: debt issuance costs | 43,123 | 49,796 |\\n| Long-term debt, net of current portion | $ | 2,024,591 | $ | 2,028,882 |\\n\\n| September 30, 2022 |\\n| (in thousands) | Fair Value | Level 1 | Level 2 | Level 3 |\\n| Assets measured at fair value |\\n| Derivative financial instruments | $ | 49,149 | $ | — | $ | 49,149 | $ | — |\\n| Total assets measured at fair value | $ | 49,149 | $ | — | $ | 49,149 | $ | — |\\n| Liabilities measured at fair value |\\n| Warrant liability | $ | 733 | $ | — | $ | 733 | $ | — |\\n| Contingent consideration liabilities | 40,431 | — | — | 40,431 |\\n| Total liabilities measured at fair value | $ | 41,164 | $ | — | $ | 733 | $ | 40,431 |\\n| December 31, 2021 |\\n| (in thousands) | Fair Value | Level 1 | Level 2 | Level 3 |\\n| Assets measured at fair value |\\n| Derivative financial instruments | $ | 10,164 | $ | — | $ | 10,164 | $ | — |\\n| Total assets measured at fair value | $ | 10,164 | $ | — | $ | 10,164 | $ | — |\\n| Liabilities measured at fair value |\\n| Derivative financial instruments | $ | 385 | $ | — | $ | 385 | $ | — |\\n| Warrant liability | 22,189 | — | — | 22,189 |\\n| Contingent consideration liabilities | 58,366 | — | — | 58,366 |\\n| Total liabilities measured at fair value | $ | 80,940 | $ | — | $ | 385 | $ | 80,555 |\\n| September 30, |\\n| (in thousands) | 2022 | 2021 |\\n| Beginning of the period | $ | 58,366 | $ | 45,901 |\\n| Fair value of acquisitions | 510 | 19,883 |\\n| Changes in fair value | 5,448 | 6,977 |\\n| Payments | ( 23,164 | ) | ( 6,399 | ) |\\n| Measurement period adjustments | — | ( 1,181 | ) |\\n| Foreign exchange translation effects | ( 729 | ) | ( 69 | ) |\\n| End of the period | $ | 40,431 | $ | 65,112 |\\n| (in thousands) | Carrying Value | Fair Value(Level 2) |\\n| Balance at September 30, 2022 |\\n| Term Loan Facility | $ | 1,301,813 | $ | 1,329,741 |\\n| Notes | 775,000 | 723,486 |\\n| Government loans for COVID-19 relief | 4,113 | 4,306 |\\n| Other | 1,492 | 1,492 |\\n| Total long-term debt | $ | 2,082,418 | $ | 2,059,025 |\\n| (in thousands) | Carrying Value | Fair Value(Level 2) |\\n| Balance at December 31, 2021 |\\n| Term Loan Facility | $ | 1,311,750 | $ | 1,406,552 |\\n| Notes | 775,000 | 894,611 |\\n| Government loans for COVID-19 relief | 5,212 | 5,615 |\\n| Other | 1,113 | 1,113 |\\n| Total long-term debt | $ | 2,093,075 | $ | 2,307,891 |\\n\\n\\n| Revenues | Accounts Receivable |\\n| Three Months Ended September 30, | Nine Months Ended September 30, | As of September 30, | As of December 31, |\\n| (in thousands) | 2022 | 2021 | 2022 | 2021 | 2022 | 2021 |\\n| Client 1 | $ | 450 | $ | — | $ | 1,275 | $ | — | $ | 301 | $ | 176 |\\n| Client 2 | 136 | 42 | 668 | 75 | 289 | 160 |\\n| Client 3 | 147 | 124 | 455 | 457 | 129 | 190 |\\n| All other clients | 30 | 1,452 | 152 | 6,694 | 16 | 10 |\\n| Total | $ | 763 | $ | 1,618 | $ | 2,550 | $ | 7,226 | $ | 735 | $ | 536 |\\n\\n8. Income TaxesThe Company’s effective tax rates were 4.7 % and 25.4 % for the three months ended September 30, 2022 and 2021, respectively. The effective tax rate is based upon the estimated income or loss before taxes for the year, by jurisdiction, and adjusted for estimated permanent tax adjustments. The fluctuation in the Company’s effective tax rate was primarily due to the three months pretax book income differences and the discrete impact of $ 5.0 million to remeasure the deferred tax liability as a result of a reduction in the Company's blended state tax rate driven primarily by a Pennsylvania statutory tax rate change for the three months ended September 30, 2022, no t included in the three months ended September 30, 2021.The Company’s effective tax rates were 20.6 % and 36.0 % for the nine months ended September 30, 2022 and 2021, respectively. The effective tax rate is based upon the estimated income or loss before taxes for the year, by jurisdiction, and adjusted for estimated permanent tax adjustments. The fluctuation in the Company’s effective tax rate was primarily due to the nine months pretax book income differences, the discrete impact of $ 5.0 million to remeasure the deferred tax liability as a result of a reduction in the Company's blended state tax rate driven primarily by a Pennsylvania statutory tax rate change for the nine months ended September 30, 2022, offset by a shortfall adjustment of $ 2.4 million of stock based compensation for the nine months ended September 30, 2022. On August 16, 2022, the U.S. government enacted the Inflation Reduction Act (“IRA”), which imposes a new corporate alternative minimum tax (“CAMT”), an excise tax on stock buybacks, and significant tax incentives for energy and climate initiatives, among other provisions. The Company does not expect the CAMT to have a material impact on its consolidated financial statements.\\n| (in thousands) | Sales | Marketing | Total |\\n| Three Months Ended September 30, 2022 |\\n| Revenues | $ | 646,246 | $ | 404,849 | $ | 1,051,095 |\\n| Depreciation and amortization | $ | 39,798 | $ | 17,987 | $ | 57,785 |\\n| Operating income | $ | 31,765 | $ | 15,077 | $ | 46,842 |\\n| Three Months Ended September 30, 2021 |\\n| Revenues | $ | 597,139 | $ | 331,621 | $ | 928,760 |\\n| Depreciation and amortization | $ | 41,515 | $ | 17,648 | $ | 59,163 |\\n| Operating income | $ | 51,906 | $ | 13,696 | $ | 65,602 |\\n| (in thousands) | Sales | Marketing | Total |\\n| Nine Months Ended September 30, 2022 |\\n| Revenues | $ | 1,842,347 | $ | 1,104,632 | $ | 2,946,979 |\\n| Depreciation and amortization | $ | 121,310 | $ | 52,687 | $ | 173,997 |\\n| Operating income | $ | 65,915 | $ | 32,217 | $ | 98,132 |\\n| Nine Months Ended September 30, 2021 |\\n| Revenues | $ | 1,693,107 | $ | 876,628 | $ | 2,569,735 |\\n| Depreciation and amortization | $ | 128,789 | $ | 52,661 | $ | 181,450 |\\n| Operating income | $ | 131,727 | $ | 13,910 | $ | 145,637 |\\n\\n10. Commitments and ContingenciesLitigationThe Company is involved in various legal matters that arise in the ordinary course of its business. Some of these legal matters purport or may be determined to be class and/or representative actions, or seek substantial damages, or penalties. The Company has accrued amounts in connection with certain legal matters, including with respect to certain of the matters described below. There can be no assurance, however, that these accruals will be sufficient to cover such matters or other legal matters or that such matters or other legal matters will not materially or adversely affect the Company’s financial position, liquidity, or results of operations.Employment MattersThe Company has also been involved in various litigation, including purported class or representative actions with respect to matters arising under the California Labor Code and Private Attorneys General Act. The Company has retained outside counsel to represent it in these matters and is vigorously defending its interests. Legal Matters Related to Take 5On April 1, 2018, the Company acquired certain assets and assumed liabilities of Take 5 Media Group (“Take 5”). In June 2019, as a result of a review of internal allegations related to inconsistency of data provided by Take 5 to its clients, the Company commenced an investigation into Take 5’s operations. In July 2019, as a result of the Company’s investigation, the Company determined that revenue during the fiscal year ended December 31, 2018 attributable to the Take 5 business had been recognized for services that were not performed on behalf of clients of Take 5 and that inaccurate reports were made to Take 5 clients about those services (referred to as the “Take 5 Matter”). As a result of these findings, in July 2019, the Company terminated all operations of Take 5, including the use of its associated trade names and the offering of its services to its clients and offered refunds to Take 5 clients of collected revenues attributable to Take 5 since the Company’s acquisition of Take 5. 20 USAO and FBI Voluntary Disclosure and Investigation Related to Take 5The Company voluntarily disclosed to the United States Attorney’s Office and the Federal Bureau of Investigation certain misconduct occurring at Take 5, a line of business that the Company closed in July 2019. The Company intends to cooperate in this and any other governmental investigations that may arise in connection with the Take 5 Matter. At this time, the Company cannot predict the ultimate outcome of any investigation related to the Take 5 Matter and is unable to estimate the potential impact such an investigation may have on the Company. Arbitration Proceedings Related to Take 5In August 2019, as a result of the Take 5 Matter, the Company provided a written indemnification claim notice to the sellers of Take 5 (the “Take 5 Sellers”) seeking monetary damages (including interest, fees and costs) based on allegations of breach of the asset purchase agreement (the “Take 5 APA”), as well as fraud. In September 2019, the Take 5 Sellers initiated arbitration proceedings against the Company, alleging breach of the Take 5 APA as a result of the Company’s decision to terminate the operations of the Take 5 business, and seeking monetary damages equal to all unpaid earn-out payments under the Take 5 APA (plus interest, fees and costs). In 2020, the Take 5 sellers amended their statement of claim to allege defamation, relating to statements the Company made to customers in connection with terminating the operations of the Take 5 business, and seeking monetary damages for the alleged injury to their reputation. The Company filed its response to the Take 5 Sellers’ claims, and asserted indemnification, fraud and other claims against the Take 5 Sellers as counterclaims and cross-claims in the arbitration proceedings. In October 2022, the arbitrator made a final award in favor of the Company. The Company is currently unable to estimate if or when it will be able to collect any amounts associated with this arbitration. Other Legal Matters Related to Take 5The Take 5 Matter may result in additional litigation against the Company, including lawsuits from clients, or governmental investigations, which may expose the Company to potential liability in excess of the amounts being offered by the Company as refunds to Take 5 clients. The Company is currently unable to determine the amount of any potential liability, costs or expenses (above the amounts already being offered as refunds) that may result from any lawsuits or investigations associated with the Take 5 Matter or determine whether any such issues will have any future material adverse effect on the Company’s financial position, liquidity, or results of operations. Although the Company has insurance covering certain liabilities, the insurance may not be sufficient to cover any potential liability or expenses associated with the Take 5 Matter.\\n| (in thousands, except share and per share data) Performance Period | Number ofSharesThreshold | Number ofSharesTarget | Number ofSharesMaximum | WeightedAverage FairValue perShare | Maximum Remaining Unrecognized Compensation Expense | Weighted-average remaining requisite service periods |\\n| January 1, 2022— December 31, 2022 | 2,479,997 | 4,959,993 | 7,439,990 | $ | 5.63 | $ | 80,689 | 1.5 years |\\n| January 1, 2021— December 31, 2021 | 1,121,698 | 1,121,698 | 1,319,458 | $ | 13.17 | $ | 4,982 | 1.1 years |\\n| Performance Share Units | Weighted Average GrantDate Fair Value |\\n| Outstanding at January 1, 2022 | 2,609,079 | $ | 13.07 |\\n| Granted | 5,393,085 | $ | 5.66 |\\n| Distributed | 660,880 | $ | 13.09 |\\n| Forfeited | 684,261 | $ | 8.19 |\\n| PSU performance adjustment | ( 377,572 | ) | $ | 11.19 |\\n| Outstanding at September 30, 2022 | 6,279,451 | $ | 7.22 |\\n| Number of RSUs | Weighted Average GrantDate Fair Value |\\n| Outstanding at January 1, 2022 | 3,660,553 | $ | 10.64 |\\n| Granted | 6,302,801 | $ | 5.74 |\\n| Distributed | 1,338,213 | $ | 10.61 |\\n| Forfeited | 869,955 | $ | 8.02 |\\n| Outstanding at September 30, 2022 | 7,755,186 | $ | 6.96 |\\n| September 30, |\\n| 2022 |\\n| Share Price | $ | 5.99 |\\n| Dividend yield | 0.0 | % |\\n| Expected volatility | 30.0 | % |\\n| Risk-free interest rate | 2.0 | % |\\n| Expected term (years) | 6.5 |\\n\\n\\n| (in thousands) |\\n| Balance at January 1, 2022 | $ | 1,893 |\\n| Fair value at acquisition | 1,987 |\\n| Net income attributable to redeemable noncontrolling interests | 124 |\\n| Dividend distribution | ( 223 | ) |\\n| Foreign currency translation adjustment | ( 428 | ) |\\n| Balance at September 30, 2022 | $ | 3,353 |\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (in thousands, except share and earnings per share data) | 2022 | 2021 | 2022 | 2021 |\\n| Basic earnings per share computation: |\\n| Numerator: |\\n| Net income attributable to stockholders of Advantage Solutions Inc. | $ | 21,059 | $ | 23,311 | $ | 43,395 | $ | 29,316 |\\n| Denominator: |\\n| Weighted average common shares - basic | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\\n| Basic earnings per common share | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\\n| Diluted earnings per share computation: |\\n| Numerator: |\\n| Net income attributable to stockholders of Advantage Solutions Inc. | $ | 21,059 | $ | 23,311 | $ | 43,395 | $ | 29,316 |\\n| Denominator: |\\n| Weighted average common shares outstanding | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\\n| Performance and Restricted Stock Units | 602,566 | 1,450,668 | 496,968 | 1,335,011 |\\n| Employee stock purchase plan and stock options | 300,604 | 106,469 | 348,271 | 106,469 |\\n| Weighted average common shares - diluted | 319,725,065 | 320,120,634 | 319,190,804 | 319,654,817 |\\n| Diluted earnings per common share | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\\n\\n24\\n14. Subsequent EventsIn October 2022, the Company granted 2,153,900 RSUs and 1,170,000 stock options, with an estimated aggregate grant date fair value of $ 4.8 million and $ 1.2 million, respectively.\\n25\\nITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\\nForward-Looking Statements\\nThis Quarterly Report on Form 10-Q (this “Quarterly Report”), including the section titled “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements that are based on current expectations, estimates, forecasts and projections about us, our future performance, our business, our beliefs and our management’s assumptions. Such words as “expect,” “anticipate,” “outlook,” “could,” “target,” “project,” “intend,” “plan,” “believe,” “seek,” “estimate,” “should,” “may,” “assume” and “continue” as well as variations of such words and similar expressions are intended to identify such forward-looking statements, although not all forward-looking statements contain such terms. These statements are not guarantees of future performance and they involve certain risks, uncertainties and assumptions that are difficult to predict. We have based our forward-looking statements on our management’s beliefs and assumptions based on information available to our management at the time the statements are made. We caution you that actual outcomes and results may differ materially from what is expressed, implied or forecasted by our forward-looking statements. More information regarding these risks and uncertainties and other important factors that could cause actual results to differ materially from those in the forward-looking statements is set forth in Part II, Item 1A “Risk Factors” of this report. Investors are cautioned not to place undue reliance on any such forward-looking statements, which speak only as of the date they are made. Except as required under the federal securities laws and the rules and regulations of the Securities and Exchange Commission, we do not have any intention or obligation to update publicly any forward-looking statements after the distribution of this report, whether as a result of new information, future events, changes in assumptions or otherwise.\\nExecutive Overview\\nWe are a leading business solutions provider to consumer goods manufacturers and retailers. We have a strong platform of competitively advantaged sales and marketing services built over multiple decades – essential, business critical services like headquarter sales, retail merchandising, in-store sampling, digital commerce and shopper marketing. For brands and retailers of all sizes, we help get the right products on the shelf (whether physical or digital) and into the hands of consumers (however they shop). We use a scaled platform to innovate as a trusted partner with our clients, solving problems to increase their efficiency and effectiveness across a broad range of channels.\\nWe have two reportable segments: sales and marketing.\\nThrough our sales segment, which generated approximately 62.5% and 65.9% of our total revenues in the nine months ended September 30, 2022 and 2021, respectively, we offer headquarter sales representation services to consumer goods manufacturers, for whom we prepare and present to retailers a business case to increase distribution of manufacturers’ products and optimize how they are displayed, priced and promoted. We also make in-store merchandising visits for both manufacturer and retailer clients to ensure the products we represent are adequately stocked and properly displayed.\\nThrough our marketing segment, which generated approximately 37.5% and 34.1% of our total revenues in the nine months ended September 30, 2022 and 2021, respectively, we help brands and retailers reach consumers through two main categories within the marketing segment. The first and largest category is our retail experiential business, also known as in-store sampling or demonstrations, where we manage highly customized large-scale sampling programs (both in-store and online) for leading retailers. The second category is our collection of specialized agency services, in which we provide private label services to retailers and develop granular marketing programs for brands and retailers through our shopper, consumer and digital marketing agencies.\\n26\\nBusiness Combination with Conyers Park\\nOn October 28, 2020, Conyers Park II Acquisition Corp. (“Conyers Park”), a Delaware corporation, consummated a merger with ASI Intermediate Corp. (“ASI”), formerly known as Advantage Solutions Inc., with ASI surviving the merger as a wholly owned subsidiary of Conyers Park (the “Merger” and, together with the other transactions contemplated by the merger agreement, the “Transactions”). On October 28, 2020, and in connection with the closing of the Transactions, Conyers Park changed its name to Advantage Solutions Inc.\\nImpacts of the COVID-19 Pandemic\\nBeginning in March 2020 and continuing through the first quarter of 2021, our services experienced the effects from reductions in client spending due to the economic impact related to the COVID-19 pandemic. While mixed by services and geography, the spending reductions impacted all of our services and markets. Globally, the most impacted services were our experiential services. Most services began to improve in April 2021, and the improvement has continued through the third quarter of 2022.\\nSummary\\nOur financial performance for the three months ended September 30, 2022 as compared to the three months ended September 30, 2021 includes:\\n•Revenues increased by $122.3 million, or 13.2%, to $1,051.1 million;\\n•Operating income decreased by $18.8 million, or 28.6%, to $46.8 million;\\n•Net income decreased by $1.1 million, or 4.5% to $23.2 million;\\n•Adjusted Net Income increased by $3.6 million, or 6.1%, to $62.7 million; and\\n•Adjusted EBITDA decreased by $15.5 million, or 11.6%, to $118.3 million.\\nOur financial performance for the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021 includes:\\n•Revenues increased by $377.2 million, or 14.7% to $2,947.0 million;\\n•Operating income decreased by $47.5 million, or 32.6% to $98.1 million;\\n•Net income increased by $14.9 million, or 50.5% to $44.4 million;\\n•Adjusted Net Income increased by $5.8 million, or 3.9% to $152.5 million; and\\n•Adjusted EBITDA decreased by $43.8 million, or 11.9% to $323.3 million.\\nDuring the nine months ended September 30, 2022, we acquired four businesses. The aggregate purchase price was $75.5 million, of which $74.1 million was paid in cash, $0.5 million in contingent consideration and $0.8 million in holdback.\\nFactors Affecting Our Business and Financial Reporting\\nThere are a number of factors, in addition to the impact of the COVID-19 pandemic and inflation, that affect the performance of our business and the comparability of our results from period to period including:\\n•Organic Growth. Part of our strategy is to generate organic growth by expanding our existing client relationships, continuing to win new clients, pursuing channel expansion and new industry opportunities, enhancing our digital technology solutions, developing our international platform, delivering operational efficiencies and expanding into logical adjacencies. We believe that by pursuing\\n27\\nthese organic growth opportunities we will be able to continue to enhance our value proposition to our clients and thereby grow our business.\\n•Acquisitions. We have grown and expect to continue to grow our business in part by acquiring quality businesses, both domestic and international. Excluding the 2017 acquisition of Daymon Worldwide Inc., we have completed 73 acquisitions from January 2014 to November 9, 2022, ranging in purchase prices from approximately $0.3 million to $98.5 million. Many of our acquisition agreements include contingent consideration arrangements, which are described below. We have completed acquisitions at what we believe are attractive purchase prices and have regularly structured our agreements to result in the generation of long-lived tax assets, which have in turn reduced our effective purchase prices when incorporating the value of those tax assets. We continue to look for strategic acquisitions that can be completed at attractive purchase prices.\\n•Contingent Consideration. Many of our acquisition agreements include contingent consideration arrangements, which are generally based on the achievement of financial performance thresholds by the operations attributable to the acquired businesses. The contingent consideration arrangements are based upon our valuations of the acquired businesses and are intended to share the investment risk with the sellers of such businesses if projected financial results are not achieved. The fair values of these contingent consideration arrangements are included as part of the purchase price of the acquired companies on their respective acquisition dates. For each transaction, we estimate the fair value of contingent consideration payments as part of the initial purchase price. We review and assess the estimated fair value of contingent consideration on a quarterly basis, and the updated fair value could differ materially from our initial estimates. Adjustments to the estimated fair value related to changes in all other unobservable inputs are reported in “Selling, general and administrative expenses” in our Condensed Consolidated Statements of Operations and Comprehensive Income.\\n•Depreciation and Amortization. As a result of the acquisition of our business by Karman Topco L.P. (“Topco”) on July 25, 2014 (the “2014 Topco Acquisition”), we acquired significant intangible assets, the value of which is amortized, on a straight-line basis, over 15 years from the date of the 2014 Topco Acquisition, unless determined to be indefinite-lived. The amortization of such intangible assets recorded in our consolidated financial statements has a significant impact on our operating income (loss) and net income (loss). Our historical acquisitions have increased, and future acquisitions likely will increase, our intangible assets. We do not believe the amortization expense associated with the intangibles created from our purchase accounting adjustments reflect a material economic cost to our business. Unlike depreciation expense which has an economic cost reflected by the fact that we must re-invest in property and equipment to maintain the asset base delivering our results of operations, we do not have any capital re-investment requirements associated with the acquired intangibles, such as client relationships and trade names, that comprise the majority of the finite-lived intangibles that create our amortization expense.\\n•Foreign Exchange Fluctuations. Our financial results are affected by fluctuations in the exchange rate between the U.S. dollar and other currencies, primarily Canadian dollars, British pounds and euros, due to our operations in such foreign jurisdictions. See also “ —Quantitative and Qualitative Disclosure of Market Risk—Foreign Currency Risk.”\\n•Seasonality. Our quarterly results are seasonal in nature, with the fourth fiscal quarter typically generating a higher proportion of our revenues than other fiscal quarters, as a result of higher consumer spending. We generally record slightly lower revenues in the first fiscal quarter of each year, as our clients begin to roll out new programs for the year, and consumer spending generally is less in the first fiscal quarter than other quarters. Timing of our clients’ marketing expenses, associated with marketing campaigns and new product launches, can also result in fluctuations from one quarter to another.\\n28\\nHow We Assess the Performance of Our Business\\nRevenues\\nRevenues related to our sales segment are primarily comprised of commissions, fee-for-service and cost-plus fees for providing retail merchandising services, category and space management, headquarter relationship management, technology solutions and administrative services. A small portion of our arrangements include performance incentive provisions, which allow us to earn additional revenues on our performance relative to specified quantitative or qualitative goals. We recognize the incentive portion of revenues under these arrangements when the related services are transferred to the customer.\\nMarketing segment revenues are primarily recognized in the form of a fee-for-service (including retainer fees, fees charged to clients based on hours incurred, project-based fees or fees for executing in-person consumer engagements or experiences, which engagements or experiences we refer to as events), commissions or on a cost-plus basis, in each case, related to services including experiential marketing, shopper and consumer marketing services, private label development or our digital, social and media services.\\nGiven our acquisition strategy, we analyze our financial performance, in part, by measuring revenue growth in two ways—revenue growth attributable to organic activities and revenue growth attributable to acquisitions, which we refer to as organic revenues and acquired revenues, respectively.\\nWe define organic revenues as any revenues that are not acquired revenues. Our organic revenues exclude the impacts of acquisitions and divestitures, when applicable, which improves comparability of our results from period to period.\\nIn general, when we acquire a business, the acquisition includes a contingent consideration arrangement (e.g., an earn-out provision) and, accordingly, we separately track the relevant metrics associated with the earnout agreement of the acquired business. In such cases, we consider revenues generated by such a business during the 12 months following its acquisition to be acquired revenues. For example, if we completed an acquisition on July 1, 2021 for a business that included a contingent consideration arrangement, we would consider revenues from the acquired business from July 1, 2021 to June 30, 2022 to be acquired revenues. We generally consider growth attributable to the financial performance of an acquired business after the 12-month anniversary of the date of acquisition to be organic.\\nIn limited cases, when the acquisition of an acquired business does not include a contingent consideration arrangement, or we otherwise do not separately track the financial performance of the acquired business due to operational integration, we consider the revenues that the business generated in the 12 months prior to its acquisition to be our acquired revenues for the 12 months following its acquisition, and any differences in revenues actually generated during the 12 months after its acquisition to be organic. For example, if we completed an acquisition on July 1, 2021 for a business that did not include a contingent consideration arrangement, we would consider the amount of revenues from the acquired business from July 1, 2020 to June 30, 2021 to be acquired revenues during the period from July 1, 2021 to June 30, 2022, with any differences from that amount actually generated during the latter period to be organic revenues.\\nAll revenues generated by our acquired businesses are considered to be organic revenues after the 12-month anniversary of the date of acquisition.\\nWhen we divest a business, we consider the revenues that the divested business generated in the 12 months prior to its divestiture to be subtracted from acquired revenues for the 12 months following its divestiture. For example, if we completed a divestiture on July 1, 2021 for a business, we would consider the amount of revenues from the divested business from July 1, 2020 to June 30, 2021 to be subtracted from acquired revenues during the period from July 1, 2021 to June 30, 2022.\\nWe measure organic revenue growth and acquired revenue growth by comparing the organic revenues or acquired revenues, respectively, period over period, net of any divestitures.\\n29\\nCost of Revenues\\nOur cost of revenues consists of both fixed and variable expenses primarily attributable to the hiring, training, compensation and benefits provided to both full-time and part-time associates, as well as other project-related expenses. A number of costs associated with our associates are subject to external factors, including inflation, increases in market specific wages and minimum wage rates at federal, state and municipal levels and minimum pay levels for exempt roles. Additionally, when we enter into certain new client relationships, we may experience an initial increase in expenses associated with hiring, training and other items needed to launch the new relationship.\\nSelling, General and Administrative Expenses\\nSelling, general and administrative expenses consist primarily of salaries, payroll taxes and benefits for corporate personnel. Other overhead costs include information technology, occupancy costs for corporate personnel, professional services fees, including accounting and legal services, and other general corporate expenses. Additionally, included in selling, general and administrative expenses are costs associated with the changes in fair value of the contingent consideration of acquisitions and other acquisition-related costs. Acquisition-related costs are comprised of fees related to change of equity ownership, transaction costs, professional fees, due diligence and integration activities.\\nOther (Income) Expenses\\nChange in Fair Value of Warrant Liability\\nChange in fair value of warrant liability represents a non-cash (income) expense resulting from a fair value adjustment to warrant liability with respect to the private placement warrants. Based on the period of time the public warrants have now been trading, we determined the fair value of the liability classified private placement warrants by approximating the value with the share price of the public warrants at the respective period end, which is inherently less subjective and judgmental given it is based on observable inputs. Previously, the fair value of the warrant liability was based on the input assumptions used in the Black-Scholes option pricing model, including our stock price at the end of the reporting period, the implied volatility or other inputs to the model and the number of private placement warrants outstanding, which may vary from period to period. We believe these amounts are not correlated to future business operations.\\nInterest Expense\\nInterest expense relates primarily to borrowings under the Senior Secured Credit Facilities as described below. See “ —Liquidity and Capital Resources.”\\nDepreciation and Amortization\\nAmortization Expense\\nIncluded in our depreciation and amortization expense is amortization of acquired intangible assets. We have ascribed value to identifiable intangible assets other than goodwill in our purchase price allocations for companies we have acquired. These assets include, but are not limited to, client relationships and trade names. To the extent we ascribe value to identifiable intangible assets that have finite lives, we amortize those values over the estimated useful lives of the assets. Such amortization expense, although non-cash in the period expensed, directly impacts our results of operations. It is difficult to predict with any precision the amount of expense we may record relating to future acquired intangible assets.\\n30\\nAs a result of the 2014 Topco Acquisition, we acquired significant intangible assets, the value of which is amortized, on a straight-line basis, over 15 years from the date of the 2014 Topco Acquisition, unless determined to be indefinite-lived.\\nDepreciation Expense\\nDepreciation expense relates to the property and equipment that we own, which represented less than 1% of our total assets at September 30, 2022 and 2021, respectively.\\nIncome Taxes\\nIncome tax expense and our effective tax rates can be affected by many factors, including state apportionment factors, our acquisition strategy, tax incentives and credits available to us, changes in judgment regarding our ability to realize our deferred tax assets, changes in our worldwide mix of pre-tax losses or earnings, changes in existing tax laws and our assessment of uncertain tax positions.\\nCash Flows\\nWe have positive cash flow characteristics, as described below, due to the limited required capital investment in the fixed assets and working capital needs to operate our business in the normal course. See “ —Liquidity and Capital Resources.”\\nOur principal sources of liquidity are cash flows from operations, borrowings under the Revolving Credit Facility, and other debt. Our principal uses of cash are operating expenses, working capital requirements, acquisitions and repayment of debt.\\nAdjusted Net Income\\nAdjusted Net Income is a non-GAAP financial measure. Adjusted Net Income means Net income before (i) impairment of goodwill and indefinite-lived assets, (ii) amortization of intangible assets, (iii) equity-based compensation of Topco, (iv) changes in fair value of warrant liability, (v) fair value adjustments of contingent consideration related to acquisitions, (vi) acquisition-related expenses, (vii) costs associated with COVID-19, net of benefits received, (viii) EBITDA for economic interests in investments, (ix) restructuring expenses, (x) litigation expenses (recovery), (xi) costs associated with the Take 5 Matter, (xii) related tax adjustments and (xiii) other adjustments that management believes are helpful in evaluating our operating performance.\\nWe present Adjusted Net Income because we use it as a supplemental measure to evaluate the performance of our business in a way that also considers our ability to generate profit without the impact of items that we do not believe are indicative of our operating performance or are unusual or infrequent in nature and aid in the comparability of our performance from period to period. Adjusted Net Income should not be considered as an alternative for Net income, our most directly comparable measure presented on a GAAP basis.\\nAdjusted EBITDA and Adjusted EBITDA by Segment\\nAdjusted EBITDA and Adjusted EBITDA by segment are supplemental non-GAAP financial measures of our operating performance. Adjusted EBITDA means Net income before (i) interest expense, net, (ii) provision for income taxes, (iii) depreciation, (iv) impairment of goodwill and indefinite-lived assets, (v) amortization of intangible assets, (vi) equity-based compensation of Topco, (vii) changes in fair value of warrant liability, (viii) stock-based compensation expense, (ix) fair value adjustments of contingent consideration related to acquisitions, (x) acquisition-related expenses, (xi) costs associated with COVID-19, net of benefits received, (xii) EBITDA for economic interests in investments, (xiii) restructuring expenses, (xiv) litigation expenses (recovery), (xv) costs associated with the Take 5 Matter and (xvi) other adjustments that management believes are helpful in evaluating our operating performance.\\n31\\nWe present Adjusted EBITDA and Adjusted EBITDA by segment because they are key operating measures used by us to assess our financial performance. These measures adjust for items that we believe do not reflect the ongoing operating performance of our business, such as certain noncash items, unusual or infrequent items or items that change from period to period without any material relevance to our operating performance. We evaluate these measures in conjunction with our results according to GAAP because we believe they provide a more complete understanding of factors and trends affecting our business than GAAP measures alone. Furthermore, the agreements governing our indebtedness contain covenants and other tests based on measures substantially similar to Adjusted EBITDA. Neither Adjusted EBITDA nor Adjusted EBITDA by segment should be considered as an alternative for Net income, our most directly comparable measure presented on a GAAP basis.\\nResults of Operations for the Three and Nine Months Ended September 30, 2022 and 2021\\nThe following table sets forth items derived from the Company’s consolidated statements of operations for the three and nine months ended September 30, 2022 and 2021 in dollars and as a percentage of total revenues.\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (amounts in thousands) | 2022 | 2021 | 2022 | 2021 |\\n| Revenues | $ | 1,051,095 | 100.0 | % | $ | 928,760 | 100.0 | % | $ | 2,946,979 | 100.0 | % | $ | 2,569,735 | 100.0 | % |\\n| Cost of revenues | 908,523 | 86.4 | % | 766,253 | 82.5 | % | 2,536,256 | 86.1 | % | 2,117,818 | 82.4 | % |\\n| Selling, general, and administrative expenses | 37,945 | 3.6 | % | 37,742 | 4.1 | % | 138,594 | 4.7 | % | 124,830 | 4.9 | % |\\n| Depreciation and amortization | 57,785 | 5.5 | % | 59,163 | 6.4 | % | 173,997 | 5.9 | % | 181,450 | 7.1 | % |\\n| Total expenses | 1,004,253 | 95.5 | % | 863,158 | 92.9 | % | 2,848,847 | 96.7 | % | 2,424,098 | 94.3 | % |\\n| Operating income | 46,842 | 4.5 | % | 65,602 | 7.1 | % | 98,132 | 3.3 | % | 145,637 | 5.7 | % |\\n| Other (income) expenses: |\\n| Change in fair value of warrant liability | (1,100 | ) | (0.1 | )% | (3,491 | ) | (0.4 | )% | (21,456 | ) | (0.7 | )% | (5,024 | ) | (0.2 | )% |\\n| Interest expense, net | 23,557 | 2.2 | % | 36,490 | 3.9 | % | 63,628 | 2.2 | % | 104,544 | 4.1 | % |\\n| Total other expenses | 22,457 | 2.1 | % | 32,999 | 3.6 | % | 42,172 | 1.4 | % | 99,520 | 3.9 | % |\\n| Income before income taxes | 24,385 | 2.3 | % | 32,603 | 3.5 | % | 55,960 | 1.9 | % | 46,117 | 1.8 | % |\\n| Provision for income taxes | 1,158 | 0.1 | % | 8,276 | 0.9 | % | 11,523 | 0.4 | % | 16,582 | 0.6 | % |\\n| Net income | $ | 23,227 | 2.2 | % | $ | 24,327 | 2.6 | % | $ | 44,437 | 1.5 | % | $ | 29,535 | 1.1 | % |\\n| Other Financial Data |\\n| Adjusted Net Income(1) | $ | 62,682 | 6.0 | % | $ | 59,101 | 6.4 | % | $ | 152,541 | 5.2 | % | $ | 146,762 | 5.7 | % |\\n| Adjusted EBITDA(1) | $ | 118,268 | 11.3 | % | $ | 133,756 | 14.4 | % | $ | 323,329 | 11.0 | % | $ | 367,155 | 14.3 | % |\\n\\n(1)Adjusted Net Income and Adjusted EBITDA are financial measures that are not calculated in accordance with GAAP. For a discussion of our presentation of Adjusted Net Income and Adjusted EBITDA and reconciliations of Net income to Adjusted Net Income and Adjusted EBITDA, see “—Non-GAAP Financial Measures.”\\nComparison of the Three Months Ended September 30, 2022 and 2021\\nRevenues\\n\\n| Three Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 646,246 | $ | 597,139 | $ | 49,107 | 8.2 | % |\\n| Marketing | 404,849 | 331,621 | 73,228 | 22.1 | % |\\n| Total revenues | $ | 1,051,095 | $ | 928,760 | $ | 122,335 | 13.2 | % |\\n\\nTotal revenues increased by $122.3 million, or 13.2%, during the three months ended September 30, 2022, as compared to the three months ended September 30, 2021.\\nThe sales segment revenues increased $49.1 million during the three months ended September 30, 2022 as compared to the three months ended September 30, 2021, of which $23.6 million were revenues from acquired\\n32\\nbusinesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $17.0 million, the segment experienced an increase of $42.5 million in organic revenues primarily due to growth in our retail merchandising services and international businesses, partially offset by a decrease in our third party selling and retailing services.\\nThe marketing segment revenues increased $73.2 million during the three months ended September 30, 2022 as compared to the three months ended September 30, 2021, of which $11.0 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $5.7 million, the segment experienced an increase of $67.9 million in organic revenues. The increase in revenues was primarily due to an increase in our in-store product demonstration and sampling services which continue to recover from the temporary suspensions as a result of the COVID-19 pandemic, partially offset by a decrease in certain of our client media spend.\\nCost of Revenues\\nCost of revenues as a percentage of revenues for the three months ended September 30, 2022 was 86.4%, as compared to 82.5% for the three months ended September 30, 2021. The increase as a percentage of revenues was largely attributable to the change in the revenue mix of our services as a result of recoveries from the COVID-19 pandemic and acquired businesses, and the ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\\nSelling, General and Administrative Expenses\\nSelling, general and administrative expenses as a percentage of revenues for the three months ended September 30, 2022 was 3.6%, compared to 4.1% for the three months ended September 30, 2021, primarily due to the change in fair value adjustments related to contingent consideration and a decrease in legal fees associated with the Take 5 Matter.\\nDepreciation and Amortization Expense\\nDepreciation and amortization expense decreased by $1.4 million, or 2.3%, to $57.8 million for the three months ended September 30, 2022 compared to $59.2 million for the three months ended September 30, 2021, which stayed relatively consistent year over year.\\nOperating Income\\n\\n| Three Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 31,765 | $ | 51,906 | $ | (20,141 | ) | (38.8 | )% |\\n| Marketing | 15,077 | 13,696 | 1,381 | 10.1 | % |\\n| Total operating income | $ | 46,842 | $ | 65,602 | $ | (18,760 | ) | (28.6 | )% |\\n\\nIn the sales segment, the decrease in operating income during the three months ended September 30, 2022 was due to a shift in revenue mix and ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\\nIn the marketing segment, the increase in operating income during the three months ended September 30, 2022 was due to the growth in revenues, partially offset by the increase in cost of revenues as described above.\\nChange in Fair Value of Warrant Liability\\nChange in fair value of warrant liability represents $1.1 million of non-cash gain resulting from a fair value adjustment to warrant liability with respect to the private placement warrants for the three months ended September 30, 2022, approximating the fair value with the warrant price of the public warrants.\\n33\\nInterest Expense, net\\nInterest expense, net decreased $12.9 million, or 35.4%, to $23.6 million for the three months ended September 30, 2022, from $36.5 million for the three months ended September 30, 2021. The decrease in interest expense, net was primarily due to the increase in fair value changes in derivatives instruments.\\nProvision for Income Taxes\\nProvision for income taxes was $1.2 million for the three months ended September 30, 2022 as compared to $8.3 million of provision for income taxes for the three months ended September 30, 2021. The fluctuation was primarily attributable to the decrease in pre-tax income during the three months ended September 30, 2022 and decrease of $4.3 million of discrete items for the three months ended September 30, 2022.\\nNet Income\\nNet income was $23.2 million for the three months ended September 30, 2022, compared to net income of $24.3 million for the three months ended September 30, 2021. The decrease in net income was primarily driven by the decrease in operating income as described above, offset by the decrease in interest expense, net and provision for income taxes.\\nAdjusted Net Income\\nThe increase in Adjusted Net Income for the three months ended September 30, 2022 was attributable to the decrease in interest expense, net as described above. For a reconciliation of Adjusted Net Income to Net income, see “ —Non-GAAP Financial Measures.”\\nAdjusted EBITDA and Adjusted EBITDA by Segment\\n\\n| Three Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 76,172 | $ | 95,199 | $ | (19,027 | ) | (20.0 | )% |\\n| Marketing | 42,096 | 38,557 | 3,539 | 9.2 | % |\\n| Total Adjusted EBITDA | $ | 118,268 | $ | 133,756 | $ | (15,488 | ) | (11.6 | )% |\\n\\nAdjusted EBITDA decreased by $15.5 million, or 11.6%, to $118.3 million for the three months ended September 30, 2022, from $133.8 million for the three months ended September 30, 2021. In the sales segment, the decrease in Adjusted EBITDA was primarily attributable to the increase in cost of revenues as described above. In the marketing segment, the increase in the Adjusted EBITDA was primarily attributable to the growth in revenues as described above. For a reconciliation of Adjusted EBITDA to Net income, see “—Non-GAAP Financial Measures.”\\nComparison of the Nine Months Ended September 30, 2022 and 2021\\nRevenues\\n\\n| Nine Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 1,842,347 | $ | 1,693,107 | $ | 149,240 | 8.8 | % |\\n| Marketing | 1,104,632 | 876,628 | 228,004 | 26.0 | % |\\n| Total revenues | $ | 2,946,979 | $ | 2,569,735 | $ | 377,244 | 14.7 | % |\\n\\n34\\nTotal revenues increased by $377.2 million, or 14.7%, during the nine months ended September 30, 2022, as compared to the nine months ended September 30, 2021.\\nThe sales segment revenues increased $149.2 million during the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021, of which $114.2 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $33.9 million, the segment experienced an increase of $68.9 million in organic revenues primarily due to our European joint venture which experienced continued recoveries from temporary reduction in services as a result of the COVID-19 pandemic and growth in our retail merchandising services partially offset by a decrease in our foodservice and third party selling and retailing services.\\nThe marketing segment revenues increased $228.0 million during the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021, of which $23.1 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $11.6 million, the segment experienced an increase of $216.5 million in organic revenues. The increase in revenues was primarily due to an increase in our in-store product demonstration and sampling services which continue to recover from the temporary suspensions as a result of the COVID-19 pandemic, partially offset by a decrease in certain of our client media spend.\\nCost of Revenues\\nCost of revenues as a percentage of revenues for the nine months ended September 30, 2022 was 86.1%, as compared to 82.4% for the nine months ended September 30, 2021. The increase as a percentage of revenues was largely attributable to the change in the revenue mix of our services as a result of recoveries from the COVID-19 pandemic and acquired businesses, and the ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\\nSelling, General and Administrative Expenses\\nSelling, general and administrative expenses as a percentage of revenues for the nine months ended September 30, 2022 was 4.7%, compared to 4.9% for the nine months ended September 30, 2021.\\nDepreciation and Amortization Expense\\nDepreciation and amortization expense decreased by $7.5 million or 4.1% to $174.0 million for the nine months ended September 30, 2022 compared to $181.5 million for the nine months ended September 30, 2021. The decrease was primarily due to a decrease in depreciation expenses from our internally developed software.\\nOperating Income\\n\\n| Nine Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 65,915 | $ | 131,727 | $ | (65,812 | ) | (50.0 | %) |\\n| Marketing | 32,217 | 13,910 | 18,307 | 131.6 | % |\\n| Total operating income | $ | 98,132 | $ | 145,637 | $ | (47,505 | ) | (32.6 | %) |\\n\\nIn the sales segment, the decrease in operating income during the nine months ended September 30, 2022 was primarily attributable to a shift in revenue mix, ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses, the change in fair value adjustments related to contingent consideration, and an increase in stock-based compensation expense, partially offset by a decrease in depreciation expense.\\n35\\nIn the marketing segment, the increase in operating income during the nine months ended September 30, 2022 was primarily attributable to the growth in revenues, partially offset by the increase in cost of revenues as described above and the change in fair value adjustments related to contingent consideration.\\nChange in Fair Value of Warrant Liability\\nChange in fair value of warrant liability represents $21.5 million of non-cash gain resulting from a fair value adjustment to warrant liability with respect to the private placement warrants for the nine months ended September 30, 2022, approximating the fair value with the warrant price of the public warrants.\\nInterest Expense, net\\nInterest expense, net decreased $40.9 million, or 39.1%, to $63.6 million for the nine months ended September 30, 2022, from $104.5 million for the nine months ended September 30, 2021. The decrease in interest expense, net was primarily due to the increase in fair value changes in derivatives instruments.\\nProvision for Income Taxes\\nProvision for income taxes was $11.5 million for the nine months ended September 30, 2022 as compared to $16.6 million for the nine months ended September 30, 2021. The fluctuation was primarily attributable to the increase in pre-tax income during the nine months ended September 30, 2022, partially offset by a decrease of $7.4 million of discrete items.\\nNet Income\\nNet income was $44.4 million for the nine months ended September 30, 2022, compared to net income of $29.5 million for the nine months ended September 30, 2021. The increase in net income was primarily driven by the decrease in change in fair value of warrant liability, interest expense, net, and provision for income taxes, partially offset by the decrease in operating income as described above.\\nAdjusted Net Income\\nThe increase in Adjusted Net Income for the nine months ended September 30, 2022 was attributable to the decrease in change in fair value of warrant liability, and interest expense, net as described above. For a reconciliation of Adjusted Net Income to Net income, see “ —Non-GAAP Financial Measures.”\\nAdjusted EBITDA and Adjusted EBITDA by Segment\\n\\n| Nine Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 216,158 | $ | 268,798 | $ | (52,640 | ) | (19.6 | )% |\\n| Marketing | 107,171 | 98,357 | 8,814 | 9.0 | % |\\n| Total Adjusted EBITDA | $ | 323,329 | $ | 367,155 | $ | (43,826 | ) | (11.9 | )% |\\n\\nAdjusted EBITDA decreased by $43.8 million, or 11.9%, to $323.3 million for the nine months ended September 30, 2022, from $367.2 million for the nine months ended September 30, 2021. In the sales segment, the decrease in Adjusted EBITDA was primarily attributable to the increase in cost of revenues as described above. In the marketing segment, the increase in the Adjusted EBITDA was primarily attributable to the growth in revenues as described above. For a reconciliation of Adjusted EBITDA to Net income, see “—Non-GAAP Financial Measures.”\\n36\\nNon-GAAP Financial Measures\\nAdjusted Net Income is a non-GAAP financial measure. Adjusted Net Income means Net income before (i) impairment of goodwill and indefinite-lived assets, (ii) amortization of intangible assets, (iii) equity-based compensation of Topco, (iv) change in fair value of warrant liability, (v) fair value adjustments of contingent consideration related to acquisitions, (vi) acquisition-related expenses, (vii) costs associated with COVID-19, net of benefits received, (viii) EBITDA for economic interests in investments, (ix) restructuring expenses, (x) litigation expenses (recovery), (xi) costs associated with the Take 5 Matter, (xii) related tax adjustments and (xiii)other adjustments that management believes are helpful in evaluating our operating performance.\\nWe present Adjusted Net Income because we use it as a supplemental measure to evaluate the performance of our business in a way that also considers our ability to generate profit without the impact of items that we do not believe are indicative of our operating performance or are unusual or infrequent in nature and aid in the comparability of our performance from period to period. Adjusted Net Income should not be considered as an alternative for our Net income, our most directly comparable measure presented on a GAAP basis.\\nA reconciliation of Adjusted Net Income to Net income is provided in the following table:\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Net income | $ | 23,227 | $ | 24,327 | $ | 44,437 | $ | 29,535 |\\n| Less: Net income attributable to noncontrolling interest | 2,168 | 1,016 | 1,042 | 219 |\\n| Add: |\\n| Equity -based compensation of Karman Topco L.P.(a) | (828 | ) | (5,575 | ) | (7,142 | ) | (10,031 | ) |\\n| Change in fair value of warrant liability | (1,100 | ) | (3,491 | ) | (21,456 | ) | (5,024 | ) |\\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (340 | ) | 3,221 | 5,448 | 5,776 |\\n| Acquisition-related expenses(d) | 4,260 | 5,110 | 19,843 | 13,053 |\\n| Restructuring expenses(e) | 3,562 | (394 | ) | 4,458 | 10,636 |\\n| Litigation(f) | — | (92 | ) | (800 | ) | (910 | ) |\\n| Amortization of intangible assets(g) | 49,997 | 49,786 | 150,930 | 148,396 |\\n| Costs associated with COVID-19, net of benefits received(h) | 2,009 | 1,087 | 4,945 | (948 | ) |\\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\\n| Tax adjustments related to non-GAAP adjustments(j) | (16,215 | ) | (15,262 | ) | (49,168 | ) | (47,113 | ) |\\n| Adjusted Net Income | $ | 62,682 | $ | 59,101 | $ | 152,541 | $ | 146,762 |\\n\\nAdjusted EBITDA and Adjusted EBITDA by segment are supplemental non-GAAP financial measures of our operating performance. Adjusted EBITDA means Net income before (i) interest expense, net, (ii) provision for income taxes, (iii) depreciation, (iv) impairment of goodwill and indefinite-lived assets, (v) amortization of intangible assets, (vi) equity-based compensation of Topco, (vii) change in fair value of warrant liability, (viii) stock-based compensation expense, (ix) fair value adjustments of contingent consideration related to acquisitions, (x) acquisition-related expenses, (xi) costs associated with COVID-19, net of benefits received, (xii) EBITDA for economic interests in investments, (xiii) restructuring expenses, (xiv) litigation expenses (recovery), (xv) costs associated with the Take 5 Matter and (xvi) other adjustments that management believes are helpful in evaluating our operating performance.\\nWe present Adjusted EBITDA and Adjusted EBITDA by segment because they are key operating measures used by us to assess our financial performance. These measures adjust for items that we believe do not reflect the ongoing operating performance of our business, such as certain noncash items, unusual or infrequent items or items that change from period to period without any material relevance to our operating performance. We evaluate these measures in conjunction with our results according to GAAP because we believe they provide a more complete understanding of factors and trends affecting our business than GAAP measures alone. Furthermore, the agreements governing our indebtedness contain covenants and other tests based on measures substantially similar to\\n37\\nAdjusted EBITDA. Neither Adjusted EBITDA nor Adjusted EBITDA by segment should be considered as an alternative for our Net income, our most directly comparable measure presented on a GAAP basis.\\nA reconciliation of Adjusted EBITDA to Net income is provided in the following table:\\n\\n| Consolidated | Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Net income | $ | 23,227 | $ | 24,327 | $ | 44,437 | $ | 29,535 |\\n| Add: |\\n| Interest expense, net | 23,557 | 36,490 | 63,628 | 104,544 |\\n| Provision for income taxes | 1,158 | 8,276 | 11,523 | 16,582 |\\n| Depreciation and amortization | 57,785 | 59,163 | 173,997 | 181,450 |\\n| Equity-based compensation of Karman Topco L.P.(a) | (828 | ) | (5,575 | ) | (7,142 | ) | (10,031 | ) |\\n| Change in fair value of warrant liability | (1,100 | ) | (3,491 | ) | (21,456 | ) | (5,024 | ) |\\n| Stock-based compensation expense(b) | 7,174 | 7,854 | 29,906 | 25,497 |\\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (340 | ) | 3,221 | 5,448 | 5,776 |\\n| Acquisition-related expenses(d) | 4,260 | 5,110 | 19,843 | 13,053 |\\n| EBITDA for economic interests in investments(k) | (2,474 | ) | (3,620 | ) | (7,546 | ) | (6,616 | ) |\\n| Restructuring expenses(e) | 3,562 | (394 | ) | 4,458 | 10,636 |\\n| Litigation(f) | — | (92 | ) | (800 | ) | (910 | ) |\\n| Costs associated with COVID-19, net of benefits received(h) | 2,009 | 1,087 | 4,945 | (948 | ) |\\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\\n| Adjusted EBITDA | $ | 118,268 | $ | 133,756 | $ | 323,329 | $ | 367,155 |\\n\\nFinancial information by segment, including a reconciliation of Adjusted EBITDA by segment to operating income, the closest GAAP financial measure, is provided in the following table:\\n\\n| Sales Segment | Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Operating income | $ | 31,765 | $ | 51,906 | $ | 65,915 | $ | 131,727 |\\n| Add: |\\n| Depreciation and amortization | 39,798 | 41,515 | 121,310 | 128,789 |\\n| Equity-based compensation of Karman Topco L.P.(a) | (320 | ) | (4,844 | ) | (4,004 | ) | (7,360 | ) |\\n| Stock-based compensation expense(b) | 4,080 | 4,371 | 18,009 | 13,795 |\\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (1,901 | ) | 192 | 4,992 | (4,057 | ) |\\n| Acquisition-related expenses(d) | 2,880 | 3,899 | 13,734 | 9,499 |\\n| EBITDA for economic interests in investments(k) | (2,656 | ) | (3,832 | ) | (8,018 | ) | (7,429 | ) |\\n| Restructuring expenses(e) | 2,360 | 1,273 | 3,519 | 3,229 |\\n| Litigation(f) | — | (68 | ) | (100 | ) | (584 | ) |\\n| Costs associated with COVID-19, net of benefits received(h) | 166 | 787 | 801 | 1,189 |\\n| Sales Segment Adjusted EBITDA | $ | 76,172 | $ | 95,199 | $ | 216,158 | $ | 268,798 |\\n\\n38\\n\\n| Marketing Segment | Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Operating income | $ | 15,077 | $ | 13,696 | $ | 32,217 | $ | 13,910 |\\n| Add: |\\n| Depreciation and amortization | 17,987 | 17,648 | 52,687 | 52,661 |\\n| Equity-based compensation of Karman Topco L.P.(a) | (508 | ) | (731 | ) | (3,138 | ) | (2,671 | ) |\\n| Stock-based compensation expense(b) | 3,094 | 3,483 | 11,897 | 11,702 |\\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | 1,561 | 3,029 | 456 | 9,833 |\\n| Acquisition-related expenses(d) | 1,380 | 1,211 | 6,109 | 3,554 |\\n| EBITDA for economic interests in investments(k) | 182 | 212 | 472 | 813 |\\n| Restructuring expenses(e) | 1,202 | (1,667 | ) | 939 | 7,407 |\\n| Litigation(f) | — | (24 | ) | (700 | ) | (326 | ) |\\n| Costs associated with COVID-19, net of benefits received(h) | 1,843 | 300 | 4,144 | (2,137 | ) |\\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\\n| Marketing Segment Adjusted EBITDA | $ | 42,096 | $ | 38,557 | $ | 107,171 | $ | 98,357 |\\n\\n\\n\\n\\n| (a) | Represents expenses related to (i) equity-based compensation expense associated with grants of Common Series D Units of Topco made to one of the Advantage Sponsors (as defined below) and (ii) equity-based compensation expense associated with the Common Series C Units of Topco. |\\n| (b) | Represents non-cash compensation expense related to the 2020 Incentive Award Plan and the 2020 Employee Stock Purchase Plan. |\\n| (c) | Represents adjustments to the estimated fair value of our contingent consideration liabilities related to our acquisitions. See Note 6—Fair Value of Financial Instruments to our unaudited condensed financial statements for the three and nine months ended September 30, 2022 and 2021. |\\n| (d) | Represents fees and costs associated with activities related to our acquisitions and restructuring activities, including professional fees, due diligence, and integration activities. |\\n| (e) | Represents fees and costs associated with various internal reorganization activities among our consolidated entities. |\\n| (f) | Represents legal settlements that are unusual or infrequent costs associated with our operating activities. |\\n| (g) | Represents the amortization of intangible assets recorded in connection with the 2014 Topco Acquisition and our other acquisitions. |\\n| (h) | Represents (i) costs related to implementation of strategies for workplace safety in response to COVID-19, including employee-relief fund, additional sick pay for front-line associates, medical benefit payments for furloughed associates, and personal protective equipment; and (ii) benefits received from government grants for COVID-19 relief. |\\n| (i) | Represents costs associated with the Take 5 Matter, primarily, professional fees and other related costs, for the three and nine months ended September 30, 2022 and 2021, respectively. |\\n| (j) | Represents the tax provision or benefit associated with the adjustments above, taking into account the Company’s applicable tax rates, after excluding adjustments related to items that do not have a related tax impact. |\\n| (k) | Represents additions to reflect our proportional share of Adjusted EBITDA related to our equity method investments and reductions to remove the Adjusted EBITDA related to the minority ownership percentage of the entities that we fully consolidate in our financial statements. |\\n\\n39\\nLiquidity and Capital Resources\\nOur principal sources of liquidity were cash flows from operations, borrowings under the Revolving Credit Facility, and other debt. Our principal uses of cash are operating expenses, working capital requirements, acquisitions, interest on debt and repayment of debt.\\nCash Flows\\nA summary of our cash operating, investing and financing activities are shown in the following table:\\n\\n| Nine Months Ended September 30, |\\n| (in thousands) | 2022 | 2021 |\\n| Net cash provided by operating activities | $ | 81,950 | $ | 101,068 |\\n| Net cash used in investing activities | (103,062 | ) | (66,152 | ) |\\n| Net cash used in financing activities | (32,920 | ) | (68,999 | ) |\\n| Net effect of foreign currency fluctuations on cash | (12,311 | ) | (1,476 | ) |\\n| Net change in cash, cash equivalents and restricted cash | $ | (66,343 | ) | $ | (35,559 | ) |\\n\\nNet Cash Provided by Operating Activities\\nNet cash used in operating activities during the nine months ended September 30, 2022 consisted of net income of $44.4 million adjusted for certain non-cash items, including depreciation and amortization of $174.0 million and effects of changes in working capital. Net cash provided by operating activities during the nine months ended September 30, 2021 consisted of net income of $29.5 million adjusted for certain non-cash items, including depreciation and amortization of $181.5 million and effects of changes in working capital. The decrease in cash provided by operating activities during the nine months ended September 30, 2022 relative to the same period in 2021 was primarily due to ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses during the nine months ended September 30, 2022.\\nNet Cash Used in Investing Activities\\nNet cash used in investing activities during the nine months ended September 30, 2022 primarily consisted of the purchase of businesses, net of cash acquired of $74.4 million and purchase of property and equipment of $30.0 million. Net cash used in investing activities during the nine months ended September 30, 2021 primarily consisted of the purchase of businesses, net of cash acquired of $40.0 million and purchase of property and equipment of $24.1 million.\\nNet Cash Used in Financing Activities\\nWe primarily finance our growth through cash flows from operations, however, we also incur long-term debt or borrow under lines of credit when necessary to execute acquisitions. Additionally, many of our acquisition agreements include contingent consideration arrangements, which are generally based on the achievement of future financial performance by the operations attributable to the acquired companies. The portion of the cash payment up to the acquisition date fair value of the contingent consideration liability are classified as financing outflows, and amounts paid in excess of the acquisition date fair value of that liability are classified as operating outflows.\\nCash flows used in financing activities during the nine months ended September 30, 2022 were primarily related to payments of contingent consideration and holdback payments of $31.7 million, repayment of principal on our Term Loan Facility of $9.9 million, partially offset by $3.3 million related to proceeds from the issuance of Class A common stock and $5.2 million of contribution from noncontrolling interest. Cash flows related to financing activities during the nine months ended September 30, 2021 were primarily related to borrowings of $51.7 million and repayment of $102.7 million on the Revolving Credit Facility and our lines of credit and $8.6 million related to payments of contingent consideration and holdback payments.\\n40\\nDescription of Credit Facilities\\nSenior Secured Credit Facilities\\nIn connection with the consummation of the Transactions, Advantage Sales & Marketing Inc. (the “Borrower”), an indirect wholly-owned subsidiary of the Company, entered into (i) a senior secured asset-based revolving credit facility in an aggregate principal amount of up to $400.0 million, subject to borrowing base capacity (as may be amended from time to time, the “Revolving Credit Facility”) and (ii) a secured first lien term loan credit facility in an aggregate principal amount of $1.325 billion (as may be amended from time to time, the “Term Loan Facility” and together with the Revolving Credit Facility, the “Senior Secured Credit Facilities”).\\nRevolving Credit Facility\\nOur Revolving Credit Facility provides for revolving loans and letters of credit in an aggregate amount of up to $400.0 million, subject to borrowing base capacity. Letters of credit are limited to the lesser of (a) $150.0 million and (b) the aggregate unused amount of commitments under our Revolving Credit Facility then in effect. Loans under the Revolving Credit Facility may be denominated in either U.S. dollars or Canadian dollars. Bank of America, N.A., is administrative agent and ABL Collateral Agent. The Revolving Credit Facility is scheduled to mature in October 2025. We may use borrowings under the Revolving Credit Facility to fund working capital and for other general corporate purposes, including permitted acquisitions and other investments. As of September 30, 2022, we had unused capacity under our Revolving Credit Facility available to us of $400.0 million, subject to borrowing base limitations (without giving effect to approximately $54.5 million of outstanding letters of credit and the borrowing base limitations for additional borrowings).\\nBorrowings under the Revolving Credit Facility are limited by borrowing base calculations based on the sum of specified percentages of eligible accounts receivable plus specified percentages of qualified cash, minus the amount of any applicable reserves. Borrowings will bear interest at a floating rate, which can be either an adjusted Eurodollar rate plus an applicable margin or, at the Borrower’s option, a base rate plus an applicable margin. The applicable margins for the Revolving Credit Facility are 2.00%, 2.25% or 2.50%, with respect to Eurodollar rate borrowings and 1.00%, 1.25% or 1.50%, with respect to base rate borrowings, in each case depending on average excess availability under the Revolving Credit Facility. The Borrower’s ability to draw under the Revolving Credit Facility or issue letters of credit thereunder will be conditioned upon, among other things, the Borrower’s delivery of prior written notice of a borrowing or issuance, as applicable, the Borrower’s ability to reaffirm the representations and warranties contained in the credit agreement governing the Revolving Credit Facility and the absence of any default or event of default thereunder.\\nThe Borrower’s obligations under the Revolving Credit Facility are guaranteed by Karman Intermediate Corp. (“Holdings”) and all of the Borrower’s direct and indirect wholly owned material U.S. subsidiaries (subject to certain permitted exceptions) and Canadian subsidiaries (subject to certain permitted exceptions, including exceptions based on immateriality thresholders of aggregate assets and revenues of Canadian subsidiaries) (the “Guarantors”). The Revolving Credit Facility is secured by a lien on substantially all of Holdings’, the Borrower’s and the Guarantors’ assets (subject to certain permitted exceptions). The Borrower’s Revolving Credit Facility has a first-priority lien on the current asset collateral and a second-priority lien on security interests in the fixed asset collateral (second in priority to the liens securing the Notes and the Term Loan Facility discussed below), in each case, subject to other permitted liens.\\nThe Revolving Credit Facility has the following fees: (i) an unused line fee of 0.375% or 0.250% per annum of the unused portion of the Revolving Credit Facility, depending on average excess availability under the Revolving Credit Facility; (ii) a letter of credit participation fee on the aggregate stated amount of each letter of credit equal to the applicable margin for adjusted Eurodollar rate loans, as applicable; and (iii) certain other customary fees and expenses of the lenders and agents thereunder.\\nThe Revolving Credit Facility contains customary covenants, including, but not limited to, restrictions on the Borrower’s ability and that of our subsidiaries to merge and consolidate with other companies, incur indebtedness, grant liens or security interests on assets, make acquisitions, loans, advances or investments, pay dividends, sell or\\n41\\notherwise transfer assets, optionally prepay or modify terms of any junior indebtedness, enter into transactions with affiliates or change our line of business. The Revolving Credit Facility will require the maintenance of a fixed charge coverage ratio (as set forth in the credit agreement governing the Revolving Credit Facility) of 1.00 to 1.00 at the end of each fiscal quarter when excess availability is less than the greater of $25 million and 10% of the lesser of the borrowing base and maximum borrowing capacity. Such fixed charge coverage ratio will be tested at the end of each quarter until such time as excess availability exceeds the level set forth above.\\nThe Revolving Credit Facility provides that, upon the occurrence of certain events of default, the Borrower’s obligations thereunder may be accelerated and the lending commitments terminated. Such events of default include payment defaults to the lenders thereunder, material inaccuracies of representations and warranties, covenant defaults, cross-defaults to other material indebtedness, voluntary and involuntary bankruptcy, insolvency, corporate arrangement, winding-up, liquidation or similar proceedings, material money judgments, material pension-plan events, certain change of control events and other customary events of default.\\nOn October 28, 2021, the Borrower and Holdings entered into the First Amendment to ABL Revolving Credit Agreement (the “ABL Amendment”), which amended the ABL Revolving Credit Agreement, dated October 28, 2020, by and among the Borrower, Holdings, the lenders from time to time party thereto and Bank of America, as administrative agent. The ABL Amendment was entered into by the Borrower to amend certain terms and provisions, including (i) reducing the interest rate floor for Eurocurrency rate loans from 0.50% to 0.00% and base rate loans from 1.50% to 1.00%, and (ii) updating the provisions by which U.S. Dollar LIBOR will eventually be replaced with the Secured Oversight Financing Rate (“SOFR”) or another interest rate benchmark to reflect the most recent standards and practices used in the industry.\\nTerm Loan Facility\\nThe Term Loan Facility is a term loan facility denominated in U.S. dollars in an aggregate principal amount of $1.325 billion. Borrowings under the Term Loan Facility amortize in equal quarterly installments in an amount equal to 1.00% per annum of the principal amount. Borrowings will bear interest at a floating rate, which can be either an adjusted Eurodollar rate plus an applicable margin or, at the Borrower’s option, a base rate plus an applicable margin. The applicable margins for the Term Loan Facility are 4.50% with respect to Eurodollar rate borrowings and 3.50% with respect to base rate borrowings.\\nThe Borrower may voluntarily prepay loans or reduce commitments under the Term Loan Facility, in whole or in part, subject to minimum amounts, with prior notice but without premium or penalty (other than a 1.00% premium on any prepayment in connection with a repricing transaction prior to the date that is six months after the effective date of the First Lien Amendment).\\nThe Borrower will be required to prepay the Term Loan Facility with 100% of the net cash proceeds of certain asset sales (such percentage subject to reduction based on the achievement of specific first lien net leverage ratios) and subject to certain reinvestment rights, 100% of the net cash proceeds of certain debt issuances and 50% of excess cash flow (such percentage subject to reduction based on the achievement of specific first lien net leverage ratios).\\nThe Borrower’s obligations under the Term Loan Facility are guaranteed by Holdings and the Guarantors. Our Term Loan Facility is secured by a lien on substantially all of Holdings’, the Borrower’s and the Guarantors’ assets (subject to certain permitted exceptions). The Term Loan Facility has a first-priority lien on the fixed asset collateral (equal in priority with the liens securing the Notes) and a second-priority lien on security interests in the current asset collateral (second in priority to the liens securing the Revolving Credit Facility), in each case, subject to other permitted liens.\\nThe Term Loan Facility contains certain customary negative covenants, including, but not limited to, restrictions on the Borrower’s ability and that of our restricted subsidiaries to merge and consolidate with other companies, incur indebtedness, grant liens or security interests on assets, pay dividends or make other restricted payments, sell or otherwise transfer assets or enter into transactions with affiliates.\\n42\\nThe Term Loan Facility provides that, upon the occurrence of certain events of default, the Borrower’s obligations thereunder may be accelerated. Such events of default will include payment defaults to the lenders thereunder, material inaccuracies of representations and warranties, covenant defaults, cross-defaults to other material indebtedness, voluntary and involuntary bankruptcy, insolvency, corporate arrangement, winding-up, liquidation or similar proceedings, material money judgments, change of control and other customary events of default.\\nOn October 28, 2021 (the “First Lien Amendment Effective Date”), the Borrower, Holdings, and certain of the Borrower’s subsidiaries, entered into Amendment No. 1 to the First Lien Credit Agreement (the “First Lien Amendment”), which amended the First Lien Credit Agreement, dated October 28, 2020, by and among the Borrower, Holdings, Bank of America, as administrative agent and collateral agent, each lender party from time to time thereto, and the other parties thereto. The First Lien Amendment was entered into by the Borrower to reduce the applicable interest rate on the term loan to 5.25% per annum, resulting in estimated interest savings of approximately $9.9 million or $7.3 million, net of tax, per annum. Additional terms and provisions amended include (i) resetting the period for six months following the First Lien Amendment Effective Date in which a 1.00% prepayment premium shall apply to any prepayment of the term loan in connection with certain repricing events, and (ii) updating the provisions by which U.S. Dollar LIBOR will eventually be replaced with SOFR or another interest rate benchmark to reflect the most recent standards and practices used in the industry and by Bank of America.\\nSenior Secured Notes\\nIn connection with the Transactions, Advantage Solutions FinCo LLC (“Finco”) issued $775.0 million aggregate principal amount of 6.50% Senior Secured Notes due 2028 (the “Notes”). Substantially concurrently with the Transactions, Finco merged with and into Advantage Sales & Marketing Inc. (in its capacity as the issuer of the Notes, the “Issuer”), with the Issuer continuing as the surviving entity and assuming the obligations of Finco. The Notes were sold to BofA Securities, Inc., Deutsche Bank Securities Inc., Morgan Stanley & Co. LLC and Apollo Global Securities, LLC. The Notes were resold to certain non-U.S. persons pursuant to Regulation S under the Securities Act of 1933, as amended (the “Securities Act”), and to persons reasonably believed to be qualified institutional buyers pursuant to Rule 144A under the Securities Act at a purchase price equal to 100% of their principal amount. The terms of the Notes are governed by an Indenture, dated as of October 28, 2020 (the “Indenture”), among Finco, the Issuer, the guarantors named therein (the “Notes Guarantors”) and Wilmington Trust, National Association, as trustee and collateral agent.\\nInterest and maturity\\nInterest on the Notes is payable semi-annually in arrears on May 15 and November 15 at a rate of 6.50% per annum, commencing on May 15, 2021. The Notes will mature on November 15, 2028.\\nGuarantees\\nThe Notes are guaranteed by Holdings and each of the Issuer’s direct and indirect wholly owned material U.S. subsidiaries (subject to certain permitted exceptions) and Canadian subsidiaries (subject to certain permitted exceptions, including exceptions based on immateriality thresholders of aggregate assets and revenues of Canadian subsidiaries) that is a borrower or guarantor under the Term Loan Facility.\\nSecurity and Ranking\\nThe Notes and the related guarantees are the general, senior secured obligations of the Issuer and the Notes Guarantors, are secured on a first-priority pari passu basis by security interests on the fixed asset collateral (equal in priority with liens securing the Term Loan Facility), and are secured on a second-priority basis by security interests on the current asset collateral (second in priority to the liens securing the Revolving Credit Facility and equal in priority with liens securing the Term Loan Facility), in each case, subject to certain limitations and exceptions and permitted liens.\\n43\\nThe Notes and related guarantees rank (i) equally in right of payment with all of the Issuer’s and the Guarantors’ senior indebtedness, without giving effect to collateral arrangements (including the Senior Secured Credit Facilities) and effectively equal to all of the Issuer’s and the Guarantors’ senior indebtedness secured on the same priority basis as the Notes, including the Term Loan Facility, (ii) effectively subordinated to any of the Issuer’s and the Guarantors’ indebtedness that is secured by assets that do not constitute collateral for the Notes to the extent of the value of the assets securing such indebtedness and to indebtedness that is secured by a senior-priority lien, including the Revolving Credit Facility to the extent of the value of the current asset collateral and (iii) structurally subordinated to the liabilities of the Issuer’s non-Guarantor subsidiaries.\\nOptional redemption for the Notes\\nThe Notes are redeemable on or after November 15, 2023 at the applicable redemption prices specified in the Indenture plus accrued and unpaid interest. The Notes may also be redeemed at any time prior to November 15, 2023 at a redemption price equal to 100% of the aggregate principal amount of such Notes to be redeemed plus a “make-whole” premium, plus accrued and unpaid interest. In addition, the Issuer may redeem up to 40% of the original aggregate principal amount of Notes before November 15, 2023 with the net cash proceeds of certain equity offerings at a redemption price equal to 106.5% of the aggregate principal amount of such Notes to be redeemed, plus accrued and unpaid interest. Furthermore, prior to November 15, 2023 the Issuer may redeem during each calendar year up to 10% of the original aggregate principal amount of the Notes at a redemption price equal to 103% of the aggregate principal amount of such Notes to be redeemed, plus accrued and unpaid interest. If the Issuer or its restricted subsidiaries sell certain of their respective assets or experience specific kinds of changes of control, subject to certain exceptions, the Issuer must offer to purchase the Notes at par. In connection with any offer to purchase all Notes, if holders of no less than 90% of the aggregate principal amount of Notes validly tender their Notes, the Issuer is entitled to redeem any remaining Notes at the price offered to each holder.\\nRestrictive covenants\\nThe Notes are subject to covenants that, among other things limit the Issuer’s ability and its restricted subsidiaries’ ability to: incur additional indebtedness or guarantee indebtedness; pay dividends or make other distributions in respect of, or repurchase or redeem, the Issuer’s or a parent entity’s capital stock; prepay, redeem or repurchase certain indebtedness; issue certain preferred stock or similar equity securities; make loans and investments; sell or otherwise dispose of assets; incur liens; enter into transactions with affiliates; enter into agreements restricting the Issuer’s subsidiaries’ ability to pay dividends; and consolidate, merge or sell all or substantially all of the Issuer’s assets. Most of these covenants will be suspended on the Notes so long as they have investment grade ratings from both Moody’s Investors Service, Inc. and S&P Global Ratings and so long as no default or event of default under the Indenture has occurred and is continuing.\\nEvents of default\\nThe following constitute events of default under the Notes, among others: default in the payment of interest; default in the payment of principal; failure to comply with covenants; failure to pay other indebtedness after final maturity or acceleration of other indebtedness exceeding a specified amount; certain events of bankruptcy; failure to pay a judgment for payment of money exceeding a specified aggregate amount; voidance of subsidiary guarantees; failure of any material provision of any security document or intercreditor agreement to be in full force and effect; and lack of perfection of liens on a material portion of the collateral, in each case subject to applicable grace periods.\\nFuture Cash Requirement\\nThere were no material changes to our contractual future cash requirements from those disclosed in our 2021 Annual Report.\\n44\\nCash and Cash Equivalents Held Outside the United States\\nAs of September 30, 2022 and December 31, 2021, $71.6 million and $86.2 million, respectively, of our cash and cash equivalents were held by foreign subsidiaries. As of September 30, 2022, and December 31, 2021, $21.6 million and $40.0 million, respectively, of our cash and cash equivalents were held by foreign branches.\\nWe assessed our determination as to our indefinite reinvestment intent for certain of our foreign subsidiaries and recorded a deferred tax liability of approximately $2.5 million of withholding tax as of December 31, 2021 for unremitted earnings in Canada with respect to which the Company does not have an indefinite reinvestment assertion. We will continue to evaluate our cash needs, however we currently do not intend, nor do we foresee a need, to repatriate funds from the foreign subsidiaries except for Canada. We have continued to assert indefinite reinvestment on all other earnings as it is necessary for continuing operations and to grow the business. If at a point in the future our assertion changes, we will evaluate tax-efficient means to repatriate the income. In addition, we expect existing domestic cash and cash flows from operations to continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, such as debt repayment and capital expenditures, for at least the next 12 months and thereafter for the foreseeable future.\\nIf we should require more capital in the United States than is generated by our domestic operations, for example, to fund significant discretionary activities such as business acquisitions, we could elect to repatriate future earnings from foreign jurisdictions. These alternatives could result in higher tax expense or increased interest expense. We consider the majority of the undistributed earnings of our foreign subsidiaries, as of December 31, 2021, to be indefinitely reinvested and, accordingly, no provision has been made for taxes in excess of the $2.5 million noted above.\\nOff-Balance Sheet Arrangements\\nWe do not have any off-balance sheet financing arrangements or liabilities, guarantee contracts, retained or contingent interests in transferred assets or any obligation arising out of a material variable interest in an unconsolidated entity. We do not have any majority-owned subsidiaries that are not included in our consolidated financial statements. Additionally, we do not have an interest in, or relationships with, any special-purpose entities.\\nCritical Accounting Policies and Estimates\\nOur critical accounting policies and estimates are included in our 2021 Annual Report and did not materially change during the nine months ended September 30, 2022.\\nRecently Issued Accounting Pronouncements\\nSee the information set forth in Note 1, Organization and Significant Accounting Policies – Recent Accounting Standards, to our unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2022 and 2021 included in “Part I, Financial Information—Item 1. Financial Statements” in this Quarterly Report.\\n45\\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nForeign Currency Risk\\nOur exposure to foreign currency exchange rate fluctuations is primarily the result of foreign subsidiaries and foreign branches primarily domiciled in Europe and Canada. We use financial derivative instruments to hedge foreign currency exchange rate risks associated with our Canadian subsidiary.\\nThe assets and liabilities of our foreign subsidiaries and foreign branches, whose functional currencies are primarily Canadian dollars, British pounds and euros, respectively, are translated into U.S. dollars at exchange rates in effect at the balance sheet date. Income and expense items are translated at the average exchange rates prevailing during the period. The cumulative translation effects for subsidiaries using a functional currency other than the U.S. dollar are included in accumulated other comprehensive loss as a separate component of stockholders’ equity. We estimate that had the exchange rate in each country unfavorably changed by ten percent relative to the U.S. dollar, our consolidated income before taxes would have decreased by approximately $2.5 million for the nine months ended September 30, 2022.\\nInterest Rate Risk\\nInterest rate exposure relates primarily to the effect of interest rate changes on borrowings outstanding under the Term Loan Facility, Revolving Credit Facility and Notes.\\nWe manage our interest rate risk through the use of derivative financial instruments. Specifically, we have entered into interest rate cap agreements to manage our exposure to potential interest rate increases that may result from fluctuations in LIBOR. We do not designate these derivatives as hedges for accounting purposes, and as a result, all changes in the fair value of derivatives, used to hedge interest rates, are recorded in “Interest expense, net” in our Condensed Consolidated Statements of Operations and Comprehensive Income.\\nAs of September 30, 2022, we had interest rate cap contracts on an additional $650.0 million of notional value of principal from other financial institutions, with a maturity date of December 16, 2024 to manage our exposure to interest rate movements on variable rate credit facilities when one-month LIBOR on term loans exceeding a cap of 0.75%. The aggregate fair value of our interest rate caps represented an outstanding net asset of $49.1 million as of September 30, 2022.\\nHolding other variables constant, a change of one-eighth percentage point in the weighted average interest rate above the floor of 0.75% on the Term Loan Facility and Revolving Credit Facility would have resulted in an increase of $0.7 million in interest expense, net of gains from interest rate caps, for the nine months ended September 30, 2022.\\nIn the future, in order to manage our interest rate risk, we may refinance our existing debt, enter into additional interest rate cap agreements or modify our existing interest rate cap agreement. However, we do not intend or expect to enter into derivative or interest rate cap transactions for speculative purposes.\\n46\\nITEM 4. CONTROLS AND PROCEDURES\\nOur management, with the participation of our chief executive officer and chief financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Quarterly Report. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of September 30, 2022, our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in reports we file or submit under the Exchange Act is (1) recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and (2) accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.\\nThere were no changes in internal control over financial reporting that occurred during the quarter ended September 30, 2022, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\\nIn designing and evaluating our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints, and that management is required to apply judgment in evaluating the benefits of possible controls and procedures relative to their costs.\\n47\\nPART II - OTHER INFORMATION\\nITEM 1. LEGAL PROCEEDINGS\\nWe are involved in various legal matters that arise in the ordinary course of our business. Some of these legal matters purport or may be determined to be class and/or representative actions, or seek substantial damages or penalties. Some of these legal matters relate to disputes regarding acquisitions. In connection with certain of the below matters and other legal matters, we have accrued amounts that we believe are appropriate. There can be no assurance, however, that the above matters and other legal matters will not result in us having to make payments in excess of such accruals or that the above matters or other legal matters will not materially or adversely affect our business, financial position or results of operations.\\nEmployment-Related Matters\\nWe have also been involved in various litigation, including purported class or representative actions with respect to matters arising under the U.S. Fair Labor Standards Act, California’s Labor Code (the “Labor Code”) and California’s Labor Code Private Attorneys General Act (“PAGA”). Many involve allegations for allegedly failing to pay wages and/or overtime, failing to provide meal and rest breaks and failing to pay reporting time pay, waiting time penalties and other penalties.\\nA former employee filed a complaint in California Superior Court, Santa Clara County in July 2017, which seeks civil damages and penalties on behalf of the plaintiff and similarly situated persons for various alleged wage and hour violations under the Labor Code, including failure to pay wages and/or overtime, failure to provide meal and rest breaks, failure to pay reporting time pay, waiting time penalties and penalties pursuant to PAGA. We filed a motion for summary judgment. The court granted our motion for summary judgment in March 2020, and the plaintiff filed an appeal of the court’s ruling in May 2020. We have retained outside counsel to represent us and intend to vigorously defend our interests in this matter.\\nProceedings Relating to Take 5\\nThe following proceedings relate to the Take 5 Matter, which is discussed in greater detail in “PART I, Financial Information —Item 1. Financial Statements—Note 10. Commitments and Contingencies” and “Risk Factors — Risks Related to the Company’s Business and Industry” in this Quarterly Report.\\nUSAO and FBI Voluntary Disclosure and Investigation Related to Take 5\\nIn connection with the Take 5 Matter, we voluntarily disclosed to the United States Attorney’s Office and the Federal Bureau of Investigation certain misconduct occurring at Take 5. We intend to cooperate in this and any other governmental investigation that may arise in connection with the Take 5 Matter. At this time, we cannot predict the ultimate outcome of any investigation related to the Take 5 Matter and are unable to estimate the potential impact such an investigation may have on us.\\nArbitration Proceedings Related to Take 5\\nIn August 2019, as a result of the Take 5 Matter, we provided a written indemnification claim notice to the sellers of Take 5, or the Take 5 Sellers, seeking monetary damages (including interest, fees and costs) based on allegations of breach of the asset purchase agreement, or Take 5 APA, as well as fraud. In September 2019, the Take 5 Sellers initiated arbitration proceedings in the state of Delaware against us, alleging breach of the Take 5 APA as a result of our decision to terminate the operations of the Take 5 business and seeking monetary damages equal to all unpaid earn-out payments under the Take 5 APA (plus interest fees and costs). In 2020, the Take 5 Sellers amended their statement of claim to allege defamation, relating to statements we made to customers in connection with terminating the operations of the Take 5 business, and seeking monetary damages for the alleged injury to their reputation. We have filed our response to the Take 5 Sellers’ claims and asserted indemnification, fraud and other claims against the Take 5 Sellers as counterclaims and cross-claims in the arbitration proceedings.\\n48\\nIn October 2022, the arbitrator made a final award in our favor. We are currently unable to estimate if or when we will be able to collect any amounts associated with this arbitration.\\nOther Legal Matters Related to Take 5\\nThe Take 5 Matter may result in additional litigation against us, including lawsuits from clients, or governmental investigations, which may expose us to potential liability in excess of the amounts being offered by us as refunds to Take 5 clients. We are currently unable to determine the amount of any potential liability, costs or expenses (above the amounts already being offered as refunds) that may result from any lawsuits or investigations associated with the Take 5 Matter or determine whether any such issues will have any future material adverse effect on our financial position, liquidity or results of operations. Although we have insurance covering certain liabilities, we cannot assure that the insurance will be sufficient to cover any potential liability or expenses associated with the Take 5 Matter.\\nITEM 1A. RISK FACTORS\\nInvesting in our securities involves risks. Before you make a decision regarding our securities, in addition to the risks and uncertainties discussed above under “Forward-Looking Statements,” you should carefully consider the specific risks set forth herein. If any of these risks actually occur, it may materially harm our business, financial condition, liquidity and results of operations. As a result, the market price of our securities could decline, and you could lose all or part of your investment. Additionally, the risks and uncertainties described in this Quarterly Report are not the only risks and uncertainties that we face. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may become material and adversely affect our business. The following discussion should be read in conjunction with the financial statements and notes to the financial statements included herein.\\nSummary of Principal Risks Associated with Our Business\\nSet forth below is a summary of some of the principal risks we face:\\n•the COVID-19 pandemic and the measures taken to mitigate its spread including its adverse effects on our business, results of operations, financial condition and liquidity;\\n•market-driven wage changes or changes to labor laws or wage or job classification regulations, including minimum wage;\\n•our ability to hire, timely train, and retain talented individuals for our workforce, and to maintain our corporate culture as we grow;\\n•developments with respect to retailers that are out of our control;\\n•our ability to continue to generate significant operating cash flow;\\n•consolidation within the industry of our clients creating pressure on the nature and pricing of our services;\\n•our reliance on continued access to retailers’ platforms;\\n•consumer goods manufacturers and retailers reviewing and changing their sales, retail, marketing, and technology programs and relationships;\\n•our ability to successfully develop and maintain relevant omni-channel services for our clients in an evolving industry and to otherwise adapt to significant technological change;\\n•client procurement strategies putting additional operational and financial pressure on our services;\\n•our ability to maintain proper and effective internal control over financial reporting in the future;\\n•potential and actual harms to our business arising from the matter related to the 2018 acquisition of Take 5 Media Group (the “Take 5 Matter”);\\n•our ability to identify attractive acquisition targets, acquire them at attractive prices, and successfully integrate the acquired businesses;\\n•our ability to avoid or manage business conflicts among competing brands;\\n49\\n•difficulties in integrating acquired businesses;\\n•our substantial indebtedness and our ability to refinance at favorable rates;\\n•limitations, restrictions, and business decisions involving our joint ventures and minority investments;\\n•our ability to respond to changes in digital practices and policies;\\n•exposure to foreign currency exchange rate fluctuations and risks related to our international operations;\\n•disruptions in global financial markets relating to terrorist attacks or geopolitical risk and the recent conflict between Russia and Ukraine;\\n•the ability to maintain applicable listing standards;\\n•changes in applicable laws or regulations; and\\n•the possibility that we may be adversely affected by other political, economic, business, and/or competitive factors.\\nRisks Related to the Company’s Business and Industry\\nThe COVID-19 pandemic and the measures taken to mitigate its spread have had, and are likely to continue to have, an adverse effect on our business, results of operations, financial condition and liquidity.\\nThe COVID-19 pandemic, including the measures taken to mitigate its spread, have had, and are likely to continue to have, adverse effects on our business and operations. There are many uncertainties regarding the current COVID-19 pandemic, including the scope of potential public health issues, the anticipated duration of the pandemic and the extent of local and worldwide social, political and economic disruption it has caused and may cause in the future. To date, the COVID-19 pandemic and measures taken to mitigate the spread of COVID-19, including restrictions on large gatherings, closures of face-to-face events and indoor dining facilities, “shelter in place” health orders and travel restrictions, have had far-reaching direct and indirect impacts on many aspects of our operations, including temporary termination of certain in-store demonstration services and other services, as well as on consumer behavior and purchasing patterns, in particular with respect to the foodservice industries, and declines in consumer demand for restaurant, school and hotel dining, where we promote our clients’ products. Since March 2020, our marketing segment has experienced a significant decline in revenues, primarily due to the temporary suspension or reduction of certain in-store demonstration services and decreased demand in our digital marketing services, both of which we believe were caused by the COVID-19 pandemic and the various governmental and private responses to the pandemic, and which may continue in the future. In our sales segment, we have experienced significant shifts in consumer spending preferences and habits. We can provide no assurances that the strength of that segment will continue or that we will be able to continue to evolve our business in the future as the COVID-19 pandemic continues to impact our clients’ businesses.\\nWe have taken several actions in response to these business disruptions, including reducing certain of our discretionary expenditures, reducing our real estate foot print, through lease terminations and amendments (including abandoning several office leases prior to reaching termination agreements with its landlords), eliminating non-essential travel and terminating, furloughing or instituting pay reductions and deferrals for some of our associates. However, the pandemic has had, and may continue to have, an adverse effect on our results of operations, including our revenues, our financial condition and liquidity.\\nThe COVID-19 pandemic also may have the effect of heightening many of the other risks described in these “Risk Factors”, including:\\n•potential changes in the policies of retailers in response to the COVID-19 pandemic, including changes to or restrictions on their outsourcing of sales and marketing functions and restrictions on the performance of in-store demonstration services, if permitted at all;\\n•potential changes in the demand for services by our clients in response to the COVID-19 pandemic;\\n•our ability to hire, timely train and retain talented individuals for our workforce;\\n•disruptions, delays and strains in certain domestic and internal supply changes that have had, and may continue to have, a negative effect on the flow or availability of certain products;\\n50\\n•the need for us to adapt to technological change and otherwise develop and maintain omni-channel solutions;\\n•our ability to generate sufficient cash to service our substantial indebtedness;\\n•our ability to maintain our credit rating;\\n•our ability to offer high-quality customer support and maintain our reputation;\\n•our ability to identify, perform adequate diligence on and consummate acquisitions of attractive business targets, and then subsequently integrate such acquired businesses;\\n•our ability to maintain our corporate culture;\\n•severe disruption and instability in the U.S. and global financial markets or deteriorations in credit and financing conditions, which could make it difficult for us to access debt and equity capital on attractive terms, or at all;\\n•our ability to effectively manage our operations while a significant amount of our associates continue to work remotely due to the COVID-19 pandemic;\\n•deteriorating economic conditions, declines in labor force participation rates, public transportation disruptions or other disruptions as a result of the COVID-19 pandemic;\\n•potential cost-saving strategies implemented by clients that reduce fees paid to third-party service providers such as ourselves; and\\n•our ability to implement additional internal control measures to improve our internal control over financial reporting.\\nWe cannot predict the full extent to which the COVID-19 pandemic may affect our business, financial condition, results of operations and liquidity as such effects will depend on how the COVID-19 pandemic and the measures taken in response to the COVID-19 pandemic continue to develop. However, these effects may continue, evolve or increase in severity, each of which could further negatively impact our business, financial condition, results of operations and liquidity.\\nMarket-driven wage increases and changes to wage or job classification regulations, including minimum wages could adversely affect our business, financial condition or results of operations.\\nMarket competition has and may continue to cause us to increase the salaries or wages paid to our associates or the benefits packages that they receive. If we experience further market-driven increases in salaries, wage rates or benefits or if we fail to increase our offered salaries, wages or benefits packages competitively, the quality of our workforce could decline, causing our client service to suffer. Low unemployment rates or lower levels of labor force participation rates may increase the likelihood or impact of such market pressures. Any of these changes affecting wages or benefits for our associates could adversely affect our business, financial condition or results of operations.\\nChanges in labor laws related to employee hours, wages, job classification and benefits, including health care benefits, could adversely affect our business, financial condition or results of operations. As of September 30, 2022, we employed approximately 75,000 associates, many of whom are paid above, but near, applicable minimum wages, and their wages may be affected by changes in minimum wage laws.\\nAdditionally, many of our salaried associates are paid at rates that could be impacted by changes to minimum pay levels for exempt roles. Certain state or municipal jurisdictions in which we operate have recently increased their minimum wage by a significant amount, and other jurisdictions are considering or plan to implement similar actions, which may increase our labor costs. Any increases at the federal, state or municipal level to the minimum pay rate required to remain exempt from overtime pay may adversely affect our business, financial condition or results of operations.\\nAn inability to hire, timely train and retain talented individuals for our workforce could slow our growth and adversely impact our ability to operate our business.\\nOur ability to meet our workforce needs, while controlling associate-related costs, including salaries, wages and benefits, is subject to numerous external factors, including the availability of talented persons in the workforce in the local markets in which we operate, prevailing unemployment rates and competitive wage rates in such\\n51\\nmarkets. We may find that there is an insufficient number of qualified individuals to fill our associate positions with the qualifications we seek. Competition in these communities for qualified staff could require us to pay higher wages and provide greater benefits, especially if there is significant improvement in regional or national economic conditions. We must also train and, in some circumstances, certify these associates under our policies and practices and any applicable legal requirements. If we are unable to hire, timely train or retain talented individuals may result in higher turnover and increased labor costs, and could compromise the quality of our service, all of which could adversely affect our business.\\nInflation may adversely affect our operating results.\\nInflationary factors such as increases in the labor costs, material costs and overhead costs may adversely affect our operating results. A high rate of inflation, including a continuation of inflation at the current rate, has had and may continue to have an adverse effect on our ability to maintain attractive levels of gross margin and general and administrative expenses as a percentage of total revenue, if we are unable to pass on these costs through increased prices, revised budget estimates, or offset them in other ways.\\nOur business and results of operations are affected by developments with and policies of retailers that are out of our control.\\nA limited number of national retailers account for a large percentage of sales for our consumer goods manufacturer clients. We expect that a significant portion of these clients’ sales will continue to be made through a relatively small number of retailers and that this percentage may increase if the growth of mass retailers and the trend of retailer consolidation continues. As a result, changes in the strategies of large retailers, including a reduction in the number of brands that these retailers carry or an increase in shelf space that they dedicate to private label products, could materially reduce the value of our services to these clients or these clients’ use of our services and, in turn, our revenues and profitability. Many retailers have critically analyzed the number and variety of brands they sell, and have reduced or discontinued the sale of certain of our clients’ product lines at their stores, and more retailers may continue to do so. If this continues to occur and these clients are unable to improve distribution for their products at other retailers, our business or results of operations could be adversely affected. These trends may be accelerated as a result of the COVID-19 pandemic.\\nAdditionally, many retailers, including several of the largest retailers in North America, which own and operate a significant number of the locations at which we provide our services, have implemented or may implement in the future, policies that designate certain service providers to be the exclusive provider or one of their preferred providers for specified services, including many of the services that we provide to such retailers or our clients.\\nSome of these designations apply across all of such retailers’ stores, while other designations are limited to specific regions. If we are unable to respond effectively to the expectations and demands of such retailers or if retailers do not designate us as their exclusive provider or one of their preferred providers for any reason, they could reduce or restrict the services that we are permitted to perform for our clients at their facilities or require our clients to purchase services from other designated services providers, which include our competitors, either of which could adversely affect our business or results of operations.\\nConsolidation in the industries we serve could put pressure on the pricing of our services, which could adversely affect our business, financial condition or results of operations.\\nConsolidation in the consumer goods and retail industries we serve could reduce aggregate demand for our services in the future and could adversely affect our business or our results of operations. In October 2022, The Kroger Co. and Albertsons Companies, Inc., two large retailers, announced an agreement to merge their businesses together with an anticipated closing in 2024. When companies consolidate, the services they previously purchased separately are often purchased by the combined entity, leading to the termination of relationships with certain service providers or demands for reduced fees and commissions. The combined company may also choose to insource certain functions that were historically outsourced, resulting in the termination of existing relationships with third-party service providers. While we attempt to mitigate the revenue impact of any consolidation by maintaining existing or winning new service arrangements with the combined companies, there can be no assurance as to the degree to which we will be able to do so as consolidation continues in the industries we serve, and our business, financial condition or results of operations may be adversely affected.\\n52\\nConsumer goods manufacturers and retailers may periodically review and change their sales, retail, marketing and technology programs and relationships to our detriment.\\nThe consumer goods manufacturers and retailers to whom we provide our business solutions operate in highly competitive and rapidly changing environments. From time to time these parties may put their sales, retail, marketing and technology programs and relationships up for competitive review, which may increase in frequency as a result of the COVID-19 pandemic and its impacts on the consumer goods manufacturers and retailer industries. We have occasionally lost accounts with significant clients as a result of these reviews in the past, and our clients are typically able to reduce or cancel current or future spending on our services on short notice for any reason. We believe that key competitive considerations for retaining existing and winning new accounts include our ability to develop solutions that meet the needs of these manufacturers and retailers in this environment, the quality and effectiveness of our services and our ability to operate efficiently. To the extent that we are not able to develop these solutions, maintain the quality and effectiveness of our services or operate efficiently, we may not be able to retain key clients, and our business, financial condition or results of operations may be adversely affected.\\nOur largest clients generate a significant portion of our revenues.\\nOur three largest clients generated approximately 11% of our revenues in the fiscal year ended December 31, 2021. These clients are generally able to reduce or cancel spending on our services on short notice for any reason. A significant reduction in spending on our services by our largest clients, or the loss of one or more of our largest clients, if not replaced by new clients or an increase in business from existing clients, would adversely affect our business and results of operations. In addition, when large retailers suspend or reduce in-store demonstration services, such as in response to the COVID-19 pandemic, our business and results of operations can be adversely affected.\\nWe are reliant on continued access to retailer platforms on commercially reasonable terms for the provision of certain of our e-commerce services in which our clients’ products are resold by us, as the vendor of record, directly to the consumer.\\nA portion of the e-commerce services we provide involve the purchase and resale by us, as the vendor of record, of our clients’ products through retailer platforms. The control that retailers such as Amazon have over the access and fee structures and/or pricing for products on their platforms could impact the volume of purchases of these products made on their platform and our revenues from the provision of such e-commerce services. If such retailers establish terms that restrict the offering of these products on their platform, significantly impact the financial terms on which such products are offered, or do not approve the inclusion of such products on their platform, our business could be negatively impacted. Additionally, we also generally rely on a retailer’s payment processing services for purchases made on its platform by consumers. To the extent such payment processing services are offered to us on less favorable terms, or become unavailable to us for any reason, our costs of revenue with respect to this aspect of our business could increase, and our margins could be materially adversely impacted. We cannot assure you that we will be successful in maintaining access to these retailer platforms on commercially reasonable terms, or at all.\\nThe retail industry is evolving, and if we do not successfully develop and maintain relevant omni-channel services for our clients, our business, financial condition or results of operations could be adversely impacted.\\nHistorically, substantially all of our sales segment revenues were generated by sales and services that ultimately occurred in traditional retail stores. The retail industry is evolving, as demonstrated by the number of retailers that offer both traditional retail stores and e-commerce platforms or exclusively e-commerce platforms. In addition, the COVID-19 pandemic has placed pressure on the traditional retail store model, including store closures, changes in consumer spending, and extensive health and safety risks and compliance requirements. Consumers are increasingly using computers, tablets, mobile phones and other devices to comparison shop, determine product availability and complete purchases online, a trend that has accelerated during the COVID-19 pandemic, and which may continue thereafter. If consumers continue to purchase more products online and e-commerce continues to displace brick-and-mortar retail sales, there may be a decrease in the demand for certain of our services. Omni-channel retailing is rapidly evolving and we believe we will need to keep pace with the changing consumer expectations and new developments by our competitors.\\n53\\nWhile we continue to seek to develop effective omni-channel solutions for our clients that support both their e-commerce and traditional retail needs, there can be no assurances that these efforts will result in revenue gains sufficient to offset potential decreases associated with a decline in traditional retail sales or that we will be able to maintain our position as a leader in our industry. If we are unable to provide, improve or develop innovative digital services and solutions in a timely manner or at all, our business, financial condition or results of operations could be adversely impacted.\\nWe may be unable to adapt to significant technological change, which could adversely affect our business, financial condition or results of operations.\\nWe operate businesses that require sophisticated data collection, processing and software for analysis and insights. Some of the technologies supporting the industries we serve are changing rapidly, particularly as a result of the COVID-19 pandemic. We will be required to continue to adapt to changing technologies, either by developing and marketing new services or by enhancing our existing services, to meet client demand.\\nMoreover, the introduction of new services embodying new technologies, including automation of certain of our in-store services, and the emergence of new industry standards could render existing services obsolete. Our continued success will depend on our ability to adapt to changing technologies, manage and process increasing amounts of data and information and improve the performance, features and reliability of our existing services in response to changing client and industry demands. We may experience difficulties that could delay or prevent the successful design, development, testing, introduction or marketing of our services. New services or enhancements to existing services may not adequately meet the requirements of current and prospective clients or achieve market acceptance.\\nOur ability to maintain our competitive position depends on our ability to attract and retain talented executives.\\nWe believe that our continued success depends to a significant extent upon the efforts, abilities and relationships of our senior executives and the strength of our middle management team. Although we have entered into employment agreements with certain of our senior executives, each of them may terminate their employment with us at any time. The replacement of any of our senior executives likely would involve significant time and costs and may significantly delay or prevent the achievement of our business objectives and could therefore have an adverse impact on our business. In addition, we do not carry any “key person” insurance policies that could offset potential loss of service under applicable circumstances. Furthermore, if we are unable to attract and retain a talented team of middle management executives, it may be difficult to maintain the expertise and industry relationships that our clients value, and they may terminate or reduce their relationship with us.\\nClient procurement and fee reduction strategies could put additional operational and financial pressure on our services or negatively impact our relationships, business, financial condition or results of operations.\\nMany of our clients seek opportunities to reduce their costs through procurement strategies that reduce fees paid to third-party service providers. As a result, certain of our clients have sought, and may continue to seek, more aggressive terms from us, including with respect to pricing and payment terms. Such activities put operational and financial pressure on our business, which could limit the amounts we earn or delay the timing of our cash receipts. Such activities may also cause disputes with our clients or negatively impact our relationships or financial results. Our clients have experienced, and may continue to experience, increases in their expenses associated with materials and logistics, which may cause them to reduce expenses elsewhere. While we attempt to mitigate negative implications to client relationships and the revenue impact of any pricing pressure by aligning our revenues opportunity with satisfactory client outcomes, there can be no assurance as to the degree to which we will be able to do so successfully. Additionally, price concessions can lead to margin compression, which in turn could adversely affect our business, financial condition or results of operations.\\nIf we fail to offer high-quality customer support, our business and reputation may suffer.\\nHigh-quality education, training and customer support are important for successful marketing and sales and for the renewal of existing customers. Providing this education, training and support requires that our personnel who manage our online training resource or provide customer support have specific inbound experience domain knowledge and expertise, making it more difficult for us to hire qualified personnel and to scale up our support operations. The importance of high-quality customer support will increase as we expand our business and pursue\\n54\\nnew customers. If we do not help our customers use multiple applications and provide effective ongoing support, our ability to sell additional functionality and services to, or to retain, existing customers may suffer and our reputation with existing or potential customers may be harmed.\\nWe may be adversely affected if clients reduce their outsourcing of sales and marketing functions.\\nOur business and growth strategies depend in large part on companies continuing to elect to outsource sales and marketing functions. Our clients and potential clients will outsource if they perceive that outsourcing may provide quality services at a lower overall cost and permit them to focus on their core business activities and have done so in the past. We cannot be certain that the industry trend to outsource will continue or not be reversed or that clients that have historically outsourced functions will not decide to perform these functions themselves. Unfavorable developments with respect to outsourcing could adversely affect our business, financial conditions and results of operations.\\nWe previously identified material weaknesses in our internal control over financial reporting. If we fail to maintain proper and effective internal control over financial reporting in the future, our ability to produce accurate and timely financial statements could be impaired, investors’ views of us could be harmed, and we could be subject to enforcement actions by the SEC.\\nDuring 2021, we completed the remediation measures related to the material weaknesses previously identified and concluded that our internal control over financial reporting was effective as of December 31, 2021. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim consolidated financial statements will not be prevented or detected on a timely basis. If we are unable to maintain effective internal control over financial reporting or disclosure controls and procedures, our ability to record, process and report financial information accurately, and to prepare financial statements within required time periods could be adversely affected, which could subject us to litigation or investigations requiring management resources and payment of legal and other expenses, negatively affect investor confidence in our financial statements and adversely impact our stock price.\\nIf we are unable to identify attractive acquisition targets, acquire them at attractive prices or successfully integrate the acquired businesses, we may be unsuccessful in growing our business.\\nA significant portion of our growth has been as a result of our acquisition of complementary businesses that grow our service offerings, expand our geographic reach and strengthen valuable relationships with clients. However, there can be no assurance that we will find attractive acquisition targets, that we will acquire them at attractive prices, that we will succeed at effectively managing the integration of acquired businesses into our existing operations or that such acquired businesses or technologies will be well received by our clients, potential clients or our investors. We could also encounter higher-than-expected earn-out payments, unforeseen transaction- and integration-related costs or delays or other circumstances such as disputes with or the loss of key or other personnel from acquired businesses, challenges or delays in integrating systems or technology of acquired businesses, a deterioration in our associate and client relationships, harm to our reputation with clients, interruptions in our business activities or unforeseen or higher-than-expected inherited liabilities. Many of these potential circumstances are outside of our control and any of them could result in increased costs, decreased revenue, decreased synergies or the diversion of management time and attention.\\nIn order for us to continue to grow our business through acquisitions we will need to identify appropriate acquisition opportunities and acquire them at attractive prices. We may choose to pay cash, incur debt or issue equity securities to pay for any such acquisition. The incurrence of indebtedness would result in increased fixed obligations and could also include covenants or other restrictions that would impede our ability to manage our operations. The sale of equity to finance any such acquisition could result in dilution to our stockholders.\\nWe may encounter significant difficulties integrating acquired businesses.\\nThe integration of any businesses is a complex, costly and time-consuming process. As a result, we have devoted, and will continue to devote, significant management attention and resources to integrating acquired businesses. The failure to meet the challenges involved in integrating businesses and to realize the anticipated benefits of any acquisition could cause an interruption of, or a loss of momentum in, the activities of our combined\\n55\\nbusiness and could adversely affect our results of operations. The difficulties of combining acquired businesses with our own include, among others:\\n•the diversion of management attention to integration matters;\\n•difficulties in integrating functional roles, processes and systems, including accounting systems;\\n•challenges in conforming standards, controls, procedures and accounting and other policies, business cultures and compensation structures between the two companies;\\n•difficulties in assimilating, attracting and retaining key personnel;\\n•challenges in keeping existing clients and obtaining new clients;\\n•difficulties in achieving anticipated cost savings, synergies, business opportunities and growth prospects from an acquisition;\\n•difficulties in managing the expanded operations of a significantly larger and more complex business;\\n•contingent liabilities, including contingent tax liabilities or litigation, that may be larger than expected; and\\n•potential unknown liabilities, adverse consequences or unforeseen increased expenses associated with an acquisition, including possible adverse tax consequences to the combined business pursuant to changes in applicable tax laws or regulations.\\nMany of these factors are outside of our control, and any one of them could result in increased costs, decreased expected revenues and diversion of management time and energy, all of which could adversely impact our business and results of operations. These difficulties have been enhanced further during the COVID-19 pandemic as a result of our office closures and work-from home policies, which may hinder assimilation of key personnel.\\nIf we are not able to successfully integrate an acquisition, if we incur significantly greater costs to achieve the expected synergies than we anticipate or if activities related to the expected synergies have unintended consequences, our business, financial condition or results of operations could be adversely affected.\\nOur corporate culture has contributed to our success and, if we are unable to maintain it as we evolve, our business, operating results and financial condition could be harmed.\\nWe believe our corporate culture has been a significant factor in our success. However, as our company evolves, including through acquisitions and the impacts of the COVID-19 pandemic, such as working remotely and reductions in workforce, it may be difficult to maintain our culture, which could reduce our ability to innovate and operate effectively. The failure to maintain the key aspects of our culture as our organization evolves could result in decreased employee satisfaction, increased difficulty in attracting top talent, increased turnover and compromised the quality of our client service, all of which are important to our success and to the effective execution of our business strategy. If we are unable to maintain our corporate culture as we evolve and execute our growth strategies, our business, operating results and financial condition could be harmed.\\nAcquiring new clients and retaining existing clients depends on our ability to avoid or manage business conflicts among competing brands.\\nOur ability to acquire new clients and to retain existing clients, whether by expansion of our own operations or through an acquired business may in some cases be limited by the other parties’ perceptions of, or policies concerning, perceived competitive conflicts arising from our other relationships. Some of our contracts expressly restrict our ability to represent competitors of the counterparty. These perceived competitive conflicts may also become more challenging to avoid or manage as a result of continued consolidation in the consumer goods and retail industries and our own acquisitions. If we are unable to avoid or manage business conflicts among competing manufacturers and retailers, we may be unable to acquire new clients or be forced to terminate existing client relationships, and in either case, our business and results of operations may be adversely affected.\\nLimitations, restrictions and business decisions involving our joint ventures and minority investments may adversely affect our growth and results of operations.\\n56\\nWe have made substantial investments in joint ventures and minority investments and may use these and other similar methods to expand our service offerings and geographical coverage in the future. These arrangements typically involve other business services companies as partners that may be competitors of ours in certain markets. Joint venture agreements may place limitations or restrictions on our services. As part of our joint venture with, and investments in Smollan, we are restricted under certain circumstances from making direct acquisitions and otherwise expanding our service offerings into markets outside of North America and Europe. As a result of our acquisition of Daymon Worldwide Inc. pursuant to the terms of our arrangements with Smollan and our joint venture, Smollan and our joint venture may elect to purchase from us, and have purchased, certain Daymon business units that operate outside of North America. If Smollan or our joint venture do not elect to purchase those business units, we may, under certain circumstances, elect to retain, sell or discontinue those business units. The limitations and restrictions tied to our joint venture and minority investments limit our potential business opportunities and reduce the economic opportunity for certain prospective international investments and operations. Additionally, though we control our joint ventures, we may rely upon our equity partners or local management for operational and compliance matters associated with our joint ventures or minority investments. Moreover, our other equity partners and minority investments may have business interests, strategies or goals that are inconsistent with ours. Business decisions, including actions or omissions, of a joint venture or other equity partner or management for a business unit may adversely affect the value of our investment, result in litigation or regulatory action against us or adversely affect our growth and results of operations.\\nOur international operations expose us to risks that could impede growth in the future, and our attempts to grow our business internationally may not be successful.\\nWe continue to explore opportunities in major international markets. International operations expose us to various additional risks that could adversely affect our business, including:\\n•costs of customizing services for clients outside of the United States;\\n•the burdens of complying with a wide variety of foreign laws;\\n•potential difficulty in enforcing contracts;\\n•being subject to U.S. laws and regulations governing international operations, including the U.S. Foreign Corrupt Practices Act and sanctions regimes;\\n•being subject to foreign anti-bribery laws in the jurisdictions in which we operate, such as the UK Bribery Act;\\n•reduced protection for intellectual property rights;\\n•increased financial accounting and reporting complexity;\\n•additional legal compliance requirements, including custom and import requirements with respect to products imported to and exported across international borders;\\n•exposure to foreign currency exchange rate fluctuations;\\n•exposure to local economic conditions;\\n•limitations on the repatriation of funds or profits from foreign operations;\\n•exposure to local or regional political conditions, including adverse tax policies and civil unrest;\\n•the risks of a natural disaster, public health crisis (including the occurrence of a contagious disease or illness, such as the coronavirus), an outbreak of war (such as Russia's invasion of Ukraine), the escalation of hostilities and acts of terrorism in the jurisdictions in which we operate; and\\n•the disparate impact of the COVID-19 pandemic, including the measures taken to mitigate its spread, across various jurisdictions.\\nAdditionally, the withdrawal of the United Kingdom from the European Union, or “Brexit,” has created economic and political uncertainty, including volatility in global financial markets and the value of foreign currencies. The impact of Brexit may not be fully realized for several years. Additionally, in many countries outside of the United States, there has not been a historical practice of using third parties to provide sales and marketing services. Accordingly, while it is part of our strategy to expand into international markets, it may be difficult for us to grow our international business units on a timely basis, or at all.\\nThe ongoing conflict between Russia and Ukraine may adversely affect our business and results of operations.\\n57\\nGiven the nature of our business and our international operations, political, economic, and other conditions in foreign countries and regions, including geopolitical risks such as those arising from the current conflict between Russia and Ukraine, may adversely affect our business and results of operations. The broader consequences of this conflict, which may include further sanctions, embargoes, regional instability, and geopolitical shifts; disruptions to transportation and distribution routes, or strategic decisions to alter certain routes; potential retaliatory action by the Russian government against companies, including us, including nationalization of foreign businesses and/or assets in Russia; increased tensions between the United States and countries in which we operate; and the extent of the conflict’s effect on our business and results of operations as well as the global economy, cannot be predicted.\\nAdditionally, we have a minority interest in a European company that owns majority interests in local agencies in Russia. In addition to the imposition of sanctions by the United States, the United Kingdom, and the European Union that affect the cross-border operations of businesses operating in Russia, Russian regulators have imposed currency restrictions and regulations that created uncertainty regarding our ability to recover our investment in operations in Russia, as well as our ability to exercise control or influence involving operations by the local agencies in Russia. As a result, we intend to use our influence to cause the European company to dispose of our ownership interests in the local agencies in Russia. Accordingly, we recorded pretax charges of $2.8 million in the first quarter of 2022, primarily consisting of our proportionate share of the net investment in our Russian interest in “Selling, general, and administrative expenses” in the Condensed Consolidated Statements of Operations and Comprehensive Income.\\nTo the extent the current conflict between Russia and Ukraine adversely affects our business, particularly in Russia, it may also have the effect of heightening many other risks disclosed in our 2021 Annual Report and this Quarterly Report, any of which could materially and adversely affect our business and results of operations. Such risks include, but are not limited to, adverse effects on macroeconomic conditions, including inflation and business spending; disruptions to our information technology infrastructure, including through cyberattack, ransom attack, or cyber-intrusion; adverse changes in international trade policies and relations; our ability to maintain or increase our prices, our ability to implement and execute our business strategy, disruptions in global supply chains, our exposure to foreign currency fluctuations, and constraints, volatility, or disruption in the capital markets, difficulty staffing and managing impacted operations, and the recoverability of assets in the region.\\nWe may be subject to unionization, work stoppages, slowdowns or increased labor costs.\\nCurrently, none of our associates in the United States are represented by a union. However, our associates have the right under the National Labor Relations Act to choose union representation. If all or a significant number of our associates become unionized and the terms of any collective bargaining agreement were significantly different from our current compensation arrangements, it could increase our costs and adversely impact our profitability. Moreover, if a significant number of our associates participate in labor unions, it could put us at increased risk of labor strikes and disruption of our operations or adversely affect our growth and results of operations. In December 2019, a union which commonly represents employees in the supermarket industry filed a petition with the National Labor Relations Board to represent approximately 120 of our associates who work in and around Boston. An election was held, and based on certified results of the election we prevailed in this election. Notwithstanding this successful election, we could face future union organization efforts or elections, which could lead to additional costs, distract management or otherwise harm our business.\\nIf goodwill or other intangible assets in connection with our acquisitions become impaired, we could take significant non-cash charges against earnings.\\nWe have made acquisitions to complement and expand the services we offer and intend to continue to do so when attractive acquisition opportunities exist in the market. As a result of prior acquisitions, including the acquisition of our business in 2014 by our current parent entity, Topco, we have goodwill and intangible assets recorded on our balance sheet of $2.2 billion and $2.2 billion, respectively, as of September 30, 2022, as further described in Note 4 to our condensed consolidated financial statements for the three and nine months ended September 30, 2022.\\nUnder accounting guidelines, we must assess, at least annually, whether the value of goodwill and other intangible assets has been impaired. We have recognized non-cash goodwill and non-cash intangible asset impairment charges, and we can make no assurances that we will not record any additional impairment charges in\\n58\\nthe future. Any future reduction or impairment of the value of goodwill or other intangible assets will similarly result in charges against earnings, which could adversely affect our reported financial results in future periods.\\nFailures in, or incidents involving, our technology infrastructure could damage our business, reputation and brand and substantially harm our business and results of operations.\\nOur business is highly dependent on our ability to manage operations and process a large number of transactions on a daily basis. We rely heavily on our operating, payroll, financial, accounting and other data processing systems which require substantial support and maintenance, and may be subject to disabilities, errors, or other harms. If our data and network infrastructure were to fail, or if we were to suffer a data security breach, or an interruption or degradation of services in our data center, third-party cloud, and other infrastructure environments, we could lose important data, which could harm our business and reputation, and cause us to incur significant liabilities. Our facilities, as well as the facilities of third-parties that provide or maintain, or have access to our data or network infrastructure, are vulnerable to damage or interruption from earthquakes, hurricanes, floods, fires, cyber security attacks, terrorist attacks, power losses, telecommunications failures and similar events. In the event that our or any third-party provider’s systems or service abilities are hindered by any of the events discussed above, our ability to operate may be impaired. Our information technology systems, and the information technology systems of our current or future third-party vendors, collaborators, consultants and service providers, could be penetrated by internal or external parties intent on extracting information, corrupting information, stealing intellectual property or trade secrets, or disrupting business processes. A third party’s decision to close facilities or terminate services without adequate notice, or other unanticipated problems, could adversely impact our operations. Any of the aforementioned risks may be augmented if our or any third-party provider’s business continuity and disaster recovery plans prove to be inadequate in preventing the loss of data, service interruptions, disruptions to our operations or damages to important systems or facilities. Our data center, third-party cloud, and managed service provider infrastructure also could be subject to break-ins, cyber-attacks (including through the use of malware, software bugs, computer viruses, ransomware, social engineering, and denial of service), sabotage, intentional acts of vandalism and other misconduct, from a spectrum of actors ranging in sophistication from threats common to most industries to more advanced and persistent, highly organized adversaries. Any security breach or incident, including personal data breaches, that we experience could result in unauthorized access to, or misuse, modification, destruction or unauthorized acquisition of, our internal sensitive corporate data, such as personal data, financial data, trade secrets, intellectual property, or other competitively sensitive or confidential data. Such unauthorized access, misuse, acquisition, or modification of sensitive data may result in data loss, corruption or alteration, interruptions in our operations or damage to our computer hardware or systems or those of our employees or customers. Our systems have been the target of cyber-attacks. Although we have taken and continue to take steps to enhance our cybersecurity posture, we cannot assure that future cyber incidents will not occur or that our systems will not be targeted or breached in the future. Any such breach or unauthorized access could result in a disruption of the Company’s operations, the theft, unauthorized use or publication of the Company’s intellectual property, other proprietary information or the personal information of customers, employees, licensees or suppliers, a reduction of the revenues the Company is able to generate from its operations, damage to the Company’s brand and reputation, a loss of confidence in the security of the Company’s business and products, and significant legal and financial exposure. If any such incident results in litigation, we may be required to make significant expenditures in the course of such litigation and may be required to pay significant amounts in damages. We may not carry sufficient business interruption insurance to compensate us for losses that may occur as a result of any events that cause interruptions in our service. Significant unavailability of our services due to attacks could cause us to incur significant liability, could cause users to cease using our services and materially and adversely affect our business, prospects, financial condition and results of operations.\\nWe use complex software in our technology infrastructure, which we seek to continually update and improve. Replacing such systems is often time-consuming and expensive and can also be intrusive to daily business operations. Further, we may not always be successful in executing these upgrades and improvements, which may result in a failure of our systems. We may experience periodic system interruptions from time to time. Any slowdown or failure of our underlying technology infrastructure could harm our business and reputation, which could materially adversely affect our results of operations. Our disaster recovery plan or those of our third-party providers may be inadequate, and our business interruption insurance may not be sufficient to compensate us for the losses that could occur.\\n59\\nFailure to comply with federal, state and foreign laws and regulations relating to privacy, data protection and consumer protection, or the expansion of current or the enactment of new laws or regulations relating to privacy, data protection and consumer protection, could adversely affect our business and our financial condition.\\nA variety of federal, state and foreign laws and regulations govern the collection, use, retention, sharing and security of personal information. The information, security and privacy requirements imposed by such governmental laws and regulations relating to privacy, data protection and consumer protection are increasingly demanding, quickly evolving and may be subject to differing interpretations or legal theories among regulators, enforcers, and civil litigants. These requirements may not be harmonized, may be interpreted and applied in a manner that is inconsistent from one jurisdiction to another or may conflict with other rules or our practices. As a result, our practices may not have complied or may not comply in the future with all such laws, regulations, requirements and obligations. Our actual or perceived failure to comply with such laws and regulations could result in fines, investigations, enforcement actions, penalties, sanctions, claims for damages by affected individuals, and damage to our reputation, among other negative consequences, any of which could have a material adverse effect on its financial performance.\\nCertain aspects of our business and/or the data it collects is subject to the California Consumer Protection Act of 2018 (“CCPA”), which became effective in 2020 and regulates the collection, use and processing of personal information relating to California residents, and which grants certain privacy rights to California residents, including rights to request access to and to request deletion of personal information relating to such individuals under certain circumstances. Compliance with the new obligations imposed by the CCPA depends in part on how its requirements are interpreted and applied by the California attorney general and courts. Alleged violations of the CCPA may result in substantial civil penalties or statutory damages when applied at scale, up to $2,500 per violation or $7,500 per intentional violation of any CCPA requirement, which may be applied on a per-person or per-record basis. The CCPA also establishes a private right of action if certain personal information of individuals is subject to an unauthorized access and exfiltration, theft, or disclosure as a result of a business’s violation of the duty to implement and maintain reasonable security procedures and practices, which authorizes statutory damages $100 to $750 per person per incident even if there is no actual harm or damage to plaintiffs. This private right of action may increase the likelihood of, and risks associated with, data breach litigation. Further, in November 2020, the State of California adopted the California Privacy Rights Act of 2020 (“CPRA”) which goes into effect January 1, 2023 and is enforceable starting on July 1, 2023. The CPRA expands and amends the CCPA, including additional and strengthened privacy rights for California residents, new requirements regarding sensitive data and data sharing for digital advertising, and tripled damages for violations involving children’s data. Also on January 1, 2023, the CCPA – as amended by the CPRA – will be newly applicable to personal information collected for employment-related purposes as well as from business-to-business contacts, creating new regulatory obligations as to datasets that until then had been largely exempt from the CCPA. The CPRA includes a 12-month “look-back” provision that requires businesses to map out all information retained since January 1, 2022. The CPRA also establishes a dedicated privacy regulator under California law, with rulemaking and enforcement responsibilities. Certain regulations implementing the CPRA are expected in draft and final form by the end of 2022, with potentially additional regulations to be proposed following the CPRA’s January 1, 2023 effective date.\\nFour other states – Virginia, Colorado, Connecticut, and Utah – have passed their own comprehensive privacy laws to go into effect in 2023. Like the CCPA and CPRA, these laws regulate the collection, use, processing, and sharing of personal information relating to residents of each state respectively, and grants certain privacy rights to those residents. The new state laws also have key differences from the CCPA and CPRA, such as requiring affirmative consent before businesses may process sensitive personal information, requiring data protection assessments, and requiring contracts between data controllers and data processors that direct data processors to assist data controllers in performing their obligations, as well as other differences among them. Each law is enforceable by its own state’s attorney general – for example, violation of the Virginia or Utah laws will cost up to $7,500 per violation – and none include an explicit private right of action. Other states are expected to consider and potentially pass similar privacy laws in 2023.\\nCertain aspects of our business and/or the data it collects is may also be subject to international privacy laws and regulations, many of which, such as the General Data Privacy Regulation (“GDPR”) and national laws implementing or supplementing the GDPR, such as the United Kingdom Data Protection Law 2018 (which retains\\n60\\nkey features of GDPR post-Brexit), as well as the EU’s Privacy and Electronic Communications Directive (“ePrivacy Directive”), are significantly more stringent than those currently enforced in the United States. The GDPR requires companies to meet requirements regarding the handling of personal data of individuals located in the European Economic Area (the “EEA”). The GDPR imposes mandatory data breach notification requirements subject to a 72-hour notification deadline. The GDPR also includes significant penalties for noncompliance, which may result in monetary penalties of up to the higher of €20.0 million or 4% of a group’s worldwide turnover for the preceding financial year for the most serious violations. The GDPR and other similar regulations such as the ePrivacy Directive and related member state regulations and directives require companies to give specific types of notice and informed consent is in many cases required for the placement of a cookie or similar technologies on a user’s device for online tracking for behavioral advertising and other purposes and for direct electronic marketing, and the GDPR also imposes additional conditions in order to satisfy such consent, such as a prohibition on pre-checked tick boxes and bundled consents. Enforcement of the GDPR and related regulations varies by each EU Member State and is ongoing. Further laws and regulations on these topics are forthcoming, including the ePrivacy Directive’s proposed successor, the Regulation on Privacy and Electronic Communications (“ePrivacy Regulation”), as well as the Digital Services Act (“DSA”) and Digital Markets Act (“DMA”). The GDPR may increase our responsibility and liability in relation to personal data that we process where that processing is subject to the GDPR. In addition, we may be required to put in place additional mechanisms to ensure compliance with the GDPR, including GDPR requirements as implemented by individual countries. Compliance with the GDPR will be a rigorous and time-intensive process that may increase our cost of doing business or require us to change our business practices.\\nIn addition, under GDPR, transfers of personal data are prohibited to countries outside of the EEA that have not been determined by the European Commission to provide adequate protections for personal data, including the United States. There are mechanisms to permit the transfer of personal data from the EEA to the United States, but there is also uncertainty as to the future of such mechanisms, which have been under consistent scrutiny and challenge. In July 2020, decision of the Court of Justice of the European Union invalidated the EU-U.S. Privacy Shield Framework, a means that previously permitted transfers of personal data from the EEA to companies in the United States that certified adherence to the Privacy Shield Framework. While the Biden Administration issued an executive order in October 2022 mandating new legal safeguards over U.S. national security agencies’ access and use of EU and U.S. personal data, it is currently unclear what, if any, formal arrangement may replace the Privacy Shield Framework. Standard contractual clauses approved by the European Commission to permit transfers from the EU to third countries currently remain as a basis on which to transfer personal data from the EEA to other countries. Standard contractual clauses are also subject to legal challenge, and in November 2020, the European Commission published a draft of updated standard contractual clauses. In January 2022, for example, Austria’s data protection authority determined that the use of Google Analytics violated the GDPR and the Court of Justice of the European Union’s “Schrems II” decision on international data transfers. We presently rely on standard contractual clauses to transfer personal data from EEA member countries, and we may be impacted by changes in law as a result of future review or invalidation of, or changes to, this mechanism by European courts or regulators. While we will continue to undertake efforts to conform to current regulatory obligations and evolving best practices, we may be unsuccessful in conforming to permitted means of transferring personal data from the European Economic Area. We may also experience hesitancy, reluctance, or refusal by European or multi-national customers to continue to use some of our services due to the potential risk exposure of personal data transfers and the current data protection obligations imposed on them by certain data protection authorities. Such customers may also view any alternative approaches to the transfer of any personal data as being too costly, too burdensome, or otherwise objectionable, and therefore may decide not to do business with us if the transfer of personal data is a necessary requirement.\\nAlthough we take reasonable efforts to comply with all applicable laws and regulations and have invested and continue to invest human and technology resources into data privacy compliance efforts, there can be no assurance that we will not be subject to regulatory action, including fines, in the event of an incident or other claim. Data protection laws and requirements may also be enacted, interpreted or applied in a manner that creates inconsistent or contradictory requirements on companies that operate across jurisdictions. We or our third-party service providers could be adversely affected if legislation or regulations are expanded to require changes in our or our third-party service providers’ business practices or if governing jurisdictions interpret or implement their legislation or regulations in ways that negatively affect our or our third-party service providers’ business, results of operations or financial condition. For example, we may find it necessary to establish alternative systems to maintain personal data in the EEA, which may involve substantial expense and may cause us to divert resources from other aspects of\\n61\\nour business, all of which may adversely affect our results from operations. Further, any inability to adequately address privacy concerns in connection with our solutions, or comply with applicable privacy or data protection laws, regulations and policies, could result in additional cost and liability to us, and adversely affect our ability to offer our solutions. GDPR, CCPA, CPRA and other similar laws and regulations, as well as any associated inquiries or investigations or any other government actions, may be costly to comply with, result in negative publicity, increase our operating costs, require significant management time and attention and subject us to remedies that may harm our business, including fines or demands or orders that we modify or cease existing business practices. Our systems may not be able to satisfy these changing requirements and manufacturer, retailer and associate expectations, or may require significant additional investments or time in order to do so.\\nWe expect that new industry standards, laws and regulations will continue to be proposed regarding privacy, data protection and information security in many jurisdictions, including the European e-Privacy Regulation, which is currently in draft form, as well as at the U.S. federal and state levels. In addition, new data processes and datasets associated with emerging technologies are coming under increased regulatory scrutiny, such as biometrics and automated decision-making. We cannot yet determine the impact such future laws, regulations and standards may have on our business. Complying with these evolving obligations is challenging, time consuming and expensive, and federal regulators, state attorneys general and plaintiff’s attorneys have been, and will likely continue to be, active in this space. Expanding definitions and interpretations of what constitutes “personal data” (or the equivalent) within the United States, the EEA and elsewhere may increase our compliance costs and legal liability. For example, various state privacy proposals have included a private right of action for basic privacy violations which, if passed, would dramatically increase both the legal costs of defending frivolous lawsuits and the penalties and costs associated with alleged violations.\\nA data breach or any failure, or perceived failure, by us to comply with any federal, state or foreign privacy or consumer protection-related laws, regulations or other principles or orders to which we may be subject or other legal obligations relating to privacy or consumer protection could adversely affect our reputation, brand and business, and may result in fines, enforcement actions, sanctions, claims (including claims for damages by affected individuals), investigations, proceedings or actions against us by governmental entities or others, or other penalties or liabilities or require us to change our operations and/or cease using certain data sets, among other negative consequences, any of which could have a material adverse effect on our business. Moreover, the proliferation of supply chain-based cyberattacks and vendor security incidents increases these potential risks and costs even in cases where the attack did not target us, occur on our systems, or result from any action or inaction by us. Depending on the nature of the information compromised, we may also have obligations to notify users, law enforcement, regulators, business partners or payment companies about the incident and provide some form of remedy, such as refunds or identity theft monitoring services, for the individuals affected by the incident.\\nThe Take 5 Matter may lead to additional harms, risks and uncertainties for us, including litigation and governmental investigations, a reduction in revenue, a potential deterioration in our relationships or reputation and a loss in investor confidence.\\nOn April 1, 2018, we acquired certain assets and assumed certain liabilities of Take 5 Media Group. In June 2019, as a result of a review of internal allegations related to inconsistency of data provided by Take 5 to its clients, we commenced an investigation into Take 5’s operations. In July 2019, as a result of our investigation, we terminated all operations of Take 5, including the use of its associated trade names and the offering of its services to its clients and offered refunds to Take 5 clients of collected revenues attributable to Take 5 since our acquisition of Take 5.\\nAs a result of these matters, we may be subject to a number of additional harms, risks and uncertainties, including substantial costs for professional services fee, potential lawsuits by clients or other interested parties who claim to have been harmed by the misconduct at Take 5, other costs and fees related to the Take 5 Matter (in excess of the amounts already offered as refunds), potential governmental investigations arising from the Take 5 Matter, a reduction in our current and anticipated revenue and a potential deterioration in our associate and client relationships or our reputation. In addition, if we do not prevail in any litigation or governmental investigation related to these matters, we could be subject to costs related to such litigation or governmental investigation, including equitable relief, civil monetary damages, treble damages, repayment or criminal penalties, which may not be covered by insurance or may materially increase our insurance costs. We have incurred and will continue to incur additional substantial professional fees regardless of the outcome of any such litigation or governmental\\n62\\ninvestigation. In addition, there can be no assurance to what degree, if any, we will be able to recover any such costs or damages from the former owners of Take 5 or whether such former owners of Take 5 engaged in further unknown improper activities that may subject us to further costs or damages, including potential reputational harm. Likewise, such events have caused and may cause further diversion of our management’s time and attention. Any adverse outcome related to these matters cannot be predicted at this time, and may materially harm our business, reputation, financial condition and/or results of operations, or the trading price of our securities.\\nOur business is seasonal in nature and quarterly operating results can fluctuate.\\nOur services are seasonal in nature, with the fourth fiscal quarter typically generating a higher proportion of our revenues than other fiscal quarters. Adverse events, such as deteriorating economic conditions, higher unemployment, higher gas prices, public transportation disruptions, public health crises (including the COVID-19 pandemic) or unanticipated adverse weather, could result in lower-than-planned sales during key revenue-producing seasons. For example, frequent or unusually heavy snowfall, ice storms, rainstorms, windstorms or other extreme weather conditions over a prolonged period could make it difficult for consumers to travel to retail stores or foodservice locations. Such events could lead to lower revenues, negatively impacting our financial condition and results of operations.\\nOur business is competitive, and increased competition could adversely affect our business and results of operations.\\nThe sales, marketing and merchandising services industry is competitive. We face competition from a few other large, national or super-regional agencies as well as many niche and regional agencies. Remaining competitive in this industry requires that we closely monitor and respond to trends in all industry sectors. We cannot assure you that we will be able to anticipate and respond successfully to such trends in a timely manner. Moreover, some of our competitors may choose to sell services competitive to ours at lower prices by accepting lower margins and profitability or may be able to sell services competitive to ours at lower prices due to proprietary ownership of data or technical superiority, which could negatively impact the rates that we can charge. If we are unable to compete successfully, it could have a material adverse effect on our business, financial condition and our results of operations. If certain competitors were to combine into integrated sales, marketing and merchandising services companies, additional sales, marketing and merchandising service companies were to enter the market or existing participants in this industry were to become more competitive, including through technological innovation such as social media and crowdsourcing, it could have a material adverse effect on our business, financial condition or results of operations.\\nDamage to our reputation could negatively impact our business, financial condition and results of operations.\\nOur reputation and the quality of our brand are critical to our business and success in existing markets and will be critical to our success as we enter new markets. We believe that we have built our reputation on the high quality of our sales and marketing services, our commitment to our clients and our performance-based culture, and we must protect and grow the value of our brand in order for us to continue to be successful. Any incident that erodes client loyalty to our brand could significantly reduce its value and damage our business. Also, there has been a marked increase in the use of social media platforms and similar devices, including blogs, social media websites, Twitter and other forms of internet-based communications that provide individuals with access to a broad audience of consumers and other interested persons. Many social media platforms immediately publish the content their subscribers and participants post, often without filters or checks on accuracy of the content posted. Information concerning us may be posted on such platforms at any time. Information posted may be adverse to our interests or may be inaccurate, each of which may harm our performance, prospects or business. The harm may be immediate without affording us an opportunity for redress or correction.\\nWe rely on third parties to provide certain data and services in connection with the provision of our services.\\nWe rely on third parties to provide certain data and services for use in connection with the provision of our services. For example, we contract with third parties to obtain the raw data on retail product sales and inventories. These suppliers of data may impose restrictions on our use of such data, fail to adhere to our quality control standards, increase the price they charge us for this data or refuse altogether to license the data to us. If we are unable to use such third-party data and services or if we are unable to contract with third parties, when necessary,\\n63\\nour business, financial condition or our results of operations could be adversely affected. In the event that such data and services are unavailable for our use or the cost of acquiring such data and services increases, our business could be adversely affected.\\nWe may be unable to timely and effectively respond to changes in digital practices and policies, which could adversely affect our business, financial condition or results of operations.\\nChanges to practices and policies of operating systems, websites and other digital platforms, including, without limitation, Apple’s or Android’s transparency policies, may reduce the quantity and quality of the data and metrics that can be collected or used by us and our clients or reduce the value of our digital services. These limitations may adversely affect both our and our clients’ ability to effectively target and measure the performance of our digital services. In addition, our clients and third party vendors routinely evaluate their digital practices and policies, and if in the future they determine to modify such practices and policies for any reasons, including, without limitation, privacy, targeting, age or content concerns, this could decrease the desire for our digital services as compared to other alternatives. If we are unable to timely or effectively respond to changes in digital practices and policies, or if our clients do not believe that our digital services will generate a competitive return on investment relative to alternatives, then our business, financial condition or results of operations could be adversely affected.\\nWe may not be able to adequately protect our intellectual property, which, in turn, could harm the value of our brands and adversely affect our business.\\nOur ability to implement our business plan successfully depends in part on our ability to further build brand recognition using our trade names, service marks, trademarks, proprietary products and other intellectual property, including our name and logos. We rely on U.S. and foreign trademark, copyright and trade secret laws, as well as license agreements, nondisclosure agreements and confidentiality and other contractual provisions to protect our intellectual property. Nevertheless, these laws and procedures may not be adequate to prevent unauthorized parties from attempting to copy or otherwise obtain our processes and technology or deter our competitors from developing similar business solutions and concepts, and adequate remedies may not be available in the event of an unauthorized use or disclosure of our trade secrets and other intellectual property.\\nThe success of our business depends on our continued ability to use our existing trademarks and service marks to increase brand awareness and further develop our brand in both domestic and international markets. We have registered and applied to register our trade names, service marks and trademarks in the United States and foreign jurisdictions. However, the steps we have taken to protect our intellectual property in the United States and in foreign countries may not be adequate, and third parties may misappropriate, dilute, infringe upon or otherwise harm the value of our intellectual property. If any of our registered or unregistered trademarks, trade names or service marks is challenged, infringed, circumvented or declared generic or determined to be infringing on other marks, it could have an adverse effect on our sales or market position. In addition, the laws of some foreign countries do not protect intellectual property to the same extent as the laws of the United States. Many companies have encountered significant problems in protecting and defending intellectual property rights in certain jurisdictions. This could make it difficult to stop the infringement or misappropriation of our intellectual property rights in foreign jurisdictions.\\nWe rely upon trade secrets and other confidential and proprietary know‑how to develop and maintain our competitive position. While it is our policy to enter into agreements imposing nondisclosure and confidentiality obligations upon our employees and third parties to protect our intellectual property, these obligations may be breached, may not provide meaningful protection for our trade secrets or proprietary know‑how, or adequate remedies may not be available in the event of an unauthorized access, use or disclosure of our trade secrets and know‑how. Furthermore, despite the existence of such nondisclosure and confidentiality agreements, or other contractual restrictions, we may not be able to prevent the unauthorized disclosure or use of our confidential proprietary information or trade secrets by consultants, vendors and employees. In addition, others could obtain knowledge of our trade secrets through independent development or other legal means.\\nAny claims or litigation initiated by us to protect our proprietary technology could be time consuming, costly and divert the attention of our technical and management resources. If we choose to go to court to stop a third party from infringing our intellectual property, that third party may ask the court to rule that our intellectual property rights are invalid and/or should not be enforced against that third party. Even if the action that we take to protect\\n64\\nour intellectual property rights is successful, any infringement may still have a material adverse effect on our business, financial condition and results of operations.\\nWe may be subject to claims of infringement of third-party intellectual property rights that are costly to defend, result in the diversion of management’s time and efforts, require the payment of damages, limit our ability to use particular technologies in the future or prevent us from marketing our existing or future products and services.\\nThird parties may assert that we infringe, misappropriate or otherwise violate their intellectual property, including with respect to our digital solutions and other technologies that are important to our business, and may sue us for intellectual property infringement. We may not be aware of whether our products or services do or will infringe existing or future patents or the intellectual property rights of others. In addition, there can be no assurance that one or more of our competitors who have developed competing technologies or our other competitors will not be granted patents for their technology and allege that we have infringed on such patents.\\nAny claims that our business infringes the intellectual property rights of others, regardless of the merit or resolution of such claims, could incur substantial costs, and the time and attention of our management and other personnel may be diverted in pursuing these proceedings. An adverse determination in any intellectual property claim could require us to pay damages, be subject to an injunction, and/or stop using our technologies, trademarks, copyrighted works and other material found to be in violation of another party’s rights, and could prevent us from licensing our technologies to others unless we enter into royalty or licensing arrangements with the prevailing party or are able to redesign our products and services to avoid infringement. With respect to any third-party intellectual property that we use or wish to use in our business (whether or not asserted against us in litigation), we may not be able to enter into licensing or other arrangements with the owner of such intellectual property at a reasonable cost or on reasonable terms. Any of the foregoing could harm our commercial success.\\nWe are dependent on proprietary technology licensed from others. If we lose our licenses, we may not be able to continue developing our products.\\nWe have obtained licenses that give us rights to third party intellectual property that is necessary or useful to our business. These license agreements may impose various royalty and other obligations on us. One or more of our licensors may allege that we have breached our license agreement with them, and could seek to terminate our license, which could adversely affect our competitive business position and harm our business prospects. In addition, any claims brought against us by our licensors could be costly, time-consuming and divert the attention of our management and key personnel from our business operations.\\nConsumer goods manufacturers and retailers, including some of our clients, are subject to extensive governmental regulation and we and they may be subject to enforcement in the event of noncompliance with applicable requirements.\\nConsumer goods manufacturers and retailers, including some of our clients, are subject to a broad range of federal, state, local and international laws and regulations governing, among other things, the research, development, manufacture, distribution, marketing and post-market reporting of consumer products. These include laws administered by the U.S. Food and Drug Administration (the “FDA”), the U.S. Drug Enforcement Administration, the U.S. Federal Trade Commission, the U.S. Department of Agriculture and other federal, state, local and international regulatory authorities. For example, certain of our clients market and sell products containing cannabidiol (“CBD”). CBD products are subject to a number of federal, state, local and international laws and regulations restricting their use in certain categories of products and in certain jurisdictions. In particular, the FDA has publicly stated it is prohibited to sell into interstate commerce food, beverages or dietary supplements that contain CBD. These laws are broad in scope and subject to evolving interpretations, which could require us to incur costs associated with new or modified compliance requirements or require us or our clients to alter or limit our activities, including marketing and promotion, of such products, or to remove them from the market altogether.\\nIf a regulatory authority determines that we or our current or future clients have not complied with the applicable regulatory requirements, our business may be materially impacted and we or our clients could be subject to enforcement actions or loss of business. We cannot predict the nature of any future laws, regulations, interpretations or applications of the laws, nor can we determine what effect additional laws, regulations or administrative policies and procedures, if and when enacted, promulgated and implemented, could have on our business.\\n65\\nWe may be subject to claims for products for which we are the vendor of record or may otherwise be in the chain of title.\\nFor certain of our clients’ products, we become the vendor of record or otherwise may be in the chain of title. For these products, we could be subject to potential claims for misbranded, adulterated, contaminated, damaged or spoiled products, or could be subject to liability in connection with claims related to infringement of intellectual property, product liability, product recalls or other liabilities arising in connection with the sale or marketing of these products. As a result, we could be subject to claims or lawsuits (including potential class action lawsuits), and we could incur liabilities that are not insured or exceed our insurance coverage or for which the manufacturer of the product does not indemnify us. Even if product claims against us are not successful or fully pursued, these claims could be costly and time consuming and may require our management to spend time defending the claims rather than operating our business.\\nA product that has been actually or allegedly misbranded, adulterated or damaged or is actually or allegedly defective could result in product withdrawals or recalls, destruction of product inventory, negative publicity and substantial costs of compliance or remediation. Any of these events, including a significant product liability judgment against us, could result in monetary damages and/or a loss of demand for our products, both of which could have an adverse effect on our business or results of operations.\\nWe generate revenues and incur expenses throughout the world that are subject to exchange rate fluctuations, and our results of operations may suffer due to currency translations.\\nOur U.S. operations earn revenues and incur expenses primarily in U.S. dollars, while our international operations earn revenues and incur expenses primarily in Canadian dollars, British pounds or euros. Because of currency exchange rate fluctuations, including possible devaluations, we are subject to currency translation exposure on the results of our operations, in addition to economic exposure. There has been, and may continue to be, volatility in currency exchange rates as a result of the United Kingdom’s withdrawal from the European Union, especially between the U.S. dollar and the British pound. These risks could adversely impact our business or results of operations.\\nFluctuations in our tax obligations and effective tax rate and realization of our deferred tax assets may result in volatility of our operating results.\\nWe are subject to taxes by the U.S. federal, state, local and foreign tax authorities, and our tax liabilities will be affected by the allocation of expenses to differing jurisdictions. We record tax expense based on our estimates of future payments, which may include reserves for uncertain tax positions in multiple tax jurisdictions, and valuation allowances related to certain net deferred tax assets. At any one time, many tax years may be subject to audit by various taxing jurisdictions. The results of these audits and negotiations with taxing authorities may affect the ultimate settlement of these matters. We expect that throughout the year there could be ongoing variability in our quarterly tax rates as events occur and exposures are evaluated. Our future effective tax rates could be subject to volatility or adversely affected by a number of factors, including:\\n•changes in the valuation of our deferred tax assets and liabilities;\\n•expected timing and amount of the release of any tax valuation allowance;\\n•tax effects of equity-based compensation;\\n•changes in tax laws, regulations or interpretations thereof; or\\n•future earnings being lower than anticipated in jurisdictions where we have lower statutory tax rates and higher than anticipated earnings in jurisdictions where we have higher statutory tax rates.\\nIn addition, our effective tax rate in a given financial statement period may be materially impacted by a variety of factors including but not limited to changes in the mix and level of earnings, varying tax rates in the different jurisdictions in which we operate, fluctuations in the valuation allowance, deductibility of certain items or changes to existing accounting rules or regulations. Further, tax legislation may be enacted in the future which could negatively impact our current or future tax structure and effective tax rates. We may be subject to audits of\\n66\\nour income, sales and other transaction taxes by U.S. federal, state, local and foreign taxing authorities. Outcomes from these audits could have an adverse effect on our operating results and financial condition.\\nRisks Related to Ownership of Our Common Stock\\nWe are controlled by Topco, the Advantage Sponsors, and the CP Sponsor, whose economic and other interests in our business may be different from yours.\\nOur authorized capital stock consists of 3,290,000,000 shares of Class A common stock, and as of November 8, 2022, certain equityholders of Topco (the “Advantage Sponsors”), Topco and Conyers Park II Sponsor LLC, an affiliate of Centerview Capital Management, LLC, which was Conyers Park’s sponsor prior to the Merger (the “CP Sponsor”), collectively own 254,310,000 shares, or 79.55% (including 65.30% held by Topco), of our outstanding Class A common stock. Subject to applicable law, the Advantage Sponsors, through their direct ownership of our common stock and their ownership of equity interests of Topco, and the CP Sponsor are able to exert significant influence in the election of our directors and control actions to be taken by our stockholders, including amendments to our third amended and restated certificate of incorporation and approval of mergers, sales of substantially all of our assets, and other significant corporate transactions. It is possible that the interests of Topco, the Advantage Sponsors and the CP Sponsor may in some circumstances conflict with our interests and the interests of our other stockholders, including you.\\nWe are a controlled company within the meaning of the Nasdaq Stock Market LLC listing requirements and as a result, may rely on exemptions from certain corporate governance requirements. To the extent we rely on such exemptions, you will not have the same protections afforded to stockholders of companies that are subject to such corporate governance requirements.\\nBecause of the voting power over our company held by Topco, the Advantage Sponsors, and the CP Sponsor and the voting arrangement between such parties, we are considered a controlled company for the purposes of the Nasdaq Stock Market LLC (“Nasdaq”) listing requirements. As such, we are exempt from the corporate governance requirements that our board of directors, compensation committee, and nominating and corporate governance committee meet the standard of independence established by those corporate governance requirements. The independence standards are intended to ensure that directors who meet the independence standards are free of any conflicting interest that could influence their actions as directors.\\nWe do not currently utilize the exemptions afforded to a controlled company, though we are entitled to do so. To the extent we utilize these exemptions, you will not have the same protections afforded to stockholders of companies that are subject to all of the corporate governance requirements of Nasdaq.\\nThe anti-takeover provisions of our certificate of incorporation and bylaws could prevent or delay a change in control of us, even if such change in control would be beneficial to our stockholders.\\nProvisions of our certificate of incorporation and bylaws, as well as provisions of Delaware law, could discourage, delay, or prevent a merger, acquisition, or other change in control of us, even if such change in control would be beneficial to our stockholders. These include:\\n•authorizing the issuance of “blank check” preferred stock that could be issued by our board of directors to increase the number of outstanding shares and thwart a takeover attempt;\\n•provision for a classified board of directors so that not all members of our board of directors are elected at one time;\\n•not permitting the use of cumulative voting for the election of directors;\\n•permitting the removal of directors only for cause;\\n•limiting the ability of stockholders to call special meetings; •requiring all stockholder actions to be taken at a meeting of our stockholders;\\n•requiring approval of the holders of at least two-thirds of the shares entitled to vote at an election of directors to adopt, amend, or repeal the proposed bylaws or repeal the provisions of the third amended and restated certificate of incorporation regarding the election and removal of directors; and\\n67\\n•establishing advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings.\\nIn addition, although we have opted out of Section 203 of the Delaware General Corporation Law (“DGCL”), our certificate of incorporation contain similar provisions providing that we may not engage in certain “business combinations” with any “interested stockholder” for a three-year period following the time that the stockholder became an interested stockholder, subject to certain exceptions. Generally, a “business combination” includes a merger, asset, or stock sale or other transaction resulting in a financial benefit to the interested stockholder.\\nSubject to certain exceptions, an “interested stockholder” is a person who, together with that person’s affiliates and associates, owns, or within the previous three years owned, 15% or more of our outstanding voting stock.\\nUnder certain circumstances, this provision will make it more difficult for a person who would be an “interested stockholder” to effect various business combinations with us for a three-year period. These provisions also may have the effect of preventing changes in our board of directors and may make it more difficult to accomplish transactions which stockholders may otherwise deem to be in their best interests.\\nMoreover, our certificate of incorporation provides that Topco and its affiliates do not constitute “interested stockholders” for purposes of this provision, and thus any business combination transaction between us and Topco and its affiliates would not be subject to the protections otherwise provided by this provision. Topco and its affiliates are not prohibited from selling a controlling interest in us to a third party and may do so without your approval and without providing for a purchase of your shares of common stock, subject to the lock-up restrictions applicable to Topco. Accordingly, your shares of common stock may be worth less than they would be if Topco and its affiliates did not maintain voting control over us.\\nThe provisions of our certificate of incorporation and bylaws requiring exclusive venue in the Court of Chancery in the State of Delaware or the federal district courts of the United States of America for certain types of lawsuits may have the effect of discouraging lawsuits against our directors and officers.\\nOur certificate of incorporation and bylaws require, to the fullest extent permitted by law, that (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of a fiduciary duty owed by any of our directors, officers, or other employees to us or our stockholders, (iii) any action asserting a claim against us arising pursuant to any provision of the DGCL or our certificate of incorporation or bylaws, or (iv) any action asserting a claim against us governed by the internal affairs doctrine will have to be brought only in the Court of Chancery in the State of Delaware (or the federal district court for the District of Delaware or other state courts of the State of Delaware if the Court of Chancery in the State of Delaware does not have jurisdiction).\\nOur certificate of incorporation and bylaws also require that the federal district courts of the United States of America will be the exclusive forum for the resolution of any complaint asserting a cause of action arising under the Securities Act; however, there is uncertainty as to whether a court would enforce such provision, and investors cannot waive compliance with federal securities laws and the rules and regulations thereunder. Although we believe these provisions benefit us by providing increased consistency in the application of applicable law in the types of lawsuits to which they apply, the provisions may have the effect of discouraging lawsuits against our directors and officers. These provisions do not apply to any suits brought to enforce any liability or duty created by the Exchange Act or any other claim for which the federal courts of the United States have exclusive jurisdiction.\\nBecause we have no current plans to pay cash dividends on our Class A common stock, you may not receive any return on investment unless you sell your Class A common stock for a price greater than that which you paid for it.\\nWe have no current plans to pay cash dividends on our Class A common stock. The declaration, amount and payment of any future dividends on our Class A common stock will be at the discretion of our board of directors and will depend upon our results of operations, financial condition, capital requirements, and other factors that our board of directors deems relevant. The payment of cash dividends is also restricted under the terms of the agreements governing our debt and our ability to pay dividend may also be restricted by the terms of any future credit agreement or any securities we or our subsidiaries may issue.\\n68\\nAn active, liquid trading market for our Class A common stock may not be available.\\nWe cannot predict the extent to which investor interest in our company will lead to availability of a trading market on Nasdaq or otherwise in the future or how active and liquid that market may be for our Class A common stock. If an active and liquid trading market is not available, you may have difficulty selling any of our Class A common stock. Among other things, in the absence of a liquid public trading market:\\n•you may not be able to liquidate your investment in shares of Class A common stock;\\n•you may not be able to resell your shares of Class A common stock at or above the price attributed to them in the Transactions;\\n•the market price of shares of Class A common stock may experience significant price volatility; and\\n•there may be less efficiency in carrying out your purchase and sale orders.\\nThe trading price of our Class A common stock may be volatile or may decline regardless of our operating performance.\\nThe market prices for our Class A common stock are likely to be volatile and may fluctuate significantly in response to a number of factors, most of which we cannot control, including:\\n•quarterly variations in our operating results compared to market expectations;\\n•changes in preferences of our clients;\\n•announcements of new products or services or significant price reductions;\\n•the size of our public float;\\n•fluctuations in stock market prices and volumes;\\n•defaults on our indebtedness;\\n•changes in senior management or key personnel;\\n•the granting, vesting, or exercise of employee stock options, restricted stock, or other equity rights;\\n•the payment of any dividends thereon in shares of our common stock;\\n•changes in financial estimates or recommendations by securities analysts;\\n•negative earnings or other announcements by us;\\n•downgrades in our credit ratings;\\n•material litigation or governmental investigations;\\n•issuances of capital stock;\\n•global economic, legal, and regulatory factors unrelated to our performance, including the COVID-19 pandemic; or\\n•the realization of any risks described in this Quarterly Report under “Risk Factors.”\\nIn addition, in the past, stockholders have instituted securities class action litigation against companies following periods of market volatility. If we were involved in securities litigation, we could incur substantial costs and our resources and the attention of management could be diverted from our business.\\nWe cannot provide any guaranty that we will continue to repurchase our common stock pursuant to our stock repurchase program.\\nIn November 2021, our board of directors authorized a share repurchase program, under which we may repurchase up to $100 million of our outstanding Class A common stock (the “2021 Share Repurchase Program”). As of September 30, 2022, the remaining amount available for repurchase pursuant to the 2021 Share Repurchase Program is $87.4 million. However, we are not obligated to make any further purchases under the 2021 Share Repurchase Program and we may suspend or permanently discontinue this program at any time or significantly reduce the amount of repurchases under the program. Any announcement of a suspension, discontinuance or reduction of this program may negatively impact our reputation and investor confidence.\\n69\\nThe valuation of our private placement warrants could increase the volatility in our net income (loss) in our consolidated statements of earnings (loss).\\nThe change in fair value of our private placement warrants is determined using the fair value of the liability classified private placement warrants by approximating the value with the share price of the public warrants. The change in fair value of warrant liability represents the mark-to-market fair value adjustments to the outstanding private placement warrants issued in connection with the initial public offering of Conyers Park. Significant changes in share price of the public warrants may adversely affect the volatility in our net income (loss) in our Condensed Consolidated Statements of Operations and Comprehensive Income.\\nRisks Related to Indebtedness\\nWe need to continue to generate significant operating cash flow in order to fund acquisitions and to service our debt.\\nOur business currently generates operating cash flow, which we use to fund acquisitions to grow our business and to service our substantial indebtedness. If, because of loss of revenue, pressure on pricing from customers, increases in our costs (including increases in costs related to servicing our indebtedness or labor costs), general economic, financial, competitive, legislative, regulatory conditions or other factors, including any acceleration of the foregoing as a result of the COVID-19 pandemic, many of which are outside of our control our business generates less operating cash flow, we may not have sufficient funds to grow our business or to service our indebtedness.\\nIf we are unable to generate sufficient cash flow or are otherwise unable to obtain funds necessary to meet required payments of principal, premium, if any, and interest on our indebtedness, or if we otherwise fail to comply with the various covenants in the agreements governing our indebtedness, we could be in default under the terms of the agreements governing such indebtedness. In the event of such default, the lenders under our credit facilities could elect to terminate their commitments thereunder, cease making further loans and institute foreclosure proceedings against our assets, and we could be forced into bankruptcy or liquidation. If our operating performance declines, we may in the future need to obtain waivers from the required lenders under our credit agreements to avoid being in default. If we or any of our subsidiaries breach the covenants under our credit agreements and seek a waiver, we may not be able to obtain a waiver from the required lenders. If this occurs, we would be in default under our credit agreements, the lenders could exercise their rights as described above, and we could be forced into bankruptcy or liquidation.\\nOur substantial indebtedness could adversely affect our financial health, restrict our activities, and affect our ability to meet our obligations.\\nWe have a significant amount of indebtedness. As of September 30, 2022, we had total indebtedness of $2.1 billion, excluding debt issuance costs, with an additional $54.5 million of letters of credit outstanding under our revolving credit facility. The agreements governing our indebtedness contain customary covenants that restrict us from taking certain actions, such as incurring additional debt, permitting liens on pledged assets, making investments, paying dividends or making distributions to equity holders, prepaying junior debt, engaging in mergers or restructurings, and selling assets, among other things, which may restrict our ability to successfully execute on our business plan. For a more detailed description of the covenants and material terms of our material indebtedness, please see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” in this Quarterly Report.\\nDespite current indebtedness levels, we and our subsidiaries may still be able to incur additional indebtedness, which could increase the risks associated with our indebtedness.\\nWe and our subsidiaries may be able to incur additional indebtedness in the future because the terms of our indebtedness do not fully prohibit us or our subsidiaries from doing so. Subject to covenant compliance and certain conditions, as of September 30, 2022, the agreements governing our indebtedness would have permitted us to borrow up to an additional $345.5 million under our revolving credit facility. In addition, we and our subsidiaries have, and will have, the ability to incur additional indebtedness as incremental facilities under our credit agreement\\n70\\nand we or our subsidiaries may issue additional notes in the future. If additional debt is added to our current debt levels and our subsidiaries’ current debt levels, the related risks that we and they now face could increase.\\nFailure to maintain our credit ratings could adversely affect our liquidity, capital position, ability to hedge certain financial risks, borrowing costs, and access to capital markets.\\nOur credit risk is evaluated by the major independent rating agencies, and such agencies have in the past downgraded, and could in the future downgrade, our ratings. Our credit rating may impact the interest rates on any future indebtedness as well as the applicability of certain covenants in the agreements governing our indebtedness. We cannot assure you that we will be able to maintain our current credit ratings, and any additional, actual or anticipated changes or downgrades in our credit ratings, including any announcement that our ratings are under further review for a downgrade, may have a negative impact on our liquidity, capital position, ability to hedge certain financial risks, and access to capital markets.\\nOur variable rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase significantly.\\nBorrowings under our credit facilities are at variable rates of interest and expose us to interest rate risk. If interest rates were to increase, our debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same, and our net income and cash flows, including cash available for servicing our indebtedness, will correspondingly decrease. On a pro forma basis, assuming no other prepayments of the credit facility and that our revolving credit facility is fully drawn (and to the extent that LIBOR is in excess of the 0.00% and 0.75% floors applicable to our revolving credit facility and our term loan credit facility, respectively), each one-eighth percentage point change in interest rates would result in an approximately $1.0 million change in interest expense, net of gains from interest rate caps, for the nine months ended September 30, 2022. In the future, we may enter into interest rate swaps that involve the exchange of floating- for fixed-rate interest payments in order to reduce interest rate volatility or risk. However, we may not maintain interest rate swaps with respect to any of our variable rate indebtedness, and any swaps we enter into may not fully or effectively mitigate our interest rate risk.\\nThe elimination of LIBOR after June 2023 may affect our financial results\\nCertain of our financial arrangements, including the Senior Secured Credit Facilities, were made at variable rates that use the London Interbank Offered Rate, or LIBOR (or metrics derived from or related to LIBOR), as a benchmark for establishing the interest rate. All LIBOR tenors relevant to us will cease to be published or will no longer be representative after June 30, 2023. This means that any of our LIBOR-based borrowings that extend beyond June 30, 2023 will need to be converted to a replacement rate. In the U.S., the Alternative Reference Rates Committee (the “ARRC”) convened by the Federal Reserve Board and the Federal Reserve Bank of New York has recommended the Secured Overnight Financing Rate (“SOFR”) plus a recommended spread adjustment as LIBOR’s replacement. There are significant differences between LIBOR and SOFR, such as LIBOR being an unsecured lending rate while SOFR is a secured lending rate, and SOFR being an overnight rate while LIBOR reflects term rates at different maturities. If our LIBOR-based financing arrangements are converted to SOFR, the differences between LIBOR and SOFR, plus the recommended spread adjustment, could result in interest costs that are higher than if LIBOR remained available, which could adversely impact our operating results. Although SOFR is the ARRC’s recommended replacement rate, it is also possible that lenders and other counterparties may instead choose alternative replacement rates that may differ from LIBOR in ways similar to SOFR or in other ways that would result in higher interest costs for us. There is no assurance that any alternative reference rate, including SOFR, will be similar to, or produce the same value or economic equivalence as, LIBOR, and there continues to be uncertainty regarding the nature of potential changes to and future utilization of specific LIBOR tenors, the development and acceptance of SOFR or alternative reference rates, and other reforms. These consequences cannot be entirely predicted and could have an adverse impact on the market value for or value of LIBOR-linked securities, loans and other financial obligations or extensions of credit held by or due to us. Changes in market interest rates may influence our financing costs, returns on financial investments and the valuation of derivative contracts and could reduce our earnings and cash flows.\\n71\\nGeneral Risk Factors\\nOur business and financial results may be affected by various litigation and regulatory proceedings.\\nWe are subject to litigation and regulatory proceedings in the normal course of business and could become subject to additional claims in the future. These proceedings have included, and in the future may include, matters involving personnel and employment issues, workers’ compensation, personal and property injury, disputes relating to acquisitions (including contingent consideration), governmental investigations and other proceedings. Some historical and current legal proceedings and future legal proceedings may purport to be brought as class actions or representative basis on behalf of similarly situated parties including with respect to employment-related matters. We cannot be certain of the ultimate outcomes of any such claims, and resolution of these types of matters against us may result in significant fines, judgments or settlements, which, if uninsured, or if the fines, judgments and settlements exceed insured levels, could adversely affect our business or financial results. See “Legal Proceedings.”\\nWe are subject to many federal, state, local and international laws with which compliance is both costly and complex.\\nOur business is subject to various, and sometimes complex, laws and regulations, including those that have been or may be implemented in response to the COVID-19 pandemic. In order to conduct our operations in compliance with these laws and regulations, we must obtain and maintain numerous permits, approvals and certificates from various federal, state, local and international governmental authorities. We may incur substantial costs in order to maintain compliance with these existing laws and regulations. In addition, our costs of compliance may increase if existing laws and regulations are revised or reinterpreted or if new laws and regulations become applicable to our operations. These costs could have an adverse impact on our business or results of operations. Moreover, our failure to comply with these laws and regulations, as interpreted and enforced, could lead to fines, penalties or management distraction or otherwise harm our business.\\nOur insurance may not provide adequate levels of coverage against claims.\\nWe believe that we maintain insurance customary for businesses of our size and type. However, there are types of losses we may incur that cannot be insured against or that we believe are not economically reasonable to insure. Further, insurance may not continue to be available to us on acceptable terms, if at all, and, if available, coverage may not be adequate. If we are unable to obtain insurance at an acceptable cost or on acceptable terms, we could be exposed to significant losses.\\nWe have incurred and will continue to incur increased costs as a public company.\\nAs a public company, we have incurred and will continue to incur significant legal, accounting, insurance, and other expenses that we did not incur as a private company, including costs associated with public company reporting requirements. We also have incurred and will incur costs associated with the Sarbanes-Oxley Act and related rules implemented by the SEC. The expenses incurred by public companies for reporting and corporate governance purposes generally have been increasing. We expect these rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly, although we are currently unable to estimate these costs with any degree of certainty. In estimating these costs, we took into account expenses related to insurance, legal, accounting, and compliance activities, as well as other expenses not currently incurred. These laws and regulations could also make it more difficult or costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. These laws and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, on our board committees, or as our executive officers. Furthermore, if we are unable to satisfy our obligations as a public company, we could be subject to delisting of our Class A common stock, fines, sanctions, and other regulatory action and potentially civil litigation.\\nOur management has limited experience in operating a public company.\\nOur executive officers have limited experience in the management of a publicly traded company. Our management team may not successfully or effectively manage our transition to a public company that will be\\n72\\nsubject to significant regulatory oversight and reporting obligations under federal securities laws. Their limited experience in dealing with the increasingly complex laws pertaining to public companies could be a significant disadvantage in that it is likely that an increasing amount of their time may be devoted to these activities which will result in less time being devoted to the management and growth of the Company. We may not have adequate personnel with the appropriate level of knowledge, experience, and training in the accounting policies, practices or internal control over financial reporting required of public companies in the United States. The development and implementation of the standards and controls necessary for the Company to achieve the level of accounting standards required of a public company in the United States may require costs greater than expected. It is possible that we will be required to expand our employee base and hire additional employees to support our operations as a public company which will increase our operating costs in future periods.\\nIf securities analysts do not publish research or reports about our business or if they publish negative evaluations of our common stock, the price of our Class A common stock could decline.\\nThe trading market for our Class A common stock will rely in part on the research and reports that industry or financial analysts publish about us or our business. If few analysts commence coverage of us, the trading price of our stock could be negatively affected. Even with analyst coverage, if one or more of the analysts covering our business downgrade their evaluations of our stock, the price of our Class A common stock could decline. If one or more of these analysts cease to cover our common stock, we could lose visibility in the market for our Class A common stock, which in turn could cause our Class A common stock price to decline.\\nSubstantial future sales of our Class A common stock, or the perception in the public markets that these sales may occur, may depress our stock price.\\nSales of substantial amounts of our common stock in the public market, or the perception that these sales could occur, could adversely affect the price of our common stock and could impair our ability to raise capital through the sale of additional shares. Certain shares of our common stock are freely tradable without restriction under the Securities Act, except for any shares of our common stock that may be held or acquired by our directors, executive officers, and other affiliates, as that term is defined in the Securities Act, which are to be restricted securities under the Securities Act. Restricted securities may not be sold in the public market unless the sale is registered under the Securities Act or an exemption from registration is available. Topco, the Advantage Sponsors, the CP Sponsor and members of our management have rights, subject to certain conditions, to require us to file registration statements covering Topco’s shares of our common stock or to include shares in registration statements that we may file for ourselves or other stockholders. In each of November 2020 and March 2021, we filed a registration statement on Form S-1 under which certain of our shareholders may sell, from time to time, 50,000,000 shares and 255,465,000 shares of our Class A common stock, respectively, that, if sold, will be freely tradable without restriction under the Securities Act. In the event a large number of shares of Class A common stock are sold in the public market, such sales could reduce the market price of our Class A common stock.\\nWe may also issue shares of our common stock or securities convertible into our common stock from time to time in connection with financings, acquisitions, investments, or otherwise. Any such issuance could result in ownership dilution to you as a stockholder and cause the trading price of our common stock to decline.\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\\nNone\\nItem 3. Defaults Upon Senior Securities\\nNone\\nItem 4. Mine Safety Disclosures\\nNone\\n73\\nItem 5. Other Information\\nNone\\nITEM 6. Exhibits\\nThe following exhibits are filed with this Report:\\n\\n| ExhibitNumber | Description |\\n| 31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934 |\\n| 31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934 |\\n| 32.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350 |\\n| 32.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350 |\\n| 101.INS | Inline XBRL Instance Document – the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document |\\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document |\\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document |\\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\\n\\n***\\n74\\nSIGNATURES\\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\n\\n| ADVANTAGE SOLUTIONS INC. |\\n| By: | /s/ Jill Griffin |\\n| Jill Griffin |\\n| Chief Executive Officer (Principal Executive Officer) |\\n| Date: | November 9, 2022 |\\n| By: | /s/ Brian Stevens |\\n| Brian Stevens |\\n| Chief Financial Officer and Chief Operating |\\n| Officer (Principal Financial Officer) |\\n| Date: | November 9, 2022 |\\n\\n75\\n \\n\\nWhat is the percentage change in the company's total net worth between July 1, 2021 and September 30, 2021?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 0.8929388668478347.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 56,\n \"input_length\": 115276\n}"}}},{"rowIdx":57,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nItem 1 – Financial Statements\n3\n Consolidated Balance Sheets (Unaudited) 3\n Consolidated Statements of Income (Unaudited) 4\n Consolidated Statements of Comprehensive Income (Unaudited) 5\n Consolidated Statements of Cash Flows (Unaudited) 6\n Notes to Consolidated Financial Statements (Unaudited) 7\n Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations 28\n Item 3 – Quantitative and Qualitative Disclosure about Market Risk 44\n Item 4 – Controls and Procedures 45\n PART II – Other Information 46\n Item 1 – Legal Proceedings 46\n Item 1A – Risk Factors 46\n Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds 46\n Item 3 – Defaults Upon Senior Securities 47\n Item 5 – Other Information 48\n Item 6 – Exhibits 48\n SIGNATURES 49\nCertifications\n2\nPART 1 – FINANCIAL INFORMATION\nItem 1 - Financial Statements\n\nREADING INTERNATIONAL, INC.\nCONSOLIDATED BALANCE SHEETS\n(Unaudited; U.S. dollars in thousands, except share information)\n\n\n| |\n| |\n| | March 31, | December 31, |\n| | 2019 | 2018 |\n| ASSETS | (unaudited) |\n| Current Assets: |\n| Cash and cash equivalents | $ | 12,648 | $ | 13,127 |\n| Receivables | 7,094 | 8,045 |\n| Inventory | 1,165 | 1,419 |\n| Prepaid and other current assets | 9,642 | 7,667 |\n| Total current assets | 30,549 | 30,258 |\n| Operating property, net | 257,402 | 257,667 |\n| Operating lease right-of-use assets | 229,266 | — |\n| Investment and development property, net | 95,156 | 86,804 |\n| Investment in unconsolidated joint ventures | 4,958 | 5,121 |\n| Goodwill | 20,836 | 19,445 |\n| Intangible assets, net | 3,694 | 7,369 |\n| Deferred tax asset, net | 26,483 | 26,235 |\n| Other assets | 6,199 | 6,129 |\n| Total assets | $ | 674,543 | $ | 439,028 |\n| LIABILITIES AND STOCKHOLDERS' EQUITY |\n| Current Liabilities: |\n| Accounts payable and accrued liabilities | $ | 23,492 | $ | 26,154 |\n| Film rent payable | 6,559 | 8,661 |\n| Debt - current portion | 40,077 | 30,393 |\n| Derivative financial instruments - current portion | 52 | 41 |\n| Taxes payable - current | 571 | 1,710 |\n| Deferred current revenue | 7,712 | 9,264 |\n| Operating lease liabilities - current portion | 19,797 | — |\n| Other current liabilities | 9,525 | 9,305 |\n| Total current liabilities | 107,785 | 85,528 |\n| Debt - long-term portion | 113,816 | 106,286 |\n| Derivative financial instruments - non-current portion | 203 | 145 |\n| Subordinated debt, net | 26,116 | 26,061 |\n| Noncurrent tax liabilities | 11,737 | 11,530 |\n| Operating lease liabilities - non-current portion | 222,594 | — |\n| Other liabilities | 12,346 | 28,931 |\n| Total liabilities | 494,597 | 258,481 |\n| Commitments and contingencies (Note 13) |\n| Stockholders’ equity: |\n| Class A non-voting common stock, par value $0.01, 100,000,000 shares authorized, |\n| 33,172,823 issued and 21,249,935 outstanding at March 31, 2019 and 33,112,337 issued and 21,194,748 outstanding at December 31, 2018 | 233 | 232 |\n| Class B voting common stock, par value $0.01, 20,000,000 shares authorized and |\n| 1,680,590 issued and outstanding at March 31, 2019 and December 31, 2018 | 17 | 17 |\n| Nonvoting preferred stock, par value $0.01, 12,000 shares authorized and no issued |\n| or outstanding shares at March 31, 2019 and December 31, 2018 | — | — |\n| Additional paid-in capital | 147,472 | 147,452 |\n| Retained earnings | 45,563 | 47,616 |\n| Treasury shares | (25,231) | (25,222) |\n| Accumulated other comprehensive income | 7,625 | 6,115 |\n| Total Reading International, Inc. stockholders’ equity | 175,679 | 176,210 |\n| Noncontrolling interests | 4,267 | 4,337 |\n| Total stockholders’ equity | 179,946 | 180,547 |\n| Total liabilities and stockholders’ equity | $ | 674,543 | $ | 439,028 |\n\n\nSee accompanying Notes to the Unaudited Consolidated Financial Statements.\n3\nREADING INTERNATIONAL, INC.\nCONSOLIDATED STATEMENTS OF INCOME\n(Unaudited; U.S. dollars in thousands, except per share data)\n\n\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| | 2019 | 2018 |\n| Revenue |\n| Cinema | $ | 57,986 | $ | 72,255 |\n| Real estate | 3,565 | 3,617 |\n| Total revenue | 61,551 | 75,872 |\n| Costs and expenses |\n| Cinema | (48,329) | (54,948) |\n| Real estate | (2,445) | (2,384) |\n| Depreciation and amortization | (5,594) | (5,250) |\n| General and administrative | (6,484) | (7,597) |\n| Total costs and expenses | (62,852) | (70,179) |\n| Operating income (loss) | (1,301) | 5,693 |\n| Interest expense, net | (1,852) | (1,594) |\n| Other income (expense) | (20) | (82) |\n| Income (loss) before income tax expense and equity earnings of unconsolidated joint ventures | (3,173) | 4,017 |\n| Equity earnings of unconsolidated joint ventures | 34 | 257 |\n| Income (loss) before income taxes | (3,139) | 4,274 |\n| Income tax benefit (expense) | 1,042 | (1,170) |\n| Net income (loss) | $ | (2,097) | $ | 3,104 |\n| Less: net income (loss) attributable to noncontrolling interests | (16) | 22 |\n| Net income (loss) attributable to Reading International, Inc. common shareholders | $ | (2,081) | $ | 3,082 |\n| Basic earnings (loss) per share attributable to Reading International, Inc. shareholders | $ | (0.09) | $ | 0.13 |\n| Diluted earnings (loss) per share attributable to Reading International, Inc. shareholders | $ | (0.09) | $ | 0.13 |\n| Weighted average number of shares outstanding–basic | 22,920,486 | 22,967,237 |\n| Weighted average number of shares outstanding–diluted | 23,124,106 | 23,132,989 |\n\n\nSee accompanying Notes to the Unaudited Consolidated Financial Statements.\n4\nREADING INTERNATIONAL, INC.\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME\n(Unaudited; U.S. dollars in thousands)\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| | 2019 | 2018 |\n| Net income (loss) | $ | (2,097) | $ | 3,104 |\n| Foreign currency translation gain (loss) | 1,526 | (803) |\n| Gain (loss) on cash flow hedges | (69) | — |\n| Other | 53 | 50 |\n| Comprehensive income (loss) | (587) | 2,351 |\n| Less: net income (loss) attributable to noncontrolling interests | (16) | 22 |\n| Less: comprehensive income (loss) attributable to noncontrolling interests | 1 | (3) |\n| Comprehensive income (loss) attributable to Reading International, Inc. | $ | (572) | $ | 2,332 |\n\n\nSee accompanying Notes to the Unaudited Consolidated Financial Statements.\n5\nREADING INTERNATIONAL, INC.\nCONSOLIDATED STATEMENTS OF CASH FLOWS\n(Unaudited; U.S. dollars in thousands)\n\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| | 2019 | 2018 |\n| Operating Activities |\n| Net income (loss) | $ | (2,097) | $ | 3,104 |\n| Adjustments to reconcile net income (loss) to net cash provided by operating activities: |\n| Equity earnings of unconsolidated joint ventures | (34) | (257) |\n| Distributions of earnings from unconsolidated joint ventures | 249 | 236 |\n| Amortization of operating leases | 5,895 | — |\n| Amortization of finance leases | 41 | — |\n| Change in operating lease liabilities | (5,754) | — |\n| Interest on hedged derivatives | (5) | — |\n| Change in net deferred tax assets | (150) | 172 |\n| Depreciation and amortization | 5,594 | 5,250 |\n| Other amortization | 341 | 224 |\n| Stock based compensation expense | 280 | 379 |\n| Net changes in operating assets and liabilities: |\n| Receivables | 993 | 3,205 |\n| Prepaid and other assets | (1,957) | (2,309) |\n| Payments for accrued pension | (171) | (2,404) |\n| Accounts payable and accrued expenses | (2,204) | 1,997 |\n| Film rent payable | (2,132) | (5,790) |\n| Taxes payable | (1,151) | 150 |\n| Deferred revenue and other liabilities | (1,579) | (1,505) |\n| Net cash provided by (used in) operating activities | (3,841) | 2,452 |\n| Investing Activities |\n| Purchases of and additions to operating and investment properties | (11,476) | (23,231) |\n| Acquisition of business combinations | (1,380) | — |\n| Change in restricted cash | 243 | (260) |\n| Net cash provided by (used in) investing activities | (12,613) | (23,491) |\n| Financing Activities |\n| Repayment of long-term borrowings | (6,113) | (9,707) |\n| Repayment of finance lease principle | (41) | — |\n| Proceeds from borrowings | 22,349 | 25,998 |\n| Repurchase of Class A Nonvoting Common Stock | (9) | (317) |\n| (Cash paid) proceeds from the exercise of stock options | (259) | 203 |\n| Noncontrolling interest contributions | 18 | 27 |\n| Noncontrolling interest distributions | (27) | (43) |\n| Net cash provided by (used in) financing activities | 15,918 | 16,161 |\n| Effect of exchange rate changes on cash and cash equivalents | 57 | (122) |\n| Net decrease in cash and cash equivalents | (479) | (5,000) |\n| Cash and cash equivalents at January 1 | 13,127 | 13,668 |\n| Cash and cash equivalents at March 31 | $ | 12,648 | $ | 8,668 |\n| Supplemental Disclosures |\n| Interest paid | $ | 2,304 | $ | 2,121 |\n| Income taxes paid | 1,883 | 808 |\n| Non-Cash Transactions |\n| Additions to operating and investing properties through accrued expenses | 3,423 | 4,530 |\n\n\nSee accompanying Notes to the Unaudited Consolidated Financial Statements.\n6\nREADING INTERNATIONAL, INC.\nNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)\nNote 1 – Description of Business and Segment Reporting\nThe Company\nReading International, Inc., a Nevada corporation (“RDI” and collectively with our consolidated subsidiaries and corporate predecessors, the “Company”, “Reading” and “we”, “us”, or “our”), was incorporated in 1999. Our businesses consist primarily of:\n| · | the operation, development and ownership of multiplex cinemas in the United States, Australia, and New Zealand; and, |\n\n| · | the development, ownership, operation and/or rental of retail, commercial and live venue real estate assets in Australia, New Zealand, and the United States. |\n\n\nBusiness Segments\nReported below are the operating segments of the Company for which separate financial information is available and evaluated regularly by the Chief Executive Officer, the chief operating decision-maker of the Company. As part of our real estate activities, we hold undeveloped land in urban and suburban centers in Australia, New Zealand, and the United States.\n\nThe table below summarizes the results of operations for each of our business segments for the quarter ended March 31, 2019 and 2018, respectively. Operating expense includes costs associated with the day-to-day operations of the cinemas and the management of rental properties, including our live theater assets.\n\n\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Revenue: |\n| Cinema exhibition | $ | 57,986 | $ | 72,255 |\n| Real estate | 5,431 | 6,008 |\n| Inter-segment elimination | (1,866) | (2,391) |\n| | $ | 61,551 | $ | 75,872 |\n| Segment operating income (loss): |\n| Cinema exhibition | $ | 2,642 | $ | 10,285 |\n| Real estate | 1,159 | 1,681 |\n| | $ | 3,801 | $ | 11,966 |\n\n\nA reconciliation of segment operating income to income before income taxes is as follows:\n\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Segment operating income (loss) | $ | 3,801 | $ | 11,966 |\n| Unallocated corporate expense |\n| Depreciation and amortization expense | (61) | (117) |\n| General and administrative expense | (5,041) | (6,156) |\n| Interest expense, net | (1,852) | (1,594) |\n| Equity earnings of unconsolidated joint ventures | 34 | 257 |\n| Other income (expense) | (20) | (82) |\n| Income (loss) before income tax expense | $ | (3,139) | $ | 4,274 |\n\nNote 2 – Summary of Significant Accounting Policies\n\nBasis of Consolidation\nThe accompanying consolidated financial statements include the accounts of the Company’s wholly-owned subsidiaries as well as majority-owned subsidiaries that the Company controls, and should be read in conjunction with the Company’s Annual Report on Form 10-K as of and for the year ended December 31, 2018 (“2018 Form 10-K”). All significant intercompany balances and transactions have been eliminated on consolidation. These consolidated financial statements were prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim reporting with the instructions for Form 10-Q and Rule 10-01 of Regulation S-X of the Securities and Exchange Commission (“SEC”). As such, they do not include\n7\nall information and footnotes required by U.S. GAAP for complete financial statements. We believe that we have included all normal and recurring adjustments necessary for a fair presentation of the results for the interim period.\n\nOperating results for the quarter ended March 31, 2019 are not necessarily indicative of the results that may be expected for the year ending December 31, 2019.\n\nUse of Estimates\nThe preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and footnotes thereto. Significant estimates include (i) projections we make regarding the recoverability and impairment of our assets (including goodwill and intangibles), (ii) valuations of our derivative instruments, (iii) recoverability of our deferred tax assets, (iv) estimation of breakage and redemption experience rates, which drive how we recognize breakage on our gift card and gift certificates, and revenue from our customer loyalty program, and (v) allocation of insurance proceeds to various recoverable components. Actual results may differ from those estimates.\n\nRecently Adopted and Issued Accounting Pronouncements\n\nAdopted:\n\nAccounting Standards Update (“ASU”) 2016-02 Leases: In February 2016, the Financial Accounting Standards Board (“FASB”) issued a new accounting standard, ASC 842 Leases, to increase transparency and comparability among organizations by requiring the recognition of right-of-use (\"ROU\") assets and lease liabilities on the balance sheet. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. A modified retrospective transition approach is required for lessees with capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available.\n\nOn January 1, 2019, we adopted the new accounting standard Accounting Standards Codification (“ASC”) 842 Leases using the modified retrospective method. We recognized the cumulative effect of initially applying the new leasing standard as an adjustment to the opening balance of retained earnings. The comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods. The standard had a material impact on our consolidated balance sheets, but not on our consolidated income statements or statements of cash flow.\n\n\n| |\n| (Dollars in thousands) | Balance atDecember 31,2018 | Adjustmentsdue to ASC842 | Balance atJanuary 1,2019 |\n| Assets |\n| Operating property, net | $ | 257,667 | $ | 370 | $ | 258,037 |\n| Operating lease right-of-use assets | — | 232,319 | 232,319 |\n| Intangible assets, net | 7,369 | (3,542) | 3,827 |\n| Deferred tax asset, net | 26,235 | 82 | 26,317 |\n| Liabilities |\n| Operating lease liabilities | $ | — | $ | 245,280 | $ | 245,280 |\n| Other non-current liabilities | 28,931 | (16,033) | 12,898 |\n| Stockholders' Equity |\n| Non-controlling interest | $ | 4,337 | $ | (46) | $ | 4,291 |\n| Retained earnings | 47,616 | 28 | 47,644 |\n\n\n\n\n| |\n| | Period Ended March 31, 2019 |\n| (Dollars in thousands) | As Reported,March 31, 2019 | BalancesWithoutAdoption ofASC 842 | Effect ofchangeHigher /(Lower) |\n| Cinema costs and expenses | $ | 48,329 | $ | 48,334 | $ | (5) |\n| Depreciation and amortization | 5,594 | 5,552 | 42 |\n| General and administrative | 6,484 | 6,528 | (44) |\n| Interest expense, net | 1,852 | 1,849 | 3 |\n| Income tax (benefit) expense | 1,042 | 1,041 | 1 |\n| Net income (loss) | $ | (2,097) | $ | (2,094) | $ | 3 |\n\n8\n\n\n\n| |\n| (Dollars in thousands) | As Reported,March 31, 2019 | BalancesWithoutAdoption ofASC 842 | Effect ofchangeHigher /(Lower) |\n| Assets |\n| Operating property, net | $ | 257,402 | $ | 257,072 | $ | 330 |\n| Intangible assets | 3,694 | 7,151 | (3,457) |\n| Operating lease right-of-use assets | 229,266 | — | 229,266 |\n| Deferred tax asset, net | 26,483 | 26,400 | 83 |\n| Liabilities |\n| Other current liabilities | $ | 9,525 | $ | 9,363 | $ | 162 |\n| Operating lease liabilities, current | 19,797 | — | 19,797 |\n| Other non-current liabilities | 12,346 | 28,643 | (16,297) |\n| Operating lease liabilities, non-current | 222,594 | — | 222,594 |\n| Stockholders' Equity |\n| Retained earnings | $ | 45,563 | $ | 45,585 | $ | (22) |\n\n\n\n| 1) | ASU 2014-09 Revenue from Contracts with Customers: On January 1, 2018, we adopted the new accounting standard ASC 606 Revenue from Contracts with Customers using the modified retrospective method. We recognized the cumulative effect of initially applying the new revenue standard as an adjustment to the opening balance of retained earnings. The comparative information was not restated. Adoption of this standard has no material effect on our consolidated financial statements. |\n\n\n| 2) | On January 1, 2018, the Company adopted ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash, a consensus of the FASB Emerging Issues Task Force. This standard requires that amounts generally described as restricted cash and cash equivalents should be combined with unrestricted cash and cash equivalents when reconciling the beginning and end of period balances on the statement of cash flows. Adoption of this standard has no material effect on our consolidated statement of cash flows. |\n\n\n| 3) | On January 1, 2018, the Company adopted ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments). The standard applies to eight (8) specific cash flow classification issues, reducing the current and potential future diversity in the presentation of certain cash flows. Adoption of this standard has no material effect on our consolidated statement of cash flows. |\n\n\n| 4) | On January 1, 2018, the Company adopted ASU 2017-07, Compensation—Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. This standard (i) requires that an employer disaggregate the service cost component from the other components of net benefit cost, and (ii) specifies how to present the service cost component and the other components of net benefit cost in the income statement and (iii) allows only the service cost component of net benefit cost to be eligible for capitalization. Adoption of this standard has no material impact on our consolidated financial statements. |\n\n\n| 5) | On January 1, 2018, the Company adopted ASU 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business. This ASU provides that when substantially all of the fair value of the gross assets acquired (or disposed of) is concentrated in a single identifiable asset or a group of similar identifiable assets, the asset is not a “business”, thus reducing the number of transactions that need further evaluation for business combination. The standard has no material impact on our current consolidated financial statements, and we do not expect it to be applicable to our consolidated financial statements in the near term unless we enter into a definitive business acquisition transaction. |\n\n\nIssued:\n\n| v | ASUs Effective 2019 and Beyond |\n\n| · | Goodwill Impairment Simplification (ASU 2017-04, Intangibles – Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment) |\n\n\nIssued by FASB in January 2017, this standard removes the second step of the two-step impairment test for measuring goodwill and is to be applied on a prospective basis only. The new standard is effective for the Company on January 1, 2020, including interim periods within the year of adoption. Early adoption is permitted for interim or annual goodwill impairment\n9\ntests performed on testing dates after January 1, 2017. It is not anticipated that adoption of this standard will have any material impact on our consolidated financial statements.\n\nPrior period financial statement correction of immaterial errors\n\nDuring the third quarter of 2018, we identified immaterial errors related to the accounting for straight line rent receivable from tenants in our real estate operations dating back to 2015. These errors resulted in an understatement of real estate revenue.\n\nWe assessed the materiality of these errors on our financial statements for prior periods in accordance with the SEC Staff Accounting Bulletin (“SAB”) No. 99, Materiality, codified in ASC 250, Presentation of Financial Statements, and concluded that they were not material to any prior annual or interim periods. However, the aggregate amount of $440k related to the prior period immaterial errors through June 30, 2018, would have been material to the quarterly accounts with our current Consolidated Statements of Income. Consequently, in accordance with ASC 250 (specifically SAB No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements), we have corrected these errors for all prior periods presented by revising the consolidated financial statements and other financial information included herein.\n\nThe following is a summary of the previously issued financial statement line items for all periods and statements included in this report.\n\nConsolidated Statements of Income:\n\n\n| |\n| | Three Months Ended March 31, 2018 |\n| (Dollars in thousands) | As Reported | Adjustment | As Revised |\n| Real estate revenue | $ | 3,567 | $ | 50 | $ | 3,617 |\n| Total revenue | 75,822 | 50 | 75,872 |\n| Operating income (loss) | 5,643 | 50 | 5,693 |\n| Income before income taxes | 4,224 | 50 | 4,274 |\n| Income tax benefit (expense) | (1,155) | (15) | (1,170) |\n| Net income (loss) | 3,069 | 35 | 3,104 |\n| Net income (loss) attributable to Reading International, Inc. common shareholders | 3,047 | 35 | 3,082 |\n| |\n| Basic earnings (loss) per share | $ | 0.13 | $ | — | $ | 0.13 |\n| Diluted earnings (loss) per share | 0.13 | — | 0.13 |\n\n\nConsolidated Balance Sheets:\n\n\n\n\n| |\n| | Summary of Equity |\n| (Dollars in thousands) | As Reported | Adjustment | As Revised |\n| Equity at January 1, 2018 | $ | 176,910 | $ | 377 | $ | 177,287 |\n| Net income (loss) | 3,047 | 35 | 3,082 |\n| Equity at March 31, 2018 | $ | 179,423 | $ | 412 | $ | 179,835 |\n\n\n\nConsolidated Statements of Cash Flows:\n\n\n| |\n| | Three Months Ended March 31, 2018 |\n| (Dollars in thousands) | As Reported | Adjustment | As Revised |\n| Net income (loss) | $ | 3,069 | $ | 35 | $ | 3,104 |\n| Change in net deferred tax assets | 157 | 15 | 172 |\n| Prepaid and other assets | (2,259) | (50) | (2,309) |\n| Net cash provided by operating activities | $ | 2,452 | $ | — | $ | 2,452 |\n\n10\nNote 3 – Operations in Foreign Currency\n\nWe have significant assets in Australia and New Zealand. Historically, we have conducted our Australian and New Zealand operations (collectively “foreign operations”) on a self-funding basis where we use cash flows generated by our foreign operations to pay for the expense of foreign operations. Our Australian and New Zealand assets and liabilities are translated from their functional currencies of Australian dollar (“AU$”) and New Zealand dollar (“NZ$”), respectively, to the U.S. dollar based on the exchange rate as of March 31, 2019. The carrying value of the assets and liabilities of our foreign operations fluctuates as a result of changes in the exchange rates between the functional currencies of the foreign operations and the U.S. dollar. The translation adjustments are accumulated in the Accumulated Other Comprehensive Income in the Consolidated Balance Sheets.\n\nDue to the natural-hedge nature of our funding policy, we have not historically used derivative financial instruments to hedge against the risk of foreign currency exposure. However, in certain circumstances, we move funds between jurisdictions where circumstances encouraged us to do so from an overall economic standpoint. Going forward, particularly in light of recent tax law changes, we intend to take a more global view of our financial resources, and to be more flexible in making use of resources from one jurisdiction in other jurisdictions.\n\nPresented in the table below are the currency exchange rates for Australia and New Zealand:\n\n\n| |\n| |\n| | Foreign Currency / USD |\n| | As of andfor thequarterended | As of andfor thetwelve monthsended | As of andfor thequarterended |\n| | March 31, 2019 | December 31, 2018 | March 31, 2018 |\n| Spot Rate |\n| Australian Dollar | 0.7104 | 0.7046 | 0.7690 |\n| New Zealand Dollar | 0.6820 | 0.6711 | 0.7239 |\n| Average Rate |\n| Australian Dollar | 0.7123 | 0.7479 | 0.7861 |\n| New Zealand Dollar | 0.6816 | 0.6930 | 0.7275 |\n\nNote 4 – Earnings Per Share\n\nBasic earnings per share (“EPS”) is calculated by dividing the net income attributable to the Company’s common stockholders by the weighted average number of common shares outstanding during the period. Diluted EPS is calculated by dividing the net income attributable to the Company’s common stockholders by the weighted average number of common and common equivalent shares outstanding during the period and is calculated using the treasury stock method for equity-based compensation awards.\n\nThe following table sets forth the computation of basic and diluted EPS and a reconciliation of the weighted average number of common and common equivalent shares outstanding:\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands, except share data) | 2019 | 2018 |\n| Numerator: |\n| Net income (loss) attributable to RDI common stockholders | $ | (2,081) | $ | 3,082 |\n| Denominator: |\n| Weighted average number of common stock – basic | 22,920,486 | 22,967,237 |\n| Weighted average dilutive impact of awards | 203,620 | 165,752 |\n| Weighted average number of common stock – diluted | 23,124,106 | 23,132,989 |\n| Basic earnings (loss) per share attributable to RDI common stockholders | $ | (0.09) | $ | 0.13 |\n| Diluted earnings (loss) per share attributable to RDI common stockholders | $ | (0.09) | $ | 0.13 |\n| Awards excluded from diluted earnings (loss) per share | 496,089 | — |\n\n\nOur weighted average number of common stock - basic decreased, primarily as a result of the repurchase of shares of Class A Non-Voting Common Stock pursuant to our current stock repurchase program offset by the issuance of shares due to the exercise of share options and vesting of restricted stock units.\n11\nNote 5 – Property and Equipment\n\nOperating Property, net\n\nAs of March 31, 2019 and December 31, 2018, property associated with our operating activities is summarized as follows:\n\n\n| |\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Land | $ | 76,110 | $ | 75,689 |\n| Building and improvements | 151,525 | 149,734 |\n| Leasehold improvements | 56,160 | 55,299 |\n| Fixtures and equipment | 171,674 | 167,943 |\n| Construction-in-progress | 3,185 | 3,478 |\n| Total cost | 458,654 | 452,143 |\n| Less: accumulated depreciation | (201,252) | (194,476) |\n| Operating property, net | $ | 257,402 | $ | 257,667 |\n\n\nDepreciation expense for operating property was $5.4 million for the quarter ended March 31, 2019 and $4.7 million for the quarter ended March 31, 2018.\n\nInvestment and Development Property, net\n\nAs of March 31, 2019 and December 31, 2018, our investment and development property is summarized below:\n\n| |\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Land | $ | 24,310 | $ | 24,371 |\n| Building | 1,900 | 1,900 |\n| Construction-in-progress (including capitalized interest) | 68,946 | 60,533 |\n| Investment and development property | $ | 95,156 | $ | 86,804 |\n\n\nConstruction-in-Progress – Operating and Investing Properties\n\nConstruction-in-Progress balances are included in both our operating and development properties. The balances of our major projects along with the movements for the three months ended March 31, 2019 are shown below:\n\n\n| |\n| |\n| (Dollars in thousands) | Balance,December 31,2018 | Additions during the period(1) | Completedduring theperiod | Foreigncurrencytranslation | Balance,March 31,2019 |\n| Union Square development | $ | 55,634 | $ | 7,724 | $ | — | $ | (1) | $ | 63,357 |\n| Newmarket Property development | 9 | 4 | — | — | 13 |\n| Courtenay Central development | 5,571 | 234 | — | 94 | 5,899 |\n| Cinema developments and improvements | 1,664 | 3,551 | (3,997) | 4 | 1,222 |\n| Other real estate projects | 1,133 | 528 | (27) | 6 | 1,640 |\n| Total | $ | 64,011 | $ | 12,041 | $ | (4,024) | $ | 103 | $ | 72,131 |\n\n\n| (1) | Includes capitalized interest of $1.3 million for the quarter ended March 31, 2019. |\n\n\nReal Estate Transactions\n\nPurchase of Income Producing Property at Auburn/Redyard, Australia – On June 29, 2018, we added 20,870 square feet of land, improved with a 16,830 square foot office building, to our Auburn/Redyard ETC. The property was acquired at auction for $3.5 million (AU$4.5 million) and is bordered by our existing ETC on three sides. The property is leased to Telstra through July 2022. This will allow us time to plan for the efficient integration of the property into our ETC. With this acquisition, Auburn/Redyard now represents approximately 519,992 square feet (48,309 square meters) of land, with approximately 1,620 feet (498 meters) of uninterrupted frontage to Parramatta Road, a major Sydney arterial motorway.\n\n12\nPurchase of Land at Cannon Park in Townsville, Australia – On June 13, 2018, we acquired a 163,000 square foot (15,150 square meter) parcel of land at our Cannon Park ETC, in connection with the restructuring of our relationship with the adjacent land owner. Prior to the restructuring, this parcel was commonly owned by us and the adjoining land owner. In the restructuring, the adjoining land owner conveyed to us its interest in the parcel for AU$1. We granted the adjoining land owner certain access rights with respect to that parcel.\n\nNote 6 – Investments in Unconsolidated Joint Ventures\n\nOur investments in unconsolidated joint ventures are accounted for under the equity method of accounting.\n\nThe table below summarizes our active investment holdings in two (2) unconsolidated joint ventures as of March 31, 2019 and December 31, 2018:\n\n| |\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | Interest | 2019 | 2018 |\n| Rialto Cinemas | 50.0% | $ | 1,224 | $ | 1,260 |\n| Mt. Gravatt | 33.3% | 3,734 | 3,861 |\n| Total investments | $ | 4,958 | $ | 5,121 |\n\n\nFor the quarter ended March 31, 2019 and 2018, the recognized share of equity earnings from our investments in unconsolidated joint ventures are as follows:\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Rialto Cinemas | $ | (56) | $ | 70 |\n| Mt. Gravatt | 90 | 187 |\n| Total equity earnings | $ | 34 | $ | 257 |\n\nNote 7 – Goodwill and Intangible Assets\n\nThe table below summarizes goodwill by business segment as of March 31, 2019 and December 31, 2018.\n\n\n| |\n| |\n| (Dollars in thousands) | Cinema | Real Estate | Total |\n| Balance at, December 31, 2018 | $ | 14,221 | $ | 5,224 | $ | 19,445 |\n| Change in goodwill due to a purchase of business combination | 1,248 | — | 1,248 |\n| Foreign currency translation adjustment | 143 | — | 143 |\n| Balance at, March 31, 2019 | $ | 15,612 | $ | 5,224 | $ | 20,836 |\n\n\nThe Company is required to test goodwill and other intangible assets for impairment on an annual basis and, if current events or circumstances require, on an interim basis. Our next annual evaluation of goodwill and other intangible assets is scheduled during the fourth quarter of 2019. To test the impairment of goodwill, the Company compares the fair value of each reporting unit to its carrying amount, including the goodwill, to determine if there is potential goodwill impairment. A reporting unit is generally one level below the operating segment. As of March 31, 2019, we were not aware that any events indicating potential impairment of goodwill had occurred.\n\nThe tables below summarize intangible assets other than goodwill as of March 31, 2019 and December 31, 2018, respectively.\n\n\n| |\n| |\n| | As of March 31, 2019 |\n| (Dollars in thousands) | BeneficialLeases | TradeName | OtherIntangibleAssets | Total |\n| Gross carrying amount | $ | 15,069 | $ | 7,255 | $ | 1,999 | $ | 24,323 |\n| Less: Accumulated amortization | (14,260) | (5,269) | (1,100) | (20,629) |\n| Net intangible assets other than goodwill | $ | 809 | $ | 1,986 | $ | 899 | $ | 3,694 |\n\n\n13\n\n| |\n| |\n| | As of December 31, 2018 |\n| (Dollars in thousands) | BeneficialLeases | TradeName | OtherIntangibleAssets | Total |\n| Gross carrying amount | $ | 28,592 | $ | 7,254 | $ | 1,951 | $ | 37,797 |\n| Less: Accumulated amortization | (24,145) | (5,207) | (1,076) | (30,428) |\n| Net intangible assets other than goodwill | $ | 4,447 | $ | 2,047 | $ | 875 | $ | 7,369 |\n\n\nBeneficial leases were amortized over the life of the lease up to 30 years up until January 1, 2019, when under ASC 842 they were incorporated into the relevant right-of-use asset. Trade names are amortized based on the accelerated amortization method over their estimated useful life of 30 years, and other intangible assets are amortized over their estimated useful lives of up to 30 years (except for transferrable liquor licenses, which are indefinite-lived assets). The table below summarizes the amortization expense of intangible assets for the quarter ended March 31, 2019.\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Beneficial lease amortization | $ | 79 | $ | 207 |\n| Other amortization | 22 | 93 |\n| Total intangible assets amortization | $ | 101 | $ | 300 |\n\nNote 8 – Prepaid and Other Assets\n\nPrepaid and other assets are summarized as follows:\n\n\n| |\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Prepaid and other current assets |\n| Prepaid expenses | $ | 2,105 | $ | 1,761 |\n| Prepaid rent | 1,020 | 930 |\n| Prepaid taxes | 1,026 | 646 |\n| Income taxes receivable | 4,106 | 2,704 |\n| Deposits | 242 | 242 |\n| Investment in marketable securities | 44 | 42 |\n| Restricted cash | 1,099 | 1,342 |\n| Total prepaid and other current assets | $ | 9,642 | $ | 7,667 |\n| Other non-current assets |\n| Straight-line rent | 4,219 | 4,150 |\n| Other non-cinema and non-rental real estate assets | 1,134 | 1,134 |\n| Investment in Reading International Trust I | 838 | 838 |\n| Long-term deposits | 8 | 7 |\n| Long-term restricted cash | — | — |\n| Total other non-current assets | $ | 6,199 | $ | 6,129 |\n\nNote 9 – Income Taxes\n\nThe interim provision for income taxes is different from the amount determined by applying the U.S. federal statutory rate to consolidated income before taxes. The differences are attributable to foreign tax rate differential, unrecognized tax benefits, and foreign tax credits. Our effective tax rate was 33.2% and 27.3% for the three months ended March 31, 2019 and 2018, respectively. The change between 2019 and 2018 is primarily related to decrease in benefits from foreign tax credits and increase in valuation allowance related to our foreign operation.\n\n14\nNote 10 – Debt\n\nThe Company’s borrowings at March 31, 2019 and December 31, 2018, net of deferred financing costs and including the impact of interest rate derivatives on effective interest rates, are summarized below:\n\n\n| |\n| |\n| | As of March 31, 2019 |\n| (Dollars in thousands) | Maturity Date | ContractualFacility | Balance,Gross | Balance, Net(1) | StatedInterest Rate | Effective Interest Rate(2) |\n| Denominated in USD |\n| Trust Preferred Securities (USA) | April 30, 2027 | $ | 27,913 | $ | 27,913 | $ | 26,116 | 6.75% | 6.75% |\n| Bank of America Credit Facility (USA) | May 1, 2020 | 55,000 | 30,000 | 30,000 | 5.02% | 5.02% |\n| Bank of America Line of Credit (USA) | October 31, 2019 | 5,000 | 3,500 | 3,500 | 5.52% | 5.52% |\n| Banc of America digital projector loan (USA) | December 28, 2019 | 1,979 | 1,979 | 1,979 | 5.00% | 5.00% |\n| Cinema 1, 2, 3 Term Loan (USA) | September 1, 2019 | 18,978 | 18,978 | 18,768 | 3.25% | 3.25% |\n| Minetta & Orpheum Theatres Loan (USA) | November 1, 2023 | 8,000 | 8,000 | 7,864 | 4.54% | 4.54% |\n| U.S. Corporate Office Term Loan (USA) | January 1, 2027 | 9,437 | 9,437 | 9,319 | 4.64% / 4.44% | 4.61% |\n| Union Square Construction Financing (USA) | December 29, 2019 | 57,500 | 33,934 | 32,463 | 6.76% / 12.51% | 8.02% |\n| Denominated in foreign currency (\"FC\") (3) |\n| NAB Corporate Term Loan (AU) | December 31, 2023 | 85,248 | 40,138 | 40,111 | 2.70% | 2.70% |\n| Westpac Bank Corporate (NZ) | December 31, 2023 | 21,824 | 9,889 | 9,889 | 3.80% | 3.80% |\n| | $ | 290,879 | $ | 183,768 | $ | 180,009 |\n\n\n| (1) | Net of deferred financing costs amounting to $3.8 million. |\n\n| (2) | Both interest rate derivatives associated with the Trust Preferred Securities and Bank of America Credit Facility expired in October 2017 so the effective interest rate no longer applies as of March 31, 2019. |\n\n| (3) | The contractual facilities and outstanding balances of the foreign currency denominated borrowings were translated into U.S. dollars based on the applicable exchange rates as of March 31, 2019. |\n\n\n| |\n| |\n| | As of December 31, 2018 |\n| (Dollars in thousands) | Maturity Date | ContractualFacility | Balance,Gross | Balance, Net(1) | StatedInterestRate | Effective Interest Rate (2) |\n| Denominated in USD |\n| Trust Preferred Securities (USA) | April 30, 2027 | $ | 27,913 | $ | 27,913 | $ | 26,061 | 6.52% | 6.52% |\n| Bank of America Credit Facility (USA) | May 1, 2020 | 55,000 | 25,000 | 25,000 | 5.02% | 5.02% |\n| Bank of America Line of Credit (USA) | October 31, 2019 | 5,000 | — | — | 5.48% | 5.48% |\n| Banc of America digital projector loan (USA) | December 28, 2019 | 2,604 | 2,604 | 2,604 | 5.00% | 5.00% |\n| Cinema 1, 2, 3 Term Loan (USA) | September 1, 2019 | 19,086 | 19,086 | 18,838 | 3.25% | 3.25% |\n| Minetta & Orpheum Theatres Loan (USA) | November 1, 2023 | 8,000 | 8,000 | 7,857 | 4.88% | 4.88% |\n| U.S. Corporate Office Term Loan (USA) | January 1, 2027 | 9,495 | 9,495 | 9,373 | 4.64% / 4.44% | 4.61% |\n| Union Square Construction Financing (USA) | December 29, 2019 | 57,500 | 27,182 | 25,280 | 6.76% / 12.51% | 8.35% |\n| Denominated in foreign currency (\"FC\")(3) |\n| NAB Corporate Loan Facility (AU) | December 31, 2023 | 46,856 | 37,696 | 37,660 | 3.05% | 3.05% |\n| Westpac Corporate Credit Facility (NZ) | December 31, 2023 | 21,475 | 10,067 | 10,067 | 3.80% | 3.80% |\n| | $ | 252,929 | $ | 167,043 | $ | 162,740 |\n\n\n| (1) | Net of deferred financing costs amounting to $4.3 million. |\n\n\n| (2) | Both interest rate derivatives associated with the Trust Preferred Securities and Bank of America Credit Facility expired in October 2017 so the effective interest rate no longer applies as of December 31, 2018. |\n\n| (3) | The contractual facilities and outstanding balances of the foreign currency denominated borrowings were translated into U.S. dollars based on the applicable exchange rates as of December 31, 2018. |\n\n\nOur loan arrangements are presented, net of the deferred financing costs, on the face of our consolidated balance sheet as follows:\n\n\n| |\n| |\n| | March 31, | December 31, |\n| Balance Sheet Caption | 2019 | 2018 |\n| Debt - current portion | $ | 40,077 | $ | 30,393 |\n| Debt - long-term portion | 113,816 | 106,286 |\n| Subordinated debt | 26,116 | 26,061 |\n| Total borrowings | $ | 180,009 | $ | 162,740 |\n\n\n15\nMinetta and Orpheum Theatres Loan\n\nOn October 12, 2018, we refinanced our $7.5 million loan with Santander Bank, which is secured by our Minetta and Orpheum Theatres, with a loan for a five year term of $8.0 million. Such modification was not considered to be substantial under US GAAP.\n\nBanc of America Digital Projector Loan\n\nOn February 5, 2018, we purchased our U.S. digital cinema projectors, which had previously been held on operating leases, using a $4.6 million loan from Banc of America. We made further U.S. digital projector purchases, of projectors similarly held on other operating leases, in March and April 2018, increasing this loan to $4.9 million. This loan carries an interest rate of 5% and is due and payable December 28, 2019.\n\nBank of America Credit Facility\n\nOn March 3, 2016, we amended our $55.0 million credit facility with Bank of America to permit real property acquisition loans. This amendment reduces the applicable consolidated leverage ratio covenant by 0.25% and modifies the term of the facility based on the earlier of the eighteen months from the date of such borrowing or the maturity date of the credit agreement. Such modification was not considered substantial in accordance with U.S. GAAP. On March 5, 2019, this Credit Facility was extended for six (6) months to May 1, 2020.\n\n44 Union Square Construction Financing\n\nOn December 29, 2016, we closed on our new construction finance facilities totaling $57.5 million to fund the non-equity portion of the anticipated construction costs of the redevelopment of our property at 44 Union Square in New York City. The combined facilities consist of $50.0 million in aggregate loans (comprised of three loan tranches) from Bank of the Ozarks (“BOTO”), and a $7.5 million mezzanine loan from Tammany Mezz Investor, LLC, an affiliate of Fisher Brothers. At December 31, 2016, Bank of the Ozarks advanced $8.0 million to repay the then existing $8.0 million loan with East West Bank. As of March 31, 2019, an additional $26.4 million had been advanced under the senior loan facility, along with the full $7.5 million available under the mezzanine loan facility.\n\nU.S. Corporate Office Term Loan\n\nOn December 13, 2016, we obtained a ten-year $8.4 million mortgage loan on our new Los Angeles Corporate Headquarters at a fixed annual interest rate of 4.64%. This loan provided for a second loan upon completion of certain improvements. On June 26, 2017, we obtained a further $1.5 million under this provision at a fixed annual interest rate of 4.44%.\n\nBank of America Line of Credit\n\nIn October 2016, the term of this $5.0 million line of credit was extended to October 31, 2019. Such modification was not considered to be substantial under US GAAP.\n\nCinema 1,2,3 Term Loan\n\nOn August 31, 2016, Sutton Hill Properties LLC (“SHP”), a 75% subsidiary of RDI, refinanced its $15.0 million Santander Bank term loan with a new lender, Valley National Bank. This new $20.0 million loan is collateralized by our Cinema 1,2,3 property and bears an interest rate of 3.25% per annum, with principal installments and accruing interest paid monthly. The new loan matures on September 1, 2019, with a one-time option to extend maturity date for another year. The Company presently intends to exercise that option and to extend the maturity date until September 1, 2020.\n\nWestpac Bank Corporate Credit Facility (NZ)\n\nOn December 20, 2018, we restructured our Westpac Corporate Credit Facilities. The maturity of the 1st tranche (general/non-construction credit line) was extended to December 31, 2023, with the available facility being reduced from NZ$35.0 million to NZ$32.0 million. The facility bears an interest rate of 1.75% above the Bank Bill Bid Rate on the drawn down balance and a 1.1% line of credit charge on the entire facility. The 2nd tranche (construction line) with a facility of NZ$18.0 million was not renewed.\n\nAustralian NAB Corporate Term Loan (AU)\n\nOn March 15, 2019, we amended our Revolving Corporate Markets Loan Facility with National Australia Bank (“NAB”) from a facility comprised of (i) a AU$66.5 million loan facility with an interest rate of 0.95% above the Bank Bill Swap Bid Rate (“BBSY”) and a maturity date of June 30, 2019 and (ii) a bank guarantee of AU$5.0 million at a rate of 1.90% per annum into a (i) AU$120.0\n16\nmillion Corporate Loan facility at rates of 0.85%-1.30% above BBSY depending on certain ratios with a due date of December 31, 2023, of which AU$80.0 million is revolving and AU$40.0 million is core and (ii) a Bank Guarantee Facility of AU$5.0 million at a rate of 1.85% per annum. Prior to this, on June 12, 2018, we had extended the maturity of these facilities from June 30, 2019, to December 31, 2019. Such modifications of this particular term loan were not considered to be substantial under US GAAP.\nNote 11 – Other Liabilities\n\nOther liabilities are summarized as follows:\n\n| |\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Current liabilities |\n| Lease liability | $ | 5,900 | $ | 5,900 |\n| Liability for demolition costs | 2,664 | 2,630 |\n| Accrued pension | 684 | 684 |\n| Security deposit payable | 88 | 84 |\n| Finance lease liabilities | 162 | — |\n| Other | 27 | 7 |\n| Other current liabilities | $ | 9,525 | $ | 9,305 |\n| Other liabilities |\n| Straight-line rent | $ | — | $ | 16,362 |\n| Lease make-good provision | 5,722 | 5,614 |\n| Accrued pension | 4,544 | 4,670 |\n| Environmental reserve | 1,656 | 1,656 |\n| Deferred revenue - real estate | 9 | 32 |\n| Acquired leases | 47 | 91 |\n| Finance lease liabilities | 169 | — |\n| Other | 199 | 506 |\n| Other liabilities | $ | 12,346 | $ | 28,931 |\n\n\nOn August 29, 2014, the Supplemental Executive Retirement Plan (“SERP”) that has been effective since March 1, 2007, was ended and replaced in accordance with the terms of a pension annuity. As a result of the termination of the SERP program, the accrued pension liability of $7.6 million was reversed and replaced with this pension annuity liability of $7.5 million. The valuation of the liability is based on the present value of $10.2 million discounted at a rate of 4.25% over a 15-year term, resulting in a monthly payment of $57,000. The discount rate of 4.25% has been applied since 2014 to determine the net periodic benefit cost and plan benefit obligation and is expected to be used in future years. The discounted value of $2.7 million (which is the difference between the estimated payout of $10.2 million and the present value of $7.5 million) as of August 29, 2014 will be amortized and expensed based on the 15-year term. In addition, the accumulated actuarial loss of $3.1 million recorded, as part of other comprehensive income will also be amortized based on the 15-year term.\n\nIn February 2018 we made a payment of $2.4 million relating to the annuity representing payments for the 42 months outstanding at the time. Monthly ongoing payments of $57,000 are now being made.\n\nAs a result of the above, included in our current and non-current liabilities are accrued pension costs of $5.2 million at March 31, 2019. The benefits of our pension plan are fully vested and therefore no service costs were recognized for the quarter ended March 31, 2019 and 2018. Our pension plan is unfunded.\n\nDuring the quarter ended March 31, 2019, the interest cost was $51,000 and actuarial loss was $51,000. During the quarter ended March 31, 2018, the interest cost was $45,000 and actuarial loss was $52,000.\n17\nNote 12 – Accumulated Other Comprehensive Income\n\nThe following table summarizes the changes in each component of accumulated other comprehensive income attributable to RDI:\n\n\n| |\n| |\n| (Dollars in thousands) | ForeignCurrencyItems | UnrealizedGain (Losses)on Available-for-SaleInvestments | AccruedPensionService Costs | Hedge Accounting Reserve | Total |\n| Balance at January 1, 2019 | $ | 8,687 | $ | 3 | $ | (2,438) | $ | (137) | $ | 6,115 |\n| |\n| Change related to derivatives |\n| Total change in hedge fair value recorded in Other Comprehensive Income | — | — | — | (81) | (81) |\n| Amounts reclassified from accumulated other comprehensive income | — | — | — | 12 | 12 |\n| Net change related to derivatives | — | — | — | (69) | (69) |\n| |\n| Net current-period other comprehensive income (loss) | 1,526 | 2 | 51 | (69) | 1,510 |\n| Balance at March 31, 2019 | $ | 10,213 | $ | 5 | $ | (2,387) | $ | (206) | $ | 7,625 |\n\nNote 13 – Commitments and Contingencies\n\nLitigation General\n\nWe are currently involved in certain legal proceedings and, as required, have accrued estimates of probable and estimable losses for the resolution of these claims, including legal costs.\n| · | Where we are a plaintiff, we accrue legal fees as incurred on an on-going basis and make no provision for any potential settlement amounts until received. In Australia, the prevailing party is usually entitled to recover its attorneys’ fees, which recoveries typically work out to be approximately 60% of the amounts actually spent where first-class legal counsel is engaged at customary rates. Where we are a plaintiff, we have likewise made no provision for the liability for the defendant’s attorneys' fees in the event we are determined not to be the prevailing party. |\n\n| · | Where we are a defendant, we accrue for probable damages that insurance may not cover as they become known and can be reasonably estimated. In our opinion, any claims and litigation in which we are currently involved are not reasonably likely to have a material adverse effect on our business, results of operations, financial position, or liquidity. It is possible, however, that future results of the operations for any particular quarterly or annual period could be materially affected by the ultimate outcome of the legal proceedings. From time-to-time, we are involved with claims and lawsuits arising in the ordinary course of our business that may include contractual obligations, insurance claims, tax claims, employment matters, and anti-trust issues, among other matters. |\n\n\nAll of these matters require significant judgments based on the facts known to us. These judgments are inherently uncertain and can change significantly when additional facts become known. We provide accruals for matters that have probable likelihood of occurrence and can be properly estimated as to their expected negative outcome. We do not record expected gains until the proceeds are received by us. However, we typically make no accruals for potential costs of defense, as such amounts are inherently uncertain and dependent upon the scope, extent and aggressiveness of the activities of the applicable plaintiff.\n\nEnvironmental and Asbestos Claims on Reading Legacy Operations\nCertain of our subsidiaries were historically involved in railroad operations, coal mining, and manufacturing. Also, certain of these subsidiaries appear in the chain-of-title of properties that may suffer from pollution. Accordingly, certain of these subsidiaries have, from time-to-time, been named in and may in the future be named in various actions brought under applicable environmental laws. Also, we are in the real estate development business and may encounter from time-to-time unanticipated environmental conditions at properties that we have acquired for development. These environmental conditions can increase the cost of such projects and adversely affect the value and potential for profit of such projects. We do not currently believe that our exposure under applicable environmental laws is material in amount.\n\nFrom time to time, there are claims brought against us relating to the exposure of former employees of our railroad operations to asbestos and coal dust. These are generally covered by an insurance settlement reached in September 1990 with our insurance providers. However, this insurance settlement does not cover litigation by people who were not our employees and who may claim second-hand exposure to asbestos, coal dust and/or other chemicals or elements now recognized as potentially causing cancer in humans. Our known exposure to these types of claims, asserted or probable of being asserted, is not material.\n\n18\nCotter Jr. Derivative Litigation\n\nThis action was originally brought by James J. Cotter, Jr. (“Cotter Jr.”) in June, 2015 in the Nevada District Court against all of the Directors of the Company and against the Company as a nominal defendant: James J. Cotter, Jr., individually and derivatively on behalf of Reading International, Inc. vs. Margaret Cotter, et al.” Case No,: A-15-719860-V. Summary judgment has been entered against Cotter, Jr., and in favor of all defendants and a $1.55 million cost judgment has been entered against Cotter, Jr., and in favor of our Company. Cotter, Jr. has appealed both judgements. Our application for $5.9 million in attorney’s fees was denied, and we have appealed that determination. The issues on appeal are currently being briefed. No date for oral argument has been set. It is unlikely that any hearing will be held this year. As the Directors and Officers Liability Insurance Policy covering Cotter, Jr.’s claims in the Derivative Case ($10.0 million) has been exhausted, the financial burden of defending our Directors against these claims, as required by applicable Nevada Law, has fallen upon our Company. During 2018, out-of-pocket third party costs in the amount of approximately $3.5 million were incurred by our Company in defending against these claims. In the quarter ended March 31, 2019, an additional $387,000 had been accrued, relating principally to the preparation of appellate briefs with respect to the Derivative Litigation.\nNote 14 – Non-controlling Interests\n\nThese are composed of the following enterprises:\n| · | Australia Country Cinemas Pty Ltd. - 25% noncontrolling interest owned by Panorama Cinemas for 21st Century Pty Ltd.; |\n\n| · | Shadow View Land and Farming, LLC - 50% noncontrolling membership interest owned by either the estate of Mr. James J. Cotter, Sr. (the “Cotter Estate”) and/or the James J. Cotter, Sr. Living Trust (the “Cotter Trust”); and, |\n\n| · | Sutton Hill Properties, LLC - 25% noncontrolling interest owned by Sutton Hill Capital, LLC (which in turn is 50% owned by the Cotter Estate and/or the Cotter Trust). |\n\n\nThe components of noncontrolling interests are as follows:\n\n| |\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Australian Country Cinemas, Pty Ltd | $ | 27 | $ | 89 |\n| Shadow View Land and Farming, LLC | 2,156 | 2,153 |\n| Sutton Hill Properties, LLC | 2,084 | 2,095 |\n| Noncontrolling interests in consolidated subsidiaries | $ | 4,267 | $ | 4,337 |\n\n\nThe components of income attributable to noncontrolling interests are as follows:\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Australian Country Cinemas, Pty Ltd | $ | 9 | $ | 41 |\n| Shadow View Land and Farming, LLC | (14) | (13) |\n| Sutton Hill Properties, LLC | (11) | (6) |\n| Net income (loss) attributable to noncontrolling interests | $ | (16) | $ | 22 |\n\n\n19\nSummary of Controlling and Noncontrolling Stockholders’ Equity\n\nA summary of the changes in controlling and noncontrolling stockholders’ equity is as follows:\n\n\n\n| |\n| |\n| (Dollars in thousands) | ControllingStockholders’Equity | NoncontrollingStockholders’Equity | TotalStockholders’Equity |\n| Equity at January 1, 2019 | $ | 176,210 | $ | 4,337 | $ | 180,547 |\n| Adjustments to opening retained earnings on adoption of ASC 842 | 28 | (46) | (18) |\n| Net income (loss) | (2,081) | (16) | (2,097) |\n| Increase in additional paid in capital | 21 | — | 21 |\n| Treasury stock purchased | (9) | — | (9) |\n| Contributions from noncontrolling stockholders | — | 18 | 18 |\n| Distributions to noncontrolling stockholders | — | (27) | (27) |\n| Accumulated other comprehensive income | 1,510 | 1 | 1,511 |\n| Equity at March 31, 2019 | $ | 175,679 | $ | 4,267 | $ | 179,946 |\n| |\n| (Dollars in thousands) | ControllingStockholders’Equity | NoncontrollingStockholders’Equity | TotalStockholders’Equity |\n| Equity at January 1, 2018 | $ | 177,287 | $ | 4,331 | $ | 181,618 |\n| Adjustments to opening retained earnings on adoption of ASC 606 | 194 | (2) | 192 |\n| Net income (loss) | 3,082 | 22 | 3,104 |\n| Increase in additional paid in capital | 339 | — | 339 |\n| Treasury stock purchased | (317) | — | (317) |\n| Contributions from noncontrolling stockholders | — | 27 | 27 |\n| Distributions to noncontrolling stockholders | — | (43) | (43) |\n| Accumulated other comprehensive loss | (750) | (3) | (753) |\n| Equity at March 31, 2018 | $ | 179,835 | $ | 4,332 | $ | 184,167 |\n\nNote 15 – Stock-Based Compensation and Stock Repurchases\n\nEmployee and Director Stock Option Plan\n\nThe Company may grant stock options and other share-based payment awards of our Common Stock to eligible employees, directors, and consultants under the 2010 Stock Incentive Plan (the “Plan”). The aggregate total number of shares of the Common Stock authorized for issuance under the Plan is 2,197,460.\n\nDuring the Company’s 2017 Annual Stockholders’ Meeting held on November 7, 2017, the Company's stockholders, upon recommendation of the Board of Directors, approved an amendment to the Plan to increase the number of shares of common stock issuable under the Plan by an additional 947,460 shares. The effect of the increase is to restore the amount of shares of Common Stock available under the Plan from the 302,540 shares available as of September 30, 2017, back up to its original reserve of 1,250,000 shares. As of March 31, 2019, we had 789,869 shares remaining for future issuances.\n\nSince the adoption of the Plan in 2010, the Company has granted awards primarily in the form of stock options. In the 1st quarter of 2016, the Company started to award restricted stock units (“RSUs”) to directors and certain members of management. Stock options are generally granted at exercise prices equal to the grant-date market prices and typically expire no later than five years from the grant date. In contrast to a stock option where the grantee buys the Company’s share at an exercise price determined on grant date, an RSU entitles the grantee to receive one share for every RSU based on a vesting plan. At the discretion of our Compensation and Stock Options Committee, the vesting period of stock options and RSUs granted to employees ranges from zero to four years. Grants to directors and certain executive officers are subject to Board approval. At the time the options are exercised or RSUs vest and are settled, at the discretion of management, we will issue treasury shares or make a new issuance of shares to the option or RSU holder.\n\nStock Options\nWe estimate the grant-date fair value of our stock options using the Black-Scholes option-valuation model, which takes into account assumptions such as the dividend yield, the risk-free interest rate, the expected stock price volatility, and the expected life of the options. We expense the estimated grant-date fair values of options over the vesting period on a straight-line basis. Based on our\n20\nhistorical experience, the “deemed exercise” of expiring in-the-money options and the relative market price to strike price of the options, we have not hereto estimated any forfeitures of vested or unvested options.\n\nThere were 219,408 stock options issued in the quarter ended March 31, 2019. The weighted average assumptions used in the option-valuation model were as follows:\n\n\n| |\n| |\n| | Three Months Ended March 31, |\n| | 2019 | 2018 |\n| Stock option exercise price | $ | 16.12 | $ | — |\n| Risk-free interest rate | 2.42% | 0.00% |\n| Expected dividend yield | — | — |\n| Expected option life in years | 3.75 | — |\n| Expected volatility | 23.32% | 0.00% |\n| Weighted average fair value | $ | 3.50 | $ | — |\n\n\nFor the quarters ended March 31, 2019 and 2018, we recorded compensation expense of $70,000 and $85,000, respectively. At March 31, 2019, the total unrecognized estimated compensation expense related to non-vested stock options was $1.5 million, which we expect to recognize over a weighted average vesting period of 2.11 years. The intrinsic, unrealized value of all options outstanding, vested and expected to vest, at March 31, 2019 was $2.0 million, of which 91% are currently exercisable.\n\nThe following table summarizes the number of options outstanding and exercisable as of March 31, 2019 and December 31, 2018:\n\n| |\n| |\n| | Outstanding Stock Options - Class A Shares |\n| | Numberof Options | WeightedAverageExercise Price | WeightedAverageRemainingYears ofContractualLife | AggregateIntrinsicValue |\n| | Class A | Class A | Class A | Class A |\n| Balance - December 31, 2017 | 524,589 | $ | 12.50 | 3.15 | $ | 3,054,325 |\n| Granted | 126,840 | 16.40 | — | — |\n| Exercised | (60,000) | 6.02 | — | 610,249 |\n| Forfeited | (4,960) | 12.08 | — | — |\n| Balance - December 31, 2018 | 586,469 | $ | 14.01 | 2.88 | $ | 1,530,528 |\n| Granted | 219,408 | 16.12 | — | — |\n| Exercised | (67,500) | 13.42 | — | 185,175 |\n| Forfeited | (25,000) | 13.42 | — | — |\n| Balance - March 31, 2019 | 713,377 | $ | 14.74 | 3.53 | $ | 1,993,628 |\n\n\n21\nRestricted Stock Units\nWe estimate the grant-date fair values of our RSUs using the Company’s stock price at grant-date and record such fair values as compensation expense over the vesting period on a straight-line basis. The following table summarizes the status of the RSUs granted to-date as of March 31, 2019:\n\n| |\n| |\n| | Outstanding Restricted Stock Units |\n| | RSU Grants (in units) | Vested, | Unvested, | Forfeited, |\n| Grant Date | Directors | Management | TotalGrants | March 31,2019 | March 31,2019 | March 31,2019 |\n| March 10, 2016 | 35,147 | 27,381 | 62,528 | 55,684 | 6,844 |\n| April 11, 2016 | — | 5,625 | 5,625 | 2,815 | 2,293 | 517 |\n| March 23, 2017 | 30,681 | 32,463 | 63,144 | 46,919 | 16,225 |\n| August 29, 2017 | — | 7,394 | 7,394 | 3,698 | 3,696 |\n| January 2, 2018 | 29,393 | — | 29,393 | 29,393 | — |\n| April 12, 2018 | — | 29,596 | 29,596 | — | 29,596 |\n| April 13, 2018 | — | 14,669 | 14,669 | — | 14,669 |\n| July 6, 2018 | — | 932 | 932 | — | — | 932 |\n| November 7, 2018 | 23,010 | — | 23,010 | — | 23,010 |\n| March 13, 2019 | — | 24,366 | 24,366 | — | 24,366 |\n| March 14, 2019 | — | 23,327 | 23,327 | — | 23,327 |\n| Total | 118,231 | 165,753 | 283,984 | 138,509 | 144,026 | 1,449 |\n\n\nRSU awards to management vest 25% at the end of each year for 4 years. Prior to November 7, 2018, RSU awards to directors vested 100% in January of the following year in which such RSUs were granted. At the November 7, 2018 Board meeting, it was determined that it would be more appropriate for the vesting of RSUs to align with the directors’ term of office. Accordingly, the RSUs granted on November 7, 2018, will vest upon the earlier of (i) the first anniversary of grant and (ii) the date of the next annual meeting of stockholders. This means that on the date of the annual meeting of stockholders on May 7, 2019, the RSUs granted to directors on November 7, 2018 vested. Due to the fact that the Company has moved up its annual meeting of stockholders from November to May this year, this created a shorter than normal vesting period for the RSUs issued on November 7, 2018. In order to adjust for this factor, the directors have determined that the award of RSUs to be made immediately following the 2019 Annual Meeting of Stockholders will be $35,000 or one half of last year's annual grant. For the quarter ended March 31, 2019 and 2018, we recorded compensation expense of $209,000 and $294,000, respectively. The total unrecognized compensation expense related to the non-vested RSUs was $1.9 million as of March 31, 2019, which we expect to recognize over a weighted average vesting period of 1.1 years.\n\nStock Repurchase Program\n\nOn March 2, 2017, the Company's Board of Directors authorized management, at its discretion, to spend up to an aggregate of $25.0 million to acquire shares of Reading’s Class A Common Stock. The previously approved stock repurchase program, which allowed management to spend up to an aggregate of $10.0 million to acquire shares of Reading’s Class A Common Stock, was completed as of December 31, 2016. On March 14, 2019, the Board of Directors extended this stock buy-back program for two years, through March 2, 2021. The Board of Directors did not increase the authorized amount which was $16.2 million at March 31, 2019.\n\nThe repurchase program allows Reading to repurchase its shares in accordance with the requirements of the SEC on the open market, in block trades and in privately negotiated transactions, depending on market conditions and other factors. All purchases are subject to the availability of shares at prices that are acceptable to Reading, and accordingly, no assurances can be given as to the timing or number of shares that may ultimately be acquired pursuant to this authorization.\n\nUnder the stock repurchase program, as of March 31, 2019, the Company has reacquired 559,627 shares of Class A Common Stock for $8.8 million at an average price of $15.81 per share (excluding transaction costs) to-date. 566 shares of Class A Common Stock were purchased during the quarter ended March 31, 2019 at an average price of $16.08 per share. This leaves $16.2 million available under the March 2, 2017 program, as extended, for repurchase as of March 31, 2019.\n\n22\nNote 16 - Leases\n\nIn all leases, whether we are the lessor or lessee, we define lease term as the non-cancellable term of the lease plus any renewals covered by renewal options that are reasonably certain of exercise based on our assessment of economic factors relevant to the lessee. The non-cancellable term of the lease commences on the date the lessor makes the underlying property in the lease available to the lessee, irrespective of when lease payments begin under the contract.\n\nAs Lessee\n\nWe have operating leases for certain cinemas and corporate offices, and finance leases for certain equipment assets. Our leases have remaining lease terms of 1 to 20 years, with certain leases having options to extend to up to a further 20 years.\n\nContracts are analyzed in accordance with the criteria set out in ASC 842 to determine if there is a lease present. For contracts that contain an operating lease, we account for the lease component and the non-lease component together as a single component. For contracts that contain a finance lease we account for the lease component and the non-lease component separately in accordance with ASC 842.\n\nIn leases where we are the lessee, we recognize a right of use asset and lease liability at lease commencement, which is measured by discounting lease payments using our incremental borrowing rate applicable to the lease term and currency of the lease as the discount rate. Subsequent amortization of the right of use asset and accretion of the lease liability for an operating lease is recognized as a single lease cost, on a straight line basis, over the term of the lease. A finance lease right-of-use asset is depreciated on a straight line basis over the lesser of the useful life of the leased asset or the lease term. Interest on each finance lease liability is determined as the amount that results in a constant periodic discount rate on the remaining balance of the liability. Property taxes and other non-lease costs are accounted for on an accrual basis.\n\nLease payments for our cinema operating leases consist of fixed base rent, and for certain leases, variable lease payments consisting of contracted percentages of revenue, changes in the relevant CPI, and/or other contracted financial metrics.\nThe components of lease expense were as follows:\n\n\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Lease cost |\n| Finance lease cost: | — |\n| Amortization of right-of-use assets | $ | 41 | $ | — |\n| Interest on lease liabilities | 3 | — |\n| Operating lease cost | 7,921 | — |\n| Variable lease cost | 105 | — |\n| Total lease cost | $ | 8,070 | $ | — |\n\n\n\nSupplemental cash flow information related to leases was as follows:\n\n\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Cash flows relating to lease cost |\n| Cash paid for amounts included in the measurement of lease liabilities: |\n| Operating cash flows from finance leases | $ | 44 | $ | — |\n| Operating cash flows from operating leases | 7,780 | — |\n| Right-of-use assets obtained in exchange for new finance lease liabilities | — | — |\n| Right-of-use assets obtained in exchange for new operating lease liabilities | 2,181 | — |\n\n23\n\n\n\nSupplemental balance sheet information related to leases was as follows:\n\n\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Operating leases |\n| Operating lease right-of-use assets | $ | 229,266 | $ | — |\n| Operating lease liabilities - current portion | 19,797 | — |\n| Operating lease liabilities - non-current portion | 222,594 | — |\n| Total operating lease liabilities | $ | 242,391 | $ | — |\n| Finance leases |\n| Property plant and equipment, gross | 372 | — |\n| Accumulated depreciation | (41) | — |\n| Property plant and equipment, net | $ | 331 | $ | — |\n| Other current liabilities | 162 | — |\n| Other long-term liabilities | 169 | — |\n| Total finance lease liabilities | $ | 331 | $ | — |\n| |\n| Other information |\n| Weighted-average remaining lease term - finance leases | 3 | — |\n| Weighted-average remaining lease term - operating leases | 11 | — |\n| Weighted-average discount rate - finance leases | 5.05% | — |\n| Weighted-average discount rate - operating leases | 4.97% | — |\n\n\n\nMaturity of leases were as follows:\n\n\n| |\n| (Dollars in thousands) | Operating leases | Finance leases |\n| 2019 | $ | 23,566 | $ | 133 |\n| 2020 | 31,434 | 101 |\n| 2021 | 31,717 | 53 |\n| 2022 | 31,901 | 43 |\n| 2023 | 31,018 | 28 |\n| Thereafter | 169,221 | — |\n| Total lease payments | $ | 318,857 | $ | 358 |\n| Less imputed interest | (76,466) | (27) |\n| Total | $ | 242,391 | $ | 331 |\n\n\n\nAs of March 31, 2019, we have additional operating leases, primarily for cinemas, that have not yet commenced of approximately $26.0 million. These operating leases will commence between fiscal year 2019 and fiscal year 2021 with lease terms of 15 to 20 years.\n\nAs Lessor\n\nThe Company has entered into various leases as a lessor for our owned real estate properties. These leases vary in length between 1 and 20 years, with certain leases containing options to extend at the behest of the applicable tenants. Lease components consist of fixed base rent, and for certain leases, variable lease payments consisting of contracted percentages of revenue, changes in the relevant CPI, and/or other contracted financial metrics. No terms exist by which a lessee is able to purchase the underlying asset.\n\nWe recognize lease payments for operating leases as property revenue on a straight-line basis over the lease term. Lease incentive payments we make to lessees are amortized as a reduction in property revenue over the lease term.\n24\nLease income relating to operating lease payments was as follows:\n\n\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Components of lease income |\n| Lease payments | $ | 2,229 | $ | 2,423 |\n| Variable lease payments | 265 | 80 |\n| Total lease income | $ | 2,494 | $ | 2,503 |\n\n\n\nThe book value of underlying assets under operating leases from owned assets was as follows:\n\n\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Building and improvements |\n| Gross balance | $ | 68,483 | $ | 67,887 |\n| Accumulated depreciation | (18,375) | (17,709) |\n| Net Book Value | $ | 50,108 | $ | 50,178 |\n\n\n\n\nMaturity of leases were as follows:\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n| |\n| (Dollars in thousands) | Operating leases |\n| 2019 | $ | 6,470 |\n| 2020 | 7,439 |\n| 2021 | 6,830 |\n| 2022 | 5,961 |\n| 2023 | 5,187 |\n| Thereafter | 10,295 |\n| Total | $ | 42,182 |\n\n\n\n\n\n\n\n\n\n\n\n\nNote 17 – Hedge Accounting\n\nAs of March 31, 2019 and March 31, 2018, the Company held interest rate derivatives in the total notional amount of $8.0 million and $nil, respectively.\n\nThe derivatives are recorded on the balance sheet at fair value and are included in the following line items:\n\n\n| |\n| | Liability Derivatives |\n| | March 31, | December 31, |\n| | 2019 | 2018 |\n| (Dollars in thousands) | Balance sheet location | Fair value | Balance sheet location | Fair value |\n| Interest rate contracts | Derivative financial instruments - current portion | $ | 52 | Derivative financial instruments - current portion | $ | 41 |\n| | Derivative financial instruments - non-current portion | 203 | Derivative financial instruments - non-current portion | 145 |\n| Total derivatives designated as hedging instruments | $ | 255 | $ | 186 |\n| Total derivatives | $ | 255 | $ | 186 |\n\n\n\n\n\n25\n\n\nWe have no derivatives designated as hedging instruments which are in asset positions.\n\nThe changes in fair value are recorded in Other Comprehensive Income and released into interest expense in the same period(s) in which the hedged transactions affect earnings. In the quarter to March 31, 2019 and March 31, 2018, respectively, the derivative instruments affected Comprehensive Income as follows:\n\n\n\n| |\n| (Dollars in thousands) | Location of Loss Recognized in Income on Derivatives | Amount of Loss Recognized in Income on Derivatives |\n| | 2019 | 2018 |\n| Interest rate contracts | Interest expense, net | $ | 12 | $ | — |\n| Total | $ | 12 | $ | — |\n\n\n\n| |\n| | Loss Recognized in OCI on Derivatives (Effective Portion) | Loss Reclassified from OCI into Income (Effective Portion) | Loss Recognized in Income on Derivatives (Ineffective Portion and Amount Excluded from Effectiveness Testing) |\n| (Dollars in thousands) | Amount | Line Item | Amount | Line Item | Amount |\n| | 2019 | 2018 | 2019 | 2018 | 2019 | 2018 |\n| Interest rate contracts | $ | 81 | $ | — | Interest expense, net | $ | 12 | $ | — | Interest expense, net | $ | — | $ | — |\n| Total | $ | 81 | $ | — | $ | 12 | $ | — | $ | — | $ | — |\n\n\n\nNote 18 – Fair Value Measurements\n\nASC 820, Fair Value Measurement establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The statement requires that assets and liabilities carried at fair value be classified and disclosed in one of the following three categories:\n| · | Level 1: Quoted market prices in active markets for identical assets or liabilities; |\n\n| · | Level 2: Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets; and, |\n\n| · | Level 3: Valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable. |\n\nAs of March 31, 2019 and December 31, 2018 material financial assets and financial liabilities were carried and measured at fair value on a recurring basis.\n\nThe following tables summarize our financial liabilities that are carried at cost and measured at fair value on a non-recurring basis as of March 31, 2019 and December 31, 2018, by level within the fair value hierarchy.\n\n\n| |\n| |\n| | Fair Value Measurement at March 31, 2019 |\n| (Dollars in thousands) | CarryingValue(1) | Level 1 | Level 2 | Level 3 | Total |\n| Notes payable | $ | 155,855 | $ | — | $ | — | $ | 159,871 | $ | 159,871 |\n| Subordinated debt | 27,913 | — | — | 19,162 | 19,162 |\n| | $ | 183,768 | $ | — | $ | — | $ | 179,033 | $ | 179,033 |\n\n\n\n| |\n| |\n| | Fair Value Measurement at December 31, 2018 |\n| (Dollars in thousands) | CarryingValue(1) | Level 1 | Level 2 | Level 3 | Total |\n| Notes payable | $ | 139,130 | $ | — | $ | — | $ | 143,564 | $ | 143,564 |\n| Subordinated debt | 27,913 | — | — | 18,895 | 18,895 |\n| | $ | 167,043 | $ | — | $ | — | $ | 162,459 | $ | 162,459 |\n\n\n| (1) | These balances are presented before any deduction for deferred financing costs. |\n\n26\n\nFollowing is a description of the valuation methodologies used to estimate the fair value of our financial assets and liabilities. There have been no changes in the methodologies used at March 31, 2019 and December 31, 2018.\n| · | Level 1 investments in marketable securities primarily consist of investments associated with the ownership of marketable securities in U.S. and New Zealand. These investments are valued based on observable market quotes on the last trading date of the reporting period. |\n\n| · | Level 2 derivative financial instruments are valued based on discounted cash flow models that incorporate observable inputs such as interest rates and yield curves from the derivative counterparties. The credit valuation adjustments associated with our non-performance risk and counterparty credit risk are incorporated in the fair value estimates of our derivatives. As of March 31, 2019 and December 31, 2018, we concluded that the credit valuation adjustments were not significant to the overall valuation of our derivatives. |\n\n| · | Level 3 borrowings include our secured and unsecured notes payable, trust preferred securities and other debt instruments. The borrowings are valued based on discounted cash flow models that incorporate appropriate market discount rates. We calculated the market discount rate by obtaining period-end treasury rates for fixed-rate debt, or LIBOR for variable-rate debt, for maturities that correspond to the maturities of our debt, adding appropriate credit spreads derived from information obtained from third-party financial institutions. These credit spreads take into account factors such as our credit rate, debt maturity, types of borrowings, and the loan-to-value ratios of the debt. |\n\n\nThe Company’s financial instruments also include cash, cash equivalents, receivables and accounts payable. The carrying values of these financial instruments approximate the fair values due to their short maturities. Additionally, there were no transfers of assets and liabilities between levels 1, 2, or 3 during the quarter ended March 31, 2019 and March 31, 2018.\nNote 19 – Business Combination\n\nOn January 30, 2019, we purchased the tenant’s interest and other operating assets of an established four-screen cinema in Devonport, Tasmania, Australia, for $1.4 million (AU$1.95 million). We commenced trading from this new cinema site on January 30, 2019.\n\nThe total purchase price was allocated to the identifiable assets acquired based on our preliminary estimates of their fair values on the acquisition date. There were no liabilities assumed. As of March 31, 2019, the Company is still finalizing its allocation and this may result in potential adjustments within the one-year measurement period from acquisition date. The determination of the fair values of the acquired assets (and the related determination of their estimated lives) requires significant judgment.\n\nOur preliminary purchase price allocation is as follows:\n\n\n| |\n| | Preliminary Purchase Price |\n| | Allocation |\n| (Dollars in thousands) | US Dollars(1) | AU dollars |\n| Tangible Assets |\n| Operating property: |\n| Fixtures and equipment | $ | 153 | $ | 213 |\n| Intangible Assets |\n| Goodwill | 1,248 | 1,734 |\n| Total assets acquired | 1,401 | 1,947 |\n| |\n| Net assets acquired | $ | 1,401 | $ | 1,947 |\n\n\n| (1) | The balances were translated into U.S. Dollars based on the applicable exchange rate as of the date of acquisition, January 30, 2019. |\n\n\n\n\n\n27\nThis MD&A should be read in conjunction with the accompanying unaudited consolidated financial statements included in Part I, Item 1 (Financial Statements). The foregoing discussions and analyses contain certain forward-looking statements. Please refer to the “Forward Looking Statements” included at the conclusion of this section and our “Risk Factors” set forth in our 2018 Form 10-K, Part 1, Item 1A and the Risk Factors set out below.\n\n\nItem 2 – Management’s Discussions and Analysis (“MD&A”) of Financial Condition and Results of Operations\n\nBUSINESS OVERVIEW\n\nWe are an internationally diversified company principally focused on the development, lease or ownership, and operation of entertainment and real estate assets in the United States, Australia, and New Zealand. As of March 31, 2019, we operate in two business segments:\n| · | Cinema exhibition, through our 60 multiplex cinemas; and, |\n\n| · | Real estate, including real estate development and the rental of retail, commercial and live theatre assets. |\n\n\nWe believe that these two business segments complement one another, as we can use the comparatively consistent cash flows generated by our cinema operations to fund the front-end cash demands of our real estate development business.\n\nCinema Exhibition\nWe manage our worldwide cinema exhibition businesses under various brands:\n| · | in the U.S., under the following brands: Reading Cinemas, Angelika Film Centers, Consolidated Theatres, and City Cinemas; |\n\n| · | in Australia, under the Reading Cinemas brand; and, |\n\n| · | in New Zealand, under the Reading Cinemas and Rialto Cinemas brands. |\n\n\nShown in the following table are the number of locations and theater screens in our theater circuit in each country, by state/territory/ region and indicating our cinema brands and our interest in the underlying assets as of March 31, 2019:\n\n\n| |\n| |\n| | State / Territory / | Location | Screen | Interest in AssetUnderlying the Cinema |\n| Country | Region | Count | Count | Leased | Owned | Operating Brands |\n| United States | Hawaii | 9 | 98 | 9 | Consolidated Theatres |\n| | California | 7 | 88 | 7 | Reading Cinemas, Angelika Film Center |\n| | New York(3) | 6 | 23 | 5 | 1 | Angelika Film Center, City Cinemas |\n| | Texas | 2 | 13 | 2 | Angelika Film Center |\n| | New Jersey | 1 | 12 | 1 | Reading Cinemas |\n| | Virginia | 1 | 8 | 1 | Angelika Film Center |\n| | Washington DC | 1 | 3 | 1 | Angelika Film Center |\n| | U.S. Total | 27 | 245 | 26 | 1 |\n| Australia | New South Wales | 6 | 44 | 4 | 2 | Reading Cinemas |\n| | Victoria | 6 | 43 | 6 | Reading Cinemas |\n| | Queensland | 5 | 50 | 2 | 3 | Reading Cinemas, Event Cinemas(1) |\n| | Western Australia | 2 | 16 | 1 | 1 | Reading Cinemas |\n| | South Australia | 2 | 15 | 2 | Reading Cinemas |\n| | Tasmania | 1 | 4 | 1 | Reading Cinemas |\n| | Australia Total | 22 | 172 | 16 | 6 |\n| New Zealand | Wellington | 2 | 15 | 1 | 1 | Reading Cinemas |\n| | Otago | 3 | 15 | 2 | 1 | Reading Cinemas, Rialto Cinemas(2) |\n| | Auckland | 2 | 15 | 2 | Reading Cinemas, Rialto Cinemas(2) |\n| | Canterbury | 1 | 8 | 1 | Reading Cinemas |\n| | Southland | 1 | 5 | 1 | Reading Cinemas |\n| | Bay of Plenty | 1 | 5 | 1 | Reading Cinemas |\n| | Hawke's Bay | 1 | 4 | 1 | Reading Cinemas |\n| | New Zealand Total | 11 | 67 | 6 | 5 |\n| GRAND TOTAL | 60 | 484 | 48 | 12 |\n\n\n| (1) | The Company has a 33.3% unincorporated joint venture interest in a 16-screen cinema located in Mt. Gravatt, Queensland managed by Event Cinemas. |\n\n| (2) | The Company is a 50% joint venture partner in two (2) New Zealand Rialto cinemas. We are responsible for the booking of these cinemas and our joint venture partner, Event Cinemas, manages their day-to-day operations. |\n\n| (3) | Our New York statistics include one (1) managed cinema, with a four-screen total. |\n\n\n28\nReal Estate\nWe engage in real estate development and the ownership, and rental or licensing to third parties of retail, commercial and live theater assets. We own the fee interests in all three of our live theaters, and in 12 of our cinemas (as presented in the preceding table). Our real estate business creates long-term value for our stockholders through the continuous improvement and development of our investment and operating properties, including our entertainment-themed centers (“ETCs”).\n\nOur real estate activities have historically consisted principally of:\n| · | the ownership of fee or long-term leasehold interests in properties used in our cinema exhibition activities or which were acquired for the development of cinemas or cinema-based real estate development projects; |\n\n| · | the acquisition and development of fee interests in land; |\n\n| · | the licensing to production companies of the use of our live theatres; and, |\n\n| · | the redevelopment of our existing fee-owned cinema or live theatre sites to their highest and best use. |\n\n\nCinema Exhibition\nOur cinema revenue consists primarily of admissions, Food & Beverage (“F&B”), advertising and theater rentals. Cinema operating expense consists of the costs directly attributable to the operation of the cinemas, including film rent expense, operating costs, and occupancy costs. Cinema revenue and expense fluctuate with the availability of quality first run films and the numbers of weeks such first run films stay in the market. For a breakdown of our current cinema assets that we own and/or manage, please see Part I, Item 1 – Our Business of our 2018 Form 10-K.\n\nWhile our capital projects in recent years have been focused in growing our real estate segment, we have over the past two years placed special emphasis on the expansion and upgrading of our cinema exhibition portfolio, as discussed below:\n\nCinema Additions (including re-openings)\nThe latest additions and enhancements to our cinema portfolio are as follows:\n| · | Opening our first dine-in concept, “Spotlight” in the United States: On March 30, 2018 we finished the conversion of one wing (six auditoriums) at our Reading Cinema in Murrieta, California (Cal Oaks) to our dine-in concept brand, “Spotlight”. |\n\n| · | AU and NZ Additions/Refurbishments On January 30, 2019, we purchased the tenant’s interest and other operating assets of an established four-screen cinema in Devonport, Tasmania, Australia, for $1.4 million (AU$1.95 million). We commenced trading from this new cinema site on January 30, 2019. For the first quarter of 2019, we invested in two additional Gold Lounge auditoriums at our Harbour Town cinema. In 2017 and 2018, we improved eight theaters: Belmont, Rouse Hill, Courtenay Central, Napier, Charlestown, Elizabeth, Auburn and Rotorua. |\n\n| · | U.S. Refurbishments For the first quarter of 2019, we continued investing in refurbishments primarily at our Mililani cinema. During 2017 and 2018, we continued to invest in the refurbishment and enhancements of our existing cinemas, as contemplated by our strategic plan. During this period, seven locations had significant refurbishment work performed: our Cal Oaks, Valley Plaza and Grossmont locations in California; our Ward, Pearlridge and Mililani locations in Hawaii; and our Manville location in New Jersey. Continuing with our strategic plan, since 2017, we converted (or are in the process of conversion), 74 of our 245 U.S. auditoriums to luxury recliner seating. |\n\nCinema Pipeline\nDuring 2019, we currently plan to upgrade or begin the upgrade of 11 cinemas in the U.S., Australia, and New Zealand.\n\nWe have entered into lease agreements for four new cinemas in Australia (25 screens), which we anticipate will come on line in 2019 - 2021.\n\nOur focus with respect to new cinemas is on featuring state-of-the-art projection and sound, luxury recliner seating, enhanced F&B (typically including alcohol service) and typically at least one major TITAN type presentation screen. Our focus is on providing best in class services and amenities that will differentiate us from in-home and mobile viewing options. We believe that a night at the movies should be a special and premium experience and, indeed, that it must be in order to compete with the variety of options being offered to consumers through other platforms.\n\nThroughout 2019, we will also be focusing on the rollout and enhancement of our proprietary on-line ticketing capabilities and social media interfaces. These are intended to enhance the convenience of our offering and to promote customer affinity with the experience and product that we are offering.\n\n29\nCinema Closures\nWe evaluate the performance of each of our cinemas and, in some instances, we may decide to close an operation when it is not economically viable to continue to operate from the location. We did not close any theaters leased from third parties in 2018 or to date in 2019. While some of our theaters have encountered new competition, and while we believe that others will benefit from planned refurbishment and upgrading, none of our leased theaters are currently slated for closure.\n\nDuring January 2019, we closed our Courtenay Central cinema in Wellington, New Zealand due to seismic concerns. We are currently assessing the redevelopment of that property. It is currently anticipated that the cinema component will be upgraded and restored in connection with any such redevelopment.\n\nUpgrades to our Film Exhibition Technology and Theatre Amenities\nWe continue to focus in areas of the matured cinema business where we believe we have growth potential and ultimately, provide long-term value to our stockholders. These are (i) upgrading of our existing cinemas and (ii) developing new cinemas to provide our customers with premium offerings, including state-of-the-art presentation (including sound, lounges and bar service) and luxury seating. As of March 31, 2019, the upgrades to our theater circuits’ film exhibition technology and amenities are summarized in the following table:\n\n| |\n| |\n| | LocationCount | ScreenCount |\n| Screen Format |\n| Digital (all cinemas in our theatre circuit) | 60 | 484 |\n| IMAX | 1 | 1 |\n| TITAN XC and LUXE | 18 | 20 |\n| Dine-in Service |\n| Gold Lounge (AU/NZ)(1) | 10 | 27 |\n| Premium (AU/NZ)(2) | 11 | 21 |\n| Spotlight (U.S.)(3) | 1 | 6 |\n| Upgraded Food & Beverage menu (U.S.)(4) | 14 | n/a |\n| Premium Seating (recliner seating features) | 22 | 142 |\n| Liquor Licenses Obtained(5) | 28 | n/a |\n\n| (1) | Gold Lounge: This is our \"First Class Full Dine-in Service\" in our Australian and New Zealand cinemas, which includes upgraded F&B menu (with alcoholic beverages), luxury recliner seating features (intimate 25-50 seat cinemas) and waiter service. |\n\n| (2) | Premium Service: This is our \"Business Class Dine-in Service\" in our Australian and New Zealand cinemas, which typically includes upgraded F&B menu (some with alcoholic beverages) and may include luxury recliner seating features (less intimate 80-seat cinemas), but no waiter service. |\n\n| (3) | Spotlight Service: On March 30, 2018 we opened “Spotlight” our first dine-in cinema concept in the United States at Cal Oaks. Six of our 17 auditoriums at this theater feature this dine-in concept. |\n\n| (4) | Upgraded Food & Beverage Menu: Fourteen of our US theaters feature an elevated food and beverage menu served from a common counter, which includes, without limitation, beer, wine and/or spirits and a food menu beyond traditional concessions. We have worked with former Food Network executives to create a menu of locally inspired and freshly prepared items. |\n\n| (5) | Liquor Licenses: Licenses are applicable at each cinema location, rather than each theatre auditorium. For accounting purposes, we capitalize the cost of successfully purchasing or applying for liquor licenses meeting certain thresholds as an intangible asset due to long-term economic benefits derived on future sales of alcoholic beverages. |\n\n\nReal Estate\nOur operating properties currently consists of the following assets:\n| · | our Newmarket, Queensland ETC, our Belmont, Western Australia ETC, our Auburn, New South Wales ETC, our Townsville, Queensland ETC and our Wellington, New Zealand ETC; and, |\n\n| · | two (2) single-auditorium live theatres in Manhattan (Minetta Lane and Orpheum) and a four-auditorium live theater complex (including the accompanying ancillary retail and commercial tenants) in Chicago (The Royal George); and, |\n\n| · | our US Headquarters building in Culver City, California and our Australia corporate office building in Melbourne, Australia; and, |\n\n| · | the ancillary retail and commercial space at some of our non-ETC cinema properties. |\n\n\nIn February 2018, we entered into a one-year license agreement with Audible, Inc. a subsidiary of Amazon, at the Minetta Lane Theatre. This agreement was extended through March 2020, with an option to extend for one additional year through March 2021. Audible intends to continue to produce one to two character plays and special engagements for live performance, to record those productions making them available through Audible streaming service.\n\nIn addition, we have various parcels of unimproved real estate held for development in Australia and New Zealand and certain unimproved land in the United States, including some that was used in our legacy activities.\n30\n\nOur key real estate transactions in recent years are as follows:\n\nStrategic Acquisitions\n| · | Purchase of Land at Cannon Park, Australia. On June 13, 2018, we acquired a 163,000 square foot (15,150 square meter) parcel at our Cannon Park ETC, in connection with the restructuring of our relationship with the adjacent land owner. Prior to the restructuring, this parcel was commonly owned by us and the adjoining land owner. In the restructuring, the adjoining land owner conveyed to us its interest in the parcel for AU$1. We granted the adjoining land owner certain access rights. |\n\n| · | Purchase of Property in Auburn, Australia – On June 29, 2018, we added 20,870 square feet of land, improved with a 16,830 office building, to our Auburn/Redyard ETC. The property was acquired at auction for $3.5 million (AU$4.5 million) and is bordered by our existing ETC on three sides. The property is leased to Telstra through July 2022. This will allow us time to plan for the efficient integration of the property into our ETC. The final settlement payment was made in early October 2018. |\n\n\nValue-creating Opportunities\nWe are engaged in several real estate development projects to take our properties to their highest and best use. The most notable of these value-creating projects are as follows:\n| · | Redevelopment of 44 Union Square Property in New York, USA. We secured construction financing for our 44 Union Square property in December 2016 and have entered into a guaranteed maximum price construction management agreement with an affiliate of CNY. We anticipate that the project will be ready for the commencement of tenant fit-out in the second quarter of 2019. Retail and office leasing interest to date has been strong and, while no assurances can be given, we are currently in exclusive negotiations with respect to long-term leases covering approximately 90% of the net rentable area of the building. This redevelopment will add approximately 23,000 square footage of rentable space to the current square footage of the building for an approximate total of 73,322 square feet of rentable space, inclusive of anticipated BOMA (Building Owners and Managers Association) adjustments and subject to lease negotiations and the final tenant mix. |\n\n| · | Expansion Project for our Newmarket Shopping Center at an affluent suburb of Brisbane, Australia. In December 2017 we opened our eight-screen Reading Cinema with TITAN LUXE, including 10,355 square feet of additional retail space and 124 parking spaces. As of March 31, 2019, approximately 80% of this new retail space has been leased. |\n\n| · | Courtenay Central Re-Development in Wellington, New Zealand. – Located in the heart of Wellington - New Zealand’s capital city – this center is comprised of 161,071 square feet of land situated proximate to the Te Papa Tongarewa Museum (attracting over 1.5 million visitors annually), across the street from the site of Wellington’s newly announced convention center (estimated to open its doors in 2022) and at a major public transit hub. Damage from the 2016 earthquake necessitated demolition of our nine-story parking garage at the site. Further, unrelated seismic issues have caused us to close the existing cinema and significant portions of the retail structure while we reevaluate the property for redevelopment as an entertainment themed urban center with a major food and grocery component. Wellington continues to be rated as one of the top cities in the world in which to live, and we continue to believe that the Courtenay Central site is located in one of the most vibrant and growing commercial and entertainment precincts of Wellington. |\n\n\n31\n\n| § | Cinema 1,2,3 Redevelopment – In June 2017, we entered into an exclusive dealing and pre-development agreement with our adjoining neighbors, 260-264 LLC, to jointly develop the properties, currently home to Cinemas 1,2,3 and Anassa Taverna. Under the terms of the agreement, Reading and 260-264 LLC worked together on a comprehensive mixed-use plan to co-develop the properties located on 3rd Avenue, between 59th Street and 60th Streets, in New York City. The parties completed an initial feasibility study, analyzing various retail, entertainment and residential uses for the site and during 2018 continued to work on the terms of a final agreement for the development of the combined property. We do not presently believe that we will be able to come to an agreement with our neighbors for a joint development of our properties and, have, accordingly, begun developing plans for an approximately 96,000 square foot mixed use stand-alone development. Our Cinemas 1,2,3, property is located on Third Avenue in New York City, between 59th and 60th Streets across from Bloomingdales. |\n\n| · | Manukau Land Rezoning – In August 2016, the Auckland City Council up-zoned 64.0 acres of our property in Manukau from agricultural to light industrial use. The remaining 6.4 acres were already zoned for heavy industrial use. Our zoning enhancement goal having been achieved, in 2018, we worked with adjoining landholders to jointly advance necessary infrastructure improvement issues. We estimate that our property will support approximately 1.6 million square feet of improvements. We see this property as a future value realization opportunity for us. This tract is adjacent to the Auckland Airport, which is currently undergoing a major improvement and expansion project. |\n\n\nCorporate Matters\n\n| § | Stock Repurchase Program – Our Board approved a $25-million repurchase program approved on March 2, 2017, and extended on March 14, 2019, and extended it on March 14, 2019. Under this authorization Reading may repurchase its Class A Common Stock from time to time in accordance with the requirements of the Securities and Exchange Commission on the open market, in block trades and in privately negotiated transactions, depending on market conditions and other factors. The new authorization continues through March 2, 2021. To date we have repurchased 559,627 shares of Class A Common Stock for $8.8 million at an average price of $15.81 per share (excluding transaction costs). 566 shares were purchased during the quarter ended March 31, 2019 at an average price of $16.08 per share. This leaves $16.2 million available under the March 2, 2017 program, as extended, for repurchase as of March 31, 2019. |\n\n\nOur Financing Strategy\n\nOur treasury management is focused on cash management using cash balances to reduce debt. We have used cash generated from operations and other excess cash, to the extent not needed for capital expenditures, to pay down our loans and credit facilities providing us flexibility on our available loan facilities for future use and, thereby, reducing interest charges. On a periodic basis, we review the maturities of our borrowing arrangements and negotiate for renewals and extensions where necessary in the current circumstances.\n\nOn March 15, 2019, we amended our Revolving Corporate Markets Loan Facility with National Australia Bank (“NAB”) from a facility comprised of (i) a AU$66.5 million loan facility with an interest rate of 0.95% above the Bank Bill Swap Bid Rate (“BBSY”) and a maturity date of June 30, 2019 and (ii) a bank guarantee of AU$5.0 million at a rate of 1.90% per annum into a (i) AU$120.0 million corporate loan facility at rates of 0.85%-1.30% above BBSY depending on certain ratios with a due date of December 31, 2023, of which AU$80.0 million is revolving and AU$40.0 million is core and (ii) a bank guarantee facility of AU$5.0 million at a rate of 1.85% per annum. Prior to this, on June 12, 2018, we had extended the maturity of these facilities from June 30, 2019, to December 31, 2019. Such modifications of this particular term loan were not considered to be substantial under US GAAP.\n\nOn December 20, 2018, we restructured our Westpac Corporate Credit Facilities. The maturity of the 1st tranche (general/non-construction credit line) was extended to December 31, 2023, with the available facility being reduced from NZ$35.0 million to NZ$32.0 million. The facility bears an interest rate of 1.75% above the Bank Bill Bid Rate on the drawn down balance and a 1.1% line of credit charge on the entire facility. The 2nd tranche (construction line) with a facility of NZ$18.0 million was removed.\n\nOn March 5, 2019, we extended our current Bank of America credit facilities until May 1, 2020 (the $55.0 million credit line). We anticipate refinancing this credit line during the second quarter of 2019.\n\nRefer to our 2018 Form 10-K for more details on our cinema and real estate segments.\n32\nRESULTS OF OPERATIONS\n\nThe table below summarizes the results of operations for each of our principal business segments along with the non-segment information for the three months ended March 31, 2019 and March 31, 2018:\n\n\n| |\n| | Three Months Ended | % Change |\n| (Dollars in thousands) | March 31,2019 | March 31,2018 | Fav/(Unfav) |\n| SEGMENT RESULTS |\n| | Revenue |\n| | Cinema exhibition | $ | 57,986 | $ | 72,255 | (20) | % |\n| | Real estate | 5,431 | 6,008 | (10) | % |\n| | Inter-segment elimination | (1,866) | (2,391) | 22 | % |\n| | Total revenue | 61,551 | 75,872 | (19) | % |\n| | Operating expense |\n| | Cinema exhibition | (50,195) | (57,339) | 12 | % |\n| | Real estate | (2,445) | (2,384) | (3) | % |\n| | Inter-segment elimination | 1,866 | 2,391 | (22) | % |\n| | Total operating expense | (50,774) | (57,332) | 11 | % |\n| | Depreciation and amortization |\n| | Cinema exhibition | (4,157) | (3,765) | (10) | % |\n| | Real estate | (1,376) | (1,369) | (1) | % |\n| | Total depreciation and amortization | (5,533) | (5,134) | (8) | % |\n| | General and administrative expense |\n| | Cinema exhibition | (992) | (866) | (15) | % |\n| | Real estate | (451) | (574) | 21 | % |\n| | Total general and administrative expense | (1,443) | (1,440) | - | % |\n| | Segment operating income |\n| | Cinema exhibition | 2,642 | 10,285 | (74) | % |\n| | Real estate | 1,159 | 1,681 | (31) | % |\n| | Total segment operating income | $ | 3,801 | $ | 11,966 | (68) | % |\n| NON-SEGMENT RESULTS |\n| | Depreciation and amortization expense | (61) | (117) | 48 | % |\n| | General and administrative expense | (5,041) | (6,156) | 18 | % |\n| | Interest expense, net | (1,852) | (1,594) | (16) | % |\n| | Equity earnings of unconsolidated joint ventures | 34 | 257 | (87) | % |\n| | Other income (expense) | (20) | (82) | 76 | % |\n| | Income before income taxes | (3,139) | 4,274 | (> 100) | % |\n| | Income tax benefit (expense) | 1,042 | (1,170) | > 100 | % |\n| Net income (loss) | (2,097) | 3,104 | (> 100) | % |\n| | Less: net (income) loss attributable to noncontrolling interests | (16) | 22 | (> 100) | % |\n| Net income (loss) attributable to RDI common stockholders | $ | (2,081) | $ | 3,082 | (> 100) | % |\n| Basic EPS | $ | (0.09) | $ | 0.13 | (> 100) | % |\n\n“nm – not meaningful”\nConsolidated and Non-Segment Results:\n\n1st Quarter Net Results\n\nNet income attributable to RDI common stockholders decreased by $5.2 million to a $(2.1) million loss. Basic EPS for the quarter ended March 31, 2019 decreased by $0.22 to $(0.09) from the prior-year quarter, mainly attributable to decreases in revenue in both the Cinema and Real Estate business segments.\n\nRevenue for the three months ended March 31, 2019 decreased by 19%or $14.3 million, to $61.6 million compared to the same period prior year. The revenue decrease was due to a decrease in revenues from our cinema business primarily due to the weak film slate experienced by the Cinema business segment worldwide, the closure of our cinema in Courtenay Central due to seismic concerns, and a decrease in revenues from the Real Estate business segment primarily due to the closure of most of the net rentable area of Courtenay Central due to seismic concerns. Overseas revenues were also adversely impacted by the continued weakness of the Australian and New Zealand Dollar compared to the U.S. dollar.\n\nU.S. admissions for the first quarter 2019 were down 19% falling from $24.7 million to $19.9 million for the same period in the prior year. According to industry sources, U.S. box office for the period was down 16%, falling from $2.5 billion to $2.1 billion. Australia and New Zealand Box Office saw similar declines. Again, in the case of New Zealand, the situation was exacerbated by the closure of our cinema at Courtenay Central. Due to the fact that our occupancy costs with respect to our cinema operations are fixed, the decrease in revenues disproportionally impacts the earnings from these operations, even though our film rent, cinema level labor and costs of goods sold are largely variable.\n\n33\nLooking forward, The Avengers: Endgame has been setting box office records, having grossed more than $620 million in North America and more than $2.2 billion worldwide since its opening weekend of April 25, 2019.\n\nNon-Segment General & Administrative Expenses\nNon-segment general and administrative expense for the quarter ended March 31, 2019 decreased by 18%, or $1.1 million, to $5.0 million compared to the same period of the prior year, respectively. This decrease mainly relates to lower legal expenses, offset by an increase in administrative occupancy cost in New Zealand attributable to the temporary closure of our administrative offices at Courtenay Central and need to lease replacement office space in Wellington.\n\nIncome Tax Expense\nIncome tax expense for the quarter ended March 31, 2019, decreased 189%, or $2.2 million compared to the same quarter prior year. The change between 2019 and 2018 is primarily related to the pretax loss in the first quarter of 2019.\nBusiness Segment Results\n\nAt March 31, 2019, we leased or owned and operated 60 cinemas with 484 screens, which includes (i) one managed cinema with 4 (four) screens and (ii) our interests in certain unconsolidated joint ventures that total 3 (three) cinemas with 29 screens. In the first quarter of 2019, we acquired a proven 4-screen cinema in Devonport, Tasmania, Australia, increasing our cinema count to 60 and our screen count to 484. We also (i) owned and operated 5 (five) ETCs located in Newmarket Village (a suburb of Brisbane), Belmont (a suburb of Perth), Auburn (a suburb of Sydney) and Townsville (a suburb of Cannon Park) in Australia and Wellington in New Zealand, (ii) owned and operated our headquarters office buildings in Culver City (an emerging high-tech and communications hub in Los Angeles County) and Melbourne, Australia, (iii) owned and operated the fee interests in three developed commercial properties in Manhattan and Chicago improved with live theaters comprising 6 (six) stages and ancillary retail and commercial space (our fourth live theatre was closed at the end of 2015 as part of the redevelopment of 44 Union Square in New York City), (iv) owned a 75% managing member interest in a limited liability company, which in turn owns the fee interest in Cinemas 1,2,3, (v) held for development approximately 70.4 acres of developable industrial land located next to the Auckland Airport in New Zealand, (vi) owned a 50% managing member interest in a limited liability company, which in turn owns a 202-acre property in Coachella, California that is zoned approximately 150 acres for single-family residential use (maximum 550 homes) and approximately 50 acres for high density mixed use in the U.S., that is held for development, and, (vii) owned 197 acres principally in Pennsylvania from our legacy railroad business, including the Reading Viaduct in downtown Philadelphia.\n\nThe Company transacts business in Australia and New Zealand and is subject to risks associated with changing foreign currency exchange rates. The Australian and New Zealand dollars based on the spot rate weakened versus prior three month period against the U.S. dollar slightly negatively impacting the value of our assets and liabilities. The average rate for the three months ended March 31, 2019 and 2018 has also weakened by 9.4% and 6.3% respectively. This has decreased the value of our Australian and New Zealand revenues and expenses. Refer to Note 3 – Operations in Foreign Currency for further information.\n\n34\nCinema Exhibition\n\nThe following table details our cinema exhibition segment operating results for the three months ended March 31, 2019 and March 31, 2018, respectively:\n\n\n| |\n| | % Change |\n| | Three Months Ended | Fav/(Unfav) |\n| (Dollars in thousands) | March 31,2019 | % of Revenue | March 31,2018 | % of Revenue | Three Months Ended |\n| REVENUE |\n| | United States | Admissions revenue | $ | 19,913 | 34% | $ | 24,706 | 34% | (19) | % |\n| | Food & beverage revenue | 9,575 | 17% | 10,765 | 15% | (11) | % |\n| | Advertising and other revenue | 2,545 | 4% | 2,516 | 3% | 1 | % |\n| | $ | 32,033 | 55% | $ | 37,987 | 53% | (16) | % |\n| | Australia | Admissions revenue | $ | 14,037 | 24% | $ | 17,051 | 24% | (18) | % |\n| | Food & beverage revenue | 6,061 | 10% | 7,837 | 11% | (23) | % |\n| | Advertising and other revenue | 1,343 | 2% | 1,829 | 3% | (27) | % |\n| | $ | 21,441 | 37% | $ | 26,717 | 37% | (20) | % |\n| | New Zealand | Admissions revenue | $ | 2,991 | 5% | $ | 4,934 | 7% | (39) | % |\n| | Food & beverage revenue | 1,309 | 3% | 2,266 | 3% | (42) | % |\n| | Advertising and other revenue | 212 | 0% | 351 | 0% | (40) | % |\n| | $ | 4,512 | 8% | $ | 7,551 | 10% | (40) | % |\n| |\n| | Total revenue | $ | 57,986 | 100% | $ | 72,255 | 100% | (20) | % |\n| OPERATING EXPENSE |\n| | United States | Film rent and advertising cost | $ | (10,127) | 17% | $ | (12,875) | 18% | 21 | % |\n| | Food & beverage cost | (2,322) | 4% | (2,302) | 3% | (1) | % |\n| | Occupancy expense | (6,945) | 12% | (7,202) | 10% | 4 | % |\n| | Other operating expense | (10,174) | 18% | (9,942) | 14% | (2) | % |\n| | $ | (29,568) | 51% | $ | (32,321) | 45% | 9 | % |\n| | Australia | Film rent and advertising cost | $ | (6,279) | 11% | $ | (7,699) | 11% | 18 | % |\n| | Food & beverage cost | (1,115) | 2% | (1,594) | 2% | 30 | % |\n| | Occupancy expense | (3,962) | 7% | (4,251) | 6% | 7 | % |\n| | Other operating expense | (5,415) | 9% | (5,754) | 8% | 6 | % |\n| | $ | (16,771) | 29% | $ | (19,298) | 27% | 13 | % |\n| | New Zealand | Film rent and advertising cost | $ | (1,336) | 3% | $ | (2,232) | 3% | 40 | % |\n| | Food & beverage cost | (292) | 1% | (491) | 1% | 41 | % |\n| | Occupancy expense | (803) | 1% | (1,344) | 2% | 40 | % |\n| | Other operating expense | (1,425) | 2% | (1,653) | 2% | 14 | % |\n| | $ | (3,856) | 7% | $ | (5,720) | 8% | 33 | % |\n| |\n| | Total operating expense | $ | (50,195) | 87% | $ | (57,339) | 79% | 12 | % |\n| DEPRECIATION, AMORTIZATION, GENERAL AND ADMINISTRATIVE EXPENSE |\n| | United States | Depreciation and amortization | $ | (2,626) | 5% | $ | (2,121) | 3% | (24) | % |\n| | General and administrative expense | (604) | 1% | (545) | 1% | (11) | % |\n| | $ | (3,230) | 6% | $ | (2,666) | 4% | (21) | % |\n| | Australia | Depreciation and amortization | $ | (1,181) | 2% | $ | (1,204) | 2% | 2 | % |\n| | General and administrative expense | (387) | 1% | (299) | 0% | (29) | % |\n| | $ | (1,568) | 3% | $ | (1,503) | 2% | (4) | % |\n| | New Zealand | Depreciation and amortization | $ | (350) | 1% | $ | (440) | 1% | 20 | % |\n| | General and administrative expense | (1) | 0% | (22) | 0% | 95 | % |\n| | $ | (351) | 1% | $ | (462) | 1% | 24 | % |\n| |\n| | Total depreciation, amortization, general and administrative expense | $ | (5,149) | 10% | $ | (4,631) | 6% | (11) | % |\n| OPERATING INCOME – CINEMA |\n| | United States | $ | (765) | (1)% | $ | 3,000 | 4% | (126) | % |\n| | Australia | 3,102 | 5% | 5,916 | 8% | (48) | % |\n| | New Zealand | 305 | 1% | 1,369 | 2% | (78) | % |\n| | Total Cinema operating income | $ | 2,642 | 5% | $ | 10,285 | 14% | (74) | % |\n\n\n“nm – not meaningful”\n\n35\n1st Quarter Results\n\nCinema Segment operating income\nCinema segment operating income decreased by 74%, or $7.6 million, to $2.6 million for the quarter ended March 31, 2019 compared to March 31, 2018, primarily driven by decreased operating income in the U.S., Australia, and New Zealand, which was due to a decrease in attendance worldwide, and fluctuations in average ticket price (“ATP”), and spend per patron (“SPP”) as outlined below.\n\nRevenue\nCinema revenue decreased by 20%, or $14.3 million, to $58.0 million for the quarter ended March 31, 2019 compared to March 31, 2018, primarily attributable to a weak foreign currency exchange rate, and a weak film slate worldwide.\n\nThe top box office performers for the first quarter of 2019 included “Captain Marvel”, ($5.1 million), “Aquaman,” ($2.9 million) and “How to Train Your Dragon: The Hidden World,” ($2.7 million), did not stack up well against the top films for the same period 2018, which included major films such as “Black Panther,” “Jumanji: Welcome to the Jungle,” and “The Greatest Showman,” (which combined totaled $15.0 million). We believe that the first quarter of 2019 results are principally the product of the film available for cinema exhibition, and not a reflection of declining consumer interest in cinema as a beyond-the-home source of entertainment.\n\nBelow are the changes in our cinema revenue by market:\n| · | U.S. cinema revenue decreased by 16%, or $6.0 million, to $32.0 million, due to a 22% decrease in attendance, offset by a 12% increase SPP, and a 4% increase in ATP. |\n\n| · | Australia cinema revenue decreased by 20%, or $5.3 million, to $21.4 million, primarily due to a 15% decrease in attendance, a 9% decrease in SPP, and a 4% decrease in ATP. |\n\n| · | New Zealand cinema revenue decreased by 40%, or $3.0 million, to $4.5 million versus the same period in 2018, due to a decrease of 40% in attendance, while ATP and SPP remained relatively flat. The decrease in New Zealand was materially greater than that in the U.S. and Australia due to the closure of our Courtenay Central cinema in January. |\n\n\nMore recently “Avengers:Endgame” had the biggest box office opening of any film since the opening weekend of April 25, 2019 with $620 million in North America box office and $2.2 billion in worldwide box office. Slated for release this spring and summer are a number of potentially strong box office performers, including “John Wick Chapter 3,” “Aladdin”, “Godzilla: King of the Monsters”, “Men in Black: International,” “Toy Story 4,” and “Spider-Man: Far From Home.”\n\nOperating expense\nOperating expense for the quarter ended March 31, 2019 decreased by 12%, to $50.2 million primarily attributable to (i) lower film rent expense driven by lower admissions revenue, and (ii) lower F&B costs due to lower F&B revenue primarily in Australia and New Zealand.\n\nOperating expense as a percentage of gross revenue has increased to 87% for the first quarter of 2019, compared to 79% for the same period in 2018, due to the lower than anticipated revenue in our box office and the fact that our occupancy costs are generally fixed, and cannot be adjusted to reflect such lower admission levels.\n\nDepreciation, amortization, general and administrative expense\nDepreciation, amortization, general and administrative expense for the quarter ended March 31, 2019 increased by 11%, or $0.5 million, to $5.1 million mainly due to the depreciation related to the completion of our capital improvements placed into service in the U.S.\n36\nReal Estate\nThe following table details our real estate segment operating results for the three months ended March 31, 2019 and 2018, respectively:\n\n\n\n| |\n| | % Change |\n| | Three Months Ended | Fav/(Unfav) |\n| (Dollars in thousands) | March 31,2019 | % ofRevenue | March 31,2018 | % ofRevenue | Three Months Ended |\n| REVENUE |\n| | United States | Live theater rental and ancillary income | $ | 936 | 17% | $ | 599 | 10% | 56 | % |\n| | Property rental income | 52 | 1% | 56 | 1% | (7) | % |\n| | 988 | 18% | 655 | 11% | 51 | % |\n| | Australia | Property rental income | 3,916 | 72% | 4,154 | 69% | (6) | % |\n| | New Zealand | Property rental income | 527 | 10% | 1,199 | 20% | (56) | % |\n| |\n| | Total revenue | $ | 5,431 | 100% | $ | 6,008 | 100% | (10) | % |\n| OPERATING EXPENSE |\n| | United States | Live theater cost | $ | (298) | 5% | $ | (296) | 5% | (1) | % |\n| | Property cost | (158) | 3% | (134) | 2% | (18) | % |\n| | Occupancy expense | (151) | 3% | (163) | 3% | 7 | % |\n| | (607) | 11% | (593) | 10% | (2) | % |\n| | Australia | Property cost | (701) | 13% | (752) | 13% | 7 | % |\n| | Occupancy expense | (692) | 13% | (567) | 9% | (22) | % |\n| | (1,393) | 26% | (1,319) | 22% | (6) | % |\n| | New Zealand | Property cost | (298) | 5% | (321) | 5% | 7 | % |\n| | Occupancy expense | (147) | 3% | (150) | 2% | 2 | % |\n| | (445) | 8% | (471) | 8% | 6 | % |\n| |\n| | Total operating expense | $ | (2,445) | 45% | $ | (2,383) | 40% | (3) | % |\n| DEPRECIATION, AMORTIZATION, GENERAL AND ADMINISTRATIVE EXPENSE |\n| | United States | Depreciation and amortization | $ | (195) | 4% | $ | (192) | 3% | (2) | % |\n| | General and administrative expense | (159) | 3% | (163) | 3% | 2 | % |\n| | (354) | 7% | (355) | 6% | - | % |\n| | Australia | Depreciation and amortization | $ | (926) | 17% | $ | (909) | 15% | (2) | % |\n| | General and administrative expense | (292) | 5% | (411) | 7% | 29 | % |\n| | (1,218) | 22% | (1,320) | 22% | 8 | % |\n| | New Zealand | Depreciation and amortization | (256) | 5% | (269) | 4% | 5 | % |\n| | General and administrative expense | — | 0% | — | 0% | - | % |\n| | (256) | 5% | (269) | 4% | 5 | % |\n| |\n| | Total depreciation, amortization, general and administrative expense | $ | (1,828) | 34% | $ | (1,944) | 32% | 6 | % |\n| OPERATING INCOME - REAL ESTATE |\n| | United States | $ | 27 | 0% | $ | (293) | (5)% | 109 | % |\n| | Australia | 1,305 | 24% | 1,515 | 25% | (14) | % |\n| | New Zealand | (174) | (3)% | 459 | 8% | (138) | % |\n| | Total real estate operating income | $ | 1,158 | 21% | $ | 1,681 | 28% | (31) | % |\n\n\n1st Quarter Results\n\nReal Estate Segment income\nReal estate segment operating income decreased by 31%, or $0.5 million, to $1.2 million for the quarter ended March 31, 2019 compared to March 31, 2018, primarily due to the closure of most of the net rentable area of Courtenay Central; offset by an increase in Live Theatre segment revenue of 56%, or $0.3 million, to $0.9 million.\n\nRevenue\nReal estate revenue for the quarter decreased by 10%, or $0.6 million, to $5.4 million primarily due to a weak foreign currency exchange rate and a decrease in revenues from our New Zealand segment, principally related to the closure of portions of Courtenay Central.\n\nOperating expense\nOperating expense for the quarter ended March 31, 2019 remained flat at $2.4 million.\n\nDepreciation, amortization, general and administrative expense\nDepreciation, amortization, general and administrative expense for the quarter ended March 31, 2019 decreased by 6%, or $0.1 million, to $1.8 million primarily driven by a weak foreign currency exchange rate and a decrease in general and administrative expenses in Australia.\n\nLIQUIDITY AND CAPITAL RESOURCES\n\nOur cinema exhibition business plan is to enhance our current cinemas where it is financially reasonable to do so; develop our specialty cinemas in select markets; expand our food and beverage offering, and continue on an opportunistic basis, to identify, develop, and acquire cinema properties that allow us to leverage our cinema expertise over a larger operating base.\n37\n\nOur real estate business is to complete the redevelopment of 44 Union Square in New York City; to reassess and master-plan the Cinemas 1,2,3 property for redevelopment as a stand-alone 96,000 square foot mixed use property and in the interim to continue to use it as a cinema; to continue the build-out of our Newmarket Village and Auburn ETCs and the master planning of the expansion of our Townsville ETC in Australia; to master plan and consider the redevelopment of our Courtenay Central site in New Zealand into an urban entertainment center with a focus on cinema exhibition, food and beverage, and grocery store uses; and in Manukau, New Zealand, to develop in concert with other major land owners, of plans for the development of the infrastructure needed to support the construction of income-producing improvements; and to continue to be sensitive to opportunities to convert our entertainment assets to higher and better uses, or, where appropriate, to dispose of such assets. We will also continue to explore potential synergistic acquisitions that may not readily fall into either our cinema or real estate segment.\nThe success of our Company is dependent on our ability to execute these business plans effectively through our available resources (both cash and available borrowing facilities) while still timely addressing our liquidity risk. Liquidity risk is the risk relating to our ability to meet our financial obligations when they come due. At the present, our financial obligations arise mainly from capital expenditure needs, working capital requirements, and debt servicing requirements. We manage the liquidity risk by ensuring our ability to generate sufficient cash flows from operating activities and to obtain adequate, reasonable financing or extension of maturity dates under reasonable arrangements, and/or to convert non-performing or non-strategic assets into cash.\n\nAt March 31, 2019, our consolidated cash and cash equivalents totaled $12.6 million. Of this amount, $3.2 million and $0.7 million were held by our Australian and New Zealand subsidiaries, respectively. Our intention is to indefinitely reinvest Australian earnings locally, but not indefinitely reinvest New Zealand earnings. If the Australian earnings were used to fund U.S. operations, they would be subject to additional state income taxes upon repatriation.\n\nThe changes in cash and cash equivalents for the three months ended March 31, 2019 and 2018 are discussed as follows:\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 | % Change |\n| Net cash provided by (used in) operating activities | $ | (3,841) | $ | 2,452 | (257) | % |\n| Net cash provided by (used in) investing activities | (12,613) | (23,491) | (46) | % |\n| Net cash provided by (used in) financing activities | 15,918 | 16,161 | 2 | % |\n| Effect of exchange rate changes on cash and cash equivalents | 57 | (122) | 147 | % |\n| Increase (decrease) in cash and cash equivalents | $ | (479) | $ | (5,000) | 90 | % |\n\n\nOperating activities\nCash provided by (used in) operating activities for the first three months of 2019 decreased by $6.3 million, to ($3.8) million primarily driven by $4.7 million lower cash inflows from operating activities as well as a $1.5 million decrease in net operating assets.\n\nInvesting activities\nCash used in investing activities during the three months ended March 31, 2019 decreased by $10.9 million compared to the same period in 2018, to net cash used of $12.6 million, primarily due to a decrease in our cinema refurbishment activities compared to the 2018 quarter and the substantial completion of the upgrading and expansion of our Newmarket and Auburn/Redyard ETCs in 2018. It is anticipated that spending on our cinema activities will pick up over the remainder of the year.\n\nFinancing Activities\nThe $15.9 million net cash provided by financing activities during the three months ended March 31, 2019 was primarily related to $22.3 million of new borrowings, offset by $6.1 million of loan repayments. Proceeds from these new borrowings related principally to the ongoing construction of our 44 Union Square project in Manhattan of $6.7 million and to fund the capital improvements in our cinemas and real estate segments.\n\nOn March 2, 2017, the Board of Directors authorized a stock repurchase program to repurchase up to $25.0 million of Reading’s Class A Common Stock. The Board on March 14, 2019, extended that program to March 2, 2021. At March 31, 2019, there was $16.2 million of capacity remaining in that authorization.\n38\n\nWe manage our cash, investments and capital structure so we are able to meet the short-term and long-term obligations of our business, while maintaining financial flexibility and liquidity. We forecast, analyze and monitor our cash flows to enable investment and financing within the overall constraints of our financial strategy. In recent years, our treasury management has been focused on more aggressive cash management using cash balances to reduce debt. In earlier years, we maintained significant cash balances in our bank accounts. We have used cash generated from operations and other excess cash, to the extent not needed for any capital expenditures, to pay down our loans and credit facilities providing us some flexibility on our available loan facilities for future use and thereby, reducing interest charges.\n\n\nThe table below presents the changes in our total available resources (cash and borrowings), debt-to-equity ratio, working capital and other relevant information addressing our liquidity for the three months ended March 31, 2019 and preceding four years:\n\n\n| |\n| |\n| | As of andfor the3-MonthsEnded | Year Ended December 31 |\n| ($ in thousands) | 3/31/2019 | 2018 | 2017 | 2016 | 2015 (2) |\n| Total Resources (cash and borrowings) |\n| Cash and cash equivalents (unrestricted) | $ | 12,648 | $ | 13,127 | $ | 13,668 | $ | 19,017 | $ | 19,702 |\n| Unused borrowing facility | 107,111 | 85,886 | 137,231 | 117,599 | 70,134 |\n| Restricted for capital projects (1) | 23,566 | 30,318 | 62,280 | 62,024 | 10,263 |\n| Unrestricted capacity | 83,545 | 55,568 | 74,951 | 55,575 | 59,871 |\n| Total resources at period end | 119,759 | 99,013 | 150,899 | 136,616 | 89,836 |\n| Total unrestricted resources at period end | 96,193 | 68,695 | 88,619 | 74,592 | 79,573 |\n| Debt-to-Equity Ratio |\n| Total contractual facility | $ | 290,879 | $ | 252,929 | $ | 271,732 | $ | 266,134 | $ | 207,075 |\n| Total debt (gross of deferred financing costs) | 184,099 | 167,043 | 134,501 | 148,535 | 130,941 |\n| Current | 40,077 | 30,393 | 8,109 | 567 | 15,000 |\n| Non-current | 143,691 | 136,650 | 126,392 | 147,968 | 115,941 |\n| Finance lease liabilities | 331 | — | — | — | — |\n| Total book equity(2) | 179,946 | 180,547 | 181,618 | 146,890 | 138,951 |\n| Debt-to-equity ratio | 1.02 | 0.93 | 0.74 | 1.01 | 0.94 |\n| Changes in Working Capital |\n| Working capital (deficit) (3) | $ | (77,236) | $ | (55,270) | $ | (46,971) | $ | 6,655 | $ | (35,581) |\n| Current ratio | 0.28 | 0.35 | 0.42 | 1.10 | 0.51 |\n| Capital Expenditures (including acquisitions) | $ | 11,476 | $ | 56,827 | $ | 76,708 | $ | 49,166 | $ | 53,119 |\n\n\n| (1) | This relates to the construction facilities specifically negotiated for: (i) Union Square redevelopment project, obtained in December 2016, and (ii) New Zealand construction projects, obtained in May 2015. The New Zealand construction loan expired December 31, 2018. |\n\n| (2) | Certain 2015 balances included the restatement impact as a result of a change in accounting principle (see Note 2 – Summary of Significant Accounting Policies – Accounting Changes). Certain 2017 and 2016 balances included the restatement impact as a result of a prior period financial statement correction of immaterial errors (see Note 2 – Summary of Significant Accounting Policies – Prior Period Financial Statement Correction of Immaterial Errors). |\n\n| (3) | Typically our working capital (deficit) is negative as we receive revenue from our cinema business ahead of the time that we have to pay our associated liabilities. We use the money we receive to pay down our borrowings in the first instance |\n\n\nCONTRACTUAL OBLIGATIONS, COMMITMENTS AND CONTINGENCIES\n\nThe following table provides information with respect to the maturities and scheduled principal repayments of our recorded contractual obligations and certain of our commitments and contingencies, either recorded or off-balance sheet, as of March 31, 2019:\n\n\n| |\n| |\n| (Dollars in thousands) | 2019 | 2020 | 2021 | 2022 | 2023 | Thereafter | Total |\n| Debt(1) | $ | 40,016 | $ | 48,799 | $ | 258 | $ | 270 | $ | 58,309 | $ | 8,204 | $ | 155,856 |\n| Operating leases, including imputed interest | 23,566 | 31,434 | 31,717 | 31,901 | 31,018 | 169,221 | 318,857 |\n| Finance leases, including imputed interest | 131 | 101 | 53 | 43 | 30 | — | 358 |\n| Subordinated debt(1) | — | — | — | — | — | 27,913 | 27,913 |\n| Pension liability | 513 | 684 | 684 | 684 | 684 | 1,979 | 5,228 |\n| Village East purchase option(3) | 5,900 | — | — | — | — | — | 5,900 |\n| Estimated interest on debt (2) | 7,717 | 6,098 | 5,156 | 5,157 | 5,134 | 7,498 | 36,761 |\n| Total | $ | 77,844 | $ | 87,116 | $ | 37,868 | $ | 38,055 | $ | 95,175 | $ | 214,815 | $ | 550,873 |\n\n\n| (1) | Information is presented gross of deferred financing costs. |\n\n| (2) | Estimated interest on debt is based on the anticipated loan balances for future periods and current applicable interest rates. |\n\n| (3) | Represents the lease liability of the option associated with the ground lease purchase of the Village East Cinema. |\n\n\nRefer to Note 13 – Commitments and Contingencies for additional information.\n\n\n\n39\nLitigation\nWe are currently involved in certain legal proceedings and, as required, have accrued estimates of probable and estimable losses for the resolution of these claims.\n\nWhere we are the plaintiffs, we expense all legal fees on an on-going basis and make no provision for any potential settlement amounts until received. In Australia, the prevailing party is usually entitled to recover its attorneys’ fees, which typically work out to be approximately 60% of the amounts actually spent where first class legal counsel is engaged at customary rates. Where we are a plaintiff, we have likewise made no provision for the liability for the defendant’s attorneys' fees in the event we are determined not to be the prevailing party.\n\nWhere we are the defendants, we accrue for probable damages that insurance may not cover as they become known and can be reasonably estimated. In our opinion, any claims and litigation in which we are currently involved are not reasonably likely to have a material adverse effect on our business, results of operations, financial position, or liquidity. It is possible, however, that future results of the operations for any particular quarterly or annual period could be materially affected by the ultimate outcome of the legal proceedings. Please refer to Item 3 – Legal Proceedings in our 2018 Form 10-K for more information. There have been no material changes to our litigation since our 2018 Form 10-K, except as set forth in Note 13 – Commitments and Contingencies in the accompanying consolidated financial statements included in this Form 10-Q.\n\nOff-Balance Sheet Arrangements\n\nSee Note 13 – Commitments and Contingencies to the Consolidated Financial Statements included herein on this report, there are no off-balance sheet arrangements or obligations (including contingent obligations) that have, or are reasonably likely to have, a current or future material effect on our financial condition, changes in the financial condition, revenue or expense, results of operations, liquidity, capital expenditures or capital resources.\n\nCRITICAL ACCOUNTING POLICIES\n\nWe believe that the application of the following accounting policies requires significant judgments and estimates in the preparation of our Consolidated Financial Statements and hence, are critical to our business operations and the understanding of our financial results:\n\n(i) Impairment of Long-lived Assets (other than Goodwill and Intangible Assets with indefinite lives) – we evaluate our long-lived assets and finite-lived intangible assets using historical and projected data of cash flows as our primary indicator of potential impairment and we take into consideration the seasonality of our business. If the sum of the estimated, undiscounted future cash flows is less than the carrying amount of the asset, then an impairment is recognized for the amount by which the carrying value of the asset exceeds its estimated fair value based on an appraisal or a discounted cash flow calculation. For certain non-income producing properties or for those assets with no consistent historical or projected cash flows, we obtain appraisals or other evidence to evaluate whether there are impairment indicators for these assets.\n\nBesides the write-down of the carrying amount of our parking structure adjacent to our Courtenay Central ETC in Wellington, New Zealand due to earthquake damage during the 4th quarter of 2016, no other impairment losses were recorded for long-lived and finite-lived intangible assets for the three years ended December 31, 2018. Refer to Note 20 – Insurance Recoveries on Impairment and Related Losses due to Earthquake in the 2018 Form 10-K for further details.\n\n(ii) Impairment of Goodwill and Intangible Assets with indefinite lives – goodwill and intangible assets with indefinite useful lives are not amortized, but instead, tested for impairment at least annually on a reporting unit basis. The impairment evaluation is based on the present value of estimated future cash flows of each reporting unit plus the expected terminal value. There are significant assumptions and estimates used in determining the future cash flows and terminal value. The most significant assumptions include our cost of debt and cost of equity assumptions that comprise the weighted average cost of capital for each reporting unit. Accordingly, actual results could vary materially from such estimates.\n\nNo impairment losses were recorded for goodwill and indefinite-lived intangible assets for the three months ended March 31, 2019.\n\nFINANCIAL RISK MANAGEMENT\n\nInternational Business Risks\nOur international operations are subject to a variety of risks, including the following:\n\n| · | Currency Risk: while we report our earnings and net assets in U.S. dollars, substantial portions of our revenue and of our obligations are denominated in either Australian or New Zealand dollars. The value of these currencies can vary significantly compared to the U.S. dollar and compared to each other. We do not hedge the currency risk, but rather have relied upon the 40 |\n| natural hedges that exist as a result of the fact that our film costs are typically fixed as a percentage of the box office, and our local operating costs and obligations are likewise typically denominated in local currencies. However, we do have intercompany debt and our ability to service this debt could be adversely impacted by declines in the relative value of the Australian and New Zealand dollar compared to the U.S. dollar. Also, our use of local borrowings to mitigate the business risk of currency fluctuations has reduced our flexibility to move cash between jurisdictions. Set forth below is a chart of the exchange ratios between these three currencies since 1996: |\n\n\n\n\nIn recent periods, we have repaid intercompany debt and used the proceeds to fund capital investment in the United States. Accordingly, our debt levels in Australia are higher than they would have been if funds had not been returned for such purposes. On a company wide basis, this means that a reduction in the relative strength of the U.S. dollar versus the Australian dollar and/or the New Zealand dollar will effectively raise the overall cost of our borrowing and capital and make it more expensive to return funds from the United States to Australia and New Zealand.\n\nOur exposure to interest rate risk arises out of our intermediate term floating-rate borrowings. To manage the risk, we utilize interest rate derivative contracts to convert certain floating-rate borrowings into fixed-rate borrowings. It is the Company’s policy to enter into interest rate derivative transactions only to the extent considered necessary to meet its objectives as stated above. The Company does not enter into these transactions or any other hedging transactions for speculative purposes.\n\nInflation\n\nWe continually monitor inflation and the effects of changing prices. Inflation increases the cost of goods and services used. Competitive conditions in many of our markets restrict our ability to recover fully the higher costs of acquired goods and services through price increases. We attempt to mitigate the impact of inflation by implementing continuous process improvement solutions to enhance productivity and efficiency and, as a result, lower costs and operating expenses. The effects of inflation have not had a material impact on our operations and the resulting financial position or liquidity.\n\n\n\n41\n\nFORWARD LOOKING STATEMENTS\n\nOur statements in this interim quarterly report contain a variety of forward-looking statements as defined by the Securities Litigation Reform Act of 1995. Forward-looking statements reflect only our expectations regarding future events and operating performance and necessarily speak only as of the date the information was prepared. No guarantees can be given that our expectation will in fact be realized, in whole or in part. You can recognize these statements by our use of words such as, by way of example, “may”, “will”, “expect”, “believe”, and “anticipate” or other similar terminology.\n\nThese forward-looking statements reflect our expectation after having considered a variety of risks and uncertainties. However, they are necessarily the product of internal discussion and do not necessarily completely reflect the views of individual members of our Board of Directors or of our management team. Individual Board members and individual members of our management team may have a different view as to the risks and uncertainties involved, and may have different views as to future events or our operating performance.\n\nAmong the factors that could cause actual results to differ materially from those expressed in or underlying our forward-looking statements are the following:\n| · | with respect to our cinema operations: |\n\n| o | the number and attractiveness to moviegoers of the films released in future periods; |\n\n| o | the amount of money spent by film distributors to promote their motion pictures; |\n\n| o | the licensing fees and terms required by film distributors from motion picture exhibitors in order to exhibit their films; |\n\n| o | the comparative attractiveness of motion pictures as a source of entertainment and willingness and/or ability of consumers (i) to spend their dollars on entertainment and (ii) to spend their entertainment dollars on movies in and outside the home environment; |\n\n| o | the extent to which we encounter competition from other cinema exhibitors, from other sources of outside-the-home entertainment, and from inside-the-home entertainment options, such as “home theaters” and competitive film product distribution technology, such as, by way of example, cable, satellite broadcast and Blu-ray/DVD rentals and sales, and so called “movies on demand;” |\n\n| o | the cost and impact of improvements to our cinemas, such as improved seating, enhanced food and beverage offerings and other improvements; |\n\n| o | disruptions from theater improvements; and |\n\n| o | the extent to and the efficiency with which we are able to integrate acquisitions of cinema circuits with our existing operations. |\n\n| · | with respect to our real estate development and operation activities: |\n\n| o | the rental rates and capitalization rates applicable to the markets in which we operate and the quality of properties that we own; |\n\n| o | the extent to which we can obtain on a timely basis the various land use approvals and entitlements needed to develop our properties; |\n\n| o | the risks and uncertainties associated with real estate development; |\n\n| o | the availability and cost of labor and materials; |\n\n| o | the ability to obtain all permits to construct improvements; |\n\n| o | the ability to finance improvements; |\n\n| o | the disruptions from construction; |\n\n| o | the possibility of construction delays, work stoppage and material shortage; |\n\n| o | competition for development sites and tenants; |\n\n| o | environmental remediation issues; |\n\n| o | the extent to which our cinemas can continue to serve as an anchor tenant that will, in turn, be influenced by the same factors as will influence generally the results of our cinema operations; |\n\n| o | the increased depreciation and amortization expenses as construction projects transition to leased real property; |\n\n| o | the ability to negotiate and execute joint venture opportunities and relationships; and |\n\n| o | certain of our activities are in geologically active areas, creating a risk of damage and/or disruption of real estate and/or cinema businesses from earthquakes. |\n\n42\n\n| · | with respect to our operations generally as an international company involved in both the development and operation of cinemas and the development and operation of real estate and previously engaged for many years in the railroad business in the United States: |\n\n| o | our ability to renew, extend or renegotiate our loans that mature in 2019; |\n\n| o | our ability to grow our Company and provide value to our stockholders; |\n\n| o | our ongoing access to borrowed funds and capital and the interest that must be paid on that debt and the returns that must be paid on such capital; |\n\n| o | expenses, management and Board distraction and other effects of the litigation efforts mounted by James Cotter, Jr. against the Company, including his efforts to cause a sale of voting control of the Company; |\n\n| o | the relative values of the currency used in the countries in which we operate; |\n\n| o | changes in government regulation, including by way of example, the costs resulting from the implementation of the requirements of Sarbanes-Oxley; |\n\n| o | our labor relations and costs of labor (including future government requirements with respect to pension liabilities, disability insurance and health coverage, and vacations and leave); |\n\n| o | our exposure from time to time to legal claims and to uninsurable risks such as those related to our historic railroad operations, including potential environmental claims and health-related claims relating to alleged exposure to asbestos or other substances now or in the future recognized as being possible causes of cancer or other health related problems; |\n\n| o | our exposure to cyber-security risks, including misappropriation of customer information or other breaches of information security; |\n\n| o | changes in future effective tax rates and the results of currently ongoing and future potential audits by taxing authorities having jurisdiction over our various companies; and |\n\n| o | changes in applicable accounting policies and practices. |\n\n\nThe above list is not necessarily exhaustive, as business is by definition unpredictable and risky, and subject to influence by numerous factors outside of our control, such as changes in government regulation or policy, competition, interest rates, supply, technological innovation, changes in consumer taste, the weather, and the extent to which consumers in our markets have the economic wherewithal to spend money on beyond-the-home entertainment. Refer to Item 1A Risk factors in the 2018 Form 10-K annual report for more information.\n\nGiven the variety and unpredictability of the factors that will ultimately influence our businesses and our results of operation, it naturally follows that no guarantees can be given that any of our forward-looking statements will ultimately prove to be correct. Actual results will undoubtedly vary and there is no guarantee as to how our securities will perform either when considered in isolation or when compared to other securities or investment opportunities.\n\nFinally, we undertake no obligation to update publicly or to revise any of our forward-looking statements, whether as a result of new information, future events or otherwise, except as may be required under applicable law. Accordingly, you should always note the date to which our forward-looking statements speak.\n\nAdditionally, certain of the presentations included in this interim quarterly report may contain “non-GAAP financial measures.” In such case, a reconciliation of this information to our GAAP financial statements will be made available in connection with such statements.\n43\n\nItem 3 –\nQuantitative and Qualitative Disclosure about Market Risk\n\nThe SEC requires that registrants include information about potential effects of changes in currency exchange and interest rates in their filings. Several alternatives, all with some limitations, have been offered. We base the following discussion on a sensitivity analysis that models the effects of fluctuations in currency exchange rates and interest rates. This analysis is constrained by several factors, including the following:\n| · | It is based on a single point in time; and |\n\n| · | It does not include the effects of other complex market reactions that would arise from the changes modeled. |\n\nAlthough the results of such an analysis may be useful as a benchmark, they should not be viewed as forecasts.\nAt March 31, 2019, approximately 33% and 11% of our assets were invested in assets denominated in Australian dollars (Reading Australia) and New Zealand dollars (Reading New Zealand), respectively, including approximately $3.9 million in cash and cash equivalents. At December 31, 2018, approximately 36% and 14% of our assets were invested in assets denominated in Australian dollars (Reading Australia) and New Zealand dollars (Reading New Zealand), including approximately $5.5 million in cash and cash equivalents.\n\nOur policy in Australia and New Zealand is to match revenues and expenses, whenever possible, in local currencies. As a result, we have procured a majority of our expenses in Australia and New Zealand in local currencies. Despite this natural hedge, recent movements in foreign currencies have had an effect on our current earnings. Although foreign currency has had an effect on our current earnings, the effect of the translation adjustment on our assets and liabilities noted in our other comprehensive income was an increase of $1.5 million for the three months ended March 31, 2019. As we continue to progress our acquisition and development activities in Australia and New Zealand, we cannot assure you that the foreign currency effect on our earnings will not be material in the future.\n\nHistorically, our policy has been to borrow in local currencies to finance the development and construction of our long-term assets in Australia and New Zealand whenever possible. As a result, the borrowings in local currencies have provided somewhat of a natural hedge against the foreign currency exchange exposure. Even so, and as a result of our issuance of subordinated Trust Preferred Securities in 2007, and their subsequent partial repayment, approximately 44% and 64% of our Australian and New Zealand assets, respectively, remain subject to such exposure, unless we elect to hedge our foreign currency exchange between the US and Australian and New Zealand dollars. If the foreign currency rates were to fluctuate by 10%, the resulting change in Australian and New Zealand assets would be $9.9 million and $4.6 million, respectively, and the change in our quarterly net income (loss) would be $0.2 million and ($0.1) million, respectively. Presently, we have no plan to hedge such exposure.\n\nWe record unrealized foreign currency translation gains or losses that could materially affect our financial position. As of March 31, 2019 and December 31, 2018, the balance of cumulative foreign currency translation adjustments was approximately $10.2 million gain and $8.7 million gain, respectively.\n\nHistorically, we maintain most of our cash and cash equivalent balances in short-term money market instruments with original maturities of three months or less. Due to the short-term nature of such investments, a change of 1% in short-term interest rates would not have a material effect on our financial condition.\n\nWe have a combination of fixed and variable interest rate loans. In connection with our variable interest rate loans, a change of approximately 1% in short-term interest rates would have resulted in approximately $239,000 increase or decrease in our quarterly interest expense.\n\nFor further discussion on market risks, please refer to International Business Risks included in Item 2, Part 1 of this Form 10-Q.\n44\n\nItem 4 –\nControls and Procedures\n\nWe maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s reports filed under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.\n\nUnder the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such, term is defined under Rule 13a-15(e) promulgated under the Exchange Act. Based upon that evaluation, we concluded that, as of March 31, 2019, our disclosure controls and procedures were effective.\n\nChanges in Internal Control over Financial Reporting\n\nThere were no other changes in our internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the quarter ended March 31, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n45\nPART II – Other Information\n\n\nItem 1 – Legal Proceedings\n\nThe information required under Part II, Item 1 (Legal Proceedings) is incorporated by reference to the information contained in Note 13 – Commitments and Contingencies to the Consolidated Financial Statements included herein in Part I, Item 1 (Financial Statements) on this Quarterly Report on Form 10-Q.\n\nIn the quarter ended March 31, 2019, the arbitration relating to the termination of Cotter, Jr.’s employment with our Company (Reading International, Inc. v. James J. Cotter, AAA Case No. 01-15-0004-2384, filed July 2015) was resolved. While our Company was the named claimant, this matter relates essentially to Cotter, Jr.’s claims for compensation and damages related to his termination as our Company’s president and chief executive officer which were originally included in the Derivative Action described in Note 13, above. The Arbitrator has determined that, while Cotter, Jr. did breach his obligations under his Employment Agreement with our Company, Cotter, Jr’s breaches were not sufficiently material to allow our Company relief from its obligations under the Employment Agreement to pay certain specified separation amounts, totaling $313,000 (the “Separation Payment Amount”). The arbitrator awarded this amount, plus interest at the rate of 10% from June 12, 2016, until the award was paid in full on March 6, 2019. The reserve set up by the Company in 2015 with respect to this claim has been reversed. The Arbitrator denied on substantive grounds Cotter, Jr’s claims for consequential damages and for damages based on various tort theories (including defamation) and/or upon wrongful termination claims and denied, on jurisdictional grounds, Cotter Jr’s claims that the unvested stock options granted to him under his Employment Agreement did not expire upon his termination and continued to be exercisable by him so long as he continued as a director of our Company. In total, Cotter, Jr., claimed specified damages in excess of $1,000,000 plus unspecified tort damages. While the award was less than half of the amount claimed by Cotter, Jr., and while finding that Cotter, Jr., was in breach of his agreement with our Company, the Arbitrator nevertheless determined that Cotter, Jr. was the prevailing party and awarded Cotter, Jr. $443,000 of his requested $787,769 in attorney’s fees and costs. The Arbitrator also assessed the costs of the arbitration against our Company and ordered a reimbursement of such costs paid to date by Cotter Jr. in the amount of $14,250. This amount is reflected in our Company’s financial statements. The determinations of the Arbitrator are final and binding on the parties, and not subject to appeal.\n\nFor further details on our legal proceedings, please refer to Item 3, Legal Proceedings, contained in our 2018 Form 10-K.\n\n\nItem 1A – Risk Factors\n\nThere have been no material changes in risk factors as previously disclosed in our 2018 Form 10-K.\n\n\nItem 2 – Unregistered Sales of Equity Securities and Use of Proceeds\n\nThere were no unregistered sales of equity securities during the periods covered by this report.\n\nThe following table summarizes our repurchases under the March 2, 2017, stock repurchase program up until March 31, 2019:\n\n| |\n| |\n| Period | Total Number of Shares Purchased | Average Price Paid per Share | Total Number of Shares Purchased as part of our Stock Buy-Back Program | Approximate Dollar Value of Shares that may yet be Purchased under the Stock Buy-Back Program |\n| March 2017 | 41,899 | $ | 15.99 | 41,899 | $ | 24,330,149 |\n| May 2017 | 98,816 | $ | 15.78 | 98,816 | $ | 22,771,316 |\n| June 2017 | 70,234 | $ | 16.39 | 70,234 | $ | 21,620,212 |\n| August 2017 | 160,489 | $ | 15.82 | 160,489 | $ | 19,081,288 |\n| September 2017 | 31,718 | $ | 15.77 | 31,718 | $ | 18,581,038 |\n| December 2017 | 6,567 | $ | 16.01 | 6,567 | $ | 18,475,900 |\n| February 2018 | 8,500 | $ | 16.98 | 8,500 | $ | 18,331,570 |\n| March 2018 | 10,138 | $ | 16.99 | 10,138 | $ | 18,159,364 |\n| April 2018 | 5,000 | $ | 16.12 | 5,000 | $ | 18,078,764 |\n| December 2018 | 125,700 | $ | 15.24 | 125,700 | $ | 16,162,529 |\n| March 2019 | 566 | $ | 16.08 | 566 | $ | 16,153,428 |\n| Total | 559,627 | $ | 15.81 | 559,627 | $ | 16,153,428 |\n\n\nFor a description of grants of stock to certain executives, see the Stock Based Compensation section under see Note 15 – Equity and Stock-Based Compensation to our Consolidated Financial Statements.\n46\n\n\nItem 3 – Defaults upon Senior Securities\n\nNone.\n\n\nItem 4 – Mine Safety Disclosure\n\nNot applicable.\n\n\n47\n\nItem 5 –\nOther Information\nNone\n\n\nItem 6 –\nExhibits\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n| |\n| 31.1 | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith. |\n| 31.2 | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith. |\n| 32 | Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, furnished herewith. |\n| 101.INS | XBRL Instance Document |\n| 101.SCH | XBRL Taxonomy Extension Schema |\n| 101.CAL | XBRL Taxonomy Extension Calculation |\n| 101.DEF | XBRL Taxonomy Extension Definition |\n| 101.LAB | XBRL Taxonomy Extension Labels |\n| 101.PRE | XBRL Taxonomy Extension Presentation |\n\n\n48\nSIGNATURES\n\nPursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\nREADING INTERNATIONAL, INC.\n\nDate: May 10, 2019\n\nBy: /s/ Ellen M. Cotter\nEllen M. Cotter\nChief Executive Officer\n\nDate: May 10, 2019\n\nBy: /s/ Gilbert Avanes\nGilbert Avanes\nInterim Chief Financial Officer\n\n\n\n\n\n\n49\n \n\nWhat is the increase or decrease in the percentage of net income to net cash provided by operating activities from 2018 to 2019?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nItem 1 – Financial Statements\\n3\\n Consolidated Balance Sheets (Unaudited) 3\\n Consolidated Statements of Income (Unaudited) 4\\n Consolidated Statements of Comprehensive Income (Unaudited) 5\\n Consolidated Statements of Cash Flows (Unaudited) 6\\n Notes to Consolidated Financial Statements (Unaudited) 7\\n Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations 28\\n Item 3 – Quantitative and Qualitative Disclosure about Market Risk 44\\n Item 4 – Controls and Procedures 45\\n PART II – Other Information 46\\n Item 1 – Legal Proceedings 46\\n Item 1A – Risk Factors 46\\n Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds 46\\n Item 3 – Defaults Upon Senior Securities 47\\n Item 5 – Other Information 48\\n Item 6 – Exhibits 48\\n SIGNATURES 49\\nCertifications\\n2\\nPART 1 – FINANCIAL INFORMATION\\nItem 1 - Financial Statements\\n\\nREADING INTERNATIONAL, INC.\\nCONSOLIDATED BALANCE SHEETS\\n(Unaudited; U.S. dollars in thousands, except share information)\\n\\n\\n| |\\n| |\\n| | March 31, | December 31, |\\n| | 2019 | 2018 |\\n| ASSETS | (unaudited) |\\n| Current Assets: |\\n| Cash and cash equivalents | $ | 12,648 | $ | 13,127 |\\n| Receivables | 7,094 | 8,045 |\\n| Inventory | 1,165 | 1,419 |\\n| Prepaid and other current assets | 9,642 | 7,667 |\\n| Total current assets | 30,549 | 30,258 |\\n| Operating property, net | 257,402 | 257,667 |\\n| Operating lease right-of-use assets | 229,266 | — |\\n| Investment and development property, net | 95,156 | 86,804 |\\n| Investment in unconsolidated joint ventures | 4,958 | 5,121 |\\n| Goodwill | 20,836 | 19,445 |\\n| Intangible assets, net | 3,694 | 7,369 |\\n| Deferred tax asset, net | 26,483 | 26,235 |\\n| Other assets | 6,199 | 6,129 |\\n| Total assets | $ | 674,543 | $ | 439,028 |\\n| LIABILITIES AND STOCKHOLDERS' EQUITY |\\n| Current Liabilities: |\\n| Accounts payable and accrued liabilities | $ | 23,492 | $ | 26,154 |\\n| Film rent payable | 6,559 | 8,661 |\\n| Debt - current portion | 40,077 | 30,393 |\\n| Derivative financial instruments - current portion | 52 | 41 |\\n| Taxes payable - current | 571 | 1,710 |\\n| Deferred current revenue | 7,712 | 9,264 |\\n| Operating lease liabilities - current portion | 19,797 | — |\\n| Other current liabilities | 9,525 | 9,305 |\\n| Total current liabilities | 107,785 | 85,528 |\\n| Debt - long-term portion | 113,816 | 106,286 |\\n| Derivative financial instruments - non-current portion | 203 | 145 |\\n| Subordinated debt, net | 26,116 | 26,061 |\\n| Noncurrent tax liabilities | 11,737 | 11,530 |\\n| Operating lease liabilities - non-current portion | 222,594 | — |\\n| Other liabilities | 12,346 | 28,931 |\\n| Total liabilities | 494,597 | 258,481 |\\n| Commitments and contingencies (Note 13) |\\n| Stockholders’ equity: |\\n| Class A non-voting common stock, par value $0.01, 100,000,000 shares authorized, |\\n| 33,172,823 issued and 21,249,935 outstanding at March 31, 2019 and 33,112,337 issued and 21,194,748 outstanding at December 31, 2018 | 233 | 232 |\\n| Class B voting common stock, par value $0.01, 20,000,000 shares authorized and |\\n| 1,680,590 issued and outstanding at March 31, 2019 and December 31, 2018 | 17 | 17 |\\n| Nonvoting preferred stock, par value $0.01, 12,000 shares authorized and no issued |\\n| or outstanding shares at March 31, 2019 and December 31, 2018 | — | — |\\n| Additional paid-in capital | 147,472 | 147,452 |\\n| Retained earnings | 45,563 | 47,616 |\\n| Treasury shares | (25,231) | (25,222) |\\n| Accumulated other comprehensive income | 7,625 | 6,115 |\\n| Total Reading International, Inc. stockholders’ equity | 175,679 | 176,210 |\\n| Noncontrolling interests | 4,267 | 4,337 |\\n| Total stockholders’ equity | 179,946 | 180,547 |\\n| Total liabilities and stockholders’ equity | $ | 674,543 | $ | 439,028 |\\n\\n\\nSee accompanying Notes to the Unaudited Consolidated Financial Statements.\\n3\\nREADING INTERNATIONAL, INC.\\nCONSOLIDATED STATEMENTS OF INCOME\\n(Unaudited; U.S. dollars in thousands, except per share data)\\n\\n\\n\\n\\n| |\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| | 2019 | 2018 |\\n| Revenue |\\n| Cinema | $ | 57,986 | $ | 72,255 |\\n| Real estate | 3,565 | 3,617 |\\n| Total revenue | 61,551 | 75,872 |\\n| Costs and expenses |\\n| Cinema | (48,329) | (54,948) |\\n| Real estate | (2,445) | (2,384) |\\n| Depreciation and amortization | (5,594) | (5,250) |\\n| General and administrative | (6,484) | (7,597) |\\n| Total costs and expenses | (62,852) | (70,179) |\\n| Operating income (loss) | (1,301) | 5,693 |\\n| Interest expense, net | (1,852) | (1,594) |\\n| Other income (expense) | (20) | (82) |\\n| Income (loss) before income tax expense and equity earnings of unconsolidated joint ventures | (3,173) | 4,017 |\\n| Equity earnings of unconsolidated joint ventures | 34 | 257 |\\n| Income (loss) before income taxes | (3,139) | 4,274 |\\n| Income tax benefit (expense) | 1,042 | (1,170) |\\n| Net income (loss) | $ | (2,097) | $ | 3,104 |\\n| Less: net income (loss) attributable to noncontrolling interests | (16) | 22 |\\n| Net income (loss) attributable to Reading International, Inc. common shareholders | $ | (2,081) | $ | 3,082 |\\n| Basic earnings (loss) per share attributable to Reading International, Inc. shareholders | $ | (0.09) | $ | 0.13 |\\n| Diluted earnings (loss) per share attributable to Reading International, Inc. shareholders | $ | (0.09) | $ | 0.13 |\\n| Weighted average number of shares outstanding–basic | 22,920,486 | 22,967,237 |\\n| Weighted average number of shares outstanding–diluted | 23,124,106 | 23,132,989 |\\n\\n\\nSee accompanying Notes to the Unaudited Consolidated Financial Statements.\\n4\\nREADING INTERNATIONAL, INC.\\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME\\n(Unaudited; U.S. dollars in thousands)\\n\\n\\n| |\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| | 2019 | 2018 |\\n| Net income (loss) | $ | (2,097) | $ | 3,104 |\\n| Foreign currency translation gain (loss) | 1,526 | (803) |\\n| Gain (loss) on cash flow hedges | (69) | — |\\n| Other | 53 | 50 |\\n| Comprehensive income (loss) | (587) | 2,351 |\\n| Less: net income (loss) attributable to noncontrolling interests | (16) | 22 |\\n| Less: comprehensive income (loss) attributable to noncontrolling interests | 1 | (3) |\\n| Comprehensive income (loss) attributable to Reading International, Inc. | $ | (572) | $ | 2,332 |\\n\\n\\nSee accompanying Notes to the Unaudited Consolidated Financial Statements.\\n5\\nREADING INTERNATIONAL, INC.\\nCONSOLIDATED STATEMENTS OF CASH FLOWS\\n(Unaudited; U.S. dollars in thousands)\\n\\n\\n\\n| |\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| | 2019 | 2018 |\\n| Operating Activities |\\n| Net income (loss) | $ | (2,097) | $ | 3,104 |\\n| Adjustments to reconcile net income (loss) to net cash provided by operating activities: |\\n| Equity earnings of unconsolidated joint ventures | (34) | (257) |\\n| Distributions of earnings from unconsolidated joint ventures | 249 | 236 |\\n| Amortization of operating leases | 5,895 | — |\\n| Amortization of finance leases | 41 | — |\\n| Change in operating lease liabilities | (5,754) | — |\\n| Interest on hedged derivatives | (5) | — |\\n| Change in net deferred tax assets | (150) | 172 |\\n| Depreciation and amortization | 5,594 | 5,250 |\\n| Other amortization | 341 | 224 |\\n| Stock based compensation expense | 280 | 379 |\\n| Net changes in operating assets and liabilities: |\\n| Receivables | 993 | 3,205 |\\n| Prepaid and other assets | (1,957) | (2,309) |\\n| Payments for accrued pension | (171) | (2,404) |\\n| Accounts payable and accrued expenses | (2,204) | 1,997 |\\n| Film rent payable | (2,132) | (5,790) |\\n| Taxes payable | (1,151) | 150 |\\n| Deferred revenue and other liabilities | (1,579) | (1,505) |\\n| Net cash provided by (used in) operating activities | (3,841) | 2,452 |\\n| Investing Activities |\\n| Purchases of and additions to operating and investment properties | (11,476) | (23,231) |\\n| Acquisition of business combinations | (1,380) | — |\\n| Change in restricted cash | 243 | (260) |\\n| Net cash provided by (used in) investing activities | (12,613) | (23,491) |\\n| Financing Activities |\\n| Repayment of long-term borrowings | (6,113) | (9,707) |\\n| Repayment of finance lease principle | (41) | — |\\n| Proceeds from borrowings | 22,349 | 25,998 |\\n| Repurchase of Class A Nonvoting Common Stock | (9) | (317) |\\n| (Cash paid) proceeds from the exercise of stock options | (259) | 203 |\\n| Noncontrolling interest contributions | 18 | 27 |\\n| Noncontrolling interest distributions | (27) | (43) |\\n| Net cash provided by (used in) financing activities | 15,918 | 16,161 |\\n| Effect of exchange rate changes on cash and cash equivalents | 57 | (122) |\\n| Net decrease in cash and cash equivalents | (479) | (5,000) |\\n| Cash and cash equivalents at January 1 | 13,127 | 13,668 |\\n| Cash and cash equivalents at March 31 | $ | 12,648 | $ | 8,668 |\\n| Supplemental Disclosures |\\n| Interest paid | $ | 2,304 | $ | 2,121 |\\n| Income taxes paid | 1,883 | 808 |\\n| Non-Cash Transactions |\\n| Additions to operating and investing properties through accrued expenses | 3,423 | 4,530 |\\n\\n\\nSee accompanying Notes to the Unaudited Consolidated Financial Statements.\\n6\\nREADING INTERNATIONAL, INC.\\nNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)\\nNote 1 – Description of Business and Segment Reporting\\nThe Company\\nReading International, Inc., a Nevada corporation (“RDI” and collectively with our consolidated subsidiaries and corporate predecessors, the “Company”, “Reading” and “we”, “us”, or “our”), was incorporated in 1999. Our businesses consist primarily of:\\n| · | the operation, development and ownership of multiplex cinemas in the United States, Australia, and New Zealand; and, |\\n\\n| · | the development, ownership, operation and/or rental of retail, commercial and live venue real estate assets in Australia, New Zealand, and the United States. |\\n\\n\\nBusiness Segments\\nReported below are the operating segments of the Company for which separate financial information is available and evaluated regularly by the Chief Executive Officer, the chief operating decision-maker of the Company. As part of our real estate activities, we hold undeveloped land in urban and suburban centers in Australia, New Zealand, and the United States.\\n\\nThe table below summarizes the results of operations for each of our business segments for the quarter ended March 31, 2019 and 2018, respectively. Operating expense includes costs associated with the day-to-day operations of the cinemas and the management of rental properties, including our live theater assets.\\n\\n\\n\\n\\n| |\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Revenue: |\\n| Cinema exhibition | $ | 57,986 | $ | 72,255 |\\n| Real estate | 5,431 | 6,008 |\\n| Inter-segment elimination | (1,866) | (2,391) |\\n| | $ | 61,551 | $ | 75,872 |\\n| Segment operating income (loss): |\\n| Cinema exhibition | $ | 2,642 | $ | 10,285 |\\n| Real estate | 1,159 | 1,681 |\\n| | $ | 3,801 | $ | 11,966 |\\n\\n\\nA reconciliation of segment operating income to income before income taxes is as follows:\\n\\n\\n\\n| |\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Segment operating income (loss) | $ | 3,801 | $ | 11,966 |\\n| Unallocated corporate expense |\\n| Depreciation and amortization expense | (61) | (117) |\\n| General and administrative expense | (5,041) | (6,156) |\\n| Interest expense, net | (1,852) | (1,594) |\\n| Equity earnings of unconsolidated joint ventures | 34 | 257 |\\n| Other income (expense) | (20) | (82) |\\n| Income (loss) before income tax expense | $ | (3,139) | $ | 4,274 |\\n\\nNote 2 – Summary of Significant Accounting Policies\\n\\nBasis of Consolidation\\nThe accompanying consolidated financial statements include the accounts of the Company’s wholly-owned subsidiaries as well as majority-owned subsidiaries that the Company controls, and should be read in conjunction with the Company’s Annual Report on Form 10-K as of and for the year ended December 31, 2018 (“2018 Form 10-K”). All significant intercompany balances and transactions have been eliminated on consolidation. These consolidated financial statements were prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim reporting with the instructions for Form 10-Q and Rule 10-01 of Regulation S-X of the Securities and Exchange Commission (“SEC”). As such, they do not include\\n7\\nall information and footnotes required by U.S. GAAP for complete financial statements. We believe that we have included all normal and recurring adjustments necessary for a fair presentation of the results for the interim period.\\n\\nOperating results for the quarter ended March 31, 2019 are not necessarily indicative of the results that may be expected for the year ending December 31, 2019.\\n\\nUse of Estimates\\nThe preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and footnotes thereto. Significant estimates include (i) projections we make regarding the recoverability and impairment of our assets (including goodwill and intangibles), (ii) valuations of our derivative instruments, (iii) recoverability of our deferred tax assets, (iv) estimation of breakage and redemption experience rates, which drive how we recognize breakage on our gift card and gift certificates, and revenue from our customer loyalty program, and (v) allocation of insurance proceeds to various recoverable components. Actual results may differ from those estimates.\\n\\nRecently Adopted and Issued Accounting Pronouncements\\n\\nAdopted:\\n\\nAccounting Standards Update (“ASU”) 2016-02 Leases: In February 2016, the Financial Accounting Standards Board (“FASB”) issued a new accounting standard, ASC 842 Leases, to increase transparency and comparability among organizations by requiring the recognition of right-of-use (\\\"ROU\\\") assets and lease liabilities on the balance sheet. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. A modified retrospective transition approach is required for lessees with capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available.\\n\\nOn January 1, 2019, we adopted the new accounting standard Accounting Standards Codification (“ASC”) 842 Leases using the modified retrospective method. We recognized the cumulative effect of initially applying the new leasing standard as an adjustment to the opening balance of retained earnings. The comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods. The standard had a material impact on our consolidated balance sheets, but not on our consolidated income statements or statements of cash flow.\\n\\n\\n| |\\n| (Dollars in thousands) | Balance atDecember 31,2018 | Adjustmentsdue to ASC842 | Balance atJanuary 1,2019 |\\n| Assets |\\n| Operating property, net | $ | 257,667 | $ | 370 | $ | 258,037 |\\n| Operating lease right-of-use assets | — | 232,319 | 232,319 |\\n| Intangible assets, net | 7,369 | (3,542) | 3,827 |\\n| Deferred tax asset, net | 26,235 | 82 | 26,317 |\\n| Liabilities |\\n| Operating lease liabilities | $ | — | $ | 245,280 | $ | 245,280 |\\n| Other non-current liabilities | 28,931 | (16,033) | 12,898 |\\n| Stockholders' Equity |\\n| Non-controlling interest | $ | 4,337 | $ | (46) | $ | 4,291 |\\n| Retained earnings | 47,616 | 28 | 47,644 |\\n\\n\\n\\n\\n| |\\n| | Period Ended March 31, 2019 |\\n| (Dollars in thousands) | As Reported,March 31, 2019 | BalancesWithoutAdoption ofASC 842 | Effect ofchangeHigher /(Lower) |\\n| Cinema costs and expenses | $ | 48,329 | $ | 48,334 | $ | (5) |\\n| Depreciation and amortization | 5,594 | 5,552 | 42 |\\n| General and administrative | 6,484 | 6,528 | (44) |\\n| Interest expense, net | 1,852 | 1,849 | 3 |\\n| Income tax (benefit) expense | 1,042 | 1,041 | 1 |\\n| Net income (loss) | $ | (2,097) | $ | (2,094) | $ | 3 |\\n\\n8\\n\\n\\n\\n| |\\n| (Dollars in thousands) | As Reported,March 31, 2019 | BalancesWithoutAdoption ofASC 842 | Effect ofchangeHigher /(Lower) |\\n| Assets |\\n| Operating property, net | $ | 257,402 | $ | 257,072 | $ | 330 |\\n| Intangible assets | 3,694 | 7,151 | (3,457) |\\n| Operating lease right-of-use assets | 229,266 | — | 229,266 |\\n| Deferred tax asset, net | 26,483 | 26,400 | 83 |\\n| Liabilities |\\n| Other current liabilities | $ | 9,525 | $ | 9,363 | $ | 162 |\\n| Operating lease liabilities, current | 19,797 | — | 19,797 |\\n| Other non-current liabilities | 12,346 | 28,643 | (16,297) |\\n| Operating lease liabilities, non-current | 222,594 | — | 222,594 |\\n| Stockholders' Equity |\\n| Retained earnings | $ | 45,563 | $ | 45,585 | $ | (22) |\\n\\n\\n\\n| 1) | ASU 2014-09 Revenue from Contracts with Customers: On January 1, 2018, we adopted the new accounting standard ASC 606 Revenue from Contracts with Customers using the modified retrospective method. We recognized the cumulative effect of initially applying the new revenue standard as an adjustment to the opening balance of retained earnings. The comparative information was not restated. Adoption of this standard has no material effect on our consolidated financial statements. |\\n\\n\\n| 2) | On January 1, 2018, the Company adopted ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash, a consensus of the FASB Emerging Issues Task Force. This standard requires that amounts generally described as restricted cash and cash equivalents should be combined with unrestricted cash and cash equivalents when reconciling the beginning and end of period balances on the statement of cash flows. Adoption of this standard has no material effect on our consolidated statement of cash flows. |\\n\\n\\n| 3) | On January 1, 2018, the Company adopted ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments). The standard applies to eight (8) specific cash flow classification issues, reducing the current and potential future diversity in the presentation of certain cash flows. Adoption of this standard has no material effect on our consolidated statement of cash flows. |\\n\\n\\n| 4) | On January 1, 2018, the Company adopted ASU 2017-07, Compensation—Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. This standard (i) requires that an employer disaggregate the service cost component from the other components of net benefit cost, and (ii) specifies how to present the service cost component and the other components of net benefit cost in the income statement and (iii) allows only the service cost component of net benefit cost to be eligible for capitalization. Adoption of this standard has no material impact on our consolidated financial statements. |\\n\\n\\n| 5) | On January 1, 2018, the Company adopted ASU 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business. This ASU provides that when substantially all of the fair value of the gross assets acquired (or disposed of) is concentrated in a single identifiable asset or a group of similar identifiable assets, the asset is not a “business”, thus reducing the number of transactions that need further evaluation for business combination. The standard has no material impact on our current consolidated financial statements, and we do not expect it to be applicable to our consolidated financial statements in the near term unless we enter into a definitive business acquisition transaction. |\\n\\n\\nIssued:\\n\\n| v | ASUs Effective 2019 and Beyond |\\n\\n| · | Goodwill Impairment Simplification (ASU 2017-04, Intangibles – Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment) |\\n\\n\\nIssued by FASB in January 2017, this standard removes the second step of the two-step impairment test for measuring goodwill and is to be applied on a prospective basis only. The new standard is effective for the Company on January 1, 2020, including interim periods within the year of adoption. Early adoption is permitted for interim or annual goodwill impairment\\n9\\ntests performed on testing dates after January 1, 2017. It is not anticipated that adoption of this standard will have any material impact on our consolidated financial statements.\\n\\nPrior period financial statement correction of immaterial errors\\n\\nDuring the third quarter of 2018, we identified immaterial errors related to the accounting for straight line rent receivable from tenants in our real estate operations dating back to 2015. These errors resulted in an understatement of real estate revenue.\\n\\nWe assessed the materiality of these errors on our financial statements for prior periods in accordance with the SEC Staff Accounting Bulletin (“SAB”) No. 99, Materiality, codified in ASC 250, Presentation of Financial Statements, and concluded that they were not material to any prior annual or interim periods. However, the aggregate amount of $440k related to the prior period immaterial errors through June 30, 2018, would have been material to the quarterly accounts with our current Consolidated Statements of Income. Consequently, in accordance with ASC 250 (specifically SAB No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements), we have corrected these errors for all prior periods presented by revising the consolidated financial statements and other financial information included herein.\\n\\nThe following is a summary of the previously issued financial statement line items for all periods and statements included in this report.\\n\\nConsolidated Statements of Income:\\n\\n\\n| |\\n| | Three Months Ended March 31, 2018 |\\n| (Dollars in thousands) | As Reported | Adjustment | As Revised |\\n| Real estate revenue | $ | 3,567 | $ | 50 | $ | 3,617 |\\n| Total revenue | 75,822 | 50 | 75,872 |\\n| Operating income (loss) | 5,643 | 50 | 5,693 |\\n| Income before income taxes | 4,224 | 50 | 4,274 |\\n| Income tax benefit (expense) | (1,155) | (15) | (1,170) |\\n| Net income (loss) | 3,069 | 35 | 3,104 |\\n| Net income (loss) attributable to Reading International, Inc. common shareholders | 3,047 | 35 | 3,082 |\\n| |\\n| Basic earnings (loss) per share | $ | 0.13 | $ | — | $ | 0.13 |\\n| Diluted earnings (loss) per share | 0.13 | — | 0.13 |\\n\\n\\nConsolidated Balance Sheets:\\n\\n\\n\\n\\n| |\\n| | Summary of Equity |\\n| (Dollars in thousands) | As Reported | Adjustment | As Revised |\\n| Equity at January 1, 2018 | $ | 176,910 | $ | 377 | $ | 177,287 |\\n| Net income (loss) | 3,047 | 35 | 3,082 |\\n| Equity at March 31, 2018 | $ | 179,423 | $ | 412 | $ | 179,835 |\\n\\n\\n\\nConsolidated Statements of Cash Flows:\\n\\n\\n| |\\n| | Three Months Ended March 31, 2018 |\\n| (Dollars in thousands) | As Reported | Adjustment | As Revised |\\n| Net income (loss) | $ | 3,069 | $ | 35 | $ | 3,104 |\\n| Change in net deferred tax assets | 157 | 15 | 172 |\\n| Prepaid and other assets | (2,259) | (50) | (2,309) |\\n| Net cash provided by operating activities | $ | 2,452 | $ | — | $ | 2,452 |\\n\\n10\\nNote 3 – Operations in Foreign Currency\\n\\nWe have significant assets in Australia and New Zealand. Historically, we have conducted our Australian and New Zealand operations (collectively “foreign operations”) on a self-funding basis where we use cash flows generated by our foreign operations to pay for the expense of foreign operations. Our Australian and New Zealand assets and liabilities are translated from their functional currencies of Australian dollar (“AU$”) and New Zealand dollar (“NZ$”), respectively, to the U.S. dollar based on the exchange rate as of March 31, 2019. The carrying value of the assets and liabilities of our foreign operations fluctuates as a result of changes in the exchange rates between the functional currencies of the foreign operations and the U.S. dollar. The translation adjustments are accumulated in the Accumulated Other Comprehensive Income in the Consolidated Balance Sheets.\\n\\nDue to the natural-hedge nature of our funding policy, we have not historically used derivative financial instruments to hedge against the risk of foreign currency exposure. However, in certain circumstances, we move funds between jurisdictions where circumstances encouraged us to do so from an overall economic standpoint. Going forward, particularly in light of recent tax law changes, we intend to take a more global view of our financial resources, and to be more flexible in making use of resources from one jurisdiction in other jurisdictions.\\n\\nPresented in the table below are the currency exchange rates for Australia and New Zealand:\\n\\n\\n| |\\n| |\\n| | Foreign Currency / USD |\\n| | As of andfor thequarterended | As of andfor thetwelve monthsended | As of andfor thequarterended |\\n| | March 31, 2019 | December 31, 2018 | March 31, 2018 |\\n| Spot Rate |\\n| Australian Dollar | 0.7104 | 0.7046 | 0.7690 |\\n| New Zealand Dollar | 0.6820 | 0.6711 | 0.7239 |\\n| Average Rate |\\n| Australian Dollar | 0.7123 | 0.7479 | 0.7861 |\\n| New Zealand Dollar | 0.6816 | 0.6930 | 0.7275 |\\n\\nNote 4 – Earnings Per Share\\n\\nBasic earnings per share (“EPS”) is calculated by dividing the net income attributable to the Company’s common stockholders by the weighted average number of common shares outstanding during the period. Diluted EPS is calculated by dividing the net income attributable to the Company’s common stockholders by the weighted average number of common and common equivalent shares outstanding during the period and is calculated using the treasury stock method for equity-based compensation awards.\\n\\nThe following table sets forth the computation of basic and diluted EPS and a reconciliation of the weighted average number of common and common equivalent shares outstanding:\\n\\n\\n| |\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| (Dollars in thousands, except share data) | 2019 | 2018 |\\n| Numerator: |\\n| Net income (loss) attributable to RDI common stockholders | $ | (2,081) | $ | 3,082 |\\n| Denominator: |\\n| Weighted average number of common stock – basic | 22,920,486 | 22,967,237 |\\n| Weighted average dilutive impact of awards | 203,620 | 165,752 |\\n| Weighted average number of common stock – diluted | 23,124,106 | 23,132,989 |\\n| Basic earnings (loss) per share attributable to RDI common stockholders | $ | (0.09) | $ | 0.13 |\\n| Diluted earnings (loss) per share attributable to RDI common stockholders | $ | (0.09) | $ | 0.13 |\\n| Awards excluded from diluted earnings (loss) per share | 496,089 | — |\\n\\n\\nOur weighted average number of common stock - basic decreased, primarily as a result of the repurchase of shares of Class A Non-Voting Common Stock pursuant to our current stock repurchase program offset by the issuance of shares due to the exercise of share options and vesting of restricted stock units.\\n11\\nNote 5 – Property and Equipment\\n\\nOperating Property, net\\n\\nAs of March 31, 2019 and December 31, 2018, property associated with our operating activities is summarized as follows:\\n\\n\\n| |\\n| |\\n| | March 31, | December 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Land | $ | 76,110 | $ | 75,689 |\\n| Building and improvements | 151,525 | 149,734 |\\n| Leasehold improvements | 56,160 | 55,299 |\\n| Fixtures and equipment | 171,674 | 167,943 |\\n| Construction-in-progress | 3,185 | 3,478 |\\n| Total cost | 458,654 | 452,143 |\\n| Less: accumulated depreciation | (201,252) | (194,476) |\\n| Operating property, net | $ | 257,402 | $ | 257,667 |\\n\\n\\nDepreciation expense for operating property was $5.4 million for the quarter ended March 31, 2019 and $4.7 million for the quarter ended March 31, 2018.\\n\\nInvestment and Development Property, net\\n\\nAs of March 31, 2019 and December 31, 2018, our investment and development property is summarized below:\\n\\n| |\\n| |\\n| | March 31, | December 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Land | $ | 24,310 | $ | 24,371 |\\n| Building | 1,900 | 1,900 |\\n| Construction-in-progress (including capitalized interest) | 68,946 | 60,533 |\\n| Investment and development property | $ | 95,156 | $ | 86,804 |\\n\\n\\nConstruction-in-Progress – Operating and Investing Properties\\n\\nConstruction-in-Progress balances are included in both our operating and development properties. The balances of our major projects along with the movements for the three months ended March 31, 2019 are shown below:\\n\\n\\n| |\\n| |\\n| (Dollars in thousands) | Balance,December 31,2018 | Additions during the period(1) | Completedduring theperiod | Foreigncurrencytranslation | Balance,March 31,2019 |\\n| Union Square development | $ | 55,634 | $ | 7,724 | $ | — | $ | (1) | $ | 63,357 |\\n| Newmarket Property development | 9 | 4 | — | — | 13 |\\n| Courtenay Central development | 5,571 | 234 | — | 94 | 5,899 |\\n| Cinema developments and improvements | 1,664 | 3,551 | (3,997) | 4 | 1,222 |\\n| Other real estate projects | 1,133 | 528 | (27) | 6 | 1,640 |\\n| Total | $ | 64,011 | $ | 12,041 | $ | (4,024) | $ | 103 | $ | 72,131 |\\n\\n\\n| (1) | Includes capitalized interest of $1.3 million for the quarter ended March 31, 2019. |\\n\\n\\nReal Estate Transactions\\n\\nPurchase of Income Producing Property at Auburn/Redyard, Australia – On June 29, 2018, we added 20,870 square feet of land, improved with a 16,830 square foot office building, to our Auburn/Redyard ETC. The property was acquired at auction for $3.5 million (AU$4.5 million) and is bordered by our existing ETC on three sides. The property is leased to Telstra through July 2022. This will allow us time to plan for the efficient integration of the property into our ETC. With this acquisition, Auburn/Redyard now represents approximately 519,992 square feet (48,309 square meters) of land, with approximately 1,620 feet (498 meters) of uninterrupted frontage to Parramatta Road, a major Sydney arterial motorway.\\n\\n12\\nPurchase of Land at Cannon Park in Townsville, Australia – On June 13, 2018, we acquired a 163,000 square foot (15,150 square meter) parcel of land at our Cannon Park ETC, in connection with the restructuring of our relationship with the adjacent land owner. Prior to the restructuring, this parcel was commonly owned by us and the adjoining land owner. In the restructuring, the adjoining land owner conveyed to us its interest in the parcel for AU$1. We granted the adjoining land owner certain access rights with respect to that parcel.\\n\\nNote 6 – Investments in Unconsolidated Joint Ventures\\n\\nOur investments in unconsolidated joint ventures are accounted for under the equity method of accounting.\\n\\nThe table below summarizes our active investment holdings in two (2) unconsolidated joint ventures as of March 31, 2019 and December 31, 2018:\\n\\n| |\\n| |\\n| | March 31, | December 31, |\\n| (Dollars in thousands) | Interest | 2019 | 2018 |\\n| Rialto Cinemas | 50.0% | $ | 1,224 | $ | 1,260 |\\n| Mt. Gravatt | 33.3% | 3,734 | 3,861 |\\n| Total investments | $ | 4,958 | $ | 5,121 |\\n\\n\\nFor the quarter ended March 31, 2019 and 2018, the recognized share of equity earnings from our investments in unconsolidated joint ventures are as follows:\\n\\n\\n| |\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Rialto Cinemas | $ | (56) | $ | 70 |\\n| Mt. Gravatt | 90 | 187 |\\n| Total equity earnings | $ | 34 | $ | 257 |\\n\\nNote 7 – Goodwill and Intangible Assets\\n\\nThe table below summarizes goodwill by business segment as of March 31, 2019 and December 31, 2018.\\n\\n\\n| |\\n| |\\n| (Dollars in thousands) | Cinema | Real Estate | Total |\\n| Balance at, December 31, 2018 | $ | 14,221 | $ | 5,224 | $ | 19,445 |\\n| Change in goodwill due to a purchase of business combination | 1,248 | — | 1,248 |\\n| Foreign currency translation adjustment | 143 | — | 143 |\\n| Balance at, March 31, 2019 | $ | 15,612 | $ | 5,224 | $ | 20,836 |\\n\\n\\nThe Company is required to test goodwill and other intangible assets for impairment on an annual basis and, if current events or circumstances require, on an interim basis. Our next annual evaluation of goodwill and other intangible assets is scheduled during the fourth quarter of 2019. To test the impairment of goodwill, the Company compares the fair value of each reporting unit to its carrying amount, including the goodwill, to determine if there is potential goodwill impairment. A reporting unit is generally one level below the operating segment. As of March 31, 2019, we were not aware that any events indicating potential impairment of goodwill had occurred.\\n\\nThe tables below summarize intangible assets other than goodwill as of March 31, 2019 and December 31, 2018, respectively.\\n\\n\\n| |\\n| |\\n| | As of March 31, 2019 |\\n| (Dollars in thousands) | BeneficialLeases | TradeName | OtherIntangibleAssets | Total |\\n| Gross carrying amount | $ | 15,069 | $ | 7,255 | $ | 1,999 | $ | 24,323 |\\n| Less: Accumulated amortization | (14,260) | (5,269) | (1,100) | (20,629) |\\n| Net intangible assets other than goodwill | $ | 809 | $ | 1,986 | $ | 899 | $ | 3,694 |\\n\\n\\n13\\n\\n| |\\n| |\\n| | As of December 31, 2018 |\\n| (Dollars in thousands) | BeneficialLeases | TradeName | OtherIntangibleAssets | Total |\\n| Gross carrying amount | $ | 28,592 | $ | 7,254 | $ | 1,951 | $ | 37,797 |\\n| Less: Accumulated amortization | (24,145) | (5,207) | (1,076) | (30,428) |\\n| Net intangible assets other than goodwill | $ | 4,447 | $ | 2,047 | $ | 875 | $ | 7,369 |\\n\\n\\nBeneficial leases were amortized over the life of the lease up to 30 years up until January 1, 2019, when under ASC 842 they were incorporated into the relevant right-of-use asset. Trade names are amortized based on the accelerated amortization method over their estimated useful life of 30 years, and other intangible assets are amortized over their estimated useful lives of up to 30 years (except for transferrable liquor licenses, which are indefinite-lived assets). The table below summarizes the amortization expense of intangible assets for the quarter ended March 31, 2019.\\n\\n\\n| |\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Beneficial lease amortization | $ | 79 | $ | 207 |\\n| Other amortization | 22 | 93 |\\n| Total intangible assets amortization | $ | 101 | $ | 300 |\\n\\nNote 8 – Prepaid and Other Assets\\n\\nPrepaid and other assets are summarized as follows:\\n\\n\\n| |\\n| |\\n| | March 31, | December 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Prepaid and other current assets |\\n| Prepaid expenses | $ | 2,105 | $ | 1,761 |\\n| Prepaid rent | 1,020 | 930 |\\n| Prepaid taxes | 1,026 | 646 |\\n| Income taxes receivable | 4,106 | 2,704 |\\n| Deposits | 242 | 242 |\\n| Investment in marketable securities | 44 | 42 |\\n| Restricted cash | 1,099 | 1,342 |\\n| Total prepaid and other current assets | $ | 9,642 | $ | 7,667 |\\n| Other non-current assets |\\n| Straight-line rent | 4,219 | 4,150 |\\n| Other non-cinema and non-rental real estate assets | 1,134 | 1,134 |\\n| Investment in Reading International Trust I | 838 | 838 |\\n| Long-term deposits | 8 | 7 |\\n| Long-term restricted cash | — | — |\\n| Total other non-current assets | $ | 6,199 | $ | 6,129 |\\n\\nNote 9 – Income Taxes\\n\\nThe interim provision for income taxes is different from the amount determined by applying the U.S. federal statutory rate to consolidated income before taxes. The differences are attributable to foreign tax rate differential, unrecognized tax benefits, and foreign tax credits. Our effective tax rate was 33.2% and 27.3% for the three months ended March 31, 2019 and 2018, respectively. The change between 2019 and 2018 is primarily related to decrease in benefits from foreign tax credits and increase in valuation allowance related to our foreign operation.\\n\\n14\\nNote 10 – Debt\\n\\nThe Company’s borrowings at March 31, 2019 and December 31, 2018, net of deferred financing costs and including the impact of interest rate derivatives on effective interest rates, are summarized below:\\n\\n\\n| |\\n| |\\n| | As of March 31, 2019 |\\n| (Dollars in thousands) | Maturity Date | ContractualFacility | Balance,Gross | Balance, Net(1) | StatedInterest Rate | Effective Interest Rate(2) |\\n| Denominated in USD |\\n| Trust Preferred Securities (USA) | April 30, 2027 | $ | 27,913 | $ | 27,913 | $ | 26,116 | 6.75% | 6.75% |\\n| Bank of America Credit Facility (USA) | May 1, 2020 | 55,000 | 30,000 | 30,000 | 5.02% | 5.02% |\\n| Bank of America Line of Credit (USA) | October 31, 2019 | 5,000 | 3,500 | 3,500 | 5.52% | 5.52% |\\n| Banc of America digital projector loan (USA) | December 28, 2019 | 1,979 | 1,979 | 1,979 | 5.00% | 5.00% |\\n| Cinema 1, 2, 3 Term Loan (USA) | September 1, 2019 | 18,978 | 18,978 | 18,768 | 3.25% | 3.25% |\\n| Minetta & Orpheum Theatres Loan (USA) | November 1, 2023 | 8,000 | 8,000 | 7,864 | 4.54% | 4.54% |\\n| U.S. Corporate Office Term Loan (USA) | January 1, 2027 | 9,437 | 9,437 | 9,319 | 4.64% / 4.44% | 4.61% |\\n| Union Square Construction Financing (USA) | December 29, 2019 | 57,500 | 33,934 | 32,463 | 6.76% / 12.51% | 8.02% |\\n| Denominated in foreign currency (\\\"FC\\\") (3) |\\n| NAB Corporate Term Loan (AU) | December 31, 2023 | 85,248 | 40,138 | 40,111 | 2.70% | 2.70% |\\n| Westpac Bank Corporate (NZ) | December 31, 2023 | 21,824 | 9,889 | 9,889 | 3.80% | 3.80% |\\n| | $ | 290,879 | $ | 183,768 | $ | 180,009 |\\n\\n\\n| (1) | Net of deferred financing costs amounting to $3.8 million. |\\n\\n| (2) | Both interest rate derivatives associated with the Trust Preferred Securities and Bank of America Credit Facility expired in October 2017 so the effective interest rate no longer applies as of March 31, 2019. |\\n\\n| (3) | The contractual facilities and outstanding balances of the foreign currency denominated borrowings were translated into U.S. dollars based on the applicable exchange rates as of March 31, 2019. |\\n\\n\\n| |\\n| |\\n| | As of December 31, 2018 |\\n| (Dollars in thousands) | Maturity Date | ContractualFacility | Balance,Gross | Balance, Net(1) | StatedInterestRate | Effective Interest Rate (2) |\\n| Denominated in USD |\\n| Trust Preferred Securities (USA) | April 30, 2027 | $ | 27,913 | $ | 27,913 | $ | 26,061 | 6.52% | 6.52% |\\n| Bank of America Credit Facility (USA) | May 1, 2020 | 55,000 | 25,000 | 25,000 | 5.02% | 5.02% |\\n| Bank of America Line of Credit (USA) | October 31, 2019 | 5,000 | — | — | 5.48% | 5.48% |\\n| Banc of America digital projector loan (USA) | December 28, 2019 | 2,604 | 2,604 | 2,604 | 5.00% | 5.00% |\\n| Cinema 1, 2, 3 Term Loan (USA) | September 1, 2019 | 19,086 | 19,086 | 18,838 | 3.25% | 3.25% |\\n| Minetta & Orpheum Theatres Loan (USA) | November 1, 2023 | 8,000 | 8,000 | 7,857 | 4.88% | 4.88% |\\n| U.S. Corporate Office Term Loan (USA) | January 1, 2027 | 9,495 | 9,495 | 9,373 | 4.64% / 4.44% | 4.61% |\\n| Union Square Construction Financing (USA) | December 29, 2019 | 57,500 | 27,182 | 25,280 | 6.76% / 12.51% | 8.35% |\\n| Denominated in foreign currency (\\\"FC\\\")(3) |\\n| NAB Corporate Loan Facility (AU) | December 31, 2023 | 46,856 | 37,696 | 37,660 | 3.05% | 3.05% |\\n| Westpac Corporate Credit Facility (NZ) | December 31, 2023 | 21,475 | 10,067 | 10,067 | 3.80% | 3.80% |\\n| | $ | 252,929 | $ | 167,043 | $ | 162,740 |\\n\\n\\n| (1) | Net of deferred financing costs amounting to $4.3 million. |\\n\\n\\n| (2) | Both interest rate derivatives associated with the Trust Preferred Securities and Bank of America Credit Facility expired in October 2017 so the effective interest rate no longer applies as of December 31, 2018. |\\n\\n| (3) | The contractual facilities and outstanding balances of the foreign currency denominated borrowings were translated into U.S. dollars based on the applicable exchange rates as of December 31, 2018. |\\n\\n\\nOur loan arrangements are presented, net of the deferred financing costs, on the face of our consolidated balance sheet as follows:\\n\\n\\n| |\\n| |\\n| | March 31, | December 31, |\\n| Balance Sheet Caption | 2019 | 2018 |\\n| Debt - current portion | $ | 40,077 | $ | 30,393 |\\n| Debt - long-term portion | 113,816 | 106,286 |\\n| Subordinated debt | 26,116 | 26,061 |\\n| Total borrowings | $ | 180,009 | $ | 162,740 |\\n\\n\\n15\\nMinetta and Orpheum Theatres Loan\\n\\nOn October 12, 2018, we refinanced our $7.5 million loan with Santander Bank, which is secured by our Minetta and Orpheum Theatres, with a loan for a five year term of $8.0 million. Such modification was not considered to be substantial under US GAAP.\\n\\nBanc of America Digital Projector Loan\\n\\nOn February 5, 2018, we purchased our U.S. digital cinema projectors, which had previously been held on operating leases, using a $4.6 million loan from Banc of America. We made further U.S. digital projector purchases, of projectors similarly held on other operating leases, in March and April 2018, increasing this loan to $4.9 million. This loan carries an interest rate of 5% and is due and payable December 28, 2019.\\n\\nBank of America Credit Facility\\n\\nOn March 3, 2016, we amended our $55.0 million credit facility with Bank of America to permit real property acquisition loans. This amendment reduces the applicable consolidated leverage ratio covenant by 0.25% and modifies the term of the facility based on the earlier of the eighteen months from the date of such borrowing or the maturity date of the credit agreement. Such modification was not considered substantial in accordance with U.S. GAAP. On March 5, 2019, this Credit Facility was extended for six (6) months to May 1, 2020.\\n\\n44 Union Square Construction Financing\\n\\nOn December 29, 2016, we closed on our new construction finance facilities totaling $57.5 million to fund the non-equity portion of the anticipated construction costs of the redevelopment of our property at 44 Union Square in New York City. The combined facilities consist of $50.0 million in aggregate loans (comprised of three loan tranches) from Bank of the Ozarks (“BOTO”), and a $7.5 million mezzanine loan from Tammany Mezz Investor, LLC, an affiliate of Fisher Brothers. At December 31, 2016, Bank of the Ozarks advanced $8.0 million to repay the then existing $8.0 million loan with East West Bank. As of March 31, 2019, an additional $26.4 million had been advanced under the senior loan facility, along with the full $7.5 million available under the mezzanine loan facility.\\n\\nU.S. Corporate Office Term Loan\\n\\nOn December 13, 2016, we obtained a ten-year $8.4 million mortgage loan on our new Los Angeles Corporate Headquarters at a fixed annual interest rate of 4.64%. This loan provided for a second loan upon completion of certain improvements. On June 26, 2017, we obtained a further $1.5 million under this provision at a fixed annual interest rate of 4.44%.\\n\\nBank of America Line of Credit\\n\\nIn October 2016, the term of this $5.0 million line of credit was extended to October 31, 2019. Such modification was not considered to be substantial under US GAAP.\\n\\nCinema 1,2,3 Term Loan\\n\\nOn August 31, 2016, Sutton Hill Properties LLC (“SHP”), a 75% subsidiary of RDI, refinanced its $15.0 million Santander Bank term loan with a new lender, Valley National Bank. This new $20.0 million loan is collateralized by our Cinema 1,2,3 property and bears an interest rate of 3.25% per annum, with principal installments and accruing interest paid monthly. The new loan matures on September 1, 2019, with a one-time option to extend maturity date for another year. The Company presently intends to exercise that option and to extend the maturity date until September 1, 2020.\\n\\nWestpac Bank Corporate Credit Facility (NZ)\\n\\nOn December 20, 2018, we restructured our Westpac Corporate Credit Facilities. The maturity of the 1st tranche (general/non-construction credit line) was extended to December 31, 2023, with the available facility being reduced from NZ$35.0 million to NZ$32.0 million. The facility bears an interest rate of 1.75% above the Bank Bill Bid Rate on the drawn down balance and a 1.1% line of credit charge on the entire facility. The 2nd tranche (construction line) with a facility of NZ$18.0 million was not renewed.\\n\\nAustralian NAB Corporate Term Loan (AU)\\n\\nOn March 15, 2019, we amended our Revolving Corporate Markets Loan Facility with National Australia Bank (“NAB”) from a facility comprised of (i) a AU$66.5 million loan facility with an interest rate of 0.95% above the Bank Bill Swap Bid Rate (“BBSY”) and a maturity date of June 30, 2019 and (ii) a bank guarantee of AU$5.0 million at a rate of 1.90% per annum into a (i) AU$120.0\\n16\\nmillion Corporate Loan facility at rates of 0.85%-1.30% above BBSY depending on certain ratios with a due date of December 31, 2023, of which AU$80.0 million is revolving and AU$40.0 million is core and (ii) a Bank Guarantee Facility of AU$5.0 million at a rate of 1.85% per annum. Prior to this, on June 12, 2018, we had extended the maturity of these facilities from June 30, 2019, to December 31, 2019. Such modifications of this particular term loan were not considered to be substantial under US GAAP.\\nNote 11 – Other Liabilities\\n\\nOther liabilities are summarized as follows:\\n\\n| |\\n| |\\n| | March 31, | December 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Current liabilities |\\n| Lease liability | $ | 5,900 | $ | 5,900 |\\n| Liability for demolition costs | 2,664 | 2,630 |\\n| Accrued pension | 684 | 684 |\\n| Security deposit payable | 88 | 84 |\\n| Finance lease liabilities | 162 | — |\\n| Other | 27 | 7 |\\n| Other current liabilities | $ | 9,525 | $ | 9,305 |\\n| Other liabilities |\\n| Straight-line rent | $ | — | $ | 16,362 |\\n| Lease make-good provision | 5,722 | 5,614 |\\n| Accrued pension | 4,544 | 4,670 |\\n| Environmental reserve | 1,656 | 1,656 |\\n| Deferred revenue - real estate | 9 | 32 |\\n| Acquired leases | 47 | 91 |\\n| Finance lease liabilities | 169 | — |\\n| Other | 199 | 506 |\\n| Other liabilities | $ | 12,346 | $ | 28,931 |\\n\\n\\nOn August 29, 2014, the Supplemental Executive Retirement Plan (“SERP”) that has been effective since March 1, 2007, was ended and replaced in accordance with the terms of a pension annuity. As a result of the termination of the SERP program, the accrued pension liability of $7.6 million was reversed and replaced with this pension annuity liability of $7.5 million. The valuation of the liability is based on the present value of $10.2 million discounted at a rate of 4.25% over a 15-year term, resulting in a monthly payment of $57,000. The discount rate of 4.25% has been applied since 2014 to determine the net periodic benefit cost and plan benefit obligation and is expected to be used in future years. The discounted value of $2.7 million (which is the difference between the estimated payout of $10.2 million and the present value of $7.5 million) as of August 29, 2014 will be amortized and expensed based on the 15-year term. In addition, the accumulated actuarial loss of $3.1 million recorded, as part of other comprehensive income will also be amortized based on the 15-year term.\\n\\nIn February 2018 we made a payment of $2.4 million relating to the annuity representing payments for the 42 months outstanding at the time. Monthly ongoing payments of $57,000 are now being made.\\n\\nAs a result of the above, included in our current and non-current liabilities are accrued pension costs of $5.2 million at March 31, 2019. The benefits of our pension plan are fully vested and therefore no service costs were recognized for the quarter ended March 31, 2019 and 2018. Our pension plan is unfunded.\\n\\nDuring the quarter ended March 31, 2019, the interest cost was $51,000 and actuarial loss was $51,000. During the quarter ended March 31, 2018, the interest cost was $45,000 and actuarial loss was $52,000.\\n17\\nNote 12 – Accumulated Other Comprehensive Income\\n\\nThe following table summarizes the changes in each component of accumulated other comprehensive income attributable to RDI:\\n\\n\\n| |\\n| |\\n| (Dollars in thousands) | ForeignCurrencyItems | UnrealizedGain (Losses)on Available-for-SaleInvestments | AccruedPensionService Costs | Hedge Accounting Reserve | Total |\\n| Balance at January 1, 2019 | $ | 8,687 | $ | 3 | $ | (2,438) | $ | (137) | $ | 6,115 |\\n| |\\n| Change related to derivatives |\\n| Total change in hedge fair value recorded in Other Comprehensive Income | — | — | — | (81) | (81) |\\n| Amounts reclassified from accumulated other comprehensive income | — | — | — | 12 | 12 |\\n| Net change related to derivatives | — | — | — | (69) | (69) |\\n| |\\n| Net current-period other comprehensive income (loss) | 1,526 | 2 | 51 | (69) | 1,510 |\\n| Balance at March 31, 2019 | $ | 10,213 | $ | 5 | $ | (2,387) | $ | (206) | $ | 7,625 |\\n\\nNote 13 – Commitments and Contingencies\\n\\nLitigation General\\n\\nWe are currently involved in certain legal proceedings and, as required, have accrued estimates of probable and estimable losses for the resolution of these claims, including legal costs.\\n| · | Where we are a plaintiff, we accrue legal fees as incurred on an on-going basis and make no provision for any potential settlement amounts until received. In Australia, the prevailing party is usually entitled to recover its attorneys’ fees, which recoveries typically work out to be approximately 60% of the amounts actually spent where first-class legal counsel is engaged at customary rates. Where we are a plaintiff, we have likewise made no provision for the liability for the defendant’s attorneys' fees in the event we are determined not to be the prevailing party. |\\n\\n| · | Where we are a defendant, we accrue for probable damages that insurance may not cover as they become known and can be reasonably estimated. In our opinion, any claims and litigation in which we are currently involved are not reasonably likely to have a material adverse effect on our business, results of operations, financial position, or liquidity. It is possible, however, that future results of the operations for any particular quarterly or annual period could be materially affected by the ultimate outcome of the legal proceedings. From time-to-time, we are involved with claims and lawsuits arising in the ordinary course of our business that may include contractual obligations, insurance claims, tax claims, employment matters, and anti-trust issues, among other matters. |\\n\\n\\nAll of these matters require significant judgments based on the facts known to us. These judgments are inherently uncertain and can change significantly when additional facts become known. We provide accruals for matters that have probable likelihood of occurrence and can be properly estimated as to their expected negative outcome. We do not record expected gains until the proceeds are received by us. However, we typically make no accruals for potential costs of defense, as such amounts are inherently uncertain and dependent upon the scope, extent and aggressiveness of the activities of the applicable plaintiff.\\n\\nEnvironmental and Asbestos Claims on Reading Legacy Operations\\nCertain of our subsidiaries were historically involved in railroad operations, coal mining, and manufacturing. Also, certain of these subsidiaries appear in the chain-of-title of properties that may suffer from pollution. Accordingly, certain of these subsidiaries have, from time-to-time, been named in and may in the future be named in various actions brought under applicable environmental laws. Also, we are in the real estate development business and may encounter from time-to-time unanticipated environmental conditions at properties that we have acquired for development. These environmental conditions can increase the cost of such projects and adversely affect the value and potential for profit of such projects. We do not currently believe that our exposure under applicable environmental laws is material in amount.\\n\\nFrom time to time, there are claims brought against us relating to the exposure of former employees of our railroad operations to asbestos and coal dust. These are generally covered by an insurance settlement reached in September 1990 with our insurance providers. However, this insurance settlement does not cover litigation by people who were not our employees and who may claim second-hand exposure to asbestos, coal dust and/or other chemicals or elements now recognized as potentially causing cancer in humans. Our known exposure to these types of claims, asserted or probable of being asserted, is not material.\\n\\n18\\nCotter Jr. Derivative Litigation\\n\\nThis action was originally brought by James J. Cotter, Jr. (“Cotter Jr.”) in June, 2015 in the Nevada District Court against all of the Directors of the Company and against the Company as a nominal defendant: James J. Cotter, Jr., individually and derivatively on behalf of Reading International, Inc. vs. Margaret Cotter, et al.” Case No,: A-15-719860-V. Summary judgment has been entered against Cotter, Jr., and in favor of all defendants and a $1.55 million cost judgment has been entered against Cotter, Jr., and in favor of our Company. Cotter, Jr. has appealed both judgements. Our application for $5.9 million in attorney’s fees was denied, and we have appealed that determination. The issues on appeal are currently being briefed. No date for oral argument has been set. It is unlikely that any hearing will be held this year. As the Directors and Officers Liability Insurance Policy covering Cotter, Jr.’s claims in the Derivative Case ($10.0 million) has been exhausted, the financial burden of defending our Directors against these claims, as required by applicable Nevada Law, has fallen upon our Company. During 2018, out-of-pocket third party costs in the amount of approximately $3.5 million were incurred by our Company in defending against these claims. In the quarter ended March 31, 2019, an additional $387,000 had been accrued, relating principally to the preparation of appellate briefs with respect to the Derivative Litigation.\\nNote 14 – Non-controlling Interests\\n\\nThese are composed of the following enterprises:\\n| · | Australia Country Cinemas Pty Ltd. - 25% noncontrolling interest owned by Panorama Cinemas for 21st Century Pty Ltd.; |\\n\\n| · | Shadow View Land and Farming, LLC - 50% noncontrolling membership interest owned by either the estate of Mr. James J. Cotter, Sr. (the “Cotter Estate”) and/or the James J. Cotter, Sr. Living Trust (the “Cotter Trust”); and, |\\n\\n| · | Sutton Hill Properties, LLC - 25% noncontrolling interest owned by Sutton Hill Capital, LLC (which in turn is 50% owned by the Cotter Estate and/or the Cotter Trust). |\\n\\n\\nThe components of noncontrolling interests are as follows:\\n\\n| |\\n| |\\n| | March 31, | December 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Australian Country Cinemas, Pty Ltd | $ | 27 | $ | 89 |\\n| Shadow View Land and Farming, LLC | 2,156 | 2,153 |\\n| Sutton Hill Properties, LLC | 2,084 | 2,095 |\\n| Noncontrolling interests in consolidated subsidiaries | $ | 4,267 | $ | 4,337 |\\n\\n\\nThe components of income attributable to noncontrolling interests are as follows:\\n\\n\\n| |\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Australian Country Cinemas, Pty Ltd | $ | 9 | $ | 41 |\\n| Shadow View Land and Farming, LLC | (14) | (13) |\\n| Sutton Hill Properties, LLC | (11) | (6) |\\n| Net income (loss) attributable to noncontrolling interests | $ | (16) | $ | 22 |\\n\\n\\n19\\nSummary of Controlling and Noncontrolling Stockholders’ Equity\\n\\nA summary of the changes in controlling and noncontrolling stockholders’ equity is as follows:\\n\\n\\n\\n| |\\n| |\\n| (Dollars in thousands) | ControllingStockholders’Equity | NoncontrollingStockholders’Equity | TotalStockholders’Equity |\\n| Equity at January 1, 2019 | $ | 176,210 | $ | 4,337 | $ | 180,547 |\\n| Adjustments to opening retained earnings on adoption of ASC 842 | 28 | (46) | (18) |\\n| Net income (loss) | (2,081) | (16) | (2,097) |\\n| Increase in additional paid in capital | 21 | — | 21 |\\n| Treasury stock purchased | (9) | — | (9) |\\n| Contributions from noncontrolling stockholders | — | 18 | 18 |\\n| Distributions to noncontrolling stockholders | — | (27) | (27) |\\n| Accumulated other comprehensive income | 1,510 | 1 | 1,511 |\\n| Equity at March 31, 2019 | $ | 175,679 | $ | 4,267 | $ | 179,946 |\\n| |\\n| (Dollars in thousands) | ControllingStockholders’Equity | NoncontrollingStockholders’Equity | TotalStockholders’Equity |\\n| Equity at January 1, 2018 | $ | 177,287 | $ | 4,331 | $ | 181,618 |\\n| Adjustments to opening retained earnings on adoption of ASC 606 | 194 | (2) | 192 |\\n| Net income (loss) | 3,082 | 22 | 3,104 |\\n| Increase in additional paid in capital | 339 | — | 339 |\\n| Treasury stock purchased | (317) | — | (317) |\\n| Contributions from noncontrolling stockholders | — | 27 | 27 |\\n| Distributions to noncontrolling stockholders | — | (43) | (43) |\\n| Accumulated other comprehensive loss | (750) | (3) | (753) |\\n| Equity at March 31, 2018 | $ | 179,835 | $ | 4,332 | $ | 184,167 |\\n\\nNote 15 – Stock-Based Compensation and Stock Repurchases\\n\\nEmployee and Director Stock Option Plan\\n\\nThe Company may grant stock options and other share-based payment awards of our Common Stock to eligible employees, directors, and consultants under the 2010 Stock Incentive Plan (the “Plan”). The aggregate total number of shares of the Common Stock authorized for issuance under the Plan is 2,197,460.\\n\\nDuring the Company’s 2017 Annual Stockholders’ Meeting held on November 7, 2017, the Company's stockholders, upon recommendation of the Board of Directors, approved an amendment to the Plan to increase the number of shares of common stock issuable under the Plan by an additional 947,460 shares. The effect of the increase is to restore the amount of shares of Common Stock available under the Plan from the 302,540 shares available as of September 30, 2017, back up to its original reserve of 1,250,000 shares. As of March 31, 2019, we had 789,869 shares remaining for future issuances.\\n\\nSince the adoption of the Plan in 2010, the Company has granted awards primarily in the form of stock options. In the 1st quarter of 2016, the Company started to award restricted stock units (“RSUs”) to directors and certain members of management. Stock options are generally granted at exercise prices equal to the grant-date market prices and typically expire no later than five years from the grant date. In contrast to a stock option where the grantee buys the Company’s share at an exercise price determined on grant date, an RSU entitles the grantee to receive one share for every RSU based on a vesting plan. At the discretion of our Compensation and Stock Options Committee, the vesting period of stock options and RSUs granted to employees ranges from zero to four years. Grants to directors and certain executive officers are subject to Board approval. At the time the options are exercised or RSUs vest and are settled, at the discretion of management, we will issue treasury shares or make a new issuance of shares to the option or RSU holder.\\n\\nStock Options\\nWe estimate the grant-date fair value of our stock options using the Black-Scholes option-valuation model, which takes into account assumptions such as the dividend yield, the risk-free interest rate, the expected stock price volatility, and the expected life of the options. We expense the estimated grant-date fair values of options over the vesting period on a straight-line basis. Based on our\\n20\\nhistorical experience, the “deemed exercise” of expiring in-the-money options and the relative market price to strike price of the options, we have not hereto estimated any forfeitures of vested or unvested options.\\n\\nThere were 219,408 stock options issued in the quarter ended March 31, 2019. The weighted average assumptions used in the option-valuation model were as follows:\\n\\n\\n| |\\n| |\\n| | Three Months Ended March 31, |\\n| | 2019 | 2018 |\\n| Stock option exercise price | $ | 16.12 | $ | — |\\n| Risk-free interest rate | 2.42% | 0.00% |\\n| Expected dividend yield | — | — |\\n| Expected option life in years | 3.75 | — |\\n| Expected volatility | 23.32% | 0.00% |\\n| Weighted average fair value | $ | 3.50 | $ | — |\\n\\n\\nFor the quarters ended March 31, 2019 and 2018, we recorded compensation expense of $70,000 and $85,000, respectively. At March 31, 2019, the total unrecognized estimated compensation expense related to non-vested stock options was $1.5 million, which we expect to recognize over a weighted average vesting period of 2.11 years. The intrinsic, unrealized value of all options outstanding, vested and expected to vest, at March 31, 2019 was $2.0 million, of which 91% are currently exercisable.\\n\\nThe following table summarizes the number of options outstanding and exercisable as of March 31, 2019 and December 31, 2018:\\n\\n| |\\n| |\\n| | Outstanding Stock Options - Class A Shares |\\n| | Numberof Options | WeightedAverageExercise Price | WeightedAverageRemainingYears ofContractualLife | AggregateIntrinsicValue |\\n| | Class A | Class A | Class A | Class A |\\n| Balance - December 31, 2017 | 524,589 | $ | 12.50 | 3.15 | $ | 3,054,325 |\\n| Granted | 126,840 | 16.40 | — | — |\\n| Exercised | (60,000) | 6.02 | — | 610,249 |\\n| Forfeited | (4,960) | 12.08 | — | — |\\n| Balance - December 31, 2018 | 586,469 | $ | 14.01 | 2.88 | $ | 1,530,528 |\\n| Granted | 219,408 | 16.12 | — | — |\\n| Exercised | (67,500) | 13.42 | — | 185,175 |\\n| Forfeited | (25,000) | 13.42 | — | — |\\n| Balance - March 31, 2019 | 713,377 | $ | 14.74 | 3.53 | $ | 1,993,628 |\\n\\n\\n21\\nRestricted Stock Units\\nWe estimate the grant-date fair values of our RSUs using the Company’s stock price at grant-date and record such fair values as compensation expense over the vesting period on a straight-line basis. The following table summarizes the status of the RSUs granted to-date as of March 31, 2019:\\n\\n| |\\n| |\\n| | Outstanding Restricted Stock Units |\\n| | RSU Grants (in units) | Vested, | Unvested, | Forfeited, |\\n| Grant Date | Directors | Management | TotalGrants | March 31,2019 | March 31,2019 | March 31,2019 |\\n| March 10, 2016 | 35,147 | 27,381 | 62,528 | 55,684 | 6,844 |\\n| April 11, 2016 | — | 5,625 | 5,625 | 2,815 | 2,293 | 517 |\\n| March 23, 2017 | 30,681 | 32,463 | 63,144 | 46,919 | 16,225 |\\n| August 29, 2017 | — | 7,394 | 7,394 | 3,698 | 3,696 |\\n| January 2, 2018 | 29,393 | — | 29,393 | 29,393 | — |\\n| April 12, 2018 | — | 29,596 | 29,596 | — | 29,596 |\\n| April 13, 2018 | — | 14,669 | 14,669 | — | 14,669 |\\n| July 6, 2018 | — | 932 | 932 | — | — | 932 |\\n| November 7, 2018 | 23,010 | — | 23,010 | — | 23,010 |\\n| March 13, 2019 | — | 24,366 | 24,366 | — | 24,366 |\\n| March 14, 2019 | — | 23,327 | 23,327 | — | 23,327 |\\n| Total | 118,231 | 165,753 | 283,984 | 138,509 | 144,026 | 1,449 |\\n\\n\\nRSU awards to management vest 25% at the end of each year for 4 years. Prior to November 7, 2018, RSU awards to directors vested 100% in January of the following year in which such RSUs were granted. At the November 7, 2018 Board meeting, it was determined that it would be more appropriate for the vesting of RSUs to align with the directors’ term of office. Accordingly, the RSUs granted on November 7, 2018, will vest upon the earlier of (i) the first anniversary of grant and (ii) the date of the next annual meeting of stockholders. This means that on the date of the annual meeting of stockholders on May 7, 2019, the RSUs granted to directors on November 7, 2018 vested. Due to the fact that the Company has moved up its annual meeting of stockholders from November to May this year, this created a shorter than normal vesting period for the RSUs issued on November 7, 2018. In order to adjust for this factor, the directors have determined that the award of RSUs to be made immediately following the 2019 Annual Meeting of Stockholders will be $35,000 or one half of last year's annual grant. For the quarter ended March 31, 2019 and 2018, we recorded compensation expense of $209,000 and $294,000, respectively. The total unrecognized compensation expense related to the non-vested RSUs was $1.9 million as of March 31, 2019, which we expect to recognize over a weighted average vesting period of 1.1 years.\\n\\nStock Repurchase Program\\n\\nOn March 2, 2017, the Company's Board of Directors authorized management, at its discretion, to spend up to an aggregate of $25.0 million to acquire shares of Reading’s Class A Common Stock. The previously approved stock repurchase program, which allowed management to spend up to an aggregate of $10.0 million to acquire shares of Reading’s Class A Common Stock, was completed as of December 31, 2016. On March 14, 2019, the Board of Directors extended this stock buy-back program for two years, through March 2, 2021. The Board of Directors did not increase the authorized amount which was $16.2 million at March 31, 2019.\\n\\nThe repurchase program allows Reading to repurchase its shares in accordance with the requirements of the SEC on the open market, in block trades and in privately negotiated transactions, depending on market conditions and other factors. All purchases are subject to the availability of shares at prices that are acceptable to Reading, and accordingly, no assurances can be given as to the timing or number of shares that may ultimately be acquired pursuant to this authorization.\\n\\nUnder the stock repurchase program, as of March 31, 2019, the Company has reacquired 559,627 shares of Class A Common Stock for $8.8 million at an average price of $15.81 per share (excluding transaction costs) to-date. 566 shares of Class A Common Stock were purchased during the quarter ended March 31, 2019 at an average price of $16.08 per share. This leaves $16.2 million available under the March 2, 2017 program, as extended, for repurchase as of March 31, 2019.\\n\\n22\\nNote 16 - Leases\\n\\nIn all leases, whether we are the lessor or lessee, we define lease term as the non-cancellable term of the lease plus any renewals covered by renewal options that are reasonably certain of exercise based on our assessment of economic factors relevant to the lessee. The non-cancellable term of the lease commences on the date the lessor makes the underlying property in the lease available to the lessee, irrespective of when lease payments begin under the contract.\\n\\nAs Lessee\\n\\nWe have operating leases for certain cinemas and corporate offices, and finance leases for certain equipment assets. Our leases have remaining lease terms of 1 to 20 years, with certain leases having options to extend to up to a further 20 years.\\n\\nContracts are analyzed in accordance with the criteria set out in ASC 842 to determine if there is a lease present. For contracts that contain an operating lease, we account for the lease component and the non-lease component together as a single component. For contracts that contain a finance lease we account for the lease component and the non-lease component separately in accordance with ASC 842.\\n\\nIn leases where we are the lessee, we recognize a right of use asset and lease liability at lease commencement, which is measured by discounting lease payments using our incremental borrowing rate applicable to the lease term and currency of the lease as the discount rate. Subsequent amortization of the right of use asset and accretion of the lease liability for an operating lease is recognized as a single lease cost, on a straight line basis, over the term of the lease. A finance lease right-of-use asset is depreciated on a straight line basis over the lesser of the useful life of the leased asset or the lease term. Interest on each finance lease liability is determined as the amount that results in a constant periodic discount rate on the remaining balance of the liability. Property taxes and other non-lease costs are accounted for on an accrual basis.\\n\\nLease payments for our cinema operating leases consist of fixed base rent, and for certain leases, variable lease payments consisting of contracted percentages of revenue, changes in the relevant CPI, and/or other contracted financial metrics.\\nThe components of lease expense were as follows:\\n\\n\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Lease cost |\\n| Finance lease cost: | — |\\n| Amortization of right-of-use assets | $ | 41 | $ | — |\\n| Interest on lease liabilities | 3 | — |\\n| Operating lease cost | 7,921 | — |\\n| Variable lease cost | 105 | — |\\n| Total lease cost | $ | 8,070 | $ | — |\\n\\n\\n\\nSupplemental cash flow information related to leases was as follows:\\n\\n\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Cash flows relating to lease cost |\\n| Cash paid for amounts included in the measurement of lease liabilities: |\\n| Operating cash flows from finance leases | $ | 44 | $ | — |\\n| Operating cash flows from operating leases | 7,780 | — |\\n| Right-of-use assets obtained in exchange for new finance lease liabilities | — | — |\\n| Right-of-use assets obtained in exchange for new operating lease liabilities | 2,181 | — |\\n\\n23\\n\\n\\n\\nSupplemental balance sheet information related to leases was as follows:\\n\\n\\n| |\\n| | March 31, | December 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Operating leases |\\n| Operating lease right-of-use assets | $ | 229,266 | $ | — |\\n| Operating lease liabilities - current portion | 19,797 | — |\\n| Operating lease liabilities - non-current portion | 222,594 | — |\\n| Total operating lease liabilities | $ | 242,391 | $ | — |\\n| Finance leases |\\n| Property plant and equipment, gross | 372 | — |\\n| Accumulated depreciation | (41) | — |\\n| Property plant and equipment, net | $ | 331 | $ | — |\\n| Other current liabilities | 162 | — |\\n| Other long-term liabilities | 169 | — |\\n| Total finance lease liabilities | $ | 331 | $ | — |\\n| |\\n| Other information |\\n| Weighted-average remaining lease term - finance leases | 3 | — |\\n| Weighted-average remaining lease term - operating leases | 11 | — |\\n| Weighted-average discount rate - finance leases | 5.05% | — |\\n| Weighted-average discount rate - operating leases | 4.97% | — |\\n\\n\\n\\nMaturity of leases were as follows:\\n\\n\\n| |\\n| (Dollars in thousands) | Operating leases | Finance leases |\\n| 2019 | $ | 23,566 | $ | 133 |\\n| 2020 | 31,434 | 101 |\\n| 2021 | 31,717 | 53 |\\n| 2022 | 31,901 | 43 |\\n| 2023 | 31,018 | 28 |\\n| Thereafter | 169,221 | — |\\n| Total lease payments | $ | 318,857 | $ | 358 |\\n| Less imputed interest | (76,466) | (27) |\\n| Total | $ | 242,391 | $ | 331 |\\n\\n\\n\\nAs of March 31, 2019, we have additional operating leases, primarily for cinemas, that have not yet commenced of approximately $26.0 million. These operating leases will commence between fiscal year 2019 and fiscal year 2021 with lease terms of 15 to 20 years.\\n\\nAs Lessor\\n\\nThe Company has entered into various leases as a lessor for our owned real estate properties. These leases vary in length between 1 and 20 years, with certain leases containing options to extend at the behest of the applicable tenants. Lease components consist of fixed base rent, and for certain leases, variable lease payments consisting of contracted percentages of revenue, changes in the relevant CPI, and/or other contracted financial metrics. No terms exist by which a lessee is able to purchase the underlying asset.\\n\\nWe recognize lease payments for operating leases as property revenue on a straight-line basis over the lease term. Lease incentive payments we make to lessees are amortized as a reduction in property revenue over the lease term.\\n24\\nLease income relating to operating lease payments was as follows:\\n\\n\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Components of lease income |\\n| Lease payments | $ | 2,229 | $ | 2,423 |\\n| Variable lease payments | 265 | 80 |\\n| Total lease income | $ | 2,494 | $ | 2,503 |\\n\\n\\n\\nThe book value of underlying assets under operating leases from owned assets was as follows:\\n\\n\\n| |\\n| | March 31, | December 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Building and improvements |\\n| Gross balance | $ | 68,483 | $ | 67,887 |\\n| Accumulated depreciation | (18,375) | (17,709) |\\n| Net Book Value | $ | 50,108 | $ | 50,178 |\\n\\n\\n\\n\\nMaturity of leases were as follows:\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n| |\\n| (Dollars in thousands) | Operating leases |\\n| 2019 | $ | 6,470 |\\n| 2020 | 7,439 |\\n| 2021 | 6,830 |\\n| 2022 | 5,961 |\\n| 2023 | 5,187 |\\n| Thereafter | 10,295 |\\n| Total | $ | 42,182 |\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\nNote 17 – Hedge Accounting\\n\\nAs of March 31, 2019 and March 31, 2018, the Company held interest rate derivatives in the total notional amount of $8.0 million and $nil, respectively.\\n\\nThe derivatives are recorded on the balance sheet at fair value and are included in the following line items:\\n\\n\\n| |\\n| | Liability Derivatives |\\n| | March 31, | December 31, |\\n| | 2019 | 2018 |\\n| (Dollars in thousands) | Balance sheet location | Fair value | Balance sheet location | Fair value |\\n| Interest rate contracts | Derivative financial instruments - current portion | $ | 52 | Derivative financial instruments - current portion | $ | 41 |\\n| | Derivative financial instruments - non-current portion | 203 | Derivative financial instruments - non-current portion | 145 |\\n| Total derivatives designated as hedging instruments | $ | 255 | $ | 186 |\\n| Total derivatives | $ | 255 | $ | 186 |\\n\\n\\n\\n\\n\\n25\\n\\n\\nWe have no derivatives designated as hedging instruments which are in asset positions.\\n\\nThe changes in fair value are recorded in Other Comprehensive Income and released into interest expense in the same period(s) in which the hedged transactions affect earnings. In the quarter to March 31, 2019 and March 31, 2018, respectively, the derivative instruments affected Comprehensive Income as follows:\\n\\n\\n\\n| |\\n| (Dollars in thousands) | Location of Loss Recognized in Income on Derivatives | Amount of Loss Recognized in Income on Derivatives |\\n| | 2019 | 2018 |\\n| Interest rate contracts | Interest expense, net | $ | 12 | $ | — |\\n| Total | $ | 12 | $ | — |\\n\\n\\n\\n| |\\n| | Loss Recognized in OCI on Derivatives (Effective Portion) | Loss Reclassified from OCI into Income (Effective Portion) | Loss Recognized in Income on Derivatives (Ineffective Portion and Amount Excluded from Effectiveness Testing) |\\n| (Dollars in thousands) | Amount | Line Item | Amount | Line Item | Amount |\\n| | 2019 | 2018 | 2019 | 2018 | 2019 | 2018 |\\n| Interest rate contracts | $ | 81 | $ | — | Interest expense, net | $ | 12 | $ | — | Interest expense, net | $ | — | $ | — |\\n| Total | $ | 81 | $ | — | $ | 12 | $ | — | $ | — | $ | — |\\n\\n\\n\\nNote 18 – Fair Value Measurements\\n\\nASC 820, Fair Value Measurement establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The statement requires that assets and liabilities carried at fair value be classified and disclosed in one of the following three categories:\\n| · | Level 1: Quoted market prices in active markets for identical assets or liabilities; |\\n\\n| · | Level 2: Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets; and, |\\n\\n| · | Level 3: Valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable. |\\n\\nAs of March 31, 2019 and December 31, 2018 material financial assets and financial liabilities were carried and measured at fair value on a recurring basis.\\n\\nThe following tables summarize our financial liabilities that are carried at cost and measured at fair value on a non-recurring basis as of March 31, 2019 and December 31, 2018, by level within the fair value hierarchy.\\n\\n\\n| |\\n| |\\n| | Fair Value Measurement at March 31, 2019 |\\n| (Dollars in thousands) | CarryingValue(1) | Level 1 | Level 2 | Level 3 | Total |\\n| Notes payable | $ | 155,855 | $ | — | $ | — | $ | 159,871 | $ | 159,871 |\\n| Subordinated debt | 27,913 | — | — | 19,162 | 19,162 |\\n| | $ | 183,768 | $ | — | $ | — | $ | 179,033 | $ | 179,033 |\\n\\n\\n\\n| |\\n| |\\n| | Fair Value Measurement at December 31, 2018 |\\n| (Dollars in thousands) | CarryingValue(1) | Level 1 | Level 2 | Level 3 | Total |\\n| Notes payable | $ | 139,130 | $ | — | $ | — | $ | 143,564 | $ | 143,564 |\\n| Subordinated debt | 27,913 | — | — | 18,895 | 18,895 |\\n| | $ | 167,043 | $ | — | $ | — | $ | 162,459 | $ | 162,459 |\\n\\n\\n| (1) | These balances are presented before any deduction for deferred financing costs. |\\n\\n26\\n\\nFollowing is a description of the valuation methodologies used to estimate the fair value of our financial assets and liabilities. There have been no changes in the methodologies used at March 31, 2019 and December 31, 2018.\\n| · | Level 1 investments in marketable securities primarily consist of investments associated with the ownership of marketable securities in U.S. and New Zealand. These investments are valued based on observable market quotes on the last trading date of the reporting period. |\\n\\n| · | Level 2 derivative financial instruments are valued based on discounted cash flow models that incorporate observable inputs such as interest rates and yield curves from the derivative counterparties. The credit valuation adjustments associated with our non-performance risk and counterparty credit risk are incorporated in the fair value estimates of our derivatives. As of March 31, 2019 and December 31, 2018, we concluded that the credit valuation adjustments were not significant to the overall valuation of our derivatives. |\\n\\n| · | Level 3 borrowings include our secured and unsecured notes payable, trust preferred securities and other debt instruments. The borrowings are valued based on discounted cash flow models that incorporate appropriate market discount rates. We calculated the market discount rate by obtaining period-end treasury rates for fixed-rate debt, or LIBOR for variable-rate debt, for maturities that correspond to the maturities of our debt, adding appropriate credit spreads derived from information obtained from third-party financial institutions. These credit spreads take into account factors such as our credit rate, debt maturity, types of borrowings, and the loan-to-value ratios of the debt. |\\n\\n\\nThe Company’s financial instruments also include cash, cash equivalents, receivables and accounts payable. The carrying values of these financial instruments approximate the fair values due to their short maturities. Additionally, there were no transfers of assets and liabilities between levels 1, 2, or 3 during the quarter ended March 31, 2019 and March 31, 2018.\\nNote 19 – Business Combination\\n\\nOn January 30, 2019, we purchased the tenant’s interest and other operating assets of an established four-screen cinema in Devonport, Tasmania, Australia, for $1.4 million (AU$1.95 million). We commenced trading from this new cinema site on January 30, 2019.\\n\\nThe total purchase price was allocated to the identifiable assets acquired based on our preliminary estimates of their fair values on the acquisition date. There were no liabilities assumed. As of March 31, 2019, the Company is still finalizing its allocation and this may result in potential adjustments within the one-year measurement period from acquisition date. The determination of the fair values of the acquired assets (and the related determination of their estimated lives) requires significant judgment.\\n\\nOur preliminary purchase price allocation is as follows:\\n\\n\\n| |\\n| | Preliminary Purchase Price |\\n| | Allocation |\\n| (Dollars in thousands) | US Dollars(1) | AU dollars |\\n| Tangible Assets |\\n| Operating property: |\\n| Fixtures and equipment | $ | 153 | $ | 213 |\\n| Intangible Assets |\\n| Goodwill | 1,248 | 1,734 |\\n| Total assets acquired | 1,401 | 1,947 |\\n| |\\n| Net assets acquired | $ | 1,401 | $ | 1,947 |\\n\\n\\n| (1) | The balances were translated into U.S. Dollars based on the applicable exchange rate as of the date of acquisition, January 30, 2019. |\\n\\n\\n\\n\\n\\n27\\nThis MD&A should be read in conjunction with the accompanying unaudited consolidated financial statements included in Part I, Item 1 (Financial Statements). The foregoing discussions and analyses contain certain forward-looking statements. Please refer to the “Forward Looking Statements” included at the conclusion of this section and our “Risk Factors” set forth in our 2018 Form 10-K, Part 1, Item 1A and the Risk Factors set out below.\\n\\n\\nItem 2 – Management’s Discussions and Analysis (“MD&A”) of Financial Condition and Results of Operations\\n\\nBUSINESS OVERVIEW\\n\\nWe are an internationally diversified company principally focused on the development, lease or ownership, and operation of entertainment and real estate assets in the United States, Australia, and New Zealand. As of March 31, 2019, we operate in two business segments:\\n| · | Cinema exhibition, through our 60 multiplex cinemas; and, |\\n\\n| · | Real estate, including real estate development and the rental of retail, commercial and live theatre assets. |\\n\\n\\nWe believe that these two business segments complement one another, as we can use the comparatively consistent cash flows generated by our cinema operations to fund the front-end cash demands of our real estate development business.\\n\\nCinema Exhibition\\nWe manage our worldwide cinema exhibition businesses under various brands:\\n| · | in the U.S., under the following brands: Reading Cinemas, Angelika Film Centers, Consolidated Theatres, and City Cinemas; |\\n\\n| · | in Australia, under the Reading Cinemas brand; and, |\\n\\n| · | in New Zealand, under the Reading Cinemas and Rialto Cinemas brands. |\\n\\n\\nShown in the following table are the number of locations and theater screens in our theater circuit in each country, by state/territory/ region and indicating our cinema brands and our interest in the underlying assets as of March 31, 2019:\\n\\n\\n| |\\n| |\\n| | State / Territory / | Location | Screen | Interest in AssetUnderlying the Cinema |\\n| Country | Region | Count | Count | Leased | Owned | Operating Brands |\\n| United States | Hawaii | 9 | 98 | 9 | Consolidated Theatres |\\n| | California | 7 | 88 | 7 | Reading Cinemas, Angelika Film Center |\\n| | New York(3) | 6 | 23 | 5 | 1 | Angelika Film Center, City Cinemas |\\n| | Texas | 2 | 13 | 2 | Angelika Film Center |\\n| | New Jersey | 1 | 12 | 1 | Reading Cinemas |\\n| | Virginia | 1 | 8 | 1 | Angelika Film Center |\\n| | Washington DC | 1 | 3 | 1 | Angelika Film Center |\\n| | U.S. Total | 27 | 245 | 26 | 1 |\\n| Australia | New South Wales | 6 | 44 | 4 | 2 | Reading Cinemas |\\n| | Victoria | 6 | 43 | 6 | Reading Cinemas |\\n| | Queensland | 5 | 50 | 2 | 3 | Reading Cinemas, Event Cinemas(1) |\\n| | Western Australia | 2 | 16 | 1 | 1 | Reading Cinemas |\\n| | South Australia | 2 | 15 | 2 | Reading Cinemas |\\n| | Tasmania | 1 | 4 | 1 | Reading Cinemas |\\n| | Australia Total | 22 | 172 | 16 | 6 |\\n| New Zealand | Wellington | 2 | 15 | 1 | 1 | Reading Cinemas |\\n| | Otago | 3 | 15 | 2 | 1 | Reading Cinemas, Rialto Cinemas(2) |\\n| | Auckland | 2 | 15 | 2 | Reading Cinemas, Rialto Cinemas(2) |\\n| | Canterbury | 1 | 8 | 1 | Reading Cinemas |\\n| | Southland | 1 | 5 | 1 | Reading Cinemas |\\n| | Bay of Plenty | 1 | 5 | 1 | Reading Cinemas |\\n| | Hawke's Bay | 1 | 4 | 1 | Reading Cinemas |\\n| | New Zealand Total | 11 | 67 | 6 | 5 |\\n| GRAND TOTAL | 60 | 484 | 48 | 12 |\\n\\n\\n| (1) | The Company has a 33.3% unincorporated joint venture interest in a 16-screen cinema located in Mt. Gravatt, Queensland managed by Event Cinemas. |\\n\\n| (2) | The Company is a 50% joint venture partner in two (2) New Zealand Rialto cinemas. We are responsible for the booking of these cinemas and our joint venture partner, Event Cinemas, manages their day-to-day operations. |\\n\\n| (3) | Our New York statistics include one (1) managed cinema, with a four-screen total. |\\n\\n\\n28\\nReal Estate\\nWe engage in real estate development and the ownership, and rental or licensing to third parties of retail, commercial and live theater assets. We own the fee interests in all three of our live theaters, and in 12 of our cinemas (as presented in the preceding table). Our real estate business creates long-term value for our stockholders through the continuous improvement and development of our investment and operating properties, including our entertainment-themed centers (“ETCs”).\\n\\nOur real estate activities have historically consisted principally of:\\n| · | the ownership of fee or long-term leasehold interests in properties used in our cinema exhibition activities or which were acquired for the development of cinemas or cinema-based real estate development projects; |\\n\\n| · | the acquisition and development of fee interests in land; |\\n\\n| · | the licensing to production companies of the use of our live theatres; and, |\\n\\n| · | the redevelopment of our existing fee-owned cinema or live theatre sites to their highest and best use. |\\n\\n\\nCinema Exhibition\\nOur cinema revenue consists primarily of admissions, Food & Beverage (“F&B”), advertising and theater rentals. Cinema operating expense consists of the costs directly attributable to the operation of the cinemas, including film rent expense, operating costs, and occupancy costs. Cinema revenue and expense fluctuate with the availability of quality first run films and the numbers of weeks such first run films stay in the market. For a breakdown of our current cinema assets that we own and/or manage, please see Part I, Item 1 – Our Business of our 2018 Form 10-K.\\n\\nWhile our capital projects in recent years have been focused in growing our real estate segment, we have over the past two years placed special emphasis on the expansion and upgrading of our cinema exhibition portfolio, as discussed below:\\n\\nCinema Additions (including re-openings)\\nThe latest additions and enhancements to our cinema portfolio are as follows:\\n| · | Opening our first dine-in concept, “Spotlight” in the United States: On March 30, 2018 we finished the conversion of one wing (six auditoriums) at our Reading Cinema in Murrieta, California (Cal Oaks) to our dine-in concept brand, “Spotlight”. |\\n\\n| · | AU and NZ Additions/Refurbishments On January 30, 2019, we purchased the tenant’s interest and other operating assets of an established four-screen cinema in Devonport, Tasmania, Australia, for $1.4 million (AU$1.95 million). We commenced trading from this new cinema site on January 30, 2019. For the first quarter of 2019, we invested in two additional Gold Lounge auditoriums at our Harbour Town cinema. In 2017 and 2018, we improved eight theaters: Belmont, Rouse Hill, Courtenay Central, Napier, Charlestown, Elizabeth, Auburn and Rotorua. |\\n\\n| · | U.S. Refurbishments For the first quarter of 2019, we continued investing in refurbishments primarily at our Mililani cinema. During 2017 and 2018, we continued to invest in the refurbishment and enhancements of our existing cinemas, as contemplated by our strategic plan. During this period, seven locations had significant refurbishment work performed: our Cal Oaks, Valley Plaza and Grossmont locations in California; our Ward, Pearlridge and Mililani locations in Hawaii; and our Manville location in New Jersey. Continuing with our strategic plan, since 2017, we converted (or are in the process of conversion), 74 of our 245 U.S. auditoriums to luxury recliner seating. |\\n\\nCinema Pipeline\\nDuring 2019, we currently plan to upgrade or begin the upgrade of 11 cinemas in the U.S., Australia, and New Zealand.\\n\\nWe have entered into lease agreements for four new cinemas in Australia (25 screens), which we anticipate will come on line in 2019 - 2021.\\n\\nOur focus with respect to new cinemas is on featuring state-of-the-art projection and sound, luxury recliner seating, enhanced F&B (typically including alcohol service) and typically at least one major TITAN type presentation screen. Our focus is on providing best in class services and amenities that will differentiate us from in-home and mobile viewing options. We believe that a night at the movies should be a special and premium experience and, indeed, that it must be in order to compete with the variety of options being offered to consumers through other platforms.\\n\\nThroughout 2019, we will also be focusing on the rollout and enhancement of our proprietary on-line ticketing capabilities and social media interfaces. These are intended to enhance the convenience of our offering and to promote customer affinity with the experience and product that we are offering.\\n\\n29\\nCinema Closures\\nWe evaluate the performance of each of our cinemas and, in some instances, we may decide to close an operation when it is not economically viable to continue to operate from the location. We did not close any theaters leased from third parties in 2018 or to date in 2019. While some of our theaters have encountered new competition, and while we believe that others will benefit from planned refurbishment and upgrading, none of our leased theaters are currently slated for closure.\\n\\nDuring January 2019, we closed our Courtenay Central cinema in Wellington, New Zealand due to seismic concerns. We are currently assessing the redevelopment of that property. It is currently anticipated that the cinema component will be upgraded and restored in connection with any such redevelopment.\\n\\nUpgrades to our Film Exhibition Technology and Theatre Amenities\\nWe continue to focus in areas of the matured cinema business where we believe we have growth potential and ultimately, provide long-term value to our stockholders. These are (i) upgrading of our existing cinemas and (ii) developing new cinemas to provide our customers with premium offerings, including state-of-the-art presentation (including sound, lounges and bar service) and luxury seating. As of March 31, 2019, the upgrades to our theater circuits’ film exhibition technology and amenities are summarized in the following table:\\n\\n| |\\n| |\\n| | LocationCount | ScreenCount |\\n| Screen Format |\\n| Digital (all cinemas in our theatre circuit) | 60 | 484 |\\n| IMAX | 1 | 1 |\\n| TITAN XC and LUXE | 18 | 20 |\\n| Dine-in Service |\\n| Gold Lounge (AU/NZ)(1) | 10 | 27 |\\n| Premium (AU/NZ)(2) | 11 | 21 |\\n| Spotlight (U.S.)(3) | 1 | 6 |\\n| Upgraded Food & Beverage menu (U.S.)(4) | 14 | n/a |\\n| Premium Seating (recliner seating features) | 22 | 142 |\\n| Liquor Licenses Obtained(5) | 28 | n/a |\\n\\n| (1) | Gold Lounge: This is our \\\"First Class Full Dine-in Service\\\" in our Australian and New Zealand cinemas, which includes upgraded F&B menu (with alcoholic beverages), luxury recliner seating features (intimate 25-50 seat cinemas) and waiter service. |\\n\\n| (2) | Premium Service: This is our \\\"Business Class Dine-in Service\\\" in our Australian and New Zealand cinemas, which typically includes upgraded F&B menu (some with alcoholic beverages) and may include luxury recliner seating features (less intimate 80-seat cinemas), but no waiter service. |\\n\\n| (3) | Spotlight Service: On March 30, 2018 we opened “Spotlight” our first dine-in cinema concept in the United States at Cal Oaks. Six of our 17 auditoriums at this theater feature this dine-in concept. |\\n\\n| (4) | Upgraded Food & Beverage Menu: Fourteen of our US theaters feature an elevated food and beverage menu served from a common counter, which includes, without limitation, beer, wine and/or spirits and a food menu beyond traditional concessions. We have worked with former Food Network executives to create a menu of locally inspired and freshly prepared items. |\\n\\n| (5) | Liquor Licenses: Licenses are applicable at each cinema location, rather than each theatre auditorium. For accounting purposes, we capitalize the cost of successfully purchasing or applying for liquor licenses meeting certain thresholds as an intangible asset due to long-term economic benefits derived on future sales of alcoholic beverages. |\\n\\n\\nReal Estate\\nOur operating properties currently consists of the following assets:\\n| · | our Newmarket, Queensland ETC, our Belmont, Western Australia ETC, our Auburn, New South Wales ETC, our Townsville, Queensland ETC and our Wellington, New Zealand ETC; and, |\\n\\n| · | two (2) single-auditorium live theatres in Manhattan (Minetta Lane and Orpheum) and a four-auditorium live theater complex (including the accompanying ancillary retail and commercial tenants) in Chicago (The Royal George); and, |\\n\\n| · | our US Headquarters building in Culver City, California and our Australia corporate office building in Melbourne, Australia; and, |\\n\\n| · | the ancillary retail and commercial space at some of our non-ETC cinema properties. |\\n\\n\\nIn February 2018, we entered into a one-year license agreement with Audible, Inc. a subsidiary of Amazon, at the Minetta Lane Theatre. This agreement was extended through March 2020, with an option to extend for one additional year through March 2021. Audible intends to continue to produce one to two character plays and special engagements for live performance, to record those productions making them available through Audible streaming service.\\n\\nIn addition, we have various parcels of unimproved real estate held for development in Australia and New Zealand and certain unimproved land in the United States, including some that was used in our legacy activities.\\n30\\n\\nOur key real estate transactions in recent years are as follows:\\n\\nStrategic Acquisitions\\n| · | Purchase of Land at Cannon Park, Australia. On June 13, 2018, we acquired a 163,000 square foot (15,150 square meter) parcel at our Cannon Park ETC, in connection with the restructuring of our relationship with the adjacent land owner. Prior to the restructuring, this parcel was commonly owned by us and the adjoining land owner. In the restructuring, the adjoining land owner conveyed to us its interest in the parcel for AU$1. We granted the adjoining land owner certain access rights. |\\n\\n| · | Purchase of Property in Auburn, Australia – On June 29, 2018, we added 20,870 square feet of land, improved with a 16,830 office building, to our Auburn/Redyard ETC. The property was acquired at auction for $3.5 million (AU$4.5 million) and is bordered by our existing ETC on three sides. The property is leased to Telstra through July 2022. This will allow us time to plan for the efficient integration of the property into our ETC. The final settlement payment was made in early October 2018. |\\n\\n\\nValue-creating Opportunities\\nWe are engaged in several real estate development projects to take our properties to their highest and best use. The most notable of these value-creating projects are as follows:\\n| · | Redevelopment of 44 Union Square Property in New York, USA. We secured construction financing for our 44 Union Square property in December 2016 and have entered into a guaranteed maximum price construction management agreement with an affiliate of CNY. We anticipate that the project will be ready for the commencement of tenant fit-out in the second quarter of 2019. Retail and office leasing interest to date has been strong and, while no assurances can be given, we are currently in exclusive negotiations with respect to long-term leases covering approximately 90% of the net rentable area of the building. This redevelopment will add approximately 23,000 square footage of rentable space to the current square footage of the building for an approximate total of 73,322 square feet of rentable space, inclusive of anticipated BOMA (Building Owners and Managers Association) adjustments and subject to lease negotiations and the final tenant mix. |\\n\\n| · | Expansion Project for our Newmarket Shopping Center at an affluent suburb of Brisbane, Australia. In December 2017 we opened our eight-screen Reading Cinema with TITAN LUXE, including 10,355 square feet of additional retail space and 124 parking spaces. As of March 31, 2019, approximately 80% of this new retail space has been leased. |\\n\\n| · | Courtenay Central Re-Development in Wellington, New Zealand. – Located in the heart of Wellington - New Zealand’s capital city – this center is comprised of 161,071 square feet of land situated proximate to the Te Papa Tongarewa Museum (attracting over 1.5 million visitors annually), across the street from the site of Wellington’s newly announced convention center (estimated to open its doors in 2022) and at a major public transit hub. Damage from the 2016 earthquake necessitated demolition of our nine-story parking garage at the site. Further, unrelated seismic issues have caused us to close the existing cinema and significant portions of the retail structure while we reevaluate the property for redevelopment as an entertainment themed urban center with a major food and grocery component. Wellington continues to be rated as one of the top cities in the world in which to live, and we continue to believe that the Courtenay Central site is located in one of the most vibrant and growing commercial and entertainment precincts of Wellington. |\\n\\n\\n31\\n\\n| § | Cinema 1,2,3 Redevelopment – In June 2017, we entered into an exclusive dealing and pre-development agreement with our adjoining neighbors, 260-264 LLC, to jointly develop the properties, currently home to Cinemas 1,2,3 and Anassa Taverna. Under the terms of the agreement, Reading and 260-264 LLC worked together on a comprehensive mixed-use plan to co-develop the properties located on 3rd Avenue, between 59th Street and 60th Streets, in New York City. The parties completed an initial feasibility study, analyzing various retail, entertainment and residential uses for the site and during 2018 continued to work on the terms of a final agreement for the development of the combined property. We do not presently believe that we will be able to come to an agreement with our neighbors for a joint development of our properties and, have, accordingly, begun developing plans for an approximately 96,000 square foot mixed use stand-alone development. Our Cinemas 1,2,3, property is located on Third Avenue in New York City, between 59th and 60th Streets across from Bloomingdales. |\\n\\n| · | Manukau Land Rezoning – In August 2016, the Auckland City Council up-zoned 64.0 acres of our property in Manukau from agricultural to light industrial use. The remaining 6.4 acres were already zoned for heavy industrial use. Our zoning enhancement goal having been achieved, in 2018, we worked with adjoining landholders to jointly advance necessary infrastructure improvement issues. We estimate that our property will support approximately 1.6 million square feet of improvements. We see this property as a future value realization opportunity for us. This tract is adjacent to the Auckland Airport, which is currently undergoing a major improvement and expansion project. |\\n\\n\\nCorporate Matters\\n\\n| § | Stock Repurchase Program – Our Board approved a $25-million repurchase program approved on March 2, 2017, and extended on March 14, 2019, and extended it on March 14, 2019. Under this authorization Reading may repurchase its Class A Common Stock from time to time in accordance with the requirements of the Securities and Exchange Commission on the open market, in block trades and in privately negotiated transactions, depending on market conditions and other factors. The new authorization continues through March 2, 2021. To date we have repurchased 559,627 shares of Class A Common Stock for $8.8 million at an average price of $15.81 per share (excluding transaction costs). 566 shares were purchased during the quarter ended March 31, 2019 at an average price of $16.08 per share. This leaves $16.2 million available under the March 2, 2017 program, as extended, for repurchase as of March 31, 2019. |\\n\\n\\nOur Financing Strategy\\n\\nOur treasury management is focused on cash management using cash balances to reduce debt. We have used cash generated from operations and other excess cash, to the extent not needed for capital expenditures, to pay down our loans and credit facilities providing us flexibility on our available loan facilities for future use and, thereby, reducing interest charges. On a periodic basis, we review the maturities of our borrowing arrangements and negotiate for renewals and extensions where necessary in the current circumstances.\\n\\nOn March 15, 2019, we amended our Revolving Corporate Markets Loan Facility with National Australia Bank (“NAB”) from a facility comprised of (i) a AU$66.5 million loan facility with an interest rate of 0.95% above the Bank Bill Swap Bid Rate (“BBSY”) and a maturity date of June 30, 2019 and (ii) a bank guarantee of AU$5.0 million at a rate of 1.90% per annum into a (i) AU$120.0 million corporate loan facility at rates of 0.85%-1.30% above BBSY depending on certain ratios with a due date of December 31, 2023, of which AU$80.0 million is revolving and AU$40.0 million is core and (ii) a bank guarantee facility of AU$5.0 million at a rate of 1.85% per annum. Prior to this, on June 12, 2018, we had extended the maturity of these facilities from June 30, 2019, to December 31, 2019. Such modifications of this particular term loan were not considered to be substantial under US GAAP.\\n\\nOn December 20, 2018, we restructured our Westpac Corporate Credit Facilities. The maturity of the 1st tranche (general/non-construction credit line) was extended to December 31, 2023, with the available facility being reduced from NZ$35.0 million to NZ$32.0 million. The facility bears an interest rate of 1.75% above the Bank Bill Bid Rate on the drawn down balance and a 1.1% line of credit charge on the entire facility. The 2nd tranche (construction line) with a facility of NZ$18.0 million was removed.\\n\\nOn March 5, 2019, we extended our current Bank of America credit facilities until May 1, 2020 (the $55.0 million credit line). We anticipate refinancing this credit line during the second quarter of 2019.\\n\\nRefer to our 2018 Form 10-K for more details on our cinema and real estate segments.\\n32\\nRESULTS OF OPERATIONS\\n\\nThe table below summarizes the results of operations for each of our principal business segments along with the non-segment information for the three months ended March 31, 2019 and March 31, 2018:\\n\\n\\n| |\\n| | Three Months Ended | % Change |\\n| (Dollars in thousands) | March 31,2019 | March 31,2018 | Fav/(Unfav) |\\n| SEGMENT RESULTS |\\n| | Revenue |\\n| | Cinema exhibition | $ | 57,986 | $ | 72,255 | (20) | % |\\n| | Real estate | 5,431 | 6,008 | (10) | % |\\n| | Inter-segment elimination | (1,866) | (2,391) | 22 | % |\\n| | Total revenue | 61,551 | 75,872 | (19) | % |\\n| | Operating expense |\\n| | Cinema exhibition | (50,195) | (57,339) | 12 | % |\\n| | Real estate | (2,445) | (2,384) | (3) | % |\\n| | Inter-segment elimination | 1,866 | 2,391 | (22) | % |\\n| | Total operating expense | (50,774) | (57,332) | 11 | % |\\n| | Depreciation and amortization |\\n| | Cinema exhibition | (4,157) | (3,765) | (10) | % |\\n| | Real estate | (1,376) | (1,369) | (1) | % |\\n| | Total depreciation and amortization | (5,533) | (5,134) | (8) | % |\\n| | General and administrative expense |\\n| | Cinema exhibition | (992) | (866) | (15) | % |\\n| | Real estate | (451) | (574) | 21 | % |\\n| | Total general and administrative expense | (1,443) | (1,440) | - | % |\\n| | Segment operating income |\\n| | Cinema exhibition | 2,642 | 10,285 | (74) | % |\\n| | Real estate | 1,159 | 1,681 | (31) | % |\\n| | Total segment operating income | $ | 3,801 | $ | 11,966 | (68) | % |\\n| NON-SEGMENT RESULTS |\\n| | Depreciation and amortization expense | (61) | (117) | 48 | % |\\n| | General and administrative expense | (5,041) | (6,156) | 18 | % |\\n| | Interest expense, net | (1,852) | (1,594) | (16) | % |\\n| | Equity earnings of unconsolidated joint ventures | 34 | 257 | (87) | % |\\n| | Other income (expense) | (20) | (82) | 76 | % |\\n| | Income before income taxes | (3,139) | 4,274 | (> 100) | % |\\n| | Income tax benefit (expense) | 1,042 | (1,170) | > 100 | % |\\n| Net income (loss) | (2,097) | 3,104 | (> 100) | % |\\n| | Less: net (income) loss attributable to noncontrolling interests | (16) | 22 | (> 100) | % |\\n| Net income (loss) attributable to RDI common stockholders | $ | (2,081) | $ | 3,082 | (> 100) | % |\\n| Basic EPS | $ | (0.09) | $ | 0.13 | (> 100) | % |\\n\\n“nm – not meaningful”\\nConsolidated and Non-Segment Results:\\n\\n1st Quarter Net Results\\n\\nNet income attributable to RDI common stockholders decreased by $5.2 million to a $(2.1) million loss. Basic EPS for the quarter ended March 31, 2019 decreased by $0.22 to $(0.09) from the prior-year quarter, mainly attributable to decreases in revenue in both the Cinema and Real Estate business segments.\\n\\nRevenue for the three months ended March 31, 2019 decreased by 19%or $14.3 million, to $61.6 million compared to the same period prior year. The revenue decrease was due to a decrease in revenues from our cinema business primarily due to the weak film slate experienced by the Cinema business segment worldwide, the closure of our cinema in Courtenay Central due to seismic concerns, and a decrease in revenues from the Real Estate business segment primarily due to the closure of most of the net rentable area of Courtenay Central due to seismic concerns. Overseas revenues were also adversely impacted by the continued weakness of the Australian and New Zealand Dollar compared to the U.S. dollar.\\n\\nU.S. admissions for the first quarter 2019 were down 19% falling from $24.7 million to $19.9 million for the same period in the prior year. According to industry sources, U.S. box office for the period was down 16%, falling from $2.5 billion to $2.1 billion. Australia and New Zealand Box Office saw similar declines. Again, in the case of New Zealand, the situation was exacerbated by the closure of our cinema at Courtenay Central. Due to the fact that our occupancy costs with respect to our cinema operations are fixed, the decrease in revenues disproportionally impacts the earnings from these operations, even though our film rent, cinema level labor and costs of goods sold are largely variable.\\n\\n33\\nLooking forward, The Avengers: Endgame has been setting box office records, having grossed more than $620 million in North America and more than $2.2 billion worldwide since its opening weekend of April 25, 2019.\\n\\nNon-Segment General & Administrative Expenses\\nNon-segment general and administrative expense for the quarter ended March 31, 2019 decreased by 18%, or $1.1 million, to $5.0 million compared to the same period of the prior year, respectively. This decrease mainly relates to lower legal expenses, offset by an increase in administrative occupancy cost in New Zealand attributable to the temporary closure of our administrative offices at Courtenay Central and need to lease replacement office space in Wellington.\\n\\nIncome Tax Expense\\nIncome tax expense for the quarter ended March 31, 2019, decreased 189%, or $2.2 million compared to the same quarter prior year. The change between 2019 and 2018 is primarily related to the pretax loss in the first quarter of 2019.\\nBusiness Segment Results\\n\\nAt March 31, 2019, we leased or owned and operated 60 cinemas with 484 screens, which includes (i) one managed cinema with 4 (four) screens and (ii) our interests in certain unconsolidated joint ventures that total 3 (three) cinemas with 29 screens. In the first quarter of 2019, we acquired a proven 4-screen cinema in Devonport, Tasmania, Australia, increasing our cinema count to 60 and our screen count to 484. We also (i) owned and operated 5 (five) ETCs located in Newmarket Village (a suburb of Brisbane), Belmont (a suburb of Perth), Auburn (a suburb of Sydney) and Townsville (a suburb of Cannon Park) in Australia and Wellington in New Zealand, (ii) owned and operated our headquarters office buildings in Culver City (an emerging high-tech and communications hub in Los Angeles County) and Melbourne, Australia, (iii) owned and operated the fee interests in three developed commercial properties in Manhattan and Chicago improved with live theaters comprising 6 (six) stages and ancillary retail and commercial space (our fourth live theatre was closed at the end of 2015 as part of the redevelopment of 44 Union Square in New York City), (iv) owned a 75% managing member interest in a limited liability company, which in turn owns the fee interest in Cinemas 1,2,3, (v) held for development approximately 70.4 acres of developable industrial land located next to the Auckland Airport in New Zealand, (vi) owned a 50% managing member interest in a limited liability company, which in turn owns a 202-acre property in Coachella, California that is zoned approximately 150 acres for single-family residential use (maximum 550 homes) and approximately 50 acres for high density mixed use in the U.S., that is held for development, and, (vii) owned 197 acres principally in Pennsylvania from our legacy railroad business, including the Reading Viaduct in downtown Philadelphia.\\n\\nThe Company transacts business in Australia and New Zealand and is subject to risks associated with changing foreign currency exchange rates. The Australian and New Zealand dollars based on the spot rate weakened versus prior three month period against the U.S. dollar slightly negatively impacting the value of our assets and liabilities. The average rate for the three months ended March 31, 2019 and 2018 has also weakened by 9.4% and 6.3% respectively. This has decreased the value of our Australian and New Zealand revenues and expenses. Refer to Note 3 – Operations in Foreign Currency for further information.\\n\\n34\\nCinema Exhibition\\n\\nThe following table details our cinema exhibition segment operating results for the three months ended March 31, 2019 and March 31, 2018, respectively:\\n\\n\\n| |\\n| | % Change |\\n| | Three Months Ended | Fav/(Unfav) |\\n| (Dollars in thousands) | March 31,2019 | % of Revenue | March 31,2018 | % of Revenue | Three Months Ended |\\n| REVENUE |\\n| | United States | Admissions revenue | $ | 19,913 | 34% | $ | 24,706 | 34% | (19) | % |\\n| | Food & beverage revenue | 9,575 | 17% | 10,765 | 15% | (11) | % |\\n| | Advertising and other revenue | 2,545 | 4% | 2,516 | 3% | 1 | % |\\n| | $ | 32,033 | 55% | $ | 37,987 | 53% | (16) | % |\\n| | Australia | Admissions revenue | $ | 14,037 | 24% | $ | 17,051 | 24% | (18) | % |\\n| | Food & beverage revenue | 6,061 | 10% | 7,837 | 11% | (23) | % |\\n| | Advertising and other revenue | 1,343 | 2% | 1,829 | 3% | (27) | % |\\n| | $ | 21,441 | 37% | $ | 26,717 | 37% | (20) | % |\\n| | New Zealand | Admissions revenue | $ | 2,991 | 5% | $ | 4,934 | 7% | (39) | % |\\n| | Food & beverage revenue | 1,309 | 3% | 2,266 | 3% | (42) | % |\\n| | Advertising and other revenue | 212 | 0% | 351 | 0% | (40) | % |\\n| | $ | 4,512 | 8% | $ | 7,551 | 10% | (40) | % |\\n| |\\n| | Total revenue | $ | 57,986 | 100% | $ | 72,255 | 100% | (20) | % |\\n| OPERATING EXPENSE |\\n| | United States | Film rent and advertising cost | $ | (10,127) | 17% | $ | (12,875) | 18% | 21 | % |\\n| | Food & beverage cost | (2,322) | 4% | (2,302) | 3% | (1) | % |\\n| | Occupancy expense | (6,945) | 12% | (7,202) | 10% | 4 | % |\\n| | Other operating expense | (10,174) | 18% | (9,942) | 14% | (2) | % |\\n| | $ | (29,568) | 51% | $ | (32,321) | 45% | 9 | % |\\n| | Australia | Film rent and advertising cost | $ | (6,279) | 11% | $ | (7,699) | 11% | 18 | % |\\n| | Food & beverage cost | (1,115) | 2% | (1,594) | 2% | 30 | % |\\n| | Occupancy expense | (3,962) | 7% | (4,251) | 6% | 7 | % |\\n| | Other operating expense | (5,415) | 9% | (5,754) | 8% | 6 | % |\\n| | $ | (16,771) | 29% | $ | (19,298) | 27% | 13 | % |\\n| | New Zealand | Film rent and advertising cost | $ | (1,336) | 3% | $ | (2,232) | 3% | 40 | % |\\n| | Food & beverage cost | (292) | 1% | (491) | 1% | 41 | % |\\n| | Occupancy expense | (803) | 1% | (1,344) | 2% | 40 | % |\\n| | Other operating expense | (1,425) | 2% | (1,653) | 2% | 14 | % |\\n| | $ | (3,856) | 7% | $ | (5,720) | 8% | 33 | % |\\n| |\\n| | Total operating expense | $ | (50,195) | 87% | $ | (57,339) | 79% | 12 | % |\\n| DEPRECIATION, AMORTIZATION, GENERAL AND ADMINISTRATIVE EXPENSE |\\n| | United States | Depreciation and amortization | $ | (2,626) | 5% | $ | (2,121) | 3% | (24) | % |\\n| | General and administrative expense | (604) | 1% | (545) | 1% | (11) | % |\\n| | $ | (3,230) | 6% | $ | (2,666) | 4% | (21) | % |\\n| | Australia | Depreciation and amortization | $ | (1,181) | 2% | $ | (1,204) | 2% | 2 | % |\\n| | General and administrative expense | (387) | 1% | (299) | 0% | (29) | % |\\n| | $ | (1,568) | 3% | $ | (1,503) | 2% | (4) | % |\\n| | New Zealand | Depreciation and amortization | $ | (350) | 1% | $ | (440) | 1% | 20 | % |\\n| | General and administrative expense | (1) | 0% | (22) | 0% | 95 | % |\\n| | $ | (351) | 1% | $ | (462) | 1% | 24 | % |\\n| |\\n| | Total depreciation, amortization, general and administrative expense | $ | (5,149) | 10% | $ | (4,631) | 6% | (11) | % |\\n| OPERATING INCOME – CINEMA |\\n| | United States | $ | (765) | (1)% | $ | 3,000 | 4% | (126) | % |\\n| | Australia | 3,102 | 5% | 5,916 | 8% | (48) | % |\\n| | New Zealand | 305 | 1% | 1,369 | 2% | (78) | % |\\n| | Total Cinema operating income | $ | 2,642 | 5% | $ | 10,285 | 14% | (74) | % |\\n\\n\\n“nm – not meaningful”\\n\\n35\\n1st Quarter Results\\n\\nCinema Segment operating income\\nCinema segment operating income decreased by 74%, or $7.6 million, to $2.6 million for the quarter ended March 31, 2019 compared to March 31, 2018, primarily driven by decreased operating income in the U.S., Australia, and New Zealand, which was due to a decrease in attendance worldwide, and fluctuations in average ticket price (“ATP”), and spend per patron (“SPP”) as outlined below.\\n\\nRevenue\\nCinema revenue decreased by 20%, or $14.3 million, to $58.0 million for the quarter ended March 31, 2019 compared to March 31, 2018, primarily attributable to a weak foreign currency exchange rate, and a weak film slate worldwide.\\n\\nThe top box office performers for the first quarter of 2019 included “Captain Marvel”, ($5.1 million), “Aquaman,” ($2.9 million) and “How to Train Your Dragon: The Hidden World,” ($2.7 million), did not stack up well against the top films for the same period 2018, which included major films such as “Black Panther,” “Jumanji: Welcome to the Jungle,” and “The Greatest Showman,” (which combined totaled $15.0 million). We believe that the first quarter of 2019 results are principally the product of the film available for cinema exhibition, and not a reflection of declining consumer interest in cinema as a beyond-the-home source of entertainment.\\n\\nBelow are the changes in our cinema revenue by market:\\n| · | U.S. cinema revenue decreased by 16%, or $6.0 million, to $32.0 million, due to a 22% decrease in attendance, offset by a 12% increase SPP, and a 4% increase in ATP. |\\n\\n| · | Australia cinema revenue decreased by 20%, or $5.3 million, to $21.4 million, primarily due to a 15% decrease in attendance, a 9% decrease in SPP, and a 4% decrease in ATP. |\\n\\n| · | New Zealand cinema revenue decreased by 40%, or $3.0 million, to $4.5 million versus the same period in 2018, due to a decrease of 40% in attendance, while ATP and SPP remained relatively flat. The decrease in New Zealand was materially greater than that in the U.S. and Australia due to the closure of our Courtenay Central cinema in January. |\\n\\n\\nMore recently “Avengers:Endgame” had the biggest box office opening of any film since the opening weekend of April 25, 2019 with $620 million in North America box office and $2.2 billion in worldwide box office. Slated for release this spring and summer are a number of potentially strong box office performers, including “John Wick Chapter 3,” “Aladdin”, “Godzilla: King of the Monsters”, “Men in Black: International,” “Toy Story 4,” and “Spider-Man: Far From Home.”\\n\\nOperating expense\\nOperating expense for the quarter ended March 31, 2019 decreased by 12%, to $50.2 million primarily attributable to (i) lower film rent expense driven by lower admissions revenue, and (ii) lower F&B costs due to lower F&B revenue primarily in Australia and New Zealand.\\n\\nOperating expense as a percentage of gross revenue has increased to 87% for the first quarter of 2019, compared to 79% for the same period in 2018, due to the lower than anticipated revenue in our box office and the fact that our occupancy costs are generally fixed, and cannot be adjusted to reflect such lower admission levels.\\n\\nDepreciation, amortization, general and administrative expense\\nDepreciation, amortization, general and administrative expense for the quarter ended March 31, 2019 increased by 11%, or $0.5 million, to $5.1 million mainly due to the depreciation related to the completion of our capital improvements placed into service in the U.S.\\n36\\nReal Estate\\nThe following table details our real estate segment operating results for the three months ended March 31, 2019 and 2018, respectively:\\n\\n\\n\\n| |\\n| | % Change |\\n| | Three Months Ended | Fav/(Unfav) |\\n| (Dollars in thousands) | March 31,2019 | % ofRevenue | March 31,2018 | % ofRevenue | Three Months Ended |\\n| REVENUE |\\n| | United States | Live theater rental and ancillary income | $ | 936 | 17% | $ | 599 | 10% | 56 | % |\\n| | Property rental income | 52 | 1% | 56 | 1% | (7) | % |\\n| | 988 | 18% | 655 | 11% | 51 | % |\\n| | Australia | Property rental income | 3,916 | 72% | 4,154 | 69% | (6) | % |\\n| | New Zealand | Property rental income | 527 | 10% | 1,199 | 20% | (56) | % |\\n| |\\n| | Total revenue | $ | 5,431 | 100% | $ | 6,008 | 100% | (10) | % |\\n| OPERATING EXPENSE |\\n| | United States | Live theater cost | $ | (298) | 5% | $ | (296) | 5% | (1) | % |\\n| | Property cost | (158) | 3% | (134) | 2% | (18) | % |\\n| | Occupancy expense | (151) | 3% | (163) | 3% | 7 | % |\\n| | (607) | 11% | (593) | 10% | (2) | % |\\n| | Australia | Property cost | (701) | 13% | (752) | 13% | 7 | % |\\n| | Occupancy expense | (692) | 13% | (567) | 9% | (22) | % |\\n| | (1,393) | 26% | (1,319) | 22% | (6) | % |\\n| | New Zealand | Property cost | (298) | 5% | (321) | 5% | 7 | % |\\n| | Occupancy expense | (147) | 3% | (150) | 2% | 2 | % |\\n| | (445) | 8% | (471) | 8% | 6 | % |\\n| |\\n| | Total operating expense | $ | (2,445) | 45% | $ | (2,383) | 40% | (3) | % |\\n| DEPRECIATION, AMORTIZATION, GENERAL AND ADMINISTRATIVE EXPENSE |\\n| | United States | Depreciation and amortization | $ | (195) | 4% | $ | (192) | 3% | (2) | % |\\n| | General and administrative expense | (159) | 3% | (163) | 3% | 2 | % |\\n| | (354) | 7% | (355) | 6% | - | % |\\n| | Australia | Depreciation and amortization | $ | (926) | 17% | $ | (909) | 15% | (2) | % |\\n| | General and administrative expense | (292) | 5% | (411) | 7% | 29 | % |\\n| | (1,218) | 22% | (1,320) | 22% | 8 | % |\\n| | New Zealand | Depreciation and amortization | (256) | 5% | (269) | 4% | 5 | % |\\n| | General and administrative expense | — | 0% | — | 0% | - | % |\\n| | (256) | 5% | (269) | 4% | 5 | % |\\n| |\\n| | Total depreciation, amortization, general and administrative expense | $ | (1,828) | 34% | $ | (1,944) | 32% | 6 | % |\\n| OPERATING INCOME - REAL ESTATE |\\n| | United States | $ | 27 | 0% | $ | (293) | (5)% | 109 | % |\\n| | Australia | 1,305 | 24% | 1,515 | 25% | (14) | % |\\n| | New Zealand | (174) | (3)% | 459 | 8% | (138) | % |\\n| | Total real estate operating income | $ | 1,158 | 21% | $ | 1,681 | 28% | (31) | % |\\n\\n\\n1st Quarter Results\\n\\nReal Estate Segment income\\nReal estate segment operating income decreased by 31%, or $0.5 million, to $1.2 million for the quarter ended March 31, 2019 compared to March 31, 2018, primarily due to the closure of most of the net rentable area of Courtenay Central; offset by an increase in Live Theatre segment revenue of 56%, or $0.3 million, to $0.9 million.\\n\\nRevenue\\nReal estate revenue for the quarter decreased by 10%, or $0.6 million, to $5.4 million primarily due to a weak foreign currency exchange rate and a decrease in revenues from our New Zealand segment, principally related to the closure of portions of Courtenay Central.\\n\\nOperating expense\\nOperating expense for the quarter ended March 31, 2019 remained flat at $2.4 million.\\n\\nDepreciation, amortization, general and administrative expense\\nDepreciation, amortization, general and administrative expense for the quarter ended March 31, 2019 decreased by 6%, or $0.1 million, to $1.8 million primarily driven by a weak foreign currency exchange rate and a decrease in general and administrative expenses in Australia.\\n\\nLIQUIDITY AND CAPITAL RESOURCES\\n\\nOur cinema exhibition business plan is to enhance our current cinemas where it is financially reasonable to do so; develop our specialty cinemas in select markets; expand our food and beverage offering, and continue on an opportunistic basis, to identify, develop, and acquire cinema properties that allow us to leverage our cinema expertise over a larger operating base.\\n37\\n\\nOur real estate business is to complete the redevelopment of 44 Union Square in New York City; to reassess and master-plan the Cinemas 1,2,3 property for redevelopment as a stand-alone 96,000 square foot mixed use property and in the interim to continue to use it as a cinema; to continue the build-out of our Newmarket Village and Auburn ETCs and the master planning of the expansion of our Townsville ETC in Australia; to master plan and consider the redevelopment of our Courtenay Central site in New Zealand into an urban entertainment center with a focus on cinema exhibition, food and beverage, and grocery store uses; and in Manukau, New Zealand, to develop in concert with other major land owners, of plans for the development of the infrastructure needed to support the construction of income-producing improvements; and to continue to be sensitive to opportunities to convert our entertainment assets to higher and better uses, or, where appropriate, to dispose of such assets. We will also continue to explore potential synergistic acquisitions that may not readily fall into either our cinema or real estate segment.\\nThe success of our Company is dependent on our ability to execute these business plans effectively through our available resources (both cash and available borrowing facilities) while still timely addressing our liquidity risk. Liquidity risk is the risk relating to our ability to meet our financial obligations when they come due. At the present, our financial obligations arise mainly from capital expenditure needs, working capital requirements, and debt servicing requirements. We manage the liquidity risk by ensuring our ability to generate sufficient cash flows from operating activities and to obtain adequate, reasonable financing or extension of maturity dates under reasonable arrangements, and/or to convert non-performing or non-strategic assets into cash.\\n\\nAt March 31, 2019, our consolidated cash and cash equivalents totaled $12.6 million. Of this amount, $3.2 million and $0.7 million were held by our Australian and New Zealand subsidiaries, respectively. Our intention is to indefinitely reinvest Australian earnings locally, but not indefinitely reinvest New Zealand earnings. If the Australian earnings were used to fund U.S. operations, they would be subject to additional state income taxes upon repatriation.\\n\\nThe changes in cash and cash equivalents for the three months ended March 31, 2019 and 2018 are discussed as follows:\\n\\n\\n| |\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| (Dollars in thousands) | 2019 | 2018 | % Change |\\n| Net cash provided by (used in) operating activities | $ | (3,841) | $ | 2,452 | (257) | % |\\n| Net cash provided by (used in) investing activities | (12,613) | (23,491) | (46) | % |\\n| Net cash provided by (used in) financing activities | 15,918 | 16,161 | 2 | % |\\n| Effect of exchange rate changes on cash and cash equivalents | 57 | (122) | 147 | % |\\n| Increase (decrease) in cash and cash equivalents | $ | (479) | $ | (5,000) | 90 | % |\\n\\n\\nOperating activities\\nCash provided by (used in) operating activities for the first three months of 2019 decreased by $6.3 million, to ($3.8) million primarily driven by $4.7 million lower cash inflows from operating activities as well as a $1.5 million decrease in net operating assets.\\n\\nInvesting activities\\nCash used in investing activities during the three months ended March 31, 2019 decreased by $10.9 million compared to the same period in 2018, to net cash used of $12.6 million, primarily due to a decrease in our cinema refurbishment activities compared to the 2018 quarter and the substantial completion of the upgrading and expansion of our Newmarket and Auburn/Redyard ETCs in 2018. It is anticipated that spending on our cinema activities will pick up over the remainder of the year.\\n\\nFinancing Activities\\nThe $15.9 million net cash provided by financing activities during the three months ended March 31, 2019 was primarily related to $22.3 million of new borrowings, offset by $6.1 million of loan repayments. Proceeds from these new borrowings related principally to the ongoing construction of our 44 Union Square project in Manhattan of $6.7 million and to fund the capital improvements in our cinemas and real estate segments.\\n\\nOn March 2, 2017, the Board of Directors authorized a stock repurchase program to repurchase up to $25.0 million of Reading’s Class A Common Stock. The Board on March 14, 2019, extended that program to March 2, 2021. At March 31, 2019, there was $16.2 million of capacity remaining in that authorization.\\n38\\n\\nWe manage our cash, investments and capital structure so we are able to meet the short-term and long-term obligations of our business, while maintaining financial flexibility and liquidity. We forecast, analyze and monitor our cash flows to enable investment and financing within the overall constraints of our financial strategy. In recent years, our treasury management has been focused on more aggressive cash management using cash balances to reduce debt. In earlier years, we maintained significant cash balances in our bank accounts. We have used cash generated from operations and other excess cash, to the extent not needed for any capital expenditures, to pay down our loans and credit facilities providing us some flexibility on our available loan facilities for future use and thereby, reducing interest charges.\\n\\n\\nThe table below presents the changes in our total available resources (cash and borrowings), debt-to-equity ratio, working capital and other relevant information addressing our liquidity for the three months ended March 31, 2019 and preceding four years:\\n\\n\\n| |\\n| |\\n| | As of andfor the3-MonthsEnded | Year Ended December 31 |\\n| ($ in thousands) | 3/31/2019 | 2018 | 2017 | 2016 | 2015 (2) |\\n| Total Resources (cash and borrowings) |\\n| Cash and cash equivalents (unrestricted) | $ | 12,648 | $ | 13,127 | $ | 13,668 | $ | 19,017 | $ | 19,702 |\\n| Unused borrowing facility | 107,111 | 85,886 | 137,231 | 117,599 | 70,134 |\\n| Restricted for capital projects (1) | 23,566 | 30,318 | 62,280 | 62,024 | 10,263 |\\n| Unrestricted capacity | 83,545 | 55,568 | 74,951 | 55,575 | 59,871 |\\n| Total resources at period end | 119,759 | 99,013 | 150,899 | 136,616 | 89,836 |\\n| Total unrestricted resources at period end | 96,193 | 68,695 | 88,619 | 74,592 | 79,573 |\\n| Debt-to-Equity Ratio |\\n| Total contractual facility | $ | 290,879 | $ | 252,929 | $ | 271,732 | $ | 266,134 | $ | 207,075 |\\n| Total debt (gross of deferred financing costs) | 184,099 | 167,043 | 134,501 | 148,535 | 130,941 |\\n| Current | 40,077 | 30,393 | 8,109 | 567 | 15,000 |\\n| Non-current | 143,691 | 136,650 | 126,392 | 147,968 | 115,941 |\\n| Finance lease liabilities | 331 | — | — | — | — |\\n| Total book equity(2) | 179,946 | 180,547 | 181,618 | 146,890 | 138,951 |\\n| Debt-to-equity ratio | 1.02 | 0.93 | 0.74 | 1.01 | 0.94 |\\n| Changes in Working Capital |\\n| Working capital (deficit) (3) | $ | (77,236) | $ | (55,270) | $ | (46,971) | $ | 6,655 | $ | (35,581) |\\n| Current ratio | 0.28 | 0.35 | 0.42 | 1.10 | 0.51 |\\n| Capital Expenditures (including acquisitions) | $ | 11,476 | $ | 56,827 | $ | 76,708 | $ | 49,166 | $ | 53,119 |\\n\\n\\n| (1) | This relates to the construction facilities specifically negotiated for: (i) Union Square redevelopment project, obtained in December 2016, and (ii) New Zealand construction projects, obtained in May 2015. The New Zealand construction loan expired December 31, 2018. |\\n\\n| (2) | Certain 2015 balances included the restatement impact as a result of a change in accounting principle (see Note 2 – Summary of Significant Accounting Policies – Accounting Changes). Certain 2017 and 2016 balances included the restatement impact as a result of a prior period financial statement correction of immaterial errors (see Note 2 – Summary of Significant Accounting Policies – Prior Period Financial Statement Correction of Immaterial Errors). |\\n\\n| (3) | Typically our working capital (deficit) is negative as we receive revenue from our cinema business ahead of the time that we have to pay our associated liabilities. We use the money we receive to pay down our borrowings in the first instance |\\n\\n\\nCONTRACTUAL OBLIGATIONS, COMMITMENTS AND CONTINGENCIES\\n\\nThe following table provides information with respect to the maturities and scheduled principal repayments of our recorded contractual obligations and certain of our commitments and contingencies, either recorded or off-balance sheet, as of March 31, 2019:\\n\\n\\n| |\\n| |\\n| (Dollars in thousands) | 2019 | 2020 | 2021 | 2022 | 2023 | Thereafter | Total |\\n| Debt(1) | $ | 40,016 | $ | 48,799 | $ | 258 | $ | 270 | $ | 58,309 | $ | 8,204 | $ | 155,856 |\\n| Operating leases, including imputed interest | 23,566 | 31,434 | 31,717 | 31,901 | 31,018 | 169,221 | 318,857 |\\n| Finance leases, including imputed interest | 131 | 101 | 53 | 43 | 30 | — | 358 |\\n| Subordinated debt(1) | — | — | — | — | — | 27,913 | 27,913 |\\n| Pension liability | 513 | 684 | 684 | 684 | 684 | 1,979 | 5,228 |\\n| Village East purchase option(3) | 5,900 | — | — | — | — | — | 5,900 |\\n| Estimated interest on debt (2) | 7,717 | 6,098 | 5,156 | 5,157 | 5,134 | 7,498 | 36,761 |\\n| Total | $ | 77,844 | $ | 87,116 | $ | 37,868 | $ | 38,055 | $ | 95,175 | $ | 214,815 | $ | 550,873 |\\n\\n\\n| (1) | Information is presented gross of deferred financing costs. |\\n\\n| (2) | Estimated interest on debt is based on the anticipated loan balances for future periods and current applicable interest rates. |\\n\\n| (3) | Represents the lease liability of the option associated with the ground lease purchase of the Village East Cinema. |\\n\\n\\nRefer to Note 13 – Commitments and Contingencies for additional information.\\n\\n\\n\\n39\\nLitigation\\nWe are currently involved in certain legal proceedings and, as required, have accrued estimates of probable and estimable losses for the resolution of these claims.\\n\\nWhere we are the plaintiffs, we expense all legal fees on an on-going basis and make no provision for any potential settlement amounts until received. In Australia, the prevailing party is usually entitled to recover its attorneys’ fees, which typically work out to be approximately 60% of the amounts actually spent where first class legal counsel is engaged at customary rates. Where we are a plaintiff, we have likewise made no provision for the liability for the defendant’s attorneys' fees in the event we are determined not to be the prevailing party.\\n\\nWhere we are the defendants, we accrue for probable damages that insurance may not cover as they become known and can be reasonably estimated. In our opinion, any claims and litigation in which we are currently involved are not reasonably likely to have a material adverse effect on our business, results of operations, financial position, or liquidity. It is possible, however, that future results of the operations for any particular quarterly or annual period could be materially affected by the ultimate outcome of the legal proceedings. Please refer to Item 3 – Legal Proceedings in our 2018 Form 10-K for more information. There have been no material changes to our litigation since our 2018 Form 10-K, except as set forth in Note 13 – Commitments and Contingencies in the accompanying consolidated financial statements included in this Form 10-Q.\\n\\nOff-Balance Sheet Arrangements\\n\\nSee Note 13 – Commitments and Contingencies to the Consolidated Financial Statements included herein on this report, there are no off-balance sheet arrangements or obligations (including contingent obligations) that have, or are reasonably likely to have, a current or future material effect on our financial condition, changes in the financial condition, revenue or expense, results of operations, liquidity, capital expenditures or capital resources.\\n\\nCRITICAL ACCOUNTING POLICIES\\n\\nWe believe that the application of the following accounting policies requires significant judgments and estimates in the preparation of our Consolidated Financial Statements and hence, are critical to our business operations and the understanding of our financial results:\\n\\n(i) Impairment of Long-lived Assets (other than Goodwill and Intangible Assets with indefinite lives) – we evaluate our long-lived assets and finite-lived intangible assets using historical and projected data of cash flows as our primary indicator of potential impairment and we take into consideration the seasonality of our business. If the sum of the estimated, undiscounted future cash flows is less than the carrying amount of the asset, then an impairment is recognized for the amount by which the carrying value of the asset exceeds its estimated fair value based on an appraisal or a discounted cash flow calculation. For certain non-income producing properties or for those assets with no consistent historical or projected cash flows, we obtain appraisals or other evidence to evaluate whether there are impairment indicators for these assets.\\n\\nBesides the write-down of the carrying amount of our parking structure adjacent to our Courtenay Central ETC in Wellington, New Zealand due to earthquake damage during the 4th quarter of 2016, no other impairment losses were recorded for long-lived and finite-lived intangible assets for the three years ended December 31, 2018. Refer to Note 20 – Insurance Recoveries on Impairment and Related Losses due to Earthquake in the 2018 Form 10-K for further details.\\n\\n(ii) Impairment of Goodwill and Intangible Assets with indefinite lives – goodwill and intangible assets with indefinite useful lives are not amortized, but instead, tested for impairment at least annually on a reporting unit basis. The impairment evaluation is based on the present value of estimated future cash flows of each reporting unit plus the expected terminal value. There are significant assumptions and estimates used in determining the future cash flows and terminal value. The most significant assumptions include our cost of debt and cost of equity assumptions that comprise the weighted average cost of capital for each reporting unit. Accordingly, actual results could vary materially from such estimates.\\n\\nNo impairment losses were recorded for goodwill and indefinite-lived intangible assets for the three months ended March 31, 2019.\\n\\nFINANCIAL RISK MANAGEMENT\\n\\nInternational Business Risks\\nOur international operations are subject to a variety of risks, including the following:\\n\\n| · | Currency Risk: while we report our earnings and net assets in U.S. dollars, substantial portions of our revenue and of our obligations are denominated in either Australian or New Zealand dollars. The value of these currencies can vary significantly compared to the U.S. dollar and compared to each other. We do not hedge the currency risk, but rather have relied upon the 40 |\\n| natural hedges that exist as a result of the fact that our film costs are typically fixed as a percentage of the box office, and our local operating costs and obligations are likewise typically denominated in local currencies. However, we do have intercompany debt and our ability to service this debt could be adversely impacted by declines in the relative value of the Australian and New Zealand dollar compared to the U.S. dollar. Also, our use of local borrowings to mitigate the business risk of currency fluctuations has reduced our flexibility to move cash between jurisdictions. Set forth below is a chart of the exchange ratios between these three currencies since 1996: |\\n\\n\\n\\n\\nIn recent periods, we have repaid intercompany debt and used the proceeds to fund capital investment in the United States. Accordingly, our debt levels in Australia are higher than they would have been if funds had not been returned for such purposes. On a company wide basis, this means that a reduction in the relative strength of the U.S. dollar versus the Australian dollar and/or the New Zealand dollar will effectively raise the overall cost of our borrowing and capital and make it more expensive to return funds from the United States to Australia and New Zealand.\\n\\nOur exposure to interest rate risk arises out of our intermediate term floating-rate borrowings. To manage the risk, we utilize interest rate derivative contracts to convert certain floating-rate borrowings into fixed-rate borrowings. It is the Company’s policy to enter into interest rate derivative transactions only to the extent considered necessary to meet its objectives as stated above. The Company does not enter into these transactions or any other hedging transactions for speculative purposes.\\n\\nInflation\\n\\nWe continually monitor inflation and the effects of changing prices. Inflation increases the cost of goods and services used. Competitive conditions in many of our markets restrict our ability to recover fully the higher costs of acquired goods and services through price increases. We attempt to mitigate the impact of inflation by implementing continuous process improvement solutions to enhance productivity and efficiency and, as a result, lower costs and operating expenses. The effects of inflation have not had a material impact on our operations and the resulting financial position or liquidity.\\n\\n\\n\\n41\\n\\nFORWARD LOOKING STATEMENTS\\n\\nOur statements in this interim quarterly report contain a variety of forward-looking statements as defined by the Securities Litigation Reform Act of 1995. Forward-looking statements reflect only our expectations regarding future events and operating performance and necessarily speak only as of the date the information was prepared. No guarantees can be given that our expectation will in fact be realized, in whole or in part. You can recognize these statements by our use of words such as, by way of example, “may”, “will”, “expect”, “believe”, and “anticipate” or other similar terminology.\\n\\nThese forward-looking statements reflect our expectation after having considered a variety of risks and uncertainties. However, they are necessarily the product of internal discussion and do not necessarily completely reflect the views of individual members of our Board of Directors or of our management team. Individual Board members and individual members of our management team may have a different view as to the risks and uncertainties involved, and may have different views as to future events or our operating performance.\\n\\nAmong the factors that could cause actual results to differ materially from those expressed in or underlying our forward-looking statements are the following:\\n| · | with respect to our cinema operations: |\\n\\n| o | the number and attractiveness to moviegoers of the films released in future periods; |\\n\\n| o | the amount of money spent by film distributors to promote their motion pictures; |\\n\\n| o | the licensing fees and terms required by film distributors from motion picture exhibitors in order to exhibit their films; |\\n\\n| o | the comparative attractiveness of motion pictures as a source of entertainment and willingness and/or ability of consumers (i) to spend their dollars on entertainment and (ii) to spend their entertainment dollars on movies in and outside the home environment; |\\n\\n| o | the extent to which we encounter competition from other cinema exhibitors, from other sources of outside-the-home entertainment, and from inside-the-home entertainment options, such as “home theaters” and competitive film product distribution technology, such as, by way of example, cable, satellite broadcast and Blu-ray/DVD rentals and sales, and so called “movies on demand;” |\\n\\n| o | the cost and impact of improvements to our cinemas, such as improved seating, enhanced food and beverage offerings and other improvements; |\\n\\n| o | disruptions from theater improvements; and |\\n\\n| o | the extent to and the efficiency with which we are able to integrate acquisitions of cinema circuits with our existing operations. |\\n\\n| · | with respect to our real estate development and operation activities: |\\n\\n| o | the rental rates and capitalization rates applicable to the markets in which we operate and the quality of properties that we own; |\\n\\n| o | the extent to which we can obtain on a timely basis the various land use approvals and entitlements needed to develop our properties; |\\n\\n| o | the risks and uncertainties associated with real estate development; |\\n\\n| o | the availability and cost of labor and materials; |\\n\\n| o | the ability to obtain all permits to construct improvements; |\\n\\n| o | the ability to finance improvements; |\\n\\n| o | the disruptions from construction; |\\n\\n| o | the possibility of construction delays, work stoppage and material shortage; |\\n\\n| o | competition for development sites and tenants; |\\n\\n| o | environmental remediation issues; |\\n\\n| o | the extent to which our cinemas can continue to serve as an anchor tenant that will, in turn, be influenced by the same factors as will influence generally the results of our cinema operations; |\\n\\n| o | the increased depreciation and amortization expenses as construction projects transition to leased real property; |\\n\\n| o | the ability to negotiate and execute joint venture opportunities and relationships; and |\\n\\n| o | certain of our activities are in geologically active areas, creating a risk of damage and/or disruption of real estate and/or cinema businesses from earthquakes. |\\n\\n42\\n\\n| · | with respect to our operations generally as an international company involved in both the development and operation of cinemas and the development and operation of real estate and previously engaged for many years in the railroad business in the United States: |\\n\\n| o | our ability to renew, extend or renegotiate our loans that mature in 2019; |\\n\\n| o | our ability to grow our Company and provide value to our stockholders; |\\n\\n| o | our ongoing access to borrowed funds and capital and the interest that must be paid on that debt and the returns that must be paid on such capital; |\\n\\n| o | expenses, management and Board distraction and other effects of the litigation efforts mounted by James Cotter, Jr. against the Company, including his efforts to cause a sale of voting control of the Company; |\\n\\n| o | the relative values of the currency used in the countries in which we operate; |\\n\\n| o | changes in government regulation, including by way of example, the costs resulting from the implementation of the requirements of Sarbanes-Oxley; |\\n\\n| o | our labor relations and costs of labor (including future government requirements with respect to pension liabilities, disability insurance and health coverage, and vacations and leave); |\\n\\n| o | our exposure from time to time to legal claims and to uninsurable risks such as those related to our historic railroad operations, including potential environmental claims and health-related claims relating to alleged exposure to asbestos or other substances now or in the future recognized as being possible causes of cancer or other health related problems; |\\n\\n| o | our exposure to cyber-security risks, including misappropriation of customer information or other breaches of information security; |\\n\\n| o | changes in future effective tax rates and the results of currently ongoing and future potential audits by taxing authorities having jurisdiction over our various companies; and |\\n\\n| o | changes in applicable accounting policies and practices. |\\n\\n\\nThe above list is not necessarily exhaustive, as business is by definition unpredictable and risky, and subject to influence by numerous factors outside of our control, such as changes in government regulation or policy, competition, interest rates, supply, technological innovation, changes in consumer taste, the weather, and the extent to which consumers in our markets have the economic wherewithal to spend money on beyond-the-home entertainment. Refer to Item 1A Risk factors in the 2018 Form 10-K annual report for more information.\\n\\nGiven the variety and unpredictability of the factors that will ultimately influence our businesses and our results of operation, it naturally follows that no guarantees can be given that any of our forward-looking statements will ultimately prove to be correct. Actual results will undoubtedly vary and there is no guarantee as to how our securities will perform either when considered in isolation or when compared to other securities or investment opportunities.\\n\\nFinally, we undertake no obligation to update publicly or to revise any of our forward-looking statements, whether as a result of new information, future events or otherwise, except as may be required under applicable law. Accordingly, you should always note the date to which our forward-looking statements speak.\\n\\nAdditionally, certain of the presentations included in this interim quarterly report may contain “non-GAAP financial measures.” In such case, a reconciliation of this information to our GAAP financial statements will be made available in connection with such statements.\\n43\\n\\nItem 3 –\\nQuantitative and Qualitative Disclosure about Market Risk\\n\\nThe SEC requires that registrants include information about potential effects of changes in currency exchange and interest rates in their filings. Several alternatives, all with some limitations, have been offered. We base the following discussion on a sensitivity analysis that models the effects of fluctuations in currency exchange rates and interest rates. This analysis is constrained by several factors, including the following:\\n| · | It is based on a single point in time; and |\\n\\n| · | It does not include the effects of other complex market reactions that would arise from the changes modeled. |\\n\\nAlthough the results of such an analysis may be useful as a benchmark, they should not be viewed as forecasts.\\nAt March 31, 2019, approximately 33% and 11% of our assets were invested in assets denominated in Australian dollars (Reading Australia) and New Zealand dollars (Reading New Zealand), respectively, including approximately $3.9 million in cash and cash equivalents. At December 31, 2018, approximately 36% and 14% of our assets were invested in assets denominated in Australian dollars (Reading Australia) and New Zealand dollars (Reading New Zealand), including approximately $5.5 million in cash and cash equivalents.\\n\\nOur policy in Australia and New Zealand is to match revenues and expenses, whenever possible, in local currencies. As a result, we have procured a majority of our expenses in Australia and New Zealand in local currencies. Despite this natural hedge, recent movements in foreign currencies have had an effect on our current earnings. Although foreign currency has had an effect on our current earnings, the effect of the translation adjustment on our assets and liabilities noted in our other comprehensive income was an increase of $1.5 million for the three months ended March 31, 2019. As we continue to progress our acquisition and development activities in Australia and New Zealand, we cannot assure you that the foreign currency effect on our earnings will not be material in the future.\\n\\nHistorically, our policy has been to borrow in local currencies to finance the development and construction of our long-term assets in Australia and New Zealand whenever possible. As a result, the borrowings in local currencies have provided somewhat of a natural hedge against the foreign currency exchange exposure. Even so, and as a result of our issuance of subordinated Trust Preferred Securities in 2007, and their subsequent partial repayment, approximately 44% and 64% of our Australian and New Zealand assets, respectively, remain subject to such exposure, unless we elect to hedge our foreign currency exchange between the US and Australian and New Zealand dollars. If the foreign currency rates were to fluctuate by 10%, the resulting change in Australian and New Zealand assets would be $9.9 million and $4.6 million, respectively, and the change in our quarterly net income (loss) would be $0.2 million and ($0.1) million, respectively. Presently, we have no plan to hedge such exposure.\\n\\nWe record unrealized foreign currency translation gains or losses that could materially affect our financial position. As of March 31, 2019 and December 31, 2018, the balance of cumulative foreign currency translation adjustments was approximately $10.2 million gain and $8.7 million gain, respectively.\\n\\nHistorically, we maintain most of our cash and cash equivalent balances in short-term money market instruments with original maturities of three months or less. Due to the short-term nature of such investments, a change of 1% in short-term interest rates would not have a material effect on our financial condition.\\n\\nWe have a combination of fixed and variable interest rate loans. In connection with our variable interest rate loans, a change of approximately 1% in short-term interest rates would have resulted in approximately $239,000 increase or decrease in our quarterly interest expense.\\n\\nFor further discussion on market risks, please refer to International Business Risks included in Item 2, Part 1 of this Form 10-Q.\\n44\\n\\nItem 4 –\\nControls and Procedures\\n\\nWe maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s reports filed under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.\\n\\nUnder the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such, term is defined under Rule 13a-15(e) promulgated under the Exchange Act. Based upon that evaluation, we concluded that, as of March 31, 2019, our disclosure controls and procedures were effective.\\n\\nChanges in Internal Control over Financial Reporting\\n\\nThere were no other changes in our internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the quarter ended March 31, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\n45\\nPART II – Other Information\\n\\n\\nItem 1 – Legal Proceedings\\n\\nThe information required under Part II, Item 1 (Legal Proceedings) is incorporated by reference to the information contained in Note 13 – Commitments and Contingencies to the Consolidated Financial Statements included herein in Part I, Item 1 (Financial Statements) on this Quarterly Report on Form 10-Q.\\n\\nIn the quarter ended March 31, 2019, the arbitration relating to the termination of Cotter, Jr.’s employment with our Company (Reading International, Inc. v. James J. Cotter, AAA Case No. 01-15-0004-2384, filed July 2015) was resolved. While our Company was the named claimant, this matter relates essentially to Cotter, Jr.’s claims for compensation and damages related to his termination as our Company’s president and chief executive officer which were originally included in the Derivative Action described in Note 13, above. The Arbitrator has determined that, while Cotter, Jr. did breach his obligations under his Employment Agreement with our Company, Cotter, Jr’s breaches were not sufficiently material to allow our Company relief from its obligations under the Employment Agreement to pay certain specified separation amounts, totaling $313,000 (the “Separation Payment Amount”). The arbitrator awarded this amount, plus interest at the rate of 10% from June 12, 2016, until the award was paid in full on March 6, 2019. The reserve set up by the Company in 2015 with respect to this claim has been reversed. The Arbitrator denied on substantive grounds Cotter, Jr’s claims for consequential damages and for damages based on various tort theories (including defamation) and/or upon wrongful termination claims and denied, on jurisdictional grounds, Cotter Jr’s claims that the unvested stock options granted to him under his Employment Agreement did not expire upon his termination and continued to be exercisable by him so long as he continued as a director of our Company. In total, Cotter, Jr., claimed specified damages in excess of $1,000,000 plus unspecified tort damages. While the award was less than half of the amount claimed by Cotter, Jr., and while finding that Cotter, Jr., was in breach of his agreement with our Company, the Arbitrator nevertheless determined that Cotter, Jr. was the prevailing party and awarded Cotter, Jr. $443,000 of his requested $787,769 in attorney’s fees and costs. The Arbitrator also assessed the costs of the arbitration against our Company and ordered a reimbursement of such costs paid to date by Cotter Jr. in the amount of $14,250. This amount is reflected in our Company’s financial statements. The determinations of the Arbitrator are final and binding on the parties, and not subject to appeal.\\n\\nFor further details on our legal proceedings, please refer to Item 3, Legal Proceedings, contained in our 2018 Form 10-K.\\n\\n\\nItem 1A – Risk Factors\\n\\nThere have been no material changes in risk factors as previously disclosed in our 2018 Form 10-K.\\n\\n\\nItem 2 – Unregistered Sales of Equity Securities and Use of Proceeds\\n\\nThere were no unregistered sales of equity securities during the periods covered by this report.\\n\\nThe following table summarizes our repurchases under the March 2, 2017, stock repurchase program up until March 31, 2019:\\n\\n| |\\n| |\\n| Period | Total Number of Shares Purchased | Average Price Paid per Share | Total Number of Shares Purchased as part of our Stock Buy-Back Program | Approximate Dollar Value of Shares that may yet be Purchased under the Stock Buy-Back Program |\\n| March 2017 | 41,899 | $ | 15.99 | 41,899 | $ | 24,330,149 |\\n| May 2017 | 98,816 | $ | 15.78 | 98,816 | $ | 22,771,316 |\\n| June 2017 | 70,234 | $ | 16.39 | 70,234 | $ | 21,620,212 |\\n| August 2017 | 160,489 | $ | 15.82 | 160,489 | $ | 19,081,288 |\\n| September 2017 | 31,718 | $ | 15.77 | 31,718 | $ | 18,581,038 |\\n| December 2017 | 6,567 | $ | 16.01 | 6,567 | $ | 18,475,900 |\\n| February 2018 | 8,500 | $ | 16.98 | 8,500 | $ | 18,331,570 |\\n| March 2018 | 10,138 | $ | 16.99 | 10,138 | $ | 18,159,364 |\\n| April 2018 | 5,000 | $ | 16.12 | 5,000 | $ | 18,078,764 |\\n| December 2018 | 125,700 | $ | 15.24 | 125,700 | $ | 16,162,529 |\\n| March 2019 | 566 | $ | 16.08 | 566 | $ | 16,153,428 |\\n| Total | 559,627 | $ | 15.81 | 559,627 | $ | 16,153,428 |\\n\\n\\nFor a description of grants of stock to certain executives, see the Stock Based Compensation section under see Note 15 – Equity and Stock-Based Compensation to our Consolidated Financial Statements.\\n46\\n\\n\\nItem 3 – Defaults upon Senior Securities\\n\\nNone.\\n\\n\\nItem 4 – Mine Safety Disclosure\\n\\nNot applicable.\\n\\n\\n47\\n\\nItem 5 –\\nOther Information\\nNone\\n\\n\\nItem 6 –\\nExhibits\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n| |\\n| 31.1 | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith. |\\n| 31.2 | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith. |\\n| 32 | Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, furnished herewith. |\\n| 101.INS | XBRL Instance Document |\\n| 101.SCH | XBRL Taxonomy Extension Schema |\\n| 101.CAL | XBRL Taxonomy Extension Calculation |\\n| 101.DEF | XBRL Taxonomy Extension Definition |\\n| 101.LAB | XBRL Taxonomy Extension Labels |\\n| 101.PRE | XBRL Taxonomy Extension Presentation |\\n\\n\\n48\\nSIGNATURES\\n\\nPursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n\\nREADING INTERNATIONAL, INC.\\n\\nDate: May 10, 2019\\n\\nBy: /s/ Ellen M. Cotter\\nEllen M. Cotter\\nChief Executive Officer\\n\\nDate: May 10, 2019\\n\\nBy: /s/ Gilbert Avanes\\nGilbert Avanes\\nInterim Chief Financial Officer\\n\\n\\n\\n\\n\\n\\n49\\n \\n\\nWhat is the increase or decrease in the percentage of net income to net cash provided by operating activities from 2018 to 2019?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is -56.872639749635646.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 57,\n \"input_length\": 45380\n}"}}},{"rowIdx":58,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nItem 1. Financial Statements\niShares®Gold Trust Micro\nStatements of Assets and Liabilities (Unaudited)\nAt September 30, 2021 and June 15, 2021 (Date of Inception)\n\n| September 30, 2021 | June 15, 2021 |\n| Assets |\n| Investment in gold bullion, at fair value(a) | $ | 607,260,237 | $ | 9,325,500 |\n| Total Assets | 607,260,237 | 9,325,500 |\n| Liabilities |\n| Sponsor’s fees payable | 34,807 | — |\n| Total Liabilities | 34,807 | — |\n| Commitments and contingent liabilities (Note 6) | — | — |\n| Net Assets | $ | 607,225,430 | $ | 9,325,500 |\n| Shares issued and outstanding(b) | 34,850,000 | 500,000 |\n| Net asset value per Share (Note 2C) | $ | 17.42 | $ | 18.65 |\n\n\n| (a) | Cost of investment in gold bullion: $626,373,040 and $9,325,500, respectively. |\n| (b) | No par value, unlimited amount authorized. |\n\nSee notes to financial statements.\n1\niShares®Gold Trust Micro\nStatements of Operations (Unaudited)\nFor the three months ended September 30, 2021 and the period from June 15, 2021 (Date of Inception) to September 30, 2021\n\n| Three Months Ended September 30, 2021 | Period from June 15, 2021 (Date of Inception) to September 30, 2021 |\n| Expenses |\n| Sponsor’s fees | $ | 200,617 | $ | 201,169 |\n| Sponsor’s fees waived | ( 107,095 | ) | ( 107,134 | ) |\n| Total expenses | 93,522 | 94,035 |\n| Net investment loss | ( 93,522 | ) | ( 94,035 | ) |\n| Net Realized and Unrealized Gain (Loss) |\n| Net realized gain (loss) from: |\n| Gold bullion sold to pay expenses | 422 | 422 |\n| Net change in unrealized appreciation/depreciation | ( 18,603,053 | ) | ( 19,112,803 | ) |\n| Net realized and unrealized loss | ( 18,602,631 | ) | ( 19,112,381 | ) |\n| Net decrease in net assets resulting from operations | $ | ( 18,696,153 | ) | $ | ( 19,206,416 | ) |\n| Net decrease in net assets per Share | $ | ( 0.61 | ) | $ | ( 0.74 | ) |\n\nSee notes to financial statements.\n2\niShares®Gold Trust Micro\nStatements of Changes in Net Assets (Unaudited)\nFor the three months ended September 30, 2021 and the period from June 15, 2021 (Date of Inception) to September 30, 2021\n\n| Period from June 15, 2021 (Date of Inception) to September 30, 2021 |\n| Net Assets at June 15, 2021 | $ | 9,325,500 |\n| Operations: |\n| Net investment loss | ( 513 | ) |\n| Net change in unrealized appreciation/depreciation | ( 509,750 | ) |\n| Net decrease in net assets resulting from operations | ( 510,263 | ) |\n| Decrease in net assets | ( 510,263 | ) |\n| Net Assets at June 30, 2021 | $ | 8,815,237 |\n| Operations: |\n| Net investment loss | ( 93,522 | ) |\n| Net realized gain | 422 |\n| Net change in unrealized appreciation/depreciation | ( 18,603,053 | ) |\n| Net decrease in net assets resulting from operations | ( 18,696,153 | ) |\n| Capital Share Transactions: |\n| Contributions for Shares issued | 617,106,346 |\n| Net increase in net assets from capital share transactions | 617,106,346 |\n| Increase in net assets | 598,410,193 |\n| Net Assets at September 30, 2021 | $ | 607,225,430 |\n| Shares issued and redeemed |\n| Shares issued | 34,350,000 |\n| Net increase in Shares issued and outstanding | 34,350,000 |\n\nSee notes to financial statements.\n3\niShares®Gold Trust Micro\nStatement of Cash Flows (Unaudited)\nFor the period from June 15, 2021 (Date of Inception) to September 30, 2021\n\n| June 15, 2021 (Date of Inception) to September 30, 2021 |\n| Cash Flows from Operating Activities |\n| Proceeds from gold bullion sold to pay expenses | $ | 59,228 |\n| Expenses – Sponsor’s fees paid | ( 59,228 | ) |\n| Net cash provided by operating activities | — |\n| Increase (decrease) in cash | — |\n| Cash, beginning of period | — |\n| Cash, end of period | $ | — |\n| Reconciliation of Net Increase (Decrease) in Net Assets Resulting from Operations to Net Cash Provided by (Used in) Operating Activities |\n| Net decrease in net assets resulting from operations | $ | ( 19,206,416 | ) |\n| Adjustments to reconcile net increase (decrease) in net assets resulting from operations to net cash provided by (used in) operating activities: |\n| Proceeds from gold bullion sold to pay expenses | 59,228 |\n| Net realized (gain) loss | ( 422 | ) |\n| Net change in unrealized appreciation/depreciation | 19,112,803 |\n| Change in operating assets and liabilities: |\n| Sponsor’s fees payable | 34,807 |\n| Net cash provided by (used in) operating activities | $ | — |\n| Supplemental disclosure of non-cash information: |\n| Gold bullion contributed for Shares issued | $ | 617,106,346 |\n\nSee notes to financial statements.\n4\niShares®Gold Trust Micro\nSchedules of Investments (Unaudited)\nAt September 30, 2021 and June 15, 2021 (Date of Inception)\n\n| September 30, 2021 |\n\n\n| Description | Ounces | Cost | Fair Value |\n| Gold bullion | 348,439 | $ | 626,373,040 | $ | 607,260,237 |\n| Total Investments – 100.01% | 607,260,237 |\n| Less Liabilities – (0.01)% | ( 34,807 | ) |\n| Net Assets – 100.00% | $ | 607,225,430 |\n\n\n| June 15, 2021 (Date of Inception) |\n\n\n| Description | Ounces | Cost | Fair Value |\n| Gold bullion | 5,000 | $ | 9,325,500 | $ | 9,325,500 |\n| Total Investments – 100.00% | 9,325,500 |\n| Less Liabilities – (0.00)% | — |\n| Net Assets – 100.00% | $ | 9,325,500 |\n\nSee notes to financial statements.\n5\niShares®Gold Trust Micro\nNotes to Financial Statements (Unaudited)\nSeptember 30, 2021\n\n| 1 - | Organization |\n\nThe iShares Gold Trust Micro (the “Trust”) was organized on June 15, 2021 as a New York trust. The trustee is The Bank of New York Mellon (the “Trustee”), which is responsible for the day-to-day administration of the Trust. The Trust’s sponsor is iShares Delaware Trust Sponsor LLC, a Delaware limited liability company (the “Sponsor”). The Trust is governed by the provisions of the Depositary Trust Agreement (the “Trust Agreement”) executed by the Trustee and the Sponsor as of June 15, 2021. The Trust issues units of beneficial interest (“Shares”) representing fractional undivided beneficial interests in its net assets.\nBlackRock Financial Management, Inc. (the “Seed Capital Investor”), contributed 5,000 ounces of Gold in exchange for 500,000 shares (the “Seed Creation Baskets”) on June 15, 2021 for the benefit of BlackRock Financial Management, Inc. At contribution, the value of the gold deposited with the Trust was based on the price of an ounce of gold of $ 1,865.10 . The Seed Capital Investor is an affiliate of the Sponsor. The Seed Capital Investor did not and will not receive from the Trust, the Sponsor or any of their affiliates any fee or other compensation in connection with the sale of the Seed Creation Baskets.\nThe Trust seeks to reflect generally the performance of the price of gold. The Trust seeks to reflect such performance before payment of the Trust’s expenses and liabilities. The Trust is designed to provide a vehicle for investors to make an investment similar to an investment in gold.\nThe accompanying unaudited financial statements were prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”) for interim financial information and with the instructions for Form 10-Q and the rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”). In the opinion of management, all material adjustments, consisting only of normal recurring adjustments considered necessary for a fair statement of the interim period financial statements, have been made. Interim period results are not necessarily indicative of results for a full-year period. These financial statements and the notes thereto should be read in conjunction with the Trust’s financial statements included in the registration statement on Form S-1 as filed with the SEC on June 23, 2021.\nThe Trust qualifies as an investment company solely for accounting purposes and not for any other purpose and follows the accounting and reporting guidance under the Financial Accounting Standards Board Accounting Standards Codification Topic 946, Financial Services - Investment Companies, but is not registered, and is not required to be registered, as an investment company under the Investment Company Act of 1940, as amended.\n\n| 2 - | Significant Accounting Policies |\n\n\n\n| A. | Basis of Accounting |\n\nThe following significant accounting policies are consistently followed by the Trust in the preparation of its financial statements in conformity with U.S. GAAP. The preparation of financial statements in conformity with U.S. GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.\n\n\n| B. | Gold Bullion |\n\nJPMorgan Chase Bank N.A., London branch (the “Custodian”), is responsible for the safekeeping of gold bullion owned by the Trust.\nFair value of the gold bullion held by the Trust is based on that day’s London Bullion Market Association (“LBMA”) Gold Price PM. “LBMA Gold Price PM” is the price per fine troy ounce of gold, stated in U.S. dollars, determined by ICE Benchmark Administration (“IBA”) following an electronic auction consisting of one or more 30-second rounds starting at 3:00 p.m. (London time), on each day that the London gold market is open for business and published shortly thereafter. If there is no LBMA Gold Price PM on any day, the Trustee is authorized to use the most recently announced price of gold determined in an electronic auction hosted by IBA that begins at 10:30 a.m. (London time) (“LBMA Gold Price AM”) unless the Trustee, in consultation with the Sponsor, determines that such price is inappropriate as a basis for evaluation.\nGain or loss on sales of gold bullion is calculated on a trade date basis using the average cost method.\n6\nThe following tables summarize activity in gold bullion for the three months ended September 30, 2021 and the period from June 15, 2021 (Date of Inception) to September 30, 2021:\n\n| Three Months Ended September 30, 2021 | Ounces | Cost | Fair Value | Realized Gain (Loss) |\n| Beginning balance | 5,000 | $ | 9,325,500 | $ | 8,815,750 | $ | — |\n| Gold bullion contributed | 343,472 | 617,106,346 | 617,106,346 | — |\n| Gold bullion distributed | — | — | — | — |\n| Gold bullion sold to pay expenses | ( 33 | ) | ( 58,806 | ) | ( 59,228 | ) | 422 |\n| Net realized gain | — | — | 422 | — |\n| Net change in unrealized appreciation/depreciation | — | — | ( 18,603,053 | ) | — |\n| Ending balance | 348,439 | $ | 626,373,040 | $ | 607,260,237 | $ | 422 |\n\n\n| Period from June 15, 2021 (Date of Inception) to September 30, 2021 | Ounces | Cost | Fair Value | Realized Gain (Loss) |\n| Beginning balance | 5,000 | $ | 9,325,500 | $ | 9,325,500 | $ | — |\n| Gold bullion contributed | 343,472 | 617,106,346 | 617,106,346 | — |\n| Gold bullion distributed | — | — | — | — |\n| Gold bullion sold to pay expenses | ( 33 | ) | ( 58,806 | ) | ( 59,228 | ) | 422 |\n| Net realized gain | — | — | 422 | — |\n| Net change in unrealized appreciation/depreciation | — | — | ( 19,112,803 | ) | — |\n| Ending balance | 348,439 | $ | 626,373,040 | $ | 607,260,237 | $ | 422 |\n\n\n\n| C. | Calculation of Net Asset Value |\n\nOn each business day, as soon as practicable after 4:00 p.m. (New York time), the net asset value of the Trust is obtained by subtracting all accrued fees, expenses and other liabilities of the Trust from the fair value of the gold and other assets held by the Trust. The Trustee computes the net asset value per Share by dividing the net asset value of the Trust by the number of Shares outstanding on the date the computation is made.\n\n\n| D. | Offering of the Shares |\n\nTrust Shares are issued and redeemed continuously in aggregations of 50,000 Shares in exchange for gold bullion rather than cash. Individual investors cannot purchase or redeem Shares in direct transactions with the Trust. The Trust only transacts with registered broker-dealers that are eligible to settle securities transactions through the book-entry facilities of the Depository Trust Company and that have entered into a contractual arrangement with the Trustee and the Sponsor governing, among other matters, the creation and redemption of Shares (such broker-dealers, the “Authorized Participants”). Holders of Shares of the Trust may redeem their Shares at any time acting through an Authorized Participant and in the prescribed aggregations of 50,000 Shares; provided, that redemptions of Shares may be suspended during any period while regular trading on NYSE Arca, Inc. (“NYSE Arca”) is suspended or restricted, or in which an emergency exists as a result of which delivery, disposal or evaluation of gold is not reasonably practicable.\nThe per Share amount of gold exchanged for a purchase or redemption represents the per Share amount of gold held by the Trust, after giving effect to its liabilities.\nWhen gold bullion is exchanged in settlement of a redemption, it is considered a sale of gold bullion for accounting purposes.\n\n\n| E. | Federal Income Taxes |\n\nThe Trust is treated as a grantor trust for federal income tax purposes and, therefore, no provision for federal income taxes is required. Any interest, expenses, gains and losses are passed through to the holders of Shares of the Trust.\nThe Sponsor has analyzed applicable tax laws and regulations and their application to the Trust as of September 30, 2021 and does not believe that there are any uncertain tax positions that require recognition of a tax liability.\n\n| 3 - | Trust Expenses |\n\nThe Trust pays to the Sponsor a Sponsor’s fee that accrues daily at an annualized rate equal to 0.15 % of the net asset value of the Trust, paid monthly in arrears. Effective June 29, 2021, the Sponsor has voluntarily agreed to waive a portion of the Sponsor’s Fee so that the Sponsor’s Fee after the fee waiver will not exceed 0.07 % through June 30, 2024. Although the Sponsor has no current intention of doing so, because the fee waiver is voluntary, the Sponsor may revert to the 0.15 % fee prior to June 30, 2024. Should the Sponsor choose to revert to the 0.15 % fee (or an amount higher than 0.07 % but no greater than 0.15 % annualized), prior to June 30, 2024, it will provide shareholders with at least 30 days’ prior written notice of such change through either a prospectus supplement to its registration statement or through a report furnished on Form 8-K. The Sponsor has agreed to assume the following administrative and marketing expenses incurred by the Trust: the Trustee’s fee and reimbursement for its reasonable out-of-pocket expenses, the Custodian’s fee, NYSE Arca listing fees, SEC registration fees, printing and mailing costs, audit fees and expenses, and up to $ 100,000 per annum in legal fees and expenses. The amount waived is included in Sponsor’s fees waived in the Statement of Operations. For the quarter ended September 30, 2021, the amount waived was $ 107,095 .\n7\n\n| 4 - | Related Parties |\n\nThe Sponsor and the Trustee are considered to be related parties to the Trust. The Trustee’s fee is paid by the Sponsor and is not a separate expense of the Trust.\nAs of September 30, 2021 BlackRock Financial Management, Inc., an affiliate of the Sponsor, owned 500,000 Shares of the Trust.\n\n| 5 - | Indemnification |\n\nThe Trust Agreement provides that the Trustee shall indemnify the Sponsor, its directors, officers, employees and agents against, and hold each of them harmless from, any loss, liability, cost, expense or judgment (including reasonable fees and expenses of counsel) (i) caused by the negligence or bad faith of the Trustee or (ii) arising out of any information furnished in writing to the Sponsor by the Trustee expressly for use in the registration statement, or any amendment thereto or periodic or other report filed with the SEC relating to the Shares that is not materially altered by the Sponsor.\nThe Trust Agreement provides that the Sponsor and its shareholders, directors, officers, employees, affiliates (as such term is defined under the Securities Act of 1933, as amended) and subsidiaries shall be indemnified from the Trust and held harmless against any loss, liability or expense incurred without their (1) negligence, bad faith, willful misconduct or willful malfeasance arising out of or in connection with the performance of their obligations under the Trust Agreement or any actions taken in accordance with the provisions of the Trust Agreement or (2) reckless disregard of their obligations and duties under the Trust Agreement.\nThe Trust has agreed that the Custodian will only be responsible for any loss or damage suffered by the Trust as a direct result of the Custodian’s negligence, fraud or willful default in the performance of its duties.\n\n| 6 - | Commitments and Contingent Liabilities |\n\nIn the normal course of business, the Trust may enter into contracts with service providers that contain general indemnification clauses. The Trust’s maximum exposure under these arrangements is unknown as this would involve future claims that may be made against the Trust that have not yet occurred.\n\n| 7 - | Concentration Risk |\n\nSubstantially all of the Trust’s assets are holdings of gold bullion, which creates a concentration risk associated with fluctuations in the price of gold. Accordingly, a decline in the price of gold will have an adverse effect on the value of the Shares of the Trust. Factors that may have the effect of causing a decline in the price of gold include large sales by the official sector (governments, central banks, and related institutions); a significant increase in the hedging activities of gold producers; significant changes in the attitude of speculators, investors and other market participants towards gold; global gold supply and demand; global or regional political, economic or financial events and situations; investors’ expectations with respect to the rate of inflation; interest rates; investment and trading activities of hedge funds and commodity funds; other economic variables such as income growth, economic output, and monetary policies; and investor confidence.\n8\n\n| 8 - | Financial Highlights |\n\nThe following financial highlights relate to investment performance and operations for a Share outstanding for the three months ended September 30, 2021 and the period from June 15, 2021 (Date of Inception) to September 30, 2021.\n\n| Three Months Ended September 30, 2021 | Period from June 15, 2021 (Date of Inception) to September 30, 2021 |\n| Net asset value per Share, beginning of period | $ | 17.63 | $ | 18.65 |\n| Net investment loss(a) | ( 0.00 | )(b) | ( 0.00 | )(b) |\n| Net realized and unrealized gain (loss)(c) | ( 0.21 | ) | ( 1.23 | ) |\n| Net decrease in net assets from operations | ( 0.21 | ) | ( 1.23 | ) |\n| Net asset value per Share, end of period | $ | 17.42 | $ | 17.42 |\n| Total return, at net asset value(d)(e) | ( 1.19 | )% | ( 6.60 | )% |\n| Ratio to average net assets: |\n| Net investment loss(f) | ( 0.07 | )% | ( 0.07 | )% |\n| Total Expenses(f) | 0.15 | % | 0.15 | % |\n| Total expenses after fees waived(f) | 0.07 | % | 0.07 | % |\n\n\n| (a) | Based on average Shares outstanding during the period. |\n| (b) | Amount is greater than $( 0.005 ) per share |\n| (c) | The amounts reported for a Share outstanding may not accord with the change in aggregate gains and losses on investment for the period due to the timing of Trust Share transactions in relation to the fluctuating fair values of the Trust’s underlying investment. |\n| (d) | Based on the change in net asset value of a Share during the period. |\n| (e) | Percentage is not annualized. |\n| (f) | Percentage is annualized. |\n\n\n| 9 - | Investment Valuation |\n\nU.S. GAAP defines fair value as the price the Trust would receive to sell an asset or pay to transfer a liability in an orderly transaction between market participants at the measurement date. The Trust’s policy is to value its investment at fair value.\nVarious inputs are used in determining the fair value of assets and liabilities. Inputs may be based on independent market data (“observable inputs”) or they may be internally developed (“unobservable inputs”). These inputs are categorized into a disclosure hierarchy consisting of three broad levels for financial reporting purposes. The level of a value determined for an asset or liability within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement in its entirety. The three levels of the fair value hierarchy are as follows:\n\n| Level 1 − | Unadjusted quoted prices in active markets for identical assets or liabilities; |\n\n\n| Level 2 − | Inputs other than quoted prices included within Level 1 that are observable for the asset or liability either directly or indirectly, including quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not considered to be active, inputs other than quoted prices that are observable for the asset or liability, and inputs that are derived principally from or corroborated by observable market data by correlation or other means; and |\n\n\n| Level 3 − | Unobservable inputs that are unobservable for the asset or liability, including the Trust’s assumptions used in determining the fair value of investments. |\n\nAt September 30, 2021, the value of the gold bullion held by the Trust is categorized as Level 1.\n9\n\ns Discussion and Analysis of Financial Condition and Results of Operations.\nThis information should be read in conjunction with the financial statements and notes to financial statements included in Item 1 of Part I of this Form 10‑Q. The discussion and analysis that follows may contain statements that relate to future events or future performance. In some cases, such forward-looking statements can be identified by terminology such as “may,” “should,” “could,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential” or the negative of these terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially. These statements are based upon certain assumptions and analyses made by the Sponsor on the basis of its perception of historical trends, current conditions and expected future developments, as well as other factors it believes are appropriate in the circumstances. Whether or not actual results and developments will conform to the Sponsor’s expectations and predictions, however, is subject to a number of risks and uncertainties, including the special considerations discussed below, general economic, market and business conditions, changes in laws or regulations, including those concerning taxes, made by governmental authorities or regulatory bodies, and other world economic and political developments. Although the Sponsor does not make forward-looking statements unless it believes it has a reasonable basis for doing so, the Sponsor cannot guarantee their accuracy. Except as required by applicable disclosure laws, neither the Trust nor the Sponsor is under a duty to update any of the forward-looking statements to conform such statements to actual results or to a change in the Sponsor’s expectations or predictions.\nIntroduction\nThe iShares Gold Trust Micro (the “Trust”) is a grantor trust formed under the laws of the State of New York. The Trust does not have any officers, directors, or employees, and is administered by The Bank of New York Mellon (the “Trustee”) acting as trustee pursuant to the Depositary Trust Agreement (the “Trust Agreement”) between the Trustee and iShares Delaware Trust Sponsor LLC, the sponsor of the Trust (the “Sponsor”). The Trust issues units of beneficial interest (“Shares”) representing fractional undivided beneficial interests in its net assets. The assets of the Trust consist primarily of gold bullion held by a custodian as an agent of the Trust responsible only to the Trustee.\nThe Trust is a passive investment vehicle and seeks to reflect generally the performance of the price of gold. The Trust seeks to reflect such performance before payment of the Trust’s expenses and liabilities. The Trust does not engage in any activities designed to obtain a profit from, or ameliorate losses caused by, changes in the price of gold.\nThe Trust issues and redeems Shares only in exchange for gold, only in aggregations of 50,000 Shares (a “Basket”) or integral multiples thereof, and only in transactions with registered broker-dealers that have previously entered into an agreement with the Sponsor and the Trustee governing the terms and conditions of such issuance (such broker-dealers, the “Authorized Participants”). A list of the current Authorized Participants is available from the Sponsor or the Trustee.\nShares of the Trust trade on NYSE Arca, Inc. under the ticker symbol IAUM.\nValuation of Gold Bullion; Computation of Net Asset Value\nOn each business day, as soon as practicable after 4:00 p.m. (New York time), the Trustee evaluates the gold held by the Trust and determines the net asset value of the Trust and the net asset value per Share (“NAV”). The Trustee values the gold held by the Trust using the price per fine troy ounce of gold determined in an electronic auction hosted by ICE Benchmark Administration (“IBA”) that begins at 3:00 p.m. (London time) and published shortly thereafter, on the day the valuation takes place (such price, the “LBMA Gold Price PM”). If there is no announced LBMA Gold Price PM on any day, the Trustee is authorized to use the most recently announced price of gold determined in an electronic auction hosted by IBA that begins at 10:30 a.m. (London time) (such price, the “LBMA Gold Price AM”), unless the Trustee, in consultation with the Sponsor, determines that such price is inappropriate as a basis for evaluation. The LBMA Gold Price AM and LBMA Gold Price PM are used by the Trust because they are commonly used by the U.S. gold market as indicators of the value of gold and are permitted to be used under the Trust Agreement. The use of indicators of the value of gold bullion other than the LBMA Gold Price AM and LBMA Gold Price PM could result in materially different fair value pricing of the gold held by the Trust, and as such, could result in different cost or market adjustments or in different redemption value adjustments of the outstanding redeemable capital Shares. Having valued the gold held by the Trust, the Trustee then subtracts all accrued fees, expenses and other liabilities of the Trust from the total value of the gold held by the Trust and other assets held by the Trust. The result is the net asset value of the Trust. The Trustee computes NAV by dividing the net asset value of the Trust by the number of Shares outstanding on the date the computation is made.\nLiquidity\nThe Trust is not aware of any trends, demands, conditions or events that are reasonably likely to result in material changes to its liquidity needs. In exchange for a fee, the Sponsor has agreed to assume most of the expenses incurred by the Trust. As a result, the only ordinary expense of the Trust during the period covered by this report was the Sponsor’s fee. The Trust’s only source of liquidity is its sales of gold.\nCritical Accounting Policies\nThe financial statements and accompanying notes are prepared in accordance with generally accepted accounting principles in the United States of America. The preparation of these financial statements relies on estimates and assumptions that impact the Trust’s financial position and results of operations. These estimates and assumptions affect the Trust’s application of accounting policies. Below is a description of the valuation of gold bullion, a critical accounting policy that the Trust believes is important to understanding its results of operations and financial position, is provided in the section entitled “Valuation of Gold Bullion; Computation of Net Asset Value” above. In addition, please refer to Note 2 to the financial statements included in this report for further discussion of the Trust’s accounting policies.\n10\nResults of Operations\nThe Quarter Ended September 30, 2021\nThe Trust’s net asset value increased from $8,815,237 at June 30, 2021 to $607,225,430 at September 30, 2021, a 6,788.36% increase. The increase in the Trust’s net asset value resulted primarily from an increase in the number of outstanding shares, which rose from 500,000 Shares at June 30, 2021 to 34,850,000 Shares at September 30, 2021, a consequence of 34,350,000 Shares (687 Baskets) being created during the quarter. The increase in the Trust’s net asset value was partially offset by a decrease in the LMBA Gold Price, which fell 1.15% from $1,763.15 at June 30, 2021 to $1,742.80 at September 30, 2021.\nThe 1.19% decrease in the NAV from $17.63 at June 30, 2021 to $17.42 at September 30, 2021 is directly related to the 1.15% decrease in the price of gold.\nThe NAV decreased slightly more than the price of gold on a percentage basis due to the Sponsor’s fees, which were $93,522 for the quarter, or 0.02% of the Trust’s average weighted assets of $537,613,742 during the quarter. The NAV of $18.29 on July 29, 2021 was the highest during the quarter, compared with a low during the quarter of $17.23 on August 10, 2021.\nNet decrease in net assets resulting from operations for the quarter ended September 30, 2021 was $18,696,153, resulting from an unrealized loss on investment in gold bullion of $18,603,053, a net realized gain of $422 from gold bullion sold to pay expenses during the quarter, and a net investment loss of $93,522. Other than the Sponsor’s fees of $93,522, the Trust had no expenses during the quarter.\nThe Period from June 15, 2021 (Date of Inception) to September 30, 2021\nThe Trust’s net asset value increased from $9,325,500 at June 15, 2021 (Date of Inception) to $607,225,430 at September 30, 2021, a 6,411.45% increase. The increase in the Trust’s net asset value resulted primarily from an increase in the number of outstanding shares, which rose from 500,000 Shares at June 15, 2021 (Date of Inception) to 34,850,000 Shares at September 30, 2021, a consequence of 34,350,000 Shares (687 Baskets) being created during the period. The increase in the Trust’s net asset value was partially offset by a decrease in the LMBA Gold Price, which fell 6.56% from $1,865.10 at June 15, 2021 (Date of Inception) to $1,742.80 at September 30, 2021.\nThe 6.60% decrease in the NAV from $18.65 at June 15, 2021 (Date of Inception) to $17.42 at September 30, 2021 is directly related to the 6.56% decrease in the price of gold.\nThe NAV decreased slightly more than the price of gold on a percentage basis due to the Sponsor’s fees, which were $94,035 for the period, or 0.02% of the Trust’s average weighted assets of $459,291,726 during the period. The NAV of $18.65 on June 15, 2021 was the highest during the period, compared with a low during the period of $17.23 on August 10, 2021.\nNet decrease in net assets resulting from operations for the period ended September 30, 2021 was $19,206,416, resulting from an unrealized loss on investment in gold bullion of $19,112,803, a net realized gain of $422 from gold bullion sold to pay expenses during the quarter, and a net investment loss of $94,035. Other than the Sponsor’s fees of $94,035, the Trust had no expenses during the period.\n\nNot applicable.\n\nThe duly authorized officers of the Sponsor performing functions equivalent to those a principal executive officer and principal financial officer of the Trust would perform if the Trust had any officers, with the participation of the Trustee, have evaluated the effectiveness of the Trust’s disclosure controls and procedures, and have concluded that the disclosure controls and procedures of the Trust were effective as of the end of the period covered by this report to provide reasonable assurance that information required to be disclosed in the reports that the Trust files or submits under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported, within the time periods specified in the applicable rules and forms, and that it is accumulated and communicated to the duly authorized officers of the Sponsor performing functions equivalent to those a principal executive officer and principal financial officer of the Trust would perform if the Trust had any officers, as appropriate to allow timely decisions regarding required disclosure.\nThere are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures.\n11\nPART II – OTHER INFORMATION\n\nNone.\n\nThere have been no material changes to the Risk Factors in the registration statement on Form S-1, initially filed with the Securities and Exchange Commission on February 26, 2021 and declared effective on June 28, 2021.\n\na) None.\nb) Not applicable.\nc) There were no Shares redeemed during the period from June 15, 2021 (Date of Inception) to September 30, 2021.\n\nNone.\n\nNot applicable.\n\nNot applicable.\n12\n\n\n| Exhibit No. | Description |\n| 4.1 | Depositary Trust Agreement is incorporated by reference to Exhibit 4.1 of the Registration Statement on Form S‑1 (File No. 333‑253614) filed by the Registrant on June 21, 2021 |\n| 4.2 | Standard Terms for Authorized Participant Agreements is incorporated by reference to Exhibit 4.2 of the Registration Statement on Form S-1 (File No. 333-253614) filed by the Registrant on June 21, 2021 |\n| 10.1 | Custodian Agreement between The Bank of New York Mellon and JP Morgan Chase Bank N.A., London branch is incorporated by reference to Exhibit 10.1 of the Registration Statement on Form S-1 (File No. 333-253614) filed by the Registrant on June 21, 2021 |\n| 10.2 | Sub-license Agreement is incorporated by reference to Exhibit 10.2 of the Registration Statement on Form S-1 (File No. 333-253614) filed by the Registrant on June 21, 2021 |\n| 31.1 | Certification by Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2 | Certification by Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1 | Certification by Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes‑Oxley Act of 2002 |\n| 32.2 | Certification by Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes‑Oxley Act of 2002 |\n| 101.INS | Inline XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104 | Cover Page Interactive Data File included as Exhibit 101 (embedded within the Inline XBRL document) |\n\n13\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned in the capacities* indicated thereunto duly authorized.\niShares Delaware Trust Sponsor LLC, Sponsor of the iShares Gold Trust Micro (registrant)\n\n| /s/ Paul Lohrey |\n| Paul Lohrey |\n| Director, President and Chief Executive Officer |\n| (Principal executive officer) |\n\n\n| Date: | November 3, 2021 |\n\n\n| /s/ Trent Walker |\n| Trent Walker |\n| Chief Financial Officer |\n| (Principal financial and accounting officer) |\n\n\n| Date: | November 3, 2021 |\n\n\n| * | The registrant is a trust and the persons are signing in their respective capacities as officers of iShares Delaware Trust Sponsor LLC, the Sponsor of the registrant. |\n\n14\n \n\nWhat is the percentage increase in the value of gold bullion from the date of inception until September 30, 2021?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nItem 1. Financial Statements\\niShares®Gold Trust Micro\\nStatements of Assets and Liabilities (Unaudited)\\nAt September 30, 2021 and June 15, 2021 (Date of Inception)\\n\\n| September 30, 2021 | June 15, 2021 |\\n| Assets |\\n| Investment in gold bullion, at fair value(a) | $ | 607,260,237 | $ | 9,325,500 |\\n| Total Assets | 607,260,237 | 9,325,500 |\\n| Liabilities |\\n| Sponsor’s fees payable | 34,807 | — |\\n| Total Liabilities | 34,807 | — |\\n| Commitments and contingent liabilities (Note 6) | — | — |\\n| Net Assets | $ | 607,225,430 | $ | 9,325,500 |\\n| Shares issued and outstanding(b) | 34,850,000 | 500,000 |\\n| Net asset value per Share (Note 2C) | $ | 17.42 | $ | 18.65 |\\n\\n\\n| (a) | Cost of investment in gold bullion: $626,373,040 and $9,325,500, respectively. |\\n| (b) | No par value, unlimited amount authorized. |\\n\\nSee notes to financial statements.\\n1\\niShares®Gold Trust Micro\\nStatements of Operations (Unaudited)\\nFor the three months ended September 30, 2021 and the period from June 15, 2021 (Date of Inception) to September 30, 2021\\n\\n| Three Months Ended September 30, 2021 | Period from June 15, 2021 (Date of Inception) to September 30, 2021 |\\n| Expenses |\\n| Sponsor’s fees | $ | 200,617 | $ | 201,169 |\\n| Sponsor’s fees waived | ( 107,095 | ) | ( 107,134 | ) |\\n| Total expenses | 93,522 | 94,035 |\\n| Net investment loss | ( 93,522 | ) | ( 94,035 | ) |\\n| Net Realized and Unrealized Gain (Loss) |\\n| Net realized gain (loss) from: |\\n| Gold bullion sold to pay expenses | 422 | 422 |\\n| Net change in unrealized appreciation/depreciation | ( 18,603,053 | ) | ( 19,112,803 | ) |\\n| Net realized and unrealized loss | ( 18,602,631 | ) | ( 19,112,381 | ) |\\n| Net decrease in net assets resulting from operations | $ | ( 18,696,153 | ) | $ | ( 19,206,416 | ) |\\n| Net decrease in net assets per Share | $ | ( 0.61 | ) | $ | ( 0.74 | ) |\\n\\nSee notes to financial statements.\\n2\\niShares®Gold Trust Micro\\nStatements of Changes in Net Assets (Unaudited)\\nFor the three months ended September 30, 2021 and the period from June 15, 2021 (Date of Inception) to September 30, 2021\\n\\n| Period from June 15, 2021 (Date of Inception) to September 30, 2021 |\\n| Net Assets at June 15, 2021 | $ | 9,325,500 |\\n| Operations: |\\n| Net investment loss | ( 513 | ) |\\n| Net change in unrealized appreciation/depreciation | ( 509,750 | ) |\\n| Net decrease in net assets resulting from operations | ( 510,263 | ) |\\n| Decrease in net assets | ( 510,263 | ) |\\n| Net Assets at June 30, 2021 | $ | 8,815,237 |\\n| Operations: |\\n| Net investment loss | ( 93,522 | ) |\\n| Net realized gain | 422 |\\n| Net change in unrealized appreciation/depreciation | ( 18,603,053 | ) |\\n| Net decrease in net assets resulting from operations | ( 18,696,153 | ) |\\n| Capital Share Transactions: |\\n| Contributions for Shares issued | 617,106,346 |\\n| Net increase in net assets from capital share transactions | 617,106,346 |\\n| Increase in net assets | 598,410,193 |\\n| Net Assets at September 30, 2021 | $ | 607,225,430 |\\n| Shares issued and redeemed |\\n| Shares issued | 34,350,000 |\\n| Net increase in Shares issued and outstanding | 34,350,000 |\\n\\nSee notes to financial statements.\\n3\\niShares®Gold Trust Micro\\nStatement of Cash Flows (Unaudited)\\nFor the period from June 15, 2021 (Date of Inception) to September 30, 2021\\n\\n| June 15, 2021 (Date of Inception) to September 30, 2021 |\\n| Cash Flows from Operating Activities |\\n| Proceeds from gold bullion sold to pay expenses | $ | 59,228 |\\n| Expenses – Sponsor’s fees paid | ( 59,228 | ) |\\n| Net cash provided by operating activities | — |\\n| Increase (decrease) in cash | — |\\n| Cash, beginning of period | — |\\n| Cash, end of period | $ | — |\\n| Reconciliation of Net Increase (Decrease) in Net Assets Resulting from Operations to Net Cash Provided by (Used in) Operating Activities |\\n| Net decrease in net assets resulting from operations | $ | ( 19,206,416 | ) |\\n| Adjustments to reconcile net increase (decrease) in net assets resulting from operations to net cash provided by (used in) operating activities: |\\n| Proceeds from gold bullion sold to pay expenses | 59,228 |\\n| Net realized (gain) loss | ( 422 | ) |\\n| Net change in unrealized appreciation/depreciation | 19,112,803 |\\n| Change in operating assets and liabilities: |\\n| Sponsor’s fees payable | 34,807 |\\n| Net cash provided by (used in) operating activities | $ | — |\\n| Supplemental disclosure of non-cash information: |\\n| Gold bullion contributed for Shares issued | $ | 617,106,346 |\\n\\nSee notes to financial statements.\\n4\\niShares®Gold Trust Micro\\nSchedules of Investments (Unaudited)\\nAt September 30, 2021 and June 15, 2021 (Date of Inception)\\n\\n| September 30, 2021 |\\n\\n\\n| Description | Ounces | Cost | Fair Value |\\n| Gold bullion | 348,439 | $ | 626,373,040 | $ | 607,260,237 |\\n| Total Investments – 100.01% | 607,260,237 |\\n| Less Liabilities – (0.01)% | ( 34,807 | ) |\\n| Net Assets – 100.00% | $ | 607,225,430 |\\n\\n\\n| June 15, 2021 (Date of Inception) |\\n\\n\\n| Description | Ounces | Cost | Fair Value |\\n| Gold bullion | 5,000 | $ | 9,325,500 | $ | 9,325,500 |\\n| Total Investments – 100.00% | 9,325,500 |\\n| Less Liabilities – (0.00)% | — |\\n| Net Assets – 100.00% | $ | 9,325,500 |\\n\\nSee notes to financial statements.\\n5\\niShares®Gold Trust Micro\\nNotes to Financial Statements (Unaudited)\\nSeptember 30, 2021\\n\\n| 1 - | Organization |\\n\\nThe iShares Gold Trust Micro (the “Trust”) was organized on June 15, 2021 as a New York trust. The trustee is The Bank of New York Mellon (the “Trustee”), which is responsible for the day-to-day administration of the Trust. The Trust’s sponsor is iShares Delaware Trust Sponsor LLC, a Delaware limited liability company (the “Sponsor”). The Trust is governed by the provisions of the Depositary Trust Agreement (the “Trust Agreement”) executed by the Trustee and the Sponsor as of June 15, 2021. The Trust issues units of beneficial interest (“Shares”) representing fractional undivided beneficial interests in its net assets.\\nBlackRock Financial Management, Inc. (the “Seed Capital Investor”), contributed 5,000 ounces of Gold in exchange for 500,000 shares (the “Seed Creation Baskets”) on June 15, 2021 for the benefit of BlackRock Financial Management, Inc. At contribution, the value of the gold deposited with the Trust was based on the price of an ounce of gold of $ 1,865.10 . The Seed Capital Investor is an affiliate of the Sponsor. The Seed Capital Investor did not and will not receive from the Trust, the Sponsor or any of their affiliates any fee or other compensation in connection with the sale of the Seed Creation Baskets.\\nThe Trust seeks to reflect generally the performance of the price of gold. The Trust seeks to reflect such performance before payment of the Trust’s expenses and liabilities. The Trust is designed to provide a vehicle for investors to make an investment similar to an investment in gold.\\nThe accompanying unaudited financial statements were prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”) for interim financial information and with the instructions for Form 10-Q and the rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”). In the opinion of management, all material adjustments, consisting only of normal recurring adjustments considered necessary for a fair statement of the interim period financial statements, have been made. Interim period results are not necessarily indicative of results for a full-year period. These financial statements and the notes thereto should be read in conjunction with the Trust’s financial statements included in the registration statement on Form S-1 as filed with the SEC on June 23, 2021.\\nThe Trust qualifies as an investment company solely for accounting purposes and not for any other purpose and follows the accounting and reporting guidance under the Financial Accounting Standards Board Accounting Standards Codification Topic 946, Financial Services - Investment Companies, but is not registered, and is not required to be registered, as an investment company under the Investment Company Act of 1940, as amended.\\n\\n| 2 - | Significant Accounting Policies |\\n\\n\\n\\n| A. | Basis of Accounting |\\n\\nThe following significant accounting policies are consistently followed by the Trust in the preparation of its financial statements in conformity with U.S. GAAP. The preparation of financial statements in conformity with U.S. GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.\\n\\n\\n| B. | Gold Bullion |\\n\\nJPMorgan Chase Bank N.A., London branch (the “Custodian”), is responsible for the safekeeping of gold bullion owned by the Trust.\\nFair value of the gold bullion held by the Trust is based on that day’s London Bullion Market Association (“LBMA”) Gold Price PM. “LBMA Gold Price PM” is the price per fine troy ounce of gold, stated in U.S. dollars, determined by ICE Benchmark Administration (“IBA”) following an electronic auction consisting of one or more 30-second rounds starting at 3:00 p.m. (London time), on each day that the London gold market is open for business and published shortly thereafter. If there is no LBMA Gold Price PM on any day, the Trustee is authorized to use the most recently announced price of gold determined in an electronic auction hosted by IBA that begins at 10:30 a.m. (London time) (“LBMA Gold Price AM”) unless the Trustee, in consultation with the Sponsor, determines that such price is inappropriate as a basis for evaluation.\\nGain or loss on sales of gold bullion is calculated on a trade date basis using the average cost method.\\n6\\nThe following tables summarize activity in gold bullion for the three months ended September 30, 2021 and the period from June 15, 2021 (Date of Inception) to September 30, 2021:\\n\\n| Three Months Ended September 30, 2021 | Ounces | Cost | Fair Value | Realized Gain (Loss) |\\n| Beginning balance | 5,000 | $ | 9,325,500 | $ | 8,815,750 | $ | — |\\n| Gold bullion contributed | 343,472 | 617,106,346 | 617,106,346 | — |\\n| Gold bullion distributed | — | — | — | — |\\n| Gold bullion sold to pay expenses | ( 33 | ) | ( 58,806 | ) | ( 59,228 | ) | 422 |\\n| Net realized gain | — | — | 422 | — |\\n| Net change in unrealized appreciation/depreciation | — | — | ( 18,603,053 | ) | — |\\n| Ending balance | 348,439 | $ | 626,373,040 | $ | 607,260,237 | $ | 422 |\\n\\n\\n| Period from June 15, 2021 (Date of Inception) to September 30, 2021 | Ounces | Cost | Fair Value | Realized Gain (Loss) |\\n| Beginning balance | 5,000 | $ | 9,325,500 | $ | 9,325,500 | $ | — |\\n| Gold bullion contributed | 343,472 | 617,106,346 | 617,106,346 | — |\\n| Gold bullion distributed | — | — | — | — |\\n| Gold bullion sold to pay expenses | ( 33 | ) | ( 58,806 | ) | ( 59,228 | ) | 422 |\\n| Net realized gain | — | — | 422 | — |\\n| Net change in unrealized appreciation/depreciation | — | — | ( 19,112,803 | ) | — |\\n| Ending balance | 348,439 | $ | 626,373,040 | $ | 607,260,237 | $ | 422 |\\n\\n\\n\\n| C. | Calculation of Net Asset Value |\\n\\nOn each business day, as soon as practicable after 4:00 p.m. (New York time), the net asset value of the Trust is obtained by subtracting all accrued fees, expenses and other liabilities of the Trust from the fair value of the gold and other assets held by the Trust. The Trustee computes the net asset value per Share by dividing the net asset value of the Trust by the number of Shares outstanding on the date the computation is made.\\n\\n\\n| D. | Offering of the Shares |\\n\\nTrust Shares are issued and redeemed continuously in aggregations of 50,000 Shares in exchange for gold bullion rather than cash. Individual investors cannot purchase or redeem Shares in direct transactions with the Trust. The Trust only transacts with registered broker-dealers that are eligible to settle securities transactions through the book-entry facilities of the Depository Trust Company and that have entered into a contractual arrangement with the Trustee and the Sponsor governing, among other matters, the creation and redemption of Shares (such broker-dealers, the “Authorized Participants”). Holders of Shares of the Trust may redeem their Shares at any time acting through an Authorized Participant and in the prescribed aggregations of 50,000 Shares; provided, that redemptions of Shares may be suspended during any period while regular trading on NYSE Arca, Inc. (“NYSE Arca”) is suspended or restricted, or in which an emergency exists as a result of which delivery, disposal or evaluation of gold is not reasonably practicable.\\nThe per Share amount of gold exchanged for a purchase or redemption represents the per Share amount of gold held by the Trust, after giving effect to its liabilities.\\nWhen gold bullion is exchanged in settlement of a redemption, it is considered a sale of gold bullion for accounting purposes.\\n\\n\\n| E. | Federal Income Taxes |\\n\\nThe Trust is treated as a grantor trust for federal income tax purposes and, therefore, no provision for federal income taxes is required. Any interest, expenses, gains and losses are passed through to the holders of Shares of the Trust.\\nThe Sponsor has analyzed applicable tax laws and regulations and their application to the Trust as of September 30, 2021 and does not believe that there are any uncertain tax positions that require recognition of a tax liability.\\n\\n| 3 - | Trust Expenses |\\n\\nThe Trust pays to the Sponsor a Sponsor’s fee that accrues daily at an annualized rate equal to 0.15 % of the net asset value of the Trust, paid monthly in arrears. Effective June 29, 2021, the Sponsor has voluntarily agreed to waive a portion of the Sponsor’s Fee so that the Sponsor’s Fee after the fee waiver will not exceed 0.07 % through June 30, 2024. Although the Sponsor has no current intention of doing so, because the fee waiver is voluntary, the Sponsor may revert to the 0.15 % fee prior to June 30, 2024. Should the Sponsor choose to revert to the 0.15 % fee (or an amount higher than 0.07 % but no greater than 0.15 % annualized), prior to June 30, 2024, it will provide shareholders with at least 30 days’ prior written notice of such change through either a prospectus supplement to its registration statement or through a report furnished on Form 8-K. The Sponsor has agreed to assume the following administrative and marketing expenses incurred by the Trust: the Trustee’s fee and reimbursement for its reasonable out-of-pocket expenses, the Custodian’s fee, NYSE Arca listing fees, SEC registration fees, printing and mailing costs, audit fees and expenses, and up to $ 100,000 per annum in legal fees and expenses. The amount waived is included in Sponsor’s fees waived in the Statement of Operations. For the quarter ended September 30, 2021, the amount waived was $ 107,095 .\\n7\\n\\n| 4 - | Related Parties |\\n\\nThe Sponsor and the Trustee are considered to be related parties to the Trust. The Trustee’s fee is paid by the Sponsor and is not a separate expense of the Trust.\\nAs of September 30, 2021 BlackRock Financial Management, Inc., an affiliate of the Sponsor, owned 500,000 Shares of the Trust.\\n\\n| 5 - | Indemnification |\\n\\nThe Trust Agreement provides that the Trustee shall indemnify the Sponsor, its directors, officers, employees and agents against, and hold each of them harmless from, any loss, liability, cost, expense or judgment (including reasonable fees and expenses of counsel) (i) caused by the negligence or bad faith of the Trustee or (ii) arising out of any information furnished in writing to the Sponsor by the Trustee expressly for use in the registration statement, or any amendment thereto or periodic or other report filed with the SEC relating to the Shares that is not materially altered by the Sponsor.\\nThe Trust Agreement provides that the Sponsor and its shareholders, directors, officers, employees, affiliates (as such term is defined under the Securities Act of 1933, as amended) and subsidiaries shall be indemnified from the Trust and held harmless against any loss, liability or expense incurred without their (1) negligence, bad faith, willful misconduct or willful malfeasance arising out of or in connection with the performance of their obligations under the Trust Agreement or any actions taken in accordance with the provisions of the Trust Agreement or (2) reckless disregard of their obligations and duties under the Trust Agreement.\\nThe Trust has agreed that the Custodian will only be responsible for any loss or damage suffered by the Trust as a direct result of the Custodian’s negligence, fraud or willful default in the performance of its duties.\\n\\n| 6 - | Commitments and Contingent Liabilities |\\n\\nIn the normal course of business, the Trust may enter into contracts with service providers that contain general indemnification clauses. The Trust’s maximum exposure under these arrangements is unknown as this would involve future claims that may be made against the Trust that have not yet occurred.\\n\\n| 7 - | Concentration Risk |\\n\\nSubstantially all of the Trust’s assets are holdings of gold bullion, which creates a concentration risk associated with fluctuations in the price of gold. Accordingly, a decline in the price of gold will have an adverse effect on the value of the Shares of the Trust. Factors that may have the effect of causing a decline in the price of gold include large sales by the official sector (governments, central banks, and related institutions); a significant increase in the hedging activities of gold producers; significant changes in the attitude of speculators, investors and other market participants towards gold; global gold supply and demand; global or regional political, economic or financial events and situations; investors’ expectations with respect to the rate of inflation; interest rates; investment and trading activities of hedge funds and commodity funds; other economic variables such as income growth, economic output, and monetary policies; and investor confidence.\\n8\\n\\n| 8 - | Financial Highlights |\\n\\nThe following financial highlights relate to investment performance and operations for a Share outstanding for the three months ended September 30, 2021 and the period from June 15, 2021 (Date of Inception) to September 30, 2021.\\n\\n| Three Months Ended September 30, 2021 | Period from June 15, 2021 (Date of Inception) to September 30, 2021 |\\n| Net asset value per Share, beginning of period | $ | 17.63 | $ | 18.65 |\\n| Net investment loss(a) | ( 0.00 | )(b) | ( 0.00 | )(b) |\\n| Net realized and unrealized gain (loss)(c) | ( 0.21 | ) | ( 1.23 | ) |\\n| Net decrease in net assets from operations | ( 0.21 | ) | ( 1.23 | ) |\\n| Net asset value per Share, end of period | $ | 17.42 | $ | 17.42 |\\n| Total return, at net asset value(d)(e) | ( 1.19 | )% | ( 6.60 | )% |\\n| Ratio to average net assets: |\\n| Net investment loss(f) | ( 0.07 | )% | ( 0.07 | )% |\\n| Total Expenses(f) | 0.15 | % | 0.15 | % |\\n| Total expenses after fees waived(f) | 0.07 | % | 0.07 | % |\\n\\n\\n| (a) | Based on average Shares outstanding during the period. |\\n| (b) | Amount is greater than $( 0.005 ) per share |\\n| (c) | The amounts reported for a Share outstanding may not accord with the change in aggregate gains and losses on investment for the period due to the timing of Trust Share transactions in relation to the fluctuating fair values of the Trust’s underlying investment. |\\n| (d) | Based on the change in net asset value of a Share during the period. |\\n| (e) | Percentage is not annualized. |\\n| (f) | Percentage is annualized. |\\n\\n\\n| 9 - | Investment Valuation |\\n\\nU.S. GAAP defines fair value as the price the Trust would receive to sell an asset or pay to transfer a liability in an orderly transaction between market participants at the measurement date. The Trust’s policy is to value its investment at fair value.\\nVarious inputs are used in determining the fair value of assets and liabilities. Inputs may be based on independent market data (“observable inputs”) or they may be internally developed (“unobservable inputs”). These inputs are categorized into a disclosure hierarchy consisting of three broad levels for financial reporting purposes. The level of a value determined for an asset or liability within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement in its entirety. The three levels of the fair value hierarchy are as follows:\\n\\n| Level 1 − | Unadjusted quoted prices in active markets for identical assets or liabilities; |\\n\\n\\n| Level 2 − | Inputs other than quoted prices included within Level 1 that are observable for the asset or liability either directly or indirectly, including quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not considered to be active, inputs other than quoted prices that are observable for the asset or liability, and inputs that are derived principally from or corroborated by observable market data by correlation or other means; and |\\n\\n\\n| Level 3 − | Unobservable inputs that are unobservable for the asset or liability, including the Trust’s assumptions used in determining the fair value of investments. |\\n\\nAt September 30, 2021, the value of the gold bullion held by the Trust is categorized as Level 1.\\n9\\n\\ns Discussion and Analysis of Financial Condition and Results of Operations.\\nThis information should be read in conjunction with the financial statements and notes to financial statements included in Item 1 of Part I of this Form 10‑Q. The discussion and analysis that follows may contain statements that relate to future events or future performance. In some cases, such forward-looking statements can be identified by terminology such as “may,” “should,” “could,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential” or the negative of these terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially. These statements are based upon certain assumptions and analyses made by the Sponsor on the basis of its perception of historical trends, current conditions and expected future developments, as well as other factors it believes are appropriate in the circumstances. Whether or not actual results and developments will conform to the Sponsor’s expectations and predictions, however, is subject to a number of risks and uncertainties, including the special considerations discussed below, general economic, market and business conditions, changes in laws or regulations, including those concerning taxes, made by governmental authorities or regulatory bodies, and other world economic and political developments. Although the Sponsor does not make forward-looking statements unless it believes it has a reasonable basis for doing so, the Sponsor cannot guarantee their accuracy. Except as required by applicable disclosure laws, neither the Trust nor the Sponsor is under a duty to update any of the forward-looking statements to conform such statements to actual results or to a change in the Sponsor’s expectations or predictions.\\nIntroduction\\nThe iShares Gold Trust Micro (the “Trust”) is a grantor trust formed under the laws of the State of New York. The Trust does not have any officers, directors, or employees, and is administered by The Bank of New York Mellon (the “Trustee”) acting as trustee pursuant to the Depositary Trust Agreement (the “Trust Agreement”) between the Trustee and iShares Delaware Trust Sponsor LLC, the sponsor of the Trust (the “Sponsor”). The Trust issues units of beneficial interest (“Shares”) representing fractional undivided beneficial interests in its net assets. The assets of the Trust consist primarily of gold bullion held by a custodian as an agent of the Trust responsible only to the Trustee.\\nThe Trust is a passive investment vehicle and seeks to reflect generally the performance of the price of gold. The Trust seeks to reflect such performance before payment of the Trust’s expenses and liabilities. The Trust does not engage in any activities designed to obtain a profit from, or ameliorate losses caused by, changes in the price of gold.\\nThe Trust issues and redeems Shares only in exchange for gold, only in aggregations of 50,000 Shares (a “Basket”) or integral multiples thereof, and only in transactions with registered broker-dealers that have previously entered into an agreement with the Sponsor and the Trustee governing the terms and conditions of such issuance (such broker-dealers, the “Authorized Participants”). A list of the current Authorized Participants is available from the Sponsor or the Trustee.\\nShares of the Trust trade on NYSE Arca, Inc. under the ticker symbol IAUM.\\nValuation of Gold Bullion; Computation of Net Asset Value\\nOn each business day, as soon as practicable after 4:00 p.m. (New York time), the Trustee evaluates the gold held by the Trust and determines the net asset value of the Trust and the net asset value per Share (“NAV”). The Trustee values the gold held by the Trust using the price per fine troy ounce of gold determined in an electronic auction hosted by ICE Benchmark Administration (“IBA”) that begins at 3:00 p.m. (London time) and published shortly thereafter, on the day the valuation takes place (such price, the “LBMA Gold Price PM”). If there is no announced LBMA Gold Price PM on any day, the Trustee is authorized to use the most recently announced price of gold determined in an electronic auction hosted by IBA that begins at 10:30 a.m. (London time) (such price, the “LBMA Gold Price AM”), unless the Trustee, in consultation with the Sponsor, determines that such price is inappropriate as a basis for evaluation. The LBMA Gold Price AM and LBMA Gold Price PM are used by the Trust because they are commonly used by the U.S. gold market as indicators of the value of gold and are permitted to be used under the Trust Agreement. The use of indicators of the value of gold bullion other than the LBMA Gold Price AM and LBMA Gold Price PM could result in materially different fair value pricing of the gold held by the Trust, and as such, could result in different cost or market adjustments or in different redemption value adjustments of the outstanding redeemable capital Shares. Having valued the gold held by the Trust, the Trustee then subtracts all accrued fees, expenses and other liabilities of the Trust from the total value of the gold held by the Trust and other assets held by the Trust. The result is the net asset value of the Trust. The Trustee computes NAV by dividing the net asset value of the Trust by the number of Shares outstanding on the date the computation is made.\\nLiquidity\\nThe Trust is not aware of any trends, demands, conditions or events that are reasonably likely to result in material changes to its liquidity needs. In exchange for a fee, the Sponsor has agreed to assume most of the expenses incurred by the Trust. As a result, the only ordinary expense of the Trust during the period covered by this report was the Sponsor’s fee. The Trust’s only source of liquidity is its sales of gold.\\nCritical Accounting Policies\\nThe financial statements and accompanying notes are prepared in accordance with generally accepted accounting principles in the United States of America. The preparation of these financial statements relies on estimates and assumptions that impact the Trust’s financial position and results of operations. These estimates and assumptions affect the Trust’s application of accounting policies. Below is a description of the valuation of gold bullion, a critical accounting policy that the Trust believes is important to understanding its results of operations and financial position, is provided in the section entitled “Valuation of Gold Bullion; Computation of Net Asset Value” above. In addition, please refer to Note 2 to the financial statements included in this report for further discussion of the Trust’s accounting policies.\\n10\\nResults of Operations\\nThe Quarter Ended September 30, 2021\\nThe Trust’s net asset value increased from $8,815,237 at June 30, 2021 to $607,225,430 at September 30, 2021, a 6,788.36% increase. The increase in the Trust’s net asset value resulted primarily from an increase in the number of outstanding shares, which rose from 500,000 Shares at June 30, 2021 to 34,850,000 Shares at September 30, 2021, a consequence of 34,350,000 Shares (687 Baskets) being created during the quarter. The increase in the Trust’s net asset value was partially offset by a decrease in the LMBA Gold Price, which fell 1.15% from $1,763.15 at June 30, 2021 to $1,742.80 at September 30, 2021.\\nThe 1.19% decrease in the NAV from $17.63 at June 30, 2021 to $17.42 at September 30, 2021 is directly related to the 1.15% decrease in the price of gold.\\nThe NAV decreased slightly more than the price of gold on a percentage basis due to the Sponsor’s fees, which were $93,522 for the quarter, or 0.02% of the Trust’s average weighted assets of $537,613,742 during the quarter. The NAV of $18.29 on July 29, 2021 was the highest during the quarter, compared with a low during the quarter of $17.23 on August 10, 2021.\\nNet decrease in net assets resulting from operations for the quarter ended September 30, 2021 was $18,696,153, resulting from an unrealized loss on investment in gold bullion of $18,603,053, a net realized gain of $422 from gold bullion sold to pay expenses during the quarter, and a net investment loss of $93,522. Other than the Sponsor’s fees of $93,522, the Trust had no expenses during the quarter.\\nThe Period from June 15, 2021 (Date of Inception) to September 30, 2021\\nThe Trust’s net asset value increased from $9,325,500 at June 15, 2021 (Date of Inception) to $607,225,430 at September 30, 2021, a 6,411.45% increase. The increase in the Trust’s net asset value resulted primarily from an increase in the number of outstanding shares, which rose from 500,000 Shares at June 15, 2021 (Date of Inception) to 34,850,000 Shares at September 30, 2021, a consequence of 34,350,000 Shares (687 Baskets) being created during the period. The increase in the Trust’s net asset value was partially offset by a decrease in the LMBA Gold Price, which fell 6.56% from $1,865.10 at June 15, 2021 (Date of Inception) to $1,742.80 at September 30, 2021.\\nThe 6.60% decrease in the NAV from $18.65 at June 15, 2021 (Date of Inception) to $17.42 at September 30, 2021 is directly related to the 6.56% decrease in the price of gold.\\nThe NAV decreased slightly more than the price of gold on a percentage basis due to the Sponsor’s fees, which were $94,035 for the period, or 0.02% of the Trust’s average weighted assets of $459,291,726 during the period. The NAV of $18.65 on June 15, 2021 was the highest during the period, compared with a low during the period of $17.23 on August 10, 2021.\\nNet decrease in net assets resulting from operations for the period ended September 30, 2021 was $19,206,416, resulting from an unrealized loss on investment in gold bullion of $19,112,803, a net realized gain of $422 from gold bullion sold to pay expenses during the quarter, and a net investment loss of $94,035. Other than the Sponsor’s fees of $94,035, the Trust had no expenses during the period.\\n\\nNot applicable.\\n\\nThe duly authorized officers of the Sponsor performing functions equivalent to those a principal executive officer and principal financial officer of the Trust would perform if the Trust had any officers, with the participation of the Trustee, have evaluated the effectiveness of the Trust’s disclosure controls and procedures, and have concluded that the disclosure controls and procedures of the Trust were effective as of the end of the period covered by this report to provide reasonable assurance that information required to be disclosed in the reports that the Trust files or submits under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported, within the time periods specified in the applicable rules and forms, and that it is accumulated and communicated to the duly authorized officers of the Sponsor performing functions equivalent to those a principal executive officer and principal financial officer of the Trust would perform if the Trust had any officers, as appropriate to allow timely decisions regarding required disclosure.\\nThere are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures.\\n11\\nPART II – OTHER INFORMATION\\n\\nNone.\\n\\nThere have been no material changes to the Risk Factors in the registration statement on Form S-1, initially filed with the Securities and Exchange Commission on February 26, 2021 and declared effective on June 28, 2021.\\n\\na) None.\\nb) Not applicable.\\nc) There were no Shares redeemed during the period from June 15, 2021 (Date of Inception) to September 30, 2021.\\n\\nNone.\\n\\nNot applicable.\\n\\nNot applicable.\\n12\\n\\n\\n| Exhibit No. | Description |\\n| 4.1 | Depositary Trust Agreement is incorporated by reference to Exhibit 4.1 of the Registration Statement on Form S‑1 (File No. 333‑253614) filed by the Registrant on June 21, 2021 |\\n| 4.2 | Standard Terms for Authorized Participant Agreements is incorporated by reference to Exhibit 4.2 of the Registration Statement on Form S-1 (File No. 333-253614) filed by the Registrant on June 21, 2021 |\\n| 10.1 | Custodian Agreement between The Bank of New York Mellon and JP Morgan Chase Bank N.A., London branch is incorporated by reference to Exhibit 10.1 of the Registration Statement on Form S-1 (File No. 333-253614) filed by the Registrant on June 21, 2021 |\\n| 10.2 | Sub-license Agreement is incorporated by reference to Exhibit 10.2 of the Registration Statement on Form S-1 (File No. 333-253614) filed by the Registrant on June 21, 2021 |\\n| 31.1 | Certification by Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 31.2 | Certification by Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 32.1 | Certification by Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes‑Oxley Act of 2002 |\\n| 32.2 | Certification by Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes‑Oxley Act of 2002 |\\n| 101.INS | Inline XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. |\\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document |\\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document |\\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\\n| 104 | Cover Page Interactive Data File included as Exhibit 101 (embedded within the Inline XBRL document) |\\n\\n13\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned in the capacities* indicated thereunto duly authorized.\\niShares Delaware Trust Sponsor LLC, Sponsor of the iShares Gold Trust Micro (registrant)\\n\\n| /s/ Paul Lohrey |\\n| Paul Lohrey |\\n| Director, President and Chief Executive Officer |\\n| (Principal executive officer) |\\n\\n\\n| Date: | November 3, 2021 |\\n\\n\\n| /s/ Trent Walker |\\n| Trent Walker |\\n| Chief Financial Officer |\\n| (Principal financial and accounting officer) |\\n\\n\\n| Date: | November 3, 2021 |\\n\\n\\n| * | The registrant is a trust and the persons are signing in their respective capacities as officers of iShares Delaware Trust Sponsor LLC, the Sponsor of the registrant. |\\n\\n14\\n \\n\\nWhat is the percentage increase in the value of gold bullion from the date of inception until September 30, 2021?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 6411.824963808911.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 58,\n \"input_length\": 9592\n}"}}},{"rowIdx":59,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nItem 1. Financial Statements.\nBETTER WORLD ACQUISITION CORP.\nCONDENSED BALANCE SHEETS\n\n| September 30, 2022 | December 31, 2021 |\n| (Unaudited) |\n| ASSETS |\n| Current assets |\n| Cash | $ | 83,760 | $ | 278,197 |\n| Prepaid expenses and other current assets | 48,251 | 30,805 |\n| Total Current Assets | 132,011 | 309,002 |\n| Cash and marketable securities held in Trust Account | 44,203,481 | 128,790,008 |\n| TOTAL ASSETS | $ | 44,335,492 | $ | 129,099,010 |\n| LIABILITIES AND STOCKHOLDERS’ DEFICIT |\n| Current liabilities - Accounts payable and accrued expenses | $ | 560,689 | $ | 430,800 |\n| Deferred legal fees | 1,371,549 | 1,009,868 |\n| Convertible promissory note – related party, at fair value | 913,900 | 958,400 |\n| Warrant Liabilities | 422,846 | 2,641,204 |\n| Income taxes payable | 27,528 | — |\n| Total Liabilities | 3,296,512 | 5,040,272 |\n| Commitments and Contingencies (Note 6) |\n| Common stock subject to possible redemption; $ 0.0001 par value; 4,213,453 shares at $ 10.49 per share redemption value as of September 30, 2022 and 12,618,600 shares at $ 10.20 per share redemption value as of December 31, 2021 | 44,203,481 | 128,709,720 |\n| Stockholders’ Deficit |\n| Preferred stock, $ 0.0001 par value; 1,000,000 shares authorized; none issued or outstanding | — | — |\n| Common stock, $ 0.0001 par value; 50,000,000 shares authorized; 3,487,070 shares issued and outstanding (excluding 4,213,453 and 12,618,600 shares subject to possible redemption) at September 30, 2022 and December 31, 2021, respectively | 348 | 348 |\n| Accumulated deficit | ( 3,164,849 | ) | ( 4,651,330 | ) |\n| Total Stockholders’ Deficit | ( 3,164,501 | ) | ( 4,650,982 | ) |\n| TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT | $ | 44,335,492 | $ | 129,099,010 |\n\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\n1\nBETTER WORLD ACQUISITION CORP.\nCONDENSED STATEMENTS OF OPERATIONS\n(UNAUDITED)\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Operational costs | $ | 396,066 | $ | 735,695 | $ | 1,327,272 | $ | 1,148,802 |\n| Loss from operations | ( 396,066 | ) | ( 735,695 | ) | ( 1,327,272 | ) | ( 1,148,802 | ) |\n| Other income (expense): |\n| Interest earned on marketable securities held in Trust Account | 254,709 | 23,138 | 423,734 | 58,976 |\n| Unrealized gain (loss) on marketable securities held in Trust Account | 1,078 | ( 4,654 | ) | — | ( 5,829 | ) |\n| Change in fair value of Private Warrants liabilities | ( 106,018 | ) | 2,192,941 | 2,218,358 | 3,302,913 |\n| Change in fair value of convertible promissory note – related party | 1,113,700 | — | 2,119,960 | — |\n| Other income, net | 1,263,469 | 2,211,425 | 4,762,052 | 3,356,060 |\n| Income before provision for income taxes | 867,403 | 1,475,730 | 3,434,780 | 2,207,258 |\n| Provision for income taxes | ( 23,249 | ) | — | ( 27,528 | ) | — |\n| Net income | $ | 844,154 | $ | 1,475,730 | $ | 3,407,252 | $ | 2,207,258 |\n| Basic and diluted weighted average shares outstanding, redeemable common stock | 5,591,938 | 12,618,600 | 9,268,327 | 12,618,600 |\n| Basic and diluted net income per share, redeemable common stock | $ | 0.09 | $ | 0.09 | $ | 0.27 | $ | 0.14 |\n| Basic and diluted weighted average shares outstanding, non-redeemable common stock | 3,487,070 | 3,487,070 | 3,487,070 | 3,487,070 |\n| Basic and diluted net income per share, non-redeemable common stock | $ | 0.09 | $ | 0.09 | $ | 0.27 | $ | 0.14 |\n\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\n2\nBETTER WORLD ACQUISITION CORP.\nCONDENSED STATEMENTS OF CHANGES IN STOCKHOLDERS’ DEFICIT\n(UNAUDITED)\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2022\n\n| Common Stock | Additional Paid | Accumulated | Total Stockholders’ |\n| Shares | Amount | in Capital | Deficit | Deficit |\n| Balance – January 1, 2022 | 3,487,070 | $ | 348 | $ | — | $ | ( 4,651,330 | ) | $ | ( 4,650,982 | ) |\n| Accretion for common stock to redemption amount | — | — | — | ( 1,261,860 | ) | ( 1,261,860 | ) |\n| Net income | — | — | — | 1,647,395 | 1,647,395 |\n| Balance – March 31, 2022 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 4,265,795 | ) | $ | ( 4,265,447 | ) |\n| Accretion for common stock to redemption amount | — | — | — | ( 500,000 | ) | ( 500,000 | ) |\n| Net income | — | — | — | 915,703 | 915,703 |\n| Balance – June 30, 2022 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 3,850,092 | ) | $ | ( 3,849,744 | ) |\n| Accretion for common stock to redemption amount | — | — | ( 346,400 | ) | ( 158,911 | ) | ( 505,311 | ) |\n| Promissory note proceeds in excess of initial fair value | — | — | 346,400 | — | 346,400 |\n| Net income | — | — | — | 844,154 | 844,154 |\n| Balance – September 30, 2022 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 3,164,849 | ) | $ | ( 3,164,501 | ) |\n\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2021\n\n| Common Stock | Additional Paid | Accumulated | Total Stockholders’ |\n| Shares | Amount | in Capital | Deficit | Deficit |\n| Balance – January 1, 2021 | 3,487,070 | $ | 348 | $ | — | $ | ( 5,489,693 | ) | $ | ( 5,489,345 | ) |\n| Net income | — | — | — | 832,646 | 832,646 |\n| Balance – March 31, 2021 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 4,657,047 | ) | $ | ( 4,656,699 | ) |\n| Net loss | — | — | — | ( 101,118 | ) | ( 101,118 | ) |\n| Balance – June 30, 2021 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 4,758,165 | ) | $ | ( 4,757,817 | ) |\n| Net income | — | — | — | 1,475,730 | 1,475,730 |\n| Balance – September 30, 2021 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 3,282,435 | ) | $ | ( 3,282,087 | ) |\n\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\n3\nBETTER WORLD ACQUISITION CORP.\nCONDENSED STATEMENTS OF CASH FLOWS\n(UNAUDITED)\n\n| Nine Months Ended September 30, |\n| 2022 | 2021 |\n| Cash Flows from Operating Activities: |\n| Net income | $ | 3,407,252 | $ | 2,207,258 |\n| Adjustments to reconcile net income to net cash used in operating activities: |\n| Interest earned on marketable securities held in Trust Account | ( 423,734 | ) | ( 58,976 | ) |\n| Unrealized gain on marketable securities held in Trust Account | — | 5,829 |\n| Change in fair value of convertible promissory note – related party | ( 2,119,960 | ) | — |\n| Change in fair value of Private Warrant liabilities | ( 2,218,358 | ) | ( 3,302,913 | ) |\n| Changes in operating assets and liabilities: |\n| Prepaid expenses and other current assets | ( 17,446 | ) | 45,890 |\n| Accounts payable and accrued expenses | 129,889 | 574,639 |\n| Income taxes payable | 27,528 | — |\n| Deferred legal fees payable | 361,681 | — |\n| Net cash used in operating activities | ( 853,148 | ) | ( 528,273 | ) |\n| Cash Flows from Investing Activities: |\n| Investment of cash into Trust Account | ( 2,121,860 | ) | — |\n| Cash withdrawn from Trust Account to pay franchise taxes | 358,711 | — |\n| Cash withdrawn from Trust Account in connection with redemption | 86,773,410 | — |\n| Net cash provided by investing activities | 85,010,261 | — |\n| Cash Flows from Financing Activities: |\n| Advances from related party | 100,000 | — |\n| Proceeds from promissory note – related party | — | 107,639 |\n| Repayment of promissory note – related party | — | ( 107,639 | ) |\n| Proceeds from convertible promissory note – related party | 2,321,860 | — |\n| Redemption of common stock | ( 86,773,410 | ) | — |\n| Net cash used in financing activities | ( 84,351,550 | ) | — |\n| Net Change in Cash | ( 194,437 | ) | ( 528,273 | ) |\n| Cash – Beginning of period | 278,197 | 1,023,178 |\n| Cash – End of period | $ | 83,760 | $ | 494,905 |\n| Non-Cash investing and financing activities: |\n| Conversion of advance to convertible promissory note – related party | $ | 100,000 | $ | — |\n| Accretion for common stock to redemption amount | $ | 1,928,271 | $ | — |\n| Promissory note proceeds in excess of initial fair value | $ | ( 338,900 | ) | $ | — |\n\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\n4\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nNOTE 1. DESCRIPTION OF ORGANIZATION, BUSINESS OPERATIONS, LIQUIDITY AND GOING CONCERN\nBetter World Acquisition Corp. (the “Company”) was incorporated in Delaware on August 5, 2020. The Company is a blank check company formed for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities (the “Business Combination”).\nAlthough the Company is not limited to a particular industry or sector for purposes of consummating a Business Combination, the Company is focused on target businesses in the healthy living industries that benefit from strong Environmental, Social and Governance (“ESG”) profiles. The Company is an early stage and emerging growth company and, as such, the Company is subject to all the risks associated with early stage and emerging growth companies.\nAs of September 30, 2022, the Company had not commenced any operations. All activity for the period from August 5, 2020 (inception) through September 30, 2022 relates to the Company’s formation, the initial public offering (“Initial Public Offering”), which is described below, and identifying a target company for a Business Combination. The Company will not generate any operating revenues until after the completion of a Business Combination, at the earliest. The Company generates non-operating income in the form of interest income from the marketable securities held in the Trust Account (as defined below).\nThe registration statement for the Company’s Initial Public Offering was declared effective on November 12, 2020. On November 17, 2020, the Company consummated the Initial Public Offering of 11,000,000 units (the “Units” and, with respect to the shares of common stock included in the Units sold, the “Public Shares”), at $ 10.00 per Unit, generating gross proceeds of $ 110,000,000 , which is described in Note 3.\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the sale of 4,800,000 warrants (the “Private Warrants”) at a price of $ 1.00 per Private Warrant in a private placement to BWA Holdings LLC (the “Sponsor”) and EarlyBirdCapital, Inc. (“EarlyBirdCapital”), generating gross proceeds of $ 4,800,000 , which is described in Note 4.\nFollowing the closing of the Initial Public Offering on November 17, 2020, an amount of $ 111,100,000 ($ 10.10 per Unit) from the net proceeds of the sale of the Units in the Initial Public Offering and the sale of the Private Warrants was placed in a trust account (the “Trust Account”) located in the United States and invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), with a maturity of 185 days or less or in any open-ended investment company that holds itself out as a money market fund selected by the Company meeting the conditions of Rule 2a-7 of the Investment Company Act, as determined by the Company, until the earlier of: (i) the completion of a Business Combination and (ii) the distribution of the funds in the Trust Account, as described below.\nOn November 17, 2020, the underwriters notified the Company of their intention to partially exercise their over-allotment option on November 19, 2020. As such, on November 19, 2020, the Company consummated the sale of an additional 1,618,600 Units, at $ 10.00 per Unit, generating gross proceeds of $ 16,186,000 , and the sale of an additional 485,580 Private Warrants, at $ 1.00 per Private Warrant, generating gross proceeds of $ 485,580 . A total of $ 16,347,860 of the net proceeds was deposited into the Trust Account on November 20, 2020, bringing the aggregate proceeds held in the Trust Account to $ 127,447,860 . On November 9, 2021, in connection with the first extension of the date by which the Company has to consummate a Business Combination, a total of $ 1,261,860 was deposited into the Trust Account. On February 17, 2022, a total of $ 1,261,860 was deposited in the Trust Account in connection with the second extension of the date by which the Company has to consummate a Business Combination to May 17, 2022. On May 18, 2022, a total of $ 500,000 was deposited into the Trust Account in connection with a further extension of the date by which the Company has to consummate a Business Combination to August 17, 2022. On August 17, 2022, a total of $ 360,000 was deposited into the Trust Account in connection with a further extension of the date by which the Company has to consummate a Business Combination to February 17, 2023.\nTransaction costs amounted to $ 2,880,354 consisting of $ 2,523,720 of underwriting fees and $ 356,634 of other offering costs.\nThe Company’s management has broad discretion with respect to the specific application of the net proceeds of the Initial Public Offering and the sale of the Private Warrants, although substantially all of the net proceeds are intended to be applied generally toward completing a Business Combination. The Company must complete a Business Combination having an aggregate fair market value of at least 80 % of the assets held in the Trust Account (excluding taxes payable on income earned on the Trust Account) at the time of the agreement to enter into an initial Business Combination. The Company will only complete a Business Combination if the post Business Combination company owns or acquires 50 % or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act. There is no assurance that the Company will be able to complete a Business Combination successfully.\n5\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nThe Company will provide its holders of the outstanding Public Shares (the “public stockholders”) with the opportunity to redeem all or a portion of their Public Shares upon the completion of a Business Combination either (i) in connection with a stockholder meeting called to approve the Business Combination or (ii) by means of a tender offer. The decision as to whether the Company will seek stockholder approval of a Business Combination or conduct a tender offer will be made by the Company, solely in its discretion. The public stockholders will be entitled to redeem their Public Shares for a pro rata portion of the amount then in the Trust Account ($ 10.46 per Public Share as of September 30, 2022 and $ 10.20 per Public Share as of December 31, 2021, plus any pro rata interest earned on the funds held in the Trust Account and not previously released to the Company to pay its tax obligations). There will be no redemption rights upon the completion of a Business Combination with respect to the Company’s warrants.\nThe Company will proceed with a Business Combination if the Company has net tangible assets of at least $ 5,000,001 immediately prior to or upon such consummation of a Business Combination and, if the Company seeks stockholder approval, a majority of the shares voted are voted in favor of the Business Combination. If a stockholder vote is not required by law and the Company does not decide to hold a stockholder vote for business or other legal reasons, the Company will, pursuant to its Amended and Restated Certificate of Incorporation (the “Amended and Restated Certificate of Incorporation”), conduct the redemptions pursuant to the tender offer rules of the U.S. Securities and Exchange Commission (“SEC”) and file tender offer documents with the SEC containing substantially the same information as would be included in a proxy statement prior to completing a Business Combination. If, however, stockholder approval of the transaction is required by law, or the Company decides to obtain stockholder approval for business or legal reasons, the Company will offer to redeem shares in conjunction with a proxy solicitation pursuant to the proxy rules and not pursuant to the tender offer rules. If the Company seeks stockholder approval in connection with a Business Combination, the Sponsor has agreed to vote its Founder Shares (as defined in Note 5), Representative Shares (as defined in Note 8) and any Public Shares purchased during or after the Initial Public Offering (a) in favor of approving a Business Combination and (b) not to redeem any shares in connection with a stockholder vote to approve a Business Combination or sell any shares to the Company in a tender offer in connection with a Business Combination. Additionally, each public stockholder may elect to redeem their Public Shares, irrespective of whether they vote for or against the proposed Business Combination.\nThe Sponsor has agreed (a) to waive its redemption rights with respect to the Founder Shares and Public Shares held by it in connection with the completion of a Business Combination and (b) not to propose an amendment to the Amended and Restated Certificate of Incorporation that would affect a public stockholders’ ability to convert or sell their shares to the Company in connection with a Business Combination or affect the substance or timing of the Company’s obligation to redeem 100 % of its Public Shares if the Company does not complete a Business Combination, unless the Company provides the public stockholders with the opportunity to redeem their Public Shares in conjunction with any such amendment.\nOn November 9, 2021, the Company’s board of directors approved the first extension of the date by which the Company has to consummate a Business Combination from November 17, 2021 to February 17, 2022. In connection with the extension, the Sponsor deposited into the Trust Account $ 0.10 for each of the 12,618,600 shares issued in the Initial Public Offering, for a total of $ 1,261,860 . The Company issued the Sponsor a non-interest bearing unsecured promissory note in the principal amount of $ 1,261,860 which is payable by the Company upon the earlier of the consummation of the Business Combination or the liquidation of the Company. The Note may be repaid in cash or convertible into Private Warrants at a price of $ 1.00 per Private Warrant. On February 16, 2022, the Company’s board of directors approved the second extension of the date by which the Company has to consummate a Business Combination from February 17, 2022 to May 17, 2022. In connection with the second extension, the Sponsor deposited into the Trust Account an additional $ 1,261,860 ($ 0.10 per Public Share) on February 17, 2022, and the Company amended and restated the promissory note in its entirety solely to increase the principal amount thereunder from $ 1,261,860 to $ 2,523,720 . On May 12, 2022, the Company held a special meeting of stockholders in which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from May 17, 2022 to August 17, 2022 (the “Combination Period”) was approved by the stockholders. In connection with this extension, the Company deposited $ 500,000 into the Trust Account on May 18, 2022. The Company amended and restated the promissory note to increase the principal amount thereunder from $ 2,523,720 to $ 3,223,720 , which included a drawdown of $ 500,000 for the extension and a drawdown of $ 200,000 for working capital needs. On August 17, 2022, the Company held a special meeting of stockholders in which the Company’s stockholders approved a second amendment to extend the date by which the Company must consummate a Business Combination from August 17, 2022 to February 17, 2023. On August 17, 2022, the Company amended and restated the promissory note to increase the principal amount thereunder from $ 3,223,720 to $ 3,683,720 , which included a drawdown of $ 360,000 for the extension and $ 100,000 for working capital purposes.\n6\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nIf the Company is unable to complete a Business Combination within the Combination Period, the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account including interest earned on the funds held in the Trust Account and not previously released to the Company to pay taxes, divided by the number of then outstanding Public Shares, which redemption will completely extinguish public stockholders’ rights as stockholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the Company’s remaining stockholders and the Company’s board of directors, dissolve and liquidate, subject in each case to the Company’s obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law.\nThe Sponsor has agreed to waive its liquidation rights with respect to the Founder Shares if the Company fails to complete a Business Combination within the Combination Period. However, if the Sponsor acquires Public Shares in or after the Initial Public Offering, such Public Shares will be entitled to liquidating distributions from the Trust Account if the Company fails to complete a Business Combination within the Combination Period. In the event of such distribution, it is possible that the per share value of the assets remaining available for distribution will be less than the amount of funds initially deposited into the Trust Account (initially $ 10.10 per share, subsequently increased to $ 10.46 per share as of September 30, 2022 following extensions).\nIn order to protect the amounts held in the Trust Account, the Sponsor has agreed to be liable to the Company if and to the extent any claims by a vendor for services rendered or products sold to the Company, or a prospective target business with which the Company has discussed entering into a transaction agreement, reduce the amount of funds in the Trust Account to below $ 10.10 per Public Share, except as to any claims by a third party who executed a valid and enforceable agreement with the Company waiving any right, title, interest or claim of any kind they may have in or to any monies held in the Trust Account and except as to any claims under the Company’s indemnity of the underwriters of Initial Public Offering against certain liabilities, including liabilities under the Securities Act of 1933, as amended (the “Securities Act”). Moreover, in the event that an executed waiver is deemed to be unenforceable against a third party, the insiders will not be responsible to the extent of any liability for such third-party claims. The Company will seek to reduce the possibility that the insiders will have to indemnify the Trust Account due to claims of creditors by endeavoring to have all vendors, service providers (except the Company’s independent registered public accounting firm), prospective target businesses or other entities with which the Company does business, execute agreements with the Company waiving any right, title, interest or claim of any kind in or to monies held in the Trust Account.\nRisks and Uncertainties\nManagement continues to evaluate the impact of the COVID-19 pandemic and the military conflict in the Ukraine and has concluded that while it is reasonably possible that the virus and the military conflict could have a negative effect on the Company’s financial position, results of its operations and/or search for a target company, the specific impacts are not readily determinable as of the date of these financial statements. The financial statements do not include any adjustments that might result from the outcome of these uncertainties.\nInflation Reduction Act of 2022\nOn August 16, 2022, the Inflation Reduction Act of 2022 (the “IR Act”) was signed into federal law. The IR Act provides for, among other things, a new U.S. federal 1 % excise tax on certain repurchases of stock by publicly traded U.S. domestic corporations and certain U.S. domestic subsidiaries of publicly traded foreign corporations occurring on or after January 1, 2023. The excise tax is imposed on the repurchasing corporation itself, not its shareholders from which shares are repurchased. The amount of the excise tax is generally 1 % of the fair market value of the shares repurchased at the time of the repurchase. However, for purposes of calculating the excise tax, repurchasing corporations are permitted to net the fair market value of certain new stock issuances against the fair market value of stock repurchases during the same taxable year. In addition, certain exceptions apply to the excise tax. The U.S. Department of the Treasury has been given authority to provide regulations and other guidance to carry out and prevent the abuse or avoidance of the excise tax.\nAny redemption or other repurchase that occurs after December 31, 2022, in connection with a Business Combination, extension vote or otherwise, may be subject to the excise tax. Whether and to what extent the Company would be subject to the excise tax in connection with a Business Combination, extension vote or otherwise would depend on a number of factors, including (i) the fair market value of the redemptions and repurchases in connection with the Business Combination, extension or otherwise, (ii) the structure of a Business Combination, (iii) the nature and amount of any “PIPE” or other equity issuances in connection with a Business Combination (or otherwise issued not in connection with a Business Combination but issued within the same taxable year of a Business Combination) and (iv) the content of regulations and other guidance from the U.S. Department of the Treasury. In addition, because the excise tax would be payable by the Company and not by the redeeming holder, the mechanics of any required payment of the excise tax have not been determined. The foregoing could cause a reduction in the cash available on hand to complete a Business Combination and in the Company’s ability to complete a Business Combination.\n7\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nLiquidity and Going Concern\nAs of September 30, 2022, the Company had $ 83,760 in its operating bank accounts and $ 44,203,481 in securities held in the Trust Account to be used for a Business Combination or to repurchase or redeem its common stock in connection therewith. As of September 30, 2022, $ 145,311 of the amount on deposit in the Trust Account represented accrued interest income, which can be withdrawn to pay the Company’s tax obligations.\nOn May 13, 2022, July 1, 2022 and August 16, 2022, the Company withdrew $ 178,564 , $ 66,751 and $ 113,396 , respectively, of accrued interest from the Trust Account to pay certain tax obligations.\nUntil the consummation of a Business Combination, the Company will use the funds not held in the Trust Account for identifying and evaluating prospective acquisition candidates, performing due diligence on prospective target businesses, paying for travel expenditures, selecting the target business to acquire, and structuring, negotiating and consummating the Business Combination.\nThe Company expects it will need to raise additional capital through loans or additional investments from its Sponsor, stockholders, officers, directors, or third parties. The Company’s officers, directors and the Sponsor may, but are not obligated to, loan the Company funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet the Company’s working capital needs. Accordingly, the Company may not be able to obtain additional financing. If the Company is unable to raise additional capital, it may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, and reducing overhead expenses. The Company cannot provide any assurance that new financing will be available to it on commercially acceptable terms, if at all.\nIn connection with the Company’s assessment of going concern considerations in accordance with Financial Accounting Standard Board’s Accounting Standards Update (“ASU”) 2014-15, “Disclosures of Uncertainties about an Entity’s Ability to Continue as a Going Concern,” the Company has until February 17, 2023 to consummate a Business Combination. It is uncertain that the Company will be able to consummate a Business Combination by this time. If a Business Combination is not consummated by this date and an extension has not been requested by the Sponsor and approved by the Company’s stockholders, there will be a mandatory liquidation and subsequent dissolution of the Company. Management has determined that the liquidity condition and the mandatory liquidation and potential subsequent dissolution raises substantial doubt about the Company’s ability to continue as a going concern. No adjustments have been made to the carrying amounts of assets or liabilities should the Company be required to liquidate after February 17, 2023. The Company intends to continue to search for and seek to complete a Business Combination before the mandatory liquidation date. The Company is within 12 months of its mandatory liquidation date as of the time of filing of this Quarterly Report on Form 10-Q.\nNOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nBasis of Presentation\nThe accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 8 of Regulation S-X of the SEC. Certain information or footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted, pursuant to the rules and regulations of the SEC for interim financial reporting. Accordingly, they do not include all the information and footnotes necessary for a complete presentation of financial position, results of operations, or cash flows. In the opinion of management, the accompanying unaudited condensed financial statements include all adjustments, consisting of a normal recurring nature, which are necessary for a fair presentation of the financial position, operating results and cash flows for the periods presented.\nThe accompanying unaudited condensed financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the period ended December 31, 2021, as filed with the SEC on March 31, 2022. The interim results for the three and nine months ended September 30, 2022 are not necessarily indicative of the results to be expected for the year ending December 31, 2022 or for any future periods.\n8\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nReclassification of Prior Year Presentation\nCertain prior year amounts have been reclassified to conform to the current period presentation. These reclassifications had no effect on the reported results of operations. An adjustment has been made to the balance sheet for December 31, 2021 to reclassify the deferred legal fees balance from accrued expenses to a separate deferred legal fees line.\nEmerging Growth Company\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the independent registered public accounting firm attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\nUse of Estimates\nThe preparation of the condensed financial statements in conformity with GAAP requires the Company’s management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements.\nMaking estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. Two of the more significant accounting estimates included in these financial statements is the determination of the fair value of the warrant liabilities as well as the fair value of the convertible promissory note. Such estimates may be subject to change as more current information becomes available and accordingly the actual results could differ significantly from those estimates.\nCash and Cash Equivalents\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did not have any cash equivalents as of September 30, 2022 and December 31, 2021.\n9\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nCash and Marketable Securities Held in Trust Account\nAt September 30, 2022, substantially all of the assets held in the Trust Account were held in money market funds which are invested primarily in U.S Treasury securities. At December 31, 2021, substantially all of the assets held in the Trust Account were held in U.S. Treasury Securities. All of the Company’s investments held in the Trust Account are classified as trading securities. Trading securities are presented on the balance sheets at fair value at the end of each reporting period. Gains and losses resulting from the change in fair value of investments held in the Trust Account are included in interest earned on marketable securities held in the Trust Account in the accompanying condensed statements of operations. The estimated fair values of investments held in the Trust Account are determined using available market information. As of September 30, 2022, the Company has withdrawn $ 358,711 of interest income from the Trust Account to pay certain tax obligations.\nCommon Stock Subject to Possible Redemption\nThe Company accounts for its common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that features redemption rights that is either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. The Company’s common stock features certain redemption rights that are considered to be outside of the Company’s control and subject to occurrence of uncertain future events. Accordingly, as of September 30, 2022 and December 31, 2021, respectively, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders’ deficit section of the Company’s condensed balance sheets.\nThe Company recognizes changes in redemption value immediately as they occur and adjusts the carrying value of redeemable common stock to equal the redemption value at the end of each reporting period. Increases or decreases in the carrying amount of redeemable common stock are affected by charges against additional paid in capital and accumulated deficit.\nAt September 30, 2022 and December 31, 2021, the common stock reflected in the condensed balance sheets are reconciled in the following table:\n\n| Gross proceeds | $ | 126,186,000 |\n| Less: |\n| Common stock issuance costs | ( 2,868,790 | ) |\n| Plus: |\n| Accretion of carrying value to redemption value | 5,392,510 |\n| Common stock subject to possible redemption – December 31, 2021 | $ | 128,709,720 |\n| Less: |\n| Redemption of shares | ( 86,773,410 | ) |\n| Plus: |\n| Accretion of carrying value to redemption value | 2,267,171 |\n| Common stock subject to possible redemption – September 30, 2022 | $ | 44,203,481 |\n\nWarrant Liabilities\nThe Company accounts for the Private Warrants in accordance with the guidance contained in ASC 815-40-15-7D and 7F under which the Private Warrants do not meet the criteria for equity treatment and must be recorded as liabilities. Accordingly, the Company classifies the Private Warrants as liabilities at their fair value and adjusts the Private Warrants to fair value at each reporting period. This liability is subject to re-measurement at each balance sheet date until exercised, and any change in fair value is recognized in our statements of operations. The Private Warrants for periods where no observable traded price was available are valued using a binomial lattice simulation model.\n10\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nConvertible Promissory Note – Related Party\nThe Company accounts for its convertible promissory note under ASC 815, Derivatives and Hedging (“ASC 815”). Under 815-15-25, the election can be at the inception of a financial instrument to account for the instrument under the fair value option under ASC 825. The Company has made such election for its convertible promissory note. Using fair value option, the convertible promissory note is required to be recorded at its initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of the note are recognized as non-cash change in the fair value of the convertible promissory note in the statements of operations. The fair value of the option to convert the convertible promissory note into Private Warrants was valued by utilizing a binomial lattice model incorporating the Cox-Ross-Rubenstein methodology.\nIncome Taxes\nThe Company accounts for income taxes under ASC 740, “Income Taxes.” ASC 740, Income Taxes, requires the recognition of deferred tax assets and liabilities for both the expected impact of differences between the unaudited condensed financial statements and tax basis of assets and liabilities and for the expected future tax benefit to be derived from tax loss and tax credit carry forwards. ASC 740 additionally requires a valuation allowance to be established when it is more likely than not that all or a portion of deferred tax assets will not be realized. As of September 30, 2022 and December 31, 2021, the Company’s deferred tax asset had a full valuation allowance recorded against it.\nThe Company’s effective tax rate was 2.68 % and 0.00 % for the three months ended September 30, 2022 and 2021, respectively, and 0.80 % and 0.00 % for the nine months ended September 30, 2022 and 2021, respectively. The effective tax rate differs from the statutory tax rate of 21 % for the three months and nine months ended September 30, 2022 and 2021, due to changes in fair value in warrant liability, changes in the fair value of the convertible promissory note and the valuation allowance on the deferred tax assets.\nASC 740 also clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. ASC 740 also provides guidance on derecognition, classification, interest and penalties, accounting in interim period, disclosure and transition.\nWhile ASC 740 identifies usage of an effective annual tax rate for purposes of an interim provision, it does allow for estimating individual elements in the current period if they are significant, unusual, or infrequent. Computing the effective tax rate for the Company is complicated due to the potential impact of the timing of any Business Combination expenses and the actual interest income that will be recognized during the year. The Company has taken a position as to the calculation of income tax expense in a current period based on ASC 740-270-25-3 which states, “If an entity is unable to estimate part of its ordinary income (or loss) or the related tax (benefit) but is otherwise able to make a reasonable estimate, the tax (or benefit) applicable to the item that cannot be estimated shall be reported in the interim period in which the item is reported.” The Company believes its calculation to be a reliable estimate and allows it to properly take into account the usual elements that can impact its annualized book income and its impact on the effective tax rate. As such, the Company is computing its taxable income (loss) and associated income tax provision based on actual results through September 30, 2022.\nThe Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of September 30, 2022 and December 31, 2021. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position.\nThe Company has identified the United States as its only “major” tax jurisdiction. The Company is subject to income taxation by major taxing authorities since inception. These examinations may include questioning the timing and amount of deductions, the nexus of income among various tax jurisdictions and compliance with federal and state tax laws. The Company’s management does not expect that the total amount of unrecognized tax benefits will materially change over the next twelve months.\nNet Income Per Common Share\nThe Company complies with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share”. Net income per common share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Accretion associated with the redeemable shares of common stock is excluded from income per common share as the redemption value approximates fair value.\nThe calculation of diluted income per share does not consider the effect of the warrants issued in connection with the (i) Initial Public Offering, and (ii) the private placement since the exercise of the warrants is contingent upon the occurrence of future events. The warrants are exercisable to purchase 17,904,180 shares of common stock in the aggregate. As of September 30, 2022 and 2021, the Company did not have any dilutive securities or other contracts that could, potentially, be exercised or converted into common stock and then participate in the earnings of the Company. As a result, diluted net income per common share is the same as basic net income per common share for the periods presented.\n11\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nReconciliation of Net Income per Common Share\nThe Company’s net income is adjusted for the portion of income that is attributable to common stock subject to possible redemption, as these shares only participate in the earnings of the Trust Account and not the income or losses of the Company. Accordingly, basic and diluted net income per common share is calculated as follows:\n\n| Three Months Ended September 30, 2022 | Three Months Ended September 30, 2021 | Nine Months Ended September 30, 2022 | Nine Months Ended September 30, 2021 |\n| Redeemable Common Stock | Non-Redeemable Common Stock | Redeemable Common Stock | Non-Redeemable Common Stock | Redeemable Common Stock | Non-Redeemable Common Stock | Redeemable Common Stock | Non-Redeemable Common Stock |\n| Basic and diluted net income per common share |\n| Numerator: |\n| Allocation of net income, as adjusted | $ | 519,931 | $ | 324,223 | $ | 1,156,217 | 319,513 | $ | 2,475,778 | $ | 931,474 | $ | 1,729,360 | $ | 477,898 |\n| Denominator: |\n| Basic and diluted weighted average shares outstanding | 5,591,938 | 3,487,070 | 12,618,600 | 3,487,070 | 9,268,327 | 3,487,070 | 12,618,600 | 3,487,070 |\n| Basic and diluted net income per common share | $ | 0.09 | $ | 0.09 | $ | 0.09 | $ | 0.09 | $ | 0.27 | $ | 0.27 | $ | 0.14 | $ | 0.14 |\n\nConcentration of Credit Risk\nFinancial instruments that potentially subject the Company to concentrations of credit risk consist of cash accounts in a financial institution, which, at times may exceed the Federal Deposit Insurance Corporation maximum coverage of $ 250,000 . The Company has not experienced losses on these accounts.\nFair Value of Financial Instruments\nThe fair value of the Company’s assets and liabilities, which qualify as financial instruments under ASC Topic 820, “Fair Value Measurement,” approximates the carrying amounts represented in the accompanying condensed balance sheets, primarily due to their short-term nature, except for warrant liabilities (see Note 9).\nFair Value Measurements\nFair value is defined as the price that would be received for sale of an asset or paid for transfer of a liability, in an orderly transaction between market participants at the measurement date. GAAP establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).\nIn some circumstances, the inputs used to measure fair value might be categorized within different levels of the fair value hierarchy. In those instances, the fair value measurement is categorized in its entirety in the fair value hierarchy based on the lowest level input that is significant to the fair value measurement.\n12\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nRecent Accounting Standards\nIn August 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2020-06, “Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity” (“ASU 2020-06”), which simplifies accounting for convertible instruments by removing major separation models required under current GAAP. ASU 2020-06 removes certain settlement conditions that are required for equity contracts to qualify for the derivative scope exception, and it also simplifies the diluted earnings per share calculation in certain areas. ASU 2020-06 is effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years, with early adoption permitted. The Company assessed the potential impact of ASU 2020-06 and determined it would not have a material impact on the condensed financial statements as presented.\nManagement does not believe that any other recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on the Company’s condensed financial statements.\nNOTE 3. PUBLIC OFFERING\nPursuant to the Initial Public Offering, the Company sold 11,000,000 Units at a price of $ 10.00 per Unit. Each Unit consists of one share of common stock and one redeemable warrant (“Public Warrant”). In connection with the underwriters’ partial exercise of the over-allotment option on November 19, 2020, the Company sold an additional 1,618,600 Units, at a purchase price of $ 10.00 per Unit. Each Public Warrant entitles the holder to purchase one share of common stock at an exercise price of $11.50 per share (see Note 8).\nNOTE 4. PRIVATE PLACEMENT\nSimultaneously with the closing of the Initial Public Offering, the Sponsor and EarlyBirdCapital purchased an aggregate of 4,800,000 Private Warrants at a price of $ 1.00 per Private Warrant for an aggregate purchase price of $ 4,800,000 . The Sponsor purchased 3,975,000 Private Warrants and EarlyBirdCapital purchased 825,000 Private Warrants. In connection with the underwriters’ partial exercise of the over-allotment option on November 19, 2020, the Sponsor and EarlyBirdCapital purchased an additional 485,580 Private Warrants, at a purchase price of $ 1.00 per Private Warrant, for an aggregate purchase price of $ 485,580 . Each Private Warrant entitles the holder to purchase one share of common stock at a price of $11.50 per full share, subject to adjustment (see Note 8). The proceeds from the Private Warrants were added to the proceeds from the Initial Public Offering held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the proceeds from the sale of the Private Warrants will be used to fund the redemption of the Public Shares (subject to the requirements of applicable law).\nNOTE 5. RELATED PARTY TRANSACTIONS\nFounder Shares\nOn August 5, 2020, the Sponsor paid $ 25,000 to cover certain offering costs of the Company in consideration for 3,593,750 shares of common stock (the “Founder Shares”). On November 9, 2020, the Sponsor returned to the Company for cancellation, at no cost, an aggregate of 718,750 Founder Shares, resulting in an aggregate of 2,875,000 Founder Shares outstanding and held by the Sponsor. On November 12, 2020, the Company effected a stock dividend of 0.1 shares for each share of common stock outstanding, resulting in an aggregate of 3,162,500 Founder Shares outstanding and held by the Sponsor. The Founder Shares included, after giving retroactive effect to the share surrender and stock dividend, an aggregate of up to 412,500 shares subject to forfeiture to the extent that the underwriters’ over-allotment was not exercised in full or in part, so that the Sponsor would collectively own 20 % of the Company’s issued and outstanding shares after the Initial Public Offering (assuming the Sponsor did not purchase any Public Shares in the Initial Public Offering). In connection with the underwriters’ partial exercise of the over-allotment option and the forfeiture of the remaining over-allotment option, 7,850 Founder Shares were forfeited, and 404,650 Founder Shares are no longer subject to forfeiture resulting in an aggregate of 3,154,650 Founder Shares outstanding at September 30, 2022.\nThe Sponsor has agreed, subject to certain limited exceptions, not to transfer, assign or sell any of the Founder Shares until (1) with respect to 50% of the Founder Shares, the earlier of one year after the completion of a Business Combination and the date on which the closing price of the common stock equals or exceeds $12.50 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing after a Business Combination and (2) with respect to the remaining 50% of the Founder Shares, one year after the completion of a Business Combination, or earlier, in either case, if, subsequent to a Business Combination, the Company completes a liquidation, merger, stock exchange or other similar transaction which results in all of the Company’s stockholders having the right to exchange their shares of common stock for cash, securities or other property.\n13\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nDue from Sponsor\nAt the closing of the Initial Public Offering on November 17, 2020, an aggregate amount of $ 25,038 was due to the Company. Such amount was paid by the Company to the Sponsor and was included in the prepaid expenses and other current assets on the balance sheet at December 31, 2020. No balance remains outstanding as of September 30, 2022.\nAdministrative Support Agreement\nThe Company has agreed, commencing on November 12, 2020 through the earlier of the Company’s consummation of a Business Combination and its liquidation, to pay an affiliate of the Company’s management a total of $ 10,000 per month for office space, utilities and secretarial support. For the three and nine months ended September 30, 2022, the Company incurred $ 30,000 and $ 90,000 , respectively, in fees for these services, of which such amounts are included in accrued expenses in the accompanying condensed balance sheets. For the three and nine months ended September 30, 2021, the Company incurred and paid $ 30,000 and $ 90,000 , respectively, in fees for these services.\nPromissory Note — Related Party\nOn August 5, 2020, the Company issued an unsecured promissory note to the Sponsor (the “Promissory Note”), pursuant to which the Company could borrow up to an aggregate principal amount of $ 300,000 . The Promissory Note was non-interest bearing and payable on the earlier of (i) March 31, 2021, (ii) the consummation of the Initial Public Offering or (iii) the date on which the Company determined not to proceed with the Initial Public Offering. The outstanding balance under the Promissory Note was repaid subsequent to the Initial Public Offering. As of September 30, 2022 and December 31, 2021, respectively, no balance is outstanding under the Promissory Note. Borrowings under the Promissory Note are no longer available.\nRelated Party Loans\nIn addition, in order to finance transaction costs in connection with a Business Combination, the Sponsor or certain of the Company’s officers and directors or their affiliates may, but are not obligated to, loan the Company funds as may be required (“Working Capital Loans”). Each loan would be evidenced by promissory note. The notes may be repaid upon completion of a Business Combination, without interest, or, at the lender’s discretion, up to $ 1,500,000 of notes may be converted upon completion of a Business Combination into warrants at a price of $ 1.00 per warrant. Such warrants would be identical to the Private Warrants. In the event that a Business Combination does not close, the Company may use a portion of proceeds held outside the Trust Account to repay the Working Capital Loans, but no proceeds held in the Trust Account would be used to repay the Working Capital Loans.\nOn April 14, 2022 the Sponsor advanced to the Company $ 100,000 to be used for working capital purposes. On August 17, 2022, the Company transferred the advance from the Sponsor to the second amended and restated promissory note (see Convertible Promissory Note – Related Party below). On October 13, 2022, the Sponsor advanced to the Company $ 200,000 to be used for working capital purposes.\nRelated Party Extension Loans\nAs discussed in Note 1, the Company previously extended the period of time to consummate a Business Combination two times, each by an additional three months (to May 17, 2022 to complete a Business Combination). In order to extend the time available for the Company to consummate a Business Combination, the Sponsor or its affiliates or designees deposited into the Trust Account $1,261,860 ($0.10 per Public Share), on or prior to the date of the applicable deadline, for each three-month extension. Payments were made in the form of a non-interest bearing, unsecured promissory note to be paid upon consummation of a Business Combination, or, at the relevant insider’s discretion, converted upon consummation of a Business Combination into additional Private Warrants at a price of $ 1.00 per Private Warrant. The Sponsor and its affiliates or designees are not obligated to fund the Trust Account to extend the time for the Company to complete a Business Combination. On May 12, 2022, the Company held a special meeting of stockholders at which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from May 17, 2022 to August 17, 2022 was approved by stockholders. In order to extend the time available for the Company to consummate a Business Combination, the Sponsor or its affiliates or designees deposited into the Trust Account $ 500,000 . On August 15, 2022, the Company held a special meeting of stockholders at which a proposal to amend the Company’s amended and restated certificate of incorporation, as amended to extend the date by which the Company must consummate a Business Combination from August 17, 2022 to February 17, 2023 was approved by stockholders. In order to extend the time available for the Company to consummate a Business Combination, the Sponsor or its affiliates or designees deposited into the Trust Account $ 360,000 .\n14\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nConvertible Promissory Note – Related Party\nOn November 9, 2021, the Company issued a promissory note in the principal amount of $ 1,261,860 to the Sponsor in connection with the Extension (“Convertible Promissory Note”) (as defined below). On February 17, 2022, April 14, 2022 and May 18, 2022, the Company amended and restated the Convertible Promissory Note to increase the principal amount thereunder from $1,261,860 to $3,223,720. On August 17, 2022 the Company amended and restated the Convertible Promissory Note to increase the principal amount thereunder from $3,223,720 to $3,683,720, which included $100,000 advanced by the Sponsor to the Company on April 14, 2022 and the payment of $360,000 for the extension from August 17, 2022 to November 17, 2022. The Note bears no interest and is due and payable upon the earlier to occur of (i) the date on which the Company’s Business Combination is consummated and (ii) the liquidation of the Company on or before February 17, 2023 or such later liquidation date as may be approved by the Company’s stockholders. On August 15, 2022, the Company held a special meeting of stockholders in which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from August 17, 2022 to February 17, 2023 was approved by stockholders. At the election of the Sponsor, up to $ 1,500,000 of the unpaid principal amount of the Note may be converted into warrants of the Company, each warrant exercisable for one share of common stock of the Company upon the consummation of its Business Combination, equal to: (x) the portion of the principal amount of the Note being converted, divided by (y) $ 1.00 , rounded up to the nearest whole number of warrants. As of September 30, 2022, there was a $ 3,683,720 balance outstanding under the Convertible Promissory Note. The Convertible Promissory Note was valued using the fair value method. The fair value of the note as of September 30, 2022, was $ 913,900 , which resulted in a change in fair value of the convertible promissory note of $ 1,113,700 and $ 2,119,960 which was recorded in the statements of operations for the three and nine months ended September 30, 2022, respectively (see Note 9).\nNOTE 6. COMMITMENTS AND CONTINGENCIES\nRegistration Rights\nPursuant to a registration rights agreement entered into on November 12, 2020, the holders of the Founder Shares and Representative Shares (as defined in Notes 5 and 8, respectively), as well as the holders of the Private Warrants (and underlying securities) and any warrants issued in payment of Working Capital Loans made to Company (and underlying securities) will be entitled to registration rights. The holders of a majority of these securities are entitled to make up to two demands that the Company register such securities. The holders of the majority of the Founder Shares can elect to exercise these registration rights at any time commencing three months prior to the date on which these shares of common stock are to be released from escrow. The holders of a majority of the Representative Shares, Private Warrants and warrants issued in payment of working capital loans made to the Company (or underlying securities) can elect to exercise these registration rights at any time after the Company consummates a Business Combination. Notwithstanding anything to the contrary, EarlyBirdCapital may only make a demand on one occasion and only during the five-year period beginning on the effective date of the registration statement of which this prospectus forms a part. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to consummation of a Business Combination; provided, however, that EarlyBirdCapital may participate in a “piggy-back” registration only during the seven-year period beginning on the effective date of the registration statement of which this prospectus forms a part. The registration rights agreement does not contain liquidating damages or other cash settlement provisions resulting from delays in registering the Company’s securities. The Company will bear the expenses incurred in connection with the filing of any such registration statements.\nUnderwriting Agreement\nThe Company granted the underwriters a 45-day option from the date of the Initial Public Offering to purchase up to 1,650,000 additional Units to cover over-allotments, if any, at the Initial Public Offering price less the underwriting discounts and commissions. On November 19, 2020, the underwriters partially exercised their over-allotment option to purchase an additional 1,618,600 Units at $ 10.00 per Unit and forfeited the remaining over-allotment option.\n15\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nBusiness Combination Marketing Agreement\nThe Company has engaged EarlyBirdCapital as an advisor in connection with a Business Combination to assist the Company in holding meetings with its stockholders to discuss the potential Business Combination and the target business’ attributes, introduce the Company to potential investors that are interested in purchasing the Company’s securities in connection with a Business Combination, assist the Company in obtaining stockholder approval for the Business Combination and assist the Company with its press releases and public filings in connection with the Business Combination. The Company will pay EarlyBirdCapital a cash fee for such services upon the consummation of a Business Combination in an amount equal to 3.5% of the gross proceeds of the Initial Public Offering, or $4,416,510, (exclusive of any applicable finders’ fees which might become payable); provided that up to 30% of the fee may be allocated at the Company’s sole discretion to other FINRA members that assist the Company in identifying and consummating a Business Combination.\nAdditionally, the Company will pay EarlyBirdCapital a cash fee equal to 1.0 % of the total consideration payable in a Business Combination if EarlyBirdCapital introduces the Company to the target business with which the Company completes a Business Combination.\nLegal Fee Agreements\nThe Company has engaged various law firms to provide legal due diligence services and business combination services related to potential target companies. All fees and expenses related to the various engagements will be deferred and are to be paid fully upon the closing of any Business Combination. The law firms will not be entitled to any contingent fees or expense reimbursement if the Company does not consummate a Business Combination within its deadline. Deferred fees of $ 1,371,549 and $ 1,009,868 related to these legal services have been accrued as of September 30, 2022 and December 31, 2021, respectively.\nTrust Extension\nOn February 16, 2022, the Company issued a press release announcing that its Sponsor has requested that the Company extend the date by which the Company has to consummate a Business Combination from February 17, 2022 to May 17, 2022 (the “Extension”). The Extension is the second of two three-month extensions permitted under the Company’s governing documents and provides the Company with additional time to complete its Business Combination. On February 18, 2022, the Company issued a press release announcing that the Sponsor had deposited an additional $ 1,261,860 (representing $ 0.10 per public share) into the Trust Account for its public stockholders. On May 12, 2022, the Company held a special meeting of stockholders in which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from May 17, 2022 to August 17, 2022 was approved by the stockholders. In connection with this extension, the Company deposited $ 500,000 into the Trust Account on May 18, 2022. In connection with the extension amendment, stockholders holding approximately 5,586,910 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $ 10.30 per share. On August 15, 2022, the Company held a special meeting of stockholders in which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from August 17, 2022 to February 17, 2023 was approved by the stockholders. In connection with this extension, the Company deposited $ 360,000 into the Trust Account on August 17, 2022. In connection with the extension amendment, stockholders holding approximately 2,818,237 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $ 10.37 per share.\nOn November 16, 2021, the Company had previously issued a promissory note (the “Note”) in the principal amount of $ 1,261,860 to the Company’s Sponsor. On February 17, 2022, April 14, 2022, May 18, 2022, and August 17, 2022, the Company amended and restated the Note in its entirety to increase the principal amount thereunder from $1,262,860 to $3,683,720.\nNOTE 7. STOCKHOLDERS’ DEFICIT\nPreferred Stock — The Company is authorized to issue 1,000,000 shares of preferred stock with a par value of $ 0.0001 per share with such designations, voting and other rights and preferences as may be determined from time to time by the Company’s board of directors. At September 30, 2022 and December 31, 2021, respectively, there were no shares of preferred stock issued or outstanding.\nCommon Stock — The Company is authorized to issue 50,000,000 shares of common stock with a par value of $ 0.0001 per share. At September 30, 2022 and December 31, 2021, there were 3,487,070 shares of common stock issued and outstanding, excluding 4,213,453 and 12,618,600 shares of common stock subject to possible redemption, respectively, which are presented as temporary equity. In connection with the extension on May 12, 2022, stockholders holding 5,586,910 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $ 10.30 per share. In connection with the extension on August 17, 2022, stockholders holding 2,818,237 shares of the Company’s redeemable stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $ 10.37 per share.\n16\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nNOTE 8. WARRANTS\nThe Public Warrants will become exercisable on the later of (a) 30 days after the completion of a Business Combination or (b) 12 months from the closing of the Initial Public Offering. No warrants will be exercisable for cash unless the Company has an effective and current registration statement covering the shares of common stock issuable upon exercise of the warrants and a current prospectus relating to such shares of common stock. Notwithstanding the foregoing, if a registration statement covering the shares of common stock issuable upon exercise of the Public Warrants is not effective within a specified period following the consummation of a Business Combination, warrant holders may, until such time as there is an effective registration statement and during any period when the Company shall have failed to maintain an effective registration statement, exercise warrants on a cashless basis pursuant to the exemption provided by Section 3(a)(9) of the Securities Act, provided that such exemption is available. If that exemption, or another exemption, is not available, holders will not be able to exercise their warrants on a cashless basis. The Public Warrants will expire five years after the completion of a Business Combination or earlier upon redemption or liquidation.\nThe Company may redeem the Public Warrants (excluding the Private Warrants and any warrants underlying units issued upon conversion of the Working Capital Loans):\n\n| ● | in whole and not in part; |\n| ● | at a price of $0.01 per warrant; |\n| ● | upon not less than 30 days’ prior written notice of redemption to each warrant holder; and |\n| ● | if, and only if, the last reported sale price of the common stock equals or exceeds $18.00 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations and the like), for any 20 trading days within a 30 trading day period ending on the third trading day prior to the date on which the Company sends the notice of redemption to the warrant holders. |\n\nIf the Company calls the Public Warrants for redemption, management will have the option to require all holders that wish to exercise the Public Warrants to do so on a “cashless basis,” as described in the warrant agreement. The exercise price and number of shares of common stock issuable upon exercise of the warrants may be adjusted in certain circumstances including in the event of a stock dividend, or recapitalization, reorganization, merger or consolidation. However, except as described below, the warrants will not be adjusted for issuance of common stock at a price below its exercise price. Additionally, in no event will the Company be required to net cash settle the warrants. If the Company is unable to complete a Business Combination within the Combination Period and the Company liquidates the funds held in the Trust Account, holders of warrants will not receive any of such funds with respect to their warrants, nor will they receive any distribution from the Company’s assets held outside of the Trust Account with the respect to such warrants. Accordingly, the warrants may expire worthless.\nIn addition, if (x) the Company issues additional common stock or equity-linked securities for capital raising purposes in connection with the closing of a Business Combination at an issue price or effective issue price of less than $9.20 per common stock (with such issue price or effective issue price to be determined in good faith by the Company’s board of directors and, in the case of any such issuance to the Sponsor or its affiliates, without taking into account any Founder Shares held by the Sponsor or such affiliates, as applicable, prior to such issuance), (y) the aggregate gross proceeds from such issuances represent more than 60% of the total equity proceeds, and interest thereon, available for the funding of a Business Combination on the date of the consummation of a Business Combination (net of redemptions), and (z) the volume weighted average trading price of its common stock during the 20 trading day period starting on the trading day prior to the day on which the Company consummates its Business Combination (such price, the “Market Value”) is below $9.20 per share, the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115% of the greater of (i) Market Value or (ii) the price at which the Company issue the additional shares of common stock or equity-linked securities.\nThe Private Warrants are identical to the Public Warrants underlying the Units sold in the Initial Public Offering, except that the Private Warrants and the shares of common stock issuable upon the exercise of the Private Warrants will not be transferable, assignable or saleable until after the completion of a Business Combination, subject to certain limited exceptions. Additionally, the Private Warrants will be exercisable for cash or on a cashless basis, at the holder’s option, and be non-redeemable so long as they are held by the initial purchasers or their permitted transferees. If the Private Warrants are held by someone other than the initial purchasers or their permitted transferees, the Private Warrants will be redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants.\n17\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nRepresentative Shares\nOn August 5, 2020, the Company issued to EarlyBirdCapital 377,750 shares of common stock (the “Representative Shares”). On November 9, 2020, EarlyBirdCapital returned to the Company for cancellation, at no cost, an aggregate of 75,550 Representative Shares, resulting in an aggregate of 302,200 Representative Shares outstanding and held by EarlyBirdCapital. On November 12, 2020, the Company effected a stock dividend of 0.1 shares for each share of common stock outstanding, resulting in EarlyBirdCapital holding an aggregate of 332,420 Representative Shares. The Company accounted for the Representative Shares as an offering cost of the Initial Public Offering, with a corresponding credit to stockholders’ equity. The Company estimated the fair value of Representative Shares to be $ 2,666 based upon the price of the Founder Shares issued to the Sponsor. The holders of the Representative Shares have agreed not to transfer, assign or sell any such shares until the completion of a Business Combination. In addition, the holders have agreed (i) to waive their redemption rights with respect to such shares in connection with the completion of a Business Combination and (ii) to waive their rights to liquidating distributions from the Trust Account with respect to such shares if the Company fails to complete a Business Combination within the Combination Period.\nThe Representative Shares have been deemed compensation by FINRA and are therefore subject to a lock-up for a period of 180 days immediately following the effective date of the registration statement related to the Initial Public Offering pursuant to Rule 5110(g)(1) of FINRA’s NASD Conduct Rules. Pursuant to FINRA Rule 5110(g)(1), these securities will not be sold during the Initial Public Offering, or sold, transferred, assigned, pledged, or hypothecated, or be the subject of any hedging, short sale, derivative, put or call transaction that would result in the economic disposition of the securities by any person for a period of 180 days immediately following the effective date of the Initial Public Offering, except to any underwriter and selected dealer participating in the Initial Public Offering and their bona fide officers or partners, provided that all securities so transferred remain subject to the lockup restriction above for the remainder of the time period.\nNOTE 9. FAIR VALUE MEASUREMENTS\nThe Company follows the guidance in ASC 820 for its financial assets and liabilities that are re-measured and reported at fair value at each reporting period, and non-financial assets and liabilities that are re-measured and reported at fair value at least annually.\nThe fair value of the Company’s financial assets and liabilities reflects management’s estimate of amounts that the Company would have received in connection with the sale of the assets or paid in connection with the transfer of the liabilities in an orderly transaction between market participants at the measurement date. In connection with measuring the fair value of its assets and liabilities, the Company seeks to maximize the use of observable inputs (market data obtained from independent sources) and to minimize the use of unobservable inputs (internal assumptions about how market participants would price assets and liabilities). The following fair value hierarchy is used to classify assets and liabilities based on the observable inputs and unobservable inputs used in order to value the assets and liabilities:\n\n| Level 1: | Quoted prices in active markets for identical assets or liabilities. An active market for an asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. |\n| Level 2: | Observable inputs other than Level 1 inputs. Examples of Level 2 inputs include quoted prices in active markets for similar assets or liabilities and quoted prices for identical assets or liabilities in markets that are not active. |\n| Level 3: | Unobservable inputs based on our assessment of the assumptions that market participants would use in pricing the asset or liability. |\n\nThe following table presents information about the Company’s assets that are measured at fair value on a recurring basis at September 30, 2022 and December 31, 2021, respectively, and indicates the fair value hierarchy of the valuation inputs the Company utilized to determine such fair value:\n\n| Description | Level | September, 2022 | December 31, 2021 |\n| Assets: |\n| Marketable securities held in Trust Account | 1 | $ | 44,203,481 | $ | 128,790,008 |\n| Liabilities: |\n| Warrant liabilities – Private Warrants | 3 | $ | 422,846 | $ | 2,641,204 |\n| Convertible promissory note – related party | 3 | $ | 913,900 | $ | 958,400 |\n\n18\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nWarrant Liabilities\nThe Private Warrants were accounted for as liabilities in accordance with ASC 815-40 and are presented within warrant liabilities on the condensed balance sheets. The warrant liabilities are measured at fair value at inception and on a recurring basis, with changes in fair value presented within change in fair value of warrant liabilities in the condensed statements of operations.\nThe Private Warrants were valued using a binomial lattice model. The Company allocated the proceeds received from (i) the sale of Units (which is inclusive of one share of common stock and one Public Warrant) and (ii) the sale of Private Warrants, first to the warrants based on their fair values as determined at initial measurement, with the remaining proceeds allocated to common stock subject to possible redemption. The Private Warrants were classified as Level 3 at the initial measurement date due to the use of unobservable inputs.\nThe following are the inputs used by the Company in establishing the fair value of its Private Warrants at September 30, 2022 and December 31, 2021.\n\n| Input | September 30, 2022 | December 31, 2021 |\n| Risk-free interest rate | 4.07 | % | 1.15 | % |\n| Trading days per year | 252 | 252 |\n| Expected volatility | 5.3 | % | 9.6 | % |\n| Exercise price | $ | 11.50 | $ | 11.50 |\n| Stock Price | $ | 10.35 | $ | 10.17 |\n\nOn December 31, 2021 and September 30, 2022, the Private Warrants were determined to be $ 0.50 per warrant and $ 0.08 per warrant, respectively, for an aggregate value of $ 2.64 million and $ 0.4 million, respectively.\nThe following table presents the changes in the fair value of the warrant liabilities:\n\n| Private Placement |\n| Fair value as of December 31, 2021 | $ | 2,641,204 |\n| Change in valuation inputs or other assumptions | ( 1,744,591 | ) |\n| Fair value as of March 31, 2022 | $ | 896,613 |\n| Change in valuation inputs or other assumptions | ( 579,785 | ) |\n| Fair value as of June 30, 2022 | $ | 316,828 |\n| Change in valuation inputs or other assumptions | 106,018 |\n| Fair value as of September 30, 2022 | $ | 422,846 |\n\n19\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nConvertible Promissory Note – Related Party\nThe fair value of the option to convert the convertible promissory note into Private Warrants was valued by utilizing a binomial lattice model incorporating the Cox-Ross-Rubenstein methodology.\nThe estimated fair value of the convertible promissory note was based on the following significant inputs:\n\n| September 30, 2022 |\n| Risk-free interest rate | 0.00 | % |\n| Time to Expiration (in years) | 1.38 |\n| Expected volatility | 5.3 | % |\n| Exercise price | $ | 11.50 |\n| Dividend yield | 0.00 | % |\n| Stock Price | $ | 10.35 |\n| Probability of transaction | 25.00 | % |\n\nThe following table presents the changes in the fair value of the Level 3 convertible promissory note:\n\n| Fair value as of January 1, 2021 | $ | 958,400 |\n| Proceeds received through Convertible Promissory Note | 1,261,860 |\n| Change in fair value | ( 337,260 | ) |\n| Fair value as of March 31, 2022 | $ | 1,883,000 |\n| Proceeds received through Convertible Promissory Note | 700,000 |\n| Change in fair value | ( 669,000 | ) |\n| Fair value as of June 30, 2022 | $ | 1,914,000 |\n| Conversion of Sponsor advance to Convertible Promissory Note | 100,000 |\n| Proceeds received through Convertible Promissory Note | 360,000 |\n| Change in fair value | ( 1,460,100 | ) |\n| Fair value as of September 30, 2022 | 913,900 |\n\nThere were no transfers in or out of Level 3 from other levels in the fair value hierarchy during the three and nine months ended September 30, 2022 for the convertible promissory note.\nNOTE 10. SUBSEQUENT EVENTS\nThe Company evaluated subsequent events and transactions that occurred after the balance sheet date up to the date that the financial statements were issued. Based upon this review the Company did not identify any subsequent events that would have required adjustment or disclosure in the condensed financial statements.\n20\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nReferences in this report (the “Quarterly Report”) to “we,” “us,” “our” or the “Company” refer to Better World Acquisition Corp. References to our “management” or our “management team” refer to our officers and directors, and references to the “Sponsor” refer to BWA Holdings LLC. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Quarterly Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\nSpecial Note Regarding Forward-Looking Statements\nThis Quarterly Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Exchange Act that are not historical facts and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. All statements, other than statements of historical fact included in this Form 10-Q including, without limitation, statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. Words such as “expect,” “believe,” “anticipate,” “intend,” “estimate,” “seek” and variations and similar words and expressions are intended to identify such forward-looking statements. Such forward-looking statements relate to future events or future performance, but reflect management’s current beliefs, based on information currently available. A number of factors could cause actual events, performance or results to differ materially from the events, performance and results discussed in the forward-looking statements. For information identifying important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements, please refer to the Risk Factors section of the Company’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission (the “SEC”) on March 31, 2022 and in our Quarterly Reports on Form 10-Q for the period ended March 31, 2022 and June 30, 2022, filed with the SEC on May 13, 2022 and August 3, 2022, respectively.\nOverview\nWe are a blank check company formed under the laws of the State of Delaware on August 5, 2020 for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities (an “initial business combination”). We intend to effectuate our initial business combination using cash from the proceeds of the Initial Public Offering and the sale of the Private Warrants, our capital stock, debt or a combination of cash, stock and debt.\nWe expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete a business combination will be successful.\n21\nResults of Operations\nWe have neither engaged in any operations nor generated any revenues to date. Our only activities from August 5, 2020 (inception) through September 30, 2022 were organizational activities, those necessary to prepare for the Initial Public Offering, described below, and identifying a target company for a business combination. We do not expect to generate any operating revenues until after the completion of our business combination. We generate non-operating income in the form of interest income on marketable securities held in the Trust Account. We incur expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence and transaction expenses.\nFor the three months ended September 30, 2022, we had net income of $844,154 which consists of the change in fair value of convertible promissory note – related party of $1,113,700, interest earned on marketable securities held in the Trust Account of $254,709 and unrealized gain on marketable securities held in the Trust Account of $1,078, offset by change in fair value of warrant liability of $106,018, a provision for income taxes of $23,249 and operational costs of $396,066.\nFor the nine months ended September 30, 2022, we had net income of $3,407,252 which consists of the change in fair value of warrant liability of $2,218,358, change in fair value of convertible promissory note – related party of $2,119,960, and interest earned on marketable securities held in the Trust Account of $423,734, offset by provision for income taxes of $27,528 and operational costs of $1,327,272.\nFor the three months ended September 30, 2021, we had net income of $1,475,730 which consists of the change in fair value of warrant liability of $2,192,941 and interest earned on marketable securities held in the Trust Account of $23,138, and unrealized loss on marketable securities held in the Trust Account of $4,654, offset by formation and operational costs of $735,695.\nFor the nine months ended September 30, 2021, we had net income of $2,207,258, which consists of the change in fair value of warrant liability of $3,302,913 and interest earned on marketable securities held in the Trust Account of $58,976, and unrealized loss on marketable securities held in the Trust Account of $5,829, offset by formation and operational costs of $1,148,802.\nLiquidity and Capital Resources\nOn November 17, 2020, we consummated the Initial Public Offering of 11,000,000 units, at $10.00 per Unit, generating gross proceeds of $110,000,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of 4,800,000 Private Warrants at a price of $1.00 per Private Warrant in a private placement to our Sponsor and EarlyBirdCapital, Inc. generating gross proceeds of $4,800,000.\nOn November 19, 2020, in connection with the underwriters’ partial exercise of their over-allotment option, we consummated the sale of an additional 1,618,600 units at a price of $10.00 per unit, generating total gross proceeds of $16,186,000. In addition, we also consummated the sale of an additional 485,580 private placement warrants at $1.00 per private placement warrant, generating total gross proceeds of $485,580.\nFollowing the initial public offering, the partial exercise of the over-allotment option, and the sale of the private placement warrants, $111,100,000 was placed in the trust account on November 18, 2020 and $16,347,860 was placed in the Trust Account on November 20, 2020, respectively, for a total of $127,447,860. We incurred $2,880,354 in the initial public offering related costs, including $2,523,720 of underwriting fees and $356,634 of other costs.\nFor the nine months ended September 30, 2022, cash used in operating activities was $853,148. Net income of $3,407,252 was affected by the change in fair value of warrant liability of $2,218,358, change in fair value of convertible promissory note – related party of $2,119,960 and interest earned on marketable securities held in the Trust Account of $423,734. Changes in operating assets and liabilities provided $501,652 of cash for operating activities.\nFor the nine months ended September 30, 2021, cash used in operating activities was $528,273. Net income of $2,207,258 was affected by the change in fair value of warrant liability of $3,302,913, interest earned on marketable securities held in the Trust Account of $58,976, and an unrealized loss on marketable securities held in our Trust Account of $5,829. Changes in operating assets and liabilities provided $620,529 of cash for operating activities.\nAs of September 30, 2022, in the U.S.-based trust account maintained by Continental Stock Transfer & Trust Company, acting as trustee, we had cash held of $947 and marketable securities held in the Trust Account of $44,202,534 (including approximately $145,311 of interest income) consisting of securities held in a money market fund that invests in U.S. Treasury securities with a maturity of 180 days or less. Interest income on the balance in the trust account may be used by us to pay taxes. In connection with the extension on May 12, 2022, stockholders holding 5,586,910 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $10.30 per share. In connection with the extension on August 15, 2022, stockholders holding 2,818,237 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds on the Trust Account at a redemption price of approximately $10.37 per share. Through September 30, 2022, we have withdrawn $358,711 of interest earned on the trust account to pay our taxes.\n22\nWe intend to use substantially all of the funds held in the trust account, to acquire a target business and to pay our expenses relating thereto upon consummation of our initial business combination for assisting us in connection with our initial business combination. To the extent that our capital stock is used in whole or in part as consideration to effect an initial business combination, the remaining funds held in the trust account will be used as working capital to finance the operations of the target business. Such working capital funds could be used in a variety of ways including continuing or expanding the target business’ operations, for strategic acquisitions and for marketing, research and development of existing or new products. Such funds could also be used to repay any operating expenses or finders’ fees which we had incurred prior to the completion of our initial business combination if the funds available to us outside of the trust account were insufficient to cover such expenses.\nAs of September 30, 2022, we had cash of $83,760 held outside the trust account. We intend to use the funds held outside the trust account for identifying and evaluating prospective acquisition candidates, performing business due diligence on prospective target businesses, traveling to and from the offices, plants or similar locations of prospective target businesses, reviewing corporate documents and material agreements of prospective target businesses, selecting the target business to acquire and structuring, negotiating and consummating the initial business combination.\nIn order to fund working capital deficiencies or finance transaction costs in connection with an initial business combination, the insiders, or certain of our officers and directors or their affiliates may, but are not obligated to, loan us funds as may be required. If we complete our initial business combination, we would repay such loaned amounts. In the event that our initial business combination does not close, we may use a portion of the working capital held outside the trust account to repay such loaned amounts but no proceeds from our trust account would be used for such repayment. Up to $1,500,000 of such loans may be convertible into warrants, at a price of $1.00 per warrant, at the option of the lender. The units would be identical to the private placement warrants. On November 9, 2021, we issued a promissory note in the principal amount of $1,261,860 to the Sponsor in connection with the Extension (“Convertible Promissory Note”) (as defined below). On February 17, 2022, April 14, 2022, May 18, 2022, and August 17, 2022, we amended and restated the Convertible Promissory Note to increase the principal amount thereunder from $1,261,860 to $3,683,720. The Note bears no interest and is due and payable upon the earlier to occur of (i) the date on which the Company’s Business Combination is consummated and (ii) the liquidation of the Company on or before February 17, 2023 or such later liquidation date as may be approved by the Company’s stockholders. At the election of the Sponsor, up to $1,500,000 of the unpaid principal amount of the Convertible Promissory Note may be converted into warrants of the Company, each warrant exercisable for one share of common stock of the Company upon the consummation of its Business Combination, equal to: (x) the portion of the principal amount of the Note being converted, divided by (y) $1.00, rounded up to the nearest whole number of warrants.\nWe expect that we will need to raise additional capital through loans or additional investments from our sponsor, stockholders, officers, directors, or third parties. Our officers, directors and sponsor may, but are not obligated to, loan us funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet our working capital needs. Accordingly, we may not be able to obtain additional financing. If we are unable to raise additional capital, we may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, and reducing overhead expenses. We cannot provide any assurance that new financing will be available to us on commercially acceptable terms, if at all.\nIn connection with the Company’s assessment of going concern considerations in accordance with Financial Accounting Standard Board’s Accounting Standards Update (“ASU”) 2014-15, “Disclosures of Uncertainties about an Entity’s Ability to Continue as a Going Concern,” the Company has until February 17, 2023 to consummate a Business Combination. It is uncertain that the Company will be able to consummate a Business Combination by this time. If a Business Combination is not consummated by this date and an extension has not been requested by the Sponsor and approved by the Company’s stockholders, there will be a mandatory liquidation and subsequent dissolution of the Company. Management has determined that the liquidity condition and the mandatory liquidation and potential subsequent dissolution raises substantial doubt about the Company’s ability to continue as a going concern. No adjustments have been made to the carrying amounts of assets or liabilities should the Company be required to liquidate after February 17, 2023. The Company intends to continue to search for and seek to complete a Business Combination before the mandatory liquidation date. The Company is within 12 months of its mandatory liquidation date as of the time of filing of this Quarterly Report on Form 10-Q.\nOff-Balance Sheet Financing Arrangements\nWe have no obligations, assets or liabilities, which would be considered off-balance sheet arrangements as of September 30, 2022. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets.\n23\nContractual Obligations\nWe have agreed, commencing on November 12, 2020 through the earlier of our consummation of an initial business combination and our liquidation, to pay an affiliate of our management a total of $10,000 per month for office space, utilities and secretarial support. For the three and nine months ended September 30, 2022, the Company incurred and accrued $30,000 and $90,000 in fees for these services, respectively, and those fees are included in accounts payable and accrued expenses in the accompanying condensed balance sheets. For the three and nine months ended September 30, 2021, the Company incurred and paid $30,000 and $90,000 in fees for these services.\nWe granted the underwriters a 45-day option from the date of the initial public offering to purchase up to 1,650,000 additional units to cover over-allotments, if any, at the initial public offering price less the underwriting discounts and commissions. On November 19, 2020, the underwriters partially exercised their over-allotment option to purchase an additional 1,618,600 units at $10.00 per unit and forfeited the remaining over-allotment option.\nWe have engaged EarlyBirdCapital as an advisor in connection with an initial business combination to assist us in holding meetings with its stockholders to discuss the potential initial business combination and the target business’ attributes, introduce us to potential investors that are interested in purchasing our securities in connection with an initial business combination, assist us in obtaining stockholder approval for the initial business combination and assist us with our press releases and public filings in connection with the initial business combination. We will pay EarlyBirdCapital a cash fee for such services upon the consummation of an initial business combination in an amount equal to 3.5% of the gross proceeds of the initial public offering, or $4,416,510 (exclusive of any applicable finders’ fees which might become payable); provided that up to 30% of the fee may be allocated at our sole discretion to other FINRA members that assist us in identifying and consummating an initial business combination.\nAdditionally, we will pay EarlyBirdCapital a cash fee equal to 1.0% of the total consideration payable in an initial business combination if EarlyBirdCapital introduces us to the target business with which we complete an initial business combination.\nWe have engaged various law firms to provide legal due diligence services and business combination services related to potential target companies. All fees and expenses related to the various engagements will be deferred and are to be paid fully upon the closing of any business combination. The law firms will not be entitled to any contingent fees or expense reimbursement if we do not consummate an initial business combination within our deadline. Deferred fees of $1,371,549 and $1,009,868 related to these legal services have been accrued as of September 30, 2022 and December 31, 2021, respectively.\nCritical Accounting Policies\nThe preparation of condensed financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have identified the following critical accounting policies:\nWarrant Liability\nThe Company accounts for the Private Warrants in accordance with the guidance contained in ASC 815-40-15-7D and 7F under which the Private Warrants do not meet the criteria for equity treatment and must be recorded as liabilities. Accordingly, the Company classifies the Private Warrants as liabilities at their fair value and adjusts the Private Warrants to fair value at each reporting period. This liability is subject to re-measurement at each balance sheet date until exercised, and any change in fair value is recognized in our statements of operations. The Private Warrants for periods where no observable traded price was available are valued using a binomial lattice simulation model.\n24\nConvertible Promissory Note\nWe account for our convertible promissory note under ASC 815, Derivatives and Hedging (“ASC 815”). Under 815-15-25, the election can be at the inception of a financial instrument to account for the instrument under the fair value option under ASC 825. We have made such election for our convertible promissory note. Using fair value option, the convertible promissory note is required to be recorded at its initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of the note are recognized as non-cash change in the fair value of the convertible promissory note in the statements of operations. The fair value of the option to convert the convertible promissory note into private placement warrants was valued by utilizing a binomial lattice model incorporating the Cox-Ross-Rubenstein methodology.\nCommon Stock Subject to Possible Redemption\nWe account for our common stock subject to possible conversion in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption is classified as a liability instrument and measured at fair value. Conditionally redeemable common stock (including common stock that features redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. Our common stock features certain redemption rights that are considered to be outside of our control and subject to occurrence of uncertain future events. Accordingly, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders’ deficit section of our condensed balance sheets.\nNet Income per Common Share\nNet income per common share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Accretion associated with the redeemable shares of common stock is excluded from net income per common share as the redemption value approximates fair value.\nRecent Accounting Standards\nIn August 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2020-06, “Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity” (“ASU 2020-06”), which simplifies accounting for convertible instruments by removing major separation models required under current GAAP. ASU 2020-06 removes certain settlement conditions that are required for equity contracts to qualify for the derivative scope exception, and it also simplifies the diluted earnings per share calculation in certain areas. ASU 2020-06 is effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years, with early adoption permitted. The Company assessed the potential impact of ASU 2020-06 and determined that it would not have a material impact on the condensed financial statements as presented.\nManagement does not believe that any other recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on our condensed financial statements.\nFactors That May Adversely Affect Our Results of Operations\nOur results of operation and our ability to complete an initial business combination may be adversely affected by various factors that could cause economic uncertainty and volatility in the financial markets, many of which are beyond our control. Our business could be impacted by, among other things, volatility in the financial markets or economic conditions, increase of oil price and interest rate, inflation, supply chain disruption, decline in consumer confidence and spending, the on-going effects of the COVID-19 pandemic, including resurgences and the emergence of new variants, and geopolitical instability, such as the military conflict in Ukraine. We cannot at this time fully predict one or more of the above events, their duration or magnitude of, or the extent to, which they may negatively impact our business and our ability to complete an initial business combination.\n25\n\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\nNot required for smaller reporting companies.\n\nItem 4. Controls and Procedures\nEvaluation of Disclosure Controls and Procedures\nDisclosure controls and procedures are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Exchange Act is recorded, processed, summarized, and reported within the time period specified in the SEC’s rules and forms. Disclosure controls and procedures are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.\nAs required by Rule 13a-15 under the Exchange Act, our Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of our disclosure controls and procedures as of September 30, 2022. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were not effective, due solely to the material weakness in our internal control over financial reporting related to our accounting for complex financial instruments. As a result, we performed additional analysis as deemed necessary to ensure that our financial statements were prepared in accordance with GAAP. Accordingly, management believes that the financial statements included in this Report present fairly in all material respects our financial position, results of operations and cash flows for the period presented.\nManagement has identified a material weakness in our internal controls related to the accounting for complex financial instruments. While we have processes to identify and appropriately apply applicable accounting requirements, we plan to continue to enhance our system of evaluating and implementing the accounting standards that apply to our financial statements, including through enhanced analyses by our personnel and third-party professionals with whom we consult regarding complex accounting applications. The elements of our remediation plan can only be accomplished over time, and we can offer no assurance that these initiatives will ultimately have the intended effects.\nManagement has implemented remediation steps to improve our internal control over financial reporting. Specifically, we expanded and improved our review process for complex securities and related accounting standards. We plan to further improve this process by enhancing access to accounting literature, identification of third-party professionals with whom to consult regarding complex accounting applications and consideration of additional staff with the requisite experience and training to supplement existing accounting professionals.\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n26\nPART II - OTHER INFORMATION\n\nItem 1. Legal Proceedings.\nTo the knowledge of our management team, there is no litigation currently pending or contemplated against us, any of our officers or directors in their capacity as such or against any of our property.\n\nItem 1A. Risk Factors\nAs of the date of this Quarterly Report on Form 10-Q, except as disclosed below, there have been no material changes to the risk factors previously disclosed in our final prospectus filed with the SEC on November 17, 2020 , in our Annual Report on Form 10-K for the year ended December 31, 2021 filed with the SEC on March 31, 2022 and in our Quarterly Reports on Form 10-Q for the period ended March 31, 2022 and June 30, 2022, filed with the SEC on May 13, 2022 and August 3, 2022, respectively. Any of these factors could result in a significant or material adverse effect on our results of operations or financial condition. Additional risk factors not presently known to us or that we currently deem immaterial may also impair our business or results of operations. We may disclose changes to such risk factors or disclose additional risk factors from time to time in our future filings with the SEC.\nA new 1% U.S. federal excise tax could be imposed on us in connection with redemptions of our shares in connection with a business combination or other stockholder vote pursuant to which stockholders would have a right to submit their shares for redemption (a “Redemption Event”).\nOn August 16, 2022, the Inflation Reduction Act of 2022 (the “IR Act”) was signed into federal law. The IR Act provides for, among other things, a new U.S. federal 1% excise tax on certain repurchases (including redemptions) of stock by publicly traded domestic corporations and certain domestic subsidiaries of publicly traded foreign corporations. The excise tax is imposed on the repurchasing corporation itself, not its stockholders from whom shares are repurchased. The amount of the excise tax is generally 1% of the fair market value of the shares repurchased at the time of the repurchase. However, for purposes of calculating the excise tax, repurchasing corporations are permitted to net the fair market value of certain new stock issuances against the fair market value of stock repurchases during the same taxable year. In addition, certain exceptions apply to the excise tax. The U.S. Department of the Treasury has been given authority to provide regulations and other guidance to carry out and prevent the abuse or avoidance of the excise tax. The IR Act applies only to repurchases that occur after December 31, 2022.\nAny redemption or other repurchase that occurs after December 31, 2022, in connection with a Redemption Event may be subject to the excise tax. Whether and to what extent we would be subject to the excise tax in connection with a Redemption Event would depend on a number of factors, including (i) the fair market value of the redemptions and repurchases in connection with the Redemption Event, (ii) the structure of the business combination, (iii) the nature and amount of any “PIPE” or other equity issuances in connection with the business combination (or otherwise issued not in connection with the Redemption Event but issued within the same taxable year of the business combination) and (iv) the content of regulations and other guidance from the U.S. Department of the Treasury. In addition, because the excise tax would be payable by us, and not by the redeeming holder, the mechanics of any required payment of the excise tax have not been determined. The foregoing could cause a reduction in the cash available on hand to complete a business combination and in our ability to complete a business combination.\nTo mitigate the risk that we might be deemed to be an investment company for purposes of the Investment Company Act, we expect to instruct the trustee to liquidate the securities held in our trust account and instead to hold the funds in our trust account in cash items until the earlier of the consummation of our initial business combination or our liquidation. As a result, we will likely receive minimal interest, if any, on the funds held in the trust account, which will likely reduce the dollar amount our public stockholders would receive upon any redemption or liquidation of the Company.\nThe funds in our trust account have, since our initial public offering, been held only in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds investing solely in U.S. government treasury obligations and meeting certain conditions under Rule 2a-7 under the Investment Company Act. However, to mitigate the risk of us being deemed to be an unregistered investment company (including under the subjective test of Section 3(a)(1)(A) of the Investment Company Act) and thus subject to regulation under the Investment Company Act, we expect to instruct Continental Stock Transfer & Trust Company, the trustee with respect to our trust account, to liquidate the U.S. government treasury obligations and money market funds held in the trust account and to hold all funds in the trust account as cash items until the earlier of the consummation of our initial business combination or the liquidation of the Company. Following such liquidation, we will likely receive minimal interest, if any, on the funds held in the trust account. However, interest previously earned on the funds held in the trust account still may be released to us to pay our taxes, if any. This will likely reduce the dollar amount our public stockholders would receive upon any redemption or liquidation of the Company. In the event that we may be deemed to be an investment company, we may be required to liquidate the Company.\n27\n\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\nNone.\n\nItem 3. Defaults Upon Senior Securities\nNone.\n\nItem 4. Mine Safety Disclosures\nNone.\n\nItem 5. Other Information\nNone.\n28\n\nItem 6. Exhibits\nThe following exhibits are filed as part of, or incorporated by reference into, this Quarterly Report on Form 10-Q.\n\n| No. | Description of Exhibit |\n| 3.1 | Second Amendment to the Amended and Restated Certificate of Incorporation, as amended (Incorporated by reference to the Company’s Form 8-K filed on August 17, 2022) |\n| 10.1 | Third Amended and Restated Promissory Note, dated August 17, 2022 (Incorporated by reference to the Company’s Form 8-K filed on August 17, 2022) |\n| 31.1* | Certification of Principal Executive Officer Pursuant to Securities Exchange Act Rules 13a-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2* | Certification of Principal Financial Officer Pursuant to Securities Exchange Act Rules 13a-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1** | Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2** | Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS* | Inline XBRL Instance Document |\n| 101.SCH* | Inline XBRL Taxonomy Extension Schema Document |\n| 101.CAL* | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF* | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB* | Inline XBRL Taxonomy Extension Labels Linkbase Document |\n| 101.PRE* | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104* | Cover Page Interactive Data File |\n\n\n| * | Filed herewith. |\n| ** | Furnished herewith. |\n\n29\nSIGNATURES\nIn accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| BETTER WORLD ACQUISITION CORP. |\n| Date: November 14, 2022 | By: | /s/ Rosemary L. Ripley |\n| Name: | Rosemary L. Ripley |\n| Title: | Chief Executive Officer |\n| (Principal Executive Officer) |\n| Date: November 14, 2022 | By: | /s/ Peter S.H. Grubstein |\n| Name: | Peter S.H. Grubstein |\n| Title: | Chief Financial Officer |\n| (Principal Financial Officer) |\n\n30\n\n \n\nWhat's the estimated worth of the company Better World Acquisition Corp. at the end of Q4 in 2022 if the company continues to follow the same trend as it did in the first three quarters of 2022, in millions of dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nItem 1. Financial Statements.\\nBETTER WORLD ACQUISITION CORP.\\nCONDENSED BALANCE SHEETS\\n\\n| September 30, 2022 | December 31, 2021 |\\n| (Unaudited) |\\n| ASSETS |\\n| Current assets |\\n| Cash | $ | 83,760 | $ | 278,197 |\\n| Prepaid expenses and other current assets | 48,251 | 30,805 |\\n| Total Current Assets | 132,011 | 309,002 |\\n| Cash and marketable securities held in Trust Account | 44,203,481 | 128,790,008 |\\n| TOTAL ASSETS | $ | 44,335,492 | $ | 129,099,010 |\\n| LIABILITIES AND STOCKHOLDERS’ DEFICIT |\\n| Current liabilities - Accounts payable and accrued expenses | $ | 560,689 | $ | 430,800 |\\n| Deferred legal fees | 1,371,549 | 1,009,868 |\\n| Convertible promissory note – related party, at fair value | 913,900 | 958,400 |\\n| Warrant Liabilities | 422,846 | 2,641,204 |\\n| Income taxes payable | 27,528 | — |\\n| Total Liabilities | 3,296,512 | 5,040,272 |\\n| Commitments and Contingencies (Note 6) |\\n| Common stock subject to possible redemption; $ 0.0001 par value; 4,213,453 shares at $ 10.49 per share redemption value as of September 30, 2022 and 12,618,600 shares at $ 10.20 per share redemption value as of December 31, 2021 | 44,203,481 | 128,709,720 |\\n| Stockholders’ Deficit |\\n| Preferred stock, $ 0.0001 par value; 1,000,000 shares authorized; none issued or outstanding | — | — |\\n| Common stock, $ 0.0001 par value; 50,000,000 shares authorized; 3,487,070 shares issued and outstanding (excluding 4,213,453 and 12,618,600 shares subject to possible redemption) at September 30, 2022 and December 31, 2021, respectively | 348 | 348 |\\n| Accumulated deficit | ( 3,164,849 | ) | ( 4,651,330 | ) |\\n| Total Stockholders’ Deficit | ( 3,164,501 | ) | ( 4,650,982 | ) |\\n| TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT | $ | 44,335,492 | $ | 129,099,010 |\\n\\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\\n1\\nBETTER WORLD ACQUISITION CORP.\\nCONDENSED STATEMENTS OF OPERATIONS\\n(UNAUDITED)\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Operational costs | $ | 396,066 | $ | 735,695 | $ | 1,327,272 | $ | 1,148,802 |\\n| Loss from operations | ( 396,066 | ) | ( 735,695 | ) | ( 1,327,272 | ) | ( 1,148,802 | ) |\\n| Other income (expense): |\\n| Interest earned on marketable securities held in Trust Account | 254,709 | 23,138 | 423,734 | 58,976 |\\n| Unrealized gain (loss) on marketable securities held in Trust Account | 1,078 | ( 4,654 | ) | — | ( 5,829 | ) |\\n| Change in fair value of Private Warrants liabilities | ( 106,018 | ) | 2,192,941 | 2,218,358 | 3,302,913 |\\n| Change in fair value of convertible promissory note – related party | 1,113,700 | — | 2,119,960 | — |\\n| Other income, net | 1,263,469 | 2,211,425 | 4,762,052 | 3,356,060 |\\n| Income before provision for income taxes | 867,403 | 1,475,730 | 3,434,780 | 2,207,258 |\\n| Provision for income taxes | ( 23,249 | ) | — | ( 27,528 | ) | — |\\n| Net income | $ | 844,154 | $ | 1,475,730 | $ | 3,407,252 | $ | 2,207,258 |\\n| Basic and diluted weighted average shares outstanding, redeemable common stock | 5,591,938 | 12,618,600 | 9,268,327 | 12,618,600 |\\n| Basic and diluted net income per share, redeemable common stock | $ | 0.09 | $ | 0.09 | $ | 0.27 | $ | 0.14 |\\n| Basic and diluted weighted average shares outstanding, non-redeemable common stock | 3,487,070 | 3,487,070 | 3,487,070 | 3,487,070 |\\n| Basic and diluted net income per share, non-redeemable common stock | $ | 0.09 | $ | 0.09 | $ | 0.27 | $ | 0.14 |\\n\\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\\n2\\nBETTER WORLD ACQUISITION CORP.\\nCONDENSED STATEMENTS OF CHANGES IN STOCKHOLDERS’ DEFICIT\\n(UNAUDITED)\\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2022\\n\\n| Common Stock | Additional Paid | Accumulated | Total Stockholders’ |\\n| Shares | Amount | in Capital | Deficit | Deficit |\\n| Balance – January 1, 2022 | 3,487,070 | $ | 348 | $ | — | $ | ( 4,651,330 | ) | $ | ( 4,650,982 | ) |\\n| Accretion for common stock to redemption amount | — | — | — | ( 1,261,860 | ) | ( 1,261,860 | ) |\\n| Net income | — | — | — | 1,647,395 | 1,647,395 |\\n| Balance – March 31, 2022 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 4,265,795 | ) | $ | ( 4,265,447 | ) |\\n| Accretion for common stock to redemption amount | — | — | — | ( 500,000 | ) | ( 500,000 | ) |\\n| Net income | — | — | — | 915,703 | 915,703 |\\n| Balance – June 30, 2022 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 3,850,092 | ) | $ | ( 3,849,744 | ) |\\n| Accretion for common stock to redemption amount | — | — | ( 346,400 | ) | ( 158,911 | ) | ( 505,311 | ) |\\n| Promissory note proceeds in excess of initial fair value | — | — | 346,400 | — | 346,400 |\\n| Net income | — | — | — | 844,154 | 844,154 |\\n| Balance – September 30, 2022 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 3,164,849 | ) | $ | ( 3,164,501 | ) |\\n\\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2021\\n\\n| Common Stock | Additional Paid | Accumulated | Total Stockholders’ |\\n| Shares | Amount | in Capital | Deficit | Deficit |\\n| Balance – January 1, 2021 | 3,487,070 | $ | 348 | $ | — | $ | ( 5,489,693 | ) | $ | ( 5,489,345 | ) |\\n| Net income | — | — | — | 832,646 | 832,646 |\\n| Balance – March 31, 2021 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 4,657,047 | ) | $ | ( 4,656,699 | ) |\\n| Net loss | — | — | — | ( 101,118 | ) | ( 101,118 | ) |\\n| Balance – June 30, 2021 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 4,758,165 | ) | $ | ( 4,757,817 | ) |\\n| Net income | — | — | — | 1,475,730 | 1,475,730 |\\n| Balance – September 30, 2021 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 3,282,435 | ) | $ | ( 3,282,087 | ) |\\n\\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\\n3\\nBETTER WORLD ACQUISITION CORP.\\nCONDENSED STATEMENTS OF CASH FLOWS\\n(UNAUDITED)\\n\\n| Nine Months Ended September 30, |\\n| 2022 | 2021 |\\n| Cash Flows from Operating Activities: |\\n| Net income | $ | 3,407,252 | $ | 2,207,258 |\\n| Adjustments to reconcile net income to net cash used in operating activities: |\\n| Interest earned on marketable securities held in Trust Account | ( 423,734 | ) | ( 58,976 | ) |\\n| Unrealized gain on marketable securities held in Trust Account | — | 5,829 |\\n| Change in fair value of convertible promissory note – related party | ( 2,119,960 | ) | — |\\n| Change in fair value of Private Warrant liabilities | ( 2,218,358 | ) | ( 3,302,913 | ) |\\n| Changes in operating assets and liabilities: |\\n| Prepaid expenses and other current assets | ( 17,446 | ) | 45,890 |\\n| Accounts payable and accrued expenses | 129,889 | 574,639 |\\n| Income taxes payable | 27,528 | — |\\n| Deferred legal fees payable | 361,681 | — |\\n| Net cash used in operating activities | ( 853,148 | ) | ( 528,273 | ) |\\n| Cash Flows from Investing Activities: |\\n| Investment of cash into Trust Account | ( 2,121,860 | ) | — |\\n| Cash withdrawn from Trust Account to pay franchise taxes | 358,711 | — |\\n| Cash withdrawn from Trust Account in connection with redemption | 86,773,410 | — |\\n| Net cash provided by investing activities | 85,010,261 | — |\\n| Cash Flows from Financing Activities: |\\n| Advances from related party | 100,000 | — |\\n| Proceeds from promissory note – related party | — | 107,639 |\\n| Repayment of promissory note – related party | — | ( 107,639 | ) |\\n| Proceeds from convertible promissory note – related party | 2,321,860 | — |\\n| Redemption of common stock | ( 86,773,410 | ) | — |\\n| Net cash used in financing activities | ( 84,351,550 | ) | — |\\n| Net Change in Cash | ( 194,437 | ) | ( 528,273 | ) |\\n| Cash – Beginning of period | 278,197 | 1,023,178 |\\n| Cash – End of period | $ | 83,760 | $ | 494,905 |\\n| Non-Cash investing and financing activities: |\\n| Conversion of advance to convertible promissory note – related party | $ | 100,000 | $ | — |\\n| Accretion for common stock to redemption amount | $ | 1,928,271 | $ | — |\\n| Promissory note proceeds in excess of initial fair value | $ | ( 338,900 | ) | $ | — |\\n\\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\\n4\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nNOTE 1. DESCRIPTION OF ORGANIZATION, BUSINESS OPERATIONS, LIQUIDITY AND GOING CONCERN\\nBetter World Acquisition Corp. (the “Company”) was incorporated in Delaware on August 5, 2020. The Company is a blank check company formed for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities (the “Business Combination”).\\nAlthough the Company is not limited to a particular industry or sector for purposes of consummating a Business Combination, the Company is focused on target businesses in the healthy living industries that benefit from strong Environmental, Social and Governance (“ESG”) profiles. The Company is an early stage and emerging growth company and, as such, the Company is subject to all the risks associated with early stage and emerging growth companies.\\nAs of September 30, 2022, the Company had not commenced any operations. All activity for the period from August 5, 2020 (inception) through September 30, 2022 relates to the Company’s formation, the initial public offering (“Initial Public Offering”), which is described below, and identifying a target company for a Business Combination. The Company will not generate any operating revenues until after the completion of a Business Combination, at the earliest. The Company generates non-operating income in the form of interest income from the marketable securities held in the Trust Account (as defined below).\\nThe registration statement for the Company’s Initial Public Offering was declared effective on November 12, 2020. On November 17, 2020, the Company consummated the Initial Public Offering of 11,000,000 units (the “Units” and, with respect to the shares of common stock included in the Units sold, the “Public Shares”), at $ 10.00 per Unit, generating gross proceeds of $ 110,000,000 , which is described in Note 3.\\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the sale of 4,800,000 warrants (the “Private Warrants”) at a price of $ 1.00 per Private Warrant in a private placement to BWA Holdings LLC (the “Sponsor”) and EarlyBirdCapital, Inc. (“EarlyBirdCapital”), generating gross proceeds of $ 4,800,000 , which is described in Note 4.\\nFollowing the closing of the Initial Public Offering on November 17, 2020, an amount of $ 111,100,000 ($ 10.10 per Unit) from the net proceeds of the sale of the Units in the Initial Public Offering and the sale of the Private Warrants was placed in a trust account (the “Trust Account”) located in the United States and invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), with a maturity of 185 days or less or in any open-ended investment company that holds itself out as a money market fund selected by the Company meeting the conditions of Rule 2a-7 of the Investment Company Act, as determined by the Company, until the earlier of: (i) the completion of a Business Combination and (ii) the distribution of the funds in the Trust Account, as described below.\\nOn November 17, 2020, the underwriters notified the Company of their intention to partially exercise their over-allotment option on November 19, 2020. As such, on November 19, 2020, the Company consummated the sale of an additional 1,618,600 Units, at $ 10.00 per Unit, generating gross proceeds of $ 16,186,000 , and the sale of an additional 485,580 Private Warrants, at $ 1.00 per Private Warrant, generating gross proceeds of $ 485,580 . A total of $ 16,347,860 of the net proceeds was deposited into the Trust Account on November 20, 2020, bringing the aggregate proceeds held in the Trust Account to $ 127,447,860 . On November 9, 2021, in connection with the first extension of the date by which the Company has to consummate a Business Combination, a total of $ 1,261,860 was deposited into the Trust Account. On February 17, 2022, a total of $ 1,261,860 was deposited in the Trust Account in connection with the second extension of the date by which the Company has to consummate a Business Combination to May 17, 2022. On May 18, 2022, a total of $ 500,000 was deposited into the Trust Account in connection with a further extension of the date by which the Company has to consummate a Business Combination to August 17, 2022. On August 17, 2022, a total of $ 360,000 was deposited into the Trust Account in connection with a further extension of the date by which the Company has to consummate a Business Combination to February 17, 2023.\\nTransaction costs amounted to $ 2,880,354 consisting of $ 2,523,720 of underwriting fees and $ 356,634 of other offering costs.\\nThe Company’s management has broad discretion with respect to the specific application of the net proceeds of the Initial Public Offering and the sale of the Private Warrants, although substantially all of the net proceeds are intended to be applied generally toward completing a Business Combination. The Company must complete a Business Combination having an aggregate fair market value of at least 80 % of the assets held in the Trust Account (excluding taxes payable on income earned on the Trust Account) at the time of the agreement to enter into an initial Business Combination. The Company will only complete a Business Combination if the post Business Combination company owns or acquires 50 % or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act. There is no assurance that the Company will be able to complete a Business Combination successfully.\\n5\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nThe Company will provide its holders of the outstanding Public Shares (the “public stockholders”) with the opportunity to redeem all or a portion of their Public Shares upon the completion of a Business Combination either (i) in connection with a stockholder meeting called to approve the Business Combination or (ii) by means of a tender offer. The decision as to whether the Company will seek stockholder approval of a Business Combination or conduct a tender offer will be made by the Company, solely in its discretion. The public stockholders will be entitled to redeem their Public Shares for a pro rata portion of the amount then in the Trust Account ($ 10.46 per Public Share as of September 30, 2022 and $ 10.20 per Public Share as of December 31, 2021, plus any pro rata interest earned on the funds held in the Trust Account and not previously released to the Company to pay its tax obligations). There will be no redemption rights upon the completion of a Business Combination with respect to the Company’s warrants.\\nThe Company will proceed with a Business Combination if the Company has net tangible assets of at least $ 5,000,001 immediately prior to or upon such consummation of a Business Combination and, if the Company seeks stockholder approval, a majority of the shares voted are voted in favor of the Business Combination. If a stockholder vote is not required by law and the Company does not decide to hold a stockholder vote for business or other legal reasons, the Company will, pursuant to its Amended and Restated Certificate of Incorporation (the “Amended and Restated Certificate of Incorporation”), conduct the redemptions pursuant to the tender offer rules of the U.S. Securities and Exchange Commission (“SEC”) and file tender offer documents with the SEC containing substantially the same information as would be included in a proxy statement prior to completing a Business Combination. If, however, stockholder approval of the transaction is required by law, or the Company decides to obtain stockholder approval for business or legal reasons, the Company will offer to redeem shares in conjunction with a proxy solicitation pursuant to the proxy rules and not pursuant to the tender offer rules. If the Company seeks stockholder approval in connection with a Business Combination, the Sponsor has agreed to vote its Founder Shares (as defined in Note 5), Representative Shares (as defined in Note 8) and any Public Shares purchased during or after the Initial Public Offering (a) in favor of approving a Business Combination and (b) not to redeem any shares in connection with a stockholder vote to approve a Business Combination or sell any shares to the Company in a tender offer in connection with a Business Combination. Additionally, each public stockholder may elect to redeem their Public Shares, irrespective of whether they vote for or against the proposed Business Combination.\\nThe Sponsor has agreed (a) to waive its redemption rights with respect to the Founder Shares and Public Shares held by it in connection with the completion of a Business Combination and (b) not to propose an amendment to the Amended and Restated Certificate of Incorporation that would affect a public stockholders’ ability to convert or sell their shares to the Company in connection with a Business Combination or affect the substance or timing of the Company’s obligation to redeem 100 % of its Public Shares if the Company does not complete a Business Combination, unless the Company provides the public stockholders with the opportunity to redeem their Public Shares in conjunction with any such amendment.\\nOn November 9, 2021, the Company’s board of directors approved the first extension of the date by which the Company has to consummate a Business Combination from November 17, 2021 to February 17, 2022. In connection with the extension, the Sponsor deposited into the Trust Account $ 0.10 for each of the 12,618,600 shares issued in the Initial Public Offering, for a total of $ 1,261,860 . The Company issued the Sponsor a non-interest bearing unsecured promissory note in the principal amount of $ 1,261,860 which is payable by the Company upon the earlier of the consummation of the Business Combination or the liquidation of the Company. The Note may be repaid in cash or convertible into Private Warrants at a price of $ 1.00 per Private Warrant. On February 16, 2022, the Company’s board of directors approved the second extension of the date by which the Company has to consummate a Business Combination from February 17, 2022 to May 17, 2022. In connection with the second extension, the Sponsor deposited into the Trust Account an additional $ 1,261,860 ($ 0.10 per Public Share) on February 17, 2022, and the Company amended and restated the promissory note in its entirety solely to increase the principal amount thereunder from $ 1,261,860 to $ 2,523,720 . On May 12, 2022, the Company held a special meeting of stockholders in which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from May 17, 2022 to August 17, 2022 (the “Combination Period”) was approved by the stockholders. In connection with this extension, the Company deposited $ 500,000 into the Trust Account on May 18, 2022. The Company amended and restated the promissory note to increase the principal amount thereunder from $ 2,523,720 to $ 3,223,720 , which included a drawdown of $ 500,000 for the extension and a drawdown of $ 200,000 for working capital needs. On August 17, 2022, the Company held a special meeting of stockholders in which the Company’s stockholders approved a second amendment to extend the date by which the Company must consummate a Business Combination from August 17, 2022 to February 17, 2023. On August 17, 2022, the Company amended and restated the promissory note to increase the principal amount thereunder from $ 3,223,720 to $ 3,683,720 , which included a drawdown of $ 360,000 for the extension and $ 100,000 for working capital purposes.\\n6\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nIf the Company is unable to complete a Business Combination within the Combination Period, the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account including interest earned on the funds held in the Trust Account and not previously released to the Company to pay taxes, divided by the number of then outstanding Public Shares, which redemption will completely extinguish public stockholders’ rights as stockholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the Company’s remaining stockholders and the Company’s board of directors, dissolve and liquidate, subject in each case to the Company’s obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law.\\nThe Sponsor has agreed to waive its liquidation rights with respect to the Founder Shares if the Company fails to complete a Business Combination within the Combination Period. However, if the Sponsor acquires Public Shares in or after the Initial Public Offering, such Public Shares will be entitled to liquidating distributions from the Trust Account if the Company fails to complete a Business Combination within the Combination Period. In the event of such distribution, it is possible that the per share value of the assets remaining available for distribution will be less than the amount of funds initially deposited into the Trust Account (initially $ 10.10 per share, subsequently increased to $ 10.46 per share as of September 30, 2022 following extensions).\\nIn order to protect the amounts held in the Trust Account, the Sponsor has agreed to be liable to the Company if and to the extent any claims by a vendor for services rendered or products sold to the Company, or a prospective target business with which the Company has discussed entering into a transaction agreement, reduce the amount of funds in the Trust Account to below $ 10.10 per Public Share, except as to any claims by a third party who executed a valid and enforceable agreement with the Company waiving any right, title, interest or claim of any kind they may have in or to any monies held in the Trust Account and except as to any claims under the Company’s indemnity of the underwriters of Initial Public Offering against certain liabilities, including liabilities under the Securities Act of 1933, as amended (the “Securities Act”). Moreover, in the event that an executed waiver is deemed to be unenforceable against a third party, the insiders will not be responsible to the extent of any liability for such third-party claims. The Company will seek to reduce the possibility that the insiders will have to indemnify the Trust Account due to claims of creditors by endeavoring to have all vendors, service providers (except the Company’s independent registered public accounting firm), prospective target businesses or other entities with which the Company does business, execute agreements with the Company waiving any right, title, interest or claim of any kind in or to monies held in the Trust Account.\\nRisks and Uncertainties\\nManagement continues to evaluate the impact of the COVID-19 pandemic and the military conflict in the Ukraine and has concluded that while it is reasonably possible that the virus and the military conflict could have a negative effect on the Company’s financial position, results of its operations and/or search for a target company, the specific impacts are not readily determinable as of the date of these financial statements. The financial statements do not include any adjustments that might result from the outcome of these uncertainties.\\nInflation Reduction Act of 2022\\nOn August 16, 2022, the Inflation Reduction Act of 2022 (the “IR Act”) was signed into federal law. The IR Act provides for, among other things, a new U.S. federal 1 % excise tax on certain repurchases of stock by publicly traded U.S. domestic corporations and certain U.S. domestic subsidiaries of publicly traded foreign corporations occurring on or after January 1, 2023. The excise tax is imposed on the repurchasing corporation itself, not its shareholders from which shares are repurchased. The amount of the excise tax is generally 1 % of the fair market value of the shares repurchased at the time of the repurchase. However, for purposes of calculating the excise tax, repurchasing corporations are permitted to net the fair market value of certain new stock issuances against the fair market value of stock repurchases during the same taxable year. In addition, certain exceptions apply to the excise tax. The U.S. Department of the Treasury has been given authority to provide regulations and other guidance to carry out and prevent the abuse or avoidance of the excise tax.\\nAny redemption or other repurchase that occurs after December 31, 2022, in connection with a Business Combination, extension vote or otherwise, may be subject to the excise tax. Whether and to what extent the Company would be subject to the excise tax in connection with a Business Combination, extension vote or otherwise would depend on a number of factors, including (i) the fair market value of the redemptions and repurchases in connection with the Business Combination, extension or otherwise, (ii) the structure of a Business Combination, (iii) the nature and amount of any “PIPE” or other equity issuances in connection with a Business Combination (or otherwise issued not in connection with a Business Combination but issued within the same taxable year of a Business Combination) and (iv) the content of regulations and other guidance from the U.S. Department of the Treasury. In addition, because the excise tax would be payable by the Company and not by the redeeming holder, the mechanics of any required payment of the excise tax have not been determined. The foregoing could cause a reduction in the cash available on hand to complete a Business Combination and in the Company’s ability to complete a Business Combination.\\n7\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nLiquidity and Going Concern\\nAs of September 30, 2022, the Company had $ 83,760 in its operating bank accounts and $ 44,203,481 in securities held in the Trust Account to be used for a Business Combination or to repurchase or redeem its common stock in connection therewith. As of September 30, 2022, $ 145,311 of the amount on deposit in the Trust Account represented accrued interest income, which can be withdrawn to pay the Company’s tax obligations.\\nOn May 13, 2022, July 1, 2022 and August 16, 2022, the Company withdrew $ 178,564 , $ 66,751 and $ 113,396 , respectively, of accrued interest from the Trust Account to pay certain tax obligations.\\nUntil the consummation of a Business Combination, the Company will use the funds not held in the Trust Account for identifying and evaluating prospective acquisition candidates, performing due diligence on prospective target businesses, paying for travel expenditures, selecting the target business to acquire, and structuring, negotiating and consummating the Business Combination.\\nThe Company expects it will need to raise additional capital through loans or additional investments from its Sponsor, stockholders, officers, directors, or third parties. The Company’s officers, directors and the Sponsor may, but are not obligated to, loan the Company funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet the Company’s working capital needs. Accordingly, the Company may not be able to obtain additional financing. If the Company is unable to raise additional capital, it may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, and reducing overhead expenses. The Company cannot provide any assurance that new financing will be available to it on commercially acceptable terms, if at all.\\nIn connection with the Company’s assessment of going concern considerations in accordance with Financial Accounting Standard Board’s Accounting Standards Update (“ASU”) 2014-15, “Disclosures of Uncertainties about an Entity’s Ability to Continue as a Going Concern,” the Company has until February 17, 2023 to consummate a Business Combination. It is uncertain that the Company will be able to consummate a Business Combination by this time. If a Business Combination is not consummated by this date and an extension has not been requested by the Sponsor and approved by the Company’s stockholders, there will be a mandatory liquidation and subsequent dissolution of the Company. Management has determined that the liquidity condition and the mandatory liquidation and potential subsequent dissolution raises substantial doubt about the Company’s ability to continue as a going concern. No adjustments have been made to the carrying amounts of assets or liabilities should the Company be required to liquidate after February 17, 2023. The Company intends to continue to search for and seek to complete a Business Combination before the mandatory liquidation date. The Company is within 12 months of its mandatory liquidation date as of the time of filing of this Quarterly Report on Form 10-Q.\\nNOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\\nBasis of Presentation\\nThe accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 8 of Regulation S-X of the SEC. Certain information or footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted, pursuant to the rules and regulations of the SEC for interim financial reporting. Accordingly, they do not include all the information and footnotes necessary for a complete presentation of financial position, results of operations, or cash flows. In the opinion of management, the accompanying unaudited condensed financial statements include all adjustments, consisting of a normal recurring nature, which are necessary for a fair presentation of the financial position, operating results and cash flows for the periods presented.\\nThe accompanying unaudited condensed financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the period ended December 31, 2021, as filed with the SEC on March 31, 2022. The interim results for the three and nine months ended September 30, 2022 are not necessarily indicative of the results to be expected for the year ending December 31, 2022 or for any future periods.\\n8\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nReclassification of Prior Year Presentation\\nCertain prior year amounts have been reclassified to conform to the current period presentation. These reclassifications had no effect on the reported results of operations. An adjustment has been made to the balance sheet for December 31, 2021 to reclassify the deferred legal fees balance from accrued expenses to a separate deferred legal fees line.\\nEmerging Growth Company\\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the independent registered public accounting firm attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved.\\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\\nUse of Estimates\\nThe preparation of the condensed financial statements in conformity with GAAP requires the Company’s management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements.\\nMaking estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. Two of the more significant accounting estimates included in these financial statements is the determination of the fair value of the warrant liabilities as well as the fair value of the convertible promissory note. Such estimates may be subject to change as more current information becomes available and accordingly the actual results could differ significantly from those estimates.\\nCash and Cash Equivalents\\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did not have any cash equivalents as of September 30, 2022 and December 31, 2021.\\n9\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nCash and Marketable Securities Held in Trust Account\\nAt September 30, 2022, substantially all of the assets held in the Trust Account were held in money market funds which are invested primarily in U.S Treasury securities. At December 31, 2021, substantially all of the assets held in the Trust Account were held in U.S. Treasury Securities. All of the Company’s investments held in the Trust Account are classified as trading securities. Trading securities are presented on the balance sheets at fair value at the end of each reporting period. Gains and losses resulting from the change in fair value of investments held in the Trust Account are included in interest earned on marketable securities held in the Trust Account in the accompanying condensed statements of operations. The estimated fair values of investments held in the Trust Account are determined using available market information. As of September 30, 2022, the Company has withdrawn $ 358,711 of interest income from the Trust Account to pay certain tax obligations.\\nCommon Stock Subject to Possible Redemption\\nThe Company accounts for its common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that features redemption rights that is either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. The Company’s common stock features certain redemption rights that are considered to be outside of the Company’s control and subject to occurrence of uncertain future events. Accordingly, as of September 30, 2022 and December 31, 2021, respectively, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders’ deficit section of the Company’s condensed balance sheets.\\nThe Company recognizes changes in redemption value immediately as they occur and adjusts the carrying value of redeemable common stock to equal the redemption value at the end of each reporting period. Increases or decreases in the carrying amount of redeemable common stock are affected by charges against additional paid in capital and accumulated deficit.\\nAt September 30, 2022 and December 31, 2021, the common stock reflected in the condensed balance sheets are reconciled in the following table:\\n\\n| Gross proceeds | $ | 126,186,000 |\\n| Less: |\\n| Common stock issuance costs | ( 2,868,790 | ) |\\n| Plus: |\\n| Accretion of carrying value to redemption value | 5,392,510 |\\n| Common stock subject to possible redemption – December 31, 2021 | $ | 128,709,720 |\\n| Less: |\\n| Redemption of shares | ( 86,773,410 | ) |\\n| Plus: |\\n| Accretion of carrying value to redemption value | 2,267,171 |\\n| Common stock subject to possible redemption – September 30, 2022 | $ | 44,203,481 |\\n\\nWarrant Liabilities\\nThe Company accounts for the Private Warrants in accordance with the guidance contained in ASC 815-40-15-7D and 7F under which the Private Warrants do not meet the criteria for equity treatment and must be recorded as liabilities. Accordingly, the Company classifies the Private Warrants as liabilities at their fair value and adjusts the Private Warrants to fair value at each reporting period. This liability is subject to re-measurement at each balance sheet date until exercised, and any change in fair value is recognized in our statements of operations. The Private Warrants for periods where no observable traded price was available are valued using a binomial lattice simulation model.\\n10\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nConvertible Promissory Note – Related Party\\nThe Company accounts for its convertible promissory note under ASC 815, Derivatives and Hedging (“ASC 815”). Under 815-15-25, the election can be at the inception of a financial instrument to account for the instrument under the fair value option under ASC 825. The Company has made such election for its convertible promissory note. Using fair value option, the convertible promissory note is required to be recorded at its initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of the note are recognized as non-cash change in the fair value of the convertible promissory note in the statements of operations. The fair value of the option to convert the convertible promissory note into Private Warrants was valued by utilizing a binomial lattice model incorporating the Cox-Ross-Rubenstein methodology.\\nIncome Taxes\\nThe Company accounts for income taxes under ASC 740, “Income Taxes.” ASC 740, Income Taxes, requires the recognition of deferred tax assets and liabilities for both the expected impact of differences between the unaudited condensed financial statements and tax basis of assets and liabilities and for the expected future tax benefit to be derived from tax loss and tax credit carry forwards. ASC 740 additionally requires a valuation allowance to be established when it is more likely than not that all or a portion of deferred tax assets will not be realized. As of September 30, 2022 and December 31, 2021, the Company’s deferred tax asset had a full valuation allowance recorded against it.\\nThe Company’s effective tax rate was 2.68 % and 0.00 % for the three months ended September 30, 2022 and 2021, respectively, and 0.80 % and 0.00 % for the nine months ended September 30, 2022 and 2021, respectively. The effective tax rate differs from the statutory tax rate of 21 % for the three months and nine months ended September 30, 2022 and 2021, due to changes in fair value in warrant liability, changes in the fair value of the convertible promissory note and the valuation allowance on the deferred tax assets.\\nASC 740 also clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. ASC 740 also provides guidance on derecognition, classification, interest and penalties, accounting in interim period, disclosure and transition.\\nWhile ASC 740 identifies usage of an effective annual tax rate for purposes of an interim provision, it does allow for estimating individual elements in the current period if they are significant, unusual, or infrequent. Computing the effective tax rate for the Company is complicated due to the potential impact of the timing of any Business Combination expenses and the actual interest income that will be recognized during the year. The Company has taken a position as to the calculation of income tax expense in a current period based on ASC 740-270-25-3 which states, “If an entity is unable to estimate part of its ordinary income (or loss) or the related tax (benefit) but is otherwise able to make a reasonable estimate, the tax (or benefit) applicable to the item that cannot be estimated shall be reported in the interim period in which the item is reported.” The Company believes its calculation to be a reliable estimate and allows it to properly take into account the usual elements that can impact its annualized book income and its impact on the effective tax rate. As such, the Company is computing its taxable income (loss) and associated income tax provision based on actual results through September 30, 2022.\\nThe Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of September 30, 2022 and December 31, 2021. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position.\\nThe Company has identified the United States as its only “major” tax jurisdiction. The Company is subject to income taxation by major taxing authorities since inception. These examinations may include questioning the timing and amount of deductions, the nexus of income among various tax jurisdictions and compliance with federal and state tax laws. The Company’s management does not expect that the total amount of unrecognized tax benefits will materially change over the next twelve months.\\nNet Income Per Common Share\\nThe Company complies with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share”. Net income per common share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Accretion associated with the redeemable shares of common stock is excluded from income per common share as the redemption value approximates fair value.\\nThe calculation of diluted income per share does not consider the effect of the warrants issued in connection with the (i) Initial Public Offering, and (ii) the private placement since the exercise of the warrants is contingent upon the occurrence of future events. The warrants are exercisable to purchase 17,904,180 shares of common stock in the aggregate. As of September 30, 2022 and 2021, the Company did not have any dilutive securities or other contracts that could, potentially, be exercised or converted into common stock and then participate in the earnings of the Company. As a result, diluted net income per common share is the same as basic net income per common share for the periods presented.\\n11\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nReconciliation of Net Income per Common Share\\nThe Company’s net income is adjusted for the portion of income that is attributable to common stock subject to possible redemption, as these shares only participate in the earnings of the Trust Account and not the income or losses of the Company. Accordingly, basic and diluted net income per common share is calculated as follows:\\n\\n| Three Months Ended September 30, 2022 | Three Months Ended September 30, 2021 | Nine Months Ended September 30, 2022 | Nine Months Ended September 30, 2021 |\\n| Redeemable Common Stock | Non-Redeemable Common Stock | Redeemable Common Stock | Non-Redeemable Common Stock | Redeemable Common Stock | Non-Redeemable Common Stock | Redeemable Common Stock | Non-Redeemable Common Stock |\\n| Basic and diluted net income per common share |\\n| Numerator: |\\n| Allocation of net income, as adjusted | $ | 519,931 | $ | 324,223 | $ | 1,156,217 | 319,513 | $ | 2,475,778 | $ | 931,474 | $ | 1,729,360 | $ | 477,898 |\\n| Denominator: |\\n| Basic and diluted weighted average shares outstanding | 5,591,938 | 3,487,070 | 12,618,600 | 3,487,070 | 9,268,327 | 3,487,070 | 12,618,600 | 3,487,070 |\\n| Basic and diluted net income per common share | $ | 0.09 | $ | 0.09 | $ | 0.09 | $ | 0.09 | $ | 0.27 | $ | 0.27 | $ | 0.14 | $ | 0.14 |\\n\\nConcentration of Credit Risk\\nFinancial instruments that potentially subject the Company to concentrations of credit risk consist of cash accounts in a financial institution, which, at times may exceed the Federal Deposit Insurance Corporation maximum coverage of $ 250,000 . The Company has not experienced losses on these accounts.\\nFair Value of Financial Instruments\\nThe fair value of the Company’s assets and liabilities, which qualify as financial instruments under ASC Topic 820, “Fair Value Measurement,” approximates the carrying amounts represented in the accompanying condensed balance sheets, primarily due to their short-term nature, except for warrant liabilities (see Note 9).\\nFair Value Measurements\\nFair value is defined as the price that would be received for sale of an asset or paid for transfer of a liability, in an orderly transaction between market participants at the measurement date. GAAP establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).\\nIn some circumstances, the inputs used to measure fair value might be categorized within different levels of the fair value hierarchy. In those instances, the fair value measurement is categorized in its entirety in the fair value hierarchy based on the lowest level input that is significant to the fair value measurement.\\n12\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nRecent Accounting Standards\\nIn August 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2020-06, “Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity” (“ASU 2020-06”), which simplifies accounting for convertible instruments by removing major separation models required under current GAAP. ASU 2020-06 removes certain settlement conditions that are required for equity contracts to qualify for the derivative scope exception, and it also simplifies the diluted earnings per share calculation in certain areas. ASU 2020-06 is effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years, with early adoption permitted. The Company assessed the potential impact of ASU 2020-06 and determined it would not have a material impact on the condensed financial statements as presented.\\nManagement does not believe that any other recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on the Company’s condensed financial statements.\\nNOTE 3. PUBLIC OFFERING\\nPursuant to the Initial Public Offering, the Company sold 11,000,000 Units at a price of $ 10.00 per Unit. Each Unit consists of one share of common stock and one redeemable warrant (“Public Warrant”). In connection with the underwriters’ partial exercise of the over-allotment option on November 19, 2020, the Company sold an additional 1,618,600 Units, at a purchase price of $ 10.00 per Unit. Each Public Warrant entitles the holder to purchase one share of common stock at an exercise price of $11.50 per share (see Note 8).\\nNOTE 4. PRIVATE PLACEMENT\\nSimultaneously with the closing of the Initial Public Offering, the Sponsor and EarlyBirdCapital purchased an aggregate of 4,800,000 Private Warrants at a price of $ 1.00 per Private Warrant for an aggregate purchase price of $ 4,800,000 . The Sponsor purchased 3,975,000 Private Warrants and EarlyBirdCapital purchased 825,000 Private Warrants. In connection with the underwriters’ partial exercise of the over-allotment option on November 19, 2020, the Sponsor and EarlyBirdCapital purchased an additional 485,580 Private Warrants, at a purchase price of $ 1.00 per Private Warrant, for an aggregate purchase price of $ 485,580 . Each Private Warrant entitles the holder to purchase one share of common stock at a price of $11.50 per full share, subject to adjustment (see Note 8). The proceeds from the Private Warrants were added to the proceeds from the Initial Public Offering held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the proceeds from the sale of the Private Warrants will be used to fund the redemption of the Public Shares (subject to the requirements of applicable law).\\nNOTE 5. RELATED PARTY TRANSACTIONS\\nFounder Shares\\nOn August 5, 2020, the Sponsor paid $ 25,000 to cover certain offering costs of the Company in consideration for 3,593,750 shares of common stock (the “Founder Shares”). On November 9, 2020, the Sponsor returned to the Company for cancellation, at no cost, an aggregate of 718,750 Founder Shares, resulting in an aggregate of 2,875,000 Founder Shares outstanding and held by the Sponsor. On November 12, 2020, the Company effected a stock dividend of 0.1 shares for each share of common stock outstanding, resulting in an aggregate of 3,162,500 Founder Shares outstanding and held by the Sponsor. The Founder Shares included, after giving retroactive effect to the share surrender and stock dividend, an aggregate of up to 412,500 shares subject to forfeiture to the extent that the underwriters’ over-allotment was not exercised in full or in part, so that the Sponsor would collectively own 20 % of the Company’s issued and outstanding shares after the Initial Public Offering (assuming the Sponsor did not purchase any Public Shares in the Initial Public Offering). In connection with the underwriters’ partial exercise of the over-allotment option and the forfeiture of the remaining over-allotment option, 7,850 Founder Shares were forfeited, and 404,650 Founder Shares are no longer subject to forfeiture resulting in an aggregate of 3,154,650 Founder Shares outstanding at September 30, 2022.\\nThe Sponsor has agreed, subject to certain limited exceptions, not to transfer, assign or sell any of the Founder Shares until (1) with respect to 50% of the Founder Shares, the earlier of one year after the completion of a Business Combination and the date on which the closing price of the common stock equals or exceeds $12.50 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing after a Business Combination and (2) with respect to the remaining 50% of the Founder Shares, one year after the completion of a Business Combination, or earlier, in either case, if, subsequent to a Business Combination, the Company completes a liquidation, merger, stock exchange or other similar transaction which results in all of the Company’s stockholders having the right to exchange their shares of common stock for cash, securities or other property.\\n13\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nDue from Sponsor\\nAt the closing of the Initial Public Offering on November 17, 2020, an aggregate amount of $ 25,038 was due to the Company. Such amount was paid by the Company to the Sponsor and was included in the prepaid expenses and other current assets on the balance sheet at December 31, 2020. No balance remains outstanding as of September 30, 2022.\\nAdministrative Support Agreement\\nThe Company has agreed, commencing on November 12, 2020 through the earlier of the Company’s consummation of a Business Combination and its liquidation, to pay an affiliate of the Company’s management a total of $ 10,000 per month for office space, utilities and secretarial support. For the three and nine months ended September 30, 2022, the Company incurred $ 30,000 and $ 90,000 , respectively, in fees for these services, of which such amounts are included in accrued expenses in the accompanying condensed balance sheets. For the three and nine months ended September 30, 2021, the Company incurred and paid $ 30,000 and $ 90,000 , respectively, in fees for these services.\\nPromissory Note — Related Party\\nOn August 5, 2020, the Company issued an unsecured promissory note to the Sponsor (the “Promissory Note”), pursuant to which the Company could borrow up to an aggregate principal amount of $ 300,000 . The Promissory Note was non-interest bearing and payable on the earlier of (i) March 31, 2021, (ii) the consummation of the Initial Public Offering or (iii) the date on which the Company determined not to proceed with the Initial Public Offering. The outstanding balance under the Promissory Note was repaid subsequent to the Initial Public Offering. As of September 30, 2022 and December 31, 2021, respectively, no balance is outstanding under the Promissory Note. Borrowings under the Promissory Note are no longer available.\\nRelated Party Loans\\nIn addition, in order to finance transaction costs in connection with a Business Combination, the Sponsor or certain of the Company’s officers and directors or their affiliates may, but are not obligated to, loan the Company funds as may be required (“Working Capital Loans”). Each loan would be evidenced by promissory note. The notes may be repaid upon completion of a Business Combination, without interest, or, at the lender’s discretion, up to $ 1,500,000 of notes may be converted upon completion of a Business Combination into warrants at a price of $ 1.00 per warrant. Such warrants would be identical to the Private Warrants. In the event that a Business Combination does not close, the Company may use a portion of proceeds held outside the Trust Account to repay the Working Capital Loans, but no proceeds held in the Trust Account would be used to repay the Working Capital Loans.\\nOn April 14, 2022 the Sponsor advanced to the Company $ 100,000 to be used for working capital purposes. On August 17, 2022, the Company transferred the advance from the Sponsor to the second amended and restated promissory note (see Convertible Promissory Note – Related Party below). On October 13, 2022, the Sponsor advanced to the Company $ 200,000 to be used for working capital purposes.\\nRelated Party Extension Loans\\nAs discussed in Note 1, the Company previously extended the period of time to consummate a Business Combination two times, each by an additional three months (to May 17, 2022 to complete a Business Combination). In order to extend the time available for the Company to consummate a Business Combination, the Sponsor or its affiliates or designees deposited into the Trust Account $1,261,860 ($0.10 per Public Share), on or prior to the date of the applicable deadline, for each three-month extension. Payments were made in the form of a non-interest bearing, unsecured promissory note to be paid upon consummation of a Business Combination, or, at the relevant insider’s discretion, converted upon consummation of a Business Combination into additional Private Warrants at a price of $ 1.00 per Private Warrant. The Sponsor and its affiliates or designees are not obligated to fund the Trust Account to extend the time for the Company to complete a Business Combination. On May 12, 2022, the Company held a special meeting of stockholders at which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from May 17, 2022 to August 17, 2022 was approved by stockholders. In order to extend the time available for the Company to consummate a Business Combination, the Sponsor or its affiliates or designees deposited into the Trust Account $ 500,000 . On August 15, 2022, the Company held a special meeting of stockholders at which a proposal to amend the Company’s amended and restated certificate of incorporation, as amended to extend the date by which the Company must consummate a Business Combination from August 17, 2022 to February 17, 2023 was approved by stockholders. In order to extend the time available for the Company to consummate a Business Combination, the Sponsor or its affiliates or designees deposited into the Trust Account $ 360,000 .\\n14\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nConvertible Promissory Note – Related Party\\nOn November 9, 2021, the Company issued a promissory note in the principal amount of $ 1,261,860 to the Sponsor in connection with the Extension (“Convertible Promissory Note”) (as defined below). On February 17, 2022, April 14, 2022 and May 18, 2022, the Company amended and restated the Convertible Promissory Note to increase the principal amount thereunder from $1,261,860 to $3,223,720. On August 17, 2022 the Company amended and restated the Convertible Promissory Note to increase the principal amount thereunder from $3,223,720 to $3,683,720, which included $100,000 advanced by the Sponsor to the Company on April 14, 2022 and the payment of $360,000 for the extension from August 17, 2022 to November 17, 2022. The Note bears no interest and is due and payable upon the earlier to occur of (i) the date on which the Company’s Business Combination is consummated and (ii) the liquidation of the Company on or before February 17, 2023 or such later liquidation date as may be approved by the Company’s stockholders. On August 15, 2022, the Company held a special meeting of stockholders in which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from August 17, 2022 to February 17, 2023 was approved by stockholders. At the election of the Sponsor, up to $ 1,500,000 of the unpaid principal amount of the Note may be converted into warrants of the Company, each warrant exercisable for one share of common stock of the Company upon the consummation of its Business Combination, equal to: (x) the portion of the principal amount of the Note being converted, divided by (y) $ 1.00 , rounded up to the nearest whole number of warrants. As of September 30, 2022, there was a $ 3,683,720 balance outstanding under the Convertible Promissory Note. The Convertible Promissory Note was valued using the fair value method. The fair value of the note as of September 30, 2022, was $ 913,900 , which resulted in a change in fair value of the convertible promissory note of $ 1,113,700 and $ 2,119,960 which was recorded in the statements of operations for the three and nine months ended September 30, 2022, respectively (see Note 9).\\nNOTE 6. COMMITMENTS AND CONTINGENCIES\\nRegistration Rights\\nPursuant to a registration rights agreement entered into on November 12, 2020, the holders of the Founder Shares and Representative Shares (as defined in Notes 5 and 8, respectively), as well as the holders of the Private Warrants (and underlying securities) and any warrants issued in payment of Working Capital Loans made to Company (and underlying securities) will be entitled to registration rights. The holders of a majority of these securities are entitled to make up to two demands that the Company register such securities. The holders of the majority of the Founder Shares can elect to exercise these registration rights at any time commencing three months prior to the date on which these shares of common stock are to be released from escrow. The holders of a majority of the Representative Shares, Private Warrants and warrants issued in payment of working capital loans made to the Company (or underlying securities) can elect to exercise these registration rights at any time after the Company consummates a Business Combination. Notwithstanding anything to the contrary, EarlyBirdCapital may only make a demand on one occasion and only during the five-year period beginning on the effective date of the registration statement of which this prospectus forms a part. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to consummation of a Business Combination; provided, however, that EarlyBirdCapital may participate in a “piggy-back” registration only during the seven-year period beginning on the effective date of the registration statement of which this prospectus forms a part. The registration rights agreement does not contain liquidating damages or other cash settlement provisions resulting from delays in registering the Company’s securities. The Company will bear the expenses incurred in connection with the filing of any such registration statements.\\nUnderwriting Agreement\\nThe Company granted the underwriters a 45-day option from the date of the Initial Public Offering to purchase up to 1,650,000 additional Units to cover over-allotments, if any, at the Initial Public Offering price less the underwriting discounts and commissions. On November 19, 2020, the underwriters partially exercised their over-allotment option to purchase an additional 1,618,600 Units at $ 10.00 per Unit and forfeited the remaining over-allotment option.\\n15\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nBusiness Combination Marketing Agreement\\nThe Company has engaged EarlyBirdCapital as an advisor in connection with a Business Combination to assist the Company in holding meetings with its stockholders to discuss the potential Business Combination and the target business’ attributes, introduce the Company to potential investors that are interested in purchasing the Company’s securities in connection with a Business Combination, assist the Company in obtaining stockholder approval for the Business Combination and assist the Company with its press releases and public filings in connection with the Business Combination. The Company will pay EarlyBirdCapital a cash fee for such services upon the consummation of a Business Combination in an amount equal to 3.5% of the gross proceeds of the Initial Public Offering, or $4,416,510, (exclusive of any applicable finders’ fees which might become payable); provided that up to 30% of the fee may be allocated at the Company’s sole discretion to other FINRA members that assist the Company in identifying and consummating a Business Combination.\\nAdditionally, the Company will pay EarlyBirdCapital a cash fee equal to 1.0 % of the total consideration payable in a Business Combination if EarlyBirdCapital introduces the Company to the target business with which the Company completes a Business Combination.\\nLegal Fee Agreements\\nThe Company has engaged various law firms to provide legal due diligence services and business combination services related to potential target companies. All fees and expenses related to the various engagements will be deferred and are to be paid fully upon the closing of any Business Combination. The law firms will not be entitled to any contingent fees or expense reimbursement if the Company does not consummate a Business Combination within its deadline. Deferred fees of $ 1,371,549 and $ 1,009,868 related to these legal services have been accrued as of September 30, 2022 and December 31, 2021, respectively.\\nTrust Extension\\nOn February 16, 2022, the Company issued a press release announcing that its Sponsor has requested that the Company extend the date by which the Company has to consummate a Business Combination from February 17, 2022 to May 17, 2022 (the “Extension”). The Extension is the second of two three-month extensions permitted under the Company’s governing documents and provides the Company with additional time to complete its Business Combination. On February 18, 2022, the Company issued a press release announcing that the Sponsor had deposited an additional $ 1,261,860 (representing $ 0.10 per public share) into the Trust Account for its public stockholders. On May 12, 2022, the Company held a special meeting of stockholders in which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from May 17, 2022 to August 17, 2022 was approved by the stockholders. In connection with this extension, the Company deposited $ 500,000 into the Trust Account on May 18, 2022. In connection with the extension amendment, stockholders holding approximately 5,586,910 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $ 10.30 per share. On August 15, 2022, the Company held a special meeting of stockholders in which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from August 17, 2022 to February 17, 2023 was approved by the stockholders. In connection with this extension, the Company deposited $ 360,000 into the Trust Account on August 17, 2022. In connection with the extension amendment, stockholders holding approximately 2,818,237 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $ 10.37 per share.\\nOn November 16, 2021, the Company had previously issued a promissory note (the “Note”) in the principal amount of $ 1,261,860 to the Company’s Sponsor. On February 17, 2022, April 14, 2022, May 18, 2022, and August 17, 2022, the Company amended and restated the Note in its entirety to increase the principal amount thereunder from $1,262,860 to $3,683,720.\\nNOTE 7. STOCKHOLDERS’ DEFICIT\\nPreferred Stock — The Company is authorized to issue 1,000,000 shares of preferred stock with a par value of $ 0.0001 per share with such designations, voting and other rights and preferences as may be determined from time to time by the Company’s board of directors. At September 30, 2022 and December 31, 2021, respectively, there were no shares of preferred stock issued or outstanding.\\nCommon Stock — The Company is authorized to issue 50,000,000 shares of common stock with a par value of $ 0.0001 per share. At September 30, 2022 and December 31, 2021, there were 3,487,070 shares of common stock issued and outstanding, excluding 4,213,453 and 12,618,600 shares of common stock subject to possible redemption, respectively, which are presented as temporary equity. In connection with the extension on May 12, 2022, stockholders holding 5,586,910 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $ 10.30 per share. In connection with the extension on August 17, 2022, stockholders holding 2,818,237 shares of the Company’s redeemable stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $ 10.37 per share.\\n16\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nNOTE 8. WARRANTS\\nThe Public Warrants will become exercisable on the later of (a) 30 days after the completion of a Business Combination or (b) 12 months from the closing of the Initial Public Offering. No warrants will be exercisable for cash unless the Company has an effective and current registration statement covering the shares of common stock issuable upon exercise of the warrants and a current prospectus relating to such shares of common stock. Notwithstanding the foregoing, if a registration statement covering the shares of common stock issuable upon exercise of the Public Warrants is not effective within a specified period following the consummation of a Business Combination, warrant holders may, until such time as there is an effective registration statement and during any period when the Company shall have failed to maintain an effective registration statement, exercise warrants on a cashless basis pursuant to the exemption provided by Section 3(a)(9) of the Securities Act, provided that such exemption is available. If that exemption, or another exemption, is not available, holders will not be able to exercise their warrants on a cashless basis. The Public Warrants will expire five years after the completion of a Business Combination or earlier upon redemption or liquidation.\\nThe Company may redeem the Public Warrants (excluding the Private Warrants and any warrants underlying units issued upon conversion of the Working Capital Loans):\\n\\n| ● | in whole and not in part; |\\n| ● | at a price of $0.01 per warrant; |\\n| ● | upon not less than 30 days’ prior written notice of redemption to each warrant holder; and |\\n| ● | if, and only if, the last reported sale price of the common stock equals or exceeds $18.00 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations and the like), for any 20 trading days within a 30 trading day period ending on the third trading day prior to the date on which the Company sends the notice of redemption to the warrant holders. |\\n\\nIf the Company calls the Public Warrants for redemption, management will have the option to require all holders that wish to exercise the Public Warrants to do so on a “cashless basis,” as described in the warrant agreement. The exercise price and number of shares of common stock issuable upon exercise of the warrants may be adjusted in certain circumstances including in the event of a stock dividend, or recapitalization, reorganization, merger or consolidation. However, except as described below, the warrants will not be adjusted for issuance of common stock at a price below its exercise price. Additionally, in no event will the Company be required to net cash settle the warrants. If the Company is unable to complete a Business Combination within the Combination Period and the Company liquidates the funds held in the Trust Account, holders of warrants will not receive any of such funds with respect to their warrants, nor will they receive any distribution from the Company’s assets held outside of the Trust Account with the respect to such warrants. Accordingly, the warrants may expire worthless.\\nIn addition, if (x) the Company issues additional common stock or equity-linked securities for capital raising purposes in connection with the closing of a Business Combination at an issue price or effective issue price of less than $9.20 per common stock (with such issue price or effective issue price to be determined in good faith by the Company’s board of directors and, in the case of any such issuance to the Sponsor or its affiliates, without taking into account any Founder Shares held by the Sponsor or such affiliates, as applicable, prior to such issuance), (y) the aggregate gross proceeds from such issuances represent more than 60% of the total equity proceeds, and interest thereon, available for the funding of a Business Combination on the date of the consummation of a Business Combination (net of redemptions), and (z) the volume weighted average trading price of its common stock during the 20 trading day period starting on the trading day prior to the day on which the Company consummates its Business Combination (such price, the “Market Value”) is below $9.20 per share, the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115% of the greater of (i) Market Value or (ii) the price at which the Company issue the additional shares of common stock or equity-linked securities.\\nThe Private Warrants are identical to the Public Warrants underlying the Units sold in the Initial Public Offering, except that the Private Warrants and the shares of common stock issuable upon the exercise of the Private Warrants will not be transferable, assignable or saleable until after the completion of a Business Combination, subject to certain limited exceptions. Additionally, the Private Warrants will be exercisable for cash or on a cashless basis, at the holder’s option, and be non-redeemable so long as they are held by the initial purchasers or their permitted transferees. If the Private Warrants are held by someone other than the initial purchasers or their permitted transferees, the Private Warrants will be redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants.\\n17\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nRepresentative Shares\\nOn August 5, 2020, the Company issued to EarlyBirdCapital 377,750 shares of common stock (the “Representative Shares”). On November 9, 2020, EarlyBirdCapital returned to the Company for cancellation, at no cost, an aggregate of 75,550 Representative Shares, resulting in an aggregate of 302,200 Representative Shares outstanding and held by EarlyBirdCapital. On November 12, 2020, the Company effected a stock dividend of 0.1 shares for each share of common stock outstanding, resulting in EarlyBirdCapital holding an aggregate of 332,420 Representative Shares. The Company accounted for the Representative Shares as an offering cost of the Initial Public Offering, with a corresponding credit to stockholders’ equity. The Company estimated the fair value of Representative Shares to be $ 2,666 based upon the price of the Founder Shares issued to the Sponsor. The holders of the Representative Shares have agreed not to transfer, assign or sell any such shares until the completion of a Business Combination. In addition, the holders have agreed (i) to waive their redemption rights with respect to such shares in connection with the completion of a Business Combination and (ii) to waive their rights to liquidating distributions from the Trust Account with respect to such shares if the Company fails to complete a Business Combination within the Combination Period.\\nThe Representative Shares have been deemed compensation by FINRA and are therefore subject to a lock-up for a period of 180 days immediately following the effective date of the registration statement related to the Initial Public Offering pursuant to Rule 5110(g)(1) of FINRA’s NASD Conduct Rules. Pursuant to FINRA Rule 5110(g)(1), these securities will not be sold during the Initial Public Offering, or sold, transferred, assigned, pledged, or hypothecated, or be the subject of any hedging, short sale, derivative, put or call transaction that would result in the economic disposition of the securities by any person for a period of 180 days immediately following the effective date of the Initial Public Offering, except to any underwriter and selected dealer participating in the Initial Public Offering and their bona fide officers or partners, provided that all securities so transferred remain subject to the lockup restriction above for the remainder of the time period.\\nNOTE 9. FAIR VALUE MEASUREMENTS\\nThe Company follows the guidance in ASC 820 for its financial assets and liabilities that are re-measured and reported at fair value at each reporting period, and non-financial assets and liabilities that are re-measured and reported at fair value at least annually.\\nThe fair value of the Company’s financial assets and liabilities reflects management’s estimate of amounts that the Company would have received in connection with the sale of the assets or paid in connection with the transfer of the liabilities in an orderly transaction between market participants at the measurement date. In connection with measuring the fair value of its assets and liabilities, the Company seeks to maximize the use of observable inputs (market data obtained from independent sources) and to minimize the use of unobservable inputs (internal assumptions about how market participants would price assets and liabilities). The following fair value hierarchy is used to classify assets and liabilities based on the observable inputs and unobservable inputs used in order to value the assets and liabilities:\\n\\n| Level 1: | Quoted prices in active markets for identical assets or liabilities. An active market for an asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. |\\n| Level 2: | Observable inputs other than Level 1 inputs. Examples of Level 2 inputs include quoted prices in active markets for similar assets or liabilities and quoted prices for identical assets or liabilities in markets that are not active. |\\n| Level 3: | Unobservable inputs based on our assessment of the assumptions that market participants would use in pricing the asset or liability. |\\n\\nThe following table presents information about the Company’s assets that are measured at fair value on a recurring basis at September 30, 2022 and December 31, 2021, respectively, and indicates the fair value hierarchy of the valuation inputs the Company utilized to determine such fair value:\\n\\n| Description | Level | September, 2022 | December 31, 2021 |\\n| Assets: |\\n| Marketable securities held in Trust Account | 1 | $ | 44,203,481 | $ | 128,790,008 |\\n| Liabilities: |\\n| Warrant liabilities – Private Warrants | 3 | $ | 422,846 | $ | 2,641,204 |\\n| Convertible promissory note – related party | 3 | $ | 913,900 | $ | 958,400 |\\n\\n18\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nWarrant Liabilities\\nThe Private Warrants were accounted for as liabilities in accordance with ASC 815-40 and are presented within warrant liabilities on the condensed balance sheets. The warrant liabilities are measured at fair value at inception and on a recurring basis, with changes in fair value presented within change in fair value of warrant liabilities in the condensed statements of operations.\\nThe Private Warrants were valued using a binomial lattice model. The Company allocated the proceeds received from (i) the sale of Units (which is inclusive of one share of common stock and one Public Warrant) and (ii) the sale of Private Warrants, first to the warrants based on their fair values as determined at initial measurement, with the remaining proceeds allocated to common stock subject to possible redemption. The Private Warrants were classified as Level 3 at the initial measurement date due to the use of unobservable inputs.\\nThe following are the inputs used by the Company in establishing the fair value of its Private Warrants at September 30, 2022 and December 31, 2021.\\n\\n| Input | September 30, 2022 | December 31, 2021 |\\n| Risk-free interest rate | 4.07 | % | 1.15 | % |\\n| Trading days per year | 252 | 252 |\\n| Expected volatility | 5.3 | % | 9.6 | % |\\n| Exercise price | $ | 11.50 | $ | 11.50 |\\n| Stock Price | $ | 10.35 | $ | 10.17 |\\n\\nOn December 31, 2021 and September 30, 2022, the Private Warrants were determined to be $ 0.50 per warrant and $ 0.08 per warrant, respectively, for an aggregate value of $ 2.64 million and $ 0.4 million, respectively.\\nThe following table presents the changes in the fair value of the warrant liabilities:\\n\\n| Private Placement |\\n| Fair value as of December 31, 2021 | $ | 2,641,204 |\\n| Change in valuation inputs or other assumptions | ( 1,744,591 | ) |\\n| Fair value as of March 31, 2022 | $ | 896,613 |\\n| Change in valuation inputs or other assumptions | ( 579,785 | ) |\\n| Fair value as of June 30, 2022 | $ | 316,828 |\\n| Change in valuation inputs or other assumptions | 106,018 |\\n| Fair value as of September 30, 2022 | $ | 422,846 |\\n\\n19\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nConvertible Promissory Note – Related Party\\nThe fair value of the option to convert the convertible promissory note into Private Warrants was valued by utilizing a binomial lattice model incorporating the Cox-Ross-Rubenstein methodology.\\nThe estimated fair value of the convertible promissory note was based on the following significant inputs:\\n\\n| September 30, 2022 |\\n| Risk-free interest rate | 0.00 | % |\\n| Time to Expiration (in years) | 1.38 |\\n| Expected volatility | 5.3 | % |\\n| Exercise price | $ | 11.50 |\\n| Dividend yield | 0.00 | % |\\n| Stock Price | $ | 10.35 |\\n| Probability of transaction | 25.00 | % |\\n\\nThe following table presents the changes in the fair value of the Level 3 convertible promissory note:\\n\\n| Fair value as of January 1, 2021 | $ | 958,400 |\\n| Proceeds received through Convertible Promissory Note | 1,261,860 |\\n| Change in fair value | ( 337,260 | ) |\\n| Fair value as of March 31, 2022 | $ | 1,883,000 |\\n| Proceeds received through Convertible Promissory Note | 700,000 |\\n| Change in fair value | ( 669,000 | ) |\\n| Fair value as of June 30, 2022 | $ | 1,914,000 |\\n| Conversion of Sponsor advance to Convertible Promissory Note | 100,000 |\\n| Proceeds received through Convertible Promissory Note | 360,000 |\\n| Change in fair value | ( 1,460,100 | ) |\\n| Fair value as of September 30, 2022 | 913,900 |\\n\\nThere were no transfers in or out of Level 3 from other levels in the fair value hierarchy during the three and nine months ended September 30, 2022 for the convertible promissory note.\\nNOTE 10. SUBSEQUENT EVENTS\\nThe Company evaluated subsequent events and transactions that occurred after the balance sheet date up to the date that the financial statements were issued. Based upon this review the Company did not identify any subsequent events that would have required adjustment or disclosure in the condensed financial statements.\\n20\\n\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\\nReferences in this report (the “Quarterly Report”) to “we,” “us,” “our” or the “Company” refer to Better World Acquisition Corp. References to our “management” or our “management team” refer to our officers and directors, and references to the “Sponsor” refer to BWA Holdings LLC. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Quarterly Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\\nSpecial Note Regarding Forward-Looking Statements\\nThis Quarterly Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Exchange Act that are not historical facts and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. All statements, other than statements of historical fact included in this Form 10-Q including, without limitation, statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. Words such as “expect,” “believe,” “anticipate,” “intend,” “estimate,” “seek” and variations and similar words and expressions are intended to identify such forward-looking statements. Such forward-looking statements relate to future events or future performance, but reflect management’s current beliefs, based on information currently available. A number of factors could cause actual events, performance or results to differ materially from the events, performance and results discussed in the forward-looking statements. For information identifying important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements, please refer to the Risk Factors section of the Company’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission (the “SEC”) on March 31, 2022 and in our Quarterly Reports on Form 10-Q for the period ended March 31, 2022 and June 30, 2022, filed with the SEC on May 13, 2022 and August 3, 2022, respectively.\\nOverview\\nWe are a blank check company formed under the laws of the State of Delaware on August 5, 2020 for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities (an “initial business combination”). We intend to effectuate our initial business combination using cash from the proceeds of the Initial Public Offering and the sale of the Private Warrants, our capital stock, debt or a combination of cash, stock and debt.\\nWe expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete a business combination will be successful.\\n21\\nResults of Operations\\nWe have neither engaged in any operations nor generated any revenues to date. Our only activities from August 5, 2020 (inception) through September 30, 2022 were organizational activities, those necessary to prepare for the Initial Public Offering, described below, and identifying a target company for a business combination. We do not expect to generate any operating revenues until after the completion of our business combination. We generate non-operating income in the form of interest income on marketable securities held in the Trust Account. We incur expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence and transaction expenses.\\nFor the three months ended September 30, 2022, we had net income of $844,154 which consists of the change in fair value of convertible promissory note – related party of $1,113,700, interest earned on marketable securities held in the Trust Account of $254,709 and unrealized gain on marketable securities held in the Trust Account of $1,078, offset by change in fair value of warrant liability of $106,018, a provision for income taxes of $23,249 and operational costs of $396,066.\\nFor the nine months ended September 30, 2022, we had net income of $3,407,252 which consists of the change in fair value of warrant liability of $2,218,358, change in fair value of convertible promissory note – related party of $2,119,960, and interest earned on marketable securities held in the Trust Account of $423,734, offset by provision for income taxes of $27,528 and operational costs of $1,327,272.\\nFor the three months ended September 30, 2021, we had net income of $1,475,730 which consists of the change in fair value of warrant liability of $2,192,941 and interest earned on marketable securities held in the Trust Account of $23,138, and unrealized loss on marketable securities held in the Trust Account of $4,654, offset by formation and operational costs of $735,695.\\nFor the nine months ended September 30, 2021, we had net income of $2,207,258, which consists of the change in fair value of warrant liability of $3,302,913 and interest earned on marketable securities held in the Trust Account of $58,976, and unrealized loss on marketable securities held in the Trust Account of $5,829, offset by formation and operational costs of $1,148,802.\\nLiquidity and Capital Resources\\nOn November 17, 2020, we consummated the Initial Public Offering of 11,000,000 units, at $10.00 per Unit, generating gross proceeds of $110,000,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of 4,800,000 Private Warrants at a price of $1.00 per Private Warrant in a private placement to our Sponsor and EarlyBirdCapital, Inc. generating gross proceeds of $4,800,000.\\nOn November 19, 2020, in connection with the underwriters’ partial exercise of their over-allotment option, we consummated the sale of an additional 1,618,600 units at a price of $10.00 per unit, generating total gross proceeds of $16,186,000. In addition, we also consummated the sale of an additional 485,580 private placement warrants at $1.00 per private placement warrant, generating total gross proceeds of $485,580.\\nFollowing the initial public offering, the partial exercise of the over-allotment option, and the sale of the private placement warrants, $111,100,000 was placed in the trust account on November 18, 2020 and $16,347,860 was placed in the Trust Account on November 20, 2020, respectively, for a total of $127,447,860. We incurred $2,880,354 in the initial public offering related costs, including $2,523,720 of underwriting fees and $356,634 of other costs.\\nFor the nine months ended September 30, 2022, cash used in operating activities was $853,148. Net income of $3,407,252 was affected by the change in fair value of warrant liability of $2,218,358, change in fair value of convertible promissory note – related party of $2,119,960 and interest earned on marketable securities held in the Trust Account of $423,734. Changes in operating assets and liabilities provided $501,652 of cash for operating activities.\\nFor the nine months ended September 30, 2021, cash used in operating activities was $528,273. Net income of $2,207,258 was affected by the change in fair value of warrant liability of $3,302,913, interest earned on marketable securities held in the Trust Account of $58,976, and an unrealized loss on marketable securities held in our Trust Account of $5,829. Changes in operating assets and liabilities provided $620,529 of cash for operating activities.\\nAs of September 30, 2022, in the U.S.-based trust account maintained by Continental Stock Transfer & Trust Company, acting as trustee, we had cash held of $947 and marketable securities held in the Trust Account of $44,202,534 (including approximately $145,311 of interest income) consisting of securities held in a money market fund that invests in U.S. Treasury securities with a maturity of 180 days or less. Interest income on the balance in the trust account may be used by us to pay taxes. In connection with the extension on May 12, 2022, stockholders holding 5,586,910 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $10.30 per share. In connection with the extension on August 15, 2022, stockholders holding 2,818,237 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds on the Trust Account at a redemption price of approximately $10.37 per share. Through September 30, 2022, we have withdrawn $358,711 of interest earned on the trust account to pay our taxes.\\n22\\nWe intend to use substantially all of the funds held in the trust account, to acquire a target business and to pay our expenses relating thereto upon consummation of our initial business combination for assisting us in connection with our initial business combination. To the extent that our capital stock is used in whole or in part as consideration to effect an initial business combination, the remaining funds held in the trust account will be used as working capital to finance the operations of the target business. Such working capital funds could be used in a variety of ways including continuing or expanding the target business’ operations, for strategic acquisitions and for marketing, research and development of existing or new products. Such funds could also be used to repay any operating expenses or finders’ fees which we had incurred prior to the completion of our initial business combination if the funds available to us outside of the trust account were insufficient to cover such expenses.\\nAs of September 30, 2022, we had cash of $83,760 held outside the trust account. We intend to use the funds held outside the trust account for identifying and evaluating prospective acquisition candidates, performing business due diligence on prospective target businesses, traveling to and from the offices, plants or similar locations of prospective target businesses, reviewing corporate documents and material agreements of prospective target businesses, selecting the target business to acquire and structuring, negotiating and consummating the initial business combination.\\nIn order to fund working capital deficiencies or finance transaction costs in connection with an initial business combination, the insiders, or certain of our officers and directors or their affiliates may, but are not obligated to, loan us funds as may be required. If we complete our initial business combination, we would repay such loaned amounts. In the event that our initial business combination does not close, we may use a portion of the working capital held outside the trust account to repay such loaned amounts but no proceeds from our trust account would be used for such repayment. Up to $1,500,000 of such loans may be convertible into warrants, at a price of $1.00 per warrant, at the option of the lender. The units would be identical to the private placement warrants. On November 9, 2021, we issued a promissory note in the principal amount of $1,261,860 to the Sponsor in connection with the Extension (“Convertible Promissory Note”) (as defined below). On February 17, 2022, April 14, 2022, May 18, 2022, and August 17, 2022, we amended and restated the Convertible Promissory Note to increase the principal amount thereunder from $1,261,860 to $3,683,720. The Note bears no interest and is due and payable upon the earlier to occur of (i) the date on which the Company’s Business Combination is consummated and (ii) the liquidation of the Company on or before February 17, 2023 or such later liquidation date as may be approved by the Company’s stockholders. At the election of the Sponsor, up to $1,500,000 of the unpaid principal amount of the Convertible Promissory Note may be converted into warrants of the Company, each warrant exercisable for one share of common stock of the Company upon the consummation of its Business Combination, equal to: (x) the portion of the principal amount of the Note being converted, divided by (y) $1.00, rounded up to the nearest whole number of warrants.\\nWe expect that we will need to raise additional capital through loans or additional investments from our sponsor, stockholders, officers, directors, or third parties. Our officers, directors and sponsor may, but are not obligated to, loan us funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet our working capital needs. Accordingly, we may not be able to obtain additional financing. If we are unable to raise additional capital, we may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, and reducing overhead expenses. We cannot provide any assurance that new financing will be available to us on commercially acceptable terms, if at all.\\nIn connection with the Company’s assessment of going concern considerations in accordance with Financial Accounting Standard Board’s Accounting Standards Update (“ASU”) 2014-15, “Disclosures of Uncertainties about an Entity’s Ability to Continue as a Going Concern,” the Company has until February 17, 2023 to consummate a Business Combination. It is uncertain that the Company will be able to consummate a Business Combination by this time. If a Business Combination is not consummated by this date and an extension has not been requested by the Sponsor and approved by the Company’s stockholders, there will be a mandatory liquidation and subsequent dissolution of the Company. Management has determined that the liquidity condition and the mandatory liquidation and potential subsequent dissolution raises substantial doubt about the Company’s ability to continue as a going concern. No adjustments have been made to the carrying amounts of assets or liabilities should the Company be required to liquidate after February 17, 2023. The Company intends to continue to search for and seek to complete a Business Combination before the mandatory liquidation date. The Company is within 12 months of its mandatory liquidation date as of the time of filing of this Quarterly Report on Form 10-Q.\\nOff-Balance Sheet Financing Arrangements\\nWe have no obligations, assets or liabilities, which would be considered off-balance sheet arrangements as of September 30, 2022. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets.\\n23\\nContractual Obligations\\nWe have agreed, commencing on November 12, 2020 through the earlier of our consummation of an initial business combination and our liquidation, to pay an affiliate of our management a total of $10,000 per month for office space, utilities and secretarial support. For the three and nine months ended September 30, 2022, the Company incurred and accrued $30,000 and $90,000 in fees for these services, respectively, and those fees are included in accounts payable and accrued expenses in the accompanying condensed balance sheets. For the three and nine months ended September 30, 2021, the Company incurred and paid $30,000 and $90,000 in fees for these services.\\nWe granted the underwriters a 45-day option from the date of the initial public offering to purchase up to 1,650,000 additional units to cover over-allotments, if any, at the initial public offering price less the underwriting discounts and commissions. On November 19, 2020, the underwriters partially exercised their over-allotment option to purchase an additional 1,618,600 units at $10.00 per unit and forfeited the remaining over-allotment option.\\nWe have engaged EarlyBirdCapital as an advisor in connection with an initial business combination to assist us in holding meetings with its stockholders to discuss the potential initial business combination and the target business’ attributes, introduce us to potential investors that are interested in purchasing our securities in connection with an initial business combination, assist us in obtaining stockholder approval for the initial business combination and assist us with our press releases and public filings in connection with the initial business combination. We will pay EarlyBirdCapital a cash fee for such services upon the consummation of an initial business combination in an amount equal to 3.5% of the gross proceeds of the initial public offering, or $4,416,510 (exclusive of any applicable finders’ fees which might become payable); provided that up to 30% of the fee may be allocated at our sole discretion to other FINRA members that assist us in identifying and consummating an initial business combination.\\nAdditionally, we will pay EarlyBirdCapital a cash fee equal to 1.0% of the total consideration payable in an initial business combination if EarlyBirdCapital introduces us to the target business with which we complete an initial business combination.\\nWe have engaged various law firms to provide legal due diligence services and business combination services related to potential target companies. All fees and expenses related to the various engagements will be deferred and are to be paid fully upon the closing of any business combination. The law firms will not be entitled to any contingent fees or expense reimbursement if we do not consummate an initial business combination within our deadline. Deferred fees of $1,371,549 and $1,009,868 related to these legal services have been accrued as of September 30, 2022 and December 31, 2021, respectively.\\nCritical Accounting Policies\\nThe preparation of condensed financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have identified the following critical accounting policies:\\nWarrant Liability\\nThe Company accounts for the Private Warrants in accordance with the guidance contained in ASC 815-40-15-7D and 7F under which the Private Warrants do not meet the criteria for equity treatment and must be recorded as liabilities. Accordingly, the Company classifies the Private Warrants as liabilities at their fair value and adjusts the Private Warrants to fair value at each reporting period. This liability is subject to re-measurement at each balance sheet date until exercised, and any change in fair value is recognized in our statements of operations. The Private Warrants for periods where no observable traded price was available are valued using a binomial lattice simulation model.\\n24\\nConvertible Promissory Note\\nWe account for our convertible promissory note under ASC 815, Derivatives and Hedging (“ASC 815”). Under 815-15-25, the election can be at the inception of a financial instrument to account for the instrument under the fair value option under ASC 825. We have made such election for our convertible promissory note. Using fair value option, the convertible promissory note is required to be recorded at its initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of the note are recognized as non-cash change in the fair value of the convertible promissory note in the statements of operations. The fair value of the option to convert the convertible promissory note into private placement warrants was valued by utilizing a binomial lattice model incorporating the Cox-Ross-Rubenstein methodology.\\nCommon Stock Subject to Possible Redemption\\nWe account for our common stock subject to possible conversion in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption is classified as a liability instrument and measured at fair value. Conditionally redeemable common stock (including common stock that features redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. Our common stock features certain redemption rights that are considered to be outside of our control and subject to occurrence of uncertain future events. Accordingly, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders’ deficit section of our condensed balance sheets.\\nNet Income per Common Share\\nNet income per common share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Accretion associated with the redeemable shares of common stock is excluded from net income per common share as the redemption value approximates fair value.\\nRecent Accounting Standards\\nIn August 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2020-06, “Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity” (“ASU 2020-06”), which simplifies accounting for convertible instruments by removing major separation models required under current GAAP. ASU 2020-06 removes certain settlement conditions that are required for equity contracts to qualify for the derivative scope exception, and it also simplifies the diluted earnings per share calculation in certain areas. ASU 2020-06 is effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years, with early adoption permitted. The Company assessed the potential impact of ASU 2020-06 and determined that it would not have a material impact on the condensed financial statements as presented.\\nManagement does not believe that any other recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on our condensed financial statements.\\nFactors That May Adversely Affect Our Results of Operations\\nOur results of operation and our ability to complete an initial business combination may be adversely affected by various factors that could cause economic uncertainty and volatility in the financial markets, many of which are beyond our control. Our business could be impacted by, among other things, volatility in the financial markets or economic conditions, increase of oil price and interest rate, inflation, supply chain disruption, decline in consumer confidence and spending, the on-going effects of the COVID-19 pandemic, including resurgences and the emergence of new variants, and geopolitical instability, such as the military conflict in Ukraine. We cannot at this time fully predict one or more of the above events, their duration or magnitude of, or the extent to, which they may negatively impact our business and our ability to complete an initial business combination.\\n25\\n\\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\\nNot required for smaller reporting companies.\\n\\nItem 4. Controls and Procedures\\nEvaluation of Disclosure Controls and Procedures\\nDisclosure controls and procedures are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Exchange Act is recorded, processed, summarized, and reported within the time period specified in the SEC’s rules and forms. Disclosure controls and procedures are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.\\nAs required by Rule 13a-15 under the Exchange Act, our Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of our disclosure controls and procedures as of September 30, 2022. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were not effective, due solely to the material weakness in our internal control over financial reporting related to our accounting for complex financial instruments. As a result, we performed additional analysis as deemed necessary to ensure that our financial statements were prepared in accordance with GAAP. Accordingly, management believes that the financial statements included in this Report present fairly in all material respects our financial position, results of operations and cash flows for the period presented.\\nManagement has identified a material weakness in our internal controls related to the accounting for complex financial instruments. While we have processes to identify and appropriately apply applicable accounting requirements, we plan to continue to enhance our system of evaluating and implementing the accounting standards that apply to our financial statements, including through enhanced analyses by our personnel and third-party professionals with whom we consult regarding complex accounting applications. The elements of our remediation plan can only be accomplished over time, and we can offer no assurance that these initiatives will ultimately have the intended effects.\\nManagement has implemented remediation steps to improve our internal control over financial reporting. Specifically, we expanded and improved our review process for complex securities and related accounting standards. We plan to further improve this process by enhancing access to accounting literature, identification of third-party professionals with whom to consult regarding complex accounting applications and consideration of additional staff with the requisite experience and training to supplement existing accounting professionals.\\nChanges in Internal Control over Financial Reporting\\nThere were no changes in our internal control over financial reporting during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\n26\\nPART II - OTHER INFORMATION\\n\\nItem 1. Legal Proceedings.\\nTo the knowledge of our management team, there is no litigation currently pending or contemplated against us, any of our officers or directors in their capacity as such or against any of our property.\\n\\nItem 1A. Risk Factors\\nAs of the date of this Quarterly Report on Form 10-Q, except as disclosed below, there have been no material changes to the risk factors previously disclosed in our final prospectus filed with the SEC on November 17, 2020 , in our Annual Report on Form 10-K for the year ended December 31, 2021 filed with the SEC on March 31, 2022 and in our Quarterly Reports on Form 10-Q for the period ended March 31, 2022 and June 30, 2022, filed with the SEC on May 13, 2022 and August 3, 2022, respectively. Any of these factors could result in a significant or material adverse effect on our results of operations or financial condition. Additional risk factors not presently known to us or that we currently deem immaterial may also impair our business or results of operations. We may disclose changes to such risk factors or disclose additional risk factors from time to time in our future filings with the SEC.\\nA new 1% U.S. federal excise tax could be imposed on us in connection with redemptions of our shares in connection with a business combination or other stockholder vote pursuant to which stockholders would have a right to submit their shares for redemption (a “Redemption Event”).\\nOn August 16, 2022, the Inflation Reduction Act of 2022 (the “IR Act”) was signed into federal law. The IR Act provides for, among other things, a new U.S. federal 1% excise tax on certain repurchases (including redemptions) of stock by publicly traded domestic corporations and certain domestic subsidiaries of publicly traded foreign corporations. The excise tax is imposed on the repurchasing corporation itself, not its stockholders from whom shares are repurchased. The amount of the excise tax is generally 1% of the fair market value of the shares repurchased at the time of the repurchase. However, for purposes of calculating the excise tax, repurchasing corporations are permitted to net the fair market value of certain new stock issuances against the fair market value of stock repurchases during the same taxable year. In addition, certain exceptions apply to the excise tax. The U.S. Department of the Treasury has been given authority to provide regulations and other guidance to carry out and prevent the abuse or avoidance of the excise tax. The IR Act applies only to repurchases that occur after December 31, 2022.\\nAny redemption or other repurchase that occurs after December 31, 2022, in connection with a Redemption Event may be subject to the excise tax. Whether and to what extent we would be subject to the excise tax in connection with a Redemption Event would depend on a number of factors, including (i) the fair market value of the redemptions and repurchases in connection with the Redemption Event, (ii) the structure of the business combination, (iii) the nature and amount of any “PIPE” or other equity issuances in connection with the business combination (or otherwise issued not in connection with the Redemption Event but issued within the same taxable year of the business combination) and (iv) the content of regulations and other guidance from the U.S. Department of the Treasury. In addition, because the excise tax would be payable by us, and not by the redeeming holder, the mechanics of any required payment of the excise tax have not been determined. The foregoing could cause a reduction in the cash available on hand to complete a business combination and in our ability to complete a business combination.\\nTo mitigate the risk that we might be deemed to be an investment company for purposes of the Investment Company Act, we expect to instruct the trustee to liquidate the securities held in our trust account and instead to hold the funds in our trust account in cash items until the earlier of the consummation of our initial business combination or our liquidation. As a result, we will likely receive minimal interest, if any, on the funds held in the trust account, which will likely reduce the dollar amount our public stockholders would receive upon any redemption or liquidation of the Company.\\nThe funds in our trust account have, since our initial public offering, been held only in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds investing solely in U.S. government treasury obligations and meeting certain conditions under Rule 2a-7 under the Investment Company Act. However, to mitigate the risk of us being deemed to be an unregistered investment company (including under the subjective test of Section 3(a)(1)(A) of the Investment Company Act) and thus subject to regulation under the Investment Company Act, we expect to instruct Continental Stock Transfer & Trust Company, the trustee with respect to our trust account, to liquidate the U.S. government treasury obligations and money market funds held in the trust account and to hold all funds in the trust account as cash items until the earlier of the consummation of our initial business combination or the liquidation of the Company. Following such liquidation, we will likely receive minimal interest, if any, on the funds held in the trust account. However, interest previously earned on the funds held in the trust account still may be released to us to pay our taxes, if any. This will likely reduce the dollar amount our public stockholders would receive upon any redemption or liquidation of the Company. In the event that we may be deemed to be an investment company, we may be required to liquidate the Company.\\n27\\n\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\\nNone.\\n\\nItem 3. Defaults Upon Senior Securities\\nNone.\\n\\nItem 4. Mine Safety Disclosures\\nNone.\\n\\nItem 5. Other Information\\nNone.\\n28\\n\\nItem 6. Exhibits\\nThe following exhibits are filed as part of, or incorporated by reference into, this Quarterly Report on Form 10-Q.\\n\\n| No. | Description of Exhibit |\\n| 3.1 | Second Amendment to the Amended and Restated Certificate of Incorporation, as amended (Incorporated by reference to the Company’s Form 8-K filed on August 17, 2022) |\\n| 10.1 | Third Amended and Restated Promissory Note, dated August 17, 2022 (Incorporated by reference to the Company’s Form 8-K filed on August 17, 2022) |\\n| 31.1* | Certification of Principal Executive Officer Pursuant to Securities Exchange Act Rules 13a-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 31.2* | Certification of Principal Financial Officer Pursuant to Securities Exchange Act Rules 13a-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 32.1** | Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 32.2** | Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 101.INS* | Inline XBRL Instance Document |\\n| 101.SCH* | Inline XBRL Taxonomy Extension Schema Document |\\n| 101.CAL* | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\\n| 101.DEF* | Inline XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101.LAB* | Inline XBRL Taxonomy Extension Labels Linkbase Document |\\n| 101.PRE* | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\\n| 104* | Cover Page Interactive Data File |\\n\\n\\n| * | Filed herewith. |\\n| ** | Furnished herewith. |\\n\\n29\\nSIGNATURES\\nIn accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\n\\n| BETTER WORLD ACQUISITION CORP. |\\n| Date: November 14, 2022 | By: | /s/ Rosemary L. Ripley |\\n| Name: | Rosemary L. Ripley |\\n| Title: | Chief Executive Officer |\\n| (Principal Executive Officer) |\\n| Date: November 14, 2022 | By: | /s/ Peter S.H. Grubstein |\\n| Name: | Peter S.H. Grubstein |\\n| Title: | Chief Financial Officer |\\n| (Principal Financial Officer) |\\n\\n30\\n\\n \\n\\nWhat's the estimated worth of the company Better World Acquisition Corp. at the end of Q4 in 2022 if the company continues to follow the same trend as it did in the first three quarters of 2022, in millions of dollars?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is -0.10797933333333326.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 59,\n \"input_length\": 29244\n}"}}},{"rowIdx":60,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nBusiness\nOrganization\nSotherly Hotels Inc. (the “Company”) is a self-managed and self-administered lodging real estate investment trust, or REIT, that was formed in August 2004 to own, acquire, renovate and reposition full-service, primarily upscale and upper-upscale hotel properties located in primary markets in the mid-Atlantic and southern United States. On December 21, 2004, the Company successfully completed its initial public offering and elected to be treated as a self-advised REIT for federal income tax purposes. The Company conducts its business through Sotherly Hotels LP, its operating partnership (the “Operating Partnership”), of which the Company is the general partner. The Company owns approximately 89.1% of the partnership units in the Operating Partnership. Limited partners (including certain of the Company’s officers and directors) own the remaining Operating Partnership units.\nAs of December 31, 2016, our portfolio consisted of twelve full-service, primarily upscale and upper-upscale hotels located in eight states with an aggregate total of 3,011 rooms and approximately 160,928 square feet of meeting space. All of our hotels are wholly-owned by subsidiaries of the Operating Partnership, and all are managed on a day to day basis by MHI Hotels Services, LLC, which does business as Chesapeake Hospitality (“Chesapeake Hospitality”).\nIn order for the Company to qualify as a REIT, it cannot directly manage or operate our wholly-owned hotels. Therefore, we lease our wholly-owned hotel properties to entities that we refer to as our TRS Lessees, which in turn have engaged Chesapeake Hospitality, an eligible independent management company, to manage our hotels. Our TRS Lessees are wholly-owned subsidiaries of MHI Hospitality TRS Holding, Inc. (“MHI Holding”, and collectively, “MHI TRS”). MHI TRS is a taxable REIT subsidiary for federal income tax purposes.\nOur corporate office is located at 410 West Francis Street, Williamsburg, Virginia 23185. Our telephone number is (757) 229-5648.\nOur Properties\nAs of December 31, 2016, our hotels were located in Florida, Georgia, Indiana, Maryland, North Carolina, Pennsylvania, Texas, and Virginia. Ten of these hotels operate under franchise agreements with major hotel brands, and two are independent hotels. Developments at our properties for the five years ended December 31, 2016 included the following:\n| • | In 2013 we acquired the Crowne Plaza Houston Downtown located in Houston, Texas at an aggregate value of approximately $30.9 million, including certain closing costs. |\n\n| • | In 2014, we acquired the Georgian Terrace located in Atlanta, Georgia at an aggregate value of approximately $61.1 million, including certain closing costs. We also, after extensive renovations, re-branded and renamed the Hilton Philadelphia Airport to the DoubleTree by Hilton Philadelphia Airport. |\n\n| • | In 2015, we acquired the remaining 75.0% interest in (i) the entity that owns the Crowne Plaza Hollywood Beach Resort, and (ii) the entity that leases the Crowne Plaza Hollywood Beach Resort. As a result, the Operating Partnership now has a 100% indirect ownership interest in the entities that own the Crowne Plaza Hollywood Beach Resort. We also, after extensive renovations, re-branded and renamed the Crowne Plaza Jacksonville Riverfront to the DoubleTree by Hilton Jacksonville Riverfront, and re-branded and renamed the Holiday Inn Laurel West to the DoubleTree by Hilton Laurel. |\n\n| • | In 2016, after extensive renovations, we re-branded and renamed the Crowne Plaza Houston Downtown to The Whitehall. |\n\nSee Items 2 and 7 of this Form 10-K for additional detail on our properties.\nOur Strategy and Investment Criteria\nOur strategy is to grow through acquisitions of full-service, upscale and upper-upscale hotel properties located in the primary markets of the southern United States. We intend to grow our portfolio through disciplined acquisitions of hotel properties and believe that we will be able to source significant external growth opportunities through our management team’s extensive network of industry, corporate and institutional relationships.\n5\nOur investment criteria are further detailed below:\n| • | Geographic Growth Markets: We are focusing our growth strategy on the major markets in the Southern region of the United States. Our management team remains confident in the long-term growth potential associated with this part of the United States. We believe these markets have, during the Company’s and our predecessors’ existence, been characterized by population growth, economic expansion, growth in new businesses and growth in the resort, recreation and leisure segments. We will continue to focus on these markets, including coastal locations, and will investigate other markets for acquisitions only if we believe these new markets will provide similar long-term growth prospects. |\n\n| • | Full-Service Hotels: We focus our acquisition strategy on the full-service hotel segment. Our full-service hotels fall primarily under the upscale to upper-upscale categories and include such brands as Hilton, Doubletree by Hilton, Sheraton and Crowne Plaza, as well as independent hotels affiliated with Preferred Hotels & Resorts. We may also acquire commercial unit(s) within upscale to upper-upscale condominium hotel projects, allowing us to establish and operate unit rental programs. We do not own economy hotels. We believe that full-service hotels, in the upscale to upper-upscale categories, will outperform the broader U.S. hotel industry, and thus offer the highest returns on invested capital. |\n\n| • | Significant Barriers to Entry: We intend to execute a strategy that entails the acquisition of hotels in prime locations with significant barriers to entry. |\n\n| • | Proximity to Demand Generators: We seek to acquire hotel properties located in central business districts for both leisure and business travelers within the respective markets, including large state universities, airports, convention centers, corporate headquarters, sports venues and office buildings. We seek to be in walking locations that are proximate to the markets’ major demand generators. |\n\nWe typically define underperforming hotels as those that are poorly managed, suffer from significant deferred maintenance and capital investment and that are not properly positioned in their respective markets. In pursuing these opportunities, we hope to improve revenue and cash flow and increase the long-term value of the underperforming hotels we acquire. Our ultimate goal is to achieve a total investment that is substantially less than replacement cost of a hotel or the acquisition cost of a market performing hotel. In analyzing a potential investment in an underperforming hotel property, we typically characterize the investment opportunity as one of the following:\n| • | Branding Opportunity: The acquisition of properties that includes a repositioning of the property through a change in brand affiliation, which may include positioning the property as an independent hotel. Branding opportunities typically include physical upgrades and enhanced efficiencies brought about by changes in operations. |\n\n| • | Shallow-Turn Opportunity: The acquisition of an underperforming but structurally sound hotel that requires moderate renovation to re-establish the hotel in its market. |\n\n| • | Deep-Turn Opportunity: The acquisition of a hotel that is closed or functionally obsolete and requires a restructuring of both the business components of the operations as well as the physical plant of the hotel, including extensive renovation of the building, furniture, fixtures and equipment. |\n\nTypically, in our experience, a deep turn opportunity takes a total of approximately four years from the initial acquisition of a property to achieving full post-renovation stabilization. Therefore, when evaluating future opportunities in underperforming hotels, we intend to focus on up-branding and shallow-turn opportunities, and to pursue deep-turn opportunities on a more limited basis and in joint venture partnerships, if possible.\nInvestment Vehicles. In pursuit of our investment strategy, we may employ various traditional and non-traditional investment vehicles:\n| • | Direct Purchase Opportunity: Our traditional investment strategy is to acquire direct ownership interests via our Operating Partnership in properties that meet our investment criteria, including opportunities that involve full-service, upscale and upper-upscale properties in identified geographic growth markets that have significant barriers to entry for new product delivery. Such properties, or portfolio of properties, may or may not be acquired subject to a mortgage, or other financing or lending instruments, by the seller or third-party. |\n\n| • | Joint Venture/Mezzanine Lending Opportunities: We may, from time to time, undertake a significant renovation and rehabilitation project that we characterize as a deep-turn opportunity. In such cases, we may acquire a functionally obsolete hotel whose renovation may be very lengthy and require significant capital. In these projects, we may choose to structure such acquisitions as a joint venture, or mezzanine lending program, in order to avoid severe short-term dilution and loss of current income commonly referred to as the “negative carry” associated with such extensive renovation programs. We will not pursue joint venture or mezzanine programs in which we would become a “de facto” lender to the real estate community. |\n\n6\nPortfolio and Asset Management Strategy\nWe intend to ensure that the management of our hotel properties maximizes market share, as evidenced by revenue per available room (“RevPAR”) penetration indices, and that our market share yields the optimum level of revenues for our hotels in their respective markets. Our strategy is designed to actively manage our hotels’ operating expenses in an effort to maximize hotel earnings before interest, taxes, depreciation and amortization (“Hotel EBITDA”).\nOver our long history in the lodging industry we have refined many portfolio and asset management techniques that we believe provide for exceptional cash returns at our hotels. We undertake extensive budgeting due diligence wherein we examine market trends, one-time or exceptional revenue opportunities, and/or changes in the regulatory climate that may impact costs. We review daily revenue results and revenue management strategies at the hotels, and we focus on our manager’s ability to produce high quality revenues that translate to higher profit margins. We look for ancillary forms of revenues, such as leasing roof-top space for cellular towers and other communication devices and also look to lease space to third parties in our hotels, which may include, but are not limited to, gift shops or restaurants. We have and will continue to engage parking management companies to maximize parking revenue. Our efforts further include periodic review of property insurance costs and coverage, and the cost of real and personal property taxes. We generally appeal tax increases in an effort to secure lower tax payments and routinely pursue strategies that allow for lower overall insurance costs, such as purchasing re-insurance and participating in state-sponsored insurance pools.\nWe also require detailed and refined reporting data from Chesapeake Hospitality, which includes detailed accounts of revenues, revenue segments, expenses and forecasts based on current and historic booking patterns. We also believe we optimize and successfully manage capital costs at our hotels while ensuring that adequate product standards are maintained to provide a positive guest experience.\nNone of our hotels are managed by a major national or global hotel franchise company. Through our long history in the lodging industry, we have found that management of our hotels by management companies other than franchisors is preferable to and more profitable than management services provided by the major franchise companies, specifically with respect to optimization of operating expenses and the delivery of guest service.\nOur portfolio management strategy includes our effort to optimize labor costs. The labor force in our hotels is predominately non-unionized, with only one property, the DoubleTree by Hilton Jacksonville Riverfront, having a total of approximately 26 employees electing to participate under a collective bargaining arrangement. Further, the labor force at our hotels is eligible to receive health and other insurance coverage through Chesapeake Hospitality, which self-insures. Self-insuring has, in our opinion and experience, provided significant savings over traditional insurance company sponsored plans.\nAsset Disposition Strategy. When a property no longer fits with our investment objectives, we will pursue a direct sale of the property for cash so that our investment capital can be redeployed according to the investment strategies outlined above. Where possible, we will seek to subsequently purchase a hotel in connection with the requirements of a tax-free exchange. Such a strategy may be deployed in order to mitigate the tax consequence that a direct sale may cause.\nOur Principal Agreements\nManagement Agreements\nChesapeake Hospitality is currently the management company for each of our hotels. Andrew M. Sims, our chairman and chief executive officer owns an equity interest in Chesapeake Hospitality. Immediately prior to March 1, 2017, our chairman and chief executive officer, and another of our directors were also directors of Chesapeake Hospitality.\nOn December 15, 2014, we entered into a master agreement (the “Master Agreement”) and a series of individual hotel management agreements (each a “Hotel Management Agreement” and, together, the “Hotel Management Agreements”) between the Company, the Operating Partnership, and MHI Hospitality TRS, LLC (and other TRS Lessees) on the one hand and Chesapeake Hospitality on the other hand, to address the scheduled expiration of the then existing master management agreement (the “MMA”) and the strategic alliance agreement (the “SA Agreement”) and to provide for ongoing management of the Company’s hotels. The Master Agreement and Hotel Management Agreements terminated and replaced the then existing MMA and individual management agreements.\nThe Master Agreement:\n| • | expires on December 31, 2019, or earlier if all of the Hotel Management Agreements expire or are terminated prior to that date. The Master Agreement will be extended beyond 2019 for such additional periods as a Hotel Management Agreement remains in effect; |\n\n7\n\n| • | terminated the then existing SA Agreement as of December 15, 2014; |\n\n| • | extended the term of the then existing MMA until December 31, 2014 and terminated the MMA and other individual management agreements for Tampa, Houston, and Atlanta as of such date; |\n\n| • | caused the Hotel Management Agreements to come into effect coincident with the termination of the MMA and other individual management agreements on December 31, 2014; |\n\n| • | requires Chesapeake Hospitality to provide dedicated executive level support for our managed hotels pursuant to certain criteria; |\n\n| • | provides a mechanism and established conditions on which the Company will offer Chesapeake Hospitality the opportunity to manage hotels acquired by the Company in the future, pursuant to a negotiated form of single facility management agreement, with the caveat that the Company is not required to offer the management of future hotels to Chesapeake Hospitality; and |\n\n| • | sets an incentive management fee for each of the hotels to be managed by Chesapeake Hospitality equal to 10% of the amount by which gross operating profit, as defined in the Hotel Management Agreement, for a given year exceeds the budgeted gross operating profit for such year; provided, however, that the incentive management fee payable in respect of any such year shall not exceed 0.25% of the gross revenues of the hotel included in such calculation. |\n\nEach of the Hotel Management Agreements has a term of five years commencing January 1, 2015, with the exception of the Hotel Management Agreement for the management of the Crowne Plaza Hollywood Beach Resort, which has a term of five years commencing July 31, 2015. Each of the Hotel Management Agreements may be extended for up to two additional periods of five years subject to the approval of both parties with respect to any such extension. The agreements provide that Chesapeake Hospitality will be the sole and exclusive manager of the hotels as the agent of the respective TRS Lessee and at the sole cost and expense of the TRS Lessee and subject to certain operating standards. Each agreement may be terminated in connection with a sale of the related hotel. In connection with a termination upon the sale of the hotel, Chesapeake Hospitality will be entitled to receive a termination fee equal to the lesser of the management fee paid with respect to the prior twelve months or the management fees paid for that number of months prior to the closing date of the hotel sale equal to the number of months remaining on the current term of the Hotel Management Agreement. No sale termination fee will be payable in the event the Company elects to provide Chesapeake Hospitality with the opportunity to manage another comparable hotel and Chesapeake Hospitality is not precluded from accepting such opportunity. Chesapeake Hospitality is required to qualify as an eligible independent contractor in order to permit the Company to continue to operate as a real estate investment trust.\nAmounts Payable under the Management Agreements. Chesapeake Hospitality receives a base management fee, and, if the hotels exceed certain financial thresholds, an additional incentive management fee for the management of our hotels.\nThe base management fee for our hotels will be a percentage of the gross revenues of the hotel and will be due monthly. The applicable percentage of gross revenue for the base management fee for each of our wholly-owned hotels is as follows (1):\n\n| 2019 | 2018 | 2017 | 2016 | 2015 | 2014 |\n| Crowne Plaza Hampton Marina (2) | N/A | N/A | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| Crowne Plaza Hollywood Beach Resort | 2.50 | % | 2.50 | % | (3) | (3) | 2.00 | % | N/A |\n| Crowne Plaza Tampa Westshore (4) | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| DoubleTree by Hilton Jacksonville Riverfront | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| DoubleTree by Hilton Laurel | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| DoubleTree by Hilton Philadelphia Airport | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| DoubleTree by Hilton Raleigh Brownstone – University | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| Georgian Terrace (5) | 2.50 | % | 2.50 | % | 2.50 | % | 2.25 | % | 2.00 | % | 2.00 | % |\n| Hilton Savannah DeSoto | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| Hilton Wilmington Riverside | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| Sheraton Louisville Riverside (6) | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| The Whitehall (7) | 2.50 | % | 2.50 | % | 2.50 | % | 2.25 | % | 2.00 | % | 2.00 | % |\n\n\n| (1) | The fees for 2014 were set by the MMA, and the individual management agreements for Tampa, Houston, and Atlanta. The fees for 2015-2019 are set by the Master Agreement and the Hotel Management Agreements. |\n\n| (2) | The Crowne Plaza Hampton Marina was sold on February 7, 2017; therefore, the base management fee no longer applies after February 7, 2017. |\n\n8\n\n| (3) | Upon acquiring the Crowne Plaza Hollywood Beach Resort in July 2015, we entered into a single facility management agreement with Chesapeake Hospitality for the management of the hotel. The terms of the agreement provide for a base management fee of 2.00% through July 2016, 2.25% through July 2017, and 2.50% thereafter. |\n\n| (4) | In January 2009, we entered a separate management agreement with Chesapeake Hospitality for the management of the Crowne Plaza Tampa Westshore. The provisions of the new agreement related to base management fee were the same as those contained in the MMA. The provisions of the agreement related to the incentive management fee were the same as those contained in the MMA except that it was calculated separately and not aggregated with the other properties covered by the MMA. |\n\n| (5) | In March 2014, we entered into the Atlanta Agreement with Chesapeake Hospitality for the management of the Georgian Terrace. The terms of the agreement provided for a base management fee of 2.0% and no incentive management fee. The Atlanta Agreement was terminated in connection with the entry into the Master Agreement and Hotel Management Agreements. |\n\n| (6) | Pursuant to the MMA, the term for each of the initial properties, which included the Holiday Inn Downtown Williamsburg, was 10 years. The management company agreed to substitute the Sheraton Louisville Riverside for the Holiday Inn Downtown Williamsburg for remainder of the term of the agreement. |\n\n| (7) | In November 2013, we assumed the existing management agreement with Chesapeake Hospitality for the management of the Crowne Plaza Houston Downtown. The terms of the agreement provided for a base management fee of 2.0% and no incentive management fee. |\n\nThe base management fee for a hotel acquired in the future which is first leased by our TRS Lessees, other than on the first day of a fiscal year, will be 2.0% for the partial year such hotel is first leased and for the first full year such hotel is managed. There is no fee cap on the base management fee.\nSubsequently Acquired Hotel Properties\n\n| First year | 2.00 | % |\n| Second year | 2.25 | % |\n| Third year and thereafter | 2.50 | % |\n\nTerminated Strategic Alliance Agreement and Management Agreements\nOn December 21, 2004, we entered into the now terminated ten-year SA Agreement with Chesapeake Hospitality pursuant to which (i) Chesapeake Hospitality agreed to refer to us (on an exclusive basis) hotel acquisition opportunities in the United States presented to Chesapeake Hospitality, and (ii) unless a majority of the Company’s independent directors in good faith concluded for valid business reasons that another management company should manage a hotel owned by us, we agreed to offer Chesapeake Hospitality or its subsidiaries the right to manage hotel properties that we acquired in the United States. The SA Agreement was terminated effective as of December 15, 2014, pursuant to the terms of the Master Agreement.\nPursuant to the terms of the now terminated MMA and other individual management agreements for Tampa, Houston and Atlanta, we engaged Chesapeake Hospitality as the property manager for each of our wholly-owned hotels through December 2015. The MMA had a term of ten (10) years for each initial hotel and a term of ten (10) years for each subsequently acquired hotel that became subject to the MMA. Chesapeake Hospitality benefited from the payment of management fees by us pursuant to the MMA. Chesapeake Hospitality received a base management fee equal to a percentage of each hotel’s revenues (2.0% for the first year, 2.5% for the second year and 3.0% thereafter). Additionally, pursuant to the MMA, Chesapeake Hospitality was entitled to receive certain incentive fees and project management fees. For Tampa, the base management and incentive management fees were the same as those contained in the MMA. For Houston and Atlanta, the base management fee was equal to 2% of the respective hotels’ revenues, and there was no incentive management fee. The MMA and the individual management agreements for Tampa, Houston, and Atlanta were terminated on December 31, 2014, pursuant to the terms of the Master Agreement.\nFranchise Agreements\nAs of December 31, 2016, all but two of our wholly-owned hotels operate under franchise licenses from national hotel companies. On March 27, 2014, we purchased an independent full-service hotel in Atlanta, Georgia, which does not operate under a franchise license. On April 12, 2016, we allowed the Crowne Plaza Houston Downtown’s franchise agreement to expire and rebranded it as The Whitehall, an independent full-service hotel.\nOur TRS Lessees hold the franchise licenses for our wholly-owned hotels. Chesapeake Hospitality must operate each of our hotels it manages in accordance with and pursuant to the terms of the franchise agreement for the hotel.\n9\nThe franchise licenses generally specify certain management, operational, record keeping, accounting, reporting and marketing standards and procedures with which the franchisee must comply. Under the franchise licenses, the franchisee must comply with the franchisors’ standards and requirements with respect to:\n| • | training of operational personnel; |\n\n| • | safety; |\n\n| • | maintaining specified insurance; |\n\n| • | the types of services and products ancillary to guest room services that may be provided; |\n\n| • | display of signage; |\n\n| • | marketing techniques including print media, billboards, and promotions standards; and |\n\n| • | the type, quality and age of furniture, fixtures and equipment included in guest rooms, lobbies and other common areas. |\n\nAdditionally, as the franchisee, our TRS Lessees are required to pay the franchise fees described below.\nThe following table sets forth certain information for the franchise licenses of our wholly-owned hotel properties as of December 31, 2016:\n\n| Marketing/ |\n| Franchise | Reservation | Expiration |\n| Fee (1) | Fee (1) | Date |\n| Crowne Plaza Hampton Marina (2) | 5.0 | % | 3.5 | % | 2/7/2017 |\n| Crowne Plaza Hollywood Beach Resort (3) | 5.0 | % | 3.5 | % | 10/31/2017 |\n| Crowne Plaza Tampa Westshore | 5.0 | % | 3.5 | % | 3/6/2019 |\n| DoubleTree by Hilton Jacksonville Riverfront (4) | 5.0 | % | 4.0 | % | 9/30/2025 |\n| DoubleTree by Hilton Laurel | 5.0 | % | 4.0 | % | 10/31/2030 |\n| DoubleTree by Hilton Philadelphia – Airport (5) | 5.0 | % | 4.0 | % | 10/31/2024 |\n| DoubleTree by Hilton Raleigh Brownstone – University (4) | 5.0 | % | 4.0 | % | 11/30/2021 |\n| Hilton Savannah DeSoto (6) | 5.0 | % | 4.0 | % | 7/31/2017 |\n| Hilton Wilmington Riverside | 5.0 | % | 4.0 | % | 3/31/2018 |\n| Sheraton Louisville Riverside | 5.0 | % | 3.5 | % | 4/25/2023 |\n\n\n| (1) | Percentage of room revenues payable to the franchisor. |\n\n| (2) | The Crowne Plaza Hampton Marina was sold on February 7, 2017, and the franchise license was transferred to the new owners. |\n\n| (3) | We have entered into a franchise agreement with Hilton to rebrand the Hollywood hotel as a DoubleTree by Hilton. |\n\n| (4) | The Franchise Fee is 3.0% for operating year 1, 4.0% for operating year 2, and 5.0% thereafter. |\n\n| (5) | The Franchise Fee is 4.0% for operating years 1 and 2, and 5.0% thereafter. |\n\n| (6) | We intend to convert the Savannah hotel to an independent hotel. |\n\nLease Agreements\nIn order for the Company to maintain qualification as a REIT, neither the Company nor the Operating Partnership or its subsidiaries can operate our hotels directly. Our wholly-owned hotels are leased to our TRS Lessees, which have engaged Chesapeake Hospitality to manage the hotels. Each lease has a non-cancelable term of three to thirty years, subject to earlier termination upon the occurrence of certain contingencies described in the lease.\nDuring the term of each lease, our TRS Lessees are obligated to pay a fixed annual base rent plus a percentage rent and certain other additional charges. Base rent accrues and is paid monthly. Percentage rent is calculated by multiplying fixed percentages by gross room revenues, in excess of certain threshold amounts and is paid monthly or quarterly, according to the terms of the agreement.\nTax Status\nThe Company elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the “Code”), commencing with its taxable year ended December 31, 2004. In order to maintain its qualification as a REIT, the Company must meet a number of organizational and operational requirements, including a requirement that it currently distribute, as “qualifying distributions,” at least 90.0% of its taxable income (determined without regard to the deduction for dividends paid and by\n10\nexcluding its net capital gains and reduced by certain non-cash items) to its stockholders. The Company has adhered to these requirements each taxable year since its formation in 2004 and intends to continue to adhere to these requirements and maintain its qualification for taxation as a REIT. As a REIT, the Company generally will not be subject to federal corporate income tax on that portion of its taxable income (including its net capital gain) that is distributed to its stockholders. If the Company fails to qualify for taxation as a REIT in any taxable year, and no relief provision applies, it will be subject to federal income taxes at regular corporate rates (as well as any applicable alternative minimum tax) and it would be disqualified from re-electing treatment as a REIT until the fifth taxable year after the year in which it failed to qualify as a REIT. Even if the Company qualifies for taxation as a REIT, it may be subject to certain state and local taxes on its income and property, and to federal income and excise taxes on its undistributed taxable income. In addition, taxable income from non-REIT activities managed through taxable REIT subsidiaries is subject to federal, state and local income taxes.\nWhile the Operating Partnership is generally not subject to federal and state income taxes, the unit holders of the Operating Partnership, including the Company, are subject to tax on their respective allocable shares of the Operating Partnership’s taxable income.\nThe Company has one taxable REIT subsidiary, MHI Holding, in which it owns an interest through the Operating Partnership. MHI Holding is subject to federal, state and local income taxes. MHI Holding has operated at a cumulative taxable loss, through December 31, 2016, of approximately $15.9 million and in addition had deferred timing differences of approximately $0.2 million attributable to start-up expenses related to the opening of several of its hotels, which was not deductible when incurred and is being amortized over 15 years and deferred timing differences of approximately $0.5 million attributable to accrued, but not deductible, vacation and sick pay amounts. The Company has not incurred federal income taxes since its formation. The cumulative taxable loss and combined timing differences result in a net deferred tax asset of approximately $6.9 million for these cumulative deferred tax loss carryforwards.\nEnvironmental Matters\nIn connection with the ownership and operation of the hotels, we are subject to various federal, state and local laws, ordinances and regulations relating to environmental protection. Under these laws, a current or previous owner or operator of real estate may be liable for the costs of removal or remediation of certain hazardous or toxic substances on, under, or in such property. Such laws often impose liability without regard to whether the owner or operator knew of, or was responsible for, the presence of hazardous or toxic substances. In addition, the presence of contamination from hazardous or toxic substances, or the failure to remediate such contaminated property properly, may adversely affect the owner’s ability to borrow using such property as collateral. Furthermore, a person who arranges for the disposal or treatment of a hazardous or toxic substance at a property owned by another, or who transports such substance to or from such property, may be liable for the costs of removal or remediation of such substance released into the environment at the disposal or treatment facility. The costs of remediation or removal of such substances may be substantial, and the presence of such substances may adversely affect the owner’s ability to sell such real estate or to borrow using such real estate as collateral. In connection with the ownership and operation of the hotels, we may be potentially liable for such costs.\nWe believe that our hotels are in compliance, in all material respects, with all federal, state and local environmental ordinances and regulations regarding hazardous or toxic substances and other environmental matters, the violation of which would have a material adverse effect on us. We have not received written notice from any governmental authority of any material noncompliance, liability or claim relating to hazardous or toxic substances or other environmental matters in connection with any of our present hotel properties.\nEmployees\nAs of December 31, 2016, we employed twelve full-time persons, all of whom work at our corporate office in Williamsburg, Virginia. All persons employed in the day-to-day operations of the hotels are employees of Chesapeake Hospitality, the management company engaged by our TRS Lessees to operate such hotels.\nSubsequent Events\nHyde Resort & Residences\nOn January 30, 2017, we purchased the commercial unit of the Hyde Resort & ResidencesTM, a condominium hotel located in the Hollywood, Florida market, for an aggregate price of approximately $4.8 million, including inventory and closing fees. The trademarked Hyde Resort & Residences is operated under license from SBE Hotel Licensing, LLC.\n11\nWe have entered into several agreements related to the Hyde Resort & Residences, which is zoned and operated as a condominium hotel with individual condominium units owned by third parties. In addition to our ownership of the commercial condominium unit, consisting of the designated lobby and front desk areas, we entered into a 20-year Lease Agreement with the condominium association responsible for the operation of the condominium, whereby we lease other common areas, including meeting rooms, office spaces, and 400 parking spaces, and also manage the parking garage. We have also entered into a 20-year Association Management Agreement with the condominium association, whereby we are engaged to manage the condominium association and to operate the Hyde Resort & Residences as a condominium hotel. Individual condominium unit owners may elect for their condominium units to be rented to condominium hotel guests pursuant to a rental management program managed for us by Chesapeake Hospitality pursuant to the Hyde Management Agreement, described below. As part of the rental management program, we have entered into individual rental agreements with condominium unit owners who have chosen to participate in our rental program, and may enter into rental agreements with unit owners in the future. We expect the number of individual condominium unit owners who elect to participate in our rental program to vary, and the number of units available for rental to condominium hotel guests at any given time will fluctuate pursuant to that participation and due to owner occupation of the condominium hotel units.\nOn February 3, 2017, we entered into a Condominium Hotel Management Agreement (the “Hyde Management Agreement”) with Chesapeake Hospitality for the management of the Hyde Resort & Residences condominium hotel. In accordance with the Master Agreement, the Hyde Management Agreement has an initial term of five years commencing January 30, 2017 and mirrors the material terms of the other Hotel Management Agreements. The terms of the Hyde Management Agreement provide for a base management fee equal to a percentage of gross revenues of the rental of condominium units participating in our rental program in the amount of 2.00% through January 2018, 2.25% through January 2019, and 2.50% thereafter. Pursuant to the Hyde Management Agreement, Chesapeake Hospitality will manage for us the rental of individually owned condominium units pursuant to rental agreements entered into with individual condominium unit owners. We also entered into an Association Sub Management and Assignment Agreement with Chesapeake Hospitality for the management and operation of the condominium association responsible for the operation of the Hyde Resort & Residences, and a Rental Management Agreement pursuant to which Chesapeake Hospitality agreed to manage the marketing and negotiation of rental agreements with individual condominium unit owners.\nCrowne Plaza Hampton Marina Disposition\nOn February 7, 2017, we sold the Crowne Plaza Hampton Marina for a price of approximately $5.6 million. Following the sale, our portfolio consisted of eleven wholly-owned hotels located in seven states with an aggregate total of 2,838 rooms and approximately 149,435 square feet of meeting space, as well as our interests in the Hyde Resort & Residences.\nEmployee Stock Ownership Plan\nBetween January 3, 2017 and February 23, 2017, the Company’s Employee Stock Ownership Plan (“ESOP”) purchased 682,500 shares of the Company’s common stock. The Company sponsors and maintains the ESOP and related trust for the benefit of its eligible employees. The ESOP, which was established January 1, 2016, is funded by a loan from the Company, pursuant to which the ESOP may borrow up to $5,000,000 to purchase shares of the Company’s common stock, which serve as collateral for the loan.\nDirector and Officer Changes\nOn March 1, 2017, Kim E. Sims resigned as a member of the board of directors of the Company.\nAvailable Information\nWe maintain an Internet site, http://www.sotherlyhotels.com, which contains additional information concerning Sotherly Hotels Inc. We make available free of charge through our Internet site all our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, definitive proxy statements and other reports filed with the Securities and Exchange Commission as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. We have also posted on this website the Company’s Code of Business Conduct and the charters of the Company’s Nominating, Corporate Governance and Compensation (“NCGC”) and Audit Committees of the Company’s board of directors. We intend to disclose on our website any changes to, or waivers from, the Company’s Code of Business Conduct. Information on the Company’s Internet site is neither part of nor incorporated into this Form 10-K.\n12\n\nItem 1A.\nRi\nsk Factors\nThe following are the material risks that may affect us. Any of the risks discussed herein can materially adversely affect our business, liquidity, operations, industry or financial position or our future financial performance.\nRisks Related to Our Debt\nWe have substantial financial leverage.\nAs of December 31, 2016, the principal balance of our debt was approximately $309.8 million, which is comprised of approximately $284.5 million secured debt and approximately $25.3 million unsecured debt related to the 7.0% senior unsecured notes due November 20, 2019 (the “7% Notes”) (not accounting for reductions of unamortized premiums or deferred financing costs as shown on our balance sheet). Historically, we have incurred debt for acquisitions and to fund our renovation, redevelopment and rebranding programs. Limitations upon our access to additional debt could adversely affect our ability to fund these programs or acquire hotels in the future.\nOur financial leverage could negatively affect our business and financial results, including the following:\n| • | require us to dedicate a substantial portion of our cash flow from operations to payments on our debt, thereby reducing funds available for operations, working capital, capital expenditures, future business opportunities, paying dividends or other purposes; |\n\n| • | limit our ability to obtain additional financing for working capital, renovation, redevelopment and rebranding plans, acquisitions, debt service requirements and other purposes; |\n\n| • | adversely affect our ability to satisfy our financial obligations, including those related to the 7% Notes; |\n\n| • | limit our ability to refinance existing debt; |\n\n| • | require us to agree to additional restrictions and limitations on our business operations and capital structure to obtain financing; |\n\n| • | force us to dispose of one or more of our properties, possibly on unfavorable terms; |\n\n| • | increase our vulnerability to adverse economic and industry conditions, and to interest rate fluctuations; |\n\n| • | force us to issue additional equity, possibly on terms unfavorable to existing shareholders; |\n\n| • | limit our flexibility to make, or react to, changes in our business and our industry; and |\n\n| • | place us at a competitive disadvantage, compared to our competitors that have less debt. |\n\nWe must comply with financial covenants in our mortgage loan agreements and in the indenture.\nOur mortgage loan agreements and indenture contain various financial covenants. Failure to comply with these financial covenants could result from, among other things, changes in the local competitive environment, general economic conditions and disruption caused by renovation activity or major weather disturbances.\nIf we violate the financial covenants contained in our mortgage loan agreements, we may attempt to negotiate waivers of the violations or amend the terms of the applicable mortgage loan agreement with the lender; however, we can make no assurance that we would be successful in any such negotiation or that, if successful in obtaining waivers or amendments, such waivers or amendments would be on attractive terms. Some mortgage loan agreements provide alternate cure provisions which may allow us to otherwise comply with the financial covenants by obtaining an appraisal of the hotel, prepaying a portion of the outstanding indebtedness or by providing cash collateral until such time as the financial covenants are met by the collateralized property without consideration of the cash collateral. Alternate cure provisions which include prepaying a portion of the outstanding indebtedness or providing cash collateral may have a material impact on our liquidity.\nIf we violate the financial covenants in the indenture, we may attempt to cure that violation by engaging in one or more transactions pursuant to the cure provision in the indenture.\nIf we are unable to negotiate a waiver or amendment or satisfy alternate cure provisions, if any, or unable to meet any alternate cure requirements and a default were to occur, we would possibly have to refinance the debt through debt financing, private or public offerings of debt securities, additional equity financing, or by disposing of an asset. We are uncertain whether we will be able to refinance these obligations or if refinancing terms will be favorable.\n13\nWe have one mortgage debt obligation maturing in 2018, and if we are not successful in extending the term of this indebtedness or in refinancing this debt on acceptable economic terms or at all, our overall financial condition could be materially and adversely affected.\nWe will be required to seek additional capital in the near future to refinance or replace existing long-term mortgage debt that is maturing. Based on current market conditions, the availability of financing is, and may continue to be, limited. There can be no assurance that we will be able to obtain future financings on acceptable terms, if at all.\nIn August 2018, the mortgage on our DoubleTree by Hilton Raleigh Brownstone University matures, and we have additional significant obligations maturing in subsequent years.\nWe have no material debt obligations maturing in 2017. The total aggregate amount of our debt obligations scheduled to mature in 2018, inclusive of monthly amortization of all our indebtedness, is approximately $24.6 million, which represents approximately 7.9% of our total debt obligation outstanding as of December 31, 2016.\nWe will need to, and plan to, renew, replace or extend our long-term indebtedness prior to the respective maturity date. If we are unable to extend this loan, we may be required to repay the outstanding principal amount at maturity or a portion of such indebtedness upon refinance. If we do not have sufficient funds to repay any portion of the indebtedness, it may be necessary to raise capital through debt financing, private or public offerings of debt securities or equity financings. We are uncertain whether we will be able to refinance this obligation or if refinancing terms will be favorable. If, at the time of any refinancing, prevailing interest rates or other factors result in higher interest rates on refinancing, increases in interest expense would lower our cash flow, and, consequently, cash available to meet our financial obligations. If we are unable to obtain alternative or additional financing arrangements in the future, or if we cannot obtain financing on acceptable terms, we may not be able to execute our business strategies or we may be forced to dispose of hotel properties on disadvantageous terms, potentially resulting in losses and potentially reducing cash flow from operating activities if the sale proceeds in excess of the amount required to satisfy the indebtedness could not be reinvested in equally profitable real property investments. Moreover, the terms of any additional financing may restrict our financial flexibility, including the debt we may incur in the future, or may restrict our ability to manage our business as we had intended. To the extent we cannot repay our outstanding debt, we risk losing some or all of our hotel properties to foreclosure and we could be required to invoke insolvency proceedings including, but not limited to, commencing a voluntary case under the U.S. Bankruptcy Code.\nFor tax purposes, a foreclosure of any of our hotels would be treated as a sale of the hotel for a purchase price equal to the outstanding balance of the debt secured by the mortgage. If the outstanding balance of the debt secured by the mortgage exceeds our tax basis in the hotel, we would recognize taxable income on foreclosure, but we would not receive any cash proceeds, which could hinder the Company’s ability to meet the REIT distribution requirements imposed by the Code. In addition, we may give full or partial guarantees to lenders of mortgage debt on behalf of the entities that own our hotels. When we give a guarantee on behalf of an entity that owns one of our hotels, we will be responsible to the lender for satisfaction of the debt if it is not paid by such entity.\nOur borrowing costs are sensitive to fluctuations in interest rates.\nHigher interest rates could increase our debt service requirements and interest expense. Currently, our floating rate debt is limited to the mortgages on the DoubleTree by Hilton Philadelphia Airport, the DoubleTree by Hilton Jacksonville Riverfront, the Crowne Plaza Tampa Westshore and The Whitehall. Each of these mortgages bears interest at rates tied to the 1-month London Interbank Offered Rate (“LIBOR”) and provide for minimum rates of interest. To the extent that increases in the LIBOR rate of interest cause the interest on the mortgages to exceed the minimum rates of interest, we are exposed to rising interest rates.\nShould we obtain new debt financing or refinance existing indebtedness, we may increase the amount of floating rate debt that currently exists. In addition, adverse economic conditions could also cause the terms on which we borrow to be unfavorable.\nRisks Related to Our Business and Properties\nIf the economy falls back into a recessionary period or fails to maintain positive growth, our operating performance and financial results may be harmed by declines in occupancy, average daily room rates and/or other operating revenues.\nThe performance of the lodging industry and the general economy historically have been closely linked. In an economic downturn, business and leisure travelers may seek to reduce costs by limiting travel and/or reducing costs on their trips. Our hotels, which are all full-service hotels, may be more susceptible to a decrease in revenue, as compared to hotels in other categories that have lower room rates. A decrease in demand for hotel stays and hotel services will negatively affect our operating revenues, which will lower our cash flow and may affect our ability to make distributions to stockholders and to maintain compliance with our loan obligations. We had net loss attributable to the common shareholders of approximately $0.2 million for the 2016 fiscal year. A renewed economic downturn may increase our losses or reduce our income in the future. A weakening of the economy may adversely and materially affect our industry, business and results of operations and we cannot predict the likelihood, severity or duration of any such downturn. Moreover, reduced revenues as a result of a weakening economy may also reduce our working capital and impact our long-term business strategy.\n14\nWe own a limited number of hotels and significant adverse changes at one hotel could have a material adverse effect on our financial performance and may limit our ability to make distributions to stockholders.\nAs of December 31, 2016, our portfolio consisted of twelve wholly-owned hotels with a total of 3,011 rooms. Significant adverse changes in the operations of any one hotel could have a material adverse effect on our financial performance and, accordingly, on our ability to make distributions to stockholders. Following the sale of the Crowne Plaza Hampton Marina on February 7, 2017, our portfolio consisted of eleven wholly-owned hotels with a total of 2,838 rooms, as well as our interests in the Hyde Resort & Residences.\nWe are subject to risks of increased hotel operating expenses and decreased hotel revenues.\nOur leases with our TRS Lessees provide for the payment of rent based in part on gross revenues from our hotels. Our TRS Lessees are subject to hotel operating risks including decreased hotel revenues and increased hotel operating expenses, including but not limited to the following:\n| • | wage and benefit costs; |\n\n| • | repair and maintenance expenses; |\n\n| • | energy costs; |\n\n| • | property taxes; |\n\n| • | insurance costs; and |\n\n| • | other operating expenses. |\n\nAny increases in these operating expenses can have a significant adverse impact on our TRS Lessees’ ability to pay rent and other operating expenses and, consequently, our earnings and cash flow.\nIn keeping with our investment strategy, we may acquire, renovate and/or re-brand hotels in new or existing geographic markets as part of our repositioning strategy. Unanticipated expenses and insufficient demand for newly repositioned hotels could adversely affect our financial performance and our ability to comply with covenants in the indenture and to make distributions to the Company’s stockholders.\nWe have in the past, and may in the future, develop or acquire hotels in geographic areas in which our management may have little or no operating experience. Additionally, those properties may also be renovated and re-branded as part of a repositioning strategy. Potential customers may not be familiar with our newly renovated hotel or be aware of the brand change. As a result, we may have to incur costs relating to the opening, operation and promotion of those new hotel properties that are substantially greater than those incurred in other geographic areas. These hotels may attract fewer customers than expected and we may choose to increase spending on advertising and marketing to promote the hotel and increase customer demand. Unanticipated expenses and insufficient demand at new hotel properties, therefore, could adversely affect our financial performance and our ability to comply with covenants in the indenture and to make distributions to the Company’s stockholders.\nWe do not have the authority to require any hotel to be operated in a particular manner or to govern any particular aspect of the daily operations of any hotel and as a result, our returns are dependent on the management of our hotels by Chesapeake Hospitality.\nSince federal income tax laws restrict REITs and their subsidiaries from operating or managing hotels, we do not operate or manage our hotels. Instead, we lease all of our hotels to our TRS Lessees, and our TRS Lessees retain third-party managers to operate our hotels pursuant to management agreements.\nUnder the terms of our management agreements with Chesapeake Hospitality and the REIT qualification rules, our ability to participate in operating decisions regarding the hotels is limited. We will depend on Chesapeake Hospitality to operate our hotels as provided in the management agreements. We do not have the authority to require any hotel to be operated in a particular manner or to govern any particular aspect of the daily operations of any hotel. Thus, even if we believe our hotels are being operated inefficiently or in a manner that does not result in satisfactory occupancy rates, RevPAR, and average daily rates (“ADR”), we may not be able to force Chesapeake Hospitality to change its method of operating our hotels. Additionally, in the event that we need to replace Chesapeake Hospitality or any other management companies in the future, we may be required by the terms of the applicable management agreement to pay substantial termination fees and may experience significant disruptions at the affected hotels.\n15\nOur ability to make distributions to the Company’s stockholders is subject to fluctuations in our financial performance, operating results and capital improvement requirements.\nAs a REIT, the Company is required to distribute, as “qualifying distributions,” at least 90.0% of its REIT taxable income (determined without regard to the dividends-paid deduction and by excluding its net capital gains, and reduced by certain non-cash items), each year to the Company’s stockholders. However, several factors may make us unable to declare or pay distributions to the Company’s stockholders, including poor operating results and financial performance or unanticipated capital improvements to our hotels, including capital improvements that may be required by our franchisors.\nWe lease all of our hotels to our TRS Lessees. Our TRS Lessees are subject to hotel operating risks, including risks of sustaining operating losses after payment of hotel operating expenses, including management fees. Among the factors which could cause our TRS Lessees to fail to make required rent payments are reduced net operating profits or operating losses, increased debt service requirements and capital expenditures at our hotels, including capital expenditures required by the franchisors of our hotels. Among the factors that could reduce the net operating profits of our TRS Lessees are decreases in hotel revenues and increases in hotel operating expenses. Hotel revenue can decrease for a number of reasons, including increased competition from a new supply of hotel rooms and decreased demand for hotel rooms. These factors can reduce both occupancy and room rates at our hotels.\nThe amount of any dividend distributions to holders of the Company’s common stock is in the sole discretion of the Company’s board of directors, which will consider, among other factors, our financial performance, debt service obligations, debt covenants and capital expenditure requirements. We cannot assure you that we will continue to generate sufficient cash to fund distributions.\nGeographic concentration of our hotels makes our business vulnerable to economic downturns in the mid-Atlantic and southern United States.\nOur hotels are located in the mid-Atlantic and southern United States. As a result, economic conditions in the mid-Atlantic and southern United States significantly affect our revenues and the value of our hotels to a greater extent than if we had a more geographically diversified portfolio. Business layoffs or downsizing, industry slowdowns, changing demographics and other similar factors that may adversely affect the economic climate in these areas could have a significant adverse impact on our business. Any resulting oversupply or reduced demand for hotels in the mid-Atlantic and southern United States and in our markets in particular would therefore have a disproportionate negative impact on our revenues and limit our ability to make distributions to stockholders.\nA substantial number of our hotels operate under a brand owned by Hilton Worldwide (Hilton), InterContinental Hotels Group (IHG) and Marriott International, Inc. (Marriott) brands; therefore, we are subject to risks associated with concentrating our portfolio in three brands.\nIn our portfolio, the majority of the hotels that we owned as of December 31, 2016 utilize brands owned by IHG, Marriott or Hilton. As a result, our success is dependent in part on the continued success of IHG, Marriott or Hilton and their respective brands. If market recognition or the positive perception of IHG, Marriott and/or Hilton is reduced or compromised, the goodwill associated with the IHG, Marriott and Hilton branded hotels in our portfolio may be adversely affected, which may have a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders.\nHedging against interest rate exposure may adversely affect us and our hedges may fail to protect us from the losses that the hedges were designed to offset.\nSubject to maintaining the Company’s qualification as a REIT, we may elect to manage our exposure to interest rate volatility by using interest rate hedging arrangements, such as cap agreements and swap agreements. These agreements involve the risks that these arrangements may fail to protect or adversely affect us because, among other things:\n| • | interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates; |\n\n| • | available interest rate hedges may not correspond directly with the interest rate risk for which protection is sought; |\n\n| • | the financial instruments we select may not have the effect of reducing our interest rate risk; |\n\n| • | the duration of the hedge may not match the duration of the related liability; |\n\n| • | the credit quality of the hedging counterparty owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; and |\n\n| • | the hedging counterparty owing money in the hedging transaction may default on its obligation to pay. |\n\n16\nAs a result of any of the foregoing, our hedging transactions, which are intended to limit losses, may fail to protect us from the losses that the hedges were designed to offset and could have a material adverse effect on us.\nOur investment opportunities and growth prospects may be affected by competition for acquisitions.\nWe compete for investment opportunities with other entities, some of which have substantially greater financial resources than we do. This competition may generally limit the number of suitable investment opportunities offered to us, which may limit our ability to grow. This competition may also increase the bargaining power of property owners seeking to sell to us, making it more difficult for us to acquire new properties on attractive terms, or at all.\nIf we fail to maintain an effective system of internal controls, we may not be able to accurately determine our financial results or prevent fraud. As a result, the Company’s stockholders could lose confidence in our financial results, which could harm our business and the value of the Company’s shares.\nEffective internal controls are necessary for us to provide reliable financial reports and effectively prevent fraud. Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate and report on our internal controls over financial reporting. Our internal controls and financial reporting are not subject to attestation by our independent registered public accounting firm pursuant to the exemption provided to issuers that are not “large accelerated filers” or “accelerated filers” under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. While we have undertaken substantial work to comply with Section 404, we cannot be certain that we will be successful in maintaining adequate internal controls over our financial reporting and financial processes in the future. We may in the future discover areas of our internal controls that need improvement. Furthermore, as we grow our business, our internal controls will become more complex, and we will require significantly more resources to ensure our internal controls remain effective. If we or our independent auditors discover a material weakness, the disclosure of that fact, even if quickly remedied, could reduce the market value of the Company’s shares. Additionally, the existence of any material weakness or significant deficiency would require management to devote significant time and incur significant expense to remediate any such material weaknesses or significant deficiencies and management may not be able to remediate any such material weaknesses or significant deficiencies in a timely manner. In 2014, we identified a material weakness in our internal control over financial reporting which has been remediated.\nWe are subject to cyber-security risks related to breaches of security pertaining to sensitive company, customer, employee and vendor information as well as breaches in the technology that manages operations and other business processes.\nOur business operations rely upon secure information technology systems for data capture, processing, storage and reporting. Despite careful security and controls design, implementation, updating and independent third party verification, our information technology systems, and those of our third party providers, could become subject to cyber-attacks. Network, system, application and data breaches could result in operational disruptions or information misappropriation including, but not limited to interruption to systems availability, denial of access to and misuse of applications required by our customers. Access to internal applications required to plan our operations could be denied or misused. Inappropriate disclosure of confidential company, employee, customer or vendor information, could stem from such incidents. Any of these operational disruptions and/or misappropriation of information could result in lost sales, business delays, and negative publicity and could have a material effect on our business.\nRisks Related to Conflicts of Interest of Our Officers and Directors\nConflicts of interest could result in our executive officers and certain of our directors acting in a manner other than in the Company’s stockholders’ best interest.\nConflicts of interest relating to Chesapeake Hospitality, the entity that manages the properties, and the terms of its management agreements may lead to management decisions that are not in the stockholders’ best interest.\nConflicts of interest relating to Chesapeake Hospitality may lead to management decisions that are not in the stockholders’ best interest. Andrew M. Sims, our chairman and chief executive officer, and Kim E. Sims, a former member of our board of directors, together own a substantial interest in Chesapeake Hospitality which manages our hotel properties.\nOur management agreements establish the terms of Chesapeake Hospitality’s management of our hotels. The new Master Agreement provides that in the event the agreement is terminated in connection with the sale of a hotel, and Chesapeake Hospitality accepts an offer to manage another hotel which is reasonable comparable to the hotel that was sold, we will not be liable for any termination fee. If we do not offer Chesapeake Hospitality such opportunity or Chesapeake Hospitality declines such opportunity, then a termination fee equivalent to the lesser of the management fees paid for the prior twelve-month period or the management fees for the period prior to the sale that is equal to the number of months remaining under the term of the agreement will be due. If we terminate the agreement at the end of any renewable five-year term, Chesapeake Hospitality is due a termination fee equivalent to one month’s management fees, as determined under the agreement.\n17\nAs a significant owner of Chesapeake Hospitality, which would receive any management and management termination fees payable by us under the management agreement, Andrew M. Sims may influence our decisions to sell a hotel or acquire or develop a hotel when it is not in the best interests of the Company’s stockholders to do so. In addition, Andrew M. Sims will have conflicts of interest with respect to decisions to enforce provisions of the management agreement, including any termination thereof.\nThere can be no assurance that provisions in our bylaws will always be successful in mitigating conflicts of interest.\nUnder our bylaws, a committee consisting of only independent directors must approve any transaction between us and Chesapeake Hospitality or its affiliates or any interested director. However, there can be no assurance that these policies always will be successful in mitigating such conflicts, and decisions could be made that might not fully reflect the interests of all of the Company’s stockholders.\nCertain of our officers and directors control trusts that hold units in our Operating Partnership and may seek to avoid adverse tax consequences, which could result from transactions that would otherwise benefit the Company’s stockholders.\nHolders of units in our Operating Partnership, including trusts controlled in whole or part by members of our management team, may suffer adverse tax consequences upon our sale or refinancing of certain properties. Therefore, holders of units, including a trust controlled by Andrew M. Sims and two former members of our board of directors, and a charitable trust controlled by Edward S. Stein, may have different objectives than holders of the Company’s stock regarding the appropriate pricing and timing of a property’s sale, or the timing and amount of a property’s refinancing. As of December 31, 2016, these trusts owned approximately 1.0% of the outstanding units in our Operating Partnership. Although the individuals controlling the trusts do not have any beneficial interest in the trusts, they may influence us not to sell or refinance certain properties, even if such sale or refinancing might be financially advantageous to the Company’s stockholders, or may influence us to enter into tax-deferred exchanges with the proceeds of such sales when such a reinvestment might not otherwise be in our best interest.\nOur agreements with Chesapeake Hospitality and its affiliates, including the contribution agreements and the partnership agreement of our Operating Partnership, were not negotiated on an arms’ length basis and may be less favorable to us than we could have obtained from third parties.\nIn connection with the Company’s initial public offering, we entered into various agreements with Chesapeake Hospitality and its affiliates, including contribution agreements, a master management agreement, a strategic alliance agreement, subleases, the partnership agreement of our Operating Partnership and employment agreements – of which only the contribution agreements and the partnership agreement of our Operating Partnership have not expired. In addition, we entered into various separate management agreements with Chesapeake Hospitality which have all been superseded by the new master management agreement and new individual hotel agreements executed in December 2014. The terms of all of these agreements were determined by our management team, who had conflicts of interest as described above and ownership interests in Chesapeake Hospitality and its affiliates. The terms of all of these agreements may be less favorable to us than we could have obtained from third parties.\nRisks Related to the Lodging Industry\nOur ability to comply with the terms of the indenture, our ability to make distributions to the Company’s stockholders and the value of our hotels in general, may be adversely affected by factors in the lodging industry.\nOperating Risks\nOur hotel properties are subject to various operating risks common to the lodging industry, many of which are beyond our control, including the following:\n| • | competition from other hotel properties in our markets; |\n\n| • | over-building of hotels in our markets, which adversely affects occupancy and revenues at our hotels; |\n\n| • | dependence on business and commercial travelers and tourism; |\n\n| • | increases in energy costs and other expenses affecting travel, which may affect travel patterns and reduce the number of business and commercial travelers and tourists; |\n\n| • | increases in operating costs due to inflation and other factors, including increases in labor costs, that may not be offset by increased room rates; |\n\n| • | changes in interest rates and in the availability, cost and terms of debt financing; |\n\n| • | changes in governmental laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance with laws and regulations, fiscal policies and ordinances; |\n\n18\n\n| • | adverse effects of international, national, regional and local economic and market conditions; |\n\n| • | adverse effects of a downturn in the lodging industry; and |\n\n| • | risks generally associated with the ownership of hotel properties and real estate, as we discuss in detail below. |\n\nThese factors could reduce the net income of our TRS Lessees, which in turn could adversely affect the value of our hotels and our ability to comply with the terms of the indenture and to make distributions to the Company’s stockholders.\nCompetition for Acquisitions\nWe may compete for investment opportunities with entities that may have substantially greater financial resources than we do. These entities generally may be able to accept more risk than we choose to prudently manage. This competition may generally limit the number of suitable investment opportunities offered to us. This competition may also increase the bargaining power of property owners seeking to sell to us, making it more difficult for us to acquire new properties on attractive terms.\nSeasonality of the Hotel Business\nThe lodging industry is seasonal in nature, which can be expected to cause quarterly fluctuations in our revenues. Our quarterly earnings may be adversely affected by factors outside our control, including weather conditions and poor economic factors. As a result, we may have to enter into short-term borrowings in certain quarters in order to offset these fluctuations in revenues and to make distributions to the Company’s stockholders.\nInvestment Concentration in Particular Segments of a Single Industry\nOur entire business is lodging-related. Therefore, a downturn in the lodging industry, in general, and the full-service, upscale and upper-upscale segments in which we operate, in particular, will have a material adverse effect on the value of our hotels, our financial condition and the extent to which cash may be available for distribution to the Company’s stockholders.\nCapital Expenditures\nOur hotel properties have an ongoing need for renovations and other capital improvements, including replacements, from time to time, of furniture, fixtures and equipment. The franchisors of our hotels also require us to make periodic capital improvements as a condition of keeping the franchise licenses. In addition, several of our mortgage lenders require that we set aside amounts for capital improvements to the secured properties on a monthly basis. For the years ended December 31, 2016 and 2015, we spent approximately $14.8 million and approximately $20.1 million, respectively, on capital improvements to our hotels. Capital improvements and renovation projects may give rise to the following risks:\n| • | possible environmental problems; |\n\n| • | construction cost overruns and delays; |\n\n| • | a possible shortage of available cash to fund capital improvements and the related possibility that financing for these capital improvements may not be available to us on affordable terms; and |\n\n| • | uncertainties as to market demand or a loss of market demand after capital improvements have begun. |\n\nThe costs of all these capital improvements as well as future capital improvements could adversely affect our financial condition and amounts available for distribution to the Company’s stockholders.\nOperating our hotels under franchise agreements could increase our operating costs and lower our net income.\nMost of our hotels operate under franchise agreements which subject us to risks in the event of negative publicity related to one of our franchisors.\nThe maintenance of the franchise licenses for our hotels is subject to our franchisors’ operating standards and other terms and conditions. Our franchisors periodically inspect our hotels to ensure that we, our TRS Lessees, and the management company follow their standards. Failure by us, our TRS Lessees or the management company to maintain these standards or other terms and conditions could result in a franchise license being canceled. If a franchise license terminates due to our failure to make required improvements or to otherwise comply with its terms, we may also be liable to the franchisor for a termination payment, which varies by franchisor and by hotel. As a condition of continuing a franchise license, a franchisor may require us to make capital expenditures, even if we do not believe the capital improvements are necessary or desirable or will result in an acceptable return on our investment. Nonetheless, we may risk losing a franchise license if we do not make franchisor-required capital expenditures.\n19\nIf a franchisor terminates the franchise license, we may try either to obtain a suitable replacement franchise license or to operate the hotel without a franchise license. The loss of a franchise license could significantly decrease the revenues at the hotel and reduce the underlying value of the hotel because of the loss of associated name recognition, marketing support and centralized reservation systems provided by the franchisor. A loss of a franchise license for one or more hotels could materially and adversely affect our revenues. This loss of revenues could, therefore, also adversely affect our financial condition and results of operations, our ability to comply with the terms of the indenture and reduce our cash available for distribution to stockholders.\nRestrictive covenants in certain of our franchise agreements contain provisions that may operate to limit our ability to sell or refinance our hotels, which could have a material adverse effect on us.\nFranchise agreements typically contain covenants that may affect our ability to sell or refinance a hotel, including requirements to obtain the consent of the franchisor in the event of such a sale or refinancing transaction. In the event that a franchisor’s consent is not forthcoming, the terms of a sale or refinancing may be less favorable to us than would otherwise be the case. Some of our franchise agreements provide the franchisor with a right of first offer in the event of certain sales or transfers of a hotel and provide that the franchisor has the right to approve any change in the hotel management company engaged to manage the hotel. Generally, we may be limited in our ability to sell, lease or otherwise transfer hotels unless the transferee is not a competitor of the franchisor and the transferee agrees to assume the related franchise agreements. If the franchisor does not consent to the sale or financing of our hotels, we may be unable to consummate transactions that are in our best interests or the terms of those transactions may be less favorable to us, which could have a material adverse effect on our financial condition and the execution of our strategies.\nHotel re-development is subject to timing, budgeting and other risks that would increase our operating costs and limit our ability to make distributions to stockholders.\nWe intend to acquire hotel properties from time to time as suitable opportunities arise, taking into consideration general economic conditions, and seek to re-develop or reposition these hotels. Redevelopment of hotel properties involves a number of risks, including risks associated with:\n| • | construction delays or cost overruns that may increase project costs; |\n\n| • | receipt of zoning, occupancy and other required governmental permits and authorizations; |\n\n| • | development costs incurred for projects that are not pursued to completion; |\n\n| • | acts of God such as earthquakes, hurricanes, floods or fires that could adversely impact a project; |\n\n| • | financing; and |\n\n| • | governmental restrictions on the nature or size of a project. |\n\nWe cannot assure you that any re-development project will be completed on time or within budget. Our inability to complete a project on time or within budget would increase our operating costs and reduce our net income.\nThe hotel business is capital intensive and our inability to obtain financing could limit our growth.\nOur hotel properties will require periodic capital expenditures and renovation to remain competitive. Acquisitions or development of additional hotel properties will require significant capital expenditures. In addition, several of our mortgage lenders require that we set aside annual amounts for capital improvements to the secured property. We may not be able to fund capital improvements or acquisitions solely from cash provided from our operating activities because we must distribute at least 90.0% of our REIT taxable income, excluding net capital gains, each year to maintain our REIT tax status. As a result, our ability to fund significant capital expenditures, acquisitions or hotel development through retained earnings is very limited. Consequently, we rely upon the availability of debt or equity capital to fund any significant investments or capital improvements. Our ability to grow through acquisitions or development of hotels will be limited if we cannot obtain satisfactory debt or equity financing which will depend on market conditions. Neither our charter nor our bylaws limit the amount of debt that we can incur. However, we cannot assure you that we will be able to obtain additional equity or debt financing or that we will be able to obtain such financing on favorable terms.\n20\nUninsured and underinsured losses could adversely affect our operating results and our ability to make distributions to the Company’s stockholders.\nWe maintain comprehensive insurance on each of our hotel properties, including liability, fire and extended coverage, of the type and amount we believe are customarily obtained for or by hotel owners. There are no assurances that current coverage will continue to be available at reasonable rates. Various types of catastrophic losses, like hurricanes, earthquakes and floods, such as Hurricane Matthew in October 2016 and Hurricane Sandy in October 2012, losses from foreign terrorist activities, such as those on September 11, 2001, or losses from domestic terrorist activities, such as the Oklahoma City bombing on April 19, 1995, may not be insurable or may not be economically insurable. Currently, our insurers provide terrorism coverage in conjunction with the Terrorism Risk Insurance Program sponsored by the federal government through which insurers are able to receive compensation for insured losses resulting from acts of terrorism.\nIn the event of a substantial loss, our insurance coverage may not be sufficient to cover the full current market value or replacement cost of our lost investment. Should an uninsured loss or a loss in excess of insured limits occur, we could lose all or a portion of the capital we have invested in a hotel, as well as the anticipated future revenue from the hotel. In that event, we might nevertheless remain obligated for any mortgage debt or other financial obligations related to the property. Inflation, changes in building codes and ordinances, environmental considerations and other factors might also keep us from using insurance proceeds to replace or renovate a hotel after it has been damaged or destroyed. Under those circumstances, the insurance proceeds we receive might be inadequate to restore our economic position on the damaged or destroyed property.\nNoncompliance with governmental regulations could adversely affect our operating results.\nEnvironmental Matters\nOur hotels may be subject to environmental liabilities. An owner of real property can face liability for environmental contamination created by the presence or discharge of hazardous substances on the property. We may face liability regardless of:\n| • | our knowledge of the contamination; |\n\n| • | the timing of the contamination; |\n\n| • | the cause of the contamination; or |\n\n| • | the party responsible for the contamination of the property. |\n\nThere may be unknown environmental problems associated with our properties. If environmental contamination exists on our properties, we could become subject to strict, joint and several liability for the contamination by virtue of our ownership interest.\nThe presence of hazardous substances on a property may adversely affect our ability to sell the property and we may incur substantial remediation costs. The discovery of environmental liabilities attached to our properties could have a material adverse effect on our results of operations and financial condition and our ability to comply with our covenants and to pay distributions to stockholders.\nAmericans with Disabilities Act and Other Changes in Governmental Rules and Regulations\nUnder the Americans with Disabilities Act of 1990, or the ADA, all public accommodations must meet various federal requirements related to access and use by disabled persons. Compliance with the ADA’s requirements could require removal of access barriers, and non-compliance could result in the U.S. government imposing fines or in private litigants winning damages. If we are required to make substantial modifications to our hotels, whether to comply with the ADA or other changes in governmental rules and regulations, our financial condition, results of operations and ability to comply with the terms of the indenture and to make distributions to the Company’s stockholders could be adversely affected.\nOur hotels may be subject to unknown or contingent liabilities which could cause us to incur substantial costs.\nThe hotel properties that we acquire may be subject to unknown or contingent liabilities for which we may have no recourse, or only limited recourse, against the sellers. Contingent or unknown liabilities with respect to entities or properties acquired might include:\n| • | liabilities for environmental conditions; |\n\n| • | losses in excess of our insured coverage; |\n\n| • | accrued but unpaid liabilities incurred in the ordinary course of business; |\n\n21\n\n| • | tax, legal and regulatory liabilities; |\n\n| • | claims of customers, vendors or other persons dealing with the Company’s predecessors prior to our formation or acquisition transactions that had not been asserted or were unknown prior to the Company’s formation or acquisition transactions; and |\n\n| • | claims for indemnification by the general partners, officers and directors and others indemnified by the former owners of our properties. |\n\nIn general, the representations and warranties provided under the transaction agreements related to the sales of the hotel properties may not survive the closing of the transactions. While we will likely seek to require the sellers to indemnify us with respect to breaches of representations and warranties that survive, such indemnification may be limited and subject to various materiality thresholds, a significant deductible or an aggregate cap on losses. As a result, there is no guarantee that we will recover any amounts with respect to losses due to breaches by the sellers of their representations and warranties. In addition, the total amount of costs and expenses that may be incurred with respect to liabilities associated with these hotels may exceed our expectations, and we may experience other unanticipated adverse effects, all of which may adversely affect our financial condition, results of operations and our ability to make distributions to the Company’s stockholders.\nFuture terrorist activities may adversely affect, and create uncertainty in, our business.\nTerrorism in the United States or elsewhere could have an adverse effect on our business, although the degree of impact will depend on a number of factors, including the U.S. and global economies and global financial markets. Previous terrorist attacks in the United States and subsequent terrorism alerts have adversely affected the travel and hospitality industries over the past several years. Such attacks, or the threat of such attacks, could have a material adverse effect on our business, our ability to finance our business, our ability to insure our properties and/or our results of operations and financial condition, as a whole.\nWe face risks related to pandemic diseases, which could materially and adversely affect travel and result in reduced demand for our hotels.\nOur business could be materially and adversely affected by the effect of a pandemic disease on the travel industry. For example, the outbreaks of SARS and avian flu in 2003 had a severe impact on the travel industry, the outbreaks of H1N1 flu in 2009 threatened to have a similar impact, and the perceived threat of a Zika virus outbreak in 2016 had an impact on the south Florida market. A prolonged recurrence of SARS, avian flu, H1N1 flu, Ebola virus, Zika virus or another pandemic disease also may result in health or other government authorities imposing restrictions on travel. Any of these events could result in a significant drop in demand for our hotels and adversely affect our financial conditions and results of operations.\nGeneral Risks Related to the Real Estate Industry\nIlliquidity of real estate investments could significantly impede our ability to respond to adverse changes in the performance of our properties and harm our financial condition.\nBecause real estate investments are relatively illiquid, our ability to promptly sell one or more hotel properties in our portfolio in response to changing economic, financial and investment conditions is limited.\nThe real estate market is affected by many factors that are beyond our control, including:\n| • | adverse changes in international, national, regional and local economic and market conditions; |\n\n| • | changes in interest rates and in the cost and terms of debt financing; |\n\n| • | absence of liquidity in credit markets which limits the availability and amount of debt financing; |\n\n| • | changes in governmental laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance with laws and regulations, fiscal policies and ordinances; |\n\n| • | the ongoing need for capital improvements, particularly in older structures; |\n\n| • | changes in operating expenses; and |\n\n| • | civil unrest, acts of God, including earthquakes, floods and other natural disasters such as Hurricane Matthew in October 2016 and Hurricane Sandy in October 2012, which may result in uninsured losses, and acts of war or terrorism, including the consequences of terrorist acts, such as those that occurred on September 11, 2001. |\n\n22\nWe may decide to sell our hotels in the future. We cannot predict whether we will be able to sell any hotel property for the price or on the terms set by us, or whether any price or other terms offered by a prospective purchaser would be acceptable to us. We also cannot predict the length of time needed to find a willing purchaser and to close the sale of a hotel property.\nWe may be required to expend funds to correct defects or to make improvements before a hotel property can be sold. We cannot assure you that we will have funds available to correct those defects or to make those improvements. In acquiring a hotel property, we may agree to lock-out provisions that materially restrict us from selling that property for a period of time or impose other restrictions, such as a limitation on the amount of debt that can be placed or repaid on that property. These factors and any others that would impede our ability to respond to adverse changes in the performance of our properties could have a material adverse effect on our operating results and financial condition, as well as our ability to comply with the terms of the indenture and to pay distributions to stockholders.\nFuture acquisitions may not yield the returns expected, may result in disruptions to our business, may strain management resources and may result in stockholder dilution.\nOur business strategy may not ultimately be successful and may not provide positive returns on our investments. Acquisitions may cause disruptions in our operations and divert management’s attention away from day-to-day operations. The issuance of equity securities in connection with any acquisition could be substantially dilutive to the Company’s stockholders.\nOur hotels may contain or develop harmful mold, which could lead to liability for adverse health effects and costs of remediating the problem.\nWhen excessive moisture accumulates in buildings or on building materials, mold growth may occur, particularly if the moisture problem remains undiscovered or is not addressed over a period of time. Some molds may produce airborne toxins or irritants. Concern about indoor exposure to mold has been increasing, as exposure to mold may cause a variety of adverse health effects and symptoms, including allergic or other reactions. As a result, the presence of significant mold at any of our properties could require us to undertake a costly remediation program to contain or remove the mold from the affected property, which would reduce our cash available for distribution. In addition, the presence of significant mold could expose us to liability from our guests, employees or the management company and others if property damage or health concerns arise and could harm our reputation.\nIncreases in property taxes would increase our operating costs, reduce our income and adversely affect our ability to make distributions to the Company’s stockholders.\nEach of our hotel properties is subject to real and personal property taxes. These taxes may increase as tax rates change and as the properties are assessed or reassessed by taxing authorities. If property taxes increase, our financial condition, results of operations and our ability to make distributions to the Company’s stockholders could be materially and adversely affected and the market price of the Company’s shares could decline.\nRisks Related to Our Organization and Structure\nOur ability to effect a merger or other business combination transaction may be restricted by our Operating Partnership agreement.\nIn the event of a change of control of the Company, the limited partners of our Operating Partnership will have the right, for a period of 30 days following the change of control event, to cause the Operating Partnership to redeem all of the units held by the limited partners for a cash amount equal to the cash redemption amount otherwise payable upon redemption pursuant to the partnership agreement. This cash redemption right may make it more unlikely or difficult for a third party to propose or consummate a change of control transaction, even if such transaction were in the best interests of the Company’s stockholders.\nProvisions of the Company’s charter may limit the ability of a third party to acquire control of the Company.\nAggregate Share and Common Share Ownership Limits\nThe Company’s charter provides that no person may directly or indirectly own more than 9.9% of the value of the Company’s outstanding shares of capital stock or more than 9.9% of the number of the Company’s outstanding shares of common stock. These ownership limitations may prevent an acquisition of control of the Company by a third party without the Company’s board of directors’ approval, even if the Company’s stockholders believe the change of control is in their interest. The Company’s board of directors has discretion to waive that ownership limit if, including other considerations, the board receives evidence that ownership in excess of the limit will not jeopardize the Company’s REIT status.\n23\nAuthority to Issue Stock\nThe Company’s amended and restated charter authorizes our board of directors to issue up to 49,000,000 shares of common stock and up to 11,000,000 shares of preferred stock, to classify or reclassify any unissued shares of common stock or preferred stock and to set the preferences, rights and other terms of the classified or reclassified shares. Issuances of additional shares of stock may have the effect of delaying or preventing a change in control of the Company, including transactions at a premium over the market price of the Company’s stock, even if stockholders believe that a change of control is in their interest. The Company will be able to issue additional shares of common or preferred stock without stockholder approval, unless stockholder approval is required by applicable law or the rules of any stock exchange or automated quotation system on which the Company’s securities may be listed or traded.\nProvisions of Maryland law may limit the ability of a third party to acquire control of the Company.\nCertain provisions of the Maryland General Corporation Law, or the MGCL, may have the effect of inhibiting a third party from making a proposal to acquire us or of impeding a change of control under circumstances that otherwise could provide the holders of shares of the Company’s common stock with the opportunity to realize a premium over the then-prevailing market price of such shares, including:\n| • | “business combination” provisions that, subject to limitations, prohibit certain business combinations between us and an “interested stockholder” (defined generally as any person who beneficially owns 10.0% or more of the voting power of our shares or an affiliate thereof) for five years after the most recent date on which the stockholder becomes an interested stockholder, and thereafter imposes special appraisal rights and special stockholder voting requirements on these combinations; and |\n\n| • | “control share” provisions that provide that “control shares” of the Company (defined as shares which, when aggregated with other shares controlled by the stockholder, entitle the stockholder to exercise one of three increasing ranges of voting power in electing directors) acquired in a “control share acquisition” (defined as the direct or indirect acquisition of ownership or control of “control shares”) have no voting rights except to the extent approved by the Company’s stockholders by the affirmative vote of at least two-thirds of all the votes entitled to be cast on the matter, excluding all interested shares. |\n\nThe Company has opted out of these provisions of the MGCL, in the case of the business combination provisions of the MGCL by resolution of the Company’s board of directors, and in the case of the control share provisions of the MGCL pursuant to a provision in the Company’s bylaws. However, the Company’s board of directors may by resolution elect to opt in to the business combination provisions of the MGCL and the Company may, by amendment to its bylaws, opt in to the control share provisions of the MGCL in the future. The Company’s board of directors has the exclusive power to amend the Company’s bylaws.\nAdditionally, Title 8, Subtitle 3 of the MGCL permits the Company’s board of directors, without stockholder approval and regardless of what is currently provided in the Company’s charter or bylaws, to implement takeover defenses, some of which (for example, a classified board) the Company does not currently have. These provisions may have the effect of inhibiting a third party from making an acquisition proposal for the Company or of delaying, deferring or preventing a change in control of the Company under the circumstances that otherwise could provide the holders of the Company’s common stock with the opportunity to realize a premium over the then current market price.\nProvisions in the Company’s executive officers’ employment agreements may make a change of control of the Company more costly or difficult.\nThe Company’s employment agreements with Andrew M. Sims, its chief executive officer, David R. Folsom, its president and chief operating officer, and Anthony E. Domalski, its chief financial officer, contain provisions providing for substantial payments to these officers in the event of a change of control of the Company. Specifically, if the Company terminates these executive’s employment without cause or the executive resigns with good reason, which includes a failure to nominate Andrew M. Sims to the Company’s board of directors or his involuntary removal from the Company’s board of directors, unless for cause or by vote of the stockholders, or if there is a change of control, each of these executives is entitled to the following:\n| • | any accrued but unpaid salary and bonuses; |\n\n| • | vesting of any previously issued stock options and restricted stock; |\n\n| • | payment of the executive’s life, health and disability insurance coverage for a period of five years following termination; |\n\n| • | any unreimbursed expenses; and |\n\n| • | a severance payment equal to three times for Andrew M. Sims’, David R. Folsom’s and Anthony E. Domalski’s respective combined salary and actual bonus compensation for the preceding fiscal year. |\n\n24\nIn addition, these executives will receive additional payments to compensate them for the additional taxes, if any, imposed on them under Section 4999 of the Code by reason of receipt of excess parachute payments. We will not be able to deduct any of the above amounts paid to the executives for tax purposes.\nThese provisions may make a change of control of the Company, even if it is in the best interests of the Company’s stockholders, more costly and difficult and may reduce the amounts the Company’s stockholders would receive in a change of control transaction.\nOur ownership limitations may restrict or prevent you from engaging in certain transfers of the Company’s common stock or preferred stock.\nIn order to maintain the Company’s REIT qualification, it cannot be closely held (i.e., more than 50.0% in value of our outstanding stock cannot be owned, directly or indirectly, by five or fewer individuals during the last half of any taxable year). To preserve the Company’s REIT qualification, the Company’s charter contains a 9.9% aggregate share ownership limit and a 9.9% common share ownership limit. Generally, any shares of the Company’s stock owned by affiliated persons will be added together for purposes of the aggregate share ownership limit, and any shares of common stock owned by affiliated owners will be added together for purposes of the common share ownership limit.\nIf anyone transfers shares in a way that would violate the aggregate share ownership limit or the common share ownership limit, or prevent the Company from continuing to qualify as a REIT under the federal income tax laws, those shares instead will be transferred to a trust for the benefit of a charitable beneficiary and will be either redeemed by us or sold to a person whose ownership of the shares will not violate the aggregate share ownership limit or the common share ownership limit. If this transfer to a trust fails to prevent such a violation or fails to preserve the Company’s continued qualification as a REIT, then the Company will consider the initial intended transfer to be null and void from the outset. The intended transferee of those shares will be deemed never to have owned the shares. Anyone who acquires shares in violation of the aggregate share ownership limit, the common share ownership limit or the other restrictions on transfer in the Company’s charter bears the risk of suffering a financial loss when the shares are redeemed or sold if the market price of the Company’s stock falls between the date of purchase and the date of redemption or sale.\nThe Company’s articles supplementary establishing and fixing the rights and preferences of Series B preferred stock provide that no person may directly or indirectly own more than 9.9% of the aggregate number of outstanding shares of Series B preferred stock, excluding any outstanding shares of Series B preferred stock not treated as outstanding for federal income tax purposes. The Company’s board of directors has discretion to waive that ownership limit if, including other considerations, the board receives evidence that ownership in excess of the limit will not jeopardize the Company’s REIT status.\nHolders of our outstanding preferred shares have dividend, liquidation and other rights that are senior to the rights of the holders of our common shares.\nOur board of directors has the authority to designate and issue preferred shares with liquidation, dividend and other rights that are senior to those of our common shares. As of December 31, 2016, 1,610,000 shares of our 8.0% Series B Cumulative Redeemable Preferred Stock were issued and outstanding. The aggregate liquidation preference with respect to the outstanding preferred shares is approximately $40.3 million, and annual dividends on our outstanding preferred shares are approximately $3.2 million. Holders of our Series B Preferred Stock are entitled to cumulative dividends before any dividends may be declared or set aside on our common shares. Upon our voluntary or involuntary liquidation, dissolution or winding up, before any payment is made to holders of our common shares, holders of these preferred shares are entitled to receive a liquidation preference of $25.00 per share plus any accrued and unpaid distributions. This will reduce the remaining amount of our assets, if any, available to distribute to holders of our common shares. In addition, holders of these preferred shares have the right to elect two additional directors to our board of directors whenever dividends on the preferred shares are in arrears in an aggregate amount equivalent to six or more quarterly dividends (whether or not consecutive). Because our decision to issue securities will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of any future preferred offerings. Thus, our stockholders bear the risk of our future securities issuances reducing the market price of our common shares and diluting their interest.\nThe change of control conversion and redemption features of the Series B Preferred Stock may make it more difficult for a party to take over our Company or discourage a party from taking over our Company.\nUpon a change of control (as defined in our charter), holders of our Series B Preferred Stock will have the right (unless, as provided in our charter, we have provided or provide notice of our election to exercise our special optional redemption right before the relevant date) to convert some or all of their shares of our Series B Preferred Stock into shares of our common stock (or equivalent value of alternative consideration). Upon such a conversion, holders will be limited to a maximum number of shares equal to the share cap, subject to adjustments. If the common stock price is less than $3.015, subject to adjustment, holders will receive a maximum of\n25\n8.29187 shares of our common stock per share of Series B Preferred Stock, which may result in a holder receiving value that is less than the liquidation preference of the Series B Preferred Stock. In addition, those features of our Series B Preferred Stock may have the effect of inhibiting or discouraging a third party from making an acquisition proposal for our Company or of delaying, deferring or preventing a change in control of our Company under circumstances that otherwise could provide the holders of shares of our common stock and shares of our Series B Preferred Stock with the opportunity to realize a premium over the then current market price or that stockholders may otherwise believe is in their best interests.\nThe board of directors’ revocation of the Company’s REIT status without stockholder approval may decrease the Company’s stockholders’ total return.\nThe Company’s charter provides that the Company’s board of directors may revoke or otherwise terminate the Company’s REIT election, without the approval of the Company’s stockholders, if the Company’s board of directors determines that it is no longer in the Company’s best interest to continue to qualify as a REIT. If the Company ceases to be a REIT, it would become subject to federal income tax on its taxable income and would no longer be required to distribute most of its taxable income to the Company’s stockholders, which may have adverse consequences on our total return to the Company’s stockholders.\nThe ability of the Company’s board of directors to change the Company’s major corporate policies may not be in your best interest.\nThe Company’s board of directors determines the Company’s major corporate policies, including its acquisition, financing, growth, operations and distribution policies. The Company’s board of directors may amend or revise these and other policies from time to time without the vote or consent of the Company’s stockholders.\nOur success depends on key personnel whose continued service is not guaranteed.\nWe depend on the efforts and expertise of our chairman and chief executive officer, Andrew M. Sims; our president and chief operating officer, David R. Folsom; and our chief financial officer, Anthony E. Domalski, to manage our day-to-day operations and strategic business direction. The loss of any of their services could have an adverse effect on our operations.\nFederal Income Tax Risks Related to the Company’s Status as a REIT\nThe federal income tax laws governing REITs are complex.\nThe Company intends to operate in a manner that will maintain its qualification as a REIT under the federal income tax laws. The REIT qualification requirements are extremely complex, however, and interpretations of the federal income tax laws governing qualification as a REIT are limited. The Company has not requested or obtained a ruling from the Internal Revenue Service, or the IRS, that it qualifies as a REIT. Accordingly, we cannot be certain that the Company will be successful in operating in a manner that will permit it to qualify as a REIT. At any time, new laws, interpretations or court decisions may change the federal tax laws or the federal income tax consequences of the Company’s qualification as a REIT. We cannot predict when or if any new federal income tax law, regulation or administrative interpretation, or any amendment to any existing federal income tax law, regulation or administrative interpretation, will be adopted, promulgated or become effective and any such law, regulation or interpretation may take effect retroactively. The Company and its stockholders could be adversely affected by any such change in, or any new, federal income tax law, regulation or administrative interpretation. We are not aware, however, of any pending tax legislation that would adversely affect the Company’s ability to qualify as a REIT.\nFailure to make distributions could subject the Company to tax.\nIn order to maintain its qualification as a REIT, each year the Company must pay out to its stockholders in distributions, as “qualifying distributions,” at least 90.0% of its REIT taxable income, computed without regard to the deductions for dividends paid and excluding net capital gains and reduced by certain non-cash items. To the extent that the Company satisfies this distribution requirement, but distributes less than 100.0% of its taxable income (including its net capital gain), it will be subject to federal corporate income tax on its undistributed taxable income. In addition, the Company will be subject to a 4.0% nondeductible excise tax if the actual amount that it pays out to its stockholders as a “qualifying distribution” for a calendar year is less than the sum of: (A) 85.0% of our ordinary income for such calendar year, plus (B) 95.0% of our capital gain net income for such calendar year. The Company’s only recurring source of funds to make these distributions comes from rent received from its TRS Lessees whose only recurring source of funds with which to make these payments and distributions is the net cash flow (after payment of operating and other costs and expenses and management fees) from hotel operations, and any dividend and other distributions that we may receive from MHI Holding. Accordingly, the Company may be required to borrow money or sell assets to make distributions sufficient to enable it to pay out enough of its taxable income to satisfy the distribution requirement and to avoid corporate income tax and the 4.0% nondeductible excise tax in a particular year.\n26\nFailure to qualify as a REIT would subject the Company to federal income tax.\nIf the Company fails to qualify as a REIT in any taxable year, it will be required to pay federal income tax (including any applicable alternative minimum tax) on its taxable income at regular corporate rates. The resulting tax liability might cause the Company to borrow funds, liquidate some of its investments or take other steps that could negatively affect its operating results in order to pay any such tax. Unless it is entitled to relief under certain statutory provisions, the Company would be disqualified from treatment as a REIT for the four taxable years following the year in which it lost its qualification. If the Company lost its REIT status, its net earnings available for investment or distribution to stockholders would be significantly reduced for each of the years involved. In addition, the Company would no longer be required to make distributions to its stockholders, and it would not be able to deduct any stockholder distributions in computing its taxable income. This would substantially reduce the Company’s earnings, cash available to pay distributions, and the value of common stock.\nFailure to qualify as a REIT may cause the Company to reduce or eliminate distributions to its stockholders, and the Company may face increased difficulty in raising capital or obtaining financing.\nIf the Company fails to remain qualified as a REIT, it may have to reduce or eliminate any distributions to its stockholders in order to satisfy its income tax liabilities. Any distributions that the Company does make to its stockholders would be treated as taxable dividends to the extent of its current and accumulated earnings and profits. This may result in negative investor and market perception regarding the market value of the Company’s stock, and the value of its stock may be reduced. In addition, the Company and the Operating Partnership may face increased difficulty in raising capital or obtaining financing if the Company fails to qualify or remain qualified as a REIT because of the resulting tax liability and potential reduction of its market valuation.\nIf MHI Holding exceeds certain value thresholds, this could cause the Company to fail to qualify as a REIT.\nFor taxable years of the Company ending on or before December 31, 2017, at the end of each quarter of each taxable year of the Company, no more than 25.0% of the value of the Company’s total assets may consist of securities of one or more taxable REIT subsidiaries (“TRSs”). For taxable years of the Company ending after December 31, 2017, at the end of each quarter of each taxable year of the Company, no more than 20.0% of the value of the Company’s total assets may consist of securities of one or more TRSs. MHI Holding is a TRS and the Company may form other TRSs in the future. The Company plans to monitor the value of its shares of MHI Holding and of any other TRS the Company may form. However, there can be no assurance that the Internal Revenue Service will not attempt to attribute additional value to the shares of MHI Holding or to the shares of any other TRS that the Company may form. If the Company is treated as owning securities of one or more TRSs with an aggregate value that is in excess of the thresholds outlined above, the Company could lose its status as a REIT or become subject to penalties.\nEven if the Company remains qualified as a REIT, it may face other tax liabilities that reduce its cash flow.\nEven if the Company remains qualified for taxation as a REIT, it may be subject to certain federal, state and local taxes on its income and assets. For example:\n| • | it will be required to pay tax on undistributed REIT taxable income (including net capital gain); |\n\n| • | it may be required to pay “alternative minimum tax” on its items of tax preference; |\n\n| • | if it has net income from the disposition of foreclosure property held primarily for sale to customers in the ordinary course of business or other non-qualifying income from foreclosure property, it must pay tax on that income at the highest corporate rate; |\n\n| • | if it (or the Operating Partnership or any subsidiary of the Operating Partnership other than MHI Holding) sells a property in a “prohibited transaction,” its gain, or its share of such gain, from the sale would be subject to a 100.0% penalty tax. A “prohibited transaction” would be a sale of property, other than a foreclosure property, held primarily for sale to customers in the ordinary course of business; |\n\n| • | MHI Holding is a fully taxable corporation and is required to pay federal and state taxes on its taxable income; and |\n\n| • | it may experience increases in its state and/or local income tax burdens as states and localities continue to look to modify their tax laws in order to raise revenues, including by (among other things) changing from a net taxable income-based regime to a gross receipts-based regime, suspending and/or limiting the use of net operating losses, increasing tax rates and fees, imposing surcharges and subjecting partnerships to an entity-level tax, and limiting or disallowing certain U.S. federal deductions such as the dividends-paid deduction. |\n\n27\nComplying with REIT requirements may cause the Company to forgo attractive opportunities that could otherwise generate strong risk-adjusted returns and instead pursue less attractive opportunities, or none at all.\nTo qualify as a REIT for federal income tax purposes, the Company must continually satisfy tests concerning, among other things, the sources of its income, the nature and diversification of its assets, the amounts it distributes to its stockholders and the ownership of its stock.\nIn general, when applying these tests, the Company is treated as owning its proportionate share of the Operating Partnership’s assets (which share is determined in accordance with the Company’s capital interest in the Operating Partnership) and as being entitled to the Operating Partnership’s income attributable to such share. Thus, compliance with the REIT requirements may hinder our ability to operate solely on the basis of generating strong risk-adjusted returns on invested capital for our stockholders.\nComplying with REIT requirements may force the Company to liquidate otherwise attractive investments, which could result in an overall loss on its investments.\nTo maintain qualification as a REIT, the Company must ensure that at the end of each calendar quarter at least 75.0% of the value of its assets consists of cash, cash items, government securities and qualified REIT real estate assets. The remainder of the Company’s assets (other than securities of one or more taxable REIT subsidiaries) generally cannot include more than 10.0% of the outstanding voting securities of any one issuer or more than 10.0% of the total value of the outstanding securities of any one issuer. In addition, in general, no more than 5.0% of the value of the Company’s assets (other than government securities, qualified real estate assets and securities of one or more taxable REIT subsidiaries) can consist of the securities of any one issuer, and no more than 25.0% (20.0% for taxable years beginning after December 31, 2017) of the value of the Company’s total assets can be represented by securities of one or more taxable REIT subsidiaries.\nWhen applying these asset tests, the Company is treated as owning its proportionate share of the Operating Partnership’s assets (which is determined in accordance with the Company’s capital interest in the Operating Partnership). If the Company fails to comply with these requirements at the end of any calendar quarter, it must correct such failure within 30 days after the end of the calendar quarter to avoid losing its REIT status and suffering adverse tax consequences. If the Company fails to comply with these requirements at the end of any calendar quarter, and the failure exceeds a de-minimis threshold, the Company may be able to preserve its REIT status if the failure was due to reasonable cause and not to willful neglect. In this case, we will be required to dispose of the assets causing the failure within six months after the last day of the quarter in which the failure occurred, and we will be required to pay an additional tax of the greater of $50,000 or the product of the highest applicable tax rate multiplied by the net income generated on those assets.\nAs a result, we may be required to liquidate otherwise attractive investments.\nIf the Operating Partnership fails to qualify as a partnership for federal income tax purposes, the Company could cease to qualify as a REIT and suffer other adverse consequences.\nWe believe that the Operating Partnership will continue to qualify to be treated as a partnership for U.S. federal income tax purposes. As a partnership, the Operating Partnership is not subject to federal income tax on its income. Instead, each of its partners, including the Company, will be required to pay tax on its allocable share of the Operating Partnership’s income. We cannot assure you, however, that the IRS will not challenge the Operating Partnership’s status as a partnership for U.S. federal income tax purposes, or that a court would not sustain such a challenge. If the IRS were successful in treating the Operating Partnership as a corporation for federal income tax purposes, the Company could fail to meet the gross income tests and certain of the asset tests applicable to REITs and, accordingly, cease to qualify as a REIT. Also, the failure of the Operating Partnership to qualify as a partnership would cause the Operating Partnership to become subject to federal and state corporate income tax, which would reduce significantly the amount of cash available for debt service and for distribution to its partners, including the Company.\nThe Company’s failure to qualify as a REIT would have serious adverse consequences to its stockholders.\nThe Company elected to be taxed as a REIT under Sections 856 through 860 of the Code, commencing with its taxable year ended December 31, 2004. The Company believes it has operated so as to qualify as a REIT under the Code and believes that its current organization and method of operation comply with the rules and regulations promulgated under the Code to enable the Company to continue to qualify as a REIT. However, it is possible that the Company has been organized or has operated in a manner that would not allow it to qualify as a REIT, or that its future operations could cause it to fail to qualify. Qualification as a REIT requires the Company to satisfy numerous requirements (some on an annual and others on a quarterly basis) established under highly technical and complex sections of the Code for which there are only limited judicial and administrative interpretations, and involves the determination of various factual matters and circumstances not entirely within its control. For example, in order to qualify as a\n28\nREIT, the Company must satisfy a 75.0% gross income test pursuant to Code Section 856(c)(3) and a 95.0% gross income test pursuant to Code Section 856(c)(2) each taxable year. In addition, the Company must pay dividends, as “qualifying distributions,” to its stockholders aggregating annually at least 90.0% of its REIT taxable income (determined without regard to the dividends-paid deduction and by excluding capital gains, and reduced by certain non-cash items) and must satisfy specified asset tests on a quarterly basis. While historically the Company has satisfied the distribution requirement discussed above by making cash distributions to its stockholders, the Company may choose to satisfy this requirement by making distributions of cash or other property, including, in limited circumstances, its stock. The provisions of the Code and applicable Treasury regulations regarding qualification as a REIT are more complicated in the Company’s case because its holds its assets through the Operating Partnership.\nIf MHI Holding does not qualify as a taxable REIT subsidiary, or if the Company’s hotel manager does not qualify as an “eligible independent contractor,” the Company would fail to qualify as a REIT and would be subject to higher taxes and have less cash available for distribution to its shareholders.\nRent paid by a lessee that is a “related party tenant” of ours will not be qualifying income for purposes of the two gross income tests applicable to REITs. The Company currently leases substantially all of its hotels to the TRS Lessees, which are disregarded entities for U.S. federal income tax purposes and are wholly-owned by MHI Holding, a taxable REIT subsidiary, and expects to continue to do so. So long as MHI Holding qualifies as a taxable REIT subsidiary, it will not be treated as a “related party tenant” with respect to the Company’s properties that are managed by an independent hotel management company that qualifies as an “eligible independent contractor.” The Company believes that MHI Holding will continue to qualify to be treated as a taxable REIT subsidiary for federal income tax purposes, but there can be no assurance that the IRS will not challenge this status or that a court would not sustain such a challenge. If the IRS were successful in such challenge, it is possible that the Company would fail to meet the asset tests applicable to REITs and substantially all of its income would fail to be qualifying income for purposes of the two gross income tests. If the Company failed to meet any of the asset or gross income tests, it would likely lose its REIT qualification for federal income tax purposes.\nAdditionally, if the Company’s hotel manager does not qualify as an “eligible independent contractor,” the Company would fail to qualify as a REIT. Each hotel manager that enters into a management contract with the TRS Lessees must qualify as an “eligible independent contractor” under the REIT rules in order for the rent paid by the TRS Lessees to be qualifying income for purposes of the REIT gross income tests. Among other requirements, in order to qualify as an eligible independent contractor, a hotel manager must not own, directly or through its shareholders, more than 35.0% of the Company’s outstanding shares, taking into account certain ownership attribution rules. The ownership attribution rules that apply for purposes of these 35.0% thresholds are complex. Although the Company intends to monitor ownership of its shares by its hotel manager and its owners, there can be no assurance that these ownership levels will not be exceeded.\nForeign investors may be subject to U.S. tax on the disposition of the Company’s stock if the Company does not qualify as a “domestically controlled” REIT.\nA foreign person disposing of a “U.S. real property interest,” which includes stock of a U.S. corporation whose assets consist principally of U.S. real property interests, is generally subject to U.S. federal income tax under the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) on the gain recognized on the disposition, unless such foreign person is a “qualified foreign pension fund” or one of the certain publicly traded non-U.S. “qualified collective investment vehicles”. Additionally, the transferee will be required to withhold 15.0% on the amount realized on the disposition if the foreign transferor is subject to U.S. federal income tax under FIRPTA. This 15.0% is creditable against the U.S. federal income tax liability of the foreign transferor in connection with such transferor’s disposition of the Company’s stock. FIRPTA does not apply, however, to the disposition of stock in a REIT if the REIT is “domestically controlled” (i.e., less than 50.0% of the REIT’s capital stock, by value, has been owned directly or indirectly by persons who are not qualifying U.S. persons during a continuous five-year period ending on the date of disposition or, if shorter, during the entire period of the REIT’s existence). We cannot be sure that the Company will qualify as a “domestically controlled” REIT. If the Company does not so qualify, gain realized by foreign investors on a sale of the Company’s stock would be subject to U.S. income and withholding tax under FIRPTA, unless the Company’s stock were traded on an established securities market and a foreign investor did not at any time during a specified testing period directly or indirectly own more than 10.0% of the value of the Company’s outstanding stock.\nMHI Holding increases our overall tax liability.\nOur TRS Lessees are single-member limited liability companies that are wholly-owned, directly or indirectly, by MHI Holding, a taxable REIT subsidiary that is wholly-owned by the Operating Partnership. Each of our TRS Lessees is disregarded as an entity separate from MHI Holding for U.S. federal income tax purposes, such that the assets, liabilities, income, gains, losses, credits and deductions of our TRS Lessees are treated as the assets, liabilities, income, gains, losses, credits and deductions of MHI Holding for U.S. federal income tax purposes. MHI Holding is subject to federal and state income tax on its taxable income, which will consist of\n29\nthe revenues from the hotels leased by the Company’s TRS Lessees, net of the operating expenses for such hotels and rent payments. Accordingly, although the Company’s ownership of MHI Holding and the TRS Lessees will allow it to participate in the operating income from its hotels in addition to receiving rent, that operating income will be fully subject to income tax. The after-tax net income of MHI Holding, if any, will be available for distribution to the Company.\nThe Company will incur a 100.0% excise tax on its transactions with MHI Holding and the TRS Lessees that are not conducted on an arm’s-length basis. For example, to the extent that the rent paid by the TRS Lessees exceeds an arm’s-length rental amount, such amount potentially will be subject to this excise tax. The Company intends that all transactions among itself, MHI Holding and the TRS Lessees will be conducted on an arm’s-length basis and, therefore, that the rent paid by the TRS Lessees will not be subject to this excise tax.\nOur ability to use net operating loss carryforwards to reduce future tax payments may be limited or restricted or may not exist at all, and if we do not sustain our profitability, we may be required to put up a valuation allowance against our deferred tax assets.\nAt December 31, 2016, our financial statements reflected deferred tax assets totaling approximately $6.9 million, of which approximately $6.0 million relates to significant federal and state net operating losses (“NOLs”) generated by our TRS Lessee over the past three years. We are generally able to carry NOLs forward to reduce taxable income in future years. Our ability to use our NOLs to reduce future tax payments is dependent upon our ability to sustain profitability during the time period over which these NOLs may be used under applicable tax law. A valuation allowance is required for deferred tax assets if, based on all available evidence, it is “more-likely-than-not” (defined as a likelihood of more than 50%) that all or a portion of the deferred tax assets will not be realized due to the inability to generate sufficient taxable income in certain financial statement periods. The net amount of deferred tax assets that are recorded on the financial statements must reflect the tax benefits that are expected to be realized using these criteria. We perform this analysis by evaluating a number of factors, including a demonstrated track record of past profitability, reasonable forecasts of future taxable income, and anticipated changes in the lease rental payments from the TRS Lessee to subsidiaries of the Operating Partnership. At December 31, 2016, we determined based on all available positive and negative evidence that it is more-likely-than-not that future taxable income will be available during the carryforward periods to absorb all of the consolidated federal and state net operating loss carryforward. We made this determination considering reasonable tax strategies available to us capable of ensuring the realization of our deferred tax assets, anticipated changes in the lease rental payments and one time losses that generated some of our net operating losses. However, there is no assurance that the TRS Lessee will be able to achieve profitability. The TRS Lessee’s ability to generate sustained profitability in the amounts necessary to realize our deferred tax assets against future taxable income depends upon general economic and market conditions, interest rates, and the TRS Lessee’s ability to meet our strategic plans. If the TRS Lessee is unable to generate adequate sustained profitability, we may be required to record a valuation allowance against some or all of our deferred tax assets, which would negatively impact our financial results.\nTaxation of dividend income could make the Company’s stock less attractive to investors and reduce the market price of its stock.\nThe federal income tax laws governing REITs, or the administrative interpretations of those laws, may be amended at any time. Any new laws or interpretations may take effect retroactively and could adversely affect the Company or could adversely affect its stockholders. Currently, “qualified dividends,” which include dividends from domestic C corporations that are paid to non-corporate stockholders, are subject to a reduced maximum U.S. federal income tax rate of 20.0%. Because REITs generally do not pay corporate-level taxes as a result of the dividends-paid deduction to which they are entitled, dividends from REITs generally are not treated as qualified dividends and thus do not qualify for a reduced tax rate. Non-corporate investors could view an investment in non-REIT corporations as more attractive than an investment in REITs because the dividends they would receive from non-REIT corporations would be subject to lower tax rates.\nInvestors may be subject to a 3.8% Medicare tax in connection with an investment in the Company’s stock or the 7% Notes.\nThe U.S. tax laws impose a 3.8% “Medicare tax” on the “net investment income” (i.e., interest, dividends, capital gains, annuities, and rents that are not derived in the ordinary course of a trade or business) of individuals with income exceeding $200,000 ($250,000 if married filing jointly or $125,000 if married filing separately), and of estates and trusts. Dividends on the Company’s stock and interest on the 7% Notes as well as gains from the disposition of the Company’s stock or the 7% Notes may be subject to the Medicare tax. Prospective investors should consult with their independent advisors as to the applicability of the Medicare tax to an investment in the Company’s stock or the 7% Notes in light of such investors’ particular circumstances.\n30\nInvestors may be subject to U.S. withholding tax under the “Foreign Account Tax Compliance Act.”\nOn March 18, 2010, the Hiring Incentives to Restore Employment Act, or the HIRE Act, was enacted in the United States. The HIRE Act includes provisions known as the Foreign Account Tax Compliance Act, or FATCA, that generally impose a 30.0% U.S. withholding tax on “withholdable payments,” which consist of (i) U.S.-source dividends, interest, rents and other “fixed or determinable annual or periodical income” paid after June 30, 2014 and (ii) certain U.S.-source gross proceeds paid after December 31, 2018 to (a) “foreign financial institutions” unless (x) they enter into an agreement with the IRS to collect and disclose to the IRS information regarding their direct and indirect U.S. owners or (y) they comply with the terms of any FATCA intergovernmental agreement executed between the authorities in their jurisdiction and the U.S., and (b) “non-financial foreign entities” (i.e., foreign entities that are not foreign financial institutions) unless they certify certain information regarding their direct and indirect U.S. owners. Final regulations under FATCA were issued by the IRS on January 17, 2013, and have been subsequently supplemented by additional regulations and guidance. FATCA does not replace the existing U.S. withholding tax regime. However, the FATCA regulations contain coordination provisions to avoid double withholding on U.S.-source income.\nA foreign investor that receives dividends on the Company’s stock or gross proceeds from a disposition of shares of the Company’s stock may be subject to FATCA withholding tax with respect to such dividends or gross proceeds.\nForeign investors will be subject to U.S. withholding tax on the receipt of ordinary dividends on the Company’s stock.\nThe portion of dividends received by a foreign investor payable out of the Company’s current and accumulated earnings and profits which are not attributable to capital gains and which are not effectively connected with a U.S. trade or business of the foreign investor will generally be subject to U.S. withholding tax at a statutory rate of 30.0%. This 30.0% withholding tax may be reduced by an applicable income tax treaty. The FATCA and nonresident withholding regulations are complex. Even if the 30.0% withholding is reduced or eliminated by treaty for payments made to a foreign investor, FATCA withholding of 30.0% could apply depending upon the foreign investor’s FATCA status. Foreign investors should consult with their independent advisors as to the U.S. withholding tax consequences to such investors with respect to their investment in the Company’s stock in light of their particular circumstances, as well as determining the appropriate documentation required to reduce or eliminate U.S. withholding tax.\nForeign investors will be subject to U.S. income tax on the receipt of capital gain dividends on the Company’s stock.\nUnder FIRPTA, distributions that we make to a foreign investor that are attributable to gains from our dispositions of U.S. real property interests (“capital gain dividends”) will be treated as income that is effectively connected with a U.S. trade or business, and therefore subject to U.S. federal income tax, in the hands of the foreign investor, unless such foreign person is a “qualified foreign pension fund” or one of certain publicly traded non-U.S. “qualified collective investment vehicles”. A foreign investor who is subject to tax under FIRPTA will be subject to U.S. federal income tax (at the rates applicable to U.S. investors) on any capital gain dividends, and will also be required to file U.S. federal income tax returns to report such capital gain dividends. Furthermore, capital gain dividends are subject to an additional 30.0% “branch profits tax” (which may be reduced by an applicable income tax treaty) in the hands of a foreign investor who is subject to tax under FIRPTA if such foreign investor is treated as a corporation for U.S. federal income tax purposes.\nLegislative or regulatory action could adversely affect you.\nBecause our operations are governed to a significant extent by the federal tax laws, new legislative or regulatory action could adversely affect our investors. You are strongly encouraged to consult with your own tax advisor with respect to the status of any legislative, regulatory or administrative developments, announcements and proposals and their potential impact on your investment in the Company’s stock.\n\nUnresolved Staff Comments\nNot applicable.\n31\n\nItem 2.\nP\nroperties\nAs of December 31, 2016, our portfolio consisted of the following properties (see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Key Operating Metrics, for definitions of Occupancy, ADR, and RevPAR):\n\n| Number of | Occupancy | ADR | RevPAR | Occupancy | ADR | RevPAR | Occupancy | ADR | RevPAR |\n| Wholly-Owned Properties | Rooms | 2016 | 2016 | 2016 | 2015 | 2015 | 2015 | 2014 | 2014 | 2014 |\n| Crowne Plaza Hampton Marina, Hampton, Virginia (1) | 173 | 55.2 | % | $ | 96.81 | $ | 53.40 | 55.2 | % | $ | 93.59 | $ | 51.64 | 50.8 | % | $ | 93.17 | $ | 48.27 |\n| Crowne Plaza Hollywood Beach Resort, Hollywood, Florida (2) | 311 | 79.6 | % | $ | 170.57 | $ | 135.74 | 83.1 | % | $ | 174.35 | $ | 144.86 | 83.1 | % | $ | 163.13 | $ | 135.55 |\n| Crowne Plaza Tampa Westshore, Tampa, Florida | 222 | 74.6 | % | $ | 116.15 | $ | 86.69 | 72.5 | % | $ | 111.08 | $ | 80.53 | 72.5 | % | $ | 104.90 | $ | 76.09 |\n| DoubleTree by Hilton Jacksonville Riverfront, Jacksonville, Florida | 293 | 77.4 | % | $ | 126.67 | $ | 98.06 | 67.4 | % | $ | 109.20 | $ | 73.60 | 65.8 | % | $ | 99.20 | $ | 65.24 |\n| DoubleTree by Hilton Laurel, Laurel, Maryland | 208 | 60.5 | % | $ | 104.35 | $ | 63.16 | 48.2 | % | $ | 95.19 | $ | 45.86 | 60.8 | % | $ | 89.08 | $ | 54.19 |\n| DoubleTree by Hilton Philadelphia Airport, Philadelphia, Pennsylvania | 331 | 77.0 | % | $ | 144.92 | $ | 111.66 | 79.3 | % | $ | 136.32 | $ | 108.13 | 75.9 | % | $ | 133.78 | $ | 101.58 |\n| DoubleTree by Hilton Raleigh Brownstone – University, Raleigh, North Carolina | 190 | 70.0 | % | $ | 134.74 | $ | 94.33 | 71.5 | % | $ | 131.61 | $ | 94.16 | 73.4 | % | $ | 122.60 | $ | 90.04 |\n| Georgian Terrace, Atlanta, Georgia (3) | 326 | 70.8 | % | $ | 160.89 | $ | 113.88 | 69.9 | % | $ | 155.56 | $ | 108.70 | 76.2 | % | $ | 137.65 | $ | 104.88 |\n| Hilton Savannah DeSoto, Savannah, Georgia | 246 | 71.5 | % | $ | 155.87 | $ | 111.48 | 76.9 | % | $ | 154.52 | $ | 118.89 | 75.7 | % | $ | 146.75 | $ | 111.14 |\n| Hilton Wilmington Riverside, Wilmington, North Carolina | 272 | 70.5 | % | $ | 147.14 | $ | 103.72 | 71.6 | % | $ | 138.36 | $ | 99.07 | 69.7 | % | $ | 139.09 | $ | 96.90 |\n| Sheraton Louisville Riverside, Jeffersonville, Indiana | 180 | 63.1 | % | $ | 137.34 | $ | 86.60 | 69.5 | % | $ | 131.74 | $ | 111.87 | 66.8 | % | $ | 150.20 | $ | 100.31 |\n| The Whitehall, Houston, Texas | 259 | 54.4 | % | $ | 140.70 | $ | 76.56 | 70.9 | % | $ | 142.05 | $ | 100.66 | 76.1 | % | $ | 138.93 | $ | 105.66 |\n| Total | 3,011 |\n\n\n| (1) | On February 7, 2017, the Company sold the Crowne Plaza Hampton Marina. |\n\n| (2) | The operating statistics for the Crowne Plaza Hollywood Beach Resort rely on information from both the period prior to, and the period subsequent to, the Company’s acquisition of the hotel. |\n\n| (3) | The operating statistics for the Georgian Terrace rely on information from both the period prior to, and the period subsequent to, the Company’s acquisition of the hotel. |\n\n\nLegal Proceedings\nWe are not involved in any material litigation, nor to our knowledge, is any material litigation threatened against us. We have settled, during the period covered by this report, all significant claims made during the same period. We are involved in routine litigation arising out of the ordinary course of business, all of which is expected to be covered by insurance, and none of which is expected to have a material impact on our financial condition or results of operations.\nMine Safety Disclosure\nNot applicable.\n32\nPART II\nMarket for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities\nSotherly Hotels Inc.\nMarket Information\nThe Company’s common stock trades on the NASDAQ ® Global Market under the symbol “SOHO”. The following table sets forth, for the indicated period, the intraday high and low prices for the common stock, as reported on NASDAQ ®:\n\n| Price Range |\n| High | Low |\n| Year Ended December 31, 2016 |\n| First Quarter | $ | 6.59 | $ | 4.59 |\n| Second Quarter | $ | 5.99 | $ | 5.00 |\n| Third Quarter | $ | 6.35 | $ | 5.22 |\n| Fourth Quarter | $ | 7.11 | $ | 4.65 |\n| Year Ended December 31, 2015 |\n| First Quarter | $ | 7.87 | $ | 6.26 |\n| Second Quarter | $ | 8.71 | $ | 6.94 |\n| Third Quarter | $ | 7.63 | $ | 5.83 |\n| Fourth Quarter | $ | 6.94 | $ | 4.50 |\n\nThe closing price of the Company’s common stock on the NASDAQ ® Global Market on March 1, 2017 was $6.97 per share.\nStockholder Information\nAs of March 1, 2017, there were 80 holders of record of the Company’s common stock and as of March 1, 2017, there were approximately 3,772 beneficial owners of the Company’s common stock.\nIn order to comply with certain requirements related to the Company’s qualification as a REIT, the Company’s charter, subject to certain exceptions, limits the number of common shares that may be owned by any single person or affiliated group to 9.9% of the outstanding common shares.\nRecent Sales of Unregistered Securities\nOn February 1, 2016, two holders of units in the Operating Partnership redeemed a total of 422,687 units for an equivalent number of shares of the Company’s common stock. The shares of common stock were issued to the unitholder pursuant to an exemption from registration under Section 4(2) of the Securities Act of 1933, as amended.\nOn December 2, 2016, the Company’s Board of Directors authorized a stock repurchase program under which the Company may purchase up to $10.0 million of its outstanding common stock, par value $0.01 per share, at prevailing prices on the open market or in privately negotiated transactions, at the discretion of management. The Company has used and expects to continue to use available working capital to fund purchases under the stock repurchase program and intends to complete the repurchase program prior to December 31, 2017, unless extended by the Board of Directors. Through December 31, 2016 the Company repurchased the following amounts of common stock and the repurchased shares have been returned to the status of authorized but unissued shares of common stock:\n\n| Period | Total Number of Shares Repurchased | Average Price Paid Per Share | Total Number of Shares Purchased As Part of PubliclyAnnounced Program | Maximum Number (or Approximate Dollar Value) of Shares ThatMay Yet Be Purchased Under the Program |\n| December 1- December 31, 2016 | 481,100 | $ | 6.53 | 481,100 | $ | 6,835,464 |\n\n33\nUse of Proceeds from Registered Securities\nOn August 23, 2016, the Company sold 1,610,000 shares, $0.01 par value per share, of its 8% Series B Cumulative Redeemable Perpetual Preferred Stock pursuant to a registration statement on Form S-3 (file no. 333-199256) for net proceeds after all expenses of approximately $37.8 million, which it contributed to the Operating Partnership for an equivalent number of preferred partnership units. The Operating Partnership used the net proceeds to redeem the entire $27.6 million aggregate principal amount of its outstanding 8.0% senior unsecured notes (the “8% Notes”), to acquire the commercial condominium unit and related inventories of the Hyde Resort & Residences for approximately $4.8 million, and will use the remainder of the proceeds for general corporate purposes.\nSotherly Hotels LP\nMarket Information\nThere is no established trading market for partnership units of the Operating Partnership. The Operating Partnership does not currently propose to offer partnership units to the public, and does not currently expect that a public market for those units will develop.\nPartnership Unitholder Information\nAs of March 1, 2017, there were 12 holders of the Operating Partnership’s partnership units, including Sotherly Hotels Inc.\nRecent Sales of Unregistered Securities\nFrom time to time, the Operating Partnership issues limited partnership units (common and/or preferred) to the Company, as required by the Amended and Restated Agreement of Limited Partnership of the Operating Partnership, to mirror the capital structure of the Company to reflect additional issuances by the Company and to preserve equitable ownership ratios.\nThere were no sales of unregistered securities in the Operating Partnership during 2016.\nUse of Proceeds from Registered Securities\nThere were no sales of registered securities in the Operating Partnership during 2016.\nSotherly Hotels Inc. and Sotherly Hotels LP\nDividend and Distribution Information\nThe Company elected to be taxed as a REIT commencing with our taxable year ending December 31, 2004. To maintain qualification as a REIT, we are required to make annual distributions to the Company’s stockholders of at least 90.0% of our REIT taxable income, excluding net capital gain, which does not necessarily equal net income as calculated in accordance with generally accepted accounting principles. Our ability to pay distributions to the Company’s stockholders will depend, in part, upon our receipt of distributions from our Operating Partnership which may depend upon receipt of lease payments with respect to our properties from our TRS Lessees, and in turn, upon the management of our properties by our hotel manager. Distributions to the Company’s stockholders will generally be taxable to the Company’s stockholders as ordinary income; however, because a portion of our investments will be equity ownership interests in hotels, which will result in depreciation and non-cash charges against our income, a portion of our distributions may constitute a tax-free return of capital. To the extent not inconsistent with maintaining our REIT status, our TRS Lessees may retain any after-tax earnings.\nIn order to maintain our qualification as a REIT, we must make distributions to our stockholders each year in an amount equal to at least:\n| • | 90% of our REIT taxable income determined without regard to the dividends paid deduction and excluding net capital gains; plus |\n\n| • | 90% of the excess of our net income from foreclosure property over the tax imposed on such income by the Code; minus |\n\n| • | Any excess noncash income (as defined in the Code). |\n\n34\nThe following tables set forth information regarding the declaration, payment and income tax characterization of distributions by the Company on its common and preferred shares to Company’s stockholders for fiscal year 2015 to 2016. The same table sets forth the Operating Partnership’s distributions per common and preferred partnership units for fiscal year 2015 to 2016:\n\n| Dividend (Distribution) Payments - Common |\n| Date Declared | For the Quarter Ended | Date Paid | Amount per Share and Unit | Ordinary Income | Return of Capital |\n| January 2015 | March 31, 2015 | April 10, 2015 | $ | 0.070 | 82.6% | 17.4% |\n| April 2015 | June 30, 2015 | July 10, 2015 | $ | 0.075 | 82.6% | 17.4% |\n| July 2015 | September 30, 2015 | October 9, 2015 | $ | 0.080 | 82.6% | 17.4% |\n| October 2015 | December 31, 2015 | January 11, 2016 | $ | 0.080 | 82.6% | 17.4% |\n| January 2016 | March 31, 2016 | April 11, 2016 | $ | 0.085 | 73.5% | 26.5% |\n| April 2016 | June 30, 2016 | July 11, 2016 | $ | 0.090 | 73.5% | 26.5% |\n| July 2016 | September 30, 2016 | October 11, 2016 | $ | 0.095 | 73.5% | 26.5% |\n| October 2016 | December 31, 2016 | January 11, 2017 | $ | 0.095 | 73.5% | 26.5% |\n\n\n| Dividend (Distribution) Payments - Preferred |\n| Date Declared | For the Quarter Ended | Date Paid | Amount per Share and Unit | Ordinary Income | Return of Capital |\n| August 2016 | September 30, 2016 | October 17, 2016 | $ | 0.2111 | 73.5% | 26.5% |\n| October 2016 | December 31, 2016 | January 17, 2017 | $ | 0.500 | 73.5% | 26.5% |\n\nThe amount of future common stock distributions will be based upon quarterly operating results, general economic conditions, requirements for capital improvements, the availability of debt and equity capital, the Code’s annual distribution requirements, and other factors, which the Company’s board of directors deems relevant. The amount, timing and frequency of distributions will be authorized by the Company’s board of directors and declared by us based upon a variety of factors deemed relevant by our directors, and no assurance can be given that our distribution policy will not change in the future.\n\nSelected Financial Data\nThe following table sets forth selected historical financial data for Sotherly Hotels Inc. and Sotherly Hotels LP for the years ended December 31, 2016, 2015, 2014, 2013, and 2012. The financial results for the Crowne Plaza Hollywood Beach Resort, in which we had a 25.0% indirect interest, are not consolidated through July 31, 2015, as we accounted for our investment under the equity method of accounting. However, from August 1, 2015 through December 31, 2015 we did consolidate the financial results for the Crowne Plaza Hollywood Beach Resort, as a result of our acquisition of the remaining 75.0% interest in the hotel. The following selected historical financial data was derived from audited consolidated financial statements contained elsewhere in this Annual Report on Form 10-K and in prior filings. The Company’s financial statements: for the year ended December 31, 2016, have been audited by Dixon Hughes Goodman LLP; for the years ended December 31, 2015 and 2014, have been audited by Grant Thornton LLP; and for the years ended December 31, 2013 and 2012, have been audited by PBMares, LLP (formerly Witt Mares, PLC), our independent registered public accounting firms, for such periods. The audited historical financial statements include reclassifications and all adjustments, consisting of normal recurring adjustments, which we consider necessary for a fair presentation of our financial condition and the results of operations as of those dates and for those periods under accounting principles generally accepted in the United States of America.\nThe information presented below is only a summary and does not provide all of the information contained in our consolidated financial statements, including notes thereto, and should be read together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K.\n35\nSOTHERLY HOTELS INC.\nSOTHERLY HOTELS LP\nSELECTED HISTORICAL FINANCIAL DATA\n\n| Year Ended | Year Ended | Year Ended | Year Ended | Year Ended |\n| December 31, | December 31, | December 31, | December 31, | December 31, |\n| 2016 | 2015 | 2014 | 2013 | 2012 |\n| Statement of Operations |\n| Total Revenues | $ | 152,845,752 | $ | 138,533,476 | $ | 122,939,919 | $ | 89,374,527 | $ | 87,343,220 |\n| Total Operating Expenses excluding Depreciation, Amortization, Disposal Gain and Impairment of Investments in Hotel Properties, net | (118,854,236 | ) | (109,153,366 | ) | (95,290,304 | ) | (69,888,820 | ) | (68,519,401 | ) |\n| Depreciation, Amortization, Disposal Gain and Impairment of Investments in Hotel Properties, net | (15,384,390 | ) | (14,050,060 | ) | (15,144,284 | ) | (9,078,228 | ) | (8,661,769 | ) |\n| Net Operating Income | 18,607,126 | 15,330,050 | 12,505,331 | 10,407,479 | 10,162,050 |\n| Interest Income | 115,785 | 50,461 | 19,865 | 17,914 | 16,158 |\n| Interest Expense | (17,735,107 | ) | (16,515,827 | ) | (14,636,870 | ) | (9,606,479 | ) | (10,399,962 | ) |\n| Other Income (Expense) – net | (1,455,289 | ) | 6,196,936 | (354,558 | ) | (3,796,410 | ) | (3,941,594 | ) |\n| Income Tax Benefit (Provision) | 1,367,634 | 1,336,033 | 1,727,723 | (1,496,096 | ) | (1,246,397 | ) |\n| Net Income (Loss) | 900,149 | 6,397,653 | (738,509 | ) | (4,473,592 | ) | (5,409,745 | ) |\n| Net (Income) Loss Attributable to Noncontrolling Interest | 26,567 | (1,040,987 | ) | 153,838 | 989,623 | 1,241,868 |\n| Net Income (Loss) Attributable to the Company | 926,716 | 5,356,666 | (584,671 | ) | (3,483,969 | ) | (4,167,877 | ) |\n| Distributions to Preferred Stockholders | (1,144,889 | ) | — | — | — | — |\n| Net Income/(Loss) Attributable to Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) | $ | (3,483,969 | ) | $ | (4,167,877 | ) |\n| Statement of Cash Flows |\n| Cash provided by Operations – net | $ | 17,139,409 | $ | 11,377,374 | $ | 14,851,255 | $ | 9,594,751 | $ | 9,011,957 |\n| Cash used in Investing – net | (12,940,766 | ) | (41,132,602 | ) | (71,096,578 | ) | (29,527,589 | ) | (3,156,121 | ) |\n| Cash provided by (used in) Financing – net | 16,074,218 | 24,614,643 | 63,503,194 | 22,133,750 | (3,090,079 | ) |\n| Net Increase (Decrease) in Cash and Cash Equivalents | $ | 20,272,861 | $ | (5,140,585 | ) | $ | 7,257,871 | $ | 2,200,912 | $ | 2,765,757 |\n| Balance Sheet |\n| Investments in Hotel Properties, Net | $ | 348,593,912 | $ | 354,963,242 | $ | 260,192,153 | $ | 202,645,633 | $ | 176,427,904 |\n| Investment in Hotel Properties Held for Sale, Net | 5,333,000 | — | — | — | — |\n| Total Assets (1) | 406,019,564 | 393,058,353 | 299,820,043 | 228,169,081 | 204,223,074 |\n| Mortgage Loans | 282,708,289 | 271,977,944 | 205,291,657 | 160,363,549 | 135,674,432 |\n| Unsecured Notes | 24,308,713 | 52,900,000 | 52,900,000 | 27,600,000 | — |\n| Redeemable Preferred Stock | — | — | — | — | 14,227,650 |\n| Total Liabilities | 324,680,276 | 340,199,985 | 272,310,186 | 197,314,286 | 167,179,121 |\n| Noncontrolling Interest (1) | 2,329,175 | 3,855,237 | 4,132,662 | 5,669,386 | 7,322,314 |\n| Total Sotherly Hotels Inc. Stockholders’ Equity (1) | $ | 79,010,113 | $ | 49,003,131 | $ | 23,377,195 | $ | 25,185,409 | $ | 29,721,639 |\n| Operating Data |\n| Average Number of Available Rooms | 3,011 | 2,828 | 2,622 | 2,148 | 2,113 |\n| Total Number of Available Room Nights | 1,102,026 | 1,032,353 | 957,060 | 783,936 | 773,358 |\n| Occupancy Percentage (2) | 69.8 | % | 69.9 | % | 70.3 | % | 67.4 | % | 68.9 | % |\n| Average Daily Rate (ADR) (2) | $ | 140.63 | $ | 134.21 | $ | 125.77 | $ | 118.91 | $ | 114.22 |\n| RevPAR (2) | $ | 98.18 | $ | 93.80 | $ | 88.42 | $ | 80.16 | $ | 78.65 |\n| Additional Financial Data |\n| FFO (3) | $ | 15,139,650 | $ | 14,103,844 | $ | 14,765,677 | $ | 5,150,303 | $ | 3,842,699 |\n| Adjusted FFO (3) | 15,100,188 | 14,904,608 | 14,142,080 | 10,766,147 | 9,218,032 |\n| Hotel EBITDA (4) | 40,012,581 | 36,447,390 | 32,084,957 | 23,220,515 | 22,296,938 |\n| Income (Loss) Per Basic Share | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) | $ | (0.34 | ) | $ | (0.42 | ) |\n\n\n| (1) | As of the period end. |\n\n| (2) | Occupancy Percent is calculated by dividing the total daily number of rooms sold by the total daily number of rooms available. ADR is calculated by dividing the total daily room revenue by the total daily number of rooms sold. RevPAR is calculated by dividing the total daily room revenue by the total daily number of rooms available. |\n\n36\n\n| (3) | Industry analysts and investors use Funds from Operations (“FFO”) as a supplemental operating performance measure of an equity REIT. FFO is calculated in accordance with the definition adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). FFO, as defined by NAREIT, represents net income or loss determined in accordance with generally accepted accounting principles (“GAAP”), excluding extraordinary items as defined under GAAP and gains or losses from sales of previously depreciated operating real estate assets, plus certain non-cash items such as real estate asset depreciation and amortization, and after adjustment for any noncontrolling interest from unconsolidated partnerships and joint ventures. |\n\nAdjusted FFO accounts for certain additional items that are not in NAREIT’s definition of FFO, including changes in deferred income taxes, any unrealized gain (loss) on its hedging instruments or warrant derivative, loan impairment losses, losses on early extinguishment of debt, aborted offering costs, franchise termination costs, loan modification fees, costs associated with the departure of executive officers, litigation settlement, over-assessed real estate taxes on appeal, change in control gains or losses and acquisition transaction costs.\n| (4) | Hotel EBITDA represents the portion of net income or loss excluding: (1) interest expense, (2) interest income, (3) income tax provision or benefit, (4) equity in the income or loss of equity investees, (5) unrealized gains and losses on derivative instruments not included in other comprehensive income, (6) gains and losses on disposal of assets, (7) realized gains and losses on investments, (8) impairment of long-lived assets or investments, (9) loss on early debt extinguishment, (10) gains or losses on change in control, (11) corporate general and administrative expense, (12) depreciation and amortization, (13) gains and losses on involuntary conversions of assets and (14) other operating revenue not related to our wholly-owned portfolio. |\n\nThe following is a reconciliation of net loss to FFO and Adjusted FFO for the years ended December 31, 2016, 2015, 2014, 2013, and 2012.\n\n| Year Ended | Year Ended | Year Ended | Year Ended | Year Ended |\n| December 31, | December 31, | December 31, | December 31, | December 31, |\n| 2016 | 2015 | 2014 | 2013 | 2012 |\n| Net Income/(Loss) Attributable to the Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) | $ | (3,483,969 | ) | $ | (4,186,709 | ) |\n| Add: Net Income (Loss) Attributable to the Noncontrolling Interest | (26,567 | ) | 1,040,987 | (153,838 | ) | (989,623 | ) | (1,223,036 | ) |\n| Depreciation and Amortization | 15,019,071 | 13,591,495 | 11,969,284 | 8,467,228 | 8,661,769 |\n| Equity in Depreciation and Amortization of Joint Venture | — | 259,279 | 529,053 | 545,667 | 590,675 |\n| Impairment of Investment in Hotel Properties, Net | — | 500,000 | 3,175,000 | 611,000 | — |\n| Gain on Change in Control | — | (6,603,148 | ) | — | — | — |\n| Gain on Involuntary Conversion of Asset | — | — | (169,151 | ) | — | — |\n| Loss (Gain) on Asset Disposal | 365,319 | (41,435 | ) | — | — | — |\n| Funds From Operations | $ | 15,139,650 | $ | 14,103,844 | $ | 14,765,677 | $ | 5,150,303 | $ | 3,842,699 |\n| (Increase) Decrease in Deferred Income Taxes | (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) | 1,370,189 | 1,241,848 |\n| Acquisition Costs | — | 634,376 | 155,187 | 89,743 | — |\n| Loss on Starwood Settlement | — | 324,271 | — | — | — |\n| Over-Assessed Real Estate Taxes Under Appeal | — | 497,733 | — | — | — |\n| Loan Modification Fees | 64,215 | 243,229 | — | — | — |\n| Franchise Termination Fee | — | — | 351,800 | — | — |\n| Realized and Unrealized (Gain) Loss on Hedging Activities (A) | 37,384 | 108,819 | — | (89,998 | ) | 13,752 |\n| Realized and Unrealized Loss on Warrant Derivative | — | — | — | 2,205,248 | 2,026,677 |\n| Impairment of Note Receivable | — | — | — | — | 110,871 |\n| Loss on Early Debt Extinguishment (A) | 1,417,905 | 772,907 | 831,079 | 2,040,662 | 1,982,184 |\n| Adjusted FFO | $ | 15,100,188 | $ | 14,904,608 | $ | 14,142,080 | $ | 10,766,147 | $ | 9,218,031 |\n\n\n| (A) | Includes equity in unrealized (gain)/loss on hedging activities and loss on early extinguishment of debt of joint venture. |\n\n37\nThe following is a reconciliation of net income/(loss) to Hotel EBITDA for the years ended December 31, 2016, 2015, 2014, 2013, and 2012.\n\n| Year Ended | Year Ended | Year Ended | Year Ended | Year Ended |\n| December 31, | December 31, | December 31, | December 31, | December 31, |\n| 2016 | 2015 | 2014 | 2013 | 2012 |\n| Net Income/(Loss) Attributable to the Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) | $ | (3,483,969 | ) | $ | (4,186,709 | ) |\n| Add: Net Income (Loss) Attributable to the Noncontrolling Interest | (26,567 | ) | 1,040,987 | (153,838 | ) | (989,623 | ) | (1,223,036 | ) |\n| Interest Expense | 17,735,107 | 16,515,827 | 14,636,870 | 9,606,479 | 10,399,962 |\n| Interest Income | (115,785 | ) | (50,461 | ) | (19,865 | ) | (17,914 | ) | (16,158 | ) |\n| Distributions to Preferred Stockholders | 1,144,889 | — | — | — | — |\n| Income Tax Provision (Benefit) | (1,367,634 | ) | (1,336,033 | ) | (1,727,723 | ) | 1,496,096 | 1,246,397 |\n| Depreciation and Amortization | 15,019,071 | 13,591,495 | 11,969,284 | 8,467,228 | 8,661,769 |\n| Equity in (Earnings) Loss of Joint Venture | — | (475,514 | ) | (307,370 | ) | (449,500 | ) | (178,138 | ) |\n| Loss (Gain) on Asset Disposal | 365,319 | (41,435 | ) | — | — | — |\n| Gain on Involuntary Conversion of Asset | — | — | (169,151 | ) | — | — |\n| Realized and Unrealized Loss (Gain) on Hedging Activities | 37,384 | 108,819 | — | — | — |\n| Realized and Unrealized Loss on Warrant Derivative | — | — | — | 2,205,248 | 2,026,677 |\n| Loss on Early Debt Extinguishment | 1,417,905 | 772,907 | 831,079 | 2,040,662 | 1,982,184 |\n| Impairment of Investment in Hotel Properties, Net | — | 500,000 | 3,175,000 | 611,000 | — |\n| Impairment of Note Receivable | — | — | — | — | 110,871 |\n| Corporate General and Administrative Expenses | 6,021,065 | 7,268,256 | 5,085,949 | 4,360,582 | 4,078,826 |\n| Gain on Change in Control | — | (6,603,148 | ) | — | — | — |\n| Net Lease Rental Income | — | — | (350,000 | ) | (350,000 | ) | (350,000 | ) |\n| Other Fee Income | — | (200,976 | ) | (300,607 | ) | (275,774 | ) | (255,707 | ) |\n| Hotel EBITDA | $ | 40,012,581 | $ | 36,447,390 | $ | 32,084,957 | $ | 23,220,515 | $ | 22,296,938 |\n\n38\n\nItem 7.\nManagement’s Discussion and Analysis of\nFinancial Condition and Results of Operations\nOverview\nThe Company is a self-managed and self-administered lodging REIT incorporated in Maryland in August 2004 to pursue opportunities in the full-service, primarily upscale and upper-upscale segments of the hotel industry located in primary and secondary markets in the mid-Atlantic and southern United States. We commenced operations in December 2004 when the Company completed its initial public offering and thereafter consummated the acquisition of six initial hotel properties. Since the Company’s initial public offering, we have engaged in the following acquisitions and dispositions:\n| • | On July 22, 2005, we acquired the Crowne Plaza Jacksonville Riverfront (formerly, the Hilton Jacksonville Riverfront). During September 2015, after extensive renovations, we re-branded and renamed the hotel the DoubleTree by Hilton Jacksonville Riverfront. |\n\n| • | On August 10, 2006, we sold the Holiday Inn Downtown Williamsburg. |\n\n| • | On September 20, 2006, we acquired the Louisville Ramada Riverfront Inn, which went through an extensive renovation and re-opened in May 2008 as the Sheraton Riverside Louisville. |\n\n| • | On August 8, 2007, through our joint venture with Carlyle, we acquired a 25.0% indirect noncontrolling interest in the Crowne Plaza Hollywood Beach Resort, a newly renovated 311-room hotel in Hollywood, Florida. |\n\n| • | On October 29, 2007, we acquired a hotel in Tampa, Florida, formerly known as the Tampa Clarion Hotel, which went through an extensive renovation and re-opened in March 2009 as the Crowne Plaza Tampa Westshore. |\n\n| • | On April 24, 2008, we acquired the Hampton Marina Hotel in Hampton, Virginia, which has been renovated and was converted to the Crowne Plaza Hampton Marina in October 2008. |\n\n| • | On November 13, 2013, we acquired the Crowne Plaza Houston Downtown in Houston, Texas. |\n\n| • | On March 27, 2014, we acquired the Georgian Terrace in Atlanta, Georgia. |\n\n| • | On July 31, 2015, we acquired the remaining 75.0% interest in (i) the entity that owns the Crowne Plaza Hollywood Beach Resort, and (ii) the entity that leases the Crowne Plaza Hollywood Beach Resort. As a result, the Operating Partnership now has a 100% indirect ownership interest in the entities that own the Crowne Plaza Hollywood Beach Resort. |\n\n| • | On January 30, 2017, we closed on the purchase of the hotel commercial unit of the Hyde Resort & Residences, a 400-unit condominium-hotel located in the Hollywood, Florida market. |\n\n| • | On February 7, 2017, we closed on the sale of the Crowne Plaza Hampton Marina. |\n\n39\nAs of December 31, 2016, our hotel portfolio consisted of twelve full-service, primarily upscale and upper-upscale hotels with 3,011 rooms, ten of which operate under well-known brands such as Hilton, Crowne Plaza, DoubleTree and Sheraton, and two of which are independent hotels. Following the sale of the Crowne Plaza Hampton Marina on February 7, 2017, our portfolio consisted of eleven wholly-owned hotels with a total of 2,838 rooms, as well as our interests in the Hyde Resort & Residences. As of December 31, 2016, we owned the following hotel properties:\n\n| Number |\n| Property | of Rooms | Location | Date of Acquisition | Chain Designation |\n| Wholly-owned |\n| Crowne Plaza Hampton Marina (1) | 173 | Hampton, VA | April 24, 2008 | Upscale |\n| Crowne Plaza Hollywood Beach Resort | 311 | Hollywood, FL | August 9, 2007 | Upscale |\n| Crowne Plaza Tampa Westshore | 222 | Tampa, FL | October 29, 2007 | Upscale |\n| DoubleTree by Hilton Jacksonville Riverfront | 293 | Jacksonville, FL | July 22, 2005 | Upscale |\n| DoubleTree by Hilton Laurel | 208 | Laurel, MD | December 21, 2004 | Upscale |\n| DoubleTree by Hilton Philadelphia Airport | 331 | Philadelphia, PA | December 21, 2004 | Upscale |\n| DoubleTree by Hilton Raleigh Brownstone-University | 190 | Raleigh, NC | December 21, 2004 | Upscale |\n| The Georgian Terrace | 326 | Atlanta, GA | March 27, 2014 | Independent(2) |\n| Hilton Savannah DeSoto | 246 | Savannah, GA | December 21, 2004 | Upper Upscale |\n| Hilton Wilmington Riverside | 272 | Wilmington, NC | December 21, 2004 | Upper Upscale |\n| Sheraton Louisville Riverside | 180 | Jeffersonville, IN | September 20, 2006 | Upper Upscale |\n| The Whitehall | 259 | Houston, TX | November 13, 2013 | Independent(2) |\n| Total | 3,011 |\n\n\n| (1) | On February 7, 2017, we closed on the sale of this hotel. |\n\n| (2) | We believe that the Georgian Terrace and The Whitehall would carry a chain scale designation of upper upscale if they were branded hotels. |\n\nWe conduct substantially all our business through the Operating Partnership, Sotherly Hotels LP. The Company is the sole general partner of the Operating Partnership and owns an approximate 89.1% interest in the Operating Partnership, with the remaining interest being held by limited partners who were contributors of our initial hotel properties and related assets.\nTo qualify as a REIT, neither the Company nor the Operating Partnership can operate our hotels. Therefore, our wholly-owned hotel properties are leased to our TRS Lessees that are wholly-owned subsidiaries of the Operating Partnership, which then engage a hotel management company to operate the hotels under a management agreement. Our TRS Lessees have engaged Chesapeake Hospitality to manage our hotels. Our TRS Lessees, and their parent, MHI Hospitality TRS Holding, Inc., are consolidated into each of our financial statements for accounting purposes. The earnings of MHI Hospitality TRS Holding, Inc. are subject to taxation similar to other C corporations.\nKey Operating Metrics\nIn the hotel industry, room revenue is considered the most important category of revenue and drives other revenue categories such as food, beverage, catering, parking and telephone. There are three key performance indicators used in the hotel industry to measure room revenues:\n| • | Occupancy, or the number of rooms sold, usually expressed as a percentage of total rooms available; |\n\n| • | Average daily rate, or ADR, which is total room revenue divided by the number of rooms sold; and |\n\n| • | Revenue per available room, or RevPAR, which is total room revenue divided by the total number of available rooms. |\n\nRevPAR changes that are primarily driven by changes in occupancy have different implications for overall revenues and profitability than changes that are driven primarily by changes in ADR. For example, an increase in occupancy at a hotel would lead to additional variable operating costs (such as housekeeping services, laundry, utilities, room supplies, franchise fees, management fees, credit card commissions and reservations expense), but could also result in increased non-room revenue from the hotel’s restaurant, banquet or parking facilities. Changes in RevPAR that are primarily driven by changes in ADR typically have a greater impact on operating margins and profitability as they do not generate all the additional variable operating costs associated with higher occupancy.\n40\nWe also use FFO, Adjusted FFO and Hotel EBITDA as measures of our operating performance. See “Non-GAAP Financial Measures”.\nResults of Operations\nComparison of Year Ended December 31, 2016 to Year Ended December 31, 2015\nThe following table illustrates the key operating metrics for the years ended December 31, 2016 and 2015 for our wholly-owned properties during each respective reporting period (“actual” properties) as well as the key operating metrics for the eleven wholly-owned properties that were under our control during all of 2015 (“same-store” properties). Accordingly, the same-store data does not reflect the performance of the Crowne Plaza Hollywood Beach Resort, which was acquired through a joint venture and in which we had a 25.0% indirect interest through July 31, 2015 and a 100.0% interest thereafter.\n\n| Year Ended December 31, 2016 | Year Ended December 31, 2015 |\n| Actual | Same-Store | Actual | Same-Store |\n| Occupancy % | 69.8 | % | 68.7 | % | 69.9 | % | 65.7 | % |\n| ADR | $ | 140.63 | $ | 136.63 | $ | 134.21 | $ | 130.09 |\n| RevPAR | $ | 98.18 | $ | 93.86 | $ | 93.80 | $ | 85.47 |\n\nRevenue. Total revenue for the year ended December 31, 2016 was approximately $152.8 million, an increase of approximately $14.3 million, or 10.3%, from total revenue for the year ended December 31, 2015 of approximately $138.5 million. Approximately $11.9 million of the increase relates to the acquisition of the remaining 75.0% interest in our property in Hollywood Beach, Florida in July 2015. Increases in revenues at our properties in Wilmington, North Carolina; Raleigh, North Carolina; Philadelphia, Pennsylvania; Laurel, Maryland; Jacksonville, Florida; Tampa, Florida; and Atlanta, Georgia of approximately $7.1 million, were offset by decreases in revenue at our properties impacted by renovation activities in Savannah, Georgia and Houston, Texas of approximately $3.3 million, as well as the remaining properties revenue decreases of $1.6 million.\nRoom revenues at our properties for the year ended December 31, 2016 increased approximately $11.4 million, or 11.7%, to approximately $108.2 million compared to room revenues for the year ended December 31, 2015 of approximately $96.8 million. The increase in room revenues for the year ended December 31, 2016 resulted mainly from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $9.6 million for the period. Our properties in Wilmington, North Carolina; Raleigh, North Carolina; Philadelphia, Pennsylvania; Jacksonville, Florida; Tampa, Florida; Hampton, Virginia and Atlanta, Georgia, experienced a significant increase in room revenues, offset by decreases at our properties impacted by renovation activities in Savannah, Georgia and Houston, Texas. We continue to expect occupancy and ADR to increase in 2017 as a result of continuing strong demand and the completion in 2016 of renovations at our properties in Houston, Texas and Atlanta, Georgia.\nFood and beverage revenues at our properties for the year ended December 31, 2016 increased approximately $2.1 million, or 6.3%, to approximately $35.4 million compared to food and beverage revenues of approximately $33.3 million for the year ended December 31, 2015. The increase in food and beverage revenues for the year ended December 31, 2016 resulted principally from our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $1.6 million for the period. Additional increases in food and beverage revenues at our properties in Savannah, Georgia; Raleigh, North Carolina; Laurel, Maryland: Jacksonville, Florida; and Tampa, Florida of approximately $1.5 million, were offset by decreases of approximately $1.0 million in food and beverage revenues at our other properties.\nOther operating revenues for the year ended December 31, 2016 increased approximately $0.8 million, or 10.0%, to approximately $9.3 million compared to other operating revenues for the year ended December 31, 2015 of approximately $8.4 million. The increase in other operating department revenues for the year ended December 31, 2016 resulted principally from our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $0.6 million for the period. Additional increases in other operating revenues at our properties in Philadelphia, Pennsylvania; Laurel, Maryland; Jacksonville, Florida; Jeffersonville, Indiana and Hampton, Virginia of approximately $0.5 million, were offset by decreases of approximately $0.5 million in other operating revenues at our other properties.\nHotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses, indirect expenses, and management fees, increased approximately $10.9 million, or 10.7%, for the year ended December 31, 2016 to approximately $112.8 million compared to hotel operating expenses for the year ended December 31, 2015 of approximately $101.9 million. The increase in hotel operating expenses for the year ended December 31, 2016 was substantially related to our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $9.0 million for the period, coupled with an increase in hotel operating expenses at our same-store properties of approximately $1.1 million, mainly from increased occupancy by 4.6%, offset with decreases in expenses at our properties in Wilmington, North Carolina; Philadelphia, Pennsylvania; Jeffersonville, Indiana; Hampton, Virginia and Houston, Texas.\n41\nRooms expense at our properties for the year ended December 31, 2016 increased approximately $3.1 million, or 12.1%, to approximately $28.9 million compared to rooms expense of approximately $25.8 million for the year ended December 31, 2015. The increase in rooms expense for the year ended December 31, 2016 was substantially related to our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $2.3 million for the period.\nFood and beverage expenses at our properties for the year ended December 31, 2016 increased approximately $1.4 million, or 5.9%, to approximately $24.4 million compared to food and beverage expense of approximately $23.0 million for the year ended December 31, 2015. The increase in food and beverage expenses for the year ended December 31, 2016 was substantially related to our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $1.2 million for the period.\nIndirect expenses at our properties for the year ended December 31, 2016 increased approximately $5.8 million, or 11.4%, to approximately $57.1 million compared to indirect expenses of approximately $51.3 million for the year ended December 31, 2015. Sales and marketing costs, franchise fees, utilities, repairs and maintenance, insurance, management fees, real and personal property taxes as well as general and administrative costs at the property level are included in indirect expenses. Most of the increase in indirect expenses related to expenses that increase proportionally with increases in occupancy and/or revenue, including management fees and franchise fees. Specifically, increases in indirect expenses were substantially related to our recently acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $5.1 million for the period, compared to the year ended December 31, 2015.\nDepreciation and Amortization. Depreciation and amortization for the year ended December 31, 2016 increased approximately $1.4 million, or 10.5%, to approximately $15.0 million compared to depreciation and amortization expense of approximately $13.6 million for the year ended December 31, 2015. The increase was mostly attributable to depreciation and amortization related to our recently acquired property in Hollywood Beach, Florida and depreciation and amortization related to our capital assets acquired in the fourth quarter of 2015 and for the year 2016, offset by reductions of intangible asset amortization during the year ended December 31, 2016 compared to the year ended December 31, 2015.\nImpairment of Investment in Hotel Properties, Net. The impairment of investment in hotel properties, net for the years ended December 31, 2016 and 2015 was $0 and $0.5 million, respectively. Our review of possible impairment of our hotel properties revealed no excess of current carrying cost over the estimated undiscounted future cash flows, as of December 31, 2016.\nGain / Loss on Disposal of Assets. During the year ended December 31, 2016, we recorded a net loss on disposal of assets of $365,319, comprised of disposals of furniture, fixtures, and equipment of $565,319, offset by a gain on sale of $200,000, compared to a $41,435 net gain on disposal of assets for the year ended December 31, 2015, comprised of a net gain on the sale of development parcel rights and the development parcel for approximately $710,250, offset by losses on disposals of furniture, fixtures and equipment of $668,815.\nCorporate General and Administrative. Corporate general and administrative expenses for the year ended December 31, 2016 decreased approximately $1.2 million, or 17.2%, to approximately $6.0 million compared to corporate general and administrative expenses of approximately $7.3 million for the year ended December 31, 2015. The decrease in corporate general and administrative expenses was mainly due to decreases in acquisition costs of approximately $0.6 million, the absence of a one-time tax penalty of $0.4 million in 2016, reduced professional fees of approximately $0.2 million, reduced loan modification costs of $0.2 million and reduced audit fees of approximately $0.2 million partially offset by additional staffing and related salary increase of approximately $0.3 million, an increase in legal fees of approximately $0.4 million and increased marketing support costs of $0.2 million.\nInterest Expense. Interest expense for the year ended December 31, 2016 increased approximately $1.2 million, or 7.4%, to approximately $17.7 million compared to approximately $16.5 million of interest expense for the year ended December 31, 2015. The increase in interest expense for the year ended December 31, 2016, was substantially related to the assumed mortgage loan for the acquired property in Hollywood Beach, Florida, accounting for an increase in interest expense of approximately $1.8 million. This increase was mainly offset by a decrease in interest from the redemption of the 8% Notes with an approximate decrease of $0.5 million.\nEquity Income (Loss) in Joint Venture. Equity in the income of the joint venture decreased approximately $0.5 million, or 100.0%, to $0 for the year ended December 31, 2016 compared to equity in the income of the joint venture of approximately $0.5 million for the year ended December 31, 2015, due the acquisition of the Crowne Plaza Hollywood Beach Resort in July 2015.\n42\nLoss on Early Debt Extinguishment. The loss on early debt extinguishment for the year ended December 31, 2016 increased approximately $0.6 million, or 83.5%, to approximately $1.4 million compared to a loss on debt extinguishment of approximately $0.8 million for the year ended December 31, 2015. During the year ended December 31, 2016, we refinanced mortgage loans at our properties in Wilmington, North Carolina; Savannah, Georgia; Jeffersonville, Indiana; Tampa, Florida and Houston, Texas with an increase in loss on early debt extinguishments of approximately $0.3 million. We also redeemed our 8% unsecured notes with the majority of the loss on early debt extinguishment of approximately $1.1 million.\nUnrealized Loss on Hedging Activities. During the year ended December 31, 2015, we refinanced a variable rate mortgage loan we had with Fifth Third Bank on the DoubleTree by Hilton Jacksonville Riverfront, with a new variable rate loan from Bank of the Ozarks. During August 2015, we purchased an interest rate cap for $179,800. As of December 31, 2016, the fair market value of the interest rate cap is $33,597 compared to the fair market value of $70,981, as of December 31, 2015. The unrealized loss on hedging activities during the year ended December 31, 2016 and 2015, was $37,384 and $108,818, respectively.\nGain on Change in Control. On July 31, 2015, we acquired from Carlyle the remaining 75.0% interest in the entities that own and lease the Crowne Plaza Hollywood Beach Resort. Due to the increased fair market value of the property for our original 25.0% interest we recognized a discounted gain on change in control. The gain on change in control during the year ended December 31, 2015, was approximately $6.6 million while no such gain was recorded in 2016.\nIncome Tax Benefit. The income tax benefit for the year ended December 31, 2016 increased approximately $32,000, or 2.4%, to approximately $1.4 million compared to an income tax provision of approximately $1.3 million for the year ended December 31, 2015. The income tax benefit was primarily derived from the operations of our TRS Lessees. Our TRS Lessees realized higher operating loss for the year ended December 31, 2016 compared to the year ended December 31, 2015. At December 31, 2016, deferred tax assets total approximately $6.9 million, of which approximately $6.0 million relate to net operating losses of our TRS Lessee. At December 31, 2016, we determined, based on all available positive and negative evidence, that it is more-likely-than-not that future taxable income will be available during the carryforward periods to absorb all of the consolidated federal and state net operating loss carryforward. We will continue to regularly evaluate the likelihood that we will be able to realize our deferred tax assets and the need for a valuation allowance for the deferred tax assets.\nNet Income. Net income for the year ended December 31, 2016 decreased approximately $5.5 million, or 85.9%, to approximately $0.9 million compared to net income of approximately $6.4 million for the year ended December 31, 2015, as a result of the operating results discussed above.\nDistributions to Preferred Stockholders. During the year ended December 31, 2016, we recorded distributions to preferred stockholders of approximately $1.1 million, compared to no distributions to preferred stockholders for the year ended December 31, 2015. As of December 31, 2016 and 2015, we accrued $805,000 and $0, as dividends on the preferred stock, respectively.\nComparison of Year Ended December 31, 2015 to Year Ended December 31, 2014\nThe following table illustrates the key operating metrics for the years ended December 31, 2015 and 2014, for our wholly-owned properties during each respective reporting period (“actual” properties) as well as the key operating metrics for the ten wholly-owned properties that were under our control during all of 2014 (“same-store” properties). Accordingly, the same-store data does not reflect the performance of the Georgian Terrace, which was acquired in March 2014. Each table excludes performance data for the Crowne Plaza Hollywood Beach Resort, which was acquired through a joint venture and in which we had a 25.0% indirect interest through July 31, 2015 and a 100.0% interest thereafter through December 31, 2015.\n\n| Year Ended December 31, 2015 | Year Ended December 31, 2014 |\n| Actual | Same-Store | Actual | Same-Store |\n| Occupancy % | 69.9 | % | 65.7 | % | 70.3 | % | 69.7 | % |\n| ADR | $ | 134.21 | $ | 130.09 | $ | 15.77 | $ | 124.27 |\n| RevPAR | $ | 93.80 | $ | 85.47 | $ | 88.42 | $ | 86.57 |\n\nRevenue. Total revenue for the year ended December 31, 2015 was approximately $138.5 million, an increase of approximately $15.6 million, or 12.7%, from total revenue for the year ended December 31, 2014 of approximately $122.9 million. Approximately $6.2 million of the increase relates to the acquisition of our property in Atlanta, Georgia in March 2014. Approximately $7.5 million of the increase relates to the acquisition of the remaining 75.0% interest in our property in Hollywood Beach, Florida in July 2015. Increases in revenues at our properties in Wilmington, North Carolina; Savannah, Georgia; Raleigh, North Carolina; Philadelphia, Pennsylvania; Jacksonville, Florida; Jeffersonville, Indiana; Tampa, Florida; Hampton, Virginia and Atlanta, Georgia were offset by decreases in revenue at our properties impacted by renovation activities in Laurel, Maryland and Houston, Texas, as well as by the loss of rental income associated with Shell Island which expired in December 2014.\n43\nRoom revenues at our properties for the year ended December 31, 2015 increased approximately $12.2 million, or 14.4%, to approximately $96.8 million compared to room revenues for the year ended December 31, 2014 of approximately $84.6 million. The increase in room revenue for the year ended December 31, 2015 resulted mainly from the acquired property in Atlanta, Georgia, accounting for an increase of approximately $3.3 million for the period and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $2.4 million for the period. Our properties in Wilmington, North Carolina; Savannah, Georgia; Raleigh, North Carolina; Philadelphia, Pennsylvania; Jacksonville, Florida; Tampa, Florida; and Hampton, Virginia and Atlanta, Georgia, experienced a significant increase in room revenue, offset by decreases at our properties impacted by renovation activities in Laurel, Maryland and Houston, Texas.\nFood and beverage revenues at our properties for the year ended December 31, 2015 increased approximately $1.8 million, or 5.8%, to approximately $33.3 million compared to food and beverage revenue of approximately $31.4 million for the year ended December 31, 2014. The increase in food and beverage revenues for the year ended December 31, 2015 resulted principally from our acquired property in Atlanta, Georgia, accounting for an increase of approximately $2.1 million for the period, and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $1.2 million for the period. Additional increases in food and beverage revenue at our properties in Wilmington, North Carolina; Raleigh, North Carolina and Jeffersonville, Indiana of approximately $0.3 million, were offset by decreases of approximately $1.6 million in banqueting revenue at our other properties.\nOther operating revenues for the year ended December 31, 2015 increased approximately $1.5 million, or 22.5%, to approximately $8.4 million compared to other operating revenues for the year ended December 31, 2014 of approximately $6.9 million. The increase in other operating departments revenues for the year ended December 31, 2015 resulted principally from our acquired property in Atlanta, Georgia, accounting for an increase of approximately $0.8 million for the period and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $0.5 million for the period.\nHotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses, indirect expenses, and management fees, increased approximately $11.7 million, or 12.9%, for the year ended December 31, 2015, to approximately $101.9 million compared to hotel operating expenses for the year ended December 31, 2014 of approximately $90.2 million. The increase in hotel operating expenses for the year ended December 31, 2015 was substantially related to our acquired property in Atlanta, Georgia, accounting for approximately $6.7 million of the increase in expenses for the year ended December 31, 2015 and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $9.2 million for the period, coupled by a decrease in hotel operating expenses at our same-store properties of approximately $1.0 million, mainly from reduced occupancy by 5.7% and RevPAR by 1.3% combined with decreases in expenses at our properties impacted by renovation activities in Laurel, Maryland and Houston, Texas.\nRooms expense at our properties for the year ended December 31, 2015 increased approximately $2.9 million, or 12.5%, to approximately $25.8 million compared to rooms expense of approximately $22.9 million for the year ended December 31, 2014. The increase in rooms expense for the year ended December 31, 2015 was substantially related to our acquired property in Atlanta, Georgia, accounting for approximately $1.0 million of the increase and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $1.3 million for the period.\nFood and beverage expenses at our properties for the year ended December 31, 2015 increased approximately $2.0 million, or 9.4%, to approximately $23.0 million compared to food and beverage expense of approximately $21.0 million for the year ended December 31, 2014. The increase in food and beverage expenses for the year ended December 31, 2015 was substantially related to our acquired property in Atlanta, Georgia, accounting for approximately $1.5 million of the increase and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $0.9 million for the period, offset by decreases in food and beverage expenses mainly from reduced occupancy and decreases in expenses at our property impacted by renovation activities in Houston, Texas.\nIndirect expenses at our properties for the year ended December 31, 2015 increased approximately $6.2 million, or 13.8%, to approximately $51.3 million compared to indirect expenses of approximately $45.1 million for the year ended December 31, 2014. Sales and marketing costs, franchise fees, utilities, repairs and maintenance, insurance, management fees, real and personal property taxes as well as general and administrative costs at the property level are included in indirect expenses. Most of the increase in indirect expenses related to expenses that increase proportionally with increases in occupancy and/or revenue, including management fees and franchise fees. Specifically, increases in indirect expenses were substantially related to our acquired property in Atlanta, Georgia, accounting for approximately $2.1 million of the increase and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $2.8 million for the period, compared to the year ended December 31, 2014.\n44\nDepreciation and Amortization. Depreciation and amortization for the year ended December 31, 2015 increased approximately $1.6 million, or 13.6%, to approximately $13.6 million compared to depreciation and amortization expense of approximately $12.0 million for the year ended December 31, 2014. The increase was mostly attributable to depreciation and amortization related to our acquired property in Atlanta, Georgia and depreciation and amortization related to our capital assets acquired in the fourth quarter of 2014 and the year of 2015, offset by reductions of intangible asset amortization during the year ended December 31, 2015 compared to the year ended December 31, 2014.\nImpairment of Investment in Hotel Properties, Net. The impairment of investment in hotel properties, net for the years ended December 31, 2015 and 2014, was approximately $0.5 million and $3.2 million, respectively. Our review of possible impairment at one of our hotel properties revealed an excess of current carrying cost over the estimated undiscounted future cash flows, which was triggered by a combination of a change in anticipated use and future branding of the property; and a re-evaluation of future revenues based on anticipated market conditions, market penetration and costs necessary to achieve such market penetration, resulting in an impairment to fair market value of $0.5 million, as of December 31, 2015.\nGain on Disposal of Assets. During the year ended December 31, 2015, we recorded a gain on disposal of assets of $41,435, compared to no gain or loss on disposal of assets for the year ended December 31, 2014.\nCorporate General and Administrative. Corporate general and administrative expenses for the year ended December 31, 2015 increased approximately $2.2 million, or 42.9%, to approximately $7.3 million compared to corporate general and administrative expenses of approximately $5.1 million for the year ended December 31, 2014. The increase in corporate general and administrative expenses was mainly due to an increase in acquisition costs of approximately $0.5 million, a one-time tax penalty of $0.4 million, additional staffing and related salary increase of approximately $0.3 million, increased professional fees of approximately $0.5 million, loan costs of $0.2 million on the loan modifications of the Crowne Plaza Hollywood Beach Resort mortgage and the DoubleTree by Hilton Laurel mortgage, and increased audit fees of approximately $0.1 million partially offset by a reduction in legal fees of approximately $0.1 million.\nInterest Expense. Interest expense for the year ended December 31, 2015 increased approximately $1.9 million, or 12.8%, to approximately $16.5 million compared to approximately $14.6 million of interest expense for the year ended December 31, 2014. The increase in interest expense for the year ended December 31, 2015 was substantially related to the additional mortgage on our acquired property in Atlanta, Georgia of $0.7 million, the assumed mortgage loan for the acquired property in Hollywood Beach, Florida, accounting for an increase in interest expense of approximately $1.4 million, the issuance of the 7% Notes due in 2019, accounting for an increase of approximately $1.6 million. These increases were offset by a decrease in interest from the reduction of the bridge loan with Richmond Hill Capital Partners, LP during the year ending December 31, 2015 of $1.3 million.\nEquity Income (Loss) in Joint Venture. Equity in the income of the joint venture increased approximately $0.2 million, or 54.7%, to approximately $0.5 million for the year ended December 31, 2015 compared to equity in the income of the joint venture of approximately $0.3 million for the year ended December 31, 2014 and represents our 25.0% share of the net income of the Crowne Plaza Hollywood Beach Resort through July 31, 2015. For the year ended December 31, 2015, the Crowne Plaza Hollywood Beach Resort reported occupancy of 83.1%, ADR of $174.35 and RevPAR of $144.86. This compares with results reported by the hotel for the year ended December 31, 2014 of occupancy of 83.1%, ADR of $163.13 and RevPAR of $135.55.\nLoss on Early Debt Extinguishment. The loss on early debt extinguishment for the year ended December 31, 2015 decreased approximately $0.1 million, or 7.0%, to approximately $0.7 million compared to a loss on debt extinguishment of approximately $0.8 million for the year ended December 31, 2014. During the year ended December 31, 2015, we refinanced a variable rate mortgage loan we had with the Bank of the Ozarks on the Georgian Terrace, with a new fixed rate loan from Bank of America. The amount of accumulated un-amortized loan costs of $697,582 was written off during 2015. In addition, we refinanced a variable rate mortgage loan we had with Fifth Third Bank on the DoubleTree by Hilton Jacksonville Riverfront, with a new variable rate loan from Bank of the Ozarks. The amount of accumulated un-amortized loan costs of $75,324 was written off during 2015.\nGain on Involuntary Conversion of Asset. Gain on involuntary conversion of asset for the year ended December 31, 2015 decreased approximately $0.2 million, or 100.0%, to $0 compared to approximately $0.2 million of gain on involuntary conversion of asset for the year ended December 31, 2014. During 2014, we had a one-time involuntary conversion of equipment at our Hilton Wilmington Riverside property for replacement of a water chiller in the amount of approximately $0.2 million.\nUnrealized Loss on Hedging Activities. During the year ended December 31, 2015, we refinanced a variable rate mortgage loan we had with Fifth Third Bank on the DoubleTree by Hilton Jacksonville Riverfront, with a new variable rate loan from Bank of the Ozarks. During August 2015, we purchased an interest rate cap for $179,800. As of December 31, 2015, the fair market value of the interest rate cap was $70,981. The unrealized loss on hedging activities during the years ended December 31, 2015 and 2014, was approximately $0.1 million and $0, respectively.\n45\nGain on Change in Control. On July 31, 2015, we acquired from Carlyle the remaining 75.0% interest in the entities that own and lease the Crowne Plaza Hollywood Beach Resort. Due to the increased fair market value of the property for our original 25.0% interest we recognized a discounted gain on change in control. The gain on change in control during the year ended December 31, 2015 was approximately $6.6 million while no such gain was recorded in 2014.\nIncome Tax Benefit. The income tax benefit for the year ended December 31, 2015 decreased approximately $0.4 million, or 22.7%, to approximately $1.3 million compared to an income tax benefit of approximately $1.7 million for the year ended December 31, 2014. The income tax benefit was primarily derived from the operations of our TRS Lessees. Our TRS Lessees realized lower operating loss for the year ended December 31, 2015 compared to the year ended December 31, 2014.\nNet Income (Loss). Net income for the year ended December 31, 2015 increased approximately $7.1 million, or 966.3%, to approximately $6.4 million compared to net loss of approximately $0.7 million for the year ended December 31, 2014 as a result of the operating results discussed above.\nSources and Uses of Cash\nThe following narrative discusses our sources and uses of cash for the year ended December 31, 2016.\nOperating Activities. Our principal source of cash to meet our operating requirements, including distributions to unit holders of the Operating Partnership and stockholders of the Company as well as debt service (excluding debt maturities), is the operations of our hotels. Cash flow provided by operating activities for the year ended December 31, 2016 was approximately $17.1 million. We expect that cash on hand and the net cash provided by operations will be adequate to fund our operating requirements, monthly and quarterly scheduled payments of principal and interest (excluding any balloon payments due upon maturity of a debt) and the payment of dividends (distributions) to the stockholders of the Company (the unitholders of the Operating Partnership) in accordance with federal income tax laws which require us to make annual distributions, as “qualifying distributions,” to the Company’s stockholders of at least 90.0% of its REIT taxable income (determined without regard to the dividends-paid deduction and by excluding its net capital gains, and reduced by certain non-cash items).\nInvesting Activities. During the year ended December 31, 2016, we spent approximately $14.9 million on capital expenditures, of which, approximately $5.3 million related to the routine replacement of furniture, fixtures and equipment; approximately $1.8 million related to the renovation of our property in Houston, Texas in anticipation of our newly independent hotel The Whitehall which opened in May 2016; approximately $4.9 million related to the renovation of our property in Savannah, Georgia; approximately $1.5 million related to the renovation of our property in Atlanta, Georgia; approximately $0.6 million related to the renovation of our property in Wilmington, North Carolina; approximately $0.4 million related to the renovation of our property in Laurel, Maryland and approximately $0.4 million related to the renovation of our property in Hollywood Beach, Florida.\nWe also contributed approximately $5.3 million during 2016 into reserves required by the lenders for ten of our hotels according to the provisions of their respective loan agreements. During 2016, we received reimbursements from those reserves of approximately $7.0 million for capital expenditures related to those properties for periods ending on or before December 31, 2016.\nFinancing Activities. Cash flow provided by financing activities for the year ended December 31, 2016 was approximately $16.1 million. This inflow was principally from proceeds from the sale of preferred stock of approximately $37.8 million and net mortgage proceeds of approximately $14.2 million, offset by redemption of the 8% Notes for $27.6 million, repurchase of common stock for approximately $2.1 million, dividend and distribution payments of approximately $6.2 million and payments of deferred financing costs of approximately $1.5 million.\nOn June 27, 2016, we entered into a promissory note and other loan documents to secure a $35.0 million mortgage on the Hilton Savannah DeSoto with MONY Life Insurance Company.\nOn June 30, 2016, we entered into a loan agreement and other loan documents, including a guaranty of payment by the Operating Partnership, to secure a $19.0 million mortgage on the Crowne Plaza Tampa Westshore with Fifth Third Bank.\nOn August 23, 2016, the Company issued 1,610,000 shares, $0.01 par value per share, of its 8% Series B Cumulative Redeemable Perpetual Preferred Stock for net proceeds after all expenses of approximately $37.8 million, which it contributed to the Operating Partnership for an equivalent number of preferred partnership units.\nOn September 30, 2016, the Operating Partnership redeemed the entire $27.6 million aggregate principal amount of its outstanding 8% Notes.\n46\nOn October 12, 2016, we entered into a loan agreement to secure a $20.5 million mortgage on The Whitehall with International Bank of Commerce. Pursuant to the loan documents, the loan provides initial proceeds of $15.0 million, with an additional $5.5 million available upon the satisfaction of certain conditions.\nOn November 3, 2016, we entered into a loan agreement to refinance the mortgage on the Sheraton Louisville Riverside with Symetra Life Insurance Company. Pursuant to the loan documents, the loan provides proceeds of $12.0 million.\nOn November 3, 2016, we entered into a loan agreement to modify and extend the $2.6 million mortgage on the Crowne Plaza Hampton Marina with TowneBank.\nOn December 1, 2016, we entered into a promissory note and other loan documents to secure a $35.0 million mortgage on the Hilton Wilmington Riverside with MONY Life Insurance Company. Pursuant to the loan documents, the loan provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions, namely, the completion of a renovation project.\nOn December 2, 2016, the Company’s Board of Directors authorized a stock repurchase program under which the Company may purchase up to $10.0 million of its outstanding common stock, par value $0.01 per share, at prevailing prices on the open market or in privately negotiated transactions, at the discretion of management. The Company expects to use available working capital to fund purchases under the stock repurchase program and intends to complete the repurchase program prior to December 31, 2017, unless extended by the Board of Directors. Through December 31, 2016, the Company repurchased 481,100 shares of common stock for $3.2 million and the repurchased shares have been returned to the status of authorized but unissued shares of common stock.\nThe following narrative discusses our sources and uses of cash for the year ended December 31, 2015.\nOperating Activities. Our principal source of cash to meet our operating requirements, including distributions to unit holders of the Operating Partnership and stockholders of the Company as well as debt service (excluding debt maturities), is the operations of our hotels. Cash flow provided by operating activities for the year ended December 31, 2015 was approximately $11.4 million. We expect that cash on hand and the net cash provided by operations will be adequate to fund our operating requirements, monthly and quarterly scheduled payments of principal and interest (excluding any balloon payments due upon maturity of a debt) and the payment of dividends (distributions) to the stockholders of the Company (the unitholders of the Operating Partnership) in accordance with federal income tax laws which require us to make annual distributions, as “qualifying distributions,” to the Company’s stockholders of at least 90.0% of its REIT taxable income (determined without regard to the dividends-paid deduction and by excluding its net capital gains, and reduced by certain non-cash items).\nInvesting Activities. During the year ended December 31, 2015, we used approximately $25.5 million to acquire the remaining 75.0% ownership interest in the Crowne Plaza Hollywood Beach Resort. We also spent approximately $20.1 million on capital expenditures, of which, approximately $5.1 million related to the routine replacement of furniture, fixtures and equipment; approximately $4.6 million related to the renovation of our property in Laurel, Maryland in anticipation of a new franchise agreement which commenced in October 2015; approximately $3.4 million related to the renovation of our property in Jacksonville, Florida in anticipation of a new franchise license which commenced in September 2015; approximately $3.1 million related to guestroom renovations at the Georgian Terrace; approximately $3.0 million in renovations at our property in Houston, Texas; and approximately $0.9 related to the renovation of our property in Philadelphia, Pennsylvania.\nWe also contributed approximately $5.0 million during 2015 into reserves required by the lenders for ten of our hotels according to the provisions of their respective loan agreements. During 2015, we received reimbursements from those reserves of approximately $6.4 million for capital expenditures related to those properties for periods ending on or before December 31, 2015 and we received net proceeds of approximately $2.4 million from the sale of a 0.3-acre parcel of excess land located adjacent to our property in Atlanta, Georgia and related development rights.\nFinancing Activities. Cash flow provided by financing activities for the year ended December 31, 2015 was approximately $24.6 million. This inflow was principally from proceeds from the sale of common stock of approximately $23.3 million and net mortgage proceeds of approximately $6.8 million, offset by dividend and distribution payments of approximately $4.1 million and payments of deferred financing costs of approximately $1.4 million.\nOn October 20, 2015, we secured $2.0 million of additional proceeds on the mortgage loan on the DoubleTree by Hilton Jacksonville Riverfront as part of an earn-out pursuant to the terms of the loan agreement.\nOn September 28, 2015, we entered into a loan agreement to secure a $60.0 million mortgage on the Crowne Plaza Hollywood Beach Resort with Bank of America, N.A.\n47\nOn July 17, 2015, the Company sold 435,000 shares of common stock for net proceeds of approximately $2.8 million, which it contributed to the Operating Partnership for an equivalent number of units.\nOn July 7, 2015, we entered into a loan agreement and other loan documents to secure an $18.5 million mortgage with Bank of the Ozarks collateralized by a first mortgage on the DoubleTree by Hilton Jacksonville Riverfront. The $18.5 million mortgage was received in two parts. We received $18.0 million on July 7, 2015 and the remainder of $0.5 million on October 20, 2015. The $0.5 million was included with the additional earn-out provision of $1.5 million, for a total of $2.0 million additional proceeds.\nOn July 1, 2015, the Company sold 3,000,000 shares of common stock, for net proceeds of approximately $19.8 million, which it contributed to the Operating Partnership for an equivalent number of units.\nDuring June 2015, the Company sold 98,682 shares of common stock for net proceeds of approximately $0.7 million, which it contributed to the Operating Partnership for an equivalent number of units.\nOn May 5, 2015, the Company obtained a $47.0 million mortgage with Bank of America, N.A. on the Georgian Terrace in Atlanta, Georgia.\nCapital Expenditures\nWe anticipate that our need for recurring capital expenditures for the replacement and refurbishment of furniture, fixtures and equipment over the next 12 to 24 months will be at historical norms for our properties and the industry. Historically, we have aimed to maintain overall capital expenditures, except for those required by our franchisors as a condition to a franchise license or license renewal, at 4.0% of gross revenue. In addition, during fiscal years 2017 and 2018 we expect total renovation capital expenditures of approximately $23.5 million related to our properties in Wilmington, North Carolina; Savannah, Georgia and Hollywood Beach, Florida.\nGiven our desire to proceed with the renovation activities at our properties in Wilmington, North Carolina; Savannah, Georgia and Hollywood Beach, Florida, we aim to restrict all other capital expenditures to the replacement of broken or damaged furniture and equipment and the acquisition of items mandated by our licensors that are necessary to maintain our brand affiliations. We anticipate that capital expenditures for the replacement and refurbishment of furniture, fixtures and equipment that are not related to these renovation activities to total 3.50% of gross revenues in 2017.\nWe expect capital expenditures for the recurring replacement or refurbishment of furniture, fixtures and equipment at our properties will be funded by our replacement reserve accounts, other than costs that we incur to make capital improvements required by our franchisors. Reserve accounts are escrowed accounts with funds deposited monthly and reserved for capital improvements or expenditures with respect to all of our hotels. We currently deposit an amount equal to 4.0% of gross revenue for the Hilton Savannah DeSoto, the Hilton Wilmington Riverside, the Crowne Plaza Hollywood Beach Resort, The DoubleTree by Hilton Jacksonville Riverside, the DoubleTree by Hilton Raleigh Brownstone-University, the Whitehall and the Georgian Terrace as well as 4.0% of room revenues for the DoubleTree by Hilton Philadelphia Airport on a monthly basis.\nLiquidity and Capital Resources\nAs of December 31, 2016, we had cash and cash equivalents of approximately $36.4 million, of which approximately $4.6 million was in restricted reserve accounts for capital improvements, real estate tax and insurance escrows. We expect that our cash on hand combined with our cash flow from our hotels should be adequate to fund continuing operations, recurring capital expenditures for the refurbishment and replacement of furniture, fixtures and equipment, and monthly and quarterly scheduled payments of principal and interest (excluding any balloon payments due upon maturity of the indentures or mortgage debt).\nWe intend to continue to invest in hotel properties as suitable opportunities arise. The success of our acquisition strategy depends, in part, on our ability to access additional capital through other sources. There can be no assurance that we will continue to make investments in properties that meet our investment criteria. Additionally, we may choose to dispose of certain hotels as a means to provide liquidity.\nWe expect to meet our liquidity requirements for hotel property acquisitions, property redevelopment, investments in new joint ventures and debt maturities, which include the repayment of the 7% Notes (which are callable after November 15, 2017) and the retirement of maturing mortgage debt, through net proceeds from additional issuances of common shares, additional issuances of preferred shares, issuances of units of limited partnership interest in our Operating Partnership, secured and unsecured borrowings, the selective disposition of non-core assets, and cash on hand. We remain committed to a flexible capital structure and strive to maintain prudent debt leverage.\n48\nWe do not have any debt obligations maturing until August 2018. In August 2018, the approximate $14.5 mortgage on our DoubleTree by Hilton Raleigh Brownstone University matures. We have approximately $87.6 million in debt obligations maturing in 2019, including $25.3 million of the Operating Partnership’s 7% Notes and approximately $62.3 million in mortgage debt, including reductions for future monthly principal payments on the mortgages.\nOn June 27, 2016, we entered into a promissory note and other loan documents to secure a $35.0 million mortgage on the Hilton Savannah DeSoto with MONY Life Insurance Company. The loan has a maturity date of July 1, 2026.\nOn June 30, 2016, we entered into a loan agreement and other loan documents, including a guaranty of payment by the Operating Partnership, to secure a $19.0 million mortgage on the Crowne Plaza Tampa Westshore with Fifth Third Bank. The loan has an initial term of three years with a maturity on July 1, 2019, and may be extended for two additional periods of one year each, subject to certain conditions.\nOn August 23, 2016, the Company issued 1,610,000 shares, $0.01 par value per share, of its 8% Series B Cumulative Redeemable Perpetual Preferred Stock for net proceeds after all expenses of approximately $37.8 million, which it contributed to the Operating Partnership for an equivalent number of preferred partnership units.\nOn September 30, 2016, the Operating Partnership redeemed the entire $27.6 million aggregate principal amount of its outstanding 8% Notes.\nOn October 12, 2016, we entered into a loan agreement to secure a $20.5 million mortgage on The Whitehall with International Bank of Commerce. Pursuant to the loan documents, the loan: provides initial proceeds of $15.0 million, with an additional $5.5 million available upon the satisfaction of certain conditions, has a term of five years, bears a floating interest rate of the one month LIBOR plus 3.5%, subject to a floor rate of 4.0%, amortizes on an 18-year schedule after a 2-year interest only period, is subject to prepayment fees, and is guaranteed by Sotherly Hotels LP.\nOn November 3, 2016, we entered into a loan agreement to refinance the mortgage on the Sheraton Louisville Riverside with Symetra Life Insurance Company. Pursuant to the loan documents, the loan: provides proceeds of $12.0 million, has a maturity date of December 1, 2026, bears a fixed interest rate of 4.27% for the first 5 years of the loan with an option for the lender to reset that rate after 5 years, amortizes on a 25-year schedule, is subject to prepayment fees, and is guaranteed by Sotherly Hotels LP at 50% of the unpaid principal balance, interest, and other amounts owed.\nOn December 1, 2016, we entered into a promissory note and other loan documents to secure a $35.0 million mortgage on the Hilton Wilmington Riverside with MONY Life Insurance Company. Pursuant to the loan documents, the loan: provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions, namely, the completion of a renovation project; has a term of 10 years; bears a fixed interest rate of 4.25%; amortizes on a 25-year schedule after a 1-year interest-only period and is subject to a prepayment premium.\nOn December 2, 2016, the Company’s Board of Directors authorized a stock repurchase program under which the Company may purchase up to $10.0 million of its outstanding common stock, par value $0.01 per share, at prevailing prices on the open market or in privately negotiated transactions, at the discretion of management. The Company expects to use available working capital to fund purchases under the stock repurchase program and intends to complete the repurchase program prior to December 31, 2017, unless extended by the Board of Directors. Through December 31, 2016, the Company repurchased 481,100 shares of common stock for approximately $3.2 million and the repurchased shares have been returned to the status of authorized but unissued shares of common stock.\nFinancial Covenants\nMortgage Loans\nOur mortgage loan agreements contain various financial covenants. Failure to comply with these financial covenants could result from, among other things, changes in the local competitive environment, general economic conditions and disruption caused by renovation activity or major weather disturbances.\n49\nIf we violate the financial covenants contained in these agreements, we may attempt to negotiate waivers of the violations or amend the terms of the applicable mortgage loan agreement with the lender; however, we can make no assurance that we would be successful in any such negotiation or that, if successful in obtaining waivers or amendments, such waivers or amendments would be on attractive terms. Some mortgage loan agreements provide alternate cure provisions which may allow us to otherwise comply with the financial covenants by obtaining an appraisal of the hotel, prepaying a portion of the outstanding indebtedness or by providing cash collateral until such time as the financial covenants are met by the collateralized property without consideration of the cash collateral. Alternate cure provisions which include prepaying a portion of the outstanding indebtedness or providing cash collateral may have a material impact on our liquidity.\nIf we are unable to negotiate a waiver or amendment or satisfy alternate cure provisions, if any, or unable to meet any alternate cure requirements and a default were to occur, we would possibly have to refinance the debt through additional debt financing, private or public offerings of debt securities, or additional equity financing.\nUnder the terms of our non-recourse secured mortgage loan agreements, failure to comply with the financial covenants in the loan agreement triggers cash flows from the property to be directed to the lender, which may limit our overall liquidity as that cash flow would not be available to us.\nAt December 31, 2016, we were in compliance with all debt covenants, current on all loan payments and not otherwise in default under any of our mortgage loans.\nUnsecured Notes\nThe indenture for the 7% Notes contains certain covenants and restrictions that require us to meet certain financial ratios. We are not permitted to incur any Debt (other than intercompany Debt), as defined in the indenture, if, immediately after giving effect to the incurrence of such Debt and to the application of the proceeds thereof, the ratio of the aggregate principal amount of all outstanding Debt to Adjusted Total Asset Value, as defined in the indenture, would be greater than 0.65 to 1.0. In addition, we are not permitted to incur any Debt if the ratio of Stabilized Consolidated Income Available for Debt Service to Stabilized Consolidated Interest Expense, both as defined in the indenture, on the date on which such additional Debt is to be incurred, on a pro-forma basis, after giving effect to the incurrence of such Debt and to the application of the proceeds thereof, would be less than 1.50 to 1.0.\n50\nThese financial measures are not calculated in accordance with GAAP and are presented below for the sole purpose of evaluating our compliance with the key financial covenants as they were or would have been applicable at December 31, 2016 and December 31, 2015, respectively.\n\n| December 31, | December 31, |\n| 2016 | 2015 |\n| Ratio of Stabilized Consolidated Income Available for Debt Service to Stabilized Consolidated Interest Expense |\n| Net income(1) | $ | 900,149 | $ | 6,397,653 |\n| Interest expense(1) | 17,735,107 | 16,515,827 |\n| Loss on early debt extinguishment | 1,417,905 | 772,907 |\n| Unrealized loss on hedging activities | 37,384 | 108,819 |\n| Gain on change in control | — | (6,603,148 | ) |\n| Loss (Gain) on disposal of assets | 365,319 | (41,435 | ) |\n| Income tax benefit(1) | (1,367,634 | ) | (1,336,033 | ) |\n| Equity in income of joint venture(1) | — | (475,514 | ) |\n| Impairment of investment in hotel properties, net(1) | — | 500,000 |\n| Depreciation and amortization(1) | 15,019,071 | 13,591,495 |\n| Corporate general and administrative expenses(1) | 6,021,065 | 7,268,256 |\n| Consolidated income available for debt service(1) | 40,128,366 | 36,698,827 |\n| Less: income of non-stabilized assets(1) | (10,203,893 | ) | (16,284,975 | ) |\n| Stabilized Consolidated Income Available for Debt Service(1) | $ | 29,924,473 | $ | 20,413,852 |\n| Interest expense(1) (2) | $ | 18,011,107 | $ | 16,515,827 |\n| Amortization of issuance costs(1) | (1,147,864 | ) | (1,300,032 | ) |\n| Consolidated interest expense(1) | 16,863,243 | 15,215,795 |\n| Less: interest expense of non-stabilized assets(1) | (3,417,412 | ) | (5,295,224 | ) |\n| Stabilized Consolidated Interest Expense(1) | $ | 13,445,831 | $ | 9,920,571 |\n| Ratio of Stabilized Consolidated Income Available for Debt Service to Stabilized Consolidated Interest Expense | 2.23 | 2.06 |\n| Threshold Ratio Minimum | 1.50 | 1.50 |\n| Ratio of Debt to Adjusted Total Asset Value: |\n| Mortgage loans | $ | 284,757,698 | $ | 271,977,944 |\n| Unsecured notes | 25,300,000 | 52,900,000 |\n| Total debt | $ | 310,057,698 | $ | 324,877,944 |\n| Stabilized Consolidated Income Available for Debt Service(1) | $ | 29,924,473 | $ | 20,413,852 |\n| Capitalization rate | 7.5 | % | 7.5 | % |\n| 398,992,973 | 272,184,693 |\n| Non-stabilized assets | 145,400,000 | 305,255,698 |\n| Total cash | 36,362,920 | 17,287,754 |\n| Adjusted Total Asset Value | $ | 580,755,893 | $ | 594,728,145 |\n| Ratio of Debt to Adjusted Total Asset Value | 0.53 | 0.55 |\n| Threshold Ratio Maximum | 0.65 | 0.65 |\n\n\n| (1) | As permitted by the indenture, the Hilton Savannah DeSoto, DoubleTree by Hilton Laurel, DoubleTree by Hilton Jacksonville Riverfront and The Whitehall, for the period ended December 31, 2016, and the DoubleTree by Hilton Laurel, DoubleTree by Hilton Jacksonville Riverfront and Crowne Plaza Hollywood Beach Resort, for the period ended December 31, 2015, are considered non-stabilized assets for purposes of the financial covenants. |\n\n| (2) | Includes losses on debt extinguishment paid for in cash of $276,000 in fiscal year 2016. |\n\n51\nMortgage Debt\nAs of December 31, 2016, we had a principal mortgage debt balance of approximately $284.5 million. The following table sets forth our mortgage debt obligations on our hotels.\n\n| December 31, | Prepayment | Maturity | Amortization |\n| Property | 2016 | Penalties | Date | Provisions | Interest Rate |\n| Crowne Plaza Hampton Marina (1) | $ | 2,584,633 | None | 11/1/2019 | $ | 3 years | 5.00% |\n| Crowne Plaza Hollywood Beach Resort (2) | 58,935,818 | N/A | 10/1/2025 | 30 years | 4.913% |\n| Crowne Plaza Tampa Westshore (3) | 15,561,400 | None | 6/30/2019 | 25 years | LIBOR plus 3.75 % |\n| DoubleTree by Hilton Jacksonville Riverfront (4) | 19,291,716 | Yes | 7/7/2019 | 25 years | LIBOR plus 3.50 % |\n| DoubleTree by Hilton Laurel (5) | 9,329,005 | Yes | 8/5/2021 | 25 years | 5.25% |\n| DoubleTree by Hilton Philadelphia Airport (6) | 31,261,991 | None | 4/1/2019 | 25 years | LIBOR plus 3.00 % |\n| DoubleTree by Hilton Raleigh Brownstone University (7) | 14,773,885 | N/A | 8/1/2018 | 30 years | 4.78% |\n| The Georgian Terrace (8) | 45,826,038 | N/A | 6/1/2025 | 30 years | 4.42% |\n| Hilton Savannah DeSoto (9) | 30,000,000 | Yes | 7/1/2026 | 25 years | 4.25% |\n| Hilton Wilmington Riverside (10) | 30,000,000 | Yes | 1/1/2027 | 25 years | 4.25% |\n| Sheraton Louisville Riverside (11) | 11,977,557 | Yes | 12/1/2026 | 25 years | 4.27% |\n| The Whitehall (12) | 15,000,000 | Yes | 10/12/2021 | 18 years | LIBOR plus 3.50 % |\n| Total Mortgage Principal Balance | 284,542,043 |\n| Deferred financing costs, net | (2,049,409) |\n| Unamortized premium on loan | 215,655 |\n| Total Mortgage Loans | $ | 282,708,289 |\n\n\n| (1) | The note was extended and modified in November 2016 for 3 years until November 1, 2019 and the Operating Partnership was required to make monthly principal payments of $15,367. The note rate was changed to a fixed rate of 5.00%, effective June 27, 2014. As of February 7, 2017, the note is no longer outstanding. |\n\n| (2) | With limited exception, the note may not be prepaid until June 2025. |\n\n| (3) | The note provides initial proceeds of $15.7 million, with an additional $3.3 million available upon the satisfaction of certain conditions; bears a floating interest rate of the 1-month LIBOR plus 3.75%, subject to a floor rate of 3.75%; the note provides that the mortgage can be extended for two additional periods of one year each, subject to certain conditions. |\n\n| (4) | The note is subject to a pre-payment penalty until July 2017. Prepayment can be made without penalty thereafter. The note provides that the mortgage can be extended until July 2020 if certain conditions have been satisfied. |\n\n| (5) | The note is subject to a pre-payment penalty except for any pre-payments made either between April 2017 and August 2017, or from April 2021 through maturity of the note. The note provides that on January 5, 2018, the rate of interest will adjust to a rate of 3.00% per annum plus the then-current five-year U.S. Treasury rate of interest, with a floor of 5.25%. |\n\n| (6) | The note bears a minimum interest rate of 3.50%. |\n\n| (7) | With limited exception, the note may not be prepaid until two months before maturity. |\n\n| (8) | With limited exception, the note may not be prepaid until February 2025. |\n\n| (9) | The note provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions, namely, the completion of a renovation project; amortizes on a 25-year schedule after a 1-year interest-only period; and is subject to a pre-payment penalty except for any pre-payments made within 120 days of the maturity date. |\n\n| (10) | The note provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions namely, the completion of a renovation project. The note amortizes on a 25-year schedule after a 1-year interest-only period; and is subject to a pre-payment penalty except for any pre-payments made within 120 days of the maturity date. |\n\n| (11) | The note bears a fixed interest rate of 4.27% for the first 5 years of the loan, with an option for the lender to reset the interest rate after 5 years. |\n\n| (12) | The note was refinanced in October 2016, provides initial proceeds of $15.0 million, with an additional $5.5 million available upon the satisfaction of certain conditions; bears a floating interest rate of the 1-month LIBOR plus 3.5%, subject to a floor rate of 4.0%; and is subject to prepayment penalties subject to a declining scale from 3.0% penalty on or before the first anniversary date, a 2.0% penalty during the second anniversary year and a 1.0% penalty after the third anniversary date. |\n\n52\nContractual Obligations\nThe following table outlines our contractual obligations as of December 31, 2016, and the effect such obligations are expected to have on our liquidity and cash flow in future periods (in thousands).\n\n| Payments due by period (in thousands) |\n| Less than | More than |\n| Contractual Obligations | Total | 1 year | 1-3 years | 3-5 years | 5 years |\n| Mortgage loans, including interest | $ | 355,927 | $ | 18,895 | $ | 119,609 | $ | 55,911 | $ | 161,512 |\n| Unsecured notes, including interest | 30,416 | 1,771 | 28,645 | — | — |\n| Ground, building, office and equipment leases | 1,137 | 224 | 276 | 191 | 446 |\n| Purchase commitment | 4,250 | 4,250 | — | — | — |\n| Totals | $ | 391,730 | $ | 25,140 | $ | 148,530 | $ | 56,102 | $ | 161,958 |\n\nIn connection with the acquisition of our six initial hotel properties, we entered into tax indemnity agreements that required us to indemnify the contributors of our initial properties against tax liabilities in the event we sold any of those properties in a taxable transaction during a 10-year period. The tax indemnity agreements expired on or about December 22, 2014. Our obligations under the contribution agreements may effectively preclude us from reducing our consolidated indebtedness below approximately $11.0 million.\nOff Balance Sheet Arrangements. Through a joint venture with a Carlyle subsidiary, we owned a 25.0% indirect, noncontrolling interest in an entity (the “JV Owner”) that acquired the 311-room Crowne Plaza Hollywood Beach Resort in Hollywood, Florida. We had the right to receive a pro rata share of operating surpluses and we had an obligation to fund our pro rata share of operating shortfalls. We also had the opportunity to earn an incentive participation in the net proceeds realized from the sale of the hotel based upon the achievement of certain overall investment returns, in addition to our pro rata share of net sale proceeds. The Crowne Plaza Hollywood Beach Resort was leased to another entity (the “Joint Venture Lessee”) in which we also owned a 25.0% indirect, noncontrolling interest.\nCarlyle owned a 75.0% controlling interest in the entities that own and lease the Crowne Plaza Hollywood Beach Resort. Carlyle had the right to dispose of the Crowne Plaza Hollywood Beach Resort without our consent. We accounted for our noncontrolling 25.0% interest in all of these entities under the equity method of accounting.\nOn July 31, 2015, indirect subsidiaries of the Operating Partnership acquired from Carlyle the remaining 75.0% interest in the entities that own and lease the Crowne Plaza Hollywood Beach Resort. As a result, the Operating Partnership now has a 100% indirect ownership interest in the entities that own the Crowne Plaza Hollywood Beach Resort. The property was refinanced on September 28, 2015 and is encumbered by a $60.0 million mortgage which matures in September 2025 and requires monthly payments of interest at a rate of 4.913%. The Crowne Plaza Hollywood Beach Resort secures the mortgage.\nDistributions to Stockholders and Holders of Units in the Operating Partnership. The Company has elected to be taxed as a REIT commencing with our taxable year ending December 31, 2004. To maintain qualification as a REIT, the Company is required to make annual distributions to its stockholders of at least 90.0% of our REIT taxable income, (excluding net capital gain, which does not necessarily equal net income as calculated in accordance with generally accepted accounting principles). The Company’s ability to pay distributions to its stockholders will depend, in part, upon its receipt of distributions from the Operating Partnership which may depend upon receipt of lease payments with respect to our properties from our TRS Lessees, and in turn, upon the management of our properties by our hotel manager. Distributions to the Company’s stockholders will generally be taxable to the Company’s stockholders as ordinary income; however, because a portion of our investments will be equity ownership interests in hotels, which will result in depreciation and non-cash charges against our income, a portion of our distributions may constitute a non-taxable return of capital. To the extent not inconsistent with maintaining the Company’s REIT status, our TRS Lessees may retain any after-tax earnings.\nDistributions to Preferred Stockholders and Holder of Preferred partnership units in the Operating Partnership. The Company is obligated to pay distributions to its preferred stockholders of the Company’s preferred stock and the Operating Partnership is obligated to pay its preferred unit holder, the Company. Holders of the Company’s 8% Series B Cumulative Redeemable Preferred Stock are entitled to receive distributions when authorized by the Company’s board of directors out of assets legally available for the payment of distributions. The amount of annual dividends on our outstanding preferred shares is approximately $3.2 million and the aggregate liquidation preference with respect to our outstanding preferred shares is approximately $40.3 million. The preferred stock is not redeemable by the holders, has no maturity date and is not convertible into any other security of the Company or its affiliates, except in the event of a change of control.\n53\nThe Company’s ability to pay distributions to its stockholders will depend, in part, upon its receipt of distributions from the Operating Partnership which may depend upon receipt of lease payments with respect to our properties from our TRS Lessees, and in turn, upon the management of our properties by our hotel manager. Distributions to the Company’s stockholders will generally be taxable to the Company’s stockholders as ordinary income; however, because a portion of our investments will be equity ownership interests in hotels, which will result in depreciation and non-cash charges against our income, a portion of our distributions may constitute a non-taxable return of capital. To the extent not inconsistent with maintaining the Company’s REIT status, our TRS Lessees may retain any after-tax earnings.\nThe amount, timing and frequency of distributions will be authorized by the Company’s board of directors and declared by the Company based upon a variety of factors deemed relevant by its directors, and no assurance can be given that the distribution policy will not change in the future.\nInflation\nWe generate revenues primarily from lease payments from our TRS Lessees and net income from the operations of our TRS Lessees. Therefore, we rely primarily on the performance of the individual properties and the ability of the management company to increase revenues and to keep pace with inflation. Operators of hotels, in general, possess the ability to adjust room rates daily to keep pace with inflation. However, competitive pressures at some or all of our hotels may limit the ability of the management company to raise room rates.\nOur expenses, including hotel operating expenses, administrative expenses, real estate taxes and property and casualty insurance are subject to inflation. These expenses are expected to grow with the general rate of inflation, except for energy, liability insurance, property and casualty insurance, property tax rates, employee benefits, and some wages, which are expected to increase at rates higher than inflation.\nGeographic Concentration and Seasonality\nOur hotels are located in Florida, Georgia, Indiana, Maryland, North Carolina, Pennsylvania, and Texas. As a result, we are particularly susceptible to adverse market conditions in these geographic areas, including industry downturns, relocation of businesses and any oversupply of hotel rooms or a reduction in lodging demand. Adverse economic developments in the markets in which we have a concentration of hotels, or in any of the other markets in which we operate, or any increase in hotel supply or decrease in lodging demand resulting from the local, regional or national business climate, could materially and adversely affect us.\nThe operations of our hotel properties have historically been seasonal. The months of April and May are traditionally strong, as is October. The periods from mid-November through mid-February are traditionally slow with the exception of hotels located in certain markets, namely Florida and Texas, which experience significant room demand during this period.\nCompetition\nThe hotel industry is highly competitive with various participants competing on the basis of price, level of service and geographic location. Each of our hotels is located in a developed area that includes other hotel properties. The number of competitive hotel properties in a particular area could have a material adverse effect on occupancy, ADR and RevPAR of our hotels or at hotel properties acquired in the future. We believe that brand recognition, location, the quality of the hotel, consistency of services provided, and price, are the principal competitive factors affecting our hotels.\nCritical Accounting Policies\nThe critical accounting policies are described below. We consider these policies critical because they involve difficult management judgments and assumptions, are subject to material change from external factors or are pervasive, and are significant to fully understand and evaluate our reported financial results.\nInvestment in Hotel Properties. Hotel properties are stated at cost, net of any impairment charges, and are depreciated using the straight-line method over an estimated useful life of 7-39 years for buildings and improvements and 3-10 years for furniture and equipment. In accordance with generally accepted accounting principles, the controlling interests in hotels comprising our accounting predecessor, MHI Hotels Services Group, and noncontrolling interests held by the controlling holders of our accounting predecessor in hotels, which were acquired from third parties contributed to us in connection with the Company’s initial public offering, are recorded at historical cost basis. Noncontrolling interests in those entities that comprise our accounting predecessor and the interests in hotels, other than those held by the controlling members of our accounting predecessor, acquired from third parties are recorded at fair value at the time of acquisition.\n54\nWe review our hotel properties for impairment whenever events or changes in circumstances indicate the carrying value of the hotel properties may not be recoverable. Events or circumstances that may cause us to perform our review include, but are not limited to, adverse permanent changes in the demand for lodging at our properties due to declining national or local economic conditions and/or new hotel construction in markets where our hotels are located. When such conditions exist, management performs a recoverability analysis to determine if the estimated undiscounted future cash flows from operating activities and the estimated proceeds from the ultimate disposition of a hotel property exceed its carrying value. If the estimated undiscounted future cash flows are found to be less than the carrying amount of the hotel property, an adjustment to reduce the carrying value to the related hotel property’s estimated fair market value would be recorded and an impairment loss recognized.\nOur review of possible impairment at one of our hotel properties revealed an excess of current carrying cost over the estimated undiscounted future cash flows, which resulted in an impairment to fair market value by an approximate amounts of $0.5 million and $3.2 million, as of December 31, 2015 and 2014, respectively.\nIn performing the recoverability analysis, we project future operating cash flows based upon significant assumptions regarding growth rates, occupancy, room rates, economic trends, property-specific operating costs and future capital expenditures required to maintain the hotel in its current operating condition. We also project cash flows from the eventual disposition of the hotel based upon various factors including property-specific capitalization rates, ratio of selling price to gross hotel revenues and the selling price per room.\nRevenue Recognition. Hotel revenues, including room, food, beverage and other hotel revenues, are recognized as the related services are delivered. We generally consider accounts receivable to be fully collectible; accordingly, no allowance for doubtful accounts is required. If we determine that amounts are uncollectible, which would generally be the result of a customer’s bankruptcy or other economic downturn, such amounts will be charged against operations when that determination is made.\nIncome Taxes. We record a valuation allowance to reduce deferred tax assets to an amount that we believe is more likely than not to be realized. Because of expected future taxable income of our TRS Lessee, we have not recorded a valuation allowance to reduce our net deferred tax asset as of December 31, 2016. We regularly evaluate the likelihood that our TRS Lessee will be able to realize its deferred tax assets and the continuing need for a valuation allowance. At December 31, 2016, we determined, based on all available positive and negative evidence, that it is more-likely-than-not that future taxable income will be available during the carryforward periods to absorb all of the consolidated federal and state net operating loss carryforward. A number of factors played a critical role in this determination, including:\n| • | a demonstrated track record of past profitability and utilization of past NOL carryforwards, |\n\n| • | reasonable forecasts of future taxable income, and |\n\n| • | anticipated changes in the lease rental payments from the TRS Lessee to subsidiaries of the Operating Partnership. |\n\nShould unanticipated adverse financial trends occur, or other negative evidence develop, a valuation allowance may be necessary in the future against some or all of our deferred tax assets.\nRecent Accounting Pronouncements\nFor a summary of recently adopted and newly issued accounting pronouncements, please refer to the Recent Accounting Pronouncements section of Note 2, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements.\nNon-GAAP Financial Measures\nWe consider FFO, Adjusted FFO and Hotel EBITDA, all of which are non-GAAP financial measures, to be key supplemental measures of our performance and could be considered along with, not alternatives to, net income (loss) as a measure of our performance. These measures do not represent cash generated from operating activities determined by generally accepted accounting principles (“GAAP”) or amounts available for our discretionary use and should not be considered alternative measures of net income, cash flows from operations or any other operating performance measure prescribed by GAAP.\nFFO and Adjusted FFO. Industry analysts and investors use Funds from Operations (“FFO”), as a supplemental operating performance measure of an equity REIT. FFO is calculated in accordance with the definition adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). FFO, as defined by NAREIT, represents net income or loss determined in accordance with GAAP, excluding extraordinary items as defined under GAAP and gains or losses from sales of previously depreciated operating real estate assets, plus certain non-cash items such as real estate asset depreciation and amortization,\n55\nand after adjustment for any noncontrolling interest from unconsolidated partnerships and joint ventures. Historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen or fallen with market conditions, many investors and analysts have considered the presentation of operating results for real estate companies that use historical cost accounting to be insufficient by itself.\nWe consider FFO to be a useful measure of adjusted net income (loss) for reviewing comparative operating and financial performance because we believe FFO is most directly comparable to net income (loss), which remains the primary measure of performance, because by excluding gains or losses related to sales of previously depreciated operating real estate assets and excluding real estate asset depreciation and amortization, FFO assists in comparing the operating performance of a company’s real estate between periods or as compared to different companies. Although FFO is intended to be a REIT industry standard, other companies may not calculate FFO in the same manner as we do, and investors should not assume that FFO as reported by us is comparable to FFO as reported by other REITs.\nWe further adjust FFO for certain additional items that are not in NAREIT’s definition of FFO, including changes in deferred income taxes, any unrealized gain (loss) on hedging instruments or warrant derivative, loan impairment losses, losses on early extinguishment of debt, aborted offering costs, loan modification fees, franchise termination costs, costs associated with the departure of executive officers, litigation settlement, over-assessed real estate taxes on appeal, change in control gains or losses and acquisition transaction costs. We exclude these items as we believe it allows for meaningful comparisons between periods and among other REITs and is more indicative than FFO of the on-going performance of our business and assets. Our calculation of Adjusted FFO may be different from similar measures calculated by other REITs.\nThe following is a reconciliation of net income (loss) to FFO and Adjusted FFO for the years ended December 31, 2016, 2015, and 2014.\n\n| Year Ended | Year Ended | Year Ended |\n| December 31, | December 31, | December 31, |\n| 2016 | 2015 | 2014 |\n| Net Income/(Loss) Attributable to the Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) |\n| Add: Net Income/(Loss) Attributable to the Noncontrolling Interest | (26,567 | ) | 1,040,987 | (153,838 | ) |\n| Depreciation and Amortization | 15,019,071 | 13,591,495 | 11,969,284 |\n| Impairment of Investment in Hotel Properties, Net | — | 500,000 | 3,175,000 |\n| Equity in Depreciation on Joint Venture | — | 259,279 | 529,053 |\n| Gain on Change in Control | — | (6,603,148 | ) | — |\n| Loss (Gain) on Disposal of Assets | 365,319 | (41,435 | ) | — |\n| Gain on Involuntary Conversion of Asset | — | — | (169,151 | ) |\n| Funds From Operations | $ | 15,139,650 | $ | 14,103,844 | $ | 14,765,677 |\n| Increase in Deferred Income Taxes | (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) |\n| Acquisition Costs | — | 634,376 | 155,187 |\n| Loss on Starwood Settlement | — | 324,271 | — |\n| Over-Assessed Real Estate Taxes Under Appeal | — | 497,733 | — |\n| Loan Modification Fees | 64,215 | 243,229 | — |\n| Franchise Termination Fee | — | — | 351,800 |\n| Realized and Unrealized Loss on Hedging Activities (A) | 37,384 | 108,819 | — |\n| Loss on Early Debt Extinguishment (A) | 1,417,905 | 772,907 | 831,079 |\n| Adjusted FFO | $ | 15,100,188 | $ | 14,904,608 | $ | 14,142,080 |\n\n\n| (A) | Includes equity in unrealized (gain)/loss on hedging activities and loss on early extinguishment of debt of joint venture. |\n\nHotel EBITDA. We define Hotel EBITDA as net income or loss excluding: (1) interest expense, (2) interest income, (3) income tax provision or benefit, (4) equity in the income or loss of equity investees, (5) unrealized gains and losses on derivative instruments not included in other comprehensive income, (6) gains and losses on disposal of assets, (7) realized gains and losses on investments, (8) impairment of long-lived assets or investments, (9) loss on early debt extinguishment, (10) gains or losses on change in control, (11) corporate general and administrative expense, (12) depreciation and amortization, (13) gains and losses on involuntary conversions of assets and (14) other operating revenue not related to our wholly-owned portfolio. We believe this provides a more\n56\ncomplete understanding of the operating results over which our wholly-owned hotels and its operators have direct control. We believe Hotel EBITDA provides investors with supplemental information on the on-going operational performance of our hotels and the effectiveness of third-party management companies operating our business on a property-level basis.\nOur calculation of Hotel EBITDA may be different from similar measures calculated by other REITs.\nThe following is a reconciliation of net loss to Hotel EBITDA for the years ended December 31, 2016, 2015, and 2014.\n\n| Year Ended | Year Ended | Year Ended |\n| December 31, | December 31, | December 31, |\n| 2016 | 2015 | 2014 |\n| Net Income/(Loss) Attributable to the Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) |\n| Add: Net Income/(Loss) Attributable to the Noncontrolling Interest | (26,567 | ) | 1,040,987 | (153,838 | ) |\n| Interest Expense | 17,735,107 | 16,515,827 | 14,636,870 |\n| Interest Income | (115,785 | ) | (50,461 | ) | (19,865 | ) |\n| Distributions to Preferred Stockholders | 1,144,889 | — | — |\n| Income Tax Benefit | (1,367,634 | ) | (1,336,033 | ) | (1,727,723 | ) |\n| Depreciation and Amortization | 15,019,071 | 13,591,495 | 11,969,284 |\n| Equity in Earnings of Joint Venture | — | (475,514 | ) | (307,370 | ) |\n| Unrealized Loss on Hedging Activities | 37,384 | 108,819 | — |\n| Gain on Change in Control | — | (6,603,148 | ) | — |\n| Loss on Debt Extinguishment | 1,417,905 | 772,907 | 831,079 |\n| Loss (Gain) on Disposal of Assets | 365,319 | (41,435 | ) | — |\n| Gain on Involuntary Conversion of Asset | — | — | (169,151 | ) |\n| Impairment of Investment in Hotel Properties, Net | — | 500,000 | 3,175,000 |\n| Corporate General and Administrative Expenses | 6,021,065 | 7,268,256 | 5,085,949 |\n| Net Lease Rental Income | — | — | (350,000 | ) |\n| Other Fee Income | — | (200,976 | ) | (300,607 | ) |\n| Hotel EBITDA | $ | 40,012,581 | $ | 36,447,390 | $ | 32,084,957 |\n\n\nQuantitative and Qualitative Disclosures about Market Risk\nThe effects of potential changes in interest rates are discussed below. Our market risk discussion includes “forward-looking statements” and represents an estimate of possible changes in fair value or future earnings that could occur assuming hypothetical future movements in interest rates. These disclosures are not precise indicators of expected future losses, but only indicators of reasonably possible losses. As a result, actual future results may differ materially from those presented. The analysis below presents the sensitivity of the market value of our financial instruments to selected changes in market interest rates.\nTo meet in part our long-term liquidity requirements, we will borrow funds at a combination of fixed and variable rates. Our interest rate risk management objective is to limit the impact of interest rate changes on earnings and cash flows and to lower our overall borrowing costs. From time to time we may enter into interest rate hedge contracts such as collars and treasury lock agreements in order to mitigate our interest rate risk with respect to various debt instruments. We do not intend to hold or issue derivative contracts for trading or speculative purposes.\nAs of December 31, 2016, we had approximately $228.7 million of fixed-rate debt and approximately $81.1 million of variable-rate debt. The weighted-average interest rate on the fixed-rate debt was 4.84%. A change in market interest rates on the fixed portion of our debt would impact the fair value of the debt, but have no impact on interest incurred or cash flows. Our variable-rate debt is exposed to changes in interest rates, specifically the changes in 1-month LIBOR. However, to the extent that 1-month LIBOR does not exceed the 1-month LIBOR floor on the mortgage on the DoubleTree by Hilton Philadelphia Airport of 0.50%, a portion of our variable-rate debt would not be exposed to changes in interest rates. Assuming that the aggregate amount outstanding on the mortgages on the Crowne Plaza Tampa Westshore, DoubleTree by Hilton Philadelphia Airport, DoubleTree by Hilton Jacksonville Riverfront and the mortgage on The Whitehall remains at approximately $81.1 million, the balance at December 31, 2016, the impact on our annual interest incurred and cash flows of a one percent increase in 1-month LIBOR would be approximately $0.8 million.\nAs of December 31, 2015, we had approximately $272.6 million of fixed-rate debt and approximately $52.3 million of variable-rate debt. The weighted-average interest rate on the fixed-rate debt was 5.58%. A change in market interest rates on the fixed portion\n57\nof our debt would impact the fair value of the debt, but have no impact on interest incurred or cash flows. Our variable-rate debt is exposed to changes in interest rates, specifically the changes in 1-month and 3-month LIBOR. However, to the extent that 1-month LIBOR does not exceed the 1-month LIBOR floor on the mortgage on the DoubleTree by Hilton Philadelphia Airport of 0.50%, a portion of our variable-rate debt would not be exposed to changes in interest rates. Assuming that the aggregate amount outstanding on the mortgage on the DoubleTree by Hilton Philadelphia Airport and the mortgage on the DoubleTree by Hilton Jacksonville Riverfront remains at approximately $52.2 million, the balance at December 31, 2015, the impact on our annual interest incurred and cash flows of a one percent increase in 1-month LIBOR and 3-month LIBOR would be approximately $0.5 million.\nFinancial Statements and Supplementary Data\nSee Index to Financial Statements and Financial Statement Schedules on page F-1.\nChanges in and Disagreements with Accountants on Accounting and Financial Disclosure\nNone.\nControls and Procedures\nSotherly Hotels Inc.\nDisclosure Controls and Procedures\nThe Company’s management, under the supervision and participation of its Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of its disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as required by paragraph (b) of Rules 13a-15 and 15d-15 under the Exchange Act), as of December 31, 2016. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of December 31, 2016, its disclosure controls and procedures were effective and designed to ensure that (i) information required to be disclosed in its reports filed under the Exchange Act is recorded, processed, summarized and reported with the time periods specified in the SEC’s rules and instructions, and (ii) information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.\nThe Company’s management, including its Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s disclosure controls and procedures or its internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of the controls can provide absolute assurance that all control issues and instances of fraud, if any, within Sotherly Hotels Inc. have been detected.\nManagement’s Report on Internal Control over Financial Reporting\nThe Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(e) under the Exchange Act). The Company’s management assessed the effectiveness over internal control over financial reporting as of December 31, 2016. In making this assessment, the Company’s management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) 2013 Internal Control-Integrated Framework. The Company’s management has concluded that, as of December 31, 2016, its internal control over financial reporting is effective based on these criteria.\nThis annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s independent registered public accounting firm pursuant to the exemption provided to issuers that are not “large accelerated filers” or “accelerated filers” under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.\n58\nChanges in Internal Control over Financial Reporting\nThere was no change in Sotherly Hotels Inc.’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Exchange Act during Sotherly Hotels Inc.’s last fiscal quarter that materially affected, or is reasonably likely to materially affect, Sotherly Hotels Inc.’s internal control over financial reporting.\nSotherly Hotels LP\nDisclosure Controls and Procedures\nThe Operating Partnership’s management, under the supervision and participation of the Chief Executive Officer and Chief Financial Officer of Sotherly Hotels Inc., as general partner, has evaluated the effectiveness of the disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, as required by paragraph (b) of Rules 13a-15 and 15d-15 under the Exchange Act), as of December 31, 2016. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of December 31, 2016, the disclosure controls and procedures were effective and designed to ensure that (i) information required to be disclosed in the reports filed under the Exchange Act is recorded, processed, summarized and reported with the time periods specified in the SEC’s rules and instructions, and (ii) information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.\nThe Operating Partnership’s management, including the Chief Executive Officer and Chief Financial Officer of Sotherly Hotels Inc., as general partner, does not expect that the disclosure controls and procedures or the internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of the controls can provide absolute assurance that all control issues and instances of fraud, if any, within Sotherly Hotels LP have been detected.\nManagement’s Report on Internal Control over Financial Reporting\nThe Operating Partnership’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(e) under the Exchange Act). Management assessed the effectiveness over internal control over financial reporting as of December 31, 2016. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in 2013 Internal Control-Integrated Framework. Management has concluded that, as of December 31, 2016, the Operating Partnership’s internal control over financial reporting is effective based on these criteria.\nThis annual report does not include an attestation report of the Operating Partnership’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Operating Partnership’s independent registered public accounting firm pursuant to the exemption provided to issuers that are not “large accelerated filers” or “accelerated filers” under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.\nChanges in Internal Control over Financial Reporting\nThere was no change in Sotherly Hotels LP’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Exchange Act during Sotherly Hotels LP’s last fiscal quarter that materially affected, or is reasonably likely to materially affect, Sotherly Hotels LP’s internal control over financial reporting.\nOther Information\nNone.\n59\nPART III\nThe information required by Items 10-14 is incorporated by reference to the Company’s proxy statement for the 2017 annual meeting of stockholders (to be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year covered by this report).\nDirectors, Executive Officers and Corporate Governance\nThe Company has adopted a code of business conduct and ethics, including a conflicts of interest policy that applies to its principal executive officer, principal financial officer, principal accounting officer or controller performing similar functions. We intend to maintain the highest standards of ethical business practices and compliance with all laws and regulations applicable to our business. A copy of the Company’s Code of Business Conduct is posted on the Company’s external website at www.sotherlyhotels.com. The Company and the Operating Partnership intend to post to its website any amendments to or waivers of its code. The Operating Partnership is managed by the Company, its sole general partner and parent company. Consequently, the Operating Partnership does not have its own separate directors or executive officers.\nInformation on the Company’s directors is incorporated by reference to the sections captioned “Proposal I – Election of Directors” and “Section 16(a) Beneficial Ownership Reporting Compliance” contained in the Company’s 2017 Proxy Statement.\n. Executive Compensation\nThe information required by this item is incorporated by reference to the section captioned “Director and Executive Compensation” contained in the Company’s 2017 Proxy Statement.\nSecurity Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters\n(a) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS\nInformation required by this item is incorporated herein by reference to the section captioned “Principal Holders” of the Company’s 2017 Proxy Statement.\n(b) SECURITY OWNERSHIP OF MANAGEMENT\nInformation required by this item is incorporated herein by reference to the section captioned “Principal Holders” of the Company’s 2017 Proxy Statement.\n(c) CHANGES IN CONTROL\nManagement of the Company knows of no arrangements, including any pledge by any person of securities of the Company, the operation of which may at a subsequent date result in a change in control of the Company.\n(d) SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS\nSet forth below is information as of December 31, 2016 with respect to compensation plans under which equity securities of the Company are authorized for issuance.\n60\nEQUITY COMPENSATION PLAN INFORMATION\n\n| NUMBER OF SECURITIES TO BE ISSUED UPON EXERCISE OF OUTSTANDING OPTIONS, WARRANTS AND RIGHTS | WEIGHTED-AVERAGE EXERCISE PRICE OF OUTSTANDING OPTIONS, WARRANTS AND RIGHTS | NUMBER OF SECURITIES REMAINING AVAILABLE FOR FUTURE ISSUANCE |\n| Equity compensation plans approved by security holders: |\n| 2013 Plan (1) | N/A | N/A | 640,900 |\n| Equity compensation plans not approved by security holders: |\n| None | N/A | N/A | N/A |\n| Total | N/A | N/A | 640,900 |\n\n\n| (1) | On February 2, 2016, we granted 8,000 shares of stock to Andrew M. Sims, 6,000 shares of stock to Anthony E. Domalski, 7,000 shares of stock to David R. Folsom, and 1,000 shares of stock to other employees of the Company. |\n\nOn February 2, 2016, we granted 12,000 shares (3,000 each) of restricted stock to certain of our independent directors that vested on December 31, 2016. Also on February 2, 2016, we granted an additional 2,250 shares of unrestricted stock to director Herschel J. Walker in consideration for his service during 2015.\nOn February 15, 2017, we granted 12,000 shares (3,000 each) of restricted stock to certain of our independent directors that will vest on December 31, 2017. These shares are included in the number of securities remaining available for future issuance at December 31, 2016.\nCertain Relationships and Related Transactions, and Director Independence\nThe information required by this item is incorporated by reference to the sections captioned “Certain Relationships and Related Transactions” and “Proposal I – Election of Directors” in the Company’s 2017 Proxy Statement.\nPrincipal Accountant Fees and Services\nThe information required by this item is incorporated by reference to the section captioned “Proposal II –Ratification of Appointment of Accountants” in the Company’s 2017 Proxy Statement.\n61\nPART IV\nExhibits and Financial Statement Schedules\n\n| 1. Financial Statements |\n| Index to Financial Statements and Financial Statement Schedules | F-1 |\n| Sotherly Hotels Inc. |\n| Report of Independent Registered Public Accounting Firm, Dixon Hughes Goodman LLP | F-2 |\n| Report of Independent Registered Public Accounting Firm, Grant Thornton LLP | F-3 |\n| Consolidated Balance Sheets for Sotherly Hotels Inc. as of December 31, 2016 and 2015 | F-4 |\n| Consolidated Statements of Operations for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-5 |\n| Consolidated Statements of Changes in Equity for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-6 |\n| Consolidated Statements of Cash Flows for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-7 |\n| Sotherly Hotels LP |\n| Report of Independent Registered Public Accounting Firm, Dixon Hughes Goodman LLP | F-8 |\n| Report of Independent Registered Public Accounting Firm, Grant Thornton LLP | F-9 |\n| Consolidated Balance Sheets for Sotherly Hotels LP as of December 31, 2016 and 2015 | F-10 |\n| Consolidated Statements of Operations for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-11 |\n| Consolidated Statements of Changes in Partners’ Capital for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-12 |\n| Consolidated Statements of Cash Flows for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-13 |\n| Notes to Consolidated Financial Statements | F-14 |\n| 2. Financial Statement Schedules |\n| Schedule III – Real Estate and Accumulated Depreciation as of December 31, 2016 | F-35 |\n\nAll other schedules for which provision is made in Regulation S-X are either not required to be included herein under the related instructions or are inapplicable or the related information is included in the footnotes to the applicable financial statement and, therefore, have been omitted.\nThe following exhibits are filed as part of this Form 10-K:\n\n| Exhibits |\n| 3.1 | Articles of Amendment and Restatement of the Company (incorporated by reference to the document previously filed as Exhibit 3.1 to the Company’s Pre-Effective Amendment No. 1 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on October 20, 2004 (File No. 333-118873)). |\n| 3.1A | Articles of Amendment to the Articles of Amendment and Restatement of the Company, effective as of April 16, 2013 (incorporated by reference to the document previously filed as Exhibit 3.7 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 16, 2013). |\n| 3.1B | Articles of Amendment to the Articles of Amendment and Restatement of the Company, effective as of August 12, 2016 (incorporated by reference to the document previously filed as Exhibit 3.1 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on August 15, 2016). |\n| 3.2 | Amended and Restated Agreement of Limited Partnership of Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 3.3 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). |\n| 3.2A | Amendment No. 1 to the Amended and Restated Agreement of Limited Partnership of Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 3.6 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 18, 2011). |\n\n62\n\n| Exhibits |\n| 3.2B | Amendment No. 2 to the Amended and Restated Agreement of Limited Partnership of Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 3.3 to the Operating Partnership’s Pre-Effective Amendment No. 1 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on August 9, 2013 (File No. 333-189821)). |\n| 3.2C | Amendment No. 3 to the Amended and Restated Agreement of Limited Partnership of Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 3.1 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on August 23, 2016). |\n| 3.3 | Articles Supplementary of Sotherly Hotels Inc. (incorporated by reference to the document previously filed as Exhibit 3.4 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 18, 2011). |\n| 3.4 | Second Amended and Restated Bylaws of the Company, effective as of April 16, 2013 (incorporated by reference to the document previously filed as Exhibit 3.8 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 16, 2013). |\n| 3.5 | Articles Supplementary designating the Series B Preferred Stock of the Company, effective as of August 19, 2016 (incorporated by reference to the document previously filed as Exhibit 3.5 to the Company’s Registration Statement on Form 8-A filed with the Securities and Exchange Commission on August 22, 2016). |\n| 4.0 | Form of Common Stock Certificate. |\n| 4.1 | Senior Unsecured Note issued by Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 4.6 to our Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2013, filed with the Securities and Exchange Commission on November 7, 2013). |\n| 4.2 | Indenture by and among Sotherly Hotels LP and Wilmington Trust, National Association, as trustee (incorporated by reference to the document previously filed as Exhibit 4.7 to our Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2013, filed with the Securities and Exchange Commission on November 7, 2013). |\n| 4.3 | Indenture by and among Sotherly Hotels Inc., Sotherly Hotels LP and Wilmington Trust, National Association, as trustee, dated November 21, 2014 (incorporated by reference to the document previously filed as Exhibit 4.8 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on November 21, 2014). |\n| 4.4 | First Supplemental Indenture, by and among Sotherly Hotels Inc., Sotherly Hotels LP and Wilmington Trust, National Association, as trustee, dated November 21, 2014 (incorporated by reference to the document previously filed as Exhibit 4.9 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on November 21, 2014). |\n| 4.5 | 7.00% Senior Unsecured Note due 2019, issued by Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 4.10 to our Annual Report on Form 10-K for the fiscal year ended December 31, 2014, filed with the Securities and Exchange Commission on April 14, 2015). |\n| 4.6 | Form of Specimen Certificate of Series B Preferred Stock of the Company (incorporated by reference to the document previously filed as Exhibit 4.1 to the Company’s Registration Statement on Form 8-A filed with the Securities and Exchange Commission on August 22, 2016). |\n| 10.1 | Sotherly Hotels Inc. 2004 Long-Term Incentive Plan (incorporated by reference to the document previously filed as Exhibit 10.1 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). * |\n| 10.1A | Form of Restricted Stock Award Agreement between Sotherly Hotels Inc. and Participant (incorporated by reference to the document previously filed as Exhibit 10.1A to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2008, filed with the Securities and Exchange Commission on March 25, 2009). * |\n| 10.2 | Executive Employment Agreement between Sotherly Hotels Inc. and Andrew M. Sims, dated January 12, 2015 (incorporated by reference to the document previously filed as Exhibit 10.2A to our Current Report on Form 8-K filed with the Securities and Exchange Commission on January 13, 2015). * |\n| 10.3 | Executive Employment Agreement between Sotherly Hotels Inc. and Anthony E. Domalski (incorporated by reference to the document previously filed as Exhibit 10.2A to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on January 3, 2013). * |\n\n63\n\n| Exhibits |\n| 10.4 | Contribution Agreement dated August 23, 2004 by and between the owners of Capitol Hotel Associates L.P., L.L.P. and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.6 to the Company’s Pre-Effective Amendment No. 6 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 15, 2004 (File No. 333-118873)). |\n| 10.5 | Contribution Agreement dated August 23, 2004 by and between the owners of Savannah Hotel Associates LLC and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.7 to the Company’s Pre-Effective Amendment No. 6 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 15, 2004 (File No. 333-118873)). |\n| 10.6 | Contribution Agreement dated August 23, 2004 by and between KDCA Partnership, MAVAS LLC, and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.8 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). |\n| 10.7 | Contribution Agreement dated September 8, 2004 by and between Elpizo Limited Partnership, Phileo Land Corporation and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.9 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). |\n| 10.8 | Asset Purchase Agreement dated August 19, 2004 by and between Accord LLC, West Laurel Corporation and MHI Hotels Services, LLC (incorporated by reference to the document previously filed as Exhibit 10.10 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). |\n| 10.9 | Agreement to Assign and Sublease Common Space Lease and Form of Sublease by and between MHI Hospitality L.P. and MHI Hotels, LLC (incorporated by reference to the document previously filed as Exhibit 10.11 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2011, filed with the Securities and Exchange Commission on November 9, 2011). |\n| 10.10 | Agreement to Assign and Sublease Commercial Space Lease and Form of Sublease by and between MHI Hospitality L.P. and MHI Hotels Two, Inc. (incorporated by reference to the document previously filed as Exhibit 10.12 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2011, filed with the Securities and Exchange Commission on November 9, 2011). |\n| 10.11 | Lease Agreement by and between Philadelphia Hotel Associates, LP and MHI Hospitality TRS, LLC (with a schedule of eight additional agreements that are substantially identical in all material respects to the Lease agreement, except as identified in such schedule, and are not being filed herewith per Instruction 2 to Item 601 of Regulation S-K (incorporated by reference to the document previously filed as Exhibit 10.13 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2011, filed with the Securities and Exchange Commission on November 9, 2011). |\n| 10.12 | Management Restructuring Agreement by and between MHI Hospitality TRS, LLC, MHI Hotels Services, LLC and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.14 to the Company’s Pre-Effective Amendment No. 3 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on November 15, 2004 (File No. 333-118873)). |\n| 10.13 | Contribution Agreement by and between MHI Hotels Services, LLC, MHI Hotels, LLC and MHI Hotels Two, Inc. (incorporated by reference to the document previously filed as Exhibit 10.15 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2011, filed with the Securities and Exchange Commission on November 9, 2011). |\n| 10.14 | Executive Employment Agreement, dated as of January 1, 2016, between Sotherly Hotels Inc. and David R. Folsom (incorporated by reference to the document previously filed as Exhibit 10.20A to our Current Report on Form 8-K filed with the Securities and Exchange Commission on January 4, 2016). * |\n| 10.15 | Promissory Note dated March 29, 2007, made by Capitol Hotel Associates, L.P., L.L.P. and MONY Life Insurance Company (incorporated by reference to the document previously filed as Exhibit 10.25 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 2, 2007). |\n| Exhibits |\n| 10.16 | Limited Liability Company Agreement of MHI/Carlyle Hotel Investment Program I, L.L.C. dated April 26, 2007 (incorporated by reference to the document previously filed as Exhibit 10.26A to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on May 2, 2007). |\n| 10.17 | Limited Liability Company Agreement of MHI/Carlyle Hotel Lessee Program I, L.L.C. dated April 26, 2007 (incorporated by reference to the document previously filed as Exhibit 10.26B to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on May 2, 2007). |\n| 10.18 | Promissory Note dated August 2, 2007 made by Savannah Hotel Associates L.L.C., to the order of MONY Life Insurance Company (incorporated by reference to the document previously filed as Exhibit 10.29 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on August 3, 2007). |\n| 10.19 | Sotherly Hotels Inc. 2013 Long-Term Incentive Plan (incorporated by reference to Appendix A to the Company’s Definitive Proxy Statement on Schedule 14A filed with the Securities and Exchange Commission on March 20, 2013). * |\n| 10.20 | Sales Agency Agreement, dated July 9, 2014, among Sotherly Hotels Inc., Sotherly Hotels LP and Sandler O’Neill & Partners, L.P. (incorporated by reference to the document previously filed as Exhibit 10.51 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on July 9, 2014). |\n| 10.21 | Master Agreement by and among Sotherly Hotels Inc., Sotherly Hotels LP, MHI Hospitality TRS, LLC and MHI Hotels Services LLC (incorporated by reference to the document previously filed as Exhibit 10.52 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on December 19, 2014). |\n| 10.22 | Purchase and Sale Agreement by and between MHI Hospitality TRS II, LLC, MHI Hotel Investments Holdings LLC and CRP/MHI Holdings, L.L.C., dated as of June 19, 2015 (incorporated by reference to the document previously filed as Exhibit 10.53 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on June 22, 2015). |\n| 10.23 | Agreement for Sale and Purchase of Property by and between Hampton Hotel Associates LLC, Three Capital Hotels, Inc., and Ajitkumar B. Patel, dated as of April 29, 2016 (incorporated by reference to the document previously filed as Exhibit 10.54 to our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2016, filed with the Securities and Exchange Commission on August 12, 2016). |\n| 10.24 | Amendment to the Agreement for Sale and Purchase of Property by and between Hampton Hotel Associates LLC, Three Capital Hotels, Inc., and Ajitkumar B. Patel, dated as of June 10, 2016 (incorporated by reference to the document previously filed as Exhibit 10.55 to our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2016, filed with the Securities and Exchange Commission on August 12, 2016). |\n| 10.25 | Commercial Unit Purchase Agreement between Sotherly Hotels Inc. and 4111 South Ocean Drive, LLC, dated as of September 14, 2016 (incorporated by reference to the document previously filed as Exhibit 10.56 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on September 20, 2016). |\n| 10.26 | Addendum to Commercial Unit Agreement between Sotherly Hotels Inc. and 4111 South Ocean Drive, LLC, dated as of September 14, 2016 (incorporated by reference to the document previously filed as Exhibit 10.57 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on September 20, 2016). |\n| 10.27 | Agreement for Sale and Purchase of Property by and between Hampton Hotel Associates LLC, Marina Hotel, LLC, Neil Amin and Shamin Hotels, Inc., dated as of October 6, 2016 (incorporated by reference to the document previously filed as Exhibit 10.58 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on February 9, 2017). |\n| 10.28 | Amendment to Agreement for Sale and Purchase of Property by and between Hampton Hotel Associates LLC, Marina Hotel, LLC, Neil Amin and Shamin Hotels, Inc., dated as of February 7, 2017 (incorporated by reference to the document previously filed as Exhibit 10.59 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on February 9, 2017). |\n| 16.1 | Letter from Grant Thornton LLP, dated April 6, 2016 (incorporated by reference to the document previously filed as Exhibit 16.1 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on April 6, 2016). |\n| 21.1 | List of Subsidiaries of Sotherly Hotels Inc. |\n| 21.2 | List of Subsidiaries of Sotherly Hotels LP. |\n| Exhibits |\n| 23.1 | Consent of Dixon Hughes Goodman LLP. |\n| 23.2 | Consent of Grant Thornton LLP. |\n| 23.3 | Consent of Dixon Hughes Goodman LLP. |\n| 23.4 | Consent of Grant Thornton LLP. |\n| 31.1 | Certification of Chief Executive Officer pursuant to Exchange Act Rule 13(a)-14 and 15(d)-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2 | Certification of Chief Financial Officer pursuant to Exchange Act Rule 13(a)-14 and 15(d)-14, as adopted, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.3 | Certification of Chief Executive Officer pursuant to Exchange Act Rule 13(a)-14 and 15(d)-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.4 | Certification of Chief Financial Officer pursuant to Exchange Act Rule 13(a)-14 and 15(d)-14, as adopted, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes-Oxley Act of 2002. |\n| 32.2 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes-Oxley Act of 2002. |\n| 32.3 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes-Oxley Act of 2002. |\n| 32.4 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes-Oxley Act of 2002. |\n| 101.INS | XBRL Instance Document |\n| 101.SCH | XBRL Taxonomy Extension Schema Document |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document |\n| * | Denotes management contract and/or compensatory plan/arrangement. |\n| SOTHERLY HOTELS INC. |\n| By: | /s/ ANDREW M. SIMS |\n| Andrew M. Sims Chief Executive Officer |\n| Signature | Title | Date |\n| /s/ ANDREW M. SIMS Andrew M. Sims | Chief Executive Officer and Chairman of the Board of Directors | March 22, 2017 |\n| /s/ DAVID R. FOLSOM David R. Folsom | President, Chief Operating Officer and Director | March 22, 2017 |\n| /s/ ANTHONY E. DOMALSKI Anthony E. Domalski | Chief Financial Officer | March 22, 2017 |\n| /s/ HERSCHEL J. WALKER Herschel J. Walker | Director | March 22, 2017 |\n| /s/ DAVID J. BEATTY David J. Beatty | Director | March 22, 2017 |\n| /s/ EDWARD S. STEIN Edward S. Stein | Director | March 22, 2017 |\n| /s/ ANTHONY C. ZINNI Anthony C. Zinni | Director | March 22, 2017 |\n| SOTHERLY HOTELS LP, |\n| by its General Partner, |\n| SOTHERLY HOTELS INC. |\n| By: | /s/ ANDREW M. SIMS |\n| Andrew M. Sims Chief Executive Officer |\n| Signature | Title | Date |\n| /s/ ANDREW M. SIMS Andrew M. Sims | Chief Executive Officer and Chairman of the Board of Directors of the General Partner | March 22, 2017 |\n| /s/ DAVID R. FOLSOM David R. Folsom | President, Chief Operating Officer and Director of the General Partner | March 22, 2017 |\n| /s/ ANTHONY E. DOMALSKI Anthony E. Domalski | Chief Financial Officer of the General Partner | March 22, 2017 |\n| /s/ HERSCHEL J. WALKER Herschel J. Walker | Director of the General Partner | March 22, 2017 |\n| /s/ DAVID J. BEATTY David J. Beatty | Director of the General Partner | March 22, 2017 |\n| /s/ EDWARD S. STEIN Edward S. Stein | Director of the General Partner | March 22, 2017 |\n| /s/ ANTHONY C. ZINNI Anthony C. Zinni | Director of the General Partner | March 22, 2017 |\n| Sotherly Hotels Inc. |\n| Report of Independent Registered Public Accounting Firm, Dixon Hughes Goodman LLP | F-2 |\n| Report of Independent Registered Public Accounting Firm, Grant Thornton LLP | F-3 |\n| Consolidated Balance Sheets for Sotherly Hotels Inc. as of December 31, 2016 and 2015 | F-4 |\n| Consolidated Statements of Operations for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-5 |\n| Consolidated Statements of Changes in Equity for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-6 |\n| Consolidated Statements of Cash Flows for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-7 |\n| Sotherly Hotels LP |\n| Report of Independent Registered Public Accounting Firm, Dixon Hughes Goodman LLP | F-8 |\n| Report of Independent Registered Public Accounting Firm, Grant Thornton LLP | F-9 |\n| Consolidated Balance Sheets for Sotherly Hotels LP as of December 31, 2016 and 2015 | F-10 |\n| Consolidated Statements of Operations for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-11 |\n| Consolidated Statements of Changes in Partners’ Capital for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-12 |\n| Consolidated Statements of Cash Flows for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-13 |\n| Notes to Consolidated Financial Statements | F-14 |\n| Schedule III – Real Estate and Accumulated Depreciation as of December 31, 2016 | F-35 |\n| December 31, 2016 | December 31, 2015 |\n| ASSETS |\n| Investment in hotel properties, net | $ | 348,593,912 | $ | 354,963,242 |\n| Investment in hotel properties held for sale, net | 5,333,000 | — |\n| Cash and cash equivalents | 31,766,775 | 11,493,914 |\n| Restricted cash | 4,596,145 | 5,793,840 |\n| Accounts receivable, net | 4,127,748 | 4,071,175 |\n| Accounts receivable-affiliate | 4,175 | 226,552 |\n| Loan proceeds receivable | — | 2,600,711 |\n| Prepaid expenses, inventory and other assets | 4,648,469 | 4,432,431 |\n| Deferred income taxes | 6,949,340 | 5,390,374 |\n| TOTAL ASSETS | $ | 406,019,564 | $ | 388,972,239 |\n| LIABILITIES |\n| Mortgage loans, net | $ | 282,708,289 | $ | 270,331,724 |\n| Unsecured notes, net | 24,308,713 | 50,460,106 |\n| Accounts payable and accrued expenses | 12,970,960 | 12,334,878 |\n| Advance deposits | 2,315,787 | 1,651,840 |\n| Dividends and distributions payable | 2,376,527 | 1,335,323 |\n| TOTAL LIABILITIES | $ | 324,680,276 | $ | 336,113,871 |\n| Commitments and contingencies (See Note 6) | — | — |\n| EQUITY |\n| Sotherly Hotels Inc. stockholders’ equity |\n| 8% Series B Cumulative Redeemable Perpetual Preferred stock, par value $0.01, 11,000,000 shares authorized, liquidation preference $25 per share, 1,610,000 shares and 0 shares issued and outstanding at December 31, 2016 and 2015, respectively | 16,100 | — |\n| Common stock, par value $0.01, 49,000,000 shares authorized, 14,468,551 shares and 14,490,714 shares issued and outstanding at December 31, 2016 and 2015, respectively | 144,685 | 144,907 |\n| Additional paid in capital | 118,395,082 | 82,749,058 |\n| Distributions in excess of retained earnings | (39,545,754 | ) | (33,890,834 | ) |\n| Total Sotherly Hotels Inc. stockholders’ equity | 79,010,113 | 49,003,131 |\n| Noncontrolling interest | 2,329,175 | 3,855,237 |\n| TOTAL EQUITY | 81,339,288 | 52,858,368 |\n| TOTAL LIABILITIES AND EQUITY | $ | 406,019,564 | $ | 388,972,239 |\n| 2016 | 2015 | 2014 |\n| REVENUE |\n| Rooms department | $ | 108,199,151 | $ | 96,837,386 | $ | 84,618,889 |\n| Food and beverage department | 35,384,530 | 33,273,599 | 31,444,984 |\n| Other operating departments | 9,262,071 | 8,422,491 | 6,876,046 |\n| Total revenue | 152,845,752 | 138,533,476 | 122,939,919 |\n| EXPENSES |\n| Hotel operating expenses |\n| Rooms department | 28,895,371 | 25,782,992 | 22,913,479 |\n| Food and beverage department | 24,357,248 | 23,005,629 | 21,026,202 |\n| Other operating departments | 2,438,860 | 1,786,197 | 1,192,183 |\n| Indirect | 57,141,692 | 51,310,292 | 45,072,491 |\n| Total hotel operating expenses | 112,833,171 | 101,885,110 | 90,204,355 |\n| Depreciation and amortization | 15,019,071 | 13,591,495 | 11,969,284 |\n| Impairment of investment in hotel properties, net | — | 500,000 | 3,175,000 |\n| Loss (gain) on disposal of assets | 365,319 | (41,435 | ) | — |\n| Corporate general and administrative | 6,021,065 | 7,268,256 | 5,085,949 |\n| Total operating expenses | 134,238,626 | 123,203,426 | 110,434,588 |\n| NET OPERATING INCOME | 18,607,126 | 15,330,050 | 12,505,331 |\n| Other income (expense) |\n| Interest expense | (17,735,107 | ) | (16,515,827 | ) | (14,636,870 | ) |\n| Interest income | 115,785 | 50,461 | 19,865 |\n| Equity income in joint venture | — | 475,514 | 307,370 |\n| Loss on early debt extinguishment | (1,417,905 | ) | (772,907 | ) | (831,079 | ) |\n| Unrealized loss on hedging activities | (37,384 | ) | (108,819 | ) | — |\n| Gain on change in control | — | 6,603,148 | — |\n| Gain on involuntary conversion of asset | — | — | 169,151 |\n| Net income/(loss) before income taxes | (467,485 | ) | 5,061,620 | (2,466,232 | ) |\n| Income tax benefit | 1,367,634 | 1,336,033 | 1,727,723 |\n| Net income/(loss) | 900,149 | 6,397,653 | (738,509 | ) |\n| Less: Net (income)/loss attributable to the noncontrolling interest | 26,567 | (1,040,987 | ) | 153,838 |\n| Net income/(loss) attributable to the Company | 926,716 | 5,356,666 | (584,671 | ) |\n| Distributions to preferred stockholders | (1,144,889 | ) | — | — |\n| Net income/(loss) attributable to common stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) |\n| Net income/(loss) per share attributable to the common stockholders |\n| Basic and diluted | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) |\n| Weighted average number of common shares outstanding |\n| Basic and diluted | 14,896,994 | 12,541,117 | 10,377,125 |\n| Additional | Distributions |\n| Preferred Stock | Common Stock | Paid- | in Excess of | Noncontrolling |\n| Shares | Par Value | Shares | Par Value | In Capital | Retained Earnings | Interest | Total |\n| Balances at December 31, 2013 | — | $ | — | 10,206,927 | $ | 102,069 | $ | 57,534,113 | $ | (32,450,773 | ) | $ | 5,669,386 | $ | 30,854,795 |\n| Net loss | — | — | — | — | — | (584,671 | ) | (153,838 | ) | (738,509 | ) |\n| Conversion of units in Operating Partnership to shares of common stock | — | — | 310,000 | 3,100 | 755,750 | — | (758,850 | ) | — |\n| Redemption of units in Operating Partnership | — | — | — | — | — | — | (25,621 | ) | (25,621 | ) |\n| Issuance of unrestricted common stock awards | — | — | 24,750 | 248 | 147,112 | — | — | 147,360 |\n| Issuance of restricted common stock awards | — | — | 12,000 | 120 | 78,165 | — | — | 78,285 |\n| Issuance of common stock through ATM offering, net | — | — | 17,255 | 172 | 124,739 | — | — | 124,911 |\n| Amortization of restricted stock award | — | — | — | — | 19,920 | — | — | 19,920 |\n| Dividends and distributions declared | — | — | — | — | (2,352,869 | ) | (598,415 | ) | (2,951,284 | ) |\n| Balances at December 31, 2014 | — | $ | — | 10,570,932 | $ | 105,709 | $ | 58,659,799 | $ | (35,388,313 | ) | $ | 4,132,662 | $ | 27,509,857 |\n| Net income | — | — | — | — | — | 5,356,666 | 1,040,987 | 6,397,653 |\n| Issuance of unrestricted common stock awards | — | — | 26,350 | 264 | 193,936 | — | — | 194,200 |\n| Issuance of restricted common stock awards | — | — | 9,750 | 98 | 71,760 | — | — | 71,858 |\n| Issuance of common stock from ATM sales | — | — | 98,682 | 986 | 681,222 | — | — | 682,208 |\n| Issuance of common stock from equity offering | — | — | 3,435,000 | 34,350 | 22,534,259 | — | — | 22,568,609 |\n| Conversion of Operating Partnership units into shares of common stock | — | — | 350,000 | 3,500 | 588,162 | — | (591,662 | ) | — |\n| Amortization of restricted stock award | — | — | — | — | 19,920 | — | — | 19,920 |\n| Dividends and distributions declared | — | — | — | — | — | (3,859,187 | ) | (726,750 | ) | (4,585,937 | ) |\n| Balances at December 31, 2015 | — | $ | — | 14,490,714 | $ | 144,907 | $ | 82,749,058 | $ | (33,890,834 | ) | $ | 3,855,237 | $ | 52,858,368 |\n| Net income (loss) | — | — | — | — | — | 926,716 | (26,567 | ) | 900,149 |\n| Issuance of Series B Preferred Stock | 1,610,000 | 16,100 | — | — | 37,750,431 | — | — | 37,766,531 |\n| Issuance of unrestricted common stock awards | — | — | 24,250 | 242 | 128,040 | — | — | 128,282 |\n| Issuance of restricted common stock awards | — | — | 12,000 | 120 | 63,360 | — | — | 63,480 |\n| Repurchase of common stock | — | — | (481,100 | ) | (4,811 | ) | (3,159,725 | ) | — | — | (3,164,536 | ) |\n| Conversion of Operating Partnership units into shares of common stock | — | — | 422,687 | 4,227 | 843,998 | — | (848,225 | ) | — |\n| Amortization of restricted stock award | — | — | — | — | 19,920 | — | — | 19,920 |\n| Preferred stock dividends declared | — | — | — | — | — | (1,144,889 | ) | — | (1,144,889 | ) |\n| Common stockholders' dividends and distributions declared | — | — | — | — | — | (5,436,747 | ) | (651,270 | ) | (6,088,017 | ) |\n| Balances at December 31, 2016 | 1,610,000 | $ | 16,100 | 14,468,551 | $ | 144,685 | $ | 118,395,082 | $ | (39,545,754 | ) | $ | 2,329,175 | $ | 81,339,288 |\n| 2016 | 2015 | 2014 |\n| Cash flows from operating activities: |\n| Net income (loss) | $ | 900,149 | $ | 6,397,653 | $ | (738,509 | ) |\n| Adjustments to reconcile net income (loss) to net cash provided by operating activities: |\n| Depreciation and amortization | 15,019,071 | 13,591,495 | 11,969,284 |\n| Gain on change in control | — | (6,603,148 | ) | — |\n| Equity income in joint venture | — | (475,514 | ) | (307,370 | ) |\n| Impairment of investment in hotel properties | — | 500,000 | 3,175,000 |\n| Amortization of deferred financing costs | 1,147,864 | 1,300,032 | 1,428,674 |\n| Amortization of mortgage premium | (24,682 | ) | (18,820 | ) | — |\n| Unrealized loss on derivative instrument | 37,384 | 108,819 | — |\n| Loss (gain) on disposal of assets | 365,319 | (41,435 | ) | — |\n| Loss on early debt extinguishment | 1,141,905 | 772,907 | — |\n| Charges related to equity-based compensation | 211,682 | 285,978 | 245,565 |\n| Changes in assets and liabilities: |\n| Restricted cash | (560,817 | ) | 584,926 | (92,439 | ) |\n| Accounts receivable | (56,573 | ) | (2,021,825 | ) | 369,685 |\n| Prepaid expenses, inventory and other assets | (334,063 | ) | (623,980 | ) | (1,677,032 | ) |\n| Deferred income taxes | (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) |\n| Accounts payable and other accrued liabilities | (35,188 | ) | (1,001,376 | ) | 2,338,688 |\n| Advance deposits | 663,947 | 431,111 | 89,099 |\n| Accounts receivable - affiliate | 222,377 | (28,878 | ) | 12,273 |\n| Net cash provided by operating activities | 17,139,409 | 11,377,374 | 14,851,255 |\n| Cash flows from investing activities: |\n| Acquisitions of hotel properties | — | (25,525,754 | ) | (61,106,085 | ) |\n| Improvements and additions to hotel properties | (14,912,677 | ) | (20,136,427 | ) | (9,801,018 | ) |\n| Payments on involuntary insurance conversions | — | — | — |\n| Distributions from joint venture | — | 600,000 | 750,000 |\n| Funding of restricted cash reserves | (5,276,518 | ) | (4,973,602 | ) | (3,692,045 | ) |\n| Proceeds of restricted cash reserves | 7,035,029 | 6,376,459 | 2,583,419 |\n| Proceeds from involuntary conversion of assets | — | 124,609 | 169,151 |\n| Proceeds from the sale of assets | 213,400 | 2,402,113 | — |\n| Net cash used in investing activities | (12,940,766 | ) | (41,132,602 | ) | (71,096,578 | ) |\n| Cash flows from financing activities: |\n| Proceeds of unsecured debt | — | — | 25,300,000 |\n| Proceeds of mortgage debt | 102,700,000 | 127,000,000 | 48,600,000 |\n| Proceeds from mortgage loan receivable | 2,600,711 | — | — |\n| Proceeds from loans | — | — | 19,000,000 |\n| Proceeds from sale of common stock, net | — | 23,250,818 | 124,911 |\n| Proceeds from sale of preferred stock, net | 37,766,531 | — | — |\n| Payments on mortgage loans | (89,619,564 | ) | (120,154,764 | ) | (24,171,892 | ) |\n| Redemption of unsecured notes | (27,600,000 | ) | — | — |\n| Repurchase of common stock | (2,061,407 | ) | — | — |\n| Payment of deferred financing costs | (1,520,351 | ) | (1,377,882 | ) | (2,637,637 | ) |\n| Dividends and distributions paid | (5,851,813 | ) | (4,103,529 | ) | (2,686,567 | ) |\n| Preferred dividends paid | (339,889 | ) | — | — |\n| Redemption of units in Operating Partnership | — | — | (25,621 | ) |\n| Net cash provided by financing activities | 16,074,218 | 24,614,643 | 63,503,194 |\n| Net increase (decrease) in cash and cash equivalents | 20,272,861 | (5,140,585 | ) | 7,257,871 |\n| Cash and cash equivalents at the beginning of the period | 11,493,914 | 16,634,499 | 9,376,628 |\n| Cash and cash equivalents at the end of the period | $ | 31,766,775 | $ | 11,493,914 | $ | 16,634,499 |\n| Supplemental disclosures: |\n| Cash paid during the period for interest | $ | 16,881,223 | $ | 15,415,695 | $ | 13,766,824 |\n| Cash paid during the period for income taxes | $ | 192,965 | $ | 570,762 | $ | 263,621 |\n| Non-cash investing and financing activities: |\n| Mortgage debt proceeds receivable and related loan costs | $ | — | $ | 2,704,415 | $ | — |\n| Assumption of mortgage loan on Crowne Plaza Hollywood Beach Resort acquisition | $ | — | $ | 57,000,000 | $ | — |\n| Assumption of loan premium on the Crowne Plaza Hollywood Beach Resort assumed loan | $ | — | $ | 246,815 | $ | — |\n| Change in amount of deferred financing and deferred offering cost in accounts payable and accrued liabilities | $ | — | $ | 624,117 | $ | 375,487 |\n| Change in amount of hotel property improvements in accounts payable and accrued liabilities | $ | 431,858 | $ | 601,895 | $ | 1,108,182 |\n| December 31, 2016 | December 31, 2015 |\n| ASSETS |\n| Investment in hotel properties, net | $ | 348,593,912 | $ | 354,963,242 |\n| Investment in hotel property held for sale, net | 5,333,000 | — |\n| Cash and cash equivalents | 31,766,775 | 11,493,914 |\n| Restricted cash | 4,596,145 | 5,793,840 |\n| Accounts receivable, net | 4,127,748 | 4,071,175 |\n| Accounts receivable-affiliate | 4,175 | 226,552 |\n| Loan proceeds receivable | — | 2,600,711 |\n| Prepaid expenses, inventory and other assets | 4,648,469 | 4,432,431 |\n| Deferred income taxes | 6,949,340 | 5,390,374 |\n| TOTAL ASSETS | $ | 406,019,564 | $ | 388,972,239 |\n| LIABILITIES |\n| Mortgage loans, net | $ | 282,708,289 | $ | 270,331,724 |\n| Unsecured notes, net | 24,308,713 | 50,460,106 |\n| Accounts payable and other accrued liabilities | 12,970,960 | 12,334,878 |\n| Advance deposits | 2,315,787 | 1,651,840 |\n| Dividends and distributions payable | 2,376,527 | 1,335,323 |\n| TOTAL LIABILITIES | $ | 324,680,276 | $ | 336,113,871 |\n| Commitments and contingencies (see Note 6) | — | — |\n| PARTNERS’ CAPITAL |\n| 8% Series B Cumulative Redeemable Perpetual Preferred partnership units, liquidation preference $25 per unit, 1,610,000 units and 0 units issued and outstanding at December 31, 2016 and 2015, respectively | 37,766,531 | — |\n| General Partner: 162,467 units and 166,915 units issued and outstanding as of December 31, 2016 and 2015, respectively | 681,389 | 774,295 |\n| Limited Partners: 16,084,224 units and 16,524,626 units issued and outstanding as of December 31, 2016 and 2015, respectively | 42,891,368 | 52,084,073 |\n| TOTAL PARTNERS’ CAPITAL | 81,339,288 | 52,858,368 |\n| TOTAL LIABILITIES AND PARTNERS’ CAPITAL | $ | 406,019,564 | $ | 388,972,239 |\n| 2016 | 2015 | 2014 |\n| REVENUE |\n| Rooms department | $ | 108,199,151 | $ | 96,837,386 | $ | 84,618,889 |\n| Food and beverage department | 35,384,530 | 33,273,599 | 31,444,984 |\n| Other operating departments | 9,262,071 | 8,422,491 | 6,876,046 |\n| Total revenue | 152,845,752 | 138,533,476 | 122,939,919 |\n| EXPENSES |\n| Hotel operating expenses |\n| Rooms department | 28,895,371 | 25,782,992 | 22,913,479 |\n| Food and beverage department | 24,357,248 | 23,005,629 | 21,026,202 |\n| Other operating departments | 2,438,860 | 1,786,197 | 1,192,183 |\n| Indirect | 57,141,692 | 51,310,292 | 45,072,491 |\n| Total hotel operating expenses | 112,833,171 | 101,885,110 | 90,204,355 |\n| Depreciation and amortization | 15,019,071 | 13,591,495 | 11,969,284 |\n| Impairment of investment in hotel properties, net | — | 500,000 | 3,175,000 |\n| Loss on disposal of assets | 365,319 | (41,435 | ) | — |\n| Corporate general and administrative | 6,021,065 | 7,268,256 | 5,085,949 |\n| Total operating expenses | 134,238,626 | 123,203,426 | 110,434,588 |\n| NET OPERATING INCOME | 18,607,126 | 15,330,050 | 12,505,331 |\n| Other income (expense) |\n| Interest expense | (17,735,107 | ) | (16,515,827 | ) | (14,636,870 | ) |\n| Interest income | 115,785 | 50,461 | 19,865 |\n| Equity income in joint venture | — | 475,514 | 307,370 |\n| Loss on early debt extinguishment | (1,417,905 | ) | (772,907 | ) | (831,079 | ) |\n| Unrealized loss on hedging activities | (37,384 | ) | (108,819 | ) | — |\n| Gain on change in control | — | 6,603,148 | — |\n| Gain on involuntary conversion of asset | — | — | 169,151 |\n| Net income/(loss) before income taxes | (467,485 | ) | 5,061,620 | (2,466,232 | ) |\n| Income tax benefit | 1,367,634 | 1,336,033 | 1,727,723 |\n| Net income/(loss) | 900,149 | 6,397,653 | (738,509 | ) |\n| Distributions to preferred unit holders | (1,144,889 | ) | — | — |\n| Net income/(loss) attributable to operating partnership unit holders | $ | (244,740 | ) | $ | 6,397,653 | $ | (738,509 | ) |\n| Net income/(loss) attributable per operating partner unit |\n| Basic and diluted | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) |\n| Weighted average number of operating partner units outstanding |\n| Basic and diluted | 16,710,935 | 14,924,410 | 13,107,413 |\n| Preferred Units | General Partner | Limited Partner |\n| Units | Amount | Units | Amount | Units | Amounts | Total |\n| Balances at December 31, 2013 | — | $ | — | 130,711 | $ | 554,316 | 12,940,343 | $ | 30,300,479 | $ | 30,854,795 |\n| Issuance of partnership units | — | — | 540 | 3,534 | 53,465 | 347,022 | 350,556 |\n| Amortization of restricted units award | — | — | — | 199 | — | 19,721 | 19,920 |\n| Distributions declared | — | — | — | (29,644 | ) | — | (2,921,640 | ) | (2,951,284 | ) |\n| Redemption of limited partnership units | — | — | (33 | ) | (228 | ) | (3,267 | ) | (25,393 | ) | (25,621 | ) |\n| Net loss | — | — | — | (7,386 | ) | — | (731,123 | ) | (738,509 | ) |\n| Balances at December 31, 2014 | — | $ | — | 131,218 | $ | 520,791 | 12,990,541 | $ | 26,989,066 | $ | 27,509,857 |\n| Issuance of partnership units | — | — | 35,697 | 235,237 | 3,534,085 | 23,281,638 | 23,516,875 |\n| Amortization of restricted units award | — | — | — | 149 | — | 19,771 | 19,920 |\n| Distributions declared | — | — | — | (45,859 | ) | — | (4,540,078 | ) | (4,585,937 | ) |\n| Net income | — | — | — | 63,977 | — | 6,333,676 | 6,397,653 |\n| Balances at December 31, 2015 | — | $ | — | 166,915 | $ | 774,295 | 16,524,626 | $ | 52,084,073 | $ | 52,858,368 |\n| Issuance of common partnership units | — | — | 363 | 1,918 | 35,887 | 189,844 | 191,762 |\n| Issuance of preferred partnership units | 1,610,000 | 37,766,531 | — | — | — | — | 37,766,531 |\n| Repurchased common units | — | — | (4,811 | ) | (31,645 | ) | (476,289 | ) | (3,132,891 | ) | (3,164,536 | ) |\n| Amortization of restricted units award | — | — | — | 149 | — | 19,771 | 19,920 |\n| Preferred partnership units distributions declared | — | (1,144,889 | ) | — | — | — | — | (1,144,889 | ) |\n| Partnership units distributions declared | — | — | — | (60,880 | ) | — | (6,027,137 | ) | (6,088,017 | ) |\n| Net income | — | 1,144,889 | — | (2,447 | ) | — | (242,293 | ) | 900,149 |\n| Balances at December 31, 2016 | 1,610,000 | $ | 37,766,531 | 162,467 | $ | 681,389 | 16,084,224 | $ | 42,891,368 | $ | 81,339,288 |\n| 2016 | 2015 | 2014 |\n| Cash flows from operating activities: |\n| Net income (loss) | $ | 900,149 | $ | 6,397,653 | $ | (738,509 | ) |\n| Adjustments to reconcile net income (loss) to net cash provided by operating activities: |\n| Depreciation and amortization | 15,019,071 | 13,591,495 | 11,969,284 |\n| Gain on change in control | — | (6,603,148 | ) | — |\n| Equity income in joint venture | — | (475,514 | ) | (307,370 | ) |\n| Impairment of investment in hotel properties | — | 500,000 | 3,175,000 |\n| Amortization of deferred financing costs | 1,147,864 | 1,300,032 | 1,428,674 |\n| Amortization of mortgage premium | (24,682 | ) | (18,820 | ) | — |\n| Unrealized loss on derivative instrument | 37,384 | 108,819 | — |\n| Loss (gain) on disposal of assets | 365,319 | (41,435 | ) | — |\n| Loss on early debt extinguishment | 1,141,905 | 772,907 | — |\n| Charges related to equity-based compensation | 211,682 | 285,978 | 245,565 |\n| Changes in assets and liabilities: |\n| Restricted cash | (560,817 | ) | 584,926 | (92,439 | ) |\n| Accounts receivable | (56,573 | ) | (2,021,825 | ) | 369,685 |\n| Prepaid expenses, inventory and other assets | (334,063 | ) | (623,980 | ) | (1,677,032 | ) |\n| Deferred income taxes | (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) |\n| Accounts payable and other accrued liabilities | (35,188 | ) | (1,001,376 | ) | 2,338,688 |\n| Advance deposits | 663,947 | 431,111 | 89,099 |\n| Accounts receivable - affiliate | 222,377 | (28,878 | ) | 12,273 |\n| Net cash provided by operating activities | 17,139,409 | 11,377,374 | 14,851,255 |\n| Cash flows from investing activities: |\n| Acquisitions of hotel properties | — | (25,525,754 | ) | (61,106,085 | ) |\n| Improvements and additions to hotel properties | (14,912,677 | ) | (20,136,427 | ) | (9,801,018 | ) |\n| Payments on involuntary insurance conversions | — | — | — |\n| Distributions from joint venture | — | 600,000 | 750,000 |\n| Funding of restricted cash reserves | (5,276,518 | ) | (4,973,602 | ) | (3,692,045 | ) |\n| Proceeds from involuntary conversion of assets | — | 124,609 | 169,151 |\n| Proceeds of restricted cash reserves | 7,035,029 | 6,376,459 | 2,583,419 |\n| Proceeds from the sale of assets | 213,400 | 2,402,113 |\n| Net cash used in investing activities | (12,940,766 | ) | (41,132,602 | ) | (71,096,578 | ) |\n| Cash flows from financing activities: |\n| Proceeds of unsecured debt | — | — | 25,300,000 |\n| Proceeds of mortgage debt | 102,700,000 | 127,000,000 | 48,600,000 |\n| Proceeds from mortgage loan receivable | 2,600,711 | — | — |\n| Proceeds from loans | — | — | 19,000,000 |\n| Proceeds from sale of operating units | — | 23,250,818 | 124,911 |\n| Proceeds from sale of preferred operating units | 37,766,531 | — | — |\n| Payments on mortgage loans | (89,619,564 | ) | (120,154,764 | ) | (24,171,892 | ) |\n| Redemption of unsecured notes | (27,600,000 | ) |\n| Repurchase of common units | (2,061,407 | ) | — | — |\n| Payment of deferred financing costs | (1,520,351 | ) | (1,377,882 | ) | (2,637,637 | ) |\n| Distributions paid | (5,851,813 | ) | (4,103,529 | ) | (2,686,567 | ) |\n| Preferred dividends paid | (339,889 | ) | — | — |\n| Redemption of units in Operating Partnership | — | — | (25,621 | ) |\n| Net cash provided by financing activities | 16,074,218 | 24,614,643 | 63,503,194 |\n| Net increase (decrease) in cash and cash equivalents | 20,272,861 | (5,140,585 | ) | 7,257,871 |\n| Cash and cash equivalents at the beginning of the period | 11,493,914 | 16,634,499 | 9,376,628 |\n| Cash and cash equivalents at the end of the period | $ | 31,766,775 | $ | 11,493,914 | $ | 16,634,499 |\n| Supplemental disclosures: |\n| Cash paid during the period for interest | $ | 16,881,223 | $ | 15,415,695 | $ | 13,766,824 |\n| Cash paid during the period for income taxes | $ | 192,965 | $ | 570,762 | $ | 263,621 |\n| Non-cash investing and financing activities: |\n| Mortgage debt proceeds receivable and related loan costs | $ | — | $ | 2,704,415 | $ | — |\n| Assumption of mortgage loan on Crowne Plaza Hollywood Beach Resort acquisition | $ | — | $ | 57,000,000 | $ | — |\n| Assumption of loan premium on the Crowne Plaza Hollywood Beach Resort assumed loan | $ | — | $ | 246,815 | $ | — |\n| Change in amount of deferred financing and deferred offering cost in accounts payable and accrued liabilities | $ | — | $ | 624,117 | $ | 375,487 |\n| Change in amount of hotel property improvements in accounts payable and accrued liabilities | $ | 431,858 | $ | 601,895 | $ | 1,108,182 |\n| Level 1 | Unadjusted quoted prices in active markets for identical assets or liabilities. |\n| Level 2 | Unadjusted quoted prices in active markets for similar assets or liabilities, or Unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or Inputs other than quoted prices that are observable for the asset or liability. |\n| Level 3 | Unobservable inputs for the asset or liability. |\n| Level 1 | Level 2 | Level 3 |\n| December 31, 2015 |\n| Investment in hotel property, net (1) | $ | — | $ | — | $ | 5,700,762 |\n| Interest Rate Cap (4) | $ | — | $ | 70,981 | $ | — |\n| Mortgage loans (2) | $ | — | $ | (272,933,327 | ) | $ | — |\n| Unsecured notes (3) | $ | (54,238,600 | ) | $ | — | $ | — |\n| December 31, 2016 |\n| Interest Rate Cap (4) | $ | — | $ | 33,597 | $ | — |\n| Mortgage loans (2) | $ | — | $ | (281,840,780 | ) | $ | — |\n| Unsecured notes (3) | $ | (26,241,160 | ) | $ | — | $ | — |\n| (1) | A non-recurring fair value measurement was conducted in 2015 for our investment in hotel property, which resulted in a recorded impairment charge for the year ended December 31, 2015, which represent the amounts by which the carrying value of the asset group exceeded its fair value. |\n| (2) | Mortgage loans are reflected at carrying value on our Consolidated Balance Sheet as of December 31, 2016 and December 31, 2015. |\n| (3) | Unsecured notes are recorded at historical cost on our Consolidated Balance Sheet as of December 31, 2016 and December 31, 2015. |\n| (4) | An interest rate cap on the DoubleTree by Hilton Jacksonville Riverfront mortgage with the Bank of the Ozarks is recorded at fair value on our Consolidated Balance Sheet as of December 31, 2016 and December 31, 2015. |\n| December 31, 2017 | $ | 1,105,165 |\n| December 31, 2018 | 632,365 |\n| December 31, 2019 | 544,920 |\n| December 31, 2020 | 499,294 |\n| December 31, 2021 | 246,388 |\n| December 31, 2022 and thereafter | 1,661,913 |\n| Total | $ | 4,690,045 |\n| Georgian Terrace | Crowne Plaza Hollywood Beach Resort |\n| Land and land improvements | $ | 10,127,687 | $ | 24,008,289 |\n| Buildings and improvements | 45,385,939 | 64,854,787 |\n| Furniture, fixtures and equipment | 5,163,135 | 2,802,135 |\n| Investment in hotel properties | 60,676,761 | 91,665,211 |\n| Restricted cash | 124,658 | 1,159,759 |\n| Accounts receivable | 465,287 | 140,588 |\n| Prepaid expenses, inventory and other assets | 430,997 | 797,505 |\n| Assumed mortgage | — | (57,259,159 | ) |\n| Accounts payable and accrued liabilities | (591,618 | ) | (2,485,442 | ) |\n| Equity investment | — | (1,889,560 | ) |\n| Gain on change in control | — | (6,603,148 | ) |\n| Net cash | $ | 61,106,085 | $ | 25,525,754 |\n| December 31, 2015 | December 31, 2014 |\n| (unaudited) | (unaudited) |\n| Pro forma revenues | $ | 151,931,931 | $ | 147,451,042 |\n| Pro forma operating expenses | $ | 133,346,497 | $ | 129,961,867 |\n| Pro forma operating income | $ | 18,585,434 | $ | 17,489,175 |\n| Pro forma net income (loss) | $ | 1,017,180 | $ | (1,671,774 | ) |\n| Pro forma earnings (loss) per basic and diluted share | $ | 0.07 | $ | (0.10 | ) |\n| Pro forma earnings (loss) per basic and diluted units | $ | 0.07 | $ | (0.10 | ) |\n| Pro forma basic and diluted common shares | 12,541,117 | 13,812,125 |\n| Pro forma basic and diluted units | 14,924,410 | 16,542,413 |\n| December 31, 2016 | December 31, 2015 |\n| Land and land improvements | $ | 57,851,380 | $ | 59,910,212 |\n| Buildings and improvements | 336,996,876 | 333,720,421 |\n| Furniture, fixtures and equipment | 43,458,781 | 42,245,334 |\n| 438,307,037 | 435,875,967 |\n| Less: accumulated depreciation and impairment | (89,713,125 | ) | (80,912,725 | ) |\n| Investment in Hotel Properties, Net | $ | 348,593,912 | $ | 354,963,242 |\n| December 31, 2016 | December 31, 2015 |\n| Land and land improvements | $ | 1,097,096 | $ | — |\n| Buildings and improvements | 6,242,504 | — |\n| Furniture, fixtures and equipment | 2,289,008 | — |\n| 9,628,608 | — |\n| Less: accumulated depreciation and impairment | (4,295,608 | ) | — |\n| Investment in Hotel Properties Held for Sale, Net | $ | 5,333,000 | $ | — |\n| Balance Outstanding as of |\n| December 31, | December 31, | Prepayment | Maturity | Amortization | Interest |\n| Property | 2016 | 2015 | Penalties | Date | Provisions | Rate |\n| Crowne Plaza Hampton Marina (1) | $ | 2,584,633 | $ | 3,512,586 | None | 11/1/2019 | 3 years | 5.00% |\n| Crowne Plaza Hollywood Beach Resort (2) | 58,935,818 | 59,795,743 | n/a | 10/1/2025 | 30 years | 4.913% |\n| Crowne Plaza Tampa Westshore (3) | 15,561,400 | 13,016,045 | None | 6/30/2019 | 25 years | LIBOR plus 3.75 % |\n| DoubleTree by Hilton Jacksonville Riverfront (4) | 19,291,716 | 19,774,577 | Yes | 7/7/2019 | 25 years | LIBOR plus 3.50 % |\n| DoubleTree by Hilton Laurel (5) | 9,329,005 | 9,500,000 | Yes | 8/5/2021 | 25 years | 5.25% |\n| DoubleTree by Hilton Philadelphia Airport (6) | 31,261,991 | 32,376,795 | None | 4/1/2019 | 25 years | LIBOR plus 3.00 % |\n| DoubleTree by Hilton Raleigh Brownstone University (7) | 14,773,885 | 15,029,121 | n/a | 8/1/2018 | 30 years | 4.78% |\n| The Georgian Terrace (8) | 45,826,038 | 46,579,011 | n/a | 6/1/2025 | 30 years | 4.42% |\n| Hilton Savannah DeSoto (9) | 30,000,000 | 20,522,836 | Yes | 7/1/2026 | 25 years | 4.25% |\n| Hilton Wilmington Riverside (10) | 30,000,000 | 19,825,772 | Yes | 1/1/2027 | 25 years | 4.25% |\n| Sheraton Louisville Riverside (11) | 11,977,557 | 11,345,866 | Yes | 12/1/2026 | 25 years | 4.27% |\n| The Whitehall (12) | 15,000,000 | 20,459,256 | Yes | 10/12/2021 | 18 years | LIBOR plus 3.50 % |\n| Total Mortgage Principal Balance | $ | 284,542,043 | $ | 271,737,608 |\n| Deferred financing costs, net | (2,049,409 | ) | (1,646,220 | ) |\n| Unamortized premium on loan | 215,655 | 240,336 |\n| Total Mortgage Loans, Net | $ | 282,708,289 | $ | 270,331,724 |\n| (1) | The note was extended and modified in November 2016 for 3 years until November 1, 2019 and the Operating Partnership was required to make monthly principal payments of $15,367. The note rate was changed to a fixed rate of 5.00%, effective June 27, 2014. As of February 7, 2017, the note is no longer outstanding. |\n| (2) | With limited exception, the note may not be prepaid until June 2025. |\n| (3) | The note provides initial proceeds of $15.7 million, with an additional $3.3 million available upon the satisfaction of certain conditions; bears a floating interest rate of the 30-day LIBOR plus 3.75%, subject to a floor rate of 3.75%; the note provides that the mortgage can be extended for two additional periods of one year each, subject to certain conditions. |\n| (4) | The note is subject to a pre-payment penalty until July 2017. Prepayment can be made without penalty thereafter. The note provides that the mortgage can be extended until July 2020 if certain conditions have been satisfied. |\n| (5) | The note is subject to a pre-payment penalty except for any pre-payments made either between April 2017 and August 2017, or from April 2021 through maturity of the note. The note provides that on January 5, 2018, the rate of interest will adjust to a rate of 3.00% per annum plus the then-current five-year U.S. Treasury rate of interest, with a floor of 5.25%. |\n| (6) | The note bears a minimum interest rate of 3.50%. |\n| (7) | With limited exception, the note may not be prepaid until two months before maturity. |\n| (8) | With limited exception, the note may not be prepaid until February 2025. |\n| (9) | The note provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions, namely, the completion of a renovation project; amortizes on a 25-year schedule after a 1-year interest-only period; and is subject to a pre-payment penalty except for any pre-payments made within 120 days of the maturity date. |\n| (10) | The note provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions namely, the completion of a renovation project; amortizes on a 25-year schedule after a 1-year interest-only period; and is subject to a pre-payment penalty except for any pre-payments made within 120 days of the maturity date. |\n| (11) | The note bears a fixed interest rate of 4.27% for the first 5 years of the loan, with an option for the lender to reset the interest rate after 5 years. |\n| (12) | The note was refinanced in October 2016, provides initial proceeds of $15.0 million, with an additional $5.5 million available upon the satisfaction of certain conditions; bears a floating interest rate of the 1-month LIBOR plus 3.5%, subject to a floor rate of 4.0% and is subject to prepayment penalties subject to a declining scale from 3.0% penalty on or before the first anniversary date, a 2.0% penalty during the second anniversary year and a 1.0% penalty after the third anniversary date. |\n| For the year ending: December 31, 2017 | $ | 6,363,323 |\n| December 31, 2018 | 24,626,923 |\n| December 31, 2019 | 73,423,203 |\n| December 31, 2020 | 9,248,750 |\n| December 31, 2021 | 31,008,186 |\n| December 31, 2022 and thereafter | 139,871,658 |\n| Total future maturities | $ | 284,542,043 |\n| For the year ending: December 31, 2017 | $ | 223,682 |\n| December 31, 2018 | 176,740 |\n| December 31, 2019 | 100,480 |\n| December 31, 2020 | 95,482 |\n| December 31, 2021 | 95,482 |\n| December 31, 2022 and thereafter | 445,583 |\n| Total | $ | 1,137,449 |\n| Quarter Ended | 2014 | 2015 | 2016 |\n| March 31, | $ | 0.045 | $ | 0.070 | $ | 0.085 |\n| June 30, | $ | 0.050 | $ | 0.075 | $ | 0.090 |\n| September 30, | $ | 0.065 | $ | 0.080 | $ | 0.095 |\n| December 31, | $ | 0.065 | $ | 0.080 | $ | 0.095 |\n| Seven Months Ended | Year Ended |\n| July 31, 2015 | December 31, 2014 |\n| Revenue |\n| Rooms department | $ | 10,605,941 | $ | 15,386,595 |\n| Food and beverage department | 1,911,950 | 2,968,395 |\n| Other operating departments | 880,564 | 1,385,469 |\n| Total revenue | 13,398,455 | 19,740,459 |\n| Expenses |\n| Hotel operating expenses |\n| Rooms department | 2,062,515 | 3,270,930 |\n| Food and beverage department | 1,442,139 | 2,270,918 |\n| Other operating departments | 388,087 | 655,818 |\n| Indirect | 4,774,322 | 7,436,198 |\n| Total hotel operating expenses | 8,667,063 | 13,633,864 |\n| Depreciation and amortization | 1,060,339 | 2,116,211 |\n| General and administrative | 252,565 | 148,873 |\n| Total operating expenses | 9,979,967 | 15,898,948 |\n| Operating income | 3,418,488 | 3,841,511 |\n| Interest expense | (1,516,433 | ) | (2,612,032 | ) |\n| Net income | $ | 1,902,055 | $ | 1,229,479 |\n| 2016 | 2015 | 2014 |\n| General and administrative | $ | 12,419,221 | $ | 11,595,819 | $ | 9,823,853 |\n| Sales and marketing | 13,754,600 | 11,426,637 | 9,788,079 |\n| Repairs and maintenance | 7,401,755 | 6,948,699 | 6,278,411 |\n| Utilities | 6,429,686 | 6,124,459 | 5,763,990 |\n| Franchise fees | 4,091,729 | 4,016,083 | 4,122,726 |\n| Management fees, including incentive | 3,865,362 | 3,490,586 | 3,439,807 |\n| Property taxes | 5,983,280 | 5,110,659 | 3,664,022 |\n| Insurance | 2,594,783 | 2,305,966 | 1,927,935 |\n| Other | 601,276 | 291,383 | 263,668 |\n| Total indirect hotel operating expenses | $ | 57,141,692 | $ | 51,310,292 | $ | 45,072,491 |\n| Year Ended | Year Ended | Year Ended |\n| December 31, 2016 | December 31, 2015 | December 31, 2014 |\n| Current: |\n| Federal | $ | — | $ | — | $ | — |\n| State | 191,332 | 444,538 | 233,940 |\n| 191,332 | 444,538 | 233,940 |\n| Deferred: |\n| Federal | (1,294,408 | ) | (1,510,726 | ) | (1,718,351 | ) |\n| State | (264,558 | ) | (269,845 | ) | (243,312 | ) |\n| (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) |\n| $ | (1,367,634 | ) | $ | (1,336,033 | ) | $ | (1,727,723 | ) |\n| Year Ended | Year Ended | Year Ended |\n| December 31, 2016 | December 31, 2015 | December 31, 2014 |\n| Statutory federal income tax expense | $ | (158,859 | ) | $ | 1,705,610 | $ | (838,519 | ) |\n| Effect of non-taxable REIT income | (1,135,549 | ) | (2,866,950 | ) | (898,576 | ) |\n| State income tax benefit | (73,226 | ) | (174,693 | ) | 9,372 |\n| $ | (1,367,634 | ) | $ | (1,336,033 | ) | $ | (1,727,723 | ) |\n| • | a demonstrated track record of past profitability and utilization of past NOL carryforwards, |\n| • | reasonable forecasts of future taxable income, and |\n| • | anticipated changes in the lease rental payments from the TRS Lessee to subsidiaries of the Operating Partnership. |\n| Year Ended | Year Ended | Year Ended |\n| December 31, 2016 | December 31, 2015 | December 31, 2014 |\n| Numerator |\n| Net income/(loss) attributable to the common shareholders for basic computation | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) |\n| Denominator |\n| Weighted average number of common shares outstanding for basic computation | 14,896,994 | 12,541,117 | 10,377,125 |\n| Basic and diluted net income (loss) per share | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) |\n| Year Ended | Year Ended | Year Ended |\n| December 31, 2016 | December 31, 2015 | December 31, 2014 |\n| Numerator |\n| Net income/(loss) attributable to the common unitholders for basic computation | $ | (244,740 | ) | $ | 6,397,653 | $ | (738,509 | ) |\n| Denominator |\n| Weighted average number of units outstanding | 16,710,935 | 14,924,410 | 13,107,413 |\n| Basic and diluted net income (loss) per unit | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) |\n| Quarters Ended 2016 |\n| March 31 | June 30 | September 30 | December 31 |\n| Total revenue | $ | 37,810,144 | $ | 41,824,954 | $ | 37,275,312 | $ | 35,935,342 |\n| Total operating expenses | 33,025,990 | 34,645,809 | 33,539,913 | 33,026,914 |\n| Net operating income | 4,784,154 | 7,179,145 | 3,735,399 | 2,908,428 |\n| Net income(loss) | 545,874 | 1,977,550 | (1,549,191 | ) | (74,084 | ) |\n| Net income (loss) attributable to common shareholders | 483,095 | 1,761,106 | (1,716,234 | ) | (746,140 | ) |\n| Earnings (loss) per share attributable to common shareholders– basic and diluted | $ | 0.03 | $ | 0.12 | $ | (0.11 | ) | $ | (0.05 | ) |\n| Quarters Ended 2015 |\n| March 31 | June 30 | September 30 | December 31 |\n| Total revenue | $ | 30,975,630 | $ | 36,865,108 | $ | 33,941,875 | $ | 36,750,863 |\n| Total operating expenses | 27,410,462 | 29,689,455 | 31,976,036 | 34,127,473 |\n| Net operating income | 3,565,168 | 7,175,653 | 1,965,839 | 2,623,390 |\n| Net income(loss) | 713,859 | 1,759,109 | 4,636,644 | (711,959 | ) |\n| Net income (loss) attributable to common shareholders | 575,336 | 1,431,110 | 3,872,394 | (522,174 | ) |\n| Earnings (loss) per share attributable to common shareholders– basic and diluted | $ | 0.05 | $ | 0.13 | $ | 0.27 | $ | (0.04 | ) |\n| Costs Capitalized | Life on |\n| Initial Costs | Subsequent to Acquisition | Gross Amount At End of Year | Accumulated | Which |\n| Building & | Building & | Building & | Depreciation | Date of | Date | Depreciation |\n| Description | Encumbrances | Land | Improvements | Land | Improvements | Land | Improvements | Total | & Impairment | Construction | Acquired | is Computed |\n| Crowne Plaza Hampton Marina – Hampton, Virginia | $ | 2,585 | $ | 1,061 | $ | 6,733 | $ | 36 | 3,796 | $ | 1,097 | $ | 10,529 | $ | 11,626 | $ | (4,296 | ) | 1988 | 2008 | 3-39 years |\n| Crowne Plaza Hollywood Beach Resort - Hollywood Beach, Florida | 58,936 | 22,865 | 67,660 | — | (124 | ) | 22,865 | 67,536 | 90,401 | (2,646 | ) | 1972 | 2015 | 3-39 years |\n| Crowne Plaza Tampa Westshore – Tampa, Florida | 15,561 | 4,153 | 9,670 | 297 | 22,259 | 4,450 | 31,929 | 36,379 | (7,707 | ) | 1973 | 2007 | 3-39 years |\n| DoubleTree by Hilton Jacksonville Riverfront – Jacksonville, Florida | 19,292 | 7,090 | 14,604 | 89 | 7,113 | 7,179 | 21,717 | 28,896 | (5,881 | ) | 1970 | 2005 | 3-39 years |\n| DoubleTree by Hilton Laurel – Laurel, Maryland | 9,329 | 900 | 9,443 | 175 | 5,679 | 1,075 | 15,122 | 16,197 | (3,913 | ) | 1985 | 2004 | 3-39 years |\n| DoubleTree by Hilton Philadelphia Airport – Philadelphia, Pennsylvania | 31,262 | 2,100 | 22,031 | 260 | 5,478 | 2,360 | 27,509 | 29,869 | (8,281 | ) | 1972 | 2004 | 3-39 years |\n| DoubleTree by Hilton Raleigh Brownstone – University – Raleigh, North Carolina | 14,774 | 815 | 7,416 | 213 | 5,761 | 1,028 | 13,177 | 14,205 | (4,831 | ) | 1971 | 2004 | 3-39 years |\n| Georgian Terrace – Atlanta, Georgia | 45,826 | 10,128 | 45,386 | (1,332 | ) | 4,811 | 8,796 | 50,197 | 58,993 | (3,715 | ) | 1911 | 2014 | 3-39 years |\n| Hilton Savannah DeSoto – Savannah, Georgia | 30,000 | 600 | 13,562 | 31 | 14,545 | 631 | 28,107 | 28,738 | (8,640 | ) | 1968 | 2004 | 3-39 years |\n| Hilton Wilmington Riverside – Wilmington, North Carolina | 30,000 | 785 | 16,829 | 228 | 12,514 | 1,013 | 29,343 | 30,356 | (11,283 | ) | 1970 | 2004 | 3-39 years |\n| Sheraton Louisville Riverside – Jeffersonville, Indiana | 11,977 | 782 | 6,891 | 222 | 14,566 | 1,004 | 21,457 | 22,461 | (5,074 | ) | 1972 | 2006 | 3-39 years |\n| The Whitehall – Houston, Texas | 15,000 | 7,374 | 22,185 | 78 | 4,431 | 7,452 | 26,616 | 34,068 | (2,239 | ) | 1963 | 2013 | 3-39 years |\n| $ | 284,542 | $ | 58,653 | $ | 242,410 | $ | 297 | $ | 100,829 | $ | 58,950 | $ | 343,239 | $ | 402,189 | $ | (68,506 | ) |\n| (1) | For the year ending December 31, 2016, the aggregate cost of our real estate assets for federal income tax purposes was approximately $398.6 million. |\n| Balance at December 31, 2014 | $ | 294,827 |\n| Acquisitions | 91,669 |\n| Improvements | 11,105 |\n| Disposal of Assets | (3,971 | ) |\n| Balance at December 31, 2015 | $ | 393,630 |\n| Acquisitions | — |\n| Improvements | 9,473 |\n| Disposal of Assets | (914 | ) |\n| Balance at December 31, 2016 | $ | 402,189 |\n| Balance at December 31, 2014 | $ | 53,233 |\n| Current Expense | 8,790 |\n| Impairment | 500 |\n| Disposal of Assets | (482 | ) |\n| Balance at December 31, 2015 | $ | 62,041 |\n| Current Expense | 7,018 |\n| Impairment | — |\n| Disposal of Assets | (553 | ) |\n| Balance at December 31, 2016 | $ | 68,506 |\n\n \n\nWhat is the average annual franchise fee, in percentage, if the company operates the franchise for a period of 5 years based on the franchise fee for operating year 1, 2 and thereafter?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nBusiness\\nOrganization\\nSotherly Hotels Inc. (the “Company”) is a self-managed and self-administered lodging real estate investment trust, or REIT, that was formed in August 2004 to own, acquire, renovate and reposition full-service, primarily upscale and upper-upscale hotel properties located in primary markets in the mid-Atlantic and southern United States. On December 21, 2004, the Company successfully completed its initial public offering and elected to be treated as a self-advised REIT for federal income tax purposes. The Company conducts its business through Sotherly Hotels LP, its operating partnership (the “Operating Partnership”), of which the Company is the general partner. The Company owns approximately 89.1% of the partnership units in the Operating Partnership. Limited partners (including certain of the Company’s officers and directors) own the remaining Operating Partnership units.\\nAs of December 31, 2016, our portfolio consisted of twelve full-service, primarily upscale and upper-upscale hotels located in eight states with an aggregate total of 3,011 rooms and approximately 160,928 square feet of meeting space. All of our hotels are wholly-owned by subsidiaries of the Operating Partnership, and all are managed on a day to day basis by MHI Hotels Services, LLC, which does business as Chesapeake Hospitality (“Chesapeake Hospitality”).\\nIn order for the Company to qualify as a REIT, it cannot directly manage or operate our wholly-owned hotels. Therefore, we lease our wholly-owned hotel properties to entities that we refer to as our TRS Lessees, which in turn have engaged Chesapeake Hospitality, an eligible independent management company, to manage our hotels. Our TRS Lessees are wholly-owned subsidiaries of MHI Hospitality TRS Holding, Inc. (“MHI Holding”, and collectively, “MHI TRS”). MHI TRS is a taxable REIT subsidiary for federal income tax purposes.\\nOur corporate office is located at 410 West Francis Street, Williamsburg, Virginia 23185. Our telephone number is (757) 229-5648.\\nOur Properties\\nAs of December 31, 2016, our hotels were located in Florida, Georgia, Indiana, Maryland, North Carolina, Pennsylvania, Texas, and Virginia. Ten of these hotels operate under franchise agreements with major hotel brands, and two are independent hotels. Developments at our properties for the five years ended December 31, 2016 included the following:\\n| • | In 2013 we acquired the Crowne Plaza Houston Downtown located in Houston, Texas at an aggregate value of approximately $30.9 million, including certain closing costs. |\\n\\n| • | In 2014, we acquired the Georgian Terrace located in Atlanta, Georgia at an aggregate value of approximately $61.1 million, including certain closing costs. We also, after extensive renovations, re-branded and renamed the Hilton Philadelphia Airport to the DoubleTree by Hilton Philadelphia Airport. |\\n\\n| • | In 2015, we acquired the remaining 75.0% interest in (i) the entity that owns the Crowne Plaza Hollywood Beach Resort, and (ii) the entity that leases the Crowne Plaza Hollywood Beach Resort. As a result, the Operating Partnership now has a 100% indirect ownership interest in the entities that own the Crowne Plaza Hollywood Beach Resort. We also, after extensive renovations, re-branded and renamed the Crowne Plaza Jacksonville Riverfront to the DoubleTree by Hilton Jacksonville Riverfront, and re-branded and renamed the Holiday Inn Laurel West to the DoubleTree by Hilton Laurel. |\\n\\n| • | In 2016, after extensive renovations, we re-branded and renamed the Crowne Plaza Houston Downtown to The Whitehall. |\\n\\nSee Items 2 and 7 of this Form 10-K for additional detail on our properties.\\nOur Strategy and Investment Criteria\\nOur strategy is to grow through acquisitions of full-service, upscale and upper-upscale hotel properties located in the primary markets of the southern United States. We intend to grow our portfolio through disciplined acquisitions of hotel properties and believe that we will be able to source significant external growth opportunities through our management team’s extensive network of industry, corporate and institutional relationships.\\n5\\nOur investment criteria are further detailed below:\\n| • | Geographic Growth Markets: We are focusing our growth strategy on the major markets in the Southern region of the United States. Our management team remains confident in the long-term growth potential associated with this part of the United States. We believe these markets have, during the Company’s and our predecessors’ existence, been characterized by population growth, economic expansion, growth in new businesses and growth in the resort, recreation and leisure segments. We will continue to focus on these markets, including coastal locations, and will investigate other markets for acquisitions only if we believe these new markets will provide similar long-term growth prospects. |\\n\\n| • | Full-Service Hotels: We focus our acquisition strategy on the full-service hotel segment. Our full-service hotels fall primarily under the upscale to upper-upscale categories and include such brands as Hilton, Doubletree by Hilton, Sheraton and Crowne Plaza, as well as independent hotels affiliated with Preferred Hotels & Resorts. We may also acquire commercial unit(s) within upscale to upper-upscale condominium hotel projects, allowing us to establish and operate unit rental programs. We do not own economy hotels. We believe that full-service hotels, in the upscale to upper-upscale categories, will outperform the broader U.S. hotel industry, and thus offer the highest returns on invested capital. |\\n\\n| • | Significant Barriers to Entry: We intend to execute a strategy that entails the acquisition of hotels in prime locations with significant barriers to entry. |\\n\\n| • | Proximity to Demand Generators: We seek to acquire hotel properties located in central business districts for both leisure and business travelers within the respective markets, including large state universities, airports, convention centers, corporate headquarters, sports venues and office buildings. We seek to be in walking locations that are proximate to the markets’ major demand generators. |\\n\\nWe typically define underperforming hotels as those that are poorly managed, suffer from significant deferred maintenance and capital investment and that are not properly positioned in their respective markets. In pursuing these opportunities, we hope to improve revenue and cash flow and increase the long-term value of the underperforming hotels we acquire. Our ultimate goal is to achieve a total investment that is substantially less than replacement cost of a hotel or the acquisition cost of a market performing hotel. In analyzing a potential investment in an underperforming hotel property, we typically characterize the investment opportunity as one of the following:\\n| • | Branding Opportunity: The acquisition of properties that includes a repositioning of the property through a change in brand affiliation, which may include positioning the property as an independent hotel. Branding opportunities typically include physical upgrades and enhanced efficiencies brought about by changes in operations. |\\n\\n| • | Shallow-Turn Opportunity: The acquisition of an underperforming but structurally sound hotel that requires moderate renovation to re-establish the hotel in its market. |\\n\\n| • | Deep-Turn Opportunity: The acquisition of a hotel that is closed or functionally obsolete and requires a restructuring of both the business components of the operations as well as the physical plant of the hotel, including extensive renovation of the building, furniture, fixtures and equipment. |\\n\\nTypically, in our experience, a deep turn opportunity takes a total of approximately four years from the initial acquisition of a property to achieving full post-renovation stabilization. Therefore, when evaluating future opportunities in underperforming hotels, we intend to focus on up-branding and shallow-turn opportunities, and to pursue deep-turn opportunities on a more limited basis and in joint venture partnerships, if possible.\\nInvestment Vehicles. In pursuit of our investment strategy, we may employ various traditional and non-traditional investment vehicles:\\n| • | Direct Purchase Opportunity: Our traditional investment strategy is to acquire direct ownership interests via our Operating Partnership in properties that meet our investment criteria, including opportunities that involve full-service, upscale and upper-upscale properties in identified geographic growth markets that have significant barriers to entry for new product delivery. Such properties, or portfolio of properties, may or may not be acquired subject to a mortgage, or other financing or lending instruments, by the seller or third-party. |\\n\\n| • | Joint Venture/Mezzanine Lending Opportunities: We may, from time to time, undertake a significant renovation and rehabilitation project that we characterize as a deep-turn opportunity. In such cases, we may acquire a functionally obsolete hotel whose renovation may be very lengthy and require significant capital. In these projects, we may choose to structure such acquisitions as a joint venture, or mezzanine lending program, in order to avoid severe short-term dilution and loss of current income commonly referred to as the “negative carry” associated with such extensive renovation programs. We will not pursue joint venture or mezzanine programs in which we would become a “de facto” lender to the real estate community. |\\n\\n6\\nPortfolio and Asset Management Strategy\\nWe intend to ensure that the management of our hotel properties maximizes market share, as evidenced by revenue per available room (“RevPAR”) penetration indices, and that our market share yields the optimum level of revenues for our hotels in their respective markets. Our strategy is designed to actively manage our hotels’ operating expenses in an effort to maximize hotel earnings before interest, taxes, depreciation and amortization (“Hotel EBITDA”).\\nOver our long history in the lodging industry we have refined many portfolio and asset management techniques that we believe provide for exceptional cash returns at our hotels. We undertake extensive budgeting due diligence wherein we examine market trends, one-time or exceptional revenue opportunities, and/or changes in the regulatory climate that may impact costs. We review daily revenue results and revenue management strategies at the hotels, and we focus on our manager’s ability to produce high quality revenues that translate to higher profit margins. We look for ancillary forms of revenues, such as leasing roof-top space for cellular towers and other communication devices and also look to lease space to third parties in our hotels, which may include, but are not limited to, gift shops or restaurants. We have and will continue to engage parking management companies to maximize parking revenue. Our efforts further include periodic review of property insurance costs and coverage, and the cost of real and personal property taxes. We generally appeal tax increases in an effort to secure lower tax payments and routinely pursue strategies that allow for lower overall insurance costs, such as purchasing re-insurance and participating in state-sponsored insurance pools.\\nWe also require detailed and refined reporting data from Chesapeake Hospitality, which includes detailed accounts of revenues, revenue segments, expenses and forecasts based on current and historic booking patterns. We also believe we optimize and successfully manage capital costs at our hotels while ensuring that adequate product standards are maintained to provide a positive guest experience.\\nNone of our hotels are managed by a major national or global hotel franchise company. Through our long history in the lodging industry, we have found that management of our hotels by management companies other than franchisors is preferable to and more profitable than management services provided by the major franchise companies, specifically with respect to optimization of operating expenses and the delivery of guest service.\\nOur portfolio management strategy includes our effort to optimize labor costs. The labor force in our hotels is predominately non-unionized, with only one property, the DoubleTree by Hilton Jacksonville Riverfront, having a total of approximately 26 employees electing to participate under a collective bargaining arrangement. Further, the labor force at our hotels is eligible to receive health and other insurance coverage through Chesapeake Hospitality, which self-insures. Self-insuring has, in our opinion and experience, provided significant savings over traditional insurance company sponsored plans.\\nAsset Disposition Strategy. When a property no longer fits with our investment objectives, we will pursue a direct sale of the property for cash so that our investment capital can be redeployed according to the investment strategies outlined above. Where possible, we will seek to subsequently purchase a hotel in connection with the requirements of a tax-free exchange. Such a strategy may be deployed in order to mitigate the tax consequence that a direct sale may cause.\\nOur Principal Agreements\\nManagement Agreements\\nChesapeake Hospitality is currently the management company for each of our hotels. Andrew M. Sims, our chairman and chief executive officer owns an equity interest in Chesapeake Hospitality. Immediately prior to March 1, 2017, our chairman and chief executive officer, and another of our directors were also directors of Chesapeake Hospitality.\\nOn December 15, 2014, we entered into a master agreement (the “Master Agreement”) and a series of individual hotel management agreements (each a “Hotel Management Agreement” and, together, the “Hotel Management Agreements”) between the Company, the Operating Partnership, and MHI Hospitality TRS, LLC (and other TRS Lessees) on the one hand and Chesapeake Hospitality on the other hand, to address the scheduled expiration of the then existing master management agreement (the “MMA”) and the strategic alliance agreement (the “SA Agreement”) and to provide for ongoing management of the Company’s hotels. The Master Agreement and Hotel Management Agreements terminated and replaced the then existing MMA and individual management agreements.\\nThe Master Agreement:\\n| • | expires on December 31, 2019, or earlier if all of the Hotel Management Agreements expire or are terminated prior to that date. The Master Agreement will be extended beyond 2019 for such additional periods as a Hotel Management Agreement remains in effect; |\\n\\n7\\n\\n| • | terminated the then existing SA Agreement as of December 15, 2014; |\\n\\n| • | extended the term of the then existing MMA until December 31, 2014 and terminated the MMA and other individual management agreements for Tampa, Houston, and Atlanta as of such date; |\\n\\n| • | caused the Hotel Management Agreements to come into effect coincident with the termination of the MMA and other individual management agreements on December 31, 2014; |\\n\\n| • | requires Chesapeake Hospitality to provide dedicated executive level support for our managed hotels pursuant to certain criteria; |\\n\\n| • | provides a mechanism and established conditions on which the Company will offer Chesapeake Hospitality the opportunity to manage hotels acquired by the Company in the future, pursuant to a negotiated form of single facility management agreement, with the caveat that the Company is not required to offer the management of future hotels to Chesapeake Hospitality; and |\\n\\n| • | sets an incentive management fee for each of the hotels to be managed by Chesapeake Hospitality equal to 10% of the amount by which gross operating profit, as defined in the Hotel Management Agreement, for a given year exceeds the budgeted gross operating profit for such year; provided, however, that the incentive management fee payable in respect of any such year shall not exceed 0.25% of the gross revenues of the hotel included in such calculation. |\\n\\nEach of the Hotel Management Agreements has a term of five years commencing January 1, 2015, with the exception of the Hotel Management Agreement for the management of the Crowne Plaza Hollywood Beach Resort, which has a term of five years commencing July 31, 2015. Each of the Hotel Management Agreements may be extended for up to two additional periods of five years subject to the approval of both parties with respect to any such extension. The agreements provide that Chesapeake Hospitality will be the sole and exclusive manager of the hotels as the agent of the respective TRS Lessee and at the sole cost and expense of the TRS Lessee and subject to certain operating standards. Each agreement may be terminated in connection with a sale of the related hotel. In connection with a termination upon the sale of the hotel, Chesapeake Hospitality will be entitled to receive a termination fee equal to the lesser of the management fee paid with respect to the prior twelve months or the management fees paid for that number of months prior to the closing date of the hotel sale equal to the number of months remaining on the current term of the Hotel Management Agreement. No sale termination fee will be payable in the event the Company elects to provide Chesapeake Hospitality with the opportunity to manage another comparable hotel and Chesapeake Hospitality is not precluded from accepting such opportunity. Chesapeake Hospitality is required to qualify as an eligible independent contractor in order to permit the Company to continue to operate as a real estate investment trust.\\nAmounts Payable under the Management Agreements. Chesapeake Hospitality receives a base management fee, and, if the hotels exceed certain financial thresholds, an additional incentive management fee for the management of our hotels.\\nThe base management fee for our hotels will be a percentage of the gross revenues of the hotel and will be due monthly. The applicable percentage of gross revenue for the base management fee for each of our wholly-owned hotels is as follows (1):\\n\\n| 2019 | 2018 | 2017 | 2016 | 2015 | 2014 |\\n| Crowne Plaza Hampton Marina (2) | N/A | N/A | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\\n| Crowne Plaza Hollywood Beach Resort | 2.50 | % | 2.50 | % | (3) | (3) | 2.00 | % | N/A |\\n| Crowne Plaza Tampa Westshore (4) | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\\n| DoubleTree by Hilton Jacksonville Riverfront | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\\n| DoubleTree by Hilton Laurel | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\\n| DoubleTree by Hilton Philadelphia Airport | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\\n| DoubleTree by Hilton Raleigh Brownstone – University | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\\n| Georgian Terrace (5) | 2.50 | % | 2.50 | % | 2.50 | % | 2.25 | % | 2.00 | % | 2.00 | % |\\n| Hilton Savannah DeSoto | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\\n| Hilton Wilmington Riverside | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\\n| Sheraton Louisville Riverside (6) | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\\n| The Whitehall (7) | 2.50 | % | 2.50 | % | 2.50 | % | 2.25 | % | 2.00 | % | 2.00 | % |\\n\\n\\n| (1) | The fees for 2014 were set by the MMA, and the individual management agreements for Tampa, Houston, and Atlanta. The fees for 2015-2019 are set by the Master Agreement and the Hotel Management Agreements. |\\n\\n| (2) | The Crowne Plaza Hampton Marina was sold on February 7, 2017; therefore, the base management fee no longer applies after February 7, 2017. |\\n\\n8\\n\\n| (3) | Upon acquiring the Crowne Plaza Hollywood Beach Resort in July 2015, we entered into a single facility management agreement with Chesapeake Hospitality for the management of the hotel. The terms of the agreement provide for a base management fee of 2.00% through July 2016, 2.25% through July 2017, and 2.50% thereafter. |\\n\\n| (4) | In January 2009, we entered a separate management agreement with Chesapeake Hospitality for the management of the Crowne Plaza Tampa Westshore. The provisions of the new agreement related to base management fee were the same as those contained in the MMA. The provisions of the agreement related to the incentive management fee were the same as those contained in the MMA except that it was calculated separately and not aggregated with the other properties covered by the MMA. |\\n\\n| (5) | In March 2014, we entered into the Atlanta Agreement with Chesapeake Hospitality for the management of the Georgian Terrace. The terms of the agreement provided for a base management fee of 2.0% and no incentive management fee. The Atlanta Agreement was terminated in connection with the entry into the Master Agreement and Hotel Management Agreements. |\\n\\n| (6) | Pursuant to the MMA, the term for each of the initial properties, which included the Holiday Inn Downtown Williamsburg, was 10 years. The management company agreed to substitute the Sheraton Louisville Riverside for the Holiday Inn Downtown Williamsburg for remainder of the term of the agreement. |\\n\\n| (7) | In November 2013, we assumed the existing management agreement with Chesapeake Hospitality for the management of the Crowne Plaza Houston Downtown. The terms of the agreement provided for a base management fee of 2.0% and no incentive management fee. |\\n\\nThe base management fee for a hotel acquired in the future which is first leased by our TRS Lessees, other than on the first day of a fiscal year, will be 2.0% for the partial year such hotel is first leased and for the first full year such hotel is managed. There is no fee cap on the base management fee.\\nSubsequently Acquired Hotel Properties\\n\\n| First year | 2.00 | % |\\n| Second year | 2.25 | % |\\n| Third year and thereafter | 2.50 | % |\\n\\nTerminated Strategic Alliance Agreement and Management Agreements\\nOn December 21, 2004, we entered into the now terminated ten-year SA Agreement with Chesapeake Hospitality pursuant to which (i) Chesapeake Hospitality agreed to refer to us (on an exclusive basis) hotel acquisition opportunities in the United States presented to Chesapeake Hospitality, and (ii) unless a majority of the Company’s independent directors in good faith concluded for valid business reasons that another management company should manage a hotel owned by us, we agreed to offer Chesapeake Hospitality or its subsidiaries the right to manage hotel properties that we acquired in the United States. The SA Agreement was terminated effective as of December 15, 2014, pursuant to the terms of the Master Agreement.\\nPursuant to the terms of the now terminated MMA and other individual management agreements for Tampa, Houston and Atlanta, we engaged Chesapeake Hospitality as the property manager for each of our wholly-owned hotels through December 2015. The MMA had a term of ten (10) years for each initial hotel and a term of ten (10) years for each subsequently acquired hotel that became subject to the MMA. Chesapeake Hospitality benefited from the payment of management fees by us pursuant to the MMA. Chesapeake Hospitality received a base management fee equal to a percentage of each hotel’s revenues (2.0% for the first year, 2.5% for the second year and 3.0% thereafter). Additionally, pursuant to the MMA, Chesapeake Hospitality was entitled to receive certain incentive fees and project management fees. For Tampa, the base management and incentive management fees were the same as those contained in the MMA. For Houston and Atlanta, the base management fee was equal to 2% of the respective hotels’ revenues, and there was no incentive management fee. The MMA and the individual management agreements for Tampa, Houston, and Atlanta were terminated on December 31, 2014, pursuant to the terms of the Master Agreement.\\nFranchise Agreements\\nAs of December 31, 2016, all but two of our wholly-owned hotels operate under franchise licenses from national hotel companies. On March 27, 2014, we purchased an independent full-service hotel in Atlanta, Georgia, which does not operate under a franchise license. On April 12, 2016, we allowed the Crowne Plaza Houston Downtown’s franchise agreement to expire and rebranded it as The Whitehall, an independent full-service hotel.\\nOur TRS Lessees hold the franchise licenses for our wholly-owned hotels. Chesapeake Hospitality must operate each of our hotels it manages in accordance with and pursuant to the terms of the franchise agreement for the hotel.\\n9\\nThe franchise licenses generally specify certain management, operational, record keeping, accounting, reporting and marketing standards and procedures with which the franchisee must comply. Under the franchise licenses, the franchisee must comply with the franchisors’ standards and requirements with respect to:\\n| • | training of operational personnel; |\\n\\n| • | safety; |\\n\\n| • | maintaining specified insurance; |\\n\\n| • | the types of services and products ancillary to guest room services that may be provided; |\\n\\n| • | display of signage; |\\n\\n| • | marketing techniques including print media, billboards, and promotions standards; and |\\n\\n| • | the type, quality and age of furniture, fixtures and equipment included in guest rooms, lobbies and other common areas. |\\n\\nAdditionally, as the franchisee, our TRS Lessees are required to pay the franchise fees described below.\\nThe following table sets forth certain information for the franchise licenses of our wholly-owned hotel properties as of December 31, 2016:\\n\\n| Marketing/ |\\n| Franchise | Reservation | Expiration |\\n| Fee (1) | Fee (1) | Date |\\n| Crowne Plaza Hampton Marina (2) | 5.0 | % | 3.5 | % | 2/7/2017 |\\n| Crowne Plaza Hollywood Beach Resort (3) | 5.0 | % | 3.5 | % | 10/31/2017 |\\n| Crowne Plaza Tampa Westshore | 5.0 | % | 3.5 | % | 3/6/2019 |\\n| DoubleTree by Hilton Jacksonville Riverfront (4) | 5.0 | % | 4.0 | % | 9/30/2025 |\\n| DoubleTree by Hilton Laurel | 5.0 | % | 4.0 | % | 10/31/2030 |\\n| DoubleTree by Hilton Philadelphia – Airport (5) | 5.0 | % | 4.0 | % | 10/31/2024 |\\n| DoubleTree by Hilton Raleigh Brownstone – University (4) | 5.0 | % | 4.0 | % | 11/30/2021 |\\n| Hilton Savannah DeSoto (6) | 5.0 | % | 4.0 | % | 7/31/2017 |\\n| Hilton Wilmington Riverside | 5.0 | % | 4.0 | % | 3/31/2018 |\\n| Sheraton Louisville Riverside | 5.0 | % | 3.5 | % | 4/25/2023 |\\n\\n\\n| (1) | Percentage of room revenues payable to the franchisor. |\\n\\n| (2) | The Crowne Plaza Hampton Marina was sold on February 7, 2017, and the franchise license was transferred to the new owners. |\\n\\n| (3) | We have entered into a franchise agreement with Hilton to rebrand the Hollywood hotel as a DoubleTree by Hilton. |\\n\\n| (4) | The Franchise Fee is 3.0% for operating year 1, 4.0% for operating year 2, and 5.0% thereafter. |\\n\\n| (5) | The Franchise Fee is 4.0% for operating years 1 and 2, and 5.0% thereafter. |\\n\\n| (6) | We intend to convert the Savannah hotel to an independent hotel. |\\n\\nLease Agreements\\nIn order for the Company to maintain qualification as a REIT, neither the Company nor the Operating Partnership or its subsidiaries can operate our hotels directly. Our wholly-owned hotels are leased to our TRS Lessees, which have engaged Chesapeake Hospitality to manage the hotels. Each lease has a non-cancelable term of three to thirty years, subject to earlier termination upon the occurrence of certain contingencies described in the lease.\\nDuring the term of each lease, our TRS Lessees are obligated to pay a fixed annual base rent plus a percentage rent and certain other additional charges. Base rent accrues and is paid monthly. Percentage rent is calculated by multiplying fixed percentages by gross room revenues, in excess of certain threshold amounts and is paid monthly or quarterly, according to the terms of the agreement.\\nTax Status\\nThe Company elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the “Code”), commencing with its taxable year ended December 31, 2004. In order to maintain its qualification as a REIT, the Company must meet a number of organizational and operational requirements, including a requirement that it currently distribute, as “qualifying distributions,” at least 90.0% of its taxable income (determined without regard to the deduction for dividends paid and by\\n10\\nexcluding its net capital gains and reduced by certain non-cash items) to its stockholders. The Company has adhered to these requirements each taxable year since its formation in 2004 and intends to continue to adhere to these requirements and maintain its qualification for taxation as a REIT. As a REIT, the Company generally will not be subject to federal corporate income tax on that portion of its taxable income (including its net capital gain) that is distributed to its stockholders. If the Company fails to qualify for taxation as a REIT in any taxable year, and no relief provision applies, it will be subject to federal income taxes at regular corporate rates (as well as any applicable alternative minimum tax) and it would be disqualified from re-electing treatment as a REIT until the fifth taxable year after the year in which it failed to qualify as a REIT. Even if the Company qualifies for taxation as a REIT, it may be subject to certain state and local taxes on its income and property, and to federal income and excise taxes on its undistributed taxable income. In addition, taxable income from non-REIT activities managed through taxable REIT subsidiaries is subject to federal, state and local income taxes.\\nWhile the Operating Partnership is generally not subject to federal and state income taxes, the unit holders of the Operating Partnership, including the Company, are subject to tax on their respective allocable shares of the Operating Partnership’s taxable income.\\nThe Company has one taxable REIT subsidiary, MHI Holding, in which it owns an interest through the Operating Partnership. MHI Holding is subject to federal, state and local income taxes. MHI Holding has operated at a cumulative taxable loss, through December 31, 2016, of approximately $15.9 million and in addition had deferred timing differences of approximately $0.2 million attributable to start-up expenses related to the opening of several of its hotels, which was not deductible when incurred and is being amortized over 15 years and deferred timing differences of approximately $0.5 million attributable to accrued, but not deductible, vacation and sick pay amounts. The Company has not incurred federal income taxes since its formation. The cumulative taxable loss and combined timing differences result in a net deferred tax asset of approximately $6.9 million for these cumulative deferred tax loss carryforwards.\\nEnvironmental Matters\\nIn connection with the ownership and operation of the hotels, we are subject to various federal, state and local laws, ordinances and regulations relating to environmental protection. Under these laws, a current or previous owner or operator of real estate may be liable for the costs of removal or remediation of certain hazardous or toxic substances on, under, or in such property. Such laws often impose liability without regard to whether the owner or operator knew of, or was responsible for, the presence of hazardous or toxic substances. In addition, the presence of contamination from hazardous or toxic substances, or the failure to remediate such contaminated property properly, may adversely affect the owner’s ability to borrow using such property as collateral. Furthermore, a person who arranges for the disposal or treatment of a hazardous or toxic substance at a property owned by another, or who transports such substance to or from such property, may be liable for the costs of removal or remediation of such substance released into the environment at the disposal or treatment facility. The costs of remediation or removal of such substances may be substantial, and the presence of such substances may adversely affect the owner’s ability to sell such real estate or to borrow using such real estate as collateral. In connection with the ownership and operation of the hotels, we may be potentially liable for such costs.\\nWe believe that our hotels are in compliance, in all material respects, with all federal, state and local environmental ordinances and regulations regarding hazardous or toxic substances and other environmental matters, the violation of which would have a material adverse effect on us. We have not received written notice from any governmental authority of any material noncompliance, liability or claim relating to hazardous or toxic substances or other environmental matters in connection with any of our present hotel properties.\\nEmployees\\nAs of December 31, 2016, we employed twelve full-time persons, all of whom work at our corporate office in Williamsburg, Virginia. All persons employed in the day-to-day operations of the hotels are employees of Chesapeake Hospitality, the management company engaged by our TRS Lessees to operate such hotels.\\nSubsequent Events\\nHyde Resort & Residences\\nOn January 30, 2017, we purchased the commercial unit of the Hyde Resort & ResidencesTM, a condominium hotel located in the Hollywood, Florida market, for an aggregate price of approximately $4.8 million, including inventory and closing fees. The trademarked Hyde Resort & Residences is operated under license from SBE Hotel Licensing, LLC.\\n11\\nWe have entered into several agreements related to the Hyde Resort & Residences, which is zoned and operated as a condominium hotel with individual condominium units owned by third parties. In addition to our ownership of the commercial condominium unit, consisting of the designated lobby and front desk areas, we entered into a 20-year Lease Agreement with the condominium association responsible for the operation of the condominium, whereby we lease other common areas, including meeting rooms, office spaces, and 400 parking spaces, and also manage the parking garage. We have also entered into a 20-year Association Management Agreement with the condominium association, whereby we are engaged to manage the condominium association and to operate the Hyde Resort & Residences as a condominium hotel. Individual condominium unit owners may elect for their condominium units to be rented to condominium hotel guests pursuant to a rental management program managed for us by Chesapeake Hospitality pursuant to the Hyde Management Agreement, described below. As part of the rental management program, we have entered into individual rental agreements with condominium unit owners who have chosen to participate in our rental program, and may enter into rental agreements with unit owners in the future. We expect the number of individual condominium unit owners who elect to participate in our rental program to vary, and the number of units available for rental to condominium hotel guests at any given time will fluctuate pursuant to that participation and due to owner occupation of the condominium hotel units.\\nOn February 3, 2017, we entered into a Condominium Hotel Management Agreement (the “Hyde Management Agreement”) with Chesapeake Hospitality for the management of the Hyde Resort & Residences condominium hotel. In accordance with the Master Agreement, the Hyde Management Agreement has an initial term of five years commencing January 30, 2017 and mirrors the material terms of the other Hotel Management Agreements. The terms of the Hyde Management Agreement provide for a base management fee equal to a percentage of gross revenues of the rental of condominium units participating in our rental program in the amount of 2.00% through January 2018, 2.25% through January 2019, and 2.50% thereafter. Pursuant to the Hyde Management Agreement, Chesapeake Hospitality will manage for us the rental of individually owned condominium units pursuant to rental agreements entered into with individual condominium unit owners. We also entered into an Association Sub Management and Assignment Agreement with Chesapeake Hospitality for the management and operation of the condominium association responsible for the operation of the Hyde Resort & Residences, and a Rental Management Agreement pursuant to which Chesapeake Hospitality agreed to manage the marketing and negotiation of rental agreements with individual condominium unit owners.\\nCrowne Plaza Hampton Marina Disposition\\nOn February 7, 2017, we sold the Crowne Plaza Hampton Marina for a price of approximately $5.6 million. Following the sale, our portfolio consisted of eleven wholly-owned hotels located in seven states with an aggregate total of 2,838 rooms and approximately 149,435 square feet of meeting space, as well as our interests in the Hyde Resort & Residences.\\nEmployee Stock Ownership Plan\\nBetween January 3, 2017 and February 23, 2017, the Company’s Employee Stock Ownership Plan (“ESOP”) purchased 682,500 shares of the Company’s common stock. The Company sponsors and maintains the ESOP and related trust for the benefit of its eligible employees. The ESOP, which was established January 1, 2016, is funded by a loan from the Company, pursuant to which the ESOP may borrow up to $5,000,000 to purchase shares of the Company’s common stock, which serve as collateral for the loan.\\nDirector and Officer Changes\\nOn March 1, 2017, Kim E. Sims resigned as a member of the board of directors of the Company.\\nAvailable Information\\nWe maintain an Internet site, http://www.sotherlyhotels.com, which contains additional information concerning Sotherly Hotels Inc. We make available free of charge through our Internet site all our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, definitive proxy statements and other reports filed with the Securities and Exchange Commission as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. We have also posted on this website the Company’s Code of Business Conduct and the charters of the Company’s Nominating, Corporate Governance and Compensation (“NCGC”) and Audit Committees of the Company’s board of directors. We intend to disclose on our website any changes to, or waivers from, the Company’s Code of Business Conduct. Information on the Company’s Internet site is neither part of nor incorporated into this Form 10-K.\\n12\\n\\nItem 1A.\\nRi\\nsk Factors\\nThe following are the material risks that may affect us. Any of the risks discussed herein can materially adversely affect our business, liquidity, operations, industry or financial position or our future financial performance.\\nRisks Related to Our Debt\\nWe have substantial financial leverage.\\nAs of December 31, 2016, the principal balance of our debt was approximately $309.8 million, which is comprised of approximately $284.5 million secured debt and approximately $25.3 million unsecured debt related to the 7.0% senior unsecured notes due November 20, 2019 (the “7% Notes”) (not accounting for reductions of unamortized premiums or deferred financing costs as shown on our balance sheet). Historically, we have incurred debt for acquisitions and to fund our renovation, redevelopment and rebranding programs. Limitations upon our access to additional debt could adversely affect our ability to fund these programs or acquire hotels in the future.\\nOur financial leverage could negatively affect our business and financial results, including the following:\\n| • | require us to dedicate a substantial portion of our cash flow from operations to payments on our debt, thereby reducing funds available for operations, working capital, capital expenditures, future business opportunities, paying dividends or other purposes; |\\n\\n| • | limit our ability to obtain additional financing for working capital, renovation, redevelopment and rebranding plans, acquisitions, debt service requirements and other purposes; |\\n\\n| • | adversely affect our ability to satisfy our financial obligations, including those related to the 7% Notes; |\\n\\n| • | limit our ability to refinance existing debt; |\\n\\n| • | require us to agree to additional restrictions and limitations on our business operations and capital structure to obtain financing; |\\n\\n| • | force us to dispose of one or more of our properties, possibly on unfavorable terms; |\\n\\n| • | increase our vulnerability to adverse economic and industry conditions, and to interest rate fluctuations; |\\n\\n| • | force us to issue additional equity, possibly on terms unfavorable to existing shareholders; |\\n\\n| • | limit our flexibility to make, or react to, changes in our business and our industry; and |\\n\\n| • | place us at a competitive disadvantage, compared to our competitors that have less debt. |\\n\\nWe must comply with financial covenants in our mortgage loan agreements and in the indenture.\\nOur mortgage loan agreements and indenture contain various financial covenants. Failure to comply with these financial covenants could result from, among other things, changes in the local competitive environment, general economic conditions and disruption caused by renovation activity or major weather disturbances.\\nIf we violate the financial covenants contained in our mortgage loan agreements, we may attempt to negotiate waivers of the violations or amend the terms of the applicable mortgage loan agreement with the lender; however, we can make no assurance that we would be successful in any such negotiation or that, if successful in obtaining waivers or amendments, such waivers or amendments would be on attractive terms. Some mortgage loan agreements provide alternate cure provisions which may allow us to otherwise comply with the financial covenants by obtaining an appraisal of the hotel, prepaying a portion of the outstanding indebtedness or by providing cash collateral until such time as the financial covenants are met by the collateralized property without consideration of the cash collateral. Alternate cure provisions which include prepaying a portion of the outstanding indebtedness or providing cash collateral may have a material impact on our liquidity.\\nIf we violate the financial covenants in the indenture, we may attempt to cure that violation by engaging in one or more transactions pursuant to the cure provision in the indenture.\\nIf we are unable to negotiate a waiver or amendment or satisfy alternate cure provisions, if any, or unable to meet any alternate cure requirements and a default were to occur, we would possibly have to refinance the debt through debt financing, private or public offerings of debt securities, additional equity financing, or by disposing of an asset. We are uncertain whether we will be able to refinance these obligations or if refinancing terms will be favorable.\\n13\\nWe have one mortgage debt obligation maturing in 2018, and if we are not successful in extending the term of this indebtedness or in refinancing this debt on acceptable economic terms or at all, our overall financial condition could be materially and adversely affected.\\nWe will be required to seek additional capital in the near future to refinance or replace existing long-term mortgage debt that is maturing. Based on current market conditions, the availability of financing is, and may continue to be, limited. There can be no assurance that we will be able to obtain future financings on acceptable terms, if at all.\\nIn August 2018, the mortgage on our DoubleTree by Hilton Raleigh Brownstone University matures, and we have additional significant obligations maturing in subsequent years.\\nWe have no material debt obligations maturing in 2017. The total aggregate amount of our debt obligations scheduled to mature in 2018, inclusive of monthly amortization of all our indebtedness, is approximately $24.6 million, which represents approximately 7.9% of our total debt obligation outstanding as of December 31, 2016.\\nWe will need to, and plan to, renew, replace or extend our long-term indebtedness prior to the respective maturity date. If we are unable to extend this loan, we may be required to repay the outstanding principal amount at maturity or a portion of such indebtedness upon refinance. If we do not have sufficient funds to repay any portion of the indebtedness, it may be necessary to raise capital through debt financing, private or public offerings of debt securities or equity financings. We are uncertain whether we will be able to refinance this obligation or if refinancing terms will be favorable. If, at the time of any refinancing, prevailing interest rates or other factors result in higher interest rates on refinancing, increases in interest expense would lower our cash flow, and, consequently, cash available to meet our financial obligations. If we are unable to obtain alternative or additional financing arrangements in the future, or if we cannot obtain financing on acceptable terms, we may not be able to execute our business strategies or we may be forced to dispose of hotel properties on disadvantageous terms, potentially resulting in losses and potentially reducing cash flow from operating activities if the sale proceeds in excess of the amount required to satisfy the indebtedness could not be reinvested in equally profitable real property investments. Moreover, the terms of any additional financing may restrict our financial flexibility, including the debt we may incur in the future, or may restrict our ability to manage our business as we had intended. To the extent we cannot repay our outstanding debt, we risk losing some or all of our hotel properties to foreclosure and we could be required to invoke insolvency proceedings including, but not limited to, commencing a voluntary case under the U.S. Bankruptcy Code.\\nFor tax purposes, a foreclosure of any of our hotels would be treated as a sale of the hotel for a purchase price equal to the outstanding balance of the debt secured by the mortgage. If the outstanding balance of the debt secured by the mortgage exceeds our tax basis in the hotel, we would recognize taxable income on foreclosure, but we would not receive any cash proceeds, which could hinder the Company’s ability to meet the REIT distribution requirements imposed by the Code. In addition, we may give full or partial guarantees to lenders of mortgage debt on behalf of the entities that own our hotels. When we give a guarantee on behalf of an entity that owns one of our hotels, we will be responsible to the lender for satisfaction of the debt if it is not paid by such entity.\\nOur borrowing costs are sensitive to fluctuations in interest rates.\\nHigher interest rates could increase our debt service requirements and interest expense. Currently, our floating rate debt is limited to the mortgages on the DoubleTree by Hilton Philadelphia Airport, the DoubleTree by Hilton Jacksonville Riverfront, the Crowne Plaza Tampa Westshore and The Whitehall. Each of these mortgages bears interest at rates tied to the 1-month London Interbank Offered Rate (“LIBOR”) and provide for minimum rates of interest. To the extent that increases in the LIBOR rate of interest cause the interest on the mortgages to exceed the minimum rates of interest, we are exposed to rising interest rates.\\nShould we obtain new debt financing or refinance existing indebtedness, we may increase the amount of floating rate debt that currently exists. In addition, adverse economic conditions could also cause the terms on which we borrow to be unfavorable.\\nRisks Related to Our Business and Properties\\nIf the economy falls back into a recessionary period or fails to maintain positive growth, our operating performance and financial results may be harmed by declines in occupancy, average daily room rates and/or other operating revenues.\\nThe performance of the lodging industry and the general economy historically have been closely linked. In an economic downturn, business and leisure travelers may seek to reduce costs by limiting travel and/or reducing costs on their trips. Our hotels, which are all full-service hotels, may be more susceptible to a decrease in revenue, as compared to hotels in other categories that have lower room rates. A decrease in demand for hotel stays and hotel services will negatively affect our operating revenues, which will lower our cash flow and may affect our ability to make distributions to stockholders and to maintain compliance with our loan obligations. We had net loss attributable to the common shareholders of approximately $0.2 million for the 2016 fiscal year. A renewed economic downturn may increase our losses or reduce our income in the future. A weakening of the economy may adversely and materially affect our industry, business and results of operations and we cannot predict the likelihood, severity or duration of any such downturn. Moreover, reduced revenues as a result of a weakening economy may also reduce our working capital and impact our long-term business strategy.\\n14\\nWe own a limited number of hotels and significant adverse changes at one hotel could have a material adverse effect on our financial performance and may limit our ability to make distributions to stockholders.\\nAs of December 31, 2016, our portfolio consisted of twelve wholly-owned hotels with a total of 3,011 rooms. Significant adverse changes in the operations of any one hotel could have a material adverse effect on our financial performance and, accordingly, on our ability to make distributions to stockholders. Following the sale of the Crowne Plaza Hampton Marina on February 7, 2017, our portfolio consisted of eleven wholly-owned hotels with a total of 2,838 rooms, as well as our interests in the Hyde Resort & Residences.\\nWe are subject to risks of increased hotel operating expenses and decreased hotel revenues.\\nOur leases with our TRS Lessees provide for the payment of rent based in part on gross revenues from our hotels. Our TRS Lessees are subject to hotel operating risks including decreased hotel revenues and increased hotel operating expenses, including but not limited to the following:\\n| • | wage and benefit costs; |\\n\\n| • | repair and maintenance expenses; |\\n\\n| • | energy costs; |\\n\\n| • | property taxes; |\\n\\n| • | insurance costs; and |\\n\\n| • | other operating expenses. |\\n\\nAny increases in these operating expenses can have a significant adverse impact on our TRS Lessees’ ability to pay rent and other operating expenses and, consequently, our earnings and cash flow.\\nIn keeping with our investment strategy, we may acquire, renovate and/or re-brand hotels in new or existing geographic markets as part of our repositioning strategy. Unanticipated expenses and insufficient demand for newly repositioned hotels could adversely affect our financial performance and our ability to comply with covenants in the indenture and to make distributions to the Company’s stockholders.\\nWe have in the past, and may in the future, develop or acquire hotels in geographic areas in which our management may have little or no operating experience. Additionally, those properties may also be renovated and re-branded as part of a repositioning strategy. Potential customers may not be familiar with our newly renovated hotel or be aware of the brand change. As a result, we may have to incur costs relating to the opening, operation and promotion of those new hotel properties that are substantially greater than those incurred in other geographic areas. These hotels may attract fewer customers than expected and we may choose to increase spending on advertising and marketing to promote the hotel and increase customer demand. Unanticipated expenses and insufficient demand at new hotel properties, therefore, could adversely affect our financial performance and our ability to comply with covenants in the indenture and to make distributions to the Company’s stockholders.\\nWe do not have the authority to require any hotel to be operated in a particular manner or to govern any particular aspect of the daily operations of any hotel and as a result, our returns are dependent on the management of our hotels by Chesapeake Hospitality.\\nSince federal income tax laws restrict REITs and their subsidiaries from operating or managing hotels, we do not operate or manage our hotels. Instead, we lease all of our hotels to our TRS Lessees, and our TRS Lessees retain third-party managers to operate our hotels pursuant to management agreements.\\nUnder the terms of our management agreements with Chesapeake Hospitality and the REIT qualification rules, our ability to participate in operating decisions regarding the hotels is limited. We will depend on Chesapeake Hospitality to operate our hotels as provided in the management agreements. We do not have the authority to require any hotel to be operated in a particular manner or to govern any particular aspect of the daily operations of any hotel. Thus, even if we believe our hotels are being operated inefficiently or in a manner that does not result in satisfactory occupancy rates, RevPAR, and average daily rates (“ADR”), we may not be able to force Chesapeake Hospitality to change its method of operating our hotels. Additionally, in the event that we need to replace Chesapeake Hospitality or any other management companies in the future, we may be required by the terms of the applicable management agreement to pay substantial termination fees and may experience significant disruptions at the affected hotels.\\n15\\nOur ability to make distributions to the Company’s stockholders is subject to fluctuations in our financial performance, operating results and capital improvement requirements.\\nAs a REIT, the Company is required to distribute, as “qualifying distributions,” at least 90.0% of its REIT taxable income (determined without regard to the dividends-paid deduction and by excluding its net capital gains, and reduced by certain non-cash items), each year to the Company’s stockholders. However, several factors may make us unable to declare or pay distributions to the Company’s stockholders, including poor operating results and financial performance or unanticipated capital improvements to our hotels, including capital improvements that may be required by our franchisors.\\nWe lease all of our hotels to our TRS Lessees. Our TRS Lessees are subject to hotel operating risks, including risks of sustaining operating losses after payment of hotel operating expenses, including management fees. Among the factors which could cause our TRS Lessees to fail to make required rent payments are reduced net operating profits or operating losses, increased debt service requirements and capital expenditures at our hotels, including capital expenditures required by the franchisors of our hotels. Among the factors that could reduce the net operating profits of our TRS Lessees are decreases in hotel revenues and increases in hotel operating expenses. Hotel revenue can decrease for a number of reasons, including increased competition from a new supply of hotel rooms and decreased demand for hotel rooms. These factors can reduce both occupancy and room rates at our hotels.\\nThe amount of any dividend distributions to holders of the Company’s common stock is in the sole discretion of the Company’s board of directors, which will consider, among other factors, our financial performance, debt service obligations, debt covenants and capital expenditure requirements. We cannot assure you that we will continue to generate sufficient cash to fund distributions.\\nGeographic concentration of our hotels makes our business vulnerable to economic downturns in the mid-Atlantic and southern United States.\\nOur hotels are located in the mid-Atlantic and southern United States. As a result, economic conditions in the mid-Atlantic and southern United States significantly affect our revenues and the value of our hotels to a greater extent than if we had a more geographically diversified portfolio. Business layoffs or downsizing, industry slowdowns, changing demographics and other similar factors that may adversely affect the economic climate in these areas could have a significant adverse impact on our business. Any resulting oversupply or reduced demand for hotels in the mid-Atlantic and southern United States and in our markets in particular would therefore have a disproportionate negative impact on our revenues and limit our ability to make distributions to stockholders.\\nA substantial number of our hotels operate under a brand owned by Hilton Worldwide (Hilton), InterContinental Hotels Group (IHG) and Marriott International, Inc. (Marriott) brands; therefore, we are subject to risks associated with concentrating our portfolio in three brands.\\nIn our portfolio, the majority of the hotels that we owned as of December 31, 2016 utilize brands owned by IHG, Marriott or Hilton. As a result, our success is dependent in part on the continued success of IHG, Marriott or Hilton and their respective brands. If market recognition or the positive perception of IHG, Marriott and/or Hilton is reduced or compromised, the goodwill associated with the IHG, Marriott and Hilton branded hotels in our portfolio may be adversely affected, which may have a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders.\\nHedging against interest rate exposure may adversely affect us and our hedges may fail to protect us from the losses that the hedges were designed to offset.\\nSubject to maintaining the Company’s qualification as a REIT, we may elect to manage our exposure to interest rate volatility by using interest rate hedging arrangements, such as cap agreements and swap agreements. These agreements involve the risks that these arrangements may fail to protect or adversely affect us because, among other things:\\n| • | interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates; |\\n\\n| • | available interest rate hedges may not correspond directly with the interest rate risk for which protection is sought; |\\n\\n| • | the financial instruments we select may not have the effect of reducing our interest rate risk; |\\n\\n| • | the duration of the hedge may not match the duration of the related liability; |\\n\\n| • | the credit quality of the hedging counterparty owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; and |\\n\\n| • | the hedging counterparty owing money in the hedging transaction may default on its obligation to pay. |\\n\\n16\\nAs a result of any of the foregoing, our hedging transactions, which are intended to limit losses, may fail to protect us from the losses that the hedges were designed to offset and could have a material adverse effect on us.\\nOur investment opportunities and growth prospects may be affected by competition for acquisitions.\\nWe compete for investment opportunities with other entities, some of which have substantially greater financial resources than we do. This competition may generally limit the number of suitable investment opportunities offered to us, which may limit our ability to grow. This competition may also increase the bargaining power of property owners seeking to sell to us, making it more difficult for us to acquire new properties on attractive terms, or at all.\\nIf we fail to maintain an effective system of internal controls, we may not be able to accurately determine our financial results or prevent fraud. As a result, the Company’s stockholders could lose confidence in our financial results, which could harm our business and the value of the Company’s shares.\\nEffective internal controls are necessary for us to provide reliable financial reports and effectively prevent fraud. Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate and report on our internal controls over financial reporting. Our internal controls and financial reporting are not subject to attestation by our independent registered public accounting firm pursuant to the exemption provided to issuers that are not “large accelerated filers” or “accelerated filers” under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. While we have undertaken substantial work to comply with Section 404, we cannot be certain that we will be successful in maintaining adequate internal controls over our financial reporting and financial processes in the future. We may in the future discover areas of our internal controls that need improvement. Furthermore, as we grow our business, our internal controls will become more complex, and we will require significantly more resources to ensure our internal controls remain effective. If we or our independent auditors discover a material weakness, the disclosure of that fact, even if quickly remedied, could reduce the market value of the Company’s shares. Additionally, the existence of any material weakness or significant deficiency would require management to devote significant time and incur significant expense to remediate any such material weaknesses or significant deficiencies and management may not be able to remediate any such material weaknesses or significant deficiencies in a timely manner. In 2014, we identified a material weakness in our internal control over financial reporting which has been remediated.\\nWe are subject to cyber-security risks related to breaches of security pertaining to sensitive company, customer, employee and vendor information as well as breaches in the technology that manages operations and other business processes.\\nOur business operations rely upon secure information technology systems for data capture, processing, storage and reporting. Despite careful security and controls design, implementation, updating and independent third party verification, our information technology systems, and those of our third party providers, could become subject to cyber-attacks. Network, system, application and data breaches could result in operational disruptions or information misappropriation including, but not limited to interruption to systems availability, denial of access to and misuse of applications required by our customers. Access to internal applications required to plan our operations could be denied or misused. Inappropriate disclosure of confidential company, employee, customer or vendor information, could stem from such incidents. Any of these operational disruptions and/or misappropriation of information could result in lost sales, business delays, and negative publicity and could have a material effect on our business.\\nRisks Related to Conflicts of Interest of Our Officers and Directors\\nConflicts of interest could result in our executive officers and certain of our directors acting in a manner other than in the Company’s stockholders’ best interest.\\nConflicts of interest relating to Chesapeake Hospitality, the entity that manages the properties, and the terms of its management agreements may lead to management decisions that are not in the stockholders’ best interest.\\nConflicts of interest relating to Chesapeake Hospitality may lead to management decisions that are not in the stockholders’ best interest. Andrew M. Sims, our chairman and chief executive officer, and Kim E. Sims, a former member of our board of directors, together own a substantial interest in Chesapeake Hospitality which manages our hotel properties.\\nOur management agreements establish the terms of Chesapeake Hospitality’s management of our hotels. The new Master Agreement provides that in the event the agreement is terminated in connection with the sale of a hotel, and Chesapeake Hospitality accepts an offer to manage another hotel which is reasonable comparable to the hotel that was sold, we will not be liable for any termination fee. If we do not offer Chesapeake Hospitality such opportunity or Chesapeake Hospitality declines such opportunity, then a termination fee equivalent to the lesser of the management fees paid for the prior twelve-month period or the management fees for the period prior to the sale that is equal to the number of months remaining under the term of the agreement will be due. If we terminate the agreement at the end of any renewable five-year term, Chesapeake Hospitality is due a termination fee equivalent to one month’s management fees, as determined under the agreement.\\n17\\nAs a significant owner of Chesapeake Hospitality, which would receive any management and management termination fees payable by us under the management agreement, Andrew M. Sims may influence our decisions to sell a hotel or acquire or develop a hotel when it is not in the best interests of the Company’s stockholders to do so. In addition, Andrew M. Sims will have conflicts of interest with respect to decisions to enforce provisions of the management agreement, including any termination thereof.\\nThere can be no assurance that provisions in our bylaws will always be successful in mitigating conflicts of interest.\\nUnder our bylaws, a committee consisting of only independent directors must approve any transaction between us and Chesapeake Hospitality or its affiliates or any interested director. However, there can be no assurance that these policies always will be successful in mitigating such conflicts, and decisions could be made that might not fully reflect the interests of all of the Company’s stockholders.\\nCertain of our officers and directors control trusts that hold units in our Operating Partnership and may seek to avoid adverse tax consequences, which could result from transactions that would otherwise benefit the Company’s stockholders.\\nHolders of units in our Operating Partnership, including trusts controlled in whole or part by members of our management team, may suffer adverse tax consequences upon our sale or refinancing of certain properties. Therefore, holders of units, including a trust controlled by Andrew M. Sims and two former members of our board of directors, and a charitable trust controlled by Edward S. Stein, may have different objectives than holders of the Company’s stock regarding the appropriate pricing and timing of a property’s sale, or the timing and amount of a property’s refinancing. As of December 31, 2016, these trusts owned approximately 1.0% of the outstanding units in our Operating Partnership. Although the individuals controlling the trusts do not have any beneficial interest in the trusts, they may influence us not to sell or refinance certain properties, even if such sale or refinancing might be financially advantageous to the Company’s stockholders, or may influence us to enter into tax-deferred exchanges with the proceeds of such sales when such a reinvestment might not otherwise be in our best interest.\\nOur agreements with Chesapeake Hospitality and its affiliates, including the contribution agreements and the partnership agreement of our Operating Partnership, were not negotiated on an arms’ length basis and may be less favorable to us than we could have obtained from third parties.\\nIn connection with the Company’s initial public offering, we entered into various agreements with Chesapeake Hospitality and its affiliates, including contribution agreements, a master management agreement, a strategic alliance agreement, subleases, the partnership agreement of our Operating Partnership and employment agreements – of which only the contribution agreements and the partnership agreement of our Operating Partnership have not expired. In addition, we entered into various separate management agreements with Chesapeake Hospitality which have all been superseded by the new master management agreement and new individual hotel agreements executed in December 2014. The terms of all of these agreements were determined by our management team, who had conflicts of interest as described above and ownership interests in Chesapeake Hospitality and its affiliates. The terms of all of these agreements may be less favorable to us than we could have obtained from third parties.\\nRisks Related to the Lodging Industry\\nOur ability to comply with the terms of the indenture, our ability to make distributions to the Company’s stockholders and the value of our hotels in general, may be adversely affected by factors in the lodging industry.\\nOperating Risks\\nOur hotel properties are subject to various operating risks common to the lodging industry, many of which are beyond our control, including the following:\\n| • | competition from other hotel properties in our markets; |\\n\\n| • | over-building of hotels in our markets, which adversely affects occupancy and revenues at our hotels; |\\n\\n| • | dependence on business and commercial travelers and tourism; |\\n\\n| • | increases in energy costs and other expenses affecting travel, which may affect travel patterns and reduce the number of business and commercial travelers and tourists; |\\n\\n| • | increases in operating costs due to inflation and other factors, including increases in labor costs, that may not be offset by increased room rates; |\\n\\n| • | changes in interest rates and in the availability, cost and terms of debt financing; |\\n\\n| • | changes in governmental laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance with laws and regulations, fiscal policies and ordinances; |\\n\\n18\\n\\n| • | adverse effects of international, national, regional and local economic and market conditions; |\\n\\n| • | adverse effects of a downturn in the lodging industry; and |\\n\\n| • | risks generally associated with the ownership of hotel properties and real estate, as we discuss in detail below. |\\n\\nThese factors could reduce the net income of our TRS Lessees, which in turn could adversely affect the value of our hotels and our ability to comply with the terms of the indenture and to make distributions to the Company’s stockholders.\\nCompetition for Acquisitions\\nWe may compete for investment opportunities with entities that may have substantially greater financial resources than we do. These entities generally may be able to accept more risk than we choose to prudently manage. This competition may generally limit the number of suitable investment opportunities offered to us. This competition may also increase the bargaining power of property owners seeking to sell to us, making it more difficult for us to acquire new properties on attractive terms.\\nSeasonality of the Hotel Business\\nThe lodging industry is seasonal in nature, which can be expected to cause quarterly fluctuations in our revenues. Our quarterly earnings may be adversely affected by factors outside our control, including weather conditions and poor economic factors. As a result, we may have to enter into short-term borrowings in certain quarters in order to offset these fluctuations in revenues and to make distributions to the Company’s stockholders.\\nInvestment Concentration in Particular Segments of a Single Industry\\nOur entire business is lodging-related. Therefore, a downturn in the lodging industry, in general, and the full-service, upscale and upper-upscale segments in which we operate, in particular, will have a material adverse effect on the value of our hotels, our financial condition and the extent to which cash may be available for distribution to the Company’s stockholders.\\nCapital Expenditures\\nOur hotel properties have an ongoing need for renovations and other capital improvements, including replacements, from time to time, of furniture, fixtures and equipment. The franchisors of our hotels also require us to make periodic capital improvements as a condition of keeping the franchise licenses. In addition, several of our mortgage lenders require that we set aside amounts for capital improvements to the secured properties on a monthly basis. For the years ended December 31, 2016 and 2015, we spent approximately $14.8 million and approximately $20.1 million, respectively, on capital improvements to our hotels. Capital improvements and renovation projects may give rise to the following risks:\\n| • | possible environmental problems; |\\n\\n| • | construction cost overruns and delays; |\\n\\n| • | a possible shortage of available cash to fund capital improvements and the related possibility that financing for these capital improvements may not be available to us on affordable terms; and |\\n\\n| • | uncertainties as to market demand or a loss of market demand after capital improvements have begun. |\\n\\nThe costs of all these capital improvements as well as future capital improvements could adversely affect our financial condition and amounts available for distribution to the Company’s stockholders.\\nOperating our hotels under franchise agreements could increase our operating costs and lower our net income.\\nMost of our hotels operate under franchise agreements which subject us to risks in the event of negative publicity related to one of our franchisors.\\nThe maintenance of the franchise licenses for our hotels is subject to our franchisors’ operating standards and other terms and conditions. Our franchisors periodically inspect our hotels to ensure that we, our TRS Lessees, and the management company follow their standards. Failure by us, our TRS Lessees or the management company to maintain these standards or other terms and conditions could result in a franchise license being canceled. If a franchise license terminates due to our failure to make required improvements or to otherwise comply with its terms, we may also be liable to the franchisor for a termination payment, which varies by franchisor and by hotel. As a condition of continuing a franchise license, a franchisor may require us to make capital expenditures, even if we do not believe the capital improvements are necessary or desirable or will result in an acceptable return on our investment. Nonetheless, we may risk losing a franchise license if we do not make franchisor-required capital expenditures.\\n19\\nIf a franchisor terminates the franchise license, we may try either to obtain a suitable replacement franchise license or to operate the hotel without a franchise license. The loss of a franchise license could significantly decrease the revenues at the hotel and reduce the underlying value of the hotel because of the loss of associated name recognition, marketing support and centralized reservation systems provided by the franchisor. A loss of a franchise license for one or more hotels could materially and adversely affect our revenues. This loss of revenues could, therefore, also adversely affect our financial condition and results of operations, our ability to comply with the terms of the indenture and reduce our cash available for distribution to stockholders.\\nRestrictive covenants in certain of our franchise agreements contain provisions that may operate to limit our ability to sell or refinance our hotels, which could have a material adverse effect on us.\\nFranchise agreements typically contain covenants that may affect our ability to sell or refinance a hotel, including requirements to obtain the consent of the franchisor in the event of such a sale or refinancing transaction. In the event that a franchisor’s consent is not forthcoming, the terms of a sale or refinancing may be less favorable to us than would otherwise be the case. Some of our franchise agreements provide the franchisor with a right of first offer in the event of certain sales or transfers of a hotel and provide that the franchisor has the right to approve any change in the hotel management company engaged to manage the hotel. Generally, we may be limited in our ability to sell, lease or otherwise transfer hotels unless the transferee is not a competitor of the franchisor and the transferee agrees to assume the related franchise agreements. If the franchisor does not consent to the sale or financing of our hotels, we may be unable to consummate transactions that are in our best interests or the terms of those transactions may be less favorable to us, which could have a material adverse effect on our financial condition and the execution of our strategies.\\nHotel re-development is subject to timing, budgeting and other risks that would increase our operating costs and limit our ability to make distributions to stockholders.\\nWe intend to acquire hotel properties from time to time as suitable opportunities arise, taking into consideration general economic conditions, and seek to re-develop or reposition these hotels. Redevelopment of hotel properties involves a number of risks, including risks associated with:\\n| • | construction delays or cost overruns that may increase project costs; |\\n\\n| • | receipt of zoning, occupancy and other required governmental permits and authorizations; |\\n\\n| • | development costs incurred for projects that are not pursued to completion; |\\n\\n| • | acts of God such as earthquakes, hurricanes, floods or fires that could adversely impact a project; |\\n\\n| • | financing; and |\\n\\n| • | governmental restrictions on the nature or size of a project. |\\n\\nWe cannot assure you that any re-development project will be completed on time or within budget. Our inability to complete a project on time or within budget would increase our operating costs and reduce our net income.\\nThe hotel business is capital intensive and our inability to obtain financing could limit our growth.\\nOur hotel properties will require periodic capital expenditures and renovation to remain competitive. Acquisitions or development of additional hotel properties will require significant capital expenditures. In addition, several of our mortgage lenders require that we set aside annual amounts for capital improvements to the secured property. We may not be able to fund capital improvements or acquisitions solely from cash provided from our operating activities because we must distribute at least 90.0% of our REIT taxable income, excluding net capital gains, each year to maintain our REIT tax status. As a result, our ability to fund significant capital expenditures, acquisitions or hotel development through retained earnings is very limited. Consequently, we rely upon the availability of debt or equity capital to fund any significant investments or capital improvements. Our ability to grow through acquisitions or development of hotels will be limited if we cannot obtain satisfactory debt or equity financing which will depend on market conditions. Neither our charter nor our bylaws limit the amount of debt that we can incur. However, we cannot assure you that we will be able to obtain additional equity or debt financing or that we will be able to obtain such financing on favorable terms.\\n20\\nUninsured and underinsured losses could adversely affect our operating results and our ability to make distributions to the Company’s stockholders.\\nWe maintain comprehensive insurance on each of our hotel properties, including liability, fire and extended coverage, of the type and amount we believe are customarily obtained for or by hotel owners. There are no assurances that current coverage will continue to be available at reasonable rates. Various types of catastrophic losses, like hurricanes, earthquakes and floods, such as Hurricane Matthew in October 2016 and Hurricane Sandy in October 2012, losses from foreign terrorist activities, such as those on September 11, 2001, or losses from domestic terrorist activities, such as the Oklahoma City bombing on April 19, 1995, may not be insurable or may not be economically insurable. Currently, our insurers provide terrorism coverage in conjunction with the Terrorism Risk Insurance Program sponsored by the federal government through which insurers are able to receive compensation for insured losses resulting from acts of terrorism.\\nIn the event of a substantial loss, our insurance coverage may not be sufficient to cover the full current market value or replacement cost of our lost investment. Should an uninsured loss or a loss in excess of insured limits occur, we could lose all or a portion of the capital we have invested in a hotel, as well as the anticipated future revenue from the hotel. In that event, we might nevertheless remain obligated for any mortgage debt or other financial obligations related to the property. Inflation, changes in building codes and ordinances, environmental considerations and other factors might also keep us from using insurance proceeds to replace or renovate a hotel after it has been damaged or destroyed. Under those circumstances, the insurance proceeds we receive might be inadequate to restore our economic position on the damaged or destroyed property.\\nNoncompliance with governmental regulations could adversely affect our operating results.\\nEnvironmental Matters\\nOur hotels may be subject to environmental liabilities. An owner of real property can face liability for environmental contamination created by the presence or discharge of hazardous substances on the property. We may face liability regardless of:\\n| • | our knowledge of the contamination; |\\n\\n| • | the timing of the contamination; |\\n\\n| • | the cause of the contamination; or |\\n\\n| • | the party responsible for the contamination of the property. |\\n\\nThere may be unknown environmental problems associated with our properties. If environmental contamination exists on our properties, we could become subject to strict, joint and several liability for the contamination by virtue of our ownership interest.\\nThe presence of hazardous substances on a property may adversely affect our ability to sell the property and we may incur substantial remediation costs. The discovery of environmental liabilities attached to our properties could have a material adverse effect on our results of operations and financial condition and our ability to comply with our covenants and to pay distributions to stockholders.\\nAmericans with Disabilities Act and Other Changes in Governmental Rules and Regulations\\nUnder the Americans with Disabilities Act of 1990, or the ADA, all public accommodations must meet various federal requirements related to access and use by disabled persons. Compliance with the ADA’s requirements could require removal of access barriers, and non-compliance could result in the U.S. government imposing fines or in private litigants winning damages. If we are required to make substantial modifications to our hotels, whether to comply with the ADA or other changes in governmental rules and regulations, our financial condition, results of operations and ability to comply with the terms of the indenture and to make distributions to the Company’s stockholders could be adversely affected.\\nOur hotels may be subject to unknown or contingent liabilities which could cause us to incur substantial costs.\\nThe hotel properties that we acquire may be subject to unknown or contingent liabilities for which we may have no recourse, or only limited recourse, against the sellers. Contingent or unknown liabilities with respect to entities or properties acquired might include:\\n| • | liabilities for environmental conditions; |\\n\\n| • | losses in excess of our insured coverage; |\\n\\n| • | accrued but unpaid liabilities incurred in the ordinary course of business; |\\n\\n21\\n\\n| • | tax, legal and regulatory liabilities; |\\n\\n| • | claims of customers, vendors or other persons dealing with the Company’s predecessors prior to our formation or acquisition transactions that had not been asserted or were unknown prior to the Company’s formation or acquisition transactions; and |\\n\\n| • | claims for indemnification by the general partners, officers and directors and others indemnified by the former owners of our properties. |\\n\\nIn general, the representations and warranties provided under the transaction agreements related to the sales of the hotel properties may not survive the closing of the transactions. While we will likely seek to require the sellers to indemnify us with respect to breaches of representations and warranties that survive, such indemnification may be limited and subject to various materiality thresholds, a significant deductible or an aggregate cap on losses. As a result, there is no guarantee that we will recover any amounts with respect to losses due to breaches by the sellers of their representations and warranties. In addition, the total amount of costs and expenses that may be incurred with respect to liabilities associated with these hotels may exceed our expectations, and we may experience other unanticipated adverse effects, all of which may adversely affect our financial condition, results of operations and our ability to make distributions to the Company’s stockholders.\\nFuture terrorist activities may adversely affect, and create uncertainty in, our business.\\nTerrorism in the United States or elsewhere could have an adverse effect on our business, although the degree of impact will depend on a number of factors, including the U.S. and global economies and global financial markets. Previous terrorist attacks in the United States and subsequent terrorism alerts have adversely affected the travel and hospitality industries over the past several years. Such attacks, or the threat of such attacks, could have a material adverse effect on our business, our ability to finance our business, our ability to insure our properties and/or our results of operations and financial condition, as a whole.\\nWe face risks related to pandemic diseases, which could materially and adversely affect travel and result in reduced demand for our hotels.\\nOur business could be materially and adversely affected by the effect of a pandemic disease on the travel industry. For example, the outbreaks of SARS and avian flu in 2003 had a severe impact on the travel industry, the outbreaks of H1N1 flu in 2009 threatened to have a similar impact, and the perceived threat of a Zika virus outbreak in 2016 had an impact on the south Florida market. A prolonged recurrence of SARS, avian flu, H1N1 flu, Ebola virus, Zika virus or another pandemic disease also may result in health or other government authorities imposing restrictions on travel. Any of these events could result in a significant drop in demand for our hotels and adversely affect our financial conditions and results of operations.\\nGeneral Risks Related to the Real Estate Industry\\nIlliquidity of real estate investments could significantly impede our ability to respond to adverse changes in the performance of our properties and harm our financial condition.\\nBecause real estate investments are relatively illiquid, our ability to promptly sell one or more hotel properties in our portfolio in response to changing economic, financial and investment conditions is limited.\\nThe real estate market is affected by many factors that are beyond our control, including:\\n| • | adverse changes in international, national, regional and local economic and market conditions; |\\n\\n| • | changes in interest rates and in the cost and terms of debt financing; |\\n\\n| • | absence of liquidity in credit markets which limits the availability and amount of debt financing; |\\n\\n| • | changes in governmental laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance with laws and regulations, fiscal policies and ordinances; |\\n\\n| • | the ongoing need for capital improvements, particularly in older structures; |\\n\\n| • | changes in operating expenses; and |\\n\\n| • | civil unrest, acts of God, including earthquakes, floods and other natural disasters such as Hurricane Matthew in October 2016 and Hurricane Sandy in October 2012, which may result in uninsured losses, and acts of war or terrorism, including the consequences of terrorist acts, such as those that occurred on September 11, 2001. |\\n\\n22\\nWe may decide to sell our hotels in the future. We cannot predict whether we will be able to sell any hotel property for the price or on the terms set by us, or whether any price or other terms offered by a prospective purchaser would be acceptable to us. We also cannot predict the length of time needed to find a willing purchaser and to close the sale of a hotel property.\\nWe may be required to expend funds to correct defects or to make improvements before a hotel property can be sold. We cannot assure you that we will have funds available to correct those defects or to make those improvements. In acquiring a hotel property, we may agree to lock-out provisions that materially restrict us from selling that property for a period of time or impose other restrictions, such as a limitation on the amount of debt that can be placed or repaid on that property. These factors and any others that would impede our ability to respond to adverse changes in the performance of our properties could have a material adverse effect on our operating results and financial condition, as well as our ability to comply with the terms of the indenture and to pay distributions to stockholders.\\nFuture acquisitions may not yield the returns expected, may result in disruptions to our business, may strain management resources and may result in stockholder dilution.\\nOur business strategy may not ultimately be successful and may not provide positive returns on our investments. Acquisitions may cause disruptions in our operations and divert management’s attention away from day-to-day operations. The issuance of equity securities in connection with any acquisition could be substantially dilutive to the Company’s stockholders.\\nOur hotels may contain or develop harmful mold, which could lead to liability for adverse health effects and costs of remediating the problem.\\nWhen excessive moisture accumulates in buildings or on building materials, mold growth may occur, particularly if the moisture problem remains undiscovered or is not addressed over a period of time. Some molds may produce airborne toxins or irritants. Concern about indoor exposure to mold has been increasing, as exposure to mold may cause a variety of adverse health effects and symptoms, including allergic or other reactions. As a result, the presence of significant mold at any of our properties could require us to undertake a costly remediation program to contain or remove the mold from the affected property, which would reduce our cash available for distribution. In addition, the presence of significant mold could expose us to liability from our guests, employees or the management company and others if property damage or health concerns arise and could harm our reputation.\\nIncreases in property taxes would increase our operating costs, reduce our income and adversely affect our ability to make distributions to the Company’s stockholders.\\nEach of our hotel properties is subject to real and personal property taxes. These taxes may increase as tax rates change and as the properties are assessed or reassessed by taxing authorities. If property taxes increase, our financial condition, results of operations and our ability to make distributions to the Company’s stockholders could be materially and adversely affected and the market price of the Company’s shares could decline.\\nRisks Related to Our Organization and Structure\\nOur ability to effect a merger or other business combination transaction may be restricted by our Operating Partnership agreement.\\nIn the event of a change of control of the Company, the limited partners of our Operating Partnership will have the right, for a period of 30 days following the change of control event, to cause the Operating Partnership to redeem all of the units held by the limited partners for a cash amount equal to the cash redemption amount otherwise payable upon redemption pursuant to the partnership agreement. This cash redemption right may make it more unlikely or difficult for a third party to propose or consummate a change of control transaction, even if such transaction were in the best interests of the Company’s stockholders.\\nProvisions of the Company’s charter may limit the ability of a third party to acquire control of the Company.\\nAggregate Share and Common Share Ownership Limits\\nThe Company’s charter provides that no person may directly or indirectly own more than 9.9% of the value of the Company’s outstanding shares of capital stock or more than 9.9% of the number of the Company’s outstanding shares of common stock. These ownership limitations may prevent an acquisition of control of the Company by a third party without the Company’s board of directors’ approval, even if the Company’s stockholders believe the change of control is in their interest. The Company’s board of directors has discretion to waive that ownership limit if, including other considerations, the board receives evidence that ownership in excess of the limit will not jeopardize the Company’s REIT status.\\n23\\nAuthority to Issue Stock\\nThe Company’s amended and restated charter authorizes our board of directors to issue up to 49,000,000 shares of common stock and up to 11,000,000 shares of preferred stock, to classify or reclassify any unissued shares of common stock or preferred stock and to set the preferences, rights and other terms of the classified or reclassified shares. Issuances of additional shares of stock may have the effect of delaying or preventing a change in control of the Company, including transactions at a premium over the market price of the Company’s stock, even if stockholders believe that a change of control is in their interest. The Company will be able to issue additional shares of common or preferred stock without stockholder approval, unless stockholder approval is required by applicable law or the rules of any stock exchange or automated quotation system on which the Company’s securities may be listed or traded.\\nProvisions of Maryland law may limit the ability of a third party to acquire control of the Company.\\nCertain provisions of the Maryland General Corporation Law, or the MGCL, may have the effect of inhibiting a third party from making a proposal to acquire us or of impeding a change of control under circumstances that otherwise could provide the holders of shares of the Company’s common stock with the opportunity to realize a premium over the then-prevailing market price of such shares, including:\\n| • | “business combination” provisions that, subject to limitations, prohibit certain business combinations between us and an “interested stockholder” (defined generally as any person who beneficially owns 10.0% or more of the voting power of our shares or an affiliate thereof) for five years after the most recent date on which the stockholder becomes an interested stockholder, and thereafter imposes special appraisal rights and special stockholder voting requirements on these combinations; and |\\n\\n| • | “control share” provisions that provide that “control shares” of the Company (defined as shares which, when aggregated with other shares controlled by the stockholder, entitle the stockholder to exercise one of three increasing ranges of voting power in electing directors) acquired in a “control share acquisition” (defined as the direct or indirect acquisition of ownership or control of “control shares”) have no voting rights except to the extent approved by the Company’s stockholders by the affirmative vote of at least two-thirds of all the votes entitled to be cast on the matter, excluding all interested shares. |\\n\\nThe Company has opted out of these provisions of the MGCL, in the case of the business combination provisions of the MGCL by resolution of the Company’s board of directors, and in the case of the control share provisions of the MGCL pursuant to a provision in the Company’s bylaws. However, the Company’s board of directors may by resolution elect to opt in to the business combination provisions of the MGCL and the Company may, by amendment to its bylaws, opt in to the control share provisions of the MGCL in the future. The Company’s board of directors has the exclusive power to amend the Company’s bylaws.\\nAdditionally, Title 8, Subtitle 3 of the MGCL permits the Company’s board of directors, without stockholder approval and regardless of what is currently provided in the Company’s charter or bylaws, to implement takeover defenses, some of which (for example, a classified board) the Company does not currently have. These provisions may have the effect of inhibiting a third party from making an acquisition proposal for the Company or of delaying, deferring or preventing a change in control of the Company under the circumstances that otherwise could provide the holders of the Company’s common stock with the opportunity to realize a premium over the then current market price.\\nProvisions in the Company’s executive officers’ employment agreements may make a change of control of the Company more costly or difficult.\\nThe Company’s employment agreements with Andrew M. Sims, its chief executive officer, David R. Folsom, its president and chief operating officer, and Anthony E. Domalski, its chief financial officer, contain provisions providing for substantial payments to these officers in the event of a change of control of the Company. Specifically, if the Company terminates these executive’s employment without cause or the executive resigns with good reason, which includes a failure to nominate Andrew M. Sims to the Company’s board of directors or his involuntary removal from the Company’s board of directors, unless for cause or by vote of the stockholders, or if there is a change of control, each of these executives is entitled to the following:\\n| • | any accrued but unpaid salary and bonuses; |\\n\\n| • | vesting of any previously issued stock options and restricted stock; |\\n\\n| • | payment of the executive’s life, health and disability insurance coverage for a period of five years following termination; |\\n\\n| • | any unreimbursed expenses; and |\\n\\n| • | a severance payment equal to three times for Andrew M. Sims’, David R. Folsom’s and Anthony E. Domalski’s respective combined salary and actual bonus compensation for the preceding fiscal year. |\\n\\n24\\nIn addition, these executives will receive additional payments to compensate them for the additional taxes, if any, imposed on them under Section 4999 of the Code by reason of receipt of excess parachute payments. We will not be able to deduct any of the above amounts paid to the executives for tax purposes.\\nThese provisions may make a change of control of the Company, even if it is in the best interests of the Company’s stockholders, more costly and difficult and may reduce the amounts the Company’s stockholders would receive in a change of control transaction.\\nOur ownership limitations may restrict or prevent you from engaging in certain transfers of the Company’s common stock or preferred stock.\\nIn order to maintain the Company’s REIT qualification, it cannot be closely held (i.e., more than 50.0% in value of our outstanding stock cannot be owned, directly or indirectly, by five or fewer individuals during the last half of any taxable year). To preserve the Company’s REIT qualification, the Company’s charter contains a 9.9% aggregate share ownership limit and a 9.9% common share ownership limit. Generally, any shares of the Company’s stock owned by affiliated persons will be added together for purposes of the aggregate share ownership limit, and any shares of common stock owned by affiliated owners will be added together for purposes of the common share ownership limit.\\nIf anyone transfers shares in a way that would violate the aggregate share ownership limit or the common share ownership limit, or prevent the Company from continuing to qualify as a REIT under the federal income tax laws, those shares instead will be transferred to a trust for the benefit of a charitable beneficiary and will be either redeemed by us or sold to a person whose ownership of the shares will not violate the aggregate share ownership limit or the common share ownership limit. If this transfer to a trust fails to prevent such a violation or fails to preserve the Company’s continued qualification as a REIT, then the Company will consider the initial intended transfer to be null and void from the outset. The intended transferee of those shares will be deemed never to have owned the shares. Anyone who acquires shares in violation of the aggregate share ownership limit, the common share ownership limit or the other restrictions on transfer in the Company’s charter bears the risk of suffering a financial loss when the shares are redeemed or sold if the market price of the Company’s stock falls between the date of purchase and the date of redemption or sale.\\nThe Company’s articles supplementary establishing and fixing the rights and preferences of Series B preferred stock provide that no person may directly or indirectly own more than 9.9% of the aggregate number of outstanding shares of Series B preferred stock, excluding any outstanding shares of Series B preferred stock not treated as outstanding for federal income tax purposes. The Company’s board of directors has discretion to waive that ownership limit if, including other considerations, the board receives evidence that ownership in excess of the limit will not jeopardize the Company’s REIT status.\\nHolders of our outstanding preferred shares have dividend, liquidation and other rights that are senior to the rights of the holders of our common shares.\\nOur board of directors has the authority to designate and issue preferred shares with liquidation, dividend and other rights that are senior to those of our common shares. As of December 31, 2016, 1,610,000 shares of our 8.0% Series B Cumulative Redeemable Preferred Stock were issued and outstanding. The aggregate liquidation preference with respect to the outstanding preferred shares is approximately $40.3 million, and annual dividends on our outstanding preferred shares are approximately $3.2 million. Holders of our Series B Preferred Stock are entitled to cumulative dividends before any dividends may be declared or set aside on our common shares. Upon our voluntary or involuntary liquidation, dissolution or winding up, before any payment is made to holders of our common shares, holders of these preferred shares are entitled to receive a liquidation preference of $25.00 per share plus any accrued and unpaid distributions. This will reduce the remaining amount of our assets, if any, available to distribute to holders of our common shares. In addition, holders of these preferred shares have the right to elect two additional directors to our board of directors whenever dividends on the preferred shares are in arrears in an aggregate amount equivalent to six or more quarterly dividends (whether or not consecutive). Because our decision to issue securities will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of any future preferred offerings. Thus, our stockholders bear the risk of our future securities issuances reducing the market price of our common shares and diluting their interest.\\nThe change of control conversion and redemption features of the Series B Preferred Stock may make it more difficult for a party to take over our Company or discourage a party from taking over our Company.\\nUpon a change of control (as defined in our charter), holders of our Series B Preferred Stock will have the right (unless, as provided in our charter, we have provided or provide notice of our election to exercise our special optional redemption right before the relevant date) to convert some or all of their shares of our Series B Preferred Stock into shares of our common stock (or equivalent value of alternative consideration). Upon such a conversion, holders will be limited to a maximum number of shares equal to the share cap, subject to adjustments. If the common stock price is less than $3.015, subject to adjustment, holders will receive a maximum of\\n25\\n8.29187 shares of our common stock per share of Series B Preferred Stock, which may result in a holder receiving value that is less than the liquidation preference of the Series B Preferred Stock. In addition, those features of our Series B Preferred Stock may have the effect of inhibiting or discouraging a third party from making an acquisition proposal for our Company or of delaying, deferring or preventing a change in control of our Company under circumstances that otherwise could provide the holders of shares of our common stock and shares of our Series B Preferred Stock with the opportunity to realize a premium over the then current market price or that stockholders may otherwise believe is in their best interests.\\nThe board of directors’ revocation of the Company’s REIT status without stockholder approval may decrease the Company’s stockholders’ total return.\\nThe Company’s charter provides that the Company’s board of directors may revoke or otherwise terminate the Company’s REIT election, without the approval of the Company’s stockholders, if the Company’s board of directors determines that it is no longer in the Company’s best interest to continue to qualify as a REIT. If the Company ceases to be a REIT, it would become subject to federal income tax on its taxable income and would no longer be required to distribute most of its taxable income to the Company’s stockholders, which may have adverse consequences on our total return to the Company’s stockholders.\\nThe ability of the Company’s board of directors to change the Company’s major corporate policies may not be in your best interest.\\nThe Company’s board of directors determines the Company’s major corporate policies, including its acquisition, financing, growth, operations and distribution policies. The Company’s board of directors may amend or revise these and other policies from time to time without the vote or consent of the Company’s stockholders.\\nOur success depends on key personnel whose continued service is not guaranteed.\\nWe depend on the efforts and expertise of our chairman and chief executive officer, Andrew M. Sims; our president and chief operating officer, David R. Folsom; and our chief financial officer, Anthony E. Domalski, to manage our day-to-day operations and strategic business direction. The loss of any of their services could have an adverse effect on our operations.\\nFederal Income Tax Risks Related to the Company’s Status as a REIT\\nThe federal income tax laws governing REITs are complex.\\nThe Company intends to operate in a manner that will maintain its qualification as a REIT under the federal income tax laws. The REIT qualification requirements are extremely complex, however, and interpretations of the federal income tax laws governing qualification as a REIT are limited. The Company has not requested or obtained a ruling from the Internal Revenue Service, or the IRS, that it qualifies as a REIT. Accordingly, we cannot be certain that the Company will be successful in operating in a manner that will permit it to qualify as a REIT. At any time, new laws, interpretations or court decisions may change the federal tax laws or the federal income tax consequences of the Company’s qualification as a REIT. We cannot predict when or if any new federal income tax law, regulation or administrative interpretation, or any amendment to any existing federal income tax law, regulation or administrative interpretation, will be adopted, promulgated or become effective and any such law, regulation or interpretation may take effect retroactively. The Company and its stockholders could be adversely affected by any such change in, or any new, federal income tax law, regulation or administrative interpretation. We are not aware, however, of any pending tax legislation that would adversely affect the Company’s ability to qualify as a REIT.\\nFailure to make distributions could subject the Company to tax.\\nIn order to maintain its qualification as a REIT, each year the Company must pay out to its stockholders in distributions, as “qualifying distributions,” at least 90.0% of its REIT taxable income, computed without regard to the deductions for dividends paid and excluding net capital gains and reduced by certain non-cash items. To the extent that the Company satisfies this distribution requirement, but distributes less than 100.0% of its taxable income (including its net capital gain), it will be subject to federal corporate income tax on its undistributed taxable income. In addition, the Company will be subject to a 4.0% nondeductible excise tax if the actual amount that it pays out to its stockholders as a “qualifying distribution” for a calendar year is less than the sum of: (A) 85.0% of our ordinary income for such calendar year, plus (B) 95.0% of our capital gain net income for such calendar year. The Company’s only recurring source of funds to make these distributions comes from rent received from its TRS Lessees whose only recurring source of funds with which to make these payments and distributions is the net cash flow (after payment of operating and other costs and expenses and management fees) from hotel operations, and any dividend and other distributions that we may receive from MHI Holding. Accordingly, the Company may be required to borrow money or sell assets to make distributions sufficient to enable it to pay out enough of its taxable income to satisfy the distribution requirement and to avoid corporate income tax and the 4.0% nondeductible excise tax in a particular year.\\n26\\nFailure to qualify as a REIT would subject the Company to federal income tax.\\nIf the Company fails to qualify as a REIT in any taxable year, it will be required to pay federal income tax (including any applicable alternative minimum tax) on its taxable income at regular corporate rates. The resulting tax liability might cause the Company to borrow funds, liquidate some of its investments or take other steps that could negatively affect its operating results in order to pay any such tax. Unless it is entitled to relief under certain statutory provisions, the Company would be disqualified from treatment as a REIT for the four taxable years following the year in which it lost its qualification. If the Company lost its REIT status, its net earnings available for investment or distribution to stockholders would be significantly reduced for each of the years involved. In addition, the Company would no longer be required to make distributions to its stockholders, and it would not be able to deduct any stockholder distributions in computing its taxable income. This would substantially reduce the Company’s earnings, cash available to pay distributions, and the value of common stock.\\nFailure to qualify as a REIT may cause the Company to reduce or eliminate distributions to its stockholders, and the Company may face increased difficulty in raising capital or obtaining financing.\\nIf the Company fails to remain qualified as a REIT, it may have to reduce or eliminate any distributions to its stockholders in order to satisfy its income tax liabilities. Any distributions that the Company does make to its stockholders would be treated as taxable dividends to the extent of its current and accumulated earnings and profits. This may result in negative investor and market perception regarding the market value of the Company’s stock, and the value of its stock may be reduced. In addition, the Company and the Operating Partnership may face increased difficulty in raising capital or obtaining financing if the Company fails to qualify or remain qualified as a REIT because of the resulting tax liability and potential reduction of its market valuation.\\nIf MHI Holding exceeds certain value thresholds, this could cause the Company to fail to qualify as a REIT.\\nFor taxable years of the Company ending on or before December 31, 2017, at the end of each quarter of each taxable year of the Company, no more than 25.0% of the value of the Company’s total assets may consist of securities of one or more taxable REIT subsidiaries (“TRSs”). For taxable years of the Company ending after December 31, 2017, at the end of each quarter of each taxable year of the Company, no more than 20.0% of the value of the Company’s total assets may consist of securities of one or more TRSs. MHI Holding is a TRS and the Company may form other TRSs in the future. The Company plans to monitor the value of its shares of MHI Holding and of any other TRS the Company may form. However, there can be no assurance that the Internal Revenue Service will not attempt to attribute additional value to the shares of MHI Holding or to the shares of any other TRS that the Company may form. If the Company is treated as owning securities of one or more TRSs with an aggregate value that is in excess of the thresholds outlined above, the Company could lose its status as a REIT or become subject to penalties.\\nEven if the Company remains qualified as a REIT, it may face other tax liabilities that reduce its cash flow.\\nEven if the Company remains qualified for taxation as a REIT, it may be subject to certain federal, state and local taxes on its income and assets. For example:\\n| • | it will be required to pay tax on undistributed REIT taxable income (including net capital gain); |\\n\\n| • | it may be required to pay “alternative minimum tax” on its items of tax preference; |\\n\\n| • | if it has net income from the disposition of foreclosure property held primarily for sale to customers in the ordinary course of business or other non-qualifying income from foreclosure property, it must pay tax on that income at the highest corporate rate; |\\n\\n| • | if it (or the Operating Partnership or any subsidiary of the Operating Partnership other than MHI Holding) sells a property in a “prohibited transaction,” its gain, or its share of such gain, from the sale would be subject to a 100.0% penalty tax. A “prohibited transaction” would be a sale of property, other than a foreclosure property, held primarily for sale to customers in the ordinary course of business; |\\n\\n| • | MHI Holding is a fully taxable corporation and is required to pay federal and state taxes on its taxable income; and |\\n\\n| • | it may experience increases in its state and/or local income tax burdens as states and localities continue to look to modify their tax laws in order to raise revenues, including by (among other things) changing from a net taxable income-based regime to a gross receipts-based regime, suspending and/or limiting the use of net operating losses, increasing tax rates and fees, imposing surcharges and subjecting partnerships to an entity-level tax, and limiting or disallowing certain U.S. federal deductions such as the dividends-paid deduction. |\\n\\n27\\nComplying with REIT requirements may cause the Company to forgo attractive opportunities that could otherwise generate strong risk-adjusted returns and instead pursue less attractive opportunities, or none at all.\\nTo qualify as a REIT for federal income tax purposes, the Company must continually satisfy tests concerning, among other things, the sources of its income, the nature and diversification of its assets, the amounts it distributes to its stockholders and the ownership of its stock.\\nIn general, when applying these tests, the Company is treated as owning its proportionate share of the Operating Partnership’s assets (which share is determined in accordance with the Company’s capital interest in the Operating Partnership) and as being entitled to the Operating Partnership’s income attributable to such share. Thus, compliance with the REIT requirements may hinder our ability to operate solely on the basis of generating strong risk-adjusted returns on invested capital for our stockholders.\\nComplying with REIT requirements may force the Company to liquidate otherwise attractive investments, which could result in an overall loss on its investments.\\nTo maintain qualification as a REIT, the Company must ensure that at the end of each calendar quarter at least 75.0% of the value of its assets consists of cash, cash items, government securities and qualified REIT real estate assets. The remainder of the Company’s assets (other than securities of one or more taxable REIT subsidiaries) generally cannot include more than 10.0% of the outstanding voting securities of any one issuer or more than 10.0% of the total value of the outstanding securities of any one issuer. In addition, in general, no more than 5.0% of the value of the Company’s assets (other than government securities, qualified real estate assets and securities of one or more taxable REIT subsidiaries) can consist of the securities of any one issuer, and no more than 25.0% (20.0% for taxable years beginning after December 31, 2017) of the value of the Company’s total assets can be represented by securities of one or more taxable REIT subsidiaries.\\nWhen applying these asset tests, the Company is treated as owning its proportionate share of the Operating Partnership’s assets (which is determined in accordance with the Company’s capital interest in the Operating Partnership). If the Company fails to comply with these requirements at the end of any calendar quarter, it must correct such failure within 30 days after the end of the calendar quarter to avoid losing its REIT status and suffering adverse tax consequences. If the Company fails to comply with these requirements at the end of any calendar quarter, and the failure exceeds a de-minimis threshold, the Company may be able to preserve its REIT status if the failure was due to reasonable cause and not to willful neglect. In this case, we will be required to dispose of the assets causing the failure within six months after the last day of the quarter in which the failure occurred, and we will be required to pay an additional tax of the greater of $50,000 or the product of the highest applicable tax rate multiplied by the net income generated on those assets.\\nAs a result, we may be required to liquidate otherwise attractive investments.\\nIf the Operating Partnership fails to qualify as a partnership for federal income tax purposes, the Company could cease to qualify as a REIT and suffer other adverse consequences.\\nWe believe that the Operating Partnership will continue to qualify to be treated as a partnership for U.S. federal income tax purposes. As a partnership, the Operating Partnership is not subject to federal income tax on its income. Instead, each of its partners, including the Company, will be required to pay tax on its allocable share of the Operating Partnership’s income. We cannot assure you, however, that the IRS will not challenge the Operating Partnership’s status as a partnership for U.S. federal income tax purposes, or that a court would not sustain such a challenge. If the IRS were successful in treating the Operating Partnership as a corporation for federal income tax purposes, the Company could fail to meet the gross income tests and certain of the asset tests applicable to REITs and, accordingly, cease to qualify as a REIT. Also, the failure of the Operating Partnership to qualify as a partnership would cause the Operating Partnership to become subject to federal and state corporate income tax, which would reduce significantly the amount of cash available for debt service and for distribution to its partners, including the Company.\\nThe Company’s failure to qualify as a REIT would have serious adverse consequences to its stockholders.\\nThe Company elected to be taxed as a REIT under Sections 856 through 860 of the Code, commencing with its taxable year ended December 31, 2004. The Company believes it has operated so as to qualify as a REIT under the Code and believes that its current organization and method of operation comply with the rules and regulations promulgated under the Code to enable the Company to continue to qualify as a REIT. However, it is possible that the Company has been organized or has operated in a manner that would not allow it to qualify as a REIT, or that its future operations could cause it to fail to qualify. Qualification as a REIT requires the Company to satisfy numerous requirements (some on an annual and others on a quarterly basis) established under highly technical and complex sections of the Code for which there are only limited judicial and administrative interpretations, and involves the determination of various factual matters and circumstances not entirely within its control. For example, in order to qualify as a\\n28\\nREIT, the Company must satisfy a 75.0% gross income test pursuant to Code Section 856(c)(3) and a 95.0% gross income test pursuant to Code Section 856(c)(2) each taxable year. In addition, the Company must pay dividends, as “qualifying distributions,” to its stockholders aggregating annually at least 90.0% of its REIT taxable income (determined without regard to the dividends-paid deduction and by excluding capital gains, and reduced by certain non-cash items) and must satisfy specified asset tests on a quarterly basis. While historically the Company has satisfied the distribution requirement discussed above by making cash distributions to its stockholders, the Company may choose to satisfy this requirement by making distributions of cash or other property, including, in limited circumstances, its stock. The provisions of the Code and applicable Treasury regulations regarding qualification as a REIT are more complicated in the Company’s case because its holds its assets through the Operating Partnership.\\nIf MHI Holding does not qualify as a taxable REIT subsidiary, or if the Company’s hotel manager does not qualify as an “eligible independent contractor,” the Company would fail to qualify as a REIT and would be subject to higher taxes and have less cash available for distribution to its shareholders.\\nRent paid by a lessee that is a “related party tenant” of ours will not be qualifying income for purposes of the two gross income tests applicable to REITs. The Company currently leases substantially all of its hotels to the TRS Lessees, which are disregarded entities for U.S. federal income tax purposes and are wholly-owned by MHI Holding, a taxable REIT subsidiary, and expects to continue to do so. So long as MHI Holding qualifies as a taxable REIT subsidiary, it will not be treated as a “related party tenant” with respect to the Company’s properties that are managed by an independent hotel management company that qualifies as an “eligible independent contractor.” The Company believes that MHI Holding will continue to qualify to be treated as a taxable REIT subsidiary for federal income tax purposes, but there can be no assurance that the IRS will not challenge this status or that a court would not sustain such a challenge. If the IRS were successful in such challenge, it is possible that the Company would fail to meet the asset tests applicable to REITs and substantially all of its income would fail to be qualifying income for purposes of the two gross income tests. If the Company failed to meet any of the asset or gross income tests, it would likely lose its REIT qualification for federal income tax purposes.\\nAdditionally, if the Company’s hotel manager does not qualify as an “eligible independent contractor,” the Company would fail to qualify as a REIT. Each hotel manager that enters into a management contract with the TRS Lessees must qualify as an “eligible independent contractor” under the REIT rules in order for the rent paid by the TRS Lessees to be qualifying income for purposes of the REIT gross income tests. Among other requirements, in order to qualify as an eligible independent contractor, a hotel manager must not own, directly or through its shareholders, more than 35.0% of the Company’s outstanding shares, taking into account certain ownership attribution rules. The ownership attribution rules that apply for purposes of these 35.0% thresholds are complex. Although the Company intends to monitor ownership of its shares by its hotel manager and its owners, there can be no assurance that these ownership levels will not be exceeded.\\nForeign investors may be subject to U.S. tax on the disposition of the Company’s stock if the Company does not qualify as a “domestically controlled” REIT.\\nA foreign person disposing of a “U.S. real property interest,” which includes stock of a U.S. corporation whose assets consist principally of U.S. real property interests, is generally subject to U.S. federal income tax under the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) on the gain recognized on the disposition, unless such foreign person is a “qualified foreign pension fund” or one of the certain publicly traded non-U.S. “qualified collective investment vehicles”. Additionally, the transferee will be required to withhold 15.0% on the amount realized on the disposition if the foreign transferor is subject to U.S. federal income tax under FIRPTA. This 15.0% is creditable against the U.S. federal income tax liability of the foreign transferor in connection with such transferor’s disposition of the Company’s stock. FIRPTA does not apply, however, to the disposition of stock in a REIT if the REIT is “domestically controlled” (i.e., less than 50.0% of the REIT’s capital stock, by value, has been owned directly or indirectly by persons who are not qualifying U.S. persons during a continuous five-year period ending on the date of disposition or, if shorter, during the entire period of the REIT’s existence). We cannot be sure that the Company will qualify as a “domestically controlled” REIT. If the Company does not so qualify, gain realized by foreign investors on a sale of the Company’s stock would be subject to U.S. income and withholding tax under FIRPTA, unless the Company’s stock were traded on an established securities market and a foreign investor did not at any time during a specified testing period directly or indirectly own more than 10.0% of the value of the Company’s outstanding stock.\\nMHI Holding increases our overall tax liability.\\nOur TRS Lessees are single-member limited liability companies that are wholly-owned, directly or indirectly, by MHI Holding, a taxable REIT subsidiary that is wholly-owned by the Operating Partnership. Each of our TRS Lessees is disregarded as an entity separate from MHI Holding for U.S. federal income tax purposes, such that the assets, liabilities, income, gains, losses, credits and deductions of our TRS Lessees are treated as the assets, liabilities, income, gains, losses, credits and deductions of MHI Holding for U.S. federal income tax purposes. MHI Holding is subject to federal and state income tax on its taxable income, which will consist of\\n29\\nthe revenues from the hotels leased by the Company’s TRS Lessees, net of the operating expenses for such hotels and rent payments. Accordingly, although the Company’s ownership of MHI Holding and the TRS Lessees will allow it to participate in the operating income from its hotels in addition to receiving rent, that operating income will be fully subject to income tax. The after-tax net income of MHI Holding, if any, will be available for distribution to the Company.\\nThe Company will incur a 100.0% excise tax on its transactions with MHI Holding and the TRS Lessees that are not conducted on an arm’s-length basis. For example, to the extent that the rent paid by the TRS Lessees exceeds an arm’s-length rental amount, such amount potentially will be subject to this excise tax. The Company intends that all transactions among itself, MHI Holding and the TRS Lessees will be conducted on an arm’s-length basis and, therefore, that the rent paid by the TRS Lessees will not be subject to this excise tax.\\nOur ability to use net operating loss carryforwards to reduce future tax payments may be limited or restricted or may not exist at all, and if we do not sustain our profitability, we may be required to put up a valuation allowance against our deferred tax assets.\\nAt December 31, 2016, our financial statements reflected deferred tax assets totaling approximately $6.9 million, of which approximately $6.0 million relates to significant federal and state net operating losses (“NOLs”) generated by our TRS Lessee over the past three years. We are generally able to carry NOLs forward to reduce taxable income in future years. Our ability to use our NOLs to reduce future tax payments is dependent upon our ability to sustain profitability during the time period over which these NOLs may be used under applicable tax law. A valuation allowance is required for deferred tax assets if, based on all available evidence, it is “more-likely-than-not” (defined as a likelihood of more than 50%) that all or a portion of the deferred tax assets will not be realized due to the inability to generate sufficient taxable income in certain financial statement periods. The net amount of deferred tax assets that are recorded on the financial statements must reflect the tax benefits that are expected to be realized using these criteria. We perform this analysis by evaluating a number of factors, including a demonstrated track record of past profitability, reasonable forecasts of future taxable income, and anticipated changes in the lease rental payments from the TRS Lessee to subsidiaries of the Operating Partnership. At December 31, 2016, we determined based on all available positive and negative evidence that it is more-likely-than-not that future taxable income will be available during the carryforward periods to absorb all of the consolidated federal and state net operating loss carryforward. We made this determination considering reasonable tax strategies available to us capable of ensuring the realization of our deferred tax assets, anticipated changes in the lease rental payments and one time losses that generated some of our net operating losses. However, there is no assurance that the TRS Lessee will be able to achieve profitability. The TRS Lessee’s ability to generate sustained profitability in the amounts necessary to realize our deferred tax assets against future taxable income depends upon general economic and market conditions, interest rates, and the TRS Lessee’s ability to meet our strategic plans. If the TRS Lessee is unable to generate adequate sustained profitability, we may be required to record a valuation allowance against some or all of our deferred tax assets, which would negatively impact our financial results.\\nTaxation of dividend income could make the Company’s stock less attractive to investors and reduce the market price of its stock.\\nThe federal income tax laws governing REITs, or the administrative interpretations of those laws, may be amended at any time. Any new laws or interpretations may take effect retroactively and could adversely affect the Company or could adversely affect its stockholders. Currently, “qualified dividends,” which include dividends from domestic C corporations that are paid to non-corporate stockholders, are subject to a reduced maximum U.S. federal income tax rate of 20.0%. Because REITs generally do not pay corporate-level taxes as a result of the dividends-paid deduction to which they are entitled, dividends from REITs generally are not treated as qualified dividends and thus do not qualify for a reduced tax rate. Non-corporate investors could view an investment in non-REIT corporations as more attractive than an investment in REITs because the dividends they would receive from non-REIT corporations would be subject to lower tax rates.\\nInvestors may be subject to a 3.8% Medicare tax in connection with an investment in the Company’s stock or the 7% Notes.\\nThe U.S. tax laws impose a 3.8% “Medicare tax” on the “net investment income” (i.e., interest, dividends, capital gains, annuities, and rents that are not derived in the ordinary course of a trade or business) of individuals with income exceeding $200,000 ($250,000 if married filing jointly or $125,000 if married filing separately), and of estates and trusts. Dividends on the Company’s stock and interest on the 7% Notes as well as gains from the disposition of the Company’s stock or the 7% Notes may be subject to the Medicare tax. Prospective investors should consult with their independent advisors as to the applicability of the Medicare tax to an investment in the Company’s stock or the 7% Notes in light of such investors’ particular circumstances.\\n30\\nInvestors may be subject to U.S. withholding tax under the “Foreign Account Tax Compliance Act.”\\nOn March 18, 2010, the Hiring Incentives to Restore Employment Act, or the HIRE Act, was enacted in the United States. The HIRE Act includes provisions known as the Foreign Account Tax Compliance Act, or FATCA, that generally impose a 30.0% U.S. withholding tax on “withholdable payments,” which consist of (i) U.S.-source dividends, interest, rents and other “fixed or determinable annual or periodical income” paid after June 30, 2014 and (ii) certain U.S.-source gross proceeds paid after December 31, 2018 to (a) “foreign financial institutions” unless (x) they enter into an agreement with the IRS to collect and disclose to the IRS information regarding their direct and indirect U.S. owners or (y) they comply with the terms of any FATCA intergovernmental agreement executed between the authorities in their jurisdiction and the U.S., and (b) “non-financial foreign entities” (i.e., foreign entities that are not foreign financial institutions) unless they certify certain information regarding their direct and indirect U.S. owners. Final regulations under FATCA were issued by the IRS on January 17, 2013, and have been subsequently supplemented by additional regulations and guidance. FATCA does not replace the existing U.S. withholding tax regime. However, the FATCA regulations contain coordination provisions to avoid double withholding on U.S.-source income.\\nA foreign investor that receives dividends on the Company’s stock or gross proceeds from a disposition of shares of the Company’s stock may be subject to FATCA withholding tax with respect to such dividends or gross proceeds.\\nForeign investors will be subject to U.S. withholding tax on the receipt of ordinary dividends on the Company’s stock.\\nThe portion of dividends received by a foreign investor payable out of the Company’s current and accumulated earnings and profits which are not attributable to capital gains and which are not effectively connected with a U.S. trade or business of the foreign investor will generally be subject to U.S. withholding tax at a statutory rate of 30.0%. This 30.0% withholding tax may be reduced by an applicable income tax treaty. The FATCA and nonresident withholding regulations are complex. Even if the 30.0% withholding is reduced or eliminated by treaty for payments made to a foreign investor, FATCA withholding of 30.0% could apply depending upon the foreign investor’s FATCA status. Foreign investors should consult with their independent advisors as to the U.S. withholding tax consequences to such investors with respect to their investment in the Company’s stock in light of their particular circumstances, as well as determining the appropriate documentation required to reduce or eliminate U.S. withholding tax.\\nForeign investors will be subject to U.S. income tax on the receipt of capital gain dividends on the Company’s stock.\\nUnder FIRPTA, distributions that we make to a foreign investor that are attributable to gains from our dispositions of U.S. real property interests (“capital gain dividends”) will be treated as income that is effectively connected with a U.S. trade or business, and therefore subject to U.S. federal income tax, in the hands of the foreign investor, unless such foreign person is a “qualified foreign pension fund” or one of certain publicly traded non-U.S. “qualified collective investment vehicles”. A foreign investor who is subject to tax under FIRPTA will be subject to U.S. federal income tax (at the rates applicable to U.S. investors) on any capital gain dividends, and will also be required to file U.S. federal income tax returns to report such capital gain dividends. Furthermore, capital gain dividends are subject to an additional 30.0% “branch profits tax” (which may be reduced by an applicable income tax treaty) in the hands of a foreign investor who is subject to tax under FIRPTA if such foreign investor is treated as a corporation for U.S. federal income tax purposes.\\nLegislative or regulatory action could adversely affect you.\\nBecause our operations are governed to a significant extent by the federal tax laws, new legislative or regulatory action could adversely affect our investors. You are strongly encouraged to consult with your own tax advisor with respect to the status of any legislative, regulatory or administrative developments, announcements and proposals and their potential impact on your investment in the Company’s stock.\\n\\nUnresolved Staff Comments\\nNot applicable.\\n31\\n\\nItem 2.\\nP\\nroperties\\nAs of December 31, 2016, our portfolio consisted of the following properties (see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Key Operating Metrics, for definitions of Occupancy, ADR, and RevPAR):\\n\\n| Number of | Occupancy | ADR | RevPAR | Occupancy | ADR | RevPAR | Occupancy | ADR | RevPAR |\\n| Wholly-Owned Properties | Rooms | 2016 | 2016 | 2016 | 2015 | 2015 | 2015 | 2014 | 2014 | 2014 |\\n| Crowne Plaza Hampton Marina, Hampton, Virginia (1) | 173 | 55.2 | % | $ | 96.81 | $ | 53.40 | 55.2 | % | $ | 93.59 | $ | 51.64 | 50.8 | % | $ | 93.17 | $ | 48.27 |\\n| Crowne Plaza Hollywood Beach Resort, Hollywood, Florida (2) | 311 | 79.6 | % | $ | 170.57 | $ | 135.74 | 83.1 | % | $ | 174.35 | $ | 144.86 | 83.1 | % | $ | 163.13 | $ | 135.55 |\\n| Crowne Plaza Tampa Westshore, Tampa, Florida | 222 | 74.6 | % | $ | 116.15 | $ | 86.69 | 72.5 | % | $ | 111.08 | $ | 80.53 | 72.5 | % | $ | 104.90 | $ | 76.09 |\\n| DoubleTree by Hilton Jacksonville Riverfront, Jacksonville, Florida | 293 | 77.4 | % | $ | 126.67 | $ | 98.06 | 67.4 | % | $ | 109.20 | $ | 73.60 | 65.8 | % | $ | 99.20 | $ | 65.24 |\\n| DoubleTree by Hilton Laurel, Laurel, Maryland | 208 | 60.5 | % | $ | 104.35 | $ | 63.16 | 48.2 | % | $ | 95.19 | $ | 45.86 | 60.8 | % | $ | 89.08 | $ | 54.19 |\\n| DoubleTree by Hilton Philadelphia Airport, Philadelphia, Pennsylvania | 331 | 77.0 | % | $ | 144.92 | $ | 111.66 | 79.3 | % | $ | 136.32 | $ | 108.13 | 75.9 | % | $ | 133.78 | $ | 101.58 |\\n| DoubleTree by Hilton Raleigh Brownstone – University, Raleigh, North Carolina | 190 | 70.0 | % | $ | 134.74 | $ | 94.33 | 71.5 | % | $ | 131.61 | $ | 94.16 | 73.4 | % | $ | 122.60 | $ | 90.04 |\\n| Georgian Terrace, Atlanta, Georgia (3) | 326 | 70.8 | % | $ | 160.89 | $ | 113.88 | 69.9 | % | $ | 155.56 | $ | 108.70 | 76.2 | % | $ | 137.65 | $ | 104.88 |\\n| Hilton Savannah DeSoto, Savannah, Georgia | 246 | 71.5 | % | $ | 155.87 | $ | 111.48 | 76.9 | % | $ | 154.52 | $ | 118.89 | 75.7 | % | $ | 146.75 | $ | 111.14 |\\n| Hilton Wilmington Riverside, Wilmington, North Carolina | 272 | 70.5 | % | $ | 147.14 | $ | 103.72 | 71.6 | % | $ | 138.36 | $ | 99.07 | 69.7 | % | $ | 139.09 | $ | 96.90 |\\n| Sheraton Louisville Riverside, Jeffersonville, Indiana | 180 | 63.1 | % | $ | 137.34 | $ | 86.60 | 69.5 | % | $ | 131.74 | $ | 111.87 | 66.8 | % | $ | 150.20 | $ | 100.31 |\\n| The Whitehall, Houston, Texas | 259 | 54.4 | % | $ | 140.70 | $ | 76.56 | 70.9 | % | $ | 142.05 | $ | 100.66 | 76.1 | % | $ | 138.93 | $ | 105.66 |\\n| Total | 3,011 |\\n\\n\\n| (1) | On February 7, 2017, the Company sold the Crowne Plaza Hampton Marina. |\\n\\n| (2) | The operating statistics for the Crowne Plaza Hollywood Beach Resort rely on information from both the period prior to, and the period subsequent to, the Company’s acquisition of the hotel. |\\n\\n| (3) | The operating statistics for the Georgian Terrace rely on information from both the period prior to, and the period subsequent to, the Company’s acquisition of the hotel. |\\n\\n\\nLegal Proceedings\\nWe are not involved in any material litigation, nor to our knowledge, is any material litigation threatened against us. We have settled, during the period covered by this report, all significant claims made during the same period. We are involved in routine litigation arising out of the ordinary course of business, all of which is expected to be covered by insurance, and none of which is expected to have a material impact on our financial condition or results of operations.\\nMine Safety Disclosure\\nNot applicable.\\n32\\nPART II\\nMarket for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities\\nSotherly Hotels Inc.\\nMarket Information\\nThe Company’s common stock trades on the NASDAQ ® Global Market under the symbol “SOHO”. The following table sets forth, for the indicated period, the intraday high and low prices for the common stock, as reported on NASDAQ ®:\\n\\n| Price Range |\\n| High | Low |\\n| Year Ended December 31, 2016 |\\n| First Quarter | $ | 6.59 | $ | 4.59 |\\n| Second Quarter | $ | 5.99 | $ | 5.00 |\\n| Third Quarter | $ | 6.35 | $ | 5.22 |\\n| Fourth Quarter | $ | 7.11 | $ | 4.65 |\\n| Year Ended December 31, 2015 |\\n| First Quarter | $ | 7.87 | $ | 6.26 |\\n| Second Quarter | $ | 8.71 | $ | 6.94 |\\n| Third Quarter | $ | 7.63 | $ | 5.83 |\\n| Fourth Quarter | $ | 6.94 | $ | 4.50 |\\n\\nThe closing price of the Company’s common stock on the NASDAQ ® Global Market on March 1, 2017 was $6.97 per share.\\nStockholder Information\\nAs of March 1, 2017, there were 80 holders of record of the Company’s common stock and as of March 1, 2017, there were approximately 3,772 beneficial owners of the Company’s common stock.\\nIn order to comply with certain requirements related to the Company’s qualification as a REIT, the Company’s charter, subject to certain exceptions, limits the number of common shares that may be owned by any single person or affiliated group to 9.9% of the outstanding common shares.\\nRecent Sales of Unregistered Securities\\nOn February 1, 2016, two holders of units in the Operating Partnership redeemed a total of 422,687 units for an equivalent number of shares of the Company’s common stock. The shares of common stock were issued to the unitholder pursuant to an exemption from registration under Section 4(2) of the Securities Act of 1933, as amended.\\nOn December 2, 2016, the Company’s Board of Directors authorized a stock repurchase program under which the Company may purchase up to $10.0 million of its outstanding common stock, par value $0.01 per share, at prevailing prices on the open market or in privately negotiated transactions, at the discretion of management. The Company has used and expects to continue to use available working capital to fund purchases under the stock repurchase program and intends to complete the repurchase program prior to December 31, 2017, unless extended by the Board of Directors. Through December 31, 2016 the Company repurchased the following amounts of common stock and the repurchased shares have been returned to the status of authorized but unissued shares of common stock:\\n\\n| Period | Total Number of Shares Repurchased | Average Price Paid Per Share | Total Number of Shares Purchased As Part of PubliclyAnnounced Program | Maximum Number (or Approximate Dollar Value) of Shares ThatMay Yet Be Purchased Under the Program |\\n| December 1- December 31, 2016 | 481,100 | $ | 6.53 | 481,100 | $ | 6,835,464 |\\n\\n33\\nUse of Proceeds from Registered Securities\\nOn August 23, 2016, the Company sold 1,610,000 shares, $0.01 par value per share, of its 8% Series B Cumulative Redeemable Perpetual Preferred Stock pursuant to a registration statement on Form S-3 (file no. 333-199256) for net proceeds after all expenses of approximately $37.8 million, which it contributed to the Operating Partnership for an equivalent number of preferred partnership units. The Operating Partnership used the net proceeds to redeem the entire $27.6 million aggregate principal amount of its outstanding 8.0% senior unsecured notes (the “8% Notes”), to acquire the commercial condominium unit and related inventories of the Hyde Resort & Residences for approximately $4.8 million, and will use the remainder of the proceeds for general corporate purposes.\\nSotherly Hotels LP\\nMarket Information\\nThere is no established trading market for partnership units of the Operating Partnership. The Operating Partnership does not currently propose to offer partnership units to the public, and does not currently expect that a public market for those units will develop.\\nPartnership Unitholder Information\\nAs of March 1, 2017, there were 12 holders of the Operating Partnership’s partnership units, including Sotherly Hotels Inc.\\nRecent Sales of Unregistered Securities\\nFrom time to time, the Operating Partnership issues limited partnership units (common and/or preferred) to the Company, as required by the Amended and Restated Agreement of Limited Partnership of the Operating Partnership, to mirror the capital structure of the Company to reflect additional issuances by the Company and to preserve equitable ownership ratios.\\nThere were no sales of unregistered securities in the Operating Partnership during 2016.\\nUse of Proceeds from Registered Securities\\nThere were no sales of registered securities in the Operating Partnership during 2016.\\nSotherly Hotels Inc. and Sotherly Hotels LP\\nDividend and Distribution Information\\nThe Company elected to be taxed as a REIT commencing with our taxable year ending December 31, 2004. To maintain qualification as a REIT, we are required to make annual distributions to the Company’s stockholders of at least 90.0% of our REIT taxable income, excluding net capital gain, which does not necessarily equal net income as calculated in accordance with generally accepted accounting principles. Our ability to pay distributions to the Company’s stockholders will depend, in part, upon our receipt of distributions from our Operating Partnership which may depend upon receipt of lease payments with respect to our properties from our TRS Lessees, and in turn, upon the management of our properties by our hotel manager. Distributions to the Company’s stockholders will generally be taxable to the Company’s stockholders as ordinary income; however, because a portion of our investments will be equity ownership interests in hotels, which will result in depreciation and non-cash charges against our income, a portion of our distributions may constitute a tax-free return of capital. To the extent not inconsistent with maintaining our REIT status, our TRS Lessees may retain any after-tax earnings.\\nIn order to maintain our qualification as a REIT, we must make distributions to our stockholders each year in an amount equal to at least:\\n| • | 90% of our REIT taxable income determined without regard to the dividends paid deduction and excluding net capital gains; plus |\\n\\n| • | 90% of the excess of our net income from foreclosure property over the tax imposed on such income by the Code; minus |\\n\\n| • | Any excess noncash income (as defined in the Code). |\\n\\n34\\nThe following tables set forth information regarding the declaration, payment and income tax characterization of distributions by the Company on its common and preferred shares to Company’s stockholders for fiscal year 2015 to 2016. The same table sets forth the Operating Partnership’s distributions per common and preferred partnership units for fiscal year 2015 to 2016:\\n\\n| Dividend (Distribution) Payments - Common |\\n| Date Declared | For the Quarter Ended | Date Paid | Amount per Share and Unit | Ordinary Income | Return of Capital |\\n| January 2015 | March 31, 2015 | April 10, 2015 | $ | 0.070 | 82.6% | 17.4% |\\n| April 2015 | June 30, 2015 | July 10, 2015 | $ | 0.075 | 82.6% | 17.4% |\\n| July 2015 | September 30, 2015 | October 9, 2015 | $ | 0.080 | 82.6% | 17.4% |\\n| October 2015 | December 31, 2015 | January 11, 2016 | $ | 0.080 | 82.6% | 17.4% |\\n| January 2016 | March 31, 2016 | April 11, 2016 | $ | 0.085 | 73.5% | 26.5% |\\n| April 2016 | June 30, 2016 | July 11, 2016 | $ | 0.090 | 73.5% | 26.5% |\\n| July 2016 | September 30, 2016 | October 11, 2016 | $ | 0.095 | 73.5% | 26.5% |\\n| October 2016 | December 31, 2016 | January 11, 2017 | $ | 0.095 | 73.5% | 26.5% |\\n\\n\\n| Dividend (Distribution) Payments - Preferred |\\n| Date Declared | For the Quarter Ended | Date Paid | Amount per Share and Unit | Ordinary Income | Return of Capital |\\n| August 2016 | September 30, 2016 | October 17, 2016 | $ | 0.2111 | 73.5% | 26.5% |\\n| October 2016 | December 31, 2016 | January 17, 2017 | $ | 0.500 | 73.5% | 26.5% |\\n\\nThe amount of future common stock distributions will be based upon quarterly operating results, general economic conditions, requirements for capital improvements, the availability of debt and equity capital, the Code’s annual distribution requirements, and other factors, which the Company’s board of directors deems relevant. The amount, timing and frequency of distributions will be authorized by the Company’s board of directors and declared by us based upon a variety of factors deemed relevant by our directors, and no assurance can be given that our distribution policy will not change in the future.\\n\\nSelected Financial Data\\nThe following table sets forth selected historical financial data for Sotherly Hotels Inc. and Sotherly Hotels LP for the years ended December 31, 2016, 2015, 2014, 2013, and 2012. The financial results for the Crowne Plaza Hollywood Beach Resort, in which we had a 25.0% indirect interest, are not consolidated through July 31, 2015, as we accounted for our investment under the equity method of accounting. However, from August 1, 2015 through December 31, 2015 we did consolidate the financial results for the Crowne Plaza Hollywood Beach Resort, as a result of our acquisition of the remaining 75.0% interest in the hotel. The following selected historical financial data was derived from audited consolidated financial statements contained elsewhere in this Annual Report on Form 10-K and in prior filings. The Company’s financial statements: for the year ended December 31, 2016, have been audited by Dixon Hughes Goodman LLP; for the years ended December 31, 2015 and 2014, have been audited by Grant Thornton LLP; and for the years ended December 31, 2013 and 2012, have been audited by PBMares, LLP (formerly Witt Mares, PLC), our independent registered public accounting firms, for such periods. The audited historical financial statements include reclassifications and all adjustments, consisting of normal recurring adjustments, which we consider necessary for a fair presentation of our financial condition and the results of operations as of those dates and for those periods under accounting principles generally accepted in the United States of America.\\nThe information presented below is only a summary and does not provide all of the information contained in our consolidated financial statements, including notes thereto, and should be read together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K.\\n35\\nSOTHERLY HOTELS INC.\\nSOTHERLY HOTELS LP\\nSELECTED HISTORICAL FINANCIAL DATA\\n\\n| Year Ended | Year Ended | Year Ended | Year Ended | Year Ended |\\n| December 31, | December 31, | December 31, | December 31, | December 31, |\\n| 2016 | 2015 | 2014 | 2013 | 2012 |\\n| Statement of Operations |\\n| Total Revenues | $ | 152,845,752 | $ | 138,533,476 | $ | 122,939,919 | $ | 89,374,527 | $ | 87,343,220 |\\n| Total Operating Expenses excluding Depreciation, Amortization, Disposal Gain and Impairment of Investments in Hotel Properties, net | (118,854,236 | ) | (109,153,366 | ) | (95,290,304 | ) | (69,888,820 | ) | (68,519,401 | ) |\\n| Depreciation, Amortization, Disposal Gain and Impairment of Investments in Hotel Properties, net | (15,384,390 | ) | (14,050,060 | ) | (15,144,284 | ) | (9,078,228 | ) | (8,661,769 | ) |\\n| Net Operating Income | 18,607,126 | 15,330,050 | 12,505,331 | 10,407,479 | 10,162,050 |\\n| Interest Income | 115,785 | 50,461 | 19,865 | 17,914 | 16,158 |\\n| Interest Expense | (17,735,107 | ) | (16,515,827 | ) | (14,636,870 | ) | (9,606,479 | ) | (10,399,962 | ) |\\n| Other Income (Expense) – net | (1,455,289 | ) | 6,196,936 | (354,558 | ) | (3,796,410 | ) | (3,941,594 | ) |\\n| Income Tax Benefit (Provision) | 1,367,634 | 1,336,033 | 1,727,723 | (1,496,096 | ) | (1,246,397 | ) |\\n| Net Income (Loss) | 900,149 | 6,397,653 | (738,509 | ) | (4,473,592 | ) | (5,409,745 | ) |\\n| Net (Income) Loss Attributable to Noncontrolling Interest | 26,567 | (1,040,987 | ) | 153,838 | 989,623 | 1,241,868 |\\n| Net Income (Loss) Attributable to the Company | 926,716 | 5,356,666 | (584,671 | ) | (3,483,969 | ) | (4,167,877 | ) |\\n| Distributions to Preferred Stockholders | (1,144,889 | ) | — | — | — | — |\\n| Net Income/(Loss) Attributable to Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) | $ | (3,483,969 | ) | $ | (4,167,877 | ) |\\n| Statement of Cash Flows |\\n| Cash provided by Operations – net | $ | 17,139,409 | $ | 11,377,374 | $ | 14,851,255 | $ | 9,594,751 | $ | 9,011,957 |\\n| Cash used in Investing – net | (12,940,766 | ) | (41,132,602 | ) | (71,096,578 | ) | (29,527,589 | ) | (3,156,121 | ) |\\n| Cash provided by (used in) Financing – net | 16,074,218 | 24,614,643 | 63,503,194 | 22,133,750 | (3,090,079 | ) |\\n| Net Increase (Decrease) in Cash and Cash Equivalents | $ | 20,272,861 | $ | (5,140,585 | ) | $ | 7,257,871 | $ | 2,200,912 | $ | 2,765,757 |\\n| Balance Sheet |\\n| Investments in Hotel Properties, Net | $ | 348,593,912 | $ | 354,963,242 | $ | 260,192,153 | $ | 202,645,633 | $ | 176,427,904 |\\n| Investment in Hotel Properties Held for Sale, Net | 5,333,000 | — | — | — | — |\\n| Total Assets (1) | 406,019,564 | 393,058,353 | 299,820,043 | 228,169,081 | 204,223,074 |\\n| Mortgage Loans | 282,708,289 | 271,977,944 | 205,291,657 | 160,363,549 | 135,674,432 |\\n| Unsecured Notes | 24,308,713 | 52,900,000 | 52,900,000 | 27,600,000 | — |\\n| Redeemable Preferred Stock | — | — | — | — | 14,227,650 |\\n| Total Liabilities | 324,680,276 | 340,199,985 | 272,310,186 | 197,314,286 | 167,179,121 |\\n| Noncontrolling Interest (1) | 2,329,175 | 3,855,237 | 4,132,662 | 5,669,386 | 7,322,314 |\\n| Total Sotherly Hotels Inc. Stockholders’ Equity (1) | $ | 79,010,113 | $ | 49,003,131 | $ | 23,377,195 | $ | 25,185,409 | $ | 29,721,639 |\\n| Operating Data |\\n| Average Number of Available Rooms | 3,011 | 2,828 | 2,622 | 2,148 | 2,113 |\\n| Total Number of Available Room Nights | 1,102,026 | 1,032,353 | 957,060 | 783,936 | 773,358 |\\n| Occupancy Percentage (2) | 69.8 | % | 69.9 | % | 70.3 | % | 67.4 | % | 68.9 | % |\\n| Average Daily Rate (ADR) (2) | $ | 140.63 | $ | 134.21 | $ | 125.77 | $ | 118.91 | $ | 114.22 |\\n| RevPAR (2) | $ | 98.18 | $ | 93.80 | $ | 88.42 | $ | 80.16 | $ | 78.65 |\\n| Additional Financial Data |\\n| FFO (3) | $ | 15,139,650 | $ | 14,103,844 | $ | 14,765,677 | $ | 5,150,303 | $ | 3,842,699 |\\n| Adjusted FFO (3) | 15,100,188 | 14,904,608 | 14,142,080 | 10,766,147 | 9,218,032 |\\n| Hotel EBITDA (4) | 40,012,581 | 36,447,390 | 32,084,957 | 23,220,515 | 22,296,938 |\\n| Income (Loss) Per Basic Share | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) | $ | (0.34 | ) | $ | (0.42 | ) |\\n\\n\\n| (1) | As of the period end. |\\n\\n| (2) | Occupancy Percent is calculated by dividing the total daily number of rooms sold by the total daily number of rooms available. ADR is calculated by dividing the total daily room revenue by the total daily number of rooms sold. RevPAR is calculated by dividing the total daily room revenue by the total daily number of rooms available. |\\n\\n36\\n\\n| (3) | Industry analysts and investors use Funds from Operations (“FFO”) as a supplemental operating performance measure of an equity REIT. FFO is calculated in accordance with the definition adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). FFO, as defined by NAREIT, represents net income or loss determined in accordance with generally accepted accounting principles (“GAAP”), excluding extraordinary items as defined under GAAP and gains or losses from sales of previously depreciated operating real estate assets, plus certain non-cash items such as real estate asset depreciation and amortization, and after adjustment for any noncontrolling interest from unconsolidated partnerships and joint ventures. |\\n\\nAdjusted FFO accounts for certain additional items that are not in NAREIT’s definition of FFO, including changes in deferred income taxes, any unrealized gain (loss) on its hedging instruments or warrant derivative, loan impairment losses, losses on early extinguishment of debt, aborted offering costs, franchise termination costs, loan modification fees, costs associated with the departure of executive officers, litigation settlement, over-assessed real estate taxes on appeal, change in control gains or losses and acquisition transaction costs.\\n| (4) | Hotel EBITDA represents the portion of net income or loss excluding: (1) interest expense, (2) interest income, (3) income tax provision or benefit, (4) equity in the income or loss of equity investees, (5) unrealized gains and losses on derivative instruments not included in other comprehensive income, (6) gains and losses on disposal of assets, (7) realized gains and losses on investments, (8) impairment of long-lived assets or investments, (9) loss on early debt extinguishment, (10) gains or losses on change in control, (11) corporate general and administrative expense, (12) depreciation and amortization, (13) gains and losses on involuntary conversions of assets and (14) other operating revenue not related to our wholly-owned portfolio. |\\n\\nThe following is a reconciliation of net loss to FFO and Adjusted FFO for the years ended December 31, 2016, 2015, 2014, 2013, and 2012.\\n\\n| Year Ended | Year Ended | Year Ended | Year Ended | Year Ended |\\n| December 31, | December 31, | December 31, | December 31, | December 31, |\\n| 2016 | 2015 | 2014 | 2013 | 2012 |\\n| Net Income/(Loss) Attributable to the Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) | $ | (3,483,969 | ) | $ | (4,186,709 | ) |\\n| Add: Net Income (Loss) Attributable to the Noncontrolling Interest | (26,567 | ) | 1,040,987 | (153,838 | ) | (989,623 | ) | (1,223,036 | ) |\\n| Depreciation and Amortization | 15,019,071 | 13,591,495 | 11,969,284 | 8,467,228 | 8,661,769 |\\n| Equity in Depreciation and Amortization of Joint Venture | — | 259,279 | 529,053 | 545,667 | 590,675 |\\n| Impairment of Investment in Hotel Properties, Net | — | 500,000 | 3,175,000 | 611,000 | — |\\n| Gain on Change in Control | — | (6,603,148 | ) | — | — | — |\\n| Gain on Involuntary Conversion of Asset | — | — | (169,151 | ) | — | — |\\n| Loss (Gain) on Asset Disposal | 365,319 | (41,435 | ) | — | — | — |\\n| Funds From Operations | $ | 15,139,650 | $ | 14,103,844 | $ | 14,765,677 | $ | 5,150,303 | $ | 3,842,699 |\\n| (Increase) Decrease in Deferred Income Taxes | (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) | 1,370,189 | 1,241,848 |\\n| Acquisition Costs | — | 634,376 | 155,187 | 89,743 | — |\\n| Loss on Starwood Settlement | — | 324,271 | — | — | — |\\n| Over-Assessed Real Estate Taxes Under Appeal | — | 497,733 | — | — | — |\\n| Loan Modification Fees | 64,215 | 243,229 | — | — | — |\\n| Franchise Termination Fee | — | — | 351,800 | — | — |\\n| Realized and Unrealized (Gain) Loss on Hedging Activities (A) | 37,384 | 108,819 | — | (89,998 | ) | 13,752 |\\n| Realized and Unrealized Loss on Warrant Derivative | — | — | — | 2,205,248 | 2,026,677 |\\n| Impairment of Note Receivable | — | — | — | — | 110,871 |\\n| Loss on Early Debt Extinguishment (A) | 1,417,905 | 772,907 | 831,079 | 2,040,662 | 1,982,184 |\\n| Adjusted FFO | $ | 15,100,188 | $ | 14,904,608 | $ | 14,142,080 | $ | 10,766,147 | $ | 9,218,031 |\\n\\n\\n| (A) | Includes equity in unrealized (gain)/loss on hedging activities and loss on early extinguishment of debt of joint venture. |\\n\\n37\\nThe following is a reconciliation of net income/(loss) to Hotel EBITDA for the years ended December 31, 2016, 2015, 2014, 2013, and 2012.\\n\\n| Year Ended | Year Ended | Year Ended | Year Ended | Year Ended |\\n| December 31, | December 31, | December 31, | December 31, | December 31, |\\n| 2016 | 2015 | 2014 | 2013 | 2012 |\\n| Net Income/(Loss) Attributable to the Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) | $ | (3,483,969 | ) | $ | (4,186,709 | ) |\\n| Add: Net Income (Loss) Attributable to the Noncontrolling Interest | (26,567 | ) | 1,040,987 | (153,838 | ) | (989,623 | ) | (1,223,036 | ) |\\n| Interest Expense | 17,735,107 | 16,515,827 | 14,636,870 | 9,606,479 | 10,399,962 |\\n| Interest Income | (115,785 | ) | (50,461 | ) | (19,865 | ) | (17,914 | ) | (16,158 | ) |\\n| Distributions to Preferred Stockholders | 1,144,889 | — | — | — | — |\\n| Income Tax Provision (Benefit) | (1,367,634 | ) | (1,336,033 | ) | (1,727,723 | ) | 1,496,096 | 1,246,397 |\\n| Depreciation and Amortization | 15,019,071 | 13,591,495 | 11,969,284 | 8,467,228 | 8,661,769 |\\n| Equity in (Earnings) Loss of Joint Venture | — | (475,514 | ) | (307,370 | ) | (449,500 | ) | (178,138 | ) |\\n| Loss (Gain) on Asset Disposal | 365,319 | (41,435 | ) | — | — | — |\\n| Gain on Involuntary Conversion of Asset | — | — | (169,151 | ) | — | — |\\n| Realized and Unrealized Loss (Gain) on Hedging Activities | 37,384 | 108,819 | — | — | — |\\n| Realized and Unrealized Loss on Warrant Derivative | — | — | — | 2,205,248 | 2,026,677 |\\n| Loss on Early Debt Extinguishment | 1,417,905 | 772,907 | 831,079 | 2,040,662 | 1,982,184 |\\n| Impairment of Investment in Hotel Properties, Net | — | 500,000 | 3,175,000 | 611,000 | — |\\n| Impairment of Note Receivable | — | — | — | — | 110,871 |\\n| Corporate General and Administrative Expenses | 6,021,065 | 7,268,256 | 5,085,949 | 4,360,582 | 4,078,826 |\\n| Gain on Change in Control | — | (6,603,148 | ) | — | — | — |\\n| Net Lease Rental Income | — | — | (350,000 | ) | (350,000 | ) | (350,000 | ) |\\n| Other Fee Income | — | (200,976 | ) | (300,607 | ) | (275,774 | ) | (255,707 | ) |\\n| Hotel EBITDA | $ | 40,012,581 | $ | 36,447,390 | $ | 32,084,957 | $ | 23,220,515 | $ | 22,296,938 |\\n\\n38\\n\\nItem 7.\\nManagement’s Discussion and Analysis of\\nFinancial Condition and Results of Operations\\nOverview\\nThe Company is a self-managed and self-administered lodging REIT incorporated in Maryland in August 2004 to pursue opportunities in the full-service, primarily upscale and upper-upscale segments of the hotel industry located in primary and secondary markets in the mid-Atlantic and southern United States. We commenced operations in December 2004 when the Company completed its initial public offering and thereafter consummated the acquisition of six initial hotel properties. Since the Company’s initial public offering, we have engaged in the following acquisitions and dispositions:\\n| • | On July 22, 2005, we acquired the Crowne Plaza Jacksonville Riverfront (formerly, the Hilton Jacksonville Riverfront). During September 2015, after extensive renovations, we re-branded and renamed the hotel the DoubleTree by Hilton Jacksonville Riverfront. |\\n\\n| • | On August 10, 2006, we sold the Holiday Inn Downtown Williamsburg. |\\n\\n| • | On September 20, 2006, we acquired the Louisville Ramada Riverfront Inn, which went through an extensive renovation and re-opened in May 2008 as the Sheraton Riverside Louisville. |\\n\\n| • | On August 8, 2007, through our joint venture with Carlyle, we acquired a 25.0% indirect noncontrolling interest in the Crowne Plaza Hollywood Beach Resort, a newly renovated 311-room hotel in Hollywood, Florida. |\\n\\n| • | On October 29, 2007, we acquired a hotel in Tampa, Florida, formerly known as the Tampa Clarion Hotel, which went through an extensive renovation and re-opened in March 2009 as the Crowne Plaza Tampa Westshore. |\\n\\n| • | On April 24, 2008, we acquired the Hampton Marina Hotel in Hampton, Virginia, which has been renovated and was converted to the Crowne Plaza Hampton Marina in October 2008. |\\n\\n| • | On November 13, 2013, we acquired the Crowne Plaza Houston Downtown in Houston, Texas. |\\n\\n| • | On March 27, 2014, we acquired the Georgian Terrace in Atlanta, Georgia. |\\n\\n| • | On July 31, 2015, we acquired the remaining 75.0% interest in (i) the entity that owns the Crowne Plaza Hollywood Beach Resort, and (ii) the entity that leases the Crowne Plaza Hollywood Beach Resort. As a result, the Operating Partnership now has a 100% indirect ownership interest in the entities that own the Crowne Plaza Hollywood Beach Resort. |\\n\\n| • | On January 30, 2017, we closed on the purchase of the hotel commercial unit of the Hyde Resort & Residences, a 400-unit condominium-hotel located in the Hollywood, Florida market. |\\n\\n| • | On February 7, 2017, we closed on the sale of the Crowne Plaza Hampton Marina. |\\n\\n39\\nAs of December 31, 2016, our hotel portfolio consisted of twelve full-service, primarily upscale and upper-upscale hotels with 3,011 rooms, ten of which operate under well-known brands such as Hilton, Crowne Plaza, DoubleTree and Sheraton, and two of which are independent hotels. Following the sale of the Crowne Plaza Hampton Marina on February 7, 2017, our portfolio consisted of eleven wholly-owned hotels with a total of 2,838 rooms, as well as our interests in the Hyde Resort & Residences. As of December 31, 2016, we owned the following hotel properties:\\n\\n| Number |\\n| Property | of Rooms | Location | Date of Acquisition | Chain Designation |\\n| Wholly-owned |\\n| Crowne Plaza Hampton Marina (1) | 173 | Hampton, VA | April 24, 2008 | Upscale |\\n| Crowne Plaza Hollywood Beach Resort | 311 | Hollywood, FL | August 9, 2007 | Upscale |\\n| Crowne Plaza Tampa Westshore | 222 | Tampa, FL | October 29, 2007 | Upscale |\\n| DoubleTree by Hilton Jacksonville Riverfront | 293 | Jacksonville, FL | July 22, 2005 | Upscale |\\n| DoubleTree by Hilton Laurel | 208 | Laurel, MD | December 21, 2004 | Upscale |\\n| DoubleTree by Hilton Philadelphia Airport | 331 | Philadelphia, PA | December 21, 2004 | Upscale |\\n| DoubleTree by Hilton Raleigh Brownstone-University | 190 | Raleigh, NC | December 21, 2004 | Upscale |\\n| The Georgian Terrace | 326 | Atlanta, GA | March 27, 2014 | Independent(2) |\\n| Hilton Savannah DeSoto | 246 | Savannah, GA | December 21, 2004 | Upper Upscale |\\n| Hilton Wilmington Riverside | 272 | Wilmington, NC | December 21, 2004 | Upper Upscale |\\n| Sheraton Louisville Riverside | 180 | Jeffersonville, IN | September 20, 2006 | Upper Upscale |\\n| The Whitehall | 259 | Houston, TX | November 13, 2013 | Independent(2) |\\n| Total | 3,011 |\\n\\n\\n| (1) | On February 7, 2017, we closed on the sale of this hotel. |\\n\\n| (2) | We believe that the Georgian Terrace and The Whitehall would carry a chain scale designation of upper upscale if they were branded hotels. |\\n\\nWe conduct substantially all our business through the Operating Partnership, Sotherly Hotels LP. The Company is the sole general partner of the Operating Partnership and owns an approximate 89.1% interest in the Operating Partnership, with the remaining interest being held by limited partners who were contributors of our initial hotel properties and related assets.\\nTo qualify as a REIT, neither the Company nor the Operating Partnership can operate our hotels. Therefore, our wholly-owned hotel properties are leased to our TRS Lessees that are wholly-owned subsidiaries of the Operating Partnership, which then engage a hotel management company to operate the hotels under a management agreement. Our TRS Lessees have engaged Chesapeake Hospitality to manage our hotels. Our TRS Lessees, and their parent, MHI Hospitality TRS Holding, Inc., are consolidated into each of our financial statements for accounting purposes. The earnings of MHI Hospitality TRS Holding, Inc. are subject to taxation similar to other C corporations.\\nKey Operating Metrics\\nIn the hotel industry, room revenue is considered the most important category of revenue and drives other revenue categories such as food, beverage, catering, parking and telephone. There are three key performance indicators used in the hotel industry to measure room revenues:\\n| • | Occupancy, or the number of rooms sold, usually expressed as a percentage of total rooms available; |\\n\\n| • | Average daily rate, or ADR, which is total room revenue divided by the number of rooms sold; and |\\n\\n| • | Revenue per available room, or RevPAR, which is total room revenue divided by the total number of available rooms. |\\n\\nRevPAR changes that are primarily driven by changes in occupancy have different implications for overall revenues and profitability than changes that are driven primarily by changes in ADR. For example, an increase in occupancy at a hotel would lead to additional variable operating costs (such as housekeeping services, laundry, utilities, room supplies, franchise fees, management fees, credit card commissions and reservations expense), but could also result in increased non-room revenue from the hotel’s restaurant, banquet or parking facilities. Changes in RevPAR that are primarily driven by changes in ADR typically have a greater impact on operating margins and profitability as they do not generate all the additional variable operating costs associated with higher occupancy.\\n40\\nWe also use FFO, Adjusted FFO and Hotel EBITDA as measures of our operating performance. See “Non-GAAP Financial Measures”.\\nResults of Operations\\nComparison of Year Ended December 31, 2016 to Year Ended December 31, 2015\\nThe following table illustrates the key operating metrics for the years ended December 31, 2016 and 2015 for our wholly-owned properties during each respective reporting period (“actual” properties) as well as the key operating metrics for the eleven wholly-owned properties that were under our control during all of 2015 (“same-store” properties). Accordingly, the same-store data does not reflect the performance of the Crowne Plaza Hollywood Beach Resort, which was acquired through a joint venture and in which we had a 25.0% indirect interest through July 31, 2015 and a 100.0% interest thereafter.\\n\\n| Year Ended December 31, 2016 | Year Ended December 31, 2015 |\\n| Actual | Same-Store | Actual | Same-Store |\\n| Occupancy % | 69.8 | % | 68.7 | % | 69.9 | % | 65.7 | % |\\n| ADR | $ | 140.63 | $ | 136.63 | $ | 134.21 | $ | 130.09 |\\n| RevPAR | $ | 98.18 | $ | 93.86 | $ | 93.80 | $ | 85.47 |\\n\\nRevenue. Total revenue for the year ended December 31, 2016 was approximately $152.8 million, an increase of approximately $14.3 million, or 10.3%, from total revenue for the year ended December 31, 2015 of approximately $138.5 million. Approximately $11.9 million of the increase relates to the acquisition of the remaining 75.0% interest in our property in Hollywood Beach, Florida in July 2015. Increases in revenues at our properties in Wilmington, North Carolina; Raleigh, North Carolina; Philadelphia, Pennsylvania; Laurel, Maryland; Jacksonville, Florida; Tampa, Florida; and Atlanta, Georgia of approximately $7.1 million, were offset by decreases in revenue at our properties impacted by renovation activities in Savannah, Georgia and Houston, Texas of approximately $3.3 million, as well as the remaining properties revenue decreases of $1.6 million.\\nRoom revenues at our properties for the year ended December 31, 2016 increased approximately $11.4 million, or 11.7%, to approximately $108.2 million compared to room revenues for the year ended December 31, 2015 of approximately $96.8 million. The increase in room revenues for the year ended December 31, 2016 resulted mainly from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $9.6 million for the period. Our properties in Wilmington, North Carolina; Raleigh, North Carolina; Philadelphia, Pennsylvania; Jacksonville, Florida; Tampa, Florida; Hampton, Virginia and Atlanta, Georgia, experienced a significant increase in room revenues, offset by decreases at our properties impacted by renovation activities in Savannah, Georgia and Houston, Texas. We continue to expect occupancy and ADR to increase in 2017 as a result of continuing strong demand and the completion in 2016 of renovations at our properties in Houston, Texas and Atlanta, Georgia.\\nFood and beverage revenues at our properties for the year ended December 31, 2016 increased approximately $2.1 million, or 6.3%, to approximately $35.4 million compared to food and beverage revenues of approximately $33.3 million for the year ended December 31, 2015. The increase in food and beverage revenues for the year ended December 31, 2016 resulted principally from our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $1.6 million for the period. Additional increases in food and beverage revenues at our properties in Savannah, Georgia; Raleigh, North Carolina; Laurel, Maryland: Jacksonville, Florida; and Tampa, Florida of approximately $1.5 million, were offset by decreases of approximately $1.0 million in food and beverage revenues at our other properties.\\nOther operating revenues for the year ended December 31, 2016 increased approximately $0.8 million, or 10.0%, to approximately $9.3 million compared to other operating revenues for the year ended December 31, 2015 of approximately $8.4 million. The increase in other operating department revenues for the year ended December 31, 2016 resulted principally from our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $0.6 million for the period. Additional increases in other operating revenues at our properties in Philadelphia, Pennsylvania; Laurel, Maryland; Jacksonville, Florida; Jeffersonville, Indiana and Hampton, Virginia of approximately $0.5 million, were offset by decreases of approximately $0.5 million in other operating revenues at our other properties.\\nHotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses, indirect expenses, and management fees, increased approximately $10.9 million, or 10.7%, for the year ended December 31, 2016 to approximately $112.8 million compared to hotel operating expenses for the year ended December 31, 2015 of approximately $101.9 million. The increase in hotel operating expenses for the year ended December 31, 2016 was substantially related to our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $9.0 million for the period, coupled with an increase in hotel operating expenses at our same-store properties of approximately $1.1 million, mainly from increased occupancy by 4.6%, offset with decreases in expenses at our properties in Wilmington, North Carolina; Philadelphia, Pennsylvania; Jeffersonville, Indiana; Hampton, Virginia and Houston, Texas.\\n41\\nRooms expense at our properties for the year ended December 31, 2016 increased approximately $3.1 million, or 12.1%, to approximately $28.9 million compared to rooms expense of approximately $25.8 million for the year ended December 31, 2015. The increase in rooms expense for the year ended December 31, 2016 was substantially related to our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $2.3 million for the period.\\nFood and beverage expenses at our properties for the year ended December 31, 2016 increased approximately $1.4 million, or 5.9%, to approximately $24.4 million compared to food and beverage expense of approximately $23.0 million for the year ended December 31, 2015. The increase in food and beverage expenses for the year ended December 31, 2016 was substantially related to our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $1.2 million for the period.\\nIndirect expenses at our properties for the year ended December 31, 2016 increased approximately $5.8 million, or 11.4%, to approximately $57.1 million compared to indirect expenses of approximately $51.3 million for the year ended December 31, 2015. Sales and marketing costs, franchise fees, utilities, repairs and maintenance, insurance, management fees, real and personal property taxes as well as general and administrative costs at the property level are included in indirect expenses. Most of the increase in indirect expenses related to expenses that increase proportionally with increases in occupancy and/or revenue, including management fees and franchise fees. Specifically, increases in indirect expenses were substantially related to our recently acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $5.1 million for the period, compared to the year ended December 31, 2015.\\nDepreciation and Amortization. Depreciation and amortization for the year ended December 31, 2016 increased approximately $1.4 million, or 10.5%, to approximately $15.0 million compared to depreciation and amortization expense of approximately $13.6 million for the year ended December 31, 2015. The increase was mostly attributable to depreciation and amortization related to our recently acquired property in Hollywood Beach, Florida and depreciation and amortization related to our capital assets acquired in the fourth quarter of 2015 and for the year 2016, offset by reductions of intangible asset amortization during the year ended December 31, 2016 compared to the year ended December 31, 2015.\\nImpairment of Investment in Hotel Properties, Net. The impairment of investment in hotel properties, net for the years ended December 31, 2016 and 2015 was $0 and $0.5 million, respectively. Our review of possible impairment of our hotel properties revealed no excess of current carrying cost over the estimated undiscounted future cash flows, as of December 31, 2016.\\nGain / Loss on Disposal of Assets. During the year ended December 31, 2016, we recorded a net loss on disposal of assets of $365,319, comprised of disposals of furniture, fixtures, and equipment of $565,319, offset by a gain on sale of $200,000, compared to a $41,435 net gain on disposal of assets for the year ended December 31, 2015, comprised of a net gain on the sale of development parcel rights and the development parcel for approximately $710,250, offset by losses on disposals of furniture, fixtures and equipment of $668,815.\\nCorporate General and Administrative. Corporate general and administrative expenses for the year ended December 31, 2016 decreased approximately $1.2 million, or 17.2%, to approximately $6.0 million compared to corporate general and administrative expenses of approximately $7.3 million for the year ended December 31, 2015. The decrease in corporate general and administrative expenses was mainly due to decreases in acquisition costs of approximately $0.6 million, the absence of a one-time tax penalty of $0.4 million in 2016, reduced professional fees of approximately $0.2 million, reduced loan modification costs of $0.2 million and reduced audit fees of approximately $0.2 million partially offset by additional staffing and related salary increase of approximately $0.3 million, an increase in legal fees of approximately $0.4 million and increased marketing support costs of $0.2 million.\\nInterest Expense. Interest expense for the year ended December 31, 2016 increased approximately $1.2 million, or 7.4%, to approximately $17.7 million compared to approximately $16.5 million of interest expense for the year ended December 31, 2015. The increase in interest expense for the year ended December 31, 2016, was substantially related to the assumed mortgage loan for the acquired property in Hollywood Beach, Florida, accounting for an increase in interest expense of approximately $1.8 million. This increase was mainly offset by a decrease in interest from the redemption of the 8% Notes with an approximate decrease of $0.5 million.\\nEquity Income (Loss) in Joint Venture. Equity in the income of the joint venture decreased approximately $0.5 million, or 100.0%, to $0 for the year ended December 31, 2016 compared to equity in the income of the joint venture of approximately $0.5 million for the year ended December 31, 2015, due the acquisition of the Crowne Plaza Hollywood Beach Resort in July 2015.\\n42\\nLoss on Early Debt Extinguishment. The loss on early debt extinguishment for the year ended December 31, 2016 increased approximately $0.6 million, or 83.5%, to approximately $1.4 million compared to a loss on debt extinguishment of approximately $0.8 million for the year ended December 31, 2015. During the year ended December 31, 2016, we refinanced mortgage loans at our properties in Wilmington, North Carolina; Savannah, Georgia; Jeffersonville, Indiana; Tampa, Florida and Houston, Texas with an increase in loss on early debt extinguishments of approximately $0.3 million. We also redeemed our 8% unsecured notes with the majority of the loss on early debt extinguishment of approximately $1.1 million.\\nUnrealized Loss on Hedging Activities. During the year ended December 31, 2015, we refinanced a variable rate mortgage loan we had with Fifth Third Bank on the DoubleTree by Hilton Jacksonville Riverfront, with a new variable rate loan from Bank of the Ozarks. During August 2015, we purchased an interest rate cap for $179,800. As of December 31, 2016, the fair market value of the interest rate cap is $33,597 compared to the fair market value of $70,981, as of December 31, 2015. The unrealized loss on hedging activities during the year ended December 31, 2016 and 2015, was $37,384 and $108,818, respectively.\\nGain on Change in Control. On July 31, 2015, we acquired from Carlyle the remaining 75.0% interest in the entities that own and lease the Crowne Plaza Hollywood Beach Resort. Due to the increased fair market value of the property for our original 25.0% interest we recognized a discounted gain on change in control. The gain on change in control during the year ended December 31, 2015, was approximately $6.6 million while no such gain was recorded in 2016.\\nIncome Tax Benefit. The income tax benefit for the year ended December 31, 2016 increased approximately $32,000, or 2.4%, to approximately $1.4 million compared to an income tax provision of approximately $1.3 million for the year ended December 31, 2015. The income tax benefit was primarily derived from the operations of our TRS Lessees. Our TRS Lessees realized higher operating loss for the year ended December 31, 2016 compared to the year ended December 31, 2015. At December 31, 2016, deferred tax assets total approximately $6.9 million, of which approximately $6.0 million relate to net operating losses of our TRS Lessee. At December 31, 2016, we determined, based on all available positive and negative evidence, that it is more-likely-than-not that future taxable income will be available during the carryforward periods to absorb all of the consolidated federal and state net operating loss carryforward. We will continue to regularly evaluate the likelihood that we will be able to realize our deferred tax assets and the need for a valuation allowance for the deferred tax assets.\\nNet Income. Net income for the year ended December 31, 2016 decreased approximately $5.5 million, or 85.9%, to approximately $0.9 million compared to net income of approximately $6.4 million for the year ended December 31, 2015, as a result of the operating results discussed above.\\nDistributions to Preferred Stockholders. During the year ended December 31, 2016, we recorded distributions to preferred stockholders of approximately $1.1 million, compared to no distributions to preferred stockholders for the year ended December 31, 2015. As of December 31, 2016 and 2015, we accrued $805,000 and $0, as dividends on the preferred stock, respectively.\\nComparison of Year Ended December 31, 2015 to Year Ended December 31, 2014\\nThe following table illustrates the key operating metrics for the years ended December 31, 2015 and 2014, for our wholly-owned properties during each respective reporting period (“actual” properties) as well as the key operating metrics for the ten wholly-owned properties that were under our control during all of 2014 (“same-store” properties). Accordingly, the same-store data does not reflect the performance of the Georgian Terrace, which was acquired in March 2014. Each table excludes performance data for the Crowne Plaza Hollywood Beach Resort, which was acquired through a joint venture and in which we had a 25.0% indirect interest through July 31, 2015 and a 100.0% interest thereafter through December 31, 2015.\\n\\n| Year Ended December 31, 2015 | Year Ended December 31, 2014 |\\n| Actual | Same-Store | Actual | Same-Store |\\n| Occupancy % | 69.9 | % | 65.7 | % | 70.3 | % | 69.7 | % |\\n| ADR | $ | 134.21 | $ | 130.09 | $ | 15.77 | $ | 124.27 |\\n| RevPAR | $ | 93.80 | $ | 85.47 | $ | 88.42 | $ | 86.57 |\\n\\nRevenue. Total revenue for the year ended December 31, 2015 was approximately $138.5 million, an increase of approximately $15.6 million, or 12.7%, from total revenue for the year ended December 31, 2014 of approximately $122.9 million. Approximately $6.2 million of the increase relates to the acquisition of our property in Atlanta, Georgia in March 2014. Approximately $7.5 million of the increase relates to the acquisition of the remaining 75.0% interest in our property in Hollywood Beach, Florida in July 2015. Increases in revenues at our properties in Wilmington, North Carolina; Savannah, Georgia; Raleigh, North Carolina; Philadelphia, Pennsylvania; Jacksonville, Florida; Jeffersonville, Indiana; Tampa, Florida; Hampton, Virginia and Atlanta, Georgia were offset by decreases in revenue at our properties impacted by renovation activities in Laurel, Maryland and Houston, Texas, as well as by the loss of rental income associated with Shell Island which expired in December 2014.\\n43\\nRoom revenues at our properties for the year ended December 31, 2015 increased approximately $12.2 million, or 14.4%, to approximately $96.8 million compared to room revenues for the year ended December 31, 2014 of approximately $84.6 million. The increase in room revenue for the year ended December 31, 2015 resulted mainly from the acquired property in Atlanta, Georgia, accounting for an increase of approximately $3.3 million for the period and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $2.4 million for the period. Our properties in Wilmington, North Carolina; Savannah, Georgia; Raleigh, North Carolina; Philadelphia, Pennsylvania; Jacksonville, Florida; Tampa, Florida; and Hampton, Virginia and Atlanta, Georgia, experienced a significant increase in room revenue, offset by decreases at our properties impacted by renovation activities in Laurel, Maryland and Houston, Texas.\\nFood and beverage revenues at our properties for the year ended December 31, 2015 increased approximately $1.8 million, or 5.8%, to approximately $33.3 million compared to food and beverage revenue of approximately $31.4 million for the year ended December 31, 2014. The increase in food and beverage revenues for the year ended December 31, 2015 resulted principally from our acquired property in Atlanta, Georgia, accounting for an increase of approximately $2.1 million for the period, and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $1.2 million for the period. Additional increases in food and beverage revenue at our properties in Wilmington, North Carolina; Raleigh, North Carolina and Jeffersonville, Indiana of approximately $0.3 million, were offset by decreases of approximately $1.6 million in banqueting revenue at our other properties.\\nOther operating revenues for the year ended December 31, 2015 increased approximately $1.5 million, or 22.5%, to approximately $8.4 million compared to other operating revenues for the year ended December 31, 2014 of approximately $6.9 million. The increase in other operating departments revenues for the year ended December 31, 2015 resulted principally from our acquired property in Atlanta, Georgia, accounting for an increase of approximately $0.8 million for the period and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $0.5 million for the period.\\nHotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses, indirect expenses, and management fees, increased approximately $11.7 million, or 12.9%, for the year ended December 31, 2015, to approximately $101.9 million compared to hotel operating expenses for the year ended December 31, 2014 of approximately $90.2 million. The increase in hotel operating expenses for the year ended December 31, 2015 was substantially related to our acquired property in Atlanta, Georgia, accounting for approximately $6.7 million of the increase in expenses for the year ended December 31, 2015 and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $9.2 million for the period, coupled by a decrease in hotel operating expenses at our same-store properties of approximately $1.0 million, mainly from reduced occupancy by 5.7% and RevPAR by 1.3% combined with decreases in expenses at our properties impacted by renovation activities in Laurel, Maryland and Houston, Texas.\\nRooms expense at our properties for the year ended December 31, 2015 increased approximately $2.9 million, or 12.5%, to approximately $25.8 million compared to rooms expense of approximately $22.9 million for the year ended December 31, 2014. The increase in rooms expense for the year ended December 31, 2015 was substantially related to our acquired property in Atlanta, Georgia, accounting for approximately $1.0 million of the increase and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $1.3 million for the period.\\nFood and beverage expenses at our properties for the year ended December 31, 2015 increased approximately $2.0 million, or 9.4%, to approximately $23.0 million compared to food and beverage expense of approximately $21.0 million for the year ended December 31, 2014. The increase in food and beverage expenses for the year ended December 31, 2015 was substantially related to our acquired property in Atlanta, Georgia, accounting for approximately $1.5 million of the increase and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $0.9 million for the period, offset by decreases in food and beverage expenses mainly from reduced occupancy and decreases in expenses at our property impacted by renovation activities in Houston, Texas.\\nIndirect expenses at our properties for the year ended December 31, 2015 increased approximately $6.2 million, or 13.8%, to approximately $51.3 million compared to indirect expenses of approximately $45.1 million for the year ended December 31, 2014. Sales and marketing costs, franchise fees, utilities, repairs and maintenance, insurance, management fees, real and personal property taxes as well as general and administrative costs at the property level are included in indirect expenses. Most of the increase in indirect expenses related to expenses that increase proportionally with increases in occupancy and/or revenue, including management fees and franchise fees. Specifically, increases in indirect expenses were substantially related to our acquired property in Atlanta, Georgia, accounting for approximately $2.1 million of the increase and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $2.8 million for the period, compared to the year ended December 31, 2014.\\n44\\nDepreciation and Amortization. Depreciation and amortization for the year ended December 31, 2015 increased approximately $1.6 million, or 13.6%, to approximately $13.6 million compared to depreciation and amortization expense of approximately $12.0 million for the year ended December 31, 2014. The increase was mostly attributable to depreciation and amortization related to our acquired property in Atlanta, Georgia and depreciation and amortization related to our capital assets acquired in the fourth quarter of 2014 and the year of 2015, offset by reductions of intangible asset amortization during the year ended December 31, 2015 compared to the year ended December 31, 2014.\\nImpairment of Investment in Hotel Properties, Net. The impairment of investment in hotel properties, net for the years ended December 31, 2015 and 2014, was approximately $0.5 million and $3.2 million, respectively. Our review of possible impairment at one of our hotel properties revealed an excess of current carrying cost over the estimated undiscounted future cash flows, which was triggered by a combination of a change in anticipated use and future branding of the property; and a re-evaluation of future revenues based on anticipated market conditions, market penetration and costs necessary to achieve such market penetration, resulting in an impairment to fair market value of $0.5 million, as of December 31, 2015.\\nGain on Disposal of Assets. During the year ended December 31, 2015, we recorded a gain on disposal of assets of $41,435, compared to no gain or loss on disposal of assets for the year ended December 31, 2014.\\nCorporate General and Administrative. Corporate general and administrative expenses for the year ended December 31, 2015 increased approximately $2.2 million, or 42.9%, to approximately $7.3 million compared to corporate general and administrative expenses of approximately $5.1 million for the year ended December 31, 2014. The increase in corporate general and administrative expenses was mainly due to an increase in acquisition costs of approximately $0.5 million, a one-time tax penalty of $0.4 million, additional staffing and related salary increase of approximately $0.3 million, increased professional fees of approximately $0.5 million, loan costs of $0.2 million on the loan modifications of the Crowne Plaza Hollywood Beach Resort mortgage and the DoubleTree by Hilton Laurel mortgage, and increased audit fees of approximately $0.1 million partially offset by a reduction in legal fees of approximately $0.1 million.\\nInterest Expense. Interest expense for the year ended December 31, 2015 increased approximately $1.9 million, or 12.8%, to approximately $16.5 million compared to approximately $14.6 million of interest expense for the year ended December 31, 2014. The increase in interest expense for the year ended December 31, 2015 was substantially related to the additional mortgage on our acquired property in Atlanta, Georgia of $0.7 million, the assumed mortgage loan for the acquired property in Hollywood Beach, Florida, accounting for an increase in interest expense of approximately $1.4 million, the issuance of the 7% Notes due in 2019, accounting for an increase of approximately $1.6 million. These increases were offset by a decrease in interest from the reduction of the bridge loan with Richmond Hill Capital Partners, LP during the year ending December 31, 2015 of $1.3 million.\\nEquity Income (Loss) in Joint Venture. Equity in the income of the joint venture increased approximately $0.2 million, or 54.7%, to approximately $0.5 million for the year ended December 31, 2015 compared to equity in the income of the joint venture of approximately $0.3 million for the year ended December 31, 2014 and represents our 25.0% share of the net income of the Crowne Plaza Hollywood Beach Resort through July 31, 2015. For the year ended December 31, 2015, the Crowne Plaza Hollywood Beach Resort reported occupancy of 83.1%, ADR of $174.35 and RevPAR of $144.86. This compares with results reported by the hotel for the year ended December 31, 2014 of occupancy of 83.1%, ADR of $163.13 and RevPAR of $135.55.\\nLoss on Early Debt Extinguishment. The loss on early debt extinguishment for the year ended December 31, 2015 decreased approximately $0.1 million, or 7.0%, to approximately $0.7 million compared to a loss on debt extinguishment of approximately $0.8 million for the year ended December 31, 2014. During the year ended December 31, 2015, we refinanced a variable rate mortgage loan we had with the Bank of the Ozarks on the Georgian Terrace, with a new fixed rate loan from Bank of America. The amount of accumulated un-amortized loan costs of $697,582 was written off during 2015. In addition, we refinanced a variable rate mortgage loan we had with Fifth Third Bank on the DoubleTree by Hilton Jacksonville Riverfront, with a new variable rate loan from Bank of the Ozarks. The amount of accumulated un-amortized loan costs of $75,324 was written off during 2015.\\nGain on Involuntary Conversion of Asset. Gain on involuntary conversion of asset for the year ended December 31, 2015 decreased approximately $0.2 million, or 100.0%, to $0 compared to approximately $0.2 million of gain on involuntary conversion of asset for the year ended December 31, 2014. During 2014, we had a one-time involuntary conversion of equipment at our Hilton Wilmington Riverside property for replacement of a water chiller in the amount of approximately $0.2 million.\\nUnrealized Loss on Hedging Activities. During the year ended December 31, 2015, we refinanced a variable rate mortgage loan we had with Fifth Third Bank on the DoubleTree by Hilton Jacksonville Riverfront, with a new variable rate loan from Bank of the Ozarks. During August 2015, we purchased an interest rate cap for $179,800. As of December 31, 2015, the fair market value of the interest rate cap was $70,981. The unrealized loss on hedging activities during the years ended December 31, 2015 and 2014, was approximately $0.1 million and $0, respectively.\\n45\\nGain on Change in Control. On July 31, 2015, we acquired from Carlyle the remaining 75.0% interest in the entities that own and lease the Crowne Plaza Hollywood Beach Resort. Due to the increased fair market value of the property for our original 25.0% interest we recognized a discounted gain on change in control. The gain on change in control during the year ended December 31, 2015 was approximately $6.6 million while no such gain was recorded in 2014.\\nIncome Tax Benefit. The income tax benefit for the year ended December 31, 2015 decreased approximately $0.4 million, or 22.7%, to approximately $1.3 million compared to an income tax benefit of approximately $1.7 million for the year ended December 31, 2014. The income tax benefit was primarily derived from the operations of our TRS Lessees. Our TRS Lessees realized lower operating loss for the year ended December 31, 2015 compared to the year ended December 31, 2014.\\nNet Income (Loss). Net income for the year ended December 31, 2015 increased approximately $7.1 million, or 966.3%, to approximately $6.4 million compared to net loss of approximately $0.7 million for the year ended December 31, 2014 as a result of the operating results discussed above.\\nSources and Uses of Cash\\nThe following narrative discusses our sources and uses of cash for the year ended December 31, 2016.\\nOperating Activities. Our principal source of cash to meet our operating requirements, including distributions to unit holders of the Operating Partnership and stockholders of the Company as well as debt service (excluding debt maturities), is the operations of our hotels. Cash flow provided by operating activities for the year ended December 31, 2016 was approximately $17.1 million. We expect that cash on hand and the net cash provided by operations will be adequate to fund our operating requirements, monthly and quarterly scheduled payments of principal and interest (excluding any balloon payments due upon maturity of a debt) and the payment of dividends (distributions) to the stockholders of the Company (the unitholders of the Operating Partnership) in accordance with federal income tax laws which require us to make annual distributions, as “qualifying distributions,” to the Company’s stockholders of at least 90.0% of its REIT taxable income (determined without regard to the dividends-paid deduction and by excluding its net capital gains, and reduced by certain non-cash items).\\nInvesting Activities. During the year ended December 31, 2016, we spent approximately $14.9 million on capital expenditures, of which, approximately $5.3 million related to the routine replacement of furniture, fixtures and equipment; approximately $1.8 million related to the renovation of our property in Houston, Texas in anticipation of our newly independent hotel The Whitehall which opened in May 2016; approximately $4.9 million related to the renovation of our property in Savannah, Georgia; approximately $1.5 million related to the renovation of our property in Atlanta, Georgia; approximately $0.6 million related to the renovation of our property in Wilmington, North Carolina; approximately $0.4 million related to the renovation of our property in Laurel, Maryland and approximately $0.4 million related to the renovation of our property in Hollywood Beach, Florida.\\nWe also contributed approximately $5.3 million during 2016 into reserves required by the lenders for ten of our hotels according to the provisions of their respective loan agreements. During 2016, we received reimbursements from those reserves of approximately $7.0 million for capital expenditures related to those properties for periods ending on or before December 31, 2016.\\nFinancing Activities. Cash flow provided by financing activities for the year ended December 31, 2016 was approximately $16.1 million. This inflow was principally from proceeds from the sale of preferred stock of approximately $37.8 million and net mortgage proceeds of approximately $14.2 million, offset by redemption of the 8% Notes for $27.6 million, repurchase of common stock for approximately $2.1 million, dividend and distribution payments of approximately $6.2 million and payments of deferred financing costs of approximately $1.5 million.\\nOn June 27, 2016, we entered into a promissory note and other loan documents to secure a $35.0 million mortgage on the Hilton Savannah DeSoto with MONY Life Insurance Company.\\nOn June 30, 2016, we entered into a loan agreement and other loan documents, including a guaranty of payment by the Operating Partnership, to secure a $19.0 million mortgage on the Crowne Plaza Tampa Westshore with Fifth Third Bank.\\nOn August 23, 2016, the Company issued 1,610,000 shares, $0.01 par value per share, of its 8% Series B Cumulative Redeemable Perpetual Preferred Stock for net proceeds after all expenses of approximately $37.8 million, which it contributed to the Operating Partnership for an equivalent number of preferred partnership units.\\nOn September 30, 2016, the Operating Partnership redeemed the entire $27.6 million aggregate principal amount of its outstanding 8% Notes.\\n46\\nOn October 12, 2016, we entered into a loan agreement to secure a $20.5 million mortgage on The Whitehall with International Bank of Commerce. Pursuant to the loan documents, the loan provides initial proceeds of $15.0 million, with an additional $5.5 million available upon the satisfaction of certain conditions.\\nOn November 3, 2016, we entered into a loan agreement to refinance the mortgage on the Sheraton Louisville Riverside with Symetra Life Insurance Company. Pursuant to the loan documents, the loan provides proceeds of $12.0 million.\\nOn November 3, 2016, we entered into a loan agreement to modify and extend the $2.6 million mortgage on the Crowne Plaza Hampton Marina with TowneBank.\\nOn December 1, 2016, we entered into a promissory note and other loan documents to secure a $35.0 million mortgage on the Hilton Wilmington Riverside with MONY Life Insurance Company. Pursuant to the loan documents, the loan provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions, namely, the completion of a renovation project.\\nOn December 2, 2016, the Company’s Board of Directors authorized a stock repurchase program under which the Company may purchase up to $10.0 million of its outstanding common stock, par value $0.01 per share, at prevailing prices on the open market or in privately negotiated transactions, at the discretion of management. The Company expects to use available working capital to fund purchases under the stock repurchase program and intends to complete the repurchase program prior to December 31, 2017, unless extended by the Board of Directors. Through December 31, 2016, the Company repurchased 481,100 shares of common stock for $3.2 million and the repurchased shares have been returned to the status of authorized but unissued shares of common stock.\\nThe following narrative discusses our sources and uses of cash for the year ended December 31, 2015.\\nOperating Activities. Our principal source of cash to meet our operating requirements, including distributions to unit holders of the Operating Partnership and stockholders of the Company as well as debt service (excluding debt maturities), is the operations of our hotels. Cash flow provided by operating activities for the year ended December 31, 2015 was approximately $11.4 million. We expect that cash on hand and the net cash provided by operations will be adequate to fund our operating requirements, monthly and quarterly scheduled payments of principal and interest (excluding any balloon payments due upon maturity of a debt) and the payment of dividends (distributions) to the stockholders of the Company (the unitholders of the Operating Partnership) in accordance with federal income tax laws which require us to make annual distributions, as “qualifying distributions,” to the Company’s stockholders of at least 90.0% of its REIT taxable income (determined without regard to the dividends-paid deduction and by excluding its net capital gains, and reduced by certain non-cash items).\\nInvesting Activities. During the year ended December 31, 2015, we used approximately $25.5 million to acquire the remaining 75.0% ownership interest in the Crowne Plaza Hollywood Beach Resort. We also spent approximately $20.1 million on capital expenditures, of which, approximately $5.1 million related to the routine replacement of furniture, fixtures and equipment; approximately $4.6 million related to the renovation of our property in Laurel, Maryland in anticipation of a new franchise agreement which commenced in October 2015; approximately $3.4 million related to the renovation of our property in Jacksonville, Florida in anticipation of a new franchise license which commenced in September 2015; approximately $3.1 million related to guestroom renovations at the Georgian Terrace; approximately $3.0 million in renovations at our property in Houston, Texas; and approximately $0.9 related to the renovation of our property in Philadelphia, Pennsylvania.\\nWe also contributed approximately $5.0 million during 2015 into reserves required by the lenders for ten of our hotels according to the provisions of their respective loan agreements. During 2015, we received reimbursements from those reserves of approximately $6.4 million for capital expenditures related to those properties for periods ending on or before December 31, 2015 and we received net proceeds of approximately $2.4 million from the sale of a 0.3-acre parcel of excess land located adjacent to our property in Atlanta, Georgia and related development rights.\\nFinancing Activities. Cash flow provided by financing activities for the year ended December 31, 2015 was approximately $24.6 million. This inflow was principally from proceeds from the sale of common stock of approximately $23.3 million and net mortgage proceeds of approximately $6.8 million, offset by dividend and distribution payments of approximately $4.1 million and payments of deferred financing costs of approximately $1.4 million.\\nOn October 20, 2015, we secured $2.0 million of additional proceeds on the mortgage loan on the DoubleTree by Hilton Jacksonville Riverfront as part of an earn-out pursuant to the terms of the loan agreement.\\nOn September 28, 2015, we entered into a loan agreement to secure a $60.0 million mortgage on the Crowne Plaza Hollywood Beach Resort with Bank of America, N.A.\\n47\\nOn July 17, 2015, the Company sold 435,000 shares of common stock for net proceeds of approximately $2.8 million, which it contributed to the Operating Partnership for an equivalent number of units.\\nOn July 7, 2015, we entered into a loan agreement and other loan documents to secure an $18.5 million mortgage with Bank of the Ozarks collateralized by a first mortgage on the DoubleTree by Hilton Jacksonville Riverfront. The $18.5 million mortgage was received in two parts. We received $18.0 million on July 7, 2015 and the remainder of $0.5 million on October 20, 2015. The $0.5 million was included with the additional earn-out provision of $1.5 million, for a total of $2.0 million additional proceeds.\\nOn July 1, 2015, the Company sold 3,000,000 shares of common stock, for net proceeds of approximately $19.8 million, which it contributed to the Operating Partnership for an equivalent number of units.\\nDuring June 2015, the Company sold 98,682 shares of common stock for net proceeds of approximately $0.7 million, which it contributed to the Operating Partnership for an equivalent number of units.\\nOn May 5, 2015, the Company obtained a $47.0 million mortgage with Bank of America, N.A. on the Georgian Terrace in Atlanta, Georgia.\\nCapital Expenditures\\nWe anticipate that our need for recurring capital expenditures for the replacement and refurbishment of furniture, fixtures and equipment over the next 12 to 24 months will be at historical norms for our properties and the industry. Historically, we have aimed to maintain overall capital expenditures, except for those required by our franchisors as a condition to a franchise license or license renewal, at 4.0% of gross revenue. In addition, during fiscal years 2017 and 2018 we expect total renovation capital expenditures of approximately $23.5 million related to our properties in Wilmington, North Carolina; Savannah, Georgia and Hollywood Beach, Florida.\\nGiven our desire to proceed with the renovation activities at our properties in Wilmington, North Carolina; Savannah, Georgia and Hollywood Beach, Florida, we aim to restrict all other capital expenditures to the replacement of broken or damaged furniture and equipment and the acquisition of items mandated by our licensors that are necessary to maintain our brand affiliations. We anticipate that capital expenditures for the replacement and refurbishment of furniture, fixtures and equipment that are not related to these renovation activities to total 3.50% of gross revenues in 2017.\\nWe expect capital expenditures for the recurring replacement or refurbishment of furniture, fixtures and equipment at our properties will be funded by our replacement reserve accounts, other than costs that we incur to make capital improvements required by our franchisors. Reserve accounts are escrowed accounts with funds deposited monthly and reserved for capital improvements or expenditures with respect to all of our hotels. We currently deposit an amount equal to 4.0% of gross revenue for the Hilton Savannah DeSoto, the Hilton Wilmington Riverside, the Crowne Plaza Hollywood Beach Resort, The DoubleTree by Hilton Jacksonville Riverside, the DoubleTree by Hilton Raleigh Brownstone-University, the Whitehall and the Georgian Terrace as well as 4.0% of room revenues for the DoubleTree by Hilton Philadelphia Airport on a monthly basis.\\nLiquidity and Capital Resources\\nAs of December 31, 2016, we had cash and cash equivalents of approximately $36.4 million, of which approximately $4.6 million was in restricted reserve accounts for capital improvements, real estate tax and insurance escrows. We expect that our cash on hand combined with our cash flow from our hotels should be adequate to fund continuing operations, recurring capital expenditures for the refurbishment and replacement of furniture, fixtures and equipment, and monthly and quarterly scheduled payments of principal and interest (excluding any balloon payments due upon maturity of the indentures or mortgage debt).\\nWe intend to continue to invest in hotel properties as suitable opportunities arise. The success of our acquisition strategy depends, in part, on our ability to access additional capital through other sources. There can be no assurance that we will continue to make investments in properties that meet our investment criteria. Additionally, we may choose to dispose of certain hotels as a means to provide liquidity.\\nWe expect to meet our liquidity requirements for hotel property acquisitions, property redevelopment, investments in new joint ventures and debt maturities, which include the repayment of the 7% Notes (which are callable after November 15, 2017) and the retirement of maturing mortgage debt, through net proceeds from additional issuances of common shares, additional issuances of preferred shares, issuances of units of limited partnership interest in our Operating Partnership, secured and unsecured borrowings, the selective disposition of non-core assets, and cash on hand. We remain committed to a flexible capital structure and strive to maintain prudent debt leverage.\\n48\\nWe do not have any debt obligations maturing until August 2018. In August 2018, the approximate $14.5 mortgage on our DoubleTree by Hilton Raleigh Brownstone University matures. We have approximately $87.6 million in debt obligations maturing in 2019, including $25.3 million of the Operating Partnership’s 7% Notes and approximately $62.3 million in mortgage debt, including reductions for future monthly principal payments on the mortgages.\\nOn June 27, 2016, we entered into a promissory note and other loan documents to secure a $35.0 million mortgage on the Hilton Savannah DeSoto with MONY Life Insurance Company. The loan has a maturity date of July 1, 2026.\\nOn June 30, 2016, we entered into a loan agreement and other loan documents, including a guaranty of payment by the Operating Partnership, to secure a $19.0 million mortgage on the Crowne Plaza Tampa Westshore with Fifth Third Bank. The loan has an initial term of three years with a maturity on July 1, 2019, and may be extended for two additional periods of one year each, subject to certain conditions.\\nOn August 23, 2016, the Company issued 1,610,000 shares, $0.01 par value per share, of its 8% Series B Cumulative Redeemable Perpetual Preferred Stock for net proceeds after all expenses of approximately $37.8 million, which it contributed to the Operating Partnership for an equivalent number of preferred partnership units.\\nOn September 30, 2016, the Operating Partnership redeemed the entire $27.6 million aggregate principal amount of its outstanding 8% Notes.\\nOn October 12, 2016, we entered into a loan agreement to secure a $20.5 million mortgage on The Whitehall with International Bank of Commerce. Pursuant to the loan documents, the loan: provides initial proceeds of $15.0 million, with an additional $5.5 million available upon the satisfaction of certain conditions, has a term of five years, bears a floating interest rate of the one month LIBOR plus 3.5%, subject to a floor rate of 4.0%, amortizes on an 18-year schedule after a 2-year interest only period, is subject to prepayment fees, and is guaranteed by Sotherly Hotels LP.\\nOn November 3, 2016, we entered into a loan agreement to refinance the mortgage on the Sheraton Louisville Riverside with Symetra Life Insurance Company. Pursuant to the loan documents, the loan: provides proceeds of $12.0 million, has a maturity date of December 1, 2026, bears a fixed interest rate of 4.27% for the first 5 years of the loan with an option for the lender to reset that rate after 5 years, amortizes on a 25-year schedule, is subject to prepayment fees, and is guaranteed by Sotherly Hotels LP at 50% of the unpaid principal balance, interest, and other amounts owed.\\nOn December 1, 2016, we entered into a promissory note and other loan documents to secure a $35.0 million mortgage on the Hilton Wilmington Riverside with MONY Life Insurance Company. Pursuant to the loan documents, the loan: provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions, namely, the completion of a renovation project; has a term of 10 years; bears a fixed interest rate of 4.25%; amortizes on a 25-year schedule after a 1-year interest-only period and is subject to a prepayment premium.\\nOn December 2, 2016, the Company’s Board of Directors authorized a stock repurchase program under which the Company may purchase up to $10.0 million of its outstanding common stock, par value $0.01 per share, at prevailing prices on the open market or in privately negotiated transactions, at the discretion of management. The Company expects to use available working capital to fund purchases under the stock repurchase program and intends to complete the repurchase program prior to December 31, 2017, unless extended by the Board of Directors. Through December 31, 2016, the Company repurchased 481,100 shares of common stock for approximately $3.2 million and the repurchased shares have been returned to the status of authorized but unissued shares of common stock.\\nFinancial Covenants\\nMortgage Loans\\nOur mortgage loan agreements contain various financial covenants. Failure to comply with these financial covenants could result from, among other things, changes in the local competitive environment, general economic conditions and disruption caused by renovation activity or major weather disturbances.\\n49\\nIf we violate the financial covenants contained in these agreements, we may attempt to negotiate waivers of the violations or amend the terms of the applicable mortgage loan agreement with the lender; however, we can make no assurance that we would be successful in any such negotiation or that, if successful in obtaining waivers or amendments, such waivers or amendments would be on attractive terms. Some mortgage loan agreements provide alternate cure provisions which may allow us to otherwise comply with the financial covenants by obtaining an appraisal of the hotel, prepaying a portion of the outstanding indebtedness or by providing cash collateral until such time as the financial covenants are met by the collateralized property without consideration of the cash collateral. Alternate cure provisions which include prepaying a portion of the outstanding indebtedness or providing cash collateral may have a material impact on our liquidity.\\nIf we are unable to negotiate a waiver or amendment or satisfy alternate cure provisions, if any, or unable to meet any alternate cure requirements and a default were to occur, we would possibly have to refinance the debt through additional debt financing, private or public offerings of debt securities, or additional equity financing.\\nUnder the terms of our non-recourse secured mortgage loan agreements, failure to comply with the financial covenants in the loan agreement triggers cash flows from the property to be directed to the lender, which may limit our overall liquidity as that cash flow would not be available to us.\\nAt December 31, 2016, we were in compliance with all debt covenants, current on all loan payments and not otherwise in default under any of our mortgage loans.\\nUnsecured Notes\\nThe indenture for the 7% Notes contains certain covenants and restrictions that require us to meet certain financial ratios. We are not permitted to incur any Debt (other than intercompany Debt), as defined in the indenture, if, immediately after giving effect to the incurrence of such Debt and to the application of the proceeds thereof, the ratio of the aggregate principal amount of all outstanding Debt to Adjusted Total Asset Value, as defined in the indenture, would be greater than 0.65 to 1.0. In addition, we are not permitted to incur any Debt if the ratio of Stabilized Consolidated Income Available for Debt Service to Stabilized Consolidated Interest Expense, both as defined in the indenture, on the date on which such additional Debt is to be incurred, on a pro-forma basis, after giving effect to the incurrence of such Debt and to the application of the proceeds thereof, would be less than 1.50 to 1.0.\\n50\\nThese financial measures are not calculated in accordance with GAAP and are presented below for the sole purpose of evaluating our compliance with the key financial covenants as they were or would have been applicable at December 31, 2016 and December 31, 2015, respectively.\\n\\n| December 31, | December 31, |\\n| 2016 | 2015 |\\n| Ratio of Stabilized Consolidated Income Available for Debt Service to Stabilized Consolidated Interest Expense |\\n| Net income(1) | $ | 900,149 | $ | 6,397,653 |\\n| Interest expense(1) | 17,735,107 | 16,515,827 |\\n| Loss on early debt extinguishment | 1,417,905 | 772,907 |\\n| Unrealized loss on hedging activities | 37,384 | 108,819 |\\n| Gain on change in control | — | (6,603,148 | ) |\\n| Loss (Gain) on disposal of assets | 365,319 | (41,435 | ) |\\n| Income tax benefit(1) | (1,367,634 | ) | (1,336,033 | ) |\\n| Equity in income of joint venture(1) | — | (475,514 | ) |\\n| Impairment of investment in hotel properties, net(1) | — | 500,000 |\\n| Depreciation and amortization(1) | 15,019,071 | 13,591,495 |\\n| Corporate general and administrative expenses(1) | 6,021,065 | 7,268,256 |\\n| Consolidated income available for debt service(1) | 40,128,366 | 36,698,827 |\\n| Less: income of non-stabilized assets(1) | (10,203,893 | ) | (16,284,975 | ) |\\n| Stabilized Consolidated Income Available for Debt Service(1) | $ | 29,924,473 | $ | 20,413,852 |\\n| Interest expense(1) (2) | $ | 18,011,107 | $ | 16,515,827 |\\n| Amortization of issuance costs(1) | (1,147,864 | ) | (1,300,032 | ) |\\n| Consolidated interest expense(1) | 16,863,243 | 15,215,795 |\\n| Less: interest expense of non-stabilized assets(1) | (3,417,412 | ) | (5,295,224 | ) |\\n| Stabilized Consolidated Interest Expense(1) | $ | 13,445,831 | $ | 9,920,571 |\\n| Ratio of Stabilized Consolidated Income Available for Debt Service to Stabilized Consolidated Interest Expense | 2.23 | 2.06 |\\n| Threshold Ratio Minimum | 1.50 | 1.50 |\\n| Ratio of Debt to Adjusted Total Asset Value: |\\n| Mortgage loans | $ | 284,757,698 | $ | 271,977,944 |\\n| Unsecured notes | 25,300,000 | 52,900,000 |\\n| Total debt | $ | 310,057,698 | $ | 324,877,944 |\\n| Stabilized Consolidated Income Available for Debt Service(1) | $ | 29,924,473 | $ | 20,413,852 |\\n| Capitalization rate | 7.5 | % | 7.5 | % |\\n| 398,992,973 | 272,184,693 |\\n| Non-stabilized assets | 145,400,000 | 305,255,698 |\\n| Total cash | 36,362,920 | 17,287,754 |\\n| Adjusted Total Asset Value | $ | 580,755,893 | $ | 594,728,145 |\\n| Ratio of Debt to Adjusted Total Asset Value | 0.53 | 0.55 |\\n| Threshold Ratio Maximum | 0.65 | 0.65 |\\n\\n\\n| (1) | As permitted by the indenture, the Hilton Savannah DeSoto, DoubleTree by Hilton Laurel, DoubleTree by Hilton Jacksonville Riverfront and The Whitehall, for the period ended December 31, 2016, and the DoubleTree by Hilton Laurel, DoubleTree by Hilton Jacksonville Riverfront and Crowne Plaza Hollywood Beach Resort, for the period ended December 31, 2015, are considered non-stabilized assets for purposes of the financial covenants. |\\n\\n| (2) | Includes losses on debt extinguishment paid for in cash of $276,000 in fiscal year 2016. |\\n\\n51\\nMortgage Debt\\nAs of December 31, 2016, we had a principal mortgage debt balance of approximately $284.5 million. The following table sets forth our mortgage debt obligations on our hotels.\\n\\n| December 31, | Prepayment | Maturity | Amortization |\\n| Property | 2016 | Penalties | Date | Provisions | Interest Rate |\\n| Crowne Plaza Hampton Marina (1) | $ | 2,584,633 | None | 11/1/2019 | $ | 3 years | 5.00% |\\n| Crowne Plaza Hollywood Beach Resort (2) | 58,935,818 | N/A | 10/1/2025 | 30 years | 4.913% |\\n| Crowne Plaza Tampa Westshore (3) | 15,561,400 | None | 6/30/2019 | 25 years | LIBOR plus 3.75 % |\\n| DoubleTree by Hilton Jacksonville Riverfront (4) | 19,291,716 | Yes | 7/7/2019 | 25 years | LIBOR plus 3.50 % |\\n| DoubleTree by Hilton Laurel (5) | 9,329,005 | Yes | 8/5/2021 | 25 years | 5.25% |\\n| DoubleTree by Hilton Philadelphia Airport (6) | 31,261,991 | None | 4/1/2019 | 25 years | LIBOR plus 3.00 % |\\n| DoubleTree by Hilton Raleigh Brownstone University (7) | 14,773,885 | N/A | 8/1/2018 | 30 years | 4.78% |\\n| The Georgian Terrace (8) | 45,826,038 | N/A | 6/1/2025 | 30 years | 4.42% |\\n| Hilton Savannah DeSoto (9) | 30,000,000 | Yes | 7/1/2026 | 25 years | 4.25% |\\n| Hilton Wilmington Riverside (10) | 30,000,000 | Yes | 1/1/2027 | 25 years | 4.25% |\\n| Sheraton Louisville Riverside (11) | 11,977,557 | Yes | 12/1/2026 | 25 years | 4.27% |\\n| The Whitehall (12) | 15,000,000 | Yes | 10/12/2021 | 18 years | LIBOR plus 3.50 % |\\n| Total Mortgage Principal Balance | 284,542,043 |\\n| Deferred financing costs, net | (2,049,409) |\\n| Unamortized premium on loan | 215,655 |\\n| Total Mortgage Loans | $ | 282,708,289 |\\n\\n\\n| (1) | The note was extended and modified in November 2016 for 3 years until November 1, 2019 and the Operating Partnership was required to make monthly principal payments of $15,367. The note rate was changed to a fixed rate of 5.00%, effective June 27, 2014. As of February 7, 2017, the note is no longer outstanding. |\\n\\n| (2) | With limited exception, the note may not be prepaid until June 2025. |\\n\\n| (3) | The note provides initial proceeds of $15.7 million, with an additional $3.3 million available upon the satisfaction of certain conditions; bears a floating interest rate of the 1-month LIBOR plus 3.75%, subject to a floor rate of 3.75%; the note provides that the mortgage can be extended for two additional periods of one year each, subject to certain conditions. |\\n\\n| (4) | The note is subject to a pre-payment penalty until July 2017. Prepayment can be made without penalty thereafter. The note provides that the mortgage can be extended until July 2020 if certain conditions have been satisfied. |\\n\\n| (5) | The note is subject to a pre-payment penalty except for any pre-payments made either between April 2017 and August 2017, or from April 2021 through maturity of the note. The note provides that on January 5, 2018, the rate of interest will adjust to a rate of 3.00% per annum plus the then-current five-year U.S. Treasury rate of interest, with a floor of 5.25%. |\\n\\n| (6) | The note bears a minimum interest rate of 3.50%. |\\n\\n| (7) | With limited exception, the note may not be prepaid until two months before maturity. |\\n\\n| (8) | With limited exception, the note may not be prepaid until February 2025. |\\n\\n| (9) | The note provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions, namely, the completion of a renovation project; amortizes on a 25-year schedule after a 1-year interest-only period; and is subject to a pre-payment penalty except for any pre-payments made within 120 days of the maturity date. |\\n\\n| (10) | The note provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions namely, the completion of a renovation project. The note amortizes on a 25-year schedule after a 1-year interest-only period; and is subject to a pre-payment penalty except for any pre-payments made within 120 days of the maturity date. |\\n\\n| (11) | The note bears a fixed interest rate of 4.27% for the first 5 years of the loan, with an option for the lender to reset the interest rate after 5 years. |\\n\\n| (12) | The note was refinanced in October 2016, provides initial proceeds of $15.0 million, with an additional $5.5 million available upon the satisfaction of certain conditions; bears a floating interest rate of the 1-month LIBOR plus 3.5%, subject to a floor rate of 4.0%; and is subject to prepayment penalties subject to a declining scale from 3.0% penalty on or before the first anniversary date, a 2.0% penalty during the second anniversary year and a 1.0% penalty after the third anniversary date. |\\n\\n52\\nContractual Obligations\\nThe following table outlines our contractual obligations as of December 31, 2016, and the effect such obligations are expected to have on our liquidity and cash flow in future periods (in thousands).\\n\\n| Payments due by period (in thousands) |\\n| Less than | More than |\\n| Contractual Obligations | Total | 1 year | 1-3 years | 3-5 years | 5 years |\\n| Mortgage loans, including interest | $ | 355,927 | $ | 18,895 | $ | 119,609 | $ | 55,911 | $ | 161,512 |\\n| Unsecured notes, including interest | 30,416 | 1,771 | 28,645 | — | — |\\n| Ground, building, office and equipment leases | 1,137 | 224 | 276 | 191 | 446 |\\n| Purchase commitment | 4,250 | 4,250 | — | — | — |\\n| Totals | $ | 391,730 | $ | 25,140 | $ | 148,530 | $ | 56,102 | $ | 161,958 |\\n\\nIn connection with the acquisition of our six initial hotel properties, we entered into tax indemnity agreements that required us to indemnify the contributors of our initial properties against tax liabilities in the event we sold any of those properties in a taxable transaction during a 10-year period. The tax indemnity agreements expired on or about December 22, 2014. Our obligations under the contribution agreements may effectively preclude us from reducing our consolidated indebtedness below approximately $11.0 million.\\nOff Balance Sheet Arrangements. Through a joint venture with a Carlyle subsidiary, we owned a 25.0% indirect, noncontrolling interest in an entity (the “JV Owner”) that acquired the 311-room Crowne Plaza Hollywood Beach Resort in Hollywood, Florida. We had the right to receive a pro rata share of operating surpluses and we had an obligation to fund our pro rata share of operating shortfalls. We also had the opportunity to earn an incentive participation in the net proceeds realized from the sale of the hotel based upon the achievement of certain overall investment returns, in addition to our pro rata share of net sale proceeds. The Crowne Plaza Hollywood Beach Resort was leased to another entity (the “Joint Venture Lessee”) in which we also owned a 25.0% indirect, noncontrolling interest.\\nCarlyle owned a 75.0% controlling interest in the entities that own and lease the Crowne Plaza Hollywood Beach Resort. Carlyle had the right to dispose of the Crowne Plaza Hollywood Beach Resort without our consent. We accounted for our noncontrolling 25.0% interest in all of these entities under the equity method of accounting.\\nOn July 31, 2015, indirect subsidiaries of the Operating Partnership acquired from Carlyle the remaining 75.0% interest in the entities that own and lease the Crowne Plaza Hollywood Beach Resort. As a result, the Operating Partnership now has a 100% indirect ownership interest in the entities that own the Crowne Plaza Hollywood Beach Resort. The property was refinanced on September 28, 2015 and is encumbered by a $60.0 million mortgage which matures in September 2025 and requires monthly payments of interest at a rate of 4.913%. The Crowne Plaza Hollywood Beach Resort secures the mortgage.\\nDistributions to Stockholders and Holders of Units in the Operating Partnership. The Company has elected to be taxed as a REIT commencing with our taxable year ending December 31, 2004. To maintain qualification as a REIT, the Company is required to make annual distributions to its stockholders of at least 90.0% of our REIT taxable income, (excluding net capital gain, which does not necessarily equal net income as calculated in accordance with generally accepted accounting principles). The Company’s ability to pay distributions to its stockholders will depend, in part, upon its receipt of distributions from the Operating Partnership which may depend upon receipt of lease payments with respect to our properties from our TRS Lessees, and in turn, upon the management of our properties by our hotel manager. Distributions to the Company’s stockholders will generally be taxable to the Company’s stockholders as ordinary income; however, because a portion of our investments will be equity ownership interests in hotels, which will result in depreciation and non-cash charges against our income, a portion of our distributions may constitute a non-taxable return of capital. To the extent not inconsistent with maintaining the Company’s REIT status, our TRS Lessees may retain any after-tax earnings.\\nDistributions to Preferred Stockholders and Holder of Preferred partnership units in the Operating Partnership. The Company is obligated to pay distributions to its preferred stockholders of the Company’s preferred stock and the Operating Partnership is obligated to pay its preferred unit holder, the Company. Holders of the Company’s 8% Series B Cumulative Redeemable Preferred Stock are entitled to receive distributions when authorized by the Company’s board of directors out of assets legally available for the payment of distributions. The amount of annual dividends on our outstanding preferred shares is approximately $3.2 million and the aggregate liquidation preference with respect to our outstanding preferred shares is approximately $40.3 million. The preferred stock is not redeemable by the holders, has no maturity date and is not convertible into any other security of the Company or its affiliates, except in the event of a change of control.\\n53\\nThe Company’s ability to pay distributions to its stockholders will depend, in part, upon its receipt of distributions from the Operating Partnership which may depend upon receipt of lease payments with respect to our properties from our TRS Lessees, and in turn, upon the management of our properties by our hotel manager. Distributions to the Company’s stockholders will generally be taxable to the Company’s stockholders as ordinary income; however, because a portion of our investments will be equity ownership interests in hotels, which will result in depreciation and non-cash charges against our income, a portion of our distributions may constitute a non-taxable return of capital. To the extent not inconsistent with maintaining the Company’s REIT status, our TRS Lessees may retain any after-tax earnings.\\nThe amount, timing and frequency of distributions will be authorized by the Company’s board of directors and declared by the Company based upon a variety of factors deemed relevant by its directors, and no assurance can be given that the distribution policy will not change in the future.\\nInflation\\nWe generate revenues primarily from lease payments from our TRS Lessees and net income from the operations of our TRS Lessees. Therefore, we rely primarily on the performance of the individual properties and the ability of the management company to increase revenues and to keep pace with inflation. Operators of hotels, in general, possess the ability to adjust room rates daily to keep pace with inflation. However, competitive pressures at some or all of our hotels may limit the ability of the management company to raise room rates.\\nOur expenses, including hotel operating expenses, administrative expenses, real estate taxes and property and casualty insurance are subject to inflation. These expenses are expected to grow with the general rate of inflation, except for energy, liability insurance, property and casualty insurance, property tax rates, employee benefits, and some wages, which are expected to increase at rates higher than inflation.\\nGeographic Concentration and Seasonality\\nOur hotels are located in Florida, Georgia, Indiana, Maryland, North Carolina, Pennsylvania, and Texas. As a result, we are particularly susceptible to adverse market conditions in these geographic areas, including industry downturns, relocation of businesses and any oversupply of hotel rooms or a reduction in lodging demand. Adverse economic developments in the markets in which we have a concentration of hotels, or in any of the other markets in which we operate, or any increase in hotel supply or decrease in lodging demand resulting from the local, regional or national business climate, could materially and adversely affect us.\\nThe operations of our hotel properties have historically been seasonal. The months of April and May are traditionally strong, as is October. The periods from mid-November through mid-February are traditionally slow with the exception of hotels located in certain markets, namely Florida and Texas, which experience significant room demand during this period.\\nCompetition\\nThe hotel industry is highly competitive with various participants competing on the basis of price, level of service and geographic location. Each of our hotels is located in a developed area that includes other hotel properties. The number of competitive hotel properties in a particular area could have a material adverse effect on occupancy, ADR and RevPAR of our hotels or at hotel properties acquired in the future. We believe that brand recognition, location, the quality of the hotel, consistency of services provided, and price, are the principal competitive factors affecting our hotels.\\nCritical Accounting Policies\\nThe critical accounting policies are described below. We consider these policies critical because they involve difficult management judgments and assumptions, are subject to material change from external factors or are pervasive, and are significant to fully understand and evaluate our reported financial results.\\nInvestment in Hotel Properties. Hotel properties are stated at cost, net of any impairment charges, and are depreciated using the straight-line method over an estimated useful life of 7-39 years for buildings and improvements and 3-10 years for furniture and equipment. In accordance with generally accepted accounting principles, the controlling interests in hotels comprising our accounting predecessor, MHI Hotels Services Group, and noncontrolling interests held by the controlling holders of our accounting predecessor in hotels, which were acquired from third parties contributed to us in connection with the Company’s initial public offering, are recorded at historical cost basis. Noncontrolling interests in those entities that comprise our accounting predecessor and the interests in hotels, other than those held by the controlling members of our accounting predecessor, acquired from third parties are recorded at fair value at the time of acquisition.\\n54\\nWe review our hotel properties for impairment whenever events or changes in circumstances indicate the carrying value of the hotel properties may not be recoverable. Events or circumstances that may cause us to perform our review include, but are not limited to, adverse permanent changes in the demand for lodging at our properties due to declining national or local economic conditions and/or new hotel construction in markets where our hotels are located. When such conditions exist, management performs a recoverability analysis to determine if the estimated undiscounted future cash flows from operating activities and the estimated proceeds from the ultimate disposition of a hotel property exceed its carrying value. If the estimated undiscounted future cash flows are found to be less than the carrying amount of the hotel property, an adjustment to reduce the carrying value to the related hotel property’s estimated fair market value would be recorded and an impairment loss recognized.\\nOur review of possible impairment at one of our hotel properties revealed an excess of current carrying cost over the estimated undiscounted future cash flows, which resulted in an impairment to fair market value by an approximate amounts of $0.5 million and $3.2 million, as of December 31, 2015 and 2014, respectively.\\nIn performing the recoverability analysis, we project future operating cash flows based upon significant assumptions regarding growth rates, occupancy, room rates, economic trends, property-specific operating costs and future capital expenditures required to maintain the hotel in its current operating condition. We also project cash flows from the eventual disposition of the hotel based upon various factors including property-specific capitalization rates, ratio of selling price to gross hotel revenues and the selling price per room.\\nRevenue Recognition. Hotel revenues, including room, food, beverage and other hotel revenues, are recognized as the related services are delivered. We generally consider accounts receivable to be fully collectible; accordingly, no allowance for doubtful accounts is required. If we determine that amounts are uncollectible, which would generally be the result of a customer’s bankruptcy or other economic downturn, such amounts will be charged against operations when that determination is made.\\nIncome Taxes. We record a valuation allowance to reduce deferred tax assets to an amount that we believe is more likely than not to be realized. Because of expected future taxable income of our TRS Lessee, we have not recorded a valuation allowance to reduce our net deferred tax asset as of December 31, 2016. We regularly evaluate the likelihood that our TRS Lessee will be able to realize its deferred tax assets and the continuing need for a valuation allowance. At December 31, 2016, we determined, based on all available positive and negative evidence, that it is more-likely-than-not that future taxable income will be available during the carryforward periods to absorb all of the consolidated federal and state net operating loss carryforward. A number of factors played a critical role in this determination, including:\\n| • | a demonstrated track record of past profitability and utilization of past NOL carryforwards, |\\n\\n| • | reasonable forecasts of future taxable income, and |\\n\\n| • | anticipated changes in the lease rental payments from the TRS Lessee to subsidiaries of the Operating Partnership. |\\n\\nShould unanticipated adverse financial trends occur, or other negative evidence develop, a valuation allowance may be necessary in the future against some or all of our deferred tax assets.\\nRecent Accounting Pronouncements\\nFor a summary of recently adopted and newly issued accounting pronouncements, please refer to the Recent Accounting Pronouncements section of Note 2, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements.\\nNon-GAAP Financial Measures\\nWe consider FFO, Adjusted FFO and Hotel EBITDA, all of which are non-GAAP financial measures, to be key supplemental measures of our performance and could be considered along with, not alternatives to, net income (loss) as a measure of our performance. These measures do not represent cash generated from operating activities determined by generally accepted accounting principles (“GAAP”) or amounts available for our discretionary use and should not be considered alternative measures of net income, cash flows from operations or any other operating performance measure prescribed by GAAP.\\nFFO and Adjusted FFO. Industry analysts and investors use Funds from Operations (“FFO”), as a supplemental operating performance measure of an equity REIT. FFO is calculated in accordance with the definition adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). FFO, as defined by NAREIT, represents net income or loss determined in accordance with GAAP, excluding extraordinary items as defined under GAAP and gains or losses from sales of previously depreciated operating real estate assets, plus certain non-cash items such as real estate asset depreciation and amortization,\\n55\\nand after adjustment for any noncontrolling interest from unconsolidated partnerships and joint ventures. Historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen or fallen with market conditions, many investors and analysts have considered the presentation of operating results for real estate companies that use historical cost accounting to be insufficient by itself.\\nWe consider FFO to be a useful measure of adjusted net income (loss) for reviewing comparative operating and financial performance because we believe FFO is most directly comparable to net income (loss), which remains the primary measure of performance, because by excluding gains or losses related to sales of previously depreciated operating real estate assets and excluding real estate asset depreciation and amortization, FFO assists in comparing the operating performance of a company’s real estate between periods or as compared to different companies. Although FFO is intended to be a REIT industry standard, other companies may not calculate FFO in the same manner as we do, and investors should not assume that FFO as reported by us is comparable to FFO as reported by other REITs.\\nWe further adjust FFO for certain additional items that are not in NAREIT’s definition of FFO, including changes in deferred income taxes, any unrealized gain (loss) on hedging instruments or warrant derivative, loan impairment losses, losses on early extinguishment of debt, aborted offering costs, loan modification fees, franchise termination costs, costs associated with the departure of executive officers, litigation settlement, over-assessed real estate taxes on appeal, change in control gains or losses and acquisition transaction costs. We exclude these items as we believe it allows for meaningful comparisons between periods and among other REITs and is more indicative than FFO of the on-going performance of our business and assets. Our calculation of Adjusted FFO may be different from similar measures calculated by other REITs.\\nThe following is a reconciliation of net income (loss) to FFO and Adjusted FFO for the years ended December 31, 2016, 2015, and 2014.\\n\\n| Year Ended | Year Ended | Year Ended |\\n| December 31, | December 31, | December 31, |\\n| 2016 | 2015 | 2014 |\\n| Net Income/(Loss) Attributable to the Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) |\\n| Add: Net Income/(Loss) Attributable to the Noncontrolling Interest | (26,567 | ) | 1,040,987 | (153,838 | ) |\\n| Depreciation and Amortization | 15,019,071 | 13,591,495 | 11,969,284 |\\n| Impairment of Investment in Hotel Properties, Net | — | 500,000 | 3,175,000 |\\n| Equity in Depreciation on Joint Venture | — | 259,279 | 529,053 |\\n| Gain on Change in Control | — | (6,603,148 | ) | — |\\n| Loss (Gain) on Disposal of Assets | 365,319 | (41,435 | ) | — |\\n| Gain on Involuntary Conversion of Asset | — | — | (169,151 | ) |\\n| Funds From Operations | $ | 15,139,650 | $ | 14,103,844 | $ | 14,765,677 |\\n| Increase in Deferred Income Taxes | (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) |\\n| Acquisition Costs | — | 634,376 | 155,187 |\\n| Loss on Starwood Settlement | — | 324,271 | — |\\n| Over-Assessed Real Estate Taxes Under Appeal | — | 497,733 | — |\\n| Loan Modification Fees | 64,215 | 243,229 | — |\\n| Franchise Termination Fee | — | — | 351,800 |\\n| Realized and Unrealized Loss on Hedging Activities (A) | 37,384 | 108,819 | — |\\n| Loss on Early Debt Extinguishment (A) | 1,417,905 | 772,907 | 831,079 |\\n| Adjusted FFO | $ | 15,100,188 | $ | 14,904,608 | $ | 14,142,080 |\\n\\n\\n| (A) | Includes equity in unrealized (gain)/loss on hedging activities and loss on early extinguishment of debt of joint venture. |\\n\\nHotel EBITDA. We define Hotel EBITDA as net income or loss excluding: (1) interest expense, (2) interest income, (3) income tax provision or benefit, (4) equity in the income or loss of equity investees, (5) unrealized gains and losses on derivative instruments not included in other comprehensive income, (6) gains and losses on disposal of assets, (7) realized gains and losses on investments, (8) impairment of long-lived assets or investments, (9) loss on early debt extinguishment, (10) gains or losses on change in control, (11) corporate general and administrative expense, (12) depreciation and amortization, (13) gains and losses on involuntary conversions of assets and (14) other operating revenue not related to our wholly-owned portfolio. We believe this provides a more\\n56\\ncomplete understanding of the operating results over which our wholly-owned hotels and its operators have direct control. We believe Hotel EBITDA provides investors with supplemental information on the on-going operational performance of our hotels and the effectiveness of third-party management companies operating our business on a property-level basis.\\nOur calculation of Hotel EBITDA may be different from similar measures calculated by other REITs.\\nThe following is a reconciliation of net loss to Hotel EBITDA for the years ended December 31, 2016, 2015, and 2014.\\n\\n| Year Ended | Year Ended | Year Ended |\\n| December 31, | December 31, | December 31, |\\n| 2016 | 2015 | 2014 |\\n| Net Income/(Loss) Attributable to the Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) |\\n| Add: Net Income/(Loss) Attributable to the Noncontrolling Interest | (26,567 | ) | 1,040,987 | (153,838 | ) |\\n| Interest Expense | 17,735,107 | 16,515,827 | 14,636,870 |\\n| Interest Income | (115,785 | ) | (50,461 | ) | (19,865 | ) |\\n| Distributions to Preferred Stockholders | 1,144,889 | — | — |\\n| Income Tax Benefit | (1,367,634 | ) | (1,336,033 | ) | (1,727,723 | ) |\\n| Depreciation and Amortization | 15,019,071 | 13,591,495 | 11,969,284 |\\n| Equity in Earnings of Joint Venture | — | (475,514 | ) | (307,370 | ) |\\n| Unrealized Loss on Hedging Activities | 37,384 | 108,819 | — |\\n| Gain on Change in Control | — | (6,603,148 | ) | — |\\n| Loss on Debt Extinguishment | 1,417,905 | 772,907 | 831,079 |\\n| Loss (Gain) on Disposal of Assets | 365,319 | (41,435 | ) | — |\\n| Gain on Involuntary Conversion of Asset | — | — | (169,151 | ) |\\n| Impairment of Investment in Hotel Properties, Net | — | 500,000 | 3,175,000 |\\n| Corporate General and Administrative Expenses | 6,021,065 | 7,268,256 | 5,085,949 |\\n| Net Lease Rental Income | — | — | (350,000 | ) |\\n| Other Fee Income | — | (200,976 | ) | (300,607 | ) |\\n| Hotel EBITDA | $ | 40,012,581 | $ | 36,447,390 | $ | 32,084,957 |\\n\\n\\nQuantitative and Qualitative Disclosures about Market Risk\\nThe effects of potential changes in interest rates are discussed below. Our market risk discussion includes “forward-looking statements” and represents an estimate of possible changes in fair value or future earnings that could occur assuming hypothetical future movements in interest rates. These disclosures are not precise indicators of expected future losses, but only indicators of reasonably possible losses. As a result, actual future results may differ materially from those presented. The analysis below presents the sensitivity of the market value of our financial instruments to selected changes in market interest rates.\\nTo meet in part our long-term liquidity requirements, we will borrow funds at a combination of fixed and variable rates. Our interest rate risk management objective is to limit the impact of interest rate changes on earnings and cash flows and to lower our overall borrowing costs. From time to time we may enter into interest rate hedge contracts such as collars and treasury lock agreements in order to mitigate our interest rate risk with respect to various debt instruments. We do not intend to hold or issue derivative contracts for trading or speculative purposes.\\nAs of December 31, 2016, we had approximately $228.7 million of fixed-rate debt and approximately $81.1 million of variable-rate debt. The weighted-average interest rate on the fixed-rate debt was 4.84%. A change in market interest rates on the fixed portion of our debt would impact the fair value of the debt, but have no impact on interest incurred or cash flows. Our variable-rate debt is exposed to changes in interest rates, specifically the changes in 1-month LIBOR. However, to the extent that 1-month LIBOR does not exceed the 1-month LIBOR floor on the mortgage on the DoubleTree by Hilton Philadelphia Airport of 0.50%, a portion of our variable-rate debt would not be exposed to changes in interest rates. Assuming that the aggregate amount outstanding on the mortgages on the Crowne Plaza Tampa Westshore, DoubleTree by Hilton Philadelphia Airport, DoubleTree by Hilton Jacksonville Riverfront and the mortgage on The Whitehall remains at approximately $81.1 million, the balance at December 31, 2016, the impact on our annual interest incurred and cash flows of a one percent increase in 1-month LIBOR would be approximately $0.8 million.\\nAs of December 31, 2015, we had approximately $272.6 million of fixed-rate debt and approximately $52.3 million of variable-rate debt. The weighted-average interest rate on the fixed-rate debt was 5.58%. A change in market interest rates on the fixed portion\\n57\\nof our debt would impact the fair value of the debt, but have no impact on interest incurred or cash flows. Our variable-rate debt is exposed to changes in interest rates, specifically the changes in 1-month and 3-month LIBOR. However, to the extent that 1-month LIBOR does not exceed the 1-month LIBOR floor on the mortgage on the DoubleTree by Hilton Philadelphia Airport of 0.50%, a portion of our variable-rate debt would not be exposed to changes in interest rates. Assuming that the aggregate amount outstanding on the mortgage on the DoubleTree by Hilton Philadelphia Airport and the mortgage on the DoubleTree by Hilton Jacksonville Riverfront remains at approximately $52.2 million, the balance at December 31, 2015, the impact on our annual interest incurred and cash flows of a one percent increase in 1-month LIBOR and 3-month LIBOR would be approximately $0.5 million.\\nFinancial Statements and Supplementary Data\\nSee Index to Financial Statements and Financial Statement Schedules on page F-1.\\nChanges in and Disagreements with Accountants on Accounting and Financial Disclosure\\nNone.\\nControls and Procedures\\nSotherly Hotels Inc.\\nDisclosure Controls and Procedures\\nThe Company’s management, under the supervision and participation of its Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of its disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as required by paragraph (b) of Rules 13a-15 and 15d-15 under the Exchange Act), as of December 31, 2016. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of December 31, 2016, its disclosure controls and procedures were effective and designed to ensure that (i) information required to be disclosed in its reports filed under the Exchange Act is recorded, processed, summarized and reported with the time periods specified in the SEC’s rules and instructions, and (ii) information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.\\nThe Company’s management, including its Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s disclosure controls and procedures or its internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of the controls can provide absolute assurance that all control issues and instances of fraud, if any, within Sotherly Hotels Inc. have been detected.\\nManagement’s Report on Internal Control over Financial Reporting\\nThe Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(e) under the Exchange Act). The Company’s management assessed the effectiveness over internal control over financial reporting as of December 31, 2016. In making this assessment, the Company’s management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) 2013 Internal Control-Integrated Framework. The Company’s management has concluded that, as of December 31, 2016, its internal control over financial reporting is effective based on these criteria.\\nThis annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s independent registered public accounting firm pursuant to the exemption provided to issuers that are not “large accelerated filers” or “accelerated filers” under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.\\n58\\nChanges in Internal Control over Financial Reporting\\nThere was no change in Sotherly Hotels Inc.’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Exchange Act during Sotherly Hotels Inc.’s last fiscal quarter that materially affected, or is reasonably likely to materially affect, Sotherly Hotels Inc.’s internal control over financial reporting.\\nSotherly Hotels LP\\nDisclosure Controls and Procedures\\nThe Operating Partnership’s management, under the supervision and participation of the Chief Executive Officer and Chief Financial Officer of Sotherly Hotels Inc., as general partner, has evaluated the effectiveness of the disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, as required by paragraph (b) of Rules 13a-15 and 15d-15 under the Exchange Act), as of December 31, 2016. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of December 31, 2016, the disclosure controls and procedures were effective and designed to ensure that (i) information required to be disclosed in the reports filed under the Exchange Act is recorded, processed, summarized and reported with the time periods specified in the SEC’s rules and instructions, and (ii) information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.\\nThe Operating Partnership’s management, including the Chief Executive Officer and Chief Financial Officer of Sotherly Hotels Inc., as general partner, does not expect that the disclosure controls and procedures or the internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of the controls can provide absolute assurance that all control issues and instances of fraud, if any, within Sotherly Hotels LP have been detected.\\nManagement’s Report on Internal Control over Financial Reporting\\nThe Operating Partnership’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(e) under the Exchange Act). Management assessed the effectiveness over internal control over financial reporting as of December 31, 2016. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in 2013 Internal Control-Integrated Framework. Management has concluded that, as of December 31, 2016, the Operating Partnership’s internal control over financial reporting is effective based on these criteria.\\nThis annual report does not include an attestation report of the Operating Partnership’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Operating Partnership’s independent registered public accounting firm pursuant to the exemption provided to issuers that are not “large accelerated filers” or “accelerated filers” under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.\\nChanges in Internal Control over Financial Reporting\\nThere was no change in Sotherly Hotels LP’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Exchange Act during Sotherly Hotels LP’s last fiscal quarter that materially affected, or is reasonably likely to materially affect, Sotherly Hotels LP’s internal control over financial reporting.\\nOther Information\\nNone.\\n59\\nPART III\\nThe information required by Items 10-14 is incorporated by reference to the Company’s proxy statement for the 2017 annual meeting of stockholders (to be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year covered by this report).\\nDirectors, Executive Officers and Corporate Governance\\nThe Company has adopted a code of business conduct and ethics, including a conflicts of interest policy that applies to its principal executive officer, principal financial officer, principal accounting officer or controller performing similar functions. We intend to maintain the highest standards of ethical business practices and compliance with all laws and regulations applicable to our business. A copy of the Company’s Code of Business Conduct is posted on the Company’s external website at www.sotherlyhotels.com. The Company and the Operating Partnership intend to post to its website any amendments to or waivers of its code. The Operating Partnership is managed by the Company, its sole general partner and parent company. Consequently, the Operating Partnership does not have its own separate directors or executive officers.\\nInformation on the Company’s directors is incorporated by reference to the sections captioned “Proposal I – Election of Directors” and “Section 16(a) Beneficial Ownership Reporting Compliance” contained in the Company’s 2017 Proxy Statement.\\n. Executive Compensation\\nThe information required by this item is incorporated by reference to the section captioned “Director and Executive Compensation” contained in the Company’s 2017 Proxy Statement.\\nSecurity Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters\\n(a) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS\\nInformation required by this item is incorporated herein by reference to the section captioned “Principal Holders” of the Company’s 2017 Proxy Statement.\\n(b) SECURITY OWNERSHIP OF MANAGEMENT\\nInformation required by this item is incorporated herein by reference to the section captioned “Principal Holders” of the Company’s 2017 Proxy Statement.\\n(c) CHANGES IN CONTROL\\nManagement of the Company knows of no arrangements, including any pledge by any person of securities of the Company, the operation of which may at a subsequent date result in a change in control of the Company.\\n(d) SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS\\nSet forth below is information as of December 31, 2016 with respect to compensation plans under which equity securities of the Company are authorized for issuance.\\n60\\nEQUITY COMPENSATION PLAN INFORMATION\\n\\n| NUMBER OF SECURITIES TO BE ISSUED UPON EXERCISE OF OUTSTANDING OPTIONS, WARRANTS AND RIGHTS | WEIGHTED-AVERAGE EXERCISE PRICE OF OUTSTANDING OPTIONS, WARRANTS AND RIGHTS | NUMBER OF SECURITIES REMAINING AVAILABLE FOR FUTURE ISSUANCE |\\n| Equity compensation plans approved by security holders: |\\n| 2013 Plan (1) | N/A | N/A | 640,900 |\\n| Equity compensation plans not approved by security holders: |\\n| None | N/A | N/A | N/A |\\n| Total | N/A | N/A | 640,900 |\\n\\n\\n| (1) | On February 2, 2016, we granted 8,000 shares of stock to Andrew M. Sims, 6,000 shares of stock to Anthony E. Domalski, 7,000 shares of stock to David R. Folsom, and 1,000 shares of stock to other employees of the Company. |\\n\\nOn February 2, 2016, we granted 12,000 shares (3,000 each) of restricted stock to certain of our independent directors that vested on December 31, 2016. Also on February 2, 2016, we granted an additional 2,250 shares of unrestricted stock to director Herschel J. Walker in consideration for his service during 2015.\\nOn February 15, 2017, we granted 12,000 shares (3,000 each) of restricted stock to certain of our independent directors that will vest on December 31, 2017. These shares are included in the number of securities remaining available for future issuance at December 31, 2016.\\nCertain Relationships and Related Transactions, and Director Independence\\nThe information required by this item is incorporated by reference to the sections captioned “Certain Relationships and Related Transactions” and “Proposal I – Election of Directors” in the Company’s 2017 Proxy Statement.\\nPrincipal Accountant Fees and Services\\nThe information required by this item is incorporated by reference to the section captioned “Proposal II –Ratification of Appointment of Accountants” in the Company’s 2017 Proxy Statement.\\n61\\nPART IV\\nExhibits and Financial Statement Schedules\\n\\n| 1. Financial Statements |\\n| Index to Financial Statements and Financial Statement Schedules | F-1 |\\n| Sotherly Hotels Inc. |\\n| Report of Independent Registered Public Accounting Firm, Dixon Hughes Goodman LLP | F-2 |\\n| Report of Independent Registered Public Accounting Firm, Grant Thornton LLP | F-3 |\\n| Consolidated Balance Sheets for Sotherly Hotels Inc. as of December 31, 2016 and 2015 | F-4 |\\n| Consolidated Statements of Operations for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-5 |\\n| Consolidated Statements of Changes in Equity for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-6 |\\n| Consolidated Statements of Cash Flows for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-7 |\\n| Sotherly Hotels LP |\\n| Report of Independent Registered Public Accounting Firm, Dixon Hughes Goodman LLP | F-8 |\\n| Report of Independent Registered Public Accounting Firm, Grant Thornton LLP | F-9 |\\n| Consolidated Balance Sheets for Sotherly Hotels LP as of December 31, 2016 and 2015 | F-10 |\\n| Consolidated Statements of Operations for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-11 |\\n| Consolidated Statements of Changes in Partners’ Capital for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-12 |\\n| Consolidated Statements of Cash Flows for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-13 |\\n| Notes to Consolidated Financial Statements | F-14 |\\n| 2. Financial Statement Schedules |\\n| Schedule III – Real Estate and Accumulated Depreciation as of December 31, 2016 | F-35 |\\n\\nAll other schedules for which provision is made in Regulation S-X are either not required to be included herein under the related instructions or are inapplicable or the related information is included in the footnotes to the applicable financial statement and, therefore, have been omitted.\\nThe following exhibits are filed as part of this Form 10-K:\\n\\n| Exhibits |\\n| 3.1 | Articles of Amendment and Restatement of the Company (incorporated by reference to the document previously filed as Exhibit 3.1 to the Company’s Pre-Effective Amendment No. 1 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on October 20, 2004 (File No. 333-118873)). |\\n| 3.1A | Articles of Amendment to the Articles of Amendment and Restatement of the Company, effective as of April 16, 2013 (incorporated by reference to the document previously filed as Exhibit 3.7 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 16, 2013). |\\n| 3.1B | Articles of Amendment to the Articles of Amendment and Restatement of the Company, effective as of August 12, 2016 (incorporated by reference to the document previously filed as Exhibit 3.1 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on August 15, 2016). |\\n| 3.2 | Amended and Restated Agreement of Limited Partnership of Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 3.3 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). |\\n| 3.2A | Amendment No. 1 to the Amended and Restated Agreement of Limited Partnership of Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 3.6 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 18, 2011). |\\n\\n62\\n\\n| Exhibits |\\n| 3.2B | Amendment No. 2 to the Amended and Restated Agreement of Limited Partnership of Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 3.3 to the Operating Partnership’s Pre-Effective Amendment No. 1 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on August 9, 2013 (File No. 333-189821)). |\\n| 3.2C | Amendment No. 3 to the Amended and Restated Agreement of Limited Partnership of Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 3.1 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on August 23, 2016). |\\n| 3.3 | Articles Supplementary of Sotherly Hotels Inc. (incorporated by reference to the document previously filed as Exhibit 3.4 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 18, 2011). |\\n| 3.4 | Second Amended and Restated Bylaws of the Company, effective as of April 16, 2013 (incorporated by reference to the document previously filed as Exhibit 3.8 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 16, 2013). |\\n| 3.5 | Articles Supplementary designating the Series B Preferred Stock of the Company, effective as of August 19, 2016 (incorporated by reference to the document previously filed as Exhibit 3.5 to the Company’s Registration Statement on Form 8-A filed with the Securities and Exchange Commission on August 22, 2016). |\\n| 4.0 | Form of Common Stock Certificate. |\\n| 4.1 | Senior Unsecured Note issued by Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 4.6 to our Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2013, filed with the Securities and Exchange Commission on November 7, 2013). |\\n| 4.2 | Indenture by and among Sotherly Hotels LP and Wilmington Trust, National Association, as trustee (incorporated by reference to the document previously filed as Exhibit 4.7 to our Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2013, filed with the Securities and Exchange Commission on November 7, 2013). |\\n| 4.3 | Indenture by and among Sotherly Hotels Inc., Sotherly Hotels LP and Wilmington Trust, National Association, as trustee, dated November 21, 2014 (incorporated by reference to the document previously filed as Exhibit 4.8 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on November 21, 2014). |\\n| 4.4 | First Supplemental Indenture, by and among Sotherly Hotels Inc., Sotherly Hotels LP and Wilmington Trust, National Association, as trustee, dated November 21, 2014 (incorporated by reference to the document previously filed as Exhibit 4.9 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on November 21, 2014). |\\n| 4.5 | 7.00% Senior Unsecured Note due 2019, issued by Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 4.10 to our Annual Report on Form 10-K for the fiscal year ended December 31, 2014, filed with the Securities and Exchange Commission on April 14, 2015). |\\n| 4.6 | Form of Specimen Certificate of Series B Preferred Stock of the Company (incorporated by reference to the document previously filed as Exhibit 4.1 to the Company’s Registration Statement on Form 8-A filed with the Securities and Exchange Commission on August 22, 2016). |\\n| 10.1 | Sotherly Hotels Inc. 2004 Long-Term Incentive Plan (incorporated by reference to the document previously filed as Exhibit 10.1 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). * |\\n| 10.1A | Form of Restricted Stock Award Agreement between Sotherly Hotels Inc. and Participant (incorporated by reference to the document previously filed as Exhibit 10.1A to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2008, filed with the Securities and Exchange Commission on March 25, 2009). * |\\n| 10.2 | Executive Employment Agreement between Sotherly Hotels Inc. and Andrew M. Sims, dated January 12, 2015 (incorporated by reference to the document previously filed as Exhibit 10.2A to our Current Report on Form 8-K filed with the Securities and Exchange Commission on January 13, 2015). * |\\n| 10.3 | Executive Employment Agreement between Sotherly Hotels Inc. and Anthony E. Domalski (incorporated by reference to the document previously filed as Exhibit 10.2A to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on January 3, 2013). * |\\n\\n63\\n\\n| Exhibits |\\n| 10.4 | Contribution Agreement dated August 23, 2004 by and between the owners of Capitol Hotel Associates L.P., L.L.P. and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.6 to the Company’s Pre-Effective Amendment No. 6 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 15, 2004 (File No. 333-118873)). |\\n| 10.5 | Contribution Agreement dated August 23, 2004 by and between the owners of Savannah Hotel Associates LLC and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.7 to the Company’s Pre-Effective Amendment No. 6 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 15, 2004 (File No. 333-118873)). |\\n| 10.6 | Contribution Agreement dated August 23, 2004 by and between KDCA Partnership, MAVAS LLC, and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.8 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). |\\n| 10.7 | Contribution Agreement dated September 8, 2004 by and between Elpizo Limited Partnership, Phileo Land Corporation and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.9 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). |\\n| 10.8 | Asset Purchase Agreement dated August 19, 2004 by and between Accord LLC, West Laurel Corporation and MHI Hotels Services, LLC (incorporated by reference to the document previously filed as Exhibit 10.10 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). |\\n| 10.9 | Agreement to Assign and Sublease Common Space Lease and Form of Sublease by and between MHI Hospitality L.P. and MHI Hotels, LLC (incorporated by reference to the document previously filed as Exhibit 10.11 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2011, filed with the Securities and Exchange Commission on November 9, 2011). |\\n| 10.10 | Agreement to Assign and Sublease Commercial Space Lease and Form of Sublease by and between MHI Hospitality L.P. and MHI Hotels Two, Inc. (incorporated by reference to the document previously filed as Exhibit 10.12 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2011, filed with the Securities and Exchange Commission on November 9, 2011). |\\n| 10.11 | Lease Agreement by and between Philadelphia Hotel Associates, LP and MHI Hospitality TRS, LLC (with a schedule of eight additional agreements that are substantially identical in all material respects to the Lease agreement, except as identified in such schedule, and are not being filed herewith per Instruction 2 to Item 601 of Regulation S-K (incorporated by reference to the document previously filed as Exhibit 10.13 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2011, filed with the Securities and Exchange Commission on November 9, 2011). |\\n| 10.12 | Management Restructuring Agreement by and between MHI Hospitality TRS, LLC, MHI Hotels Services, LLC and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.14 to the Company’s Pre-Effective Amendment No. 3 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on November 15, 2004 (File No. 333-118873)). |\\n| 10.13 | Contribution Agreement by and between MHI Hotels Services, LLC, MHI Hotels, LLC and MHI Hotels Two, Inc. (incorporated by reference to the document previously filed as Exhibit 10.15 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2011, filed with the Securities and Exchange Commission on November 9, 2011). |\\n| 10.14 | Executive Employment Agreement, dated as of January 1, 2016, between Sotherly Hotels Inc. and David R. Folsom (incorporated by reference to the document previously filed as Exhibit 10.20A to our Current Report on Form 8-K filed with the Securities and Exchange Commission on January 4, 2016). * |\\n| 10.15 | Promissory Note dated March 29, 2007, made by Capitol Hotel Associates, L.P., L.L.P. and MONY Life Insurance Company (incorporated by reference to the document previously filed as Exhibit 10.25 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 2, 2007). |\\n| Exhibits |\\n| 10.16 | Limited Liability Company Agreement of MHI/Carlyle Hotel Investment Program I, L.L.C. dated April 26, 2007 (incorporated by reference to the document previously filed as Exhibit 10.26A to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on May 2, 2007). |\\n| 10.17 | Limited Liability Company Agreement of MHI/Carlyle Hotel Lessee Program I, L.L.C. dated April 26, 2007 (incorporated by reference to the document previously filed as Exhibit 10.26B to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on May 2, 2007). |\\n| 10.18 | Promissory Note dated August 2, 2007 made by Savannah Hotel Associates L.L.C., to the order of MONY Life Insurance Company (incorporated by reference to the document previously filed as Exhibit 10.29 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on August 3, 2007). |\\n| 10.19 | Sotherly Hotels Inc. 2013 Long-Term Incentive Plan (incorporated by reference to Appendix A to the Company’s Definitive Proxy Statement on Schedule 14A filed with the Securities and Exchange Commission on March 20, 2013). * |\\n| 10.20 | Sales Agency Agreement, dated July 9, 2014, among Sotherly Hotels Inc., Sotherly Hotels LP and Sandler O’Neill & Partners, L.P. (incorporated by reference to the document previously filed as Exhibit 10.51 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on July 9, 2014). |\\n| 10.21 | Master Agreement by and among Sotherly Hotels Inc., Sotherly Hotels LP, MHI Hospitality TRS, LLC and MHI Hotels Services LLC (incorporated by reference to the document previously filed as Exhibit 10.52 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on December 19, 2014). |\\n| 10.22 | Purchase and Sale Agreement by and between MHI Hospitality TRS II, LLC, MHI Hotel Investments Holdings LLC and CRP/MHI Holdings, L.L.C., dated as of June 19, 2015 (incorporated by reference to the document previously filed as Exhibit 10.53 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on June 22, 2015). |\\n| 10.23 | Agreement for Sale and Purchase of Property by and between Hampton Hotel Associates LLC, Three Capital Hotels, Inc., and Ajitkumar B. Patel, dated as of April 29, 2016 (incorporated by reference to the document previously filed as Exhibit 10.54 to our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2016, filed with the Securities and Exchange Commission on August 12, 2016). |\\n| 10.24 | Amendment to the Agreement for Sale and Purchase of Property by and between Hampton Hotel Associates LLC, Three Capital Hotels, Inc., and Ajitkumar B. Patel, dated as of June 10, 2016 (incorporated by reference to the document previously filed as Exhibit 10.55 to our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2016, filed with the Securities and Exchange Commission on August 12, 2016). |\\n| 10.25 | Commercial Unit Purchase Agreement between Sotherly Hotels Inc. and 4111 South Ocean Drive, LLC, dated as of September 14, 2016 (incorporated by reference to the document previously filed as Exhibit 10.56 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on September 20, 2016). |\\n| 10.26 | Addendum to Commercial Unit Agreement between Sotherly Hotels Inc. and 4111 South Ocean Drive, LLC, dated as of September 14, 2016 (incorporated by reference to the document previously filed as Exhibit 10.57 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on September 20, 2016). |\\n| 10.27 | Agreement for Sale and Purchase of Property by and between Hampton Hotel Associates LLC, Marina Hotel, LLC, Neil Amin and Shamin Hotels, Inc., dated as of October 6, 2016 (incorporated by reference to the document previously filed as Exhibit 10.58 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on February 9, 2017). |\\n| 10.28 | Amendment to Agreement for Sale and Purchase of Property by and between Hampton Hotel Associates LLC, Marina Hotel, LLC, Neil Amin and Shamin Hotels, Inc., dated as of February 7, 2017 (incorporated by reference to the document previously filed as Exhibit 10.59 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on February 9, 2017). |\\n| 16.1 | Letter from Grant Thornton LLP, dated April 6, 2016 (incorporated by reference to the document previously filed as Exhibit 16.1 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on April 6, 2016). |\\n| 21.1 | List of Subsidiaries of Sotherly Hotels Inc. |\\n| 21.2 | List of Subsidiaries of Sotherly Hotels LP. |\\n| Exhibits |\\n| 23.1 | Consent of Dixon Hughes Goodman LLP. |\\n| 23.2 | Consent of Grant Thornton LLP. |\\n| 23.3 | Consent of Dixon Hughes Goodman LLP. |\\n| 23.4 | Consent of Grant Thornton LLP. |\\n| 31.1 | Certification of Chief Executive Officer pursuant to Exchange Act Rule 13(a)-14 and 15(d)-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| 31.2 | Certification of Chief Financial Officer pursuant to Exchange Act Rule 13(a)-14 and 15(d)-14, as adopted, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| 31.3 | Certification of Chief Executive Officer pursuant to Exchange Act Rule 13(a)-14 and 15(d)-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| 31.4 | Certification of Chief Financial Officer pursuant to Exchange Act Rule 13(a)-14 and 15(d)-14, as adopted, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| 32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes-Oxley Act of 2002. |\\n| 32.2 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes-Oxley Act of 2002. |\\n| 32.3 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes-Oxley Act of 2002. |\\n| 32.4 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes-Oxley Act of 2002. |\\n| 101.INS | XBRL Instance Document |\\n| 101.SCH | XBRL Taxonomy Extension Schema Document |\\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document |\\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document |\\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document |\\n| * | Denotes management contract and/or compensatory plan/arrangement. |\\n| SOTHERLY HOTELS INC. |\\n| By: | /s/ ANDREW M. SIMS |\\n| Andrew M. Sims Chief Executive Officer |\\n| Signature | Title | Date |\\n| /s/ ANDREW M. SIMS Andrew M. Sims | Chief Executive Officer and Chairman of the Board of Directors | March 22, 2017 |\\n| /s/ DAVID R. FOLSOM David R. Folsom | President, Chief Operating Officer and Director | March 22, 2017 |\\n| /s/ ANTHONY E. DOMALSKI Anthony E. Domalski | Chief Financial Officer | March 22, 2017 |\\n| /s/ HERSCHEL J. WALKER Herschel J. Walker | Director | March 22, 2017 |\\n| /s/ DAVID J. BEATTY David J. Beatty | Director | March 22, 2017 |\\n| /s/ EDWARD S. STEIN Edward S. Stein | Director | March 22, 2017 |\\n| /s/ ANTHONY C. ZINNI Anthony C. Zinni | Director | March 22, 2017 |\\n| SOTHERLY HOTELS LP, |\\n| by its General Partner, |\\n| SOTHERLY HOTELS INC. |\\n| By: | /s/ ANDREW M. SIMS |\\n| Andrew M. Sims Chief Executive Officer |\\n| Signature | Title | Date |\\n| /s/ ANDREW M. SIMS Andrew M. Sims | Chief Executive Officer and Chairman of the Board of Directors of the General Partner | March 22, 2017 |\\n| /s/ DAVID R. FOLSOM David R. Folsom | President, Chief Operating Officer and Director of the General Partner | March 22, 2017 |\\n| /s/ ANTHONY E. DOMALSKI Anthony E. Domalski | Chief Financial Officer of the General Partner | March 22, 2017 |\\n| /s/ HERSCHEL J. WALKER Herschel J. Walker | Director of the General Partner | March 22, 2017 |\\n| /s/ DAVID J. BEATTY David J. Beatty | Director of the General Partner | March 22, 2017 |\\n| /s/ EDWARD S. STEIN Edward S. Stein | Director of the General Partner | March 22, 2017 |\\n| /s/ ANTHONY C. ZINNI Anthony C. Zinni | Director of the General Partner | March 22, 2017 |\\n| Sotherly Hotels Inc. |\\n| Report of Independent Registered Public Accounting Firm, Dixon Hughes Goodman LLP | F-2 |\\n| Report of Independent Registered Public Accounting Firm, Grant Thornton LLP | F-3 |\\n| Consolidated Balance Sheets for Sotherly Hotels Inc. as of December 31, 2016 and 2015 | F-4 |\\n| Consolidated Statements of Operations for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-5 |\\n| Consolidated Statements of Changes in Equity for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-6 |\\n| Consolidated Statements of Cash Flows for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-7 |\\n| Sotherly Hotels LP |\\n| Report of Independent Registered Public Accounting Firm, Dixon Hughes Goodman LLP | F-8 |\\n| Report of Independent Registered Public Accounting Firm, Grant Thornton LLP | F-9 |\\n| Consolidated Balance Sheets for Sotherly Hotels LP as of December 31, 2016 and 2015 | F-10 |\\n| Consolidated Statements of Operations for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-11 |\\n| Consolidated Statements of Changes in Partners’ Capital for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-12 |\\n| Consolidated Statements of Cash Flows for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-13 |\\n| Notes to Consolidated Financial Statements | F-14 |\\n| Schedule III – Real Estate and Accumulated Depreciation as of December 31, 2016 | F-35 |\\n| December 31, 2016 | December 31, 2015 |\\n| ASSETS |\\n| Investment in hotel properties, net | $ | 348,593,912 | $ | 354,963,242 |\\n| Investment in hotel properties held for sale, net | 5,333,000 | — |\\n| Cash and cash equivalents | 31,766,775 | 11,493,914 |\\n| Restricted cash | 4,596,145 | 5,793,840 |\\n| Accounts receivable, net | 4,127,748 | 4,071,175 |\\n| Accounts receivable-affiliate | 4,175 | 226,552 |\\n| Loan proceeds receivable | — | 2,600,711 |\\n| Prepaid expenses, inventory and other assets | 4,648,469 | 4,432,431 |\\n| Deferred income taxes | 6,949,340 | 5,390,374 |\\n| TOTAL ASSETS | $ | 406,019,564 | $ | 388,972,239 |\\n| LIABILITIES |\\n| Mortgage loans, net | $ | 282,708,289 | $ | 270,331,724 |\\n| Unsecured notes, net | 24,308,713 | 50,460,106 |\\n| Accounts payable and accrued expenses | 12,970,960 | 12,334,878 |\\n| Advance deposits | 2,315,787 | 1,651,840 |\\n| Dividends and distributions payable | 2,376,527 | 1,335,323 |\\n| TOTAL LIABILITIES | $ | 324,680,276 | $ | 336,113,871 |\\n| Commitments and contingencies (See Note 6) | — | — |\\n| EQUITY |\\n| Sotherly Hotels Inc. stockholders’ equity |\\n| 8% Series B Cumulative Redeemable Perpetual Preferred stock, par value $0.01, 11,000,000 shares authorized, liquidation preference $25 per share, 1,610,000 shares and 0 shares issued and outstanding at December 31, 2016 and 2015, respectively | 16,100 | — |\\n| Common stock, par value $0.01, 49,000,000 shares authorized, 14,468,551 shares and 14,490,714 shares issued and outstanding at December 31, 2016 and 2015, respectively | 144,685 | 144,907 |\\n| Additional paid in capital | 118,395,082 | 82,749,058 |\\n| Distributions in excess of retained earnings | (39,545,754 | ) | (33,890,834 | ) |\\n| Total Sotherly Hotels Inc. stockholders’ equity | 79,010,113 | 49,003,131 |\\n| Noncontrolling interest | 2,329,175 | 3,855,237 |\\n| TOTAL EQUITY | 81,339,288 | 52,858,368 |\\n| TOTAL LIABILITIES AND EQUITY | $ | 406,019,564 | $ | 388,972,239 |\\n| 2016 | 2015 | 2014 |\\n| REVENUE |\\n| Rooms department | $ | 108,199,151 | $ | 96,837,386 | $ | 84,618,889 |\\n| Food and beverage department | 35,384,530 | 33,273,599 | 31,444,984 |\\n| Other operating departments | 9,262,071 | 8,422,491 | 6,876,046 |\\n| Total revenue | 152,845,752 | 138,533,476 | 122,939,919 |\\n| EXPENSES |\\n| Hotel operating expenses |\\n| Rooms department | 28,895,371 | 25,782,992 | 22,913,479 |\\n| Food and beverage department | 24,357,248 | 23,005,629 | 21,026,202 |\\n| Other operating departments | 2,438,860 | 1,786,197 | 1,192,183 |\\n| Indirect | 57,141,692 | 51,310,292 | 45,072,491 |\\n| Total hotel operating expenses | 112,833,171 | 101,885,110 | 90,204,355 |\\n| Depreciation and amortization | 15,019,071 | 13,591,495 | 11,969,284 |\\n| Impairment of investment in hotel properties, net | — | 500,000 | 3,175,000 |\\n| Loss (gain) on disposal of assets | 365,319 | (41,435 | ) | — |\\n| Corporate general and administrative | 6,021,065 | 7,268,256 | 5,085,949 |\\n| Total operating expenses | 134,238,626 | 123,203,426 | 110,434,588 |\\n| NET OPERATING INCOME | 18,607,126 | 15,330,050 | 12,505,331 |\\n| Other income (expense) |\\n| Interest expense | (17,735,107 | ) | (16,515,827 | ) | (14,636,870 | ) |\\n| Interest income | 115,785 | 50,461 | 19,865 |\\n| Equity income in joint venture | — | 475,514 | 307,370 |\\n| Loss on early debt extinguishment | (1,417,905 | ) | (772,907 | ) | (831,079 | ) |\\n| Unrealized loss on hedging activities | (37,384 | ) | (108,819 | ) | — |\\n| Gain on change in control | — | 6,603,148 | — |\\n| Gain on involuntary conversion of asset | — | — | 169,151 |\\n| Net income/(loss) before income taxes | (467,485 | ) | 5,061,620 | (2,466,232 | ) |\\n| Income tax benefit | 1,367,634 | 1,336,033 | 1,727,723 |\\n| Net income/(loss) | 900,149 | 6,397,653 | (738,509 | ) |\\n| Less: Net (income)/loss attributable to the noncontrolling interest | 26,567 | (1,040,987 | ) | 153,838 |\\n| Net income/(loss) attributable to the Company | 926,716 | 5,356,666 | (584,671 | ) |\\n| Distributions to preferred stockholders | (1,144,889 | ) | — | — |\\n| Net income/(loss) attributable to common stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) |\\n| Net income/(loss) per share attributable to the common stockholders |\\n| Basic and diluted | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) |\\n| Weighted average number of common shares outstanding |\\n| Basic and diluted | 14,896,994 | 12,541,117 | 10,377,125 |\\n| Additional | Distributions |\\n| Preferred Stock | Common Stock | Paid- | in Excess of | Noncontrolling |\\n| Shares | Par Value | Shares | Par Value | In Capital | Retained Earnings | Interest | Total |\\n| Balances at December 31, 2013 | — | $ | — | 10,206,927 | $ | 102,069 | $ | 57,534,113 | $ | (32,450,773 | ) | $ | 5,669,386 | $ | 30,854,795 |\\n| Net loss | — | — | — | — | — | (584,671 | ) | (153,838 | ) | (738,509 | ) |\\n| Conversion of units in Operating Partnership to shares of common stock | — | — | 310,000 | 3,100 | 755,750 | — | (758,850 | ) | — |\\n| Redemption of units in Operating Partnership | — | — | — | — | — | — | (25,621 | ) | (25,621 | ) |\\n| Issuance of unrestricted common stock awards | — | — | 24,750 | 248 | 147,112 | — | — | 147,360 |\\n| Issuance of restricted common stock awards | — | — | 12,000 | 120 | 78,165 | — | — | 78,285 |\\n| Issuance of common stock through ATM offering, net | — | — | 17,255 | 172 | 124,739 | — | — | 124,911 |\\n| Amortization of restricted stock award | — | — | — | — | 19,920 | — | — | 19,920 |\\n| Dividends and distributions declared | — | — | — | — | (2,352,869 | ) | (598,415 | ) | (2,951,284 | ) |\\n| Balances at December 31, 2014 | — | $ | — | 10,570,932 | $ | 105,709 | $ | 58,659,799 | $ | (35,388,313 | ) | $ | 4,132,662 | $ | 27,509,857 |\\n| Net income | — | — | — | — | — | 5,356,666 | 1,040,987 | 6,397,653 |\\n| Issuance of unrestricted common stock awards | — | — | 26,350 | 264 | 193,936 | — | — | 194,200 |\\n| Issuance of restricted common stock awards | — | — | 9,750 | 98 | 71,760 | — | — | 71,858 |\\n| Issuance of common stock from ATM sales | — | — | 98,682 | 986 | 681,222 | — | — | 682,208 |\\n| Issuance of common stock from equity offering | — | — | 3,435,000 | 34,350 | 22,534,259 | — | — | 22,568,609 |\\n| Conversion of Operating Partnership units into shares of common stock | — | — | 350,000 | 3,500 | 588,162 | — | (591,662 | ) | — |\\n| Amortization of restricted stock award | — | — | — | — | 19,920 | — | — | 19,920 |\\n| Dividends and distributions declared | — | — | — | — | — | (3,859,187 | ) | (726,750 | ) | (4,585,937 | ) |\\n| Balances at December 31, 2015 | — | $ | — | 14,490,714 | $ | 144,907 | $ | 82,749,058 | $ | (33,890,834 | ) | $ | 3,855,237 | $ | 52,858,368 |\\n| Net income (loss) | — | — | — | — | — | 926,716 | (26,567 | ) | 900,149 |\\n| Issuance of Series B Preferred Stock | 1,610,000 | 16,100 | — | — | 37,750,431 | — | — | 37,766,531 |\\n| Issuance of unrestricted common stock awards | — | — | 24,250 | 242 | 128,040 | — | — | 128,282 |\\n| Issuance of restricted common stock awards | — | — | 12,000 | 120 | 63,360 | — | — | 63,480 |\\n| Repurchase of common stock | — | — | (481,100 | ) | (4,811 | ) | (3,159,725 | ) | — | — | (3,164,536 | ) |\\n| Conversion of Operating Partnership units into shares of common stock | — | — | 422,687 | 4,227 | 843,998 | — | (848,225 | ) | — |\\n| Amortization of restricted stock award | — | — | — | — | 19,920 | — | — | 19,920 |\\n| Preferred stock dividends declared | — | — | — | — | — | (1,144,889 | ) | — | (1,144,889 | ) |\\n| Common stockholders' dividends and distributions declared | — | — | — | — | — | (5,436,747 | ) | (651,270 | ) | (6,088,017 | ) |\\n| Balances at December 31, 2016 | 1,610,000 | $ | 16,100 | 14,468,551 | $ | 144,685 | $ | 118,395,082 | $ | (39,545,754 | ) | $ | 2,329,175 | $ | 81,339,288 |\\n| 2016 | 2015 | 2014 |\\n| Cash flows from operating activities: |\\n| Net income (loss) | $ | 900,149 | $ | 6,397,653 | $ | (738,509 | ) |\\n| Adjustments to reconcile net income (loss) to net cash provided by operating activities: |\\n| Depreciation and amortization | 15,019,071 | 13,591,495 | 11,969,284 |\\n| Gain on change in control | — | (6,603,148 | ) | — |\\n| Equity income in joint venture | — | (475,514 | ) | (307,370 | ) |\\n| Impairment of investment in hotel properties | — | 500,000 | 3,175,000 |\\n| Amortization of deferred financing costs | 1,147,864 | 1,300,032 | 1,428,674 |\\n| Amortization of mortgage premium | (24,682 | ) | (18,820 | ) | — |\\n| Unrealized loss on derivative instrument | 37,384 | 108,819 | — |\\n| Loss (gain) on disposal of assets | 365,319 | (41,435 | ) | — |\\n| Loss on early debt extinguishment | 1,141,905 | 772,907 | — |\\n| Charges related to equity-based compensation | 211,682 | 285,978 | 245,565 |\\n| Changes in assets and liabilities: |\\n| Restricted cash | (560,817 | ) | 584,926 | (92,439 | ) |\\n| Accounts receivable | (56,573 | ) | (2,021,825 | ) | 369,685 |\\n| Prepaid expenses, inventory and other assets | (334,063 | ) | (623,980 | ) | (1,677,032 | ) |\\n| Deferred income taxes | (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) |\\n| Accounts payable and other accrued liabilities | (35,188 | ) | (1,001,376 | ) | 2,338,688 |\\n| Advance deposits | 663,947 | 431,111 | 89,099 |\\n| Accounts receivable - affiliate | 222,377 | (28,878 | ) | 12,273 |\\n| Net cash provided by operating activities | 17,139,409 | 11,377,374 | 14,851,255 |\\n| Cash flows from investing activities: |\\n| Acquisitions of hotel properties | — | (25,525,754 | ) | (61,106,085 | ) |\\n| Improvements and additions to hotel properties | (14,912,677 | ) | (20,136,427 | ) | (9,801,018 | ) |\\n| Payments on involuntary insurance conversions | — | — | — |\\n| Distributions from joint venture | — | 600,000 | 750,000 |\\n| Funding of restricted cash reserves | (5,276,518 | ) | (4,973,602 | ) | (3,692,045 | ) |\\n| Proceeds of restricted cash reserves | 7,035,029 | 6,376,459 | 2,583,419 |\\n| Proceeds from involuntary conversion of assets | — | 124,609 | 169,151 |\\n| Proceeds from the sale of assets | 213,400 | 2,402,113 | — |\\n| Net cash used in investing activities | (12,940,766 | ) | (41,132,602 | ) | (71,096,578 | ) |\\n| Cash flows from financing activities: |\\n| Proceeds of unsecured debt | — | — | 25,300,000 |\\n| Proceeds of mortgage debt | 102,700,000 | 127,000,000 | 48,600,000 |\\n| Proceeds from mortgage loan receivable | 2,600,711 | — | — |\\n| Proceeds from loans | — | — | 19,000,000 |\\n| Proceeds from sale of common stock, net | — | 23,250,818 | 124,911 |\\n| Proceeds from sale of preferred stock, net | 37,766,531 | — | — |\\n| Payments on mortgage loans | (89,619,564 | ) | (120,154,764 | ) | (24,171,892 | ) |\\n| Redemption of unsecured notes | (27,600,000 | ) | — | — |\\n| Repurchase of common stock | (2,061,407 | ) | — | — |\\n| Payment of deferred financing costs | (1,520,351 | ) | (1,377,882 | ) | (2,637,637 | ) |\\n| Dividends and distributions paid | (5,851,813 | ) | (4,103,529 | ) | (2,686,567 | ) |\\n| Preferred dividends paid | (339,889 | ) | — | — |\\n| Redemption of units in Operating Partnership | — | — | (25,621 | ) |\\n| Net cash provided by financing activities | 16,074,218 | 24,614,643 | 63,503,194 |\\n| Net increase (decrease) in cash and cash equivalents | 20,272,861 | (5,140,585 | ) | 7,257,871 |\\n| Cash and cash equivalents at the beginning of the period | 11,493,914 | 16,634,499 | 9,376,628 |\\n| Cash and cash equivalents at the end of the period | $ | 31,766,775 | $ | 11,493,914 | $ | 16,634,499 |\\n| Supplemental disclosures: |\\n| Cash paid during the period for interest | $ | 16,881,223 | $ | 15,415,695 | $ | 13,766,824 |\\n| Cash paid during the period for income taxes | $ | 192,965 | $ | 570,762 | $ | 263,621 |\\n| Non-cash investing and financing activities: |\\n| Mortgage debt proceeds receivable and related loan costs | $ | — | $ | 2,704,415 | $ | — |\\n| Assumption of mortgage loan on Crowne Plaza Hollywood Beach Resort acquisition | $ | — | $ | 57,000,000 | $ | — |\\n| Assumption of loan premium on the Crowne Plaza Hollywood Beach Resort assumed loan | $ | — | $ | 246,815 | $ | — |\\n| Change in amount of deferred financing and deferred offering cost in accounts payable and accrued liabilities | $ | — | $ | 624,117 | $ | 375,487 |\\n| Change in amount of hotel property improvements in accounts payable and accrued liabilities | $ | 431,858 | $ | 601,895 | $ | 1,108,182 |\\n| December 31, 2016 | December 31, 2015 |\\n| ASSETS |\\n| Investment in hotel properties, net | $ | 348,593,912 | $ | 354,963,242 |\\n| Investment in hotel property held for sale, net | 5,333,000 | — |\\n| Cash and cash equivalents | 31,766,775 | 11,493,914 |\\n| Restricted cash | 4,596,145 | 5,793,840 |\\n| Accounts receivable, net | 4,127,748 | 4,071,175 |\\n| Accounts receivable-affiliate | 4,175 | 226,552 |\\n| Loan proceeds receivable | — | 2,600,711 |\\n| Prepaid expenses, inventory and other assets | 4,648,469 | 4,432,431 |\\n| Deferred income taxes | 6,949,340 | 5,390,374 |\\n| TOTAL ASSETS | $ | 406,019,564 | $ | 388,972,239 |\\n| LIABILITIES |\\n| Mortgage loans, net | $ | 282,708,289 | $ | 270,331,724 |\\n| Unsecured notes, net | 24,308,713 | 50,460,106 |\\n| Accounts payable and other accrued liabilities | 12,970,960 | 12,334,878 |\\n| Advance deposits | 2,315,787 | 1,651,840 |\\n| Dividends and distributions payable | 2,376,527 | 1,335,323 |\\n| TOTAL LIABILITIES | $ | 324,680,276 | $ | 336,113,871 |\\n| Commitments and contingencies (see Note 6) | — | — |\\n| PARTNERS’ CAPITAL |\\n| 8% Series B Cumulative Redeemable Perpetual Preferred partnership units, liquidation preference $25 per unit, 1,610,000 units and 0 units issued and outstanding at December 31, 2016 and 2015, respectively | 37,766,531 | — |\\n| General Partner: 162,467 units and 166,915 units issued and outstanding as of December 31, 2016 and 2015, respectively | 681,389 | 774,295 |\\n| Limited Partners: 16,084,224 units and 16,524,626 units issued and outstanding as of December 31, 2016 and 2015, respectively | 42,891,368 | 52,084,073 |\\n| TOTAL PARTNERS’ CAPITAL | 81,339,288 | 52,858,368 |\\n| TOTAL LIABILITIES AND PARTNERS’ CAPITAL | $ | 406,019,564 | $ | 388,972,239 |\\n| 2016 | 2015 | 2014 |\\n| REVENUE |\\n| Rooms department | $ | 108,199,151 | $ | 96,837,386 | $ | 84,618,889 |\\n| Food and beverage department | 35,384,530 | 33,273,599 | 31,444,984 |\\n| Other operating departments | 9,262,071 | 8,422,491 | 6,876,046 |\\n| Total revenue | 152,845,752 | 138,533,476 | 122,939,919 |\\n| EXPENSES |\\n| Hotel operating expenses |\\n| Rooms department | 28,895,371 | 25,782,992 | 22,913,479 |\\n| Food and beverage department | 24,357,248 | 23,005,629 | 21,026,202 |\\n| Other operating departments | 2,438,860 | 1,786,197 | 1,192,183 |\\n| Indirect | 57,141,692 | 51,310,292 | 45,072,491 |\\n| Total hotel operating expenses | 112,833,171 | 101,885,110 | 90,204,355 |\\n| Depreciation and amortization | 15,019,071 | 13,591,495 | 11,969,284 |\\n| Impairment of investment in hotel properties, net | — | 500,000 | 3,175,000 |\\n| Loss on disposal of assets | 365,319 | (41,435 | ) | — |\\n| Corporate general and administrative | 6,021,065 | 7,268,256 | 5,085,949 |\\n| Total operating expenses | 134,238,626 | 123,203,426 | 110,434,588 |\\n| NET OPERATING INCOME | 18,607,126 | 15,330,050 | 12,505,331 |\\n| Other income (expense) |\\n| Interest expense | (17,735,107 | ) | (16,515,827 | ) | (14,636,870 | ) |\\n| Interest income | 115,785 | 50,461 | 19,865 |\\n| Equity income in joint venture | — | 475,514 | 307,370 |\\n| Loss on early debt extinguishment | (1,417,905 | ) | (772,907 | ) | (831,079 | ) |\\n| Unrealized loss on hedging activities | (37,384 | ) | (108,819 | ) | — |\\n| Gain on change in control | — | 6,603,148 | — |\\n| Gain on involuntary conversion of asset | — | — | 169,151 |\\n| Net income/(loss) before income taxes | (467,485 | ) | 5,061,620 | (2,466,232 | ) |\\n| Income tax benefit | 1,367,634 | 1,336,033 | 1,727,723 |\\n| Net income/(loss) | 900,149 | 6,397,653 | (738,509 | ) |\\n| Distributions to preferred unit holders | (1,144,889 | ) | — | — |\\n| Net income/(loss) attributable to operating partnership unit holders | $ | (244,740 | ) | $ | 6,397,653 | $ | (738,509 | ) |\\n| Net income/(loss) attributable per operating partner unit |\\n| Basic and diluted | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) |\\n| Weighted average number of operating partner units outstanding |\\n| Basic and diluted | 16,710,935 | 14,924,410 | 13,107,413 |\\n| Preferred Units | General Partner | Limited Partner |\\n| Units | Amount | Units | Amount | Units | Amounts | Total |\\n| Balances at December 31, 2013 | — | $ | — | 130,711 | $ | 554,316 | 12,940,343 | $ | 30,300,479 | $ | 30,854,795 |\\n| Issuance of partnership units | — | — | 540 | 3,534 | 53,465 | 347,022 | 350,556 |\\n| Amortization of restricted units award | — | — | — | 199 | — | 19,721 | 19,920 |\\n| Distributions declared | — | — | — | (29,644 | ) | — | (2,921,640 | ) | (2,951,284 | ) |\\n| Redemption of limited partnership units | — | — | (33 | ) | (228 | ) | (3,267 | ) | (25,393 | ) | (25,621 | ) |\\n| Net loss | — | — | — | (7,386 | ) | — | (731,123 | ) | (738,509 | ) |\\n| Balances at December 31, 2014 | — | $ | — | 131,218 | $ | 520,791 | 12,990,541 | $ | 26,989,066 | $ | 27,509,857 |\\n| Issuance of partnership units | — | — | 35,697 | 235,237 | 3,534,085 | 23,281,638 | 23,516,875 |\\n| Amortization of restricted units award | — | — | — | 149 | — | 19,771 | 19,920 |\\n| Distributions declared | — | — | — | (45,859 | ) | — | (4,540,078 | ) | (4,585,937 | ) |\\n| Net income | — | — | — | 63,977 | — | 6,333,676 | 6,397,653 |\\n| Balances at December 31, 2015 | — | $ | — | 166,915 | $ | 774,295 | 16,524,626 | $ | 52,084,073 | $ | 52,858,368 |\\n| Issuance of common partnership units | — | — | 363 | 1,918 | 35,887 | 189,844 | 191,762 |\\n| Issuance of preferred partnership units | 1,610,000 | 37,766,531 | — | — | — | — | 37,766,531 |\\n| Repurchased common units | — | — | (4,811 | ) | (31,645 | ) | (476,289 | ) | (3,132,891 | ) | (3,164,536 | ) |\\n| Amortization of restricted units award | — | — | — | 149 | — | 19,771 | 19,920 |\\n| Preferred partnership units distributions declared | — | (1,144,889 | ) | — | — | — | — | (1,144,889 | ) |\\n| Partnership units distributions declared | — | — | — | (60,880 | ) | — | (6,027,137 | ) | (6,088,017 | ) |\\n| Net income | — | 1,144,889 | — | (2,447 | ) | — | (242,293 | ) | 900,149 |\\n| Balances at December 31, 2016 | 1,610,000 | $ | 37,766,531 | 162,467 | $ | 681,389 | 16,084,224 | $ | 42,891,368 | $ | 81,339,288 |\\n| 2016 | 2015 | 2014 |\\n| Cash flows from operating activities: |\\n| Net income (loss) | $ | 900,149 | $ | 6,397,653 | $ | (738,509 | ) |\\n| Adjustments to reconcile net income (loss) to net cash provided by operating activities: |\\n| Depreciation and amortization | 15,019,071 | 13,591,495 | 11,969,284 |\\n| Gain on change in control | — | (6,603,148 | ) | — |\\n| Equity income in joint venture | — | (475,514 | ) | (307,370 | ) |\\n| Impairment of investment in hotel properties | — | 500,000 | 3,175,000 |\\n| Amortization of deferred financing costs | 1,147,864 | 1,300,032 | 1,428,674 |\\n| Amortization of mortgage premium | (24,682 | ) | (18,820 | ) | — |\\n| Unrealized loss on derivative instrument | 37,384 | 108,819 | — |\\n| Loss (gain) on disposal of assets | 365,319 | (41,435 | ) | — |\\n| Loss on early debt extinguishment | 1,141,905 | 772,907 | — |\\n| Charges related to equity-based compensation | 211,682 | 285,978 | 245,565 |\\n| Changes in assets and liabilities: |\\n| Restricted cash | (560,817 | ) | 584,926 | (92,439 | ) |\\n| Accounts receivable | (56,573 | ) | (2,021,825 | ) | 369,685 |\\n| Prepaid expenses, inventory and other assets | (334,063 | ) | (623,980 | ) | (1,677,032 | ) |\\n| Deferred income taxes | (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) |\\n| Accounts payable and other accrued liabilities | (35,188 | ) | (1,001,376 | ) | 2,338,688 |\\n| Advance deposits | 663,947 | 431,111 | 89,099 |\\n| Accounts receivable - affiliate | 222,377 | (28,878 | ) | 12,273 |\\n| Net cash provided by operating activities | 17,139,409 | 11,377,374 | 14,851,255 |\\n| Cash flows from investing activities: |\\n| Acquisitions of hotel properties | — | (25,525,754 | ) | (61,106,085 | ) |\\n| Improvements and additions to hotel properties | (14,912,677 | ) | (20,136,427 | ) | (9,801,018 | ) |\\n| Payments on involuntary insurance conversions | — | — | — |\\n| Distributions from joint venture | — | 600,000 | 750,000 |\\n| Funding of restricted cash reserves | (5,276,518 | ) | (4,973,602 | ) | (3,692,045 | ) |\\n| Proceeds from involuntary conversion of assets | — | 124,609 | 169,151 |\\n| Proceeds of restricted cash reserves | 7,035,029 | 6,376,459 | 2,583,419 |\\n| Proceeds from the sale of assets | 213,400 | 2,402,113 |\\n| Net cash used in investing activities | (12,940,766 | ) | (41,132,602 | ) | (71,096,578 | ) |\\n| Cash flows from financing activities: |\\n| Proceeds of unsecured debt | — | — | 25,300,000 |\\n| Proceeds of mortgage debt | 102,700,000 | 127,000,000 | 48,600,000 |\\n| Proceeds from mortgage loan receivable | 2,600,711 | — | — |\\n| Proceeds from loans | — | — | 19,000,000 |\\n| Proceeds from sale of operating units | — | 23,250,818 | 124,911 |\\n| Proceeds from sale of preferred operating units | 37,766,531 | — | — |\\n| Payments on mortgage loans | (89,619,564 | ) | (120,154,764 | ) | (24,171,892 | ) |\\n| Redemption of unsecured notes | (27,600,000 | ) |\\n| Repurchase of common units | (2,061,407 | ) | — | — |\\n| Payment of deferred financing costs | (1,520,351 | ) | (1,377,882 | ) | (2,637,637 | ) |\\n| Distributions paid | (5,851,813 | ) | (4,103,529 | ) | (2,686,567 | ) |\\n| Preferred dividends paid | (339,889 | ) | — | — |\\n| Redemption of units in Operating Partnership | — | — | (25,621 | ) |\\n| Net cash provided by financing activities | 16,074,218 | 24,614,643 | 63,503,194 |\\n| Net increase (decrease) in cash and cash equivalents | 20,272,861 | (5,140,585 | ) | 7,257,871 |\\n| Cash and cash equivalents at the beginning of the period | 11,493,914 | 16,634,499 | 9,376,628 |\\n| Cash and cash equivalents at the end of the period | $ | 31,766,775 | $ | 11,493,914 | $ | 16,634,499 |\\n| Supplemental disclosures: |\\n| Cash paid during the period for interest | $ | 16,881,223 | $ | 15,415,695 | $ | 13,766,824 |\\n| Cash paid during the period for income taxes | $ | 192,965 | $ | 570,762 | $ | 263,621 |\\n| Non-cash investing and financing activities: |\\n| Mortgage debt proceeds receivable and related loan costs | $ | — | $ | 2,704,415 | $ | — |\\n| Assumption of mortgage loan on Crowne Plaza Hollywood Beach Resort acquisition | $ | — | $ | 57,000,000 | $ | — |\\n| Assumption of loan premium on the Crowne Plaza Hollywood Beach Resort assumed loan | $ | — | $ | 246,815 | $ | — |\\n| Change in amount of deferred financing and deferred offering cost in accounts payable and accrued liabilities | $ | — | $ | 624,117 | $ | 375,487 |\\n| Change in amount of hotel property improvements in accounts payable and accrued liabilities | $ | 431,858 | $ | 601,895 | $ | 1,108,182 |\\n| Level 1 | Unadjusted quoted prices in active markets for identical assets or liabilities. |\\n| Level 2 | Unadjusted quoted prices in active markets for similar assets or liabilities, or Unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or Inputs other than quoted prices that are observable for the asset or liability. |\\n| Level 3 | Unobservable inputs for the asset or liability. |\\n| Level 1 | Level 2 | Level 3 |\\n| December 31, 2015 |\\n| Investment in hotel property, net (1) | $ | — | $ | — | $ | 5,700,762 |\\n| Interest Rate Cap (4) | $ | — | $ | 70,981 | $ | — |\\n| Mortgage loans (2) | $ | — | $ | (272,933,327 | ) | $ | — |\\n| Unsecured notes (3) | $ | (54,238,600 | ) | $ | — | $ | — |\\n| December 31, 2016 |\\n| Interest Rate Cap (4) | $ | — | $ | 33,597 | $ | — |\\n| Mortgage loans (2) | $ | — | $ | (281,840,780 | ) | $ | — |\\n| Unsecured notes (3) | $ | (26,241,160 | ) | $ | — | $ | — |\\n| (1) | A non-recurring fair value measurement was conducted in 2015 for our investment in hotel property, which resulted in a recorded impairment charge for the year ended December 31, 2015, which represent the amounts by which the carrying value of the asset group exceeded its fair value. |\\n| (2) | Mortgage loans are reflected at carrying value on our Consolidated Balance Sheet as of December 31, 2016 and December 31, 2015. |\\n| (3) | Unsecured notes are recorded at historical cost on our Consolidated Balance Sheet as of December 31, 2016 and December 31, 2015. |\\n| (4) | An interest rate cap on the DoubleTree by Hilton Jacksonville Riverfront mortgage with the Bank of the Ozarks is recorded at fair value on our Consolidated Balance Sheet as of December 31, 2016 and December 31, 2015. |\\n| December 31, 2017 | $ | 1,105,165 |\\n| December 31, 2018 | 632,365 |\\n| December 31, 2019 | 544,920 |\\n| December 31, 2020 | 499,294 |\\n| December 31, 2021 | 246,388 |\\n| December 31, 2022 and thereafter | 1,661,913 |\\n| Total | $ | 4,690,045 |\\n| Georgian Terrace | Crowne Plaza Hollywood Beach Resort |\\n| Land and land improvements | $ | 10,127,687 | $ | 24,008,289 |\\n| Buildings and improvements | 45,385,939 | 64,854,787 |\\n| Furniture, fixtures and equipment | 5,163,135 | 2,802,135 |\\n| Investment in hotel properties | 60,676,761 | 91,665,211 |\\n| Restricted cash | 124,658 | 1,159,759 |\\n| Accounts receivable | 465,287 | 140,588 |\\n| Prepaid expenses, inventory and other assets | 430,997 | 797,505 |\\n| Assumed mortgage | — | (57,259,159 | ) |\\n| Accounts payable and accrued liabilities | (591,618 | ) | (2,485,442 | ) |\\n| Equity investment | — | (1,889,560 | ) |\\n| Gain on change in control | — | (6,603,148 | ) |\\n| Net cash | $ | 61,106,085 | $ | 25,525,754 |\\n| December 31, 2015 | December 31, 2014 |\\n| (unaudited) | (unaudited) |\\n| Pro forma revenues | $ | 151,931,931 | $ | 147,451,042 |\\n| Pro forma operating expenses | $ | 133,346,497 | $ | 129,961,867 |\\n| Pro forma operating income | $ | 18,585,434 | $ | 17,489,175 |\\n| Pro forma net income (loss) | $ | 1,017,180 | $ | (1,671,774 | ) |\\n| Pro forma earnings (loss) per basic and diluted share | $ | 0.07 | $ | (0.10 | ) |\\n| Pro forma earnings (loss) per basic and diluted units | $ | 0.07 | $ | (0.10 | ) |\\n| Pro forma basic and diluted common shares | 12,541,117 | 13,812,125 |\\n| Pro forma basic and diluted units | 14,924,410 | 16,542,413 |\\n| December 31, 2016 | December 31, 2015 |\\n| Land and land improvements | $ | 57,851,380 | $ | 59,910,212 |\\n| Buildings and improvements | 336,996,876 | 333,720,421 |\\n| Furniture, fixtures and equipment | 43,458,781 | 42,245,334 |\\n| 438,307,037 | 435,875,967 |\\n| Less: accumulated depreciation and impairment | (89,713,125 | ) | (80,912,725 | ) |\\n| Investment in Hotel Properties, Net | $ | 348,593,912 | $ | 354,963,242 |\\n| December 31, 2016 | December 31, 2015 |\\n| Land and land improvements | $ | 1,097,096 | $ | — |\\n| Buildings and improvements | 6,242,504 | — |\\n| Furniture, fixtures and equipment | 2,289,008 | — |\\n| 9,628,608 | — |\\n| Less: accumulated depreciation and impairment | (4,295,608 | ) | — |\\n| Investment in Hotel Properties Held for Sale, Net | $ | 5,333,000 | $ | — |\\n| Balance Outstanding as of |\\n| December 31, | December 31, | Prepayment | Maturity | Amortization | Interest |\\n| Property | 2016 | 2015 | Penalties | Date | Provisions | Rate |\\n| Crowne Plaza Hampton Marina (1) | $ | 2,584,633 | $ | 3,512,586 | None | 11/1/2019 | 3 years | 5.00% |\\n| Crowne Plaza Hollywood Beach Resort (2) | 58,935,818 | 59,795,743 | n/a | 10/1/2025 | 30 years | 4.913% |\\n| Crowne Plaza Tampa Westshore (3) | 15,561,400 | 13,016,045 | None | 6/30/2019 | 25 years | LIBOR plus 3.75 % |\\n| DoubleTree by Hilton Jacksonville Riverfront (4) | 19,291,716 | 19,774,577 | Yes | 7/7/2019 | 25 years | LIBOR plus 3.50 % |\\n| DoubleTree by Hilton Laurel (5) | 9,329,005 | 9,500,000 | Yes | 8/5/2021 | 25 years | 5.25% |\\n| DoubleTree by Hilton Philadelphia Airport (6) | 31,261,991 | 32,376,795 | None | 4/1/2019 | 25 years | LIBOR plus 3.00 % |\\n| DoubleTree by Hilton Raleigh Brownstone University (7) | 14,773,885 | 15,029,121 | n/a | 8/1/2018 | 30 years | 4.78% |\\n| The Georgian Terrace (8) | 45,826,038 | 46,579,011 | n/a | 6/1/2025 | 30 years | 4.42% |\\n| Hilton Savannah DeSoto (9) | 30,000,000 | 20,522,836 | Yes | 7/1/2026 | 25 years | 4.25% |\\n| Hilton Wilmington Riverside (10) | 30,000,000 | 19,825,772 | Yes | 1/1/2027 | 25 years | 4.25% |\\n| Sheraton Louisville Riverside (11) | 11,977,557 | 11,345,866 | Yes | 12/1/2026 | 25 years | 4.27% |\\n| The Whitehall (12) | 15,000,000 | 20,459,256 | Yes | 10/12/2021 | 18 years | LIBOR plus 3.50 % |\\n| Total Mortgage Principal Balance | $ | 284,542,043 | $ | 271,737,608 |\\n| Deferred financing costs, net | (2,049,409 | ) | (1,646,220 | ) |\\n| Unamortized premium on loan | 215,655 | 240,336 |\\n| Total Mortgage Loans, Net | $ | 282,708,289 | $ | 270,331,724 |\\n| (1) | The note was extended and modified in November 2016 for 3 years until November 1, 2019 and the Operating Partnership was required to make monthly principal payments of $15,367. The note rate was changed to a fixed rate of 5.00%, effective June 27, 2014. As of February 7, 2017, the note is no longer outstanding. |\\n| (2) | With limited exception, the note may not be prepaid until June 2025. |\\n| (3) | The note provides initial proceeds of $15.7 million, with an additional $3.3 million available upon the satisfaction of certain conditions; bears a floating interest rate of the 30-day LIBOR plus 3.75%, subject to a floor rate of 3.75%; the note provides that the mortgage can be extended for two additional periods of one year each, subject to certain conditions. |\\n| (4) | The note is subject to a pre-payment penalty until July 2017. Prepayment can be made without penalty thereafter. The note provides that the mortgage can be extended until July 2020 if certain conditions have been satisfied. |\\n| (5) | The note is subject to a pre-payment penalty except for any pre-payments made either between April 2017 and August 2017, or from April 2021 through maturity of the note. The note provides that on January 5, 2018, the rate of interest will adjust to a rate of 3.00% per annum plus the then-current five-year U.S. Treasury rate of interest, with a floor of 5.25%. |\\n| (6) | The note bears a minimum interest rate of 3.50%. |\\n| (7) | With limited exception, the note may not be prepaid until two months before maturity. |\\n| (8) | With limited exception, the note may not be prepaid until February 2025. |\\n| (9) | The note provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions, namely, the completion of a renovation project; amortizes on a 25-year schedule after a 1-year interest-only period; and is subject to a pre-payment penalty except for any pre-payments made within 120 days of the maturity date. |\\n| (10) | The note provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions namely, the completion of a renovation project; amortizes on a 25-year schedule after a 1-year interest-only period; and is subject to a pre-payment penalty except for any pre-payments made within 120 days of the maturity date. |\\n| (11) | The note bears a fixed interest rate of 4.27% for the first 5 years of the loan, with an option for the lender to reset the interest rate after 5 years. |\\n| (12) | The note was refinanced in October 2016, provides initial proceeds of $15.0 million, with an additional $5.5 million available upon the satisfaction of certain conditions; bears a floating interest rate of the 1-month LIBOR plus 3.5%, subject to a floor rate of 4.0% and is subject to prepayment penalties subject to a declining scale from 3.0% penalty on or before the first anniversary date, a 2.0% penalty during the second anniversary year and a 1.0% penalty after the third anniversary date. |\\n| For the year ending: December 31, 2017 | $ | 6,363,323 |\\n| December 31, 2018 | 24,626,923 |\\n| December 31, 2019 | 73,423,203 |\\n| December 31, 2020 | 9,248,750 |\\n| December 31, 2021 | 31,008,186 |\\n| December 31, 2022 and thereafter | 139,871,658 |\\n| Total future maturities | $ | 284,542,043 |\\n| For the year ending: December 31, 2017 | $ | 223,682 |\\n| December 31, 2018 | 176,740 |\\n| December 31, 2019 | 100,480 |\\n| December 31, 2020 | 95,482 |\\n| December 31, 2021 | 95,482 |\\n| December 31, 2022 and thereafter | 445,583 |\\n| Total | $ | 1,137,449 |\\n| Quarter Ended | 2014 | 2015 | 2016 |\\n| March 31, | $ | 0.045 | $ | 0.070 | $ | 0.085 |\\n| June 30, | $ | 0.050 | $ | 0.075 | $ | 0.090 |\\n| September 30, | $ | 0.065 | $ | 0.080 | $ | 0.095 |\\n| December 31, | $ | 0.065 | $ | 0.080 | $ | 0.095 |\\n| Seven Months Ended | Year Ended |\\n| July 31, 2015 | December 31, 2014 |\\n| Revenue |\\n| Rooms department | $ | 10,605,941 | $ | 15,386,595 |\\n| Food and beverage department | 1,911,950 | 2,968,395 |\\n| Other operating departments | 880,564 | 1,385,469 |\\n| Total revenue | 13,398,455 | 19,740,459 |\\n| Expenses |\\n| Hotel operating expenses |\\n| Rooms department | 2,062,515 | 3,270,930 |\\n| Food and beverage department | 1,442,139 | 2,270,918 |\\n| Other operating departments | 388,087 | 655,818 |\\n| Indirect | 4,774,322 | 7,436,198 |\\n| Total hotel operating expenses | 8,667,063 | 13,633,864 |\\n| Depreciation and amortization | 1,060,339 | 2,116,211 |\\n| General and administrative | 252,565 | 148,873 |\\n| Total operating expenses | 9,979,967 | 15,898,948 |\\n| Operating income | 3,418,488 | 3,841,511 |\\n| Interest expense | (1,516,433 | ) | (2,612,032 | ) |\\n| Net income | $ | 1,902,055 | $ | 1,229,479 |\\n| 2016 | 2015 | 2014 |\\n| General and administrative | $ | 12,419,221 | $ | 11,595,819 | $ | 9,823,853 |\\n| Sales and marketing | 13,754,600 | 11,426,637 | 9,788,079 |\\n| Repairs and maintenance | 7,401,755 | 6,948,699 | 6,278,411 |\\n| Utilities | 6,429,686 | 6,124,459 | 5,763,990 |\\n| Franchise fees | 4,091,729 | 4,016,083 | 4,122,726 |\\n| Management fees, including incentive | 3,865,362 | 3,490,586 | 3,439,807 |\\n| Property taxes | 5,983,280 | 5,110,659 | 3,664,022 |\\n| Insurance | 2,594,783 | 2,305,966 | 1,927,935 |\\n| Other | 601,276 | 291,383 | 263,668 |\\n| Total indirect hotel operating expenses | $ | 57,141,692 | $ | 51,310,292 | $ | 45,072,491 |\\n| Year Ended | Year Ended | Year Ended |\\n| December 31, 2016 | December 31, 2015 | December 31, 2014 |\\n| Current: |\\n| Federal | $ | — | $ | — | $ | — |\\n| State | 191,332 | 444,538 | 233,940 |\\n| 191,332 | 444,538 | 233,940 |\\n| Deferred: |\\n| Federal | (1,294,408 | ) | (1,510,726 | ) | (1,718,351 | ) |\\n| State | (264,558 | ) | (269,845 | ) | (243,312 | ) |\\n| (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) |\\n| $ | (1,367,634 | ) | $ | (1,336,033 | ) | $ | (1,727,723 | ) |\\n| Year Ended | Year Ended | Year Ended |\\n| December 31, 2016 | December 31, 2015 | December 31, 2014 |\\n| Statutory federal income tax expense | $ | (158,859 | ) | $ | 1,705,610 | $ | (838,519 | ) |\\n| Effect of non-taxable REIT income | (1,135,549 | ) | (2,866,950 | ) | (898,576 | ) |\\n| State income tax benefit | (73,226 | ) | (174,693 | ) | 9,372 |\\n| $ | (1,367,634 | ) | $ | (1,336,033 | ) | $ | (1,727,723 | ) |\\n| • | a demonstrated track record of past profitability and utilization of past NOL carryforwards, |\\n| • | reasonable forecasts of future taxable income, and |\\n| • | anticipated changes in the lease rental payments from the TRS Lessee to subsidiaries of the Operating Partnership. |\\n| Year Ended | Year Ended | Year Ended |\\n| December 31, 2016 | December 31, 2015 | December 31, 2014 |\\n| Numerator |\\n| Net income/(loss) attributable to the common shareholders for basic computation | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) |\\n| Denominator |\\n| Weighted average number of common shares outstanding for basic computation | 14,896,994 | 12,541,117 | 10,377,125 |\\n| Basic and diluted net income (loss) per share | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) |\\n| Year Ended | Year Ended | Year Ended |\\n| December 31, 2016 | December 31, 2015 | December 31, 2014 |\\n| Numerator |\\n| Net income/(loss) attributable to the common unitholders for basic computation | $ | (244,740 | ) | $ | 6,397,653 | $ | (738,509 | ) |\\n| Denominator |\\n| Weighted average number of units outstanding | 16,710,935 | 14,924,410 | 13,107,413 |\\n| Basic and diluted net income (loss) per unit | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) |\\n| Quarters Ended 2016 |\\n| March 31 | June 30 | September 30 | December 31 |\\n| Total revenue | $ | 37,810,144 | $ | 41,824,954 | $ | 37,275,312 | $ | 35,935,342 |\\n| Total operating expenses | 33,025,990 | 34,645,809 | 33,539,913 | 33,026,914 |\\n| Net operating income | 4,784,154 | 7,179,145 | 3,735,399 | 2,908,428 |\\n| Net income(loss) | 545,874 | 1,977,550 | (1,549,191 | ) | (74,084 | ) |\\n| Net income (loss) attributable to common shareholders | 483,095 | 1,761,106 | (1,716,234 | ) | (746,140 | ) |\\n| Earnings (loss) per share attributable to common shareholders– basic and diluted | $ | 0.03 | $ | 0.12 | $ | (0.11 | ) | $ | (0.05 | ) |\\n| Quarters Ended 2015 |\\n| March 31 | June 30 | September 30 | December 31 |\\n| Total revenue | $ | 30,975,630 | $ | 36,865,108 | $ | 33,941,875 | $ | 36,750,863 |\\n| Total operating expenses | 27,410,462 | 29,689,455 | 31,976,036 | 34,127,473 |\\n| Net operating income | 3,565,168 | 7,175,653 | 1,965,839 | 2,623,390 |\\n| Net income(loss) | 713,859 | 1,759,109 | 4,636,644 | (711,959 | ) |\\n| Net income (loss) attributable to common shareholders | 575,336 | 1,431,110 | 3,872,394 | (522,174 | ) |\\n| Earnings (loss) per share attributable to common shareholders– basic and diluted | $ | 0.05 | $ | 0.13 | $ | 0.27 | $ | (0.04 | ) |\\n| Costs Capitalized | Life on |\\n| Initial Costs | Subsequent to Acquisition | Gross Amount At End of Year | Accumulated | Which |\\n| Building & | Building & | Building & | Depreciation | Date of | Date | Depreciation |\\n| Description | Encumbrances | Land | Improvements | Land | Improvements | Land | Improvements | Total | & Impairment | Construction | Acquired | is Computed |\\n| Crowne Plaza Hampton Marina – Hampton, Virginia | $ | 2,585 | $ | 1,061 | $ | 6,733 | $ | 36 | 3,796 | $ | 1,097 | $ | 10,529 | $ | 11,626 | $ | (4,296 | ) | 1988 | 2008 | 3-39 years |\\n| Crowne Plaza Hollywood Beach Resort - Hollywood Beach, Florida | 58,936 | 22,865 | 67,660 | — | (124 | ) | 22,865 | 67,536 | 90,401 | (2,646 | ) | 1972 | 2015 | 3-39 years |\\n| Crowne Plaza Tampa Westshore – Tampa, Florida | 15,561 | 4,153 | 9,670 | 297 | 22,259 | 4,450 | 31,929 | 36,379 | (7,707 | ) | 1973 | 2007 | 3-39 years |\\n| DoubleTree by Hilton Jacksonville Riverfront – Jacksonville, Florida | 19,292 | 7,090 | 14,604 | 89 | 7,113 | 7,179 | 21,717 | 28,896 | (5,881 | ) | 1970 | 2005 | 3-39 years |\\n| DoubleTree by Hilton Laurel – Laurel, Maryland | 9,329 | 900 | 9,443 | 175 | 5,679 | 1,075 | 15,122 | 16,197 | (3,913 | ) | 1985 | 2004 | 3-39 years |\\n| DoubleTree by Hilton Philadelphia Airport – Philadelphia, Pennsylvania | 31,262 | 2,100 | 22,031 | 260 | 5,478 | 2,360 | 27,509 | 29,869 | (8,281 | ) | 1972 | 2004 | 3-39 years |\\n| DoubleTree by Hilton Raleigh Brownstone – University – Raleigh, North Carolina | 14,774 | 815 | 7,416 | 213 | 5,761 | 1,028 | 13,177 | 14,205 | (4,831 | ) | 1971 | 2004 | 3-39 years |\\n| Georgian Terrace – Atlanta, Georgia | 45,826 | 10,128 | 45,386 | (1,332 | ) | 4,811 | 8,796 | 50,197 | 58,993 | (3,715 | ) | 1911 | 2014 | 3-39 years |\\n| Hilton Savannah DeSoto – Savannah, Georgia | 30,000 | 600 | 13,562 | 31 | 14,545 | 631 | 28,107 | 28,738 | (8,640 | ) | 1968 | 2004 | 3-39 years |\\n| Hilton Wilmington Riverside – Wilmington, North Carolina | 30,000 | 785 | 16,829 | 228 | 12,514 | 1,013 | 29,343 | 30,356 | (11,283 | ) | 1970 | 2004 | 3-39 years |\\n| Sheraton Louisville Riverside – Jeffersonville, Indiana | 11,977 | 782 | 6,891 | 222 | 14,566 | 1,004 | 21,457 | 22,461 | (5,074 | ) | 1972 | 2006 | 3-39 years |\\n| The Whitehall – Houston, Texas | 15,000 | 7,374 | 22,185 | 78 | 4,431 | 7,452 | 26,616 | 34,068 | (2,239 | ) | 1963 | 2013 | 3-39 years |\\n| $ | 284,542 | $ | 58,653 | $ | 242,410 | $ | 297 | $ | 100,829 | $ | 58,950 | $ | 343,239 | $ | 402,189 | $ | (68,506 | ) |\\n| (1) | For the year ending December 31, 2016, the aggregate cost of our real estate assets for federal income tax purposes was approximately $398.6 million. |\\n| Balance at December 31, 2014 | $ | 294,827 |\\n| Acquisitions | 91,669 |\\n| Improvements | 11,105 |\\n| Disposal of Assets | (3,971 | ) |\\n| Balance at December 31, 2015 | $ | 393,630 |\\n| Acquisitions | — |\\n| Improvements | 9,473 |\\n| Disposal of Assets | (914 | ) |\\n| Balance at December 31, 2016 | $ | 402,189 |\\n| Balance at December 31, 2014 | $ | 53,233 |\\n| Current Expense | 8,790 |\\n| Impairment | 500 |\\n| Disposal of Assets | (482 | ) |\\n| Balance at December 31, 2015 | $ | 62,041 |\\n| Current Expense | 7,018 |\\n| Impairment | — |\\n| Disposal of Assets | (553 | ) |\\n| Balance at December 31, 2016 | $ | 68,506 |\\n\\n \\n\\nWhat is the average annual franchise fee, in percentage, if the company operates the franchise for a period of 5 years based on the franchise fee for operating year 1, 2 and thereafter?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 4.4.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 60,\n \"input_length\": 87912\n}"}}},{"rowIdx":61,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nPART I—FINANCIAL INFORMATION\nITEM 1. FINANCIAL STATEMENTS\nQWEST CORPORATION\nCONSOLIDATED STATEMENTS OF OPERATIONS\n(UNAUDITED)\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| (Dollars in millions) |\n| OPERATING REVENUES |\n| Operating revenues | $ | 1,573 | 1,618 | 3,172 | 3,254 |\n| Operating revenues - affiliates | 650 | 604 | 1,304 | 1,185 |\n| Total operating revenues | 2,223 | 2,222 | 4,476 | 4,439 |\n| OPERATING EXPENSES |\n| Cost of services and products (exclusive of depreciation and amortization) | 731 | 743 | 1,439 | 1,435 |\n| Selling, general and administrative | 235 | 256 | 485 | 526 |\n| Operating expenses - affiliates | 231 | 238 | 482 | 486 |\n| Depreciation and amortization | 424 | 464 | 843 | 926 |\n| Total operating expenses | 1,621 | 1,701 | 3,249 | 3,373 |\n| OPERATING INCOME | 602 | 521 | 1,227 | 1,066 |\n| OTHER (EXPENSE) INCOME |\n| Interest expense | (120 | ) | (119 | ) | (241 | ) | (237 | ) |\n| Interest expense - affiliates, net | (15 | ) | (13 | ) | (29 | ) | (26 | ) |\n| Other income, net | — | 1 | 2 | 1 |\n| Total other expense, net | (135 | ) | (131 | ) | (268 | ) | (262 | ) |\n| INCOME BEFORE INCOME TAX EXPENSE | 467 | 390 | 959 | 804 |\n| Income tax expense | 179 | 152 | 367 | 319 |\n| NET INCOME | $ | 288 | 238 | 592 | 485 |\n\nSee accompanying notes to consolidated financial statements.\n3\nQWEST CORPORATION\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME\n(UNAUDITED)\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| (Dollars in millions) |\n| NET INCOME | $ | 288 | 238 | 592 | 485 |\n| OTHER COMPREHENSIVE INCOME: |\n| Foreign currency translation adjustment, net of $—, $—, $— and $— tax | 3 | — | — | — |\n| Other comprehensive income | 3 | — | — | — |\n| COMPREHENSIVE INCOME | $ | 291 | 238 | 592 | 485 |\n\nSee accompanying notes to consolidated financial statements.\n4\nQWEST CORPORATION\nCONSOLIDATED BALANCE SHEETS\n(UNAUDITED)\n| As of June 30, 2016 | As of December 31, 2015 |\n| (Dollars in millions) |\n| ASSETS |\n| CURRENT ASSETS |\n| Cash and cash equivalents | $ | 4 | 3 |\n| Accounts receivable, less allowance of $48 and $47 | 688 | 688 |\n| Advances to affiliates | 811 | 788 |\n| Other | 148 | 123 |\n| Total current assets | 1,651 | 1,602 |\n| NET PROPERTY, PLANT AND EQUIPMENT |\n| Property, plant and equipment | 12,619 | 12,182 |\n| Accumulated depreciation | (5,182 | ) | (4,808 | ) |\n| Net property, plant and equipment | 7,437 | 7,374 |\n| GOODWILL AND OTHER ASSETS |\n| Goodwill | 9,354 | 9,354 |\n| Customer relationships, less accumulated amortization of $3,549 and $3,264 | 2,150 | 2,435 |\n| Other intangible assets, less accumulated amortization of $1,435 and $1,383 | 539 | 613 |\n| Other, net | 98 | 92 |\n| Total goodwill and other assets | 12,141 | 12,494 |\n| TOTAL ASSETS | $ | 21,229 | 21,470 |\n| LIABILITIES AND STOCKHOLDER'S EQUITY |\n| CURRENT LIABILITIES |\n| Current maturities of long-term debt | $ | 509 | 242 |\n| Accounts payable | 350 | 369 |\n| Note payable - affiliate | 884 | 855 |\n| Accrued expenses and other liabilities |\n| Salaries and benefits | 186 | 211 |\n| Income and other taxes | 165 | 189 |\n| Other | 146 | 135 |\n| Current affiliate obligations, net | 94 | 97 |\n| Advance billings and customer deposits | 322 | 324 |\n| Total current liabilities | 2,656 | 2,422 |\n| LONG-TERM DEBT | 6,726 | 6,997 |\n| DEFERRED CREDITS AND OTHER LIABILITIES |\n| Deferred revenues | 123 | 137 |\n| Deferred income taxes, net | 1,861 | 1,896 |\n| Affiliate obligations, net | 1,003 | 1,051 |\n| Other | 61 | 60 |\n| Total deferred credits and other liabilities | 3,048 | 3,144 |\n| COMMITMENTS AND CONTINGENCIES (Note 5) |\n| STOCKHOLDER'S EQUITY |\n| Common stock - one share without par value, owned by Qwest Services Corporation | 10,050 | 10,050 |\n| Accumulated deficit | (1,251 | ) | (1,143 | ) |\n| Total stockholder's equity | 8,799 | 8,907 |\n| TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY | $ | 21,229 | 21,470 |\n\nSee accompanying notes to consolidated financial statements.\n5\nQWEST CORPORATION\nCONSOLIDATED STATEMENTS OF CASH FLOWS\n(UNAUDITED)\n| Six Months Ended June 30, |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| OPERATING ACTIVITIES |\n| Net income | $ | 592 | 485 |\n| Adjustments to reconcile net income to net cash provided by operating activities: |\n| Depreciation and amortization | 843 | 926 |\n| Deferred income taxes | (35 | ) | (180 | ) |\n| Provision for uncollectible accounts | 40 | 39 |\n| Net long-term debt issuance costs and premium amortization | (7 | ) | (11 | ) |\n| Accrued interest on affiliate note | 29 | 31 |\n| Changes in current assets and liabilities: |\n| Accounts receivable | (40 | ) | 8 |\n| Accounts payable | (20 | ) | 30 |\n| Accrued income and other taxes | (24 | ) | (14 | ) |\n| Other current assets and liabilities, net | (40 | ) | (34 | ) |\n| Other current assets and liabilities - affiliates, net | — | (4 | ) |\n| Changes in other noncurrent assets and liabilities, net | (11 | ) | (23 | ) |\n| Changes in affiliate obligations, net | (51 | ) | (4 | ) |\n| Other, net | 8 | 5 |\n| Net cash provided by operating activities | 1,284 | 1,254 |\n| INVESTING ACTIVITIES |\n| Payments for property, plant and equipment and capitalized software | (546 | ) | (564 | ) |\n| Changes in advances to affiliates | (23 | ) | (383 | ) |\n| Net cash used in investing activities | (569 | ) | (947 | ) |\n| FINANCING ACTIVITIES |\n| Net proceeds from issuance of long-term debt | 227 | 99 |\n| Payments of long-term debt | (241 | ) | (106 | ) |\n| Dividends paid to Qwest Services Corporation | (700 | ) | (300 | ) |\n| Net cash used in financing activities | (714 | ) | (307 | ) |\n| Net increase in cash and cash equivalents | 1 | — |\n| Cash and cash equivalents at beginning of period | 3 | 6 |\n| Cash and cash equivalents at end of period | $ | 4 | 6 |\n| Supplemental cash flow information: |\n| Income taxes paid, net | $ | (401 | ) | (379 | ) |\n| Interest paid (net of capitalized interest of $8 and $9) | $ | (249 | ) | (247 | ) |\n\nSee accompanying notes to consolidated financial statements.\n6\nQWEST CORPORATION\nCONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY\n(UNAUDITED)\n| Six Months Ended June 30, |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| COMMON STOCK |\n| Balance at beginning of period | $ | 10,050 | 10,050 |\n| Balance at end of period | 10,050 | 10,050 |\n| ACCUMULATED DEFICIT |\n| Balance at beginning of period | (1,143 | ) | (867 | ) |\n| Net income | 592 | 485 |\n| Dividends declared to Qwest Services Corporation | (700 | ) | (300 | ) |\n| Balance at end of period | (1,251 | ) | (682 | ) |\n| TOTAL STOCKHOLDER'S EQUITY | $ | 8,799 | 9,368 |\n\nSee accompanying notes to consolidated financial statements.\n7\nQWEST CORPORATION\nNOTES TO CONSOLIDATED FINANCIAL STATEMENTS\n(UNAUDITED)\nUnless the context requires otherwise, references in this report to \"QC\" refer to Qwest Corporation, references to \"Qwest,\" \"we,\" \"us,\" and \"our\" refer to Qwest Corporation and its consolidated subsidiaries, references to \"QSC\" refer to our direct parent company, Qwest Services Corporation, and its consolidated subsidiaries, references to \"QCII\" refer to QSC's direct parent company and our indirect parent company, Qwest Communications International Inc., and its consolidated subsidiaries, and references to \"CenturyLink\" refer to QCII's direct parent company and our ultimate parent company, CenturyLink, Inc., and its consolidated subsidiaries.\n(1) Basis of Presentation\nGeneral\nWe are an integrated communications company engaged primarily in providing an array of services to our residential and business customers. Our communications services include local voice, broadband, private line (including special access), network access, Ethernet, information technology, video and other ancillary services. In certain local and regional markets, we also provide local access and fiber transport services to competitive local exchange carriers.\nWe generate the majority of our total consolidated operating revenues from services provided in the 14-state region of Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and Wyoming. We refer to this region as our local service area.\nOur consolidated balance sheet as of December 31, 2015, which was derived from our audited consolidated financial statements, and our unaudited interim consolidated financial statements provided herein have been prepared in accordance with the instructions for Form 10-Q. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to rules and regulations of the Securities and Exchange Commission (\"SEC\"); however, in our opinion, the disclosures made are adequate to make the information presented not misleading. We believe that these consolidated financial statements include all normal recurring adjustments necessary to fairly present the results for the interim periods. The consolidated results of operations for the first six months of the year are not necessarily indicative of the consolidated results of operations that might be expected for the entire year. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2015.\nThe accompanying consolidated financial statements include our accounts and the accounts of our subsidiaries. Intercompany amounts and transactions with our consolidated subsidiaries have been eliminated. Transactions with our non-consolidated affiliates (referred to herein as affiliates) have not been eliminated.\nWe reclassified certain prior period amounts to conform to the current period presentation, including the categorization of our revenues. See Note 4—Products and Services Revenues for additional information. These changes had no impact on total operating revenues, total operating expenses or net income for any period.\nConnect America Fund\nIn 2015, CenturyLink accepted funding from the Federal Communications Commission's (\"FCC\") Connect America Fund (\"CAF\") of approximately $500 million per year for six years to fund the deployment of voice and broadband capable infrastructure for approximately 1.2 million rural households and businesses in 33 states under the CAF Phase 2 high-cost support program. The funding from the CAF Phase 2 support program in these 33 states will substantially supplant funding from the interstate Universal Service Fund (\"USF\") high-cost program that we previously utilized to support voice services in high-cost rural markets. Of these amounts, approximately $150 million per year is attributable to our service area, to provide service to approximately 0.3 million rural households and businesses in 13 states. In late 2015, we began receiving these support payments from the FCC under the new CAF Phase 2 support program, which included monthly support payments at a higher rate than under the interstate USF support program. We recorded $24 million and $48 million more in revenue for the three and six months ended June 30, 2016, respectively, than in the comparable periods for 2015 with respect to our 13 states. We received a substantial one-time cumulative catch-up payment related to the first half of 2015 from the FCC in the third quarter of 2015, and, as a result, we do not expect funding from the CAF Phase 2 support program to materially change our \"affiliate and other services\" revenues for the full year 2016 when compared to the full year 2015.\n8\nRecent Accounting Pronouncements\nFinancial Instruments\nOn June 16, 2016, the Financial Accounting Standards Board (\"FASB\") issued Accounting Standards Update (\"ASU\") 2016-13, “Measurement of Credit Losses on Financial Instruments” (“ASU 2016-13”). The primary impact of ASU 2016-13 for us is a change in the model for the recognition of credit losses related to our financial instruments from an incurred loss model, which recognized credit losses only if it was probable that a loss had been incurred to an expected loss model, which requires our management team to estimate the total credit losses expected on the portfolio of financial instruments. We are currently reviewing the requirements of the standard and evaluating the impact on our consolidated financial statements.\nWe are required to adopt the provisions of ASU 2016-13 effective January 1, 2020, but could elect to early adopt the provisions as of January 1, 2019. We expect to recognize the impacts of adopting ASU 2016-13 through a cumulative adjustment to retained earnings as of the date of adoption.\nShare-based Compensation\nOn March 30, 2016, the FASB issued ASU 2016-09, “Improvement to Employee Share-Based Payment Accounting\" (“ASU 2016-09”). ASU 2016-09 modifies the accounting and associated income tax accounting for share-based compensation in order to reduce the cost and complexity associated with current generally accepted accounting principles. ASU 2016-09 is effective for us as of January 1, 2017, but early adoption may be elected. ASU 2016-09 includes different transition requirements for the different changes implemented, including some provisions which allow retrospective application. We have not determined when we will implement this standard or if we will retrospectively apply the requirements when allowed.\nThe primary provisions of ASU 2016-09 that we expect will affect our financial statements are: 1) a reclassification of the tax effect associated with the difference between the expense recognized for share-based payments and the associated tax deduction from additional paid-in capital to income tax expense; 2) a reclassification of the tax effect associated with the difference between compensation expense and associated deduction from financing cash flow to operating cash flow; and 3) an optional accounting policy election to account for forfeitures of share-based payment grants as they occur as opposed to our current policy of estimating the forfeitures on the grant date. These provisions would not have had a material impact on our previously issued financial statements; however, this is not necessarily representative of future impacts. Adoption of ASU 2016-09 may increase the volatility of income tax expense and cash flow from operating activities.\nLeases\nOn February 25, 2016, the FASB issued ASU 2016-02, “Leases” (“ASU 2016-02”). The core principle of ASU 2016-02 will require lessees to present right-of-use assets and lease liabilities on their balance sheets for operating leases, which are currently not reflected on their balance sheets.\nASU 2016-02 is effective for annual and interim periods beginning January 1, 2019. Early adoption of ASU 2016-02 is permitted. Upon adoption of ASU 2016-02, we are required to recognize and measure leases at the beginning of the earliest period presented in our consolidated financial statements using a modified retrospective approach. The modified retrospective approach includes a number of optional practical expedients that we may elect to apply. We have not yet decided when we will adopt ASU 2016-02 or which practical expedient options we will elect. We are currently evaluating and assessing the impact ASU 2016-02 will have on us and our consolidated financial statements. As of the date of this report, we cannot provide any estimate of the impact of adopting ASU 2016-02.\nRevenue Recognition\nOn May 28, 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers” (“ASU 2014-09”). ASU 2014-09 replaces virtually all existing generally accepted accounting principles (“GAAP”) on revenue recognition and replaces them with a principles-based approach for determining revenue recognition using a new five step model. The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 also includes new accounting principles related to the deferral and amortization of contract acquisition and fulfillment costs. We currently do not defer any contract acquisition costs and we defer contract fulfillment costs only up to the extent of any revenue deferred.\n9\nOn July 9, 2015, the FASB approved the deferral of the effective date of ASU 2014-09 by one year until January 1, 2018, which is the date we plan to adopt this standard. ASU 2014-09 may be adopted by applying the provisions of this standard on a retrospective basis to the periods included in the financial statements or on a modified retrospective basis which would result in the recognition of a cumulative effect of adopting ASU 2014-09 in the first quarter of 2018. We have not yet decided which implementation method we will adopt. We are studying ASU 2014-09 and are assessing the impact this standard will have on us and our consolidated financial statements. We cannot at this time, however, provide any estimate of the impact of adopting ASU 2014-09.\n(2) Long-Term Debt and Revolving Promissory Note\nLong-term debt, including unamortized discounts and premiums, unamortized debt issuance costs and note payable - affiliate, were as follows:\n| Interest Rates | Maturities | As of June 30, 2016 | As of December 31, 2015 |\n| (Dollars in millions) |\n| Senior notes | 6.125% - 7.750% | 2017 - 2056 | $ | 7,229 | 7,229 |\n| Term loan | 2.220% | 2025 | 100 | 100 |\n| Capital lease and other obligations | Various | Various | 28 | 17 |\n| Unamortized premiums, net | 8 | 16 |\n| Unamortized debt issuance costs | (130 | ) | (123 | ) |\n| Total long-term debt | 7,235 | 7,239 |\n| Less current maturities | (509 | ) | (242 | ) |\n| Long-term debt, excluding current maturities | $ | 6,726 | 6,997 |\n| Note payable - affiliate | 6.795% | 2022 | $ | 884 | 855 |\n\nNew Issuance\nIn January 2016, QC issued $235 million aggregate principal amount of 7% Notes due 2056, in exchange for net proceeds, after deducting underwriting discounts and other expenses, of approximately $227 million. All of the 7% Notes are unsecured obligations and may be redeemed by QC, in whole or in part, on or after February 1, 2021, at a redemption price equal to 100% of the principal amount redeemed plus accrued and unpaid interest to the redemption date.\nRepayment\nOn May 2, 2016, QC paid at maturity the $235 million principal amount and accrued and unpaid interest due under its 8.375% Notes.\nRevolving Promissory Note\nWe are currently indebted to an affiliate of our ultimate parent company, CenturyLink, under a revolving promissory note that provides us with a funding commitment of up to $1.0 billion aggregate principal amount through June 30, 2022, of which $884 million was outstanding as of June 30, 2016. As of June 30, 2016, the weighted average interest rate was 6.795%. As of June 30, 2016 and December 31, 2015, this revolving promissory note is reflected on our consolidated balance sheets as a current liability under note payable - affiliate. As of June 30, 2016, $5 million of accrued interest is reflected in other current liabilities on our consolidated balance sheet. In accordance with the note agreement, all accrued interest and unpaid interest is capitalized to the unpaid principal balance on June 1 and December 1 of each year.\nCovenants\nThe indentures governing our notes contain certain covenants including, but not limited to: (i) a prohibition on certain liens on our assets; and (ii) a limitation on mergers or sales of all, or substantially all, of our assets, which limitation requires that a successor assume the obligation with regard to these notes. These indentures do not contain any cross-default provisions.\nOur senior notes were issued under indentures dated April 15, 1990 and October 15, 1999. These indentures do not contain any financial covenants, but do include restrictions that limit our ability to (i) incur, issue or create liens upon our property and (ii) consolidate with or merge into, transfer or lease all or substantially all of our assets to any other party.\nAs of June 30, 2016, we believe we were in compliance with the provisions and covenants of our debt agreements.\n10\n(3) Fair Value Disclosure\nOur financial instruments consist of cash and cash equivalents, accounts receivable, advances to affiliates, accounts payable, note payable - affiliate and long-term debt, excluding capital lease and other obligations. Due to their short-term nature, the carrying amounts of our cash and cash equivalents, accounts receivable, advances to affiliates, accounts payable, and note payable - affiliate approximate their fair values.\nFair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between independent and knowledgeable parties who are willing and able to transact for an asset or liability at the measurement date. We use valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs when determining fair value and then we rank the estimated values based on the reliability of the inputs used following the fair value hierarchy set forth by the FASB. We determined the fair values of our long-term debt, including the current portion, based on quoted market prices where available or, if not available, based on discounted future cash flows using current market interest rates.\n| Input Level | Description of Input |\n| Level 1 | Observable inputs such as quoted market prices in active markets. |\n| Level 2 | Inputs other than quoted prices in active markets that are either directly or indirectly observable. |\n| Level 3 | Unobservable inputs in which little or no market data exists. |\n\n| As of June 30, 2016 | As of December 31, 2015 |\n| InputLevel | CarryingAmount | FairValue | CarryingAmount | FairValue |\n| (Dollars in millions) |\n| Liabilities—Long-term debt, excluding capital lease and other obligations | 2 | $ | 7,207 | 7,579 | 7,222 | 7,456 |\n\n(4) Products and Services Revenues\nWe are an integrated communications company engaged primarily in providing an array of services, including local voice, broadband, private line (including special access), network access, Ethernet, information technology, video and other ancillary services. We strive to maintain our customer relationships by, among other things, bundling our service offerings to provide our customers with a complete offering of integrated communications services.\nFrom time to time, we may change the categorization of our products and services. During the second quarter of 2016, we determined that because of declines due to customer migration to other strategic products and services, certain of our services, specifically our private line (including special access) services, are now more closely aligned with our legacy services than with our strategic services. As a result, we now reflect these operating revenues as legacy services, and we have reclassified certain prior period amounts to conform to this change. The revision resulted in a reduction of revenue from strategic services and a corresponding increase in revenue from legacy services of $209 million and $426 million (net of $1 million and $2 million of deferred revenue included in affiliate and other services) for the three and six months ended June 30, 2015, respectively.\n11\nWe now categorize our products, services and revenues among the following three categories:\n| • | Strategic services, which include primarily broadband, Ethernet, video and other ancillary services; |\n\n| • | Legacy services, which include primarily local voice, private line (including special access), Integrated Services Digital Network (\"ISDN\") (which use regular telephone lines to support voice, video and data applications), switched access, traditional wide area network (\"WAN\") (which allow a local communications network to link to networks in remote locations) and other ancillary services; and |\n\n| • | Affiliates and other services, which consist primarily of CAF support payments, USF support payments, USF surcharges and services we provide to our affiliates. We receive federal support payments from both CAF Phase 1 and CAF Phase 2 programs, and support payments from both federal and state USF programs. These support payments are government subsidies designed to reimburse us for various costs related to certain telecommunications services, including the costs of deploying, maintaining and operating voice and broadband infrastructure in high-cost rural areas where we are not able to fully recover our costs from our customers. USF surcharges are the amounts we collect based on specific items we list on our customers' invoices to fund the FCC's universal service programs. We provide to our affiliates, telecommunication services that we also provide to external customers. In addition, we provide to our affiliates, computer system development and support services, network support and technical services. |\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| (Dollars in millions) |\n| Strategic services | $ | 674 | 650 | 1,345 | 1,291 |\n| Legacy services | 814 | 904 | 1,658 | 1,833 |\n| Affiliates and other services | 735 | 668 | 1,473 | 1,315 |\n| Total operating revenues | $ | 2,223 | 2,222 | 4,476 | 4,439 |\n\nWe do not have any single external customer that provides more than 10% of our total consolidated operating revenues. Substantially all of our consolidated revenues come from customers located in the United States.\nWe recognize revenues in our consolidated statements of operations for certain USF surcharges and transaction taxes that we bill to our customers. Our consolidated statements of operations also reflect the related expense for the amounts we remit to the government agencies. The total amount of such surcharges and transaction taxes that we included in revenues aggregated approximately $38 million for each of the three months ended June 30, 2016 and 2015, respectively, and approximately $76 million and $75 million for the six months ended June 30, 2016 and 2015, respectively. These USF surcharges, where we record revenue, are included in \"affiliate and other services\" revenues and these transaction taxes are included in \"legacy services\" revenues. We also act as a collection agent for certain other USF and transaction taxes that we are required by government agencies to bill our customers, for which we do not record any revenue or expense because we only act as a pass-through agent.\nOur operations are integrated into and reported as part of the consolidated segment data of CenturyLink. CenturyLink's chief operating decision maker (\"CODM\") is our CODM, but reviews our financial information on an aggregate basis only in connection with our quarterly and annual reports that we file with the Securities and Exchange Commission. Consequently, we do not provide our discrete financial information to the CODM on a regular basis. As such, we believe we have one reportable segment.\n(5) Commitments and Contingencies\nPending Matters\nSubsidiaries of CenturyLink, Inc., including us, are among hundreds of companies in an industry-wide dispute, raised in nearly 100 federal lawsuits (filed between 2014 and 2016) that have been consolidated in the United States District Court for the District of Northern Texas for pretrial procedures. The disputes relate to switched access charges that local exchange carriers (\"LECs\") collect from interexchange carriers (\"IXCs\") for IXCs' use of LEC's access services. In the lawsuits, three IXCs, Sprint Communications Company L.P. (\"Sprint\"), affiliates of Verizon Communications Inc. (\"Verizon\") and affiliates of Level 3 Communications LLC (\"Level 3\"), assert that federal and state laws bar LECs from collecting access charges when IXCs exchange certain types of calls between mobile and wireline devices that are routed through an IXC. Some of these IXCs have asserted claims seeking refunds of payments for access charges previously paid and relief from future access charges. In addition, Level 3 has ceased paying switched access charges on these calls.\n12\nIn November 2015, the federal court agreed with the LECs and rejected the IXCs' contention that federal law prohibits these particular access charges, and also allowed the IXCs to refile state-law claims. Since then, many of the LECs and IXCs have filed revised pleadings and additional motions, which remain pending. Separately, some of the defendants, including us, have petitioned the Federal Communications Commission to address these issues on an industry-wide basis.\nThe outcome of these disputes and lawsuits, as well as any related regulatory proceedings that could ensue, are currently not predictable. If we are required to stop assessing these charges or to pay refunds of any such charges, our financial results could be negatively affected.\nOther Proceedings and Disputes\nFrom time to time, we are involved in other proceedings incidental to our business, including patent infringement allegations, administrative hearings of state public utility commissions relating primarily to our rates or services, actions relating to employee claims, various tax issues, environmental law issues, grievance hearings before labor regulatory agencies and miscellaneous third party tort actions.\nWe are currently defending several patent infringement lawsuits asserted against us by non-practicing entities, many of whom are seeking substantial recoveries. These cases have progressed to various stages and one or more may go to trial in the coming 24 months if they are not otherwise resolved. Where applicable, we are seeking full or partial indemnification from our vendors and suppliers. As with all litigation, we are vigorously defending these actions and, as a matter of course, are prepared to litigate these matters to judgment, as well as to evaluate and consider all reasonable settlement opportunities.\nWe are subject to various federal, state and local environmental protection and health and safety laws. From time to time, we are subject to judicial and administrative proceedings brought by various governmental authorities under these laws. Several such proceedings are currently pending, but none is reasonably expected to exceed $100,000 in fines and penalties.\nThe outcome of these other proceedings is not predictable. However, based on current circumstances, we do not believe that the ultimate resolution of these other proceedings, after considering available defenses and any insurance coverage or indemnification rights, will have a material adverse effect on our financial position, results of operations or cash flows.\nCenturyLink, Inc. and its affiliates are involved in several legal proceedings to which we are not a party that, if resolved against them, could have a material adverse effect on their business and financial condition. As an indirect wholly-owned subsidiary of CenturyLink, Inc., our business and financial condition could be similarly affected. You can find descriptions of these legal proceedings in CenturyLink, Inc.'s quarterly and annual reports filed with the Securities and Exchange Commission. Because we are not a party to any of the matters, we have not accrued any liabilities for the matters.\n(6) Dividends\nDuring the six months ended June 30, 2016, we declared and paid dividends of $700 million to our direct parent company, Qwest Services Corporation. Dividends paid are reflected on our consolidated statements of cash flows as financing activities.\n(7) Other Financial Information\nOther Current Assets\n| As of June 30, 2016 | As of December 31, 2015 |\n| (Dollars in millions) |\n| Prepaid expenses | $ | 70 | 46 |\n| Other | 78 | 77 |\n| Total other current assets | $ | 148 | 123 |\n\n13\nSelected Current Liabilities\n| As of June 30, 2016 | As of December 31, 2015 |\n| (Dollars in millions) |\n| Accounts payable | $ | 350 | 369 |\n\nIncluded in accounts payable at both June 30, 2016 and December 31, 2015, was $29 million associated with capital expenditures.\n14\nITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nUnless the context requires otherwise, references in this report to \"QC\" refer to Qwest Corporation, and references to \"Qwest,\" \"we,\" \"us\" and \"our\" refer to Qwest Corporation and its consolidated subsidiaries.\nAll references to \"Notes\" in this Item 2 of Part I refer to the Notes to Consolidated Financial Statements included in Item 1 of Part I of this report.\nCertain statements in this report constitute forward-looking statements. See the last paragraph of this Item 2 of Part I and \"Risk Factors\" in Item 1A of Part II of this report for a discussion of certain factors that could cause our actual results to differ from our anticipated results or otherwise impact our business, financial condition, results of operations, liquidity or prospects.\nOverview\nManagement's Discussion and Analysis of Financial Condition and Results of Operations (\"MD&A\") included herein should be read in conjunction with MD&A and the other information included in our Annual Report on Form 10-K for the year ended December 31, 2015, and with the consolidated financial statements and related notes in Item 1 of Part I of this report. The results of operations for the first six months of the year are not necessarily indicative of the results of operations that might be expected for the entire year.\nWe are an integrated communications company engaged primarily in providing an array of services to our residential and business customers. Our communications services include local voice, broadband, private line (including special access), network access, Ethernet, information technology, video and other ancillary services. In certain local and regional markets, we also provide local access and fiber transport services to competitive local exchange carriers. We strive to maintain our customer relationships by, among other things, bundling our service offerings to provide our customers with a complete offering of integrated communications services.\nWe generate the majority of our total consolidated operating revenues from services provided in the 14-state region of Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and Wyoming. We refer to this region as our local service area.\nOur ultimate parent company, CenturyLink, Inc. (\"CenturyLink\"), has cash management arrangements between certain of its subsidiaries that include lines of credit, affiliate obligations, capital contributions and dividends. As part of these cash management arrangements, affiliates provide lines of credit to certain other affiliates. Amounts outstanding under these lines of credit and intercompany obligations vary from time to time. Under these arrangements, the majority of our cash balance is advanced on a daily basis to CenturyLink. From time to time we may declare and pay dividends to Qwest Services Corporation (\"QSC\"), our direct parent, using cash owed to us under these advances, which has the net effect of reducing the amount of these advances. We report the balance of these transfers on our consolidated balance sheet as advances to affiliates.\nFor the reasons noted in Note 4—Products and Services Revenues to our consolidated financial statements in Item 1 of Part I of this report, we believe we have one reportable segment.\nFrom time to time, we may change the categorization of our products and services. During the second quarter of 2016, we determined that because of declines due to customer migration to other strategic products and services, certain of our services, specifically our private line (including special access) services, are now more closely aligned with our legacy services than with our strategic services. As described in greater detail in Note 4—Products and Services Revenues, these operating revenues are now reflected as legacy services.\nWe now categorize our products, services and revenues among the following three categories:\n| • | Strategic services, which include primarily broadband, Ethernet, video and other ancillary services; |\n\n| • | Legacy services, which include primarily local voice, private line (including special access), Integrated Services Digital Network (\"ISDN\") (which use regular telephone lines to support voice, video and data applications), switched access, traditional wide area network (\"WAN\") (which allow a local communications network to link to networks in remote locations) and other ancillary services; and |\n\n15\n| • | Affiliates and other services, which consist primarily of Connect America Fund (\"CAF\") support payments, Universal Service Fund (\"USF\") support payments, USF surcharges and services we provide to our affiliates. We receive federal support payments from both CAF Phase 1 and CAF Phase 2 programs, and support payments from both federal and state USF programs. These support payments are government subsidies designed to reimburse us for various costs related to certain telecommunications services, including the costs of deploying, maintaining and operating voice and broadband infrastructure in high-cost rural areas where we are not able to fully recover our costs from our customers. USF surcharges are the amounts we collect based on specific items we list on our customers' invoices to fund the Federal Communications Commission's (\"FCC\") universal service programs. We provide to our affiliates, telecommunication services that we also provide to external customers. In addition, we provide to our affiliates, computer system development and support services, network support and technical services. |\n\nAt June 30, 2016, we operated approximately 6.8 million access lines and served approximately 3.5 million broadband subscribers. Our methodology for counting access lines and broadband subscribers, which is described further in the operational metrics table below under \"Results of Operations\", may not be comparable to those of other companies.\nThe following analysis is organized to provide the information we believe will be useful for understanding material trends affecting our business.\nBusiness Trends\nOur financial results were impacted by several significant trends, which are described below. We expect that these trends will continue to affect our results of operations, cash flows or financial position.\n| • | Strategic services. We continue to see shifts in the makeup of our total revenues as customers move to lower margin strategic services, such as broadband and video services, from higher margin legacy services. Revenues from our strategic services represented 30% and 29% of our total revenues for both the three and six months ended June 30, 2016 and 2015, respectively. We continue to experienced price compression due to competition, which negatively impacted the growth of our strategic revenues. We continue to focus on increasing subscribers of our broadband services, particularly among consumer and small business customers. We believe that continually increasing the scope and connection speeds of our broadband services is important to remaining competitive in our industry. As a result, we continue to invest in our broadband network, which allows for the delivery of higher speed broadband services to a greater number of customers. We compete in a maturing broadband market in which most customers already have broadband services and growth rates in new subscribers have slowed. Moreover, as described further in \"Risk Factors\" in Item 1A of Part II of this report, demand for our broadband services could be adversely affected by competitors continuing to provide services at higher broadband speeds than ours or expanding their advanced wireless data service offerings. Our Ethernet-based services in the wholesale market face competition from cable companies and competitive fiber-based telecommunications providers; |\n\n| • | Legacy services. Revenues from our legacy services represented 37% and 41% of our total revenues for the three and six months ended June 30, 2016 and 2015, respectively. We expect these percentages to continue to decline. Our legacy services revenues have been, and we expect they will continue to be adversely affected by access line losses and price compression. Intense competition and product substitution continue to drive our access line losses. For example, many consumers are replacing traditional voice telecommunications service with substitute services, including (i) cable and wireless voice services and (ii) electronic mail, texting and social networking services. We expect that these factors will continue to negatively impact our business. As a result of the expected loss of revenue associated with access lines, we continue to offer our customers service bundling and other product promotions to help mitigate this trend, as described below. Demand for our private line services (including special access) continues to decline due to customers' optimization of their networks, industry consolidation and technological migration to higher-speed services; |\n\n| • | Service bundling and product promotions. We offer our customers the ability to bundle multiple products and services. These customers can bundle local services with other services such as broadband and video. While we believe our bundled service offerings can help retain customers, they also tend to lower our profit margins due to the related discounts; and |\n\n| • | Operating efficiencies. We continue to evaluate our operating structure and focus. This involves balancing our workforce in response to our workload requirements, productivity improvements and changes in industry, competitive, technological and regulatory conditions. |\n\nWhile these trends are important to understanding and evaluating our financial results, the other transactions, events, uncertainties and trends discussed in \"Risk Factors\" in Item 1A of Part II of this report may also materially impact our business operations and financial results.\n16\nResults of Operations\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| (Dollars in millions) |\n| Operating revenues | $ | 2,223 | 2,222 | 4,476 | 4,439 |\n| Operating expenses | 1,621 | 1,701 | 3,249 | 3,373 |\n| Operating income | 602 | 521 | 1,227 | 1,066 |\n| Other expense, net | (135 | ) | (131 | ) | (268 | ) | (262 | ) |\n| Income tax expense | 179 | 152 | 367 | 319 |\n| Net income | $ | 288 | 238 | 592 | 485 |\n\n| As of June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (in thousands) |\n| Operational metrics: |\n| Total access lines (1) | 6,808 | 7,184 | (376 | ) | (5 | )% |\n| Total broadband subscribers (1) | 3,516 | 3,556 | (40 | ) | (1 | )% |\n| Total employees | 22.9 | 22.5 | 0.4 | 2 | % |\n\n(1) Access lines are lines reaching from the customers' premises to a connection with the public network and broadband subscribers are customers that purchase broadband connection service through their existing telephone lines, stand-alone telephone lines, or fiber-optic cables. Our methodology for counting our access lines and broadband subscribers includes only those lines that we use to provide services to external customers and excludes lines used solely by us and our affiliates. It also excludes unbundled loops and includes stand-alone broadband subscribers. We count lines when we install the service.\nOperating Revenues\n| Three Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Strategic services | $ | 674 | 650 | 24 | 4 | % |\n| Legacy services | 814 | 904 | (90 | ) | (10 | )% |\n| Affiliates and other services | 735 | 668 | 67 | 10 | % |\n| Total operating revenues | $ | 2,223 | 2,222 | 1 | — | % |\n\n| Six Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Strategic services | $ | 1,345 | 1,291 | 54 | 4 | % |\n| Legacy services | 1,658 | 1,833 | (175 | ) | (10 | )% |\n| Affiliates and other services | 1,473 | 1,315 | 158 | 12 | % |\n| Total operating revenues | $ | 4,476 | 4,439 | 37 | 1 | % |\n\n17\nStrategic Services\nStrategic services revenues increased by $24 million, or 4%, and increased by $54 million, or 4%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The increase in our strategic services revenues for both periods was primarily due to price increases for broadband services, volume increases in Ethernet services and price increases for other services.\nLegacy Services\nLegacy services revenues decreased by $90 million, or 10%, and decreased by $175 million, or 10%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The decline in our legacy services revenues for both periods was primarily due to lower local voice services revenues due to access line loss and reduced access services usage related to customer migration, competitive pressures and product substitution and to reductions in the volumes of our private line (including special access) services.\nAffiliates and Other Services\nAffiliates and other services revenues increased by $67 million, or 10%, and increased by $158 million, or 12%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The increase in our affiliates and other services revenues for both periods was primarily due to increases in the volume and in the rates we charge for the support services we provided to affiliates and to the additional revenue recorded under the FCC's CAF Phase 2 support program. We recorded $24 million and $48 million more in revenue for the three and six months ended June 30, 2016, respectively, than for the three and six months ended June 30, 2015, with respect to our 13 CAF Phase 2 states. We received a substantial one-time cumulative catch-up payment related to the first half of 2015 from the FCC in the third quarter of 2015, and, as a result, we do not expect funding from the CAF Phase 2 support program to materially change our other operating revenues for the full year 2016 when compared to the full year 2015.\nOperating Expenses\nThe following tables summarize our consolidated operating expenses:\n| Three Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Cost of services and products (exclusive of depreciation and amortization) | $ | 731 | 743 | (12 | ) | (2 | )% |\n| Selling, general and administrative | 235 | 256 | (21 | ) | (8 | )% |\n| Operating expenses - affiliates | 231 | 238 | (7 | ) | (3 | )% |\n| Depreciation and amortization | 424 | 464 | (40 | ) | (9 | )% |\n| Total operating expenses | $ | 1,621 | 1,701 | (80 | ) | (5 | )% |\n\n| Six Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Cost of services and products (exclusive of depreciation and amortization) | $ | 1,439 | 1,435 | 4 | — | % |\n| Selling, general and administrative | 485 | 526 | (41 | ) | (8 | )% |\n| Operating expenses - affiliates | 482 | 486 | (4 | ) | (1 | )% |\n| Depreciation and amortization | 843 | 926 | (83 | ) | (9 | )% |\n| Total operating expenses | $ | 3,249 | 3,373 | (124 | ) | (4 | )% |\n\n18\nCost of Services and Products (exclusive of depreciation and amortization)\nCost of services and products (exclusive of depreciation and amortization) are expenses incurred in providing products and services to our customers. These expenses include: employee-related expenses directly attributable to operating and maintaining our network (such as salaries, wages, benefits and professional fees); facilities expenses (which include third-party telecommunications expenses we incur for using other carriers' networks to provide services to our customers); rents and utilities expenses; equipment sales expenses (such as modem expenses); payments of universal service funds (which are federal and state funds that are established to promote the availability of telecommunications services to all consumers at reasonable and affordable rates, among other things, and to which we are often required to contribute); litigation expenses associated with our operations; and other expenses directly related to our operations.\nCost of services and products (exclusive of depreciation and amortization) decreased by $12 million, or 2%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015. The decrease in our cost of services and products was primarily due to decreases in employee benefits expense, professional fees and contract labor costs, which were partially offset by increases in facility costs and network expense. Cost of services and products (exclusive of depreciation and amortization) increased by $4 million, or less than 1%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The increase in our cost of services and products was primarily due to increases in facility costs and allocated corporate costs from affiliates, which were substantially offset by decreases in salaries and wages and related employee benefits expense (driven by increases in the amount of labor capitalized and allocated to our affiliates), professional fees and contract labor costs.\nSelling, General and Administrative\nSelling, general and administrative expenses are expenses incurred in selling products and services to our customers, corporate overhead and other operating expenses. These expenses include: employee-related expenses (such as salaries, wages, internal commissions, benefits and professional fees) directly attributable to selling products or services and employee-related expenses for administrative functions; marketing and advertising; property and other operating taxes and fees; external commissions; litigation expenses associated with general matters; bad debt expense; and other selling, general and administrative expenses.\nSelling, general and administrative expenses decreased by $21 million, or 8%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015. The decrease in our selling, general and administrative expenses was primarily due to decreases in salaries and wages and related employee benefits expense (driven by increases in the amount of labor capitalized and allocated to our affiliates), contract labor costs and property and other taxes, which were partially offset by an increase in external commissions. Selling, general and administrative expenses decreased by $41 million, or 8%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The decrease in our selling, general and administrative expenses was primarily due to decreases in salaries and wages and related employee benefits expense (driven by increases in the amount of labor capitalized and allocated to our affiliates), contract labor costs, property and other taxes and regulatory fines of $15 million associated with a 911 system outage in 2015, which were partially offset by an increase in external commissions.\nOperating Expenses - Affiliates\nSince CenturyLink's acquisition of us, we have incurred affiliates expenses related to our use of telecommunication services, marketing and employee related support services provided by CenturyLink and its subsidiaries.\nOperating expenses - affiliates decreased by $7 million, or 3%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015 and decreased by $4 million, or 1%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The decrease in operating expenses - affiliates for both periods was primarily due to decreases in level of services provided to us by our affiliates.\n19\nDepreciation and Amortization\nThe following tables provide detail of our depreciation and amortization expense:\n| Three Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Depreciation | $ | 230 | 244 | (14 | ) | (6 | )% |\n| Amortization | 194 | 220 | (26 | ) | (12 | )% |\n| Total depreciation and amortization | $ | 424 | 464 | (40 | ) | (9 | )% |\n\n| Six Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Depreciation | $ | 452 | 484 | (32 | ) | (7 | )% |\n| Amortization | 391 | 442 | (51 | ) | (12 | )% |\n| Total depreciation and amortization | $ | 843 | 926 | (83 | ) | (9 | )% |\n\nDepreciation expense is impacted by several factors, including changes in our depreciable cost basis, changes in our estimates of the remaining economic life of certain network assets and the addition of new plant. Depreciation expense decreased by $14 million, or 6%, and decreased by $32 million, or 7%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The depreciation expense related to our plant for the six months ended June 30, 2016 was lower than the depreciation expense for the six months ended June 30, 2015 due to full depreciation and retirement of certain plant placed in service prior to 2016. This decrease was partially offset by an increase in depreciation expense attributable to new plant placed in service since June 30, 2015.\nAmortization expense decreased by $26 million, or 12%, and decreased by $51 million, or 12%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The decrease in amortization expense for both periods was primarily due to software becoming fully amortized faster than new software was acquired or developed.\nOther Consolidated Results\nThe following tables summarize our total other expense, net and income tax expense:\n| Three Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Interest expense | $ | (120 | ) | (119 | ) | 1 | 1 | % |\n| Interest expense - affiliate | (15 | ) | (13 | ) | 2 | 15 | % |\n| Other income, net | — | 1 | (1 | ) | 100 | % |\n| Total other expense, net | $ | (135 | ) | (131 | ) | 4 | 3 | % |\n| Income tax expense | $ | 179 | 152 | 27 | 18 | % |\n\n20\n| Six Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Interest expense | $ | (241 | ) | (237 | ) | 4 | 2 | % |\n| Interest expense - affiliate | (29 | ) | (26 | ) | 3 | 12 | % |\n| Other income, net | 2 | 1 | 1 | 100 | % |\n| Total other expense, net | $ | (268 | ) | (262 | ) | 6 | 2 | % |\n| Income tax expense | $ | 367 | 319 | 48 | 15 | % |\n\nInterest Expense\nInterest expense increased by $1 million, or 1%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015 and increased by $4 million, or 2%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The increase in interest expense for both periods was primarily due to a reduction in the amount of net premium amortization recorded at acquisition primarily due to the retirement of several issuances of debt during the period. See Note 2—Long-Term Debt and Revolving Promissory Note to our consolidated financial statements in Item 1 of Part I of this report and Liquidity and Capital Resources below for additional information about our debt.\nInterest Expense - Affiliates, Net\nAffiliate interest expense increased by $2 million, or 15%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015 and increased by $3 million, or 12%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The increase in affiliate interest expense for both periods was primarily due to the increase in the average amount outstanding on our intercompany revolving indebtedness.\nIncome Tax Expense\nIncome tax expense for the three months ended June 30, 2016 was $179 million, or an effective tax rate of 38.3%, compared to $152 million, or an effective tax rate of 39.0%, for the three months ended June 30, 2015. Income tax expense for the six months ended June 30, 2016 was $367 million, or an effective tax rate of 38.3%, compared to $319 million, or an effective tax rate of 39.7%, for the six months ended June 30, 2015. The 2016 rates include the effect of changes in state apportionment factors and research and development credits. The 2015 rates include the effect of regulatory fines associated with a 911 system outage and state tax rate changes.\nLiquidity and Capital Resources\nOverview\nWe are an indirectly wholly-owned subsidiary of CenturyLink. As such, factors relating to, or affecting, CenturyLink's liquidity and capital resources could have material impacts on us, including impacts on our credit ratings, our access to capital markets and changes in the financial market's perception of us.\nCenturyLink has cash management arrangements between certain of its subsidiaries that include lines of credit, affiliate advances and obligations, capital contributions and dividends. As part of these cash management arrangements, affiliates provide lines of credit to certain other affiliates. Amounts outstanding under these lines of credit and intercompany obligations vary from time to time. Under these arrangements, the majority of our cash balance is advanced on a daily basis to CenturyLink. From time to time we may declare and pay dividends to our stockholder, QSC, in excess of our earnings to the extent permitted by applicable law, using cash owed to us under these advances, which has the net effect of reducing the amount of these advances. Our debt covenants do not currently limit the amount of dividends we can pay to QSC. Given our cash management arrangement with our ultimate parent, CenturyLink, and the resulting amounts due to us from CenturyLink, a significant component of our liquidity is dependent upon CenturyLink's ability to repay its obligation to us.\n21\nAt June 30, 2016, we had a working capital deficit of $1.005 billion, reflecting current liabilities of $2.656 billion and current assets of $1.651 billion, compared to a working capital deficit of approximately $820 million as of December 31, 2015. We have historically operated with a working capital deficit due to our practice of declaring and paying regular cash dividends to QSC. As long as we continue declaring and paying cash dividends to QSC, it is likely that we will continue to operate with a working capital deficit in the future. We anticipate that our future liquidity needs will be met through (i) our cash provided by our operating activities, (ii) amounts due to us from CenturyLink and (iii) capital contributions, advances or loans from CenturyLink or its affiliates if and to the extent they have available funds or access to available funds that they are willing and able to contribute, advance or loan.\nCapital Expenditures\nWe incur capital expenditures on an ongoing basis in order to enhance and modernize our networks, compete effectively in our markets and expand our service offerings. CenturyLink evaluates capital expenditure projects based on a variety of factors, including expected strategic impacts (such as forecasted impact on revenue growth, productivity, expenses, service levels and customer retention) and the expected return on investment. The amount of CenturyLink’s consolidated capital investment is influenced by, among other things, demand for CenturyLink’s services and products, cash flow generated by operating activities, cash required for other purposes and regulatory considerations (such as our CAF Phase 2 infrastructure buildout requirements discussed below). Based on the type and volume of services we provide, approximately 38% to 43% of CenturyLink’s annual consolidated capital expenditures have been attributed over the last couple of years to us for use in our operations. For more information on CenturyLink’s total capital expenditures, please see its annual and quarterly reports filed with the SEC.\nOur capital expenditures continue to be focused on our strategic services. For more information on our capital spending, see Item 1of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\nDebt and Other Financing Arrangements\nSubject to market conditions, and to the extent feasible, we expect to continue to issue debt securities from time to time in the future to refinance a substantial portion of our maturing debt. The availability, interest rate and other terms of any new borrowings will depend on the ratings assigned to us by credit rating agencies, among other factors. We have no debt maturities due during the remainder of 2016.\n| Agency | Credit Ratings |\n| Standard & Poor's | BBB- |\n| Moody's Investors Service, Inc. (1) | Ba1 |\n| Fitch Ratings | BBB- |\n\n| (1) | On March 15, 2016, Moody's Investors Service, Inc. downgraded CenturyLink's rating from Ba2 to Ba3 and downgraded Qwest Corporation's rating from Baa3 to Ba1. |\n\nOur credit ratings are reviewed and adjusted from time to time by the rating agencies, and downgrades could impact CenturyLink's and our access to debt capital or further raise CenturyLink's and our borrowing costs. Additional downgrades of CenturyLink's senior unsecured debt ratings could, under certain circumstances, incrementally increase the cost of CenturyLink's borrowing under its revolving credit facility, which could indirectly impact us. See \"Risk Factors—Risks Affecting our Liquidity and Capital Resources\" in Item 1A of Part II of this report.\nTerm Loan\nIn 2015, we entered into a term loan in the amount of $100 million with CoBank, ACB. The outstanding unpaid principal amount of this term loan plus any accrued and unpaid interest is due on February 20, 2025. Interest is paid monthly based upon either the London Interbank Offered Rate (“LIBOR”) or the base rate (as defined in the credit agreement) plus an applicable margin between 1.50% to 2.50% per annum for LIBOR loans and 0.50% to 1.50% per annum for base rate loans depending on our then current senior unsecured long-term debt rating. As of June 30, 2016, the outstanding principal balance on this term loan was $100 million.\n22\nRevolving Promissory Note\nWe are currently indebted to an affiliate of CenturyLink under a revolving promissory note that provides us with a funding commitment of up to $1.0 billion aggregate principal amount through June 30, 2022, of which $884 million was outstanding as of June 30, 2016. The revolving promissory note is due on demand and ranks equally to our outstanding Senior Notes. Interest is accrued on the outstanding balance using a weighted average per annum interest rate of CenturyLink's outstanding borrowings for the interest period. As of June 30, 2016, the weighted average interest rate was 6.795%. As of June 30, 2016 and December 31, 2015, this revolving promissory note is reflected on our consolidated balance sheets as a current liability under note payable - affiliate. As of June 30, 2016, $5 million of accrued interest is reflected in other current liabilities on our consolidated balance sheet.\nDividends\nWe periodically pay dividends to our direct parent company. See Note 6—Dividends and the discussion above under the heading \"Overview\".\nPension and Post-retirement Benefit Obligations\nCenturyLink is subject to material obligations under its existing defined benefit pension plans and post-retirement benefit plans. At December 31, 2015, the accounting unfunded status of CenturyLink's qualified and non-qualified defined benefit pension plans and post-retirement benefit plans was $2.277 billion and $3.374 billion, respectively. For additional information about CenturyLink's pension and post-retirement benefit arrangements, see \"Critical Accounting Policies and Estimates—Pensions and Post-Retirement Benefits\" in Item 7 of CenturyLink's Annual Report on Form 10-K for the year ended December 31, 2015, and see Note 7—Employee Benefits to the consolidated financial statements in Item 8 of Part II of the same report.\nA substantial portion of our active and retired employees participate in CenturyLink's qualified Combined Pension Plan and post-retirement benefit plans. On December 31, 2014, the Qwest Communications International Inc. (\"QCII\") pension plan and a pension plan of an affiliate were merged into the CenturyLink Retirement Plan, which was renamed the CenturyLink Combined Pension Plan. Our contributions to the trust are not segregated or restricted to pay amounts due to our employees and may be used to provide benefits to other employees of our affiliates. Prior to the pension plan merger, the above-noted employees participated in the QCII pension plan.\nThe affiliate obligations, net in current and noncurrent liabilities on our consolidated balance sheets represents the cumulative allocation of expense, net of payments, associated with QCII's pension plans and post-retirement benefits plans prior to the plan mergers. In 2015, we agreed to a plan to settle the outstanding pension and post-retirement affiliate obligations, net balance with QCII over a 30 year term. Payments will be made on a monthly basis. For the six months ended June 30, 2016, we made a settlement payment of $49 million to QCII on our affiliate obligations, net balance. Changes in the affiliate obligations, net are reflected in operating activities on our consolidated statements of cash flows. For the year ending December 31, 2016, we expect to make a settlement payment of $97 million to QCII on our affiliate obligations, net balance.\nFor 2016, CenturyLink's estimated annual long-term rate of return is 7.0% for both the pension plan trust assets and post-retirement plans trust assets, based on the assets currently held. However, actual returns could be substantially different.\nFor additional information, see “Risk Factors—Risks Affecting Our Liquidity and Capital Resources—Adverse changes in the value of assets or obligations associated with CenturyLink’s qualified pension plan could negatively impact CenturyLink’s liquidity, which may in turn affect our business and liquidity” in Item 1A of Part II of this report.\nConnect America Fund\nIn 2015, CenturyLink accepted CAF funding from the FCC of approximately $500 million per year for six years to fund the deployment of voice and broadband capable infrastructure for approximately 1.2 million rural households and businesses in 33 states under the CAF Phase 2 support program. Of these amounts, approximately $150 million per year is attributable to our service area, to provide service to approximately 0.3 million rural households and businesses in 13 states. The funding from the CAF Phase 2 support program is expected to substantially supplant the funding we previously received from the interstate USF program that we previously utilized to support voice services in high-cost rural markets in these 13 states. In late 2015, we began receiving these payments from the FCC under the new CAF Phase 2 support program, which included monthly support payments at a higher rate than under the interstate USF support program. We received a substantial one-time cumulative catch-up payment from the FCC in the third quarter of 2015, and, as a result, we do not expect our funding from the CAF Phase 2 support program to materially change our operating revenues for the full year 2016 when compared to the full year 2015.\n23\nAs a result of accepting CAF Phase 2 support payments for 13 states, we will be obligated to make substantial capital expenditures to build infrastructure over the next several years. See \"Capital Expenditures\" above.\nFor additional information on the FCC's CAF order and the USF program, see \"Business—Regulation\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015 and see \"Risk Factors—Risks Affecting our Liquidity and Capital Resources\" in Item 1A of Part II of this report.\nIn 2013, under the second round of the first phase of the CAF program, CenturyLink received $40 million in funding, $15 million attributed to our service areas, for deployment of broadband services in rural areas. For various reasons, we failed to meet certain broadband deployment requirements by specified deadlines, but we are currently developing alternate solutions, which may satisfy some or all of the requirements. If the FCC does not recognize our alternate deployment plans or grant us an extension of time to fulfill the deployment requirements, we anticipate that we will be requested to refund a substantial portion of the $15 million in funding we received. As of June 30, 2016, we have included approximately $8 million of CAF 1 Round 2 funding in other current liabilities and the remaining approximately $7 million of funding in other noncurrent liabilities on our consolidated balance sheet.\nFuture Contractual Obligations\nFor information regarding our estimated future contractual obligations, see the MD&A discussion included in our Annual Report on Form 10-K for the year ended December 31, 2015.\nHistorical Information\n| Six Months Ended June 30, | Increase / (Decrease) |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Cash Flows Provided By (Used In) |\n| Net cash provided by operating activities | $ | 1,284 | 1,254 | 30 |\n| Net cash used in investing activities | (569 | ) | (947 | ) | (378 | ) |\n| Net cash used in financing activities | (714 | ) | (307 | ) | 407 |\n\nNet cash provided by operating activities increased by $30 million for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015 primarily due to an increase in net income (which was directly impacted by the cash received from the CAF Phase 2 support program, which was $50 million greater than the cash we received in the first six months of 2015) adjusted for non-cash items, which was partially offset by negative variances in the changes in accounts receivable, accounts payable and affiliate obligations, net. For additional information about our operating results, see \"Results of Operations\" above.\nNet cash used in investing activities decreased by $378 million for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015 primarily due to a positive variance in the change in the amount of funds advanced to our affiliates.\nNet cash used in financing activities increased by $407 million for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015 primarily due to an increase in the amount of dividends paid to our direct parent company. For additional information regarding our financing activities, see Note 2—Long-Term Debt and Revolving Promissory Note to our consolidated financial statements in Item 1 of this report.\nOn May 2, 2016, QC paid at maturity the $235 million principal amount and accrued and unpaid interest due under its 8.375% Notes.\nIn January 2016, QC issued $235 million aggregate principal amount of 7% Notes due 2056, in exchange for net proceeds, after deducting underwriting discounts and other expenses, of approximately $227 million. For additional information on the terms of QC's 7% Notes due in 2056, see Note 2—Long-Term Debt and Revolving Promissory Note to our consolidated financial statements in Item 1 of this report.\n24\nOther Matters\nIn February 2015, the FCC adopted new regulations that regulate broadband services as a public utility under Title II of the Communications Act. In light of pending litigation, we believe it is premature for us to determine the ultimate impact of the new regulations on our operations; however, we currently expect that they will negatively impact our operations. For additional information, see “Risk Factors—Risks Relating to Legal and Regulatory Matters” in Item 1A of Part II of this report.\nCenturyLink and its affiliates are involved in several legal proceedings to which we are not a party that, if resolved against them, could have a material adverse effect on their business and financial condition. As a wholly-owned subsidiary of CenturyLink, our business and financial condition could be similarly affected. You can find descriptions of these legal proceedings in CenturyLink's quarterly and annual reports filed with the Securities and Exchange Commission (\"SEC\"). Because we are not a party to any of the matters, we have not accrued any liabilities for these matters as of June 30, 2016.\nMarket Risk\nWe are exposed to market risk from changes in interest rates on our variable rate long-term debt obligations and revolving promissory note. We seek to maintain a favorable mix of fixed and variable rate debt in an effort to limit interest costs and cash flow volatility resulting from changes in rates.\nManagement periodically reviews our exposure to interest rate fluctuations and periodically implements strategies to manage the exposure. From time to time, we have used derivative instruments to (i) lock-in or swap our exposure to changing or variable interest rates for fixed interest rates or (ii) to swap obligations to pay fixed interest rates for variable interest rates. As of June 30, 2016, we had no such instruments outstanding. We have established policies and procedures for risk assessment and the approval, reporting and monitoring of derivative instrument activities. We do not hold or issue derivative financial instruments for trading or speculative purposes.\nWe do not believe that there were any material changes to market risks arising from changes in interest rates for the six months ended June 30, 2016, when compared to the disclosures provided in our Annual Report on Form 10-K for the year ended December 31, 2015.\nCertain shortcomings are inherent in the method of analysis presented in the computation of exposures to market risks. Actual values may differ materially from those disclosed by us from time to time if market conditions vary from the assumptions used in the analyses performed. These analyses only incorporate the risk exposures that existed at June 30, 2016.\nOff-Balance Sheet Arrangements\nWe have no special purpose or limited purpose entities that provide off-balance sheet financing, liquidity, or market or credit risk support and we do not engage in leasing, hedging or other similar activities that expose us to any significant liabilities that are not (i) reflected on the face of the consolidated financial statements, (ii) disclosed in Note 15—Commitments and Contingencies to our consolidated financial statements in Item 8 of Part II of our Annual Report on Form 10-K for the year ended December 31, 2015 or (iii) discussed under the heading \"Market Risk\" above.\n25\nOther Information\nCenturyLink's and our website is www.centurylink.com. We routinely post important investor information in the \"Investor Relations\" section of our website at ir.centurylink.com. The information contained on, or that may be accessed through, our website is not part of this quarterly report. You may obtain free electronic copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports in the \"Investor Relations\" section of our website (ir.centurylink.com) under the heading \"SEC Filings.\" These reports are available on our website as soon as reasonably practicable after we electronically file them with the SEC.\nIn addition to historical information, this quarterly report includes certain forward-looking statements that are based upon our judgment and assumptions as of the date of this report concerning future developments and events, many of which are beyond our control. These forward-looking statements, and the assumptions upon which they are based, are not guarantees of future results, are inherently speculative and are subject to a number of risks and uncertainties. Actual events and results may differ materially from those anticipated, estimated, projected or implied by us in those statements if one or more of these risks or uncertainties materialize, or if underlying assumptions prove incorrect. Factors that could affect actual results include but are not limited to: the effects of competition from a wide variety of competitive providers, including lower demand for our legacy offerings; the effects of new, emerging or competing technologies, including those that could make our products less desirable or obsolete; the effects of ongoing changes in the regulation of the communications industry, including the outcome of regulatory or judicial proceedings relating to intercarrier compensation, interconnection obligations, access charges, universal service, broadband deployment, data protection and net neutrality; our ability to effectively adjust to changes in the communications industry, and changes in the composition of our markets and product mix; possible changes in the demand for, or pricing of, our products and services, including our ability to effectively respond to increased demand for high-speed broadband service; our ability to successfully maintain the quality and profitability of our existing product and service offerings and to introduce new offerings on a timely and cost-effective basis; the adverse impact on our business and network from possible equipment failures, service outages, security breaches or similar events impacting our network; our ability to generate cash flows sufficient to fund our financial commitments and objectives, including our capital expenditures, operating costs, dividends, pension contributions and debt payments; changes in our operating plans, corporate strategies, dividend payment plans or other capital allocation plans, whether based upon changes in our cash flows, cash requirements, financial performance, financial position, or otherwise; our ability to effectively retain and hire key personnel and to successfully negotiate collective bargaining agreements on reasonable terms without work stoppages; increases in the costs of CenturyLink's pension, health, post-employment or other benefits, including those caused by changes in markets, interest rates, mortality rates, demographics or regulations, which may in turn affect our business and liquidity; adverse changes in our access to credit markets on favorable terms, whether caused by changes in our financial position, lower debt credit ratings, unstable markets or otherwise; our ability to maintain favorable relations with our key business partners, suppliers, vendors, landlords and financial institutions; our ability to effectively manage our network buildout project and other expansion opportunities; our ability to collect our receivables from financially troubled customers; any adverse developments in legal or regulatory proceedings involving us or our affiliates (including CenturyLink); changes in tax, communications, pension, healthcare or other laws or regulations, in governmental support programs, or in general government funding levels; the effects of changes in accounting policies or practices, including potential future impairment charges; the effects of terrorism, adverse weather or other natural or man-made disasters; the effects of more general factors such as changes in interest rates, in operating costs, in general market, labor, economic or geo-political conditions, or in public policy; and other risks referenced in Item 1A or elsewhere in this Quarterly Report or other of our filings with the SEC. You should be aware that new factors may emerge from time to time and it is not possible for us to identify all such factors nor can we predict the impact of each such factor on the business or the extent to which any one or more factors may cause actual results to differ from those reflected in any forward-looking statements. Given these uncertainties, we caution investors not to unduly rely upon our forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements for any reason, whether as a result of new information, future events or developments, changed circumstances, or otherwise. Furthermore, any information about our intentions contained in any of our forward-looking statements reflects our intentions as of the date of this report, and is based upon, among other things, existing regulatory, technological, industry, competitive, economic and market conditions, and our assumptions as of such date. We may change our intentions, strategies or plans at any time and without notice, based upon any changes in such factors, in our assumptions or otherwise.\n26\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nWe have omitted this information pursuant to General Instruction H(2).\nITEM 4. CONTROLS AND PROCEDURES\nDisclosure Controls and Procedures\nThe Company maintains disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”)) designed to provide reasonable assurance that the information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. These include controls and procedures designed to ensure that this information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Management, with the participation of our Chief Executive Officer, Glen F. Post, III, and our Chief Financial Officer, R. Stewart Ewing, Jr., evaluated the effectiveness of the Company’s disclosure controls and procedures as of June 30, 2016. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2016, in providing reasonable assurance that the information required to be disclosed by us in this report was accumulated and communicated in the manner provided above.\nThe effectiveness of our or any system of disclosure controls and procedures is subject to certain limitations, including the exercise of judgment in designing, implementing and evaluating the controls and procedures, the assumptions used in identifying the likelihood of future events and the inability to eliminate misconduct completely. As a result, there can be no assurance that our disclosure controls and procedures will detect all errors or fraud. By their nature, our or any system of disclosure controls and procedures can provide only reasonable assurance regarding management's control objectives.\nChanges in Internal Control Over Financial Reporting\nThere were no changes in our internal control over financial reporting during the second quarter of 2016 that materially affected, or that we believe are reasonably likely to materially affect, our internal control over financial reporting.\n27\nPART II—OTHER INFORMATION\nITEM 1. LEGAL PROCEEDINGS\nThe information contained in Note 5—Commitments and Contingencies included in Item 1 of Part I of this report is incorporated herein by reference.\nITEM 1A. RISK FACTORS\nThe following discussion of “risk factors” identifies the most significant risks or uncertainties that could (i) materially and adversely affect our business, financial condition, results of operations, liquidity or prospects or (ii) cause our actual results to differ materially from our anticipated results or other expectations. You should carefully consider these factors, in addition to the other information set forth in this report and our subsequent filings with the SEC, when evaluating our business and whether to purchase, sell or hold our securities. Please note that the following discussion is not intended to comprehensively list all risks or uncertainties faced by us. Our operations or actual results could also be similarly impacted by additional risks and uncertainties that are not currently known to us, that we currently deem to be immaterial, that arise in the future or that are not specific to us, such as general economic conditions.\nRisks Affecting Our Business\nWe may not be able to compete successfully against current or future competitors.\nEach of our offerings to our residential and business customers face increasingly intense competition from a variety of sources under evolving market conditions. We expect these trends will continue. In addition to competition from larger national telecommunications providers, we are facing increasing competition from several other sources, including cable and satellite companies, wireless providers, technology companies, broadband providers, device providers, resellers, sales agents and facilities-based providers using their own networks as well as those leasing parts of our network. In particular, (i) intense competition from wireless and other communications providers has led to a long-term systemic decline in the number of our customers for wireline voice services, (ii) strong competition from cable companies and others has impacted the growth of our broadband operations and (iii) aggressive competition from a wide range of technology companies and other market entrants has limited the prospects for our cloud computing operations. For more detailed information, see \"Competition\" under Item 1 of our Annual Report on Form 10-K for the year ended December 31, 2015.\nSome of our current and potential competitors (i) offer products or services that are substitutes for our wireline voice services, including wireless voice and non-voice communication services, (ii) offer a more comprehensive range of communications products and services, (iii) offer products or services with features that we cannot readily match in some or all of our markets, including faster average broadband transmission speeds and greater content, (iv) offer shorter installation intervals, allowing customers to begin receiving services sooner after ordering, (v) have market presence, engineering and technical capabilities, and financial and other resources greater than ours, (vi) have larger or more diverse networks with greater transmission capacity or other advantages, (vii) conduct operations or raise capital at a lower cost than us, (viii) are subject to less regulation, which we believe enables such competitors to operate more flexibly than us with respect to certain offerings, (ix) offer services nationally or internationally to a larger geographic area or larger base of customers, (x) have substantially stronger brand names, which may provide them with greater pricing power than ours, or (xi) have larger operations than ours, which may enable them to offer higher compensation packages in connection with recruiting and retaining top technological, managerial and operational talent. Consequently, these competitors may be better equipped to provide more attractive offerings, to charge lower prices for their products and services, to develop and expand their communications and network infrastructure more quickly, to adapt more swiftly to new or emerging technologies and changes in customer requirements, to devote greater resources to the marketing and sale of their products and services, to provide more comprehensive customer service, to provide greater resources to research and development initiatives and to take advantage of acquisition or other opportunities more readily. In the past, several of our competitors and their operations have grown through acquisitions and aggressive product development. The continued growth of our competitors could further enhance their competitive positions.\nCompetition could adversely impact us in several ways, including (i) the loss of customers and market share, (ii) the possibility of customers reducing their usage of our services or shifting to less profitable services, (iii) reduced traffic on our networks, (iv) our need to expend substantial time or money on new capital improvement projects, (v) our need to lower prices or increase marketing expenses to remain competitive and (vi) our inability to diversify by successfully offering new products or services.\n28\nWe are continually taking steps to respond to these competitive pressures, but these efforts may not be successful. Our operating results and financial condition would be adversely affected if these initiatives are unsuccessful or insufficient and if we otherwise are unable to sufficiently stem our continuing access line losses and our legacy revenue declines. If this occurred, our ability to pay our debt and other obligations and to re-invest in the business would also be adversely affected.\nRapid technological changes could significantly impact our competitive and financial position.\nThe communications industry has been and continues to be impacted by significant technological changes, which in general are enhancing non-voice communications and enabling a broader array of companies to offer services competitive with ours. Many of those technological changes are (i) displacing or reducing demand for our wireline voice services, (ii) enabling the development of competitive products or services, or (iii) enabling our current customers to reduce or bypass use of our networks. Rapid changes in technology are increasing the competitiveness of the information technology services industry. In addition, demand for our broadband services has been constrained by certain technologies permitting cable companies and other competitors to deliver faster average broadband transmission speeds than ours. Demand for our broadband services could be further reduced by advanced wireless data transmission technologies being deployed by wireless providers, including \"long-term evolution\" or \"LTE\" technologies, especially if these wireless providers continue to increase their broadband transmission speed and decrease their service rates. To enhance the competitiveness of our broadband services, we may be required to expend additional capital to augment the capabilities of our copper-based services or to install more fiber optic cable.\nWe may not be able to accurately predict or respond to changes in technology or industry standards, or to the introduction of newly-offered services. Any of these developments could make some or all of our offerings less desirable or even obsolete. These developments could also require us to (i) expend capital or other resources in excess of currently contemplated levels, (ii) forego the development or provision of products or services that others can provide more efficiently, or (iii) make other changes to our operating plans, corporate strategies or capital allocation plans, any of which could be contrary to the expectations of our security holders or could adversely impact our operations. If we are not able to develop new products and services to keep pace with technological advances, or if those products and services are not widely accepted by customers, our ability to compete could be adversely affected and our market share could decline. Any inability to effectively respond to technological changes could also adversely affect our operating results and financial condition, as well as our ability to service debt and fund other commitments or initiatives.\nEven if we succeed in adapting to changes in technology or industry standards by developing new products or services, there is no assurance that the new products or services would have a positive impact on our profit margins or financial performance.\nIn addition to introducing new technologies and offerings, we may need, from time to time, to phase out outdated and unprofitable technologies and services. If we are unable to do so, on a cost-effective basis, we could experience reduced profits.\nFor additional information on the risks of increased expenditures, see \"Risk Factors—Risks Affecting our Liquidity and Capital Resources—Our business requires us to incur substantial capital and operating expenses, which reduces our available free cash flow.\"\nOur legacy services continue to experience declining revenues, and our efforts to offset these declines may not be successful.\nPrimarily as a result of the competitive and technological changes discussed above, we have experienced a prolonged systemic decline in our access lines and network access revenues. We have also experienced a decline in our private line revenues due to our customers' optimization of their networks, industry consolidation, price compression and technological migration to higher-speed services.\nWe have taken a variety of steps to counter these declines in our legacy services revenues, including:\n| • | an increased focus on selling a broader range of higher-growth strategic services, which are described in detail elsewhere in this report; |\n\n| • | an increased focus on serving a broader range of business, governmental and wholesale customers; and |\n\n| • | greater use of service bundles. |\n\nHowever, for the reasons described elsewhere in this report, most of our strategic services generate lower profit margins than our legacy services, and some can be expected to experience slowing growth as increasing numbers of our existing or potential customers subscribe to our newer strategic product and service offerings. Moreover, we cannot assure you that the revenues generated from our new offerings will offset revenue losses associated with our legacy services. In addition, our reliance on third parties to provide certain of these strategic services could constrain our flexibility, as described further below.\n29\nOur ability to successfully introduce new product or service offerings on a timely and cost-effective basis could be constrained by a range of factors, including network limitations, limited capital, an inability to attract key personnel with the necessary skills, intellectual property constraints, testing delays, or an inability to act as quickly as smaller, more nimble start-up competitors. Similarly, our ability to grow through acquisitions could be limited by several factors, including our leverage and inability to identify attractively-priced target companies. For these reasons, we cannot assure you that our new product or service offerings will be as successful as anticipated, or that we will be able to continue to grow through acquisitions.\nWe may not be able to successfully adjust to changes in our industry, our markets and our product mix.\nOngoing changes in the communications industry have fundamentally changed consumers’ communications expectations and requirements. In response to these changes, we have substantially altered our product and service offerings through acquisitions and internal product development. Many of these changes have placed a higher premium on sales, marketing and product development functions, and necessitated ongoing changes in our processes and operating protocols, as well as periodic reorganizations of our sales and leadership teams. In addition, we now offer a more complex range of products and services, operate larger and more complex networks and serve a much larger and more diverse set of customers. Consequently, we now face greater challenges in effectively managing and administering our operations and allocating capital and other resources to our various offerings. For all these reasons, we cannot assure you that our efforts to adjust to these changes will be timely or successful.\nWe could be harmed by security breaches, damages or other significant disruptions or failures of our networks, information technology infrastructure or related systems, or of those we operate for certain of our customers.\nWe are materially reliant upon our networks, information technology infrastructure and related technology systems (including our billing and provisioning systems) to provide products and services to our customers and to manage our operations and affairs. We face the risk, as does any company, of a security breach or significant disruption of our information technology infrastructure and related systems. As a communications company that transmits large amounts of sensitive and proprietary information over communications networks, we face an added risk that a security breach or other significant disruption of our public networks or information technology infrastructure and related systems that we develop, install, operate and maintain for certain of our business customers (which includes our wholesale and governmental customers) could lead to material interruptions or curtailments of service. Moreover, in connection with processing and storing confidential customer data, we face a heightened risk that a security breach or disruption could result in unauthorized access to our customers' proprietary information on our public networks or internal systems or the systems that we operate and maintain for certain of our customers.\nWe make significant efforts to maintain the security and integrity of information and systems under our control, and maintain contingency plans in the event of security breaches or other system disruptions. Nonetheless, we cannot assure you that our security efforts and measures will prevent unauthorized access to our systems, loss or destruction of data (including confidential customer information), account takeovers, unavailability of service, computer viruses, malware, distributed denial-of-service attacks, or other forms of cyber-attacks or similar events. These threats may derive from human error, hardware or software vulnerabilities, fraud, malice or sabotage on the part of employees, third parties or other nations, or could result from aging equipment or other accidental technological failure. These threats may also arise from failure or breaches of systems owned, operated or controlled by other unaffiliated operators to the extent we rely on such other operations to deliver services to our customers.\nSimilar to other large telecommunications companies, we are a constant target of cyber-attacks of varying degrees. Although some of these attacks have resulted in security breaches, to date, none of these breaches have resulted in a material adverse effect on our operating results or financial condition. You should be aware, however, that defenses against cyber-attacks currently available to U.S. companies are unlikely to prevent intrusions by a highly-determined, highly-sophisticated hacker. Consequently, you should assume that we will be unable to implement security barriers or other preventative measures that repel all future cyber-attacks. Any such future security breaches or disruptions could materially adversely affect our business, results of operations or financial condition, especially in light of the growing frequency, scope and well-documented sophistication of cyber-attacks and intrusions.\nAlthough CenturyLink maintains insurance coverage that may, subject to policy terms and conditions (including self-insured deductibles, coverage restrictions and monetary coverage caps), cover certain aspects of our cyber risks, such insurance coverage may be unavailable or insufficient to cover our losses.\nAdditional risks to our network, infrastructure and related systems include:\n| • | power losses or physical damage, whether caused by fire, adverse weather conditions, terrorism, sabotage, vandalism or otherwise; |\n\n30\n| • | capacity or system configuration limitations, including those resulting from changes in our customer's usage patterns, the introduction of new technologies or products, or incompatibilities between our newer and older systems; |\n\n| • | theft or failure of our equipment; |\n\n| • | software or hardware obsolescence, defects or malfunctions; |\n\n| • | deficiencies in our processes or controls; |\n\n| • | programming, processing and other human error; and |\n\n| • | service failures of our third-party vendors and other disruptions that are beyond our control. |\n\nDue to these factors, from time to time in the ordinary course of our business we experience short disruptions in our service, and could experience more significant disruptions in the future.\nDisruptions, security breaches and other significant failures of the above-described networks and systems could:\n| • | disrupt the proper functioning of these networks and systems, which could in turn disrupt (i) our operations or (ii) the operations of certain of our customers who rely upon us to provide services critical to their operations; |\n\n| • | require significant management attention or financial resources to remedy the damages that result or to change our systems, including expenses to repair systems, add new personnel or develop additional protective systems; |\n\n| • | result in the unauthorized access to, and destruction, loss, theft, misappropriation or release of proprietary, confidential, sensitive, classified or otherwise valuable information of ours, our customers or our customers' end users, including trade secrets, which others could use for competitive, disruptive, destructive or otherwise harmful purposes and outcomes; |\n\n| • | require us to notify customers, regulatory agencies or the public of data breaches; |\n\n| • | require us to provide credits for future service under certain service level commitments we have provided contractually to our customers or to offer expensive incentives to retain customers; |\n\n| • | subject us to claims for damages, fines, penalties, termination or other remedies under our customer contracts or service standards set by state regulatory commissions, which in certain cases could exceed our insurance coverage; or |\n\n| • | result in a loss of business, damage our reputation among our customers and the public generally, subject us to additional regulatory scrutiny or expose us to prolonged litigation. |\n\nWe could experience difficulties in expanding and updating our technical infrastructure.\nOur ability to expand and update our systems and information technology infrastructure in response to our growth and changing business needs is important to our ability to maintain and develop attractive product and service offerings. As discussed further under “Business—Network Architecture” in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015, we are currently undertaking several complex, costly and time-consuming projects to simplify and modernize our network, which combines our legacy network and CenturyLink's networks. Unanticipated delays in the completion of these projects may lead to increased project costs or operational inefficiencies. In addition, there may be issues related to our expanded or updated infrastructure that are not identified by our testing processes, and which may only become evident after we have started to fully utilize the redesigned systems. Our failure to modernize and upgrade our technology infrastructure could have adverse consequences, including the delayed implementation of new service offerings, decreased competitiveness of existing service offerings, network instabilities, increased operating or acquisition integration costs, service or billing interruptions, and the diversion of development resources.\nAny or all of the foregoing developments could have a negative impact on our business, results of operations, financial condition and cash flows.\n31\nIf we fail to hire and retain qualified executives, managers and employees, our operating results could be harmed.\nOur future success depends on our ability to identify, hire, train and retain executives, managers and employees with technological, engineering, product development, operational, provisioning, marketing, sales, administrative and managerial skills. There is a shortage of qualified personnel in several of these fields nationally and in our headquarters city of Monroe, Louisiana, in particular. We compete with several other companies for this limited pool of potential employees. As our industry increasingly becomes more competitive, it could become especially difficult to attract and retain top personnel with skills in high demand. In addition, subject to limited exceptions, none of our executives or domestic employees have long-term employment agreements. For all these reasons, there is no assurance that our efforts to recruit and retain qualified personnel will be successful.\nIncreases in broadband usage may cause network capacity limitations, resulting in service disruptions, reduced capacity or slower transmission speeds for our customers.\nVideo streaming services, gaming and peer-to-peer file sharing applications use significantly more bandwidth than other Internet activity such as web browsing and email. As use of these newer services continues to grow, our broadband customers will likely use much more bandwidth than in the past. If this occurs, we could be required to make significant capital expenditures to increase network capacity in order to avoid service disruptions, service degradation or slower transmission speeds for our customers. Alternatively, we could choose to implement network management practices to reduce the network capacity available to bandwidth-intensive activities during certain times in market areas experiencing congestion, which could negatively affect our ability to retain and attract customers in affected markets. While we believe demand for these services may drive broadband customers to pay for faster broadband speeds, competitive or regulatory constraints may preclude us from recovering the costs of the necessary network investments. This could result in an adverse impact to our operating margins, results of operations, financial condition and cash flows.\nWe have been accused of infringing the intellectual property rights of others and will likely face similar accusations in the future, which could subject us to costly and time-consuming litigation or require us to seek third-party licenses.\nFrom time to time, we receive notices from third parties or are named in lawsuits filed by third parties claiming we have infringed or are infringing upon their intellectual property rights. We are currently responding to several of these notices and claims. Like other communications companies, we have received an increasing number of these notices and claims in the past several years, and expect this industry-wide trend will continue. Responding to these claims may require us to expend significant time and money defending our use of the applicable technology, and divert management’s time and resources away from other business. In certain instances, we may be required to enter into licensing agreements requiring royalty payments or, in the case of litigation, to pay damages. If we are required to take one or more of these actions, our profit margins may decline. In addition, in responding to these claims, we may be required to stop selling or redesign one or more of our products or services, which could significantly and adversely affect our business, results of operations, financial condition and cash flows.\nSimilarly, from time to time, we may need to obtain the right to use certain patents or other intellectual property from third parties to be able to offer new products and services. If we cannot license or otherwise obtain rights to use any required technology from a third party on reasonable terms, our ability to offer new products and services may be prohibited, restricted, made more costly or delayed.\nOur operations, financial performance and liquidity are materially reliant on various third parties.\nReliance on other communications providers. To offer voice or data services in certain of our markets, we must either lease network capacity from, or interconnect our network with the infrastructure of, other communications companies who typically compete against us in those markets. Our reliance on these lease or interconnection arrangements limits our control over the quality of our services and exposes us to the risk that our ability to market our services could be adversely impacted by changes in the plans or properties of the carriers upon which we are reliant. In addition, we are exposed to the risk that the other carriers may be unwilling to continue or renew these arrangements in the future on terms favorable to us, or at all. This risk is heightened when the other carrier is a competitor of ours and may benefit from terminating the agreement. If we lose these arrangements and cannot timely replace them, our ability to provide services to our customers and conduct our business could be materially adversely affected.\nConversely, certain of our operations carry a significant amount of voice or data traffic for other communications providers. Their reliance on our services exposes us to the risk that they may transfer all or a portion of this traffic from our network to networks built, owned or leased by them, thereby reducing our revenues. For additional information, see \"Management's Discussion and Analysis of Financial Condition and Results of Operations—Business Trends\" included in Item 2 of Part I of this report.\n32\nWe also rely on reseller and sales agency arrangements with our affiliates and other communications companies to provide some of the services that we offer to our customers, including video services. As a reseller or sales agent, we do not control the availability, retail price, design, function, quality, reliability, customer service or branding of these products and services, nor do we directly control all of the marketing and promotion of these products and services. Similar to the risks described above regarding our reliance upon other carriers, we could be adversely affected if these communication companies fail to maintain competitive products or services, or fail to continue to make them available to us on attractive terms, or at all.\nOur operations and financial performance could be adversely affected if our relationships with any of these other communications companies are disrupted or terminated for any other reason, including if such other companies:\n| • | become bankrupt or experience substantial financial difficulties; |\n\n| • | suffer work stoppages or other labor strife; |\n\n| • | challenge our right to receive payments or services under applicable regulations or the terms of our existing contract arrangements; or |\n\n| • | are otherwise unable or unwilling to make payments or provide services to us. |\n\nReliance on other key suppliers and vendors. We depend on a limited number of suppliers and vendors for equipment and services relating to our network infrastructure. Our local exchange carrier networks consist of central office and remote sites, all with advanced digital switches. If any of these suppliers experience interruptions or other problems delivering or servicing these network components on a timely basis, our operations could suffer significantly. To the extent that proprietary technology of a supplier is an integral component of our network, we may have limited flexibility to purchase key network components from alternative suppliers and may be adversely affected if third parties assert patent infringement claims against our suppliers or us. We also rely on a limited number of software vendors to support our business management systems and contractors to assist us in connection with our network construction and maintenance activities. In the event it becomes necessary to seek alternative suppliers and vendors, we may be unable to obtain satisfactory replacement supplies, services or utilities on economically attractive terms, on a timely basis, or at all, which could increase costs or cause disruptions in our services.\nReliance on governmental payments. We receive a material amount of revenue or government subsidies under various government programs, which are further described under the heading \"Risk Factors—Risks Relating to Legal and Regulatory Matters.\" We also provide products or services to various federal, state and local agencies. Governmental agencies frequently reserve the right to terminate their contracts for convenience, or to suspend or debar companies from receiving future subsidies or contracts under certain circumstances. If our governmental contracts are terminated for any reason, or if we are suspended or debarred from governmental programs or contracts, our results of operations and financial condition could be materially adversely affected.\nIf we fail to extend or renegotiate our collective bargaining agreements with our labor unions as they expire from time to time, or if our unionized employees were to engage in a strike or other work stoppage, our business and operating results could be materially harmed.\nAs of June 30, 2016, approximately 49% of our employees were members of various bargaining units represented by the Communications Workers of America or the International Brotherhood of Electrical Workers. From time to time, our labor agreements with unions expire. Although we typically are able to negotiate new bargaining agreements, we cannot predict the outcome of our future negotiations of these agreements. We may be unable to reach new agreements, and union employees may engage in strikes, work slowdowns or other labor actions, which could materially disrupt our ability to provide services and result in increased cost to us. In addition, new labor agreements may impose significant new costs on us, which could impair our financial condition or results of operations in the future. To the extent they contain benefit provisions, these agreements may also limit our flexibility to change benefits in response to industry or competitive changes. In particular, post-employment benefits provided under these agreements could cause us to incur costs not faced by many of our competitors, which could ultimately hinder our competitive position.\nPortions of our property, plant and equipment are located on property owned by third parties.\nOver the past few years, certain utilities, cooperatives and municipalities in certain of the states in which we operate have requested significant rate increases for attaching our plant to their facilities. To the extent that these entities are successful in increasing the amount we pay for these attachments, our future operating costs will increase.\n33\nIn addition, we rely on rights-of-way, colocation agreements and other authorizations granted by governmental bodies and other third parties to locate our cable, conduit and other network equipment on or under their respective properties. Our operations could be adversely affected if any of these authorizations terminate or lapse, or if the landowner requests price increases.\nOur business customers may seek to shift risk to us.\nWe furnish to and receive from our business customers indemnities relating to damages caused or sustained by us in connection with certain of our operations. Our customers’ changing views on risk allocation could cause us to accept greater risk to win new business or could result in us losing business if we are not prepared to take such risks. To the extent that we accept such additional risk, and seek to insure against it, our insurance premiums could rise.\nUnfavorable general economic conditions could negatively impact our operating results and financial condition.\nUnfavorable general economic conditions, including unstable economic and credit markets, could negatively affect our business. Worldwide economic growth has been sluggish since 2008, and many experts believe that a confluence of global factors may result in a prolonged period of economic stagnation, slow growth or economic uncertainty. While it is difficult to predict the ultimate impact of these general economic conditions, they could adversely affect demand for some of our products and services and could cause customers to shift to lower priced products and services or to delay or forego purchases of our products and services. These conditions impact, in particular, our ability to sell discretionary products or services to business customers that are under pressure to reduce costs or to governmental customers that have suffered substantial budget cuts in recent years. Any one or more of these circumstances could continue to depress our revenues. Also, our customers may encounter financial hardships or may not be able to obtain adequate access to credit, which could negatively impact their ability to make timely payments to us. In addition, as discussed further below, unstable economic and credit markets may preclude us from refinancing maturing debt at terms that are as favorable as those from which we previously benefited, at terms that are acceptable to us, or at all. For these reasons, among others, if current economic conditions persist or decline, our operating results, financial condition, and liquidity could be adversely affected.\nFor additional information about our business and operations, see Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\nRisks Relating to Legal and Regulatory Matters\nWe operate in a highly regulated industry and are therefore exposed to restrictions on our operations and a variety of claims relating to such regulation.\nGeneral. We are subject to significant regulation by, among others, (i) the Federal Communications Commission (“FCC”), which regulates interstate communications, (ii) state utility commissions, which regulate intrastate communications, and (iii) various foreign governments and international bodies, which regulate our international operations. Generally, we must obtain and maintain certificates of authority or licenses from these bodies in most territories where we offer regulated services. We cannot assure you that we will be successful in obtaining or retaining all licenses necessary to carry out our business plan, and, even if we are, the prescribed service standards and conditions imposed on us in connection with obtaining or acquiring control of these licenses may impose on us substantial costs and limitations. We are also subject to numerous requirements and interpretations under various international, federal, state and local laws, rules and regulations, which are quite detailed and occasionally in conflict with each other. Accordingly, we cannot ensure that we are always considered to be in compliance with all these requirements at any single point in time. The agencies responsible for the enforcement of these laws, rules and regulations may initiate inquiries or actions based on customer complaints or on their own initiative. Even if we are ultimately found to have complied with applicable regulations, such actions or inquiries could create adverse publicity that negatively impacts our business.\nRegulation of the telecommunications industry continues to change, and the regulatory environment varies substantially from jurisdiction to jurisdiction. A substantial portion of our local voice services revenue remains subject to FCC and state utility commission pricing regulation, which periodically exposes us to pricing or earnings disputes and could expose us to unanticipated price declines. Interexchange carriers have filed complaints in various forums requesting reductions in our access rates. In addition, several long distance providers are disputing or refusing to pay amounts owed to us for carrying Voice over Internet Protocol (\"VoIP\") traffic, or traffic they claim to be VoIP traffic. Similarly, some carriers are refusing to pay access charges for certain calls between mobile and wireline devices routed through an interexchange carrier. There can be no assurance that future regulatory, judicial or legislative activities will not have a material adverse effect on our operations, or that regulators or third parties will not raise material issues with regard to our compliance or noncompliance with applicable regulations.\n34\nRisks associated with recent changes in regulation. Historically, our financial performance has been substantially impacted by various aspects of federal regulation, including our receipt in the past of significant universal service payments designed to promote rural telephony. In October 2011, the FCC adopted the Connect America and Intercarrier Compensation Reform order (\"the 2011 order\") intended to comprehensively reform the existing regulatory regime to focus support on networks capable of providing new technologies, including VoIP and other broadband services, and re-direct federal universal service funding to foster nationwide voice and broadband infrastructure. The 2011 order provides for a multi-year transition as intercarrier compensation charges are reduced, federal universal service funding is explicitly targeted to broadband deployment, and subscriber line charges paid by end-user customers are gradually increased. These changes have, among other things, fundamentally altered the manner in which federal subsidies are calculated and disbursed to us (including terminating substantially all of the old universal service payments paid to us under predecessor support programs), and have substantially increased the pace of reductions in the amount of switched access revenues we receive from our wholesale customers. We expect our participation in the FCC's CAF Phase 2 support program will significantly impact our financial results and capital expenditures in the coming years. For more information, see \"Regulation\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015, and \"Management's Discussion and Analysis of Financial Condition and Results of Operations\" in Item 2 of Part I of this report.\nAlthough the primary judicial challenges to the 2011 order have been resolved in the FCC's favor, petitions asking that the FCC reconsider certain aspects of the 2011 order remain pending and, as a result, future judicial challenges on related issues remain possible. Such proceedings could still cause parts of the 2011 order to be altered or delayed. In addition, based on the outcome of the FCC proceedings, various state commissions may consider changes to their rates and support programs. Moreover, FCC proceedings relating to implementation of the order remain pending. For these and other reasons, we cannot predict the ultimate impact of these proceedings at this time.\nIn addition, during the last few years Congress or the FCC has initiated various other changes, including various broadband and Internet regulation initiatives including “network neutrality” regulations (as discussed further below) and actions that will restrict our ability to discontinue or reduce certain services, even if unprofitable. In second quarter of 2016, the FCC concluded its special access tariff investigation and initiated a Notice of Proposed Rulemaking (\"NPRM\") to consider changes in Business Data Services (\"BDS\") regulation. The results of the special access tariff investigation should not have a material impact on us. Several rules changes are being evaluated in the Business Data Services NPRM that may or may not have a material adverse impact on our financial results. The FCC is considering redefining which markets are subject to BDS regulation, broadband speed thresholds that trigger BDS regulation and potential productivity factors that may be limited to specific services or geographies. Given the inextricably intertwined nature of the issues under review in the BDS rulemaking, we will be unable to determine the NPRM’s impact until a final FCC order is issued. The FCC has signaled its desire to issue a BDS order by year end 2016. Any of these recent or pending initiatives could adversely affect our operations or financial results. Moreover, many of the FCC’s regulations adopted in recent years remain subject to judicial review and additional rulemakings, thus increasing the difficulty of determining the ultimate impact of these changes on us and our competitors.\nCertain states have recently taken steps that could reduce the amount of their universal service support payments to incumbent local exchange companies. If these trends continue, we would suffer a reduction in our revenues from state support programs.\nRisks of higher costs. Regulations continue to create significant operating and capital costs for us. Challenges to our tariffs by regulators or third parties or delays in obtaining certifications and regulatory approvals could cause us to incur substantial legal and administrative expenses, and, if successful, such challenges could adversely affect the rates that we are able to charge our customers.\nOur business also may be impacted by legislation and regulation imposing new or greater obligations related to regulations or laws related to regulating broadband services, storing records, bolstering homeland security or cyber security, increasing disaster recovery requirements, minimizing environmental impacts, enhancing privacy, restricting data collection, protecting intellectual property rights of third parties, or addressing other issues that impact our business, including (i) the Communications Assistance for Law Enforcement Act, which requires communications carriers to ensure that their equipment, facilities, and services are able to facilitate authorized electronic surveillance, and (ii) the USA Freedom Act, which requires communication companies to store records of communications of their customers. We expect our compliance costs to increase if future laws or regulations continue to increase our obligations. In addition, increased regulation of our suppliers could increase our costs.\nIncreased risks of fines. We have recently paid certain regulatory fines associated with network or service outages, particularly with respect to outages impacting the availability of emergency - 911 services. We believe that regulators are now pursuing higher fines than in the past for these types of incidents, and expect this trend to continue.\n35\nRisks of reduced flexibility. As a diversified full service incumbent local exchange carrier in most of our key markets, we have traditionally been subject to significant regulation that does not apply to many of our competitors. This regulation in many instances restricts our ability to change rates, to compete and to respond rapidly to changing industry conditions. As our business becomes increasingly competitive, regulatory disparities between us and our competitors could impede our ability to compete.\nRisks posed by other regulations. All of our operations are also subject to a variety of environmental, safety, health and other governmental regulations. We monitor our compliance with federal, state and local regulations governing the management, discharge and disposal of hazardous and environmentally sensitive materials. Although we believe that we are in compliance with these regulations in all material respects, our management, discharge or disposal of hazardous and environmentally sensitive materials might expose us to claims or actions that could potentially have a material adverse effect on our business, financial condition and operating results.\nOur participation in the FCC's Connect America Fund (\"CAF\") Phase 2 support program poses certain risks.\nOur participation in the CAF Phase 2 support program subjects us to certain financial risks. If we fail to attain certain specified infrastructure buildout requirements, the FCC could withhold future CAF support payments until these shortcomings are rectified. In addition, if we are not in compliance with FCC measures at the end of the six-year CAF Phase 2 period, we will have 12 months to attain full compliance. If we are not in full compliance after the additional 12 months, we would incur a penalty equal to 1.89 times the average amount of support per location received in the state over the six-year term, plus a potential penalty of 10% of the total CAF Phase 2 support over the six-year term for the state. The amount of these penalties could be material. To comply with the FCC's buildout requirements, we believe we will need to dedicate a substantial portion of our future capital expenditure budget to the construction of new infrastructure. The CAF-related expenditures could reduce the amount of funds we are willing or able to allocate to other initiatives or projects.\n\"Open Internet\" regulation could limit our ability to operate our broadband business profitably and to manage our broadband facilities efficiently.\nIn order to continue to provide quality broadband service at attractive prices, we believe we need the continued flexibility to respond to changing consumer demands, to manage bandwidth usage efficiently for the benefit of all customers and to invest in our networks. In 2015, the FCC adopted new regulations that regulate broadband services as a public utility under Title II of the Communications Act. Several companies, including us, have initiated judicial actions challenging the new regulations, which remain pending. The ultimate impact of the new regulations will depend on several factors, including the results of pending litigation and the manner in which the new regulations are implemented and enforced. Although it is premature for us to determine the ultimate impact of the new regulations upon our operations, we currently anticipate that the proposed rules could hamper our ability to operate our data networks efficiently, restrict our ability to implement network management practices necessary to ensure quality service, increase the cost of network extensions and upgrades, and otherwise negatively impact our current operations. It is possible that Congress, the FCC or the courts could take further action in the future to modify regulations affecting the provision of broadband Internet services.\nWe may be liable for the material that content providers distribute over our network.\nAlthough we believe our liability for third party information stored on or transmitted through our networks is limited, the liability of private network operators is impacted both by changing technology and evolving legal principles that remain unsettled in many jurisdictions. As a private network provider, we could be exposed to legal claims relating to third party content stored or transmitted on our networks. Such claims could involve, among others, allegations of defamation, invasion of privacy, copyright infringement, or aiding and abetting restricted activities such as online gambling or pornography. If we decide to implement additional measures to reduce our exposure to these risks, or if we are required to defend ourselves against these kinds of claims, our operations and financial results could be negatively affected.\nAny adverse outcome in any material litigation of CenturyLink or its affiliates could have a material adverse impact on our financial condition and operating results, on the trading price of our debt securities and on our ability to access the capital markets.\nThere are several material proceedings pending against CenturyLink and its affiliates, as described in Note 8—Commitments and Contingencies in Item 1 of Part I of CenturyLink's Quarterly Report on Form 10-Q for the quarter ended June 30, 2016. Depending on their outcome, any of these matters could have a material adverse effect on our financial position or operating results. We can give you no assurances as to the impact of these matters on our operating results or financial condition.\n36\nWe are subject to franchising requirements that could impede our expansion opportunities or result in potential fines or penalties.\nWe may be required to obtain from municipal authorities operating franchises to install or expand certain facilities related to our fiber transport operations, our competitive local exchange carrier operations, and our facilities-based video services. Some of these franchises may require us to pay franchise fees. Many of our franchise agreements have compliance obligations and failure to comply may result in fines or penalties. In some cases, certain franchise requirements could delay us in expanding our operations or increase the costs of providing these services.\nWe are exposed to risks arising out of recent legislation affecting U.S. public companies.\nChanging laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act and the Dodd-Frank Wall Street Reform and Consumer Protection Act, and related regulations implemented thereunder, are increasing our legal and financial compliance costs and making some activities more time consuming. Any failure to successfully or timely complete annual assessments of our internal controls required by Section 404 of the Sarbanes-Oxley Act could subject us to sanctions or investigation by regulatory authorities. Any such action could adversely affect our financial results or our reputation with investors, lenders or others.\nChanges in any of the above-described laws or regulations may limit our ability to plan, and could subject us to further costs or constraints.\nFrom time to time, the laws or regulations governing us or our customers, or the government's policy of enforcing those laws or regulations, have changed frequently and materially. The variability of these laws could hamper the ability of us and our customers to plan for the future or establish long-term strategies. Moreover, future changes in these laws or regulations could further increase our operating or compliance costs, or further restrict our operational flexibility, any of which could have a material adverse effect on our results of operations, competitive position, financial condition or prospects.\nFor a more thorough discussion of the regulatory issues that may affect our business, see \"Regulation\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\nRisks Affecting Our Liquidity and Capital Resources\nCenturyLink's and our high debt levels expose us to a broad range of risks.\nOur ultimate parent, CenturyLink, and we continue to carry significant debt. As of June 30, 2016, the aggregate principal amount of our consolidated long-term debt excluding unamortized premiums, net, and unamortized debt issuance costs, was approximately $7.357 billion (excluding our note payable - affiliate of $884 million), which was included in CenturyLink's consolidated long-term debt of approximately $19.940 billion as of that date. As of the date of this report, approximately $1.946 billion aggregate principal amount of CenturyLink's consolidated debt securities (excluding capital lease and other obligations), which includes approximately $500 million of our debt securities, is scheduled to mature prior to June 30, 2019. While we currently believe that CenturyLink and we will have the financial resources to meet or refinance our obligations when they come due, we cannot fully anticipate our future performance or financial condition, the future condition of CenturyLink, the credit markets or the economy generally. We may incur unexpected expenses or liabilities, and we may have limited access to financing.\nOur significant levels of debt can adversely affect us in several other respects, including:\n| • | limiting our ability to obtain additional financing for working capital, capital expenditures, refinancings or other general corporate purposes, particularly if, as discussed further in the risk factor disclosure below, (i) the ratings assigned to our debt securities by nationally recognized credit rating organizations are revised downward or (ii) we seek capital during periods of turbulent or unsettled market conditions; |\n\n| • | requiring us to dedicate a substantial portion of our cash flow from operations to the payment of interest and principal on our debt, thereby reducing the funds available to us for other purposes, including acquisitions, capital expenditures, strategic initiatives, dividends; |\n\n| • | hindering our ability to capitalize on business opportunities and to plan for or react to changing market, industry, competitive or economic conditions; |\n\n| • | increasing our future borrowing costs; |\n\n| • | increasing the risk that third parties will be unwilling or unable to engage in hedging or other financial or commercial arrangements with us; |\n\n37\n| • | making us more vulnerable to economic or industry downturns, including interest rate increases; |\n\n| • | placing us at a competitive disadvantage compared to less leveraged competitors; |\n\n| • | increasing the risk that we will need to sell assets, possibly on unfavorable terms, or take other unfavorable actions to meet payment obligations; or |\n\n| • | increasing the risk that we may not meet the financial covenants contained in our debt agreements or timely make all required debt payments. |\n\nThe effects of each of these factors could be intensified if we increase our borrowings.\nWe expect to periodically require financing to meet our debt obligations as they come due. Due to the unstable economy and credit markets, we may not be able to refinance maturing debt at terms that are as favorable as those from which we previously benefited, at terms that are acceptable to us or at all. See below “Risk Factors—Risks Affecting our Liquidity and Capital Resources—CenturyLink and we plan to access the public debt markets, and we cannot assure you that these markets will remain free of disruptions.”\nWe may also need to obtain additional financing or capital, or to investigate other methods to generate cash (such as further cost reductions or the sale of assets) under a variety of other circumstances, including if revenues and cash provided by operations decline, if economic conditions weaken, if competitive pressures increase, if regulatory requirements change, if CenturyLink is required to contribute a material amount of cash to its pension plans, if CenturyLink is required to begin to pay other post-retirement benefits significantly earlier than is anticipated, or if CenturyLink becomes subject to significant judgments or settlements in one or more of the matters discussed in Note 5—Commitments and Contingencies to our consolidated financial statements in Item 1 of Part I of this report and Note 8—Commitments and Contingencies to the consolidated financial statements in Item 1 of Part I of CenturyLink's Quarterly Report on Form 10-Q for the quarter ended June 30, 2016. For all the reasons mentioned above, we can give no assurance that additional financing for any of these purposes will be available on terms that are acceptable to us, or at all.\nCertain of CenturyLink's and our debt instruments have cross payment default or cross acceleration provisions. When present, these provisions could have a wider impact on liquidity than might otherwise arise from a default or acceleration of a single debt instrument. Any such event could adversely affect our ability to conduct business or access the capital markets and could adversely impact our credit ratings. See \"Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources\" in CenturyLink's quarterly and annual reports filed with the SEC for additional information about CenturyLink's indebtedness.\nIn addition, our ability to borrow funds in the future will depend in part on the satisfaction of the covenants in our term loan and other debt instruments. If we are unable to satisfy the covenants contained in those instruments, or are unable to generate cash sufficient to make required debt payments, the parties to whom we are indebted could accelerate the maturity of some or all of our outstanding indebtedness.\nAs noted above, if we are unable to make required debt payments or refinance our debt, we would likely have to consider other options, such as selling assets, issuing additional securities, cutting costs or otherwise reducing our cash requirements, or negotiating with our lenders to restructure our applicable debt. The indentures governing our senior notes may restrict, or market or business conditions may limit, our ability to do some of these things on favorable terms, or at all.\nOur debt agreements and the debt agreements of CenturyLink and its other subsidiaries allow us to incur significantly more debt, which could exacerbate the other risks described in this report.\nThe terms of our debt instruments and the debt instruments of CenturyLink and its other subsidiaries permit us to incur additional indebtedness. Additional debt may be necessary for many reasons, including those discussed above. Incremental borrowings that impose additional financial risks could exacerbate the other risks described in this report.\n38\nAny downgrade in our credit ratings could limit our ability to obtain future financing, increase our borrowing costs and adversely affect the market price of our existing debt securities or otherwise impair our business, financial condition and results of operations.\nAs noted above in Item 2 of Part I of this report, our long-term debt is currently rated BBB- by Standard and Poor's Ratings Services and BBB- by Fitch Ratings, (i) both of which are the lowest investment grade ratings issued by each of these agencies and (ii) rated Ba1 by Moody's Investors Services, which is a non-investment grade rating. If either Standard and Poor's Rating Services or Fitch Ratings assigned us a non-investment grade, we would no longer be viewed as an \"investment grade\" issuer and would lose the benefits attendant thereto. Credit rating agencies continually review their ratings for the companies that they follow, including us. Credit rating agencies also evaluate the industries in which we operate as a whole and may change their credit rating for us based on their overall view of such industries. There can be no assurance that any rating assigned to any of these debt securities will remain in effect for any given period of time or that any such ratings will not be lowered, suspended or withdrawn entirely by a rating agency if, in that rating agency's judgment, circumstances so warrant. A downgrade of our credit ratings could adversely affect the market price of some or all of our outstanding debt securities, limit our access to the capital markets or otherwise adversely affect the availability of other new financing on favorable terms, if at all, trigger the application of restrictive covenants in certain of our debt agreements or result in new or more restrictive covenants in agreements governing the terms of any future indebtedness that we may incur, increase our cost of borrowing, and impair our business, financial condition and results of operations.\nOur business requires us to incur substantial capital and operating expenses, which reduce our available free cash flow.\nOur business is capital intensive, and we anticipate that our capital requirements will continue to be significant in the coming years. As noted elsewhere in this report, we committed to spend substantial sums to construct infrastructure in connection with our participation in the FCC's CAF Phase 2 program. In addition, as discussed further under \"Risk Factors—Risks Affecting Our Business—Increases in broadband usage may cause network capacity limitations, resulting in service disruptions, reduced capacity or slower transmission speeds for our customers,\" increased bandwidth consumption by consumers and businesses has placed increased demands on the transmission capacity of our networks. If we determine that our networks must be expanded to handle these increased demands or as needed to meet CAF Phase 2 infrastructure requirements, we may determine that substantial additional capital expenditures are required, even though there is no assurance that the return on our investment will be satisfactory. In addition, many of our growth and modernization initiatives are capital intensive and changes in technology could require further spending. In addition to investing in expanded networks, new products or new technologies, we must from time to time invest capital to (i) replace some of our aging equipment that supports many of our legacy services that are experiencing revenue declines or (ii) convert older systems to simplify and modernize our network. While we believe that our planned level of capital expenditures will meet both our maintenance and core growth requirements, this may not be the case if demands on our network continue to accelerate or other circumstances underlying our expectations change. Increased spending could, among other things, adversely affect our operating margins, cash flows, results of operations and financial position.\nSimilarly, we continue to anticipate incurring substantial operating expenses to support our incumbent services and growth initiatives. Although we have successfully reduced certain of our operating expenses over the past few years, we may be unable to further reduce these costs, even if revenues in some of our lines of business are decreasing. If so, our operating margins will be adversely impacted.\nAdverse changes in the value of assets or obligations associated with CenturyLink's qualified pension plan could negatively impact CenturyLink's liquidity, which may in turn affect our business and liquidity.\nA substantial amount of our employees participate in a qualified pension plan sponsored by CenturyLink that has assumed the obligations under QCII's predecessor pension plan.\nThe funded status of CenturyLink's qualified pension plan is the difference between the value of the plan's assets and the benefit obligation. The accounting unfunded status of CenturyLink's qualified pension plan was $2.215 billion as of December 31, 2015. Adverse changes in interest rates or market conditions, among other assumptions and factors, could cause a significant increase in CenturyLink's benefit obligation or a significant decrease in the value of the plan's assets. These adverse changes could require CenturyLink to contribute a material amount of cash to its pension plan or could accelerate the timing of required cash payments. The amounts contributed by us through CenturyLink are not segregated or restricted and may be used to provide benefits to employees of CenturyLink's other subsidiaries. Based on current laws and circumstances, CenturyLink does not expect it will be required to make a contribution to its plan in 2016. The actual amount of required contributions to its plan in 2017 and beyond will depend on earnings on plan investments, prevailing interest and discount rates, demographic experience, changes in plan benefits and changes in funding laws and regulations. Any future material cash contributions could have a negative impact on CenturyLink's liquidity by reducing their cash flows, which in turn could affect our liquidity.\n39\nCenturyLink and we plan to access the public debt markets, and we cannot assure you that these markets will remain free of disruptions.\nCenturyLink and we have a significant amount of indebtedness that we both intend to refinance over the next several years, principally we expect through the issuance of debt securities of CenturyLink, us or both. CenturyLink's and our ability to arrange additional financing will depend on, among other factors, the financial position, performance, and credit ratings of CenturyLink and QC, as well as prevailing market conditions and other factors beyond its or our control. Prevailing market conditions could be adversely affected by the ongoing disruptions in domestic or overseas sovereign or corporate debt markets, contractions or limited growth in the economy or other similar adverse economic developments in the U.S. or abroad. Instability in the global financial markets has from time to time resulted in periodic volatility in the capital markets. This volatility could limit CenturyLink's and our access to the credit markets, leading to higher borrowing costs or, in some cases, the inability to obtain financing on terms that are acceptable to it, or at all. Any such failure to obtain additional financing could jeopardize its and our ability to repay, refinance or reduce its or our debt obligations.\nOther Risks\nWe regularly transfer our cash to CenturyLink, which exposes us to certain risks.\nUnder our cash management arrangement with CenturyLink, we regularly transfer our cash to CenturyLink, which we recognize on our consolidated balance sheets as advances to affiliates. Although CenturyLink periodically repays these advances to fund our cash requirements throughout the year, at any given point in time CenturyLink may owe us a substantial sum under this arrangement. Accordingly, developments that adversely impact CenturyLink could adversely impact our ability to collect these advances.\nIf conditions or assumptions differ from the judgments, assumptions or estimates used in our critical accounting policies, our consolidated financial statements and related disclosures could be materially affected.\nThe preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles requires management to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes. Our critical accounting policies, which are described in \"Management's Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates\" in Item 7 of Part II of our Annual Report on Form 10-K for the year ended December 31, 2015, describe those significant accounting policies and methods used in the preparation of our consolidated financial statements that are considered \"critical\" because they require judgments, assumptions and estimates that materially impact our consolidated financial statements and related disclosures. As a result, if future events or assumptions differ significantly from the judgments, assumptions and estimates in our critical accounting policies, these events or assumptions could have a material impact on our consolidated financial statements and related disclosures.\nLapses in disclosure controls and procedures or internal control over financial reporting could materially and adversely affect our operations, profitability or reputation.\nThere can be no assurance that our disclosure controls and procedures will be effective in the future or that we will not experience a material weakness or significant deficiency in internal control over financial reporting. Any such lapses or deficiencies may materially and adversely affect our business, operating results or financial condition, restrict our ability to access the capital markets, require us to expend significant resources to correct the lapses or deficiencies, expose us to regulatory or legal proceedings, including litigation brought by private individuals, subject us to fines, penalties or judgments, harm our reputation, or otherwise cause a decline in investor confidence.\nWe have a significant amount of goodwill, customer relationships and other intangible assets on our consolidated balance sheet. If our goodwill or other intangible assets become impaired, we may be required to record a significant charge to earnings and reduce our stockholders' equity.\nAs of June 30, 2016, approximately 57% of our total consolidated assets reflected on the consolidated balance sheet included in this report consisted of goodwill, customer relationships and other intangible assets. Under U.S. generally accepted accounting principles, most of these intangible assets must be tested for impairment on an annual basis or more frequently whenever events or circumstances indicate that their carrying value may not be recoverable. From time to time, our affiliates or predecessors have recorded large non-cash charges to earnings in connection with required reductions of the value of their intangible assets. If our intangible assets are determined to be impaired in the future, we may similarly be required to record significant, non-cash charges to earnings during the period in which the impairment is determined to have occurred.\n40\nTax audits or changes in tax laws could adversely affect us.\nFor periods after the April 1, 2011 closing of CenturyLink's acquisition of QCII, we are included in the consolidated federal income tax return of CenturyLink. As such, we could be severally liable for tax examinations and adjustments attributable to other members of the QCII or CenturyLink affiliated groups, as applicable. Significant taxpayers (such as QCII for periods prior to the CenturyLink acquisition and CenturyLink for periods after the CenturyLink acquisition) are subject to frequent and regular audits by the Internal Revenue Service as well as state and local tax authorities. These audits could subject us to tax liabilities if adverse positions are taken by these tax authorities.\nTax sharing agreements have been executed between QCII and previous affiliates, and QCII believes the liabilities, if any, arising from adjustments to previously filed returns would be borne by the affiliated group member determined to have a deficiency under the terms and conditions of such agreements and applicable tax law. We have not generally provided reserves for liabilities attributable to former affiliated companies or for claims they have asserted or may assert against us.\nWe believe that we have adequately provided for tax contingencies. However, CenturyLink's or QCII's tax audits and examinations may result in tax liabilities that differ materially from those that we have recognized in our consolidated financial statements. Because the ultimate outcomes of all of these matters are uncertain, we can give no assurance as to whether an adverse result from one or more of them will have a material effect on our financial results.\nLegislators and regulators at all levels of government may from time to time change existing tax laws or regulations or enact new laws or regulations that could negatively impact our operating results or financial condition.\nFor information on risk faced by CenturyLink that could weaken its financial position (and thereby indirectly impact us), see the risk factor disclosures set forth in CenturyLink's annual and quarterly reports filed with the SEC.\n41\n25\nOther Information\nCenturyLink's and our website is www.centurylink.com. We routinely post important investor information in the \"Investor Relations\" section of our website at ir.centurylink.com. The information contained on, or that may be accessed through, our website is not part of this quarterly report. You may obtain free electronic copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports in the \"Investor Relations\" section of our website (ir.centurylink.com) under the heading \"SEC Filings.\" These reports are available on our website as soon as reasonably practicable after we electronically file them with the SEC.\nIn addition to historical information, this quarterly report includes certain forward-looking statements that are based upon our judgment and assumptions as of the date of this report concerning future developments and events, many of which are beyond our control. These forward-looking statements, and the assumptions upon which they are based, are not guarantees of future results, are inherently speculative and are subject to a number of risks and uncertainties. Actual events and results may differ materially from those anticipated, estimated, projected or implied by us in those statements if one or more of these risks or uncertainties materialize, or if underlying assumptions prove incorrect. Factors that could affect actual results include but are not limited to: the effects of competition from a wide variety of competitive providers, including lower demand for our legacy offerings; the effects of new, emerging or competing technologies, including those that could make our products less desirable or obsolete; the effects of ongoing changes in the regulation of the communications industry, including the outcome of regulatory or judicial proceedings relating to intercarrier compensation, interconnection obligations, access charges, universal service, broadband deployment, data protection and net neutrality; our ability to effectively adjust to changes in the communications industry, and changes in the composition of our markets and product mix; possible changes in the demand for, or pricing of, our products and services, including our ability to effectively respond to increased demand for high-speed broadband service; our ability to successfully maintain the quality and profitability of our existing product and service offerings and to introduce new offerings on a timely and cost-effective basis; the adverse impact on our business and network from possible equipment failures, service outages, security breaches or similar events impacting our network; our ability to generate cash flows sufficient to fund our financial commitments and objectives, including our capital expenditures, operating costs, dividends, pension contributions and debt payments; changes in our operating plans, corporate strategies, dividend payment plans or other capital allocation plans, whether based upon changes in our cash flows, cash requirements, financial performance, financial position, or otherwise; our ability to effectively retain and hire key personnel and to successfully negotiate collective bargaining agreements on reasonable terms without work stoppages; increases in the costs of CenturyLink's pension, health, post-employment or other benefits, including those caused by changes in markets, interest rates, mortality rates, demographics or regulations, which may in turn affect our business and liquidity; adverse changes in our access to credit markets on favorable terms, whether caused by changes in our financial position, lower debt credit ratings, unstable markets or otherwise; our ability to maintain favorable relations with our key business partners, suppliers, vendors, landlords and financial institutions; our ability to effectively manage our network buildout project and other expansion opportunities; our ability to collect our receivables from financially troubled customers; any adverse developments in legal or regulatory proceedings involving us or our affiliates (including CenturyLink); changes in tax, communications, pension, healthcare or other laws or regulations, in governmental support programs, or in general government funding levels; the effects of changes in accounting policies or practices, including potential future impairment charges; the effects of terrorism, adverse weather or other natural or man-made disasters; the effects of more general factors such as changes in interest rates, in operating costs, in general market, labor, economic or geo-political conditions, or in public policy; and other risks referenced in Item 1A or elsewhere in this Quarterly Report or other of our filings with the SEC. You should be aware that new factors may emerge from time to time and it is not possible for us to identify all such factors nor can we predict the impact of each such factor on the business or the extent to which any one or more factors may cause actual results to differ from those reflected in any forward-looking statements. Given these uncertainties, we caution investors not to unduly rely upon our forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements for any reason, whether as a result of new information, future events or developments, changed circumstances, or otherwise. Furthermore, any information about our intentions contained in any of our forward-looking statements reflects our intentions as of the date of this report, and is based upon, among other things, existing regulatory, technological, industry, competitive, economic and market conditions, and our assumptions as of such date. We may change our intentions, strategies or plans at any time and without notice, based upon any changes in such factors, in our assumptions or otherwise.\n26\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nWe have omitted this information pursuant to General Instruction H(2).\nITEM 4. CONTROLS AND PROCEDURES\nDisclosure Controls and Procedures\nThe Company maintains disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”)) designed to provide reasonable assurance that the information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. These include controls and procedures designed to ensure that this information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Management, with the participation of our Chief Executive Officer, Glen F. Post, III, and our Chief Financial Officer, R. Stewart Ewing, Jr., evaluated the effectiveness of the Company’s disclosure controls and procedures as of June 30, 2016. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2016, in providing reasonable assurance that the information required to be disclosed by us in this report was accumulated and communicated in the manner provided above.\nThe effectiveness of our or any system of disclosure controls and procedures is subject to certain limitations, including the exercise of judgment in designing, implementing and evaluating the controls and procedures, the assumptions used in identifying the likelihood of future events and the inability to eliminate misconduct completely. As a result, there can be no assurance that our disclosure controls and procedures will detect all errors or fraud. By their nature, our or any system of disclosure controls and procedures can provide only reasonable assurance regarding management's control objectives.\nChanges in Internal Control Over Financial Reporting\nThere were no changes in our internal control over financial reporting during the second quarter of 2016 that materially affected, or that we believe are reasonably likely to materially affect, our internal control over financial reporting.\n27\nPART II—OTHER INFORMATION\nITEM 1. LEGAL PROCEEDINGS\nThe information contained in Note 5—Commitments and Contingencies included in Item 1 of Part I of this report is incorporated herein by reference.\nITEM 1A. RISK FACTORS\nThe following discussion of “risk factors” identifies the most significant risks or uncertainties that could (i) materially and adversely affect our business, financial condition, results of operations, liquidity or prospects or (ii) cause our actual results to differ materially from our anticipated results or other expectations. You should carefully consider these factors, in addition to the other information set forth in this report and our subsequent filings with the SEC, when evaluating our business and whether to purchase, sell or hold our securities. Please note that the following discussion is not intended to comprehensively list all risks or uncertainties faced by us. Our operations or actual results could also be similarly impacted by additional risks and uncertainties that are not currently known to us, that we currently deem to be immaterial, that arise in the future or that are not specific to us, such as general economic conditions.\nRisks Affecting Our Business\nWe may not be able to compete successfully against current or future competitors.\nEach of our offerings to our residential and business customers face increasingly intense competition from a variety of sources under evolving market conditions. We expect these trends will continue. In addition to competition from larger national telecommunications providers, we are facing increasing competition from several other sources, including cable and satellite companies, wireless providers, technology companies, broadband providers, device providers, resellers, sales agents and facilities-based providers using their own networks as well as those leasing parts of our network. In particular, (i) intense competition from wireless and other communications providers has led to a long-term systemic decline in the number of our customers for wireline voice services, (ii) strong competition from cable companies and others has impacted the growth of our broadband operations and (iii) aggressive competition from a wide range of technology companies and other market entrants has limited the prospects for our cloud computing operations. For more detailed information, see \"Competition\" under Item 1 of our Annual Report on Form 10-K for the year ended December 31, 2015.\nSome of our current and potential competitors (i) offer products or services that are substitutes for our wireline voice services, including wireless voice and non-voice communication services, (ii) offer a more comprehensive range of communications products and services, (iii) offer products or services with features that we cannot readily match in some or all of our markets, including faster average broadband transmission speeds and greater content, (iv) offer shorter installation intervals, allowing customers to begin receiving services sooner after ordering, (v) have market presence, engineering and technical capabilities, and financial and other resources greater than ours, (vi) have larger or more diverse networks with greater transmission capacity or other advantages, (vii) conduct operations or raise capital at a lower cost than us, (viii) are subject to less regulation, which we believe enables such competitors to operate more flexibly than us with respect to certain offerings, (ix) offer services nationally or internationally to a larger geographic area or larger base of customers, (x) have substantially stronger brand names, which may provide them with greater pricing power than ours, or (xi) have larger operations than ours, which may enable them to offer higher compensation packages in connection with recruiting and retaining top technological, managerial and operational talent. Consequently, these competitors may be better equipped to provide more attractive offerings, to charge lower prices for their products and services, to develop and expand their communications and network infrastructure more quickly, to adapt more swiftly to new or emerging technologies and changes in customer requirements, to devote greater resources to the marketing and sale of their products and services, to provide more comprehensive customer service, to provide greater resources to research and development initiatives and to take advantage of acquisition or other opportunities more readily. In the past, several of our competitors and their operations have grown through acquisitions and aggressive product development. The continued growth of our competitors could further enhance their competitive positions.\nCompetition could adversely impact us in several ways, including (i) the loss of customers and market share, (ii) the possibility of customers reducing their usage of our services or shifting to less profitable services, (iii) reduced traffic on our networks, (iv) our need to expend substantial time or money on new capital improvement projects, (v) our need to lower prices or increase marketing expenses to remain competitive and (vi) our inability to diversify by successfully offering new products or services.\n28\nWe are continually taking steps to respond to these competitive pressures, but these efforts may not be successful. Our operating results and financial condition would be adversely affected if these initiatives are unsuccessful or insufficient and if we otherwise are unable to sufficiently stem our continuing access line losses and our legacy revenue declines. If this occurred, our ability to pay our debt and other obligations and to re-invest in the business would also be adversely affected.\nRapid technological changes could significantly impact our competitive and financial position.\nThe communications industry has been and continues to be impacted by significant technological changes, which in general are enhancing non-voice communications and enabling a broader array of companies to offer services competitive with ours. Many of those technological changes are (i) displacing or reducing demand for our wireline voice services, (ii) enabling the development of competitive products or services, or (iii) enabling our current customers to reduce or bypass use of our networks. Rapid changes in technology are increasing the competitiveness of the information technology services industry. In addition, demand for our broadband services has been constrained by certain technologies permitting cable companies and other competitors to deliver faster average broadband transmission speeds than ours. Demand for our broadband services could be further reduced by advanced wireless data transmission technologies being deployed by wireless providers, including \"long-term evolution\" or \"LTE\" technologies, especially if these wireless providers continue to increase their broadband transmission speed and decrease their service rates. To enhance the competitiveness of our broadband services, we may be required to expend additional capital to augment the capabilities of our copper-based services or to install more fiber optic cable.\nWe may not be able to accurately predict or respond to changes in technology or industry standards, or to the introduction of newly-offered services. Any of these developments could make some or all of our offerings less desirable or even obsolete. These developments could also require us to (i) expend capital or other resources in excess of currently contemplated levels, (ii) forego the development or provision of products or services that others can provide more efficiently, or (iii) make other changes to our operating plans, corporate strategies or capital allocation plans, any of which could be contrary to the expectations of our security holders or could adversely impact our operations. If we are not able to develop new products and services to keep pace with technological advances, or if those products and services are not widely accepted by customers, our ability to compete could be adversely affected and our market share could decline. Any inability to effectively respond to technological changes could also adversely affect our operating results and financial condition, as well as our ability to service debt and fund other commitments or initiatives.\nEven if we succeed in adapting to changes in technology or industry standards by developing new products or services, there is no assurance that the new products or services would have a positive impact on our profit margins or financial performance.\nIn addition to introducing new technologies and offerings, we may need, from time to time, to phase out outdated and unprofitable technologies and services. If we are unable to do so, on a cost-effective basis, we could experience reduced profits.\nFor additional information on the risks of increased expenditures, see \"Risk Factors—Risks Affecting our Liquidity and Capital Resources—Our business requires us to incur substantial capital and operating expenses, which reduces our available free cash flow.\"\nOur legacy services continue to experience declining revenues, and our efforts to offset these declines may not be successful.\nPrimarily as a result of the competitive and technological changes discussed above, we have experienced a prolonged systemic decline in our access lines and network access revenues. We have also experienced a decline in our private line revenues due to our customers' optimization of their networks, industry consolidation, price compression and technological migration to higher-speed services.\nWe have taken a variety of steps to counter these declines in our legacy services revenues, including:\n| • | an increased focus on selling a broader range of higher-growth strategic services, which are described in detail elsewhere in this report; |\n\n| • | an increased focus on serving a broader range of business, governmental and wholesale customers; and |\n\n| • | greater use of service bundles. |\n\nHowever, for the reasons described elsewhere in this report, most of our strategic services generate lower profit margins than our legacy services, and some can be expected to experience slowing growth as increasing numbers of our existing or potential customers subscribe to our newer strategic product and service offerings. Moreover, we cannot assure you that the revenues generated from our new offerings will offset revenue losses associated with our legacy services. In addition, our reliance on third parties to provide certain of these strategic services could constrain our flexibility, as described further below.\n29\nOur ability to successfully introduce new product or service offerings on a timely and cost-effective basis could be constrained by a range of factors, including network limitations, limited capital, an inability to attract key personnel with the necessary skills, intellectual property constraints, testing delays, or an inability to act as quickly as smaller, more nimble start-up competitors. Similarly, our ability to grow through acquisitions could be limited by several factors, including our leverage and inability to identify attractively-priced target companies. For these reasons, we cannot assure you that our new product or service offerings will be as successful as anticipated, or that we will be able to continue to grow through acquisitions.\nWe may not be able to successfully adjust to changes in our industry, our markets and our product mix.\nOngoing changes in the communications industry have fundamentally changed consumers’ communications expectations and requirements. In response to these changes, we have substantially altered our product and service offerings through acquisitions and internal product development. Many of these changes have placed a higher premium on sales, marketing and product development functions, and necessitated ongoing changes in our processes and operating protocols, as well as periodic reorganizations of our sales and leadership teams. In addition, we now offer a more complex range of products and services, operate larger and more complex networks and serve a much larger and more diverse set of customers. Consequently, we now face greater challenges in effectively managing and administering our operations and allocating capital and other resources to our various offerings. For all these reasons, we cannot assure you that our efforts to adjust to these changes will be timely or successful.\nWe could be harmed by security breaches, damages or other significant disruptions or failures of our networks, information technology infrastructure or related systems, or of those we operate for certain of our customers.\nWe are materially reliant upon our networks, information technology infrastructure and related technology systems (including our billing and provisioning systems) to provide products and services to our customers and to manage our operations and affairs. We face the risk, as does any company, of a security breach or significant disruption of our information technology infrastructure and related systems. As a communications company that transmits large amounts of sensitive and proprietary information over communications networks, we face an added risk that a security breach or other significant disruption of our public networks or information technology infrastructure and related systems that we develop, install, operate and maintain for certain of our business customers (which includes our wholesale and governmental customers) could lead to material interruptions or curtailments of service. Moreover, in connection with processing and storing confidential customer data, we face a heightened risk that a security breach or disruption could result in unauthorized access to our customers' proprietary information on our public networks or internal systems or the systems that we operate and maintain for certain of our customers.\nWe make significant efforts to maintain the security and integrity of information and systems under our control, and maintain contingency plans in the event of security breaches or other system disruptions. Nonetheless, we cannot assure you that our security efforts and measures will prevent unauthorized access to our systems, loss or destruction of data (including confidential customer information), account takeovers, unavailability of service, computer viruses, malware, distributed denial-of-service attacks, or other forms of cyber-attacks or similar events. These threats may derive from human error, hardware or software vulnerabilities, fraud, malice or sabotage on the part of employees, third parties or other nations, or could result from aging equipment or other accidental technological failure. These threats may also arise from failure or breaches of systems owned, operated or controlled by other unaffiliated operators to the extent we rely on such other operations to deliver services to our customers.\nSimilar to other large telecommunications companies, we are a constant target of cyber-attacks of varying degrees. Although some of these attacks have resulted in security breaches, to date, none of these breaches have resulted in a material adverse effect on our operating results or financial condition. You should be aware, however, that defenses against cyber-attacks currently available to U.S. companies are unlikely to prevent intrusions by a highly-determined, highly-sophisticated hacker. Consequently, you should assume that we will be unable to implement security barriers or other preventative measures that repel all future cyber-attacks. Any such future security breaches or disruptions could materially adversely affect our business, results of operations or financial condition, especially in light of the growing frequency, scope and well-documented sophistication of cyber-attacks and intrusions.\nAlthough CenturyLink maintains insurance coverage that may, subject to policy terms and conditions (including self-insured deductibles, coverage restrictions and monetary coverage caps), cover certain aspects of our cyber risks, such insurance coverage may be unavailable or insufficient to cover our losses.\nAdditional risks to our network, infrastructure and related systems include:\n| • | power losses or physical damage, whether caused by fire, adverse weather conditions, terrorism, sabotage, vandalism or otherwise; |\n\n30\n| • | capacity or system configuration limitations, including those resulting from changes in our customer's usage patterns, the introduction of new technologies or products, or incompatibilities between our newer and older systems; |\n\n| • | theft or failure of our equipment; |\n\n| • | software or hardware obsolescence, defects or malfunctions; |\n\n| • | deficiencies in our processes or controls; |\n\n| • | programming, processing and other human error; and |\n\n| • | service failures of our third-party vendors and other disruptions that are beyond our control. |\n\nDue to these factors, from time to time in the ordinary course of our business we experience short disruptions in our service, and could experience more significant disruptions in the future.\nDisruptions, security breaches and other significant failures of the above-described networks and systems could:\n| • | disrupt the proper functioning of these networks and systems, which could in turn disrupt (i) our operations or (ii) the operations of certain of our customers who rely upon us to provide services critical to their operations; |\n\n| • | require significant management attention or financial resources to remedy the damages that result or to change our systems, including expenses to repair systems, add new personnel or develop additional protective systems; |\n\n| • | result in the unauthorized access to, and destruction, loss, theft, misappropriation or release of proprietary, confidential, sensitive, classified or otherwise valuable information of ours, our customers or our customers' end users, including trade secrets, which others could use for competitive, disruptive, destructive or otherwise harmful purposes and outcomes; |\n\n| • | require us to notify customers, regulatory agencies or the public of data breaches; |\n\n| • | require us to provide credits for future service under certain service level commitments we have provided contractually to our customers or to offer expensive incentives to retain customers; |\n\n| • | subject us to claims for damages, fines, penalties, termination or other remedies under our customer contracts or service standards set by state regulatory commissions, which in certain cases could exceed our insurance coverage; or |\n\n| • | result in a loss of business, damage our reputation among our customers and the public generally, subject us to additional regulatory scrutiny or expose us to prolonged litigation. |\n\nWe could experience difficulties in expanding and updating our technical infrastructure.\nOur ability to expand and update our systems and information technology infrastructure in response to our growth and changing business needs is important to our ability to maintain and develop attractive product and service offerings. As discussed further under “Business—Network Architecture” in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015, we are currently undertaking several complex, costly and time-consuming projects to simplify and modernize our network, which combines our legacy network and CenturyLink's networks. Unanticipated delays in the completion of these projects may lead to increased project costs or operational inefficiencies. In addition, there may be issues related to our expanded or updated infrastructure that are not identified by our testing processes, and which may only become evident after we have started to fully utilize the redesigned systems. Our failure to modernize and upgrade our technology infrastructure could have adverse consequences, including the delayed implementation of new service offerings, decreased competitiveness of existing service offerings, network instabilities, increased operating or acquisition integration costs, service or billing interruptions, and the diversion of development resources.\nAny or all of the foregoing developments could have a negative impact on our business, results of operations, financial condition and cash flows.\n31\nIf we fail to hire and retain qualified executives, managers and employees, our operating results could be harmed.\nOur future success depends on our ability to identify, hire, train and retain executives, managers and employees with technological, engineering, product development, operational, provisioning, marketing, sales, administrative and managerial skills. There is a shortage of qualified personnel in several of these fields nationally and in our headquarters city of Monroe, Louisiana, in particular. We compete with several other companies for this limited pool of potential employees. As our industry increasingly becomes more competitive, it could become especially difficult to attract and retain top personnel with skills in high demand. In addition, subject to limited exceptions, none of our executives or domestic employees have long-term employment agreements. For all these reasons, there is no assurance that our efforts to recruit and retain qualified personnel will be successful.\nIncreases in broadband usage may cause network capacity limitations, resulting in service disruptions, reduced capacity or slower transmission speeds for our customers.\nVideo streaming services, gaming and peer-to-peer file sharing applications use significantly more bandwidth than other Internet activity such as web browsing and email. As use of these newer services continues to grow, our broadband customers will likely use much more bandwidth than in the past. If this occurs, we could be required to make significant capital expenditures to increase network capacity in order to avoid service disruptions, service degradation or slower transmission speeds for our customers. Alternatively, we could choose to implement network management practices to reduce the network capacity available to bandwidth-intensive activities during certain times in market areas experiencing congestion, which could negatively affect our ability to retain and attract customers in affected markets. While we believe demand for these services may drive broadband customers to pay for faster broadband speeds, competitive or regulatory constraints may preclude us from recovering the costs of the necessary network investments. This could result in an adverse impact to our operating margins, results of operations, financial condition and cash flows.\nWe have been accused of infringing the intellectual property rights of others and will likely face similar accusations in the future, which could subject us to costly and time-consuming litigation or require us to seek third-party licenses.\nFrom time to time, we receive notices from third parties or are named in lawsuits filed by third parties claiming we have infringed or are infringing upon their intellectual property rights. We are currently responding to several of these notices and claims. Like other communications companies, we have received an increasing number of these notices and claims in the past several years, and expect this industry-wide trend will continue. Responding to these claims may require us to expend significant time and money defending our use of the applicable technology, and divert management’s time and resources away from other business. In certain instances, we may be required to enter into licensing agreements requiring royalty payments or, in the case of litigation, to pay damages. If we are required to take one or more of these actions, our profit margins may decline. In addition, in responding to these claims, we may be required to stop selling or redesign one or more of our products or services, which could significantly and adversely affect our business, results of operations, financial condition and cash flows.\nSimilarly, from time to time, we may need to obtain the right to use certain patents or other intellectual property from third parties to be able to offer new products and services. If we cannot license or otherwise obtain rights to use any required technology from a third party on reasonable terms, our ability to offer new products and services may be prohibited, restricted, made more costly or delayed.\nOur operations, financial performance and liquidity are materially reliant on various third parties.\nReliance on other communications providers. To offer voice or data services in certain of our markets, we must either lease network capacity from, or interconnect our network with the infrastructure of, other communications companies who typically compete against us in those markets. Our reliance on these lease or interconnection arrangements limits our control over the quality of our services and exposes us to the risk that our ability to market our services could be adversely impacted by changes in the plans or properties of the carriers upon which we are reliant. In addition, we are exposed to the risk that the other carriers may be unwilling to continue or renew these arrangements in the future on terms favorable to us, or at all. This risk is heightened when the other carrier is a competitor of ours and may benefit from terminating the agreement. If we lose these arrangements and cannot timely replace them, our ability to provide services to our customers and conduct our business could be materially adversely affected.\nConversely, certain of our operations carry a significant amount of voice or data traffic for other communications providers. Their reliance on our services exposes us to the risk that they may transfer all or a portion of this traffic from our network to networks built, owned or leased by them, thereby reducing our revenues. For additional information, see \"Management's Discussion and Analysis of Financial Condition and Results of Operations—Business Trends\" included in Item 2 of Part I of this report.\n32\nWe also rely on reseller and sales agency arrangements with our affiliates and other communications companies to provide some of the services that we offer to our customers, including video services. As a reseller or sales agent, we do not control the availability, retail price, design, function, quality, reliability, customer service or branding of these products and services, nor do we directly control all of the marketing and promotion of these products and services. Similar to the risks described above regarding our reliance upon other carriers, we could be adversely affected if these communication companies fail to maintain competitive products or services, or fail to continue to make them available to us on attractive terms, or at all.\nOur operations and financial performance could be adversely affected if our relationships with any of these other communications companies are disrupted or terminated for any other reason, including if such other companies:\n| • | become bankrupt or experience substantial financial difficulties; |\n\n| • | suffer work stoppages or other labor strife; |\n\n| • | challenge our right to receive payments or services under applicable regulations or the terms of our existing contract arrangements; or |\n\n| • | are otherwise unable or unwilling to make payments or provide services to us. |\n\nReliance on other key suppliers and vendors. We depend on a limited number of suppliers and vendors for equipment and services relating to our network infrastructure. Our local exchange carrier networks consist of central office and remote sites, all with advanced digital switches. If any of these suppliers experience interruptions or other problems delivering or servicing these network components on a timely basis, our operations could suffer significantly. To the extent that proprietary technology of a supplier is an integral component of our network, we may have limited flexibility to purchase key network components from alternative suppliers and may be adversely affected if third parties assert patent infringement claims against our suppliers or us. We also rely on a limited number of software vendors to support our business management systems and contractors to assist us in connection with our network construction and maintenance activities. In the event it becomes necessary to seek alternative suppliers and vendors, we may be unable to obtain satisfactory replacement supplies, services or utilities on economically attractive terms, on a timely basis, or at all, which could increase costs or cause disruptions in our services.\nReliance on governmental payments. We receive a material amount of revenue or government subsidies under various government programs, which are further described under the heading \"Risk Factors—Risks Relating to Legal and Regulatory Matters.\" We also provide products or services to various federal, state and local agencies. Governmental agencies frequently reserve the right to terminate their contracts for convenience, or to suspend or debar companies from receiving future subsidies or contracts under certain circumstances. If our governmental contracts are terminated for any reason, or if we are suspended or debarred from governmental programs or contracts, our results of operations and financial condition could be materially adversely affected.\nIf we fail to extend or renegotiate our collective bargaining agreements with our labor unions as they expire from time to time, or if our unionized employees were to engage in a strike or other work stoppage, our business and operating results could be materially harmed.\nAs of June 30, 2016, approximately 49% of our employees were members of various bargaining units represented by the Communications Workers of America or the International Brotherhood of Electrical Workers. From time to time, our labor agreements with unions expire. Although we typically are able to negotiate new bargaining agreements, we cannot predict the outcome of our future negotiations of these agreements. We may be unable to reach new agreements, and union employees may engage in strikes, work slowdowns or other labor actions, which could materially disrupt our ability to provide services and result in increased cost to us. In addition, new labor agreements may impose significant new costs on us, which could impair our financial condition or results of operations in the future. To the extent they contain benefit provisions, these agreements may also limit our flexibility to change benefits in response to industry or competitive changes. In particular, post-employment benefits provided under these agreements could cause us to incur costs not faced by many of our competitors, which could ultimately hinder our competitive position.\nPortions of our property, plant and equipment are located on property owned by third parties.\nOver the past few years, certain utilities, cooperatives and municipalities in certain of the states in which we operate have requested significant rate increases for attaching our plant to their facilities. To the extent that these entities are successful in increasing the amount we pay for these attachments, our future operating costs will increase.\n33\nIn addition, we rely on rights-of-way, colocation agreements and other authorizations granted by governmental bodies and other third parties to locate our cable, conduit and other network equipment on or under their respective properties. Our operations could be adversely affected if any of these authorizations terminate or lapse, or if the landowner requests price increases.\nOur business customers may seek to shift risk to us.\nWe furnish to and receive from our business customers indemnities relating to damages caused or sustained by us in connection with certain of our operations. Our customers’ changing views on risk allocation could cause us to accept greater risk to win new business or could result in us losing business if we are not prepared to take such risks. To the extent that we accept such additional risk, and seek to insure against it, our insurance premiums could rise.\nUnfavorable general economic conditions could negatively impact our operating results and financial condition.\nUnfavorable general economic conditions, including unstable economic and credit markets, could negatively affect our business. Worldwide economic growth has been sluggish since 2008, and many experts believe that a confluence of global factors may result in a prolonged period of economic stagnation, slow growth or economic uncertainty. While it is difficult to predict the ultimate impact of these general economic conditions, they could adversely affect demand for some of our products and services and could cause customers to shift to lower priced products and services or to delay or forego purchases of our products and services. These conditions impact, in particular, our ability to sell discretionary products or services to business customers that are under pressure to reduce costs or to governmental customers that have suffered substantial budget cuts in recent years. Any one or more of these circumstances could continue to depress our revenues. Also, our customers may encounter financial hardships or may not be able to obtain adequate access to credit, which could negatively impact their ability to make timely payments to us. In addition, as discussed further below, unstable economic and credit markets may preclude us from refinancing maturing debt at terms that are as favorable as those from which we previously benefited, at terms that are acceptable to us, or at all. For these reasons, among others, if current economic conditions persist or decline, our operating results, financial condition, and liquidity could be adversely affected.\nFor additional information about our business and operations, see Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\nRisks Relating to Legal and Regulatory Matters\nWe operate in a highly regulated industry and are therefore exposed to restrictions on our operations and a variety of claims relating to such regulation.\nGeneral. We are subject to significant regulation by, among others, (i) the Federal Communications Commission (“FCC”), which regulates interstate communications, (ii) state utility commissions, which regulate intrastate communications, and (iii) various foreign governments and international bodies, which regulate our international operations. Generally, we must obtain and maintain certificates of authority or licenses from these bodies in most territories where we offer regulated services. We cannot assure you that we will be successful in obtaining or retaining all licenses necessary to carry out our business plan, and, even if we are, the prescribed service standards and conditions imposed on us in connection with obtaining or acquiring control of these licenses may impose on us substantial costs and limitations. We are also subject to numerous requirements and interpretations under various international, federal, state and local laws, rules and regulations, which are quite detailed and occasionally in conflict with each other. Accordingly, we cannot ensure that we are always considered to be in compliance with all these requirements at any single point in time. The agencies responsible for the enforcement of these laws, rules and regulations may initiate inquiries or actions based on customer complaints or on their own initiative. Even if we are ultimately found to have complied with applicable regulations, such actions or inquiries could create adverse publicity that negatively impacts our business.\nRegulation of the telecommunications industry continues to change, and the regulatory environment varies substantially from jurisdiction to jurisdiction. A substantial portion of our local voice services revenue remains subject to FCC and state utility commission pricing regulation, which periodically exposes us to pricing or earnings disputes and could expose us to unanticipated price declines. Interexchange carriers have filed complaints in various forums requesting reductions in our access rates. In addition, several long distance providers are disputing or refusing to pay amounts owed to us for carrying Voice over Internet Protocol (\"VoIP\") traffic, or traffic they claim to be VoIP traffic. Similarly, some carriers are refusing to pay access charges for certain calls between mobile and wireline devices routed through an interexchange carrier. There can be no assurance that future regulatory, judicial or legislative activities will not have a material adverse effect on our operations, or that regulators or third parties will not raise material issues with regard to our compliance or noncompliance with applicable regulations.\n34\nRisks associated with recent changes in regulation. Historically, our financial performance has been substantially impacted by various aspects of federal regulation, including our receipt in the past of significant universal service payments designed to promote rural telephony. In October 2011, the FCC adopted the Connect America and Intercarrier Compensation Reform order (\"the 2011 order\") intended to comprehensively reform the existing regulatory regime to focus support on networks capable of providing new technologies, including VoIP and other broadband services, and re-direct federal universal service funding to foster nationwide voice and broadband infrastructure. The 2011 order provides for a multi-year transition as intercarrier compensation charges are reduced, federal universal service funding is explicitly targeted to broadband deployment, and subscriber line charges paid by end-user customers are gradually increased. These changes have, among other things, fundamentally altered the manner in which federal subsidies are calculated and disbursed to us (including terminating substantially all of the old universal service payments paid to us under predecessor support programs), and have substantially increased the pace of reductions in the amount of switched access revenues we receive from our wholesale customers. We expect our participation in the FCC's CAF Phase 2 support program will significantly impact our financial results and capital expenditures in the coming years. For more information, see \"Regulation\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015, and \"Management's Discussion and Analysis of Financial Condition and Results of Operations\" in Item 2 of Part I of this report.\nAlthough the primary judicial challenges to the 2011 order have been resolved in the FCC's favor, petitions asking that the FCC reconsider certain aspects of the 2011 order remain pending and, as a result, future judicial challenges on related issues remain possible. Such proceedings could still cause parts of the 2011 order to be altered or delayed. In addition, based on the outcome of the FCC proceedings, various state commissions may consider changes to their rates and support programs. Moreover, FCC proceedings relating to implementation of the order remain pending. For these and other reasons, we cannot predict the ultimate impact of these proceedings at this time.\nIn addition, during the last few years Congress or the FCC has initiated various other changes, including various broadband and Internet regulation initiatives including “network neutrality” regulations (as discussed further below) and actions that will restrict our ability to discontinue or reduce certain services, even if unprofitable. In second quarter of 2016, the FCC concluded its special access tariff investigation and initiated a Notice of Proposed Rulemaking (\"NPRM\") to consider changes in Business Data Services (\"BDS\") regulation. The results of the special access tariff investigation should not have a material impact on us. Several rules changes are being evaluated in the Business Data Services NPRM that may or may not have a material adverse impact on our financial results. The FCC is considering redefining which markets are subject to BDS regulation, broadband speed thresholds that trigger BDS regulation and potential productivity factors that may be limited to specific services or geographies. Given the inextricably intertwined nature of the issues under review in the BDS rulemaking, we will be unable to determine the NPRM’s impact until a final FCC order is issued. The FCC has signaled its desire to issue a BDS order by year end 2016. Any of these recent or pending initiatives could adversely affect our operations or financial results. Moreover, many of the FCC’s regulations adopted in recent years remain subject to judicial review and additional rulemakings, thus increasing the difficulty of determining the ultimate impact of these changes on us and our competitors.\nCertain states have recently taken steps that could reduce the amount of their universal service support payments to incumbent local exchange companies. If these trends continue, we would suffer a reduction in our revenues from state support programs.\nRisks of higher costs. Regulations continue to create significant operating and capital costs for us. Challenges to our tariffs by regulators or third parties or delays in obtaining certifications and regulatory approvals could cause us to incur substantial legal and administrative expenses, and, if successful, such challenges could adversely affect the rates that we are able to charge our customers.\nOur business also may be impacted by legislation and regulation imposing new or greater obligations related to regulations or laws related to regulating broadband services, storing records, bolstering homeland security or cyber security, increasing disaster recovery requirements, minimizing environmental impacts, enhancing privacy, restricting data collection, protecting intellectual property rights of third parties, or addressing other issues that impact our business, including (i) the Communications Assistance for Law Enforcement Act, which requires communications carriers to ensure that their equipment, facilities, and services are able to facilitate authorized electronic surveillance, and (ii) the USA Freedom Act, which requires communication companies to store records of communications of their customers. We expect our compliance costs to increase if future laws or regulations continue to increase our obligations. In addition, increased regulation of our suppliers could increase our costs.\nIncreased risks of fines. We have recently paid certain regulatory fines associated with network or service outages, particularly with respect to outages impacting the availability of emergency - 911 services. We believe that regulators are now pursuing higher fines than in the past for these types of incidents, and expect this trend to continue.\n35\nRisks of reduced flexibility. As a diversified full service incumbent local exchange carrier in most of our key markets, we have traditionally been subject to significant regulation that does not apply to many of our competitors. This regulation in many instances restricts our ability to change rates, to compete and to respond rapidly to changing industry conditions. As our business becomes increasingly competitive, regulatory disparities between us and our competitors could impede our ability to compete.\nRisks posed by other regulations. All of our operations are also subject to a variety of environmental, safety, health and other governmental regulations. We monitor our compliance with federal, state and local regulations governing the management, discharge and disposal of hazardous and environmentally sensitive materials. Although we believe that we are in compliance with these regulations in all material respects, our management, discharge or disposal of hazardous and environmentally sensitive materials might expose us to claims or actions that could potentially have a material adverse effect on our business, financial condition and operating results.\nOur participation in the FCC's Connect America Fund (\"CAF\") Phase 2 support program poses certain risks.\nOur participation in the CAF Phase 2 support program subjects us to certain financial risks. If we fail to attain certain specified infrastructure buildout requirements, the FCC could withhold future CAF support payments until these shortcomings are rectified. In addition, if we are not in compliance with FCC measures at the end of the six-year CAF Phase 2 period, we will have 12 months to attain full compliance. If we are not in full compliance after the additional 12 months, we would incur a penalty equal to 1.89 times the average amount of support per location received in the state over the six-year term, plus a potential penalty of 10% of the total CAF Phase 2 support over the six-year term for the state. The amount of these penalties could be material. To comply with the FCC's buildout requirements, we believe we will need to dedicate a substantial portion of our future capital expenditure budget to the construction of new infrastructure. The CAF-related expenditures could reduce the amount of funds we are willing or able to allocate to other initiatives or projects.\n\"Open Internet\" regulation could limit our ability to operate our broadband business profitably and to manage our broadband facilities efficiently.\nIn order to continue to provide quality broadband service at attractive prices, we believe we need the continued flexibility to respond to changing consumer demands, to manage bandwidth usage efficiently for the benefit of all customers and to invest in our networks. In 2015, the FCC adopted new regulations that regulate broadband services as a public utility under Title II of the Communications Act. Several companies, including us, have initiated judicial actions challenging the new regulations, which remain pending. The ultimate impact of the new regulations will depend on several factors, including the results of pending litigation and the manner in which the new regulations are implemented and enforced. Although it is premature for us to determine the ultimate impact of the new regulations upon our operations, we currently anticipate that the proposed rules could hamper our ability to operate our data networks efficiently, restrict our ability to implement network management practices necessary to ensure quality service, increase the cost of network extensions and upgrades, and otherwise negatively impact our current operations. It is possible that Congress, the FCC or the courts could take further action in the future to modify regulations affecting the provision of broadband Internet services.\nWe may be liable for the material that content providers distribute over our network.\nAlthough we believe our liability for third party information stored on or transmitted through our networks is limited, the liability of private network operators is impacted both by changing technology and evolving legal principles that remain unsettled in many jurisdictions. As a private network provider, we could be exposed to legal claims relating to third party content stored or transmitted on our networks. Such claims could involve, among others, allegations of defamation, invasion of privacy, copyright infringement, or aiding and abetting restricted activities such as online gambling or pornography. If we decide to implement additional measures to reduce our exposure to these risks, or if we are required to defend ourselves against these kinds of claims, our operations and financial results could be negatively affected.\nAny adverse outcome in any material litigation of CenturyLink or its affiliates could have a material adverse impact on our financial condition and operating results, on the trading price of our debt securities and on our ability to access the capital markets.\nThere are several material proceedings pending against CenturyLink and its affiliates, as described in Note 8—Commitments and Contingencies in Item 1 of Part I of CenturyLink's Quarterly Report on Form 10-Q for the quarter ended June 30, 2016. Depending on their outcome, any of these matters could have a material adverse effect on our financial position or operating results. We can give you no assurances as to the impact of these matters on our operating results or financial condition.\n36\nWe are subject to franchising requirements that could impede our expansion opportunities or result in potential fines or penalties.\nWe may be required to obtain from municipal authorities operating franchises to install or expand certain facilities related to our fiber transport operations, our competitive local exchange carrier operations, and our facilities-based video services. Some of these franchises may require us to pay franchise fees. Many of our franchise agreements have compliance obligations and failure to comply may result in fines or penalties. In some cases, certain franchise requirements could delay us in expanding our operations or increase the costs of providing these services.\nWe are exposed to risks arising out of recent legislation affecting U.S. public companies.\nChanging laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act and the Dodd-Frank Wall Street Reform and Consumer Protection Act, and related regulations implemented thereunder, are increasing our legal and financial compliance costs and making some activities more time consuming. Any failure to successfully or timely complete annual assessments of our internal controls required by Section 404 of the Sarbanes-Oxley Act could subject us to sanctions or investigation by regulatory authorities. Any such action could adversely affect our financial results or our reputation with investors, lenders or others.\nChanges in any of the above-described laws or regulations may limit our ability to plan, and could subject us to further costs or constraints.\nFrom time to time, the laws or regulations governing us or our customers, or the government's policy of enforcing those laws or regulations, have changed frequently and materially. The variability of these laws could hamper the ability of us and our customers to plan for the future or establish long-term strategies. Moreover, future changes in these laws or regulations could further increase our operating or compliance costs, or further restrict our operational flexibility, any of which could have a material adverse effect on our results of operations, competitive position, financial condition or prospects.\nFor a more thorough discussion of the regulatory issues that may affect our business, see \"Regulation\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\nRisks Affecting Our Liquidity and Capital Resources\nCenturyLink's and our high debt levels expose us to a broad range of risks.\nOur ultimate parent, CenturyLink, and we continue to carry significant debt. As of June 30, 2016, the aggregate principal amount of our consolidated long-term debt excluding unamortized premiums, net, and unamortized debt issuance costs, was approximately $7.357 billion (excluding our note payable - affiliate of $884 million), which was included in CenturyLink's consolidated long-term debt of approximately $19.940 billion as of that date. As of the date of this report, approximately $1.946 billion aggregate principal amount of CenturyLink's consolidated debt securities (excluding capital lease and other obligations), which includes approximately $500 million of our debt securities, is scheduled to mature prior to June 30, 2019. While we currently believe that CenturyLink and we will have the financial resources to meet or refinance our obligations when they come due, we cannot fully anticipate our future performance or financial condition, the future condition of CenturyLink, the credit markets or the economy generally. We may incur unexpected expenses or liabilities, and we may have limited access to financing.\nOur significant levels of debt can adversely affect us in several other respects, including:\n| • | limiting our ability to obtain additional financing for working capital, capital expenditures, refinancings or other general corporate purposes, particularly if, as discussed further in the risk factor disclosure below, (i) the ratings assigned to our debt securities by nationally recognized credit rating organizations are revised downward or (ii) we seek capital during periods of turbulent or unsettled market conditions; |\n\n| • | requiring us to dedicate a substantial portion of our cash flow from operations to the payment of interest and principal on our debt, thereby reducing the funds available to us for other purposes, including acquisitions, capital expenditures, strategic initiatives, dividends; |\n\n| • | hindering our ability to capitalize on business opportunities and to plan for or react to changing market, industry, competitive or economic conditions; |\n\n| • | increasing our future borrowing costs; |\n\n| • | increasing the risk that third parties will be unwilling or unable to engage in hedging or other financial or commercial arrangements with us; |\n\n37\n| • | making us more vulnerable to economic or industry downturns, including interest rate increases; |\n\n| • | placing us at a competitive disadvantage compared to less leveraged competitors; |\n\n| • | increasing the risk that we will need to sell assets, possibly on unfavorable terms, or take other unfavorable actions to meet payment obligations; or |\n\n| • | increasing the risk that we may not meet the financial covenants contained in our debt agreements or timely make all required debt payments. |\n\nThe effects of each of these factors could be intensified if we increase our borrowings.\nWe expect to periodically require financing to meet our debt obligations as they come due. Due to the unstable economy and credit markets, we may not be able to refinance maturing debt at terms that are as favorable as those from which we previously benefited, at terms that are acceptable to us or at all. See below “Risk Factors—Risks Affecting our Liquidity and Capital Resources—CenturyLink and we plan to access the public debt markets, and we cannot assure you that these markets will remain free of disruptions.”\nWe may also need to obtain additional financing or capital, or to investigate other methods to generate cash (such as further cost reductions or the sale of assets) under a variety of other circumstances, including if revenues and cash provided by operations decline, if economic conditions weaken, if competitive pressures increase, if regulatory requirements change, if CenturyLink is required to contribute a material amount of cash to its pension plans, if CenturyLink is required to begin to pay other post-retirement benefits significantly earlier than is anticipated, or if CenturyLink becomes subject to significant judgments or settlements in one or more of the matters discussed in Note 5—Commitments and Contingencies to our consolidated financial statements in Item 1 of Part I of this report and Note 8—Commitments and Contingencies to the consolidated financial statements in Item 1 of Part I of CenturyLink's Quarterly Report on Form 10-Q for the quarter ended June 30, 2016. For all the reasons mentioned above, we can give no assurance that additional financing for any of these purposes will be available on terms that are acceptable to us, or at all.\nCertain of CenturyLink's and our debt instruments have cross payment default or cross acceleration provisions. When present, these provisions could have a wider impact on liquidity than might otherwise arise from a default or acceleration of a single debt instrument. Any such event could adversely affect our ability to conduct business or access the capital markets and could adversely impact our credit ratings. See \"Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources\" in CenturyLink's quarterly and annual reports filed with the SEC for additional information about CenturyLink's indebtedness.\nIn addition, our ability to borrow funds in the future will depend in part on the satisfaction of the covenants in our term loan and other debt instruments. If we are unable to satisfy the covenants contained in those instruments, or are unable to generate cash sufficient to make required debt payments, the parties to whom we are indebted could accelerate the maturity of some or all of our outstanding indebtedness.\nAs noted above, if we are unable to make required debt payments or refinance our debt, we would likely have to consider other options, such as selling assets, issuing additional securities, cutting costs or otherwise reducing our cash requirements, or negotiating with our lenders to restructure our applicable debt. The indentures governing our senior notes may restrict, or market or business conditions may limit, our ability to do some of these things on favorable terms, or at all.\nOur debt agreements and the debt agreements of CenturyLink and its other subsidiaries allow us to incur significantly more debt, which could exacerbate the other risks described in this report.\nThe terms of our debt instruments and the debt instruments of CenturyLink and its other subsidiaries permit us to incur additional indebtedness. Additional debt may be necessary for many reasons, including those discussed above. Incremental borrowings that impose additional financial risks could exacerbate the other risks described in this report.\n38\nAny downgrade in our credit ratings could limit our ability to obtain future financing, increase our borrowing costs and adversely affect the market price of our existing debt securities or otherwise impair our business, financial condition and results of operations.\nAs noted above in Item 2 of Part I of this report, our long-term debt is currently rated BBB- by Standard and Poor's Ratings Services and BBB- by Fitch Ratings, (i) both of which are the lowest investment grade ratings issued by each of these agencies and (ii) rated Ba1 by Moody's Investors Services, which is a non-investment grade rating. If either Standard and Poor's Rating Services or Fitch Ratings assigned us a non-investment grade, we would no longer be viewed as an \"investment grade\" issuer and would lose the benefits attendant thereto. Credit rating agencies continually review their ratings for the companies that they follow, including us. Credit rating agencies also evaluate the industries in which we operate as a whole and may change their credit rating for us based on their overall view of such industries. There can be no assurance that any rating assigned to any of these debt securities will remain in effect for any given period of time or that any such ratings will not be lowered, suspended or withdrawn entirely by a rating agency if, in that rating agency's judgment, circumstances so warrant. A downgrade of our credit ratings could adversely affect the market price of some or all of our outstanding debt securities, limit our access to the capital markets or otherwise adversely affect the availability of other new financing on favorable terms, if at all, trigger the application of restrictive covenants in certain of our debt agreements or result in new or more restrictive covenants in agreements governing the terms of any future indebtedness that we may incur, increase our cost of borrowing, and impair our business, financial condition and results of operations.\nOur business requires us to incur substantial capital and operating expenses, which reduce our available free cash flow.\nOur business is capital intensive, and we anticipate that our capital requirements will continue to be significant in the coming years. As noted elsewhere in this report, we committed to spend substantial sums to construct infrastructure in connection with our participation in the FCC's CAF Phase 2 program. In addition, as discussed further under \"Risk Factors—Risks Affecting Our Business—Increases in broadband usage may cause network capacity limitations, resulting in service disruptions, reduced capacity or slower transmission speeds for our customers,\" increased bandwidth consumption by consumers and businesses has placed increased demands on the transmission capacity of our networks. If we determine that our networks must be expanded to handle these increased demands or as needed to meet CAF Phase 2 infrastructure requirements, we may determine that substantial additional capital expenditures are required, even though there is no assurance that the return on our investment will be satisfactory. In addition, many of our growth and modernization initiatives are capital intensive and changes in technology could require further spending. In addition to investing in expanded networks, new products or new technologies, we must from time to time invest capital to (i) replace some of our aging equipment that supports many of our legacy services that are experiencing revenue declines or (ii) convert older systems to simplify and modernize our network. While we believe that our planned level of capital expenditures will meet both our maintenance and core growth requirements, this may not be the case if demands on our network continue to accelerate or other circumstances underlying our expectations change. Increased spending could, among other things, adversely affect our operating margins, cash flows, results of operations and financial position.\nSimilarly, we continue to anticipate incurring substantial operating expenses to support our incumbent services and growth initiatives. Although we have successfully reduced certain of our operating expenses over the past few years, we may be unable to further reduce these costs, even if revenues in some of our lines of business are decreasing. If so, our operating margins will be adversely impacted.\nAdverse changes in the value of assets or obligations associated with CenturyLink's qualified pension plan could negatively impact CenturyLink's liquidity, which may in turn affect our business and liquidity.\nA substantial amount of our employees participate in a qualified pension plan sponsored by CenturyLink that has assumed the obligations under QCII's predecessor pension plan.\nThe funded status of CenturyLink's qualified pension plan is the difference between the value of the plan's assets and the benefit obligation. The accounting unfunded status of CenturyLink's qualified pension plan was $2.215 billion as of December 31, 2015. Adverse changes in interest rates or market conditions, among other assumptions and factors, could cause a significant increase in CenturyLink's benefit obligation or a significant decrease in the value of the plan's assets. These adverse changes could require CenturyLink to contribute a material amount of cash to its pension plan or could accelerate the timing of required cash payments. The amounts contributed by us through CenturyLink are not segregated or restricted and may be used to provide benefits to employees of CenturyLink's other subsidiaries. Based on current laws and circumstances, CenturyLink does not expect it will be required to make a contribution to its plan in 2016. The actual amount of required contributions to its plan in 2017 and beyond will depend on earnings on plan investments, prevailing interest and discount rates, demographic experience, changes in plan benefits and changes in funding laws and regulations. Any future material cash contributions could have a negative impact on CenturyLink's liquidity by reducing their cash flows, which in turn could affect our liquidity.\n39\nCenturyLink and we plan to access the public debt markets, and we cannot assure you that these markets will remain free of disruptions.\nCenturyLink and we have a significant amount of indebtedness that we both intend to refinance over the next several years, principally we expect through the issuance of debt securities of CenturyLink, us or both. CenturyLink's and our ability to arrange additional financing will depend on, among other factors, the financial position, performance, and credit ratings of CenturyLink and QC, as well as prevailing market conditions and other factors beyond its or our control. Prevailing market conditions could be adversely affected by the ongoing disruptions in domestic or overseas sovereign or corporate debt markets, contractions or limited growth in the economy or other similar adverse economic developments in the U.S. or abroad. Instability in the global financial markets has from time to time resulted in periodic volatility in the capital markets. This volatility could limit CenturyLink's and our access to the credit markets, leading to higher borrowing costs or, in some cases, the inability to obtain financing on terms that are acceptable to it, or at all. Any such failure to obtain additional financing could jeopardize its and our ability to repay, refinance or reduce its or our debt obligations.\nOther Risks\nWe regularly transfer our cash to CenturyLink, which exposes us to certain risks.\nUnder our cash management arrangement with CenturyLink, we regularly transfer our cash to CenturyLink, which we recognize on our consolidated balance sheets as advances to affiliates. Although CenturyLink periodically repays these advances to fund our cash requirements throughout the year, at any given point in time CenturyLink may owe us a substantial sum under this arrangement. Accordingly, developments that adversely impact CenturyLink could adversely impact our ability to collect these advances.\nIf conditions or assumptions differ from the judgments, assumptions or estimates used in our critical accounting policies, our consolidated financial statements and related disclosures could be materially affected.\nThe preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles requires management to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes. Our critical accounting policies, which are described in \"Management's Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates\" in Item 7 of Part II of our Annual Report on Form 10-K for the year ended December 31, 2015, describe those significant accounting policies and methods used in the preparation of our consolidated financial statements that are considered \"critical\" because they require judgments, assumptions and estimates that materially impact our consolidated financial statements and related disclosures. As a result, if future events or assumptions differ significantly from the judgments, assumptions and estimates in our critical accounting policies, these events or assumptions could have a material impact on our consolidated financial statements and related disclosures.\nLapses in disclosure controls and procedures or internal control over financial reporting could materially and adversely affect our operations, profitability or reputation.\nThere can be no assurance that our disclosure controls and procedures will be effective in the future or that we will not experience a material weakness or significant deficiency in internal control over financial reporting. Any such lapses or deficiencies may materially and adversely affect our business, operating results or financial condition, restrict our ability to access the capital markets, require us to expend significant resources to correct the lapses or deficiencies, expose us to regulatory or legal proceedings, including litigation brought by private individuals, subject us to fines, penalties or judgments, harm our reputation, or otherwise cause a decline in investor confidence.\nWe have a significant amount of goodwill, customer relationships and other intangible assets on our consolidated balance sheet. If our goodwill or other intangible assets become impaired, we may be required to record a significant charge to earnings and reduce our stockholders' equity.\nAs of June 30, 2016, approximately 57% of our total consolidated assets reflected on the consolidated balance sheet included in this report consisted of goodwill, customer relationships and other intangible assets. Under U.S. generally accepted accounting principles, most of these intangible assets must be tested for impairment on an annual basis or more frequently whenever events or circumstances indicate that their carrying value may not be recoverable. From time to time, our affiliates or predecessors have recorded large non-cash charges to earnings in connection with required reductions of the value of their intangible assets. If our intangible assets are determined to be impaired in the future, we may similarly be required to record significant, non-cash charges to earnings during the period in which the impairment is determined to have occurred.\n40\nTax audits or changes in tax laws could adversely affect us.\nFor periods after the April 1, 2011 closing of CenturyLink's acquisition of QCII, we are included in the consolidated federal income tax return of CenturyLink. As such, we could be severally liable for tax examinations and adjustments attributable to other members of the QCII or CenturyLink affiliated groups, as applicable. Significant taxpayers (such as QCII for periods prior to the CenturyLink acquisition and CenturyLink for periods after the CenturyLink acquisition) are subject to frequent and regular audits by the Internal Revenue Service as well as state and local tax authorities. These audits could subject us to tax liabilities if adverse positions are taken by these tax authorities.\nTax sharing agreements have been executed between QCII and previous affiliates, and QCII believes the liabilities, if any, arising from adjustments to previously filed returns would be borne by the affiliated group member determined to have a deficiency under the terms and conditions of such agreements and applicable tax law. We have not generally provided reserves for liabilities attributable to former affiliated companies or for claims they have asserted or may assert against us.\nWe believe that we have adequately provided for tax contingencies. However, CenturyLink's or QCII's tax audits and examinations may result in tax liabilities that differ materially from those that we have recognized in our consolidated financial statements. Because the ultimate outcomes of all of these matters are uncertain, we can give no assurance as to whether an adverse result from one or more of them will have a material effect on our financial results.\nLegislators and regulators at all levels of government may from time to time change existing tax laws or regulations or enact new laws or regulations that could negatively impact our operating results or financial condition.\nFor information on risk faced by CenturyLink that could weaken its financial position (and thereby indirectly impact us), see the risk factor disclosures set forth in CenturyLink's annual and quarterly reports filed with the SEC.\n41\nITEM 6. EXHIBITS\n| ExhibitNumber | Description |\n| 3.1 | Amended and restated Articles of Incorporation of Qwest Corporation (incorporated by reference to Exhibit 3.1 of Qwest Corporation's Quarterly Report on Form 10-Q for the period ended March 31, 2013 (File No. 001-03040) filed with the Securities and Exchange Commission on May 13, 2013). |\n| 3.2 | Articles of Amendment to the Articles of Incorporation of Qwest Corporation (incorporated by reference to Exhibit 3.1 of Qwest Corporation's Quarterly Report on Form 10-Q for the period ended June 30, 2000 (File No. 001-03040) filed with the Securities and Exchange Commission on August 11, 2000). |\n| 3.3 | Amended and Restated Bylaws of Qwest Corporation (incorporated by reference to Exhibit 3.3 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2002 (File No. 001-03040) filed with the Securities and Exchange Commission on January 13, 2004). |\n| 4.1 | Indenture, dated as of April 15, 1990, by and between The Mountain States Telephone and Telegraph Company (currently named Qwest Corporation) and The First National Bank of Chicago (incorporated by reference to Exhibit 4.2 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2002 (File No. 001-03040) filed with the Securities and Exchange Commission on January 13, 2004). |\n| a. | First Supplemental Indenture, dated as of April 16, 1991, by and between U S WEST Communications, Inc. (currently named Qwest Corporation) and The First National Bank of Chicago (incorporated by reference to Exhibit 4.3 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2002 (File No. 001-03040) filed with the Securities and Exchange Commission on January 13, 2004). |\n| 4.2 | Indenture, dated as of April 15, 1990, by and between Northwestern Bell Telephone Company (predecessor to Qwest Corporation) and The First National Bank of Chicago (incorporated by reference to Exhibit 4.5(b) of CenturyLink, Inc.'s Quarterly Report on Form 10-Q for the period ended March 31, 2012 (File No. 001-07784) filed with the Securities and Exchange Commission on May 10, 2012). |\n| a. | First Supplemental Indenture, dated as of April 16, 1991, by and between U S WEST Communications, Inc. (currently named Qwest Corporation) and The First National Bank of Chicago (incorporated by reference to Exhibit 4.3 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2002 (File No. 001-03040) filed with the Securities and Exchange Commission on January 13, 2004). |\n| 4.3 | Indenture, dated as of October 15, 1999, by and between U S West Communications, Inc. (currently named Qwest Corporation) and Bank One Trust Company, N.A., as trustee (incorporated by reference to Exhibit 4(b) of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 1999 (File No. 001-03040) filed with the Securities and Exchange Commission on March 3, 2000). |\n| a. | Fifth Supplemental Indenture, dated as of May 16, 2007, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.1 of Qwest Corporation's Current Report on Form 8-K (File No. 001-03040) filed with the Securities and Exchange Commission on May 18, 2007). |\n| b. | Seventh Supplemental Indenture, dated as of June 8, 2011, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.8 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on June 7, 2011). |\n| c. | Eighth Supplemental Indenture, dated as of September 21, 2011, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.9 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on September 20, 2011). |\n| d. | Ninth Supplemental Indenture, dated as of October 4, 2011, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.1 of Qwest Corporation's Current Report on Form 8-K (File No. 001-03040) filed with the Securities and Exchange Commission on October 4, 2011). |\n\n_______________________________________________________________________________\n| (1) | Certain of the items in Sections 4.1 through 4.3 (j) omit supplemental indentures or other instruments governing debt that has been retired, or (ii) refer to trustees who may have been replaced, acquired or affected by similar changes. In accordance with Item 601(b) (4) (iii) (A) of Regulation S-K, copies of certain instruments defining the rights of holders of certain of our long-term debt are not filed herewith. Pursuant to this registration, we hereby agree to furnish a copy of any such instrument to the SEC upon request. |\n\n42\n| ExhibitNumber | Description |\n| e | Tenth Supplemental Indenture, dated as of April 2, 2012, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on March 30, 2012). |\n| f. | Eleventh Supplemental Indenture, dated as of June 25, 2012, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on June 22, 2012). |\n| g | Twelfth Supplemental Indenture, dated as of May 23, 2013, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.13 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on May 22, 2013). |\n| h. | Thirteenth Supplemental Indenture, dated as of September 29, 2014, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.14 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on September 26, 2014). |\n| i. | Fourteenth Supplemental Indenture, dated as of September 21, 2015, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.15 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on September 21, 2015). |\n| j. | Fifteenth Supplemental Indenture, dated as of January 29, 2016, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.16 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on January 29, 2016). |\n| 4.4 | Revolving Promissory Note, dated as of April 18, 2012, pursuant to which Qwest Corporation may borrow from an affiliate of CenturyLink, Inc. up to $1.0 billion on a revolving basis (incorporated by reference to Exhibit 4.7(b) of CenturyLink, Inc.'s Quarterly Report on Form 10-Q for the period ended June 30, 2012 (File No 001-07784) filed with the Securities and Exchange Commission on August 9, 2012). |\n| 4.5 | Credit Agreement, dated as of February 20, 2015, by and among Qwest Corporation, the several lenders from time to time parties thereto, and CoBank, ACB, as administrative agent (incorporated by reference to Exhibit 4.5 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2014 (File No. 001-03040) filed with the Securities and Exchange Commission on February 27, 2015). |\n| 12* | Calculation of Ratio of Earnings to Fixed Charges. |\n| 31.1* | Certification of the Chief Executive Officer of CenturyLink, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2* | Certification of the Chief Financial Officer of CenturyLink, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32* | Certification of the Chief Executive Officer and Chief Financial Officer of CenturyLink, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 101* | Financial statements from the Quarterly Report on Form 10-Q of Qwest Corporation for the period ended June 30, 2016, formatted in XBRL: (i) the Consolidated Statements of Operations, (ii) the Consolidated Statements of Comprehensive Income, (iii) the Consolidated Balance Sheets, (iv) the Consolidated Statements of Cash Flows, (v) the Consolidated Statements of Stockholder's Equity and (vi) the Notes to the Consolidated Financial Statements. |\n\n_______________________________________________________________________________\n| * | Exhibit filed herewith. |\n\n43\nSIGNATURE\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on August 5, 2016.\n| QWEST CORPORATION |\n| By: | /s/ DAVID D. COLE |\n| David D. ColeExecutive Vice President, Controller and Operations Support (Chief Accounting Officer) |\n\n44\n \n\nWhat is the total expected penalty per state if the regulatory company decides to implement penalties due to non-compliance with FCC measures? This includes both the end-of-period penalty and potential additional penalty, assuming the organization received $5000 support per location over the six-year term and a total CAF Phase 2 support of $2,000,000 over the six-year term for the state.\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nPART I—FINANCIAL INFORMATION\\nITEM 1. FINANCIAL STATEMENTS\\nQWEST CORPORATION\\nCONSOLIDATED STATEMENTS OF OPERATIONS\\n(UNAUDITED)\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| (Dollars in millions) |\\n| OPERATING REVENUES |\\n| Operating revenues | $ | 1,573 | 1,618 | 3,172 | 3,254 |\\n| Operating revenues - affiliates | 650 | 604 | 1,304 | 1,185 |\\n| Total operating revenues | 2,223 | 2,222 | 4,476 | 4,439 |\\n| OPERATING EXPENSES |\\n| Cost of services and products (exclusive of depreciation and amortization) | 731 | 743 | 1,439 | 1,435 |\\n| Selling, general and administrative | 235 | 256 | 485 | 526 |\\n| Operating expenses - affiliates | 231 | 238 | 482 | 486 |\\n| Depreciation and amortization | 424 | 464 | 843 | 926 |\\n| Total operating expenses | 1,621 | 1,701 | 3,249 | 3,373 |\\n| OPERATING INCOME | 602 | 521 | 1,227 | 1,066 |\\n| OTHER (EXPENSE) INCOME |\\n| Interest expense | (120 | ) | (119 | ) | (241 | ) | (237 | ) |\\n| Interest expense - affiliates, net | (15 | ) | (13 | ) | (29 | ) | (26 | ) |\\n| Other income, net | — | 1 | 2 | 1 |\\n| Total other expense, net | (135 | ) | (131 | ) | (268 | ) | (262 | ) |\\n| INCOME BEFORE INCOME TAX EXPENSE | 467 | 390 | 959 | 804 |\\n| Income tax expense | 179 | 152 | 367 | 319 |\\n| NET INCOME | $ | 288 | 238 | 592 | 485 |\\n\\nSee accompanying notes to consolidated financial statements.\\n3\\nQWEST CORPORATION\\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME\\n(UNAUDITED)\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| (Dollars in millions) |\\n| NET INCOME | $ | 288 | 238 | 592 | 485 |\\n| OTHER COMPREHENSIVE INCOME: |\\n| Foreign currency translation adjustment, net of $—, $—, $— and $— tax | 3 | — | — | — |\\n| Other comprehensive income | 3 | — | — | — |\\n| COMPREHENSIVE INCOME | $ | 291 | 238 | 592 | 485 |\\n\\nSee accompanying notes to consolidated financial statements.\\n4\\nQWEST CORPORATION\\nCONSOLIDATED BALANCE SHEETS\\n(UNAUDITED)\\n| As of June 30, 2016 | As of December 31, 2015 |\\n| (Dollars in millions) |\\n| ASSETS |\\n| CURRENT ASSETS |\\n| Cash and cash equivalents | $ | 4 | 3 |\\n| Accounts receivable, less allowance of $48 and $47 | 688 | 688 |\\n| Advances to affiliates | 811 | 788 |\\n| Other | 148 | 123 |\\n| Total current assets | 1,651 | 1,602 |\\n| NET PROPERTY, PLANT AND EQUIPMENT |\\n| Property, plant and equipment | 12,619 | 12,182 |\\n| Accumulated depreciation | (5,182 | ) | (4,808 | ) |\\n| Net property, plant and equipment | 7,437 | 7,374 |\\n| GOODWILL AND OTHER ASSETS |\\n| Goodwill | 9,354 | 9,354 |\\n| Customer relationships, less accumulated amortization of $3,549 and $3,264 | 2,150 | 2,435 |\\n| Other intangible assets, less accumulated amortization of $1,435 and $1,383 | 539 | 613 |\\n| Other, net | 98 | 92 |\\n| Total goodwill and other assets | 12,141 | 12,494 |\\n| TOTAL ASSETS | $ | 21,229 | 21,470 |\\n| LIABILITIES AND STOCKHOLDER'S EQUITY |\\n| CURRENT LIABILITIES |\\n| Current maturities of long-term debt | $ | 509 | 242 |\\n| Accounts payable | 350 | 369 |\\n| Note payable - affiliate | 884 | 855 |\\n| Accrued expenses and other liabilities |\\n| Salaries and benefits | 186 | 211 |\\n| Income and other taxes | 165 | 189 |\\n| Other | 146 | 135 |\\n| Current affiliate obligations, net | 94 | 97 |\\n| Advance billings and customer deposits | 322 | 324 |\\n| Total current liabilities | 2,656 | 2,422 |\\n| LONG-TERM DEBT | 6,726 | 6,997 |\\n| DEFERRED CREDITS AND OTHER LIABILITIES |\\n| Deferred revenues | 123 | 137 |\\n| Deferred income taxes, net | 1,861 | 1,896 |\\n| Affiliate obligations, net | 1,003 | 1,051 |\\n| Other | 61 | 60 |\\n| Total deferred credits and other liabilities | 3,048 | 3,144 |\\n| COMMITMENTS AND CONTINGENCIES (Note 5) |\\n| STOCKHOLDER'S EQUITY |\\n| Common stock - one share without par value, owned by Qwest Services Corporation | 10,050 | 10,050 |\\n| Accumulated deficit | (1,251 | ) | (1,143 | ) |\\n| Total stockholder's equity | 8,799 | 8,907 |\\n| TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY | $ | 21,229 | 21,470 |\\n\\nSee accompanying notes to consolidated financial statements.\\n5\\nQWEST CORPORATION\\nCONSOLIDATED STATEMENTS OF CASH FLOWS\\n(UNAUDITED)\\n| Six Months Ended June 30, |\\n| 2016 | 2015 |\\n| (Dollars in millions) |\\n| OPERATING ACTIVITIES |\\n| Net income | $ | 592 | 485 |\\n| Adjustments to reconcile net income to net cash provided by operating activities: |\\n| Depreciation and amortization | 843 | 926 |\\n| Deferred income taxes | (35 | ) | (180 | ) |\\n| Provision for uncollectible accounts | 40 | 39 |\\n| Net long-term debt issuance costs and premium amortization | (7 | ) | (11 | ) |\\n| Accrued interest on affiliate note | 29 | 31 |\\n| Changes in current assets and liabilities: |\\n| Accounts receivable | (40 | ) | 8 |\\n| Accounts payable | (20 | ) | 30 |\\n| Accrued income and other taxes | (24 | ) | (14 | ) |\\n| Other current assets and liabilities, net | (40 | ) | (34 | ) |\\n| Other current assets and liabilities - affiliates, net | — | (4 | ) |\\n| Changes in other noncurrent assets and liabilities, net | (11 | ) | (23 | ) |\\n| Changes in affiliate obligations, net | (51 | ) | (4 | ) |\\n| Other, net | 8 | 5 |\\n| Net cash provided by operating activities | 1,284 | 1,254 |\\n| INVESTING ACTIVITIES |\\n| Payments for property, plant and equipment and capitalized software | (546 | ) | (564 | ) |\\n| Changes in advances to affiliates | (23 | ) | (383 | ) |\\n| Net cash used in investing activities | (569 | ) | (947 | ) |\\n| FINANCING ACTIVITIES |\\n| Net proceeds from issuance of long-term debt | 227 | 99 |\\n| Payments of long-term debt | (241 | ) | (106 | ) |\\n| Dividends paid to Qwest Services Corporation | (700 | ) | (300 | ) |\\n| Net cash used in financing activities | (714 | ) | (307 | ) |\\n| Net increase in cash and cash equivalents | 1 | — |\\n| Cash and cash equivalents at beginning of period | 3 | 6 |\\n| Cash and cash equivalents at end of period | $ | 4 | 6 |\\n| Supplemental cash flow information: |\\n| Income taxes paid, net | $ | (401 | ) | (379 | ) |\\n| Interest paid (net of capitalized interest of $8 and $9) | $ | (249 | ) | (247 | ) |\\n\\nSee accompanying notes to consolidated financial statements.\\n6\\nQWEST CORPORATION\\nCONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY\\n(UNAUDITED)\\n| Six Months Ended June 30, |\\n| 2016 | 2015 |\\n| (Dollars in millions) |\\n| COMMON STOCK |\\n| Balance at beginning of period | $ | 10,050 | 10,050 |\\n| Balance at end of period | 10,050 | 10,050 |\\n| ACCUMULATED DEFICIT |\\n| Balance at beginning of period | (1,143 | ) | (867 | ) |\\n| Net income | 592 | 485 |\\n| Dividends declared to Qwest Services Corporation | (700 | ) | (300 | ) |\\n| Balance at end of period | (1,251 | ) | (682 | ) |\\n| TOTAL STOCKHOLDER'S EQUITY | $ | 8,799 | 9,368 |\\n\\nSee accompanying notes to consolidated financial statements.\\n7\\nQWEST CORPORATION\\nNOTES TO CONSOLIDATED FINANCIAL STATEMENTS\\n(UNAUDITED)\\nUnless the context requires otherwise, references in this report to \\\"QC\\\" refer to Qwest Corporation, references to \\\"Qwest,\\\" \\\"we,\\\" \\\"us,\\\" and \\\"our\\\" refer to Qwest Corporation and its consolidated subsidiaries, references to \\\"QSC\\\" refer to our direct parent company, Qwest Services Corporation, and its consolidated subsidiaries, references to \\\"QCII\\\" refer to QSC's direct parent company and our indirect parent company, Qwest Communications International Inc., and its consolidated subsidiaries, and references to \\\"CenturyLink\\\" refer to QCII's direct parent company and our ultimate parent company, CenturyLink, Inc., and its consolidated subsidiaries.\\n(1) Basis of Presentation\\nGeneral\\nWe are an integrated communications company engaged primarily in providing an array of services to our residential and business customers. Our communications services include local voice, broadband, private line (including special access), network access, Ethernet, information technology, video and other ancillary services. In certain local and regional markets, we also provide local access and fiber transport services to competitive local exchange carriers.\\nWe generate the majority of our total consolidated operating revenues from services provided in the 14-state region of Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and Wyoming. We refer to this region as our local service area.\\nOur consolidated balance sheet as of December 31, 2015, which was derived from our audited consolidated financial statements, and our unaudited interim consolidated financial statements provided herein have been prepared in accordance with the instructions for Form 10-Q. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to rules and regulations of the Securities and Exchange Commission (\\\"SEC\\\"); however, in our opinion, the disclosures made are adequate to make the information presented not misleading. We believe that these consolidated financial statements include all normal recurring adjustments necessary to fairly present the results for the interim periods. The consolidated results of operations for the first six months of the year are not necessarily indicative of the consolidated results of operations that might be expected for the entire year. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2015.\\nThe accompanying consolidated financial statements include our accounts and the accounts of our subsidiaries. Intercompany amounts and transactions with our consolidated subsidiaries have been eliminated. Transactions with our non-consolidated affiliates (referred to herein as affiliates) have not been eliminated.\\nWe reclassified certain prior period amounts to conform to the current period presentation, including the categorization of our revenues. See Note 4—Products and Services Revenues for additional information. These changes had no impact on total operating revenues, total operating expenses or net income for any period.\\nConnect America Fund\\nIn 2015, CenturyLink accepted funding from the Federal Communications Commission's (\\\"FCC\\\") Connect America Fund (\\\"CAF\\\") of approximately $500 million per year for six years to fund the deployment of voice and broadband capable infrastructure for approximately 1.2 million rural households and businesses in 33 states under the CAF Phase 2 high-cost support program. The funding from the CAF Phase 2 support program in these 33 states will substantially supplant funding from the interstate Universal Service Fund (\\\"USF\\\") high-cost program that we previously utilized to support voice services in high-cost rural markets. Of these amounts, approximately $150 million per year is attributable to our service area, to provide service to approximately 0.3 million rural households and businesses in 13 states. In late 2015, we began receiving these support payments from the FCC under the new CAF Phase 2 support program, which included monthly support payments at a higher rate than under the interstate USF support program. We recorded $24 million and $48 million more in revenue for the three and six months ended June 30, 2016, respectively, than in the comparable periods for 2015 with respect to our 13 states. We received a substantial one-time cumulative catch-up payment related to the first half of 2015 from the FCC in the third quarter of 2015, and, as a result, we do not expect funding from the CAF Phase 2 support program to materially change our \\\"affiliate and other services\\\" revenues for the full year 2016 when compared to the full year 2015.\\n8\\nRecent Accounting Pronouncements\\nFinancial Instruments\\nOn June 16, 2016, the Financial Accounting Standards Board (\\\"FASB\\\") issued Accounting Standards Update (\\\"ASU\\\") 2016-13, “Measurement of Credit Losses on Financial Instruments” (“ASU 2016-13”). The primary impact of ASU 2016-13 for us is a change in the model for the recognition of credit losses related to our financial instruments from an incurred loss model, which recognized credit losses only if it was probable that a loss had been incurred to an expected loss model, which requires our management team to estimate the total credit losses expected on the portfolio of financial instruments. We are currently reviewing the requirements of the standard and evaluating the impact on our consolidated financial statements.\\nWe are required to adopt the provisions of ASU 2016-13 effective January 1, 2020, but could elect to early adopt the provisions as of January 1, 2019. We expect to recognize the impacts of adopting ASU 2016-13 through a cumulative adjustment to retained earnings as of the date of adoption.\\nShare-based Compensation\\nOn March 30, 2016, the FASB issued ASU 2016-09, “Improvement to Employee Share-Based Payment Accounting\\\" (“ASU 2016-09”). ASU 2016-09 modifies the accounting and associated income tax accounting for share-based compensation in order to reduce the cost and complexity associated with current generally accepted accounting principles. ASU 2016-09 is effective for us as of January 1, 2017, but early adoption may be elected. ASU 2016-09 includes different transition requirements for the different changes implemented, including some provisions which allow retrospective application. We have not determined when we will implement this standard or if we will retrospectively apply the requirements when allowed.\\nThe primary provisions of ASU 2016-09 that we expect will affect our financial statements are: 1) a reclassification of the tax effect associated with the difference between the expense recognized for share-based payments and the associated tax deduction from additional paid-in capital to income tax expense; 2) a reclassification of the tax effect associated with the difference between compensation expense and associated deduction from financing cash flow to operating cash flow; and 3) an optional accounting policy election to account for forfeitures of share-based payment grants as they occur as opposed to our current policy of estimating the forfeitures on the grant date. These provisions would not have had a material impact on our previously issued financial statements; however, this is not necessarily representative of future impacts. Adoption of ASU 2016-09 may increase the volatility of income tax expense and cash flow from operating activities.\\nLeases\\nOn February 25, 2016, the FASB issued ASU 2016-02, “Leases” (“ASU 2016-02”). The core principle of ASU 2016-02 will require lessees to present right-of-use assets and lease liabilities on their balance sheets for operating leases, which are currently not reflected on their balance sheets.\\nASU 2016-02 is effective for annual and interim periods beginning January 1, 2019. Early adoption of ASU 2016-02 is permitted. Upon adoption of ASU 2016-02, we are required to recognize and measure leases at the beginning of the earliest period presented in our consolidated financial statements using a modified retrospective approach. The modified retrospective approach includes a number of optional practical expedients that we may elect to apply. We have not yet decided when we will adopt ASU 2016-02 or which practical expedient options we will elect. We are currently evaluating and assessing the impact ASU 2016-02 will have on us and our consolidated financial statements. As of the date of this report, we cannot provide any estimate of the impact of adopting ASU 2016-02.\\nRevenue Recognition\\nOn May 28, 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers” (“ASU 2014-09”). ASU 2014-09 replaces virtually all existing generally accepted accounting principles (“GAAP”) on revenue recognition and replaces them with a principles-based approach for determining revenue recognition using a new five step model. The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 also includes new accounting principles related to the deferral and amortization of contract acquisition and fulfillment costs. We currently do not defer any contract acquisition costs and we defer contract fulfillment costs only up to the extent of any revenue deferred.\\n9\\nOn July 9, 2015, the FASB approved the deferral of the effective date of ASU 2014-09 by one year until January 1, 2018, which is the date we plan to adopt this standard. ASU 2014-09 may be adopted by applying the provisions of this standard on a retrospective basis to the periods included in the financial statements or on a modified retrospective basis which would result in the recognition of a cumulative effect of adopting ASU 2014-09 in the first quarter of 2018. We have not yet decided which implementation method we will adopt. We are studying ASU 2014-09 and are assessing the impact this standard will have on us and our consolidated financial statements. We cannot at this time, however, provide any estimate of the impact of adopting ASU 2014-09.\\n(2) Long-Term Debt and Revolving Promissory Note\\nLong-term debt, including unamortized discounts and premiums, unamortized debt issuance costs and note payable - affiliate, were as follows:\\n| Interest Rates | Maturities | As of June 30, 2016 | As of December 31, 2015 |\\n| (Dollars in millions) |\\n| Senior notes | 6.125% - 7.750% | 2017 - 2056 | $ | 7,229 | 7,229 |\\n| Term loan | 2.220% | 2025 | 100 | 100 |\\n| Capital lease and other obligations | Various | Various | 28 | 17 |\\n| Unamortized premiums, net | 8 | 16 |\\n| Unamortized debt issuance costs | (130 | ) | (123 | ) |\\n| Total long-term debt | 7,235 | 7,239 |\\n| Less current maturities | (509 | ) | (242 | ) |\\n| Long-term debt, excluding current maturities | $ | 6,726 | 6,997 |\\n| Note payable - affiliate | 6.795% | 2022 | $ | 884 | 855 |\\n\\nNew Issuance\\nIn January 2016, QC issued $235 million aggregate principal amount of 7% Notes due 2056, in exchange for net proceeds, after deducting underwriting discounts and other expenses, of approximately $227 million. All of the 7% Notes are unsecured obligations and may be redeemed by QC, in whole or in part, on or after February 1, 2021, at a redemption price equal to 100% of the principal amount redeemed plus accrued and unpaid interest to the redemption date.\\nRepayment\\nOn May 2, 2016, QC paid at maturity the $235 million principal amount and accrued and unpaid interest due under its 8.375% Notes.\\nRevolving Promissory Note\\nWe are currently indebted to an affiliate of our ultimate parent company, CenturyLink, under a revolving promissory note that provides us with a funding commitment of up to $1.0 billion aggregate principal amount through June 30, 2022, of which $884 million was outstanding as of June 30, 2016. As of June 30, 2016, the weighted average interest rate was 6.795%. As of June 30, 2016 and December 31, 2015, this revolving promissory note is reflected on our consolidated balance sheets as a current liability under note payable - affiliate. As of June 30, 2016, $5 million of accrued interest is reflected in other current liabilities on our consolidated balance sheet. In accordance with the note agreement, all accrued interest and unpaid interest is capitalized to the unpaid principal balance on June 1 and December 1 of each year.\\nCovenants\\nThe indentures governing our notes contain certain covenants including, but not limited to: (i) a prohibition on certain liens on our assets; and (ii) a limitation on mergers or sales of all, or substantially all, of our assets, which limitation requires that a successor assume the obligation with regard to these notes. These indentures do not contain any cross-default provisions.\\nOur senior notes were issued under indentures dated April 15, 1990 and October 15, 1999. These indentures do not contain any financial covenants, but do include restrictions that limit our ability to (i) incur, issue or create liens upon our property and (ii) consolidate with or merge into, transfer or lease all or substantially all of our assets to any other party.\\nAs of June 30, 2016, we believe we were in compliance with the provisions and covenants of our debt agreements.\\n10\\n(3) Fair Value Disclosure\\nOur financial instruments consist of cash and cash equivalents, accounts receivable, advances to affiliates, accounts payable, note payable - affiliate and long-term debt, excluding capital lease and other obligations. Due to their short-term nature, the carrying amounts of our cash and cash equivalents, accounts receivable, advances to affiliates, accounts payable, and note payable - affiliate approximate their fair values.\\nFair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between independent and knowledgeable parties who are willing and able to transact for an asset or liability at the measurement date. We use valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs when determining fair value and then we rank the estimated values based on the reliability of the inputs used following the fair value hierarchy set forth by the FASB. We determined the fair values of our long-term debt, including the current portion, based on quoted market prices where available or, if not available, based on discounted future cash flows using current market interest rates.\\n| Input Level | Description of Input |\\n| Level 1 | Observable inputs such as quoted market prices in active markets. |\\n| Level 2 | Inputs other than quoted prices in active markets that are either directly or indirectly observable. |\\n| Level 3 | Unobservable inputs in which little or no market data exists. |\\n\\n| As of June 30, 2016 | As of December 31, 2015 |\\n| InputLevel | CarryingAmount | FairValue | CarryingAmount | FairValue |\\n| (Dollars in millions) |\\n| Liabilities—Long-term debt, excluding capital lease and other obligations | 2 | $ | 7,207 | 7,579 | 7,222 | 7,456 |\\n\\n(4) Products and Services Revenues\\nWe are an integrated communications company engaged primarily in providing an array of services, including local voice, broadband, private line (including special access), network access, Ethernet, information technology, video and other ancillary services. We strive to maintain our customer relationships by, among other things, bundling our service offerings to provide our customers with a complete offering of integrated communications services.\\nFrom time to time, we may change the categorization of our products and services. During the second quarter of 2016, we determined that because of declines due to customer migration to other strategic products and services, certain of our services, specifically our private line (including special access) services, are now more closely aligned with our legacy services than with our strategic services. As a result, we now reflect these operating revenues as legacy services, and we have reclassified certain prior period amounts to conform to this change. The revision resulted in a reduction of revenue from strategic services and a corresponding increase in revenue from legacy services of $209 million and $426 million (net of $1 million and $2 million of deferred revenue included in affiliate and other services) for the three and six months ended June 30, 2015, respectively.\\n11\\nWe now categorize our products, services and revenues among the following three categories:\\n| • | Strategic services, which include primarily broadband, Ethernet, video and other ancillary services; |\\n\\n| • | Legacy services, which include primarily local voice, private line (including special access), Integrated Services Digital Network (\\\"ISDN\\\") (which use regular telephone lines to support voice, video and data applications), switched access, traditional wide area network (\\\"WAN\\\") (which allow a local communications network to link to networks in remote locations) and other ancillary services; and |\\n\\n| • | Affiliates and other services, which consist primarily of CAF support payments, USF support payments, USF surcharges and services we provide to our affiliates. We receive federal support payments from both CAF Phase 1 and CAF Phase 2 programs, and support payments from both federal and state USF programs. These support payments are government subsidies designed to reimburse us for various costs related to certain telecommunications services, including the costs of deploying, maintaining and operating voice and broadband infrastructure in high-cost rural areas where we are not able to fully recover our costs from our customers. USF surcharges are the amounts we collect based on specific items we list on our customers' invoices to fund the FCC's universal service programs. We provide to our affiliates, telecommunication services that we also provide to external customers. In addition, we provide to our affiliates, computer system development and support services, network support and technical services. |\\n\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| (Dollars in millions) |\\n| Strategic services | $ | 674 | 650 | 1,345 | 1,291 |\\n| Legacy services | 814 | 904 | 1,658 | 1,833 |\\n| Affiliates and other services | 735 | 668 | 1,473 | 1,315 |\\n| Total operating revenues | $ | 2,223 | 2,222 | 4,476 | 4,439 |\\n\\nWe do not have any single external customer that provides more than 10% of our total consolidated operating revenues. Substantially all of our consolidated revenues come from customers located in the United States.\\nWe recognize revenues in our consolidated statements of operations for certain USF surcharges and transaction taxes that we bill to our customers. Our consolidated statements of operations also reflect the related expense for the amounts we remit to the government agencies. The total amount of such surcharges and transaction taxes that we included in revenues aggregated approximately $38 million for each of the three months ended June 30, 2016 and 2015, respectively, and approximately $76 million and $75 million for the six months ended June 30, 2016 and 2015, respectively. These USF surcharges, where we record revenue, are included in \\\"affiliate and other services\\\" revenues and these transaction taxes are included in \\\"legacy services\\\" revenues. We also act as a collection agent for certain other USF and transaction taxes that we are required by government agencies to bill our customers, for which we do not record any revenue or expense because we only act as a pass-through agent.\\nOur operations are integrated into and reported as part of the consolidated segment data of CenturyLink. CenturyLink's chief operating decision maker (\\\"CODM\\\") is our CODM, but reviews our financial information on an aggregate basis only in connection with our quarterly and annual reports that we file with the Securities and Exchange Commission. Consequently, we do not provide our discrete financial information to the CODM on a regular basis. As such, we believe we have one reportable segment.\\n(5) Commitments and Contingencies\\nPending Matters\\nSubsidiaries of CenturyLink, Inc., including us, are among hundreds of companies in an industry-wide dispute, raised in nearly 100 federal lawsuits (filed between 2014 and 2016) that have been consolidated in the United States District Court for the District of Northern Texas for pretrial procedures. The disputes relate to switched access charges that local exchange carriers (\\\"LECs\\\") collect from interexchange carriers (\\\"IXCs\\\") for IXCs' use of LEC's access services. In the lawsuits, three IXCs, Sprint Communications Company L.P. (\\\"Sprint\\\"), affiliates of Verizon Communications Inc. (\\\"Verizon\\\") and affiliates of Level 3 Communications LLC (\\\"Level 3\\\"), assert that federal and state laws bar LECs from collecting access charges when IXCs exchange certain types of calls between mobile and wireline devices that are routed through an IXC. Some of these IXCs have asserted claims seeking refunds of payments for access charges previously paid and relief from future access charges. In addition, Level 3 has ceased paying switched access charges on these calls.\\n12\\nIn November 2015, the federal court agreed with the LECs and rejected the IXCs' contention that federal law prohibits these particular access charges, and also allowed the IXCs to refile state-law claims. Since then, many of the LECs and IXCs have filed revised pleadings and additional motions, which remain pending. Separately, some of the defendants, including us, have petitioned the Federal Communications Commission to address these issues on an industry-wide basis.\\nThe outcome of these disputes and lawsuits, as well as any related regulatory proceedings that could ensue, are currently not predictable. If we are required to stop assessing these charges or to pay refunds of any such charges, our financial results could be negatively affected.\\nOther Proceedings and Disputes\\nFrom time to time, we are involved in other proceedings incidental to our business, including patent infringement allegations, administrative hearings of state public utility commissions relating primarily to our rates or services, actions relating to employee claims, various tax issues, environmental law issues, grievance hearings before labor regulatory agencies and miscellaneous third party tort actions.\\nWe are currently defending several patent infringement lawsuits asserted against us by non-practicing entities, many of whom are seeking substantial recoveries. These cases have progressed to various stages and one or more may go to trial in the coming 24 months if they are not otherwise resolved. Where applicable, we are seeking full or partial indemnification from our vendors and suppliers. As with all litigation, we are vigorously defending these actions and, as a matter of course, are prepared to litigate these matters to judgment, as well as to evaluate and consider all reasonable settlement opportunities.\\nWe are subject to various federal, state and local environmental protection and health and safety laws. From time to time, we are subject to judicial and administrative proceedings brought by various governmental authorities under these laws. Several such proceedings are currently pending, but none is reasonably expected to exceed $100,000 in fines and penalties.\\nThe outcome of these other proceedings is not predictable. However, based on current circumstances, we do not believe that the ultimate resolution of these other proceedings, after considering available defenses and any insurance coverage or indemnification rights, will have a material adverse effect on our financial position, results of operations or cash flows.\\nCenturyLink, Inc. and its affiliates are involved in several legal proceedings to which we are not a party that, if resolved against them, could have a material adverse effect on their business and financial condition. As an indirect wholly-owned subsidiary of CenturyLink, Inc., our business and financial condition could be similarly affected. You can find descriptions of these legal proceedings in CenturyLink, Inc.'s quarterly and annual reports filed with the Securities and Exchange Commission. Because we are not a party to any of the matters, we have not accrued any liabilities for the matters.\\n(6) Dividends\\nDuring the six months ended June 30, 2016, we declared and paid dividends of $700 million to our direct parent company, Qwest Services Corporation. Dividends paid are reflected on our consolidated statements of cash flows as financing activities.\\n(7) Other Financial Information\\nOther Current Assets\\n| As of June 30, 2016 | As of December 31, 2015 |\\n| (Dollars in millions) |\\n| Prepaid expenses | $ | 70 | 46 |\\n| Other | 78 | 77 |\\n| Total other current assets | $ | 148 | 123 |\\n\\n13\\nSelected Current Liabilities\\n| As of June 30, 2016 | As of December 31, 2015 |\\n| (Dollars in millions) |\\n| Accounts payable | $ | 350 | 369 |\\n\\nIncluded in accounts payable at both June 30, 2016 and December 31, 2015, was $29 million associated with capital expenditures.\\n14\\nITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\\nUnless the context requires otherwise, references in this report to \\\"QC\\\" refer to Qwest Corporation, and references to \\\"Qwest,\\\" \\\"we,\\\" \\\"us\\\" and \\\"our\\\" refer to Qwest Corporation and its consolidated subsidiaries.\\nAll references to \\\"Notes\\\" in this Item 2 of Part I refer to the Notes to Consolidated Financial Statements included in Item 1 of Part I of this report.\\nCertain statements in this report constitute forward-looking statements. See the last paragraph of this Item 2 of Part I and \\\"Risk Factors\\\" in Item 1A of Part II of this report for a discussion of certain factors that could cause our actual results to differ from our anticipated results or otherwise impact our business, financial condition, results of operations, liquidity or prospects.\\nOverview\\nManagement's Discussion and Analysis of Financial Condition and Results of Operations (\\\"MD&A\\\") included herein should be read in conjunction with MD&A and the other information included in our Annual Report on Form 10-K for the year ended December 31, 2015, and with the consolidated financial statements and related notes in Item 1 of Part I of this report. The results of operations for the first six months of the year are not necessarily indicative of the results of operations that might be expected for the entire year.\\nWe are an integrated communications company engaged primarily in providing an array of services to our residential and business customers. Our communications services include local voice, broadband, private line (including special access), network access, Ethernet, information technology, video and other ancillary services. In certain local and regional markets, we also provide local access and fiber transport services to competitive local exchange carriers. We strive to maintain our customer relationships by, among other things, bundling our service offerings to provide our customers with a complete offering of integrated communications services.\\nWe generate the majority of our total consolidated operating revenues from services provided in the 14-state region of Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and Wyoming. We refer to this region as our local service area.\\nOur ultimate parent company, CenturyLink, Inc. (\\\"CenturyLink\\\"), has cash management arrangements between certain of its subsidiaries that include lines of credit, affiliate obligations, capital contributions and dividends. As part of these cash management arrangements, affiliates provide lines of credit to certain other affiliates. Amounts outstanding under these lines of credit and intercompany obligations vary from time to time. Under these arrangements, the majority of our cash balance is advanced on a daily basis to CenturyLink. From time to time we may declare and pay dividends to Qwest Services Corporation (\\\"QSC\\\"), our direct parent, using cash owed to us under these advances, which has the net effect of reducing the amount of these advances. We report the balance of these transfers on our consolidated balance sheet as advances to affiliates.\\nFor the reasons noted in Note 4—Products and Services Revenues to our consolidated financial statements in Item 1 of Part I of this report, we believe we have one reportable segment.\\nFrom time to time, we may change the categorization of our products and services. During the second quarter of 2016, we determined that because of declines due to customer migration to other strategic products and services, certain of our services, specifically our private line (including special access) services, are now more closely aligned with our legacy services than with our strategic services. As described in greater detail in Note 4—Products and Services Revenues, these operating revenues are now reflected as legacy services.\\nWe now categorize our products, services and revenues among the following three categories:\\n| • | Strategic services, which include primarily broadband, Ethernet, video and other ancillary services; |\\n\\n| • | Legacy services, which include primarily local voice, private line (including special access), Integrated Services Digital Network (\\\"ISDN\\\") (which use regular telephone lines to support voice, video and data applications), switched access, traditional wide area network (\\\"WAN\\\") (which allow a local communications network to link to networks in remote locations) and other ancillary services; and |\\n\\n15\\n| • | Affiliates and other services, which consist primarily of Connect America Fund (\\\"CAF\\\") support payments, Universal Service Fund (\\\"USF\\\") support payments, USF surcharges and services we provide to our affiliates. We receive federal support payments from both CAF Phase 1 and CAF Phase 2 programs, and support payments from both federal and state USF programs. These support payments are government subsidies designed to reimburse us for various costs related to certain telecommunications services, including the costs of deploying, maintaining and operating voice and broadband infrastructure in high-cost rural areas where we are not able to fully recover our costs from our customers. USF surcharges are the amounts we collect based on specific items we list on our customers' invoices to fund the Federal Communications Commission's (\\\"FCC\\\") universal service programs. We provide to our affiliates, telecommunication services that we also provide to external customers. In addition, we provide to our affiliates, computer system development and support services, network support and technical services. |\\n\\nAt June 30, 2016, we operated approximately 6.8 million access lines and served approximately 3.5 million broadband subscribers. Our methodology for counting access lines and broadband subscribers, which is described further in the operational metrics table below under \\\"Results of Operations\\\", may not be comparable to those of other companies.\\nThe following analysis is organized to provide the information we believe will be useful for understanding material trends affecting our business.\\nBusiness Trends\\nOur financial results were impacted by several significant trends, which are described below. We expect that these trends will continue to affect our results of operations, cash flows or financial position.\\n| • | Strategic services. We continue to see shifts in the makeup of our total revenues as customers move to lower margin strategic services, such as broadband and video services, from higher margin legacy services. Revenues from our strategic services represented 30% and 29% of our total revenues for both the three and six months ended June 30, 2016 and 2015, respectively. We continue to experienced price compression due to competition, which negatively impacted the growth of our strategic revenues. We continue to focus on increasing subscribers of our broadband services, particularly among consumer and small business customers. We believe that continually increasing the scope and connection speeds of our broadband services is important to remaining competitive in our industry. As a result, we continue to invest in our broadband network, which allows for the delivery of higher speed broadband services to a greater number of customers. We compete in a maturing broadband market in which most customers already have broadband services and growth rates in new subscribers have slowed. Moreover, as described further in \\\"Risk Factors\\\" in Item 1A of Part II of this report, demand for our broadband services could be adversely affected by competitors continuing to provide services at higher broadband speeds than ours or expanding their advanced wireless data service offerings. Our Ethernet-based services in the wholesale market face competition from cable companies and competitive fiber-based telecommunications providers; |\\n\\n| • | Legacy services. Revenues from our legacy services represented 37% and 41% of our total revenues for the three and six months ended June 30, 2016 and 2015, respectively. We expect these percentages to continue to decline. Our legacy services revenues have been, and we expect they will continue to be adversely affected by access line losses and price compression. Intense competition and product substitution continue to drive our access line losses. For example, many consumers are replacing traditional voice telecommunications service with substitute services, including (i) cable and wireless voice services and (ii) electronic mail, texting and social networking services. We expect that these factors will continue to negatively impact our business. As a result of the expected loss of revenue associated with access lines, we continue to offer our customers service bundling and other product promotions to help mitigate this trend, as described below. Demand for our private line services (including special access) continues to decline due to customers' optimization of their networks, industry consolidation and technological migration to higher-speed services; |\\n\\n| • | Service bundling and product promotions. We offer our customers the ability to bundle multiple products and services. These customers can bundle local services with other services such as broadband and video. While we believe our bundled service offerings can help retain customers, they also tend to lower our profit margins due to the related discounts; and |\\n\\n| • | Operating efficiencies. We continue to evaluate our operating structure and focus. This involves balancing our workforce in response to our workload requirements, productivity improvements and changes in industry, competitive, technological and regulatory conditions. |\\n\\nWhile these trends are important to understanding and evaluating our financial results, the other transactions, events, uncertainties and trends discussed in \\\"Risk Factors\\\" in Item 1A of Part II of this report may also materially impact our business operations and financial results.\\n16\\nResults of Operations\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| (Dollars in millions) |\\n| Operating revenues | $ | 2,223 | 2,222 | 4,476 | 4,439 |\\n| Operating expenses | 1,621 | 1,701 | 3,249 | 3,373 |\\n| Operating income | 602 | 521 | 1,227 | 1,066 |\\n| Other expense, net | (135 | ) | (131 | ) | (268 | ) | (262 | ) |\\n| Income tax expense | 179 | 152 | 367 | 319 |\\n| Net income | $ | 288 | 238 | 592 | 485 |\\n\\n| As of June 30, | Increase/(Decrease) | % Change |\\n| 2016 | 2015 |\\n| (in thousands) |\\n| Operational metrics: |\\n| Total access lines (1) | 6,808 | 7,184 | (376 | ) | (5 | )% |\\n| Total broadband subscribers (1) | 3,516 | 3,556 | (40 | ) | (1 | )% |\\n| Total employees | 22.9 | 22.5 | 0.4 | 2 | % |\\n\\n(1) Access lines are lines reaching from the customers' premises to a connection with the public network and broadband subscribers are customers that purchase broadband connection service through their existing telephone lines, stand-alone telephone lines, or fiber-optic cables. Our methodology for counting our access lines and broadband subscribers includes only those lines that we use to provide services to external customers and excludes lines used solely by us and our affiliates. It also excludes unbundled loops and includes stand-alone broadband subscribers. We count lines when we install the service.\\nOperating Revenues\\n| Three Months Ended June 30, | Increase/(Decrease) | % Change |\\n| 2016 | 2015 |\\n| (Dollars in millions) |\\n| Strategic services | $ | 674 | 650 | 24 | 4 | % |\\n| Legacy services | 814 | 904 | (90 | ) | (10 | )% |\\n| Affiliates and other services | 735 | 668 | 67 | 10 | % |\\n| Total operating revenues | $ | 2,223 | 2,222 | 1 | — | % |\\n\\n| Six Months Ended June 30, | Increase/(Decrease) | % Change |\\n| 2016 | 2015 |\\n| (Dollars in millions) |\\n| Strategic services | $ | 1,345 | 1,291 | 54 | 4 | % |\\n| Legacy services | 1,658 | 1,833 | (175 | ) | (10 | )% |\\n| Affiliates and other services | 1,473 | 1,315 | 158 | 12 | % |\\n| Total operating revenues | $ | 4,476 | 4,439 | 37 | 1 | % |\\n\\n17\\nStrategic Services\\nStrategic services revenues increased by $24 million, or 4%, and increased by $54 million, or 4%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The increase in our strategic services revenues for both periods was primarily due to price increases for broadband services, volume increases in Ethernet services and price increases for other services.\\nLegacy Services\\nLegacy services revenues decreased by $90 million, or 10%, and decreased by $175 million, or 10%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The decline in our legacy services revenues for both periods was primarily due to lower local voice services revenues due to access line loss and reduced access services usage related to customer migration, competitive pressures and product substitution and to reductions in the volumes of our private line (including special access) services.\\nAffiliates and Other Services\\nAffiliates and other services revenues increased by $67 million, or 10%, and increased by $158 million, or 12%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The increase in our affiliates and other services revenues for both periods was primarily due to increases in the volume and in the rates we charge for the support services we provided to affiliates and to the additional revenue recorded under the FCC's CAF Phase 2 support program. We recorded $24 million and $48 million more in revenue for the three and six months ended June 30, 2016, respectively, than for the three and six months ended June 30, 2015, with respect to our 13 CAF Phase 2 states. We received a substantial one-time cumulative catch-up payment related to the first half of 2015 from the FCC in the third quarter of 2015, and, as a result, we do not expect funding from the CAF Phase 2 support program to materially change our other operating revenues for the full year 2016 when compared to the full year 2015.\\nOperating Expenses\\nThe following tables summarize our consolidated operating expenses:\\n| Three Months Ended June 30, | Increase/(Decrease) | % Change |\\n| 2016 | 2015 |\\n| (Dollars in millions) |\\n| Cost of services and products (exclusive of depreciation and amortization) | $ | 731 | 743 | (12 | ) | (2 | )% |\\n| Selling, general and administrative | 235 | 256 | (21 | ) | (8 | )% |\\n| Operating expenses - affiliates | 231 | 238 | (7 | ) | (3 | )% |\\n| Depreciation and amortization | 424 | 464 | (40 | ) | (9 | )% |\\n| Total operating expenses | $ | 1,621 | 1,701 | (80 | ) | (5 | )% |\\n\\n| Six Months Ended June 30, | Increase/(Decrease) | % Change |\\n| 2016 | 2015 |\\n| (Dollars in millions) |\\n| Cost of services and products (exclusive of depreciation and amortization) | $ | 1,439 | 1,435 | 4 | — | % |\\n| Selling, general and administrative | 485 | 526 | (41 | ) | (8 | )% |\\n| Operating expenses - affiliates | 482 | 486 | (4 | ) | (1 | )% |\\n| Depreciation and amortization | 843 | 926 | (83 | ) | (9 | )% |\\n| Total operating expenses | $ | 3,249 | 3,373 | (124 | ) | (4 | )% |\\n\\n18\\nCost of Services and Products (exclusive of depreciation and amortization)\\nCost of services and products (exclusive of depreciation and amortization) are expenses incurred in providing products and services to our customers. These expenses include: employee-related expenses directly attributable to operating and maintaining our network (such as salaries, wages, benefits and professional fees); facilities expenses (which include third-party telecommunications expenses we incur for using other carriers' networks to provide services to our customers); rents and utilities expenses; equipment sales expenses (such as modem expenses); payments of universal service funds (which are federal and state funds that are established to promote the availability of telecommunications services to all consumers at reasonable and affordable rates, among other things, and to which we are often required to contribute); litigation expenses associated with our operations; and other expenses directly related to our operations.\\nCost of services and products (exclusive of depreciation and amortization) decreased by $12 million, or 2%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015. The decrease in our cost of services and products was primarily due to decreases in employee benefits expense, professional fees and contract labor costs, which were partially offset by increases in facility costs and network expense. Cost of services and products (exclusive of depreciation and amortization) increased by $4 million, or less than 1%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The increase in our cost of services and products was primarily due to increases in facility costs and allocated corporate costs from affiliates, which were substantially offset by decreases in salaries and wages and related employee benefits expense (driven by increases in the amount of labor capitalized and allocated to our affiliates), professional fees and contract labor costs.\\nSelling, General and Administrative\\nSelling, general and administrative expenses are expenses incurred in selling products and services to our customers, corporate overhead and other operating expenses. These expenses include: employee-related expenses (such as salaries, wages, internal commissions, benefits and professional fees) directly attributable to selling products or services and employee-related expenses for administrative functions; marketing and advertising; property and other operating taxes and fees; external commissions; litigation expenses associated with general matters; bad debt expense; and other selling, general and administrative expenses.\\nSelling, general and administrative expenses decreased by $21 million, or 8%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015. The decrease in our selling, general and administrative expenses was primarily due to decreases in salaries and wages and related employee benefits expense (driven by increases in the amount of labor capitalized and allocated to our affiliates), contract labor costs and property and other taxes, which were partially offset by an increase in external commissions. Selling, general and administrative expenses decreased by $41 million, or 8%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The decrease in our selling, general and administrative expenses was primarily due to decreases in salaries and wages and related employee benefits expense (driven by increases in the amount of labor capitalized and allocated to our affiliates), contract labor costs, property and other taxes and regulatory fines of $15 million associated with a 911 system outage in 2015, which were partially offset by an increase in external commissions.\\nOperating Expenses - Affiliates\\nSince CenturyLink's acquisition of us, we have incurred affiliates expenses related to our use of telecommunication services, marketing and employee related support services provided by CenturyLink and its subsidiaries.\\nOperating expenses - affiliates decreased by $7 million, or 3%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015 and decreased by $4 million, or 1%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The decrease in operating expenses - affiliates for both periods was primarily due to decreases in level of services provided to us by our affiliates.\\n19\\nDepreciation and Amortization\\nThe following tables provide detail of our depreciation and amortization expense:\\n| Three Months Ended June 30, | Increase/(Decrease) | % Change |\\n| 2016 | 2015 |\\n| (Dollars in millions) |\\n| Depreciation | $ | 230 | 244 | (14 | ) | (6 | )% |\\n| Amortization | 194 | 220 | (26 | ) | (12 | )% |\\n| Total depreciation and amortization | $ | 424 | 464 | (40 | ) | (9 | )% |\\n\\n| Six Months Ended June 30, | Increase/(Decrease) | % Change |\\n| 2016 | 2015 |\\n| (Dollars in millions) |\\n| Depreciation | $ | 452 | 484 | (32 | ) | (7 | )% |\\n| Amortization | 391 | 442 | (51 | ) | (12 | )% |\\n| Total depreciation and amortization | $ | 843 | 926 | (83 | ) | (9 | )% |\\n\\nDepreciation expense is impacted by several factors, including changes in our depreciable cost basis, changes in our estimates of the remaining economic life of certain network assets and the addition of new plant. Depreciation expense decreased by $14 million, or 6%, and decreased by $32 million, or 7%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The depreciation expense related to our plant for the six months ended June 30, 2016 was lower than the depreciation expense for the six months ended June 30, 2015 due to full depreciation and retirement of certain plant placed in service prior to 2016. This decrease was partially offset by an increase in depreciation expense attributable to new plant placed in service since June 30, 2015.\\nAmortization expense decreased by $26 million, or 12%, and decreased by $51 million, or 12%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The decrease in amortization expense for both periods was primarily due to software becoming fully amortized faster than new software was acquired or developed.\\nOther Consolidated Results\\nThe following tables summarize our total other expense, net and income tax expense:\\n| Three Months Ended June 30, | Increase/(Decrease) | % Change |\\n| 2016 | 2015 |\\n| (Dollars in millions) |\\n| Interest expense | $ | (120 | ) | (119 | ) | 1 | 1 | % |\\n| Interest expense - affiliate | (15 | ) | (13 | ) | 2 | 15 | % |\\n| Other income, net | — | 1 | (1 | ) | 100 | % |\\n| Total other expense, net | $ | (135 | ) | (131 | ) | 4 | 3 | % |\\n| Income tax expense | $ | 179 | 152 | 27 | 18 | % |\\n\\n20\\n| Six Months Ended June 30, | Increase/(Decrease) | % Change |\\n| 2016 | 2015 |\\n| (Dollars in millions) |\\n| Interest expense | $ | (241 | ) | (237 | ) | 4 | 2 | % |\\n| Interest expense - affiliate | (29 | ) | (26 | ) | 3 | 12 | % |\\n| Other income, net | 2 | 1 | 1 | 100 | % |\\n| Total other expense, net | $ | (268 | ) | (262 | ) | 6 | 2 | % |\\n| Income tax expense | $ | 367 | 319 | 48 | 15 | % |\\n\\nInterest Expense\\nInterest expense increased by $1 million, or 1%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015 and increased by $4 million, or 2%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The increase in interest expense for both periods was primarily due to a reduction in the amount of net premium amortization recorded at acquisition primarily due to the retirement of several issuances of debt during the period. See Note 2—Long-Term Debt and Revolving Promissory Note to our consolidated financial statements in Item 1 of Part I of this report and Liquidity and Capital Resources below for additional information about our debt.\\nInterest Expense - Affiliates, Net\\nAffiliate interest expense increased by $2 million, or 15%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015 and increased by $3 million, or 12%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The increase in affiliate interest expense for both periods was primarily due to the increase in the average amount outstanding on our intercompany revolving indebtedness.\\nIncome Tax Expense\\nIncome tax expense for the three months ended June 30, 2016 was $179 million, or an effective tax rate of 38.3%, compared to $152 million, or an effective tax rate of 39.0%, for the three months ended June 30, 2015. Income tax expense for the six months ended June 30, 2016 was $367 million, or an effective tax rate of 38.3%, compared to $319 million, or an effective tax rate of 39.7%, for the six months ended June 30, 2015. The 2016 rates include the effect of changes in state apportionment factors and research and development credits. The 2015 rates include the effect of regulatory fines associated with a 911 system outage and state tax rate changes.\\nLiquidity and Capital Resources\\nOverview\\nWe are an indirectly wholly-owned subsidiary of CenturyLink. As such, factors relating to, or affecting, CenturyLink's liquidity and capital resources could have material impacts on us, including impacts on our credit ratings, our access to capital markets and changes in the financial market's perception of us.\\nCenturyLink has cash management arrangements between certain of its subsidiaries that include lines of credit, affiliate advances and obligations, capital contributions and dividends. As part of these cash management arrangements, affiliates provide lines of credit to certain other affiliates. Amounts outstanding under these lines of credit and intercompany obligations vary from time to time. Under these arrangements, the majority of our cash balance is advanced on a daily basis to CenturyLink. From time to time we may declare and pay dividends to our stockholder, QSC, in excess of our earnings to the extent permitted by applicable law, using cash owed to us under these advances, which has the net effect of reducing the amount of these advances. Our debt covenants do not currently limit the amount of dividends we can pay to QSC. Given our cash management arrangement with our ultimate parent, CenturyLink, and the resulting amounts due to us from CenturyLink, a significant component of our liquidity is dependent upon CenturyLink's ability to repay its obligation to us.\\n21\\nAt June 30, 2016, we had a working capital deficit of $1.005 billion, reflecting current liabilities of $2.656 billion and current assets of $1.651 billion, compared to a working capital deficit of approximately $820 million as of December 31, 2015. We have historically operated with a working capital deficit due to our practice of declaring and paying regular cash dividends to QSC. As long as we continue declaring and paying cash dividends to QSC, it is likely that we will continue to operate with a working capital deficit in the future. We anticipate that our future liquidity needs will be met through (i) our cash provided by our operating activities, (ii) amounts due to us from CenturyLink and (iii) capital contributions, advances or loans from CenturyLink or its affiliates if and to the extent they have available funds or access to available funds that they are willing and able to contribute, advance or loan.\\nCapital Expenditures\\nWe incur capital expenditures on an ongoing basis in order to enhance and modernize our networks, compete effectively in our markets and expand our service offerings. CenturyLink evaluates capital expenditure projects based on a variety of factors, including expected strategic impacts (such as forecasted impact on revenue growth, productivity, expenses, service levels and customer retention) and the expected return on investment. The amount of CenturyLink’s consolidated capital investment is influenced by, among other things, demand for CenturyLink’s services and products, cash flow generated by operating activities, cash required for other purposes and regulatory considerations (such as our CAF Phase 2 infrastructure buildout requirements discussed below). Based on the type and volume of services we provide, approximately 38% to 43% of CenturyLink’s annual consolidated capital expenditures have been attributed over the last couple of years to us for use in our operations. For more information on CenturyLink’s total capital expenditures, please see its annual and quarterly reports filed with the SEC.\\nOur capital expenditures continue to be focused on our strategic services. For more information on our capital spending, see Item 1of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\\nDebt and Other Financing Arrangements\\nSubject to market conditions, and to the extent feasible, we expect to continue to issue debt securities from time to time in the future to refinance a substantial portion of our maturing debt. The availability, interest rate and other terms of any new borrowings will depend on the ratings assigned to us by credit rating agencies, among other factors. We have no debt maturities due during the remainder of 2016.\\n| Agency | Credit Ratings |\\n| Standard & Poor's | BBB- |\\n| Moody's Investors Service, Inc. (1) | Ba1 |\\n| Fitch Ratings | BBB- |\\n\\n| (1) | On March 15, 2016, Moody's Investors Service, Inc. downgraded CenturyLink's rating from Ba2 to Ba3 and downgraded Qwest Corporation's rating from Baa3 to Ba1. |\\n\\nOur credit ratings are reviewed and adjusted from time to time by the rating agencies, and downgrades could impact CenturyLink's and our access to debt capital or further raise CenturyLink's and our borrowing costs. Additional downgrades of CenturyLink's senior unsecured debt ratings could, under certain circumstances, incrementally increase the cost of CenturyLink's borrowing under its revolving credit facility, which could indirectly impact us. See \\\"Risk Factors—Risks Affecting our Liquidity and Capital Resources\\\" in Item 1A of Part II of this report.\\nTerm Loan\\nIn 2015, we entered into a term loan in the amount of $100 million with CoBank, ACB. The outstanding unpaid principal amount of this term loan plus any accrued and unpaid interest is due on February 20, 2025. Interest is paid monthly based upon either the London Interbank Offered Rate (“LIBOR”) or the base rate (as defined in the credit agreement) plus an applicable margin between 1.50% to 2.50% per annum for LIBOR loans and 0.50% to 1.50% per annum for base rate loans depending on our then current senior unsecured long-term debt rating. As of June 30, 2016, the outstanding principal balance on this term loan was $100 million.\\n22\\nRevolving Promissory Note\\nWe are currently indebted to an affiliate of CenturyLink under a revolving promissory note that provides us with a funding commitment of up to $1.0 billion aggregate principal amount through June 30, 2022, of which $884 million was outstanding as of June 30, 2016. The revolving promissory note is due on demand and ranks equally to our outstanding Senior Notes. Interest is accrued on the outstanding balance using a weighted average per annum interest rate of CenturyLink's outstanding borrowings for the interest period. As of June 30, 2016, the weighted average interest rate was 6.795%. As of June 30, 2016 and December 31, 2015, this revolving promissory note is reflected on our consolidated balance sheets as a current liability under note payable - affiliate. As of June 30, 2016, $5 million of accrued interest is reflected in other current liabilities on our consolidated balance sheet.\\nDividends\\nWe periodically pay dividends to our direct parent company. See Note 6—Dividends and the discussion above under the heading \\\"Overview\\\".\\nPension and Post-retirement Benefit Obligations\\nCenturyLink is subject to material obligations under its existing defined benefit pension plans and post-retirement benefit plans. At December 31, 2015, the accounting unfunded status of CenturyLink's qualified and non-qualified defined benefit pension plans and post-retirement benefit plans was $2.277 billion and $3.374 billion, respectively. For additional information about CenturyLink's pension and post-retirement benefit arrangements, see \\\"Critical Accounting Policies and Estimates—Pensions and Post-Retirement Benefits\\\" in Item 7 of CenturyLink's Annual Report on Form 10-K for the year ended December 31, 2015, and see Note 7—Employee Benefits to the consolidated financial statements in Item 8 of Part II of the same report.\\nA substantial portion of our active and retired employees participate in CenturyLink's qualified Combined Pension Plan and post-retirement benefit plans. On December 31, 2014, the Qwest Communications International Inc. (\\\"QCII\\\") pension plan and a pension plan of an affiliate were merged into the CenturyLink Retirement Plan, which was renamed the CenturyLink Combined Pension Plan. Our contributions to the trust are not segregated or restricted to pay amounts due to our employees and may be used to provide benefits to other employees of our affiliates. Prior to the pension plan merger, the above-noted employees participated in the QCII pension plan.\\nThe affiliate obligations, net in current and noncurrent liabilities on our consolidated balance sheets represents the cumulative allocation of expense, net of payments, associated with QCII's pension plans and post-retirement benefits plans prior to the plan mergers. In 2015, we agreed to a plan to settle the outstanding pension and post-retirement affiliate obligations, net balance with QCII over a 30 year term. Payments will be made on a monthly basis. For the six months ended June 30, 2016, we made a settlement payment of $49 million to QCII on our affiliate obligations, net balance. Changes in the affiliate obligations, net are reflected in operating activities on our consolidated statements of cash flows. For the year ending December 31, 2016, we expect to make a settlement payment of $97 million to QCII on our affiliate obligations, net balance.\\nFor 2016, CenturyLink's estimated annual long-term rate of return is 7.0% for both the pension plan trust assets and post-retirement plans trust assets, based on the assets currently held. However, actual returns could be substantially different.\\nFor additional information, see “Risk Factors—Risks Affecting Our Liquidity and Capital Resources—Adverse changes in the value of assets or obligations associated with CenturyLink’s qualified pension plan could negatively impact CenturyLink’s liquidity, which may in turn affect our business and liquidity” in Item 1A of Part II of this report.\\nConnect America Fund\\nIn 2015, CenturyLink accepted CAF funding from the FCC of approximately $500 million per year for six years to fund the deployment of voice and broadband capable infrastructure for approximately 1.2 million rural households and businesses in 33 states under the CAF Phase 2 support program. Of these amounts, approximately $150 million per year is attributable to our service area, to provide service to approximately 0.3 million rural households and businesses in 13 states. The funding from the CAF Phase 2 support program is expected to substantially supplant the funding we previously received from the interstate USF program that we previously utilized to support voice services in high-cost rural markets in these 13 states. In late 2015, we began receiving these payments from the FCC under the new CAF Phase 2 support program, which included monthly support payments at a higher rate than under the interstate USF support program. We received a substantial one-time cumulative catch-up payment from the FCC in the third quarter of 2015, and, as a result, we do not expect our funding from the CAF Phase 2 support program to materially change our operating revenues for the full year 2016 when compared to the full year 2015.\\n23\\nAs a result of accepting CAF Phase 2 support payments for 13 states, we will be obligated to make substantial capital expenditures to build infrastructure over the next several years. See \\\"Capital Expenditures\\\" above.\\nFor additional information on the FCC's CAF order and the USF program, see \\\"Business—Regulation\\\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015 and see \\\"Risk Factors—Risks Affecting our Liquidity and Capital Resources\\\" in Item 1A of Part II of this report.\\nIn 2013, under the second round of the first phase of the CAF program, CenturyLink received $40 million in funding, $15 million attributed to our service areas, for deployment of broadband services in rural areas. For various reasons, we failed to meet certain broadband deployment requirements by specified deadlines, but we are currently developing alternate solutions, which may satisfy some or all of the requirements. If the FCC does not recognize our alternate deployment plans or grant us an extension of time to fulfill the deployment requirements, we anticipate that we will be requested to refund a substantial portion of the $15 million in funding we received. As of June 30, 2016, we have included approximately $8 million of CAF 1 Round 2 funding in other current liabilities and the remaining approximately $7 million of funding in other noncurrent liabilities on our consolidated balance sheet.\\nFuture Contractual Obligations\\nFor information regarding our estimated future contractual obligations, see the MD&A discussion included in our Annual Report on Form 10-K for the year ended December 31, 2015.\\nHistorical Information\\n| Six Months Ended June 30, | Increase / (Decrease) |\\n| 2016 | 2015 |\\n| (Dollars in millions) |\\n| Cash Flows Provided By (Used In) |\\n| Net cash provided by operating activities | $ | 1,284 | 1,254 | 30 |\\n| Net cash used in investing activities | (569 | ) | (947 | ) | (378 | ) |\\n| Net cash used in financing activities | (714 | ) | (307 | ) | 407 |\\n\\nNet cash provided by operating activities increased by $30 million for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015 primarily due to an increase in net income (which was directly impacted by the cash received from the CAF Phase 2 support program, which was $50 million greater than the cash we received in the first six months of 2015) adjusted for non-cash items, which was partially offset by negative variances in the changes in accounts receivable, accounts payable and affiliate obligations, net. For additional information about our operating results, see \\\"Results of Operations\\\" above.\\nNet cash used in investing activities decreased by $378 million for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015 primarily due to a positive variance in the change in the amount of funds advanced to our affiliates.\\nNet cash used in financing activities increased by $407 million for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015 primarily due to an increase in the amount of dividends paid to our direct parent company. For additional information regarding our financing activities, see Note 2—Long-Term Debt and Revolving Promissory Note to our consolidated financial statements in Item 1 of this report.\\nOn May 2, 2016, QC paid at maturity the $235 million principal amount and accrued and unpaid interest due under its 8.375% Notes.\\nIn January 2016, QC issued $235 million aggregate principal amount of 7% Notes due 2056, in exchange for net proceeds, after deducting underwriting discounts and other expenses, of approximately $227 million. For additional information on the terms of QC's 7% Notes due in 2056, see Note 2—Long-Term Debt and Revolving Promissory Note to our consolidated financial statements in Item 1 of this report.\\n24\\nOther Matters\\nIn February 2015, the FCC adopted new regulations that regulate broadband services as a public utility under Title II of the Communications Act. In light of pending litigation, we believe it is premature for us to determine the ultimate impact of the new regulations on our operations; however, we currently expect that they will negatively impact our operations. For additional information, see “Risk Factors—Risks Relating to Legal and Regulatory Matters” in Item 1A of Part II of this report.\\nCenturyLink and its affiliates are involved in several legal proceedings to which we are not a party that, if resolved against them, could have a material adverse effect on their business and financial condition. As a wholly-owned subsidiary of CenturyLink, our business and financial condition could be similarly affected. You can find descriptions of these legal proceedings in CenturyLink's quarterly and annual reports filed with the Securities and Exchange Commission (\\\"SEC\\\"). Because we are not a party to any of the matters, we have not accrued any liabilities for these matters as of June 30, 2016.\\nMarket Risk\\nWe are exposed to market risk from changes in interest rates on our variable rate long-term debt obligations and revolving promissory note. We seek to maintain a favorable mix of fixed and variable rate debt in an effort to limit interest costs and cash flow volatility resulting from changes in rates.\\nManagement periodically reviews our exposure to interest rate fluctuations and periodically implements strategies to manage the exposure. From time to time, we have used derivative instruments to (i) lock-in or swap our exposure to changing or variable interest rates for fixed interest rates or (ii) to swap obligations to pay fixed interest rates for variable interest rates. As of June 30, 2016, we had no such instruments outstanding. We have established policies and procedures for risk assessment and the approval, reporting and monitoring of derivative instrument activities. We do not hold or issue derivative financial instruments for trading or speculative purposes.\\nWe do not believe that there were any material changes to market risks arising from changes in interest rates for the six months ended June 30, 2016, when compared to the disclosures provided in our Annual Report on Form 10-K for the year ended December 31, 2015.\\nCertain shortcomings are inherent in the method of analysis presented in the computation of exposures to market risks. Actual values may differ materially from those disclosed by us from time to time if market conditions vary from the assumptions used in the analyses performed. These analyses only incorporate the risk exposures that existed at June 30, 2016.\\nOff-Balance Sheet Arrangements\\nWe have no special purpose or limited purpose entities that provide off-balance sheet financing, liquidity, or market or credit risk support and we do not engage in leasing, hedging or other similar activities that expose us to any significant liabilities that are not (i) reflected on the face of the consolidated financial statements, (ii) disclosed in Note 15—Commitments and Contingencies to our consolidated financial statements in Item 8 of Part II of our Annual Report on Form 10-K for the year ended December 31, 2015 or (iii) discussed under the heading \\\"Market Risk\\\" above.\\n25\\nOther Information\\nCenturyLink's and our website is www.centurylink.com. We routinely post important investor information in the \\\"Investor Relations\\\" section of our website at ir.centurylink.com. The information contained on, or that may be accessed through, our website is not part of this quarterly report. You may obtain free electronic copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports in the \\\"Investor Relations\\\" section of our website (ir.centurylink.com) under the heading \\\"SEC Filings.\\\" These reports are available on our website as soon as reasonably practicable after we electronically file them with the SEC.\\nIn addition to historical information, this quarterly report includes certain forward-looking statements that are based upon our judgment and assumptions as of the date of this report concerning future developments and events, many of which are beyond our control. These forward-looking statements, and the assumptions upon which they are based, are not guarantees of future results, are inherently speculative and are subject to a number of risks and uncertainties. Actual events and results may differ materially from those anticipated, estimated, projected or implied by us in those statements if one or more of these risks or uncertainties materialize, or if underlying assumptions prove incorrect. Factors that could affect actual results include but are not limited to: the effects of competition from a wide variety of competitive providers, including lower demand for our legacy offerings; the effects of new, emerging or competing technologies, including those that could make our products less desirable or obsolete; the effects of ongoing changes in the regulation of the communications industry, including the outcome of regulatory or judicial proceedings relating to intercarrier compensation, interconnection obligations, access charges, universal service, broadband deployment, data protection and net neutrality; our ability to effectively adjust to changes in the communications industry, and changes in the composition of our markets and product mix; possible changes in the demand for, or pricing of, our products and services, including our ability to effectively respond to increased demand for high-speed broadband service; our ability to successfully maintain the quality and profitability of our existing product and service offerings and to introduce new offerings on a timely and cost-effective basis; the adverse impact on our business and network from possible equipment failures, service outages, security breaches or similar events impacting our network; our ability to generate cash flows sufficient to fund our financial commitments and objectives, including our capital expenditures, operating costs, dividends, pension contributions and debt payments; changes in our operating plans, corporate strategies, dividend payment plans or other capital allocation plans, whether based upon changes in our cash flows, cash requirements, financial performance, financial position, or otherwise; our ability to effectively retain and hire key personnel and to successfully negotiate collective bargaining agreements on reasonable terms without work stoppages; increases in the costs of CenturyLink's pension, health, post-employment or other benefits, including those caused by changes in markets, interest rates, mortality rates, demographics or regulations, which may in turn affect our business and liquidity; adverse changes in our access to credit markets on favorable terms, whether caused by changes in our financial position, lower debt credit ratings, unstable markets or otherwise; our ability to maintain favorable relations with our key business partners, suppliers, vendors, landlords and financial institutions; our ability to effectively manage our network buildout project and other expansion opportunities; our ability to collect our receivables from financially troubled customers; any adverse developments in legal or regulatory proceedings involving us or our affiliates (including CenturyLink); changes in tax, communications, pension, healthcare or other laws or regulations, in governmental support programs, or in general government funding levels; the effects of changes in accounting policies or practices, including potential future impairment charges; the effects of terrorism, adverse weather or other natural or man-made disasters; the effects of more general factors such as changes in interest rates, in operating costs, in general market, labor, economic or geo-political conditions, or in public policy; and other risks referenced in Item 1A or elsewhere in this Quarterly Report or other of our filings with the SEC. You should be aware that new factors may emerge from time to time and it is not possible for us to identify all such factors nor can we predict the impact of each such factor on the business or the extent to which any one or more factors may cause actual results to differ from those reflected in any forward-looking statements. Given these uncertainties, we caution investors not to unduly rely upon our forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements for any reason, whether as a result of new information, future events or developments, changed circumstances, or otherwise. Furthermore, any information about our intentions contained in any of our forward-looking statements reflects our intentions as of the date of this report, and is based upon, among other things, existing regulatory, technological, industry, competitive, economic and market conditions, and our assumptions as of such date. We may change our intentions, strategies or plans at any time and without notice, based upon any changes in such factors, in our assumptions or otherwise.\\n26\\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nWe have omitted this information pursuant to General Instruction H(2).\\nITEM 4. CONTROLS AND PROCEDURES\\nDisclosure Controls and Procedures\\nThe Company maintains disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”)) designed to provide reasonable assurance that the information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. These include controls and procedures designed to ensure that this information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Management, with the participation of our Chief Executive Officer, Glen F. Post, III, and our Chief Financial Officer, R. Stewart Ewing, Jr., evaluated the effectiveness of the Company’s disclosure controls and procedures as of June 30, 2016. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2016, in providing reasonable assurance that the information required to be disclosed by us in this report was accumulated and communicated in the manner provided above.\\nThe effectiveness of our or any system of disclosure controls and procedures is subject to certain limitations, including the exercise of judgment in designing, implementing and evaluating the controls and procedures, the assumptions used in identifying the likelihood of future events and the inability to eliminate misconduct completely. As a result, there can be no assurance that our disclosure controls and procedures will detect all errors or fraud. By their nature, our or any system of disclosure controls and procedures can provide only reasonable assurance regarding management's control objectives.\\nChanges in Internal Control Over Financial Reporting\\nThere were no changes in our internal control over financial reporting during the second quarter of 2016 that materially affected, or that we believe are reasonably likely to materially affect, our internal control over financial reporting.\\n27\\nPART II—OTHER INFORMATION\\nITEM 1. LEGAL PROCEEDINGS\\nThe information contained in Note 5—Commitments and Contingencies included in Item 1 of Part I of this report is incorporated herein by reference.\\nITEM 1A. RISK FACTORS\\nThe following discussion of “risk factors” identifies the most significant risks or uncertainties that could (i) materially and adversely affect our business, financial condition, results of operations, liquidity or prospects or (ii) cause our actual results to differ materially from our anticipated results or other expectations. You should carefully consider these factors, in addition to the other information set forth in this report and our subsequent filings with the SEC, when evaluating our business and whether to purchase, sell or hold our securities. Please note that the following discussion is not intended to comprehensively list all risks or uncertainties faced by us. Our operations or actual results could also be similarly impacted by additional risks and uncertainties that are not currently known to us, that we currently deem to be immaterial, that arise in the future or that are not specific to us, such as general economic conditions.\\nRisks Affecting Our Business\\nWe may not be able to compete successfully against current or future competitors.\\nEach of our offerings to our residential and business customers face increasingly intense competition from a variety of sources under evolving market conditions. We expect these trends will continue. In addition to competition from larger national telecommunications providers, we are facing increasing competition from several other sources, including cable and satellite companies, wireless providers, technology companies, broadband providers, device providers, resellers, sales agents and facilities-based providers using their own networks as well as those leasing parts of our network. In particular, (i) intense competition from wireless and other communications providers has led to a long-term systemic decline in the number of our customers for wireline voice services, (ii) strong competition from cable companies and others has impacted the growth of our broadband operations and (iii) aggressive competition from a wide range of technology companies and other market entrants has limited the prospects for our cloud computing operations. For more detailed information, see \\\"Competition\\\" under Item 1 of our Annual Report on Form 10-K for the year ended December 31, 2015.\\nSome of our current and potential competitors (i) offer products or services that are substitutes for our wireline voice services, including wireless voice and non-voice communication services, (ii) offer a more comprehensive range of communications products and services, (iii) offer products or services with features that we cannot readily match in some or all of our markets, including faster average broadband transmission speeds and greater content, (iv) offer shorter installation intervals, allowing customers to begin receiving services sooner after ordering, (v) have market presence, engineering and technical capabilities, and financial and other resources greater than ours, (vi) have larger or more diverse networks with greater transmission capacity or other advantages, (vii) conduct operations or raise capital at a lower cost than us, (viii) are subject to less regulation, which we believe enables such competitors to operate more flexibly than us with respect to certain offerings, (ix) offer services nationally or internationally to a larger geographic area or larger base of customers, (x) have substantially stronger brand names, which may provide them with greater pricing power than ours, or (xi) have larger operations than ours, which may enable them to offer higher compensation packages in connection with recruiting and retaining top technological, managerial and operational talent. Consequently, these competitors may be better equipped to provide more attractive offerings, to charge lower prices for their products and services, to develop and expand their communications and network infrastructure more quickly, to adapt more swiftly to new or emerging technologies and changes in customer requirements, to devote greater resources to the marketing and sale of their products and services, to provide more comprehensive customer service, to provide greater resources to research and development initiatives and to take advantage of acquisition or other opportunities more readily. In the past, several of our competitors and their operations have grown through acquisitions and aggressive product development. The continued growth of our competitors could further enhance their competitive positions.\\nCompetition could adversely impact us in several ways, including (i) the loss of customers and market share, (ii) the possibility of customers reducing their usage of our services or shifting to less profitable services, (iii) reduced traffic on our networks, (iv) our need to expend substantial time or money on new capital improvement projects, (v) our need to lower prices or increase marketing expenses to remain competitive and (vi) our inability to diversify by successfully offering new products or services.\\n28\\nWe are continually taking steps to respond to these competitive pressures, but these efforts may not be successful. Our operating results and financial condition would be adversely affected if these initiatives are unsuccessful or insufficient and if we otherwise are unable to sufficiently stem our continuing access line losses and our legacy revenue declines. If this occurred, our ability to pay our debt and other obligations and to re-invest in the business would also be adversely affected.\\nRapid technological changes could significantly impact our competitive and financial position.\\nThe communications industry has been and continues to be impacted by significant technological changes, which in general are enhancing non-voice communications and enabling a broader array of companies to offer services competitive with ours. Many of those technological changes are (i) displacing or reducing demand for our wireline voice services, (ii) enabling the development of competitive products or services, or (iii) enabling our current customers to reduce or bypass use of our networks. Rapid changes in technology are increasing the competitiveness of the information technology services industry. In addition, demand for our broadband services has been constrained by certain technologies permitting cable companies and other competitors to deliver faster average broadband transmission speeds than ours. Demand for our broadband services could be further reduced by advanced wireless data transmission technologies being deployed by wireless providers, including \\\"long-term evolution\\\" or \\\"LTE\\\" technologies, especially if these wireless providers continue to increase their broadband transmission speed and decrease their service rates. To enhance the competitiveness of our broadband services, we may be required to expend additional capital to augment the capabilities of our copper-based services or to install more fiber optic cable.\\nWe may not be able to accurately predict or respond to changes in technology or industry standards, or to the introduction of newly-offered services. Any of these developments could make some or all of our offerings less desirable or even obsolete. These developments could also require us to (i) expend capital or other resources in excess of currently contemplated levels, (ii) forego the development or provision of products or services that others can provide more efficiently, or (iii) make other changes to our operating plans, corporate strategies or capital allocation plans, any of which could be contrary to the expectations of our security holders or could adversely impact our operations. If we are not able to develop new products and services to keep pace with technological advances, or if those products and services are not widely accepted by customers, our ability to compete could be adversely affected and our market share could decline. Any inability to effectively respond to technological changes could also adversely affect our operating results and financial condition, as well as our ability to service debt and fund other commitments or initiatives.\\nEven if we succeed in adapting to changes in technology or industry standards by developing new products or services, there is no assurance that the new products or services would have a positive impact on our profit margins or financial performance.\\nIn addition to introducing new technologies and offerings, we may need, from time to time, to phase out outdated and unprofitable technologies and services. If we are unable to do so, on a cost-effective basis, we could experience reduced profits.\\nFor additional information on the risks of increased expenditures, see \\\"Risk Factors—Risks Affecting our Liquidity and Capital Resources—Our business requires us to incur substantial capital and operating expenses, which reduces our available free cash flow.\\\"\\nOur legacy services continue to experience declining revenues, and our efforts to offset these declines may not be successful.\\nPrimarily as a result of the competitive and technological changes discussed above, we have experienced a prolonged systemic decline in our access lines and network access revenues. We have also experienced a decline in our private line revenues due to our customers' optimization of their networks, industry consolidation, price compression and technological migration to higher-speed services.\\nWe have taken a variety of steps to counter these declines in our legacy services revenues, including:\\n| • | an increased focus on selling a broader range of higher-growth strategic services, which are described in detail elsewhere in this report; |\\n\\n| • | an increased focus on serving a broader range of business, governmental and wholesale customers; and |\\n\\n| • | greater use of service bundles. |\\n\\nHowever, for the reasons described elsewhere in this report, most of our strategic services generate lower profit margins than our legacy services, and some can be expected to experience slowing growth as increasing numbers of our existing or potential customers subscribe to our newer strategic product and service offerings. Moreover, we cannot assure you that the revenues generated from our new offerings will offset revenue losses associated with our legacy services. In addition, our reliance on third parties to provide certain of these strategic services could constrain our flexibility, as described further below.\\n29\\nOur ability to successfully introduce new product or service offerings on a timely and cost-effective basis could be constrained by a range of factors, including network limitations, limited capital, an inability to attract key personnel with the necessary skills, intellectual property constraints, testing delays, or an inability to act as quickly as smaller, more nimble start-up competitors. Similarly, our ability to grow through acquisitions could be limited by several factors, including our leverage and inability to identify attractively-priced target companies. For these reasons, we cannot assure you that our new product or service offerings will be as successful as anticipated, or that we will be able to continue to grow through acquisitions.\\nWe may not be able to successfully adjust to changes in our industry, our markets and our product mix.\\nOngoing changes in the communications industry have fundamentally changed consumers’ communications expectations and requirements. In response to these changes, we have substantially altered our product and service offerings through acquisitions and internal product development. Many of these changes have placed a higher premium on sales, marketing and product development functions, and necessitated ongoing changes in our processes and operating protocols, as well as periodic reorganizations of our sales and leadership teams. In addition, we now offer a more complex range of products and services, operate larger and more complex networks and serve a much larger and more diverse set of customers. Consequently, we now face greater challenges in effectively managing and administering our operations and allocating capital and other resources to our various offerings. For all these reasons, we cannot assure you that our efforts to adjust to these changes will be timely or successful.\\nWe could be harmed by security breaches, damages or other significant disruptions or failures of our networks, information technology infrastructure or related systems, or of those we operate for certain of our customers.\\nWe are materially reliant upon our networks, information technology infrastructure and related technology systems (including our billing and provisioning systems) to provide products and services to our customers and to manage our operations and affairs. We face the risk, as does any company, of a security breach or significant disruption of our information technology infrastructure and related systems. As a communications company that transmits large amounts of sensitive and proprietary information over communications networks, we face an added risk that a security breach or other significant disruption of our public networks or information technology infrastructure and related systems that we develop, install, operate and maintain for certain of our business customers (which includes our wholesale and governmental customers) could lead to material interruptions or curtailments of service. Moreover, in connection with processing and storing confidential customer data, we face a heightened risk that a security breach or disruption could result in unauthorized access to our customers' proprietary information on our public networks or internal systems or the systems that we operate and maintain for certain of our customers.\\nWe make significant efforts to maintain the security and integrity of information and systems under our control, and maintain contingency plans in the event of security breaches or other system disruptions. Nonetheless, we cannot assure you that our security efforts and measures will prevent unauthorized access to our systems, loss or destruction of data (including confidential customer information), account takeovers, unavailability of service, computer viruses, malware, distributed denial-of-service attacks, or other forms of cyber-attacks or similar events. These threats may derive from human error, hardware or software vulnerabilities, fraud, malice or sabotage on the part of employees, third parties or other nations, or could result from aging equipment or other accidental technological failure. These threats may also arise from failure or breaches of systems owned, operated or controlled by other unaffiliated operators to the extent we rely on such other operations to deliver services to our customers.\\nSimilar to other large telecommunications companies, we are a constant target of cyber-attacks of varying degrees. Although some of these attacks have resulted in security breaches, to date, none of these breaches have resulted in a material adverse effect on our operating results or financial condition. You should be aware, however, that defenses against cyber-attacks currently available to U.S. companies are unlikely to prevent intrusions by a highly-determined, highly-sophisticated hacker. Consequently, you should assume that we will be unable to implement security barriers or other preventative measures that repel all future cyber-attacks. Any such future security breaches or disruptions could materially adversely affect our business, results of operations or financial condition, especially in light of the growing frequency, scope and well-documented sophistication of cyber-attacks and intrusions.\\nAlthough CenturyLink maintains insurance coverage that may, subject to policy terms and conditions (including self-insured deductibles, coverage restrictions and monetary coverage caps), cover certain aspects of our cyber risks, such insurance coverage may be unavailable or insufficient to cover our losses.\\nAdditional risks to our network, infrastructure and related systems include:\\n| • | power losses or physical damage, whether caused by fire, adverse weather conditions, terrorism, sabotage, vandalism or otherwise; |\\n\\n30\\n| • | capacity or system configuration limitations, including those resulting from changes in our customer's usage patterns, the introduction of new technologies or products, or incompatibilities between our newer and older systems; |\\n\\n| • | theft or failure of our equipment; |\\n\\n| • | software or hardware obsolescence, defects or malfunctions; |\\n\\n| • | deficiencies in our processes or controls; |\\n\\n| • | programming, processing and other human error; and |\\n\\n| • | service failures of our third-party vendors and other disruptions that are beyond our control. |\\n\\nDue to these factors, from time to time in the ordinary course of our business we experience short disruptions in our service, and could experience more significant disruptions in the future.\\nDisruptions, security breaches and other significant failures of the above-described networks and systems could:\\n| • | disrupt the proper functioning of these networks and systems, which could in turn disrupt (i) our operations or (ii) the operations of certain of our customers who rely upon us to provide services critical to their operations; |\\n\\n| • | require significant management attention or financial resources to remedy the damages that result or to change our systems, including expenses to repair systems, add new personnel or develop additional protective systems; |\\n\\n| • | result in the unauthorized access to, and destruction, loss, theft, misappropriation or release of proprietary, confidential, sensitive, classified or otherwise valuable information of ours, our customers or our customers' end users, including trade secrets, which others could use for competitive, disruptive, destructive or otherwise harmful purposes and outcomes; |\\n\\n| • | require us to notify customers, regulatory agencies or the public of data breaches; |\\n\\n| • | require us to provide credits for future service under certain service level commitments we have provided contractually to our customers or to offer expensive incentives to retain customers; |\\n\\n| • | subject us to claims for damages, fines, penalties, termination or other remedies under our customer contracts or service standards set by state regulatory commissions, which in certain cases could exceed our insurance coverage; or |\\n\\n| • | result in a loss of business, damage our reputation among our customers and the public generally, subject us to additional regulatory scrutiny or expose us to prolonged litigation. |\\n\\nWe could experience difficulties in expanding and updating our technical infrastructure.\\nOur ability to expand and update our systems and information technology infrastructure in response to our growth and changing business needs is important to our ability to maintain and develop attractive product and service offerings. As discussed further under “Business—Network Architecture” in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015, we are currently undertaking several complex, costly and time-consuming projects to simplify and modernize our network, which combines our legacy network and CenturyLink's networks. Unanticipated delays in the completion of these projects may lead to increased project costs or operational inefficiencies. In addition, there may be issues related to our expanded or updated infrastructure that are not identified by our testing processes, and which may only become evident after we have started to fully utilize the redesigned systems. Our failure to modernize and upgrade our technology infrastructure could have adverse consequences, including the delayed implementation of new service offerings, decreased competitiveness of existing service offerings, network instabilities, increased operating or acquisition integration costs, service or billing interruptions, and the diversion of development resources.\\nAny or all of the foregoing developments could have a negative impact on our business, results of operations, financial condition and cash flows.\\n31\\nIf we fail to hire and retain qualified executives, managers and employees, our operating results could be harmed.\\nOur future success depends on our ability to identify, hire, train and retain executives, managers and employees with technological, engineering, product development, operational, provisioning, marketing, sales, administrative and managerial skills. There is a shortage of qualified personnel in several of these fields nationally and in our headquarters city of Monroe, Louisiana, in particular. We compete with several other companies for this limited pool of potential employees. As our industry increasingly becomes more competitive, it could become especially difficult to attract and retain top personnel with skills in high demand. In addition, subject to limited exceptions, none of our executives or domestic employees have long-term employment agreements. For all these reasons, there is no assurance that our efforts to recruit and retain qualified personnel will be successful.\\nIncreases in broadband usage may cause network capacity limitations, resulting in service disruptions, reduced capacity or slower transmission speeds for our customers.\\nVideo streaming services, gaming and peer-to-peer file sharing applications use significantly more bandwidth than other Internet activity such as web browsing and email. As use of these newer services continues to grow, our broadband customers will likely use much more bandwidth than in the past. If this occurs, we could be required to make significant capital expenditures to increase network capacity in order to avoid service disruptions, service degradation or slower transmission speeds for our customers. Alternatively, we could choose to implement network management practices to reduce the network capacity available to bandwidth-intensive activities during certain times in market areas experiencing congestion, which could negatively affect our ability to retain and attract customers in affected markets. While we believe demand for these services may drive broadband customers to pay for faster broadband speeds, competitive or regulatory constraints may preclude us from recovering the costs of the necessary network investments. This could result in an adverse impact to our operating margins, results of operations, financial condition and cash flows.\\nWe have been accused of infringing the intellectual property rights of others and will likely face similar accusations in the future, which could subject us to costly and time-consuming litigation or require us to seek third-party licenses.\\nFrom time to time, we receive notices from third parties or are named in lawsuits filed by third parties claiming we have infringed or are infringing upon their intellectual property rights. We are currently responding to several of these notices and claims. Like other communications companies, we have received an increasing number of these notices and claims in the past several years, and expect this industry-wide trend will continue. Responding to these claims may require us to expend significant time and money defending our use of the applicable technology, and divert management’s time and resources away from other business. In certain instances, we may be required to enter into licensing agreements requiring royalty payments or, in the case of litigation, to pay damages. If we are required to take one or more of these actions, our profit margins may decline. In addition, in responding to these claims, we may be required to stop selling or redesign one or more of our products or services, which could significantly and adversely affect our business, results of operations, financial condition and cash flows.\\nSimilarly, from time to time, we may need to obtain the right to use certain patents or other intellectual property from third parties to be able to offer new products and services. If we cannot license or otherwise obtain rights to use any required technology from a third party on reasonable terms, our ability to offer new products and services may be prohibited, restricted, made more costly or delayed.\\nOur operations, financial performance and liquidity are materially reliant on various third parties.\\nReliance on other communications providers. To offer voice or data services in certain of our markets, we must either lease network capacity from, or interconnect our network with the infrastructure of, other communications companies who typically compete against us in those markets. Our reliance on these lease or interconnection arrangements limits our control over the quality of our services and exposes us to the risk that our ability to market our services could be adversely impacted by changes in the plans or properties of the carriers upon which we are reliant. In addition, we are exposed to the risk that the other carriers may be unwilling to continue or renew these arrangements in the future on terms favorable to us, or at all. This risk is heightened when the other carrier is a competitor of ours and may benefit from terminating the agreement. If we lose these arrangements and cannot timely replace them, our ability to provide services to our customers and conduct our business could be materially adversely affected.\\nConversely, certain of our operations carry a significant amount of voice or data traffic for other communications providers. Their reliance on our services exposes us to the risk that they may transfer all or a portion of this traffic from our network to networks built, owned or leased by them, thereby reducing our revenues. For additional information, see \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations—Business Trends\\\" included in Item 2 of Part I of this report.\\n32\\nWe also rely on reseller and sales agency arrangements with our affiliates and other communications companies to provide some of the services that we offer to our customers, including video services. As a reseller or sales agent, we do not control the availability, retail price, design, function, quality, reliability, customer service or branding of these products and services, nor do we directly control all of the marketing and promotion of these products and services. Similar to the risks described above regarding our reliance upon other carriers, we could be adversely affected if these communication companies fail to maintain competitive products or services, or fail to continue to make them available to us on attractive terms, or at all.\\nOur operations and financial performance could be adversely affected if our relationships with any of these other communications companies are disrupted or terminated for any other reason, including if such other companies:\\n| • | become bankrupt or experience substantial financial difficulties; |\\n\\n| • | suffer work stoppages or other labor strife; |\\n\\n| • | challenge our right to receive payments or services under applicable regulations or the terms of our existing contract arrangements; or |\\n\\n| • | are otherwise unable or unwilling to make payments or provide services to us. |\\n\\nReliance on other key suppliers and vendors. We depend on a limited number of suppliers and vendors for equipment and services relating to our network infrastructure. Our local exchange carrier networks consist of central office and remote sites, all with advanced digital switches. If any of these suppliers experience interruptions or other problems delivering or servicing these network components on a timely basis, our operations could suffer significantly. To the extent that proprietary technology of a supplier is an integral component of our network, we may have limited flexibility to purchase key network components from alternative suppliers and may be adversely affected if third parties assert patent infringement claims against our suppliers or us. We also rely on a limited number of software vendors to support our business management systems and contractors to assist us in connection with our network construction and maintenance activities. In the event it becomes necessary to seek alternative suppliers and vendors, we may be unable to obtain satisfactory replacement supplies, services or utilities on economically attractive terms, on a timely basis, or at all, which could increase costs or cause disruptions in our services.\\nReliance on governmental payments. We receive a material amount of revenue or government subsidies under various government programs, which are further described under the heading \\\"Risk Factors—Risks Relating to Legal and Regulatory Matters.\\\" We also provide products or services to various federal, state and local agencies. Governmental agencies frequently reserve the right to terminate their contracts for convenience, or to suspend or debar companies from receiving future subsidies or contracts under certain circumstances. If our governmental contracts are terminated for any reason, or if we are suspended or debarred from governmental programs or contracts, our results of operations and financial condition could be materially adversely affected.\\nIf we fail to extend or renegotiate our collective bargaining agreements with our labor unions as they expire from time to time, or if our unionized employees were to engage in a strike or other work stoppage, our business and operating results could be materially harmed.\\nAs of June 30, 2016, approximately 49% of our employees were members of various bargaining units represented by the Communications Workers of America or the International Brotherhood of Electrical Workers. From time to time, our labor agreements with unions expire. Although we typically are able to negotiate new bargaining agreements, we cannot predict the outcome of our future negotiations of these agreements. We may be unable to reach new agreements, and union employees may engage in strikes, work slowdowns or other labor actions, which could materially disrupt our ability to provide services and result in increased cost to us. In addition, new labor agreements may impose significant new costs on us, which could impair our financial condition or results of operations in the future. To the extent they contain benefit provisions, these agreements may also limit our flexibility to change benefits in response to industry or competitive changes. In particular, post-employment benefits provided under these agreements could cause us to incur costs not faced by many of our competitors, which could ultimately hinder our competitive position.\\nPortions of our property, plant and equipment are located on property owned by third parties.\\nOver the past few years, certain utilities, cooperatives and municipalities in certain of the states in which we operate have requested significant rate increases for attaching our plant to their facilities. To the extent that these entities are successful in increasing the amount we pay for these attachments, our future operating costs will increase.\\n33\\nIn addition, we rely on rights-of-way, colocation agreements and other authorizations granted by governmental bodies and other third parties to locate our cable, conduit and other network equipment on or under their respective properties. Our operations could be adversely affected if any of these authorizations terminate or lapse, or if the landowner requests price increases.\\nOur business customers may seek to shift risk to us.\\nWe furnish to and receive from our business customers indemnities relating to damages caused or sustained by us in connection with certain of our operations. Our customers’ changing views on risk allocation could cause us to accept greater risk to win new business or could result in us losing business if we are not prepared to take such risks. To the extent that we accept such additional risk, and seek to insure against it, our insurance premiums could rise.\\nUnfavorable general economic conditions could negatively impact our operating results and financial condition.\\nUnfavorable general economic conditions, including unstable economic and credit markets, could negatively affect our business. Worldwide economic growth has been sluggish since 2008, and many experts believe that a confluence of global factors may result in a prolonged period of economic stagnation, slow growth or economic uncertainty. While it is difficult to predict the ultimate impact of these general economic conditions, they could adversely affect demand for some of our products and services and could cause customers to shift to lower priced products and services or to delay or forego purchases of our products and services. These conditions impact, in particular, our ability to sell discretionary products or services to business customers that are under pressure to reduce costs or to governmental customers that have suffered substantial budget cuts in recent years. Any one or more of these circumstances could continue to depress our revenues. Also, our customers may encounter financial hardships or may not be able to obtain adequate access to credit, which could negatively impact their ability to make timely payments to us. In addition, as discussed further below, unstable economic and credit markets may preclude us from refinancing maturing debt at terms that are as favorable as those from which we previously benefited, at terms that are acceptable to us, or at all. For these reasons, among others, if current economic conditions persist or decline, our operating results, financial condition, and liquidity could be adversely affected.\\nFor additional information about our business and operations, see Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\\nRisks Relating to Legal and Regulatory Matters\\nWe operate in a highly regulated industry and are therefore exposed to restrictions on our operations and a variety of claims relating to such regulation.\\nGeneral. We are subject to significant regulation by, among others, (i) the Federal Communications Commission (“FCC”), which regulates interstate communications, (ii) state utility commissions, which regulate intrastate communications, and (iii) various foreign governments and international bodies, which regulate our international operations. Generally, we must obtain and maintain certificates of authority or licenses from these bodies in most territories where we offer regulated services. We cannot assure you that we will be successful in obtaining or retaining all licenses necessary to carry out our business plan, and, even if we are, the prescribed service standards and conditions imposed on us in connection with obtaining or acquiring control of these licenses may impose on us substantial costs and limitations. We are also subject to numerous requirements and interpretations under various international, federal, state and local laws, rules and regulations, which are quite detailed and occasionally in conflict with each other. Accordingly, we cannot ensure that we are always considered to be in compliance with all these requirements at any single point in time. The agencies responsible for the enforcement of these laws, rules and regulations may initiate inquiries or actions based on customer complaints or on their own initiative. Even if we are ultimately found to have complied with applicable regulations, such actions or inquiries could create adverse publicity that negatively impacts our business.\\nRegulation of the telecommunications industry continues to change, and the regulatory environment varies substantially from jurisdiction to jurisdiction. A substantial portion of our local voice services revenue remains subject to FCC and state utility commission pricing regulation, which periodically exposes us to pricing or earnings disputes and could expose us to unanticipated price declines. Interexchange carriers have filed complaints in various forums requesting reductions in our access rates. In addition, several long distance providers are disputing or refusing to pay amounts owed to us for carrying Voice over Internet Protocol (\\\"VoIP\\\") traffic, or traffic they claim to be VoIP traffic. Similarly, some carriers are refusing to pay access charges for certain calls between mobile and wireline devices routed through an interexchange carrier. There can be no assurance that future regulatory, judicial or legislative activities will not have a material adverse effect on our operations, or that regulators or third parties will not raise material issues with regard to our compliance or noncompliance with applicable regulations.\\n34\\nRisks associated with recent changes in regulation. Historically, our financial performance has been substantially impacted by various aspects of federal regulation, including our receipt in the past of significant universal service payments designed to promote rural telephony. In October 2011, the FCC adopted the Connect America and Intercarrier Compensation Reform order (\\\"the 2011 order\\\") intended to comprehensively reform the existing regulatory regime to focus support on networks capable of providing new technologies, including VoIP and other broadband services, and re-direct federal universal service funding to foster nationwide voice and broadband infrastructure. The 2011 order provides for a multi-year transition as intercarrier compensation charges are reduced, federal universal service funding is explicitly targeted to broadband deployment, and subscriber line charges paid by end-user customers are gradually increased. These changes have, among other things, fundamentally altered the manner in which federal subsidies are calculated and disbursed to us (including terminating substantially all of the old universal service payments paid to us under predecessor support programs), and have substantially increased the pace of reductions in the amount of switched access revenues we receive from our wholesale customers. We expect our participation in the FCC's CAF Phase 2 support program will significantly impact our financial results and capital expenditures in the coming years. For more information, see \\\"Regulation\\\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015, and \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations\\\" in Item 2 of Part I of this report.\\nAlthough the primary judicial challenges to the 2011 order have been resolved in the FCC's favor, petitions asking that the FCC reconsider certain aspects of the 2011 order remain pending and, as a result, future judicial challenges on related issues remain possible. Such proceedings could still cause parts of the 2011 order to be altered or delayed. In addition, based on the outcome of the FCC proceedings, various state commissions may consider changes to their rates and support programs. Moreover, FCC proceedings relating to implementation of the order remain pending. For these and other reasons, we cannot predict the ultimate impact of these proceedings at this time.\\nIn addition, during the last few years Congress or the FCC has initiated various other changes, including various broadband and Internet regulation initiatives including “network neutrality” regulations (as discussed further below) and actions that will restrict our ability to discontinue or reduce certain services, even if unprofitable. In second quarter of 2016, the FCC concluded its special access tariff investigation and initiated a Notice of Proposed Rulemaking (\\\"NPRM\\\") to consider changes in Business Data Services (\\\"BDS\\\") regulation. The results of the special access tariff investigation should not have a material impact on us. Several rules changes are being evaluated in the Business Data Services NPRM that may or may not have a material adverse impact on our financial results. The FCC is considering redefining which markets are subject to BDS regulation, broadband speed thresholds that trigger BDS regulation and potential productivity factors that may be limited to specific services or geographies. Given the inextricably intertwined nature of the issues under review in the BDS rulemaking, we will be unable to determine the NPRM’s impact until a final FCC order is issued. The FCC has signaled its desire to issue a BDS order by year end 2016. Any of these recent or pending initiatives could adversely affect our operations or financial results. Moreover, many of the FCC’s regulations adopted in recent years remain subject to judicial review and additional rulemakings, thus increasing the difficulty of determining the ultimate impact of these changes on us and our competitors.\\nCertain states have recently taken steps that could reduce the amount of their universal service support payments to incumbent local exchange companies. If these trends continue, we would suffer a reduction in our revenues from state support programs.\\nRisks of higher costs. Regulations continue to create significant operating and capital costs for us. Challenges to our tariffs by regulators or third parties or delays in obtaining certifications and regulatory approvals could cause us to incur substantial legal and administrative expenses, and, if successful, such challenges could adversely affect the rates that we are able to charge our customers.\\nOur business also may be impacted by legislation and regulation imposing new or greater obligations related to regulations or laws related to regulating broadband services, storing records, bolstering homeland security or cyber security, increasing disaster recovery requirements, minimizing environmental impacts, enhancing privacy, restricting data collection, protecting intellectual property rights of third parties, or addressing other issues that impact our business, including (i) the Communications Assistance for Law Enforcement Act, which requires communications carriers to ensure that their equipment, facilities, and services are able to facilitate authorized electronic surveillance, and (ii) the USA Freedom Act, which requires communication companies to store records of communications of their customers. We expect our compliance costs to increase if future laws or regulations continue to increase our obligations. In addition, increased regulation of our suppliers could increase our costs.\\nIncreased risks of fines. We have recently paid certain regulatory fines associated with network or service outages, particularly with respect to outages impacting the availability of emergency - 911 services. We believe that regulators are now pursuing higher fines than in the past for these types of incidents, and expect this trend to continue.\\n35\\nRisks of reduced flexibility. As a diversified full service incumbent local exchange carrier in most of our key markets, we have traditionally been subject to significant regulation that does not apply to many of our competitors. This regulation in many instances restricts our ability to change rates, to compete and to respond rapidly to changing industry conditions. As our business becomes increasingly competitive, regulatory disparities between us and our competitors could impede our ability to compete.\\nRisks posed by other regulations. All of our operations are also subject to a variety of environmental, safety, health and other governmental regulations. We monitor our compliance with federal, state and local regulations governing the management, discharge and disposal of hazardous and environmentally sensitive materials. Although we believe that we are in compliance with these regulations in all material respects, our management, discharge or disposal of hazardous and environmentally sensitive materials might expose us to claims or actions that could potentially have a material adverse effect on our business, financial condition and operating results.\\nOur participation in the FCC's Connect America Fund (\\\"CAF\\\") Phase 2 support program poses certain risks.\\nOur participation in the CAF Phase 2 support program subjects us to certain financial risks. If we fail to attain certain specified infrastructure buildout requirements, the FCC could withhold future CAF support payments until these shortcomings are rectified. In addition, if we are not in compliance with FCC measures at the end of the six-year CAF Phase 2 period, we will have 12 months to attain full compliance. If we are not in full compliance after the additional 12 months, we would incur a penalty equal to 1.89 times the average amount of support per location received in the state over the six-year term, plus a potential penalty of 10% of the total CAF Phase 2 support over the six-year term for the state. The amount of these penalties could be material. To comply with the FCC's buildout requirements, we believe we will need to dedicate a substantial portion of our future capital expenditure budget to the construction of new infrastructure. The CAF-related expenditures could reduce the amount of funds we are willing or able to allocate to other initiatives or projects.\\n\\\"Open Internet\\\" regulation could limit our ability to operate our broadband business profitably and to manage our broadband facilities efficiently.\\nIn order to continue to provide quality broadband service at attractive prices, we believe we need the continued flexibility to respond to changing consumer demands, to manage bandwidth usage efficiently for the benefit of all customers and to invest in our networks. In 2015, the FCC adopted new regulations that regulate broadband services as a public utility under Title II of the Communications Act. Several companies, including us, have initiated judicial actions challenging the new regulations, which remain pending. The ultimate impact of the new regulations will depend on several factors, including the results of pending litigation and the manner in which the new regulations are implemented and enforced. Although it is premature for us to determine the ultimate impact of the new regulations upon our operations, we currently anticipate that the proposed rules could hamper our ability to operate our data networks efficiently, restrict our ability to implement network management practices necessary to ensure quality service, increase the cost of network extensions and upgrades, and otherwise negatively impact our current operations. It is possible that Congress, the FCC or the courts could take further action in the future to modify regulations affecting the provision of broadband Internet services.\\nWe may be liable for the material that content providers distribute over our network.\\nAlthough we believe our liability for third party information stored on or transmitted through our networks is limited, the liability of private network operators is impacted both by changing technology and evolving legal principles that remain unsettled in many jurisdictions. As a private network provider, we could be exposed to legal claims relating to third party content stored or transmitted on our networks. Such claims could involve, among others, allegations of defamation, invasion of privacy, copyright infringement, or aiding and abetting restricted activities such as online gambling or pornography. If we decide to implement additional measures to reduce our exposure to these risks, or if we are required to defend ourselves against these kinds of claims, our operations and financial results could be negatively affected.\\nAny adverse outcome in any material litigation of CenturyLink or its affiliates could have a material adverse impact on our financial condition and operating results, on the trading price of our debt securities and on our ability to access the capital markets.\\nThere are several material proceedings pending against CenturyLink and its affiliates, as described in Note 8—Commitments and Contingencies in Item 1 of Part I of CenturyLink's Quarterly Report on Form 10-Q for the quarter ended June 30, 2016. Depending on their outcome, any of these matters could have a material adverse effect on our financial position or operating results. We can give you no assurances as to the impact of these matters on our operating results or financial condition.\\n36\\nWe are subject to franchising requirements that could impede our expansion opportunities or result in potential fines or penalties.\\nWe may be required to obtain from municipal authorities operating franchises to install or expand certain facilities related to our fiber transport operations, our competitive local exchange carrier operations, and our facilities-based video services. Some of these franchises may require us to pay franchise fees. Many of our franchise agreements have compliance obligations and failure to comply may result in fines or penalties. In some cases, certain franchise requirements could delay us in expanding our operations or increase the costs of providing these services.\\nWe are exposed to risks arising out of recent legislation affecting U.S. public companies.\\nChanging laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act and the Dodd-Frank Wall Street Reform and Consumer Protection Act, and related regulations implemented thereunder, are increasing our legal and financial compliance costs and making some activities more time consuming. Any failure to successfully or timely complete annual assessments of our internal controls required by Section 404 of the Sarbanes-Oxley Act could subject us to sanctions or investigation by regulatory authorities. Any such action could adversely affect our financial results or our reputation with investors, lenders or others.\\nChanges in any of the above-described laws or regulations may limit our ability to plan, and could subject us to further costs or constraints.\\nFrom time to time, the laws or regulations governing us or our customers, or the government's policy of enforcing those laws or regulations, have changed frequently and materially. The variability of these laws could hamper the ability of us and our customers to plan for the future or establish long-term strategies. Moreover, future changes in these laws or regulations could further increase our operating or compliance costs, or further restrict our operational flexibility, any of which could have a material adverse effect on our results of operations, competitive position, financial condition or prospects.\\nFor a more thorough discussion of the regulatory issues that may affect our business, see \\\"Regulation\\\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\\nRisks Affecting Our Liquidity and Capital Resources\\nCenturyLink's and our high debt levels expose us to a broad range of risks.\\nOur ultimate parent, CenturyLink, and we continue to carry significant debt. As of June 30, 2016, the aggregate principal amount of our consolidated long-term debt excluding unamortized premiums, net, and unamortized debt issuance costs, was approximately $7.357 billion (excluding our note payable - affiliate of $884 million), which was included in CenturyLink's consolidated long-term debt of approximately $19.940 billion as of that date. As of the date of this report, approximately $1.946 billion aggregate principal amount of CenturyLink's consolidated debt securities (excluding capital lease and other obligations), which includes approximately $500 million of our debt securities, is scheduled to mature prior to June 30, 2019. While we currently believe that CenturyLink and we will have the financial resources to meet or refinance our obligations when they come due, we cannot fully anticipate our future performance or financial condition, the future condition of CenturyLink, the credit markets or the economy generally. We may incur unexpected expenses or liabilities, and we may have limited access to financing.\\nOur significant levels of debt can adversely affect us in several other respects, including:\\n| • | limiting our ability to obtain additional financing for working capital, capital expenditures, refinancings or other general corporate purposes, particularly if, as discussed further in the risk factor disclosure below, (i) the ratings assigned to our debt securities by nationally recognized credit rating organizations are revised downward or (ii) we seek capital during periods of turbulent or unsettled market conditions; |\\n\\n| • | requiring us to dedicate a substantial portion of our cash flow from operations to the payment of interest and principal on our debt, thereby reducing the funds available to us for other purposes, including acquisitions, capital expenditures, strategic initiatives, dividends; |\\n\\n| • | hindering our ability to capitalize on business opportunities and to plan for or react to changing market, industry, competitive or economic conditions; |\\n\\n| • | increasing our future borrowing costs; |\\n\\n| • | increasing the risk that third parties will be unwilling or unable to engage in hedging or other financial or commercial arrangements with us; |\\n\\n37\\n| • | making us more vulnerable to economic or industry downturns, including interest rate increases; |\\n\\n| • | placing us at a competitive disadvantage compared to less leveraged competitors; |\\n\\n| • | increasing the risk that we will need to sell assets, possibly on unfavorable terms, or take other unfavorable actions to meet payment obligations; or |\\n\\n| • | increasing the risk that we may not meet the financial covenants contained in our debt agreements or timely make all required debt payments. |\\n\\nThe effects of each of these factors could be intensified if we increase our borrowings.\\nWe expect to periodically require financing to meet our debt obligations as they come due. Due to the unstable economy and credit markets, we may not be able to refinance maturing debt at terms that are as favorable as those from which we previously benefited, at terms that are acceptable to us or at all. See below “Risk Factors—Risks Affecting our Liquidity and Capital Resources—CenturyLink and we plan to access the public debt markets, and we cannot assure you that these markets will remain free of disruptions.”\\nWe may also need to obtain additional financing or capital, or to investigate other methods to generate cash (such as further cost reductions or the sale of assets) under a variety of other circumstances, including if revenues and cash provided by operations decline, if economic conditions weaken, if competitive pressures increase, if regulatory requirements change, if CenturyLink is required to contribute a material amount of cash to its pension plans, if CenturyLink is required to begin to pay other post-retirement benefits significantly earlier than is anticipated, or if CenturyLink becomes subject to significant judgments or settlements in one or more of the matters discussed in Note 5—Commitments and Contingencies to our consolidated financial statements in Item 1 of Part I of this report and Note 8—Commitments and Contingencies to the consolidated financial statements in Item 1 of Part I of CenturyLink's Quarterly Report on Form 10-Q for the quarter ended June 30, 2016. For all the reasons mentioned above, we can give no assurance that additional financing for any of these purposes will be available on terms that are acceptable to us, or at all.\\nCertain of CenturyLink's and our debt instruments have cross payment default or cross acceleration provisions. When present, these provisions could have a wider impact on liquidity than might otherwise arise from a default or acceleration of a single debt instrument. Any such event could adversely affect our ability to conduct business or access the capital markets and could adversely impact our credit ratings. See \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources\\\" in CenturyLink's quarterly and annual reports filed with the SEC for additional information about CenturyLink's indebtedness.\\nIn addition, our ability to borrow funds in the future will depend in part on the satisfaction of the covenants in our term loan and other debt instruments. If we are unable to satisfy the covenants contained in those instruments, or are unable to generate cash sufficient to make required debt payments, the parties to whom we are indebted could accelerate the maturity of some or all of our outstanding indebtedness.\\nAs noted above, if we are unable to make required debt payments or refinance our debt, we would likely have to consider other options, such as selling assets, issuing additional securities, cutting costs or otherwise reducing our cash requirements, or negotiating with our lenders to restructure our applicable debt. The indentures governing our senior notes may restrict, or market or business conditions may limit, our ability to do some of these things on favorable terms, or at all.\\nOur debt agreements and the debt agreements of CenturyLink and its other subsidiaries allow us to incur significantly more debt, which could exacerbate the other risks described in this report.\\nThe terms of our debt instruments and the debt instruments of CenturyLink and its other subsidiaries permit us to incur additional indebtedness. Additional debt may be necessary for many reasons, including those discussed above. Incremental borrowings that impose additional financial risks could exacerbate the other risks described in this report.\\n38\\nAny downgrade in our credit ratings could limit our ability to obtain future financing, increase our borrowing costs and adversely affect the market price of our existing debt securities or otherwise impair our business, financial condition and results of operations.\\nAs noted above in Item 2 of Part I of this report, our long-term debt is currently rated BBB- by Standard and Poor's Ratings Services and BBB- by Fitch Ratings, (i) both of which are the lowest investment grade ratings issued by each of these agencies and (ii) rated Ba1 by Moody's Investors Services, which is a non-investment grade rating. If either Standard and Poor's Rating Services or Fitch Ratings assigned us a non-investment grade, we would no longer be viewed as an \\\"investment grade\\\" issuer and would lose the benefits attendant thereto. Credit rating agencies continually review their ratings for the companies that they follow, including us. Credit rating agencies also evaluate the industries in which we operate as a whole and may change their credit rating for us based on their overall view of such industries. There can be no assurance that any rating assigned to any of these debt securities will remain in effect for any given period of time or that any such ratings will not be lowered, suspended or withdrawn entirely by a rating agency if, in that rating agency's judgment, circumstances so warrant. A downgrade of our credit ratings could adversely affect the market price of some or all of our outstanding debt securities, limit our access to the capital markets or otherwise adversely affect the availability of other new financing on favorable terms, if at all, trigger the application of restrictive covenants in certain of our debt agreements or result in new or more restrictive covenants in agreements governing the terms of any future indebtedness that we may incur, increase our cost of borrowing, and impair our business, financial condition and results of operations.\\nOur business requires us to incur substantial capital and operating expenses, which reduce our available free cash flow.\\nOur business is capital intensive, and we anticipate that our capital requirements will continue to be significant in the coming years. As noted elsewhere in this report, we committed to spend substantial sums to construct infrastructure in connection with our participation in the FCC's CAF Phase 2 program. In addition, as discussed further under \\\"Risk Factors—Risks Affecting Our Business—Increases in broadband usage may cause network capacity limitations, resulting in service disruptions, reduced capacity or slower transmission speeds for our customers,\\\" increased bandwidth consumption by consumers and businesses has placed increased demands on the transmission capacity of our networks. If we determine that our networks must be expanded to handle these increased demands or as needed to meet CAF Phase 2 infrastructure requirements, we may determine that substantial additional capital expenditures are required, even though there is no assurance that the return on our investment will be satisfactory. In addition, many of our growth and modernization initiatives are capital intensive and changes in technology could require further spending. In addition to investing in expanded networks, new products or new technologies, we must from time to time invest capital to (i) replace some of our aging equipment that supports many of our legacy services that are experiencing revenue declines or (ii) convert older systems to simplify and modernize our network. While we believe that our planned level of capital expenditures will meet both our maintenance and core growth requirements, this may not be the case if demands on our network continue to accelerate or other circumstances underlying our expectations change. Increased spending could, among other things, adversely affect our operating margins, cash flows, results of operations and financial position.\\nSimilarly, we continue to anticipate incurring substantial operating expenses to support our incumbent services and growth initiatives. Although we have successfully reduced certain of our operating expenses over the past few years, we may be unable to further reduce these costs, even if revenues in some of our lines of business are decreasing. If so, our operating margins will be adversely impacted.\\nAdverse changes in the value of assets or obligations associated with CenturyLink's qualified pension plan could negatively impact CenturyLink's liquidity, which may in turn affect our business and liquidity.\\nA substantial amount of our employees participate in a qualified pension plan sponsored by CenturyLink that has assumed the obligations under QCII's predecessor pension plan.\\nThe funded status of CenturyLink's qualified pension plan is the difference between the value of the plan's assets and the benefit obligation. The accounting unfunded status of CenturyLink's qualified pension plan was $2.215 billion as of December 31, 2015. Adverse changes in interest rates or market conditions, among other assumptions and factors, could cause a significant increase in CenturyLink's benefit obligation or a significant decrease in the value of the plan's assets. These adverse changes could require CenturyLink to contribute a material amount of cash to its pension plan or could accelerate the timing of required cash payments. The amounts contributed by us through CenturyLink are not segregated or restricted and may be used to provide benefits to employees of CenturyLink's other subsidiaries. Based on current laws and circumstances, CenturyLink does not expect it will be required to make a contribution to its plan in 2016. The actual amount of required contributions to its plan in 2017 and beyond will depend on earnings on plan investments, prevailing interest and discount rates, demographic experience, changes in plan benefits and changes in funding laws and regulations. Any future material cash contributions could have a negative impact on CenturyLink's liquidity by reducing their cash flows, which in turn could affect our liquidity.\\n39\\nCenturyLink and we plan to access the public debt markets, and we cannot assure you that these markets will remain free of disruptions.\\nCenturyLink and we have a significant amount of indebtedness that we both intend to refinance over the next several years, principally we expect through the issuance of debt securities of CenturyLink, us or both. CenturyLink's and our ability to arrange additional financing will depend on, among other factors, the financial position, performance, and credit ratings of CenturyLink and QC, as well as prevailing market conditions and other factors beyond its or our control. Prevailing market conditions could be adversely affected by the ongoing disruptions in domestic or overseas sovereign or corporate debt markets, contractions or limited growth in the economy or other similar adverse economic developments in the U.S. or abroad. Instability in the global financial markets has from time to time resulted in periodic volatility in the capital markets. This volatility could limit CenturyLink's and our access to the credit markets, leading to higher borrowing costs or, in some cases, the inability to obtain financing on terms that are acceptable to it, or at all. Any such failure to obtain additional financing could jeopardize its and our ability to repay, refinance or reduce its or our debt obligations.\\nOther Risks\\nWe regularly transfer our cash to CenturyLink, which exposes us to certain risks.\\nUnder our cash management arrangement with CenturyLink, we regularly transfer our cash to CenturyLink, which we recognize on our consolidated balance sheets as advances to affiliates. Although CenturyLink periodically repays these advances to fund our cash requirements throughout the year, at any given point in time CenturyLink may owe us a substantial sum under this arrangement. Accordingly, developments that adversely impact CenturyLink could adversely impact our ability to collect these advances.\\nIf conditions or assumptions differ from the judgments, assumptions or estimates used in our critical accounting policies, our consolidated financial statements and related disclosures could be materially affected.\\nThe preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles requires management to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes. Our critical accounting policies, which are described in \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates\\\" in Item 7 of Part II of our Annual Report on Form 10-K for the year ended December 31, 2015, describe those significant accounting policies and methods used in the preparation of our consolidated financial statements that are considered \\\"critical\\\" because they require judgments, assumptions and estimates that materially impact our consolidated financial statements and related disclosures. As a result, if future events or assumptions differ significantly from the judgments, assumptions and estimates in our critical accounting policies, these events or assumptions could have a material impact on our consolidated financial statements and related disclosures.\\nLapses in disclosure controls and procedures or internal control over financial reporting could materially and adversely affect our operations, profitability or reputation.\\nThere can be no assurance that our disclosure controls and procedures will be effective in the future or that we will not experience a material weakness or significant deficiency in internal control over financial reporting. Any such lapses or deficiencies may materially and adversely affect our business, operating results or financial condition, restrict our ability to access the capital markets, require us to expend significant resources to correct the lapses or deficiencies, expose us to regulatory or legal proceedings, including litigation brought by private individuals, subject us to fines, penalties or judgments, harm our reputation, or otherwise cause a decline in investor confidence.\\nWe have a significant amount of goodwill, customer relationships and other intangible assets on our consolidated balance sheet. If our goodwill or other intangible assets become impaired, we may be required to record a significant charge to earnings and reduce our stockholders' equity.\\nAs of June 30, 2016, approximately 57% of our total consolidated assets reflected on the consolidated balance sheet included in this report consisted of goodwill, customer relationships and other intangible assets. Under U.S. generally accepted accounting principles, most of these intangible assets must be tested for impairment on an annual basis or more frequently whenever events or circumstances indicate that their carrying value may not be recoverable. From time to time, our affiliates or predecessors have recorded large non-cash charges to earnings in connection with required reductions of the value of their intangible assets. If our intangible assets are determined to be impaired in the future, we may similarly be required to record significant, non-cash charges to earnings during the period in which the impairment is determined to have occurred.\\n40\\nTax audits or changes in tax laws could adversely affect us.\\nFor periods after the April 1, 2011 closing of CenturyLink's acquisition of QCII, we are included in the consolidated federal income tax return of CenturyLink. As such, we could be severally liable for tax examinations and adjustments attributable to other members of the QCII or CenturyLink affiliated groups, as applicable. Significant taxpayers (such as QCII for periods prior to the CenturyLink acquisition and CenturyLink for periods after the CenturyLink acquisition) are subject to frequent and regular audits by the Internal Revenue Service as well as state and local tax authorities. These audits could subject us to tax liabilities if adverse positions are taken by these tax authorities.\\nTax sharing agreements have been executed between QCII and previous affiliates, and QCII believes the liabilities, if any, arising from adjustments to previously filed returns would be borne by the affiliated group member determined to have a deficiency under the terms and conditions of such agreements and applicable tax law. We have not generally provided reserves for liabilities attributable to former affiliated companies or for claims they have asserted or may assert against us.\\nWe believe that we have adequately provided for tax contingencies. However, CenturyLink's or QCII's tax audits and examinations may result in tax liabilities that differ materially from those that we have recognized in our consolidated financial statements. Because the ultimate outcomes of all of these matters are uncertain, we can give no assurance as to whether an adverse result from one or more of them will have a material effect on our financial results.\\nLegislators and regulators at all levels of government may from time to time change existing tax laws or regulations or enact new laws or regulations that could negatively impact our operating results or financial condition.\\nFor information on risk faced by CenturyLink that could weaken its financial position (and thereby indirectly impact us), see the risk factor disclosures set forth in CenturyLink's annual and quarterly reports filed with the SEC.\\n41\\n25\\nOther Information\\nCenturyLink's and our website is www.centurylink.com. We routinely post important investor information in the \\\"Investor Relations\\\" section of our website at ir.centurylink.com. The information contained on, or that may be accessed through, our website is not part of this quarterly report. You may obtain free electronic copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports in the \\\"Investor Relations\\\" section of our website (ir.centurylink.com) under the heading \\\"SEC Filings.\\\" These reports are available on our website as soon as reasonably practicable after we electronically file them with the SEC.\\nIn addition to historical information, this quarterly report includes certain forward-looking statements that are based upon our judgment and assumptions as of the date of this report concerning future developments and events, many of which are beyond our control. These forward-looking statements, and the assumptions upon which they are based, are not guarantees of future results, are inherently speculative and are subject to a number of risks and uncertainties. Actual events and results may differ materially from those anticipated, estimated, projected or implied by us in those statements if one or more of these risks or uncertainties materialize, or if underlying assumptions prove incorrect. Factors that could affect actual results include but are not limited to: the effects of competition from a wide variety of competitive providers, including lower demand for our legacy offerings; the effects of new, emerging or competing technologies, including those that could make our products less desirable or obsolete; the effects of ongoing changes in the regulation of the communications industry, including the outcome of regulatory or judicial proceedings relating to intercarrier compensation, interconnection obligations, access charges, universal service, broadband deployment, data protection and net neutrality; our ability to effectively adjust to changes in the communications industry, and changes in the composition of our markets and product mix; possible changes in the demand for, or pricing of, our products and services, including our ability to effectively respond to increased demand for high-speed broadband service; our ability to successfully maintain the quality and profitability of our existing product and service offerings and to introduce new offerings on a timely and cost-effective basis; the adverse impact on our business and network from possible equipment failures, service outages, security breaches or similar events impacting our network; our ability to generate cash flows sufficient to fund our financial commitments and objectives, including our capital expenditures, operating costs, dividends, pension contributions and debt payments; changes in our operating plans, corporate strategies, dividend payment plans or other capital allocation plans, whether based upon changes in our cash flows, cash requirements, financial performance, financial position, or otherwise; our ability to effectively retain and hire key personnel and to successfully negotiate collective bargaining agreements on reasonable terms without work stoppages; increases in the costs of CenturyLink's pension, health, post-employment or other benefits, including those caused by changes in markets, interest rates, mortality rates, demographics or regulations, which may in turn affect our business and liquidity; adverse changes in our access to credit markets on favorable terms, whether caused by changes in our financial position, lower debt credit ratings, unstable markets or otherwise; our ability to maintain favorable relations with our key business partners, suppliers, vendors, landlords and financial institutions; our ability to effectively manage our network buildout project and other expansion opportunities; our ability to collect our receivables from financially troubled customers; any adverse developments in legal or regulatory proceedings involving us or our affiliates (including CenturyLink); changes in tax, communications, pension, healthcare or other laws or regulations, in governmental support programs, or in general government funding levels; the effects of changes in accounting policies or practices, including potential future impairment charges; the effects of terrorism, adverse weather or other natural or man-made disasters; the effects of more general factors such as changes in interest rates, in operating costs, in general market, labor, economic or geo-political conditions, or in public policy; and other risks referenced in Item 1A or elsewhere in this Quarterly Report or other of our filings with the SEC. You should be aware that new factors may emerge from time to time and it is not possible for us to identify all such factors nor can we predict the impact of each such factor on the business or the extent to which any one or more factors may cause actual results to differ from those reflected in any forward-looking statements. Given these uncertainties, we caution investors not to unduly rely upon our forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements for any reason, whether as a result of new information, future events or developments, changed circumstances, or otherwise. Furthermore, any information about our intentions contained in any of our forward-looking statements reflects our intentions as of the date of this report, and is based upon, among other things, existing regulatory, technological, industry, competitive, economic and market conditions, and our assumptions as of such date. We may change our intentions, strategies or plans at any time and without notice, based upon any changes in such factors, in our assumptions or otherwise.\\n26\\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nWe have omitted this information pursuant to General Instruction H(2).\\nITEM 4. CONTROLS AND PROCEDURES\\nDisclosure Controls and Procedures\\nThe Company maintains disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”)) designed to provide reasonable assurance that the information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. These include controls and procedures designed to ensure that this information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Management, with the participation of our Chief Executive Officer, Glen F. Post, III, and our Chief Financial Officer, R. Stewart Ewing, Jr., evaluated the effectiveness of the Company’s disclosure controls and procedures as of June 30, 2016. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2016, in providing reasonable assurance that the information required to be disclosed by us in this report was accumulated and communicated in the manner provided above.\\nThe effectiveness of our or any system of disclosure controls and procedures is subject to certain limitations, including the exercise of judgment in designing, implementing and evaluating the controls and procedures, the assumptions used in identifying the likelihood of future events and the inability to eliminate misconduct completely. As a result, there can be no assurance that our disclosure controls and procedures will detect all errors or fraud. By their nature, our or any system of disclosure controls and procedures can provide only reasonable assurance regarding management's control objectives.\\nChanges in Internal Control Over Financial Reporting\\nThere were no changes in our internal control over financial reporting during the second quarter of 2016 that materially affected, or that we believe are reasonably likely to materially affect, our internal control over financial reporting.\\n27\\nPART II—OTHER INFORMATION\\nITEM 1. LEGAL PROCEEDINGS\\nThe information contained in Note 5—Commitments and Contingencies included in Item 1 of Part I of this report is incorporated herein by reference.\\nITEM 1A. RISK FACTORS\\nThe following discussion of “risk factors” identifies the most significant risks or uncertainties that could (i) materially and adversely affect our business, financial condition, results of operations, liquidity or prospects or (ii) cause our actual results to differ materially from our anticipated results or other expectations. You should carefully consider these factors, in addition to the other information set forth in this report and our subsequent filings with the SEC, when evaluating our business and whether to purchase, sell or hold our securities. Please note that the following discussion is not intended to comprehensively list all risks or uncertainties faced by us. Our operations or actual results could also be similarly impacted by additional risks and uncertainties that are not currently known to us, that we currently deem to be immaterial, that arise in the future or that are not specific to us, such as general economic conditions.\\nRisks Affecting Our Business\\nWe may not be able to compete successfully against current or future competitors.\\nEach of our offerings to our residential and business customers face increasingly intense competition from a variety of sources under evolving market conditions. We expect these trends will continue. In addition to competition from larger national telecommunications providers, we are facing increasing competition from several other sources, including cable and satellite companies, wireless providers, technology companies, broadband providers, device providers, resellers, sales agents and facilities-based providers using their own networks as well as those leasing parts of our network. In particular, (i) intense competition from wireless and other communications providers has led to a long-term systemic decline in the number of our customers for wireline voice services, (ii) strong competition from cable companies and others has impacted the growth of our broadband operations and (iii) aggressive competition from a wide range of technology companies and other market entrants has limited the prospects for our cloud computing operations. For more detailed information, see \\\"Competition\\\" under Item 1 of our Annual Report on Form 10-K for the year ended December 31, 2015.\\nSome of our current and potential competitors (i) offer products or services that are substitutes for our wireline voice services, including wireless voice and non-voice communication services, (ii) offer a more comprehensive range of communications products and services, (iii) offer products or services with features that we cannot readily match in some or all of our markets, including faster average broadband transmission speeds and greater content, (iv) offer shorter installation intervals, allowing customers to begin receiving services sooner after ordering, (v) have market presence, engineering and technical capabilities, and financial and other resources greater than ours, (vi) have larger or more diverse networks with greater transmission capacity or other advantages, (vii) conduct operations or raise capital at a lower cost than us, (viii) are subject to less regulation, which we believe enables such competitors to operate more flexibly than us with respect to certain offerings, (ix) offer services nationally or internationally to a larger geographic area or larger base of customers, (x) have substantially stronger brand names, which may provide them with greater pricing power than ours, or (xi) have larger operations than ours, which may enable them to offer higher compensation packages in connection with recruiting and retaining top technological, managerial and operational talent. Consequently, these competitors may be better equipped to provide more attractive offerings, to charge lower prices for their products and services, to develop and expand their communications and network infrastructure more quickly, to adapt more swiftly to new or emerging technologies and changes in customer requirements, to devote greater resources to the marketing and sale of their products and services, to provide more comprehensive customer service, to provide greater resources to research and development initiatives and to take advantage of acquisition or other opportunities more readily. In the past, several of our competitors and their operations have grown through acquisitions and aggressive product development. The continued growth of our competitors could further enhance their competitive positions.\\nCompetition could adversely impact us in several ways, including (i) the loss of customers and market share, (ii) the possibility of customers reducing their usage of our services or shifting to less profitable services, (iii) reduced traffic on our networks, (iv) our need to expend substantial time or money on new capital improvement projects, (v) our need to lower prices or increase marketing expenses to remain competitive and (vi) our inability to diversify by successfully offering new products or services.\\n28\\nWe are continually taking steps to respond to these competitive pressures, but these efforts may not be successful. Our operating results and financial condition would be adversely affected if these initiatives are unsuccessful or insufficient and if we otherwise are unable to sufficiently stem our continuing access line losses and our legacy revenue declines. If this occurred, our ability to pay our debt and other obligations and to re-invest in the business would also be adversely affected.\\nRapid technological changes could significantly impact our competitive and financial position.\\nThe communications industry has been and continues to be impacted by significant technological changes, which in general are enhancing non-voice communications and enabling a broader array of companies to offer services competitive with ours. Many of those technological changes are (i) displacing or reducing demand for our wireline voice services, (ii) enabling the development of competitive products or services, or (iii) enabling our current customers to reduce or bypass use of our networks. Rapid changes in technology are increasing the competitiveness of the information technology services industry. In addition, demand for our broadband services has been constrained by certain technologies permitting cable companies and other competitors to deliver faster average broadband transmission speeds than ours. Demand for our broadband services could be further reduced by advanced wireless data transmission technologies being deployed by wireless providers, including \\\"long-term evolution\\\" or \\\"LTE\\\" technologies, especially if these wireless providers continue to increase their broadband transmission speed and decrease their service rates. To enhance the competitiveness of our broadband services, we may be required to expend additional capital to augment the capabilities of our copper-based services or to install more fiber optic cable.\\nWe may not be able to accurately predict or respond to changes in technology or industry standards, or to the introduction of newly-offered services. Any of these developments could make some or all of our offerings less desirable or even obsolete. These developments could also require us to (i) expend capital or other resources in excess of currently contemplated levels, (ii) forego the development or provision of products or services that others can provide more efficiently, or (iii) make other changes to our operating plans, corporate strategies or capital allocation plans, any of which could be contrary to the expectations of our security holders or could adversely impact our operations. If we are not able to develop new products and services to keep pace with technological advances, or if those products and services are not widely accepted by customers, our ability to compete could be adversely affected and our market share could decline. Any inability to effectively respond to technological changes could also adversely affect our operating results and financial condition, as well as our ability to service debt and fund other commitments or initiatives.\\nEven if we succeed in adapting to changes in technology or industry standards by developing new products or services, there is no assurance that the new products or services would have a positive impact on our profit margins or financial performance.\\nIn addition to introducing new technologies and offerings, we may need, from time to time, to phase out outdated and unprofitable technologies and services. If we are unable to do so, on a cost-effective basis, we could experience reduced profits.\\nFor additional information on the risks of increased expenditures, see \\\"Risk Factors—Risks Affecting our Liquidity and Capital Resources—Our business requires us to incur substantial capital and operating expenses, which reduces our available free cash flow.\\\"\\nOur legacy services continue to experience declining revenues, and our efforts to offset these declines may not be successful.\\nPrimarily as a result of the competitive and technological changes discussed above, we have experienced a prolonged systemic decline in our access lines and network access revenues. We have also experienced a decline in our private line revenues due to our customers' optimization of their networks, industry consolidation, price compression and technological migration to higher-speed services.\\nWe have taken a variety of steps to counter these declines in our legacy services revenues, including:\\n| • | an increased focus on selling a broader range of higher-growth strategic services, which are described in detail elsewhere in this report; |\\n\\n| • | an increased focus on serving a broader range of business, governmental and wholesale customers; and |\\n\\n| • | greater use of service bundles. |\\n\\nHowever, for the reasons described elsewhere in this report, most of our strategic services generate lower profit margins than our legacy services, and some can be expected to experience slowing growth as increasing numbers of our existing or potential customers subscribe to our newer strategic product and service offerings. Moreover, we cannot assure you that the revenues generated from our new offerings will offset revenue losses associated with our legacy services. In addition, our reliance on third parties to provide certain of these strategic services could constrain our flexibility, as described further below.\\n29\\nOur ability to successfully introduce new product or service offerings on a timely and cost-effective basis could be constrained by a range of factors, including network limitations, limited capital, an inability to attract key personnel with the necessary skills, intellectual property constraints, testing delays, or an inability to act as quickly as smaller, more nimble start-up competitors. Similarly, our ability to grow through acquisitions could be limited by several factors, including our leverage and inability to identify attractively-priced target companies. For these reasons, we cannot assure you that our new product or service offerings will be as successful as anticipated, or that we will be able to continue to grow through acquisitions.\\nWe may not be able to successfully adjust to changes in our industry, our markets and our product mix.\\nOngoing changes in the communications industry have fundamentally changed consumers’ communications expectations and requirements. In response to these changes, we have substantially altered our product and service offerings through acquisitions and internal product development. Many of these changes have placed a higher premium on sales, marketing and product development functions, and necessitated ongoing changes in our processes and operating protocols, as well as periodic reorganizations of our sales and leadership teams. In addition, we now offer a more complex range of products and services, operate larger and more complex networks and serve a much larger and more diverse set of customers. Consequently, we now face greater challenges in effectively managing and administering our operations and allocating capital and other resources to our various offerings. For all these reasons, we cannot assure you that our efforts to adjust to these changes will be timely or successful.\\nWe could be harmed by security breaches, damages or other significant disruptions or failures of our networks, information technology infrastructure or related systems, or of those we operate for certain of our customers.\\nWe are materially reliant upon our networks, information technology infrastructure and related technology systems (including our billing and provisioning systems) to provide products and services to our customers and to manage our operations and affairs. We face the risk, as does any company, of a security breach or significant disruption of our information technology infrastructure and related systems. As a communications company that transmits large amounts of sensitive and proprietary information over communications networks, we face an added risk that a security breach or other significant disruption of our public networks or information technology infrastructure and related systems that we develop, install, operate and maintain for certain of our business customers (which includes our wholesale and governmental customers) could lead to material interruptions or curtailments of service. Moreover, in connection with processing and storing confidential customer data, we face a heightened risk that a security breach or disruption could result in unauthorized access to our customers' proprietary information on our public networks or internal systems or the systems that we operate and maintain for certain of our customers.\\nWe make significant efforts to maintain the security and integrity of information and systems under our control, and maintain contingency plans in the event of security breaches or other system disruptions. Nonetheless, we cannot assure you that our security efforts and measures will prevent unauthorized access to our systems, loss or destruction of data (including confidential customer information), account takeovers, unavailability of service, computer viruses, malware, distributed denial-of-service attacks, or other forms of cyber-attacks or similar events. These threats may derive from human error, hardware or software vulnerabilities, fraud, malice or sabotage on the part of employees, third parties or other nations, or could result from aging equipment or other accidental technological failure. These threats may also arise from failure or breaches of systems owned, operated or controlled by other unaffiliated operators to the extent we rely on such other operations to deliver services to our customers.\\nSimilar to other large telecommunications companies, we are a constant target of cyber-attacks of varying degrees. Although some of these attacks have resulted in security breaches, to date, none of these breaches have resulted in a material adverse effect on our operating results or financial condition. You should be aware, however, that defenses against cyber-attacks currently available to U.S. companies are unlikely to prevent intrusions by a highly-determined, highly-sophisticated hacker. Consequently, you should assume that we will be unable to implement security barriers or other preventative measures that repel all future cyber-attacks. Any such future security breaches or disruptions could materially adversely affect our business, results of operations or financial condition, especially in light of the growing frequency, scope and well-documented sophistication of cyber-attacks and intrusions.\\nAlthough CenturyLink maintains insurance coverage that may, subject to policy terms and conditions (including self-insured deductibles, coverage restrictions and monetary coverage caps), cover certain aspects of our cyber risks, such insurance coverage may be unavailable or insufficient to cover our losses.\\nAdditional risks to our network, infrastructure and related systems include:\\n| • | power losses or physical damage, whether caused by fire, adverse weather conditions, terrorism, sabotage, vandalism or otherwise; |\\n\\n30\\n| • | capacity or system configuration limitations, including those resulting from changes in our customer's usage patterns, the introduction of new technologies or products, or incompatibilities between our newer and older systems; |\\n\\n| • | theft or failure of our equipment; |\\n\\n| • | software or hardware obsolescence, defects or malfunctions; |\\n\\n| • | deficiencies in our processes or controls; |\\n\\n| • | programming, processing and other human error; and |\\n\\n| • | service failures of our third-party vendors and other disruptions that are beyond our control. |\\n\\nDue to these factors, from time to time in the ordinary course of our business we experience short disruptions in our service, and could experience more significant disruptions in the future.\\nDisruptions, security breaches and other significant failures of the above-described networks and systems could:\\n| • | disrupt the proper functioning of these networks and systems, which could in turn disrupt (i) our operations or (ii) the operations of certain of our customers who rely upon us to provide services critical to their operations; |\\n\\n| • | require significant management attention or financial resources to remedy the damages that result or to change our systems, including expenses to repair systems, add new personnel or develop additional protective systems; |\\n\\n| • | result in the unauthorized access to, and destruction, loss, theft, misappropriation or release of proprietary, confidential, sensitive, classified or otherwise valuable information of ours, our customers or our customers' end users, including trade secrets, which others could use for competitive, disruptive, destructive or otherwise harmful purposes and outcomes; |\\n\\n| • | require us to notify customers, regulatory agencies or the public of data breaches; |\\n\\n| • | require us to provide credits for future service under certain service level commitments we have provided contractually to our customers or to offer expensive incentives to retain customers; |\\n\\n| • | subject us to claims for damages, fines, penalties, termination or other remedies under our customer contracts or service standards set by state regulatory commissions, which in certain cases could exceed our insurance coverage; or |\\n\\n| • | result in a loss of business, damage our reputation among our customers and the public generally, subject us to additional regulatory scrutiny or expose us to prolonged litigation. |\\n\\nWe could experience difficulties in expanding and updating our technical infrastructure.\\nOur ability to expand and update our systems and information technology infrastructure in response to our growth and changing business needs is important to our ability to maintain and develop attractive product and service offerings. As discussed further under “Business—Network Architecture” in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015, we are currently undertaking several complex, costly and time-consuming projects to simplify and modernize our network, which combines our legacy network and CenturyLink's networks. Unanticipated delays in the completion of these projects may lead to increased project costs or operational inefficiencies. In addition, there may be issues related to our expanded or updated infrastructure that are not identified by our testing processes, and which may only become evident after we have started to fully utilize the redesigned systems. Our failure to modernize and upgrade our technology infrastructure could have adverse consequences, including the delayed implementation of new service offerings, decreased competitiveness of existing service offerings, network instabilities, increased operating or acquisition integration costs, service or billing interruptions, and the diversion of development resources.\\nAny or all of the foregoing developments could have a negative impact on our business, results of operations, financial condition and cash flows.\\n31\\nIf we fail to hire and retain qualified executives, managers and employees, our operating results could be harmed.\\nOur future success depends on our ability to identify, hire, train and retain executives, managers and employees with technological, engineering, product development, operational, provisioning, marketing, sales, administrative and managerial skills. There is a shortage of qualified personnel in several of these fields nationally and in our headquarters city of Monroe, Louisiana, in particular. We compete with several other companies for this limited pool of potential employees. As our industry increasingly becomes more competitive, it could become especially difficult to attract and retain top personnel with skills in high demand. In addition, subject to limited exceptions, none of our executives or domestic employees have long-term employment agreements. For all these reasons, there is no assurance that our efforts to recruit and retain qualified personnel will be successful.\\nIncreases in broadband usage may cause network capacity limitations, resulting in service disruptions, reduced capacity or slower transmission speeds for our customers.\\nVideo streaming services, gaming and peer-to-peer file sharing applications use significantly more bandwidth than other Internet activity such as web browsing and email. As use of these newer services continues to grow, our broadband customers will likely use much more bandwidth than in the past. If this occurs, we could be required to make significant capital expenditures to increase network capacity in order to avoid service disruptions, service degradation or slower transmission speeds for our customers. Alternatively, we could choose to implement network management practices to reduce the network capacity available to bandwidth-intensive activities during certain times in market areas experiencing congestion, which could negatively affect our ability to retain and attract customers in affected markets. While we believe demand for these services may drive broadband customers to pay for faster broadband speeds, competitive or regulatory constraints may preclude us from recovering the costs of the necessary network investments. This could result in an adverse impact to our operating margins, results of operations, financial condition and cash flows.\\nWe have been accused of infringing the intellectual property rights of others and will likely face similar accusations in the future, which could subject us to costly and time-consuming litigation or require us to seek third-party licenses.\\nFrom time to time, we receive notices from third parties or are named in lawsuits filed by third parties claiming we have infringed or are infringing upon their intellectual property rights. We are currently responding to several of these notices and claims. Like other communications companies, we have received an increasing number of these notices and claims in the past several years, and expect this industry-wide trend will continue. Responding to these claims may require us to expend significant time and money defending our use of the applicable technology, and divert management’s time and resources away from other business. In certain instances, we may be required to enter into licensing agreements requiring royalty payments or, in the case of litigation, to pay damages. If we are required to take one or more of these actions, our profit margins may decline. In addition, in responding to these claims, we may be required to stop selling or redesign one or more of our products or services, which could significantly and adversely affect our business, results of operations, financial condition and cash flows.\\nSimilarly, from time to time, we may need to obtain the right to use certain patents or other intellectual property from third parties to be able to offer new products and services. If we cannot license or otherwise obtain rights to use any required technology from a third party on reasonable terms, our ability to offer new products and services may be prohibited, restricted, made more costly or delayed.\\nOur operations, financial performance and liquidity are materially reliant on various third parties.\\nReliance on other communications providers. To offer voice or data services in certain of our markets, we must either lease network capacity from, or interconnect our network with the infrastructure of, other communications companies who typically compete against us in those markets. Our reliance on these lease or interconnection arrangements limits our control over the quality of our services and exposes us to the risk that our ability to market our services could be adversely impacted by changes in the plans or properties of the carriers upon which we are reliant. In addition, we are exposed to the risk that the other carriers may be unwilling to continue or renew these arrangements in the future on terms favorable to us, or at all. This risk is heightened when the other carrier is a competitor of ours and may benefit from terminating the agreement. If we lose these arrangements and cannot timely replace them, our ability to provide services to our customers and conduct our business could be materially adversely affected.\\nConversely, certain of our operations carry a significant amount of voice or data traffic for other communications providers. Their reliance on our services exposes us to the risk that they may transfer all or a portion of this traffic from our network to networks built, owned or leased by them, thereby reducing our revenues. For additional information, see \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations—Business Trends\\\" included in Item 2 of Part I of this report.\\n32\\nWe also rely on reseller and sales agency arrangements with our affiliates and other communications companies to provide some of the services that we offer to our customers, including video services. As a reseller or sales agent, we do not control the availability, retail price, design, function, quality, reliability, customer service or branding of these products and services, nor do we directly control all of the marketing and promotion of these products and services. Similar to the risks described above regarding our reliance upon other carriers, we could be adversely affected if these communication companies fail to maintain competitive products or services, or fail to continue to make them available to us on attractive terms, or at all.\\nOur operations and financial performance could be adversely affected if our relationships with any of these other communications companies are disrupted or terminated for any other reason, including if such other companies:\\n| • | become bankrupt or experience substantial financial difficulties; |\\n\\n| • | suffer work stoppages or other labor strife; |\\n\\n| • | challenge our right to receive payments or services under applicable regulations or the terms of our existing contract arrangements; or |\\n\\n| • | are otherwise unable or unwilling to make payments or provide services to us. |\\n\\nReliance on other key suppliers and vendors. We depend on a limited number of suppliers and vendors for equipment and services relating to our network infrastructure. Our local exchange carrier networks consist of central office and remote sites, all with advanced digital switches. If any of these suppliers experience interruptions or other problems delivering or servicing these network components on a timely basis, our operations could suffer significantly. To the extent that proprietary technology of a supplier is an integral component of our network, we may have limited flexibility to purchase key network components from alternative suppliers and may be adversely affected if third parties assert patent infringement claims against our suppliers or us. We also rely on a limited number of software vendors to support our business management systems and contractors to assist us in connection with our network construction and maintenance activities. In the event it becomes necessary to seek alternative suppliers and vendors, we may be unable to obtain satisfactory replacement supplies, services or utilities on economically attractive terms, on a timely basis, or at all, which could increase costs or cause disruptions in our services.\\nReliance on governmental payments. We receive a material amount of revenue or government subsidies under various government programs, which are further described under the heading \\\"Risk Factors—Risks Relating to Legal and Regulatory Matters.\\\" We also provide products or services to various federal, state and local agencies. Governmental agencies frequently reserve the right to terminate their contracts for convenience, or to suspend or debar companies from receiving future subsidies or contracts under certain circumstances. If our governmental contracts are terminated for any reason, or if we are suspended or debarred from governmental programs or contracts, our results of operations and financial condition could be materially adversely affected.\\nIf we fail to extend or renegotiate our collective bargaining agreements with our labor unions as they expire from time to time, or if our unionized employees were to engage in a strike or other work stoppage, our business and operating results could be materially harmed.\\nAs of June 30, 2016, approximately 49% of our employees were members of various bargaining units represented by the Communications Workers of America or the International Brotherhood of Electrical Workers. From time to time, our labor agreements with unions expire. Although we typically are able to negotiate new bargaining agreements, we cannot predict the outcome of our future negotiations of these agreements. We may be unable to reach new agreements, and union employees may engage in strikes, work slowdowns or other labor actions, which could materially disrupt our ability to provide services and result in increased cost to us. In addition, new labor agreements may impose significant new costs on us, which could impair our financial condition or results of operations in the future. To the extent they contain benefit provisions, these agreements may also limit our flexibility to change benefits in response to industry or competitive changes. In particular, post-employment benefits provided under these agreements could cause us to incur costs not faced by many of our competitors, which could ultimately hinder our competitive position.\\nPortions of our property, plant and equipment are located on property owned by third parties.\\nOver the past few years, certain utilities, cooperatives and municipalities in certain of the states in which we operate have requested significant rate increases for attaching our plant to their facilities. To the extent that these entities are successful in increasing the amount we pay for these attachments, our future operating costs will increase.\\n33\\nIn addition, we rely on rights-of-way, colocation agreements and other authorizations granted by governmental bodies and other third parties to locate our cable, conduit and other network equipment on or under their respective properties. Our operations could be adversely affected if any of these authorizations terminate or lapse, or if the landowner requests price increases.\\nOur business customers may seek to shift risk to us.\\nWe furnish to and receive from our business customers indemnities relating to damages caused or sustained by us in connection with certain of our operations. Our customers’ changing views on risk allocation could cause us to accept greater risk to win new business or could result in us losing business if we are not prepared to take such risks. To the extent that we accept such additional risk, and seek to insure against it, our insurance premiums could rise.\\nUnfavorable general economic conditions could negatively impact our operating results and financial condition.\\nUnfavorable general economic conditions, including unstable economic and credit markets, could negatively affect our business. Worldwide economic growth has been sluggish since 2008, and many experts believe that a confluence of global factors may result in a prolonged period of economic stagnation, slow growth or economic uncertainty. While it is difficult to predict the ultimate impact of these general economic conditions, they could adversely affect demand for some of our products and services and could cause customers to shift to lower priced products and services or to delay or forego purchases of our products and services. These conditions impact, in particular, our ability to sell discretionary products or services to business customers that are under pressure to reduce costs or to governmental customers that have suffered substantial budget cuts in recent years. Any one or more of these circumstances could continue to depress our revenues. Also, our customers may encounter financial hardships or may not be able to obtain adequate access to credit, which could negatively impact their ability to make timely payments to us. In addition, as discussed further below, unstable economic and credit markets may preclude us from refinancing maturing debt at terms that are as favorable as those from which we previously benefited, at terms that are acceptable to us, or at all. For these reasons, among others, if current economic conditions persist or decline, our operating results, financial condition, and liquidity could be adversely affected.\\nFor additional information about our business and operations, see Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\\nRisks Relating to Legal and Regulatory Matters\\nWe operate in a highly regulated industry and are therefore exposed to restrictions on our operations and a variety of claims relating to such regulation.\\nGeneral. We are subject to significant regulation by, among others, (i) the Federal Communications Commission (“FCC”), which regulates interstate communications, (ii) state utility commissions, which regulate intrastate communications, and (iii) various foreign governments and international bodies, which regulate our international operations. Generally, we must obtain and maintain certificates of authority or licenses from these bodies in most territories where we offer regulated services. We cannot assure you that we will be successful in obtaining or retaining all licenses necessary to carry out our business plan, and, even if we are, the prescribed service standards and conditions imposed on us in connection with obtaining or acquiring control of these licenses may impose on us substantial costs and limitations. We are also subject to numerous requirements and interpretations under various international, federal, state and local laws, rules and regulations, which are quite detailed and occasionally in conflict with each other. Accordingly, we cannot ensure that we are always considered to be in compliance with all these requirements at any single point in time. The agencies responsible for the enforcement of these laws, rules and regulations may initiate inquiries or actions based on customer complaints or on their own initiative. Even if we are ultimately found to have complied with applicable regulations, such actions or inquiries could create adverse publicity that negatively impacts our business.\\nRegulation of the telecommunications industry continues to change, and the regulatory environment varies substantially from jurisdiction to jurisdiction. A substantial portion of our local voice services revenue remains subject to FCC and state utility commission pricing regulation, which periodically exposes us to pricing or earnings disputes and could expose us to unanticipated price declines. Interexchange carriers have filed complaints in various forums requesting reductions in our access rates. In addition, several long distance providers are disputing or refusing to pay amounts owed to us for carrying Voice over Internet Protocol (\\\"VoIP\\\") traffic, or traffic they claim to be VoIP traffic. Similarly, some carriers are refusing to pay access charges for certain calls between mobile and wireline devices routed through an interexchange carrier. There can be no assurance that future regulatory, judicial or legislative activities will not have a material adverse effect on our operations, or that regulators or third parties will not raise material issues with regard to our compliance or noncompliance with applicable regulations.\\n34\\nRisks associated with recent changes in regulation. Historically, our financial performance has been substantially impacted by various aspects of federal regulation, including our receipt in the past of significant universal service payments designed to promote rural telephony. In October 2011, the FCC adopted the Connect America and Intercarrier Compensation Reform order (\\\"the 2011 order\\\") intended to comprehensively reform the existing regulatory regime to focus support on networks capable of providing new technologies, including VoIP and other broadband services, and re-direct federal universal service funding to foster nationwide voice and broadband infrastructure. The 2011 order provides for a multi-year transition as intercarrier compensation charges are reduced, federal universal service funding is explicitly targeted to broadband deployment, and subscriber line charges paid by end-user customers are gradually increased. These changes have, among other things, fundamentally altered the manner in which federal subsidies are calculated and disbursed to us (including terminating substantially all of the old universal service payments paid to us under predecessor support programs), and have substantially increased the pace of reductions in the amount of switched access revenues we receive from our wholesale customers. We expect our participation in the FCC's CAF Phase 2 support program will significantly impact our financial results and capital expenditures in the coming years. For more information, see \\\"Regulation\\\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015, and \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations\\\" in Item 2 of Part I of this report.\\nAlthough the primary judicial challenges to the 2011 order have been resolved in the FCC's favor, petitions asking that the FCC reconsider certain aspects of the 2011 order remain pending and, as a result, future judicial challenges on related issues remain possible. Such proceedings could still cause parts of the 2011 order to be altered or delayed. In addition, based on the outcome of the FCC proceedings, various state commissions may consider changes to their rates and support programs. Moreover, FCC proceedings relating to implementation of the order remain pending. For these and other reasons, we cannot predict the ultimate impact of these proceedings at this time.\\nIn addition, during the last few years Congress or the FCC has initiated various other changes, including various broadband and Internet regulation initiatives including “network neutrality” regulations (as discussed further below) and actions that will restrict our ability to discontinue or reduce certain services, even if unprofitable. In second quarter of 2016, the FCC concluded its special access tariff investigation and initiated a Notice of Proposed Rulemaking (\\\"NPRM\\\") to consider changes in Business Data Services (\\\"BDS\\\") regulation. The results of the special access tariff investigation should not have a material impact on us. Several rules changes are being evaluated in the Business Data Services NPRM that may or may not have a material adverse impact on our financial results. The FCC is considering redefining which markets are subject to BDS regulation, broadband speed thresholds that trigger BDS regulation and potential productivity factors that may be limited to specific services or geographies. Given the inextricably intertwined nature of the issues under review in the BDS rulemaking, we will be unable to determine the NPRM’s impact until a final FCC order is issued. The FCC has signaled its desire to issue a BDS order by year end 2016. Any of these recent or pending initiatives could adversely affect our operations or financial results. Moreover, many of the FCC’s regulations adopted in recent years remain subject to judicial review and additional rulemakings, thus increasing the difficulty of determining the ultimate impact of these changes on us and our competitors.\\nCertain states have recently taken steps that could reduce the amount of their universal service support payments to incumbent local exchange companies. If these trends continue, we would suffer a reduction in our revenues from state support programs.\\nRisks of higher costs. Regulations continue to create significant operating and capital costs for us. Challenges to our tariffs by regulators or third parties or delays in obtaining certifications and regulatory approvals could cause us to incur substantial legal and administrative expenses, and, if successful, such challenges could adversely affect the rates that we are able to charge our customers.\\nOur business also may be impacted by legislation and regulation imposing new or greater obligations related to regulations or laws related to regulating broadband services, storing records, bolstering homeland security or cyber security, increasing disaster recovery requirements, minimizing environmental impacts, enhancing privacy, restricting data collection, protecting intellectual property rights of third parties, or addressing other issues that impact our business, including (i) the Communications Assistance for Law Enforcement Act, which requires communications carriers to ensure that their equipment, facilities, and services are able to facilitate authorized electronic surveillance, and (ii) the USA Freedom Act, which requires communication companies to store records of communications of their customers. We expect our compliance costs to increase if future laws or regulations continue to increase our obligations. In addition, increased regulation of our suppliers could increase our costs.\\nIncreased risks of fines. We have recently paid certain regulatory fines associated with network or service outages, particularly with respect to outages impacting the availability of emergency - 911 services. We believe that regulators are now pursuing higher fines than in the past for these types of incidents, and expect this trend to continue.\\n35\\nRisks of reduced flexibility. As a diversified full service incumbent local exchange carrier in most of our key markets, we have traditionally been subject to significant regulation that does not apply to many of our competitors. This regulation in many instances restricts our ability to change rates, to compete and to respond rapidly to changing industry conditions. As our business becomes increasingly competitive, regulatory disparities between us and our competitors could impede our ability to compete.\\nRisks posed by other regulations. All of our operations are also subject to a variety of environmental, safety, health and other governmental regulations. We monitor our compliance with federal, state and local regulations governing the management, discharge and disposal of hazardous and environmentally sensitive materials. Although we believe that we are in compliance with these regulations in all material respects, our management, discharge or disposal of hazardous and environmentally sensitive materials might expose us to claims or actions that could potentially have a material adverse effect on our business, financial condition and operating results.\\nOur participation in the FCC's Connect America Fund (\\\"CAF\\\") Phase 2 support program poses certain risks.\\nOur participation in the CAF Phase 2 support program subjects us to certain financial risks. If we fail to attain certain specified infrastructure buildout requirements, the FCC could withhold future CAF support payments until these shortcomings are rectified. In addition, if we are not in compliance with FCC measures at the end of the six-year CAF Phase 2 period, we will have 12 months to attain full compliance. If we are not in full compliance after the additional 12 months, we would incur a penalty equal to 1.89 times the average amount of support per location received in the state over the six-year term, plus a potential penalty of 10% of the total CAF Phase 2 support over the six-year term for the state. The amount of these penalties could be material. To comply with the FCC's buildout requirements, we believe we will need to dedicate a substantial portion of our future capital expenditure budget to the construction of new infrastructure. The CAF-related expenditures could reduce the amount of funds we are willing or able to allocate to other initiatives or projects.\\n\\\"Open Internet\\\" regulation could limit our ability to operate our broadband business profitably and to manage our broadband facilities efficiently.\\nIn order to continue to provide quality broadband service at attractive prices, we believe we need the continued flexibility to respond to changing consumer demands, to manage bandwidth usage efficiently for the benefit of all customers and to invest in our networks. In 2015, the FCC adopted new regulations that regulate broadband services as a public utility under Title II of the Communications Act. Several companies, including us, have initiated judicial actions challenging the new regulations, which remain pending. The ultimate impact of the new regulations will depend on several factors, including the results of pending litigation and the manner in which the new regulations are implemented and enforced. Although it is premature for us to determine the ultimate impact of the new regulations upon our operations, we currently anticipate that the proposed rules could hamper our ability to operate our data networks efficiently, restrict our ability to implement network management practices necessary to ensure quality service, increase the cost of network extensions and upgrades, and otherwise negatively impact our current operations. It is possible that Congress, the FCC or the courts could take further action in the future to modify regulations affecting the provision of broadband Internet services.\\nWe may be liable for the material that content providers distribute over our network.\\nAlthough we believe our liability for third party information stored on or transmitted through our networks is limited, the liability of private network operators is impacted both by changing technology and evolving legal principles that remain unsettled in many jurisdictions. As a private network provider, we could be exposed to legal claims relating to third party content stored or transmitted on our networks. Such claims could involve, among others, allegations of defamation, invasion of privacy, copyright infringement, or aiding and abetting restricted activities such as online gambling or pornography. If we decide to implement additional measures to reduce our exposure to these risks, or if we are required to defend ourselves against these kinds of claims, our operations and financial results could be negatively affected.\\nAny adverse outcome in any material litigation of CenturyLink or its affiliates could have a material adverse impact on our financial condition and operating results, on the trading price of our debt securities and on our ability to access the capital markets.\\nThere are several material proceedings pending against CenturyLink and its affiliates, as described in Note 8—Commitments and Contingencies in Item 1 of Part I of CenturyLink's Quarterly Report on Form 10-Q for the quarter ended June 30, 2016. Depending on their outcome, any of these matters could have a material adverse effect on our financial position or operating results. We can give you no assurances as to the impact of these matters on our operating results or financial condition.\\n36\\nWe are subject to franchising requirements that could impede our expansion opportunities or result in potential fines or penalties.\\nWe may be required to obtain from municipal authorities operating franchises to install or expand certain facilities related to our fiber transport operations, our competitive local exchange carrier operations, and our facilities-based video services. Some of these franchises may require us to pay franchise fees. Many of our franchise agreements have compliance obligations and failure to comply may result in fines or penalties. In some cases, certain franchise requirements could delay us in expanding our operations or increase the costs of providing these services.\\nWe are exposed to risks arising out of recent legislation affecting U.S. public companies.\\nChanging laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act and the Dodd-Frank Wall Street Reform and Consumer Protection Act, and related regulations implemented thereunder, are increasing our legal and financial compliance costs and making some activities more time consuming. Any failure to successfully or timely complete annual assessments of our internal controls required by Section 404 of the Sarbanes-Oxley Act could subject us to sanctions or investigation by regulatory authorities. Any such action could adversely affect our financial results or our reputation with investors, lenders or others.\\nChanges in any of the above-described laws or regulations may limit our ability to plan, and could subject us to further costs or constraints.\\nFrom time to time, the laws or regulations governing us or our customers, or the government's policy of enforcing those laws or regulations, have changed frequently and materially. The variability of these laws could hamper the ability of us and our customers to plan for the future or establish long-term strategies. Moreover, future changes in these laws or regulations could further increase our operating or compliance costs, or further restrict our operational flexibility, any of which could have a material adverse effect on our results of operations, competitive position, financial condition or prospects.\\nFor a more thorough discussion of the regulatory issues that may affect our business, see \\\"Regulation\\\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\\nRisks Affecting Our Liquidity and Capital Resources\\nCenturyLink's and our high debt levels expose us to a broad range of risks.\\nOur ultimate parent, CenturyLink, and we continue to carry significant debt. As of June 30, 2016, the aggregate principal amount of our consolidated long-term debt excluding unamortized premiums, net, and unamortized debt issuance costs, was approximately $7.357 billion (excluding our note payable - affiliate of $884 million), which was included in CenturyLink's consolidated long-term debt of approximately $19.940 billion as of that date. As of the date of this report, approximately $1.946 billion aggregate principal amount of CenturyLink's consolidated debt securities (excluding capital lease and other obligations), which includes approximately $500 million of our debt securities, is scheduled to mature prior to June 30, 2019. While we currently believe that CenturyLink and we will have the financial resources to meet or refinance our obligations when they come due, we cannot fully anticipate our future performance or financial condition, the future condition of CenturyLink, the credit markets or the economy generally. We may incur unexpected expenses or liabilities, and we may have limited access to financing.\\nOur significant levels of debt can adversely affect us in several other respects, including:\\n| • | limiting our ability to obtain additional financing for working capital, capital expenditures, refinancings or other general corporate purposes, particularly if, as discussed further in the risk factor disclosure below, (i) the ratings assigned to our debt securities by nationally recognized credit rating organizations are revised downward or (ii) we seek capital during periods of turbulent or unsettled market conditions; |\\n\\n| • | requiring us to dedicate a substantial portion of our cash flow from operations to the payment of interest and principal on our debt, thereby reducing the funds available to us for other purposes, including acquisitions, capital expenditures, strategic initiatives, dividends; |\\n\\n| • | hindering our ability to capitalize on business opportunities and to plan for or react to changing market, industry, competitive or economic conditions; |\\n\\n| • | increasing our future borrowing costs; |\\n\\n| • | increasing the risk that third parties will be unwilling or unable to engage in hedging or other financial or commercial arrangements with us; |\\n\\n37\\n| • | making us more vulnerable to economic or industry downturns, including interest rate increases; |\\n\\n| • | placing us at a competitive disadvantage compared to less leveraged competitors; |\\n\\n| • | increasing the risk that we will need to sell assets, possibly on unfavorable terms, or take other unfavorable actions to meet payment obligations; or |\\n\\n| • | increasing the risk that we may not meet the financial covenants contained in our debt agreements or timely make all required debt payments. |\\n\\nThe effects of each of these factors could be intensified if we increase our borrowings.\\nWe expect to periodically require financing to meet our debt obligations as they come due. Due to the unstable economy and credit markets, we may not be able to refinance maturing debt at terms that are as favorable as those from which we previously benefited, at terms that are acceptable to us or at all. See below “Risk Factors—Risks Affecting our Liquidity and Capital Resources—CenturyLink and we plan to access the public debt markets, and we cannot assure you that these markets will remain free of disruptions.”\\nWe may also need to obtain additional financing or capital, or to investigate other methods to generate cash (such as further cost reductions or the sale of assets) under a variety of other circumstances, including if revenues and cash provided by operations decline, if economic conditions weaken, if competitive pressures increase, if regulatory requirements change, if CenturyLink is required to contribute a material amount of cash to its pension plans, if CenturyLink is required to begin to pay other post-retirement benefits significantly earlier than is anticipated, or if CenturyLink becomes subject to significant judgments or settlements in one or more of the matters discussed in Note 5—Commitments and Contingencies to our consolidated financial statements in Item 1 of Part I of this report and Note 8—Commitments and Contingencies to the consolidated financial statements in Item 1 of Part I of CenturyLink's Quarterly Report on Form 10-Q for the quarter ended June 30, 2016. For all the reasons mentioned above, we can give no assurance that additional financing for any of these purposes will be available on terms that are acceptable to us, or at all.\\nCertain of CenturyLink's and our debt instruments have cross payment default or cross acceleration provisions. When present, these provisions could have a wider impact on liquidity than might otherwise arise from a default or acceleration of a single debt instrument. Any such event could adversely affect our ability to conduct business or access the capital markets and could adversely impact our credit ratings. See \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources\\\" in CenturyLink's quarterly and annual reports filed with the SEC for additional information about CenturyLink's indebtedness.\\nIn addition, our ability to borrow funds in the future will depend in part on the satisfaction of the covenants in our term loan and other debt instruments. If we are unable to satisfy the covenants contained in those instruments, or are unable to generate cash sufficient to make required debt payments, the parties to whom we are indebted could accelerate the maturity of some or all of our outstanding indebtedness.\\nAs noted above, if we are unable to make required debt payments or refinance our debt, we would likely have to consider other options, such as selling assets, issuing additional securities, cutting costs or otherwise reducing our cash requirements, or negotiating with our lenders to restructure our applicable debt. The indentures governing our senior notes may restrict, or market or business conditions may limit, our ability to do some of these things on favorable terms, or at all.\\nOur debt agreements and the debt agreements of CenturyLink and its other subsidiaries allow us to incur significantly more debt, which could exacerbate the other risks described in this report.\\nThe terms of our debt instruments and the debt instruments of CenturyLink and its other subsidiaries permit us to incur additional indebtedness. Additional debt may be necessary for many reasons, including those discussed above. Incremental borrowings that impose additional financial risks could exacerbate the other risks described in this report.\\n38\\nAny downgrade in our credit ratings could limit our ability to obtain future financing, increase our borrowing costs and adversely affect the market price of our existing debt securities or otherwise impair our business, financial condition and results of operations.\\nAs noted above in Item 2 of Part I of this report, our long-term debt is currently rated BBB- by Standard and Poor's Ratings Services and BBB- by Fitch Ratings, (i) both of which are the lowest investment grade ratings issued by each of these agencies and (ii) rated Ba1 by Moody's Investors Services, which is a non-investment grade rating. If either Standard and Poor's Rating Services or Fitch Ratings assigned us a non-investment grade, we would no longer be viewed as an \\\"investment grade\\\" issuer and would lose the benefits attendant thereto. Credit rating agencies continually review their ratings for the companies that they follow, including us. Credit rating agencies also evaluate the industries in which we operate as a whole and may change their credit rating for us based on their overall view of such industries. There can be no assurance that any rating assigned to any of these debt securities will remain in effect for any given period of time or that any such ratings will not be lowered, suspended or withdrawn entirely by a rating agency if, in that rating agency's judgment, circumstances so warrant. A downgrade of our credit ratings could adversely affect the market price of some or all of our outstanding debt securities, limit our access to the capital markets or otherwise adversely affect the availability of other new financing on favorable terms, if at all, trigger the application of restrictive covenants in certain of our debt agreements or result in new or more restrictive covenants in agreements governing the terms of any future indebtedness that we may incur, increase our cost of borrowing, and impair our business, financial condition and results of operations.\\nOur business requires us to incur substantial capital and operating expenses, which reduce our available free cash flow.\\nOur business is capital intensive, and we anticipate that our capital requirements will continue to be significant in the coming years. As noted elsewhere in this report, we committed to spend substantial sums to construct infrastructure in connection with our participation in the FCC's CAF Phase 2 program. In addition, as discussed further under \\\"Risk Factors—Risks Affecting Our Business—Increases in broadband usage may cause network capacity limitations, resulting in service disruptions, reduced capacity or slower transmission speeds for our customers,\\\" increased bandwidth consumption by consumers and businesses has placed increased demands on the transmission capacity of our networks. If we determine that our networks must be expanded to handle these increased demands or as needed to meet CAF Phase 2 infrastructure requirements, we may determine that substantial additional capital expenditures are required, even though there is no assurance that the return on our investment will be satisfactory. In addition, many of our growth and modernization initiatives are capital intensive and changes in technology could require further spending. In addition to investing in expanded networks, new products or new technologies, we must from time to time invest capital to (i) replace some of our aging equipment that supports many of our legacy services that are experiencing revenue declines or (ii) convert older systems to simplify and modernize our network. While we believe that our planned level of capital expenditures will meet both our maintenance and core growth requirements, this may not be the case if demands on our network continue to accelerate or other circumstances underlying our expectations change. Increased spending could, among other things, adversely affect our operating margins, cash flows, results of operations and financial position.\\nSimilarly, we continue to anticipate incurring substantial operating expenses to support our incumbent services and growth initiatives. Although we have successfully reduced certain of our operating expenses over the past few years, we may be unable to further reduce these costs, even if revenues in some of our lines of business are decreasing. If so, our operating margins will be adversely impacted.\\nAdverse changes in the value of assets or obligations associated with CenturyLink's qualified pension plan could negatively impact CenturyLink's liquidity, which may in turn affect our business and liquidity.\\nA substantial amount of our employees participate in a qualified pension plan sponsored by CenturyLink that has assumed the obligations under QCII's predecessor pension plan.\\nThe funded status of CenturyLink's qualified pension plan is the difference between the value of the plan's assets and the benefit obligation. The accounting unfunded status of CenturyLink's qualified pension plan was $2.215 billion as of December 31, 2015. Adverse changes in interest rates or market conditions, among other assumptions and factors, could cause a significant increase in CenturyLink's benefit obligation or a significant decrease in the value of the plan's assets. These adverse changes could require CenturyLink to contribute a material amount of cash to its pension plan or could accelerate the timing of required cash payments. The amounts contributed by us through CenturyLink are not segregated or restricted and may be used to provide benefits to employees of CenturyLink's other subsidiaries. Based on current laws and circumstances, CenturyLink does not expect it will be required to make a contribution to its plan in 2016. The actual amount of required contributions to its plan in 2017 and beyond will depend on earnings on plan investments, prevailing interest and discount rates, demographic experience, changes in plan benefits and changes in funding laws and regulations. Any future material cash contributions could have a negative impact on CenturyLink's liquidity by reducing their cash flows, which in turn could affect our liquidity.\\n39\\nCenturyLink and we plan to access the public debt markets, and we cannot assure you that these markets will remain free of disruptions.\\nCenturyLink and we have a significant amount of indebtedness that we both intend to refinance over the next several years, principally we expect through the issuance of debt securities of CenturyLink, us or both. CenturyLink's and our ability to arrange additional financing will depend on, among other factors, the financial position, performance, and credit ratings of CenturyLink and QC, as well as prevailing market conditions and other factors beyond its or our control. Prevailing market conditions could be adversely affected by the ongoing disruptions in domestic or overseas sovereign or corporate debt markets, contractions or limited growth in the economy or other similar adverse economic developments in the U.S. or abroad. Instability in the global financial markets has from time to time resulted in periodic volatility in the capital markets. This volatility could limit CenturyLink's and our access to the credit markets, leading to higher borrowing costs or, in some cases, the inability to obtain financing on terms that are acceptable to it, or at all. Any such failure to obtain additional financing could jeopardize its and our ability to repay, refinance or reduce its or our debt obligations.\\nOther Risks\\nWe regularly transfer our cash to CenturyLink, which exposes us to certain risks.\\nUnder our cash management arrangement with CenturyLink, we regularly transfer our cash to CenturyLink, which we recognize on our consolidated balance sheets as advances to affiliates. Although CenturyLink periodically repays these advances to fund our cash requirements throughout the year, at any given point in time CenturyLink may owe us a substantial sum under this arrangement. Accordingly, developments that adversely impact CenturyLink could adversely impact our ability to collect these advances.\\nIf conditions or assumptions differ from the judgments, assumptions or estimates used in our critical accounting policies, our consolidated financial statements and related disclosures could be materially affected.\\nThe preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles requires management to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes. Our critical accounting policies, which are described in \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates\\\" in Item 7 of Part II of our Annual Report on Form 10-K for the year ended December 31, 2015, describe those significant accounting policies and methods used in the preparation of our consolidated financial statements that are considered \\\"critical\\\" because they require judgments, assumptions and estimates that materially impact our consolidated financial statements and related disclosures. As a result, if future events or assumptions differ significantly from the judgments, assumptions and estimates in our critical accounting policies, these events or assumptions could have a material impact on our consolidated financial statements and related disclosures.\\nLapses in disclosure controls and procedures or internal control over financial reporting could materially and adversely affect our operations, profitability or reputation.\\nThere can be no assurance that our disclosure controls and procedures will be effective in the future or that we will not experience a material weakness or significant deficiency in internal control over financial reporting. Any such lapses or deficiencies may materially and adversely affect our business, operating results or financial condition, restrict our ability to access the capital markets, require us to expend significant resources to correct the lapses or deficiencies, expose us to regulatory or legal proceedings, including litigation brought by private individuals, subject us to fines, penalties or judgments, harm our reputation, or otherwise cause a decline in investor confidence.\\nWe have a significant amount of goodwill, customer relationships and other intangible assets on our consolidated balance sheet. If our goodwill or other intangible assets become impaired, we may be required to record a significant charge to earnings and reduce our stockholders' equity.\\nAs of June 30, 2016, approximately 57% of our total consolidated assets reflected on the consolidated balance sheet included in this report consisted of goodwill, customer relationships and other intangible assets. Under U.S. generally accepted accounting principles, most of these intangible assets must be tested for impairment on an annual basis or more frequently whenever events or circumstances indicate that their carrying value may not be recoverable. From time to time, our affiliates or predecessors have recorded large non-cash charges to earnings in connection with required reductions of the value of their intangible assets. If our intangible assets are determined to be impaired in the future, we may similarly be required to record significant, non-cash charges to earnings during the period in which the impairment is determined to have occurred.\\n40\\nTax audits or changes in tax laws could adversely affect us.\\nFor periods after the April 1, 2011 closing of CenturyLink's acquisition of QCII, we are included in the consolidated federal income tax return of CenturyLink. As such, we could be severally liable for tax examinations and adjustments attributable to other members of the QCII or CenturyLink affiliated groups, as applicable. Significant taxpayers (such as QCII for periods prior to the CenturyLink acquisition and CenturyLink for periods after the CenturyLink acquisition) are subject to frequent and regular audits by the Internal Revenue Service as well as state and local tax authorities. These audits could subject us to tax liabilities if adverse positions are taken by these tax authorities.\\nTax sharing agreements have been executed between QCII and previous affiliates, and QCII believes the liabilities, if any, arising from adjustments to previously filed returns would be borne by the affiliated group member determined to have a deficiency under the terms and conditions of such agreements and applicable tax law. We have not generally provided reserves for liabilities attributable to former affiliated companies or for claims they have asserted or may assert against us.\\nWe believe that we have adequately provided for tax contingencies. However, CenturyLink's or QCII's tax audits and examinations may result in tax liabilities that differ materially from those that we have recognized in our consolidated financial statements. Because the ultimate outcomes of all of these matters are uncertain, we can give no assurance as to whether an adverse result from one or more of them will have a material effect on our financial results.\\nLegislators and regulators at all levels of government may from time to time change existing tax laws or regulations or enact new laws or regulations that could negatively impact our operating results or financial condition.\\nFor information on risk faced by CenturyLink that could weaken its financial position (and thereby indirectly impact us), see the risk factor disclosures set forth in CenturyLink's annual and quarterly reports filed with the SEC.\\n41\\nITEM 6. EXHIBITS\\n| ExhibitNumber | Description |\\n| 3.1 | Amended and restated Articles of Incorporation of Qwest Corporation (incorporated by reference to Exhibit 3.1 of Qwest Corporation's Quarterly Report on Form 10-Q for the period ended March 31, 2013 (File No. 001-03040) filed with the Securities and Exchange Commission on May 13, 2013). |\\n| 3.2 | Articles of Amendment to the Articles of Incorporation of Qwest Corporation (incorporated by reference to Exhibit 3.1 of Qwest Corporation's Quarterly Report on Form 10-Q for the period ended June 30, 2000 (File No. 001-03040) filed with the Securities and Exchange Commission on August 11, 2000). |\\n| 3.3 | Amended and Restated Bylaws of Qwest Corporation (incorporated by reference to Exhibit 3.3 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2002 (File No. 001-03040) filed with the Securities and Exchange Commission on January 13, 2004). |\\n| 4.1 | Indenture, dated as of April 15, 1990, by and between The Mountain States Telephone and Telegraph Company (currently named Qwest Corporation) and The First National Bank of Chicago (incorporated by reference to Exhibit 4.2 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2002 (File No. 001-03040) filed with the Securities and Exchange Commission on January 13, 2004). |\\n| a. | First Supplemental Indenture, dated as of April 16, 1991, by and between U S WEST Communications, Inc. (currently named Qwest Corporation) and The First National Bank of Chicago (incorporated by reference to Exhibit 4.3 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2002 (File No. 001-03040) filed with the Securities and Exchange Commission on January 13, 2004). |\\n| 4.2 | Indenture, dated as of April 15, 1990, by and between Northwestern Bell Telephone Company (predecessor to Qwest Corporation) and The First National Bank of Chicago (incorporated by reference to Exhibit 4.5(b) of CenturyLink, Inc.'s Quarterly Report on Form 10-Q for the period ended March 31, 2012 (File No. 001-07784) filed with the Securities and Exchange Commission on May 10, 2012). |\\n| a. | First Supplemental Indenture, dated as of April 16, 1991, by and between U S WEST Communications, Inc. (currently named Qwest Corporation) and The First National Bank of Chicago (incorporated by reference to Exhibit 4.3 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2002 (File No. 001-03040) filed with the Securities and Exchange Commission on January 13, 2004). |\\n| 4.3 | Indenture, dated as of October 15, 1999, by and between U S West Communications, Inc. (currently named Qwest Corporation) and Bank One Trust Company, N.A., as trustee (incorporated by reference to Exhibit 4(b) of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 1999 (File No. 001-03040) filed with the Securities and Exchange Commission on March 3, 2000). |\\n| a. | Fifth Supplemental Indenture, dated as of May 16, 2007, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.1 of Qwest Corporation's Current Report on Form 8-K (File No. 001-03040) filed with the Securities and Exchange Commission on May 18, 2007). |\\n| b. | Seventh Supplemental Indenture, dated as of June 8, 2011, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.8 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on June 7, 2011). |\\n| c. | Eighth Supplemental Indenture, dated as of September 21, 2011, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.9 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on September 20, 2011). |\\n| d. | Ninth Supplemental Indenture, dated as of October 4, 2011, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.1 of Qwest Corporation's Current Report on Form 8-K (File No. 001-03040) filed with the Securities and Exchange Commission on October 4, 2011). |\\n\\n_______________________________________________________________________________\\n| (1) | Certain of the items in Sections 4.1 through 4.3 (j) omit supplemental indentures or other instruments governing debt that has been retired, or (ii) refer to trustees who may have been replaced, acquired or affected by similar changes. In accordance with Item 601(b) (4) (iii) (A) of Regulation S-K, copies of certain instruments defining the rights of holders of certain of our long-term debt are not filed herewith. Pursuant to this registration, we hereby agree to furnish a copy of any such instrument to the SEC upon request. |\\n\\n42\\n| ExhibitNumber | Description |\\n| e | Tenth Supplemental Indenture, dated as of April 2, 2012, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on March 30, 2012). |\\n| f. | Eleventh Supplemental Indenture, dated as of June 25, 2012, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on June 22, 2012). |\\n| g | Twelfth Supplemental Indenture, dated as of May 23, 2013, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.13 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on May 22, 2013). |\\n| h. | Thirteenth Supplemental Indenture, dated as of September 29, 2014, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.14 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on September 26, 2014). |\\n| i. | Fourteenth Supplemental Indenture, dated as of September 21, 2015, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.15 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on September 21, 2015). |\\n| j. | Fifteenth Supplemental Indenture, dated as of January 29, 2016, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.16 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on January 29, 2016). |\\n| 4.4 | Revolving Promissory Note, dated as of April 18, 2012, pursuant to which Qwest Corporation may borrow from an affiliate of CenturyLink, Inc. up to $1.0 billion on a revolving basis (incorporated by reference to Exhibit 4.7(b) of CenturyLink, Inc.'s Quarterly Report on Form 10-Q for the period ended June 30, 2012 (File No 001-07784) filed with the Securities and Exchange Commission on August 9, 2012). |\\n| 4.5 | Credit Agreement, dated as of February 20, 2015, by and among Qwest Corporation, the several lenders from time to time parties thereto, and CoBank, ACB, as administrative agent (incorporated by reference to Exhibit 4.5 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2014 (File No. 001-03040) filed with the Securities and Exchange Commission on February 27, 2015). |\\n| 12* | Calculation of Ratio of Earnings to Fixed Charges. |\\n| 31.1* | Certification of the Chief Executive Officer of CenturyLink, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| 31.2* | Certification of the Chief Financial Officer of CenturyLink, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| 32* | Certification of the Chief Executive Officer and Chief Financial Officer of CenturyLink, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\\n| 101* | Financial statements from the Quarterly Report on Form 10-Q of Qwest Corporation for the period ended June 30, 2016, formatted in XBRL: (i) the Consolidated Statements of Operations, (ii) the Consolidated Statements of Comprehensive Income, (iii) the Consolidated Balance Sheets, (iv) the Consolidated Statements of Cash Flows, (v) the Consolidated Statements of Stockholder's Equity and (vi) the Notes to the Consolidated Financial Statements. |\\n\\n_______________________________________________________________________________\\n| * | Exhibit filed herewith. |\\n\\n43\\nSIGNATURE\\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on August 5, 2016.\\n| QWEST CORPORATION |\\n| By: | /s/ DAVID D. COLE |\\n| David D. ColeExecutive Vice President, Controller and Operations Support (Chief Accounting Officer) |\\n\\n44\\n \\n\\nWhat is the total expected penalty per state if the regulatory company decides to implement penalties due to non-compliance with FCC measures? This includes both the end-of-period penalty and potential additional penalty, assuming the organization received $5000 support per location over the six-year term and a total CAF Phase 2 support of $2,000,000 over the six-year term for the state.\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 209450.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 61,\n \"input_length\": 49317\n}"}}},{"rowIdx":62,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nFINANCIAL STATEMENTS\nDENALI CAPITAL ACQUISITION CORP. UNAUDITED CONDENSED BALANCE SHEET AS OF SEPTEMBER 30, 2022\n\n| ASSETS |\n| Current Assets: |\n| Cash | $ | 985,578 |\n| Prepaid expenses | 132,427 |\n| Total Current Assets | 1,118,005 |\n| Cash and Equivalents held in Trust Account | 84,645,261 |\n| Total Assets | $ | 85,763,266 |\n| LIABILITIES, TEMPORARY EQUITY AND SHAREHOLDERS’DEFICIT |\n| Current Liabilities: |\n| Accounts Payable and accrued expenses | $ | 90,803 |\n| Total Current Liabilities | 90,803 |\n| Deferred Underwriter Compensation | 2,887,500 |\n| Total Liabilities | 2,978,303 |\n| Commitments and contingencies |\n| Class A ordinary shares subject to possible redemption; 8,250,000 shares at $ 10.20 per share | 84,645,261 |\n| Shareholders’ Deficit: |\n| Preference shares $ 0.0001 par value; 1,000,000 shares authorized; none issued and outstanding | — |\n| Class A ordinary shares, $ 0.0001 par value; 200,000,000 shares authorized; 510,000 shares issued and outstanding (excluding 8,250,000 shares subject to possible redemption) | 51 |\n| Class B ordinary shares, $ 0.0001 par value; 20,000,000 shares authorized; 2,062,500 shares issued and outstanding | 206 |\n| Additional paid-in capital | — |\n| Accumulated deficit | ( 1,860,555 | ) |\n| Total Shareholders’ Deficit | ( 1,860,298 | ) |\n| Total Liabilities, Temporary Equity and Shareholders’ Deficit | $ | 85,763,266 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n\n| 2 |\n\nDENALI CAPITAL ACQUISITION CORP. UNAUDITED CONDENSED STATEMENT OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2022 AND FOR THE PERIOD FROM JANUARY 5, 2022 (INCEPTION) THROUGH SEPTEMBER 30, 2022\n\n| Three months ended September 30, 2022 | From January 5, 2022 (inception) through September 30, 2022 |\n| Formation and operating costs | $ | 72,961 | $ | 229,983 |\n| Other (Income)/expenses |\n| Income on Trust Account | ( 380,429 | ) | ( 495,261 | ) |\n| Net Income | $ | ( 307,468 | ) | $ | ( 265,278 | ) |\n| Weighted average shares outstanding of redeemable ordinary shares | 8,250,000 | 5,305,762 |\n| Basic and diluted net income per share, ordinary shares | $ | 0.04 | $ | 0.93 |\n| Weighted average shares outstanding of non-redeemable ordinary shares | 2,572,500 | 2,121,441 |\n| Basic and diluted net (loss) per share, non-redeemable ordinary shares | $ | ( 0.01 | ) | $ | ( 2.20 | ) |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n\n| 3 |\n\nDENALI CAPITAL ACQUISITION CORP. UNAUDITED CONDENSED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY/(DEFICIT) FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2022 AND FOR THE PERIOD FROM JANUARY 5, 2022 (INCEPTION) THROUGH SEPTEMBER 30, 2022\n\n| Class A Ordinary Shares | Class B Ordinary Shares | Additional Paid-in | Accumulated | Total Shareholder’s |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Equity/(Deficit) |\n| Balance as of January 5, 2022 (inception) | — | $ | — | — | $ | — | $ | — | $ | — | $ | — |\n| Issuance of Class B ordinary shares to Sponsor | — | — | 2,156,250 | 216 | 24,784 | — | 25,000 |\n| Net loss | — | — | — | — | — | ( 11,343 | ) | ( 11,343 | ) |\n| Balance as of March 31, 2022 | — | $ | — | 2,156,250 | $ | 216 | $ | 24,784 | $ | ( 11,343 | ) | $ | 13,657 |\n| Proceeds from sale of public units | 7,500,000 | $ | 750 | — | $ | — | $ | 74,999,250 | $ | — | $ | 75,000,000 |\n| Proceeds from sale of public units-over-allotment | 750,000 | 75 | — | — | 7,499,925 | — | 7,500,000 |\n| Proceeds from sale of private placement units | 480,000 | 48 | — | — | 4,799,952 | — | 4,800,000 |\n| Proceeds from sale of private placement units -over-allotment | 30,000 | 3 | — | — | 299,997 | — | 300,000 |\n| Deferred underwriting fees payable @3.5% of gross proceeds | — | — | — | — | ( 2,887,500 | ) | — | ( 2,887,500 | ) |\n| Underwriters Discount @2% of gross proceeds | — | — | — | — | ( 1,650,000 | ) | — | ( 1,650,000 | ) |\n| Other deferred offering costs | — | — | — | — | ( 567,815 | ) | — | ( 567,815 | ) |\n| Reclassification and initial measurement of Class A ordinary shares subject to possible redemption under ASC 480-10-S99 against additional paid-in capital | ( 8,250,000 | ) | ( 825 | ) | — | — | ( 72,525,774 | ) | — | ( 72,526,599 | ) |\n| Allocation of offering costs to Class A ordinary shares subject to possible redemption | — | — | — | — | 4,488,135 | — | 4,488,135 |\n| Remeasurement adjustment on class A ordinary shares subject to possible redemption | — | — | — | — | ( 14,480,964 | ) | ( 1,630,752 | ) | ( 16,111,536 | ) |\n| Forfeiture of Class B ordinary shares | — | — | ( 93,750 | ) | ( 10 | ) | 10 | — | — |\n| Net loss | — | — | — | — | — | ( 30,847 | ) | ( 30,847 | ) |\n| Balance as of June 30, 2022 | 510,000 | $ | 51 | 2,062,500 | $ | 206 | $ | — | $ | ( 1,672,762 | ) | $ | ( 1,672,505 | ) |\n| Subsequent measurement of Class A ordinary shares subject to possible redemption (interest earned on trust account) | — | — | — | — | — | ( 495,261 | ) | ( 495,261 | ) |\n| Net income | — | — | — | — | — | 307,468 | 307,468 |\n| Balance as of September 30, 2022 | 510,000 | $ | 51 | 2,062,500 | $ | 206 | $ | — | $ | ( 1,860,555 | ) | $ | ( 1,860,298 | ) |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n\n| 4 |\n\nDENALI CAPITAL ACQUISITION CORP. UNAUDITED CONDENSED STATEMENT OF CASH FLOWS FOR THE PERIOD FROM JANUARY 5, 2022 (INCEPTION) THROUGH SEPTEMBER 30, 2022\n\n| Cash flows from operating activities: |\n| Net income | $ | 265,278 |\n| Formation costs paid by related party | 11,343 |\n| Income on Trust Account | ( 495,261 | ) |\n| Changes in current assets and liabilities: |\n| Prepaid expenses | ( 132,427 | ) |\n| Accounts payable and accrued expenses | 90,803 |\n| Net cash used in operating activities | ( 260,264 | ) |\n| Cash flows from investing activities: |\n| Investment held in Trust Account | ( 84,150,000 | ) |\n| Net cash used in investing activities | ( 84,150,000 | ) |\n| Cash flows from financing activities: |\n| Proceeds from issuance of promissory note to related party | 80,000 |\n| Payment of promissory note to related party | ( 80,000 | ) |\n| Proceeds from related party | 25,000 |\n| Payment to related party | ( 240,020 | ) |\n| Proceeds from issuance of private placement units, including over-allotment | 5,100,000 |\n| Proceeds from issuance of public units through public offering, including over-allotment | 82,500,000 |\n| Payment of offering costs | ( 339,138 | ) |\n| Payment of deferred underwriter's discount | ( 1,650,000 | ) |\n| Net cash provided by financing activities | 85,395,842 |\n| Net change in cash | 985,578 |\n| Cash at beginning of period | — |\n| Cash at end of period | $ | 985,578 |\n| Supplemental information for non-cash financing activities: |\n| Deferred offering costs paid by Sponsor in exchange for issuance of Class B ordinary shares | $ | 25,000 |\n| Deferred offering costs charged to additional paid-in capital | $ | 567,815 |\n| Deferred offering cost settled through related party | $ | 203,677 |\n| Allocation of offering costs to Class A ordinary shares subject to redemption | $ | 4,488,135 |\n| Reclassification of Class A ordinary shares subject to redemption | $ | 72,526,599 |\n| Remeasurement adjustment on Class A ordinary shares subject to possible redemption | $ | 16,111,536 |\n| Subsequent measurement of Class A ordinary shares subject to possible redemption (interest earned on trust account) | $ | 495,261 |\n| Deferred underwriter's fee charged to additional paid-in capital | $ | 2,887,500 |\n| Forfeiture of Class B ordinary shares | $ | 10 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n\n| 5 |\n\nDENALI CAPITAL ACQUISITION CORP. NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\nNOTE 1 - ORGANIZATION AND BUSINESS OPERATION\nDenali Capital Acquisition Corp. (the “Company”) is a newly organized blank check company incorporated in the Cayman Islands on January 5, 2022 . The Company was formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization, or similar business combination with one or more businesses (a “Business Combination”).\nThe Company is not limited to a particular industry or sector for purposes of consummating a Business Combination. The Company is an early stage emerging growth company and, as such, the Company is subject to all of the risks associated with early stage emerging growth companies.\nAs of September 30, 2022, the Company had not commenced any operations. All activity for the period from January 5, 2022 (inception) through September 30, 2022 relates to the Company’s formation and the initial public offering (“IPO”), which is described below. The Company will not generate any operating revenues until after the completion of an initial Business Combination, at the earliest. The Company will generate non-operating income in the form of interest income from the proceeds derived from the IPO. The Company has selected December 31 as its fiscal year end.\nThe Company’s sponsor is Denali Capital Global Investments LLC, a Cayman Islands limited liability company (the “Sponsor”).\nFinancing\nThe registration statement for the Company’s IPO became effective on April 6, 2022. On April 11, 2022, the Company consummated the IPO of 8,250,000 units (including over-allotment of 750,000 units) (“Public Units”). Each Public Unit consists of one Class A ordinary share, $ 0.0001 par value per share (such shares included in the Public Units, the “Public Shares”), and one redeemable warrant (the “Public Warrants”), each whole Public Warrant entitling the holder thereof to purchase one Public Share at an exercise price of $ 11.50 per share. The Public Units were sold at a price of $ 10.00 per Public Unit, generating gross proceeds of $ 82,500,000 , which is described in Note 3. Simultaneously with the closing of the IPO, the Company consummated the sale of 510,000 units (including over-allotment of 30,000 units) (the “Private Placement Units”) to the Sponsor at a price of $ 10.00 per Private Placement Unit in a private placement generating gross proceeds of $ 5,100,000 , which is described in Note 4. Transaction costs amounted to $ 5,105,315 , consisting of $ 1,650,000 of underwriting fees, $ 2,887,500 of deferred underwriters’ fees and $ 567,815 of other offering costs, and were all initially charged to shareholders’ equity.\nTrust Account\nFollowing the consummation of the IPO on April 11, 2022, a total of $ 84,150,000 of the net proceeds from the IPO, including proceeds from the sale of the Private Placement Units, was deposited in a trust account (the “Trust Account”) and will be invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), with a maturity of 185 days or less, or in any open-ended investment company that holds itself out as a money market fund investing solely in U.S. Treasuries and meeting certain conditions under Rule 2a-7 of the Investment Company Act, as determined by the Company, until the earlier of (i) the completion of a Business Combination or (ii) the distribution of the funds in the Trust Account to the Company’s shareholders, as described below.\nThe Company’s management has broad discretion with respect to the specific application of the net proceeds of the IPO and the sale of the Private Placement Units, although substantially all of the net proceeds are intended to be applied generally toward consummating a Business Combination. The stock exchange listing rules require that the Business Combination must be with one or more operating businesses or assets with a fair market value equal to at least 80 % of the value of the assets held in the Trust Account (excluding any deferred underwriters’ fees and taxes payable on the interest income earned on the Trust Account). The Company will only complete a Business Combination if the post-Business Combination company owns or acquires 50 % or more of the issued and outstanding voting securities of the target or otherwise acquires a controlling interest in the target business sufficient for it not to be required to register as an investment company under the Investment Company Act. There is no assurance that the Company will be able to successfully effect a Business Combination.\n\n| 6 |\n\nBusiness Combination\nThe Company will provide the holders of the outstanding Public Shares (the “Public Shareholders”) with the opportunity to redeem all or a portion of their Public Shares either (i) in connection with a shareholder meeting called to approve the Business Combination or (ii) by means of a tender offer in connection with the Business Combination. The decision as to whether the Company will seek shareholder approval of a Business Combination or conduct a tender offer will be made by the Company. The Public Shareholders will be entitled to redeem their Public Shares for a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account calculated as of two business days prior to the consummation of the initial Business Combination (initially anticipated to be $ 10.20 per Public Unit, plus any pro rata interest then in the Trust Account, net of taxes payable). The Public Shares subject to redemption were recorded at a redemption value and classified as temporary equity upon the completion of the IPO in accordance with the Financial Accounting Standards Board (the “FASB”) Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” The Company will not redeem Public Shares in an amount that would cause its net tangible assets to be less than $ 5,000,001 (so that it does not then become subject to the “penny stock” rules of the Securities and Exchange Commission (the “SEC”)) either prior to or upon consummation of an initial Business Combination. However, a greater net tangible asset or cash requirement may be contained in the agreement relating to the Business Combination. The Company will have only 12 months from the closing of the IPO (or up to 18 months from the closing of the IPO, if the Company extends the period of time to consummate a Business Combination) to complete the initial Business Combination (the “Combination Period”). If the Company is unable to complete the initial Business Combination within the Combination Period, the Company will: (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including interest earned on the funds held in the Trust Account and not previously released to the Company to pay the Company’s franchise and income taxes, if any (less up to $ 100,000 of interest to pay dissolution expenses), divided by the number of then-issued and outstanding Public Shares, which redemption will completely extinguish Public Shareholders’ rights as shareholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the Company’s remaining shareholders and its board of directors, dissolve and liquidate, subject in each case to the Company’s obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law. There will be no redemption rights or liquidating distributions with respect to the Company’s warrants, which will expire worthless if the Company fails to complete the Business Combination within 12 months from the closing of the IPO (or up to 18 months from the closing of the IPO, if the Company extends the period of time to consummate a Business Combination).\nThe founder shares are designated as Class B ordinary shares (the “Founder Shares”) and, except as described below, are identical to the Public Shares, and holders of Founder Shares have the same shareholder rights as Public Shareholders, except that (i) prior to the Company’s initial Business Combination, only holders of the Founder Shares have the right to vote on the appointment of directors, including in connection with the completion of the Company’s initial Business Combination, and holders of a majority of the Founder Shares may remove a member of the board of directors of the Company for any reason, (ii) the Founder Shares are subject to certain transfer restrictions, as described in more detail below, (iii) the Company’s initial shareholders have entered into an agreement with the Company, pursuant to which they have agreed to (A) waive their redemption rights with respect to their Founder Shares and Public Shares in connection with the completion of the Company’s initial Business Combination, (B) waive their redemption rights with respect to their Founder Shares and Public Shares in connection with a shareholder vote to approve an amendment to the Company’s amended and restated memorandum and articles of association that would affect the substance or timing of the Company’s obligation to provide for the redemption of the Company’s Public Shares in connection with an initial Business Combination or to redeem 100 % of the Company’s Public Shares if the Company has not consummated an initial Business Combination within 12 months from the closing of the IPO (or up to 18 months from the closing of the IPO, if the Company extends the period of time to consummate a Business Combination) and (C) waive their rights to liquidating distributions from the Trust Account with respect to their Founder Shares if the Company fails to complete its initial Business Combination within 12 months from the closing of the IPO (or up to 18 months from the closing of the IPO, if the Company extends the period of time to consummate a Business Combination) although they will be entitled to liquidating distributions from the Trust Account with respect to any Public Shares they hold if the Company fails to complete its initial Business Combination within the prescribed time frame, (iv) the Founder Shares will automatically convert into Public Shares concurrently with or immediately following the consummation of the Company’s initial Business Combination, or earlier at the option of the holder thereof, and (v) the Founder Shares are entitled to registration rights. If the Company submits its initial Business Combination to its Public Shareholders for a vote, the Sponsor and each member of the Company’s management team have agreed to vote their Founder Shares and Public Shares in favor of the Company’s initial Business Combination.\n| 7 |\n\nThe Sponsor has agreed that it will be liable to the Company if and to the extent any claims by a third party for services rendered or products sold to the Company, or by a prospective target business with which the Company has discussed entering into a transaction agreement, reduce the amount of funds in the Trust Account to below the lesser of (i) $ 10.20 per Public Share or (ii) the actual amount per Public Share held in the Trust Account as of the date of the liquidation of the Trust Account due to reductions in the value of the trust assets, in each case net of the interest which may be withdrawn to pay taxes. This liability will not apply with respect to any claims by a third party or prospective target business who executed a waiver of any and all rights to seek access to the Trust Account, nor will it apply to any claims under the Company’s indemnity of the underwriters of the IPO against certain liabilities, including liabilities under the Securities Act of 1933, as amended, (the “Securities Act”). Moreover, in the event that an executed waiver is deemed to be unenforceable against a third party, then the Company’s Sponsor will not be responsible to the extent of any liability for such third party claims.\nLiquidity, Capital Resources and Going Concern Consideration\nThe Company’s liquidity needs prior to the consummation of the IPO had been satisfied through a payment from the Sponsor of $ 25,000 (see Note 5) for the Founder Shares and the loan under an unsecured promissory note (the “Promissory Note”) from the Sponsor of up to $ 400,000 (see Note 5) which was fully repaid on December 31, 2021. Subsequent to the consummation of the IPO, the Company’s liquidity has been satisfied through the net proceeds from the consummation of the IPO and the sale of Private Placement Units in a private placement to the Sponsor, held outside of the Trust Account. As of September 30, 2022, the Company had cash of $ 985,578 and working capital of $ 1,027,202 .\nIn addition, in order to finance transaction costs in connection with a Business Combination, the Company’s Sponsor or an affiliate of the Sponsor or certain of the Company’s officers and directors may, but are not obligated to, provide the Company Working Capital Loans, as defined below (see Note 5). As of September 30, 2022, there were no amounts outstanding under any Working Capital Loans.\nBased on the foregoing, management believes that the Company will not have sufficient working capital and borrowing capacity to meet its needs through the earlier of the consummation of a Business Combination or one year from the date of this Quarterly Report. Over this time period, the Company will use funds in the Trust Account to pay existing accounts payable, identify and evaluate prospective initial Business Combination candidates, perform due diligence on prospective target businesses, pay for travel expenditures in connection with the identification and evaluation of prospective target businesses, select the target business with which to effectuate an initial Business Combination, and structure, negotiate and consummate the Business Combination.\nIn connection with the Company’s assessment of going concern considerations in accordance with FASB ASC 205-40, Presentation of Financial Statements – Going Concern, management has determined that the date for mandatory liquidation and dissolution, and the Company’s liquidity situation as discussed above, raises substantial doubt about the Company’s ability to continue as a going concern through April 6, 2023, the scheduled liquidation date of the Company if it does not complete a Business Combination prior to such date.\nRisks and Uncertainties\nIn February 2022, the Russian Federation and Belarus commenced a military action with the country of Ukraine. As a result of this action, various nations, including the United States, have instituted economic sanctions against the Russian Federation and Belarus. Further, the impact of this action and related sanctions on the world economy are not determinable as of the date of these unaudited condensed financial statements. The specific impact on the Company’s financial condition, results of operations, and cash flows is also not determinable as of the date of these unaudited condensed financial statements.\nManagement continues to evaluate the impact of the COVID-19 pandemic and has concluded that while it is reasonably possible that the virus and war could have a negative effect on the Company’s financial position, results of operations and search for a target company, the specific impact is not readily determinable as of the date of these unaudited condensed financial statements. The unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty.\n| 8 |\n\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nBasis of Presentation\nThe accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 8 of Regulation S-X under the Securities Act. Certain information or footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted, pursuant to the rules and regulations of the SEC for interim financial reporting. Accordingly, they do not include all the information and footnotes necessary for a complete presentation of financial position, results of operations, or cash flows. In the opinion of management, the accompanying unaudited condensed financial statements include all adjustments, consisting of a normal recurring nature, which are necessary for a fair presentation of the financial position, operating results and cash flows for the periods presented.\nThe accompanying unaudited condensed financial statements should be read in conjunction with the Company’s prospectus, which contains the initial audited financial statements and notes thereto for the period from January 5, 2022 (inception) to February 7, 2022, as filed with the SEC on March 1, 2022, and the Company’s report on Form 8-K, which contains the Company’s audited balance sheet and notes thereto as of April 11, 2022, as filed with the SEC on April 15, 2022. The interim results for the period from January 5, 2022 (inception) to September 30, 2022 are not necessarily indicative of the results to be expected for the fiscal year ending December 31, 2022 or for any future interim periods.\nEmerging Growth Company Status\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012, (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies, including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies, but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\nUse of Estimates\nThe preparation of the unaudited condensed financial statements in conformity with GAAP requires the Company’s management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the reporting period. Accordingly, the actual results could differ significantly from those estimates.\nCash and Cash Equivalents\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did no t have any cash equivalents on September 30, 2022.\n| 9 |\n\nInvestments Held in Trust Account\nThe Company’s portfolio of investments held in the Trust Account is comprised of investments in money market funds that invest in U.S. government securities and generally have a readily determinable fair value, or a combination thereof. Gains and losses resulting from the change in fair value of these securities and interest earned on investments held in the Trust Account are included in income on Trust Account in the accompanying unaudited condensed statements of operations. The estimated fair values of investments held in the Trust Account are determined using available market information.\nOffering Costs\nOffering costs were $ 5,105,315 consisting principally of underwriting, legal, accounting and other expenses incurred through the balance sheet date that are related to the IPO and were initially charged to shareholders’ equity upon the completion of the IPO. The Company complies with the requirements of FASB ASC 340-10-S99-1 and SEC Staff Accounting Bulletin Topic 5A - “Expenses of Offering.” The Company allocates offering costs between the Public Shares and Public Warrants (as defined below in Note 3) based on the relative fair values of the Public Shares and Public Warrants. Accordingly, $ 4,488,135 was allocated to the Public Shares and charged to temporary equity, and $ 617,180 was allocated to Public Warrants and charged to shareholders’ equity/(deficit).\nFair Value of Financial Instruments\nThe fair value of the Company’s assets and liabilities, which qualify as financial instruments under the FASB ASC 825, “Financial Instruments,” approximates the carrying amounts represented in the balance sheet, primarily due to its short-term nature.\nWarrants\nThe Company accounts for warrants as either equity-classified or liability-classified instruments based on an assessment of the warrant’s specific terms and applicable authoritative guidance in FASB ASC 480, “Distinguishing Liabilities from Equity” (“ASC 480”) and FASB ASC 815. The assessment considers whether the warrants are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and meet all of the requirements for equity classification under FASB ASC 815, including whether the warrants are indexed to the Company’s own ordinary shares and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of the Company’s control, among other conditions for equity classification. This assessment is conducted at the time of warrant issuance and as of each subsequent quarterly period end date while the warrants are outstanding.\nFor issued or modified warrants that meet all of the criteria for equity classification, the warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all of the criteria for equity classification, the warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. The Company accounts for the 8,250,000 Public Warrants (as defined in Note 3) and 510,000 Private Warrants (as defined in Note 4) as equity-classified instruments.\nThe over-allotment liabilities during the period from January 5, 2022 to September 30, 2022 are not material to these financial statements.\nClass A Ordinary Shares Subject to Possible Redemption\nThe Company accounts for its Class A ordinary shares subject to possible redemption in accordance with ASC 480. Class A ordinary shares subject to mandatory redemption (if any) is classified as a liability instrument and measured at fair value. Conditionally redeemable ordinary shares (including shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, ordinary shares are classified as shareholders’ equity. The Company’s ordinary shares feature certain redemption rights that are considered to be outside of the Company’s control and are subject to the occurrence of uncertain future events. Accordingly, as of September 30, 2022, 8,250,000 Class A ordinary shares subject to possible redemption are presented at redemption value as temporary equity, outside of the shareholders’ equity section of the Company’s unaudited condensed balance sheet.\nThe Company recognizes changes in redemption value immediately as they occur and adjusts the carrying value of redeemable ordinary shares to equal the redemption value at the end of each reporting period. Increases or decreases in the carrying amount of redeemable ordinary shares are affected by charges against additional paid-in capital or accumulated deficit if additional paid-in capital equals to zero.\n| 10 |\n\nAs of September 30, 2022, the ordinary shares reflected in the unaudited condensed balance sheet are reconciled in the following table:\n\n| Gross proceeds | $ | 82,500,000 |\n| Less: |\n| Proceeds allocated to Public Warrants | ( 9,973,401 | ) |\n| Allocation of offering costs related to redeemable shares | ( 4,488,135 | ) |\n| Plus: |\n| Initial measurement of carrying value to redemption value | 16,111,536 |\n| Subsequent measurement of Class A ordinary shares subject to possible redemption (interest earned on Trust Account) | 495,261 |\n| Ordinary shares subject to possible redemption | 84,645,261 |\n\nConcentration of Credit Risk\nFinancial instruments that potentially subject the Company to concentrations of credit risk consist of a cash account in a financial institution, which, at times, may exceed the Federal Depository Insurance Coverage of $ 250,000 . The Company has not experienced losses on this account.\nNet Income/(Loss) Per Ordinary Share\nThe Company complies with the accounting and disclosure requirements of FASB ASC 260, “Earnings Per Share.” Net loss per ordinary share is computed by dividing net loss by the weighted average number of ordinary shares outstanding during the period, excluding ordinary shares subject to forfeiture. Weighted average shares were reduced for the effect of an aggregate of 93,750 Founder Shares that were forfeited due to the underwriters’ partial exercise of the over-allotment option. Any remeasurement of the accretion to redemption value of the Class A ordinary shares subject to possible redemption was considered to be dividends paid to the Public Shareholders. Warrants issued are contingently exercisable (i.e., on the later of 30 days after the completion of the initial Business Combination or 12 months from the closing of the IPO). For Earnings Per Share (“EPS”) purposes, the warrants are anti-dilutive since they would generally not be reflected in basic or diluted EPS until the contingency is resolved. As of September 30, 2022, the Company did not have any dilutive securities and other contracts that could, potentially, be exercised or converted into ordinary shares and then share in the earnings of the Company. As a result, diluted income (loss) per ordinary share is the same as basic earnings per ordinary share for the periods presented.\nThe net income (loss) per share presented in the unaudited condensed statements of operations is based on the following:\n\n| Three months ended September 30, 2022 | From January 5, 2022 (inception) through September 30, 2022 |\n| Net income | $ | 307,468 | $ | 265,278 |\n| Interest earned on investment held in Trust Account | ( 380,429 | ) | ( 495,261 | ) |\n| Accretion of temporary equity into redemption value | - | ( 16,111,536 | ) |\n| Net loss including accretion of equity into redemption value | $ | ( 72,961 | ) | $ | ( 16,341,519 | ) |\n\n\n| Three months ended September 30, 2022 | From January 5, 2022 (inception) through September 30, 2022 |\n| Redeemable Shares | Non- Redeemable Shares | Redeemable Shares | Non- Redeemable Shares |\n| Basic and diluted net income/(loss) per share: |\n| Numerators: |\n| Allocation of net loss including accretion of temporary equity | $ | ( 55,618 | ) | $ | ( 17,343 | ) | $ | ( 11,673,872 | ) | $ | ( 4,667,647 | ) |\n| Interest earned on investment held in Trust Account | 380,429 | - | 495,261 | - |\n| Accretion of temporary equity to redemption value | - | - | 16,111,536 | - |\n| Allocation of net income/(loss) | $ | 324,811 | $ | ( 17,343 | ) | $ | 4,932,925 | $ | ( 4,667,647 | ) |\n| Denominators: |\n| Weighted-average shares outstanding | 8,250,000 | 2,572,500 | 5,305,762 | 2,121,441 |\n| Basic and diluted net income/(loss) per share | 0.04 | ( 0.01 | ) | 0.93 | ( 2.20 | ) |\n\n\n| 11 |\n\nIncome Taxes\nThe Company accounts for income taxes under FASB ASC 740, “Income Taxes” (“ASC 740”). ASC 740 requires the recognition of deferred tax assets and liabilities for both the expected impact of differences between the financial statement and tax basis of assets and liabilities and for the expected future tax benefit to be derived from tax loss and tax credit carry forwards. ASC 740 additionally requires a valuation allowance to be established when it is more likely than not that all or a portion of deferred tax assets will not be realized.\nASC 740 also clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statement and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. ASC 740 also provides guidance on derecognition, classification, interest and penalties, accounting in interim period, disclosure and transition.\nThe Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of September 30, 2022. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position.\nThe Company determined that the Cayman Islands is the Company’s only major tax jurisdiction.\nThe Company may be subject to potential examination by federal and state taxing authorities in the areas of income taxes. These potential examinations may include questioning the timing and amount of deductions, the nexus of income among various tax jurisdictions and compliance with federal and state tax laws. The Company’s management does not expect that the total amount of unrecognized tax benefits will materially change over the next 12 months.\nThere is currently no taxation imposed on income by the Government of the Cayman Islands for the period from January 5, 2022 (inception) through September 30, 2022.\nRecent Accounting Pronouncements\nManagement does not believe that any recently issued, but not effective, accounting standards, if currently adopted, would have a material effect on the Company’s unaudited condensed financial statements.\nNOTE 3 - INITIAL PUBLIC OFFERING\nOn April 11, 2022, the Company sold 8,250,000 Public Units at a purchase price of $ 10.00 per Public Unit, generating gross proceeds of $ 82,500,000 (including 750,000 Public Units pursuant to the underwriters’ partial exercise of the over-allotment option) related to the IPO. Each Public Unit consists of one Public Share and one Public Warrant. Each Public Warrant entitles the holder thereof to purchase one Public Share at a price of $ 11.50 per share, and only whole warrants are exercisable.\nThe warrants will become exercisable on the later of 30 days after the completion of the Company’s initial Business Combination or 12 months from the closing of the IPO and will expire five years after the completion of the Company’s initial Business Combination or earlier upon redemption or liquidation (see Note 7).\n| 12 |\n\nNOTE 4 - PRIVATE PLACEMENT\nSimultaneously with the closing of the IPO, the Sponsor purchased an aggregate of 510,000 Private Placement Units (including 30,000 Private Placement Units pursuant to the underwriters’ partial exercise of the over-allotment option) at a price of $ 10.00 per Private Placement Unit, for an aggregate purchase price of $ 5,100,000 , in a private placement. Each whole Private Placement Unit consists of one Class A ordinary share (“Private Placement Shares”) and one warrant (“Private Warrants”). Each Private Warrant entitles the holder to purchase one Class A ordinary share at a price of $ 11.50 per share, subject to adjustment. Certain of the proceeds from the sale of the Private Placement Units were added to the net proceeds from the IPO held in the Trust Account.\nIf the Company does not complete a Business Combination within 12 months from the closing of the IPO (or up to 18 months from the closing of the IPO, if the Company extends the period of time to consummate a Business Combination), the proceeds from the sale of the Private Placement Units held in the Trust Account will be used to fund the redemption of the Company’s Class A ordinary shares (subject to the requirements of applicable law) and the Private Placement Units and all underlying securities will expire worthless. The Private Placement Units will not be transferable, assignable, or saleable until 30 days after the completion of an initial Business Combination, subject to certain exceptions.\nNOTE 5 - RELATED PARTY TRANSACTIONS\nFounder Shares\nOn February 3, 2022, the Sponsor acquired 2,156,250 Founder Shares in exchange for $ 25,000 paid for deferred offering costs borne by the Sponsor. On May 23, 2022, 93,750 Founder Shares were forfeited as the underwriters did not exercise the over-allotment option on the remaining 375,000 Public Units (see Note 6).\nThe Founder Shares are identical to the Class A ordinary shares included in the units sold in the IPO, except that the Founder Shares will automatically convert into Class A ordinary shares at the time of the Company’s initial Business Combination. Also, the Sponsor and each member of the management team have entered into an agreement with the Company, pursuant to which they have agreed to waive their redemption rights with respect to any Founder Shares and Public Shares held by them.\nThe Sponsor and the Company’s directors and executive officers have agreed not to transfer, assign or sell any of their Founder Shares until the earlier of (A) one year after the completion of an initial Business Combination and (B) subsequent to the Company’s initial Business Combination, (x) if the closing price of Class A ordinary shares equals or exceeds $ 12.00 per share (as adjusted for share subdivisions, share capitalizations, reorganizations, recapitalizations and the like) for any 20 trading days within any 30 -trading day period commencing at least 150 days after an initial Business Combination, or (y) the date on which the Company completes a liquidation, merger, share exchange or other similar transaction that results in all Public Shareholders having the right to exchange their Public Shares for cash, securities or other property. Any permitted transferees would be subject to the same restrictions and other agreements of the Sponsor and the Company’s directors and executive officers with respect to any Founder Shares.\nPromissory Note - Related Party\nOn February 3, 2022, the Sponsor agreed to loan the Company up to $ 400,000 to be used for a portion of the expenses of the IPO. As of April 11, 2022, there was $ 80,000 outstanding under the Promissory Note. This loan was non-interest bearing, unsecured and due at the earlier of (i) September 30, 2022 or (ii) the closing of the IPO. On April 12, 2022, the loan was repaid upon the closing of the IPO out of the offering proceeds not held in the Trust Account.\nDue to Related Party\nThe Sponsor paid certain formation, operating or offering costs on behalf of the Company. These amounts are due on demand and are non-interest bearing. During the period from January 5, 2022 (inception) through March 31, 2022, the Sponsor paid $ 215,020 of formation, operating costs and offering costs on behalf of the Company. On April 12, 2022, the Company paid the Sponsor $ 160,020 and on April 14, 2022, the Company received $ 25,000 from the Sponsor. Subsequently on July 19, 2022, the Company fully paid $ 80,000 to the related party. As of September 30, 2022, there were no amounts outstanding due to related party.\n| 13 |\n\nWorking Capital Loan\nIn order to finance transaction costs in connection with a Business Combination, the Sponsor or an affiliate of the Sponsor, or certain of the Company’s officers and directors, may, but are not obligated to, loan the Company funds as may be required (the “Working Capital Loans”). If the Company completes a Business Combination, the Company would repay the Working Capital Loans out of the proceeds of the Trust Account released to the Company. Otherwise, the Working Capital Loans would be repaid only out of funds held outside of the Trust Account. In the event that a Business Combination does not complete, the Company may use a portion of proceeds held outside of the Trust Account to repay the Working Capital Loans, but no proceeds held in the Trust Account would be used to repay the Working Capital Loans.\nExcept for the foregoing, the terms of such Working Capital Loans, if any, have not been determined and no written agreements exist with respect to such loans. The Working Capital Loans would either be repaid upon consummation of a Business Combination, without interest, or, at the lender’s discretion, up to $ 1.5 million of such Working Capital Loans may be convertible into units of the post-business combination entity at a price of $ 10.00 per unit. The units would be identical to the Private Placement Units. As of September 30, 2022, no Working Capital Loans were outstanding.\nNOTE 6 - COMMITMENTS AND CONTINGENCIES\nRegistration Rights\nThe holders of the Founder Shares, Private Placement Shares and Private Warrants, including any of those issued upon conversion of Working Capital Loans (and any Private Placement Shares issuable upon the exercise of the Private Warrants that may be issued upon conversion of Working Capital Loans) will be entitled to registration rights pursuant to a registration and shareholder rights agreement signed on April 6, 2022. The holders of these securities are entitled to make up to three demands, excluding short-form demands, that the Company register such securities. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed after the completion of the initial Business Combination and rights to require the Company to register for resale such securities pursuant to Rule 415 under the Securities Act. The Company will bear the costs and expenses of filing any such registration statements.\nUnderwriting Agreement\nThe Company granted the underwriters a 45 -day option from the date of IPO to purchase up to 1,125,000 additional Public Units to cover over-allotments, if any, at the IPO price less the underwriting discounts and commissions. The underwriters exercised the over-allotment option in part for 750,000 Public Units on April 11, 2022. On May 23, 2022, the underwriters decided not to exercise the over-allotment option on the remaining 375,000 Public Units within the 45 -day period.\nThe underwriters received a cash underwriting discount of $ 0.20 per Public Unit, or $ 1,650,000 in the aggregate, paid upon the closing of the IPO. In addition, the underwriters will be entitled to a deferred fee of $ 0.35 per Public Unit, or $ 2,887,500 in the aggregate, which is included in the accompanying condensed balance sheet. The deferred fee will become payable to the underwriters from the amounts held in the Trust Account solely in the event that the Company completes a Business Combination, subject to the terms of the underwriting agreement.\nNOTE 7 - SHAREHOLDERS’ DEFICIT\nPreference shares - The Company is authorized to issue 1,000,000 preference shares with a par value of $ 0.0001 per share with such designations, voting and other rights and preferences as may be determined from time to time by the Company’s board of directors. As of September 30, 2022, there were no preference shares issued or outstanding.\n\n| 14 |\n\nClass A Ordinary Shares - The Company is authorized to issue 200,000,000 Class A ordinary shares with a par value of $ 0.0001 per share. As of September 30, 2022, there were 510,000 Class A ordinary shares issued and outstanding, excluding 8,250,000 Class A ordinary shares subject to possible redemption.\nClass B Ordinary Shares - The Company is authorized to issue 20,000,000 Class B ordinary shares with a par value of $ 0.0001 per share. As of September 30, 2022, there were 2,062,500 Class B ordinary shares issued and outstanding. On May 23, 2022, 93,750 Class B ordinary shares were forfeited as the underwriters did not exercise the over-allotment option on the remaining 375,000 Public Units.\nPrior to the Company’s initial Business Combination, only holders of Class B ordinary shares will have the right to vote on the appointment of directors and holders of a majority of the Company’s Class B ordinary shares may remove a member of the board of directors of the Company for any reason. In addition, in a vote to continue the Company in a jurisdiction outside the Cayman Islands (which requires the approval of at least two thirds of the votes of all ordinary shares voted at a general meeting), holders of Founder Shares will have ten votes for every Founder Share and holders of Class A ordinary shares will have one vote for every Class A ordinary share and, as a result, the Company’s initial shareholders will be able to approve any such proposal without the vote of any other shareholder.\nThe Class B ordinary shares will automatically convert into Class A ordinary shares on the consummation of the initial Business Combination at a ratio such that the number of Class A ordinary shares issuable upon conversion of all Founder Shares will equal, in the aggregate, on an as- converted basis, approximately 20 % of the sum of (i) the total number of ordinary shares issued and outstanding upon completion of the IPO, plus (ii) the total number of Class A ordinary shares issued or deemed issued or issuable upon conversion or exercise of any equity-linked securities or rights issued or deemed issued, by the Company in connection with or in relation to the consummation of the initial Business Combination (after giving effect to any redemptions of Class A ordinary shares by Public Shareholders), excluding any Class A ordinary shares or equity-linked securities exercisable for or convertible into Class A ordinary shares issued, deemed issued, or to be issued, to any seller in the initial Business Combination and any Private Placement Units issued to the Sponsor, its affiliates or any member of the Company’s management team upon conversion of Working Capital Loans. Any conversion of Class B ordinary shares described herein will take effect as a compulsory redemption of Class B ordinary shares and an issuance of Class A ordinary shares as a matter of Cayman Islands law. In no event will the Class B ordinary shares convert into Class A ordinary shares at a rate of less than one-to-one.\nWarrants\nAll warrants (Public Warrants and Private Warrants) will become exercisable at $ 11.50 per share, subject to adjustment, on the later of 30 days after the completion of the initial Business Combination or 12 months from the closing of the IPO; provided in each case that the Company has an effective registration statement under the Securities Act covering the issuance of the Class A ordinary shares issuable upon exercise of the warrants and a current prospectus relating to them is available (or the Company permits holders to exercise their warrants on a cashless basis under the circumstances specified in the warrant agreement). The warrants will expire at 5:00 p.m., New York City time, five years after the completion of the initial Business Combination or earlier upon redemption or liquidation. On the exercise of any warrant, the warrant exercise price will be paid directly to the Company and not placed in the Trust Account.\nIn addition, if (x) the Company issues additional Class A ordinary shares or equity-linked securities for capital raising purposes in connection with the closing of an initial Business Combination at an issue price or effective issue price of less than $ 9.20 per ordinary share (with such issue price or effective issue price to be determined in good faith by the board of directors of the Company and, in the case of any such issuance to the Sponsor or its affiliates, without taking into account any Founder Shares held by the Sponsor or such affiliates, as applicable, prior to such issuance) (the “Newly Issued Price”), (y) the aggregate gross proceeds from such issuances represent more than 60 % of the total equity proceeds, and interest thereon, available for the funding of an initial Business Combination on the date of the consummation of an initial Business Combination (net of redemptions), and (z) the volume weighted average trading price of Class A ordinary shares during the 20 -trading day period starting on the trading day prior to the day on which the Company consummates an initial Business Combination (such price, the “Market Value”) is below $9.20 per share, the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115 % of the higher of the Market Value or the Newly Issued Price and the $ 16.50 per share redemption trigger price will be adjusted (to the nearest cent) to be equal to 165 % of the higher of the Market Value or the Newly Issued Price.\n| 15 |\n\nThe Company is not registering the ordinary shares issuable upon exercise of the warrants at this time. However, the Company has agreed that as soon as practicable, but in no event later than 20 business days after the closing of the initial Business Combination, it will use commercially reasonable efforts to file with the SEC a registration statement covering the Class A ordinary shares issuable upon exercise of the warrants, and it will use commercially reasonable efforts to cause the same to become effective within 60 business days following the initial Business Combination and to maintain a current prospectus relating to those ordinary shares until the warrants expire or are redeemed; provided, that if the ordinary shares are at the time of any exercise of a warrant not listed on a national securities exchange such that they satisfy the definition of a “covered security” under Section 18(b)(1) of the Securities Act, the Company may, at its option, require holders of Public Warrants who exercise their warrants to do so on a “cashless basis” in accordance with Section 3(a)(9) of the Securities Act and, in the event the Company so elects, it will not be required to file or maintain in effect a registration statement, but the Company will be required to use commercially reasonable efforts to register or qualify the shares under applicable blue sky laws to the extent an exemption is not available.\nRedemption of Warrants\nOnce the warrants become exercisable, the Company may redeem the outstanding warrants:\n\n| | in whole and not in part; |\n\n| | at a price of $ 0.01 per warrant; |\n\n| | upon a minimum of 30 days’ prior written notice of redemption, which is referred to as the 30 -day redemption period; and |\n\n| | if, and only if, the last reported sale price of ordinary shares equals or exceeds $ 16.50 per share (as adjusted for share splits, share dividends, reorganizations, recapitalizations, and the like) for any 20 trading days within a 30 -trading day period ending on the third trading day prior to the date on which the Company sends the notice of redemption to the warrant holders. |\n\nThe Company will not redeem the warrants unless a registration statement under the Securities Act covering the ordinary shares issuable upon exercise of the warrants is effective and a current prospectus relating to those ordinary shares is available throughout the 30-day redemption period, except if the warrants may be exercised on a cashless basis and such cashless exercise is exempt from registration under the Securities Act. If and when the warrants become redeemable by the Company, the Company may exercise its redemption right even if it is unable to register or qualify the underlying securities for sale under all applicable state securities laws.\nIf the Company calls the warrants for redemption as described above, its management will have the option to require all holders that wish to exercise warrants to do so on a “cashless basis.” In determining whether to require all holders to exercise their warrants on a “cashless basis,” the Company’s management will consider, among other factors, the cash position, the number of warrants that are outstanding and the dilutive effect on the Company’s shareholders of issuing the maximum number of ordinary shares issuable upon the exercise of the Company’s warrants. In such event, each holder would pay the exercise price by surrendering the warrants for that number of ordinary shares equal to the quotient obtained by dividing (x) the product of the number of ordinary shares underlying the warrants, multiplied by the excess of the “fair market value” over the exercise price of the warrants by (y) the fair market value. The “fair market value” shall mean the average volume weighted average last reported sale price of the Class A ordinary shares for the 10 trading days ending on the third trading day prior to the date on which the notice of redemption is sent to the holders of warrants.\nNOTE 8 - FAIR VALUE MEASUREMENTS\nThe fair value of the Company’s financial assets and liabilities reflects management’s estimate of amounts that the Company would have received in connection with the sale of the assets or paid in connection with the transfer of the liabilities in an orderly transaction between market participants at the measurement date. In connection with measuring the fair value of its assets and liabilities, the Company seeks to maximize the use of observable inputs (market data obtained from independent sources) and to minimize the use of unobservable inputs (internal assumptions about how market participants would price assets and liabilities). The following fair value hierarchy is used to classify assets and liabilities based on the observable inputs and unobservable inputs used in order to value the assets and liabilities:\nLevel 1: Quoted prices in active markets for identical assets or liabilities. An active market for an asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis.\n| 16 |\n\nLevel 2: Observable inputs other than Level 1 inputs. Examples of Level 2 inputs include quoted prices in active markets for similar assets or liabilities and quoted prices for identical assets or liabilities in markets that are not active.\nLevel 3: Unobservable inputs based on our assessment of the assumptions that market participants would use in pricing the asset or liability.\nThe following table presents information about the Company’s assets that are measured at fair value on a recurring basis as of September 30, 2022 and indicates the fair value hierarchy of the valuation inputs the Company utilized to determine such fair value.\n\n| As of September 30, 2022 | QuotedPrices inActiveMarkets(Level 1) | SignificantOtherObservableInputs(Level 2) | SignificantOtherUnobservableInputs(Level 3) |\n| Assets: |\n| Investment held in Trust Account | $ | 84,645,261 | 84,645,261 | - | - |\n\nNOTE 9 - SUBSEQUENT EVENTS\nThe Company has evaluated subsequent events through November 15, 2022 , which was the date these unaudited condensed financial statements were available for issuance and determined that there were no significant unrecognized events through that date.\n| 17 |\n\nI\nMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nReferences in this Quarterly Report to “we,” “us” or the “Company” refer to Denali Capital Acquisition Corp. References to our “management” or our “management team” refer to our officers and directors, and references to the “Sponsor” refer to Denali Capital Global Investment LLC. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Quarterly Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\nSpecial Note Regarding Forward-Looking Statements\nThis Quarterly Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, that are not historical facts, and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. All statements, other than statements of historical fact included in this Form 10‑Q including, without limitation, statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward- looking statements. Words such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intends,” “may,” “might,” “plan,” “possible,” “potential,” “predict,” “project,” “should,” “would” and variations thereof and similar words and expressions are intended to identify such forward-looking statements. Such forward-looking statements relate to future events or future performance, but reflect management’s current beliefs, based on information currently available. A number of factors could cause actual events, performance or results to differ materially from the events, performance and results discussed in the forward-looking statements. For information identifying important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements, please refer to the Risk Factors section of the Company’s final prospectus for its initial public offering (“IPO”) filed with the SEC on April 7, 2022, and in its Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2022, filed with the SEC on August 12, 2022. The Company’s securities filings can be accessed on the EDGAR section of the SEC’s website at www.sec.gov. Except as expressly required by applicable securities law, the Company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.\nOverview\nWe are a blank check company incorporated in the Cayman Islands on January 5, 2022 (inception) formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses (a “Business Combination”). We intend to effectuate our Business Combination using cash derived from the proceeds of our initial public offering (“IPO”) and the sale of units (the “Private Placement Units”) in a private placement (the “Private Placement”) to the Company’s founder and sponsor, Denali Capital Global Investments LLC (the “Sponsor”), additional shares, debt or a combination of cash, shares and debt.\nWe expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete a Business Combination will be successful.\nResults of Operations\nWe have neither engaged in any operations nor generated any operating revenues to date. Our only activities from January 5, 2022 (inception) through September 30, 2022 were organizational activities and those necessary to prepare for and complete the IPO, described below. We do not expect to generate any operating revenues until after the completion of our initial Business Combination. We expect to generate non-operating income in the form of interest income on marketable securities held after the IPO. We expect that we will incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses in connection with searching for, and completing, a Business Combination.\n| 18 |\n\nFor the three months ended September 30, 2022, we had net income of $307,468, which consists of interest earned on investment held in the Trust Account, as defined below, of $380,429 partially offset by $72,961 of formation and operating costs.\nFor the period from January 5, 2022 (inception) through September 30, 2022, we had net income of $265,278, which consists of interest earned on investment held in the Trust Account of $495,261 partially offset by $229,983 of formation and operating costs.\nFor the period from January 5, 2022 (inception) through September 30, 2022, we had an increase in cash flows of $985,578 resulting from net cash used in operating activities of $260,264, net cash used in investing activities of $84,150,000 and net cash provided by financing activities of $85,395,842.\nCash Flows from Operating Activities- For the period from January 5, 2022 (inception) through September 30, 2022, net cash used in operations was $260,264 primarily due to net income of $265,278 for the period and the changes in current assets and liabilities of $(41,624), prepaid expenses of $(132,427) and accounts payable and accrued expenses of $90,803. In addition, net cash used in operating activities includes adjustments to reconcile net income from formation costs paid by related party of $11,343 and income on Trust Account of $495,261.\nCash Flows from Investing Activities- For the period from January 5, 2022 (inception) through September 30, 2022, net cash used in investing activities was $84,150,000 due to investment held in Trust Account.\nCash Flows from Financing Activities- For the period from January 5, 2022 (inception) through September 30, 2022, net cash provided by financing activities was $85,395,842 primarily due to proceeds from issuance of promissory note to related party of $80,000, proceeds from related party of $25,000, proceeds from issuance of private placement units of $5,100,000, proceeds from issuance of public units through public offering of $82,500,000, payment of promissory note to related party of $80,000, payment to related party of $240,020, payment of offering costs of $339,138 and payment of underwriter’s discount of $1,650,000.\nLiquidity and Capital Resources\nOur liquidity needs prior to the consummation of the IPO were satisfied through a payment from the Sponsor and the loan under an unsecured promissory note from the Sponsor of up to $400,000.\nOn April 11, 2022, we consummated the IPO of 8,250,000 units (“Public Units”), inclusive of 750,000 Public Units sold to the underwriters upon the underwriters’ election to partially exercise their over-allotment option. Each Public Unit consists of one Class A ordinary share, $0.0001 par value per share (such shares included in the Public Units, the “Public Shares”), and one redeemable warrant (the “Public Warrants”), each whole Public Warrant entitling the holder thereof to purchase one Public Share at an exercise price of $11.50 per share. The Public Units were sold at a price of $10.00 per Public Unit, generating gross proceeds of $82,500,000. Simultaneously with the closing of the IPO, we consummated the sale of 510,000 Private Placement Units, inclusive of 30,000 Private Placement Units sold to the Sponsor pursuant to the underwriters’ election to partially exercise their over-allotment option. Each whole Private Placement Unit consists of one Class A ordinary share (“Private Placement Shares”) and one warrant (“Private Warrants”), each whole Private Warrant entitling the holder thereof to purchase one Class A ordinary share at an exercise price of $11.50 per share. The Private Placement Units were sold at a price of $10.00 per Private Placement Unit, generating gross proceeds of $5,100,000.\nFollowing the closing of the IPO and sale of the Private Placement Units on April 11, 2022, a total of $84,150,000 was placed in a U.S.-based trust account maintained by Wilmington Trust, National Association, acting as trustee (the “Trust Account”), and we had $1,515,795 of cash held outside of the Trust Account, after payment of costs related to the IPO, and available for working capital purposes. In connection with the IPO, we incurred $5,105,315 in transaction costs, consisting of $1,650,000 of underwriting fees, $2,887,500 of deferred underwriting fees and $567,815 of other offering costs. Deferred offering costs consist of legal, accounting, and underwriting fees and other costs incurred through the balance sheet date that are directly related to the IPO.\nAs of September 30, 2022, we had marketable securities held in the Trust Account of $84,645,261. We intend to use substantially all of the funds held in the Trust Account, including any amounts representing interest earned on the Trust Account, excluding deferred underwriting commissions, to complete our Business Combination. We may withdraw interest from the Trust Account to pay taxes, if any. To the extent that our share capital or debt is used, in whole or in part, as consideration to complete a Business Combination, the remaining proceeds held in the Trust Account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies. We intend to use the funds held outside of the Trust Account to primarily identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, structure, negotiate and complete a Business Combination.\n| 19 |\n\nIn order to fund working capital deficiencies or finance transaction costs in connection with a Business Combination, our Sponsor or an affiliate of our Sponsor or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If the Company completes the initial Business Combination, it would repay such loaned amounts. In the event that the initial Business Combination does not close, the Company may use a portion of the working capital held outside of the Trust Account to repay such loaned amounts, but no proceeds from the Trust Account would be used for such repayment. Up to $1,500,000 of such loans may be convertible into units of the post-business combination entity, at a price of $10.00 per unit at the option of the lender. The units would be identical to the Private Placement Units. In the event that the initial Business Combination does not close, the Company may use a portion of the working capital held outside of the Trust Account to repay such loaned amounts, but no proceeds from the Trust Account would be used for such repayment.\nAs of September 30, 2022, we had cash of $985,578 and working capital of $1,027,202. In addition, in order to finance transaction costs in connection with a Business Combination, our Sponsor or an affiliate of our Sponsor or certain of our officers and directors may, but are not obligated to, provide us funds as may be required (the “Working Capital Loans”). As of September 30, 2022, there were no amounts outstanding under any Working Capital Loans.\nAccordingly, the accompanying unaudited condensed financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) which contemplates continuation of the Company as a going concern and the realization of assets and the satisfaction of liabilities in the normal course of business. The unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty. Further, we have incurred and expect to continue to incur significant costs in pursuit of our financing and acquisition plans. Management plans to address this uncertainty during the period leading up to the initial Business Combination. Based on the foregoing, management believes that the Company will not have sufficient working capital and borrowing capacity to meet its needs through the earlier of the consummation of a Business Combination or one year from the date of this filing. These factors, among others, raise substantial doubt about our ability to continue as a going concern. Over this time period, the Company will use these funds to pay existing accounts payable, identify and evaluate prospective initial Business Combination candidates, perform due diligence on prospective target businesses, pay for travel expenditures in connection with the identification and evaluation of prospective target businesses, select the target business with which to effectuate an initial Business Combination, and structure, negotiate and consummate the Business Combination. In case the Company is unable to consummate the initial Business Combination by April 6, 2023, it will seek to extend the combination period up to 18 months from the date of the IPO by resolution of the board of directors of the Company. In order to extend the time available for the Company to consummate an initial Business Combination for an additional three months, the Sponsor or its affiliates or designees must deposit into the Trust Account $825,000, (or $0.1 per share) or up to an aggregate of $1,500,000, or ($0.20) per share, on or prior to the date of the deadline. The Company will issue a press release announcing each extension at least three days prior to the deadline. In addition, it will issue a press release the day after the deadline, announcing whether the funds have been timely deposited. The Sponsor and its affiliates or designees are obligated to fund the Trust Account in order to extend the time for us to complete our initial Business Combination, but the Sponsor will not be obligated to extend such time. In addition to the foregoing arrangements, the Company may extend the period of time to consummate an initial Business Combination by a shareholder vote to amend our amended and restated memorandum and articles of association (“Shareholder Extension Period”).\nIf our estimate of the costs of identifying a target business, undertaking in-depth due diligence and negotiating a Business Combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our initial Business Combination. Moreover, we may need to obtain additional financing either to complete our Business Combination or because we become obligated to redeem a significant number of our Public Shares upon completion of our Business Combination, in which case we may issue additional securities or incur debt in connection with such Business Combination.\nOff-Balance Sheet Financing Arrangements\nWe have no obligations, assets or liabilities that would be considered off-balance sheet arrangements as of September 30, 2022. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets.\n| 20 |\n\nOther Contractual Obligations\nRegistration Rights\nThe holders of our Class B ordinary shares initially issued to our Sponsor in a private placement prior to the IPO (the “Founder Shares”), Private Placement Shares and Private Warrants, including any of those issued upon conversion of Working Capital Loans (and any Private Placement Shares issuable upon the exercise of the Private Warrants that may be issued upon conversion of Working Capital Loans) will be entitled to registration rights pursuant to a registration and shareholder rights agreement signed on April 6, 2022. The holders of these securities are entitled to make up to three demands, excluding short form demands, that the Company register such securities. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed after the completion of our initial Business Combination and rights to require us to register for resale such securities pursuant to Rule 415 under the Securities Act. The Company will bear the costs and expenses of filing any such registration statements.\nUnderwriting Agreement\nWe granted the underwriters a 45-day option from the date of IPO to purchase up to 1,125,000 additional Public Units to cover over-allotments, if any, at the IPO price less the underwriting discounts and commissions. The underwriters exercised the over-allotment option in part for 750,000 Public Units on April 11, 2022. On May 23, 2022, the underwriters decided not to exercise the over-allotment option on the remaining 375,000 Public Units.\nThe underwriters received a cash underwriting discount of $0.20 per Public Unit, or $1,650,000 in the aggregate, paid upon the closing of the IPO. In addition, the underwriters will be entitled to a deferred fee of $0.35 per Public Unit, or $2,887,500 in the aggregate. The deferred fee will become payable to the underwriters from the amounts held in the Trust Account solely in the event that the Company completes a Business Combination, subject to the terms of the underwriting agreement.\nCritical Accounting Policies\nBasis of Presentation\nThe accompanying unaudited condensed financial statements are presented in conformity with GAAP and pursuant to the rules and regulations of the SEC.\nEmerging Growth Company Status\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012, (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies, including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies, but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\n| 21 |\n\nClass A Ordinary Shares Subject to Possible Redemption\nThe Company will account for its Class A ordinary shares subject to possible redemption in accordance with the guidance in the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 480 “Distinguishing Liabilities from Equity.” Class A ordinary shares subject to mandatory redemption (if any) is classified as a liability instrument and measured at fair value. Conditionally redeemable ordinary shares (including shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, ordinary shares are classified as shareholders’ equity. The Company’s ordinary shares will feature certain redemption rights that are considered to be outside of the Company’s control and will be subject to the occurrence of uncertain future events. Accordingly, as of September 30, 2022, 8,250,000 Class A ordinary shares subject to possible redemption are presented at redemption value as temporary equity, outside of the shareholders’ equity section of the Company’s unaudited condensed balance sheet.\nThe Company recognizes changes in redemption value immediately as they occur and adjusts the carrying value of redeemable ordinary shares to equal the redemption value at the end of each reporting period. Increases or decreases in the carrying amount of redeemable ordinary shares are affected by charges against additional paid in capital or accumulated deficit if additional paid in capital equals to zero.\nWarrants\nThe Company accounts for warrants as either equity-classified or liability-classified instruments based on an assessment of the warrant’s specific terms and applicable authoritative guidance in FASB ASC 480, “Distinguishing Liabilities from Equity” (“ASC 480”) and FASB ASC 815. The assessment considers whether the warrants are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and meet all of the requirements for equity classification under FASB ASC 815, including whether the warrants are indexed to the Company’s own ordinary shares and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of the Company’s control, among other conditions for equity classification. This assessment is conducted at the time of warrant issuance and as of each subsequent quarterly period end date while the warrants are outstanding.\nFor issued or modified warrants that meet all of the criteria for equity classification, the warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all of the criteria for equity classification, the warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. The Company accounts for the 8,250,000 Public Warrants (as defined in Note 3) and 510,000 Private Warrants (as defined in Note 4) as equity-classified instruments.\nNet Income/(Loss) Per Ordinary Share\nThe Company complies with the accounting and disclosure requirements of FASB ASC 260, “Earnings Per Share.” Net loss per ordinary share is computed by dividing net loss by the weighted average number of ordinary shares outstanding during the period, excluding ordinary shares subject to forfeiture. Weighted average shares were reduced for the effect of an aggregate of 93,750 Founder Shares that were forfeited due to the underwriters’ partial exercise of the over-allotment option. Any remeasurement of the accretion to redemption value of the Class A ordinary shares subject to possible redemption was considered to be dividends paid to the Public Shareholders. Warrants issued are contingently exercisable (i.e., on the later of 30 days after the completion of the initial Business Combination or 12 months from the closing of the IPO). For Earnings Per Share (“EPS”) purposes, the warrants are anti-dilutive since they would generally not be reflected in basic or diluted EPS until the contingency is resolved. As of September 30, 2022, the Company did not have any dilutive securities and other contracts that could, potentially, be exercised or converted into ordinary shares and then share in the earnings of the Company. As a result, diluted profit (loss) per ordinary share is the same as basic earnings per ordinary share for the periods presented.\n| 22 |\n\nRecent Accounting Pronouncements\nManagement does not believe that any recently issued, but not effective, accounting standards, if currently adopted, would have a material effect on the Company’s financial statements.\nI\nQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nAs of September 30, 2022, we were not subject to any market or interest rate risk. Following the consummation of our IPO, the net proceeds of our IPO, including amounts in the Trust Account, have been invested in certain U.S. government securities with a maturity of 185 days or less or in certain money market funds that invest solely in U.S. treasuries. Due to the short-term nature of these investments, we believe there will be no associated material exposure to interest rate risk.\nI\nCONTROLS AND PROCEDURES\nDisclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.\n| 23 |\n\nEvaluation of Disclosure Controls and Procedures\nAs required by Rules 13a‑15 and 15d‑15 under the Exchange Act, our Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2022. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rules 13a‑15(e) and 15d‑15(e) under the Exchange Act) were effective.\nChanges in Internal Control Over Financial Reporting\nDuring the most recently completed fiscal quarter, there has been no change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\nPart II. OTHER INFORMATION\nI\nLEGAL PROCEEDINGS.\nNone.\nI\nRISK FACTORS.\nFactors that could cause our actual results to differ materially from those in this Quarterly Report are any of the risks described in our final prospectus for our IPO filed with the SEC on April 7, 2022, and in other filings with the SEC as described below. Any of these factors could result in a significant or material adverse effect on our results of operations or financial condition. We may disclose changes to such factors or disclose additional factors from time to time in our future filings with the SEC. Additional risk factors not currently known to us or that we currently deem immaterial may also impair our business or results of operations. As of the date of this Quarterly Report, there have been no material changes to the risk factors disclosed in (i) our final prospectus for our IPO filed with the SEC on April 7, 2022, and (ii) our Quarterly Report on Form 10-Q for the quarter ended June 30, 2022, as filed with the SEC on August 12, 2022. except for the following:\nChanges in laws or regulations or in how such laws or regulations are interpreted or applied, or a failure to comply with any laws, regulations, interpretations or applications, may adversely affect our business, investments and results of operations, and our ability to negotiate and complete our initial Business Combination.\nWe are subject to laws and regulations, and interpretations and applications of such laws and regulations enacted by national, regional, state and local governments and, potentially, non-U.S. jurisdictions. In particular, we will be required to comply with certain SEC and other legal and regulatory requirements, and our consummation of an initial Business Combination may be contingent upon our ability to comply with certain laws, regulations, interpretations and applications and any post-business combination company may be subject to additional laws, regulations, interpretations and applications. Compliance with, and monitoring of, the foregoing may be difficult, time consuming and costly. Those laws and regulations and their interpretation and application may also change from time to time, and those changes could have a material adverse effect on our business, investments and results of operations, and our ability to negotiate and complete an initial business combination. In addition, a failure to comply with applicable laws or regulations, as interpreted and applied, could have a material adverse effect on our business and results of operations, and our ability to negotiate and complete an initial business combination.\nOn March 30, 2022, the SEC issued proposed rules (the “SPAC Rule Proposals”) relating to, among other items, enhancing disclosures in business combination transactions involving special purpose acquisition companies (“SPACs”) and private operating companies; amending the financial statement requirements applicable to transactions involving shell companies; changing the treatment of financial projections in SEC filings in connection with proposed business combination transactions; increasing the potential liability of certain participants in proposed business combination transactions; and a proposed safe harbor for SPACs under the Investment Company Act of 1940, as amended (including certain time limits to announce and consummate a business combination) (the “Investment Company Act”). These proposed rules, if adopted, whether in the form proposed or in revised form, or pursuant to the SEC’s views expressed in the SPAC Rule Proposals, may materially adversely affect our ability to negotiate and complete our initial business combination and may increase the costs and time related thereto.\n| 24 |\n\nThe current economic downturn may lead to increased difficulty in completing our initial business combination.\nOur ability to consummate our initial Business Combination may depend, in part, on worldwide economic conditions. In recent months, we have observed increased economic uncertainty in the United States and abroad. Impacts of such economic weakness include:\n\n| ● | falling overall demand for goods and services, leading to reduced profitability; |\n\n\n| ● | reduced credit availability; |\n\n\n| ● | higher borrowing costs; |\n\n\n| ● | reduced liquidity; |\n\n\n| ● | volatility in credit, equity and foreign exchange markets; and |\n\n\n| ● | bankruptcies. |\n\nThese developments could lead to inflation, higher interest rates, and uncertainty about business continuity, which may adversely affect the business of our potential target businesses and create difficulties in obtaining debt or equity financing for our initial Business Combination, as well as leading to an increase in the number of Public Shareholders exercising redemption rights in connection therewith.\nRecent volatility in capital markets may affect our ability to obtain financing for our initial Business Combination through sales of ordinary shares or issuance of indebtedness.\nWith uncertainty in the capital markets and other factors, financing for our initial Business Combination may not be available on terms favorable to us or at all. If we raise additional funds through further issuances of equity or convertible debt securities, our existing shareholders could suffer significant dilution, and any new equity securities we issue could have rights, preferences, and privileges superior to those of holders of our ordinary shares. Any debt financing secured by us could involve additional restrictive covenants relating to our capital-raising activities and other financial and operational matters, which may limit the operations and growth of the surviving company of our initial Business Combination. If we are unable to obtain adequate financing or financing on terms satisfactory to us, we could face significant limitations on our ability to complete our initial Business Combination.\nMilitary conflict in Ukraine or elsewhere may lead to increased and price volatility for publicly traded securities, which could make it more difficult for us to consummate an initial Business Combination.\nMilitary conflict in Ukraine or elsewhere may lead to increased and price volatility for publicly traded securities, including ours, and to other national, regional and international economic disruptions and economic uncertainty, any of which could make it more difficult for us to identify a business combination target and consummate an initial Business Combination on acceptable commercial terms or at all.\nThere may be significant competition for us to find an attractive target for an initial Business Combination. This could increase the costs associated with completing our initial Business Combination and may result in our inability to find a suitable target for our initial Business Combination.\nIn recent years, the number of SPACs that have been formed has increased substantially. Many companies have entered into business combinations with SPACs, and there are still many SPACs seeking targets for their initial business combination, as well as additional SPACs currently in registration. As a result, at times, fewer attractive targets may be available, and it may require more time, effort and resources to identify a suitable target for an initial Business Combination.\n| 25 |\n\nIn addition, because there are a large number of SPACs seeking to enter into an initial Business Combination with available targets, the competition for available targets with attractive fundamentals or business models may increase, which could cause target companies to demand improved financial terms. Attractive deals could also become scarcer for other reasons, such as economic or industry sector downturns, geopolitical tensions or increases in the cost of additional capital needed to close business combinations or operate targets post-business combination. This could increase the cost of, delay or otherwise complicate or frustrate our ability to find a suitable target for and/or complete our initial Business Combination and may result in our inability to consummate an initial Business Combination on terms favorable to our investors altogether.\nIf we are deemed to be an investment company for purposes of the Investment Company Act, we would be required to institute burdensome compliance requirements and our activities would be severely restricted. As a result, in such circumstances, unless we are able to modify our activities so that we would not be deemed an investment company, we would expect to abandon our efforts to complete an initial Business Combination and instead to liquidate the Company.\nAs described further above, the SPAC Rule Proposals relate, among other matters, to the circumstances in which SPACs such as the Company could potentially be subject to the Investment Company Act and the regulations thereunder. The SPAC Rule Proposals would provide a safe harbor for such companies from the definition of “investment company” under Section 3(a)(1)(A) of the Investment Company Act, provided that a SPAC satisfies certain criteria, including a limited time period to announce and complete a de-SPAC transaction. Specifically, to comply with the safe harbor, the SPAC Rule Proposals would require a company to file a report on Form 8-K announcing that it has entered into an agreement with a target company for a business combination no later than 18 months after the effective date of its IPO registration statement. A company would then be required to complete its initial business combination no later than 24 months after the effective date of the IPO registration statement.\nBecause the SPAC Rule Proposals have not yet been adopted, there is currently uncertainty concerning the applicability of the Investment Company Act to a SPAC, including a company like ours that does not complete its business combination within 24 months after the effective date of the IPO registration statement.\nIf we are deemed to be an investment company under the Investment Company Act, our activities would be severely restricted. In addition, we would be subject to burdensome compliance requirements. We do not believe that our principal activities will subject us to regulation as an investment company under the Investment Company Act. However, if we are deemed to be an investment company and subject to compliance with and regulation under the Investment Company Act, we would be subject to additional regulatory burdens and expenses for which we have not allotted funds. As a result, unless we are able to modify our activities so that we would not be deemed an investment company, we would expect to abandon our efforts to complete an initial business combination and instead to liquidate the Company.\nTo mitigate the risk that we might be deemed to be an investment company for purposes of the Investment Company Act, we may, at any time, instruct the trustee to liquidate the securities held in the Trust Account and instead to hold the funds in the Trust Account in cash until the earlier of the consummation of our initial Business Combination or our liquidation. As a result, following the liquidation of securities in the Trust Account, we would likely receive minimal interest, if any, on the funds held in the Trust Account, which would reduce the dollar amount our Public Shareholders would receive upon any redemption or liquidation of the Company.\nThe funds in the Trust Account have, since our IPO, been held only in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds investing solely in U.S. government treasury obligations and meeting certain conditions under Rule 2a-7 under the Investment Company Act. However, to mitigate the risk of us being deemed to be an unregistered investment company (including under the subjective test of Section 3(a)(1)(A) of the Investment Company Act) and thus subject to regulation under the Investment Company Act, we may, at any time, and we expect that we will, on or prior to the 12-month anniversary of the effective date of the Registration Statement, instruct Wilmington Trust, National Association, the trustee with respect to the Trust Account, to liquidate the U.S. government treasury obligations or money market funds held in the Trust Account and thereafter to hold all funds in the Trust Account in cash until the earlier of consummation of our initial Business Combination or liquidation of the Company. Following such movement of funds, we would likely receive minimal interest, if any, on the funds held in the Trust Account. However, interest previously earned on the funds held in the Trust Account still may be released to us to pay our taxes, if any. As a result, any decision to liquidate the securities held in the Trust Account and thereafter to hold all funds in the Trust Account in cash would reduce the dollar amount our Public Shareholders would receive upon any redemption or liquidation of the Company.\n| 26 |\n\nIn addition, even prior to the 12-month anniversary of the effective date of the IPO Registration Statement, we may be deemed to be an investment company. The longer that the funds in the Trust Account are held in short-term U.S. government treasury obligations or in money market funds invested exclusively in such securities, the greater the risk that we may be considered an unregistered investment company, in which case we may be required to liquidate the Company. Accordingly, we may determine, in our discretion, to liquidate the securities held in the Trust Account at any time, even prior to the 12-month anniversary, and instead hold all funds in the Trust Account in cash, which would further reduce the dollar amount our Public Shareholders would receive upon any redemption or liquidation of the Company.\nThere is substantial doubt about our ability to continue as a “going concern.”\nIn connection with the Company’s assessment of going concern considerations under applicable accounting standards, management has determined that our possible need for additional financing to enable us to negotiate and complete our initial Business Combination, as well as the deadline by which we may be required to liquidate our Trust Account, raise substantial doubt about the Company’s ability to continue as a going concern through one year from the date the financial statements included elsewhere in this Quarterly Report were issued. In case the Company is unable to consummate the initial Business Combination by April 6, 2023, it will seek to extend the combination period up to 18 months from the date of the IPO.\nI\nUNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.\nOn February 3, 2022, the Sponsor acquired 2,156,250 Founder Shares for an aggregate purchase price of $25,000. The issuance of such Founder Shares to the Sponsor was made pursuant to the exemption from registration contained in Section 4(a)(2) of the Securities Act.\nSubstantially concurrently with the closing of the IPO, the Company completed the private sale of 510,000 Private Placement Units to the Sponsor at a purchase price of $10.00 per Private Placement Unit, generating gross proceeds to the Company of $5,100,000.\nThe Private Placement Shares sold as part of the Private Placement Units are identical to the Public Shares sold as part of the Public Units in the IPO, except that the Sponsor has agreed not to transfer, assign or sell any of the Private Placement Shares (except to certain permitted transferees) until 30 days after the completion of the Company’s initial business combination. The issuance of the Private Placement Shares was made pursuant to the exemption from registration contained in Section 4(a)(2) of the Securities Act.\nA total of $84,150,000, comprised of $80,850,000 of the proceeds from the IPO, and $3,300,000 of the proceeds from the Private Placement, were placed in a U.S.-based trust account maintained by Wilmington Trust, acting as trustee.\nFor a description of the use of the proceeds generated in the Private Placement, see Part I, Item 2 of this Form 10‑Q.\nI\nDEFAULTS UPON SENIOR SECURITIES.\nNone.\nI\nMINE SAFETY DISCLOSURES.\nNot applicable.\nI\nOTHER INFORMATION.\nNone.\n| 27 |\n\nI\nEXHIBITS.\nThe following exhibits are filed as part of, or incorporated by reference into, this Quarterly Report on Form 10‑Q.\n\n| No. | Description of Exhibit |\n| 31.1** | Certification of Chief Executive Officer (Principal Executive Officer) Pursuant to Rules 13a‑14(a) and 15d‑14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2** | Certification of Chief Financial Officer (Principal Financial and Accounting Officer) Pursuant to Rules 13a‑14(a) and 15d‑14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32.1*** | Certification of Chief Executive Officer (Principal Executive Officer) Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 32.2*** | Certification of Chief Financial Officer (Principal Financial and Accounting Officer) Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 101.INS** | XBRL Instance Document. |\n| 101.CAL** | XBRL Taxonomy Extension Calculation Linkbase Document. |\n| 101.SCH** | XBRL Taxonomy Extension Schema Document. |\n| 101.DEF** | XBRL Taxonomy Extension Definition Linkbase Document. |\n| 101.LAB** | XBRL Taxonomy Extension Labels Linkbase Document. |\n| 101.PRE** | XBRL Taxonomy Extension Presentation Linkbase Document. |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101). |\n\n\n| * | Incorporated herein by reference as indicated. |\n\n| ** | Filed herein. |\n\n| *** | Furnished herein. |\n\nPart III. SIGNATURES\nPursuant to the requirements of Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| Date: November 15, 2022 | DENALI CAPITAL ACQUISITION CORP. |\n| By: | /s/ Lei Huang |\n| Chief Executive Officer |\n| (Principal Executive Officer) |\n| By: | /s/ You “Patrick” Sun |\n| Chief Financial Officer |\n| (Principal Financial and Accounting Officer) |\n\n\n| 28 |\n\n\n \n\nIf the company completes a business combination and all of the public warrants and private warrants are exercised at the price of $11.50 per share, what will be the total inflow of cash into the company from the exercise of these warrants in million dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nFINANCIAL STATEMENTS\\nDENALI CAPITAL ACQUISITION CORP. UNAUDITED CONDENSED BALANCE SHEET AS OF SEPTEMBER 30, 2022\\n\\n| ASSETS |\\n| Current Assets: |\\n| Cash | $ | 985,578 |\\n| Prepaid expenses | 132,427 |\\n| Total Current Assets | 1,118,005 |\\n| Cash and Equivalents held in Trust Account | 84,645,261 |\\n| Total Assets | $ | 85,763,266 |\\n| LIABILITIES, TEMPORARY EQUITY AND SHAREHOLDERS’DEFICIT |\\n| Current Liabilities: |\\n| Accounts Payable and accrued expenses | $ | 90,803 |\\n| Total Current Liabilities | 90,803 |\\n| Deferred Underwriter Compensation | 2,887,500 |\\n| Total Liabilities | 2,978,303 |\\n| Commitments and contingencies |\\n| Class A ordinary shares subject to possible redemption; 8,250,000 shares at $ 10.20 per share | 84,645,261 |\\n| Shareholders’ Deficit: |\\n| Preference shares $ 0.0001 par value; 1,000,000 shares authorized; none issued and outstanding | — |\\n| Class A ordinary shares, $ 0.0001 par value; 200,000,000 shares authorized; 510,000 shares issued and outstanding (excluding 8,250,000 shares subject to possible redemption) | 51 |\\n| Class B ordinary shares, $ 0.0001 par value; 20,000,000 shares authorized; 2,062,500 shares issued and outstanding | 206 |\\n| Additional paid-in capital | — |\\n| Accumulated deficit | ( 1,860,555 | ) |\\n| Total Shareholders’ Deficit | ( 1,860,298 | ) |\\n| Total Liabilities, Temporary Equity and Shareholders’ Deficit | $ | 85,763,266 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\\n\\n| 2 |\\n\\nDENALI CAPITAL ACQUISITION CORP. UNAUDITED CONDENSED STATEMENT OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2022 AND FOR THE PERIOD FROM JANUARY 5, 2022 (INCEPTION) THROUGH SEPTEMBER 30, 2022\\n\\n| Three months ended September 30, 2022 | From January 5, 2022 (inception) through September 30, 2022 |\\n| Formation and operating costs | $ | 72,961 | $ | 229,983 |\\n| Other (Income)/expenses |\\n| Income on Trust Account | ( 380,429 | ) | ( 495,261 | ) |\\n| Net Income | $ | ( 307,468 | ) | $ | ( 265,278 | ) |\\n| Weighted average shares outstanding of redeemable ordinary shares | 8,250,000 | 5,305,762 |\\n| Basic and diluted net income per share, ordinary shares | $ | 0.04 | $ | 0.93 |\\n| Weighted average shares outstanding of non-redeemable ordinary shares | 2,572,500 | 2,121,441 |\\n| Basic and diluted net (loss) per share, non-redeemable ordinary shares | $ | ( 0.01 | ) | $ | ( 2.20 | ) |\\n\\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\\n\\n| 3 |\\n\\nDENALI CAPITAL ACQUISITION CORP. UNAUDITED CONDENSED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY/(DEFICIT) FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2022 AND FOR THE PERIOD FROM JANUARY 5, 2022 (INCEPTION) THROUGH SEPTEMBER 30, 2022\\n\\n| Class A Ordinary Shares | Class B Ordinary Shares | Additional Paid-in | Accumulated | Total Shareholder’s |\\n| Shares | Amount | Shares | Amount | Capital | Deficit | Equity/(Deficit) |\\n| Balance as of January 5, 2022 (inception) | — | $ | — | — | $ | — | $ | — | $ | — | $ | — |\\n| Issuance of Class B ordinary shares to Sponsor | — | — | 2,156,250 | 216 | 24,784 | — | 25,000 |\\n| Net loss | — | — | — | — | — | ( 11,343 | ) | ( 11,343 | ) |\\n| Balance as of March 31, 2022 | — | $ | — | 2,156,250 | $ | 216 | $ | 24,784 | $ | ( 11,343 | ) | $ | 13,657 |\\n| Proceeds from sale of public units | 7,500,000 | $ | 750 | — | $ | — | $ | 74,999,250 | $ | — | $ | 75,000,000 |\\n| Proceeds from sale of public units-over-allotment | 750,000 | 75 | — | — | 7,499,925 | — | 7,500,000 |\\n| Proceeds from sale of private placement units | 480,000 | 48 | — | — | 4,799,952 | — | 4,800,000 |\\n| Proceeds from sale of private placement units -over-allotment | 30,000 | 3 | — | — | 299,997 | — | 300,000 |\\n| Deferred underwriting fees payable @3.5% of gross proceeds | — | — | — | — | ( 2,887,500 | ) | — | ( 2,887,500 | ) |\\n| Underwriters Discount @2% of gross proceeds | — | — | — | — | ( 1,650,000 | ) | — | ( 1,650,000 | ) |\\n| Other deferred offering costs | — | — | — | — | ( 567,815 | ) | — | ( 567,815 | ) |\\n| Reclassification and initial measurement of Class A ordinary shares subject to possible redemption under ASC 480-10-S99 against additional paid-in capital | ( 8,250,000 | ) | ( 825 | ) | — | — | ( 72,525,774 | ) | — | ( 72,526,599 | ) |\\n| Allocation of offering costs to Class A ordinary shares subject to possible redemption | — | — | — | — | 4,488,135 | — | 4,488,135 |\\n| Remeasurement adjustment on class A ordinary shares subject to possible redemption | — | — | — | — | ( 14,480,964 | ) | ( 1,630,752 | ) | ( 16,111,536 | ) |\\n| Forfeiture of Class B ordinary shares | — | — | ( 93,750 | ) | ( 10 | ) | 10 | — | — |\\n| Net loss | — | — | — | — | — | ( 30,847 | ) | ( 30,847 | ) |\\n| Balance as of June 30, 2022 | 510,000 | $ | 51 | 2,062,500 | $ | 206 | $ | — | $ | ( 1,672,762 | ) | $ | ( 1,672,505 | ) |\\n| Subsequent measurement of Class A ordinary shares subject to possible redemption (interest earned on trust account) | — | — | — | — | — | ( 495,261 | ) | ( 495,261 | ) |\\n| Net income | — | — | — | — | — | 307,468 | 307,468 |\\n| Balance as of September 30, 2022 | 510,000 | $ | 51 | 2,062,500 | $ | 206 | $ | — | $ | ( 1,860,555 | ) | $ | ( 1,860,298 | ) |\\n\\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\\n\\n| 4 |\\n\\nDENALI CAPITAL ACQUISITION CORP. UNAUDITED CONDENSED STATEMENT OF CASH FLOWS FOR THE PERIOD FROM JANUARY 5, 2022 (INCEPTION) THROUGH SEPTEMBER 30, 2022\\n\\n| Cash flows from operating activities: |\\n| Net income | $ | 265,278 |\\n| Formation costs paid by related party | 11,343 |\\n| Income on Trust Account | ( 495,261 | ) |\\n| Changes in current assets and liabilities: |\\n| Prepaid expenses | ( 132,427 | ) |\\n| Accounts payable and accrued expenses | 90,803 |\\n| Net cash used in operating activities | ( 260,264 | ) |\\n| Cash flows from investing activities: |\\n| Investment held in Trust Account | ( 84,150,000 | ) |\\n| Net cash used in investing activities | ( 84,150,000 | ) |\\n| Cash flows from financing activities: |\\n| Proceeds from issuance of promissory note to related party | 80,000 |\\n| Payment of promissory note to related party | ( 80,000 | ) |\\n| Proceeds from related party | 25,000 |\\n| Payment to related party | ( 240,020 | ) |\\n| Proceeds from issuance of private placement units, including over-allotment | 5,100,000 |\\n| Proceeds from issuance of public units through public offering, including over-allotment | 82,500,000 |\\n| Payment of offering costs | ( 339,138 | ) |\\n| Payment of deferred underwriter's discount | ( 1,650,000 | ) |\\n| Net cash provided by financing activities | 85,395,842 |\\n| Net change in cash | 985,578 |\\n| Cash at beginning of period | — |\\n| Cash at end of period | $ | 985,578 |\\n| Supplemental information for non-cash financing activities: |\\n| Deferred offering costs paid by Sponsor in exchange for issuance of Class B ordinary shares | $ | 25,000 |\\n| Deferred offering costs charged to additional paid-in capital | $ | 567,815 |\\n| Deferred offering cost settled through related party | $ | 203,677 |\\n| Allocation of offering costs to Class A ordinary shares subject to redemption | $ | 4,488,135 |\\n| Reclassification of Class A ordinary shares subject to redemption | $ | 72,526,599 |\\n| Remeasurement adjustment on Class A ordinary shares subject to possible redemption | $ | 16,111,536 |\\n| Subsequent measurement of Class A ordinary shares subject to possible redemption (interest earned on trust account) | $ | 495,261 |\\n| Deferred underwriter's fee charged to additional paid-in capital | $ | 2,887,500 |\\n| Forfeiture of Class B ordinary shares | $ | 10 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\\n\\n| 5 |\\n\\nDENALI CAPITAL ACQUISITION CORP. NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\nNOTE 1 - ORGANIZATION AND BUSINESS OPERATION\\nDenali Capital Acquisition Corp. (the “Company”) is a newly organized blank check company incorporated in the Cayman Islands on January 5, 2022 . The Company was formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization, or similar business combination with one or more businesses (a “Business Combination”).\\nThe Company is not limited to a particular industry or sector for purposes of consummating a Business Combination. The Company is an early stage emerging growth company and, as such, the Company is subject to all of the risks associated with early stage emerging growth companies.\\nAs of September 30, 2022, the Company had not commenced any operations. All activity for the period from January 5, 2022 (inception) through September 30, 2022 relates to the Company’s formation and the initial public offering (“IPO”), which is described below. The Company will not generate any operating revenues until after the completion of an initial Business Combination, at the earliest. The Company will generate non-operating income in the form of interest income from the proceeds derived from the IPO. The Company has selected December 31 as its fiscal year end.\\nThe Company’s sponsor is Denali Capital Global Investments LLC, a Cayman Islands limited liability company (the “Sponsor”).\\nFinancing\\nThe registration statement for the Company’s IPO became effective on April 6, 2022. On April 11, 2022, the Company consummated the IPO of 8,250,000 units (including over-allotment of 750,000 units) (“Public Units”). Each Public Unit consists of one Class A ordinary share, $ 0.0001 par value per share (such shares included in the Public Units, the “Public Shares”), and one redeemable warrant (the “Public Warrants”), each whole Public Warrant entitling the holder thereof to purchase one Public Share at an exercise price of $ 11.50 per share. The Public Units were sold at a price of $ 10.00 per Public Unit, generating gross proceeds of $ 82,500,000 , which is described in Note 3. Simultaneously with the closing of the IPO, the Company consummated the sale of 510,000 units (including over-allotment of 30,000 units) (the “Private Placement Units”) to the Sponsor at a price of $ 10.00 per Private Placement Unit in a private placement generating gross proceeds of $ 5,100,000 , which is described in Note 4. Transaction costs amounted to $ 5,105,315 , consisting of $ 1,650,000 of underwriting fees, $ 2,887,500 of deferred underwriters’ fees and $ 567,815 of other offering costs, and were all initially charged to shareholders’ equity.\\nTrust Account\\nFollowing the consummation of the IPO on April 11, 2022, a total of $ 84,150,000 of the net proceeds from the IPO, including proceeds from the sale of the Private Placement Units, was deposited in a trust account (the “Trust Account”) and will be invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), with a maturity of 185 days or less, or in any open-ended investment company that holds itself out as a money market fund investing solely in U.S. Treasuries and meeting certain conditions under Rule 2a-7 of the Investment Company Act, as determined by the Company, until the earlier of (i) the completion of a Business Combination or (ii) the distribution of the funds in the Trust Account to the Company’s shareholders, as described below.\\nThe Company’s management has broad discretion with respect to the specific application of the net proceeds of the IPO and the sale of the Private Placement Units, although substantially all of the net proceeds are intended to be applied generally toward consummating a Business Combination. The stock exchange listing rules require that the Business Combination must be with one or more operating businesses or assets with a fair market value equal to at least 80 % of the value of the assets held in the Trust Account (excluding any deferred underwriters’ fees and taxes payable on the interest income earned on the Trust Account). The Company will only complete a Business Combination if the post-Business Combination company owns or acquires 50 % or more of the issued and outstanding voting securities of the target or otherwise acquires a controlling interest in the target business sufficient for it not to be required to register as an investment company under the Investment Company Act. There is no assurance that the Company will be able to successfully effect a Business Combination.\\n\\n| 6 |\\n\\nBusiness Combination\\nThe Company will provide the holders of the outstanding Public Shares (the “Public Shareholders”) with the opportunity to redeem all or a portion of their Public Shares either (i) in connection with a shareholder meeting called to approve the Business Combination or (ii) by means of a tender offer in connection with the Business Combination. The decision as to whether the Company will seek shareholder approval of a Business Combination or conduct a tender offer will be made by the Company. The Public Shareholders will be entitled to redeem their Public Shares for a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account calculated as of two business days prior to the consummation of the initial Business Combination (initially anticipated to be $ 10.20 per Public Unit, plus any pro rata interest then in the Trust Account, net of taxes payable). The Public Shares subject to redemption were recorded at a redemption value and classified as temporary equity upon the completion of the IPO in accordance with the Financial Accounting Standards Board (the “FASB”) Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” The Company will not redeem Public Shares in an amount that would cause its net tangible assets to be less than $ 5,000,001 (so that it does not then become subject to the “penny stock” rules of the Securities and Exchange Commission (the “SEC”)) either prior to or upon consummation of an initial Business Combination. However, a greater net tangible asset or cash requirement may be contained in the agreement relating to the Business Combination. The Company will have only 12 months from the closing of the IPO (or up to 18 months from the closing of the IPO, if the Company extends the period of time to consummate a Business Combination) to complete the initial Business Combination (the “Combination Period”). If the Company is unable to complete the initial Business Combination within the Combination Period, the Company will: (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including interest earned on the funds held in the Trust Account and not previously released to the Company to pay the Company’s franchise and income taxes, if any (less up to $ 100,000 of interest to pay dissolution expenses), divided by the number of then-issued and outstanding Public Shares, which redemption will completely extinguish Public Shareholders’ rights as shareholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the Company’s remaining shareholders and its board of directors, dissolve and liquidate, subject in each case to the Company’s obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law. There will be no redemption rights or liquidating distributions with respect to the Company’s warrants, which will expire worthless if the Company fails to complete the Business Combination within 12 months from the closing of the IPO (or up to 18 months from the closing of the IPO, if the Company extends the period of time to consummate a Business Combination).\\nThe founder shares are designated as Class B ordinary shares (the “Founder Shares”) and, except as described below, are identical to the Public Shares, and holders of Founder Shares have the same shareholder rights as Public Shareholders, except that (i) prior to the Company’s initial Business Combination, only holders of the Founder Shares have the right to vote on the appointment of directors, including in connection with the completion of the Company’s initial Business Combination, and holders of a majority of the Founder Shares may remove a member of the board of directors of the Company for any reason, (ii) the Founder Shares are subject to certain transfer restrictions, as described in more detail below, (iii) the Company’s initial shareholders have entered into an agreement with the Company, pursuant to which they have agreed to (A) waive their redemption rights with respect to their Founder Shares and Public Shares in connection with the completion of the Company’s initial Business Combination, (B) waive their redemption rights with respect to their Founder Shares and Public Shares in connection with a shareholder vote to approve an amendment to the Company’s amended and restated memorandum and articles of association that would affect the substance or timing of the Company’s obligation to provide for the redemption of the Company’s Public Shares in connection with an initial Business Combination or to redeem 100 % of the Company’s Public Shares if the Company has not consummated an initial Business Combination within 12 months from the closing of the IPO (or up to 18 months from the closing of the IPO, if the Company extends the period of time to consummate a Business Combination) and (C) waive their rights to liquidating distributions from the Trust Account with respect to their Founder Shares if the Company fails to complete its initial Business Combination within 12 months from the closing of the IPO (or up to 18 months from the closing of the IPO, if the Company extends the period of time to consummate a Business Combination) although they will be entitled to liquidating distributions from the Trust Account with respect to any Public Shares they hold if the Company fails to complete its initial Business Combination within the prescribed time frame, (iv) the Founder Shares will automatically convert into Public Shares concurrently with or immediately following the consummation of the Company’s initial Business Combination, or earlier at the option of the holder thereof, and (v) the Founder Shares are entitled to registration rights. If the Company submits its initial Business Combination to its Public Shareholders for a vote, the Sponsor and each member of the Company’s management team have agreed to vote their Founder Shares and Public Shares in favor of the Company’s initial Business Combination.\\n| 7 |\\n\\nThe Sponsor has agreed that it will be liable to the Company if and to the extent any claims by a third party for services rendered or products sold to the Company, or by a prospective target business with which the Company has discussed entering into a transaction agreement, reduce the amount of funds in the Trust Account to below the lesser of (i) $ 10.20 per Public Share or (ii) the actual amount per Public Share held in the Trust Account as of the date of the liquidation of the Trust Account due to reductions in the value of the trust assets, in each case net of the interest which may be withdrawn to pay taxes. This liability will not apply with respect to any claims by a third party or prospective target business who executed a waiver of any and all rights to seek access to the Trust Account, nor will it apply to any claims under the Company’s indemnity of the underwriters of the IPO against certain liabilities, including liabilities under the Securities Act of 1933, as amended, (the “Securities Act”). Moreover, in the event that an executed waiver is deemed to be unenforceable against a third party, then the Company’s Sponsor will not be responsible to the extent of any liability for such third party claims.\\nLiquidity, Capital Resources and Going Concern Consideration\\nThe Company’s liquidity needs prior to the consummation of the IPO had been satisfied through a payment from the Sponsor of $ 25,000 (see Note 5) for the Founder Shares and the loan under an unsecured promissory note (the “Promissory Note”) from the Sponsor of up to $ 400,000 (see Note 5) which was fully repaid on December 31, 2021. Subsequent to the consummation of the IPO, the Company’s liquidity has been satisfied through the net proceeds from the consummation of the IPO and the sale of Private Placement Units in a private placement to the Sponsor, held outside of the Trust Account. As of September 30, 2022, the Company had cash of $ 985,578 and working capital of $ 1,027,202 .\\nIn addition, in order to finance transaction costs in connection with a Business Combination, the Company’s Sponsor or an affiliate of the Sponsor or certain of the Company’s officers and directors may, but are not obligated to, provide the Company Working Capital Loans, as defined below (see Note 5). As of September 30, 2022, there were no amounts outstanding under any Working Capital Loans.\\nBased on the foregoing, management believes that the Company will not have sufficient working capital and borrowing capacity to meet its needs through the earlier of the consummation of a Business Combination or one year from the date of this Quarterly Report. Over this time period, the Company will use funds in the Trust Account to pay existing accounts payable, identify and evaluate prospective initial Business Combination candidates, perform due diligence on prospective target businesses, pay for travel expenditures in connection with the identification and evaluation of prospective target businesses, select the target business with which to effectuate an initial Business Combination, and structure, negotiate and consummate the Business Combination.\\nIn connection with the Company’s assessment of going concern considerations in accordance with FASB ASC 205-40, Presentation of Financial Statements – Going Concern, management has determined that the date for mandatory liquidation and dissolution, and the Company’s liquidity situation as discussed above, raises substantial doubt about the Company’s ability to continue as a going concern through April 6, 2023, the scheduled liquidation date of the Company if it does not complete a Business Combination prior to such date.\\nRisks and Uncertainties\\nIn February 2022, the Russian Federation and Belarus commenced a military action with the country of Ukraine. As a result of this action, various nations, including the United States, have instituted economic sanctions against the Russian Federation and Belarus. Further, the impact of this action and related sanctions on the world economy are not determinable as of the date of these unaudited condensed financial statements. The specific impact on the Company’s financial condition, results of operations, and cash flows is also not determinable as of the date of these unaudited condensed financial statements.\\nManagement continues to evaluate the impact of the COVID-19 pandemic and has concluded that while it is reasonably possible that the virus and war could have a negative effect on the Company’s financial position, results of operations and search for a target company, the specific impact is not readily determinable as of the date of these unaudited condensed financial statements. The unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty.\\n| 8 |\\n\\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\\nBasis of Presentation\\nThe accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 8 of Regulation S-X under the Securities Act. Certain information or footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted, pursuant to the rules and regulations of the SEC for interim financial reporting. Accordingly, they do not include all the information and footnotes necessary for a complete presentation of financial position, results of operations, or cash flows. In the opinion of management, the accompanying unaudited condensed financial statements include all adjustments, consisting of a normal recurring nature, which are necessary for a fair presentation of the financial position, operating results and cash flows for the periods presented.\\nThe accompanying unaudited condensed financial statements should be read in conjunction with the Company’s prospectus, which contains the initial audited financial statements and notes thereto for the period from January 5, 2022 (inception) to February 7, 2022, as filed with the SEC on March 1, 2022, and the Company’s report on Form 8-K, which contains the Company’s audited balance sheet and notes thereto as of April 11, 2022, as filed with the SEC on April 15, 2022. The interim results for the period from January 5, 2022 (inception) to September 30, 2022 are not necessarily indicative of the results to be expected for the fiscal year ending December 31, 2022 or for any future interim periods.\\nEmerging Growth Company Status\\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012, (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies, including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies, but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\\nUse of Estimates\\nThe preparation of the unaudited condensed financial statements in conformity with GAAP requires the Company’s management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the reporting period. Accordingly, the actual results could differ significantly from those estimates.\\nCash and Cash Equivalents\\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did no t have any cash equivalents on September 30, 2022.\\n| 9 |\\n\\nInvestments Held in Trust Account\\nThe Company’s portfolio of investments held in the Trust Account is comprised of investments in money market funds that invest in U.S. government securities and generally have a readily determinable fair value, or a combination thereof. Gains and losses resulting from the change in fair value of these securities and interest earned on investments held in the Trust Account are included in income on Trust Account in the accompanying unaudited condensed statements of operations. The estimated fair values of investments held in the Trust Account are determined using available market information.\\nOffering Costs\\nOffering costs were $ 5,105,315 consisting principally of underwriting, legal, accounting and other expenses incurred through the balance sheet date that are related to the IPO and were initially charged to shareholders’ equity upon the completion of the IPO. The Company complies with the requirements of FASB ASC 340-10-S99-1 and SEC Staff Accounting Bulletin Topic 5A - “Expenses of Offering.” The Company allocates offering costs between the Public Shares and Public Warrants (as defined below in Note 3) based on the relative fair values of the Public Shares and Public Warrants. Accordingly, $ 4,488,135 was allocated to the Public Shares and charged to temporary equity, and $ 617,180 was allocated to Public Warrants and charged to shareholders’ equity/(deficit).\\nFair Value of Financial Instruments\\nThe fair value of the Company’s assets and liabilities, which qualify as financial instruments under the FASB ASC 825, “Financial Instruments,” approximates the carrying amounts represented in the balance sheet, primarily due to its short-term nature.\\nWarrants\\nThe Company accounts for warrants as either equity-classified or liability-classified instruments based on an assessment of the warrant’s specific terms and applicable authoritative guidance in FASB ASC 480, “Distinguishing Liabilities from Equity” (“ASC 480”) and FASB ASC 815. The assessment considers whether the warrants are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and meet all of the requirements for equity classification under FASB ASC 815, including whether the warrants are indexed to the Company’s own ordinary shares and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of the Company’s control, among other conditions for equity classification. This assessment is conducted at the time of warrant issuance and as of each subsequent quarterly period end date while the warrants are outstanding.\\nFor issued or modified warrants that meet all of the criteria for equity classification, the warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all of the criteria for equity classification, the warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. The Company accounts for the 8,250,000 Public Warrants (as defined in Note 3) and 510,000 Private Warrants (as defined in Note 4) as equity-classified instruments.\\nThe over-allotment liabilities during the period from January 5, 2022 to September 30, 2022 are not material to these financial statements.\\nClass A Ordinary Shares Subject to Possible Redemption\\nThe Company accounts for its Class A ordinary shares subject to possible redemption in accordance with ASC 480. Class A ordinary shares subject to mandatory redemption (if any) is classified as a liability instrument and measured at fair value. Conditionally redeemable ordinary shares (including shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, ordinary shares are classified as shareholders’ equity. The Company’s ordinary shares feature certain redemption rights that are considered to be outside of the Company’s control and are subject to the occurrence of uncertain future events. Accordingly, as of September 30, 2022, 8,250,000 Class A ordinary shares subject to possible redemption are presented at redemption value as temporary equity, outside of the shareholders’ equity section of the Company’s unaudited condensed balance sheet.\\nThe Company recognizes changes in redemption value immediately as they occur and adjusts the carrying value of redeemable ordinary shares to equal the redemption value at the end of each reporting period. Increases or decreases in the carrying amount of redeemable ordinary shares are affected by charges against additional paid-in capital or accumulated deficit if additional paid-in capital equals to zero.\\n| 10 |\\n\\nAs of September 30, 2022, the ordinary shares reflected in the unaudited condensed balance sheet are reconciled in the following table:\\n\\n| Gross proceeds | $ | 82,500,000 |\\n| Less: |\\n| Proceeds allocated to Public Warrants | ( 9,973,401 | ) |\\n| Allocation of offering costs related to redeemable shares | ( 4,488,135 | ) |\\n| Plus: |\\n| Initial measurement of carrying value to redemption value | 16,111,536 |\\n| Subsequent measurement of Class A ordinary shares subject to possible redemption (interest earned on Trust Account) | 495,261 |\\n| Ordinary shares subject to possible redemption | 84,645,261 |\\n\\nConcentration of Credit Risk\\nFinancial instruments that potentially subject the Company to concentrations of credit risk consist of a cash account in a financial institution, which, at times, may exceed the Federal Depository Insurance Coverage of $ 250,000 . The Company has not experienced losses on this account.\\nNet Income/(Loss) Per Ordinary Share\\nThe Company complies with the accounting and disclosure requirements of FASB ASC 260, “Earnings Per Share.” Net loss per ordinary share is computed by dividing net loss by the weighted average number of ordinary shares outstanding during the period, excluding ordinary shares subject to forfeiture. Weighted average shares were reduced for the effect of an aggregate of 93,750 Founder Shares that were forfeited due to the underwriters’ partial exercise of the over-allotment option. Any remeasurement of the accretion to redemption value of the Class A ordinary shares subject to possible redemption was considered to be dividends paid to the Public Shareholders. Warrants issued are contingently exercisable (i.e., on the later of 30 days after the completion of the initial Business Combination or 12 months from the closing of the IPO). For Earnings Per Share (“EPS”) purposes, the warrants are anti-dilutive since they would generally not be reflected in basic or diluted EPS until the contingency is resolved. As of September 30, 2022, the Company did not have any dilutive securities and other contracts that could, potentially, be exercised or converted into ordinary shares and then share in the earnings of the Company. As a result, diluted income (loss) per ordinary share is the same as basic earnings per ordinary share for the periods presented.\\nThe net income (loss) per share presented in the unaudited condensed statements of operations is based on the following:\\n\\n| Three months ended September 30, 2022 | From January 5, 2022 (inception) through September 30, 2022 |\\n| Net income | $ | 307,468 | $ | 265,278 |\\n| Interest earned on investment held in Trust Account | ( 380,429 | ) | ( 495,261 | ) |\\n| Accretion of temporary equity into redemption value | - | ( 16,111,536 | ) |\\n| Net loss including accretion of equity into redemption value | $ | ( 72,961 | ) | $ | ( 16,341,519 | ) |\\n\\n\\n| Three months ended September 30, 2022 | From January 5, 2022 (inception) through September 30, 2022 |\\n| Redeemable Shares | Non- Redeemable Shares | Redeemable Shares | Non- Redeemable Shares |\\n| Basic and diluted net income/(loss) per share: |\\n| Numerators: |\\n| Allocation of net loss including accretion of temporary equity | $ | ( 55,618 | ) | $ | ( 17,343 | ) | $ | ( 11,673,872 | ) | $ | ( 4,667,647 | ) |\\n| Interest earned on investment held in Trust Account | 380,429 | - | 495,261 | - |\\n| Accretion of temporary equity to redemption value | - | - | 16,111,536 | - |\\n| Allocation of net income/(loss) | $ | 324,811 | $ | ( 17,343 | ) | $ | 4,932,925 | $ | ( 4,667,647 | ) |\\n| Denominators: |\\n| Weighted-average shares outstanding | 8,250,000 | 2,572,500 | 5,305,762 | 2,121,441 |\\n| Basic and diluted net income/(loss) per share | 0.04 | ( 0.01 | ) | 0.93 | ( 2.20 | ) |\\n\\n\\n| 11 |\\n\\nIncome Taxes\\nThe Company accounts for income taxes under FASB ASC 740, “Income Taxes” (“ASC 740”). ASC 740 requires the recognition of deferred tax assets and liabilities for both the expected impact of differences between the financial statement and tax basis of assets and liabilities and for the expected future tax benefit to be derived from tax loss and tax credit carry forwards. ASC 740 additionally requires a valuation allowance to be established when it is more likely than not that all or a portion of deferred tax assets will not be realized.\\nASC 740 also clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statement and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. ASC 740 also provides guidance on derecognition, classification, interest and penalties, accounting in interim period, disclosure and transition.\\nThe Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of September 30, 2022. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position.\\nThe Company determined that the Cayman Islands is the Company’s only major tax jurisdiction.\\nThe Company may be subject to potential examination by federal and state taxing authorities in the areas of income taxes. These potential examinations may include questioning the timing and amount of deductions, the nexus of income among various tax jurisdictions and compliance with federal and state tax laws. The Company’s management does not expect that the total amount of unrecognized tax benefits will materially change over the next 12 months.\\nThere is currently no taxation imposed on income by the Government of the Cayman Islands for the period from January 5, 2022 (inception) through September 30, 2022.\\nRecent Accounting Pronouncements\\nManagement does not believe that any recently issued, but not effective, accounting standards, if currently adopted, would have a material effect on the Company’s unaudited condensed financial statements.\\nNOTE 3 - INITIAL PUBLIC OFFERING\\nOn April 11, 2022, the Company sold 8,250,000 Public Units at a purchase price of $ 10.00 per Public Unit, generating gross proceeds of $ 82,500,000 (including 750,000 Public Units pursuant to the underwriters’ partial exercise of the over-allotment option) related to the IPO. Each Public Unit consists of one Public Share and one Public Warrant. Each Public Warrant entitles the holder thereof to purchase one Public Share at a price of $ 11.50 per share, and only whole warrants are exercisable.\\nThe warrants will become exercisable on the later of 30 days after the completion of the Company’s initial Business Combination or 12 months from the closing of the IPO and will expire five years after the completion of the Company’s initial Business Combination or earlier upon redemption or liquidation (see Note 7).\\n| 12 |\\n\\nNOTE 4 - PRIVATE PLACEMENT\\nSimultaneously with the closing of the IPO, the Sponsor purchased an aggregate of 510,000 Private Placement Units (including 30,000 Private Placement Units pursuant to the underwriters’ partial exercise of the over-allotment option) at a price of $ 10.00 per Private Placement Unit, for an aggregate purchase price of $ 5,100,000 , in a private placement. Each whole Private Placement Unit consists of one Class A ordinary share (“Private Placement Shares”) and one warrant (“Private Warrants”). Each Private Warrant entitles the holder to purchase one Class A ordinary share at a price of $ 11.50 per share, subject to adjustment. Certain of the proceeds from the sale of the Private Placement Units were added to the net proceeds from the IPO held in the Trust Account.\\nIf the Company does not complete a Business Combination within 12 months from the closing of the IPO (or up to 18 months from the closing of the IPO, if the Company extends the period of time to consummate a Business Combination), the proceeds from the sale of the Private Placement Units held in the Trust Account will be used to fund the redemption of the Company’s Class A ordinary shares (subject to the requirements of applicable law) and the Private Placement Units and all underlying securities will expire worthless. The Private Placement Units will not be transferable, assignable, or saleable until 30 days after the completion of an initial Business Combination, subject to certain exceptions.\\nNOTE 5 - RELATED PARTY TRANSACTIONS\\nFounder Shares\\nOn February 3, 2022, the Sponsor acquired 2,156,250 Founder Shares in exchange for $ 25,000 paid for deferred offering costs borne by the Sponsor. On May 23, 2022, 93,750 Founder Shares were forfeited as the underwriters did not exercise the over-allotment option on the remaining 375,000 Public Units (see Note 6).\\nThe Founder Shares are identical to the Class A ordinary shares included in the units sold in the IPO, except that the Founder Shares will automatically convert into Class A ordinary shares at the time of the Company’s initial Business Combination. Also, the Sponsor and each member of the management team have entered into an agreement with the Company, pursuant to which they have agreed to waive their redemption rights with respect to any Founder Shares and Public Shares held by them.\\nThe Sponsor and the Company’s directors and executive officers have agreed not to transfer, assign or sell any of their Founder Shares until the earlier of (A) one year after the completion of an initial Business Combination and (B) subsequent to the Company’s initial Business Combination, (x) if the closing price of Class A ordinary shares equals or exceeds $ 12.00 per share (as adjusted for share subdivisions, share capitalizations, reorganizations, recapitalizations and the like) for any 20 trading days within any 30 -trading day period commencing at least 150 days after an initial Business Combination, or (y) the date on which the Company completes a liquidation, merger, share exchange or other similar transaction that results in all Public Shareholders having the right to exchange their Public Shares for cash, securities or other property. Any permitted transferees would be subject to the same restrictions and other agreements of the Sponsor and the Company’s directors and executive officers with respect to any Founder Shares.\\nPromissory Note - Related Party\\nOn February 3, 2022, the Sponsor agreed to loan the Company up to $ 400,000 to be used for a portion of the expenses of the IPO. As of April 11, 2022, there was $ 80,000 outstanding under the Promissory Note. This loan was non-interest bearing, unsecured and due at the earlier of (i) September 30, 2022 or (ii) the closing of the IPO. On April 12, 2022, the loan was repaid upon the closing of the IPO out of the offering proceeds not held in the Trust Account.\\nDue to Related Party\\nThe Sponsor paid certain formation, operating or offering costs on behalf of the Company. These amounts are due on demand and are non-interest bearing. During the period from January 5, 2022 (inception) through March 31, 2022, the Sponsor paid $ 215,020 of formation, operating costs and offering costs on behalf of the Company. On April 12, 2022, the Company paid the Sponsor $ 160,020 and on April 14, 2022, the Company received $ 25,000 from the Sponsor. Subsequently on July 19, 2022, the Company fully paid $ 80,000 to the related party. As of September 30, 2022, there were no amounts outstanding due to related party.\\n| 13 |\\n\\nWorking Capital Loan\\nIn order to finance transaction costs in connection with a Business Combination, the Sponsor or an affiliate of the Sponsor, or certain of the Company’s officers and directors, may, but are not obligated to, loan the Company funds as may be required (the “Working Capital Loans”). If the Company completes a Business Combination, the Company would repay the Working Capital Loans out of the proceeds of the Trust Account released to the Company. Otherwise, the Working Capital Loans would be repaid only out of funds held outside of the Trust Account. In the event that a Business Combination does not complete, the Company may use a portion of proceeds held outside of the Trust Account to repay the Working Capital Loans, but no proceeds held in the Trust Account would be used to repay the Working Capital Loans.\\nExcept for the foregoing, the terms of such Working Capital Loans, if any, have not been determined and no written agreements exist with respect to such loans. The Working Capital Loans would either be repaid upon consummation of a Business Combination, without interest, or, at the lender’s discretion, up to $ 1.5 million of such Working Capital Loans may be convertible into units of the post-business combination entity at a price of $ 10.00 per unit. The units would be identical to the Private Placement Units. As of September 30, 2022, no Working Capital Loans were outstanding.\\nNOTE 6 - COMMITMENTS AND CONTINGENCIES\\nRegistration Rights\\nThe holders of the Founder Shares, Private Placement Shares and Private Warrants, including any of those issued upon conversion of Working Capital Loans (and any Private Placement Shares issuable upon the exercise of the Private Warrants that may be issued upon conversion of Working Capital Loans) will be entitled to registration rights pursuant to a registration and shareholder rights agreement signed on April 6, 2022. The holders of these securities are entitled to make up to three demands, excluding short-form demands, that the Company register such securities. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed after the completion of the initial Business Combination and rights to require the Company to register for resale such securities pursuant to Rule 415 under the Securities Act. The Company will bear the costs and expenses of filing any such registration statements.\\nUnderwriting Agreement\\nThe Company granted the underwriters a 45 -day option from the date of IPO to purchase up to 1,125,000 additional Public Units to cover over-allotments, if any, at the IPO price less the underwriting discounts and commissions. The underwriters exercised the over-allotment option in part for 750,000 Public Units on April 11, 2022. On May 23, 2022, the underwriters decided not to exercise the over-allotment option on the remaining 375,000 Public Units within the 45 -day period.\\nThe underwriters received a cash underwriting discount of $ 0.20 per Public Unit, or $ 1,650,000 in the aggregate, paid upon the closing of the IPO. In addition, the underwriters will be entitled to a deferred fee of $ 0.35 per Public Unit, or $ 2,887,500 in the aggregate, which is included in the accompanying condensed balance sheet. The deferred fee will become payable to the underwriters from the amounts held in the Trust Account solely in the event that the Company completes a Business Combination, subject to the terms of the underwriting agreement.\\nNOTE 7 - SHAREHOLDERS’ DEFICIT\\nPreference shares - The Company is authorized to issue 1,000,000 preference shares with a par value of $ 0.0001 per share with such designations, voting and other rights and preferences as may be determined from time to time by the Company’s board of directors. As of September 30, 2022, there were no preference shares issued or outstanding.\\n\\n| 14 |\\n\\nClass A Ordinary Shares - The Company is authorized to issue 200,000,000 Class A ordinary shares with a par value of $ 0.0001 per share. As of September 30, 2022, there were 510,000 Class A ordinary shares issued and outstanding, excluding 8,250,000 Class A ordinary shares subject to possible redemption.\\nClass B Ordinary Shares - The Company is authorized to issue 20,000,000 Class B ordinary shares with a par value of $ 0.0001 per share. As of September 30, 2022, there were 2,062,500 Class B ordinary shares issued and outstanding. On May 23, 2022, 93,750 Class B ordinary shares were forfeited as the underwriters did not exercise the over-allotment option on the remaining 375,000 Public Units.\\nPrior to the Company’s initial Business Combination, only holders of Class B ordinary shares will have the right to vote on the appointment of directors and holders of a majority of the Company’s Class B ordinary shares may remove a member of the board of directors of the Company for any reason. In addition, in a vote to continue the Company in a jurisdiction outside the Cayman Islands (which requires the approval of at least two thirds of the votes of all ordinary shares voted at a general meeting), holders of Founder Shares will have ten votes for every Founder Share and holders of Class A ordinary shares will have one vote for every Class A ordinary share and, as a result, the Company’s initial shareholders will be able to approve any such proposal without the vote of any other shareholder.\\nThe Class B ordinary shares will automatically convert into Class A ordinary shares on the consummation of the initial Business Combination at a ratio such that the number of Class A ordinary shares issuable upon conversion of all Founder Shares will equal, in the aggregate, on an as- converted basis, approximately 20 % of the sum of (i) the total number of ordinary shares issued and outstanding upon completion of the IPO, plus (ii) the total number of Class A ordinary shares issued or deemed issued or issuable upon conversion or exercise of any equity-linked securities or rights issued or deemed issued, by the Company in connection with or in relation to the consummation of the initial Business Combination (after giving effect to any redemptions of Class A ordinary shares by Public Shareholders), excluding any Class A ordinary shares or equity-linked securities exercisable for or convertible into Class A ordinary shares issued, deemed issued, or to be issued, to any seller in the initial Business Combination and any Private Placement Units issued to the Sponsor, its affiliates or any member of the Company’s management team upon conversion of Working Capital Loans. Any conversion of Class B ordinary shares described herein will take effect as a compulsory redemption of Class B ordinary shares and an issuance of Class A ordinary shares as a matter of Cayman Islands law. In no event will the Class B ordinary shares convert into Class A ordinary shares at a rate of less than one-to-one.\\nWarrants\\nAll warrants (Public Warrants and Private Warrants) will become exercisable at $ 11.50 per share, subject to adjustment, on the later of 30 days after the completion of the initial Business Combination or 12 months from the closing of the IPO; provided in each case that the Company has an effective registration statement under the Securities Act covering the issuance of the Class A ordinary shares issuable upon exercise of the warrants and a current prospectus relating to them is available (or the Company permits holders to exercise their warrants on a cashless basis under the circumstances specified in the warrant agreement). The warrants will expire at 5:00 p.m., New York City time, five years after the completion of the initial Business Combination or earlier upon redemption or liquidation. On the exercise of any warrant, the warrant exercise price will be paid directly to the Company and not placed in the Trust Account.\\nIn addition, if (x) the Company issues additional Class A ordinary shares or equity-linked securities for capital raising purposes in connection with the closing of an initial Business Combination at an issue price or effective issue price of less than $ 9.20 per ordinary share (with such issue price or effective issue price to be determined in good faith by the board of directors of the Company and, in the case of any such issuance to the Sponsor or its affiliates, without taking into account any Founder Shares held by the Sponsor or such affiliates, as applicable, prior to such issuance) (the “Newly Issued Price”), (y) the aggregate gross proceeds from such issuances represent more than 60 % of the total equity proceeds, and interest thereon, available for the funding of an initial Business Combination on the date of the consummation of an initial Business Combination (net of redemptions), and (z) the volume weighted average trading price of Class A ordinary shares during the 20 -trading day period starting on the trading day prior to the day on which the Company consummates an initial Business Combination (such price, the “Market Value”) is below $9.20 per share, the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115 % of the higher of the Market Value or the Newly Issued Price and the $ 16.50 per share redemption trigger price will be adjusted (to the nearest cent) to be equal to 165 % of the higher of the Market Value or the Newly Issued Price.\\n| 15 |\\n\\nThe Company is not registering the ordinary shares issuable upon exercise of the warrants at this time. However, the Company has agreed that as soon as practicable, but in no event later than 20 business days after the closing of the initial Business Combination, it will use commercially reasonable efforts to file with the SEC a registration statement covering the Class A ordinary shares issuable upon exercise of the warrants, and it will use commercially reasonable efforts to cause the same to become effective within 60 business days following the initial Business Combination and to maintain a current prospectus relating to those ordinary shares until the warrants expire or are redeemed; provided, that if the ordinary shares are at the time of any exercise of a warrant not listed on a national securities exchange such that they satisfy the definition of a “covered security” under Section 18(b)(1) of the Securities Act, the Company may, at its option, require holders of Public Warrants who exercise their warrants to do so on a “cashless basis” in accordance with Section 3(a)(9) of the Securities Act and, in the event the Company so elects, it will not be required to file or maintain in effect a registration statement, but the Company will be required to use commercially reasonable efforts to register or qualify the shares under applicable blue sky laws to the extent an exemption is not available.\\nRedemption of Warrants\\nOnce the warrants become exercisable, the Company may redeem the outstanding warrants:\\n\\n| | in whole and not in part; |\\n\\n| | at a price of $ 0.01 per warrant; |\\n\\n| | upon a minimum of 30 days’ prior written notice of redemption, which is referred to as the 30 -day redemption period; and |\\n\\n| | if, and only if, the last reported sale price of ordinary shares equals or exceeds $ 16.50 per share (as adjusted for share splits, share dividends, reorganizations, recapitalizations, and the like) for any 20 trading days within a 30 -trading day period ending on the third trading day prior to the date on which the Company sends the notice of redemption to the warrant holders. |\\n\\nThe Company will not redeem the warrants unless a registration statement under the Securities Act covering the ordinary shares issuable upon exercise of the warrants is effective and a current prospectus relating to those ordinary shares is available throughout the 30-day redemption period, except if the warrants may be exercised on a cashless basis and such cashless exercise is exempt from registration under the Securities Act. If and when the warrants become redeemable by the Company, the Company may exercise its redemption right even if it is unable to register or qualify the underlying securities for sale under all applicable state securities laws.\\nIf the Company calls the warrants for redemption as described above, its management will have the option to require all holders that wish to exercise warrants to do so on a “cashless basis.” In determining whether to require all holders to exercise their warrants on a “cashless basis,” the Company’s management will consider, among other factors, the cash position, the number of warrants that are outstanding and the dilutive effect on the Company’s shareholders of issuing the maximum number of ordinary shares issuable upon the exercise of the Company’s warrants. In such event, each holder would pay the exercise price by surrendering the warrants for that number of ordinary shares equal to the quotient obtained by dividing (x) the product of the number of ordinary shares underlying the warrants, multiplied by the excess of the “fair market value” over the exercise price of the warrants by (y) the fair market value. The “fair market value” shall mean the average volume weighted average last reported sale price of the Class A ordinary shares for the 10 trading days ending on the third trading day prior to the date on which the notice of redemption is sent to the holders of warrants.\\nNOTE 8 - FAIR VALUE MEASUREMENTS\\nThe fair value of the Company’s financial assets and liabilities reflects management’s estimate of amounts that the Company would have received in connection with the sale of the assets or paid in connection with the transfer of the liabilities in an orderly transaction between market participants at the measurement date. In connection with measuring the fair value of its assets and liabilities, the Company seeks to maximize the use of observable inputs (market data obtained from independent sources) and to minimize the use of unobservable inputs (internal assumptions about how market participants would price assets and liabilities). The following fair value hierarchy is used to classify assets and liabilities based on the observable inputs and unobservable inputs used in order to value the assets and liabilities:\\nLevel 1: Quoted prices in active markets for identical assets or liabilities. An active market for an asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis.\\n| 16 |\\n\\nLevel 2: Observable inputs other than Level 1 inputs. Examples of Level 2 inputs include quoted prices in active markets for similar assets or liabilities and quoted prices for identical assets or liabilities in markets that are not active.\\nLevel 3: Unobservable inputs based on our assessment of the assumptions that market participants would use in pricing the asset or liability.\\nThe following table presents information about the Company’s assets that are measured at fair value on a recurring basis as of September 30, 2022 and indicates the fair value hierarchy of the valuation inputs the Company utilized to determine such fair value.\\n\\n| As of September 30, 2022 | QuotedPrices inActiveMarkets(Level 1) | SignificantOtherObservableInputs(Level 2) | SignificantOtherUnobservableInputs(Level 3) |\\n| Assets: |\\n| Investment held in Trust Account | $ | 84,645,261 | 84,645,261 | - | - |\\n\\nNOTE 9 - SUBSEQUENT EVENTS\\nThe Company has evaluated subsequent events through November 15, 2022 , which was the date these unaudited condensed financial statements were available for issuance and determined that there were no significant unrecognized events through that date.\\n| 17 |\\n\\nI\\nMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\\nReferences in this Quarterly Report to “we,” “us” or the “Company” refer to Denali Capital Acquisition Corp. References to our “management” or our “management team” refer to our officers and directors, and references to the “Sponsor” refer to Denali Capital Global Investment LLC. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Quarterly Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\\nSpecial Note Regarding Forward-Looking Statements\\nThis Quarterly Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, that are not historical facts, and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. All statements, other than statements of historical fact included in this Form 10‑Q including, without limitation, statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward- looking statements. Words such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intends,” “may,” “might,” “plan,” “possible,” “potential,” “predict,” “project,” “should,” “would” and variations thereof and similar words and expressions are intended to identify such forward-looking statements. Such forward-looking statements relate to future events or future performance, but reflect management’s current beliefs, based on information currently available. A number of factors could cause actual events, performance or results to differ materially from the events, performance and results discussed in the forward-looking statements. For information identifying important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements, please refer to the Risk Factors section of the Company’s final prospectus for its initial public offering (“IPO”) filed with the SEC on April 7, 2022, and in its Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2022, filed with the SEC on August 12, 2022. The Company’s securities filings can be accessed on the EDGAR section of the SEC’s website at www.sec.gov. Except as expressly required by applicable securities law, the Company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.\\nOverview\\nWe are a blank check company incorporated in the Cayman Islands on January 5, 2022 (inception) formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses (a “Business Combination”). We intend to effectuate our Business Combination using cash derived from the proceeds of our initial public offering (“IPO”) and the sale of units (the “Private Placement Units”) in a private placement (the “Private Placement”) to the Company’s founder and sponsor, Denali Capital Global Investments LLC (the “Sponsor”), additional shares, debt or a combination of cash, shares and debt.\\nWe expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete a Business Combination will be successful.\\nResults of Operations\\nWe have neither engaged in any operations nor generated any operating revenues to date. Our only activities from January 5, 2022 (inception) through September 30, 2022 were organizational activities and those necessary to prepare for and complete the IPO, described below. We do not expect to generate any operating revenues until after the completion of our initial Business Combination. We expect to generate non-operating income in the form of interest income on marketable securities held after the IPO. We expect that we will incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses in connection with searching for, and completing, a Business Combination.\\n| 18 |\\n\\nFor the three months ended September 30, 2022, we had net income of $307,468, which consists of interest earned on investment held in the Trust Account, as defined below, of $380,429 partially offset by $72,961 of formation and operating costs.\\nFor the period from January 5, 2022 (inception) through September 30, 2022, we had net income of $265,278, which consists of interest earned on investment held in the Trust Account of $495,261 partially offset by $229,983 of formation and operating costs.\\nFor the period from January 5, 2022 (inception) through September 30, 2022, we had an increase in cash flows of $985,578 resulting from net cash used in operating activities of $260,264, net cash used in investing activities of $84,150,000 and net cash provided by financing activities of $85,395,842.\\nCash Flows from Operating Activities- For the period from January 5, 2022 (inception) through September 30, 2022, net cash used in operations was $260,264 primarily due to net income of $265,278 for the period and the changes in current assets and liabilities of $(41,624), prepaid expenses of $(132,427) and accounts payable and accrued expenses of $90,803. In addition, net cash used in operating activities includes adjustments to reconcile net income from formation costs paid by related party of $11,343 and income on Trust Account of $495,261.\\nCash Flows from Investing Activities- For the period from January 5, 2022 (inception) through September 30, 2022, net cash used in investing activities was $84,150,000 due to investment held in Trust Account.\\nCash Flows from Financing Activities- For the period from January 5, 2022 (inception) through September 30, 2022, net cash provided by financing activities was $85,395,842 primarily due to proceeds from issuance of promissory note to related party of $80,000, proceeds from related party of $25,000, proceeds from issuance of private placement units of $5,100,000, proceeds from issuance of public units through public offering of $82,500,000, payment of promissory note to related party of $80,000, payment to related party of $240,020, payment of offering costs of $339,138 and payment of underwriter’s discount of $1,650,000.\\nLiquidity and Capital Resources\\nOur liquidity needs prior to the consummation of the IPO were satisfied through a payment from the Sponsor and the loan under an unsecured promissory note from the Sponsor of up to $400,000.\\nOn April 11, 2022, we consummated the IPO of 8,250,000 units (“Public Units”), inclusive of 750,000 Public Units sold to the underwriters upon the underwriters’ election to partially exercise their over-allotment option. Each Public Unit consists of one Class A ordinary share, $0.0001 par value per share (such shares included in the Public Units, the “Public Shares”), and one redeemable warrant (the “Public Warrants”), each whole Public Warrant entitling the holder thereof to purchase one Public Share at an exercise price of $11.50 per share. The Public Units were sold at a price of $10.00 per Public Unit, generating gross proceeds of $82,500,000. Simultaneously with the closing of the IPO, we consummated the sale of 510,000 Private Placement Units, inclusive of 30,000 Private Placement Units sold to the Sponsor pursuant to the underwriters’ election to partially exercise their over-allotment option. Each whole Private Placement Unit consists of one Class A ordinary share (“Private Placement Shares”) and one warrant (“Private Warrants”), each whole Private Warrant entitling the holder thereof to purchase one Class A ordinary share at an exercise price of $11.50 per share. The Private Placement Units were sold at a price of $10.00 per Private Placement Unit, generating gross proceeds of $5,100,000.\\nFollowing the closing of the IPO and sale of the Private Placement Units on April 11, 2022, a total of $84,150,000 was placed in a U.S.-based trust account maintained by Wilmington Trust, National Association, acting as trustee (the “Trust Account”), and we had $1,515,795 of cash held outside of the Trust Account, after payment of costs related to the IPO, and available for working capital purposes. In connection with the IPO, we incurred $5,105,315 in transaction costs, consisting of $1,650,000 of underwriting fees, $2,887,500 of deferred underwriting fees and $567,815 of other offering costs. Deferred offering costs consist of legal, accounting, and underwriting fees and other costs incurred through the balance sheet date that are directly related to the IPO.\\nAs of September 30, 2022, we had marketable securities held in the Trust Account of $84,645,261. We intend to use substantially all of the funds held in the Trust Account, including any amounts representing interest earned on the Trust Account, excluding deferred underwriting commissions, to complete our Business Combination. We may withdraw interest from the Trust Account to pay taxes, if any. To the extent that our share capital or debt is used, in whole or in part, as consideration to complete a Business Combination, the remaining proceeds held in the Trust Account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies. We intend to use the funds held outside of the Trust Account to primarily identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, structure, negotiate and complete a Business Combination.\\n| 19 |\\n\\nIn order to fund working capital deficiencies or finance transaction costs in connection with a Business Combination, our Sponsor or an affiliate of our Sponsor or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If the Company completes the initial Business Combination, it would repay such loaned amounts. In the event that the initial Business Combination does not close, the Company may use a portion of the working capital held outside of the Trust Account to repay such loaned amounts, but no proceeds from the Trust Account would be used for such repayment. Up to $1,500,000 of such loans may be convertible into units of the post-business combination entity, at a price of $10.00 per unit at the option of the lender. The units would be identical to the Private Placement Units. In the event that the initial Business Combination does not close, the Company may use a portion of the working capital held outside of the Trust Account to repay such loaned amounts, but no proceeds from the Trust Account would be used for such repayment.\\nAs of September 30, 2022, we had cash of $985,578 and working capital of $1,027,202. In addition, in order to finance transaction costs in connection with a Business Combination, our Sponsor or an affiliate of our Sponsor or certain of our officers and directors may, but are not obligated to, provide us funds as may be required (the “Working Capital Loans”). As of September 30, 2022, there were no amounts outstanding under any Working Capital Loans.\\nAccordingly, the accompanying unaudited condensed financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) which contemplates continuation of the Company as a going concern and the realization of assets and the satisfaction of liabilities in the normal course of business. The unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty. Further, we have incurred and expect to continue to incur significant costs in pursuit of our financing and acquisition plans. Management plans to address this uncertainty during the period leading up to the initial Business Combination. Based on the foregoing, management believes that the Company will not have sufficient working capital and borrowing capacity to meet its needs through the earlier of the consummation of a Business Combination or one year from the date of this filing. These factors, among others, raise substantial doubt about our ability to continue as a going concern. Over this time period, the Company will use these funds to pay existing accounts payable, identify and evaluate prospective initial Business Combination candidates, perform due diligence on prospective target businesses, pay for travel expenditures in connection with the identification and evaluation of prospective target businesses, select the target business with which to effectuate an initial Business Combination, and structure, negotiate and consummate the Business Combination. In case the Company is unable to consummate the initial Business Combination by April 6, 2023, it will seek to extend the combination period up to 18 months from the date of the IPO by resolution of the board of directors of the Company. In order to extend the time available for the Company to consummate an initial Business Combination for an additional three months, the Sponsor or its affiliates or designees must deposit into the Trust Account $825,000, (or $0.1 per share) or up to an aggregate of $1,500,000, or ($0.20) per share, on or prior to the date of the deadline. The Company will issue a press release announcing each extension at least three days prior to the deadline. In addition, it will issue a press release the day after the deadline, announcing whether the funds have been timely deposited. The Sponsor and its affiliates or designees are obligated to fund the Trust Account in order to extend the time for us to complete our initial Business Combination, but the Sponsor will not be obligated to extend such time. In addition to the foregoing arrangements, the Company may extend the period of time to consummate an initial Business Combination by a shareholder vote to amend our amended and restated memorandum and articles of association (“Shareholder Extension Period”).\\nIf our estimate of the costs of identifying a target business, undertaking in-depth due diligence and negotiating a Business Combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our initial Business Combination. Moreover, we may need to obtain additional financing either to complete our Business Combination or because we become obligated to redeem a significant number of our Public Shares upon completion of our Business Combination, in which case we may issue additional securities or incur debt in connection with such Business Combination.\\nOff-Balance Sheet Financing Arrangements\\nWe have no obligations, assets or liabilities that would be considered off-balance sheet arrangements as of September 30, 2022. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets.\\n| 20 |\\n\\nOther Contractual Obligations\\nRegistration Rights\\nThe holders of our Class B ordinary shares initially issued to our Sponsor in a private placement prior to the IPO (the “Founder Shares”), Private Placement Shares and Private Warrants, including any of those issued upon conversion of Working Capital Loans (and any Private Placement Shares issuable upon the exercise of the Private Warrants that may be issued upon conversion of Working Capital Loans) will be entitled to registration rights pursuant to a registration and shareholder rights agreement signed on April 6, 2022. The holders of these securities are entitled to make up to three demands, excluding short form demands, that the Company register such securities. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed after the completion of our initial Business Combination and rights to require us to register for resale such securities pursuant to Rule 415 under the Securities Act. The Company will bear the costs and expenses of filing any such registration statements.\\nUnderwriting Agreement\\nWe granted the underwriters a 45-day option from the date of IPO to purchase up to 1,125,000 additional Public Units to cover over-allotments, if any, at the IPO price less the underwriting discounts and commissions. The underwriters exercised the over-allotment option in part for 750,000 Public Units on April 11, 2022. On May 23, 2022, the underwriters decided not to exercise the over-allotment option on the remaining 375,000 Public Units.\\nThe underwriters received a cash underwriting discount of $0.20 per Public Unit, or $1,650,000 in the aggregate, paid upon the closing of the IPO. In addition, the underwriters will be entitled to a deferred fee of $0.35 per Public Unit, or $2,887,500 in the aggregate. The deferred fee will become payable to the underwriters from the amounts held in the Trust Account solely in the event that the Company completes a Business Combination, subject to the terms of the underwriting agreement.\\nCritical Accounting Policies\\nBasis of Presentation\\nThe accompanying unaudited condensed financial statements are presented in conformity with GAAP and pursuant to the rules and regulations of the SEC.\\nEmerging Growth Company Status\\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012, (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies, including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies, but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\\n| 21 |\\n\\nClass A Ordinary Shares Subject to Possible Redemption\\nThe Company will account for its Class A ordinary shares subject to possible redemption in accordance with the guidance in the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 480 “Distinguishing Liabilities from Equity.” Class A ordinary shares subject to mandatory redemption (if any) is classified as a liability instrument and measured at fair value. Conditionally redeemable ordinary shares (including shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, ordinary shares are classified as shareholders’ equity. The Company’s ordinary shares will feature certain redemption rights that are considered to be outside of the Company’s control and will be subject to the occurrence of uncertain future events. Accordingly, as of September 30, 2022, 8,250,000 Class A ordinary shares subject to possible redemption are presented at redemption value as temporary equity, outside of the shareholders’ equity section of the Company’s unaudited condensed balance sheet.\\nThe Company recognizes changes in redemption value immediately as they occur and adjusts the carrying value of redeemable ordinary shares to equal the redemption value at the end of each reporting period. Increases or decreases in the carrying amount of redeemable ordinary shares are affected by charges against additional paid in capital or accumulated deficit if additional paid in capital equals to zero.\\nWarrants\\nThe Company accounts for warrants as either equity-classified or liability-classified instruments based on an assessment of the warrant’s specific terms and applicable authoritative guidance in FASB ASC 480, “Distinguishing Liabilities from Equity” (“ASC 480”) and FASB ASC 815. The assessment considers whether the warrants are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and meet all of the requirements for equity classification under FASB ASC 815, including whether the warrants are indexed to the Company’s own ordinary shares and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of the Company’s control, among other conditions for equity classification. This assessment is conducted at the time of warrant issuance and as of each subsequent quarterly period end date while the warrants are outstanding.\\nFor issued or modified warrants that meet all of the criteria for equity classification, the warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all of the criteria for equity classification, the warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. The Company accounts for the 8,250,000 Public Warrants (as defined in Note 3) and 510,000 Private Warrants (as defined in Note 4) as equity-classified instruments.\\nNet Income/(Loss) Per Ordinary Share\\nThe Company complies with the accounting and disclosure requirements of FASB ASC 260, “Earnings Per Share.” Net loss per ordinary share is computed by dividing net loss by the weighted average number of ordinary shares outstanding during the period, excluding ordinary shares subject to forfeiture. Weighted average shares were reduced for the effect of an aggregate of 93,750 Founder Shares that were forfeited due to the underwriters’ partial exercise of the over-allotment option. Any remeasurement of the accretion to redemption value of the Class A ordinary shares subject to possible redemption was considered to be dividends paid to the Public Shareholders. Warrants issued are contingently exercisable (i.e., on the later of 30 days after the completion of the initial Business Combination or 12 months from the closing of the IPO). For Earnings Per Share (“EPS”) purposes, the warrants are anti-dilutive since they would generally not be reflected in basic or diluted EPS until the contingency is resolved. As of September 30, 2022, the Company did not have any dilutive securities and other contracts that could, potentially, be exercised or converted into ordinary shares and then share in the earnings of the Company. As a result, diluted profit (loss) per ordinary share is the same as basic earnings per ordinary share for the periods presented.\\n| 22 |\\n\\nRecent Accounting Pronouncements\\nManagement does not believe that any recently issued, but not effective, accounting standards, if currently adopted, would have a material effect on the Company’s financial statements.\\nI\\nQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nAs of September 30, 2022, we were not subject to any market or interest rate risk. Following the consummation of our IPO, the net proceeds of our IPO, including amounts in the Trust Account, have been invested in certain U.S. government securities with a maturity of 185 days or less or in certain money market funds that invest solely in U.S. treasuries. Due to the short-term nature of these investments, we believe there will be no associated material exposure to interest rate risk.\\nI\\nCONTROLS AND PROCEDURES\\nDisclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.\\n| 23 |\\n\\nEvaluation of Disclosure Controls and Procedures\\nAs required by Rules 13a‑15 and 15d‑15 under the Exchange Act, our Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2022. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rules 13a‑15(e) and 15d‑15(e) under the Exchange Act) were effective.\\nChanges in Internal Control Over Financial Reporting\\nDuring the most recently completed fiscal quarter, there has been no change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\\nPart II. OTHER INFORMATION\\nI\\nLEGAL PROCEEDINGS.\\nNone.\\nI\\nRISK FACTORS.\\nFactors that could cause our actual results to differ materially from those in this Quarterly Report are any of the risks described in our final prospectus for our IPO filed with the SEC on April 7, 2022, and in other filings with the SEC as described below. Any of these factors could result in a significant or material adverse effect on our results of operations or financial condition. We may disclose changes to such factors or disclose additional factors from time to time in our future filings with the SEC. Additional risk factors not currently known to us or that we currently deem immaterial may also impair our business or results of operations. As of the date of this Quarterly Report, there have been no material changes to the risk factors disclosed in (i) our final prospectus for our IPO filed with the SEC on April 7, 2022, and (ii) our Quarterly Report on Form 10-Q for the quarter ended June 30, 2022, as filed with the SEC on August 12, 2022. except for the following:\\nChanges in laws or regulations or in how such laws or regulations are interpreted or applied, or a failure to comply with any laws, regulations, interpretations or applications, may adversely affect our business, investments and results of operations, and our ability to negotiate and complete our initial Business Combination.\\nWe are subject to laws and regulations, and interpretations and applications of such laws and regulations enacted by national, regional, state and local governments and, potentially, non-U.S. jurisdictions. In particular, we will be required to comply with certain SEC and other legal and regulatory requirements, and our consummation of an initial Business Combination may be contingent upon our ability to comply with certain laws, regulations, interpretations and applications and any post-business combination company may be subject to additional laws, regulations, interpretations and applications. Compliance with, and monitoring of, the foregoing may be difficult, time consuming and costly. Those laws and regulations and their interpretation and application may also change from time to time, and those changes could have a material adverse effect on our business, investments and results of operations, and our ability to negotiate and complete an initial business combination. In addition, a failure to comply with applicable laws or regulations, as interpreted and applied, could have a material adverse effect on our business and results of operations, and our ability to negotiate and complete an initial business combination.\\nOn March 30, 2022, the SEC issued proposed rules (the “SPAC Rule Proposals”) relating to, among other items, enhancing disclosures in business combination transactions involving special purpose acquisition companies (“SPACs”) and private operating companies; amending the financial statement requirements applicable to transactions involving shell companies; changing the treatment of financial projections in SEC filings in connection with proposed business combination transactions; increasing the potential liability of certain participants in proposed business combination transactions; and a proposed safe harbor for SPACs under the Investment Company Act of 1940, as amended (including certain time limits to announce and consummate a business combination) (the “Investment Company Act”). These proposed rules, if adopted, whether in the form proposed or in revised form, or pursuant to the SEC’s views expressed in the SPAC Rule Proposals, may materially adversely affect our ability to negotiate and complete our initial business combination and may increase the costs and time related thereto.\\n| 24 |\\n\\nThe current economic downturn may lead to increased difficulty in completing our initial business combination.\\nOur ability to consummate our initial Business Combination may depend, in part, on worldwide economic conditions. In recent months, we have observed increased economic uncertainty in the United States and abroad. Impacts of such economic weakness include:\\n\\n| ● | falling overall demand for goods and services, leading to reduced profitability; |\\n\\n\\n| ● | reduced credit availability; |\\n\\n\\n| ● | higher borrowing costs; |\\n\\n\\n| ● | reduced liquidity; |\\n\\n\\n| ● | volatility in credit, equity and foreign exchange markets; and |\\n\\n\\n| ● | bankruptcies. |\\n\\nThese developments could lead to inflation, higher interest rates, and uncertainty about business continuity, which may adversely affect the business of our potential target businesses and create difficulties in obtaining debt or equity financing for our initial Business Combination, as well as leading to an increase in the number of Public Shareholders exercising redemption rights in connection therewith.\\nRecent volatility in capital markets may affect our ability to obtain financing for our initial Business Combination through sales of ordinary shares or issuance of indebtedness.\\nWith uncertainty in the capital markets and other factors, financing for our initial Business Combination may not be available on terms favorable to us or at all. If we raise additional funds through further issuances of equity or convertible debt securities, our existing shareholders could suffer significant dilution, and any new equity securities we issue could have rights, preferences, and privileges superior to those of holders of our ordinary shares. Any debt financing secured by us could involve additional restrictive covenants relating to our capital-raising activities and other financial and operational matters, which may limit the operations and growth of the surviving company of our initial Business Combination. If we are unable to obtain adequate financing or financing on terms satisfactory to us, we could face significant limitations on our ability to complete our initial Business Combination.\\nMilitary conflict in Ukraine or elsewhere may lead to increased and price volatility for publicly traded securities, which could make it more difficult for us to consummate an initial Business Combination.\\nMilitary conflict in Ukraine or elsewhere may lead to increased and price volatility for publicly traded securities, including ours, and to other national, regional and international economic disruptions and economic uncertainty, any of which could make it more difficult for us to identify a business combination target and consummate an initial Business Combination on acceptable commercial terms or at all.\\nThere may be significant competition for us to find an attractive target for an initial Business Combination. This could increase the costs associated with completing our initial Business Combination and may result in our inability to find a suitable target for our initial Business Combination.\\nIn recent years, the number of SPACs that have been formed has increased substantially. Many companies have entered into business combinations with SPACs, and there are still many SPACs seeking targets for their initial business combination, as well as additional SPACs currently in registration. As a result, at times, fewer attractive targets may be available, and it may require more time, effort and resources to identify a suitable target for an initial Business Combination.\\n| 25 |\\n\\nIn addition, because there are a large number of SPACs seeking to enter into an initial Business Combination with available targets, the competition for available targets with attractive fundamentals or business models may increase, which could cause target companies to demand improved financial terms. Attractive deals could also become scarcer for other reasons, such as economic or industry sector downturns, geopolitical tensions or increases in the cost of additional capital needed to close business combinations or operate targets post-business combination. This could increase the cost of, delay or otherwise complicate or frustrate our ability to find a suitable target for and/or complete our initial Business Combination and may result in our inability to consummate an initial Business Combination on terms favorable to our investors altogether.\\nIf we are deemed to be an investment company for purposes of the Investment Company Act, we would be required to institute burdensome compliance requirements and our activities would be severely restricted. As a result, in such circumstances, unless we are able to modify our activities so that we would not be deemed an investment company, we would expect to abandon our efforts to complete an initial Business Combination and instead to liquidate the Company.\\nAs described further above, the SPAC Rule Proposals relate, among other matters, to the circumstances in which SPACs such as the Company could potentially be subject to the Investment Company Act and the regulations thereunder. The SPAC Rule Proposals would provide a safe harbor for such companies from the definition of “investment company” under Section 3(a)(1)(A) of the Investment Company Act, provided that a SPAC satisfies certain criteria, including a limited time period to announce and complete a de-SPAC transaction. Specifically, to comply with the safe harbor, the SPAC Rule Proposals would require a company to file a report on Form 8-K announcing that it has entered into an agreement with a target company for a business combination no later than 18 months after the effective date of its IPO registration statement. A company would then be required to complete its initial business combination no later than 24 months after the effective date of the IPO registration statement.\\nBecause the SPAC Rule Proposals have not yet been adopted, there is currently uncertainty concerning the applicability of the Investment Company Act to a SPAC, including a company like ours that does not complete its business combination within 24 months after the effective date of the IPO registration statement.\\nIf we are deemed to be an investment company under the Investment Company Act, our activities would be severely restricted. In addition, we would be subject to burdensome compliance requirements. We do not believe that our principal activities will subject us to regulation as an investment company under the Investment Company Act. However, if we are deemed to be an investment company and subject to compliance with and regulation under the Investment Company Act, we would be subject to additional regulatory burdens and expenses for which we have not allotted funds. As a result, unless we are able to modify our activities so that we would not be deemed an investment company, we would expect to abandon our efforts to complete an initial business combination and instead to liquidate the Company.\\nTo mitigate the risk that we might be deemed to be an investment company for purposes of the Investment Company Act, we may, at any time, instruct the trustee to liquidate the securities held in the Trust Account and instead to hold the funds in the Trust Account in cash until the earlier of the consummation of our initial Business Combination or our liquidation. As a result, following the liquidation of securities in the Trust Account, we would likely receive minimal interest, if any, on the funds held in the Trust Account, which would reduce the dollar amount our Public Shareholders would receive upon any redemption or liquidation of the Company.\\nThe funds in the Trust Account have, since our IPO, been held only in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds investing solely in U.S. government treasury obligations and meeting certain conditions under Rule 2a-7 under the Investment Company Act. However, to mitigate the risk of us being deemed to be an unregistered investment company (including under the subjective test of Section 3(a)(1)(A) of the Investment Company Act) and thus subject to regulation under the Investment Company Act, we may, at any time, and we expect that we will, on or prior to the 12-month anniversary of the effective date of the Registration Statement, instruct Wilmington Trust, National Association, the trustee with respect to the Trust Account, to liquidate the U.S. government treasury obligations or money market funds held in the Trust Account and thereafter to hold all funds in the Trust Account in cash until the earlier of consummation of our initial Business Combination or liquidation of the Company. Following such movement of funds, we would likely receive minimal interest, if any, on the funds held in the Trust Account. However, interest previously earned on the funds held in the Trust Account still may be released to us to pay our taxes, if any. As a result, any decision to liquidate the securities held in the Trust Account and thereafter to hold all funds in the Trust Account in cash would reduce the dollar amount our Public Shareholders would receive upon any redemption or liquidation of the Company.\\n| 26 |\\n\\nIn addition, even prior to the 12-month anniversary of the effective date of the IPO Registration Statement, we may be deemed to be an investment company. The longer that the funds in the Trust Account are held in short-term U.S. government treasury obligations or in money market funds invested exclusively in such securities, the greater the risk that we may be considered an unregistered investment company, in which case we may be required to liquidate the Company. Accordingly, we may determine, in our discretion, to liquidate the securities held in the Trust Account at any time, even prior to the 12-month anniversary, and instead hold all funds in the Trust Account in cash, which would further reduce the dollar amount our Public Shareholders would receive upon any redemption or liquidation of the Company.\\nThere is substantial doubt about our ability to continue as a “going concern.”\\nIn connection with the Company’s assessment of going concern considerations under applicable accounting standards, management has determined that our possible need for additional financing to enable us to negotiate and complete our initial Business Combination, as well as the deadline by which we may be required to liquidate our Trust Account, raise substantial doubt about the Company’s ability to continue as a going concern through one year from the date the financial statements included elsewhere in this Quarterly Report were issued. In case the Company is unable to consummate the initial Business Combination by April 6, 2023, it will seek to extend the combination period up to 18 months from the date of the IPO.\\nI\\nUNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.\\nOn February 3, 2022, the Sponsor acquired 2,156,250 Founder Shares for an aggregate purchase price of $25,000. The issuance of such Founder Shares to the Sponsor was made pursuant to the exemption from registration contained in Section 4(a)(2) of the Securities Act.\\nSubstantially concurrently with the closing of the IPO, the Company completed the private sale of 510,000 Private Placement Units to the Sponsor at a purchase price of $10.00 per Private Placement Unit, generating gross proceeds to the Company of $5,100,000.\\nThe Private Placement Shares sold as part of the Private Placement Units are identical to the Public Shares sold as part of the Public Units in the IPO, except that the Sponsor has agreed not to transfer, assign or sell any of the Private Placement Shares (except to certain permitted transferees) until 30 days after the completion of the Company’s initial business combination. The issuance of the Private Placement Shares was made pursuant to the exemption from registration contained in Section 4(a)(2) of the Securities Act.\\nA total of $84,150,000, comprised of $80,850,000 of the proceeds from the IPO, and $3,300,000 of the proceeds from the Private Placement, were placed in a U.S.-based trust account maintained by Wilmington Trust, acting as trustee.\\nFor a description of the use of the proceeds generated in the Private Placement, see Part I, Item 2 of this Form 10‑Q.\\nI\\nDEFAULTS UPON SENIOR SECURITIES.\\nNone.\\nI\\nMINE SAFETY DISCLOSURES.\\nNot applicable.\\nI\\nOTHER INFORMATION.\\nNone.\\n| 27 |\\n\\nI\\nEXHIBITS.\\nThe following exhibits are filed as part of, or incorporated by reference into, this Quarterly Report on Form 10‑Q.\\n\\n| No. | Description of Exhibit |\\n| 31.1** | Certification of Chief Executive Officer (Principal Executive Officer) Pursuant to Rules 13a‑14(a) and 15d‑14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| 31.2** | Certification of Chief Financial Officer (Principal Financial and Accounting Officer) Pursuant to Rules 13a‑14(a) and 15d‑14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| 32.1*** | Certification of Chief Executive Officer (Principal Executive Officer) Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\\n| 32.2*** | Certification of Chief Financial Officer (Principal Financial and Accounting Officer) Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\\n| 101.INS** | XBRL Instance Document. |\\n| 101.CAL** | XBRL Taxonomy Extension Calculation Linkbase Document. |\\n| 101.SCH** | XBRL Taxonomy Extension Schema Document. |\\n| 101.DEF** | XBRL Taxonomy Extension Definition Linkbase Document. |\\n| 101.LAB** | XBRL Taxonomy Extension Labels Linkbase Document. |\\n| 101.PRE** | XBRL Taxonomy Extension Presentation Linkbase Document. |\\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101). |\\n\\n\\n| * | Incorporated herein by reference as indicated. |\\n\\n| ** | Filed herein. |\\n\\n| *** | Furnished herein. |\\n\\nPart III. SIGNATURES\\nPursuant to the requirements of Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\n\\n| Date: November 15, 2022 | DENALI CAPITAL ACQUISITION CORP. |\\n| By: | /s/ Lei Huang |\\n| Chief Executive Officer |\\n| (Principal Executive Officer) |\\n| By: | /s/ You “Patrick” Sun |\\n| Chief Financial Officer |\\n| (Principal Financial and Accounting Officer) |\\n\\n\\n| 28 |\\n\\n\\n \\n\\nIf the company completes a business combination and all of the public warrants and private warrants are exercised at the price of $11.50 per share, what will be the total inflow of cash into the company from the exercise of these warrants in million dollars?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 100.74.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 62,\n \"input_length\": 23999\n}"}}},{"rowIdx":63,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nItem 1. Financial Statements.\nAKEBIA THERAPEUTICS, INC.\nCondensed Consolidated Balance Sheets\n(Unaudited)\n(in thousands, except share and per share data)\n| September 30,2022 | December 31,2021 |\n| Assets |\n| Current assets: |\n| Cash and cash equivalents | $ | 144,761 | $ | 149,800 |\n| Inventory | 40,039 | 38,195 |\n| Accounts receivable, net | 23,094 | 50,875 |\n| Prepaid expenses and other current assets | 29,618 | 33,140 |\n| Total current assets | 237,512 | 272,010 |\n| Property and equipment, net | 5,622 | 6,754 |\n| Operating lease assets | 30,337 | 33,852 |\n| Goodwill | 55,053 | 55,053 |\n| Other intangible assets, net | 81,095 | 108,127 |\n| Other assets | 26,275 | 49,754 |\n| Total assets | $ | 435,894 | $ | 525,550 |\n| Liabilities and stockholders' equity |\n| Current liabilities: |\n| Accounts payable | $ | 19,708 | $ | 33,588 |\n| Accrued expenses and other current liabilities | 87,364 | 104,456 |\n| Short-term deferred revenue | 1,265 | 20,906 |\n| Current portion of refund liability to customer | 13,681 | — |\n| Current portion of long-term debt | 65,947 | 97,543 |\n| Total current liabilities | 187,965 | 256,493 |\n| Deferred revenue, net of current portion | 43,296 | 21,474 |\n| Operating lease liabilities, net of current portion | 30,683 | 33,703 |\n| Derivative liability | 760 | 1,820 |\n| Liability related to sale of future royalties, net | 58,236 | 53,079 |\n| Refund liability to customer, net of current portion | 26,788 | — |\n| Other non-current liabilities | 74,313 | 82,525 |\n| Total liabilities | 422,041 | 449,094 |\n| Commitments and contingencies (Note 13) |\n| Stockholders' equity: |\n| Preferred stock $ 0.00001 par value, 25,000,000 shares authorized; 0 shares issued and outstanding at September 30, 2022 and December 31, 2021 | — | — |\n| Common stock $ 0.00001 par value; 350,000,000 shares authorized at September 30, 2022 and December 31, 2021; 183,951,583 and 177,000,963 shares issued and outstanding at September 30, 2022 and December 31, 2021, respectively | 2 | 1 |\n| Additional paid-in capital | 1,559,206 | 1,536,800 |\n| Accumulated other comprehensive loss | 6 | 6 |\n| Accumulated deficit | ( 1,545,361 ) | ( 1,460,351 ) |\n| Total stockholders' equity | 13,853 | 76,456 |\n| Total liabilities and stockholders' equity | $ | 435,894 | $ | 525,550 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n7\nAKEBIA THERAPEUTICS, INC.\nCondensed Consolidated Statements of Operations and Comprehensive Loss\n(Unaudited)\n(in thousands, except share and per share data)\n\n| Three Months EndedSeptember 30, | Nine Months EndedSeptember 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Revenues: |\n| Product revenue, net | $ | 42,239 | $ | 36,753 | $ | 127,390 | $ | 100,120 |\n| License, collaboration and other revenue | 6,725 | 12,003 | 110,032 | 53,853 |\n| Total revenues | 48,964 | 48,756 | 237,422 | 153,973 |\n| Cost of goods sold: |\n| Product | 28,936 | 6,933 | 60,859 | 76,012 |\n| Amortization of intangibles | 9,011 | 9,011 | 27,032 | 27,032 |\n| Total cost of goods sold | 37,947 | 15,944 | 87,891 | 103,044 |\n| Operating expenses: |\n| Research and development | 27,350 | 40,471 | 97,210 | 118,296 |\n| Selling, general and administrative | 30,918 | 46,357 | 108,052 | 129,336 |\n| License expense | 743 | 870 | 2,323 | 2,460 |\n| Restructuring | 180 | — | 14,711 | — |\n| Total operating expenses | 59,191 | 87,698 | 222,296 | 250,092 |\n| Operating loss | ( 48,174 ) | ( 54,886 ) | ( 72,765 ) | ( 199,163 ) |\n| Other income (expense): |\n| Interest expense | ( 3,952 ) | ( 5,085 ) | ( 14,051 ) | ( 14,853 ) |\n| Other income | 1,167 | 427 | 2,712 | 1,854 |\n| Loss on extinguishment of debt | ( 906 ) | — | ( 906 ) | — |\n| Net loss | $ | ( 51,865 ) | $ | ( 59,544 ) | $ | ( 85,010 ) | $ | ( 212,162 ) |\n| Net loss per share - basic and diluted | $ | ( 0.28 ) | $ | ( 0.34 ) | $ | ( 0.47 ) | $ | ( 1.30 ) |\n| Weighted-average number of common shares - basic and diluted | 183,882,446 | 173,782,151 | 182,375,443 | 163,050,769 |\n| Comprehensive loss: |\n| Net loss | $ | ( 51,865 ) | $ | ( 59,544 ) | $ | ( 85,010 ) | $ | ( 212,162 ) |\n| Other comprehensive loss - unrealized loss on debt securities | — | — | — | ( 7 ) |\n| Total comprehensive loss | $ | ( 51,865 ) | $ | ( 59,544 ) | $ | ( 85,010 ) | $ | ( 212,169 ) |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n8\nAKEBIA THERAPEUTICS, INC.\nCondensed Consolidated Statements of Stockholders’ Equity\n(Unaudited)\n(in thousands, except share data)\n| Common Stock |\n| Number ofShares | $ 0.00001 Par Value | Additional Paid-InCapital | UnrealizedGain/(Loss) | AccumulatedDeficit | Total Stockholders'Equity |\n| Balance at December 31, 2020 | 148,074,085 | $ | 1 | $ | 1,425,115 | $ | 13 | $ | ( 1,177,511 ) | $ | 247,618 |\n| Issuance of common stock, net of issuance costs | 9,228,017 | 1 | 29,497 | — | — | 29,498 |\n| Proceeds from sale of stock under employee stock purchase plan | 154,276 | — | 367 | — | — | 367 |\n| Stock-based compensation expense | — | — | 5,992 | — | — | 5,992 |\n| Restricted stock unit vesting | 1,063,711 | — | — | — | — | — |\n| Unrealized loss | — | — | — | ( 4 ) | — | ( 4 ) |\n| Net loss | — | — | — | — | ( 69,580 ) | ( 69,580 ) |\n| Balance at March 31, 2021 | 158,520,089 | $ | 2 | $ | 1,460,971 | $ | 9 | $ | ( 1,247,091 ) | $ | 213,891 |\n| Issuance of common stock, net of issuance costs | 10,446,160 | — | 37,266 | — | — | 37,266 |\n| Stock-based compensation expense | — | — | 6,515 | — | — | 6,515 |\n| Restricted stock unit vesting | 685,174 | — | — | — | — | — |\n| Unrealized loss | — | — | — | ( 3 ) | — | ( 3 ) |\n| Net loss | — | — | — | — | ( 83,038 ) | ( 83,038 ) |\n| Balance at June 30, 2021 | 169,651,423 | $ | 2 | $ | 1,504,752 | $ | 6 | $ | ( 1,330,129 ) | $ | 174,631 |\n| Issuance of common stock, net of issuance costs | 4,730,466 | — | 16,092 | — | — | 16,092 |\n| Proceeds from sale of stock under employee stock purchase plan | 152,917 | — | 379 | — | — | 379 |\n| Share-based compensation expense | — | — | 5,592 | — | — | 5,592 |\n| Restricted stock unit vesting | 17,183 | — | — | — | — | — |\n| Net loss | — | — | — | — | ( 59,544 ) | ( 59,544 ) |\n| Balance at September 30, 2021 | 174,551,989 | $ | 2 | $ | 1,526,815 | $ | 6 | $ | ( 1,389,673 ) | $ | 137,150 |\n| Balance at December 31, 2021 | 177,000,963 | $ | 1 | $ | 1,536,800 | $ | 6 | $ | ( 1,460,351 ) | $ | 76,456 |\n| Issuance of common stock, net of issuance costs | 4,404,600 | 1 | 7,177 | — | — | 7,178 |\n| Proceeds from sale of stock under employee stock purchase plan | 191,146 | — | 367 | — | — | 367 |\n| Stock-based compensation expense | — | — | 4,536 | — | — | 4,536 |\n| Restricted stock unit vesting | 1,789,326 | — | — | — | — | — |\n| Net loss | — | — | — | — | ( 62,421 ) | ( 62,421 ) |\n| Balance at March 31, 2022 | 183,386,035 | $ | 2 | $ | 1,548,880 | $ | 6 | $ | ( 1,522,772 ) | $ | 26,116 |\n| Stock-based compensation expense | — | — | 6,841 | — | — | 6,841 |\n| Exercise of options | 142,440 | — | 67 | — | — | 67 |\n| Restricted stock unit vesting | 176,179 | — | — | — | — | — |\n| Net income | — | — | — | — | 29,276 | 29,276 |\n| Balance at June 30, 2022 | 183,704,654 | $ | 2 | $ | 1,555,788 | $ | 6 | $ | ( 1,493,496 ) | $ | 62,300 |\n| Share-based compensation expense | — | — | 3,375 | — | — | 3,375 |\n| Proceeds from sale of stock under employee stock purchase plan | 144,000 | — | 43 | — | — | 43 |\n| Restricted stock unit vesting | 102,929 | — | — | — | — | — |\n| Net loss | — | — | — | — | ( 51,865 ) | ( 51,865 ) |\n| Balance at September 30, 2022 | 183,951,583 | $ | 2 | $ | 1,559,206 | $ | 6 | $ | ( 1,545,361 ) | $ | 13,853 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements\n9\nAKEBIA THERAPEUTICS, INC.\nCondensed Consolidated Statements of Cash Flows\n(Unaudited)\n(in thousands)\n10\n| Nine Months Ended |\n| September 30, 2022 | September 30, 2021 |\n| Operating activities: |\n| Net loss | $ | ( 85,010 ) | $ | ( 212,162 ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: |\n| Depreciation and amortization | 1,246 | 1,485 |\n| Amortization of intangibles | 27,032 | 27,032 |\n| Amortization of premium/discount on investments | — | ( 15 ) |\n| Non-cash interest expense related to sale of future royalties | 6,352 | 6,779 |\n| Non-cash royalty revenue related to sale of future royalties | ( 1,195 ) | ( 425 ) |\n| Non-cash collaboration revenue | ( 9,550 ) | — |\n| Non-cash R&D expense | 3,941 | — |\n| Non-cash interest expense | 1,467 | 852 |\n| Non-cash operating lease expense | ( 1,818 ) | ( 1,415 ) |\n| Non-cash loss on extinguishment of debt | 406 | — |\n| Fair value step-up of inventory sold or written off | — | 21,575 |\n| Write-down of inventory | 10,002 | 7,126 |\n| Change in excess inventory purchase commitments | 12,422 | 15,376 |\n| Stock-based compensation | 14,808 | 18,099 |\n| Change in fair value of derivative liability | ( 1,060 ) | ( 490 ) |\n| Changes in operating assets and liabilities: |\n| Accounts receivable | 27,781 | ( 22,837 ) |\n| Inventory | 1,405 | ( 35,282 ) |\n| Prepaid expenses and other current assets | 9,131 | ( 25,020 ) |\n| Other long-term assets | 14,817 | 4,728 |\n| Accounts payable | ( 17,420 ) | ( 14,933 ) |\n| Accrued expense | ( 22,364 ) | 15,099 |\n| Operating lease liabilities | 1,771 | 1,173 |\n| Deferred revenue | 2,181 | 3,098 |\n| Other non-current liabilities | ( 14,820 ) | — |\n| Net cash used in operating activities | ( 18,475 ) | ( 190,157 ) |\n| Investing activities: |\n| Purchase of equipment | ( 114 ) | ( 59 ) |\n| Proceeds from the maturities of available for sale securities | — | 40,000 |\n| Net cash (used in) provided by investing activities | ( 114 ) | 39,941 |\n| Financing activities: |\n| Proceeds from sale of future royalties, net | — | 44,783 |\n| Proceeds from refund liabilities to customers | 40,000 | — |\n| Proceeds from the issuance of common stock, net of issuance costs | 7,122 | 82,799 |\n| Proceeds from the sale of stock under employee stock purchase plan | 410 | 746 |\n| Proceeds from the exercise of stock options | 67 | — |\n| Payments on debt | ( 33,000 ) | — |\n| Net cash provided by financing activities | 14,599 | 128,328 |\n| (Decrease) in cash, cash equivalents, and restricted cash | ( 3,990 ) | ( 21,888 ) |\n| Cash, cash equivalents, and restricted cash at beginning of the period | 151,839 | 231,132 |\n| Cash, cash equivalents, and restricted cash at end of the period | $ | 147,849 | $ | 209,244 |\n| Non-cash financing activities |\n| Unpaid offering costs | $ | — | $ | 57 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements\n11\nAkebia Therapeutics, Inc.\nNotes to Condensed Consolidated Financial Statements\n(Unaudited)\n1. Nature of Organization and Operations\nAkebia Therapeutics, Inc., referred to as Akebia or the Company, was incorporated in the State of Delaware in 2007. Akebia is a biopharmaceutical company with the purpose of bettering the lives of people impacted by kidney disease. The Company has one commercial product, Auryxia® (ferric citrate), which is approved by the U.S. Food and Drug Administration, or FDA, and marketed for two indications in the United States: the control of serum phosphorus levels in adult patients with chronic kidney disease, or CKD, on dialysis, or DD-CKD, and the treatment of iron deficiency anemia, or IDA, in adult patients with CKD not on dialysis, or NDD-CKD. Ferric citrate is also approved and marketed in Japan as an oral treatment for IDA in adult patients for the improvement of hyperphosphatemia in such patients with DD-CKD and NDD-CKD under the trade name Riona (ferric citrate hydrate).\nVadadustat, the Company’s lead investigational product candidate, is an investigational oral hypoxia-inducible factor prolyl hydroxylase, or HIF-PH, inhibitor designed to mimic the physiologic effect of altitude on oxygen availability. On March 29, 2022, the Company received a complete response letter, or CRL, from the FDA. The CRL provided that the FDA had completed its review of the Company's new drug application, or NDA, for vadadustat for the treatment of anemia due to CKD in adult patients and had determined that it could not approve the NDA in its present form. In July 2022, the Company held an end of review meeting with the FDA to inform the Company's next steps with respect to the potential U.S. approval of vadadustat, if any, and in October 2022, the Company submitted a Formal Dispute Resolution Request, or FDRR, with the FDA. The FDRR focuses on the favorable balance between the benefits and risks of vadadustat for the treatment of anemia due to CKD in adult patients on dialysis in light of safety concerns expressed by the FDA in the CRL related to the rate of adjudicated thromboembolic events driven by vascular access thrombosis for vadadustat compared to the active comparator and the risk of drug-induced liver injury. On May 12, 2022, the Company received notice from its former collaboration partner, Otsuka Pharmaceutical Co. Ltd., or Otsuka, that Otsuka had elected to terminate the Collaboration and License Agreement dated December 18, 2016, or the Otsuka U.S. Agreement, and the Collaboration and License Agreement dated April 25, 2017, or the Otsuka International Agreement. On June 30, 2022, the Company and Otsuka entered into a Termination and Settlement Agreement, or the Termination Agreement, pursuant to which, among other things, the Company and Otsuka agreed to terminate the Otsuka U.S. Agreement and the Otsuka International Agreement as of June 30, 2022 (see Note 4 for further details). In October 2021, Otsuka submitted a Marketing Authorization Application, or MAA, for vadadustat for the treatment of anemia due to CKD in adult patients with DD-CKD and NDD-CKD to the European Medicines Agency, or EMA. In connection with the Termination Agreement, Otsuka transferred the MAA for vadadustat with the EMA to the Company. Vadadustat is approved in Japan as a treatment for anemia due to CKD in both DD-CKD and NDD-CKD patients under the trade name VafseoTM, and marketed and sold in Japan by Mitsubishi Tanabe Pharma Corporation, or MTPC.\nIn addition, the Company continues to explore additional development opportunities to expand its pipeline and portfolio of novel therapeutics.\nSince inception, the Company has devoted most of its resources to research and development, including its preclinical and clinical development activities, commercializing Auryxia, and providing general and administrative support for these operations. The Company began recording revenue from the U.S. sales of Auryxia and revenue from sublicensing rights to Auryxia in Japan from the Company’s Japanese partners, Japan Tobacco, Inc. and its subsidiary Torii Pharmaceutical Co., Ltd., collectively JT and Torii, in December 2018. Additionally, following regulatory approval of vadadustat in Japan, the Company began recognizing royalty revenues from MTPC from the sale of Vafseo in August 2020. In February 2021, the Company entered into a royalty interest acquisition agreement with HealthCare Royalty Partners IV, L.P., or HCR, or the Royalty Agreement, whereby the Company sold its right to receive royalties and sales milestones under its Collaboration Agreement with MTPC, or the MTPC Agreement, subject to certain caps and other terms and conditions (see Note 6 for additional information). The Company has not generated a profit to date, and may never generate profits, from product sales. Vadadustat and the Company’s other potential product candidates are subject to long development cycles, and the Company may be unsuccessful in its efforts to develop, obtain marketing approval for or market vadadustat and its other potential product candidates. If the Company does not successfully commercialize Auryxia, vadadustat, if approved, or any other potential product candidate, it may be unable to achieve profitability.\nGoing Concern\nThe Company’s management completed its going concern assessment in accordance with Accounting Standards Codification, or ASC, 205-40, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern, or ASC 205-40. Pursuant to the requirements of ASC 205-40, the Company’s management must evaluate whether there are conditions or events,\n12\nconsidered in the aggregate, that raise substantial doubt about the Company’s ability to continue as a going concern within one year after the date the financial statements are issued. This evaluation initially does not take into consideration the potential mitigating effect of management’s plans that have not been fully implemented as of the date the financial statements are issued.\nWhen substantial doubt exists under this methodology, the Company’s management evaluates whether the mitigating effect of its plans sufficiently alleviates substantial doubt about the Company’s ability to continue as a going concern. The mitigating effect of the Company’s plans, however, is only considered if both (1) it is probable that the plans will be effectively implemented within one year after the date that the financial statements are issued and (2) it is probable that the plans, when implemented, will mitigate the relevant conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued.\nAs of September 30, 2022, the Company had cash and cash equivalents of approximately $ 144.8 million. The Company believes that its cash resources will be sufficient to allow the Company to fund its current operating plan through at least the next twelve months from the filing of this Quarterly Report on Form 10-Q. However, the Company's operating plan includes assumptions pertaining to cost avoidance measures and the reduction of overhead costs that would result from the planned amendment of contractual arrangements with certain supply and collaboration partners, and the reduction of operating expenses. Therefore, because these cost avoidance measures and certain other elements of the Company's operating plan are outside of its control, including the planned amendment of contractual arrangements with certain supply and collaboration partners, and the reduction of operating expenses, there is uncertainty as to whether the Company's cash resources will be adequate to support its operations for a period through at least the next twelve months from the date of issuance of these financial statements.\nIn addition, on July 15, 2022, or the Effective Date, the Company entered into the Second Amendment and Waiver with BioPharma Credit PLC, or the Collateral Agent, BPCR Limited Partnership, as a Lender, and BioPharma Credit Investments V (Master) LP, as a Lender, or the Second Amendment and Waiver, which amends and waives certain provisions of the loan agreement entered on November 11, 2019, between the Company, with Keryx Biopharmaceuticals, Inc., or Keryx, as guarantor, and the Collateral Agent, as collateral agent and a lender, and BioPharma Credit Investments V (Master) LP as a lender, or the Loan Agreement, as amended by the First Amendment and Waiver among the Collateral Agent, the Lenders and the Company, dated February 18, 2022, or the First Amendment and Waiver. The Collateral Agent and the Lenders are collectively referred to as Pharmakon (see Note 11). Pursuant to the Second Amendment and Waiver, on the Effective Date, the Company made prepayments totaling $ 25.0 million together with a prepayment premium of $ 0.5 million plus all accrued and unpaid interest on such prepayments of principal to the Effective Date, and Pharmakon agreed to waive or modify certain covenants in the Loan Agreement (see Note 11). If an event of default occurs and is continuing under the Loan Agreement, the Collateral Agent is entitled to take enforcement action, including acceleration of amounts due under the Loan Agreement, which the Company may not have the available cash resources to repay at such time. For example, pursuant to covenants in the Loan Agreement, the Company's Annual Reports on Form 10-K must not be subject to any qualification as a going concern. If any of the Company's future Annual Reports on Form 10-K is subject to any qualification related to going concern, it will result in an event of default under the Loan Agreement.\nThese conditions raise substantial doubt regarding the Company’s ability to continue as a going concern for a period of one year after the date the financial statements are issued. Management’s plans to alleviate the conditions that raise substantial doubt through cost avoidance measures, including amending contractual arrangements with certain supply and collaboration partners, and reducing operating expenses, for the Company to continue as a going concern for a period of twelve months from the date the financial statements are issued. However, the Company has concluded that the likelihood that its plan to extend its cash runway from one or more of these approaches will be successful, while reasonably possible, is less than probable. Accordingly, the Company has concluded that substantial doubt exists about its ability to continue as a going concern for a period of at least twelve months from the date of issuance of these financial statements.\nThe accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the ordinary course of business. The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities, other than obligations under the Loan Agreement classified as current, that might result from the outcome of the uncertainties described above.\n2. Summary of Significant Accounting Policies\nBasis of Presentation\nThe accompanying unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the U.S., or GAAP, for interim financial reporting and as required by Regulation S-X, Rule 10-01. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. Any reference in these notes to applicable guidance is meant to refer to the authoritative GAAP as found in the ASC and Accounting Standards Update, or ASU, of the Financial Accounting Standards Board, or FASB.\n13\nIn the opinion of management, all adjustments, consisting of normal recurring accruals and revisions of estimates, considered necessary for a fair presentation of the unaudited condensed consolidated financial statements have been included. Interim results for the three and nine months ended September 30, 2022 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2022 or any other future period.\nThe accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. Management has determined that the Company operates in one segment, which is the business of developing and commercializing novel therapeutics for people with kidney disease. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the Company’s consolidated financial statements and the accompanying notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2021 filed with the U.S. Securities and Exchange Commission on March 1, 2022, or the 2021 Annual Report on Form 10-K.\nThe significant accounting policies used in preparation of these unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2022 are consistent with those discussed in Note 2 to the consolidated financial statements in the Company’s 2021 Annual Report on Form 10-K and are updated below as necessary.\nNew Accounting Pronouncements – Not Yet Adopted\nIn March 2020, the FASB issued ASU 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting. The amendments provide optional guidance for a limited time to ease the potential burden in accounting for reference rate reform. The new guidance provides optional expedients and exceptions for applying GAAP to contracts, hedging relationships and other transactions affected by reference rate reform if certain criteria are met. The amendments apply only to contracts and hedging relationships that reference LIBOR or another reference rate expected to be discontinued due to reference rate reform. These amendments are effective immediately and may be applied prospectively to contract modifications made and hedging relationships entered into or evaluated on or before December 31, 2022. The Company is currently evaluating its contracts and the optional expedients provided by the new standard.\nUse of Estimates\nThe preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ from those estimates. Management considers many factors in selecting appropriate financial accounting policies and controls, and in developing the estimates and assumptions that are used in the preparation of these financial statements. Management must apply significant judgment in this process. In addition, other factors may affect estimates, including expected business and operational changes, sensitivity and volatility associated with the assumptions used in developing estimates, and whether historical trends are expected to be representative of future trends. The estimation process often may yield a range of potentially reasonable estimates of the ultimate future outcomes, and management must select an amount that falls within that range of reasonable estimates. Estimates are used in the following areas, among others: prepaid and accrued research and development expense, operating lease assets and liabilities, derivative liabilities, refund liabilities to customers, other non-current liabilities, including the excess purchase commitment liability, stock-based compensation expense, product and collaboration revenues including various rebates and reserves related to product sales, non-cash interest expense on the liability related to sale of future royalties, inventories, income taxes, intangible assets and goodwill.\nAlthough the Company regularly assesses these estimates, actual results could differ materially from these estimates. Changes in estimates are recorded in the period they become known. The Company bases its estimates on historical experience and various other assumptions that it believes to be reasonable under the circumstances.\n3. Product Revenue and Reserves for Variable Consideration\nTo date, the Company’s only source of product revenue has been from the U.S. sales of Auryxia. Total net product revenue was $ 42.2 million and $ 36.8 million for the three months ended September 30, 2022 and 2021, respectively, and $ 127.4 million and $ 100.1 million for the nine months ended September 30, 2022 and 2021, respectively. The following table summarizes activity in each of the product revenue allowance and reserve categories for the nine months ended September 30, 2022 and 2021 (in thousands):\n14\n| Chargebacksand Discounts | Rebates, Feesand otherDeductions | Returns | Total |\n| Balance at December 31, 2021 | $ | 1,278 | $ | 26,625 | $ | 475 | $ | 28,378 |\n| Current provisions related to sales in current year | 8,592 | 64,322 | 3,692 | 76,606 |\n| Adjustments related to prior year sales | ( 248 ) | 33 | — | ( 215 ) |\n| Credits/payments made | ( 8,194 ) | ( 65,611 ) | ( 3,669 ) | ( 77,474 ) |\n| Balance at September 30, 2022 | $ | 1,428 | $ | 25,369 | $ | 498 | $ | 27,295 |\n| Balance at December 31, 2020 | $ | 802 | $ | 39,912 | $ | 649 | $ | 41,363 |\n| Current provisions related to sales in current year | 8,911 | 105,432 | 4,866 | 119,209 |\n| Adjustments related to prior year sales | ( 1 ) | ( 1,590 ) | — | ( 1,591 ) |\n| Credits/payments made | ( 8,593 ) | ( 99,518 ) | ( 4,979 ) | ( 113,090 ) |\n| Balance at September 30, 2021 | $ | 1,119 | $ | 44,236 | $ | 536 | $ | 45,891 |\n\nChargebacks, discounts and returns are recorded as a direct reduction of revenue on the unaudited condensed consolidated statement of operations with a corresponding reduction to accounts receivable on the unaudited condensed consolidated balance sheets. Rebates, distribution-related fees, and other sales-related deductions are recorded as a reduction in revenue on the unaudited condensed consolidated statement of operations with a corresponding increase to accrued liabilities or accounts payable on the unaudited condensed consolidated balance sheets.\nAccounts receivable, net related to product sales was approximately $ 24.0 million and $ 24.6 million as of September 30, 2022 and December 31, 2021, respectively.\n4. License, Collaboration and Other Significant Agreements\nDuring the three and nine months ended September 30, 2022 and 2021, the Company recognized the following revenues from its license, collaboration and other significant agreements and had the following deferred revenue balances as of September 30, 2022:\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| License, Collaboration and Other Revenue: | (in thousands) | (in thousands) |\n| MTPC Agreement | $ | 5,487 | $ | 2,555 | $ | 13,885 | $ | 7,167 |\n| Otsuka U.S. Agreement | — | 6,144 | 86,773 | 28,988 |\n| Otsuka International Agreement | — | 1,860 | 5,503 | 13,532 |\n| Total Proportional Performance Revenue | $ | 5,487 | $ | 10,559 | $ | 106,161 | $ | 49,687 |\n| JT and Torii | 1,238 | 1,444 | 3,871 | 4,093 |\n| MTPC Other Revenue | — | — | — | 73 |\n| Total License, Collaboration and Other Revenue | $ | 6,725 | $ | 12,003 | $ | 110,032 | $ | 53,853 |\n\n\n| September 30, 2022 |\n| Short-Term | Long-Term | Total |\n| Deferred Revenue: | (in thousands) |\n| MTPC Agreement | $ | 1,265 | $ | — | $ | 1,265 |\n| Vifor Pharma Agreement | — | 43,296 | 43,296 |\n| Total | $ | 1,265 | $ | 43,296 | $ | 44,561 |\n\nThe following table presents changes in the Company’s contract assets and liabilities during the nine months ended September 30, 2022 and 2021 (in thousands):\n15\n| Nine Months Ended September 30, 2022 | Balance atBeginning ofPeriod | Additions | Deductions | Balance at Endof Period |\n| Contract assets: |\n| Accounts receivable(1) | $ | 19,094 | $ | 92,612 | $ | ( 109,836 ) | $ | 1,870 |\n| Prepaid expenses and other current assets | $ | 4,309 | $ | 9,550 | $ | ( 8,250 ) | $ | 5,609 |\n| Contract liabilities: |\n| Deferred revenue | $ | 42,380 | $ | 66,307 | $ | ( 64,126 ) | $ | 44,561 |\n| Accounts payable | $ | 3,171 | $ | — | $ | ( 3,171 ) | $ | — |\n| Accrued expenses and other current liabilities | $ | — | $ | — | $ | — | $ | — |\n| Nine Months Ended September 30, 2021 |\n| Contract assets: |\n| Accounts receivable(1) | $ | 3,045 | $ | 38,795 | $ | ( 20,427 ) | $ | 21,413 |\n| Prepaid expenses and other current assets | $ | 1,722 | $ | 1,725 | $ | ( 5 ) | $ | 3,442 |\n| Contract liabilities: |\n| Deferred revenue | $ | 40,559 | $ | 65,890 | $ | ( 62,792 ) | $ | 43,657 |\n| Accounts payable | $ | 7,227 | $ | — | $ | ( 7,227 ) | $ | — |\n| Accrued expenses and other current liabilities | $ | 10,000 | $ | — | $ | — | $ | 10,000 |\n\n(1)Excludes accounts receivable from other services related to clinical and regulatory activities performed by the Company on behalf of MTPC that are not included in the performance obligations identified under the MTPC Agreement as of September 30, 2022 and 2021 and December 31, 2021 and 2020. Also excludes accounts receivable related to amounts due to the Company from product sales which are included in the accompanying unaudited condensed consolidated balance sheet as of September 30, 2022 and December 31, 2021.\nDuring the three and nine months ended September 30, 2022 and 2021, the Company recognized the following revenues as a result of changes in the contract asset and contract liability balances in the respective periods (in thousands):\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| Revenue Recognized in the Period: | 2022 | 2021 | 2022 | 2021 |\n| Amounts included in deferred revenue at the beginning of the period | $ | 5,047 | $ | 9,159 | $ | 29,574 | $ | 20,363 |\n| Performance obligations satisfied in previous periods | $ | — | $ | — | $ | — | $ | — |\n\nMitsubishi Tanabe Pharma Corporation Collaboration Agreement\nSummary of Agreement\nOn December 11, 2015, the Company and MTPC entered into the MTPC Agreement, providing MTPC with exclusive development and commercialization rights to vadadustat in Japan and certain other Asian countries, collectively, the MTPC Territory. In addition, the Company will supply vadadustat for both clinical and commercial use in the MTPC Territory, subject to MTPC’s option to manufacture commercial drug product in the MTPC Territory. In February 2021, the Company entered into the Royalty Agreement with HCR, whereby the Company sold its right to receive royalties and sales milestones under the MTPC Agreement, subject to certain caps and other terms and conditions (see Note 6 for additional information). A more detailed description of the MTPC Agreement and the Company's evaluation of this agreement under ASC 606 can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\nThe Company identified two performance obligations in connection with its material promises under the MTPC Agreement as follows: (i) License, Research and Clinical Supply Performance Obligation and (ii) Rights to Future Know-How Performance Obligation. The Company allocates the transaction price to each performance obligation based on the Company’s best estimate of the relative standalone selling price. The Company developed a best estimate of the standalone selling price for the Rights to Future Know-How Performance Obligation primarily based on the likelihood that additional intellectual property covered by the license conveyed will be developed during the term of the arrangement and determined it is immaterial. As such, the\n16\nCompany did not develop a best estimate of standalone selling price for the License, Research and Clinical Supply Performance Obligation and allocated the entire transaction price to this performance obligation. The deliverables associated with the License, Research and Clinical Supply Performance Obligation were satisfied as of June 30, 2018.\nAs of September 30, 2022, the transaction price was comprised of: (i) the up-front payment of $ 20.0 million, (ii) the cost for the Phase 2 studies of $ 20.5 million, (iii) the cost of all clinical supply provided to MTPC for the Phase 3 studies, (iv) $ 10.0 million in development milestones received, (v) $ 25.0 million in regulatory milestones received, comprised of $ 10.0 million relating to the NDA filing in Japan and $ 15.0 million relating to regulatory approval of vadadustat in Japan, and (vi) $ 2.4 million in royalties from net sales of Vafseo. As of September 30, 2022, all development milestones and $ 25.0 million in regulatory milestones have been achieved. No other regulatory milestones have been assessed as probable of being achieved and as a result have been fully constrained. The Company re-evaluates the transaction price in each reporting period and as uncertain events are resolved or other changes in circumstances occur. Revenue for the License, Research and Clinical Supply Performance Obligation for the MTPC Agreement is being recognized using a proportional performance method, for which all deliverables have been completed. During the three and nine months ended September 30, 2022, the Company recognized revenue from MTPC royalties totaling approximately $ 0.4 million and $ 1.2 million, respectively, and approximately $ 0.3 million and $ 0.4 million during the three and nine months ended September 30, 2021, respectively. As noted above, in February 2021, the Company entered into the Royalty Agreement, whereby the Company sold its right to receive these royalties and sales milestones under the MTPC Agreement, subject to certain caps and other terms and conditions (see Note 6 for additional information). The revenue is classified as license, collaboration and other revenue in the accompanying unaudited condensed consolidated statements of operations and comprehensive loss. As of September 30, 2022, the Company recorded $ 0.2 million in accounts receivable, no deferred revenue, and no contract assets. There were no asset or liability balances classified as long-term in the unaudited condensed consolidated balance sheet as of September 30, 2022.\nSupply of Drug Product to MTPC\nOn July 15, 2020, the Company and its collaboration partner MTPC entered into a supply agreement, or the MTPC Supply Agreement. The MTPC Supply Agreement includes the terms and conditions under which the Company will supply vadadustat drug product to MTPC for commercial use in Japan and certain other Asian countries, as contemplated by the MTPC Agreement. A more detailed description of this supply agreement can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\nThe Company recognized $ 5.1 million in revenue and $ 12.7 million in revenue under the MTPC Supply Agreement during the three and nine months ended September 30, 2022, respectively, and $ 2.2 million and $ 6.7 million during the three and nine months ended September 30, 2021, respectively. As of September 30, 2022, the Company recorded $ 0.2 million in accounts receivable, $ 1.3 million in deferred revenue and $ 18.6 million in other current liabilities.\nU.S. Collaboration and License Agreement with Otsuka Pharmaceutical Co. Ltd.\nOn December 18, 2016, the Company entered into the Otsuka U.S. Agreement. The collaboration was focused on the development and commercialization of vadadustat in the United States. The Company was responsible for leading the development of vadadustat, for which it submitted an NDA to the FDA in March 2021, and for which it received the CRL in March 2022.\nUnder the terms of the Otsuka U.S. Agreement, the Company granted to Otsuka a co-exclusive, non-sublicensable license under certain intellectual property controlled by the Company solely to perform medical affairs activities and to conduct non-promotional and commercialization activities related to vadadustat in the United States in accordance with the associated plans. The co-exclusive license related to activities that would be jointly conducted by the Company and Otsuka pursuant to the terms of the Otsuka U.S. Agreement. A more detailed description of this collaboration agreement and the Company's evaluation of this agreement under ASC 606 can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\nThe Company identified three performance obligations in connection with its obligations under the Otsuka U.S. Agreement as follows: (i) License and Development Services Combined (License Performance Obligation); (ii) Rights to Future Intellectual Property (Future IP Performance Obligation) and (iii) Joint Committee Services (Committee Performance Obligation). The Company allocated the transaction price to each performance obligation based on the Company’s best estimate of the relative standalone selling price. The Company developed a best estimate of standalone selling price for the Committee Performance Obligation after considering the nature of the services to be performed and estimates of the associated effort and rates applicable to such services that would be expected to be realized under similar contracts. The Company developed a best estimate of standalone selling price for the Future IP Performance Obligation primarily based on the likelihood that additional\n17\nintellectual property covered by the license conveyed would be developed during the term of the arrangement. The Company did not develop a best estimate of standalone selling price for the License Performance Obligation due to the following: (i) the best estimates of standalone selling price associated with the Future IP Performance Obligation was determined to be immaterial and (ii) the period of performance and pattern of recognition for the License Performance Obligation and the Committee Performance Obligation was determined to be similar.\nThe Company re-evaluated the transaction price in each reporting period and as uncertain events were resolved or other changes in circumstances occurred. The Company determined that under ASC 606, the contract was modified in the second quarter of 2019, when the Company elected to require Otsuka to increase the aggregate percentage of current global development costs it funds under the Otsuka U.S. Agreement and the Otsuka International Agreement from 52.5 % to 80 %, or the Otsuka Funding Option, and the Company became eligible to receive the amount from the Otsuka Funding Option. In connection with the modification, the Company adjusted the transaction price to include the amount from the Otsuka Funding Option as additional variable consideration. The Company constrained the variable consideration to an amount for which a significant revenue reversal is not probable.\nPursuant to the Otsuka U.S. Agreement, the Company received: (i) an up-front payment of $ 125.0 million, (ii) a cost share payment with respect to amounts incurred by the Company through December 31, 2016 of $ 33.8 million, and (iii) net cost share consideration with respect to amounts incurred by the Company under the global development plan of approximately $ 319.2 million with respect to amounts incurred by the Company subsequent to December 31, 2016.\nOn May 12, 2022, the Company received notice from Otsuka that it had elected to terminate the Otsuka U.S. Agreement and the Otsuka International Agreement. On June 30, 2022, the Company and Otsuka entered into the Termination Agreement, pursuant to which, among other things, the Company and Otsuka agreed to terminate, as of June 30, 2022, the Otsuka U.S. Agreement and the Otsuka International Agreement. In July 2022, the Company received a nonrefundable and non-creditable payment of $ 55.0 million in consideration for the covenants and agreements set forth in the Termination Agreement, including the settlement and release of all disputes and claims as provided therein. The Company determined that the Termination Agreement met the definition of a contract modification and was accounted for as a cumulative catch-up adjustment at the time of modification under ASC 606.\nDuring the three and nine months ended September 30, 2022, the Company recognized $ 0 and $ 92.3 million of collaboration revenue from the Otsuka U.S. Agreement and the Otsuka International Agreement combined in its condensed consolidated statement of operations and comprehensive loss. The collaboration revenue for the nine months ended September 30, 2022 is primarily comprised of the $ 55.0 million payment received pursuant to the Termination Agreement, $ 15.5 million related to previously deferred revenue as of the date of termination and $ 9.6 million of non-cash consideration related to Otsuka's obligations to complete certain agreed upon clinical activities related to the Phase 3b clinical trial of vadadustat Otsuka is conducting.\nDuring the three and nine months ended September 30, 2021, the Company recognized collaboration revenue totaling $ 6.1 million and $ 29.0 million, respectively, with respect to the Otsuka U.S. Agreement. Additionally, as of September 30, 2022, there was $ 5.6 million in prepaid expenses and other current assets in the accompanying unaudited condensed consolidated balance sheet. As of December 31, 2021, there was approximately $ 2.0 million in contract liabilities (included in accounts payable) and $ 3.0 million in prepaid expenses and other current assets in the consolidated balance sheet.\nInternational Collaboration and License Agreement with Otsuka Pharmaceutical Co. Ltd.\nOn April 25, 2017, the Company entered into the Otsuka International Agreement. The collaboration was focused on the development and commercialization of vadadustat in Europe, Russia, China, Canada, Australia, the Middle East and certain other territories, collectively, the Otsuka International Territory.\nUnder the terms of the Otsuka International Agreement, the Company granted to Otsuka an exclusive, sublicensable license under certain intellectual property controlled by the Company to develop and commercialize vadadustat and products containing or comprising vadadustat in the Otsuka International Territory. Additionally, under the terms of this agreement, the Company was responsible for leading the development of vadadustat. Otsuka had the sole responsibility, at its own cost, for the commercialization of vadadustat in the Otsuka International Territory, subject to the approval by the relevant regulatory authorities. A more detailed description of this collaboration agreement and the Company's evaluation of this agreement under ASC 606 can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\nThe Company identified three performance obligations in connection with its obligations under the Otsuka International Agreement as follows: (i) License and Development Services Combined (License Performance Obligation); (ii) Rights to\n18\nFuture Intellectual Property (Future IP Performance Obligation) and (iii) Joint Committee Services (Committee Performance Obligation). The Company allocated the transaction price to each performance obligation based on the Company’s best estimate of the relative standalone selling price. The Company developed a best estimate of standalone selling price for the Committee Performance Obligation after considering the nature of the services to be performed and estimates of the associated effort and rates applicable to such services that would be expected to be realized under similar contracts. The Company developed a best estimate of standalone selling price for the Future IP Performance Obligation primarily based on the likelihood that additional intellectual property covered by the license conveyed will be developed during the term of the arrangement. The Company did not develop a best estimate of standalone selling price for the License Performance Obligation due to the following: (i) the best estimates of standalone selling price associated with the Future IP Performance Obligation was determined to be immaterial and (ii) the period of performance and pattern of recognition for the License Performance Obligation and the Committee Performance Obligation was determined to be similar.\nThe Company re-evaluated the transaction price in each reporting period and as uncertain events were resolved or other changes in circumstances occurred. Pursuant to the Otsuka International Agreement, the Company received: (i) an up-front payment of $ 73.0 million, (ii) the cost share payment with respect to amounts incurred by the Company during the quarter ended March 31, 2017 of $ 0.2 million, and (iii) the net cost share consideration with respect to amounts incurred by the Company under the global development plan subsequent to March 31, 2017 of $ 216.7 million.\nAs discussed above, the Otsuka International Agreement was terminated on June 30, 2022 pursuant to the Termination Agreement. Refer to earlier in this Note 4 for further details of the recognition of this Termination Agreement in the Company's condensed consolidated statement of operations and comprehensive loss.\nDuring the three and nine months ended September 30, 2021, the Company recognized collaboration revenue totaling approximately $ 1.9 million and $ 13.5 million, respectively, with respect to the Otsuka International Agreement. As of December 31, 2021, there was approximately $ 0.9 million in contract liabilities (included in accounts payable) and $ 1.3 million in prepaid expenses and other current assets in the consolidated balance sheet.\nJanssen Pharmaceutica NV Research and License Agreement\nOn February 9, 2017, the Company entered into a Research and License Agreement, or the Janssen Agreement, with Janssen Pharmaceutica NV, or Janssen, a subsidiary of Johnson & Johnson, pursuant to which Janssen granted the Company an exclusive license under certain intellectual property rights to develop and commercialize worldwide certain HIF prolyl hydroxylase targeted compounds. Under the terms of the Janssen Agreement, Janssen granted to the Company a license for a three-year research term to conduct research on the HIF compound portfolio, which research term is now expired. A more detailed description of this collaboration agreement can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\nUnder the terms of the Janssen Agreement, the Company made an upfront payment of $ 1.0 million in cash to Janssen and issued a warrant, or the Warrant, to purchase 509,611 shares of the Company’s common stock, which expired on February 9, 2022. In addition, Janssen could be eligible to receive up to an aggregate of $ 16.5 million from the Company in specified development milestone payments on a product-by-product basis. Janssen could also be eligible to receive up to $ 215.0 million from the Company in specified commercial milestones as well as tiered, escalating royalties ranging from a low- to mid-single digit percentage of net sales, on a product-by-product basis, and subject to reduction upon expiration of patent rights or the launch of a generic product in the territory. A more detailed description of this collaboration agreement can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K. On August 1, 2022, the Company notified Janssen that it was exercising its right to terminate the Janssen Agreement, and Janssen agreed to the termination which became effective on August 2, 2022.\nCyclerion Therapeutics License Agreement\nOn June 4, 2021, the Company entered into a License Agreement, the Cyclerion Agreement, with Cyclerion Therapeutics Inc., or Cyclerion, pursuant to which Cyclerion granted the Company an exclusive global license under certain intellectual property rights to research, develop and commercialize praliciguat, an investigational oral soluble guanylate stimulator.\nUnder the terms of the Cyclerion Agreement, the Company made an upfront payment of $ 3.0 million in cash to Cyclerion, which was paid and recorded to research and development expense in June 2021. Substantially all of the fair value of the assets acquired in conjunction with the Cyclerion Agreement was concentrated in the acquired license. As a result, the Company accounted for this transaction as an asset acquisition under ASU No. 2017-01, Business Combinations (Topic 805): Clarifying\n19\nthe Definition of a Business. The upfront payment was charged to expense at acquisition, as it relates to a development stage compound with no alternative future use. In addition, Cyclerion is eligible to receive up to an aggregate of $ 222.0 million from the Company in specified development and regulatory milestone payments on a product-by-product basis. Cyclerion will also be eligible to receive specified commercial milestones as well as tiered royalties ranging from a low-single-digit- to mid-double-digit percentage of net sales, on a product-by-product basis, and subject to reduction upon expiration of patent rights or the launch of a generic product in the territory. A more detailed description of this agreement can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\nVifor Pharma License Agreement\nSummary of License Agreement\nOn May 12, 2017, the Company entered into a License Agreement, or the Vifor Agreement, with Vifor (International) Ltd., or Vifor Pharma, pursuant to which the Company granted Vifor Pharma an exclusive license to sell vadadustat solely to Fresenius Kidney Care Group LLC, an affiliate of Fresenius Medical Care North America, or FMCNA, in the United States. On April 8, 2019, the Company and Vifor Pharma entered into an Amended and Restated License Agreement, or the Vifor First Amended Agreement, which amended and restated in full the Vifor Agreement. On February 18, 2022, the Company and Vifor Pharma entered into a Second Amended and Restated License Agreement, or the Vifor Second Amended Agreement, which amends and restates the Vifor First Amended Agreement.\nPursuant to the Vifor Second Amended Agreement, the Company granted Vifor Pharma an exclusive license to sell vadadustat to FMCNA and its affiliates, including Fresenius Kidney Care Group LLC, to certain third party dialysis organizations approved by the Company, to independent dialysis organizations that are members of certain group purchasing organizations, and to certain non-retail specialty pharmacies, or collectively, the Supply Group, in the United States, or the Territory. Pursuant to the Vifor Second Amended Agreement, Vifor Pharma agreed that it would not sell or otherwise supply vadadustat until the FDA has granted regulatory approval for vadadustat in the DD-CKD Indication in the Territory and until Vifor Pharma has entered a supply agreement with the applicable member of the Supply Group.\nSimilar to the Vifor First Amended Agreement, the Vifor Second Amended Agreement is structured as a profit share arrangement between the Company and Vifor Pharma in which the Company will receive approximately 66 % of the profit, net of certain pre-specified costs. Under the Vifor Second Amended Agreement, Vifor Pharma made an upfront payment to the Company of $ 25.0 million in lieu of the previously disclosed milestone payment of $ 25.0 million that Vifor Pharma was to pay the Company following approval of vadadustat by the FDA, as established under the Vifor First Amended Agreement.\nUnless earlier terminated, the Vifor Second Amended Agreement will expire upon the later of the expiration of all patents that claim or cover vadadustat or expiration of marketing or regulatory exclusivity for vadadustat in the Territory. Vifor Pharma may terminate the Vifor Second Amended Agreement in its entirety upon 30 months' prior written notice after the first anniversary of the receipt of regulatory approval, if approved from the FDA for vadadustat for dialysis-dependent CKD patients. The Company may terminate the Vifor Second Amended Agreement in its entirety for convenience, following the earlier of a certain period of time elapsing or following certain specified regulatory events, and upon six months ’ prior written notice. If the Company so terminates for convenience, subject to specified exceptions, the Company will pay a termination fee to Vifor Pharma. In addition, either party may, subject to a cure period, terminate the Vifor Second Amended Agreement in the event of the other party’s uncured material breach or bankruptcy.\nInvestment Agreement\nIn connection with the Vifor Agreement, in May 2017, the Company and Vifor Pharma entered into an investment agreement, or the First Investment Agreement, pursuant to which the Company sold an aggregate of 3,571,429 shares of the Company’s common stock, or the 2017 Shares, to Vifor Pharma at a price per share of $ 14.00 for a total of $ 50.0 million. The amount representing the premium over the closing stock price of $ 12.69 on the date of the transaction, totaling $ 4.7 million, was determined by the Company to represent consideration related to the Vifor Agreement.\nVifor Pharma agreed to a lock-up restriction such that it agreed not to sell the 2017 Shares for a period of time following the effective date of the First Investment Agreement as well as a customary standstill agreement. In addition, the First Investment Agreement contains voting agreements made by Vifor Pharma with respect to the 2017 Shares. The 2017 Shares have not been registered pursuant to the Securities Act of 1933, as amended, or the Securities Act, and were issued and sold in reliance upon the exemption from registration contained in Section 4(a)(2) of the Securities Act and Rule 506 promulgated thereunder.\nIn connection with entering into the Vifor Second Amended Agreement, on February 18, 2022, the Company and Vifor Pharma entered into an investment agreement, or the Second Investment Agreement, pursuant to which the Company sold an aggregate\n20\nof 4,000,000 shares of its common stock, or the 2022 Shares, to Vifor Pharma for a total of $ 20 million on February 22, 2022. The amount representing the premium over the grant date fair value on the date of the transaction, $ 13.6 million, was determined by the Company to represent the consideration related to the Vifor Second Amended Agreement. Vifor Pharma has agreed to a lock-up restriction to not sell or otherwise dispose of the 2022 Shares for a period of time following the effective date of the Second Investment Agreement as well as a customary standstill agreement. In addition, the Second Investment Agreement contains voting agreements made by Vifor Pharma with respect to the 2022 Shares. The 2022 Shares have not been registered pursuant to the Securities Act and were issued and sold in reliance upon the exemption from registration contained in Section 4(a)(2) of the Securities Act and/or Rule 506 promulgated thereunder, as the transaction did not involve any public offering within the meaning of Section 4(a)(2) of the Securities Act.\nRevenue Recognition\nThe Company evaluated the elements of the Vifor Second Amended Agreement in accordance with the provisions of ASC 606 and concluded that the contract counterparty, Vifor Pharma, is a customer. The Company’s arrangement with Vifor Pharma contains one material promise under the contract at inception, which is the non-sublicensable, non-transferrable license under certain of the Company’s intellectual property to (i) sell vadadustat solely to the Supply Group, (ii) sell vadadustat to Designated Wholesalers solely for resale to members of the Supply Group, (iii) conduct medical affairs with respect to vadadustat in the Territory in the field during the term of the Vifor Second Amended Agreement and (iv) use the Akebia Trademark solely in connection with the sale of vadadustat (the License Deliverable).\nThe Company has identified one performance obligation in connection with its obligations under the Vifor Second Amended Agreement, which is the License Deliverable, or License Performance Obligation. The transaction price at inception was comprised of: (i) the up-front payment of $ 25.0 million, (ii) the premium paid by Vifor Pharma on the First Investment Agreement of $ 4.7 million, and (iii) the premium paid by Vifor Pharma on the Second Investment Agreement of $ 13.6 million. Pursuant to the terms of the Vifor Second Amended Agreement, these payments from Vifor Pharma are non-refundable and non-creditable against any other amount due to the Company. Also pursuant to the Vifor Second Amended Agreement, if the Centers for Medicare & Medicaid Services, or CMS, determines that vadadustat is excluded from the Transitional Drug Add-on Payment Adjustment, or TDAPA, the Company can terminate the Vifor Second Amended Agreement and will be required to repay the up-front payment and the premiums paid by Vifor Pharma in the First Investment Agreement and Second Investment Agreement, respectively. The Company considered whether the transaction price was constrained as required per the guidance in ASC 606-10-32-11. As part of its evaluation of the constraint, the Company considered numerous factors, including the CRL received from the FDA for vadadustat, the uncertainty associated with a potential future approval of vadadustat by the FDA, and if approval of vadadustat is received in the future, whether vadadustat would be included in certain reimbursement bundles by CMS, which are all outside of the Company’s control. Vifor Pharma also agreed that it will not sell or otherwise supply vadadustat until the FDA has granted regulatory approval for vadadustat in the DD-CKD Indication. The Company constrains the variable consideration to an amount for which a significant revenue reversal is not probable. Therefore, the Company determined that the entire transaction price at inception was constrained under ASC 606, and the Company has recorded the transaction price to deferred revenue as of September 30, 2022.\nRefund Liability to Customer\nPursuant to the Vifor Second Amended Agreement, Vifor Pharma contributed $ 40.0 million to a working capital fund established to partially fund the Company’s costs of purchasing vadadustat from its contract manufacturers, or the Working Capital Fund, which amount of funding will fluctuate, and which funding the Company will repay to Vifor over time. The $ 40 million initial contribution to the Working Capital Fund represents 50 % of the amount of purchase orders that the Company has placed with its contract manufacturers for the supply of vadadustat for the Territory already delivered as of the effective date of the Vifor Second Amended Agreement, and to be delivered through the end of 2022. The amount of the Working Capital Fund will be reviewed at specified intervals and is adjusted based on a number of factors including outstanding supply commitments for vadadustat for the Territory and agreed upon vadadustat inventory levels held by the Company for the Territory. Upon termination or expiration of the Vifor Second Amended Agreement for any reason other than convenience by Vifor Pharma (including following receipt of the CRL for vadadustat), the Company will be required to refund the outstanding balance of the Working Capital Fund on the date of termination or expiration.\nThe Company has recorded the Working Capital Fund as a refund liability under ASC 606. The Company has determined that the refund liability itself does not represent an obligation to transfer goods or services to Vifor Pharma in the future. The Company has therefore determined that this refund liability is not a contract liability under ASC 606. The Company accounted for the refund liability as a debt arrangement with zero coupon interest. The Company imputed interest on the refund liability to the customer at a rate of 15.0 % per annum, which was determined based on certain factors, including the Company's credit rating, comparable securities yield, and the expected repayment period of the Working Capital Fund. The Company recorded an\n21\ninitial discount on the refund liability to the customer and a corresponding deferred gain to the refund liability to customer on the condensed consolidated balance sheet as of the date the funds were received from Vifor Pharma, which was March 18, 2022. The discount on the note payable is being amortized to interest expense using the effective interest method over the expected term of the refund liability. The deferred gain is being amortized to interest income on a straight-line basis over the expected term of the refund liability. The amortization of the discount was $ 1.1 million and $ 2.3 million for the three and nine months ended September 30, 2022, respectively. The amortization of the deferred gain was $ 0.9 million and $ 1.8 million for the three and nine months ended September 30, 2022, respectively. Of the $ 40.5 million total refund liability, net of deferred gain and discount, the Company classified $ 13.7 million as a short-term refund liability based on management's estimate of potential amounts that could be refundable within a one-year period as a result of anticipated changes to the Company's operating plan following the CRL.\nPriority Review Voucher Letter Agreement\nOn February 14, 2020, the Company entered into a letter agreement, or the Letter Agreement, with Vifor Pharma relating to Vifor Pharma’s agreement with a third party to purchase a Priority Review Voucher, or the PRV, issued by the FDA, subject to satisfaction of customary closing conditions, or the PRV Purchase. A PRV entitles the holder to priority review of an NDA, or a Biologics License Application for a new drug, which reduces the target FDA review time to six months after official acceptance of the submission, and could lead to expedited approval. Pursuant to the Letter Agreement, Akebia paid Vifor Pharma $ 10.0 million in connection with the closing of the PRV Purchase.\nOn August 21, 2021, the Company and Vifor Pharma executed an amendment to the Letter Agreement whereby the parties agreed that Vifor Pharma would sell the PRV to a third party, and the Company and Vifor Pharma would share the proceeds from the sale based on certain terms. In the fourth quarter of 2021, Vifor Pharma sold the PRV to a third party, and Vifor Pharma paid the Company $ 8.6 million in proceeds from the sale, which was recorded as contra research and development expense. These proceeds were subsequently paid to Otsuka as reimbursement for their contribution to the purchase of the PRV, as required under a separate letter agreement executed with Otsuka. A more detailed description of this transaction can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\nLicense Agreement with Panion & BF Biotech, Inc.\nAs a result of the merger with Keryx, or the Merger, the Company had a license agreement, which was amended from time to time, with Panion & BF Biotech, Inc., or Panion, under which Keryx, the Company's wholly owned subsidiary, was the contracting party, or the Panion License Agreement, pursuant to which Keryx in-licensed the exclusive worldwide rights, excluding certain Asian-Pacific countries, or the Licensor Territory, for the development and commercialization of ferric citrate.\nOn April 17, 2019, the Company and Panion entered into a second amended and restated license agreement, or the Panion Amended License Agreement, which amends and restates in full the Panion License Agreement, effective as of April 17, 2019. The Panion Amended License Agreement provides Keryx with an exclusive license under Panion-owned know-how and patents with the right to sublicense, develop, make, use, sell, offer for sale, import and export ferric citrate worldwide, excluding the Licensor Territory. The Panion Amended License Agreement also provides Panion with an exclusive license under the Keryx-owned patents, with the right to sublicense (with the Company’s written consent), develop, make, use, sell, offer for sale, import and export ferric citrate in certain countries in the Licensor Territory. Under the Panion Amended License Agreement, Panion is eligible to receive from the Company or any sublicensee royalty payments based on a mid-single digit percentage of sales of ferric citrate in the Company’s licensed territories. The Company is eligible to receive from Panion or any sublicensee royalty payments based on a mid-single digit percentage of net sales of ferric citrate in Panion’s licensed territories. A more detailed description of this license agreement can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\nThe Company recognized royalty payments due to Panion of approximately $ 2.9 million and $ 3.0 million during the three months ended September 30, 2022 and 2021, respectively, and $ 9.5 million and $ 8.3 million during the nine months ended September 30, 2022 and 2021, respectively, relating to the Company’s sales of Auryxia in the United States and JT and Torii’s net sales of Riona in Japan, as the Company is required to pay a mid-single digit percentage of net sales of ferric citrate in the Company’s licensed territories to Panion under the terms of the Panion Amended License Agreement.\n22\nSublicense Agreement with Japan Tobacco, Inc. and its subsidiary, Torii Pharmaceutical Co., Ltd.\nAs a result of the Merger, the Company has an Amended and Restated Sublicense Agreement, which was amended in June 2013, with JT and Torii, or the JT and Torii Sublicense Agreement, under which Keryx, the Company’s wholly owned subsidiary, remains the contracting party. Under the JT and Torii Sublicense Agreement, JT and Torii obtained the exclusive sublicense rights for the development and commercialization of ferric citrate hydrate in Japan. JT and Torii are responsible for the future development and commercialization costs in Japan. A more detailed description of this sublicense agreement can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\nThe Company identified two performance obligations in connection with its obligations under the JT and Torii Sublicense Agreement: (i) License and Supply Performance Obligation and (ii) Rights to Future Know-How Performance Obligation. The Company allocated the transaction price to each performance obligation based on the Company’s best estimate of the relative standalone selling price. The Company developed a best estimate of the standalone selling price for the Rights to Future Know-How Performance Obligation primarily based on the likelihood that additional intellectual property covered by the license conveyed will be developed during the term of the arrangement and determined it immaterial. As such, the Company did not develop a best estimate of standalone selling price for the License and Supply Performance Obligation and allocated the entire transaction price to this performance obligation.\nThe Company recognized license revenue of $ 1.2 million and $ 1.4 million during the three months ended September 30, 2022 and 2021, respectively, and $ 3.9 million and $ 4.1 million during the nine months ended September 30, 2022 and 2021, respectively, related to royalties earned on net sales of Riona in Japan. The Company records the associated mid-single digit percentage of net sales royalty expense due to Panion, the licensor of Riona, in the same period as the royalty revenue from JT and Torii is recorded.\n5. Restructuring\nOn April 4, 2022, the Board of Directors of the Company approved a reduction of the Company’s workforce by approximately 42 % across all areas of the Company ( 47 % inclusive of the closing of the majority of open positions) following the receipt of the CRL from the FDA to the Company’s NDA for vadadustat for the treatment of anemia due to CKD in adult patients. The workforce reduction was substantially completed as of June 30, 2022. On May 5, 2022, the Company implemented a further reduction in workforce consisting of several members of management. The workforce reduction is expected to be substantially complete by the end of May 2023. These actions reflect the Company’s determination to refocus its strategic priorities around its commercial product, Auryxia®, and its development portfolio, and are steps in a cost savings plan to significantly reduce the Company’s expense profile in line with being a single commercial product company.\nThe workforce reduction is expected to include total restructuring charges of approximately $ 14.7 million. During the three and nine months ended September 30, 2022, the Company recognized $ 0.2 million and $ 14.7 million, respectively, of restructuring charges in the condensed consolidated statement of operations. These charges included $ 11.4 million of one-time termination benefits and contractual termination benefits for severance, healthcare, and related benefits and $ 3.3 million of non-cash share-based compensation expense. The charges were recorded pursuant to ASC 712, Compensation-Nonretirement Postemployment Benefits or ASC 420, Exit or Disposal Cost Obligations, depending on the employee.\nDetails of the restructuring liability activity for the Company's workforce reduction for the period ended September 30, 2022 are as follows:\n| September 30, 2022 |\n| (in thousands) |\n| Balance at December 31, 2021 | $ | — |\n| Restructuring charges | 14,711 |\n| Stock-based compensation expense | ( 3,253 ) |\n| Severance payments and adjustments | ( 7,220 ) |\n| Balance at September 30, 2022 | $ | 4,238 |\n\n23\n6. Liability Related to Sale of Future Royalties\nOn February 25, 2021, the Company entered into the Royalty Agreement with HCR, pursuant to which the Company sold to HCR its right to receive royalties and sales milestones for vadadustat in Japan and certain other Asian countries, such countries, collectively, the MTPC Territory, and such payments collectively the Royalty Interest Payments, in each case, payable to the Company under the MTPC Agreement, subject to an annual maximum “cap” of $ 13.0 million, or the Annual Cap, and an aggregate maximum “cap” of $ 150.0 million, or the Aggregate Cap. The Company received $ 44.8 million from HCR (net of certain transaction expenses) under the Royalty Agreement. The Company retains the right to receive all potential future regulatory milestones for vadadustat under the MTPC Agreement. Although the Company sold its right to receive royalties and sales milestones for vadadustat in the MTPC Territory as described above, as a result of its ongoing involvement in the cash flows related to these royalties, the Company will continue to account for these royalties as revenue. The Company recognized the proceeds received from HCR as a liability that is being amortized using the effective interest method over the life of the arrangement. At the transaction date, the Company recorded the net proceeds of $ 44.8 million as a liability. In order to determine the amortization of the liability, the Company is required to estimate the total amount of future net royalty payments to be made to HCR over the term of the Royalty Agreement. The total threshold of net royalties to be paid, less the net proceeds received, will be recorded as interest expense over the life of the liability. The Company imputes interest on the unamortized portion of the liability using the effective interest method. The annual effective interest rate as of September 30, 2022 was 13.6 % which is reflected as interest expense in the unaudited condensed consolidated statements of operations and comprehensive loss. On a quarterly basis, the Company reassesses the effective interest rate and adjusts the rate prospectively as needed. A more detailed description of Royalty Agreement can be found in Note 5 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\nThe following table shows the activity within the liability account for the nine months ended September 30, 2022:\n| September 30, 2022 |\n| (in thousands) |\n| Liability related to sale of future royalties, net beginning balance at December 31, 2021 | $ | 53,079 |\n| MTPC royalties payable | ( 1,195 ) |\n| Non-cash interest expense recognized | 6,352 |\n| Liability related to sale of future royalties, net — ending balance | $ | 58,236 |\n\n7. Fair Value of Financial Instruments\nThe Company utilizes a portfolio management company for the valuation of the majority of its investments. This portfolio management company is an independent, third-party vendor recognized to be an industry leader with access to market information that obtains or computes fair market values from quoted market prices, pricing for similar securities, recently executed transactions, cash flow models with yield curves and other pricing models. For valuations obtained from the pricing service, the Company performs due diligence to understand how the valuation was calculated or derived, focusing on the valuation technique used and the nature of the inputs.\nBased on the fair value hierarchy, the Company classifies its cash equivalents within Level 1 or Level 2. This is because the Company values its cash equivalents using quoted market prices or alternative pricing sources and models utilizing market observable inputs.\n24\nAssets measured or disclosed at fair value on a recurring basis as of September 30, 2022 and December 31, 2021 are summarized below:\n| Fair Value Measurements Using |\n| Level 1 | Level 2 | Level 3 | Total |\n| (in thousands) |\n| September 30, 2022 |\n| Assets: |\n| Cash and cash equivalents | $ | 144,761 | $ | — | $ | — | $ | 144,761 |\n| $ | 144,761 | $ | — | $ | — | $ | 144,761 |\n| Liabilities: |\n| Derivative liability | $ | — | $ | — | $ | 760 | $ | 760 |\n| $ | — | $ | — | $ | 760 | $ | 760 |\n\n\n| Fair Value Measurements Using |\n| Level 1 | Level 2 | Level 3 | Total |\n| (in thousands) |\n| December 31, 2021 |\n| Assets: |\n| Cash and cash equivalents | $ | 149,800 | $ | — | $ | — | $ | 149,800 |\n| $ | 149,800 | $ | — | $ | — | $ | 149,800 |\n| Liabilities: |\n| Derivative liability | $ | — | $ | — | $ | 1,820 | $ | 1,820 |\n| $ | — | $ | — | $ | 1,820 | $ | 1,820 |\n\nThe Company’s Loan Agreement with Pharmakon (see Note 11) contains certain provisions that change the underlying cash flows of the debt instrument, including a potential extension to the interest-only period dependent on both (i) no event of default having occurred and continuing and (ii) the Company achieving certain regulatory and revenue conditions. One of the regulatory conditions was approval of vadadustat by August 2022, however, in March 2022, the Company received the CRL from the FDA stating that the FDA had determined that it could not approve the NDA for vadadustat in its present form. Therefore, the Company is no longer eligible for the interest-only extension period and this no longer changes the underlying cash flows of the debt instrument. The Company also assessed the acceleration of the obligations under the Loan Agreement under certain events of default. In addition, under certain circumstances, a default interest rate will apply on all outstanding obligations during the occurrence and continuance of an event of default. In accordance with ASC 815, the Company concluded that these features are not clearly and closely related to the host instrument, and represent a single compound derivative that is required to be re-measured at fair value on a quarterly basis.\nThe potential events of default assessed include failure to maintain, on an annual basis, a minimum liquidity threshold which started in 2021, and on a quarterly basis, a minimum net sales threshold for Auryxia which started in the fourth quarter of 2020. The Company recorded a derivative liability related to the Company’s Loan Agreement with Pharmakon of $ 0.8 million and $ 1.8 million as of September 30, 2022 and December 31, 2021, respectively. The Company classified the derivative liability as a non-current liability on the unaudited condensed consolidated balance sheet as of September 30, 2022 and December 31, 2021. The estimated fair value of the derivative liability on both September 30, 2022 and December 31, 2021 was determined using a scenario-based approach and discounted cash flow model that includes principal and interest payments under various scenarios involving clinical development success for vadadustat and various cash flow assumptions. The Company used a 0 % probability of clinical development success due to receipt of the CRL from the FDA for vadadustat. Should the Company’s assessment of the probabilities around these scenarios change, including for changes in market conditions, there could be a change to the fair value of the derivative liability.\n25\nThe following table provides a roll-forward of the fair value of the derivative liability (in thousands):\n\n| Balance at December 31, 2021 | $ | 1,820 |\n| Change in fair value of derivative liability, recorded as other income | ( 710 ) |\n| Balance at March 31, 2022 | $ | 1,110 |\n| Change in fair value of derivative liability, recorded as other income | — |\n| Balance at June 30, 2022 | $ | 1,110 |\n| Change in fair value of derivative liability, recorded as other income | ( 350 ) |\n| Balance at September 30, 2022 | $ | 760 |\n\nThe Company had no other assets or liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) at September 30, 2022 and December 31, 2021.\n8. Inventory\nThe components of inventory are summarized as follows:\n\n| September 30, 2022 | December 31, 2021 |\n| (in thousands) |\n| Raw materials | $ | 397 | $ | 1,763 |\n| Work in process | 32,855 | 62,635 |\n| Finished goods | 18,970 | 14,661 |\n| Total inventory | $ | 52,222 | $ | 79,059 |\n\nLong-term inventory, which primarily consists of raw materials and work in process, is included in other assets in the Company’s unaudited condensed consolidated balance sheets.\n\n| September 30, 2022 | December 31, 2021 |\n| (in thousands) |\n| Balance Sheet Classification: |\n| Inventory | $ | 40,039 | $ | 38,195 |\n| Other assets | 12,183 | 40,864 |\n| Total inventory | $ | 52,222 | $ | 79,059 |\n\nInventory amounts written down as a result of excess, obsolescence, scrap or other reasons and charged to cost of goods sold totaled $ 2.6 million and $ 1.7 million during the three months ended September 30, 2022 and 2021, respectively, and $ 10.0 million and $ 7.1 million during the nine months ended September 30, 2022 and 2021, respectively. The increase in inventory amounts written down for the three and nine months ended September 30, 2022 as compared to the three and nine months ended September 30, 2021 was primarily due to higher write-downs to inventory reserves related to expired inventory. In addition, there were no related step-up charges during the nine months ended September 30, 2022 and $ 8.7 million related step-up charges during the nine months ended September 30, 2021. During the nine months ended September 30, 2022, the Company recorded $ 14.8 million of long-term inventory reserves and related reduction to the excess purchases commitment liability related to Auryxia inventory previously identified as excess, reflecting Auryxia inventory that was received during the period.\nIf future sales of Auryxia are lower than expected, the Company may be required to write-down the value of such inventories. Inventory write-downs and losses on purchase commitments are recorded as a component of cost of goods sold in the unaudited condensed consolidated statement of operations.\n26\n9. Intangible Assets and Goodwill\nIntangible Assets\nThe following table presents the Company’s intangible assets at September 30, 2022 and December 31, 2021 (in thousands):\n\n| September 30, 2022 |\n| Gross CarryingValue | Accumulated Amortization | Total |\n| Intangible assets: |\n| Developed product rights for Auryxia | $ | 213,603 | $ | ( 132,508 ) | $ | 81,095 |\n| Total | $ | 213,603 | $ | ( 132,508 ) | $ | 81,095 |\n\n| December 31, 2021 |\n| Gross CarryingValue | AccumulatedAmortization | Total |\n| Intangible assets: |\n| Developed product rights for Auryxia | $ | 213,603 | $ | ( 105,476 ) | $ | 108,127 |\n| Total | $ | 213,603 | $ | ( 105,476 ) | $ | 108,127 |\n\nThe Company amortizes its definite-lived intangible assets using the straight-line method, which is considered the best estimate of economic benefit, over its estimated useful life of six years . The Company recorded $ 9.0 million in amortization expense related to the developed product rights for Auryxia during each of the three months ended September 30, 2022 and 2021, and $ 27.0 million during each of the nine months ended September 30, 2022 and 2021.\nGoodwill\nThe Company's goodwill results from the acquisition of Keryx in December 2018. Goodwill was $ 55.1 million as of September 30, 2022 and December 31, 2021. The Company operates in one operating segment which the Company considers to be the only reporting unit. Goodwill is evaluated for impairment at the reporting unit level on an annual basis as of October 1, and more frequently if indicators are present or changes in circumstances suggest that it is more likely than not that the fair value of the reporting unit is less than its carrying amount. Events that could indicate impairment and trigger an interim impairment assessment include, but are not limited to, an adverse change in current economic or market conditions, including a significant prolonged decline in market capitalization, a significant adverse change in legal factors, unexpected adverse business conditions, and an adverse action by a regulator. During the nine months ended September 30, 2022, the Company evaluated business factors, including the receipt of the CRL from the FDA for vadadustat, the Company's market capitalization as impacted by a recent decline in the Company's stock price, the impact of the Otsuka Termination Agreement on the Company's future cash flows, and the increase to the Company's excess purchase commitment liability to determine if there were events or changes in circumstance to indicate that the fair value of the reporting unit was less than its carrying value. The Company performed qualitative interim impairment assessments of the Company's goodwill balance as of each of the three months ended March 31, 2022, June 30, 2022, and September 30, 2022. The Company determined that it was not more likely than not that the fair value of the reporting unit was less than its carrying value and, therefore, did not perform a further quantitative interim impairment test for any period.\nThe Company's qualitative assessments were based on the Company's estimates and assumptions, a number of which are dependent on external factors and actual results may differ materially from these estimates. In addition, the future occurrence of events including, but not limited to, an adverse change in current economic and market conditions, including a significant prolonged decline in market capitalization, a significant adverse change in legal factors, unexpected adverse business conditions and an adverse action or assessment by a regulator could indicate potential impairment and trigger an interim impairment assessment of goodwill, which could result in an impairment of goodwill. As a result of the significance of goodwill, the Company's results of operations and financial position in a future period could be negatively impacted should an impairment test be triggered that results in an impairment of goodwill.\n10. Accrued Expenses\nAccrued expenses as of September 30, 2022 and December 31, 2021 are as follows:\n27\n| September 30, 2022 | December 31, 2021 |\n| (in thousands) |\n| Product revenue allowances | $ | 25,222 | $ | 26,624 |\n| Accrued clinical | 8,652 | 14,036 |\n| Amounts due to collaboration partners | 19,550 | 22,654 |\n| Accrued payroll and related | 9,140 | 15,863 |\n| Lease liability | 4,260 | 4,802 |\n| Royalties | 2,916 | 3,472 |\n| Professional fees | 1,725 | 1,899 |\n| Accrued commercial manufacturing | 3,167 | 3,843 |\n| Accrued restructuring | 4,238 | — |\n| Accrued other | 8,494 | 11,263 |\n| Total accrued expenses | $ | 87,364 | $ | 104,456 |\n\n11. Debt\nTerm Loans\nOn November 11, 2019, the Company, with Keryx as guarantor, entered into a loan agreement, or the Loan Agreement, with BioPharma Credit PLC as collateral agent and a lender, or the Collateral Agent, and BioPharma Credit Investments V (Master) LP as a lender, pursuant to which term loans in an aggregate principal amount of $ 100.0 million were made available to the Company in two tranches, subject to certain terms and conditions, or the Term Loans. BioPharma Credit PLC subsequently transferred its interest in the Term Loans, solely in its capacity as a lender, to its affiliate, BPCR Limited Partnership. The Collateral Agent and the lenders are collectively referred to as Pharmakon (see Note 1 to our condensed consolidated financial statements). The first tranche of $ 80.0 million, or Tranche A, was drawn on November 25, 2019, or the Tranche A Funding Date, and the second tranche of $ 20.0 million, or Tranche B, was drawn on December 10, 2020, or the Tranche B Funding Date. Each of the Tranche A Funding Date and the Tranche B Funding Date, a Funding Date.\nProceeds from the Term Loans may be used for general corporate purposes. The Company and Keryx entered into a Guaranty and Security Agreement with the Collateral Agent, or the Guaranty and Security Agreement, on the Tranche A Funding Date. Pursuant to the Guaranty and Security Agreement, the Company’s obligations under the Term Loans are unconditionally guaranteed by Keryx, or the Guarantee. Additionally, the obligations of the Company and Keryx under the Term Loans and the Guarantee are secured by a first priority lien on certain assets of the Company and Keryx, including Auryxia and certain related assets, cash, and certain equity interests held by the Company and Keryx, collectively the Collateral.\nThe Term Loans bear interest at a floating rate per annum equal to the three-month LIBOR rate plus 7.50 %, subject to a 2.00 % LIBOR floor and a 3.35 % LIBOR cap, payable quarterly in arrears. The Term Loans will mature on the fifth anniversary of the Tranche A Funding Date, or the Maturity Date. The Company will repay the principal under the Term Loans in equal quarterly payments starting on the 33 rd-month anniversary of the applicable Funding Date, or the Amortization Schedule. If certain conditions were met, it would have had the option to repay the principal in equal quarterly payments starting on the 48 th-month anniversary of the applicable Funding Date. One of these conditions was approval of vadadustat; however, the Company received the CRL from the FDA in March 2022 stating that the FDA had determined that it could not approve the NDA in its present form. Therefore, the Company is no longer eligible for this option to delay repayment of the principal under the Loan Agreement. As of September 30, 2022, the Company made its first quarterly principal payment under the Term Loans of $ 8.0 million. Under certain circumstances, unless certain liquidity conditions are met, the Maturity Date may decrease by up to one year , and the Amortization Schedule may correspondingly commence up to one year earlier.\nOn the Tranche A Funding Date, the Company paid to Pharmakon a facility fee equal to 2.00 % of the aggregate principal amount of the Term Loans, or $ 2.0 million, in addition to other expenses incurred by Pharmakon and reimbursed by the Company, or Lender Expenses. The Tranche A draw was $ 77.3 million, net of facility fee, Lender Expenses and issuance costs. The Tranche B draw was $ 20.0 million, net of immaterial Lender Expenses and issuance costs. The Loan Agreement permits voluntary prepayment at any time in whole or in part, subject to a prepayment premium. The prepayment premium would be 2.00 % of the principal amount being prepaid prior to the third anniversary of the applicable Funding Date, 1.00 % on or after the third anniversary, but prior to the fourth anniversary, of the applicable Funding Date, and 0.50 % on or after the fourth anniversary of the applicable Funding Date but prior to the Maturity Date, and a make-whole premium on or prior to the second\n28\nanniversary of the applicable Funding Date in an amount equal to foregone interest through the second anniversary of the applicable Funding Date. A change of control triggers a mandatory prepayment of the Term Loans.\nThe Loan Agreement contains customary representations, warranties, events of default and covenants of the Company and its subsidiaries, including maintaining, on an annual basis, a minimum liquidity threshold which started in 2021, and on a quarterly basis, a minimum net sales threshold for Auryxia which started in the fourth quarter of 2020. On February 18, 2022, the Loan Agreement was amended by the First Amendment and Waiver, which waived the provision under the Loan Agreement that required the Company to not be subject to any qualification as a going concern within the Company's 2021 Annual Report on Form 10-K. Pursuant to the First Amendment and Waiver, the Company's filings of Form 10-Q for fiscal quarters ending June 30, 2022 and September 30, 2022, and its future Annual Reports on Form 10-K, must not be subject to any qualification as to going concern, which requirement as to the Company's filings on Form 10-Q was waived in the Second Amendment and Waiver. If the Company does not satisfy the covenant as to going concern in any of these filings, the Company will be in default under the Loan Agreement. There is uncertainty as to whether or not the Company will meet its future annual debt covenants related to qualification as to going concern. If an event of default occurs and is continuing under the Loan Agreement, the Collateral Agent is entitled to take enforcement action, including acceleration of amounts due under the Loan Agreement. Therefore, as of September 30, 2022, the Company continued to classify the borrowings under the Loan Agreement as current. Under certain circumstances, a default interest rate will apply on all outstanding obligations during the occurrence and continuance of an event of default. As of September 30, 2022 and December 31, 2021, the Company determined that no events of default had occurred.\nOn July 15, 2022, or the Effective Date, the Company and Pharmakon entered into the Second Amendment and Waiver, or the Second Amendment and Waiver, which amended and waived certain provisions of the Loan Agreement, as amended by the First Amendment and Waiver.\nPursuant to the Second Amendment and Waiver, on the Effective Date, the Company made a $ 5.0 million prepayment of the principal of the tranche A loan, or the Second Amendment Effective Date Tranche A Prepayment, and a $ 20.0 million prepayment of principal of the tranche B loan, or the Second Amendment Effective Date Tranche B Prepayment, in each case, together with any and all accrued and unpaid interest on such prepayments of principal to the Effective Date. In connection therewith, the Company also paid $ 0.5 million in prepayment premiums under the Loan Agreement. During each of the three and nine months ended September 30, 2022, the Company recorded a debt extinguishment loss of $ 0.9 million. Subject to the payment in full of the Second Amendment Effective Date Tranche A Prepayment and the Second Amendment Effective Date Tranche B Prepayment, Pharmakon agreed to, among other things, (1) increase the amount of the working capital facility established in connection with the Company’s Second Amended and Restated License Agreement with Vifor Pharma, which facility is part of the definition of Permitted Indebtedness (as such term is defined in the Loan Agreement) under the Loan Agreement, that the Company is permitted to repay to Vifor Pharma without causing an acceleration of the liabilities under the Loan Agreement, (2) waive the requirement that the Company’s Quarterly Reports on Form 10-Q for the fiscal quarters ending June 30, 2022 and September 30, 2022 not be subject to any qualification as to going concern, and (3) waive certain amounts payable under the Loan Agreement in connection with the Second Amendment Effective Date Tranche B Prepayment. Future principal payments pursuant to the contractual terms of the Loan Agreement, as amended by the Second Amendment and Waiver, are as follows (in thousands):\n| Principal |\n| Payments |\n| (in thousands) |\n| 2022 | $ | — |\n| 2023 | 32,000 |\n| 2024 | 35,000 |\n| Total before unamortized discount and issuance costs | 67,000 |\n| Less: unamortized discount and issuance costs | ( 1,053 ) |\n| Total term loans | $ | 65,947 |\n\nThe Company assessed the terms and features of the Loan Agreement in order to identify any potential embedded features that would require bifurcation or any beneficial conversion feature. As part of this analysis, the Company assessed the economic characteristics and risks of the Loan Agreement, including put and call features. The terms and features assessed include a potential extension to the interest-only period dependent on both no event of default having occurred and continuing and the Company achieving certain regulatory and revenue conditions. The Company also assessed the acceleration of the obligations under the Loan Agreement under an event of default. In addition, under certain circumstances, a default interest rate will apply\n29\non all outstanding obligations during the occurrence and continuance of an event of default. In accordance with ASC 815, the Company concluded that these features are not clearly and closely related to the host instrument, and represent a single compound derivative that is required to be re-measured at fair value on a quarterly basis.\nThe fair value of the derivative liability related to the Company’s Loan Agreement with Pharmakon was $ 0.8 million and $ 1.8 million as of September 30, 2022 and December 31, 2021, respectively. The Company classified the derivative liability as a non-current liability on the unaudited condensed consolidated balance sheet as of September 30, 2022.\nThe Company recognized interest expense related to the Loan Agreement of $ 2.1 million and $ 2.7 million during the three months ended September 30, 2022 and 2021, respectively, and $ 7.5 million and $ 8.1 million for the nine months ended September 30, 2022 and 2021, respectively.\n12. Stockholders’ Equity\nAuthorized and Outstanding Capital Stock\nOn June 5, 2020, the Company filed a Certificate of Amendment to its Ninth Amended and Restated Certificate of Incorporation, or its Charter, to increase the number of authorized shares of common stock from 175,000,000 to 350,000,000 . As of September 30, 2022, the authorized capital stock of the Company included 350,000,000 shares of common stock, par value $ 0.00001 per share, of which 183,951,583 and 177,000,963 shares were issued and outstanding as of September 30, 2022 and December 31, 2021, respectively; and 25,000,000 shares of undesignated preferred stock, par value $ 0.00001 per share, of which no shares were issued and outstanding as of September 30, 2022 and December 31, 2021.\nAt-the-Market Facility\nOn March 12, 2020, the Company filed a prospectus supplement relating to the Company's sales agreement with Cantor Fitzgerald & Co., or the Prior Sales Agreement, pursuant to which it was able to offer and sell up to $ 65.0 million of its common stock at current market prices from time to time. Through December 31, 2020, the Company sold 3,509,381 shares of common stock under this program with net proceeds (after deducting commissions and other offering expenses) of $ 10.6 million. During the three months ended March 31, 2021, the Company sold 5,224,278 shares of common stock under this program with net proceeds (after deducting commissions and other offering expenses) of $ 15.9 million.\nOn February 25, 2021, the Company filed a prospectus relating to the Prior Sales Agreement with its new shelf registration statement (which replaced the prior shelf registration statement and the sales agreement prospectus supplement), pursuant to which it was able to offer and sell up to $ 100.0 million of its common stock at current market prices from time to time. Through December 31, 2021, the Company sold 21,128,065 shares of common stock under this program with net proceeds (after deducting commissions and other offering expenses) of $ 72.4 million. On March 1, 2022, the Company filed a prospectus relating to the Prior Sales Agreement, pursuant to which it was authorized to offer and sell up to $ 25.3 million of its common stock at current market prices from time to time. On March 16, 2022, the Company terminated the Prior Sales Agreement. During the three months ended March 31, 2022, the Company sold 404,600 shares of common stock under this program with net proceeds (after deducting commissions and other offering expenses) of $ 0.8 million.\nOn April 7, 2022, the Company entered into an Open Market Sale AgreementSM, or the Sales Agreement, with Jefferies LLC, or Jefferies, as agent, for the offer and sale of common stock at current market prices in amounts to be determined from time to time. Also, on April 7, 2022, the Company filed a prospectus supplement relating to the Sales Agreement, pursuant to which it is able to offer and sell under the Sales Agreement up to $ 26.0 million of its common stock at current market prices from time to time. From the date of filing of the prospectus supplement through the date of the filing of this Quarterly Report on Form 10-Q, the Company has not sold any shares of its common stock under this program.\nEquity Plans\nThe Company maintains one stock incentive plan, the 2014 Incentive Plan, or the 2014 Plan, as well as the 2014 Employee Stock Purchase Plan, or the 2014 ESPP. The 2014 Plan replaced the Company’s Amended and Restated 2008 Equity Incentive Plan, or the 2008 Plan, however, options or other awards granted under the 2008 Plan prior to the adoption of the 2014 Plan that have not been settled or forfeited remain outstanding and effective. On June 6, 2019, the Company’s stockholders approved the Amended and Restated 2014 Employee Stock Purchase Plan, or the ESPP. The Company also maintains an inducement award program that is separate from the Company's equity plans under which inducement awards may be granted consistent with Nasdaq Listing Rule 5635(c)(4). During the nine months ended September 30, 2022, the Company granted 400,000 options to purchase shares of the Company’s common stock to new hires as inducements material to such employees' entering into employment with the Company, of which 266,000 options remained outstanding as of September 30, 2022.\n30\nThe 2014 Plan allows for the granting of stock options, stock appreciation rights, or SARs, restricted stock, unrestricted stock, RSUs, performance awards and other awards convertible into or otherwise based on shares of the Company’s common stock. Dividend equivalents may also be provided in connection with an award under the 2014 Plan. The Company’s employees, officers, directors and consultants and advisors are eligible to receive awards under the 2014 Plan. The Company initially reserved 1,785,000 shares of its common stock for the issuance of awards under the 2014 Plan. The 2014 Plan provides that the number of shares reserved and available for issuance under the 2014 Plan will automatically increase annually on January 1 of each calendar year, by an amount equal to three percent ( 3 %) of the number of the Company's outstanding shares on a fully diluted basis as of the close of business on the immediately preceding December 31, or the 2014 Plan Evergreen Provision. The Company’s Board of Directors may act prior to January 1 of any year to provide that there will be no automatic increase in the number of Akebia Shares available for grant under the 2014 Plan for that year (or that the increase will be less than the amount that would otherwise have automatically been made). On December 12, 2018, in connection with the consummation of the Merger, the Company assumed outstanding and unexercised options to purchase Keryx's stock, as adjusted by the Exchange Multiplier pursuant to the terms of the Merger Agreement, under the following Keryx equity plans, or the Keryx Equity Plans: the Keryx 1999 Share Option Plan, the Keryx 2004 Long-Term Incentive Plan, the Keryx 2007 Incentive Plan, the Keryx Amended and Restated 2013 Incentive Plan, and the Keryx 2018 Equity Incentive Plan, or the Keryx 2018 Plan. In addition, the number of Keryx Shares available for issuance under the Keryx 2018 Plan, as adjusted by the Exchange Multiplier pursuant to the terms of the Merger Agreement, may be used for awards granted by the Company under its 2014 Plan, or the Assumed Shares, provided that the Company uses the Assumed Shares for individuals who were not employees or directors of the Company prior to the consummation of the Merger.\nThe Company grants annual service-based stock options to employees under the 2014 Plan. During the nine months ended September 30, 2022, the Company issued 3,233,500 options to employees under the 2014 Plan. In addition, the Company issues stock options to directors, new hires and occasionally to other employees not in connection with the annual grant process. During the nine months ended September 30, 2022, the Company issued 140,700 options to directors under the 2014 Plan. Options granted by the Company generally vest over periods of between 12 and 48 months, subject, in each case, to the individual’s continued service through the applicable vesting date. Options generally vest either 100 % on the first anniversary of the grant date or in installments of (i) 25 % at the one year anniversary and (ii) 12 equal quarterly installments beginning after the one year anniversary of the grant date, subject to the individual’s continuous service with the Company. Options generally expire 10 years after the date of grant.\nThe Company also grants performance-based stock options to employees under the 2014 Plan. The Company issued 400,000 performance-based stock options under the 2014 Plan during the nine months ended September 30, 2022. The performance-based stock options granted by the Company generally vest in connection with the achievement of specified commercial and regulatory milestones. The performance-based stock options also generally feature a time-based vesting component. The expense recognized for these awards is based on the grant date fair value of the Company’s common stock multiplied by the number of options granted and recognized over time based on the probability of meeting such commercial and regulatory milestones.\nThe Company also grants annual service-based restricted stock units, or RSUs, to employees and directors under the 2014 Plan. The Company also occasionally issues RSUs not in connection with the annual grant process to employees and directors. During the nine months ended September 30, 2022, the Company issued 5,216,908 RSUs to employees and 95,900 RSUs to directors under the 2014 Plan. Generally, RSUs granted by the Company vest in one of the following ways: (i) 100 % of each RSU grant vests on the first anniversary of the grant date, (ii) one third of each RSU grant vests on the first, second and third anniversaries of the grant date, (iii) 50 % of each RSU grant vests on the first anniversary and 25 % of each RSU grant vests every six months after the one year anniversary of the grant date, or (iv) one third of each RSU grant vests on the first anniversary and the remaining two thirds vests in eight substantially equal quarterly installments beginning after the one year anniversary, subject, in each case, to the individual’s continued service through the applicable vesting date. The expense recognized for these awards is based on the grant date fair value of the Company’s common stock multiplied by the number of units granted and recognized on a straight-line basis over the vesting period.\nThe Company also grants performance-based restricted stock units, or PSUs, to employees under the 2014 Plan. The Company issued 400,000 PSUs during the nine months ended September 30, 2022. The PSUs granted by the Company generally vest in connection with the achievement of specified commercial, regulatory and corporate milestones. The PSUs also generally feature a time-based vesting component. The expense recognized for these awards is based on the grant date fair value of the Company’s common stock multiplied by the number of units granted and recognized over time based on the probability of meeting such commercial, regulatory and corporate milestones.\nThe ESPP provides for the issuance of options to purchase shares of the Company’s common stock to participating employees at a discount to their fair market value. As noted above, the Company’s stockholders approved the ESPP, which amended and restated the Company’s 2014 ESPP, on June 6, 2019. As of September 30, 2022, the maximum aggregate number of shares of\n31\nthe Company’s common stock available for future issuance under the ESPP is 4,837,995 . Under the ESPP, each offering period is six months , at the end of which employees who elect to purchase shares of the Company’s common stock through payroll deductions made over the term of the offering. The per-share purchase price at the end of each offering period is equal to the lesser of eighty-five percent ( 85 %) of the closing price of the Company’s common stock at the beginning or end of the offering period. The Company issued 335,146 shares under the ESPP during the nine months ended September 30, 2022.\n13. Commitments and Contingencies\nLeases\nThe Company leases approximately 65,167 square feet of office and lab space in Cambridge, Massachusetts under a lease which was most recently amended in November 2020, collectively the Cambridge Lease. Under the Third Amendment to the Cambridge Lease, or the Third Amendment, executed in July 2016, total monthly lease payments under the initial base rent were approximately $ 242,000 and are subject to annual rent escalations. In addition to such annual rent escalations, base rent payments for a portion of said premises commenced on January 1, 2017 in the monthly amount of approximately $ 22,000 . The Fourth Amendment to the Cambridge Lease, executed in May 2017, provided additional storage space to the Company and did not impact rent payments. In April 2018, the Company entered into a Fifth Amendment to the Cambridge Lease, or the Fifth Amendment, for an additional 19,805 square feet of office space on the 12th floor. Monthly lease payments for the existing 45,362 square feet of office and lab space, under the Third Amendment, remain unchanged. The new space leased by the Company was delivered in September 2018 and additional monthly lease payments of approximately $ 135,000 commenced in February 2019 and are subject to annual rent escalations, which commenced in September 2019. In November 2020, the Company entered into a Sixth Amendment to the Cambridge Lease, or the Sixth Amendment, to extend the term of the Cambridge Lease with respect to the lab space from November 30, 2021 to January 31, 2025. The Sixth Amendment includes two months of free rent starting in December 2020 and additional monthly lease payments of approximately $ 48,000 , which commenced in December 2021, and is subject to annual rent escalations, which commence in December 2022.\nAdditionally, as a result of the Merger, the Company has a lease for 27,300 square feet of office space in Boston, Massachusetts, or the Boston Lease. The total monthly lease payments under the initial base rent were approximately $ 136,000 and are subject to annual rent escalations. In February 2022, the Company entered into the First Amendment to the Boston Lease, or the First Lease Amendment, to extend the term of the Boston Lease from February 2023 to July 2031. The First Lease Amendment includes five months of free rent starting in March 2023 and monthly lease payments of $ 200,122 commencing on August 1, 2023, with an annual rent escalation of approximately 2 % commencing on August 1, 2024. The First Lease Amendment also includes a landlord's allowance for certain leasehold improvements to the premises in an amount of up to $ 1,954,680 , provided that such allowance must be used prior to August 1, 2024.\nThe term of the Cambridge Lease with respect to the office space expires on September 11, 2026, with one five-year extension option available. The term of the Boston Lease office space expires on July 31, 2031, with an extension option for one additional five-year term available. The renewal options in these real estate leases were not included in the calculation of the operating lease assets and operating lease liabilities as the renewal is not reasonably certain. The term of the Cambridge Lease with respect to the lab space expires on January 31, 2025, with an extension option for one additional period through September 11, 2026. The renewal option in this real estate lease was included in the calculation of the operating lease assets and operating lease liabilities as the renewal is reasonably certain. The lease agreements do not contain residual value guarantees. Operating lease costs were $ 1.8 million and $ 1.7 million for the three months ended September 30, 2022 and 2021, respectively, and $ 5.4 million and $ 5.0 million for the nine months ended September 30, 2022 and 2021, respectively. Cash paid for amounts included in the measurement of operating lease liabilities was $ 1.8 million for each of the three months ended September 30, 2022 and 2021 and $ 5.5 million and $ 5.3 million for the nine months ended September 30, 2022 and 2021, respectively.\nIn September 2019, Keryx entered into an agreement to sublease the Boston office space to Foundation Medicine, Inc., or Foundation. The sublease is subject and subordinate to the Boston Lease between Keryx and the landlord. The term of the sublease commenced on October 16, 2019, upon receipt of the required consent from the landlord for the sublease agreement, and expires on February 27, 2023. Foundation is obligated to pay Keryx rent that approximates the rent due from Keryx to its landlord with respect to the Boston Lease. Sublease rental income is recorded to other income. Keryx continues to be obligated for all payment terms pursuant to the Boston Lease, and the Company will guaranty Keryx’s obligations under the sublease. Keryx recorded $ 0.5 million and $ 0.4 million in sublease rental income from Foundation during the three months ended September 30, 2022 and 2021, respectively, and $ 1.4 million and $ 1.3 million during the nine months ended September 30, 2022 and 2021, respectively.\nThe Company has not entered into any material short-term leases or financing leases as of September 30, 2022.\n32\nThe total security deposit in connection with the Cambridge Lease is $ 1.6 million as of September 30, 2022. Additionally, the Company recorded $ 1.4 million for the security deposit under the Boston Lease. Both the Cambridge Lease and the Boston Lease have their security deposits in the form of a letter of credit, all of which are included as restricted cash in other assets in the Company’s unaudited condensed consolidated balance sheets as of September 30, 2022.\nAs of September 30, 2022, undiscounted minimum rental commitments under non-cancelable leases, for each of the next five years and total thereafter are as follows:\n| OperatingLeases | Lease Paymentsto be Receivedfrom Sublease | Net OperatingLease Payments |\n| (in thousands) |\n| Remaining 2022 | $ | 1,837 | $ | 461 | $ | 1,376 |\n| 2023 | 6,954 | 307 | 6,647 |\n| 2024 | 8,167 | — | 8,167 |\n| 2025 | 8,293 | — | 8,293 |\n| 2026 | 6,571 | — | 6,571 |\n| Thereafter | 12,200 | — | 12,200 |\n| Total | $ | 44,022 | $ | 768 | $ | 43,254 |\n\nIn arriving at the operating lease liabilities, the Company applied incremental borrowing rates ranging from 6.65 % to 7.25 %, which were based on the remaining lease term at either the date of adoption of ASC 842 or the effective date of any subsequent lease term extensions. As of September 30, 2022, the remaining lease terms ranged from 3.95 years to 8.84 years. As of September 30, 2022, the following represents the difference between the remaining undiscounted minimum rental commitments under non-cancelable leases and the operating lease liabilities:\n\n| Operating Leases |\n| (in thousands) |\n| Undiscounted minimum rental commitments | $ | 44,022 |\n| Present value adjustment using incremental borrowing rate | ( 8,733 ) |\n| Operating lease liabilities | $ | 35,289 |\n\nManufacturing Agreements\nAs a result of the Merger, the Company's contractual obligations include Keryx’s commercial supply agreements with BioVectra Inc., or BioVectra, and Siegfried Evionnaz SA, or Siegfried, to supply commercial drug substance for Auryxia.\nPursuant to the Manufacture and Supply Agreement with BioVectra and the Product Manufacture and Supply and Facility Construction Agreement with BioVectra, the Company agreed to purchase minimum quantities of Auryxia drug substance annually at predetermined prices. On September 4, 2020, the Company and BioVectra entered into an Amended and Restated Product Manufacture and Supply and Facility Construction Agreement, which provided for reduced minimum quantity commitments and revised the predetermined prices. The price per kilogram decreases with an increase in quantity above the predetermined purchase quantity tiers. In addition, the Manufacture and Supply Agreement with BioVectra and the Amended and Restated Product Manufacture and Supply and Facility Construction Agreement with BioVectra, require the Company to reimburse BioVectra for certain costs in connection with construction of a new facility for the manufacture and supply of Auryxia drug substance. These construction costs are recorded in other assets and amortized into drug substance as inventory is released to the Company from BioVectra. The term of the Manufacture and Supply Agreement with BioVectra expires on December 31, 2022. The term of the Amended and Restated Product Manufacture and Supply and Facility Construction Agreement expires on December 31, 2026, after which it automatically renews for successive one-year terms unless either party gives notice of its intention to terminate within a specified time prior to the end of the then-current term. In addition, the Company and BioVectra each have the ability to terminate these agreements upon the occurrence of certain conditions. As of September 30, 2022, the Company is required to reimburse BioVectra for certain costs in connection with the construction of the new facility and to purchase minimum quantities of Auryxia drug substance annually for a total cost of approximately $ 74.8 million through the end of the contract term.\nPursuant to the Siegfried Master Manufacturing Services and Supply Agreement, as amended (the most recent amendment having been executed on February 11, 2021), or the Siegfried Agreement, the Company has agreed to purchase a minimum\n33\nquantity of drug substance of Auryxia at predetermined prices. The price per kilogram will decrease with an increase in quantity above the minimum purchase quantity. The term of the Siegfried Agreement expires on December 31, 2022, subject to the Company's option to extend the term through December 31, 2023 by providing 12 months’ prior written notice to Siegfried. The Siegfried Agreement provides the Company and Siegfried with certain early termination rights. In the first quarter of 2022, the Company notified Siegfried that the Company had elected not to exercise the option to extend the term of the Siegfried Agreement through December 31, 2023. As of September 30, 2022, the Company is required to purchase a minimum quantity of drug substance for Auryxia annually at a total cost of approximately $ 9.9 million through the year ending December 31, 2022.\nCertain of the Company's commercial supply agreements are executory contracts between Keryx and its contract manufacturers for Auryxia, which include future firm purchase commitments. These executory contracts were deemed to have an off-market element related to the amount of purchase commitments that exceed the current forecast. The Company regularly reviews its estimate of the excess purchase commitment liability including a review of assumptions of expected future demand, estimates of anticipated expiry of inventory under firm purchase commitments that are estimated to expire before they could be sold as well as any modifications to supply agreements during each reporting period. The excess purchase commitment liability relating to these executory contracts was $ 74.3 million and $ 76.7 million as of September 30, 2022 and December 31, 2021, respectively. During the quarter ended September 30, 2022, the Company increased the excess purchase commitment liability and recorded a $ 13.2 million charge to cost of goods sold as a result of a routine long-term forecast update and continued declines in the binder market and a reduction in its contractual purchase commitment with a supplier. During the quarter ended September 30, 2022, the Company also reduced the excess purchase commitment liability by $ 5.8 million for inventory received that had previously been identified as excess. The Company considered whether the increase in the excess purchase commitment liability was a potential indicator of impairment of the Auryxia asset group as of September 30, 2022. As part of its assessment, the Company reviewed the Auryxia net sales and estimated future cash flows included in its forecast and concluded that the increase in excess purchase commitment liability was not an indicator of impairment of the Auryxia asset group as of September 30, 2022. During the quarter ended June 30, 2022, the Company reduced the excess purchase commitment liability by $ 5.8 million for inventory received that had been previously identified as excess. During the quarter ended March 31, 2022, the Company recorded a $ 0.8 million reduction to the excess purchase commitments liability within cost of goods sold and reduced the excess purchase commitment liability by $ 3.2 million for inventory received that had previously been identified as excess.\nOn April 9, 2019, the Company entered into a Supply Agreement with Esteve Química, S.A., or Esteve, or the Esteve Agreement. The Esteve Agreement includes the terms and conditions under which Esteve will manufacture vadadustat drug substance for commercial use. Pursuant to the Esteve Agreement, the Company provides rolling forecasts to Esteve on a quarterly basis, or the Esteve Forecast. The Esteve Forecast reflects the Company’s needs for vadadustat drug substance produced by Esteve over a certain number of months, represented as a quantity of vadadustat drug substance per calendar quarter. The parties have agreed to a volume-based pricing structure under the Esteve Agreement. The Esteve Agreement has an initial term of four years , beginning April 9, 2019 and ending April 9, 2023. Pursuant to the Esteve Agreement, the Company has agreed to purchase a certain percentage of the global demand for vadadustat drug substance from Esteve. As of September 30, 2022, the Company has committed to purchase $ 26.9 million of vadadustat drug substance from Esteve through the second quarter of 2023.\nOn March 11, 2020, the Company entered into a Supply Agreement with Patheon Inc., or Patheon, or the Patheon Agreement. The Patheon Agreement includes the terms and conditions under which Patheon will manufacture vadadustat drug product for commercial use. Pursuant to the Patheon Agreement, the Company provides Patheon a long-term forecast on an annual basis, as well as short-term forecasts on a quarterly basis, or the Patheon Forecast. The Patheon Forecast reflects the Company’s needs for commercial supply of vadadustat drug product produced by Patheon, represented as a quantity of drug product per calendar quarter. The parties have agreed to a volume-based pricing structure under the Patheon Agreement. The Patheon Agreement has an initial term, which began on March 11, 2020 and ends on June 30, 2023. Pursuant to the Patheon Agreement, the Company has agreed to purchase a certain percentage of the global demand for vadadustat drug product from Patheon. As of September 30, 2022, the Company had a minimum commitment with Patheon for $ 3.2 million through the fourth quarter of 2022.\nOn April 2, 2020, the Company entered into a Supply Agreement with STA Pharmaceutical Hong Kong Limited, a subsidiary of WuXi AppTec, or WuXi STA, as amended on April 15, 2021, or the WuXi STA DS Agreement. The WuXi STA DS Agreement includes the terms and conditions under which WuXi STA will manufacture vadadustat drug substance for commercial use. Pursuant to the WuXi STA DS Agreement, the Company provides rolling forecasts to WuXi STA on a quarterly basis, or the WuXi STA DS Forecast. The WuXi STA DS Forecast reflects the Company’s needs for vadadustat drug substance produced by WuXi STA over a certain number of quarters. The parties have agreed to a volume-based pricing structure under the WuXi STA DS Agreement. The WuXi STA DS Agreement has an initial term of four years , beginning April 2, 2020 and ending April 2, 2024. Pursuant to the WuXi STA DS Agreement, the Company has agreed to purchase a certain percentage of the global demand for vadadustat drug substance from WuXi STA. As of September 30, 2022, the Company has committed to purchase $ 19.2 million of vadadustat drug substance from WuXi STA through the end of 2023.\n34\nOn February 10, 2021, the Company entered into a Supply Agreement with WuXi STA, or the WuXi STA DP Agreement. The WuXi STA DP Agreement includes the terms and conditions under which WuXi STA will manufacture and supply vadadustat drug product for commercial purposes. Pursuant to the WuXi STA DP Agreement, the Company will provide rolling forecasts to WuXi STA on a quarterly basis, or the WuXi STA DP Forecast. Each WuXi STA DP Forecast will reflect the quantities of vadadustat drug product that the Company expects to order from WuXi STA over a certain number of months, represented as a quantity of vadadustat drug product per calendar quarter. Pursuant to the WuXi STA DP Agreement, the Company has agreed to purchase a certain percentage of global demand for vadadustat drug product from WuXi STA. The parties have agreed to a volume-based pricing structure under the WuXi STA DP Agreement. The vadadustat drug product price will remain fixed for the first 12 months and thereafter shall be annually reviewed by the Company and WuXi STA. The Company will also reimburse WuXi STA for certain reasonable expenses. The WuXi STA DP Agreement has an initial term of four years , beginning February 10, 2021 and ending February 10, 2025.\nOther Third-Party Contracts\nUnder the Company’s agreement with IQVIA to provide contract research organization services for the PRO2TECT and INNO2VATE programs, the total remaining contract costs as of September 30, 2022 were approximately $ 4.6 million. Substantive performance for the committed work with IQVIA was completed in 2020 and close out activities will be performed throughout 2022. The Company also contracts with various other organizations to conduct research and development activities with remaining contract costs to the Company of approximately $ 176.3 million at September 30, 2022. The scope of the services under these research and development contracts can be modified and the contracts cancelled by the Company upon written notice. In some instances, the contracts may be cancelled by the third party upon written notice.\nLitigation and Related Matters\nFrom time to time, the Company may become subject to legal proceedings and claims which arise in the ordinary course of its business. Consistent with ASC 450, Contingencies, the Company’s policy is to record a liability if a loss in a significant legal dispute is considered probable and an amount can be reasonably estimated. The Company provides disclosure when a loss in excess of any reserve is reasonably possible, and if estimable, the Company discloses the potential loss or range of possible loss. Significant judgment is required to assess the likelihood of various potential outcomes and the quantification of loss in those scenarios. The Company’s estimates change as litigation progresses and new information comes to light. Changes in Company estimates could have a material impact on the Company’s results and financial position. As of September 30, 2022, the Company does not have any significant legal disputes that require a loss liability to be recorded. The Company continually monitors the need for a loss liability for litigation and related matters.\n14. Net Loss per Share\nFor purposes of the diluted net loss per share calculation, preferred stock, stock options, warrants, restricted stock and RSUs are considered to be common stock equivalents and have been excluded from the calculation of diluted net loss per share, as their effect would be anti-dilutive for periods presented. Therefore, basic and diluted net loss per share were the same for all periods presented in the unaudited condensed consolidated statement of operations and comprehensive loss. The shares in the table below were excluded from the calculation of diluted net loss per share, prior to the use of the treasury stock method, due to their anti-dilutive effect:\n| As of September 30, |\n| 2022 | 2021 |\n| Warrant | — | 509,611 |\n| Outstanding stock options | 11,844,609 | 11,593,539 |\n| Unvested restricted stock units | 6,971,930 | 5,378,916 |\n| Total | 18,816,539 | 17,482,066 |\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nThe following information should be read in conjunction with our unaudited condensed consolidated financial statements and related notes included in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2021 filed with the U.S. Securities and Exchange Commission, or the SEC, on March 1, 2022, or the 2021 Annual Report on Form 10-K, including the audited consolidated financial statements and related notes therein. This discussion and analysis contains forward-looking statements that involve significant risks and uncertainties. As a result of many factors, such as those set forth under “Risk Factors” in Part II, Item 1A. of this Quarterly Report on Form 10-Q, our actual results may differ materially from those anticipated in these forward-looking statements.\n35\nBusiness Overview\nWe are a biopharmaceutical company with the purpose of bettering the life of each person impacted by kidney disease. Since our initial public offering in 2014, we have built a business focused on developing and commercializing innovative renal therapeutics that we believe serves as a foundation for future growth. We established ourselves as a leader in the kidney community, and we remain committed to our purpose as we believe our current and future products have the ability to deliver value. Our current portfolio includes a commercial product and a late-stage investigational product candidate:\n•Auryxia® (ferric citrate) is approved and marketed in the United States for two indications: (1) the control of serum phosphorus levels in adult patients with chronic kidney disease, or CKD, on dialysis, or DD-CKD, or the Hyperphosphatemia Indication, and (2) the treatment of iron deficiency anemia, or IDA, in adult patients with CKD not on dialysis, or NDD-CKD, or the IDA Indication. Ferric citrate is also approved and marketed in Japan as an oral treatment the improvement of hyperphosphatemia in adult patients with CKD, including DD-CKD and NDD-CKD, and for the treatment of patients with IDA under the trade name Riona (ferric citrate hydrate). Auryxia is our only product approved for sale in the United States and it generated approximately $42.2 million and $36.8 million in revenue from U.S. product sales during the three months ended September 30, 2022 and 2021, respectively.\n•Vadadustat is an investigational oral hypoxia-inducible factor prolyl hydroxylase, or HIF-PH, inhibitor designed to mimic the physiologic effect of altitude on oxygen availability. At higher altitudes, the body responds to lower oxygen availability with stabilization of hypoxia-inducible factor, or HIF, which stimulates erythropoietin, or EPO, production and can lead to red blood cell, or RBC, production and improved oxygen delivery to tissues. The significance of the HIF pathway was recognized by the 2019 Nobel Prize and the 2016 Albert Lasker Basic Medical Research Award, which honored the three physician-scientists who discovered the HIF pathway and elucidated this primary oxygen sensing mechanism that is essential for survival.\nOn March 29, 2022, we received a complete response letter, or CRL, from the U.S. Food and Drug Administration, or FDA. The CRL provided that the FDA had completed its review of our new drug application, or NDA, for vadadustat for the treatment of anemia due to CKD in adult patients, and determined that it could not approve the NDA in its present form. In July 2022, we held an end of review meeting with the FDA to inform the Company's next steps with respect to the potential U.S. approval of vadadustat, if any, and in October 2022, we submitted a Formal Dispute Resolution Request, or FDRR, to the FDA. The FDRR focuses on the favorable balance between the benefits and risks of vadadustat for the treatment of anemia due to CKD in adult patients on dialysis in light of safety concerns expressed by the FDA in the CRL related to the rate of adjudicated thromboembolic events driven by vascular access thrombosis for vadadustat compared to the active comparator and the risk of drug-induced liver injury. Based on the typical FDRR process, we expect to receive a response to the FDRR from the FDA by the end of 2022. Also, on April 1, 2022, we were notified by the FDA that the FDA had placed a partial clinical hold on our clinical trials of vadadustat in pediatric patients with anemia due to CKD in the United States. In addition, in May 2022, the Paediatric Committee of the European Medicines Agency, or the EMA, recommended that we not initiate such clinical trials in the European Union until the safety issues identified by the FDA in the CRL were addressed. As a result of the partial clinical hold and the EMA’s recommendations, all activities in the United States and Europe for and related to our clinical trials of vadadustat in pediatric patients were suspended.\nOur former collaboration partner, Otsuka Pharmaceutical Co. Ltd., or Otsuka, submitted a Marketing Authorization Application, or MAA, for vadadustat for the treatment of anemia due to CKD in both DD-CKD and NDD-CKD adult patients to the EMA, in October 2021, and in each of the United Kingdom, Switzerland, and Australia in the first quarter of 2022. On June 30, 2022, we and Otsuka entered into a Termination and Settlement Agreement, or the Termination Agreement, and pursuant to the Termination Agreement, Otsuka has transferred the MAAs for vadadustat with the EMA, and in the United Kingdom, Switzerland and Australia to us. Based on the current review timeline, we expect a decision on the MAA from EMA in the first quarter of 2023. As vadadustat did not meet the PRO2TECT program's primary safety endpoint, we are remaining cautious in our outlook for potential approval of vadadustat in NDD-CKD adult patients in Europe, the United Kingdom, Switzerland and Australia.\nIn June of 2020, we announced the first regulatory approval of vadadustat for the treatment of anemia due to CKD in DD-CKD and NDD-CKD adult patients in Japan. Our collaboration partner in Japan, Mitsubishi Tanabe Pharma Corporation, or MTPC, commenced commercial sales of vadadustat in Japan under the trade name, VafseoTM, in August 2020. In addition, MTPC filed new drug applications for vadadustat for the treatment of anemia due to CKD in adult patients in Taiwan in January of 2022 and in Korea in March 2022.\n36\nIn August of 2022, we announced initial findings from an investigator-sponsored clinical study by The University of Texas Health Science Center at Houston, or UTHealth, in Houston, Texas, evaluating the use of vadadustat as a potential therapy to prevent and treat acute respiratory distress syndrome, or ARDS, in patients with COVID-19 and hypoxemia, or the VSTAT Study. The VSTAT Study was a phase 2, randomized, double-blind, placebo-controlled study conducted by UTHealth and partially funded by Akebia. UTHealth was awarded $5.1 million in funding from the U.S. Department of Defense for the study. The VSTAT Study enrolled 449 adult patients at 5 hospitals who were randomized 1:1 to vadadustat 900mg or placebo once per day orally for up to 14 days while hospitalized. The VSTAT Study measured the proportion of patients with either 6 (non-invasive ventilation or high flow oxygen devices), 7 (invasive mechanical ventilation or extracorporeal membrane oxygenation), or 8 (death) on the National Institute of Allergy and Infectious Disease Ordinal Scale, or NIAID-OS, at Day 14 (primary) and Day 7. While a smaller proportion of patients in the vadadustat group had a score of 6, 7, or 8 on the NIAID-OS than in the placebo group at Day 14, the trial failed to meet its primary superiority threshold of >95% probability. Those receiving vadadustat, however, did demonstrate 94% probability of conferring benefit on the NIAID-OS at Day 14. While the VSTAT Study missed the primary endpoint, we are encouraged by the data and believe the data supports further development of vadadustat as a potential treatment for ARDS due to COVID-19 or other causes.\nIf we are successful in addressing the deficiencies noted in the CRL and in the event we receive FDA approval of vadadustat in the United States, we plan to commercialize vadadustat in the United States with our well-established, nephrology-focused commercial organization, which we may expand if vadadustat is approved. In addition, in February 2022, we entered into a Second Amended and Restated License Agreement, or the Vifor Second Amended Agreement, with Vifor (International) Ltd., or Vifor Pharma, which amended and restated the Amended and Restated License Agreement, dated April 8, 2019, or the Vifor First Amended Agreement. Pursuant to the Vifor Second Amended Agreement, we granted Vifor Pharma an exclusive license to sell vadadustat to Fresenius Medical Care North America and its affiliates, including Fresenius Kidney Care Group LLC, to certain third-party dialysis organizations approved by us, to independent dialysis organizations that are members of group purchase organizations, and to certain non-retail specialty pharmacies in the United States, or the Territory. We refer to Fresenius Medical Care North America and its affiliates, these organizations and specialty pharmacies collectively as the \"Supply Group\". We currently retain rights to commercialize vadadustat for use in the non-dialysis dependent CKD market and to sell to dialysis organizations outside of the Supply Group. During the term of the Vifor Second Amended Agreement, Vifor Pharma is not permitted to sell any HIF product that competes with vadadustat in the Territory to the Supply Group. We granted MTPC exclusive rights to commercialize vadadustat in Japan, where MTPC commenced commercial sales of vadadustat under the trade name, VafseoTM, in August 2020, and in certain other countries in Asia, subject to marketing approvals.\nIn addition, we continue to explore additional development opportunities to expand our pipeline and portfolio of novel therapeutics through both internal research and external innovation. Our development pipeline includes several earlier stage opportunities, including praliciguat, an investigational oral soluble guanylate cyclase, or sGC, stimulator, that we licensed from Cyclerion Therapeutics, Inc., or Cyclerion, in June 2021. One indication of interest is the treatment of focal segmental glomerulosclerosis, which is highly complementary of our strategy to identify and develop novel therapeutics for people impacted by kidney diseases.\nOperating Overview\nWe have incurred net losses in each year since inception. Our net losses were $51.9 million and $59.5 million for the three months ended September 30, 2022 and 2021, respectively. Our net losses were $85.0 million and $212.2 million for the nine months ended September 30, 2022 and 2021, respectively. Substantially all of our net losses resulted from costs incurred in connection with the continued commercialization of Auryxia and development efforts relating to vadadustat, including conducting clinical trials of, and seeking regulatory approval for, vadadustat, providing general and administrative support for these operations and protecting our intellectual property.\nOur ability to achieve profitability depends in part on our ability to manage our expenses. Following receipt of the CRL, in April 2022 and May 2022, we implemented a reduction of our workforce by approximately 42% across all areas of our company including several members of management (47% inclusive of the closing of the majority of open positions). These actions reflect our determination to refocus our strategic priorities around our commercial product, Auryxia®, and our development portfolio, and are steps in a cost savings plan to significantly reduce our expense profile in line with being a single commercial product company. The workforce reduction included net charges totaling approximately $14.7 million, including costs for one-time termination benefits and contractual termination benefits for severance, healthcare, and related benefits of $11.4 million and non-cash stock-based compensation expense of $3.3 million. During the three and nine months ended September 30, 2022, we recognized $0.2 million and 14.7 million, respectively, of restructuring charges in the condensed consolidated statement of operations and comprehensive loss. Refer to Note 5 to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for further details.\n37\nEven in light of the reduction in workforce, we expect to continue to incur significant expenses and operating losses for the foreseeable future. In addition to any additional costs not currently contemplated due to the events associated with or resulting from the workforce reduction noted above, our ability to achieve profitability and our financial position will depend, in part, on the rate of our future expenditures, on our product revenue from Auryxia, collaboration revenue, our ability to successfully implement cost avoidance measures and reduce overhead costs and our ability to obtain additional funding. We expect to continue to incur significant expenses if and as we:\n•continue our commercialization activities for Auryxia and vadadustat, if we are able to obtain marketing approval for vadadustat following receipt of the CRL from the FDA in March 2022, and any other product or product candidate, including those that may be in-licensed or acquired;\n•address the issues identified in the CRL for vadadustat that we received from the FDA and, in the event our FDRR is accepted by the FDA, pursue our appeal of the CRL for vadadustat with the FDA;\n•conduct and enroll patients in any clinical trials, including post-marketing studies or any other clinical trials for Auryxia, vadadustat or any other product or product candidate, including those that may be in-licensed or acquired;\n•seek marketing approvals for vadadustat and any other product candidate, including those that may be in-licensed or acquired;\n•maintain marketing approvals for Auryxia and vadadustat, if we are able to obtain marketing approval for vadadustat following receipt of the CRL from the FDA in March 2022, and any other product, including those that may be in-licensed or acquired;\n•manufacture Auryxia, vadadustat and any other product or product candidate, including those that may be in-licensed or acquired, for commercial sale and clinical trials;\n•conduct discovery and development activities for additional product candidates or platforms that may lead to the discovery of additional product candidates;\n•engage in transactions, including strategic, merger, collaboration, acquisition and licensing transactions, pursuant to which we would market and develop commercial products, or develop and commercialize other product candidates and technologies;\n•continue to repay, and pay any associated pre-payment penalties, if applicable, the senior secured term loans in an aggregate principal amount of $67.0 million, or the Term Loans, that were made available to us pursuant to the loan agreement that we entered into with funds managed by Pharmakon Advisors LP, in November 2019, which was amended in February 2022, and further amended in July 2022, or as amended, the Loan Agreement;\n•make royalty, milestone or other payments under our license agreements and any future license agreements;\n•maintain, protect and expand our intellectual property portfolio;\n•make decisions with respect to our personnel, including the retention of key employees;\n•make decisions with respect to our infrastructure, including to support our operations as a fully integrated publicly traded biopharmaceutical company; and\n•experience any additional delays or encounter issues with any of the above.\nWe have not generated, and may not generate, enough product revenue to realize net profits from product sales. We have no manufacturing facilities, and all of our manufacturing activities are contracted out to third parties. Additionally, we currently utilize contract research organizations, or CROs, to carry out our clinical development activities. If we obtain marketing approval for vadadustat, and as we continue to commercialize Auryxia, we expect to incur significant commercialization expenses related to product sales, marketing, manufacturing and distribution. We expect to finance future cash needs through product revenue, public or private equity or debt transactions, royalty transactions, strategic transactions, or a combination of these approaches. If we are unable to raise additional capital in sufficient amounts when needed or on attractive terms, we may not be able to pursue development and commercial activities related to Auryxia and vadadustat, if approved, or any additional products and product candidates, including those that may be in-licensed or acquired. Any of these events could significantly harm our business, financial condition and prospects.\n38\nFrom inception through September 30, 2022, we raised approximately $793.5 million of net proceeds from the sale of equity, including $519.8 million from various underwritten public offerings, $223.7 million from at-the-market offerings, or ATM offerings, pursuant to prior sales agreements with Cantor Fitzgerald & Co., and $70.0 million from the sale of 7,571,429 shares of common stock to Vifor Pharma. As of September 30, 2022, through our collaboration agreement with MTPC and our prior collaboration agreements with Otsuka we received approximately $837.1 million in cost-share funding, and are not entitled to receive any additional cost-share funding. On June 30, 2022, we entered into the Termination Agreement with Otsuka, pursuant to which we received a nonrefundable and non-creditable payment of $55.0 million in consideration for the covenants and agreements set forth in the Termination Agreement.\nOn November 11, 2019, we entered into the Loan Agreement with funds managed by Pharmakon, pursuant to which term loans in an aggregate principal amount of $100.0 million were made available to us in two tranches, subject to certain terms and conditions, or the Term Loans. As of September 30, 2022, we had drawn down the full $100.0 million made available to us under the Loan Agreement. On July 15, 2022, or the Effective Date, we entered into the Second Amendment and Waiver with BioPharma Credit PLC, or the Collateral Agent, BPCR Limited Partnership, as a Lender, and BioPharma Credit Investments V (Master) LP, as a Lender, or the Second Amendment and Waiver, which amends and waives certain provisions of the Loan Agreement as amended by the First Amendment and Waiver between the Collateral Agent, the Lenders and us, dated February 18, 2022, or the First Amendment and Waiver. The Collateral Agent and the Lenders are collectively referred to as Pharmakon (see Note 11 to our condensed consolidated financial statements). Pursuant to the Second Amendment and Waiver, we made prepayments totaling $25.0 million together with a prepayment premium of $0.5 million plus all accrued and unpaid interest on such prepayments of principal to the Effective Date, and Pharmakon agreed to waive or modify certain covenants in the Loan Agreement (see Note 11 to our condensed consolidated financial statements). In addition, on February 25, 2021, we received an upfront payment of $44.8 million (net of certain transaction expenses) in connection with our sale to HealthCare Royalty Partners IV, L.P., or HCR, of the right to receive all royalties and sales milestones payable to us under our collaboration agreement with MTPC, or the MTPC Agreement, subject to certain caps and other terms and conditions described elsewhere in this Quarterly Report on Form 10-Q. Finally, on February 18, 2022, we entered into a Second Amended and Restated License Agreement, or the Vifor Second Amended Agreement, with Vifor Pharma. Pursuant to the Vifor Second Amended Agreement, Vifor Pharma made an upfront payment to us of $25.0 million in lieu of the previously disclosed milestone payment of $25.0 million that Vifor Pharma was to pay to us following approval of vadadustat by the FDA. Also pursuant to the Vifor Second Amended Agreement, Vifor contributed $40 million to a working capital fund established to partially fund our costs of purchasing vadadustat from our contract manufacturers, or the Working Capital Fund, which amount of funding will fluctuate, and which funding we will repay to Vifor Pharma over time.\nImpacts of COVID-19 Pandemic\nThe COVID-19 pandemic has presented a substantial public health and economic challenge around the world and continues to affect our employees, patients, healthcare providers with whom we interact, customers, collaboration partners, CROs, contract manufacturing organizations, or CMOs, vendors, communities and business operations. The full extent to which the COVID-19 pandemic will directly or indirectly impact our business, results of operations and financial condition continues to depend on future developments that are highly uncertain and cannot be accurately predicted, including new information that may emerge concerning the COVID-19 pandemic, any resurgences or variants of COVID-19, the actions taken to contain it or treat its impact and the economic and other impacts on local, regional, national and international markets where the healthcare providers with whom we interact, our partners, our CROs, our CMOs, and our other vendors operate.\nWe believe our revenue growth was negatively impacted by the COVID-19 pandemic in 2021 and the first three quarters of 2022 primarily as the CKD patient populations that we serve experienced both high hospitalization and mortality rates due to COVID-19, and the pandemic had an adverse impact on the phosphate binder market in which Auryxia competes. Labor shortages and costs have adversely impacted dialysis providers. These impacts have refocused clinical efforts in addressing bone and mineral disorders like hyperphosphatemia to more acute operational issues to ensure patients receive dialysis treatments and still some patients have been rescheduled or missed treatments due to labor shortages. We believe, this and potentially other factors, has led to the reduction in the phosphate binder market, which has not experienced growth since early 2020. While we are unable to quantify the impact of the COVID-19 pandemic on future revenues and revenue growth, the COVID-19 pandemic and the ongoing impacts from the COVID-19 pandemic continue to adversely and disproportionately impact CKD patients and the phosphate binder market; therefore, we expect the COVID-19 pandemic and the ongoing impacts from the pandemic to continue to have a negative impact on our revenue growth for the foreseeable future.\nAs a result of the COVID-19 pandemic we adopted a flexible workplace policy allowing employees to work from home on a full or part-time basis, which may make it difficult for us to maintain our corporate culture or retain employees. Moreover, our future success substantially depends on the management skills of our executives and certain other key employees. The unanticipated loss or unavailability of key employees due to the pandemic could harm our ability to operate our business or execute our business strategy and we may not be successful in finding and integrating suitable successors in the event any of our key employees leave or are unavailable.\n39\nIn addition, several healthcare facilities have previously restricted access for non-patients, including the members of our sales force. For example, DaVita, Inc., or DaVita, and Fresenius Medical Care, or Fresenius, which account for a vast majority of the dialysis population in the United States, have previously restricted access to their clinics. As a result, we continue to engage with some healthcare providers and other customers virtually, where possible. The restrictions on our customer-facing employees' in-person interactions with healthcare providers have, and could continue to, negatively impact our access to healthcare providers and, ultimately, our sales, including with respect to vadadustat, if approved. Recently, such precautionary measures have been relaxed at certain healthcare facilities and, as a result, members of our sales force have resumed in person interactions with certain customers. Nevertheless, some restrictions remain, and more restrictions may be put in place again due to a resurgence in COVID-19 cases, including those involving new variants of COVID-19 which may be more contagious and more severe than prior strains of the virus. Given this uncertain environment and the disproportionate impact of the COVID-19 pandemic on CKD patients, we are actively monitoring the demand in the United States for Auryxia and will be for vadadustat, if approved, including the potential for further declines or changes in prescription trends and customer orders, which could have a material adverse effect on our business, results of operations and financial condition.\nIn addition, the direct and indirect impacts of the pandemic or the response efforts to the pandemic, including among others, competition for labor and resources and increases in labor, sourcing, manufacturing and shipping costs, may cause disruptions to, closures of, or other impacts on our CMOs and other vendors in our supply chain on which we rely for the supply of our products and product candidates. For example, areas of China have recently continued to implement lockdowns for COVID-19, which could impact the global supply chain. At this time, our third party contract manufacturers continue to operate at or near normal levels. However, it is possible that the COVID-19 pandemic and response efforts may have an impact in the future on our contract manufacturers' ability to manufacture and deliver Auryxia and vadadustat (if approved in the United States and EMA and which is currently marketed under the trade name VafseoTM by MTPC in Japan), which may result in increased costs and delays, or disruptions to the manufacturing and supply of our products.\nCOVID-19 pandemic precautions have caused moderate delays in enrolling new clinical trials and may cause delays in enrolling other new clinical trials. We are using remote monitoring and central monitoring, where possible.\nThis uncertain pandemic environment has presented new risks to our business. While we are working aggressively to mitigate the impacts on our business, we are mindful that many of these risks and the impact to the larger healthcare market are outside of our control.\nFor additional information on the various risks posed by the COVID-19 pandemic, please refer to Part II, Item 1A. Risk Factors below.\nFinancial Overview\nRevenue\nTo date, our revenues have been derived from product revenue from commercial sales of Auryxia, collaboration revenues, which include license and milestone payments, royalty and cost-sharing revenue generated through collaboration and license agreements with partners for the development and commercialization of vadadustat, a nonrefundable, non-creditable termination fee pursuant to the terms of the Termination Agreement with Otsuka, and royalty revenue from sales of Riona in Japan. Cost-sharing revenue represents amounts reimbursed by our collaboration partners for expenses incurred by us for research and development activities and, potentially, co-promotion activities, under our collaboration agreements.\nWe expect our revenue to continue to be generated primarily from our commercial sales of Auryxia, our collaboration with MTPC and any other collaborations into which we may enter, and royalty revenue from Japan Tobacco, Inc., and its subsidiary, Torii Pharmaceutical Co., Ltd., collectively JT and Torii, based on net sales of Riona in Japan. We will not recognize any future revenue pursuant to our collaboration with Otsuka.\nCost of Goods Sold\nCost of goods sold includes direct costs to manufacture commercial drug substance and drug product for Auryxia, as well as indirect costs including costs for packaging, shipping, insurance and quality assurance, idle capacity charges, write-offs for inventory that fails to meet specifications or is otherwise no longer suitable for commercial sale, changes in our excess purchase commitment liability, and royalties due to the licensor of Auryxia related to the U.S. product sales recognized during the period. Cost of goods sold also includes costs to manufacture drug product provided to MTPC for commercial sale of Vafseo in Japan.\nAs a result of the merger with Keryx Biopharmaceuticals, Inc., or Keryx, or the Merger, and the application of purchase accounting, costs of goods sold also includes both amortization expense and, if applicable, impairment charges associated with the fair value of the developed product rights for Auryxia as well as expense associated with the fair value inventory step-up. The fair value of the developed product rights for Auryxia is being amortized over its estimated useful life, which as of\n40\nSeptember 30, 2022 is estimated to be six years. The fair value inventory step-up as a result of the Merger was fully amortized as of the first quarter of 2021.\nResearch and Development Expenses\nResearch and development expenses consist primarily of costs incurred for the development of vadadustat, which include:\n•personnel-related expenses, including salaries, benefits, recruiting fees, travel and stock-based compensation expense of our research and development personnel;\n•expenses incurred under agreements with CROs and investigative sites that conduct our clinical studies;\n•the cost of acquiring, developing and manufacturing clinical study materials through CMOs;\n•facilities, depreciation and other expenses, which include direct and allocated expenses for rent and maintenance of facilities, insurance and other supplies;\n•costs associated with preclinical, clinical and regulatory activities; and\n•costs associated with pre-launch inventory build for vadadustat in the United States and Europe, for which we received the CRL from the FDA in the United States in March 2022.\nResearch and development costs are expensed as incurred. Costs for certain development activities are recognized based on an evaluation of the progress to completion of specific tasks using information and data provided to us by our vendors and our clinical sites.\nWe cannot determine with certainty the duration and completion costs of current or future clinical studies of Auryxia and vadadustat or if, when, or to what extent we will receive marketing approval for vadadustat or generate revenue from the commercialization and sale of vadadustat, if approved. We may never succeed in achieving marketing approval for vadadustat.\nThe duration, costs and timing of clinical studies and development of Auryxia and vadadustat will depend on a variety of factors including, but not limited to, those described in Part II, Item 1A. Risk Factors. A change in the outcome of any of these variables with respect to the development of Auryxia and vadadustat could mean a significant change in the costs and timing associated with that development. For example, if the FDA, the EMA, or other regulatory authorities were to require us to conduct clinical studies in addition to or different from those that we currently anticipate, or if we experience delays in any of our clinical studies, we could be required to expend significant additional financial resources and time on the completion of clinical development.\nFrom inception through September 30, 2022, we have incurred $1.5 billion in research and development expenses. We expect to incur significant research and development expenditures for the foreseeable future as we continue the development of Auryxia, vadadustat and any other product or product candidate, including those that may be in-licensed or acquired.\nOur direct research and development expenses consist principally of external costs, such as fees paid to clinical trial sites, consultants, central laboratories and CROs in connection with our clinical studies, and drug substance and drug product manufacturing for clinical studies.\nIn 2020, we completed our global Phase 3 clinical program for vadadustat to which the majority of our research and development costs have been attributable. A significant portion of our research and development costs have been external costs, which we track on a program-by-program basis. These external costs include fees paid to investigators, consultants, central laboratories and CROs in connection with our clinical trials, and costs related to acquiring and manufacturing clinical trial materials. Our internal research and development costs are primarily personnel-related costs, depreciation and other indirect costs. We do not track our internal research and development expenses on a program-by-program basis as they are deployed across multiple projects under development.\nThe following table summarizes our external research and development expenses by program, as well as expenses not allocated to programs, for the three and nine months ended September 30, 2022 and 2021:\n41\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) | (in thousands) |\n| Vadadustat external costs | $ | 13,840 | $ | 14,339 | $ | 42,752 | $ | 44,059 |\n| External costs for other programs | 3,823 | 7,425 | 15,279 | 18,989 |\n| Total external research and development expenses | 17,663 | 21,764 | 58,031 | 63,048 |\n| Headcount, consulting, facilities and other | 9,687 | 18,707 | 39,179 | 55,248 |\n| Total research and development expenses | $ | 27,350 | $ | 40,471 | $ | 97,210 | $ | 118,296 |\n\nSelling, General and Administrative Expenses\nSelling, general and administrative expenses consist primarily of salaries and related costs for personnel, including stock-based compensation and travel expenses for our commercial personnel, including our field sales force and other commercial support personnel, as well as personnel in executive and other administrative or non-research and development functions. Other selling, general and administrative expenses include facility-related costs, fees for directors, accounting and legal services fees, recruiting fees and expenses associated with obtaining and maintaining patents.\nResults of Operations\nComparison of the Three Months Ended September 30, 2022 and 2021\n\n| Three Months Ended | Increase |\n| September 30, 2022 | September 30, 2021 | (Decrease) |\n| (in thousands) |\n| Revenues: |\n| Product revenue, net | $ | 42,239 | $ | 36,753 | $ | 5,486 |\n| License, collaboration and other revenue | 6,725 | 12,003 | (5,278) |\n| Total revenues | 48,964 | 48,756 | 208 |\n| Cost of goods sold: |\n| Product | 28,936 | 6,933 | 22,003 |\n| Amortization of intangibles | 9,011 | 9,011 | — |\n| Total cost of goods sold | 37,947 | 15,944 | 22,003 |\n| Operating expenses: |\n| Research and development | 27,350 | 40,471 | (13,121) |\n| Selling, general and administrative | 30,918 | 46,357 | (15,439) |\n| License expense | 743 | 870 | (127) |\n| Restructuring | 180 | — | 180 |\n| Total operating expenses | 59,191 | 87,698 | (28,507) |\n| Operating loss | (48,174) | (54,886) | 6,712 |\n| Other expense, net | (2,785) | (4,658) | 1,873 |\n| Loss on extinguishment of debt | (906) | — | (906) |\n| Net loss | $ | (51,865) | $ | (59,544) | $ | 7,679 |\n\nProduct Revenue, Net. Net product revenue is derived from sales of our only commercial product in the United States, Auryxia. We distribute our product principally through a limited number of wholesale distributors as well as certain specialty pharmacy providers. Net product revenue was $42.2 million for the three months ended September 30, 2022, compared to $36.8 million for the three months ended September 30, 2021. The increase was primarily due to pricing and improved payer mix.\nLicense, Collaboration and Other Revenue. License, collaboration and other revenue was $6.7 million for the three months ended September 30, 2022 compared to $12.0 million for the three months ended September 30, 2021. The decrease is primarily due to a reduction in revenue from the Otsuka collaboration agreement because on June 30, 2022, we and Otsuka\n42\nentered into the Termination Agreement, which, among other things, terminated the cost sharing arrangement under the Otsuka collaboration agreement for the United States, or the Otsuka U.S. Agreement, and the Otsuka collaboration agreement for certain territories outside the United States, or the Otsuka International Agreement. Refer to Note 4 to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for further details. We will not recognize any future revenue under the Otsuka U.S. Agreement or the Otsuka International Agreement.\nCost of Goods Sold - Product. Cost of goods sold of $28.9 million for the three months ended September 30, 2022 consisted of costs associated with the manufacturing of Auryxia and supply of Vafseo to MTPC for commercial sale in Japan, $2.6 million related to excess and obsolescence reserves associated with inventory, and a $13.2 million non-cash charge related to an increase to the liability for excess purchase commitments. Refer to Note 13 to our condensed consolidated financial statements for further details on the excess purchase commitments liability.\nCost of goods sold of $6.9 million for the three months ended September 30, 2021 consisted of costs associated with the manufacturing of Auryxia partially offset by a $6.0 million reduction to the liability for excess purchase commitments, primarily due to the settlement of all patent litigation proceedings related to Abbreviated New Drug Applications filed with respect to Auryxia, which allows for generic versions of Auryxia beginning in March 2025. Refer to Note 13 to our condensed consolidated financial statements for further details on the excess purchase commitments liability.\nCost of Goods Sold - Amortization of Intangibles. Amortization of intangibles relates to the acquired developed product rights for Auryxia, which is being amortized using a straight-line method over its estimated useful life of approximately six years. Amortization of intangibles during each of the three months ended September 30, 2022 and 2021 was $9.0 million.\nResearch and Development Expenses. Research and development expenses were $27.4 million for the three months ended September 30, 2022, compared to $40.5 million for the three months ended September 30, 2021, a decrease of $13.1 million. The decrease was primarily due to the following:\n| (in millions) |\n| Vadadustat development expenses | $ | (0.5) |\n| Headcount, consulting, facilities and other | (12.6) |\n| Total net decrease | $ | (13.1) |\n\nThe decrease in research and development expense was primarily due to decreased headcount related costs as a result of the reduction in force and decreased consulting costs. Although we expect our research and development expenses to continue to decrease for the remainder of 2022, compared to 2021, we will continue to incur significant research and development expenses in future periods in support of ongoing or planned studies with respect to Auryxia and vadadustat and development of other potential product candidates.\nSelling, General and Administrative Expenses. Selling, general and administrative expenses were $30.9 million for the three months ended September 30, 2022, compared to $46.4 million for the three months ended September 30, 2021. The decrease of $15.4 million was primarily due to decreased headcount related costs as a result of the reduction in force, lower one-time legal costs, and lower marketing expenses. For the remainder of 2022, we expect our selling, general and administrative expenses to continue to decrease from 2021 as we continue to reduce our expense profile in line with being a single commercial product company.\nLicense Expenses. License expense related to royalties due to Panion relating to sales of Riona in Japan were $0.7 million for the three months ended September 30, 2022 compared to $0.9 million for the three months ended September 30, 2021.\nRestructuring. Restructuring expenses were $0.2 million for the three months ended September 30, 2022 due to one-time termination benefits for severance, healthcare, and related benefits related to the reduction in force. There were no restructuring expenses for the three months ended September 30, 2021.\nOther Expense, Net. Other expense, net, was $2.8 million for the three months ended September 30, 2022 compared to $4.7 million for the three months ended September 30, 2021. The decrease of $1.9 million was primarily due to a decrease in interest expense as a result of principal prepayments totaling $25.0 million made on the Term Loans pursuant to the Second Amendment and Waiver in the three months ended September 30, 2022, reducing our outstanding balance on the Term Loans. The decrease was also related to a decrease in the fair value of our derivative liability related to the Loan Agreement with Pharmakon during the three months ended September 30, 2022.\n43\nLoss on Extinguishment of Debt. During the three months ended September 30, 2022, the Company recorded a debt extinguishment loss of $0.9 million related to the principal prepayments made on the Term Loans pursuant to the Second Amendment and Waiver.\nComparison of the Nine Months Ended September 30, 2022 and 2021\n| Nine Months Ended | Increase |\n| September 30, 2022 | September 30, 2021 | (Decrease) |\n| (in thousands) |\n| Revenues: |\n| Product revenue, net | $ | 127,390 | $ | 100,120 | $ | 27,270 |\n| License, collaboration and other revenue | 110,032 | $ | 53,853 | 56,179 |\n| Total revenues | 237,422 | 153,973 | 83,449 |\n| Cost of goods sold: |\n| Product | 60,859 | $ | 76,012 | (15,153) |\n| Amortization of intangibles | 27,032 | 27,032 | — |\n| Total cost of goods sold | 87,891 | 103,044 | (15,153) |\n| Operating expenses: |\n| Research and development | 97,210 | 118,296 | (21,086) |\n| Selling, general and administrative | 108,052 | 129,336 | (21,284) |\n| License expense | 2,323 | 2,460 | (137) |\n| Restructuring | 14,711 | — | 14,711 |\n| Total operating expenses | 222,296 | 250,092 | (27,796) |\n| Operating loss | (72,765) | (199,163) | 126,398 |\n| Other expense, net | (11,339) | (12,999) | 1,660 |\n| Loss on extinguishment of debt | (906) | — | (906) |\n| Net loss | (85,010) | (212,162) | 127,152 |\n\nProduct Revenue, Net. Net product revenue is derived from sales of our only commercial product in the United States, Auryxia. We distribute our product principally through a limited number of wholesale distributors as well as certain specialty pharmacy providers. Net product revenue was $127.4 million for the nine months ended September 30, 2022, compared to net product revenue of $100.1 million for the nine months ended September 30, 2021. The increase was primarily due to pricing and improved payor mix.\nLicense, Collaboration and Other Revenue. License, collaboration and other revenue was $110.0 million for the nine months ended September 30, 2022, compared to $53.9 million for the nine months ended September 30, 2021. On June 30, 2022, we and Otsuka entered into the Termination Agreement, which, among other things, terminated the cost sharing arrangement under the Otsuka U.S. Agreement, and the Otsuka International Agreement. During the nine months ended September 30, 2022, we recognized $55.0 million in collaboration revenue related to a payment received pursuant to the terms of the Termination Agreement with Otsuka, $15.5 million related to previously deferred revenue as of the date of termination and $9.6 million of non-cash consideration related to Otsuka's obligations to complete certain agreed upon clinical activities related to the MODIFY Study, in accordance with the current study protocol, at its own cost and expense. We also recognized $19.1 million in collaboration revenue for the nine months ended September 30, 2022 from the Otsuka U.S. Agreement and the Otsuka International Agreement prior to the termination, as well as royalty revenue under the MTPC Agreement, and revenue under the MTPC Supply Agreement. We recognized $49.7 million in collaboration revenue for the nine months ended September 30, 2021 from the Otsuka U.S. Agreement, the Otsuka International Agreement, royalty revenue under our collaboration agreement with MTPC, and revenue under the MTPC Supply Agreement.\nCost of Goods Sold - Product. Cost of goods sold of $60.9 million for the nine months ended September 30, 2022 consisted of costs associated with the manufacturing of Auryxia and supply of Vafseo to MTPC for commercial sale in Japan, $10.0 million related to excess and obsolescence reserves associated with inventory, and a $12.4 million increase to the liability for excess\n44\npurchase commitments. Refer to Note 13 to our condensed consolidated financial statements for further details on the excess purchase commitments liability.\nCost of goods sold of $76.0 million for the nine months ended September 30, 2021 consisted primarily of costs associated with the manufacturing of Auryxia, $15.4 million in non-cash charges related to an increase to the liability for excess purchase commitments, $21.6 million in non-cash charges related to the fair-value inventory step-up from the application of purchase accounting, and $7.1 million related to inventory reserves associated with a previously disclosed manufacturing quality issue related to Auryxia.\nCost of Goods Sold - Amortization of Intangibles. Amortization of intangibles relates to the acquired developed product rights for Auryxia, which is being amortized using a straight-line method over its estimated useful life of approximately six years. Amortization of intangibles during each of the nine months ended September 30, 2022 and 2021 was $27.0 million.\nResearch and Development Expenses. Research and development expenses were $97.2 million for the nine months ended September 30, 2022, compared to $118.3 million for the nine months ended September 30, 2021, a decrease of $21.1 million. The decrease was primarily due to the following:\n| (in millions) |\n| Vadadustat development expenses | $ | (1.3) |\n| Headcount, consulting, facilities and other | (19.8) |\n| Total net decrease | (21.1) |\n\nThe decrease in research and development expense was primarily due to decreased headcount related costs as a result of the reduction in force, decreased consulting costs, and decreased regulatory fees. Also during the nine months ended September 30, 2021, we made an upfront payment of $3.0 million to Cyclerion for an exclusive global license to develop and commercialize praliciguat, an investigational oral sGC, stimulator, which was recorded to research and development expense which did not reoccur during the nine months ended September 30, 2022. Although we expect our research and development expenses for the remainder of 2022 to continue to decrease compared to 2021, we will continue to incur significant research and development expenses in future periods in support of ongoing or planned studies with respect to Auryxia and vadadustat and development of other potential product candidates.\nSelling, General and Administrative Expenses. Selling, general and administrative expenses were $108.1 million for the nine months ended September 30, 2022, compared to $129.3 million for the nine months ended September 30, 2021. The decrease of $21.3 million was primarily due to decreased headcount related costs as a result of the reduction in force, decreased one-time legal costs, and lower marketing expense following receipt of the CRL for vadadustat. For the remainder of 2022, we expect our selling, general and administrative expenses to continue to decrease from 2021 as we significantly reduce our expense profile in line with being a single commercial product company.\nLicense Expenses. License expense related to royalties due to Panion relating to sales of Riona in Japan was $2.3 million and $2.5 million for the nine months ended September 30, 2022 and 2021, respectively.\nRestructuring. Restructuring expenses were $14.7 million for the nine months ended September 30, 2022 due to one-time termination benefits and contractual termination benefits for severance, healthcare, and non-cash stock-based compensation related to the reduction in force. There were no restructuring expenses for the nine months ended September 30, 2021.\nOther Expense, Net. Other expense, net, was $11.3 million for the nine months ended September 30, 2022 compared to $13.0 million for the nine months ended September 30, 2021. The decrease in other expense compared to September 30, 2021 was primarily due to a decrease in interest expense as a result of principal prepayments totaling $25.0 million made on the Term Loans pursuant to the Second Amendment and Waiver in the nine months ended September 30, 2022, reducing our outstanding balance on the Term Loans. The decrease was also related to a decrease in the fair value of our derivative liability related to the Loan Agreement with Pharmakon during the nine months ended September 30, 2022.\nLoss on Extinguishment of Debt. During the three months ended September 30, 2022, the Company recorded a debt extinguishment loss of $0.9 million related to the principal prepayments made on the Term Loans pursuant to the Second Amendment and Waiver.\n45\nLiquidity and Capital Resources\nWe have funded our operations principally through sales of our common stock, payments received from our collaboration partners, product sales, debt, a royalty transaction, and a refund liability to a customer. As of September 30, 2022, we had cash and cash equivalents of approximately $144.8 million. Cash in excess of immediate requirements is invested in accordance with our investment policy, primarily with a view to liquidity and capital preservation. On April 7, 2022, we entered into an Open Market Sale AgreementSM, or the Sales Agreement, with Jefferies LLC, or Jefferies, as agent, for the offer and sale of common stock at current market prices in amounts to be determined from time to time. Also, on April 7, 2022, we filed a prospectus supplement relating to the Sales Agreement, pursuant to which we are able to offer and sell under the Sales Agreement up to $26.0 million of our common stock at current market prices from time to time. From the date of filing of the prospectus supplement through the date of the filing of this Quarterly Report on Form 10-Q, we have not sold any shares of our common stock under this program. As of September 30, 2022, through our collaboration agreements with Otsuka and MTPC we received approximately $837.1 million in cost-share funding, and are not entitled to receive any additional cost-share funding.\nCash Flows\nThe following table sets forth the primary sources and uses of cash for each of the periods set forth below:\n| Nine Months Ended |\n| September 30, 2022 | September 30, 2021 |\n| (in thousands) |\n| Net cash provided by (used in): |\n| Operating activities | $ | (18,475) | $ | (190,157) |\n| Investing activities | (114) | 39,941 |\n| Financing activities | 14,599 | 128,328 |\n| Net (decrease) in cash, cash equivalents, and restricted cash | $ | (3,990) | $ | (21,888) |\n\nOperating Activities. Net cash used in operating activities of $18.5 million for the nine months ended September 30, 2022 was driven by the net operating loss for the period and changes in working capital at period end.\nNet cash used in operating activities of $190.2 million for the nine months ended September 30, 2021 was largely driven by the net operating loss for the period and changes in working capital at period end.\nInvesting Activities. Net cash used in investing activities for the nine months ended September 30, 2022 was $0.1 million and was comprised of purchases of equipment.\nNet cash provided by investing activities for the nine months ended September 30, 2021 was $39.9 million and was primarily comprised of proceeds from the sale of available for sale securities of $40.0 million.\nFinancing Activities. Net cash provided by financing activities for the nine months ended September 30, 2022 was $14.6 million and consisted of net proceeds from refund liabilities to customers of $40.0 million, net proceeds from the issuance of common stock of $7.1 million, and proceeds from the sale of stock under our employee stock purchase plan, partially offset by principal payments of debt of $33.0 million.\nNet cash provided by financing activities for the nine months ended September 30, 2021 was $128.3 million and consisted of net proceeds from the sale of future royalties of $44.8 million, net proceeds from the public issuance of common stock in connection with our prior at-the-market sales agreement with Cantor Fitzgerald & Co. of $82.8 million, and proceeds from the sale of stock under our employee stock purchase plan.\nOperating Capital Requirements\nWe have one product, Auryxia, approved for commercial sale in the United States, but have not generated, and may not generate, enough product revenue from the sale of Auryxia to realize net profits from product sales. We have incurred losses and cumulative negative cash flows from operations in each year since our inception in February 2007, and as of September 30, 2022, we had an accumulated deficit of $1.5 billion. We anticipate that we will continue to incur losses for the foreseeable future, and we expect to continue to incur additional research and development expenses related to vadadustat and our\n46\ndevelopment pipeline, and research and development and selling, general and administrative expenses for our ongoing development and commercialization of Auryxia.\nWe expect our cash resources will be sufficient to fund our current operating plan through at least the next twelve months from the date of this filing. However, our operating plan includes assumptions pertaining to cost avoidance measures and the reduction of overhead costs that would result from the planned amendment of contractual arrangements with certain supply and collaboration partners and reduction of operating expenses. The outcome of certain of these cost avoidance measures are outside of our control, such as the planned amendment of contractual arrangements with certain supply partners. During 2022, we implemented some of the cost avoidance measures, and we have additional cost avoidance measures we plan to implement. For example, during the third quarter of 2022, we reduced future contractual commitments with certain supply partners, and we continue to work with our supply partners to further reduce costs. In addition, during the second quarter of 2022, we reduced our workforce by approximately 42% across all areas of our company following receipt of the CRL. These actions reflect our determination to refocus our strategic priorities around our commercial product, Auryxia® and our development portfolio, and is a step in a cost savings plan to significantly reduce our expense profile in line with being a single commercial product company (see Note 5 to our condensed consolidated financial statements). However, because certain of the other cost avoidance measures and certain other elements of our operating plan are outside of our control, there is uncertainty as to whether our cash resources will be adequate to support our operations for a period through at least the next twelve months from the date of issuance of these financial statements.\nIn addition, pursuant to the Second Amendment and Waiver, on the Effective Date, we made prepayments totaling $25.0 million together with a prepayment premium of $0.5 million plus all accrued and unpaid interest on such prepayments of principal to the Effective Date, and Pharmakon agreed to waive or modify certain covenants in the Loan Agreement (see Note 11 to our condensed consolidated financial statements). If an event of default occurs and is continuing under the Loan Agreement, the Collateral Agent is entitled to take enforcement action, including acceleration of amounts due under the Loan Agreement, which we may not have the available cash resources to repay at such time. For example, pursuant to covenants in the Loan Agreement, our Annual Reports on Form 10-K must not be subject to any qualification as a going concern. If any of our future Annual Reports on Form 10-K is subject to any qualification related to going concern, it will result in an event of default under the Loan Agreement. Should we not be able to meet the annual covenants in the future, we would seek a waiver of this provision. However, there can be no assurances that we would be successful in obtaining such waiver.\nWe believe that the execution of the cost avoidance measures detailed previously, future decisions by the FDA or foreign regulatory agencies related to the potential regulatory approval of vadadustat, and our ability to generate additional value from vadadustat, if approved through partnerships or other transactions could potentially further extend our cash runway for a period greater than twelve months. However, these future decisions or transactions are not contemplated in our operating plan. In addition, because the cost avoidance measures and certain other elements of our operating plan are outside of our control, they cannot be considered probable in the context of our going concern assessment. Therefore, there can be no assurance that our cash resources will fund our operating plan for the period anticipated by us.\nWe expect to finance future cash needs through product revenue, strategic transactions, or a combination of these approaches. We plan to reduce our need for future financing through the planned amendment of contractual arrangements with certain supply and collaboration partners, expense management, and cost avoidance measures in line with being a single commercial product company. Assuming we are successful in those endeavors, we will require additional funding to fund our strategic growth beyond Auryxia or to pursue later stage development and commercial activities for any additional product or product candidates, including those that may be in-licensed or acquired. There can be no assurance that the current operating plan will be achieved in the time frame anticipated by us, or that our cash resources will fund our operating plan for the period anticipated by us or that additional funding will be available on terms acceptable to us, or at all.\nGoing Concern\nOur operating plan includes assumptions pertaining to cost avoidance measures and the reduction of overhead costs that would result from the planned amendment of contractual arrangements with certain supply and collaboration partners, and reduction of operating expenses. However, because these cost avoidance measures and certain other elements of our operating plan are outside of our control, including the planned amendment of certain contractual arrangements and the reduction of operating expenses, there is uncertainty as to whether our cash resources will be adequate to support our operations for a period through at least the next twelve months from the date of issuance of these financial statements. The conditions above and the annual going concern covenant in our Loan Agreement raise substantial doubt regarding our ability to continue as a going concern for a period of twelve months after the date the financial statements are issued.\nManagement’s plans to alleviate the conditions that raise substantial doubt include cost avoidance measures, including amending contractual arrangements with certain supply and collaboration partners, and reducing operating expenses, for us to continue as a going concern for a period of twelve months from the date the financial statements are issued. However, we have concluded that the likelihood that our plan to extend our cash runway from one or more of these approaches will be successful, while reasonably possible, is less than probable. Accordingly, we have concluded that substantial doubt exists about our ability to continue as a going concern for a period of at least twelve months from the date of issuance of these financial statements.\n47\nOur forecast of the period of time through which our financial resources will be adequate to support our operations is a forward-looking statement and involves numerous risks and uncertainties, and actual results could vary as a result of a number of factors, many of which are outside our control. We have based this estimate on assumptions that may be substantially different than actual results, and we could utilize our available capital resources sooner than we currently expect. Our future funding requirements, both near- and long-term, will depend on many factors including, but not limited to, those described under Part I, Item 1A. Risk Factors under the heading \"Risks Related to our Financial Position, Need for Additional Capital and Growth Strategy.\"\nContractual Obligations\nAs of September 30, 2022, other than as disclosed in Note 13 to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q, there have been no material changes to our contractual obligations and commitments from those described under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our 2021 Annual Report on Form 10-K.\nTerm Loans\nOn November 11, 2019, Akebia, with Keryx as guarantor, entered into a loan agreement, or the Loan Agreement, with BioPharma Credit PLC as collateral agent and a lender, or the Collateral Agent, and BioPharma Credit Investments V (Master) LP as a lender, pursuant to which term loans in an aggregate principal amount of $100.0 million were made available to us in two tranches, subject to certain terms and conditions, or the Term Loans. BioPharma Credit PLC subsequently transferred its interest in the Term Loans, solely in its capacity as a lender, to its affiliate, BPCR Limited Partnership. The Collateral Agent and the lenders are collectively referred to as Pharmakon. The first tranche of $80.0 million, or Tranche A, was drawn on November 25, 2019, or the Tranche A Funding Date, and the second tranche of $20.0 million, or Tranche B, was drawn on December 10, 2020, or the Tranche B Funding Date. As of September 30, 2022, we made our first quarterly principal payment under the Term Loans of $8.0 million. In addition, on July 15, 2022, pursuant to the Loan Agreement, as amended, we made prepayments totaling $25.0 million together with a prepayment premium of $0.5 million plus all accrued and unpaid interest on such prepayments of principal to the Effective Date, and Pharmakon agreed to waive or modify certain covenants in the Loan Agreement. A more detailed description of the Term Loans can be found in Note 11 to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q.\nLiability Related to Sale of Future Royalties\nOn February 25, 2021, we entered into a royalty interest acquisition agreement, or the Royalty Agreement, with HCR, pursuant to which we sold to HCR our right to receive royalties and sales milestones for vadadustat in the MTPC Territory, such payments collectively the Royalty Interest Payments, in each case, payable to us under the MTPC Agreement, subject to an annual maximum “cap” of $13.0 million, or the Annual Cap, and an aggregate maximum “cap” of $150.0 million, or the Aggregate Cap. After HCR receives Royalty Interest Payments equal to the Annual Cap in a given calendar year, we will receive 85% of the Royalty Interest Payments for the remainder of that year. After HCR receives Royalty Interest Payments equal to the Aggregate Cap, or we pay the Aggregate Cap to HCR (net of the Royalty Interest Payments already received by HCR), the Royalty Interest Payments will revert back to us, and HCR would have no further right to any Royalty Interest Payments. We received $44.8 million from HCR (net of certain transaction expenses) under the Royalty Agreement, and we are eligible to receive an additional $5.0 million in each year from 2021 through 2023 under the Royalty Agreement if specified annual sales milestones are achieved for vadadustat in the MTPC Territory, subject to the satisfaction of certain customary conditions. We retain the right to receive all potential future regulatory milestones for vadadustat under the MTPC Agreement. A more detailed description of the liability related to the sale of future royalties can be found in Note 6 to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q.\nRefund Liability to Customer\nOn February 18, 2022, pursuant to the Vifor Second Amended Agreement, Vifor Pharma contributed $40.0 million to the Working Capital Fund, established to partially fund our costs of purchasing vadadustat from its contract manufacturers, which amount of funding will fluctuate, and which funding we will repay to Vifor over time. The $40.0 million initial contribution to the Working Capital Fund represents 50% of the amount of purchase orders that the Company has placed with its contract manufacturers for the supply of vadadustat for the United States, or the Territory, already delivered as of the effective date of the Vifor Second Amended Agreement, and to be delivered through the end of 2022.\nWe have recorded the Working Capital Fund as a refund liability under ASC 606. We accounted for the refund liability as a debt arrangement with zero coupon interest. We imputed interest on the refund liability to the customer at a rate of 15.0% per annum and recorded an initial discount on the refund liability to the customer and a related deferred gain as of the date the funds were received from Vifor Pharma, which was March 18, 2022. The discount on the note payable is being amortized to interest expense using the effective interest method over the expected term of the refund liability. The deferred gain is being amortized to interest income on a straight-line basis over the expected term of the refund liability. A more detailed description of the refund liability can be found in Note 4 to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q.\n48\nCritical Accounting Estimates and Significant Judgments\nOur management’s discussion and analysis of our financial condition and results of operations are based on our unaudited condensed consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these unaudited condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, and expenses and the disclosure of contingent assets and liabilities in our unaudited condensed consolidated financial statements. On an ongoing basis, we evaluate our estimates and judgments, including those related to revenue, inventory, our excess purchase commitment liability, liabilities related to sale of future royalties, refund liabilities to customers, impairment of intangible assets and income taxes. We base our estimates on historical experience, known trends and events, and various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. In making estimates and judgments, management employs critical accounting policies.\nDuring the nine months ended September 30, 2022, we had the following material change to our critical accounting estimates as reported in our 2021 Annual Report on Form 10-K:\nRefund Liability to Customer\nWe treat the refund liability to customer as a zero-coupon debt financing, which is recorded at net present value. We recorded an initial discount on the refund liability to the customer and a corresponding deferred gain to the refund liability to customer on the condensed consolidated balance sheet as of the date the funds were received from Vifor Pharma, which was March 18, 2022. The discount on the note payable is being amortized to interest expense using the effective interest method over the expected term of the refund liability. The deferred gain is being amortized to interest income on a straight-line basis over the expected term of the refund liability.\nRecent Accounting Pronouncements\nFor additional discussion of recent accounting pronouncements, please refer to New Accounting Pronouncements – Not Yet Adopted included within Note 2 to our condensed consolidated financial statements in Part I, Item 1. Financial Statements (unaudited) included in this Quarterly Report on Form 10-Q.\nItem 3. Quantitative and Qualitative Disclosures about Market Risk.\nWe are exposed to market risk related to changes in interest rates. As of September 30, 2022 and December 31, 2021, we had cash and cash equivalents of $144.8 million and $149.8 million, respectively, consisting primarily of money market mutual funds consisting of certificates of deposit and corporate debt securities. Interest rate sensitivity is affected by changes in the general level of U.S. interest rates, particularly because our investments are in short-term securities. Our investments are subject to interest rate risk and will fall in value if market interest rates increase. Due to the short-term duration of our investment portfolio and the low risk profile of our investments, an immediate 100 basis point change in interest rates would not have a material effect on the fair market value of our portfolio.\nIn addition, we are exposed to market risk related to exchange rates. A portion of our revenues for the nine months ended September 30, 2022 was received in royalty payments converted to U.S. dollars based on the net sales of Riona and VafseoTM in Japanese yen. Our exchange rate risk arises from such foreign currency net sales. As a result, we are exposed to movements in the exchange rates of the Japanese yen against the U.S. dollar.\nFor the royalty payments we received based on net sales of Riona and Vafseo in Japan for the nine months ended September 30, 2022 a 5.0% appreciation or depreciation of the Japanese yen against the U.S. dollar would have increased or decreased, respectively, our revenues in the nine months ended September 30, 2022 by approximately $0.2 million.\nWe have generally accepted the exposure to exchange rate movements without using derivative financial instruments to manage this foreign currency risk.\nItem 4. Controls and Procedures.\nManagement’s Evaluation of our Disclosure Controls and Procedures\nWe maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports that we file or submit under the Securities Exchange Act of 1934, as amended, or the Exchange Act, is (1) recorded, processed, summarized, and reported within the time periods specified in the SEC's rules and forms and (2) accumulated and\n49\ncommunicated to our management, including our principal executive officer and principal financial officer, to allow timely decisions regarding required disclosure.\nAs of September 30, 2022, our management, with the participation of our principal executive officer and principal financial officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives, and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on our evaluation, our management concluded that, as of September 30, 2022, our disclosure controls and procedures were not effective because our internal control over financial reporting was not adequate due to the material weakness described below.\nAs reported in our 2021 Annual Report on Form 10-K, our internal control over financial reporting as of December 31, 2021 was not effective due to the following material weakness: the Company did not design and maintain effective controls over the completeness, accuracy, existence and presentation and disclosure of inventory. A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of a company’s annual or interim consolidated financial statements will not be prevented or detected on a timely basis. Specifically, we did not maintain effective controls related to (i) the review of inventory reconciliations, (ii) the validation of the inventory costing, (iii) the periodic assessment of excess and obsolete inventory related reserves and (iv) verification that the existence of all inventories subject to physical inventory counts were correctly counted as of December 31, 2021. Management has taken and will continue to take actions to remediate the deficiencies in its internal control over financial reporting and implemented additional processes and controls designed to address the underlying causes associated with the material weakness. Management is committed to finalizing the remediation of the material weakness during 2022.\nAs management continues to evaluate and work to improve its internal control over financial reporting, management may determine it is necessary to take additional measures to address the material weakness. Until the controls have been operating for a sufficient period of time and management has concluded, through testing, that these controls are operating effectively, the material weakness described above will continue to exist. As such, management has concluded that the material weakness cannot be considered remediated as of September 30, 2022.\nChanges in Internal Control over Financial Reporting\nDuring the nine months ended September 30, 2022, we implemented certain internal controls in connection with our remediation efforts described above. There have been no other changes in our internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) promulgated under the Exchange Act, during our most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n50\nPART II—OTHER INFORMATION\nItem 1. Legal Proceedings.\nLegal Proceedings Relating to Vadadustat\nOpposition Proceedings Against Akebia\nIn September 2018, Dr. Reddy’s Laboratories Limited filed an opposition to our issued Indian Patent No. 287720 in the Indian Patent Office.\nOn July 26, 2022, Sandoz AG filed an opposition against our issued European Patent No. 3277270 in the European Patent Office.\nProceedings Filed by Akebia Against FibroGen, Inc.\nEurope\nWe filed an opposition in the European Patent Office, or the EPO, against FibroGen, Inc.’s, or FibroGen’s, European Patent No. 1463823, or the ’823 EP Patent on December 5, 2013, and an oral proceeding took place March 8 and 9, 2016. Following the oral proceeding, the Opposition Division of EPO ruled that the patent as granted did not meet the requirements for patentability under the European Patent Convention and, therefore, revoked the patent in its entirety. FibroGen has appealed that decision. Oral hearing for the appeal is scheduled for February 28 – March 1, 2023.\nOn May 13, 2015, May 20, 2015 and July 6, 2015, we filed oppositions to FibroGen’s European Patent Nos. 2322155, or the ’155 EP Patent, 1633333, or the ’333 EP Patent, and 2322153, or the ’153 EP Patent in the EPO, respectively, requesting the patents be revoked in their entirety. These method of use patents do not prevent persons from using the compound for other uses, including any previously known use of the compound. In particular, these patents do not claim methods of using any of our product candidates for purposes of inhibiting HIF-PH for the treatment of anemia due to chronic kidney disease, or CKD. While we do not believe these patents will prevent us from commercializing vadadustat for the treatment of anemia due to CKD, we filed these oppositions to provide us with maximum flexibility for developing vadadustat and our pipeline of investigational oral hypoxia-inducible factor prolyl hydroxylase, or HIF-PH, inhibitor compounds.\nWith regard to the opposition that we filed in Europe against the ’333 EP Patent, an oral proceeding took place on December 8 and 9, 2016. Following the oral proceeding, the Opposition Division of the EPO ruled that the patent as granted did not meet the requirements for patentability under the European Patent Convention and, therefore, revoked the patent in its entirety. On December 9, 2016, FibroGen filed a notice to appeal the decision to revoke the ’333 EP Patent. The Board of Appeal held an oral proceeding on this appeal on February 24 and 25, 2022, during which proceeding the '333 EP Patent was maintained in restricted form. The ‘333 EP patent was originally granted with four independent claims, one of which was found obvious on appeal. The remaining claims are directed to: treatment of anemia of chronic disease in subjects having a percent transferrin saturation of less than 20% (claim 1), treatment of anemia that is refractory to treatment with exogenously administered erythropoietin (claim 6), and treatment of iron deficiency (claim 15).\nIn oral proceedings held on May 29, 2017, regarding the ’155 EP Patent, the European Opposition Division ruled that the ’155 EP Patent as granted did not meet the requirements for patentability under the European Patent Convention and, therefore, revoked the patent in its entirety. FibroGen filed a notice to appeal the decision to revoke the ’155 EP Patent on May 29, 2017. An oral proceeding for the appeal was held on February 22, 2022, during which proceeding the Board of Appeal maintained the revocation of the ‘155 EP Patent in its entirety.\nIn related oral proceedings held on May 31, 2017 and June 1, 2017 for the ’153 EP Patent, the Opposition Division of the EPO maintained the patent after FibroGen significantly narrowed the claims to an indication for which vadadustat is not intended to be developed. We and Glaxo separately filed notices to appeal the decision to maintain the ’153 EP Patent on November 9, 2017. Bayer filed a notice to appeal the decision on November 14, 2017. Glaxo withdrew its appeal on March 2, 2020 and Bayer withdrew its appeal on June 30, 2021. An oral proceeding for the appeal was held on February 21, 2022, during which proceeding the Board of Appeal revoked the ‘153 patent in its entirety.\nOn April 3, 2019, we filed oppositions to FibroGen’s European Patent Nos. 2289531, or the ’531 EP Patent, and 2298301, or the ’301 EP Patent in the EPO, respectively, requesting the patents be revoked in their entirety. Oral proceedings for oppositions to the two patents were held on September 7-8 and 10, 2021. Following oral proceedings, the Opposition Division of the EPO maintained certain claims in amended form in the two patents. On January 26, 2022, we filed notice to appeal the Opposition Division’s decision for ’531 EP Patent. On July 8, 2022, FibroGen filed notice to appeal the Opposition Division’s\n51\ndecision for the ’301 EP Patent. These two patents will expire in December 2022, and we do not expect the Opposition Division’s decision on the two patents to have any effect on our commercialization of vadadustat in Europe.\nJapan\nOn June 2, 2014, we filed an invalidity proceeding before the Japan Patent Office, or JPO, against certain claims of FibroGen’s Japanese Patent No. 4804131, or the ’131 JP Patent, which is the Japanese counterpart to the ’823 EP Patent, and the JPO issued a preliminary decision finding all of the challenged claims to be invalid. FibroGen subsequently amended the claims and the JPO accepted the amendments. The resulting ’131 JP Patent does not cover vadadustat or any pyridine carboxamide compounds.\nIn 2018, we and our collaboration partner in Japan, Mitsubishi Tanabe Pharma Corporation, or MTPC, jointly filed a Request for Trial before the JPO to challenge the validity of certain of FibroGen’s HIF-related patents in Japan: JP4845728, JP5474872 and JP5474741. On September 26, 2019, the JPO conducted an invalidation trial for JP5474872 and JP4845728. On November 11, 2019, the JPO conducted an invalidation trial for JP5474741. On April 1, 2022, the JPO issued a final decision for JP4845728, which invalidated all claims except claims directed to the medical use to treat anemia that does not respond to erythropoiesis. On May 18, 2022, the JPO issued a final decision for JP5474741 and JP5474872, which maintained the claims in amended form. In May 2022, MTPC filed revocation lawsuits for the three patents in the Intellectual Property High Court requesting cancellation of the JPO’s decisions. In July 2022, we filed a revocation lawsuit for JP4845728 in the Intellectual Property High Court requesting cancellation of the JPO’s decision. In August 2022, we filed revocation lawsuits for JP5474741 and JP5474872 in the Intellectual Property High Court requesting cancellation of the JPO’s decisions. In September 2022, FibroGen filed a revocation lawsuit for JP4845728 in the Intellectual Property High Court requesting cancellation of the JPO’s decision on the claims that were invalidated. We do not believe the JPO’s decisions will prevent our collaboration partner MTPC from continuing to commercialize vadadustat for the treatment of anemia due to CKD in Japan.\nUnited Kingdom\nOn December 13, 2018, we filed Particulars of Claim in the Patents Court of the United Kingdom to challenge the validity of FibroGen’s six HIF-related patents in the UK: the ’823 EP Patent (UK), the ’333 EP Patent (UK), the ’153 EP Patent (UK), the ’155 EP Patent (UK), European Patent (UK) No. 2,289,531, or the ’531 EP Patent (UK), and European Patent (UK) No. 2,298,301, or the ’301 EP Patent (UK). In May 2019, Astellas Pharma Inc., or Astellas, the exclusive licensee of FibroGen’s HIF-related patents, sued Akebia for patent infringement in the Patents Court of the UK. In September 2019, we filed an Amended Particulars of Claim to include FibroGen’s European Patent No. 1487472, or the ’472 EP Patent (UK). On February 28, 2020, the parties agreed to dismiss the ’472 EP Patent (UK) from the trial.\nA trial was conducted in March 2020. On April 20, 2020, the Patents Court of the UK issued a judgment in favor of Akebia, which invalidated all the claims at issue in each of the ’823 EP Patent (UK), the ’333 EP Patent (UK), the ’153 EP Patent (UK), the ’155 EP Patent (UK) and the ’301 EP Patent (UK). The ’531 EP Patent (UK) was amended to a single claim to recite one specific compound; this claim was held to be valid but not infringed by vadadustat. On June 11, 2020, FibroGen and Astellas appealed the Patents Court’s judgment on the invalidity of the ’823 EP Patent (UK), the ’301 EP Patent (UK), the ’333 EP Patent (UK), the ’153 EP Patent (UK), and the ’155 EP Patent (UK) in the Court of Appeal (Civil Division). On June 8, 2021 - June 10, 2021, the United Kingdom Court of Appeal held a three-day hearing for the appeal. On August 24, 2021, the Court of Appeal issued a judgment, which reversed the Patents Court’s judgment on the invalidity of the ’823 EP Patent (UK) and maintained certain claims of the ’823 EP Patent (UK) and the ’301 EP Patent (UK) in amended form, and which affirmed the Patents Court’s judgment on the invalidity of the ’333 EP Patent (UK), the ’155 EP Patent (UK), and the ’153 EP Patent (UK). Akebia sought permission to appeal to the UK Supreme Court, which was granted on October 3, 2022. We do not expect the UK Court of Appeal’s judgment to have any effect on our commercialization of vadadustat in the UK.\nUnited States\nOn March 29, 2021, we filed a lawsuit against FibroGen and AstraZeneca AB in the United States District Court for the District of Delaware to seek a declaratory judgment of non-infringement and invalidity of FibroGen’s twelve HIF-related patents in the United States: U.S. Patent Nos. 8,318,703, 8,466,172, 8,614,204, 9,920,011, 8,629,131, 8,604,012, 8,609,646, 8,604,013, 10,626,090, 10,894,774, 10,882,827, and 10,927,081. On April 5, 2022, we voluntarily dismissed, without prejudice, our declaratory judgment complaint against FibroGen and AstraZeneca under Rule 41(a)(1)(A)(i) of the Federal Rules of Civil Procedure.\nLegal Proceedings Relating to Auryxia\nANDA Litigation\n52\nIn 2018 and 2019, Keryx Biopharmaceuticals, Inc., or Keryx, received Paragraph IV certification notice letters regarding Abbreviated New Drug Applications, or ANDAs, submitted to the U.S. Food and Drug Administration, or FDA, by third parties requesting approval for generic versions of Auryxia tablets (210 mg ferric iron per tablet). In response to such ANDA filings, Keryx and its licensors, Panion & BF Biotech, Inc., or Panion, and, as applicable, Chen Hsing Hsu, M.D., filed complaints for patent infringement against such third parties. Keryx, Panion and, as applicable, Dr. Hsu have now entered into settlement and license agreements resolving all patent litigation proceedings brought by Keryx, Panion and, as applicable, Dr. Hsu, in response to ANDAs filed by third parties seeking approval to market generic versions of Auryxia® (ferric citrate) tablets prior to the expiration of the applicable patents. Each settlement agreement granted the defendants a license to market a generic version of Auryxia in the United States beginning on March 20, 2025 (subject to FDA approval), or earlier under certain circumstances customary for settlement agreements of this nature.\nStockholder Litigation Relating to the Merger\nOn June 28, 2018, we entered into an Agreement and Plan of Merger with Keryx and Alpha Therapeutics Merger Sub, Inc., or the Merger Sub, pursuant to which the Merger Sub would merge with and into Keryx, with Keryx becoming a wholly owned subsidiary of ours, or the Merger. On December 12, 2018, we completed the Merger. In October and November 2018, four purported shareholders of Keryx filed four separate putative class actions, or the Merger Securities Actions, against Keryx, a former officer and director of Keryx (Jodie P. Morrison), former directors of Keryx (Kevin J. Cameron, Mark J. Enyedy, Steven C. Gilman, Michael T. Heffernan, Daniel P. Regan and Michael Rogers, some of whom are current members of our Board of Directors), and, with respect to the Rosenblatt action discussed below, the Merger Sub and Akebia, challenging the disclosures made in connection with the Merger.\nThree of the Merger Securities Actions were filed in the Delaware District Court: Corwin v. Keryx Biopharmaceuticals, Inc., et al. (filed October 16, 2018); Van Hulst v. Keryx Biopharmaceuticals, Inc., et al. (filed October 24, 2018); and Andreula v. Keryx Biopharmaceuticals, Inc., et al. (filed November 1, 2018). The fourth Merger Securities Action was filed in the Massachusetts District Court: Rosenblatt v. Keryx Biopharmaceuticals, Inc., et al. (filed October 23, 2018). On February 19, 2019, the plaintiff in the Rosenblatt action filed a notice of voluntary dismissal of the action without prejudice. On March 27, 2019, the plaintiff in the Van Hulst action filed a notice of voluntary dismissal of the action without prejudice.\nOn April 2, 2019, the Delaware District Court granted Abraham Kiswani, a member of the putative class in both the Andreula and Corwin actions, and plaintiff John Andreula’s motion to consolidate the remaining two Merger Securities Actions pending in the Delaware District Court and consolidated the Corwin and Andreula cases under the caption In re Keryx Biopharmaceuticals, Inc., or the Consolidated Federal Action. The Delaware District Court also appointed Kiswani and plaintiff Andreula as lead plaintiffs for the Consolidated Federal Action. On June 3, 2019, the lead plaintiffs filed a consolidated amended complaint in the Consolidated Federal Action, or the Consolidated Complaint. The Consolidated Complaint generally alleged that the registration statement filed in connection with the Merger contained allegedly false and misleading statements or failed to disclose certain allegedly material information in violation of Section 14(a) and 20(a) of the Exchange Act and Rule 14a-9 promulgated thereunder. The alleged misstatements or omissions related to (i) certain financial projections for Keryx and Akebia and certain financial analyses performed by our advisors and (ii) any alleged negotiations that may have taken place regarding the conversion of certain convertible notes of Keryx in connection with the Merger. The Consolidated Complaint sought compensatory and/or rescissory damages, a declaration that the defendants violated Sections 14(a) and 20(a) of the Exchange Act and Rule 14a-9 thereunder, and an award of lead plaintiffs’ costs, including reasonable allowance for attorneys’ fees and experts’ fees. The defendants in the Consolidated Federal Action moved to dismiss the Consolidated Complaint in its entirety and with prejudice on August 2, 2019. On April 15, 2020, the Delaware District Court granted the defendants’ motion and dismissed the Consolidated Complaint in its entirety. On July 2, 2020, lead plaintiffs filed a second consolidated amended complaint, or the Second Consolidated Complaint. The Second Consolidated Complaint (i) asserted the same claims under the Exchange Act as the Consolidated Complaint, (ii) named the same defendants as the Consolidated Complaint, (iii) sought the same relief as the Consolidated Complaint and (iv) as with the Consolidated Complaint, challenged as false or misleading alleged misstatements or omissions related to certain financial projections for Keryx and Akebia and certain financial analyses performed by our advisors. The defendants in the Consolidated Federal Action moved to dismiss the Second Consolidated Complaint in its entirety with prejudice on August 10, 2020. Briefing on defendants’ motion to dismiss was completed on September 28, 2020, and on April 1, 2021, the District Court granted Defendants’ motion in its entirety and dismissed the Second Consolidated Complaint with prejudice. The lead plaintiffs appealed, and briefing on the appeal was completed on October 7, 2021. The Third Circuit submitted the case on the briefs without oral argument on February 10, 2022. On July 21, 2022, the Third Circuit affirmed the District Court’s order of dismissal.\nOn July 15, 2021, a purported former Keryx stockholder filed a putative class action in the Supreme Court of the State of New York against Akebia, a current officer of Akebia (John P. Butler), a former officer of Akebia (Jason A. Amello), former directors of Akebia (Muneer A. Satter, Scott A. Canute, Michael D. Clayman, Maxine Gowen, Duane Nash, Ronald C. Renaud, Jr., and Michael S. Wyzga), a current director of Akebia (Cynthia Smith), a former director and officer of Keryx (Jodie P.\n53\nMorrison), a former officer of Keryx (Scott A. Holmes) and former directors of Keryx (Michael Rogers, Kevin J. Cameron, Steven C. Gilman, Daniel P. Regan, Mark J. Enyedy, and Michael T. Heffernan, some of whom are current members of our Board of Directors). The action is captioned Loper v. Akebia Therapeutics, Inc., et al., or the Loper Action. The complaint in the Loper Action alleges that the registration statement filed in connection with the Merger contained allegedly false and misleading statements or failed to disclose certain allegedly material information in violation of Section 11, 12(a)(2), and 15 of the Securities Act of 1933, as amended. It alleges, among other things, that Akebia failed to disclose heightened safety risks that allegedly threatened the prospects of the Phase 3 PRO2TECT clinical trial and the commercial viability of vadadustat. The complaint in the Loper Action seeks damages including interest thereon, an award of plaintiffs’ and the class’s costs and expenses, including counsel fees and expert fees, and rescission, disgorgement, or such other equitable or injunctive relief that the Court deems appropriate.\nOn August 16, 2021, another purported former Keryx stockholder filed a putative class action making substantially similar allegations and asserting the same claims as the Loper Action, also in the Supreme Court of the State of New York against Akebia and many of the same individual defendants named in the Loper Action. The action is captioned Panicho v. Akebia Therapeutics, Inc., et al., or the Panicho Action.\nOn September 13, 2021, the parties in the Loper Action and Panicho Action entered into a joint stipulation and proposed order, which provided for the consolidation of the two actions under the caption In re Akebia Therapeutics, Inc. Securities Litigation, or the Consolidated State Action. On October 27, 2021, plaintiffs filed a consolidated complaint in the Consolidated State Action. On January 10, 2022, defendants moved to dismiss the consolidated complaint in its entirety. Briefing on defendants’ motion to dismiss was completed on April 22, 2022. Oral argument was held on October 7, 2022, and the Court dismissed the complaint without prejudice on October 17, 2022, giving plaintiffs thirty days to amend their complaint. The Court further ordered that, in the event plaintiffs do not file an amended complaint within thirty days of the dismissal, the dismissal shall be deemed to be with prejudice.\nOn March 14, 2022, a purported stockholder of Akebia filed a putative federal securities class action against Akebia as well as three present and former officers of Akebia in the U.S. District Court for the Eastern District of New York. The action was captioned Deputy v. Akebia Therapeutics, Inc., et al., No. 1:22-cv-01411, or the EDNY Action. The complaint in the EDNY Action alleged that defendants made materially false and misleading statements in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. The alleged misstatements or omissions related to heightened safety risks that allegedly threatened the prospects of the Phase 3 PRO2TECT clinical trial and the commercial viability of vadadustat. The complaint in the EDNY Action sought damages including interest thereon, an award of plaintiffs’ and the class’s costs and expenses, including counsel fees and expert fees, or such other and further relief that the Court deems appropriate. Plaintiffs Abraham Kiswani and Joseph Gorski were appointed co-lead plaintiffs on June 28, 2022, and on July 22, 2022, a stipulated scheduling order was entered allowing co-lead plaintiffs to file an amended complaint on or before August 29, 2022. On August 29, 2022, co-lead plaintiffs filed a stipulation of voluntary dismissal, and the Court entered an order dismissing the co-lead plaintiffs from the action on August 30, 2022. The original named plaintiff filed a stipulation of voluntary dismissal on September 7, 2022, and the court formally terminated the case on September 8, 2022.\nWe deny any allegations of wrongdoing and intend to continue vigorously defending against the one active stockholder lawsuit described in this Legal Proceedings section, the Consolidated State Action. There is no assurance, however, that we will be successful in the defense of this action, or any associated appeals, or that insurance will be available or adequate to fund any settlement or judgment or the litigation costs of this action. Moreover, we are unable to predict the outcome or reasonably estimate a range of possible losses at this time. A resolution of the Consolidated State Action in a manner adverse to us, however, could have a material effect on our financial position and results of operations in the period in which the action is resolved.\nItem 1A. Risk Factors.\nWe face a variety of risks and uncertainties in our business. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may also become important factors that affect our business. If any of the following risks occurs, our business, financial condition, financial statements, results of operations and future growth prospects could be materially and adversely affected.\nRisks Related to our Financial Position, Need for Additional Capital and Growth Strategy\nWe have incurred significant losses since our inception, and anticipate that we will continue to incur significant losses and cannot guarantee when, if ever, we will become profitable or attain positive cash flows.\nInvestment in pharmaceutical product development and commercialization is highly speculative because it requires upfront capital expenditures and there is significant risk that a product candidate will fail to gain marketing approval or that an\n54\napproved product will not be commercially viable. Since our inception, we have devoted most of our resources to research and development, including our preclinical and clinical development activities and, following the merger, or the Merger, whereby Keryx Biopharmaceuticals, Inc., or Keryx, became a wholly owned subsidiary of ours, commercialization. We have financed our operations primarily through sales of equity securities, our strategic collaborations and, following the Merger, product revenues, a royalty monetization transaction and debt. Prior to the Merger, we had no products approved for commercial sale and had not generated any revenue from the sale of products. We are not currently profitable, and we have incurred net losses each year since our inception, including a net loss of $51.9 million for the three months ended September 30, 2022, and a net loss of $85.0 million for the nine months ended September 30, 2022. As of September 30, 2022, we had an accumulated deficit of $1.5 billion. We cannot guarantee when, if ever, we will become profitable.\nIn March 2022, we received a complete response letter, or CRL, from the FDA regarding our NDA for vadadustat, our lead investigational product candidate, for the treatment of anemia associated with CKD. The FDA concluded that the data in the NDA do not support a favorable benefit-risk assessment of vadadustat for dialysis and non-dialysis patients. In July 2022, we held an end of review meeting with the FDA to inform the Company's next steps with respect to the potential U.S. approval of vadadustat, if any, and in October 2022, we submitted a Formal Dispute Resolution Request, or FDRR, to the FDA. The FDRR focuses on the favorable balance between the benefits and risks of vadadustat for the treatment of anemia due to CKD in adult patients on dialysis in light of safety concerns expressed by the FDA in the CRL related to the rate of adjudicated thromboembolic events driven by vascular access thrombosis for vadadustat compared to the active comparator and the risk of drug-induced liver injury. There can be no assurances that our FDRR will be accepted by the FDA, or that, if accepted, we will be successful in our appeal and obtain approval for vadadustat in a timely manner, on favorable terms, or at all. As a result, the regulatory approval process for vadadustat in the U.S. is highly uncertain. We may not obtain approval at all, and if we are able to obtain approval, the expense and time to do so could adversely impact our ability to successfully commercialize vadadustat or conduct our other business operations, and our financial condition could be materially harmed.\nOur ability to generate product revenue and achieve profitability depends on the overall success of Auryxia(R), vadadustat, if approved, and any current or future product candidates, including those that may be in-licensed or acquired, which depends on several factors, including:\n•obtaining adequate or favorable pricing and reimbursement from private and governmental payors for Auryxia, vadadustat, if approved, and any other product or product candidate, including those that may be in-licensed or acquired;\n•obtaining and maintaining market acceptance of Auryxia, vadadustat, if approved, and any other product candidate, including those that may be in-licensed or acquired;\n•the size of any market in which Auryxia, vadadustat and any other product or product candidate, including those that may be in-licensed or acquired, receives approval and obtaining adequate market share in those markets;\n•addressing the issues identified in the CRL for vadadustat that we received from the FDA, including the results of the end of review meeting and, in the event our FDRR is accepted by the FDA, the outcome of our appeal;\n•the timing and scope of marketing approvals for vadadustat, if approved, and any other product candidate, if approved, including those that may be in-licensed or acquired; maintaining marketing approvals for Auryxia, vadadustat, if approved, and any other product, including those that may be in-licensed or acquired;\n•actual or perceived advantages or disadvantages of our products or product candidates as compared to alternative treatments, including their respective safety, tolerability and efficacy profiles, the potential convenience and ease of administration and cost;\n•maintaining an acceptable safety and tolerability profile of our approved products, including the frequency and severity of any side effects;\n•the willingness of the target patient population to try new therapies and of physicians to prescribe these therapies, based, in part, on their perception of our clinical trial data and/or the actual or perceived safety, tolerability and efficacy profile;\n•establishing and maintaining supply and manufacturing relationships with third parties that can provide adequate supplies of products that are compliant with good manufacturing practices, or GMPs, to support the clinical development and the market demand for Auryxia, vadadustat, if approved, and any other product and product candidate, including those that may be in-licensed or acquired;\n•current and future restrictions or limitations on our approved or future indications and patient populations or other adverse regulatory actions or in the event that the FDA requires Risk Evaluation and Mitigation Strategies, or REMS, or risk management plans that use restrictive risk minimization strategies;\n•the effectiveness of our sales, marketing, manufacturing and distribution strategies and operations;\n•competing effectively with any products for the same or similar indications as our products;\n•maintaining, protecting and expanding our portfolio of intellectual property rights, including patents and trade secrets; and\n55\n•the impact of the COVID-19 pandemic on the above factors, including the disproportionate impact of the COVID-19 pandemic on CKD patients, the adverse impact on the phosphate binder market in which we compete, and the limitation of our sales professionals to meet in person with healthcare professionals as the result of travel restrictions or limitations on access for non-patients.\nOur ability to achieve profitability also depends on our ability to manage our expenses. Following receipt of the CRL, in April and May 2022, we implemented a reduction of our workforce, by approximately 42% across all areas of the Company (47% inclusive of the closing of the majority of open positions), including several members of management. We recorded a restructuring charge of $14.7 million in the aggregate primarily related to contractual termination benefits including severance, non-cash stock-based compensation expense, healthcare and related benefits in the nine months ended September 30, 2022. However, we may incur additional costs not currently contemplated due to events associated with or resulting from the workforce reduction. Additionally, the reduction in workforce could impact our operations, including our commercialization of Auryxia, which could affect our ability to generate revenue.\nEven in light of the reduction in workforce, we expect to continue to incur significant expenses and operating losses for the foreseeable future. In addition to any additional costs not currently contemplated due to events associated with or resulting from the workforce reduction noted above, our ability to achieve profitability and our financial position will depend, in part, on the rate of our future expenditures, on product revenue, collaboration revenue, and our ability to obtain additional funding. On June 30, 2022, we entered into a Termination and Settlement Agreement, or the Termination Agreement, with Otsuka Pharmaceutical Co. Ltd., or Otsuka, pursuant to which we agreed to the immediate termination of the December 18, 2016 collaboration and license agreement with Otsuka, or the Otsuka U.S. Agreement, and the April 25, 2017 collaboration and license agreement with Otsuka, or the Otsuka International Agreement, in exchange for the payment of $55.0 million to us and the agreement between the parties with respect to the conduct of certain activities. Unless and until we are able to find a new partner for vadadustat in Europe and other countries previously licensed to Otsuka, we will incur additional expenses in connection with the development of vadadustat and will receive less collaboration revenue and, if approved, product revenue than originally anticipated. In addition, we expect to continue to incur significant expenses if and as we:\n•continue our commercialization activities for Auryxia and vadadustat, if we are able to obtain marketing approval for vadadustat following receipt of the CRL from the FDA in March 2022, and any other product or product candidate, including those that may be in-licensed or acquired;\n•address the issues identified in the CRL for vadadustat that we received from the FDA and pursue our appeal of the CRL for vadadustat with the FDA, in the event our FDRR is accepted;\n•conduct and enroll patients in any clinical trials, including post-marketing studies or any other clinical trials for Auryxia, vadadustat or any other product or product candidate, including those that may be in-licensed or acquired;\n•seek marketing approvals for vadadustat and any other product candidate, including those that may be in-licensed or acquired;\n•maintain marketing approvals for Auryxia and vadadustat, if we are able to obtain marketing approval for vadadustat following receipt of the CRL from the FDA in March 2022, and any other product, including those that may be in-licensed or acquired;\n•manufacture Auryxia, vadadustat and any other product or product candidate, including those that may be in-licensed or acquired, for commercial sale and clinical trials;\n•conduct discovery and development activities for additional product candidates or platforms that may lead to the discovery of additional product candidates;\n•engage in transactions, including strategic, merger, collaboration, acquisition and licensing transactions, pursuant to which we would market and develop commercial products, or develop and commercialize other product candidates and technologies;\n•continue to repay, and pay any associated pre-payment penalties, if applicable, the senior secured term loans in an aggregate principal amount of $67.0 million, or the Term Loans, that were made available to us pursuant to the Loan Agreement;\n•make royalty, milestone or other payments under our license agreements and any future license agreements;\n•maintain, protect and expand our intellectual property portfolio;\n•make decisions with respect to our personnel, including the retention of key employees;\n•make decisions with respect to our infrastructure, including to support our operations as a fully integrated, publicly traded biopharmaceutical company; and\n•experience any additional delays or encounter issues with any of the above.\nWe have and will continue to expend significant resources in our legal proceedings, as described above under Part II, Item I. Legal Proceedings, or any other legal proceedings brought by or against us in the future.\n56\nBecause of the numerous risks and uncertainties associated with pharmaceutical product development and commercialization, we are unable to accurately predict the timing or amount of increased expenses. The net losses we incur may fluctuate significantly from quarter to quarter and year to year, such that a period-to-period comparison of our results of operations may not be a good indication of our future performance. In any particular quarter, the progress of our clinical development and our operating results could be below the expectations of securities analysts or investors, which could cause our stock price to decline.\nWe will continue to incur substantial expenditures relating to continued commercialization and post-marketing requirements for Auryxia and vadadustat, if we are able to obtain marketing approval for vadadustat following receipt of the CRL from the FDA in March 2022, and any other products, including those that may be in-licensed or acquired, as well as costs relating to the research and development of any other product candidate, including those that may be in-licensed or acquired. Our prior losses and expected future losses have had and will continue to have an adverse effect on our stockholders’ equity and working capital.\nOur expenses could increase beyond expectations if we are required by the FDA, the European Medicines Agency, or the EMA, or other regulatory authorities, or if we otherwise believe it is necessary, to change our manufacturing processes or assays, to amend or replace our study protocols, to conduct any additional clinical trials, whether in order to obtain approval or as a post-approval study, including any additional clinical trial that we decide to conduct for vadadustat, to perform studies in addition to, different from or larger than those currently planned, if there are any delays in completing our clinical trials or if there are further delays in or issues with obtaining marketing approval for vadadustat in the United States, the European Union, or EU, or other jurisdictions. In addition, our ability to generate revenue would be negatively affected if the size of our addressable patient population is not as significant as we estimate, the indication approved by regulatory authorities is narrower than we sought or the patient population for treatment is narrowed by competition, physician choice, coverage or reimbursement, or payor or treatment guidelines. Even though we generate product revenue from Auryxia and royalties from RionaTM and VafseoTM in Japan and may generate revenue and royalties from the sale of any products that may be approved in the future, including those that may be in-licensed or acquired, we may never generate revenue and royalties that are significant enough for us to become and remain profitable, and we will need to obtain additional funding to continue to fund our operating plan and achieve strategic growth.\nWe will require substantial additional financing to achieve our goals. A failure to obtain this necessary capital when needed, or on acceptable terms, could force us to delay, limit, reduce or terminate our product development or commercialization efforts.\nAs of September 30, 2022, our cash and cash equivalents were $144.8 million. We expect to continue to expend substantial amounts of cash for the foreseeable future as we continue to commercialize Auryxia; in the event our FDRR is accepted by the FDA, pursue our appeal for vadadustat in the U.S. with the FDA; support the regulatory process with respect to vadadustat with the EMA and ACCESS Consortium; and develop and commercialize any other product or product candidate, including those that may be in-licensed or acquired. These expenditures will include costs associated with research and development, manufacturing, potentially obtaining marketing approvals and marketing products approved for sale. In addition, other unanticipated costs may arise. Because the outcomes of our current and anticipated clinical trials are highly uncertain, we cannot reasonably estimate the actual amount of funding necessary to successfully complete clinical development for any current or future product candidates, including vadadustat depending on what is required to address the issues identified in the CRL for vadadustat, including the outcome of our appeal and if additional clinical trials are required in order to obtain marketing approval, or to complete post-marketing studies for Auryxia and vadadustat, if approved. Our future capital requirements depend on many factors, including:\n•the scope, progress, results and costs of conducting clinical trials or any post-marketing requirements or any other clinical trials for Auryxia, vadadustat and any other product or product candidate, including those that may be in-licensed or acquired;\n•the cost and timing of commercialization activities, including product manufacturing, marketing, sales and distribution costs, for Auryxia, vadadustat, if approved, and any other product or product candidate, including those that may be in-licensed or acquired;\n•the results of our meetings with the FDA, the EMA and other regulatory authorities and any consequential effects, including on timing of and ability to obtain and maintain marketing approval, study design, study size and resulting operating costs;\n•any difficulties or delays in conducting our clinical trials, or enrolling patients in our clinical trials, for Auryxia, vadadustat or any other product candidates;\n•the outcome of our efforts to obtain marketing approval for vadadustat in the United States, Europe and in other jurisdictions and any other product candidates, including those that may be in-licensed or acquired, including any additional clinical trials or post-approval commitments imposed by regulatory authorities;\n57\n•the timing of, and the costs involved in obtaining, marketing approvals for vadadustat, including in the United States, Europe, China and certain other markets, and any other product candidate, including those that may be in-licensed or acquired, including to fund the preparation, filing and prosecution of regulatory submissions;\n•the costs of maintaining marketing approvals for Auryxia or any other product, including those that may be in-licensed or acquired;\n•the cost of securing and validating commercial manufacturing for any of our product candidates, including those that may be in-licensed or acquired, and maintaining our manufacturing arrangements for Auryxia and vadadustat or any other product, including those that may be in-licensed or acquired, or securing and validating additional arrangements;\n•the costs involved in preparing, filing and prosecuting patent applications and maintaining, defending and enforcing our intellectual property rights, including litigation costs, and the outcome of such litigation;\n•the costs involved in any legal proceedings to which we are a party;\n•our status as a publicly traded company on the Nasdaq Global Market;\n•our decisions with respect to personnel;\n•our decisions with respect to infrastructure; and\n•the extent to which we engage in transactions, including strategic, merger, collaboration, acquisition and licensing transactions, pursuant to which we could develop and market commercial products, or develop other product candidates and technologies.\nFurthermore, we expect to continue to incur costs associated with operating as a fully integrated, publicly traded biopharmaceutical company. Accordingly, we will need to obtain substantial additional funding to fund our operating plan beyond Auryxia and achieve strategic growth. If we are unable to raise capital when needed or on attractive terms, we could be forced to delay, reduce or eliminate our research and development programs or any future commercialization efforts.\nWe expect our cash resources to fund our current operating plan through at least the next twelve months from the filing of this Quarterly Report on Form 10-Q. However, our operating plan includes assumptions pertaining to cost avoidance measures and the reduction of overhead costs that would result from the planned amendment of contractual arrangements with certain supply and collaboration partners, and the reduction of operating expenses. If we are not able to execute any of the planned amendments of contractual arrangements with certain supply and collaboration partners, or to reduce our operating expenses, our cash resources may be inadequate to support our operations for a period through at least the next twelve months from the date of issuance of these financial statements. In addition, if we fail to satisfy any of the covenants under our Loan Agreement with Pharmakon, including the covenant that our Annual Report on Form 10-K for the fiscal year ending December 31, 2022 not be qualified as to going concern, and the loan is accelerated, we may not have sufficient resources to fund our operating plan through the next twelve months. There can be no assurance that the current operating plan will be achieved in the time frame anticipated by us, or that our cash resources will fund our operating plan for the period anticipated by us or that additional funding will be available on terms acceptable to us, or at all.\nAny additional fundraising efforts may divert our management’s attention away from their day-to-day activities, which may adversely affect our ability to develop and commercialize Auryxia and any other products or product candidates, including those that may be in-licensed or acquired, or to continue to seek regulatory approval for vadadustat. Also, additional funds may not be available to us in sufficient amounts or on acceptable terms or at all. If we are unable to raise additional capital in sufficient amounts when needed or on terms acceptable to us, we may have to significantly delay, scale back or discontinue the development and/or commercialization of Auryxia and any other products or product candidates, including those that may be in-licensed or acquired, or to take any actions with respect to vadadustat depending on future decisions with respect to vadadustat in the U.S. Any of these events could significantly harm our business, financial condition and prospects.\nOur independent registered public accounting firm included an explanatory paragraph relating to our ability to continue as a going concern in its report on our audited financial statements included in our Annual Report on Form 10-K and any future concerns relating to our ability to continue as a going concern would materially adversely affect us.\nWe believe that our cash resources will be sufficient to fund our current operating plan through at least the next twelve months from the filing of this Quarterly Report on Form 10-Q. However, there were conditions or events, considered in the aggregate, that raised substantial doubt about our ability to continue as a going concern within twelve months after the date the financial statements for December 31, 2021 were issued and certain elements of our operating plan were outside of our control at that time and continue to be outside of our control. In addition, as of the date of the financial statements included in this Quarterly Report on Form 10-Q, our operating plan includes assumptions pertaining to cost avoidance measures and the reduction of overhead costs that would result from the planned amendment of contractual arrangements with certain supply and collaboration partners, and the reduction of operating expenses. Because these cost avoidance measures and certain other elements of our operating plan are outside of our control, there is uncertainty as to whether our cash resources will be adequate to support our operations for a period through at least the next twelve months from the date of issuance of the financial statements included in this Quarterly Report on Form 10-Q. These conditions raise substantial doubt regarding our ability to continue as a going concern for a period of one year after the date these financial statements are issued. In the event we are not able to continue as a going concern, our business would be materially impacted. See Note 1 to our consolidated financial statements appearing elsewhere in our 2021 Annual Report on Form 10-K and Note 1 to this Quarterly Report on Form 10-Q,\n58\nas applicable, for additional information on our assessments. Future concerns relating to our ability to continue as a going concern, could have a material adverse affect on us.\nIf we are unable to manage our spending, generate sufficient product revenue from sales of Auryxia, or otherwise obtain sufficient funding, our business, prospects, financial condition and results of operations will be materially and adversely affected and we may be unable to continue as a going concern. If we are unable to continue as a going concern, we may have to liquidate our assets and may receive less than the value at which those assets are carried on our audited financial statements, and it is likely that investors will lose all or a part of their investment. If we seek additional financing to fund our business activities in the future and there remains substantial doubt about our ability to continue as a going concern, investors or other financing sources may be unwilling to provide additional funding to us on commercially reasonable terms or at all. There can be no assurance that the current operating plan will be achieved in the time frame anticipated by us, or that our cash resources will fund our operating plan for the period we anticipate or that additional funding will be available on terms acceptable to us, or at all.\nPursuant to covenants in the Loan Agreement, as amended by the First Amendment and Waiver and the Second Amendment and Waiver, our Annual Reports on Form 10-K, must not be subject to any qualification as to going concern. If we do not satisfy the covenant as to going concern in any of the required filings, we will be in default under the Loan Agreement. If an event of default occurs and is continuing under the Loan Agreement, the Collateral Agent is entitled to take enforcement action, including acceleration of amounts due under the Loan Agreement, and we may not have the available cash resources to repay at such time. If we are required to repay additional amounts due under the Loan Agreement earlier than anticipated, it would have a material adverse effect on our business, results of operations and financial condition.\nRaising additional capital may cause dilution to our existing stockholders, restrict our operations or require us to relinquish rights to our product and product candidates on unfavorable terms to us.\nWe expect to finance future cash needs through product revenue, royalty transactions, strategic transactions, public or private equity or debt transactions, or a combination of these approaches. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the ownership interests of our common stockholders will be diluted, our fixed payment obligations may increase, any such securities may have rights senior to those of our common stock, and the terms may include liquidation or other preferences and anti-dilution protections that adversely affect the rights of our common stockholders. Additional debt financing, if available, may involve agreements that would restrict our operations and potentially impair our competitiveness, such as limitations on our ability to incur additional debt, make capital expenditures, declare dividends, acquire, sell or license intellectual property rights, and other operating restrictions that could adversely impact our ability to conduct our business. If we raise additional funds through royalty transactions, we may have to relinquish valuable rights to our portfolio and future revenue streams, and enter into agreements that would restrict our operations and strategic flexibility. If we raise additional funds through strategic transactions with third parties, we may have to do so at an earlier stage than otherwise would be desirable. In connection with any such strategic transactions, we may be required to relinquish valuable rights to our product and product candidates, future revenue streams or research programs or grant licenses on terms that are not favorable to us. If we are unable to raise additional funds when needed, we may not be able to pursue planned development and commercialization activities and we may need to grant rights to develop and market product candidates that we would otherwise prefer to develop and market ourselves.\nIf we fail to regain compliance with the continued listing requirements of Nasdaq, our common stock may be delisted and the price of our common stock and our ability to access the capital markets could be negatively impacted.\nOn May 12, 2022, we received a deficiency letter from the Listing Qualifications Department of the Nasdaq Stock Market, or Nasdaq, notifying us that, for the last 30 consecutive business days, the bid price for our common stock had closed below the minimum $1.00 per share requirement for continued inclusion on the Nasdaq Global Market, referred to as the minimum bid price rule. In accordance with Nasdaq Listing Rules, we have an initial period of 180 calendar days, or until November 8, 2022, to regain compliance with the minimum bid price rule.\nTo date, we have not regained compliance with the minimum bid price rule. However, we have applied to transfer the listing of our common stock to the Nasdaq Capital Market. If the application is approved, then we may be eligible for an additional 180 day compliance period. However, there can be no assurance that we will satisfy the continued listing requirement for the market value of publicly held shares and all other initial listing standards for the Nasdaq Capital Market, with the exception of the minimum bid price requirement, and as such, we may not be eligible for the additional 180 day compliance period. If we are successful in transferring the listing of our common stock to the Nasdaq Capital Market and at any time during any additional compliance period the bid price for our common stock closes at $1.00 or more per share for a minimum of 10 consecutive business days, the Nasdaq Listing Qualifications Department staff will provide written notification to us that we are in compliance with the minimum bid price rule, unless the staff exercises its discretion to extend this 10-day period pursuant to the Nasdaq Listing Rules.\n59\nIf we do not regain compliance with the minimum bid price rule by the required date and we are not eligible for any additional compliance period at that time, the Nasdaq Listing Qualifications Department staff will provide us written notification that our common stock may be delisted. At that time, we may appeal the staff’s delisting determination to a Nasdaq Listing Qualifications Panel. We expect that our common stock would remain listed pending the panel’s decision. However, there can be no assurance that, even if we appeal the staff’s delisting determination to the Nasdaq Listing Qualifications Panel, such appeal would be successful.\nWe intend to monitor the closing bid price of our common stock and may, if appropriate, consider available options to regain compliance with the minimum bid price rule, which could include seeking to effect a reverse stock split. However, there can be no assurance that we will be able to regain compliance with the minimum bid price rule.\nThere are many factors that may adversely affect our minimum bid price, including those described throughout this section titled “Risk Factors.” Many of these factors are outside of our control. As a result, we may not be able to sustain compliance with the minimum bid price rule in the long term. Any potential delisting of our common stock from the Nasdaq Global Market would likely result in decreased liquidity and increased volatility for our common stock and would adversely affect our ability to raise additional capital or to enter into strategic transactions. Any potential delisting of our common stock from the Nasdaq Global Market would also make it more difficult for our stockholders to sell our common stock in the public market.\nWe may not be successful in our efforts to identify, acquire, in-license, discover, develop and commercialize additional products or product candidates or our decisions to prioritize the development of certain product candidates over others may not be successful, which could impair our ability to grow.\nAlthough we continue to focus a substantial amount of our efforts on the commercialization of Auryxia and in the event our FDRR is accepted by the FDA, to pursue our appeal for vadadustat in the U.S. with the FDA, including through the appeal process, a key element of our long-term growth strategy is to develop additional product candidates and acquire, in-license, develop and/or market additional products and product candidates.\nResearch programs to identify product candidates require substantial technical, financial and human resources, regardless of whether product candidates are ultimately identified. Our research and development programs may initially show promise, yet fail to yield product candidates for clinical development or commercialization for many reasons, including the following:\n•the research methodology used may not be successful in identifying potential indications and/or product candidates;\n•we may not be able or willing to assemble sufficient resources to acquire or discover additional product candidates;\n•a product candidate may be shown to have harmful side effects, a lack of efficacy or other characteristics that indicate that they are unlikely to be drugs that will receive marketing approval and/or achieve market acceptance;\n•a product candidate we develop and seek regulatory approval for, including vadadustat, may not be approved by the FDA on a timely basis, or at all;\n•product candidates we develop may nevertheless be covered by third party patents or other exclusive rights;\n•the market for a product candidate may change during our program so that the continued development of that product candidate is no longer commercially reasonable;\n•a product candidate may not be capable of being produced in commercial quantities at an acceptable cost, or at all; or\n•a product candidate may not be accepted as safe and effective by patients, the medical community, or third party payors, if applicable.\nIf any of these events occur, we may be forced to abandon our research and development efforts for one or more of our programs, or we may not be able to identify, discover, develop or commercialize additional product candidates, which may have a material adverse effect on our business.\nBecause we have limited financial and managerial resources, especially as a result of the CRL for vadadustat that we received in March 2022 and the reduction in workforce that we implemented in April and May 2022, we focus on products, research programs and product candidates for specific indications. As a result, we may forgo or delay pursuit of opportunities with other product candidates or for other indications, or out license rights to product candidates, that later prove to have greater commercial potential. For example, as a result of receipt of the CRL and implementation of the reduction in workforce, we delayed certain research activities. Our resource allocation decisions may cause us to fail to capitalize on viable commercial products or profitable market opportunities. Our spending on current and future research and development programs and product candidates for specific indications may not yield any commercially viable products.\nBecause our internal research capabilities are limited, we may be dependent upon other pharmaceutical and biotechnology companies, academic scientists, and other researchers to sell or license product candidates, products or technology to us. The success of this strategy depends partly upon our ability to identify, select, and acquire promising product candidates and products. The process of identifying, selecting, negotiating and implementing a license or acquisition of a product candidate or an approved product is lengthy and complex. Other companies, including some with substantially greater financial, marketing\n60\nand sales resources, may compete with us for the license or acquisition of a product candidate or an approved product. We have limited resources to identify and execute the acquisition or in-licensing of third party products, businesses, and technologies and integrate them into our current infrastructure.\nMoreover, we may devote resources to potential acquisitions or in-licensing opportunities that are never completed, or we may fail to realize the anticipated benefits of such efforts. Any product candidate that we acquire may require additional development efforts prior to commercial sale, including extensive clinical testing and approval by the FDA, the EMA, the Japanese Pharmaceuticals and Medical Devices Agency, or PMDA, or other regulatory authorities, or post-approval testing or other requirements if approved. All product candidates are prone to risks of failure typical of pharmaceutical product development, including the possibility that a product candidate will not be shown to be sufficiently safe and effective for approval by regulatory authorities. In addition, we cannot provide assurance that any of our products will be manufactured profitably, achieve market acceptance or not require substantial post-marketing clinical trials.\nAccordingly, there can be no assurance that we will ever be able to identify, acquire, in-license or develop suitable additional products or product candidates, which could materially adversely affect our future growth and prospects. We may focus our efforts and resources on potential products, product candidates or other programs that ultimately prove to be unsuccessful.\nWe may engage in strategic transactions to acquire assets, businesses, or rights to products, product candidates or technologies or form collaborations or make investments in other companies or technologies that could harm our operating results, dilute our stockholders’ ownership, increase our debt, or cause us to incur significant expense.\nAs part of our business strategy, we may engage in additional strategic transactions to expand and diversify our portfolio, including through the merger, acquisition or in-license of assets, businesses, or rights to products, product candidates or technologies or through strategic alliances or collaborations, similar to the Merger and our existing and prior collaboration and license arrangements. We may not identify suitable strategic transactions, or complete such transactions in a timely manner, on favorable terms, on a cost-effective basis, or at all. Moreover, we may devote resources to potential opportunities that are never completed or we may incorrectly judge the value or worth of such opportunities. Even if we successfully execute a strategic transaction, we may not be able to realize the anticipated benefits of such transaction and may experience losses related to our investments in such transactions. Integration of an acquired company or assets into our existing business may not be successful and may disrupt ongoing operations, require the hiring of additional personnel and the implementation and integration of additional internal systems and infrastructure, and require management resources that would otherwise focus on developing our existing business. Even if we are able to achieve the long-term benefits of a strategic transaction, our expenses and short-term costs may increase materially and adversely affect our liquidity. Any of the foregoing could have a detrimental effect on our business, results of operations and financial condition. For example, on June 4, 2021, we entered into a license agreement, the Cyclerion Agreement, with Cyclerion Therapeutics Inc., or Cyclerion, pursuant to which Cyclerion granted us an exclusive global license under certain intellectual property rights to research, develop and commercialize praliciguat, an investigational oral soluble guanylate cyclase, or sGC, stimulator. Although we have progressed pre-clinical studies for praliciguat, we may be unsuccessful in developing praliciguat. If any of the assumptions that we made in valuing the transaction, including the costs or timing of development of, or the potential benefits of, praliciguat, were incorrect, we may not recognize the anticipated benefits of the transaction and our business could be harmed.\nIn addition, future transactions may entail numerous operational, financial and legal risks, including:\n•incurring substantial debt, dilutive issuances of securities or depletion of cash to pay for acquisitions;\n•exposure to known and unknown liabilities, including contingent liabilities, possible intellectual property infringement claims, violations of laws, tax liabilities and commercial disputes;\n•higher than expected acquisition and integration costs;\n•difficulty in integrating operations, processes, systems and personnel of any acquired business;\n•increased amortization expenses or, in the case of a write-down of the value of acquired assets, impairment losses, such as the Auryxia intangible asset impairment in the second quarter of 2020 and corresponding adjustments to the estimated useful life of the developed product rights for Auryxia;\n•impairment of relationships with key suppliers or customers of any acquired business due to changes in management and ownership;\n•inability to retain personnel, customers, distributors, vendors and other business partners integral to an in-licensed or acquired product, product candidate or technology;\n•potential failure of the due diligence processes to identify significant problems, liabilities or other shortcomings or challenges;\n•entry into indications or markets in which we have no or limited development or commercial experience and where competitors in such markets have stronger market positions; and\n61\n•other challenges associated with managing an increasingly diversified business.\nIf we are unable to successfully manage any transaction in which we may engage, our ability to develop new products and continue to expand and diversify our portfolio may be limited.\nOur business has been and may continue to be, directly or indirectly, adversely affected by the COVID-19 pandemic.\nThe COVID-19 pandemic has presented a substantial public health and economic challenge around the world and continues to affect our employees, patients, healthcare providers with whom we interact, customers, collaboration partners, contract research organizations, or CROs, our contract manufacturing organizations, or CMOs, vendors, communities and business operations. The full extent to which the COVID-19 pandemic will directly or indirectly impact our business, results of operations and financial condition continues to depend on future developments that are highly uncertain and cannot be accurately predicted, including new information that may emerge concerning the COVID-19 pandemic, any resurgences or variants of COVID-19, the actions taken to contain it or treat its impact and the economic and other impacts on local, regional, national and international markets where the healthcare providers with whom we interact, our partners, our CROs, our CMOs, and our other vendors operate.\nWe believe our revenue growth was negatively impacted by the COVID-19 pandemic in 2021 and the first three quarters of 2022 primarily as the CKD patient populations that we serve experienced both high hospitalization and mortality rates due to COVID-19, and the pandemic had an adverse impact on the phosphate binder market in which Auryxia competes. Labor shortages and costs have adversely impacted dialysis providers. These impacts have refocused clinical efforts in addressing bone and mineral disorders like hyperphosphatemia to more acute operational issues to ensure patients receive dialysis treatments and still some patients have been rescheduled or missed treatments due to labor shortages. We believe, this and potentially other factors, has led to the reduction in the phosphate binder market, which has not experienced growth since early 2020. While we are unable to quantify the impact of the COVID-19 pandemic on future revenues and revenue growth, the COVID-19 pandemic and the ongoing impacts from the COVID-19 pandemic continue to adversely and disproportionately impact CKD patients and the phosphate binder market; therefore, we expect the COVID-19 pandemic and the ongoing impacts from the pandemic to continue to have a negative impact on our revenue growth for the foreseeable future.\nAs a result of the COVID-19 pandemic, we adopted a flexible workplace policy allowing employees to work from home on a full or part-time basis, which may make it difficult for us to maintain our corporate culture or retain employees. Moreover, our future success substantially depends on the management skills of our executives and certain other key employees. The unanticipated loss or unavailability of key employees due to the pandemic could harm our ability to operate our business or execute our business strategy, and we may not be successful in finding and integrating suitable successors in the event any of our key employees leave or are unavailable. This could have an adverse effect on our business, results of operations and cash flows.\nIn addition, several healthcare facilities have previously restricted access for non-patients, including the members of our sales force. For example, DaVita, Inc., or DaVita, and Fresenius Medical Care, or Fresenius, which account for a vast majority of the dialysis population in the United States, have previously restricted access to their clinics. As a result, we continue to engage with some healthcare providers and other customers virtually, where possible. The restrictions on our customer-facing employees’ in-person interactions with healthcare providers have, and could continue to, negatively impact our access to healthcare providers and, ultimately, our sales, including with respect to vadadustat, if approved. Recently, such precautionary measures have been relaxed at certain healthcare facilities and, as a result, members of our sales force have resumed in person interactions with certain customers. Nevertheless, some restrictions remain, and more restrictions may be put in place again due to a resurgence in COVID-19 cases, including those involving new variants of COVID-19, which may be more contagious and more severe than prior strains of the virus. Given this uncertain environment and the disproportionate impact of the COVID-19 pandemic on CKD patients, we are actively monitoring the demand in the United States for Auryxia and will be for vadadustat, if approved, including the potential for further declines or changes in prescription trends and customer orders, which could have a material adverse effect on our business, results of operations, and financial condition.\nIn addition, the direct and indirect impacts of the pandemic or the response efforts to the pandemic, including, among others, competition for labor and resources and increases in labor, sourcing, manufacturing and shipping costs, may cause disruptions to, closures of or other impacts on our CMOs and other vendors in our supply chain on which we rely for the supply of our products and product candidates. For example, areas of China have recently continued to implement lockdowns for COVID-19, which could impact the global supply chain. At this time, our CMOs continue to operate at or near normal levels. However, it is possible that the COVID-19 pandemic and response efforts may have an impact in the future on our contract manufacturers’ ability to manufacture and deliver Auryxia and vadadustat (if approved in the United States or EMA and which is currently marketed under the trade name VafseoTM by MTPC in Japan), which may result in increased costs and delays, or disruptions to the manufacturing and supply of our products. These impacts could have a negative effect on our inventory reserves, which could result in an increase in inventory write-offs due to expiry.\n62\nOutside of the impacts to our clinical trials as a result of the CRL, the pandemic has resulted in closures of and may continue to impact clinical trial sites on which we rely and will rely on in the future for the completion of certain clinical trials. COVID-19 pandemic precautions have caused moderate delays in enrolling new clinical trials and may cause delays in enrolling future clinical trials. Further, the pandemic has impacted and is likely to continue to impact the business of the FDA, the EMA and other government authorities, which potentially could result in delays in meetings, reviews, inspections and approvals relating to our product and product candidates. Any decision by the FDA, EMA or other governmental authorities to delay meeting with us or our collaboration partners or delay scheduling inspections in light of the COVID-19 pandemic could have a material adverse effect on clinical trials of our product candidates or on our efforts to obtain marketing approvals for vadadustat, which could increase our operating expenses and have a material adverse effect on our financial results, including the timing and amount of future regulatory milestones we could receive from our collaboration partners.\nIf we or any of the third parties with whom we engage, including our collaboration partners, or any of our customers were to experience further shutdowns, delays or other business disruptions, our ability to conduct our business in the manner and on the timelines presently planned, and our revenue expectations, could be materially and negatively impacted, which could have a material adverse effect on our business and our financial results.\nThe COVID-19 pandemic may continue to significantly impact economies and financial markets worldwide, which could result in adverse effects on our business and operations, impact our ability to raise additional funds and impact the volatility of our stock price and trading in our stock. Even after the COVID-19 pandemic has been contained or mitigated, we may continue to experience adverse impacts to our business as a result of any economic recession or depression that has occurred or may occur in the future.\nThe global impact of the COVID-19 pandemic continues to rapidly evolve, and we will continue to monitor the situation closely. In particular, areas we are monitoring include possible COVID-related changes in our commercial revenue payor mix, overall product sales, and reserves and allowances, as well as negative trends that could potentially have a further significant impact on product demand and, ultimately, product revenue, or could cause goodwill, intangible assets, and other assets to be impaired. This uncertain pandemic environment has presented new risks to our business. While we are working to mitigate the impacts on our business, we are mindful that many of these risks and the impact to the larger healthcare market are outside of our control. The extent to which the COVID-19 pandemic impacts our business will depend on future developments, which are highly uncertain and the magnitude of which cannot be predicted, including new information that may emerge concerning the severity of COVID-19 and the actions to contain COVID-19, and the effectiveness of vaccines against virus variants.\nRisks Related to our Financial Arrangements\nOur obligations in connection with the loan agreement with Pharmakon and requirements and restrictions in the loan agreement could adversely affect our financial condition and restrict our operations.\nWe entered into the Loan Agreement with Pharmakon, pursuant to which the Term Loans were made available to us in two tranches. The first tranche of $80.0 million closed on November 25, 2019, and the second tranche of $20.0 million closed on December 10, 2020. See Note 11 to our condensed consolidated financial statements in Part I, Item 1. Financial Statements of this Quarterly Report on Form 10-Q for additional information regarding our obligations under the Loan Agreement.\nThe Loan Agreement contains affirmative and negative covenants applicable to us and our subsidiaries, including maintaining, on an annual basis, a minimum liquidity threshold, which started in 2021, and on a quarterly basis, a minimum net sales threshold for Auryxia, which started in the fourth quarter of 2020. In addition, the Loan Agreement contains covenants that our Annual Reports on Form 10-K, must not be subject to any qualification as to going concern. Failure to maintain compliance with these or other covenants would result in an event of default under the Loan Agreement, which could result in enforcement action, including acceleration of amounts due under the Loan Agreement. Additionally, the liabilities under the Loan Agreement will be accelerated, subject to certain exceptions, if we are required to repay to Vifor Pharma all or a part of the working capital facility established in connection with the Second Amended and Restated License Agreement that we entered into with Vifor Pharma, in February 2022, or the Vifor Second Amended Agreement, as a result of certain terminations of the Vifor Second Amended Agreement or due to a reduction in the balance of the working capital facility by more than a prespecified amount.\nIn the event there is an acceleration of our and certain of our subsidiaries’ liabilities under the Loan Agreement as a result of an event of default or otherwise, we may not have sufficient funds or may be unable to arrange for additional financing to repay the liabilities or to make any accelerated payments, and Pharmakon could seek to enforce security interests in the collateral securing the Loan Agreement and our guarantee of the Term Loans, which would have a material adverse effect on our business, financial condition and results of operations.\n63\nThe Loan Agreement permits voluntary prepayment at any time in whole or in part, subject to prepayment premiums and make-whole premiums prior to certain dates. We made a voluntary prepayment of $25.0 million, including $0.5 million of prepayment penalties on July 15, 2022, pursuant to the Second Amendment and Waiver. This represented the repayment of $5.0 million of the first tranche and the full $20.0 million of the second tranche. Upon a change of control, mandatory prepayment provisions require us to prepay the principal amount outstanding, the applicable prepayment premium and make-whole premium and accrued and unpaid interest. In addition, our obligations in connection with the Loan Agreement could have additional significant adverse consequences, including, among other things:\n•restricting our activities, including limitations on transferring certain of our assets, engaging in certain transactions, terminating certain agreements, including the Vifor Second Amended Agreement, incurring certain additional indebtedness, creating certain liens, paying dividends or making certain other distributions and investments;\n•limiting our flexibility in planning for, or reacting to, changes in our business and our industry;\n•placing us at a possible competitive disadvantage compared to our competitors who have a smaller amount of debt or competitors with comparable debt at more favorable interest rates; and\n•limiting our ability to borrow additional amounts for working capital, capital expenditures, research and development efforts, acquisitions, debt service requirements, execution of our business strategy and other purposes.\nAny of these factors could materially and adversely affect our business, financial condition and results of operations.\nOur Royalty Interest Acquisition Agreement with HealthCare Royalty Partners IV, L.P. contains various covenants and other provisions, which, if violated, could materially adversely affect our financial condition.\nOn February 25, 2021, we entered into a royalty interest acquisition agreement, or the Royalty Agreement, with HealthCare Royalty Partners IV, L.P., or HCR, pursuant to which we sold to HCR our right to the to receive royalties and sales milestones for vadadustat, collectively the Royalty Interest Payments, in each case, payable to us under our Collaboration Agreement dated December 11, 2015, or the MTPC Agreement, with Mitsubishi Tanabe Pharma Corporation, or MTPC, subject to an annual maximum “cap” of $13.0 million, or the Annual Cap, and an aggregate maximum “cap” of $150.0 million, or the Aggregate Cap. Under the Royalty Agreement, we are required to comply with various covenants, including obligations to take certain actions, such as actions with respect to the Royalty Interest Payments, the MTPC Agreement, our agreement with MTPC for the commercial supply of vadadustat drug product, and our intellectual property. In addition, the Royalty Agreement includes customary events of default upon the occurrence of enumerated events, including failure to perform certain covenants and the occurrence of insolvency events. In the event we violate certain covenants and other provisions, we may not receive sales milestones from HCR even if the applicable sales thresholds are met. Upon the occurrence of an event of default, HCR would have the ability to exercise all available remedies in law and equity, which could have a material adverse effect on our financial condition.\nRisks Related to Commercialization\nOur business is substantially dependent on the commercial success of Auryxia. If we are unable to continue to successfully commercialize Auryxia, our results or operations and financial condition will be materially harmed.\nOur business and our ability to generate product revenue largely depend on our, and our collaborators’, ability to successfully commercialize Auryxia. Our ability to generate revenue depends on our ability to execute on our commercialization plans, and the size of the market for, and the level of market acceptance of, Auryxia and any other product or product candidate, including those that may be in-licensed or acquired. If the size of any market for which a product or product candidate is approved decreases or is smaller than we anticipate, our revenue and results of operations could be materially adversely affected. For example, the phosphate binder market declined since 2020, which we believe was partially a result of the COVID-19 pandemic. If the phosphate market does not recover or continues to decline, our revenue from Auyxia could be materially adversely affected.\nMarket acceptance is critical to our ability to generate significant product revenue. Any product may achieve only limited market acceptance or none at all. If Auryxia, or any of our product candidates that is approved, is not accepted by the market to the extent that we expect or market acceptance decreases, we may not be able to generate significant product revenue and our business would be materially harmed. Market acceptance of Auryxia or any other approved product depends on a number of factors, including:\n•the availability of adequate coverage and reimbursement by and the availability of discounts, rebates and price concessions from third party payors, pharmacy benefit managers, or PBMs, and governmental authorities;\n•the safety and efficacy of the product, as demonstrated in clinical trials and in the post-marketing setting;\n64\n•the prevalence and complications of the disease treated by the product;\n•the clinical indications for which the product is approved and the product label approved by regulatory authorities, including any warnings or limitations that may be required on the label as a consequence of potential safety risks associated with the product;\n•the countries in which marketing approvals are obtained;\n•the claims we and our collaborators are able to make regarding the safety and efficacy of the product;\n•the success of our physician and patient communications and education programs;\n•acceptance by physicians and patients of the product as a safe and effective treatment and the willingness of the target patient population to try new therapies and of physicians to prescribe new therapies;\n•the cost, safety and efficacy of the product in relation to alternative treatments;\n•the timing of receipt of marketing approvals and product launch relative to competing products and potential generic entrants;\n•relative convenience and ease of administration;\n•the frequency and severity of adverse side effects;\n•favorable or adverse publicity about our products or favorable or adverse publicity about competing products;\n•the effectiveness of our and our collaborators’ sales, marketing and distribution efforts; and\n•the restrictions on the use of the product together with other medications, if any.\nIf we are unable to maintain or expand, or, if vadadustat is approved, initiate, sales and marketing capabilities or enter into additional agreements with third parties, we may not be successful in commercializing Auryxia, vadadustat, if approved, or any other product candidates that may be approved.\nIn order to market Auryxia and any other approved product, we intend to continue to invest in sales and marketing, which will require substantial effort and significant management and financial resources. We have built a commercial infrastructure and sales force in the United States for Auryxia, our first commercial product. However, following receipt of the CRL, in April and May 2022, we implemented a reduction of our workforce by approximately 42% across all areas of the Company (47% inclusive of the closing of the majority of open positions), including several members of management. If the remaining sales and marketing team cannot successfully commercialize Auryxia, or if additional sales and marketing employees decide to leave as a result of the reduction in workforce or otherwise, it could have a material adverse effect on Auryxia revenue and our financial condition.\nIf we obtain regulatory approval to market vadadustat in the U.S., we believe that we can leverage the current commercial foundation for vadadustat in the U.S., but if we are unable to do so successfully this would materially harm our business. Additionally, training a sales force to successfully sell and market a new commercial product is expensive and time-consuming and could delay any commercial launch of such product candidate. We may underestimate the size of the sales force required for a successful product launch and we may need to expand our sales force earlier and at a higher cost than we anticipated. In 2021 and early 2022, we incurred commercialization expenses for vadadustat that were premature or unnecessary as a result of the receipt of the CRL for vadadustat, and may in the future incur additional commercialization expenses prematurely or unnecessarily if we do not receive marketing approval in the timeframe we expect, or at all, we may have prematurely or unnecessarily incurred commercialization expenses.\nWe devote significant effort, in particular, to recruiting individuals with experience in the sales and marketing of pharmaceutical products. Competition for personnel with these skills is significant and retaining qualified personnel with experience in our industry is difficult. Further, the continuing or recurring restrictions placed on recruiting, training and retention as a result of the COVID-19 pandemic and our recent reduction in workforce may further exacerbate these conditions and interfere with our ability to find and retain qualified personnel. As a result, we may not be able to retain our existing employees or hire new employees quickly enough to meet our needs. At the same time, we may face high turnover, requiring us to expend time and resources to source, train and integrate new employees.\nThere are risks involved with maintaining our own sales and marketing capabilities, including the following:\n•potential inability to recruit, train and retain adequate numbers of effective sales and marketing personnel;\n•potential inability of sales personnel to obtain access to physicians, including because of restrictions due to the COVID-19 pandemic;\n•potential lack of complementary products to be offered by sales personnel, which may put us at a competitive disadvantage relative to companies with more extensive product lines, especially as a result of the receipt of the CRL for vadadustat; and\n•costs and expenses associated with maintaining our own sales and marketing organization.\n65\nIf we are unable to maintain our own sales and marketing capabilities, we will not be successful in commercializing Auryxia, vadadustat, if approved, and any other product candidate that may be approved.\nFurthermore, if we are unable to maintain our arrangements with third parties with respect to sales and marketing, if we are unsuccessful in entering into additional arrangements with third parties to sell and market our products or we are unable to do so on terms that are favorable to us, or if such third parties are unable to carry out their obligations under such arrangements, it will be difficult to successfully commercialize our product and product candidates, including vadadustat, if approved. For example, if in connection with the Vifor Second Amended Agreement, we experience difficulties with Vifor Pharma, or if Vifor Pharma experiences difficulties with other parties to whom it expects to sell vadadustat, if approved, our ability to commercialize vadadustat, if approved, will be severely hindered and our business operations will be materially harmed.\nOur, or our partners', failure to obtain or maintain adequate coverage, pricing and reimbursement for Auryxia, vadadustat, if approved, or any other future approved products, could have a material adverse effect on our or our collaboration partners’ ability to sell such approved products profitably and otherwise have a material adverse impact on our business.\nMarket acceptance and sales of any approved products, including Auryxia and, if approved, vadadustat, depends significantly on the availability of adequate coverage and reimbursement from third party payors and may be affected by existing and future healthcare reform measures. Governmental authorities, third party payors, and PBMs decide which drugs they will cover, as well as establish formularies or implement other mechanisms to manage utilization of products and determine reimbursement levels. We cannot be sure that coverage or adequate reimbursement will be available for Auryxia, vadadustat, if approved, or any of our potential future products. Even if we obtain coverage for an approved product, third party payors may not establish adequate reimbursement amounts, which may reduce the demand for our product and prompt us to have to reduce pricing for the product. If reimbursement is not available or is limited, we may not be able to commercialize certain of our products. Coverage and reimbursement by a governmental authority, third-party payor or PBM may depend upon a number of factors, including the determination that use of a product is:\n•a covered benefit under the health plan;\n•safe, effective and medically necessary;\n•appropriate for the specific patient; and\n•cost effective.\nObtaining coverage and reimbursement approval for a product from a governmental authority, PBM or a third-party payor is a time consuming and costly process that could require us to provide supporting scientific, clinical and cost-effectiveness data for the use of our products to the payor. In the United States, there are multiple governmental authorities, PBMs and third-party payors with varying coverage and reimbursement levels for pharmaceutical products, and the timing of commencement of reimbursement by a governmental payor can be dependent on the assignment of codes via the Healthcare Common Procedural Coding System, which codes are assigned on a quarterly basis. Within Medicare, for oral drugs dispensed by pharmacies and also administered in facilities, coverage and reimbursement may vary depending on the setting. CMS, local Medicare administrative contractors, Medicare Part D plans and/or PBMs operating on behalf of Medicare Part D plans, may have some responsibility for determining the medical necessity of such drugs, and therefore coverage, for different patients. Different reimbursement methodologies may apply, and CMS may have some discretion in interpreting their application in certain settings.\nAs an oral drug, Auryxia is covered by Medicare under Part D. However, in September 2018, CMS decided that Auryxia would no longer be covered by Medicare for the treatment of iron deficiency anemia, or IDA, in adult patients with NDD-CKD, or the CMS Decision. While this decision does not impact CMS coverage for the control of serum phosphorus levels in adult patients with DD-CKD, or the Hyperphosphatemia Indication, it requires Part D plan sponsors to impose prior authorization or other steps to ensure that Auryxia is reimbursed only for the Hyperphosphatemia Indication. While we believe that the vast majority of the Medicare prescriptions written for Auryxia today are for the Hyperphosphatemia Indication and therefore will continue to be covered by Medicare with prior authorization, the CMS Decision has had and will continue to have an adverse impact on the sales and future growth of Auryxia for the Hyperphosphatemia Indication and the IDA Indication. For example, in the second quarter of 2020, we reduced our short-term and long-term Auryxia revenue forecast, primarily driven by the compounding impact of the CMS Decision. As a result, we recorded an impairment charge of $115.5 million to the Auryxia intangible asset associated with the developed product rights for Auryxia during the three months ended June 30, 2020.\nMedicaid reimbursement of drugs varies by state. Private third-party payor reimbursement policies also vary and may or may not be consistent with Medicare reimbursement methodologies. Manufacturers of outpatient prescription drugs may be required to provide discounts or rebates under government healthcare programs or to certain third-party payors in order to obtain coverage of such products.\n66\nAdditionally, we may be required to enter into contracts with third party payors and/or PBMs offering rebates or discounts on our products in order to obtain favorable formulary status and we may not be able to agree upon commercially reasonable terms with such third party payors or PBMs, or provide data sufficient to obtain favorable coverage and reimbursement for many reasons, including that we may be at a competitive disadvantage relative to companies with more extensive product lines. In addition, third party payors, PBMs and other entities that purchase our products may impose restrictions on our ability to raise prices for our products over time without incurring additional costs. Four distributors, Fresenius Medical Care Rx, McKesson Corporation, Cardinal Health, Inc. and Amerisource Bergen Drug Corporation, in the aggregate, accounted for a significant percentage of our gross accounts receivable as of September 30, 2022. If we are not able to maintain our arrangements with these key distributors on favorable terms, on a timely basis or at all, or if there is any adverse change in one or more of these distributors’ business practices or financial condition, it would adversely impact the market opportunity for Auryxia, our product revenues and operating results.\nFurthermore, vadadustat was approved in Japan for the treatment of adult patients with anemia due to CKD and is being marketed by MTPC in Japan under the trade name VafseoTM. Pricing and reimbursement strategy is a key component of MTPC’s commercialization plans for Vafseo in Japan. If coverage and reimbursement terms change, MTPC may not be able to, or may decide not to, continue commercialization of Vafseo in Japan.\nAlthough we currently believe it is likely that vadadustat, if approved, will be reimbursed using the Transitional Drug Add-on Payment Adjustment, or TDAPA, followed by reimbursement via the bundled reimbursement model, if vadadustat is neither reimbursed under the TDAPA nor the bundled reimbursement model, then patients would access vadadustat through contracts we negotiate with third party payors for reimbursement of vadadustat, which would be subject to the risks and uncertainties described above. Additionally, applying for and obtaining reimbursement under the TDAPA is expected to take several months following approval, which will affect adoption, uptake and product revenue for vadadustat during that time, and if there are updates to the TDAPA rule that decrease the basis for reimbursement or eligibility criteria during the transition period or if the TDAPA is eliminated, then our profitability may be adversely affected. For example, the Medicare Payment Advisory Commission, or MedPAC, an independent legislative branch advisory body to Congress on issues related to the Medicare program, has recommended that TDAPA not be provided to newly approved drug products considered to fall within “functional categories” for which costs are already accounted for in the bundled reimbursement model, such as for anemia management drugs.\nFurther, if vadadustat is approved in the United States and included in the fixed reimbursement model for a bundle of dialysis services, or the bundle, we would be required to enter into contracts to supply vadadustat to specific dialysis providers, instead of through distributors, which we believe could be challenging. The dialysis market is unique and is dominated by two providers: DaVita and Fresenius, which account for a vast majority of the dialysis population in the United States. Under the Vifor Second Amended Agreement, we granted Vifor Pharma an exclusive license to sell vadadustat to Fresenius Medical Care North America and its affiliates, including Fresenius Kidney Care Group LLC, to certain third-party dialysis organizations approved by us, to independent dialysis organizations that are members of group purchase organizations, and to certain non-retail specialty pharmacies in the United States. We refer to Fresenius Medical Care North America and its affiliates, these organizations and specialty pharmacies collectively as the “Supply Group\". See Note 4 to our consolidated financial statements in Part I, Item 1. Financial Statements of this Quarterly Report on Form 10-Q for additional information regarding the Vifor Second Amended Agreement. If vadadustat is approved and we are not able to maintain the Vifor Second Amended Agreement or enter into a supply agreement with DaVita or other dialysis clinics, our business may be materially harmed.\nSimilar to how payor coverage may affect the sales of a product, formulary status within dialysis organizations may affect what products are prescribed within that specific organization. Therefore, if a product is not on a formulary, the prescribers within that organization may be less likely to prescribe that product or may have a difficult time prescribing that product, resulting in less sales. Further, one dialysis organization’s determination to add a product to their formulary does not assure that other dialysis organizations will also add the product to theirs. There is always a risk a dialysis organization will not contract with a drug manufacturer for a specific product, resulting in that product not being on that organization’s formulary. If any dialysis organization does not add vadadustat, if approved, to the formulary, our business may be materially harmed.\nIn addition, we may be unable to sell Auryxia or vadadustat, if approved, to dialysis providers on a profitable basis if CMS significantly reduces the level of reimbursement for dialysis services and providers choose to use alternative therapies or look to re-negotiate their contracts with us. Our profitability may also be affected if our costs of production increase faster than increases in reimbursement levels. Adequate coverage and reimbursement of our products by government and private insurance plans are central to patient and provider acceptance of any products for which we receive marketing approval.\nFurther, in many countries outside the United States, a drug must be approved for reimbursement before it can be marketed or sold in that country. In some cases, the prices that we intend to charge for our products are also subject to approval. Approval by the FDA does not ensure approval by reimbursement authorities outside the United States, and approval by one\n67\nreimbursement authority outside the United States does not ensure approval by any other reimbursement authorities. However, the failure to obtain reimbursement in one jurisdiction may negatively impact our ability to obtain reimbursement in another jurisdiction. We may not be able to obtain such reimbursement approvals on a timely basis, if at all, and favorable pricing in certain countries depends on a number of factors, some of which are outside of our control.\nWe face substantial competition, which may result in others discovering, developing or commercializing products before, or more successfully than, we do.\nThe development and commercialization of new drugs is highly competitive and subject to rapid and significant technological change. Our future success depends on our ability to demonstrate and maintain a competitive advantage with respect to the development and commercialization of Auryxia, vadadustat, if approved, and any other product or product candidate, including those that may be in-licensed or acquired. Our objective is to continue to commercialize Auryxia and develop and commercialize new products with clinically proven efficacy, convenience, tolerability and/or safety. In many cases, any approved products that we commercialize will compete with existing, market-leading products.\nAuryxia is competing in the hyperphosphatemia market in the United States with other FDA-approved phosphate binders such as Renagel® (sevelamer hydrochloride) and Renvela® (sevelamer carbonate), both marketed by Sanofi, PhosLo® and Phoslyra® (calcium acetate), marketed by Fresenius Medical Care North America, Fosrenol® (lanthanum carbonate), marketed by Shire Pharmaceuticals Group plc, and Velphoro® (sucroferric oxyhydroxide), marketed by Fresenius Medical Care North America, as well as over-the-counter calcium carbonate products such as TUMS® and metal-based options such as aluminum, lanthanum and magnesium. Most of the phosphate binders listed above are now also available in generic forms. In addition, other agents are in development, including OPKO Health Inc.’s Alpharen™ Tablets (fermagate tablets) or could otherwise enter the market, including Ardelyx, Inc.’s tenapanor (which is approved in the United States for the treatment of adults with irritable bowel syndrome with constipation, but for which the FDA issued a complete response letter for with respect to the control of serum phosphorus in adult patients with CKD on dialysis), that may impact the market for Auryxia.\nAuryxia is competing in the IDA market in the United States with over-the-counter oral iron, ferrous sulfate, other prescription oral iron formulations, including ferrous gluconate, ferrous fumerate, and polysaccharide iron complex, and intravenous iron formulations, including Feraheme® (ferumoxytol injection), Venofer® (iron sucrose injection), Ferrlicit® (sodium ferric gluconate complex in sucrose injection), Injectafer® (ferric carboxymaltose injection), and Triferic® (ferric pyrophosphate citrate). In addition, other new therapies for the treatment of IDA may impact the market for Auryxia, such as Shield Therapeutics plc's Feraccru® (ferric maltol), which is available in Europe for the treatment of IDA and Accrufer® (ferric maltol), which was launched in the United States for the treatment of IDA in July 2021.\nFurthermore, Auryxia’s commercial opportunities may be reduced or eliminated if our competitors develop and market products that are less expensive, more effective, safer or offer greater patient convenience than Auryxia. Other companies have product candidates in various stages of preclinical or clinical development to treat diseases and complications of the diseases for which we are marketing Auryxia. In addition, we and Keryx’s licensors, Panion & BF Biotech, Inc., or Panion, and, as applicable, Dr. Hsu, entered into settlement agreements with each of the third parties who submitted Paragraph IV certification notice letters regarding Abbreviated New Drug Applications, or ANDAs, submitted to the FDA, pursuant to which we granted licenses to market a generic version of Auryxia in the United States beginning in March 2025 (subject to FDA approval), or earlier under certain circumstances customary for settlement agreements of this nature, which may impact our business and results of operation.\nDrugs that may compete with vadadustat include Epogen® (epoetin alfa) and Aranesp® (darbepoetin alfa), both commercialized by Amgen, Procrit® (epoetin alfa) and Eprex® (epoetin alfa), commercialized by Johnson & Johnson in the United States and Europe, respectively, and Mircera® (methoxy PEG-epoetin beta), commercialized by Vifor Pharma in the United States and Roche Holding Ltd. outside of the United States.\nWe and our partners may also face competition from potential new anemia therapies. There are several other HIF-PH inhibitor product candidates in various stages of development for anemia indications that may be in direct competition with vadadustat if and when they are approved and launched commercially. These candidates are being developed by companies such as FibroGen Inc., or FibroGen, together with its collaboration partners, Astellas Pharma Inc. and AstraZeneca PLC, Japan Tobacco International, or JT, GlaxoSmithKline plc, or GSK, and Bayer HealthCare AG, or Bayer.\nFurthermore, certain companies are developing potential new therapies for renal-related diseases that could potentially reduce injectable erythropoiesis stimulating agent, or ESA, utilization and thus limit the market potential for vadadustat if they are approved and launched commercially. Other new therapies are in development for the treatment of conditions inclusive of renal anemia that may impact the market for anemia-targeted treatment.\n68\nIn addition, in the United States, FibroGen filed an NDA for its product candidate, roxadustat, with the FDA, but the FDA issued a complete response letter indicating the FDA will not approve the NDA in its present form and requested that an additional clinical trial for roxadustat be conducted prior to resubmission of the NDA or additional response to the FDA's complete response letter. In Europe however, roxadustat is approved for the treatment of anemia in patients with CKD. Further, GSK filed an NDA for daprodustat, its product candidate for the treatment of anemia due to CKD, with the FDA in April 2022. If we obtain approval for vadadustat in the U.S., and roxadustat or daprodustat are also approved by the FDA, they will compete with vadadustat.\nIn Japan, Vafseo, which is approved for both the DD and NDD indications, competes with roxadustat, daprodustat and enarodustat. Roxadustat is approved for the treatment of anemia due to CKD in patients on dialysis, or DD-CKD, and patients not on dialysis, or NDD-CKD. In addition, daprodustat, GSK’s product candidate, and enarodustat, JT’s product candidate, are approved in Japan for the treatment of anemia due to CKD. In addition. Bayer HealthCare AG has submitted an NDA for its product candidate for the treatment of renal anemia in Japan. In China, roxadustat has launched for the treatment of anemia of DD-CKD and for the treatment of anemia due to CKD in NDD-CKD patients.\nA biosimilar is a biologic product that is approved based on demonstrating that it is highly similar to an existing, FDA-approved branded biologic product. The patents for the existing, branded biologic product must expire in a given market before biosimilars may enter that market without risk of being sued for patent infringement. In addition, an application for a biosimilar product cannot be approved by the FDA until 12 years after the existing, branded product was approved under a Biologics License Application, or BLA. The patents for epoetin alfa, an injectable ESA, expired in 2004 in the EU, and the remaining patents expired between 2012 and 2016 in the United States. Because injectable ESAs are biologic products, the introduction of biosimilars into the injectable ESA market in the United States will constitute additional competition for vadadustat if we are able to obtain approval for and commercially launch vadadustat. In the United States, Pfizer’s biosimilar version of injectable ESAs, Retacrit® (epoetin alfa-epbx), was approved by the FDA in May 2018 and launched in November 2018 and several biosimilar versions of injectable ESAs are available for sale in the EU.\nMany of our potential competitors have significantly greater financial, manufacturing, marketing, drug development, technical and human resources than we do. Large pharmaceutical companies, in particular, have extensive experience in clinical testing, obtaining marketing approvals, recruiting patients and manufacturing pharmaceutical products. Large and established companies such as Amgen and Roche, among others, compete in the market for drug products to treat kidney disease. In particular, these companies have greater experience and expertise in conducting preclinical testing and clinical trials, obtaining marketing approvals, manufacturing such products on a broad scale and marketing approved products. These companies also have significantly greater research and marketing capabilities than we do and may also have products that have been approved or are in late stages of development and have collaborative arrangements in our target markets with leading companies and research institutions. Established pharmaceutical companies may also invest heavily to accelerate discovery and development of novel compounds or to in-license novel compounds that could make the product candidates that we are developing obsolete. Smaller and other early-stage companies may also prove to be significant competitors. As a result of all of these factors, our competitors may succeed in obtaining patent protection and/or marketing approval, or discovering, developing and commercializing competitive products, before, or more effectively than, we do. If we are not able to compete effectively against potential competitors, our business will not grow and our financial condition and operations will suffer.\nThe commercialization of RionaTM and VafseoTM in Japan and our current and potential future efforts with respect to the development and commercialization of our products and product candidates outside of the United States subject us to a variety of risks associated with international operations, which could materially adversely affect our business.\nOur Japanese sublicensee, JT, and its subsidiary, Torii Pharmaceutical Co., Ltd., or Torii, commercialize Riona, the trade name for ferric citrate hydrate in Japan, as an oral treatment for the improvement of hyperphosphatemia in patients with CKD, including DD-CKD and NDD-CKD, and for the treatment of adult patients with IDA in Japan. In Japan and certain other countries in Asia, we granted MTPC exclusive rights to commercialize vadadustat, which has been approved and is being marketed by MTPC in Japan under the trade name VafseoTM.\nPursuant to the terms of the Termination Agreement with Otsuka, Otsuka has transferred to us the marketing authorization application, or MAA, for vadadustat with the EMA, and in the United Kingdom, Switzerland and Australia. In addition, we have conducted and in the future plan to conduct clinical trials outside of the United States for Auryxia, vadadustat and any other product or product candidate that may be in-licensed or acquired. As a result of these and other activities, we are or may become subject to additional risks in developing and commercializing Auryxia and vadadustat outside the United States, including, among others:\n•political, regulatory, compliance and economic developments, weakness or instability that could restrict our ability to manufacture, market and sell our products;\n•changes in international medical reimbursement policies and programs;\n69\n•changes in healthcare policies of foreign jurisdictions;\n•trade protection measures, including import or export licensing requirements and tariffs and our compliance therewith;\n•our ability to develop or manage relationships with qualified local distributors and trading companies;\n•diminished protection of intellectual property in some countries outside of the United States;\n•differing labor regulations and business practices;\n•compliance with laws, including the U.S. Foreign Corrupt Practices Act, or FCPA, the UK Bribery Act or similar local regulation, the EU General Data Protection Regulation, or GDPR, and similar data protection laws, and tax, employment, immigration and labor laws;\n•economic weakness, including inflation, or political instability in particular foreign economies and markets;\n•foreign currency fluctuations, which could result in increased operating expenses and reduced revenues, and other obligations incident to doing business in another country;\n•production shortages resulting from any events affecting raw material supply or manufacturing capabilities abroad, including as a result of the COVID-19 pandemic; and\n•business interruptions resulting from geopolitical actions, including war and terrorism, global pandemics, or natural disasters including earthquakes, typhoons, floods and fires.\nIn addition, we receive revenues from royalty payments converted to U.S. dollars based on net sales of Riona and VafseoTM in Japanese yen. The exchange rates between the Japanese yen on the one hand, and the U.S. dollar, on the other hand, have changed substantially in recent years and may fluctuate substantially in the future. Our results of operations could be adversely affected over time by certain movements in exchange rates, particularly if the Japanese yen depreciates against the U.S. dollar.\nAny of these factors may, individually or as a group, have a material adverse effect on our business and results of operations. As and if we continue to expand our commercialization efforts, we may encounter new risks.\nRisks Related to Product Development\nClinical drug development involves a lengthy and expensive process with an uncertain outcome, and we will incur additional costs in connection with, and may experience delays in completing, or ultimately be unable to complete, the development and, if approved, commercialization of vadadustat and any other product candidates.\nThe risk of failure in drug development is high. Before obtaining marketing approval from regulatory authorities for the sale of any product candidate, we must complete preclinical development and conduct extensive clinical trials to demonstrate the safety and efficacy of our product candidates in humans. Preclinical studies and clinical trials are expensive, difficult to design and implement, can take several years to complete, and their outcomes are inherently uncertain. Failure can occur at any time during the process. For example, we are currently conducting a clinical trial to evaluate three times per week oral dosing of vadadustat for dialysis dependent patients with anemia due to chronic kidney disease. If we experience delays in the conduct of this clinical trial or the results are not positive, it could affect the market potential of vadadustat, if approved.\nWe may be unable to successfully obtain approval of vadadustat or other product candidates, or to successfully complete clinical trials of Auryxia, vadadustat and other product candidates if the results of those trials and studies are not positive or are only modestly positive, or if there are concerns with the profile due to efficacy or safety. Further, the results of preclinical studies and early clinical trials of our product candidates may not be predictive of the results of later-stage clinical trials, interim results of a clinical trial do not necessarily predict final results, and results of Phase 3 clinical trials for one indication may not be predictive of results of Phase 3 clinical trials for another indication. For example, we announced positive top-line results from INNO2VATE and vadadustat achieved the primary and key secondary efficacy endpoint in each of the two PRO2TECT studies, but the PRO2TECT program did not meet the primary major adverse cardiovascular event, or MACE, safety endpoint. Many companies in the biopharmaceutical industry have suffered significant setbacks in late-stage clinical trials after achieving positive results in early-stage development, and we may face similar setbacks. Moreover, preclinical and clinical data are often susceptible to varying interpretations and analyses, and many companies that have believed their product candidates performed satisfactorily in preclinical studies and clinical trials have nonetheless failed to obtain marketing approval of their product candidates. In addition, in March 2022, we received the CRL for vadadustat indicating that the FDA had determined that it could not approve the NDA in its present form, thus delaying any potential approval of vadadustat. In July 2022, we held an end of review meeting with the FDA to inform the Company's next steps with respect to the potential U.S. approval of vadadustat, if any, and in October 2022, we submitted the FDRR to the FDA. However, it is impossible to predict when or if vadadustat or any of our other product candidates will prove effective or safe in humans or will receive marketing approval or on what terms.\nWe may experience numerous unforeseen events during, or as a result of, preclinical development or clinical trials that could delay, prevent or make more challenging our ability to receive or maintain marketing approval or commercialize our product\n70\ncandidates. We may be required to complete additional clinical trials for Auryxia, vadadustat and any other product or product candidate, including those that may be in-licensed or acquired, in order to obtain or maintain required regulatory approvals. Our preclinical studies and clinical trials may take longer to complete than currently anticipated, or may be delayed, suspended, required to be repeated, prematurely terminated or may not successfully demonstrate safety and/or efficacy needed to obtain or maintain regulatory approval for a variety of other reasons, such as:\n•the costs may be greater than we anticipate;\n•the number of patients required for clinical trials may be larger than we anticipate;\n•enrollment in our clinical trials may be slower than we anticipate, or participants may drop out of these clinical trials at a higher rate than we anticipate;\n•our third party contractors, such as our CROs, may fail to comply with regulatory requirements, perform effectively, or meet their contractual obligations to us in a timely manner, or at all, or we may fail to communicate effectively or provide the appropriate level of oversight of such third party contractors;\n•the supply or quality of our starting materials, drug substance and drug product necessary to conduct clinical trials of our product candidates may be insufficient or inadequate;\n•regulators, independent data monitoring committees, or IDMCs, institutional review boards, or IRBs, safety committees, or ethics committees, may require that we suspend or terminate our clinical trials for various reasons, including noncompliance with regulatory requirements, unforeseen safety issues or adverse side effects, failure to demonstrate a benefit from using our product candidate, or a finding that the participants are being exposed to unacceptable health risks;\n•clinical trials of our product candidates may produce negative or inconclusive results or results that may be interpreted in a manner different than we interpret them, and we may decide, or regulators may require us, to conduct additional clinical trials, repeat a clinical trial or abandon product development programs;\n•lack of adequate funding to continue a clinical trial, including unforeseen costs due to enrollment delays, requirements to conduct additional clinical trials or repeat a clinical trial and increased expenses associated with the services of our CROs and other third parties;\n•we may fail to initiate, delay of or failure to complete a clinical trial as a result of an Investigational New Drug application, or IND, being placed on clinical hold by the FDA, the EMA, the PMDA, or other regulatory authorities, or for other reasons, such as failure to recruit or enroll suitable patients or patients' failure to return for post-treatment follow up;\n•we may determine to change or expand a clinical trial, including after it has begun;\n•clinical trial sites and investigators deviating from the clinical protocol, failing to conduct the trial in accordance with regulatory requirements, or dropping out of a trial, or failure by us or our CROs to communicate effectively or provide the appropriate level of oversight of such clinical sites and investigators;\n•there may be an inability, delay, or failure in identifying and maintaining a sufficient number of clinical trial sites, many of which may already be engaged in other clinical programs;\n•there may be a delay or failure in reaching agreement with the FDA, the EMA, the PMDA or other regulatory authorities on a clinical trial design upon which we are able to execute;\n•there may be a delay or failure in obtaining authorization to commence a clinical trial or inability to comply with conditions imposed by a regulatory authority regarding the scope or design of a clinical trial;\n•there may be delays in reaching, or failure to reach, agreement on acceptable terms with prospective clinical trial sites and prospective CROs, the terms of which can be subject to extensive negotiation and may vary significantly among different CROs and clinical trial sites;\n•the FDA, the EMA, the PMDA or other regulatory authorities may require us to submit additional data or impose further requirements before permitting us to initiate a clinical trial or during an ongoing clinical trial;\n•the FDA, the EMA, the PMDA or other regulatory authorities may disagree with our clinical trial design and our interpretation of data from clinical trials, or may change the requirements for approval even after it has reviewed and commented on the design for our clinical trials;\n•third parties with which we work may fail to comply with good practice quality guidelines and regulations, or GXP, including good laboratory practice, good clinical practice, or GCP, and current good manufacturing practice, or cGMP; or\n•there may be changes in governmental regulations or administrative actions.\nIf any of the foregoing occurs, the following may occur:\n•regulators may require that we conduct additional clinical trials, repeat clinical trials or conduct other studies beyond those that we currently contemplate;\n•we may be delayed in obtaining marketing approval for vadadustat or other product candidates;\n•we may not obtain marketing approval for vadadustat or other product candidates at all;\n•we may obtain approval for indications or patient populations that are not as broad as intended or desired;\n71\n•we may obtain approval with labeling that includes significant use or distribution restrictions or safety warnings that would reduce the potential market for any approved product or inhibit our ability to successfully commercialize any approved product;\n•a REMS or FDA-imposed risk management plan that use risk minimization strategies to ensure that the benefits of certain prescription drugs outweigh their risks, may be required;\n•we may be subject to additional post-marketing restrictions and/or requirements; or\n•the product may be removed from the market after obtaining marketing approval.\nThe COVID-19 pandemic resulted in temporary closures of, and may continue to impact, clinical trial sites on which we rely and will rely for the completion of certain clinical trials and may delay enrollment of certain planned and ongoing clinical trials. In response to the COVID-19 pandemic, the FDA issued guidance on March 18, 2020, and has thereafter updated it, to address and facilitate the conduct of clinical trials during the pandemic. The guidance sets out a number of considerations for sponsors of clinical trials impacted by the pandemic, including the requirement to include in the clinical study report (or as a separate document) contingency measures implemented to manage the study, and any disruption of the study as a result of the pandemic.\nOur product development costs may also increase if we experience development delays or delays in receiving the requisite marketing approvals. Our preclinical studies or clinical trials may need to be restructured or may not be completed on schedule, or at all. Significant preclinical or clinical trial delays also could shorten any periods during which we may have the exclusive right to commercialize vadadustat, if approved, or any other product candidate, including those that may be in-licensed or acquired, or allow our competitors to bring products to market before we do. This could impair our ability to successfully commercialize our product candidates and may harm our business and results of operations.\nWe may find it difficult to enroll patients in our clinical trials, which could delay or prevent clinical trials of Auryxia, vadadustat or any other product or product candidate, including those that may be in-licensed or acquired.\nIdentifying and qualifying patients to participate in clinical trials is critical to our success. The timing of our clinical trials depends, in part, on the speed at which we can recruit patients to participate in our clinical trials. Patients may be unwilling to participate in our clinical trials because of concerns about adverse events observed with the product candidate under study, the current standard of care, competitor products and/or other investigational agents, in each case for the same indications and/or similar patient populations. In addition, in the case of clinical trials of any product candidate, patients currently receiving treatment with the current standard of care or a competitor product may be reluctant to participate in a clinical trial with an investigational drug. Furthermore, the COVID-19 pandemic resulted in temporary closures of, and may continue to impact, clinical trial sites on which we rely for the conduct of certain clinical trials and COVID-19 pandemic precautions have caused moderate delays in enrolling new clinical trials and may cause delays in enrolling other new clinical trials.\nIn addition, following receipt of the CRL, in April 2022, we were notified by the FDA that the FDA had placed a partial clinical hold on our clinical trials of vadadustat in pediatric patients with anemia due to chronic kidney disease in the United States. In addition, in May 2022, the Paediatric Committee of the EMA recommended that we not initiate such clinical trials in the European Union until the safety issues identified by the FDA were addressed. As a result of the partial clinical hold and EMA’s recommendations, all activities in the United States and Europe for and related to our clinical trials of vadadustat in pediatric patients were suspended. Furthermore, we are currently conducting clinical trials to evaluate three times per week oral dosing of vadadustat for dialysis dependent patients with anemia due to chronic kidney disease. If the FDA, investigators or patients are worried about the safety of vadadustat as a result of the CRL or partial clinical hold or otherwise decide not to participate or continue in those trials, we may not be able to complete those studies in a timely basis, or at all.\nFinally, competition for clinical study sites may limit our access to patients appropriate for our clinical trials. As a result, the timeline for recruiting patients and conducting studies may be delayed. These delays could result in increased costs, delays in advancing our development of any product or product candidate, or termination of the clinical trial altogether.\nWe may not be able to identify, recruit and enroll a sufficient number of patients, or those with required or desired characteristics, to complete our clinical trials in a timely manner. Patient enrollment is affected by many factors, including:\n•severity of the disease under investigation;\n•design of the study protocol;\n•size and nature of the patient population;\n•eligibility criteria for, and design of, the study in question;\n•perceived risks and benefits of the product or product candidate under study, including as a result of adverse effects observed in similar or competing therapies;\n•proximity and availability of clinical study sites for prospective patients;\n72\n•availability of competing therapies and clinical trials and clinicians’ and patients’ perceptions as to the potential advantages of the product or product candidate being studied in relation to available therapies or other product candidates in development;\n•efforts to facilitate timely enrollment in clinical trials;\n•clinical trial sites and investigators failing to perform effectively; and\n•patient referral practices of physicians.\nWe may not be able to initiate or complete clinical trials in a timely manner, or at all, if we cannot enroll a sufficient number of eligible patients to participate in the clinical trials required by regulatory agencies. If we have difficulty enrolling a sufficient number of patients to conduct our clinical trials as planned, we may need to delay, limit or terminate ongoing or planned clinical trials, any of which may delay approval, or result in failure to obtain approval, of our product candidates, which would have a material adverse effect on our business.\nConducting clinical trials outside of the United States, as we have done historically and as we may decide to do in the future, presents additional risks and complexities and, if we decide to conduct a clinical trial outside of the United States in the future, we may not complete such trials successfully, in a timely manner, or at all, which could affect our ability to obtain regulatory approvals.\nOur ability to successfully initiate, enroll and complete a clinical study in any country outside of the United States is subject to numerous additional risks unique to conducting business in jurisdictions outside the United States, including:\n•difficulty in establishing or managing relationships with qualified CROs, physicians and clinical trial sites;\n•difficulty in complying with different local standards for the conduct of clinical trials;\n•difficulty in complying with various and complex import laws and regulations when shipping drug to certain countries; and\n•the potential burden of complying with a variety of laws, medical standards and regulatory requirements, including the regulation of pharmaceutical and biotechnology products and treatments.\nData obtained from studies conducted in the United States may not be accepted by the EMA, the PMDA and other regulatory authorities outside of the United States. Also, certain jurisdictions require data from studies conducted in their country in order to obtain approval in that country.\nIf we or our collaboration partners have difficulty conducting future clinical trials in jurisdictions outside the United States as planned, we may need to delay, limit or terminate such clinical trials, any of which could have an adverse effect on our business.\nAuryxia, vadadustat or any other product or product candidate, including those that may be in-licensed or acquired, may cause undesirable side effects or have other properties that may delay or prevent marketing approval or limit their commercial potential.\nUndesirable effects caused by, or other undesirable properties of, Auryxia, vadadustat or any other product or product candidate, including those that may be in-licensed or acquired, or competing commercial products or product candidates in development that utilize a common mechanism of action could cause us or regulatory authorities to interrupt, delay or halt clinical trials, could result in a more restrictive label or the delay, denial or withdrawal of marketing approval by the FDA or other regulatory authorities, and could lead to potential product liability claims. In addition, results of our clinical trials could reveal a high frequency of undesirable effects or unexpected characteristics. For example, in March 2022, we received the CRL from the FDA for our NDA for vadadustat in which the FDA concluded that the data in the NDA do not support a favorable benefit-risk assessment of vadadustat for dialysis and non-dialysis patients. The FDA expressed safety concerns noting failure to meet non-inferiority in MACE in the non-dialysis patient population, the increased risk of thromboembolic events, driven by vascular access thrombosis in dialysis patients, and the risk of drug-induced liver injury. In July 2022, we held an end of review meeting with the FDA to inform the Company's next steps with respect to the potential U.S. approval of vadadustat, if any, and in October 2022, we submitted the FDRR to the FDA. The FDRR focuses on the favorable balance between the benefits and risks of vadadustat for the treatment of anemia due to CKD in adult patients on dialysis in light of safety concerns expressed by the FDA in the CRL related to the rate of adjudicated thromboembolic events driven by vascular access thrombosis for vadadustat compared to the active comparator and the risk of drug-induced liver injury. There can be no assurances that our FDRR will be accepted by the FDA, or that, if accepted, we will be successful in our appeal. If we are unable to overcome these concerns, vadadustat may not be approved by the FDA on favorable terms, or at all, and our financial condition could be materially harmed.\n73\nIf we or others identify undesirable effects caused by, or other undesirable properties of, Auryxia, vadadustat, or any other product or product candidate, including those that may be in-licensed or acquired, or if known undesirable effects are more frequent or severe than in the past, or if any of the foregoing are perceived to have occurred, either before or after receipt of marketing approval, a number of potentially significant negative consequences could result, including:\n•our product candidates may not be approved by regulatory authorities;\n•our clinical trials may be put on hold;\n•patient recruitment could be slowed, and enrolled patients may not want to complete the clinical trial;\n•regulatory authorities may require warnings on the label, such as the warning on Auryxia’s label regarding iron overload;\n•REMS or FDA-imposed risk management plans that use restrictive risk minimization strategies may be required;\n•we may decide to, or be required to, send drug warnings or safety alerts to physicians, pharmacists and hospitals (or the FDA or other regulatory authorities may choose to issue such alerts), or we may decide to conduct a product recall or be requested to do so by the FDA or other regulatory authority;\n•reformulation of the product, additional non-clinical or clinical trials, restrictive changes in labeling or changes to or re-approvals of manufacturing facilities may be required;\n•we may be precluded from pursuing additional development opportunities to enhance the clinical profile of a product within its indicated populations, or studying the product or product candidate in additional indications and populations or in new formulations; and\n•we could be investigated by the government or sued and held liable for harm caused to patients, including in class action lawsuits; and\n•our reputation may suffer.\nAny of these events could prevent us from achieving or maintaining, whether on a restricted basis or at all, marketing approval and, ultimately, market acceptance or penetration of Auryxia, vadadustat or any other product or product candidate, including those that may be in-licensed or acquired. In addition, any of these events could substantially increase our costs, and could significantly impact our ability to successfully commercialize Auryxia, vadadustat or any other product and product candidate, including those that may be in-licensed or acquired, and generate product revenue.\nThe patient populations treated with Auryxia and potential patient populations for vadadustat, if approved, have CKD, a serious disease that increases the risk of cardiovascular disease including heart attacks and stroke and, in its most severe form, results in, kidney failure and the need for dialysis or kidney transplant. Many patients with CKD are elderly with comorbidities making them susceptible to significant health risks. Therefore, the likelihood of these patients having adverse events, including serious adverse events is high.\nWith respect to the global INNO2VATE Phase 3 program, the incidence of treatment emergent adverse events during the Correction and Conversion study in vadadustat treated patients was 83.8% and 85.5% in darbepoetin alfa treated patients. During the study, the most common treatment emergent adverse events reported in vadadustat/darbepoetin alfa treated patients were hypertension (16.2%/ 12.9%) and diarrhea (10.1%/ 9.7%). Serious treatment emergent adverse events were lower in vadadustat treated patients at 49.7% compared to 56.5% for darbepoetin alfa treated patients. The incidence of treatment emergent adverse events during the prevalent dialysis patient study (Conversion) in the vadadustat treated patients was 88.3%, and 89.3% in darbepoetin alfa treated patients. During the study, the most common treatment emergent adverse events reported in vadadustat/darbepoetin alfa treated patients were diarrhea (13.0%/ 10.1%), pneumonia (11.0%/ 9.7%), hypertension (10.6%/ 13.8%), and hyperkalemia (9.0%/ 10.8%). Serious treatment emergent adverse events were slightly lower for vadadustat treated patients at 55.0% and 58.3% for darbepoetin alfa-treated patients. Patients with DD-CKD experienced an increased risk of thromboembolic events compared to darbepoetin alfa with a time to first event HR of 1.20 (95% CI 0.96 - 1.50) driven by thrombosis of vascular access.\nWith respect to the global PRO2TECT Phase 3 program, the incidence of treatment emergent adverse events during the ESA untreated patients study (Correction) in the vadadustat-treated patients was 90.9%, and 91.6% in darbepoetin alfa-treated patients. During the study, the most common treatment emergent adverse events reported in vadadustat/darbepoetin alfa-treated patients were end-stage renal disease (34.7%/ 35.2%), hypertension (17.7%/ 22.1.%), hyperkalemia (12.3.%/ 15.6%), urinary tract infection (12.9%/ 12.0%), diarrhea (13.9%/ 10.0%), peripheral oedema (12.5%/ 10.5%), fall (9.6%/ 10%) and nausea (10%/ 8.2%). Serious treatment emergent adverse events were 65.3% for vadadustat-treated patients and 64.5% for darbepoetin alfa-treated patients. The incidence of treatment emergent adverse events during the ESA-treated patients study (Conversion) in vadadustat treated patients was 89.1% and 87.7% in darbepoetin alfa-treated patients. During the study, the most common treatment emergent adverse events reported in vadadustat/darbepoetin alfa-treated patients were end-stage renal disease (27.5%/ 28.4%), hypertension (14.4%/ 14.8%), urinary tract infection (12.2%/ 14.5%), diarrhea (13.8.%/ 8.8.%), peripheral oedema\n74\n(9.9%/ 10.1%) and pneumonia (10.0%/ 9.7%). Serious treatment emergent adverse events were 58.5% for vadadustat-treated patients and 56.6% for darbepoetin alfa-treated patients.\nFor example, during the conduct of our Phase 3 program our team and hepatic experts analyzed hepatic cases (unblinded to treatment) and, following the completion of our global Phase 3 clinical program for vadadustat, there was a review of hepatic safety across the vadadustat clinical program, which included eight completed Phase 2 and 3 studies in NDD-CKD patients, 10 completed Phase 1, 2, and 3 studies, and two then-ongoing Phase 3b studies in DD-CKD patients, and 18 completed studies in healthy subjects (17 Phase 1 and one Phase 3). This review consisted of a blinded re-assessment of hepatic events conducted by a separate panel of hepatic experts. While hepatocellular injury attributed to vadadustat was reported in less than 1% of patients, there was one case of severe hepatocellular injury with jaundice, and we cannot guarantee that similar events will not happen in the future. Additionally, the FDA expressed safety concerns related to the risk of drug-induced liver injury in the CRL that it issued in March 2022.\nSerious adverse events considered related to vadadustat, including those noted in the CRL, and any other product candidates could have material adverse consequences on the development and potential approval of such product candidates and our business as a whole. Our understanding of adverse events in prior clinical trials of our product candidates may change as we gather more information, the FDA may not agree with our assessment of adverse events and additional unexpected adverse events may be observed in future clinical trials or in the market.\nAny of the above safety data or other occurrences could delay or prevent us from achieving or maintaining marketing approval, harm or prevent sales of Auryxia or, if approved, vadadustat or any other product or product candidate, including those that may be in-licensed or acquired, increase our expenses and impair or prevent our ability to successfully commercialize Auryxia, vadadustat or any other products or product candidates.\nIn addition, any post-marketing clinical trials conducted, if successful, may expand the patient populations treated with Auryxia, vadadustat or any other product we acquire or for which we receive marketing approval, within or outside of their current indications or patient populations, which could result in the identification of previously unknown undesirable effects, increased frequency or severity of known undesirable effects, or result in the identification of unexpected safety signals. In addition, as Auryxia, vadadustat, if approved, and any other products are commercialized, they will be used in significantly larger patient populations, in less rigorously controlled environments and, in some cases, by less experienced and less expert treating practitioners, than in clinical trials, which could result in increased or more serious adverse effects being reported. As a result, regulatory authorities, healthcare practitioners, third party payors or patients may perceive or conclude that the use of Auryxia, vadadustat, if approved, or any other products are associated with serious adverse effects, undermining our commercialization efforts.\nRisks Related to Regulatory Approval\nWe may not be able to obtain marketing approval for, or successfully commercialize, vadadustat or any other product candidate, or we may experience significant delays in doing so, any of which would materially harm our business.\nClinical trials, manufacturing and marketing of any product or product candidate are subject to extensive and rigorous review and regulation by numerous governmental authorities in the United States and other jurisdictions. Before obtaining marketing approval for the commercial sale of any product candidate, we must demonstrate through extensive preclinical testing and clinical trials that the product candidate is safe and effective for use in each target indication. This process can take many years and marketing approval may never be achieved. Of the large number of drugs in development in the United States and in other jurisdictions, only a small percentage successfully complete the FDA’s and other jurisdictions’ marketing approval processes and are commercialized. Accordingly, even if we are able to obtain the requisite capital to continue to fund our development and commercialization efforts, we may be unable to successfully obtain regulatory approval for or commercialize vadadustat or any other product or product candidate, including those that may be in-licensed or acquired.\nWe are not permitted to market vadadustat in the United States until we receive approval from the FDA, in the EU until we receive approval from the EMA, or in any other jurisdiction until the requisite approval from regulatory authorities in such jurisdiction is received. As a condition to receiving marketing approval for vadadustat, we may be required by the FDA, the EMA or other regulatory authorities to conduct additional preclinical studies or clinical trials.\nIn March 2022, we received the CRL from the FDA regarding our NDA for vadadustat for the treatment of anemia due to CKD. The FDA concluded that the data in the NDA do not support a favorable benefit-risk assessment of vadadustat for dialysis and non-dialysis patients. In July 2022, we held an end of review meeting with the FDA to inform the Company's next steps with respect to the potential U.S. approval of vadadustat, if any, and in October 2022, we submitted a Formal Dispute Resolution Request, or FDRR, to the FDA. The FDRR focuses on the favorable balance between the benefits and risks of vadadustat for the treatment of anemia due to CKD in adult patients on dialysis in light of safety concerns expressed by the FDA in the CRL\n75\nrelated to the rate of adjudicated thromboembolic events driven by vascular access thrombosis for vadadustat compared to the active comparator and the risk of drug-induced liver injury. There can be no assurances that our FDRR will be accepted by the FDA, or that, if accepted, we will be successful in our appeal and obtain approval for vadadustat in a timely manner, on favorable terms, or at all. As a result, the regulatory approval process for vadadustat in the U.S. is highly uncertain. We may not obtain approval at all, and if we are able to obtain approval, it may only be for patients with DD-CKD and, in any event, the expense and time to do so could adversely impact our ability to successfully commercialize vadadustat, and our financial condition could be materially harmed.\nFurther, vadadustat and any other product candidate may not receive marketing approval in the United States or the EU even if it is approved in other countries. For example, although vadadustat is approved in Japan for the treatment of anemia due to CKD in DD-CKD and NDD-CKD adult patients, such approval does not guarantee approval in the United States by the FDA or in the EU by the EMA for these indications or at all. In addition, while each regulatory authority makes their own assessment as to the safety and efficacy of a drug, FDA’s concern about the safety or efficacy of vadadustat or any other product candidate could impact the regulatory authority’s decision in another country.\nObtaining marketing approval in the United States and other jurisdictions for any product candidate depends upon numerous factors, many of which are subject to the substantial discretion of the regulatory authorities, including that regulatory agencies may not complete their review processes in a timely manner and, following completion of the review process, may not grant marketing approval or such marketing approval may be limited. Furthermore, approval of a drug does not ensure successful commercialization. For example, on September 23, 2015, the European Commission, or EC, approved Fexeric for the control of hyperphosphatemia in adult patients with CKD. Pursuant to the sunset clause under EU law, the EC’s approval of Fexeric in the EU was contingent on, among other things, our commencing marketing of Fexeric within three years; although we successfully negotiated an extension to December 23, 2019, we did not commence marketing Fexeric by such date and therefore the Fexeric approval in the EU has ceased to be valid.\nWe could face heightened risks with respect to seeking marketing approval in the United Kingdom, or UK, as a result of the recent withdrawal of the UK from the EU, commonly referred to as Brexit. Pursuant to the formal withdrawal arrangements agreed between the UK and the EU, the UK withdrew from the EU, effective December 31, 2020. On December 24, 2020, the UK and the EU entered into a Trade and Cooperation Agreement. The agreement sets out certain procedures for approval and recognition of medical products in each jurisdiction. Any delay in obtaining, or an inability to obtain, any marketing approvals, as a result of the Trade and Cooperation Agreement would prevent us from commercializing vadadustat or any other product candidate, including those that may be in-licensed or acquired, in the UK and/or the EU and restrict our ability to generate revenue and achieve and sustain profitability. If any of these outcomes occur, we may be forced to restrict or delay efforts to seek regulatory approval in the UK and/or the EU for vadadustat or any other product candidate, which could significantly and materially harm our business. As of January 1, 2021, the Medicines and Healthcare Products Regulatory Agency, or the MHRA, became responsible for supervising medicines and medical devices in Great Britain, comprising England, Scotland and Wales under domestic law, whereas Northern Ireland will continue to be subject to European Union rules under the Northern Ireland Protocol. The MHRA will rely on the Human Medicines Regulations 2012 (SI 2012/1916) (as amended) as the basis for regulating medicines.\nIn addition, the safety concerns associated with the current standard of care for the indications for which we are seeking marketing approval for vadadustat may affect the FDA’s, the EMA’s or other regulatory authorities’ review of the safety results of vadadustat. Additionally, these regulatory authorities may not agree with our assessment of adverse events. Further, the policies or regulations, or the type and amount of clinical data necessary to gain approval, may change during the course of a product candidate’s clinical development and may vary among jurisdictions. It is possible that vadadustat will never obtain marketing approval in the United States or certain other jurisdictions or for some or all of the indications for which we seek approval. The FDA, the EMA or other regulatory authorities may delay, limit or deny approval of vadadustat for many reasons including, among others:\n•we may not be able to demonstrate that vadadustat is safe and effective in treating adult patients with anemia due to CKD to the satisfaction of the relevant regulatory authority;\n•the results of our clinical trials may only be modestly positive, or there may be concerns with the profile due to efficacy or safety;\n•the results of our clinical trials may not meet the level of statistical or clinical significance required by the relevant regulatory authority for review and/or marketing approval;\n•the relevant regulatory authority may disagree with our interpretation of data from our preclinical studies and clinical trials;\n•the relevant regulatory authority may disagree with the number, design, size, conduct or implementation of our clinical trials;\n•the relevant regulatory authority may not approve the formulation, labeling or specifications we request for vadadustat;\n76\n•the relevant regulatory authority may approve vadadustat or any other product candidate for use only in a small patient population or for fewer or more limited indications than we request;\n•the relevant regulatory authority may require that we conduct additional clinical trials or repeat one or more clinical trials;\n•the FDA or other relevant regulatory authority may require development of a REMS as a condition of approval or post-approval;\n•the relevant regulatory authority may grant approval contingent on the performance of costly post-marketing clinical trials;\n•the relevant regulatory authority's onsite inspections may be delayed due to the COVID-19 pandemic;\n•we, or our CROs or other vendors, may fail to comply with GXP or fail to pass any regulatory inspections or audits;\n•we or our third party manufacturers may fail to perform in accordance with the FDA’s or other relevant regulatory authority's cGMP requirements and guidance;\n•the FDA may disagree with inclusion of data obtained from certain regions outside the United States to support the NDA for potential reasons such as differences in clinical practice from United States standards;\n•the relevant regulatory authority could deem that our financial relationships with certain principal investigators constitute a conflict of interest, such that the data from those principal investigators may not be used to support our applications;\n•as part of any future regulatory process, the FDA may ask an Advisory Committee to review portions of the NDA, the FDA may have difficulty scheduling an Advisory Committee meeting in a timely manner or, if convened, an FDA Advisory Committee could recommend non-approval, conditions of approval or restrictions on approval, and the FDA may ultimately agree with the recommendations;\n•the relevant regulatory authority’s review process and decision-making regarding vadadustat and any other product candidate may be impacted by the results of our and our competitors’ clinical trials and safety concerns of marketed products used to treat the same indications as the indications for which vadadustat and any other product candidate are being developed;\n•the relevant regulatory authority may not approve the manufacturing processes or facilities of third party manufacturers with whom we contract; or\n•the policies or regulations of the relevant regulatory authority may significantly change in a manner that renders our clinical data insufficient for approval or requires us to amend or submit new clinical protocols.\nIf we experience further delays in obtaining approval, or if we fail to obtain approval of vadadustat for some or all of the indications for which we have sought approval, the commercial prospects for vadadustat may be harmed and our ability to generate revenues will be materially impaired, which could have a material adverse effect on our business. For example, the FDRR we submitted to the FDA in October 2022 focuses on the favorable balance between the benefits and risks of vadadustat for the treatment of anemia due to CKD in adult patients on dialysis.\nProducts approved for marketing are subject to extensive post-marketing regulatory requirements and could be subject to post-marketing restrictions or withdrawal from the market, and we may be subject to penalties, including withdrawal of marketing approval, if we fail to comply with regulatory requirements or if we experience unanticipated problems with our products, or product candidates, when and if any of them is approved.\nMarketing approvals may be subject to limitations on the approved indicated uses for which the product may be marketed or other conditions of approval, or contain requirements or commitments for potentially costly post-marketing studies and surveillance to monitor the safety and efficacy of the product, including REMS, or registries or observational studies. For example, in connection with the FDA approvals of Auryxia, we initially committed to the FDA to conduct certain post-approval pediatric studies of Auryxia under the Pediatric Research Equity Act of 2003, or PREA. With regard to the Hyperphosphatemia Indication for Auryxia, we committed to completing the post-approval pediatric study and submitting a final report to the FDA by December 31, 2019. However, we did not complete the study and therefore did not submit the post-marketing requirement pediatric clinical study report by December 31, 2019. Consequently, we received a notification of noncompliance with PREA. Our request to extend this deadline was denied, and the study is considered delayed although we have initiated sites in the study and are recruiting for one patient cohort. Recruitment of the other patients is pending receipt of further data regarding the manufacturing of the smaller size tablets and the FDA’s concurrence before proceeding with the use of such formulation. With regard to our IDA Indication, we initially committed to completing the post-approval pediatric study and submitting a final report to the FDA by January 2023. We did not meet a milestone relating to this post-approval pediatric study of Auryxia in a timely manner and received a notification from the FDA. Subsequently, the FDA agreed to extend the pediatric clinical study timelines for the IDA Indication. We subsequently communicated to the FDA that we would be delaying the start of the clinical trial in the IDA Indication while we work to produce smaller size tablets. In response, the FDA issued a partial clinical hold until we manufacture the smaller tablets and provide the FDA with relevant information regarding the smaller sized tablets for\n77\nreview. The FDA lifted the partial clinical hold in June 2022, however, we have not commenced start up of this study pending resolution of the manufacturing of the smaller size tablets. If we are unable to complete these studies successfully, or have further delays in completing these studies, we will need to inform the FDA, have further discussions and, if the FDA finds that we failed to comply with pediatric study requirements, in violation of applicable law, it could institute enforcement proceedings to seize or enjoin the sale of Auryxia or seek civil penalties, which would have a material adverse impact on our ability to commercialize Auryxia and our ability to generate revenues from Auryxia.\nIn addition, the manufacturing processes, labeling, packaging, distribution, adverse event reporting, storage, advertising, promotion and recordkeeping for Auryxia, vadadustat, if approved, and any other product for which we receive regulatory approval will be subject to extensive and ongoing regulatory requirements and guidance. These requirements and guidance include manufacturing processes and procedures (including record keeping), the implementation and operation of quality systems to control and assure the quality of the product, submissions of safety and other post-marketing information and reports, as well as continued compliance with cGMPs and GCPs for any clinical trials that we conduct post-approval. If we, our CMOs or other third parties we engage fail to adhere to such regulatory requirements and guidance, we could suffer significant consequences, including product seizures or recalls, loss of product approval, fines and sanctions, reputational damage, loss of customer confidence, shipment delays, inventory shortages, inventory write-offs and other product-related charges and increased manufacturing costs, and our development or commercialization efforts may be materially harmed.\nMoreover, the FDA and other regulatory authorities closely regulate the post-approval marketing and promotion of drugs to ensure drugs are marketed only for the approved indications and in accordance with the provisions of the approved labeling. The FDA and other regulatory authorities impose stringent restrictions on companies’ communications regarding use of their products, and if we promote any approved product beyond its approved indications or inconsistent with the approved label, we may be subject to enforcement actions or prosecution arising from such activities. Violations of the U.S. Federal Food, Drug, and Cosmetic Act, or the FDCA, relating to the promotion of prescription drugs may lead to investigations alleging violations of federal and state healthcare fraud and abuse and other laws, as well as state consumer protection laws, insurance fraud laws, third party payor actions, stockholder actions and other lawsuits.\nPost-approval discovery of previously unknown problems with an approved product, including adverse events of unanticipated severity or frequency or relating to manufacturing operations or processes, or failure to comply with regulatory requirements, may result in, among other things:\n•restrictions on the marketing, distribution, use or manufacturing of the product;\n•withdrawal of the product from the market, or product recalls;\n•restrictions on the labeling or marketing of a product;\n•fines, restitution or disgorgement of profits or revenues;\n•warning or untitled letters or clinical holds;\n•refusal by the FDA or other regulatory authorities to approve pending applications or supplements to approved applications filed by us, or suspension or revocation of product approvals;\n•product seizure or detention, or refusal to permit the import or export of products;\n•REMS; and\n•injunctions or the imposition of civil or criminal penalties.\nFor example, we previously had three limited, voluntary recalls of Auryxia. These and any other recalls or any supply, quality or manufacturing issues in the future could result in significant negative consequences, including reputational harm, loss of customer confidence, and a negative impact on our financials, any of which could have a material adverse effect on our business and results of operations, and may impact our ability to supply Auryxia, VafseoTM, in Japan or vadadustat for commercial (if approved) and clinical use.\nNon-compliance with the FDA, the EMA, the PMDA and other regulatory authorities’ requirements regarding safety monitoring or pharmacovigilance can also result in significant financial penalties.\nThe FDA’s policies and those of other regulatory authorities may change, and additional government regulations may be enacted. We cannot predict the likelihood, nature or extent of government regulations that may arise from future legislation or administrative action, either in the United States or in other jurisdictions. If we are slow or unable to adapt to changes in existing requirements or the adoption of new requirements or policies, or are not able to maintain regulatory compliance, we may lose any marketing approval that we may have obtained and we may not achieve or sustain profitability, which would materially adversely affect our business.\nRisks Related to Governmental Regulation and Compliance\n78\nWe are subject to a complex regulatory scheme that requires significant resources to ensure compliance and our failure to comply with applicable laws could subject us to government scrutiny or enforcement, potentially resulting in costly investigations, fines, penalties or sanctions, contractual damages, reputational harm, administrative burdens and diminished profits and future earnings.\nIn general, a variety of laws apply to us or may otherwise restrict our activities, including the following:\n•laws and regulations governing the conduct of preclinical studies and clinical trials in the United States and other countries in which we are conducting such studies;\n•anti-corruption and anti-bribery laws, including the FCPA, the UK Bribery Act and various other anti-corruption laws in countries outside of the United States;\n•data privacy laws existing in the United States, the EU, the UK and other countries in which we operate, including the U.S. Health Insurance Portability and Accountability Act of 1996, or HIPAA, as amended by the Health Information Technology for Economic and Clinical Health Act, or HITECH, state privacy and data protection laws, such as the California Consumer Privacy Act, or CCPA, and the California Privacy Rights Act of 2020, or CPRA, as well as state consumer protection laws, GDPR, any additional applicable EU member state data protection laws in force from time to time, the retained EU law version of the General Data Protection Regulation as saved into United Kingdom law by virtue of section 3 of the United Kingdom's European Union (Withdrawal) Act 2018, or the EU GDPR;\n•federal and state laws requiring the submission of accurate product prices and notifications of price increases;\n•federal and state securities laws;\n•environmental, health and safety laws and regulations; and\n•international trade laws, which are laws that regulate the sale, purchase, import, export, re-export, transfer and shipment of goods, products, materials, services and technology.\nIn addition, our relationships with healthcare providers, physicians and third party payors expose us to broadly applicable fraud and abuse laws that may constrain the business or financial arrangements and relationships through which we market, sell and distribute Auryxia and vadadustat, if approved, and any other products for which we may obtain marketing approval. As such, these arrangements are subject to applicable anti-kickback, fraud and abuse, false claims, transparency, health information privacy and security, and other healthcare laws and regulations at federal, state and international levels. These restrictions include, but are not limited to, the following:\n•the FDCA which among other things, strictly regulates drug product marketing and promotion and prohibits manufacturers from marketing such products for off-label use;\n•federal laws that require pharmaceutical manufacturers to report certain calculated product prices to the government or provide certain discounts or rebates to government authorities or private entities, often as a condition of reimbursement under government healthcare programs, and laws requiring notification of price increases;\n•the federal Anti-Kickback Statute, which prohibits, among other things, persons from knowingly and willfully soliciting, offering, receiving or providing remuneration, directly or indirectly, in cash or in kind, to induce or reward, or in return for, either the referral of an individual for, or the purchase, order or recommendation or arranging of, any good or service, for which payment may be made under a federal healthcare program such as Medicare and Medicaid;\n•the federal False Claims Act, which imposes criminal and civil penalties, including through civil whistleblower or qui tam actions, against individuals or entities for, among other things, knowingly presenting, or causing to be presented, false or fraudulent claims for payment by a federal healthcare program or making a false statement or record material to payment of a false claim or avoiding, decreasing or concealing an obligation to pay money to the federal government, with potential liability including mandatory treble damages and significant per-claim penalties, and violations of the FDCA, the federal government pricing laws, and the federal Anti-Kickback Statute trigger liability under the federal False Claims Act;\n•HIPAA, which imposes criminal and civil liability for executing a scheme to defraud any healthcare benefit program or making false statements relating to healthcare matters;\n•HIPAA, as amended by the HITECH, and their respective implementing regulations, also imposes obligations, including mandatory contractual terms, with respect to safeguarding the privacy, security and transmission of individually identifiable health information;\n•the federal Physician Payments Sunshine Act (renamed the Open Payments Act) requires applicable manufacturers of covered drugs to report payments and other transfers of value to physicians, other healthcare providers and teaching hospitals, as well as ownership and investment interests held by physicians and their immediate family members;\n•analogous state and foreign laws and regulations, such as state anti-kickback and false claims laws and gift ban and transparency statutes, which may apply to sales or marketing arrangements and claims involving healthcare items or services reimbursed by state Medicaid or other programs, or non-governmental third party payors, including private\n79\ninsurers, and which are not preempted by federal laws and often differ from state to state, thus complicating compliance efforts; and\n•U.S. state laws restricting interactions with healthcare providers and other members of the healthcare community or requiring pharmaceutical manufacturers to implement certain compliance standards, which vary from state to state.\nBecause of the breadth of these U.S. laws, and their non-U.S. equivalents, and the narrowness of the statutory exceptions and safe harbors available, it is possible that some of our business activities could be subject to challenge under one or more of such laws. In addition, recent healthcare reforms have strengthened these laws. For example, the Health Care Reform Act, among other things, amended the intent requirement of the federal Anti-Kickback Statute. A person or entity no longer needs to have actual knowledge of the statute or specific intent to violate the law. The Health Care Reform Act also amended the False Claims Act, such that violations of the Anti-Kickback Statute are now deemed violations of the False Claims Act.\nSome state laws require pharmaceutical companies to comply with the pharmaceutical industry’s voluntary compliance guidelines, such as the Pharmaceutical Research and Manufacturers of America Code on Interactions with Health Care Professionals, known as the PhRMA Code. Additionally, some state and local laws require the registration of pharmaceutical sales representatives in the jurisdiction. State and foreign laws also govern the privacy and security of health information in some circumstances, many of which differ from each other in significant ways and often are not preempted by HIPAA.\nEfforts to ensure that our business complies with applicable healthcare laws and regulations involves substantial costs and requires us to expend significant resources. One of the potential areas for governmental scrutiny involves federal and state requirements for pharmaceutical manufacturers to submit accurate price reports to the government. Because our processes for calculating applicable government prices and the judgments involved in making these calculations involve subjective decisions and complex methodologies, these calculations are subject to risk of errors and differing interpretations. In addition, they are subject to review and challenge by the applicable governmental agencies, or potential qui tam complaints, and it is possible that such reviews could result in changes, recalculations, or defense costs that may have adverse legal or financial consequences. It is possible that governmental authorities will conclude that our business practices may not comply with current or future statutes, regulations or case law involving applicable fraud and abuse or other healthcare laws and regulations. If our operations are found to be in violation of any of these laws or any other governmental regulations that may apply to us, we may be subject to significant civil, criminal and administrative penalties, damages, fines, imprisonment, exclusion of products from government funded healthcare programs, such as Medicare and Medicaid, and the curtailment or restructuring of our operations, any of which could materially adversely affect our business and would result in increased costs and diversion of management attention and could negatively impact the development, regulatory approval and commercialization of Auryxia or vadadustat, any of which could have a material adverse effect on our business. Further, if any of the physicians or other healthcare providers or entities with whom we expect to do business is found to be not in compliance with applicable laws, they may be subject to criminal, civil or administrative sanctions, including exclusions from participation in government funded healthcare programs.\nWe will incur significant liability if it is determined that we are promoting any “off-label” use of Auryxia or any other product we may develop, in-license or acquire or if it is determined that any of our activities violates the federal Anti-Kickback Statute.\nPhysicians are permitted to prescribe drug products for uses that differ from those approved by the FDA or other applicable regulatory agencies. Although the FDA and other regulatory agencies do not regulate a physician’s choice of treatments, the FDA and other regulatory agencies do restrict manufacturer communications regarding unapproved uses of an approved drug. Companies are not permitted to promote drugs for unapproved uses or in a manner that is inconsistent with the FDA-approved labeling. There are also restrictions about making comparative or superiority claims based on safety or efficacy that are not supported by substantial evidence. Accordingly, we may not promote Auryxia in the United States for use in any indications other than the Hyperphosphatemia Indication and the IDA Indication, and all promotional claims must be consistent with the FDA-approved labeling for Auryxia.\nPromoting a drug off-label is a violation of the FDCA and can give rise to liability under the federal False Claims Act, as well as under additional federal and state laws and insurance statutes. The FDA, the Department of Justice and other regulatory and enforcement authorities enforce laws and regulations prohibiting promotion of off-label uses and the promotion of products for which marketing approval has not been obtained, as well as the false advertising or misleading promotion of drugs. In September 2021, the FDA published final regulations which describe the types of evidence that the agency will consider in determining the intended use of a drug product. In addition, laws and regulations govern the distribution and tracing of prescription drugs and prescription drug samples, including the Prescription Drug Marketing Act of 1976 and the Drug Supply Chain Security Act, which regulate the distribution and tracing of prescription drugs and prescription drug samples at the federal level and set minimum standards for the regulation of drug distributors by the states. A company that is found to have improperly promoted off-label uses or to have otherwise engaged in false or misleading promotion or improper distribution of\n80\ndrugs will be subject to significant liability, potentially including civil and administrative remedies as well as criminal sanctions. It may also be subject to exclusion and debarment from federal healthcare reimbursement programs.\nNotwithstanding the regulatory restrictions on off-label promotion, the FDA and other regulatory authorities allow companies to engage in truthful, non-misleading, and non-promotional scientific communications concerning their products in certain circumstances. In addition, under some relatively recent guidance from the FDA, companies may also promote information that is consistent with the prescribing information and proactively speak to formulary committee members of payors regarding data for an unapproved drug or unapproved uses of an approved drug. We intend to engage in these discussions and communicate with healthcare providers, payors and other constituencies in compliance with all applicable laws, regulatory guidance and industry best practices. Although we believe we have put in place a robust compliance program and processes designed to ensure that all such activities are performed in a legal and compliant manner, such program and processes may not be sufficient to deter or detect all violations.\nIn addition, if a company’s activities are determined to have violated the federal Anti-Kickback Statute, this can also give rise to liability under the federal False Claims Act and such violations can result in significant fines, criminal and civil remedies, and exclusion from Medicare and Medicaid. There is increased government focus on relationships between the pharmaceutical industry and physicians, pharmacies (especially specialty pharmacies), and other sources of referrals. Common industry activities, such as speaker programs, insurance assistance and support, relationships with foundations providing copayment assistance, and relationships with patient organizations and patients are receiving increased governmental attention. If any of our relationships or activities is determined to violate applicable federal and state anti-kickback laws, false claims laws, or other laws or regulations, the company and/or company executives, employees, and other representatives could be subject to significant fines and criminal sanctions, imprisonment, and potential exclusion from Medicare and Medicaid, and could harm our reputation or result in significant legal expenses and distraction of management.\nDisruptions in the FDA, regulatory authorities outside the U.S. and other government agencies caused by global health concerns or funding shortages could prevent new products and services from being developed or commercialized in a timely manner, which could negatively impact our business.\nThe ability of the FDA and regulatory authorities outside the U.S. to review and approve new products can be affected by a variety of factors, including global health concerns, government budget and funding levels, staffing shortages, statutory, regulatory, and policy changes and other events that may otherwise affect the FDA’s or other regulatory authorities' ability to perform routine functions. Average review times at the FDA have fluctuated in recent years as a result of certain of these factors. In addition, government funding of other government agencies that fund research and development activities is subject to the political process, which is inherently fluid and unpredictable. Disruptions at the FDA and other agencies may increase the time necessary for new drugs to be reviewed or approved by necessary government agencies, which would adversely affect our business. If a prolonged government shutdown occurs, it could significantly impact the ability of the FDA or other regulatory authorities to timely review and process our, or our collaboration partners', regulatory submissions, which could have a material adverse effect on our business.\nIn response to the COVID-19 pandemic, a number of companies in 2020 and 2021 announced receipt of complete response letters due to the FDA’s inability to complete required inspections for their applications. Following a period of false starts, and temporary suspensions due to the omicron variant, the FDA announced on February 2, 2022 that it would resume domestic inspections beginning on February 7, 2022, and indicated that it would conduct foreign inspections beginning in April 2022 on a prioritized basis. However, the FDA may not be able to continue its current pace and review timelines could be extended, including where a pre-approval inspection or an inspection of clinical sites is required and due to the ongoing COVID-19 pandemic and travel restrictions, the FDA is unable to complete such required inspections during the review period. Regulatory authorities outside the United States may also impose similar restrictions or other policy measures in response to the COVID-19 pandemic. If a prolonged government shutdown occurs, or if global health concerns continue to prevent the FDA or other regulatory authorities from conducting their regular inspections, reviews, or other regulatory activities, it could significantly impact the ability of the FDA or other regulatory authorities to timely review and process our regulatory submissions, which could have a material adverse effect on our business.\nCompliance with privacy and data security requirements could result in additional costs and liabilities to us or inhibit our ability to collect and process data globally, and the failure to comply with such requirements could subject us to significant fines and penalties, which may have a material adverse effect on our business, financial condition or results of operations.\nThe regulatory framework for the collection, use, safeguarding, sharing, transfer and other processing of information worldwide is rapidly evolving and is likely to remain uncertain for the foreseeable future. Globally, virtually every jurisdiction in which we operate has established its own data security and privacy frameworks with which we must comply. For example, the collection, use, disclosure, transfer, or other processing of personal data regarding individuals in the EU, including personal health data, is subject to the GDPR, which took effect across all member states of the European Economic Area, or EEA, in May 2018.\n81\nFollowing the withdrawal of the U.K. from the EU, the U.K. Data Protection Act 2018 applies to the processing of personal data that takes place in the U.K. and includes parallel obligations to those set forth by GDPR. The GDPR is wide-ranging in scope and imposes numerous requirements on companies that process personal data when required, including requirements relating to processing health and other sensitive data, obtaining consent of the individuals to whom the personal data relates, when required, providing information to individuals regarding data processing activities, implementing safeguards to protect the security and confidentiality of personal data, providing notification of data breaches, and taking certain measures when engaging third party processors. The GDPR increases our obligations as a sponsor in clinical trials in the EEA by expanding the definition of personal data to include coded data and requiring changes to informed consent practices and more detailed notices for clinical trial patients and investigators. In addition, the GDPR also imposes strict rules on the transfer of personal data to countries outside the EU, including the United States and, as a result, increases the scrutiny that we should apply to transfers of personal data from such sites to countries that are considered to lack an adequate level of data protection, such as the United States. The GDPR also permits data protection authorities to require destruction of improperly gathered or used personal information and/or impose substantial fines for violations of the GDPR, which can be up to four percent of global revenues or 20 million Euros, whichever is greater, and it also confers a private right of action on data subjects and consumer associations to lodge complaints with supervisory authorities, seek judicial remedies, and obtain compensation for damages resulting from violations of the GDPR. In addition, the GDPR provides that EU member states may make their own further laws and regulations limiting the processing of personal data, including genetic, biometric or health data and permits EU member states to adopt further penalties for violations that are not subject to the administrative fines outlined in the GDPR.\nGiven the breadth and depth of changes in data protection obligations, complying with the GDPR’s requirements is rigorous and time intensive and requires significant resources and a review of our technologies, systems and practices, as well as those of any third party collaborators, service providers, contractors or consultants that process or transfer personal data collected in the EU. The GDPR and other changes in laws or regulations associated with the enhanced protection of certain types of sensitive data, such as healthcare data or other personal information from our clinical trials, could require us to change our business practices and put in place additional compliance mechanisms, may interrupt or delay our development, regulatory and commercialization activities and increase our cost of doing business, and could lead to government enforcement actions, private litigation and significant fines and penalties against us and could have a material adverse effect on our business, financial condition or results of operations.\nSimilar privacy and data security requirements are either in place or underway in the United States. There are a broad variety of data protection laws that may be applicable to our activities, and a range of enforcement agencies at both the state and federal levels that can review companies for privacy and data security concerns. The Federal Trade Commission and state Attorneys General all are aggressive in reviewing privacy and data security protections for consumers. New laws also are being considered at both the state and federal levels. For example, the CCPA, which went into effect on January 1, 2020, and the CPRA, which amends CCPA by expanding the scope and applicability, while also introducing new privacy protections, is creating similar risks and obligations as those created by GDPR. Because of this, we may need to engage in additional activities (e.g., data mapping) to identify the personal information we are collecting and the purposes for which such information is collected. In addition, we will need to ensure that our policies recognize the rights granted to consumers (as that phrase is broadly defined in the CCPA and can include business contact information). Many other states are considering similar legislation. A broad range of legislative measures also have been introduced at the federal level. Accordingly, failure to comply with current and any future federal and state laws regarding privacy and security of personal information could expose us to fines and penalties. We also face a threat of potential consumer class actions related to these laws and the overall protection of personal data. Even if we are not determined to have violated these laws, investigations into these issues typically require the expenditure of significant resources and generate negative publicity, which could harm our reputation and our business.\nLegislative and regulatory healthcare reform may increase the difficulty and cost for us to obtain marketing approval of and commercialize our product candidates and affect the prices we may obtain for any products that are approved in the United States or foreign jurisdictions.\nIn the United States and some foreign jurisdictions, there have been a number of legislative and regulatory changes and proposed changes regarding the healthcare system that could prevent or delay marketing approval of vadadustat, or any other product candidate, restrict or regulate post-approval activities and affect our ability to profitably sell Auryxia and vadadustat, if approved. The pharmaceutical industry has been a particular focus of these efforts and has been significantly affected by legislative initiatives. Current laws, as well as other healthcare reform measures that may be adopted in the future, may result in more rigorous coverage criteria and in additional downward pressure on the price that we receive for any FDA approved product, such as Auryxia or vadadustat, if approved, or any reimbursement that physicians receive for administering any approved product.\nIn the United States, the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, or the MMA, changed the way Medicare covers and pays for pharmaceutical products. The legislation expanded Medicare coverage for drug purchases by the elderly and introduced a new reimbursement methodology based on average sales prices for physician-administered drugs. In addition, this legislation provided authority for limiting the number of drugs that will be covered in any therapeutic class. Cost reduction initiatives and other provisions of this legislation could decrease the coverage and price that we receive for Auryxia and any other approved products. While the MMA applies only to drug benefits for Medicare beneficiaries, private\n82\npayors often follow Medicare coverage policy and payment limitations in setting their own reimbursement rates. Therefore, any reduction in reimbursement that results from the MMA may result in a similar reduction in payments from private payors.\nIn March 2010, President Obama signed into law the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act of 2010, or, collectively, the ACA. Among the provisions of the ACA of potential importance to our business including, without limitation, our ability to commercialize and the prices we obtain for Auryxia and may obtain for any of our product candidates that are approved for sale, are the following:\n•an annual, non-deductible fee on any entity that manufactures or imports specified branded prescription drugs and biologic agents;\n•an increase in the statutory minimum rebates a manufacturer must pay under the Medicaid Drug Rebate Program;\n•expansion of healthcare fraud and abuse laws, including the civil False Claims Act and the federal anti-kickback statute, new government investigative powers and enhanced penalties for noncompliance;\n•a new Medicare Part D coverage gap discount program, in which manufacturers must agree to offer 70% point-of-sale discounts off negotiated prices;\n•extension of manufacturers’ Medicaid rebate liability;\n•expansion of eligibility criteria for Medicaid programs;\n•expansion of the entities eligible for discounts under the Public Health Service pharmaceutical pricing program;\n•new requirements to report certain financial arrangements with physicians and teaching hospitals;\n•a new requirement to annually report drug samples that manufacturers and distributors provide to physicians; and\n•a new Patient-Centered Outcomes Research Institute to oversee, identify priorities in, and conduct comparative clinical effectiveness research, along with funding for such research.\nIn addition, other legislative changes and regulatory have been proposed and adopted since the ACA was enacted. These changes include the Budget Control Act of 2011, which, among other things, led to aggregate reductions to Medicare payments to providers of up to 2% per fiscal year, which will remain in effect through 2031. However, pursuant to the Coronavirus Aid, Relief, and Economic Security Act, or the CARES Act, and subsequent legislation, these Medicare sequester reductions were suspended and reduced through the end of June 2022 but with the full 2% cut resuming as of July 1, 2022. The American Taxpayer Relief Act of 2012, which, among other things, reduced Medicare payments to several types of providers and increased the statute of limitations period for the government to recover overpayments to providers from three to five years. In addition, other legislative and regulatory changes have been proposed, but not yet adopted. For example, in July 2019, HHS proposed regulatory changes in kidney health policy and reimbursement. Any new legislative or regulatory changes may result in additional reductions in Medicare and other healthcare funding and otherwise affect the prices we may obtain for Auryxia or vadadustat, if approved, or the frequency with which Auryxia and vadadustat, if approved, is prescribed or used.\nThe costs and prices of prescription pharmaceuticals have also been the subject of considerable discussion in the United States. To date, there have been several recent U.S. congressional inquiries and proposed and enacted state and federal legislation designed to, among other things, bring more transparency to drug pricing, review the relationship between pricing and manufacturer patient programs, reduce the costs of drugs under Medicare and reform government program reimbursement methodologies for drug products. At the federal level, Congress and the current administration have each indicated that it will continue to seek new legislative and/or administrative measures to control drug costs.\nFor example, the former administration issued several executive orders intended to lower the costs of prescription products and certain provisions in these orders have been incorporated into regulations. These regulations include an interim final rule implementing a most favored nation model for prices that would tie Medicare Part B payments for certain physician-administered pharmaceuticals to the lowest price paid in other economically advanced countries, effective January 1, 2021. That rule, however, has been subject to a nationwide preliminary injunction and, on December 29, 2021, CMS issued a final rule to rescind it. With issuance of this rule, CMS stated that it will explore all options to incorporate value into payments for Medicare Part B pharmaceuticals and improve beneficiaries' access to evidence-based care.\nAt the same time, the administration may seek to limit Medicare Part D and public option drug prices through a tax penalty on manufacturers for increases in the cost of drugs and biologics above the general inflation rate. The American Rescue Plan Act of 2021, comprehensive COVID-19 pandemic relief legislation recently enacted under the current administration, includes a number of healthcare-related provisions, such as support to rural health care providers, increased tax subsidies for health insurance purchased through insurance exchange marketplaces, financial incentives to states to expand Medicaid programs and elimination of the Medicaid drug rebate cap effective in 2024.\nFurther, on July 9, 2021, the current administration signed Executive Order 14063, which focuses on, among other things, the price of pharmaceuticals. The Order directs HHS to create a plan within 45 days to combat “excessive pricing of prescription pharmaceuticals and enhance domestic pharmaceutical supply chains, to reduce the prices paid by the federal government for such pharmaceuticals, and to address the recurrent problem of price gouging.” On September 9, 2021, HHS released its plan to reduce pharmaceutical prices. The key features of that plan are to: (a) make pharmaceutical prices more affordable and\n83\nequitable for all consumers and throughout the health care system by supporting pharmaceutical price negotiations with manufacturers; (b) improve and promote competition throughout the prescription pharmaceutical industry by supporting market changes that strengthen supply chains, promote biosimilars and generic drugs, and increase transparency; and (c) foster scientific innovation to promote better healthcare and improve health by supporting public and private research and making sure that market incentives promote discovery of valuable and accessible new treatments.\nMore recently, with passage of the Inflation Reduction Act in August 2022, Congress authorized Medicare beginning in 2026 to negotiate lower prices for certain costly single-source drug and biologic products that do not have competing generics or biosimilars. This provision is limited in terms of the number of pharmaceuticals whose prices can be negotiated in any given year and it only applies to drug products that have been approved for at least nine years and biologics that have been licensed for 13 years. Drugs and biologics that have been approved for a single rare disease or condition are categorically excluded from price negotiation. Further, the new legislation provides that, effective October 1, 2022, if pharmaceutical companies raise commercial prices faster than the rate of inflation, they must pay rebates back to the government for the difference. The new law also caps Medicare out-of-pocket drug costs at an estimated $4,000 a year in 2024 and, thereafter beginning in 2025, at $2,000 a year.\nAt the state level, individual states are increasingly aggressive in passing legislation and implementing regulations designed to control pharmaceutical and biological product pricing, including price or patient reimbursement constraints, discounts, restrictions on certain product access, marketing cost disclosure and transparency measures, and, in some cases, designed to encourage importation from other countries and bulk purchasing. A number of states, for example, require drug manufacturers and other entities in the drug supply chain, including health carriers, pharmacy benefit managers, wholesale distributors, to disclose information about pricing of pharmaceuticals. In addition, regional healthcare authorities and individual hospitals are increasingly using bidding procedures to determine what pharmaceutical products and which suppliers will be included in their prescription drug and other healthcare programs. These measures could reduce the ultimate demand for our products or put pressure on our product pricing.\nIt is likely that federal and state legislatures within the United States and foreign governments will continue to consider changes to existing healthcare legislation. We expect that additional state and federal healthcare reform measures will be adopted in the future, any of which could limit the amounts that federal and state governments will pay for healthcare products and services, which could result in reduced demand for Auryxia and any product candidates for which we receive marketing approval or additional pricing pressures. We cannot predict the reform initiatives that may be adopted in the future or whether initiatives that have been adopted will be repealed or modified. The continuing efforts of the government, insurance companies, managed care organizations and other payors of healthcare services to contain or reduce costs of healthcare may adversely affect:\n•the demand for Auryxia and any products candidates for which we receive marketing approval;\n•our ability to set a price that we believe is fair for our products;\n•our ability to obtain and maintain coverage and reimbursement approval for Auryxia or any other approved product;\n•our ability to generate revenues and achieve or maintain profitability; and\n•the level of taxes that we are required to pay.\nIn addition, in some countries, including member states of the EU the pricing of prescription pharmaceuticals is subject to governmental control. In these countries, pricing negotiations with governmental authorities can take a significant amount of time after receipt of marketing approval for a product. In addition, there can be considerable pressure by governments and other stakeholders on prices and reimbursement levels, including as part of cost containment measures. Political, economic and regulatory developments may further complicate pricing negotiations, and pricing negotiations may continue after reimbursement has been obtained. Reference pricing used by various EU member states and parallel distribution, or arbitrage between low-priced and high-priced member states, can further reduce prices, and in certain instances render commercialization in certain markets infeasible or disadvantageous from a financial perspective. In some countries, we or our collaborators may be required to conduct a clinical trial or other studies that compare the cost-effectiveness of our product and/or our product candidates to other available products in order to obtain or maintain reimbursement or pricing approval. Publication of discounts by third party payors or government authorities may lead to further pressure on the prices or reimbursement levels. If reimbursement of our products is unavailable or limited in scope or amount, or if pricing is set at unsatisfactory levels, the commercial launch of our product and/or product candidates could be delayed, possibly for lengthy periods of time, we or our collaborators may not launch at all in a particular country, we may not be able to recoup our investment in one or more product candidates, and there could be a material adverse effect on our business.\nIf we fail to comply with environmental, health and safety laws and regulations, we could become subject to fines or penalties or incur costs that could harm our business.\nWe are subject to numerous environmental, health and safety laws and regulations, including those governing laboratory procedures and the handling, use, storage, treatment and disposal of hazardous materials and wastes. Our operations involve the use of hazardous and flammable materials, including chemicals and biological materials. Our operations also produce hazardous\n84\nwaste products. We generally contract with third parties for the use and disposal of these materials and wastes. We cannot eliminate the risk of contamination or injury from these materials. In the event of contamination or injury resulting from the use of hazardous materials by our employees, contractors or consultants, we could be held liable for any resulting damages, and any liability could exceed our resources. We also could incur significant costs associated with civil or criminal fines and penalties for failure to comply with such laws and regulations.\nAlthough we maintain workers’ compensation insurance to cover us for costs and expenses, we may incur due to injuries to our employees resulting from the use of hazardous materials, this insurance may not provide adequate coverage against potential liabilities. We do not maintain insurance for environmental liability or toxic tort claims that may be asserted against us in connection with our storage or disposal of biological, hazardous or radioactive materials.\nIn addition, we may incur substantial costs in order to comply with current or future environmental, health and safety laws and regulations. These current or future laws and regulations may impair our research, development or production efforts. Our failure to comply with these laws and regulations also may result in substantial fines, penalties or other sanctions.\nRisks Related to our Reliance on Third Parties\nWe depend on collaborations with third parties for the development and commercialization of Auryxia, Riona, Vafseo and vadadustat and if these collaborations are not successful or if our collaborators terminate their agreements with us, we may not be able to capitalize on the market potential of Auryxia, Riona, Vafseo and vadadustat, and our business could be materially harmed.\nWe sublicensed the rights to commercialize Riona to JT and Torii in Japan. We also entered into a collaboration agreement with MTPC to develop and commercialize vadadustat in Japan and certain other Asian countries. In addition, we entered into the Vifor Second Amended Agreement pursuant to which we granted Vifor Pharma an exclusive license to sell vadadustat to the Supply Group in the United States. We may form or seek other strategic alliances, joint ventures, or collaborations, or enter into additional licensing arrangements with third parties that we believe will complement or augment our and our partners' commercialization efforts with respect to Auryxia, Riona, Vafseo and our and our partners' development and, if approved, commercialization efforts with respect to vadadustat and any other product candidates. We may not be able to maintain our collaborations for development and commercialization. For example, on May 13, 2022, Otsuka elected to terminate our collaboration agreements with them, and we subsequently negotiated the Termination Agreement with Otsuka. This termination by Otsuka may make it difficult for us to attract a new collaborator or adversely affect how we are perceived in scientific and financial communities. We plan to pursue a new partner to develop and commercialize vadadustat in Europe and other territories previously licensed to Otsuka. If we are unsuccessful in entering into such agreements or arrangements in a timely manner, or at all, it may result in a need for additional capital and expansion of our internal capabilities to pursue further development or commercialization of the applicable products and product candidates, particularly the development and commercialization of vadadustat in the United States, Europe, China and certain other territories.\nIn addition, our current and any future collaborations may not be successful due to a number of important factors, including the following:\n•collaborators may have significant discretion in determining the efforts and resources that they will apply to these collaborations;\n•collaborations may be terminated in accordance with the terms of the collaboration agreements and, if terminated, may make it difficult for us to attract new collaborators or adversely affect how we are perceived in scientific and financial communities, and may result in a need for additional capital and expansion of our internal capabilities to pursue further development or commercialization of the applicable products and product candidates;\n•if permitted by the terms of the collaboration agreements, collaborators may elect not to continue or renew development or commercialization programs based on clinical trial results, changes in their strategic focus, availability of funding or other external factors such as a business combination that diverts resources or creates competing priorities;\n•if permitted by the terms of the collaboration agreements, collaborators may delay clinical trials, provide insufficient funding for a clinical trial program, stop a clinical trial, abandon a product candidate, repeat or conduct new clinical trials or require a new formulation of a product candidate for clinical testing;\n•a collaborator with marketing and distribution rights to our products may not commit sufficient resources to their marketing and distribution;\n•if permitted by the terms of the collaboration agreements, we and our collaborator may have a difference of opinion regarding the development or commercialization strategy for a particular product or product candidate, and our collaborator may have ultimate decision making authority;\n•disputes may arise between a collaborator and us that cause the delay or termination of activities related to research, development, supply or commercialization of Auryxia, Riona, Vafseo or vadadustat and any other product candidate, or that result in costly litigation or arbitration that diverts management attention and resources;\n85\n•collaborations may not lead to development or commercialization of products and product candidates, if approved, in the most efficient manner or at all;\n•a significant change in the senior management team, a change in the financial condition or a change in the business operations, including a change in control or internal corporate restructuring, of any of our collaborators, could result in delayed timelines, re-prioritization of our programs, decreasing resources or funding allocated to support our programs, or termination of the collaborations; and\n•collaborators may not comply with all applicable regulatory and legal requirements.\nIf any of these events occurs, the market potential of Auryxia, Riona, Vafseo and vadadustat, if and where approved, and any other products or product candidates, could be reduced, and our business could be materially harmed. Collaborations may also divert resources, including the attention of management and other employees, from other parts of our business, which could have an adverse effect on other parts of our business, and we cannot be certain that the benefits of the collaboration will outweigh the potential risks.\nWe may seek to establish additional collaborations and, if we are not able to establish them on commercially reasonable terms, or at all, we may have to alter our development and commercialization plans.\nWe will require substantial additional cash to fund the continued commercialization of Auryxia and the development and potential commercialization of any of our product candidates, including vadadustat, if approved, especially following the termination of our collaboration agreements with Otsuka. We may decide to enter into additional collaborations for the development and commercialization of vadadustat or Auryxia, both within and outside of the United States. For example, we plan to pursue a new partner to develop and commercialize vadadustat in Europe and other territories previously licensed to Otsuka. Any of these relationships may require us to incur non-recurring and other charges, increase our near and long-term expenditures, issue securities that dilute our existing stockholders, divert management’s attention, or disrupt our business.\nWe may not be successful in entering into additional collaborations as a result of many factors, including the following:\n•competition in seeking appropriate collaborators;\n•a reduced number of potential collaborators due to recent business combinations in the pharmaceutical industry;\n•an inability to negotiate collaborations on acceptable terms, on a timely basis or at all;\n•any international rules, regulations, guidance, laws, risks or uncertainties with respect to potential partners outside of the United States;\n•a potential collaborator’s evaluation of Auryxia, vadadustat or any other product or product candidate may differ substantially from ours;\n•a potential collaborator’s evaluation of our financial stability and resources;\n•a potential collaborator’s resources and expertise; and\n•restrictions due to an existing collaboration agreement.\nIf we are unable to enter into additional collaborations in a timely manner, or at all, we may have to delay or curtail the commercialization of Auryxia or vadadustat, if and where approved, reduce or delay its development program or other of our other development programs, or increase our expenditures and undertake additional development or commercialization activities at our own expense. If we elect to increase our expenditures to fund development or commercialization activities on our own, we may need to obtain additional capital, which may not be available to us on acceptable terms or at all. If we do not have sufficient funds, we may not be able to further develop or commercialize Auryxia or vadadustat, if approved.\nEven if we enter into additional collaboration agreements and strategic partnerships or license our intellectual property, we may not be able to maintain them or they may be unsuccessful, which could delay our timelines or otherwise adversely affect our business.\nRoyalties from commercial sales of vadadustat under our MTPC Agreement will likely fluctuate and will impact our rights to receive future payments under our Royalty Agreement with HCR.\nPursuant to the Royalty Agreement with HCR, we sold to HCR our right to receive the Royalty Interest Payments payable to us under the MTPC Agreement, subject to the Annual Cap and the Aggregate Cap. After HCR receives Royalty Interest Payments equal to the Annual Cap in a given calendar year, we will receive 85% of the Royalty Interest Payments for the remainder of that year. After HCR receives Royalty Interest Payments equal to the Aggregate Cap, or we pay the Aggregate Cap to HCR (net of the Royalty Interest Payments already received by HCR), the Royalty Interest Payments will revert back to us, and HCR would have no further right to any Royalty Interest Payments. We received $44.8 million from HCR (net of certain transaction expenses) under the Royalty Agreement, and we are eligible to receive up to an additional $15.0 million under the Royalty\n86\nAgreement if specified sales milestones are achieved for vadadustat in the territory covered by the MTPC Agreement, subject to the satisfaction of certain customary conditions.\nThe royalty revenues under the MTPC Agreement may fluctuate considerably because they depend upon, among other things, the rate of growth of sales of vadadustat in the territory covered by the MTPC Agreement. Negative fluctuations in these royalty revenues could delay, diminish or eliminate our right to receive up to the additional $15.0 million under the Royalty Agreement upon achievement of the specified sales milestones, our ability to receive 85% of the Royalty Interest Payments after the Annual Cap is achieved in a given calendar year, or our ability to receive 100% of the Royalty Interest Payments after the Aggregate Cap is achieved.\nWe rely upon third parties to conduct all aspects of our product manufacturing and the loss of these manufacturers, their failure to supply us on a timely basis, or at all, or their failure to successfully carry out their contractual duties or comply with regulatory requirements, cGMP requirements, or guidance could cause delays in or disruptions to our supply chain and substantially harm our business.\nWe do not have any manufacturing facilities and do not expect to independently manufacture any product or product candidates. We currently rely, and expect to continue to rely, on third party manufacturers to produce all of our commercial, clinical and preclinical supply, including the vadadustat drug product that we supply to our collaboration partner, MTPC, for the Japanese market. Our reliance on third party manufacturers, who have control over the manufacturing process, increases the risk that we will not have or be able to maintain sufficient quantities of Auryxia and vadadustat or the ability to obtain such quantities at an acceptable cost or quality, which could delay, prevent or impair our and our partners' development or commercialization efforts.\nWe currently have two suppliers of Auryxia drug substance, Siegfried Evionnaz SA (two approved sites) and BioVectra Inc. (one approved site), and one supplier of Auryxia drug product, Patheon Inc., or Patheon (three approved sites, two of which are active). However, our supply agreement with Siegfried Evionnaz SA expires on December 31, 2022, at which time we will only have one supplier for Auryxia drug substance. We have entered into supply agreements with Esteve Química, S.A. and STA Pharmaceutical Hong Kong Limited, a subsidiary of Wuxi AppTec, or STA, for the commercial manufacture of vadadustat drug substance and Patheon Inc. and STA for the commercial manufacture of vadadustat drug product. If any of the following occurs, we may not have sufficient quantities of Auryxia and/or vadadustat to support our clinical trials, development, commercialization, or obtaining and maintaining marketing approvals, which could materially and adversely impact our business and results of operations:\n•we are unsuccessful in maintaining our current supply arrangements for commercial quantities of Auryxia and vadadustat;\n•our commercial supply arrangements for Auryxia or vadadustat are terminated;\n•any of our third party manufacturers are unable to fulfill the terms of their agreements with us, including with respect to quality and quantity, or are unable or unwilling to continue to manufacture on the manufacturing lines included in our regulatory filings; or\n•any of our third party manufacturers breach our supply agreements, do not comply with quality or regulatory requirements and guidance, including cGMP or are subject to regulatory review or ceases their operations for any reason.\nIf any of our third party manufacturers cannot or do not perform as agreed or expected, including as a result of the COVID-19 pandemic, if they misappropriate our proprietary information, if they terminate their engagements with us, if we terminate our engagements with them, or if there is a significant disagreement, we may be forced to manufacture the materials ourselves, for which we currently do not have the capabilities or resources, or enter into agreements with other third party manufacturers, which we may not be able to do in a timely manner or on favorable or reasonable terms, if at all. For example, one of our manufacturers has notified us that it will be discontinuing operations at one site at a future date. In some cases, there may be a limited number of qualified replacement manufacturers, or the technical skills or equipment required to manufacture a product or product candidate may be unique or proprietary to the original manufacturer and we may have difficulty transferring such skills or technology to another third party, or a feasible alternative may not exist. These factors would increase our reliance on our current manufacturers or require us to obtain necessary regulatory approvals and licenses in order to have another third party manufacture Auryxia or vadadustat. If we are required to change manufacturers for any reason, we will be required to verify that the new manufacturer maintains facilities and procedures that comply with quality standards and with all applicable regulations and guidelines. The delays associated with the qualification of a new manufacturer and validation of manufacturing processes would negatively affect our ability to supply clinical trials, obtain and maintain marketing approval, or commercialize or satisfy patient demand for Auryxia and vadadustat, where approved, in a timely manner within budget or at all.\n87\nIn addition, the cost of obtaining Auryxia and vadadustat is subject to adjustment based on our third party manufacturers’ costs of obtaining raw materials and producing the product. We have limited control over the production of Auryxia and vadadustat, including the costs of raw materials, and any significant increase in the cost of obtaining our products could materially adversely affect our revenue for Auryxia and vadadustat, if approved.\nMoreover, issues that may arise in any scale-up and technology transfer and continued commercial scale manufacture of our products may lead to significant delays in our development, marketing approval and commercial timelines and negatively impact our financial performance. For example, a production-related issue resulted in an interruption in the supply of Auryxia in the third and fourth quarters of 2016. This supply interruption negatively impacted Keryx’s revenues in 2016. This supply interruption was resolved, and we have taken and continue to take actions designed to prevent future interruptions in the supply of Auryxia. However, we recently experienced issues in manufacturing Auryxia, and if we continue to experience manufacturing issues or our actions to prevent future interruptions are not successful, we may experience additional supply issues. Any future supply interruptions, whether quality or quantity based, for Auryxia or vadadustat, if and where approved, would negatively and materially impact our reputation and financial condition.\nThere are a limited number of manufacturers that are capable of manufacturing Auryxia and vadadustat for us and complying with cGMP regulations and guidance and other stringent regulatory requirements and guidance enforced by the FDA, EMA, PMDA and other regulatory authorities. These requirements include, among other things, quality control, quality assurance and the maintenance of records and documentation, which occur in addition to our own quality assurance releases. The facilities and processes used by our third party manufacturers to manufacture Auryxia may be inspected by the FDA and other regulatory authorities at any time, and the facilities and processes used by our third party manufacturers to manufacture vadadustat will be inspected by the FDA, the EMA and other regulatory authorities prior to or after we submit our marketing applications. Although we have general visibility into the manufacturing processes of our third party manufacturers, we do not ultimately control such manufacturing processes of, and have little control over, our third party manufacturers, including, without limitation, their compliance with cGMP requirements and guidance for the manufacture of certain starting materials, drug substance and finished drug product. Similarly, although we review final production, we have little control over the ability of our third party manufacturers to maintain adequate quality control, quality assurance and qualified personnel. Our third party manufacturers may experience problems with their manufacturing and distribution operations and processes, including, for example, quality issues, such as product specification and stability failures, procedural deviations, improper equipment installation or operation, utility failures, contamination, natural disasters and public health epidemics. We may also encounter difficulties relating to our own quality processes and procedures, including regulatory compliance, lot release, quality control and quality assurance, as well as shortages of qualified personnel. If our third party manufacturers cannot successfully manufacture material that conforms to our specifications and regulatory requirements and guidance, or if we or our third party manufacturers experience manufacturing, operations and/or quality issues, including an inability or unwillingness to continue manufacturing our products at all, in accordance with agreed-upon processes or on currently validated manufacturing lines, we may not be able to supply patient demand or maintain marketing approval for Auryxia, secure and maintain marketing approval for vadadustat, and we might be required to expend additional resources to obtain material from other manufacturers. If any of these events occur, our reputation and financial condition would be negatively and materially impacted.\nIf the FDA, the EMA or other regulatory authorities do not approve the facilities being used to manufacture vadadustat, or if they withdraw any approval of the facilities being used to manufacture Auryxia or vadadustat, we may need to find alternative manufacturing facilities, which would significantly impact our ability to continue commercializing Auryxia or Vafseo in Japan, or develop, obtain marketing approval for or market vadadustat or our other product candidates, if approved.\nMoreover, our failure or the failure of our third party manufacturers to comply with applicable regulations or guidance, or our failure to oversee or facilitate such compliance, could result in sanctions being imposed on us or our third party manufacturers, including, where applicable, clinical holds, fines, injunctions, civil penalties, delays in, suspension of or withdrawal of approvals, license revocation, seizures or recalls of Auryxia or Vafseo in Japan, operating restrictions, receipt of a Form 483 or warning letter, or criminal prosecutions, any of which could significantly and adversely affect the supply of Auryxia or vadadustat. For example, we previously conducted three limited, voluntary recalls of Auryxia. These and any other recalls or any supply, quality or manufacturing issues in the future and any related write-downs of inventory or other consequences could result in significant negative consequences, including reputational harm, loss of customer confidence, and a negative impact on our financials, any of which could have a material adverse effect on our business and results of operations, and may impact our ability to supply Auryxia, Vafseo in Japan or vadadustat for clinical and commercial use. Also, if our starting materials, drug substance or drug product are damaged or lost while in our or our third party manufacturers’ control, it may adversely impact our ability to supply Auryxia or vadadustat, and we may incur significant financial harm.\nIn addition, Auryxia and vadadustat may compete with other products and product candidates for access to third party manufacturing facilities. A third party manufacturer may also encounter delays or operational issues brought on by sudden internal resource constraints, labor disputes, shifting priorities or shifting regulatory protocols including, in each case, relating to the COVID-19 pandemic. Certain of these third party manufacturing facilities may be contractually prohibited from manufacturing Auryxia or vadadustat due to exclusivity provisions in agreements with our competitors. Any of the foregoing\n88\ncould negatively impact our third party manufacturers' ability to meet our demand, which could adversely impact our ability to supply Auryxia or vadadustat, and we may incur significant financial harm.\nOur current and anticipated future dependence on third parties for the manufacture of Auryxia and vadadustat may adversely affect our and our partners' ability to commercialize Auryxia and vadadustat, where approved, on a timely and competitive basis and may reduce any future profit margins.\nWe rely upon third parties to conduct our clinical trials and certain of our preclinical studies. If they do not successfully carry out their contractual duties, comply with regulatory requirements or meet expected deadlines, we may not be able to obtain or maintain marketing approval for Auryxia, vadadustat or any of our product candidates, and our business could be substantially harmed.\nWe do not have the ability to independently conduct certain preclinical studies and clinical trials. We are currently relying, and expect to continue to rely, upon third parties, such as CROs, clinical data management organizations, medical institutions and clinical investigators, to conduct our current and future preclinical studies and clinical trials. The third parties upon whom we rely may fail to perform effectively, or terminate their engagement with us, for a number of reasons, including the following:\n•if they experience staffing difficulties;\n•if we fail to communicate effectively or provide the appropriate level of oversight;\n•if they undergo changes in priorities or corporate structure including as a result of a merger or acquisition or other transaction, or become financially distressed; or\n•if they form relationships with other entities, some of which may be our competitors.\nIf the third parties upon whom we rely to conduct our trials fail to adhere to clinical trial protocols or to regulatory requirements, the quantity, quality or accuracy of the data obtained by the third parties may be compromised. We are exposed to risk of fraud or other misconduct by such third parties.\nAny of these events could cause our preclinical studies and clinical trials, including post-approval clinical trials, to be extended, delayed, suspended, required to be repeated or terminated, or we may receive untitled warning letters or be the subject of an enforcement action, which could result in our failing to obtain and maintain marketing approval of vadadustat or any other product candidates on a timely basis, or at all, or fail to maintain marketing approval of Auryxia, or any other products, any of which would adversely affect our business operations. In addition, if the third parties upon whom we rely fail to perform effectively or terminate their engagement with us, we may need to enter into alternative arrangements, which could delay, perhaps significantly, the development and commercialization of vadadustat, if approved, or any other product candidates.\nEven though we do not directly control the third parties upon whom we rely to conduct our preclinical studies and clinical trials and therefore cannot guarantee the satisfactory and timely performance of their obligations to us, we are nevertheless responsible for ensuring that each of our clinical trials and preclinical studies is conducted in accordance with the applicable protocol, legal and regulatory requirements, including GXP requirements, and scientific standards, and our reliance on these third parties, including CROs, will not relieve us of our regulatory responsibilities. If we or any of our CROs, their subcontractors, or clinical or preclinical trial sites fail to comply with applicable GXP requirements, the clinical data generated in our trials may be deemed unreliable or insufficient, our clinical trials could be put on hold, and/or the FDA, the EMA or other regulatory authorities may require us to perform additional clinical trials before approving our marketing applications. In addition, our clinical and preclinical trials must be conducted with drug product that meets certain specifications and is manufactured under applicable cGMP regulations. These requirements include, among other things, quality control, quality assurance, and the satisfactory maintenance of records and documentation.\nWe also rely upon third parties to store and distribute drug product for our clinical trials. For example, we use third parties to store product at various sites in the United States to distribute to our clinical trial sites. Any performance failure on the part of our storage or distributor partners could delay clinical development, marketing approval or commercialization, resulting in additional costs and depriving us of potential product revenue.\nIf the licensor of certain intellectual property relating to Auryxia terminates, modifies or threatens to terminate existing contracts or relationships with us, our business may be materially harmed.\nWe do not own all of the rights to our product, Auryxia. We have licensed and sublicensed certain rights, patent and otherwise, to Auryxia from a third party, Panion & BF Biotech, Inc., or Panion, who in turn licenses certain rights to Auryxia from one of the inventors of Auryxia. The license agreement with Panion, or the Panion License Agreement, requires us to meet development milestones and imposes development and commercialization due diligence requirements on us. In addition, under the Panion License Agreement, we must pay royalties based on a mid-single digit percentage of net sales of product resulting\n89\nfrom the licensed technologies, including Auryxia, and pay the patent filing, prosecution and maintenance costs related to the license. If we do not meet our obligations in a timely manner, or if we otherwise breach the terms of the Panion License Agreement, Panion could terminate the agreement, and we would lose the rights to Auryxia. For example, following announcement of the Merger, Panion notified Keryx in writing that Panion would terminate the Panion License Agreement on November 21, 2018 if Keryx did not cure the breach alleged by Panion, specifically, that Keryx failed to use commercially reasonable best efforts to commercialize Auryxia outside the United States. Keryx disagreed with Panion’s claims, and the parties entered discussions to resolve this dispute. On October 24, 2018, prior to the consummation of the Merger, we, Keryx and Panion entered into a letter agreement, or the Panion Letter Agreement, pursuant to which Panion agreed to rescind any and all prior termination threats or notices relating to the Panion License Agreement and waived its rights to terminate the license agreement based on any breach by us of our obligation to use commercially reasonable efforts to commercialize Auryxia outside the United States until the parties executed an amendment to the Panion License Agreement in accordance with the terms of the Panion Letter Agreement, following consummation of the Merger. On April 17, 2019, we and Panion entered into an amendment and restatement of the Panion License Agreement, or the Panion Amended License Agreement, which reflects certain revisions consistent with the terms of the Panion Letter Agreement. See Note 4 to our consolidated financial statements in Part I, Item 1. Financial Statements of this Quarterly Report on Form 10-Q for additional information regarding the Panion Amended License Agreement. Even though we entered into the Panion Amended License Agreement, there are no assurances that Panion will not allege other breaches of the Panion Amended License Agreement or otherwise attempt to terminate the Panion Amended License Agreement in the future. In addition, if Panion breaches its agreement with the inventor from whom it licenses rights to Auryxia, Panion could lose its license, which could impair or delay our ability to develop and commercialize Auryxia.\nFrom time to time, we may have disagreements with Panion, or Panion may have disagreements with the inventor from whom it licenses rights to Auryxia, regarding the terms of the agreements or ownership of proprietary rights, which could impact the commercialization of Auryxia, could require or result in litigation or arbitration, which would be time-consuming and expensive, could lead to the termination of the Panion Amended License Agreement, or force us to negotiate a revised or new license agreement on terms less favorable than the original. In addition, in the event that the owners and/or licensors of the rights we license were to enter into bankruptcy or similar proceedings, we could potentially lose our rights to Auryxia or our rights could otherwise be adversely affected, which could prevent us from continuing to commercialize Auryxia.\nRisks Related to our Intellectual Property\nIf we are unable to adequately protect our intellectual property, third parties may be able to use our intellectual property, which could adversely affect our ability to compete in the market.\nOur commercial success will depend in part on our ability, and the ability of our licensors, to obtain and maintain patent protection on our drug product and technologies, and to successfully defend these patents against third party challenges. We seek to protect our proprietary products and technology by filing patent applications in the United States and certain foreign jurisdictions. The process for obtaining patent protection is expensive and time consuming, and we may not be able to file and prosecute all necessary or desirable patent applications in a cost effective or timely manner. In addition, we may fail to identify patentable subject matter early enough to obtain patent protection. Further, license agreements with third parties may not allow us to control the preparation, filing and prosecution of patent applications, or the maintenance or enforcement of patents. Such third parties may decide not to enforce such patents or enforce such patents without our involvement. Thus, these patent applications and patents may not, under these circumstances, be prosecuted or enforced in a manner consistent with the best interests of the company.\nOur pending patent applications may not issue as patents and may not issue in all countries in which we develop, manufacture or potentially sell our product or in countries where others develop, manufacture and potentially sell products using our technologies. Moreover, our pending patent applications, if issued as patents, may not provide additional protection for our product.\nThe patent positions of pharmaceutical and biotechnology companies can be highly uncertain and involve complex legal and factual questions. No consistent policy regarding the breadth of claims allowed in pharmaceutical and biotechnology patents has emerged to date. Changes in the patent laws or the interpretation of the patent laws in the United States and other jurisdictions may diminish the value of our patents or narrow the scope of our patent protection. Accordingly, the patents we own or license may not be sufficiently broad to prevent others from practicing our technologies or from developing competing products. Furthermore, others may independently develop similar or alternative drug products or technologies or design around our patented drug product and technologies which may have an adverse effect on our business. If our competitors prepare and file patent applications in the United States that claim technology also claimed by us, we may have to participate in interference or derivation proceedings in front of the U.S. Patent and Trademark Office, or USPTO, to determine priority of invention, which could result in substantial cost, even if the eventual outcome is favorable to us. Because of the extensive time required for development, testing and regulatory review of a potential product, it is possible that any related patent may expire prior to, or\n90\nremain in existence for only a short period following, commercialization, which may significantly diminish our ability to exclude others from commercializing products that are similar or identical to ours. The patents we own or license may be challenged or invalidated or may fail to provide us with any competitive advantage. Since we have licensed or sublicensed many patents from third parties, we may not be able to enforce such licensed patents against third party infringers without the cooperation of the patent owner and the licensor, which may not be forthcoming. In addition, we may not be successful or timely in obtaining any patents for which we submit applications.\nGenerally, the first to file a patent application is entitled to the patent if all other requirements of patentability are met. However, prior to March 16, 2013, in the United States, the first to invent was entitled to the patent. Since publications of discoveries in the scientific literature often lag behind the actual discoveries, and patent applications in the United States and other jurisdictions are typically not published until 18 months after filing, or in some cases not at all, we cannot know with certainty whether we were the first to make the inventions claimed in our patents or pending patent applications, or that we were the first to file for patent protection of such inventions. Moreover, the laws enacted by the Leahy-Smith America Invents Act of 2011, which reformed certain patent laws in the United States, introduce procedures that permit competitors to challenge our patents in the USPTO after grant, including inter partes review and post grant review. Similar laws exist outside of the United States. The laws of the European Patent Convention, for example, provide for post-grant opposition procedures that permit competitors to challenge, or oppose, our European patents administratively at the European Patent Office.\nWe may become involved in addressing patentability objections based on third party submission of references, or we may become involved in defending our patent rights in oppositions, derivation proceedings, reexamination, inter partes review, post grant review, interference proceedings or other patent office proceedings or litigation, in the United States or elsewhere, challenging our patent rights or the patent rights of others. An adverse result in any such proceeding or litigation could reduce the scope of, or invalidate, our patent rights, allow third parties to commercialize our technology or products and compete directly with us, without payment to us.\nThe issuance of a patent is not conclusive as to its inventorship, scope, validity or enforceability, and our owned and licensed patents may be challenged on such a basis in the courts or patent offices in the United States and abroad. As a result of such challenges, we may lose exclusivity or freedom-to-operate or patent claims may be narrowed, invalidated or held unenforceable, in whole or in part, which could limit our ability to prevent third parties from using or commercializing similar or identical products, or limit the duration of the patent protection for our products.\nPeriodic maintenance fees on any issued patent are due to be paid to the USPTO and foreign patent agencies in several stages over the lifetime of the patent. The USPTO and governmental patent agencies in other jurisdictions also require compliance with a number of procedural, documentary, fee payment (such as annuities) and other similar provisions during the patent application process. While an inadvertent lapse in many cases can be cured by payment of a late fee or by other means in accordance with the applicable rules, there are situations in which non-compliance can result in abandonment or lapse of the patent or patent application, resulting in partial or complete loss of patent rights in the relevant jurisdiction. Non-compliance events that could result in abandonment or lapse of a patent or patent application include, but are not limited to, failure to respond to official actions within prescribed time limits, non-payment of fees, and failure to properly legalize and submit formal documents. In such an event, our competitors might be able to enter the market sooner than we expect, which would have a material adverse effect on our business.\nIn addition, patents protecting our product candidate might expire before or shortly after such candidate is commercialized. Thus, our patent portfolio may not provide sufficient rights to exclude others from commercializing products similar or identical to ours.\nWe also rely on trade secrets and know-how to protect our intellectual property where we believe patent protection is not appropriate or obtainable. Trade secrets are difficult to protect. While we require our employees, licensees, collaborators and consultants to enter into confidentiality agreements, this may not be sufficient to adequately protect our trade secrets or other proprietary information. In addition, in some cases, we share certain ownership and publication rights to data relating to some of our products and product candidates with research collaborators, licensees and other third parties. If we cannot maintain the confidentiality of this information, our ability to receive patent protection or protect our trade secrets or other proprietary information will be at risk.\nWe may not be able to protect our intellectual property rights throughout the world.\nFiling, prosecuting and defending patents on our products and product candidates in all countries throughout the world would be prohibitively expensive. Consequently, the breadth of our intellectual property rights in some countries outside the United States may be less extensive than those in the United States. In addition, the laws of some countries do not protect intellectual property rights to the same extent as laws in the United States. As a result, we may not be able to prevent third parties from practicing our inventions in all countries outside the United States, or from selling or importing products made using our\n91\ninventions in and into the United States or other countries. Competitors may use our technologies in countries where we have not obtained patent protection to develop their own products and, further, may infringe our patents in territories where we have patent protection, but where enforcement is not as strong as in the United States. These products may compete with our products and our patents or other intellectual property rights may not be effective or sufficient to prevent them from competing.\nMany companies have encountered significant problems in protecting and defending intellectual property rights in certain countries. The legal systems of certain countries, particularly certain developing countries, do not favor the enforcement of patents, trade secrets and other intellectual property, particularly those relating to pharmaceutical and biotechnology products, which could make it difficult for us to stop the infringement of our patents or the marketing of competing products in violation of our proprietary rights generally. Proceedings to enforce our patent rights in countries outside of the United States could result in substantial costs and divert our efforts and attention from other aspects of our business, could put our patents at risk of being invalidated or interpreted narrowly and our patent applications at risk of not issuing, and could provoke third parties to assert claims against us. We may not prevail in any lawsuits that we initiate, and the damages or other remedies awarded, if any, may not be commercially meaningful. Accordingly, our efforts to enforce our intellectual property rights around the world may be inadequate to obtain a significant commercial advantage for our products and product candidates from the intellectual property that we develop or license.\nThe intellectual property that we own or have licensed and related non-patent exclusivity relating to our current and future products is, and may be, limited, which could adversely affect our ability to compete in the market and adversely affect the value of Auryxia.\nThe patent rights and related non-patent exclusivity that we own or have licensed relating to Auryxia are limited in ways that may affect our ability to exclude third parties from competing against us. For example, a third party may design around our owned or licensed composition of matter patent claims or market a product for the methods of use not covered by our owned or licensed patents.\nObtaining proof of direct infringement by a competitor for a method of use patent requires us to demonstrate that the competitors make and market a product for the patented use(s). Alternatively, we can prove that our competitors induce or contribute to others in engaging in direct infringement. Proving that a competitor contributes to or induces infringement of a patented method by another has additional proof requirements. For example, proving inducement of infringement requires proof of intent by the competitor. If we are required to defend ourselves against claims or to protect our own proprietary rights against others, it could result in substantial costs to us and the distraction of our management. An adverse ruling in any litigation or administrative proceeding could prevent us from marketing and selling Auryxia, increase the risk that a generic or other similar version of Auryxia could enter the market to compete with Auryxia, limit our development and commercialization of Auryxia, or otherwise harm our competitive position and result in additional significant costs.\nMoreover, physicians may prescribe a competitive identical product for indications other than the one for which the product has been approved, or “off-label” indications, that are covered by the applicable patents. Although such off-label prescriptions may directly infringe or contribute to or induce infringement of method of use patents, such infringement is difficult to prevent.\nIn addition, any limitations of our patent protection described above may adversely affect the value of our drug product and may inhibit our ability to obtain a collaboration partner at terms acceptable to us, if at all.\nIn the United States, the FDA has the authority to grant additional regulatory exclusivity protection for approved drugs where the sponsor conducts specified testing in pediatric or adolescent populations. If granted, this pediatric exclusivity may provide an additional six months which are added to the term of any non-patent exclusivity that has been awarded as well as to the regulatory protection related to the term of a relevant patent, to the extent these protections have not already expired.\nIn addition to pediatric exclusivity protection, we may seek additional non-patent exclusivity for vadadustat and other product candidates under other provisions of the FDCA such as new chemical entity, or NCE, exclusivity, or exclusivity for a new use or new formulation, but there is no guarantee that vadadustat or any other product candidates will receive such exclusivity. The FDCA provides a five-year period of non-patent exclusivity within the United States to the first applicant to gain approval of an NDA for an NCE. A drug is an NCE if the FDA has not previously approved any other new drug containing the same active moiety, which consists of the molecule(s) or ion(s) responsible for the action of the drug substance (but not including those portions of the molecule that cause it to be a salt or ester or which are not bound to the molecule by covalent or similar bonds). During the exclusivity period, the FDA may not accept for review an ANDA or a 505(b)(2) NDA submitted by another company for another version of such drug where the applicant does not own or have a legal right of reference to all the data required for approval. However, an ANDA or 505(b)(2).\nAn ANDA that references an NDA product with NCE exclusivity may be submitted after four years if it contains a certification of patent invalidity or non-infringement. The FDCA also provides three years of exclusivity for an NDA, particularly a\n92\n505(b)(2) NDA or supplement to an existing NDA, if new clinical investigations, other than bioavailability studies, that were conducted or sponsored by the applicant are deemed by the FDA to be essential to the approval of the application (for example, for new indications, dosages, or strengths of an existing drug). This three-year exclusivity covers only the conditions associated with the new clinical investigations and does not prohibit the FDA from approving ANDAs for drugs containing the original active agent. The three-year exclusivity period, unlike five-year exclusivity, does not prevent the submission of a competing ANDA or 505(b)(2) NDA. Instead, it only prevents the FDA from granting final approval to such a product until expiration of the exclusivity period. Five-year and three-year exclusivity will not delay the submission (in the case of five-year exclusivity) or the approval (in the case of three-year exclusivity) of a full NDA submitted under section 505(b)(1) of the FDCA; however, an applicant submitting a full NDA would be required to conduct all of its own studies needed to independently support a finding of safety and effectiveness for the proposed product, or have a full right of reference to all studies not conducted by the applicant.\nWe received Paragraph IV certification notice letters regarding ANDAs submitted to the FDA requesting approval for generic versions of Auryxia tablets (210 mg iron per tablet), with the first received on October 31, 2018. We and Panion & BF Biotech, Inc., or Panion, and, Dr. Hsu, as applicable, filed certain complaints for patent infringement relating to such ANDAs, and have entered into settlement and license agreements with each of the ANDA filers.\nIn cases where NCE exclusivity has been granted to a new drug product, the 30-month stay triggered by such litigation is extended by the amount of time such that seven years and six months will elapse from the date of approval of the NDA for that product. Without NCE exclusivity, the 30-month stay on FDA final approval of an ANDA runs from the date on which the sponsor of the reference listed drug receives notice of a Paragraph IV certification from the ANDA applicant.\nWe cannot assure you that Auryxia, vadadustat, if approved, or any of our potential future products will obtain such pediatric exclusivity, NCE exclusivity or any other market exclusivity in the United States, EU or any other territory, or that we will be the first to receive the respective regulatory approval for such drugs so as to be eligible for any non-patent exclusivity protection. We also cannot assure you that Auryxia, vadadustat, if approved, or any of our potential future products will obtain patent term extension.\nThe market entry of one or more generic competitors or any third party’s attempt to challenge our intellectual property rights will likely limit Auryxia sales and have an adverse impact on our business and results of operation.\nAlthough the composition and use of Auryxia is currently claimed by 15 issued patents that are listed in the FDA’s Orange Book, we cannot assure you that we will be successful in defending against third parties attempting to invalidate or design around our patents or assert that our patents are invalid or otherwise unenforceable or not infringed, or in competing against third parties introducing generic equivalents of Auryxia or any of our potential future products. If our Orange Book-listed patents are successfully challenged by a third party and a generic version of Auryxia is approved and launched, revenue from Auryxia could decline significantly, which would have a material adverse effect on our sales, results of operations and financial condition.\nWe previously received Paragraph IV certification notice letters regarding ANDAs submitted to the FDA requesting approval for generic versions of Auryxia tablets (210 mg ferric iron per tablet). We filed complaints for patent infringement relating to such ANDAs, and subsequently entered into settlement and license agreements with all such ANDA filers that allow such ANDA filers to market a generic version of Auryxia in the United States beginning on March 20, 2025. It is possible that we may receive Paragraph IV certification notice letters from additional ANDA filers and may not ultimately be successful in an ANDA litigation. Generic competition for Auryxia or any of our potential future products could have a material adverse effect on our sales, results of operations and financial condition.\nLitigation, including third party claims of intellectual property infringement, may be costly and time consuming and may delay or harm our drug discovery, development and commercialization efforts.\nWe may be forced to initiate litigation to enforce our contractual and intellectual property rights, or we may be sued by third parties asserting claims based on contract, tort or intellectual property infringement. In addition, third parties may have or may obtain patents in the future and claim that our products or other technologies infringe their patents. If we are required to defend against suits brought by third parties, or if we sue third parties to protect our rights, we may be required to pay substantial litigation costs, and our management’s attention may be diverted from operating our business. In addition, any legal action against our licensor, licensees or us that seeks damages or an injunction of commercial activities relating to Auryxia, vadadustat or any other product candidates or other technologies, including those that may be in-licensed or acquired, could subject us to monetary liability, a temporary or permanent injunction preventing the development, marketing and sale of such products or such technologies, and/or require our licensor, licensees or us to obtain a license to continue to use such products or other technologies. We cannot predict whether our licensor, licensees or we would prevail in any of these types of actions or that any required license would be made available on commercially acceptable terms, if at all.\n93\nOur commercial success depends in part on our avoiding infringement of the patents and proprietary rights of third parties. The pharmaceutical and biotechnology industries are characterized by extensive litigation over patent and other intellectual property rights. We have in the past and may in the future become a party to, or be threatened with, future adversarial litigation or other proceedings regarding intellectual property rights with respect to our product and product candidates. As the pharmaceutical and biotechnology industries expand and more patents are issued, the risk increases that our drug candidates may give rise to claims of infringement of the patent rights of others.\nWhile our product candidates are in preclinical studies and clinical trials, we believe that the use of our product candidates in these preclinical studies and clinical trials in the United States falls within the scope of the exemptions provided by 35 U.S.C. Section 271(e), which provides that it shall not be an act of infringement to make, use, offer to sell, or sell within the United States or import into the United States a patented invention solely for uses reasonably related to the development and submission of information to the FDA. There is an increased possibility of a patent infringement claim against us with respect to commercial products. Our portfolio includes one commercial product, Auryxia. We received the CRL from the FDA regarding our NDA for vadadustat in March 2022, and, if in the future vadadustat is approved, vadadustat could be commercialized. We attempt to ensure that our products and product candidates and the methods we employ to manufacture them, as well as the methods for their use which we intend to promote, do not infringe other parties’ patents and other proprietary rights. There can be no assurance they do not, however, and competitors or other parties may assert that we infringe their proprietary rights in any event.\nFibroGen has filed patent applications in the United States and other countries directed to purportedly new methods of using previously known heterocyclic carboxamide compounds for purposes of treating or affecting specified conditions, and some of these applications have since issued as patents. To the extent any such patents issue or have been issued, we may initiate opposition or other legal proceedings with respect to such patents. We discuss the status of the opposition and/or invalidation proceedings against certain FibroGen patents in Part II, Item 1. Legal Proceedings of this Quarterly Report on Form 10-Q.\nThere may be patents of third parties of which we are currently unaware with claims to compounds, materials, formulations, methods of manufacture or methods for treatment related to the use or manufacture of our product candidates. Also, because patent applications can take many years to issue, there may be currently pending patent applications which may later result in issued patents that our product candidates may infringe.\nThird parties, including FibroGen, may in the future claim that our product and product candidates and other technologies infringe upon their patents and may challenge our ability to commercialize Auryxia and vadadustat, if approved. Parties making claims against us or our licensees may seek and obtain injunctive or other equitable relief, which could effectively block our or their ability to continue to commercialize Auryxia or further develop and commercialize vadadustat or any other product candidates, including those that may be in-licensed or acquired. If any third party patents were held by a court of competent jurisdiction to cover the manufacturing process of any of our products or product candidates, any molecules formed during the manufacturing process or any final product itself, the holders of any such patents may be able to block our ability to commercialize such product or product candidate unless we obtained a license under the applicable patents, or until such patents expire or they are finally determined to be held invalid or unenforceable. Similarly, if any third party patent were held by a court of competent jurisdiction to cover aspects of our formulations, processes for manufacture or our intended methods of use, the holders of any such patent may be able to block or impair our ability to develop and commercialize the applicable product candidate unless we obtained a license or until such patent expires or is finally determined to be held invalid or unenforceable. We may also elect to enter into a license in order to settle litigation or in order to resolve disputes prior to litigation. Furthermore, even in the absence of litigation, we may need to obtain licenses from third parties to advance our research or allow commercialization of our products or product candidates. Should a license to a third party patent become necessary, we cannot predict whether we would be able to obtain a license or, if a license were available, whether it would be available on commercially reasonable terms. If such a license is necessary and a license under the applicable patent is unavailable on commercially reasonable terms, or at all, our ability to commercialize our product or product candidate may be impaired or delayed, which could in turn significantly harm our business.\nFurther, defense of infringement claims, regardless of their merit, would involve substantial litigation expense and would be a substantial diversion of employee resources from our business. In the event of a successful claim of infringement against us, we may have to pay substantial damages, including treble damages and attorneys’ fees for willful infringement, pay royalties or redesign our products, which may be impossible or require substantial time and monetary expenditure.\nWe are currently involved in an opposition and invalidation proceedings and may in the future be involved in additional lawsuits or administrative proceedings to challenge the patents of our competitors or to protect or enforce our patents, which could be expensive, time consuming, and unsuccessful.\n94\nCompetitors may infringe our patents or misappropriate our trade secrets or confidential information. To counter infringement or unauthorized use, we may be required to file infringement or misappropriation claims, which can be expensive and time-consuming. We may not be able to prevent infringement of our patents or misappropriation of our trade secrets or confidential information, particularly in countries where the laws may not protect those rights as fully as in the United States. In addition, in an infringement proceeding, a court may decide that a patent of ours is not valid or is unenforceable, or may refuse to stop the other party from using the technology at issue on the grounds that our patents do not cover the technology in question. An adverse result in any litigation or defense proceedings could put one or more of our patents at risk of being invalidated, held unenforceable, or interpreted narrowly and held not infringed and could put our patent applications at risk of not issuing.\nIn addition, there may be a challenge or dispute regarding inventorship or ownership of patents or applications currently identified as being owned by or licensed to us. Defense of these claims, regardless of their merit, would involve substantial litigation expense and would be a substantial diversion of employee resources from our business. Interference proceedings provoked by third parties or brought by the USPTO may be necessary to determine the priority of inventions with respect to our patents or patent applications.\nVarious administrative proceedings are also available for challenging patents, including interference, reexamination, inter partes review, and post-grant review proceedings before the USPTO or oppositions and other comparable proceedings in foreign jurisdictions. An unfavorable outcome in any current or future proceeding in which we are challenging third party patents could require us to cease using the patented technology or to attempt to license rights to it from the prevailing party. Our business could be harmed if the prevailing party does not offer us a license on commercially reasonable terms or at all. Even if we are successful, participation in interference or other administrative proceedings before the USPTO or a foreign patent office may result in substantial costs and distract our management and other employees.\nWe are currently involved in opposition and invalidation proceedings in the European Patent Office, the Japan Patent Office, and the Patents Court of the UK. These proceedings may be ongoing for a number of years and may involve substantial expense and diversion of employee resources from our business. In addition, we may become involved in additional opposition proceedings or other legal or administrative proceedings in the future. For more information, see the other risk factors under “Risks Related to our Intellectual Property”.\nFurthermore, because of the substantial amount of discovery required in connection with intellectual property litigation and some administrative proceedings, there is a risk that some of our confidential information could be compromised by disclosure during discovery. In addition, there could be public announcements of the results of hearings, motions or other interim proceedings or developments. If securities analysts or investors perceive these results to be negative, it could have a substantial adverse effect on the price of our common stock.\nWe may be subject to claims that our employees, consultants or independent contractors have wrongfully used or disclosed confidential information of third parties.\nWe have received confidential and proprietary information from potential collaborators, prospective licensees and other third parties. In addition, we employ individuals who were previously employed at other biotechnology or pharmaceutical companies. We may be subject to claims that we or our employees, consultants or independent contractors have inadvertently or otherwise used or disclosed confidential information of these third parties or our employees’ former employers. We may also be subject to claims that former employees, collaborators or other third parties have an ownership interest in our patents or other intellectual property. We may be subject to ownership disputes in the future arising, for example, from conflicting obligations of consultants or others who are involved in developing our product candidates. Litigation may be necessary to defend against these claims. If we fail in defending any such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights, such as exclusive ownership of, or right to use, valuable intellectual property. Such an outcome could have a material adverse effect on our business. Even if we are successful in defending against these claims, litigation could result in substantial cost and be a distraction to our management and employees.\nRisks Related to our Business and Managing Growth\nIf we fail to attract, retain and motivate senior management and qualified personnel, we may be unable to successfully develop, obtain and/or maintain marketing approval of and commercialize vadadustat or commercialize Auryxia.\nRecruiting and retaining qualified personnel is critical to our success. We are also highly dependent on our executives, certain members of our senior management and certain members of our commercial organization. The loss of the services of our executives, senior managers or other employees could impede the achievement of our research, development, regulatory and commercialization objectives and seriously harm our ability to successfully implement our business strategy. Specifically, following receipt of the CRL, in April and May 2022, we implemented a reduction of our workforce by approximately 42% across all areas of our company (47% inclusive of the closing of the majority of open positions), including several members of\n95\nmanagement. Losing members of management and other key personnel subjects us to a number of risks, including the failure to coordinate responsibilities and tasks, the necessity to create new management systems and processes, the impact on corporate culture, and the retention of historical knowledge.\nFurthermore, replacing executives, senior managers and other key employees may be difficult and may take an extended period of time because of the limited number of individuals in our industry with the breadth of skills and experience required to successfully develop, obtain and/or maintain marketing approval of and commercialize Auryxia, vadadustat and other product candidates. Our future financial performance and our ability to develop, obtain and/or maintain marketing approval of and commercialize Auryxia and vadadustat and to compete effectively will depend, in part, on our ability to manage any future growth effectively. To that end, we must be able to hire, train, integrate, and retain additional qualified personnel with sufficient experience. We may be unable to hire, train, retain or motivate these personnel on acceptable terms given the intense competition among numerous biopharmaceutical companies for similar personnel, particularly in our geographic region.\nWe also experience competition for the hiring of personnel from universities and research institutions. In addition, we rely on contractors, consultants and advisors, including scientific and clinical advisors, to assist us in formulating and executing our research and development and commercialization strategy. Our contractors, consultants and advisors may become employed by companies other than ours and may have commitments with other entities that may limit their availability to us. If additional members of management or other personnel leave, or we are unable to continue to attract and retain high quality personnel, our ability to grow and pursue our business strategy will be limited.\nOur cost savings plan and the associated workforce reduction implemented in April and May 2022 may not result in anticipated savings, could result in total costs and expenses that are greater than expected and could disrupt our business.\nFollowing receipt of the CRL, in April and May 2022, we implemented a reduction in workforce by approximately 42% across all areas of our company (47% inclusive of the closing of the majority of open positions), including several members of management. The reduction in workforce reflects our determination to refocus our strategic priorities around our commercial product, Auryxia, and our development portfolio, and was the first step in a cost savings plan to significantly reduce our expense profile in line with being a single commercial product company. We may not realize, in full or in part, the anticipated benefits, savings and improvements in our cost structure from our restructuring efforts due to unforeseen difficulties, delays or unexpected costs. We recorded a restructuring charge of approximately $14.7 million in the aggregate primarily related to contractual termination benefits including severance, non-cash stock-based compensation expense, healthcare and related benefits in the nine months ended September 30, 2022. If we are unable to realize the expected operational efficiencies and cost savings from the restructuring, our operating results and financial condition would be adversely affected. We also cannot guarantee that we will not have to undertake additional workforce reductions or restructuring activities in the future. Furthermore, our cost savings plan may be disruptive to our operations, including our commercialization of Auryxia, which could affect our ability to generate product revenue. In addition, our workforce reductions could yield unanticipated consequences, such as attrition beyond planned staff reductions, or disruptions in our day-to-day operations. Our workforce reduction could also harm our ability to attract and retain qualified management, scientific, clinical, manufacturing and sales and marketing personnel who are critical to our business. Any failure to attract or retain qualified personnel could prevent us from successfully commercializing Auryxia and from successfully developing and commercializing our product candidates in the future, including vadadustat, if approved. If we are ultimately successful in obtaining approval of vadadustat in the United States, we will need to hire additional employees to support the commercialization of vadadustat in the United States, and if we are unsuccessful or delayed in doing so, the potential launch of vadadustat could be delayed.\nWe may encounter difficulties in managing our growth, including with respect to our employee base, and managing our operations successfully.\nIn our day-to-day operations, we may encounter difficulties in managing the size of our operations as well as challenges associated with managing our business. We have strategic collaborations for the commercialization of Riona and the development and commercialization of vadadustat, which is now being marketed under the trade name VafseoTM by our collaboration partner, MTPC, in Japan. Additionally, in the United States, we have a strategic relationship with Vifor Pharma related to the commercialization of vadadustat, if approved. As our operations continue, we expect that we will need to manage our current relationships and enter into new relationships, especially in light of the termination of our collaboration agreements with Otsuka, with various strategic collaborators, consultants, vendors, suppliers and other third parties. These relationships are complex and create numerous risks as we deal with issues that arise.\nOur future financial performance and our ability to commercialize Auryxia and vadadustat, if and where approved, and to compete effectively will depend, in part, on our ability to manage any future growth effectively. This future growth will impose significant added responsibilities on the business and members of management. To manage our recent and any future growth, we must continue to implement and improve our managerial, operational and financial systems, procedures and processes. We may not be able to implement these improvements in an efficient or timely manner and may discover deficiencies in existing\n96\nsystems, procedures and processes. Moreover, the systems, procedures and processes currently in place or to be implemented may not be adequate for any such growth. Any expansion of our operations may lead to significant costs and may divert our management and business development resources. Any inability to manage growth could delay the execution of our business plans or disrupt our operations. We may not be able to accomplish these tasks, and our failure to accomplish any of them could prevent us from successfully managing and, as applicable, growing our company.\nIn addition, we may need to further adjust the size of our workforce as a result of changes to our expectations for our business, which can result in management being required to divert a disproportionate amount of its attention away from our day-to-day activities and devote a substantial amount of time to managing these growth-related activities and related expenses.\nWe have identified a material weakness in our internal control over financial reporting relating to our inventory process. If we are not able to remediate this material weakness, or if we experience additional material weaknesses or other deficiencies in the future or otherwise fail to maintain an effective system of internal control over financial reporting, we may not be able to accurately report our financial results or prevent fraud.\nEffective internal control over financial reporting is necessary for us to provide reliable financial reports and, together with adequate disclosure controls and procedures, is designed to prevent fraud. Any failure to maintain or implement required new or improved controls, or difficulties encountered in implementation could cause us to fail to meet our reporting obligations. In addition, any testing by us, as and when required, conducted in connection with Section 404 of the Sarbanes-Oxley Act, or Section 404, or any testing by our independent registered public accounting firm, which became required for us as of December 31, 2019, may reveal deficiencies in our internal control over financial reporting that are deemed to be material weaknesses or that may require prospective or retroactive changes to our financial statements or identify other areas for further attention or improvement. As of December 31, 2019, management and our independent registered public accounting firm concluded that our internal control over financial reporting relating to our inventory process was not effective because of a material weakness due to our failure to design and maintain effective controls over the completeness, accuracy and presentation and disclosure of inventory. Despite remediation efforts we undertook during fiscal 2020 and 2021 and continue to make, our management and independent registered public accounting firm concluded that, as of September 30, 2022, our internal control over financial reporting relating to our inventory process was not effective because we did not maintain effective controls related to the review of inventory reconciliations, the validation of the inventory costing, the periodic assessment of excess and obsolete inventory related reserves and verification that the existence of all inventories subject to physical inventory counts were correctly counted. Additionally, as revised and enhanced controls need to be in operation for a sufficient period of time and be tested to ensure that the controls are operating as designed, management has concluded that the material weakness cannot be considered remediated as of September 30, 2022. Although we have initiated remediation measures to address the material weakness, we cannot provide assurance that we will be able to correct this material weakness in a timely manner or that our remediation efforts will be adequate to allow us to conclude that our internal controls will be effective in the future. Even if this material weakness is remediated in the future, our internal control over financial reporting could in the future have additional material weaknesses, deficiencies or conditions that could require correction or remediation.\nWe will need to continue to dedicate internal resources, engage outside consultants and maintain a detailed work plan to assess and document the adequacy of internal control over financial reporting, continue steps to remediate the material weakness relating to our inventory process described above and any future control deficiencies or material weaknesses, and improve control processes as appropriate, validate through testing that controls are functioning as documented and maintain a continuous reporting and improvement process for internal control over financial reporting. If we are not able to correct material weaknesses or deficiencies in internal controls in a timely manner or otherwise comply with the requirements of Section 404 in a timely manner, our ability to record, process, summarize and report financial information accurately and within applicable time periods may be adversely affected and we could be subject to sanctions or investigations by the SEC, the Nasdaq Stock Market or other regulatory authorities as well as stockholder litigation which would require additional financial and management resources and could adversely affect the market price of our common stock. Furthermore, if we cannot provide reliable financial reports or prevent fraud, our business and results of operations could be harmed. Inferior internal controls could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our common stock.\nSecurity breaches and unauthorized use of our information technology systems and information, or the information technology systems or information in the possession of our collaborators and other third parties, could damage the integrity of our clinical trials, impact our regulatory filings, compromise our ability to protect our intellectual property, and subject us to regulatory actions that could result in significant fines or other penalties.\nWe, our collaborators, contractors and other third parties rely significantly upon information technology, and any failure, inadequacy, interruption or security lapse of that technology, including any cybersecurity incidents, could harm our ability to operate our business effectively. In addition, we and our collaborators, contractors and other third parties rely on information technology networks and systems, including the Internet, to process, transmit and store clinical trial data, patient information, and other electronic information, and manage or support a variety of business processes, including operational and financial transactions and records, personal identifying information, payroll data and workforce scheduling information. We purchase\n97\nmost of our information technology from vendors, on whom our systems depend. We rely on commercially available systems, software, tools and monitoring to provide security for the processing, transmission and storage of company and customer information.\nIn the ordinary course of our business, we and our third party contractors maintain personal and other sensitive data on our and their respective networks, including our intellectual property and proprietary or confidential business information relating to our business and that of our clinical trial patients and business partners. In particular, we rely on CROs and other third parties to store and manage information from our clinical trials. We also rely on third parties to manage patient information for Auryxia. The secure maintenance of this sensitive information is critical to our business and reputation.\nCompanies and other entities and individuals have been increasingly subject to a wide variety of security incidents, cyber-attacks and other attempts to gain unauthorized access to systems and information. These threats can come from a variety of sources, ranging in sophistication from individual hackers to state-sponsored attacks. Cyber threats may be broadly targeted, or they may be custom-crafted against our information systems or those of our vendors or third party service providers. A security breach, cyberattack or unauthorized access of our clinical data or other data could damage the integrity of our clinical trials, impact our regulatory filings, cause significant risk to our business, compromise our ability to protect our intellectual property, and subject us to regulatory actions, including under the GDPR and CCPA discussed elsewhere in these risk factors and the privacy or security rules under federal, state, or other local laws outside of the United States protecting confidential or personal information, that could be expensive to defend and could result in significant fines or other penalties. Cyberattacks can include malware, computer viruses, hacking or other unauthorized access or other significant compromise of our computer, communications and related systems. Although we take steps to manage and avoid these risks and to be prepared to respond to attacks, our preventive and any remedial actions may not be successful and no such measures can eliminate the possibility of the systems’ improper functioning or the improper access or disclosure of confidential or personally identifiable information such as in the event of cyberattacks. Security breaches, whether through physical or electronic break-ins, computer viruses, ransomware, impersonation of authorized users, attacks by hackers or other means, can create system disruptions or shutdowns or the unauthorized disclosure of confidential information.\nAlthough we believe our collaborators, vendors and service providers, such as our CROs, take steps to manage and avoid information security risks and respond to attacks, we may be adversely affected by attacks against our collaborators, vendors or service providers, and we may not have adequate contractual remedies against such collaborators, vendors and service providers to remedy any harm to our business caused by such event. Additionally, outside parties may attempt to fraudulently induce employees, collaborators, or other contractors to disclose sensitive information or take other actions, including making fraudulent payments or downloading malware, by using “spoofing” and “phishing” emails or other types of attacks. Our employees may be targeted by such fraudulent activities. Outside parties may also subject us to distributed denial of services attacks or introduce viruses or other malware through “trojan horse” programs to our users’ computers in order to gain access to our systems and the data stored therein. In the recent past, cyber-attacks have become more prevalent and much harder to detect and defend against and, because the techniques used to obtain unauthorized access, disable or degrade service, or sabotage systems change frequently and continuously become more sophisticated, often are not recognized until launched against a target and may be difficult to detect for a long time, we may be unable to anticipate these techniques or to implement adequate preventive or detective measures, and we might not immediately detect such incidents and the damage caused by such incidents.\nSuch attacks, whether successful or unsuccessful, or other compromises with respect to our information security and the measures we implement to prevent, detect and respond to them, could:\n•result in our incurring significant costs related to, for example, rebuilding internal systems, defending against litigation, responding to regulatory inquiries or actions, paying damages or fines, or taking other remedial steps with respect to third parties;\n•lead to public exposure of personal information of participants in our clinical trials, Auryxia patients and others;\n•damage the integrity of our studies or delay their completion, disrupt our development programs, our business operations and commercialization efforts;\n•compromise our ability to protect our trade secrets and proprietary information;\n•damage our reputation and deter business partners from working with us; or\n•divert the attention of our management and key information technology resources.\nAny failure to maintain proper functionality and security of our internal computer and information systems could result in a loss of, or damage to, our data or marketing applications or inappropriate disclosure of confidential or proprietary information, interrupt our operations, damage our reputation, subject us to liability claims or regulatory penalties, under a variety of federal, state or other applicable privacy laws, such as HIPAA, the GDPR, or state data protection laws including the CCPA, harm our\n98\ncompetitive position and delay the further development and commercialization of our products and product candidates, or impact our relationships with customers and patients.\nOur employees, independent contractors, principal investigators, CROs, CMOs, consultants and vendors may engage in misconduct or other improper activities, including non-compliance with regulatory standards and requirements and insider trading.\nWe are exposed to the risk that our employees, independent contractors, principal investigators, CROs, CMOs, consultants and vendors may engage in fraudulent conduct or other illegal activity. Misconduct by these parties could include intentional, reckless and/or negligent conduct or unauthorized activities that violate applicable laws, including the following:\n•FDA and other healthcare authorities’ regulations, including those laws that require the reporting of true, complete and accurate information to regulatory authorities, and those prohibiting the promotion of unapproved drugs or approved drugs for an unapproved use;\n•quality standards, including GXP;\n•federal and state healthcare fraud and abuse laws and regulations and their non-U.S. equivalents;\n•anti-bribery and anti-corruption laws, such as the FCPA and the UK Bribery Act or country-specific anti-bribery or anti-corruption laws, as well as various import and export laws and regulations;\n•laws that require the reporting of true and accurate financial information and data; and\n•U.S. state and federal securities laws and regulations and their non-U.S. equivalents, including those related to insider trading.\nWe conducted our global clinical trials for vadadustat, and may in the future conduct additional trials, in countries where corruption is prevalent, and violations of any of these laws by our personnel or by any of our vendors or agents, such as our CROs or CMOs, could have a material adverse impact on our clinical trials and our business and could result in criminal or civil fines and sanctions. We are subject to complex laws that govern our international business practices. These laws include the FCPA, which prohibits U.S. companies and their intermediaries, such as CROs or CMOs, from making improper payments to foreign government officials for the purpose of obtaining or keeping business or obtaining any kind of advantage for the company. The FCPA also requires companies to keep accurate books and records and maintain adequate accounting controls. A number of past and recent FCPA investigations by the Department of Justice and the SEC have focused on the life sciences sector.\nCompliance with the FCPA is expensive and difficult, particularly in countries in which corruption is a recognized problem. Some of the countries in which we have conducted clinical trials and in which we have CMOs have a history of corruption, which increases our risks of FCPA violations. In addition, the FCPA presents unique challenges in the pharmaceutical industry because in many countries’ hospitals are operated by the government, and doctors and other hospital employees are considered foreign government officials. Certain payments made by pharmaceutical companies, or on their behalf by CROs, to hospitals in connection with clinical trials and other work have been deemed to be improper payments to government officials and have led to FCPA enforcement actions.\nAdditionally, the UK Bribery Act applies to our global activities and prohibits bribery of private individuals as well as public officials. The UK Bribery Act prohibits both the offering and accepting of a bribe and imposes strict liability on companies for failing to prevent bribery, unless the company can show that it had “adequate procedures” in place to prevent bribery. There are also local anti-bribery and anti-corruption laws in countries where we have conducted clinical trials, and many of these also carry the risk of significant financial or criminal penalties.\nWe are also subject to trade control regulations and trade sanctions laws that restrict the movement of certain goods, currency, products, materials, services and technology to, and certain operations in, various countries or with certain persons. Our ability to transfer commercial and clinical product and other clinical trial supplies, and for our employees, independent contractors, principal investigators, CROs, CMOs, consultants and vendors ability to travel, between certain countries is subject to maintaining required licenses and complying with these laws and regulations.\nEmployee misconduct could also involve the improper use of information obtained in the course of clinical trials, which could result in regulatory sanctions and serious harm to our reputation. This could include violations of HIPAA, other U.S. federal and state laws, and requirements of non-U.S. jurisdictions, including the GDPR. We are also exposed to risks in connection with any insider trading violations by employees or others affiliated with us.\nThe internal controls, policies and procedures, and training and compliance programs we have implemented to deter prohibited practices may not be effective in preventing our employees, contractors, consultants, agents or other representatives from\n99\nviolating or circumventing such internal policies or violating applicable laws and regulations. The failure to comply with laws governing international business practices may impact any future clinical trials, result in substantial civil or criminal penalties for us and any such individuals, including imprisonment, suspension or debarment from government contracting, withdrawal of our products, if approved, from the market, or being delisted from The Nasdaq Global Market. In addition, we may incur significant costs in implementing sufficient systems, controls and processes to ensure compliance with the aforementioned laws. The laws and regulations referenced above may restrict or prohibit a wide range of pricing, discounting, marketing and promotion, sales commission, customer incentive programs and other business arrangements that could adversely affect our business.\nAdditionally, it is not always possible to identify and deter misconduct by employees and third parties, and the precautions we take to detect and prevent this activity may not be effective in controlling known or unknown risks or preventing losses or in protecting us from governmental investigations or other actions or lawsuits stemming from a failure to be in compliance with such laws or regulations. If any such actions are instituted against us, and we are not successful in defending ourselves or asserting our rights, or if any such action is instituted against our employees, consultants, independent contractors, CROs, CMOs, vendors or principal investigators, those actions could have a significant impact on our business, including the imposition of civil, criminal and administrative penalties, damages, monetary fines, possible exclusion from participation in Medicare, Medicaid and other federal healthcare programs, contractual damages, reputational harm, diminished profits and future earnings, curtailment of our operations, disclosure of our confidential information and imprisonment, any of which could adversely affect our ability to operate our business and our results of operations.\nIf any of our service providers are later legally deemed to be employees, we could be subject to employment and tax withholding liabilities and other additional costs as well as other multiple damages and attorneys’ fees.\nWe rely on independent third parties to provide certain services to us. We structure our relationships with these outside service providers in a manner that we believe results in an independent contractor relationship, not an employee relationship. An independent contractor is generally distinguished from an employee by his or her degree of autonomy and independence in providing services. A high degree of autonomy and independence is generally indicative of an independent contractor relationship, while a high degree of control is generally indicative of an employment relationship. Tax or other regulatory authorities may challenge our characterization of services providers as independent contractors both under existing laws and regulations and under laws and regulations adopted in the future. If such regulatory authorities or state, federal or foreign courts were to determine that our service providers are employees and not independent contractors, we would, among other things, be required to withhold income taxes, to withhold and pay Social Security, Medicare and similar taxes, to pay unemployment and other related payroll taxes, and to provide certain employee benefits. We could also be liable for unpaid past taxes, interest and other costs and subject to penalties. Likewise, our service providers themselves may later challenge their classification as independent contractors, which may result in additional damages, including back wages, penalties, interest and attorneys’ fees. As a result, any legally binding determination that the service providers we characterize as independent contractors are actually our employees could have a material adverse effect on our business, financial condition and results of operations.\nOur financial statements include goodwill and an intangible asset as a result of the Merger. The intangible asset has become impaired and could become further impaired in the future under certain conditions. In addition, goodwill could become impaired in the future under certain conditions. Any potential future impairment of goodwill or intangible assets may significantly impact our results of operations and financial condition.\nAs of September 30, 2022, we had approximately $136.1 million in the aggregate of goodwill and a definite lived intangible asset from the Merger. In accordance with generally accepted accounting principles, or GAAP, we are required annually, or more frequently upon certain indicators of impairment, to review our estimates and assumptions underlying the fair value of our goodwill and our definite lived intangible assets when indicators of impairment are present. Events giving rise to impairment of goodwill or intangible assets are an inherent risk in the pharmaceutical industry and often cannot be predicted.\nConditions that could indicate impairment and necessitate such a review include, but are not limited to, Auryxia’s commercial performance, our inability to execute on our strategic initiatives, the deterioration of our market capitalization such that it is significantly below our net book value, a significant adverse change in legal factors, unexpected adverse business conditions, and an adverse action or assessment by a regulator. To the extent we conclude that goodwill and/or definite lived intangible assets have become impaired, we may be required to incur material write-offs relating to such impairment and any such write-offs could have a material impact on our future operating results and financial position. For example, in the second quarter of 2020, in connection with a routine business review, we reduced our short-term and long-term Auryxia revenue forecast. This reduction was primarily driven by the impact of the September 2018 CMS decision that Auryxia would no longer be covered by Medicare for the treatment of the IDA Indication. While this decision does not impact CMS coverage for the use of Auryxia for the control of serum phosphorus levels in adult patients with CKD on dialysis, or the Hyperphosphatemia Indication, it requires all Auryxia prescriptions for Medicare patients to undergo a prior authorization to ensure their use of Auryxia for the Hyperphosphatemia Indication. As a result, we recorded an impairment charge of $115.5 million during the three months ended\n100\nJune 30, 2020, which was entirely allocated to our only intangible asset, the developed product rights for Auryxia, and made a corresponding adjustment to the estimated useful life of the developed product rights for Auryxia, which we again adjusted during the three months ended December 31, 2020. The estimates, judgments and assumptions used in our impairment testing, and the results of our testing, are discussed in Note 9 to our consolidated financial statements in Part I, Item 1. Financial Statements of this Quarterly Report on Form 10-Q. If these estimates, judgments and assumptions change in the future, including if the Auryxia asset group does not meet its current forecasted projections, additional impairment charges related to goodwill or our intangible asset could be recorded in the future and additional corresponding adjustments may need to be made to the estimated useful life of the developed product rights for Auryxia, which could materially impact our financial position, certain of our material agreements, and our future operating results.\nIf product liability lawsuits are brought against us, we may incur substantial liabilities and may be required to limit commercialization of Auryxia or vadadustat, if approved.\nWe face an inherent risk of product liability as a result of the clinical and commercial use of Auryxia and vadadustat. For example, we may be sued if Auryxia or vadadustat allegedly causes injury or is found to be otherwise unsuitable during clinical trials, manufacturing, marketing or sale. Any such product liability claims may include allegations of defects in manufacturing, defects in design, a failure to warn of dangers inherent in the product or product candidate, negligence, strict liability and breach of warranties. Claims could also be asserted under state consumer protection acts. If we cannot successfully defend ourselves against product liability claims, we may incur substantial liabilities or be required to limit commercialization of Auryxia or vadadustat, if approved. Even a successful defense would require significant financial and management resources. Regardless of the merits or eventual outcome, product liability claims may result in:\n•decreased demand for Auryxia or vadadustat, if approved;\n•injury to our reputation and significant negative media attention;\n•withdrawal of clinical trial participants;\n•delay or termination of clinical trials;\n•our inability to continue to develop Auryxia or vadadustat;\n•significant costs to defend the related litigation;\n•a diversion of management’s time and our resources;\n•substantial monetary awards to study subjects or patients;\n•product recalls or withdrawals, or labeling, marketing or promotional restrictions;\n•decreased demand for Auryxia or vadadustat, if approved;\n•loss of revenue;\n•the inability to commercialize Auryxia or vadadustat, if approved; and\n•a decline in our stock price.\nFailure to obtain and retain sufficient product liability insurance at an acceptable cost to protect against potential product liability claims could prevent or inhibit the commercialization of products we develop. We currently carry product liability insurance that we believe is appropriate for our company. Although we maintain product liability insurance, any claim that may be brought against us could result in a court judgment or settlement in an amount that is not covered, in whole or in part, by our insurance or that is in excess of the limits of our insurance coverage. Our insurance policies also have various exclusions, and we may be subject to a product liability claim for which we have insufficient or no coverage. If we have to pay any amounts awarded by a court or negotiated in a settlement that exceed our coverage limitations or that are not covered by our insurance, we may not have, or be able to obtain, sufficient capital to pay such amounts. In addition, insurance coverage is becoming increasingly expensive, and we may not be able to maintain insurance coverage at a reasonable cost. We also may not be able to obtain additional insurance coverage that will be adequate to cover additional product liability risks that may arise. Consequently, a product liability claim may result in losses that could be material to our business.\nWe will continue to incur increased costs as a result of operating as a public company, and our management will be required to devote substantial time to compliance initiatives and corporate governance practices.\nAs a public company, we operate in a demanding regulatory environment, and we have and will continue to incur significant legal, accounting and other expenses. The Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act, the Dodd-Frank Wall Street Reform and Consumer Protection Act, the listing requirements of The Nasdaq Global Market and other applicable securities rules and regulations impose various requirements on public companies, including establishment and maintenance of effective disclosure and financial controls and certain corporate governance practices. In particular, our compliance with Section 404 of the Sarbanes-Oxley Act has required and will continue to require that we incur substantial accounting-related expenses and expend significant management efforts. Our testing, or the testing by our independent registered public accounting firm, may reveal deficiencies in our internal controls that we would be required to remediate in a timely manner. If we are not able to\n101\ncomply with the requirements of the Sarbanes-Oxley Act, we could be subject to sanctions or investigations by the SEC, the Nasdaq Global Market or other regulatory authorities, which would require additional financial and management resources and could adversely affect the market price of our securities. Furthermore, if we cannot provide reliable financial reports or prevent fraud, including as a result of remote working by our employees which has increased since the beginning of the COVID-19 pandemic, our business and results of operations would likely be materially and adversely affected.\nWe cannot predict or estimate the amount of additional costs we may incur to continue to operate as a public company, nor can we predict the timing of such costs. These rules and regulations are often subject to varying interpretations, in many cases due to their lack of specificity and, as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices.\nClaims for indemnification by our directors and officers may reduce our available funds to satisfy successful third-party claims against us and may reduce the amount of money available to us.\nOur Ninth Amended and Restated Certificate of Incorporation, as amended, or Charter, and our Amended and Restated By-Laws, or Bylaws, as amended to date, contain provisions that eliminate, to the maximum extent permitted by the General Corporation Law of the State of Delaware, or DGCL, the personal liability of our directors and executive officers for monetary damages for breach of their fiduciary duties as a director or officer. Our Charter and our Bylaws also provide that we will indemnify our directors and executive officers and may indemnify our employees and other agents to the fullest extent permitted by the DGCL.\nIn addition, as permitted by Section 145 of the DGCL our Bylaws and our indemnification agreements that we have entered into with our directors and executive officers provide that:\n•We will indemnify our directors and officers, as defined in our Bylaws, for serving us in those capacities or for serving other related business enterprises at our request, to the fullest extent permitted by Delaware law. Delaware law provides that a corporation may indemnify such person if such person acted in good faith and in a manner such person reasonably believed to be in or not opposed to the best interests of Akebia and, with respect to any criminal proceeding, had no reasonable cause to believe such person’s conduct was unlawful.\n•We may, in our discretion, indemnify employees and agents in those circumstances where indemnification is permitted by applicable law.\n•We are required to advance expenses, as incurred, to our directors and officers in connection with defending a proceeding, except that such directors or officers shall undertake to repay such advances if it is ultimately determined that such person is not entitled to indemnification.\n•The rights conferred in our Bylaws are not exclusive, and we are authorized to enter into indemnification agreements with our directors, officers, employees and agents and to obtain insurance to indemnify such persons.\nAny claims for indemnification made by our directors or officers could impact our cash resources and our ability to fund the business.\nOur ability to use net operating losses to offset future taxable income may be subject to certain limitations.\nUnder Section 382 of the Internal Revenue Code, or Section 382, a corporation that undergoes an “ownership change” is subject to limitations on its ability to utilize its pre-change net operating losses, or NOLs, to offset future taxable income. On December 12, 2018, we completed the Merger, which we believe has resulted in an ownership change under Section 382. In addition, the Tax Cuts and Jobs Act, including amendments made by the CARES Act, includes changes to U.S. federal tax rates and the rules governing net operating loss carryforwards that may significantly impact our ability to utilize our net operating losses to fully offset taxable income in the future. Future changes in our stock ownership, many of which are outside of our control, could result in an additional ownership change under Section 382. As a result, if we generate taxable income, our ability to use our pre-change NOL carryforwards to offset federal taxable income may be subject to limitations, which could potentially result in increased future tax liability to us. At the state level, state net operating losses generated in one state cannot be used to offset income generated in another state and there may be periods during which the use of NOL carryforwards is suspended or otherwise limited, which could accelerate or permanently increase state taxes owed.\nFurthermore, our ability to utilize our NOLs is conditioned upon our attaining profitability and generating U.S. taxable income. As described above under “—Risks Related to our Financial Position, Need for Additional Capital and Growth Strategy,” we have incurred significant net losses since our inception and anticipate that we will continue to incur significant losses for the\n102\nforeseeable future; thus, we do not know whether or when we will generate the U.S. taxable income necessary to utilize our NOLs.\nOur Charter designates the Court of Chancery of the State of Delaware as the sole and exclusive forum for certain types of actions and proceedings that may be initiated by our stockholders, which could limit our stockholders’ ability to obtain a favorable judicial forum for disputes with us or our directors, officers or employees.\nOur Charter provides that, subject to limited exceptions, the Court of Chancery of the State of Delaware will be the sole and exclusive forum for (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of a fiduciary duty owed by any of our directors, officers or other employees to us or our stockholders, (iii) any action asserting a claim against us arising pursuant to any provision of the DGCL our Charter or our Bylaws, or (iv) any other action asserting a claim against us, our directors, officers or other employees that is governed by the internal affairs doctrine. Under our Charter, this exclusive forum provision will not apply to claims that are vested in the exclusive jurisdiction of a court or forum other than the Court of Chancery of the State of Delaware, or for which the Court of Chancery of the State of Delaware does not have subject matter jurisdiction. For instance, the provision would not apply to actions arising under federal securities laws, including suits brought to enforce any liability or duty created by the Exchange Act, or the rules and regulations thereunder. Any person or entity purchasing or otherwise acquiring any interest in shares of our capital stock shall be deemed to have notice of and to have consented to the provisions of our Charter described above. This choice of forum provision may limit a stockholder’s ability to bring a claim in a judicial forum that it finds favorable for disputes with us or our directors, officers or other employees, which may discourage such lawsuits against us and our directors, officers and employees. Alternatively, if a court were to find these provisions of our Charter inapplicable to, or unenforceable with respect to, one or more of the specified types of actions or proceedings, we may incur additional costs associated with resolving such matters in other jurisdictions, which could adversely affect our business and financial condition.\nWe are currently subject to legal proceedings that could result in substantial costs and divert management's attention, and we could be subject to additional legal proceedings.\nWe are currently subject to legal proceedings, including those described in Part II, Item 1 in this Quarterly Report on Form 10-Q, and additional claims may arise in the future. In addition, securities class action and derivative lawsuits and other legal proceedings are often brought against companies for any of the risks described in this Quarterly Report on Form 10-Q following a decline in the market price of their securities. For example, we were party to a putative class action lawsuit in state court filed by purported Keryx stockholders challenging the disclosures made in connection with the Merger, including those that relate to vadadustat’s safety, approvability and commercial viability. Oral argument was held on October 7, 2022, and the Court dismissed the complaint without prejudice on October 17, 2022, giving plaintiffs thirty days to amend their complaint. The Court further ordered that, in the event plaintiffs do not file an amended complaint within thirty days of the dismissal, the dismissal shall be deemed to be with prejudice. In connection with any litigation or other legal proceedings, we could incur substantial costs, and such costs and any related settlements or judgments may not be covered by insurance. Monetary damages or any other adverse judgment would have a material adverse effect on our business and financial position. In addition, if other resolution or actions taken as a result of legal proceedings were to restrain our ability to operate or market our products and services, our consolidated financial position, results of operations or cash flows could be materially adversely affected. We could also suffer an adverse impact on our reputation, negative publicity and a diversion of management’s attention and resources, which could have a material adverse effect on our business.\nRisks Related to our Common Stock\nOur stock price has been and may continue to be volatile, which could result in substantial losses for holders or future purchasers of our common stock and lawsuits against us and our officers and directors.\nOur stock price has been and will likely continue to be volatile. The stock market in general and the market for similarly situated biopharmaceutical companies specifically have experienced extreme volatility that has often been unrelated to the operating performance of particular companies. Since our initial public offering in March 2014, the price of our common stock as reported on The Nasdaq Global Market has ranged from a low of $0.24 on October 24, 2022 to a high of $31.00 on June 20, 2014. The daily closing market price for our common stock varied between a high price of $0.46 on July 6, 2022 and a low price of $0.30 on September 29, 2022 in the three-month period ending on September 30, 2022. During that time, the price of our common stock ranged from an intra-day low of $0.30 per share to an intra-day high of $0.50 per share. From October 1, 2022 through the date of this Quarterly Report on Form 10-Q, the daily closing market price for our common stock has varied between a high price of $0.33 on October 6, 2022 and a low price of $0.25 on October 24, 2022. The market price of shares of our common stock could be subject to wide fluctuations in response to many risk factors listed in this section, including, among others, developments related to and results of our research or clinical trials, developments related to our regulatory submissions and meetings with regulatory authorities, in particular as it relates to vadadustat, commercialization of Auryxia, vadadustat, if and as approved in the U.S. and foreign markets including Europe, and any other product candidates, announcements by us or\n103\nour competitors of significant transactions or strategic collaborations, negative publicity around Auryxia or vadadustat, regulatory or legal developments in the United States and other countries, developments or disputes concerning our intellectual property, the recruitment or departure of key personnel including as a result of our recent reduction in workforce, actual or anticipated changes in estimates as to financial results, changes in the structure of healthcare payment systems, market conditions in the biopharmaceutical sector and other factors beyond our control. As a result of this volatility, our stockholders may not be able to sell their common stock at or above the price at which they purchased it.\nIn addition, companies that have experienced volatility in the market price of their stock have frequently been the subject of securities class action and shareholder derivative litigation. See Part II, Item 1. Legal Proceedings of this Quarterly Report on Form 10-Q for information concerning securities class action initiated against Keryx and certain current and former directors and officers of ours and Keryx’s. In addition, we could be the target of other such litigation in the future. Class action and shareholder derivative lawsuits, whether successful or not, could result in substantial costs, damage or settlement awards and a diversion of our management’s resources and attention from running our business, which could materially harm our reputation, financial condition and results of operations.\nThe issuance of additional shares of our common stock or the sale of shares of our common stock by any of our directors, officers or significant stockholders will dilute our stockholders’ ownership interest in Akebia and may cause the market price of our common stock to decline.\nMost of our outstanding common stock can be traded without restriction at any time. As such, sales of a substantial number of shares of our common stock in the public market could occur at any time. These sales, or the perception in the market that the holders of a large number of shares intend to sell such shares, could reduce the market price of our common stock.\nAs of September 30, 2022 and based on the amounts reported in the most recent filings made under Section 13(d) and 13(g) of the Securities Exchange Act of 1934, as amended, or the Exchange Act, the Vanguard Group, or Vanguard, beneficially owned just under 10.0% of our outstanding shares of common stock, State Street Corporation, or State Street, beneficially owned approximately 6.4% of our outstanding shares of common stock and Vifor Pharma beneficially owned approximately 4.1% of our outstanding shares of common stock. By selling a large number of shares of common stock, Vanguard or State Street could cause the price of our common stock to decline. The shares beneficially owned by Vifor Pharma have not been registered pursuant to the Securities Act and were issued and sold in reliance upon the exemption from registration contained in Section 4(a)(2) of the Securities Act and Rule 506 promulgated thereunder, but if they are registered in the future, those shares would become freely tradable and, if a large portion of such shares are sold, could cause the price of our common stock to decline.\nWe have a significant number of shares that are subject to outstanding options and restricted stock units, and in the future we may issue additional options, restricted stock units, or other derivative securities convertible into our common stock. The exercise or vesting of any such options, restricted stock units, or other derivative securities, and the subsequent sale of the underlying common stock, could cause a further decline in our stock price. These sales also might make it difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate. Such sales of our common stock could result in higher than average trading volume and may cause the market price for our common stock to decline.\nIn addition, we currently have on file with the SEC a shelf registration statement, which allows us to offer and sell up to $300 million in registered securities, such as common stock, preferred stock, debt securities, warrants and units, from time to time pursuant to one or more offerings at prices and terms to be determined at the time of sale, including a sales agreement prospectus that covers the offering, issuance and sale by us of up to a maximum aggregate offering price of up to $26 million of our common stock that may be issued and sold from time to time under a sales agreement with Jefferies LLC.\nSales of substantial amounts of shares of our common stock or other securities by our employees or our other stockholders or by us under our shelf registration statement, pursuant to at-the-market offerings or otherwise, could dilute our stockholders, lower the market price of our common stock and impair our ability to raise capital through the sale of equity securities.\nOur executive officers, directors and principal stockholders maintain the ability to significantly influence all matters submitted to stockholders for approval.\nAs of September 30, 2022, our executive officers, directors and principal stockholders, in the aggregate, beneficially owned shares representing a significant percentage of our capital stock. As a result, if these stockholders were to choose to act together, they would be able to significantly influence all matters submitted to our stockholders for approval, as well as our management and affairs. For example, these persons could significantly influence the election of directors and approval of any merger, consolidation or sale of all or substantially all of our assets. This concentration of voting power could delay or prevent an acquisition of our company on terms that other stockholders may desire.\n104\nProvisions in our organizational documents and Delaware law may have anti-takeover effects that could discourage an acquisition of us by others, even if an acquisition would be beneficial to our stockholders, and may prevent attempts by our stockholders to replace or remove our current management.\nProvisions in our Charter and our Bylaws contain provisions that may have the effect of discouraging, delaying or preventing a change in control of us or changes in our management. These provisions could also limit the price that investors might be willing to pay in the future for shares of our common stock, thereby depressing the market price of our common stock. In addition, because our Board of Directors is responsible for appointing certain members of our management team, these provisions may frustrate or prevent any attempts by our stockholders to replace or remove our current management by making it more difficult for stockholders to replace members of our Board of Directors. Among other things, these provisions:\n•authorize “blank check” preferred stock, which could be issued by our Board of Directors without stockholder approval and may contain voting, liquidation, dividend and other rights superior to our common stock;\n•create a classified Board of Directors whose members serve staggered three-year terms;\n•specify that special meetings of our stockholders can be called only by our Board of Directors pursuant to a resolution adopted by a majority of the total number of directors;\n•prohibit stockholder action by written consent;\n•establish an advance notice procedure for stockholder approvals to be brought before an annual meeting of our stockholders, including proposed nominations of persons for election to our Board of Directors;\n•provide that our directors may be removed only for cause;\n•provide that vacancies on our Board of Directors may be filled only by a majority of directors then in office, even though less than a quorum;\n•require a supermajority vote of 75% of the holders of our capital stock entitled to vote or the majority vote of our Board of Directors to amend our Bylaws; and\n•require a supermajority vote of 85% of the holders of our capital stock entitled to vote to amend the classification of our Board of Directors and to amend certain other provisions of our Charter.\nThese provisions, alone or together, could delay or prevent hostile takeovers, changes in control or changes in our management.\nIn addition, Section 203 of the DGCL prohibits a publicly-held Delaware corporation from engaging in a business combination with an interested stockholder, generally a person which together with its affiliates owns, or within the last three years has owned, 15% of our voting stock, for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner.\nBecause we do not anticipate paying any cash dividends on our capital in the foreseeable future, capital appreciation, if any, will be our stockholders’ sole source of gain.\nWe have never declared or paid cash dividends on our capital stock and we currently intend to retain all of our future earnings, if any, to finance the development and growth of our business. Any payment of cash dividends in the future would be at the discretion of our Board of Directors and would depend on, among other things, our earnings, financial condition, capital requirements, level of indebtedness, statutory and contractual restrictions applying to the payment of dividends and other considerations that the Board of Directors deems relevant. In addition, the terms of the Loan Agreement preclude us from paying cash dividends and future debt agreements may preclude us from paying cash dividends. As a result, capital appreciation, if any, of our common stock will be our stockholders’ sole source of gain for the foreseeable future.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\nSales of Unregistered Securities\nDuring the quarter ended September 30, 2022, we did not have any sales of unregistered securities.\nItem 3. Defaults Upon Senior Securities.\nNot applicable.\nItem 4. Mine Safety Disclosures.\nNot applicable.\n105\nItem 5. Other Information.\nAs previously disclosed, on May 9, 2022, in connection with our workforce reduction, we announced certain management transitions, including that we and Michel Dahan, our Chief Operating Officer, agreed that his employment with us would terminate effective January 23, 2023, except in the event of certain specified events when his employment with us would terminate later, but in no event later than July 1, 2023. On November 2, 2022, we and Mr. Dahan agreed to extend the effective date of his termination to May 5, 2023, and, in the event of certain specified events, the effective date of his termination may extend to October 20, 2023.\n106\nItem 6. Exhibits.\n| Exhibits |\n| 3.1 | Ninth Amended and Restated Certificate of Incorporation (incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K, filed on March 28, 2014). |\n| 3.2 | Certificate of Amendment of Ninth Amended and Restated Certificate of Incorporation of Akebia Therapeutics, Inc. (incorporated by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K, filed on June 9, 2020). |\n| 3.3 | Amended and Restated Bylaws (incorporated by reference to Exhibit 3.2 to the Company’s Current Report on Form 8-K, filed on March 28, 2014). |\n| 10.1# | Second Amendment and Waiver, dated July 15, 2022, by and among the Company, Biopharma Credit plc, BCPR Limited Partnership and Biopharma Credit Investments V (Master) LP (incorporated by reference to Exhibit 10.9 to the Company’s Quarterly Report on Form 10-Q (001-36352), filed on August 4, 2022). |\n| 10.2*# | Form of Amendment to Retention and Separation Agreement for Michel Dahan and Nicole R. Hadas. |\n| 31.1* | Certification of Principal Executive Officer Required Under Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended. |\n| 31.2* | Certification of Principal Financial Officer Required Under Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended. |\n| 32.1* | Certification of Principal Executive Officer and Principal Financial Officer Required Under Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C. 1350. |\n| 101.INS* | Inline XBRL Instance Document (the instance document does not appear in the Interactive Data File because XBRL tags are embedded within the Inline XBRL document) |\n| 101.SCH* | Inline XBRL Taxonomy Extension Schema Document |\n| 101.CAL* | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF* | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB* | Inline XBRL Taxonomy Extension Labels Linkbase Document |\n| 101.PRE* | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104* | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\n\n* Filed, or submitted electronically, herewith\n# Indicates portions of the exhibit (indicated by asterisks) have been omitted pursuant to Item 601(b)(10)(iv) of Regulation S-K\n107\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n| AKEBIA THERAPEUTICS, INC. |\n| Date: November 3, 2022 | By: | /s/ John P. Butler |\n| John P. Butler |\n| President and Chief Executive Officer (Principal Executive Officer) |\n| Date: November 3, 2022 | By: | /s/ David A. Spellman |\n| David A. Spellman |\n| Senior Vice President, Chief Financial Officer and Treasurer (Principal Financial Officer) |\n| Date: November 3, 2022 | By: | /s/ Violetta Cotreau |\n| Violetta Cotreau |\n| Senior Vice President, Chief Accounting Officer (Principal Accounting Officer) |\n\n108\n \n\nIf the Company continues to earn revenue from the MTPC Supply Agreement at the same rate as in the nine months ended September 30, 2022, how many months of operation could the Company fund using solely this revenue, with its cash and cash equivalents as of September 30, 2022?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nItem 1. Financial Statements.\\nAKEBIA THERAPEUTICS, INC.\\nCondensed Consolidated Balance Sheets\\n(Unaudited)\\n(in thousands, except share and per share data)\\n| September 30,2022 | December 31,2021 |\\n| Assets |\\n| Current assets: |\\n| Cash and cash equivalents | $ | 144,761 | $ | 149,800 |\\n| Inventory | 40,039 | 38,195 |\\n| Accounts receivable, net | 23,094 | 50,875 |\\n| Prepaid expenses and other current assets | 29,618 | 33,140 |\\n| Total current assets | 237,512 | 272,010 |\\n| Property and equipment, net | 5,622 | 6,754 |\\n| Operating lease assets | 30,337 | 33,852 |\\n| Goodwill | 55,053 | 55,053 |\\n| Other intangible assets, net | 81,095 | 108,127 |\\n| Other assets | 26,275 | 49,754 |\\n| Total assets | $ | 435,894 | $ | 525,550 |\\n| Liabilities and stockholders' equity |\\n| Current liabilities: |\\n| Accounts payable | $ | 19,708 | $ | 33,588 |\\n| Accrued expenses and other current liabilities | 87,364 | 104,456 |\\n| Short-term deferred revenue | 1,265 | 20,906 |\\n| Current portion of refund liability to customer | 13,681 | — |\\n| Current portion of long-term debt | 65,947 | 97,543 |\\n| Total current liabilities | 187,965 | 256,493 |\\n| Deferred revenue, net of current portion | 43,296 | 21,474 |\\n| Operating lease liabilities, net of current portion | 30,683 | 33,703 |\\n| Derivative liability | 760 | 1,820 |\\n| Liability related to sale of future royalties, net | 58,236 | 53,079 |\\n| Refund liability to customer, net of current portion | 26,788 | — |\\n| Other non-current liabilities | 74,313 | 82,525 |\\n| Total liabilities | 422,041 | 449,094 |\\n| Commitments and contingencies (Note 13) |\\n| Stockholders' equity: |\\n| Preferred stock $ 0.00001 par value, 25,000,000 shares authorized; 0 shares issued and outstanding at September 30, 2022 and December 31, 2021 | — | — |\\n| Common stock $ 0.00001 par value; 350,000,000 shares authorized at September 30, 2022 and December 31, 2021; 183,951,583 and 177,000,963 shares issued and outstanding at September 30, 2022 and December 31, 2021, respectively | 2 | 1 |\\n| Additional paid-in capital | 1,559,206 | 1,536,800 |\\n| Accumulated other comprehensive loss | 6 | 6 |\\n| Accumulated deficit | ( 1,545,361 ) | ( 1,460,351 ) |\\n| Total stockholders' equity | 13,853 | 76,456 |\\n| Total liabilities and stockholders' equity | $ | 435,894 | $ | 525,550 |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n7\\nAKEBIA THERAPEUTICS, INC.\\nCondensed Consolidated Statements of Operations and Comprehensive Loss\\n(Unaudited)\\n(in thousands, except share and per share data)\\n\\n| Three Months EndedSeptember 30, | Nine Months EndedSeptember 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Revenues: |\\n| Product revenue, net | $ | 42,239 | $ | 36,753 | $ | 127,390 | $ | 100,120 |\\n| License, collaboration and other revenue | 6,725 | 12,003 | 110,032 | 53,853 |\\n| Total revenues | 48,964 | 48,756 | 237,422 | 153,973 |\\n| Cost of goods sold: |\\n| Product | 28,936 | 6,933 | 60,859 | 76,012 |\\n| Amortization of intangibles | 9,011 | 9,011 | 27,032 | 27,032 |\\n| Total cost of goods sold | 37,947 | 15,944 | 87,891 | 103,044 |\\n| Operating expenses: |\\n| Research and development | 27,350 | 40,471 | 97,210 | 118,296 |\\n| Selling, general and administrative | 30,918 | 46,357 | 108,052 | 129,336 |\\n| License expense | 743 | 870 | 2,323 | 2,460 |\\n| Restructuring | 180 | — | 14,711 | — |\\n| Total operating expenses | 59,191 | 87,698 | 222,296 | 250,092 |\\n| Operating loss | ( 48,174 ) | ( 54,886 ) | ( 72,765 ) | ( 199,163 ) |\\n| Other income (expense): |\\n| Interest expense | ( 3,952 ) | ( 5,085 ) | ( 14,051 ) | ( 14,853 ) |\\n| Other income | 1,167 | 427 | 2,712 | 1,854 |\\n| Loss on extinguishment of debt | ( 906 ) | — | ( 906 ) | — |\\n| Net loss | $ | ( 51,865 ) | $ | ( 59,544 ) | $ | ( 85,010 ) | $ | ( 212,162 ) |\\n| Net loss per share - basic and diluted | $ | ( 0.28 ) | $ | ( 0.34 ) | $ | ( 0.47 ) | $ | ( 1.30 ) |\\n| Weighted-average number of common shares - basic and diluted | 183,882,446 | 173,782,151 | 182,375,443 | 163,050,769 |\\n| Comprehensive loss: |\\n| Net loss | $ | ( 51,865 ) | $ | ( 59,544 ) | $ | ( 85,010 ) | $ | ( 212,162 ) |\\n| Other comprehensive loss - unrealized loss on debt securities | — | — | — | ( 7 ) |\\n| Total comprehensive loss | $ | ( 51,865 ) | $ | ( 59,544 ) | $ | ( 85,010 ) | $ | ( 212,169 ) |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n8\\nAKEBIA THERAPEUTICS, INC.\\nCondensed Consolidated Statements of Stockholders’ Equity\\n(Unaudited)\\n(in thousands, except share data)\\n| Common Stock |\\n| Number ofShares | $ 0.00001 Par Value | Additional Paid-InCapital | UnrealizedGain/(Loss) | AccumulatedDeficit | Total Stockholders'Equity |\\n| Balance at December 31, 2020 | 148,074,085 | $ | 1 | $ | 1,425,115 | $ | 13 | $ | ( 1,177,511 ) | $ | 247,618 |\\n| Issuance of common stock, net of issuance costs | 9,228,017 | 1 | 29,497 | — | — | 29,498 |\\n| Proceeds from sale of stock under employee stock purchase plan | 154,276 | — | 367 | — | — | 367 |\\n| Stock-based compensation expense | — | — | 5,992 | — | — | 5,992 |\\n| Restricted stock unit vesting | 1,063,711 | — | — | — | — | — |\\n| Unrealized loss | — | — | — | ( 4 ) | — | ( 4 ) |\\n| Net loss | — | — | — | — | ( 69,580 ) | ( 69,580 ) |\\n| Balance at March 31, 2021 | 158,520,089 | $ | 2 | $ | 1,460,971 | $ | 9 | $ | ( 1,247,091 ) | $ | 213,891 |\\n| Issuance of common stock, net of issuance costs | 10,446,160 | — | 37,266 | — | — | 37,266 |\\n| Stock-based compensation expense | — | — | 6,515 | — | — | 6,515 |\\n| Restricted stock unit vesting | 685,174 | — | — | — | — | — |\\n| Unrealized loss | — | — | — | ( 3 ) | — | ( 3 ) |\\n| Net loss | — | — | — | — | ( 83,038 ) | ( 83,038 ) |\\n| Balance at June 30, 2021 | 169,651,423 | $ | 2 | $ | 1,504,752 | $ | 6 | $ | ( 1,330,129 ) | $ | 174,631 |\\n| Issuance of common stock, net of issuance costs | 4,730,466 | — | 16,092 | — | — | 16,092 |\\n| Proceeds from sale of stock under employee stock purchase plan | 152,917 | — | 379 | — | — | 379 |\\n| Share-based compensation expense | — | — | 5,592 | — | — | 5,592 |\\n| Restricted stock unit vesting | 17,183 | — | — | — | — | — |\\n| Net loss | — | — | — | — | ( 59,544 ) | ( 59,544 ) |\\n| Balance at September 30, 2021 | 174,551,989 | $ | 2 | $ | 1,526,815 | $ | 6 | $ | ( 1,389,673 ) | $ | 137,150 |\\n| Balance at December 31, 2021 | 177,000,963 | $ | 1 | $ | 1,536,800 | $ | 6 | $ | ( 1,460,351 ) | $ | 76,456 |\\n| Issuance of common stock, net of issuance costs | 4,404,600 | 1 | 7,177 | — | — | 7,178 |\\n| Proceeds from sale of stock under employee stock purchase plan | 191,146 | — | 367 | — | — | 367 |\\n| Stock-based compensation expense | — | — | 4,536 | — | — | 4,536 |\\n| Restricted stock unit vesting | 1,789,326 | — | — | — | — | — |\\n| Net loss | — | — | — | — | ( 62,421 ) | ( 62,421 ) |\\n| Balance at March 31, 2022 | 183,386,035 | $ | 2 | $ | 1,548,880 | $ | 6 | $ | ( 1,522,772 ) | $ | 26,116 |\\n| Stock-based compensation expense | — | — | 6,841 | — | — | 6,841 |\\n| Exercise of options | 142,440 | — | 67 | — | — | 67 |\\n| Restricted stock unit vesting | 176,179 | — | — | — | — | — |\\n| Net income | — | — | — | — | 29,276 | 29,276 |\\n| Balance at June 30, 2022 | 183,704,654 | $ | 2 | $ | 1,555,788 | $ | 6 | $ | ( 1,493,496 ) | $ | 62,300 |\\n| Share-based compensation expense | — | — | 3,375 | — | — | 3,375 |\\n| Proceeds from sale of stock under employee stock purchase plan | 144,000 | — | 43 | — | — | 43 |\\n| Restricted stock unit vesting | 102,929 | — | — | — | — | — |\\n| Net loss | — | — | — | — | ( 51,865 ) | ( 51,865 ) |\\n| Balance at September 30, 2022 | 183,951,583 | $ | 2 | $ | 1,559,206 | $ | 6 | $ | ( 1,545,361 ) | $ | 13,853 |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements\\n9\\nAKEBIA THERAPEUTICS, INC.\\nCondensed Consolidated Statements of Cash Flows\\n(Unaudited)\\n(in thousands)\\n10\\n| Nine Months Ended |\\n| September 30, 2022 | September 30, 2021 |\\n| Operating activities: |\\n| Net loss | $ | ( 85,010 ) | $ | ( 212,162 ) |\\n| Adjustments to reconcile net loss to net cash used in operating activities: |\\n| Depreciation and amortization | 1,246 | 1,485 |\\n| Amortization of intangibles | 27,032 | 27,032 |\\n| Amortization of premium/discount on investments | — | ( 15 ) |\\n| Non-cash interest expense related to sale of future royalties | 6,352 | 6,779 |\\n| Non-cash royalty revenue related to sale of future royalties | ( 1,195 ) | ( 425 ) |\\n| Non-cash collaboration revenue | ( 9,550 ) | — |\\n| Non-cash R&D expense | 3,941 | — |\\n| Non-cash interest expense | 1,467 | 852 |\\n| Non-cash operating lease expense | ( 1,818 ) | ( 1,415 ) |\\n| Non-cash loss on extinguishment of debt | 406 | — |\\n| Fair value step-up of inventory sold or written off | — | 21,575 |\\n| Write-down of inventory | 10,002 | 7,126 |\\n| Change in excess inventory purchase commitments | 12,422 | 15,376 |\\n| Stock-based compensation | 14,808 | 18,099 |\\n| Change in fair value of derivative liability | ( 1,060 ) | ( 490 ) |\\n| Changes in operating assets and liabilities: |\\n| Accounts receivable | 27,781 | ( 22,837 ) |\\n| Inventory | 1,405 | ( 35,282 ) |\\n| Prepaid expenses and other current assets | 9,131 | ( 25,020 ) |\\n| Other long-term assets | 14,817 | 4,728 |\\n| Accounts payable | ( 17,420 ) | ( 14,933 ) |\\n| Accrued expense | ( 22,364 ) | 15,099 |\\n| Operating lease liabilities | 1,771 | 1,173 |\\n| Deferred revenue | 2,181 | 3,098 |\\n| Other non-current liabilities | ( 14,820 ) | — |\\n| Net cash used in operating activities | ( 18,475 ) | ( 190,157 ) |\\n| Investing activities: |\\n| Purchase of equipment | ( 114 ) | ( 59 ) |\\n| Proceeds from the maturities of available for sale securities | — | 40,000 |\\n| Net cash (used in) provided by investing activities | ( 114 ) | 39,941 |\\n| Financing activities: |\\n| Proceeds from sale of future royalties, net | — | 44,783 |\\n| Proceeds from refund liabilities to customers | 40,000 | — |\\n| Proceeds from the issuance of common stock, net of issuance costs | 7,122 | 82,799 |\\n| Proceeds from the sale of stock under employee stock purchase plan | 410 | 746 |\\n| Proceeds from the exercise of stock options | 67 | — |\\n| Payments on debt | ( 33,000 ) | — |\\n| Net cash provided by financing activities | 14,599 | 128,328 |\\n| (Decrease) in cash, cash equivalents, and restricted cash | ( 3,990 ) | ( 21,888 ) |\\n| Cash, cash equivalents, and restricted cash at beginning of the period | 151,839 | 231,132 |\\n| Cash, cash equivalents, and restricted cash at end of the period | $ | 147,849 | $ | 209,244 |\\n| Non-cash financing activities |\\n| Unpaid offering costs | $ | — | $ | 57 |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements\\n11\\nAkebia Therapeutics, Inc.\\nNotes to Condensed Consolidated Financial Statements\\n(Unaudited)\\n1. Nature of Organization and Operations\\nAkebia Therapeutics, Inc., referred to as Akebia or the Company, was incorporated in the State of Delaware in 2007. Akebia is a biopharmaceutical company with the purpose of bettering the lives of people impacted by kidney disease. The Company has one commercial product, Auryxia® (ferric citrate), which is approved by the U.S. Food and Drug Administration, or FDA, and marketed for two indications in the United States: the control of serum phosphorus levels in adult patients with chronic kidney disease, or CKD, on dialysis, or DD-CKD, and the treatment of iron deficiency anemia, or IDA, in adult patients with CKD not on dialysis, or NDD-CKD. Ferric citrate is also approved and marketed in Japan as an oral treatment for IDA in adult patients for the improvement of hyperphosphatemia in such patients with DD-CKD and NDD-CKD under the trade name Riona (ferric citrate hydrate).\\nVadadustat, the Company’s lead investigational product candidate, is an investigational oral hypoxia-inducible factor prolyl hydroxylase, or HIF-PH, inhibitor designed to mimic the physiologic effect of altitude on oxygen availability. On March 29, 2022, the Company received a complete response letter, or CRL, from the FDA. The CRL provided that the FDA had completed its review of the Company's new drug application, or NDA, for vadadustat for the treatment of anemia due to CKD in adult patients and had determined that it could not approve the NDA in its present form. In July 2022, the Company held an end of review meeting with the FDA to inform the Company's next steps with respect to the potential U.S. approval of vadadustat, if any, and in October 2022, the Company submitted a Formal Dispute Resolution Request, or FDRR, with the FDA. The FDRR focuses on the favorable balance between the benefits and risks of vadadustat for the treatment of anemia due to CKD in adult patients on dialysis in light of safety concerns expressed by the FDA in the CRL related to the rate of adjudicated thromboembolic events driven by vascular access thrombosis for vadadustat compared to the active comparator and the risk of drug-induced liver injury. On May 12, 2022, the Company received notice from its former collaboration partner, Otsuka Pharmaceutical Co. Ltd., or Otsuka, that Otsuka had elected to terminate the Collaboration and License Agreement dated December 18, 2016, or the Otsuka U.S. Agreement, and the Collaboration and License Agreement dated April 25, 2017, or the Otsuka International Agreement. On June 30, 2022, the Company and Otsuka entered into a Termination and Settlement Agreement, or the Termination Agreement, pursuant to which, among other things, the Company and Otsuka agreed to terminate the Otsuka U.S. Agreement and the Otsuka International Agreement as of June 30, 2022 (see Note 4 for further details). In October 2021, Otsuka submitted a Marketing Authorization Application, or MAA, for vadadustat for the treatment of anemia due to CKD in adult patients with DD-CKD and NDD-CKD to the European Medicines Agency, or EMA. In connection with the Termination Agreement, Otsuka transferred the MAA for vadadustat with the EMA to the Company. Vadadustat is approved in Japan as a treatment for anemia due to CKD in both DD-CKD and NDD-CKD patients under the trade name VafseoTM, and marketed and sold in Japan by Mitsubishi Tanabe Pharma Corporation, or MTPC.\\nIn addition, the Company continues to explore additional development opportunities to expand its pipeline and portfolio of novel therapeutics.\\nSince inception, the Company has devoted most of its resources to research and development, including its preclinical and clinical development activities, commercializing Auryxia, and providing general and administrative support for these operations. The Company began recording revenue from the U.S. sales of Auryxia and revenue from sublicensing rights to Auryxia in Japan from the Company’s Japanese partners, Japan Tobacco, Inc. and its subsidiary Torii Pharmaceutical Co., Ltd., collectively JT and Torii, in December 2018. Additionally, following regulatory approval of vadadustat in Japan, the Company began recognizing royalty revenues from MTPC from the sale of Vafseo in August 2020. In February 2021, the Company entered into a royalty interest acquisition agreement with HealthCare Royalty Partners IV, L.P., or HCR, or the Royalty Agreement, whereby the Company sold its right to receive royalties and sales milestones under its Collaboration Agreement with MTPC, or the MTPC Agreement, subject to certain caps and other terms and conditions (see Note 6 for additional information). The Company has not generated a profit to date, and may never generate profits, from product sales. Vadadustat and the Company’s other potential product candidates are subject to long development cycles, and the Company may be unsuccessful in its efforts to develop, obtain marketing approval for or market vadadustat and its other potential product candidates. If the Company does not successfully commercialize Auryxia, vadadustat, if approved, or any other potential product candidate, it may be unable to achieve profitability.\\nGoing Concern\\nThe Company’s management completed its going concern assessment in accordance with Accounting Standards Codification, or ASC, 205-40, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern, or ASC 205-40. Pursuant to the requirements of ASC 205-40, the Company’s management must evaluate whether there are conditions or events,\\n12\\nconsidered in the aggregate, that raise substantial doubt about the Company’s ability to continue as a going concern within one year after the date the financial statements are issued. This evaluation initially does not take into consideration the potential mitigating effect of management’s plans that have not been fully implemented as of the date the financial statements are issued.\\nWhen substantial doubt exists under this methodology, the Company’s management evaluates whether the mitigating effect of its plans sufficiently alleviates substantial doubt about the Company’s ability to continue as a going concern. The mitigating effect of the Company’s plans, however, is only considered if both (1) it is probable that the plans will be effectively implemented within one year after the date that the financial statements are issued and (2) it is probable that the plans, when implemented, will mitigate the relevant conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued.\\nAs of September 30, 2022, the Company had cash and cash equivalents of approximately $ 144.8 million. The Company believes that its cash resources will be sufficient to allow the Company to fund its current operating plan through at least the next twelve months from the filing of this Quarterly Report on Form 10-Q. However, the Company's operating plan includes assumptions pertaining to cost avoidance measures and the reduction of overhead costs that would result from the planned amendment of contractual arrangements with certain supply and collaboration partners, and the reduction of operating expenses. Therefore, because these cost avoidance measures and certain other elements of the Company's operating plan are outside of its control, including the planned amendment of contractual arrangements with certain supply and collaboration partners, and the reduction of operating expenses, there is uncertainty as to whether the Company's cash resources will be adequate to support its operations for a period through at least the next twelve months from the date of issuance of these financial statements.\\nIn addition, on July 15, 2022, or the Effective Date, the Company entered into the Second Amendment and Waiver with BioPharma Credit PLC, or the Collateral Agent, BPCR Limited Partnership, as a Lender, and BioPharma Credit Investments V (Master) LP, as a Lender, or the Second Amendment and Waiver, which amends and waives certain provisions of the loan agreement entered on November 11, 2019, between the Company, with Keryx Biopharmaceuticals, Inc., or Keryx, as guarantor, and the Collateral Agent, as collateral agent and a lender, and BioPharma Credit Investments V (Master) LP as a lender, or the Loan Agreement, as amended by the First Amendment and Waiver among the Collateral Agent, the Lenders and the Company, dated February 18, 2022, or the First Amendment and Waiver. The Collateral Agent and the Lenders are collectively referred to as Pharmakon (see Note 11). Pursuant to the Second Amendment and Waiver, on the Effective Date, the Company made prepayments totaling $ 25.0 million together with a prepayment premium of $ 0.5 million plus all accrued and unpaid interest on such prepayments of principal to the Effective Date, and Pharmakon agreed to waive or modify certain covenants in the Loan Agreement (see Note 11). If an event of default occurs and is continuing under the Loan Agreement, the Collateral Agent is entitled to take enforcement action, including acceleration of amounts due under the Loan Agreement, which the Company may not have the available cash resources to repay at such time. For example, pursuant to covenants in the Loan Agreement, the Company's Annual Reports on Form 10-K must not be subject to any qualification as a going concern. If any of the Company's future Annual Reports on Form 10-K is subject to any qualification related to going concern, it will result in an event of default under the Loan Agreement.\\nThese conditions raise substantial doubt regarding the Company’s ability to continue as a going concern for a period of one year after the date the financial statements are issued. Management’s plans to alleviate the conditions that raise substantial doubt through cost avoidance measures, including amending contractual arrangements with certain supply and collaboration partners, and reducing operating expenses, for the Company to continue as a going concern for a period of twelve months from the date the financial statements are issued. However, the Company has concluded that the likelihood that its plan to extend its cash runway from one or more of these approaches will be successful, while reasonably possible, is less than probable. Accordingly, the Company has concluded that substantial doubt exists about its ability to continue as a going concern for a period of at least twelve months from the date of issuance of these financial statements.\\nThe accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the ordinary course of business. The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities, other than obligations under the Loan Agreement classified as current, that might result from the outcome of the uncertainties described above.\\n2. Summary of Significant Accounting Policies\\nBasis of Presentation\\nThe accompanying unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the U.S., or GAAP, for interim financial reporting and as required by Regulation S-X, Rule 10-01. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. Any reference in these notes to applicable guidance is meant to refer to the authoritative GAAP as found in the ASC and Accounting Standards Update, or ASU, of the Financial Accounting Standards Board, or FASB.\\n13\\nIn the opinion of management, all adjustments, consisting of normal recurring accruals and revisions of estimates, considered necessary for a fair presentation of the unaudited condensed consolidated financial statements have been included. Interim results for the three and nine months ended September 30, 2022 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2022 or any other future period.\\nThe accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. Management has determined that the Company operates in one segment, which is the business of developing and commercializing novel therapeutics for people with kidney disease. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the Company’s consolidated financial statements and the accompanying notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2021 filed with the U.S. Securities and Exchange Commission on March 1, 2022, or the 2021 Annual Report on Form 10-K.\\nThe significant accounting policies used in preparation of these unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2022 are consistent with those discussed in Note 2 to the consolidated financial statements in the Company’s 2021 Annual Report on Form 10-K and are updated below as necessary.\\nNew Accounting Pronouncements – Not Yet Adopted\\nIn March 2020, the FASB issued ASU 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting. The amendments provide optional guidance for a limited time to ease the potential burden in accounting for reference rate reform. The new guidance provides optional expedients and exceptions for applying GAAP to contracts, hedging relationships and other transactions affected by reference rate reform if certain criteria are met. The amendments apply only to contracts and hedging relationships that reference LIBOR or another reference rate expected to be discontinued due to reference rate reform. These amendments are effective immediately and may be applied prospectively to contract modifications made and hedging relationships entered into or evaluated on or before December 31, 2022. The Company is currently evaluating its contracts and the optional expedients provided by the new standard.\\nUse of Estimates\\nThe preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ from those estimates. Management considers many factors in selecting appropriate financial accounting policies and controls, and in developing the estimates and assumptions that are used in the preparation of these financial statements. Management must apply significant judgment in this process. In addition, other factors may affect estimates, including expected business and operational changes, sensitivity and volatility associated with the assumptions used in developing estimates, and whether historical trends are expected to be representative of future trends. The estimation process often may yield a range of potentially reasonable estimates of the ultimate future outcomes, and management must select an amount that falls within that range of reasonable estimates. Estimates are used in the following areas, among others: prepaid and accrued research and development expense, operating lease assets and liabilities, derivative liabilities, refund liabilities to customers, other non-current liabilities, including the excess purchase commitment liability, stock-based compensation expense, product and collaboration revenues including various rebates and reserves related to product sales, non-cash interest expense on the liability related to sale of future royalties, inventories, income taxes, intangible assets and goodwill.\\nAlthough the Company regularly assesses these estimates, actual results could differ materially from these estimates. Changes in estimates are recorded in the period they become known. The Company bases its estimates on historical experience and various other assumptions that it believes to be reasonable under the circumstances.\\n3. Product Revenue and Reserves for Variable Consideration\\nTo date, the Company’s only source of product revenue has been from the U.S. sales of Auryxia. Total net product revenue was $ 42.2 million and $ 36.8 million for the three months ended September 30, 2022 and 2021, respectively, and $ 127.4 million and $ 100.1 million for the nine months ended September 30, 2022 and 2021, respectively. The following table summarizes activity in each of the product revenue allowance and reserve categories for the nine months ended September 30, 2022 and 2021 (in thousands):\\n14\\n| Chargebacksand Discounts | Rebates, Feesand otherDeductions | Returns | Total |\\n| Balance at December 31, 2021 | $ | 1,278 | $ | 26,625 | $ | 475 | $ | 28,378 |\\n| Current provisions related to sales in current year | 8,592 | 64,322 | 3,692 | 76,606 |\\n| Adjustments related to prior year sales | ( 248 ) | 33 | — | ( 215 ) |\\n| Credits/payments made | ( 8,194 ) | ( 65,611 ) | ( 3,669 ) | ( 77,474 ) |\\n| Balance at September 30, 2022 | $ | 1,428 | $ | 25,369 | $ | 498 | $ | 27,295 |\\n| Balance at December 31, 2020 | $ | 802 | $ | 39,912 | $ | 649 | $ | 41,363 |\\n| Current provisions related to sales in current year | 8,911 | 105,432 | 4,866 | 119,209 |\\n| Adjustments related to prior year sales | ( 1 ) | ( 1,590 ) | — | ( 1,591 ) |\\n| Credits/payments made | ( 8,593 ) | ( 99,518 ) | ( 4,979 ) | ( 113,090 ) |\\n| Balance at September 30, 2021 | $ | 1,119 | $ | 44,236 | $ | 536 | $ | 45,891 |\\n\\nChargebacks, discounts and returns are recorded as a direct reduction of revenue on the unaudited condensed consolidated statement of operations with a corresponding reduction to accounts receivable on the unaudited condensed consolidated balance sheets. Rebates, distribution-related fees, and other sales-related deductions are recorded as a reduction in revenue on the unaudited condensed consolidated statement of operations with a corresponding increase to accrued liabilities or accounts payable on the unaudited condensed consolidated balance sheets.\\nAccounts receivable, net related to product sales was approximately $ 24.0 million and $ 24.6 million as of September 30, 2022 and December 31, 2021, respectively.\\n4. License, Collaboration and Other Significant Agreements\\nDuring the three and nine months ended September 30, 2022 and 2021, the Company recognized the following revenues from its license, collaboration and other significant agreements and had the following deferred revenue balances as of September 30, 2022:\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| License, Collaboration and Other Revenue: | (in thousands) | (in thousands) |\\n| MTPC Agreement | $ | 5,487 | $ | 2,555 | $ | 13,885 | $ | 7,167 |\\n| Otsuka U.S. Agreement | — | 6,144 | 86,773 | 28,988 |\\n| Otsuka International Agreement | — | 1,860 | 5,503 | 13,532 |\\n| Total Proportional Performance Revenue | $ | 5,487 | $ | 10,559 | $ | 106,161 | $ | 49,687 |\\n| JT and Torii | 1,238 | 1,444 | 3,871 | 4,093 |\\n| MTPC Other Revenue | — | — | — | 73 |\\n| Total License, Collaboration and Other Revenue | $ | 6,725 | $ | 12,003 | $ | 110,032 | $ | 53,853 |\\n\\n\\n| September 30, 2022 |\\n| Short-Term | Long-Term | Total |\\n| Deferred Revenue: | (in thousands) |\\n| MTPC Agreement | $ | 1,265 | $ | — | $ | 1,265 |\\n| Vifor Pharma Agreement | — | 43,296 | 43,296 |\\n| Total | $ | 1,265 | $ | 43,296 | $ | 44,561 |\\n\\nThe following table presents changes in the Company’s contract assets and liabilities during the nine months ended September 30, 2022 and 2021 (in thousands):\\n15\\n| Nine Months Ended September 30, 2022 | Balance atBeginning ofPeriod | Additions | Deductions | Balance at Endof Period |\\n| Contract assets: |\\n| Accounts receivable(1) | $ | 19,094 | $ | 92,612 | $ | ( 109,836 ) | $ | 1,870 |\\n| Prepaid expenses and other current assets | $ | 4,309 | $ | 9,550 | $ | ( 8,250 ) | $ | 5,609 |\\n| Contract liabilities: |\\n| Deferred revenue | $ | 42,380 | $ | 66,307 | $ | ( 64,126 ) | $ | 44,561 |\\n| Accounts payable | $ | 3,171 | $ | — | $ | ( 3,171 ) | $ | — |\\n| Accrued expenses and other current liabilities | $ | — | $ | — | $ | — | $ | — |\\n| Nine Months Ended September 30, 2021 |\\n| Contract assets: |\\n| Accounts receivable(1) | $ | 3,045 | $ | 38,795 | $ | ( 20,427 ) | $ | 21,413 |\\n| Prepaid expenses and other current assets | $ | 1,722 | $ | 1,725 | $ | ( 5 ) | $ | 3,442 |\\n| Contract liabilities: |\\n| Deferred revenue | $ | 40,559 | $ | 65,890 | $ | ( 62,792 ) | $ | 43,657 |\\n| Accounts payable | $ | 7,227 | $ | — | $ | ( 7,227 ) | $ | — |\\n| Accrued expenses and other current liabilities | $ | 10,000 | $ | — | $ | — | $ | 10,000 |\\n\\n(1)Excludes accounts receivable from other services related to clinical and regulatory activities performed by the Company on behalf of MTPC that are not included in the performance obligations identified under the MTPC Agreement as of September 30, 2022 and 2021 and December 31, 2021 and 2020. Also excludes accounts receivable related to amounts due to the Company from product sales which are included in the accompanying unaudited condensed consolidated balance sheet as of September 30, 2022 and December 31, 2021.\\nDuring the three and nine months ended September 30, 2022 and 2021, the Company recognized the following revenues as a result of changes in the contract asset and contract liability balances in the respective periods (in thousands):\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| Revenue Recognized in the Period: | 2022 | 2021 | 2022 | 2021 |\\n| Amounts included in deferred revenue at the beginning of the period | $ | 5,047 | $ | 9,159 | $ | 29,574 | $ | 20,363 |\\n| Performance obligations satisfied in previous periods | $ | — | $ | — | $ | — | $ | — |\\n\\nMitsubishi Tanabe Pharma Corporation Collaboration Agreement\\nSummary of Agreement\\nOn December 11, 2015, the Company and MTPC entered into the MTPC Agreement, providing MTPC with exclusive development and commercialization rights to vadadustat in Japan and certain other Asian countries, collectively, the MTPC Territory. In addition, the Company will supply vadadustat for both clinical and commercial use in the MTPC Territory, subject to MTPC’s option to manufacture commercial drug product in the MTPC Territory. In February 2021, the Company entered into the Royalty Agreement with HCR, whereby the Company sold its right to receive royalties and sales milestones under the MTPC Agreement, subject to certain caps and other terms and conditions (see Note 6 for additional information). A more detailed description of the MTPC Agreement and the Company's evaluation of this agreement under ASC 606 can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\\nThe Company identified two performance obligations in connection with its material promises under the MTPC Agreement as follows: (i) License, Research and Clinical Supply Performance Obligation and (ii) Rights to Future Know-How Performance Obligation. The Company allocates the transaction price to each performance obligation based on the Company’s best estimate of the relative standalone selling price. The Company developed a best estimate of the standalone selling price for the Rights to Future Know-How Performance Obligation primarily based on the likelihood that additional intellectual property covered by the license conveyed will be developed during the term of the arrangement and determined it is immaterial. As such, the\\n16\\nCompany did not develop a best estimate of standalone selling price for the License, Research and Clinical Supply Performance Obligation and allocated the entire transaction price to this performance obligation. The deliverables associated with the License, Research and Clinical Supply Performance Obligation were satisfied as of June 30, 2018.\\nAs of September 30, 2022, the transaction price was comprised of: (i) the up-front payment of $ 20.0 million, (ii) the cost for the Phase 2 studies of $ 20.5 million, (iii) the cost of all clinical supply provided to MTPC for the Phase 3 studies, (iv) $ 10.0 million in development milestones received, (v) $ 25.0 million in regulatory milestones received, comprised of $ 10.0 million relating to the NDA filing in Japan and $ 15.0 million relating to regulatory approval of vadadustat in Japan, and (vi) $ 2.4 million in royalties from net sales of Vafseo. As of September 30, 2022, all development milestones and $ 25.0 million in regulatory milestones have been achieved. No other regulatory milestones have been assessed as probable of being achieved and as a result have been fully constrained. The Company re-evaluates the transaction price in each reporting period and as uncertain events are resolved or other changes in circumstances occur. Revenue for the License, Research and Clinical Supply Performance Obligation for the MTPC Agreement is being recognized using a proportional performance method, for which all deliverables have been completed. During the three and nine months ended September 30, 2022, the Company recognized revenue from MTPC royalties totaling approximately $ 0.4 million and $ 1.2 million, respectively, and approximately $ 0.3 million and $ 0.4 million during the three and nine months ended September 30, 2021, respectively. As noted above, in February 2021, the Company entered into the Royalty Agreement, whereby the Company sold its right to receive these royalties and sales milestones under the MTPC Agreement, subject to certain caps and other terms and conditions (see Note 6 for additional information). The revenue is classified as license, collaboration and other revenue in the accompanying unaudited condensed consolidated statements of operations and comprehensive loss. As of September 30, 2022, the Company recorded $ 0.2 million in accounts receivable, no deferred revenue, and no contract assets. There were no asset or liability balances classified as long-term in the unaudited condensed consolidated balance sheet as of September 30, 2022.\\nSupply of Drug Product to MTPC\\nOn July 15, 2020, the Company and its collaboration partner MTPC entered into a supply agreement, or the MTPC Supply Agreement. The MTPC Supply Agreement includes the terms and conditions under which the Company will supply vadadustat drug product to MTPC for commercial use in Japan and certain other Asian countries, as contemplated by the MTPC Agreement. A more detailed description of this supply agreement can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\\nThe Company recognized $ 5.1 million in revenue and $ 12.7 million in revenue under the MTPC Supply Agreement during the three and nine months ended September 30, 2022, respectively, and $ 2.2 million and $ 6.7 million during the three and nine months ended September 30, 2021, respectively. As of September 30, 2022, the Company recorded $ 0.2 million in accounts receivable, $ 1.3 million in deferred revenue and $ 18.6 million in other current liabilities.\\nU.S. Collaboration and License Agreement with Otsuka Pharmaceutical Co. Ltd.\\nOn December 18, 2016, the Company entered into the Otsuka U.S. Agreement. The collaboration was focused on the development and commercialization of vadadustat in the United States. The Company was responsible for leading the development of vadadustat, for which it submitted an NDA to the FDA in March 2021, and for which it received the CRL in March 2022.\\nUnder the terms of the Otsuka U.S. Agreement, the Company granted to Otsuka a co-exclusive, non-sublicensable license under certain intellectual property controlled by the Company solely to perform medical affairs activities and to conduct non-promotional and commercialization activities related to vadadustat in the United States in accordance with the associated plans. The co-exclusive license related to activities that would be jointly conducted by the Company and Otsuka pursuant to the terms of the Otsuka U.S. Agreement. A more detailed description of this collaboration agreement and the Company's evaluation of this agreement under ASC 606 can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\\nThe Company identified three performance obligations in connection with its obligations under the Otsuka U.S. Agreement as follows: (i) License and Development Services Combined (License Performance Obligation); (ii) Rights to Future Intellectual Property (Future IP Performance Obligation) and (iii) Joint Committee Services (Committee Performance Obligation). The Company allocated the transaction price to each performance obligation based on the Company’s best estimate of the relative standalone selling price. The Company developed a best estimate of standalone selling price for the Committee Performance Obligation after considering the nature of the services to be performed and estimates of the associated effort and rates applicable to such services that would be expected to be realized under similar contracts. The Company developed a best estimate of standalone selling price for the Future IP Performance Obligation primarily based on the likelihood that additional\\n17\\nintellectual property covered by the license conveyed would be developed during the term of the arrangement. The Company did not develop a best estimate of standalone selling price for the License Performance Obligation due to the following: (i) the best estimates of standalone selling price associated with the Future IP Performance Obligation was determined to be immaterial and (ii) the period of performance and pattern of recognition for the License Performance Obligation and the Committee Performance Obligation was determined to be similar.\\nThe Company re-evaluated the transaction price in each reporting period and as uncertain events were resolved or other changes in circumstances occurred. The Company determined that under ASC 606, the contract was modified in the second quarter of 2019, when the Company elected to require Otsuka to increase the aggregate percentage of current global development costs it funds under the Otsuka U.S. Agreement and the Otsuka International Agreement from 52.5 % to 80 %, or the Otsuka Funding Option, and the Company became eligible to receive the amount from the Otsuka Funding Option. In connection with the modification, the Company adjusted the transaction price to include the amount from the Otsuka Funding Option as additional variable consideration. The Company constrained the variable consideration to an amount for which a significant revenue reversal is not probable.\\nPursuant to the Otsuka U.S. Agreement, the Company received: (i) an up-front payment of $ 125.0 million, (ii) a cost share payment with respect to amounts incurred by the Company through December 31, 2016 of $ 33.8 million, and (iii) net cost share consideration with respect to amounts incurred by the Company under the global development plan of approximately $ 319.2 million with respect to amounts incurred by the Company subsequent to December 31, 2016.\\nOn May 12, 2022, the Company received notice from Otsuka that it had elected to terminate the Otsuka U.S. Agreement and the Otsuka International Agreement. On June 30, 2022, the Company and Otsuka entered into the Termination Agreement, pursuant to which, among other things, the Company and Otsuka agreed to terminate, as of June 30, 2022, the Otsuka U.S. Agreement and the Otsuka International Agreement. In July 2022, the Company received a nonrefundable and non-creditable payment of $ 55.0 million in consideration for the covenants and agreements set forth in the Termination Agreement, including the settlement and release of all disputes and claims as provided therein. The Company determined that the Termination Agreement met the definition of a contract modification and was accounted for as a cumulative catch-up adjustment at the time of modification under ASC 606.\\nDuring the three and nine months ended September 30, 2022, the Company recognized $ 0 and $ 92.3 million of collaboration revenue from the Otsuka U.S. Agreement and the Otsuka International Agreement combined in its condensed consolidated statement of operations and comprehensive loss. The collaboration revenue for the nine months ended September 30, 2022 is primarily comprised of the $ 55.0 million payment received pursuant to the Termination Agreement, $ 15.5 million related to previously deferred revenue as of the date of termination and $ 9.6 million of non-cash consideration related to Otsuka's obligations to complete certain agreed upon clinical activities related to the Phase 3b clinical trial of vadadustat Otsuka is conducting.\\nDuring the three and nine months ended September 30, 2021, the Company recognized collaboration revenue totaling $ 6.1 million and $ 29.0 million, respectively, with respect to the Otsuka U.S. Agreement. Additionally, as of September 30, 2022, there was $ 5.6 million in prepaid expenses and other current assets in the accompanying unaudited condensed consolidated balance sheet. As of December 31, 2021, there was approximately $ 2.0 million in contract liabilities (included in accounts payable) and $ 3.0 million in prepaid expenses and other current assets in the consolidated balance sheet.\\nInternational Collaboration and License Agreement with Otsuka Pharmaceutical Co. Ltd.\\nOn April 25, 2017, the Company entered into the Otsuka International Agreement. The collaboration was focused on the development and commercialization of vadadustat in Europe, Russia, China, Canada, Australia, the Middle East and certain other territories, collectively, the Otsuka International Territory.\\nUnder the terms of the Otsuka International Agreement, the Company granted to Otsuka an exclusive, sublicensable license under certain intellectual property controlled by the Company to develop and commercialize vadadustat and products containing or comprising vadadustat in the Otsuka International Territory. Additionally, under the terms of this agreement, the Company was responsible for leading the development of vadadustat. Otsuka had the sole responsibility, at its own cost, for the commercialization of vadadustat in the Otsuka International Territory, subject to the approval by the relevant regulatory authorities. A more detailed description of this collaboration agreement and the Company's evaluation of this agreement under ASC 606 can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\\nThe Company identified three performance obligations in connection with its obligations under the Otsuka International Agreement as follows: (i) License and Development Services Combined (License Performance Obligation); (ii) Rights to\\n18\\nFuture Intellectual Property (Future IP Performance Obligation) and (iii) Joint Committee Services (Committee Performance Obligation). The Company allocated the transaction price to each performance obligation based on the Company’s best estimate of the relative standalone selling price. The Company developed a best estimate of standalone selling price for the Committee Performance Obligation after considering the nature of the services to be performed and estimates of the associated effort and rates applicable to such services that would be expected to be realized under similar contracts. The Company developed a best estimate of standalone selling price for the Future IP Performance Obligation primarily based on the likelihood that additional intellectual property covered by the license conveyed will be developed during the term of the arrangement. The Company did not develop a best estimate of standalone selling price for the License Performance Obligation due to the following: (i) the best estimates of standalone selling price associated with the Future IP Performance Obligation was determined to be immaterial and (ii) the period of performance and pattern of recognition for the License Performance Obligation and the Committee Performance Obligation was determined to be similar.\\nThe Company re-evaluated the transaction price in each reporting period and as uncertain events were resolved or other changes in circumstances occurred. Pursuant to the Otsuka International Agreement, the Company received: (i) an up-front payment of $ 73.0 million, (ii) the cost share payment with respect to amounts incurred by the Company during the quarter ended March 31, 2017 of $ 0.2 million, and (iii) the net cost share consideration with respect to amounts incurred by the Company under the global development plan subsequent to March 31, 2017 of $ 216.7 million.\\nAs discussed above, the Otsuka International Agreement was terminated on June 30, 2022 pursuant to the Termination Agreement. Refer to earlier in this Note 4 for further details of the recognition of this Termination Agreement in the Company's condensed consolidated statement of operations and comprehensive loss.\\nDuring the three and nine months ended September 30, 2021, the Company recognized collaboration revenue totaling approximately $ 1.9 million and $ 13.5 million, respectively, with respect to the Otsuka International Agreement. As of December 31, 2021, there was approximately $ 0.9 million in contract liabilities (included in accounts payable) and $ 1.3 million in prepaid expenses and other current assets in the consolidated balance sheet.\\nJanssen Pharmaceutica NV Research and License Agreement\\nOn February 9, 2017, the Company entered into a Research and License Agreement, or the Janssen Agreement, with Janssen Pharmaceutica NV, or Janssen, a subsidiary of Johnson & Johnson, pursuant to which Janssen granted the Company an exclusive license under certain intellectual property rights to develop and commercialize worldwide certain HIF prolyl hydroxylase targeted compounds. Under the terms of the Janssen Agreement, Janssen granted to the Company a license for a three-year research term to conduct research on the HIF compound portfolio, which research term is now expired. A more detailed description of this collaboration agreement can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\\nUnder the terms of the Janssen Agreement, the Company made an upfront payment of $ 1.0 million in cash to Janssen and issued a warrant, or the Warrant, to purchase 509,611 shares of the Company’s common stock, which expired on February 9, 2022. In addition, Janssen could be eligible to receive up to an aggregate of $ 16.5 million from the Company in specified development milestone payments on a product-by-product basis. Janssen could also be eligible to receive up to $ 215.0 million from the Company in specified commercial milestones as well as tiered, escalating royalties ranging from a low- to mid-single digit percentage of net sales, on a product-by-product basis, and subject to reduction upon expiration of patent rights or the launch of a generic product in the territory. A more detailed description of this collaboration agreement can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K. On August 1, 2022, the Company notified Janssen that it was exercising its right to terminate the Janssen Agreement, and Janssen agreed to the termination which became effective on August 2, 2022.\\nCyclerion Therapeutics License Agreement\\nOn June 4, 2021, the Company entered into a License Agreement, the Cyclerion Agreement, with Cyclerion Therapeutics Inc., or Cyclerion, pursuant to which Cyclerion granted the Company an exclusive global license under certain intellectual property rights to research, develop and commercialize praliciguat, an investigational oral soluble guanylate stimulator.\\nUnder the terms of the Cyclerion Agreement, the Company made an upfront payment of $ 3.0 million in cash to Cyclerion, which was paid and recorded to research and development expense in June 2021. Substantially all of the fair value of the assets acquired in conjunction with the Cyclerion Agreement was concentrated in the acquired license. As a result, the Company accounted for this transaction as an asset acquisition under ASU No. 2017-01, Business Combinations (Topic 805): Clarifying\\n19\\nthe Definition of a Business. The upfront payment was charged to expense at acquisition, as it relates to a development stage compound with no alternative future use. In addition, Cyclerion is eligible to receive up to an aggregate of $ 222.0 million from the Company in specified development and regulatory milestone payments on a product-by-product basis. Cyclerion will also be eligible to receive specified commercial milestones as well as tiered royalties ranging from a low-single-digit- to mid-double-digit percentage of net sales, on a product-by-product basis, and subject to reduction upon expiration of patent rights or the launch of a generic product in the territory. A more detailed description of this agreement can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\\nVifor Pharma License Agreement\\nSummary of License Agreement\\nOn May 12, 2017, the Company entered into a License Agreement, or the Vifor Agreement, with Vifor (International) Ltd., or Vifor Pharma, pursuant to which the Company granted Vifor Pharma an exclusive license to sell vadadustat solely to Fresenius Kidney Care Group LLC, an affiliate of Fresenius Medical Care North America, or FMCNA, in the United States. On April 8, 2019, the Company and Vifor Pharma entered into an Amended and Restated License Agreement, or the Vifor First Amended Agreement, which amended and restated in full the Vifor Agreement. On February 18, 2022, the Company and Vifor Pharma entered into a Second Amended and Restated License Agreement, or the Vifor Second Amended Agreement, which amends and restates the Vifor First Amended Agreement.\\nPursuant to the Vifor Second Amended Agreement, the Company granted Vifor Pharma an exclusive license to sell vadadustat to FMCNA and its affiliates, including Fresenius Kidney Care Group LLC, to certain third party dialysis organizations approved by the Company, to independent dialysis organizations that are members of certain group purchasing organizations, and to certain non-retail specialty pharmacies, or collectively, the Supply Group, in the United States, or the Territory. Pursuant to the Vifor Second Amended Agreement, Vifor Pharma agreed that it would not sell or otherwise supply vadadustat until the FDA has granted regulatory approval for vadadustat in the DD-CKD Indication in the Territory and until Vifor Pharma has entered a supply agreement with the applicable member of the Supply Group.\\nSimilar to the Vifor First Amended Agreement, the Vifor Second Amended Agreement is structured as a profit share arrangement between the Company and Vifor Pharma in which the Company will receive approximately 66 % of the profit, net of certain pre-specified costs. Under the Vifor Second Amended Agreement, Vifor Pharma made an upfront payment to the Company of $ 25.0 million in lieu of the previously disclosed milestone payment of $ 25.0 million that Vifor Pharma was to pay the Company following approval of vadadustat by the FDA, as established under the Vifor First Amended Agreement.\\nUnless earlier terminated, the Vifor Second Amended Agreement will expire upon the later of the expiration of all patents that claim or cover vadadustat or expiration of marketing or regulatory exclusivity for vadadustat in the Territory. Vifor Pharma may terminate the Vifor Second Amended Agreement in its entirety upon 30 months' prior written notice after the first anniversary of the receipt of regulatory approval, if approved from the FDA for vadadustat for dialysis-dependent CKD patients. The Company may terminate the Vifor Second Amended Agreement in its entirety for convenience, following the earlier of a certain period of time elapsing or following certain specified regulatory events, and upon six months ’ prior written notice. If the Company so terminates for convenience, subject to specified exceptions, the Company will pay a termination fee to Vifor Pharma. In addition, either party may, subject to a cure period, terminate the Vifor Second Amended Agreement in the event of the other party’s uncured material breach or bankruptcy.\\nInvestment Agreement\\nIn connection with the Vifor Agreement, in May 2017, the Company and Vifor Pharma entered into an investment agreement, or the First Investment Agreement, pursuant to which the Company sold an aggregate of 3,571,429 shares of the Company’s common stock, or the 2017 Shares, to Vifor Pharma at a price per share of $ 14.00 for a total of $ 50.0 million. The amount representing the premium over the closing stock price of $ 12.69 on the date of the transaction, totaling $ 4.7 million, was determined by the Company to represent consideration related to the Vifor Agreement.\\nVifor Pharma agreed to a lock-up restriction such that it agreed not to sell the 2017 Shares for a period of time following the effective date of the First Investment Agreement as well as a customary standstill agreement. In addition, the First Investment Agreement contains voting agreements made by Vifor Pharma with respect to the 2017 Shares. The 2017 Shares have not been registered pursuant to the Securities Act of 1933, as amended, or the Securities Act, and were issued and sold in reliance upon the exemption from registration contained in Section 4(a)(2) of the Securities Act and Rule 506 promulgated thereunder.\\nIn connection with entering into the Vifor Second Amended Agreement, on February 18, 2022, the Company and Vifor Pharma entered into an investment agreement, or the Second Investment Agreement, pursuant to which the Company sold an aggregate\\n20\\nof 4,000,000 shares of its common stock, or the 2022 Shares, to Vifor Pharma for a total of $ 20 million on February 22, 2022. The amount representing the premium over the grant date fair value on the date of the transaction, $ 13.6 million, was determined by the Company to represent the consideration related to the Vifor Second Amended Agreement. Vifor Pharma has agreed to a lock-up restriction to not sell or otherwise dispose of the 2022 Shares for a period of time following the effective date of the Second Investment Agreement as well as a customary standstill agreement. In addition, the Second Investment Agreement contains voting agreements made by Vifor Pharma with respect to the 2022 Shares. The 2022 Shares have not been registered pursuant to the Securities Act and were issued and sold in reliance upon the exemption from registration contained in Section 4(a)(2) of the Securities Act and/or Rule 506 promulgated thereunder, as the transaction did not involve any public offering within the meaning of Section 4(a)(2) of the Securities Act.\\nRevenue Recognition\\nThe Company evaluated the elements of the Vifor Second Amended Agreement in accordance with the provisions of ASC 606 and concluded that the contract counterparty, Vifor Pharma, is a customer. The Company’s arrangement with Vifor Pharma contains one material promise under the contract at inception, which is the non-sublicensable, non-transferrable license under certain of the Company’s intellectual property to (i) sell vadadustat solely to the Supply Group, (ii) sell vadadustat to Designated Wholesalers solely for resale to members of the Supply Group, (iii) conduct medical affairs with respect to vadadustat in the Territory in the field during the term of the Vifor Second Amended Agreement and (iv) use the Akebia Trademark solely in connection with the sale of vadadustat (the License Deliverable).\\nThe Company has identified one performance obligation in connection with its obligations under the Vifor Second Amended Agreement, which is the License Deliverable, or License Performance Obligation. The transaction price at inception was comprised of: (i) the up-front payment of $ 25.0 million, (ii) the premium paid by Vifor Pharma on the First Investment Agreement of $ 4.7 million, and (iii) the premium paid by Vifor Pharma on the Second Investment Agreement of $ 13.6 million. Pursuant to the terms of the Vifor Second Amended Agreement, these payments from Vifor Pharma are non-refundable and non-creditable against any other amount due to the Company. Also pursuant to the Vifor Second Amended Agreement, if the Centers for Medicare & Medicaid Services, or CMS, determines that vadadustat is excluded from the Transitional Drug Add-on Payment Adjustment, or TDAPA, the Company can terminate the Vifor Second Amended Agreement and will be required to repay the up-front payment and the premiums paid by Vifor Pharma in the First Investment Agreement and Second Investment Agreement, respectively. The Company considered whether the transaction price was constrained as required per the guidance in ASC 606-10-32-11. As part of its evaluation of the constraint, the Company considered numerous factors, including the CRL received from the FDA for vadadustat, the uncertainty associated with a potential future approval of vadadustat by the FDA, and if approval of vadadustat is received in the future, whether vadadustat would be included in certain reimbursement bundles by CMS, which are all outside of the Company’s control. Vifor Pharma also agreed that it will not sell or otherwise supply vadadustat until the FDA has granted regulatory approval for vadadustat in the DD-CKD Indication. The Company constrains the variable consideration to an amount for which a significant revenue reversal is not probable. Therefore, the Company determined that the entire transaction price at inception was constrained under ASC 606, and the Company has recorded the transaction price to deferred revenue as of September 30, 2022.\\nRefund Liability to Customer\\nPursuant to the Vifor Second Amended Agreement, Vifor Pharma contributed $ 40.0 million to a working capital fund established to partially fund the Company’s costs of purchasing vadadustat from its contract manufacturers, or the Working Capital Fund, which amount of funding will fluctuate, and which funding the Company will repay to Vifor over time. The $ 40 million initial contribution to the Working Capital Fund represents 50 % of the amount of purchase orders that the Company has placed with its contract manufacturers for the supply of vadadustat for the Territory already delivered as of the effective date of the Vifor Second Amended Agreement, and to be delivered through the end of 2022. The amount of the Working Capital Fund will be reviewed at specified intervals and is adjusted based on a number of factors including outstanding supply commitments for vadadustat for the Territory and agreed upon vadadustat inventory levels held by the Company for the Territory. Upon termination or expiration of the Vifor Second Amended Agreement for any reason other than convenience by Vifor Pharma (including following receipt of the CRL for vadadustat), the Company will be required to refund the outstanding balance of the Working Capital Fund on the date of termination or expiration.\\nThe Company has recorded the Working Capital Fund as a refund liability under ASC 606. The Company has determined that the refund liability itself does not represent an obligation to transfer goods or services to Vifor Pharma in the future. The Company has therefore determined that this refund liability is not a contract liability under ASC 606. The Company accounted for the refund liability as a debt arrangement with zero coupon interest. The Company imputed interest on the refund liability to the customer at a rate of 15.0 % per annum, which was determined based on certain factors, including the Company's credit rating, comparable securities yield, and the expected repayment period of the Working Capital Fund. The Company recorded an\\n21\\ninitial discount on the refund liability to the customer and a corresponding deferred gain to the refund liability to customer on the condensed consolidated balance sheet as of the date the funds were received from Vifor Pharma, which was March 18, 2022. The discount on the note payable is being amortized to interest expense using the effective interest method over the expected term of the refund liability. The deferred gain is being amortized to interest income on a straight-line basis over the expected term of the refund liability. The amortization of the discount was $ 1.1 million and $ 2.3 million for the three and nine months ended September 30, 2022, respectively. The amortization of the deferred gain was $ 0.9 million and $ 1.8 million for the three and nine months ended September 30, 2022, respectively. Of the $ 40.5 million total refund liability, net of deferred gain and discount, the Company classified $ 13.7 million as a short-term refund liability based on management's estimate of potential amounts that could be refundable within a one-year period as a result of anticipated changes to the Company's operating plan following the CRL.\\nPriority Review Voucher Letter Agreement\\nOn February 14, 2020, the Company entered into a letter agreement, or the Letter Agreement, with Vifor Pharma relating to Vifor Pharma’s agreement with a third party to purchase a Priority Review Voucher, or the PRV, issued by the FDA, subject to satisfaction of customary closing conditions, or the PRV Purchase. A PRV entitles the holder to priority review of an NDA, or a Biologics License Application for a new drug, which reduces the target FDA review time to six months after official acceptance of the submission, and could lead to expedited approval. Pursuant to the Letter Agreement, Akebia paid Vifor Pharma $ 10.0 million in connection with the closing of the PRV Purchase.\\nOn August 21, 2021, the Company and Vifor Pharma executed an amendment to the Letter Agreement whereby the parties agreed that Vifor Pharma would sell the PRV to a third party, and the Company and Vifor Pharma would share the proceeds from the sale based on certain terms. In the fourth quarter of 2021, Vifor Pharma sold the PRV to a third party, and Vifor Pharma paid the Company $ 8.6 million in proceeds from the sale, which was recorded as contra research and development expense. These proceeds were subsequently paid to Otsuka as reimbursement for their contribution to the purchase of the PRV, as required under a separate letter agreement executed with Otsuka. A more detailed description of this transaction can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\\nLicense Agreement with Panion & BF Biotech, Inc.\\nAs a result of the merger with Keryx, or the Merger, the Company had a license agreement, which was amended from time to time, with Panion & BF Biotech, Inc., or Panion, under which Keryx, the Company's wholly owned subsidiary, was the contracting party, or the Panion License Agreement, pursuant to which Keryx in-licensed the exclusive worldwide rights, excluding certain Asian-Pacific countries, or the Licensor Territory, for the development and commercialization of ferric citrate.\\nOn April 17, 2019, the Company and Panion entered into a second amended and restated license agreement, or the Panion Amended License Agreement, which amends and restates in full the Panion License Agreement, effective as of April 17, 2019. The Panion Amended License Agreement provides Keryx with an exclusive license under Panion-owned know-how and patents with the right to sublicense, develop, make, use, sell, offer for sale, import and export ferric citrate worldwide, excluding the Licensor Territory. The Panion Amended License Agreement also provides Panion with an exclusive license under the Keryx-owned patents, with the right to sublicense (with the Company’s written consent), develop, make, use, sell, offer for sale, import and export ferric citrate in certain countries in the Licensor Territory. Under the Panion Amended License Agreement, Panion is eligible to receive from the Company or any sublicensee royalty payments based on a mid-single digit percentage of sales of ferric citrate in the Company’s licensed territories. The Company is eligible to receive from Panion or any sublicensee royalty payments based on a mid-single digit percentage of net sales of ferric citrate in Panion’s licensed territories. A more detailed description of this license agreement can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\\nThe Company recognized royalty payments due to Panion of approximately $ 2.9 million and $ 3.0 million during the three months ended September 30, 2022 and 2021, respectively, and $ 9.5 million and $ 8.3 million during the nine months ended September 30, 2022 and 2021, respectively, relating to the Company’s sales of Auryxia in the United States and JT and Torii’s net sales of Riona in Japan, as the Company is required to pay a mid-single digit percentage of net sales of ferric citrate in the Company’s licensed territories to Panion under the terms of the Panion Amended License Agreement.\\n22\\nSublicense Agreement with Japan Tobacco, Inc. and its subsidiary, Torii Pharmaceutical Co., Ltd.\\nAs a result of the Merger, the Company has an Amended and Restated Sublicense Agreement, which was amended in June 2013, with JT and Torii, or the JT and Torii Sublicense Agreement, under which Keryx, the Company’s wholly owned subsidiary, remains the contracting party. Under the JT and Torii Sublicense Agreement, JT and Torii obtained the exclusive sublicense rights for the development and commercialization of ferric citrate hydrate in Japan. JT and Torii are responsible for the future development and commercialization costs in Japan. A more detailed description of this sublicense agreement can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\\nThe Company identified two performance obligations in connection with its obligations under the JT and Torii Sublicense Agreement: (i) License and Supply Performance Obligation and (ii) Rights to Future Know-How Performance Obligation. The Company allocated the transaction price to each performance obligation based on the Company’s best estimate of the relative standalone selling price. The Company developed a best estimate of the standalone selling price for the Rights to Future Know-How Performance Obligation primarily based on the likelihood that additional intellectual property covered by the license conveyed will be developed during the term of the arrangement and determined it immaterial. As such, the Company did not develop a best estimate of standalone selling price for the License and Supply Performance Obligation and allocated the entire transaction price to this performance obligation.\\nThe Company recognized license revenue of $ 1.2 million and $ 1.4 million during the three months ended September 30, 2022 and 2021, respectively, and $ 3.9 million and $ 4.1 million during the nine months ended September 30, 2022 and 2021, respectively, related to royalties earned on net sales of Riona in Japan. The Company records the associated mid-single digit percentage of net sales royalty expense due to Panion, the licensor of Riona, in the same period as the royalty revenue from JT and Torii is recorded.\\n5. Restructuring\\nOn April 4, 2022, the Board of Directors of the Company approved a reduction of the Company’s workforce by approximately 42 % across all areas of the Company ( 47 % inclusive of the closing of the majority of open positions) following the receipt of the CRL from the FDA to the Company’s NDA for vadadustat for the treatment of anemia due to CKD in adult patients. The workforce reduction was substantially completed as of June 30, 2022. On May 5, 2022, the Company implemented a further reduction in workforce consisting of several members of management. The workforce reduction is expected to be substantially complete by the end of May 2023. These actions reflect the Company’s determination to refocus its strategic priorities around its commercial product, Auryxia®, and its development portfolio, and are steps in a cost savings plan to significantly reduce the Company’s expense profile in line with being a single commercial product company.\\nThe workforce reduction is expected to include total restructuring charges of approximately $ 14.7 million. During the three and nine months ended September 30, 2022, the Company recognized $ 0.2 million and $ 14.7 million, respectively, of restructuring charges in the condensed consolidated statement of operations. These charges included $ 11.4 million of one-time termination benefits and contractual termination benefits for severance, healthcare, and related benefits and $ 3.3 million of non-cash share-based compensation expense. The charges were recorded pursuant to ASC 712, Compensation-Nonretirement Postemployment Benefits or ASC 420, Exit or Disposal Cost Obligations, depending on the employee.\\nDetails of the restructuring liability activity for the Company's workforce reduction for the period ended September 30, 2022 are as follows:\\n| September 30, 2022 |\\n| (in thousands) |\\n| Balance at December 31, 2021 | $ | — |\\n| Restructuring charges | 14,711 |\\n| Stock-based compensation expense | ( 3,253 ) |\\n| Severance payments and adjustments | ( 7,220 ) |\\n| Balance at September 30, 2022 | $ | 4,238 |\\n\\n23\\n6. Liability Related to Sale of Future Royalties\\nOn February 25, 2021, the Company entered into the Royalty Agreement with HCR, pursuant to which the Company sold to HCR its right to receive royalties and sales milestones for vadadustat in Japan and certain other Asian countries, such countries, collectively, the MTPC Territory, and such payments collectively the Royalty Interest Payments, in each case, payable to the Company under the MTPC Agreement, subject to an annual maximum “cap” of $ 13.0 million, or the Annual Cap, and an aggregate maximum “cap” of $ 150.0 million, or the Aggregate Cap. The Company received $ 44.8 million from HCR (net of certain transaction expenses) under the Royalty Agreement. The Company retains the right to receive all potential future regulatory milestones for vadadustat under the MTPC Agreement. Although the Company sold its right to receive royalties and sales milestones for vadadustat in the MTPC Territory as described above, as a result of its ongoing involvement in the cash flows related to these royalties, the Company will continue to account for these royalties as revenue. The Company recognized the proceeds received from HCR as a liability that is being amortized using the effective interest method over the life of the arrangement. At the transaction date, the Company recorded the net proceeds of $ 44.8 million as a liability. In order to determine the amortization of the liability, the Company is required to estimate the total amount of future net royalty payments to be made to HCR over the term of the Royalty Agreement. The total threshold of net royalties to be paid, less the net proceeds received, will be recorded as interest expense over the life of the liability. The Company imputes interest on the unamortized portion of the liability using the effective interest method. The annual effective interest rate as of September 30, 2022 was 13.6 % which is reflected as interest expense in the unaudited condensed consolidated statements of operations and comprehensive loss. On a quarterly basis, the Company reassesses the effective interest rate and adjusts the rate prospectively as needed. A more detailed description of Royalty Agreement can be found in Note 5 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\\nThe following table shows the activity within the liability account for the nine months ended September 30, 2022:\\n| September 30, 2022 |\\n| (in thousands) |\\n| Liability related to sale of future royalties, net beginning balance at December 31, 2021 | $ | 53,079 |\\n| MTPC royalties payable | ( 1,195 ) |\\n| Non-cash interest expense recognized | 6,352 |\\n| Liability related to sale of future royalties, net — ending balance | $ | 58,236 |\\n\\n7. Fair Value of Financial Instruments\\nThe Company utilizes a portfolio management company for the valuation of the majority of its investments. This portfolio management company is an independent, third-party vendor recognized to be an industry leader with access to market information that obtains or computes fair market values from quoted market prices, pricing for similar securities, recently executed transactions, cash flow models with yield curves and other pricing models. For valuations obtained from the pricing service, the Company performs due diligence to understand how the valuation was calculated or derived, focusing on the valuation technique used and the nature of the inputs.\\nBased on the fair value hierarchy, the Company classifies its cash equivalents within Level 1 or Level 2. This is because the Company values its cash equivalents using quoted market prices or alternative pricing sources and models utilizing market observable inputs.\\n24\\nAssets measured or disclosed at fair value on a recurring basis as of September 30, 2022 and December 31, 2021 are summarized below:\\n| Fair Value Measurements Using |\\n| Level 1 | Level 2 | Level 3 | Total |\\n| (in thousands) |\\n| September 30, 2022 |\\n| Assets: |\\n| Cash and cash equivalents | $ | 144,761 | $ | — | $ | — | $ | 144,761 |\\n| $ | 144,761 | $ | — | $ | — | $ | 144,761 |\\n| Liabilities: |\\n| Derivative liability | $ | — | $ | — | $ | 760 | $ | 760 |\\n| $ | — | $ | — | $ | 760 | $ | 760 |\\n\\n\\n| Fair Value Measurements Using |\\n| Level 1 | Level 2 | Level 3 | Total |\\n| (in thousands) |\\n| December 31, 2021 |\\n| Assets: |\\n| Cash and cash equivalents | $ | 149,800 | $ | — | $ | — | $ | 149,800 |\\n| $ | 149,800 | $ | — | $ | — | $ | 149,800 |\\n| Liabilities: |\\n| Derivative liability | $ | — | $ | — | $ | 1,820 | $ | 1,820 |\\n| $ | — | $ | — | $ | 1,820 | $ | 1,820 |\\n\\nThe Company’s Loan Agreement with Pharmakon (see Note 11) contains certain provisions that change the underlying cash flows of the debt instrument, including a potential extension to the interest-only period dependent on both (i) no event of default having occurred and continuing and (ii) the Company achieving certain regulatory and revenue conditions. One of the regulatory conditions was approval of vadadustat by August 2022, however, in March 2022, the Company received the CRL from the FDA stating that the FDA had determined that it could not approve the NDA for vadadustat in its present form. Therefore, the Company is no longer eligible for the interest-only extension period and this no longer changes the underlying cash flows of the debt instrument. The Company also assessed the acceleration of the obligations under the Loan Agreement under certain events of default. In addition, under certain circumstances, a default interest rate will apply on all outstanding obligations during the occurrence and continuance of an event of default. In accordance with ASC 815, the Company concluded that these features are not clearly and closely related to the host instrument, and represent a single compound derivative that is required to be re-measured at fair value on a quarterly basis.\\nThe potential events of default assessed include failure to maintain, on an annual basis, a minimum liquidity threshold which started in 2021, and on a quarterly basis, a minimum net sales threshold for Auryxia which started in the fourth quarter of 2020. The Company recorded a derivative liability related to the Company’s Loan Agreement with Pharmakon of $ 0.8 million and $ 1.8 million as of September 30, 2022 and December 31, 2021, respectively. The Company classified the derivative liability as a non-current liability on the unaudited condensed consolidated balance sheet as of September 30, 2022 and December 31, 2021. The estimated fair value of the derivative liability on both September 30, 2022 and December 31, 2021 was determined using a scenario-based approach and discounted cash flow model that includes principal and interest payments under various scenarios involving clinical development success for vadadustat and various cash flow assumptions. The Company used a 0 % probability of clinical development success due to receipt of the CRL from the FDA for vadadustat. Should the Company’s assessment of the probabilities around these scenarios change, including for changes in market conditions, there could be a change to the fair value of the derivative liability.\\n25\\nThe following table provides a roll-forward of the fair value of the derivative liability (in thousands):\\n\\n| Balance at December 31, 2021 | $ | 1,820 |\\n| Change in fair value of derivative liability, recorded as other income | ( 710 ) |\\n| Balance at March 31, 2022 | $ | 1,110 |\\n| Change in fair value of derivative liability, recorded as other income | — |\\n| Balance at June 30, 2022 | $ | 1,110 |\\n| Change in fair value of derivative liability, recorded as other income | ( 350 ) |\\n| Balance at September 30, 2022 | $ | 760 |\\n\\nThe Company had no other assets or liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) at September 30, 2022 and December 31, 2021.\\n8. Inventory\\nThe components of inventory are summarized as follows:\\n\\n| September 30, 2022 | December 31, 2021 |\\n| (in thousands) |\\n| Raw materials | $ | 397 | $ | 1,763 |\\n| Work in process | 32,855 | 62,635 |\\n| Finished goods | 18,970 | 14,661 |\\n| Total inventory | $ | 52,222 | $ | 79,059 |\\n\\nLong-term inventory, which primarily consists of raw materials and work in process, is included in other assets in the Company’s unaudited condensed consolidated balance sheets.\\n\\n| September 30, 2022 | December 31, 2021 |\\n| (in thousands) |\\n| Balance Sheet Classification: |\\n| Inventory | $ | 40,039 | $ | 38,195 |\\n| Other assets | 12,183 | 40,864 |\\n| Total inventory | $ | 52,222 | $ | 79,059 |\\n\\nInventory amounts written down as a result of excess, obsolescence, scrap or other reasons and charged to cost of goods sold totaled $ 2.6 million and $ 1.7 million during the three months ended September 30, 2022 and 2021, respectively, and $ 10.0 million and $ 7.1 million during the nine months ended September 30, 2022 and 2021, respectively. The increase in inventory amounts written down for the three and nine months ended September 30, 2022 as compared to the three and nine months ended September 30, 2021 was primarily due to higher write-downs to inventory reserves related to expired inventory. In addition, there were no related step-up charges during the nine months ended September 30, 2022 and $ 8.7 million related step-up charges during the nine months ended September 30, 2021. During the nine months ended September 30, 2022, the Company recorded $ 14.8 million of long-term inventory reserves and related reduction to the excess purchases commitment liability related to Auryxia inventory previously identified as excess, reflecting Auryxia inventory that was received during the period.\\nIf future sales of Auryxia are lower than expected, the Company may be required to write-down the value of such inventories. Inventory write-downs and losses on purchase commitments are recorded as a component of cost of goods sold in the unaudited condensed consolidated statement of operations.\\n26\\n9. Intangible Assets and Goodwill\\nIntangible Assets\\nThe following table presents the Company’s intangible assets at September 30, 2022 and December 31, 2021 (in thousands):\\n\\n| September 30, 2022 |\\n| Gross CarryingValue | Accumulated Amortization | Total |\\n| Intangible assets: |\\n| Developed product rights for Auryxia | $ | 213,603 | $ | ( 132,508 ) | $ | 81,095 |\\n| Total | $ | 213,603 | $ | ( 132,508 ) | $ | 81,095 |\\n\\n| December 31, 2021 |\\n| Gross CarryingValue | AccumulatedAmortization | Total |\\n| Intangible assets: |\\n| Developed product rights for Auryxia | $ | 213,603 | $ | ( 105,476 ) | $ | 108,127 |\\n| Total | $ | 213,603 | $ | ( 105,476 ) | $ | 108,127 |\\n\\nThe Company amortizes its definite-lived intangible assets using the straight-line method, which is considered the best estimate of economic benefit, over its estimated useful life of six years . The Company recorded $ 9.0 million in amortization expense related to the developed product rights for Auryxia during each of the three months ended September 30, 2022 and 2021, and $ 27.0 million during each of the nine months ended September 30, 2022 and 2021.\\nGoodwill\\nThe Company's goodwill results from the acquisition of Keryx in December 2018. Goodwill was $ 55.1 million as of September 30, 2022 and December 31, 2021. The Company operates in one operating segment which the Company considers to be the only reporting unit. Goodwill is evaluated for impairment at the reporting unit level on an annual basis as of October 1, and more frequently if indicators are present or changes in circumstances suggest that it is more likely than not that the fair value of the reporting unit is less than its carrying amount. Events that could indicate impairment and trigger an interim impairment assessment include, but are not limited to, an adverse change in current economic or market conditions, including a significant prolonged decline in market capitalization, a significant adverse change in legal factors, unexpected adverse business conditions, and an adverse action by a regulator. During the nine months ended September 30, 2022, the Company evaluated business factors, including the receipt of the CRL from the FDA for vadadustat, the Company's market capitalization as impacted by a recent decline in the Company's stock price, the impact of the Otsuka Termination Agreement on the Company's future cash flows, and the increase to the Company's excess purchase commitment liability to determine if there were events or changes in circumstance to indicate that the fair value of the reporting unit was less than its carrying value. The Company performed qualitative interim impairment assessments of the Company's goodwill balance as of each of the three months ended March 31, 2022, June 30, 2022, and September 30, 2022. The Company determined that it was not more likely than not that the fair value of the reporting unit was less than its carrying value and, therefore, did not perform a further quantitative interim impairment test for any period.\\nThe Company's qualitative assessments were based on the Company's estimates and assumptions, a number of which are dependent on external factors and actual results may differ materially from these estimates. In addition, the future occurrence of events including, but not limited to, an adverse change in current economic and market conditions, including a significant prolonged decline in market capitalization, a significant adverse change in legal factors, unexpected adverse business conditions and an adverse action or assessment by a regulator could indicate potential impairment and trigger an interim impairment assessment of goodwill, which could result in an impairment of goodwill. As a result of the significance of goodwill, the Company's results of operations and financial position in a future period could be negatively impacted should an impairment test be triggered that results in an impairment of goodwill.\\n10. Accrued Expenses\\nAccrued expenses as of September 30, 2022 and December 31, 2021 are as follows:\\n27\\n| September 30, 2022 | December 31, 2021 |\\n| (in thousands) |\\n| Product revenue allowances | $ | 25,222 | $ | 26,624 |\\n| Accrued clinical | 8,652 | 14,036 |\\n| Amounts due to collaboration partners | 19,550 | 22,654 |\\n| Accrued payroll and related | 9,140 | 15,863 |\\n| Lease liability | 4,260 | 4,802 |\\n| Royalties | 2,916 | 3,472 |\\n| Professional fees | 1,725 | 1,899 |\\n| Accrued commercial manufacturing | 3,167 | 3,843 |\\n| Accrued restructuring | 4,238 | — |\\n| Accrued other | 8,494 | 11,263 |\\n| Total accrued expenses | $ | 87,364 | $ | 104,456 |\\n\\n11. Debt\\nTerm Loans\\nOn November 11, 2019, the Company, with Keryx as guarantor, entered into a loan agreement, or the Loan Agreement, with BioPharma Credit PLC as collateral agent and a lender, or the Collateral Agent, and BioPharma Credit Investments V (Master) LP as a lender, pursuant to which term loans in an aggregate principal amount of $ 100.0 million were made available to the Company in two tranches, subject to certain terms and conditions, or the Term Loans. BioPharma Credit PLC subsequently transferred its interest in the Term Loans, solely in its capacity as a lender, to its affiliate, BPCR Limited Partnership. The Collateral Agent and the lenders are collectively referred to as Pharmakon (see Note 1 to our condensed consolidated financial statements). The first tranche of $ 80.0 million, or Tranche A, was drawn on November 25, 2019, or the Tranche A Funding Date, and the second tranche of $ 20.0 million, or Tranche B, was drawn on December 10, 2020, or the Tranche B Funding Date. Each of the Tranche A Funding Date and the Tranche B Funding Date, a Funding Date.\\nProceeds from the Term Loans may be used for general corporate purposes. The Company and Keryx entered into a Guaranty and Security Agreement with the Collateral Agent, or the Guaranty and Security Agreement, on the Tranche A Funding Date. Pursuant to the Guaranty and Security Agreement, the Company’s obligations under the Term Loans are unconditionally guaranteed by Keryx, or the Guarantee. Additionally, the obligations of the Company and Keryx under the Term Loans and the Guarantee are secured by a first priority lien on certain assets of the Company and Keryx, including Auryxia and certain related assets, cash, and certain equity interests held by the Company and Keryx, collectively the Collateral.\\nThe Term Loans bear interest at a floating rate per annum equal to the three-month LIBOR rate plus 7.50 %, subject to a 2.00 % LIBOR floor and a 3.35 % LIBOR cap, payable quarterly in arrears. The Term Loans will mature on the fifth anniversary of the Tranche A Funding Date, or the Maturity Date. The Company will repay the principal under the Term Loans in equal quarterly payments starting on the 33 rd-month anniversary of the applicable Funding Date, or the Amortization Schedule. If certain conditions were met, it would have had the option to repay the principal in equal quarterly payments starting on the 48 th-month anniversary of the applicable Funding Date. One of these conditions was approval of vadadustat; however, the Company received the CRL from the FDA in March 2022 stating that the FDA had determined that it could not approve the NDA in its present form. Therefore, the Company is no longer eligible for this option to delay repayment of the principal under the Loan Agreement. As of September 30, 2022, the Company made its first quarterly principal payment under the Term Loans of $ 8.0 million. Under certain circumstances, unless certain liquidity conditions are met, the Maturity Date may decrease by up to one year , and the Amortization Schedule may correspondingly commence up to one year earlier.\\nOn the Tranche A Funding Date, the Company paid to Pharmakon a facility fee equal to 2.00 % of the aggregate principal amount of the Term Loans, or $ 2.0 million, in addition to other expenses incurred by Pharmakon and reimbursed by the Company, or Lender Expenses. The Tranche A draw was $ 77.3 million, net of facility fee, Lender Expenses and issuance costs. The Tranche B draw was $ 20.0 million, net of immaterial Lender Expenses and issuance costs. The Loan Agreement permits voluntary prepayment at any time in whole or in part, subject to a prepayment premium. The prepayment premium would be 2.00 % of the principal amount being prepaid prior to the third anniversary of the applicable Funding Date, 1.00 % on or after the third anniversary, but prior to the fourth anniversary, of the applicable Funding Date, and 0.50 % on or after the fourth anniversary of the applicable Funding Date but prior to the Maturity Date, and a make-whole premium on or prior to the second\\n28\\nanniversary of the applicable Funding Date in an amount equal to foregone interest through the second anniversary of the applicable Funding Date. A change of control triggers a mandatory prepayment of the Term Loans.\\nThe Loan Agreement contains customary representations, warranties, events of default and covenants of the Company and its subsidiaries, including maintaining, on an annual basis, a minimum liquidity threshold which started in 2021, and on a quarterly basis, a minimum net sales threshold for Auryxia which started in the fourth quarter of 2020. On February 18, 2022, the Loan Agreement was amended by the First Amendment and Waiver, which waived the provision under the Loan Agreement that required the Company to not be subject to any qualification as a going concern within the Company's 2021 Annual Report on Form 10-K. Pursuant to the First Amendment and Waiver, the Company's filings of Form 10-Q for fiscal quarters ending June 30, 2022 and September 30, 2022, and its future Annual Reports on Form 10-K, must not be subject to any qualification as to going concern, which requirement as to the Company's filings on Form 10-Q was waived in the Second Amendment and Waiver. If the Company does not satisfy the covenant as to going concern in any of these filings, the Company will be in default under the Loan Agreement. There is uncertainty as to whether or not the Company will meet its future annual debt covenants related to qualification as to going concern. If an event of default occurs and is continuing under the Loan Agreement, the Collateral Agent is entitled to take enforcement action, including acceleration of amounts due under the Loan Agreement. Therefore, as of September 30, 2022, the Company continued to classify the borrowings under the Loan Agreement as current. Under certain circumstances, a default interest rate will apply on all outstanding obligations during the occurrence and continuance of an event of default. As of September 30, 2022 and December 31, 2021, the Company determined that no events of default had occurred.\\nOn July 15, 2022, or the Effective Date, the Company and Pharmakon entered into the Second Amendment and Waiver, or the Second Amendment and Waiver, which amended and waived certain provisions of the Loan Agreement, as amended by the First Amendment and Waiver.\\nPursuant to the Second Amendment and Waiver, on the Effective Date, the Company made a $ 5.0 million prepayment of the principal of the tranche A loan, or the Second Amendment Effective Date Tranche A Prepayment, and a $ 20.0 million prepayment of principal of the tranche B loan, or the Second Amendment Effective Date Tranche B Prepayment, in each case, together with any and all accrued and unpaid interest on such prepayments of principal to the Effective Date. In connection therewith, the Company also paid $ 0.5 million in prepayment premiums under the Loan Agreement. During each of the three and nine months ended September 30, 2022, the Company recorded a debt extinguishment loss of $ 0.9 million. Subject to the payment in full of the Second Amendment Effective Date Tranche A Prepayment and the Second Amendment Effective Date Tranche B Prepayment, Pharmakon agreed to, among other things, (1) increase the amount of the working capital facility established in connection with the Company’s Second Amended and Restated License Agreement with Vifor Pharma, which facility is part of the definition of Permitted Indebtedness (as such term is defined in the Loan Agreement) under the Loan Agreement, that the Company is permitted to repay to Vifor Pharma without causing an acceleration of the liabilities under the Loan Agreement, (2) waive the requirement that the Company’s Quarterly Reports on Form 10-Q for the fiscal quarters ending June 30, 2022 and September 30, 2022 not be subject to any qualification as to going concern, and (3) waive certain amounts payable under the Loan Agreement in connection with the Second Amendment Effective Date Tranche B Prepayment. Future principal payments pursuant to the contractual terms of the Loan Agreement, as amended by the Second Amendment and Waiver, are as follows (in thousands):\\n| Principal |\\n| Payments |\\n| (in thousands) |\\n| 2022 | $ | — |\\n| 2023 | 32,000 |\\n| 2024 | 35,000 |\\n| Total before unamortized discount and issuance costs | 67,000 |\\n| Less: unamortized discount and issuance costs | ( 1,053 ) |\\n| Total term loans | $ | 65,947 |\\n\\nThe Company assessed the terms and features of the Loan Agreement in order to identify any potential embedded features that would require bifurcation or any beneficial conversion feature. As part of this analysis, the Company assessed the economic characteristics and risks of the Loan Agreement, including put and call features. The terms and features assessed include a potential extension to the interest-only period dependent on both no event of default having occurred and continuing and the Company achieving certain regulatory and revenue conditions. The Company also assessed the acceleration of the obligations under the Loan Agreement under an event of default. In addition, under certain circumstances, a default interest rate will apply\\n29\\non all outstanding obligations during the occurrence and continuance of an event of default. In accordance with ASC 815, the Company concluded that these features are not clearly and closely related to the host instrument, and represent a single compound derivative that is required to be re-measured at fair value on a quarterly basis.\\nThe fair value of the derivative liability related to the Company’s Loan Agreement with Pharmakon was $ 0.8 million and $ 1.8 million as of September 30, 2022 and December 31, 2021, respectively. The Company classified the derivative liability as a non-current liability on the unaudited condensed consolidated balance sheet as of September 30, 2022.\\nThe Company recognized interest expense related to the Loan Agreement of $ 2.1 million and $ 2.7 million during the three months ended September 30, 2022 and 2021, respectively, and $ 7.5 million and $ 8.1 million for the nine months ended September 30, 2022 and 2021, respectively.\\n12. Stockholders’ Equity\\nAuthorized and Outstanding Capital Stock\\nOn June 5, 2020, the Company filed a Certificate of Amendment to its Ninth Amended and Restated Certificate of Incorporation, or its Charter, to increase the number of authorized shares of common stock from 175,000,000 to 350,000,000 . As of September 30, 2022, the authorized capital stock of the Company included 350,000,000 shares of common stock, par value $ 0.00001 per share, of which 183,951,583 and 177,000,963 shares were issued and outstanding as of September 30, 2022 and December 31, 2021, respectively; and 25,000,000 shares of undesignated preferred stock, par value $ 0.00001 per share, of which no shares were issued and outstanding as of September 30, 2022 and December 31, 2021.\\nAt-the-Market Facility\\nOn March 12, 2020, the Company filed a prospectus supplement relating to the Company's sales agreement with Cantor Fitzgerald & Co., or the Prior Sales Agreement, pursuant to which it was able to offer and sell up to $ 65.0 million of its common stock at current market prices from time to time. Through December 31, 2020, the Company sold 3,509,381 shares of common stock under this program with net proceeds (after deducting commissions and other offering expenses) of $ 10.6 million. During the three months ended March 31, 2021, the Company sold 5,224,278 shares of common stock under this program with net proceeds (after deducting commissions and other offering expenses) of $ 15.9 million.\\nOn February 25, 2021, the Company filed a prospectus relating to the Prior Sales Agreement with its new shelf registration statement (which replaced the prior shelf registration statement and the sales agreement prospectus supplement), pursuant to which it was able to offer and sell up to $ 100.0 million of its common stock at current market prices from time to time. Through December 31, 2021, the Company sold 21,128,065 shares of common stock under this program with net proceeds (after deducting commissions and other offering expenses) of $ 72.4 million. On March 1, 2022, the Company filed a prospectus relating to the Prior Sales Agreement, pursuant to which it was authorized to offer and sell up to $ 25.3 million of its common stock at current market prices from time to time. On March 16, 2022, the Company terminated the Prior Sales Agreement. During the three months ended March 31, 2022, the Company sold 404,600 shares of common stock under this program with net proceeds (after deducting commissions and other offering expenses) of $ 0.8 million.\\nOn April 7, 2022, the Company entered into an Open Market Sale AgreementSM, or the Sales Agreement, with Jefferies LLC, or Jefferies, as agent, for the offer and sale of common stock at current market prices in amounts to be determined from time to time. Also, on April 7, 2022, the Company filed a prospectus supplement relating to the Sales Agreement, pursuant to which it is able to offer and sell under the Sales Agreement up to $ 26.0 million of its common stock at current market prices from time to time. From the date of filing of the prospectus supplement through the date of the filing of this Quarterly Report on Form 10-Q, the Company has not sold any shares of its common stock under this program.\\nEquity Plans\\nThe Company maintains one stock incentive plan, the 2014 Incentive Plan, or the 2014 Plan, as well as the 2014 Employee Stock Purchase Plan, or the 2014 ESPP. The 2014 Plan replaced the Company’s Amended and Restated 2008 Equity Incentive Plan, or the 2008 Plan, however, options or other awards granted under the 2008 Plan prior to the adoption of the 2014 Plan that have not been settled or forfeited remain outstanding and effective. On June 6, 2019, the Company’s stockholders approved the Amended and Restated 2014 Employee Stock Purchase Plan, or the ESPP. The Company also maintains an inducement award program that is separate from the Company's equity plans under which inducement awards may be granted consistent with Nasdaq Listing Rule 5635(c)(4). During the nine months ended September 30, 2022, the Company granted 400,000 options to purchase shares of the Company’s common stock to new hires as inducements material to such employees' entering into employment with the Company, of which 266,000 options remained outstanding as of September 30, 2022.\\n30\\nThe 2014 Plan allows for the granting of stock options, stock appreciation rights, or SARs, restricted stock, unrestricted stock, RSUs, performance awards and other awards convertible into or otherwise based on shares of the Company’s common stock. Dividend equivalents may also be provided in connection with an award under the 2014 Plan. The Company’s employees, officers, directors and consultants and advisors are eligible to receive awards under the 2014 Plan. The Company initially reserved 1,785,000 shares of its common stock for the issuance of awards under the 2014 Plan. The 2014 Plan provides that the number of shares reserved and available for issuance under the 2014 Plan will automatically increase annually on January 1 of each calendar year, by an amount equal to three percent ( 3 %) of the number of the Company's outstanding shares on a fully diluted basis as of the close of business on the immediately preceding December 31, or the 2014 Plan Evergreen Provision. The Company’s Board of Directors may act prior to January 1 of any year to provide that there will be no automatic increase in the number of Akebia Shares available for grant under the 2014 Plan for that year (or that the increase will be less than the amount that would otherwise have automatically been made). On December 12, 2018, in connection with the consummation of the Merger, the Company assumed outstanding and unexercised options to purchase Keryx's stock, as adjusted by the Exchange Multiplier pursuant to the terms of the Merger Agreement, under the following Keryx equity plans, or the Keryx Equity Plans: the Keryx 1999 Share Option Plan, the Keryx 2004 Long-Term Incentive Plan, the Keryx 2007 Incentive Plan, the Keryx Amended and Restated 2013 Incentive Plan, and the Keryx 2018 Equity Incentive Plan, or the Keryx 2018 Plan. In addition, the number of Keryx Shares available for issuance under the Keryx 2018 Plan, as adjusted by the Exchange Multiplier pursuant to the terms of the Merger Agreement, may be used for awards granted by the Company under its 2014 Plan, or the Assumed Shares, provided that the Company uses the Assumed Shares for individuals who were not employees or directors of the Company prior to the consummation of the Merger.\\nThe Company grants annual service-based stock options to employees under the 2014 Plan. During the nine months ended September 30, 2022, the Company issued 3,233,500 options to employees under the 2014 Plan. In addition, the Company issues stock options to directors, new hires and occasionally to other employees not in connection with the annual grant process. During the nine months ended September 30, 2022, the Company issued 140,700 options to directors under the 2014 Plan. Options granted by the Company generally vest over periods of between 12 and 48 months, subject, in each case, to the individual’s continued service through the applicable vesting date. Options generally vest either 100 % on the first anniversary of the grant date or in installments of (i) 25 % at the one year anniversary and (ii) 12 equal quarterly installments beginning after the one year anniversary of the grant date, subject to the individual’s continuous service with the Company. Options generally expire 10 years after the date of grant.\\nThe Company also grants performance-based stock options to employees under the 2014 Plan. The Company issued 400,000 performance-based stock options under the 2014 Plan during the nine months ended September 30, 2022. The performance-based stock options granted by the Company generally vest in connection with the achievement of specified commercial and regulatory milestones. The performance-based stock options also generally feature a time-based vesting component. The expense recognized for these awards is based on the grant date fair value of the Company’s common stock multiplied by the number of options granted and recognized over time based on the probability of meeting such commercial and regulatory milestones.\\nThe Company also grants annual service-based restricted stock units, or RSUs, to employees and directors under the 2014 Plan. The Company also occasionally issues RSUs not in connection with the annual grant process to employees and directors. During the nine months ended September 30, 2022, the Company issued 5,216,908 RSUs to employees and 95,900 RSUs to directors under the 2014 Plan. Generally, RSUs granted by the Company vest in one of the following ways: (i) 100 % of each RSU grant vests on the first anniversary of the grant date, (ii) one third of each RSU grant vests on the first, second and third anniversaries of the grant date, (iii) 50 % of each RSU grant vests on the first anniversary and 25 % of each RSU grant vests every six months after the one year anniversary of the grant date, or (iv) one third of each RSU grant vests on the first anniversary and the remaining two thirds vests in eight substantially equal quarterly installments beginning after the one year anniversary, subject, in each case, to the individual’s continued service through the applicable vesting date. The expense recognized for these awards is based on the grant date fair value of the Company’s common stock multiplied by the number of units granted and recognized on a straight-line basis over the vesting period.\\nThe Company also grants performance-based restricted stock units, or PSUs, to employees under the 2014 Plan. The Company issued 400,000 PSUs during the nine months ended September 30, 2022. The PSUs granted by the Company generally vest in connection with the achievement of specified commercial, regulatory and corporate milestones. The PSUs also generally feature a time-based vesting component. The expense recognized for these awards is based on the grant date fair value of the Company’s common stock multiplied by the number of units granted and recognized over time based on the probability of meeting such commercial, regulatory and corporate milestones.\\nThe ESPP provides for the issuance of options to purchase shares of the Company’s common stock to participating employees at a discount to their fair market value. As noted above, the Company’s stockholders approved the ESPP, which amended and restated the Company’s 2014 ESPP, on June 6, 2019. As of September 30, 2022, the maximum aggregate number of shares of\\n31\\nthe Company’s common stock available for future issuance under the ESPP is 4,837,995 . Under the ESPP, each offering period is six months , at the end of which employees who elect to purchase shares of the Company’s common stock through payroll deductions made over the term of the offering. The per-share purchase price at the end of each offering period is equal to the lesser of eighty-five percent ( 85 %) of the closing price of the Company’s common stock at the beginning or end of the offering period. The Company issued 335,146 shares under the ESPP during the nine months ended September 30, 2022.\\n13. Commitments and Contingencies\\nLeases\\nThe Company leases approximately 65,167 square feet of office and lab space in Cambridge, Massachusetts under a lease which was most recently amended in November 2020, collectively the Cambridge Lease. Under the Third Amendment to the Cambridge Lease, or the Third Amendment, executed in July 2016, total monthly lease payments under the initial base rent were approximately $ 242,000 and are subject to annual rent escalations. In addition to such annual rent escalations, base rent payments for a portion of said premises commenced on January 1, 2017 in the monthly amount of approximately $ 22,000 . The Fourth Amendment to the Cambridge Lease, executed in May 2017, provided additional storage space to the Company and did not impact rent payments. In April 2018, the Company entered into a Fifth Amendment to the Cambridge Lease, or the Fifth Amendment, for an additional 19,805 square feet of office space on the 12th floor. Monthly lease payments for the existing 45,362 square feet of office and lab space, under the Third Amendment, remain unchanged. The new space leased by the Company was delivered in September 2018 and additional monthly lease payments of approximately $ 135,000 commenced in February 2019 and are subject to annual rent escalations, which commenced in September 2019. In November 2020, the Company entered into a Sixth Amendment to the Cambridge Lease, or the Sixth Amendment, to extend the term of the Cambridge Lease with respect to the lab space from November 30, 2021 to January 31, 2025. The Sixth Amendment includes two months of free rent starting in December 2020 and additional monthly lease payments of approximately $ 48,000 , which commenced in December 2021, and is subject to annual rent escalations, which commence in December 2022.\\nAdditionally, as a result of the Merger, the Company has a lease for 27,300 square feet of office space in Boston, Massachusetts, or the Boston Lease. The total monthly lease payments under the initial base rent were approximately $ 136,000 and are subject to annual rent escalations. In February 2022, the Company entered into the First Amendment to the Boston Lease, or the First Lease Amendment, to extend the term of the Boston Lease from February 2023 to July 2031. The First Lease Amendment includes five months of free rent starting in March 2023 and monthly lease payments of $ 200,122 commencing on August 1, 2023, with an annual rent escalation of approximately 2 % commencing on August 1, 2024. The First Lease Amendment also includes a landlord's allowance for certain leasehold improvements to the premises in an amount of up to $ 1,954,680 , provided that such allowance must be used prior to August 1, 2024.\\nThe term of the Cambridge Lease with respect to the office space expires on September 11, 2026, with one five-year extension option available. The term of the Boston Lease office space expires on July 31, 2031, with an extension option for one additional five-year term available. The renewal options in these real estate leases were not included in the calculation of the operating lease assets and operating lease liabilities as the renewal is not reasonably certain. The term of the Cambridge Lease with respect to the lab space expires on January 31, 2025, with an extension option for one additional period through September 11, 2026. The renewal option in this real estate lease was included in the calculation of the operating lease assets and operating lease liabilities as the renewal is reasonably certain. The lease agreements do not contain residual value guarantees. Operating lease costs were $ 1.8 million and $ 1.7 million for the three months ended September 30, 2022 and 2021, respectively, and $ 5.4 million and $ 5.0 million for the nine months ended September 30, 2022 and 2021, respectively. Cash paid for amounts included in the measurement of operating lease liabilities was $ 1.8 million for each of the three months ended September 30, 2022 and 2021 and $ 5.5 million and $ 5.3 million for the nine months ended September 30, 2022 and 2021, respectively.\\nIn September 2019, Keryx entered into an agreement to sublease the Boston office space to Foundation Medicine, Inc., or Foundation. The sublease is subject and subordinate to the Boston Lease between Keryx and the landlord. The term of the sublease commenced on October 16, 2019, upon receipt of the required consent from the landlord for the sublease agreement, and expires on February 27, 2023. Foundation is obligated to pay Keryx rent that approximates the rent due from Keryx to its landlord with respect to the Boston Lease. Sublease rental income is recorded to other income. Keryx continues to be obligated for all payment terms pursuant to the Boston Lease, and the Company will guaranty Keryx’s obligations under the sublease. Keryx recorded $ 0.5 million and $ 0.4 million in sublease rental income from Foundation during the three months ended September 30, 2022 and 2021, respectively, and $ 1.4 million and $ 1.3 million during the nine months ended September 30, 2022 and 2021, respectively.\\nThe Company has not entered into any material short-term leases or financing leases as of September 30, 2022.\\n32\\nThe total security deposit in connection with the Cambridge Lease is $ 1.6 million as of September 30, 2022. Additionally, the Company recorded $ 1.4 million for the security deposit under the Boston Lease. Both the Cambridge Lease and the Boston Lease have their security deposits in the form of a letter of credit, all of which are included as restricted cash in other assets in the Company’s unaudited condensed consolidated balance sheets as of September 30, 2022.\\nAs of September 30, 2022, undiscounted minimum rental commitments under non-cancelable leases, for each of the next five years and total thereafter are as follows:\\n| OperatingLeases | Lease Paymentsto be Receivedfrom Sublease | Net OperatingLease Payments |\\n| (in thousands) |\\n| Remaining 2022 | $ | 1,837 | $ | 461 | $ | 1,376 |\\n| 2023 | 6,954 | 307 | 6,647 |\\n| 2024 | 8,167 | — | 8,167 |\\n| 2025 | 8,293 | — | 8,293 |\\n| 2026 | 6,571 | — | 6,571 |\\n| Thereafter | 12,200 | — | 12,200 |\\n| Total | $ | 44,022 | $ | 768 | $ | 43,254 |\\n\\nIn arriving at the operating lease liabilities, the Company applied incremental borrowing rates ranging from 6.65 % to 7.25 %, which were based on the remaining lease term at either the date of adoption of ASC 842 or the effective date of any subsequent lease term extensions. As of September 30, 2022, the remaining lease terms ranged from 3.95 years to 8.84 years. As of September 30, 2022, the following represents the difference between the remaining undiscounted minimum rental commitments under non-cancelable leases and the operating lease liabilities:\\n\\n| Operating Leases |\\n| (in thousands) |\\n| Undiscounted minimum rental commitments | $ | 44,022 |\\n| Present value adjustment using incremental borrowing rate | ( 8,733 ) |\\n| Operating lease liabilities | $ | 35,289 |\\n\\nManufacturing Agreements\\nAs a result of the Merger, the Company's contractual obligations include Keryx’s commercial supply agreements with BioVectra Inc., or BioVectra, and Siegfried Evionnaz SA, or Siegfried, to supply commercial drug substance for Auryxia.\\nPursuant to the Manufacture and Supply Agreement with BioVectra and the Product Manufacture and Supply and Facility Construction Agreement with BioVectra, the Company agreed to purchase minimum quantities of Auryxia drug substance annually at predetermined prices. On September 4, 2020, the Company and BioVectra entered into an Amended and Restated Product Manufacture and Supply and Facility Construction Agreement, which provided for reduced minimum quantity commitments and revised the predetermined prices. The price per kilogram decreases with an increase in quantity above the predetermined purchase quantity tiers. In addition, the Manufacture and Supply Agreement with BioVectra and the Amended and Restated Product Manufacture and Supply and Facility Construction Agreement with BioVectra, require the Company to reimburse BioVectra for certain costs in connection with construction of a new facility for the manufacture and supply of Auryxia drug substance. These construction costs are recorded in other assets and amortized into drug substance as inventory is released to the Company from BioVectra. The term of the Manufacture and Supply Agreement with BioVectra expires on December 31, 2022. The term of the Amended and Restated Product Manufacture and Supply and Facility Construction Agreement expires on December 31, 2026, after which it automatically renews for successive one-year terms unless either party gives notice of its intention to terminate within a specified time prior to the end of the then-current term. In addition, the Company and BioVectra each have the ability to terminate these agreements upon the occurrence of certain conditions. As of September 30, 2022, the Company is required to reimburse BioVectra for certain costs in connection with the construction of the new facility and to purchase minimum quantities of Auryxia drug substance annually for a total cost of approximately $ 74.8 million through the end of the contract term.\\nPursuant to the Siegfried Master Manufacturing Services and Supply Agreement, as amended (the most recent amendment having been executed on February 11, 2021), or the Siegfried Agreement, the Company has agreed to purchase a minimum\\n33\\nquantity of drug substance of Auryxia at predetermined prices. The price per kilogram will decrease with an increase in quantity above the minimum purchase quantity. The term of the Siegfried Agreement expires on December 31, 2022, subject to the Company's option to extend the term through December 31, 2023 by providing 12 months’ prior written notice to Siegfried. The Siegfried Agreement provides the Company and Siegfried with certain early termination rights. In the first quarter of 2022, the Company notified Siegfried that the Company had elected not to exercise the option to extend the term of the Siegfried Agreement through December 31, 2023. As of September 30, 2022, the Company is required to purchase a minimum quantity of drug substance for Auryxia annually at a total cost of approximately $ 9.9 million through the year ending December 31, 2022.\\nCertain of the Company's commercial supply agreements are executory contracts between Keryx and its contract manufacturers for Auryxia, which include future firm purchase commitments. These executory contracts were deemed to have an off-market element related to the amount of purchase commitments that exceed the current forecast. The Company regularly reviews its estimate of the excess purchase commitment liability including a review of assumptions of expected future demand, estimates of anticipated expiry of inventory under firm purchase commitments that are estimated to expire before they could be sold as well as any modifications to supply agreements during each reporting period. The excess purchase commitment liability relating to these executory contracts was $ 74.3 million and $ 76.7 million as of September 30, 2022 and December 31, 2021, respectively. During the quarter ended September 30, 2022, the Company increased the excess purchase commitment liability and recorded a $ 13.2 million charge to cost of goods sold as a result of a routine long-term forecast update and continued declines in the binder market and a reduction in its contractual purchase commitment with a supplier. During the quarter ended September 30, 2022, the Company also reduced the excess purchase commitment liability by $ 5.8 million for inventory received that had previously been identified as excess. The Company considered whether the increase in the excess purchase commitment liability was a potential indicator of impairment of the Auryxia asset group as of September 30, 2022. As part of its assessment, the Company reviewed the Auryxia net sales and estimated future cash flows included in its forecast and concluded that the increase in excess purchase commitment liability was not an indicator of impairment of the Auryxia asset group as of September 30, 2022. During the quarter ended June 30, 2022, the Company reduced the excess purchase commitment liability by $ 5.8 million for inventory received that had been previously identified as excess. During the quarter ended March 31, 2022, the Company recorded a $ 0.8 million reduction to the excess purchase commitments liability within cost of goods sold and reduced the excess purchase commitment liability by $ 3.2 million for inventory received that had previously been identified as excess.\\nOn April 9, 2019, the Company entered into a Supply Agreement with Esteve Química, S.A., or Esteve, or the Esteve Agreement. The Esteve Agreement includes the terms and conditions under which Esteve will manufacture vadadustat drug substance for commercial use. Pursuant to the Esteve Agreement, the Company provides rolling forecasts to Esteve on a quarterly basis, or the Esteve Forecast. The Esteve Forecast reflects the Company’s needs for vadadustat drug substance produced by Esteve over a certain number of months, represented as a quantity of vadadustat drug substance per calendar quarter. The parties have agreed to a volume-based pricing structure under the Esteve Agreement. The Esteve Agreement has an initial term of four years , beginning April 9, 2019 and ending April 9, 2023. Pursuant to the Esteve Agreement, the Company has agreed to purchase a certain percentage of the global demand for vadadustat drug substance from Esteve. As of September 30, 2022, the Company has committed to purchase $ 26.9 million of vadadustat drug substance from Esteve through the second quarter of 2023.\\nOn March 11, 2020, the Company entered into a Supply Agreement with Patheon Inc., or Patheon, or the Patheon Agreement. The Patheon Agreement includes the terms and conditions under which Patheon will manufacture vadadustat drug product for commercial use. Pursuant to the Patheon Agreement, the Company provides Patheon a long-term forecast on an annual basis, as well as short-term forecasts on a quarterly basis, or the Patheon Forecast. The Patheon Forecast reflects the Company’s needs for commercial supply of vadadustat drug product produced by Patheon, represented as a quantity of drug product per calendar quarter. The parties have agreed to a volume-based pricing structure under the Patheon Agreement. The Patheon Agreement has an initial term, which began on March 11, 2020 and ends on June 30, 2023. Pursuant to the Patheon Agreement, the Company has agreed to purchase a certain percentage of the global demand for vadadustat drug product from Patheon. As of September 30, 2022, the Company had a minimum commitment with Patheon for $ 3.2 million through the fourth quarter of 2022.\\nOn April 2, 2020, the Company entered into a Supply Agreement with STA Pharmaceutical Hong Kong Limited, a subsidiary of WuXi AppTec, or WuXi STA, as amended on April 15, 2021, or the WuXi STA DS Agreement. The WuXi STA DS Agreement includes the terms and conditions under which WuXi STA will manufacture vadadustat drug substance for commercial use. Pursuant to the WuXi STA DS Agreement, the Company provides rolling forecasts to WuXi STA on a quarterly basis, or the WuXi STA DS Forecast. The WuXi STA DS Forecast reflects the Company’s needs for vadadustat drug substance produced by WuXi STA over a certain number of quarters. The parties have agreed to a volume-based pricing structure under the WuXi STA DS Agreement. The WuXi STA DS Agreement has an initial term of four years , beginning April 2, 2020 and ending April 2, 2024. Pursuant to the WuXi STA DS Agreement, the Company has agreed to purchase a certain percentage of the global demand for vadadustat drug substance from WuXi STA. As of September 30, 2022, the Company has committed to purchase $ 19.2 million of vadadustat drug substance from WuXi STA through the end of 2023.\\n34\\nOn February 10, 2021, the Company entered into a Supply Agreement with WuXi STA, or the WuXi STA DP Agreement. The WuXi STA DP Agreement includes the terms and conditions under which WuXi STA will manufacture and supply vadadustat drug product for commercial purposes. Pursuant to the WuXi STA DP Agreement, the Company will provide rolling forecasts to WuXi STA on a quarterly basis, or the WuXi STA DP Forecast. Each WuXi STA DP Forecast will reflect the quantities of vadadustat drug product that the Company expects to order from WuXi STA over a certain number of months, represented as a quantity of vadadustat drug product per calendar quarter. Pursuant to the WuXi STA DP Agreement, the Company has agreed to purchase a certain percentage of global demand for vadadustat drug product from WuXi STA. The parties have agreed to a volume-based pricing structure under the WuXi STA DP Agreement. The vadadustat drug product price will remain fixed for the first 12 months and thereafter shall be annually reviewed by the Company and WuXi STA. The Company will also reimburse WuXi STA for certain reasonable expenses. The WuXi STA DP Agreement has an initial term of four years , beginning February 10, 2021 and ending February 10, 2025.\\nOther Third-Party Contracts\\nUnder the Company’s agreement with IQVIA to provide contract research organization services for the PRO2TECT and INNO2VATE programs, the total remaining contract costs as of September 30, 2022 were approximately $ 4.6 million. Substantive performance for the committed work with IQVIA was completed in 2020 and close out activities will be performed throughout 2022. The Company also contracts with various other organizations to conduct research and development activities with remaining contract costs to the Company of approximately $ 176.3 million at September 30, 2022. The scope of the services under these research and development contracts can be modified and the contracts cancelled by the Company upon written notice. In some instances, the contracts may be cancelled by the third party upon written notice.\\nLitigation and Related Matters\\nFrom time to time, the Company may become subject to legal proceedings and claims which arise in the ordinary course of its business. Consistent with ASC 450, Contingencies, the Company’s policy is to record a liability if a loss in a significant legal dispute is considered probable and an amount can be reasonably estimated. The Company provides disclosure when a loss in excess of any reserve is reasonably possible, and if estimable, the Company discloses the potential loss or range of possible loss. Significant judgment is required to assess the likelihood of various potential outcomes and the quantification of loss in those scenarios. The Company’s estimates change as litigation progresses and new information comes to light. Changes in Company estimates could have a material impact on the Company’s results and financial position. As of September 30, 2022, the Company does not have any significant legal disputes that require a loss liability to be recorded. The Company continually monitors the need for a loss liability for litigation and related matters.\\n14. Net Loss per Share\\nFor purposes of the diluted net loss per share calculation, preferred stock, stock options, warrants, restricted stock and RSUs are considered to be common stock equivalents and have been excluded from the calculation of diluted net loss per share, as their effect would be anti-dilutive for periods presented. Therefore, basic and diluted net loss per share were the same for all periods presented in the unaudited condensed consolidated statement of operations and comprehensive loss. The shares in the table below were excluded from the calculation of diluted net loss per share, prior to the use of the treasury stock method, due to their anti-dilutive effect:\\n| As of September 30, |\\n| 2022 | 2021 |\\n| Warrant | — | 509,611 |\\n| Outstanding stock options | 11,844,609 | 11,593,539 |\\n| Unvested restricted stock units | 6,971,930 | 5,378,916 |\\n| Total | 18,816,539 | 17,482,066 |\\n\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\\nThe following information should be read in conjunction with our unaudited condensed consolidated financial statements and related notes included in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2021 filed with the U.S. Securities and Exchange Commission, or the SEC, on March 1, 2022, or the 2021 Annual Report on Form 10-K, including the audited consolidated financial statements and related notes therein. This discussion and analysis contains forward-looking statements that involve significant risks and uncertainties. As a result of many factors, such as those set forth under “Risk Factors” in Part II, Item 1A. of this Quarterly Report on Form 10-Q, our actual results may differ materially from those anticipated in these forward-looking statements.\\n35\\nBusiness Overview\\nWe are a biopharmaceutical company with the purpose of bettering the life of each person impacted by kidney disease. Since our initial public offering in 2014, we have built a business focused on developing and commercializing innovative renal therapeutics that we believe serves as a foundation for future growth. We established ourselves as a leader in the kidney community, and we remain committed to our purpose as we believe our current and future products have the ability to deliver value. Our current portfolio includes a commercial product and a late-stage investigational product candidate:\\n•Auryxia® (ferric citrate) is approved and marketed in the United States for two indications: (1) the control of serum phosphorus levels in adult patients with chronic kidney disease, or CKD, on dialysis, or DD-CKD, or the Hyperphosphatemia Indication, and (2) the treatment of iron deficiency anemia, or IDA, in adult patients with CKD not on dialysis, or NDD-CKD, or the IDA Indication. Ferric citrate is also approved and marketed in Japan as an oral treatment the improvement of hyperphosphatemia in adult patients with CKD, including DD-CKD and NDD-CKD, and for the treatment of patients with IDA under the trade name Riona (ferric citrate hydrate). Auryxia is our only product approved for sale in the United States and it generated approximately $42.2 million and $36.8 million in revenue from U.S. product sales during the three months ended September 30, 2022 and 2021, respectively.\\n•Vadadustat is an investigational oral hypoxia-inducible factor prolyl hydroxylase, or HIF-PH, inhibitor designed to mimic the physiologic effect of altitude on oxygen availability. At higher altitudes, the body responds to lower oxygen availability with stabilization of hypoxia-inducible factor, or HIF, which stimulates erythropoietin, or EPO, production and can lead to red blood cell, or RBC, production and improved oxygen delivery to tissues. The significance of the HIF pathway was recognized by the 2019 Nobel Prize and the 2016 Albert Lasker Basic Medical Research Award, which honored the three physician-scientists who discovered the HIF pathway and elucidated this primary oxygen sensing mechanism that is essential for survival.\\nOn March 29, 2022, we received a complete response letter, or CRL, from the U.S. Food and Drug Administration, or FDA. The CRL provided that the FDA had completed its review of our new drug application, or NDA, for vadadustat for the treatment of anemia due to CKD in adult patients, and determined that it could not approve the NDA in its present form. In July 2022, we held an end of review meeting with the FDA to inform the Company's next steps with respect to the potential U.S. approval of vadadustat, if any, and in October 2022, we submitted a Formal Dispute Resolution Request, or FDRR, to the FDA. The FDRR focuses on the favorable balance between the benefits and risks of vadadustat for the treatment of anemia due to CKD in adult patients on dialysis in light of safety concerns expressed by the FDA in the CRL related to the rate of adjudicated thromboembolic events driven by vascular access thrombosis for vadadustat compared to the active comparator and the risk of drug-induced liver injury. Based on the typical FDRR process, we expect to receive a response to the FDRR from the FDA by the end of 2022. Also, on April 1, 2022, we were notified by the FDA that the FDA had placed a partial clinical hold on our clinical trials of vadadustat in pediatric patients with anemia due to CKD in the United States. In addition, in May 2022, the Paediatric Committee of the European Medicines Agency, or the EMA, recommended that we not initiate such clinical trials in the European Union until the safety issues identified by the FDA in the CRL were addressed. As a result of the partial clinical hold and the EMA’s recommendations, all activities in the United States and Europe for and related to our clinical trials of vadadustat in pediatric patients were suspended.\\nOur former collaboration partner, Otsuka Pharmaceutical Co. Ltd., or Otsuka, submitted a Marketing Authorization Application, or MAA, for vadadustat for the treatment of anemia due to CKD in both DD-CKD and NDD-CKD adult patients to the EMA, in October 2021, and in each of the United Kingdom, Switzerland, and Australia in the first quarter of 2022. On June 30, 2022, we and Otsuka entered into a Termination and Settlement Agreement, or the Termination Agreement, and pursuant to the Termination Agreement, Otsuka has transferred the MAAs for vadadustat with the EMA, and in the United Kingdom, Switzerland and Australia to us. Based on the current review timeline, we expect a decision on the MAA from EMA in the first quarter of 2023. As vadadustat did not meet the PRO2TECT program's primary safety endpoint, we are remaining cautious in our outlook for potential approval of vadadustat in NDD-CKD adult patients in Europe, the United Kingdom, Switzerland and Australia.\\nIn June of 2020, we announced the first regulatory approval of vadadustat for the treatment of anemia due to CKD in DD-CKD and NDD-CKD adult patients in Japan. Our collaboration partner in Japan, Mitsubishi Tanabe Pharma Corporation, or MTPC, commenced commercial sales of vadadustat in Japan under the trade name, VafseoTM, in August 2020. In addition, MTPC filed new drug applications for vadadustat for the treatment of anemia due to CKD in adult patients in Taiwan in January of 2022 and in Korea in March 2022.\\n36\\nIn August of 2022, we announced initial findings from an investigator-sponsored clinical study by The University of Texas Health Science Center at Houston, or UTHealth, in Houston, Texas, evaluating the use of vadadustat as a potential therapy to prevent and treat acute respiratory distress syndrome, or ARDS, in patients with COVID-19 and hypoxemia, or the VSTAT Study. The VSTAT Study was a phase 2, randomized, double-blind, placebo-controlled study conducted by UTHealth and partially funded by Akebia. UTHealth was awarded $5.1 million in funding from the U.S. Department of Defense for the study. The VSTAT Study enrolled 449 adult patients at 5 hospitals who were randomized 1:1 to vadadustat 900mg or placebo once per day orally for up to 14 days while hospitalized. The VSTAT Study measured the proportion of patients with either 6 (non-invasive ventilation or high flow oxygen devices), 7 (invasive mechanical ventilation or extracorporeal membrane oxygenation), or 8 (death) on the National Institute of Allergy and Infectious Disease Ordinal Scale, or NIAID-OS, at Day 14 (primary) and Day 7. While a smaller proportion of patients in the vadadustat group had a score of 6, 7, or 8 on the NIAID-OS than in the placebo group at Day 14, the trial failed to meet its primary superiority threshold of >95% probability. Those receiving vadadustat, however, did demonstrate 94% probability of conferring benefit on the NIAID-OS at Day 14. While the VSTAT Study missed the primary endpoint, we are encouraged by the data and believe the data supports further development of vadadustat as a potential treatment for ARDS due to COVID-19 or other causes.\\nIf we are successful in addressing the deficiencies noted in the CRL and in the event we receive FDA approval of vadadustat in the United States, we plan to commercialize vadadustat in the United States with our well-established, nephrology-focused commercial organization, which we may expand if vadadustat is approved. In addition, in February 2022, we entered into a Second Amended and Restated License Agreement, or the Vifor Second Amended Agreement, with Vifor (International) Ltd., or Vifor Pharma, which amended and restated the Amended and Restated License Agreement, dated April 8, 2019, or the Vifor First Amended Agreement. Pursuant to the Vifor Second Amended Agreement, we granted Vifor Pharma an exclusive license to sell vadadustat to Fresenius Medical Care North America and its affiliates, including Fresenius Kidney Care Group LLC, to certain third-party dialysis organizations approved by us, to independent dialysis organizations that are members of group purchase organizations, and to certain non-retail specialty pharmacies in the United States, or the Territory. We refer to Fresenius Medical Care North America and its affiliates, these organizations and specialty pharmacies collectively as the \\\"Supply Group\\\". We currently retain rights to commercialize vadadustat for use in the non-dialysis dependent CKD market and to sell to dialysis organizations outside of the Supply Group. During the term of the Vifor Second Amended Agreement, Vifor Pharma is not permitted to sell any HIF product that competes with vadadustat in the Territory to the Supply Group. We granted MTPC exclusive rights to commercialize vadadustat in Japan, where MTPC commenced commercial sales of vadadustat under the trade name, VafseoTM, in August 2020, and in certain other countries in Asia, subject to marketing approvals.\\nIn addition, we continue to explore additional development opportunities to expand our pipeline and portfolio of novel therapeutics through both internal research and external innovation. Our development pipeline includes several earlier stage opportunities, including praliciguat, an investigational oral soluble guanylate cyclase, or sGC, stimulator, that we licensed from Cyclerion Therapeutics, Inc., or Cyclerion, in June 2021. One indication of interest is the treatment of focal segmental glomerulosclerosis, which is highly complementary of our strategy to identify and develop novel therapeutics for people impacted by kidney diseases.\\nOperating Overview\\nWe have incurred net losses in each year since inception. Our net losses were $51.9 million and $59.5 million for the three months ended September 30, 2022 and 2021, respectively. Our net losses were $85.0 million and $212.2 million for the nine months ended September 30, 2022 and 2021, respectively. Substantially all of our net losses resulted from costs incurred in connection with the continued commercialization of Auryxia and development efforts relating to vadadustat, including conducting clinical trials of, and seeking regulatory approval for, vadadustat, providing general and administrative support for these operations and protecting our intellectual property.\\nOur ability to achieve profitability depends in part on our ability to manage our expenses. Following receipt of the CRL, in April 2022 and May 2022, we implemented a reduction of our workforce by approximately 42% across all areas of our company including several members of management (47% inclusive of the closing of the majority of open positions). These actions reflect our determination to refocus our strategic priorities around our commercial product, Auryxia®, and our development portfolio, and are steps in a cost savings plan to significantly reduce our expense profile in line with being a single commercial product company. The workforce reduction included net charges totaling approximately $14.7 million, including costs for one-time termination benefits and contractual termination benefits for severance, healthcare, and related benefits of $11.4 million and non-cash stock-based compensation expense of $3.3 million. During the three and nine months ended September 30, 2022, we recognized $0.2 million and 14.7 million, respectively, of restructuring charges in the condensed consolidated statement of operations and comprehensive loss. Refer to Note 5 to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for further details.\\n37\\nEven in light of the reduction in workforce, we expect to continue to incur significant expenses and operating losses for the foreseeable future. In addition to any additional costs not currently contemplated due to the events associated with or resulting from the workforce reduction noted above, our ability to achieve profitability and our financial position will depend, in part, on the rate of our future expenditures, on our product revenue from Auryxia, collaboration revenue, our ability to successfully implement cost avoidance measures and reduce overhead costs and our ability to obtain additional funding. We expect to continue to incur significant expenses if and as we:\\n•continue our commercialization activities for Auryxia and vadadustat, if we are able to obtain marketing approval for vadadustat following receipt of the CRL from the FDA in March 2022, and any other product or product candidate, including those that may be in-licensed or acquired;\\n•address the issues identified in the CRL for vadadustat that we received from the FDA and, in the event our FDRR is accepted by the FDA, pursue our appeal of the CRL for vadadustat with the FDA;\\n•conduct and enroll patients in any clinical trials, including post-marketing studies or any other clinical trials for Auryxia, vadadustat or any other product or product candidate, including those that may be in-licensed or acquired;\\n•seek marketing approvals for vadadustat and any other product candidate, including those that may be in-licensed or acquired;\\n•maintain marketing approvals for Auryxia and vadadustat, if we are able to obtain marketing approval for vadadustat following receipt of the CRL from the FDA in March 2022, and any other product, including those that may be in-licensed or acquired;\\n•manufacture Auryxia, vadadustat and any other product or product candidate, including those that may be in-licensed or acquired, for commercial sale and clinical trials;\\n•conduct discovery and development activities for additional product candidates or platforms that may lead to the discovery of additional product candidates;\\n•engage in transactions, including strategic, merger, collaboration, acquisition and licensing transactions, pursuant to which we would market and develop commercial products, or develop and commercialize other product candidates and technologies;\\n•continue to repay, and pay any associated pre-payment penalties, if applicable, the senior secured term loans in an aggregate principal amount of $67.0 million, or the Term Loans, that were made available to us pursuant to the loan agreement that we entered into with funds managed by Pharmakon Advisors LP, in November 2019, which was amended in February 2022, and further amended in July 2022, or as amended, the Loan Agreement;\\n•make royalty, milestone or other payments under our license agreements and any future license agreements;\\n•maintain, protect and expand our intellectual property portfolio;\\n•make decisions with respect to our personnel, including the retention of key employees;\\n•make decisions with respect to our infrastructure, including to support our operations as a fully integrated publicly traded biopharmaceutical company; and\\n•experience any additional delays or encounter issues with any of the above.\\nWe have not generated, and may not generate, enough product revenue to realize net profits from product sales. We have no manufacturing facilities, and all of our manufacturing activities are contracted out to third parties. Additionally, we currently utilize contract research organizations, or CROs, to carry out our clinical development activities. If we obtain marketing approval for vadadustat, and as we continue to commercialize Auryxia, we expect to incur significant commercialization expenses related to product sales, marketing, manufacturing and distribution. We expect to finance future cash needs through product revenue, public or private equity or debt transactions, royalty transactions, strategic transactions, or a combination of these approaches. If we are unable to raise additional capital in sufficient amounts when needed or on attractive terms, we may not be able to pursue development and commercial activities related to Auryxia and vadadustat, if approved, or any additional products and product candidates, including those that may be in-licensed or acquired. Any of these events could significantly harm our business, financial condition and prospects.\\n38\\nFrom inception through September 30, 2022, we raised approximately $793.5 million of net proceeds from the sale of equity, including $519.8 million from various underwritten public offerings, $223.7 million from at-the-market offerings, or ATM offerings, pursuant to prior sales agreements with Cantor Fitzgerald & Co., and $70.0 million from the sale of 7,571,429 shares of common stock to Vifor Pharma. As of September 30, 2022, through our collaboration agreement with MTPC and our prior collaboration agreements with Otsuka we received approximately $837.1 million in cost-share funding, and are not entitled to receive any additional cost-share funding. On June 30, 2022, we entered into the Termination Agreement with Otsuka, pursuant to which we received a nonrefundable and non-creditable payment of $55.0 million in consideration for the covenants and agreements set forth in the Termination Agreement.\\nOn November 11, 2019, we entered into the Loan Agreement with funds managed by Pharmakon, pursuant to which term loans in an aggregate principal amount of $100.0 million were made available to us in two tranches, subject to certain terms and conditions, or the Term Loans. As of September 30, 2022, we had drawn down the full $100.0 million made available to us under the Loan Agreement. On July 15, 2022, or the Effective Date, we entered into the Second Amendment and Waiver with BioPharma Credit PLC, or the Collateral Agent, BPCR Limited Partnership, as a Lender, and BioPharma Credit Investments V (Master) LP, as a Lender, or the Second Amendment and Waiver, which amends and waives certain provisions of the Loan Agreement as amended by the First Amendment and Waiver between the Collateral Agent, the Lenders and us, dated February 18, 2022, or the First Amendment and Waiver. The Collateral Agent and the Lenders are collectively referred to as Pharmakon (see Note 11 to our condensed consolidated financial statements). Pursuant to the Second Amendment and Waiver, we made prepayments totaling $25.0 million together with a prepayment premium of $0.5 million plus all accrued and unpaid interest on such prepayments of principal to the Effective Date, and Pharmakon agreed to waive or modify certain covenants in the Loan Agreement (see Note 11 to our condensed consolidated financial statements). In addition, on February 25, 2021, we received an upfront payment of $44.8 million (net of certain transaction expenses) in connection with our sale to HealthCare Royalty Partners IV, L.P., or HCR, of the right to receive all royalties and sales milestones payable to us under our collaboration agreement with MTPC, or the MTPC Agreement, subject to certain caps and other terms and conditions described elsewhere in this Quarterly Report on Form 10-Q. Finally, on February 18, 2022, we entered into a Second Amended and Restated License Agreement, or the Vifor Second Amended Agreement, with Vifor Pharma. Pursuant to the Vifor Second Amended Agreement, Vifor Pharma made an upfront payment to us of $25.0 million in lieu of the previously disclosed milestone payment of $25.0 million that Vifor Pharma was to pay to us following approval of vadadustat by the FDA. Also pursuant to the Vifor Second Amended Agreement, Vifor contributed $40 million to a working capital fund established to partially fund our costs of purchasing vadadustat from our contract manufacturers, or the Working Capital Fund, which amount of funding will fluctuate, and which funding we will repay to Vifor Pharma over time.\\nImpacts of COVID-19 Pandemic\\nThe COVID-19 pandemic has presented a substantial public health and economic challenge around the world and continues to affect our employees, patients, healthcare providers with whom we interact, customers, collaboration partners, CROs, contract manufacturing organizations, or CMOs, vendors, communities and business operations. The full extent to which the COVID-19 pandemic will directly or indirectly impact our business, results of operations and financial condition continues to depend on future developments that are highly uncertain and cannot be accurately predicted, including new information that may emerge concerning the COVID-19 pandemic, any resurgences or variants of COVID-19, the actions taken to contain it or treat its impact and the economic and other impacts on local, regional, national and international markets where the healthcare providers with whom we interact, our partners, our CROs, our CMOs, and our other vendors operate.\\nWe believe our revenue growth was negatively impacted by the COVID-19 pandemic in 2021 and the first three quarters of 2022 primarily as the CKD patient populations that we serve experienced both high hospitalization and mortality rates due to COVID-19, and the pandemic had an adverse impact on the phosphate binder market in which Auryxia competes. Labor shortages and costs have adversely impacted dialysis providers. These impacts have refocused clinical efforts in addressing bone and mineral disorders like hyperphosphatemia to more acute operational issues to ensure patients receive dialysis treatments and still some patients have been rescheduled or missed treatments due to labor shortages. We believe, this and potentially other factors, has led to the reduction in the phosphate binder market, which has not experienced growth since early 2020. While we are unable to quantify the impact of the COVID-19 pandemic on future revenues and revenue growth, the COVID-19 pandemic and the ongoing impacts from the COVID-19 pandemic continue to adversely and disproportionately impact CKD patients and the phosphate binder market; therefore, we expect the COVID-19 pandemic and the ongoing impacts from the pandemic to continue to have a negative impact on our revenue growth for the foreseeable future.\\nAs a result of the COVID-19 pandemic we adopted a flexible workplace policy allowing employees to work from home on a full or part-time basis, which may make it difficult for us to maintain our corporate culture or retain employees. Moreover, our future success substantially depends on the management skills of our executives and certain other key employees. The unanticipated loss or unavailability of key employees due to the pandemic could harm our ability to operate our business or execute our business strategy and we may not be successful in finding and integrating suitable successors in the event any of our key employees leave or are unavailable.\\n39\\nIn addition, several healthcare facilities have previously restricted access for non-patients, including the members of our sales force. For example, DaVita, Inc., or DaVita, and Fresenius Medical Care, or Fresenius, which account for a vast majority of the dialysis population in the United States, have previously restricted access to their clinics. As a result, we continue to engage with some healthcare providers and other customers virtually, where possible. The restrictions on our customer-facing employees' in-person interactions with healthcare providers have, and could continue to, negatively impact our access to healthcare providers and, ultimately, our sales, including with respect to vadadustat, if approved. Recently, such precautionary measures have been relaxed at certain healthcare facilities and, as a result, members of our sales force have resumed in person interactions with certain customers. Nevertheless, some restrictions remain, and more restrictions may be put in place again due to a resurgence in COVID-19 cases, including those involving new variants of COVID-19 which may be more contagious and more severe than prior strains of the virus. Given this uncertain environment and the disproportionate impact of the COVID-19 pandemic on CKD patients, we are actively monitoring the demand in the United States for Auryxia and will be for vadadustat, if approved, including the potential for further declines or changes in prescription trends and customer orders, which could have a material adverse effect on our business, results of operations and financial condition.\\nIn addition, the direct and indirect impacts of the pandemic or the response efforts to the pandemic, including among others, competition for labor and resources and increases in labor, sourcing, manufacturing and shipping costs, may cause disruptions to, closures of, or other impacts on our CMOs and other vendors in our supply chain on which we rely for the supply of our products and product candidates. For example, areas of China have recently continued to implement lockdowns for COVID-19, which could impact the global supply chain. At this time, our third party contract manufacturers continue to operate at or near normal levels. However, it is possible that the COVID-19 pandemic and response efforts may have an impact in the future on our contract manufacturers' ability to manufacture and deliver Auryxia and vadadustat (if approved in the United States and EMA and which is currently marketed under the trade name VafseoTM by MTPC in Japan), which may result in increased costs and delays, or disruptions to the manufacturing and supply of our products.\\nCOVID-19 pandemic precautions have caused moderate delays in enrolling new clinical trials and may cause delays in enrolling other new clinical trials. We are using remote monitoring and central monitoring, where possible.\\nThis uncertain pandemic environment has presented new risks to our business. While we are working aggressively to mitigate the impacts on our business, we are mindful that many of these risks and the impact to the larger healthcare market are outside of our control.\\nFor additional information on the various risks posed by the COVID-19 pandemic, please refer to Part II, Item 1A. Risk Factors below.\\nFinancial Overview\\nRevenue\\nTo date, our revenues have been derived from product revenue from commercial sales of Auryxia, collaboration revenues, which include license and milestone payments, royalty and cost-sharing revenue generated through collaboration and license agreements with partners for the development and commercialization of vadadustat, a nonrefundable, non-creditable termination fee pursuant to the terms of the Termination Agreement with Otsuka, and royalty revenue from sales of Riona in Japan. Cost-sharing revenue represents amounts reimbursed by our collaboration partners for expenses incurred by us for research and development activities and, potentially, co-promotion activities, under our collaboration agreements.\\nWe expect our revenue to continue to be generated primarily from our commercial sales of Auryxia, our collaboration with MTPC and any other collaborations into which we may enter, and royalty revenue from Japan Tobacco, Inc., and its subsidiary, Torii Pharmaceutical Co., Ltd., collectively JT and Torii, based on net sales of Riona in Japan. We will not recognize any future revenue pursuant to our collaboration with Otsuka.\\nCost of Goods Sold\\nCost of goods sold includes direct costs to manufacture commercial drug substance and drug product for Auryxia, as well as indirect costs including costs for packaging, shipping, insurance and quality assurance, idle capacity charges, write-offs for inventory that fails to meet specifications or is otherwise no longer suitable for commercial sale, changes in our excess purchase commitment liability, and royalties due to the licensor of Auryxia related to the U.S. product sales recognized during the period. Cost of goods sold also includes costs to manufacture drug product provided to MTPC for commercial sale of Vafseo in Japan.\\nAs a result of the merger with Keryx Biopharmaceuticals, Inc., or Keryx, or the Merger, and the application of purchase accounting, costs of goods sold also includes both amortization expense and, if applicable, impairment charges associated with the fair value of the developed product rights for Auryxia as well as expense associated with the fair value inventory step-up. The fair value of the developed product rights for Auryxia is being amortized over its estimated useful life, which as of\\n40\\nSeptember 30, 2022 is estimated to be six years. The fair value inventory step-up as a result of the Merger was fully amortized as of the first quarter of 2021.\\nResearch and Development Expenses\\nResearch and development expenses consist primarily of costs incurred for the development of vadadustat, which include:\\n•personnel-related expenses, including salaries, benefits, recruiting fees, travel and stock-based compensation expense of our research and development personnel;\\n•expenses incurred under agreements with CROs and investigative sites that conduct our clinical studies;\\n•the cost of acquiring, developing and manufacturing clinical study materials through CMOs;\\n•facilities, depreciation and other expenses, which include direct and allocated expenses for rent and maintenance of facilities, insurance and other supplies;\\n•costs associated with preclinical, clinical and regulatory activities; and\\n•costs associated with pre-launch inventory build for vadadustat in the United States and Europe, for which we received the CRL from the FDA in the United States in March 2022.\\nResearch and development costs are expensed as incurred. Costs for certain development activities are recognized based on an evaluation of the progress to completion of specific tasks using information and data provided to us by our vendors and our clinical sites.\\nWe cannot determine with certainty the duration and completion costs of current or future clinical studies of Auryxia and vadadustat or if, when, or to what extent we will receive marketing approval for vadadustat or generate revenue from the commercialization and sale of vadadustat, if approved. We may never succeed in achieving marketing approval for vadadustat.\\nThe duration, costs and timing of clinical studies and development of Auryxia and vadadustat will depend on a variety of factors including, but not limited to, those described in Part II, Item 1A. Risk Factors. A change in the outcome of any of these variables with respect to the development of Auryxia and vadadustat could mean a significant change in the costs and timing associated with that development. For example, if the FDA, the EMA, or other regulatory authorities were to require us to conduct clinical studies in addition to or different from those that we currently anticipate, or if we experience delays in any of our clinical studies, we could be required to expend significant additional financial resources and time on the completion of clinical development.\\nFrom inception through September 30, 2022, we have incurred $1.5 billion in research and development expenses. We expect to incur significant research and development expenditures for the foreseeable future as we continue the development of Auryxia, vadadustat and any other product or product candidate, including those that may be in-licensed or acquired.\\nOur direct research and development expenses consist principally of external costs, such as fees paid to clinical trial sites, consultants, central laboratories and CROs in connection with our clinical studies, and drug substance and drug product manufacturing for clinical studies.\\nIn 2020, we completed our global Phase 3 clinical program for vadadustat to which the majority of our research and development costs have been attributable. A significant portion of our research and development costs have been external costs, which we track on a program-by-program basis. These external costs include fees paid to investigators, consultants, central laboratories and CROs in connection with our clinical trials, and costs related to acquiring and manufacturing clinical trial materials. Our internal research and development costs are primarily personnel-related costs, depreciation and other indirect costs. We do not track our internal research and development expenses on a program-by-program basis as they are deployed across multiple projects under development.\\nThe following table summarizes our external research and development expenses by program, as well as expenses not allocated to programs, for the three and nine months ended September 30, 2022 and 2021:\\n41\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) | (in thousands) |\\n| Vadadustat external costs | $ | 13,840 | $ | 14,339 | $ | 42,752 | $ | 44,059 |\\n| External costs for other programs | 3,823 | 7,425 | 15,279 | 18,989 |\\n| Total external research and development expenses | 17,663 | 21,764 | 58,031 | 63,048 |\\n| Headcount, consulting, facilities and other | 9,687 | 18,707 | 39,179 | 55,248 |\\n| Total research and development expenses | $ | 27,350 | $ | 40,471 | $ | 97,210 | $ | 118,296 |\\n\\nSelling, General and Administrative Expenses\\nSelling, general and administrative expenses consist primarily of salaries and related costs for personnel, including stock-based compensation and travel expenses for our commercial personnel, including our field sales force and other commercial support personnel, as well as personnel in executive and other administrative or non-research and development functions. Other selling, general and administrative expenses include facility-related costs, fees for directors, accounting and legal services fees, recruiting fees and expenses associated with obtaining and maintaining patents.\\nResults of Operations\\nComparison of the Three Months Ended September 30, 2022 and 2021\\n\\n| Three Months Ended | Increase |\\n| September 30, 2022 | September 30, 2021 | (Decrease) |\\n| (in thousands) |\\n| Revenues: |\\n| Product revenue, net | $ | 42,239 | $ | 36,753 | $ | 5,486 |\\n| License, collaboration and other revenue | 6,725 | 12,003 | (5,278) |\\n| Total revenues | 48,964 | 48,756 | 208 |\\n| Cost of goods sold: |\\n| Product | 28,936 | 6,933 | 22,003 |\\n| Amortization of intangibles | 9,011 | 9,011 | — |\\n| Total cost of goods sold | 37,947 | 15,944 | 22,003 |\\n| Operating expenses: |\\n| Research and development | 27,350 | 40,471 | (13,121) |\\n| Selling, general and administrative | 30,918 | 46,357 | (15,439) |\\n| License expense | 743 | 870 | (127) |\\n| Restructuring | 180 | — | 180 |\\n| Total operating expenses | 59,191 | 87,698 | (28,507) |\\n| Operating loss | (48,174) | (54,886) | 6,712 |\\n| Other expense, net | (2,785) | (4,658) | 1,873 |\\n| Loss on extinguishment of debt | (906) | — | (906) |\\n| Net loss | $ | (51,865) | $ | (59,544) | $ | 7,679 |\\n\\nProduct Revenue, Net. Net product revenue is derived from sales of our only commercial product in the United States, Auryxia. We distribute our product principally through a limited number of wholesale distributors as well as certain specialty pharmacy providers. Net product revenue was $42.2 million for the three months ended September 30, 2022, compared to $36.8 million for the three months ended September 30, 2021. The increase was primarily due to pricing and improved payer mix.\\nLicense, Collaboration and Other Revenue. License, collaboration and other revenue was $6.7 million for the three months ended September 30, 2022 compared to $12.0 million for the three months ended September 30, 2021. The decrease is primarily due to a reduction in revenue from the Otsuka collaboration agreement because on June 30, 2022, we and Otsuka\\n42\\nentered into the Termination Agreement, which, among other things, terminated the cost sharing arrangement under the Otsuka collaboration agreement for the United States, or the Otsuka U.S. Agreement, and the Otsuka collaboration agreement for certain territories outside the United States, or the Otsuka International Agreement. Refer to Note 4 to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for further details. We will not recognize any future revenue under the Otsuka U.S. Agreement or the Otsuka International Agreement.\\nCost of Goods Sold - Product. Cost of goods sold of $28.9 million for the three months ended September 30, 2022 consisted of costs associated with the manufacturing of Auryxia and supply of Vafseo to MTPC for commercial sale in Japan, $2.6 million related to excess and obsolescence reserves associated with inventory, and a $13.2 million non-cash charge related to an increase to the liability for excess purchase commitments. Refer to Note 13 to our condensed consolidated financial statements for further details on the excess purchase commitments liability.\\nCost of goods sold of $6.9 million for the three months ended September 30, 2021 consisted of costs associated with the manufacturing of Auryxia partially offset by a $6.0 million reduction to the liability for excess purchase commitments, primarily due to the settlement of all patent litigation proceedings related to Abbreviated New Drug Applications filed with respect to Auryxia, which allows for generic versions of Auryxia beginning in March 2025. Refer to Note 13 to our condensed consolidated financial statements for further details on the excess purchase commitments liability.\\nCost of Goods Sold - Amortization of Intangibles. Amortization of intangibles relates to the acquired developed product rights for Auryxia, which is being amortized using a straight-line method over its estimated useful life of approximately six years. Amortization of intangibles during each of the three months ended September 30, 2022 and 2021 was $9.0 million.\\nResearch and Development Expenses. Research and development expenses were $27.4 million for the three months ended September 30, 2022, compared to $40.5 million for the three months ended September 30, 2021, a decrease of $13.1 million. The decrease was primarily due to the following:\\n| (in millions) |\\n| Vadadustat development expenses | $ | (0.5) |\\n| Headcount, consulting, facilities and other | (12.6) |\\n| Total net decrease | $ | (13.1) |\\n\\nThe decrease in research and development expense was primarily due to decreased headcount related costs as a result of the reduction in force and decreased consulting costs. Although we expect our research and development expenses to continue to decrease for the remainder of 2022, compared to 2021, we will continue to incur significant research and development expenses in future periods in support of ongoing or planned studies with respect to Auryxia and vadadustat and development of other potential product candidates.\\nSelling, General and Administrative Expenses. Selling, general and administrative expenses were $30.9 million for the three months ended September 30, 2022, compared to $46.4 million for the three months ended September 30, 2021. The decrease of $15.4 million was primarily due to decreased headcount related costs as a result of the reduction in force, lower one-time legal costs, and lower marketing expenses. For the remainder of 2022, we expect our selling, general and administrative expenses to continue to decrease from 2021 as we continue to reduce our expense profile in line with being a single commercial product company.\\nLicense Expenses. License expense related to royalties due to Panion relating to sales of Riona in Japan were $0.7 million for the three months ended September 30, 2022 compared to $0.9 million for the three months ended September 30, 2021.\\nRestructuring. Restructuring expenses were $0.2 million for the three months ended September 30, 2022 due to one-time termination benefits for severance, healthcare, and related benefits related to the reduction in force. There were no restructuring expenses for the three months ended September 30, 2021.\\nOther Expense, Net. Other expense, net, was $2.8 million for the three months ended September 30, 2022 compared to $4.7 million for the three months ended September 30, 2021. The decrease of $1.9 million was primarily due to a decrease in interest expense as a result of principal prepayments totaling $25.0 million made on the Term Loans pursuant to the Second Amendment and Waiver in the three months ended September 30, 2022, reducing our outstanding balance on the Term Loans. The decrease was also related to a decrease in the fair value of our derivative liability related to the Loan Agreement with Pharmakon during the three months ended September 30, 2022.\\n43\\nLoss on Extinguishment of Debt. During the three months ended September 30, 2022, the Company recorded a debt extinguishment loss of $0.9 million related to the principal prepayments made on the Term Loans pursuant to the Second Amendment and Waiver.\\nComparison of the Nine Months Ended September 30, 2022 and 2021\\n| Nine Months Ended | Increase |\\n| September 30, 2022 | September 30, 2021 | (Decrease) |\\n| (in thousands) |\\n| Revenues: |\\n| Product revenue, net | $ | 127,390 | $ | 100,120 | $ | 27,270 |\\n| License, collaboration and other revenue | 110,032 | $ | 53,853 | 56,179 |\\n| Total revenues | 237,422 | 153,973 | 83,449 |\\n| Cost of goods sold: |\\n| Product | 60,859 | $ | 76,012 | (15,153) |\\n| Amortization of intangibles | 27,032 | 27,032 | — |\\n| Total cost of goods sold | 87,891 | 103,044 | (15,153) |\\n| Operating expenses: |\\n| Research and development | 97,210 | 118,296 | (21,086) |\\n| Selling, general and administrative | 108,052 | 129,336 | (21,284) |\\n| License expense | 2,323 | 2,460 | (137) |\\n| Restructuring | 14,711 | — | 14,711 |\\n| Total operating expenses | 222,296 | 250,092 | (27,796) |\\n| Operating loss | (72,765) | (199,163) | 126,398 |\\n| Other expense, net | (11,339) | (12,999) | 1,660 |\\n| Loss on extinguishment of debt | (906) | — | (906) |\\n| Net loss | (85,010) | (212,162) | 127,152 |\\n\\nProduct Revenue, Net. Net product revenue is derived from sales of our only commercial product in the United States, Auryxia. We distribute our product principally through a limited number of wholesale distributors as well as certain specialty pharmacy providers. Net product revenue was $127.4 million for the nine months ended September 30, 2022, compared to net product revenue of $100.1 million for the nine months ended September 30, 2021. The increase was primarily due to pricing and improved payor mix.\\nLicense, Collaboration and Other Revenue. License, collaboration and other revenue was $110.0 million for the nine months ended September 30, 2022, compared to $53.9 million for the nine months ended September 30, 2021. On June 30, 2022, we and Otsuka entered into the Termination Agreement, which, among other things, terminated the cost sharing arrangement under the Otsuka U.S. Agreement, and the Otsuka International Agreement. During the nine months ended September 30, 2022, we recognized $55.0 million in collaboration revenue related to a payment received pursuant to the terms of the Termination Agreement with Otsuka, $15.5 million related to previously deferred revenue as of the date of termination and $9.6 million of non-cash consideration related to Otsuka's obligations to complete certain agreed upon clinical activities related to the MODIFY Study, in accordance with the current study protocol, at its own cost and expense. We also recognized $19.1 million in collaboration revenue for the nine months ended September 30, 2022 from the Otsuka U.S. Agreement and the Otsuka International Agreement prior to the termination, as well as royalty revenue under the MTPC Agreement, and revenue under the MTPC Supply Agreement. We recognized $49.7 million in collaboration revenue for the nine months ended September 30, 2021 from the Otsuka U.S. Agreement, the Otsuka International Agreement, royalty revenue under our collaboration agreement with MTPC, and revenue under the MTPC Supply Agreement.\\nCost of Goods Sold - Product. Cost of goods sold of $60.9 million for the nine months ended September 30, 2022 consisted of costs associated with the manufacturing of Auryxia and supply of Vafseo to MTPC for commercial sale in Japan, $10.0 million related to excess and obsolescence reserves associated with inventory, and a $12.4 million increase to the liability for excess\\n44\\npurchase commitments. Refer to Note 13 to our condensed consolidated financial statements for further details on the excess purchase commitments liability.\\nCost of goods sold of $76.0 million for the nine months ended September 30, 2021 consisted primarily of costs associated with the manufacturing of Auryxia, $15.4 million in non-cash charges related to an increase to the liability for excess purchase commitments, $21.6 million in non-cash charges related to the fair-value inventory step-up from the application of purchase accounting, and $7.1 million related to inventory reserves associated with a previously disclosed manufacturing quality issue related to Auryxia.\\nCost of Goods Sold - Amortization of Intangibles. Amortization of intangibles relates to the acquired developed product rights for Auryxia, which is being amortized using a straight-line method over its estimated useful life of approximately six years. Amortization of intangibles during each of the nine months ended September 30, 2022 and 2021 was $27.0 million.\\nResearch and Development Expenses. Research and development expenses were $97.2 million for the nine months ended September 30, 2022, compared to $118.3 million for the nine months ended September 30, 2021, a decrease of $21.1 million. The decrease was primarily due to the following:\\n| (in millions) |\\n| Vadadustat development expenses | $ | (1.3) |\\n| Headcount, consulting, facilities and other | (19.8) |\\n| Total net decrease | (21.1) |\\n\\nThe decrease in research and development expense was primarily due to decreased headcount related costs as a result of the reduction in force, decreased consulting costs, and decreased regulatory fees. Also during the nine months ended September 30, 2021, we made an upfront payment of $3.0 million to Cyclerion for an exclusive global license to develop and commercialize praliciguat, an investigational oral sGC, stimulator, which was recorded to research and development expense which did not reoccur during the nine months ended September 30, 2022. Although we expect our research and development expenses for the remainder of 2022 to continue to decrease compared to 2021, we will continue to incur significant research and development expenses in future periods in support of ongoing or planned studies with respect to Auryxia and vadadustat and development of other potential product candidates.\\nSelling, General and Administrative Expenses. Selling, general and administrative expenses were $108.1 million for the nine months ended September 30, 2022, compared to $129.3 million for the nine months ended September 30, 2021. The decrease of $21.3 million was primarily due to decreased headcount related costs as a result of the reduction in force, decreased one-time legal costs, and lower marketing expense following receipt of the CRL for vadadustat. For the remainder of 2022, we expect our selling, general and administrative expenses to continue to decrease from 2021 as we significantly reduce our expense profile in line with being a single commercial product company.\\nLicense Expenses. License expense related to royalties due to Panion relating to sales of Riona in Japan was $2.3 million and $2.5 million for the nine months ended September 30, 2022 and 2021, respectively.\\nRestructuring. Restructuring expenses were $14.7 million for the nine months ended September 30, 2022 due to one-time termination benefits and contractual termination benefits for severance, healthcare, and non-cash stock-based compensation related to the reduction in force. There were no restructuring expenses for the nine months ended September 30, 2021.\\nOther Expense, Net. Other expense, net, was $11.3 million for the nine months ended September 30, 2022 compared to $13.0 million for the nine months ended September 30, 2021. The decrease in other expense compared to September 30, 2021 was primarily due to a decrease in interest expense as a result of principal prepayments totaling $25.0 million made on the Term Loans pursuant to the Second Amendment and Waiver in the nine months ended September 30, 2022, reducing our outstanding balance on the Term Loans. The decrease was also related to a decrease in the fair value of our derivative liability related to the Loan Agreement with Pharmakon during the nine months ended September 30, 2022.\\nLoss on Extinguishment of Debt. During the three months ended September 30, 2022, the Company recorded a debt extinguishment loss of $0.9 million related to the principal prepayments made on the Term Loans pursuant to the Second Amendment and Waiver.\\n45\\nLiquidity and Capital Resources\\nWe have funded our operations principally through sales of our common stock, payments received from our collaboration partners, product sales, debt, a royalty transaction, and a refund liability to a customer. As of September 30, 2022, we had cash and cash equivalents of approximately $144.8 million. Cash in excess of immediate requirements is invested in accordance with our investment policy, primarily with a view to liquidity and capital preservation. On April 7, 2022, we entered into an Open Market Sale AgreementSM, or the Sales Agreement, with Jefferies LLC, or Jefferies, as agent, for the offer and sale of common stock at current market prices in amounts to be determined from time to time. Also, on April 7, 2022, we filed a prospectus supplement relating to the Sales Agreement, pursuant to which we are able to offer and sell under the Sales Agreement up to $26.0 million of our common stock at current market prices from time to time. From the date of filing of the prospectus supplement through the date of the filing of this Quarterly Report on Form 10-Q, we have not sold any shares of our common stock under this program. As of September 30, 2022, through our collaboration agreements with Otsuka and MTPC we received approximately $837.1 million in cost-share funding, and are not entitled to receive any additional cost-share funding.\\nCash Flows\\nThe following table sets forth the primary sources and uses of cash for each of the periods set forth below:\\n| Nine Months Ended |\\n| September 30, 2022 | September 30, 2021 |\\n| (in thousands) |\\n| Net cash provided by (used in): |\\n| Operating activities | $ | (18,475) | $ | (190,157) |\\n| Investing activities | (114) | 39,941 |\\n| Financing activities | 14,599 | 128,328 |\\n| Net (decrease) in cash, cash equivalents, and restricted cash | $ | (3,990) | $ | (21,888) |\\n\\nOperating Activities. Net cash used in operating activities of $18.5 million for the nine months ended September 30, 2022 was driven by the net operating loss for the period and changes in working capital at period end.\\nNet cash used in operating activities of $190.2 million for the nine months ended September 30, 2021 was largely driven by the net operating loss for the period and changes in working capital at period end.\\nInvesting Activities. Net cash used in investing activities for the nine months ended September 30, 2022 was $0.1 million and was comprised of purchases of equipment.\\nNet cash provided by investing activities for the nine months ended September 30, 2021 was $39.9 million and was primarily comprised of proceeds from the sale of available for sale securities of $40.0 million.\\nFinancing Activities. Net cash provided by financing activities for the nine months ended September 30, 2022 was $14.6 million and consisted of net proceeds from refund liabilities to customers of $40.0 million, net proceeds from the issuance of common stock of $7.1 million, and proceeds from the sale of stock under our employee stock purchase plan, partially offset by principal payments of debt of $33.0 million.\\nNet cash provided by financing activities for the nine months ended September 30, 2021 was $128.3 million and consisted of net proceeds from the sale of future royalties of $44.8 million, net proceeds from the public issuance of common stock in connection with our prior at-the-market sales agreement with Cantor Fitzgerald & Co. of $82.8 million, and proceeds from the sale of stock under our employee stock purchase plan.\\nOperating Capital Requirements\\nWe have one product, Auryxia, approved for commercial sale in the United States, but have not generated, and may not generate, enough product revenue from the sale of Auryxia to realize net profits from product sales. We have incurred losses and cumulative negative cash flows from operations in each year since our inception in February 2007, and as of September 30, 2022, we had an accumulated deficit of $1.5 billion. We anticipate that we will continue to incur losses for the foreseeable future, and we expect to continue to incur additional research and development expenses related to vadadustat and our\\n46\\ndevelopment pipeline, and research and development and selling, general and administrative expenses for our ongoing development and commercialization of Auryxia.\\nWe expect our cash resources will be sufficient to fund our current operating plan through at least the next twelve months from the date of this filing. However, our operating plan includes assumptions pertaining to cost avoidance measures and the reduction of overhead costs that would result from the planned amendment of contractual arrangements with certain supply and collaboration partners and reduction of operating expenses. The outcome of certain of these cost avoidance measures are outside of our control, such as the planned amendment of contractual arrangements with certain supply partners. During 2022, we implemented some of the cost avoidance measures, and we have additional cost avoidance measures we plan to implement. For example, during the third quarter of 2022, we reduced future contractual commitments with certain supply partners, and we continue to work with our supply partners to further reduce costs. In addition, during the second quarter of 2022, we reduced our workforce by approximately 42% across all areas of our company following receipt of the CRL. These actions reflect our determination to refocus our strategic priorities around our commercial product, Auryxia® and our development portfolio, and is a step in a cost savings plan to significantly reduce our expense profile in line with being a single commercial product company (see Note 5 to our condensed consolidated financial statements). However, because certain of the other cost avoidance measures and certain other elements of our operating plan are outside of our control, there is uncertainty as to whether our cash resources will be adequate to support our operations for a period through at least the next twelve months from the date of issuance of these financial statements.\\nIn addition, pursuant to the Second Amendment and Waiver, on the Effective Date, we made prepayments totaling $25.0 million together with a prepayment premium of $0.5 million plus all accrued and unpaid interest on such prepayments of principal to the Effective Date, and Pharmakon agreed to waive or modify certain covenants in the Loan Agreement (see Note 11 to our condensed consolidated financial statements). If an event of default occurs and is continuing under the Loan Agreement, the Collateral Agent is entitled to take enforcement action, including acceleration of amounts due under the Loan Agreement, which we may not have the available cash resources to repay at such time. For example, pursuant to covenants in the Loan Agreement, our Annual Reports on Form 10-K must not be subject to any qualification as a going concern. If any of our future Annual Reports on Form 10-K is subject to any qualification related to going concern, it will result in an event of default under the Loan Agreement. Should we not be able to meet the annual covenants in the future, we would seek a waiver of this provision. However, there can be no assurances that we would be successful in obtaining such waiver.\\nWe believe that the execution of the cost avoidance measures detailed previously, future decisions by the FDA or foreign regulatory agencies related to the potential regulatory approval of vadadustat, and our ability to generate additional value from vadadustat, if approved through partnerships or other transactions could potentially further extend our cash runway for a period greater than twelve months. However, these future decisions or transactions are not contemplated in our operating plan. In addition, because the cost avoidance measures and certain other elements of our operating plan are outside of our control, they cannot be considered probable in the context of our going concern assessment. Therefore, there can be no assurance that our cash resources will fund our operating plan for the period anticipated by us.\\nWe expect to finance future cash needs through product revenue, strategic transactions, or a combination of these approaches. We plan to reduce our need for future financing through the planned amendment of contractual arrangements with certain supply and collaboration partners, expense management, and cost avoidance measures in line with being a single commercial product company. Assuming we are successful in those endeavors, we will require additional funding to fund our strategic growth beyond Auryxia or to pursue later stage development and commercial activities for any additional product or product candidates, including those that may be in-licensed or acquired. There can be no assurance that the current operating plan will be achieved in the time frame anticipated by us, or that our cash resources will fund our operating plan for the period anticipated by us or that additional funding will be available on terms acceptable to us, or at all.\\nGoing Concern\\nOur operating plan includes assumptions pertaining to cost avoidance measures and the reduction of overhead costs that would result from the planned amendment of contractual arrangements with certain supply and collaboration partners, and reduction of operating expenses. However, because these cost avoidance measures and certain other elements of our operating plan are outside of our control, including the planned amendment of certain contractual arrangements and the reduction of operating expenses, there is uncertainty as to whether our cash resources will be adequate to support our operations for a period through at least the next twelve months from the date of issuance of these financial statements. The conditions above and the annual going concern covenant in our Loan Agreement raise substantial doubt regarding our ability to continue as a going concern for a period of twelve months after the date the financial statements are issued.\\nManagement’s plans to alleviate the conditions that raise substantial doubt include cost avoidance measures, including amending contractual arrangements with certain supply and collaboration partners, and reducing operating expenses, for us to continue as a going concern for a period of twelve months from the date the financial statements are issued. However, we have concluded that the likelihood that our plan to extend our cash runway from one or more of these approaches will be successful, while reasonably possible, is less than probable. Accordingly, we have concluded that substantial doubt exists about our ability to continue as a going concern for a period of at least twelve months from the date of issuance of these financial statements.\\n47\\nOur forecast of the period of time through which our financial resources will be adequate to support our operations is a forward-looking statement and involves numerous risks and uncertainties, and actual results could vary as a result of a number of factors, many of which are outside our control. We have based this estimate on assumptions that may be substantially different than actual results, and we could utilize our available capital resources sooner than we currently expect. Our future funding requirements, both near- and long-term, will depend on many factors including, but not limited to, those described under Part I, Item 1A. Risk Factors under the heading \\\"Risks Related to our Financial Position, Need for Additional Capital and Growth Strategy.\\\"\\nContractual Obligations\\nAs of September 30, 2022, other than as disclosed in Note 13 to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q, there have been no material changes to our contractual obligations and commitments from those described under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our 2021 Annual Report on Form 10-K.\\nTerm Loans\\nOn November 11, 2019, Akebia, with Keryx as guarantor, entered into a loan agreement, or the Loan Agreement, with BioPharma Credit PLC as collateral agent and a lender, or the Collateral Agent, and BioPharma Credit Investments V (Master) LP as a lender, pursuant to which term loans in an aggregate principal amount of $100.0 million were made available to us in two tranches, subject to certain terms and conditions, or the Term Loans. BioPharma Credit PLC subsequently transferred its interest in the Term Loans, solely in its capacity as a lender, to its affiliate, BPCR Limited Partnership. The Collateral Agent and the lenders are collectively referred to as Pharmakon. The first tranche of $80.0 million, or Tranche A, was drawn on November 25, 2019, or the Tranche A Funding Date, and the second tranche of $20.0 million, or Tranche B, was drawn on December 10, 2020, or the Tranche B Funding Date. As of September 30, 2022, we made our first quarterly principal payment under the Term Loans of $8.0 million. In addition, on July 15, 2022, pursuant to the Loan Agreement, as amended, we made prepayments totaling $25.0 million together with a prepayment premium of $0.5 million plus all accrued and unpaid interest on such prepayments of principal to the Effective Date, and Pharmakon agreed to waive or modify certain covenants in the Loan Agreement. A more detailed description of the Term Loans can be found in Note 11 to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q.\\nLiability Related to Sale of Future Royalties\\nOn February 25, 2021, we entered into a royalty interest acquisition agreement, or the Royalty Agreement, with HCR, pursuant to which we sold to HCR our right to receive royalties and sales milestones for vadadustat in the MTPC Territory, such payments collectively the Royalty Interest Payments, in each case, payable to us under the MTPC Agreement, subject to an annual maximum “cap” of $13.0 million, or the Annual Cap, and an aggregate maximum “cap” of $150.0 million, or the Aggregate Cap. After HCR receives Royalty Interest Payments equal to the Annual Cap in a given calendar year, we will receive 85% of the Royalty Interest Payments for the remainder of that year. After HCR receives Royalty Interest Payments equal to the Aggregate Cap, or we pay the Aggregate Cap to HCR (net of the Royalty Interest Payments already received by HCR), the Royalty Interest Payments will revert back to us, and HCR would have no further right to any Royalty Interest Payments. We received $44.8 million from HCR (net of certain transaction expenses) under the Royalty Agreement, and we are eligible to receive an additional $5.0 million in each year from 2021 through 2023 under the Royalty Agreement if specified annual sales milestones are achieved for vadadustat in the MTPC Territory, subject to the satisfaction of certain customary conditions. We retain the right to receive all potential future regulatory milestones for vadadustat under the MTPC Agreement. A more detailed description of the liability related to the sale of future royalties can be found in Note 6 to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q.\\nRefund Liability to Customer\\nOn February 18, 2022, pursuant to the Vifor Second Amended Agreement, Vifor Pharma contributed $40.0 million to the Working Capital Fund, established to partially fund our costs of purchasing vadadustat from its contract manufacturers, which amount of funding will fluctuate, and which funding we will repay to Vifor over time. The $40.0 million initial contribution to the Working Capital Fund represents 50% of the amount of purchase orders that the Company has placed with its contract manufacturers for the supply of vadadustat for the United States, or the Territory, already delivered as of the effective date of the Vifor Second Amended Agreement, and to be delivered through the end of 2022.\\nWe have recorded the Working Capital Fund as a refund liability under ASC 606. We accounted for the refund liability as a debt arrangement with zero coupon interest. We imputed interest on the refund liability to the customer at a rate of 15.0% per annum and recorded an initial discount on the refund liability to the customer and a related deferred gain as of the date the funds were received from Vifor Pharma, which was March 18, 2022. The discount on the note payable is being amortized to interest expense using the effective interest method over the expected term of the refund liability. The deferred gain is being amortized to interest income on a straight-line basis over the expected term of the refund liability. A more detailed description of the refund liability can be found in Note 4 to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q.\\n48\\nCritical Accounting Estimates and Significant Judgments\\nOur management’s discussion and analysis of our financial condition and results of operations are based on our unaudited condensed consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these unaudited condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, and expenses and the disclosure of contingent assets and liabilities in our unaudited condensed consolidated financial statements. On an ongoing basis, we evaluate our estimates and judgments, including those related to revenue, inventory, our excess purchase commitment liability, liabilities related to sale of future royalties, refund liabilities to customers, impairment of intangible assets and income taxes. We base our estimates on historical experience, known trends and events, and various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. In making estimates and judgments, management employs critical accounting policies.\\nDuring the nine months ended September 30, 2022, we had the following material change to our critical accounting estimates as reported in our 2021 Annual Report on Form 10-K:\\nRefund Liability to Customer\\nWe treat the refund liability to customer as a zero-coupon debt financing, which is recorded at net present value. We recorded an initial discount on the refund liability to the customer and a corresponding deferred gain to the refund liability to customer on the condensed consolidated balance sheet as of the date the funds were received from Vifor Pharma, which was March 18, 2022. The discount on the note payable is being amortized to interest expense using the effective interest method over the expected term of the refund liability. The deferred gain is being amortized to interest income on a straight-line basis over the expected term of the refund liability.\\nRecent Accounting Pronouncements\\nFor additional discussion of recent accounting pronouncements, please refer to New Accounting Pronouncements – Not Yet Adopted included within Note 2 to our condensed consolidated financial statements in Part I, Item 1. Financial Statements (unaudited) included in this Quarterly Report on Form 10-Q.\\nItem 3. Quantitative and Qualitative Disclosures about Market Risk.\\nWe are exposed to market risk related to changes in interest rates. As of September 30, 2022 and December 31, 2021, we had cash and cash equivalents of $144.8 million and $149.8 million, respectively, consisting primarily of money market mutual funds consisting of certificates of deposit and corporate debt securities. Interest rate sensitivity is affected by changes in the general level of U.S. interest rates, particularly because our investments are in short-term securities. Our investments are subject to interest rate risk and will fall in value if market interest rates increase. Due to the short-term duration of our investment portfolio and the low risk profile of our investments, an immediate 100 basis point change in interest rates would not have a material effect on the fair market value of our portfolio.\\nIn addition, we are exposed to market risk related to exchange rates. A portion of our revenues for the nine months ended September 30, 2022 was received in royalty payments converted to U.S. dollars based on the net sales of Riona and VafseoTM in Japanese yen. Our exchange rate risk arises from such foreign currency net sales. As a result, we are exposed to movements in the exchange rates of the Japanese yen against the U.S. dollar.\\nFor the royalty payments we received based on net sales of Riona and Vafseo in Japan for the nine months ended September 30, 2022 a 5.0% appreciation or depreciation of the Japanese yen against the U.S. dollar would have increased or decreased, respectively, our revenues in the nine months ended September 30, 2022 by approximately $0.2 million.\\nWe have generally accepted the exposure to exchange rate movements without using derivative financial instruments to manage this foreign currency risk.\\nItem 4. Controls and Procedures.\\nManagement’s Evaluation of our Disclosure Controls and Procedures\\nWe maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports that we file or submit under the Securities Exchange Act of 1934, as amended, or the Exchange Act, is (1) recorded, processed, summarized, and reported within the time periods specified in the SEC's rules and forms and (2) accumulated and\\n49\\ncommunicated to our management, including our principal executive officer and principal financial officer, to allow timely decisions regarding required disclosure.\\nAs of September 30, 2022, our management, with the participation of our principal executive officer and principal financial officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives, and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on our evaluation, our management concluded that, as of September 30, 2022, our disclosure controls and procedures were not effective because our internal control over financial reporting was not adequate due to the material weakness described below.\\nAs reported in our 2021 Annual Report on Form 10-K, our internal control over financial reporting as of December 31, 2021 was not effective due to the following material weakness: the Company did not design and maintain effective controls over the completeness, accuracy, existence and presentation and disclosure of inventory. A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of a company’s annual or interim consolidated financial statements will not be prevented or detected on a timely basis. Specifically, we did not maintain effective controls related to (i) the review of inventory reconciliations, (ii) the validation of the inventory costing, (iii) the periodic assessment of excess and obsolete inventory related reserves and (iv) verification that the existence of all inventories subject to physical inventory counts were correctly counted as of December 31, 2021. Management has taken and will continue to take actions to remediate the deficiencies in its internal control over financial reporting and implemented additional processes and controls designed to address the underlying causes associated with the material weakness. Management is committed to finalizing the remediation of the material weakness during 2022.\\nAs management continues to evaluate and work to improve its internal control over financial reporting, management may determine it is necessary to take additional measures to address the material weakness. Until the controls have been operating for a sufficient period of time and management has concluded, through testing, that these controls are operating effectively, the material weakness described above will continue to exist. As such, management has concluded that the material weakness cannot be considered remediated as of September 30, 2022.\\nChanges in Internal Control over Financial Reporting\\nDuring the nine months ended September 30, 2022, we implemented certain internal controls in connection with our remediation efforts described above. There have been no other changes in our internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) promulgated under the Exchange Act, during our most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\n50\\nPART II—OTHER INFORMATION\\nItem 1. Legal Proceedings.\\nLegal Proceedings Relating to Vadadustat\\nOpposition Proceedings Against Akebia\\nIn September 2018, Dr. Reddy’s Laboratories Limited filed an opposition to our issued Indian Patent No. 287720 in the Indian Patent Office.\\nOn July 26, 2022, Sandoz AG filed an opposition against our issued European Patent No. 3277270 in the European Patent Office.\\nProceedings Filed by Akebia Against FibroGen, Inc.\\nEurope\\nWe filed an opposition in the European Patent Office, or the EPO, against FibroGen, Inc.’s, or FibroGen’s, European Patent No. 1463823, or the ’823 EP Patent on December 5, 2013, and an oral proceeding took place March 8 and 9, 2016. Following the oral proceeding, the Opposition Division of EPO ruled that the patent as granted did not meet the requirements for patentability under the European Patent Convention and, therefore, revoked the patent in its entirety. FibroGen has appealed that decision. Oral hearing for the appeal is scheduled for February 28 – March 1, 2023.\\nOn May 13, 2015, May 20, 2015 and July 6, 2015, we filed oppositions to FibroGen’s European Patent Nos. 2322155, or the ’155 EP Patent, 1633333, or the ’333 EP Patent, and 2322153, or the ’153 EP Patent in the EPO, respectively, requesting the patents be revoked in their entirety. These method of use patents do not prevent persons from using the compound for other uses, including any previously known use of the compound. In particular, these patents do not claim methods of using any of our product candidates for purposes of inhibiting HIF-PH for the treatment of anemia due to chronic kidney disease, or CKD. While we do not believe these patents will prevent us from commercializing vadadustat for the treatment of anemia due to CKD, we filed these oppositions to provide us with maximum flexibility for developing vadadustat and our pipeline of investigational oral hypoxia-inducible factor prolyl hydroxylase, or HIF-PH, inhibitor compounds.\\nWith regard to the opposition that we filed in Europe against the ’333 EP Patent, an oral proceeding took place on December 8 and 9, 2016. Following the oral proceeding, the Opposition Division of the EPO ruled that the patent as granted did not meet the requirements for patentability under the European Patent Convention and, therefore, revoked the patent in its entirety. On December 9, 2016, FibroGen filed a notice to appeal the decision to revoke the ’333 EP Patent. The Board of Appeal held an oral proceeding on this appeal on February 24 and 25, 2022, during which proceeding the '333 EP Patent was maintained in restricted form. The ‘333 EP patent was originally granted with four independent claims, one of which was found obvious on appeal. The remaining claims are directed to: treatment of anemia of chronic disease in subjects having a percent transferrin saturation of less than 20% (claim 1), treatment of anemia that is refractory to treatment with exogenously administered erythropoietin (claim 6), and treatment of iron deficiency (claim 15).\\nIn oral proceedings held on May 29, 2017, regarding the ’155 EP Patent, the European Opposition Division ruled that the ’155 EP Patent as granted did not meet the requirements for patentability under the European Patent Convention and, therefore, revoked the patent in its entirety. FibroGen filed a notice to appeal the decision to revoke the ’155 EP Patent on May 29, 2017. An oral proceeding for the appeal was held on February 22, 2022, during which proceeding the Board of Appeal maintained the revocation of the ‘155 EP Patent in its entirety.\\nIn related oral proceedings held on May 31, 2017 and June 1, 2017 for the ’153 EP Patent, the Opposition Division of the EPO maintained the patent after FibroGen significantly narrowed the claims to an indication for which vadadustat is not intended to be developed. We and Glaxo separately filed notices to appeal the decision to maintain the ’153 EP Patent on November 9, 2017. Bayer filed a notice to appeal the decision on November 14, 2017. Glaxo withdrew its appeal on March 2, 2020 and Bayer withdrew its appeal on June 30, 2021. An oral proceeding for the appeal was held on February 21, 2022, during which proceeding the Board of Appeal revoked the ‘153 patent in its entirety.\\nOn April 3, 2019, we filed oppositions to FibroGen’s European Patent Nos. 2289531, or the ’531 EP Patent, and 2298301, or the ’301 EP Patent in the EPO, respectively, requesting the patents be revoked in their entirety. Oral proceedings for oppositions to the two patents were held on September 7-8 and 10, 2021. Following oral proceedings, the Opposition Division of the EPO maintained certain claims in amended form in the two patents. On January 26, 2022, we filed notice to appeal the Opposition Division’s decision for ’531 EP Patent. On July 8, 2022, FibroGen filed notice to appeal the Opposition Division’s\\n51\\ndecision for the ’301 EP Patent. These two patents will expire in December 2022, and we do not expect the Opposition Division’s decision on the two patents to have any effect on our commercialization of vadadustat in Europe.\\nJapan\\nOn June 2, 2014, we filed an invalidity proceeding before the Japan Patent Office, or JPO, against certain claims of FibroGen’s Japanese Patent No. 4804131, or the ’131 JP Patent, which is the Japanese counterpart to the ’823 EP Patent, and the JPO issued a preliminary decision finding all of the challenged claims to be invalid. FibroGen subsequently amended the claims and the JPO accepted the amendments. The resulting ’131 JP Patent does not cover vadadustat or any pyridine carboxamide compounds.\\nIn 2018, we and our collaboration partner in Japan, Mitsubishi Tanabe Pharma Corporation, or MTPC, jointly filed a Request for Trial before the JPO to challenge the validity of certain of FibroGen’s HIF-related patents in Japan: JP4845728, JP5474872 and JP5474741. On September 26, 2019, the JPO conducted an invalidation trial for JP5474872 and JP4845728. On November 11, 2019, the JPO conducted an invalidation trial for JP5474741. On April 1, 2022, the JPO issued a final decision for JP4845728, which invalidated all claims except claims directed to the medical use to treat anemia that does not respond to erythropoiesis. On May 18, 2022, the JPO issued a final decision for JP5474741 and JP5474872, which maintained the claims in amended form. In May 2022, MTPC filed revocation lawsuits for the three patents in the Intellectual Property High Court requesting cancellation of the JPO’s decisions. In July 2022, we filed a revocation lawsuit for JP4845728 in the Intellectual Property High Court requesting cancellation of the JPO’s decision. In August 2022, we filed revocation lawsuits for JP5474741 and JP5474872 in the Intellectual Property High Court requesting cancellation of the JPO’s decisions. In September 2022, FibroGen filed a revocation lawsuit for JP4845728 in the Intellectual Property High Court requesting cancellation of the JPO’s decision on the claims that were invalidated. We do not believe the JPO’s decisions will prevent our collaboration partner MTPC from continuing to commercialize vadadustat for the treatment of anemia due to CKD in Japan.\\nUnited Kingdom\\nOn December 13, 2018, we filed Particulars of Claim in the Patents Court of the United Kingdom to challenge the validity of FibroGen’s six HIF-related patents in the UK: the ’823 EP Patent (UK), the ’333 EP Patent (UK), the ’153 EP Patent (UK), the ’155 EP Patent (UK), European Patent (UK) No. 2,289,531, or the ’531 EP Patent (UK), and European Patent (UK) No. 2,298,301, or the ’301 EP Patent (UK). In May 2019, Astellas Pharma Inc., or Astellas, the exclusive licensee of FibroGen’s HIF-related patents, sued Akebia for patent infringement in the Patents Court of the UK. In September 2019, we filed an Amended Particulars of Claim to include FibroGen’s European Patent No. 1487472, or the ’472 EP Patent (UK). On February 28, 2020, the parties agreed to dismiss the ’472 EP Patent (UK) from the trial.\\nA trial was conducted in March 2020. On April 20, 2020, the Patents Court of the UK issued a judgment in favor of Akebia, which invalidated all the claims at issue in each of the ’823 EP Patent (UK), the ’333 EP Patent (UK), the ’153 EP Patent (UK), the ’155 EP Patent (UK) and the ’301 EP Patent (UK). The ’531 EP Patent (UK) was amended to a single claim to recite one specific compound; this claim was held to be valid but not infringed by vadadustat. On June 11, 2020, FibroGen and Astellas appealed the Patents Court’s judgment on the invalidity of the ’823 EP Patent (UK), the ’301 EP Patent (UK), the ’333 EP Patent (UK), the ’153 EP Patent (UK), and the ’155 EP Patent (UK) in the Court of Appeal (Civil Division). On June 8, 2021 - June 10, 2021, the United Kingdom Court of Appeal held a three-day hearing for the appeal. On August 24, 2021, the Court of Appeal issued a judgment, which reversed the Patents Court’s judgment on the invalidity of the ’823 EP Patent (UK) and maintained certain claims of the ’823 EP Patent (UK) and the ’301 EP Patent (UK) in amended form, and which affirmed the Patents Court’s judgment on the invalidity of the ’333 EP Patent (UK), the ’155 EP Patent (UK), and the ’153 EP Patent (UK). Akebia sought permission to appeal to the UK Supreme Court, which was granted on October 3, 2022. We do not expect the UK Court of Appeal’s judgment to have any effect on our commercialization of vadadustat in the UK.\\nUnited States\\nOn March 29, 2021, we filed a lawsuit against FibroGen and AstraZeneca AB in the United States District Court for the District of Delaware to seek a declaratory judgment of non-infringement and invalidity of FibroGen’s twelve HIF-related patents in the United States: U.S. Patent Nos. 8,318,703, 8,466,172, 8,614,204, 9,920,011, 8,629,131, 8,604,012, 8,609,646, 8,604,013, 10,626,090, 10,894,774, 10,882,827, and 10,927,081. On April 5, 2022, we voluntarily dismissed, without prejudice, our declaratory judgment complaint against FibroGen and AstraZeneca under Rule 41(a)(1)(A)(i) of the Federal Rules of Civil Procedure.\\nLegal Proceedings Relating to Auryxia\\nANDA Litigation\\n52\\nIn 2018 and 2019, Keryx Biopharmaceuticals, Inc., or Keryx, received Paragraph IV certification notice letters regarding Abbreviated New Drug Applications, or ANDAs, submitted to the U.S. Food and Drug Administration, or FDA, by third parties requesting approval for generic versions of Auryxia tablets (210 mg ferric iron per tablet). In response to such ANDA filings, Keryx and its licensors, Panion & BF Biotech, Inc., or Panion, and, as applicable, Chen Hsing Hsu, M.D., filed complaints for patent infringement against such third parties. Keryx, Panion and, as applicable, Dr. Hsu have now entered into settlement and license agreements resolving all patent litigation proceedings brought by Keryx, Panion and, as applicable, Dr. Hsu, in response to ANDAs filed by third parties seeking approval to market generic versions of Auryxia® (ferric citrate) tablets prior to the expiration of the applicable patents. Each settlement agreement granted the defendants a license to market a generic version of Auryxia in the United States beginning on March 20, 2025 (subject to FDA approval), or earlier under certain circumstances customary for settlement agreements of this nature.\\nStockholder Litigation Relating to the Merger\\nOn June 28, 2018, we entered into an Agreement and Plan of Merger with Keryx and Alpha Therapeutics Merger Sub, Inc., or the Merger Sub, pursuant to which the Merger Sub would merge with and into Keryx, with Keryx becoming a wholly owned subsidiary of ours, or the Merger. On December 12, 2018, we completed the Merger. In October and November 2018, four purported shareholders of Keryx filed four separate putative class actions, or the Merger Securities Actions, against Keryx, a former officer and director of Keryx (Jodie P. Morrison), former directors of Keryx (Kevin J. Cameron, Mark J. Enyedy, Steven C. Gilman, Michael T. Heffernan, Daniel P. Regan and Michael Rogers, some of whom are current members of our Board of Directors), and, with respect to the Rosenblatt action discussed below, the Merger Sub and Akebia, challenging the disclosures made in connection with the Merger.\\nThree of the Merger Securities Actions were filed in the Delaware District Court: Corwin v. Keryx Biopharmaceuticals, Inc., et al. (filed October 16, 2018); Van Hulst v. Keryx Biopharmaceuticals, Inc., et al. (filed October 24, 2018); and Andreula v. Keryx Biopharmaceuticals, Inc., et al. (filed November 1, 2018). The fourth Merger Securities Action was filed in the Massachusetts District Court: Rosenblatt v. Keryx Biopharmaceuticals, Inc., et al. (filed October 23, 2018). On February 19, 2019, the plaintiff in the Rosenblatt action filed a notice of voluntary dismissal of the action without prejudice. On March 27, 2019, the plaintiff in the Van Hulst action filed a notice of voluntary dismissal of the action without prejudice.\\nOn April 2, 2019, the Delaware District Court granted Abraham Kiswani, a member of the putative class in both the Andreula and Corwin actions, and plaintiff John Andreula’s motion to consolidate the remaining two Merger Securities Actions pending in the Delaware District Court and consolidated the Corwin and Andreula cases under the caption In re Keryx Biopharmaceuticals, Inc., or the Consolidated Federal Action. The Delaware District Court also appointed Kiswani and plaintiff Andreula as lead plaintiffs for the Consolidated Federal Action. On June 3, 2019, the lead plaintiffs filed a consolidated amended complaint in the Consolidated Federal Action, or the Consolidated Complaint. The Consolidated Complaint generally alleged that the registration statement filed in connection with the Merger contained allegedly false and misleading statements or failed to disclose certain allegedly material information in violation of Section 14(a) and 20(a) of the Exchange Act and Rule 14a-9 promulgated thereunder. The alleged misstatements or omissions related to (i) certain financial projections for Keryx and Akebia and certain financial analyses performed by our advisors and (ii) any alleged negotiations that may have taken place regarding the conversion of certain convertible notes of Keryx in connection with the Merger. The Consolidated Complaint sought compensatory and/or rescissory damages, a declaration that the defendants violated Sections 14(a) and 20(a) of the Exchange Act and Rule 14a-9 thereunder, and an award of lead plaintiffs’ costs, including reasonable allowance for attorneys’ fees and experts’ fees. The defendants in the Consolidated Federal Action moved to dismiss the Consolidated Complaint in its entirety and with prejudice on August 2, 2019. On April 15, 2020, the Delaware District Court granted the defendants’ motion and dismissed the Consolidated Complaint in its entirety. On July 2, 2020, lead plaintiffs filed a second consolidated amended complaint, or the Second Consolidated Complaint. The Second Consolidated Complaint (i) asserted the same claims under the Exchange Act as the Consolidated Complaint, (ii) named the same defendants as the Consolidated Complaint, (iii) sought the same relief as the Consolidated Complaint and (iv) as with the Consolidated Complaint, challenged as false or misleading alleged misstatements or omissions related to certain financial projections for Keryx and Akebia and certain financial analyses performed by our advisors. The defendants in the Consolidated Federal Action moved to dismiss the Second Consolidated Complaint in its entirety with prejudice on August 10, 2020. Briefing on defendants’ motion to dismiss was completed on September 28, 2020, and on April 1, 2021, the District Court granted Defendants’ motion in its entirety and dismissed the Second Consolidated Complaint with prejudice. The lead plaintiffs appealed, and briefing on the appeal was completed on October 7, 2021. The Third Circuit submitted the case on the briefs without oral argument on February 10, 2022. On July 21, 2022, the Third Circuit affirmed the District Court’s order of dismissal.\\nOn July 15, 2021, a purported former Keryx stockholder filed a putative class action in the Supreme Court of the State of New York against Akebia, a current officer of Akebia (John P. Butler), a former officer of Akebia (Jason A. Amello), former directors of Akebia (Muneer A. Satter, Scott A. Canute, Michael D. Clayman, Maxine Gowen, Duane Nash, Ronald C. Renaud, Jr., and Michael S. Wyzga), a current director of Akebia (Cynthia Smith), a former director and officer of Keryx (Jodie P.\\n53\\nMorrison), a former officer of Keryx (Scott A. Holmes) and former directors of Keryx (Michael Rogers, Kevin J. Cameron, Steven C. Gilman, Daniel P. Regan, Mark J. Enyedy, and Michael T. Heffernan, some of whom are current members of our Board of Directors). The action is captioned Loper v. Akebia Therapeutics, Inc., et al., or the Loper Action. The complaint in the Loper Action alleges that the registration statement filed in connection with the Merger contained allegedly false and misleading statements or failed to disclose certain allegedly material information in violation of Section 11, 12(a)(2), and 15 of the Securities Act of 1933, as amended. It alleges, among other things, that Akebia failed to disclose heightened safety risks that allegedly threatened the prospects of the Phase 3 PRO2TECT clinical trial and the commercial viability of vadadustat. The complaint in the Loper Action seeks damages including interest thereon, an award of plaintiffs’ and the class’s costs and expenses, including counsel fees and expert fees, and rescission, disgorgement, or such other equitable or injunctive relief that the Court deems appropriate.\\nOn August 16, 2021, another purported former Keryx stockholder filed a putative class action making substantially similar allegations and asserting the same claims as the Loper Action, also in the Supreme Court of the State of New York against Akebia and many of the same individual defendants named in the Loper Action. The action is captioned Panicho v. Akebia Therapeutics, Inc., et al., or the Panicho Action.\\nOn September 13, 2021, the parties in the Loper Action and Panicho Action entered into a joint stipulation and proposed order, which provided for the consolidation of the two actions under the caption In re Akebia Therapeutics, Inc. Securities Litigation, or the Consolidated State Action. On October 27, 2021, plaintiffs filed a consolidated complaint in the Consolidated State Action. On January 10, 2022, defendants moved to dismiss the consolidated complaint in its entirety. Briefing on defendants’ motion to dismiss was completed on April 22, 2022. Oral argument was held on October 7, 2022, and the Court dismissed the complaint without prejudice on October 17, 2022, giving plaintiffs thirty days to amend their complaint. The Court further ordered that, in the event plaintiffs do not file an amended complaint within thirty days of the dismissal, the dismissal shall be deemed to be with prejudice.\\nOn March 14, 2022, a purported stockholder of Akebia filed a putative federal securities class action against Akebia as well as three present and former officers of Akebia in the U.S. District Court for the Eastern District of New York. The action was captioned Deputy v. Akebia Therapeutics, Inc., et al., No. 1:22-cv-01411, or the EDNY Action. The complaint in the EDNY Action alleged that defendants made materially false and misleading statements in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. The alleged misstatements or omissions related to heightened safety risks that allegedly threatened the prospects of the Phase 3 PRO2TECT clinical trial and the commercial viability of vadadustat. The complaint in the EDNY Action sought damages including interest thereon, an award of plaintiffs’ and the class’s costs and expenses, including counsel fees and expert fees, or such other and further relief that the Court deems appropriate. Plaintiffs Abraham Kiswani and Joseph Gorski were appointed co-lead plaintiffs on June 28, 2022, and on July 22, 2022, a stipulated scheduling order was entered allowing co-lead plaintiffs to file an amended complaint on or before August 29, 2022. On August 29, 2022, co-lead plaintiffs filed a stipulation of voluntary dismissal, and the Court entered an order dismissing the co-lead plaintiffs from the action on August 30, 2022. The original named plaintiff filed a stipulation of voluntary dismissal on September 7, 2022, and the court formally terminated the case on September 8, 2022.\\nWe deny any allegations of wrongdoing and intend to continue vigorously defending against the one active stockholder lawsuit described in this Legal Proceedings section, the Consolidated State Action. There is no assurance, however, that we will be successful in the defense of this action, or any associated appeals, or that insurance will be available or adequate to fund any settlement or judgment or the litigation costs of this action. Moreover, we are unable to predict the outcome or reasonably estimate a range of possible losses at this time. A resolution of the Consolidated State Action in a manner adverse to us, however, could have a material effect on our financial position and results of operations in the period in which the action is resolved.\\nItem 1A. Risk Factors.\\nWe face a variety of risks and uncertainties in our business. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may also become important factors that affect our business. If any of the following risks occurs, our business, financial condition, financial statements, results of operations and future growth prospects could be materially and adversely affected.\\nRisks Related to our Financial Position, Need for Additional Capital and Growth Strategy\\nWe have incurred significant losses since our inception, and anticipate that we will continue to incur significant losses and cannot guarantee when, if ever, we will become profitable or attain positive cash flows.\\nInvestment in pharmaceutical product development and commercialization is highly speculative because it requires upfront capital expenditures and there is significant risk that a product candidate will fail to gain marketing approval or that an\\n54\\napproved product will not be commercially viable. Since our inception, we have devoted most of our resources to research and development, including our preclinical and clinical development activities and, following the merger, or the Merger, whereby Keryx Biopharmaceuticals, Inc., or Keryx, became a wholly owned subsidiary of ours, commercialization. We have financed our operations primarily through sales of equity securities, our strategic collaborations and, following the Merger, product revenues, a royalty monetization transaction and debt. Prior to the Merger, we had no products approved for commercial sale and had not generated any revenue from the sale of products. We are not currently profitable, and we have incurred net losses each year since our inception, including a net loss of $51.9 million for the three months ended September 30, 2022, and a net loss of $85.0 million for the nine months ended September 30, 2022. As of September 30, 2022, we had an accumulated deficit of $1.5 billion. We cannot guarantee when, if ever, we will become profitable.\\nIn March 2022, we received a complete response letter, or CRL, from the FDA regarding our NDA for vadadustat, our lead investigational product candidate, for the treatment of anemia associated with CKD. The FDA concluded that the data in the NDA do not support a favorable benefit-risk assessment of vadadustat for dialysis and non-dialysis patients. In July 2022, we held an end of review meeting with the FDA to inform the Company's next steps with respect to the potential U.S. approval of vadadustat, if any, and in October 2022, we submitted a Formal Dispute Resolution Request, or FDRR, to the FDA. The FDRR focuses on the favorable balance between the benefits and risks of vadadustat for the treatment of anemia due to CKD in adult patients on dialysis in light of safety concerns expressed by the FDA in the CRL related to the rate of adjudicated thromboembolic events driven by vascular access thrombosis for vadadustat compared to the active comparator and the risk of drug-induced liver injury. There can be no assurances that our FDRR will be accepted by the FDA, or that, if accepted, we will be successful in our appeal and obtain approval for vadadustat in a timely manner, on favorable terms, or at all. As a result, the regulatory approval process for vadadustat in the U.S. is highly uncertain. We may not obtain approval at all, and if we are able to obtain approval, the expense and time to do so could adversely impact our ability to successfully commercialize vadadustat or conduct our other business operations, and our financial condition could be materially harmed.\\nOur ability to generate product revenue and achieve profitability depends on the overall success of Auryxia(R), vadadustat, if approved, and any current or future product candidates, including those that may be in-licensed or acquired, which depends on several factors, including:\\n•obtaining adequate or favorable pricing and reimbursement from private and governmental payors for Auryxia, vadadustat, if approved, and any other product or product candidate, including those that may be in-licensed or acquired;\\n•obtaining and maintaining market acceptance of Auryxia, vadadustat, if approved, and any other product candidate, including those that may be in-licensed or acquired;\\n•the size of any market in which Auryxia, vadadustat and any other product or product candidate, including those that may be in-licensed or acquired, receives approval and obtaining adequate market share in those markets;\\n•addressing the issues identified in the CRL for vadadustat that we received from the FDA, including the results of the end of review meeting and, in the event our FDRR is accepted by the FDA, the outcome of our appeal;\\n•the timing and scope of marketing approvals for vadadustat, if approved, and any other product candidate, if approved, including those that may be in-licensed or acquired; maintaining marketing approvals for Auryxia, vadadustat, if approved, and any other product, including those that may be in-licensed or acquired;\\n•actual or perceived advantages or disadvantages of our products or product candidates as compared to alternative treatments, including their respective safety, tolerability and efficacy profiles, the potential convenience and ease of administration and cost;\\n•maintaining an acceptable safety and tolerability profile of our approved products, including the frequency and severity of any side effects;\\n•the willingness of the target patient population to try new therapies and of physicians to prescribe these therapies, based, in part, on their perception of our clinical trial data and/or the actual or perceived safety, tolerability and efficacy profile;\\n•establishing and maintaining supply and manufacturing relationships with third parties that can provide adequate supplies of products that are compliant with good manufacturing practices, or GMPs, to support the clinical development and the market demand for Auryxia, vadadustat, if approved, and any other product and product candidate, including those that may be in-licensed or acquired;\\n•current and future restrictions or limitations on our approved or future indications and patient populations or other adverse regulatory actions or in the event that the FDA requires Risk Evaluation and Mitigation Strategies, or REMS, or risk management plans that use restrictive risk minimization strategies;\\n•the effectiveness of our sales, marketing, manufacturing and distribution strategies and operations;\\n•competing effectively with any products for the same or similar indications as our products;\\n•maintaining, protecting and expanding our portfolio of intellectual property rights, including patents and trade secrets; and\\n55\\n•the impact of the COVID-19 pandemic on the above factors, including the disproportionate impact of the COVID-19 pandemic on CKD patients, the adverse impact on the phosphate binder market in which we compete, and the limitation of our sales professionals to meet in person with healthcare professionals as the result of travel restrictions or limitations on access for non-patients.\\nOur ability to achieve profitability also depends on our ability to manage our expenses. Following receipt of the CRL, in April and May 2022, we implemented a reduction of our workforce, by approximately 42% across all areas of the Company (47% inclusive of the closing of the majority of open positions), including several members of management. We recorded a restructuring charge of $14.7 million in the aggregate primarily related to contractual termination benefits including severance, non-cash stock-based compensation expense, healthcare and related benefits in the nine months ended September 30, 2022. However, we may incur additional costs not currently contemplated due to events associated with or resulting from the workforce reduction. Additionally, the reduction in workforce could impact our operations, including our commercialization of Auryxia, which could affect our ability to generate revenue.\\nEven in light of the reduction in workforce, we expect to continue to incur significant expenses and operating losses for the foreseeable future. In addition to any additional costs not currently contemplated due to events associated with or resulting from the workforce reduction noted above, our ability to achieve profitability and our financial position will depend, in part, on the rate of our future expenditures, on product revenue, collaboration revenue, and our ability to obtain additional funding. On June 30, 2022, we entered into a Termination and Settlement Agreement, or the Termination Agreement, with Otsuka Pharmaceutical Co. Ltd., or Otsuka, pursuant to which we agreed to the immediate termination of the December 18, 2016 collaboration and license agreement with Otsuka, or the Otsuka U.S. Agreement, and the April 25, 2017 collaboration and license agreement with Otsuka, or the Otsuka International Agreement, in exchange for the payment of $55.0 million to us and the agreement between the parties with respect to the conduct of certain activities. Unless and until we are able to find a new partner for vadadustat in Europe and other countries previously licensed to Otsuka, we will incur additional expenses in connection with the development of vadadustat and will receive less collaboration revenue and, if approved, product revenue than originally anticipated. In addition, we expect to continue to incur significant expenses if and as we:\\n•continue our commercialization activities for Auryxia and vadadustat, if we are able to obtain marketing approval for vadadustat following receipt of the CRL from the FDA in March 2022, and any other product or product candidate, including those that may be in-licensed or acquired;\\n•address the issues identified in the CRL for vadadustat that we received from the FDA and pursue our appeal of the CRL for vadadustat with the FDA, in the event our FDRR is accepted;\\n•conduct and enroll patients in any clinical trials, including post-marketing studies or any other clinical trials for Auryxia, vadadustat or any other product or product candidate, including those that may be in-licensed or acquired;\\n•seek marketing approvals for vadadustat and any other product candidate, including those that may be in-licensed or acquired;\\n•maintain marketing approvals for Auryxia and vadadustat, if we are able to obtain marketing approval for vadadustat following receipt of the CRL from the FDA in March 2022, and any other product, including those that may be in-licensed or acquired;\\n•manufacture Auryxia, vadadustat and any other product or product candidate, including those that may be in-licensed or acquired, for commercial sale and clinical trials;\\n•conduct discovery and development activities for additional product candidates or platforms that may lead to the discovery of additional product candidates;\\n•engage in transactions, including strategic, merger, collaboration, acquisition and licensing transactions, pursuant to which we would market and develop commercial products, or develop and commercialize other product candidates and technologies;\\n•continue to repay, and pay any associated pre-payment penalties, if applicable, the senior secured term loans in an aggregate principal amount of $67.0 million, or the Term Loans, that were made available to us pursuant to the Loan Agreement;\\n•make royalty, milestone or other payments under our license agreements and any future license agreements;\\n•maintain, protect and expand our intellectual property portfolio;\\n•make decisions with respect to our personnel, including the retention of key employees;\\n•make decisions with respect to our infrastructure, including to support our operations as a fully integrated, publicly traded biopharmaceutical company; and\\n•experience any additional delays or encounter issues with any of the above.\\nWe have and will continue to expend significant resources in our legal proceedings, as described above under Part II, Item I. Legal Proceedings, or any other legal proceedings brought by or against us in the future.\\n56\\nBecause of the numerous risks and uncertainties associated with pharmaceutical product development and commercialization, we are unable to accurately predict the timing or amount of increased expenses. The net losses we incur may fluctuate significantly from quarter to quarter and year to year, such that a period-to-period comparison of our results of operations may not be a good indication of our future performance. In any particular quarter, the progress of our clinical development and our operating results could be below the expectations of securities analysts or investors, which could cause our stock price to decline.\\nWe will continue to incur substantial expenditures relating to continued commercialization and post-marketing requirements for Auryxia and vadadustat, if we are able to obtain marketing approval for vadadustat following receipt of the CRL from the FDA in March 2022, and any other products, including those that may be in-licensed or acquired, as well as costs relating to the research and development of any other product candidate, including those that may be in-licensed or acquired. Our prior losses and expected future losses have had and will continue to have an adverse effect on our stockholders’ equity and working capital.\\nOur expenses could increase beyond expectations if we are required by the FDA, the European Medicines Agency, or the EMA, or other regulatory authorities, or if we otherwise believe it is necessary, to change our manufacturing processes or assays, to amend or replace our study protocols, to conduct any additional clinical trials, whether in order to obtain approval or as a post-approval study, including any additional clinical trial that we decide to conduct for vadadustat, to perform studies in addition to, different from or larger than those currently planned, if there are any delays in completing our clinical trials or if there are further delays in or issues with obtaining marketing approval for vadadustat in the United States, the European Union, or EU, or other jurisdictions. In addition, our ability to generate revenue would be negatively affected if the size of our addressable patient population is not as significant as we estimate, the indication approved by regulatory authorities is narrower than we sought or the patient population for treatment is narrowed by competition, physician choice, coverage or reimbursement, or payor or treatment guidelines. Even though we generate product revenue from Auryxia and royalties from RionaTM and VafseoTM in Japan and may generate revenue and royalties from the sale of any products that may be approved in the future, including those that may be in-licensed or acquired, we may never generate revenue and royalties that are significant enough for us to become and remain profitable, and we will need to obtain additional funding to continue to fund our operating plan and achieve strategic growth.\\nWe will require substantial additional financing to achieve our goals. A failure to obtain this necessary capital when needed, or on acceptable terms, could force us to delay, limit, reduce or terminate our product development or commercialization efforts.\\nAs of September 30, 2022, our cash and cash equivalents were $144.8 million. We expect to continue to expend substantial amounts of cash for the foreseeable future as we continue to commercialize Auryxia; in the event our FDRR is accepted by the FDA, pursue our appeal for vadadustat in the U.S. with the FDA; support the regulatory process with respect to vadadustat with the EMA and ACCESS Consortium; and develop and commercialize any other product or product candidate, including those that may be in-licensed or acquired. These expenditures will include costs associated with research and development, manufacturing, potentially obtaining marketing approvals and marketing products approved for sale. In addition, other unanticipated costs may arise. Because the outcomes of our current and anticipated clinical trials are highly uncertain, we cannot reasonably estimate the actual amount of funding necessary to successfully complete clinical development for any current or future product candidates, including vadadustat depending on what is required to address the issues identified in the CRL for vadadustat, including the outcome of our appeal and if additional clinical trials are required in order to obtain marketing approval, or to complete post-marketing studies for Auryxia and vadadustat, if approved. Our future capital requirements depend on many factors, including:\\n•the scope, progress, results and costs of conducting clinical trials or any post-marketing requirements or any other clinical trials for Auryxia, vadadustat and any other product or product candidate, including those that may be in-licensed or acquired;\\n•the cost and timing of commercialization activities, including product manufacturing, marketing, sales and distribution costs, for Auryxia, vadadustat, if approved, and any other product or product candidate, including those that may be in-licensed or acquired;\\n•the results of our meetings with the FDA, the EMA and other regulatory authorities and any consequential effects, including on timing of and ability to obtain and maintain marketing approval, study design, study size and resulting operating costs;\\n•any difficulties or delays in conducting our clinical trials, or enrolling patients in our clinical trials, for Auryxia, vadadustat or any other product candidates;\\n•the outcome of our efforts to obtain marketing approval for vadadustat in the United States, Europe and in other jurisdictions and any other product candidates, including those that may be in-licensed or acquired, including any additional clinical trials or post-approval commitments imposed by regulatory authorities;\\n57\\n•the timing of, and the costs involved in obtaining, marketing approvals for vadadustat, including in the United States, Europe, China and certain other markets, and any other product candidate, including those that may be in-licensed or acquired, including to fund the preparation, filing and prosecution of regulatory submissions;\\n•the costs of maintaining marketing approvals for Auryxia or any other product, including those that may be in-licensed or acquired;\\n•the cost of securing and validating commercial manufacturing for any of our product candidates, including those that may be in-licensed or acquired, and maintaining our manufacturing arrangements for Auryxia and vadadustat or any other product, including those that may be in-licensed or acquired, or securing and validating additional arrangements;\\n•the costs involved in preparing, filing and prosecuting patent applications and maintaining, defending and enforcing our intellectual property rights, including litigation costs, and the outcome of such litigation;\\n•the costs involved in any legal proceedings to which we are a party;\\n•our status as a publicly traded company on the Nasdaq Global Market;\\n•our decisions with respect to personnel;\\n•our decisions with respect to infrastructure; and\\n•the extent to which we engage in transactions, including strategic, merger, collaboration, acquisition and licensing transactions, pursuant to which we could develop and market commercial products, or develop other product candidates and technologies.\\nFurthermore, we expect to continue to incur costs associated with operating as a fully integrated, publicly traded biopharmaceutical company. Accordingly, we will need to obtain substantial additional funding to fund our operating plan beyond Auryxia and achieve strategic growth. If we are unable to raise capital when needed or on attractive terms, we could be forced to delay, reduce or eliminate our research and development programs or any future commercialization efforts.\\nWe expect our cash resources to fund our current operating plan through at least the next twelve months from the filing of this Quarterly Report on Form 10-Q. However, our operating plan includes assumptions pertaining to cost avoidance measures and the reduction of overhead costs that would result from the planned amendment of contractual arrangements with certain supply and collaboration partners, and the reduction of operating expenses. If we are not able to execute any of the planned amendments of contractual arrangements with certain supply and collaboration partners, or to reduce our operating expenses, our cash resources may be inadequate to support our operations for a period through at least the next twelve months from the date of issuance of these financial statements. In addition, if we fail to satisfy any of the covenants under our Loan Agreement with Pharmakon, including the covenant that our Annual Report on Form 10-K for the fiscal year ending December 31, 2022 not be qualified as to going concern, and the loan is accelerated, we may not have sufficient resources to fund our operating plan through the next twelve months. There can be no assurance that the current operating plan will be achieved in the time frame anticipated by us, or that our cash resources will fund our operating plan for the period anticipated by us or that additional funding will be available on terms acceptable to us, or at all.\\nAny additional fundraising efforts may divert our management’s attention away from their day-to-day activities, which may adversely affect our ability to develop and commercialize Auryxia and any other products or product candidates, including those that may be in-licensed or acquired, or to continue to seek regulatory approval for vadadustat. Also, additional funds may not be available to us in sufficient amounts or on acceptable terms or at all. If we are unable to raise additional capital in sufficient amounts when needed or on terms acceptable to us, we may have to significantly delay, scale back or discontinue the development and/or commercialization of Auryxia and any other products or product candidates, including those that may be in-licensed or acquired, or to take any actions with respect to vadadustat depending on future decisions with respect to vadadustat in the U.S. Any of these events could significantly harm our business, financial condition and prospects.\\nOur independent registered public accounting firm included an explanatory paragraph relating to our ability to continue as a going concern in its report on our audited financial statements included in our Annual Report on Form 10-K and any future concerns relating to our ability to continue as a going concern would materially adversely affect us.\\nWe believe that our cash resources will be sufficient to fund our current operating plan through at least the next twelve months from the filing of this Quarterly Report on Form 10-Q. However, there were conditions or events, considered in the aggregate, that raised substantial doubt about our ability to continue as a going concern within twelve months after the date the financial statements for December 31, 2021 were issued and certain elements of our operating plan were outside of our control at that time and continue to be outside of our control. In addition, as of the date of the financial statements included in this Quarterly Report on Form 10-Q, our operating plan includes assumptions pertaining to cost avoidance measures and the reduction of overhead costs that would result from the planned amendment of contractual arrangements with certain supply and collaboration partners, and the reduction of operating expenses. Because these cost avoidance measures and certain other elements of our operating plan are outside of our control, there is uncertainty as to whether our cash resources will be adequate to support our operations for a period through at least the next twelve months from the date of issuance of the financial statements included in this Quarterly Report on Form 10-Q. These conditions raise substantial doubt regarding our ability to continue as a going concern for a period of one year after the date these financial statements are issued. In the event we are not able to continue as a going concern, our business would be materially impacted. See Note 1 to our consolidated financial statements appearing elsewhere in our 2021 Annual Report on Form 10-K and Note 1 to this Quarterly Report on Form 10-Q,\\n58\\nas applicable, for additional information on our assessments. Future concerns relating to our ability to continue as a going concern, could have a material adverse affect on us.\\nIf we are unable to manage our spending, generate sufficient product revenue from sales of Auryxia, or otherwise obtain sufficient funding, our business, prospects, financial condition and results of operations will be materially and adversely affected and we may be unable to continue as a going concern. If we are unable to continue as a going concern, we may have to liquidate our assets and may receive less than the value at which those assets are carried on our audited financial statements, and it is likely that investors will lose all or a part of their investment. If we seek additional financing to fund our business activities in the future and there remains substantial doubt about our ability to continue as a going concern, investors or other financing sources may be unwilling to provide additional funding to us on commercially reasonable terms or at all. There can be no assurance that the current operating plan will be achieved in the time frame anticipated by us, or that our cash resources will fund our operating plan for the period we anticipate or that additional funding will be available on terms acceptable to us, or at all.\\nPursuant to covenants in the Loan Agreement, as amended by the First Amendment and Waiver and the Second Amendment and Waiver, our Annual Reports on Form 10-K, must not be subject to any qualification as to going concern. If we do not satisfy the covenant as to going concern in any of the required filings, we will be in default under the Loan Agreement. If an event of default occurs and is continuing under the Loan Agreement, the Collateral Agent is entitled to take enforcement action, including acceleration of amounts due under the Loan Agreement, and we may not have the available cash resources to repay at such time. If we are required to repay additional amounts due under the Loan Agreement earlier than anticipated, it would have a material adverse effect on our business, results of operations and financial condition.\\nRaising additional capital may cause dilution to our existing stockholders, restrict our operations or require us to relinquish rights to our product and product candidates on unfavorable terms to us.\\nWe expect to finance future cash needs through product revenue, royalty transactions, strategic transactions, public or private equity or debt transactions, or a combination of these approaches. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the ownership interests of our common stockholders will be diluted, our fixed payment obligations may increase, any such securities may have rights senior to those of our common stock, and the terms may include liquidation or other preferences and anti-dilution protections that adversely affect the rights of our common stockholders. Additional debt financing, if available, may involve agreements that would restrict our operations and potentially impair our competitiveness, such as limitations on our ability to incur additional debt, make capital expenditures, declare dividends, acquire, sell or license intellectual property rights, and other operating restrictions that could adversely impact our ability to conduct our business. If we raise additional funds through royalty transactions, we may have to relinquish valuable rights to our portfolio and future revenue streams, and enter into agreements that would restrict our operations and strategic flexibility. If we raise additional funds through strategic transactions with third parties, we may have to do so at an earlier stage than otherwise would be desirable. In connection with any such strategic transactions, we may be required to relinquish valuable rights to our product and product candidates, future revenue streams or research programs or grant licenses on terms that are not favorable to us. If we are unable to raise additional funds when needed, we may not be able to pursue planned development and commercialization activities and we may need to grant rights to develop and market product candidates that we would otherwise prefer to develop and market ourselves.\\nIf we fail to regain compliance with the continued listing requirements of Nasdaq, our common stock may be delisted and the price of our common stock and our ability to access the capital markets could be negatively impacted.\\nOn May 12, 2022, we received a deficiency letter from the Listing Qualifications Department of the Nasdaq Stock Market, or Nasdaq, notifying us that, for the last 30 consecutive business days, the bid price for our common stock had closed below the minimum $1.00 per share requirement for continued inclusion on the Nasdaq Global Market, referred to as the minimum bid price rule. In accordance with Nasdaq Listing Rules, we have an initial period of 180 calendar days, or until November 8, 2022, to regain compliance with the minimum bid price rule.\\nTo date, we have not regained compliance with the minimum bid price rule. However, we have applied to transfer the listing of our common stock to the Nasdaq Capital Market. If the application is approved, then we may be eligible for an additional 180 day compliance period. However, there can be no assurance that we will satisfy the continued listing requirement for the market value of publicly held shares and all other initial listing standards for the Nasdaq Capital Market, with the exception of the minimum bid price requirement, and as such, we may not be eligible for the additional 180 day compliance period. If we are successful in transferring the listing of our common stock to the Nasdaq Capital Market and at any time during any additional compliance period the bid price for our common stock closes at $1.00 or more per share for a minimum of 10 consecutive business days, the Nasdaq Listing Qualifications Department staff will provide written notification to us that we are in compliance with the minimum bid price rule, unless the staff exercises its discretion to extend this 10-day period pursuant to the Nasdaq Listing Rules.\\n59\\nIf we do not regain compliance with the minimum bid price rule by the required date and we are not eligible for any additional compliance period at that time, the Nasdaq Listing Qualifications Department staff will provide us written notification that our common stock may be delisted. At that time, we may appeal the staff’s delisting determination to a Nasdaq Listing Qualifications Panel. We expect that our common stock would remain listed pending the panel’s decision. However, there can be no assurance that, even if we appeal the staff’s delisting determination to the Nasdaq Listing Qualifications Panel, such appeal would be successful.\\nWe intend to monitor the closing bid price of our common stock and may, if appropriate, consider available options to regain compliance with the minimum bid price rule, which could include seeking to effect a reverse stock split. However, there can be no assurance that we will be able to regain compliance with the minimum bid price rule.\\nThere are many factors that may adversely affect our minimum bid price, including those described throughout this section titled “Risk Factors.” Many of these factors are outside of our control. As a result, we may not be able to sustain compliance with the minimum bid price rule in the long term. Any potential delisting of our common stock from the Nasdaq Global Market would likely result in decreased liquidity and increased volatility for our common stock and would adversely affect our ability to raise additional capital or to enter into strategic transactions. Any potential delisting of our common stock from the Nasdaq Global Market would also make it more difficult for our stockholders to sell our common stock in the public market.\\nWe may not be successful in our efforts to identify, acquire, in-license, discover, develop and commercialize additional products or product candidates or our decisions to prioritize the development of certain product candidates over others may not be successful, which could impair our ability to grow.\\nAlthough we continue to focus a substantial amount of our efforts on the commercialization of Auryxia and in the event our FDRR is accepted by the FDA, to pursue our appeal for vadadustat in the U.S. with the FDA, including through the appeal process, a key element of our long-term growth strategy is to develop additional product candidates and acquire, in-license, develop and/or market additional products and product candidates.\\nResearch programs to identify product candidates require substantial technical, financial and human resources, regardless of whether product candidates are ultimately identified. Our research and development programs may initially show promise, yet fail to yield product candidates for clinical development or commercialization for many reasons, including the following:\\n•the research methodology used may not be successful in identifying potential indications and/or product candidates;\\n•we may not be able or willing to assemble sufficient resources to acquire or discover additional product candidates;\\n•a product candidate may be shown to have harmful side effects, a lack of efficacy or other characteristics that indicate that they are unlikely to be drugs that will receive marketing approval and/or achieve market acceptance;\\n•a product candidate we develop and seek regulatory approval for, including vadadustat, may not be approved by the FDA on a timely basis, or at all;\\n•product candidates we develop may nevertheless be covered by third party patents or other exclusive rights;\\n•the market for a product candidate may change during our program so that the continued development of that product candidate is no longer commercially reasonable;\\n•a product candidate may not be capable of being produced in commercial quantities at an acceptable cost, or at all; or\\n•a product candidate may not be accepted as safe and effective by patients, the medical community, or third party payors, if applicable.\\nIf any of these events occur, we may be forced to abandon our research and development efforts for one or more of our programs, or we may not be able to identify, discover, develop or commercialize additional product candidates, which may have a material adverse effect on our business.\\nBecause we have limited financial and managerial resources, especially as a result of the CRL for vadadustat that we received in March 2022 and the reduction in workforce that we implemented in April and May 2022, we focus on products, research programs and product candidates for specific indications. As a result, we may forgo or delay pursuit of opportunities with other product candidates or for other indications, or out license rights to product candidates, that later prove to have greater commercial potential. For example, as a result of receipt of the CRL and implementation of the reduction in workforce, we delayed certain research activities. Our resource allocation decisions may cause us to fail to capitalize on viable commercial products or profitable market opportunities. Our spending on current and future research and development programs and product candidates for specific indications may not yield any commercially viable products.\\nBecause our internal research capabilities are limited, we may be dependent upon other pharmaceutical and biotechnology companies, academic scientists, and other researchers to sell or license product candidates, products or technology to us. The success of this strategy depends partly upon our ability to identify, select, and acquire promising product candidates and products. The process of identifying, selecting, negotiating and implementing a license or acquisition of a product candidate or an approved product is lengthy and complex. Other companies, including some with substantially greater financial, marketing\\n60\\nand sales resources, may compete with us for the license or acquisition of a product candidate or an approved product. We have limited resources to identify and execute the acquisition or in-licensing of third party products, businesses, and technologies and integrate them into our current infrastructure.\\nMoreover, we may devote resources to potential acquisitions or in-licensing opportunities that are never completed, or we may fail to realize the anticipated benefits of such efforts. Any product candidate that we acquire may require additional development efforts prior to commercial sale, including extensive clinical testing and approval by the FDA, the EMA, the Japanese Pharmaceuticals and Medical Devices Agency, or PMDA, or other regulatory authorities, or post-approval testing or other requirements if approved. All product candidates are prone to risks of failure typical of pharmaceutical product development, including the possibility that a product candidate will not be shown to be sufficiently safe and effective for approval by regulatory authorities. In addition, we cannot provide assurance that any of our products will be manufactured profitably, achieve market acceptance or not require substantial post-marketing clinical trials.\\nAccordingly, there can be no assurance that we will ever be able to identify, acquire, in-license or develop suitable additional products or product candidates, which could materially adversely affect our future growth and prospects. We may focus our efforts and resources on potential products, product candidates or other programs that ultimately prove to be unsuccessful.\\nWe may engage in strategic transactions to acquire assets, businesses, or rights to products, product candidates or technologies or form collaborations or make investments in other companies or technologies that could harm our operating results, dilute our stockholders’ ownership, increase our debt, or cause us to incur significant expense.\\nAs part of our business strategy, we may engage in additional strategic transactions to expand and diversify our portfolio, including through the merger, acquisition or in-license of assets, businesses, or rights to products, product candidates or technologies or through strategic alliances or collaborations, similar to the Merger and our existing and prior collaboration and license arrangements. We may not identify suitable strategic transactions, or complete such transactions in a timely manner, on favorable terms, on a cost-effective basis, or at all. Moreover, we may devote resources to potential opportunities that are never completed or we may incorrectly judge the value or worth of such opportunities. Even if we successfully execute a strategic transaction, we may not be able to realize the anticipated benefits of such transaction and may experience losses related to our investments in such transactions. Integration of an acquired company or assets into our existing business may not be successful and may disrupt ongoing operations, require the hiring of additional personnel and the implementation and integration of additional internal systems and infrastructure, and require management resources that would otherwise focus on developing our existing business. Even if we are able to achieve the long-term benefits of a strategic transaction, our expenses and short-term costs may increase materially and adversely affect our liquidity. Any of the foregoing could have a detrimental effect on our business, results of operations and financial condition. For example, on June 4, 2021, we entered into a license agreement, the Cyclerion Agreement, with Cyclerion Therapeutics Inc., or Cyclerion, pursuant to which Cyclerion granted us an exclusive global license under certain intellectual property rights to research, develop and commercialize praliciguat, an investigational oral soluble guanylate cyclase, or sGC, stimulator. Although we have progressed pre-clinical studies for praliciguat, we may be unsuccessful in developing praliciguat. If any of the assumptions that we made in valuing the transaction, including the costs or timing of development of, or the potential benefits of, praliciguat, were incorrect, we may not recognize the anticipated benefits of the transaction and our business could be harmed.\\nIn addition, future transactions may entail numerous operational, financial and legal risks, including:\\n•incurring substantial debt, dilutive issuances of securities or depletion of cash to pay for acquisitions;\\n•exposure to known and unknown liabilities, including contingent liabilities, possible intellectual property infringement claims, violations of laws, tax liabilities and commercial disputes;\\n•higher than expected acquisition and integration costs;\\n•difficulty in integrating operations, processes, systems and personnel of any acquired business;\\n•increased amortization expenses or, in the case of a write-down of the value of acquired assets, impairment losses, such as the Auryxia intangible asset impairment in the second quarter of 2020 and corresponding adjustments to the estimated useful life of the developed product rights for Auryxia;\\n•impairment of relationships with key suppliers or customers of any acquired business due to changes in management and ownership;\\n•inability to retain personnel, customers, distributors, vendors and other business partners integral to an in-licensed or acquired product, product candidate or technology;\\n•potential failure of the due diligence processes to identify significant problems, liabilities or other shortcomings or challenges;\\n•entry into indications or markets in which we have no or limited development or commercial experience and where competitors in such markets have stronger market positions; and\\n61\\n•other challenges associated with managing an increasingly diversified business.\\nIf we are unable to successfully manage any transaction in which we may engage, our ability to develop new products and continue to expand and diversify our portfolio may be limited.\\nOur business has been and may continue to be, directly or indirectly, adversely affected by the COVID-19 pandemic.\\nThe COVID-19 pandemic has presented a substantial public health and economic challenge around the world and continues to affect our employees, patients, healthcare providers with whom we interact, customers, collaboration partners, contract research organizations, or CROs, our contract manufacturing organizations, or CMOs, vendors, communities and business operations. The full extent to which the COVID-19 pandemic will directly or indirectly impact our business, results of operations and financial condition continues to depend on future developments that are highly uncertain and cannot be accurately predicted, including new information that may emerge concerning the COVID-19 pandemic, any resurgences or variants of COVID-19, the actions taken to contain it or treat its impact and the economic and other impacts on local, regional, national and international markets where the healthcare providers with whom we interact, our partners, our CROs, our CMOs, and our other vendors operate.\\nWe believe our revenue growth was negatively impacted by the COVID-19 pandemic in 2021 and the first three quarters of 2022 primarily as the CKD patient populations that we serve experienced both high hospitalization and mortality rates due to COVID-19, and the pandemic had an adverse impact on the phosphate binder market in which Auryxia competes. Labor shortages and costs have adversely impacted dialysis providers. These impacts have refocused clinical efforts in addressing bone and mineral disorders like hyperphosphatemia to more acute operational issues to ensure patients receive dialysis treatments and still some patients have been rescheduled or missed treatments due to labor shortages. We believe, this and potentially other factors, has led to the reduction in the phosphate binder market, which has not experienced growth since early 2020. While we are unable to quantify the impact of the COVID-19 pandemic on future revenues and revenue growth, the COVID-19 pandemic and the ongoing impacts from the COVID-19 pandemic continue to adversely and disproportionately impact CKD patients and the phosphate binder market; therefore, we expect the COVID-19 pandemic and the ongoing impacts from the pandemic to continue to have a negative impact on our revenue growth for the foreseeable future.\\nAs a result of the COVID-19 pandemic, we adopted a flexible workplace policy allowing employees to work from home on a full or part-time basis, which may make it difficult for us to maintain our corporate culture or retain employees. Moreover, our future success substantially depends on the management skills of our executives and certain other key employees. The unanticipated loss or unavailability of key employees due to the pandemic could harm our ability to operate our business or execute our business strategy, and we may not be successful in finding and integrating suitable successors in the event any of our key employees leave or are unavailable. This could have an adverse effect on our business, results of operations and cash flows.\\nIn addition, several healthcare facilities have previously restricted access for non-patients, including the members of our sales force. For example, DaVita, Inc., or DaVita, and Fresenius Medical Care, or Fresenius, which account for a vast majority of the dialysis population in the United States, have previously restricted access to their clinics. As a result, we continue to engage with some healthcare providers and other customers virtually, where possible. The restrictions on our customer-facing employees’ in-person interactions with healthcare providers have, and could continue to, negatively impact our access to healthcare providers and, ultimately, our sales, including with respect to vadadustat, if approved. Recently, such precautionary measures have been relaxed at certain healthcare facilities and, as a result, members of our sales force have resumed in person interactions with certain customers. Nevertheless, some restrictions remain, and more restrictions may be put in place again due to a resurgence in COVID-19 cases, including those involving new variants of COVID-19, which may be more contagious and more severe than prior strains of the virus. Given this uncertain environment and the disproportionate impact of the COVID-19 pandemic on CKD patients, we are actively monitoring the demand in the United States for Auryxia and will be for vadadustat, if approved, including the potential for further declines or changes in prescription trends and customer orders, which could have a material adverse effect on our business, results of operations, and financial condition.\\nIn addition, the direct and indirect impacts of the pandemic or the response efforts to the pandemic, including, among others, competition for labor and resources and increases in labor, sourcing, manufacturing and shipping costs, may cause disruptions to, closures of or other impacts on our CMOs and other vendors in our supply chain on which we rely for the supply of our products and product candidates. For example, areas of China have recently continued to implement lockdowns for COVID-19, which could impact the global supply chain. At this time, our CMOs continue to operate at or near normal levels. However, it is possible that the COVID-19 pandemic and response efforts may have an impact in the future on our contract manufacturers’ ability to manufacture and deliver Auryxia and vadadustat (if approved in the United States or EMA and which is currently marketed under the trade name VafseoTM by MTPC in Japan), which may result in increased costs and delays, or disruptions to the manufacturing and supply of our products. These impacts could have a negative effect on our inventory reserves, which could result in an increase in inventory write-offs due to expiry.\\n62\\nOutside of the impacts to our clinical trials as a result of the CRL, the pandemic has resulted in closures of and may continue to impact clinical trial sites on which we rely and will rely on in the future for the completion of certain clinical trials. COVID-19 pandemic precautions have caused moderate delays in enrolling new clinical trials and may cause delays in enrolling future clinical trials. Further, the pandemic has impacted and is likely to continue to impact the business of the FDA, the EMA and other government authorities, which potentially could result in delays in meetings, reviews, inspections and approvals relating to our product and product candidates. Any decision by the FDA, EMA or other governmental authorities to delay meeting with us or our collaboration partners or delay scheduling inspections in light of the COVID-19 pandemic could have a material adverse effect on clinical trials of our product candidates or on our efforts to obtain marketing approvals for vadadustat, which could increase our operating expenses and have a material adverse effect on our financial results, including the timing and amount of future regulatory milestones we could receive from our collaboration partners.\\nIf we or any of the third parties with whom we engage, including our collaboration partners, or any of our customers were to experience further shutdowns, delays or other business disruptions, our ability to conduct our business in the manner and on the timelines presently planned, and our revenue expectations, could be materially and negatively impacted, which could have a material adverse effect on our business and our financial results.\\nThe COVID-19 pandemic may continue to significantly impact economies and financial markets worldwide, which could result in adverse effects on our business and operations, impact our ability to raise additional funds and impact the volatility of our stock price and trading in our stock. Even after the COVID-19 pandemic has been contained or mitigated, we may continue to experience adverse impacts to our business as a result of any economic recession or depression that has occurred or may occur in the future.\\nThe global impact of the COVID-19 pandemic continues to rapidly evolve, and we will continue to monitor the situation closely. In particular, areas we are monitoring include possible COVID-related changes in our commercial revenue payor mix, overall product sales, and reserves and allowances, as well as negative trends that could potentially have a further significant impact on product demand and, ultimately, product revenue, or could cause goodwill, intangible assets, and other assets to be impaired. This uncertain pandemic environment has presented new risks to our business. While we are working to mitigate the impacts on our business, we are mindful that many of these risks and the impact to the larger healthcare market are outside of our control. The extent to which the COVID-19 pandemic impacts our business will depend on future developments, which are highly uncertain and the magnitude of which cannot be predicted, including new information that may emerge concerning the severity of COVID-19 and the actions to contain COVID-19, and the effectiveness of vaccines against virus variants.\\nRisks Related to our Financial Arrangements\\nOur obligations in connection with the loan agreement with Pharmakon and requirements and restrictions in the loan agreement could adversely affect our financial condition and restrict our operations.\\nWe entered into the Loan Agreement with Pharmakon, pursuant to which the Term Loans were made available to us in two tranches. The first tranche of $80.0 million closed on November 25, 2019, and the second tranche of $20.0 million closed on December 10, 2020. See Note 11 to our condensed consolidated financial statements in Part I, Item 1. Financial Statements of this Quarterly Report on Form 10-Q for additional information regarding our obligations under the Loan Agreement.\\nThe Loan Agreement contains affirmative and negative covenants applicable to us and our subsidiaries, including maintaining, on an annual basis, a minimum liquidity threshold, which started in 2021, and on a quarterly basis, a minimum net sales threshold for Auryxia, which started in the fourth quarter of 2020. In addition, the Loan Agreement contains covenants that our Annual Reports on Form 10-K, must not be subject to any qualification as to going concern. Failure to maintain compliance with these or other covenants would result in an event of default under the Loan Agreement, which could result in enforcement action, including acceleration of amounts due under the Loan Agreement. Additionally, the liabilities under the Loan Agreement will be accelerated, subject to certain exceptions, if we are required to repay to Vifor Pharma all or a part of the working capital facility established in connection with the Second Amended and Restated License Agreement that we entered into with Vifor Pharma, in February 2022, or the Vifor Second Amended Agreement, as a result of certain terminations of the Vifor Second Amended Agreement or due to a reduction in the balance of the working capital facility by more than a prespecified amount.\\nIn the event there is an acceleration of our and certain of our subsidiaries’ liabilities under the Loan Agreement as a result of an event of default or otherwise, we may not have sufficient funds or may be unable to arrange for additional financing to repay the liabilities or to make any accelerated payments, and Pharmakon could seek to enforce security interests in the collateral securing the Loan Agreement and our guarantee of the Term Loans, which would have a material adverse effect on our business, financial condition and results of operations.\\n63\\nThe Loan Agreement permits voluntary prepayment at any time in whole or in part, subject to prepayment premiums and make-whole premiums prior to certain dates. We made a voluntary prepayment of $25.0 million, including $0.5 million of prepayment penalties on July 15, 2022, pursuant to the Second Amendment and Waiver. This represented the repayment of $5.0 million of the first tranche and the full $20.0 million of the second tranche. Upon a change of control, mandatory prepayment provisions require us to prepay the principal amount outstanding, the applicable prepayment premium and make-whole premium and accrued and unpaid interest. In addition, our obligations in connection with the Loan Agreement could have additional significant adverse consequences, including, among other things:\\n•restricting our activities, including limitations on transferring certain of our assets, engaging in certain transactions, terminating certain agreements, including the Vifor Second Amended Agreement, incurring certain additional indebtedness, creating certain liens, paying dividends or making certain other distributions and investments;\\n•limiting our flexibility in planning for, or reacting to, changes in our business and our industry;\\n•placing us at a possible competitive disadvantage compared to our competitors who have a smaller amount of debt or competitors with comparable debt at more favorable interest rates; and\\n•limiting our ability to borrow additional amounts for working capital, capital expenditures, research and development efforts, acquisitions, debt service requirements, execution of our business strategy and other purposes.\\nAny of these factors could materially and adversely affect our business, financial condition and results of operations.\\nOur Royalty Interest Acquisition Agreement with HealthCare Royalty Partners IV, L.P. contains various covenants and other provisions, which, if violated, could materially adversely affect our financial condition.\\nOn February 25, 2021, we entered into a royalty interest acquisition agreement, or the Royalty Agreement, with HealthCare Royalty Partners IV, L.P., or HCR, pursuant to which we sold to HCR our right to the to receive royalties and sales milestones for vadadustat, collectively the Royalty Interest Payments, in each case, payable to us under our Collaboration Agreement dated December 11, 2015, or the MTPC Agreement, with Mitsubishi Tanabe Pharma Corporation, or MTPC, subject to an annual maximum “cap” of $13.0 million, or the Annual Cap, and an aggregate maximum “cap” of $150.0 million, or the Aggregate Cap. Under the Royalty Agreement, we are required to comply with various covenants, including obligations to take certain actions, such as actions with respect to the Royalty Interest Payments, the MTPC Agreement, our agreement with MTPC for the commercial supply of vadadustat drug product, and our intellectual property. In addition, the Royalty Agreement includes customary events of default upon the occurrence of enumerated events, including failure to perform certain covenants and the occurrence of insolvency events. In the event we violate certain covenants and other provisions, we may not receive sales milestones from HCR even if the applicable sales thresholds are met. Upon the occurrence of an event of default, HCR would have the ability to exercise all available remedies in law and equity, which could have a material adverse effect on our financial condition.\\nRisks Related to Commercialization\\nOur business is substantially dependent on the commercial success of Auryxia. If we are unable to continue to successfully commercialize Auryxia, our results or operations and financial condition will be materially harmed.\\nOur business and our ability to generate product revenue largely depend on our, and our collaborators’, ability to successfully commercialize Auryxia. Our ability to generate revenue depends on our ability to execute on our commercialization plans, and the size of the market for, and the level of market acceptance of, Auryxia and any other product or product candidate, including those that may be in-licensed or acquired. If the size of any market for which a product or product candidate is approved decreases or is smaller than we anticipate, our revenue and results of operations could be materially adversely affected. For example, the phosphate binder market declined since 2020, which we believe was partially a result of the COVID-19 pandemic. If the phosphate market does not recover or continues to decline, our revenue from Auyxia could be materially adversely affected.\\nMarket acceptance is critical to our ability to generate significant product revenue. Any product may achieve only limited market acceptance or none at all. If Auryxia, or any of our product candidates that is approved, is not accepted by the market to the extent that we expect or market acceptance decreases, we may not be able to generate significant product revenue and our business would be materially harmed. Market acceptance of Auryxia or any other approved product depends on a number of factors, including:\\n•the availability of adequate coverage and reimbursement by and the availability of discounts, rebates and price concessions from third party payors, pharmacy benefit managers, or PBMs, and governmental authorities;\\n•the safety and efficacy of the product, as demonstrated in clinical trials and in the post-marketing setting;\\n64\\n•the prevalence and complications of the disease treated by the product;\\n•the clinical indications for which the product is approved and the product label approved by regulatory authorities, including any warnings or limitations that may be required on the label as a consequence of potential safety risks associated with the product;\\n•the countries in which marketing approvals are obtained;\\n•the claims we and our collaborators are able to make regarding the safety and efficacy of the product;\\n•the success of our physician and patient communications and education programs;\\n•acceptance by physicians and patients of the product as a safe and effective treatment and the willingness of the target patient population to try new therapies and of physicians to prescribe new therapies;\\n•the cost, safety and efficacy of the product in relation to alternative treatments;\\n•the timing of receipt of marketing approvals and product launch relative to competing products and potential generic entrants;\\n•relative convenience and ease of administration;\\n•the frequency and severity of adverse side effects;\\n•favorable or adverse publicity about our products or favorable or adverse publicity about competing products;\\n•the effectiveness of our and our collaborators’ sales, marketing and distribution efforts; and\\n•the restrictions on the use of the product together with other medications, if any.\\nIf we are unable to maintain or expand, or, if vadadustat is approved, initiate, sales and marketing capabilities or enter into additional agreements with third parties, we may not be successful in commercializing Auryxia, vadadustat, if approved, or any other product candidates that may be approved.\\nIn order to market Auryxia and any other approved product, we intend to continue to invest in sales and marketing, which will require substantial effort and significant management and financial resources. We have built a commercial infrastructure and sales force in the United States for Auryxia, our first commercial product. However, following receipt of the CRL, in April and May 2022, we implemented a reduction of our workforce by approximately 42% across all areas of the Company (47% inclusive of the closing of the majority of open positions), including several members of management. If the remaining sales and marketing team cannot successfully commercialize Auryxia, or if additional sales and marketing employees decide to leave as a result of the reduction in workforce or otherwise, it could have a material adverse effect on Auryxia revenue and our financial condition.\\nIf we obtain regulatory approval to market vadadustat in the U.S., we believe that we can leverage the current commercial foundation for vadadustat in the U.S., but if we are unable to do so successfully this would materially harm our business. Additionally, training a sales force to successfully sell and market a new commercial product is expensive and time-consuming and could delay any commercial launch of such product candidate. We may underestimate the size of the sales force required for a successful product launch and we may need to expand our sales force earlier and at a higher cost than we anticipated. In 2021 and early 2022, we incurred commercialization expenses for vadadustat that were premature or unnecessary as a result of the receipt of the CRL for vadadustat, and may in the future incur additional commercialization expenses prematurely or unnecessarily if we do not receive marketing approval in the timeframe we expect, or at all, we may have prematurely or unnecessarily incurred commercialization expenses.\\nWe devote significant effort, in particular, to recruiting individuals with experience in the sales and marketing of pharmaceutical products. Competition for personnel with these skills is significant and retaining qualified personnel with experience in our industry is difficult. Further, the continuing or recurring restrictions placed on recruiting, training and retention as a result of the COVID-19 pandemic and our recent reduction in workforce may further exacerbate these conditions and interfere with our ability to find and retain qualified personnel. As a result, we may not be able to retain our existing employees or hire new employees quickly enough to meet our needs. At the same time, we may face high turnover, requiring us to expend time and resources to source, train and integrate new employees.\\nThere are risks involved with maintaining our own sales and marketing capabilities, including the following:\\n•potential inability to recruit, train and retain adequate numbers of effective sales and marketing personnel;\\n•potential inability of sales personnel to obtain access to physicians, including because of restrictions due to the COVID-19 pandemic;\\n•potential lack of complementary products to be offered by sales personnel, which may put us at a competitive disadvantage relative to companies with more extensive product lines, especially as a result of the receipt of the CRL for vadadustat; and\\n•costs and expenses associated with maintaining our own sales and marketing organization.\\n65\\nIf we are unable to maintain our own sales and marketing capabilities, we will not be successful in commercializing Auryxia, vadadustat, if approved, and any other product candidate that may be approved.\\nFurthermore, if we are unable to maintain our arrangements with third parties with respect to sales and marketing, if we are unsuccessful in entering into additional arrangements with third parties to sell and market our products or we are unable to do so on terms that are favorable to us, or if such third parties are unable to carry out their obligations under such arrangements, it will be difficult to successfully commercialize our product and product candidates, including vadadustat, if approved. For example, if in connection with the Vifor Second Amended Agreement, we experience difficulties with Vifor Pharma, or if Vifor Pharma experiences difficulties with other parties to whom it expects to sell vadadustat, if approved, our ability to commercialize vadadustat, if approved, will be severely hindered and our business operations will be materially harmed.\\nOur, or our partners', failure to obtain or maintain adequate coverage, pricing and reimbursement for Auryxia, vadadustat, if approved, or any other future approved products, could have a material adverse effect on our or our collaboration partners’ ability to sell such approved products profitably and otherwise have a material adverse impact on our business.\\nMarket acceptance and sales of any approved products, including Auryxia and, if approved, vadadustat, depends significantly on the availability of adequate coverage and reimbursement from third party payors and may be affected by existing and future healthcare reform measures. Governmental authorities, third party payors, and PBMs decide which drugs they will cover, as well as establish formularies or implement other mechanisms to manage utilization of products and determine reimbursement levels. We cannot be sure that coverage or adequate reimbursement will be available for Auryxia, vadadustat, if approved, or any of our potential future products. Even if we obtain coverage for an approved product, third party payors may not establish adequate reimbursement amounts, which may reduce the demand for our product and prompt us to have to reduce pricing for the product. If reimbursement is not available or is limited, we may not be able to commercialize certain of our products. Coverage and reimbursement by a governmental authority, third-party payor or PBM may depend upon a number of factors, including the determination that use of a product is:\\n•a covered benefit under the health plan;\\n•safe, effective and medically necessary;\\n•appropriate for the specific patient; and\\n•cost effective.\\nObtaining coverage and reimbursement approval for a product from a governmental authority, PBM or a third-party payor is a time consuming and costly process that could require us to provide supporting scientific, clinical and cost-effectiveness data for the use of our products to the payor. In the United States, there are multiple governmental authorities, PBMs and third-party payors with varying coverage and reimbursement levels for pharmaceutical products, and the timing of commencement of reimbursement by a governmental payor can be dependent on the assignment of codes via the Healthcare Common Procedural Coding System, which codes are assigned on a quarterly basis. Within Medicare, for oral drugs dispensed by pharmacies and also administered in facilities, coverage and reimbursement may vary depending on the setting. CMS, local Medicare administrative contractors, Medicare Part D plans and/or PBMs operating on behalf of Medicare Part D plans, may have some responsibility for determining the medical necessity of such drugs, and therefore coverage, for different patients. Different reimbursement methodologies may apply, and CMS may have some discretion in interpreting their application in certain settings.\\nAs an oral drug, Auryxia is covered by Medicare under Part D. However, in September 2018, CMS decided that Auryxia would no longer be covered by Medicare for the treatment of iron deficiency anemia, or IDA, in adult patients with NDD-CKD, or the CMS Decision. While this decision does not impact CMS coverage for the control of serum phosphorus levels in adult patients with DD-CKD, or the Hyperphosphatemia Indication, it requires Part D plan sponsors to impose prior authorization or other steps to ensure that Auryxia is reimbursed only for the Hyperphosphatemia Indication. While we believe that the vast majority of the Medicare prescriptions written for Auryxia today are for the Hyperphosphatemia Indication and therefore will continue to be covered by Medicare with prior authorization, the CMS Decision has had and will continue to have an adverse impact on the sales and future growth of Auryxia for the Hyperphosphatemia Indication and the IDA Indication. For example, in the second quarter of 2020, we reduced our short-term and long-term Auryxia revenue forecast, primarily driven by the compounding impact of the CMS Decision. As a result, we recorded an impairment charge of $115.5 million to the Auryxia intangible asset associated with the developed product rights for Auryxia during the three months ended June 30, 2020.\\nMedicaid reimbursement of drugs varies by state. Private third-party payor reimbursement policies also vary and may or may not be consistent with Medicare reimbursement methodologies. Manufacturers of outpatient prescription drugs may be required to provide discounts or rebates under government healthcare programs or to certain third-party payors in order to obtain coverage of such products.\\n66\\nAdditionally, we may be required to enter into contracts with third party payors and/or PBMs offering rebates or discounts on our products in order to obtain favorable formulary status and we may not be able to agree upon commercially reasonable terms with such third party payors or PBMs, or provide data sufficient to obtain favorable coverage and reimbursement for many reasons, including that we may be at a competitive disadvantage relative to companies with more extensive product lines. In addition, third party payors, PBMs and other entities that purchase our products may impose restrictions on our ability to raise prices for our products over time without incurring additional costs. Four distributors, Fresenius Medical Care Rx, McKesson Corporation, Cardinal Health, Inc. and Amerisource Bergen Drug Corporation, in the aggregate, accounted for a significant percentage of our gross accounts receivable as of September 30, 2022. If we are not able to maintain our arrangements with these key distributors on favorable terms, on a timely basis or at all, or if there is any adverse change in one or more of these distributors’ business practices or financial condition, it would adversely impact the market opportunity for Auryxia, our product revenues and operating results.\\nFurthermore, vadadustat was approved in Japan for the treatment of adult patients with anemia due to CKD and is being marketed by MTPC in Japan under the trade name VafseoTM. Pricing and reimbursement strategy is a key component of MTPC’s commercialization plans for Vafseo in Japan. If coverage and reimbursement terms change, MTPC may not be able to, or may decide not to, continue commercialization of Vafseo in Japan.\\nAlthough we currently believe it is likely that vadadustat, if approved, will be reimbursed using the Transitional Drug Add-on Payment Adjustment, or TDAPA, followed by reimbursement via the bundled reimbursement model, if vadadustat is neither reimbursed under the TDAPA nor the bundled reimbursement model, then patients would access vadadustat through contracts we negotiate with third party payors for reimbursement of vadadustat, which would be subject to the risks and uncertainties described above. Additionally, applying for and obtaining reimbursement under the TDAPA is expected to take several months following approval, which will affect adoption, uptake and product revenue for vadadustat during that time, and if there are updates to the TDAPA rule that decrease the basis for reimbursement or eligibility criteria during the transition period or if the TDAPA is eliminated, then our profitability may be adversely affected. For example, the Medicare Payment Advisory Commission, or MedPAC, an independent legislative branch advisory body to Congress on issues related to the Medicare program, has recommended that TDAPA not be provided to newly approved drug products considered to fall within “functional categories” for which costs are already accounted for in the bundled reimbursement model, such as for anemia management drugs.\\nFurther, if vadadustat is approved in the United States and included in the fixed reimbursement model for a bundle of dialysis services, or the bundle, we would be required to enter into contracts to supply vadadustat to specific dialysis providers, instead of through distributors, which we believe could be challenging. The dialysis market is unique and is dominated by two providers: DaVita and Fresenius, which account for a vast majority of the dialysis population in the United States. Under the Vifor Second Amended Agreement, we granted Vifor Pharma an exclusive license to sell vadadustat to Fresenius Medical Care North America and its affiliates, including Fresenius Kidney Care Group LLC, to certain third-party dialysis organizations approved by us, to independent dialysis organizations that are members of group purchase organizations, and to certain non-retail specialty pharmacies in the United States. We refer to Fresenius Medical Care North America and its affiliates, these organizations and specialty pharmacies collectively as the “Supply Group\\\". See Note 4 to our consolidated financial statements in Part I, Item 1. Financial Statements of this Quarterly Report on Form 10-Q for additional information regarding the Vifor Second Amended Agreement. If vadadustat is approved and we are not able to maintain the Vifor Second Amended Agreement or enter into a supply agreement with DaVita or other dialysis clinics, our business may be materially harmed.\\nSimilar to how payor coverage may affect the sales of a product, formulary status within dialysis organizations may affect what products are prescribed within that specific organization. Therefore, if a product is not on a formulary, the prescribers within that organization may be less likely to prescribe that product or may have a difficult time prescribing that product, resulting in less sales. Further, one dialysis organization’s determination to add a product to their formulary does not assure that other dialysis organizations will also add the product to theirs. There is always a risk a dialysis organization will not contract with a drug manufacturer for a specific product, resulting in that product not being on that organization’s formulary. If any dialysis organization does not add vadadustat, if approved, to the formulary, our business may be materially harmed.\\nIn addition, we may be unable to sell Auryxia or vadadustat, if approved, to dialysis providers on a profitable basis if CMS significantly reduces the level of reimbursement for dialysis services and providers choose to use alternative therapies or look to re-negotiate their contracts with us. Our profitability may also be affected if our costs of production increase faster than increases in reimbursement levels. Adequate coverage and reimbursement of our products by government and private insurance plans are central to patient and provider acceptance of any products for which we receive marketing approval.\\nFurther, in many countries outside the United States, a drug must be approved for reimbursement before it can be marketed or sold in that country. In some cases, the prices that we intend to charge for our products are also subject to approval. Approval by the FDA does not ensure approval by reimbursement authorities outside the United States, and approval by one\\n67\\nreimbursement authority outside the United States does not ensure approval by any other reimbursement authorities. However, the failure to obtain reimbursement in one jurisdiction may negatively impact our ability to obtain reimbursement in another jurisdiction. We may not be able to obtain such reimbursement approvals on a timely basis, if at all, and favorable pricing in certain countries depends on a number of factors, some of which are outside of our control.\\nWe face substantial competition, which may result in others discovering, developing or commercializing products before, or more successfully than, we do.\\nThe development and commercialization of new drugs is highly competitive and subject to rapid and significant technological change. Our future success depends on our ability to demonstrate and maintain a competitive advantage with respect to the development and commercialization of Auryxia, vadadustat, if approved, and any other product or product candidate, including those that may be in-licensed or acquired. Our objective is to continue to commercialize Auryxia and develop and commercialize new products with clinically proven efficacy, convenience, tolerability and/or safety. In many cases, any approved products that we commercialize will compete with existing, market-leading products.\\nAuryxia is competing in the hyperphosphatemia market in the United States with other FDA-approved phosphate binders such as Renagel® (sevelamer hydrochloride) and Renvela® (sevelamer carbonate), both marketed by Sanofi, PhosLo® and Phoslyra® (calcium acetate), marketed by Fresenius Medical Care North America, Fosrenol® (lanthanum carbonate), marketed by Shire Pharmaceuticals Group plc, and Velphoro® (sucroferric oxyhydroxide), marketed by Fresenius Medical Care North America, as well as over-the-counter calcium carbonate products such as TUMS® and metal-based options such as aluminum, lanthanum and magnesium. Most of the phosphate binders listed above are now also available in generic forms. In addition, other agents are in development, including OPKO Health Inc.’s Alpharen™ Tablets (fermagate tablets) or could otherwise enter the market, including Ardelyx, Inc.’s tenapanor (which is approved in the United States for the treatment of adults with irritable bowel syndrome with constipation, but for which the FDA issued a complete response letter for with respect to the control of serum phosphorus in adult patients with CKD on dialysis), that may impact the market for Auryxia.\\nAuryxia is competing in the IDA market in the United States with over-the-counter oral iron, ferrous sulfate, other prescription oral iron formulations, including ferrous gluconate, ferrous fumerate, and polysaccharide iron complex, and intravenous iron formulations, including Feraheme® (ferumoxytol injection), Venofer® (iron sucrose injection), Ferrlicit® (sodium ferric gluconate complex in sucrose injection), Injectafer® (ferric carboxymaltose injection), and Triferic® (ferric pyrophosphate citrate). In addition, other new therapies for the treatment of IDA may impact the market for Auryxia, such as Shield Therapeutics plc's Feraccru® (ferric maltol), which is available in Europe for the treatment of IDA and Accrufer® (ferric maltol), which was launched in the United States for the treatment of IDA in July 2021.\\nFurthermore, Auryxia’s commercial opportunities may be reduced or eliminated if our competitors develop and market products that are less expensive, more effective, safer or offer greater patient convenience than Auryxia. Other companies have product candidates in various stages of preclinical or clinical development to treat diseases and complications of the diseases for which we are marketing Auryxia. In addition, we and Keryx’s licensors, Panion & BF Biotech, Inc., or Panion, and, as applicable, Dr. Hsu, entered into settlement agreements with each of the third parties who submitted Paragraph IV certification notice letters regarding Abbreviated New Drug Applications, or ANDAs, submitted to the FDA, pursuant to which we granted licenses to market a generic version of Auryxia in the United States beginning in March 2025 (subject to FDA approval), or earlier under certain circumstances customary for settlement agreements of this nature, which may impact our business and results of operation.\\nDrugs that may compete with vadadustat include Epogen® (epoetin alfa) and Aranesp® (darbepoetin alfa), both commercialized by Amgen, Procrit® (epoetin alfa) and Eprex® (epoetin alfa), commercialized by Johnson & Johnson in the United States and Europe, respectively, and Mircera® (methoxy PEG-epoetin beta), commercialized by Vifor Pharma in the United States and Roche Holding Ltd. outside of the United States.\\nWe and our partners may also face competition from potential new anemia therapies. There are several other HIF-PH inhibitor product candidates in various stages of development for anemia indications that may be in direct competition with vadadustat if and when they are approved and launched commercially. These candidates are being developed by companies such as FibroGen Inc., or FibroGen, together with its collaboration partners, Astellas Pharma Inc. and AstraZeneca PLC, Japan Tobacco International, or JT, GlaxoSmithKline plc, or GSK, and Bayer HealthCare AG, or Bayer.\\nFurthermore, certain companies are developing potential new therapies for renal-related diseases that could potentially reduce injectable erythropoiesis stimulating agent, or ESA, utilization and thus limit the market potential for vadadustat if they are approved and launched commercially. Other new therapies are in development for the treatment of conditions inclusive of renal anemia that may impact the market for anemia-targeted treatment.\\n68\\nIn addition, in the United States, FibroGen filed an NDA for its product candidate, roxadustat, with the FDA, but the FDA issued a complete response letter indicating the FDA will not approve the NDA in its present form and requested that an additional clinical trial for roxadustat be conducted prior to resubmission of the NDA or additional response to the FDA's complete response letter. In Europe however, roxadustat is approved for the treatment of anemia in patients with CKD. Further, GSK filed an NDA for daprodustat, its product candidate for the treatment of anemia due to CKD, with the FDA in April 2022. If we obtain approval for vadadustat in the U.S., and roxadustat or daprodustat are also approved by the FDA, they will compete with vadadustat.\\nIn Japan, Vafseo, which is approved for both the DD and NDD indications, competes with roxadustat, daprodustat and enarodustat. Roxadustat is approved for the treatment of anemia due to CKD in patients on dialysis, or DD-CKD, and patients not on dialysis, or NDD-CKD. In addition, daprodustat, GSK’s product candidate, and enarodustat, JT’s product candidate, are approved in Japan for the treatment of anemia due to CKD. In addition. Bayer HealthCare AG has submitted an NDA for its product candidate for the treatment of renal anemia in Japan. In China, roxadustat has launched for the treatment of anemia of DD-CKD and for the treatment of anemia due to CKD in NDD-CKD patients.\\nA biosimilar is a biologic product that is approved based on demonstrating that it is highly similar to an existing, FDA-approved branded biologic product. The patents for the existing, branded biologic product must expire in a given market before biosimilars may enter that market without risk of being sued for patent infringement. In addition, an application for a biosimilar product cannot be approved by the FDA until 12 years after the existing, branded product was approved under a Biologics License Application, or BLA. The patents for epoetin alfa, an injectable ESA, expired in 2004 in the EU, and the remaining patents expired between 2012 and 2016 in the United States. Because injectable ESAs are biologic products, the introduction of biosimilars into the injectable ESA market in the United States will constitute additional competition for vadadustat if we are able to obtain approval for and commercially launch vadadustat. In the United States, Pfizer’s biosimilar version of injectable ESAs, Retacrit® (epoetin alfa-epbx), was approved by the FDA in May 2018 and launched in November 2018 and several biosimilar versions of injectable ESAs are available for sale in the EU.\\nMany of our potential competitors have significantly greater financial, manufacturing, marketing, drug development, technical and human resources than we do. Large pharmaceutical companies, in particular, have extensive experience in clinical testing, obtaining marketing approvals, recruiting patients and manufacturing pharmaceutical products. Large and established companies such as Amgen and Roche, among others, compete in the market for drug products to treat kidney disease. In particular, these companies have greater experience and expertise in conducting preclinical testing and clinical trials, obtaining marketing approvals, manufacturing such products on a broad scale and marketing approved products. These companies also have significantly greater research and marketing capabilities than we do and may also have products that have been approved or are in late stages of development and have collaborative arrangements in our target markets with leading companies and research institutions. Established pharmaceutical companies may also invest heavily to accelerate discovery and development of novel compounds or to in-license novel compounds that could make the product candidates that we are developing obsolete. Smaller and other early-stage companies may also prove to be significant competitors. As a result of all of these factors, our competitors may succeed in obtaining patent protection and/or marketing approval, or discovering, developing and commercializing competitive products, before, or more effectively than, we do. If we are not able to compete effectively against potential competitors, our business will not grow and our financial condition and operations will suffer.\\nThe commercialization of RionaTM and VafseoTM in Japan and our current and potential future efforts with respect to the development and commercialization of our products and product candidates outside of the United States subject us to a variety of risks associated with international operations, which could materially adversely affect our business.\\nOur Japanese sublicensee, JT, and its subsidiary, Torii Pharmaceutical Co., Ltd., or Torii, commercialize Riona, the trade name for ferric citrate hydrate in Japan, as an oral treatment for the improvement of hyperphosphatemia in patients with CKD, including DD-CKD and NDD-CKD, and for the treatment of adult patients with IDA in Japan. In Japan and certain other countries in Asia, we granted MTPC exclusive rights to commercialize vadadustat, which has been approved and is being marketed by MTPC in Japan under the trade name VafseoTM.\\nPursuant to the terms of the Termination Agreement with Otsuka, Otsuka has transferred to us the marketing authorization application, or MAA, for vadadustat with the EMA, and in the United Kingdom, Switzerland and Australia. In addition, we have conducted and in the future plan to conduct clinical trials outside of the United States for Auryxia, vadadustat and any other product or product candidate that may be in-licensed or acquired. As a result of these and other activities, we are or may become subject to additional risks in developing and commercializing Auryxia and vadadustat outside the United States, including, among others:\\n•political, regulatory, compliance and economic developments, weakness or instability that could restrict our ability to manufacture, market and sell our products;\\n•changes in international medical reimbursement policies and programs;\\n69\\n•changes in healthcare policies of foreign jurisdictions;\\n•trade protection measures, including import or export licensing requirements and tariffs and our compliance therewith;\\n•our ability to develop or manage relationships with qualified local distributors and trading companies;\\n•diminished protection of intellectual property in some countries outside of the United States;\\n•differing labor regulations and business practices;\\n•compliance with laws, including the U.S. Foreign Corrupt Practices Act, or FCPA, the UK Bribery Act or similar local regulation, the EU General Data Protection Regulation, or GDPR, and similar data protection laws, and tax, employment, immigration and labor laws;\\n•economic weakness, including inflation, or political instability in particular foreign economies and markets;\\n•foreign currency fluctuations, which could result in increased operating expenses and reduced revenues, and other obligations incident to doing business in another country;\\n•production shortages resulting from any events affecting raw material supply or manufacturing capabilities abroad, including as a result of the COVID-19 pandemic; and\\n•business interruptions resulting from geopolitical actions, including war and terrorism, global pandemics, or natural disasters including earthquakes, typhoons, floods and fires.\\nIn addition, we receive revenues from royalty payments converted to U.S. dollars based on net sales of Riona and VafseoTM in Japanese yen. The exchange rates between the Japanese yen on the one hand, and the U.S. dollar, on the other hand, have changed substantially in recent years and may fluctuate substantially in the future. Our results of operations could be adversely affected over time by certain movements in exchange rates, particularly if the Japanese yen depreciates against the U.S. dollar.\\nAny of these factors may, individually or as a group, have a material adverse effect on our business and results of operations. As and if we continue to expand our commercialization efforts, we may encounter new risks.\\nRisks Related to Product Development\\nClinical drug development involves a lengthy and expensive process with an uncertain outcome, and we will incur additional costs in connection with, and may experience delays in completing, or ultimately be unable to complete, the development and, if approved, commercialization of vadadustat and any other product candidates.\\nThe risk of failure in drug development is high. Before obtaining marketing approval from regulatory authorities for the sale of any product candidate, we must complete preclinical development and conduct extensive clinical trials to demonstrate the safety and efficacy of our product candidates in humans. Preclinical studies and clinical trials are expensive, difficult to design and implement, can take several years to complete, and their outcomes are inherently uncertain. Failure can occur at any time during the process. For example, we are currently conducting a clinical trial to evaluate three times per week oral dosing of vadadustat for dialysis dependent patients with anemia due to chronic kidney disease. If we experience delays in the conduct of this clinical trial or the results are not positive, it could affect the market potential of vadadustat, if approved.\\nWe may be unable to successfully obtain approval of vadadustat or other product candidates, or to successfully complete clinical trials of Auryxia, vadadustat and other product candidates if the results of those trials and studies are not positive or are only modestly positive, or if there are concerns with the profile due to efficacy or safety. Further, the results of preclinical studies and early clinical trials of our product candidates may not be predictive of the results of later-stage clinical trials, interim results of a clinical trial do not necessarily predict final results, and results of Phase 3 clinical trials for one indication may not be predictive of results of Phase 3 clinical trials for another indication. For example, we announced positive top-line results from INNO2VATE and vadadustat achieved the primary and key secondary efficacy endpoint in each of the two PRO2TECT studies, but the PRO2TECT program did not meet the primary major adverse cardiovascular event, or MACE, safety endpoint. Many companies in the biopharmaceutical industry have suffered significant setbacks in late-stage clinical trials after achieving positive results in early-stage development, and we may face similar setbacks. Moreover, preclinical and clinical data are often susceptible to varying interpretations and analyses, and many companies that have believed their product candidates performed satisfactorily in preclinical studies and clinical trials have nonetheless failed to obtain marketing approval of their product candidates. In addition, in March 2022, we received the CRL for vadadustat indicating that the FDA had determined that it could not approve the NDA in its present form, thus delaying any potential approval of vadadustat. In July 2022, we held an end of review meeting with the FDA to inform the Company's next steps with respect to the potential U.S. approval of vadadustat, if any, and in October 2022, we submitted the FDRR to the FDA. However, it is impossible to predict when or if vadadustat or any of our other product candidates will prove effective or safe in humans or will receive marketing approval or on what terms.\\nWe may experience numerous unforeseen events during, or as a result of, preclinical development or clinical trials that could delay, prevent or make more challenging our ability to receive or maintain marketing approval or commercialize our product\\n70\\ncandidates. We may be required to complete additional clinical trials for Auryxia, vadadustat and any other product or product candidate, including those that may be in-licensed or acquired, in order to obtain or maintain required regulatory approvals. Our preclinical studies and clinical trials may take longer to complete than currently anticipated, or may be delayed, suspended, required to be repeated, prematurely terminated or may not successfully demonstrate safety and/or efficacy needed to obtain or maintain regulatory approval for a variety of other reasons, such as:\\n•the costs may be greater than we anticipate;\\n•the number of patients required for clinical trials may be larger than we anticipate;\\n•enrollment in our clinical trials may be slower than we anticipate, or participants may drop out of these clinical trials at a higher rate than we anticipate;\\n•our third party contractors, such as our CROs, may fail to comply with regulatory requirements, perform effectively, or meet their contractual obligations to us in a timely manner, or at all, or we may fail to communicate effectively or provide the appropriate level of oversight of such third party contractors;\\n•the supply or quality of our starting materials, drug substance and drug product necessary to conduct clinical trials of our product candidates may be insufficient or inadequate;\\n•regulators, independent data monitoring committees, or IDMCs, institutional review boards, or IRBs, safety committees, or ethics committees, may require that we suspend or terminate our clinical trials for various reasons, including noncompliance with regulatory requirements, unforeseen safety issues or adverse side effects, failure to demonstrate a benefit from using our product candidate, or a finding that the participants are being exposed to unacceptable health risks;\\n•clinical trials of our product candidates may produce negative or inconclusive results or results that may be interpreted in a manner different than we interpret them, and we may decide, or regulators may require us, to conduct additional clinical trials, repeat a clinical trial or abandon product development programs;\\n•lack of adequate funding to continue a clinical trial, including unforeseen costs due to enrollment delays, requirements to conduct additional clinical trials or repeat a clinical trial and increased expenses associated with the services of our CROs and other third parties;\\n•we may fail to initiate, delay of or failure to complete a clinical trial as a result of an Investigational New Drug application, or IND, being placed on clinical hold by the FDA, the EMA, the PMDA, or other regulatory authorities, or for other reasons, such as failure to recruit or enroll suitable patients or patients' failure to return for post-treatment follow up;\\n•we may determine to change or expand a clinical trial, including after it has begun;\\n•clinical trial sites and investigators deviating from the clinical protocol, failing to conduct the trial in accordance with regulatory requirements, or dropping out of a trial, or failure by us or our CROs to communicate effectively or provide the appropriate level of oversight of such clinical sites and investigators;\\n•there may be an inability, delay, or failure in identifying and maintaining a sufficient number of clinical trial sites, many of which may already be engaged in other clinical programs;\\n•there may be a delay or failure in reaching agreement with the FDA, the EMA, the PMDA or other regulatory authorities on a clinical trial design upon which we are able to execute;\\n•there may be a delay or failure in obtaining authorization to commence a clinical trial or inability to comply with conditions imposed by a regulatory authority regarding the scope or design of a clinical trial;\\n•there may be delays in reaching, or failure to reach, agreement on acceptable terms with prospective clinical trial sites and prospective CROs, the terms of which can be subject to extensive negotiation and may vary significantly among different CROs and clinical trial sites;\\n•the FDA, the EMA, the PMDA or other regulatory authorities may require us to submit additional data or impose further requirements before permitting us to initiate a clinical trial or during an ongoing clinical trial;\\n•the FDA, the EMA, the PMDA or other regulatory authorities may disagree with our clinical trial design and our interpretation of data from clinical trials, or may change the requirements for approval even after it has reviewed and commented on the design for our clinical trials;\\n•third parties with which we work may fail to comply with good practice quality guidelines and regulations, or GXP, including good laboratory practice, good clinical practice, or GCP, and current good manufacturing practice, or cGMP; or\\n•there may be changes in governmental regulations or administrative actions.\\nIf any of the foregoing occurs, the following may occur:\\n•regulators may require that we conduct additional clinical trials, repeat clinical trials or conduct other studies beyond those that we currently contemplate;\\n•we may be delayed in obtaining marketing approval for vadadustat or other product candidates;\\n•we may not obtain marketing approval for vadadustat or other product candidates at all;\\n•we may obtain approval for indications or patient populations that are not as broad as intended or desired;\\n71\\n•we may obtain approval with labeling that includes significant use or distribution restrictions or safety warnings that would reduce the potential market for any approved product or inhibit our ability to successfully commercialize any approved product;\\n•a REMS or FDA-imposed risk management plan that use risk minimization strategies to ensure that the benefits of certain prescription drugs outweigh their risks, may be required;\\n•we may be subject to additional post-marketing restrictions and/or requirements; or\\n•the product may be removed from the market after obtaining marketing approval.\\nThe COVID-19 pandemic resulted in temporary closures of, and may continue to impact, clinical trial sites on which we rely and will rely for the completion of certain clinical trials and may delay enrollment of certain planned and ongoing clinical trials. In response to the COVID-19 pandemic, the FDA issued guidance on March 18, 2020, and has thereafter updated it, to address and facilitate the conduct of clinical trials during the pandemic. The guidance sets out a number of considerations for sponsors of clinical trials impacted by the pandemic, including the requirement to include in the clinical study report (or as a separate document) contingency measures implemented to manage the study, and any disruption of the study as a result of the pandemic.\\nOur product development costs may also increase if we experience development delays or delays in receiving the requisite marketing approvals. Our preclinical studies or clinical trials may need to be restructured or may not be completed on schedule, or at all. Significant preclinical or clinical trial delays also could shorten any periods during which we may have the exclusive right to commercialize vadadustat, if approved, or any other product candidate, including those that may be in-licensed or acquired, or allow our competitors to bring products to market before we do. This could impair our ability to successfully commercialize our product candidates and may harm our business and results of operations.\\nWe may find it difficult to enroll patients in our clinical trials, which could delay or prevent clinical trials of Auryxia, vadadustat or any other product or product candidate, including those that may be in-licensed or acquired.\\nIdentifying and qualifying patients to participate in clinical trials is critical to our success. The timing of our clinical trials depends, in part, on the speed at which we can recruit patients to participate in our clinical trials. Patients may be unwilling to participate in our clinical trials because of concerns about adverse events observed with the product candidate under study, the current standard of care, competitor products and/or other investigational agents, in each case for the same indications and/or similar patient populations. In addition, in the case of clinical trials of any product candidate, patients currently receiving treatment with the current standard of care or a competitor product may be reluctant to participate in a clinical trial with an investigational drug. Furthermore, the COVID-19 pandemic resulted in temporary closures of, and may continue to impact, clinical trial sites on which we rely for the conduct of certain clinical trials and COVID-19 pandemic precautions have caused moderate delays in enrolling new clinical trials and may cause delays in enrolling other new clinical trials.\\nIn addition, following receipt of the CRL, in April 2022, we were notified by the FDA that the FDA had placed a partial clinical hold on our clinical trials of vadadustat in pediatric patients with anemia due to chronic kidney disease in the United States. In addition, in May 2022, the Paediatric Committee of the EMA recommended that we not initiate such clinical trials in the European Union until the safety issues identified by the FDA were addressed. As a result of the partial clinical hold and EMA’s recommendations, all activities in the United States and Europe for and related to our clinical trials of vadadustat in pediatric patients were suspended. Furthermore, we are currently conducting clinical trials to evaluate three times per week oral dosing of vadadustat for dialysis dependent patients with anemia due to chronic kidney disease. If the FDA, investigators or patients are worried about the safety of vadadustat as a result of the CRL or partial clinical hold or otherwise decide not to participate or continue in those trials, we may not be able to complete those studies in a timely basis, or at all.\\nFinally, competition for clinical study sites may limit our access to patients appropriate for our clinical trials. As a result, the timeline for recruiting patients and conducting studies may be delayed. These delays could result in increased costs, delays in advancing our development of any product or product candidate, or termination of the clinical trial altogether.\\nWe may not be able to identify, recruit and enroll a sufficient number of patients, or those with required or desired characteristics, to complete our clinical trials in a timely manner. Patient enrollment is affected by many factors, including:\\n•severity of the disease under investigation;\\n•design of the study protocol;\\n•size and nature of the patient population;\\n•eligibility criteria for, and design of, the study in question;\\n•perceived risks and benefits of the product or product candidate under study, including as a result of adverse effects observed in similar or competing therapies;\\n•proximity and availability of clinical study sites for prospective patients;\\n72\\n•availability of competing therapies and clinical trials and clinicians’ and patients’ perceptions as to the potential advantages of the product or product candidate being studied in relation to available therapies or other product candidates in development;\\n•efforts to facilitate timely enrollment in clinical trials;\\n•clinical trial sites and investigators failing to perform effectively; and\\n•patient referral practices of physicians.\\nWe may not be able to initiate or complete clinical trials in a timely manner, or at all, if we cannot enroll a sufficient number of eligible patients to participate in the clinical trials required by regulatory agencies. If we have difficulty enrolling a sufficient number of patients to conduct our clinical trials as planned, we may need to delay, limit or terminate ongoing or planned clinical trials, any of which may delay approval, or result in failure to obtain approval, of our product candidates, which would have a material adverse effect on our business.\\nConducting clinical trials outside of the United States, as we have done historically and as we may decide to do in the future, presents additional risks and complexities and, if we decide to conduct a clinical trial outside of the United States in the future, we may not complete such trials successfully, in a timely manner, or at all, which could affect our ability to obtain regulatory approvals.\\nOur ability to successfully initiate, enroll and complete a clinical study in any country outside of the United States is subject to numerous additional risks unique to conducting business in jurisdictions outside the United States, including:\\n•difficulty in establishing or managing relationships with qualified CROs, physicians and clinical trial sites;\\n•difficulty in complying with different local standards for the conduct of clinical trials;\\n•difficulty in complying with various and complex import laws and regulations when shipping drug to certain countries; and\\n•the potential burden of complying with a variety of laws, medical standards and regulatory requirements, including the regulation of pharmaceutical and biotechnology products and treatments.\\nData obtained from studies conducted in the United States may not be accepted by the EMA, the PMDA and other regulatory authorities outside of the United States. Also, certain jurisdictions require data from studies conducted in their country in order to obtain approval in that country.\\nIf we or our collaboration partners have difficulty conducting future clinical trials in jurisdictions outside the United States as planned, we may need to delay, limit or terminate such clinical trials, any of which could have an adverse effect on our business.\\nAuryxia, vadadustat or any other product or product candidate, including those that may be in-licensed or acquired, may cause undesirable side effects or have other properties that may delay or prevent marketing approval or limit their commercial potential.\\nUndesirable effects caused by, or other undesirable properties of, Auryxia, vadadustat or any other product or product candidate, including those that may be in-licensed or acquired, or competing commercial products or product candidates in development that utilize a common mechanism of action could cause us or regulatory authorities to interrupt, delay or halt clinical trials, could result in a more restrictive label or the delay, denial or withdrawal of marketing approval by the FDA or other regulatory authorities, and could lead to potential product liability claims. In addition, results of our clinical trials could reveal a high frequency of undesirable effects or unexpected characteristics. For example, in March 2022, we received the CRL from the FDA for our NDA for vadadustat in which the FDA concluded that the data in the NDA do not support a favorable benefit-risk assessment of vadadustat for dialysis and non-dialysis patients. The FDA expressed safety concerns noting failure to meet non-inferiority in MACE in the non-dialysis patient population, the increased risk of thromboembolic events, driven by vascular access thrombosis in dialysis patients, and the risk of drug-induced liver injury. In July 2022, we held an end of review meeting with the FDA to inform the Company's next steps with respect to the potential U.S. approval of vadadustat, if any, and in October 2022, we submitted the FDRR to the FDA. The FDRR focuses on the favorable balance between the benefits and risks of vadadustat for the treatment of anemia due to CKD in adult patients on dialysis in light of safety concerns expressed by the FDA in the CRL related to the rate of adjudicated thromboembolic events driven by vascular access thrombosis for vadadustat compared to the active comparator and the risk of drug-induced liver injury. There can be no assurances that our FDRR will be accepted by the FDA, or that, if accepted, we will be successful in our appeal. If we are unable to overcome these concerns, vadadustat may not be approved by the FDA on favorable terms, or at all, and our financial condition could be materially harmed.\\n73\\nIf we or others identify undesirable effects caused by, or other undesirable properties of, Auryxia, vadadustat, or any other product or product candidate, including those that may be in-licensed or acquired, or if known undesirable effects are more frequent or severe than in the past, or if any of the foregoing are perceived to have occurred, either before or after receipt of marketing approval, a number of potentially significant negative consequences could result, including:\\n•our product candidates may not be approved by regulatory authorities;\\n•our clinical trials may be put on hold;\\n•patient recruitment could be slowed, and enrolled patients may not want to complete the clinical trial;\\n•regulatory authorities may require warnings on the label, such as the warning on Auryxia’s label regarding iron overload;\\n•REMS or FDA-imposed risk management plans that use restrictive risk minimization strategies may be required;\\n•we may decide to, or be required to, send drug warnings or safety alerts to physicians, pharmacists and hospitals (or the FDA or other regulatory authorities may choose to issue such alerts), or we may decide to conduct a product recall or be requested to do so by the FDA or other regulatory authority;\\n•reformulation of the product, additional non-clinical or clinical trials, restrictive changes in labeling or changes to or re-approvals of manufacturing facilities may be required;\\n•we may be precluded from pursuing additional development opportunities to enhance the clinical profile of a product within its indicated populations, or studying the product or product candidate in additional indications and populations or in new formulations; and\\n•we could be investigated by the government or sued and held liable for harm caused to patients, including in class action lawsuits; and\\n•our reputation may suffer.\\nAny of these events could prevent us from achieving or maintaining, whether on a restricted basis or at all, marketing approval and, ultimately, market acceptance or penetration of Auryxia, vadadustat or any other product or product candidate, including those that may be in-licensed or acquired. In addition, any of these events could substantially increase our costs, and could significantly impact our ability to successfully commercialize Auryxia, vadadustat or any other product and product candidate, including those that may be in-licensed or acquired, and generate product revenue.\\nThe patient populations treated with Auryxia and potential patient populations for vadadustat, if approved, have CKD, a serious disease that increases the risk of cardiovascular disease including heart attacks and stroke and, in its most severe form, results in, kidney failure and the need for dialysis or kidney transplant. Many patients with CKD are elderly with comorbidities making them susceptible to significant health risks. Therefore, the likelihood of these patients having adverse events, including serious adverse events is high.\\nWith respect to the global INNO2VATE Phase 3 program, the incidence of treatment emergent adverse events during the Correction and Conversion study in vadadustat treated patients was 83.8% and 85.5% in darbepoetin alfa treated patients. During the study, the most common treatment emergent adverse events reported in vadadustat/darbepoetin alfa treated patients were hypertension (16.2%/ 12.9%) and diarrhea (10.1%/ 9.7%). Serious treatment emergent adverse events were lower in vadadustat treated patients at 49.7% compared to 56.5% for darbepoetin alfa treated patients. The incidence of treatment emergent adverse events during the prevalent dialysis patient study (Conversion) in the vadadustat treated patients was 88.3%, and 89.3% in darbepoetin alfa treated patients. During the study, the most common treatment emergent adverse events reported in vadadustat/darbepoetin alfa treated patients were diarrhea (13.0%/ 10.1%), pneumonia (11.0%/ 9.7%), hypertension (10.6%/ 13.8%), and hyperkalemia (9.0%/ 10.8%). Serious treatment emergent adverse events were slightly lower for vadadustat treated patients at 55.0% and 58.3% for darbepoetin alfa-treated patients. Patients with DD-CKD experienced an increased risk of thromboembolic events compared to darbepoetin alfa with a time to first event HR of 1.20 (95% CI 0.96 - 1.50) driven by thrombosis of vascular access.\\nWith respect to the global PRO2TECT Phase 3 program, the incidence of treatment emergent adverse events during the ESA untreated patients study (Correction) in the vadadustat-treated patients was 90.9%, and 91.6% in darbepoetin alfa-treated patients. During the study, the most common treatment emergent adverse events reported in vadadustat/darbepoetin alfa-treated patients were end-stage renal disease (34.7%/ 35.2%), hypertension (17.7%/ 22.1.%), hyperkalemia (12.3.%/ 15.6%), urinary tract infection (12.9%/ 12.0%), diarrhea (13.9%/ 10.0%), peripheral oedema (12.5%/ 10.5%), fall (9.6%/ 10%) and nausea (10%/ 8.2%). Serious treatment emergent adverse events were 65.3% for vadadustat-treated patients and 64.5% for darbepoetin alfa-treated patients. The incidence of treatment emergent adverse events during the ESA-treated patients study (Conversion) in vadadustat treated patients was 89.1% and 87.7% in darbepoetin alfa-treated patients. During the study, the most common treatment emergent adverse events reported in vadadustat/darbepoetin alfa-treated patients were end-stage renal disease (27.5%/ 28.4%), hypertension (14.4%/ 14.8%), urinary tract infection (12.2%/ 14.5%), diarrhea (13.8.%/ 8.8.%), peripheral oedema\\n74\\n(9.9%/ 10.1%) and pneumonia (10.0%/ 9.7%). Serious treatment emergent adverse events were 58.5% for vadadustat-treated patients and 56.6% for darbepoetin alfa-treated patients.\\nFor example, during the conduct of our Phase 3 program our team and hepatic experts analyzed hepatic cases (unblinded to treatment) and, following the completion of our global Phase 3 clinical program for vadadustat, there was a review of hepatic safety across the vadadustat clinical program, which included eight completed Phase 2 and 3 studies in NDD-CKD patients, 10 completed Phase 1, 2, and 3 studies, and two then-ongoing Phase 3b studies in DD-CKD patients, and 18 completed studies in healthy subjects (17 Phase 1 and one Phase 3). This review consisted of a blinded re-assessment of hepatic events conducted by a separate panel of hepatic experts. While hepatocellular injury attributed to vadadustat was reported in less than 1% of patients, there was one case of severe hepatocellular injury with jaundice, and we cannot guarantee that similar events will not happen in the future. Additionally, the FDA expressed safety concerns related to the risk of drug-induced liver injury in the CRL that it issued in March 2022.\\nSerious adverse events considered related to vadadustat, including those noted in the CRL, and any other product candidates could have material adverse consequences on the development and potential approval of such product candidates and our business as a whole. Our understanding of adverse events in prior clinical trials of our product candidates may change as we gather more information, the FDA may not agree with our assessment of adverse events and additional unexpected adverse events may be observed in future clinical trials or in the market.\\nAny of the above safety data or other occurrences could delay or prevent us from achieving or maintaining marketing approval, harm or prevent sales of Auryxia or, if approved, vadadustat or any other product or product candidate, including those that may be in-licensed or acquired, increase our expenses and impair or prevent our ability to successfully commercialize Auryxia, vadadustat or any other products or product candidates.\\nIn addition, any post-marketing clinical trials conducted, if successful, may expand the patient populations treated with Auryxia, vadadustat or any other product we acquire or for which we receive marketing approval, within or outside of their current indications or patient populations, which could result in the identification of previously unknown undesirable effects, increased frequency or severity of known undesirable effects, or result in the identification of unexpected safety signals. In addition, as Auryxia, vadadustat, if approved, and any other products are commercialized, they will be used in significantly larger patient populations, in less rigorously controlled environments and, in some cases, by less experienced and less expert treating practitioners, than in clinical trials, which could result in increased or more serious adverse effects being reported. As a result, regulatory authorities, healthcare practitioners, third party payors or patients may perceive or conclude that the use of Auryxia, vadadustat, if approved, or any other products are associated with serious adverse effects, undermining our commercialization efforts.\\nRisks Related to Regulatory Approval\\nWe may not be able to obtain marketing approval for, or successfully commercialize, vadadustat or any other product candidate, or we may experience significant delays in doing so, any of which would materially harm our business.\\nClinical trials, manufacturing and marketing of any product or product candidate are subject to extensive and rigorous review and regulation by numerous governmental authorities in the United States and other jurisdictions. Before obtaining marketing approval for the commercial sale of any product candidate, we must demonstrate through extensive preclinical testing and clinical trials that the product candidate is safe and effective for use in each target indication. This process can take many years and marketing approval may never be achieved. Of the large number of drugs in development in the United States and in other jurisdictions, only a small percentage successfully complete the FDA’s and other jurisdictions’ marketing approval processes and are commercialized. Accordingly, even if we are able to obtain the requisite capital to continue to fund our development and commercialization efforts, we may be unable to successfully obtain regulatory approval for or commercialize vadadustat or any other product or product candidate, including those that may be in-licensed or acquired.\\nWe are not permitted to market vadadustat in the United States until we receive approval from the FDA, in the EU until we receive approval from the EMA, or in any other jurisdiction until the requisite approval from regulatory authorities in such jurisdiction is received. As a condition to receiving marketing approval for vadadustat, we may be required by the FDA, the EMA or other regulatory authorities to conduct additional preclinical studies or clinical trials.\\nIn March 2022, we received the CRL from the FDA regarding our NDA for vadadustat for the treatment of anemia due to CKD. The FDA concluded that the data in the NDA do not support a favorable benefit-risk assessment of vadadustat for dialysis and non-dialysis patients. In July 2022, we held an end of review meeting with the FDA to inform the Company's next steps with respect to the potential U.S. approval of vadadustat, if any, and in October 2022, we submitted a Formal Dispute Resolution Request, or FDRR, to the FDA. The FDRR focuses on the favorable balance between the benefits and risks of vadadustat for the treatment of anemia due to CKD in adult patients on dialysis in light of safety concerns expressed by the FDA in the CRL\\n75\\nrelated to the rate of adjudicated thromboembolic events driven by vascular access thrombosis for vadadustat compared to the active comparator and the risk of drug-induced liver injury. There can be no assurances that our FDRR will be accepted by the FDA, or that, if accepted, we will be successful in our appeal and obtain approval for vadadustat in a timely manner, on favorable terms, or at all. As a result, the regulatory approval process for vadadustat in the U.S. is highly uncertain. We may not obtain approval at all, and if we are able to obtain approval, it may only be for patients with DD-CKD and, in any event, the expense and time to do so could adversely impact our ability to successfully commercialize vadadustat, and our financial condition could be materially harmed.\\nFurther, vadadustat and any other product candidate may not receive marketing approval in the United States or the EU even if it is approved in other countries. For example, although vadadustat is approved in Japan for the treatment of anemia due to CKD in DD-CKD and NDD-CKD adult patients, such approval does not guarantee approval in the United States by the FDA or in the EU by the EMA for these indications or at all. In addition, while each regulatory authority makes their own assessment as to the safety and efficacy of a drug, FDA’s concern about the safety or efficacy of vadadustat or any other product candidate could impact the regulatory authority’s decision in another country.\\nObtaining marketing approval in the United States and other jurisdictions for any product candidate depends upon numerous factors, many of which are subject to the substantial discretion of the regulatory authorities, including that regulatory agencies may not complete their review processes in a timely manner and, following completion of the review process, may not grant marketing approval or such marketing approval may be limited. Furthermore, approval of a drug does not ensure successful commercialization. For example, on September 23, 2015, the European Commission, or EC, approved Fexeric for the control of hyperphosphatemia in adult patients with CKD. Pursuant to the sunset clause under EU law, the EC’s approval of Fexeric in the EU was contingent on, among other things, our commencing marketing of Fexeric within three years; although we successfully negotiated an extension to December 23, 2019, we did not commence marketing Fexeric by such date and therefore the Fexeric approval in the EU has ceased to be valid.\\nWe could face heightened risks with respect to seeking marketing approval in the United Kingdom, or UK, as a result of the recent withdrawal of the UK from the EU, commonly referred to as Brexit. Pursuant to the formal withdrawal arrangements agreed between the UK and the EU, the UK withdrew from the EU, effective December 31, 2020. On December 24, 2020, the UK and the EU entered into a Trade and Cooperation Agreement. The agreement sets out certain procedures for approval and recognition of medical products in each jurisdiction. Any delay in obtaining, or an inability to obtain, any marketing approvals, as a result of the Trade and Cooperation Agreement would prevent us from commercializing vadadustat or any other product candidate, including those that may be in-licensed or acquired, in the UK and/or the EU and restrict our ability to generate revenue and achieve and sustain profitability. If any of these outcomes occur, we may be forced to restrict or delay efforts to seek regulatory approval in the UK and/or the EU for vadadustat or any other product candidate, which could significantly and materially harm our business. As of January 1, 2021, the Medicines and Healthcare Products Regulatory Agency, or the MHRA, became responsible for supervising medicines and medical devices in Great Britain, comprising England, Scotland and Wales under domestic law, whereas Northern Ireland will continue to be subject to European Union rules under the Northern Ireland Protocol. The MHRA will rely on the Human Medicines Regulations 2012 (SI 2012/1916) (as amended) as the basis for regulating medicines.\\nIn addition, the safety concerns associated with the current standard of care for the indications for which we are seeking marketing approval for vadadustat may affect the FDA’s, the EMA’s or other regulatory authorities’ review of the safety results of vadadustat. Additionally, these regulatory authorities may not agree with our assessment of adverse events. Further, the policies or regulations, or the type and amount of clinical data necessary to gain approval, may change during the course of a product candidate’s clinical development and may vary among jurisdictions. It is possible that vadadustat will never obtain marketing approval in the United States or certain other jurisdictions or for some or all of the indications for which we seek approval. The FDA, the EMA or other regulatory authorities may delay, limit or deny approval of vadadustat for many reasons including, among others:\\n•we may not be able to demonstrate that vadadustat is safe and effective in treating adult patients with anemia due to CKD to the satisfaction of the relevant regulatory authority;\\n•the results of our clinical trials may only be modestly positive, or there may be concerns with the profile due to efficacy or safety;\\n•the results of our clinical trials may not meet the level of statistical or clinical significance required by the relevant regulatory authority for review and/or marketing approval;\\n•the relevant regulatory authority may disagree with our interpretation of data from our preclinical studies and clinical trials;\\n•the relevant regulatory authority may disagree with the number, design, size, conduct or implementation of our clinical trials;\\n•the relevant regulatory authority may not approve the formulation, labeling or specifications we request for vadadustat;\\n76\\n•the relevant regulatory authority may approve vadadustat or any other product candidate for use only in a small patient population or for fewer or more limited indications than we request;\\n•the relevant regulatory authority may require that we conduct additional clinical trials or repeat one or more clinical trials;\\n•the FDA or other relevant regulatory authority may require development of a REMS as a condition of approval or post-approval;\\n•the relevant regulatory authority may grant approval contingent on the performance of costly post-marketing clinical trials;\\n•the relevant regulatory authority's onsite inspections may be delayed due to the COVID-19 pandemic;\\n•we, or our CROs or other vendors, may fail to comply with GXP or fail to pass any regulatory inspections or audits;\\n•we or our third party manufacturers may fail to perform in accordance with the FDA’s or other relevant regulatory authority's cGMP requirements and guidance;\\n•the FDA may disagree with inclusion of data obtained from certain regions outside the United States to support the NDA for potential reasons such as differences in clinical practice from United States standards;\\n•the relevant regulatory authority could deem that our financial relationships with certain principal investigators constitute a conflict of interest, such that the data from those principal investigators may not be used to support our applications;\\n•as part of any future regulatory process, the FDA may ask an Advisory Committee to review portions of the NDA, the FDA may have difficulty scheduling an Advisory Committee meeting in a timely manner or, if convened, an FDA Advisory Committee could recommend non-approval, conditions of approval or restrictions on approval, and the FDA may ultimately agree with the recommendations;\\n•the relevant regulatory authority’s review process and decision-making regarding vadadustat and any other product candidate may be impacted by the results of our and our competitors’ clinical trials and safety concerns of marketed products used to treat the same indications as the indications for which vadadustat and any other product candidate are being developed;\\n•the relevant regulatory authority may not approve the manufacturing processes or facilities of third party manufacturers with whom we contract; or\\n•the policies or regulations of the relevant regulatory authority may significantly change in a manner that renders our clinical data insufficient for approval or requires us to amend or submit new clinical protocols.\\nIf we experience further delays in obtaining approval, or if we fail to obtain approval of vadadustat for some or all of the indications for which we have sought approval, the commercial prospects for vadadustat may be harmed and our ability to generate revenues will be materially impaired, which could have a material adverse effect on our business. For example, the FDRR we submitted to the FDA in October 2022 focuses on the favorable balance between the benefits and risks of vadadustat for the treatment of anemia due to CKD in adult patients on dialysis.\\nProducts approved for marketing are subject to extensive post-marketing regulatory requirements and could be subject to post-marketing restrictions or withdrawal from the market, and we may be subject to penalties, including withdrawal of marketing approval, if we fail to comply with regulatory requirements or if we experience unanticipated problems with our products, or product candidates, when and if any of them is approved.\\nMarketing approvals may be subject to limitations on the approved indicated uses for which the product may be marketed or other conditions of approval, or contain requirements or commitments for potentially costly post-marketing studies and surveillance to monitor the safety and efficacy of the product, including REMS, or registries or observational studies. For example, in connection with the FDA approvals of Auryxia, we initially committed to the FDA to conduct certain post-approval pediatric studies of Auryxia under the Pediatric Research Equity Act of 2003, or PREA. With regard to the Hyperphosphatemia Indication for Auryxia, we committed to completing the post-approval pediatric study and submitting a final report to the FDA by December 31, 2019. However, we did not complete the study and therefore did not submit the post-marketing requirement pediatric clinical study report by December 31, 2019. Consequently, we received a notification of noncompliance with PREA. Our request to extend this deadline was denied, and the study is considered delayed although we have initiated sites in the study and are recruiting for one patient cohort. Recruitment of the other patients is pending receipt of further data regarding the manufacturing of the smaller size tablets and the FDA’s concurrence before proceeding with the use of such formulation. With regard to our IDA Indication, we initially committed to completing the post-approval pediatric study and submitting a final report to the FDA by January 2023. We did not meet a milestone relating to this post-approval pediatric study of Auryxia in a timely manner and received a notification from the FDA. Subsequently, the FDA agreed to extend the pediatric clinical study timelines for the IDA Indication. We subsequently communicated to the FDA that we would be delaying the start of the clinical trial in the IDA Indication while we work to produce smaller size tablets. In response, the FDA issued a partial clinical hold until we manufacture the smaller tablets and provide the FDA with relevant information regarding the smaller sized tablets for\\n77\\nreview. The FDA lifted the partial clinical hold in June 2022, however, we have not commenced start up of this study pending resolution of the manufacturing of the smaller size tablets. If we are unable to complete these studies successfully, or have further delays in completing these studies, we will need to inform the FDA, have further discussions and, if the FDA finds that we failed to comply with pediatric study requirements, in violation of applicable law, it could institute enforcement proceedings to seize or enjoin the sale of Auryxia or seek civil penalties, which would have a material adverse impact on our ability to commercialize Auryxia and our ability to generate revenues from Auryxia.\\nIn addition, the manufacturing processes, labeling, packaging, distribution, adverse event reporting, storage, advertising, promotion and recordkeeping for Auryxia, vadadustat, if approved, and any other product for which we receive regulatory approval will be subject to extensive and ongoing regulatory requirements and guidance. These requirements and guidance include manufacturing processes and procedures (including record keeping), the implementation and operation of quality systems to control and assure the quality of the product, submissions of safety and other post-marketing information and reports, as well as continued compliance with cGMPs and GCPs for any clinical trials that we conduct post-approval. If we, our CMOs or other third parties we engage fail to adhere to such regulatory requirements and guidance, we could suffer significant consequences, including product seizures or recalls, loss of product approval, fines and sanctions, reputational damage, loss of customer confidence, shipment delays, inventory shortages, inventory write-offs and other product-related charges and increased manufacturing costs, and our development or commercialization efforts may be materially harmed.\\nMoreover, the FDA and other regulatory authorities closely regulate the post-approval marketing and promotion of drugs to ensure drugs are marketed only for the approved indications and in accordance with the provisions of the approved labeling. The FDA and other regulatory authorities impose stringent restrictions on companies’ communications regarding use of their products, and if we promote any approved product beyond its approved indications or inconsistent with the approved label, we may be subject to enforcement actions or prosecution arising from such activities. Violations of the U.S. Federal Food, Drug, and Cosmetic Act, or the FDCA, relating to the promotion of prescription drugs may lead to investigations alleging violations of federal and state healthcare fraud and abuse and other laws, as well as state consumer protection laws, insurance fraud laws, third party payor actions, stockholder actions and other lawsuits.\\nPost-approval discovery of previously unknown problems with an approved product, including adverse events of unanticipated severity or frequency or relating to manufacturing operations or processes, or failure to comply with regulatory requirements, may result in, among other things:\\n•restrictions on the marketing, distribution, use or manufacturing of the product;\\n•withdrawal of the product from the market, or product recalls;\\n•restrictions on the labeling or marketing of a product;\\n•fines, restitution or disgorgement of profits or revenues;\\n•warning or untitled letters or clinical holds;\\n•refusal by the FDA or other regulatory authorities to approve pending applications or supplements to approved applications filed by us, or suspension or revocation of product approvals;\\n•product seizure or detention, or refusal to permit the import or export of products;\\n•REMS; and\\n•injunctions or the imposition of civil or criminal penalties.\\nFor example, we previously had three limited, voluntary recalls of Auryxia. These and any other recalls or any supply, quality or manufacturing issues in the future could result in significant negative consequences, including reputational harm, loss of customer confidence, and a negative impact on our financials, any of which could have a material adverse effect on our business and results of operations, and may impact our ability to supply Auryxia, VafseoTM, in Japan or vadadustat for commercial (if approved) and clinical use.\\nNon-compliance with the FDA, the EMA, the PMDA and other regulatory authorities’ requirements regarding safety monitoring or pharmacovigilance can also result in significant financial penalties.\\nThe FDA’s policies and those of other regulatory authorities may change, and additional government regulations may be enacted. We cannot predict the likelihood, nature or extent of government regulations that may arise from future legislation or administrative action, either in the United States or in other jurisdictions. If we are slow or unable to adapt to changes in existing requirements or the adoption of new requirements or policies, or are not able to maintain regulatory compliance, we may lose any marketing approval that we may have obtained and we may not achieve or sustain profitability, which would materially adversely affect our business.\\nRisks Related to Governmental Regulation and Compliance\\n78\\nWe are subject to a complex regulatory scheme that requires significant resources to ensure compliance and our failure to comply with applicable laws could subject us to government scrutiny or enforcement, potentially resulting in costly investigations, fines, penalties or sanctions, contractual damages, reputational harm, administrative burdens and diminished profits and future earnings.\\nIn general, a variety of laws apply to us or may otherwise restrict our activities, including the following:\\n•laws and regulations governing the conduct of preclinical studies and clinical trials in the United States and other countries in which we are conducting such studies;\\n•anti-corruption and anti-bribery laws, including the FCPA, the UK Bribery Act and various other anti-corruption laws in countries outside of the United States;\\n•data privacy laws existing in the United States, the EU, the UK and other countries in which we operate, including the U.S. Health Insurance Portability and Accountability Act of 1996, or HIPAA, as amended by the Health Information Technology for Economic and Clinical Health Act, or HITECH, state privacy and data protection laws, such as the California Consumer Privacy Act, or CCPA, and the California Privacy Rights Act of 2020, or CPRA, as well as state consumer protection laws, GDPR, any additional applicable EU member state data protection laws in force from time to time, the retained EU law version of the General Data Protection Regulation as saved into United Kingdom law by virtue of section 3 of the United Kingdom's European Union (Withdrawal) Act 2018, or the EU GDPR;\\n•federal and state laws requiring the submission of accurate product prices and notifications of price increases;\\n•federal and state securities laws;\\n•environmental, health and safety laws and regulations; and\\n•international trade laws, which are laws that regulate the sale, purchase, import, export, re-export, transfer and shipment of goods, products, materials, services and technology.\\nIn addition, our relationships with healthcare providers, physicians and third party payors expose us to broadly applicable fraud and abuse laws that may constrain the business or financial arrangements and relationships through which we market, sell and distribute Auryxia and vadadustat, if approved, and any other products for which we may obtain marketing approval. As such, these arrangements are subject to applicable anti-kickback, fraud and abuse, false claims, transparency, health information privacy and security, and other healthcare laws and regulations at federal, state and international levels. These restrictions include, but are not limited to, the following:\\n•the FDCA which among other things, strictly regulates drug product marketing and promotion and prohibits manufacturers from marketing such products for off-label use;\\n•federal laws that require pharmaceutical manufacturers to report certain calculated product prices to the government or provide certain discounts or rebates to government authorities or private entities, often as a condition of reimbursement under government healthcare programs, and laws requiring notification of price increases;\\n•the federal Anti-Kickback Statute, which prohibits, among other things, persons from knowingly and willfully soliciting, offering, receiving or providing remuneration, directly or indirectly, in cash or in kind, to induce or reward, or in return for, either the referral of an individual for, or the purchase, order or recommendation or arranging of, any good or service, for which payment may be made under a federal healthcare program such as Medicare and Medicaid;\\n•the federal False Claims Act, which imposes criminal and civil penalties, including through civil whistleblower or qui tam actions, against individuals or entities for, among other things, knowingly presenting, or causing to be presented, false or fraudulent claims for payment by a federal healthcare program or making a false statement or record material to payment of a false claim or avoiding, decreasing or concealing an obligation to pay money to the federal government, with potential liability including mandatory treble damages and significant per-claim penalties, and violations of the FDCA, the federal government pricing laws, and the federal Anti-Kickback Statute trigger liability under the federal False Claims Act;\\n•HIPAA, which imposes criminal and civil liability for executing a scheme to defraud any healthcare benefit program or making false statements relating to healthcare matters;\\n•HIPAA, as amended by the HITECH, and their respective implementing regulations, also imposes obligations, including mandatory contractual terms, with respect to safeguarding the privacy, security and transmission of individually identifiable health information;\\n•the federal Physician Payments Sunshine Act (renamed the Open Payments Act) requires applicable manufacturers of covered drugs to report payments and other transfers of value to physicians, other healthcare providers and teaching hospitals, as well as ownership and investment interests held by physicians and their immediate family members;\\n•analogous state and foreign laws and regulations, such as state anti-kickback and false claims laws and gift ban and transparency statutes, which may apply to sales or marketing arrangements and claims involving healthcare items or services reimbursed by state Medicaid or other programs, or non-governmental third party payors, including private\\n79\\ninsurers, and which are not preempted by federal laws and often differ from state to state, thus complicating compliance efforts; and\\n•U.S. state laws restricting interactions with healthcare providers and other members of the healthcare community or requiring pharmaceutical manufacturers to implement certain compliance standards, which vary from state to state.\\nBecause of the breadth of these U.S. laws, and their non-U.S. equivalents, and the narrowness of the statutory exceptions and safe harbors available, it is possible that some of our business activities could be subject to challenge under one or more of such laws. In addition, recent healthcare reforms have strengthened these laws. For example, the Health Care Reform Act, among other things, amended the intent requirement of the federal Anti-Kickback Statute. A person or entity no longer needs to have actual knowledge of the statute or specific intent to violate the law. The Health Care Reform Act also amended the False Claims Act, such that violations of the Anti-Kickback Statute are now deemed violations of the False Claims Act.\\nSome state laws require pharmaceutical companies to comply with the pharmaceutical industry’s voluntary compliance guidelines, such as the Pharmaceutical Research and Manufacturers of America Code on Interactions with Health Care Professionals, known as the PhRMA Code. Additionally, some state and local laws require the registration of pharmaceutical sales representatives in the jurisdiction. State and foreign laws also govern the privacy and security of health information in some circumstances, many of which differ from each other in significant ways and often are not preempted by HIPAA.\\nEfforts to ensure that our business complies with applicable healthcare laws and regulations involves substantial costs and requires us to expend significant resources. One of the potential areas for governmental scrutiny involves federal and state requirements for pharmaceutical manufacturers to submit accurate price reports to the government. Because our processes for calculating applicable government prices and the judgments involved in making these calculations involve subjective decisions and complex methodologies, these calculations are subject to risk of errors and differing interpretations. In addition, they are subject to review and challenge by the applicable governmental agencies, or potential qui tam complaints, and it is possible that such reviews could result in changes, recalculations, or defense costs that may have adverse legal or financial consequences. It is possible that governmental authorities will conclude that our business practices may not comply with current or future statutes, regulations or case law involving applicable fraud and abuse or other healthcare laws and regulations. If our operations are found to be in violation of any of these laws or any other governmental regulations that may apply to us, we may be subject to significant civil, criminal and administrative penalties, damages, fines, imprisonment, exclusion of products from government funded healthcare programs, such as Medicare and Medicaid, and the curtailment or restructuring of our operations, any of which could materially adversely affect our business and would result in increased costs and diversion of management attention and could negatively impact the development, regulatory approval and commercialization of Auryxia or vadadustat, any of which could have a material adverse effect on our business. Further, if any of the physicians or other healthcare providers or entities with whom we expect to do business is found to be not in compliance with applicable laws, they may be subject to criminal, civil or administrative sanctions, including exclusions from participation in government funded healthcare programs.\\nWe will incur significant liability if it is determined that we are promoting any “off-label” use of Auryxia or any other product we may develop, in-license or acquire or if it is determined that any of our activities violates the federal Anti-Kickback Statute.\\nPhysicians are permitted to prescribe drug products for uses that differ from those approved by the FDA or other applicable regulatory agencies. Although the FDA and other regulatory agencies do not regulate a physician’s choice of treatments, the FDA and other regulatory agencies do restrict manufacturer communications regarding unapproved uses of an approved drug. Companies are not permitted to promote drugs for unapproved uses or in a manner that is inconsistent with the FDA-approved labeling. There are also restrictions about making comparative or superiority claims based on safety or efficacy that are not supported by substantial evidence. Accordingly, we may not promote Auryxia in the United States for use in any indications other than the Hyperphosphatemia Indication and the IDA Indication, and all promotional claims must be consistent with the FDA-approved labeling for Auryxia.\\nPromoting a drug off-label is a violation of the FDCA and can give rise to liability under the federal False Claims Act, as well as under additional federal and state laws and insurance statutes. The FDA, the Department of Justice and other regulatory and enforcement authorities enforce laws and regulations prohibiting promotion of off-label uses and the promotion of products for which marketing approval has not been obtained, as well as the false advertising or misleading promotion of drugs. In September 2021, the FDA published final regulations which describe the types of evidence that the agency will consider in determining the intended use of a drug product. In addition, laws and regulations govern the distribution and tracing of prescription drugs and prescription drug samples, including the Prescription Drug Marketing Act of 1976 and the Drug Supply Chain Security Act, which regulate the distribution and tracing of prescription drugs and prescription drug samples at the federal level and set minimum standards for the regulation of drug distributors by the states. A company that is found to have improperly promoted off-label uses or to have otherwise engaged in false or misleading promotion or improper distribution of\\n80\\ndrugs will be subject to significant liability, potentially including civil and administrative remedies as well as criminal sanctions. It may also be subject to exclusion and debarment from federal healthcare reimbursement programs.\\nNotwithstanding the regulatory restrictions on off-label promotion, the FDA and other regulatory authorities allow companies to engage in truthful, non-misleading, and non-promotional scientific communications concerning their products in certain circumstances. In addition, under some relatively recent guidance from the FDA, companies may also promote information that is consistent with the prescribing information and proactively speak to formulary committee members of payors regarding data for an unapproved drug or unapproved uses of an approved drug. We intend to engage in these discussions and communicate with healthcare providers, payors and other constituencies in compliance with all applicable laws, regulatory guidance and industry best practices. Although we believe we have put in place a robust compliance program and processes designed to ensure that all such activities are performed in a legal and compliant manner, such program and processes may not be sufficient to deter or detect all violations.\\nIn addition, if a company’s activities are determined to have violated the federal Anti-Kickback Statute, this can also give rise to liability under the federal False Claims Act and such violations can result in significant fines, criminal and civil remedies, and exclusion from Medicare and Medicaid. There is increased government focus on relationships between the pharmaceutical industry and physicians, pharmacies (especially specialty pharmacies), and other sources of referrals. Common industry activities, such as speaker programs, insurance assistance and support, relationships with foundations providing copayment assistance, and relationships with patient organizations and patients are receiving increased governmental attention. If any of our relationships or activities is determined to violate applicable federal and state anti-kickback laws, false claims laws, or other laws or regulations, the company and/or company executives, employees, and other representatives could be subject to significant fines and criminal sanctions, imprisonment, and potential exclusion from Medicare and Medicaid, and could harm our reputation or result in significant legal expenses and distraction of management.\\nDisruptions in the FDA, regulatory authorities outside the U.S. and other government agencies caused by global health concerns or funding shortages could prevent new products and services from being developed or commercialized in a timely manner, which could negatively impact our business.\\nThe ability of the FDA and regulatory authorities outside the U.S. to review and approve new products can be affected by a variety of factors, including global health concerns, government budget and funding levels, staffing shortages, statutory, regulatory, and policy changes and other events that may otherwise affect the FDA’s or other regulatory authorities' ability to perform routine functions. Average review times at the FDA have fluctuated in recent years as a result of certain of these factors. In addition, government funding of other government agencies that fund research and development activities is subject to the political process, which is inherently fluid and unpredictable. Disruptions at the FDA and other agencies may increase the time necessary for new drugs to be reviewed or approved by necessary government agencies, which would adversely affect our business. If a prolonged government shutdown occurs, it could significantly impact the ability of the FDA or other regulatory authorities to timely review and process our, or our collaboration partners', regulatory submissions, which could have a material adverse effect on our business.\\nIn response to the COVID-19 pandemic, a number of companies in 2020 and 2021 announced receipt of complete response letters due to the FDA’s inability to complete required inspections for their applications. Following a period of false starts, and temporary suspensions due to the omicron variant, the FDA announced on February 2, 2022 that it would resume domestic inspections beginning on February 7, 2022, and indicated that it would conduct foreign inspections beginning in April 2022 on a prioritized basis. However, the FDA may not be able to continue its current pace and review timelines could be extended, including where a pre-approval inspection or an inspection of clinical sites is required and due to the ongoing COVID-19 pandemic and travel restrictions, the FDA is unable to complete such required inspections during the review period. Regulatory authorities outside the United States may also impose similar restrictions or other policy measures in response to the COVID-19 pandemic. If a prolonged government shutdown occurs, or if global health concerns continue to prevent the FDA or other regulatory authorities from conducting their regular inspections, reviews, or other regulatory activities, it could significantly impact the ability of the FDA or other regulatory authorities to timely review and process our regulatory submissions, which could have a material adverse effect on our business.\\nCompliance with privacy and data security requirements could result in additional costs and liabilities to us or inhibit our ability to collect and process data globally, and the failure to comply with such requirements could subject us to significant fines and penalties, which may have a material adverse effect on our business, financial condition or results of operations.\\nThe regulatory framework for the collection, use, safeguarding, sharing, transfer and other processing of information worldwide is rapidly evolving and is likely to remain uncertain for the foreseeable future. Globally, virtually every jurisdiction in which we operate has established its own data security and privacy frameworks with which we must comply. For example, the collection, use, disclosure, transfer, or other processing of personal data regarding individuals in the EU, including personal health data, is subject to the GDPR, which took effect across all member states of the European Economic Area, or EEA, in May 2018.\\n81\\nFollowing the withdrawal of the U.K. from the EU, the U.K. Data Protection Act 2018 applies to the processing of personal data that takes place in the U.K. and includes parallel obligations to those set forth by GDPR. The GDPR is wide-ranging in scope and imposes numerous requirements on companies that process personal data when required, including requirements relating to processing health and other sensitive data, obtaining consent of the individuals to whom the personal data relates, when required, providing information to individuals regarding data processing activities, implementing safeguards to protect the security and confidentiality of personal data, providing notification of data breaches, and taking certain measures when engaging third party processors. The GDPR increases our obligations as a sponsor in clinical trials in the EEA by expanding the definition of personal data to include coded data and requiring changes to informed consent practices and more detailed notices for clinical trial patients and investigators. In addition, the GDPR also imposes strict rules on the transfer of personal data to countries outside the EU, including the United States and, as a result, increases the scrutiny that we should apply to transfers of personal data from such sites to countries that are considered to lack an adequate level of data protection, such as the United States. The GDPR also permits data protection authorities to require destruction of improperly gathered or used personal information and/or impose substantial fines for violations of the GDPR, which can be up to four percent of global revenues or 20 million Euros, whichever is greater, and it also confers a private right of action on data subjects and consumer associations to lodge complaints with supervisory authorities, seek judicial remedies, and obtain compensation for damages resulting from violations of the GDPR. In addition, the GDPR provides that EU member states may make their own further laws and regulations limiting the processing of personal data, including genetic, biometric or health data and permits EU member states to adopt further penalties for violations that are not subject to the administrative fines outlined in the GDPR.\\nGiven the breadth and depth of changes in data protection obligations, complying with the GDPR’s requirements is rigorous and time intensive and requires significant resources and a review of our technologies, systems and practices, as well as those of any third party collaborators, service providers, contractors or consultants that process or transfer personal data collected in the EU. The GDPR and other changes in laws or regulations associated with the enhanced protection of certain types of sensitive data, such as healthcare data or other personal information from our clinical trials, could require us to change our business practices and put in place additional compliance mechanisms, may interrupt or delay our development, regulatory and commercialization activities and increase our cost of doing business, and could lead to government enforcement actions, private litigation and significant fines and penalties against us and could have a material adverse effect on our business, financial condition or results of operations.\\nSimilar privacy and data security requirements are either in place or underway in the United States. There are a broad variety of data protection laws that may be applicable to our activities, and a range of enforcement agencies at both the state and federal levels that can review companies for privacy and data security concerns. The Federal Trade Commission and state Attorneys General all are aggressive in reviewing privacy and data security protections for consumers. New laws also are being considered at both the state and federal levels. For example, the CCPA, which went into effect on January 1, 2020, and the CPRA, which amends CCPA by expanding the scope and applicability, while also introducing new privacy protections, is creating similar risks and obligations as those created by GDPR. Because of this, we may need to engage in additional activities (e.g., data mapping) to identify the personal information we are collecting and the purposes for which such information is collected. In addition, we will need to ensure that our policies recognize the rights granted to consumers (as that phrase is broadly defined in the CCPA and can include business contact information). Many other states are considering similar legislation. A broad range of legislative measures also have been introduced at the federal level. Accordingly, failure to comply with current and any future federal and state laws regarding privacy and security of personal information could expose us to fines and penalties. We also face a threat of potential consumer class actions related to these laws and the overall protection of personal data. Even if we are not determined to have violated these laws, investigations into these issues typically require the expenditure of significant resources and generate negative publicity, which could harm our reputation and our business.\\nLegislative and regulatory healthcare reform may increase the difficulty and cost for us to obtain marketing approval of and commercialize our product candidates and affect the prices we may obtain for any products that are approved in the United States or foreign jurisdictions.\\nIn the United States and some foreign jurisdictions, there have been a number of legislative and regulatory changes and proposed changes regarding the healthcare system that could prevent or delay marketing approval of vadadustat, or any other product candidate, restrict or regulate post-approval activities and affect our ability to profitably sell Auryxia and vadadustat, if approved. The pharmaceutical industry has been a particular focus of these efforts and has been significantly affected by legislative initiatives. Current laws, as well as other healthcare reform measures that may be adopted in the future, may result in more rigorous coverage criteria and in additional downward pressure on the price that we receive for any FDA approved product, such as Auryxia or vadadustat, if approved, or any reimbursement that physicians receive for administering any approved product.\\nIn the United States, the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, or the MMA, changed the way Medicare covers and pays for pharmaceutical products. The legislation expanded Medicare coverage for drug purchases by the elderly and introduced a new reimbursement methodology based on average sales prices for physician-administered drugs. In addition, this legislation provided authority for limiting the number of drugs that will be covered in any therapeutic class. Cost reduction initiatives and other provisions of this legislation could decrease the coverage and price that we receive for Auryxia and any other approved products. While the MMA applies only to drug benefits for Medicare beneficiaries, private\\n82\\npayors often follow Medicare coverage policy and payment limitations in setting their own reimbursement rates. Therefore, any reduction in reimbursement that results from the MMA may result in a similar reduction in payments from private payors.\\nIn March 2010, President Obama signed into law the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act of 2010, or, collectively, the ACA. Among the provisions of the ACA of potential importance to our business including, without limitation, our ability to commercialize and the prices we obtain for Auryxia and may obtain for any of our product candidates that are approved for sale, are the following:\\n•an annual, non-deductible fee on any entity that manufactures or imports specified branded prescription drugs and biologic agents;\\n•an increase in the statutory minimum rebates a manufacturer must pay under the Medicaid Drug Rebate Program;\\n•expansion of healthcare fraud and abuse laws, including the civil False Claims Act and the federal anti-kickback statute, new government investigative powers and enhanced penalties for noncompliance;\\n•a new Medicare Part D coverage gap discount program, in which manufacturers must agree to offer 70% point-of-sale discounts off negotiated prices;\\n•extension of manufacturers’ Medicaid rebate liability;\\n•expansion of eligibility criteria for Medicaid programs;\\n•expansion of the entities eligible for discounts under the Public Health Service pharmaceutical pricing program;\\n•new requirements to report certain financial arrangements with physicians and teaching hospitals;\\n•a new requirement to annually report drug samples that manufacturers and distributors provide to physicians; and\\n•a new Patient-Centered Outcomes Research Institute to oversee, identify priorities in, and conduct comparative clinical effectiveness research, along with funding for such research.\\nIn addition, other legislative changes and regulatory have been proposed and adopted since the ACA was enacted. These changes include the Budget Control Act of 2011, which, among other things, led to aggregate reductions to Medicare payments to providers of up to 2% per fiscal year, which will remain in effect through 2031. However, pursuant to the Coronavirus Aid, Relief, and Economic Security Act, or the CARES Act, and subsequent legislation, these Medicare sequester reductions were suspended and reduced through the end of June 2022 but with the full 2% cut resuming as of July 1, 2022. The American Taxpayer Relief Act of 2012, which, among other things, reduced Medicare payments to several types of providers and increased the statute of limitations period for the government to recover overpayments to providers from three to five years. In addition, other legislative and regulatory changes have been proposed, but not yet adopted. For example, in July 2019, HHS proposed regulatory changes in kidney health policy and reimbursement. Any new legislative or regulatory changes may result in additional reductions in Medicare and other healthcare funding and otherwise affect the prices we may obtain for Auryxia or vadadustat, if approved, or the frequency with which Auryxia and vadadustat, if approved, is prescribed or used.\\nThe costs and prices of prescription pharmaceuticals have also been the subject of considerable discussion in the United States. To date, there have been several recent U.S. congressional inquiries and proposed and enacted state and federal legislation designed to, among other things, bring more transparency to drug pricing, review the relationship between pricing and manufacturer patient programs, reduce the costs of drugs under Medicare and reform government program reimbursement methodologies for drug products. At the federal level, Congress and the current administration have each indicated that it will continue to seek new legislative and/or administrative measures to control drug costs.\\nFor example, the former administration issued several executive orders intended to lower the costs of prescription products and certain provisions in these orders have been incorporated into regulations. These regulations include an interim final rule implementing a most favored nation model for prices that would tie Medicare Part B payments for certain physician-administered pharmaceuticals to the lowest price paid in other economically advanced countries, effective January 1, 2021. That rule, however, has been subject to a nationwide preliminary injunction and, on December 29, 2021, CMS issued a final rule to rescind it. With issuance of this rule, CMS stated that it will explore all options to incorporate value into payments for Medicare Part B pharmaceuticals and improve beneficiaries' access to evidence-based care.\\nAt the same time, the administration may seek to limit Medicare Part D and public option drug prices through a tax penalty on manufacturers for increases in the cost of drugs and biologics above the general inflation rate. The American Rescue Plan Act of 2021, comprehensive COVID-19 pandemic relief legislation recently enacted under the current administration, includes a number of healthcare-related provisions, such as support to rural health care providers, increased tax subsidies for health insurance purchased through insurance exchange marketplaces, financial incentives to states to expand Medicaid programs and elimination of the Medicaid drug rebate cap effective in 2024.\\nFurther, on July 9, 2021, the current administration signed Executive Order 14063, which focuses on, among other things, the price of pharmaceuticals. The Order directs HHS to create a plan within 45 days to combat “excessive pricing of prescription pharmaceuticals and enhance domestic pharmaceutical supply chains, to reduce the prices paid by the federal government for such pharmaceuticals, and to address the recurrent problem of price gouging.” On September 9, 2021, HHS released its plan to reduce pharmaceutical prices. The key features of that plan are to: (a) make pharmaceutical prices more affordable and\\n83\\nequitable for all consumers and throughout the health care system by supporting pharmaceutical price negotiations with manufacturers; (b) improve and promote competition throughout the prescription pharmaceutical industry by supporting market changes that strengthen supply chains, promote biosimilars and generic drugs, and increase transparency; and (c) foster scientific innovation to promote better healthcare and improve health by supporting public and private research and making sure that market incentives promote discovery of valuable and accessible new treatments.\\nMore recently, with passage of the Inflation Reduction Act in August 2022, Congress authorized Medicare beginning in 2026 to negotiate lower prices for certain costly single-source drug and biologic products that do not have competing generics or biosimilars. This provision is limited in terms of the number of pharmaceuticals whose prices can be negotiated in any given year and it only applies to drug products that have been approved for at least nine years and biologics that have been licensed for 13 years. Drugs and biologics that have been approved for a single rare disease or condition are categorically excluded from price negotiation. Further, the new legislation provides that, effective October 1, 2022, if pharmaceutical companies raise commercial prices faster than the rate of inflation, they must pay rebates back to the government for the difference. The new law also caps Medicare out-of-pocket drug costs at an estimated $4,000 a year in 2024 and, thereafter beginning in 2025, at $2,000 a year.\\nAt the state level, individual states are increasingly aggressive in passing legislation and implementing regulations designed to control pharmaceutical and biological product pricing, including price or patient reimbursement constraints, discounts, restrictions on certain product access, marketing cost disclosure and transparency measures, and, in some cases, designed to encourage importation from other countries and bulk purchasing. A number of states, for example, require drug manufacturers and other entities in the drug supply chain, including health carriers, pharmacy benefit managers, wholesale distributors, to disclose information about pricing of pharmaceuticals. In addition, regional healthcare authorities and individual hospitals are increasingly using bidding procedures to determine what pharmaceutical products and which suppliers will be included in their prescription drug and other healthcare programs. These measures could reduce the ultimate demand for our products or put pressure on our product pricing.\\nIt is likely that federal and state legislatures within the United States and foreign governments will continue to consider changes to existing healthcare legislation. We expect that additional state and federal healthcare reform measures will be adopted in the future, any of which could limit the amounts that federal and state governments will pay for healthcare products and services, which could result in reduced demand for Auryxia and any product candidates for which we receive marketing approval or additional pricing pressures. We cannot predict the reform initiatives that may be adopted in the future or whether initiatives that have been adopted will be repealed or modified. The continuing efforts of the government, insurance companies, managed care organizations and other payors of healthcare services to contain or reduce costs of healthcare may adversely affect:\\n•the demand for Auryxia and any products candidates for which we receive marketing approval;\\n•our ability to set a price that we believe is fair for our products;\\n•our ability to obtain and maintain coverage and reimbursement approval for Auryxia or any other approved product;\\n•our ability to generate revenues and achieve or maintain profitability; and\\n•the level of taxes that we are required to pay.\\nIn addition, in some countries, including member states of the EU the pricing of prescription pharmaceuticals is subject to governmental control. In these countries, pricing negotiations with governmental authorities can take a significant amount of time after receipt of marketing approval for a product. In addition, there can be considerable pressure by governments and other stakeholders on prices and reimbursement levels, including as part of cost containment measures. Political, economic and regulatory developments may further complicate pricing negotiations, and pricing negotiations may continue after reimbursement has been obtained. Reference pricing used by various EU member states and parallel distribution, or arbitrage between low-priced and high-priced member states, can further reduce prices, and in certain instances render commercialization in certain markets infeasible or disadvantageous from a financial perspective. In some countries, we or our collaborators may be required to conduct a clinical trial or other studies that compare the cost-effectiveness of our product and/or our product candidates to other available products in order to obtain or maintain reimbursement or pricing approval. Publication of discounts by third party payors or government authorities may lead to further pressure on the prices or reimbursement levels. If reimbursement of our products is unavailable or limited in scope or amount, or if pricing is set at unsatisfactory levels, the commercial launch of our product and/or product candidates could be delayed, possibly for lengthy periods of time, we or our collaborators may not launch at all in a particular country, we may not be able to recoup our investment in one or more product candidates, and there could be a material adverse effect on our business.\\nIf we fail to comply with environmental, health and safety laws and regulations, we could become subject to fines or penalties or incur costs that could harm our business.\\nWe are subject to numerous environmental, health and safety laws and regulations, including those governing laboratory procedures and the handling, use, storage, treatment and disposal of hazardous materials and wastes. Our operations involve the use of hazardous and flammable materials, including chemicals and biological materials. Our operations also produce hazardous\\n84\\nwaste products. We generally contract with third parties for the use and disposal of these materials and wastes. We cannot eliminate the risk of contamination or injury from these materials. In the event of contamination or injury resulting from the use of hazardous materials by our employees, contractors or consultants, we could be held liable for any resulting damages, and any liability could exceed our resources. We also could incur significant costs associated with civil or criminal fines and penalties for failure to comply with such laws and regulations.\\nAlthough we maintain workers’ compensation insurance to cover us for costs and expenses, we may incur due to injuries to our employees resulting from the use of hazardous materials, this insurance may not provide adequate coverage against potential liabilities. We do not maintain insurance for environmental liability or toxic tort claims that may be asserted against us in connection with our storage or disposal of biological, hazardous or radioactive materials.\\nIn addition, we may incur substantial costs in order to comply with current or future environmental, health and safety laws and regulations. These current or future laws and regulations may impair our research, development or production efforts. Our failure to comply with these laws and regulations also may result in substantial fines, penalties or other sanctions.\\nRisks Related to our Reliance on Third Parties\\nWe depend on collaborations with third parties for the development and commercialization of Auryxia, Riona, Vafseo and vadadustat and if these collaborations are not successful or if our collaborators terminate their agreements with us, we may not be able to capitalize on the market potential of Auryxia, Riona, Vafseo and vadadustat, and our business could be materially harmed.\\nWe sublicensed the rights to commercialize Riona to JT and Torii in Japan. We also entered into a collaboration agreement with MTPC to develop and commercialize vadadustat in Japan and certain other Asian countries. In addition, we entered into the Vifor Second Amended Agreement pursuant to which we granted Vifor Pharma an exclusive license to sell vadadustat to the Supply Group in the United States. We may form or seek other strategic alliances, joint ventures, or collaborations, or enter into additional licensing arrangements with third parties that we believe will complement or augment our and our partners' commercialization efforts with respect to Auryxia, Riona, Vafseo and our and our partners' development and, if approved, commercialization efforts with respect to vadadustat and any other product candidates. We may not be able to maintain our collaborations for development and commercialization. For example, on May 13, 2022, Otsuka elected to terminate our collaboration agreements with them, and we subsequently negotiated the Termination Agreement with Otsuka. This termination by Otsuka may make it difficult for us to attract a new collaborator or adversely affect how we are perceived in scientific and financial communities. We plan to pursue a new partner to develop and commercialize vadadustat in Europe and other territories previously licensed to Otsuka. If we are unsuccessful in entering into such agreements or arrangements in a timely manner, or at all, it may result in a need for additional capital and expansion of our internal capabilities to pursue further development or commercialization of the applicable products and product candidates, particularly the development and commercialization of vadadustat in the United States, Europe, China and certain other territories.\\nIn addition, our current and any future collaborations may not be successful due to a number of important factors, including the following:\\n•collaborators may have significant discretion in determining the efforts and resources that they will apply to these collaborations;\\n•collaborations may be terminated in accordance with the terms of the collaboration agreements and, if terminated, may make it difficult for us to attract new collaborators or adversely affect how we are perceived in scientific and financial communities, and may result in a need for additional capital and expansion of our internal capabilities to pursue further development or commercialization of the applicable products and product candidates;\\n•if permitted by the terms of the collaboration agreements, collaborators may elect not to continue or renew development or commercialization programs based on clinical trial results, changes in their strategic focus, availability of funding or other external factors such as a business combination that diverts resources or creates competing priorities;\\n•if permitted by the terms of the collaboration agreements, collaborators may delay clinical trials, provide insufficient funding for a clinical trial program, stop a clinical trial, abandon a product candidate, repeat or conduct new clinical trials or require a new formulation of a product candidate for clinical testing;\\n•a collaborator with marketing and distribution rights to our products may not commit sufficient resources to their marketing and distribution;\\n•if permitted by the terms of the collaboration agreements, we and our collaborator may have a difference of opinion regarding the development or commercialization strategy for a particular product or product candidate, and our collaborator may have ultimate decision making authority;\\n•disputes may arise between a collaborator and us that cause the delay or termination of activities related to research, development, supply or commercialization of Auryxia, Riona, Vafseo or vadadustat and any other product candidate, or that result in costly litigation or arbitration that diverts management attention and resources;\\n85\\n•collaborations may not lead to development or commercialization of products and product candidates, if approved, in the most efficient manner or at all;\\n•a significant change in the senior management team, a change in the financial condition or a change in the business operations, including a change in control or internal corporate restructuring, of any of our collaborators, could result in delayed timelines, re-prioritization of our programs, decreasing resources or funding allocated to support our programs, or termination of the collaborations; and\\n•collaborators may not comply with all applicable regulatory and legal requirements.\\nIf any of these events occurs, the market potential of Auryxia, Riona, Vafseo and vadadustat, if and where approved, and any other products or product candidates, could be reduced, and our business could be materially harmed. Collaborations may also divert resources, including the attention of management and other employees, from other parts of our business, which could have an adverse effect on other parts of our business, and we cannot be certain that the benefits of the collaboration will outweigh the potential risks.\\nWe may seek to establish additional collaborations and, if we are not able to establish them on commercially reasonable terms, or at all, we may have to alter our development and commercialization plans.\\nWe will require substantial additional cash to fund the continued commercialization of Auryxia and the development and potential commercialization of any of our product candidates, including vadadustat, if approved, especially following the termination of our collaboration agreements with Otsuka. We may decide to enter into additional collaborations for the development and commercialization of vadadustat or Auryxia, both within and outside of the United States. For example, we plan to pursue a new partner to develop and commercialize vadadustat in Europe and other territories previously licensed to Otsuka. Any of these relationships may require us to incur non-recurring and other charges, increase our near and long-term expenditures, issue securities that dilute our existing stockholders, divert management’s attention, or disrupt our business.\\nWe may not be successful in entering into additional collaborations as a result of many factors, including the following:\\n•competition in seeking appropriate collaborators;\\n•a reduced number of potential collaborators due to recent business combinations in the pharmaceutical industry;\\n•an inability to negotiate collaborations on acceptable terms, on a timely basis or at all;\\n•any international rules, regulations, guidance, laws, risks or uncertainties with respect to potential partners outside of the United States;\\n•a potential collaborator’s evaluation of Auryxia, vadadustat or any other product or product candidate may differ substantially from ours;\\n•a potential collaborator’s evaluation of our financial stability and resources;\\n•a potential collaborator’s resources and expertise; and\\n•restrictions due to an existing collaboration agreement.\\nIf we are unable to enter into additional collaborations in a timely manner, or at all, we may have to delay or curtail the commercialization of Auryxia or vadadustat, if and where approved, reduce or delay its development program or other of our other development programs, or increase our expenditures and undertake additional development or commercialization activities at our own expense. If we elect to increase our expenditures to fund development or commercialization activities on our own, we may need to obtain additional capital, which may not be available to us on acceptable terms or at all. If we do not have sufficient funds, we may not be able to further develop or commercialize Auryxia or vadadustat, if approved.\\nEven if we enter into additional collaboration agreements and strategic partnerships or license our intellectual property, we may not be able to maintain them or they may be unsuccessful, which could delay our timelines or otherwise adversely affect our business.\\nRoyalties from commercial sales of vadadustat under our MTPC Agreement will likely fluctuate and will impact our rights to receive future payments under our Royalty Agreement with HCR.\\nPursuant to the Royalty Agreement with HCR, we sold to HCR our right to receive the Royalty Interest Payments payable to us under the MTPC Agreement, subject to the Annual Cap and the Aggregate Cap. After HCR receives Royalty Interest Payments equal to the Annual Cap in a given calendar year, we will receive 85% of the Royalty Interest Payments for the remainder of that year. After HCR receives Royalty Interest Payments equal to the Aggregate Cap, or we pay the Aggregate Cap to HCR (net of the Royalty Interest Payments already received by HCR), the Royalty Interest Payments will revert back to us, and HCR would have no further right to any Royalty Interest Payments. We received $44.8 million from HCR (net of certain transaction expenses) under the Royalty Agreement, and we are eligible to receive up to an additional $15.0 million under the Royalty\\n86\\nAgreement if specified sales milestones are achieved for vadadustat in the territory covered by the MTPC Agreement, subject to the satisfaction of certain customary conditions.\\nThe royalty revenues under the MTPC Agreement may fluctuate considerably because they depend upon, among other things, the rate of growth of sales of vadadustat in the territory covered by the MTPC Agreement. Negative fluctuations in these royalty revenues could delay, diminish or eliminate our right to receive up to the additional $15.0 million under the Royalty Agreement upon achievement of the specified sales milestones, our ability to receive 85% of the Royalty Interest Payments after the Annual Cap is achieved in a given calendar year, or our ability to receive 100% of the Royalty Interest Payments after the Aggregate Cap is achieved.\\nWe rely upon third parties to conduct all aspects of our product manufacturing and the loss of these manufacturers, their failure to supply us on a timely basis, or at all, or their failure to successfully carry out their contractual duties or comply with regulatory requirements, cGMP requirements, or guidance could cause delays in or disruptions to our supply chain and substantially harm our business.\\nWe do not have any manufacturing facilities and do not expect to independently manufacture any product or product candidates. We currently rely, and expect to continue to rely, on third party manufacturers to produce all of our commercial, clinical and preclinical supply, including the vadadustat drug product that we supply to our collaboration partner, MTPC, for the Japanese market. Our reliance on third party manufacturers, who have control over the manufacturing process, increases the risk that we will not have or be able to maintain sufficient quantities of Auryxia and vadadustat or the ability to obtain such quantities at an acceptable cost or quality, which could delay, prevent or impair our and our partners' development or commercialization efforts.\\nWe currently have two suppliers of Auryxia drug substance, Siegfried Evionnaz SA (two approved sites) and BioVectra Inc. (one approved site), and one supplier of Auryxia drug product, Patheon Inc., or Patheon (three approved sites, two of which are active). However, our supply agreement with Siegfried Evionnaz SA expires on December 31, 2022, at which time we will only have one supplier for Auryxia drug substance. We have entered into supply agreements with Esteve Química, S.A. and STA Pharmaceutical Hong Kong Limited, a subsidiary of Wuxi AppTec, or STA, for the commercial manufacture of vadadustat drug substance and Patheon Inc. and STA for the commercial manufacture of vadadustat drug product. If any of the following occurs, we may not have sufficient quantities of Auryxia and/or vadadustat to support our clinical trials, development, commercialization, or obtaining and maintaining marketing approvals, which could materially and adversely impact our business and results of operations:\\n•we are unsuccessful in maintaining our current supply arrangements for commercial quantities of Auryxia and vadadustat;\\n•our commercial supply arrangements for Auryxia or vadadustat are terminated;\\n•any of our third party manufacturers are unable to fulfill the terms of their agreements with us, including with respect to quality and quantity, or are unable or unwilling to continue to manufacture on the manufacturing lines included in our regulatory filings; or\\n•any of our third party manufacturers breach our supply agreements, do not comply with quality or regulatory requirements and guidance, including cGMP or are subject to regulatory review or ceases their operations for any reason.\\nIf any of our third party manufacturers cannot or do not perform as agreed or expected, including as a result of the COVID-19 pandemic, if they misappropriate our proprietary information, if they terminate their engagements with us, if we terminate our engagements with them, or if there is a significant disagreement, we may be forced to manufacture the materials ourselves, for which we currently do not have the capabilities or resources, or enter into agreements with other third party manufacturers, which we may not be able to do in a timely manner or on favorable or reasonable terms, if at all. For example, one of our manufacturers has notified us that it will be discontinuing operations at one site at a future date. In some cases, there may be a limited number of qualified replacement manufacturers, or the technical skills or equipment required to manufacture a product or product candidate may be unique or proprietary to the original manufacturer and we may have difficulty transferring such skills or technology to another third party, or a feasible alternative may not exist. These factors would increase our reliance on our current manufacturers or require us to obtain necessary regulatory approvals and licenses in order to have another third party manufacture Auryxia or vadadustat. If we are required to change manufacturers for any reason, we will be required to verify that the new manufacturer maintains facilities and procedures that comply with quality standards and with all applicable regulations and guidelines. The delays associated with the qualification of a new manufacturer and validation of manufacturing processes would negatively affect our ability to supply clinical trials, obtain and maintain marketing approval, or commercialize or satisfy patient demand for Auryxia and vadadustat, where approved, in a timely manner within budget or at all.\\n87\\nIn addition, the cost of obtaining Auryxia and vadadustat is subject to adjustment based on our third party manufacturers’ costs of obtaining raw materials and producing the product. We have limited control over the production of Auryxia and vadadustat, including the costs of raw materials, and any significant increase in the cost of obtaining our products could materially adversely affect our revenue for Auryxia and vadadustat, if approved.\\nMoreover, issues that may arise in any scale-up and technology transfer and continued commercial scale manufacture of our products may lead to significant delays in our development, marketing approval and commercial timelines and negatively impact our financial performance. For example, a production-related issue resulted in an interruption in the supply of Auryxia in the third and fourth quarters of 2016. This supply interruption negatively impacted Keryx’s revenues in 2016. This supply interruption was resolved, and we have taken and continue to take actions designed to prevent future interruptions in the supply of Auryxia. However, we recently experienced issues in manufacturing Auryxia, and if we continue to experience manufacturing issues or our actions to prevent future interruptions are not successful, we may experience additional supply issues. Any future supply interruptions, whether quality or quantity based, for Auryxia or vadadustat, if and where approved, would negatively and materially impact our reputation and financial condition.\\nThere are a limited number of manufacturers that are capable of manufacturing Auryxia and vadadustat for us and complying with cGMP regulations and guidance and other stringent regulatory requirements and guidance enforced by the FDA, EMA, PMDA and other regulatory authorities. These requirements include, among other things, quality control, quality assurance and the maintenance of records and documentation, which occur in addition to our own quality assurance releases. The facilities and processes used by our third party manufacturers to manufacture Auryxia may be inspected by the FDA and other regulatory authorities at any time, and the facilities and processes used by our third party manufacturers to manufacture vadadustat will be inspected by the FDA, the EMA and other regulatory authorities prior to or after we submit our marketing applications. Although we have general visibility into the manufacturing processes of our third party manufacturers, we do not ultimately control such manufacturing processes of, and have little control over, our third party manufacturers, including, without limitation, their compliance with cGMP requirements and guidance for the manufacture of certain starting materials, drug substance and finished drug product. Similarly, although we review final production, we have little control over the ability of our third party manufacturers to maintain adequate quality control, quality assurance and qualified personnel. Our third party manufacturers may experience problems with their manufacturing and distribution operations and processes, including, for example, quality issues, such as product specification and stability failures, procedural deviations, improper equipment installation or operation, utility failures, contamination, natural disasters and public health epidemics. We may also encounter difficulties relating to our own quality processes and procedures, including regulatory compliance, lot release, quality control and quality assurance, as well as shortages of qualified personnel. If our third party manufacturers cannot successfully manufacture material that conforms to our specifications and regulatory requirements and guidance, or if we or our third party manufacturers experience manufacturing, operations and/or quality issues, including an inability or unwillingness to continue manufacturing our products at all, in accordance with agreed-upon processes or on currently validated manufacturing lines, we may not be able to supply patient demand or maintain marketing approval for Auryxia, secure and maintain marketing approval for vadadustat, and we might be required to expend additional resources to obtain material from other manufacturers. If any of these events occur, our reputation and financial condition would be negatively and materially impacted.\\nIf the FDA, the EMA or other regulatory authorities do not approve the facilities being used to manufacture vadadustat, or if they withdraw any approval of the facilities being used to manufacture Auryxia or vadadustat, we may need to find alternative manufacturing facilities, which would significantly impact our ability to continue commercializing Auryxia or Vafseo in Japan, or develop, obtain marketing approval for or market vadadustat or our other product candidates, if approved.\\nMoreover, our failure or the failure of our third party manufacturers to comply with applicable regulations or guidance, or our failure to oversee or facilitate such compliance, could result in sanctions being imposed on us or our third party manufacturers, including, where applicable, clinical holds, fines, injunctions, civil penalties, delays in, suspension of or withdrawal of approvals, license revocation, seizures or recalls of Auryxia or Vafseo in Japan, operating restrictions, receipt of a Form 483 or warning letter, or criminal prosecutions, any of which could significantly and adversely affect the supply of Auryxia or vadadustat. For example, we previously conducted three limited, voluntary recalls of Auryxia. These and any other recalls or any supply, quality or manufacturing issues in the future and any related write-downs of inventory or other consequences could result in significant negative consequences, including reputational harm, loss of customer confidence, and a negative impact on our financials, any of which could have a material adverse effect on our business and results of operations, and may impact our ability to supply Auryxia, Vafseo in Japan or vadadustat for clinical and commercial use. Also, if our starting materials, drug substance or drug product are damaged or lost while in our or our third party manufacturers’ control, it may adversely impact our ability to supply Auryxia or vadadustat, and we may incur significant financial harm.\\nIn addition, Auryxia and vadadustat may compete with other products and product candidates for access to third party manufacturing facilities. A third party manufacturer may also encounter delays or operational issues brought on by sudden internal resource constraints, labor disputes, shifting priorities or shifting regulatory protocols including, in each case, relating to the COVID-19 pandemic. Certain of these third party manufacturing facilities may be contractually prohibited from manufacturing Auryxia or vadadustat due to exclusivity provisions in agreements with our competitors. Any of the foregoing\\n88\\ncould negatively impact our third party manufacturers' ability to meet our demand, which could adversely impact our ability to supply Auryxia or vadadustat, and we may incur significant financial harm.\\nOur current and anticipated future dependence on third parties for the manufacture of Auryxia and vadadustat may adversely affect our and our partners' ability to commercialize Auryxia and vadadustat, where approved, on a timely and competitive basis and may reduce any future profit margins.\\nWe rely upon third parties to conduct our clinical trials and certain of our preclinical studies. If they do not successfully carry out their contractual duties, comply with regulatory requirements or meet expected deadlines, we may not be able to obtain or maintain marketing approval for Auryxia, vadadustat or any of our product candidates, and our business could be substantially harmed.\\nWe do not have the ability to independently conduct certain preclinical studies and clinical trials. We are currently relying, and expect to continue to rely, upon third parties, such as CROs, clinical data management organizations, medical institutions and clinical investigators, to conduct our current and future preclinical studies and clinical trials. The third parties upon whom we rely may fail to perform effectively, or terminate their engagement with us, for a number of reasons, including the following:\\n•if they experience staffing difficulties;\\n•if we fail to communicate effectively or provide the appropriate level of oversight;\\n•if they undergo changes in priorities or corporate structure including as a result of a merger or acquisition or other transaction, or become financially distressed; or\\n•if they form relationships with other entities, some of which may be our competitors.\\nIf the third parties upon whom we rely to conduct our trials fail to adhere to clinical trial protocols or to regulatory requirements, the quantity, quality or accuracy of the data obtained by the third parties may be compromised. We are exposed to risk of fraud or other misconduct by such third parties.\\nAny of these events could cause our preclinical studies and clinical trials, including post-approval clinical trials, to be extended, delayed, suspended, required to be repeated or terminated, or we may receive untitled warning letters or be the subject of an enforcement action, which could result in our failing to obtain and maintain marketing approval of vadadustat or any other product candidates on a timely basis, or at all, or fail to maintain marketing approval of Auryxia, or any other products, any of which would adversely affect our business operations. In addition, if the third parties upon whom we rely fail to perform effectively or terminate their engagement with us, we may need to enter into alternative arrangements, which could delay, perhaps significantly, the development and commercialization of vadadustat, if approved, or any other product candidates.\\nEven though we do not directly control the third parties upon whom we rely to conduct our preclinical studies and clinical trials and therefore cannot guarantee the satisfactory and timely performance of their obligations to us, we are nevertheless responsible for ensuring that each of our clinical trials and preclinical studies is conducted in accordance with the applicable protocol, legal and regulatory requirements, including GXP requirements, and scientific standards, and our reliance on these third parties, including CROs, will not relieve us of our regulatory responsibilities. If we or any of our CROs, their subcontractors, or clinical or preclinical trial sites fail to comply with applicable GXP requirements, the clinical data generated in our trials may be deemed unreliable or insufficient, our clinical trials could be put on hold, and/or the FDA, the EMA or other regulatory authorities may require us to perform additional clinical trials before approving our marketing applications. In addition, our clinical and preclinical trials must be conducted with drug product that meets certain specifications and is manufactured under applicable cGMP regulations. These requirements include, among other things, quality control, quality assurance, and the satisfactory maintenance of records and documentation.\\nWe also rely upon third parties to store and distribute drug product for our clinical trials. For example, we use third parties to store product at various sites in the United States to distribute to our clinical trial sites. Any performance failure on the part of our storage or distributor partners could delay clinical development, marketing approval or commercialization, resulting in additional costs and depriving us of potential product revenue.\\nIf the licensor of certain intellectual property relating to Auryxia terminates, modifies or threatens to terminate existing contracts or relationships with us, our business may be materially harmed.\\nWe do not own all of the rights to our product, Auryxia. We have licensed and sublicensed certain rights, patent and otherwise, to Auryxia from a third party, Panion & BF Biotech, Inc., or Panion, who in turn licenses certain rights to Auryxia from one of the inventors of Auryxia. The license agreement with Panion, or the Panion License Agreement, requires us to meet development milestones and imposes development and commercialization due diligence requirements on us. In addition, under the Panion License Agreement, we must pay royalties based on a mid-single digit percentage of net sales of product resulting\\n89\\nfrom the licensed technologies, including Auryxia, and pay the patent filing, prosecution and maintenance costs related to the license. If we do not meet our obligations in a timely manner, or if we otherwise breach the terms of the Panion License Agreement, Panion could terminate the agreement, and we would lose the rights to Auryxia. For example, following announcement of the Merger, Panion notified Keryx in writing that Panion would terminate the Panion License Agreement on November 21, 2018 if Keryx did not cure the breach alleged by Panion, specifically, that Keryx failed to use commercially reasonable best efforts to commercialize Auryxia outside the United States. Keryx disagreed with Panion’s claims, and the parties entered discussions to resolve this dispute. On October 24, 2018, prior to the consummation of the Merger, we, Keryx and Panion entered into a letter agreement, or the Panion Letter Agreement, pursuant to which Panion agreed to rescind any and all prior termination threats or notices relating to the Panion License Agreement and waived its rights to terminate the license agreement based on any breach by us of our obligation to use commercially reasonable efforts to commercialize Auryxia outside the United States until the parties executed an amendment to the Panion License Agreement in accordance with the terms of the Panion Letter Agreement, following consummation of the Merger. On April 17, 2019, we and Panion entered into an amendment and restatement of the Panion License Agreement, or the Panion Amended License Agreement, which reflects certain revisions consistent with the terms of the Panion Letter Agreement. See Note 4 to our consolidated financial statements in Part I, Item 1. Financial Statements of this Quarterly Report on Form 10-Q for additional information regarding the Panion Amended License Agreement. Even though we entered into the Panion Amended License Agreement, there are no assurances that Panion will not allege other breaches of the Panion Amended License Agreement or otherwise attempt to terminate the Panion Amended License Agreement in the future. In addition, if Panion breaches its agreement with the inventor from whom it licenses rights to Auryxia, Panion could lose its license, which could impair or delay our ability to develop and commercialize Auryxia.\\nFrom time to time, we may have disagreements with Panion, or Panion may have disagreements with the inventor from whom it licenses rights to Auryxia, regarding the terms of the agreements or ownership of proprietary rights, which could impact the commercialization of Auryxia, could require or result in litigation or arbitration, which would be time-consuming and expensive, could lead to the termination of the Panion Amended License Agreement, or force us to negotiate a revised or new license agreement on terms less favorable than the original. In addition, in the event that the owners and/or licensors of the rights we license were to enter into bankruptcy or similar proceedings, we could potentially lose our rights to Auryxia or our rights could otherwise be adversely affected, which could prevent us from continuing to commercialize Auryxia.\\nRisks Related to our Intellectual Property\\nIf we are unable to adequately protect our intellectual property, third parties may be able to use our intellectual property, which could adversely affect our ability to compete in the market.\\nOur commercial success will depend in part on our ability, and the ability of our licensors, to obtain and maintain patent protection on our drug product and technologies, and to successfully defend these patents against third party challenges. We seek to protect our proprietary products and technology by filing patent applications in the United States and certain foreign jurisdictions. The process for obtaining patent protection is expensive and time consuming, and we may not be able to file and prosecute all necessary or desirable patent applications in a cost effective or timely manner. In addition, we may fail to identify patentable subject matter early enough to obtain patent protection. Further, license agreements with third parties may not allow us to control the preparation, filing and prosecution of patent applications, or the maintenance or enforcement of patents. Such third parties may decide not to enforce such patents or enforce such patents without our involvement. Thus, these patent applications and patents may not, under these circumstances, be prosecuted or enforced in a manner consistent with the best interests of the company.\\nOur pending patent applications may not issue as patents and may not issue in all countries in which we develop, manufacture or potentially sell our product or in countries where others develop, manufacture and potentially sell products using our technologies. Moreover, our pending patent applications, if issued as patents, may not provide additional protection for our product.\\nThe patent positions of pharmaceutical and biotechnology companies can be highly uncertain and involve complex legal and factual questions. No consistent policy regarding the breadth of claims allowed in pharmaceutical and biotechnology patents has emerged to date. Changes in the patent laws or the interpretation of the patent laws in the United States and other jurisdictions may diminish the value of our patents or narrow the scope of our patent protection. Accordingly, the patents we own or license may not be sufficiently broad to prevent others from practicing our technologies or from developing competing products. Furthermore, others may independently develop similar or alternative drug products or technologies or design around our patented drug product and technologies which may have an adverse effect on our business. If our competitors prepare and file patent applications in the United States that claim technology also claimed by us, we may have to participate in interference or derivation proceedings in front of the U.S. Patent and Trademark Office, or USPTO, to determine priority of invention, which could result in substantial cost, even if the eventual outcome is favorable to us. Because of the extensive time required for development, testing and regulatory review of a potential product, it is possible that any related patent may expire prior to, or\\n90\\nremain in existence for only a short period following, commercialization, which may significantly diminish our ability to exclude others from commercializing products that are similar or identical to ours. The patents we own or license may be challenged or invalidated or may fail to provide us with any competitive advantage. Since we have licensed or sublicensed many patents from third parties, we may not be able to enforce such licensed patents against third party infringers without the cooperation of the patent owner and the licensor, which may not be forthcoming. In addition, we may not be successful or timely in obtaining any patents for which we submit applications.\\nGenerally, the first to file a patent application is entitled to the patent if all other requirements of patentability are met. However, prior to March 16, 2013, in the United States, the first to invent was entitled to the patent. Since publications of discoveries in the scientific literature often lag behind the actual discoveries, and patent applications in the United States and other jurisdictions are typically not published until 18 months after filing, or in some cases not at all, we cannot know with certainty whether we were the first to make the inventions claimed in our patents or pending patent applications, or that we were the first to file for patent protection of such inventions. Moreover, the laws enacted by the Leahy-Smith America Invents Act of 2011, which reformed certain patent laws in the United States, introduce procedures that permit competitors to challenge our patents in the USPTO after grant, including inter partes review and post grant review. Similar laws exist outside of the United States. The laws of the European Patent Convention, for example, provide for post-grant opposition procedures that permit competitors to challenge, or oppose, our European patents administratively at the European Patent Office.\\nWe may become involved in addressing patentability objections based on third party submission of references, or we may become involved in defending our patent rights in oppositions, derivation proceedings, reexamination, inter partes review, post grant review, interference proceedings or other patent office proceedings or litigation, in the United States or elsewhere, challenging our patent rights or the patent rights of others. An adverse result in any such proceeding or litigation could reduce the scope of, or invalidate, our patent rights, allow third parties to commercialize our technology or products and compete directly with us, without payment to us.\\nThe issuance of a patent is not conclusive as to its inventorship, scope, validity or enforceability, and our owned and licensed patents may be challenged on such a basis in the courts or patent offices in the United States and abroad. As a result of such challenges, we may lose exclusivity or freedom-to-operate or patent claims may be narrowed, invalidated or held unenforceable, in whole or in part, which could limit our ability to prevent third parties from using or commercializing similar or identical products, or limit the duration of the patent protection for our products.\\nPeriodic maintenance fees on any issued patent are due to be paid to the USPTO and foreign patent agencies in several stages over the lifetime of the patent. The USPTO and governmental patent agencies in other jurisdictions also require compliance with a number of procedural, documentary, fee payment (such as annuities) and other similar provisions during the patent application process. While an inadvertent lapse in many cases can be cured by payment of a late fee or by other means in accordance with the applicable rules, there are situations in which non-compliance can result in abandonment or lapse of the patent or patent application, resulting in partial or complete loss of patent rights in the relevant jurisdiction. Non-compliance events that could result in abandonment or lapse of a patent or patent application include, but are not limited to, failure to respond to official actions within prescribed time limits, non-payment of fees, and failure to properly legalize and submit formal documents. In such an event, our competitors might be able to enter the market sooner than we expect, which would have a material adverse effect on our business.\\nIn addition, patents protecting our product candidate might expire before or shortly after such candidate is commercialized. Thus, our patent portfolio may not provide sufficient rights to exclude others from commercializing products similar or identical to ours.\\nWe also rely on trade secrets and know-how to protect our intellectual property where we believe patent protection is not appropriate or obtainable. Trade secrets are difficult to protect. While we require our employees, licensees, collaborators and consultants to enter into confidentiality agreements, this may not be sufficient to adequately protect our trade secrets or other proprietary information. In addition, in some cases, we share certain ownership and publication rights to data relating to some of our products and product candidates with research collaborators, licensees and other third parties. If we cannot maintain the confidentiality of this information, our ability to receive patent protection or protect our trade secrets or other proprietary information will be at risk.\\nWe may not be able to protect our intellectual property rights throughout the world.\\nFiling, prosecuting and defending patents on our products and product candidates in all countries throughout the world would be prohibitively expensive. Consequently, the breadth of our intellectual property rights in some countries outside the United States may be less extensive than those in the United States. In addition, the laws of some countries do not protect intellectual property rights to the same extent as laws in the United States. As a result, we may not be able to prevent third parties from practicing our inventions in all countries outside the United States, or from selling or importing products made using our\\n91\\ninventions in and into the United States or other countries. Competitors may use our technologies in countries where we have not obtained patent protection to develop their own products and, further, may infringe our patents in territories where we have patent protection, but where enforcement is not as strong as in the United States. These products may compete with our products and our patents or other intellectual property rights may not be effective or sufficient to prevent them from competing.\\nMany companies have encountered significant problems in protecting and defending intellectual property rights in certain countries. The legal systems of certain countries, particularly certain developing countries, do not favor the enforcement of patents, trade secrets and other intellectual property, particularly those relating to pharmaceutical and biotechnology products, which could make it difficult for us to stop the infringement of our patents or the marketing of competing products in violation of our proprietary rights generally. Proceedings to enforce our patent rights in countries outside of the United States could result in substantial costs and divert our efforts and attention from other aspects of our business, could put our patents at risk of being invalidated or interpreted narrowly and our patent applications at risk of not issuing, and could provoke third parties to assert claims against us. We may not prevail in any lawsuits that we initiate, and the damages or other remedies awarded, if any, may not be commercially meaningful. Accordingly, our efforts to enforce our intellectual property rights around the world may be inadequate to obtain a significant commercial advantage for our products and product candidates from the intellectual property that we develop or license.\\nThe intellectual property that we own or have licensed and related non-patent exclusivity relating to our current and future products is, and may be, limited, which could adversely affect our ability to compete in the market and adversely affect the value of Auryxia.\\nThe patent rights and related non-patent exclusivity that we own or have licensed relating to Auryxia are limited in ways that may affect our ability to exclude third parties from competing against us. For example, a third party may design around our owned or licensed composition of matter patent claims or market a product for the methods of use not covered by our owned or licensed patents.\\nObtaining proof of direct infringement by a competitor for a method of use patent requires us to demonstrate that the competitors make and market a product for the patented use(s). Alternatively, we can prove that our competitors induce or contribute to others in engaging in direct infringement. Proving that a competitor contributes to or induces infringement of a patented method by another has additional proof requirements. For example, proving inducement of infringement requires proof of intent by the competitor. If we are required to defend ourselves against claims or to protect our own proprietary rights against others, it could result in substantial costs to us and the distraction of our management. An adverse ruling in any litigation or administrative proceeding could prevent us from marketing and selling Auryxia, increase the risk that a generic or other similar version of Auryxia could enter the market to compete with Auryxia, limit our development and commercialization of Auryxia, or otherwise harm our competitive position and result in additional significant costs.\\nMoreover, physicians may prescribe a competitive identical product for indications other than the one for which the product has been approved, or “off-label” indications, that are covered by the applicable patents. Although such off-label prescriptions may directly infringe or contribute to or induce infringement of method of use patents, such infringement is difficult to prevent.\\nIn addition, any limitations of our patent protection described above may adversely affect the value of our drug product and may inhibit our ability to obtain a collaboration partner at terms acceptable to us, if at all.\\nIn the United States, the FDA has the authority to grant additional regulatory exclusivity protection for approved drugs where the sponsor conducts specified testing in pediatric or adolescent populations. If granted, this pediatric exclusivity may provide an additional six months which are added to the term of any non-patent exclusivity that has been awarded as well as to the regulatory protection related to the term of a relevant patent, to the extent these protections have not already expired.\\nIn addition to pediatric exclusivity protection, we may seek additional non-patent exclusivity for vadadustat and other product candidates under other provisions of the FDCA such as new chemical entity, or NCE, exclusivity, or exclusivity for a new use or new formulation, but there is no guarantee that vadadustat or any other product candidates will receive such exclusivity. The FDCA provides a five-year period of non-patent exclusivity within the United States to the first applicant to gain approval of an NDA for an NCE. A drug is an NCE if the FDA has not previously approved any other new drug containing the same active moiety, which consists of the molecule(s) or ion(s) responsible for the action of the drug substance (but not including those portions of the molecule that cause it to be a salt or ester or which are not bound to the molecule by covalent or similar bonds). During the exclusivity period, the FDA may not accept for review an ANDA or a 505(b)(2) NDA submitted by another company for another version of such drug where the applicant does not own or have a legal right of reference to all the data required for approval. However, an ANDA or 505(b)(2).\\nAn ANDA that references an NDA product with NCE exclusivity may be submitted after four years if it contains a certification of patent invalidity or non-infringement. The FDCA also provides three years of exclusivity for an NDA, particularly a\\n92\\n505(b)(2) NDA or supplement to an existing NDA, if new clinical investigations, other than bioavailability studies, that were conducted or sponsored by the applicant are deemed by the FDA to be essential to the approval of the application (for example, for new indications, dosages, or strengths of an existing drug). This three-year exclusivity covers only the conditions associated with the new clinical investigations and does not prohibit the FDA from approving ANDAs for drugs containing the original active agent. The three-year exclusivity period, unlike five-year exclusivity, does not prevent the submission of a competing ANDA or 505(b)(2) NDA. Instead, it only prevents the FDA from granting final approval to such a product until expiration of the exclusivity period. Five-year and three-year exclusivity will not delay the submission (in the case of five-year exclusivity) or the approval (in the case of three-year exclusivity) of a full NDA submitted under section 505(b)(1) of the FDCA; however, an applicant submitting a full NDA would be required to conduct all of its own studies needed to independently support a finding of safety and effectiveness for the proposed product, or have a full right of reference to all studies not conducted by the applicant.\\nWe received Paragraph IV certification notice letters regarding ANDAs submitted to the FDA requesting approval for generic versions of Auryxia tablets (210 mg iron per tablet), with the first received on October 31, 2018. We and Panion & BF Biotech, Inc., or Panion, and, Dr. Hsu, as applicable, filed certain complaints for patent infringement relating to such ANDAs, and have entered into settlement and license agreements with each of the ANDA filers.\\nIn cases where NCE exclusivity has been granted to a new drug product, the 30-month stay triggered by such litigation is extended by the amount of time such that seven years and six months will elapse from the date of approval of the NDA for that product. Without NCE exclusivity, the 30-month stay on FDA final approval of an ANDA runs from the date on which the sponsor of the reference listed drug receives notice of a Paragraph IV certification from the ANDA applicant.\\nWe cannot assure you that Auryxia, vadadustat, if approved, or any of our potential future products will obtain such pediatric exclusivity, NCE exclusivity or any other market exclusivity in the United States, EU or any other territory, or that we will be the first to receive the respective regulatory approval for such drugs so as to be eligible for any non-patent exclusivity protection. We also cannot assure you that Auryxia, vadadustat, if approved, or any of our potential future products will obtain patent term extension.\\nThe market entry of one or more generic competitors or any third party’s attempt to challenge our intellectual property rights will likely limit Auryxia sales and have an adverse impact on our business and results of operation.\\nAlthough the composition and use of Auryxia is currently claimed by 15 issued patents that are listed in the FDA’s Orange Book, we cannot assure you that we will be successful in defending against third parties attempting to invalidate or design around our patents or assert that our patents are invalid or otherwise unenforceable or not infringed, or in competing against third parties introducing generic equivalents of Auryxia or any of our potential future products. If our Orange Book-listed patents are successfully challenged by a third party and a generic version of Auryxia is approved and launched, revenue from Auryxia could decline significantly, which would have a material adverse effect on our sales, results of operations and financial condition.\\nWe previously received Paragraph IV certification notice letters regarding ANDAs submitted to the FDA requesting approval for generic versions of Auryxia tablets (210 mg ferric iron per tablet). We filed complaints for patent infringement relating to such ANDAs, and subsequently entered into settlement and license agreements with all such ANDA filers that allow such ANDA filers to market a generic version of Auryxia in the United States beginning on March 20, 2025. It is possible that we may receive Paragraph IV certification notice letters from additional ANDA filers and may not ultimately be successful in an ANDA litigation. Generic competition for Auryxia or any of our potential future products could have a material adverse effect on our sales, results of operations and financial condition.\\nLitigation, including third party claims of intellectual property infringement, may be costly and time consuming and may delay or harm our drug discovery, development and commercialization efforts.\\nWe may be forced to initiate litigation to enforce our contractual and intellectual property rights, or we may be sued by third parties asserting claims based on contract, tort or intellectual property infringement. In addition, third parties may have or may obtain patents in the future and claim that our products or other technologies infringe their patents. If we are required to defend against suits brought by third parties, or if we sue third parties to protect our rights, we may be required to pay substantial litigation costs, and our management’s attention may be diverted from operating our business. In addition, any legal action against our licensor, licensees or us that seeks damages or an injunction of commercial activities relating to Auryxia, vadadustat or any other product candidates or other technologies, including those that may be in-licensed or acquired, could subject us to monetary liability, a temporary or permanent injunction preventing the development, marketing and sale of such products or such technologies, and/or require our licensor, licensees or us to obtain a license to continue to use such products or other technologies. We cannot predict whether our licensor, licensees or we would prevail in any of these types of actions or that any required license would be made available on commercially acceptable terms, if at all.\\n93\\nOur commercial success depends in part on our avoiding infringement of the patents and proprietary rights of third parties. The pharmaceutical and biotechnology industries are characterized by extensive litigation over patent and other intellectual property rights. We have in the past and may in the future become a party to, or be threatened with, future adversarial litigation or other proceedings regarding intellectual property rights with respect to our product and product candidates. As the pharmaceutical and biotechnology industries expand and more patents are issued, the risk increases that our drug candidates may give rise to claims of infringement of the patent rights of others.\\nWhile our product candidates are in preclinical studies and clinical trials, we believe that the use of our product candidates in these preclinical studies and clinical trials in the United States falls within the scope of the exemptions provided by 35 U.S.C. Section 271(e), which provides that it shall not be an act of infringement to make, use, offer to sell, or sell within the United States or import into the United States a patented invention solely for uses reasonably related to the development and submission of information to the FDA. There is an increased possibility of a patent infringement claim against us with respect to commercial products. Our portfolio includes one commercial product, Auryxia. We received the CRL from the FDA regarding our NDA for vadadustat in March 2022, and, if in the future vadadustat is approved, vadadustat could be commercialized. We attempt to ensure that our products and product candidates and the methods we employ to manufacture them, as well as the methods for their use which we intend to promote, do not infringe other parties’ patents and other proprietary rights. There can be no assurance they do not, however, and competitors or other parties may assert that we infringe their proprietary rights in any event.\\nFibroGen has filed patent applications in the United States and other countries directed to purportedly new methods of using previously known heterocyclic carboxamide compounds for purposes of treating or affecting specified conditions, and some of these applications have since issued as patents. To the extent any such patents issue or have been issued, we may initiate opposition or other legal proceedings with respect to such patents. We discuss the status of the opposition and/or invalidation proceedings against certain FibroGen patents in Part II, Item 1. Legal Proceedings of this Quarterly Report on Form 10-Q.\\nThere may be patents of third parties of which we are currently unaware with claims to compounds, materials, formulations, methods of manufacture or methods for treatment related to the use or manufacture of our product candidates. Also, because patent applications can take many years to issue, there may be currently pending patent applications which may later result in issued patents that our product candidates may infringe.\\nThird parties, including FibroGen, may in the future claim that our product and product candidates and other technologies infringe upon their patents and may challenge our ability to commercialize Auryxia and vadadustat, if approved. Parties making claims against us or our licensees may seek and obtain injunctive or other equitable relief, which could effectively block our or their ability to continue to commercialize Auryxia or further develop and commercialize vadadustat or any other product candidates, including those that may be in-licensed or acquired. If any third party patents were held by a court of competent jurisdiction to cover the manufacturing process of any of our products or product candidates, any molecules formed during the manufacturing process or any final product itself, the holders of any such patents may be able to block our ability to commercialize such product or product candidate unless we obtained a license under the applicable patents, or until such patents expire or they are finally determined to be held invalid or unenforceable. Similarly, if any third party patent were held by a court of competent jurisdiction to cover aspects of our formulations, processes for manufacture or our intended methods of use, the holders of any such patent may be able to block or impair our ability to develop and commercialize the applicable product candidate unless we obtained a license or until such patent expires or is finally determined to be held invalid or unenforceable. We may also elect to enter into a license in order to settle litigation or in order to resolve disputes prior to litigation. Furthermore, even in the absence of litigation, we may need to obtain licenses from third parties to advance our research or allow commercialization of our products or product candidates. Should a license to a third party patent become necessary, we cannot predict whether we would be able to obtain a license or, if a license were available, whether it would be available on commercially reasonable terms. If such a license is necessary and a license under the applicable patent is unavailable on commercially reasonable terms, or at all, our ability to commercialize our product or product candidate may be impaired or delayed, which could in turn significantly harm our business.\\nFurther, defense of infringement claims, regardless of their merit, would involve substantial litigation expense and would be a substantial diversion of employee resources from our business. In the event of a successful claim of infringement against us, we may have to pay substantial damages, including treble damages and attorneys’ fees for willful infringement, pay royalties or redesign our products, which may be impossible or require substantial time and monetary expenditure.\\nWe are currently involved in an opposition and invalidation proceedings and may in the future be involved in additional lawsuits or administrative proceedings to challenge the patents of our competitors or to protect or enforce our patents, which could be expensive, time consuming, and unsuccessful.\\n94\\nCompetitors may infringe our patents or misappropriate our trade secrets or confidential information. To counter infringement or unauthorized use, we may be required to file infringement or misappropriation claims, which can be expensive and time-consuming. We may not be able to prevent infringement of our patents or misappropriation of our trade secrets or confidential information, particularly in countries where the laws may not protect those rights as fully as in the United States. In addition, in an infringement proceeding, a court may decide that a patent of ours is not valid or is unenforceable, or may refuse to stop the other party from using the technology at issue on the grounds that our patents do not cover the technology in question. An adverse result in any litigation or defense proceedings could put one or more of our patents at risk of being invalidated, held unenforceable, or interpreted narrowly and held not infringed and could put our patent applications at risk of not issuing.\\nIn addition, there may be a challenge or dispute regarding inventorship or ownership of patents or applications currently identified as being owned by or licensed to us. Defense of these claims, regardless of their merit, would involve substantial litigation expense and would be a substantial diversion of employee resources from our business. Interference proceedings provoked by third parties or brought by the USPTO may be necessary to determine the priority of inventions with respect to our patents or patent applications.\\nVarious administrative proceedings are also available for challenging patents, including interference, reexamination, inter partes review, and post-grant review proceedings before the USPTO or oppositions and other comparable proceedings in foreign jurisdictions. An unfavorable outcome in any current or future proceeding in which we are challenging third party patents could require us to cease using the patented technology or to attempt to license rights to it from the prevailing party. Our business could be harmed if the prevailing party does not offer us a license on commercially reasonable terms or at all. Even if we are successful, participation in interference or other administrative proceedings before the USPTO or a foreign patent office may result in substantial costs and distract our management and other employees.\\nWe are currently involved in opposition and invalidation proceedings in the European Patent Office, the Japan Patent Office, and the Patents Court of the UK. These proceedings may be ongoing for a number of years and may involve substantial expense and diversion of employee resources from our business. In addition, we may become involved in additional opposition proceedings or other legal or administrative proceedings in the future. For more information, see the other risk factors under “Risks Related to our Intellectual Property”.\\nFurthermore, because of the substantial amount of discovery required in connection with intellectual property litigation and some administrative proceedings, there is a risk that some of our confidential information could be compromised by disclosure during discovery. In addition, there could be public announcements of the results of hearings, motions or other interim proceedings or developments. If securities analysts or investors perceive these results to be negative, it could have a substantial adverse effect on the price of our common stock.\\nWe may be subject to claims that our employees, consultants or independent contractors have wrongfully used or disclosed confidential information of third parties.\\nWe have received confidential and proprietary information from potential collaborators, prospective licensees and other third parties. In addition, we employ individuals who were previously employed at other biotechnology or pharmaceutical companies. We may be subject to claims that we or our employees, consultants or independent contractors have inadvertently or otherwise used or disclosed confidential information of these third parties or our employees’ former employers. We may also be subject to claims that former employees, collaborators or other third parties have an ownership interest in our patents or other intellectual property. We may be subject to ownership disputes in the future arising, for example, from conflicting obligations of consultants or others who are involved in developing our product candidates. Litigation may be necessary to defend against these claims. If we fail in defending any such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights, such as exclusive ownership of, or right to use, valuable intellectual property. Such an outcome could have a material adverse effect on our business. Even if we are successful in defending against these claims, litigation could result in substantial cost and be a distraction to our management and employees.\\nRisks Related to our Business and Managing Growth\\nIf we fail to attract, retain and motivate senior management and qualified personnel, we may be unable to successfully develop, obtain and/or maintain marketing approval of and commercialize vadadustat or commercialize Auryxia.\\nRecruiting and retaining qualified personnel is critical to our success. We are also highly dependent on our executives, certain members of our senior management and certain members of our commercial organization. The loss of the services of our executives, senior managers or other employees could impede the achievement of our research, development, regulatory and commercialization objectives and seriously harm our ability to successfully implement our business strategy. Specifically, following receipt of the CRL, in April and May 2022, we implemented a reduction of our workforce by approximately 42% across all areas of our company (47% inclusive of the closing of the majority of open positions), including several members of\\n95\\nmanagement. Losing members of management and other key personnel subjects us to a number of risks, including the failure to coordinate responsibilities and tasks, the necessity to create new management systems and processes, the impact on corporate culture, and the retention of historical knowledge.\\nFurthermore, replacing executives, senior managers and other key employees may be difficult and may take an extended period of time because of the limited number of individuals in our industry with the breadth of skills and experience required to successfully develop, obtain and/or maintain marketing approval of and commercialize Auryxia, vadadustat and other product candidates. Our future financial performance and our ability to develop, obtain and/or maintain marketing approval of and commercialize Auryxia and vadadustat and to compete effectively will depend, in part, on our ability to manage any future growth effectively. To that end, we must be able to hire, train, integrate, and retain additional qualified personnel with sufficient experience. We may be unable to hire, train, retain or motivate these personnel on acceptable terms given the intense competition among numerous biopharmaceutical companies for similar personnel, particularly in our geographic region.\\nWe also experience competition for the hiring of personnel from universities and research institutions. In addition, we rely on contractors, consultants and advisors, including scientific and clinical advisors, to assist us in formulating and executing our research and development and commercialization strategy. Our contractors, consultants and advisors may become employed by companies other than ours and may have commitments with other entities that may limit their availability to us. If additional members of management or other personnel leave, or we are unable to continue to attract and retain high quality personnel, our ability to grow and pursue our business strategy will be limited.\\nOur cost savings plan and the associated workforce reduction implemented in April and May 2022 may not result in anticipated savings, could result in total costs and expenses that are greater than expected and could disrupt our business.\\nFollowing receipt of the CRL, in April and May 2022, we implemented a reduction in workforce by approximately 42% across all areas of our company (47% inclusive of the closing of the majority of open positions), including several members of management. The reduction in workforce reflects our determination to refocus our strategic priorities around our commercial product, Auryxia, and our development portfolio, and was the first step in a cost savings plan to significantly reduce our expense profile in line with being a single commercial product company. We may not realize, in full or in part, the anticipated benefits, savings and improvements in our cost structure from our restructuring efforts due to unforeseen difficulties, delays or unexpected costs. We recorded a restructuring charge of approximately $14.7 million in the aggregate primarily related to contractual termination benefits including severance, non-cash stock-based compensation expense, healthcare and related benefits in the nine months ended September 30, 2022. If we are unable to realize the expected operational efficiencies and cost savings from the restructuring, our operating results and financial condition would be adversely affected. We also cannot guarantee that we will not have to undertake additional workforce reductions or restructuring activities in the future. Furthermore, our cost savings plan may be disruptive to our operations, including our commercialization of Auryxia, which could affect our ability to generate product revenue. In addition, our workforce reductions could yield unanticipated consequences, such as attrition beyond planned staff reductions, or disruptions in our day-to-day operations. Our workforce reduction could also harm our ability to attract and retain qualified management, scientific, clinical, manufacturing and sales and marketing personnel who are critical to our business. Any failure to attract or retain qualified personnel could prevent us from successfully commercializing Auryxia and from successfully developing and commercializing our product candidates in the future, including vadadustat, if approved. If we are ultimately successful in obtaining approval of vadadustat in the United States, we will need to hire additional employees to support the commercialization of vadadustat in the United States, and if we are unsuccessful or delayed in doing so, the potential launch of vadadustat could be delayed.\\nWe may encounter difficulties in managing our growth, including with respect to our employee base, and managing our operations successfully.\\nIn our day-to-day operations, we may encounter difficulties in managing the size of our operations as well as challenges associated with managing our business. We have strategic collaborations for the commercialization of Riona and the development and commercialization of vadadustat, which is now being marketed under the trade name VafseoTM by our collaboration partner, MTPC, in Japan. Additionally, in the United States, we have a strategic relationship with Vifor Pharma related to the commercialization of vadadustat, if approved. As our operations continue, we expect that we will need to manage our current relationships and enter into new relationships, especially in light of the termination of our collaboration agreements with Otsuka, with various strategic collaborators, consultants, vendors, suppliers and other third parties. These relationships are complex and create numerous risks as we deal with issues that arise.\\nOur future financial performance and our ability to commercialize Auryxia and vadadustat, if and where approved, and to compete effectively will depend, in part, on our ability to manage any future growth effectively. This future growth will impose significant added responsibilities on the business and members of management. To manage our recent and any future growth, we must continue to implement and improve our managerial, operational and financial systems, procedures and processes. We may not be able to implement these improvements in an efficient or timely manner and may discover deficiencies in existing\\n96\\nsystems, procedures and processes. Moreover, the systems, procedures and processes currently in place or to be implemented may not be adequate for any such growth. Any expansion of our operations may lead to significant costs and may divert our management and business development resources. Any inability to manage growth could delay the execution of our business plans or disrupt our operations. We may not be able to accomplish these tasks, and our failure to accomplish any of them could prevent us from successfully managing and, as applicable, growing our company.\\nIn addition, we may need to further adjust the size of our workforce as a result of changes to our expectations for our business, which can result in management being required to divert a disproportionate amount of its attention away from our day-to-day activities and devote a substantial amount of time to managing these growth-related activities and related expenses.\\nWe have identified a material weakness in our internal control over financial reporting relating to our inventory process. If we are not able to remediate this material weakness, or if we experience additional material weaknesses or other deficiencies in the future or otherwise fail to maintain an effective system of internal control over financial reporting, we may not be able to accurately report our financial results or prevent fraud.\\nEffective internal control over financial reporting is necessary for us to provide reliable financial reports and, together with adequate disclosure controls and procedures, is designed to prevent fraud. Any failure to maintain or implement required new or improved controls, or difficulties encountered in implementation could cause us to fail to meet our reporting obligations. In addition, any testing by us, as and when required, conducted in connection with Section 404 of the Sarbanes-Oxley Act, or Section 404, or any testing by our independent registered public accounting firm, which became required for us as of December 31, 2019, may reveal deficiencies in our internal control over financial reporting that are deemed to be material weaknesses or that may require prospective or retroactive changes to our financial statements or identify other areas for further attention or improvement. As of December 31, 2019, management and our independent registered public accounting firm concluded that our internal control over financial reporting relating to our inventory process was not effective because of a material weakness due to our failure to design and maintain effective controls over the completeness, accuracy and presentation and disclosure of inventory. Despite remediation efforts we undertook during fiscal 2020 and 2021 and continue to make, our management and independent registered public accounting firm concluded that, as of September 30, 2022, our internal control over financial reporting relating to our inventory process was not effective because we did not maintain effective controls related to the review of inventory reconciliations, the validation of the inventory costing, the periodic assessment of excess and obsolete inventory related reserves and verification that the existence of all inventories subject to physical inventory counts were correctly counted. Additionally, as revised and enhanced controls need to be in operation for a sufficient period of time and be tested to ensure that the controls are operating as designed, management has concluded that the material weakness cannot be considered remediated as of September 30, 2022. Although we have initiated remediation measures to address the material weakness, we cannot provide assurance that we will be able to correct this material weakness in a timely manner or that our remediation efforts will be adequate to allow us to conclude that our internal controls will be effective in the future. Even if this material weakness is remediated in the future, our internal control over financial reporting could in the future have additional material weaknesses, deficiencies or conditions that could require correction or remediation.\\nWe will need to continue to dedicate internal resources, engage outside consultants and maintain a detailed work plan to assess and document the adequacy of internal control over financial reporting, continue steps to remediate the material weakness relating to our inventory process described above and any future control deficiencies or material weaknesses, and improve control processes as appropriate, validate through testing that controls are functioning as documented and maintain a continuous reporting and improvement process for internal control over financial reporting. If we are not able to correct material weaknesses or deficiencies in internal controls in a timely manner or otherwise comply with the requirements of Section 404 in a timely manner, our ability to record, process, summarize and report financial information accurately and within applicable time periods may be adversely affected and we could be subject to sanctions or investigations by the SEC, the Nasdaq Stock Market or other regulatory authorities as well as stockholder litigation which would require additional financial and management resources and could adversely affect the market price of our common stock. Furthermore, if we cannot provide reliable financial reports or prevent fraud, our business and results of operations could be harmed. Inferior internal controls could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our common stock.\\nSecurity breaches and unauthorized use of our information technology systems and information, or the information technology systems or information in the possession of our collaborators and other third parties, could damage the integrity of our clinical trials, impact our regulatory filings, compromise our ability to protect our intellectual property, and subject us to regulatory actions that could result in significant fines or other penalties.\\nWe, our collaborators, contractors and other third parties rely significantly upon information technology, and any failure, inadequacy, interruption or security lapse of that technology, including any cybersecurity incidents, could harm our ability to operate our business effectively. In addition, we and our collaborators, contractors and other third parties rely on information technology networks and systems, including the Internet, to process, transmit and store clinical trial data, patient information, and other electronic information, and manage or support a variety of business processes, including operational and financial transactions and records, personal identifying information, payroll data and workforce scheduling information. We purchase\\n97\\nmost of our information technology from vendors, on whom our systems depend. We rely on commercially available systems, software, tools and monitoring to provide security for the processing, transmission and storage of company and customer information.\\nIn the ordinary course of our business, we and our third party contractors maintain personal and other sensitive data on our and their respective networks, including our intellectual property and proprietary or confidential business information relating to our business and that of our clinical trial patients and business partners. In particular, we rely on CROs and other third parties to store and manage information from our clinical trials. We also rely on third parties to manage patient information for Auryxia. The secure maintenance of this sensitive information is critical to our business and reputation.\\nCompanies and other entities and individuals have been increasingly subject to a wide variety of security incidents, cyber-attacks and other attempts to gain unauthorized access to systems and information. These threats can come from a variety of sources, ranging in sophistication from individual hackers to state-sponsored attacks. Cyber threats may be broadly targeted, or they may be custom-crafted against our information systems or those of our vendors or third party service providers. A security breach, cyberattack or unauthorized access of our clinical data or other data could damage the integrity of our clinical trials, impact our regulatory filings, cause significant risk to our business, compromise our ability to protect our intellectual property, and subject us to regulatory actions, including under the GDPR and CCPA discussed elsewhere in these risk factors and the privacy or security rules under federal, state, or other local laws outside of the United States protecting confidential or personal information, that could be expensive to defend and could result in significant fines or other penalties. Cyberattacks can include malware, computer viruses, hacking or other unauthorized access or other significant compromise of our computer, communications and related systems. Although we take steps to manage and avoid these risks and to be prepared to respond to attacks, our preventive and any remedial actions may not be successful and no such measures can eliminate the possibility of the systems’ improper functioning or the improper access or disclosure of confidential or personally identifiable information such as in the event of cyberattacks. Security breaches, whether through physical or electronic break-ins, computer viruses, ransomware, impersonation of authorized users, attacks by hackers or other means, can create system disruptions or shutdowns or the unauthorized disclosure of confidential information.\\nAlthough we believe our collaborators, vendors and service providers, such as our CROs, take steps to manage and avoid information security risks and respond to attacks, we may be adversely affected by attacks against our collaborators, vendors or service providers, and we may not have adequate contractual remedies against such collaborators, vendors and service providers to remedy any harm to our business caused by such event. Additionally, outside parties may attempt to fraudulently induce employees, collaborators, or other contractors to disclose sensitive information or take other actions, including making fraudulent payments or downloading malware, by using “spoofing” and “phishing” emails or other types of attacks. Our employees may be targeted by such fraudulent activities. Outside parties may also subject us to distributed denial of services attacks or introduce viruses or other malware through “trojan horse” programs to our users’ computers in order to gain access to our systems and the data stored therein. In the recent past, cyber-attacks have become more prevalent and much harder to detect and defend against and, because the techniques used to obtain unauthorized access, disable or degrade service, or sabotage systems change frequently and continuously become more sophisticated, often are not recognized until launched against a target and may be difficult to detect for a long time, we may be unable to anticipate these techniques or to implement adequate preventive or detective measures, and we might not immediately detect such incidents and the damage caused by such incidents.\\nSuch attacks, whether successful or unsuccessful, or other compromises with respect to our information security and the measures we implement to prevent, detect and respond to them, could:\\n•result in our incurring significant costs related to, for example, rebuilding internal systems, defending against litigation, responding to regulatory inquiries or actions, paying damages or fines, or taking other remedial steps with respect to third parties;\\n•lead to public exposure of personal information of participants in our clinical trials, Auryxia patients and others;\\n•damage the integrity of our studies or delay their completion, disrupt our development programs, our business operations and commercialization efforts;\\n•compromise our ability to protect our trade secrets and proprietary information;\\n•damage our reputation and deter business partners from working with us; or\\n•divert the attention of our management and key information technology resources.\\nAny failure to maintain proper functionality and security of our internal computer and information systems could result in a loss of, or damage to, our data or marketing applications or inappropriate disclosure of confidential or proprietary information, interrupt our operations, damage our reputation, subject us to liability claims or regulatory penalties, under a variety of federal, state or other applicable privacy laws, such as HIPAA, the GDPR, or state data protection laws including the CCPA, harm our\\n98\\ncompetitive position and delay the further development and commercialization of our products and product candidates, or impact our relationships with customers and patients.\\nOur employees, independent contractors, principal investigators, CROs, CMOs, consultants and vendors may engage in misconduct or other improper activities, including non-compliance with regulatory standards and requirements and insider trading.\\nWe are exposed to the risk that our employees, independent contractors, principal investigators, CROs, CMOs, consultants and vendors may engage in fraudulent conduct or other illegal activity. Misconduct by these parties could include intentional, reckless and/or negligent conduct or unauthorized activities that violate applicable laws, including the following:\\n•FDA and other healthcare authorities’ regulations, including those laws that require the reporting of true, complete and accurate information to regulatory authorities, and those prohibiting the promotion of unapproved drugs or approved drugs for an unapproved use;\\n•quality standards, including GXP;\\n•federal and state healthcare fraud and abuse laws and regulations and their non-U.S. equivalents;\\n•anti-bribery and anti-corruption laws, such as the FCPA and the UK Bribery Act or country-specific anti-bribery or anti-corruption laws, as well as various import and export laws and regulations;\\n•laws that require the reporting of true and accurate financial information and data; and\\n•U.S. state and federal securities laws and regulations and their non-U.S. equivalents, including those related to insider trading.\\nWe conducted our global clinical trials for vadadustat, and may in the future conduct additional trials, in countries where corruption is prevalent, and violations of any of these laws by our personnel or by any of our vendors or agents, such as our CROs or CMOs, could have a material adverse impact on our clinical trials and our business and could result in criminal or civil fines and sanctions. We are subject to complex laws that govern our international business practices. These laws include the FCPA, which prohibits U.S. companies and their intermediaries, such as CROs or CMOs, from making improper payments to foreign government officials for the purpose of obtaining or keeping business or obtaining any kind of advantage for the company. The FCPA also requires companies to keep accurate books and records and maintain adequate accounting controls. A number of past and recent FCPA investigations by the Department of Justice and the SEC have focused on the life sciences sector.\\nCompliance with the FCPA is expensive and difficult, particularly in countries in which corruption is a recognized problem. Some of the countries in which we have conducted clinical trials and in which we have CMOs have a history of corruption, which increases our risks of FCPA violations. In addition, the FCPA presents unique challenges in the pharmaceutical industry because in many countries’ hospitals are operated by the government, and doctors and other hospital employees are considered foreign government officials. Certain payments made by pharmaceutical companies, or on their behalf by CROs, to hospitals in connection with clinical trials and other work have been deemed to be improper payments to government officials and have led to FCPA enforcement actions.\\nAdditionally, the UK Bribery Act applies to our global activities and prohibits bribery of private individuals as well as public officials. The UK Bribery Act prohibits both the offering and accepting of a bribe and imposes strict liability on companies for failing to prevent bribery, unless the company can show that it had “adequate procedures” in place to prevent bribery. There are also local anti-bribery and anti-corruption laws in countries where we have conducted clinical trials, and many of these also carry the risk of significant financial or criminal penalties.\\nWe are also subject to trade control regulations and trade sanctions laws that restrict the movement of certain goods, currency, products, materials, services and technology to, and certain operations in, various countries or with certain persons. Our ability to transfer commercial and clinical product and other clinical trial supplies, and for our employees, independent contractors, principal investigators, CROs, CMOs, consultants and vendors ability to travel, between certain countries is subject to maintaining required licenses and complying with these laws and regulations.\\nEmployee misconduct could also involve the improper use of information obtained in the course of clinical trials, which could result in regulatory sanctions and serious harm to our reputation. This could include violations of HIPAA, other U.S. federal and state laws, and requirements of non-U.S. jurisdictions, including the GDPR. We are also exposed to risks in connection with any insider trading violations by employees or others affiliated with us.\\nThe internal controls, policies and procedures, and training and compliance programs we have implemented to deter prohibited practices may not be effective in preventing our employees, contractors, consultants, agents or other representatives from\\n99\\nviolating or circumventing such internal policies or violating applicable laws and regulations. The failure to comply with laws governing international business practices may impact any future clinical trials, result in substantial civil or criminal penalties for us and any such individuals, including imprisonment, suspension or debarment from government contracting, withdrawal of our products, if approved, from the market, or being delisted from The Nasdaq Global Market. In addition, we may incur significant costs in implementing sufficient systems, controls and processes to ensure compliance with the aforementioned laws. The laws and regulations referenced above may restrict or prohibit a wide range of pricing, discounting, marketing and promotion, sales commission, customer incentive programs and other business arrangements that could adversely affect our business.\\nAdditionally, it is not always possible to identify and deter misconduct by employees and third parties, and the precautions we take to detect and prevent this activity may not be effective in controlling known or unknown risks or preventing losses or in protecting us from governmental investigations or other actions or lawsuits stemming from a failure to be in compliance with such laws or regulations. If any such actions are instituted against us, and we are not successful in defending ourselves or asserting our rights, or if any such action is instituted against our employees, consultants, independent contractors, CROs, CMOs, vendors or principal investigators, those actions could have a significant impact on our business, including the imposition of civil, criminal and administrative penalties, damages, monetary fines, possible exclusion from participation in Medicare, Medicaid and other federal healthcare programs, contractual damages, reputational harm, diminished profits and future earnings, curtailment of our operations, disclosure of our confidential information and imprisonment, any of which could adversely affect our ability to operate our business and our results of operations.\\nIf any of our service providers are later legally deemed to be employees, we could be subject to employment and tax withholding liabilities and other additional costs as well as other multiple damages and attorneys’ fees.\\nWe rely on independent third parties to provide certain services to us. We structure our relationships with these outside service providers in a manner that we believe results in an independent contractor relationship, not an employee relationship. An independent contractor is generally distinguished from an employee by his or her degree of autonomy and independence in providing services. A high degree of autonomy and independence is generally indicative of an independent contractor relationship, while a high degree of control is generally indicative of an employment relationship. Tax or other regulatory authorities may challenge our characterization of services providers as independent contractors both under existing laws and regulations and under laws and regulations adopted in the future. If such regulatory authorities or state, federal or foreign courts were to determine that our service providers are employees and not independent contractors, we would, among other things, be required to withhold income taxes, to withhold and pay Social Security, Medicare and similar taxes, to pay unemployment and other related payroll taxes, and to provide certain employee benefits. We could also be liable for unpaid past taxes, interest and other costs and subject to penalties. Likewise, our service providers themselves may later challenge their classification as independent contractors, which may result in additional damages, including back wages, penalties, interest and attorneys’ fees. As a result, any legally binding determination that the service providers we characterize as independent contractors are actually our employees could have a material adverse effect on our business, financial condition and results of operations.\\nOur financial statements include goodwill and an intangible asset as a result of the Merger. The intangible asset has become impaired and could become further impaired in the future under certain conditions. In addition, goodwill could become impaired in the future under certain conditions. Any potential future impairment of goodwill or intangible assets may significantly impact our results of operations and financial condition.\\nAs of September 30, 2022, we had approximately $136.1 million in the aggregate of goodwill and a definite lived intangible asset from the Merger. In accordance with generally accepted accounting principles, or GAAP, we are required annually, or more frequently upon certain indicators of impairment, to review our estimates and assumptions underlying the fair value of our goodwill and our definite lived intangible assets when indicators of impairment are present. Events giving rise to impairment of goodwill or intangible assets are an inherent risk in the pharmaceutical industry and often cannot be predicted.\\nConditions that could indicate impairment and necessitate such a review include, but are not limited to, Auryxia’s commercial performance, our inability to execute on our strategic initiatives, the deterioration of our market capitalization such that it is significantly below our net book value, a significant adverse change in legal factors, unexpected adverse business conditions, and an adverse action or assessment by a regulator. To the extent we conclude that goodwill and/or definite lived intangible assets have become impaired, we may be required to incur material write-offs relating to such impairment and any such write-offs could have a material impact on our future operating results and financial position. For example, in the second quarter of 2020, in connection with a routine business review, we reduced our short-term and long-term Auryxia revenue forecast. This reduction was primarily driven by the impact of the September 2018 CMS decision that Auryxia would no longer be covered by Medicare for the treatment of the IDA Indication. While this decision does not impact CMS coverage for the use of Auryxia for the control of serum phosphorus levels in adult patients with CKD on dialysis, or the Hyperphosphatemia Indication, it requires all Auryxia prescriptions for Medicare patients to undergo a prior authorization to ensure their use of Auryxia for the Hyperphosphatemia Indication. As a result, we recorded an impairment charge of $115.5 million during the three months ended\\n100\\nJune 30, 2020, which was entirely allocated to our only intangible asset, the developed product rights for Auryxia, and made a corresponding adjustment to the estimated useful life of the developed product rights for Auryxia, which we again adjusted during the three months ended December 31, 2020. The estimates, judgments and assumptions used in our impairment testing, and the results of our testing, are discussed in Note 9 to our consolidated financial statements in Part I, Item 1. Financial Statements of this Quarterly Report on Form 10-Q. If these estimates, judgments and assumptions change in the future, including if the Auryxia asset group does not meet its current forecasted projections, additional impairment charges related to goodwill or our intangible asset could be recorded in the future and additional corresponding adjustments may need to be made to the estimated useful life of the developed product rights for Auryxia, which could materially impact our financial position, certain of our material agreements, and our future operating results.\\nIf product liability lawsuits are brought against us, we may incur substantial liabilities and may be required to limit commercialization of Auryxia or vadadustat, if approved.\\nWe face an inherent risk of product liability as a result of the clinical and commercial use of Auryxia and vadadustat. For example, we may be sued if Auryxia or vadadustat allegedly causes injury or is found to be otherwise unsuitable during clinical trials, manufacturing, marketing or sale. Any such product liability claims may include allegations of defects in manufacturing, defects in design, a failure to warn of dangers inherent in the product or product candidate, negligence, strict liability and breach of warranties. Claims could also be asserted under state consumer protection acts. If we cannot successfully defend ourselves against product liability claims, we may incur substantial liabilities or be required to limit commercialization of Auryxia or vadadustat, if approved. Even a successful defense would require significant financial and management resources. Regardless of the merits or eventual outcome, product liability claims may result in:\\n•decreased demand for Auryxia or vadadustat, if approved;\\n•injury to our reputation and significant negative media attention;\\n•withdrawal of clinical trial participants;\\n•delay or termination of clinical trials;\\n•our inability to continue to develop Auryxia or vadadustat;\\n•significant costs to defend the related litigation;\\n•a diversion of management’s time and our resources;\\n•substantial monetary awards to study subjects or patients;\\n•product recalls or withdrawals, or labeling, marketing or promotional restrictions;\\n•decreased demand for Auryxia or vadadustat, if approved;\\n•loss of revenue;\\n•the inability to commercialize Auryxia or vadadustat, if approved; and\\n•a decline in our stock price.\\nFailure to obtain and retain sufficient product liability insurance at an acceptable cost to protect against potential product liability claims could prevent or inhibit the commercialization of products we develop. We currently carry product liability insurance that we believe is appropriate for our company. Although we maintain product liability insurance, any claim that may be brought against us could result in a court judgment or settlement in an amount that is not covered, in whole or in part, by our insurance or that is in excess of the limits of our insurance coverage. Our insurance policies also have various exclusions, and we may be subject to a product liability claim for which we have insufficient or no coverage. If we have to pay any amounts awarded by a court or negotiated in a settlement that exceed our coverage limitations or that are not covered by our insurance, we may not have, or be able to obtain, sufficient capital to pay such amounts. In addition, insurance coverage is becoming increasingly expensive, and we may not be able to maintain insurance coverage at a reasonable cost. We also may not be able to obtain additional insurance coverage that will be adequate to cover additional product liability risks that may arise. Consequently, a product liability claim may result in losses that could be material to our business.\\nWe will continue to incur increased costs as a result of operating as a public company, and our management will be required to devote substantial time to compliance initiatives and corporate governance practices.\\nAs a public company, we operate in a demanding regulatory environment, and we have and will continue to incur significant legal, accounting and other expenses. The Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act, the Dodd-Frank Wall Street Reform and Consumer Protection Act, the listing requirements of The Nasdaq Global Market and other applicable securities rules and regulations impose various requirements on public companies, including establishment and maintenance of effective disclosure and financial controls and certain corporate governance practices. In particular, our compliance with Section 404 of the Sarbanes-Oxley Act has required and will continue to require that we incur substantial accounting-related expenses and expend significant management efforts. Our testing, or the testing by our independent registered public accounting firm, may reveal deficiencies in our internal controls that we would be required to remediate in a timely manner. If we are not able to\\n101\\ncomply with the requirements of the Sarbanes-Oxley Act, we could be subject to sanctions or investigations by the SEC, the Nasdaq Global Market or other regulatory authorities, which would require additional financial and management resources and could adversely affect the market price of our securities. Furthermore, if we cannot provide reliable financial reports or prevent fraud, including as a result of remote working by our employees which has increased since the beginning of the COVID-19 pandemic, our business and results of operations would likely be materially and adversely affected.\\nWe cannot predict or estimate the amount of additional costs we may incur to continue to operate as a public company, nor can we predict the timing of such costs. These rules and regulations are often subject to varying interpretations, in many cases due to their lack of specificity and, as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices.\\nClaims for indemnification by our directors and officers may reduce our available funds to satisfy successful third-party claims against us and may reduce the amount of money available to us.\\nOur Ninth Amended and Restated Certificate of Incorporation, as amended, or Charter, and our Amended and Restated By-Laws, or Bylaws, as amended to date, contain provisions that eliminate, to the maximum extent permitted by the General Corporation Law of the State of Delaware, or DGCL, the personal liability of our directors and executive officers for monetary damages for breach of their fiduciary duties as a director or officer. Our Charter and our Bylaws also provide that we will indemnify our directors and executive officers and may indemnify our employees and other agents to the fullest extent permitted by the DGCL.\\nIn addition, as permitted by Section 145 of the DGCL our Bylaws and our indemnification agreements that we have entered into with our directors and executive officers provide that:\\n•We will indemnify our directors and officers, as defined in our Bylaws, for serving us in those capacities or for serving other related business enterprises at our request, to the fullest extent permitted by Delaware law. Delaware law provides that a corporation may indemnify such person if such person acted in good faith and in a manner such person reasonably believed to be in or not opposed to the best interests of Akebia and, with respect to any criminal proceeding, had no reasonable cause to believe such person’s conduct was unlawful.\\n•We may, in our discretion, indemnify employees and agents in those circumstances where indemnification is permitted by applicable law.\\n•We are required to advance expenses, as incurred, to our directors and officers in connection with defending a proceeding, except that such directors or officers shall undertake to repay such advances if it is ultimately determined that such person is not entitled to indemnification.\\n•The rights conferred in our Bylaws are not exclusive, and we are authorized to enter into indemnification agreements with our directors, officers, employees and agents and to obtain insurance to indemnify such persons.\\nAny claims for indemnification made by our directors or officers could impact our cash resources and our ability to fund the business.\\nOur ability to use net operating losses to offset future taxable income may be subject to certain limitations.\\nUnder Section 382 of the Internal Revenue Code, or Section 382, a corporation that undergoes an “ownership change” is subject to limitations on its ability to utilize its pre-change net operating losses, or NOLs, to offset future taxable income. On December 12, 2018, we completed the Merger, which we believe has resulted in an ownership change under Section 382. In addition, the Tax Cuts and Jobs Act, including amendments made by the CARES Act, includes changes to U.S. federal tax rates and the rules governing net operating loss carryforwards that may significantly impact our ability to utilize our net operating losses to fully offset taxable income in the future. Future changes in our stock ownership, many of which are outside of our control, could result in an additional ownership change under Section 382. As a result, if we generate taxable income, our ability to use our pre-change NOL carryforwards to offset federal taxable income may be subject to limitations, which could potentially result in increased future tax liability to us. At the state level, state net operating losses generated in one state cannot be used to offset income generated in another state and there may be periods during which the use of NOL carryforwards is suspended or otherwise limited, which could accelerate or permanently increase state taxes owed.\\nFurthermore, our ability to utilize our NOLs is conditioned upon our attaining profitability and generating U.S. taxable income. As described above under “—Risks Related to our Financial Position, Need for Additional Capital and Growth Strategy,” we have incurred significant net losses since our inception and anticipate that we will continue to incur significant losses for the\\n102\\nforeseeable future; thus, we do not know whether or when we will generate the U.S. taxable income necessary to utilize our NOLs.\\nOur Charter designates the Court of Chancery of the State of Delaware as the sole and exclusive forum for certain types of actions and proceedings that may be initiated by our stockholders, which could limit our stockholders’ ability to obtain a favorable judicial forum for disputes with us or our directors, officers or employees.\\nOur Charter provides that, subject to limited exceptions, the Court of Chancery of the State of Delaware will be the sole and exclusive forum for (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of a fiduciary duty owed by any of our directors, officers or other employees to us or our stockholders, (iii) any action asserting a claim against us arising pursuant to any provision of the DGCL our Charter or our Bylaws, or (iv) any other action asserting a claim against us, our directors, officers or other employees that is governed by the internal affairs doctrine. Under our Charter, this exclusive forum provision will not apply to claims that are vested in the exclusive jurisdiction of a court or forum other than the Court of Chancery of the State of Delaware, or for which the Court of Chancery of the State of Delaware does not have subject matter jurisdiction. For instance, the provision would not apply to actions arising under federal securities laws, including suits brought to enforce any liability or duty created by the Exchange Act, or the rules and regulations thereunder. Any person or entity purchasing or otherwise acquiring any interest in shares of our capital stock shall be deemed to have notice of and to have consented to the provisions of our Charter described above. This choice of forum provision may limit a stockholder’s ability to bring a claim in a judicial forum that it finds favorable for disputes with us or our directors, officers or other employees, which may discourage such lawsuits against us and our directors, officers and employees. Alternatively, if a court were to find these provisions of our Charter inapplicable to, or unenforceable with respect to, one or more of the specified types of actions or proceedings, we may incur additional costs associated with resolving such matters in other jurisdictions, which could adversely affect our business and financial condition.\\nWe are currently subject to legal proceedings that could result in substantial costs and divert management's attention, and we could be subject to additional legal proceedings.\\nWe are currently subject to legal proceedings, including those described in Part II, Item 1 in this Quarterly Report on Form 10-Q, and additional claims may arise in the future. In addition, securities class action and derivative lawsuits and other legal proceedings are often brought against companies for any of the risks described in this Quarterly Report on Form 10-Q following a decline in the market price of their securities. For example, we were party to a putative class action lawsuit in state court filed by purported Keryx stockholders challenging the disclosures made in connection with the Merger, including those that relate to vadadustat’s safety, approvability and commercial viability. Oral argument was held on October 7, 2022, and the Court dismissed the complaint without prejudice on October 17, 2022, giving plaintiffs thirty days to amend their complaint. The Court further ordered that, in the event plaintiffs do not file an amended complaint within thirty days of the dismissal, the dismissal shall be deemed to be with prejudice. In connection with any litigation or other legal proceedings, we could incur substantial costs, and such costs and any related settlements or judgments may not be covered by insurance. Monetary damages or any other adverse judgment would have a material adverse effect on our business and financial position. In addition, if other resolution or actions taken as a result of legal proceedings were to restrain our ability to operate or market our products and services, our consolidated financial position, results of operations or cash flows could be materially adversely affected. We could also suffer an adverse impact on our reputation, negative publicity and a diversion of management’s attention and resources, which could have a material adverse effect on our business.\\nRisks Related to our Common Stock\\nOur stock price has been and may continue to be volatile, which could result in substantial losses for holders or future purchasers of our common stock and lawsuits against us and our officers and directors.\\nOur stock price has been and will likely continue to be volatile. The stock market in general and the market for similarly situated biopharmaceutical companies specifically have experienced extreme volatility that has often been unrelated to the operating performance of particular companies. Since our initial public offering in March 2014, the price of our common stock as reported on The Nasdaq Global Market has ranged from a low of $0.24 on October 24, 2022 to a high of $31.00 on June 20, 2014. The daily closing market price for our common stock varied between a high price of $0.46 on July 6, 2022 and a low price of $0.30 on September 29, 2022 in the three-month period ending on September 30, 2022. During that time, the price of our common stock ranged from an intra-day low of $0.30 per share to an intra-day high of $0.50 per share. From October 1, 2022 through the date of this Quarterly Report on Form 10-Q, the daily closing market price for our common stock has varied between a high price of $0.33 on October 6, 2022 and a low price of $0.25 on October 24, 2022. The market price of shares of our common stock could be subject to wide fluctuations in response to many risk factors listed in this section, including, among others, developments related to and results of our research or clinical trials, developments related to our regulatory submissions and meetings with regulatory authorities, in particular as it relates to vadadustat, commercialization of Auryxia, vadadustat, if and as approved in the U.S. and foreign markets including Europe, and any other product candidates, announcements by us or\\n103\\nour competitors of significant transactions or strategic collaborations, negative publicity around Auryxia or vadadustat, regulatory or legal developments in the United States and other countries, developments or disputes concerning our intellectual property, the recruitment or departure of key personnel including as a result of our recent reduction in workforce, actual or anticipated changes in estimates as to financial results, changes in the structure of healthcare payment systems, market conditions in the biopharmaceutical sector and other factors beyond our control. As a result of this volatility, our stockholders may not be able to sell their common stock at or above the price at which they purchased it.\\nIn addition, companies that have experienced volatility in the market price of their stock have frequently been the subject of securities class action and shareholder derivative litigation. See Part II, Item 1. Legal Proceedings of this Quarterly Report on Form 10-Q for information concerning securities class action initiated against Keryx and certain current and former directors and officers of ours and Keryx’s. In addition, we could be the target of other such litigation in the future. Class action and shareholder derivative lawsuits, whether successful or not, could result in substantial costs, damage or settlement awards and a diversion of our management’s resources and attention from running our business, which could materially harm our reputation, financial condition and results of operations.\\nThe issuance of additional shares of our common stock or the sale of shares of our common stock by any of our directors, officers or significant stockholders will dilute our stockholders’ ownership interest in Akebia and may cause the market price of our common stock to decline.\\nMost of our outstanding common stock can be traded without restriction at any time. As such, sales of a substantial number of shares of our common stock in the public market could occur at any time. These sales, or the perception in the market that the holders of a large number of shares intend to sell such shares, could reduce the market price of our common stock.\\nAs of September 30, 2022 and based on the amounts reported in the most recent filings made under Section 13(d) and 13(g) of the Securities Exchange Act of 1934, as amended, or the Exchange Act, the Vanguard Group, or Vanguard, beneficially owned just under 10.0% of our outstanding shares of common stock, State Street Corporation, or State Street, beneficially owned approximately 6.4% of our outstanding shares of common stock and Vifor Pharma beneficially owned approximately 4.1% of our outstanding shares of common stock. By selling a large number of shares of common stock, Vanguard or State Street could cause the price of our common stock to decline. The shares beneficially owned by Vifor Pharma have not been registered pursuant to the Securities Act and were issued and sold in reliance upon the exemption from registration contained in Section 4(a)(2) of the Securities Act and Rule 506 promulgated thereunder, but if they are registered in the future, those shares would become freely tradable and, if a large portion of such shares are sold, could cause the price of our common stock to decline.\\nWe have a significant number of shares that are subject to outstanding options and restricted stock units, and in the future we may issue additional options, restricted stock units, or other derivative securities convertible into our common stock. The exercise or vesting of any such options, restricted stock units, or other derivative securities, and the subsequent sale of the underlying common stock, could cause a further decline in our stock price. These sales also might make it difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate. Such sales of our common stock could result in higher than average trading volume and may cause the market price for our common stock to decline.\\nIn addition, we currently have on file with the SEC a shelf registration statement, which allows us to offer and sell up to $300 million in registered securities, such as common stock, preferred stock, debt securities, warrants and units, from time to time pursuant to one or more offerings at prices and terms to be determined at the time of sale, including a sales agreement prospectus that covers the offering, issuance and sale by us of up to a maximum aggregate offering price of up to $26 million of our common stock that may be issued and sold from time to time under a sales agreement with Jefferies LLC.\\nSales of substantial amounts of shares of our common stock or other securities by our employees or our other stockholders or by us under our shelf registration statement, pursuant to at-the-market offerings or otherwise, could dilute our stockholders, lower the market price of our common stock and impair our ability to raise capital through the sale of equity securities.\\nOur executive officers, directors and principal stockholders maintain the ability to significantly influence all matters submitted to stockholders for approval.\\nAs of September 30, 2022, our executive officers, directors and principal stockholders, in the aggregate, beneficially owned shares representing a significant percentage of our capital stock. As a result, if these stockholders were to choose to act together, they would be able to significantly influence all matters submitted to our stockholders for approval, as well as our management and affairs. For example, these persons could significantly influence the election of directors and approval of any merger, consolidation or sale of all or substantially all of our assets. This concentration of voting power could delay or prevent an acquisition of our company on terms that other stockholders may desire.\\n104\\nProvisions in our organizational documents and Delaware law may have anti-takeover effects that could discourage an acquisition of us by others, even if an acquisition would be beneficial to our stockholders, and may prevent attempts by our stockholders to replace or remove our current management.\\nProvisions in our Charter and our Bylaws contain provisions that may have the effect of discouraging, delaying or preventing a change in control of us or changes in our management. These provisions could also limit the price that investors might be willing to pay in the future for shares of our common stock, thereby depressing the market price of our common stock. In addition, because our Board of Directors is responsible for appointing certain members of our management team, these provisions may frustrate or prevent any attempts by our stockholders to replace or remove our current management by making it more difficult for stockholders to replace members of our Board of Directors. Among other things, these provisions:\\n•authorize “blank check” preferred stock, which could be issued by our Board of Directors without stockholder approval and may contain voting, liquidation, dividend and other rights superior to our common stock;\\n•create a classified Board of Directors whose members serve staggered three-year terms;\\n•specify that special meetings of our stockholders can be called only by our Board of Directors pursuant to a resolution adopted by a majority of the total number of directors;\\n•prohibit stockholder action by written consent;\\n•establish an advance notice procedure for stockholder approvals to be brought before an annual meeting of our stockholders, including proposed nominations of persons for election to our Board of Directors;\\n•provide that our directors may be removed only for cause;\\n•provide that vacancies on our Board of Directors may be filled only by a majority of directors then in office, even though less than a quorum;\\n•require a supermajority vote of 75% of the holders of our capital stock entitled to vote or the majority vote of our Board of Directors to amend our Bylaws; and\\n•require a supermajority vote of 85% of the holders of our capital stock entitled to vote to amend the classification of our Board of Directors and to amend certain other provisions of our Charter.\\nThese provisions, alone or together, could delay or prevent hostile takeovers, changes in control or changes in our management.\\nIn addition, Section 203 of the DGCL prohibits a publicly-held Delaware corporation from engaging in a business combination with an interested stockholder, generally a person which together with its affiliates owns, or within the last three years has owned, 15% of our voting stock, for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner.\\nBecause we do not anticipate paying any cash dividends on our capital in the foreseeable future, capital appreciation, if any, will be our stockholders’ sole source of gain.\\nWe have never declared or paid cash dividends on our capital stock and we currently intend to retain all of our future earnings, if any, to finance the development and growth of our business. Any payment of cash dividends in the future would be at the discretion of our Board of Directors and would depend on, among other things, our earnings, financial condition, capital requirements, level of indebtedness, statutory and contractual restrictions applying to the payment of dividends and other considerations that the Board of Directors deems relevant. In addition, the terms of the Loan Agreement preclude us from paying cash dividends and future debt agreements may preclude us from paying cash dividends. As a result, capital appreciation, if any, of our common stock will be our stockholders’ sole source of gain for the foreseeable future.\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\\nSales of Unregistered Securities\\nDuring the quarter ended September 30, 2022, we did not have any sales of unregistered securities.\\nItem 3. Defaults Upon Senior Securities.\\nNot applicable.\\nItem 4. Mine Safety Disclosures.\\nNot applicable.\\n105\\nItem 5. Other Information.\\nAs previously disclosed, on May 9, 2022, in connection with our workforce reduction, we announced certain management transitions, including that we and Michel Dahan, our Chief Operating Officer, agreed that his employment with us would terminate effective January 23, 2023, except in the event of certain specified events when his employment with us would terminate later, but in no event later than July 1, 2023. On November 2, 2022, we and Mr. Dahan agreed to extend the effective date of his termination to May 5, 2023, and, in the event of certain specified events, the effective date of his termination may extend to October 20, 2023.\\n106\\nItem 6. Exhibits.\\n| Exhibits |\\n| 3.1 | Ninth Amended and Restated Certificate of Incorporation (incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K, filed on March 28, 2014). |\\n| 3.2 | Certificate of Amendment of Ninth Amended and Restated Certificate of Incorporation of Akebia Therapeutics, Inc. (incorporated by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K, filed on June 9, 2020). |\\n| 3.3 | Amended and Restated Bylaws (incorporated by reference to Exhibit 3.2 to the Company’s Current Report on Form 8-K, filed on March 28, 2014). |\\n| 10.1# | Second Amendment and Waiver, dated July 15, 2022, by and among the Company, Biopharma Credit plc, BCPR Limited Partnership and Biopharma Credit Investments V (Master) LP (incorporated by reference to Exhibit 10.9 to the Company’s Quarterly Report on Form 10-Q (001-36352), filed on August 4, 2022). |\\n| 10.2*# | Form of Amendment to Retention and Separation Agreement for Michel Dahan and Nicole R. Hadas. |\\n| 31.1* | Certification of Principal Executive Officer Required Under Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended. |\\n| 31.2* | Certification of Principal Financial Officer Required Under Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended. |\\n| 32.1* | Certification of Principal Executive Officer and Principal Financial Officer Required Under Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C. 1350. |\\n| 101.INS* | Inline XBRL Instance Document (the instance document does not appear in the Interactive Data File because XBRL tags are embedded within the Inline XBRL document) |\\n| 101.SCH* | Inline XBRL Taxonomy Extension Schema Document |\\n| 101.CAL* | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\\n| 101.DEF* | Inline XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101.LAB* | Inline XBRL Taxonomy Extension Labels Linkbase Document |\\n| 101.PRE* | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\\n| 104* | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\\n\\n* Filed, or submitted electronically, herewith\\n# Indicates portions of the exhibit (indicated by asterisks) have been omitted pursuant to Item 601(b)(10)(iv) of Regulation S-K\\n107\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n| AKEBIA THERAPEUTICS, INC. |\\n| Date: November 3, 2022 | By: | /s/ John P. Butler |\\n| John P. Butler |\\n| President and Chief Executive Officer (Principal Executive Officer) |\\n| Date: November 3, 2022 | By: | /s/ David A. Spellman |\\n| David A. Spellman |\\n| Senior Vice President, Chief Financial Officer and Treasurer (Principal Financial Officer) |\\n| Date: November 3, 2022 | By: | /s/ Violetta Cotreau |\\n| Violetta Cotreau |\\n| Senior Vice President, Chief Accounting Officer (Principal Accounting Officer) |\\n\\n108\\n \\n\\nIf the Company continues to earn revenue from the MTPC Supply Agreement at the same rate as in the nine months ended September 30, 2022, how many months of operation could the Company fund using solely this revenue, with its cash and cash equivalents as of September 30, 2022?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 102.61.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 63,\n \"input_length\": 112947\n}"}}},{"rowIdx":64,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n2\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations (Item 2) 3\nOverview 3\nNon-GAAP Financial Measures 8\nRecent Accounting Standards 10\nCritical Accounting Policies 10\nStatements of Income Analysis 11\nBalance Sheet Analysis 22\nBusiness Segment Review 29\nRisk Management—Overview 37\nCredit Risk Management 38\nInterest Rate and Price Risk Management 57\nLiquidity Risk Management 62\nOperational Risk Management 64\nLegal and Regulatory Compliance Risk Management 65\nCapital Management 66\nQuantitative and Qualitative Disclosures about Market Risk (Item 3) 69\nControls and Procedures (Item 4) 69\nCondensed Consolidated Financial Statements and Notes (Item 1) 70\nBalance Sheets (unaudited) 70\nStatements of Income (unaudited) 71\nStatements of Comprehensive Income (unaudited) 72\nStatements of Changes in Equity (unaudited) 73\nStatements of Cash Flows (unaudited) 75\nNotes to Condensed Consolidated Financial Statements (unaudited) 76\nPart II. Other Information\nLegal Proceedings (Item 1) 138\nRisk Factors (Item 1A) 138\nUnregistered Sales of Equity Securities and Use of Proceeds (Item 2) 139\nOther Information (Item 5) 139\nExhibits (Item 6) 140\nSignature 141\nFORWARD-LOOKING STATEMENTS\nThis report contains statements that we believe are “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Rule 175 promulgated thereunder, and Section 21E of the Securities Exchange Act of 1934, as amended, and Rule 3b-6 promulgated thereunder. These statements relate to our financial condition, results of operations, plans, objectives, future performance, capital actions or business. They usually can be identified by the use of forward-looking language such as “will likely result,” “may,” “are expected to,” “is anticipated,” “potential,” “estimate,” “forecast,” “projected,” “intends to,” or may include other similar words or phrases such as “believes,” “plans,” “trend,” “objective,” “continue,” “remain,” or similar expressions, or future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” “can,” or similar verbs. You should not place undue reliance on these statements, as they are subject to risks and uncertainties, including but not limited to the risk factors set forth in our most recent Annual Report on Form 10-K as updated by our Quarterly Reports on Form 10-Q. When considering these forward-looking statements, you should keep in mind these risks and uncertainties, as well as any cautionary statements we may make. Moreover, you should treat these statements as speaking only as of the date they are made and based only on information then actually known to us. We undertake no obligation to release revisions to these forward-looking statements or reflect events or circumstances after the date of this document. There are a number of important factors that could cause future results to differ materially from historical performance and these forward-looking statements. Factors that might cause such a difference include, but are not limited to: (1) effects of the global COVID-19 pandemic; (2) deteriorating credit quality; (3) loan concentration by location or industry of borrowers or collateral; (4) problems encountered by other financial institutions; (5) inadequate sources of funding or liquidity; (6) unfavorable actions of rating agencies; (7) inability to maintain or grow deposits; (8) limitations on the ability to receive dividends from subsidiaries; (9) cyber-security risks; (10) Fifth Third’s ability to secure confidential information and deliver products and services through the use of computer systems and telecommunications networks; (11) failures by third-party service providers; (12) inability to manage strategic initiatives and/or organizational changes; (13) inability to implement technology system enhancements; (14) failure of internal controls and other risk management systems; (15) losses related to fraud, theft, misappropriation or violence; (16) inability to attract and retain skilled personnel; (17) adverse impacts of government regulation; (18) governmental or regulatory changes or other actions; (19) failures to meet applicable capital requirements; (20) regulatory objections to Fifth Third’s capital plan; (21) regulation of Fifth Third’s derivatives activities; (22) deposit insurance premiums; (23) assessments for the orderly liquidation fund; (24) replacement of LIBOR; (25) weakness in the national or local economies; (26) global political and economic uncertainty or negative actions; (27) changes in interest rates; (28) changes and trends in capital markets; (29) fluctuation of Fifth Third’s stock price; (30) volatility in mortgage banking revenue; (31) litigation, investigations, and enforcement proceedings by governmental authorities; (32) breaches of contractual covenants, representations and warranties; (33) competition and changes in the financial services industry; (34) changing retail distribution strategies, customer preferences and behavior; (35) difficulties in identifying, acquiring or integrating suitable strategic partnerships, investments or acquisitions; (36) potential dilution from future acquisitions; (37) loss of income and/or difficulties encountered in the sale and separation of businesses, investments or other assets; (38) results of investments or acquired entities; (39) changes in accounting standards or interpretation or declines in the value of Fifth Third’s goodwill or other intangible assets; (40) inaccuracies or other failures from the use of models; (41) effects of critical accounting policies and judgments or the use of inaccurate estimates; (42) weather-related events, other natural disasters, or health emergencies (including pandemics); (43) the impact of reputational risk created by these or other developments on such matters as business generation and retention, funding and liquidity; and (44) changes in law or requirements imposed by Fifth Third’s regulators impacting our capital actions, including dividend payments and stock repurchases.\n1\n| PART I. FINANCIAL INFORMATION |\n| Glossary of Abbreviations and Acronyms |\n\nFifth Third Bancorp provides the following list of abbreviations and acronyms as a tool for the reader that are used in Management’s Discussion and Analysis of Financial Condition and Results of Operations, the Condensed Consolidated Financial Statements and the Notes to Condensed Consolidated Financial Statements.\n| ACL: Allowance for Credit Losses | GNMA: Government National Mortgage Association |\n| AFS: Available For Sale | GSE: United States Government Sponsored Enterprise |\n| ALCO: Asset Liability Management Committee | HTM: Held-To-Maturity |\n| ALLL: Allowance for Loan and Lease Losses | IPO: Initial Public Offering |\n| AOCI: Accumulated Other Comprehensive Income (Loss) | IRC: Internal Revenue Code |\n| APR: Annual Percentage Rate | IRLC: Interest Rate Lock Commitment |\n| ARM: Adjustable Rate Mortgage | ISDA: International Swaps and Derivatives Association, Inc. |\n| ASC: Accounting Standards Codification | LIBOR: London Interbank Offered Rate |\n| ASU: Accounting Standards Update | LIHTC: Low-Income Housing Tax Credit |\n| ATM: Automated Teller Machine | LLC: Limited Liability Company |\n| BHC: Bank Holding Company | LTV: Loan-to-Value Ratio |\n| BOLI: Bank Owned Life Insurance | MD&A: Management’s Discussion and Analysis of Financial |\n| bps: Basis Points | Condition and Results of Operations |\n| CARES: Coronavirus Aid, Relief and Economic Security | MSR: Mortgage Servicing Right |\n| CDC: Fifth Third Community Development Corporation | N/A: Not Applicable |\n| CECL: Current Expected Credit Loss | NII: Net Interest Income |\n| CET1: Common Equity Tier 1 | NM: Not Meaningful |\n| CFPB: United States Consumer Financial Protection Bureau | OAS: Option-Adjusted Spread |\n| C&I: Commercial and Industrial | OCC: Office of the Comptroller of the Currency |\n| DCF: Discounted Cash Flow | OCI: Other Comprehensive Income (Loss) |\n| DTCC: Depository Trust & Clearing Corporation | OREO: Other Real Estate Owned |\n| DTI: Debt-to-Income Ratio | PCD: Purchased Credit Deteriorated |\n| ERM: Enterprise Risk Management | PPP: Paycheck Protection Program |\n| ERMC: Enterprise Risk Management Committee | RCC: Risk Compliance Committee |\n| EVE: Economic Value of Equity | ROU: Right-of-Use |\n| FASB: Financial Accounting Standards Board | SBA: Small Business Administration |\n| FDIC: Federal Deposit Insurance Corporation | SEC: United States Securities and Exchange Commission |\n| FHA: Federal Housing Administration | SOFR: Secured Overnight Financing Rate |\n| FHLB: Federal Home Loan Bank | TBA: To Be Announced |\n| FHLMC: Federal Home Loan Mortgage Corporation | TDR: Troubled Debt Restructuring |\n| FICO: Fair Isaac Corporation (credit rating) | TILA: Truth in Lending Act |\n| FINRA: Financial Industry Regulatory Authority | U.S.: United States of America |\n| FNMA: Federal National Mortgage Association | USD: United States Dollar |\n| FOMC: Federal Open Market Committee | U.S. GAAP: United States Generally Accepted Accounting |\n| FRB: Federal Reserve Bank | Principles |\n| FTE: Fully Taxable Equivalent | VA: United States Department of Veterans Affairs |\n| FTP: Funds Transfer Pricing | VIE: Variable Interest Entity |\n| FTS: Fifth Third Securities | VRDN: Variable Rate Demand Note |\n| GDP: Gross Domestic Product |\n\n2\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (Item 2) |\n\nThe following is Management’s Discussion and Analysis of Financial Condition and Results of Operations of certain significant factors that have affected Fifth Third Bancorp’s (the “Bancorp” or “Fifth Third”) financial condition and results of operations during the periods included in the Condensed Consolidated Financial Statements, which are a part of this filing. Reference to the Bancorp incorporates the parent holding company and all consolidated subsidiaries. The Bancorp’s banking subsidiary is referred to as the Bank.\nOVERVIEW\nFifth Third Bancorp is a diversified financial services company headquartered in Cincinnati, Ohio. At June 30, 2021, the Bancorp had $205 billion in assets and operated 1,096 full-service banking centers and 2,369 Fifth Third branded ATMs in eleven states throughout the Midwestern and Southeastern regions of the U.S. The Bancorp reports on four business segments: Commercial Banking, Branch Banking, Consumer Lending and Wealth and Asset Management.\nThis overview of MD&A highlights selected information in the financial results of the Bancorp and may not contain all of the information that is important to you. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources and critical accounting policies and estimates, you should carefully read this entire document as well as the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020. Each of these items could have an impact on the Bancorp’s financial condition, results of operations and cash flows. In addition, refer to the Glossary of Abbreviations and Acronyms in this report for a list of terms included as a tool for the reader of this Quarterly Report on Form 10-Q. The abbreviations and acronyms identified therein are used throughout this MD&A, as well as the Condensed Consolidated Financial Statements and Notes to Condensed Consolidated Financial Statements.\nNet interest income, net interest margin, net interest rate spread and the efficiency ratio are presented in MD&A on an FTE basis. The FTE basis adjusts for the tax-favored status of income from certain loans and leases and securities held by the Bancorp that are not taxable for federal income tax purposes. The Bancorp believes this presentation to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and non-taxable amounts. The FTE basis for presenting net interest income is a non-GAAP measure. For further information, refer to the Non-GAAP Financial Measures section of MD&A.\nThe Bancorp’s revenues are dependent on both net interest income and noninterest income. For both the three and six months ended June 30, 2021, net interest income on an FTE basis and noninterest income provided 62% and 38% of total revenue, respectively. The Bancorp derives the majority of its revenues within the U.S. from customers domiciled in the U.S. Revenue from foreign countries and external customers domiciled in foreign countries was immaterial to the Condensed Consolidated Financial Statements for the three and six months ended June 30, 2021. Changes in interest rates, credit quality, economic trends and the capital markets are primary factors that drive the performance of the Bancorp. As discussed later in the Risk Management section of MD&A, risk identification, measurement, monitoring, control and reporting are important to the management of risk and to the financial performance and capital strength of the Bancorp.\nNet interest income is the difference between interest income earned on assets such as loans, leases and securities, and interest expense incurred on liabilities such as deposits, other short-term borrowings and long-term debt. Net interest income is affected by the general level of interest rates, the relative level of short-term and long-term interest rates, changes in interest rates and changes in the amount and composition of interest-earning assets and interest-bearing liabilities. Generally, the rates of interest the Bancorp earns on its assets and pays on its liabilities are established for a period of time. The change in market interest rates over time exposes the Bancorp to interest rate risk through potential adverse changes to net interest income and financial position. The Bancorp manages this risk by continually analyzing and adjusting the composition of its assets and liabilities based on their payment streams and interest rates, the timing of their maturities and their sensitivity to changes in market interest rates. Additionally, in the ordinary course of business, the Bancorp enters into certain derivative transactions as part of its overall strategy to manage its interest rate and prepayment risks. The Bancorp is also exposed to the risk of loss on its loan and lease portfolio, as a result of changing expected cash flows caused by borrower credit events, such as loan defaults and inadequate collateral.\nNoninterest income is derived from commercial banking revenue, service charges on deposits, wealth and asset management revenue, card and processing revenue, mortgage banking net revenue, leasing business revenue, other noninterest income and net securities gains or losses. Noninterest expense includes compensation and benefits, technology and communications, net occupancy expense, equipment expense, leasing business expense, card and processing expense, marketing expense and other noninterest expense.\nCOVID-19 Global Pandemic\nThe COVID-19 pandemic created significant economic uncertainty and financial disruptions during the year ended December 31, 2020, which has continued into 2021. Government and public responses to the COVID-19 pandemic, including temporary closures of businesses and the implementation of social distancing protocols, have caused and continue to cause, reductions and instability in economic activity that have resulted in increased unemployment levels in certain industries and volatility in the financial markets. During the year ended December 31, 2020 and the six months ended June 30, 2021, low interest rates, reduced economic activity and market volatility have had the most immediate negative impacts on the Bancorp’s performance. The Bancorp is unable to estimate the extent of the impact that these factors have had on its operating results since the pandemic began and it is likely that these factors will continue to adversely impact its future operating results.\n3\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe increased availability of COVID-19 vaccinations has begun to mitigate the public health effects of the pandemic, although there has been a rise of the Delta variant of COVID-19 and slower progress on vaccination rates, and recovery from the related economic crisis continues to disproportionately affect certain industries, geographies and demographics more than others. This uneven recovery, combined with the unprecedented nature of the government response to the pandemic, makes it difficult to predict the extent to which the pandemic will continue to adversely impact the Bancorp and its customers. Furthermore, resurgence risk remains present as new virus variants are identified. The Bancorp continues to closely monitor the pandemic and its effects on customers, employees, communities and markets.\nThe Bancorp has provided a variety of relief options for both commercial and consumer customers that were affected by the COVID-19 pandemic, including loan covenant relief, loan maturity extensions, payment deferrals, forbearances and fee waivers. For further information about these programs, refer to the Credit Risk Management subsection of the Risk Management section of MD&A included herein, and also Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\nGovernment Response to the COVID-19 Pandemic\nCongress, the FRB and the other U.S. state and federal financial regulatory agencies have taken actions to mitigate disruptions to economic activity and financial stability resulting from the COVID-19 pandemic. The descriptions below summarize certain significant government actions taken in response to the COVID-19 pandemic. The descriptions are qualified in their entirety by reference to the particular statutory or regulatory provisions or government programs summarized.\nThe CARES Act\nThe Coronavirus Aid, Relief and Economic Security (“CARES”) Act was signed into law on March 27, 2020 and has subsequently been amended several times, including by the Consolidated Appropriations Act, 2021. Among other provisions, the CARES Act included funding for the SBA to expand lending, relief from certain U.S. GAAP requirements to allow COVID-19-related loan modifications to not be categorized as TDRs, direct stimulus payments and a range of incentives to encourage deferment, forbearance or modification of consumer credit and mortgage contracts. One of the key CARES Act programs is the Paycheck Protection Program, discussed further below, which temporarily expanded the SBA’s business loan guarantee program.\nThe CARES Act contains additional protections for homeowners and renters of properties with federally-backed mortgages, including a 60-day moratorium on the initiation of foreclosure proceedings beginning on March 18, 2020 and a 120-day moratorium on initiating eviction proceedings effective March 27, 2020. Borrowers of federally-backed mortgages have the right under the CARES Act to request up to 360 days of forbearance on their mortgage payments if they experience financial hardship directly or indirectly due to the COVID-19 public health emergency. The FHA, FNMA and FHLMC independently extended their moratorium on foreclosures and evictions for single-family federally-backed mortgages through July 31, 2021.\nAlso pursuant to the CARES Act, the U.S. Treasury has the authority to provide loans, guarantees and other investments in support of eligible businesses, states and municipalities affected by the economic effects of COVID-19. Some of these funds have been used to support several FRB programs and facilities described below or additional programs or facilities that are established by its authority under Section 13(3) of the Federal Reserve Act which meet certain criteria.\nFRB Actions\nThe FRB has taken a range of actions to support the flow of credit to households and businesses, offset forced liquidations and restore liquidity in the financial markets. For example, on March 15, 2020, the FRB reduced the target range for the federal funds rate to 0 to 0.25% and announced that it would increase its holdings of U.S. Treasury securities and agency mortgage-backed securities and begin purchasing agency commercial mortgage-backed securities. The FRB has also encouraged depository institutions to borrow from the discount window and has lowered the primary credit rate for such borrowing by 150 basis points while extending the term of such loans up to 90 days. Reserve requirements have been reduced to zero as of March 26, 2020.\nIn addition, the FRB established a range of facilities and programs to support the U.S. economy and U.S. marketplace participants in response to economic disruptions associated with COVID-19. Through these facilities and programs, the FRB, relying on its authority under Section 13(3) of the Federal Reserve Act, has taken steps to directly or indirectly purchase assets from, or make loans to, U.S. companies, financial institutions, municipalities and other market participants.\nPaycheck Protection Program\nThe Bancorp is a participating lender in PPP, which is a program administered by the SBA to provide forgivable, guaranteed loans to eligible borrowers that have been affected by the COVID-19 pandemic. As of June 30, 2021, the Bancorp held PPP loans with a carrying amount of $3.7 billion under the program. PPP loans are available to a broader range of entities than ordinary SBA loans, require deferral of principal and interest repayment, and may be forgiven if the borrower demonstrates that the loan proceeds were used for qualified payroll costs and certain other expenses. The PPP has been expanded to permit second and third rounds of funding, including for certain borrowers who have already received a PPP loan, subject to certain conditions.\n4\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nAmerican Rescue Plan Act\nThe American Rescue Plan Act of 2021, which was signed into law on March 21, 2021, provides additional relief for businesses, states, municipalities and individuals by, among other things, allocating additional funds for the PPP, providing a third round of economic impact payments to individuals, extending supplemental federal unemployment benefits and providing advance payments of an expanded child tax credit. The impacts of the stimulus on the Bancorp’s business, results of operations and financial condition are highly uncertain and will depend on future developments, including the scope and duration of the pandemic and its impact on the economy in general.\nAccelerated Share Repurchase Transactions\nDuring the six months ended June 30, 2021, the Bancorp entered into and settled accelerated share repurchase transactions. As part of the transactions, the Bancorp entered into forward contracts in which the final number of shares delivered at settlement was based generally on a discount to the average daily volume weighted-average price of the Bancorp’s common stock during the term of the repurchase agreements. Refer to Note 15 and Note 23 of the Notes to Condensed Consolidated Financial Statements for additional information on share repurchase activity.\nThe following table presents a summary of the Bancorp’s accelerated share repurchase transactions that were entered into and settled during the six months ended June 30, 2021:\n| TABLE 1: Summary of Accelerated Share Repurchase Transactions |\n| Repurchase Date | Amount ($ in millions) | Shares Repurchased on Repurchase Date | Shares Received from Forward Contract Settlement | Total Shares Repurchased | Final Settlement Date |\n| January 26, 2021 | $ | 180 | 4,951,456 | 366,939 | 5,318,395 | March 31, 2021 |\n| April 23, 2021 | 347 | 7,894,807 | 675,295 | 8,570,102 | June 11, 2021 |\n\nLIBOR Transition\nIn July 2017, the Chief Executive of the United Kingdom Financial Conduct Authority (the “FCA”), which regulates LIBOR, announced that the FCA will stop persuading or compelling banks to submit rates for the calculation of LIBOR to the administrator of LIBOR after 2021. Since then, central banks around the world, including the Federal Reserve, have commissioned working groups of market participants and official sector representatives with the goal of finding suitable replacements for LIBOR. The Bancorp has substantial exposure to LIBOR-based products within its commercial lending, commercial deposits, business banking, consumer lending and capital markets lines of business as well as corporate treasury function. On November 30, 2020, the Federal Reserve, OCC, and FDIC issued a public statement that the administrator of LIBOR announced it will consult on an extension of publication of certain U.S. Dollar (“USD”) LIBOR tenors until June 30, 2023, which would allow additional legacy USD LIBOR contracts to mature before the succession of LIBOR. The administrator then announced on March 5, 2021, that it will cease publication of 1-week and 2-month USD LIBOR on December 31, 2021, and that overnight and 1-, 3-, 6-, and 12-month USD LIBOR will cease to be published on June 30, 2023. Although the full impact of LIBOR reforms and actions remains unclear, the Bancorp continues to prepare to transition from LIBOR to alternative reference rates, and it is expected that a broad transition away from the use of LIBOR to alternative reference rates for new financial contracts will occur by the end of 2021. In the United States, LIBOR-priced transactions and products will transfer to the Secured Overnight Financing Rate (“SOFR”), Prime Rate or other similar indices (collectively, “Alternative Rates”). There are risks inherent with the transition to any Alternative Rate as the rate may behave differently than LIBOR in reaction to monetary, market and economic events.\nThe Bancorp’s LIBOR transition plan is organized around key work streams, including continued engagement with central banks and industry working groups and regulators, active client engagement, comprehensive review of legacy documentation, internal operational and technological readiness, and risk management, among other things, to facilitate the transition to Alternative Rates. The Bancorp has implemented certain SOFR conventions and is in the process of developing other products and transaction agreements which are based on reference rates other than LIBOR. The Bancorp has also developed a transition plan for existing LIBOR-based financial contracts that are not expected to mature or settle prior to the cessation of LIBOR publication.\nFor a further discussion of the various risks the Bancorp faces in connection with the expected replacement of LIBOR on its operations, see “Risk Factors—Market Risks—The replacement of LIBOR could adversely affect Fifth Third’s revenue or expenses and the value of those assets or obligations.” in Item 1A. Risk Factors of the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\nKey Performance Indicators\nThe Bancorp, as a banking institution, utilizes various key indicators of financial condition and operating results in managing and monitoring the performance of the business. In addition to traditional financial metrics, such as revenue and expense trends, the Bancorp monitors other financial measures that assist in evaluating growth trends, capital strength and operational efficiencies. The Bancorp analyzes these key performance indicators against its past performance, its forecasted performance and with the performance of its peer banking institutions. These indicators may change from time to time as the operating environment and businesses change.\n5\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following are some of the key indicators used by management to assess the Bancorp’s business performance, including those which are considered in the Bancorp’s compensation programs:\n•CET1 Capital Ratio: CET1 capital divided by risk-weighted assets as defined by the Basel III standardized approach to risk-weighting of assets\n•Return on Average Tangible Common Equity (non-GAAP): Tangible net income available to common shareholders (annualized) divided by average tangible common equity\n•Net Interest Margin (non-GAAP): Net interest income on an FTE basis (annualized) divided by average interest-earning assets\n•Efficiency Ratio (non-GAAP): Noninterest expense divided by the sum of net interest income on an FTE basis and noninterest income\n•Earnings Per Share, Diluted: Net income allocated to common shareholders divided by average common shares outstanding after the effect of dilutive stock-based awards\n•Nonperforming Portfolio Assets Ratio: Nonperforming portfolio assets divided by portfolio loans and leases and OREO\n•Net Charge-off Ratio: Net losses charged-off (annualized) divided by average portfolio loans and leases\n•Return on Average Assets: Net income (annualized) divided by quarterly average assets\n•Loan-to-Deposit Ratio: Total loans divided by total deposits\nThe list of indicators above is intended to summarize some of the most important metrics utilized by management in evaluating the Bancorp’s performance and does not represent an all-inclusive list of all performance measures that may be considered relevant or important to management or investors.\n| TABLE 2: Earnings Summary |\n| For the three months endedJune 30, | % | For the six months endedJune 30, | % |\n| ($ in millions, except for per share data) | 2021 | 2020 | Change | 2021 | 2020 | Change |\n| Income Statement Data |\n| Net interest income (U.S. GAAP) | $ | 1,208 | 1,200 | 1 | $ | 2,385 | 2,429 | (2) |\n| Net interest income (FTE)(a)(b) | 1,211 | 1,203 | 1 | 2,391 | 2,436 | (2) |\n| Noninterest income | 741 | 650 | 14 | 1,490 | 1,321 | 13 |\n| Total revenue (FTE)(a)(b) | 1,952 | 1,853 | 5 | 3,881 | 3,757 | 3 |\n| (Benefit from) provision for credit losses(c) | (115) | 485 | NM | (288) | 1,125 | NM |\n| Noninterest expense | 1,153 | 1,121 | 3 | 2,369 | 2,321 | 2 |\n| Net income | 709 | 195 | 264 | 1,403 | 243 | 477 |\n| Net income available to common shareholders | 674 | 163 | 313 | 1,348 | 193 | 598 |\n| Common Share Data |\n| Earnings per share - basic | $ | 0.95 | 0.23 | 313 | $ | 1.89 | 0.27 | 600 |\n| Earnings per share - diluted | 0.94 | 0.23 | 309 | 1.87 | 0.27 | 593 |\n| Cash dividends declared per common share | 0.27 | 0.27 | — | 0.54 | 0.54 | — |\n| Book value per share | 29.57 | 28.88 | 2 | 29.57 | 28.88 | 2 |\n| Market value per share | 38.23 | 19.28 | 98 | 38.23 | 19.28 | 98 |\n| Financial Ratios |\n| Return on average assets | 1.38 | % | 0.40 | 245 | 1.38 | % | 0.26 | 431 |\n| Return on average common equity | 13.0 | 3.2 | 306 | 13.1 | 1.9 | 589 |\n| Return on average tangible common equity(b) | 16.6 | 4.3 | 286 | 16.7 | 2.7 | 519 |\n| Dividend payout | 28.4 | 117.4 | (76) | 28.6 | 200.0 | (86) |\n| Average total Bancorp shareholders’ equity as a percent of average assets | 11.11 | 11.30 | (2) | 11.18 | 11.92 | (74) |\n\n(a)Amounts presented on an FTE basis. The FTE adjustments were $3 for both the three months ended June 30, 2021 and 2020 and $6 and $7 for the six months ended June 30, 2021 and 2020, respectively.\n(b)These are non-GAAP measures. For further information, refer to the Non-GAAP Financial Measures section of MD&A.\n(c)The provision for credit losses is the sum of the provision for loan and lease losses and the provision for the reserve for unfunded commitments.\nEarnings Summary\nThe Bancorp’s net income available to common shareholders for the second quarter of 2021 was $674 million, or $0.94 per diluted share, which was net of $35 million in preferred stock dividends. The Bancorp’s net income available to common shareholders for the second quarter of 2020 was $163 million, or $0.23 per diluted share, which was net of $32 million in preferred stock dividends. The Bancorp’s net income available to common shareholders for the six months ended June 30, 2021 was $1.3 billion, or $1.87 per diluted share, which was net of $55 million in preferred stock dividends. The Bancorp’s net income available to common shareholders for the six months ended June 30, 2020 was $193 million, or $0.27 per diluted share, which was net of $50 million in preferred stock dividends.\n6\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nNet interest income on an FTE basis (non-GAAP) was $1.2 billion for the three months ended June 30, 2021, an increase of $8 million compared to the same period in the prior year. Net interest income benefited from increases in average residential mortgage loans and average indirect secured consumer loans from the three months ended June 30, 2020. Net interest income was also positively impacted by decreases in rates paid on average interest-bearing liabilities and a decrease in average long-term debt for the three months ended June 30, 2021 compared to the same period in the prior year. An increase in interest income recognized from PPP loans also positively impacted net interest income for the three months ended June 30, 2021. These benefits were partially offset by decreases in average balances in commercial and industrial loans and credit card from the three months ended June 30, 2020 and decreases in yields on average loans and leases due to the portfolio repricing to lower market interest rates.\nNet interest income on an FTE basis (non-GAAP) was $2.4 billion for the six months ended June 30, 2021, a decrease of $45 million compared to the same period in the prior year primarily due to the impact of lower market rates, which decreased the yield on total average loans and leases. In addition to market rate impacts on interest-earning assets, net interest income was also negatively impacted by decreases in average commercial and industrial loans, average credit card and average home equity balances from the six months ended June 30, 2020. These negative impacts were partially offset by decreases in rates paid on average interest-bearing liabilities. Net interest income also benefited from increases in average residential mortgage loan and average indirect secured consumer loan balances and a decrease in average long-term debt from the six months ended June 30, 2020. An increase in interest income recognized from PPP loans also positively impacted net interest income for the six months ended June 30, 2021. Net interest margin on an FTE basis (non-GAAP) was 2.63% and 2.62% for the three and six months ended June 30, 2021, respectively, compared to 2.75% and 2.99% for the comparable periods in the prior year.\nThe benefit from credit losses was $115 million and $288 million for the three and six months ended June 30, 2021, respectively, compared to a provision for credit losses of $485 million and $1.1 billion during the same periods in the prior year. Provision expense decreased for the three and six months ended June 30, 2021 compared to the same periods in the prior year primarily driven by factors which caused decreases in the ACL during those periods including improved economic forecasts, improved commercial and consumer credit quality and lower period-end loan and lease balances. Net losses charged off as a percent of average portfolio loans and leases were 0.16% and 0.44% for the three months ended June 30, 2021 and 2020, respectively, and 0.21% and 0.44% for the six months ended June 30, 2021 and 2020, respectively. At June 30, 2021, nonperforming portfolio assets as a percent of portfolio loans and leases and OREO decreased to 0.61% compared to 0.79% at December 31, 2020. For further discussion on credit quality refer to the Credit Risk Management subsection of the Risk Management section of MD&A as well as Note 6 of the Notes to Condensed Consolidated Financial Statements.\nNoninterest income increased $91 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to increases in other noninterest income, service charges on deposits, wealth and asset management revenue, commercial banking revenue and card and processing revenue of $37 million, $27 million, $25 million, $23 million, and $20 million, respectively. These increases were partially offset by a decrease in mortgage banking net revenue of $35 million.\nNoninterest income increased $169 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to increases in other noninterest income, commercial banking revenue, wealth and asset management revenue, card and processing revenue, service charges on deposits and leasing business revenue of $74 million, $52 million, $33 million, $29 million, $22 million and $17 million, respectively. These increases were partially offset by a decrease in mortgage banking net revenue of $70 million.\nNoninterest expense increased $32 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to increases in other noninterest expense and compensation and benefits expense of $29 million and $11 million, respectively. These increases were partially offset by decreases in card and processing expense and net occupancy expense of $9 million and $5 million, respectively.\nNoninterest expense increased $48 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to an increase in compensation and benefits expense of $69 million partially offset by decreases in card and processing expense, net occupancy expense and marketing expense of $10 million, $8 million and $8 million, respectively.\nFor more information on net interest income, noninterest income and noninterest expense refer to the Statements of Income Analysis section of MD&A.\nCapital Summary\nThe Bancorp calculated its regulatory capital ratios under the Basel III standardized approach to risk-weighting of assets and pursuant to the five-year transition provision option to phase in the effects of CECL on regulatory capital as of June 30, 2021. As of June 30, 2021, the Bancorp’s capital ratios, as defined by the U.S. banking agencies, were:\n•CET1 capital ratio: 10.37%;\n•Tier I risk-based capital ratio: 11.83%;\n•Total risk-based capital ratio: 14.60%; and\n•Tier I leverage ratio: 8.55%.\n7\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nNON-GAAP FINANCIAL MEASURES\nThe following are non-GAAP financial measures which provide useful insight to the reader of the Condensed Consolidated Financial Statements but should be supplemental to primary U.S. GAAP measures and should not be read in isolation or relied upon as a substitute for the primary U.S. GAAP measures.\nThe FTE basis adjusts for the tax-favored status of income from certain loans and leases and securities held by the Bancorp that are not taxable for federal income tax purposes. The Bancorp believes this presentation to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and non-taxable amounts.\nThe following table reconciles the non-GAAP financial measures of net interest income on an FTE basis, interest income on an FTE basis, net interest margin, net interest rate spread and the efficiency ratio to U.S. GAAP:\n| TABLE 3: Non-GAAP Financial Measures - Financial Measures and Ratios on an FTE basis |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Net interest income (U.S. GAAP) | $ | 1,208 | 1,200 | 2,385 | 2,429 |\n| Add: FTE adjustment | 3 | 3 | 6 | 7 |\n| Net interest income on an FTE basis (1) | $ | 1,211 | 1,203 | 2,391 | 2,436 |\n| Net interest income on an FTE basis (annualized) (2) | 4,857 | 4,838 | 4,822 | 4,899 |\n| Interest income (U.S. GAAP) | $ | 1,323 | 1,403 | 2,624 | 2,928 |\n| Add: FTE adjustment | 3 | 3 | 6 | 7 |\n| Interest income on an FTE basis | $ | 1,326 | 1,406 | 2,630 | 2,935 |\n| Interest income on an FTE basis (annualized) (3) | 5,319 | 5,655 | 5,304 | 5,902 |\n| Interest expense (annualized) (4) | $ | 461 | 816 | 482 | 1,003 |\n| Noninterest income (5) | 741 | 650 | 1,490 | 1,321 |\n| Noninterest expense (6) | 1,153 | 1,121 | 2,369 | 2,321 |\n| Average interest-earning assets (7) | 184,918 | 176,224 | 183,823 | 163,719 |\n| Average interest-bearing liabilities (8) | 115,951 | 124,478 | 116,315 | 116,861 |\n| Ratios: |\n| Net interest margin on an FTE basis (2) / (7) | 2.63 | % | 2.75 | 2.62 | 2.99 |\n| Net interest rate spread on an FTE basis ((3) / (7)) - ((4) / (8)) | 2.48 | 2.55 | 2.47 | 2.75 |\n| Efficiency ratio on an FTE basis (6) / ((1) + (5)) | 59.1 | 60.5 | 61.0 | 61.8 |\n\nThe Bancorp believes return on average tangible common equity is an important measure for comparative purposes with other financial institutions, but is not defined under U.S. GAAP, and therefore is considered a non-GAAP financial measure. This measure is useful for evaluating the performance of a business as it calculates the return available to common shareholders without the impact of intangible assets and their related amortization.\n8\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following table reconciles the non-GAAP financial measure of return on average tangible common equity to U.S. GAAP:\n| TABLE 4: Non-GAAP Financial Measures - Return on Average Tangible Common Equity |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Net income available to common shareholders (U.S. GAAP) | $ | 674 | 163 | 1,348 | 193 |\n| Add: Intangible amortization, net of tax | 8 | 9 | 17 | 20 |\n| Tangible net income available to common shareholders | $ | 682 | 172 | 1,365 | 213 |\n| Tangible net income available to common shareholders (annualized) (1) | 2,735 | 692 | 2,753 | 428 |\n| Average Bancorp shareholders’ equity (U.S. GAAP) | $ | 22,927 | 22,420 | 22,939 | 22,066 |\n| Less: Average preferred stock | 2,116 | 1,770 | 2,116 | 1,770 |\n| Average goodwill | 4,259 | 4,261 | 4,259 | 4,256 |\n| Average intangible assets | 122 | 178 | 128 | 186 |\n| Average tangible common equity (2) | $ | 16,430 | 16,211 | 16,436 | 15,854 |\n| Return on average tangible common equity (1) / (2) | 16.6 | % | 4.3 | 16.7 | 2.7 |\n\nThe Bancorp considers various measures when evaluating capital utilization and adequacy, including the tangible equity ratio and tangible common equity ratio, in addition to capital ratios defined by the U.S. banking agencies. These calculations are intended to complement the capital ratios defined by the U.S. banking agencies for both absolute and comparative purposes. Because U.S. GAAP does not include capital ratio measures, the Bancorp believes there are no comparable U.S. GAAP financial measures to these ratios. These ratios are not formally defined by U.S. GAAP or codified in the federal banking regulations and, therefore, are considered to be non-GAAP financial measures. The Bancorp encourages readers to consider its Condensed Consolidated Financial Statements in their entirety and not to rely on any single financial measure.\nThe following table reconciles non-GAAP capital ratios to U.S. GAAP:\n| TABLE 5: Non-GAAP Financial Measures - Capital Ratios |\n| As of ($ in millions) | June 30,2021 | December 31,2020 |\n| Total Bancorp Shareholders’ Equity (U.S. GAAP) | $ | 22,926 | 23,111 |\n| Less: Preferred stock | 2,116 | 2,116 |\n| Goodwill | 4,259 | 4,258 |\n| Intangible assets | 117 | 139 |\n| AOCI | 1,974 | 2,601 |\n| Tangible common equity, excluding AOCI (1) | $ | 14,460 | 13,997 |\n| Add: Preferred stock | 2,116 | 2,116 |\n| Tangible equity (2) | $ | 16,576 | 16,113 |\n| Total Assets (U.S. GAAP) | $ | 205,390 | 204,680 |\n| Less: Goodwill | 4,259 | 4,258 |\n| Intangible assets | 117 | 139 |\n| AOCI, before tax | 2,499 | 3,292 |\n| Tangible assets, excluding AOCI (3) | $ | 198,515 | 196,991 |\n| Ratios: |\n| Tangible equity as a percentage of tangible assets (2) / (3) | 8.35 | % | 8.18 |\n| Tangible common equity as a percentage of tangible assets (1) / (3) | 7.28 | 7.11 |\n\n9\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nRECENT ACCOUNTING STANDARDS\nNote 3 of the Notes to Condensed Consolidated Financial Statements provides a discussion of a significant new accounting standard applicable to the Bancorp.\nCRITICAL ACCOUNTING POLICIES\nThe Bancorp’s Condensed Consolidated Financial Statements are prepared in accordance with U.S. GAAP. Certain accounting policies require management to exercise judgment in determining methodologies, economic assumptions and estimates that may materially affect the Bancorp’s financial position, results of operations and cash flows. The Bancorp’s critical accounting policies include the accounting for the ALLL, reserve for unfunded commitments, valuation of servicing rights, fair value measurements, goodwill and legal contingencies. These accounting policies are discussed in detail in the Critical Accounting Policies section of the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020. There have been no material changes to the valuation techniques or models during the six months ended June 30, 2021.\n10\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nSTATEMENTS OF INCOME ANALYSIS\nNet Interest Income\nNet interest income is the interest earned on loans and leases (including yield-related fees), securities and other short-term investments less the interest incurred on core deposits (includes transaction deposits and other time deposits) and wholesale funding (includes certificates $100,000 and over, other deposits, federal funds purchased, other short-term borrowings and long-term debt). The net interest margin is calculated by dividing net interest income by average interest-earning assets. Net interest rate spread is the difference between the average yield earned on interest-earning assets and the average rate paid on interest-bearing liabilities. Net interest margin is typically greater than net interest rate spread due to the interest income earned on those assets that are funded by noninterest-bearing liabilities, or free funding, such as demand deposits or shareholders’ equity.\nTables 6 and 7 present the components of net interest income, net interest margin and net interest rate spread for the three and six months ended June 30, 2021 and 2020, as well as the relative impact of changes in the average balance sheet and changes in interest rates on net interest income. Nonaccrual loans and leases and loans and leases held for sale have been included in the average loan and lease balances. Average outstanding securities balances are based on amortized cost with any unrealized gains or losses included in average other assets.\nNet interest income on an FTE basis (non-GAAP) was $1.2 billion for the three months ended June 30, 2021, an increase of $8 million compared to the same period in the prior year. Net interest income benefited from increases in average residential mortgage loans and average indirect secured consumer loan balances of $4.3 billion and $2.6 billion, respectively, from the three months ended June 30, 2020. Net interest income was also positively impacted by decreases in rates paid on average interest-bearing liabilities primarily driven by decreases in rates paid on average money market deposits and average interest checking deposits of 27 bps and 18 bps, respectively, for the three months ended June 30, 2021 compared to the same period in the prior year. Net interest income also benefited from a decrease in average long-term debt of $3.1 billion for the three months ended June 30, 2021 compared to the same period in the prior year. Interest income recognized from PPP loans also positively impacted net interest income by $53 million for the three months ended June 30, 2021 compared to $23 million in the same period in the prior year. These benefits were partially offset by decreases in average commercial and industrial loan balances and average credit card balances of $10.3 billion and $478 million, respectively, from the three months ended June 30, 2020. Net interest income was also negatively impacted by loan portfolio repricing due to lower market interest rates, including a 63 bps decrease in yields on average indirect secured consumer loans for the three months ended June 30, 2021 compared to the same period in the prior year.\nNet interest income on an FTE basis (non-GAAP) was $2.4 billion for the six months ended June 30, 2021, a decrease of $45 million compared to the same period in the prior year primarily due to the impact of lower market rates. Monetary policy actions in response to the COVID-19 pandemic, including lowering the target range of the federal funds rate and the FRB’s bond purchase programs, have continued to adversely impact market rates since March of 2020. Yields on total average loans and leases decreased by 43 bps for the six months ended June 30, 2021 compared to the prior year driven by decreases in yields on average commercial loans and average consumer loans of 40 bps and 58 bps, respectively, for the six months ended June 30, 2021 compared to the same period in the prior year. The Bancorp has significant portfolios of floating interest rate loans (primarily LIBOR- or Prime-based) that were impacted by these decreases in yields. The Bancorp’s portfolios of fixed interest rate loans also decreased in yield as a result of increased refinance activity and lower reinvestment yields due to lower overall market rates. In addition to market rate impacts on interest-earning assets, net interest income was also negatively impacted by decreases in average commercial and industrial loans, average credit card and average home equity of $6.1 billion, $549 million and $1.1 billion, respectively, from the six months ended June 30, 2020. These negative impacts were partially offset by decreases in rates paid on average interest-bearing liabilities primarily driven by decreases in rates paid on average interest checking deposits and average money market deposits of 40 bps and 46 bps, respectively, for the six months ended June 30, 2021 compared to the same period in the prior year. Net interest income also benefited from increases in average residential mortgage loans and average indirect secured consumer loans of $3.4 billion and $2.4 billion, respectively, and a decrease in average long-term debt of $2.0 billion from the six months ended June 30, 2020. Interest income recognized from PPP loans also positively impacted net interest income by $106 million for the six months ended June 30, 2021 compared to $23 million in the same period in the prior year.\nNet interest rate spread on an FTE basis (non-GAAP) was 2.48% and 2.47% during the three and six months ended June 30, 2021, respectively, compared to 2.55% and 2.75% in the same periods in the prior year. Yields on average interest-earning assets decreased 33 bps and 72 bps for the three and six months ended June 30, 2021, respectively, partially offset by decreases in rates paid on average interest-bearing liabilities of 26 bps and 44 bps for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020.\nNet interest margin on an FTE basis (non-GAAP) was 2.63% and 2.62% for the three and six months ended June 30, 2021, respectively, compared to 2.75% and 2.99% for the comparable periods in the prior year. Net interest margin was negatively impacted by increases in low-yielding reserves held at the FRB reported in other short-term investments, which were primarily driven by elevated levels in average demand deposits and average interest-bearing deposits for the three and six months ended June 30, 2021 compared to the same periods in the prior year. Net interest margin results are expected to remain suppressed as a result of sustained excess cash balances, which are expected to remain elevated, driven by the amount of liquidity injected into the banking system as a result of monetary and fiscal stimulus programs implemented in response to the COVID-19 pandemic.\n11\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nInterest income on an FTE basis (non-GAAP) from loans and leases decreased $81 million and $288 million during the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020 driven by the previously mentioned decreases in yields and average balances of loans and leases. For more information on the Bancorp’s loan and lease portfolio, refer to the Loans and Leases subsection of the Balance Sheet Analysis section of MD&A. Interest income on an FTE basis (non-GAAP) from investment securities and other short-term investments increased $1 million during the three months ended June 30, 2021 compared to the three months ended June 30, 2020 primarily due to increases in the average balances of securities exempt from income taxes and other short-term investments, partially offset by a decrease in the average balance of taxable securities. Interest income on an FTE basis (non-GAAP) from investment securities and other short-term investments decreased $17 million during the six months ended June 30, 2021 compared to the six months ended June 30, 2020 primarily due to decreases in yields on average investment securities and average other short-term investments, partially offset by an increase in the average balance of other short-term investments.\nInterest expense on core deposits decreased $56 million and $188 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020 primarily due to decreases in the cost of average interest-bearing core deposits to 5 bps and 6 bps for the three and six months ended June 30, 2021, respectively, from 27 bps and 46 bps for the three and six months ended June 30, 2020. The decreases in the cost of average interest-bearing core deposits were primarily due to the previously mentioned decreases in rates paid on average interest checking deposits and average money market deposits. Refer to the Deposits subsection of the Balance Sheet Analysis section of MD&A for additional information on the Bancorp’s deposits.\nInterest expense on average wholesale funding decreased $32 million and $72 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020 primarily due to decreases in average balances of long-term debt and certificates $100,000 and over and decreases in rates paid on certificates $100,000 and over. Refer to the Borrowings subsection of the Balance Sheet Analysis section of MD&A for additional information on the Bancorp’s borrowings. During the three and six months ended June 30, 2021, average wholesale funding represented 14% and 15%, respectively, of average interest-bearing liabilities, compared to 19% for both the three and six months ended June 30, 2020. For more information on the Bancorp’s interest rate risk management, including estimated earnings sensitivity to changes in market interest rates, see the Interest Rate and Price Risk Management subsection of the Risk Management section of MD&A.\n12\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\n| TABLE 6: Condensed Average Balance Sheets and Analysis of Net Interest Income on an FTE Basis |\n| For the three months ended | June 30, 2021 | June 30, 2020 | Attribution of Change in Net Interest Income(a) |\n| ($ in millions) | Average Balance | Revenue/Cost | Average Yield/ Rate | Average Balance | Revenue/Cost | Average Yield/ Rate | Volume | Yield/ Rate | Total |\n| Assets: |\n| Interest-earning assets: |\n| Loans and leases:(b) |\n| Commercial and industrial loans | $ | 48,817 | 441 | 3.62 | % | $ | 59,106 | 510 | 3.47 | % | $ | (91) | 22 | (69) |\n| Commercial mortgage loans | 10,467 | 81 | 3.11 | 11,224 | 96 | 3.44 | (6) | (9) | (15) |\n| Commercial construction loans | 6,043 | 47 | 3.09 | 5,548 | 49 | 3.53 | 4 | (6) | (2) |\n| Commercial leases | 3,174 | 23 | 2.94 | 3,056 | 26 | 3.47 | 1 | (4) | (3) |\n| Total commercial loans and leases | $ | 68,501 | 592 | 3.47 | $ | 78,934 | 681 | 3.47 | $ | (92) | 3 | (89) |\n| Residential mortgage loans | 21,740 | 178 | 3.29 | 17,405 | 153 | 3.53 | 36 | (11) | 25 |\n| Home equity | 4,674 | 42 | 3.60 | 5,820 | 52 | 3.60 | (10) | — | (10) |\n| Indirect secured consumer loans | 14,702 | 125 | 3.41 | 12,124 | 122 | 4.04 | 24 | (21) | 3 |\n| Credit card | 1,770 | 54 | 12.13 | 2,248 | 63 | 11.28 | (14) | 5 | (9) |\n| Other consumer loans | 3,056 | 46 | 5.96 | 2,887 | 47 | 6.50 | 3 | (4) | (1) |\n| Total consumer loans | $ | 45,942 | 445 | 3.88 | $ | 40,484 | 437 | 4.34 | $ | 39 | (31) | 8 |\n| Total loans and leases | $ | 114,443 | 1,037 | 3.63 | % | $ | 119,418 | 1,118 | 3.76 | % | $ | (53) | (28) | (81) |\n| Securities: |\n| Taxable | 36,097 | 275 | 3.06 | 36,817 | 282 | 3.08 | (5) | (2) | (7) |\n| Exempt from income taxes(b) | 820 | 5 | 2.47 | 156 | 1 | 2.96 | 4 | — | 4 |\n| Other short-term investments | 33,558 | 9 | 0.11 | 19,833 | 5 | 0.11 | 4 | — | 4 |\n| Total interest-earning assets | $ | 184,918 | 1,326 | 2.88 | % | $ | 176,224 | 1,406 | 3.21 | % | $ | (50) | (30) | (80) |\n| Cash and due from banks | 3,033 | 3,121 |\n| Other assets | 20,608 | 21,394 |\n| Allowance for loan and lease losses | (2,206) | (2,352) |\n| Total assets | $ | 206,353 | $ | 198,387 |\n| Liabilities and Equity: |\n| Interest-bearing liabilities: |\n| Interest checking deposits | $ | 45,307 | 6 | 0.06 | % | $ | 49,760 | 29 | 0.24 | % | $ | (3) | (20) | (23) |\n| Savings deposits | 20,494 | 1 | 0.02 | 16,354 | 3 | 0.06 | — | (2) | (2) |\n| Money market deposits | 30,844 | 4 | 0.05 | 30,022 | 24 | 0.32 | 1 | (21) | (20) |\n| Foreign office deposits | 140 | — | 0.03 | 182 | — | 0.09 | — | — | — |\n| Other time deposits | 2,696 | 2 | 0.27 | 4,421 | 13 | 1.21 | (3) | (8) | (11) |\n| Total interest-bearing core deposits | $ | 99,481 | 13 | 0.05 | $ | 100,739 | 69 | 0.27 | $ | (5) | (51) | (56) |\n| Certificates $100,000 and over | 1,144 | 2 | 0.80 | 4,067 | 14 | 1.40 | (8) | (4) | (12) |\n| Other deposits | — | — | — | 31 | — | 0.04 | — | — | — |\n| Federal funds purchased | 346 | — | 0.10 | 309 | — | 0.16 | — | — | — |\n| Other short-term borrowings | 1,097 | — | 0.12 | 2,377 | 2 | 0.32 | (1) | (1) | (2) |\n| Long-term debt | 13,883 | 100 | 2.85 | 16,955 | 118 | 2.80 | (20) | 2 | (18) |\n| Total interest-bearing liabilities | $ | 115,951 | 115 | 0.40 | % | $ | 124,478 | 203 | 0.66 | % | $ | (34) | (54) | (88) |\n| Demand deposits | 61,994 | 45,761 |\n| Other liabilities | 5,481 | 5,727 |\n| Total liabilities | $ | 183,426 | $ | 175,966 |\n| Total equity | $ | 22,927 | $ | 22,421 |\n| Total liabilities and equity | $ | 206,353 | $ | 198,387 |\n| Net interest income (FTE)(c) | $ | 1,211 | $ | 1,203 | $ | (16) | 24 | 8 |\n| Net interest margin (FTE)(c) | 2.63 | % | 2.75 | % |\n| Net interest rate spread (FTE)(c) | 2.48 | 2.55 |\n| Interest-bearing liabilities to interest-earning assets | 62.70 | 70.64 |\n\n(a)Changes in interest not solely due to volume or yield/rate are allocated in proportion to the absolute dollar amount of change in volume and yield/rate.\n(b)The FTE adjustments included in the above table were $3 for both the three months ended June 30, 2021 and 2020.\n(c)Net interest income (FTE), net interest margin (FTE) and net interest rate spread (FTE) are non-GAAP measures. For further information, refer to the Non-GAAP Financial Measures section of MD&A.\n13\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\n| TABLE 7: Condensed Average Balance Sheets and Analysis of Net Interest Income on an FTE Basis |\n| For the six months ended | June 30, 2021 | June 30, 2020 | Attribution of Change in Net Interest Income(a) |\n| ($ in millions) | Average Balance | Revenue/Cost | Average Yield/ Rate | Average Balance | Revenue/Cost | Average Yield/ Rate | Volume | Yield/ Rate | Total |\n| Assets: |\n| Interest-earning assets: |\n| Loans and leases:(b) |\n| Commercial and industrial loans | $ | 49,263 | 882 | 3.61 | % | $ | 55,399 | 1,056 | 3.83 | % | $ | (115) | (59) | (174) |\n| Commercial mortgage loans | 10,500 | 161 | 3.09 | 11,122 | 218 | 3.94 | (12) | (45) | (57) |\n| Commercial construction loans | 6,041 | 94 | 3.15 | 5,340 | 110 | 4.15 | 13 | (29) | (16) |\n| Commercial leases | 3,152 | 48 | 3.05 | 3,128 | 54 | 3.47 | — | (6) | (6) |\n| Total commercial loans and leases | $ | 68,956 | 1,185 | 3.46 | $ | 74,989 | 1,438 | 3.86 | $ | (114) | (139) | (253) |\n| Residential mortgage loans | 21,095 | 347 | 3.32 | 17,715 | 315 | 3.58 | 56 | (24) | 32 |\n| Home equity | 4,841 | 86 | 3.59 | 5,913 | 123 | 4.16 | (22) | (15) | (37) |\n| Indirect secured consumer loans | 14,331 | 248 | 3.49 | 11,967 | 242 | 4.07 | 43 | (37) | 6 |\n| Credit card | 1,824 | 111 | 12.25 | 2,373 | 138 | 11.72 | (33) | 6 | (27) |\n| Other consumer loans | 3,027 | 91 | 6.04 | 2,842 | 100 | 7.09 | 6 | (15) | (9) |\n| Total consumer loans | $ | 45,118 | 883 | 3.95 | $ | 40,810 | 918 | 4.53 | $ | 50 | (85) | (35) |\n| Total loans and leases | $ | 114,074 | 2,068 | 3.66 | % | $ | 115,799 | 2,356 | 4.09 | % | $ | (64) | (224) | (288) |\n| Securities: |\n| Taxable | 35,932 | 537 | 3.01 | 36,395 | 564 | 3.12 | (8) | (19) | (27) |\n| Exempt from income taxes(b) | 677 | 8 | 2.39 | 159 | 3 | 3.00 | 6 | (1) | 5 |\n| Other short-term investments | 33,140 | 17 | 0.10 | 11,366 | 12 | 0.22 | 14 | (9) | 5 |\n| Total interest-earning assets | $ | 183,823 | 2,630 | 2.89 | % | $ | 163,719 | 2,935 | 3.61 | % | $ | (52) | (253) | (305) |\n| Cash and due from banks | 3,012 | 3,000 |\n| Other assets | 20,595 | 20,509 |\n| Allowance for loan and lease losses | (2,328) | (2,099) |\n| Total assets | $ | 205,102 | $ | 185,129 |\n| Liabilities and Equity: |\n| Interest-bearing liabilities: |\n| Interest checking deposits | $ | 45,437 | 14 | 0.06 | % | $ | 45,029 | 104 | 0.46 | % | $ | 1 | (91) | (90) |\n| Savings deposits | 19,727 | 2 | 0.02 | 15,534 | 7 | 0.09 | 1 | (6) | (5) |\n| Money market deposits | 30,723 | 7 | 0.05 | 28,565 | 72 | 0.51 | 5 | (70) | (65) |\n| Foreign office deposits | 134 | — | 0.04 | 196 | — | 0.35 | — | — | — |\n| Other time deposits | 2,870 | 5 | 0.36 | 4,751 | 33 | 1.40 | (10) | (18) | (28) |\n| Total interest-bearing core deposits | $ | 98,891 | 28 | 0.06 | $ | 94,075 | 216 | 0.46 | $ | (3) | (185) | (188) |\n| Certificates $100,000 and over | 1,574 | 8 | 0.98 | 3,711 | 31 | 1.71 | (13) | (10) | (23) |\n| Other deposits | — | — | — | 144 | 1 | 0.76 | (1) | — | (1) |\n| Federal funds purchased | 335 | — | 0.11 | 481 | 2 | 0.82 | (1) | (1) | (2) |\n| Other short-term borrowings | 1,153 | 1 | 0.18 | 2,063 | 8 | 0.74 | (3) | (4) | (7) |\n| Long-term debt | 14,362 | 202 | 2.84 | 16,387 | 241 | 2.95 | (30) | (9) | (39) |\n| Total interest-bearing liabilities | $ | 116,315 | 239 | 0.42 | % | $ | 116,861 | 499 | 0.86 | % | $ | (51) | (209) | (260) |\n| Demand deposits | 60,300 | 40,763 |\n| Other liabilities | 5,548 | 5,438 |\n| Total liabilities | $ | 182,163 | $ | 163,062 |\n| Total equity | $ | 22,939 | $ | 22,067 |\n| Total liabilities and equity | $ | 205,102 | $ | 185,129 |\n| Net interest income (FTE)(c) | $ | 2,391 | $ | 2,436 | $ | (1) | (44) | (45) |\n| Net interest margin (FTE)(c) | 2.62 | % | 2.99 | % |\n| Net interest rate spread (FTE)(c) | 2.47 | 2.75 |\n| Interest-bearing liabilities to interest-earning assets | 63.28 | 71.38 |\n\n(a)Changes in interest not solely due to volume or yield/rate are allocated in proportion to the absolute dollar amount of change in volume and yield/rate.\n(b)The FTE adjustments included in the above table were $6 and $7 for the six months ended June 30, 2021 and 2020, respectively.\n(c)Net interest income (FTE), net interest margin (FTE) and net interest rate spread (FTE) are non-GAAP measures. For further information, refer to the Non-GAAP Financial Measures section of MD&A.\n14\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nProvision for Credit Losses\nThe Bancorp provides, as an expense, an amount for expected credit losses within the loan and lease portfolio and the portfolio of unfunded loan commitments and letters of credit that is based on factors previously discussed in the Critical Accounting Policies section of the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020. The provision is recorded to bring the ALLL and reserve for unfunded commitments to a level deemed appropriate by the Bancorp to cover losses expected in the portfolios. Actual credit losses on loans and leases are charged against the ALLL. The amount of loans and leases actually removed from the Condensed Consolidated Balance Sheets are referred to as charge-offs. Net charge-offs include current period charge-offs less recoveries on previously charged-off loans and leases.\nThe benefit from credit losses was $115 million and $288 million for the three and six months ended June 30, 2021, respectively, compared to a provision for credit losses of $485 million and $1.1 billion during the same periods in the prior year. Provision expense decreased for the three and six months ended June 30, 2021 compared to the same periods in the prior year primarily driven by factors which caused decreases in the ACL during those periods including improved economic forecasts, improved commercial and consumer credit quality and lower period-end loan and lease balances. Provision expense was elevated in 2020 as the Bancorp increased its ACL in response to deterioration and uncertainty in the macroeconomic environment as a result of the impact of the COVID-19 pandemic, continued pressure on energy prices and the resulting impact of these factors on commercial borrowers as reflected in increased levels of commercial criticized assets. In the first and second quarters of 2021, the Bancorp decreased the ACL, reflecting credit quality and stabilization in the macroeconomic environment, aided by fiscal and monetary stimulus programs as well as the easing of government-imposed restrictions related to the COVID-19 pandemic.\nThe ALLL decreased $420 million from December 31, 2020 to $2.0 billion at June 30, 2021. At June 30, 2021, the ALLL as a percent of portfolio loans and leases decreased to 1.89%, compared to 2.25% at December 31, 2020. The reserve for unfunded commitments increased $17 million from December 31, 2020 to $189 million at June 30, 2021. The ACL as a percent of portfolio loans and leases decreased to 2.06% at June 30, 2021, compared to 2.41% at December 31, 2020.\nRefer to the Credit Risk Management subsection of the Risk Management section of MD&A as well as Note 6 of the Notes to Condensed Consolidated Financial Statements for more detailed information on the provision for credit losses, including an analysis of loan and lease portfolio composition, nonperforming assets, net charge-offs and other factors considered by the Bancorp in assessing the credit quality of the loan and lease portfolio and determining the level of the ACL.\nNoninterest Income\nNoninterest income increased $91 million and $169 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020.\nThe following table presents the components of noninterest income:\n| TABLE 8: Components of Noninterest Income |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | % Change | 2021 | 2020 | % Change |\n| Commercial banking revenue | $ | 160 | 137 | 17 | $ | 313 | 261 | 20 |\n| Service charges on deposits | 149 | 122 | 22 | 292 | 270 | 8 |\n| Wealth and asset management revenue | 145 | 120 | 21 | 288 | 255 | 13 |\n| Card and processing revenue | 102 | 82 | 24 | 196 | 167 | 17 |\n| Mortgage banking net revenue | 64 | 99 | (35) | 149 | 219 | (32) |\n| Leasing business revenue | 61 | 57 | 7 | 148 | 131 | 13 |\n| Other noninterest income | 49 | 12 | 308 | 92 | 18 | 411 |\n| Securities gains (losses), net | 10 | 21 | (52) | 13 | (3) | NM |\n| Securities (losses) gains, net – non-qualifying hedges on mortgage servicing rights | 1 | — | NM | (1) | 3 | NM |\n| Total noninterest income | $ | 741 | 650 | 14 | $ | 1,490 | 1,321 | 13 |\n\nCommercial banking revenue\nCommercial banking revenue increased $23 million and $52 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020. The increase for the three months ended June 30, 2021 compared to the same period in the prior year was primarily driven by increases in loan syndication fees and business lending fees of $20 million and $10 million, respectively, partially offset by a decrease in institutional sales of $10 million. The increase for the six months ended June 30, 2021 compared to the same period in the prior year was primarily due to increases in loan syndication fees, business lending fees and institutional sales of $29 million, $14 million and $12 million, respectively, partially offset by a decrease in contract revenue from commercial customer derivatives of $7 million.\n15\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nService charges on deposits\nService charges on deposits increased $27 million and $22 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020. The increase for the three months ended June 30, 2021 compared to the same period in the prior year was due to increases in commercial deposit fees and consumer deposit fees of $17 million and $10 million, respectively. The increase for the six months ended June 30, 2021 compared to the same period in the prior year was primarily due to an increase of $22 million in commercial deposit fees.\nWealth and asset management revenue\nWealth and asset management revenue increased $25 million and $33 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in private client service fees of $19 million and $28 million, respectively, and broker income of $10 million and $14 million, respectively. These increases were partially offset by decreases in institutional fees of $4 million and $7 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020. The Bancorp’s trust and registered investment advisory businesses had approximately $483 billion and $405 billion in total assets under care as of June 30, 2021 and 2020, respectively, and managed $61 billion and $49 billion in assets for individuals, corporations and not-for-profit organizations as of June 30, 2021 and 2020, respectively.\nCard and processing revenue\nCard and processing revenue increased $20 million and $29 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020 primarily due to an increase in debit and credit card interchange, partially offset by increased reward costs, all of which were driven by an increase in consumer and business card spend volume.\nMortgage banking net revenue\nMortgage banking net revenue decreased $35 million and $70 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020 primarily due to lower net mortgage servicing revenue.\nThe following table presents the components of mortgage banking net revenue:\n| TABLE 9: Components of Mortgage Banking Net Revenue |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Origination fees and gains on loan sales | $ | 81 | 95 | 170 | 176 |\n| Net mortgage servicing revenue: |\n| Gross mortgage servicing fees | 59 | 63 | 117 | 130 |\n| Net valuation adjustments on MSRs and free-standing derivatives purchased to economically hedge MSRs | (76) | (59) | (138) | (87) |\n| Net mortgage servicing revenue | (17) | 4 | (21) | 43 |\n| Total mortgage banking net revenue | $ | 64 | 99 | 149 | 219 |\n\nOrigination fees and gains on loan sales decreased $14 million and $6 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020 primarily driven by decreases in gain on sale margins partially offset by gains from sales of loans that were previously repurchased from GNMA. Residential mortgage loan originations increased to $5.0 billion and $9.7 billion for the three and six months ended June 30, 2021, respectively, from $3.4 billion and $7.4 billion for the three and six months ended June 30, 2020, respectively.\nNet mortgage servicing revenue decreased $21 million and $64 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020 primarily due to increases in net negative valuation adjustments of $17 million and $51 million, respectively, as well as decreases in gross mortgage servicing fees of $4 million and $13 million, respectively. Refer to Table 10 for the components of net valuation adjustments on the MSR portfolio and the impact of the non-qualifying hedging strategy.\n16\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\n| TABLE 10: Components of Net Valuation Adjustments on MSRs |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Changes in fair value and settlement of free-standing derivatives purchased to economically hedge the MSR portfolio | $ | 46 | 11 | (88) | 361 |\n| Changes in fair value: |\n| Due to changes in inputs or assumptions(a) | (49) | (12) | 103 | (343) |\n| Other changes in fair value(b) | (73) | (58) | (153) | (105) |\n| Net valuation adjustments on MSRs and free-standing derivatives purchased to economically hedge MSRs | $ | (76) | (59) | (138) | (87) |\n\n(a)Primarily reflects changes in prepayment speed and OAS assumptions which are updated based on market interest rates.\n(b)Primarily reflects changes due to realized cash flows and the passage of time.\nFor the three and six months ended June 30, 2021, the Bancorp recognized losses of $122 million and $50 million, respectively, in mortgage banking net revenue for valuation adjustments on the MSR portfolio. The valuation adjustments on the MSR portfolio included a decrease of $49 million for the three months ended June 30, 2021 and an increase of $103 million for the six months ended June 30, 2021 due to changes in market rates and other inputs in the valuation model, including future prepayment speeds and OAS assumptions. For the three months ended June 30, 2021, a decrease in mortgage rates caused modeled prepayment speeds to rise. For the six months ended June 30, 2021, an increase in mortgage rates resulted in a reduction to modeled prepayment speeds, and a tightening of the spread between mortgage rates and swap rates resulted in a decrease in the modeled OAS assumptions. The fair value of the MSR portfolio also decreased $73 million and $153 million as a result of contractual principal payments and actual prepayment activity for the three and six months ended June 30, 2021, respectively.\nMortgage rates decreased during both the three and six months ended June 30, 2020, which caused modeled prepayment speeds to rise. The fair value of the MSR portfolio decreased $12 million and $343 million for the three and six months ended June 30, 2020, respectively, due to changes to inputs to the valuation model including prepayment speeds and OAS assumptions and decreased $58 million and $105 million for the three and six months ended June 30, 2020, respectively, due to the impact of contractual principal payments and actual prepayment activity.\nFurther detail on the valuation of MSRs can be found in Note 12 of the Notes to Condensed Consolidated Financial Statements. The Bancorp maintains a non-qualifying hedging strategy to manage a portion of the risk associated with changes in the valuation of the MSR portfolio. Refer to Note 13 of the Notes to Condensed Consolidated Financial Statements for more information on the free-standing derivatives used to economically hedge the MSR portfolio.\nIn addition to the derivative positions used to economically hedge the MSR portfolio, the Bancorp acquires various securities as a component of its non-qualifying hedging strategy. The Bancorp recognized net gains of $1 million and net losses of $1 million during the three and six months ended June 30, 2021, respectively, compared to net gains of an immaterial amount and $3 million during the three and six months ended June 30, 2020, respectively, recorded in securities (losses) gains, net – non-qualifying hedges on mortgage servicing rights in the Bancorp’s Condensed Consolidated Statements of Income.\nThe Bancorp’s total residential mortgage loans serviced as of June 30, 2021 and 2020 were $93.0 billion and $95.4 billion, respectively, with $71.5 billion and $78.8 billion, respectively, of residential mortgage loans serviced for others.\nLeasing business revenue\nLeasing business revenue increased $4 million and $17 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020. The increase for the three months ended June 30, 2021 compared to the same period in the prior year was primarily due to increases in lease remarketing fees and leasing business solutions revenue of $3 million and $2 million respectively. The increase for the six months ended June 30, 2021 compared to the same period in the prior year was primarily due to an increase of $39 million in lease syndication fees, partially offset by a decrease of $22 million in lease remarketing fees.\n17\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nOther noninterest income\nThe following table presents the components of other noninterest income:\n| TABLE 11: Components of Other Noninterest Income |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| BOLI income | $ | 15 | 17 | 31 | 32 |\n| Cardholder fees | 13 | 10 | 25 | 21 |\n| Equity method investment income | 14 | — | 21 | 3 |\n| Private equity investment income (loss) | 20 | 6 | 19 | (8) |\n| Banking center income | 6 | 4 | 11 | 10 |\n| Consumer loan fees | 4 | 5 | 8 | 10 |\n| Insurance income | 2 | 4 | 3 | 10 |\n| Loss on swap associated with the sale of Visa, Inc. Class B Shares | (37) | (29) | (50) | (51) |\n| Net losses on disposition and impairment of bank premises and equipment | (1) | (12) | (1) | (15) |\n| Other, net | 13 | 7 | 25 | 6 |\n| Total other noninterest income | $ | 49 | 12 | 92 | 18 |\n\nOther noninterest income increased $37 million for the three months ended June 30, 2021 compared to the three months ended June 30, 2020 primarily due to increases in private equity investment income and equity method investment income as well as a decrease in net losses on disposition and impairment of bank premises and equipment, partially offset by an increase in the loss on the swap associated with the sale of Visa, Inc. Class B Shares.\nPrivate equity investment income increased $14 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily driven by the recognition of positive net valuation adjustments on certain private equity investments during the three months ended June 30, 2021. Equity method investment income increased $14 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to gains and proportional earnings recognized on certain equity method investments during the three months ended June 30, 2021. Net losses on disposition and impairment of bank premises and equipment decreased $11 million for the three months ended June 30, 2021 compared to the three months ended June 30, 2020 driven by the impact of impairment charges of $2 million during the three months ended June 30, 2021 compared to $12 million during the three months ended June 30, 2020. For additional information, refer to Note 7 of the Notes to Condensed Consolidated Financial Statements. The Bancorp recognized negative valuation adjustments of $37 million related to the Visa total return swap during the three months ended June 30, 2021 compared to negative valuation adjustments of $29 million during the three months ended June 30, 2020. For additional information on the valuation of the swap associated with the sale of Visa, Inc. Class B Shares, refer to Note 21 of the Notes to Condensed Consolidated Financial Statements.\nOther noninterest income increased $74 million for the six months ended June 30, 2021 compared to the six months ended June 30, 2020 primarily due to increases in private equity investment income and equity method investment income and a decrease in net losses on disposition and impairment of bank premises and equipment, partially offset by a decrease in insurance income.\nPrivate equity investment income increased $27 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily driven by the recognition of positive net valuation adjustments on certain private equity investments during the six months ended June 30, 2021 and the impact of impairment charges recognized on certain private equity investments during the six months ended June 30, 2020. For additional information on the valuation of private equity investments, refer to Note 21 of the Notes to Condensed Consolidated Financial Statements. Equity method investment income increased $18 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to gains and proportional earnings recognized on certain equity method investments during the six months ended June 30, 2021. Net losses on disposition and impairment of bank premises and equipment decreased $14 million for the six months ended June 30, 2021 compared to the six months ended June 30, 2020 driven by the impact of impairment charges of $4 million during the six months ended June 30, 2021 compared to $14 million during the six months ended June 30, 2020. For additional information, refer to Note 7 of the Notes to Condensed Consolidated Financial Statements. Insurance income decreased $7 million for the six months ended June 30, 2021 compared to the same period in the prior year driven by the sale of the Bancorp’s property and casualty insurance business in the fourth quarter of 2020.\n18\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nNoninterest Expense\nNoninterest expense increased $32 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to increases in other noninterest expense and compensation and benefits expense, partially offset by decreases in card and processing expense and net occupancy expense. Noninterest expense increased $48 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to an increase in compensation and benefits expense, partially offset by decreases in card and processing expense, net occupancy expense and marketing expense.\nThe following table presents the components of noninterest expense:\n| TABLE 12: Components of Noninterest Expense |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | % Change | 2021 | 2020 | % Change |\n| Compensation and benefits | $ | 638 | 627 | 2 | $ | 1,343 | 1,274 | 5 |\n| Technology and communications | 94 | 90 | 4 | 187 | 183 | 2 |\n| Net occupancy expense | 77 | 82 | (6) | 156 | 164 | (5) |\n| Equipment expense | 34 | 32 | 6 | 68 | 64 | 6 |\n| Leasing business expense | 33 | 33 | — | 68 | 68 | — |\n| Card and processing expense | 20 | 29 | (31) | 50 | 60 | (17) |\n| Marketing expense | 20 | 20 | — | 43 | 51 | (16) |\n| Other noninterest expense | 237 | 208 | 14 | 454 | 457 | (1) |\n| Total noninterest expense | $ | 1,153 | 1,121 | 3 | $ | 2,369 | 2,321 | 2 |\n| Efficiency ratio on an FTE basis(a) | 59.1 | % | 60.5 | 61.0 | % | 61.8 |\n\n(a)This is a non-GAAP measure. For further information, refer to the Non-GAAP Financial Measures section of MD&A.\nCompensation and benefits expense increased $11 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to an increase in performance-based compensation. Compensation and benefits expense increased $69 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to an increase in non-qualified deferred compensation expense and performance-based compensation. Full-time equivalent employees totaled 19,402 at June 30, 2021 compared to 20,340 at June 30, 2020.\nCard and processing expense decreased $9 million and $10 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to contract renegotiations with a third-party vendor. Net occupancy expense decreased $5 million and $8 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to a reduction of leased square footage. Marketing expense decreased $8 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to the impact of the COVID-19 pandemic, which resulted in a pause or slowdown in numerous marketing campaigns, including running less advertising, as well as the suspension of cash bonuses and other account acquisition programs.\n19\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following table presents the components of other noninterest expense:\n| TABLE 13: Components of Other Noninterest Expense |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Loan and lease | $ | 55 | 40 | 104 | 75 |\n| FDIC insurance and other taxes | 30 | 24 | 58 | 49 |\n| Data processing | 20 | 17 | 40 | 35 |\n| Professional service fees | 16 | 13 | 32 | 23 |\n| Losses and adjustments | 23 | 17 | 30 | 71 |\n| Intangible amortization | 10 | 12 | 21 | 25 |\n| Postal and courier | 9 | 8 | 18 | 18 |\n| Travel | 7 | 4 | 10 | 19 |\n| Recruitment and education | 5 | 5 | 10 | 11 |\n| Insurance | 4 | 3 | 8 | 7 |\n| Supplies | 3 | 3 | 5 | 7 |\n| Donations | 3 | 4 | 5 | 7 |\n| Other, net | 52 | 58 | 113 | 110 |\n| Total other noninterest expense | $ | 237 | 208 | 454 | 457 |\n\nOther noninterest expense increased $29 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to increases in loan and lease expense, losses and adjustments and FDIC insurance and other taxes. Other noninterest expense decreased $3 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to decreases in losses and adjustments and travel expense, partially offset by increases in loan and lease expense, FDIC insurance and other taxes and professional service fees.\nLoan and lease expense increased $15 million and $29 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to an increase in loan servicing expenses associated with the Bancorp’s purchases of certain government-guaranteed residential mortgage loans in forbearance programs. FDIC insurance and other taxes increased $6 million and $9 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily as a result of an increase in the assessment rate due to a change in asset mix as well as an increase in the assessment base.\nLosses and adjustments increased $6 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to an increase in legal settlements, partially offset by a decline in credit valuation adjustments on derivatives associated with customer accommodation contracts. Losses and adjustments decreased $41 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to a decline in credit valuation adjustments on derivatives associated with customer accommodation contracts, partially offset by an increase in legal settlements.\nTravel expense decreased $9 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to reduced business travel as a direct result of the COVID-19 pandemic.\nProfessional service fees increased $9 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily driven by increases in consulting fees and legal fees.\nApplicable Income Taxes\nThe Bancorp’s income before income taxes, applicable income tax expense and effective tax rate are as follows:\n| TABLE 14: Applicable Income Taxes |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Income before income taxes | $ | 911 | 244 | 1,794 | 304 |\n| Applicable income tax expense | 202 | 49 | 391 | 61 |\n| Effective tax rate | 22.1 | % | 19.9 | 21.8 | 20.4 |\n\nApplicable income tax expense for all periods presented includes the benefit from tax-exempt income, tax-advantaged investments, and tax credits (and other related tax benefits), partially offset by the effect of proportional amortization of qualifying LIHTC investments and certain nondeductible expenses. The tax credits are primarily associated with the Low-Income Housing Tax Credit program established under\n20\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nSection 42 of the IRC, the New Markets Tax Credit program established under Section 45D of the IRC, the Rehabilitation Investment Tax Credit program established under Section 47 of the IRC and the Qualified Zone Academy Bond program established under Section 1397E of the IRC.\nThe effective tax rate increased to 22.1% and 21.8% for the three and six months ended June 30, 2021, respectively, from 19.9% and 20.4% for the same periods in the prior year primarily related to an increase in forecasted income before income taxes.\n21\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nBALANCE SHEET ANALYSIS\nLoans and Leases\nThe Bancorp classifies its commercial loans and leases based upon primary purpose and consumer loans based upon product or collateral. Table 15 summarizes end of period loans and leases, including loans and leases held for sale and Table 16 summarizes average total loans and leases, including average loans and leases held for sale.\n| TABLE 15: Components of Total Loans and Leases (including loans and leases held for sale) |\n| June 30, 2021 | December 31, 2020 |\n| As of ($ in millions) | Carrying Value | % of Total | Carrying Value | % of Total |\n| Commercial loans and leases: |\n| Commercial and industrial loans(a) | $ | 47,575 | 42 | % | $ | 49,895 | 44 | % |\n| Commercial mortgage loans | 10,380 | 9 | 10,609 | 9 |\n| Commercial construction loans | 5,873 | 5 | 5,815 | 5 |\n| Commercial leases | 3,238 | 3 | 2,954 | 3 |\n| Total commercial loans and leases | $ | 67,066 | 59 | $ | 69,273 | 61 |\n| Consumer loans: |\n| Residential mortgage loans(b) | 21,815 | 19 | 20,393 | 18 |\n| Home equity | 4,545 | 4 | 5,183 | 4 |\n| Indirect secured consumer loans | 15,192 | 13 | 13,653 | 12 |\n| Credit card | 1,793 | 2 | 2,007 | 2 |\n| Other consumer loans | 3,052 | 3 | 3,014 | 3 |\n| Total consumer loans | $ | 46,397 | 41 | $ | 44,250 | 39 |\n| Total loans and leases | $ | 113,463 | 100 | % | $ | 113,523 | 100 | % |\n| Total portfolio loans and leases (excluding loans and leases held for sale) | $ | 107,733 | $ | 108,782 |\n\n(a)Includes $3.7 billion and $4.8 billion as of June 30, 2021 and December 31, 2020, respectively, related to the SBA’s Paycheck Protection Program.\n(b)Includes $39 as of December 31, 2020 of residential mortgage loans previously sold to GNMA for which the Bancorp was deemed to have regained effective control over under ASC Topic 860, but did not exercise its option to repurchase. Refer to Note 14 for further information.\nTotal loans and leases, including loans and leases held for sale, decreased $60 million from December 31, 2020. The decrease from December 31, 2020 was the result of a $2.2 billion, or 3%, decrease in commercial loans and leases, partially offset by a $2.1 billion, or 5%, increase in consumer loans.\nCommercial loans and leases decreased $2.2 billion from December 31, 2020 due to decreases in commercial and industrial loans and commercial mortgage loans, partially offset by increases in commercial leases and commercial construction loans. Commercial and industrial loans decreased $2.3 billion, or 5%, from December 31, 2020 primarily as a result of PPP loan forgiveness and paydowns in excess of loan originations. Commercial mortgage loans decreased $229 million, or 2%, from December 31, 2020 as payoffs exceeded loan originations. Commercial leases increased $284 million, or 10%, from December 31, 2020 primarily as a result of an increase in lease originations. Commercial construction loans increased $58 million, or 1%, from December 31, 2020 as draws on existing commitments exceeded payoffs.\nConsumer loans increased $2.1 billion from December 31, 2020 due to increases in indirect secured consumer loans, residential mortgage loans and other consumer loans, partially offset by decreases in home equity and credit card. Indirect secured consumer loans increased $1.5 billion, or 11%, from December 31, 2020 primarily as a result of loan production exceeding payoffs. Residential mortgage loans increased $1.4 billion, or 7%, from December 31, 2020 primarily due to increases in residential mortgage loans held for sale as the Bancorp purchased government-guaranteed loans in forbearance programs. Other consumer loans increased $38 million, or 1%, from December 31, 2020 primarily as a result of the purchase of a portfolio of point-of-sale loans. Home equity decreased $638 million, or 12%, from December 31, 2020 as payoffs exceeded loan originations. Credit card decreased $214 million, or 11%, from December 31, 2020 primarily due to seasonal paydowns on year-end balances as well as continuing impacts from the COVID-19 pandemic, including accelerated paydown activity driven by the amount of fiscal stimulus programs.\n22\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\n| TABLE 16: Components of Average Loans and Leases (including average loans and leases held for sale) |\n| June 30, 2021 | June 30, 2020 |\n| For the three months ended ($ in millions) | Carrying Value | % of Total | Carrying Value | % of Total |\n| Commercial loans and leases: |\n| Commercial and industrial loans | $ | 48,817 | 43 | % | $ | 59,106 | 49 | % |\n| Commercial mortgage loans | 10,467 | 9 | 11,224 | 9 |\n| Commercial construction loans | 6,043 | 5 | 5,548 | 5 |\n| Commercial leases | 3,174 | 3 | 3,056 | 3 |\n| Total commercial loans and leases | $ | 68,501 | 60 | $ | 78,934 | 66 |\n| Consumer loans: |\n| Residential mortgage loans | 21,740 | 19 | 17,405 | 15 |\n| Home equity | 4,674 | 4 | 5,820 | 5 |\n| Indirect secured consumer loans | 14,702 | 13 | 12,124 | 10 |\n| Credit card | 1,770 | 2 | 2,248 | 2 |\n| Other consumer loans | 3,056 | 2 | 2,887 | 2 |\n| Total consumer loans | $ | 45,942 | 40 | $ | 40,484 | 34 |\n| Total average loans and leases | $ | 114,443 | 100 | % | $ | 119,418 | 100 | % |\n| Total average portfolio loans and leases (excluding loans and leases held for sale) | $ | 108,534 | $ | 118,506 |\n\nAverage loans and leases, including average loans and leases held for sale, decreased $5.0 billion, or 4%, for the three months ended June 30, 2021 compared to the same period in the prior year as a result of a $10.4 billion, or 13%, decrease in average commercial loans and leases, partially offset by a $5.5 billion, or 13%, increase in average consumer loans.\nAverage commercial loans and leases decreased $10.4 billion for the three months ended June 30, 2021 compared to the same period in the prior year due to decreases in average commercial and industrial loans and average commercial mortgage loans, partially offset by increases in average commercial construction loans and average commercial leases. Average commercial and industrial loans decreased $10.3 billion, or 17%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily driven by continued paydowns on revolving lines of credit, partially offset by PPP loans originated since June of 2020. Average commercial mortgage loans decreased $757 million, or 7%, for the three months ended June 30, 2021 compared to the same period in the prior year as payoffs exceeded loan originations. Average commercial construction loans increased $495 million, or 9%, for the three months ended June 30, 2021 compared to the same period in the prior year as draws on existing commitments exceeded payoffs. Average commercial leases increased $118 million, or 4%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily as a result of an increase in lease originations.\nAverage consumer loans increased $5.5 billion for the three months ended June 30, 2021 compared to the same period in the prior year due to increases in average residential mortgage loans, average indirect secured consumer loans and average other consumer loans, partially offset by decreases in average home equity and average credit card. Average residential mortgage loans increased $4.3 billion, or 25%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to increases in residential mortgage loans held for sale as the Bancorp purchased government-guaranteed loans in forbearance programs, partially offset by higher runoff due to payoffs exceeding loan originations. Average indirect secured consumer loans increased $2.6 billion, or 21%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to loan production exceeding payoffs. Average other consumer loans increased $169 million, or 6%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily as a result of purchases of portfolios of point-of-sale loans. Average home equity decreased $1.1 billion, or 20%, for the three months ended June 30, 2021 compared to the same period in the prior year as payoffs exceeded loan originations. Average credit card decreased $478 million, or 21%, for the three months ended June 30, 2021 compared to the same period in the prior year driven by continuing impacts from the COVID-19 pandemic, including accelerated paydown activity driven by the amount of fiscal stimulus.\nInvestment Securities\nThe Bancorp uses investment securities as a means of managing interest rate risk, providing collateral for pledging purposes and for liquidity risk management. Total investment securities were $39.1 billion and $38.4 billion at June 30, 2021 and December 31, 2020, respectively. The taxable available-for-sale debt and other investment securities portfolio had an effective duration of 4.9 at June 30, 2021 compared to 4.4 at December 31, 2020.\nDebt securities are classified as available-for-sale when, in management’s judgment, they may be sold in response to, or in anticipation of, changes in market conditions. Securities that management has the intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized cost. Debt securities are classified as trading when bought and held principally for the purpose of selling them in the near term. At June 30, 2021, the Bancorp’s investment portfolio consisted primarily of AAA-rated available-for-sale debt and other securities. The Bancorp held an immaterial amount in below-investment grade available-for-sale debt and other securities at both June 30, 2021 and December 31, 2020. In the first quarter of 2021, the Bancorp recognized $7 million of impairment losses on its available-for-sale debt and\n23\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nother securities, included in securities gains (losses), net, in the Condensed Consolidated Statements of Income. These losses related to certain securities in unrealized loss positions that the Bancorp intended to sell prior to recovery of their amortized cost bases. The Bancorp did not consider these losses to be credit-related.\nAt both June 30, 2021 and December 31, 2020, the Bancorp completed its evaluation of the available-for-sale debt and other securities in an unrealized loss position and did not recognize an allowance for credit losses. The Bancorp did not recognize provision expense related to available-for-sale debt and other securities in an unrealized loss position during both the three and six months ended June 30, 2021 and June 30, 2020.\nThe following table summarizes the end of period components of investment securities:\n| TABLE 17: Components of Investment Securities |\n| As of ($ in millions) | June 30,2021 | December 31, 2020 |\n| Available-for-sale debt and other securities (amortized cost basis): |\n| U.S. Treasury and federal agencies securities | $ | 105 | 74 |\n| Obligations of states and political subdivisions securities | 18 | 17 |\n| Mortgage-backed securities: |\n| Agency residential mortgage-backed securities | 10,256 | 11,147 |\n| Agency commercial mortgage-backed securities | 18,142 | 16,745 |\n| Non-agency commercial mortgage-backed securities | 3,276 | 3,323 |\n| Asset-backed securities and other debt securities | 3,764 | 3,152 |\n| Other securities(a) | 520 | 524 |\n| Total available-for-sale debt and other securities | $ | 36,081 | 34,982 |\n| Held-to-maturity securities (amortized cost basis): |\n| Obligations of states and political subdivisions securities | $ | 9 | 9 |\n| Asset-backed securities and other debt securities | 1 | 2 |\n| Total held-to-maturity securities | $ | 10 | 11 |\n| Trading debt securities (fair value): |\n| U.S. Treasury and federal agencies securities | $ | 96 | 81 |\n| Obligations of states and political subdivisions securities | 63 | 10 |\n| Agency residential mortgage-backed securities | 69 | 30 |\n| Asset-backed securities and other debt securities | 483 | 439 |\n| Total trading debt securities | $ | 711 | 560 |\n| Total equity securities (fair value) | $ | 341 | 313 |\n\n(a)Other securities consist of FHLB, FRB and DTCC restricted stock holdings of $33, $485 and $2, respectively, at June 30, 2021 and $40, $482 and $2, respectively, at December 31, 2020, that are carried at cost.\nOn an amortized cost basis, available-for-sale debt and other securities increased $1.1 billion from December 31, 2020 primarily due to increases in agency commercial mortgage-backed securities and asset-backed securities and other debt securities, partially offset by a decrease in agency residential mortgage-backed securities.\nOn an amortized cost basis, available-for-sale debt and other securities were 20% and 19% of total interest-earning assets at June 30, 2021 and December 31, 2020, respectively. The estimated weighted-average life of the debt securities in the available-for-sale debt and other securities portfolio was 6.3 years at June 30, 2021 compared to 5.7 years at December 31, 2020. In addition, at June 30, 2021, the debt securities in the available-for-sale debt and other securities portfolio had a weighted-average yield of 2.88% compared to 3.05% at December 31, 2020.\nInformation presented in Table 18 is on a weighted-average life basis, anticipating future prepayments. Yield information is presented on an FTE basis and is computed using amortized cost balances and reflects the impact of prepayments. Maturity and yield calculations for the total available-for-sale debt and other securities portfolio exclude other securities that have no stated yield or maturity. Total net unrealized gains on the available-for-sale debt and other securities portfolio were $1.9 billion at June 30, 2021 compared to $2.5 billion at December 31, 2020. The fair value of investment securities is impacted by interest rates, credit spreads, market volatility and liquidity conditions. The fair value of investment securities generally increases when interest rates decrease or when credit spreads contract.\n24\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\n| TABLE 18: Characteristics of Available-for-Sale Debt and Other Securities |\n| As of June 30, 2021 ($ in millions) | Amortized Cost | Fair Value | Weighted-Average Life(in years) | Weighted-Average Yield |\n| U.S. Treasury and federal agencies securities: |\n| Average life of 1 year or less | $ | 30 | 30 | 0.1 | 0.02 | % |\n| Average life 1 – 5 years | 75 | 77 | 1.6 | 2.16 |\n| Total | $ | 105 | 107 | 1.2 | 2.05 | % |\n| Obligations of states and political subdivisions securities: |\n| Average life 1 – 5 years | 17 | 17 | 1.7 | 1.80 |\n| Average life greater than 10 years | 1 | 1 | 15.4 | 7.00 |\n| Total | $ | 18 | 18 | 2.5 | 2.12 | % |\n| Agency residential mortgage-backed securities: |\n| Average life of 1 year or less | 427 | 434 | 0.5 | 3.60 |\n| Average life 1 – 5 years | 4,471 | 4,665 | 3.4 | 3.08 |\n| Average life 5 – 10 years | 4,570 | 4,864 | 6.6 | 3.02 |\n| Average life greater than 10 years | 788 | 846 | 13.3 | 2.92 |\n| Total | $ | 10,256 | 10,809 | 5.5 | 3.06 | % |\n| Agency commercial mortgage-backed securities:(a) |\n| Average life of 1 year or less | 422 | 436 | 0.6 | 3.90 |\n| Average life 1 – 5 years | 6,293 | 6,661 | 2.9 | 3.31 |\n| Average life 5 – 10 years | 6,309 | 6,852 | 6.9 | 3.11 |\n| Average life greater than 10 years | 5,118 | 5,345 | 13.9 | 2.18 |\n| Total | $ | 18,142 | 19,294 | 7.4 | 2.94 | % |\n| Non-agency commercial mortgage-backed securities: |\n| Average life of 1 year or less | 7 | 7 | 0.4 | 2.58 |\n| Average life 1 – 5 years | 2,733 | 2,906 | 3.3 | 3.28 |\n| Average life 5 – 10 years | 526 | 556 | 7.0 | 2.59 |\n| Average life greater than 10 years | 10 | 10 | 10.0 | 2.40 |\n| Total | $ | 3,276 | 3,479 | 3.9 | 3.16 | % |\n| Asset-backed securities and other debt securities: |\n| Average life of 1 year or less | 342 | 342 | 0.5 | 3.19 |\n| Average life 1 – 5 years | 1,600 | 1,613 | 3.3 | 2.16 |\n| Average life 5 – 10 years | 1,256 | 1,254 | 6.9 | 1.47 |\n| Average life greater than 10 years | 566 | 576 | 14.8 | 1.43 |\n| Total | $ | 3,764 | 3,785 | 6.0 | 1.91 | % |\n| Other securities | 520 | 520 |\n| Total available-for-sale debt and other securities | $ | 36,081 | 38,012 | 6.3 | 2.88 | % |\n\n(a)Taxable-equivalent yield adjustments included in the above table are 0.05% and 0.01% for securities with an average life greater than 10 years and in total, respectively.\nOther Short-Term Investments\nOther short-term investments primarily include overnight interest-earning investments, including reserves held at the FRB. The Bancorp uses other short-term investments as part of its liquidity risk management tools. Other short-term investments were $32.4 billion and $33.4 billion at June 30, 2021 and December 31, 2020, respectively. The decrease of $990 million from December 31, 2020 was primarily due to wholesale funding maturities during the six months ended June 30, 2021.\nDeposits\nThe Bancorp’s deposit balances represent an important source of funding and revenue growth opportunity. The Bancorp continues to focus on core deposit growth in its retail and commercial franchises by improving customer satisfaction, building full relationships and offering competitive rates. Average core deposits represented 78% and 74% of the Bancorp’s average asset funding base for the three months ended June 30, 2021 and 2020, respectively.\n25\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following table presents the end of period components of deposits:\n| TABLE 19: Components of Deposits |\n| June 30, 2021 | December 31, 2020 |\n| As of ($ in millions) | Balance | % of Total | Balance | % of Total |\n| Demand | $ | 62,760 | 39 | % | $ | 57,711 | 36 | % |\n| Interest checking | 44,872 | 27 | 47,270 | 30 |\n| Savings | 20,667 | 13 | 18,258 | 12 |\n| Money market | 30,564 | 19 | 30,650 | 19 |\n| Foreign office | 152 | — | 143 | — |\n| Total transaction deposits | $ | 159,015 | 98 | $ | 154,032 | 97 |\n| Other time | 2,408 | 1 | 3,023 | 2 |\n| Total core deposits | $ | 161,423 | 99 | $ | 157,055 | 99 |\n| Certificates $100,000 and over(a) | 860 | 1 | 2,026 | 1 |\n| Total deposits | $ | 162,283 | 100 | % | $ | 159,081 | 100 | % |\n\n(a)Includes $310 million and $1.3 billion of institutional, retail and wholesale certificates $250,000 and over at June 30, 2021 and December 31, 2020, respectively.\nCore deposits increased $4.4 billion, or 3%, from December 31, 2020 as a result of an increase in transaction deposits, partially offset by a decrease in other time deposits. Transaction deposits increased $5.0 billion, or 3%, from December 31, 2020 primarily due to increases in demand deposits and savings deposits, partially offset by a decrease in interest checking deposits. Demand deposits increased $5.0 billion, or 9%, from December 31, 2020 primarily as a result of customers maintaining increased levels of liquidity driven by the amount of fiscal and monetary stimulus, as well as growth in the number of accounts and migration of balances from interest checking deposits during the six months ended June 30, 2021. Savings deposits increased $2.4 billion, or 13%, from December 31, 2020 primarily as a result of higher balances per customer account due to the amount of fiscal stimulus as well as decreased consumer spending. Interest checking deposits decreased $2.4 billion, or 5%, from December 31, 2020 primarily as a result of lower balances per commercial customer account as well as the aforementioned balance migration into demand deposits during the six months ended June 30, 2021. Other time deposits decreased $615 million, or 20%, from December 31, 2020 primarily due to lower offering rates on certificates less than $100,000.\nCertificates $100,000 and over decreased $1.2 billion, or 58%, from December 31, 2020 primarily due to maturities which were not replaced with new issuances given current market conditions and liquidity levels.\nThe following table presents the components of average deposits for the three months ended:\n| TABLE 20: Components of Average Deposits |\n| June 30, 2021 | June 30, 2020 |\n| ($ in millions) | Balance | % of Total | Balance | % of Total |\n| Demand | $ | 61,994 | 38 | % | $ | 45,761 | 30 | % |\n| Interest checking | 45,307 | 28 | 49,760 | 33 |\n| Savings | 20,494 | 12 | 16,354 | 11 |\n| Money market | 30,844 | 19 | 30,022 | 20 |\n| Foreign office | 140 | — | 182 | — |\n| Total transaction deposits | $ | 158,779 | 97 | $ | 142,079 | 94 |\n| Other time | 2,696 | 2 | 4,421 | 3 |\n| Total core deposits | $ | 161,475 | 99 | $ | 146,500 | 97 |\n| Certificates $100,000 and over(a) | 1,144 | 1 | 4,067 | 3 |\n| Other deposits | — | — | 31 | — |\n| Total average deposits | $ | 162,619 | 100 | % | $ | 150,598 | 100 | % |\n\n(a)Includes $326 million and $3.2 billion of average institutional, retail and wholesale certificates $250,000 and over for the three months ended June 30, 2021 and 2020, respectively.\nOn an average basis, core deposits increased $15.0 billion, or 10%, for the three months ended June 30, 2021 compared to the same period in the prior year due to an increase of $16.7 billion, or 12%, in average transaction deposits, partially offset by a decrease of $1.7 billion, or 39%, in average other time deposits. The increase in average transaction deposits was driven primarily by increases in average demand deposits, average savings deposits and average money market deposits, partially offset by a decrease in average interest checking deposits. Average demand deposits increased $16.2 billion, or 35%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily as a result of commercial customers maintaining increased levels of liquidity driven by the amount of fiscal and monetary stimulus, as well as growth in the number of accounts and migration of balances from interest checking deposits. Average savings deposits increased $4.1 billion, or 25%, and average money market deposits increased $822 million, or 3%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily as a result of higher average balances per customer account due to the amount of\n26\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nfiscal stimulus, uncertainty regarding the COVID-19 pandemic and decreased consumer spending. Average interest checking deposits decreased $4.5 billion, or 9%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily as a result of the aforementioned balance migration into demand deposits and lower average balances per commercial customer account, partially offset by higher average balances per consumer customer account due to the previously mentioned increased liquidity levels in the current economic environment in the form of excess cash balances driven by the amount of fiscal stimulus. Average other time deposits decreased primarily due to lower offering rates on certificates less than $100,000.\nAverage certificates $100,000 and over decreased $2.9 billion, or 72%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to maturities which were not replaced with new issuances given current market conditions and liquidity levels.\nContractual maturities\nThe contractual maturities of certificates $100,000 and over as of June 30, 2021 are summarized in the following table:\n| TABLE 21: Contractual Maturities of Certificates $100,000 and Over |\n| ($ in millions) |\n| Next 3 months | $ | 321 |\n| 3-6 months | 208 |\n| 6-12 months | 172 |\n| After 12 months | 159 |\n| Total certificates $100,000 and over | $ | 860 |\n\nThe contractual maturities of other time deposits and certificates $100,000 and over as of June 30, 2021 are summarized in the following table:\n| TABLE 22: Contractual Maturities of Other Time Deposits and Certificates $100,000 and Over |\n| ($ in millions) |\n| Next 12 months | $ | 2,717 |\n| 13-24 months | 269 |\n| 25-36 months | 126 |\n| 37-48 months | 88 |\n| 49-60 months | 62 |\n| After 60 months | 6 |\n| Total other time deposits and certificates $100,000 and over | $ | 3,268 |\n\nBorrowings\nThe Bancorp accesses a variety of short-term and long-term funding sources. Borrowings with original maturities of one year or less are classified as short-term and include federal funds purchased and other short-term borrowings. Total average borrowings as a percent of average interest-bearing liabilities were 13% and 16% for the three months ended June 30, 2021 and 2020, respectively.\nThe following table summarizes the end of period components of borrowings:\n| TABLE 23: Components of Borrowings |\n| As of ($ in millions) | June 30,2021 | December 31,2020 |\n| Federal funds purchased | $ | 338 | 300 |\n| Other short-term borrowings | 1,130 | 1,192 |\n| Long-term debt | 12,364 | 14,973 |\n| Total borrowings | $ | 13,832 | 16,465 |\n\nTotal borrowings decreased $2.6 billion, or 16%, from December 31, 2020 primarily due to decreases in long-term debt and other short-term borrowings. Long-term debt decreased $2.6 billion from December 31, 2020 driven by the early redemptions under the par call options of $2.3 billion of notes and $244 million of paydowns on long-term debt associated with automobile loan securitizations during the six months ended June 30, 2021. Other short-term borrowings decreased $62 million from December 31, 2020 primarily as a result of decreased short-term funding needs given continued core deposit growth. The level of other short-term borrowings can fluctuate significantly from period to period depending on funding needs and the sources that are used to satisfy those needs. For further information on the components of other short-term borrowings, refer to Note 14 of the Notes to Condensed Consolidated Financial Statements.\n27\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following table summarizes components of average borrowings for the three months ended:\n| TABLE 24: Components of Average Borrowings |\n| ($ in millions) | June 30,2021 | June 30,2020 |\n| Federal funds purchased | $ | 346 | 309 |\n| Other short-term borrowings | 1,097 | 2,377 |\n| Long-term debt | 13,883 | 16,955 |\n| Total average borrowings | $ | 15,326 | 19,641 |\n\nTotal average borrowings decreased $4.3 billion, or 22%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to decreases in average long-term debt and average other short-term borrowings. Average long-term debt decreased $3.1 billion for the three months ended June 30, 2021 compared to the same period in the prior year primarily driven by maturities of $3.4 billion and $508 million of paydowns on long-term debt associated with automobile loan securitizations since June of 2020. Average other short-term borrowings decreased $1.3 billion for the three months ended June 30, 2021 compared to the same period in the prior year primarily as a result of decreased short-term funding needs given continued core deposit growth. Information on the average rates paid on borrowings is discussed in the Net Interest Income subsection of the Statements of Income Analysis section of MD&A. In addition, refer to the Liquidity Risk Management subsection of the Risk Management section of MD&A for a discussion on the role of borrowings in the Bancorp’s liquidity management.\n28\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nBUSINESS SEGMENT REVIEW\nThe Bancorp reports on four business segments: Commercial Banking, Branch Banking, Consumer Lending and Wealth and Asset Management. Additional information on each business segment is included in Note 22 of the Notes to Condensed Consolidated Financial Statements. Results of the Bancorp’s business segments are presented based on its management structure and management accounting practices. The structure and accounting practices are specific to the Bancorp; therefore, the financial results of the Bancorp’s business segments are not necessarily comparable with similar information for other financial institutions. The Bancorp refines its methodologies from time to time as management’s accounting practices and businesses change.\nThe Bancorp manages interest rate risk centrally at the corporate level. By employing an FTP methodology, the business segments are insulated from most benchmark interest rate volatility, enabling them to focus on serving customers through the origination of loans and acceptance of deposits. The FTP methodology assigns charge and credit rates to classes of assets and liabilities, respectively, based on the estimated amount and timing of cash flows for each transaction. Assigning the FTP rate based on matching the duration of cash flows allocates interest income and interest expense to each business segment so its resulting net interest income is insulated from future changes in benchmark interest rates. The Bancorp’s FTP methodology also allocates the contribution to net interest income of the asset-generating and deposit-providing businesses on a duration-adjusted basis to better attribute the driver of the performance. As the asset and liability durations are not perfectly matched, the residual impact of the FTP methodology is captured in General Corporate and Other. The charge and credit rates are determined using the FTP rate curve, which is based on an estimate of Fifth Third’s marginal borrowing cost in the wholesale funding markets. The FTP curve is constructed using the U.S. swap curve, brokered CD pricing and unsecured debt pricing.\nThe Bancorp adjusts the FTP charge and credit rates as dictated by changes in interest rates for various interest-earning assets and interest-bearing liabilities and by the review of behavioral assumptions, such as prepayment rates on interest-earning assets and the estimated durations for indeterminate-lived deposits. Key assumptions, including the credit rates provided for deposit accounts, are reviewed annually. Credit rates for deposit products and charge rates for loan products may be reset more frequently in response to changes in market conditions. In general, the charge rates on assets have declined since December 31, 2020 as they were affected by the prevailing level of interest rates and by the duration and repricing characteristics of the portfolio. The credit rates for deposit products also modestly declined due to lower interest rates and modified assumptions. Thus, net interest income for asset-generating business segments improved while deposit-providing business segments were negatively impacted during the six months ended June 30, 2021.\nThe Bancorp’s methodology for allocating provision for credit losses expense to the business segments includes charges or benefits associated with changes in criticized commercial loan levels in addition to actual net charge-offs experienced by the loans and leases owned by each business segment. Provision for credit losses expense attributable to loan and lease growth and changes in ALLL factors is captured in General Corporate and Other. The financial results of the business segments include allocations for shared services and headquarters expenses. Additionally, the business segments form synergies by taking advantage of relationship depth opportunities and funding operations by accessing the capital markets as a collective unit.\nThe following table summarizes net income (loss) by business segment:\n| TABLE 25: Net Income (Loss) by Business Segment |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Income Statement Data |\n| Commercial Banking | $ | 393 | 12 | 704 | 237 |\n| Branch Banking | 40 | 138 | 16 | 258 |\n| Consumer Lending | 33 | 48 | 65 | 107 |\n| Wealth and Asset Management | 26 | 40 | 45 | 64 |\n| General Corporate and Other | 217 | (43) | 573 | (423) |\n| Net income | $ | 709 | 195 | 1,403 | 243 |\n\n29\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nCommercial Banking\nCommercial Banking offers credit intermediation, cash management and financial services to large and middle-market businesses and government and professional customers. In addition to the traditional lending and depository offerings, Commercial Banking products and services include global cash management, foreign exchange and international trade finance, derivatives and capital markets services, asset-based lending, real estate finance, public finance, commercial leasing and syndicated finance.\nThe following table contains selected financial data for the Commercial Banking segment:\n| TABLE 26: Commercial Banking |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Income Statement Data |\n| Net interest income (FTE)(a) | $ | 378 | 573 | 745 | 1,085 |\n| (Benefit from) provision for credit losses | (151) | 457 | (227) | 502 |\n| Noninterest income: |\n| Commercial banking revenue | 156 | 136 | 307 | 260 |\n| Service charges on deposits | 92 | 79 | 181 | 162 |\n| Leasing business revenue | 61 | 57 | 148 | 131 |\n| Other noninterest income | 46 | 22 | 79 | 27 |\n| Noninterest expense: |\n| Compensation and benefits | 136 | 129 | 292 | 278 |\n| Leasing business expense | 33 | 33 | 68 | 68 |\n| Other noninterest expense | 230 | 243 | 459 | 538 |\n| Income before income taxes (FTE) | 485 | 5 | 868 | 279 |\n| Applicable income tax expense (benefit)(a)(b) | 92 | (7) | 164 | 42 |\n| Net income | $ | 393 | 12 | 704 | 237 |\n| Average Balance Sheet Data |\n| Commercial loans and leases, including held for sale | $ | 59,729 | 71,894 | 59,989 | 69,788 |\n| Demand deposits | 32,827 | 22,939 | 32,177 | 20,032 |\n| Interest checking deposits | 20,871 | 28,742 | 21,000 | 24,595 |\n| Savings and money market deposits | 6,315 | 6,955 | 6,341 | 5,958 |\n| Other time deposits and certificates $100,000 and over | 91 | 159 | 96 | 182 |\n| Foreign office deposits | 139 | 181 | 133 | 195 |\n\n(a)Includes FTE adjustments of $2 and $3 for the three months ended June 30, 2021 and 2020, respectively, and $4 and $7 for the six months ended June 30, 2021 and 2020, respectively.\n(b)Applicable income tax expense for all periods includes the tax benefit from tax-exempt income, tax-advantaged investments and tax credits partially offset by the effect of certain nondeductible expenses. Refer to the Applicable Income Taxes subsection of the Statements of Income Analysis section of MD&A for additional information.\nNet income was $393 million and $704 million for the three and six months ended June 30, 2021, respectively, compared to $12 million and $237 million, respectively, for the same periods in the prior year. The increases were primarily driven by decreases in the provision for credit losses as well as increases in noninterest income and decreases in noninterest expense, partially offset by decreases in net interest income on an FTE basis.\nNet interest income on an FTE basis decreased $195 million and $340 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in yields on and average balances of commercial loans and leases as well as decreases in FTP credit rates on interest checking deposits, demand deposits and savings and money market deposits. These negative impacts were partially offset by decreases in FTP charge rates on loans and leases as well as decreases in rates paid on average interest checking deposits and average savings and money market deposits.\nThe benefit from credit losses was $151 million and $227 million for the three and six months ended June 30, 2021, respectively, compared to a provision for credit losses of $457 million and $502 million for the three and six months ended June 30, 2020, respectively. The decreases for the three and six months ended June 30, 2021 compared to the same periods in the prior year were primarily driven by a decrease in commercial criticized asset levels as well as decreases in net charge-offs on commercial and industrial loans and commercial leases. Net charge-offs as a percent of average portfolio loans and leases decreased to 4 bps and 10 bps for the three and six months ended June 30, 2021, respectively, compared to 41 bps and 35 bps for the same periods in the prior year, respectively.\nNoninterest income increased $61 million and $135 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year driven by increases in other noninterest income, commercial banking revenue and service charges on deposits.\n30\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe increase for the six months ended June 30, 2021 was also driven by an increase in leasing business revenue. Other noninterest income increased $24 million and $52 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in private equity investment income and card and processing revenue. The increase for the six months ended June 30, 2021 was also driven by the recognition of securities gains, net of $6 million. Commercial banking revenue increased $20 million and $47 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year. The increase for the three months ended June 30, 2021 was primarily due to increases in loan syndication fees and business lending fees partially offset by a decrease in institutional sales. The increase for the six months ended June 30, 2021 was primarily due to increases in loan syndication fees, business lending fees and institutional sales partially offset by a decrease in contract revenue from commercial customer derivatives. Service charges on deposits increased $13 million and $19 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year driven by increases in commercial deposit fees primarily due to growth in volume-based service revenues, with continued benefit from lower earnings credit rates. Leasing business revenue increased $17 million for the six months ended June 30, 2021 compared to the same periods in the prior year primarily due to an increase in lease syndication fees partially offset by a decrease in lease remarketing fees.\nNoninterest expense decreased $6 million and $65 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year driven by decreases in other noninterest expense partially offset by increases in compensation and benefits. Other noninterest expense decreased $13 million and $79 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year. The decreases for both the three and six months ended June 30, 2021 reflect decreases in allocated expenses related to cash management services. The decrease for the six months ended June 30, 2021 was also due to a decline in credit valuation adjustments on derivatives associated with customer accommodation contracts. Compensation and benefits increased $7 million and $14 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily as a result of increases in incentive compensation and employee benefits expense driven by strong performance in fees related to business growth and expansion initiatives during the three and six months ended June 30, 2021.\nAverage commercial loans and leases decreased $12.2 billion and $9.8 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to decreases in average commercial and industrial loans and average commercial mortgage loans partially offset by increases in average commercial construction loans. Average commercial and industrial loans decreased for the three and six months ended June 30, 2021 compared to the same periods in the prior year primarily driven by continued paydowns on revolving lines of credit. Average commercial mortgage loans decreased for the three and six months ended June 30, 2021 compared to the same periods in the prior year as payoffs exceeded loan originations. Average commercial construction loans increased for the three and six months ended June 30, 2021 compared to the same periods in the prior year as draws on existing commitments exceeded payoffs.\nAverage core deposits increased $1.3 billion and $8.9 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to increases in average demand deposits partially offset by decreases in average interest checking deposits. The increase for the three months ended June 30, 2021 was also partially offset by a decrease in average savings and money market deposits. The increase for the six months ended June 30, 2021 also included an increase in average savings and money market deposits. Average demand deposits increased $9.9 billion and $12.1 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily as a result of commercial customers maintaining increased levels of liquidity driven by the amount of fiscal and monetary stimulus, as well as growth in the number of accounts and migration of balances from interest checking deposits. Average interest checking deposits decreased $7.9 billion and $3.6 billion, respectively, for the three and six months ended June 30, 2021 compared to the same periods in the prior year primarily as a result of the aforementioned balance migration into demand deposits and lower average balances per commercial customer account. Average savings and money market deposits decreased $640 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily as a result of a decline in commercial customer accounts. Average savings and money market deposits increased $383 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily as a result of new customers as well as higher average balances per commercial customer account due to the amount of fiscal stimulus and economic uncertainty regarding the COVID-19 pandemic.\n31\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nBranch Banking\nBranch Banking provides a full range of deposit and loan products to individuals and small businesses through 1,096 full-service banking centers. Branch Banking offers depository and loan products, such as checking and savings accounts, home equity loans and lines of credit, credit cards and loans for automobiles and other personal financing needs, as well as products designed to meet the specific needs of small businesses, including cash management services.\nThe following table contains selected financial data for the Branch Banking segment:\n| TABLE 27: Branch Banking |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Income Statement Data |\n| Net interest income | $ | 301 | 513 | 596 | 1,017 |\n| Provision for credit losses | 25 | 52 | 66 | 114 |\n| Noninterest income: |\n| Card and processing revenue | 84 | 68 | 161 | 133 |\n| Service charges on deposits | 57 | 42 | 111 | 107 |\n| Wealth and asset management revenue | 52 | 39 | 102 | 84 |\n| Other noninterest income | 31 | 18 | 55 | 40 |\n| Noninterest expense: |\n| Compensation and benefits | 158 | 161 | 328 | 330 |\n| Net occupancy and equipment expense | 58 | 54 | 115 | 108 |\n| Card and processing expense | 19 | 28 | 49 | 58 |\n| Other noninterest expense | 215 | 211 | 447 | 444 |\n| Income before income taxes | $ | 50 | 174 | 20 | 327 |\n| Applicable income tax expense | 10 | 36 | 4 | 69 |\n| Net income | $ | 40 | 138 | 16 | 258 |\n| Average Balance Sheet Data |\n| Consumer loans | $ | 11,867 | 12,964 | 11,974 | 13,124 |\n| Commercial loans, including held for sale | 2,983 | 2,288 | 2,982 | 2,292 |\n| Demand deposits | 26,227 | 19,840 | 25,105 | 18,108 |\n| Interest checking deposits | 15,830 | 12,323 | 15,604 | 11,914 |\n| Savings and money market deposits | 42,476 | 36,687 | 41,524 | 35,584 |\n| Other time deposits and certificates $100,000 and over | 3,453 | 5,759 | 3,672 | 6,276 |\n\nNet income was $40 million and $16 million for the three and six months ended June 30, 2021, respectively, compared to $138 million and $258 million, respectively for the same periods in the prior year. The decreases were primarily driven by decreases in net interest income partially offset by increases in noninterest income and decreases in provision for credit losses.\nNet interest income decreased $212 million and $421 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to decreases in FTP credit rates on core deposits and certificates $100,000 and over as well as decreases in average balances of credit card and home equity and decreases in yields on average other consumer loans. These negative impacts were partially offset by decreases in the rates paid on average interest-bearing deposits and a decrease in FTP charge rates on loans and leases.\nProvision for credit losses decreased $27 million and $48 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to decreases in net charge-offs on credit card, other consumer loans and home equity partially offset by increases in net charge-offs on commercial and industrial loans. The decrease in provision for credit losses for the three and six months ended June 30, 2021 compared to the same periods in the prior year also included the impact of a decrease in commercial criticized asset levels. Net charge-offs as a percent of average portfolio loans and leases decreased to 102 bps and 106 bps for the three and six months ended June 30, 2021, respectively, compared to 128 bps and 143 bps, respectively, for the same periods in the prior year.\nNoninterest income increased $57 million and $65 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in card and processing revenue, wealth and asset management revenue, other noninterest income and service charges on deposits. Card and processing revenue increased $16 million and $28 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily as a result of an increase in consumer customer spend volume, partially offset by increased reward costs. Wealth and asset management revenue increased $13 million and $18\n32\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nmillion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to increases in broker income and private client service fees. Other noninterest income increased $13 million and $15 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in cardholder fees, banking center income and decreases in net losses on disposition and impairment of bank premises and equipment. Service charges on deposits increased $15 million and $4 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year driven by increases in both commercial deposit fees and consumer deposit fees.\nNoninterest expense decreased $4 million and $1 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in card and processing expense partially offset by increases in net occupancy and equipment expense. Card and processing expense decreased $9 million for both the three and six months ended June 30, 2021 compared to the same periods in the prior year primarily driven by contract renegotiations with a third-party vendor. Net occupancy and equipment expense increased $4 million and $7 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to increases in allocated occupancy costs.\nAverage consumer loans decreased $1.1 billion and $1.2 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in average home equity as payoffs exceeded loan originations as well as decreases in average credit card driven by higher paydowns which were affected by the amount of fiscal stimulus. These decreases were partially offset by increases in average residential mortgage loans of $502 million and $447 million for the three and six months ended June 30, 2021, respectively, primarily as a result of increases in loan originations. Average commercial loans increased $695 million and $690 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in average commercial mortgage loans and average commercial and industrial loans.\nAverage deposits increased $13.4 billion and $14.0 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in average demand deposits, average savings and money market deposits and average interest checking deposits partially offset by decreases in average other time deposits and certificates $100,000 and over. Average demand deposits increased $6.4 billion and $7.0 billion, average savings and money market deposits increased $5.8 billion and $5.9 billion and average interest checking deposits increased $3.5 billion and $3.7 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily as a result of higher balances per customer account due to the amount of fiscal stimulus, uncertainty regarding the COVID-19 pandemic as well as decreased consumer spending. Average other time deposits and certificates $100,000 and over decreased $2.3 billion and $2.6 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to maturities on certificates greater than $100,000 as well as lower offering rates on certificates less than $100,000.\n33\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nConsumer Lending\nConsumer Lending includes the Bancorp’s residential mortgage, automobile and other indirect lending activities. Residential mortgage activities within Consumer Lending include the origination, retention and servicing of residential mortgage loans, sales and securitizations of those loans and all associated hedging activities. Residential mortgages are primarily originated through a dedicated sales force and through third-party correspondent lenders. Automobile and other indirect lending activities include extending loans to consumers through automobile dealers, motorcycle dealers, powersport dealers, recreational vehicle dealers and marine dealers.\nThe following table contains selected financial data for the Consumer Lending segment:\n| TABLE 28: Consumer Lending |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Income Statement Data |\n| Net interest income | $ | 142 | 92 | 269 | 181 |\n| Provision for credit losses | — | 10 | 8 | 23 |\n| Noninterest income: |\n| Mortgage banking net revenue | 60 | 96 | 142 | 213 |\n| Other noninterest income | 3 | 2 | 3 | 9 |\n| Noninterest expense: |\n| Compensation and benefits | 61 | 53 | 127 | 104 |\n| Other noninterest expense | 102 | 67 | 197 | 140 |\n| Income before income taxes | $ | 42 | 60 | 82 | 136 |\n| Applicable income tax expense | 9 | 12 | 17 | 29 |\n| Net income | $ | 33 | 48 | 65 | 107 |\n| Average Balance Sheet Data |\n| Residential mortgage loans, including held for sale | $ | 16,567 | 12,823 | 16,023 | 13,187 |\n| Home equity | 153 | 200 | 158 | 203 |\n| Indirect secured consumer loans | 14,577 | 11,935 | 14,198 | 11,770 |\n\nNet income was $33 million and $65 million for the three and six months ended June 30, 2021, respectively, compared to net income of $48 million and $107 million, respectively, for the same periods in the prior year. The decreases were primarily due to increases in noninterest expense and decreases in noninterest income partially offset by increases in net interest income and decreases in provision for credit losses.\nNet interest income increased $50 million and $88 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in FTP charge rates on loans and leases and increases in average residential mortgage loans and average indirect secured consumer loans. These increases were partially offset by decreases in yields on average residential mortgage loans and average indirect secured consumer loans as well as decreases in FTP credit rates on demand deposits.\nProvision for credit losses decreased $10 million and $15 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in net charge-offs on indirect secured consumer loans and residential mortgage loans. Net charge-offs as a percent of average portfolio loans and leases were an immaterial amount and 7 bps for the three and six months ended June 30, 2021, respectively, compared to 16 bps and 19 bps for the three and six months ended June 30, 2020, respectively.\nNoninterest income decreased $35 million and $77 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in mortgage banking net revenue. Refer to the Noninterest Income subsection of the Statements of Income Analysis section of MD&A for additional information on the fluctuations in mortgage banking net revenue.\nNoninterest expense increased $43 million and $80 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year due to increases in other noninterest expense and compensation and benefits. Other noninterest expense increased $35 million and $57 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in loan and lease expense, corporate overhead allocations and losses and adjustments. Compensation and benefits increased $8 million and $23 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to increases in base compensation and incentive compensation resulting from the increased mortgage origination activity for both the three and six months ended June 30, 2021.\nAverage consumer loans increased $6.3 billion and $5.2 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to increases in average residential mortgage loans and average indirect secured consumer loans. Average residential mortgage loans increased $3.7 billion and $2.8 billion for the three and six months ended June 30, 2021,\n34\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nrespectively, compared to the same periods in the prior year primarily due to increases in residential mortgage loans held for sale as the Bancorp purchased government-guaranteed loans in forbearance programs. Average indirect secured consumer loans increased $2.6 billion and $2.4 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to loan production exceeding payoffs.\nWealth and Asset Management\nWealth and Asset Management provides a full range of wealth management services for individuals, companies and not-for-profit organizations. Wealth and Asset Management is made up of three main businesses: FTS, an indirect wholly-owned subsidiary of the Bancorp; Fifth Third Private Bank; and Fifth Third Institutional Services. FTS offers full-service retail brokerage services to individual clients and broker-dealer services to the institutional marketplace. Fifth Third Private Bank offers wealth management strategies to high net worth and ultra-high net worth clients through wealth planning, investment management, banking, insurance, trust and estate services. Fifth Third Institutional Services provides advisory services for institutional clients including middle market businesses, non-profits, states and municipalities.\nThe following table contains selected financial data for the Wealth and Asset Management segment:\n| TABLE 29: Wealth and Asset Management |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Income Statement Data |\n| Net interest income | $ | 21 | 51 | 42 | 88 |\n| Benefit from credit losses | — | (1) | (1) | — |\n| Noninterest income: |\n| Wealth and asset management revenue | 138 | 115 | 274 | 244 |\n| Other noninterest income | 5 | 6 | 7 | 14 |\n| Noninterest expense: |\n| Compensation and benefits | 49 | 50 | 103 | 112 |\n| Other noninterest expense | 82 | 72 | 164 | 154 |\n| Income before income taxes | $ | 33 | 51 | 57 | 80 |\n| Applicable income tax expense | 7 | 11 | 12 | 16 |\n| Net income | $ | 26 | 40 | 45 | 64 |\n| Average Balance Sheet Data |\n| Loans and leases, including held for sale | $ | 3,772 | 3,597 | 3,759 | 3,589 |\n| Core deposits | 11,163 | 11,091 | 11,426 | 10,807 |\n\nNet income was $26 million and $45 million for the three and six months ended June 30, 2021, respectively, compared to net income of $40 million and $64 million, respectively, for the same periods in the prior year. The decreases were primarily driven by decreases in net interest income partially offset by increases in noninterest income. The decrease for the three months ended June 30, 2021 also included an increase in noninterest expense.\nNet interest income decreased $30 million and $46 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in FTP credit rates on interest-bearing core deposits as well as decreases in yields on average loans and leases. These negative impacts were partially offset by decreases in rates paid on average interest-bearing core deposits as well as decreases in FTP charge rates on loans and leases.\nNoninterest income increased $22 million and $23 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year driven by increases in wealth and asset management revenue partially offset by decreases in other noninterest income. Wealth and asset management revenue increased $23 million and $30 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily as a result of increases in private client service fees and broker income partially offset by decreases in institutional fees. Other noninterest income decreased $1 million and $7 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to decreases in insurance income driven by the sale of the Bancorp’s property and casualty insurance business in the fourth quarter of 2020.\nNoninterest expense increased $9 million and $1 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year driven by increases in other noninterest expense partially offset by decreases in compensation and benefits. Other noninterest expense increased $10 million for both the three and six months ended June 30, 2021 compared to the same periods in the prior year primarily due to increases in expenses associated with intercompany revenue sharing agreements. Compensation and benefits decreased $1 million and $9 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior\n35\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nyear primarily as a result of decreases in base compensation which included a decline due to the sale of the Bancorp’s property and casualty insurance business in the fourth quarter of 2020.\nAverage loans and leases increased $175 million and $170 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in average other consumer loans and average residential mortgage loans as a result of higher loan production partially offset by decreases in average commercial and industrial loans and average home equity as payoffs exceeded new loan production.\nAverage core deposits increased $72 million and $619 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year. The increase for the three months ended June 30, 2021 compared to the same period in the prior year was primarily driven by increases in average savings and money market deposits, partially offset by a decrease in average interest checking deposits as a result of fiscal stimulus and migration of balances from interest checking deposits. The increase for the six months ended June 30, 2021 compared to the same period in the prior year was primarily driven by increases in average savings and money market deposits, interest checking deposits and demand deposits as a result of higher average balances per customer account due to the amount of fiscal stimulus, uncertainty regarding the COVID-19 pandemic and decreased consumer spending.\nGeneral Corporate and Other\nGeneral Corporate and Other includes the unallocated portion of the investment securities portfolio, securities gains and losses, certain non-core deposit funding, unassigned equity, unallocated provision for credit losses expense or a benefit from the reduction of the ACL, the payment of preferred stock dividends and certain support activities and other items not attributed to the business segments.\nNet interest income on an FTE basis increased $394 million and $672 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in FTP credit rates on deposits allocated to the business segments, increases in interest income on loans and leases and decreases in interest expense on long-term debt and deposits. These positive impacts were partially offset by decreases in the benefit related to FTP charge rates on loans and leases allocated to the business segments and a decrease in interest income on investment securities.\nThe provision for credit losses was $11 million for the three months ended June 30, 2021 compared to a benefit from credit losses of $33 million for the three months ended June 30, 2020. The increase in provision expense for the three months ended June 30, 2021 compared to the same period in the prior year was primarily driven by the impact of the benefits provided to the business segments driven by lower commercial criticized assets owned by each business segment, partially offset by factors which caused a decrease in the ACL including improved economic forecasts, improved commercial and consumer credit quality and lower period-end loan and lease balances. The benefit from credit losses was $134 million for the six months ended June 30, 2021 compared to a provision for credit losses of $486 million for the six months ended June 30, 2020. The decrease in provision expense for the six months ended June 30, 2021 compared to the same period in the prior year was primarily driven by factors which caused a decrease in the ACL including improved economic forecasts, improved commercial and consumer credit quality and lower period-end loan balances. The decrease for the six months ended June 30, 2021 was partially offset by the impact of the benefits provided to the business segments driven by lower commercial criticized assets owned by each business segment.\nNoninterest income decreased $3 million and increased $37 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year. The decrease for the three months ended June 30, 2021 compared to the same period in the prior year was primarily driven by the recognition of securities gains of $10 million for the three months ended June 30, 2021 compared to securities gains of $21 million for the three months ended June 30, 2020 as well as an increase in the loss on the swap associated with the sale of Visa, Inc. Class B shares. These negative impacts were partially offset by a decrease in net losses on disposition and impairment of bank premises and equipment as well as an increase in equity method investment income during the three months ended June 30, 2021 compared to the same period in the prior year. The increase for the six months ended June 30, 2021 compared to the same period in the prior year was primarily driven by the recognition of securities gains of $7 million for the six months ended June 30, 2021 compared to securities losses of $3 million for the six months ended June 30, 2020 as well as a decrease in net losses on disposition and impairment of bank premises and equipment and an increase in equity method investment income during the six months ended June 30, 2021 compared to the same period in the prior year.\nNoninterest expense increased $1 million and $47 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year. The increase for the three months ended June 30, 2021 compared to the same period in the prior year was primarily driven by an increase in equipment expense, a decrease in corporate overhead allocations from General Corporate and Other to the other business segments as well as an increase in technology and communications expense partially offset by a decrease in net occupancy expense. The increase for the six months ended June 30, 2021 compared to the same period in the prior year was primarily due to an increase in compensation and benefits, a decrease in corporate overhead allocations from General Corporate and Other to the other business segments and an increase in equipment expense partially offset by a decrease in net occupancy expense.\n36\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nRISK MANAGEMENT – OVERVIEW\nEffective risk management is critical to the Bancorp’s ongoing success and ensures that the Bancorp operates in a safe and sound manner, complies with applicable laws and regulations and safeguards the Bancorp’s brand and reputation. Risks are inherent in the Bancorp’s business and are influenced by both internal and external factors. The Bancorp is responsible for managing these risks effectively to deliver through-the-cycle value and performance for the Bancorp’s shareholders, customers, employees and communities.\nFifth Third’s Risk Management Framework, which is approved annually by the Capital Committee, ERMC, RCC and the Board of Directors, includes the following key elements:\n•The Bancorp ensures transparency and escalation of risk through defined risk policies and a governance structure that includes the RCC, ERMC and other management-level risk committees and councils.\n•The Bancorp establishes a risk appetite in alignment with its strategic, financial and capital plans. The Bancorp’s risk appetite is defined using quantitative metrics and qualitative measures to ensure prudent risk taking and drive balanced decision making. The Bancorp’s goal is to ensure that aggregate residual risks do not exceed the Bancorp’s risk appetite, and that risks taken are supportive of the Bancorp’s portfolio diversification and profitability objectives. The Board and executive management approve the risk appetite, which is considered in the development of business strategies and forms the basis for enterprise risk management.\n•The core principles that define the Bancorp’s risk appetite are as follows:\n◦Act with integrity in all activities.\n◦Understand the risks taken and ensure that they are in alignment with the Bancorp’s business strategies and risk appetite.\n◦Avoid risks that cannot be understood, managed or monitored.\n◦Provide transparency of risk to the Bancorp’s management and Board by escalating risks and issues as necessary.\n◦Ensure Fifth Third’s products and services are aligned to the Bancorp’s core customer base and are designed, delivered and maintained to provide value and benefit to the Bancorp’s customers and to Fifth Third.\n◦Only offer products or services that are appropriate or suitable for the Bancorp’s customers.\n◦Focus on providing operational excellence by providing reliable, accurate and efficient services to meet the Bancorp’s customers’ needs.\n◦Maintain a strong financial position to ensure the Bancorp meets its strategic objectives through all economic cycles and is able to access the capital markets at all times, even under stressed conditions.\n◦Protect the Bancorp’s reputation by thoroughly understanding the consequences of business strategies, products and processes.\n◦Conduct the Bancorp’s business in compliance with all applicable laws, rules and regulations and in alignment with internal policies and procedures.\n•Fifth Third’s core values and culture provide the foundation for sound risk management practices by establishing expectations for appropriate conduct and accountability across the organization. All employees are expected to conduct themselves in alignment with Fifth Third’s Code of Business Conduct and Ethics, which may be found on www.53.com, while carrying out their responsibilities. Fifth Third’s Corporate Responsibility and Reputation Committee provides oversight of business conduct policies, programs and strategies, and monitors reporting of potential misconduct, trends or themes across the enterprise. Prudent risk management is a responsibility that is expected from all employees and is a foundational element of Fifth Third’s culture.\n•The Bancorp manages eight defined risk types to a prescribed appetite. The risk types are credit risk, liquidity risk, interest rate risk, price risk, legal and regulatory compliance risk, operational risk, reputational risk and strategic risk.\n•The Bancorp identifies and monitors existing and potential risks that may impact the company’s risk profile, including emerging risks that create uncertainties and/or would have broad implications if materialized (e.g. global pandemic, etc.). Enhanced monitoring and action plans are implemented as necessary to proactively mitigate risk.\n•Fifth Third’s Risk Management Process provides a consistent and integrated approach for managing risks. The five components of the Risk Management Process are: identify, assess, manage, monitor and report. The Bancorp has also established processes and programs to manage and report concentration risks, to ensure robust talent, compensation and performance management and to aggregate risks across the enterprise.\nFifth Third drives accountability for managing risk through its Three Lines of Defense structure:\n•The first line of defense is comprised of front-line units that create risk and are accountable for managing risk. These groups are the Bancorp’s primary risk takers and are responsible for implementing effective internal controls and maintaining processes for identifying, assessing and managing the risks associated with their activities consistent with established risk appetite and limits. The first line of defense also includes enterprise-wide functions that provide information technology, operations, servicing, processing or other support.\n•The second line of defense, or Independent Risk Management, consists of Risk Management, Compliance and Credit Review. The second line is responsible for developing frameworks and policies to govern risk-taking activities, overseeing risk-taking of the organization, advising on controlling that risk and providing input on key risk decisions. Risk Management complements the front line’s management of risk-taking activities through its monitoring and reporting responsibilities, including adherence to the risk appetite. Additionally, Risk Management is responsible for identifying, assessing, managing, monitoring and reporting on aggregate risks enterprise-wide.\n•The third line of defense is Internal Audit, which provides oversight of the first and second lines of defense, and independent assurance to the Board on the effectiveness of governance, risk management and internal controls.\n37\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nCREDIT RISK MANAGEMENT\nThe objective of the Bancorp’s credit risk management strategy is to quantify and manage credit risk on an aggregate portfolio basis, as well as to limit the risk of loss resulting from the failure of a borrower or counterparty to honor its financial or contractual obligations to the Bancorp. The Bancorp’s credit risk management strategy is based on three core principles: conservatism, diversification and monitoring. The Bancorp believes that effective credit risk management begins with conservative lending practices which are described below. These practices include the use of intentional risk-based limits for single name exposures and counterparty selection criteria designed to reduce or eliminate exposure to borrowers who have higher than average default risk and defined weaknesses in financial performance. The Bancorp carefully designed and monitors underwriting, documentation and collection standards. The Bancorp’s credit risk management strategy also emphasizes diversification on a geographic, industry and customer level as well as ongoing portfolio monitoring and timely management reviews of large credit exposures and credits experiencing deterioration of credit quality. Credit officers with the authority to extend credit are delegated specific authority amounts, the utilization of which is closely monitored. Underwriting activities are centrally managed, and ERM manages the policy and the authority delegation process directly. The Credit Risk Review function provides independent and objective assessments of the quality of underwriting and documentation, the accuracy of risk grades and the charge-off, nonaccrual and reserve analysis process. The Bancorp’s credit review process and overall assessment of the adequacy of the allowance for credit losses is based on quarterly assessments of the estimated losses expected in the loan and lease portfolio. The Bancorp uses these assessments to promptly identify potential problem loans or leases within the portfolio, maintain an adequate allowance for credit losses and record any necessary charge-offs. The Bancorp defines potential problem loans and leases as those rated substandard that do not meet the definition of a nonaccrual loan or a restructured loan. Refer to Note 6 of the Notes to Condensed Consolidated Financial Statements for further information on the Bancorp’s credit grade categories, which are derived from standard regulatory rating definitions. In addition, stress testing is performed on various commercial and consumer portfolios utilizing various models. For certain portfolios, such as real estate and leveraged lending, stress testing is performed by Credit department personnel at the individual loan level during credit underwriting.\nThe following tables provide a summary of potential problem portfolio loans and leases:\n| TABLE 30: Potential Problem Portfolio Loans and Leases |\n| As of June 30, 2021 ($ in millions) | CarryingValue | UnpaidPrincipalBalance | Exposure |\n| Commercial and industrial loans | $ | 2,071 | 2,077 | 3,436 |\n| Commercial mortgage loans | 983 | 991 | 996 |\n| Commercial construction loans | 462 | 463 | 500 |\n| Commercial leases | 72 | 72 | 87 |\n| Total potential problem portfolio loans and leases | $ | 3,588 | 3,603 | 5,019 |\n| TABLE 31: Potential Problem Portfolio Loans and Leases |\n| As of December 31, 2020 ($ in millions) | CarryingValue | UnpaidPrincipalBalance | Exposure |\n| Commercial and industrial loans | $ | 2,641 | 2,651 | 3,687 |\n| Commercial mortgage loans | 784 | 798 | 792 |\n| Commercial construction loans | 240 | 240 | 252 |\n| Commercial leases | 72 | 72 | 72 |\n| Total potential problem portfolio loans and leases | $ | 3,737 | 3,761 | 4,803 |\n\nIn addition to the individual review of larger commercial loans that exhibit probable or observed credit weaknesses, the commercial credit review process includes the use of two risk grading systems. The first of these risk grading systems encompasses ten categories, which are based on regulatory guidance for credit risk systems. These ratings are used by the Bancorp to monitor and manage its credit risk. The Bancorp also maintains a dual risk rating system for credit approval and pricing, portfolio monitoring and capital allocation that includes a “through-the-cycle” rating philosophy for assessing a borrower’s creditworthiness. A “through-the-cycle” rating philosophy uses a grading scale that assigns ratings based on average default rates through an entire business cycle for borrowers with similar financial performance. The dual risk rating system includes thirteen probabilities of default grade categories and an additional eleven grade categories for estimating losses given an event of default. The probability of default and loss given default evaluations are not separated in the ten-category regulatory risk rating system.\nThe Bancorp utilizes internally developed models to estimate expected credit losses for portfolio loans and leases. For loans and leases that are collectively evaluated, the Bancorp utilizes these models to forecast expected credit losses over a reasonable and supportable forecast period based on the probability of a loan or lease defaulting, the expected balance at the estimated date of default and the expected loss percentage given a default. Refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for additional information about the Bancorp’s processes for developing these models,\n38\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nestimating credit losses for periods beyond the reasonable and supportable forecast period and for estimating credit losses for individually evaluated loans.\nFor the commercial portfolio segment, the estimated probabilities of default are primarily based on the probability of default ratings assigned under the through-the-cycle dual risk rating system and historical observations of how those ratings migrate to a default over time in the context of macroeconomic conditions. For loans with available credit, the estimate of the expected balance at the time of default considers expected utilization rates, which are primarily based on macroeconomic conditions and the utilization history of similar borrowers under those economic conditions. The estimates for loss severity are primarily based on collateral type and coverage levels and the susceptibility of those characteristics to changes in macroeconomic conditions.\nFor collectively evaluated loans in the consumer and residential mortgage portfolio segments, the Bancorp’s expected credit loss models primarily utilize the borrower’s FICO score and delinquency history in combination with macroeconomic conditions when estimating the probability of default. The estimates for loss severity are primarily based on collateral type and coverage levels and the susceptibility of those characteristics to changes in macroeconomic conditions. The expected balance at the estimated date of default is also especially impactful in the expected credit loss models for portfolio classes which generally have longer terms (such as residential mortgage loans and home equity) and portfolio classes containing a high concentration of loans with revolving privileges (such as credit card and home equity). The estimate of the expected balance at the time of default considers expected prepayment and utilization rates where applicable, which are primarily based on macroeconomic conditions and the utilization history of similar borrowers under those economic conditions. The Bancorp also utilizes various scoring systems, analytical tools and portfolio performance monitoring processes to assess the credit risk of the consumer and residential mortgage portfolios.\nOverview\nThe consensus outlook for economic growth in 2021 continued to improve in the second quarter of 2021 as the reopening of the U.S. economy led to an upswing in demand for consumer goods and services. Although the rise of the Delta variant of COVID-19 and slower progress on vaccinations presents some downside risk to the economic outlook in the second half of 2021, the underlying fundamentals of the economy continue to strengthen as consumers and businesses return to more normal levels of activity. With the economy gaining momentum, nonfarm payrolls increased by 850,000 in June of 2021 while wages were up 3.6% year-over-year. The robust economic growth is leading to more persistent inflationary pressures throughout the economy as supply chain constraints limit production while labor supply remains constrained due to federal economic impact payments to individuals, COVID-19 health concerns and aging demographics.\nIn June 2021, the core Consumer Price Index rose 4.5% over the last 12-months, the largest 12-month increase since the period ending November 1991. At the June 2021 FOMC meeting, participants raised their 2021 core Personal Consumption Expenditures (“PCE”) inflation forecast to 3.0% from 2.2% and their risk assessment for core PCE inflation was weighted to the upside. Despite the upside risk around inflation, most meeting participants saw the increase as transitory and expected core PCE to drop back to 2% in 2022 and 2023. The FOMC also retired the language around “not talking about tapering bond purchases” and discussions have begun on when to begin tapering the monthly purchases of $80 billion of treasury securities and $40 billion of agency mortgage-backed securities.\nCOVID-19 Hardship Relief Programs\nIn response to the COVID-19 pandemic, the Bancorp began providing financial hardship relief in March 2020 to borrowers that were negatively impacted by the pandemic and its related economic impacts. For retail borrowers, these relief programs included three-month payment deferrals for non-real estate secured and unsecured portfolios, six-month payment deferrals for home equity loans and lines of credit and six-month forbearances for residential mortgages. The Bancorp also temporarily waived fees for certain products and services, suspended initiating any new repossession actions on vehicles and suspended all residential foreclosure activity. The fee waiver, repossession suspension and payment deferral programs for non-real estate secured and unsecured and home equity loans and lines of credit were discontinued early in the third quarter of 2020. However, new programs to assist consumer customers are now being offered to meet the uniqueness of the current economic environment. These primarily include a short-term hardship program which allows for a reduced payment amount for six months with full payments resuming thereafter or placement into a loan modification program that could include permanent rate reductions or maturity extensions. In most cases, these offers were not classified as TDRs if qualified for the TDR relief provisions provided by the CARES Act. As of June 30, 2021, substantially all of these borrowers have resumed making payments except for certain residential mortgage loans which continue to be in forbearance.\nThe Bancorp currently plans to continue to offer a forbearance program for its residential mortgage borrowers in alignment with the forbearances offered for federally-backed mortgage loans under the provisions of the CARES Act and GSE servicing guidance. Under the provisions of the CARES Act, borrowers with federally-backed residential mortgage loans were able to request a six-month forbearance with an option to extend the forbearance period for an additional period of up to six months. The GSEs have also permitted certain forbearances to be extended for an additional six months for a total of up to 18 months. Additionally, the Bancorp will continue to follow the specific GSE guidance for other non-forbearance COVID-19 pandemic relief programs when servicing its residential mortgage portfolio. These programs include traditional loan modifications and/or deferral of past due payments to the maturity of the loan. The Bancorp has continued to suspend residential foreclosure activity in alignment with GSE practices and will also be responsive to any legislative changes related to foreclosure activity. The foreclosure moratorium expired on July 31, 2021 but some foreclosure activity will remain suspended for a longer period in\n39\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\ncertain circumstances. Also, borrowers that have not taken advantage of a forbearance to date will have until September 30, 2021 to enter into a COVID-19-related forbearance.\nThe Bancorp offered a variety of relief options to its commercial borrowers that had been impacted by the COVID-19 pandemic. While these offers were individually negotiated and tailored to each borrower’s specific facts and circumstances, the most commonly offered relief measures included temporary covenant waivers and/or deferrals of principal and/or interest payments for up to 90 days. After the deferral program, a customer had the option to resume normal payments, enter into a formal loan modification program or restructure the loan arrangement. These relief options were discontinued in 2021.\nThe following table provides a summary of portfolio loans and leases as of June 30, 2021, by class, that have received payment deferrals or forbearances as part of the Bancorp’s COVID-19 pandemic hardship relief programs:\n| TABLE 32: Residential Mortgage and Consumer Portfolio Loans Enrolled In Hardship Relief Programs |\n| Amortized Cost Basis of Loans and Leases | Past Due(c) |\n| Completed Relief Period | In Active Relief Period(a) | Total that Have Received Payment Relief(b) |\n| June 30, 2021 ($ in millions) | Current(c) | 30-89 Days | 90 Days or More | Total Past Due |\n| Residential mortgage loans(b) | $ | 999 | 322 | 1,321 | 1,130 | 31 | 160 | 191 |\n| Consumer loans: |\n| Home equity | 177 | 2 | 179 | 165 | 5 | 9 | 14 |\n| Indirect secured consumer loans(d) | 806 | 85 | 891 | 855 | 32 | 4 | 36 |\n| Credit card | 85 | 14 | 99 | 85 | 7 | 7 | 14 |\n| Other consumer loans | 96 | 3 | 99 | 95 | 3 | 1 | 4 |\n| Total residential mortgage and consumer portfolio loans | $ | 2,163 | 426 | 2,589 | 2,330 | 78 | 181 | 259 |\n\n(a)Includes loans and leases that are still in the initial payment relief period (primarily residential mortgage and home equity loans) and loans that have requested additional relief.\n(b)Excludes $803 of loans previously sold to GNMA that the Bancorp had the option to repurchase as a result of forbearance, all of which were repurchased and are classified as held for sale.\n(c)For loans which are still in an active relief period, past due status is based on the borrower’s status as of March 1, 2020, as adjusted based on the borrower’s compliance with modified loan terms.\n(d)Indirect secured consumer loans which are still in an active relief period as of June 30, 2021 are required to make payments but at a reduced amount from original contractual terms.\nAs of June 30, 2021, $1.3 billion of the Bancorp’s residential mortgage loans had been enrolled in a COVID-19 forbearance program (either active or completed). These loans had a weighted-average FICO score of approximately 683 and a weighted-average origination LTV of approximately 81%. Approximately 72% of these borrowers made at least one payment since entering forbearance, and 85% of balances are reported as current as of June 30, 2021. The Bancorp had $322 million of these loans in an active relief period as of June 30, 2021 and these loans had a weighted-average FICO score of approximately 652 and a weighted-average origination LTV of approximately 83%. Approximately one third of borrowers in an active forbearance period have made at least one payment since entering forbearance and approximately 88% of the residential mortgage loans still in an active relief period have completed the initial six-month forbearance period and have requested an extended forbearance.\nCommercial Portfolio\nThe Bancorp’s credit risk management strategy seeks to minimize concentrations of risk through diversification. The Bancorp has commercial loan concentration limits based on industry, lines of business within the commercial segment, geography and credit product type. The risk within the commercial loan and lease portfolio is managed and monitored through an underwriting process utilizing detailed origination policies, continuous loan level reviews, monitoring of industry concentration and product type limits and continuous portfolio risk management reporting.\nThe Bancorp provides loans to a variety of customers ranging from large multinational firms to middle market businesses, sole proprietors and high net worth individuals. The origination policies for commercial and industrial loans outline the risks and underwriting requirements for loans to businesses in various industries. Included in the policies are maturity and amortization terms, collateral and leverage requirements, cash flow coverage measures and hold limits. The Bancorp aligns credit and sales teams with specific industry expertise to better monitor and manage different industry segments of the portfolio.\nCertain industries have experienced increased stress due to the COVID-19 pandemic. These include consumer-driven industries that require gathering or congregation such as leisure and recreation (including casinos, restaurants, sports, fitness, hotels and other industries), non-essential retail and leisure travel (primarily including airlines and cruise lines). Certain segments of the healthcare industry (including skilled\n40\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nnursing, physician offices and surgery/outpatient centers, among others) have also been impacted by the pandemic given delays and restrictions on in-person visits and elective procedures.\nThe following table presents industries impacted the most severely within the Bancorp’s commercial and industrial and commercial real estate loan portfolios as of June 30, 2021:\n| TABLE 33: Industries Impacted the Most Severely by the COVID-19 Pandemic |\n| ($ in millions) | Balance | Exposure | Industry Classification(b) |\n| Commercial and industrial loans:(a) |\n| Leisure and recreation(c) | $ | 3,260 | 7,084 | Accommodation and food / Entertainment and recreation |\n| Retail - non-essential | 645 | 2,941 | Retail trade |\n| Healthcare | 1,013 | 1,740 | Healthcare |\n| Leisure travel | 393 | 594 | Transportation and warehousing |\n| Total commercial and industrial loans | $ | 5,311 | 12,359 |\n| Commercial real estate owner-occupied loans: |\n| Leisure and recreation(c) | 366 | 414 | Accommodation and food / Entertainment and recreation |\n| Retail - non-essential | 70 | 70 | Real estate |\n| Healthcare | 1,535 | 1,786 | Healthcare |\n| Total commercial real estate owner-occupied loans | $ | 1,971 | 2,270 |\n| Commercial real estate nonowner-occupied loans: |\n| Leisure and recreation(c) | 1,929 | 2,178 | Accommodation and food / Entertainment and recreation |\n| Retail - non-essential | 983 | 1,011 | Real estate |\n| Healthcare | 111 | 132 | Healthcare |\n| Total commercial real estate nonowner-occupied loans | $ | 3,023 | 3,321 |\n| Total | $ | 10,305 | 17,950 |\n\n(a)Excludes PPP loans.\n(b)As defined by the North American Industry Classification System.\n(c)Balances include exposures to casinos, restaurants, sports, fitness, hotels and other.\n41\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following table provides detail on commercial loans and leases by industry classification (as defined by the North American Industry Classification System), by loan size and by state, illustrating the diversity and granularity of the Bancorp’s commercial loans and leases as of:\n| TABLE 34: Commercial Loan and Lease Portfolio (excluding loans and leases held for sale) |\n| June 30, 2021 | December 31, 2020 |\n| ($ in millions) | Outstanding | Exposure | Nonaccrual | Outstanding | Exposure | Nonaccrual |\n| By Industry: |\n| Real estate | $ | 10,790 | 16,227 | 62 | 11,416 | 16,865 | 143 |\n| Manufacturing | 10,517 | 21,588 | 59 | 10,699 | 21,986 | 68 |\n| Financial services and insurance | 7,056 | 16,141 | — | 6,868 | 15,113 | — |\n| Healthcare | 5,057 | 7,664 | 5 | 5,168 | 7,874 | 41 |\n| Business services | 5,003 | 9,129 | 24 | 5,344 | 9,114 | 66 |\n| Accommodation and food | 4,163 | 6,764 | 27 | 4,166 | 6,600 | 35 |\n| Wholesale trade | 4,162 | 8,307 | 7 | 4,204 | 7,990 | 25 |\n| Retail trade | 3,637 | 9,114 | 2 | 3,651 | 8,871 | 6 |\n| Communication and information | 3,052 | 6,956 | 25 | 3,128 | 5,802 | 39 |\n| Construction | 2,766 | 6,208 | 4 | 2,631 | 6,053 | 4 |\n| Transportation and warehousing | 2,660 | 4,503 | 16 | 2,846 | 4,596 | 13 |\n| Mining | 2,589 | 4,645 | 71 | 2,626 | 4,171 | 94 |\n| Entertainment and recreation | 1,804 | 3,299 | 80 | 2,248 | 3,537 | 84 |\n| Other services | 1,308 | 1,759 | 6 | 1,362 | 1,770 | 7 |\n| Utilities | 1,177 | 2,986 | — | 1,162 | 3,011 | — |\n| Public administration | 676 | 1,117 | 9 | 880 | 1,428 | — |\n| Agribusiness | 429 | 599 | 10 | 394 | 616 | 10 |\n| Other | 110 | 113 | 1 | 127 | 129 | 2 |\n| Individuals | 64 | 112 | 1 | 77 | 123 | 1 |\n| Total | $ | 67,020 | 127,231 | 409 | 68,997 | 125,649 | 638 |\n| By Loan Size: |\n| Less than $1 million | 6 | % | 4 | 10 | 7 | 5 | 10 |\n| $1 million to $5 million | 9 | 7 | 12 | 9 | 7 | 18 |\n| $5 million to $10 million | 7 | 6 | 10 | 7 | 6 | 14 |\n| $10 million to $25 million | 17 | 15 | 41 | 18 | 16 | 27 |\n| $25 million to $50 million | 24 | 23 | 27 | 24 | 23 | 31 |\n| Greater than $50 million | 37 | 45 | — | 35 | 43 | — |\n| Total | 100 | % | 100 | 100 | 100 | 100 | 100 |\n| By State: |\n| Illinois | 12 | % | 11 | 25 | 14 | 12 | 28 |\n| Ohio | 10 | 12 | 3 | 11 | 12 | 4 |\n| Florida | 8 | 7 | 1 | 8 | 7 | 1 |\n| California | 8 | 7 | 1 | 7 | 7 | 1 |\n| Texas | 7 | 7 | 13 | 7 | 7 | 10 |\n| Michigan | 6 | 6 | 11 | 6 | 6 | 7 |\n| Indiana | 4 | 4 | 2 | 4 | 4 | 1 |\n| Georgia | 3 | 4 | 8 | 3 | 4 | 7 |\n| North Carolina | 3 | 2 | 1 | 3 | 2 | 3 |\n| Tennessee | 3 | 3 | 1 | 2 | 3 | 1 |\n| Kentucky | 2 | 2 | — | 2 | 2 | 4 |\n| South Carolina | 2 | 1 | — | 2 | 1 | — |\n| Other | 32 | 34 | 34 | 31 | 33 | 33 |\n| Total | 100 | % | 100 | 100 | 100 | 100 | 100 |\n\n42\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe origination policies for commercial real estate outline the risks and underwriting requirements for owner and nonowner-occupied and construction lending. Included in the policies are maturity and amortization terms, maximum LTVs, minimum debt service coverage ratios, construction loan monitoring procedures, appraisal requirements, pre-leasing requirements (as applicable), pro forma analysis requirements and interest rate sensitivity. The Bancorp requires a valuation of real estate collateral, which may include third-party appraisals, be performed at the time of origination and renewal in accordance with regulatory requirements and on an as-needed basis when market conditions justify. Although the Bancorp does not back test these collateral value assumptions, the Bancorp maintains an appraisal review department to order and review third-party appraisals in accordance with regulatory requirements. Collateral values on criticized assets with relationships exceeding $1 million are reviewed quarterly to assess the appropriateness of the value ascribed in the assessment of charge-offs and specific reserves.\nThe Bancorp assesses all real estate and non-real estate collateral securing a loan and considers all cross-collateralized loans in the calculation of the LTV ratio. The following tables provide detail on the most recent LTV ratios for commercial mortgage loans greater than $1 million, excluding commercial mortgage loans that are individually evaluated. The Bancorp does not typically aggregate the LTV ratios for commercial mortgage loans less than $1 million.\n| TABLE 35: Commercial Mortgage Loans Outstanding by LTV, Loans Greater Than $1 Million |\n| As of June 30, 2021 ($ in millions) | LTV > 100% | LTV 80-100% | LTV < 80% |\n| Commercial mortgage owner-occupied loans | $ | 132 | 261 | 3,419 |\n| Commercial mortgage nonowner-occupied loans | 17 | 109 | 4,397 |\n| Total | $ | 149 | 370 | 7,816 |\n| TABLE 36: Commercial Mortgage Loans Outstanding by LTV, Loans Greater Than $1 Million |\n| As of December 31, 2020 ($ in millions) | LTV > 100% | LTV 80-100% | LTV < 80% |\n| Commercial mortgage owner-occupied loans | $ | 121 | 310 | 3,209 |\n| Commercial mortgage nonowner-occupied loans | 51 | 72 | 4,757 |\n| Total | $ | 172 | 382 | 7,966 |\n\nThe Bancorp views non-owner-occupied commercial real estate as a higher credit risk product compared to some other commercial loan portfolios due to the higher volatility of the industry.\nThe following tables provide an analysis of nonowner-occupied commercial real estate loans by state (excluding loans held for sale):\n| TABLE 37: Nonowner-Occupied Commercial Real Estate (excluding loans held for sale)(a) |\n| As of June 30, 2021 ($ in millions) | For the three months ended June 30, 2021 | For the six months ended June 30, 2021 |\n| Outstanding | Exposure | 90 DaysPast Due | Nonaccrual | Net (Recoveries) Charge-offs | Net (Recoveries) Charge-offs |\n| By State: |\n| Illinois | $ | 2,376 | 2,763 | — | 21 | — | — |\n| Ohio | 1,416 | 1,998 | — | — | — | — |\n| Florida | 1,094 | 1,678 | — | — | — | — |\n| North Carolina | 945 | 1,174 | — | 2 | — | — |\n| Michigan | 771 | 886 | — | — | — | — |\n| Indiana | 676 | 967 | — | — | — | — |\n| All other states | 3,433 | 5,369 | — | 1 | (1) | (1) |\n| Total | $ | 10,711 | 14,835 | — | 24 | (1) | (1) |\n\n(a)Included in commercial mortgage loans and commercial construction loans in the Loans and Leases subsection of the Balance Sheet Analysis section of MD&A.\n43\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\n| TABLE 38: Nonowner-Occupied Commercial Real Estate (excluding loans held for sale)(a) |\n| As of June 30, 2020 ($ in millions) | For the three months ended June 30, 2020 | For the six months ended June 30, 2020 |\n| Outstanding | Exposure | 90 DaysPast Due | Nonaccrual | Net Charge-offs | Net Charge-offs |\n| By State: |\n| Illinois | $ | 3,073 | 3,680 | 10 | 5 | 1 | 1 |\n| Ohio | 1,357 | 1,823 | — | 5 | — | — |\n| Florida | 1,026 | 1,620 | — | — | — | — |\n| North Carolina | 808 | 1,116 | — | 2 | — | — |\n| Michigan | 805 | 961 | — | 1 | — | — |\n| Indiana | 559 | 1,040 | — | — | — | — |\n| All other states | 3,580 | 5,722 | — | 59 | — | 1 |\n| Total | $ | 11,208 | 15,962 | 10 | 72 | 1 | 2 |\n\n(a)Included in commercial mortgage loans and commercial construction loans in the Loans and Leases subsection of the Balance Sheet Analysis section of MD&A.\nConsumer Portfolio\nConsumer credit risk management utilizes a framework that encompasses consistent processes for identifying, assessing, managing, monitoring and reporting credit risk. These processes are supported by a credit risk governance structure that includes Board oversight, policies, risk limits and risk committees.\nThe Bancorp’s consumer portfolio is materially comprised of five categories of loans: residential mortgage loans, home equity, indirect secured consumer loans, credit card and other consumer loans. The Bancorp has identified certain credit characteristics within these five categories of loans which it believes represent a higher level of risk compared to the rest of the consumer loan portfolio. The Bancorp does not update LTVs for the consumer portfolio subsequent to origination except as part of the charge-off process for real estate secured loans. Credit risk management continues to closely monitor the indirect secured consumer portfolio performance, which includes automobile loans. The automobile market has exhibited industry-wide gradual loosening of credit standards such as lower FICOs, longer terms and higher LTVs. The Bancorp has adjusted credit standards focused on improving risk-adjusted returns while maintaining credit risk tolerance. The Bancorp actively manages the automobile portfolio through concentration limits, which mitigate credit risk through limiting the exposure to lower FICO scores, higher advance rates and extended term originations.\nThe Bancorp enhanced its credit underwriting guidelines across the entire consumer portfolio in response to the economic stress created by the COVID-19 pandemic. As the economic environment stabilizes, the current set of credit guidelines have generally returned to pre-pandemic levels as the Bancorp continues to ensure that underwriting standards reflect forward-looking outlooks on both risks and market opportunities, support strategic objectives, provide value to consumers and ensure adherence to risk appetite.\nResidential mortgage portfolio\nThe Bancorp manages credit risk in the residential mortgage portfolio through underwriting guidelines that limit exposure to higher LTVs and lower FICO scores. Additionally, the portfolio is governed by concentration limits that ensure geographic, product and channel diversification. The Bancorp may also package and sell loans in the portfolio.\nThe Bancorp does not originate residential mortgage loans that permit customers to defer principal payments or make payments that are less than the accruing interest. The Bancorp originates both fixed-rate and ARM loans. Within the ARM portfolio, approximately $529 million of ARM loans will have rate resets during the next twelve months. Of these resets, 4% are expected to experience an increase in rate, with an average increase of approximately 0.23%. Underlying characteristics of these borrowers are relatively strong with a weighted average origination DTI of 32% and weighted average origination LTV of 71%.\nCertain residential mortgage products have contractual features that may increase credit exposure to the Bancorp in the event of a decline in housing values. These types of mortgage products offered by the Bancorp include loans with high LTVs, multiple loans secured by the same collateral that when combined result in an LTV greater than 80% and interest-only loans. The Bancorp has deemed residential mortgage loans with greater than 80% LTVs and no mortgage insurance as loans that represent a higher level of risk.\nIn response to the COVID-19 pandemic, the Bancorp is following GSE guidance regarding forbearance and foreclosure regulations which currently allow up to 18 months of forbearance. The foreclosure moratorium expired on July 31, 2021 but some foreclosure activity will remain suspended for a longer period in certain circumstances. Also, borrowers that have not taken advantage of a forbearance to date will have until September 30, 2021 to enter into a COVID-19-related forbearance.\n44\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following table provides an analysis of the residential mortgage portfolio loans outstanding by LTV at origination as of:\n| TABLE 39: Residential Mortgage Portfolio Loans by LTV at Origination |\n| June 30, 2021 | December 31, 2020 |\n| ($ in millions) | Outstanding | Weighted-Average LTV | Outstanding | Weighted-Average LTV |\n| LTV ≤ 80% | $ | 11,882 | 63.8 | % | $ | 11,336 | 65.2 | % |\n| LTV > 80%, with mortgage insurance(a) | 2,259 | 95.4 | 2,535 | 95.5 |\n| LTV > 80%, no mortgage insurance | 1,990 | 91.2 | 2,057 | 91.1 |\n| Total | $ | 16,131 | 72.5 | % | $ | 15,928 | 73.9 | % |\n\n(a)Includes loans with both borrower and lender paid mortgage insurance.\nThe following tables provide an analysis of the residential mortgage portfolio loans outstanding by state with a greater than 80% LTV at origination and no mortgage insurance:\n| TABLE 40: Residential Mortgage Portfolio Loans, LTV Greater Than 80% at Origination, No Mortgage Insurance |\n| As of June 30, 2021 ($ in millions) | For the three months ended June 30, 2021 | For the six months ended June 30, 2021 |\n| Outstanding | 90 DaysPast Due | Nonaccrual | Net Charge-offs | Net Charge-offs |\n| By State: |\n| Ohio | $ | 451 | 5 | 4 | — | — |\n| Illinois | 412 | 4 | 1 | — | — |\n| Florida | 301 | 1 | 2 | — | — |\n| Michigan | 156 | 1 | 1 | — | — |\n| Indiana | 140 | 1 | — | — | — |\n| North Carolina | 136 | 1 | — | — | — |\n| Kentucky | 93 | 1 | — | — | — |\n| All other states | 301 | 2 | 2 | — | — |\n| Total | $ | 1,990 | 16 | 10 | — | — |\n\n| TABLE 41: Residential Mortgage Portfolio Loans, LTV Greater Than 80% at Origination, No Mortgage Insurance |\n| As of June 30, 2020 ($ in millions) | For the three months endedJune 30, 2020 | For the six months endedJune 30, 2020 |\n| Outstanding | 90 DaysPast Due | Nonaccrual | Net Charge-offs | Net Charge-offs |\n| By State: |\n| Ohio | $ | 493 | 3 | 4 | — | — |\n| Illinois | 460 | 2 | 3 | — | — |\n| Florida | 325 | 1 | 2 | — | — |\n| Michigan | 210 | 2 | 1 | — | — |\n| Indiana | 177 | 1 | 1 | — | — |\n| North Carolina | 149 | 2 | — | — | — |\n| Kentucky | 100 | 1 | 1 | — | — |\n| All other states | 373 | 3 | 4 | — | — |\n| Total | $ | 2,287 | 15 | 16 | — | — |\n\nHome equity portfolio\nThe Bancorp’s home equity portfolio is primarily comprised of home equity lines of credit. Beginning in the first quarter of 2013, the Bancorp’s newly originated home equity lines of credit have a 10-year interest-only draw period followed by a 20-year amortization period. The home equity line of credit previously offered by the Bancorp was a revolving facility with a 20-year term, minimum payments of interest-only and a balloon payment of principal at maturity. Peak maturity years for the balloon home equity lines of credit are 2025 to 2028 and approximately 21% of the balances mature before 2025.\n45\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe ALLL provides coverage for expected losses in the home equity portfolio. The allowance attributable to the portion of the home equity portfolio that has not been restructured in a TDR is determined on a pooled basis using a probability of default, loss given default and exposure at default model framework to generate expected losses. The expected losses for the home equity portfolio are dependent upon loan delinquency, FICO scores, LTV, loan age and their historical correlation with macroeconomic variables including unemployment and the home price index. The expected losses generated from models are adjusted by certain qualitative adjustment factors to reflect risks associated with current conditions and trends. The qualitative factors include adjustments for changes in policies or procedures in underwriting, monitoring or collections, economic conditions, portfolio mix, lending and risk management personnel, results of internal audit and quality control reviews, collateral values and geographic concentrations.\nThe home equity portfolio is managed in two primary groups: loans outstanding with a combined LTV greater than 80% and those loans with an LTV of 80% or less based upon appraisals at origination. For additional information on these loans, refer to Table 43 and Table 44. Of the total $4.5 billion of outstanding home equity loans:\n● 81% reside within the Bancorp’s Midwest footprint of Ohio, Michigan, Kentucky, Indiana and Illinois as of June 30, 2021;\n● 40% are in senior lien positions and 60% are in junior lien positions at June 30, 2021;\n● 79% of non-delinquent borrowers made at least one payment greater than the minimum payment during the three months ended June 30, 2021; and\n● The portfolio had a weighted average refreshed FICO score of 748 at June 30, 2021.\nThe Bancorp actively manages lines of credit and makes adjustments in lending limits when it believes it is necessary based on FICO score deterioration and property devaluation. The Bancorp does not routinely obtain appraisals on performing loans to update LTVs after origination. However, the Bancorp monitors the local housing markets by reviewing various home price indices and incorporates the impact of the changing market conditions in its ongoing credit monitoring processes. For junior lien home equity loans which become 60 days or more past due, the Bancorp tracks the performance of the senior lien loans in which the Bancorp is the servicer and utilizes consumer credit bureau attributes to monitor the status of the senior lien loans that the Bancorp does not service. If the senior lien loan is found to be 120 days or more past due, the junior lien home equity loan is placed on nonaccrual status unless both loans are well-secured and in the process of collection. Additionally, if the junior lien home equity loan becomes 120 days or more past due and the senior lien loan is also 120 days or more past due, the junior lien home equity loan is assessed for charge-off. Refer to the Analysis of Nonperforming Assets subsection of the Risk Management section of MD&A for more information.\nThe following table provides an analysis of home equity portfolio loans outstanding disaggregated based upon refreshed FICO score as of:\n| TABLE 42: Home Equity Portfolio Loans Outstanding by Refreshed FICO Score |\n| June 30, 2021 | December 31, 2020 |\n| ($ in millions) | Outstanding | % of Total | Outstanding | % of Total |\n| Senior Liens: |\n| FICO ≤ 659 | $ | 151 | 3 | % | $ | 174 | 3 | % |\n| FICO 660-719 | 264 | 6 | 284 | 6 |\n| FICO ≥ 720 | 1,416 | 31 | 1,546 | 30 |\n| Total senior liens | $ | 1,831 | 40 | 2,004 | 39 |\n| Junior Liens: |\n| FICO ≤ 659 | 290 | 7 | 339 | 6 |\n| FICO 660-719 | 506 | 11 | 610 | 12 |\n| FICO ≥ 720 | 1,918 | 42 | 2,230 | 43 |\n| Total junior liens | $ | 2,714 | 60 | 3,179 | 61 |\n| Total | $ | 4,545 | 100 | % | $ | 5,183 | 100 | % |\n\n46\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe Bancorp believes that home equity portfolio loans with a greater than 80% combined LTV present a higher level of risk. The following table provides an analysis of the home equity portfolio loans outstanding in a senior and junior lien position by LTV at origination as of:\n| TABLE 43: Home Equity Portfolio Loans Outstanding by LTV at Origination |\n| June 30, 2021 | December 31, 2020 |\n| ($ in millions) | Outstanding | Weighted-Average LTV | Outstanding | Weighted-Average LTV |\n| Senior Liens: |\n| LTV ≤ 80% | $ | 1,588 | 53.7 | % | $ | 1,728 | 53.8 | % |\n| LTV > 80% | 243 | 89.1 | 276 | 89.1 |\n| Total senior liens | $ | 1,831 | 58.7 | 2,004 | 58.8 |\n| Junior Liens: |\n| LTV ≤ 80% | 1,623 | 66.5 | 1,864 | 66.5 |\n| LTV > 80% | 1,091 | 89.7 | 1,315 | 89.8 |\n| Total junior liens | $ | 2,714 | 76.7 | 3,179 | 77.1 |\n| Total | $ | 4,545 | 69.2 | % | $ | 5,183 | 69.8 | % |\n\nThe following tables provide an analysis of home equity portfolio loans outstanding by state with a combined LTV greater than 80% at origination:\n| TABLE 44: Home Equity Portfolio Loans Outstanding with an LTV Greater than 80% at Origination |\n| As of June 30, 2021 ($ in millions) | For the three months endedJune 30, 2021 | For the six months endedJune 30, 2021 |\n| Outstanding | Exposure | 90 DaysPast Due | Nonaccrual | Net (Recoveries) Charge-offs | Net (Recoveries) Charge-offs |\n| By State: |\n| Ohio | $ | 417 | 993 | — | 8 | — | — |\n| Michigan | 235 | 524 | — | 4 | — | — |\n| Illinois | 215 | 420 | 1 | 6 | (1) | (1) |\n| Indiana | 126 | 286 | — | 3 | — | — |\n| Kentucky | 105 | 250 | — | 2 | — | — |\n| Florida | 91 | 190 | — | 2 | — | — |\n| All other states | 145 | 306 | — | 4 | — | — |\n| Total | $ | 1,334 | 2,969 | 1 | 29 | (1) | (1) |\n\n| TABLE 45: Home Equity Portfolio Loans Outstanding with an LTV Greater than 80% at Origination |\n| As of June 30, 2020 ($ in millions) | For the three months endedJune 30, 2020 | For the six months endedJune 30, 2020 |\n| Outstanding | Exposure | 90 DaysPast Due | Nonaccrual | Net Charge-offs | Net Charge-offs |\n| By State: |\n| Ohio | $ | 564 | 1,231 | — | 9 | — | 1 |\n| Michigan | 328 | 656 | — | 6 | — | — |\n| Illinois | 249 | 483 | — | 6 | — | — |\n| Indiana | 166 | 355 | — | 3 | — | — |\n| Kentucky | 141 | 311 | — | 1 | — | — |\n| Florida | 128 | 245 | — | 3 | — | — |\n| All other states | 199 | 387 | — | 4 | — | — |\n| Total | $ | 1,775 | 3,668 | — | 32 | — | 1 |\n\nIndirect secured consumer portfolio\nThe indirect secured consumer portfolio is comprised of $14.1 billion of automobile loans and $1.1 billion of indirect motorcycle, powersport, recreational vehicle and marine loans as of June 30, 2021. The concentration of lower FICO (≤659) origination balances remained within targeted credit risk tolerance during the six months ended June 30, 2021. All concentration and guideline changes are monitored monthly to ensure alignment with original credit performance and return projections.\n47\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following table provides an analysis of indirect secured consumer portfolio loans outstanding disaggregated based upon FICO score at origination as of:\n| TABLE 46: Indirect Secured Consumer Portfolio Loans Outstanding by FICO Score at Origination |\n| June 30, 2021 | December 31, 2020 |\n| ($ in millions) | Outstanding | % of Total | Outstanding | % of Total |\n| FICO ≤ 659 | $ | 360 | 2 | % | $ | 417 | 3 | % |\n| FICO 660-719 | 3,653 | 24 | 3,568 | 26 |\n| FICO ≥ 720 | 11,179 | 74 | 9,668 | 71 |\n| Total | $ | 15,192 | 100 | % | $ | 13,653 | 100 | % |\n\nAs of June 30, 2021, 94% of the indirect secured consumer loan portfolio is comprised of automobile loans, powersport loans and motorcycle loans. It is a common industry practice to advance on these types of loans an amount in excess of the collateral value due to the inclusion of negative equity trade-in, maintenance/warranty products, taxes, title and other fees paid at closing. The Bancorp monitors its exposure to these higher risk loans. The remainder of the indirect secured consumer loan portfolio is comprised of marine and recreational vehicle loans. The Bancorp’s credit policies limit the maximum advance rate on these to 100% of collateral value.\nThe following table provides an analysis of indirect secured consumer portfolio loans outstanding by LTV at origination as of:\n| TABLE 47: Indirect Secured Consumer Portfolio Loans Outstanding by LTV at Origination |\n| June 30, 2021 | December 31, 2020 |\n| ($ in millions) | Outstanding | Weighted- Average LTV | Outstanding | Weighted- Average LTV |\n| LTV ≤ 100% | $ | 10,945 | 79.8 | % | $ | 9,371 | 80.3 | % |\n| LTV > 100% | 4,247 | 111.9 | 4,282 | 112.7 |\n| Total | $ | 15,192 | 89.0 | % | $ | 13,653 | 90.8 | % |\n\nThe following table provides an analysis of the Bancorp’s indirect secured consumer portfolio loans outstanding with an LTV greater than 100% at origination:\n| TABLE 48: Indirect Secured Consumer Portfolio Loans Outstanding with an LTV Greater than 100% at Origination |\n| As of ($ in millions) | Outstanding | 90 Days PastDue and Accruing | Nonaccrual | Net Charge-offs for the Three Months Ended | Net Charge-offs for the Six Months Ended |\n| June 30, 2021 | $ | 4,247 | 3 | 30 | 1 | 7 |\n| June 30, 2020 | 4,410 | 7 | 7 | 6 | 15 |\n\nCredit card portfolio\nThe credit card portfolio consists of predominantly prime accounts with 98% and 97% of balances existing within the Bancorp’s footprint at June 30, 2021 and December 31, 2020, respectively. At June 30, 2021 and December 31, 2020, 71% and 69%, respectively, of the outstanding balances were originated through branch-based relationships with the remainder coming from direct mail campaigns and online acquisitions.\nThe following table provides an analysis of credit card portfolio loans outstanding disaggregated based upon FICO score at origination as of:\n| TABLE 49: Credit Card Portfolio Loans Outstanding by FICO Score at Origination |\n| June 30, 2021 | December 31, 2020 |\n| ($ in millions) | Outstanding | % of Total | Outstanding | % of Total |\n| FICO ≤ 659 | $ | 82 | 5 | % | $ | 94 | 5 | % |\n| FICO 660-719 | 544 | 30 | 654 | 32 |\n| FICO ≥ 720 | 1,167 | 65 | 1,259 | 63 |\n| Total | $ | 1,793 | 100 | % | $ | 2,007 | 100 | % |\n\nOther consumer portfolio loans\nOther consumer portfolio loans are comprised of secured and unsecured loans originated through the Bancorp’s branch network as well as point-of-sale loans originated or purchased in connection with third-party financial technology companies. The Bancorp had $269 million in unfunded commitments associated with loans originated in connection with third-party financial technology companies as of June 30, 2021. The Bancorp closely monitors the credit performance of point-of-sale loans. Loans originated in connection with third-party financial technology companies are impacted by certain credit loss protection coverage provided by those companies.\n48\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following table provides an analysis of other consumer portfolio loans outstanding by product type as of:\n| TABLE 50: Other Consumer Portfolio Loans Outstanding by Product Type |\n| June 30, 2021 | December 31, 2020 |\n| ($ in millions) | Outstanding | % of Total | Outstanding | % of Total |\n| Unsecured | $ | 629 | 21 | % | $ | 683 | 23 | % |\n| Other secured | 817 | 27 | 774 | 26 |\n| Point-of-sale | 1,606 | 52 | 1,557 | 51 |\n| Total | $ | 3,052 | 100 | % | $ | 3,014 | 100 | % |\n\nAnalysis of Nonperforming Assets\nNonperforming assets include nonaccrual loans and leases for which ultimate collectability of the full amount of the principal and/or interest is uncertain; restructured commercial, credit card and certain consumer loans which have not yet met the requirements to be classified as a performing asset; restructured consumer loans which are 90 days past due based on the restructured terms unless the loan is both well-secured and in the process of collection; and certain other assets, including OREO and other repossessed property. A summary of nonperforming assets is included in Table 51. For further information on the Bancorp’s policies related to accounting for delinquent and nonperforming loans and leases, refer to the Nonaccrual Loans and Leases section of Note 1 of the Notes to the Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\nNonperforming assets were $697 million at June 30, 2021 compared to $870 million at December 31, 2020. At June 30, 2021, $40 million of nonaccrual loans were held for sale, compared to $6 million at December 31, 2020.\nNonperforming portfolio assets as a percent of portfolio loans and leases and OREO were 0.61% as of June 30, 2021 compared to 0.79% as of December 31, 2020. Nonaccrual loans and leases secured by real estate were 32% of nonaccrual loans and leases as of June 30, 2021 compared to 36% as of December 31, 2020.\nPortfolio commercial nonaccrual loans and leases were $409 million at June 30, 2021, a decrease of $229 million from December 31, 2020. Portfolio consumer nonaccrual loans were $212 million at June 30, 2021, an increase of $16 million from December 31, 2020. Refer to Table 52 for a rollforward of the portfolio nonaccrual loans and leases.\nOREO and other repossessed property was $36 million and $30 million at June 30, 2021 and December 31, 2020, respectively. The Bancorp recognized an immaterial amount and $1 million in losses on the transfer, sale or write-down of OREO properties for the three months ended June 30, 2021 and 2020, respectively, and $6 million in losses on the transfer, sale or write-down of OREO properties for both the six months ended June 30, 2021 and 2020.\nFor the three and six months ended June 30, 2021, approximately $8 million and $18 million, respectively, of interest income would have been recognized if the nonaccrual and renegotiated loans and leases on nonaccrual status had been current in accordance with their original terms compared to $9 million and $17 million in the same periods in the prior year. Although these values help demonstrate the costs of carrying nonaccrual credits, the Bancorp does not expect to recover the full amount of interest as nonaccrual loans and leases are generally carried below their principal balance.\n49\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\n| TABLE 51: Summary of Nonperforming Assets and Delinquent Loans and Leases |\n| As of ($ in millions) | June 30,2021 | December 31,2020 |\n| Nonaccrual portfolio loans and leases: |\n| Commercial and industrial loans | $ | 193 | 230 |\n| Commercial mortgage loans | 43 | 82 |\n| Commercial leases | 9 | 7 |\n| Residential mortgage loans(a) | 17 | 25 |\n| Home equity | 53 | 52 |\n| Indirect secured consumer loans | 6 | 9 |\n| Other consumer loans | 1 | 2 |\n| Nonaccrual portfolio restructured loans and leases: |\n| Commercial and industrial loans | 155 | 243 |\n| Commercial mortgage loans | 9 | 75 |\n| Commercial construction loans | — | 1 |\n| Residential mortgage loans(a) | 32 | 35 |\n| Home equity | 32 | 34 |\n| Indirect secured consumer loans | 43 | 7 |\n| Credit card | 27 | 32 |\n| Other consumer loans | 1 | — |\n| Total nonaccrual portfolio loans and leases(b) | $ | 621 | 834 |\n| OREO and other repossessed property | 36 | 30 |\n| Total nonperforming portfolio loans and leases and OREO | $ | 657 | 864 |\n| Nonaccrual loans held for sale | 13 | 5 |\n| Nonaccrual restructured loans held for sale | 27 | 1 |\n| Total nonperforming assets | $ | 697 | 870 |\n| Total portfolio loans and leases 90 days past due and still accruing: |\n| Commercial and industrial loans | $ | 2 | 39 |\n| Commercial mortgage loans | 4 | 8 |\n| Commercial leases | — | 1 |\n| Residential mortgage loans(a) | 57 | 70 |\n| Home equity | 1 | 2 |\n| Indirect secured consumer loans | 4 | 10 |\n| Credit card | 14 | 31 |\n| Other consumer loans | 1 | 2 |\n| Total portfolio loans and leases 90 days past due and still accruing | $ | 83 | 163 |\n| Nonperforming portfolio assets as a percent of portfolio loans and leases and OREO | 0.61 | % | 0.79 |\n| ALLL as a percent of nonperforming portfolio assets | 310 | 284 |\n| ACL as a percent of nonperforming portfolio assets | 338 | 304 |\n\n(a)Information for all periods presented excludes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. These advances were $316 as of June 30, 2021 and $317 as of December 31, 2020. The Bancorp recognized losses of an immaterial amount and $1 for the three months ended June 30, 2021 and 2020, respectively, and $1 and $2 for the six months ended June 30, 2021 and 2020, respectively, due to claim denials and curtailments associated with these insured or guaranteed loans.\n(b)Includes $26 and $29 of nonaccrual government insured commercial loans whose repayments are insured by the SBA as of June 30, 2021 and December 31, 2020, respectively, of which $13 and $17 are restructured nonaccrual government insured commercial loans as of June 30, 2021 and December 31, 2020, respectively.\n50\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following tables provide a rollforward of portfolio nonaccrual loans and leases, by portfolio segment:\n| TABLE 52: Rollforward of Portfolio Nonaccrual Loans and Leases |\n| For the six months ended June 30, 2021 ($ in millions) | Commercial | Residential Mortgage | Consumer | Total |\n| Balance, beginning of period | $ | 638 | 60 | 136 | 834 |\n| Transfers to nonaccrual status | 130 | 26 | 117 | 273 |\n| Transfers to accrual status | (1) | (36) | (45) | (82) |\n| Transfers to held for sale | (87) | — | — | (87) |\n| Loan paydowns/payoffs | (215) | — | (28) | (243) |\n| Transfers to OREO | (1) | (2) | — | (3) |\n| Charge-offs | (81) | — | (18) | (99) |\n| Draws/other extensions of credit | 26 | 1 | 1 | 28 |\n| Balance, end of period | $ | 409 | 49 | 163 | 621 |\n\n| TABLE 53: Rollforward of Portfolio Nonaccrual Loans and Leases |\n| For the six months ended June 30, 2020 ($ in millions) | Commercial | Residential Mortgage | Consumer | Total |\n| Balance, beginning of period | $ | 397 | 91 | 130 | 618 |\n| Transfers to nonaccrual status | 349 | 73 | 82 | 504 |\n| Transfers to accrual status | (31) | (72) | (45) | (148) |\n| Transfers to held for sale | (10) | — | — | (10) |\n| Loan paydowns/payoffs | (81) | (6) | (19) | (106) |\n| Transfers to OREO | — | (7) | — | (7) |\n| Charge-offs | (142) | — | (15) | (157) |\n| Draws/other extensions of credit | 5 | — | 1 | 6 |\n| Balance, end of period | $ | 487 | 79 | 134 | 700 |\n\nTroubled Debt Restructurings\nA loan is accounted for as a TDR if the Bancorp, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. TDRs include concessions granted under reorganization, arrangement or other provisions of the Federal Bankruptcy Act. A TDR typically involves a modification of terms such as a reduction of the stated interest rate or remaining principal amount of the loan, a reduction of accrued interest or an extension of the maturity date at a stated interest rate lower than the current market rate for a new loan with similar risk.\nAt the time of modification, the Bancorp maintains certain consumer loan TDRs (including certain residential mortgage loans, home equity loans and other consumer loans) on accrual status, provided there is reasonable assurance of repayment and performance according to the modified terms based upon a current, well-documented credit evaluation. Loans discharged in a Chapter 7 bankruptcy and not reaffirmed by the borrower are classified as collateral-dependent TDRs and placed on nonaccrual status regardless of the borrower’s payment history or capacity to repay in the future. These loans are returned to accrual status provided there is a sustained payment history of twelve months after bankruptcy and collectability is reasonably assured for all remaining contractual payments. Commercial loans modified as part of a TDR are maintained on accrual status provided there is a sustained payment history of six months or greater prior to the modification in accordance with the modified terms and all remaining contractual payments under the modified terms are reasonably assured of collection. TDRs of commercial loans and credit card loans that do not have a sustained payment history of six months or greater in accordance with the modified terms remain on nonaccrual status until a six-month payment history is sustained. Refer to the Regulatory Developments Related to the COVID-19 Pandemic section of Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for additional information on loans that were modified related to the COVID-19 pandemic but not classified as TDRs.\nConsumer restructured loans on accrual status totaled $699 million and $796 million at June 30, 2021 and December 31, 2020, respectively. As of June 30, 2021, the percentages of restructured residential mortgage loans, home equity loans and credit card loans that were past due 30 days or more from their modified terms were 28%, 19% and 24%, respectively.\n51\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following tables summarize portfolio TDRs by loan type and delinquency status:\n| TABLE 54: Accruing and Nonaccruing Portfolio TDRs |\n| Accruing |\n| 30-89 Days | 90 Days or |\n| As of June 30, 2021 ($ in millions) | Current | Past Due | More Past Due | Nonaccruing | Total |\n| Commercial loans(a) | $ | 80 | — | — | 164 | 244 |\n| Residential mortgage loans(b) | 387 | 26 | 94 | 32 | 539 |\n| Home equity | 157 | 5 | — | 32 | 194 |\n| Indirect secured consumer loans | 9 | — | — | 43 | 52 |\n| Credit card | 19 | 2 | — | 27 | 48 |\n| Other consumer | — | — | — | 1 | 1 |\n| Total | $ | 652 | 33 | 94 | 299 | 1,078 |\n\n(a)Excludes restructured nonaccrual loans held for sale.\n(b)Information includes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. As of June 30, 2021, these advances represented $188 of current loans, $21 of 30-89 days past due loans and $85 of 90 days or more past due loans.\n| TABLE 55: Accruing and Nonaccruing Portfolio TDRs |\n| Accruing |\n| 30-89 Days | 90 Days or |\n| As of December 31, 2020 ($ in millions) | Current | Past Due | More Past Due | Nonaccruing | Total |\n| Commercial loans(a) | $ | 92 | — | — | 319 | 411 |\n| Residential mortgage loans(b) | 462 | 32 | 102 | 35 | 631 |\n| Home equity | 171 | 7 | — | 34 | 212 |\n| Indirect secured consumer loans | 5 | — | — | 7 | 12 |\n| Credit card | 15 | 2 | — | 32 | 49 |\n| Total | $ | 745 | 41 | 102 | 427 | 1,315 |\n\n(a)Excludes restructured nonaccrual loans held for sale.\n(b)Information includes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. As of December 31, 2020, these advances represented $276 of current loans, $28 of 30-89 days past due loans and $78 of 90 days or more past due loans.\nAnalysis of Net Loan Charge-offs\nNet charge-offs were 16 bps and 44 bps of average portfolio loans and leases for the three months ended June 30, 2021 and 2020, respectively, and were 21 bps and 44 bps of average portfolio loans and leases for the six months ended June 30, 2021 and 2020, respectively. Table 56 provides a summary of credit loss experience and net charge-offs as a percent of average portfolio loans and leases outstanding by loan category.\nThe ratio of commercial loan and lease net charge-offs as a percent of average portfolio commercial loans and leases decreased to 10 bps and 14 bps during the three and six months ended June 30, 2021, respectively, compared to 40 bps and 36 bps during the three and six months ended June 30, 2020, respectively. The decrease was primarily due to decreases in net charge-offs on commercial and industrial loans of $52 million and $75 million for the three and six months ended June 30, 2021, respectively. Additionally, there were net recoveries on commercial leases of $2 million for both the three and six months ended June 30, 2021 compared to net charge-offs on commercial leases of $11 million and $16 million for the three and six months ended June 30, 2020, respectively.\nThe ratio of consumer loan net charge-offs as a percent of average portfolio consumer loans decreased to 26 bps and 34 bps during the three and six months ended June 30, 2021, respectively, compared to 52 bps and 59 bps during the three and six months ended June 30, 2020, respectively. The decrease was primarily due to decreases in net charge-offs on credit card loans of $14 million and $26 million for the three and six months ended June 30, 2021, respectively, and decreases in net charge-offs on indirect secured consumer loans of $7 million and $11 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year. The decrease for both the three and six months ended June 30, 2021 included the impact of government stimulus programs and the Bancorp’s hardship programs. Additionally, the Bancorp continued to see increased used car values through the second quarter of 2021 which has directly impacted loss severity.\n52\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\n| TABLE 56: Summary of Credit Loss Experience |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Losses charged-off: |\n| Commercial and industrial loans | $ | (36) | (68) | (68) | (122) |\n| Commercial mortgage loans | (8) | (2) | (12) | (4) |\n| Commercial leases | (1) | (11) | (1) | (16) |\n| Residential mortgage loans | (1) | (2) | (2) | (4) |\n| Home equity | (2) | (3) | (4) | (8) |\n| Indirect secured consumer loans | (11) | (15) | (30) | (37) |\n| Credit card | (26) | (40) | (57) | (82) |\n| Other consumer loans(a) | (18) | (22) | (37) | (49) |\n| Total losses charged-off | $ | (103) | (163) | (211) | (322) |\n| Recoveries of losses previously charged-off: |\n| Commercial and industrial loans | $ | 23 | 3 | 28 | 7 |\n| Commercial mortgage loans | 2 | — | 4 | — |\n| Commercial leases | 3 | — | 3 | — |\n| Residential mortgage loans | 1 | 1 | 3 | 2 |\n| Home equity | 3 | 2 | 5 | 4 |\n| Indirect secured consumer loans | 11 | 8 | 21 | 17 |\n| Credit card | 6 | 6 | 12 | 11 |\n| Other consumer loans(a) | 10 | 13 | 20 | 29 |\n| Total recoveries of losses previously charged-off | $ | 59 | 33 | 96 | 70 |\n| Net losses charged-off: |\n| Commercial and industrial loans | $ | (13) | (65) | (40) | (115) |\n| Commercial mortgage loans | (6) | (2) | (8) | (4) |\n| Commercial leases | 2 | (11) | 2 | (16) |\n| Residential mortgage loans | — | (1) | 1 | (2) |\n| Home equity | 1 | (1) | 1 | (4) |\n| Indirect secured consumer loans | — | (7) | (9) | (20) |\n| Credit card | (20) | (34) | (45) | (71) |\n| Other consumer loans | (8) | (9) | (17) | (20) |\n| Total net losses charged-off | $ | (44) | (130) | (115) | (252) |\n| Net losses charged-off as a percent of average portfolio loans and leases: |\n| Commercial and industrial loans | 0.11 | % | 0.45 | 0.16 | 0.42 |\n| Commercial mortgage loans | 0.22 | 0.07 | 0.16 | 0.07 |\n| Commercial leases | (0.21) | 1.47 | (0.15) | 1.02 |\n| Total commercial loans and leases | 0.10 | % | 0.40 | 0.14 | 0.36 |\n| Residential mortgage loans | (0.01) | 0.02 | (0.01) | 0.02 |\n| Home equity | (0.09) | 0.07 | (0.04) | 0.12 |\n| Indirect secured consumer loans | 0.01 | 0.24 | 0.12 | 0.33 |\n| Credit card | 4.52 | 6.17 | 5.02 | 6.01 |\n| Other consumer loans | 0.91 | 1.17 | 1.03 | 1.51 |\n| Total consumer loans | 0.26 | % | 0.52 | 0.34 | 0.59 |\n| Total net losses charged-off as a percent of average portfolio loans and leases | 0.16 | % | 0.44 | 0.21 | 0.44 |\n\n(a)For the three and six months ended June 30, 2021, the Bancorp recorded $8 and $18, respectively, in both losses charged-off and recoveries of losses previously charged-off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements. For the three and six months ended June 30, 2020, the Bancorp recorded $9 and $22, respectively, in both losses charged-off and recoveries of losses previously charged-off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements.\nAllowance for Credit Losses\nThe allowance for credit losses is comprised of the ALLL and the reserve for unfunded commitments. As described in Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020, the Bancorp maintains the ALLL to absorb the amount of credit losses that are expected to be incurred over the remaining contractual terms of the related loans and leases (as adjusted for prepayments and reasonably expected TDRs). The Bancorp’s methodology for determining the ALLL includes an estimate of expected credit losses on a collective basis for groups of loans and leases with similar risk characteristics and\n53\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nspecific allowances for loans and leases which are individually evaluated. For collectively evaluated loans and leases, the Bancorp uses quantitative models to forecast expected credit losses based on the probability of a loan or lease defaulting, the expected balance at the estimated date of default and the expected loss percentage given a default. The Bancorp’s expected credit loss models consider historical credit loss experience, current market and economic conditions, and forecasted changes in market and economic conditions if such forecasts are considered reasonable and supportable.\nThe Bancorp also considers qualitative factors in determining the ALLL. Qualitative adjustments are used to capture characteristics in the portfolio that impact expected credit losses which are not fully captured within the Bancorp’s expected credit loss models. These factors include adjustments for changes in policies or procedures in underwriting, monitoring or collections, lending and risk management personnel and results of internal audit and quality control reviews. In addition, the qualitative adjustment framework can be utilized to address specific idiosyncratic risks such as geopolitical events, natural disasters or changes in current economic conditions that are not reflected in the quantitative credit loss models, and their effects on regional borrowers and changes in product structures. Qualitative factors may also be used to address the impacts of unforeseen events on key inputs and assumptions within the Bancorp’s expected credit loss models, such as the reasonable and supportable forecast period, changes to historical loss information or changes to the reversion period or methodology.\nIn addition to the ALLL, the Bancorp maintains a reserve for unfunded commitments recorded in other liabilities in the Condensed Consolidated Balance Sheets. The methodology used to determine the adequacy of this reserve is similar to the Bancorp’s methodology for determining the ALLL. The provision for unfunded commitments is included in the provision for credit losses in the Condensed Consolidated Statements of Income.\nFor the commercial portfolio segment, the estimates for probability of default are primarily based on internal ratings assigned to each commercial borrower on a 13-point scale and historical observations of how those ratings migrate to a default over time in the context of macroeconomic conditions. For loans with available credit, the estimate of the expected balance at the time of default considers expected utilization rates, which are primarily based on macroeconomic conditions and the utilization history of similar borrowers under those economic conditions. The estimates for loss severity are primarily based on collateral type and coverage levels and the susceptibility of those characteristics to changes in macroeconomic conditions.\nFor collectively evaluated loans in the consumer and residential mortgage portfolio segments, the Bancorp’s expected credit loss models primarily utilize the borrower’s FICO score and delinquency history in combination with macroeconomic conditions when estimating the probability of default. The estimates for loss severity are primarily based on collateral type and coverage levels and the susceptibility of those characteristics to changes in macroeconomic conditions. The expected balance at the estimated date of default is also especially impactful in the expected credit loss models for portfolio classes which generally have longer terms (such as residential mortgage loans and home equity) and portfolio classes containing a high concentration of loans with revolving privileges (such as credit card and home equity). The estimate of the expected balance at the time of default considers expected prepayment and utilization rates where applicable, which are primarily based on macroeconomic conditions and the utilization history of similar borrowers under those economic conditions.\nDay 1 Adoption Impact\nUpon adoption of ASU 2016-13 on January 1, 2020, the Bancorp used three forward-looking economic scenarios during the reasonable and supportable forecast period in its expected credit loss models to address the inherent imprecision in macroeconomic forecasting. Each of the three scenarios was developed by a third party that is subject to the Bancorp’s Third-Party Risk Management program including oversight by the Bancorp’s independent model risk management group. The scenarios included a most likely outcome (Baseline) and two less probable scenarios with one being more favorable than the Baseline and the other being less favorable. The more favorable alternative scenario (Upside) depicted a stronger near-term growth outlook while the less favorable outlook (Downside) depicted a moderate recession. The Baseline scenario was assigned a probability weighting of 80% with each of the Upside and Downside scenarios being assigned a 10% weighting.\nThe Baseline scenario was developed such that the expectation is that the economy will perform better than the projection 50% of the time and worse than the projection 50% of the time. The Upside scenario was developed such that there is a 10% probability that the economy will perform better than the projection and a 90% probability that it will perform worse. The Downside scenario was developed such that there is a 90% probability that the economy will perform better than the projection and a 10% probability that it will perform worse.\nJune 30, 2021 ACL\nThe ACL as of June 30, 2021 was impacted by several factors, including improvement in both the economic outlook and credit quality. As a result of these factors, the Bancorp incorporated a combination of quantitative model-based estimates and qualitative adjustments. For the quantitative estimates, the Bancorp incorporated three scenarios developed by the third party in May 2021 that included estimates of the expected impacts of the changes in economic conditions caused by the COVID-19 pandemic. The Baseline scenario was assigned a probability weighting of 60%, with a more favorable scenario (Upside) assigned a probability weighting of 20% and a less favorable scenario (Downside) assigned a probability of 20%. The Baseline scenario assumed that a “Build Back Better” program will be passed in late 2021, with implementation early next year. In 2021, real GDP is expected to rise 6.8%, while real consumer spending is forecast to increase 10.7% at an annualized rate. The Baseline scenario also assumes an average unemployment rate of 4.5% in the fourth quarter of 2021, decreasing to\n54\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\n3.7% in 2022. The Upside scenario assumes a faster than expected boost in consumer sentiment and spending as a result of the government stimulus programs. On an average annual basis, the change in real GDP is 7.3% in 2021 and 6.5% in 2022, and a full-employment rate is expected to be achieved by the third quarter of 2021. The Downside scenario excludes any additional stimulus package beyond the American Rescue Plan passed in March 2021. Real GDP declines through the first quarter of 2022, and the unemployment rate peaks at 9.2% in the third quarter of 2022 with full-employment not reached until the third quarter of 2026.\nThe Bancorp’s quantitative credit loss models are sensitive to changes in economic forecast assumptions over the reasonable and supportable forecast period. Applying a 100% probability weighting to the Downside scenario rather than using the probability-weighted three scenario approach would result in an increase in the quantitative ACL of approximately $763 million. This sensitivity calculation only reflects the impact of changing the probability weighting of the scenarios in the quantitative credit loss models and excludes any additional considerations associated with the qualitative component of the ACL that might be warranted if probability weights were adjusted.\nAt June 30, 2021, the qualitative component of the ACL included consideration of certain factors that represent emerging risks specifically associated with the current economic environment and the COVID-19 pandemic. These considerations resulted in qualitative adjustments to increase the ACL, primarily related to volatility in short-term unemployment rates, commercial borrowers experiencing prolonged distress, commercial borrowers in certain industries which have been severely impacted by the COVID-19 pandemic and consumer borrowers that deferred contractual payments under COVID-19 forbearance or hardship programs.\nThe following table provides a rollforward of the Bancorp’s ACL:\n| TABLE 57: Changes in Allowance for Credit Losses |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| ALLL: |\n| Balance, beginning of period | $ | 2,208 | 2,348 | 2,453 | 1,202 |\n| Losses charged-off(a) | (103) | (163) | (211) | (322) |\n| Recoveries of losses previously charged-off(a) | 59 | 33 | 96 | 70 |\n| (Benefit from) provision for loan and lease losses | (131) | 478 | (305) | 1,103 |\n| Impact of adoption of ASU 2016-13 | — | — | — | 643 |\n| Balance, end of period | $ | 2,033 | 2,696 | 2,033 | 2,696 |\n| Reserve for unfunded commitments: |\n| Balance, beginning of period | $ | 173 | 169 | 172 | 144 |\n| Provision for the reserve for unfunded commitments | 16 | 7 | 17 | 22 |\n| Impact of adoption of ASU 2016-13 | — | — | — | 10 |\n| Balance, end of period | $ | 189 | 176 | 189 | 176 |\n\n(a)For the three and six months ended June 30, 2021, the Bancorp recorded $8 and $18, respectively, in both losses charged-off and recoveries of losses previously charged-off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements. For the three and six months ended June 30, 2020, the Bancorp recorded $9 and $22, respectively, in both losses charged-off and recoveries of losses previously charged-off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements.\n55\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following table provides an attribution of the Bancorp’s ALLL to portfolio loans and leases:\n| TABLE 58: Attribution of Allowance for Loan and Lease Losses to Portfolio Loans and Leases |\n| As of ($ in millions) | June 30,2021 | December 31,2020 |\n| Attributed ALLL: |\n| Commercial and industrial loans | $ | 744 | 901 |\n| Commercial mortgage loans | 371 | 402 |\n| Commercial construction loans | 85 | 124 |\n| Commercial leases | 24 | 29 |\n| Residential mortgage loans | 235 | 294 |\n| Home equity | 152 | 201 |\n| Indirect secured consumer loans | 109 | 131 |\n| Credit card | 198 | 252 |\n| Other consumer loans | 115 | 119 |\n| Total ALLL | $ | 2,033 | 2,453 |\n| Portfolio loans and leases: |\n| Commercial and industrial loans | $ | 47,564 | 49,665 |\n| Commercial mortgage loans | 10,347 | 10,602 |\n| Commercial construction loans | 5,871 | 5,815 |\n| Commercial leases | 3,238 | 2,915 |\n| Residential mortgage loans | 16,131 | 15,928 |\n| Home equity | 4,545 | 5,183 |\n| Indirect secured consumer loans | 15,192 | 13,653 |\n| Credit card | 1,793 | 2,007 |\n| Other consumer loans | 3,052 | 3,014 |\n| Total portfolio loans and leases | $ | 107,733 | 108,782 |\n| Attributed ALLL as a percent of respective portfolio loans and leases: |\n| Commercial and industrial loans | 1.56 | % | 1.81 |\n| Commercial mortgage loans | 3.59 | 3.79 |\n| Commercial construction loans | 1.45 | 2.13 |\n| Commercial leases | 0.74 | 0.99 |\n| Residential mortgage loans | 1.46 | 1.85 |\n| Home equity | 3.34 | 3.88 |\n| Indirect secured consumer loans | 0.72 | 0.96 |\n| Credit card | 11.04 | 12.56 |\n| Other consumer loans | 3.77 | 3.95 |\n| Total ALLL as a percent of portfolio loans and leases | 1.89 | % | 2.25 |\n| Total ACL as a percent of portfolio loans and leases | 2.06 | 2.41 |\n\nThe Bancorp’s ALLL may vary significantly from period to period based on changes in economic conditions, economic forecasts and the composition and credit quality of the Bancorp’s loan and lease portfolio. For additional information on the Bancorp’s methodology for measuring the ACL, refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10‑K for the year ended December 31, 2020.\n56\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nINTEREST RATE AND PRICE RISK MANAGEMENT\nInterest rate risk is the risk to earnings or capital arising from movement of interest rates. This risk primarily impacts the Bancorp’s income categories through changes in interest income on earning assets and the cost of interest-bearing liabilities, and through fee items that are related to interest sensitive activities such as mortgage origination and servicing income and through earnings credits earned on commercial deposits that offset commercial deposit fees. Price risk is the risk to earnings or capital arising from changes in the value of financial instruments and portfolios due to movements in interest rates, volatilities, foreign exchange rates, equity prices and commodity prices. Management considers interest rate risk a prominent market risk in terms of its potential impact on earnings. Interest rate risk may occur for any one or more of the following reasons:\n•Assets and liabilities mature or reprice at different times;\n•Short-term and long-term market interest rates change by different amounts; or\n•The expected maturities of various assets or liabilities shorten or lengthen as interest rates change.\nIn addition to the direct impact of interest rate changes on NII and interest-sensitive fees, interest rates can impact earnings through their effect on loan and deposit demand, credit losses, mortgage origination volumes, the value of servicing rights and other sources of the Bancorp’s earnings. Changes in interest rates and other market factors can impact earnings through changes in the value of portfolios, if not appropriately hedged. Stability of the Bancorp’s net income is largely dependent upon the effective management of interest rate risk and to a lesser extent price risk. Management continually reviews the Bancorp’s on- and off-balance sheet composition, earnings flows, and hedging strategies and models interest rate risk and price risk exposures, and possible actions to manage these risks, given numerous possible future interest rate and market factor scenarios. A series of Policy Limits and Key Risk Indicators are employed to ensure that risks are managed within the Bancorp’s risk tolerance for interest rate risk and price risk.\nIn addition to the traditional forms of interest rate risk discussed in this section, the Bancorp is exposed to interest rate risk associated with the retirement and replacement of LIBOR. For more information on the LIBOR transition, refer to the Overview section of MD&A.\nThe Commercial and Wealth and Asset Management lines of business manage price risk for capital markets sales and trading activities related to their respective businesses. The Mortgage line of business manages price risk for the origination and sale of conforming residential mortgage loans to government agencies and government-sponsored enterprises. The Bancorp’s Treasury department manages interest rate risk and price risk for all other activities. Independent oversight is provided by ERM, and key risk indicators and Board-approved policy limits are used to ensure risks are managed within the Bancorp’s risk tolerance.\nThe Bancorp’s Market Risk Management Committee, which includes senior management representatives, is accountable to the ERMC, provides oversight and monitors price risk for the capital markets sales and trading activities. The Bancorp’s ALCO, which includes senior management representatives and is accountable to the ERMC, provides oversight and monitors interest rate and price risks for Mortgage and Treasury activities.\nNet Interest Income Sensitivity\nThe Bancorp employs a variety of measurement techniques to identify and manage its interest rate risk, including the use of an NII simulation model to analyze the sensitivity of NII to changes in interest rates. The model is based on contractual and estimated cash flows and repricing characteristics for all of the Bancorp’s assets, liabilities and off-balance sheet exposures and incorporates market-based assumptions regarding the effect of changing interest rates on the prepayment rates of certain assets and attrition rates of certain liabilities. The model also includes senior management’s projections of the future volume and pricing of each of the product lines offered by the Bancorp as well as other pertinent assumptions. Actual results may differ from simulated results due to timing, magnitude and frequency of interest rate changes, deviations from projected assumptions as well as from changes in market conditions and management strategies.\nAs of June 30, 2021, the Bancorp’s interest rate risk exposure is governed by a risk framework that utilizes the change in NII over 12-month and 24-month horizons assuming a 200 bps parallel ramped increase in interest rates. Given the unlikely probability associated with a potential negative rate environment, the Bancorp does not have a policy limit for scenarios that include negative rates. Therefore, the Bancorp has no policy limit for a scenario with a decrease in interest rates currently in effect as the Federal Funds target range is currently between zero and 25 basis points. However, the Bancorp routinely analyzes various potential and extreme scenarios, including parallel ramps and shocks as well as steepening and other non-parallel shifts in rates, including negative rate scenarios, to assess where risks to net interest income persist or develop as changes in the balance sheet and market rates evolve. Additionally, the Bancorp routinely evaluates its exposures to changes in the bases between interest rates. The ongoing COVID-19 pandemic has caused significant changes to interest rates, volatilities and the composition of the Bancorp’s balance sheet, including significant increases in deposit funding related to stimulus programs, which has resulted in an excess liquidity position. The excess liquidity is likely to continue negatively impacting net interest margin if short-term interest rates hold steady or move lower but may be partially offset by the amortization of fees related to PPP loans and investment opportunities should the yield curve steepen.\nIn order to recognize the risk of noninterest-bearing demand deposit balance run-off in a rising interest rate environment, the Bancorp’s NII sensitivity modeling assumes that approximately $5 billion of additional demand deposit balances run-off over 24 months above what is\n57\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nincluded in senior management’s baseline projections for each 100 bps increase in short-term market interest rates. Similarly, the Bancorp’s NII sensitivity modeling incorporates approximately $5 billion of incremental growth in noninterest-bearing deposit balances over 24 months above senior management’s baseline projections for each 100 bps decrease in short-term market interest rates. The incremental balance run-off and growth are modeled to flow into and out of funding products that reprice in conjunction with short-term market rate changes and reflect the Bank’s excess liquidity position.\nAnother important deposit modeling assumption is the amount by which interest-bearing deposit rates will increase or decrease when market interest rates increase or decrease. This deposit repricing sensitivity is known as the beta, and it represents the expected amount by which Bancorp deposit rates will change for a given change in short-term market rates. At June 30, 2021, the modeling assumed a weighted-average rising-rate interest-bearing deposit beta of 37%, which is aligned with the portfolio’s experience in the last rate hike cycle. In the event of further rate cuts by the FRB into negative territory, the Bancorp’s NII sensitivity modeling assumes a weighted-average falling-rate interest-bearing deposit beta of 32% at June 30, 2021, while maintaining that deposit rates themselves will not become negative. In addition, the modeling assumes there is no lag between the timing of changes in market rates and the timing of deposit repricing despite such timing lags having occurred in prior rate cycles.\nThe Bancorp continually evaluates the sensitivity of its interest rate risk measures to these important deposit modeling assumptions. The Bancorp also regularly monitors the sensitivity of other important modeling assumptions, such as loan and security prepayments and early withdrawals on fixed-rate customer liabilities.\nThe following table shows the Bancorp’s estimated NII sensitivity profile and ALCO policy limits as of:\n| TABLE 59: Estimated NII Sensitivity Profile and ALCO Policy Limits |\n| June 30, 2021 | June 30, 2020 |\n| % Change in NII (FTE) | ALCOPolicy Limit | % Change in NII (FTE) | ALCOPolicy Limit |\n| Change in Interest Rates (bps) | 12 Months | 13-24Months | 12Months | 13-24Months | 12 Months | 13-24Months | 12Months | 13-24Months |\n| +200 Ramp over 12 months | 10.79 | % | 22.38 | (4.00) | (6.00) | 1.98 | 7.26 | (4.00) | (6.00) |\n| +100 Ramp over 12 months | 5.64 | 12.37 | N/A | N/A | 1.02 | 3.88 | N/A | N/A |\n| -25 Ramp over 3 months | (2.06) | (3.15) | N/A | N/A | (1.64) | (2.53) | N/A | N/A |\n\nAt June 30, 2021, the Bancorp’s NII would benefit significantly in both year one and year two under the parallel rate ramp increases. The Bancorp maintains an asymmetric NII sensitivity profile, which is attributable to the level of floating-rate assets, including the predominantly floating-rate commercial loan portfolio, exceeding the level of floating-rate liabilities due to the increased amount of deposit rates near zero in this low interest rate environment and other fixed-rate borrowings. Reductions in the yield of the commercial loan portfolio would be expected to be only partially offset by a decline in the cost of interest-bearing deposits in a falling-rate scenario. However, proactive management of the securities and derivatives portfolios has reduced the ongoing near-term risk to declining market rates and provided significant protection from the decline in rates experienced as the COVID-19 pandemic unfolded. The changes in the estimated NII sensitivity profile compared to June 30, 2020 were primarily attributable to the revision of the deposit beta assumptions in the first quarter of 2021 and the significant increase in noninterest-bearing and low-cost interest-bearing deposits. The falling-rate scenario was also impacted by the higher composition of low-cost deposits hitting their floor rates more quickly in the current-year scenario due to the low-rate environment.\nTables 60 and 61 provide the sensitivity of the Bancorp’s estimated NII profile at June 30, 2021 to changes to certain deposit balance and deposit repricing sensitivity (betas) assumptions.\nThe following table includes the Bancorp’s estimated NII sensitivity profile at June 30, 2021 with an immediate $5 billion decrease and an immediate $5 billion increase in demand deposit balances:\n| TABLE 60: Estimated NII Sensitivity Profile at June 30, 2021 with a $5 Billion Change in Demand Deposit Assumption |\n| % Change in NII (FTE) |\n| Immediate $5 Billion BalanceDecrease | Immediate $5 Billion BalanceIncrease |\n| Change in Interest Rates (bps) | 12 Months | 13-24Months | 12Months | 13-24Months |\n| +200 Ramp over 12 months | 9.72 | % | 20.22 | 11.86 | 24.53 |\n| +100 Ramp over 12 months | 5.11 | 11.29 | 6.18 | 13.45 |\n| -25 Ramp over 3 months | (2.31) | (3.42) | (1.82) | (2.88) |\n\n58\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following table includes the Bancorp’s estimated NII sensitivity profile with a 25% increase and a 25% decrease to the corresponding deposit beta assumptions as of June 30, 2021:\n| TABLE 61: Estimated NII Sensitivity Profile at June 30, 2021 with Deposit Beta Assumptions Changes |\n| % Change in NII (FTE) |\n| Betas 25% Higher(a) | Betas 25% Lower(b) |\n| Change in Interest Rates (bps) | 12 Months | 13-24Months | 12Months | 13-24Months |\n| +200 Ramp over 12 months | 8.65 | % | 18.49 | 12.93 | 26.27 |\n| +100 Ramp over 12 months | 4.59 | 10.49 | 6.70 | 14.26 |\n| -25 Ramp over 3 months | (2.04) | (3.12) | (2.15) | (3.23) |\n\n(a)Includes weighted-average rising-rate and falling-rate interest-bearing deposit betas of 46% and 40%, respectively.\n(b)Includes weighted-average rising-rate and falling-rate interest-bearing deposit betas of 28% and 24%, respectively.\nEconomic Value of Equity Sensitivity\nThe Bancorp also uses EVE as a measurement tool in managing interest rate risk. Whereas the NII sensitivity analysis highlights the impact on forecasted NII on an FTE basis (non-GAAP) over one- and two-year time horizons, EVE is a point-in-time analysis of the economic sensitivity of current positions that incorporates all cash flows over their estimated remaining lives. The EVE of the balance sheet is defined as the discounted present value of all asset and net derivative cash flows less the discounted value of all liability cash flows. Due to this longer horizon, the sensitivity of EVE to changes in the level of interest rates is a measure of longer-term interest rate risk. EVE values only the current balance sheet and does not incorporate the balance growth assumptions used in the NII sensitivity analysis. As with the NII simulation model, assumptions about the timing and variability of existing balance sheet cash flows are critical in the EVE analysis. Particularly important are assumptions driving loan and security prepayments and the expected balance attrition and pricing of indeterminate-lived deposits.\nThe following table shows the Bancorp’s estimated EVE sensitivity profile as of:\n| TABLE 62: Estimated EVE Sensitivity Profile |\n| June 30, 2021 | June 30, 2020 |\n| Change in Interest Rates (bps) | % Change in EVE | ALCOPolicy Limit | % Change in EVE | ALCOPolicy Limit |\n| +200 Shock | 6.25 | % | (12.00) | (2.86) | (12.00) |\n| +100 Shock | 3.63 | N/A | (0.82) | N/A |\n| -25 Shock | (1.18) | N/A | N/A | N/A |\n\nThe EVE sensitivity is significantly positive in a +200 bps rising-rate scenario at June 30, 2021. The changes in the estimated EVE sensitivity profile from June 30, 2020 were primarily related to the revision of the deposit beta assumptions in the first quarter of 2021, growth in noninterest-bearing and low-cost interest-bearing deposits and the shorter expected lives of prepayable, fixed-rate assets due to the decrease in market interest rates. These items were partially offset by continued repositioning of the investment portfolio into securities with less principal cash flows in the near term.\nWhile an instantaneous shift in interest rates is used in this analysis to provide an estimate of exposure, the Bancorp believes that a gradual shift in interest rates would have a much more modest impact. Since EVE measures the discounted present value of cash flows over the estimated lives of instruments, the change in EVE does not directly correlate to the degree that earnings would be impacted over a shorter time horizon (e.g., the current fiscal year). Further, EVE does not account for factors such as future balance sheet growth, changes in product mix, changes in yield curve relationships and changing product spreads that could mitigate or exacerbate the impact of changes in interest rates. The NII simulations and EVE analyses do not necessarily include certain actions that management may undertake to manage risk in response to actual changes in interest rates.\nThe Bancorp regularly evaluates its exposures to a static balance sheet forecast, LIBOR, Prime Rate and other basis risks, yield curve twist risks and embedded options risks. In addition, the impacts on NII on an FTE basis and EVE of extreme changes in interest rates are modeled, wherein the Bancorp employs the use of yield curve shocks and environment-specific scenarios.\nUse of Derivatives to Manage Interest Rate Risk\nAn integral component of the Bancorp’s interest rate risk management strategy is its use of derivative instruments to minimize significant fluctuations in earnings caused by changes in market interest rates. Examples of derivative instruments that the Bancorp may use as part of its interest rate risk management strategy include interest rate swaps, interest rate floors, interest rate caps, forward contracts, forward starting interest rate swaps, options, swaptions and TBA securities.\n59\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nTables 63 and 64 show all swap and floor positions that are utilized for purposes of managing the Bancorp’s exposures to the variability of interest rates. These positions are used to convert the contractual interest rate index of agreed-upon amounts of assets and liabilities (i.e., notional amounts) to another interest rate index or to hedge forecasted transactions for the variability in cash flows attributable to the contractually specified interest rate. The volume, maturity and mix of portfolio swaps change frequently as the Bancorp adjusts its broader interest rate risk management objectives and the balance sheet positions to be hedged. For further information, including the notional amount and fair values of these derivatives, refer to Note 13 of the Notes to Condensed Consolidated Financial Statements.\nThe following tables present additional information about the interest rate swaps and floors used in Fifth Third’s asset and liability management activities:\n| TABLE 63: Weighted-Average Maturity, Receive Rate and Pay Rate on Qualifying Hedging Instruments |\n| As of June 30, 2021 ($ in millions) | NotionalAmount | FairValue | Remaining(years) | Receive/Strike Rate |\n| Interest rate swaps – cash flow – receive-fixed | $ | 8,000 | (1) | 2.5 | 3.02 | % | 1 ML |\n| Interest rate swaps – fair value – receive-fixed | 1,455 | 429 | 10.2 | 6.03 | 1 ML / 3 ML |\n| Total interest rate swaps | $ | 9,455 | 428 |\n| Interest rate floors – cash flow – receive-fixed | $ | 3,000 | 183 | 3.5 | 2.25 | 1 ML |\n| TABLE 64: Weighted-Average Maturity, Receive Rate and Pay Rate on Qualifying Hedging Instruments |\n| As of December 31, 2020 ($ in millions) | Notional Amount | Fair Value | Remaining (years) | Receive/Strike Rate |\n| Interest rate swaps – cash flow – receive-fixed | $ | 8,000 | 14 | 3.0 | 3.02 | % | 1 ML |\n| Interest rate swaps – fair value – receive-fixed | 1,955 | 528 | 8.1 | 5.35 | 1 ML / 3 ML |\n| Total interest rate swaps | $ | 9,955 | 542 |\n| Interest rate floors – cash flow – receive-fixed | $ | 3,000 | 244 | 4.0 | 2.25 | 1 ML |\n\nAdditionally, as part of its overall risk management strategy relative to its residential mortgage banking activities, the Bancorp enters into forward contracts accounted for as free-standing derivatives to economically hedge IRLCs that are also considered free-standing derivatives. The Bancorp economically hedges its exposure to residential mortgage loans held for sale through the use of forward contracts and mortgage options as well. See the Residential Mortgage Servicing Rights and Price Risk section for the discussion of the use of derivatives to economically hedge this exposure.\nThe Bancorp also enters into derivative contracts with major financial institutions to economically hedge market risks assumed in interest rate derivative contracts with commercial customers. Generally, these contracts have similar terms in order to protect the Bancorp from market volatility. Credit risk arises from the possible inability of the counterparties to meet the terms of their contracts, which the Bancorp minimizes through collateral arrangements, approvals, limits and monitoring procedures. The Bancorp has risk limits and internal controls in place to help ensure excessive risk is not being taken in providing this service to customers. These controls include an independent determination of interest rate volatility and credit equivalent exposure on these contracts and counterparty credit approvals performed by independent risk management. For further information, including the notional amount and fair values of these derivatives, refer to Note 13 of the Notes to Condensed Consolidated Financial Statements.\nResidential Mortgage Servicing Rights and Price Risk\nThe fair value of the residential MSR portfolio was $818 million and $656 million at June 30, 2021 and December 31, 2020, respectively. The value of servicing rights can fluctuate sharply depending on changes in interest rates and other factors. Generally, as interest rates decline and loans are prepaid to take advantage of refinancing, the total value of existing servicing rights declines because no further servicing fees are collected on repaid loans. The Bancorp maintains a non-qualifying hedging strategy relative to its mortgage banking activity in order to manage a portion of the risk associated with changes in the value of its MSR portfolio as a result of changing interest rates.\nFor the three and six months ended June 30, 2021, the Bancorp recognized losses of $122 million and $50 million, respectively, in mortgage banking net revenue for valuation adjustments on the MSR portfolio. The valuation adjustments on the MSR portfolio included a decrease of $49 million for the three months ended June 30, 2021 and an increase of $103 million for the six months ended June 30, 2021 due to changes to inputs in the valuation model, including future prepayment speeds and OAS assumptions. Assumptions were updated as a result of market rate changes during the three and six months ended June 30, 2021. For the three months ended June 30, 2021, a decrease in mortgage rates caused modeled prepayment speeds to rise. For the six months ended June 30, 2021, an increase in mortgage rates resulted in a reduction to modeled prepayment speeds, and a tightening of the spread between mortgage rates and swap rates resulted in a decrease in the modeled OAS assumptions. The fair value of the MSR portfolio also decreased $73 million and $153 million as a result of contractual principal payments and actual prepayment activity for the three and six months ended June 30, 2021, respectively.\n60\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nMortgage rates decreased during both the three and six months ended June 30, 2020, which caused modeled prepayment speeds to rise. The fair value of the MSR portfolio decreased $12 million and $343 million for the three and six months ended June 30, 2020, respectively, due to changes to inputs to the valuation model including prepayment speeds and OAS assumptions and decreased $58 million and $105 million for the three and six months ended June 30, 2020, respectively, due to the impact of contractual principal payments and actual prepayment activity.\nThe Bancorp recognized net gains of $47 million and net losses of $89 million on its non-qualifying hedging strategy for the three and six months ended June 30, 2021, respectively, compared to net gains of $11 million and $364 million during the three and six months ended June 30, 2020, respectively. These amounts included net gains of $1 million and net losses of $1 million for the three and six months ended June 30, 2021, respectively, compared to net gains of an immaterial amount and $3 million for the three and six months ended June 30, 2020, respectively, on securities related to the Bancorp’s non-qualifying hedging strategy. The Bancorp may adjust its hedging strategy to reflect its assessment of the composition of its MSR portfolio, the cost of hedging and the anticipated effectiveness of the hedges given the economic environment. Refer to Note 12 of the Notes to Condensed Consolidated Financial Statements for further discussion on servicing rights and the instruments used to hedge price risk on MSRs.\nForeign Currency Risk\nThe Bancorp may enter into foreign exchange derivative contracts to economically hedge certain foreign denominated loans. The derivatives are classified as free-standing instruments with the revaluation gain or loss being recorded in other noninterest income in the Condensed Consolidated Statements of Income. The balance of the Bancorp’s foreign denominated loans at June 30, 2021 and December 31, 2020 was $841 million and $655 million, respectively. The Bancorp also enters into foreign exchange contracts for the benefit of commercial customers to hedge their exposure to foreign currency fluctuations. Similar to the hedging of price risk from interest rate derivative contracts entered into with commercial customers, the Bancorp also enters into foreign exchange contracts with major financial institutions to economically hedge a substantial portion of the exposure from client-driven foreign exchange activity. The Bancorp has risk limits and internal controls in place to help ensure excessive risk is not being taken in providing this service to customers. These controls include an independent determination of currency volatility and credit equivalent exposure on these contracts, counterparty credit approvals and country limits performed by independent risk management.\nCommodity Risk\nThe Bancorp also enters into commodity contracts for the benefit of commercial customers to hedge their exposure to commodity price fluctuations. Similar to the hedging of foreign exchange and price risk from interest rate derivative contracts, the Bancorp also enters into commodity contracts with major financial institutions to economically hedge a substantial portion of the exposure from client-driven commodity activity. The Bancorp may also offset this risk with exchange-traded commodity contracts. The Bancorp has risk limits and internal controls in place to help ensure excessive risk is not taken in providing this service to customers. These controls include an independent determination of commodity volatility and credit equivalent exposure on these contracts and counterparty credit approvals performed by independent risk management.\n61\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nLIQUIDITY RISK MANAGEMENT\nThe goal of liquidity management is to provide adequate funds to meet changes in loan and lease demand, unexpected levels of deposit withdrawals and other contractual obligations. Mitigating liquidity risk is accomplished by maintaining liquid assets in the form of cash and investment securities, maintaining sufficient unused borrowing capacity in the debt markets and delivering consistent growth in core deposits. A summary of certain obligations and commitments to make future payments under contracts is included in Note 16 of the Notes to Condensed Consolidated Financial Statements.\nThe Bancorp’s Treasury department manages funding and liquidity based on point-in-time metrics as well as forward-looking projections, which incorporate different sources and uses of funds under base and stress scenarios. Liquidity risk is monitored and managed by the Treasury department with independent oversight provided by ERM, and a series of Policy Limits and Key Risk Indicators are established to ensure risks are managed within the Bancorp’s risk tolerance. The Bancorp maintains a contingency funding plan that provides for liquidity stress testing, which assesses the liquidity needs under varying market conditions, time horizons, asset growth rates and other events. The contingency plan provides for ongoing monitoring of unused borrowing capacity and available sources of contingent liquidity to prepare for unexpected liquidity needs and to cover unanticipated events that could affect liquidity. The contingency plan also outlines the Bancorp’s response to various levels of liquidity stress and actions that should be taken during various scenarios.\nLiquidity risk is monitored and managed for both Fifth Third Bancorp and its subsidiaries. The Bancorp receives substantially all of its liquidity from dividends from its subsidiaries, primarily Fifth Third Bank, National Association. Subsidiary dividends are supplemented with term debt to enable the Bancorp to maintain sufficient liquidity to meet its cash obligations, including debt service and scheduled maturities, common and preferred dividends, unfunded commitments to subsidiaries and other planned capital actions in the form of share repurchases. Liquidity resources are more limited at the Bancorp, making its liquidity position more susceptible to market disruptions. Bancorp liquidity is assessed using a cash coverage horizon, ensuring the entity maintains sufficient liquidity to withstand a period of sustained market disruption while meeting its anticipated obligations over an extended stressed horizon.\nThe Bancorp’s ALCO, which includes senior management representatives and is accountable to the ERMC, monitors and manages liquidity and funding risk within Board-approved policy limits. In addition to the risk management activities of ALCO, the Bancorp has a liquidity risk management function as part of ERM that provides independent oversight of liquidity risk management.\nSources of Funds\nThe Bancorp’s primary sources of funds relate to cash flows from loan and lease repayments, payments from securities related to sales and maturities, the sale or securitization of loans and leases and funds generated by core deposits, in addition to the use of public and private debt offerings.\nRefer to the Interest Rate and Price Risk Management subsection of the Risk Management section of MD&A included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for information about the expected cash flows from loan and lease repayments. Of the $38.0 billion of securities in the Bancorp’s available-for-sale debt and other securities portfolio at June 30, 2021, $4.7 billion in principal and interest is expected to be received in the next 12 months and an additional $4.2 billion is expected to be received in the next 13 to 24 months. For further information on the Bancorp’s securities portfolio, refer to the Investment Securities subsection of the Balance Sheet Analysis section of MD&A.\nAsset-driven liquidity is provided by the Bancorp’s ability to sell or securitize loans and leases. In order to reduce the exposure to interest rate fluctuations and to manage liquidity, the Bancorp has developed securitization and sale procedures for several types of interest-sensitive assets. A majority of the long-term, fixed-rate single-family residential mortgage loans underwritten according to FHLMC or FNMA guidelines are sold for cash upon origination. Additional assets such as certain other residential mortgage loans, certain commercial loans and leases, home equity loans, automobile loans and other consumer loans are also capable of being securitized or sold. For the three and six months ended June 30, 2021, the Bancorp sold or securitized loans and leases totaling $4.5 billion and $8.1 billion, respectively, compared to $3.1 billion and $6.2 billion during the three and six months ended June 30, 2020, respectively. For further information, refer to Note 12 of the Notes to Condensed Consolidated Financial Statements.\nCore deposits have historically provided the Bancorp with a sizeable source of relatively stable and low-cost funds. The Bancorp’s average core deposits and average shareholders’ equity funded 89% of its average total assets for both the three and six months ended June 30, 2021, compared to 85% for both the three and six months ended June 30, 2020. In addition to core deposit funding, the Bancorp also accesses a variety of other short-term and long-term funding sources, which include the use of the FHLB system. Certificates $100,000 and over and certain deposits in the Bancorp’s foreign branch located in the Cayman Islands are wholesale funding tools utilized to fund asset growth. Management does not rely on any one source of liquidity and manages availability in response to changing balance sheet needs.\nAs of June 30, 2021, $4.7 billion of debt or other securities were available for issuance under the current Bancorp’s Board of Directors’ authorizations and the Bancorp is authorized to file any necessary registration statements with the SEC to permit ready access to the public securities markets; however, access to these markets may depend on market conditions.\n62\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nAs of June 30, 2021, the Bank’s global bank note program had a borrowing capacity of $25.0 billion, of which $21.1 billion was available for issuance. Additionally, at June 30, 2021, the Bank had approximately $47.3 billion of borrowing capacity available through secured borrowing sources, including the FRB and FHLB.\nCurrent Liquidity Position\nThe COVID-19 pandemic has significantly impacted the economic environment, although financial markets, initially supported by Federal Reserve programs, have been stable and well-functioning following the onset of the crisis, aided by significant monetary and fiscal response. The Bancorp maintains a strong liquidity profile driven by strong core deposit funding and over $100 billion in current available liquidity. The Bancorp is managing liquidity prudently in the current environment and maintains a liquidity profile focused on core deposit and stable long-term funding sources which allows for the effective management of concentration and rollover risk.\nAs of June 30, 2021, the Bancorp has sufficient liquidity to meet contractual obligations and all preferred and common dividends without accessing the capital markets or receiving upstream dividends from the Bank subsidiary for 30 months.\nCredit Ratings\nThe cost and availability of financing to the Bancorp and Bank are impacted by its credit ratings. A downgrade to the Bancorp’s or Bank’s credit ratings could affect its ability to access the credit markets and increase its borrowing costs, thereby adversely impacting the Bancorp’s or Bank’s financial condition and liquidity. Key factors in maintaining high credit ratings include a stable and diverse earnings stream, strong credit quality, strong capital ratios and diverse funding sources, in addition to disciplined liquidity monitoring procedures.\nThe Bancorp’s and Bank’s credit ratings are summarized in Table 65. The ratings reflect the ratings agency’s view on the Bancorp’s and Bank’s capacity to meet financial commitments.*\n*As an investor, you should be aware that a security rating is not a recommendation to buy, sell or hold securities, that it may be subject to revision or withdrawal at any time by the assigning rating organization and that each rating should be evaluated independently of any other rating. Additional information on the credit rating ranking within the overall classification system is located on the website of each credit rating agency.\n| TABLE 65: Agency Ratings |\n| As of August 6, 2021 | Moody’s | Standard and Poor’s | Fitch | DBRS Morningstar |\n| Fifth Third Bancorp: |\n| Short-term borrowings | No rating | A-2 | F1 | R-1L |\n| Senior debt | Baa1 | BBB+ | A- | A |\n| Subordinated debt | Baa1 | BBB | BBB+ | AL |\n| Fifth Third Bank, National Association: |\n| Short-term borrowings | P-2 | A-2 | F1 | R-1M |\n| Short-term deposit | P-1 | No rating | F1 | No rating |\n| Long-term deposit | A1 | No rating | A | AH |\n| Senior debt | A3 | A- | A- | AH |\n| Subordinated debt | A3 | BBB+ | BBB+ | A |\n| Rating Agency Outlook for Fifth Third Bancorp and Fifth Third Bank, National Association | Stable | Stable | Stable | Negative |\n\n63\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nOPERATIONAL RISK MANAGEMENT\nOperational risk is the risk to current or projected financial condition and resilience arising from inadequate or failed internal processes or systems, human errors or misconduct or adverse external events that are neither market- nor credit-related. Operational risk is inherent in the Bancorp’s activities and can manifest itself in various ways, including fraudulent acts, business interruptions, inappropriate behavior of employees, unintentional failure to comply with applicable laws and regulations, poor design or delivery of products and services, cyber-security or physical security incidents and privacy breaches or failure of third parties to perform in accordance with their arrangements. These events could result in financial losses, litigation and regulatory fines, as well as other damage to the Bancorp. The Bancorp’s risk management goal is to keep operational risk at appropriate levels consistent with the Bancorp’s risk appetite, financial strength, the characteristics of its businesses, the markets in which it operates and the competitive and regulatory environment to which it is subject.\nTo control, monitor and govern operational risk, the Bancorp maintains an overall Risk Management Framework which comprises governance oversight, risk assessment, capital measurement, monitoring and reporting as well as a formal three lines of defense approach. ERM is responsible for prescribing the framework to the lines of business and corporate functions and providing independent oversight of its implementation (second line of defense). Business Controls groups are in place in each of the lines of business to ensure consistent implementation and execution of managing day-to-day operational risk (first line of defense).\nThe Bancorp’s risk management framework consists of five integrated components, including identifying, assessing, managing, monitoring and independent governance reporting of risk. The corporate Operational Risk Management function within Enterprise Risk is responsible for developing and overseeing the implementation of the Bancorp’s approach to managing operational risk. This includes providing governance, awareness and training, tools, guidance and oversight to support implementation of key risk programs and systems as they relate to operational risk management, such as risk and control self-assessments, product delivery risk assessment, scenario analysis, new product/initiative risk reviews, key risk indicators, Third-Party Risk Management, cyber-security risk management and review of operational losses. The function is also responsible for developing reports that support the proactive management of operational risk across the enterprise. The lines of business and corporate functions are responsible for managing the operational risks associated with their areas in accordance with the risk management framework. The framework is intended to enable the Bancorp to function with a sound and well-controlled operational environment. These processes support the Bancorp’s goals to minimize future operational losses and strengthen the Bancorp’s performance by maintaining sufficient capital to absorb operational losses that are incurred.\nThe Bancorp also maintains a robust information security program to support the management of cyber-security risk within the organization with a focus on prevention, detection and recovery processes. Fifth Third utilizes a wide array of techniques to secure its operations and proprietary information such as Board-approved policies and programs, network monitoring and testing, access controls and dedicated security personnel. Fifth Third has adopted the National Institute of Standards and Technology Cybersecurity Framework for the management and deployment of cyber-security controls and is an active participant in the financial sector information sharing organization structure, known as the Financial Services Information Sharing and Analysis Center. To ensure resiliency of key Bancorp functions, Fifth Third also employs redundancy protocols that include a robust business continuity function that works to mitigate any potential impacts to Fifth Third customers and its systems.\nFifth Third also focuses on the reporting and escalation of operational control issues to senior management and the Board of Directors. The Operational Risk Committee is the key committee that oversees and supports Fifth Third in the management of operational risk across the enterprise. The Information Security Governance Committee and Model Risk Committee report to the Operational Risk Committee and are responsible for governance of information security and model risks. The Operational Risk Committee reports to the ERMC, which reports to the Risk and Compliance Joint Committee of the Board of Directors of Fifth Third Bancorp and Fifth Third Bank, National Association.\nThe COVID-19 pandemic continues to put pressure on operational risk including cyber, fraud and third-party risks driven by factors such as remote work strategies, relief programs and outsourced service providers. Additionally, increased external threats have elevated fraud and cyber-security risks. These risks continue to be carefully managed and monitored to ensure effective controls are in place, with appropriate oversight and governance by the second line of defense. Fifth Third has a defined pandemic plan and a robust business continuity management process, which have been leveraged to support the continuity of processes across the Bank.\n64\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nLEGAL AND REGULATORY COMPLIANCE RISK MANAGEMENT\nLegal and regulatory compliance risk is the risk of legal or regulatory sanctions, financial loss or damage to reputation as a result of noncompliance with (i) applicable laws, regulations, rules and other regulatory requirements (including but not limited to the risk of consumers experiencing economic loss or other legal harm as a result of noncompliance with consumer protection laws, regulations and requirements); (ii) internal policies and procedures, standards of best practice or codes of conduct; and (iii) principles of integrity and fair dealing applicable to Fifth Third’s activities and functions. Legal risks include the risk of actions against the institution that result in unenforceable contracts, lawsuits, legal sanctions, or adverse judgments, which disrupt or otherwise negatively affect the operations or condition of the institution. Failure to effectively manage such risks can elevate the risk level or manifest itself as other types of key risks, including reputational or operational risk. Fifth Third focuses on managing legal and regulatory compliance risk in accordance with the Bancorp’s integrated risk management framework, which ensures consistent processes for identifying, assessing, managing, monitoring and reporting risks. The Bancorp’s risk management goal is to keep compliance risk at appropriate levels, consistent with the Bancorp’s risk appetite.\nTo mitigate such risks, Compliance Risk Management provides independent oversight to foster consistency and sufficiency in the execution of the program, and ensures that lines of business and support functions are adequately identifying, assessing and monitoring legal and regulatory compliance risks and adopting proper mitigation strategies. Moreover, such strategies are modified from time to time to respond to new or emerging risks in the environment. Compliance Risk Management and the Legal Division provide guidance to the lines of business and enterprise functions, which are ultimately responsible for managing such risks associated with their areas. The Chief Compliance Officer and Director of Financial Crimes is responsible for formulating and directing the strategy, development, implementation, communication and maintenance of the Compliance Risk Management program, which implements key compliance processes, including but not limited to, executive- and board-level governance and reporting routines, compliance-related policies, risk assessments, key risk indicators, issues tracking, regulatory change management and regulatory compliance testing and monitoring. As part of Compliance Risk Management, the Financial Crimes Division conducts and oversees anti-money laundering and economic sanctions processes. Compliance Risk Management partners with the Community and Economic Development team to oversee the Bancorp’s compliance with the Community Reinvestment Act.\nFifth Third also reports and escalates legal and regulatory compliance issues to senior management and the Board of Directors. The Management Compliance Committee, which is chaired by the Chief Compliance Officer and Director of Financial Crimes, is the key committee that oversees and supports Fifth Third in the management of compliance risk across the enterprise. The Management Compliance Committee oversees Bancorp-wide compliance issues, industry best practices, legislative developments, regulatory concerns and other leading indicators of legal and regulatory compliance risk. The Management Compliance Committee reports to the ERMC, which reports to the RCC of the Board of Directors of Fifth Third Bancorp and Fifth Third Bank, National Association.\n65\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nCAPITAL MANAGEMENT\nManagement regularly reviews the Bancorp’s capital levels to help ensure it is appropriately positioned under various operating environments. The Bancorp has established a Capital Committee which is responsible for making capital plan recommendations to management. These recommendations are reviewed by the ERMC and the annual capital plan is approved by the Board of Directors. The Capital Committee is responsible for execution and oversight of the capital actions of the capital plan.\nRegulatory Capital Ratios\nThe Basel III Final Rule sets minimum regulatory capital ratios as well as defines the measure of “well-capitalized” for insured depository institutions.\n| TABLE 66: Prescribed Capital Ratios |\n| Minimum | Well-Capitalized |\n| CET1 capital: |\n| Fifth Third Bancorp | 4.50 | % | N/A |\n| Fifth Third Bank, National Association | 4.50 | 6.50 |\n| Tier I risk-based capital: |\n| Fifth Third Bancorp | 6.00 | 6.00 |\n| Fifth Third Bank, National Association | 6.00 | 8.00 |\n| Total risk-based capital: |\n| Fifth Third Bancorp | 8.00 | 10.00 |\n| Fifth Third Bank, National Association | 8.00 | 10.00 |\n| Tier I leverage: |\n| Fifth Third Bancorp | 4.00 | N/A |\n| Fifth Third Bank, National Association | 4.00 | 5.00 |\n\nThe Bancorp is subject to the stress capital buffer requirement, which replaced the capital conservation buffer on October 1, 2020. Institutions subject to the stress capital buffer requirement must maintain capital ratios above their respective buffered minimum (regulatory minimum plus stress capital buffer) in order to avoid certain limitations on capital distributions and discretionary bonuses to executive officers. The FRB uses the supervisory stress test to determine the Bancorp’s stress capital buffer, subject to a floor of 2.5%. The Bancorp’s stress capital buffer requirement has been 2.5% since the introduction of this framework and was most recently affirmed on June 24, 2021. The Bancorp’s capital ratios have exceeded the stress capital buffer requirement for all periods presented.\nIn April 2018, the federal banking regulators proposed transitional arrangements to permit banking organizations to phase in the day-one impact of the adoption of ASU 2016-13, referred to as CECL, on regulatory capital over a period of three years. The proposed rule was adopted as final effective July 1, 2019. The phase-in provisions of the final rule are optional for a banking organization that experiences a reduction in retained earnings due to CECL adoption as of the beginning of the fiscal year in which the banking organization adopts CECL. A banking organization that elects the phase-in provisions of the final rule for regulatory capital purposes must phase in 25% of the transitional amounts impacting regulatory capital in the first year of adoption of CECL, 50% in the second year, 75% in the third year, with full impact beginning in the fourth year.\nIn March 2020, the banking agencies issued an interim final rule for additional transitional relief to regulatory capital related to the impact of the adoption of CECL given the disruption in economic activity caused by the COVID-19 pandemic. The interim final rule provides banking organizations that adopt CECL in the 2020 calendar year with the option to delay for two years the estimated impact of CECL on regulatory capital, followed by the aforementioned three-year transition period to phase out the aggregate amount of benefit during the initial two-year delay for a total five-year transition. The estimated impact of CECL on regulatory capital (modified CECL transitional amount) is calculated as the sum of the day-one impact on retained earnings upon adoption of CECL (CECL transitional amount) and the calculated change in the ACL relative to the day-one ACL upon adoption of CECL multiplied by a scaling factor of 25%. The scaling factor is used to approximate the difference in the ACL under CECL relative to the incurred loss methodology. The modified CECL transitional amount will be calculated each quarter for the first two years of the five-year transition. The amount of the modified CECL transition amount will be fixed as of December 31, 2021 and that amount will be subject to the three-year phase out.\nThe Bancorp adopted ASU 2016-13 on January 1, 2020 and elected the five-year transition phase-in option for the impact of CECL on regulatory capital with its regulatory filings as of March 31, 2020. The impact of the modified CECL transition amount on the Bancorp’s regulatory capital at June 30, 2021 was an increase in capital of approximately $535 million. On a fully phased-in basis, the Bancorp’s CET1 ratio would be reduced by 34 basis points as of June 30, 2021. The CECL transition amount will begin to phase in during the fiscal year starting January 1, 2022 and will be fully phased in by January 1, 2025.\n66\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following table summarizes the Bancorp’s capital ratios as of:\n| TABLE 67: Capital Ratios |\n| ($ in millions) | June 30,2021 | December 31,2020 |\n| Quarterly average total Bancorp shareholders’ equity as a percent of average assets | 11.11 | % | 11.34 |\n| Tangible equity as a percent of tangible assets(a)(b) | 8.35 | 8.18 |\n| Tangible common equity as a percent of tangible assets(a)(b) | 7.28 | 7.11 |\n| Regulatory capital:(c) |\n| CET1 capital | $ | 15,050 | 14,682 |\n| Tier I capital | 17,166 | 16,797 |\n| Total regulatory capital | 21,184 | 21,412 |\n| Risk-weighted assets | 145,084 | 141,974 |\n| Regulatory capital ratios:(c) |\n| CET1 capital | 10.37 | % | 10.34 |\n| Tier I risk-based capital | 11.83 | 11.83 |\n| Total risk-based capital | 14.60 | 15.08 |\n| Tier I leverage | 8.55 | 8.49 |\n\n(a)These are non-GAAP measures. For further information, refer to the Non-GAAP Financial Measures section of MD&A.\n(b)Excludes AOCI.\n(c)Regulatory capital ratios as of June 30, 2021 are calculated pursuant to the five-year transition provision option to phase in the effects of CECL on regulatory capital.\nCapital Planning\nIn 2011, the FRB adopted the capital plan rule, which requires BHCs with consolidated assets of $50 billion or more to submit annual capital plans to the FRB for review. Under the rule, these capital plans must include detailed descriptions of the following: the BHC’s internal processes for assessing capital adequacy; the policies governing capital actions such as common stock issuances, dividends and share repurchases; and all planned capital actions over a nine-quarter planning horizon. Furthermore, each BHC must report to the FRB the results of stress tests conducted by the BHC under a number of scenarios that assess the sources and uses of capital under baseline and stressed economic conditions.\nOn October 10, 2019, the Federal Reserve Board adopted final rules to tailor certain prudential standards for large domestic and foreign banking organizations. As a result of the EPS Tailoring Rule, the Bancorp is subject to Category IV standards, under which the Bancorp is no longer required to file semi-annual, company-run stress tests with the FRB and publicly disclose the results. However, the Bancorp is required to develop and maintain a capital plan approved by the Board of Directors on an annual basis. As an institution subject to Category IV standards, the Bancorp is subject to the FRB’s supervisory stress tests every two years, the Board capital plan rule and certain FR Y-14 reporting requirements. The supervisory stress tests are forward-looking quantitative evaluations of the impact of stressful economic and financial market conditions on the Bancorp’s capital. The Bancorp became subject to Category IV standards on December 31, 2019, and the requirements outlined above apply to the stress test cycle that started on January 1, 2020. The Bancorp is not subject to the 2021 supervisory stress test conducted by the FRB but has submitted its Board-approved capital plan as required.\nIn June 2020, the FRB took several actions in connection with its announcement of stress test results in light of the uncertainty caused by the COVID-19 pandemic. Specifically, for the third quarter of 2020, the FRB required large banking organizations, including the Bancorp, to suspend share repurchases, cap dividend payments to the amount paid during the second quarter of 2020, and further limit dividends according to a formula based on recent income. These restrictions were extended, quarterly, with certain modifications, throughout the remainder of 2020.\nThe FRB extended these restrictions into the first and second quarters of 2021, with certain modifications to permit a limited amount of share repurchases. During the first and second quarters of 2021, the Bancorp was authorized to pay dividends and execute share repurchases according to a formula based on recent income provided the Bancorp did not increase the amount of its common dividend.\nIn June 2021, the FRB lifted the COVID-19 pandemic induced capital distribution limitations, which prohibited increases to the common dividend and placed limitations on share repurchases, and authorized the Bancorp, beginning July 1, 2021, to make capital distributions that are consistent with the requirements in the Board’s capital plan rule, inclusive of the Bancorp’s stress capital buffer requirement. The Bancorp maintains a comprehensive process for managing capital and expects the stress capital buffer framework to provide greater flexibility for the Bancorp to assess and deploy capital.\n67\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nDividend Policy and Stock Repurchase Program\nThe Bancorp’s common stock dividend policy and stock repurchase program reflect its earnings outlook, desired payout ratios, the need to maintain adequate capital levels, the ability of its subsidiaries to pay dividends and the need to comply with safe and sound banking practices as well as meet regulatory requirements and expectations. The Bancorp declared dividends per common share of $0.27 for both the three months ended June 30, 2021 and 2020, and $0.54 for both the six months ended June 30, 2021 and 2020. Pursuant to the Bancorp’s Board-approved capital plan, during the second quarter of 2021, the Bancorp entered into and settled an accelerated share repurchase transaction in the amount of $347 million. Refer to Note 15 and Note 23 of the Notes to Condensed Consolidated Financial Statements for additional information on share repurchase activity.\nThe following table summarizes the monthly share repurchase activity for the three months ended June 30, 2021:\n| TABLE 68: Share Repurchases |\n| Period | Total Numberof Shares Purchased(a) | Average PricePaid per Share | Total Number of SharesPurchased as a Part ofPublicly Announced Plans or Programs | Maximum Number ofShares that May Yet BePurchased under the Plans or Programs(b) |\n| April 1 - April 30, 2021 | 8,022,822 | $ | 40.46 | 7,894,807 | 63,224,146 |\n| May 1 - May 31, 2021 | 126,867 | 41.73 | — | 63,224,146 |\n| June 1 - June 30, 2021 | 713,157 | 40.53 | 675,295 | 62,548,851 |\n| Total | 8,862,846 | $ | 40.48 | 8,570,102 | 62,548,851 |\n\n(a) Includes 292,744 shares repurchased during the second quarter of 2021 in connection with various employee compensation plans. These purchases do not count against the maximum number of shares that may yet be purchased under the Board of Directors’ authorization.\n(b) In June 2019, the Bancorp announced that its Board of Directors had authorized management to purchase 100 million shares of the Bancorp’s common stock through the open market or in any private party transactions. This authorization did not include specific targets or an expiration date.\n68\n| Quantitative and Qualitative Disclosures about Market Risk (Item 3) |\n\nInformation presented in the Interest Rate and Price Risk Management section of Management’s Discussion and Analysis of Financial Condition and Results of Operations is incorporated herein by reference. This information contains certain statements that we believe are forward-looking statements. Refer to page 1 for cautionary information regarding forward-looking statements.\n| Controls and Procedures (Item 4) |\n\nThe Bancorp conducted an evaluation, under the supervision and with the participation of the Bancorp’s management, including the Bancorp’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Bancorp’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based on the foregoing, as of the end of the period covered by this report, the Bancorp’s Chief Executive Officer and Chief Financial Officer concluded that the Bancorp’s disclosure controls and procedures were effective, in all material respects, to ensure that information required to be disclosed in the reports the Bancorp files and submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported as and when required and information is accumulated and communicated to the Bancorp’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.\nThe Bancorp’s management also conducted an evaluation of internal control over financial reporting to determine whether any changes occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Bancorp’s internal control over financial reporting. Based on this evaluation there has been no such change during the period covered by this report.\n69\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (Item 1) |\n\n| CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited) |\n| As of |\n| June 30, | December 31, |\n| ($ in millions, except share data) | 2021 | 2020 |\n| Assets |\n| Cash and due from banks | $ | 3,285 | 3,147 |\n| Other short-term investments(a) | 32,409 | 33,399 |\n| Available-for-sale debt and other securities(b) | 38,012 | 37,513 |\n| Held-to-maturity securities(c) | 10 | 11 |\n| Trading debt securities | 711 | 560 |\n| Equity securities | 341 | 313 |\n| Loans and leases held for sale(d) | 5,730 | 4,741 |\n| Portfolio loans and leases(a)(e) | 107,733 | 108,782 |\n| Allowance for loan and lease losses(a) | ( 2,033 ) | ( 2,453 ) |\n| Portfolio loans and leases, net | 105,700 | 106,329 |\n| Bank premises and equipment(f) | 2,073 | 2,088 |\n| Operating lease equipment | 715 | 777 |\n| Goodwill | 4,259 | 4,258 |\n| Intangible assets | 117 | 139 |\n| Servicing rights | 818 | 656 |\n| Other assets(a) | 11,210 | 10,749 |\n| Total Assets | $ | 205,390 | 204,680 |\n| Liabilities |\n| Deposits: |\n| Noninterest-bearing deposits | $ | 62,760 | 57,711 |\n| Interest-bearing deposits(g) | 99,523 | 101,370 |\n| Total deposits | 162,283 | 159,081 |\n| Federal funds purchased | 338 | 300 |\n| Other short-term borrowings | 1,130 | 1,192 |\n| Accrued taxes, interest and expenses | 2,045 | 2,614 |\n| Other liabilities(a) | 4,304 | 3,409 |\n| Long-term debt(a) | 12,364 | 14,973 |\n| Total Liabilities | $ | 182,464 | 181,569 |\n| Equity |\n| Common stock(h) | $ | 2,051 | 2,051 |\n| Preferred stock(i) | 2,116 | 2,116 |\n| Capital surplus | 3,602 | 3,635 |\n| Retained earnings | 19,343 | 18,384 |\n| Accumulated other comprehensive income | 1,974 | 2,601 |\n| Treasury stock(h) | ( 6,160 ) | ( 5,676 ) |\n| Total Equity | $ | 22,926 | 23,111 |\n| Total Liabilities and Equity | $ | 205,390 | 204,680 |\n\n(a) Includes $ 33 and $ 55 of other short-term investments, $ 455 and $ 756 of portfolio loans and leases, $( 3 ) and $( 7 ) of ALLL, $ 3 and $ 5 of other assets, $ 1 and $ 2 of other liabilities, and $ 400 and $ 656 of long-term debt from consolidated VIEs that are included in their respective captions above at June 30, 2021 and December 31, 2020, respectively. For further information, refer to Note 11.\n(b) Amortized cost of $ 36,081 and $ 34,982 at June 30, 2021 and December 31, 2020, respectively.\n(c) Fair value of $ 10 and $ 11 at June 30, 2021 and December 31, 2020, respectively.\n(d) Includes $ 1,633 and $ 1,481 of residential mortgage loans held for sale measured at fair value at June 30, 2021 and December 31, 2020, respectively.\n(e) Includes $ 151 and $ 161 of residential mortgage loans measured at fair value at June 30, 2021 and December 31, 2020, respectively.\n(f) Includes $ 25 and $ 35 of bank premises and equipment held for sale at June 30, 2021 and December 31, 2020, respectively.\n(g) Includes $ 341 and $ 351 of interest checking deposits held for sale at June 30, 2021 and December 31, 2020, respectively.\n(h) Common shares: Stated value $ 2.22 per share; authorized 2,000,000,000 ; outstanding at June 30, 2021 – 703,739,634 (excludes 220,152,947 treasury shares), December 31, 2020 – 712,760,325 (excludes 211,132,256 treasury shares).\n(i) 500,000 shares of no par value preferred stock were authorized at both June 30, 2021 and December 31, 2020. There were 422,000 unissued shares of undesignated no par value preferred stock at both June 30, 2021 and December 31, 2020. Each issued share of no par value preferred stock has a liquidation preference of $ 25,000 . 500,000 shares of no par value Class B preferred stock were authorized at both June 30, 2021 and December 31, 2020. There were 300,000 unissued shares of undesignated no par value Class B preferred stock at both June 30, 2021 and December 31, 2020. Each issued share of no par value Class B preferred stock has a liquidation preference of $ 1,000 .\nRefer to the Notes to Condensed Consolidated Financial Statements.\n70\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\n| CONDENSED CONSOLIDATED STATEMENTS OF INCOME (unaudited) |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions, except share data) | 2021 | 2020 | 2021 | 2020 |\n| Interest Income |\n| Interest and fees on loans and leases | $ | 1,035 | 1,115 | 2,064 | 2,350 |\n| Interest on securities | 279 | 283 | 543 | 566 |\n| Interest on other short-term investments | 9 | 5 | 17 | 12 |\n| Total interest income | 1,323 | 1,403 | 2,624 | 2,928 |\n| Interest Expense |\n| Interest on deposits | 15 | 83 | 36 | 248 |\n| Interest on federal funds purchased | — | — | — | 2 |\n| Interest on other short-term borrowings | — | 2 | 1 | 8 |\n| Interest on long-term debt | 100 | 118 | 202 | 241 |\n| Total interest expense | 115 | 203 | 239 | 499 |\n| Net Interest Income | 1,208 | 1,200 | 2,385 | 2,429 |\n| (Benefit from) provision for credit losses | ( 115 ) | 485 | ( 288 ) | 1,125 |\n| Net Interest Income After (Benefit from) Provision for Credit Losses | 1,323 | 715 | 2,673 | 1,304 |\n| Noninterest Income |\n| Commercial banking revenue | 160 | 137 | 313 | 261 |\n| Service charges on deposits | 149 | 122 | 292 | 270 |\n| Wealth and asset management revenue | 145 | 120 | 288 | 255 |\n| Card and processing revenue | 102 | 82 | 196 | 167 |\n| Mortgage banking net revenue | 64 | 99 | 149 | 219 |\n| Leasing business revenue | 61 | 57 | 148 | 131 |\n| Other noninterest income | 49 | 12 | 92 | 18 |\n| Securities gains (losses), net | 10 | 21 | 13 | ( 3 ) |\n| Securities (losses) gains, net – non-qualifying hedges on mortgage servicing rights | 1 | — | ( 1 ) | 3 |\n| Total noninterest income | 741 | 650 | 1,490 | 1,321 |\n| Noninterest Expense |\n| Compensation and benefits | 638 | 627 | 1,343 | 1,274 |\n| Technology and communications | 94 | 90 | 187 | 183 |\n| Net occupancy expense | 77 | 82 | 156 | 164 |\n| Equipment expense | 34 | 32 | 68 | 64 |\n| Leasing business expense | 33 | 33 | 68 | 68 |\n| Card and processing expense | 20 | 29 | 50 | 60 |\n| Marketing expense | 20 | 20 | 43 | 51 |\n| Other noninterest expense | 237 | 208 | 454 | 457 |\n| Total noninterest expense | 1,153 | 1,121 | 2,369 | 2,321 |\n| Income Before Income Taxes | 911 | 244 | 1,794 | 304 |\n| Applicable income tax expense | 202 | 49 | 391 | 61 |\n| Net Income | 709 | 195 | 1,403 | 243 |\n| Dividends on preferred stock | 35 | 32 | 55 | 50 |\n| Net Income Available to Common Shareholders | $ | 674 | 163 | 1,348 | 193 |\n| Earnings per share - basic | $ | 0.95 | 0.23 | 1.89 | 0.27 |\n| Earnings per share - diluted | $ | 0.94 | 0.23 | 1.87 | 0.27 |\n| Average common shares outstanding - basic | 708,832,787 | 714,766,570 | 711,617,331 | 714,161,131 |\n| Average common shares outstanding - diluted | 718,084,745 | 717,571,890 | 720,740,176 | 718,967,293 |\n\nRefer to the Notes to Condensed Consolidated Financial Statements.\n71\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\n| CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (unaudited) |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Net Income | $ | 709 | 195 | 1,403 | 243 |\n| Other Comprehensive (Loss) Income, Net of Tax: |\n| Unrealized gains on available-for-sale debt securities: |\n| Unrealized holding (losses) gains arising during period | 235 | 456 | ( 466 ) | 1,338 |\n| Reclassification adjustment for net losses (gains) included in net income | ( 5 ) | — | 7 | — |\n| Unrealized gains on cash flow hedge derivatives: |\n| Unrealized holding (losses) gains arising during period | 9 | 66 | ( 55 ) | 493 |\n| Reclassification adjustment for net gains included in net income | ( 58 ) | ( 49 ) | ( 115 ) | ( 74 ) |\n| Defined benefit pension plans, net: |\n| Net actuarial loss arising during the year | ( 1 ) | — | ( 1 ) | — |\n| Reclassification of amounts to net periodic benefit costs | 2 | 1 | 3 | 2 |\n| Other comprehensive (loss) income, net of tax | 182 | 474 | ( 627 ) | 1,759 |\n| Comprehensive Income | $ | 891 | 669 | 776 | 2,002 |\n\nRefer to the Notes to Condensed Consolidated Financial Statements.\n72\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\n| CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY (unaudited) |\n| ($ in millions, except per share data) | CommonStock | PreferredStock | CapitalSurplus | RetainedEarnings | AccumulatedOtherComprehensiveIncome | TreasuryStock | TotalEquity |\n| Balance at March 31, 2020 | $ | 2,051 | 1,770 | 3,597 | 17,677 | 2,477 | ( 5,699 ) | 21,873 |\n| Net income | 195 | 195 |\n| Other comprehensive income, net of tax | 474 | 474 |\n| Cash dividends declared: |\n| Common stock ($ 0.27 per share) | ( 195 ) | ( 195 ) |\n| Preferred stock: |\n| Series H ($ 637.50 per share) | ( 15 ) | ( 15 ) |\n| Series I ($ 414.06 per share) | ( 7 ) | ( 7 ) |\n| Series J ($ 289.38 per share) | ( 4 ) | ( 4 ) |\n| Series K ($ 309.38 per share) | ( 3 ) | ( 3 ) |\n| Class B, Series A ($ 15.00 per share) | ( 3 ) | ( 3 ) |\n| Impact of stock transactions under stock compensation plans, net | 6 | 14 | 20 |\n| Other | ( 2 ) | 2 | — |\n| Balance at June 30, 2020 | $ | 2,051 | 1,770 | 3,603 | 17,643 | 2,951 | ( 5,683 ) | 22,335 |\n| Balance at March 31, 2021 | $ | 2,051 | 2,116 | 3,592 | 18,863 | 1,792 | ( 5,819 ) | 22,595 |\n| Net income | 709 | 709 |\n| Other comprehensive income, net of tax | 182 | 182 |\n| Cash dividends declared: |\n| Common stock ($ 0.27 per share) | ( 192 ) | ( 192 ) |\n| Preferred stock: |\n| Series H ($ 637.50 per share) | ( 15 ) | ( 15 ) |\n| Series I ($ 414.06 per share) | ( 7 ) | ( 7 ) |\n| Series J ($ 210.44 per share) | ( 3 ) | ( 3 ) |\n| Series K ($ 309.38 per share) | ( 3 ) | ( 3 ) |\n| Series L ($ 281.25 per share) | ( 4 ) | ( 4 ) |\n| Class B, Series A ($ 15.00 per share) | ( 3 ) | ( 3 ) |\n| Shares acquired for treasury | ( 347 ) | ( 347 ) |\n| Impact of stock transactions under stock compensation plans, net | 10 | 5 |\n\nQuantitative and Qualitative Disclosures about Market Risk (Item 3)\nInformation presented in the Interest Rate and Price Risk Management section of Management’s Discussion and Analysis of Financial Condition and Results of Operations is incorporated herein by reference. This information contains certain statements that we believe are forward-looking statements. Refer to page 1 for cautionary information regarding forward-looking statements.\nControls and Procedures (Item 4)\nThe Bancorp conducted an evaluation, under the supervision and with the participation of the Bancorp’s management, including the Bancorp’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Bancorp’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based on the foregoing, as of the end of the period covered by this report, the Bancorp’s Chief Executive Officer and Chief Financial Officer concluded that the Bancorp’s disclosure controls and procedures were effective, in all material respects, to ensure that information required to be disclosed in the reports the Bancorp files and submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported as and when required and information is accumulated and communicated to the Bancorp’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.\nThe Bancorp’s management also conducted an evaluation of internal control over financial reporting to determine whether any changes occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Bancorp’s internal control over financial reporting. Based on this evaluation there has been no such change during the period covered by this report.\n69\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (Item 1) |\n\n| CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited) |\n| As of |\n| June 30, | December 31, |\n| ($ in millions, except share data) | 2021 | 2020 |\n| Assets |\n| Cash and due from banks | $ | 3,285 | 3,147 |\n| Other short-term investments(a) | 32,409 | 33,399 |\n| Available-for-sale debt and other securities(b) | 38,012 | 37,513 |\n| Held-to-maturity securities(c) | 10 | 11 |\n| Trading debt securities | 711 | 560 |\n| Equity securities | 341 | 313 |\n| Loans and leases held for sale(d) | 5,730 | 4,741 |\n| Portfolio loans and leases(a)(e) | 107,733 | 108,782 |\n| Allowance for loan and lease losses(a) | ( 2,033 ) | ( 2,453 ) |\n| Portfolio loans and leases, net | 105,700 | 106,329 |\n| Bank premises and equipment(f) | 2,073 | 2,088 |\n| Operating lease equipment | 715 | 777 |\n| Goodwill | 4,259 | 4,258 |\n| Intangible assets | 117 | 139 |\n| Servicing rights | 818 | 656 |\n| Other assets(a) | 11,210 | 10,749 |\n| Total Assets | $ | 205,390 | 204,680 |\n| Liabilities |\n| Deposits: |\n| Noninterest-bearing deposits | $ | 62,760 | 57,711 |\n| Interest-bearing deposits(g) | 99,523 | 101,370 |\n| Total deposits | 162,283 | 159,081 |\n| Federal funds purchased | 338 | 300 |\n| Other short-term borrowings | 1,130 | 1,192 |\n| Accrued taxes, interest and expenses | 2,045 | 2,614 |\n| Other liabilities(a) | 4,304 | 3,409 |\n| Long-term debt(a) | 12,364 | 14,973 |\n| Total Liabilities | $ | 182,464 | 181,569 |\n| Equity |\n| Common stock(h) | $ | 2,051 | 2,051 |\n| Preferred stock(i) | 2,116 | 2,116 |\n| Capital surplus | 3,602 | 3,635 |\n| Retained earnings | 19,343 | 18,384 |\n| Accumulated other comprehensive income | 1,974 | 2,601 |\n| Treasury stock(h) | ( 6,160 ) | ( 5,676 ) |\n| Total Equity | $ | 22,926 | 23,111 |\n| Total Liabilities and Equity | $ | 205,390 | 204,680 |\n\n(a) Includes $ 33 and $ 55 of other short-term investments, $ 455 and $ 756 of portfolio loans and leases, $( 3 ) and $( 7 ) of ALLL, $ 3 and $ 5 of other assets, $ 1 and $ 2 of other liabilities, and $ 400 and $ 656 of long-term debt from consolidated VIEs that are included in their respective captions above at June 30, 2021 and December 31, 2020, respectively. For further information, refer to Note 11.\n(b) Amortized cost of $ 36,081 and $ 34,982 at June 30, 2021 and December 31, 2020, respectively.\n(c) Fair value of $ 10 and $ 11 at June 30, 2021 and December 31, 2020, respectively.\n(d) Includes $ 1,633 and $ 1,481 of residential mortgage loans held for sale measured at fair value at June 30, 2021 and December 31, 2020, respectively.\n(e) Includes $ 151 and $ 161 of residential mortgage loans measured at fair value at June 30, 2021 and December 31, 2020, respectively.\n(f) Includes $ 25 and $ 35 of bank premises and equipment held for sale at June 30, 2021 and December 31, 2020, respectively.\n(g) Includes $ 341 and $ 351 of interest checking deposits held for sale at June 30, 2021 and December 31, 2020, respectively.\n(h) Common shares: Stated value $ 2.22 per share; authorized 2,000,000,000 ; outstanding at June 30, 2021 – 703,739,634 (excludes 220,152,947 treasury shares), December 31, 2020 – 712,760,325 (excludes 211,132,256 treasury shares).\n(i) 500,000 shares of no par value preferred stock were authorized at both June 30, 2021 and December 31, 2020. There were 422,000 unissued shares of undesignated no par value preferred stock at both June 30, 2021 and December 31, 2020. Each issued share of no par value preferred stock has a liquidation preference of $ 25,000 . 500,000 shares of no par value Class B preferred stock were authorized at both June 30, 2021 and December 31, 2020. There were 300,000 unissued shares of undesignated no par value Class B preferred stock at both June 30, 2021 and December 31, 2020. Each issued share of no par value Class B preferred stock has a liquidation preference of $ 1,000 .\nRefer to the Notes to Condensed Consolidated Financial Statements.\n70\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\n| CONDENSED CONSOLIDATED STATEMENTS OF INCOME (unaudited) |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions, except share data) | 2021 | 2020 | 2021 | 2020 |\n| Interest Income |\n| Interest and fees on loans and leases | $ | 1,035 | 1,115 | 2,064 | 2,350 |\n| Interest on securities | 279 | 283 | 543 | 566 |\n| Interest on other short-term investments | 9 | 5 | 17 | 12 |\n| Total interest income | 1,323 | 1,403 | 2,624 | 2,928 |\n| Interest Expense |\n| Interest on deposits | 15 | 83 | 36 | 248 |\n| Interest on federal funds purchased | — | — | — | 2 |\n| Interest on other short-term borrowings | — | 2 | 1 | 8 |\n| Interest on long-term debt | 100 | 118 | 202 | 241 |\n| Total interest expense | 115 | 203 | 239 | 499 |\n| Net Interest Income | 1,208 | 1,200 | 2,385 | 2,429 |\n| (Benefit from) provision for credit losses | ( 115 ) | 485 | ( 288 ) | 1,125 |\n| Net Interest Income After (Benefit from) Provision for Credit Losses | 1,323 | 715 | 2,673 | 1,304 |\n| Noninterest Income |\n| Commercial banking revenue | 160 | 137 | 313 | 261 |\n| Service charges on deposits | 149 | 122 | 292 | 270 |\n| Wealth and asset management revenue | 145 | 120 | 288 | 255 |\n| Card and processing revenue | 102 | 82 | 196 | 167 |\n| Mortgage banking net revenue | 64 | 99 | 149 | 219 |\n| Leasing business revenue | 61 | 57 | 148 | 131 |\n| Other noninterest income | 49 | 12 | 92 | 18 |\n| Securities gains (losses), net | 10 | 21 | 13 | ( 3 ) |\n| Securities (losses) gains, net – non-qualifying hedges on mortgage servicing rights | 1 | — | ( 1 ) | 3 |\n| Total noninterest income | 741 | 650 | 1,490 | 1,321 |\n| Noninterest Expense |\n| Compensation and benefits | 638 | 627 | 1,343 | 1,274 |\n| Technology and communications | 94 | 90 | 187 | 183 |\n| Net occupancy expense | 77 | 82 | 156 | 164 |\n| Equipment expense | 34 | 32 | 68 | 64 |\n| Leasing business expense | 33 | 33 | 68 | 68 |\n| Card and processing expense | 20 | 29 | 50 | 60 |\n| Marketing expense | 20 | 20 | 43 | 51 |\n| Other noninterest expense | 237 | 208 | 454 | 457 |\n| Total noninterest expense | 1,153 | 1,121 | 2,369 | 2,321 |\n| Income Before Income Taxes | 911 | 244 | 1,794 | 304 |\n| Applicable income tax expense | 202 | 49 | 391 | 61 |\n| Net Income | 709 | 195 | 1,403 | 243 |\n| Dividends on preferred stock | 35 | 32 | 55 | 50 |\n| Net Income Available to Common Shareholders | $ | 674 | 163 | 1,348 | 193 |\n| Earnings per share - basic | $ | 0.95 | 0.23 | 1.89 | 0.27 |\n| Earnings per share - diluted | $ | 0.94 | 0.23 | 1.87 | 0.27 |\n| Average common shares outstanding - basic | 708,832,787 | 714,766,570 | 711,617,331 | 714,161,131 |\n| Average common shares outstanding - diluted | 718,084,745 | 717,571,890 | 720,740,176 | 718,967,293 |\n\nRefer to the Notes to Condensed Consolidated Financial Statements.\n71\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\n| CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (unaudited) |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Net Income | $ | 709 | 195 | 1,403 | 243 |\n| Other Comprehensive (Loss) Income, Net of Tax: |\n| Unrealized gains on available-for-sale debt securities: |\n| Unrealized holding (losses) gains arising during period | 235 | 456 | ( 466 ) | 1,338 |\n| Reclassification adjustment for net losses (gains) included in net income | ( 5 ) | — | 7 | — |\n| Unrealized gains on cash flow hedge derivatives: |\n| Unrealized holding (losses) gains arising during period | 9 | 66 | ( 55 ) | 493 |\n| Reclassification adjustment for net gains included in net income | ( 58 ) | ( 49 ) | ( 115 ) | ( 74 ) |\n| Defined benefit pension plans, net: |\n| Net actuarial loss arising during the year | ( 1 ) | — | ( 1 ) | — |\n| Reclassification of amounts to net periodic benefit costs | 2 | 1 | 3 | 2 |\n| Other comprehensive (loss) income, net of tax | 182 | 474 | ( 627 ) | 1,759 |\n| Comprehensive Income | $ | 891 | 669 | 776 | 2,002 |\n\nRefer to the Notes to Condensed Consolidated Financial Statements.\n72\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\n| CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY (unaudited) |\n| ($ in millions, except per share data) | CommonStock | PreferredStock | CapitalSurplus | RetainedEarnings | AccumulatedOtherComprehensiveIncome | TreasuryStock | TotalEquity |\n| Balance at March 31, 2020 | $ | 2,051 | 1,770 | 3,597 | 17,677 | 2,477 | ( 5,699 ) | 21,873 |\n| Net income | 195 | 195 |\n| Other comprehensive income, net of tax | 474 | 474 |\n| Cash dividends declared: |\n| Common stock ($ 0.27 per share) | ( 195 ) | ( 195 ) |\n| Preferred stock: |\n| Series H ($ 637.50 per share) | ( 15 ) | ( 15 ) |\n| Series I ($ 414.06 per share) | ( 7 ) | ( 7 ) |\n| Series J ($ 289.38 per share) | ( 4 ) | ( 4 ) |\n| Series K ($ 309.38 per share) | ( 3 ) | ( 3 ) |\n| Class B, Series A ($ 15.00 per share) | ( 3 ) | ( 3 ) |\n| Impact of stock transactions under stock compensation plans, net | 6 | 14 | 20 |\n| Other | ( 2 ) | 2 | — |\n| Balance at June 30, 2020 | $ | 2,051 | 1,770 | 3,603 | 17,643 | 2,951 | ( 5,683 ) | 22,335 |\n| Balance at March 31, 2021 | $ | 2,051 | 2,116 | 3,592 | 18,863 | 1,792 | ( 5,819 ) | 22,595 |\n| Net income | 709 | 709 |\n| Other comprehensive income, net of tax | 182 | 182 |\n| Cash dividends declared: |\n| Common stock ($ 0.27 per share) | ( 192 ) | ( 192 ) |\n| Preferred stock: |\n| Series H ($ 637.50 per share) | ( 15 ) | ( 15 ) |\n| Series I ($ 414.06 per share) | ( 7 ) | ( 7 ) |\n| Series J ($ 210.44 per share) | ( 3 ) | ( 3 ) |\n| Series K ($ 309.38 per share) | ( 3 ) | ( 3 ) |\n| Series L ($ 281.25 per share) | ( 4 ) | ( 4 ) |\n| Class B, Series A ($ 15.00 per share) | ( 3 ) | ( 3 ) |\n| Shares acquired for treasury | ( 347 ) | ( 347 ) |\n| Impact of stock transactions under stock compensation plans, net | 10 | 5 | 15 |\n| Other | ( 2 ) | 1 | ( 1 ) |\n| Balance at June 30, 2021 | $ | 2,051 | 2,116 | 3,602 | 19,343 | 1,974 | ( 6,160 ) | 22,926 |\n\n73\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\n| CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY (unaudited) |\n| ($ in millions, except per share data) | CommonStock | PreferredStock | CapitalSurplus | RetainedEarnings | AccumulatedOtherComprehensiveIncome | TreasuryStock | TotalEquity |\n| Balance at December 31, 2019 | $ | 2,051 | 1,770 | 3,599 | 18,315 | 1,192 | ( 5,724 ) | 21,203 |\n| Impact of cumulative effect of change in accounting principle | ( 472 ) | ( 472 ) |\n| Balance at January 1, 2020 | $ | 2,051 | 1,770 | 3,599 | 17,843 | 1,192 | ( 5,724 ) | 20,731 |\n| Net income | 243 | 243 |\n| Other comprehensive income, net of tax | 1,759 | 1,759 |\n| Cash dividends declared: |\n| Common stock ($ 0.54 per share) | ( 390 ) | ( 390 ) |\n| Preferred stock: |\n| Series H ($ 637.50 per share) | ( 15 ) | ( 15 ) |\n| Series I ($ 828.12 per share) | ( 15 ) | ( 15 ) |\n| Series J ($ 609.93 per share) | ( 8 ) | ( 8 ) |\n| Series K ($ 618.76 per share) | ( 6 ) | ( 6 ) |\n| Class B, Series A ($ 30.00 per share) | ( 6 ) | ( 6 ) |\n| Impact of stock transactions under stock compensation plans, net | 4 | 39 | 43 |\n| Other | ( 3 ) | 2 | ( 1 ) |\n| Balance at June 30, 2020 | $ | 2,051 | 1,770 | 3,603 | 17,643 | 2,951 | ( 5,683 ) | 22,335 |\n| Balance at December 31, 2020 | $ | 2,051 | 2,116 | 3,635 | 18,384 | 2,601 | ( 5,676 ) | 23,111 |\n| Net income | 1,403 | 1,403 |\n| Other comprehensive loss, net of tax | ( 627 ) | ( 627 ) |\n| Cash dividends declared: |\n| Common stock ($ 0.54 per share) | ( 387 ) | ( 387 ) |\n| Preferred stock: |\n| Series H ($ 637.50 per share) | ( 15 ) | ( 15 ) |\n| Series I ($ 828.12 per share) | ( 15 ) | ( 15 ) |\n| Series J ($ 421.94 per share) | ( 5 ) | ( 5 ) |\n| Series K ($ 618.75 per share) | ( 6 ) | ( 6 ) |\n| Series L ($ 562.50 per share) | ( 8 ) | ( 8 ) |\n| Class B, Series A ($ 30.00 per share) | ( 6 ) | ( 6 ) |\n| Shares acquired for treasury | ( 527 ) | ( 527 ) |\n| Impact of stock transactions under stock compensation plans, net | ( 33 ) | 42 | 9 |\n| Other | ( 2 ) | 1 | ( 1 ) |\n| Balance at June 30, 2021 | $ | 2,051 | 2,116 | 3,602 | 19,343 | 1,974 | ( 6,160 ) | 22,926 |\n\nRefer to the Notes to Condensed Consolidated Financial Statements.\n74\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\n| CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) |\n| For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 |\n| Operating Activities |\n| Net income | $ | 1,403 | 243 |\n| Adjustments to reconcile net income to net cash provided by operating activities: |\n| (Benefit from) provision for credit losses | ( 288 ) | 1,125 |\n| Depreciation, amortization and accretion | 243 | 231 |\n| Stock-based compensation expense | 79 | 77 |\n| Benefit from deferred income taxes | ( 239 ) | ( 48 ) |\n| Securities gains, net | ( 9 ) | ( 6 ) |\n| MSR fair value adjustment | 50 | 448 |\n| Net gains on sales of loans and fair value adjustments on loans held for sale | ( 176 ) | ( 88 ) |\n| Net losses on disposition and impairment of bank premises and equipment | 1 | 15 |\n| Net losses (gains) on disposition and impairment of operating lease equipment | 20 | ( 5 ) |\n| Proceeds from sales of loans held for sale | 7,974 | 6,234 |\n| Loans originated or purchased for sale, net of repayments | ( 8,899 ) | ( 5,706 ) |\n| Dividends representing return on equity investments | 20 | 6 |\n| Net change in: |\n| Equity and trading debt securities | ( 163 ) | 68 |\n| Other assets | 232 | ( 529 ) |\n| Accrued taxes, interest and expenses and other liabilities | ( 125 ) | ( 113 ) |\n| Net Cash Provided by Operating Activities | 123 | 1,952 |\n| Investing Activities |\n| Proceeds from sales: |\n| AFS securities and other investments | 1,454 | 868 |\n| Loans and leases | 436 | 57 |\n| Bank premises and equipment | 17 | 12 |\n| Proceeds from repayments / maturities of AFS and HTM securities and other investments | 2,948 | 1,252 |\n| Purchases: |\n| AFS securities and other investments | ( 5,825 ) | ( 2,815 ) |\n| Bank premises and equipment | ( 126 ) | ( 133 ) |\n| MSRs | ( 109 ) | ( 30 ) |\n| Proceeds from settlement of BOLI | 15 | 8 |\n| Proceeds from sales and dividends representing return of equity investments | 29 | 8 |\n| Net change in: |\n| Other short-term investments | 990 | ( 26,293 ) |\n| Portfolio loans and leases | 582 | ( 5,605 ) |\n| Operating lease equipment | ( 23 ) | ( 20 ) |\n| Net Cash Provided by (Used in) Investing Activities | 388 | ( 32,691 ) |\n| Financing Activities |\n| Net change in deposits | 3,202 | 29,884 |\n| Net change in other short-term borrowings and federal funds purchased | 14 | 195 |\n| Dividends paid on common and preferred stock | ( 444 ) | ( 417 ) |\n| Proceeds from issuance of long-term debt | 44 | 2,511 |\n| Repayment of long-term debt | ( 2,585 ) | ( 1,450 ) |\n| Repurchases of treasury stock and related forward contract | ( 527 ) | — |\n| Other | ( 77 ) | ( 41 ) |\n| Net Cash (Used in) Provided by Financing Activities | ( 373 ) | 30,682 |\n| Increase (Decrease) in Cash and Due from Banks | 138 | ( 57 ) |\n| Cash and Due from Banks at Beginning of Period | 3,147 | 3,278 |\n| Cash and Due from Banks at End of Period | $ | 3,285 | 3,221 |\n\nRefer to the Notes to Condensed Consolidated Financial Statements. Note 2 contains cash payments related to interest and income taxes in addition to non-cash investing and financing activities.\n75\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n1. Basis of Presentation\nThe Condensed Consolidated Financial Statements include the accounts of the Bancorp and its majority-owned subsidiaries and VIEs in which the Bancorp has been determined to be the primary beneficiary. Other entities, including certain joint ventures in which the Bancorp has the ability to exercise significant influence over operating and financial policies of the investee, but upon which the Bancorp does not possess control, are accounted for by the equity method and not consolidated. The investments in those entities in which the Bancorp does not have the ability to exercise significant influence are generally carried at fair value unless the investment does not have a readily determinable fair value. The Bancorp accounts for equity investments without a readily determinable fair value using the measurement alternative to fair value, representing the cost of the investment minus impairment recorded, if any, plus or minus changes resulting from observable price changes in orderly transactions for an identical or a similar investment of the same issuer. Intercompany transactions and balances among consolidated entities have been eliminated.\nIn the opinion of management, the unaudited Condensed Consolidated Financial Statements include all adjustments, which consist of normal recurring accruals, necessary to present fairly the results for the periods presented. In accordance with U.S. GAAP and the rules and regulations of the SEC for interim financial information, these statements do not include certain information and footnote disclosures required for complete annual financial statements and it is suggested that these Condensed Consolidated Financial Statements be read in conjunction with the Bancorp’s Annual Report on Form 10-K. The results of operations, comprehensive income and changes in equity for the three and six months ended June 30, 2021 and 2020 and the cash flows for the six months ended June 30, 2021 and 2020 are not necessarily indicative of the results to be expected for the full year. Financial information as of December 31, 2020 has been derived from the Bancorp’s Annual Report on Form 10-K.\nThe preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.\n2. Supplemental Cash Flow Information\nCash payments related to interest and income taxes in addition to non-cash investing and financing activities are presented in the following table for the six months ended June 30:\n| ($ in millions) | 2021 | 2020 |\n| Cash Payments: |\n| Interest | $ | 256 | 528 |\n| Income taxes | 336 | 268 |\n| Transfers: |\n| Portfolio loans and leases to loans and leases held for sale(a) | $ | 337 | 31 |\n| Loans and leases held for sale to portfolio loans and leases | 20 | 29 |\n| Portfolio loans and leases to OREO | 9 | 6 |\n| Loans and leases held for sale to OREO | — | 2 |\n| Bank premises and equipment to OREO | 17 | — |\n| Supplemental Disclosures: |\n| Net additions to lease liabilities under operating leases | $ | 31 | 27 |\n| Net additions to lease liabilities under finance leases | 25 | 76 |\n\n(a) Includes $ 139 of residential mortgage loans previously sold to GNMA which the Bancorp was initially deemed to have regained effective control over under ASC Topic 860 and which were recorded as portfolio loans. The Bancorp subsequently repurchased these loans and classified them as held for sal e.\n76\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n3. Accounting and Reporting Developments\nStandards Adopted in 2021\nThe Bancorp adopted the following new accounting standard during the six months ended June 30, 2021:\nASU 2019-12 – Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes\nIn December 2019, the FASB issued ASU 2019-12, which simplifies the accounting for income taxes by removing certain exceptions to the general principles in Topic 740. The amendments also clarify and amend existing guidance for other areas of Topic 740. The Bancorp adopted the amended guidance on January 1, 2021 on a modified retrospective basis, except for certain provisions of the amended guidance which were required to be adopted prospectively. The adoption of the amended guidance did not have a material impact on the Condensed Consolidated Financial Statements.\nReference Rate Reform and LIBOR Transition\nIn March 2020, the FASB issued ASU 2020-04, which provides optional expedients and exceptions for applying U.S. GAAP to contracts, hedging relationships and other transactions affected by reference rate reform if certain criteria are met. The amendments in the ASU apply only to contracts, hedging relationships and other transactions that reference LIBOR or another reference rate expected to be discontinued because of reference rate reform. Subsequently, in January 2021, the FASB issued ASU 2021-01, which clarified that the optional expedients and exceptions in Topic 848 for contract modifications and hedge accounting also apply to derivatives that are affected by the discounting transition. The expedients and exceptions provided by the amendments do not apply to contract modifications made and hedging relationships entered into or evaluated after December 31, 2022, except for hedging relationships existing as of December 31, 2022 for which an entity has elected certain optional expedients and that are retained through the end of the hedging relationship. The amendments in this ASU are effective for the Bancorp as of March 12, 2020 through December 31, 2022. The Bancorp is in the process of evaluating and applying, as applicable, the optional expedients and exceptions in accounting for eligible contract modifications, eligible existing hedging relationships and new hedging relationships available through December 31, 2022.\n77\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n4. Investment Securities\nThe following tables provide the amortized cost, unrealized gains and losses and fair value for the major categories of the available-for-sale debt and other securities and held-to-maturity securities portfolios as of:\n| June 30, 2021 ($ in millions) | AmortizedCost | UnrealizedGains | UnrealizedLosses | FairValue |\n| Available-for-sale debt and other securities: |\n| U.S. Treasury and federal agencies securities | $ | 105 | 2 | — | 107 |\n| Obligations of states and political subdivisions securities | 18 | — | — | 18 |\n| Mortgage-backed securities: |\n| Agency residential mortgage-backed securities | 10,256 | 573 | ( 20 ) | 10,809 |\n| Agency commercial mortgage-backed securities | 18,142 | 1,188 | ( 36 ) | 19,294 |\n| Non-agency commercial mortgage-backed securities | 3,276 | 203 | — | 3,479 |\n| Asset-backed securities and other debt securities | 3,764 | 48 | ( 27 ) | 3,785 |\n| Other securities(a) | 520 | — | — | 520 |\n| Total available-for-sale debt and other securities | $ | 36,081 | 2,014 | ( 83 ) | 38,012 |\n| Held-to-maturity securities: |\n| Obligations of states and political subdivisions securities | $ | 9 | — | — | 9 |\n| Asset-backed securities and other debt securities | 1 | — | — | 1 |\n| Total held-to-maturity securities | $ | 10 | — | — | 10 |\n\n(a)Other securities consist of FHLB, FRB and DTCC restricted stock holdings of $ 33 , $ 485 and $ 2 , respectively, at June 30, 2021, that are carried at cost.\n| December 31, 2020 ($ in millions) | AmortizedCost | UnrealizedGains | UnrealizedLosses | FairValue |\n| Available-for-sale debt and other securities: |\n| U.S. Treasury and federal agencies securities | $ | 74 | 4 | — | 78 |\n| Obligations of states and political subdivisions securities | 17 | — | — | 17 |\n| Mortgage-backed securities: |\n| Agency residential mortgage-backed securities | 11,147 | 768 | ( 8 ) | 11,907 |\n| Agency commercial mortgage-backed securities | 16,745 | 1,481 | ( 5 ) | 18,221 |\n| Non-agency commercial mortgage-backed securities | 3,323 | 267 | — | 3,590 |\n| Asset-backed securities and other debt securities | 3,152 | 48 | ( 24 ) | 3,176 |\n| Other securities(a) | 524 | — | — | 524 |\n| Total available-for-sale debt and other securities | $ | 34,982 | 2,568 | ( 37 ) | 37,513 |\n| Held-to-maturity securities: |\n| Obligations of states and political subdivisions securities | $ | 9 | — | — | 9 |\n| Asset-backed securities and other debt securities | 2 | — | — | 2 |\n| Total held-to-maturity securities | $ | 11 | — | — | 11 |\n\n(a)Other securities consist of FHLB, FRB and DTCC restricted stock holdings of $ 40 , $ 482 and $ 2 , respectively, at December 31, 2020, that are carried at cost.\nThe following table provides the fair value of trading debt securities and equity securities as of:\n| ($ in millions) | June 30,2021 | December 31,2020 |\n| Trading debt securities | $ | 711 | 560 |\n| Equity securities | 341 | 313 |\n\nThe amounts reported in the preceding tables exclude accrued interest receivable on investment securities of $ 86 million and $ 87 million at June 30, 2021 and December 31, 2020, respectively, which are presented as a component of other assets in the Condensed Consolidated Balance Sheets.\nThe Bancorp uses investment securities as a means of managing interest rate risk, providing collateral for pledging purposes and for liquidity to satisfy regulatory requirements. As part of managing interest rate risk, the Bancorp acquires securities as a component of its MSR non-qualifying hedging strategy, with net gains or losses recorded in securities (losses) gains, net – non-qualifying hedges on mortgage servicing rights in the Condensed Consolidated Statements of Income.\n78\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following table presents securities gains (losses) recognized in the Condensed Consolidated Statements of Income:\n| For the three months ended June 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Available-for-sale debt and other securities: |\n| Realized gains | $ | 7 | — | 8 | 1 |\n| Realized losses | — | — | ( 10 ) | ( 1 ) |\n| Impairment losses | — | — | ( 7 ) | — |\n| Net (losses) gains on available-for sale debt and other securities | $ | 7 | — | ( 9 ) | — |\n| Total trading debt securities (losses) gains | $ | ( 7 ) | — | — | 3 |\n| Total equity securities gains (losses)(a) | $ | 11 | 21 | 21 | ( 3 ) |\n| Total gains recognized in income from available-for-sale debt and other securities, trading debt securities and equity securities(b) | $ | 11 | 21 | 12 | — |\n\n(a)Includes net unrealized gains of $ 10 and $ 17 for the three and six months ended June 30, 2021, respectively, and net unrealized gains of $ 21 and net unrealized losses of $ 2 for the three and six months ended June 30, 2020, respectively.\n(b)Excludes $ 1 and $ 3 of net securities losses for the three and six months ended June 30, 2021, respectively, and $ 8 and $ 6 of net securities gains for the three and six months ended June 30, 2020, respectively, related to securities held by FTS to facilitate the timely execution of customer transactions. These losses and gains are included in commercial banking revenue and wealth and asset management revenue in the Condensed Consolidated Statements of Income.\nIn the first quarter of 2021, the Bancorp recognized impairment losses on available-for-sale debt and other securities of $ 7 million. These losses related to certain securities in unrealized loss positions that the Bancorp intended to sell prior to recovery of their amortized cost bases. The Bancorp did not consider these losses to be credit-related.\nAt both June 30, 2021 and December 31, 2020, the Bancorp completed its evaluation of the available-for-sale debt and other securities in an unrealized loss position and did not recognize an allowance for credit losses. The Bancorp did not recognize provision expense related to available-for-sale debt and other securities in an unrealized loss position during both the three and six months ended June 30, 2021 and 2020.\nAt both June 30, 2021 and December 31, 2020, investment securities with a fair value of $ 11.0 billion were pledged to secure borrowings, public deposits, trust funds, derivative contracts and for other purposes as required or permitted by law.\nThe expected maturity distribution of the Bancorp’s mortgage-backed securities and the contractual maturity distribution of the remainder of the Bancorp’s available-for-sale debt and other securities and held-to-maturity securities as of June 30, 2021 are shown in the following table:\n| ($ in millions) | Available-for-Sale Debt and Other | Held-to-Maturity |\n| Amortized Cost | Fair Value | Amortized Cost | Fair Value |\n| Debt securities:(a) |\n| Less than 1 year | $ | 886 | 907 | 4 | 4 |\n| 1-5 years | 14,074 | 14,825 | 4 | 4 |\n| 5-10 years | 11,482 | 12,349 | — | — |\n| Over 10 years | 9,119 | 9,411 | 2 | 2 |\n| Other securities | 520 | 520 | — | — |\n| Total | $ | 36,081 | 38,012 | 10 | 10 |\n\n(a)Actual maturities may differ from contractual maturities when a right to call or prepay obligations exists with or without call or prepayment penalties.\n79\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following table provides the fair value and gross unrealized losses on available-for-sale debt and other securities in an unrealized loss position, aggregated by investment category and length of time the individual securities have been in a continuous unrealized loss position as of:\n| Less than 12 months | 12 months or more | Total |\n| ($ in millions) | Fair Value | UnrealizedLosses | Fair Value | UnrealizedLosses | Fair Value | UnrealizedLosses |\n| June 30, 2021 |\n| Agency residential mortgage-backed securities | $ | 701 | ( 20 ) | 1 | — | 702 | ( 20 ) |\n| Agency commercial mortgage-backed securities | 1,632 | ( 36 ) | — | — | 1,632 | ( 36 ) |\n| Non-agency commercial mortgage-backed securities | 1 | — | — | — | 1 | — |\n| Asset-backed securities and other debt securities | 435 | ( 7 ) | 843 | ( 20 ) | 1,278 | ( 27 ) |\n| Total | $ | 2,769 | ( 63 ) | 844 | ( 20 ) | 3,613 | ( 83 ) |\n| December 31, 2020 |\n| Agency residential mortgage-backed securities | $ | 426 | ( 8 ) | 1 | — | 427 | ( 8 ) |\n| Agency commercial mortgage-backed securities | 388 | ( 5 ) | — | — | 388 | ( 5 ) |\n| Non-agency commercial mortgage-backed securities | 2 | — | — | — | 2 | — |\n| Asset-backed securities and other debt securities | 520 | ( 7 ) | 603 | ( 17 ) | 1,123 | ( 24 ) |\n| Total | $ | 1,336 | ( 20 ) | 604 | ( 17 ) | 1,940 | ( 37 ) |\n\nAt both June 30, 2021 and December 31, 2020, $ 1 million of unrealized losses in the available-for-sale debt and other securities portfolio were represented by non-rated securities.\n80\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n5. Loans and Leases\nThe Bancorp diversifies its loan and lease portfolio by offering a variety of loan and lease products with various payment terms and rate structures. The Bancorp’s commercial loan and lease portfolio consists of lending to various industry types. Management periodically reviews the performance of its loan and lease products to evaluate whether they are performing within acceptable interest rate and credit risk levels and changes are made to underwriting policies and procedures as needed. The Bancorp maintains an allowance to absorb loan and lease losses that are expected to be incurred over the remaining contractual terms of the related loans and leases. For further information on credit quality and the ALLL, refer to Note 6.\nThe following table provides a summary of commercial loans and leases classified by primary purpose and consumer loans classified based upon product or collateral as of:\n| ($ in millions) | June 30,2021 | December 31,2020 |\n| Loans and leases held for sale: |\n| Commercial and industrial loans | $ | 11 | 230 |\n| Commercial mortgage loans | 33 | 7 |\n| Commercial construction loans | 2 | — |\n| Commercial leases | — | 39 |\n| Residential mortgage loans | 5,684 | 4,465 |\n| Total loans and leases held for sale | $ | 5,730 | 4,741 |\n| Portfolio loans and leases: |\n| Commercial and industrial loans(a) | $ | 47,564 | 49,665 |\n| Commercial mortgage loans | 10,347 | 10,602 |\n| Commercial construction loans | 5,871 | 5,815 |\n| Commercial leases | 3,238 | 2,915 |\n| Total commercial loans and leases | $ | 67,020 | 68,997 |\n| Residential mortgage loans(b) | $ | 16,131 | 15,928 |\n| Home equity | 4,545 | 5,183 |\n| Indirect secured consumer loans | 15,192 | 13,653 |\n| Credit card | 1,793 | 2,007 |\n| Other consumer loans | 3,052 | 3,014 |\n| Total consumer loans | $ | 40,713 | 39,785 |\n| Total portfolio loans and leases | $ | 107,733 | 108,782 |\n\n(a)Includes $ 3.7 billion and $ 4.8 billion as of June 30, 2021 and December 31, 2020, respectively, related to the SBA’s Paycheck Protection Program.\n(b)Includes $ 39 as of December 31, 2020 of residential mortgage loans previously sold to GNMA for which the Bancorp was deemed to have regained effective control over under ASC Topic 860, but did not exercise its option to repurchase. Refer to Note 14 for further information.\nPortfolio loans and leases are recorded net of unearned income, which totaled $ 274 million as of June 30, 2021 and $ 280 million as of December 31, 2020. Additionally, portfolio loans and leases are recorded net of unamortized premiums and discounts, deferred direct loan origination fees and costs and fair value adjustments (associated with acquired loans or loans designated as fair value upon origination), which totaled a net premium of $ 356 million and $ 251 million as of June 30, 2021 and December 31, 2020, respectively. The amortized cost basis of loans and leases excludes accrued interest receivable of $ 372 million and $ 350 million at June 30, 2021 and December 31, 2020, respectively, which is presented as a component of other assets in the Condensed Consolidated Balance Sheets.\nThe Bancorp’s FHLB and FRB borrowings are primarily secured by loans. The Bancorp had loans of $ 15.2 billion and $ 15.5 billion at June 30, 2021 and December 31, 2020, respectively, pledged at the FHLB, and loans of $ 42.0 billion and $ 37.8 billion at June 30, 2021 and December 31, 2020, respectively, pledged at the FRB.\n81\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following table presents a summary of the total loans and leases owned by the Bancorp as of:\n| Carrying Value | 90 Days Past Dueand Still Accruing |\n| ($ in millions) | June 30,2021 | December 31,2020 | June 30,2021 | December 31,2020 |\n| Commercial and industrial loans | $ | 47,575 | 49,895 | 2 | 39 |\n| Commercial mortgage loans | 10,380 | 10,609 | 4 | 8 |\n| Commercial construction loans | 5,873 | 5,815 | — | — |\n| Commercial leases | 3,238 | 2,954 | — | 1 |\n| Residential mortgage loans | 21,815 | 20,393 | 57 | 70 |\n| Home equity | 4,545 | 5,183 | 1 | 2 |\n| Indirect secured consumer loans | 15,192 | 13,653 | 4 | 10 |\n| Credit card | 1,793 | 2,007 | 14 | 31 |\n| Other consumer loans | 3,052 | 3,014 | 1 | 2 |\n| Total loans and leases | $ | 113,463 | 113,523 | 83 | 163 |\n| Less: Loans and leases held for sale | $ | 5,730 | 4,741 |\n| Total portfolio loans and leases | $ | 107,733 | 108,782 |\n\nThe following table presents a summary of net charge-offs (recoveries):\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Commercial and industrial loans | $ | 13 | 65 | 40 | 115 |\n| Commercial mortgage loans | 6 | 2 | 8 | 4 |\n| Commercial leases | ( 2 ) | 11 | ( 2 ) | 16 |\n| Residential mortgage loans | — | 1 | ( 1 ) | 2 |\n| Home equity | ( 1 ) | 1 | ( 1 ) | 4 |\n| Indirect secured consumer loans | — | 7 | 9 | 20 |\n| Credit card | 20 | 34 | 45 | 71 |\n| Other consumer loans | 8 | 9 | 17 | 20 |\n| Total net charge-offs | $ | 44 | 130 | 115 | 252 |\n\nThe Bancorp engages in commercial lease products primarily related to the financing of commercial equipment. Leases are classified as sales-type if the Bancorp transfers control of the underlying asset to the lessee. The Bancorp classifies leases that do not meet any of the criteria for a sales-type lease as a direct financing lease if the present value of the sum of the lease payments and any residual value guaranteed by the lessee and/or any other third party equals or exceeds substantially all of the fair value of the underlying asset and the collection of the lease payments and residual value guarantee is probable.\nThe following table presents the components of the net investment in leases as of:\n| ($ in millions)(a) | June 30,2021 | December 31, 2020 |\n| Net investment in direct financing leases: |\n| Lease payment receivable (present value) | $ | 1,161 | 1,400 |\n| Unguaranteed residual assets (present value) | 167 | 181 |\n| Net discount on acquired leases | — | ( 1 ) |\n| Net investment in sales-type leases: |\n| Lease payment receivable (present value) | 1,551 | 976 |\n| Unguaranteed residual assets (present value) | 48 | 36 |\n\n(a)Excludes $ 311 and $ 323 of leveraged leases at June 30, 2021 and December 31, 2020, respectively.\nInterest income recognized in the Condensed Consolidated Statements of Income for the three and six months ended June 30, 2021 was $ 11 million and $ 23 million, respectively, for direct financing leases and $ 10 million and $ 20 million, respectively, for sales-type leases. For the three and six months ended June 30, 2020, interest income recognized was $ 17 million and $ 35 million, respectively, for direct financing leases and $ 6 million and $ 13 million, respectively, for sales-type leases.\n82\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following table presents undiscounted cash flows for both direct financing and sales-type leases for the remainder of 2021 through 2026 and thereafter as well as a reconciliation of the undiscounted cash flows to the total lease receivables as follows:\n| As of June 30, 2021 ($ in millions) | Direct FinancingLeases | Sales-Type Leases |\n| Remainder of 2021 | $ | 216 | 278 |\n| 2022 | 350 | 479 |\n| 2023 | 224 | 288 |\n| 2024 | 160 | 216 |\n| 2025 | 114 | 150 |\n| 2026 | 69 | 82 |\n| Thereafter | 105 | 165 |\n| Total undiscounted cash flows | $ | 1,238 | 1,658 |\n| Less: Difference between undiscounted cash flows and discounted cash flows | 77 | 107 |\n| Present value of lease payments (recognized as lease receivables) | $ | 1,161 | 1,551 |\n\nThe lease residual value represents the present value of the estimated fair value of the leased equipment at the end of the lease. The Bancorp performs quarterly reviews of residual values associated with its leasing portfolio considering factors such as the subject equipment, structure of the transaction, industry, prior experience with the lessee and other factors that impact the residual value to assess for impairment. The Bancorp maintained an allowance of $ 24 million and $ 29 million at June 30, 2021 and December 31, 2020, respectively, to cover the losses that are expected to be incurred over the remaining contractual terms of the related leases, including the potential losses related to the residual value, in the net investment in leases. Refer to Note 6 for additional information on credit quality and the ALLL.\n83\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n6. Credit Quality and the Allowance for Loan and Lease Losses\nThe Bancorp disaggregates ALLL balances and transactions in the ALLL by portfolio segment. Credit quality related disclosures for loans and leases are further disaggregated by class.\nAllowance for Loan and Lease Losses\nThe following tables summarize transactions in the ALLL by portfolio segment:\n| For the three months ended June 30, 2021 ($ in millions) | Commercial | ResidentialMortgage | Consumer | Total |\n| Balance, beginning of period | $ | 1,329 | 247 | 632 | 2,208 |\n| Losses charged off(a) | ( 45 ) | ( 1 ) | ( 57 ) | ( 103 ) |\n| Recoveries of losses previously charged off(a) | 28 | 1 | 30 | 59 |\n| Benefit from loan and lease losses | ( 88 ) | ( 12 ) | ( 31 ) | ( 131 ) |\n| Balance, end of period | $ | 1,224 | 235 | 574 | 2,033 |\n\n(a)The Bancorp recorded $ 8 in both losses charged off and recoveries of losses previously charged off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements.\n| For the three months ended June 30, 2020 ($ in millions) | Commercial | ResidentialMortgage | Consumer | Total |\n| Balance, beginning of period | $ | 1,313 | 260 | 775 | 2,348 |\n| Losses charged off(a) | ( 81 ) | ( 2 ) | ( 80 ) | ( 163 ) |\n| Recoveries of losses previously charged off(a) | 3 | 1 | 29 | 33 |\n| Provision for loan and lease losses(b) | 267 | 68 | 143 | 478 |\n| Balance, end of period | $ | 1,502 | 327 | 867 | 2,696 |\n\n(a)The Bancorp recorded $ 9 in both losses charged off and recoveries of losses previously charged off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements.\n(b)Includes $ 1 in Residential Mortgage related to the initial recognition of an ALLL on PCD loans.\n| For the six months ended June 30, 2021 ($ in millions) | Commercial | ResidentialMortgage | Consumer | Total |\n| Balance, beginning of period | $ | 1,456 | 294 | 703 | 2,453 |\n| Losses charged off(a) | ( 81 ) | ( 2 ) | ( 128 ) | ( 211 ) |\n| Recoveries of losses previously charged off(a) | 35 | 3 | 58 | 96 |\n| Benefit from loan and lease losses | ( 186 ) | ( 60 ) | ( 59 ) | ( 305 ) |\n| Balance, end of period | $ | 1,224 | 235 | 574 | 2,033 |\n\n(a)The Bancorp recorded $ 18 in both losses charged off and recoveries of losses previously charged off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements.\n| For the six months ended June 30, 2020 ($ in millions) | Commercial | Residential Mortgage | Consumer | Unallocated | Total |\n| Balance, beginning of period | $ | 710 | 73 | 298 | 121 | 1,202 |\n| Impact of adoption of ASU 2016-13(a) | 160 | 196 | 408 | ( 121 ) | 643 |\n| Losses charged off(b) | ( 142 ) | ( 4 ) | ( 176 ) | — | ( 322 ) |\n| Recoveries of losses previously charged off(b) | 7 | 2 | 61 | — | 70 |\n| Provision for loan and lease losses | 767 | 60 | 276 | — | 1,103 |\n| Balance, end of period | $ | 1,502 | 327 | 867 | — | 2,696 |\n\n(a)Includes $ 31 , $ 2 and $ 1 in Commercial, Residential Mortgage and Consumer, respectively, related to the initial recognition of an ALLL on PCD loans.\n(b)The Bancorp recorded $ 22 in both losses charged off and recoveries of losses previously charged off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements.\n84\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following tables provide a summary of the ALLL and related loans and leases classified by portfolio segment:\n| As of June 30, 2021 ($ in millions) | Commercial | ResidentialMortgage | Consumer | Total |\n| ALLL:(a) |\n| Individually evaluated | $ | 101 | 55 | 38 | 194 |\n| Collectively evaluated | 1,123 | 180 | 536 | 1,839 |\n| Total ALLL | $ | 1,224 | 235 | 574 | 2,033 |\n| Portfolio loans and leases:(b) |\n| Individually evaluated | $ | 629 | 539 | 295 | 1,463 |\n| Collectively evaluated | 66,391 | 15,441 | 24,287 | 106,119 |\n| Total portfolio loans and leases | $ | 67,020 | 15,980 | 24,582 | 107,582 |\n\n(a)Includes $ 3 related to commercial leveraged leases at June 30, 2021.\n(b)Excludes $ 151 of residential mortgage loans measured at fair value and includes $ 311 of commercial leveraged leases, net of unearned income at June 30, 2021.\n| As of December 31, 2020 ($ in millions) | Commercial | ResidentialMortgage | Consumer | Total |\n| ALLL:(a) |\n| Individually evaluated | $ | 114 | 68 | 43 | 225 |\n| Collectively evaluated | 1,342 | 226 | 660 | 2,228 |\n| Total ALLL | $ | 1,456 | 294 | 703 | 2,453 |\n| Portfolio loans and leases:(b) |\n| Individually evaluated | $ | 962 | 628 | 273 | 1,863 |\n| Collectively evaluated | 67,701 | 15,073 | 23,569 | 106,343 |\n| Purchased credit deteriorated(c) | 334 | 66 | 15 | 415 |\n| Total portfolio loans and leases | $ | 68,997 | 15,767 | 23,857 | 108,621 |\n\n(a)Includes $ 3 related to commercial leveraged leases at December 31, 2020.\n(b)Excludes $ 161 of residential mortgage loans measured at fair value and includes $ 323 of commercial leveraged leases, net of unearned income at December 31, 2020.\n(c)Includes $ 39 , as of December 31, 2020, of residential mortgage loans previously sold to GNMA for which the Bancorp was deemed to have regained effective control over under ASC Topic 860, but did not exercise its option to repurchase. Refer to Note 14 for further information.\nCREDIT RISK PROFILE\nCommercial Portfolio Segment\nFor purposes of monitoring the credit quality and risk characteristics of its commercial portfolio segment, the Bancorp disaggregates the segment into the following classes: commercial and industrial, commercial mortgage owner-occupied, commercial mortgage nonowner-occupied, commercial construction and commercial leases.\nTo facilitate the monitoring of credit quality within the commercial portfolio segment, the Bancorp utilizes the following categories of credit grades: pass, special mention, substandard, doubtful and loss. The five categories, which are derived from standard regulatory rating definitions, are assigned upon initial approval of credit to borrowers and updated periodically thereafter.\nPass ratings, which are assigned to those borrowers that do not have identified potential or well-defined weaknesses and for which there is a high likelihood of orderly repayment, are updated at least annually based on the size and credit characteristics of the borrower. All other categories are updated on a quarterly basis during the month preceding the end of the calendar quarter.\nThe Bancorp assigns a special mention rating to loans and leases that have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may, at some future date, result in the deterioration of the repayment prospects for the loan or lease or the Bancorp’s credit position.\nThe Bancorp assigns a substandard rating to loans and leases that are inadequately protected by the current sound worth and paying capacity of the borrower or of the collateral pledged. Substandard loans and leases have well-defined weaknesses or weaknesses that could jeopardize the orderly repayment of the debt. Loans and leases in this grade also are characterized by the distinct possibility that the Bancorp will sustain some loss if the deficiencies noted are not addressed and corrected.\nThe Bancorp assigns a doubtful rating to loans and leases that have all the attributes of a substandard rating with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. The possibility of loss is extremely high, but because of certain important and reasonable specific pending factors that may work to the advantage of and strengthen the credit quality of the loan or lease, its classification as an estimated loss is deferred until its more exact\n85\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nstatus may be determined. Pending factors may include a proposed merger or acquisition, liquidation proceeding, capital injection, perfecting liens on additional collateral or refinancing plans.\nLoans and leases classified as loss are considered uncollectible and are charged off in the period in which they are determined to be uncollectible. Because loans and leases in this category are fully charged off, they are not included in the following tables.\nFor loans and leases that are collectively evaluated, the Bancorp utilizes models to forecast expected credit losses over a reasonable and supportable forecast period based on the probability of a loan or lease defaulting, the expected balance at the estimated date of default and the expected loss percentage given a default. For the commercial portfolio segment, the estimates for probability of default are primarily based on internal ratings assigned to each commercial borrower on a 13-point scale and historical observations of how those ratings migrate to a default over time in the context of macroeconomic conditions. For loans with available credit, the estimate of the expected balance at the time of default considers expected utilization rates, which are primarily based on macroeconomic conditions and the utilization history of similar borrowers under those economic conditions. The estimates for loss severity are primarily based on collateral type and coverage levels and the susceptibility of those characteristics to changes in macroeconomic conditions. For more information about the Bancorp’s processes for developing these models, estimating credit losses for periods beyond the reasonable and supportable forecast period and for estimating credit losses for individually evaluated loans, refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\n86\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following tables present the amortized cost basis of the Bancorp’s commercial portfolio segment, by class and vintage, disaggregated by credit risk grade:\n| As of June 30, 2021 ($ in millions) | Term Loans and Leases by Origination Year | Revolving Loans | Revolving Loans Converted to Term Loans |\n| 2021 | 2020 | 2019 | 2018 | 2017 | Prior | Total |\n| Commercial and industrial loans: |\n| Pass | $ | 3,164 | 4,183 | 1,733 | 743 | 466 | 928 | 32,500 | — | 43,717 |\n| Special mention | 17 | 33 | 35 | 26 | 30 | 21 | 1,210 | — | 1,372 |\n| Substandard | 26 | 92 | 59 | 119 | 70 | 109 | 2,000 | — | 2,475 |\n| Doubtful | — | — | — | — | — | — | — | — | — |\n| Total commercial and industrial loans | $ | 3,207 | 4,308 | 1,827 | 888 | 566 | 1,058 | 35,710 | — | 47,564 |\n| Commercial mortgage owner-occupied loans: |\n| Pass | $ | 517 | 927 | 596 | 358 | 246 | 513 | 1,140 | — | 4,297 |\n| Special mention | 4 | 30 | 40 | 2 | — | 22 | 85 | — | 183 |\n| Substandard | 38 | 67 | 11 | 25 | 2 | 27 | 107 | — | 277 |\n| Doubtful | — | — | — | — | — | — | — | — | — |\n| Total commercial mortgage owner- occupied loans | $ | 559 | 1,024 | 647 | 385 | 248 | 562 | 1,332 | — | 4,757 |\n| Commercial mortgage nonowner-occupied loans: |\n| Pass | $ | 205 | 736 | 627 | 381 | 207 | 459 | 1,598 | — | 4,213 |\n| Special mention | 31 | 120 | 57 | 61 | 8 | — | 338 | — | 615 |\n| Substandard | 31 | 195 | 26 | 64 | 3 | 11 | 432 | — | 762 |\n| Doubtful | — | — | — | — | — | — | — | — | — |\n| Total commercial mortgage nonowner-occupied loans | $ | 267 | 1,051 | 710 | 506 | 218 | 470 | 2,368 | — | 5,590 |\n| Commercial construction loans: |\n| Pass | $ | 28 | 73 | 47 | 27 | — | 11 | 4,715 | — | 4,901 |\n| Special mention | — | 66 | — | — | — | — | 442 | — | 508 |\n| Substandard | 15 | — | — | — | — | — | 447 | — | 462 |\n| Doubtful | — | — | — | — | — | — | — | — | — |\n| Total commercial construction loans | $ | 43 | 139 | 47 | 27 | — | 11 | 5,604 | — | 5,871 |\n| Commercial leases: |\n| Pass | $ | 732 | 511 | 350 | 276 | 297 | 989 | — | — | 3,155 |\n| Special mention | 1 | 7 | 7 | 5 | — | 4 | — | — | 24 |\n| Substandard | 10 | 3 | 7 | 12 | 16 | 11 | — | — | 59 |\n| Doubtful | — | — | — | — | — | — | — | — | — |\n| Total commercial leases | $ | 743 | 521 | 364 | 293 | 313 | 1,004 | — | — | 3,238 |\n| Total commercial loans and leases: |\n| Pass | $ | 4,646 | 6,430 | 3,353 | 1,785 | 1,216 | 2,900 | 39,953 | — | 60,283 |\n| Special mention | 53 | 256 | 139 | 94 | 38 | 47 | 2,075 | — | 2,702 |\n| Substandard | 120 | 357 | 103 | 220 | 91 | 158 | 2,986 | — | 4,035 |\n| Doubtful | — | — | — | — | — | — | — | — | — |\n| Total commercial loans and leases | $ | 4,819 | 7,043 | 3,595 | 2,099 | 1,345 | 3,105 | 45,014 | — | 67,020 |\n\n87\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n| As of December 31, 2020 ($ in millions) | Term Loans and Leases by Origination Year | Revolving Loans | Revolving Loans Converted to Term Loans |\n| 2020 | 2019 | 2018 | 2017 | 2016 | Prior | Total |\n| Commercial and industrial loans: |\n| Pass | $ | 7,042 | 2,144 | 1,114 | 700 | 471 | 703 | 31,657 | — | 43,831 |\n| Special mention | 66 | 46 | 167 | 46 | 5 | 21 | 2,317 | — | 2,668 |\n| Substandard | 119 | 80 | 107 | 60 | 39 | 104 | 2,639 | — | 3,148 |\n| Doubtful | — | 2 | 9 | — | — | — | 7 | — | 18 |\n| Total commercial and industrial loans | $ | 7,227 | 2,272 | 1,397 | 806 | 515 | 828 | 36,620 | — | 49,665 |\n| Commercial mortgage owner-occupied loans: |\n| Pass | $ | 1,047 | 655 | 416 | 288 | 249 | 420 | 1,025 | — | 4,100 |\n| Special mention | 58 | 12 | 16 | 7 | 2 | 17 | 64 | — | 176 |\n| Substandard | 211 | 17 | 33 | 7 | 13 | 30 | 88 | — | 399 |\n| Doubtful | — | — | — | — | — | — | — | — | — |\n| Total commercial mortgage owner-occupied loans | $ | 1,316 | 684 | 465 | 302 | 264 | 467 | 1,177 | — | 4,675 |\n| Commercial mortgage nonowner-occupied loans: |\n| Pass | $ | 902 | 679 | 548 | 247 | 223 | 341 | 1,626 | — | 4,566 |\n| Special mention | 252 | 68 | 17 | 8 | 36 | 9 | 416 | — | 806 |\n| Substandard | 149 | 3 | 49 | 14 | 2 | 25 | 301 | — | 543 |\n| Doubtful | 12 | — | — | — | — | — | — | — | 12 |\n| Total commercial mortgage nonowner-occupied loans | $ | 1,315 | 750 | 614 | 269 | 261 | 375 | 2,343 | — | 5,927 |\n| Commercial construction loans: |\n| Pass | $ | 98 | 49 | 27 | — | 9 | 12 | 4,721 | — | 4,916 |\n| Special mention | 67 | — | — | — | — | — | 591 | — | 658 |\n| Substandard | 8 | — | — | — | — | — | 233 | — | 241 |\n| Doubtful | — | — | — | — | — | — | — | — | — |\n| Total commercial construction loans | $ | 173 | 49 | 27 | — | 9 | 12 | 5,545 | — | 5,815 |\n| Commercial leases: |\n| Pass | $ | 622 | 374 | 315 | 369 | 314 | 824 | — | — | 2,818 |\n| Special mention | 5 | 16 | 5 | — | — | — | — | — | 26 |\n| Substandard | 7 | 4 | 16 | 21 | 6 | 17 | — | — | 71 |\n| Doubtful | — | — | — | — | — | — | — | — | — |\n| Total commercial leases | $ | 634 | 394 | 336 | 390 | 320 | 841 | — | — | 2,915 |\n| Total commercial loans and leases: |\n| Pass | $ | 9,711 | 3,901 | 2,420 | 1,604 | 1,266 | 2,300 | 39,029 | — | 60,231 |\n| Special mention | 448 | 142 | 205 | 61 | 43 | 47 | 3,388 | — | 4,334 |\n| Substandard | 494 | 104 | 205 | 102 | 60 | 176 | 3,261 | — | 4,402 |\n| Doubtful | 12 | 2 | 9 | — | — | — | 7 | — | 30 |\n| Total commercial loans and leases | $ | 10,665 | 4,149 | 2,839 | 1,767 | 1,369 | 2,523 | 45,685 | — | 68,997 |\n\n88\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nAge Analysis of Past Due Commercial Loans and Leases\nThe following tables summarize the Bancorp’s amortized cost basis in portfolio commercial loans and leases, by age and class:\n| CurrentLoans andLeases(a) | Past Due | Total Loans and Leases | 90 Days PastDue and StillAccruing |\n| As of June 30, 2021 ($ in millions) | 30-89Days(a) | 90 Daysor More(a) | TotalPast Due |\n| Commercial loans and leases: |\n| Commercial and industrial loans | $ | 47,398 | 111 | 55 | 166 | 47,564 | 2 |\n| Commercial mortgage owner-occupied loans | 4,706 | 35 | 16 | 51 | 4,757 | 4 |\n| Commercial mortgage nonowner-occupied loans | 5,587 | 1 | 2 | 3 | 5,590 | — |\n| Commercial construction loans | 5,871 | — | — | — | 5,871 | — |\n| Commercial leases | 3,224 | 13 | 1 | 14 | 3,238 | — |\n| Total portfolio commercial loans and leases | $ | 66,786 | 160 | 74 | 234 | 67,020 | 6 |\n\n(a)Includes accrual and nonaccrual loans and leases.\n| CurrentLoans andLeases(a) | Past Due | Total Loans and Leases | 90 Days PastDue and StillAccruing |\n| As of December 31, 2020 ($ in millions) | 30-89Days(a) | 90 Daysor More(a) | TotalPast Due |\n| Commercial loans and leases: |\n| Commercial and industrial loans | $ | 49,421 | 119 | 125 | 244 | 49,665 | 39 |\n| Commercial mortgage owner-occupied loans | 4,645 | 7 | 23 | 30 | 4,675 | 7 |\n| Commercial mortgage nonowner-occupied loans | 5,860 | 31 | 36 | 67 | 5,927 | 1 |\n| Commercial construction loans | 5,808 | 7 | — | 7 | 5,815 | — |\n| Commercial leases | 2,906 | 7 | 2 | 9 | 2,915 | 1 |\n| Total portfolio commercial loans and leases | $ | 68,640 | 171 | 186 | 357 | 68,997 | 48 |\n\n(a)Includes accrual and nonaccrual loans and leases.\nResidential Mortgage and Consumer Portfolio Segments\nFor purposes of monitoring the credit quality and risk characteristics of its consumer portfolio segment, the Bancorp disaggregates the segment into the following classes: home equity, indirect secured consumer loans, credit card and other consumer loans. The Bancorp’s residential mortgage portfolio segment is also a separate class.\nThe Bancorp considers repayment performance as the best indicator of credit quality for residential mortgage and consumer loans, which includes both the delinquency status and performing versus nonperforming status of the loans. The delinquency status of all residential mortgage and consumer loans and the performing versus nonperforming status is presented in the following table. Refer to the nonaccrual loans and leases section of Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for additional delinquency and nonperforming information. Loans and leases which received payment deferrals or forbearances as part of the Bancorp’s COVID-19 customer relief programs are generally not reported as delinquent during the forbearance or deferral period if the loan or lease was less than 30 days past due at March 1, 2020 (the effective date of the COVID-19 national emergency declaration) unless the loan or lease subsequently becomes delinquent according to its modified terms. Refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for additional information.\nFor collectively evaluated loans in the consumer and residential mortgage portfolio segments, the Bancorp’s expected credit loss models primarily utilize the borrower’s FICO score and delinquency history in combination with macroeconomic conditions when estimating the probability of default. The estimates for loss severity are primarily based on collateral type and coverage levels and the susceptibility of those characteristics to changes in macroeconomic conditions. The expected balance at the estimated date of default is also particularly significant for portfolio classes which generally have longer terms (such as residential mortgage loans and home equity) and portfolio classes containing a high concentration of loans with revolving privileges (such as credit card and home equity). The estimate of the expected balance at the time of default considers expected prepayment and utilization rates where applicable, which are primarily based on macroeconomic conditions and the utilization history of similar borrowers under those economic conditions. Refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for additional information about the Bancorp’s process for developing these models and its process for estimating credit losses for periods beyond the reasonable and supportable forecast period.\n89\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following tables present the amortized cost basis of the Bancorp’s residential mortgage and consumer portfolio segments, by class and vintage, disaggregated by both age and performing versus nonperforming status:\n| As of June 30, 2021 ($ in millions) | Term Loans by Origination Year | Revolving Loans | Revolving Loans Converted to Term Loans |\n| 2021 | 2020 | 2019 | 2018 | 2017 | Prior | Total |\n| Residential mortgage loans: |\n| Performing: |\n| Current(a) | $ | 3,080 | 3,840 | 1,696 | 574 | 1,226 | 5,439 | — | — | 15,855 |\n| 30-89 days past due | 1 | 2 | 1 | — | 2 | 13 | — | — | 19 |\n| 90 days or more past due | — | 3 | 4 | 2 | 5 | 43 | — | — | 57 |\n| Total performing | 3,081 | 3,845 | 1,701 | 576 | 1,233 | 5,495 | — | — | 15,931 |\n| Nonperforming | — | — | — | 1 | 3 | 45 | — | — | 49 |\n| Total residential mortgage loans(b) | $ | 3,081 | 3,845 | 1,701 | 577 | 1,236 | 5,540 | — | — | 15,980 |\n| Home equity: |\n| Performing: |\n| Current | $ | 1 | 9 | 18 | 23 | 3 | 134 | 4,243 | 8 | 4,439 |\n| 30-89 days past due | — | — | — | — | — | 3 | 17 | — | 20 |\n| 90 days or more past due | — | — | — | — | — | 1 | — | — | 1 |\n| Total performing | 1 | 9 | 18 | 23 | 3 | 138 | 4,260 | 8 | 4,460 |\n| Nonperforming | — | — | — | — | — | 10 | 74 | 1 | 85 |\n| Total home equity | $ | 1 | 9 | 18 | 23 | 3 | 148 | 4,334 | 9 | 4,545 |\n| Indirect secured consumer loans: |\n| Performing: |\n| Current | $ | 4,691 | 5,268 | 2,930 | 1,252 | 593 | 337 | — | — | 15,071 |\n| 30-89 days past due | 5 | 17 | 20 | 15 | 7 | 4 | — | — | 68 |\n| 90 days or more past due | — | 1 | 1 | 1 | 1 | — | — | — | 4 |\n| Total performing | 4,696 | 5,286 | 2,951 | 1,268 | 601 | 341 | — | — | 15,143 |\n| Nonperforming | — | 29 | 6 | 7 | 4 | 3 | — | — | 49 |\n| Total indirect secured consumer loans | $ | 4,696 | 5,315 | 2,957 | 1,275 | 605 | 344 | — | — | 15,192 |\n| Credit card: |\n| Performing: |\n| Current | $ | — | — | — | — | — | — | 1,737 | — | 1,737 |\n| 30-89 days past due | — | — | — | — | — | — | 15 | — | 15 |\n| 90 days or more past due | — | — | — | — | — | — | 14 | — | 14 |\n| Total performing | — | — | — | — | — | — | 1,766 | — | 1,766 |\n| Nonperforming | — | — | — | — | — | — | 27 | — | 27 |\n| Total credit card | $ | — | — | — | — | — | — | 1,793 | — | 1,793 |\n| Other consumer loans: |\n| Performing: |\n| Current | $ | 451 | 702 | 382 | 371 | 138 | 57 | 936 | 1 | 3,038 |\n| 30-89 days past due | 1 | 2 | 3 | 2 | 1 | — | 2 | — | 11 |\n| 90 days or more past due | — | — | 1 | — | — | — | — | — | 1 |\n| Total performing | 452 | 704 | 386 | 373 | 139 | 57 | 938 | 1 | 3,050 |\n| Nonperforming | — | 1 | — | — | — | — | 1 | — | 2 |\n| Total other consumer loans | $ | 452 | 705 | 386 | 373 | 139 | 57 | 939 | 1 | 3,052 |\n| Total residential mortgage and consumer loans: |\n| Performing: |\n| Current | $ | 8,223 | 9,819 | 5,026 | 2,220 | 1,960 | 5,967 | 6,916 | 9 | 40,140 |\n| 30-89 days past due | 7 | 21 | 24 | 17 | 10 | 20 | 34 | — | 133 |\n| 90 days or more past due | — | 4 | 6 | 3 | 6 | 44 | 14 | — | 77 |\n| Total performing | 8,230 | 9,844 | 5,056 | 2,240 | 1,976 | 6,031 | 6,964 | 9 | 40,350 |\n| Nonperforming | — | 30 | 6 | 8 | 7 | 58 | 102 | 1 | 212 |\n| Total residential mortgage and consumer loans(b) | $ | 8,230 | 9,874 | 5,062 | 2,248 | 1,983 | 6,089 | 7,066 | 10 | 40,562 |\n\n(a)Information includes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. As of June 30, 2021, $ 65 of these loans were 30-89 days past due and $ 163 were 90 days or more past due. The Bancorp recognized an immaterial amount and $ 1 of losses during the three and six months ended June 30, 2021, respectively, due to claim denials and curtailments associated with these insured or guaranteed loans.\n(b)Excludes $ 151 of residential mortgage loans measured at fair value at June 30, 2021.\n90\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n| As of December 31, 2020 ($ in millions) | Term Loans by Origination Year | Revolving Loans | Revolving Loans Converted to Term Loans |\n| 2020 | 2019 | 2018 | 2017 | 2016 | Prior | Total |\n| Residential mortgage loans: |\n| Performing: |\n| Current(a) | $ | 4,006 | 2,128 | 827 | 1,635 | 2,301 | 4,719 | — | — | 15,616 |\n| 30-89 days past due | 1 | 1 | 3 | 3 | 1 | 12 | — | — | 21 |\n| 90 days or more past due | — | 6 | 2 | 7 | 7 | 48 | — | — | 70 |\n| Total performing | 4,007 | 2,135 | 832 | 1,645 | 2,309 | 4,779 | — | — | 15,707 |\n| Nonperforming | 1 | — | 2 | 2 | 3 | 52 | — | — | 60 |\n| Total residential mortgage loans(b) | $ | 4,008 | 2,135 | 834 | 1,647 | 2,312 | 4,831 | — | — | 15,767 |\n| Home equity: |\n| Performing: |\n| Current | $ | 11 | 24 | 30 | 4 | 2 | 153 | 4,825 | 10 | 5,059 |\n| 30-89 days past due | — | — | — | — | — | 3 | 33 | — | 36 |\n| 90 days or more past due | — | — | — | — | — | 2 | — | — | 2 |\n| Total performing | 11 | 24 | 30 | 4 | 2 | 158 | 4,858 | 10 | 5,097 |\n| Nonperforming | — | — | — | — | — | 10 | 75 | 1 | 86 |\n| Total home equity | $ | 11 | 24 | 30 | 4 | 2 | 168 | 4,933 | 11 | 5,183 |\n| Indirect secured consumer loans: |\n| Performing: |\n| Current | $ | 6,626 | 3,752 | 1,678 | 860 | 372 | 214 | — | — | 13,502 |\n| 30-89 days past due | 25 | 41 | 31 | 17 | 7 | 4 | — | — | 125 |\n| 90 days or more past due | 1 | 2 | 3 | 2 | 1 | 1 | — | — | 10 |\n| Total performing | 6,652 | 3,795 | 1,712 | 879 | 380 | 219 | — | — | 13,637 |\n| Nonperforming | 1 | 5 | 4 | 3 | 2 | 1 | — | — | 16 |\n| Total indirect secured consumer loans | $ | 6,653 | 3,800 | 1,716 | 882 | 382 | 220 | — | — | 13,653 |\n| Credit card: |\n| Performing: |\n| Current | $ | — | — | — | — | — | — | 1,914 | — | 1,914 |\n| 30-89 days past due | — | — | — | — | — | — | 30 | — | 30 |\n| 90 days or more past due | — | — | — | — | — | — | 31 | — | 31 |\n| Total performing | — | — | — | — | — | — | 1,975 | — | 1,975 |\n| Nonperforming | — | — | — | — | — | — | 32 | — | 32 |\n| Total credit card | $ | — | — | — | — | — | — | 2,007 | — | 2,007 |\n| Other consumer loans: |\n| Performing: |\n| Current | $ | 883 | 546 | 437 | 178 | 32 | 40 | 878 | 1 | 2,995 |\n| 30-89 days past due | 2 | 5 | 4 | 2 | — | — | 2 | — | 15 |\n| 90 days or more past due | — | 2 | — | — | — | — | — | — | 2 |\n| Total performing | 885 | 553 | 441 | 180 | 32 | 40 | 880 | 1 | 3,012 |\n| Nonperforming | — | — | — | — | — | 1 | 1 | — | 2 |\n| Total other consumer loans | $ | 885 | 553 | 441 | 180 | 32 | 41 | 881 | 1 | 3,014 |\n| Total residential mortgage and consumer loans: |\n| Performing: |\n| Current | $ | 11,526 | 6,450 | 2,972 | 2,677 | 2,707 | 5,126 | 7,617 | 11 | 39,086 |\n| 30-89 days past due | 28 | 47 | 38 | 22 | 8 | 19 | 65 | — | 227 |\n| 90 days or more past due | 1 | 10 | 5 | 9 | 8 | 51 | 31 | — | 115 |\n| Total performing | 11,555 | 6,507 | 3,015 | 2,708 | 2,723 | 5,196 | 7,713 | 11 | 39,428 |\n| Nonperforming | 2 | 5 | 6 | 5 | 5 | 64 | 108 | 1 | 196 |\n| Total residential mortgage and consumer loans(b) | $ | 11,557 | 6,512 | 3,021 | 2,713 | 2,728 | 5,260 | 7,821 | 12 | 39,624 |\n\n(a)Information includes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. As of December 31, 2020, $ 103 of these loans were 30-89 days past due and $ 242 were 90 days or more past due. The Bancorp recognized $ 1 and $ 2 of losses during the three and six months ended June 30, 2020, respectively, due to claim denials and curtailments associated with these insured or guaranteed loans.\n(b)Excludes $ 161 of residential mortgage loans measured at fair value at December 31, 2020.\n91\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nCollateral-Dependent Loans and Leases\nThe Bancorp considers a loan or lease to be collateral-dependent when the borrower is experiencing financial difficulty and repayment is expected to be provided substantially through the operation or sale of the collateral. When a loan or lease is collateral-dependent, its fair value is generally based on the fair value less cost to sell of the underlying collateral.\nThe following table presents the amortized cost basis of the Bancorp’s collateral-dependent loans and leases, by portfolio class, as of:\n| ($ in millions) | June 30,2021 | December 31,2020 |\n| Commercial loans and leases: |\n| Commercial and industrial loans | $ | 539 | 810 |\n| Commercial mortgage owner-occupied loans | 35 | 101 |\n| Commercial mortgage nonowner-occupied loans | 29 | 82 |\n| Commercial construction loans | 18 | 19 |\n| Commercial leases | 8 | 6 |\n| Total commercial loans and leases | $ | 629 | 1,018 |\n| Residential mortgage loans | 67 | 80 |\n| Consumer loans: |\n| Home equity | 65 | 71 |\n| Indirect secured consumer loans | 9 | 9 |\n| Total consumer loans | $ | 74 | 80 |\n| Total portfolio loans and leases | $ | 770 | 1,178 |\n\nNonperforming Assets\nNonperforming assets include nonaccrual loans and leases for which ultimate collectability of the full amount of the principal and/or interest is uncertain; restructured loans which have not yet met the requirements to be returned to accrual status; certain restructured consumer and residential mortgage loans which are 90 days past due based on the restructured terms unless the loan is both well-secured and in the process of collection; and certain other assets, including OREO and other repossessed property.\nThe following table presents the amortized cost basis of the Bancorp’s nonaccrual loans and leases, by class, and OREO and other repossessed property as of:\n| June 30, 2021 | December 31, 2020 |\n| ($ in millions) | With an ALLL | No RelatedALLL | Total | With an ALLL | No RelatedALLL | Total |\n| Commercial loans and leases: |\n| Commercial and industrial loans | $ | 181 | 167 | 348 | 213 | 260 | 473 |\n| Commercial mortgage owner-occupied loans | 11 | 17 | 28 | 20 | 60 | 80 |\n| Commercial mortgage nonowner-occupied loans | 23 | 1 | 24 | 34 | 43 | 77 |\n| Commercial construction loans | — | — | — | 1 | — | 1 |\n| Commercial leases | 6 | 3 | 9 | 6 | 1 | 7 |\n| Total nonaccrual portfolio commercial loans and leases | $ | 221 | 188 | 409 | 274 | 364 | 638 |\n| Residential mortgage loans | 3 | 46 | 49 | 11 | 49 | 60 |\n| Consumer loans: |\n| Home equity | 56 | 29 | 85 | 55 | 31 | 86 |\n| Indirect secured consumer loans | 42 | 7 | 49 | 8 | 8 | 16 |\n| Credit card | 27 | — | 27 | 32 | — | 32 |\n| Other consumer loans | 2 | — | 2 | 2 | — | 2 |\n| Total nonaccrual portfolio consumer loans | $ | 127 | 36 | 163 | 97 | 39 | 136 |\n| Total nonaccrual portfolio loans and leases(a)(b) | $ | 351 | 270 | 621 | 382 | 452 | 834 |\n| OREO and other repossessed property | — | 36 | 36 | — | 30 | 30 |\n| Total nonperforming portfolio assets(a)(b) | $ | 351 | 306 | 657 | 382 | 482 | 864 |\n\n(a)Excludes $ 13 and $ 5 of nonaccrual loans held for sale as of June 30, 2021 and December 31, 2020, respectively, and $ 27 and $ 1 of nonaccrual restructured loans held for sale as of June 30, 2021 and December 31, 2020, respectively.\n(b)Includes $ 26 and $ 29 of nonaccrual government insured commercial loans whose repayments are insured by the SBA as of June 30, 2021 and December 31, 2020, respectively, of which $ 13 and $ 17 are restructured nonaccrual government insured commercial loans as of June 30, 2021 and December 31, 2020, respectively.\n92\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following table presents the interest income recognized on the Bancorp’s nonaccrual loans and leases, by class:\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Commercial loans and leases: |\n| Commercial and industrial loans | $ | 4 | 3 | 9 | 4 |\n| Commercial mortgage owner-occupied loans | 2 | — | 7 | — |\n| Commercial mortgage nonowner-occupied loans | 2 | — | 2 | — |\n| Commercial leases | — | — | — | 1 |\n| Total nonaccrual portfolio commercial loans and leases | $ | 8 | 3 | 18 | 5 |\n| Residential mortgage loans | 6 | 7 | 13 | 15 |\n| Consumer loans: |\n| Home equity | 2 | 2 | 4 | 5 |\n| Indirect secured consumer loans | — | — | 1 | — |\n| Credit card | 1 | 1 | 2 | 2 |\n| Total nonaccrual portfolio consumer loans | $ | 3 | 3 | 7 | 7 |\n| Total nonaccrual portfolio loans and leases | $ | 17 | 13 | 38 | 27 |\n\nThe Bancorp’s amortized cost basis of consumer mortgage loans secured by residential real estate properties for which formal foreclosure proceedings are in process according to local requirements of the applicable jurisdiction was $ 118 million and $ 136 million as of June 30, 2021 and December 31, 2020, respectively.\nTroubled Debt Restructurings\nA loan is accounted for as a TDR if the Bancorp, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. TDRs include concessions granted under reorganization, arrangement or other provisions of the Federal Bankruptcy Act. Within each of the Bancorp’s loan classes, TDRs typically involve either a reduction of the stated interest rate of the loan, an extension of the loan’s maturity date with a stated rate lower than the current market rate for a new loan with similar risk, or in limited circumstances, a reduction of the principal balance of the loan or the loan’s accrued interest. Modifying the terms of a loan may result in an increase or decrease to the ALLL depending upon the terms modified, the method used to measure the ALLL for a loan prior to modification, the extent of collateral, and whether any charge-offs were recorded on the loan before or at the time of modification. Refer to the ALLL section of Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for information on the Bancorp’s ALLL methodology. Upon modification of a loan, the Bancorp measures the expected credit loss as either the difference between the amortized cost of the loan and the fair value of collateral less cost to sell or the difference between the estimated future cash flows expected to be collected on the modified loan, discounted at the original effective yield of the loan, and the carrying value of the loan. The resulting measurement may result in the need for minimal or no allowance regardless of which is used because it is probable that all cash flows will be collected under the modified terms of the loan. In addition, if the stated interest rate was increased in a TDR that is not collateral-dependent, the cash flows on the modified loan, using the pre-modification interest rate as the discount rate, often exceed the amortized cost basis of the loan. Conversely, upon a modification that reduces the stated interest rate on a loan that is not collateral-dependent, the Bancorp recognizes an increase to the ALLL. If a TDR involves a reduction of the principal balance of the loan or the loan’s accrued interest, that amount is charged off to the ALLL. Loans discharged in a Chapter 7 bankruptcy and not reaffirmed by the borrower are treated as nonaccrual collateral-dependent loans with a charge-off recognized to reduce the carrying values of such loans to the fair value of the related collateral less costs to sell. Certain loan modifications which were made in response to the COVID-19 pandemic were not evaluated for classification as a TDR. Refer to the Regulatory Developments Related to the COVID-19 Pandemic section of Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for additional information.\nThe Bancorp had commitments to lend additional funds to borrowers whose terms have been modified in a TDR, consisting of line of credit and letter of credit commitments of $ 41 million and $ 67 million, respectively, as of June 30, 2021 compared to $ 67 million and $ 72 million, respectively, as of December 31, 2020.\n93\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following tables provide a summary of portfolio loans, by class, modified in a TDR by the Bancorp during the three months ended:\n| June 30, 2021 ($ in millions) | Number of LoansModified in a TDRDuring the Period(a) | Amortized Cost Basisof Loans Modifiedin a TDRDuring the Period | Increaseto ALLL UponModification | Charge-offsRecognized Upon Modification |\n| Commercial loans: |\n| Commercial and industrial loans | 7 | $ | 25 | — | — |\n| Residential mortgage loans | 124 | 23 | 1 | — |\n| Consumer loans: |\n| Home equity | 39 | 2 | — | — |\n| Indirect secured consumer loans | 450 | 8 | — | — |\n| Credit card | 1,373 | 8 | 1 | — |\n| Total portfolio loans | 1,993 | $ | 66 | 2 | — |\n\n(a)Represents number of loans post-modification and excludes loans previously modified in a TDR.\n| June 30, 2020 ($ in millions) | Number of LoansModified in a TDRDuring the Period(a) | Amortized Cost Basisin Loans Modifiedin a TDRDuring the Period | Increase to ALLL Upon Modification | Charge-offsRecognized Upon Modification |\n| Commercial loans: |\n| Commercial and industrial loans | 33 | $ | 107 | 14 | — |\n| Commercial mortgage owner-occupied loans | 17 | 12 | — | — |\n| Commercial mortgage nonowner-occupied loans | 9 | 14 | — | — |\n| Commercial construction | 2 | 21 | 1 | — |\n| Residential mortgage loans | 109 | 13 | 1 | — |\n| Consumer loans: |\n| Home equity | 21 | 2 | — | — |\n| Indirect secured consumer loans | 20 | — | — | — |\n| Credit card | 973 | 5 | 2 | — |\n| Total portfolio loans | 1,184 | $ | 174 | 18 | — |\n\n(a)Represents number of loans post-modification and excludes loans previously modified in a TDR.\nThe following tables provide a summary of portfolio loans, by class, modified in a TDR by the Bancorp during the six months ended:\n| June 30, 2021 ($ in millions) | Number of LoansModified in a TDRDuring the Period(a) | Amortized Cost Basisof Loans Modifiedin a TDRDuring the Period | Increase (Decrease)to ALLL UponModification | Charge-offsRecognized Upon Modification |\n| Commercial loans: |\n| Commercial and industrial loans | 26 | $ | 31 | 1 | — |\n| Commercial mortgage owner-occupied loans | 1 | 4 | — | — |\n| Commercial mortgage nonowner-occupied loans | 3 | 25 | — | — |\n| Residential mortgage loans | 302 | 59 | 2 | — |\n| Consumer loans: |\n| Home equity | 97 | 5 | ( 1 ) | — |\n| Indirect secured consumer loans | 2,193 | 51 | 1 | — |\n| Credit card | 3,168 | 18 | 4 | — |\n| Total portfolio loans | 5,790 | $ | 193 | 7 | — |\n\n(a)Represents number of loans post-modification and excludes loans previously modified in a TDR.\n94\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n| June 30, 2020 ($ in millions) | Number of LoansModified in a TDRDuring the Period(a) | Recorded Investmentin Loans Modifiedin a TDRDuring the Period | Increase(Decrease)to ALLL UponModification | Charge-offsRecognized Upon Modification |\n| Commercial loans: |\n| Commercial and industrial loans | 63 | $ | 176 | 24 | — |\n| Commercial mortgage owner-occupied loans | 28 | 19 | — | — |\n| Commercial mortgage nonowner-occupied loans | 12 | 22 | — | — |\n| Commercial construction | 3 | 21 | 1 | — |\n| Residential mortgage loans | 293 | 37 | 1 | — |\n| Consumer loans: |\n| Home equity | 42 | 4 | ( 1 ) | — |\n| Indirect secured consumer loans | 42 | — | — | — |\n| Credit card | 2,857 | 15 | 6 | — |\n| Total portfolio loans | 3,340 | $ | 294 | 31 | — |\n\n(a)Represents number of loans post-modification and excludes loans previously modified in a TDR.\nThe Bancorp considers TDRs that become 90 days or more past due under the modified terms as subsequently defaulted. For commercial loans not subject to individual evaluation for an ALLL, the applicable commercial models are applied for purposes of determining the ALLL as well as qualitatively assessing whether those loans are reasonably expected to be further restructured prior to their maturity date and, if so, the impact such a restructuring would have on the remaining contractual life of the loans. When a residential mortgage, home equity, indirect secured consumer or other consumer loan that has been modified in a TDR subsequently defaults, the present value of expected cash flows used in the measurement of the expected credit loss is generally limited to the expected net proceeds from the sale of the loan’s underlying collateral and any resulting collateral shortfall is reflected as a charge-off or an increase in ALLL. The Bancorp recognizes an ALLL for the entire balance of the credit card loans modified in a TDR that subsequently default.\nThe following tables provide a summary of TDRs that subsequently defaulted during the three months ended June 30, 2021 and 2020 and were within 12 months of the restructuring date:\n| June 30, 2021 ($ in millions)(a) | Number ofContracts | AmortizedCost |\n| Commercial loans: |\n| Commercial and industrial loans | 1 | $ | — |\n| Residential mortgage loans | 16 | 2 |\n| Consumer loans: |\n| Home equity | 5 | — |\n| Indirect secured consumer loans | 32 | — |\n| Credit card | 11 | — |\n| Total portfolio loans | 65 | $ | 2 |\n\n(a)Excludes all loans held for sale and loans acquired with deteriorated credit quality which were accounted for within a pool.\n| June 30, 2020 ($ in millions)(a) | Number ofContracts | AmortizedCost |\n| Commercial loans: |\n| Commercial and industrial loans | 6 | $ | 4 |\n| Commercial mortgage owner-occupied loans | 5 | 1 |\n| Commercial mortgage nonowner-occupied loans | 1 | 4 |\n| Residential mortgage loans | 25 | 4 |\n| Consumer loans: |\n| Home equity | 2 | — |\n| Indirect secured consumer loans | 3 | — |\n| Credit card | 16 | — |\n| Total portfolio loans | 58 | $ | 13 |\n\n(a)Excludes all loans held for sale and loans acquired with deteriorated credit quality which were accounted for within a pool.\n95\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following tables provide a summary of TDRs that subsequently defaulted during the six months ended June 30, 2021 and 2020 and were within 12 months of the restructuring date:\n| June 30, 2021 ($ in millions)(a) | Number ofContracts | AmortizedCost |\n| Commercial loans: |\n| Commercial and industrial loans | 1 | $ | — |\n| Commercial mortgage nonowner-occupied loans | 1 | 25 |\n| Residential mortgage loans | 51 | 7 |\n| Consumer loans: |\n| Home equity | 17 | 1 |\n| Indirect secured consumer loans | 58 | 1 |\n| Credit card | 34 | — |\n| Total portfolio loans | 162 | $ | 34 |\n\n(a)Excludes all loans and leases held for sale and loans acquired with deteriorated credit quality which were accounted for within a pool.\n| June 30, 2020 ($ in millions)(a) | Number ofContracts | AmortizedCost |\n| Commercial loans: |\n| Commercial and industrial loans | 6 | $ | 4 |\n| Commercial mortgage owner-occupied loans | 7 | 2 |\n| Commercial mortgage nonowner-occupied loans | 2 | 9 |\n| Residential mortgage loans | 72 | 10 |\n| Consumer loans: |\n| Home equity | 3 | — |\n| Indirect secured consumer loans | 6 | — |\n| Credit card | 217 | 1 |\n| Total portfolio loans | 313 | $ | 26 |\n\n(a)Excludes all loans and leases held for sale and loans acquired with deteriorated credit quality which were accounted for within a pool.\n96\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n7. Bank Premises and Equipment\nThe following table provides a summary of bank premises and equipment as of:\n| ($ in millions) | June 30,2021 | December 31,2020 |\n| Equipment | $ | 2,348 | 2,302 |\n| Buildings(a) | 1,625 | 1,612 |\n| Land and improvements(a) | 641 | 636 |\n| Leasehold improvements | 472 | 467 |\n| Construction in progress(a) | 103 | 108 |\n| Bank premises and equipment held for sale: |\n| Land and improvements | 18 | 27 |\n| Buildings | 7 | 8 |\n| Accumulated depreciation and amortization | ( 3,141 ) | ( 3,072 ) |\n| Total bank premises and equipment | $ | 2,073 | 2,088 |\n\n(a)Buildings, land and improvements and construction in progress included $ 50 and $ 46 associated with parcels of undeveloped land intended for future branch expansion at June 30, 2021 and December 31, 2020, respectively.\nThe Bancorp monitors changing customer preferences associated with the channels it uses for banking transactions to evaluate the efficiency, competitiveness and quality of the customer service experience in its consumer distribution network. As part of this ongoing assessment, the Bancorp may determine that it is no longer fully committed to maintaining full-service banking centers at certain locations. Similarly, the Bancorp may also determine that it is no longer fully committed to building banking centers on certain parcels of land which had previously been held for future branch expansion. The Bancorp closed a total of 43 banking centers throughout its footprint during the six months ended June 30, 2021.\nThe Bancorp performs assessments of the recoverability of long-lived assets when events or changes in circumstances indicate that their carrying values may not be recoverable. Impairment losses associated with such assessments and lower of cost or market adjustments were $ 2 million and $ 12 million for the three months ended June 30, 2021 and 2020, respectively, and $ 4 million and $ 14 million for the six months ended June 30, 2021 and 2020, respectively. The recognized impairment losses were recorded in other noninterest income in the Condensed Consolidated Statements of Income.\n8. Operating Lease Equipment\nOperating lease equipment was $ 715 million and $ 777 million at June 30, 2021 and December 31, 2020, respectively, net of accumulated depreciation of $ 298 million and $ 290 million at June 30, 2021 and December 31, 2020, respectively. The Bancorp recorded lease income of $ 39 million relating to lease payments for operating leases in leasing business revenue in the Condensed Consolidated Statements of Income during both the three months ended June 30, 2021 and 2020, and $ 78 million during both the six months ended June 30, 2021 and 2020. Depreciation expense related to operating lease equipment was $ 31 million during both the three months ended June 30, 2021 and 2020, and $ 64 million and $ 63 million during the six months ended June 30, 2021 and 2020, respectively. The Bancorp received payments of $ 80 million related to operating leases during both the six months ended June 30, 2021 and 2020.\nThe Bancorp performs assessments of the recoverability of long-lived assets when events or changes in circumstances indicate that their carrying values may not be recoverable. As a result of these recoverability assessments, the Bancorp recognized an immaterial amount of impairment losses associated with operating lease assets for both the three months ended June 30, 2021 and 2020 and recognized $ 25 million and $ 3 million of impairment losses for the six months ended June 30, 2021 and 2020, respectively. The recognized impairment losses were recorded in leasing business revenue in the Condensed Consolidated Statements of Income.\nThe following table presents future lease payments receivable from operating leases for the remainder of 2021 through 2026 and thereafter:\n| As of June 30, 2021 ($ in millions) | Undiscounted Cash Flows |\n| Remainder of 2021 | $ | 73 |\n| 2022 | 129 |\n| 2023 | 102 |\n| 2024 | 65 |\n| 2025 | 42 |\n| 2026 | 26 |\n| Thereafter | 39 |\n| Total operating lease payments | $ | 476 |\n\n97\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n9. Lease Obligations – Lessee\nThe Bancorp leases certain banking centers, ATM sites, land for owned buildings and equipment. The Bancorp’s lease agreements typically do not contain any residual value guarantees or any material restrictive covenants. For more information on the accounting for lease obligations, refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\nThe following table provides a summary of lease assets and lease liabilities as of:\n| ($ in millions) | Condensed Consolidated Balance Sheets Caption | June 30,2021 | December 31,2020 |\n| Assets |\n| Operating lease right-of-use assets | Other assets | $ | 425 | 423 |\n| Finance lease right-of-use assets | Bank premises and equipment | 144 | 129 |\n| Total right-of-use assets(a) | $ | 569 | 552 |\n| Liabilities |\n| Operating lease liabilities | Accrued taxes, interest and expenses | $ | 523 | 527 |\n| Finance lease liabilities | Long-term debt | 146 | 130 |\n| Total lease liabilities | $ | 669 | 657 |\n\n(a) Operating and finance lease right-of-use assets are recorded net of accumulated amortization of $ 169 and $ 38 , respectively, as of June 30, 2021, and $ 152 and $ 29 , respectively, as of December 31, 2020.\nThe following table presents the components of lease costs:\n| ($ in millions) | Condensed Consolidated Statements of Income Caption | For the three months endedJune 30, | For the six months endedJune 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Lease costs: |\n| Amortization of ROU assets | Net occupancy and equipment expense | $ | 4 | 2 | 9 | 3 |\n| Interest on lease liabilities | Interest on long-term debt | 1 | — | 2 | 1 |\n| Total finance lease costs | $ | 5 | 2 | 11 | 4 |\n| Operating lease cost | Net occupancy expense | $ | 19 | 22 | 39 | 46 |\n| Short-term lease cost | Net occupancy expense | — | — | 1 | 1 |\n| Variable lease cost | Net occupancy expense | 8 | 7 | 16 | 14 |\n| Sublease income | Net occupancy expense | — | — | ( 1 ) | ( 1 ) |\n| Total operating lease costs | $ | 27 | 29 | 55 | 60 |\n| Total lease costs | $ | 32 | 31 | 66 | 64 |\n\nThe Bancorp performs impairment assessments for ROU assets when events or changes in circumstances indicate that their carrying values may not be recoverable. In addition to the lease costs disclosed in the table above, the Bancorp recognized $ 2 million and $ 3 million of impairment losses and termination charges for the ROU assets related to certain operating leases during the three months ended June 30, 2021 and 2020, respectively, and $ 2 million and $ 5 million during the six months ended June 30, 2021 and 2020, respectively. The recognized losses were recorded in net occupancy expense in the Condensed Consolidated Statements of Income.\nThe following table presents undiscounted cash flows payable for both operating leases and finance leases for the remainder of 2021 through 2026 and thereafter as well as a reconciliation of the undiscounted cash flows to the total lease liabilities as follows:\n| As of June 30, 2021 ($ in millions) | OperatingLeases | FinanceLeases | Total |\n| Remainder of 2021 | $ | 44 | 9 | 53 |\n| 2022 | 83 | 20 | 103 |\n| 2023 | 76 | 18 | 94 |\n| 2024 | 68 | 18 | 86 |\n| 2025 | 60 | 12 | 72 |\n| 2026 | 51 | 6 | 57 |\n| Thereafter | 220 | 100 | 320 |\n| Total undiscounted cash flows | $ | 602 | 183 | 785 |\n| Less: Difference between undiscounted cash flows and discounted cash flows | 79 | 37 | 116 |\n| Present value of lease liabilities | $ | 523 | 146 | 669 |\n\n98\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following table presents the weighted-average remaining lease term and weighted-average discount rate as of:\n| June 30,2021 | December 31,2020 |\n| Weighted-average remaining lease term (years): |\n| Operating leases | 9.09 | 9.06 |\n| Finance leases | 14.42 | 12.93 |\n| Weighted-average discount rate: |\n| Operating leases | 2.95 | % | 3.05 |\n| Finance leases | 2.58 | 2.39 |\n\nThe following table presents information related to lease transactions for the six months ended June 30:\n| ($ in millions) | 2021 | 2020 |\n| Cash paid for amounts included in the measurement of lease liabilities:(a) |\n| Operating cash flows from operating leases | $ | 44 | 47 |\n| Operating cash flows from finance leases | 2 | 1 |\n| Financing cash flows from finance leases | 9 | 2 |\n| Gains on sale-leaseback transactions | 2 | — |\n\n(a) The cash flows related to the short-term and variable lease payments are not included in the amounts in the table as they were not included in the measurement of lease liabilities.\n10. Intangible Assets\nIntangible assets consist of core deposit intangibles, customer relationships, operating leases, non-compete agreements, trade names and books of business. Intangible assets are amortized on either a straight-line or an accelerated basis over their estimated useful lives and, based on the type of intangible asset, the amortization expense may be recorded in either leasing business revenue or other noninterest expense in the Condensed Consolidated Statements of Income.\nThe details of the Bancorp’s intangible assets are shown in the following table:\n| ($ in millions) | Gross CarryingAmount | AccumulatedAmortization | Net CarryingAmount |\n| As of June 30, 2021 |\n| Core deposit intangibles | $ | 229 | ( 135 ) | 94 |\n| Customer relationships | 24 | ( 6 ) | 18 |\n| Operating leases | 14 | ( 11 ) | 3 |\n| Other | 3 | ( 1 ) | 2 |\n| Total intangible assets | $ | 270 | ( 153 ) | 117 |\n| As of December 31, 2020 |\n| Core deposit intangibles | $ | 229 | ( 116 ) | 113 |\n| Customer relationships | 24 | ( 5 ) | 19 |\n| Operating leases | 17 | ( 12 ) | 5 |\n| Other | 3 | ( 1 ) | 2 |\n| Total intangible assets | $ | 273 | ( 134 ) | 139 |\n\nAs of June 30, 2021, all of the Bancorp’s intangible assets were being amortized. Amortization expense recognized on intangible assets was $ 10 million and $ 13 million for the three months ended June 30, 2021 and 2020, respectively, and $ 22 million and $ 29 million for the six months ended June 30, 2021 and 2020, respectively. The Bancorp’s projections of amortization expense shown in the following table are based on existing asset balances as of June 30, 2021. Future amortization expense may vary from these projections.\nEstimated amortization expense for the remainder of 2021 through 2025 is as follows:\n| ($ in millions) | Total |\n| Remainder of 2021 | $ | 20 |\n| 2022 | 33 |\n| 2023 | 24 |\n| 2024 | 16 |\n| 2025 | 9 |\n\n99\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n11. Variable Interest Entities\nThe Bancorp, in the normal course of business, engages in a variety of activities that involve VIEs, which are legal entities that lack sufficient equity at risk to finance their activities without additional subordinated financial support or the equity investors of the entities as a group lack any of the characteristics of a controlling interest. The Bancorp evaluates its interest in certain entities to determine if these entities meet the definition of a VIE and whether the Bancorp is the primary beneficiary and should consolidate the entity based on the variable interests it held both at inception and when there is a change in circumstances that requires a reconsideration. If the Bancorp is determined to be the primary beneficiary of a VIE, it must account for the VIE as a consolidated subsidiary. If the Bancorp is determined not to be the primary beneficiary of a VIE but holds a variable interest in the entity, such variable interests are accounted for under the equity method of accounting or other accounting standards as appropriate.\nConsolidated VIEs\nThe Bancorp has consolidated VIEs related to certain automobile loan securitizations where it has determined that it is the primary beneficiary. The following table provides a summary of assets and liabilities carried on the Condensed Consolidated Balance Sheets for consolidated VIEs as of:\n| ($ in millions) | June 30,2021 | December 31,2020 |\n| Assets: |\n| Other short-term investments | $ | 33 | 55 |\n| Indirect secured consumer loans | 455 | 756 |\n| ALLL | ( 3 ) | ( 7 ) |\n| Other assets | 3 | 5 |\n| Total assets | $ | 488 | 809 |\n| Liabilities: |\n| Other liabilities | $ | 1 | 2 |\n| Long-term debt | 400 | 656 |\n| Total liabilities | $ | 401 | 658 |\n\nThe Bancorp has previously completed securitization transactions in which the Bancorp transferred certain consumer automobile loans to bankruptcy remote trusts which were also deemed to be VIEs. In each of these securitization transactions, the primary purposes of the VIEs were to issue asset-backed securities with varying levels of credit subordination and payment priority, as well as residual interests, and to provide the Bancorp with access to liquidity for its originated loans. The Bancorp retained residual interests in the VIEs and, therefore, has an obligation to absorb losses and a right to receive benefits from the VIEs that could potentially be significant to the VIEs. In addition, the Bancorp retained servicing rights for the underlying loans and, therefore, holds the power to direct the activities of the VIEs that most significantly impact the economic performance of the VIEs. As a result, the Bancorp concluded that it is the primary beneficiary of the VIEs and has consolidated these VIEs. The assets of the VIEs are restricted to the settlement of the asset-backed securities and other obligations of the VIEs. The third-party holders of the asset-backed notes do not have recourse to the general assets of the Bancorp.\nThe economic performance of the VIEs is most significantly impacted by the performance of the underlying loans. The principal risks to which the VIEs are exposed include credit risk and prepayment risk. The credit and prepayment risks are managed through credit enhancements in the form of reserve accounts, overcollateralization, excess interest on the loans and the subordination of certain classes of asset-backed securities to other classes.\nNon-consolidated VIEs\nThe following tables provide a summary of assets and liabilities carried on the Condensed Consolidated Balance Sheets related to non-consolidated VIEs for which the Bancorp holds an interest, but is not the primary beneficiary of the VIE, as well as the Bancorp’s maximum exposure to losses associated with its interests in the entities as of:\n| June 30, 2021 ($ in millions) | TotalAssets | TotalLiabilities | MaximumExposure |\n| CDC investments | $ | 1,668 | 519 | 1,668 |\n| Private equity investments | 117 | — | 208 |\n| Loans provided to VIEs | 2,872 | — | 4,268 |\n| Lease pool entities | 75 | — | 75 |\n\n100\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n| December 31, 2020 ($ in millions) | TotalAssets | TotalLiabilities | MaximumExposure |\n| CDC investments | $ | 1,546 | 478 | 1,546 |\n| Private equity investments | 117 | — | 200 |\n| Loans provided to VIEs | 2,420 | — | 3,649 |\n| Lease pool entities | 73 | — | 73 |\n\nCDC investments\nCDC, a wholly-owned indirect subsidiary of the Bancorp, was created to invest in projects to create affordable housing, revitalize business and residential areas and preserve historic landmarks. CDC generally co-invests with other unrelated companies and/or individuals and typically makes investments in a separate legal entity that owns the property under development. The entities are usually formed as limited partnerships and LLCs and CDC typically invests as a limited partner/investor member in the form of equity contributions. The economic performance of the VIEs is driven by the performance of their underlying investment projects as well as the VIEs’ ability to operate in compliance with the rules and regulations necessary for the qualification of tax credits generated by equity investments. The Bancorp has determined that it is not the primary beneficiary of these VIEs because it lacks the power to direct the activities that most significantly impact the economic performance of the underlying project or the VIEs’ ability to operate in compliance with the rules and regulations necessary for the qualification of tax credits generated by equity investments. This power is held by the managing members who exercise full and exclusive control of the operations of the VIEs. For information regarding the Bancorp’s accounting for these investments, refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\nThe Bancorp’s funding requirements are limited to its invested capital and any additional unfunded commitments for future equity contributions. The Bancorp’s maximum exposure to loss as a result of its involvement with the VIEs is limited to the carrying amounts of the investments, including the unfunded commitments. The carrying amounts of these investments, which are included in other assets in the Condensed Consolidated Balance Sheets, and the liabilities related to the unfunded commitments, which are included in other liabilities in the Condensed Consolidated Balance Sheets, are included in the previous tables for all periods presented. The Bancorp has no other liquidity arrangements or obligations to purchase assets of the VIEs that would expose the Bancorp to a loss. In certain arrangements, the general partner/managing member of the VIE has guaranteed a level of projected tax credits to be received by the limited partners/investor members, thereby minimizing a portion of the Bancorp’s risk.\nThe Bancorp’s CDC investments included $ 1.4 billion and $ 1.3 billion of investments in affordable housing tax credits recognized in other assets in the Condensed Consolidated Balance Sheets at June 30, 2021 and December 31, 2020, respectively. The unfunded commitments related to these investments were $ 514 million and $ 478 million at June 30, 2021 and December 31, 2020, respectively. The unfunded commitments as of June 30, 2021 are expected to be funded from 2021 to 2039 .\nThe Bancorp has accounted for all of its qualifying LIHTC investments using the proportional amortization method of accounting. The following table summarizes the impact to the Condensed Consolidated Statements of Income related to these investments:\n| Condensed ConsolidatedStatements of Income Caption(a) | For the three months ended June 30, | For the six months ended June 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Proportional amortization | Applicable income tax expense | $ | 43 | 27 | 87 | 32 |\n| Tax credits and other benefits | Applicable income tax expense | ( 50 ) | ( 32 ) | ( 101 ) | ( 37 ) |\n\n(a)The Bancorp did no t recognize impairment losses resulting from the forfeiture or ineligibility of tax credits or other circumstances during both the three and six months ended June 30, 2021 and 2020.\nPrivate equity investments\nThe Bancorp invests as a limited partner in private equity investments which provide the Bancorp an opportunity to obtain higher rates of return on invested capital, while also creating cross-selling opportunities for the Bancorp’s commercial products. Each of the limited partnerships has an unrelated third-party general partner responsible for appointing the fund manager. The Bancorp has not been appointed fund manager for any of these private equity investments. The funds finance primarily all of their activities from the partners’ capital contributions and investment returns. The Bancorp has determined that it is not the primary beneficiary of the funds because it does not have the obligation to absorb the funds’ expected losses or the right to receive the funds’ expected residual returns that could potentially be significant to the funds and lacks the power to direct the activities that most significantly impact the economic performance of the funds. The Bancorp, as a limited partner, does not have substantive participating or substantive kick-out rights over the general partner. Therefore, the Bancorp accounts for its investments in these limited partnerships under the equity method of accounting.\nThe Bancorp is exposed to losses arising from the negative performance of the underlying investments in the private equity investments. As a limited partner, the Bancorp’s maximum exposure to loss is limited to the carrying amounts of the investments plus unfunded commitments. The carrying amounts of these investments, which are included in other assets in the Condensed Consolidated Balance Sheets, are presented\n101\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nin previous tables. Also, at June 30, 2021 and December 31, 2020, the Bancorp’s unfunded commitment amounts to the private equity funds were $ 91 million and $ 83 million, respectively. As part of previous commitments, the Bancorp made capital contributions to private equity investments of $ 6 million and $ 1 million during the three months ended June 30, 2021 and 2020, respectively, and $ 7 million and $ 5 million during the six months ended June 30, 2021 and 2020, respectively.\nLoans provided to VIEs\nThe Bancorp has provided funding to certain unconsolidated VIEs sponsored by third parties. These VIEs are generally established to finance certain consumer and small business loans originated by third parties. The entities are primarily funded through the issuance of a loan from the Bancorp or a syndication through which the Bancorp is involved. The sponsor/administrator of the entities is responsible for servicing the underlying assets in the VIEs. Because the sponsor/administrator, not the Bancorp, holds the servicing responsibilities, which include the establishment and employment of default mitigation policies and procedures, the Bancorp does not hold the power to direct the activities that most significantly impact the economic performance of the entity and, therefore, is not the primary beneficiary.\nThe principal risk to which these entities are exposed is credit risk related to the underlying assets. The Bancorp’s maximum exposure to loss is equal to the carrying amounts of the loans and unfunded commitments to the VIEs. The Bancorp’s outstanding loans to these VIEs are included in commercial loans in Note 5. As of June 30, 2021 and December 31, 2020, the Bancorp’s unfunded commitments to these entities were $ 1.4 billion and $ 1.2 billion, respectively. The loans and unfunded commitments to these VIEs are included in the Bancorp’s overall analysis of the ALLL and reserve for unfunded commitments, respectively. The Bancorp does not provide any implicit or explicit liquidity guarantees or principal value guarantees to these VIEs.\nLease pool entities\nThe Bancorp is a co-investor with other unrelated leasing companies in three LLCs designed for the purpose of purchasing pools of residual interests in leases which have been originated or purchased by the other investing member. For each LLC, the leasing company is the managing member and has full authority over the day-to-day operations of the entity. While the Bancorp holds more than 50 % of the equity interests in each LLC, the operating agreements require both members to consent to significant corporate actions, such as liquidating the entity or removing the manager. In addition, the Bancorp has a preference with regards to distributions such that all of the Bancorp’s equity contribution for each pool must be distributed, plus a pre-defined rate of return, before the other member may receive distributions. The leasing company is also entitled to the return of its investment plus a pre-defined rate of return before any residual profits are distributed to the members.\nThe lease pool entities are primarily subject to risk of losses on the lease residuals purchased. The Bancorp has determined that it is not the primary beneficiary of these VIEs because it does not have the power to direct the activities that most significantly impact the economic performance of the entities. This power is held by the leasing company, who as managing member controls the servicing of the leases and collection of the proceeds on the residual interests.\n102\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n12. Sales of Receivables and Servicing Rights\nResidential Mortgage Loan Sales\nThe Bancorp sold fixed and adjustable-rate residential mortgage loans during the three and six months ended June 30, 2021 and 2020. In those sales, the Bancorp obtained servicing responsibilities and provided certain standard representations and warranties; however, the investors have no recourse to the Bancorp’s other assets for failure of debtors to pay when due. The Bancorp receives servicing fees based on a percentage of the outstanding balance. The Bancorp identifies classes of servicing assets based on financial asset type and interest rates.\nInformation related to residential mortgage loan sales and the Bancorp’s mortgage banking activity, which is included in mortgage banking net revenue in the Condensed Consolidated Statements of Income, is as follows:\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Residential mortgage loan sales(a) | $ | 4,416 | 3,063 | 7,626 | 6,018 |\n| Origination fees and gains on loan sales | 81 | 95 | 170 | 176 |\n| Gross mortgage servicing fees | 59 | 63 | 117 | 130 |\n\n(a)Represents the unpaid principal balance at the time of the sale.\nServicing Rights\nThe Bancorp measures all of its servicing rights at fair value with changes in fair value reported in mortgage banking net revenue in the Condensed Consolidated Statements of Income.\nThe following table presents changes in the servicing rights related to residential mortgage loans for the six months ended June 30:\n| ($ in millions) | 2021 | 2020 |\n| Balance, beginning of period | $ | 656 | 993 |\n| Servicing rights originated | 103 | 101 |\n| Servicing rights purchased | 109 | 30 |\n| Changes in fair value: |\n| Due to changes in inputs or assumptions(a) | 103 | ( 343 ) |\n| Other changes in fair value(b) | ( 153 ) | ( 105 ) |\n| Balance, end of period | $ | 818 | 676 |\n\n(a)Primarily reflects changes in prepayment speed and OAS assumptions which are updated based on market interest rates.\n(b)Primarily reflects changes due to realized cash flows and the passage of time.\nThe Bancorp maintains a non-qualifying hedging strategy to manage a portion of the risk associated with changes in the value of the MSR portfolio. This strategy may include the purchase of free-standing derivatives and various available-for-sale debt and trading debt securities. The interest income, mark-to-market adjustments and gain or loss from sale activities associated with these portfolios are expected to economically hedge a portion of the change in value of the MSR portfolio caused by fluctuating OAS, earnings rates and prepayment speeds. The fair value of the servicing asset is based on the present value of expected future cash flows.\nThe following table presents activity related to valuations of the MSR portfolio and the impact of the non-qualifying hedging strategy:\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Securities (losses) gains, net – non-qualifying hedges on mortgage servicing rights | $ | 1 | — | ( 1 ) | 3 |\n| Changes in fair value and settlement of free-standing derivatives purchased to economically hedge the MSR portfolio(a) | 46 | 11 | ( 88 ) | 361 |\n| MSR fair value adjustment due to changes in inputs or assumptions(a) | ( 49 ) | ( 12 ) | 103 | ( 343 ) |\n\n(a)Included in mortgage banking net revenue in the Condensed Consolidated Statements of Income.\n103\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe key economic assumptions used in measuring the servicing rights related to residential mortgage loans that continued to be held by the Bancorp at the date of sale, securitization or purchase resulting from transactions completed during the three months ended June 30, 2021 and 2020 were as follows:\n| June 30, 2021 | June 30, 2020 |\n| Weighted-Average Life(in years) | PrepaymentSpeed(annual) | OAS(bps) | Weighted-Average Life(in years) | PrepaymentSpeed(annual) | OAS(bps) |\n| Fixed-rate | 5.9 | 12.3 | % | 610 | 5.8 | 12.4 | % | 777 |\n| Adjustable-rate | — | — | — | 3.0 | 27.1 | 725 |\n\nBased on historical credit experience, expected credit losses for residential mortgage loan servicing rights have been deemed immaterial, as the Bancorp sold the majority of the underlying loans without recourse. At June 30, 2021 and December 31, 2020, the Bancorp serviced $ 71.5 billion and $ 68.8 billion, respectively, of residential mortgage loans for other investors. The value of MSRs that continue to be held by the Bancorp is subject to credit, prepayment and interest rate risks on the sold financial assets.\nAt June 30, 2021, the sensitivity of the current fair value of residual cash flows to immediate 10%, 20% and 50% adverse changes in prepayment speed assumptions and immediate 10% and 20% adverse changes in OAS for servicing rights related to residential mortgage loans are as follows:\n| PrepaymentSpeed Assumption | OASAssumption |\n| Fair Value($ in millions)(a) | Weighted-Average Life(in years) | Impact of Adverse Changeon Fair Value | OAS(bps) | Impact of Adverse Change on Fair Value |\n| Rate | 10% | 20% | 50% | 10% | 20% |\n| Fixed-rate | $ | 812 | 5.0 | 14.5 | % | $ | ( 29 ) | ( 55 ) | ( 125 ) | 542 | $ | ( 16 ) | ( 32 ) |\n| Adjustable-rate | 6 | 3.7 | 21.6 | — | ( 1 ) | ( 2 ) | 978 | — | — |\n\n(a)The impact of the weighted-average default rate on the current fair value of residual cash flows for all scenarios is immaterial.\nThese sensitivities are hypothetical and should be used with caution. As the figures indicate, changes in fair value based on these variations in the assumptions typically cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. The Bancorp believes that variations of these levels are reasonably possible; however, there is the potential that adverse changes in key assumptions could be even greater. Also, in the previous table, the effect of a variation in a particular assumption on the fair value of the interests that continue to be held by the Bancorp is calculated without changing any other assumption; in reality, changes in one factor may result in changes in another (for example, increases in market interest rates may result in lower prepayments), which might magnify or counteract these sensitivities.\n104\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n13. Derivative Financial Instruments\nThe Bancorp maintains an overall risk management strategy that incorporates the use of derivative instruments to reduce certain risks related to interest rate, prepayment and foreign currency volatility. Additionally, the Bancorp holds derivative instruments for the benefit of its commercial customers and for other business purposes. The Bancorp does not enter into unhedged speculative derivative positions.\nThe Bancorp’s interest rate risk management strategy involves modifying the repricing characteristics of certain financial instruments so that changes in interest rates do not adversely affect the Bancorp’s net interest margin and cash flows. Derivative instruments that the Bancorp may use as part of its interest rate risk management strategy include interest rate swaps, interest rate floors, interest rate caps, forward contracts, forward starting interest rate swaps, options, swaptions and TBA securities. Interest rate swap contracts are exchanges of interest payments, such as fixed-rate payments for floating-rate payments, based on a stated notional amount and maturity date. Interest rate floors protect against declining rates, while interest rate caps protect against rising interest rates. Forward contracts are contracts in which the buyer agrees to purchase, and the seller agrees to make delivery of, a specific financial instrument at a predetermined price or yield. Options provide the purchaser with the right, but not the obligation, to purchase or sell a contracted item during a specified period at an agreed-upon price. Swaptions are financial instruments granting the owner the right, but not the obligation, to enter into or cancel a swap.\nPrepayment volatility arises mostly from changes in fair value of the largely fixed-rate MSR portfolio, mortgage loans and mortgage-backed securities. The Bancorp may enter into various free-standing derivatives (principal-only swaps, interest rate swaptions, interest rate floors, mortgage options, TBA securities and interest rate swaps) to economically hedge prepayment volatility. Principal-only swaps are total return swaps based on changes in the value of the underlying mortgage principal-only trust. TBA securities are a forward purchase agreement for a mortgage-backed securities trade whereby the terms of the security are undefined at the time the trade is made.\nForeign currency volatility occurs as the Bancorp enters into certain loans denominated in foreign currencies. Derivative instruments that the Bancorp may use to economically hedge these foreign denominated loans include foreign exchange swaps and forward contracts.\nThe Bancorp also enters into derivative contracts (including foreign exchange contracts, commodity contracts and interest rate contracts) for the benefit of commercial customers and other business purposes. The Bancorp economically hedges significant exposures related to these free-standing derivatives by entering into offsetting third-party contracts with approved, reputable and independent counterparties with substantially matching terms and currencies. Credit risk arises from the possible inability of counterparties to meet the terms of their contracts. The Bancorp’s exposure is limited to the replacement value of the contracts rather than the notional, principal or contract amounts. Credit risk is minimized through credit approvals, limits, counterparty collateral and monitoring procedures.\nThe fair value of derivative instruments is presented on a gross basis, even when the derivative instruments are subject to master netting arrangements. Derivative instruments with a positive fair value are reported in other assets in the Condensed Consolidated Balance Sheets while derivative instruments with a negative fair value are reported in other liabilities in the Condensed Consolidated Balance Sheets. Cash collateral payables and receivables associated with the derivative instruments are not added to or netted against the fair value amounts with the exception of certain variation margin payments that are considered legal settlements of the derivative contracts. For derivative contracts cleared through certain central clearing parties who have modified their rules to treat variation margin payments as settlements, the variation margin payments are applied to net the fair value of the respective derivative contracts.\nThe Bancorp’s derivative assets include certain contractual features in which the Bancorp requires the counterparties to provide collateral in the form of cash and securities to offset changes in the fair value of the derivatives, including changes in the fair value due to credit risk of the counterparty. As of June 30, 2021 and December 31, 2020, the balance of collateral held by the Bancorp for derivative assets was $ 1.1 billion and $ 1.0 billion, respectively. For derivative contracts cleared through certain central clearing parties whose rules treat variation margin payments as settlement of the derivative contract, the payments for variation margin of $ 898 million and $ 1.1 billion were applied to reduce the respective derivative contracts and were also not included in the total amount of collateral held as of June 30, 2021 and December 31, 2020, respectively. As of June 30, 2021 and December 31, 2020, the credit component negatively impacting the fair value of derivative assets associated with customer accommodation contracts was $ 26 million and $ 42 million, respectively.\nIn measuring the fair value of derivative liabilities, the Bancorp considers its own credit risk, taking into consideration collateral maintenance requirements of certain derivative counterparties and the duration of instruments with counterparties that do not require collateral maintenance. When necessary, the Bancorp posts collateral primarily in the form of cash and securities to offset changes in fair value of the derivatives, including changes in fair value due to the Bancorp’s credit risk. As of June 30, 2021 and December 31, 2020, the balance of collateral posted by the Bancorp for derivative liabilities was $ 1.1 billion and $ 463 million, respectively. Additionally, as of June 30, 2021 and December 31, 2020, $ 768 million and $ 1.1 billion, respectively, of variation margin payments were applied to the respective derivative contracts to reduce the Bancorp’s derivative liabilities and were also not included in the total amount of collateral posted. Certain of the Bancorp’s derivative liabilities contain credit-risk related contingent features that could result in the requirement to post additional collateral upon the occurrence of specified events. As of both June 30, 2021 and December 31, 2020, the fair value of the additional collateral that could be required to be posted as a result of the credit-risk-related contingent features being triggered was immaterial to the Bancorp’s Condensed Consolidated Financial Statements. The posting of collateral has been determined to remove the need for further consideration of\n105\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\ncredit risk. As a result, the Bancorp determined that the impact of the Bancorp’s credit risk to the valuation of its derivative liabilities was immaterial to the Bancorp’s Condensed Consolidated Financial Statements.\nThe Bancorp holds certain derivative instruments that qualify for hedge accounting treatment and are designated as either fair value hedges or cash flow hedges. Derivative instruments that do not qualify for hedge accounting treatment, or for which hedge accounting is not established, are held as free-standing derivatives. All customer accommodation derivatives are held as free-standing derivatives.\nThe following tables reflect the notional amounts and fair values for all derivative instruments included in the Condensed Consolidated Balance Sheets as of:\n| Fair Value |\n| June 30, 2021 ($ in millions) | NotionalAmount | DerivativeAssets | DerivativeLiabilities |\n| Derivatives Designated as Qualifying Hedging Instruments: |\n| Fair value hedges: |\n| Interest rate swaps related to long-term debt | $ | 1,455 | 429 | — |\n| Total fair value hedges | 429 | — |\n| Cash flow hedges: |\n| Interest rate floors related to C&I loans | 3,000 | 183 | — |\n| Interest rate swaps related to C&I loans | 8,000 | — | 1 |\n| Total cash flow hedges | 183 | 1 |\n| Total derivatives designated as qualifying hedging instruments | 612 | 1 |\n| Derivatives Not Designated as Qualifying Hedging Instruments: |\n| Free-standing derivatives - risk management and other business purposes: |\n| Interest rate contracts related to MSR portfolio | 6,310 | 146 | — |\n| Forward contracts related to residential mortgage loans held for sale(b) | 3,395 | 1 | 8 |\n| Swap associated with the sale of Visa, Inc. Class B Shares | 3,836 | — | 213 |\n| Foreign exchange contracts | 208 | 5 | — |\n| Interest rate contracts for collateral management | 12,000 | 5 | 5 |\n| Interest rate contracts for LIBOR transition | 2,372 | — | — |\n| Total free-standing derivatives – risk management and other business purposes | 157 | 226 |\n| Free-standing derivatives – customer accommodation: |\n| Interest rate contracts(a) | 80,338 | 879 | 225 |\n| Interest rate lock commitments | 1,865 | 39 | — |\n| Commodity contracts | 10,369 | 1,240 | 1,209 |\n| TBA securities | 92 | — | — |\n| Foreign exchange contracts | 19,778 | 281 | 246 |\n| Total free-standing derivatives – customer accommodation | 2,439 | 1,680 |\n| Total derivatives not designated as qualifying hedging instruments | 2,596 | 1,906 |\n| Total | $ | 3,208 | 1,907 |\n\n(a)Derivative assets and liabilities are presented net of variation margin of $ 52 and $ 734 , respectively.\n(b)Includes forward sale and forward purchase contracts which are utilized to manage market risk on residential mortgage loans held for sale and the related interest rate lock commitments.\n106\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n| Fair Value |\n| December 31, 2020 ($ in millions) | NotionalAmount | DerivativeAssets | DerivativeLiabilities |\n| Derivatives Designated as Qualifying Hedging Instruments: |\n| Fair value hedges: |\n| Interest rate swaps related to long-term debt | $ | 1,955 | 528 | — |\n| Total fair value hedges | 528 | — |\n| Cash flow hedges: |\n| Interest rate floors related to C&I loans | 3,000 | 244 | — |\n| Interest rate swaps related to C&I loans | 8,000 | 16 | 2 |\n| Total cash flow hedges | 260 | 2 |\n| Total derivatives designated as qualifying hedging instruments | 788 | 2 |\n| Derivatives Not Designated as Qualifying Hedging Instruments: |\n| Free-standing derivatives – risk management and other business purposes: |\n| Interest rate contracts related to MSR portfolio | 6,910 | 202 | 1 |\n| Forward contracts related to residential mortgage loans held for sale | 2,903 | 1 | 16 |\n| Swap associated with the sale of Visa, Inc. Class B Shares | 3,588 | — | 201 |\n| Foreign exchange contracts | 204 | — | 3 |\n| Interest rate contracts for collateral management | 12,000 | 3 | 1 |\n| Interest rate contracts for LIBOR transition | 2,372 | — | — |\n| Total free-standing derivatives – risk management and other business purposes | 206 | 222 |\n| Free-standing derivatives – customer accommodation: |\n| Interest rate contracts(a) | 77,806 | 1,238 | 265 |\n| Interest rate lock commitments | 1,830 | 57 | — |\n| Commodity contracts | 7,762 | 375 | 359 |\n| Foreign exchange contracts | 14,587 | 255 | 224 |\n| Total free-standing derivatives – customer accommodation | 1,925 | 848 |\n| Total derivatives not designated as qualifying hedging instruments | 2,131 | 1,070 |\n| Total | $ | 2,919 | 1,072 |\n\n(a)Derivative assets and liabilities are presented net of variation margin of $ 47 and $ 1,063 , respectively.\nFair Value Hedges\nThe Bancorp may enter into interest rate swaps to convert its fixed-rate funding to floating-rate. Decisions to convert fixed-rate funding to floating are made primarily through consideration of the asset/liability mix of the Bancorp, the desired asset/liability sensitivity and interest rate levels. As of June 30, 2021, certain interest rate swaps met the criteria required to qualify for the shortcut method of accounting that permits the assumption of perfect offset. For all designated fair value hedges of interest rate risk as of June 30, 2021 that were not accounted for under the shortcut method of accounting, the Bancorp performed an assessment of hedge effectiveness using regression analysis with changes in the fair value of the derivative instrument and changes in the fair value of the hedged asset or liability attributable to the hedged risk recorded in the same income statement line in current period net income.\nThe following table reflects the change in fair value of interest rate contracts, designated as fair value hedges, as well as the change in fair value of the related hedged items attributable to the risk being hedged, included in the Condensed Consolidated Statements of Income:\n| Condensed ConsolidatedStatements ofIncome Caption | For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Change in fair value of interest rate swaps hedging long- term debt | Interest on long-term debt | $ | 46 | ( 1 ) | ( 99 ) | 226 |\n| Change in fair value of hedged long-term debt attributable to the risk being hedged | Interest on long-term debt | ( 46 ) | 2 | 99 | ( 225 ) |\n\n107\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following amounts were recorded in the Condensed Consolidated Balance Sheets related to cumulative basis adjustments for fair value hedges as of:\n| ($ in millions) | Condensed ConsolidatedBalance Sheets Caption | June 30,2021 | December 31,2020 |\n| Carrying amount of the hedged items | Long-term debt | $ | 1,879 | 2,478 |\n| Cumulative amount of fair value hedging adjustments included in the carrying amount of the hedged items | Long-term debt | 435 | 534 |\n\nCash Flow Hedges\nThe Bancorp may enter into interest rate swaps to convert floating-rate assets and liabilities to fixed rates or to hedge certain forecasted transactions for the variability in cash flows attributable to the contractually specified interest rate. The assets or liabilities may be grouped in circumstances where they share the same risk exposure that the Bancorp desires to hedge. The Bancorp may also enter into interest rate caps and floors to limit cash flow variability of floating-rate assets and liabilities. As of June 30, 2021, all hedges designated as cash flow hedges were assessed for effectiveness using regression analysis. The entire change in the fair value of the interest rate swap included in the assessment of hedge effectiveness is recorded in AOCI and reclassified from AOCI to current period earnings when the hedged item affects earnings. As of June 30, 2021, the maximum length of time over which the Bancorp is hedging its exposure to the variability in future cash flows is 42 months.\nReclassified gains and losses on interest rate contracts related to commercial and industrial loans are recorded within interest income in the Condensed Consolidated Statements of Income. As of June 30, 2021 and December 31, 2020, $ 548 million and $ 718 million, respectively, of net deferred gains, net of tax, on cash flow hedges were recorded in AOCI in the Condensed Consolidated Balance Sheets. As of June 30, 2021, $ 213 million in net unrealized gains, net of tax, recorded in AOCI are expected to be reclassified into earnings during the next 12 months. This amount could differ from amounts actually recognized due to changes in interest rates, hedge de-designations or the addition of other hedges subsequent to June 30, 2021.\nDuring both the three and six months ended June 30, 2021 and 2020, there were no gains or losses reclassified from AOCI into earnings associated with the discontinuance of cash flow hedges because it was probable that the original forecasted transaction would no longer occur by the end of the originally specified time period or within the additional period of time as defined by U.S. GAAP.\nThe following table presents the pre-tax net (losses) gains recorded in the Condensed Consolidated Statements of Income and in the Condensed Consolidated Statements of Comprehensive Income relating to derivative instruments designated as cash flow hedges:\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Amount of pre-tax net (losses) gains recognized in OCI | $ | 11 | 83 | ( 70 ) | 624 |\n| Amount of pre-tax net gains reclassified from OCI into net income | 73 | 62 | 146 | 94 |\n\nFree-Standing Derivative Instruments – Risk Management and Other Business Purposes\nAs part of its overall risk management strategy relative to its mortgage banking activity, the Bancorp may enter into various free-standing derivatives (principal-only swaps, interest rate swaptions, interest rate floors, mortgage options, TBA securities and interest rate swaps) to economically hedge changes in fair value of its largely fixed-rate MSR portfolio. Principal-only swaps hedge the spread between mortgage rates and LIBOR because these swaps appreciate in value as a result of tightening spreads. Principal-only swaps also provide prepayment protection by increasing in value when prepayment speeds increase, as opposed to MSRs that lose value in a faster prepayment environment. Receive fixed/pay floating interest rate swaps and swaptions increase in value when interest rates do not increase as quickly as expected.\nThe Bancorp enters into forward contracts and mortgage options to economically hedge the change in fair value of certain residential mortgage loans held for sale due to changes in interest rates. IRLCs issued on residential mortgage loan commitments that will be held for sale are also considered free-standing derivative instruments and the interest rate exposure on these commitments is economically hedged primarily with forward contracts. Revaluation gains and losses from free-standing derivatives related to mortgage banking activity are recorded as a component of mortgage banking net revenue in the Condensed Consolidated Statements of Income.\nIn conjunction with the sale of Visa, Inc. Class B Shares in 2009, the Bancorp entered into a total return swap in which the Bancorp will make or receive payments based on subsequent changes in the conversion rate of the Class B Shares into Class A Shares. This total return swap is accounted for as a free-standing derivative. Refer to Note 21 for further discussion of significant inputs and assumptions used in the valuation of this instrument.\nThe Bancorp entered into certain interest rate swap contracts for the purpose of managing its collateral positions across two central clearing parties. These interest rate swaps were perfectly offsetting positions that allowed the Bancorp to lower the cash posted as required initial\n108\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nmargin at the clearing parties, which reduced its credit exposure to the clearing parties. Given that all relevant terms for these interest rate swaps are offsetting, these trades create no additional market risk for the Bancorp.\nAs part of the LIBOR to SOFR transition, the Bancorp received certain interest rate swap contracts from the two central clearing parties that are moving from an Effective Federal Funds Rate discounting curve to a SOFR discounting curve. The purpose of these interest rate swaps was to neutralize the impact on collateral requirements due to the change in discounting curves implemented by the central clearing parties.\nThe net gains (losses) recorded in the Condensed Consolidated Statements of Income relating to free-standing derivative instruments used for risk management and other business purposes are summarized in the following table:\n| Condensed ConsolidatedStatements ofIncome Caption | For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Interest rate contracts: |\n| Forward contracts related to residential mortgage loans held for sale | Mortgage banking net revenue | $ | ( 58 ) | 47 | 9 | ( 11 ) |\n| Interest rate contracts related to MSR portfolio | Mortgage banking net revenue | 46 | 11 | ( 88 ) | 361 |\n| Foreign exchange contracts: |\n| Foreign exchange contracts for risk management purposes | Other noninterest income | ( 3 ) | ( 6 ) | ( 5 ) | 8 |\n| Equity contracts: |\n| Swap associated with sale of Visa, Inc. Class B Shares | Other noninterest income | ( 37 ) | ( 29 ) | ( 50 ) | ( 51 ) |\n\nFree-Standing Derivative Instruments – Customer Accommodation\nThe majority of the free-standing derivative instruments the Bancorp enters into are for the benefit of its commercial customers. These derivative contracts are not designated against specific assets or liabilities on the Condensed Consolidated Balance Sheets or to forecasted transactions and, therefore, do not qualify for hedge accounting. These instruments include foreign exchange derivative contracts entered into for the benefit of commercial customers involved in international trade to hedge their exposure to foreign currency fluctuations and commodity contracts to hedge such items as natural gas and various other derivative contracts. The Bancorp may economically hedge significant exposures related to these derivative contracts entered into for the benefit of customers by entering into offsetting contracts with approved, reputable, independent counterparties with substantially matching terms. The Bancorp hedges its interest rate exposure on commercial customer transactions by executing offsetting swap agreements with primary dealers. Revaluation gains and losses on interest rate, foreign exchange, commodity and other commercial customer derivative contracts are recorded as a component of commercial banking revenue or other noninterest income in the Condensed Consolidated Statements of Income.\nThe Bancorp enters into risk participation agreements, under which the Bancorp assumes credit exposure relating to certain underlying interest rate derivative contracts. The Bancorp only enters into these risk participation agreements in instances in which the Bancorp has participated in the loan that the underlying interest rate derivative contract was designed to hedge. The Bancorp will make payments under these agreements if a customer defaults on its obligation to perform under the terms of the underlying interest rate derivative contract. The total notional amount of the risk participation agreements was $ 3.4 billion at both June 30, 2021 and December 31, 2020 and the fair value was a liability of $ 8 million at both June 30, 2021 and December 31, 2020, which is included in other liabilities in the Condensed Consolidated Balance Sheets. As of June 30, 2021, the risk participation agreements had a weighted-average remaining life of 3.2 years.\nThe Bancorp’s maximum exposure in the risk participation agreements is contingent on the fair value of the underlying interest rate derivative contracts in an asset position at the time of default. The Bancorp monitors the credit risk associated with the underlying customers in the risk participation agreements through the same risk grading system currently utilized for establishing loss reserves in its loan and lease portfolio.\nRisk ratings of the notional amount of risk participation agreements under this risk rating system are summarized in the following table as of:\n| ($ in millions) | June 30,2021 | December 31,2020 |\n| Pass | $ | 3,385 | 3,231 |\n| Special mention | 14 | 113 |\n| Substandard | 49 | 52 |\n| Total | $ | 3,448 | 3,396 |\n\n109\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe net gains (losses) recorded in the Condensed Consolidated Statements of Income relating to free-standing derivative instruments used for customer accommodation are summarized in the following table:\n| Condensed ConsolidatedStatements of Income Caption | For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Interest rate contracts: |\n| Interest rate contracts for customers (contract revenue) | Commercial banking revenue | $ | 12 | 12 | 19 | 26 |\n| Interest rate contracts for customers (credit portion of fair value adjustment) | Other noninterest expense | 1 | ( 1 ) | 16 | ( 34 ) |\n| Interest rate lock commitments | Mortgage banking net revenue | 57 | 82 | 89 | 182 |\n| Commodity contracts: |\n| Commodity contracts for customers (contract revenue) | Commercial banking revenue | 6 | 4 | 11 | 7 |\n| Commodity contracts for customers (credit portion of fair value adjustment) | Other noninterest expense | ( 1 ) | — | — | ( 1 ) |\n| Commodity contracts for customers (credit losses) | Other noninterest expense | — | ( 1 ) | — | ( 1 ) |\n| Foreign exchange contracts: |\n| Foreign exchange contracts for customers (contract revenue) | Commercial banking revenue | 16 | 14 | 30 | 26 |\n| Foreign exchange contracts for customers (contract revenue) | Other noninterest income | ( 2 ) | ( 3 ) | ( 1 ) | 3 |\n| Foreign exchange contracts for customers (credit portion of fair value adjustment) | Other noninterest expense | — | 1 | — | ( 1 ) |\n\nOffsetting Derivative Financial Instruments\nThe Bancorp’s derivative transactions are generally governed by ISDA Master Agreements and similar arrangements, which include provisions governing the setoff of assets and liabilities between the parties. When the Bancorp has more than one outstanding derivative transaction with a single counterparty, the setoff provisions contained within these agreements generally allow the non-defaulting party the right to reduce its liability to the defaulting party by amounts eligible for setoff, including the collateral received as well as eligible offsetting transactions with that counterparty, irrespective of the currency, place of payment or booking office. The Bancorp’s policy is to present its derivative assets and derivative liabilities on the Condensed Consolidated Balance Sheets on a gross basis, even when provisions allowing for setoff are in place. However, for derivative contracts cleared through certain central clearing parties who have modified their rules to treat variation margin payments as settlements, the fair value of the respective derivative contracts is reported net of the variation margin payments.\nCollateral amounts included in the tables below consist primarily of cash and highly rated government-backed securities and do not include variation margin payments for derivative contracts with legal rights of setoff for both periods shown.\nThe following tables provide a summary of offsetting derivative financial instruments:\n| Gross AmountRecognized in theCondensed ConsolidatedBalance Sheets(a) | Gross Amounts Not Offset in theCondensed Consolidated Balance Sheets |\n| Derivatives | Collateral(b) | Net Amount |\n| As of June 30, 2021 |\n| Derivative assets | $ | 3,169 | ( 742 ) | ( 632 ) | 1,795 |\n| Derivative liabilities | 1,907 | ( 742 ) | ( 811 ) | 354 |\n| As of December 31, 2020 |\n| Derivative assets | $ | 2,862 | ( 621 ) | ( 755 ) | 1,486 |\n| Derivative liabilities | 1,072 | ( 621 ) | ( 221 ) | 230 |\n\n(a)Amount does not include IRLCs because these instruments are not subject to master netting or similar arrangements.\n(b)Amount of collateral received as an offset to asset positions or pledged as an offset to liability positions. Collateral values in excess of related derivative amounts recognized in the Condensed Consolidated Balance Sheets were excluded from this table.\n110\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n14. Other Short-Term Borrowings\nBorrowings with original maturities of one year or less are classified as short-term. The following table presents a summary of the Bancorp’s other short-term borrowings as of:\n| ($ in millions) | June 30,2021 | December 31,2020 |\n| Securities sold under repurchase agreements | $ | 533 | 679 |\n| Derivative collateral | 596 | 474 |\n| Other secured borrowings | 1 | 39 |\n| Total other short-term borrowings | $ | 1,130 | 1,192 |\n\nThe Bancorp’s securities sold under repurchase agreements are accounted for as secured borrowings and are collateralized by securities included in available-for-sale debt and other securities in the Condensed Consolidated Balance Sheets. These securities are subject to changes in market value and, therefore, the Bancorp may increase or decrease the level of securities pledged as collateral based upon these movements in market value. As of both June 30, 2021 and December 31, 2020, all securities sold under repurchase agreements were secured by agency residential mortgage-backed securities and the repurchase agreements had an overnight remaining contractual maturity.\nThe Bancorp’s other secured borrowings at December 31, 2020 primarily included obligations recognized by the Bancorp under ASC Topic 860 related to certain loans sold to GNMA and serviced by the Bancorp. Under ASC Topic 860, once the Bancorp has the unilateral right to repurchase the GNMA loans due to the borrower missing three consecutive payments, the Bancorp is considered to have regained effective control over the loan. As such, the Bancorp is required to recognize both the loan and the repurchase liability, regardless of the intent to repurchase the loans. The Bancorp repurchased these loans during the second quarter of 2021.\n15. Capital Actions\nAccelerated Share Repurchase Transactions\nDuring the six months ended June 30, 2021, the Bancorp entered into and settled accelerated share repurchase transactions. As part of these transactions, the Bancorp entered into forward contracts in which the final number of shares delivered at settlement was based generally on a discount to the average daily volume weighted-average price of the Bancorp’s common stock during the term of these repurchase agreements. The accelerated share repurchases were treated as two separate transactions, (i) the repurchase of treasury shares on the repurchase date and (ii) a forward contract indexed to the Bancorp’s common stock.\nThe following table presents a summary of the Bancorp’s accelerated share repurchase transactions that were entered into and settled during the six months ended June 30, 2021:\n| Repurchase Date | Amount ($ in millions) | Shares Repurchased on Repurchase Date | Shares Received from Forward Contract Settlement | Total Shares Repurchased | Final Settlement Date |\n| January 26, 2021 | $ | 180 | 4,951,456 | 366,939 | 5,318,395 | March 31, 2021 |\n| April 23, 2021 | 347 | 7,894,807 | 675,295 | 8,570,102 | June 11, 2021 |\n\nFor further information on a subsequent event related to capital actions, refer to Note 23.\n111\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n16. Commitments, Contingent Liabilities and Guarantees\nThe Bancorp, in the normal course of business, enters into financial instruments and various agreements to meet the financing needs of its customers. The Bancorp also enters into certain transactions and agreements to manage its interest rate and prepayment risks, provide funding, equipment and locations for its operations and invest in its communities. These instruments and agreements involve, to varying degrees, elements of credit risk, counterparty risk and market risk in excess of the amounts recognized in the Condensed Consolidated Balance Sheets. The creditworthiness of counterparties for all instruments and agreements is evaluated on a case-by-case basis in accordance with the Bancorp’s credit policies. The Bancorp’s significant commitments, contingent liabilities and guarantees in excess of the amounts recognized in the Condensed Consolidated Balance Sheets are discussed in the following sections.\nCommitments\nThe Bancorp has certain commitments to make future payments under contracts. The following table reflects a summary of significant commitments as of:\n| ($ in millions) | June 30,2021 | December 31,2020 |\n| Commitments to extend credit | $ | 77,081 | 74,499 |\n| Forward contracts related to residential mortgage loans held for sale | 3,395 | 2,903 |\n| Letters of credit | 1,858 | 1,982 |\n| Purchase obligations | 161 | 195 |\n| Capital expenditures | 93 | 75 |\n| Capital commitments for private equity investments | 91 | 83 |\n\nCommitments to extend credit\nCommitments to extend credit are agreements to lend, typically having fixed expiration dates or other termination clauses that may require payment of a fee. Since many of the commitments to extend credit may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash flow requirements. The Bancorp is exposed to credit risk in the event of nonperformance by the counterparty for the amount of the contract. Fixed-rate commitments are also subject to market risk resulting from fluctuations in interest rates and the Bancorp’s exposure is limited to the replacement value of those commitments. As of June 30, 2021 and December 31, 2020, the Bancorp had a reserve for unfunded commitments, including letters of credit, totaling $ 189 million and $ 172 million, respectively, included in other liabilities in the Condensed Consolidated Balance Sheets. The Bancorp monitors the credit risk associated with commitments to extend credit using the same standard regulatory risk rating systems utilized for its loan and lease portfolio.\nRisk ratings of outstanding commitments to extend credit under this risk rating system are summarized in the following table as of:\n| ($ in millions) | June 30,2021 | December 31,2020 |\n| Pass | $ | 74,230 | 71,386 |\n| Special mention | 1,468 | 2,049 |\n| Substandard | 1,383 | 1,063 |\n| Doubtful | — | 1 |\n| Total commitments to extend credit | $ | 77,081 | 74,499 |\n\nLetters of credit\nStandby and commercial letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party and expire as summarized in the following table as of June 30, 2021:\n| ($ in millions) |\n| Less than 1 year(a) | $ | 999 |\n| 1 - 5 years(a) | 856 |\n| Over 5 years | 3 |\n| Total letters of credit | $ | 1,858 |\n\n(a)Includes $ 14 and $ 3 issued on behalf of commercial customers to facilitate trade payments in U.S. dollars and foreign currencies which expire less than 1 year and between 1 -5 years, respectively.\nStandby letters of credit accounted for approximately 99 % of total letters of credit at both June 30, 2021 and December 31, 2020, and are considered guarantees in accordance with U.S. GAAP. Approximately 72 % and 68 % of the total standby letters of credit were collateralized as of June 30, 2021 and December 31, 2020, respectively. In the event of nonperformance by the customers, the Bancorp has rights to the underlying collateral, which can include commercial real estate, physical plant and property, inventory, receivables, cash and marketable securities. The reserve related to these standby letters of credit, which was included in the total reserve for unfunded commitments, was $ 25\n112\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nmillion and $ 27 million at June 30, 2021 and December 31, 2020, respectively. The Bancorp monitors the credit risk associated with letters of credit using the same standard regulatory risk rating systems utilized for its loan and lease portfolio.\nRisk ratings of outstanding letters of credit under this risk rating system are summarized in the following table as of:\n| ($ in millions) | June 30,2021 | December 31,2020 |\n| Pass | $ | 1,632 | 1,739 |\n| Special mention | 66 | 111 |\n| Substandard | 160 | 132 |\n| Total letters of credit | $ | 1,858 | 1,982 |\n\nAt June 30, 2021 and December 31, 2020, the Bancorp had outstanding letters of credit that were supporting certain securities issued as VRDNs. The Bancorp facilitates financing for its commercial customers, which consist of companies and municipalities, by marketing the VRDNs to investors. The VRDNs pay interest to holders at a rate of interest that fluctuates based upon market demand. The VRDNs generally have long-term maturity dates, but can be tendered by the holder for purchase at par value upon proper advance notice. When the VRDNs are tendered, a remarketing agent generally finds another investor to purchase the VRDNs to keep the securities outstanding in the market. As of June 30, 2021 and December 31, 2020, total VRDNs in which the Bancorp was the remarketing agent or that were supported by a Bancorp letter of credit were $ 485 million and $ 385 million, respectively, of which FTS acted as the remarketing agent to issuers on $ 485 million and $ 385 million, respectively. As remarketing agent, FTS is responsible for actively remarketing VRDNs to other investors when they have been tendered. If another investor is not identified, FTS may choose to purchase the VRDNs into inventory at its discretion while it continues to remarket them. If FTS purchases the VRDNs into inventory, it can subsequently tender back the VRDNs to the issuer’s trustee with proper advance notice. The Bancorp issued letters of credit, as a credit enhancement, to $ 138 million and $ 142 million of the VRDNs remarketed by FTS at June 30, 2021 and December 31, 2020, respectively. These letters of credit are included in the total letters of credit balance provided in the previous table. The Bancorp did no t hold any of these VRDNs in its portfolio at June 30, 2021 or December 31, 2020 but classifies them as trading debt securities when held.\nForward contracts related to residential mortgage loans held for sale\nThe Bancorp enters into forward contracts to economically hedge the change in fair value of certain residential mortgage loans held for sale due to changes in interest rates. The outstanding notional amounts of these forward contracts are included in the summary of significant commitments table for all periods presented.\nOther commitments\nThe Bancorp has entered into a limited number of agreements for work related to banking center construction and to purchase goods or services.\nContingent Liabilities\nLegal claims\nThere are legal claims pending against the Bancorp and its subsidiaries that have arisen in the normal course of business. Refer to Note 17 for additional information regarding these proceedings.\nGuarantees\nThe Bancorp has performance obligations upon the occurrence of certain events under financial guarantees provided in certain contractual arrangements as discussed in the following sections.\nResidential mortgage loans sold with representation and warranty provisions\nConforming residential mortgage loans sold to unrelated third parties are generally sold with representation and warranty provisions. A contractual liability arises only in the event of a breach of these representations and warranties and, in general, only when a loss results from the breach. The Bancorp may be required to repurchase any previously sold loan, or indemnify or make whole the investor or insurer for which the representation or warranty of the Bancorp proves to be inaccurate, incomplete or misleading. For more information on how the Bancorp establishes the residential mortgage repurchase reserve, refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\nAs of June 30, 2021 and December 31, 2020, the Bancorp maintained reserves related to loans sold with representation and warranty provisions totaling $ 9 million and $ 8 million, respectively, included in other liabilities in the Condensed Consolidated Balance Sheets.\nThe Bancorp uses the best information available when estimating its mortgage representation and warranty reserve; however, the estimation process is inherently uncertain and imprecise and, accordingly, losses in excess of the amounts reserved as of June 30, 2021 are reasonably possible. The Bancorp currently estimates that it is reasonably possible that it could incur losses related to mortgage representation and warranty provisions in an amount up to approximately $ 11 million in excess of amounts reserved. This estimate was derived by modifying\n113\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nthe key assumptions to reflect management’s judgment regarding reasonably possible adverse changes to those assumptions. The actual repurchase losses could vary significantly from the recorded mortgage representation and warranty reserve or this estimate of reasonably possible losses, depending on the outcome of various factors, including those previously discussed.\nFor both the three months ended June 30, 2021 and 2020, the Bancorp paid an immaterial amount in the form of make-whole payments and repurchased $ 9 million and $ 7 million, respectively, in outstanding principal of loans to satisfy investor demands. For the six months ended June 30, 2021 and 2020, the Bancorp paid $ 1 million and an immaterial amount, respectively, in the form of make-whole payments and repurchased $ 19 million and $ 13 million, respectively, in outstanding principal of loans to satisfy investor demands. Total repurchase demand requests during the three months ended June 30, 2021 and 2020 were $ 18 million and $ 9 million, respectively. Total repurchase demand requests during the six months ended June 30, 2021 and 2020 were $ 28 million and $ 19 million, respectively. Total outstanding repurchase demand inventory was $ 11 million and $ 5 million at June 30, 2021 and December 31, 2020, respectively.\nMargin accounts\nFTS, an indirect wholly-owned subsidiary of the Bancorp, guarantees the collection of all margin account balances held by its brokerage clearing agent for the benefit of its customers. FTS is responsible for payment to its brokerage clearing agent for any loss, liability, damage, cost or expense incurred as a result of customers failing to comply with margin or margin maintenance calls on all margin accounts. The margin account balances held by the brokerage clearing agent were $ 27 million and $ 14 million at June 30, 2021 and December 31, 2020, respectively. In the event of any customer default, FTS has rights to the underlying collateral provided. Given the existence of the underlying collateral provided and negligible historical credit losses, the Bancorp does not maintain a loss reserve related to the margin accounts.\nLong-term borrowing obligations\nThe Bancorp had certain fully and unconditionally guaranteed long-term borrowing obligations issued by wholly-owned issuing trust entities of $ 62 million at both June 30, 2021 and December 31, 2020.\nVisa litigation\nThe Bancorp, as a member bank of Visa prior to Visa’s reorganization and IPO (the “IPO”) of its Class A common shares (the “Class A Shares”) in 2008, had certain indemnification obligations pursuant to Visa’s certificate of incorporation and bylaws and in accordance with its membership agreements. In accordance with Visa’s bylaws prior to the IPO, the Bancorp could have been required to indemnify Visa for the Bancorp’s proportional share of losses based on the pre-IPO membership interests. As part of its reorganization and IPO, the Bancorp’s indemnification obligation was modified to include only certain known or anticipated litigation (the “Covered Litigation”) as of the date of the restructuring. This modification triggered a requirement for the Bancorp to recognize a liability equal to the fair value of the indemnification liability.\nIn conjunction with the IPO, the Bancorp received 10.1 million of Visa’s Class B common shares (the “Class B Shares”) based on the Bancorp’s membership percentage in Visa prior to the IPO. The Class B Shares are not transferable (other than to another member bank) until the later of the third anniversary of the IPO closing or the date on which the Covered Litigation has been resolved; therefore, the Bancorp’s Class B Shares were classified in other assets and accounted for at their carryover basis of $ 0 . Visa deposited $ 3 billion of the proceeds from the IPO into a litigation escrow account, established for the purpose of funding judgments in, or settlements of, the Covered Litigation. Since then, when Visa’s litigation committee determined that the escrow account was insufficient, Visa issued additional Class A Shares and deposited the proceeds from the sale of the Class A Shares into the litigation escrow account. When Visa funded the litigation escrow account, the Class B Shares were subjected to dilution through an adjustment in the conversion rate of Class B Shares into Class A Shares.\nIn 2009, the Bancorp completed the sale of Visa, Inc. Class B Shares and entered into a total return swap in which the Bancorp will make or receive payments based on subsequent changes in the conversion rate of the Class B Shares into Class A Shares. The swap terminates on the later of the third anniversary of Visa’s IPO or the date on which the Covered Litigation is settled. Refer to Note 21 for additional information on the valuation of the swap. The counterparty to the swap as a result of its ownership of the Class B Shares will be impacted by dilutive adjustments to the conversion rate of the Class B Shares into Class A Shares caused by any Covered Litigation losses in excess of the litigation escrow account. If actual judgments in, or settlements of, the Covered Litigation significantly exceed current expectations, then additional funding by Visa of the litigation escrow account and the resulting dilution of the Class B Shares could result in a scenario where the Bancorp’s ultimate exposure associated with the Covered Litigation (the “Visa Litigation Exposure”) exceeds the value of the Class B Shares owned by the swap counterparty (the “Class B Value”). In the event the Bancorp concludes that it is probable that the Visa Litigation Exposure exceeds the Class B Value, the Bancorp would record a litigation reserve liability and a corresponding amount of other noninterest expense for the amount of the excess. Any such litigation reserve liability would be separate and distinct from the fair value derivative liability associated with the total return swap.\nAs of the date of the Bancorp’s sale of the Visa Class B Shares and through June 30, 2021, the Bancorp has concluded that it is not probable that the Visa Litigation Exposure will exceed the Class B value. Based on this determination, upon the sale of Class B Shares, the Bancorp reversed its net Visa litigation reserve liability and recognized a free-standing derivative liability associated with the total return swap. The fair value of the swap liability was $ 213 million at June 30, 2021 and $ 201 million at December 31, 2020. Refer to Note 13 and Note 21 for further information.\n114\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nAfter the Bancorp’s sale of the Class B Shares, Visa has funded additional amounts into the litigation escrow account which have resulted in further dilutive adjustments to the conversion of Class B Shares into Class A Shares, and along with other terms of the total return swap, required the Bancorp to make cash payments in varying amounts to the swap counterparty as follows:\n| Period ($ in millions) | VisaFunding Amount | Bancorp CashPayment Amount |\n| Q2 2010 | $ | 500 | 20 |\n| Q4 2010 | 800 | 35 |\n| Q2 2011 | 400 | 19 |\n| Q1 2012 | 1,565 | 75 |\n| Q3 2012 | 150 | 6 |\n| Q3 2014 | 450 | 18 |\n| Q2 2018 | 600 | 26 |\n| Q3 2019 | 300 | 12 |\n\n115\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n17. Legal and Regulatory Proceedings\nLitigation\nVisa/MasterCard Merchant Interchange Litigation\nIn April 2006, the Bancorp was added as a defendant in a consolidated antitrust class action lawsuit originally filed against Visa®, MasterCard® and several other major financial institutions in the United States District Court for the Eastern District of New York (In re: Payment Card Interchange Fee and Merchant Discount Antitrust Litigation, Case No. 5-MD-1720). The plaintiffs, merchants operating commercial businesses throughout the U.S. and trade associations, claimed that the interchange fees charged by card-issuing banks were unreasonable and sought injunctive relief and unspecified damages. In addition to being a named defendant, the Bancorp is currently also subject to a possible indemnification obligation of Visa as discussed in Note 16 and has also entered into judgment and loss sharing agreements with Visa, MasterCard and certain other named defendants. In October 2012, the parties to the litigation entered into a settlement agreement that was initially approved by the trial court but reversed by the U.S. Second Circuit Court of Appeals and remanded to the district court for further proceedings. Pursuant to the terms of the overturned settlement agreement, the Bancorp had previously paid $ 46 million into a class settlement escrow account. Approximately 8,000 merchants requested exclusion from the class settlement, and therefore, pursuant to the terms of the overturned settlement agreement, approximately 25 % of the funds paid into the class settlement escrow account had been already returned to the control of the defendants. The remaining settlement funds paid by the Bancorp have been maintained in the escrow account. More than 500 of the merchants who requested exclusion from the class filed separate federal lawsuits against Visa, MasterCard and certain other defendants alleging similar antitrust violations. These individual federal lawsuits were transferred to the United States District Court for the Eastern District of New York. While the Bancorp is only named as a defendant in one of the individual federal lawsuits, it may have obligations pursuant to indemnification arrangements and/or the judgment or loss sharing agreements noted above. On September 17, 2018, the defendants in the consolidated class action signed a second settlement agreement (the “Amended Settlement Agreement”) resolving the claims seeking monetary damages by the proposed plaintiffs’ class (the “Plaintiff Damages Class”) and superseding the original settlement agreement entered into in October 2012. The Amended Settlement Agreement included, among other terms, a release from participating class members for liability for claims that accrue no later than five years after the Amended Settlement Agreement becomes final. The Amended Settlement Agreement provided for a total payment by all defendants of approximately $ 6.24 billion, composed of approximately $ 5.34 billion held in escrow plus an additional $ 900 million in new funds. Pursuant to the terms of the Settlement Agreement, $ 700 million of the additional $ 900 million has been returned to the defendants due to the level of opt-outs from the class. The Bancorp’s allocated share of the settlement is within existing reserves, including funds maintained in escrow. On December 13, 2019, the Court entered an order granting final approval for the settlement. The settlement does not resolve the claims of the separate proposed plaintiffs’ class seeking injunctive relief or the claims of merchants who have opted out of the proposed class settlement and are pursuing, or may in the future decide to pursue, private lawsuits. The ultimate outcome in this matter, including the timing of resolution, therefore remains uncertain. Refer to Note 16 for further information.\nKlopfenstein v. Fifth Third Bank\nOn August 3, 2012, William Klopfenstein and Adam McKinney filed a lawsuit against Fifth Third Bank in the United States District Court for the Northern District of Ohio (Klopfenstein et al. v. Fifth Third Bank), alleging that the 120 % APR that Fifth Third disclosed on its Early Access program was misleading. Early Access is a deposit-advance program offered to eligible customers with checking accounts. The plaintiffs sought to represent a nationwide class of customers who used the Early Access program and repaid their cash advances within 30 days. On October 31, 2012, the case was transferred to the United States District Court for the Southern District of Ohio. In 2013, four similar putative class action lawsuits were filed against Fifth Third Bank in federal courts throughout the country (Lori and Danielle Laskaris v. Fifth Third Bank, Janet Fyock v. Fifth Third Bank, Jesse McQuillen v. Fifth Third Bank, and Brian Harrison v. Fifth Third Bank). Those four lawsuits were transferred to the Southern District of Ohio and consolidated with the original lawsuit as In re: Fifth Third Early Access Cash Advance Litigation (Case No. 1:12-CV-851). On behalf of a putative class, the plaintiffs sought unspecified monetary and statutory damages, injunctive relief, punitive damages, attorneys’ fees, and pre- and post-judgment interest. On March 30, 2015, the court dismissed all claims alleged in the consolidated lawsuit except a claim under the TILA. On May 28, 2019, the Sixth Circuit Court of Appeals reversed the dismissal of plaintiffs’ breach of contract claim and remanded for further proceedings. The plaintiffs’ claimed damages for the alleged breach of contract claim exceed $ 280 million. On March 26, 2021, the trial court granted plaintiffs’ motion for class certification. No trial date has been set.\nHelton v. Fifth Third Bank\nOn August 31, 2015, trust beneficiaries filed an action against Fifth Third Bank, as trustee, in the Probate Court for Hamilton County, Ohio (Helen Clarke Helton, et al. v. Fifth Third Bank, Case No. 2015003814). The plaintiffs alleged breach of the duty to diversify, breach of the duty of impartiality, breach of trust/fiduciary duty, and unjust enrichment, based on Fifth Third’s alleged failure to diversify assets held in two trusts for the plaintiffs’ benefit. The lawsuit sought over $ 800 million in alleged damages, attorneys’ fees, removal of Fifth Third as trustee, and injunctive relief. On April 20, 2018, the Court denied plaintiffs’ motion for summary judgment and granted summary judgment to Fifth Third, dismissing the case in its entirety. On December 18, 2019, the Ohio Court of Appeals affirmed the Probate Court’s dismissal of all of plaintiffs’ claims based upon allegations of Fifth Third’s alleged failure to diversify assets held in two trusts for plaintiffs’ benefit. The appeals court reversed summary judgment on one claim related to Fifth Third’s alleged unjust enrichment through its receipt of certain fees in managing the trusts. The Court of Appeals remanded the case to the Probate Court for further consideration of the lone surviving claim, which comprises a small fraction of the damages originally sought by plaintiffs in the lawsuit. Plaintiffs filed an appeal to the Ohio Supreme\n116\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nCourt, seeking review of the decision from the Ohio Court of Appeals. On April 14, 2020, the Ohio Supreme Court announced its denial of plaintiffs’ request for review, and subsequently denied plaintiffs’ request for reconsideration. Thereafter, the case returned to the trial court for further adjudication of the lone surviving claim. On July 28, 2021 the trial court issued an order granting summary judgment to Fifth Third on a portion of plaintiffs’ unjust enrichment claim, leaving the remainder of the claim to be resolved at trial, currently scheduled for February 22, 2022.\nBureau of Consumer Financial Protection v. Fifth Third Bank, National Association\nOn March 9, 2020, the CFPB filed a lawsuit against Fifth Third in the United States District Court for the Northern District of Illinois entitled CFPB v. Fifth Third Bank, National Association, Case No. 1:20-CV-1683 (N.D. Ill.) (ABW), alleging violations of the Consumer Financial Protection Act, TILA, and Truth in Savings Act related to Fifth Third’s alleged opening of unspecified numbers of allegedly unauthorized credit card, savings, checking, online banking and early access accounts from 2010 through 2016. The CFPB seeks unspecified amounts of civil monetary penalties as well as unspecified customer remediation. On February 12, 2021, the court granted Fifth Third’s motion to transfer venue to the United States District Court for the Southern District of Ohio. The Bancorp is also subject to a consumer class action lawsuit related to the alleged opening of unauthorized accounts which has also been transferred to the United States District Court for the Southern District of Ohio (Zanni v. Fifth Third Bank, et al., Case No. 2020CH04022).\nShareholder Litigation\nOn April 7, 2020, Plaintiff Lee Christakis filed a putative class action lawsuit against Fifth Third Bancorp, Fifth Third Chairman and Chief Executive Officer Greg D. Carmichael, and former Fifth Third Chief Financial Officer Tayfun Tuzun in the U.S. District Court for the Northern District of Illinois entitled Lee Christakis, individually and on behalf of all others similarly situated v. Fifth Third Bancorp, et al., Case No. 1:20-cv-2176 (N.D. Ill). The case brings two claims for violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, alleging that the Defendants made material misstatements and omissions in connection with the alleged unauthorized opening of credit card, savings, checking, online banking and early access accounts from 2010 through 2016. The plaintiff seeks certification of a class, unspecified damages, attorneys’ fees and costs. On June 29, 2020, the Court appointed Heavy & General Laborers’ Local 472 & 172 Pension and Annuity Funds as lead plaintiff, and Robins Geller Rudman & Dowd LLP as lead counsel for the plaintiff. On September 14, 2020, the lead plaintiff filed its amended consolidated complaint. On April 27, 2021, the Court granted the defendants’ motion to dismiss and provided plaintiff with leave to amend to attempt to cure the deficiencies.\nOn July 31, 2020, a second putative shareholder class action lawsuit captioned Dr. Steven Fox, individually and on behalf of all others similarly situated v. Fifth Third Bancorp, et al., Case No. 2020CH05219 was filed on behalf of former shareholders of MB Financial, Inc. in the Cook County, Illinois Circuit Court. The suit brings claims for violation of Sections 11 and 12(a)(2) of the Securities Act of 1933, alleging that the Bancorp and certain of its officers and directors made material misstatements and omissions regarding the alleged improper cross-selling strategy in filings made in connection with the Bancorp’s merger with MB Financial, Inc. On March 19, 2021, the trial court denied the defendants’ motion to dismiss.\nIn addition, shareholder derivative lawsuits have been filed seeking monetary damages on behalf of the Bancorp alleging certain claims against various officers and directors relating to an alleged improper cross-selling strategy. Four lawsuits filed in the U.S. District Court for the Northern District of Illinois have been consolidated into a single action captioned In re Fifth Third Bancorp Derivative Litigation, Case No. 1:20-cv-04115. Those cases consist of: (1) Pemberton v. Carmichael, et al., Case No. 20-cv-4115 (filed July 13, 2020); (2) Meyer v. Carmichael, et al., Case No. 20-cv-4244 (filed July 17, 2020); (3) Cox v. Carmichael, et al., Case No. 20-cv-4660 (filed August 7, 2020); and (4) Hansen v. Carmichael, et al., Case No. 20-cv-5339 (filed September 10, 2020). Also pending are shareholder derivative matters Reese v. Carmichael, et al., Case No. 20-cv-866 pending in the U.S. District Court of the Southern District of Ohio (filed November 4, 2020), which was subsequently transferred to the Northern District of Illinois (Case No. 1:21-cv-01631) and Sandys v. Carmichael, et al., Case No. A2004539 pending in the Hamilton County, Ohio Court of Common Pleas (filed December 28, 2020).\nThe Bancorp has also received several shareholder demands under Ohio Rev. Code § 1701.37(c) and lawsuits have been filed arising out of the same. Finally, the Bancorp has received shareholder demands that the Bancorp’s Board of Directors investigate and commence a civil action for failure to detect and/or prevent the alleged illegal cross-selling strategy. One of those shareholders subsequently filed the aforementioned Sandys v. Carmichael, et al. matter.\nOther litigation\nThe Bancorp and its subsidiaries are not parties to any other material litigation. However, there are other litigation matters that arise in the normal course of business. While it is impossible to ascertain the ultimate resolution or range of financial liability with respect to these contingent matters, management believes that the resulting liability, if any, from these other actions would not have a material effect upon the Bancorp’s consolidated financial position, results of operations or cash flows.\nGovernmental Investigations and Proceedings\nThe Bancorp and/or its affiliates are or may become involved in information-gathering requests, reviews, investigations and proceedings (both formal and informal) by various governmental regulatory agencies and law enforcement authorities, including but not limited to the FRB, OCC, CFPB, SEC, FINRA, U.S. Department of Justice, etc., as well as state and other governmental authorities and self-regulatory\n117\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nbodies regarding their respective businesses. Additional matters will likely arise from time to time. Any of these matters may result in material adverse consequences or reputational harm to the Bancorp, its affiliates and/or their respective directors, officers and other personnel, including adverse judgments, findings, settlements, fines, penalties, orders, injunctions or other actions, amendments and/or restatements of the Bancorp’s SEC filings and/or financial statements, as applicable, and/or determinations of material weaknesses in our disclosure controls and procedures. Investigations by regulatory authorities may from time to time result in civil or criminal referrals to law enforcement. Additionally, in some cases, regulatory authorities may take supervisory actions that are considered to be confidential supervisory information which may not be publicly disclosed.\nReasonably Possible Losses in Excess of Accruals\nThe Bancorp and its subsidiaries are parties to numerous claims and lawsuits as well as threatened or potential actions or claims concerning matters arising from the conduct of its business activities. The outcome of claims or litigation and the timing of ultimate resolution are inherently difficult to predict. The following factors, among others, contribute to this lack of predictability: claims often include significant legal uncertainties, damages alleged by plaintiffs are often unspecified or overstated, discovery may not have started or may not be complete and material facts may be disputed or unsubstantiated. As a result of these factors, the Bancorp is not always able to provide an estimate of the range of reasonably possible outcomes for each claim. An accrual for a potential litigation loss is established when information related to the loss contingency indicates both that a loss is probable and that the amount of loss can be reasonably estimated. Any such accrual is adjusted from time to time thereafter as appropriate to reflect changes in circumstances. The Bancorp also determines, when possible (due to the uncertainties described above), estimates of reasonably possible losses or ranges of reasonably possible losses, in excess of amounts accrued. Under U.S. GAAP, an event is “reasonably possible” if “the chance of the future event or events occurring is more than remote but less than likely” and an event is “remote” if “the chance of the future event or events occurring is slight.” Thus, references to the upper end of the range of reasonably possible loss for cases in which the Bancorp is able to estimate a range of reasonably possible loss mean the upper end of the range of loss for cases for which the Bancorp believes the risk of loss is more than slight. For matters where the Bancorp is able to estimate such possible losses or ranges of possible losses, the Bancorp currently estimates that it is reasonably possible that it could incur losses related to legal and regulatory proceedings, in an aggregate amount up to approximately $ 49 million in excess of amounts accrued, with it also being reasonably possible that no losses will be incurred in these matters. The estimates included in this amount are based on the Bancorp’s analysis of currently available information, and as new information is obtained the Bancorp may change its estimates.\nFor these matters and others where an unfavorable outcome is reasonably possible but not probable, there may be a range of possible losses in excess of the established accrual that cannot be estimated. Based on information currently available, advice of counsel, available insurance coverage and established accruals, the Bancorp believes that the eventual outcome of the actions against the Bancorp and/or its subsidiaries, including the matters described above, will not, individually or in the aggregate, have a material adverse effect on the Bancorp’s consolidated financial position. However, in the event of unexpected future developments, it is possible that the ultimate resolution of those matters, if unfavorable, may be material to the Bancorp’s results of operations for any particular period, depending, in part, upon the size of the loss or liability imposed and the operating results for the applicable period.\n18. Income Taxes\nThe applicable income tax expense was $ 202 million and $ 49 million for the three months ended June 30, 2021 and 2020, respectively, and $ 391 million and $ 61 million for the six months ended June 30, 2021 and 2020, respectively. The effective tax rates for the three months ended June 30, 2021 and 2020 were 22.1 % and 19.9 %, respectively, and 21.8 % and 20.4 % for the six months ended June 30, 2021 and 2020, respectively.\nWhile it is reasonably possible that the amount of the unrecognized tax benefits with respect to certain of the Bancorp’s uncertain tax positions could increase or decrease during the next 12 months, the Bancorp believes it is unlikely that its unrecognized tax benefits will change by a material amount during the next 12 months.\n118\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n19. Accumulated Other Comprehensive Income\nThe tables below present the activity of the components of OCI and AOCI for the three months ended:\n| Total OCI | Total AOCI |\n| June 30, 2021 ($ in millions) | Pre-tax Activity | TaxEffect | NetActivity | Beginning Balance | NetActivity | EndingBalance |\n| Unrealized holding gains on available-for-sale debt securities arising during period | $ | 306 | ( 71 ) | 235 |\n| Reclassification adjustment for net gains on available-for-sale debt securities included in net income | ( 7 ) | 2 | ( 5 ) |\n| Net unrealized gains on available-for-sale debt securities | 299 | ( 69 ) | 230 | 1,242 | 230 | 1,472 |\n| Unrealized holding gains on cash flow hedge derivatives arising during period | 11 | ( 2 ) | 9 |\n| Reclassification adjustment for net gains on cash flow hedge derivatives included in net income | ( 73 ) | 15 | ( 58 ) |\n| Net unrealized gains on cash flow hedge derivatives | ( 62 ) | 13 | ( 49 ) | 597 | ( 49 ) | 548 |\n| Net actuarial loss arising during the year | ( 1 ) | — | ( 1 ) |\n| Reclassification of amounts to net periodic benefit costs | 3 | ( 1 ) | 2 |\n| Defined benefit pension plans, net | 2 | ( 1 ) | 1 | ( 43 ) | 1 | ( 42 ) |\n| Other | — | — | — | ( 4 ) | — | ( 4 ) |\n| Total | $ | 239 | ( 57 ) | 182 | 1,792 | 182 | 1,974 |\n\n| Total OCI | Total AOCI |\n| June 30, 2020 ($ in millions) | Pre-tax Activity | TaxEffect | NetActivity | Beginning Balance | NetActivity | EndingBalance |\n| Unrealized holding gains on available-for-sale debt securities arising during period | $ | 602 | ( 146 ) | 456 |\n| Net unrealized gains on available-for-sale debt securities | 602 | ( 146 ) | 456 | 1,694 | 456 | 2,150 |\n| Unrealized holding gains on cash flow hedge derivatives arising during period | 83 | ( 17 ) | 66 |\n| Reclassification adjustment for net gains on cash flow hedge derivatives included in net income | ( 62 ) | 13 | ( 49 ) |\n| Net unrealized gains on cash flow hedge derivatives | 21 | ( 4 ) | 17 | 824 | 17 | 841 |\n| Reclassification of amounts to net periodic benefit costs | 1 | — | 1 |\n| Defined benefit pension plans, net | 1 | — | 1 | ( 41 ) | 1 | ( 40 ) |\n| Total | $ | 624 | ( 150 ) | 474 | 2,477 | 474 | 2,951 |\n\n119\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe tables below present the activity of the components of OCI and AOCI for the six months ended:\n| Total OCI | Total AOCI |\n| June 30, 2021 ($ in millions) | Pre-tax Activity | Tax Effect | Net Activity | Beginning Balance | Net Activity | Ending Balance |\n| Unrealized holding losses on available-for-sale debt securities arising during period | $ | ( 609 ) | 143 | ( 466 ) |\n| Reclassification adjustment for net losses on available-for-sale debt securities included in net income | 9 | ( 2 ) | 7 |\n| Net unrealized gains on available-for-sale debt securities | ( 600 ) | 141 | ( 459 ) | 1,931 | ( 459 ) | 1,472 |\n| Unrealized holding losses on cash flow hedge derivatives arising during period | ( 70 ) | 15 | ( 55 ) |\n| Reclassification adjustment for net gains on cash flow hedge derivatives included in net income | ( 146 ) | 31 | ( 115 ) |\n| Net unrealized gains on cash flow hedge derivatives | ( 216 ) | 46 | ( 170 ) | 718 | ( 170 ) | 548 |\n| Net actuarial loss arising during the year | ( 1 ) | — | ( 1 ) |\n| Reclassification of amounts to net periodic benefit costs | 4 | ( 1 ) | 3 |\n| Defined benefit pension plans, net | 3 | ( 1 ) | 2 | ( 44 ) | 2 | ( 42 ) |\n| Other | — | — | — | ( 4 ) | — | ( 4 ) |\n| Total | $ | ( 813 ) | 186 | ( 627 ) | 2,601 | ( 627 ) | 1,974 |\n\n| Total OCI | Total AOCI |\n| June 30, 2020 ($ in millions) | Pre-tax Activity | Tax Effect | Net Activity | Beginning Balance | Net Activity | Ending Balance |\n| Unrealized holding gains on available-for-sale debt securities arising during period | $ | 1,757 | ( 419 ) | 1,338 |\n| Net unrealized gains on available-for-sale debt securities | 1,757 | ( 419 ) | 1,338 | 812 | 1,338 | 2,150 |\n| Unrealized holding gains on cash flow hedge derivatives arising during period | 624 | ( 131 ) | 493 |\n| Reclassification adjustment for net gains on cash flow hedge derivatives included in net income | ( 94 ) | 20 | ( 74 ) |\n| Net unrealized gains on cash flow hedge derivatives | 530 | ( 111 ) | 419 | 422 | 419 | 841 |\n| Reclassification of amounts to net periodic benefit costs | 3 | ( 1 ) | 2 |\n| Defined benefit pension plans, net | 3 | ( 1 ) | 2 | ( 42 ) | 2 | ( 40 ) |\n| Total | $ | 2,290 | ( 531 ) | 1,759 | 1,192 | 1,759 | 2,951 |\n\n120\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe table below presents reclassifications out of AOCI:\n| Condensed Consolidated Statements ofIncome Caption | For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Net unrealized gains on available-for-sale debt securities:(b) |\n| Net losses included in net income | Securities gains (losses), net | $ | 7 | — | ( 9 ) | — |\n| Income before income taxes | 7 | — | ( 9 ) | — |\n| Applicable income tax expense | ( 2 ) | — | 2 | — |\n| Net income | 5 | — | ( 7 ) | — |\n| Net unrealized gains on cash flow hedge derivatives:(b) |\n| Interest rate contracts related to C&I loans | Interest and fees on loans and leases | 73 | 62 | 146 | 94 |\n| Income before income taxes | 73 | 62 | 146 | 94 |\n| Applicable income tax expense | ( 15 ) | ( 13 ) | ( 31 ) | ( 20 ) |\n| Net income | 58 | 49 | 115 | 74 |\n| Net periodic benefit costs:(b) |\n| Amortization of net actuarial loss | Compensation and benefits(a) | ( 2 ) | ( 1 ) | ( 3 ) | ( 3 ) |\n| Settlements | Compensation and benefits(a) | ( 1 ) | — | ( 1 ) | — |\n| Income before income taxes | ( 3 ) | ( 1 ) | ( 4 ) | ( 3 ) |\n| Applicable income tax expense | 1 | — | 1 | 1 |\n| Net income | ( 2 ) | ( 1 ) | ( 3 ) | ( 2 ) |\n| Total reclassifications for the period | Net income | $ | 61 | 48 | 105 | 72 |\n\n(a)This AOCI component is included in the computation of net periodic benefit cost. Refer to Note 23 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for further information.\n(b)Amounts in parentheses indicate reductions to net income.\n121\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n20. Earnings Per Share\nThe following tables provide the calculation of earnings per share and the reconciliation of earnings per share and earnings per diluted share:\n| 2021 | 2020 |\n| For the three months ended June 30,(in millions, except per share data) | Income | AverageShares | Per ShareAmount | Income | AverageShares | Per ShareAmount |\n| Earnings Per Share: |\n| Net income available to common shareholders | $ | 674 | $ | 163 |\n| Less: Income allocated to participating securities | 1 | 1 |\n| Net income allocated to common shareholders | $ | 673 | 709 | $ | 0.95 | $ | 162 | 715 | $ | 0.23 |\n| Earnings Per Diluted Share: |\n| Net income available to common shareholders | $ | 674 | $ | 163 |\n| Effect of dilutive securities: |\n| Stock-based awards | — | 9 | — | 3 |\n| Net income available to common shareholders plus assumed conversions | $ | 674 | $ | 163 |\n| Less: Income allocated to participating securities | 1 | 1 |\n| Net income allocated to common shareholders plus assumed conversions | $ | 673 | 718 | $ | 0.94 | $ | 162 | 718 | $ | 0.23 |\n\n| 2021 | 2020 |\n| For the six months ended June 30,(in millions, except per share data) | Income | Average Shares | Per Share Amount | Income | Average Shares | Per Share Amount |\n| Earnings Per Share: |\n| Net income available to common shareholders | $ | 1,348 | $ | 193 |\n| Less: Income allocated to participating securities | 4 | 2 |\n| Net income allocated to common shareholders | $ | 1,344 | 712 | $ | 1.89 | $ | 191 | 714 | $ | 0.27 |\n| Earnings Per Diluted Share: |\n| Net income available to common shareholders | $ | 1,348 | $ | 193 |\n| Effect of dilutive securities: |\n| Stock-based awards | — | 9 | — | 5 |\n| Net income available to common shareholders plus assumed conversions | $ | 1,348 | $ | 193 |\n| Less: Income allocated to participating securities | 4 | 2 |\n| Net income allocated to common shareholders plus assumed conversions | $ | 1,344 | 721 | $ | 1.87 | $ | 191 | 719 | $ | 0.27 |\n\nShares are excluded from the computation of earnings per diluted share when their inclusion has an anti-dilutive effect on earnings per share. The diluted earnings per share computation for both the three and six months ended June 30, 2021 excludes an immaterial amount of stock-based awards because their inclusion would have been anti-dilutive. The diluted earnings per share computation for the three and six months ended June 30, 2020 excludes 12 million and 9 million shares, respectively, of stock-based awards because their inclusion would have been anti-dilutive.\n122\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n21. Fair Value Measurements\nThe Bancorp measures certain financial assets and liabilities at fair value in accordance with U.S. GAAP, which defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. U.S. GAAP also establishes a fair value hierarchy, which prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the instrument’s fair value measurement. For more information regarding the fair value hierarchy, refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\nAssets and Liabilities Measured at Fair Value on a Recurring Basis\nThe following tables summarize assets and liabilities measured at fair value on a recurring basis as of:\n| Fair Value Measurements Using |\n| June 30, 2021 ($ in millions) | Level 1 | Level 2 | Level 3 | Total Fair Value |\n| Assets: |\n| Available-for-sale debt and other securities: |\n| U.S. Treasury and federal agencies securities | $ | 107 | — | — | 107 |\n| Obligations of states and political subdivisions securities | — | 18 | — | 18 |\n| Mortgage-backed securities: |\n| Agency residential mortgage-backed securities | — | 10,809 | — | 10,809 |\n| Agency commercial mortgage-backed securities | — | 19,294 | — | 19,294 |\n| Non-agency commercial mortgage-backed securities | — | 3,479 | — | 3,479 |\n| Asset-backed securities and other debt securities | — | 3,785 | — | 3,785 |\n| Available-for-sale debt and other securities(a) | 107 | 37,385 | — | 37,492 |\n| Trading debt securities: |\n| U.S. Treasury and federal agencies securities | 96 | — | — | 96 |\n| Obligations of states and political subdivisions securities | — | 63 | — | 63 |\n| Agency residential mortgage-backed securities | — | 69 | — | 69 |\n| Asset-backed securities and other debt securities | — | 483 | — | 483 |\n| Trading debt securities | 96 | 615 | — | 711 |\n| Equity securities | 329 | 12 | — | 341 |\n| Residential mortgage loans held for sale | — | 1,633 | — | 1,633 |\n| Residential mortgage loans(b) | — | — | 151 | 151 |\n| Servicing rights | — | — | 818 | 818 |\n| Derivative assets: |\n| Interest rate contracts | 1 | 1,642 | 39 | 1,682 |\n| Foreign exchange contracts | — | 286 | — | 286 |\n| Commodity contracts | 27 | 1,213 | — | 1,240 |\n| Derivative assets(c) | 28 | 3,141 | 39 | 3,208 |\n| Total assets | $ | 560 | 42,786 | 1,008 | 44,354 |\n| Liabilities: |\n| Derivative liabilities: |\n| Interest rate contracts | $ | 8 | 223 | 8 | 239 |\n| Foreign exchange contracts | — | 246 | — | 246 |\n| Equity contracts | — | — | 213 | 213 |\n| Commodity contracts | 397 | 812 | — | 1,209 |\n| Derivative liabilities(d) | 405 | 1,281 | 221 | 1,907 |\n| Short positions: |\n| U.S. Treasury and federal agencies securities | 110 | — | — | 110 |\n| Asset-backed securities and other debt securities | — | 417 | — | 417 |\n| Short positions(d) | 110 | 417 | — | 527 |\n| Total liabilities | $ | 515 | 1,698 | 221 | 2,434 |\n\n(a)Excludes FHLB, FRB and DTCC restricted stock holdings totaling $ 33 , $ 485 and $ 2 , respectively, at June 30, 2021.\n(b)Includes residential mortgage loans originated as held for sale and subsequently transferred to held for investment.\n(c)Included in other assets in the Condensed Consolidated Balance Sheets.\n(d)Included in other liabilities in the Condensed Consolidated Balance Sheets.\n123\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n| Fair Value Measurements Using |\n| December 31, 2020 ($ in millions) | Level 1 | Level 2 | Level 3 | Total Fair Value |\n| Assets: |\n| Available-for-sale debt and other securities: |\n| U.S. Treasury and federal agencies securities | $ | 78 | — | — | 78 |\n| Obligations of states and political subdivisions securities | — | 17 | — | 17 |\n| Mortgage-backed securities: |\n| Agency residential mortgage-backed securities | — | 11,907 | — | 11,907 |\n| Agency commercial mortgage-backed securities | — | 18,221 | — | 18,221 |\n| Non-agency commercial mortgage-backed securities | — | 3,590 | — | 3,590 |\n| Asset-backed securities and other debt securities | — | 3,176 | — | 3,176 |\n| Available-for-sale debt and other securities(a) | 78 | 36,911 | — | 36,989 |\n| Trading debt securities: |\n| U.S. Treasury and federal agencies securities | 81 | — | — | 81 |\n| Obligations of states and political subdivisions securities | — | 10 | — | 10 |\n| Agency residential mortgage-backed securities | — | 30 | — | 30 |\n| Asset-backed securities and other debt securities | — | 439 | — | 439 |\n| Trading debt securities | 81 | 479 | — | 560 |\n| Equity securities | 293 | 20 | — | 313 |\n| Residential mortgage loans held for sale | — | 1,481 | — | 1,481 |\n| Residential mortgage loans(b) | — | — | 161 | 161 |\n| Servicing rights | — | — | 656 | 656 |\n| Derivative assets: |\n| Interest rate contracts | 1 | 2,227 | 61 | 2,289 |\n| Foreign exchange contracts | — | 255 | — | 255 |\n| Commodity contracts | 24 | 351 | — | 375 |\n| Derivative assets(c) | 25 | 2,833 | 61 | 2,919 |\n| Total assets | $ | 477 | 41,724 | 878 | 43,079 |\n| Liabilities: |\n| Derivative liabilities: |\n| Interest rate contracts | $ | 16 | 261 | 8 | 285 |\n| Foreign exchange contracts | — | 227 | — | 227 |\n| Equity contracts | — | — | 201 | 201 |\n| Commodity contracts | 55 | 304 | — | 359 |\n| Derivative liabilities(d) | 71 | 792 | 209 | 1,072 |\n| Short positions: |\n| U.S. Treasury and federal agencies securities | 63 | — | — | 63 |\n| Asset-backed securities and other debt securities | — | 392 | — | 392 |\n| Short positions(d) | 63 | 392 | — | 455 |\n| Total liabilities | $ | 134 | 1,184 | 209 | 1,527 |\n\n(a)Excludes FHLB, FRB and DTCC restricted stock holdings totaling $ 40 , $ 482 and $ 2 , respectively, at December 31, 2020.\n(b)Includes residential mortgage loans originated as held for sale and subsequently transferred to held for investment.\n(c)Included in other assets in the Condensed Consolidated Balance Sheets.\n(d)Included in other liabilities in the Condensed Consolidated Balance Sheets.\nThe following is a description of the valuation methodologies used for significant instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy.\nAvailable-for-sale debt and other securities, trading debt securities and equity securities\nWhere quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities include U.S. Treasury securities and equity securities. If quoted market prices are not available, then fair values are estimated using pricing models which primarily utilize quoted prices of securities with similar characteristics. Level 2 securities may include federal agencies securities, obligations of states and political subdivisions securities, agency residential mortgage-backed securities, agency and non-agency commercial mortgage-backed securities, asset-backed securities and other debt securities and equity securities. These securities are generally valued using a market approach based on observable prices of securities with similar characteristics.\n124\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nResidential mortgage loans held for sale\nFor residential mortgage loans held for sale for which the fair value election has been made, fair value is estimated based upon mortgage-backed securities prices and spreads to those prices or, for certain ARM loans, DCF models that may incorporate the anticipated portfolio composition, credit spreads of asset-backed securities with similar collateral and market conditions. The anticipated portfolio composition includes the effect of interest rate spreads and discount rates due to loan characteristics such as the state in which the loan was originated, the loan amount and the ARM margin. Residential mortgage loans held for sale that are valued based on mortgage-backed securities prices are classified within Level 2 of the valuation hierarchy as the valuation is based on external pricing for similar instruments. ARM loans classified as held for sale are also classified within Level 2 of the valuation hierarchy due to the use of observable inputs in the DCF model. These observable inputs include interest rate spreads from agency mortgage-backed securities market rates and observable discount rates.\nResidential mortgage loans\nResidential mortgage loans held for sale that are reclassified to held for investment are transferred from Level 2 to Level 3 of the fair value hierarchy. For residential mortgage loans for which the fair value election has been made, and that are reclassified from held for sale to held for investment, the fair value estimation is based on mortgage-backed securities prices, interest rate risk and an internally developed credit component. Therefore, these loans are classified within Level 3 of the valuation hierarchy. An adverse change in the loss rate or severity assumption would result in a decrease in fair value of the related loans.\nServicing rights\nMSRs do not trade in an active, open market with readily observable prices. While sales of MSRs do occur, the precise terms and conditions typically are not readily available. Accordingly, the Bancorp estimates the fair value of MSRs using internal OAS models with certain unobservable inputs, primarily prepayment speed assumptions, OAS and weighted-average lives, resulting in a classification within Level 3 of the valuation hierarchy. Refer to Note 12 for further information on the assumptions used in the valuation of the Bancorp’s MSRs.\nDerivatives\nExchange-traded derivatives valued using quoted prices and certain over-the-counter derivatives valued using active bids are classified within Level 1 of the valuation hierarchy. Most of the Bancorp’s derivative contracts are valued using DCF or other models that incorporate current market interest rates, credit spreads assigned to the derivative counterparties and other market parameters and, therefore, are classified within Level 2 of the valuation hierarchy. Such derivatives include basic and structured interest rate, foreign exchange and commodity swaps and options. Derivatives that are valued based upon models with significant unobservable market parameters are classified within Level 3 of the valuation hierarchy. At June 30, 2021 and December 31, 2020, derivatives classified as Level 3, which are valued using models containing unobservable inputs, consisted primarily of a total return swap associated with the Bancorp’s sale of Visa, Inc. Class B Shares as well as IRLCs, which utilize internally generated loan closing rate assumptions as a significant unobservable input in the valuation process.\nUnder the terms of the total return swap, the Bancorp will make or receive payments based on subsequent changes in the conversion rate of the Visa, Inc. Class B Shares into Class A Shares. Additionally, the Bancorp will make a quarterly payment based on Visa’s stock price and the conversion rate of the Visa, Inc. Class B Shares into Class A Shares until the date on which the Covered Litigation is settled. The fair value of the total return swap was calculated using a DCF model based on unobservable inputs consisting of management’s estimate of the probability of certain litigation scenarios, the timing of the resolution of the Covered Litigation and Visa litigation loss estimates in excess, or shortfall, of the Bancorp’s proportional share of escrow funds.\nAn increase in the loss estimate or a delay in the resolution of the Covered Litigation would result in an increase in the fair value of the derivative liability; conversely, a decrease in the loss estimate or an acceleration of the resolution of the Covered Litigation would result in a decrease in the fair value of the derivative liability. Refer to Note 16 for additional information on the Covered Litigation.\nThe net asset fair value of the Bancorp’s IRLCs at June 30, 2021 was $ 39 million. Immediate decreases in current interest rates of 25 bps and 50 bps would result in increases in the fair value of the IRLCs of approximately $ 16 million and $ 29 million, respectively. Immediate increases of current interest rates of 25 bps and 50 bps would result in decreases in the fair value of the IRLCs of approximately $ 18 million and $ 37 million, respectively. The decrease in fair value of IRLCs due to immediate 10% and 20% adverse changes in the assumed loan closing rates would be approximately $ 4 million and $ 8 million, respectively, and the increase in fair value due to immediate 10% and 20% favorable changes in the assumed loan closing rates would be approximately $ 4 million and $ 8 million, respectively. These sensitivities are hypothetical and should be used with caution, as changes in fair value based on a variation in assumptions typically cannot be extrapolated because the relationship of the change in assumptions to the change in fair value may not be linear.\nShort positions\nWhere quoted prices are available in an active market, short positions are classified within Level 1 of the valuation hierarchy. Level 1 securities include U.S. Treasury securities. If quoted market prices are not available, then fair values are estimated using pricing models which primarily utilize quoted prices of securities with similar characteristics and therefore are classified within Level 2 of the valuation hierarchy. Level 2 securities include asset-backed and other debt securities.\n125\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following tables are a reconciliation of assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3):\n| Fair Value Measurements Using Significant Unobservable Inputs (Level 3) |\n| For the three months ended June 30, 2021 ($ in millions) | ResidentialMortgageLoans | ServicingRights | Interest RateDerivatives,Net(a) | EquityDerivatives | TotalFair Value |\n| Balance, beginning of period | $ | 153 | 784 | 30 | ( 195 ) | 772 |\n| Total (losses) gains (realized/unrealized):(b) |\n| Included in earnings | — | ( 122 ) | 57 | ( 37 ) | ( 102 ) |\n| Purchases/originations | — | 156 | — | — | 156 |\n| Settlements | ( 12 ) | — | ( 56 ) | 19 | ( 49 ) |\n| Transfers into Level 3(c) | 10 | — | — | — | 10 |\n| Balance, end of period | $ | 151 | 818 | 31 | ( 213 ) | 787 |\n| The amount of total (losses) gains for the period included in earnings attributable to the change in unrealized gains or losses relating to instruments still held at June 30, 2021 | $ | — | ( 56 ) | 37 | ( 37 ) | ( 56 ) |\n\n(a)Net interest rate derivatives include derivative assets and liabilities of $ 39 and $ 8 , respectively, as of June 30, 2021.\n(b)There were no unrealized gains or losses for the period included in other comprehensive income for instruments still held at June 30, 2021.\n(c)Includes certain residential mortgage loans originated as held for sale that were transferred to held for investment.\n| Fair Value Measurements Using Significant Unobservable Inputs (Level 3) |\n| For the three months ended June 30, 2020 ($ in millions) | ResidentialMortgageLoans | ServicingRights | Interest RateDerivatives,Net(a) | EquityDerivatives | TotalFair Value |\n| Balance, beginning of period | $ | 185 | 685 | 61 | ( 171 ) | 760 |\n| Total (losses) gains (realized/unrealized):(b) |\n| Included in earnings | ( 2 ) | ( 70 ) | 83 | ( 29 ) | ( 18 ) |\n| Purchases/originations | — | 61 | 5 | — | 66 |\n| Settlements | ( 20 ) | — | ( 60 ) | 17 | ( 63 ) |\n| Transfers into Level 3(c) | 22 | — | — | — | 22 |\n| Balance, end of period | $ | 185 | 676 | 89 | ( 183 ) | 767 |\n| The amount of total gains (losses) for the period included in earnings attributable to the change in unrealized gains or losses relating to instruments still held at June 30, 2020 | $ | ( 2 ) | ( 23 ) | 85 | ( 29 ) | 31 |\n\n(a)Net interest rate derivatives include derivative assets and liabilities of $ 98 and $ 9 , respectively, as of June 30, 2020.\n(b)There were no unrealized gains or losses for the period included in other comprehensive income for instruments still held at June 30, 2020.\n(c)Includes certain residential mortgage loans originated as held for sale that were transferred to held for investment.\n| Fair Value Measurements Using Significant Unobservable Inputs (Level 3) |\n| For the six months ended June 30, 2021 ($ in millions) | ResidentialMortgageLoans | ServicingRights | Interest RateDerivatives,Net(a) | EquityDerivatives | TotalFair Value |\n| Balance, beginning of period | $ | 161 | 656 | 53 | ( 201 ) | 669 |\n| Total (losses) gains (realized/unrealized):(b) |\n| Included in earnings | ( 1 ) | ( 50 ) | 91 | ( 50 ) | ( 10 ) |\n| Purchases/originations | — | 212 | ( 1 ) | — | 211 |\n| Settlements | ( 29 ) | — | ( 112 ) | 38 | ( 103 ) |\n| Transfers into Level 3(c) | 20 | — | — | — | 20 |\n| Balance, end of period | $ | 151 | 818 | 31 | ( 213 ) | 787 |\n| The amount of total gains (losses) for the period included in earnings attributable to the change in unrealized gains or losses relating to instruments still held at June 30, 2021 | $ | ( 1 ) | 69 | 40 | ( 50 ) | 58 |\n\n(a)Net interest rate derivatives include derivative assets and liabilities of $ 39 and $ 8 , respectively, as of June 30, 2021.\n(b)There were no unrealized gains or losses for the period included in other comprehensive income for instruments still held at June 30, 2021.\n(c)Includes certain residential mortgage loans originated as held for sale that were transferred to held for investment.\n126\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n| Fair Value Measurements Using Significant Unobservable Inputs (Level 3) |\n| For the six months ended June 30, 2020 ($ in millions) | ResidentialMortgageLoans | ServicingRights | Interest RateDerivatives,Net(a) | EquityDerivatives | TotalFair Value |\n| Balance, beginning of period | $ | 183 | 993 | 10 | ( 163 ) | 1,023 |\n| Total (losses) gains (realized/unrealized):(b) |\n| Included in earnings | 2 | ( 448 ) | 186 | ( 51 ) | ( 311 ) |\n| Purchases/originations | — | 131 | 4 | — | 135 |\n| Settlements | ( 29 ) | — | ( 111 ) | 31 | ( 109 ) |\n| Transfers into Level 3(c) | 29 | — | — | — | 29 |\n| Balance, end of period | $ | 185 | 676 | 89 | ( 183 ) | 767 |\n| The amount of total (losses) gains for the period included in earnings attributable to the change in unrealized gains or losses relating to instruments still held at June 30, 2020 | $ | 2 | ( 331 ) | 93 | ( 51 ) | ( 287 ) |\n\n(a)Net interest rate derivatives include derivative assets and liabilities of $ 98 and $ 9 , respectively, as of June 30, 2020.\n(b)There were no unrealized gains or losses for the period included in other comprehensive income for instruments still held at June 30, 2020.\n(c)Includes certain residential mortgage loans originated as held for sale that were transferred to held for investment.\nThe total losses and gains included in earnings for assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) were recorded in the Condensed Consolidated Statements of Income as follows:\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Mortgage banking net revenue | $ | ( 66 ) | 10 | 39 | ( 261 ) |\n| Commercial banking revenue | 1 | 1 | 1 | 1 |\n| Other noninterest income | ( 37 ) | ( 29 ) | ( 50 ) | ( 51 ) |\n| Total losses | $ | ( 102 ) | ( 18 ) | ( 10 ) | ( 311 ) |\n\nThe total gains and losses included in earnings attributable to changes in unrealized gains and losses related to Level 3 assets and liabilities still held at June 30, 2021 and 2020 were recorded in the Condensed Consolidated Statements of Income as follows:\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Mortgage banking net revenue | $ | ( 20 ) | 59 | 107 | ( 237 ) |\n| Commercial banking revenue | 1 | 1 | 1 | 1 |\n| Other noninterest income | ( 37 ) | ( 29 ) | ( 50 ) | ( 51 ) |\n| Total gains (losses) | $ | ( 56 ) | 31 | 58 | ( 287 ) |\n\n127\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following tables present information as of June 30, 2021 and 2020 about significant unobservable inputs related to the Bancorp’s material categories of Level 3 financial assets and liabilities measured at fair value on a recurring basis:\n| As of June 30, 2021 ($ in millions) |\n| Financial Instrument | Fair Value | ValuationTechnique | SignificantUnobservable Inputs | Range of Inputs | Weighted-Average |\n| Residential mortgage loans | $ | 151 | Loss rate model | Interest rate risk factor | ( 9.2 ) | - | 9.0 % | 1.1 | % | (a) |\n| Credit risk factor | — | - | 24.8 % | 0.5 | % | (a) |\n| (Fixed) | 14.5 | % | (b) |\n| Servicing rights | 818 | DCF | Prepayment speed | — | - | 100.0 % | (Adjustable) | 21.6 | % | (b) |\n| (Fixed) | 542 | (b) |\n| OAS (bps) | 406 | - | 1,587 | (Adjustable) | 978 | (b) |\n| IRLCs, net | 39 | DCF | Loan closing rates | 10.0 | - | 97.2 % | 76.5 | % | (c) |\n| Swap associated with the sale of Visa, Inc. Class B Shares | ( 213 ) | DCF | Timing of the resolution of the Covered Litigation | Q1 2023 | - | Q1 2025 | Q4 2023 | (d) |\n\n(a)Unobservable inputs were weighted by the relative carrying value of the instruments.\n(b)Unobservable inputs were weighted by the relative unpaid principal balance of the instruments.\n(c)Unobservable inputs were weighted by the relative notional amount of the instruments.\n(d)Unobservable inputs were weighted by the probability of the final funding date of the instruments.\n| As of June 30, 2020 ($ in millions) |\n| Financial Instrument | Fair Value | ValuationTechnique | SignificantUnobservable Inputs | Range of Inputs | Weighted-Average |\n| Residential mortgage loans | $ | 185 | Loss rate model | Interest rate risk factor | ( 7.4 ) | - | 11.6 % | 0.7 | % | (a) |\n| Credit risk factor | — | - | 26.4 % | 0.4 | % | (a) |\n| (Fixed) | 20.1 | % | (b) |\n| Servicing rights | 676 | DCF | Prepayment speed | 0.5 | - | 99.6 % | (Adjustable) | 23.4 | % | (b) |\n| (Fixed) | 784 | (b) |\n| OAS (bps) | 536 | - | 1,386 | (Adjustable) | 934 | (b) |\n| IRLCs, net | 91 | DCF | Loan closing rates | 7.2 | - | 97.2 % | 65.7 | % | (c) |\n| Swap associated with the sale of Visa, Inc. Class B Shares | ( 183 ) | DCF | Timing of the resolution of the Covered Litigation | Q3 2022 | - | Q2 2024 | Q1 2023 | (d) |\n\n(a)Unobservable inputs were weighted by the relative carrying value of the instruments.\n(b)Unobservable inputs were weighted by the relative unpaid principal balance of the instruments.\n(c)Unobservable inputs were weighted by the relative notional amount of the instruments.\n(d)Unobservable inputs were weighted by the probability of the final funding date of the instruments.\nAssets and Liabilities Measured at Fair Value on a Nonrecurring Basis\nCertain assets and liabilities are measured at fair value on a nonrecurring basis. These assets and liabilities are not measured at fair value on an ongoing basis; however, they are subject to fair value adjustments in certain circumstances, such as when there is evidence of impairment.\nThe following tables provide the fair value hierarchy and carrying amount of all assets that were held as of June 30, 2021 and 2020, and for which a nonrecurring fair value adjustment was recorded during the three and six months ended June 30, 2021 and 2020, and the related gains and losses from fair value adjustments on assets sold during the period as well as assets still held as of the end of the period.\n| Fair Value Measurements Using | Total (Losses) Gains |\n| As of June 30, 2021 ($ in millions) | Level 1 | Level 2 | Level 3 | Total | For the three months ended June 30, 2021 | For the six months ended June 30, 2021 |\n| Commercial loans held for sale | $ | — | — | 2 | 2 | — | 1 |\n| Commercial loans and leases | — | — | 313 | 313 | ( 39 ) | ( 44 ) |\n| Consumer and residential mortgage loans | — | — | 140 | 140 | 1 | ( 1 ) |\n| OREO | — | — | 6 | 6 | — | ( 6 ) |\n| Bank premises and equipment | — | — | 7 | 7 | ( 1 ) | ( 2 ) |\n| Operating lease equipment | — | — | 34 | 34 | — | ( 25 ) |\n| Private equity investments | — | 1 | — | 1 | — | — |\n| Total | $ | — | 1 | 502 | 503 | ( 39 ) | ( 77 ) |\n\n128\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n| Fair Value Measurements Using | Total (Losses) Gains |\n| As of June 30, 2020 ($ in millions) | Level 1 | Level 2 | Level 3 | Total | For the three months ended June 30, 2020 | For the six months ended June 30, 2020 |\n| Commercial loans held for sale | $ | — | 37 | 17 | 54 | ( 1 ) | ( 4 ) |\n| Commercial loans and leases | — | — | 569 | 569 | ( 118 ) | ( 192 ) |\n| Consumer and residential mortgage loans | — | — | 186 | 186 | 2 | 3 |\n| OREO | — | — | 18 | 18 | ( 1 ) | ( 6 ) |\n| Bank premises and equipment | — | — | 14 | 14 | ( 12 ) | ( 14 ) |\n| Operating lease equipment | — | — | 10 | 10 | — | ( 3 ) |\n| Private equity investments | — | — | 70 | 70 | — | ( 9 ) |\n| Total | $ | — | 37 | 884 | 921 | ( 130 ) | ( 225 ) |\n\nThe following tables present information as of June 30, 2021 and 2020 about significant unobservable inputs related to the Bancorp’s material categories of Level 3 financial assets and liabilities measured on a nonrecurring basis:\n| As of June 30, 2021 ($ in millions) |\n| Financial Instrument | Fair Value | Valuation Technique | Significant Unobservable Inputs | Ranges ofInputs | Weighted-Average |\n| Commercial loans held for sale | $ | 2 | Comparable company analysis | Market comparable transactions | NM | NM |\n| Commercial loans and leases | 313 | Appraised value | Collateral value | NM | NM |\n| Consumer and residential mortgage loans | 140 | Appraised value | Collateral value | NM | NM |\n| OREO | 6 | Appraised value | Appraised value | NM | NM |\n| Bank premises and equipment | 7 | Appraised value | Appraised value | NM | NM |\n| Operating lease equipment | 34 | Appraised value | Appraised value | NM | NM |\n\n| As of June 30, 2020 ($ in millions) |\n| Financial Instrument | Fair Value | Valuation Technique | Significant Unobservable Inputs | Ranges ofInputs | Weighted-Average |\n| Commercial loans held for sale | $ | 16 | Comparable company analysis | Market comparable transactions | NM | NM |\n| 1 | Appraised value | Appraised value | NM | NM |\n| Commercial loans and leases | 569 | Appraised value | Collateral value | NM | NM |\n| Consumer and residential mortgage loans | 186 | Appraised value | Collateral value | NM | NM |\n| OREO | 18 | Appraised value | Appraised value | NM | NM |\n| Bank premises and equipment | 14 | Appraised value | Appraised value | NM | NM |\n| Operating lease equipment | 10 | Appraised value | Appraised value | NM | NM |\n| Private equity investments | 70 | Comparable company analysis | Market comparable transactions | NM | NM |\n\nCommercial loans held for sale\nThe Bancorp estimated the fair value of certain commercial loans held for sale during the six months ended June 30, 2021 and 2020, resulting in positive fair value adjustments of an immaterial amount during both the three and six months ended June 30, 2021, and negative fair value adjustments of $ 1 million and $ 4 million during the three and six months ended June 30, 2020, respectively. These valuations were based on quoted prices for similar assets in active markets (Level 2 of the valuation hierarchy), appraisals of the underlying collateral or by applying unobservable inputs such as an estimated market discount to the unpaid principal balance of the loans or the appraised values of the assets (Level 3 of the valuation hierarchy). The Bancorp recognized losses of an immaterial amount and gains of $ 1 million on the sale of certain commercial loans held for sale during the three and six months ended June 30, 2021, respectively, and gains of an immaterial amount during both the three and six months ended June 30, 2020.\nPortfolio loans and leases\nDuring the three and six months ended June 30, 2021 and 2020, the Bancorp recorded nonrecurring impairment adjustments to certain collateral-dependent portfolio loans and leases. When a loan is collateral-dependent, the fair value of the loan is generally based on the fair value less cost to sell of the underlying collateral supporting the loan and therefore these loans were classified within Level 3 of the valuation hierarchy. In cases where the carrying value exceeds the fair value, an impairment loss is recognized. The fair values and recognized impairment losses are reflected in the previous tables.\nOREO\nDuring the three and six months ended June 30, 2021 and 2020, the Bancorp recorded nonrecurring adjustments to certain commercial and residential real estate properties and branch-related real estate no longer intended to be used for banking purposes classified as OREO and\n129\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nmeasured at the lower of carrying amount or fair value. These nonrecurring losses were primarily due to declines in real estate values of the properties recorded in OREO. These losses include an immaterial amount and $ 6 million in losses, respectively, recorded as charge-offs on new OREO properties transferred from loans, during the three and six months ended June 30, 2021 compared to an immaterial amount and $ 2 million in losses during the three and six months ended June 30, 2020, respectively. These losses also included an immaterial amount for both the three and six months ended June 30, 2021, and $ 1 million and $ 4 million for the three and six months ended June 30, 2020, respectively, recorded as negative fair value adjustments on OREO in other noninterest expense or other noninterest income in the Condensed Consolidated Statements of Income subsequent to their transfer into OREO. The fair value amounts are generally based on appraisals of the property values, resulting in a classification within Level 3 of the valuation hierarchy. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized. The previous tables reflect the fair value measurements of the properties before deducting the estimated costs to sell.\nBank premises and equipment\nThe Bancorp performs assessments of the recoverability of long-lived assets when events or changes in circumstances indicate that their carrying values may not be recoverable. These properties were written down to their lower of cost or market values. At least annually thereafter, the Bancorp will review these properties for market fluctuations. The fair value amounts were generally based on appraisals of the property values, resulting in a classification within Level 3 of the valuation hierarchy. For further information on bank premises and equipment, refer to Note 7.\nOperating lease equipment\nThe Bancorp performs assessments of the recoverability of long-lived assets when events or changes in circumstances indicate that their carrying values may not be recoverable. When evaluating whether an individual asset is impaired, the Bancorp considers the current fair value of the asset, the changes in overall market demand for the asset and the rate of change in advancements associated with technological improvements that impact the demand for the specific asset under review. As part of this ongoing assessment, the Bancorp determined that the carrying values of certain operating lease equipment were not recoverable and, as a result, the Bancorp recorded an impairment loss equal to the amount by which the carrying value of the assets exceeded the fair value. The fair value amounts were generally based on appraised values of the assets, resulting in a classification within Level 3 of the valuation hierarchy.\nPrivate equity investments\nThe Bancorp accounts for its private equity investments using the measurement alternative to fair value, except for those accounted for under the equity method of accounting. Under the measurement alternative, the Bancorp carries each investment at its cost basis minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for identical or similar investments of the same issuer. The Bancorp recognized an immaterial amount of gains resulting from observable price changes during both the three and six months ended June 30, 2021 and 2020. The carrying value of the Bancorp’s private equity investments still held as of June 30, 2021 includes a cumulative $ 70 million of positive adjustments as a result of observable price changes since January 1, 2018. Because these adjustments are based on observable transactions in inactive markets, they are classified in Level 2 of the fair value hierarchy.\nFor private equity investments which are accounted for using the measurement alternative to fair value, the Bancorp qualitatively evaluates each investment quarterly to determine if impairment may exist. If necessary, the Bancorp then measures impairment by estimating the value of its investment and comparing that to the investment’s carrying value, whether or not the Bancorp considers the impairment to be temporary. These valuations are typically developed using a DCF method, but other methods may be used if more appropriate for the circumstances. These valuations are based on unobservable inputs and therefore are classified in Level 3 of the fair value hierarchy. The Bancorp recognized impairments of an immaterial amount for both the three and six months ended June 30, 2021 compared to zero and $ 9 million for the three and six months ended June 30, 2020, respectively. The carrying value of the Bancorp’s private equity investments still held as of June 30, 2021 includes a cumulative $ 21 million of impairment charges recognized since adoption of the measurement alternative to fair value on January 1, 2018.\nFair Value Option\nThe Bancorp elected to measure certain residential mortgage loans held for sale under the fair value option as allowed under U.S. GAAP. Electing to measure residential mortgage loans held for sale at fair value reduces certain timing differences and better matches changes in the value of these assets with changes in the value of derivatives used as economic hedges for these assets. Management’s intent to sell residential mortgage loans classified as held for sale may change over time due to such factors as changes in the overall liquidity in markets or changes in characteristics specific to certain loans held for sale. Consequently, these loans may be reclassified to loans held for investment and maintained in the Bancorp’s loan portfolio. In such cases, the loans will continue to be measured at fair value.\nFair value changes recognized in earnings for residential mortgage loans held at June 30, 2021 and 2020 for which the fair value option was elected, as well as the changes in fair value of the underlying IRLCs, included gains of $ 59 million and $ 45 million, respectively. These gains are reported in mortgage banking net revenue in the Condensed Consolidated Statements of Income.\n130\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nValuation adjustments related to instrument-specific credit risk for residential mortgage loans measured at fair value negatively impacted the fair value of those loans by $ 1 million at both June 30, 2021 and December 31, 2020. Interest on loans measured at fair value is accrued as it is earned using the effective interest method and is reported as interest income in the Condensed Consolidated Statements of Income.\nThe following table summarizes the difference between the fair value and the unpaid principal balance for residential mortgage loans measured at fair value as of:\n| June 30, 2021 ($ in millions) | AggregateFair Value | Aggregate UnpaidPrincipal Balance | Difference |\n| Residential mortgage loans measured at fair value | $ | 1,784 | 1,725 | 59 |\n| Past due loans of 90 days or more | 2 | 3 | ( 1 ) |\n| Nonaccrual loans | — | — | — |\n| December 31, 2020 |\n| Residential mortgage loans measured at fair value | $ | 1,642 | 1,567 | 75 |\n| Past due loans of 90 days or more | 3 | 3 | — |\n| Nonaccrual loans | — | — | — |\n\nThe Bancorp invests in certain hybrid financial instruments with embedded derivatives that are not clearly and closely related to the host contracts. The Bancorp has elected to measure the entire instrument at fair value with changes in fair value recognized in earnings. The carrying value of these investments was $ 48 million as of June 30, 2021 and the investments are classified as trading debt securities on the Condensed Consolidated Balance Sheets. Fair value changes recognized in earnings included losses of $ 8 million and gains of $ 1 million for the three and six months ended June 30, 2021, respectively, reported in securities gains (losses), net in the Condensed Consolidated Statements of Income.\nFair Value of Certain Financial Instruments\nThe following tables summarize the carrying amounts and estimated fair values for certain financial instruments, excluding financial instruments measured at fair value on a recurring basis:\n| Net CarryingAmount | Fair Value Measurements Using | TotalFair Value |\n| As of June 30, 2021 ($ in millions) | Level 1 | Level 2 | Level 3 |\n| Financial assets: |\n| Cash and due from banks | $ | 3,285 | 3,285 | — | — | 3,285 |\n| Other short-term investments | 32,409 | 32,409 | — | — | 32,409 |\n| Other securities | 520 | — | 520 | — | 520 |\n| Held-to-maturity securities | 10 | — | — | 10 | 10 |\n| Loans and leases held for sale | 4,097 | — | — | 4,104 | 4,104 |\n| Portfolio loans and leases: |\n| Commercial loans and leases | 65,796 | — | — | 66,498 | 66,498 |\n| Consumer and residential mortgage loans | 39,753 | — | — | 40,941 | 40,941 |\n| Total portfolio loans and leases, net | $ | 105,549 | — | — | 107,439 | 107,439 |\n| Financial liabilities: |\n| Deposits | $ | 162,283 | — | 162,285 | — | 162,285 |\n| Federal funds purchased | 338 | 338 | — | — | 338 |\n| Other short-term borrowings | 1,130 | — | 1,130 | — | 1,130 |\n| Long-term debt | 12,364 | 12,821 | 850 | — | 13,671 |\n\n131\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n| Net CarryingAmount | Fair Value Measurements Using | TotalFair Value |\n| As of December 31, 2020 ($ in millions) | Level 1 | Level 2 | Level 3 |\n| Financial assets: |\n| Cash and due from banks | $ | 3,147 | 3,147 | — | — | 3,147 |\n| Other short-term investments | 33,399 | 33,399 | — | — | 33,399 |\n| Other securities | 524 | — | 524 | — | 524 |\n| Held-to-maturity securities | 11 | — | — | 11 | 11 |\n| Loans and leases held for sale | 3,260 | — | — | 3,269 | 3,269 |\n| Portfolio loans and leases: |\n| Commercial loans and leases | 67,541 | — | — | 67,810 | 67,810 |\n| Consumer loans | 38,627 | — | — | 40,522 | 40,522 |\n| Total portfolio loans and leases, net | $ | 106,168 | — | — | 108,332 | 108,332 |\n| Financial liabilities: |\n| Deposits | $ | 159,081 | — | 159,094 | — | 159,094 |\n| Federal funds purchased | 300 | 300 | — | — | 300 |\n| Other short-term borrowings | 1,192 | — | 1,192 | — | 1,192 |\n| Long-term debt | 14,973 | 15,606 | 923 | — | 16,529 |\n\n132\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n22. Business Segments\nThe Bancorp reports on four business segments: Commercial Banking, Branch Banking, Consumer Lending and Wealth and Asset Management. Results of the Bancorp’s business segments are presented based on its management structure and management accounting practices. The structure and accounting practices are specific to the Bancorp; therefore, the financial results of the Bancorp’s business segments are not necessarily comparable with similar information for other financial institutions. The Bancorp refines its methodologies from time to time as management’s accounting practices and businesses change.\nThe Bancorp manages interest rate risk centrally at the corporate level. By employing an FTP methodology, the business segments are insulated from most benchmark interest rate volatility, enabling them to focus on serving customers through the origination of loans and acceptance of deposits. The FTP methodology assigns charge and credit rates to classes of assets and liabilities, respectively, based on the estimated amount and timing of the cash flows for each transaction. Assigning the FTP rate based on matching the duration of cash flows allocates interest income and interest expense to each business segment so its resulting net interest income is insulated from future changes in benchmark interest rates. The Bancorp’s FTP methodology also allocates the contribution to net interest income of the asset-generating and deposit-providing businesses on a duration-adjusted basis to better attribute the driver of the performance. As the asset and liability durations are not perfectly matched, the residual impact of the FTP methodology is captured in General Corporate and Other. The charge and credit rates are determined using the FTP rate curve, which is based on an estimate of Fifth Third’s marginal borrowing cost in the wholesale funding markets. The FTP curve is constructed using the U.S. swap curve, brokered CD pricing and unsecured debt pricing.\nThe Bancorp adjusts the FTP charge and credit rates as dictated by changes in interest rates for various interest-earning assets and interest-bearing liabilities and by the review of behavioral assumptions, such as prepayment rates on interest-earning assets and the estimated durations for indeterminate-lived deposits. Key assumptions, including the credit rates provided for deposit accounts, are reviewed annually. Credit rates for deposit products and charge rates for loan products may be reset more frequently in response to changes in market conditions.\nThe Bancorp’s methodology for allocating provision for credit losses expense to the business segments includes charges or benefits associated with changes in criticized commercial loan levels in addition to actual net charge-offs experienced by the loans and leases owned by each business segment. Provision for credit losses expense attributable to loan and lease growth and changes in ALLL factors is captured in General Corporate and Other. The financial results of the business segments include allocations for shared services and headquarters expenses. Additionally, the business segments form synergies by taking advantage of relationship depth opportunities and funding operations by accessing the capital markets as a collective unit.\nThe following is a description of each of the Bancorp’s business segments and the products and services they provide to their respective client bases.\nCommercial Banking offers credit intermediation, cash management and financial services to large and middle-market businesses and government and professional customers. In addition to the traditional lending and depository offerings, Commercial Banking products and services include global cash management, foreign exchange and international trade finance, derivatives and capital markets services, asset-based lending, real estate finance, public finance, commercial leasing and syndicated finance.\nBranch Banking provides a full range of deposit and loan and lease products to individuals and small businesses through 1,096 full-service banking centers. Branch Banking offers depository and loan products, such as checking and savings accounts, home equity loans and lines of credit, credit cards and loans for automobiles and other personal financing needs, as well as products designed to meet the specific needs of small businesses, including cash management services.\nConsumer Lending includes the Bancorp’s residential mortgage, automobile and other indirect lending activities. Residential mortgage activities within Consumer Lending include the origination, retention and servicing of residential mortgage loans, sales and securitizations of those loans and all associated hedging activities. Residential mortgages are primarily originated through a dedicated sales force and through third-party correspondent lenders. Automobile and other indirect lending activities include extending loans to consumers through automobile dealers, motorcycle dealers, powersport dealers, recreational vehicle dealers and marine dealers.\nWealth and Asset Management provides a full range of wealth management services for individuals, companies and not-for-profit organizations. Wealth and Asset Management is made up of three main businesses: FTS, an indirect wholly-owned subsidiary of the Bancorp; Fifth Third Private Bank; and Fifth Third Institutional Services. FTS offers full service retail brokerage services to individual clients and broker-dealer services to the institutional marketplace. Fifth Third Private Bank offers wealth management strategies to high net worth and ultra-high net worth clients through wealth planning, investment management, banking, insurance, trust and estate services. Fifth Third Institutional Services provides advisory services for institutional clients, including middle market businesses, non-profits, states and municipalities.\n133\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following tables present the results of operations and assets by business segment for the three months ended:\n| June 30, 2021 ($ in millions) | CommercialBanking | BranchBanking | ConsumerLending | Wealthand AssetManagement | GeneralCorporate and Other | Eliminations | Total |\n| Net interest income | $ | 376 | 301 | 142 | 21 | 368 | — | 1,208 |\n| (Benefit from) provision for credit losses | ( 151 ) | 25 | — | — | 11 | — | ( 115 ) |\n| Net interest income after (benefit from) provision for credit losses | $ | 527 | 276 | 142 | 21 | 357 | — | 1,323 |\n| Noninterest income: |\n| Commercial banking revenue | $ | 156 | 3 | — | 1 | — | — | 160 |\n| Service charges on deposits | 92 | 57 | — | — | — | — | 149 |\n| Wealth and asset management revenue | 1 | 52 | — | 138 | — | ( 46 ) | (a) | 145 |\n| Card and processing revenue | 15 | 84 | — | 1 | 2 | — | 102 |\n| Mortgage banking net revenue | — | 3 | 60 | 1 | — | — | 64 |\n| Leasing business revenue | 61 | — | — | — | — | — | 61 |\n| Other noninterest income(b) | 30 | 25 | 2 | 2 | ( 10 ) | — | 49 |\n| Securities gains, net | — | — | — | — | 10 | — | 10 |\n| Securities gains, net – non-qualifying hedges on MSRs | — | — | 1 | — | — | — | 1 |\n| Total noninterest income | $ | 355 | 224 | 63 | 143 | 2 | ( 46 ) | 741 |\n| Noninterest expense: |\n| Compensation and benefits | $ | 136 | 158 | 61 | 49 | 234 | — | 638 |\n| Technology and communications | 4 | 1 | 3 | — | 86 | — | 94 |\n| Net occupancy expense(c) | 8 | 49 | 3 | 4 | 13 | — | 77 |\n| Equipment expense | 7 | 9 | — | — | 18 | — | 34 |\n| Leasing business expense | 33 | — | — | — | — | — | 33 |\n| Card and processing expense | 2 | 19 | — | — | ( 1 ) | — | 20 |\n| Marketing expense | 2 | 7 | 1 | — | 10 | — | 20 |\n| Other noninterest expense | 207 | 207 | 95 | 78 | ( 304 ) | ( 46 ) | 237 |\n| Total noninterest expense | $ | 399 | 450 | 163 | 131 | 56 | ( 46 ) | 1,153 |\n| Income before income taxes | $ | 483 | 50 | 42 | 33 | 303 | — | 911 |\n| Applicable income tax expense | 90 | 10 | 9 | 7 | 86 | — | 202 |\n| Net income | $ | 393 | 40 | 33 | 26 | 217 | — | 709 |\n| Total goodwill | $ | 1,981 | 2,047 | — | 231 | — | — | 4,259 |\n| Total assets | $ | 68,851 | 87,646 | 33,215 | 10,881 | 4,797 | (d) | — | 205,390 |\n\n(a)Revenue sharing agreements between wealth and asset management and branch banking are eliminated in the Condensed Consolidated Statements of Income.\n(b)Includes impairment charges of $ 2 for branches and land recorded in Branch Banking. For more information, refer to Note 7 and Note 21.\n(c)Includes impairment losses and termination charges of $ 2 for ROU assets related to certain operating leases. For more information refer to Note 9.\n(d)Includes bank premises and equipment of $ 25 classified as held for sale. For more information, refer to Note 7.\n134\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n| June 30, 2020 ($ in millions) | CommercialBanking | BranchBanking | ConsumerLending | Wealthand AssetManagement | GeneralCorporate and Other | Eliminations | Total |\n| Net interest income | $ | 570 | 513 | 92 | 51 | ( 26 ) | — | 1,200 |\n| Provision for (benefit from) credit losses | 457 | 52 | 10 | ( 1 ) | ( 33 ) | — | 485 |\n| Net interest income after provision for (benefit from) credit losses | $ | 113 | 461 | 82 | 52 | 7 | — | 715 |\n| Noninterest income: |\n| Commercial banking revenue | $ | 136 | 1 | — | 1 | ( 1 ) | — | 137 |\n| Service charges on deposits | 79 | 42 | — | — | 1 | — | 122 |\n| Wealth and asset management revenue | 1 | 39 | — | 115 | — | ( 35 ) | (a) | 120 |\n| Card and processing revenue | 11 | 68 | — | — | 3 | — | 82 |\n| Mortgage banking net revenue | — | 2 | 96 | 1 | — | — | 99 |\n| Leasing business revenue | 57 | — | — | — | — | — | 57 |\n| Other noninterest income(b) | 10 | 15 | 2 | 4 | ( 19 ) | — | 12 |\n| Securities gains, net | — | — | — | — | 21 | — | 21 |\n| Securities gains, net – non-qualifying hedges on MSRs | — | — | — | — | — | — | — |\n| Total noninterest income | $ | 294 | 167 | 98 | 121 | 5 | ( 35 ) | 650 |\n| Noninterest expense: |\n| Compensation and benefits | $ | 129 | 161 | 53 | 50 | 234 | — | 627 |\n| Technology and communications | 3 | 1 | 2 | — | 84 | — | 90 |\n| Net occupancy expense(c) | 8 | 44 | 2 | 3 | 25 | — | 82 |\n| Equipment expense | 7 | 10 | — | — | 15 | — | 32 |\n| Leasing business expense | 33 | — | — | — | — | — | 33 |\n| Card and processing expense | 2 | 28 | — | — | ( 1 ) | — | 29 |\n| Marketing expense | 2 | 5 | 1 | — | 12 | — | 20 |\n| Other noninterest expense | 221 | 205 | 62 | 69 | ( 314 ) | ( 35 ) | 208 |\n| Total noninterest expense | $ | 405 | 454 | 120 | 122 | 55 | ( 35 ) | 1,121 |\n| Income (loss) before income taxes | $ | 2 | 174 | 60 | 51 | ( 43 ) | — | 244 |\n| Applicable income tax expense (benefit) | ( 10 ) | 36 | 12 | 11 | — | — | 49 |\n| Net income (loss) | $ | 12 | 138 | 48 | 40 | ( 43 ) | — | 195 |\n| Total goodwill | $ | 1,961 | 2,047 | — | 253 | — | — | 4,261 |\n| Total assets | $ | 76,437 | 77,219 | 26,451 | 11,680 | 11,119 | (d) | — | 202,906 |\n\n(a)Revenue sharing agreements between wealth and asset management and branch banking are eliminated in the Condensed Consolidated Statements of Income.\n(b)Includes impairment charges of $ 4 and $ 8 for branches and land recorded in Branch Banking and General Corporate and Other, respectively. For more information, refer to Note 7 and Note 21.\n(c)Includes impairment losses and termination charges of $ 3 for ROU assets related to certain operating leases. For more information refer to Note 9.\n(d)Includes bank premises and equipment of $ 53 classified as held for sale. For more information, refer to Note 7.\n135\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following tables present the results of operations and assets by business segment for the six months ended:\n| June 30, 2021 ($ in millions) | CommercialBanking | BranchBanking | ConsumerLending | Wealthand AssetManagement | GeneralCorporate and Other | Eliminations | Total |\n| Net interest income | $ | 741 | 596 | 269 | 42 | 737 | — | 2,385 |\n| (Benefit from) provision for credit losses | ( 227 ) | 66 | 8 | ( 1 ) | ( 134 ) | — | ( 288 ) |\n| Net interest income after (benefit from) provision for credit losses | $ | 968 | 530 | 261 | 43 | 871 | — | 2,673 |\n| Noninterest income: |\n| Commercial banking revenue | $ | 307 | 5 | — | 1 | — | — | 313 |\n| Service charges on deposits | 181 | 111 | — | — | — | — | 292 |\n| Wealth and asset management revenue | 1 | 102 | — | 274 | — | ( 89 ) | (a) | 288 |\n| Card and processing revenue | 29 | 161 | — | 1 | 5 | — | 196 |\n| Mortgage banking net revenue | — | 5 | 142 | 2 | — | — | 149 |\n| Leasing business revenue | 148 | (c) | — | — | — | — | — | 148 |\n| Other noninterest income(b) | 42 | 45 | 4 | 3 | ( 2 ) | — | 92 |\n| Securities gains, net | 7 | — | — | — | 6 | — | 13 |\n| Securities losses, net – non-qualifying hedges on MSRs | — | — | ( 1 ) | — | — | — | ( 1 ) |\n| Total noninterest income | $ | 715 | 429 | 145 | 281 | 9 | ( 89 ) | 1,490 |\n| Noninterest expense: |\n| Compensation and benefits | $ | 292 | 328 | 127 | 103 | 493 | — | 1,343 |\n| Technology and communications | 7 | 2 | 5 | — | 173 | — | 187 |\n| Net occupancy expense(d) | 17 | 96 | 5 | 7 | 31 | — | 156 |\n| Equipment expense | 13 | 19 | — | — | 36 | — | 68 |\n| Leasing business expense | 68 | — | — | — | — | — | 68 |\n| Card and processing expense | 3 | 49 | — | — | ( 2 ) | — | 50 |\n| Marketing expense | 3 | 15 | 1 | 1 | 23 | — | 43 |\n| Other noninterest expense | 416 | 430 | 186 | 156 | ( 645 ) | ( 89 ) | 454 |\n| Total noninterest expense | $ | 819 | 939 | 324 | 267 | 109 | ( 89 ) | 2,369 |\n| Income before income taxes | $ | 864 | 20 | 82 | 57 | 771 | — | 1,794 |\n| Applicable income tax expense | 160 | 4 | 17 | 12 | 198 | — | 391 |\n| Net income | $ | 704 | 16 | 65 | 45 | 573 | — | 1,403 |\n| Total goodwill | $ | 1,981 | 2,047 | — | 231 | — | — | 4,259 |\n| Total assets | $ | 68,851 | 87,646 | 33,215 | 10,881 | 4,797 | (e) | — | 205,390 |\n\n(a)Revenue sharing agreements between wealth and asset management and branch banking are eliminated in the Condensed Consolidated Statements of Income.\n(b)Includes impairment charges of $ 3 and $ 1 for branches and land recorded in Branch Banking and General Corporate and Other, respectively. For more information, refer to Note 7 and Note 21.\n(c)Includes impairment charges of $ 25 for operating lease equipment. For more information, refer to Note 8 and Note 21.\n(d)Includes impairment losses and termination charges of $ 2 for ROU assets related to certain operating leases. For more information refer to Note 9.\n(e)Includes bank premises and equipment of $ 25 classified as held for sale. For more information, refer to Note 7.\n136\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n| June 30, 2020 ($ in millions) | CommercialBanking | BranchBanking | ConsumerLending | Wealthand AssetManagement | GeneralCorporate and Other | Eliminations | Total |\n| Net interest income | $ | 1,078 | 1,017 | 181 | 88 | 65 | — | 2,429 |\n| Provision for credit losses | 502 | 114 | 23 | — | 486 | — | 1,125 |\n| Net interest income after provision for credit losses | $ | 576 | 903 | 158 | 88 | ( 421 ) | — | 1,304 |\n| Noninterest income: |\n| Commercial banking revenue | $ | 260 | 2 | — | 1 | ( 2 ) | — | 261 |\n| Service charges on deposits | 162 | 107 | — | 1 | — | — | 270 |\n| Wealth and asset management revenue | 2 | 84 | — | 244 | — | ( 75 ) | (a) | 255 |\n| Card and processing revenue | 26 | 133 | — | 1 | 7 | — | 167 |\n| Mortgage banking net revenue | — | 4 | 213 | 2 | — | — | 219 |\n| Leasing business revenue | 131 | (c) | — | — | — | — | — | 131 |\n| Other noninterest income(b) | ( 1 ) | 34 | 6 | 9 | ( 30 ) | — | 18 |\n| Securities losses, net | — | — | — | — | ( 3 ) | — | ( 3 ) |\n| Securities gains, net – non-qualifying hedges on MSRs | — | — | 3 | — | — | — | 3 |\n| Total noninterest income | $ | 580 | 364 | 222 | 258 | ( 28 ) | ( 75 ) | 1,321 |\n| Noninterest expense: |\n| Compensation and benefits | $ | 278 | 330 | 104 | 112 | 450 | — | 1,274 |\n| Technology and communications | 6 | 1 | 5 | — | 171 | — | 183 |\n| Net occupancy expense(e) | 15 | 87 | 5 | 6 | 51 | — | 164 |\n| Equipment expense | 14 | 21 | — | — | 29 | — | 64 |\n| Leasing business expense | 68 | — | — | — | — | — | 68 |\n| Card and processing expense | 4 | 58 | — | — | ( 2 ) | — | 60 |\n| Marketing expense | 4 | 17 | 2 | 1 | 27 | — | 51 |\n| Other noninterest expense | 495 | 426 | 128 | 147 | ( 664 ) | ( 75 ) | 457 |\n| Total noninterest expense | $ | 884 | 940 | 244 | 266 | 62 | ( 75 ) | 2,321 |\n| Income (loss) before income taxes | $ | 272 | 327 | 136 | 80 | ( 511 ) | — | 304 |\n| Applicable income tax expense (benefit) | 35 | 69 | 29 | 16 | ( 88 ) | — | 61 |\n| Net income (loss) | $ | 237 | 258 | 107 | 64 | ( 423 ) | — | 243 |\n| Total goodwill | $ | 1,961 | 2,047 | — | 253 | — | — | 4,261 |\n| Total assets | $ | 76,437 | 77,219 | 26,451 | 11,680 | 11,119 | (d) | — | 202,906 |\n\n(a)Revenue sharing agreements between wealth and asset management and branch banking are eliminated in the Condensed Consolidated Statements of Income.\n(b)Includes impairment charges of $ 4 and $ 10 for branches and land recorded in Branch Banking and General Corporate and Other, respectively. For more information, refer to Note 7 and Note 21.\n(c)Includes impairment charges of $ 3 for operating lease equipment. For more information, refer to Note 8 and Note 21.\n(d)Includes bank premises and equipment of $ 53 classified as held for sale. For more information, refer to Note 7.\n(e)Includes impairment losses of and termination charges of $ 5 for ROU assets related to certain operating leases. For more information, refer to Note 9.\n23. Subsequent Event\nOn July 23, 2021, the Bancorp entered into an accelerated share repurchase transaction with a counterparty pursuant to which the Bancorp paid $ 550 million on July 27, 2021 to repurchase shares of its outstanding common stock. The Bancorp is repurchasing the shares of its common stock as part of its Board-approved 100 million share repurchase program previously announced on June 18, 2019. The Bancorp expects the final settlement of the transaction to occur on or before September 29, 2021.\n137\nPART II. OTHER INFORMATION\nLegal Proceedings (Item 1)\nRefer to Note 17 of the Notes to Condensed Consolidated Financial Statements in Part I, Item 1 for information regarding legal proceedings.\nRisk Factors (Item 1A)\nThe following is a change to the risk factors as previously disclosed in Item 1A of the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2020. Other than as set forth below, there were no material changes to the risk factors disclosed in Item 1A of the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2020.\nThe COVID-19 pandemic creates significant risks and uncertainties for Fifth Third’s business.\nIn March 2020, the World Health Organization declared novel coronavirus disease 2019 (COVID-19) a global pandemic. The COVID-19 pandemic has negatively impacted the global economy, disrupted global supply chains, created significant volatility and disruption in financial markets and increased unemployment levels, all of which may become heightened concerns upon subsequent waves of infection or future developments. In addition, the pandemic resulted in temporary closures of many businesses and the institution of social distancing and sheltering in place requirements in many states and communities, including those in major markets in which the Bancorp is located or does business.\nAs a result, the demand for the Bancorp’s products and services has been, and is expected to continue to be, significantly impacted. Furthermore, the pandemic could influence the recognition of credit losses in the Bancorp’s loan and lease portfolios and increase its allowance for credit losses as both businesses and consumers are negatively impacted by the economic downturn. In addition, governmental actions are meaningfully influencing the interest-rate environment, which could continue to adversely affect the Bancorp’s results of operations and financial condition. The business operations of subsidiaries of the Bancorp, such as Fifth Third Bank, National Association, have been, and may also be disrupted in the future, if significant portions of their workforce are unable to work effectively, including because of illness, quarantines, government actions, travel restrictions, technology limitations and/or disruptions or other restrictions in connection with the pandemic. Furthermore, the business operations of subsidiaries of the Bancorp have been, and may again in the future be, disrupted due to vendors and third party service providers being unable to work or provide services effectively, including because of illness, quarantines, government actions, or other restrictions in connection with the pandemic. An increase in the remote work force due to the COVID-19 pandemic and the potential for a long-term change in Fifth Third’s remote work strategy may also increase risks related to cybersecurity and information security.\nIn response to the pandemic, the Bancorp provided financial hardship relief to borrowers that were negatively impacted by the pandemic and its related economic impacts. These programs included payment deferrals and forbearances for both commercial and retail borrowers. The Bancorp has also temporarily suspended all residential foreclosure activity. These actions are expected to negatively impact revenue and other results of operations of the Bancorp in the near term and, if not effective in mitigating the effects of the COVID-19 pandemic on the Bancorp’s customers, may adversely affect the Bancorp’s business and results of operations more substantially over a longer period of time.\nGovernmental authorities have taken significant measures to provide economic assistance to households and businesses, to stabilize the markets and to support economic growth. For example, in response to the COVID-19 pandemic, the FRB and other U.S. state and federal financial regulatory agencies took action to mitigate the resulting disruptions to economic activity and financial stability by implementing a number of facilities to provide emergency liquidity to various segments of the U.S. economy and financial markets. Many of these facilities expired on or before December 31, 2020 or were extended for brief periods into 2021. The expiration of these facilities could have an adverse effect on U.S. economy and ultimately on the Bancorp’s business.\nAmong other relief programs, the Bancorp is a participating lender in the SBA’s Paycheck Protection Program. Paycheck Protection Program loans are fixed, unsecured, low interest rate loans that are guaranteed by the SBA and subject to numerous other regulatory requirements, and a borrower may apply to have all or a portion of the loan forgiven. If Paycheck Protection Program borrowers fail to qualify for loan forgiveness, the Bancorp faces a heightened risk of holding these loans at unfavorable interest rates for an extended period of time. While the Paycheck Protection Program loans are guaranteed by the SBA, various regulatory requirements will apply to the Bancorp’s ability to seek recourse under the guarantees and the related procedures are currently subject to uncertainty. If a borrower defaults on a Paycheck Protection Program loan, these requirements and uncertainties may limit the Bancorp’s ability to fully recover against the loan guarantee or to seek full recourse against the borrower. These assistance efforts may adversely affect the Bancorp’s revenue and results of operations and may make the Bancorp’s results more difficult to forecast. Further, the timing and amount of forgiveness to which the Bancorp’s borrowers will be entitled cannot be predicted. The Paycheck Protection Program and other government programs in which the Bancorp may participate are complex and the Bancorp’s participation may lead to governmental and regulatory scrutiny, negative publicity and damage to the Bancorp’s reputation.\nThe extent to which the COVID-19 pandemic impacts the Bancorp’s business, results of operations, and financial condition, as well as its regulatory capital and liquidity ratios, will depend on highly uncertain future developments, including the scope and duration of the pandemic (including the possibility of further surges of COVID-19 and any virus variants, which may or may not respond to available vaccinations), the timing and efficacy of the vaccination program in the U.S. and further actions taken by governmental authorities and other third parties in response to the pandemic. Government actions to mitigate the economic suffering caused by the COVID-19 pandemic may not be successful\n138\nor may result in increased pressure on the banking sector, which could adversely affect the Bancorp’s business, results of operations and financial condition more substantially over a longer period of time. In addition, the unique historical nature of the pandemic and the unprecedented level of governmental response may also significantly impact the Bancorp’s ability to effectively manage its business or predict future performance.\nAs the COVID-19 pandemic subsides, the U.S. economy may require some time to fully recover from its effects, the length of which is unknown. The effects of the COVID-19 pandemic may heighten many of the other risks described in Item 1A. Risk Factors of the Bancorp’s Annual Report on Form 10-K and any subsequent Quarterly Report on Form 10-Q or Current Report on Form 8-K, including, but not limited to, risks of credit deterioration, interest rate changes, rating agency actions, governmental actions, market volatility, theft, fraud, security breaches and technology interruptions.\nUnregistered Sales of Equity Securities and Use of Proceeds (Item 2)\nRefer to the “Capital Management” section within Management’s Discussion and Analysis in Part I, Item 2 for information regarding purchases and sales of equity securities by the Bancorp during the second quarter of 2021.\nDefaults Upon Senior Securities (Item 3)\nNone.\nMine Safety Disclosures (Item 4)\nNot applicable.\nOther Information (Item 5)\nNone.\n139\nExhibits (Item 6)\n| 3.1 | Amended Articles of Incorporation of Fifth Third Bancorp. Incorporated by reference to Exhibit 3.1 of the Registrant’s Quarterly Report on Form 10-Q filed on May 7, 2021. |\n| 3.2 | Regulations of Fifth Third Bancorp as Amended as of March 23, 2020. Incorporated by reference to Exhibit 3.2 of the Registrant’s Current Report on Form 8-K filed on March 24, 2020. |\n| 10.1 | Fifth Third Bancorp 2021 Incentive Compensation Plan. Incorporated by reference to Annex A to the Registrant’s Proxy Statement filed on March 2, 2021. |\n| 10.2 | Supplemental Confirmation dated April 21, 2021, to Master Confirmation dated July 29, 2015, for accelerated share repurchase transaction between Fifth Third Bancorp and Morgan Stanley & Co. LLC* |\n| 10.3 | 2021 Restricted Stock Unit Grant Agreement (for Directors). |\n| 31(i) | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 by Chief Executive Officer. |\n| 31(ii) | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 by Chief Financial Officer. |\n| 32(i) | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Chief Executive Officer. |\n| 32(ii) | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Chief Financial Officer. |\n| 101.INS | Inline XBRL Instance Document. |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema. |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase. |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase. |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase. |\n| 101.DEF | Inline XBRL Taxonomy Definition Linkbase. |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101). |\n| * Selected portions of this exhibit have been omitted in accordance with Item 601(b)(10) of Regulation S-K. |\n\n140\nSignature\nPursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n| Fifth Third Bancorp |\n| Registrant |\n\nDate: August 6, 2021\n| /s/ James C. Leonard |\n| James C. Leonard |\n| Executive Vice President and |\n| Chief Financial Officer |\n| (Duly Authorized Officer & Principal Financial Officer) |\n\n141\n \n\nWhat is the adjusted Return on Average Tangible Common Equity (ROATCE) for the first half of the year 2021 in percent, considering net income available to common shareholders (U.S. GAAP), average tangible common equity, and attributable changes in net interest income due to volume and yield/rate?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n2\\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations (Item 2) 3\\nOverview 3\\nNon-GAAP Financial Measures 8\\nRecent Accounting Standards 10\\nCritical Accounting Policies 10\\nStatements of Income Analysis 11\\nBalance Sheet Analysis 22\\nBusiness Segment Review 29\\nRisk Management—Overview 37\\nCredit Risk Management 38\\nInterest Rate and Price Risk Management 57\\nLiquidity Risk Management 62\\nOperational Risk Management 64\\nLegal and Regulatory Compliance Risk Management 65\\nCapital Management 66\\nQuantitative and Qualitative Disclosures about Market Risk (Item 3) 69\\nControls and Procedures (Item 4) 69\\nCondensed Consolidated Financial Statements and Notes (Item 1) 70\\nBalance Sheets (unaudited) 70\\nStatements of Income (unaudited) 71\\nStatements of Comprehensive Income (unaudited) 72\\nStatements of Changes in Equity (unaudited) 73\\nStatements of Cash Flows (unaudited) 75\\nNotes to Condensed Consolidated Financial Statements (unaudited) 76\\nPart II. Other Information\\nLegal Proceedings (Item 1) 138\\nRisk Factors (Item 1A) 138\\nUnregistered Sales of Equity Securities and Use of Proceeds (Item 2) 139\\nOther Information (Item 5) 139\\nExhibits (Item 6) 140\\nSignature 141\\nFORWARD-LOOKING STATEMENTS\\nThis report contains statements that we believe are “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Rule 175 promulgated thereunder, and Section 21E of the Securities Exchange Act of 1934, as amended, and Rule 3b-6 promulgated thereunder. These statements relate to our financial condition, results of operations, plans, objectives, future performance, capital actions or business. They usually can be identified by the use of forward-looking language such as “will likely result,” “may,” “are expected to,” “is anticipated,” “potential,” “estimate,” “forecast,” “projected,” “intends to,” or may include other similar words or phrases such as “believes,” “plans,” “trend,” “objective,” “continue,” “remain,” or similar expressions, or future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” “can,” or similar verbs. You should not place undue reliance on these statements, as they are subject to risks and uncertainties, including but not limited to the risk factors set forth in our most recent Annual Report on Form 10-K as updated by our Quarterly Reports on Form 10-Q. When considering these forward-looking statements, you should keep in mind these risks and uncertainties, as well as any cautionary statements we may make. Moreover, you should treat these statements as speaking only as of the date they are made and based only on information then actually known to us. We undertake no obligation to release revisions to these forward-looking statements or reflect events or circumstances after the date of this document. There are a number of important factors that could cause future results to differ materially from historical performance and these forward-looking statements. Factors that might cause such a difference include, but are not limited to: (1) effects of the global COVID-19 pandemic; (2) deteriorating credit quality; (3) loan concentration by location or industry of borrowers or collateral; (4) problems encountered by other financial institutions; (5) inadequate sources of funding or liquidity; (6) unfavorable actions of rating agencies; (7) inability to maintain or grow deposits; (8) limitations on the ability to receive dividends from subsidiaries; (9) cyber-security risks; (10) Fifth Third’s ability to secure confidential information and deliver products and services through the use of computer systems and telecommunications networks; (11) failures by third-party service providers; (12) inability to manage strategic initiatives and/or organizational changes; (13) inability to implement technology system enhancements; (14) failure of internal controls and other risk management systems; (15) losses related to fraud, theft, misappropriation or violence; (16) inability to attract and retain skilled personnel; (17) adverse impacts of government regulation; (18) governmental or regulatory changes or other actions; (19) failures to meet applicable capital requirements; (20) regulatory objections to Fifth Third’s capital plan; (21) regulation of Fifth Third’s derivatives activities; (22) deposit insurance premiums; (23) assessments for the orderly liquidation fund; (24) replacement of LIBOR; (25) weakness in the national or local economies; (26) global political and economic uncertainty or negative actions; (27) changes in interest rates; (28) changes and trends in capital markets; (29) fluctuation of Fifth Third’s stock price; (30) volatility in mortgage banking revenue; (31) litigation, investigations, and enforcement proceedings by governmental authorities; (32) breaches of contractual covenants, representations and warranties; (33) competition and changes in the financial services industry; (34) changing retail distribution strategies, customer preferences and behavior; (35) difficulties in identifying, acquiring or integrating suitable strategic partnerships, investments or acquisitions; (36) potential dilution from future acquisitions; (37) loss of income and/or difficulties encountered in the sale and separation of businesses, investments or other assets; (38) results of investments or acquired entities; (39) changes in accounting standards or interpretation or declines in the value of Fifth Third’s goodwill or other intangible assets; (40) inaccuracies or other failures from the use of models; (41) effects of critical accounting policies and judgments or the use of inaccurate estimates; (42) weather-related events, other natural disasters, or health emergencies (including pandemics); (43) the impact of reputational risk created by these or other developments on such matters as business generation and retention, funding and liquidity; and (44) changes in law or requirements imposed by Fifth Third’s regulators impacting our capital actions, including dividend payments and stock repurchases.\\n1\\n| PART I. FINANCIAL INFORMATION |\\n| Glossary of Abbreviations and Acronyms |\\n\\nFifth Third Bancorp provides the following list of abbreviations and acronyms as a tool for the reader that are used in Management’s Discussion and Analysis of Financial Condition and Results of Operations, the Condensed Consolidated Financial Statements and the Notes to Condensed Consolidated Financial Statements.\\n| ACL: Allowance for Credit Losses | GNMA: Government National Mortgage Association |\\n| AFS: Available For Sale | GSE: United States Government Sponsored Enterprise |\\n| ALCO: Asset Liability Management Committee | HTM: Held-To-Maturity |\\n| ALLL: Allowance for Loan and Lease Losses | IPO: Initial Public Offering |\\n| AOCI: Accumulated Other Comprehensive Income (Loss) | IRC: Internal Revenue Code |\\n| APR: Annual Percentage Rate | IRLC: Interest Rate Lock Commitment |\\n| ARM: Adjustable Rate Mortgage | ISDA: International Swaps and Derivatives Association, Inc. |\\n| ASC: Accounting Standards Codification | LIBOR: London Interbank Offered Rate |\\n| ASU: Accounting Standards Update | LIHTC: Low-Income Housing Tax Credit |\\n| ATM: Automated Teller Machine | LLC: Limited Liability Company |\\n| BHC: Bank Holding Company | LTV: Loan-to-Value Ratio |\\n| BOLI: Bank Owned Life Insurance | MD&A: Management’s Discussion and Analysis of Financial |\\n| bps: Basis Points | Condition and Results of Operations |\\n| CARES: Coronavirus Aid, Relief and Economic Security | MSR: Mortgage Servicing Right |\\n| CDC: Fifth Third Community Development Corporation | N/A: Not Applicable |\\n| CECL: Current Expected Credit Loss | NII: Net Interest Income |\\n| CET1: Common Equity Tier 1 | NM: Not Meaningful |\\n| CFPB: United States Consumer Financial Protection Bureau | OAS: Option-Adjusted Spread |\\n| C&I: Commercial and Industrial | OCC: Office of the Comptroller of the Currency |\\n| DCF: Discounted Cash Flow | OCI: Other Comprehensive Income (Loss) |\\n| DTCC: Depository Trust & Clearing Corporation | OREO: Other Real Estate Owned |\\n| DTI: Debt-to-Income Ratio | PCD: Purchased Credit Deteriorated |\\n| ERM: Enterprise Risk Management | PPP: Paycheck Protection Program |\\n| ERMC: Enterprise Risk Management Committee | RCC: Risk Compliance Committee |\\n| EVE: Economic Value of Equity | ROU: Right-of-Use |\\n| FASB: Financial Accounting Standards Board | SBA: Small Business Administration |\\n| FDIC: Federal Deposit Insurance Corporation | SEC: United States Securities and Exchange Commission |\\n| FHA: Federal Housing Administration | SOFR: Secured Overnight Financing Rate |\\n| FHLB: Federal Home Loan Bank | TBA: To Be Announced |\\n| FHLMC: Federal Home Loan Mortgage Corporation | TDR: Troubled Debt Restructuring |\\n| FICO: Fair Isaac Corporation (credit rating) | TILA: Truth in Lending Act |\\n| FINRA: Financial Industry Regulatory Authority | U.S.: United States of America |\\n| FNMA: Federal National Mortgage Association | USD: United States Dollar |\\n| FOMC: Federal Open Market Committee | U.S. GAAP: United States Generally Accepted Accounting |\\n| FRB: Federal Reserve Bank | Principles |\\n| FTE: Fully Taxable Equivalent | VA: United States Department of Veterans Affairs |\\n| FTP: Funds Transfer Pricing | VIE: Variable Interest Entity |\\n| FTS: Fifth Third Securities | VRDN: Variable Rate Demand Note |\\n| GDP: Gross Domestic Product |\\n\\n2\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (Item 2) |\\n\\nThe following is Management’s Discussion and Analysis of Financial Condition and Results of Operations of certain significant factors that have affected Fifth Third Bancorp’s (the “Bancorp” or “Fifth Third”) financial condition and results of operations during the periods included in the Condensed Consolidated Financial Statements, which are a part of this filing. Reference to the Bancorp incorporates the parent holding company and all consolidated subsidiaries. The Bancorp’s banking subsidiary is referred to as the Bank.\\nOVERVIEW\\nFifth Third Bancorp is a diversified financial services company headquartered in Cincinnati, Ohio. At June 30, 2021, the Bancorp had $205 billion in assets and operated 1,096 full-service banking centers and 2,369 Fifth Third branded ATMs in eleven states throughout the Midwestern and Southeastern regions of the U.S. The Bancorp reports on four business segments: Commercial Banking, Branch Banking, Consumer Lending and Wealth and Asset Management.\\nThis overview of MD&A highlights selected information in the financial results of the Bancorp and may not contain all of the information that is important to you. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources and critical accounting policies and estimates, you should carefully read this entire document as well as the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020. Each of these items could have an impact on the Bancorp’s financial condition, results of operations and cash flows. In addition, refer to the Glossary of Abbreviations and Acronyms in this report for a list of terms included as a tool for the reader of this Quarterly Report on Form 10-Q. The abbreviations and acronyms identified therein are used throughout this MD&A, as well as the Condensed Consolidated Financial Statements and Notes to Condensed Consolidated Financial Statements.\\nNet interest income, net interest margin, net interest rate spread and the efficiency ratio are presented in MD&A on an FTE basis. The FTE basis adjusts for the tax-favored status of income from certain loans and leases and securities held by the Bancorp that are not taxable for federal income tax purposes. The Bancorp believes this presentation to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and non-taxable amounts. The FTE basis for presenting net interest income is a non-GAAP measure. For further information, refer to the Non-GAAP Financial Measures section of MD&A.\\nThe Bancorp’s revenues are dependent on both net interest income and noninterest income. For both the three and six months ended June 30, 2021, net interest income on an FTE basis and noninterest income provided 62% and 38% of total revenue, respectively. The Bancorp derives the majority of its revenues within the U.S. from customers domiciled in the U.S. Revenue from foreign countries and external customers domiciled in foreign countries was immaterial to the Condensed Consolidated Financial Statements for the three and six months ended June 30, 2021. Changes in interest rates, credit quality, economic trends and the capital markets are primary factors that drive the performance of the Bancorp. As discussed later in the Risk Management section of MD&A, risk identification, measurement, monitoring, control and reporting are important to the management of risk and to the financial performance and capital strength of the Bancorp.\\nNet interest income is the difference between interest income earned on assets such as loans, leases and securities, and interest expense incurred on liabilities such as deposits, other short-term borrowings and long-term debt. Net interest income is affected by the general level of interest rates, the relative level of short-term and long-term interest rates, changes in interest rates and changes in the amount and composition of interest-earning assets and interest-bearing liabilities. Generally, the rates of interest the Bancorp earns on its assets and pays on its liabilities are established for a period of time. The change in market interest rates over time exposes the Bancorp to interest rate risk through potential adverse changes to net interest income and financial position. The Bancorp manages this risk by continually analyzing and adjusting the composition of its assets and liabilities based on their payment streams and interest rates, the timing of their maturities and their sensitivity to changes in market interest rates. Additionally, in the ordinary course of business, the Bancorp enters into certain derivative transactions as part of its overall strategy to manage its interest rate and prepayment risks. The Bancorp is also exposed to the risk of loss on its loan and lease portfolio, as a result of changing expected cash flows caused by borrower credit events, such as loan defaults and inadequate collateral.\\nNoninterest income is derived from commercial banking revenue, service charges on deposits, wealth and asset management revenue, card and processing revenue, mortgage banking net revenue, leasing business revenue, other noninterest income and net securities gains or losses. Noninterest expense includes compensation and benefits, technology and communications, net occupancy expense, equipment expense, leasing business expense, card and processing expense, marketing expense and other noninterest expense.\\nCOVID-19 Global Pandemic\\nThe COVID-19 pandemic created significant economic uncertainty and financial disruptions during the year ended December 31, 2020, which has continued into 2021. Government and public responses to the COVID-19 pandemic, including temporary closures of businesses and the implementation of social distancing protocols, have caused and continue to cause, reductions and instability in economic activity that have resulted in increased unemployment levels in certain industries and volatility in the financial markets. During the year ended December 31, 2020 and the six months ended June 30, 2021, low interest rates, reduced economic activity and market volatility have had the most immediate negative impacts on the Bancorp’s performance. The Bancorp is unable to estimate the extent of the impact that these factors have had on its operating results since the pandemic began and it is likely that these factors will continue to adversely impact its future operating results.\\n3\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nThe increased availability of COVID-19 vaccinations has begun to mitigate the public health effects of the pandemic, although there has been a rise of the Delta variant of COVID-19 and slower progress on vaccination rates, and recovery from the related economic crisis continues to disproportionately affect certain industries, geographies and demographics more than others. This uneven recovery, combined with the unprecedented nature of the government response to the pandemic, makes it difficult to predict the extent to which the pandemic will continue to adversely impact the Bancorp and its customers. Furthermore, resurgence risk remains present as new virus variants are identified. The Bancorp continues to closely monitor the pandemic and its effects on customers, employees, communities and markets.\\nThe Bancorp has provided a variety of relief options for both commercial and consumer customers that were affected by the COVID-19 pandemic, including loan covenant relief, loan maturity extensions, payment deferrals, forbearances and fee waivers. For further information about these programs, refer to the Credit Risk Management subsection of the Risk Management section of MD&A included herein, and also Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\\nGovernment Response to the COVID-19 Pandemic\\nCongress, the FRB and the other U.S. state and federal financial regulatory agencies have taken actions to mitigate disruptions to economic activity and financial stability resulting from the COVID-19 pandemic. The descriptions below summarize certain significant government actions taken in response to the COVID-19 pandemic. The descriptions are qualified in their entirety by reference to the particular statutory or regulatory provisions or government programs summarized.\\nThe CARES Act\\nThe Coronavirus Aid, Relief and Economic Security (“CARES”) Act was signed into law on March 27, 2020 and has subsequently been amended several times, including by the Consolidated Appropriations Act, 2021. Among other provisions, the CARES Act included funding for the SBA to expand lending, relief from certain U.S. GAAP requirements to allow COVID-19-related loan modifications to not be categorized as TDRs, direct stimulus payments and a range of incentives to encourage deferment, forbearance or modification of consumer credit and mortgage contracts. One of the key CARES Act programs is the Paycheck Protection Program, discussed further below, which temporarily expanded the SBA’s business loan guarantee program.\\nThe CARES Act contains additional protections for homeowners and renters of properties with federally-backed mortgages, including a 60-day moratorium on the initiation of foreclosure proceedings beginning on March 18, 2020 and a 120-day moratorium on initiating eviction proceedings effective March 27, 2020. Borrowers of federally-backed mortgages have the right under the CARES Act to request up to 360 days of forbearance on their mortgage payments if they experience financial hardship directly or indirectly due to the COVID-19 public health emergency. The FHA, FNMA and FHLMC independently extended their moratorium on foreclosures and evictions for single-family federally-backed mortgages through July 31, 2021.\\nAlso pursuant to the CARES Act, the U.S. Treasury has the authority to provide loans, guarantees and other investments in support of eligible businesses, states and municipalities affected by the economic effects of COVID-19. Some of these funds have been used to support several FRB programs and facilities described below or additional programs or facilities that are established by its authority under Section 13(3) of the Federal Reserve Act which meet certain criteria.\\nFRB Actions\\nThe FRB has taken a range of actions to support the flow of credit to households and businesses, offset forced liquidations and restore liquidity in the financial markets. For example, on March 15, 2020, the FRB reduced the target range for the federal funds rate to 0 to 0.25% and announced that it would increase its holdings of U.S. Treasury securities and agency mortgage-backed securities and begin purchasing agency commercial mortgage-backed securities. The FRB has also encouraged depository institutions to borrow from the discount window and has lowered the primary credit rate for such borrowing by 150 basis points while extending the term of such loans up to 90 days. Reserve requirements have been reduced to zero as of March 26, 2020.\\nIn addition, the FRB established a range of facilities and programs to support the U.S. economy and U.S. marketplace participants in response to economic disruptions associated with COVID-19. Through these facilities and programs, the FRB, relying on its authority under Section 13(3) of the Federal Reserve Act, has taken steps to directly or indirectly purchase assets from, or make loans to, U.S. companies, financial institutions, municipalities and other market participants.\\nPaycheck Protection Program\\nThe Bancorp is a participating lender in PPP, which is a program administered by the SBA to provide forgivable, guaranteed loans to eligible borrowers that have been affected by the COVID-19 pandemic. As of June 30, 2021, the Bancorp held PPP loans with a carrying amount of $3.7 billion under the program. PPP loans are available to a broader range of entities than ordinary SBA loans, require deferral of principal and interest repayment, and may be forgiven if the borrower demonstrates that the loan proceeds were used for qualified payroll costs and certain other expenses. The PPP has been expanded to permit second and third rounds of funding, including for certain borrowers who have already received a PPP loan, subject to certain conditions.\\n4\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nAmerican Rescue Plan Act\\nThe American Rescue Plan Act of 2021, which was signed into law on March 21, 2021, provides additional relief for businesses, states, municipalities and individuals by, among other things, allocating additional funds for the PPP, providing a third round of economic impact payments to individuals, extending supplemental federal unemployment benefits and providing advance payments of an expanded child tax credit. The impacts of the stimulus on the Bancorp’s business, results of operations and financial condition are highly uncertain and will depend on future developments, including the scope and duration of the pandemic and its impact on the economy in general.\\nAccelerated Share Repurchase Transactions\\nDuring the six months ended June 30, 2021, the Bancorp entered into and settled accelerated share repurchase transactions. As part of the transactions, the Bancorp entered into forward contracts in which the final number of shares delivered at settlement was based generally on a discount to the average daily volume weighted-average price of the Bancorp’s common stock during the term of the repurchase agreements. Refer to Note 15 and Note 23 of the Notes to Condensed Consolidated Financial Statements for additional information on share repurchase activity.\\nThe following table presents a summary of the Bancorp’s accelerated share repurchase transactions that were entered into and settled during the six months ended June 30, 2021:\\n| TABLE 1: Summary of Accelerated Share Repurchase Transactions |\\n| Repurchase Date | Amount ($ in millions) | Shares Repurchased on Repurchase Date | Shares Received from Forward Contract Settlement | Total Shares Repurchased | Final Settlement Date |\\n| January 26, 2021 | $ | 180 | 4,951,456 | 366,939 | 5,318,395 | March 31, 2021 |\\n| April 23, 2021 | 347 | 7,894,807 | 675,295 | 8,570,102 | June 11, 2021 |\\n\\nLIBOR Transition\\nIn July 2017, the Chief Executive of the United Kingdom Financial Conduct Authority (the “FCA”), which regulates LIBOR, announced that the FCA will stop persuading or compelling banks to submit rates for the calculation of LIBOR to the administrator of LIBOR after 2021. Since then, central banks around the world, including the Federal Reserve, have commissioned working groups of market participants and official sector representatives with the goal of finding suitable replacements for LIBOR. The Bancorp has substantial exposure to LIBOR-based products within its commercial lending, commercial deposits, business banking, consumer lending and capital markets lines of business as well as corporate treasury function. On November 30, 2020, the Federal Reserve, OCC, and FDIC issued a public statement that the administrator of LIBOR announced it will consult on an extension of publication of certain U.S. Dollar (“USD”) LIBOR tenors until June 30, 2023, which would allow additional legacy USD LIBOR contracts to mature before the succession of LIBOR. The administrator then announced on March 5, 2021, that it will cease publication of 1-week and 2-month USD LIBOR on December 31, 2021, and that overnight and 1-, 3-, 6-, and 12-month USD LIBOR will cease to be published on June 30, 2023. Although the full impact of LIBOR reforms and actions remains unclear, the Bancorp continues to prepare to transition from LIBOR to alternative reference rates, and it is expected that a broad transition away from the use of LIBOR to alternative reference rates for new financial contracts will occur by the end of 2021. In the United States, LIBOR-priced transactions and products will transfer to the Secured Overnight Financing Rate (“SOFR”), Prime Rate or other similar indices (collectively, “Alternative Rates”). There are risks inherent with the transition to any Alternative Rate as the rate may behave differently than LIBOR in reaction to monetary, market and economic events.\\nThe Bancorp’s LIBOR transition plan is organized around key work streams, including continued engagement with central banks and industry working groups and regulators, active client engagement, comprehensive review of legacy documentation, internal operational and technological readiness, and risk management, among other things, to facilitate the transition to Alternative Rates. The Bancorp has implemented certain SOFR conventions and is in the process of developing other products and transaction agreements which are based on reference rates other than LIBOR. The Bancorp has also developed a transition plan for existing LIBOR-based financial contracts that are not expected to mature or settle prior to the cessation of LIBOR publication.\\nFor a further discussion of the various risks the Bancorp faces in connection with the expected replacement of LIBOR on its operations, see “Risk Factors—Market Risks—The replacement of LIBOR could adversely affect Fifth Third’s revenue or expenses and the value of those assets or obligations.” in Item 1A. Risk Factors of the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\\nKey Performance Indicators\\nThe Bancorp, as a banking institution, utilizes various key indicators of financial condition and operating results in managing and monitoring the performance of the business. In addition to traditional financial metrics, such as revenue and expense trends, the Bancorp monitors other financial measures that assist in evaluating growth trends, capital strength and operational efficiencies. The Bancorp analyzes these key performance indicators against its past performance, its forecasted performance and with the performance of its peer banking institutions. These indicators may change from time to time as the operating environment and businesses change.\\n5\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nThe following are some of the key indicators used by management to assess the Bancorp’s business performance, including those which are considered in the Bancorp’s compensation programs:\\n•CET1 Capital Ratio: CET1 capital divided by risk-weighted assets as defined by the Basel III standardized approach to risk-weighting of assets\\n•Return on Average Tangible Common Equity (non-GAAP): Tangible net income available to common shareholders (annualized) divided by average tangible common equity\\n•Net Interest Margin (non-GAAP): Net interest income on an FTE basis (annualized) divided by average interest-earning assets\\n•Efficiency Ratio (non-GAAP): Noninterest expense divided by the sum of net interest income on an FTE basis and noninterest income\\n•Earnings Per Share, Diluted: Net income allocated to common shareholders divided by average common shares outstanding after the effect of dilutive stock-based awards\\n•Nonperforming Portfolio Assets Ratio: Nonperforming portfolio assets divided by portfolio loans and leases and OREO\\n•Net Charge-off Ratio: Net losses charged-off (annualized) divided by average portfolio loans and leases\\n•Return on Average Assets: Net income (annualized) divided by quarterly average assets\\n•Loan-to-Deposit Ratio: Total loans divided by total deposits\\nThe list of indicators above is intended to summarize some of the most important metrics utilized by management in evaluating the Bancorp’s performance and does not represent an all-inclusive list of all performance measures that may be considered relevant or important to management or investors.\\n| TABLE 2: Earnings Summary |\\n| For the three months endedJune 30, | % | For the six months endedJune 30, | % |\\n| ($ in millions, except for per share data) | 2021 | 2020 | Change | 2021 | 2020 | Change |\\n| Income Statement Data |\\n| Net interest income (U.S. GAAP) | $ | 1,208 | 1,200 | 1 | $ | 2,385 | 2,429 | (2) |\\n| Net interest income (FTE)(a)(b) | 1,211 | 1,203 | 1 | 2,391 | 2,436 | (2) |\\n| Noninterest income | 741 | 650 | 14 | 1,490 | 1,321 | 13 |\\n| Total revenue (FTE)(a)(b) | 1,952 | 1,853 | 5 | 3,881 | 3,757 | 3 |\\n| (Benefit from) provision for credit losses(c) | (115) | 485 | NM | (288) | 1,125 | NM |\\n| Noninterest expense | 1,153 | 1,121 | 3 | 2,369 | 2,321 | 2 |\\n| Net income | 709 | 195 | 264 | 1,403 | 243 | 477 |\\n| Net income available to common shareholders | 674 | 163 | 313 | 1,348 | 193 | 598 |\\n| Common Share Data |\\n| Earnings per share - basic | $ | 0.95 | 0.23 | 313 | $ | 1.89 | 0.27 | 600 |\\n| Earnings per share - diluted | 0.94 | 0.23 | 309 | 1.87 | 0.27 | 593 |\\n| Cash dividends declared per common share | 0.27 | 0.27 | — | 0.54 | 0.54 | — |\\n| Book value per share | 29.57 | 28.88 | 2 | 29.57 | 28.88 | 2 |\\n| Market value per share | 38.23 | 19.28 | 98 | 38.23 | 19.28 | 98 |\\n| Financial Ratios |\\n| Return on average assets | 1.38 | % | 0.40 | 245 | 1.38 | % | 0.26 | 431 |\\n| Return on average common equity | 13.0 | 3.2 | 306 | 13.1 | 1.9 | 589 |\\n| Return on average tangible common equity(b) | 16.6 | 4.3 | 286 | 16.7 | 2.7 | 519 |\\n| Dividend payout | 28.4 | 117.4 | (76) | 28.6 | 200.0 | (86) |\\n| Average total Bancorp shareholders’ equity as a percent of average assets | 11.11 | 11.30 | (2) | 11.18 | 11.92 | (74) |\\n\\n(a)Amounts presented on an FTE basis. The FTE adjustments were $3 for both the three months ended June 30, 2021 and 2020 and $6 and $7 for the six months ended June 30, 2021 and 2020, respectively.\\n(b)These are non-GAAP measures. For further information, refer to the Non-GAAP Financial Measures section of MD&A.\\n(c)The provision for credit losses is the sum of the provision for loan and lease losses and the provision for the reserve for unfunded commitments.\\nEarnings Summary\\nThe Bancorp’s net income available to common shareholders for the second quarter of 2021 was $674 million, or $0.94 per diluted share, which was net of $35 million in preferred stock dividends. The Bancorp’s net income available to common shareholders for the second quarter of 2020 was $163 million, or $0.23 per diluted share, which was net of $32 million in preferred stock dividends. The Bancorp’s net income available to common shareholders for the six months ended June 30, 2021 was $1.3 billion, or $1.87 per diluted share, which was net of $55 million in preferred stock dividends. The Bancorp’s net income available to common shareholders for the six months ended June 30, 2020 was $193 million, or $0.27 per diluted share, which was net of $50 million in preferred stock dividends.\\n6\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nNet interest income on an FTE basis (non-GAAP) was $1.2 billion for the three months ended June 30, 2021, an increase of $8 million compared to the same period in the prior year. Net interest income benefited from increases in average residential mortgage loans and average indirect secured consumer loans from the three months ended June 30, 2020. Net interest income was also positively impacted by decreases in rates paid on average interest-bearing liabilities and a decrease in average long-term debt for the three months ended June 30, 2021 compared to the same period in the prior year. An increase in interest income recognized from PPP loans also positively impacted net interest income for the three months ended June 30, 2021. These benefits were partially offset by decreases in average balances in commercial and industrial loans and credit card from the three months ended June 30, 2020 and decreases in yields on average loans and leases due to the portfolio repricing to lower market interest rates.\\nNet interest income on an FTE basis (non-GAAP) was $2.4 billion for the six months ended June 30, 2021, a decrease of $45 million compared to the same period in the prior year primarily due to the impact of lower market rates, which decreased the yield on total average loans and leases. In addition to market rate impacts on interest-earning assets, net interest income was also negatively impacted by decreases in average commercial and industrial loans, average credit card and average home equity balances from the six months ended June 30, 2020. These negative impacts were partially offset by decreases in rates paid on average interest-bearing liabilities. Net interest income also benefited from increases in average residential mortgage loan and average indirect secured consumer loan balances and a decrease in average long-term debt from the six months ended June 30, 2020. An increase in interest income recognized from PPP loans also positively impacted net interest income for the six months ended June 30, 2021. Net interest margin on an FTE basis (non-GAAP) was 2.63% and 2.62% for the three and six months ended June 30, 2021, respectively, compared to 2.75% and 2.99% for the comparable periods in the prior year.\\nThe benefit from credit losses was $115 million and $288 million for the three and six months ended June 30, 2021, respectively, compared to a provision for credit losses of $485 million and $1.1 billion during the same periods in the prior year. Provision expense decreased for the three and six months ended June 30, 2021 compared to the same periods in the prior year primarily driven by factors which caused decreases in the ACL during those periods including improved economic forecasts, improved commercial and consumer credit quality and lower period-end loan and lease balances. Net losses charged off as a percent of average portfolio loans and leases were 0.16% and 0.44% for the three months ended June 30, 2021 and 2020, respectively, and 0.21% and 0.44% for the six months ended June 30, 2021 and 2020, respectively. At June 30, 2021, nonperforming portfolio assets as a percent of portfolio loans and leases and OREO decreased to 0.61% compared to 0.79% at December 31, 2020. For further discussion on credit quality refer to the Credit Risk Management subsection of the Risk Management section of MD&A as well as Note 6 of the Notes to Condensed Consolidated Financial Statements.\\nNoninterest income increased $91 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to increases in other noninterest income, service charges on deposits, wealth and asset management revenue, commercial banking revenue and card and processing revenue of $37 million, $27 million, $25 million, $23 million, and $20 million, respectively. These increases were partially offset by a decrease in mortgage banking net revenue of $35 million.\\nNoninterest income increased $169 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to increases in other noninterest income, commercial banking revenue, wealth and asset management revenue, card and processing revenue, service charges on deposits and leasing business revenue of $74 million, $52 million, $33 million, $29 million, $22 million and $17 million, respectively. These increases were partially offset by a decrease in mortgage banking net revenue of $70 million.\\nNoninterest expense increased $32 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to increases in other noninterest expense and compensation and benefits expense of $29 million and $11 million, respectively. These increases were partially offset by decreases in card and processing expense and net occupancy expense of $9 million and $5 million, respectively.\\nNoninterest expense increased $48 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to an increase in compensation and benefits expense of $69 million partially offset by decreases in card and processing expense, net occupancy expense and marketing expense of $10 million, $8 million and $8 million, respectively.\\nFor more information on net interest income, noninterest income and noninterest expense refer to the Statements of Income Analysis section of MD&A.\\nCapital Summary\\nThe Bancorp calculated its regulatory capital ratios under the Basel III standardized approach to risk-weighting of assets and pursuant to the five-year transition provision option to phase in the effects of CECL on regulatory capital as of June 30, 2021. As of June 30, 2021, the Bancorp’s capital ratios, as defined by the U.S. banking agencies, were:\\n•CET1 capital ratio: 10.37%;\\n•Tier I risk-based capital ratio: 11.83%;\\n•Total risk-based capital ratio: 14.60%; and\\n•Tier I leverage ratio: 8.55%.\\n7\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nNON-GAAP FINANCIAL MEASURES\\nThe following are non-GAAP financial measures which provide useful insight to the reader of the Condensed Consolidated Financial Statements but should be supplemental to primary U.S. GAAP measures and should not be read in isolation or relied upon as a substitute for the primary U.S. GAAP measures.\\nThe FTE basis adjusts for the tax-favored status of income from certain loans and leases and securities held by the Bancorp that are not taxable for federal income tax purposes. The Bancorp believes this presentation to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and non-taxable amounts.\\nThe following table reconciles the non-GAAP financial measures of net interest income on an FTE basis, interest income on an FTE basis, net interest margin, net interest rate spread and the efficiency ratio to U.S. GAAP:\\n| TABLE 3: Non-GAAP Financial Measures - Financial Measures and Ratios on an FTE basis |\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Net interest income (U.S. GAAP) | $ | 1,208 | 1,200 | 2,385 | 2,429 |\\n| Add: FTE adjustment | 3 | 3 | 6 | 7 |\\n| Net interest income on an FTE basis (1) | $ | 1,211 | 1,203 | 2,391 | 2,436 |\\n| Net interest income on an FTE basis (annualized) (2) | 4,857 | 4,838 | 4,822 | 4,899 |\\n| Interest income (U.S. GAAP) | $ | 1,323 | 1,403 | 2,624 | 2,928 |\\n| Add: FTE adjustment | 3 | 3 | 6 | 7 |\\n| Interest income on an FTE basis | $ | 1,326 | 1,406 | 2,630 | 2,935 |\\n| Interest income on an FTE basis (annualized) (3) | 5,319 | 5,655 | 5,304 | 5,902 |\\n| Interest expense (annualized) (4) | $ | 461 | 816 | 482 | 1,003 |\\n| Noninterest income (5) | 741 | 650 | 1,490 | 1,321 |\\n| Noninterest expense (6) | 1,153 | 1,121 | 2,369 | 2,321 |\\n| Average interest-earning assets (7) | 184,918 | 176,224 | 183,823 | 163,719 |\\n| Average interest-bearing liabilities (8) | 115,951 | 124,478 | 116,315 | 116,861 |\\n| Ratios: |\\n| Net interest margin on an FTE basis (2) / (7) | 2.63 | % | 2.75 | 2.62 | 2.99 |\\n| Net interest rate spread on an FTE basis ((3) / (7)) - ((4) / (8)) | 2.48 | 2.55 | 2.47 | 2.75 |\\n| Efficiency ratio on an FTE basis (6) / ((1) + (5)) | 59.1 | 60.5 | 61.0 | 61.8 |\\n\\nThe Bancorp believes return on average tangible common equity is an important measure for comparative purposes with other financial institutions, but is not defined under U.S. GAAP, and therefore is considered a non-GAAP financial measure. This measure is useful for evaluating the performance of a business as it calculates the return available to common shareholders without the impact of intangible assets and their related amortization.\\n8\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nThe following table reconciles the non-GAAP financial measure of return on average tangible common equity to U.S. GAAP:\\n| TABLE 4: Non-GAAP Financial Measures - Return on Average Tangible Common Equity |\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Net income available to common shareholders (U.S. GAAP) | $ | 674 | 163 | 1,348 | 193 |\\n| Add: Intangible amortization, net of tax | 8 | 9 | 17 | 20 |\\n| Tangible net income available to common shareholders | $ | 682 | 172 | 1,365 | 213 |\\n| Tangible net income available to common shareholders (annualized) (1) | 2,735 | 692 | 2,753 | 428 |\\n| Average Bancorp shareholders’ equity (U.S. GAAP) | $ | 22,927 | 22,420 | 22,939 | 22,066 |\\n| Less: Average preferred stock | 2,116 | 1,770 | 2,116 | 1,770 |\\n| Average goodwill | 4,259 | 4,261 | 4,259 | 4,256 |\\n| Average intangible assets | 122 | 178 | 128 | 186 |\\n| Average tangible common equity (2) | $ | 16,430 | 16,211 | 16,436 | 15,854 |\\n| Return on average tangible common equity (1) / (2) | 16.6 | % | 4.3 | 16.7 | 2.7 |\\n\\nThe Bancorp considers various measures when evaluating capital utilization and adequacy, including the tangible equity ratio and tangible common equity ratio, in addition to capital ratios defined by the U.S. banking agencies. These calculations are intended to complement the capital ratios defined by the U.S. banking agencies for both absolute and comparative purposes. Because U.S. GAAP does not include capital ratio measures, the Bancorp believes there are no comparable U.S. GAAP financial measures to these ratios. These ratios are not formally defined by U.S. GAAP or codified in the federal banking regulations and, therefore, are considered to be non-GAAP financial measures. The Bancorp encourages readers to consider its Condensed Consolidated Financial Statements in their entirety and not to rely on any single financial measure.\\nThe following table reconciles non-GAAP capital ratios to U.S. GAAP:\\n| TABLE 5: Non-GAAP Financial Measures - Capital Ratios |\\n| As of ($ in millions) | June 30,2021 | December 31,2020 |\\n| Total Bancorp Shareholders’ Equity (U.S. GAAP) | $ | 22,926 | 23,111 |\\n| Less: Preferred stock | 2,116 | 2,116 |\\n| Goodwill | 4,259 | 4,258 |\\n| Intangible assets | 117 | 139 |\\n| AOCI | 1,974 | 2,601 |\\n| Tangible common equity, excluding AOCI (1) | $ | 14,460 | 13,997 |\\n| Add: Preferred stock | 2,116 | 2,116 |\\n| Tangible equity (2) | $ | 16,576 | 16,113 |\\n| Total Assets (U.S. GAAP) | $ | 205,390 | 204,680 |\\n| Less: Goodwill | 4,259 | 4,258 |\\n| Intangible assets | 117 | 139 |\\n| AOCI, before tax | 2,499 | 3,292 |\\n| Tangible assets, excluding AOCI (3) | $ | 198,515 | 196,991 |\\n| Ratios: |\\n| Tangible equity as a percentage of tangible assets (2) / (3) | 8.35 | % | 8.18 |\\n| Tangible common equity as a percentage of tangible assets (1) / (3) | 7.28 | 7.11 |\\n\\n9\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nRECENT ACCOUNTING STANDARDS\\nNote 3 of the Notes to Condensed Consolidated Financial Statements provides a discussion of a significant new accounting standard applicable to the Bancorp.\\nCRITICAL ACCOUNTING POLICIES\\nThe Bancorp’s Condensed Consolidated Financial Statements are prepared in accordance with U.S. GAAP. Certain accounting policies require management to exercise judgment in determining methodologies, economic assumptions and estimates that may materially affect the Bancorp’s financial position, results of operations and cash flows. The Bancorp’s critical accounting policies include the accounting for the ALLL, reserve for unfunded commitments, valuation of servicing rights, fair value measurements, goodwill and legal contingencies. These accounting policies are discussed in detail in the Critical Accounting Policies section of the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020. There have been no material changes to the valuation techniques or models during the six months ended June 30, 2021.\\n10\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nSTATEMENTS OF INCOME ANALYSIS\\nNet Interest Income\\nNet interest income is the interest earned on loans and leases (including yield-related fees), securities and other short-term investments less the interest incurred on core deposits (includes transaction deposits and other time deposits) and wholesale funding (includes certificates $100,000 and over, other deposits, federal funds purchased, other short-term borrowings and long-term debt). The net interest margin is calculated by dividing net interest income by average interest-earning assets. Net interest rate spread is the difference between the average yield earned on interest-earning assets and the average rate paid on interest-bearing liabilities. Net interest margin is typically greater than net interest rate spread due to the interest income earned on those assets that are funded by noninterest-bearing liabilities, or free funding, such as demand deposits or shareholders’ equity.\\nTables 6 and 7 present the components of net interest income, net interest margin and net interest rate spread for the three and six months ended June 30, 2021 and 2020, as well as the relative impact of changes in the average balance sheet and changes in interest rates on net interest income. Nonaccrual loans and leases and loans and leases held for sale have been included in the average loan and lease balances. Average outstanding securities balances are based on amortized cost with any unrealized gains or losses included in average other assets.\\nNet interest income on an FTE basis (non-GAAP) was $1.2 billion for the three months ended June 30, 2021, an increase of $8 million compared to the same period in the prior year. Net interest income benefited from increases in average residential mortgage loans and average indirect secured consumer loan balances of $4.3 billion and $2.6 billion, respectively, from the three months ended June 30, 2020. Net interest income was also positively impacted by decreases in rates paid on average interest-bearing liabilities primarily driven by decreases in rates paid on average money market deposits and average interest checking deposits of 27 bps and 18 bps, respectively, for the three months ended June 30, 2021 compared to the same period in the prior year. Net interest income also benefited from a decrease in average long-term debt of $3.1 billion for the three months ended June 30, 2021 compared to the same period in the prior year. Interest income recognized from PPP loans also positively impacted net interest income by $53 million for the three months ended June 30, 2021 compared to $23 million in the same period in the prior year. These benefits were partially offset by decreases in average commercial and industrial loan balances and average credit card balances of $10.3 billion and $478 million, respectively, from the three months ended June 30, 2020. Net interest income was also negatively impacted by loan portfolio repricing due to lower market interest rates, including a 63 bps decrease in yields on average indirect secured consumer loans for the three months ended June 30, 2021 compared to the same period in the prior year.\\nNet interest income on an FTE basis (non-GAAP) was $2.4 billion for the six months ended June 30, 2021, a decrease of $45 million compared to the same period in the prior year primarily due to the impact of lower market rates. Monetary policy actions in response to the COVID-19 pandemic, including lowering the target range of the federal funds rate and the FRB’s bond purchase programs, have continued to adversely impact market rates since March of 2020. Yields on total average loans and leases decreased by 43 bps for the six months ended June 30, 2021 compared to the prior year driven by decreases in yields on average commercial loans and average consumer loans of 40 bps and 58 bps, respectively, for the six months ended June 30, 2021 compared to the same period in the prior year. The Bancorp has significant portfolios of floating interest rate loans (primarily LIBOR- or Prime-based) that were impacted by these decreases in yields. The Bancorp’s portfolios of fixed interest rate loans also decreased in yield as a result of increased refinance activity and lower reinvestment yields due to lower overall market rates. In addition to market rate impacts on interest-earning assets, net interest income was also negatively impacted by decreases in average commercial and industrial loans, average credit card and average home equity of $6.1 billion, $549 million and $1.1 billion, respectively, from the six months ended June 30, 2020. These negative impacts were partially offset by decreases in rates paid on average interest-bearing liabilities primarily driven by decreases in rates paid on average interest checking deposits and average money market deposits of 40 bps and 46 bps, respectively, for the six months ended June 30, 2021 compared to the same period in the prior year. Net interest income also benefited from increases in average residential mortgage loans and average indirect secured consumer loans of $3.4 billion and $2.4 billion, respectively, and a decrease in average long-term debt of $2.0 billion from the six months ended June 30, 2020. Interest income recognized from PPP loans also positively impacted net interest income by $106 million for the six months ended June 30, 2021 compared to $23 million in the same period in the prior year.\\nNet interest rate spread on an FTE basis (non-GAAP) was 2.48% and 2.47% during the three and six months ended June 30, 2021, respectively, compared to 2.55% and 2.75% in the same periods in the prior year. Yields on average interest-earning assets decreased 33 bps and 72 bps for the three and six months ended June 30, 2021, respectively, partially offset by decreases in rates paid on average interest-bearing liabilities of 26 bps and 44 bps for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020.\\nNet interest margin on an FTE basis (non-GAAP) was 2.63% and 2.62% for the three and six months ended June 30, 2021, respectively, compared to 2.75% and 2.99% for the comparable periods in the prior year. Net interest margin was negatively impacted by increases in low-yielding reserves held at the FRB reported in other short-term investments, which were primarily driven by elevated levels in average demand deposits and average interest-bearing deposits for the three and six months ended June 30, 2021 compared to the same periods in the prior year. Net interest margin results are expected to remain suppressed as a result of sustained excess cash balances, which are expected to remain elevated, driven by the amount of liquidity injected into the banking system as a result of monetary and fiscal stimulus programs implemented in response to the COVID-19 pandemic.\\n11\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nInterest income on an FTE basis (non-GAAP) from loans and leases decreased $81 million and $288 million during the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020 driven by the previously mentioned decreases in yields and average balances of loans and leases. For more information on the Bancorp’s loan and lease portfolio, refer to the Loans and Leases subsection of the Balance Sheet Analysis section of MD&A. Interest income on an FTE basis (non-GAAP) from investment securities and other short-term investments increased $1 million during the three months ended June 30, 2021 compared to the three months ended June 30, 2020 primarily due to increases in the average balances of securities exempt from income taxes and other short-term investments, partially offset by a decrease in the average balance of taxable securities. Interest income on an FTE basis (non-GAAP) from investment securities and other short-term investments decreased $17 million during the six months ended June 30, 2021 compared to the six months ended June 30, 2020 primarily due to decreases in yields on average investment securities and average other short-term investments, partially offset by an increase in the average balance of other short-term investments.\\nInterest expense on core deposits decreased $56 million and $188 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020 primarily due to decreases in the cost of average interest-bearing core deposits to 5 bps and 6 bps for the three and six months ended June 30, 2021, respectively, from 27 bps and 46 bps for the three and six months ended June 30, 2020. The decreases in the cost of average interest-bearing core deposits were primarily due to the previously mentioned decreases in rates paid on average interest checking deposits and average money market deposits. Refer to the Deposits subsection of the Balance Sheet Analysis section of MD&A for additional information on the Bancorp’s deposits.\\nInterest expense on average wholesale funding decreased $32 million and $72 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020 primarily due to decreases in average balances of long-term debt and certificates $100,000 and over and decreases in rates paid on certificates $100,000 and over. Refer to the Borrowings subsection of the Balance Sheet Analysis section of MD&A for additional information on the Bancorp’s borrowings. During the three and six months ended June 30, 2021, average wholesale funding represented 14% and 15%, respectively, of average interest-bearing liabilities, compared to 19% for both the three and six months ended June 30, 2020. For more information on the Bancorp’s interest rate risk management, including estimated earnings sensitivity to changes in market interest rates, see the Interest Rate and Price Risk Management subsection of the Risk Management section of MD&A.\\n12\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\n| TABLE 6: Condensed Average Balance Sheets and Analysis of Net Interest Income on an FTE Basis |\\n| For the three months ended | June 30, 2021 | June 30, 2020 | Attribution of Change in Net Interest Income(a) |\\n| ($ in millions) | Average Balance | Revenue/Cost | Average Yield/ Rate | Average Balance | Revenue/Cost | Average Yield/ Rate | Volume | Yield/ Rate | Total |\\n| Assets: |\\n| Interest-earning assets: |\\n| Loans and leases:(b) |\\n| Commercial and industrial loans | $ | 48,817 | 441 | 3.62 | % | $ | 59,106 | 510 | 3.47 | % | $ | (91) | 22 | (69) |\\n| Commercial mortgage loans | 10,467 | 81 | 3.11 | 11,224 | 96 | 3.44 | (6) | (9) | (15) |\\n| Commercial construction loans | 6,043 | 47 | 3.09 | 5,548 | 49 | 3.53 | 4 | (6) | (2) |\\n| Commercial leases | 3,174 | 23 | 2.94 | 3,056 | 26 | 3.47 | 1 | (4) | (3) |\\n| Total commercial loans and leases | $ | 68,501 | 592 | 3.47 | $ | 78,934 | 681 | 3.47 | $ | (92) | 3 | (89) |\\n| Residential mortgage loans | 21,740 | 178 | 3.29 | 17,405 | 153 | 3.53 | 36 | (11) | 25 |\\n| Home equity | 4,674 | 42 | 3.60 | 5,820 | 52 | 3.60 | (10) | — | (10) |\\n| Indirect secured consumer loans | 14,702 | 125 | 3.41 | 12,124 | 122 | 4.04 | 24 | (21) | 3 |\\n| Credit card | 1,770 | 54 | 12.13 | 2,248 | 63 | 11.28 | (14) | 5 | (9) |\\n| Other consumer loans | 3,056 | 46 | 5.96 | 2,887 | 47 | 6.50 | 3 | (4) | (1) |\\n| Total consumer loans | $ | 45,942 | 445 | 3.88 | $ | 40,484 | 437 | 4.34 | $ | 39 | (31) | 8 |\\n| Total loans and leases | $ | 114,443 | 1,037 | 3.63 | % | $ | 119,418 | 1,118 | 3.76 | % | $ | (53) | (28) | (81) |\\n| Securities: |\\n| Taxable | 36,097 | 275 | 3.06 | 36,817 | 282 | 3.08 | (5) | (2) | (7) |\\n| Exempt from income taxes(b) | 820 | 5 | 2.47 | 156 | 1 | 2.96 | 4 | — | 4 |\\n| Other short-term investments | 33,558 | 9 | 0.11 | 19,833 | 5 | 0.11 | 4 | — | 4 |\\n| Total interest-earning assets | $ | 184,918 | 1,326 | 2.88 | % | $ | 176,224 | 1,406 | 3.21 | % | $ | (50) | (30) | (80) |\\n| Cash and due from banks | 3,033 | 3,121 |\\n| Other assets | 20,608 | 21,394 |\\n| Allowance for loan and lease losses | (2,206) | (2,352) |\\n| Total assets | $ | 206,353 | $ | 198,387 |\\n| Liabilities and Equity: |\\n| Interest-bearing liabilities: |\\n| Interest checking deposits | $ | 45,307 | 6 | 0.06 | % | $ | 49,760 | 29 | 0.24 | % | $ | (3) | (20) | (23) |\\n| Savings deposits | 20,494 | 1 | 0.02 | 16,354 | 3 | 0.06 | — | (2) | (2) |\\n| Money market deposits | 30,844 | 4 | 0.05 | 30,022 | 24 | 0.32 | 1 | (21) | (20) |\\n| Foreign office deposits | 140 | — | 0.03 | 182 | — | 0.09 | — | — | — |\\n| Other time deposits | 2,696 | 2 | 0.27 | 4,421 | 13 | 1.21 | (3) | (8) | (11) |\\n| Total interest-bearing core deposits | $ | 99,481 | 13 | 0.05 | $ | 100,739 | 69 | 0.27 | $ | (5) | (51) | (56) |\\n| Certificates $100,000 and over | 1,144 | 2 | 0.80 | 4,067 | 14 | 1.40 | (8) | (4) | (12) |\\n| Other deposits | — | — | — | 31 | — | 0.04 | — | — | — |\\n| Federal funds purchased | 346 | — | 0.10 | 309 | — | 0.16 | — | — | — |\\n| Other short-term borrowings | 1,097 | — | 0.12 | 2,377 | 2 | 0.32 | (1) | (1) | (2) |\\n| Long-term debt | 13,883 | 100 | 2.85 | 16,955 | 118 | 2.80 | (20) | 2 | (18) |\\n| Total interest-bearing liabilities | $ | 115,951 | 115 | 0.40 | % | $ | 124,478 | 203 | 0.66 | % | $ | (34) | (54) | (88) |\\n| Demand deposits | 61,994 | 45,761 |\\n| Other liabilities | 5,481 | 5,727 |\\n| Total liabilities | $ | 183,426 | $ | 175,966 |\\n| Total equity | $ | 22,927 | $ | 22,421 |\\n| Total liabilities and equity | $ | 206,353 | $ | 198,387 |\\n| Net interest income (FTE)(c) | $ | 1,211 | $ | 1,203 | $ | (16) | 24 | 8 |\\n| Net interest margin (FTE)(c) | 2.63 | % | 2.75 | % |\\n| Net interest rate spread (FTE)(c) | 2.48 | 2.55 |\\n| Interest-bearing liabilities to interest-earning assets | 62.70 | 70.64 |\\n\\n(a)Changes in interest not solely due to volume or yield/rate are allocated in proportion to the absolute dollar amount of change in volume and yield/rate.\\n(b)The FTE adjustments included in the above table were $3 for both the three months ended June 30, 2021 and 2020.\\n(c)Net interest income (FTE), net interest margin (FTE) and net interest rate spread (FTE) are non-GAAP measures. For further information, refer to the Non-GAAP Financial Measures section of MD&A.\\n13\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\n| TABLE 7: Condensed Average Balance Sheets and Analysis of Net Interest Income on an FTE Basis |\\n| For the six months ended | June 30, 2021 | June 30, 2020 | Attribution of Change in Net Interest Income(a) |\\n| ($ in millions) | Average Balance | Revenue/Cost | Average Yield/ Rate | Average Balance | Revenue/Cost | Average Yield/ Rate | Volume | Yield/ Rate | Total |\\n| Assets: |\\n| Interest-earning assets: |\\n| Loans and leases:(b) |\\n| Commercial and industrial loans | $ | 49,263 | 882 | 3.61 | % | $ | 55,399 | 1,056 | 3.83 | % | $ | (115) | (59) | (174) |\\n| Commercial mortgage loans | 10,500 | 161 | 3.09 | 11,122 | 218 | 3.94 | (12) | (45) | (57) |\\n| Commercial construction loans | 6,041 | 94 | 3.15 | 5,340 | 110 | 4.15 | 13 | (29) | (16) |\\n| Commercial leases | 3,152 | 48 | 3.05 | 3,128 | 54 | 3.47 | — | (6) | (6) |\\n| Total commercial loans and leases | $ | 68,956 | 1,185 | 3.46 | $ | 74,989 | 1,438 | 3.86 | $ | (114) | (139) | (253) |\\n| Residential mortgage loans | 21,095 | 347 | 3.32 | 17,715 | 315 | 3.58 | 56 | (24) | 32 |\\n| Home equity | 4,841 | 86 | 3.59 | 5,913 | 123 | 4.16 | (22) | (15) | (37) |\\n| Indirect secured consumer loans | 14,331 | 248 | 3.49 | 11,967 | 242 | 4.07 | 43 | (37) | 6 |\\n| Credit card | 1,824 | 111 | 12.25 | 2,373 | 138 | 11.72 | (33) | 6 | (27) |\\n| Other consumer loans | 3,027 | 91 | 6.04 | 2,842 | 100 | 7.09 | 6 | (15) | (9) |\\n| Total consumer loans | $ | 45,118 | 883 | 3.95 | $ | 40,810 | 918 | 4.53 | $ | 50 | (85) | (35) |\\n| Total loans and leases | $ | 114,074 | 2,068 | 3.66 | % | $ | 115,799 | 2,356 | 4.09 | % | $ | (64) | (224) | (288) |\\n| Securities: |\\n| Taxable | 35,932 | 537 | 3.01 | 36,395 | 564 | 3.12 | (8) | (19) | (27) |\\n| Exempt from income taxes(b) | 677 | 8 | 2.39 | 159 | 3 | 3.00 | 6 | (1) | 5 |\\n| Other short-term investments | 33,140 | 17 | 0.10 | 11,366 | 12 | 0.22 | 14 | (9) | 5 |\\n| Total interest-earning assets | $ | 183,823 | 2,630 | 2.89 | % | $ | 163,719 | 2,935 | 3.61 | % | $ | (52) | (253) | (305) |\\n| Cash and due from banks | 3,012 | 3,000 |\\n| Other assets | 20,595 | 20,509 |\\n| Allowance for loan and lease losses | (2,328) | (2,099) |\\n| Total assets | $ | 205,102 | $ | 185,129 |\\n| Liabilities and Equity: |\\n| Interest-bearing liabilities: |\\n| Interest checking deposits | $ | 45,437 | 14 | 0.06 | % | $ | 45,029 | 104 | 0.46 | % | $ | 1 | (91) | (90) |\\n| Savings deposits | 19,727 | 2 | 0.02 | 15,534 | 7 | 0.09 | 1 | (6) | (5) |\\n| Money market deposits | 30,723 | 7 | 0.05 | 28,565 | 72 | 0.51 | 5 | (70) | (65) |\\n| Foreign office deposits | 134 | — | 0.04 | 196 | — | 0.35 | — | — | — |\\n| Other time deposits | 2,870 | 5 | 0.36 | 4,751 | 33 | 1.40 | (10) | (18) | (28) |\\n| Total interest-bearing core deposits | $ | 98,891 | 28 | 0.06 | $ | 94,075 | 216 | 0.46 | $ | (3) | (185) | (188) |\\n| Certificates $100,000 and over | 1,574 | 8 | 0.98 | 3,711 | 31 | 1.71 | (13) | (10) | (23) |\\n| Other deposits | — | — | — | 144 | 1 | 0.76 | (1) | — | (1) |\\n| Federal funds purchased | 335 | — | 0.11 | 481 | 2 | 0.82 | (1) | (1) | (2) |\\n| Other short-term borrowings | 1,153 | 1 | 0.18 | 2,063 | 8 | 0.74 | (3) | (4) | (7) |\\n| Long-term debt | 14,362 | 202 | 2.84 | 16,387 | 241 | 2.95 | (30) | (9) | (39) |\\n| Total interest-bearing liabilities | $ | 116,315 | 239 | 0.42 | % | $ | 116,861 | 499 | 0.86 | % | $ | (51) | (209) | (260) |\\n| Demand deposits | 60,300 | 40,763 |\\n| Other liabilities | 5,548 | 5,438 |\\n| Total liabilities | $ | 182,163 | $ | 163,062 |\\n| Total equity | $ | 22,939 | $ | 22,067 |\\n| Total liabilities and equity | $ | 205,102 | $ | 185,129 |\\n| Net interest income (FTE)(c) | $ | 2,391 | $ | 2,436 | $ | (1) | (44) | (45) |\\n| Net interest margin (FTE)(c) | 2.62 | % | 2.99 | % |\\n| Net interest rate spread (FTE)(c) | 2.47 | 2.75 |\\n| Interest-bearing liabilities to interest-earning assets | 63.28 | 71.38 |\\n\\n(a)Changes in interest not solely due to volume or yield/rate are allocated in proportion to the absolute dollar amount of change in volume and yield/rate.\\n(b)The FTE adjustments included in the above table were $6 and $7 for the six months ended June 30, 2021 and 2020, respectively.\\n(c)Net interest income (FTE), net interest margin (FTE) and net interest rate spread (FTE) are non-GAAP measures. For further information, refer to the Non-GAAP Financial Measures section of MD&A.\\n14\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nProvision for Credit Losses\\nThe Bancorp provides, as an expense, an amount for expected credit losses within the loan and lease portfolio and the portfolio of unfunded loan commitments and letters of credit that is based on factors previously discussed in the Critical Accounting Policies section of the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020. The provision is recorded to bring the ALLL and reserve for unfunded commitments to a level deemed appropriate by the Bancorp to cover losses expected in the portfolios. Actual credit losses on loans and leases are charged against the ALLL. The amount of loans and leases actually removed from the Condensed Consolidated Balance Sheets are referred to as charge-offs. Net charge-offs include current period charge-offs less recoveries on previously charged-off loans and leases.\\nThe benefit from credit losses was $115 million and $288 million for the three and six months ended June 30, 2021, respectively, compared to a provision for credit losses of $485 million and $1.1 billion during the same periods in the prior year. Provision expense decreased for the three and six months ended June 30, 2021 compared to the same periods in the prior year primarily driven by factors which caused decreases in the ACL during those periods including improved economic forecasts, improved commercial and consumer credit quality and lower period-end loan and lease balances. Provision expense was elevated in 2020 as the Bancorp increased its ACL in response to deterioration and uncertainty in the macroeconomic environment as a result of the impact of the COVID-19 pandemic, continued pressure on energy prices and the resulting impact of these factors on commercial borrowers as reflected in increased levels of commercial criticized assets. In the first and second quarters of 2021, the Bancorp decreased the ACL, reflecting credit quality and stabilization in the macroeconomic environment, aided by fiscal and monetary stimulus programs as well as the easing of government-imposed restrictions related to the COVID-19 pandemic.\\nThe ALLL decreased $420 million from December 31, 2020 to $2.0 billion at June 30, 2021. At June 30, 2021, the ALLL as a percent of portfolio loans and leases decreased to 1.89%, compared to 2.25% at December 31, 2020. The reserve for unfunded commitments increased $17 million from December 31, 2020 to $189 million at June 30, 2021. The ACL as a percent of portfolio loans and leases decreased to 2.06% at June 30, 2021, compared to 2.41% at December 31, 2020.\\nRefer to the Credit Risk Management subsection of the Risk Management section of MD&A as well as Note 6 of the Notes to Condensed Consolidated Financial Statements for more detailed information on the provision for credit losses, including an analysis of loan and lease portfolio composition, nonperforming assets, net charge-offs and other factors considered by the Bancorp in assessing the credit quality of the loan and lease portfolio and determining the level of the ACL.\\nNoninterest Income\\nNoninterest income increased $91 million and $169 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020.\\nThe following table presents the components of noninterest income:\\n| TABLE 8: Components of Noninterest Income |\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | % Change | 2021 | 2020 | % Change |\\n| Commercial banking revenue | $ | 160 | 137 | 17 | $ | 313 | 261 | 20 |\\n| Service charges on deposits | 149 | 122 | 22 | 292 | 270 | 8 |\\n| Wealth and asset management revenue | 145 | 120 | 21 | 288 | 255 | 13 |\\n| Card and processing revenue | 102 | 82 | 24 | 196 | 167 | 17 |\\n| Mortgage banking net revenue | 64 | 99 | (35) | 149 | 219 | (32) |\\n| Leasing business revenue | 61 | 57 | 7 | 148 | 131 | 13 |\\n| Other noninterest income | 49 | 12 | 308 | 92 | 18 | 411 |\\n| Securities gains (losses), net | 10 | 21 | (52) | 13 | (3) | NM |\\n| Securities (losses) gains, net – non-qualifying hedges on mortgage servicing rights | 1 | — | NM | (1) | 3 | NM |\\n| Total noninterest income | $ | 741 | 650 | 14 | $ | 1,490 | 1,321 | 13 |\\n\\nCommercial banking revenue\\nCommercial banking revenue increased $23 million and $52 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020. The increase for the three months ended June 30, 2021 compared to the same period in the prior year was primarily driven by increases in loan syndication fees and business lending fees of $20 million and $10 million, respectively, partially offset by a decrease in institutional sales of $10 million. The increase for the six months ended June 30, 2021 compared to the same period in the prior year was primarily due to increases in loan syndication fees, business lending fees and institutional sales of $29 million, $14 million and $12 million, respectively, partially offset by a decrease in contract revenue from commercial customer derivatives of $7 million.\\n15\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nService charges on deposits\\nService charges on deposits increased $27 million and $22 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020. The increase for the three months ended June 30, 2021 compared to the same period in the prior year was due to increases in commercial deposit fees and consumer deposit fees of $17 million and $10 million, respectively. The increase for the six months ended June 30, 2021 compared to the same period in the prior year was primarily due to an increase of $22 million in commercial deposit fees.\\nWealth and asset management revenue\\nWealth and asset management revenue increased $25 million and $33 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in private client service fees of $19 million and $28 million, respectively, and broker income of $10 million and $14 million, respectively. These increases were partially offset by decreases in institutional fees of $4 million and $7 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020. The Bancorp’s trust and registered investment advisory businesses had approximately $483 billion and $405 billion in total assets under care as of June 30, 2021 and 2020, respectively, and managed $61 billion and $49 billion in assets for individuals, corporations and not-for-profit organizations as of June 30, 2021 and 2020, respectively.\\nCard and processing revenue\\nCard and processing revenue increased $20 million and $29 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020 primarily due to an increase in debit and credit card interchange, partially offset by increased reward costs, all of which were driven by an increase in consumer and business card spend volume.\\nMortgage banking net revenue\\nMortgage banking net revenue decreased $35 million and $70 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020 primarily due to lower net mortgage servicing revenue.\\nThe following table presents the components of mortgage banking net revenue:\\n| TABLE 9: Components of Mortgage Banking Net Revenue |\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Origination fees and gains on loan sales | $ | 81 | 95 | 170 | 176 |\\n| Net mortgage servicing revenue: |\\n| Gross mortgage servicing fees | 59 | 63 | 117 | 130 |\\n| Net valuation adjustments on MSRs and free-standing derivatives purchased to economically hedge MSRs | (76) | (59) | (138) | (87) |\\n| Net mortgage servicing revenue | (17) | 4 | (21) | 43 |\\n| Total mortgage banking net revenue | $ | 64 | 99 | 149 | 219 |\\n\\nOrigination fees and gains on loan sales decreased $14 million and $6 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020 primarily driven by decreases in gain on sale margins partially offset by gains from sales of loans that were previously repurchased from GNMA. Residential mortgage loan originations increased to $5.0 billion and $9.7 billion for the three and six months ended June 30, 2021, respectively, from $3.4 billion and $7.4 billion for the three and six months ended June 30, 2020, respectively.\\nNet mortgage servicing revenue decreased $21 million and $64 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020 primarily due to increases in net negative valuation adjustments of $17 million and $51 million, respectively, as well as decreases in gross mortgage servicing fees of $4 million and $13 million, respectively. Refer to Table 10 for the components of net valuation adjustments on the MSR portfolio and the impact of the non-qualifying hedging strategy.\\n16\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\n| TABLE 10: Components of Net Valuation Adjustments on MSRs |\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Changes in fair value and settlement of free-standing derivatives purchased to economically hedge the MSR portfolio | $ | 46 | 11 | (88) | 361 |\\n| Changes in fair value: |\\n| Due to changes in inputs or assumptions(a) | (49) | (12) | 103 | (343) |\\n| Other changes in fair value(b) | (73) | (58) | (153) | (105) |\\n| Net valuation adjustments on MSRs and free-standing derivatives purchased to economically hedge MSRs | $ | (76) | (59) | (138) | (87) |\\n\\n(a)Primarily reflects changes in prepayment speed and OAS assumptions which are updated based on market interest rates.\\n(b)Primarily reflects changes due to realized cash flows and the passage of time.\\nFor the three and six months ended June 30, 2021, the Bancorp recognized losses of $122 million and $50 million, respectively, in mortgage banking net revenue for valuation adjustments on the MSR portfolio. The valuation adjustments on the MSR portfolio included a decrease of $49 million for the three months ended June 30, 2021 and an increase of $103 million for the six months ended June 30, 2021 due to changes in market rates and other inputs in the valuation model, including future prepayment speeds and OAS assumptions. For the three months ended June 30, 2021, a decrease in mortgage rates caused modeled prepayment speeds to rise. For the six months ended June 30, 2021, an increase in mortgage rates resulted in a reduction to modeled prepayment speeds, and a tightening of the spread between mortgage rates and swap rates resulted in a decrease in the modeled OAS assumptions. The fair value of the MSR portfolio also decreased $73 million and $153 million as a result of contractual principal payments and actual prepayment activity for the three and six months ended June 30, 2021, respectively.\\nMortgage rates decreased during both the three and six months ended June 30, 2020, which caused modeled prepayment speeds to rise. The fair value of the MSR portfolio decreased $12 million and $343 million for the three and six months ended June 30, 2020, respectively, due to changes to inputs to the valuation model including prepayment speeds and OAS assumptions and decreased $58 million and $105 million for the three and six months ended June 30, 2020, respectively, due to the impact of contractual principal payments and actual prepayment activity.\\nFurther detail on the valuation of MSRs can be found in Note 12 of the Notes to Condensed Consolidated Financial Statements. The Bancorp maintains a non-qualifying hedging strategy to manage a portion of the risk associated with changes in the valuation of the MSR portfolio. Refer to Note 13 of the Notes to Condensed Consolidated Financial Statements for more information on the free-standing derivatives used to economically hedge the MSR portfolio.\\nIn addition to the derivative positions used to economically hedge the MSR portfolio, the Bancorp acquires various securities as a component of its non-qualifying hedging strategy. The Bancorp recognized net gains of $1 million and net losses of $1 million during the three and six months ended June 30, 2021, respectively, compared to net gains of an immaterial amount and $3 million during the three and six months ended June 30, 2020, respectively, recorded in securities (losses) gains, net – non-qualifying hedges on mortgage servicing rights in the Bancorp’s Condensed Consolidated Statements of Income.\\nThe Bancorp’s total residential mortgage loans serviced as of June 30, 2021 and 2020 were $93.0 billion and $95.4 billion, respectively, with $71.5 billion and $78.8 billion, respectively, of residential mortgage loans serviced for others.\\nLeasing business revenue\\nLeasing business revenue increased $4 million and $17 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020. The increase for the three months ended June 30, 2021 compared to the same period in the prior year was primarily due to increases in lease remarketing fees and leasing business solutions revenue of $3 million and $2 million respectively. The increase for the six months ended June 30, 2021 compared to the same period in the prior year was primarily due to an increase of $39 million in lease syndication fees, partially offset by a decrease of $22 million in lease remarketing fees.\\n17\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nOther noninterest income\\nThe following table presents the components of other noninterest income:\\n| TABLE 11: Components of Other Noninterest Income |\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| BOLI income | $ | 15 | 17 | 31 | 32 |\\n| Cardholder fees | 13 | 10 | 25 | 21 |\\n| Equity method investment income | 14 | — | 21 | 3 |\\n| Private equity investment income (loss) | 20 | 6 | 19 | (8) |\\n| Banking center income | 6 | 4 | 11 | 10 |\\n| Consumer loan fees | 4 | 5 | 8 | 10 |\\n| Insurance income | 2 | 4 | 3 | 10 |\\n| Loss on swap associated with the sale of Visa, Inc. Class B Shares | (37) | (29) | (50) | (51) |\\n| Net losses on disposition and impairment of bank premises and equipment | (1) | (12) | (1) | (15) |\\n| Other, net | 13 | 7 | 25 | 6 |\\n| Total other noninterest income | $ | 49 | 12 | 92 | 18 |\\n\\nOther noninterest income increased $37 million for the three months ended June 30, 2021 compared to the three months ended June 30, 2020 primarily due to increases in private equity investment income and equity method investment income as well as a decrease in net losses on disposition and impairment of bank premises and equipment, partially offset by an increase in the loss on the swap associated with the sale of Visa, Inc. Class B Shares.\\nPrivate equity investment income increased $14 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily driven by the recognition of positive net valuation adjustments on certain private equity investments during the three months ended June 30, 2021. Equity method investment income increased $14 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to gains and proportional earnings recognized on certain equity method investments during the three months ended June 30, 2021. Net losses on disposition and impairment of bank premises and equipment decreased $11 million for the three months ended June 30, 2021 compared to the three months ended June 30, 2020 driven by the impact of impairment charges of $2 million during the three months ended June 30, 2021 compared to $12 million during the three months ended June 30, 2020. For additional information, refer to Note 7 of the Notes to Condensed Consolidated Financial Statements. The Bancorp recognized negative valuation adjustments of $37 million related to the Visa total return swap during the three months ended June 30, 2021 compared to negative valuation adjustments of $29 million during the three months ended June 30, 2020. For additional information on the valuation of the swap associated with the sale of Visa, Inc. Class B Shares, refer to Note 21 of the Notes to Condensed Consolidated Financial Statements.\\nOther noninterest income increased $74 million for the six months ended June 30, 2021 compared to the six months ended June 30, 2020 primarily due to increases in private equity investment income and equity method investment income and a decrease in net losses on disposition and impairment of bank premises and equipment, partially offset by a decrease in insurance income.\\nPrivate equity investment income increased $27 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily driven by the recognition of positive net valuation adjustments on certain private equity investments during the six months ended June 30, 2021 and the impact of impairment charges recognized on certain private equity investments during the six months ended June 30, 2020. For additional information on the valuation of private equity investments, refer to Note 21 of the Notes to Condensed Consolidated Financial Statements. Equity method investment income increased $18 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to gains and proportional earnings recognized on certain equity method investments during the six months ended June 30, 2021. Net losses on disposition and impairment of bank premises and equipment decreased $14 million for the six months ended June 30, 2021 compared to the six months ended June 30, 2020 driven by the impact of impairment charges of $4 million during the six months ended June 30, 2021 compared to $14 million during the six months ended June 30, 2020. For additional information, refer to Note 7 of the Notes to Condensed Consolidated Financial Statements. Insurance income decreased $7 million for the six months ended June 30, 2021 compared to the same period in the prior year driven by the sale of the Bancorp’s property and casualty insurance business in the fourth quarter of 2020.\\n18\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nNoninterest Expense\\nNoninterest expense increased $32 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to increases in other noninterest expense and compensation and benefits expense, partially offset by decreases in card and processing expense and net occupancy expense. Noninterest expense increased $48 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to an increase in compensation and benefits expense, partially offset by decreases in card and processing expense, net occupancy expense and marketing expense.\\nThe following table presents the components of noninterest expense:\\n| TABLE 12: Components of Noninterest Expense |\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | % Change | 2021 | 2020 | % Change |\\n| Compensation and benefits | $ | 638 | 627 | 2 | $ | 1,343 | 1,274 | 5 |\\n| Technology and communications | 94 | 90 | 4 | 187 | 183 | 2 |\\n| Net occupancy expense | 77 | 82 | (6) | 156 | 164 | (5) |\\n| Equipment expense | 34 | 32 | 6 | 68 | 64 | 6 |\\n| Leasing business expense | 33 | 33 | — | 68 | 68 | — |\\n| Card and processing expense | 20 | 29 | (31) | 50 | 60 | (17) |\\n| Marketing expense | 20 | 20 | — | 43 | 51 | (16) |\\n| Other noninterest expense | 237 | 208 | 14 | 454 | 457 | (1) |\\n| Total noninterest expense | $ | 1,153 | 1,121 | 3 | $ | 2,369 | 2,321 | 2 |\\n| Efficiency ratio on an FTE basis(a) | 59.1 | % | 60.5 | 61.0 | % | 61.8 |\\n\\n(a)This is a non-GAAP measure. For further information, refer to the Non-GAAP Financial Measures section of MD&A.\\nCompensation and benefits expense increased $11 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to an increase in performance-based compensation. Compensation and benefits expense increased $69 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to an increase in non-qualified deferred compensation expense and performance-based compensation. Full-time equivalent employees totaled 19,402 at June 30, 2021 compared to 20,340 at June 30, 2020.\\nCard and processing expense decreased $9 million and $10 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to contract renegotiations with a third-party vendor. Net occupancy expense decreased $5 million and $8 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to a reduction of leased square footage. Marketing expense decreased $8 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to the impact of the COVID-19 pandemic, which resulted in a pause or slowdown in numerous marketing campaigns, including running less advertising, as well as the suspension of cash bonuses and other account acquisition programs.\\n19\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nThe following table presents the components of other noninterest expense:\\n| TABLE 13: Components of Other Noninterest Expense |\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Loan and lease | $ | 55 | 40 | 104 | 75 |\\n| FDIC insurance and other taxes | 30 | 24 | 58 | 49 |\\n| Data processing | 20 | 17 | 40 | 35 |\\n| Professional service fees | 16 | 13 | 32 | 23 |\\n| Losses and adjustments | 23 | 17 | 30 | 71 |\\n| Intangible amortization | 10 | 12 | 21 | 25 |\\n| Postal and courier | 9 | 8 | 18 | 18 |\\n| Travel | 7 | 4 | 10 | 19 |\\n| Recruitment and education | 5 | 5 | 10 | 11 |\\n| Insurance | 4 | 3 | 8 | 7 |\\n| Supplies | 3 | 3 | 5 | 7 |\\n| Donations | 3 | 4 | 5 | 7 |\\n| Other, net | 52 | 58 | 113 | 110 |\\n| Total other noninterest expense | $ | 237 | 208 | 454 | 457 |\\n\\nOther noninterest expense increased $29 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to increases in loan and lease expense, losses and adjustments and FDIC insurance and other taxes. Other noninterest expense decreased $3 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to decreases in losses and adjustments and travel expense, partially offset by increases in loan and lease expense, FDIC insurance and other taxes and professional service fees.\\nLoan and lease expense increased $15 million and $29 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to an increase in loan servicing expenses associated with the Bancorp’s purchases of certain government-guaranteed residential mortgage loans in forbearance programs. FDIC insurance and other taxes increased $6 million and $9 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily as a result of an increase in the assessment rate due to a change in asset mix as well as an increase in the assessment base.\\nLosses and adjustments increased $6 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to an increase in legal settlements, partially offset by a decline in credit valuation adjustments on derivatives associated with customer accommodation contracts. Losses and adjustments decreased $41 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to a decline in credit valuation adjustments on derivatives associated with customer accommodation contracts, partially offset by an increase in legal settlements.\\nTravel expense decreased $9 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to reduced business travel as a direct result of the COVID-19 pandemic.\\nProfessional service fees increased $9 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily driven by increases in consulting fees and legal fees.\\nApplicable Income Taxes\\nThe Bancorp’s income before income taxes, applicable income tax expense and effective tax rate are as follows:\\n| TABLE 14: Applicable Income Taxes |\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Income before income taxes | $ | 911 | 244 | 1,794 | 304 |\\n| Applicable income tax expense | 202 | 49 | 391 | 61 |\\n| Effective tax rate | 22.1 | % | 19.9 | 21.8 | 20.4 |\\n\\nApplicable income tax expense for all periods presented includes the benefit from tax-exempt income, tax-advantaged investments, and tax credits (and other related tax benefits), partially offset by the effect of proportional amortization of qualifying LIHTC investments and certain nondeductible expenses. The tax credits are primarily associated with the Low-Income Housing Tax Credit program established under\\n20\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nSection 42 of the IRC, the New Markets Tax Credit program established under Section 45D of the IRC, the Rehabilitation Investment Tax Credit program established under Section 47 of the IRC and the Qualified Zone Academy Bond program established under Section 1397E of the IRC.\\nThe effective tax rate increased to 22.1% and 21.8% for the three and six months ended June 30, 2021, respectively, from 19.9% and 20.4% for the same periods in the prior year primarily related to an increase in forecasted income before income taxes.\\n21\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nBALANCE SHEET ANALYSIS\\nLoans and Leases\\nThe Bancorp classifies its commercial loans and leases based upon primary purpose and consumer loans based upon product or collateral. Table 15 summarizes end of period loans and leases, including loans and leases held for sale and Table 16 summarizes average total loans and leases, including average loans and leases held for sale.\\n| TABLE 15: Components of Total Loans and Leases (including loans and leases held for sale) |\\n| June 30, 2021 | December 31, 2020 |\\n| As of ($ in millions) | Carrying Value | % of Total | Carrying Value | % of Total |\\n| Commercial loans and leases: |\\n| Commercial and industrial loans(a) | $ | 47,575 | 42 | % | $ | 49,895 | 44 | % |\\n| Commercial mortgage loans | 10,380 | 9 | 10,609 | 9 |\\n| Commercial construction loans | 5,873 | 5 | 5,815 | 5 |\\n| Commercial leases | 3,238 | 3 | 2,954 | 3 |\\n| Total commercial loans and leases | $ | 67,066 | 59 | $ | 69,273 | 61 |\\n| Consumer loans: |\\n| Residential mortgage loans(b) | 21,815 | 19 | 20,393 | 18 |\\n| Home equity | 4,545 | 4 | 5,183 | 4 |\\n| Indirect secured consumer loans | 15,192 | 13 | 13,653 | 12 |\\n| Credit card | 1,793 | 2 | 2,007 | 2 |\\n| Other consumer loans | 3,052 | 3 | 3,014 | 3 |\\n| Total consumer loans | $ | 46,397 | 41 | $ | 44,250 | 39 |\\n| Total loans and leases | $ | 113,463 | 100 | % | $ | 113,523 | 100 | % |\\n| Total portfolio loans and leases (excluding loans and leases held for sale) | $ | 107,733 | $ | 108,782 |\\n\\n(a)Includes $3.7 billion and $4.8 billion as of June 30, 2021 and December 31, 2020, respectively, related to the SBA’s Paycheck Protection Program.\\n(b)Includes $39 as of December 31, 2020 of residential mortgage loans previously sold to GNMA for which the Bancorp was deemed to have regained effective control over under ASC Topic 860, but did not exercise its option to repurchase. Refer to Note 14 for further information.\\nTotal loans and leases, including loans and leases held for sale, decreased $60 million from December 31, 2020. The decrease from December 31, 2020 was the result of a $2.2 billion, or 3%, decrease in commercial loans and leases, partially offset by a $2.1 billion, or 5%, increase in consumer loans.\\nCommercial loans and leases decreased $2.2 billion from December 31, 2020 due to decreases in commercial and industrial loans and commercial mortgage loans, partially offset by increases in commercial leases and commercial construction loans. Commercial and industrial loans decreased $2.3 billion, or 5%, from December 31, 2020 primarily as a result of PPP loan forgiveness and paydowns in excess of loan originations. Commercial mortgage loans decreased $229 million, or 2%, from December 31, 2020 as payoffs exceeded loan originations. Commercial leases increased $284 million, or 10%, from December 31, 2020 primarily as a result of an increase in lease originations. Commercial construction loans increased $58 million, or 1%, from December 31, 2020 as draws on existing commitments exceeded payoffs.\\nConsumer loans increased $2.1 billion from December 31, 2020 due to increases in indirect secured consumer loans, residential mortgage loans and other consumer loans, partially offset by decreases in home equity and credit card. Indirect secured consumer loans increased $1.5 billion, or 11%, from December 31, 2020 primarily as a result of loan production exceeding payoffs. Residential mortgage loans increased $1.4 billion, or 7%, from December 31, 2020 primarily due to increases in residential mortgage loans held for sale as the Bancorp purchased government-guaranteed loans in forbearance programs. Other consumer loans increased $38 million, or 1%, from December 31, 2020 primarily as a result of the purchase of a portfolio of point-of-sale loans. Home equity decreased $638 million, or 12%, from December 31, 2020 as payoffs exceeded loan originations. Credit card decreased $214 million, or 11%, from December 31, 2020 primarily due to seasonal paydowns on year-end balances as well as continuing impacts from the COVID-19 pandemic, including accelerated paydown activity driven by the amount of fiscal stimulus programs.\\n22\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\n| TABLE 16: Components of Average Loans and Leases (including average loans and leases held for sale) |\\n| June 30, 2021 | June 30, 2020 |\\n| For the three months ended ($ in millions) | Carrying Value | % of Total | Carrying Value | % of Total |\\n| Commercial loans and leases: |\\n| Commercial and industrial loans | $ | 48,817 | 43 | % | $ | 59,106 | 49 | % |\\n| Commercial mortgage loans | 10,467 | 9 | 11,224 | 9 |\\n| Commercial construction loans | 6,043 | 5 | 5,548 | 5 |\\n| Commercial leases | 3,174 | 3 | 3,056 | 3 |\\n| Total commercial loans and leases | $ | 68,501 | 60 | $ | 78,934 | 66 |\\n| Consumer loans: |\\n| Residential mortgage loans | 21,740 | 19 | 17,405 | 15 |\\n| Home equity | 4,674 | 4 | 5,820 | 5 |\\n| Indirect secured consumer loans | 14,702 | 13 | 12,124 | 10 |\\n| Credit card | 1,770 | 2 | 2,248 | 2 |\\n| Other consumer loans | 3,056 | 2 | 2,887 | 2 |\\n| Total consumer loans | $ | 45,942 | 40 | $ | 40,484 | 34 |\\n| Total average loans and leases | $ | 114,443 | 100 | % | $ | 119,418 | 100 | % |\\n| Total average portfolio loans and leases (excluding loans and leases held for sale) | $ | 108,534 | $ | 118,506 |\\n\\nAverage loans and leases, including average loans and leases held for sale, decreased $5.0 billion, or 4%, for the three months ended June 30, 2021 compared to the same period in the prior year as a result of a $10.4 billion, or 13%, decrease in average commercial loans and leases, partially offset by a $5.5 billion, or 13%, increase in average consumer loans.\\nAverage commercial loans and leases decreased $10.4 billion for the three months ended June 30, 2021 compared to the same period in the prior year due to decreases in average commercial and industrial loans and average commercial mortgage loans, partially offset by increases in average commercial construction loans and average commercial leases. Average commercial and industrial loans decreased $10.3 billion, or 17%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily driven by continued paydowns on revolving lines of credit, partially offset by PPP loans originated since June of 2020. Average commercial mortgage loans decreased $757 million, or 7%, for the three months ended June 30, 2021 compared to the same period in the prior year as payoffs exceeded loan originations. Average commercial construction loans increased $495 million, or 9%, for the three months ended June 30, 2021 compared to the same period in the prior year as draws on existing commitments exceeded payoffs. Average commercial leases increased $118 million, or 4%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily as a result of an increase in lease originations.\\nAverage consumer loans increased $5.5 billion for the three months ended June 30, 2021 compared to the same period in the prior year due to increases in average residential mortgage loans, average indirect secured consumer loans and average other consumer loans, partially offset by decreases in average home equity and average credit card. Average residential mortgage loans increased $4.3 billion, or 25%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to increases in residential mortgage loans held for sale as the Bancorp purchased government-guaranteed loans in forbearance programs, partially offset by higher runoff due to payoffs exceeding loan originations. Average indirect secured consumer loans increased $2.6 billion, or 21%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to loan production exceeding payoffs. Average other consumer loans increased $169 million, or 6%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily as a result of purchases of portfolios of point-of-sale loans. Average home equity decreased $1.1 billion, or 20%, for the three months ended June 30, 2021 compared to the same period in the prior year as payoffs exceeded loan originations. Average credit card decreased $478 million, or 21%, for the three months ended June 30, 2021 compared to the same period in the prior year driven by continuing impacts from the COVID-19 pandemic, including accelerated paydown activity driven by the amount of fiscal stimulus.\\nInvestment Securities\\nThe Bancorp uses investment securities as a means of managing interest rate risk, providing collateral for pledging purposes and for liquidity risk management. Total investment securities were $39.1 billion and $38.4 billion at June 30, 2021 and December 31, 2020, respectively. The taxable available-for-sale debt and other investment securities portfolio had an effective duration of 4.9 at June 30, 2021 compared to 4.4 at December 31, 2020.\\nDebt securities are classified as available-for-sale when, in management’s judgment, they may be sold in response to, or in anticipation of, changes in market conditions. Securities that management has the intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized cost. Debt securities are classified as trading when bought and held principally for the purpose of selling them in the near term. At June 30, 2021, the Bancorp’s investment portfolio consisted primarily of AAA-rated available-for-sale debt and other securities. The Bancorp held an immaterial amount in below-investment grade available-for-sale debt and other securities at both June 30, 2021 and December 31, 2020. In the first quarter of 2021, the Bancorp recognized $7 million of impairment losses on its available-for-sale debt and\\n23\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nother securities, included in securities gains (losses), net, in the Condensed Consolidated Statements of Income. These losses related to certain securities in unrealized loss positions that the Bancorp intended to sell prior to recovery of their amortized cost bases. The Bancorp did not consider these losses to be credit-related.\\nAt both June 30, 2021 and December 31, 2020, the Bancorp completed its evaluation of the available-for-sale debt and other securities in an unrealized loss position and did not recognize an allowance for credit losses. The Bancorp did not recognize provision expense related to available-for-sale debt and other securities in an unrealized loss position during both the three and six months ended June 30, 2021 and June 30, 2020.\\nThe following table summarizes the end of period components of investment securities:\\n| TABLE 17: Components of Investment Securities |\\n| As of ($ in millions) | June 30,2021 | December 31, 2020 |\\n| Available-for-sale debt and other securities (amortized cost basis): |\\n| U.S. Treasury and federal agencies securities | $ | 105 | 74 |\\n| Obligations of states and political subdivisions securities | 18 | 17 |\\n| Mortgage-backed securities: |\\n| Agency residential mortgage-backed securities | 10,256 | 11,147 |\\n| Agency commercial mortgage-backed securities | 18,142 | 16,745 |\\n| Non-agency commercial mortgage-backed securities | 3,276 | 3,323 |\\n| Asset-backed securities and other debt securities | 3,764 | 3,152 |\\n| Other securities(a) | 520 | 524 |\\n| Total available-for-sale debt and other securities | $ | 36,081 | 34,982 |\\n| Held-to-maturity securities (amortized cost basis): |\\n| Obligations of states and political subdivisions securities | $ | 9 | 9 |\\n| Asset-backed securities and other debt securities | 1 | 2 |\\n| Total held-to-maturity securities | $ | 10 | 11 |\\n| Trading debt securities (fair value): |\\n| U.S. Treasury and federal agencies securities | $ | 96 | 81 |\\n| Obligations of states and political subdivisions securities | 63 | 10 |\\n| Agency residential mortgage-backed securities | 69 | 30 |\\n| Asset-backed securities and other debt securities | 483 | 439 |\\n| Total trading debt securities | $ | 711 | 560 |\\n| Total equity securities (fair value) | $ | 341 | 313 |\\n\\n(a)Other securities consist of FHLB, FRB and DTCC restricted stock holdings of $33, $485 and $2, respectively, at June 30, 2021 and $40, $482 and $2, respectively, at December 31, 2020, that are carried at cost.\\nOn an amortized cost basis, available-for-sale debt and other securities increased $1.1 billion from December 31, 2020 primarily due to increases in agency commercial mortgage-backed securities and asset-backed securities and other debt securities, partially offset by a decrease in agency residential mortgage-backed securities.\\nOn an amortized cost basis, available-for-sale debt and other securities were 20% and 19% of total interest-earning assets at June 30, 2021 and December 31, 2020, respectively. The estimated weighted-average life of the debt securities in the available-for-sale debt and other securities portfolio was 6.3 years at June 30, 2021 compared to 5.7 years at December 31, 2020. In addition, at June 30, 2021, the debt securities in the available-for-sale debt and other securities portfolio had a weighted-average yield of 2.88% compared to 3.05% at December 31, 2020.\\nInformation presented in Table 18 is on a weighted-average life basis, anticipating future prepayments. Yield information is presented on an FTE basis and is computed using amortized cost balances and reflects the impact of prepayments. Maturity and yield calculations for the total available-for-sale debt and other securities portfolio exclude other securities that have no stated yield or maturity. Total net unrealized gains on the available-for-sale debt and other securities portfolio were $1.9 billion at June 30, 2021 compared to $2.5 billion at December 31, 2020. The fair value of investment securities is impacted by interest rates, credit spreads, market volatility and liquidity conditions. The fair value of investment securities generally increases when interest rates decrease or when credit spreads contract.\\n24\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\n| TABLE 18: Characteristics of Available-for-Sale Debt and Other Securities |\\n| As of June 30, 2021 ($ in millions) | Amortized Cost | Fair Value | Weighted-Average Life(in years) | Weighted-Average Yield |\\n| U.S. Treasury and federal agencies securities: |\\n| Average life of 1 year or less | $ | 30 | 30 | 0.1 | 0.02 | % |\\n| Average life 1 – 5 years | 75 | 77 | 1.6 | 2.16 |\\n| Total | $ | 105 | 107 | 1.2 | 2.05 | % |\\n| Obligations of states and political subdivisions securities: |\\n| Average life 1 – 5 years | 17 | 17 | 1.7 | 1.80 |\\n| Average life greater than 10 years | 1 | 1 | 15.4 | 7.00 |\\n| Total | $ | 18 | 18 | 2.5 | 2.12 | % |\\n| Agency residential mortgage-backed securities: |\\n| Average life of 1 year or less | 427 | 434 | 0.5 | 3.60 |\\n| Average life 1 – 5 years | 4,471 | 4,665 | 3.4 | 3.08 |\\n| Average life 5 – 10 years | 4,570 | 4,864 | 6.6 | 3.02 |\\n| Average life greater than 10 years | 788 | 846 | 13.3 | 2.92 |\\n| Total | $ | 10,256 | 10,809 | 5.5 | 3.06 | % |\\n| Agency commercial mortgage-backed securities:(a) |\\n| Average life of 1 year or less | 422 | 436 | 0.6 | 3.90 |\\n| Average life 1 – 5 years | 6,293 | 6,661 | 2.9 | 3.31 |\\n| Average life 5 – 10 years | 6,309 | 6,852 | 6.9 | 3.11 |\\n| Average life greater than 10 years | 5,118 | 5,345 | 13.9 | 2.18 |\\n| Total | $ | 18,142 | 19,294 | 7.4 | 2.94 | % |\\n| Non-agency commercial mortgage-backed securities: |\\n| Average life of 1 year or less | 7 | 7 | 0.4 | 2.58 |\\n| Average life 1 – 5 years | 2,733 | 2,906 | 3.3 | 3.28 |\\n| Average life 5 – 10 years | 526 | 556 | 7.0 | 2.59 |\\n| Average life greater than 10 years | 10 | 10 | 10.0 | 2.40 |\\n| Total | $ | 3,276 | 3,479 | 3.9 | 3.16 | % |\\n| Asset-backed securities and other debt securities: |\\n| Average life of 1 year or less | 342 | 342 | 0.5 | 3.19 |\\n| Average life 1 – 5 years | 1,600 | 1,613 | 3.3 | 2.16 |\\n| Average life 5 – 10 years | 1,256 | 1,254 | 6.9 | 1.47 |\\n| Average life greater than 10 years | 566 | 576 | 14.8 | 1.43 |\\n| Total | $ | 3,764 | 3,785 | 6.0 | 1.91 | % |\\n| Other securities | 520 | 520 |\\n| Total available-for-sale debt and other securities | $ | 36,081 | 38,012 | 6.3 | 2.88 | % |\\n\\n(a)Taxable-equivalent yield adjustments included in the above table are 0.05% and 0.01% for securities with an average life greater than 10 years and in total, respectively.\\nOther Short-Term Investments\\nOther short-term investments primarily include overnight interest-earning investments, including reserves held at the FRB. The Bancorp uses other short-term investments as part of its liquidity risk management tools. Other short-term investments were $32.4 billion and $33.4 billion at June 30, 2021 and December 31, 2020, respectively. The decrease of $990 million from December 31, 2020 was primarily due to wholesale funding maturities during the six months ended June 30, 2021.\\nDeposits\\nThe Bancorp’s deposit balances represent an important source of funding and revenue growth opportunity. The Bancorp continues to focus on core deposit growth in its retail and commercial franchises by improving customer satisfaction, building full relationships and offering competitive rates. Average core deposits represented 78% and 74% of the Bancorp’s average asset funding base for the three months ended June 30, 2021 and 2020, respectively.\\n25\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nThe following table presents the end of period components of deposits:\\n| TABLE 19: Components of Deposits |\\n| June 30, 2021 | December 31, 2020 |\\n| As of ($ in millions) | Balance | % of Total | Balance | % of Total |\\n| Demand | $ | 62,760 | 39 | % | $ | 57,711 | 36 | % |\\n| Interest checking | 44,872 | 27 | 47,270 | 30 |\\n| Savings | 20,667 | 13 | 18,258 | 12 |\\n| Money market | 30,564 | 19 | 30,650 | 19 |\\n| Foreign office | 152 | — | 143 | — |\\n| Total transaction deposits | $ | 159,015 | 98 | $ | 154,032 | 97 |\\n| Other time | 2,408 | 1 | 3,023 | 2 |\\n| Total core deposits | $ | 161,423 | 99 | $ | 157,055 | 99 |\\n| Certificates $100,000 and over(a) | 860 | 1 | 2,026 | 1 |\\n| Total deposits | $ | 162,283 | 100 | % | $ | 159,081 | 100 | % |\\n\\n(a)Includes $310 million and $1.3 billion of institutional, retail and wholesale certificates $250,000 and over at June 30, 2021 and December 31, 2020, respectively.\\nCore deposits increased $4.4 billion, or 3%, from December 31, 2020 as a result of an increase in transaction deposits, partially offset by a decrease in other time deposits. Transaction deposits increased $5.0 billion, or 3%, from December 31, 2020 primarily due to increases in demand deposits and savings deposits, partially offset by a decrease in interest checking deposits. Demand deposits increased $5.0 billion, or 9%, from December 31, 2020 primarily as a result of customers maintaining increased levels of liquidity driven by the amount of fiscal and monetary stimulus, as well as growth in the number of accounts and migration of balances from interest checking deposits during the six months ended June 30, 2021. Savings deposits increased $2.4 billion, or 13%, from December 31, 2020 primarily as a result of higher balances per customer account due to the amount of fiscal stimulus as well as decreased consumer spending. Interest checking deposits decreased $2.4 billion, or 5%, from December 31, 2020 primarily as a result of lower balances per commercial customer account as well as the aforementioned balance migration into demand deposits during the six months ended June 30, 2021. Other time deposits decreased $615 million, or 20%, from December 31, 2020 primarily due to lower offering rates on certificates less than $100,000.\\nCertificates $100,000 and over decreased $1.2 billion, or 58%, from December 31, 2020 primarily due to maturities which were not replaced with new issuances given current market conditions and liquidity levels.\\nThe following table presents the components of average deposits for the three months ended:\\n| TABLE 20: Components of Average Deposits |\\n| June 30, 2021 | June 30, 2020 |\\n| ($ in millions) | Balance | % of Total | Balance | % of Total |\\n| Demand | $ | 61,994 | 38 | % | $ | 45,761 | 30 | % |\\n| Interest checking | 45,307 | 28 | 49,760 | 33 |\\n| Savings | 20,494 | 12 | 16,354 | 11 |\\n| Money market | 30,844 | 19 | 30,022 | 20 |\\n| Foreign office | 140 | — | 182 | — |\\n| Total transaction deposits | $ | 158,779 | 97 | $ | 142,079 | 94 |\\n| Other time | 2,696 | 2 | 4,421 | 3 |\\n| Total core deposits | $ | 161,475 | 99 | $ | 146,500 | 97 |\\n| Certificates $100,000 and over(a) | 1,144 | 1 | 4,067 | 3 |\\n| Other deposits | — | — | 31 | — |\\n| Total average deposits | $ | 162,619 | 100 | % | $ | 150,598 | 100 | % |\\n\\n(a)Includes $326 million and $3.2 billion of average institutional, retail and wholesale certificates $250,000 and over for the three months ended June 30, 2021 and 2020, respectively.\\nOn an average basis, core deposits increased $15.0 billion, or 10%, for the three months ended June 30, 2021 compared to the same period in the prior year due to an increase of $16.7 billion, or 12%, in average transaction deposits, partially offset by a decrease of $1.7 billion, or 39%, in average other time deposits. The increase in average transaction deposits was driven primarily by increases in average demand deposits, average savings deposits and average money market deposits, partially offset by a decrease in average interest checking deposits. Average demand deposits increased $16.2 billion, or 35%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily as a result of commercial customers maintaining increased levels of liquidity driven by the amount of fiscal and monetary stimulus, as well as growth in the number of accounts and migration of balances from interest checking deposits. Average savings deposits increased $4.1 billion, or 25%, and average money market deposits increased $822 million, or 3%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily as a result of higher average balances per customer account due to the amount of\\n26\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nfiscal stimulus, uncertainty regarding the COVID-19 pandemic and decreased consumer spending. Average interest checking deposits decreased $4.5 billion, or 9%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily as a result of the aforementioned balance migration into demand deposits and lower average balances per commercial customer account, partially offset by higher average balances per consumer customer account due to the previously mentioned increased liquidity levels in the current economic environment in the form of excess cash balances driven by the amount of fiscal stimulus. Average other time deposits decreased primarily due to lower offering rates on certificates less than $100,000.\\nAverage certificates $100,000 and over decreased $2.9 billion, or 72%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to maturities which were not replaced with new issuances given current market conditions and liquidity levels.\\nContractual maturities\\nThe contractual maturities of certificates $100,000 and over as of June 30, 2021 are summarized in the following table:\\n| TABLE 21: Contractual Maturities of Certificates $100,000 and Over |\\n| ($ in millions) |\\n| Next 3 months | $ | 321 |\\n| 3-6 months | 208 |\\n| 6-12 months | 172 |\\n| After 12 months | 159 |\\n| Total certificates $100,000 and over | $ | 860 |\\n\\nThe contractual maturities of other time deposits and certificates $100,000 and over as of June 30, 2021 are summarized in the following table:\\n| TABLE 22: Contractual Maturities of Other Time Deposits and Certificates $100,000 and Over |\\n| ($ in millions) |\\n| Next 12 months | $ | 2,717 |\\n| 13-24 months | 269 |\\n| 25-36 months | 126 |\\n| 37-48 months | 88 |\\n| 49-60 months | 62 |\\n| After 60 months | 6 |\\n| Total other time deposits and certificates $100,000 and over | $ | 3,268 |\\n\\nBorrowings\\nThe Bancorp accesses a variety of short-term and long-term funding sources. Borrowings with original maturities of one year or less are classified as short-term and include federal funds purchased and other short-term borrowings. Total average borrowings as a percent of average interest-bearing liabilities were 13% and 16% for the three months ended June 30, 2021 and 2020, respectively.\\nThe following table summarizes the end of period components of borrowings:\\n| TABLE 23: Components of Borrowings |\\n| As of ($ in millions) | June 30,2021 | December 31,2020 |\\n| Federal funds purchased | $ | 338 | 300 |\\n| Other short-term borrowings | 1,130 | 1,192 |\\n| Long-term debt | 12,364 | 14,973 |\\n| Total borrowings | $ | 13,832 | 16,465 |\\n\\nTotal borrowings decreased $2.6 billion, or 16%, from December 31, 2020 primarily due to decreases in long-term debt and other short-term borrowings. Long-term debt decreased $2.6 billion from December 31, 2020 driven by the early redemptions under the par call options of $2.3 billion of notes and $244 million of paydowns on long-term debt associated with automobile loan securitizations during the six months ended June 30, 2021. Other short-term borrowings decreased $62 million from December 31, 2020 primarily as a result of decreased short-term funding needs given continued core deposit growth. The level of other short-term borrowings can fluctuate significantly from period to period depending on funding needs and the sources that are used to satisfy those needs. For further information on the components of other short-term borrowings, refer to Note 14 of the Notes to Condensed Consolidated Financial Statements.\\n27\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nThe following table summarizes components of average borrowings for the three months ended:\\n| TABLE 24: Components of Average Borrowings |\\n| ($ in millions) | June 30,2021 | June 30,2020 |\\n| Federal funds purchased | $ | 346 | 309 |\\n| Other short-term borrowings | 1,097 | 2,377 |\\n| Long-term debt | 13,883 | 16,955 |\\n| Total average borrowings | $ | 15,326 | 19,641 |\\n\\nTotal average borrowings decreased $4.3 billion, or 22%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to decreases in average long-term debt and average other short-term borrowings. Average long-term debt decreased $3.1 billion for the three months ended June 30, 2021 compared to the same period in the prior year primarily driven by maturities of $3.4 billion and $508 million of paydowns on long-term debt associated with automobile loan securitizations since June of 2020. Average other short-term borrowings decreased $1.3 billion for the three months ended June 30, 2021 compared to the same period in the prior year primarily as a result of decreased short-term funding needs given continued core deposit growth. Information on the average rates paid on borrowings is discussed in the Net Interest Income subsection of the Statements of Income Analysis section of MD&A. In addition, refer to the Liquidity Risk Management subsection of the Risk Management section of MD&A for a discussion on the role of borrowings in the Bancorp’s liquidity management.\\n28\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nBUSINESS SEGMENT REVIEW\\nThe Bancorp reports on four business segments: Commercial Banking, Branch Banking, Consumer Lending and Wealth and Asset Management. Additional information on each business segment is included in Note 22 of the Notes to Condensed Consolidated Financial Statements. Results of the Bancorp’s business segments are presented based on its management structure and management accounting practices. The structure and accounting practices are specific to the Bancorp; therefore, the financial results of the Bancorp’s business segments are not necessarily comparable with similar information for other financial institutions. The Bancorp refines its methodologies from time to time as management’s accounting practices and businesses change.\\nThe Bancorp manages interest rate risk centrally at the corporate level. By employing an FTP methodology, the business segments are insulated from most benchmark interest rate volatility, enabling them to focus on serving customers through the origination of loans and acceptance of deposits. The FTP methodology assigns charge and credit rates to classes of assets and liabilities, respectively, based on the estimated amount and timing of cash flows for each transaction. Assigning the FTP rate based on matching the duration of cash flows allocates interest income and interest expense to each business segment so its resulting net interest income is insulated from future changes in benchmark interest rates. The Bancorp’s FTP methodology also allocates the contribution to net interest income of the asset-generating and deposit-providing businesses on a duration-adjusted basis to better attribute the driver of the performance. As the asset and liability durations are not perfectly matched, the residual impact of the FTP methodology is captured in General Corporate and Other. The charge and credit rates are determined using the FTP rate curve, which is based on an estimate of Fifth Third’s marginal borrowing cost in the wholesale funding markets. The FTP curve is constructed using the U.S. swap curve, brokered CD pricing and unsecured debt pricing.\\nThe Bancorp adjusts the FTP charge and credit rates as dictated by changes in interest rates for various interest-earning assets and interest-bearing liabilities and by the review of behavioral assumptions, such as prepayment rates on interest-earning assets and the estimated durations for indeterminate-lived deposits. Key assumptions, including the credit rates provided for deposit accounts, are reviewed annually. Credit rates for deposit products and charge rates for loan products may be reset more frequently in response to changes in market conditions. In general, the charge rates on assets have declined since December 31, 2020 as they were affected by the prevailing level of interest rates and by the duration and repricing characteristics of the portfolio. The credit rates for deposit products also modestly declined due to lower interest rates and modified assumptions. Thus, net interest income for asset-generating business segments improved while deposit-providing business segments were negatively impacted during the six months ended June 30, 2021.\\nThe Bancorp’s methodology for allocating provision for credit losses expense to the business segments includes charges or benefits associated with changes in criticized commercial loan levels in addition to actual net charge-offs experienced by the loans and leases owned by each business segment. Provision for credit losses expense attributable to loan and lease growth and changes in ALLL factors is captured in General Corporate and Other. The financial results of the business segments include allocations for shared services and headquarters expenses. Additionally, the business segments form synergies by taking advantage of relationship depth opportunities and funding operations by accessing the capital markets as a collective unit.\\nThe following table summarizes net income (loss) by business segment:\\n| TABLE 25: Net Income (Loss) by Business Segment |\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Income Statement Data |\\n| Commercial Banking | $ | 393 | 12 | 704 | 237 |\\n| Branch Banking | 40 | 138 | 16 | 258 |\\n| Consumer Lending | 33 | 48 | 65 | 107 |\\n| Wealth and Asset Management | 26 | 40 | 45 | 64 |\\n| General Corporate and Other | 217 | (43) | 573 | (423) |\\n| Net income | $ | 709 | 195 | 1,403 | 243 |\\n\\n29\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nCommercial Banking\\nCommercial Banking offers credit intermediation, cash management and financial services to large and middle-market businesses and government and professional customers. In addition to the traditional lending and depository offerings, Commercial Banking products and services include global cash management, foreign exchange and international trade finance, derivatives and capital markets services, asset-based lending, real estate finance, public finance, commercial leasing and syndicated finance.\\nThe following table contains selected financial data for the Commercial Banking segment:\\n| TABLE 26: Commercial Banking |\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Income Statement Data |\\n| Net interest income (FTE)(a) | $ | 378 | 573 | 745 | 1,085 |\\n| (Benefit from) provision for credit losses | (151) | 457 | (227) | 502 |\\n| Noninterest income: |\\n| Commercial banking revenue | 156 | 136 | 307 | 260 |\\n| Service charges on deposits | 92 | 79 | 181 | 162 |\\n| Leasing business revenue | 61 | 57 | 148 | 131 |\\n| Other noninterest income | 46 | 22 | 79 | 27 |\\n| Noninterest expense: |\\n| Compensation and benefits | 136 | 129 | 292 | 278 |\\n| Leasing business expense | 33 | 33 | 68 | 68 |\\n| Other noninterest expense | 230 | 243 | 459 | 538 |\\n| Income before income taxes (FTE) | 485 | 5 | 868 | 279 |\\n| Applicable income tax expense (benefit)(a)(b) | 92 | (7) | 164 | 42 |\\n| Net income | $ | 393 | 12 | 704 | 237 |\\n| Average Balance Sheet Data |\\n| Commercial loans and leases, including held for sale | $ | 59,729 | 71,894 | 59,989 | 69,788 |\\n| Demand deposits | 32,827 | 22,939 | 32,177 | 20,032 |\\n| Interest checking deposits | 20,871 | 28,742 | 21,000 | 24,595 |\\n| Savings and money market deposits | 6,315 | 6,955 | 6,341 | 5,958 |\\n| Other time deposits and certificates $100,000 and over | 91 | 159 | 96 | 182 |\\n| Foreign office deposits | 139 | 181 | 133 | 195 |\\n\\n(a)Includes FTE adjustments of $2 and $3 for the three months ended June 30, 2021 and 2020, respectively, and $4 and $7 for the six months ended June 30, 2021 and 2020, respectively.\\n(b)Applicable income tax expense for all periods includes the tax benefit from tax-exempt income, tax-advantaged investments and tax credits partially offset by the effect of certain nondeductible expenses. Refer to the Applicable Income Taxes subsection of the Statements of Income Analysis section of MD&A for additional information.\\nNet income was $393 million and $704 million for the three and six months ended June 30, 2021, respectively, compared to $12 million and $237 million, respectively, for the same periods in the prior year. The increases were primarily driven by decreases in the provision for credit losses as well as increases in noninterest income and decreases in noninterest expense, partially offset by decreases in net interest income on an FTE basis.\\nNet interest income on an FTE basis decreased $195 million and $340 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in yields on and average balances of commercial loans and leases as well as decreases in FTP credit rates on interest checking deposits, demand deposits and savings and money market deposits. These negative impacts were partially offset by decreases in FTP charge rates on loans and leases as well as decreases in rates paid on average interest checking deposits and average savings and money market deposits.\\nThe benefit from credit losses was $151 million and $227 million for the three and six months ended June 30, 2021, respectively, compared to a provision for credit losses of $457 million and $502 million for the three and six months ended June 30, 2020, respectively. The decreases for the three and six months ended June 30, 2021 compared to the same periods in the prior year were primarily driven by a decrease in commercial criticized asset levels as well as decreases in net charge-offs on commercial and industrial loans and commercial leases. Net charge-offs as a percent of average portfolio loans and leases decreased to 4 bps and 10 bps for the three and six months ended June 30, 2021, respectively, compared to 41 bps and 35 bps for the same periods in the prior year, respectively.\\nNoninterest income increased $61 million and $135 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year driven by increases in other noninterest income, commercial banking revenue and service charges on deposits.\\n30\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nThe increase for the six months ended June 30, 2021 was also driven by an increase in leasing business revenue. Other noninterest income increased $24 million and $52 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in private equity investment income and card and processing revenue. The increase for the six months ended June 30, 2021 was also driven by the recognition of securities gains, net of $6 million. Commercial banking revenue increased $20 million and $47 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year. The increase for the three months ended June 30, 2021 was primarily due to increases in loan syndication fees and business lending fees partially offset by a decrease in institutional sales. The increase for the six months ended June 30, 2021 was primarily due to increases in loan syndication fees, business lending fees and institutional sales partially offset by a decrease in contract revenue from commercial customer derivatives. Service charges on deposits increased $13 million and $19 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year driven by increases in commercial deposit fees primarily due to growth in volume-based service revenues, with continued benefit from lower earnings credit rates. Leasing business revenue increased $17 million for the six months ended June 30, 2021 compared to the same periods in the prior year primarily due to an increase in lease syndication fees partially offset by a decrease in lease remarketing fees.\\nNoninterest expense decreased $6 million and $65 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year driven by decreases in other noninterest expense partially offset by increases in compensation and benefits. Other noninterest expense decreased $13 million and $79 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year. The decreases for both the three and six months ended June 30, 2021 reflect decreases in allocated expenses related to cash management services. The decrease for the six months ended June 30, 2021 was also due to a decline in credit valuation adjustments on derivatives associated with customer accommodation contracts. Compensation and benefits increased $7 million and $14 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily as a result of increases in incentive compensation and employee benefits expense driven by strong performance in fees related to business growth and expansion initiatives during the three and six months ended June 30, 2021.\\nAverage commercial loans and leases decreased $12.2 billion and $9.8 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to decreases in average commercial and industrial loans and average commercial mortgage loans partially offset by increases in average commercial construction loans. Average commercial and industrial loans decreased for the three and six months ended June 30, 2021 compared to the same periods in the prior year primarily driven by continued paydowns on revolving lines of credit. Average commercial mortgage loans decreased for the three and six months ended June 30, 2021 compared to the same periods in the prior year as payoffs exceeded loan originations. Average commercial construction loans increased for the three and six months ended June 30, 2021 compared to the same periods in the prior year as draws on existing commitments exceeded payoffs.\\nAverage core deposits increased $1.3 billion and $8.9 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to increases in average demand deposits partially offset by decreases in average interest checking deposits. The increase for the three months ended June 30, 2021 was also partially offset by a decrease in average savings and money market deposits. The increase for the six months ended June 30, 2021 also included an increase in average savings and money market deposits. Average demand deposits increased $9.9 billion and $12.1 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily as a result of commercial customers maintaining increased levels of liquidity driven by the amount of fiscal and monetary stimulus, as well as growth in the number of accounts and migration of balances from interest checking deposits. Average interest checking deposits decreased $7.9 billion and $3.6 billion, respectively, for the three and six months ended June 30, 2021 compared to the same periods in the prior year primarily as a result of the aforementioned balance migration into demand deposits and lower average balances per commercial customer account. Average savings and money market deposits decreased $640 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily as a result of a decline in commercial customer accounts. Average savings and money market deposits increased $383 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily as a result of new customers as well as higher average balances per commercial customer account due to the amount of fiscal stimulus and economic uncertainty regarding the COVID-19 pandemic.\\n31\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nBranch Banking\\nBranch Banking provides a full range of deposit and loan products to individuals and small businesses through 1,096 full-service banking centers. Branch Banking offers depository and loan products, such as checking and savings accounts, home equity loans and lines of credit, credit cards and loans for automobiles and other personal financing needs, as well as products designed to meet the specific needs of small businesses, including cash management services.\\nThe following table contains selected financial data for the Branch Banking segment:\\n| TABLE 27: Branch Banking |\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Income Statement Data |\\n| Net interest income | $ | 301 | 513 | 596 | 1,017 |\\n| Provision for credit losses | 25 | 52 | 66 | 114 |\\n| Noninterest income: |\\n| Card and processing revenue | 84 | 68 | 161 | 133 |\\n| Service charges on deposits | 57 | 42 | 111 | 107 |\\n| Wealth and asset management revenue | 52 | 39 | 102 | 84 |\\n| Other noninterest income | 31 | 18 | 55 | 40 |\\n| Noninterest expense: |\\n| Compensation and benefits | 158 | 161 | 328 | 330 |\\n| Net occupancy and equipment expense | 58 | 54 | 115 | 108 |\\n| Card and processing expense | 19 | 28 | 49 | 58 |\\n| Other noninterest expense | 215 | 211 | 447 | 444 |\\n| Income before income taxes | $ | 50 | 174 | 20 | 327 |\\n| Applicable income tax expense | 10 | 36 | 4 | 69 |\\n| Net income | $ | 40 | 138 | 16 | 258 |\\n| Average Balance Sheet Data |\\n| Consumer loans | $ | 11,867 | 12,964 | 11,974 | 13,124 |\\n| Commercial loans, including held for sale | 2,983 | 2,288 | 2,982 | 2,292 |\\n| Demand deposits | 26,227 | 19,840 | 25,105 | 18,108 |\\n| Interest checking deposits | 15,830 | 12,323 | 15,604 | 11,914 |\\n| Savings and money market deposits | 42,476 | 36,687 | 41,524 | 35,584 |\\n| Other time deposits and certificates $100,000 and over | 3,453 | 5,759 | 3,672 | 6,276 |\\n\\nNet income was $40 million and $16 million for the three and six months ended June 30, 2021, respectively, compared to $138 million and $258 million, respectively for the same periods in the prior year. The decreases were primarily driven by decreases in net interest income partially offset by increases in noninterest income and decreases in provision for credit losses.\\nNet interest income decreased $212 million and $421 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to decreases in FTP credit rates on core deposits and certificates $100,000 and over as well as decreases in average balances of credit card and home equity and decreases in yields on average other consumer loans. These negative impacts were partially offset by decreases in the rates paid on average interest-bearing deposits and a decrease in FTP charge rates on loans and leases.\\nProvision for credit losses decreased $27 million and $48 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to decreases in net charge-offs on credit card, other consumer loans and home equity partially offset by increases in net charge-offs on commercial and industrial loans. The decrease in provision for credit losses for the three and six months ended June 30, 2021 compared to the same periods in the prior year also included the impact of a decrease in commercial criticized asset levels. Net charge-offs as a percent of average portfolio loans and leases decreased to 102 bps and 106 bps for the three and six months ended June 30, 2021, respectively, compared to 128 bps and 143 bps, respectively, for the same periods in the prior year.\\nNoninterest income increased $57 million and $65 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in card and processing revenue, wealth and asset management revenue, other noninterest income and service charges on deposits. Card and processing revenue increased $16 million and $28 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily as a result of an increase in consumer customer spend volume, partially offset by increased reward costs. Wealth and asset management revenue increased $13 million and $18\\n32\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nmillion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to increases in broker income and private client service fees. Other noninterest income increased $13 million and $15 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in cardholder fees, banking center income and decreases in net losses on disposition and impairment of bank premises and equipment. Service charges on deposits increased $15 million and $4 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year driven by increases in both commercial deposit fees and consumer deposit fees.\\nNoninterest expense decreased $4 million and $1 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in card and processing expense partially offset by increases in net occupancy and equipment expense. Card and processing expense decreased $9 million for both the three and six months ended June 30, 2021 compared to the same periods in the prior year primarily driven by contract renegotiations with a third-party vendor. Net occupancy and equipment expense increased $4 million and $7 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to increases in allocated occupancy costs.\\nAverage consumer loans decreased $1.1 billion and $1.2 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in average home equity as payoffs exceeded loan originations as well as decreases in average credit card driven by higher paydowns which were affected by the amount of fiscal stimulus. These decreases were partially offset by increases in average residential mortgage loans of $502 million and $447 million for the three and six months ended June 30, 2021, respectively, primarily as a result of increases in loan originations. Average commercial loans increased $695 million and $690 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in average commercial mortgage loans and average commercial and industrial loans.\\nAverage deposits increased $13.4 billion and $14.0 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in average demand deposits, average savings and money market deposits and average interest checking deposits partially offset by decreases in average other time deposits and certificates $100,000 and over. Average demand deposits increased $6.4 billion and $7.0 billion, average savings and money market deposits increased $5.8 billion and $5.9 billion and average interest checking deposits increased $3.5 billion and $3.7 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily as a result of higher balances per customer account due to the amount of fiscal stimulus, uncertainty regarding the COVID-19 pandemic as well as decreased consumer spending. Average other time deposits and certificates $100,000 and over decreased $2.3 billion and $2.6 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to maturities on certificates greater than $100,000 as well as lower offering rates on certificates less than $100,000.\\n33\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nConsumer Lending\\nConsumer Lending includes the Bancorp’s residential mortgage, automobile and other indirect lending activities. Residential mortgage activities within Consumer Lending include the origination, retention and servicing of residential mortgage loans, sales and securitizations of those loans and all associated hedging activities. Residential mortgages are primarily originated through a dedicated sales force and through third-party correspondent lenders. Automobile and other indirect lending activities include extending loans to consumers through automobile dealers, motorcycle dealers, powersport dealers, recreational vehicle dealers and marine dealers.\\nThe following table contains selected financial data for the Consumer Lending segment:\\n| TABLE 28: Consumer Lending |\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Income Statement Data |\\n| Net interest income | $ | 142 | 92 | 269 | 181 |\\n| Provision for credit losses | — | 10 | 8 | 23 |\\n| Noninterest income: |\\n| Mortgage banking net revenue | 60 | 96 | 142 | 213 |\\n| Other noninterest income | 3 | 2 | 3 | 9 |\\n| Noninterest expense: |\\n| Compensation and benefits | 61 | 53 | 127 | 104 |\\n| Other noninterest expense | 102 | 67 | 197 | 140 |\\n| Income before income taxes | $ | 42 | 60 | 82 | 136 |\\n| Applicable income tax expense | 9 | 12 | 17 | 29 |\\n| Net income | $ | 33 | 48 | 65 | 107 |\\n| Average Balance Sheet Data |\\n| Residential mortgage loans, including held for sale | $ | 16,567 | 12,823 | 16,023 | 13,187 |\\n| Home equity | 153 | 200 | 158 | 203 |\\n| Indirect secured consumer loans | 14,577 | 11,935 | 14,198 | 11,770 |\\n\\nNet income was $33 million and $65 million for the three and six months ended June 30, 2021, respectively, compared to net income of $48 million and $107 million, respectively, for the same periods in the prior year. The decreases were primarily due to increases in noninterest expense and decreases in noninterest income partially offset by increases in net interest income and decreases in provision for credit losses.\\nNet interest income increased $50 million and $88 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in FTP charge rates on loans and leases and increases in average residential mortgage loans and average indirect secured consumer loans. These increases were partially offset by decreases in yields on average residential mortgage loans and average indirect secured consumer loans as well as decreases in FTP credit rates on demand deposits.\\nProvision for credit losses decreased $10 million and $15 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in net charge-offs on indirect secured consumer loans and residential mortgage loans. Net charge-offs as a percent of average portfolio loans and leases were an immaterial amount and 7 bps for the three and six months ended June 30, 2021, respectively, compared to 16 bps and 19 bps for the three and six months ended June 30, 2020, respectively.\\nNoninterest income decreased $35 million and $77 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in mortgage banking net revenue. Refer to the Noninterest Income subsection of the Statements of Income Analysis section of MD&A for additional information on the fluctuations in mortgage banking net revenue.\\nNoninterest expense increased $43 million and $80 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year due to increases in other noninterest expense and compensation and benefits. Other noninterest expense increased $35 million and $57 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in loan and lease expense, corporate overhead allocations and losses and adjustments. Compensation and benefits increased $8 million and $23 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to increases in base compensation and incentive compensation resulting from the increased mortgage origination activity for both the three and six months ended June 30, 2021.\\nAverage consumer loans increased $6.3 billion and $5.2 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to increases in average residential mortgage loans and average indirect secured consumer loans. Average residential mortgage loans increased $3.7 billion and $2.8 billion for the three and six months ended June 30, 2021,\\n34\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nrespectively, compared to the same periods in the prior year primarily due to increases in residential mortgage loans held for sale as the Bancorp purchased government-guaranteed loans in forbearance programs. Average indirect secured consumer loans increased $2.6 billion and $2.4 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to loan production exceeding payoffs.\\nWealth and Asset Management\\nWealth and Asset Management provides a full range of wealth management services for individuals, companies and not-for-profit organizations. Wealth and Asset Management is made up of three main businesses: FTS, an indirect wholly-owned subsidiary of the Bancorp; Fifth Third Private Bank; and Fifth Third Institutional Services. FTS offers full-service retail brokerage services to individual clients and broker-dealer services to the institutional marketplace. Fifth Third Private Bank offers wealth management strategies to high net worth and ultra-high net worth clients through wealth planning, investment management, banking, insurance, trust and estate services. Fifth Third Institutional Services provides advisory services for institutional clients including middle market businesses, non-profits, states and municipalities.\\nThe following table contains selected financial data for the Wealth and Asset Management segment:\\n| TABLE 29: Wealth and Asset Management |\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Income Statement Data |\\n| Net interest income | $ | 21 | 51 | 42 | 88 |\\n| Benefit from credit losses | — | (1) | (1) | — |\\n| Noninterest income: |\\n| Wealth and asset management revenue | 138 | 115 | 274 | 244 |\\n| Other noninterest income | 5 | 6 | 7 | 14 |\\n| Noninterest expense: |\\n| Compensation and benefits | 49 | 50 | 103 | 112 |\\n| Other noninterest expense | 82 | 72 | 164 | 154 |\\n| Income before income taxes | $ | 33 | 51 | 57 | 80 |\\n| Applicable income tax expense | 7 | 11 | 12 | 16 |\\n| Net income | $ | 26 | 40 | 45 | 64 |\\n| Average Balance Sheet Data |\\n| Loans and leases, including held for sale | $ | 3,772 | 3,597 | 3,759 | 3,589 |\\n| Core deposits | 11,163 | 11,091 | 11,426 | 10,807 |\\n\\nNet income was $26 million and $45 million for the three and six months ended June 30, 2021, respectively, compared to net income of $40 million and $64 million, respectively, for the same periods in the prior year. The decreases were primarily driven by decreases in net interest income partially offset by increases in noninterest income. The decrease for the three months ended June 30, 2021 also included an increase in noninterest expense.\\nNet interest income decreased $30 million and $46 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in FTP credit rates on interest-bearing core deposits as well as decreases in yields on average loans and leases. These negative impacts were partially offset by decreases in rates paid on average interest-bearing core deposits as well as decreases in FTP charge rates on loans and leases.\\nNoninterest income increased $22 million and $23 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year driven by increases in wealth and asset management revenue partially offset by decreases in other noninterest income. Wealth and asset management revenue increased $23 million and $30 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily as a result of increases in private client service fees and broker income partially offset by decreases in institutional fees. Other noninterest income decreased $1 million and $7 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to decreases in insurance income driven by the sale of the Bancorp’s property and casualty insurance business in the fourth quarter of 2020.\\nNoninterest expense increased $9 million and $1 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year driven by increases in other noninterest expense partially offset by decreases in compensation and benefits. Other noninterest expense increased $10 million for both the three and six months ended June 30, 2021 compared to the same periods in the prior year primarily due to increases in expenses associated with intercompany revenue sharing agreements. Compensation and benefits decreased $1 million and $9 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior\\n35\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nyear primarily as a result of decreases in base compensation which included a decline due to the sale of the Bancorp’s property and casualty insurance business in the fourth quarter of 2020.\\nAverage loans and leases increased $175 million and $170 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in average other consumer loans and average residential mortgage loans as a result of higher loan production partially offset by decreases in average commercial and industrial loans and average home equity as payoffs exceeded new loan production.\\nAverage core deposits increased $72 million and $619 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year. The increase for the three months ended June 30, 2021 compared to the same period in the prior year was primarily driven by increases in average savings and money market deposits, partially offset by a decrease in average interest checking deposits as a result of fiscal stimulus and migration of balances from interest checking deposits. The increase for the six months ended June 30, 2021 compared to the same period in the prior year was primarily driven by increases in average savings and money market deposits, interest checking deposits and demand deposits as a result of higher average balances per customer account due to the amount of fiscal stimulus, uncertainty regarding the COVID-19 pandemic and decreased consumer spending.\\nGeneral Corporate and Other\\nGeneral Corporate and Other includes the unallocated portion of the investment securities portfolio, securities gains and losses, certain non-core deposit funding, unassigned equity, unallocated provision for credit losses expense or a benefit from the reduction of the ACL, the payment of preferred stock dividends and certain support activities and other items not attributed to the business segments.\\nNet interest income on an FTE basis increased $394 million and $672 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in FTP credit rates on deposits allocated to the business segments, increases in interest income on loans and leases and decreases in interest expense on long-term debt and deposits. These positive impacts were partially offset by decreases in the benefit related to FTP charge rates on loans and leases allocated to the business segments and a decrease in interest income on investment securities.\\nThe provision for credit losses was $11 million for the three months ended June 30, 2021 compared to a benefit from credit losses of $33 million for the three months ended June 30, 2020. The increase in provision expense for the three months ended June 30, 2021 compared to the same period in the prior year was primarily driven by the impact of the benefits provided to the business segments driven by lower commercial criticized assets owned by each business segment, partially offset by factors which caused a decrease in the ACL including improved economic forecasts, improved commercial and consumer credit quality and lower period-end loan and lease balances. The benefit from credit losses was $134 million for the six months ended June 30, 2021 compared to a provision for credit losses of $486 million for the six months ended June 30, 2020. The decrease in provision expense for the six months ended June 30, 2021 compared to the same period in the prior year was primarily driven by factors which caused a decrease in the ACL including improved economic forecasts, improved commercial and consumer credit quality and lower period-end loan balances. The decrease for the six months ended June 30, 2021 was partially offset by the impact of the benefits provided to the business segments driven by lower commercial criticized assets owned by each business segment.\\nNoninterest income decreased $3 million and increased $37 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year. The decrease for the three months ended June 30, 2021 compared to the same period in the prior year was primarily driven by the recognition of securities gains of $10 million for the three months ended June 30, 2021 compared to securities gains of $21 million for the three months ended June 30, 2020 as well as an increase in the loss on the swap associated with the sale of Visa, Inc. Class B shares. These negative impacts were partially offset by a decrease in net losses on disposition and impairment of bank premises and equipment as well as an increase in equity method investment income during the three months ended June 30, 2021 compared to the same period in the prior year. The increase for the six months ended June 30, 2021 compared to the same period in the prior year was primarily driven by the recognition of securities gains of $7 million for the six months ended June 30, 2021 compared to securities losses of $3 million for the six months ended June 30, 2020 as well as a decrease in net losses on disposition and impairment of bank premises and equipment and an increase in equity method investment income during the six months ended June 30, 2021 compared to the same period in the prior year.\\nNoninterest expense increased $1 million and $47 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year. The increase for the three months ended June 30, 2021 compared to the same period in the prior year was primarily driven by an increase in equipment expense, a decrease in corporate overhead allocations from General Corporate and Other to the other business segments as well as an increase in technology and communications expense partially offset by a decrease in net occupancy expense. The increase for the six months ended June 30, 2021 compared to the same period in the prior year was primarily due to an increase in compensation and benefits, a decrease in corporate overhead allocations from General Corporate and Other to the other business segments and an increase in equipment expense partially offset by a decrease in net occupancy expense.\\n36\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nRISK MANAGEMENT – OVERVIEW\\nEffective risk management is critical to the Bancorp’s ongoing success and ensures that the Bancorp operates in a safe and sound manner, complies with applicable laws and regulations and safeguards the Bancorp’s brand and reputation. Risks are inherent in the Bancorp’s business and are influenced by both internal and external factors. The Bancorp is responsible for managing these risks effectively to deliver through-the-cycle value and performance for the Bancorp’s shareholders, customers, employees and communities.\\nFifth Third’s Risk Management Framework, which is approved annually by the Capital Committee, ERMC, RCC and the Board of Directors, includes the following key elements:\\n•The Bancorp ensures transparency and escalation of risk through defined risk policies and a governance structure that includes the RCC, ERMC and other management-level risk committees and councils.\\n•The Bancorp establishes a risk appetite in alignment with its strategic, financial and capital plans. The Bancorp’s risk appetite is defined using quantitative metrics and qualitative measures to ensure prudent risk taking and drive balanced decision making. The Bancorp’s goal is to ensure that aggregate residual risks do not exceed the Bancorp’s risk appetite, and that risks taken are supportive of the Bancorp’s portfolio diversification and profitability objectives. The Board and executive management approve the risk appetite, which is considered in the development of business strategies and forms the basis for enterprise risk management.\\n•The core principles that define the Bancorp’s risk appetite are as follows:\\n◦Act with integrity in all activities.\\n◦Understand the risks taken and ensure that they are in alignment with the Bancorp’s business strategies and risk appetite.\\n◦Avoid risks that cannot be understood, managed or monitored.\\n◦Provide transparency of risk to the Bancorp’s management and Board by escalating risks and issues as necessary.\\n◦Ensure Fifth Third’s products and services are aligned to the Bancorp’s core customer base and are designed, delivered and maintained to provide value and benefit to the Bancorp’s customers and to Fifth Third.\\n◦Only offer products or services that are appropriate or suitable for the Bancorp’s customers.\\n◦Focus on providing operational excellence by providing reliable, accurate and efficient services to meet the Bancorp’s customers’ needs.\\n◦Maintain a strong financial position to ensure the Bancorp meets its strategic objectives through all economic cycles and is able to access the capital markets at all times, even under stressed conditions.\\n◦Protect the Bancorp’s reputation by thoroughly understanding the consequences of business strategies, products and processes.\\n◦Conduct the Bancorp’s business in compliance with all applicable laws, rules and regulations and in alignment with internal policies and procedures.\\n•Fifth Third’s core values and culture provide the foundation for sound risk management practices by establishing expectations for appropriate conduct and accountability across the organization. All employees are expected to conduct themselves in alignment with Fifth Third’s Code of Business Conduct and Ethics, which may be found on www.53.com, while carrying out their responsibilities. Fifth Third’s Corporate Responsibility and Reputation Committee provides oversight of business conduct policies, programs and strategies, and monitors reporting of potential misconduct, trends or themes across the enterprise. Prudent risk management is a responsibility that is expected from all employees and is a foundational element of Fifth Third’s culture.\\n•The Bancorp manages eight defined risk types to a prescribed appetite. The risk types are credit risk, liquidity risk, interest rate risk, price risk, legal and regulatory compliance risk, operational risk, reputational risk and strategic risk.\\n•The Bancorp identifies and monitors existing and potential risks that may impact the company’s risk profile, including emerging risks that create uncertainties and/or would have broad implications if materialized (e.g. global pandemic, etc.). Enhanced monitoring and action plans are implemented as necessary to proactively mitigate risk.\\n•Fifth Third’s Risk Management Process provides a consistent and integrated approach for managing risks. The five components of the Risk Management Process are: identify, assess, manage, monitor and report. The Bancorp has also established processes and programs to manage and report concentration risks, to ensure robust talent, compensation and performance management and to aggregate risks across the enterprise.\\nFifth Third drives accountability for managing risk through its Three Lines of Defense structure:\\n•The first line of defense is comprised of front-line units that create risk and are accountable for managing risk. These groups are the Bancorp’s primary risk takers and are responsible for implementing effective internal controls and maintaining processes for identifying, assessing and managing the risks associated with their activities consistent with established risk appetite and limits. The first line of defense also includes enterprise-wide functions that provide information technology, operations, servicing, processing or other support.\\n•The second line of defense, or Independent Risk Management, consists of Risk Management, Compliance and Credit Review. The second line is responsible for developing frameworks and policies to govern risk-taking activities, overseeing risk-taking of the organization, advising on controlling that risk and providing input on key risk decisions. Risk Management complements the front line’s management of risk-taking activities through its monitoring and reporting responsibilities, including adherence to the risk appetite. Additionally, Risk Management is responsible for identifying, assessing, managing, monitoring and reporting on aggregate risks enterprise-wide.\\n•The third line of defense is Internal Audit, which provides oversight of the first and second lines of defense, and independent assurance to the Board on the effectiveness of governance, risk management and internal controls.\\n37\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nCREDIT RISK MANAGEMENT\\nThe objective of the Bancorp’s credit risk management strategy is to quantify and manage credit risk on an aggregate portfolio basis, as well as to limit the risk of loss resulting from the failure of a borrower or counterparty to honor its financial or contractual obligations to the Bancorp. The Bancorp’s credit risk management strategy is based on three core principles: conservatism, diversification and monitoring. The Bancorp believes that effective credit risk management begins with conservative lending practices which are described below. These practices include the use of intentional risk-based limits for single name exposures and counterparty selection criteria designed to reduce or eliminate exposure to borrowers who have higher than average default risk and defined weaknesses in financial performance. The Bancorp carefully designed and monitors underwriting, documentation and collection standards. The Bancorp’s credit risk management strategy also emphasizes diversification on a geographic, industry and customer level as well as ongoing portfolio monitoring and timely management reviews of large credit exposures and credits experiencing deterioration of credit quality. Credit officers with the authority to extend credit are delegated specific authority amounts, the utilization of which is closely monitored. Underwriting activities are centrally managed, and ERM manages the policy and the authority delegation process directly. The Credit Risk Review function provides independent and objective assessments of the quality of underwriting and documentation, the accuracy of risk grades and the charge-off, nonaccrual and reserve analysis process. The Bancorp’s credit review process and overall assessment of the adequacy of the allowance for credit losses is based on quarterly assessments of the estimated losses expected in the loan and lease portfolio. The Bancorp uses these assessments to promptly identify potential problem loans or leases within the portfolio, maintain an adequate allowance for credit losses and record any necessary charge-offs. The Bancorp defines potential problem loans and leases as those rated substandard that do not meet the definition of a nonaccrual loan or a restructured loan. Refer to Note 6 of the Notes to Condensed Consolidated Financial Statements for further information on the Bancorp’s credit grade categories, which are derived from standard regulatory rating definitions. In addition, stress testing is performed on various commercial and consumer portfolios utilizing various models. For certain portfolios, such as real estate and leveraged lending, stress testing is performed by Credit department personnel at the individual loan level during credit underwriting.\\nThe following tables provide a summary of potential problem portfolio loans and leases:\\n| TABLE 30: Potential Problem Portfolio Loans and Leases |\\n| As of June 30, 2021 ($ in millions) | CarryingValue | UnpaidPrincipalBalance | Exposure |\\n| Commercial and industrial loans | $ | 2,071 | 2,077 | 3,436 |\\n| Commercial mortgage loans | 983 | 991 | 996 |\\n| Commercial construction loans | 462 | 463 | 500 |\\n| Commercial leases | 72 | 72 | 87 |\\n| Total potential problem portfolio loans and leases | $ | 3,588 | 3,603 | 5,019 |\\n| TABLE 31: Potential Problem Portfolio Loans and Leases |\\n| As of December 31, 2020 ($ in millions) | CarryingValue | UnpaidPrincipalBalance | Exposure |\\n| Commercial and industrial loans | $ | 2,641 | 2,651 | 3,687 |\\n| Commercial mortgage loans | 784 | 798 | 792 |\\n| Commercial construction loans | 240 | 240 | 252 |\\n| Commercial leases | 72 | 72 | 72 |\\n| Total potential problem portfolio loans and leases | $ | 3,737 | 3,761 | 4,803 |\\n\\nIn addition to the individual review of larger commercial loans that exhibit probable or observed credit weaknesses, the commercial credit review process includes the use of two risk grading systems. The first of these risk grading systems encompasses ten categories, which are based on regulatory guidance for credit risk systems. These ratings are used by the Bancorp to monitor and manage its credit risk. The Bancorp also maintains a dual risk rating system for credit approval and pricing, portfolio monitoring and capital allocation that includes a “through-the-cycle” rating philosophy for assessing a borrower’s creditworthiness. A “through-the-cycle” rating philosophy uses a grading scale that assigns ratings based on average default rates through an entire business cycle for borrowers with similar financial performance. The dual risk rating system includes thirteen probabilities of default grade categories and an additional eleven grade categories for estimating losses given an event of default. The probability of default and loss given default evaluations are not separated in the ten-category regulatory risk rating system.\\nThe Bancorp utilizes internally developed models to estimate expected credit losses for portfolio loans and leases. For loans and leases that are collectively evaluated, the Bancorp utilizes these models to forecast expected credit losses over a reasonable and supportable forecast period based on the probability of a loan or lease defaulting, the expected balance at the estimated date of default and the expected loss percentage given a default. Refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for additional information about the Bancorp’s processes for developing these models,\\n38\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nestimating credit losses for periods beyond the reasonable and supportable forecast period and for estimating credit losses for individually evaluated loans.\\nFor the commercial portfolio segment, the estimated probabilities of default are primarily based on the probability of default ratings assigned under the through-the-cycle dual risk rating system and historical observations of how those ratings migrate to a default over time in the context of macroeconomic conditions. For loans with available credit, the estimate of the expected balance at the time of default considers expected utilization rates, which are primarily based on macroeconomic conditions and the utilization history of similar borrowers under those economic conditions. The estimates for loss severity are primarily based on collateral type and coverage levels and the susceptibility of those characteristics to changes in macroeconomic conditions.\\nFor collectively evaluated loans in the consumer and residential mortgage portfolio segments, the Bancorp’s expected credit loss models primarily utilize the borrower’s FICO score and delinquency history in combination with macroeconomic conditions when estimating the probability of default. The estimates for loss severity are primarily based on collateral type and coverage levels and the susceptibility of those characteristics to changes in macroeconomic conditions. The expected balance at the estimated date of default is also especially impactful in the expected credit loss models for portfolio classes which generally have longer terms (such as residential mortgage loans and home equity) and portfolio classes containing a high concentration of loans with revolving privileges (such as credit card and home equity). The estimate of the expected balance at the time of default considers expected prepayment and utilization rates where applicable, which are primarily based on macroeconomic conditions and the utilization history of similar borrowers under those economic conditions. The Bancorp also utilizes various scoring systems, analytical tools and portfolio performance monitoring processes to assess the credit risk of the consumer and residential mortgage portfolios.\\nOverview\\nThe consensus outlook for economic growth in 2021 continued to improve in the second quarter of 2021 as the reopening of the U.S. economy led to an upswing in demand for consumer goods and services. Although the rise of the Delta variant of COVID-19 and slower progress on vaccinations presents some downside risk to the economic outlook in the second half of 2021, the underlying fundamentals of the economy continue to strengthen as consumers and businesses return to more normal levels of activity. With the economy gaining momentum, nonfarm payrolls increased by 850,000 in June of 2021 while wages were up 3.6% year-over-year. The robust economic growth is leading to more persistent inflationary pressures throughout the economy as supply chain constraints limit production while labor supply remains constrained due to federal economic impact payments to individuals, COVID-19 health concerns and aging demographics.\\nIn June 2021, the core Consumer Price Index rose 4.5% over the last 12-months, the largest 12-month increase since the period ending November 1991. At the June 2021 FOMC meeting, participants raised their 2021 core Personal Consumption Expenditures (“PCE”) inflation forecast to 3.0% from 2.2% and their risk assessment for core PCE inflation was weighted to the upside. Despite the upside risk around inflation, most meeting participants saw the increase as transitory and expected core PCE to drop back to 2% in 2022 and 2023. The FOMC also retired the language around “not talking about tapering bond purchases” and discussions have begun on when to begin tapering the monthly purchases of $80 billion of treasury securities and $40 billion of agency mortgage-backed securities.\\nCOVID-19 Hardship Relief Programs\\nIn response to the COVID-19 pandemic, the Bancorp began providing financial hardship relief in March 2020 to borrowers that were negatively impacted by the pandemic and its related economic impacts. For retail borrowers, these relief programs included three-month payment deferrals for non-real estate secured and unsecured portfolios, six-month payment deferrals for home equity loans and lines of credit and six-month forbearances for residential mortgages. The Bancorp also temporarily waived fees for certain products and services, suspended initiating any new repossession actions on vehicles and suspended all residential foreclosure activity. The fee waiver, repossession suspension and payment deferral programs for non-real estate secured and unsecured and home equity loans and lines of credit were discontinued early in the third quarter of 2020. However, new programs to assist consumer customers are now being offered to meet the uniqueness of the current economic environment. These primarily include a short-term hardship program which allows for a reduced payment amount for six months with full payments resuming thereafter or placement into a loan modification program that could include permanent rate reductions or maturity extensions. In most cases, these offers were not classified as TDRs if qualified for the TDR relief provisions provided by the CARES Act. As of June 30, 2021, substantially all of these borrowers have resumed making payments except for certain residential mortgage loans which continue to be in forbearance.\\nThe Bancorp currently plans to continue to offer a forbearance program for its residential mortgage borrowers in alignment with the forbearances offered for federally-backed mortgage loans under the provisions of the CARES Act and GSE servicing guidance. Under the provisions of the CARES Act, borrowers with federally-backed residential mortgage loans were able to request a six-month forbearance with an option to extend the forbearance period for an additional period of up to six months. The GSEs have also permitted certain forbearances to be extended for an additional six months for a total of up to 18 months. Additionally, the Bancorp will continue to follow the specific GSE guidance for other non-forbearance COVID-19 pandemic relief programs when servicing its residential mortgage portfolio. These programs include traditional loan modifications and/or deferral of past due payments to the maturity of the loan. The Bancorp has continued to suspend residential foreclosure activity in alignment with GSE practices and will also be responsive to any legislative changes related to foreclosure activity. The foreclosure moratorium expired on July 31, 2021 but some foreclosure activity will remain suspended for a longer period in\\n39\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\ncertain circumstances. Also, borrowers that have not taken advantage of a forbearance to date will have until September 30, 2021 to enter into a COVID-19-related forbearance.\\nThe Bancorp offered a variety of relief options to its commercial borrowers that had been impacted by the COVID-19 pandemic. While these offers were individually negotiated and tailored to each borrower’s specific facts and circumstances, the most commonly offered relief measures included temporary covenant waivers and/or deferrals of principal and/or interest payments for up to 90 days. After the deferral program, a customer had the option to resume normal payments, enter into a formal loan modification program or restructure the loan arrangement. These relief options were discontinued in 2021.\\nThe following table provides a summary of portfolio loans and leases as of June 30, 2021, by class, that have received payment deferrals or forbearances as part of the Bancorp’s COVID-19 pandemic hardship relief programs:\\n| TABLE 32: Residential Mortgage and Consumer Portfolio Loans Enrolled In Hardship Relief Programs |\\n| Amortized Cost Basis of Loans and Leases | Past Due(c) |\\n| Completed Relief Period | In Active Relief Period(a) | Total that Have Received Payment Relief(b) |\\n| June 30, 2021 ($ in millions) | Current(c) | 30-89 Days | 90 Days or More | Total Past Due |\\n| Residential mortgage loans(b) | $ | 999 | 322 | 1,321 | 1,130 | 31 | 160 | 191 |\\n| Consumer loans: |\\n| Home equity | 177 | 2 | 179 | 165 | 5 | 9 | 14 |\\n| Indirect secured consumer loans(d) | 806 | 85 | 891 | 855 | 32 | 4 | 36 |\\n| Credit card | 85 | 14 | 99 | 85 | 7 | 7 | 14 |\\n| Other consumer loans | 96 | 3 | 99 | 95 | 3 | 1 | 4 |\\n| Total residential mortgage and consumer portfolio loans | $ | 2,163 | 426 | 2,589 | 2,330 | 78 | 181 | 259 |\\n\\n(a)Includes loans and leases that are still in the initial payment relief period (primarily residential mortgage and home equity loans) and loans that have requested additional relief.\\n(b)Excludes $803 of loans previously sold to GNMA that the Bancorp had the option to repurchase as a result of forbearance, all of which were repurchased and are classified as held for sale.\\n(c)For loans which are still in an active relief period, past due status is based on the borrower’s status as of March 1, 2020, as adjusted based on the borrower’s compliance with modified loan terms.\\n(d)Indirect secured consumer loans which are still in an active relief period as of June 30, 2021 are required to make payments but at a reduced amount from original contractual terms.\\nAs of June 30, 2021, $1.3 billion of the Bancorp’s residential mortgage loans had been enrolled in a COVID-19 forbearance program (either active or completed). These loans had a weighted-average FICO score of approximately 683 and a weighted-average origination LTV of approximately 81%. Approximately 72% of these borrowers made at least one payment since entering forbearance, and 85% of balances are reported as current as of June 30, 2021. The Bancorp had $322 million of these loans in an active relief period as of June 30, 2021 and these loans had a weighted-average FICO score of approximately 652 and a weighted-average origination LTV of approximately 83%. Approximately one third of borrowers in an active forbearance period have made at least one payment since entering forbearance and approximately 88% of the residential mortgage loans still in an active relief period have completed the initial six-month forbearance period and have requested an extended forbearance.\\nCommercial Portfolio\\nThe Bancorp’s credit risk management strategy seeks to minimize concentrations of risk through diversification. The Bancorp has commercial loan concentration limits based on industry, lines of business within the commercial segment, geography and credit product type. The risk within the commercial loan and lease portfolio is managed and monitored through an underwriting process utilizing detailed origination policies, continuous loan level reviews, monitoring of industry concentration and product type limits and continuous portfolio risk management reporting.\\nThe Bancorp provides loans to a variety of customers ranging from large multinational firms to middle market businesses, sole proprietors and high net worth individuals. The origination policies for commercial and industrial loans outline the risks and underwriting requirements for loans to businesses in various industries. Included in the policies are maturity and amortization terms, collateral and leverage requirements, cash flow coverage measures and hold limits. The Bancorp aligns credit and sales teams with specific industry expertise to better monitor and manage different industry segments of the portfolio.\\nCertain industries have experienced increased stress due to the COVID-19 pandemic. These include consumer-driven industries that require gathering or congregation such as leisure and recreation (including casinos, restaurants, sports, fitness, hotels and other industries), non-essential retail and leisure travel (primarily including airlines and cruise lines). Certain segments of the healthcare industry (including skilled\\n40\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nnursing, physician offices and surgery/outpatient centers, among others) have also been impacted by the pandemic given delays and restrictions on in-person visits and elective procedures.\\nThe following table presents industries impacted the most severely within the Bancorp’s commercial and industrial and commercial real estate loan portfolios as of June 30, 2021:\\n| TABLE 33: Industries Impacted the Most Severely by the COVID-19 Pandemic |\\n| ($ in millions) | Balance | Exposure | Industry Classification(b) |\\n| Commercial and industrial loans:(a) |\\n| Leisure and recreation(c) | $ | 3,260 | 7,084 | Accommodation and food / Entertainment and recreation |\\n| Retail - non-essential | 645 | 2,941 | Retail trade |\\n| Healthcare | 1,013 | 1,740 | Healthcare |\\n| Leisure travel | 393 | 594 | Transportation and warehousing |\\n| Total commercial and industrial loans | $ | 5,311 | 12,359 |\\n| Commercial real estate owner-occupied loans: |\\n| Leisure and recreation(c) | 366 | 414 | Accommodation and food / Entertainment and recreation |\\n| Retail - non-essential | 70 | 70 | Real estate |\\n| Healthcare | 1,535 | 1,786 | Healthcare |\\n| Total commercial real estate owner-occupied loans | $ | 1,971 | 2,270 |\\n| Commercial real estate nonowner-occupied loans: |\\n| Leisure and recreation(c) | 1,929 | 2,178 | Accommodation and food / Entertainment and recreation |\\n| Retail - non-essential | 983 | 1,011 | Real estate |\\n| Healthcare | 111 | 132 | Healthcare |\\n| Total commercial real estate nonowner-occupied loans | $ | 3,023 | 3,321 |\\n| Total | $ | 10,305 | 17,950 |\\n\\n(a)Excludes PPP loans.\\n(b)As defined by the North American Industry Classification System.\\n(c)Balances include exposures to casinos, restaurants, sports, fitness, hotels and other.\\n41\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nThe following table provides detail on commercial loans and leases by industry classification (as defined by the North American Industry Classification System), by loan size and by state, illustrating the diversity and granularity of the Bancorp’s commercial loans and leases as of:\\n| TABLE 34: Commercial Loan and Lease Portfolio (excluding loans and leases held for sale) |\\n| June 30, 2021 | December 31, 2020 |\\n| ($ in millions) | Outstanding | Exposure | Nonaccrual | Outstanding | Exposure | Nonaccrual |\\n| By Industry: |\\n| Real estate | $ | 10,790 | 16,227 | 62 | 11,416 | 16,865 | 143 |\\n| Manufacturing | 10,517 | 21,588 | 59 | 10,699 | 21,986 | 68 |\\n| Financial services and insurance | 7,056 | 16,141 | — | 6,868 | 15,113 | — |\\n| Healthcare | 5,057 | 7,664 | 5 | 5,168 | 7,874 | 41 |\\n| Business services | 5,003 | 9,129 | 24 | 5,344 | 9,114 | 66 |\\n| Accommodation and food | 4,163 | 6,764 | 27 | 4,166 | 6,600 | 35 |\\n| Wholesale trade | 4,162 | 8,307 | 7 | 4,204 | 7,990 | 25 |\\n| Retail trade | 3,637 | 9,114 | 2 | 3,651 | 8,871 | 6 |\\n| Communication and information | 3,052 | 6,956 | 25 | 3,128 | 5,802 | 39 |\\n| Construction | 2,766 | 6,208 | 4 | 2,631 | 6,053 | 4 |\\n| Transportation and warehousing | 2,660 | 4,503 | 16 | 2,846 | 4,596 | 13 |\\n| Mining | 2,589 | 4,645 | 71 | 2,626 | 4,171 | 94 |\\n| Entertainment and recreation | 1,804 | 3,299 | 80 | 2,248 | 3,537 | 84 |\\n| Other services | 1,308 | 1,759 | 6 | 1,362 | 1,770 | 7 |\\n| Utilities | 1,177 | 2,986 | — | 1,162 | 3,011 | — |\\n| Public administration | 676 | 1,117 | 9 | 880 | 1,428 | — |\\n| Agribusiness | 429 | 599 | 10 | 394 | 616 | 10 |\\n| Other | 110 | 113 | 1 | 127 | 129 | 2 |\\n| Individuals | 64 | 112 | 1 | 77 | 123 | 1 |\\n| Total | $ | 67,020 | 127,231 | 409 | 68,997 | 125,649 | 638 |\\n| By Loan Size: |\\n| Less than $1 million | 6 | % | 4 | 10 | 7 | 5 | 10 |\\n| $1 million to $5 million | 9 | 7 | 12 | 9 | 7 | 18 |\\n| $5 million to $10 million | 7 | 6 | 10 | 7 | 6 | 14 |\\n| $10 million to $25 million | 17 | 15 | 41 | 18 | 16 | 27 |\\n| $25 million to $50 million | 24 | 23 | 27 | 24 | 23 | 31 |\\n| Greater than $50 million | 37 | 45 | — | 35 | 43 | — |\\n| Total | 100 | % | 100 | 100 | 100 | 100 | 100 |\\n| By State: |\\n| Illinois | 12 | % | 11 | 25 | 14 | 12 | 28 |\\n| Ohio | 10 | 12 | 3 | 11 | 12 | 4 |\\n| Florida | 8 | 7 | 1 | 8 | 7 | 1 |\\n| California | 8 | 7 | 1 | 7 | 7 | 1 |\\n| Texas | 7 | 7 | 13 | 7 | 7 | 10 |\\n| Michigan | 6 | 6 | 11 | 6 | 6 | 7 |\\n| Indiana | 4 | 4 | 2 | 4 | 4 | 1 |\\n| Georgia | 3 | 4 | 8 | 3 | 4 | 7 |\\n| North Carolina | 3 | 2 | 1 | 3 | 2 | 3 |\\n| Tennessee | 3 | 3 | 1 | 2 | 3 | 1 |\\n| Kentucky | 2 | 2 | — | 2 | 2 | 4 |\\n| South Carolina | 2 | 1 | — | 2 | 1 | — |\\n| Other | 32 | 34 | 34 | 31 | 33 | 33 |\\n| Total | 100 | % | 100 | 100 | 100 | 100 | 100 |\\n\\n42\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nThe origination policies for commercial real estate outline the risks and underwriting requirements for owner and nonowner-occupied and construction lending. Included in the policies are maturity and amortization terms, maximum LTVs, minimum debt service coverage ratios, construction loan monitoring procedures, appraisal requirements, pre-leasing requirements (as applicable), pro forma analysis requirements and interest rate sensitivity. The Bancorp requires a valuation of real estate collateral, which may include third-party appraisals, be performed at the time of origination and renewal in accordance with regulatory requirements and on an as-needed basis when market conditions justify. Although the Bancorp does not back test these collateral value assumptions, the Bancorp maintains an appraisal review department to order and review third-party appraisals in accordance with regulatory requirements. Collateral values on criticized assets with relationships exceeding $1 million are reviewed quarterly to assess the appropriateness of the value ascribed in the assessment of charge-offs and specific reserves.\\nThe Bancorp assesses all real estate and non-real estate collateral securing a loan and considers all cross-collateralized loans in the calculation of the LTV ratio. The following tables provide detail on the most recent LTV ratios for commercial mortgage loans greater than $1 million, excluding commercial mortgage loans that are individually evaluated. The Bancorp does not typically aggregate the LTV ratios for commercial mortgage loans less than $1 million.\\n| TABLE 35: Commercial Mortgage Loans Outstanding by LTV, Loans Greater Than $1 Million |\\n| As of June 30, 2021 ($ in millions) | LTV > 100% | LTV 80-100% | LTV < 80% |\\n| Commercial mortgage owner-occupied loans | $ | 132 | 261 | 3,419 |\\n| Commercial mortgage nonowner-occupied loans | 17 | 109 | 4,397 |\\n| Total | $ | 149 | 370 | 7,816 |\\n| TABLE 36: Commercial Mortgage Loans Outstanding by LTV, Loans Greater Than $1 Million |\\n| As of December 31, 2020 ($ in millions) | LTV > 100% | LTV 80-100% | LTV < 80% |\\n| Commercial mortgage owner-occupied loans | $ | 121 | 310 | 3,209 |\\n| Commercial mortgage nonowner-occupied loans | 51 | 72 | 4,757 |\\n| Total | $ | 172 | 382 | 7,966 |\\n\\nThe Bancorp views non-owner-occupied commercial real estate as a higher credit risk product compared to some other commercial loan portfolios due to the higher volatility of the industry.\\nThe following tables provide an analysis of nonowner-occupied commercial real estate loans by state (excluding loans held for sale):\\n| TABLE 37: Nonowner-Occupied Commercial Real Estate (excluding loans held for sale)(a) |\\n| As of June 30, 2021 ($ in millions) | For the three months ended June 30, 2021 | For the six months ended June 30, 2021 |\\n| Outstanding | Exposure | 90 DaysPast Due | Nonaccrual | Net (Recoveries) Charge-offs | Net (Recoveries) Charge-offs |\\n| By State: |\\n| Illinois | $ | 2,376 | 2,763 | — | 21 | — | — |\\n| Ohio | 1,416 | 1,998 | — | — | — | — |\\n| Florida | 1,094 | 1,678 | — | — | — | — |\\n| North Carolina | 945 | 1,174 | — | 2 | — | — |\\n| Michigan | 771 | 886 | — | — | — | — |\\n| Indiana | 676 | 967 | — | — | — | — |\\n| All other states | 3,433 | 5,369 | — | 1 | (1) | (1) |\\n| Total | $ | 10,711 | 14,835 | — | 24 | (1) | (1) |\\n\\n(a)Included in commercial mortgage loans and commercial construction loans in the Loans and Leases subsection of the Balance Sheet Analysis section of MD&A.\\n43\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\n| TABLE 38: Nonowner-Occupied Commercial Real Estate (excluding loans held for sale)(a) |\\n| As of June 30, 2020 ($ in millions) | For the three months ended June 30, 2020 | For the six months ended June 30, 2020 |\\n| Outstanding | Exposure | 90 DaysPast Due | Nonaccrual | Net Charge-offs | Net Charge-offs |\\n| By State: |\\n| Illinois | $ | 3,073 | 3,680 | 10 | 5 | 1 | 1 |\\n| Ohio | 1,357 | 1,823 | — | 5 | — | — |\\n| Florida | 1,026 | 1,620 | — | — | — | — |\\n| North Carolina | 808 | 1,116 | — | 2 | — | — |\\n| Michigan | 805 | 961 | — | 1 | — | — |\\n| Indiana | 559 | 1,040 | — | — | — | — |\\n| All other states | 3,580 | 5,722 | — | 59 | — | 1 |\\n| Total | $ | 11,208 | 15,962 | 10 | 72 | 1 | 2 |\\n\\n(a)Included in commercial mortgage loans and commercial construction loans in the Loans and Leases subsection of the Balance Sheet Analysis section of MD&A.\\nConsumer Portfolio\\nConsumer credit risk management utilizes a framework that encompasses consistent processes for identifying, assessing, managing, monitoring and reporting credit risk. These processes are supported by a credit risk governance structure that includes Board oversight, policies, risk limits and risk committees.\\nThe Bancorp’s consumer portfolio is materially comprised of five categories of loans: residential mortgage loans, home equity, indirect secured consumer loans, credit card and other consumer loans. The Bancorp has identified certain credit characteristics within these five categories of loans which it believes represent a higher level of risk compared to the rest of the consumer loan portfolio. The Bancorp does not update LTVs for the consumer portfolio subsequent to origination except as part of the charge-off process for real estate secured loans. Credit risk management continues to closely monitor the indirect secured consumer portfolio performance, which includes automobile loans. The automobile market has exhibited industry-wide gradual loosening of credit standards such as lower FICOs, longer terms and higher LTVs. The Bancorp has adjusted credit standards focused on improving risk-adjusted returns while maintaining credit risk tolerance. The Bancorp actively manages the automobile portfolio through concentration limits, which mitigate credit risk through limiting the exposure to lower FICO scores, higher advance rates and extended term originations.\\nThe Bancorp enhanced its credit underwriting guidelines across the entire consumer portfolio in response to the economic stress created by the COVID-19 pandemic. As the economic environment stabilizes, the current set of credit guidelines have generally returned to pre-pandemic levels as the Bancorp continues to ensure that underwriting standards reflect forward-looking outlooks on both risks and market opportunities, support strategic objectives, provide value to consumers and ensure adherence to risk appetite.\\nResidential mortgage portfolio\\nThe Bancorp manages credit risk in the residential mortgage portfolio through underwriting guidelines that limit exposure to higher LTVs and lower FICO scores. Additionally, the portfolio is governed by concentration limits that ensure geographic, product and channel diversification. The Bancorp may also package and sell loans in the portfolio.\\nThe Bancorp does not originate residential mortgage loans that permit customers to defer principal payments or make payments that are less than the accruing interest. The Bancorp originates both fixed-rate and ARM loans. Within the ARM portfolio, approximately $529 million of ARM loans will have rate resets during the next twelve months. Of these resets, 4% are expected to experience an increase in rate, with an average increase of approximately 0.23%. Underlying characteristics of these borrowers are relatively strong with a weighted average origination DTI of 32% and weighted average origination LTV of 71%.\\nCertain residential mortgage products have contractual features that may increase credit exposure to the Bancorp in the event of a decline in housing values. These types of mortgage products offered by the Bancorp include loans with high LTVs, multiple loans secured by the same collateral that when combined result in an LTV greater than 80% and interest-only loans. The Bancorp has deemed residential mortgage loans with greater than 80% LTVs and no mortgage insurance as loans that represent a higher level of risk.\\nIn response to the COVID-19 pandemic, the Bancorp is following GSE guidance regarding forbearance and foreclosure regulations which currently allow up to 18 months of forbearance. The foreclosure moratorium expired on July 31, 2021 but some foreclosure activity will remain suspended for a longer period in certain circumstances. Also, borrowers that have not taken advantage of a forbearance to date will have until September 30, 2021 to enter into a COVID-19-related forbearance.\\n44\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nThe following table provides an analysis of the residential mortgage portfolio loans outstanding by LTV at origination as of:\\n| TABLE 39: Residential Mortgage Portfolio Loans by LTV at Origination |\\n| June 30, 2021 | December 31, 2020 |\\n| ($ in millions) | Outstanding | Weighted-Average LTV | Outstanding | Weighted-Average LTV |\\n| LTV ≤ 80% | $ | 11,882 | 63.8 | % | $ | 11,336 | 65.2 | % |\\n| LTV > 80%, with mortgage insurance(a) | 2,259 | 95.4 | 2,535 | 95.5 |\\n| LTV > 80%, no mortgage insurance | 1,990 | 91.2 | 2,057 | 91.1 |\\n| Total | $ | 16,131 | 72.5 | % | $ | 15,928 | 73.9 | % |\\n\\n(a)Includes loans with both borrower and lender paid mortgage insurance.\\nThe following tables provide an analysis of the residential mortgage portfolio loans outstanding by state with a greater than 80% LTV at origination and no mortgage insurance:\\n| TABLE 40: Residential Mortgage Portfolio Loans, LTV Greater Than 80% at Origination, No Mortgage Insurance |\\n| As of June 30, 2021 ($ in millions) | For the three months ended June 30, 2021 | For the six months ended June 30, 2021 |\\n| Outstanding | 90 DaysPast Due | Nonaccrual | Net Charge-offs | Net Charge-offs |\\n| By State: |\\n| Ohio | $ | 451 | 5 | 4 | — | — |\\n| Illinois | 412 | 4 | 1 | — | — |\\n| Florida | 301 | 1 | 2 | — | — |\\n| Michigan | 156 | 1 | 1 | — | — |\\n| Indiana | 140 | 1 | — | — | — |\\n| North Carolina | 136 | 1 | — | — | — |\\n| Kentucky | 93 | 1 | — | — | — |\\n| All other states | 301 | 2 | 2 | — | — |\\n| Total | $ | 1,990 | 16 | 10 | — | — |\\n\\n| TABLE 41: Residential Mortgage Portfolio Loans, LTV Greater Than 80% at Origination, No Mortgage Insurance |\\n| As of June 30, 2020 ($ in millions) | For the three months endedJune 30, 2020 | For the six months endedJune 30, 2020 |\\n| Outstanding | 90 DaysPast Due | Nonaccrual | Net Charge-offs | Net Charge-offs |\\n| By State: |\\n| Ohio | $ | 493 | 3 | 4 | — | — |\\n| Illinois | 460 | 2 | 3 | — | — |\\n| Florida | 325 | 1 | 2 | — | — |\\n| Michigan | 210 | 2 | 1 | — | — |\\n| Indiana | 177 | 1 | 1 | — | — |\\n| North Carolina | 149 | 2 | — | — | — |\\n| Kentucky | 100 | 1 | 1 | — | — |\\n| All other states | 373 | 3 | 4 | — | — |\\n| Total | $ | 2,287 | 15 | 16 | — | — |\\n\\nHome equity portfolio\\nThe Bancorp’s home equity portfolio is primarily comprised of home equity lines of credit. Beginning in the first quarter of 2013, the Bancorp’s newly originated home equity lines of credit have a 10-year interest-only draw period followed by a 20-year amortization period. The home equity line of credit previously offered by the Bancorp was a revolving facility with a 20-year term, minimum payments of interest-only and a balloon payment of principal at maturity. Peak maturity years for the balloon home equity lines of credit are 2025 to 2028 and approximately 21% of the balances mature before 2025.\\n45\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nThe ALLL provides coverage for expected losses in the home equity portfolio. The allowance attributable to the portion of the home equity portfolio that has not been restructured in a TDR is determined on a pooled basis using a probability of default, loss given default and exposure at default model framework to generate expected losses. The expected losses for the home equity portfolio are dependent upon loan delinquency, FICO scores, LTV, loan age and their historical correlation with macroeconomic variables including unemployment and the home price index. The expected losses generated from models are adjusted by certain qualitative adjustment factors to reflect risks associated with current conditions and trends. The qualitative factors include adjustments for changes in policies or procedures in underwriting, monitoring or collections, economic conditions, portfolio mix, lending and risk management personnel, results of internal audit and quality control reviews, collateral values and geographic concentrations.\\nThe home equity portfolio is managed in two primary groups: loans outstanding with a combined LTV greater than 80% and those loans with an LTV of 80% or less based upon appraisals at origination. For additional information on these loans, refer to Table 43 and Table 44. Of the total $4.5 billion of outstanding home equity loans:\\n● 81% reside within the Bancorp’s Midwest footprint of Ohio, Michigan, Kentucky, Indiana and Illinois as of June 30, 2021;\\n● 40% are in senior lien positions and 60% are in junior lien positions at June 30, 2021;\\n● 79% of non-delinquent borrowers made at least one payment greater than the minimum payment during the three months ended June 30, 2021; and\\n● The portfolio had a weighted average refreshed FICO score of 748 at June 30, 2021.\\nThe Bancorp actively manages lines of credit and makes adjustments in lending limits when it believes it is necessary based on FICO score deterioration and property devaluation. The Bancorp does not routinely obtain appraisals on performing loans to update LTVs after origination. However, the Bancorp monitors the local housing markets by reviewing various home price indices and incorporates the impact of the changing market conditions in its ongoing credit monitoring processes. For junior lien home equity loans which become 60 days or more past due, the Bancorp tracks the performance of the senior lien loans in which the Bancorp is the servicer and utilizes consumer credit bureau attributes to monitor the status of the senior lien loans that the Bancorp does not service. If the senior lien loan is found to be 120 days or more past due, the junior lien home equity loan is placed on nonaccrual status unless both loans are well-secured and in the process of collection. Additionally, if the junior lien home equity loan becomes 120 days or more past due and the senior lien loan is also 120 days or more past due, the junior lien home equity loan is assessed for charge-off. Refer to the Analysis of Nonperforming Assets subsection of the Risk Management section of MD&A for more information.\\nThe following table provides an analysis of home equity portfolio loans outstanding disaggregated based upon refreshed FICO score as of:\\n| TABLE 42: Home Equity Portfolio Loans Outstanding by Refreshed FICO Score |\\n| June 30, 2021 | December 31, 2020 |\\n| ($ in millions) | Outstanding | % of Total | Outstanding | % of Total |\\n| Senior Liens: |\\n| FICO ≤ 659 | $ | 151 | 3 | % | $ | 174 | 3 | % |\\n| FICO 660-719 | 264 | 6 | 284 | 6 |\\n| FICO ≥ 720 | 1,416 | 31 | 1,546 | 30 |\\n| Total senior liens | $ | 1,831 | 40 | 2,004 | 39 |\\n| Junior Liens: |\\n| FICO ≤ 659 | 290 | 7 | 339 | 6 |\\n| FICO 660-719 | 506 | 11 | 610 | 12 |\\n| FICO ≥ 720 | 1,918 | 42 | 2,230 | 43 |\\n| Total junior liens | $ | 2,714 | 60 | 3,179 | 61 |\\n| Total | $ | 4,545 | 100 | % | $ | 5,183 | 100 | % |\\n\\n46\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nThe Bancorp believes that home equity portfolio loans with a greater than 80% combined LTV present a higher level of risk. The following table provides an analysis of the home equity portfolio loans outstanding in a senior and junior lien position by LTV at origination as of:\\n| TABLE 43: Home Equity Portfolio Loans Outstanding by LTV at Origination |\\n| June 30, 2021 | December 31, 2020 |\\n| ($ in millions) | Outstanding | Weighted-Average LTV | Outstanding | Weighted-Average LTV |\\n| Senior Liens: |\\n| LTV ≤ 80% | $ | 1,588 | 53.7 | % | $ | 1,728 | 53.8 | % |\\n| LTV > 80% | 243 | 89.1 | 276 | 89.1 |\\n| Total senior liens | $ | 1,831 | 58.7 | 2,004 | 58.8 |\\n| Junior Liens: |\\n| LTV ≤ 80% | 1,623 | 66.5 | 1,864 | 66.5 |\\n| LTV > 80% | 1,091 | 89.7 | 1,315 | 89.8 |\\n| Total junior liens | $ | 2,714 | 76.7 | 3,179 | 77.1 |\\n| Total | $ | 4,545 | 69.2 | % | $ | 5,183 | 69.8 | % |\\n\\nThe following tables provide an analysis of home equity portfolio loans outstanding by state with a combined LTV greater than 80% at origination:\\n| TABLE 44: Home Equity Portfolio Loans Outstanding with an LTV Greater than 80% at Origination |\\n| As of June 30, 2021 ($ in millions) | For the three months endedJune 30, 2021 | For the six months endedJune 30, 2021 |\\n| Outstanding | Exposure | 90 DaysPast Due | Nonaccrual | Net (Recoveries) Charge-offs | Net (Recoveries) Charge-offs |\\n| By State: |\\n| Ohio | $ | 417 | 993 | — | 8 | — | — |\\n| Michigan | 235 | 524 | — | 4 | — | — |\\n| Illinois | 215 | 420 | 1 | 6 | (1) | (1) |\\n| Indiana | 126 | 286 | — | 3 | — | — |\\n| Kentucky | 105 | 250 | — | 2 | — | — |\\n| Florida | 91 | 190 | — | 2 | — | — |\\n| All other states | 145 | 306 | — | 4 | — | — |\\n| Total | $ | 1,334 | 2,969 | 1 | 29 | (1) | (1) |\\n\\n| TABLE 45: Home Equity Portfolio Loans Outstanding with an LTV Greater than 80% at Origination |\\n| As of June 30, 2020 ($ in millions) | For the three months endedJune 30, 2020 | For the six months endedJune 30, 2020 |\\n| Outstanding | Exposure | 90 DaysPast Due | Nonaccrual | Net Charge-offs | Net Charge-offs |\\n| By State: |\\n| Ohio | $ | 564 | 1,231 | — | 9 | — | 1 |\\n| Michigan | 328 | 656 | — | 6 | — | — |\\n| Illinois | 249 | 483 | — | 6 | — | — |\\n| Indiana | 166 | 355 | — | 3 | — | — |\\n| Kentucky | 141 | 311 | — | 1 | — | — |\\n| Florida | 128 | 245 | — | 3 | — | — |\\n| All other states | 199 | 387 | — | 4 | — | — |\\n| Total | $ | 1,775 | 3,668 | — | 32 | — | 1 |\\n\\nIndirect secured consumer portfolio\\nThe indirect secured consumer portfolio is comprised of $14.1 billion of automobile loans and $1.1 billion of indirect motorcycle, powersport, recreational vehicle and marine loans as of June 30, 2021. The concentration of lower FICO (≤659) origination balances remained within targeted credit risk tolerance during the six months ended June 30, 2021. All concentration and guideline changes are monitored monthly to ensure alignment with original credit performance and return projections.\\n47\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nThe following table provides an analysis of indirect secured consumer portfolio loans outstanding disaggregated based upon FICO score at origination as of:\\n| TABLE 46: Indirect Secured Consumer Portfolio Loans Outstanding by FICO Score at Origination |\\n| June 30, 2021 | December 31, 2020 |\\n| ($ in millions) | Outstanding | % of Total | Outstanding | % of Total |\\n| FICO ≤ 659 | $ | 360 | 2 | % | $ | 417 | 3 | % |\\n| FICO 660-719 | 3,653 | 24 | 3,568 | 26 |\\n| FICO ≥ 720 | 11,179 | 74 | 9,668 | 71 |\\n| Total | $ | 15,192 | 100 | % | $ | 13,653 | 100 | % |\\n\\nAs of June 30, 2021, 94% of the indirect secured consumer loan portfolio is comprised of automobile loans, powersport loans and motorcycle loans. It is a common industry practice to advance on these types of loans an amount in excess of the collateral value due to the inclusion of negative equity trade-in, maintenance/warranty products, taxes, title and other fees paid at closing. The Bancorp monitors its exposure to these higher risk loans. The remainder of the indirect secured consumer loan portfolio is comprised of marine and recreational vehicle loans. The Bancorp’s credit policies limit the maximum advance rate on these to 100% of collateral value.\\nThe following table provides an analysis of indirect secured consumer portfolio loans outstanding by LTV at origination as of:\\n| TABLE 47: Indirect Secured Consumer Portfolio Loans Outstanding by LTV at Origination |\\n| June 30, 2021 | December 31, 2020 |\\n| ($ in millions) | Outstanding | Weighted- Average LTV | Outstanding | Weighted- Average LTV |\\n| LTV ≤ 100% | $ | 10,945 | 79.8 | % | $ | 9,371 | 80.3 | % |\\n| LTV > 100% | 4,247 | 111.9 | 4,282 | 112.7 |\\n| Total | $ | 15,192 | 89.0 | % | $ | 13,653 | 90.8 | % |\\n\\nThe following table provides an analysis of the Bancorp’s indirect secured consumer portfolio loans outstanding with an LTV greater than 100% at origination:\\n| TABLE 48: Indirect Secured Consumer Portfolio Loans Outstanding with an LTV Greater than 100% at Origination |\\n| As of ($ in millions) | Outstanding | 90 Days PastDue and Accruing | Nonaccrual | Net Charge-offs for the Three Months Ended | Net Charge-offs for the Six Months Ended |\\n| June 30, 2021 | $ | 4,247 | 3 | 30 | 1 | 7 |\\n| June 30, 2020 | 4,410 | 7 | 7 | 6 | 15 |\\n\\nCredit card portfolio\\nThe credit card portfolio consists of predominantly prime accounts with 98% and 97% of balances existing within the Bancorp’s footprint at June 30, 2021 and December 31, 2020, respectively. At June 30, 2021 and December 31, 2020, 71% and 69%, respectively, of the outstanding balances were originated through branch-based relationships with the remainder coming from direct mail campaigns and online acquisitions.\\nThe following table provides an analysis of credit card portfolio loans outstanding disaggregated based upon FICO score at origination as of:\\n| TABLE 49: Credit Card Portfolio Loans Outstanding by FICO Score at Origination |\\n| June 30, 2021 | December 31, 2020 |\\n| ($ in millions) | Outstanding | % of Total | Outstanding | % of Total |\\n| FICO ≤ 659 | $ | 82 | 5 | % | $ | 94 | 5 | % |\\n| FICO 660-719 | 544 | 30 | 654 | 32 |\\n| FICO ≥ 720 | 1,167 | 65 | 1,259 | 63 |\\n| Total | $ | 1,793 | 100 | % | $ | 2,007 | 100 | % |\\n\\nOther consumer portfolio loans\\nOther consumer portfolio loans are comprised of secured and unsecured loans originated through the Bancorp’s branch network as well as point-of-sale loans originated or purchased in connection with third-party financial technology companies. The Bancorp had $269 million in unfunded commitments associated with loans originated in connection with third-party financial technology companies as of June 30, 2021. The Bancorp closely monitors the credit performance of point-of-sale loans. Loans originated in connection with third-party financial technology companies are impacted by certain credit loss protection coverage provided by those companies.\\n48\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nThe following table provides an analysis of other consumer portfolio loans outstanding by product type as of:\\n| TABLE 50: Other Consumer Portfolio Loans Outstanding by Product Type |\\n| June 30, 2021 | December 31, 2020 |\\n| ($ in millions) | Outstanding | % of Total | Outstanding | % of Total |\\n| Unsecured | $ | 629 | 21 | % | $ | 683 | 23 | % |\\n| Other secured | 817 | 27 | 774 | 26 |\\n| Point-of-sale | 1,606 | 52 | 1,557 | 51 |\\n| Total | $ | 3,052 | 100 | % | $ | 3,014 | 100 | % |\\n\\nAnalysis of Nonperforming Assets\\nNonperforming assets include nonaccrual loans and leases for which ultimate collectability of the full amount of the principal and/or interest is uncertain; restructured commercial, credit card and certain consumer loans which have not yet met the requirements to be classified as a performing asset; restructured consumer loans which are 90 days past due based on the restructured terms unless the loan is both well-secured and in the process of collection; and certain other assets, including OREO and other repossessed property. A summary of nonperforming assets is included in Table 51. For further information on the Bancorp’s policies related to accounting for delinquent and nonperforming loans and leases, refer to the Nonaccrual Loans and Leases section of Note 1 of the Notes to the Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\\nNonperforming assets were $697 million at June 30, 2021 compared to $870 million at December 31, 2020. At June 30, 2021, $40 million of nonaccrual loans were held for sale, compared to $6 million at December 31, 2020.\\nNonperforming portfolio assets as a percent of portfolio loans and leases and OREO were 0.61% as of June 30, 2021 compared to 0.79% as of December 31, 2020. Nonaccrual loans and leases secured by real estate were 32% of nonaccrual loans and leases as of June 30, 2021 compared to 36% as of December 31, 2020.\\nPortfolio commercial nonaccrual loans and leases were $409 million at June 30, 2021, a decrease of $229 million from December 31, 2020. Portfolio consumer nonaccrual loans were $212 million at June 30, 2021, an increase of $16 million from December 31, 2020. Refer to Table 52 for a rollforward of the portfolio nonaccrual loans and leases.\\nOREO and other repossessed property was $36 million and $30 million at June 30, 2021 and December 31, 2020, respectively. The Bancorp recognized an immaterial amount and $1 million in losses on the transfer, sale or write-down of OREO properties for the three months ended June 30, 2021 and 2020, respectively, and $6 million in losses on the transfer, sale or write-down of OREO properties for both the six months ended June 30, 2021 and 2020.\\nFor the three and six months ended June 30, 2021, approximately $8 million and $18 million, respectively, of interest income would have been recognized if the nonaccrual and renegotiated loans and leases on nonaccrual status had been current in accordance with their original terms compared to $9 million and $17 million in the same periods in the prior year. Although these values help demonstrate the costs of carrying nonaccrual credits, the Bancorp does not expect to recover the full amount of interest as nonaccrual loans and leases are generally carried below their principal balance.\\n49\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\n| TABLE 51: Summary of Nonperforming Assets and Delinquent Loans and Leases |\\n| As of ($ in millions) | June 30,2021 | December 31,2020 |\\n| Nonaccrual portfolio loans and leases: |\\n| Commercial and industrial loans | $ | 193 | 230 |\\n| Commercial mortgage loans | 43 | 82 |\\n| Commercial leases | 9 | 7 |\\n| Residential mortgage loans(a) | 17 | 25 |\\n| Home equity | 53 | 52 |\\n| Indirect secured consumer loans | 6 | 9 |\\n| Other consumer loans | 1 | 2 |\\n| Nonaccrual portfolio restructured loans and leases: |\\n| Commercial and industrial loans | 155 | 243 |\\n| Commercial mortgage loans | 9 | 75 |\\n| Commercial construction loans | — | 1 |\\n| Residential mortgage loans(a) | 32 | 35 |\\n| Home equity | 32 | 34 |\\n| Indirect secured consumer loans | 43 | 7 |\\n| Credit card | 27 | 32 |\\n| Other consumer loans | 1 | — |\\n| Total nonaccrual portfolio loans and leases(b) | $ | 621 | 834 |\\n| OREO and other repossessed property | 36 | 30 |\\n| Total nonperforming portfolio loans and leases and OREO | $ | 657 | 864 |\\n| Nonaccrual loans held for sale | 13 | 5 |\\n| Nonaccrual restructured loans held for sale | 27 | 1 |\\n| Total nonperforming assets | $ | 697 | 870 |\\n| Total portfolio loans and leases 90 days past due and still accruing: |\\n| Commercial and industrial loans | $ | 2 | 39 |\\n| Commercial mortgage loans | 4 | 8 |\\n| Commercial leases | — | 1 |\\n| Residential mortgage loans(a) | 57 | 70 |\\n| Home equity | 1 | 2 |\\n| Indirect secured consumer loans | 4 | 10 |\\n| Credit card | 14 | 31 |\\n| Other consumer loans | 1 | 2 |\\n| Total portfolio loans and leases 90 days past due and still accruing | $ | 83 | 163 |\\n| Nonperforming portfolio assets as a percent of portfolio loans and leases and OREO | 0.61 | % | 0.79 |\\n| ALLL as a percent of nonperforming portfolio assets | 310 | 284 |\\n| ACL as a percent of nonperforming portfolio assets | 338 | 304 |\\n\\n(a)Information for all periods presented excludes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. These advances were $316 as of June 30, 2021 and $317 as of December 31, 2020. The Bancorp recognized losses of an immaterial amount and $1 for the three months ended June 30, 2021 and 2020, respectively, and $1 and $2 for the six months ended June 30, 2021 and 2020, respectively, due to claim denials and curtailments associated with these insured or guaranteed loans.\\n(b)Includes $26 and $29 of nonaccrual government insured commercial loans whose repayments are insured by the SBA as of June 30, 2021 and December 31, 2020, respectively, of which $13 and $17 are restructured nonaccrual government insured commercial loans as of June 30, 2021 and December 31, 2020, respectively.\\n50\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nThe following tables provide a rollforward of portfolio nonaccrual loans and leases, by portfolio segment:\\n| TABLE 52: Rollforward of Portfolio Nonaccrual Loans and Leases |\\n| For the six months ended June 30, 2021 ($ in millions) | Commercial | Residential Mortgage | Consumer | Total |\\n| Balance, beginning of period | $ | 638 | 60 | 136 | 834 |\\n| Transfers to nonaccrual status | 130 | 26 | 117 | 273 |\\n| Transfers to accrual status | (1) | (36) | (45) | (82) |\\n| Transfers to held for sale | (87) | — | — | (87) |\\n| Loan paydowns/payoffs | (215) | — | (28) | (243) |\\n| Transfers to OREO | (1) | (2) | — | (3) |\\n| Charge-offs | (81) | — | (18) | (99) |\\n| Draws/other extensions of credit | 26 | 1 | 1 | 28 |\\n| Balance, end of period | $ | 409 | 49 | 163 | 621 |\\n\\n| TABLE 53: Rollforward of Portfolio Nonaccrual Loans and Leases |\\n| For the six months ended June 30, 2020 ($ in millions) | Commercial | Residential Mortgage | Consumer | Total |\\n| Balance, beginning of period | $ | 397 | 91 | 130 | 618 |\\n| Transfers to nonaccrual status | 349 | 73 | 82 | 504 |\\n| Transfers to accrual status | (31) | (72) | (45) | (148) |\\n| Transfers to held for sale | (10) | — | — | (10) |\\n| Loan paydowns/payoffs | (81) | (6) | (19) | (106) |\\n| Transfers to OREO | — | (7) | — | (7) |\\n| Charge-offs | (142) | — | (15) | (157) |\\n| Draws/other extensions of credit | 5 | — | 1 | 6 |\\n| Balance, end of period | $ | 487 | 79 | 134 | 700 |\\n\\nTroubled Debt Restructurings\\nA loan is accounted for as a TDR if the Bancorp, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. TDRs include concessions granted under reorganization, arrangement or other provisions of the Federal Bankruptcy Act. A TDR typically involves a modification of terms such as a reduction of the stated interest rate or remaining principal amount of the loan, a reduction of accrued interest or an extension of the maturity date at a stated interest rate lower than the current market rate for a new loan with similar risk.\\nAt the time of modification, the Bancorp maintains certain consumer loan TDRs (including certain residential mortgage loans, home equity loans and other consumer loans) on accrual status, provided there is reasonable assurance of repayment and performance according to the modified terms based upon a current, well-documented credit evaluation. Loans discharged in a Chapter 7 bankruptcy and not reaffirmed by the borrower are classified as collateral-dependent TDRs and placed on nonaccrual status regardless of the borrower’s payment history or capacity to repay in the future. These loans are returned to accrual status provided there is a sustained payment history of twelve months after bankruptcy and collectability is reasonably assured for all remaining contractual payments. Commercial loans modified as part of a TDR are maintained on accrual status provided there is a sustained payment history of six months or greater prior to the modification in accordance with the modified terms and all remaining contractual payments under the modified terms are reasonably assured of collection. TDRs of commercial loans and credit card loans that do not have a sustained payment history of six months or greater in accordance with the modified terms remain on nonaccrual status until a six-month payment history is sustained. Refer to the Regulatory Developments Related to the COVID-19 Pandemic section of Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for additional information on loans that were modified related to the COVID-19 pandemic but not classified as TDRs.\\nConsumer restructured loans on accrual status totaled $699 million and $796 million at June 30, 2021 and December 31, 2020, respectively. As of June 30, 2021, the percentages of restructured residential mortgage loans, home equity loans and credit card loans that were past due 30 days or more from their modified terms were 28%, 19% and 24%, respectively.\\n51\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nThe following tables summarize portfolio TDRs by loan type and delinquency status:\\n| TABLE 54: Accruing and Nonaccruing Portfolio TDRs |\\n| Accruing |\\n| 30-89 Days | 90 Days or |\\n| As of June 30, 2021 ($ in millions) | Current | Past Due | More Past Due | Nonaccruing | Total |\\n| Commercial loans(a) | $ | 80 | — | — | 164 | 244 |\\n| Residential mortgage loans(b) | 387 | 26 | 94 | 32 | 539 |\\n| Home equity | 157 | 5 | — | 32 | 194 |\\n| Indirect secured consumer loans | 9 | — | — | 43 | 52 |\\n| Credit card | 19 | 2 | — | 27 | 48 |\\n| Other consumer | — | — | — | 1 | 1 |\\n| Total | $ | 652 | 33 | 94 | 299 | 1,078 |\\n\\n(a)Excludes restructured nonaccrual loans held for sale.\\n(b)Information includes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. As of June 30, 2021, these advances represented $188 of current loans, $21 of 30-89 days past due loans and $85 of 90 days or more past due loans.\\n| TABLE 55: Accruing and Nonaccruing Portfolio TDRs |\\n| Accruing |\\n| 30-89 Days | 90 Days or |\\n| As of December 31, 2020 ($ in millions) | Current | Past Due | More Past Due | Nonaccruing | Total |\\n| Commercial loans(a) | $ | 92 | — | — | 319 | 411 |\\n| Residential mortgage loans(b) | 462 | 32 | 102 | 35 | 631 |\\n| Home equity | 171 | 7 | — | 34 | 212 |\\n| Indirect secured consumer loans | 5 | — | — | 7 | 12 |\\n| Credit card | 15 | 2 | — | 32 | 49 |\\n| Total | $ | 745 | 41 | 102 | 427 | 1,315 |\\n\\n(a)Excludes restructured nonaccrual loans held for sale.\\n(b)Information includes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. As of December 31, 2020, these advances represented $276 of current loans, $28 of 30-89 days past due loans and $78 of 90 days or more past due loans.\\nAnalysis of Net Loan Charge-offs\\nNet charge-offs were 16 bps and 44 bps of average portfolio loans and leases for the three months ended June 30, 2021 and 2020, respectively, and were 21 bps and 44 bps of average portfolio loans and leases for the six months ended June 30, 2021 and 2020, respectively. Table 56 provides a summary of credit loss experience and net charge-offs as a percent of average portfolio loans and leases outstanding by loan category.\\nThe ratio of commercial loan and lease net charge-offs as a percent of average portfolio commercial loans and leases decreased to 10 bps and 14 bps during the three and six months ended June 30, 2021, respectively, compared to 40 bps and 36 bps during the three and six months ended June 30, 2020, respectively. The decrease was primarily due to decreases in net charge-offs on commercial and industrial loans of $52 million and $75 million for the three and six months ended June 30, 2021, respectively. Additionally, there were net recoveries on commercial leases of $2 million for both the three and six months ended June 30, 2021 compared to net charge-offs on commercial leases of $11 million and $16 million for the three and six months ended June 30, 2020, respectively.\\nThe ratio of consumer loan net charge-offs as a percent of average portfolio consumer loans decreased to 26 bps and 34 bps during the three and six months ended June 30, 2021, respectively, compared to 52 bps and 59 bps during the three and six months ended June 30, 2020, respectively. The decrease was primarily due to decreases in net charge-offs on credit card loans of $14 million and $26 million for the three and six months ended June 30, 2021, respectively, and decreases in net charge-offs on indirect secured consumer loans of $7 million and $11 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year. The decrease for both the three and six months ended June 30, 2021 included the impact of government stimulus programs and the Bancorp’s hardship programs. Additionally, the Bancorp continued to see increased used car values through the second quarter of 2021 which has directly impacted loss severity.\\n52\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\n| TABLE 56: Summary of Credit Loss Experience |\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Losses charged-off: |\\n| Commercial and industrial loans | $ | (36) | (68) | (68) | (122) |\\n| Commercial mortgage loans | (8) | (2) | (12) | (4) |\\n| Commercial leases | (1) | (11) | (1) | (16) |\\n| Residential mortgage loans | (1) | (2) | (2) | (4) |\\n| Home equity | (2) | (3) | (4) | (8) |\\n| Indirect secured consumer loans | (11) | (15) | (30) | (37) |\\n| Credit card | (26) | (40) | (57) | (82) |\\n| Other consumer loans(a) | (18) | (22) | (37) | (49) |\\n| Total losses charged-off | $ | (103) | (163) | (211) | (322) |\\n| Recoveries of losses previously charged-off: |\\n| Commercial and industrial loans | $ | 23 | 3 | 28 | 7 |\\n| Commercial mortgage loans | 2 | — | 4 | — |\\n| Commercial leases | 3 | — | 3 | — |\\n| Residential mortgage loans | 1 | 1 | 3 | 2 |\\n| Home equity | 3 | 2 | 5 | 4 |\\n| Indirect secured consumer loans | 11 | 8 | 21 | 17 |\\n| Credit card | 6 | 6 | 12 | 11 |\\n| Other consumer loans(a) | 10 | 13 | 20 | 29 |\\n| Total recoveries of losses previously charged-off | $ | 59 | 33 | 96 | 70 |\\n| Net losses charged-off: |\\n| Commercial and industrial loans | $ | (13) | (65) | (40) | (115) |\\n| Commercial mortgage loans | (6) | (2) | (8) | (4) |\\n| Commercial leases | 2 | (11) | 2 | (16) |\\n| Residential mortgage loans | — | (1) | 1 | (2) |\\n| Home equity | 1 | (1) | 1 | (4) |\\n| Indirect secured consumer loans | — | (7) | (9) | (20) |\\n| Credit card | (20) | (34) | (45) | (71) |\\n| Other consumer loans | (8) | (9) | (17) | (20) |\\n| Total net losses charged-off | $ | (44) | (130) | (115) | (252) |\\n| Net losses charged-off as a percent of average portfolio loans and leases: |\\n| Commercial and industrial loans | 0.11 | % | 0.45 | 0.16 | 0.42 |\\n| Commercial mortgage loans | 0.22 | 0.07 | 0.16 | 0.07 |\\n| Commercial leases | (0.21) | 1.47 | (0.15) | 1.02 |\\n| Total commercial loans and leases | 0.10 | % | 0.40 | 0.14 | 0.36 |\\n| Residential mortgage loans | (0.01) | 0.02 | (0.01) | 0.02 |\\n| Home equity | (0.09) | 0.07 | (0.04) | 0.12 |\\n| Indirect secured consumer loans | 0.01 | 0.24 | 0.12 | 0.33 |\\n| Credit card | 4.52 | 6.17 | 5.02 | 6.01 |\\n| Other consumer loans | 0.91 | 1.17 | 1.03 | 1.51 |\\n| Total consumer loans | 0.26 | % | 0.52 | 0.34 | 0.59 |\\n| Total net losses charged-off as a percent of average portfolio loans and leases | 0.16 | % | 0.44 | 0.21 | 0.44 |\\n\\n(a)For the three and six months ended June 30, 2021, the Bancorp recorded $8 and $18, respectively, in both losses charged-off and recoveries of losses previously charged-off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements. For the three and six months ended June 30, 2020, the Bancorp recorded $9 and $22, respectively, in both losses charged-off and recoveries of losses previously charged-off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements.\\nAllowance for Credit Losses\\nThe allowance for credit losses is comprised of the ALLL and the reserve for unfunded commitments. As described in Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020, the Bancorp maintains the ALLL to absorb the amount of credit losses that are expected to be incurred over the remaining contractual terms of the related loans and leases (as adjusted for prepayments and reasonably expected TDRs). The Bancorp’s methodology for determining the ALLL includes an estimate of expected credit losses on a collective basis for groups of loans and leases with similar risk characteristics and\\n53\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nspecific allowances for loans and leases which are individually evaluated. For collectively evaluated loans and leases, the Bancorp uses quantitative models to forecast expected credit losses based on the probability of a loan or lease defaulting, the expected balance at the estimated date of default and the expected loss percentage given a default. The Bancorp’s expected credit loss models consider historical credit loss experience, current market and economic conditions, and forecasted changes in market and economic conditions if such forecasts are considered reasonable and supportable.\\nThe Bancorp also considers qualitative factors in determining the ALLL. Qualitative adjustments are used to capture characteristics in the portfolio that impact expected credit losses which are not fully captured within the Bancorp’s expected credit loss models. These factors include adjustments for changes in policies or procedures in underwriting, monitoring or collections, lending and risk management personnel and results of internal audit and quality control reviews. In addition, the qualitative adjustment framework can be utilized to address specific idiosyncratic risks such as geopolitical events, natural disasters or changes in current economic conditions that are not reflected in the quantitative credit loss models, and their effects on regional borrowers and changes in product structures. Qualitative factors may also be used to address the impacts of unforeseen events on key inputs and assumptions within the Bancorp’s expected credit loss models, such as the reasonable and supportable forecast period, changes to historical loss information or changes to the reversion period or methodology.\\nIn addition to the ALLL, the Bancorp maintains a reserve for unfunded commitments recorded in other liabilities in the Condensed Consolidated Balance Sheets. The methodology used to determine the adequacy of this reserve is similar to the Bancorp’s methodology for determining the ALLL. The provision for unfunded commitments is included in the provision for credit losses in the Condensed Consolidated Statements of Income.\\nFor the commercial portfolio segment, the estimates for probability of default are primarily based on internal ratings assigned to each commercial borrower on a 13-point scale and historical observations of how those ratings migrate to a default over time in the context of macroeconomic conditions. For loans with available credit, the estimate of the expected balance at the time of default considers expected utilization rates, which are primarily based on macroeconomic conditions and the utilization history of similar borrowers under those economic conditions. The estimates for loss severity are primarily based on collateral type and coverage levels and the susceptibility of those characteristics to changes in macroeconomic conditions.\\nFor collectively evaluated loans in the consumer and residential mortgage portfolio segments, the Bancorp’s expected credit loss models primarily utilize the borrower’s FICO score and delinquency history in combination with macroeconomic conditions when estimating the probability of default. The estimates for loss severity are primarily based on collateral type and coverage levels and the susceptibility of those characteristics to changes in macroeconomic conditions. The expected balance at the estimated date of default is also especially impactful in the expected credit loss models for portfolio classes which generally have longer terms (such as residential mortgage loans and home equity) and portfolio classes containing a high concentration of loans with revolving privileges (such as credit card and home equity). The estimate of the expected balance at the time of default considers expected prepayment and utilization rates where applicable, which are primarily based on macroeconomic conditions and the utilization history of similar borrowers under those economic conditions.\\nDay 1 Adoption Impact\\nUpon adoption of ASU 2016-13 on January 1, 2020, the Bancorp used three forward-looking economic scenarios during the reasonable and supportable forecast period in its expected credit loss models to address the inherent imprecision in macroeconomic forecasting. Each of the three scenarios was developed by a third party that is subject to the Bancorp’s Third-Party Risk Management program including oversight by the Bancorp’s independent model risk management group. The scenarios included a most likely outcome (Baseline) and two less probable scenarios with one being more favorable than the Baseline and the other being less favorable. The more favorable alternative scenario (Upside) depicted a stronger near-term growth outlook while the less favorable outlook (Downside) depicted a moderate recession. The Baseline scenario was assigned a probability weighting of 80% with each of the Upside and Downside scenarios being assigned a 10% weighting.\\nThe Baseline scenario was developed such that the expectation is that the economy will perform better than the projection 50% of the time and worse than the projection 50% of the time. The Upside scenario was developed such that there is a 10% probability that the economy will perform better than the projection and a 90% probability that it will perform worse. The Downside scenario was developed such that there is a 90% probability that the economy will perform better than the projection and a 10% probability that it will perform worse.\\nJune 30, 2021 ACL\\nThe ACL as of June 30, 2021 was impacted by several factors, including improvement in both the economic outlook and credit quality. As a result of these factors, the Bancorp incorporated a combination of quantitative model-based estimates and qualitative adjustments. For the quantitative estimates, the Bancorp incorporated three scenarios developed by the third party in May 2021 that included estimates of the expected impacts of the changes in economic conditions caused by the COVID-19 pandemic. The Baseline scenario was assigned a probability weighting of 60%, with a more favorable scenario (Upside) assigned a probability weighting of 20% and a less favorable scenario (Downside) assigned a probability of 20%. The Baseline scenario assumed that a “Build Back Better” program will be passed in late 2021, with implementation early next year. In 2021, real GDP is expected to rise 6.8%, while real consumer spending is forecast to increase 10.7% at an annualized rate. The Baseline scenario also assumes an average unemployment rate of 4.5% in the fourth quarter of 2021, decreasing to\\n54\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\n3.7% in 2022. The Upside scenario assumes a faster than expected boost in consumer sentiment and spending as a result of the government stimulus programs. On an average annual basis, the change in real GDP is 7.3% in 2021 and 6.5% in 2022, and a full-employment rate is expected to be achieved by the third quarter of 2021. The Downside scenario excludes any additional stimulus package beyond the American Rescue Plan passed in March 2021. Real GDP declines through the first quarter of 2022, and the unemployment rate peaks at 9.2% in the third quarter of 2022 with full-employment not reached until the third quarter of 2026.\\nThe Bancorp’s quantitative credit loss models are sensitive to changes in economic forecast assumptions over the reasonable and supportable forecast period. Applying a 100% probability weighting to the Downside scenario rather than using the probability-weighted three scenario approach would result in an increase in the quantitative ACL of approximately $763 million. This sensitivity calculation only reflects the impact of changing the probability weighting of the scenarios in the quantitative credit loss models and excludes any additional considerations associated with the qualitative component of the ACL that might be warranted if probability weights were adjusted.\\nAt June 30, 2021, the qualitative component of the ACL included consideration of certain factors that represent emerging risks specifically associated with the current economic environment and the COVID-19 pandemic. These considerations resulted in qualitative adjustments to increase the ACL, primarily related to volatility in short-term unemployment rates, commercial borrowers experiencing prolonged distress, commercial borrowers in certain industries which have been severely impacted by the COVID-19 pandemic and consumer borrowers that deferred contractual payments under COVID-19 forbearance or hardship programs.\\nThe following table provides a rollforward of the Bancorp’s ACL:\\n| TABLE 57: Changes in Allowance for Credit Losses |\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| ALLL: |\\n| Balance, beginning of period | $ | 2,208 | 2,348 | 2,453 | 1,202 |\\n| Losses charged-off(a) | (103) | (163) | (211) | (322) |\\n| Recoveries of losses previously charged-off(a) | 59 | 33 | 96 | 70 |\\n| (Benefit from) provision for loan and lease losses | (131) | 478 | (305) | 1,103 |\\n| Impact of adoption of ASU 2016-13 | — | — | — | 643 |\\n| Balance, end of period | $ | 2,033 | 2,696 | 2,033 | 2,696 |\\n| Reserve for unfunded commitments: |\\n| Balance, beginning of period | $ | 173 | 169 | 172 | 144 |\\n| Provision for the reserve for unfunded commitments | 16 | 7 | 17 | 22 |\\n| Impact of adoption of ASU 2016-13 | — | — | — | 10 |\\n| Balance, end of period | $ | 189 | 176 | 189 | 176 |\\n\\n(a)For the three and six months ended June 30, 2021, the Bancorp recorded $8 and $18, respectively, in both losses charged-off and recoveries of losses previously charged-off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements. For the three and six months ended June 30, 2020, the Bancorp recorded $9 and $22, respectively, in both losses charged-off and recoveries of losses previously charged-off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements.\\n55\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nThe following table provides an attribution of the Bancorp’s ALLL to portfolio loans and leases:\\n| TABLE 58: Attribution of Allowance for Loan and Lease Losses to Portfolio Loans and Leases |\\n| As of ($ in millions) | June 30,2021 | December 31,2020 |\\n| Attributed ALLL: |\\n| Commercial and industrial loans | $ | 744 | 901 |\\n| Commercial mortgage loans | 371 | 402 |\\n| Commercial construction loans | 85 | 124 |\\n| Commercial leases | 24 | 29 |\\n| Residential mortgage loans | 235 | 294 |\\n| Home equity | 152 | 201 |\\n| Indirect secured consumer loans | 109 | 131 |\\n| Credit card | 198 | 252 |\\n| Other consumer loans | 115 | 119 |\\n| Total ALLL | $ | 2,033 | 2,453 |\\n| Portfolio loans and leases: |\\n| Commercial and industrial loans | $ | 47,564 | 49,665 |\\n| Commercial mortgage loans | 10,347 | 10,602 |\\n| Commercial construction loans | 5,871 | 5,815 |\\n| Commercial leases | 3,238 | 2,915 |\\n| Residential mortgage loans | 16,131 | 15,928 |\\n| Home equity | 4,545 | 5,183 |\\n| Indirect secured consumer loans | 15,192 | 13,653 |\\n| Credit card | 1,793 | 2,007 |\\n| Other consumer loans | 3,052 | 3,014 |\\n| Total portfolio loans and leases | $ | 107,733 | 108,782 |\\n| Attributed ALLL as a percent of respective portfolio loans and leases: |\\n| Commercial and industrial loans | 1.56 | % | 1.81 |\\n| Commercial mortgage loans | 3.59 | 3.79 |\\n| Commercial construction loans | 1.45 | 2.13 |\\n| Commercial leases | 0.74 | 0.99 |\\n| Residential mortgage loans | 1.46 | 1.85 |\\n| Home equity | 3.34 | 3.88 |\\n| Indirect secured consumer loans | 0.72 | 0.96 |\\n| Credit card | 11.04 | 12.56 |\\n| Other consumer loans | 3.77 | 3.95 |\\n| Total ALLL as a percent of portfolio loans and leases | 1.89 | % | 2.25 |\\n| Total ACL as a percent of portfolio loans and leases | 2.06 | 2.41 |\\n\\nThe Bancorp’s ALLL may vary significantly from period to period based on changes in economic conditions, economic forecasts and the composition and credit quality of the Bancorp’s loan and lease portfolio. For additional information on the Bancorp’s methodology for measuring the ACL, refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10‑K for the year ended December 31, 2020.\\n56\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nINTEREST RATE AND PRICE RISK MANAGEMENT\\nInterest rate risk is the risk to earnings or capital arising from movement of interest rates. This risk primarily impacts the Bancorp’s income categories through changes in interest income on earning assets and the cost of interest-bearing liabilities, and through fee items that are related to interest sensitive activities such as mortgage origination and servicing income and through earnings credits earned on commercial deposits that offset commercial deposit fees. Price risk is the risk to earnings or capital arising from changes in the value of financial instruments and portfolios due to movements in interest rates, volatilities, foreign exchange rates, equity prices and commodity prices. Management considers interest rate risk a prominent market risk in terms of its potential impact on earnings. Interest rate risk may occur for any one or more of the following reasons:\\n•Assets and liabilities mature or reprice at different times;\\n•Short-term and long-term market interest rates change by different amounts; or\\n•The expected maturities of various assets or liabilities shorten or lengthen as interest rates change.\\nIn addition to the direct impact of interest rate changes on NII and interest-sensitive fees, interest rates can impact earnings through their effect on loan and deposit demand, credit losses, mortgage origination volumes, the value of servicing rights and other sources of the Bancorp’s earnings. Changes in interest rates and other market factors can impact earnings through changes in the value of portfolios, if not appropriately hedged. Stability of the Bancorp’s net income is largely dependent upon the effective management of interest rate risk and to a lesser extent price risk. Management continually reviews the Bancorp’s on- and off-balance sheet composition, earnings flows, and hedging strategies and models interest rate risk and price risk exposures, and possible actions to manage these risks, given numerous possible future interest rate and market factor scenarios. A series of Policy Limits and Key Risk Indicators are employed to ensure that risks are managed within the Bancorp’s risk tolerance for interest rate risk and price risk.\\nIn addition to the traditional forms of interest rate risk discussed in this section, the Bancorp is exposed to interest rate risk associated with the retirement and replacement of LIBOR. For more information on the LIBOR transition, refer to the Overview section of MD&A.\\nThe Commercial and Wealth and Asset Management lines of business manage price risk for capital markets sales and trading activities related to their respective businesses. The Mortgage line of business manages price risk for the origination and sale of conforming residential mortgage loans to government agencies and government-sponsored enterprises. The Bancorp’s Treasury department manages interest rate risk and price risk for all other activities. Independent oversight is provided by ERM, and key risk indicators and Board-approved policy limits are used to ensure risks are managed within the Bancorp’s risk tolerance.\\nThe Bancorp’s Market Risk Management Committee, which includes senior management representatives, is accountable to the ERMC, provides oversight and monitors price risk for the capital markets sales and trading activities. The Bancorp’s ALCO, which includes senior management representatives and is accountable to the ERMC, provides oversight and monitors interest rate and price risks for Mortgage and Treasury activities.\\nNet Interest Income Sensitivity\\nThe Bancorp employs a variety of measurement techniques to identify and manage its interest rate risk, including the use of an NII simulation model to analyze the sensitivity of NII to changes in interest rates. The model is based on contractual and estimated cash flows and repricing characteristics for all of the Bancorp’s assets, liabilities and off-balance sheet exposures and incorporates market-based assumptions regarding the effect of changing interest rates on the prepayment rates of certain assets and attrition rates of certain liabilities. The model also includes senior management’s projections of the future volume and pricing of each of the product lines offered by the Bancorp as well as other pertinent assumptions. Actual results may differ from simulated results due to timing, magnitude and frequency of interest rate changes, deviations from projected assumptions as well as from changes in market conditions and management strategies.\\nAs of June 30, 2021, the Bancorp’s interest rate risk exposure is governed by a risk framework that utilizes the change in NII over 12-month and 24-month horizons assuming a 200 bps parallel ramped increase in interest rates. Given the unlikely probability associated with a potential negative rate environment, the Bancorp does not have a policy limit for scenarios that include negative rates. Therefore, the Bancorp has no policy limit for a scenario with a decrease in interest rates currently in effect as the Federal Funds target range is currently between zero and 25 basis points. However, the Bancorp routinely analyzes various potential and extreme scenarios, including parallel ramps and shocks as well as steepening and other non-parallel shifts in rates, including negative rate scenarios, to assess where risks to net interest income persist or develop as changes in the balance sheet and market rates evolve. Additionally, the Bancorp routinely evaluates its exposures to changes in the bases between interest rates. The ongoing COVID-19 pandemic has caused significant changes to interest rates, volatilities and the composition of the Bancorp’s balance sheet, including significant increases in deposit funding related to stimulus programs, which has resulted in an excess liquidity position. The excess liquidity is likely to continue negatively impacting net interest margin if short-term interest rates hold steady or move lower but may be partially offset by the amortization of fees related to PPP loans and investment opportunities should the yield curve steepen.\\nIn order to recognize the risk of noninterest-bearing demand deposit balance run-off in a rising interest rate environment, the Bancorp’s NII sensitivity modeling assumes that approximately $5 billion of additional demand deposit balances run-off over 24 months above what is\\n57\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nincluded in senior management’s baseline projections for each 100 bps increase in short-term market interest rates. Similarly, the Bancorp’s NII sensitivity modeling incorporates approximately $5 billion of incremental growth in noninterest-bearing deposit balances over 24 months above senior management’s baseline projections for each 100 bps decrease in short-term market interest rates. The incremental balance run-off and growth are modeled to flow into and out of funding products that reprice in conjunction with short-term market rate changes and reflect the Bank’s excess liquidity position.\\nAnother important deposit modeling assumption is the amount by which interest-bearing deposit rates will increase or decrease when market interest rates increase or decrease. This deposit repricing sensitivity is known as the beta, and it represents the expected amount by which Bancorp deposit rates will change for a given change in short-term market rates. At June 30, 2021, the modeling assumed a weighted-average rising-rate interest-bearing deposit beta of 37%, which is aligned with the portfolio’s experience in the last rate hike cycle. In the event of further rate cuts by the FRB into negative territory, the Bancorp’s NII sensitivity modeling assumes a weighted-average falling-rate interest-bearing deposit beta of 32% at June 30, 2021, while maintaining that deposit rates themselves will not become negative. In addition, the modeling assumes there is no lag between the timing of changes in market rates and the timing of deposit repricing despite such timing lags having occurred in prior rate cycles.\\nThe Bancorp continually evaluates the sensitivity of its interest rate risk measures to these important deposit modeling assumptions. The Bancorp also regularly monitors the sensitivity of other important modeling assumptions, such as loan and security prepayments and early withdrawals on fixed-rate customer liabilities.\\nThe following table shows the Bancorp’s estimated NII sensitivity profile and ALCO policy limits as of:\\n| TABLE 59: Estimated NII Sensitivity Profile and ALCO Policy Limits |\\n| June 30, 2021 | June 30, 2020 |\\n| % Change in NII (FTE) | ALCOPolicy Limit | % Change in NII (FTE) | ALCOPolicy Limit |\\n| Change in Interest Rates (bps) | 12 Months | 13-24Months | 12Months | 13-24Months | 12 Months | 13-24Months | 12Months | 13-24Months |\\n| +200 Ramp over 12 months | 10.79 | % | 22.38 | (4.00) | (6.00) | 1.98 | 7.26 | (4.00) | (6.00) |\\n| +100 Ramp over 12 months | 5.64 | 12.37 | N/A | N/A | 1.02 | 3.88 | N/A | N/A |\\n| -25 Ramp over 3 months | (2.06) | (3.15) | N/A | N/A | (1.64) | (2.53) | N/A | N/A |\\n\\nAt June 30, 2021, the Bancorp’s NII would benefit significantly in both year one and year two under the parallel rate ramp increases. The Bancorp maintains an asymmetric NII sensitivity profile, which is attributable to the level of floating-rate assets, including the predominantly floating-rate commercial loan portfolio, exceeding the level of floating-rate liabilities due to the increased amount of deposit rates near zero in this low interest rate environment and other fixed-rate borrowings. Reductions in the yield of the commercial loan portfolio would be expected to be only partially offset by a decline in the cost of interest-bearing deposits in a falling-rate scenario. However, proactive management of the securities and derivatives portfolios has reduced the ongoing near-term risk to declining market rates and provided significant protection from the decline in rates experienced as the COVID-19 pandemic unfolded. The changes in the estimated NII sensitivity profile compared to June 30, 2020 were primarily attributable to the revision of the deposit beta assumptions in the first quarter of 2021 and the significant increase in noninterest-bearing and low-cost interest-bearing deposits. The falling-rate scenario was also impacted by the higher composition of low-cost deposits hitting their floor rates more quickly in the current-year scenario due to the low-rate environment.\\nTables 60 and 61 provide the sensitivity of the Bancorp’s estimated NII profile at June 30, 2021 to changes to certain deposit balance and deposit repricing sensitivity (betas) assumptions.\\nThe following table includes the Bancorp’s estimated NII sensitivity profile at June 30, 2021 with an immediate $5 billion decrease and an immediate $5 billion increase in demand deposit balances:\\n| TABLE 60: Estimated NII Sensitivity Profile at June 30, 2021 with a $5 Billion Change in Demand Deposit Assumption |\\n| % Change in NII (FTE) |\\n| Immediate $5 Billion BalanceDecrease | Immediate $5 Billion BalanceIncrease |\\n| Change in Interest Rates (bps) | 12 Months | 13-24Months | 12Months | 13-24Months |\\n| +200 Ramp over 12 months | 9.72 | % | 20.22 | 11.86 | 24.53 |\\n| +100 Ramp over 12 months | 5.11 | 11.29 | 6.18 | 13.45 |\\n| -25 Ramp over 3 months | (2.31) | (3.42) | (1.82) | (2.88) |\\n\\n58\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nThe following table includes the Bancorp’s estimated NII sensitivity profile with a 25% increase and a 25% decrease to the corresponding deposit beta assumptions as of June 30, 2021:\\n| TABLE 61: Estimated NII Sensitivity Profile at June 30, 2021 with Deposit Beta Assumptions Changes |\\n| % Change in NII (FTE) |\\n| Betas 25% Higher(a) | Betas 25% Lower(b) |\\n| Change in Interest Rates (bps) | 12 Months | 13-24Months | 12Months | 13-24Months |\\n| +200 Ramp over 12 months | 8.65 | % | 18.49 | 12.93 | 26.27 |\\n| +100 Ramp over 12 months | 4.59 | 10.49 | 6.70 | 14.26 |\\n| -25 Ramp over 3 months | (2.04) | (3.12) | (2.15) | (3.23) |\\n\\n(a)Includes weighted-average rising-rate and falling-rate interest-bearing deposit betas of 46% and 40%, respectively.\\n(b)Includes weighted-average rising-rate and falling-rate interest-bearing deposit betas of 28% and 24%, respectively.\\nEconomic Value of Equity Sensitivity\\nThe Bancorp also uses EVE as a measurement tool in managing interest rate risk. Whereas the NII sensitivity analysis highlights the impact on forecasted NII on an FTE basis (non-GAAP) over one- and two-year time horizons, EVE is a point-in-time analysis of the economic sensitivity of current positions that incorporates all cash flows over their estimated remaining lives. The EVE of the balance sheet is defined as the discounted present value of all asset and net derivative cash flows less the discounted value of all liability cash flows. Due to this longer horizon, the sensitivity of EVE to changes in the level of interest rates is a measure of longer-term interest rate risk. EVE values only the current balance sheet and does not incorporate the balance growth assumptions used in the NII sensitivity analysis. As with the NII simulation model, assumptions about the timing and variability of existing balance sheet cash flows are critical in the EVE analysis. Particularly important are assumptions driving loan and security prepayments and the expected balance attrition and pricing of indeterminate-lived deposits.\\nThe following table shows the Bancorp’s estimated EVE sensitivity profile as of:\\n| TABLE 62: Estimated EVE Sensitivity Profile |\\n| June 30, 2021 | June 30, 2020 |\\n| Change in Interest Rates (bps) | % Change in EVE | ALCOPolicy Limit | % Change in EVE | ALCOPolicy Limit |\\n| +200 Shock | 6.25 | % | (12.00) | (2.86) | (12.00) |\\n| +100 Shock | 3.63 | N/A | (0.82) | N/A |\\n| -25 Shock | (1.18) | N/A | N/A | N/A |\\n\\nThe EVE sensitivity is significantly positive in a +200 bps rising-rate scenario at June 30, 2021. The changes in the estimated EVE sensitivity profile from June 30, 2020 were primarily related to the revision of the deposit beta assumptions in the first quarter of 2021, growth in noninterest-bearing and low-cost interest-bearing deposits and the shorter expected lives of prepayable, fixed-rate assets due to the decrease in market interest rates. These items were partially offset by continued repositioning of the investment portfolio into securities with less principal cash flows in the near term.\\nWhile an instantaneous shift in interest rates is used in this analysis to provide an estimate of exposure, the Bancorp believes that a gradual shift in interest rates would have a much more modest impact. Since EVE measures the discounted present value of cash flows over the estimated lives of instruments, the change in EVE does not directly correlate to the degree that earnings would be impacted over a shorter time horizon (e.g., the current fiscal year). Further, EVE does not account for factors such as future balance sheet growth, changes in product mix, changes in yield curve relationships and changing product spreads that could mitigate or exacerbate the impact of changes in interest rates. The NII simulations and EVE analyses do not necessarily include certain actions that management may undertake to manage risk in response to actual changes in interest rates.\\nThe Bancorp regularly evaluates its exposures to a static balance sheet forecast, LIBOR, Prime Rate and other basis risks, yield curve twist risks and embedded options risks. In addition, the impacts on NII on an FTE basis and EVE of extreme changes in interest rates are modeled, wherein the Bancorp employs the use of yield curve shocks and environment-specific scenarios.\\nUse of Derivatives to Manage Interest Rate Risk\\nAn integral component of the Bancorp’s interest rate risk management strategy is its use of derivative instruments to minimize significant fluctuations in earnings caused by changes in market interest rates. Examples of derivative instruments that the Bancorp may use as part of its interest rate risk management strategy include interest rate swaps, interest rate floors, interest rate caps, forward contracts, forward starting interest rate swaps, options, swaptions and TBA securities.\\n59\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nTables 63 and 64 show all swap and floor positions that are utilized for purposes of managing the Bancorp’s exposures to the variability of interest rates. These positions are used to convert the contractual interest rate index of agreed-upon amounts of assets and liabilities (i.e., notional amounts) to another interest rate index or to hedge forecasted transactions for the variability in cash flows attributable to the contractually specified interest rate. The volume, maturity and mix of portfolio swaps change frequently as the Bancorp adjusts its broader interest rate risk management objectives and the balance sheet positions to be hedged. For further information, including the notional amount and fair values of these derivatives, refer to Note 13 of the Notes to Condensed Consolidated Financial Statements.\\nThe following tables present additional information about the interest rate swaps and floors used in Fifth Third’s asset and liability management activities:\\n| TABLE 63: Weighted-Average Maturity, Receive Rate and Pay Rate on Qualifying Hedging Instruments |\\n| As of June 30, 2021 ($ in millions) | NotionalAmount | FairValue | Remaining(years) | Receive/Strike Rate |\\n| Interest rate swaps – cash flow – receive-fixed | $ | 8,000 | (1) | 2.5 | 3.02 | % | 1 ML |\\n| Interest rate swaps – fair value – receive-fixed | 1,455 | 429 | 10.2 | 6.03 | 1 ML / 3 ML |\\n| Total interest rate swaps | $ | 9,455 | 428 |\\n| Interest rate floors – cash flow – receive-fixed | $ | 3,000 | 183 | 3.5 | 2.25 | 1 ML |\\n| TABLE 64: Weighted-Average Maturity, Receive Rate and Pay Rate on Qualifying Hedging Instruments |\\n| As of December 31, 2020 ($ in millions) | Notional Amount | Fair Value | Remaining (years) | Receive/Strike Rate |\\n| Interest rate swaps – cash flow – receive-fixed | $ | 8,000 | 14 | 3.0 | 3.02 | % | 1 ML |\\n| Interest rate swaps – fair value – receive-fixed | 1,955 | 528 | 8.1 | 5.35 | 1 ML / 3 ML |\\n| Total interest rate swaps | $ | 9,955 | 542 |\\n| Interest rate floors – cash flow – receive-fixed | $ | 3,000 | 244 | 4.0 | 2.25 | 1 ML |\\n\\nAdditionally, as part of its overall risk management strategy relative to its residential mortgage banking activities, the Bancorp enters into forward contracts accounted for as free-standing derivatives to economically hedge IRLCs that are also considered free-standing derivatives. The Bancorp economically hedges its exposure to residential mortgage loans held for sale through the use of forward contracts and mortgage options as well. See the Residential Mortgage Servicing Rights and Price Risk section for the discussion of the use of derivatives to economically hedge this exposure.\\nThe Bancorp also enters into derivative contracts with major financial institutions to economically hedge market risks assumed in interest rate derivative contracts with commercial customers. Generally, these contracts have similar terms in order to protect the Bancorp from market volatility. Credit risk arises from the possible inability of the counterparties to meet the terms of their contracts, which the Bancorp minimizes through collateral arrangements, approvals, limits and monitoring procedures. The Bancorp has risk limits and internal controls in place to help ensure excessive risk is not being taken in providing this service to customers. These controls include an independent determination of interest rate volatility and credit equivalent exposure on these contracts and counterparty credit approvals performed by independent risk management. For further information, including the notional amount and fair values of these derivatives, refer to Note 13 of the Notes to Condensed Consolidated Financial Statements.\\nResidential Mortgage Servicing Rights and Price Risk\\nThe fair value of the residential MSR portfolio was $818 million and $656 million at June 30, 2021 and December 31, 2020, respectively. The value of servicing rights can fluctuate sharply depending on changes in interest rates and other factors. Generally, as interest rates decline and loans are prepaid to take advantage of refinancing, the total value of existing servicing rights declines because no further servicing fees are collected on repaid loans. The Bancorp maintains a non-qualifying hedging strategy relative to its mortgage banking activity in order to manage a portion of the risk associated with changes in the value of its MSR portfolio as a result of changing interest rates.\\nFor the three and six months ended June 30, 2021, the Bancorp recognized losses of $122 million and $50 million, respectively, in mortgage banking net revenue for valuation adjustments on the MSR portfolio. The valuation adjustments on the MSR portfolio included a decrease of $49 million for the three months ended June 30, 2021 and an increase of $103 million for the six months ended June 30, 2021 due to changes to inputs in the valuation model, including future prepayment speeds and OAS assumptions. Assumptions were updated as a result of market rate changes during the three and six months ended June 30, 2021. For the three months ended June 30, 2021, a decrease in mortgage rates caused modeled prepayment speeds to rise. For the six months ended June 30, 2021, an increase in mortgage rates resulted in a reduction to modeled prepayment speeds, and a tightening of the spread between mortgage rates and swap rates resulted in a decrease in the modeled OAS assumptions. The fair value of the MSR portfolio also decreased $73 million and $153 million as a result of contractual principal payments and actual prepayment activity for the three and six months ended June 30, 2021, respectively.\\n60\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nMortgage rates decreased during both the three and six months ended June 30, 2020, which caused modeled prepayment speeds to rise. The fair value of the MSR portfolio decreased $12 million and $343 million for the three and six months ended June 30, 2020, respectively, due to changes to inputs to the valuation model including prepayment speeds and OAS assumptions and decreased $58 million and $105 million for the three and six months ended June 30, 2020, respectively, due to the impact of contractual principal payments and actual prepayment activity.\\nThe Bancorp recognized net gains of $47 million and net losses of $89 million on its non-qualifying hedging strategy for the three and six months ended June 30, 2021, respectively, compared to net gains of $11 million and $364 million during the three and six months ended June 30, 2020, respectively. These amounts included net gains of $1 million and net losses of $1 million for the three and six months ended June 30, 2021, respectively, compared to net gains of an immaterial amount and $3 million for the three and six months ended June 30, 2020, respectively, on securities related to the Bancorp’s non-qualifying hedging strategy. The Bancorp may adjust its hedging strategy to reflect its assessment of the composition of its MSR portfolio, the cost of hedging and the anticipated effectiveness of the hedges given the economic environment. Refer to Note 12 of the Notes to Condensed Consolidated Financial Statements for further discussion on servicing rights and the instruments used to hedge price risk on MSRs.\\nForeign Currency Risk\\nThe Bancorp may enter into foreign exchange derivative contracts to economically hedge certain foreign denominated loans. The derivatives are classified as free-standing instruments with the revaluation gain or loss being recorded in other noninterest income in the Condensed Consolidated Statements of Income. The balance of the Bancorp’s foreign denominated loans at June 30, 2021 and December 31, 2020 was $841 million and $655 million, respectively. The Bancorp also enters into foreign exchange contracts for the benefit of commercial customers to hedge their exposure to foreign currency fluctuations. Similar to the hedging of price risk from interest rate derivative contracts entered into with commercial customers, the Bancorp also enters into foreign exchange contracts with major financial institutions to economically hedge a substantial portion of the exposure from client-driven foreign exchange activity. The Bancorp has risk limits and internal controls in place to help ensure excessive risk is not being taken in providing this service to customers. These controls include an independent determination of currency volatility and credit equivalent exposure on these contracts, counterparty credit approvals and country limits performed by independent risk management.\\nCommodity Risk\\nThe Bancorp also enters into commodity contracts for the benefit of commercial customers to hedge their exposure to commodity price fluctuations. Similar to the hedging of foreign exchange and price risk from interest rate derivative contracts, the Bancorp also enters into commodity contracts with major financial institutions to economically hedge a substantial portion of the exposure from client-driven commodity activity. The Bancorp may also offset this risk with exchange-traded commodity contracts. The Bancorp has risk limits and internal controls in place to help ensure excessive risk is not taken in providing this service to customers. These controls include an independent determination of commodity volatility and credit equivalent exposure on these contracts and counterparty credit approvals performed by independent risk management.\\n61\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nLIQUIDITY RISK MANAGEMENT\\nThe goal of liquidity management is to provide adequate funds to meet changes in loan and lease demand, unexpected levels of deposit withdrawals and other contractual obligations. Mitigating liquidity risk is accomplished by maintaining liquid assets in the form of cash and investment securities, maintaining sufficient unused borrowing capacity in the debt markets and delivering consistent growth in core deposits. A summary of certain obligations and commitments to make future payments under contracts is included in Note 16 of the Notes to Condensed Consolidated Financial Statements.\\nThe Bancorp’s Treasury department manages funding and liquidity based on point-in-time metrics as well as forward-looking projections, which incorporate different sources and uses of funds under base and stress scenarios. Liquidity risk is monitored and managed by the Treasury department with independent oversight provided by ERM, and a series of Policy Limits and Key Risk Indicators are established to ensure risks are managed within the Bancorp’s risk tolerance. The Bancorp maintains a contingency funding plan that provides for liquidity stress testing, which assesses the liquidity needs under varying market conditions, time horizons, asset growth rates and other events. The contingency plan provides for ongoing monitoring of unused borrowing capacity and available sources of contingent liquidity to prepare for unexpected liquidity needs and to cover unanticipated events that could affect liquidity. The contingency plan also outlines the Bancorp’s response to various levels of liquidity stress and actions that should be taken during various scenarios.\\nLiquidity risk is monitored and managed for both Fifth Third Bancorp and its subsidiaries. The Bancorp receives substantially all of its liquidity from dividends from its subsidiaries, primarily Fifth Third Bank, National Association. Subsidiary dividends are supplemented with term debt to enable the Bancorp to maintain sufficient liquidity to meet its cash obligations, including debt service and scheduled maturities, common and preferred dividends, unfunded commitments to subsidiaries and other planned capital actions in the form of share repurchases. Liquidity resources are more limited at the Bancorp, making its liquidity position more susceptible to market disruptions. Bancorp liquidity is assessed using a cash coverage horizon, ensuring the entity maintains sufficient liquidity to withstand a period of sustained market disruption while meeting its anticipated obligations over an extended stressed horizon.\\nThe Bancorp’s ALCO, which includes senior management representatives and is accountable to the ERMC, monitors and manages liquidity and funding risk within Board-approved policy limits. In addition to the risk management activities of ALCO, the Bancorp has a liquidity risk management function as part of ERM that provides independent oversight of liquidity risk management.\\nSources of Funds\\nThe Bancorp’s primary sources of funds relate to cash flows from loan and lease repayments, payments from securities related to sales and maturities, the sale or securitization of loans and leases and funds generated by core deposits, in addition to the use of public and private debt offerings.\\nRefer to the Interest Rate and Price Risk Management subsection of the Risk Management section of MD&A included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for information about the expected cash flows from loan and lease repayments. Of the $38.0 billion of securities in the Bancorp’s available-for-sale debt and other securities portfolio at June 30, 2021, $4.7 billion in principal and interest is expected to be received in the next 12 months and an additional $4.2 billion is expected to be received in the next 13 to 24 months. For further information on the Bancorp’s securities portfolio, refer to the Investment Securities subsection of the Balance Sheet Analysis section of MD&A.\\nAsset-driven liquidity is provided by the Bancorp’s ability to sell or securitize loans and leases. In order to reduce the exposure to interest rate fluctuations and to manage liquidity, the Bancorp has developed securitization and sale procedures for several types of interest-sensitive assets. A majority of the long-term, fixed-rate single-family residential mortgage loans underwritten according to FHLMC or FNMA guidelines are sold for cash upon origination. Additional assets such as certain other residential mortgage loans, certain commercial loans and leases, home equity loans, automobile loans and other consumer loans are also capable of being securitized or sold. For the three and six months ended June 30, 2021, the Bancorp sold or securitized loans and leases totaling $4.5 billion and $8.1 billion, respectively, compared to $3.1 billion and $6.2 billion during the three and six months ended June 30, 2020, respectively. For further information, refer to Note 12 of the Notes to Condensed Consolidated Financial Statements.\\nCore deposits have historically provided the Bancorp with a sizeable source of relatively stable and low-cost funds. The Bancorp’s average core deposits and average shareholders’ equity funded 89% of its average total assets for both the three and six months ended June 30, 2021, compared to 85% for both the three and six months ended June 30, 2020. In addition to core deposit funding, the Bancorp also accesses a variety of other short-term and long-term funding sources, which include the use of the FHLB system. Certificates $100,000 and over and certain deposits in the Bancorp’s foreign branch located in the Cayman Islands are wholesale funding tools utilized to fund asset growth. Management does not rely on any one source of liquidity and manages availability in response to changing balance sheet needs.\\nAs of June 30, 2021, $4.7 billion of debt or other securities were available for issuance under the current Bancorp’s Board of Directors’ authorizations and the Bancorp is authorized to file any necessary registration statements with the SEC to permit ready access to the public securities markets; however, access to these markets may depend on market conditions.\\n62\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nAs of June 30, 2021, the Bank’s global bank note program had a borrowing capacity of $25.0 billion, of which $21.1 billion was available for issuance. Additionally, at June 30, 2021, the Bank had approximately $47.3 billion of borrowing capacity available through secured borrowing sources, including the FRB and FHLB.\\nCurrent Liquidity Position\\nThe COVID-19 pandemic has significantly impacted the economic environment, although financial markets, initially supported by Federal Reserve programs, have been stable and well-functioning following the onset of the crisis, aided by significant monetary and fiscal response. The Bancorp maintains a strong liquidity profile driven by strong core deposit funding and over $100 billion in current available liquidity. The Bancorp is managing liquidity prudently in the current environment and maintains a liquidity profile focused on core deposit and stable long-term funding sources which allows for the effective management of concentration and rollover risk.\\nAs of June 30, 2021, the Bancorp has sufficient liquidity to meet contractual obligations and all preferred and common dividends without accessing the capital markets or receiving upstream dividends from the Bank subsidiary for 30 months.\\nCredit Ratings\\nThe cost and availability of financing to the Bancorp and Bank are impacted by its credit ratings. A downgrade to the Bancorp’s or Bank’s credit ratings could affect its ability to access the credit markets and increase its borrowing costs, thereby adversely impacting the Bancorp’s or Bank’s financial condition and liquidity. Key factors in maintaining high credit ratings include a stable and diverse earnings stream, strong credit quality, strong capital ratios and diverse funding sources, in addition to disciplined liquidity monitoring procedures.\\nThe Bancorp’s and Bank’s credit ratings are summarized in Table 65. The ratings reflect the ratings agency’s view on the Bancorp’s and Bank’s capacity to meet financial commitments.*\\n*As an investor, you should be aware that a security rating is not a recommendation to buy, sell or hold securities, that it may be subject to revision or withdrawal at any time by the assigning rating organization and that each rating should be evaluated independently of any other rating. Additional information on the credit rating ranking within the overall classification system is located on the website of each credit rating agency.\\n| TABLE 65: Agency Ratings |\\n| As of August 6, 2021 | Moody’s | Standard and Poor’s | Fitch | DBRS Morningstar |\\n| Fifth Third Bancorp: |\\n| Short-term borrowings | No rating | A-2 | F1 | R-1L |\\n| Senior debt | Baa1 | BBB+ | A- | A |\\n| Subordinated debt | Baa1 | BBB | BBB+ | AL |\\n| Fifth Third Bank, National Association: |\\n| Short-term borrowings | P-2 | A-2 | F1 | R-1M |\\n| Short-term deposit | P-1 | No rating | F1 | No rating |\\n| Long-term deposit | A1 | No rating | A | AH |\\n| Senior debt | A3 | A- | A- | AH |\\n| Subordinated debt | A3 | BBB+ | BBB+ | A |\\n| Rating Agency Outlook for Fifth Third Bancorp and Fifth Third Bank, National Association | Stable | Stable | Stable | Negative |\\n\\n63\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nOPERATIONAL RISK MANAGEMENT\\nOperational risk is the risk to current or projected financial condition and resilience arising from inadequate or failed internal processes or systems, human errors or misconduct or adverse external events that are neither market- nor credit-related. Operational risk is inherent in the Bancorp’s activities and can manifest itself in various ways, including fraudulent acts, business interruptions, inappropriate behavior of employees, unintentional failure to comply with applicable laws and regulations, poor design or delivery of products and services, cyber-security or physical security incidents and privacy breaches or failure of third parties to perform in accordance with their arrangements. These events could result in financial losses, litigation and regulatory fines, as well as other damage to the Bancorp. The Bancorp’s risk management goal is to keep operational risk at appropriate levels consistent with the Bancorp’s risk appetite, financial strength, the characteristics of its businesses, the markets in which it operates and the competitive and regulatory environment to which it is subject.\\nTo control, monitor and govern operational risk, the Bancorp maintains an overall Risk Management Framework which comprises governance oversight, risk assessment, capital measurement, monitoring and reporting as well as a formal three lines of defense approach. ERM is responsible for prescribing the framework to the lines of business and corporate functions and providing independent oversight of its implementation (second line of defense). Business Controls groups are in place in each of the lines of business to ensure consistent implementation and execution of managing day-to-day operational risk (first line of defense).\\nThe Bancorp’s risk management framework consists of five integrated components, including identifying, assessing, managing, monitoring and independent governance reporting of risk. The corporate Operational Risk Management function within Enterprise Risk is responsible for developing and overseeing the implementation of the Bancorp’s approach to managing operational risk. This includes providing governance, awareness and training, tools, guidance and oversight to support implementation of key risk programs and systems as they relate to operational risk management, such as risk and control self-assessments, product delivery risk assessment, scenario analysis, new product/initiative risk reviews, key risk indicators, Third-Party Risk Management, cyber-security risk management and review of operational losses. The function is also responsible for developing reports that support the proactive management of operational risk across the enterprise. The lines of business and corporate functions are responsible for managing the operational risks associated with their areas in accordance with the risk management framework. The framework is intended to enable the Bancorp to function with a sound and well-controlled operational environment. These processes support the Bancorp’s goals to minimize future operational losses and strengthen the Bancorp’s performance by maintaining sufficient capital to absorb operational losses that are incurred.\\nThe Bancorp also maintains a robust information security program to support the management of cyber-security risk within the organization with a focus on prevention, detection and recovery processes. Fifth Third utilizes a wide array of techniques to secure its operations and proprietary information such as Board-approved policies and programs, network monitoring and testing, access controls and dedicated security personnel. Fifth Third has adopted the National Institute of Standards and Technology Cybersecurity Framework for the management and deployment of cyber-security controls and is an active participant in the financial sector information sharing organization structure, known as the Financial Services Information Sharing and Analysis Center. To ensure resiliency of key Bancorp functions, Fifth Third also employs redundancy protocols that include a robust business continuity function that works to mitigate any potential impacts to Fifth Third customers and its systems.\\nFifth Third also focuses on the reporting and escalation of operational control issues to senior management and the Board of Directors. The Operational Risk Committee is the key committee that oversees and supports Fifth Third in the management of operational risk across the enterprise. The Information Security Governance Committee and Model Risk Committee report to the Operational Risk Committee and are responsible for governance of information security and model risks. The Operational Risk Committee reports to the ERMC, which reports to the Risk and Compliance Joint Committee of the Board of Directors of Fifth Third Bancorp and Fifth Third Bank, National Association.\\nThe COVID-19 pandemic continues to put pressure on operational risk including cyber, fraud and third-party risks driven by factors such as remote work strategies, relief programs and outsourced service providers. Additionally, increased external threats have elevated fraud and cyber-security risks. These risks continue to be carefully managed and monitored to ensure effective controls are in place, with appropriate oversight and governance by the second line of defense. Fifth Third has a defined pandemic plan and a robust business continuity management process, which have been leveraged to support the continuity of processes across the Bank.\\n64\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nLEGAL AND REGULATORY COMPLIANCE RISK MANAGEMENT\\nLegal and regulatory compliance risk is the risk of legal or regulatory sanctions, financial loss or damage to reputation as a result of noncompliance with (i) applicable laws, regulations, rules and other regulatory requirements (including but not limited to the risk of consumers experiencing economic loss or other legal harm as a result of noncompliance with consumer protection laws, regulations and requirements); (ii) internal policies and procedures, standards of best practice or codes of conduct; and (iii) principles of integrity and fair dealing applicable to Fifth Third’s activities and functions. Legal risks include the risk of actions against the institution that result in unenforceable contracts, lawsuits, legal sanctions, or adverse judgments, which disrupt or otherwise negatively affect the operations or condition of the institution. Failure to effectively manage such risks can elevate the risk level or manifest itself as other types of key risks, including reputational or operational risk. Fifth Third focuses on managing legal and regulatory compliance risk in accordance with the Bancorp’s integrated risk management framework, which ensures consistent processes for identifying, assessing, managing, monitoring and reporting risks. The Bancorp’s risk management goal is to keep compliance risk at appropriate levels, consistent with the Bancorp’s risk appetite.\\nTo mitigate such risks, Compliance Risk Management provides independent oversight to foster consistency and sufficiency in the execution of the program, and ensures that lines of business and support functions are adequately identifying, assessing and monitoring legal and regulatory compliance risks and adopting proper mitigation strategies. Moreover, such strategies are modified from time to time to respond to new or emerging risks in the environment. Compliance Risk Management and the Legal Division provide guidance to the lines of business and enterprise functions, which are ultimately responsible for managing such risks associated with their areas. The Chief Compliance Officer and Director of Financial Crimes is responsible for formulating and directing the strategy, development, implementation, communication and maintenance of the Compliance Risk Management program, which implements key compliance processes, including but not limited to, executive- and board-level governance and reporting routines, compliance-related policies, risk assessments, key risk indicators, issues tracking, regulatory change management and regulatory compliance testing and monitoring. As part of Compliance Risk Management, the Financial Crimes Division conducts and oversees anti-money laundering and economic sanctions processes. Compliance Risk Management partners with the Community and Economic Development team to oversee the Bancorp’s compliance with the Community Reinvestment Act.\\nFifth Third also reports and escalates legal and regulatory compliance issues to senior management and the Board of Directors. The Management Compliance Committee, which is chaired by the Chief Compliance Officer and Director of Financial Crimes, is the key committee that oversees and supports Fifth Third in the management of compliance risk across the enterprise. The Management Compliance Committee oversees Bancorp-wide compliance issues, industry best practices, legislative developments, regulatory concerns and other leading indicators of legal and regulatory compliance risk. The Management Compliance Committee reports to the ERMC, which reports to the RCC of the Board of Directors of Fifth Third Bancorp and Fifth Third Bank, National Association.\\n65\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nCAPITAL MANAGEMENT\\nManagement regularly reviews the Bancorp’s capital levels to help ensure it is appropriately positioned under various operating environments. The Bancorp has established a Capital Committee which is responsible for making capital plan recommendations to management. These recommendations are reviewed by the ERMC and the annual capital plan is approved by the Board of Directors. The Capital Committee is responsible for execution and oversight of the capital actions of the capital plan.\\nRegulatory Capital Ratios\\nThe Basel III Final Rule sets minimum regulatory capital ratios as well as defines the measure of “well-capitalized” for insured depository institutions.\\n| TABLE 66: Prescribed Capital Ratios |\\n| Minimum | Well-Capitalized |\\n| CET1 capital: |\\n| Fifth Third Bancorp | 4.50 | % | N/A |\\n| Fifth Third Bank, National Association | 4.50 | 6.50 |\\n| Tier I risk-based capital: |\\n| Fifth Third Bancorp | 6.00 | 6.00 |\\n| Fifth Third Bank, National Association | 6.00 | 8.00 |\\n| Total risk-based capital: |\\n| Fifth Third Bancorp | 8.00 | 10.00 |\\n| Fifth Third Bank, National Association | 8.00 | 10.00 |\\n| Tier I leverage: |\\n| Fifth Third Bancorp | 4.00 | N/A |\\n| Fifth Third Bank, National Association | 4.00 | 5.00 |\\n\\nThe Bancorp is subject to the stress capital buffer requirement, which replaced the capital conservation buffer on October 1, 2020. Institutions subject to the stress capital buffer requirement must maintain capital ratios above their respective buffered minimum (regulatory minimum plus stress capital buffer) in order to avoid certain limitations on capital distributions and discretionary bonuses to executive officers. The FRB uses the supervisory stress test to determine the Bancorp’s stress capital buffer, subject to a floor of 2.5%. The Bancorp’s stress capital buffer requirement has been 2.5% since the introduction of this framework and was most recently affirmed on June 24, 2021. The Bancorp’s capital ratios have exceeded the stress capital buffer requirement for all periods presented.\\nIn April 2018, the federal banking regulators proposed transitional arrangements to permit banking organizations to phase in the day-one impact of the adoption of ASU 2016-13, referred to as CECL, on regulatory capital over a period of three years. The proposed rule was adopted as final effective July 1, 2019. The phase-in provisions of the final rule are optional for a banking organization that experiences a reduction in retained earnings due to CECL adoption as of the beginning of the fiscal year in which the banking organization adopts CECL. A banking organization that elects the phase-in provisions of the final rule for regulatory capital purposes must phase in 25% of the transitional amounts impacting regulatory capital in the first year of adoption of CECL, 50% in the second year, 75% in the third year, with full impact beginning in the fourth year.\\nIn March 2020, the banking agencies issued an interim final rule for additional transitional relief to regulatory capital related to the impact of the adoption of CECL given the disruption in economic activity caused by the COVID-19 pandemic. The interim final rule provides banking organizations that adopt CECL in the 2020 calendar year with the option to delay for two years the estimated impact of CECL on regulatory capital, followed by the aforementioned three-year transition period to phase out the aggregate amount of benefit during the initial two-year delay for a total five-year transition. The estimated impact of CECL on regulatory capital (modified CECL transitional amount) is calculated as the sum of the day-one impact on retained earnings upon adoption of CECL (CECL transitional amount) and the calculated change in the ACL relative to the day-one ACL upon adoption of CECL multiplied by a scaling factor of 25%. The scaling factor is used to approximate the difference in the ACL under CECL relative to the incurred loss methodology. The modified CECL transitional amount will be calculated each quarter for the first two years of the five-year transition. The amount of the modified CECL transition amount will be fixed as of December 31, 2021 and that amount will be subject to the three-year phase out.\\nThe Bancorp adopted ASU 2016-13 on January 1, 2020 and elected the five-year transition phase-in option for the impact of CECL on regulatory capital with its regulatory filings as of March 31, 2020. The impact of the modified CECL transition amount on the Bancorp’s regulatory capital at June 30, 2021 was an increase in capital of approximately $535 million. On a fully phased-in basis, the Bancorp’s CET1 ratio would be reduced by 34 basis points as of June 30, 2021. The CECL transition amount will begin to phase in during the fiscal year starting January 1, 2022 and will be fully phased in by January 1, 2025.\\n66\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nThe following table summarizes the Bancorp’s capital ratios as of:\\n| TABLE 67: Capital Ratios |\\n| ($ in millions) | June 30,2021 | December 31,2020 |\\n| Quarterly average total Bancorp shareholders’ equity as a percent of average assets | 11.11 | % | 11.34 |\\n| Tangible equity as a percent of tangible assets(a)(b) | 8.35 | 8.18 |\\n| Tangible common equity as a percent of tangible assets(a)(b) | 7.28 | 7.11 |\\n| Regulatory capital:(c) |\\n| CET1 capital | $ | 15,050 | 14,682 |\\n| Tier I capital | 17,166 | 16,797 |\\n| Total regulatory capital | 21,184 | 21,412 |\\n| Risk-weighted assets | 145,084 | 141,974 |\\n| Regulatory capital ratios:(c) |\\n| CET1 capital | 10.37 | % | 10.34 |\\n| Tier I risk-based capital | 11.83 | 11.83 |\\n| Total risk-based capital | 14.60 | 15.08 |\\n| Tier I leverage | 8.55 | 8.49 |\\n\\n(a)These are non-GAAP measures. For further information, refer to the Non-GAAP Financial Measures section of MD&A.\\n(b)Excludes AOCI.\\n(c)Regulatory capital ratios as of June 30, 2021 are calculated pursuant to the five-year transition provision option to phase in the effects of CECL on regulatory capital.\\nCapital Planning\\nIn 2011, the FRB adopted the capital plan rule, which requires BHCs with consolidated assets of $50 billion or more to submit annual capital plans to the FRB for review. Under the rule, these capital plans must include detailed descriptions of the following: the BHC’s internal processes for assessing capital adequacy; the policies governing capital actions such as common stock issuances, dividends and share repurchases; and all planned capital actions over a nine-quarter planning horizon. Furthermore, each BHC must report to the FRB the results of stress tests conducted by the BHC under a number of scenarios that assess the sources and uses of capital under baseline and stressed economic conditions.\\nOn October 10, 2019, the Federal Reserve Board adopted final rules to tailor certain prudential standards for large domestic and foreign banking organizations. As a result of the EPS Tailoring Rule, the Bancorp is subject to Category IV standards, under which the Bancorp is no longer required to file semi-annual, company-run stress tests with the FRB and publicly disclose the results. However, the Bancorp is required to develop and maintain a capital plan approved by the Board of Directors on an annual basis. As an institution subject to Category IV standards, the Bancorp is subject to the FRB’s supervisory stress tests every two years, the Board capital plan rule and certain FR Y-14 reporting requirements. The supervisory stress tests are forward-looking quantitative evaluations of the impact of stressful economic and financial market conditions on the Bancorp’s capital. The Bancorp became subject to Category IV standards on December 31, 2019, and the requirements outlined above apply to the stress test cycle that started on January 1, 2020. The Bancorp is not subject to the 2021 supervisory stress test conducted by the FRB but has submitted its Board-approved capital plan as required.\\nIn June 2020, the FRB took several actions in connection with its announcement of stress test results in light of the uncertainty caused by the COVID-19 pandemic. Specifically, for the third quarter of 2020, the FRB required large banking organizations, including the Bancorp, to suspend share repurchases, cap dividend payments to the amount paid during the second quarter of 2020, and further limit dividends according to a formula based on recent income. These restrictions were extended, quarterly, with certain modifications, throughout the remainder of 2020.\\nThe FRB extended these restrictions into the first and second quarters of 2021, with certain modifications to permit a limited amount of share repurchases. During the first and second quarters of 2021, the Bancorp was authorized to pay dividends and execute share repurchases according to a formula based on recent income provided the Bancorp did not increase the amount of its common dividend.\\nIn June 2021, the FRB lifted the COVID-19 pandemic induced capital distribution limitations, which prohibited increases to the common dividend and placed limitations on share repurchases, and authorized the Bancorp, beginning July 1, 2021, to make capital distributions that are consistent with the requirements in the Board’s capital plan rule, inclusive of the Bancorp’s stress capital buffer requirement. The Bancorp maintains a comprehensive process for managing capital and expects the stress capital buffer framework to provide greater flexibility for the Bancorp to assess and deploy capital.\\n67\\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\\n\\nDividend Policy and Stock Repurchase Program\\nThe Bancorp’s common stock dividend policy and stock repurchase program reflect its earnings outlook, desired payout ratios, the need to maintain adequate capital levels, the ability of its subsidiaries to pay dividends and the need to comply with safe and sound banking practices as well as meet regulatory requirements and expectations. The Bancorp declared dividends per common share of $0.27 for both the three months ended June 30, 2021 and 2020, and $0.54 for both the six months ended June 30, 2021 and 2020. Pursuant to the Bancorp’s Board-approved capital plan, during the second quarter of 2021, the Bancorp entered into and settled an accelerated share repurchase transaction in the amount of $347 million. Refer to Note 15 and Note 23 of the Notes to Condensed Consolidated Financial Statements for additional information on share repurchase activity.\\nThe following table summarizes the monthly share repurchase activity for the three months ended June 30, 2021:\\n| TABLE 68: Share Repurchases |\\n| Period | Total Numberof Shares Purchased(a) | Average PricePaid per Share | Total Number of SharesPurchased as a Part ofPublicly Announced Plans or Programs | Maximum Number ofShares that May Yet BePurchased under the Plans or Programs(b) |\\n| April 1 - April 30, 2021 | 8,022,822 | $ | 40.46 | 7,894,807 | 63,224,146 |\\n| May 1 - May 31, 2021 | 126,867 | 41.73 | — | 63,224,146 |\\n| June 1 - June 30, 2021 | 713,157 | 40.53 | 675,295 | 62,548,851 |\\n| Total | 8,862,846 | $ | 40.48 | 8,570,102 | 62,548,851 |\\n\\n(a) Includes 292,744 shares repurchased during the second quarter of 2021 in connection with various employee compensation plans. These purchases do not count against the maximum number of shares that may yet be purchased under the Board of Directors’ authorization.\\n(b) In June 2019, the Bancorp announced that its Board of Directors had authorized management to purchase 100 million shares of the Bancorp’s common stock through the open market or in any private party transactions. This authorization did not include specific targets or an expiration date.\\n68\\n| Quantitative and Qualitative Disclosures about Market Risk (Item 3) |\\n\\nInformation presented in the Interest Rate and Price Risk Management section of Management’s Discussion and Analysis of Financial Condition and Results of Operations is incorporated herein by reference. This information contains certain statements that we believe are forward-looking statements. Refer to page 1 for cautionary information regarding forward-looking statements.\\n| Controls and Procedures (Item 4) |\\n\\nThe Bancorp conducted an evaluation, under the supervision and with the participation of the Bancorp’s management, including the Bancorp’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Bancorp’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based on the foregoing, as of the end of the period covered by this report, the Bancorp’s Chief Executive Officer and Chief Financial Officer concluded that the Bancorp’s disclosure controls and procedures were effective, in all material respects, to ensure that information required to be disclosed in the reports the Bancorp files and submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported as and when required and information is accumulated and communicated to the Bancorp’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.\\nThe Bancorp’s management also conducted an evaluation of internal control over financial reporting to determine whether any changes occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Bancorp’s internal control over financial reporting. Based on this evaluation there has been no such change during the period covered by this report.\\n69\\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (Item 1) |\\n\\n| CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited) |\\n| As of |\\n| June 30, | December 31, |\\n| ($ in millions, except share data) | 2021 | 2020 |\\n| Assets |\\n| Cash and due from banks | $ | 3,285 | 3,147 |\\n| Other short-term investments(a) | 32,409 | 33,399 |\\n| Available-for-sale debt and other securities(b) | 38,012 | 37,513 |\\n| Held-to-maturity securities(c) | 10 | 11 |\\n| Trading debt securities | 711 | 560 |\\n| Equity securities | 341 | 313 |\\n| Loans and leases held for sale(d) | 5,730 | 4,741 |\\n| Portfolio loans and leases(a)(e) | 107,733 | 108,782 |\\n| Allowance for loan and lease losses(a) | ( 2,033 ) | ( 2,453 ) |\\n| Portfolio loans and leases, net | 105,700 | 106,329 |\\n| Bank premises and equipment(f) | 2,073 | 2,088 |\\n| Operating lease equipment | 715 | 777 |\\n| Goodwill | 4,259 | 4,258 |\\n| Intangible assets | 117 | 139 |\\n| Servicing rights | 818 | 656 |\\n| Other assets(a) | 11,210 | 10,749 |\\n| Total Assets | $ | 205,390 | 204,680 |\\n| Liabilities |\\n| Deposits: |\\n| Noninterest-bearing deposits | $ | 62,760 | 57,711 |\\n| Interest-bearing deposits(g) | 99,523 | 101,370 |\\n| Total deposits | 162,283 | 159,081 |\\n| Federal funds purchased | 338 | 300 |\\n| Other short-term borrowings | 1,130 | 1,192 |\\n| Accrued taxes, interest and expenses | 2,045 | 2,614 |\\n| Other liabilities(a) | 4,304 | 3,409 |\\n| Long-term debt(a) | 12,364 | 14,973 |\\n| Total Liabilities | $ | 182,464 | 181,569 |\\n| Equity |\\n| Common stock(h) | $ | 2,051 | 2,051 |\\n| Preferred stock(i) | 2,116 | 2,116 |\\n| Capital surplus | 3,602 | 3,635 |\\n| Retained earnings | 19,343 | 18,384 |\\n| Accumulated other comprehensive income | 1,974 | 2,601 |\\n| Treasury stock(h) | ( 6,160 ) | ( 5,676 ) |\\n| Total Equity | $ | 22,926 | 23,111 |\\n| Total Liabilities and Equity | $ | 205,390 | 204,680 |\\n\\n(a) Includes $ 33 and $ 55 of other short-term investments, $ 455 and $ 756 of portfolio loans and leases, $( 3 ) and $( 7 ) of ALLL, $ 3 and $ 5 of other assets, $ 1 and $ 2 of other liabilities, and $ 400 and $ 656 of long-term debt from consolidated VIEs that are included in their respective captions above at June 30, 2021 and December 31, 2020, respectively. For further information, refer to Note 11.\\n(b) Amortized cost of $ 36,081 and $ 34,982 at June 30, 2021 and December 31, 2020, respectively.\\n(c) Fair value of $ 10 and $ 11 at June 30, 2021 and December 31, 2020, respectively.\\n(d) Includes $ 1,633 and $ 1,481 of residential mortgage loans held for sale measured at fair value at June 30, 2021 and December 31, 2020, respectively.\\n(e) Includes $ 151 and $ 161 of residential mortgage loans measured at fair value at June 30, 2021 and December 31, 2020, respectively.\\n(f) Includes $ 25 and $ 35 of bank premises and equipment held for sale at June 30, 2021 and December 31, 2020, respectively.\\n(g) Includes $ 341 and $ 351 of interest checking deposits held for sale at June 30, 2021 and December 31, 2020, respectively.\\n(h) Common shares: Stated value $ 2.22 per share; authorized 2,000,000,000 ; outstanding at June 30, 2021 – 703,739,634 (excludes 220,152,947 treasury shares), December 31, 2020 – 712,760,325 (excludes 211,132,256 treasury shares).\\n(i) 500,000 shares of no par value preferred stock were authorized at both June 30, 2021 and December 31, 2020. There were 422,000 unissued shares of undesignated no par value preferred stock at both June 30, 2021 and December 31, 2020. Each issued share of no par value preferred stock has a liquidation preference of $ 25,000 . 500,000 shares of no par value Class B preferred stock were authorized at both June 30, 2021 and December 31, 2020. There were 300,000 unissued shares of undesignated no par value Class B preferred stock at both June 30, 2021 and December 31, 2020. Each issued share of no par value Class B preferred stock has a liquidation preference of $ 1,000 .\\nRefer to the Notes to Condensed Consolidated Financial Statements.\\n70\\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\\n| CONDENSED CONSOLIDATED STATEMENTS OF INCOME (unaudited) |\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions, except share data) | 2021 | 2020 | 2021 | 2020 |\\n| Interest Income |\\n| Interest and fees on loans and leases | $ | 1,035 | 1,115 | 2,064 | 2,350 |\\n| Interest on securities | 279 | 283 | 543 | 566 |\\n| Interest on other short-term investments | 9 | 5 | 17 | 12 |\\n| Total interest income | 1,323 | 1,403 | 2,624 | 2,928 |\\n| Interest Expense |\\n| Interest on deposits | 15 | 83 | 36 | 248 |\\n| Interest on federal funds purchased | — | — | — | 2 |\\n| Interest on other short-term borrowings | — | 2 | 1 | 8 |\\n| Interest on long-term debt | 100 | 118 | 202 | 241 |\\n| Total interest expense | 115 | 203 | 239 | 499 |\\n| Net Interest Income | 1,208 | 1,200 | 2,385 | 2,429 |\\n| (Benefit from) provision for credit losses | ( 115 ) | 485 | ( 288 ) | 1,125 |\\n| Net Interest Income After (Benefit from) Provision for Credit Losses | 1,323 | 715 | 2,673 | 1,304 |\\n| Noninterest Income |\\n| Commercial banking revenue | 160 | 137 | 313 | 261 |\\n| Service charges on deposits | 149 | 122 | 292 | 270 |\\n| Wealth and asset management revenue | 145 | 120 | 288 | 255 |\\n| Card and processing revenue | 102 | 82 | 196 | 167 |\\n| Mortgage banking net revenue | 64 | 99 | 149 | 219 |\\n| Leasing business revenue | 61 | 57 | 148 | 131 |\\n| Other noninterest income | 49 | 12 | 92 | 18 |\\n| Securities gains (losses), net | 10 | 21 | 13 | ( 3 ) |\\n| Securities (losses) gains, net – non-qualifying hedges on mortgage servicing rights | 1 | — | ( 1 ) | 3 |\\n| Total noninterest income | 741 | 650 | 1,490 | 1,321 |\\n| Noninterest Expense |\\n| Compensation and benefits | 638 | 627 | 1,343 | 1,274 |\\n| Technology and communications | 94 | 90 | 187 | 183 |\\n| Net occupancy expense | 77 | 82 | 156 | 164 |\\n| Equipment expense | 34 | 32 | 68 | 64 |\\n| Leasing business expense | 33 | 33 | 68 | 68 |\\n| Card and processing expense | 20 | 29 | 50 | 60 |\\n| Marketing expense | 20 | 20 | 43 | 51 |\\n| Other noninterest expense | 237 | 208 | 454 | 457 |\\n| Total noninterest expense | 1,153 | 1,121 | 2,369 | 2,321 |\\n| Income Before Income Taxes | 911 | 244 | 1,794 | 304 |\\n| Applicable income tax expense | 202 | 49 | 391 | 61 |\\n| Net Income | 709 | 195 | 1,403 | 243 |\\n| Dividends on preferred stock | 35 | 32 | 55 | 50 |\\n| Net Income Available to Common Shareholders | $ | 674 | 163 | 1,348 | 193 |\\n| Earnings per share - basic | $ | 0.95 | 0.23 | 1.89 | 0.27 |\\n| Earnings per share - diluted | $ | 0.94 | 0.23 | 1.87 | 0.27 |\\n| Average common shares outstanding - basic | 708,832,787 | 714,766,570 | 711,617,331 | 714,161,131 |\\n| Average common shares outstanding - diluted | 718,084,745 | 717,571,890 | 720,740,176 | 718,967,293 |\\n\\nRefer to the Notes to Condensed Consolidated Financial Statements.\\n71\\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\\n| CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (unaudited) |\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Net Income | $ | 709 | 195 | 1,403 | 243 |\\n| Other Comprehensive (Loss) Income, Net of Tax: |\\n| Unrealized gains on available-for-sale debt securities: |\\n| Unrealized holding (losses) gains arising during period | 235 | 456 | ( 466 ) | 1,338 |\\n| Reclassification adjustment for net losses (gains) included in net income | ( 5 ) | — | 7 | — |\\n| Unrealized gains on cash flow hedge derivatives: |\\n| Unrealized holding (losses) gains arising during period | 9 | 66 | ( 55 ) | 493 |\\n| Reclassification adjustment for net gains included in net income | ( 58 ) | ( 49 ) | ( 115 ) | ( 74 ) |\\n| Defined benefit pension plans, net: |\\n| Net actuarial loss arising during the year | ( 1 ) | — | ( 1 ) | — |\\n| Reclassification of amounts to net periodic benefit costs | 2 | 1 | 3 | 2 |\\n| Other comprehensive (loss) income, net of tax | 182 | 474 | ( 627 ) | 1,759 |\\n| Comprehensive Income | $ | 891 | 669 | 776 | 2,002 |\\n\\nRefer to the Notes to Condensed Consolidated Financial Statements.\\n72\\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\\n| CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY (unaudited) |\\n| ($ in millions, except per share data) | CommonStock | PreferredStock | CapitalSurplus | RetainedEarnings | AccumulatedOtherComprehensiveIncome | TreasuryStock | TotalEquity |\\n| Balance at March 31, 2020 | $ | 2,051 | 1,770 | 3,597 | 17,677 | 2,477 | ( 5,699 ) | 21,873 |\\n| Net income | 195 | 195 |\\n| Other comprehensive income, net of tax | 474 | 474 |\\n| Cash dividends declared: |\\n| Common stock ($ 0.27 per share) | ( 195 ) | ( 195 ) |\\n| Preferred stock: |\\n| Series H ($ 637.50 per share) | ( 15 ) | ( 15 ) |\\n| Series I ($ 414.06 per share) | ( 7 ) | ( 7 ) |\\n| Series J ($ 289.38 per share) | ( 4 ) | ( 4 ) |\\n| Series K ($ 309.38 per share) | ( 3 ) | ( 3 ) |\\n| Class B, Series A ($ 15.00 per share) | ( 3 ) | ( 3 ) |\\n| Impact of stock transactions under stock compensation plans, net | 6 | 14 | 20 |\\n| Other | ( 2 ) | 2 | — |\\n| Balance at June 30, 2020 | $ | 2,051 | 1,770 | 3,603 | 17,643 | 2,951 | ( 5,683 ) | 22,335 |\\n| Balance at March 31, 2021 | $ | 2,051 | 2,116 | 3,592 | 18,863 | 1,792 | ( 5,819 ) | 22,595 |\\n| Net income | 709 | 709 |\\n| Other comprehensive income, net of tax | 182 | 182 |\\n| Cash dividends declared: |\\n| Common stock ($ 0.27 per share) | ( 192 ) | ( 192 ) |\\n| Preferred stock: |\\n| Series H ($ 637.50 per share) | ( 15 ) | ( 15 ) |\\n| Series I ($ 414.06 per share) | ( 7 ) | ( 7 ) |\\n| Series J ($ 210.44 per share) | ( 3 ) | ( 3 ) |\\n| Series K ($ 309.38 per share) | ( 3 ) | ( 3 ) |\\n| Series L ($ 281.25 per share) | ( 4 ) | ( 4 ) |\\n| Class B, Series A ($ 15.00 per share) | ( 3 ) | ( 3 ) |\\n| Shares acquired for treasury | ( 347 ) | ( 347 ) |\\n| Impact of stock transactions under stock compensation plans, net | 10 | 5 |\\n\\nQuantitative and Qualitative Disclosures about Market Risk (Item 3)\\nInformation presented in the Interest Rate and Price Risk Management section of Management’s Discussion and Analysis of Financial Condition and Results of Operations is incorporated herein by reference. This information contains certain statements that we believe are forward-looking statements. Refer to page 1 for cautionary information regarding forward-looking statements.\\nControls and Procedures (Item 4)\\nThe Bancorp conducted an evaluation, under the supervision and with the participation of the Bancorp’s management, including the Bancorp’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Bancorp’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based on the foregoing, as of the end of the period covered by this report, the Bancorp’s Chief Executive Officer and Chief Financial Officer concluded that the Bancorp’s disclosure controls and procedures were effective, in all material respects, to ensure that information required to be disclosed in the reports the Bancorp files and submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported as and when required and information is accumulated and communicated to the Bancorp’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.\\nThe Bancorp’s management also conducted an evaluation of internal control over financial reporting to determine whether any changes occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Bancorp’s internal control over financial reporting. Based on this evaluation there has been no such change during the period covered by this report.\\n69\\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (Item 1) |\\n\\n| CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited) |\\n| As of |\\n| June 30, | December 31, |\\n| ($ in millions, except share data) | 2021 | 2020 |\\n| Assets |\\n| Cash and due from banks | $ | 3,285 | 3,147 |\\n| Other short-term investments(a) | 32,409 | 33,399 |\\n| Available-for-sale debt and other securities(b) | 38,012 | 37,513 |\\n| Held-to-maturity securities(c) | 10 | 11 |\\n| Trading debt securities | 711 | 560 |\\n| Equity securities | 341 | 313 |\\n| Loans and leases held for sale(d) | 5,730 | 4,741 |\\n| Portfolio loans and leases(a)(e) | 107,733 | 108,782 |\\n| Allowance for loan and lease losses(a) | ( 2,033 ) | ( 2,453 ) |\\n| Portfolio loans and leases, net | 105,700 | 106,329 |\\n| Bank premises and equipment(f) | 2,073 | 2,088 |\\n| Operating lease equipment | 715 | 777 |\\n| Goodwill | 4,259 | 4,258 |\\n| Intangible assets | 117 | 139 |\\n| Servicing rights | 818 | 656 |\\n| Other assets(a) | 11,210 | 10,749 |\\n| Total Assets | $ | 205,390 | 204,680 |\\n| Liabilities |\\n| Deposits: |\\n| Noninterest-bearing deposits | $ | 62,760 | 57,711 |\\n| Interest-bearing deposits(g) | 99,523 | 101,370 |\\n| Total deposits | 162,283 | 159,081 |\\n| Federal funds purchased | 338 | 300 |\\n| Other short-term borrowings | 1,130 | 1,192 |\\n| Accrued taxes, interest and expenses | 2,045 | 2,614 |\\n| Other liabilities(a) | 4,304 | 3,409 |\\n| Long-term debt(a) | 12,364 | 14,973 |\\n| Total Liabilities | $ | 182,464 | 181,569 |\\n| Equity |\\n| Common stock(h) | $ | 2,051 | 2,051 |\\n| Preferred stock(i) | 2,116 | 2,116 |\\n| Capital surplus | 3,602 | 3,635 |\\n| Retained earnings | 19,343 | 18,384 |\\n| Accumulated other comprehensive income | 1,974 | 2,601 |\\n| Treasury stock(h) | ( 6,160 ) | ( 5,676 ) |\\n| Total Equity | $ | 22,926 | 23,111 |\\n| Total Liabilities and Equity | $ | 205,390 | 204,680 |\\n\\n(a) Includes $ 33 and $ 55 of other short-term investments, $ 455 and $ 756 of portfolio loans and leases, $( 3 ) and $( 7 ) of ALLL, $ 3 and $ 5 of other assets, $ 1 and $ 2 of other liabilities, and $ 400 and $ 656 of long-term debt from consolidated VIEs that are included in their respective captions above at June 30, 2021 and December 31, 2020, respectively. For further information, refer to Note 11.\\n(b) Amortized cost of $ 36,081 and $ 34,982 at June 30, 2021 and December 31, 2020, respectively.\\n(c) Fair value of $ 10 and $ 11 at June 30, 2021 and December 31, 2020, respectively.\\n(d) Includes $ 1,633 and $ 1,481 of residential mortgage loans held for sale measured at fair value at June 30, 2021 and December 31, 2020, respectively.\\n(e) Includes $ 151 and $ 161 of residential mortgage loans measured at fair value at June 30, 2021 and December 31, 2020, respectively.\\n(f) Includes $ 25 and $ 35 of bank premises and equipment held for sale at June 30, 2021 and December 31, 2020, respectively.\\n(g) Includes $ 341 and $ 351 of interest checking deposits held for sale at June 30, 2021 and December 31, 2020, respectively.\\n(h) Common shares: Stated value $ 2.22 per share; authorized 2,000,000,000 ; outstanding at June 30, 2021 – 703,739,634 (excludes 220,152,947 treasury shares), December 31, 2020 – 712,760,325 (excludes 211,132,256 treasury shares).\\n(i) 500,000 shares of no par value preferred stock were authorized at both June 30, 2021 and December 31, 2020. There were 422,000 unissued shares of undesignated no par value preferred stock at both June 30, 2021 and December 31, 2020. Each issued share of no par value preferred stock has a liquidation preference of $ 25,000 . 500,000 shares of no par value Class B preferred stock were authorized at both June 30, 2021 and December 31, 2020. There were 300,000 unissued shares of undesignated no par value Class B preferred stock at both June 30, 2021 and December 31, 2020. Each issued share of no par value Class B preferred stock has a liquidation preference of $ 1,000 .\\nRefer to the Notes to Condensed Consolidated Financial Statements.\\n70\\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\\n| CONDENSED CONSOLIDATED STATEMENTS OF INCOME (unaudited) |\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions, except share data) | 2021 | 2020 | 2021 | 2020 |\\n| Interest Income |\\n| Interest and fees on loans and leases | $ | 1,035 | 1,115 | 2,064 | 2,350 |\\n| Interest on securities | 279 | 283 | 543 | 566 |\\n| Interest on other short-term investments | 9 | 5 | 17 | 12 |\\n| Total interest income | 1,323 | 1,403 | 2,624 | 2,928 |\\n| Interest Expense |\\n| Interest on deposits | 15 | 83 | 36 | 248 |\\n| Interest on federal funds purchased | — | — | — | 2 |\\n| Interest on other short-term borrowings | — | 2 | 1 | 8 |\\n| Interest on long-term debt | 100 | 118 | 202 | 241 |\\n| Total interest expense | 115 | 203 | 239 | 499 |\\n| Net Interest Income | 1,208 | 1,200 | 2,385 | 2,429 |\\n| (Benefit from) provision for credit losses | ( 115 ) | 485 | ( 288 ) | 1,125 |\\n| Net Interest Income After (Benefit from) Provision for Credit Losses | 1,323 | 715 | 2,673 | 1,304 |\\n| Noninterest Income |\\n| Commercial banking revenue | 160 | 137 | 313 | 261 |\\n| Service charges on deposits | 149 | 122 | 292 | 270 |\\n| Wealth and asset management revenue | 145 | 120 | 288 | 255 |\\n| Card and processing revenue | 102 | 82 | 196 | 167 |\\n| Mortgage banking net revenue | 64 | 99 | 149 | 219 |\\n| Leasing business revenue | 61 | 57 | 148 | 131 |\\n| Other noninterest income | 49 | 12 | 92 | 18 |\\n| Securities gains (losses), net | 10 | 21 | 13 | ( 3 ) |\\n| Securities (losses) gains, net – non-qualifying hedges on mortgage servicing rights | 1 | — | ( 1 ) | 3 |\\n| Total noninterest income | 741 | 650 | 1,490 | 1,321 |\\n| Noninterest Expense |\\n| Compensation and benefits | 638 | 627 | 1,343 | 1,274 |\\n| Technology and communications | 94 | 90 | 187 | 183 |\\n| Net occupancy expense | 77 | 82 | 156 | 164 |\\n| Equipment expense | 34 | 32 | 68 | 64 |\\n| Leasing business expense | 33 | 33 | 68 | 68 |\\n| Card and processing expense | 20 | 29 | 50 | 60 |\\n| Marketing expense | 20 | 20 | 43 | 51 |\\n| Other noninterest expense | 237 | 208 | 454 | 457 |\\n| Total noninterest expense | 1,153 | 1,121 | 2,369 | 2,321 |\\n| Income Before Income Taxes | 911 | 244 | 1,794 | 304 |\\n| Applicable income tax expense | 202 | 49 | 391 | 61 |\\n| Net Income | 709 | 195 | 1,403 | 243 |\\n| Dividends on preferred stock | 35 | 32 | 55 | 50 |\\n| Net Income Available to Common Shareholders | $ | 674 | 163 | 1,348 | 193 |\\n| Earnings per share - basic | $ | 0.95 | 0.23 | 1.89 | 0.27 |\\n| Earnings per share - diluted | $ | 0.94 | 0.23 | 1.87 | 0.27 |\\n| Average common shares outstanding - basic | 708,832,787 | 714,766,570 | 711,617,331 | 714,161,131 |\\n| Average common shares outstanding - diluted | 718,084,745 | 717,571,890 | 720,740,176 | 718,967,293 |\\n\\nRefer to the Notes to Condensed Consolidated Financial Statements.\\n71\\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\\n| CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (unaudited) |\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Net Income | $ | 709 | 195 | 1,403 | 243 |\\n| Other Comprehensive (Loss) Income, Net of Tax: |\\n| Unrealized gains on available-for-sale debt securities: |\\n| Unrealized holding (losses) gains arising during period | 235 | 456 | ( 466 ) | 1,338 |\\n| Reclassification adjustment for net losses (gains) included in net income | ( 5 ) | — | 7 | — |\\n| Unrealized gains on cash flow hedge derivatives: |\\n| Unrealized holding (losses) gains arising during period | 9 | 66 | ( 55 ) | 493 |\\n| Reclassification adjustment for net gains included in net income | ( 58 ) | ( 49 ) | ( 115 ) | ( 74 ) |\\n| Defined benefit pension plans, net: |\\n| Net actuarial loss arising during the year | ( 1 ) | — | ( 1 ) | — |\\n| Reclassification of amounts to net periodic benefit costs | 2 | 1 | 3 | 2 |\\n| Other comprehensive (loss) income, net of tax | 182 | 474 | ( 627 ) | 1,759 |\\n| Comprehensive Income | $ | 891 | 669 | 776 | 2,002 |\\n\\nRefer to the Notes to Condensed Consolidated Financial Statements.\\n72\\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\\n| CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY (unaudited) |\\n| ($ in millions, except per share data) | CommonStock | PreferredStock | CapitalSurplus | RetainedEarnings | AccumulatedOtherComprehensiveIncome | TreasuryStock | TotalEquity |\\n| Balance at March 31, 2020 | $ | 2,051 | 1,770 | 3,597 | 17,677 | 2,477 | ( 5,699 ) | 21,873 |\\n| Net income | 195 | 195 |\\n| Other comprehensive income, net of tax | 474 | 474 |\\n| Cash dividends declared: |\\n| Common stock ($ 0.27 per share) | ( 195 ) | ( 195 ) |\\n| Preferred stock: |\\n| Series H ($ 637.50 per share) | ( 15 ) | ( 15 ) |\\n| Series I ($ 414.06 per share) | ( 7 ) | ( 7 ) |\\n| Series J ($ 289.38 per share) | ( 4 ) | ( 4 ) |\\n| Series K ($ 309.38 per share) | ( 3 ) | ( 3 ) |\\n| Class B, Series A ($ 15.00 per share) | ( 3 ) | ( 3 ) |\\n| Impact of stock transactions under stock compensation plans, net | 6 | 14 | 20 |\\n| Other | ( 2 ) | 2 | — |\\n| Balance at June 30, 2020 | $ | 2,051 | 1,770 | 3,603 | 17,643 | 2,951 | ( 5,683 ) | 22,335 |\\n| Balance at March 31, 2021 | $ | 2,051 | 2,116 | 3,592 | 18,863 | 1,792 | ( 5,819 ) | 22,595 |\\n| Net income | 709 | 709 |\\n| Other comprehensive income, net of tax | 182 | 182 |\\n| Cash dividends declared: |\\n| Common stock ($ 0.27 per share) | ( 192 ) | ( 192 ) |\\n| Preferred stock: |\\n| Series H ($ 637.50 per share) | ( 15 ) | ( 15 ) |\\n| Series I ($ 414.06 per share) | ( 7 ) | ( 7 ) |\\n| Series J ($ 210.44 per share) | ( 3 ) | ( 3 ) |\\n| Series K ($ 309.38 per share) | ( 3 ) | ( 3 ) |\\n| Series L ($ 281.25 per share) | ( 4 ) | ( 4 ) |\\n| Class B, Series A ($ 15.00 per share) | ( 3 ) | ( 3 ) |\\n| Shares acquired for treasury | ( 347 ) | ( 347 ) |\\n| Impact of stock transactions under stock compensation plans, net | 10 | 5 | 15 |\\n| Other | ( 2 ) | 1 | ( 1 ) |\\n| Balance at June 30, 2021 | $ | 2,051 | 2,116 | 3,602 | 19,343 | 1,974 | ( 6,160 ) | 22,926 |\\n\\n73\\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\\n| CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY (unaudited) |\\n| ($ in millions, except per share data) | CommonStock | PreferredStock | CapitalSurplus | RetainedEarnings | AccumulatedOtherComprehensiveIncome | TreasuryStock | TotalEquity |\\n| Balance at December 31, 2019 | $ | 2,051 | 1,770 | 3,599 | 18,315 | 1,192 | ( 5,724 ) | 21,203 |\\n| Impact of cumulative effect of change in accounting principle | ( 472 ) | ( 472 ) |\\n| Balance at January 1, 2020 | $ | 2,051 | 1,770 | 3,599 | 17,843 | 1,192 | ( 5,724 ) | 20,731 |\\n| Net income | 243 | 243 |\\n| Other comprehensive income, net of tax | 1,759 | 1,759 |\\n| Cash dividends declared: |\\n| Common stock ($ 0.54 per share) | ( 390 ) | ( 390 ) |\\n| Preferred stock: |\\n| Series H ($ 637.50 per share) | ( 15 ) | ( 15 ) |\\n| Series I ($ 828.12 per share) | ( 15 ) | ( 15 ) |\\n| Series J ($ 609.93 per share) | ( 8 ) | ( 8 ) |\\n| Series K ($ 618.76 per share) | ( 6 ) | ( 6 ) |\\n| Class B, Series A ($ 30.00 per share) | ( 6 ) | ( 6 ) |\\n| Impact of stock transactions under stock compensation plans, net | 4 | 39 | 43 |\\n| Other | ( 3 ) | 2 | ( 1 ) |\\n| Balance at June 30, 2020 | $ | 2,051 | 1,770 | 3,603 | 17,643 | 2,951 | ( 5,683 ) | 22,335 |\\n| Balance at December 31, 2020 | $ | 2,051 | 2,116 | 3,635 | 18,384 | 2,601 | ( 5,676 ) | 23,111 |\\n| Net income | 1,403 | 1,403 |\\n| Other comprehensive loss, net of tax | ( 627 ) | ( 627 ) |\\n| Cash dividends declared: |\\n| Common stock ($ 0.54 per share) | ( 387 ) | ( 387 ) |\\n| Preferred stock: |\\n| Series H ($ 637.50 per share) | ( 15 ) | ( 15 ) |\\n| Series I ($ 828.12 per share) | ( 15 ) | ( 15 ) |\\n| Series J ($ 421.94 per share) | ( 5 ) | ( 5 ) |\\n| Series K ($ 618.75 per share) | ( 6 ) | ( 6 ) |\\n| Series L ($ 562.50 per share) | ( 8 ) | ( 8 ) |\\n| Class B, Series A ($ 30.00 per share) | ( 6 ) | ( 6 ) |\\n| Shares acquired for treasury | ( 527 ) | ( 527 ) |\\n| Impact of stock transactions under stock compensation plans, net | ( 33 ) | 42 | 9 |\\n| Other | ( 2 ) | 1 | ( 1 ) |\\n| Balance at June 30, 2021 | $ | 2,051 | 2,116 | 3,602 | 19,343 | 1,974 | ( 6,160 ) | 22,926 |\\n\\nRefer to the Notes to Condensed Consolidated Financial Statements.\\n74\\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\\n| CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) |\\n| For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 |\\n| Operating Activities |\\n| Net income | $ | 1,403 | 243 |\\n| Adjustments to reconcile net income to net cash provided by operating activities: |\\n| (Benefit from) provision for credit losses | ( 288 ) | 1,125 |\\n| Depreciation, amortization and accretion | 243 | 231 |\\n| Stock-based compensation expense | 79 | 77 |\\n| Benefit from deferred income taxes | ( 239 ) | ( 48 ) |\\n| Securities gains, net | ( 9 ) | ( 6 ) |\\n| MSR fair value adjustment | 50 | 448 |\\n| Net gains on sales of loans and fair value adjustments on loans held for sale | ( 176 ) | ( 88 ) |\\n| Net losses on disposition and impairment of bank premises and equipment | 1 | 15 |\\n| Net losses (gains) on disposition and impairment of operating lease equipment | 20 | ( 5 ) |\\n| Proceeds from sales of loans held for sale | 7,974 | 6,234 |\\n| Loans originated or purchased for sale, net of repayments | ( 8,899 ) | ( 5,706 ) |\\n| Dividends representing return on equity investments | 20 | 6 |\\n| Net change in: |\\n| Equity and trading debt securities | ( 163 ) | 68 |\\n| Other assets | 232 | ( 529 ) |\\n| Accrued taxes, interest and expenses and other liabilities | ( 125 ) | ( 113 ) |\\n| Net Cash Provided by Operating Activities | 123 | 1,952 |\\n| Investing Activities |\\n| Proceeds from sales: |\\n| AFS securities and other investments | 1,454 | 868 |\\n| Loans and leases | 436 | 57 |\\n| Bank premises and equipment | 17 | 12 |\\n| Proceeds from repayments / maturities of AFS and HTM securities and other investments | 2,948 | 1,252 |\\n| Purchases: |\\n| AFS securities and other investments | ( 5,825 ) | ( 2,815 ) |\\n| Bank premises and equipment | ( 126 ) | ( 133 ) |\\n| MSRs | ( 109 ) | ( 30 ) |\\n| Proceeds from settlement of BOLI | 15 | 8 |\\n| Proceeds from sales and dividends representing return of equity investments | 29 | 8 |\\n| Net change in: |\\n| Other short-term investments | 990 | ( 26,293 ) |\\n| Portfolio loans and leases | 582 | ( 5,605 ) |\\n| Operating lease equipment | ( 23 ) | ( 20 ) |\\n| Net Cash Provided by (Used in) Investing Activities | 388 | ( 32,691 ) |\\n| Financing Activities |\\n| Net change in deposits | 3,202 | 29,884 |\\n| Net change in other short-term borrowings and federal funds purchased | 14 | 195 |\\n| Dividends paid on common and preferred stock | ( 444 ) | ( 417 ) |\\n| Proceeds from issuance of long-term debt | 44 | 2,511 |\\n| Repayment of long-term debt | ( 2,585 ) | ( 1,450 ) |\\n| Repurchases of treasury stock and related forward contract | ( 527 ) | — |\\n| Other | ( 77 ) | ( 41 ) |\\n| Net Cash (Used in) Provided by Financing Activities | ( 373 ) | 30,682 |\\n| Increase (Decrease) in Cash and Due from Banks | 138 | ( 57 ) |\\n| Cash and Due from Banks at Beginning of Period | 3,147 | 3,278 |\\n| Cash and Due from Banks at End of Period | $ | 3,285 | 3,221 |\\n\\nRefer to the Notes to Condensed Consolidated Financial Statements. Note 2 contains cash payments related to interest and income taxes in addition to non-cash investing and financing activities.\\n75\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n1. Basis of Presentation\\nThe Condensed Consolidated Financial Statements include the accounts of the Bancorp and its majority-owned subsidiaries and VIEs in which the Bancorp has been determined to be the primary beneficiary. Other entities, including certain joint ventures in which the Bancorp has the ability to exercise significant influence over operating and financial policies of the investee, but upon which the Bancorp does not possess control, are accounted for by the equity method and not consolidated. The investments in those entities in which the Bancorp does not have the ability to exercise significant influence are generally carried at fair value unless the investment does not have a readily determinable fair value. The Bancorp accounts for equity investments without a readily determinable fair value using the measurement alternative to fair value, representing the cost of the investment minus impairment recorded, if any, plus or minus changes resulting from observable price changes in orderly transactions for an identical or a similar investment of the same issuer. Intercompany transactions and balances among consolidated entities have been eliminated.\\nIn the opinion of management, the unaudited Condensed Consolidated Financial Statements include all adjustments, which consist of normal recurring accruals, necessary to present fairly the results for the periods presented. In accordance with U.S. GAAP and the rules and regulations of the SEC for interim financial information, these statements do not include certain information and footnote disclosures required for complete annual financial statements and it is suggested that these Condensed Consolidated Financial Statements be read in conjunction with the Bancorp’s Annual Report on Form 10-K. The results of operations, comprehensive income and changes in equity for the three and six months ended June 30, 2021 and 2020 and the cash flows for the six months ended June 30, 2021 and 2020 are not necessarily indicative of the results to be expected for the full year. Financial information as of December 31, 2020 has been derived from the Bancorp’s Annual Report on Form 10-K.\\nThe preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.\\n2. Supplemental Cash Flow Information\\nCash payments related to interest and income taxes in addition to non-cash investing and financing activities are presented in the following table for the six months ended June 30:\\n| ($ in millions) | 2021 | 2020 |\\n| Cash Payments: |\\n| Interest | $ | 256 | 528 |\\n| Income taxes | 336 | 268 |\\n| Transfers: |\\n| Portfolio loans and leases to loans and leases held for sale(a) | $ | 337 | 31 |\\n| Loans and leases held for sale to portfolio loans and leases | 20 | 29 |\\n| Portfolio loans and leases to OREO | 9 | 6 |\\n| Loans and leases held for sale to OREO | — | 2 |\\n| Bank premises and equipment to OREO | 17 | — |\\n| Supplemental Disclosures: |\\n| Net additions to lease liabilities under operating leases | $ | 31 | 27 |\\n| Net additions to lease liabilities under finance leases | 25 | 76 |\\n\\n(a) Includes $ 139 of residential mortgage loans previously sold to GNMA which the Bancorp was initially deemed to have regained effective control over under ASC Topic 860 and which were recorded as portfolio loans. The Bancorp subsequently repurchased these loans and classified them as held for sal e.\\n76\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n3. Accounting and Reporting Developments\\nStandards Adopted in 2021\\nThe Bancorp adopted the following new accounting standard during the six months ended June 30, 2021:\\nASU 2019-12 – Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes\\nIn December 2019, the FASB issued ASU 2019-12, which simplifies the accounting for income taxes by removing certain exceptions to the general principles in Topic 740. The amendments also clarify and amend existing guidance for other areas of Topic 740. The Bancorp adopted the amended guidance on January 1, 2021 on a modified retrospective basis, except for certain provisions of the amended guidance which were required to be adopted prospectively. The adoption of the amended guidance did not have a material impact on the Condensed Consolidated Financial Statements.\\nReference Rate Reform and LIBOR Transition\\nIn March 2020, the FASB issued ASU 2020-04, which provides optional expedients and exceptions for applying U.S. GAAP to contracts, hedging relationships and other transactions affected by reference rate reform if certain criteria are met. The amendments in the ASU apply only to contracts, hedging relationships and other transactions that reference LIBOR or another reference rate expected to be discontinued because of reference rate reform. Subsequently, in January 2021, the FASB issued ASU 2021-01, which clarified that the optional expedients and exceptions in Topic 848 for contract modifications and hedge accounting also apply to derivatives that are affected by the discounting transition. The expedients and exceptions provided by the amendments do not apply to contract modifications made and hedging relationships entered into or evaluated after December 31, 2022, except for hedging relationships existing as of December 31, 2022 for which an entity has elected certain optional expedients and that are retained through the end of the hedging relationship. The amendments in this ASU are effective for the Bancorp as of March 12, 2020 through December 31, 2022. The Bancorp is in the process of evaluating and applying, as applicable, the optional expedients and exceptions in accounting for eligible contract modifications, eligible existing hedging relationships and new hedging relationships available through December 31, 2022.\\n77\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n4. Investment Securities\\nThe following tables provide the amortized cost, unrealized gains and losses and fair value for the major categories of the available-for-sale debt and other securities and held-to-maturity securities portfolios as of:\\n| June 30, 2021 ($ in millions) | AmortizedCost | UnrealizedGains | UnrealizedLosses | FairValue |\\n| Available-for-sale debt and other securities: |\\n| U.S. Treasury and federal agencies securities | $ | 105 | 2 | — | 107 |\\n| Obligations of states and political subdivisions securities | 18 | — | — | 18 |\\n| Mortgage-backed securities: |\\n| Agency residential mortgage-backed securities | 10,256 | 573 | ( 20 ) | 10,809 |\\n| Agency commercial mortgage-backed securities | 18,142 | 1,188 | ( 36 ) | 19,294 |\\n| Non-agency commercial mortgage-backed securities | 3,276 | 203 | — | 3,479 |\\n| Asset-backed securities and other debt securities | 3,764 | 48 | ( 27 ) | 3,785 |\\n| Other securities(a) | 520 | — | — | 520 |\\n| Total available-for-sale debt and other securities | $ | 36,081 | 2,014 | ( 83 ) | 38,012 |\\n| Held-to-maturity securities: |\\n| Obligations of states and political subdivisions securities | $ | 9 | — | — | 9 |\\n| Asset-backed securities and other debt securities | 1 | — | — | 1 |\\n| Total held-to-maturity securities | $ | 10 | — | — | 10 |\\n\\n(a)Other securities consist of FHLB, FRB and DTCC restricted stock holdings of $ 33 , $ 485 and $ 2 , respectively, at June 30, 2021, that are carried at cost.\\n| December 31, 2020 ($ in millions) | AmortizedCost | UnrealizedGains | UnrealizedLosses | FairValue |\\n| Available-for-sale debt and other securities: |\\n| U.S. Treasury and federal agencies securities | $ | 74 | 4 | — | 78 |\\n| Obligations of states and political subdivisions securities | 17 | — | — | 17 |\\n| Mortgage-backed securities: |\\n| Agency residential mortgage-backed securities | 11,147 | 768 | ( 8 ) | 11,907 |\\n| Agency commercial mortgage-backed securities | 16,745 | 1,481 | ( 5 ) | 18,221 |\\n| Non-agency commercial mortgage-backed securities | 3,323 | 267 | — | 3,590 |\\n| Asset-backed securities and other debt securities | 3,152 | 48 | ( 24 ) | 3,176 |\\n| Other securities(a) | 524 | — | — | 524 |\\n| Total available-for-sale debt and other securities | $ | 34,982 | 2,568 | ( 37 ) | 37,513 |\\n| Held-to-maturity securities: |\\n| Obligations of states and political subdivisions securities | $ | 9 | — | — | 9 |\\n| Asset-backed securities and other debt securities | 2 | — | — | 2 |\\n| Total held-to-maturity securities | $ | 11 | — | — | 11 |\\n\\n(a)Other securities consist of FHLB, FRB and DTCC restricted stock holdings of $ 40 , $ 482 and $ 2 , respectively, at December 31, 2020, that are carried at cost.\\nThe following table provides the fair value of trading debt securities and equity securities as of:\\n| ($ in millions) | June 30,2021 | December 31,2020 |\\n| Trading debt securities | $ | 711 | 560 |\\n| Equity securities | 341 | 313 |\\n\\nThe amounts reported in the preceding tables exclude accrued interest receivable on investment securities of $ 86 million and $ 87 million at June 30, 2021 and December 31, 2020, respectively, which are presented as a component of other assets in the Condensed Consolidated Balance Sheets.\\nThe Bancorp uses investment securities as a means of managing interest rate risk, providing collateral for pledging purposes and for liquidity to satisfy regulatory requirements. As part of managing interest rate risk, the Bancorp acquires securities as a component of its MSR non-qualifying hedging strategy, with net gains or losses recorded in securities (losses) gains, net – non-qualifying hedges on mortgage servicing rights in the Condensed Consolidated Statements of Income.\\n78\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nThe following table presents securities gains (losses) recognized in the Condensed Consolidated Statements of Income:\\n| For the three months ended June 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Available-for-sale debt and other securities: |\\n| Realized gains | $ | 7 | — | 8 | 1 |\\n| Realized losses | — | — | ( 10 ) | ( 1 ) |\\n| Impairment losses | — | — | ( 7 ) | — |\\n| Net (losses) gains on available-for sale debt and other securities | $ | 7 | — | ( 9 ) | — |\\n| Total trading debt securities (losses) gains | $ | ( 7 ) | — | — | 3 |\\n| Total equity securities gains (losses)(a) | $ | 11 | 21 | 21 | ( 3 ) |\\n| Total gains recognized in income from available-for-sale debt and other securities, trading debt securities and equity securities(b) | $ | 11 | 21 | 12 | — |\\n\\n(a)Includes net unrealized gains of $ 10 and $ 17 for the three and six months ended June 30, 2021, respectively, and net unrealized gains of $ 21 and net unrealized losses of $ 2 for the three and six months ended June 30, 2020, respectively.\\n(b)Excludes $ 1 and $ 3 of net securities losses for the three and six months ended June 30, 2021, respectively, and $ 8 and $ 6 of net securities gains for the three and six months ended June 30, 2020, respectively, related to securities held by FTS to facilitate the timely execution of customer transactions. These losses and gains are included in commercial banking revenue and wealth and asset management revenue in the Condensed Consolidated Statements of Income.\\nIn the first quarter of 2021, the Bancorp recognized impairment losses on available-for-sale debt and other securities of $ 7 million. These losses related to certain securities in unrealized loss positions that the Bancorp intended to sell prior to recovery of their amortized cost bases. The Bancorp did not consider these losses to be credit-related.\\nAt both June 30, 2021 and December 31, 2020, the Bancorp completed its evaluation of the available-for-sale debt and other securities in an unrealized loss position and did not recognize an allowance for credit losses. The Bancorp did not recognize provision expense related to available-for-sale debt and other securities in an unrealized loss position during both the three and six months ended June 30, 2021 and 2020.\\nAt both June 30, 2021 and December 31, 2020, investment securities with a fair value of $ 11.0 billion were pledged to secure borrowings, public deposits, trust funds, derivative contracts and for other purposes as required or permitted by law.\\nThe expected maturity distribution of the Bancorp’s mortgage-backed securities and the contractual maturity distribution of the remainder of the Bancorp’s available-for-sale debt and other securities and held-to-maturity securities as of June 30, 2021 are shown in the following table:\\n| ($ in millions) | Available-for-Sale Debt and Other | Held-to-Maturity |\\n| Amortized Cost | Fair Value | Amortized Cost | Fair Value |\\n| Debt securities:(a) |\\n| Less than 1 year | $ | 886 | 907 | 4 | 4 |\\n| 1-5 years | 14,074 | 14,825 | 4 | 4 |\\n| 5-10 years | 11,482 | 12,349 | — | — |\\n| Over 10 years | 9,119 | 9,411 | 2 | 2 |\\n| Other securities | 520 | 520 | — | — |\\n| Total | $ | 36,081 | 38,012 | 10 | 10 |\\n\\n(a)Actual maturities may differ from contractual maturities when a right to call or prepay obligations exists with or without call or prepayment penalties.\\n79\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nThe following table provides the fair value and gross unrealized losses on available-for-sale debt and other securities in an unrealized loss position, aggregated by investment category and length of time the individual securities have been in a continuous unrealized loss position as of:\\n| Less than 12 months | 12 months or more | Total |\\n| ($ in millions) | Fair Value | UnrealizedLosses | Fair Value | UnrealizedLosses | Fair Value | UnrealizedLosses |\\n| June 30, 2021 |\\n| Agency residential mortgage-backed securities | $ | 701 | ( 20 ) | 1 | — | 702 | ( 20 ) |\\n| Agency commercial mortgage-backed securities | 1,632 | ( 36 ) | — | — | 1,632 | ( 36 ) |\\n| Non-agency commercial mortgage-backed securities | 1 | — | — | — | 1 | — |\\n| Asset-backed securities and other debt securities | 435 | ( 7 ) | 843 | ( 20 ) | 1,278 | ( 27 ) |\\n| Total | $ | 2,769 | ( 63 ) | 844 | ( 20 ) | 3,613 | ( 83 ) |\\n| December 31, 2020 |\\n| Agency residential mortgage-backed securities | $ | 426 | ( 8 ) | 1 | — | 427 | ( 8 ) |\\n| Agency commercial mortgage-backed securities | 388 | ( 5 ) | — | — | 388 | ( 5 ) |\\n| Non-agency commercial mortgage-backed securities | 2 | — | — | — | 2 | — |\\n| Asset-backed securities and other debt securities | 520 | ( 7 ) | 603 | ( 17 ) | 1,123 | ( 24 ) |\\n| Total | $ | 1,336 | ( 20 ) | 604 | ( 17 ) | 1,940 | ( 37 ) |\\n\\nAt both June 30, 2021 and December 31, 2020, $ 1 million of unrealized losses in the available-for-sale debt and other securities portfolio were represented by non-rated securities.\\n80\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n5. Loans and Leases\\nThe Bancorp diversifies its loan and lease portfolio by offering a variety of loan and lease products with various payment terms and rate structures. The Bancorp’s commercial loan and lease portfolio consists of lending to various industry types. Management periodically reviews the performance of its loan and lease products to evaluate whether they are performing within acceptable interest rate and credit risk levels and changes are made to underwriting policies and procedures as needed. The Bancorp maintains an allowance to absorb loan and lease losses that are expected to be incurred over the remaining contractual terms of the related loans and leases. For further information on credit quality and the ALLL, refer to Note 6.\\nThe following table provides a summary of commercial loans and leases classified by primary purpose and consumer loans classified based upon product or collateral as of:\\n| ($ in millions) | June 30,2021 | December 31,2020 |\\n| Loans and leases held for sale: |\\n| Commercial and industrial loans | $ | 11 | 230 |\\n| Commercial mortgage loans | 33 | 7 |\\n| Commercial construction loans | 2 | — |\\n| Commercial leases | — | 39 |\\n| Residential mortgage loans | 5,684 | 4,465 |\\n| Total loans and leases held for sale | $ | 5,730 | 4,741 |\\n| Portfolio loans and leases: |\\n| Commercial and industrial loans(a) | $ | 47,564 | 49,665 |\\n| Commercial mortgage loans | 10,347 | 10,602 |\\n| Commercial construction loans | 5,871 | 5,815 |\\n| Commercial leases | 3,238 | 2,915 |\\n| Total commercial loans and leases | $ | 67,020 | 68,997 |\\n| Residential mortgage loans(b) | $ | 16,131 | 15,928 |\\n| Home equity | 4,545 | 5,183 |\\n| Indirect secured consumer loans | 15,192 | 13,653 |\\n| Credit card | 1,793 | 2,007 |\\n| Other consumer loans | 3,052 | 3,014 |\\n| Total consumer loans | $ | 40,713 | 39,785 |\\n| Total portfolio loans and leases | $ | 107,733 | 108,782 |\\n\\n(a)Includes $ 3.7 billion and $ 4.8 billion as of June 30, 2021 and December 31, 2020, respectively, related to the SBA’s Paycheck Protection Program.\\n(b)Includes $ 39 as of December 31, 2020 of residential mortgage loans previously sold to GNMA for which the Bancorp was deemed to have regained effective control over under ASC Topic 860, but did not exercise its option to repurchase. Refer to Note 14 for further information.\\nPortfolio loans and leases are recorded net of unearned income, which totaled $ 274 million as of June 30, 2021 and $ 280 million as of December 31, 2020. Additionally, portfolio loans and leases are recorded net of unamortized premiums and discounts, deferred direct loan origination fees and costs and fair value adjustments (associated with acquired loans or loans designated as fair value upon origination), which totaled a net premium of $ 356 million and $ 251 million as of June 30, 2021 and December 31, 2020, respectively. The amortized cost basis of loans and leases excludes accrued interest receivable of $ 372 million and $ 350 million at June 30, 2021 and December 31, 2020, respectively, which is presented as a component of other assets in the Condensed Consolidated Balance Sheets.\\nThe Bancorp’s FHLB and FRB borrowings are primarily secured by loans. The Bancorp had loans of $ 15.2 billion and $ 15.5 billion at June 30, 2021 and December 31, 2020, respectively, pledged at the FHLB, and loans of $ 42.0 billion and $ 37.8 billion at June 30, 2021 and December 31, 2020, respectively, pledged at the FRB.\\n81\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nThe following table presents a summary of the total loans and leases owned by the Bancorp as of:\\n| Carrying Value | 90 Days Past Dueand Still Accruing |\\n| ($ in millions) | June 30,2021 | December 31,2020 | June 30,2021 | December 31,2020 |\\n| Commercial and industrial loans | $ | 47,575 | 49,895 | 2 | 39 |\\n| Commercial mortgage loans | 10,380 | 10,609 | 4 | 8 |\\n| Commercial construction loans | 5,873 | 5,815 | — | — |\\n| Commercial leases | 3,238 | 2,954 | — | 1 |\\n| Residential mortgage loans | 21,815 | 20,393 | 57 | 70 |\\n| Home equity | 4,545 | 5,183 | 1 | 2 |\\n| Indirect secured consumer loans | 15,192 | 13,653 | 4 | 10 |\\n| Credit card | 1,793 | 2,007 | 14 | 31 |\\n| Other consumer loans | 3,052 | 3,014 | 1 | 2 |\\n| Total loans and leases | $ | 113,463 | 113,523 | 83 | 163 |\\n| Less: Loans and leases held for sale | $ | 5,730 | 4,741 |\\n| Total portfolio loans and leases | $ | 107,733 | 108,782 |\\n\\nThe following table presents a summary of net charge-offs (recoveries):\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Commercial and industrial loans | $ | 13 | 65 | 40 | 115 |\\n| Commercial mortgage loans | 6 | 2 | 8 | 4 |\\n| Commercial leases | ( 2 ) | 11 | ( 2 ) | 16 |\\n| Residential mortgage loans | — | 1 | ( 1 ) | 2 |\\n| Home equity | ( 1 ) | 1 | ( 1 ) | 4 |\\n| Indirect secured consumer loans | — | 7 | 9 | 20 |\\n| Credit card | 20 | 34 | 45 | 71 |\\n| Other consumer loans | 8 | 9 | 17 | 20 |\\n| Total net charge-offs | $ | 44 | 130 | 115 | 252 |\\n\\nThe Bancorp engages in commercial lease products primarily related to the financing of commercial equipment. Leases are classified as sales-type if the Bancorp transfers control of the underlying asset to the lessee. The Bancorp classifies leases that do not meet any of the criteria for a sales-type lease as a direct financing lease if the present value of the sum of the lease payments and any residual value guaranteed by the lessee and/or any other third party equals or exceeds substantially all of the fair value of the underlying asset and the collection of the lease payments and residual value guarantee is probable.\\nThe following table presents the components of the net investment in leases as of:\\n| ($ in millions)(a) | June 30,2021 | December 31, 2020 |\\n| Net investment in direct financing leases: |\\n| Lease payment receivable (present value) | $ | 1,161 | 1,400 |\\n| Unguaranteed residual assets (present value) | 167 | 181 |\\n| Net discount on acquired leases | — | ( 1 ) |\\n| Net investment in sales-type leases: |\\n| Lease payment receivable (present value) | 1,551 | 976 |\\n| Unguaranteed residual assets (present value) | 48 | 36 |\\n\\n(a)Excludes $ 311 and $ 323 of leveraged leases at June 30, 2021 and December 31, 2020, respectively.\\nInterest income recognized in the Condensed Consolidated Statements of Income for the three and six months ended June 30, 2021 was $ 11 million and $ 23 million, respectively, for direct financing leases and $ 10 million and $ 20 million, respectively, for sales-type leases. For the three and six months ended June 30, 2020, interest income recognized was $ 17 million and $ 35 million, respectively, for direct financing leases and $ 6 million and $ 13 million, respectively, for sales-type leases.\\n82\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nThe following table presents undiscounted cash flows for both direct financing and sales-type leases for the remainder of 2021 through 2026 and thereafter as well as a reconciliation of the undiscounted cash flows to the total lease receivables as follows:\\n| As of June 30, 2021 ($ in millions) | Direct FinancingLeases | Sales-Type Leases |\\n| Remainder of 2021 | $ | 216 | 278 |\\n| 2022 | 350 | 479 |\\n| 2023 | 224 | 288 |\\n| 2024 | 160 | 216 |\\n| 2025 | 114 | 150 |\\n| 2026 | 69 | 82 |\\n| Thereafter | 105 | 165 |\\n| Total undiscounted cash flows | $ | 1,238 | 1,658 |\\n| Less: Difference between undiscounted cash flows and discounted cash flows | 77 | 107 |\\n| Present value of lease payments (recognized as lease receivables) | $ | 1,161 | 1,551 |\\n\\nThe lease residual value represents the present value of the estimated fair value of the leased equipment at the end of the lease. The Bancorp performs quarterly reviews of residual values associated with its leasing portfolio considering factors such as the subject equipment, structure of the transaction, industry, prior experience with the lessee and other factors that impact the residual value to assess for impairment. The Bancorp maintained an allowance of $ 24 million and $ 29 million at June 30, 2021 and December 31, 2020, respectively, to cover the losses that are expected to be incurred over the remaining contractual terms of the related leases, including the potential losses related to the residual value, in the net investment in leases. Refer to Note 6 for additional information on credit quality and the ALLL.\\n83\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n6. Credit Quality and the Allowance for Loan and Lease Losses\\nThe Bancorp disaggregates ALLL balances and transactions in the ALLL by portfolio segment. Credit quality related disclosures for loans and leases are further disaggregated by class.\\nAllowance for Loan and Lease Losses\\nThe following tables summarize transactions in the ALLL by portfolio segment:\\n| For the three months ended June 30, 2021 ($ in millions) | Commercial | ResidentialMortgage | Consumer | Total |\\n| Balance, beginning of period | $ | 1,329 | 247 | 632 | 2,208 |\\n| Losses charged off(a) | ( 45 ) | ( 1 ) | ( 57 ) | ( 103 ) |\\n| Recoveries of losses previously charged off(a) | 28 | 1 | 30 | 59 |\\n| Benefit from loan and lease losses | ( 88 ) | ( 12 ) | ( 31 ) | ( 131 ) |\\n| Balance, end of period | $ | 1,224 | 235 | 574 | 2,033 |\\n\\n(a)The Bancorp recorded $ 8 in both losses charged off and recoveries of losses previously charged off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements.\\n| For the three months ended June 30, 2020 ($ in millions) | Commercial | ResidentialMortgage | Consumer | Total |\\n| Balance, beginning of period | $ | 1,313 | 260 | 775 | 2,348 |\\n| Losses charged off(a) | ( 81 ) | ( 2 ) | ( 80 ) | ( 163 ) |\\n| Recoveries of losses previously charged off(a) | 3 | 1 | 29 | 33 |\\n| Provision for loan and lease losses(b) | 267 | 68 | 143 | 478 |\\n| Balance, end of period | $ | 1,502 | 327 | 867 | 2,696 |\\n\\n(a)The Bancorp recorded $ 9 in both losses charged off and recoveries of losses previously charged off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements.\\n(b)Includes $ 1 in Residential Mortgage related to the initial recognition of an ALLL on PCD loans.\\n| For the six months ended June 30, 2021 ($ in millions) | Commercial | ResidentialMortgage | Consumer | Total |\\n| Balance, beginning of period | $ | 1,456 | 294 | 703 | 2,453 |\\n| Losses charged off(a) | ( 81 ) | ( 2 ) | ( 128 ) | ( 211 ) |\\n| Recoveries of losses previously charged off(a) | 35 | 3 | 58 | 96 |\\n| Benefit from loan and lease losses | ( 186 ) | ( 60 ) | ( 59 ) | ( 305 ) |\\n| Balance, end of period | $ | 1,224 | 235 | 574 | 2,033 |\\n\\n(a)The Bancorp recorded $ 18 in both losses charged off and recoveries of losses previously charged off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements.\\n| For the six months ended June 30, 2020 ($ in millions) | Commercial | Residential Mortgage | Consumer | Unallocated | Total |\\n| Balance, beginning of period | $ | 710 | 73 | 298 | 121 | 1,202 |\\n| Impact of adoption of ASU 2016-13(a) | 160 | 196 | 408 | ( 121 ) | 643 |\\n| Losses charged off(b) | ( 142 ) | ( 4 ) | ( 176 ) | — | ( 322 ) |\\n| Recoveries of losses previously charged off(b) | 7 | 2 | 61 | — | 70 |\\n| Provision for loan and lease losses | 767 | 60 | 276 | — | 1,103 |\\n| Balance, end of period | $ | 1,502 | 327 | 867 | — | 2,696 |\\n\\n(a)Includes $ 31 , $ 2 and $ 1 in Commercial, Residential Mortgage and Consumer, respectively, related to the initial recognition of an ALLL on PCD loans.\\n(b)The Bancorp recorded $ 22 in both losses charged off and recoveries of losses previously charged off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements.\\n84\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nThe following tables provide a summary of the ALLL and related loans and leases classified by portfolio segment:\\n| As of June 30, 2021 ($ in millions) | Commercial | ResidentialMortgage | Consumer | Total |\\n| ALLL:(a) |\\n| Individually evaluated | $ | 101 | 55 | 38 | 194 |\\n| Collectively evaluated | 1,123 | 180 | 536 | 1,839 |\\n| Total ALLL | $ | 1,224 | 235 | 574 | 2,033 |\\n| Portfolio loans and leases:(b) |\\n| Individually evaluated | $ | 629 | 539 | 295 | 1,463 |\\n| Collectively evaluated | 66,391 | 15,441 | 24,287 | 106,119 |\\n| Total portfolio loans and leases | $ | 67,020 | 15,980 | 24,582 | 107,582 |\\n\\n(a)Includes $ 3 related to commercial leveraged leases at June 30, 2021.\\n(b)Excludes $ 151 of residential mortgage loans measured at fair value and includes $ 311 of commercial leveraged leases, net of unearned income at June 30, 2021.\\n| As of December 31, 2020 ($ in millions) | Commercial | ResidentialMortgage | Consumer | Total |\\n| ALLL:(a) |\\n| Individually evaluated | $ | 114 | 68 | 43 | 225 |\\n| Collectively evaluated | 1,342 | 226 | 660 | 2,228 |\\n| Total ALLL | $ | 1,456 | 294 | 703 | 2,453 |\\n| Portfolio loans and leases:(b) |\\n| Individually evaluated | $ | 962 | 628 | 273 | 1,863 |\\n| Collectively evaluated | 67,701 | 15,073 | 23,569 | 106,343 |\\n| Purchased credit deteriorated(c) | 334 | 66 | 15 | 415 |\\n| Total portfolio loans and leases | $ | 68,997 | 15,767 | 23,857 | 108,621 |\\n\\n(a)Includes $ 3 related to commercial leveraged leases at December 31, 2020.\\n(b)Excludes $ 161 of residential mortgage loans measured at fair value and includes $ 323 of commercial leveraged leases, net of unearned income at December 31, 2020.\\n(c)Includes $ 39 , as of December 31, 2020, of residential mortgage loans previously sold to GNMA for which the Bancorp was deemed to have regained effective control over under ASC Topic 860, but did not exercise its option to repurchase. Refer to Note 14 for further information.\\nCREDIT RISK PROFILE\\nCommercial Portfolio Segment\\nFor purposes of monitoring the credit quality and risk characteristics of its commercial portfolio segment, the Bancorp disaggregates the segment into the following classes: commercial and industrial, commercial mortgage owner-occupied, commercial mortgage nonowner-occupied, commercial construction and commercial leases.\\nTo facilitate the monitoring of credit quality within the commercial portfolio segment, the Bancorp utilizes the following categories of credit grades: pass, special mention, substandard, doubtful and loss. The five categories, which are derived from standard regulatory rating definitions, are assigned upon initial approval of credit to borrowers and updated periodically thereafter.\\nPass ratings, which are assigned to those borrowers that do not have identified potential or well-defined weaknesses and for which there is a high likelihood of orderly repayment, are updated at least annually based on the size and credit characteristics of the borrower. All other categories are updated on a quarterly basis during the month preceding the end of the calendar quarter.\\nThe Bancorp assigns a special mention rating to loans and leases that have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may, at some future date, result in the deterioration of the repayment prospects for the loan or lease or the Bancorp’s credit position.\\nThe Bancorp assigns a substandard rating to loans and leases that are inadequately protected by the current sound worth and paying capacity of the borrower or of the collateral pledged. Substandard loans and leases have well-defined weaknesses or weaknesses that could jeopardize the orderly repayment of the debt. Loans and leases in this grade also are characterized by the distinct possibility that the Bancorp will sustain some loss if the deficiencies noted are not addressed and corrected.\\nThe Bancorp assigns a doubtful rating to loans and leases that have all the attributes of a substandard rating with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. The possibility of loss is extremely high, but because of certain important and reasonable specific pending factors that may work to the advantage of and strengthen the credit quality of the loan or lease, its classification as an estimated loss is deferred until its more exact\\n85\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nstatus may be determined. Pending factors may include a proposed merger or acquisition, liquidation proceeding, capital injection, perfecting liens on additional collateral or refinancing plans.\\nLoans and leases classified as loss are considered uncollectible and are charged off in the period in which they are determined to be uncollectible. Because loans and leases in this category are fully charged off, they are not included in the following tables.\\nFor loans and leases that are collectively evaluated, the Bancorp utilizes models to forecast expected credit losses over a reasonable and supportable forecast period based on the probability of a loan or lease defaulting, the expected balance at the estimated date of default and the expected loss percentage given a default. For the commercial portfolio segment, the estimates for probability of default are primarily based on internal ratings assigned to each commercial borrower on a 13-point scale and historical observations of how those ratings migrate to a default over time in the context of macroeconomic conditions. For loans with available credit, the estimate of the expected balance at the time of default considers expected utilization rates, which are primarily based on macroeconomic conditions and the utilization history of similar borrowers under those economic conditions. The estimates for loss severity are primarily based on collateral type and coverage levels and the susceptibility of those characteristics to changes in macroeconomic conditions. For more information about the Bancorp’s processes for developing these models, estimating credit losses for periods beyond the reasonable and supportable forecast period and for estimating credit losses for individually evaluated loans, refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\\n86\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nThe following tables present the amortized cost basis of the Bancorp’s commercial portfolio segment, by class and vintage, disaggregated by credit risk grade:\\n| As of June 30, 2021 ($ in millions) | Term Loans and Leases by Origination Year | Revolving Loans | Revolving Loans Converted to Term Loans |\\n| 2021 | 2020 | 2019 | 2018 | 2017 | Prior | Total |\\n| Commercial and industrial loans: |\\n| Pass | $ | 3,164 | 4,183 | 1,733 | 743 | 466 | 928 | 32,500 | — | 43,717 |\\n| Special mention | 17 | 33 | 35 | 26 | 30 | 21 | 1,210 | — | 1,372 |\\n| Substandard | 26 | 92 | 59 | 119 | 70 | 109 | 2,000 | — | 2,475 |\\n| Doubtful | — | — | — | — | — | — | — | — | — |\\n| Total commercial and industrial loans | $ | 3,207 | 4,308 | 1,827 | 888 | 566 | 1,058 | 35,710 | — | 47,564 |\\n| Commercial mortgage owner-occupied loans: |\\n| Pass | $ | 517 | 927 | 596 | 358 | 246 | 513 | 1,140 | — | 4,297 |\\n| Special mention | 4 | 30 | 40 | 2 | — | 22 | 85 | — | 183 |\\n| Substandard | 38 | 67 | 11 | 25 | 2 | 27 | 107 | — | 277 |\\n| Doubtful | — | — | — | — | — | — | — | — | — |\\n| Total commercial mortgage owner- occupied loans | $ | 559 | 1,024 | 647 | 385 | 248 | 562 | 1,332 | — | 4,757 |\\n| Commercial mortgage nonowner-occupied loans: |\\n| Pass | $ | 205 | 736 | 627 | 381 | 207 | 459 | 1,598 | — | 4,213 |\\n| Special mention | 31 | 120 | 57 | 61 | 8 | — | 338 | — | 615 |\\n| Substandard | 31 | 195 | 26 | 64 | 3 | 11 | 432 | — | 762 |\\n| Doubtful | — | — | — | — | — | — | — | — | — |\\n| Total commercial mortgage nonowner-occupied loans | $ | 267 | 1,051 | 710 | 506 | 218 | 470 | 2,368 | — | 5,590 |\\n| Commercial construction loans: |\\n| Pass | $ | 28 | 73 | 47 | 27 | — | 11 | 4,715 | — | 4,901 |\\n| Special mention | — | 66 | — | — | — | — | 442 | — | 508 |\\n| Substandard | 15 | — | — | — | — | — | 447 | — | 462 |\\n| Doubtful | — | — | — | — | — | — | — | — | — |\\n| Total commercial construction loans | $ | 43 | 139 | 47 | 27 | — | 11 | 5,604 | — | 5,871 |\\n| Commercial leases: |\\n| Pass | $ | 732 | 511 | 350 | 276 | 297 | 989 | — | — | 3,155 |\\n| Special mention | 1 | 7 | 7 | 5 | — | 4 | — | — | 24 |\\n| Substandard | 10 | 3 | 7 | 12 | 16 | 11 | — | — | 59 |\\n| Doubtful | — | — | — | — | — | — | — | — | — |\\n| Total commercial leases | $ | 743 | 521 | 364 | 293 | 313 | 1,004 | — | — | 3,238 |\\n| Total commercial loans and leases: |\\n| Pass | $ | 4,646 | 6,430 | 3,353 | 1,785 | 1,216 | 2,900 | 39,953 | — | 60,283 |\\n| Special mention | 53 | 256 | 139 | 94 | 38 | 47 | 2,075 | — | 2,702 |\\n| Substandard | 120 | 357 | 103 | 220 | 91 | 158 | 2,986 | — | 4,035 |\\n| Doubtful | — | — | — | — | — | — | — | — | — |\\n| Total commercial loans and leases | $ | 4,819 | 7,043 | 3,595 | 2,099 | 1,345 | 3,105 | 45,014 | — | 67,020 |\\n\\n87\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n| As of December 31, 2020 ($ in millions) | Term Loans and Leases by Origination Year | Revolving Loans | Revolving Loans Converted to Term Loans |\\n| 2020 | 2019 | 2018 | 2017 | 2016 | Prior | Total |\\n| Commercial and industrial loans: |\\n| Pass | $ | 7,042 | 2,144 | 1,114 | 700 | 471 | 703 | 31,657 | — | 43,831 |\\n| Special mention | 66 | 46 | 167 | 46 | 5 | 21 | 2,317 | — | 2,668 |\\n| Substandard | 119 | 80 | 107 | 60 | 39 | 104 | 2,639 | — | 3,148 |\\n| Doubtful | — | 2 | 9 | — | — | — | 7 | — | 18 |\\n| Total commercial and industrial loans | $ | 7,227 | 2,272 | 1,397 | 806 | 515 | 828 | 36,620 | — | 49,665 |\\n| Commercial mortgage owner-occupied loans: |\\n| Pass | $ | 1,047 | 655 | 416 | 288 | 249 | 420 | 1,025 | — | 4,100 |\\n| Special mention | 58 | 12 | 16 | 7 | 2 | 17 | 64 | — | 176 |\\n| Substandard | 211 | 17 | 33 | 7 | 13 | 30 | 88 | — | 399 |\\n| Doubtful | — | — | — | — | — | — | — | — | — |\\n| Total commercial mortgage owner-occupied loans | $ | 1,316 | 684 | 465 | 302 | 264 | 467 | 1,177 | — | 4,675 |\\n| Commercial mortgage nonowner-occupied loans: |\\n| Pass | $ | 902 | 679 | 548 | 247 | 223 | 341 | 1,626 | — | 4,566 |\\n| Special mention | 252 | 68 | 17 | 8 | 36 | 9 | 416 | — | 806 |\\n| Substandard | 149 | 3 | 49 | 14 | 2 | 25 | 301 | — | 543 |\\n| Doubtful | 12 | — | — | — | — | — | — | — | 12 |\\n| Total commercial mortgage nonowner-occupied loans | $ | 1,315 | 750 | 614 | 269 | 261 | 375 | 2,343 | — | 5,927 |\\n| Commercial construction loans: |\\n| Pass | $ | 98 | 49 | 27 | — | 9 | 12 | 4,721 | — | 4,916 |\\n| Special mention | 67 | — | — | — | — | — | 591 | — | 658 |\\n| Substandard | 8 | — | — | — | — | — | 233 | — | 241 |\\n| Doubtful | — | — | — | — | — | — | — | — | — |\\n| Total commercial construction loans | $ | 173 | 49 | 27 | — | 9 | 12 | 5,545 | — | 5,815 |\\n| Commercial leases: |\\n| Pass | $ | 622 | 374 | 315 | 369 | 314 | 824 | — | — | 2,818 |\\n| Special mention | 5 | 16 | 5 | — | — | — | — | — | 26 |\\n| Substandard | 7 | 4 | 16 | 21 | 6 | 17 | — | — | 71 |\\n| Doubtful | — | — | — | — | — | — | — | — | — |\\n| Total commercial leases | $ | 634 | 394 | 336 | 390 | 320 | 841 | — | — | 2,915 |\\n| Total commercial loans and leases: |\\n| Pass | $ | 9,711 | 3,901 | 2,420 | 1,604 | 1,266 | 2,300 | 39,029 | — | 60,231 |\\n| Special mention | 448 | 142 | 205 | 61 | 43 | 47 | 3,388 | — | 4,334 |\\n| Substandard | 494 | 104 | 205 | 102 | 60 | 176 | 3,261 | — | 4,402 |\\n| Doubtful | 12 | 2 | 9 | — | — | — | 7 | — | 30 |\\n| Total commercial loans and leases | $ | 10,665 | 4,149 | 2,839 | 1,767 | 1,369 | 2,523 | 45,685 | — | 68,997 |\\n\\n88\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nAge Analysis of Past Due Commercial Loans and Leases\\nThe following tables summarize the Bancorp’s amortized cost basis in portfolio commercial loans and leases, by age and class:\\n| CurrentLoans andLeases(a) | Past Due | Total Loans and Leases | 90 Days PastDue and StillAccruing |\\n| As of June 30, 2021 ($ in millions) | 30-89Days(a) | 90 Daysor More(a) | TotalPast Due |\\n| Commercial loans and leases: |\\n| Commercial and industrial loans | $ | 47,398 | 111 | 55 | 166 | 47,564 | 2 |\\n| Commercial mortgage owner-occupied loans | 4,706 | 35 | 16 | 51 | 4,757 | 4 |\\n| Commercial mortgage nonowner-occupied loans | 5,587 | 1 | 2 | 3 | 5,590 | — |\\n| Commercial construction loans | 5,871 | — | — | — | 5,871 | — |\\n| Commercial leases | 3,224 | 13 | 1 | 14 | 3,238 | — |\\n| Total portfolio commercial loans and leases | $ | 66,786 | 160 | 74 | 234 | 67,020 | 6 |\\n\\n(a)Includes accrual and nonaccrual loans and leases.\\n| CurrentLoans andLeases(a) | Past Due | Total Loans and Leases | 90 Days PastDue and StillAccruing |\\n| As of December 31, 2020 ($ in millions) | 30-89Days(a) | 90 Daysor More(a) | TotalPast Due |\\n| Commercial loans and leases: |\\n| Commercial and industrial loans | $ | 49,421 | 119 | 125 | 244 | 49,665 | 39 |\\n| Commercial mortgage owner-occupied loans | 4,645 | 7 | 23 | 30 | 4,675 | 7 |\\n| Commercial mortgage nonowner-occupied loans | 5,860 | 31 | 36 | 67 | 5,927 | 1 |\\n| Commercial construction loans | 5,808 | 7 | — | 7 | 5,815 | — |\\n| Commercial leases | 2,906 | 7 | 2 | 9 | 2,915 | 1 |\\n| Total portfolio commercial loans and leases | $ | 68,640 | 171 | 186 | 357 | 68,997 | 48 |\\n\\n(a)Includes accrual and nonaccrual loans and leases.\\nResidential Mortgage and Consumer Portfolio Segments\\nFor purposes of monitoring the credit quality and risk characteristics of its consumer portfolio segment, the Bancorp disaggregates the segment into the following classes: home equity, indirect secured consumer loans, credit card and other consumer loans. The Bancorp’s residential mortgage portfolio segment is also a separate class.\\nThe Bancorp considers repayment performance as the best indicator of credit quality for residential mortgage and consumer loans, which includes both the delinquency status and performing versus nonperforming status of the loans. The delinquency status of all residential mortgage and consumer loans and the performing versus nonperforming status is presented in the following table. Refer to the nonaccrual loans and leases section of Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for additional delinquency and nonperforming information. Loans and leases which received payment deferrals or forbearances as part of the Bancorp’s COVID-19 customer relief programs are generally not reported as delinquent during the forbearance or deferral period if the loan or lease was less than 30 days past due at March 1, 2020 (the effective date of the COVID-19 national emergency declaration) unless the loan or lease subsequently becomes delinquent according to its modified terms. Refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for additional information.\\nFor collectively evaluated loans in the consumer and residential mortgage portfolio segments, the Bancorp’s expected credit loss models primarily utilize the borrower’s FICO score and delinquency history in combination with macroeconomic conditions when estimating the probability of default. The estimates for loss severity are primarily based on collateral type and coverage levels and the susceptibility of those characteristics to changes in macroeconomic conditions. The expected balance at the estimated date of default is also particularly significant for portfolio classes which generally have longer terms (such as residential mortgage loans and home equity) and portfolio classes containing a high concentration of loans with revolving privileges (such as credit card and home equity). The estimate of the expected balance at the time of default considers expected prepayment and utilization rates where applicable, which are primarily based on macroeconomic conditions and the utilization history of similar borrowers under those economic conditions. Refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for additional information about the Bancorp’s process for developing these models and its process for estimating credit losses for periods beyond the reasonable and supportable forecast period.\\n89\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nThe following tables present the amortized cost basis of the Bancorp’s residential mortgage and consumer portfolio segments, by class and vintage, disaggregated by both age and performing versus nonperforming status:\\n| As of June 30, 2021 ($ in millions) | Term Loans by Origination Year | Revolving Loans | Revolving Loans Converted to Term Loans |\\n| 2021 | 2020 | 2019 | 2018 | 2017 | Prior | Total |\\n| Residential mortgage loans: |\\n| Performing: |\\n| Current(a) | $ | 3,080 | 3,840 | 1,696 | 574 | 1,226 | 5,439 | — | — | 15,855 |\\n| 30-89 days past due | 1 | 2 | 1 | — | 2 | 13 | — | — | 19 |\\n| 90 days or more past due | — | 3 | 4 | 2 | 5 | 43 | — | — | 57 |\\n| Total performing | 3,081 | 3,845 | 1,701 | 576 | 1,233 | 5,495 | — | — | 15,931 |\\n| Nonperforming | — | — | — | 1 | 3 | 45 | — | — | 49 |\\n| Total residential mortgage loans(b) | $ | 3,081 | 3,845 | 1,701 | 577 | 1,236 | 5,540 | — | — | 15,980 |\\n| Home equity: |\\n| Performing: |\\n| Current | $ | 1 | 9 | 18 | 23 | 3 | 134 | 4,243 | 8 | 4,439 |\\n| 30-89 days past due | — | — | — | — | — | 3 | 17 | — | 20 |\\n| 90 days or more past due | — | — | — | — | — | 1 | — | — | 1 |\\n| Total performing | 1 | 9 | 18 | 23 | 3 | 138 | 4,260 | 8 | 4,460 |\\n| Nonperforming | — | — | — | — | — | 10 | 74 | 1 | 85 |\\n| Total home equity | $ | 1 | 9 | 18 | 23 | 3 | 148 | 4,334 | 9 | 4,545 |\\n| Indirect secured consumer loans: |\\n| Performing: |\\n| Current | $ | 4,691 | 5,268 | 2,930 | 1,252 | 593 | 337 | — | — | 15,071 |\\n| 30-89 days past due | 5 | 17 | 20 | 15 | 7 | 4 | — | — | 68 |\\n| 90 days or more past due | — | 1 | 1 | 1 | 1 | — | — | — | 4 |\\n| Total performing | 4,696 | 5,286 | 2,951 | 1,268 | 601 | 341 | — | — | 15,143 |\\n| Nonperforming | — | 29 | 6 | 7 | 4 | 3 | — | — | 49 |\\n| Total indirect secured consumer loans | $ | 4,696 | 5,315 | 2,957 | 1,275 | 605 | 344 | — | — | 15,192 |\\n| Credit card: |\\n| Performing: |\\n| Current | $ | — | — | — | — | — | — | 1,737 | — | 1,737 |\\n| 30-89 days past due | — | — | — | — | — | — | 15 | — | 15 |\\n| 90 days or more past due | — | — | — | — | — | — | 14 | — | 14 |\\n| Total performing | — | — | — | — | — | — | 1,766 | — | 1,766 |\\n| Nonperforming | — | — | — | — | — | — | 27 | — | 27 |\\n| Total credit card | $ | — | — | — | — | — | — | 1,793 | — | 1,793 |\\n| Other consumer loans: |\\n| Performing: |\\n| Current | $ | 451 | 702 | 382 | 371 | 138 | 57 | 936 | 1 | 3,038 |\\n| 30-89 days past due | 1 | 2 | 3 | 2 | 1 | — | 2 | — | 11 |\\n| 90 days or more past due | — | — | 1 | — | — | — | — | — | 1 |\\n| Total performing | 452 | 704 | 386 | 373 | 139 | 57 | 938 | 1 | 3,050 |\\n| Nonperforming | — | 1 | — | — | — | — | 1 | — | 2 |\\n| Total other consumer loans | $ | 452 | 705 | 386 | 373 | 139 | 57 | 939 | 1 | 3,052 |\\n| Total residential mortgage and consumer loans: |\\n| Performing: |\\n| Current | $ | 8,223 | 9,819 | 5,026 | 2,220 | 1,960 | 5,967 | 6,916 | 9 | 40,140 |\\n| 30-89 days past due | 7 | 21 | 24 | 17 | 10 | 20 | 34 | — | 133 |\\n| 90 days or more past due | — | 4 | 6 | 3 | 6 | 44 | 14 | — | 77 |\\n| Total performing | 8,230 | 9,844 | 5,056 | 2,240 | 1,976 | 6,031 | 6,964 | 9 | 40,350 |\\n| Nonperforming | — | 30 | 6 | 8 | 7 | 58 | 102 | 1 | 212 |\\n| Total residential mortgage and consumer loans(b) | $ | 8,230 | 9,874 | 5,062 | 2,248 | 1,983 | 6,089 | 7,066 | 10 | 40,562 |\\n\\n(a)Information includes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. As of June 30, 2021, $ 65 of these loans were 30-89 days past due and $ 163 were 90 days or more past due. The Bancorp recognized an immaterial amount and $ 1 of losses during the three and six months ended June 30, 2021, respectively, due to claim denials and curtailments associated with these insured or guaranteed loans.\\n(b)Excludes $ 151 of residential mortgage loans measured at fair value at June 30, 2021.\\n90\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n| As of December 31, 2020 ($ in millions) | Term Loans by Origination Year | Revolving Loans | Revolving Loans Converted to Term Loans |\\n| 2020 | 2019 | 2018 | 2017 | 2016 | Prior | Total |\\n| Residential mortgage loans: |\\n| Performing: |\\n| Current(a) | $ | 4,006 | 2,128 | 827 | 1,635 | 2,301 | 4,719 | — | — | 15,616 |\\n| 30-89 days past due | 1 | 1 | 3 | 3 | 1 | 12 | — | — | 21 |\\n| 90 days or more past due | — | 6 | 2 | 7 | 7 | 48 | — | — | 70 |\\n| Total performing | 4,007 | 2,135 | 832 | 1,645 | 2,309 | 4,779 | — | — | 15,707 |\\n| Nonperforming | 1 | — | 2 | 2 | 3 | 52 | — | — | 60 |\\n| Total residential mortgage loans(b) | $ | 4,008 | 2,135 | 834 | 1,647 | 2,312 | 4,831 | — | — | 15,767 |\\n| Home equity: |\\n| Performing: |\\n| Current | $ | 11 | 24 | 30 | 4 | 2 | 153 | 4,825 | 10 | 5,059 |\\n| 30-89 days past due | — | — | — | — | — | 3 | 33 | — | 36 |\\n| 90 days or more past due | — | — | — | — | — | 2 | — | — | 2 |\\n| Total performing | 11 | 24 | 30 | 4 | 2 | 158 | 4,858 | 10 | 5,097 |\\n| Nonperforming | — | — | — | — | — | 10 | 75 | 1 | 86 |\\n| Total home equity | $ | 11 | 24 | 30 | 4 | 2 | 168 | 4,933 | 11 | 5,183 |\\n| Indirect secured consumer loans: |\\n| Performing: |\\n| Current | $ | 6,626 | 3,752 | 1,678 | 860 | 372 | 214 | — | — | 13,502 |\\n| 30-89 days past due | 25 | 41 | 31 | 17 | 7 | 4 | — | — | 125 |\\n| 90 days or more past due | 1 | 2 | 3 | 2 | 1 | 1 | — | — | 10 |\\n| Total performing | 6,652 | 3,795 | 1,712 | 879 | 380 | 219 | — | — | 13,637 |\\n| Nonperforming | 1 | 5 | 4 | 3 | 2 | 1 | — | — | 16 |\\n| Total indirect secured consumer loans | $ | 6,653 | 3,800 | 1,716 | 882 | 382 | 220 | — | — | 13,653 |\\n| Credit card: |\\n| Performing: |\\n| Current | $ | — | — | — | — | — | — | 1,914 | — | 1,914 |\\n| 30-89 days past due | — | — | — | — | — | — | 30 | — | 30 |\\n| 90 days or more past due | — | — | — | — | — | — | 31 | — | 31 |\\n| Total performing | — | — | — | — | — | — | 1,975 | — | 1,975 |\\n| Nonperforming | — | — | — | — | — | — | 32 | — | 32 |\\n| Total credit card | $ | — | — | — | — | — | — | 2,007 | — | 2,007 |\\n| Other consumer loans: |\\n| Performing: |\\n| Current | $ | 883 | 546 | 437 | 178 | 32 | 40 | 878 | 1 | 2,995 |\\n| 30-89 days past due | 2 | 5 | 4 | 2 | — | — | 2 | — | 15 |\\n| 90 days or more past due | — | 2 | — | — | — | — | — | — | 2 |\\n| Total performing | 885 | 553 | 441 | 180 | 32 | 40 | 880 | 1 | 3,012 |\\n| Nonperforming | — | — | — | — | — | 1 | 1 | — | 2 |\\n| Total other consumer loans | $ | 885 | 553 | 441 | 180 | 32 | 41 | 881 | 1 | 3,014 |\\n| Total residential mortgage and consumer loans: |\\n| Performing: |\\n| Current | $ | 11,526 | 6,450 | 2,972 | 2,677 | 2,707 | 5,126 | 7,617 | 11 | 39,086 |\\n| 30-89 days past due | 28 | 47 | 38 | 22 | 8 | 19 | 65 | — | 227 |\\n| 90 days or more past due | 1 | 10 | 5 | 9 | 8 | 51 | 31 | — | 115 |\\n| Total performing | 11,555 | 6,507 | 3,015 | 2,708 | 2,723 | 5,196 | 7,713 | 11 | 39,428 |\\n| Nonperforming | 2 | 5 | 6 | 5 | 5 | 64 | 108 | 1 | 196 |\\n| Total residential mortgage and consumer loans(b) | $ | 11,557 | 6,512 | 3,021 | 2,713 | 2,728 | 5,260 | 7,821 | 12 | 39,624 |\\n\\n(a)Information includes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. As of December 31, 2020, $ 103 of these loans were 30-89 days past due and $ 242 were 90 days or more past due. The Bancorp recognized $ 1 and $ 2 of losses during the three and six months ended June 30, 2020, respectively, due to claim denials and curtailments associated with these insured or guaranteed loans.\\n(b)Excludes $ 161 of residential mortgage loans measured at fair value at December 31, 2020.\\n91\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nCollateral-Dependent Loans and Leases\\nThe Bancorp considers a loan or lease to be collateral-dependent when the borrower is experiencing financial difficulty and repayment is expected to be provided substantially through the operation or sale of the collateral. When a loan or lease is collateral-dependent, its fair value is generally based on the fair value less cost to sell of the underlying collateral.\\nThe following table presents the amortized cost basis of the Bancorp’s collateral-dependent loans and leases, by portfolio class, as of:\\n| ($ in millions) | June 30,2021 | December 31,2020 |\\n| Commercial loans and leases: |\\n| Commercial and industrial loans | $ | 539 | 810 |\\n| Commercial mortgage owner-occupied loans | 35 | 101 |\\n| Commercial mortgage nonowner-occupied loans | 29 | 82 |\\n| Commercial construction loans | 18 | 19 |\\n| Commercial leases | 8 | 6 |\\n| Total commercial loans and leases | $ | 629 | 1,018 |\\n| Residential mortgage loans | 67 | 80 |\\n| Consumer loans: |\\n| Home equity | 65 | 71 |\\n| Indirect secured consumer loans | 9 | 9 |\\n| Total consumer loans | $ | 74 | 80 |\\n| Total portfolio loans and leases | $ | 770 | 1,178 |\\n\\nNonperforming Assets\\nNonperforming assets include nonaccrual loans and leases for which ultimate collectability of the full amount of the principal and/or interest is uncertain; restructured loans which have not yet met the requirements to be returned to accrual status; certain restructured consumer and residential mortgage loans which are 90 days past due based on the restructured terms unless the loan is both well-secured and in the process of collection; and certain other assets, including OREO and other repossessed property.\\nThe following table presents the amortized cost basis of the Bancorp’s nonaccrual loans and leases, by class, and OREO and other repossessed property as of:\\n| June 30, 2021 | December 31, 2020 |\\n| ($ in millions) | With an ALLL | No RelatedALLL | Total | With an ALLL | No RelatedALLL | Total |\\n| Commercial loans and leases: |\\n| Commercial and industrial loans | $ | 181 | 167 | 348 | 213 | 260 | 473 |\\n| Commercial mortgage owner-occupied loans | 11 | 17 | 28 | 20 | 60 | 80 |\\n| Commercial mortgage nonowner-occupied loans | 23 | 1 | 24 | 34 | 43 | 77 |\\n| Commercial construction loans | — | — | — | 1 | — | 1 |\\n| Commercial leases | 6 | 3 | 9 | 6 | 1 | 7 |\\n| Total nonaccrual portfolio commercial loans and leases | $ | 221 | 188 | 409 | 274 | 364 | 638 |\\n| Residential mortgage loans | 3 | 46 | 49 | 11 | 49 | 60 |\\n| Consumer loans: |\\n| Home equity | 56 | 29 | 85 | 55 | 31 | 86 |\\n| Indirect secured consumer loans | 42 | 7 | 49 | 8 | 8 | 16 |\\n| Credit card | 27 | — | 27 | 32 | — | 32 |\\n| Other consumer loans | 2 | — | 2 | 2 | — | 2 |\\n| Total nonaccrual portfolio consumer loans | $ | 127 | 36 | 163 | 97 | 39 | 136 |\\n| Total nonaccrual portfolio loans and leases(a)(b) | $ | 351 | 270 | 621 | 382 | 452 | 834 |\\n| OREO and other repossessed property | — | 36 | 36 | — | 30 | 30 |\\n| Total nonperforming portfolio assets(a)(b) | $ | 351 | 306 | 657 | 382 | 482 | 864 |\\n\\n(a)Excludes $ 13 and $ 5 of nonaccrual loans held for sale as of June 30, 2021 and December 31, 2020, respectively, and $ 27 and $ 1 of nonaccrual restructured loans held for sale as of June 30, 2021 and December 31, 2020, respectively.\\n(b)Includes $ 26 and $ 29 of nonaccrual government insured commercial loans whose repayments are insured by the SBA as of June 30, 2021 and December 31, 2020, respectively, of which $ 13 and $ 17 are restructured nonaccrual government insured commercial loans as of June 30, 2021 and December 31, 2020, respectively.\\n92\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nThe following table presents the interest income recognized on the Bancorp’s nonaccrual loans and leases, by class:\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Commercial loans and leases: |\\n| Commercial and industrial loans | $ | 4 | 3 | 9 | 4 |\\n| Commercial mortgage owner-occupied loans | 2 | — | 7 | — |\\n| Commercial mortgage nonowner-occupied loans | 2 | — | 2 | — |\\n| Commercial leases | — | — | — | 1 |\\n| Total nonaccrual portfolio commercial loans and leases | $ | 8 | 3 | 18 | 5 |\\n| Residential mortgage loans | 6 | 7 | 13 | 15 |\\n| Consumer loans: |\\n| Home equity | 2 | 2 | 4 | 5 |\\n| Indirect secured consumer loans | — | — | 1 | — |\\n| Credit card | 1 | 1 | 2 | 2 |\\n| Total nonaccrual portfolio consumer loans | $ | 3 | 3 | 7 | 7 |\\n| Total nonaccrual portfolio loans and leases | $ | 17 | 13 | 38 | 27 |\\n\\nThe Bancorp’s amortized cost basis of consumer mortgage loans secured by residential real estate properties for which formal foreclosure proceedings are in process according to local requirements of the applicable jurisdiction was $ 118 million and $ 136 million as of June 30, 2021 and December 31, 2020, respectively.\\nTroubled Debt Restructurings\\nA loan is accounted for as a TDR if the Bancorp, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. TDRs include concessions granted under reorganization, arrangement or other provisions of the Federal Bankruptcy Act. Within each of the Bancorp’s loan classes, TDRs typically involve either a reduction of the stated interest rate of the loan, an extension of the loan’s maturity date with a stated rate lower than the current market rate for a new loan with similar risk, or in limited circumstances, a reduction of the principal balance of the loan or the loan’s accrued interest. Modifying the terms of a loan may result in an increase or decrease to the ALLL depending upon the terms modified, the method used to measure the ALLL for a loan prior to modification, the extent of collateral, and whether any charge-offs were recorded on the loan before or at the time of modification. Refer to the ALLL section of Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for information on the Bancorp’s ALLL methodology. Upon modification of a loan, the Bancorp measures the expected credit loss as either the difference between the amortized cost of the loan and the fair value of collateral less cost to sell or the difference between the estimated future cash flows expected to be collected on the modified loan, discounted at the original effective yield of the loan, and the carrying value of the loan. The resulting measurement may result in the need for minimal or no allowance regardless of which is used because it is probable that all cash flows will be collected under the modified terms of the loan. In addition, if the stated interest rate was increased in a TDR that is not collateral-dependent, the cash flows on the modified loan, using the pre-modification interest rate as the discount rate, often exceed the amortized cost basis of the loan. Conversely, upon a modification that reduces the stated interest rate on a loan that is not collateral-dependent, the Bancorp recognizes an increase to the ALLL. If a TDR involves a reduction of the principal balance of the loan or the loan’s accrued interest, that amount is charged off to the ALLL. Loans discharged in a Chapter 7 bankruptcy and not reaffirmed by the borrower are treated as nonaccrual collateral-dependent loans with a charge-off recognized to reduce the carrying values of such loans to the fair value of the related collateral less costs to sell. Certain loan modifications which were made in response to the COVID-19 pandemic were not evaluated for classification as a TDR. Refer to the Regulatory Developments Related to the COVID-19 Pandemic section of Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for additional information.\\nThe Bancorp had commitments to lend additional funds to borrowers whose terms have been modified in a TDR, consisting of line of credit and letter of credit commitments of $ 41 million and $ 67 million, respectively, as of June 30, 2021 compared to $ 67 million and $ 72 million, respectively, as of December 31, 2020.\\n93\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nThe following tables provide a summary of portfolio loans, by class, modified in a TDR by the Bancorp during the three months ended:\\n| June 30, 2021 ($ in millions) | Number of LoansModified in a TDRDuring the Period(a) | Amortized Cost Basisof Loans Modifiedin a TDRDuring the Period | Increaseto ALLL UponModification | Charge-offsRecognized Upon Modification |\\n| Commercial loans: |\\n| Commercial and industrial loans | 7 | $ | 25 | — | — |\\n| Residential mortgage loans | 124 | 23 | 1 | — |\\n| Consumer loans: |\\n| Home equity | 39 | 2 | — | — |\\n| Indirect secured consumer loans | 450 | 8 | — | — |\\n| Credit card | 1,373 | 8 | 1 | — |\\n| Total portfolio loans | 1,993 | $ | 66 | 2 | — |\\n\\n(a)Represents number of loans post-modification and excludes loans previously modified in a TDR.\\n| June 30, 2020 ($ in millions) | Number of LoansModified in a TDRDuring the Period(a) | Amortized Cost Basisin Loans Modifiedin a TDRDuring the Period | Increase to ALLL Upon Modification | Charge-offsRecognized Upon Modification |\\n| Commercial loans: |\\n| Commercial and industrial loans | 33 | $ | 107 | 14 | — |\\n| Commercial mortgage owner-occupied loans | 17 | 12 | — | — |\\n| Commercial mortgage nonowner-occupied loans | 9 | 14 | — | — |\\n| Commercial construction | 2 | 21 | 1 | — |\\n| Residential mortgage loans | 109 | 13 | 1 | — |\\n| Consumer loans: |\\n| Home equity | 21 | 2 | — | — |\\n| Indirect secured consumer loans | 20 | — | — | — |\\n| Credit card | 973 | 5 | 2 | — |\\n| Total portfolio loans | 1,184 | $ | 174 | 18 | — |\\n\\n(a)Represents number of loans post-modification and excludes loans previously modified in a TDR.\\nThe following tables provide a summary of portfolio loans, by class, modified in a TDR by the Bancorp during the six months ended:\\n| June 30, 2021 ($ in millions) | Number of LoansModified in a TDRDuring the Period(a) | Amortized Cost Basisof Loans Modifiedin a TDRDuring the Period | Increase (Decrease)to ALLL UponModification | Charge-offsRecognized Upon Modification |\\n| Commercial loans: |\\n| Commercial and industrial loans | 26 | $ | 31 | 1 | — |\\n| Commercial mortgage owner-occupied loans | 1 | 4 | — | — |\\n| Commercial mortgage nonowner-occupied loans | 3 | 25 | — | — |\\n| Residential mortgage loans | 302 | 59 | 2 | — |\\n| Consumer loans: |\\n| Home equity | 97 | 5 | ( 1 ) | — |\\n| Indirect secured consumer loans | 2,193 | 51 | 1 | — |\\n| Credit card | 3,168 | 18 | 4 | — |\\n| Total portfolio loans | 5,790 | $ | 193 | 7 | — |\\n\\n(a)Represents number of loans post-modification and excludes loans previously modified in a TDR.\\n94\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n| June 30, 2020 ($ in millions) | Number of LoansModified in a TDRDuring the Period(a) | Recorded Investmentin Loans Modifiedin a TDRDuring the Period | Increase(Decrease)to ALLL UponModification | Charge-offsRecognized Upon Modification |\\n| Commercial loans: |\\n| Commercial and industrial loans | 63 | $ | 176 | 24 | — |\\n| Commercial mortgage owner-occupied loans | 28 | 19 | — | — |\\n| Commercial mortgage nonowner-occupied loans | 12 | 22 | — | — |\\n| Commercial construction | 3 | 21 | 1 | — |\\n| Residential mortgage loans | 293 | 37 | 1 | — |\\n| Consumer loans: |\\n| Home equity | 42 | 4 | ( 1 ) | — |\\n| Indirect secured consumer loans | 42 | — | — | — |\\n| Credit card | 2,857 | 15 | 6 | — |\\n| Total portfolio loans | 3,340 | $ | 294 | 31 | — |\\n\\n(a)Represents number of loans post-modification and excludes loans previously modified in a TDR.\\nThe Bancorp considers TDRs that become 90 days or more past due under the modified terms as subsequently defaulted. For commercial loans not subject to individual evaluation for an ALLL, the applicable commercial models are applied for purposes of determining the ALLL as well as qualitatively assessing whether those loans are reasonably expected to be further restructured prior to their maturity date and, if so, the impact such a restructuring would have on the remaining contractual life of the loans. When a residential mortgage, home equity, indirect secured consumer or other consumer loan that has been modified in a TDR subsequently defaults, the present value of expected cash flows used in the measurement of the expected credit loss is generally limited to the expected net proceeds from the sale of the loan’s underlying collateral and any resulting collateral shortfall is reflected as a charge-off or an increase in ALLL. The Bancorp recognizes an ALLL for the entire balance of the credit card loans modified in a TDR that subsequently default.\\nThe following tables provide a summary of TDRs that subsequently defaulted during the three months ended June 30, 2021 and 2020 and were within 12 months of the restructuring date:\\n| June 30, 2021 ($ in millions)(a) | Number ofContracts | AmortizedCost |\\n| Commercial loans: |\\n| Commercial and industrial loans | 1 | $ | — |\\n| Residential mortgage loans | 16 | 2 |\\n| Consumer loans: |\\n| Home equity | 5 | — |\\n| Indirect secured consumer loans | 32 | — |\\n| Credit card | 11 | — |\\n| Total portfolio loans | 65 | $ | 2 |\\n\\n(a)Excludes all loans held for sale and loans acquired with deteriorated credit quality which were accounted for within a pool.\\n| June 30, 2020 ($ in millions)(a) | Number ofContracts | AmortizedCost |\\n| Commercial loans: |\\n| Commercial and industrial loans | 6 | $ | 4 |\\n| Commercial mortgage owner-occupied loans | 5 | 1 |\\n| Commercial mortgage nonowner-occupied loans | 1 | 4 |\\n| Residential mortgage loans | 25 | 4 |\\n| Consumer loans: |\\n| Home equity | 2 | — |\\n| Indirect secured consumer loans | 3 | — |\\n| Credit card | 16 | — |\\n| Total portfolio loans | 58 | $ | 13 |\\n\\n(a)Excludes all loans held for sale and loans acquired with deteriorated credit quality which were accounted for within a pool.\\n95\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nThe following tables provide a summary of TDRs that subsequently defaulted during the six months ended June 30, 2021 and 2020 and were within 12 months of the restructuring date:\\n| June 30, 2021 ($ in millions)(a) | Number ofContracts | AmortizedCost |\\n| Commercial loans: |\\n| Commercial and industrial loans | 1 | $ | — |\\n| Commercial mortgage nonowner-occupied loans | 1 | 25 |\\n| Residential mortgage loans | 51 | 7 |\\n| Consumer loans: |\\n| Home equity | 17 | 1 |\\n| Indirect secured consumer loans | 58 | 1 |\\n| Credit card | 34 | — |\\n| Total portfolio loans | 162 | $ | 34 |\\n\\n(a)Excludes all loans and leases held for sale and loans acquired with deteriorated credit quality which were accounted for within a pool.\\n| June 30, 2020 ($ in millions)(a) | Number ofContracts | AmortizedCost |\\n| Commercial loans: |\\n| Commercial and industrial loans | 6 | $ | 4 |\\n| Commercial mortgage owner-occupied loans | 7 | 2 |\\n| Commercial mortgage nonowner-occupied loans | 2 | 9 |\\n| Residential mortgage loans | 72 | 10 |\\n| Consumer loans: |\\n| Home equity | 3 | — |\\n| Indirect secured consumer loans | 6 | — |\\n| Credit card | 217 | 1 |\\n| Total portfolio loans | 313 | $ | 26 |\\n\\n(a)Excludes all loans and leases held for sale and loans acquired with deteriorated credit quality which were accounted for within a pool.\\n96\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n7. Bank Premises and Equipment\\nThe following table provides a summary of bank premises and equipment as of:\\n| ($ in millions) | June 30,2021 | December 31,2020 |\\n| Equipment | $ | 2,348 | 2,302 |\\n| Buildings(a) | 1,625 | 1,612 |\\n| Land and improvements(a) | 641 | 636 |\\n| Leasehold improvements | 472 | 467 |\\n| Construction in progress(a) | 103 | 108 |\\n| Bank premises and equipment held for sale: |\\n| Land and improvements | 18 | 27 |\\n| Buildings | 7 | 8 |\\n| Accumulated depreciation and amortization | ( 3,141 ) | ( 3,072 ) |\\n| Total bank premises and equipment | $ | 2,073 | 2,088 |\\n\\n(a)Buildings, land and improvements and construction in progress included $ 50 and $ 46 associated with parcels of undeveloped land intended for future branch expansion at June 30, 2021 and December 31, 2020, respectively.\\nThe Bancorp monitors changing customer preferences associated with the channels it uses for banking transactions to evaluate the efficiency, competitiveness and quality of the customer service experience in its consumer distribution network. As part of this ongoing assessment, the Bancorp may determine that it is no longer fully committed to maintaining full-service banking centers at certain locations. Similarly, the Bancorp may also determine that it is no longer fully committed to building banking centers on certain parcels of land which had previously been held for future branch expansion. The Bancorp closed a total of 43 banking centers throughout its footprint during the six months ended June 30, 2021.\\nThe Bancorp performs assessments of the recoverability of long-lived assets when events or changes in circumstances indicate that their carrying values may not be recoverable. Impairment losses associated with such assessments and lower of cost or market adjustments were $ 2 million and $ 12 million for the three months ended June 30, 2021 and 2020, respectively, and $ 4 million and $ 14 million for the six months ended June 30, 2021 and 2020, respectively. The recognized impairment losses were recorded in other noninterest income in the Condensed Consolidated Statements of Income.\\n8. Operating Lease Equipment\\nOperating lease equipment was $ 715 million and $ 777 million at June 30, 2021 and December 31, 2020, respectively, net of accumulated depreciation of $ 298 million and $ 290 million at June 30, 2021 and December 31, 2020, respectively. The Bancorp recorded lease income of $ 39 million relating to lease payments for operating leases in leasing business revenue in the Condensed Consolidated Statements of Income during both the three months ended June 30, 2021 and 2020, and $ 78 million during both the six months ended June 30, 2021 and 2020. Depreciation expense related to operating lease equipment was $ 31 million during both the three months ended June 30, 2021 and 2020, and $ 64 million and $ 63 million during the six months ended June 30, 2021 and 2020, respectively. The Bancorp received payments of $ 80 million related to operating leases during both the six months ended June 30, 2021 and 2020.\\nThe Bancorp performs assessments of the recoverability of long-lived assets when events or changes in circumstances indicate that their carrying values may not be recoverable. As a result of these recoverability assessments, the Bancorp recognized an immaterial amount of impairment losses associated with operating lease assets for both the three months ended June 30, 2021 and 2020 and recognized $ 25 million and $ 3 million of impairment losses for the six months ended June 30, 2021 and 2020, respectively. The recognized impairment losses were recorded in leasing business revenue in the Condensed Consolidated Statements of Income.\\nThe following table presents future lease payments receivable from operating leases for the remainder of 2021 through 2026 and thereafter:\\n| As of June 30, 2021 ($ in millions) | Undiscounted Cash Flows |\\n| Remainder of 2021 | $ | 73 |\\n| 2022 | 129 |\\n| 2023 | 102 |\\n| 2024 | 65 |\\n| 2025 | 42 |\\n| 2026 | 26 |\\n| Thereafter | 39 |\\n| Total operating lease payments | $ | 476 |\\n\\n97\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n9. Lease Obligations – Lessee\\nThe Bancorp leases certain banking centers, ATM sites, land for owned buildings and equipment. The Bancorp’s lease agreements typically do not contain any residual value guarantees or any material restrictive covenants. For more information on the accounting for lease obligations, refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\\nThe following table provides a summary of lease assets and lease liabilities as of:\\n| ($ in millions) | Condensed Consolidated Balance Sheets Caption | June 30,2021 | December 31,2020 |\\n| Assets |\\n| Operating lease right-of-use assets | Other assets | $ | 425 | 423 |\\n| Finance lease right-of-use assets | Bank premises and equipment | 144 | 129 |\\n| Total right-of-use assets(a) | $ | 569 | 552 |\\n| Liabilities |\\n| Operating lease liabilities | Accrued taxes, interest and expenses | $ | 523 | 527 |\\n| Finance lease liabilities | Long-term debt | 146 | 130 |\\n| Total lease liabilities | $ | 669 | 657 |\\n\\n(a) Operating and finance lease right-of-use assets are recorded net of accumulated amortization of $ 169 and $ 38 , respectively, as of June 30, 2021, and $ 152 and $ 29 , respectively, as of December 31, 2020.\\nThe following table presents the components of lease costs:\\n| ($ in millions) | Condensed Consolidated Statements of Income Caption | For the three months endedJune 30, | For the six months endedJune 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Lease costs: |\\n| Amortization of ROU assets | Net occupancy and equipment expense | $ | 4 | 2 | 9 | 3 |\\n| Interest on lease liabilities | Interest on long-term debt | 1 | — | 2 | 1 |\\n| Total finance lease costs | $ | 5 | 2 | 11 | 4 |\\n| Operating lease cost | Net occupancy expense | $ | 19 | 22 | 39 | 46 |\\n| Short-term lease cost | Net occupancy expense | — | — | 1 | 1 |\\n| Variable lease cost | Net occupancy expense | 8 | 7 | 16 | 14 |\\n| Sublease income | Net occupancy expense | — | — | ( 1 ) | ( 1 ) |\\n| Total operating lease costs | $ | 27 | 29 | 55 | 60 |\\n| Total lease costs | $ | 32 | 31 | 66 | 64 |\\n\\nThe Bancorp performs impairment assessments for ROU assets when events or changes in circumstances indicate that their carrying values may not be recoverable. In addition to the lease costs disclosed in the table above, the Bancorp recognized $ 2 million and $ 3 million of impairment losses and termination charges for the ROU assets related to certain operating leases during the three months ended June 30, 2021 and 2020, respectively, and $ 2 million and $ 5 million during the six months ended June 30, 2021 and 2020, respectively. The recognized losses were recorded in net occupancy expense in the Condensed Consolidated Statements of Income.\\nThe following table presents undiscounted cash flows payable for both operating leases and finance leases for the remainder of 2021 through 2026 and thereafter as well as a reconciliation of the undiscounted cash flows to the total lease liabilities as follows:\\n| As of June 30, 2021 ($ in millions) | OperatingLeases | FinanceLeases | Total |\\n| Remainder of 2021 | $ | 44 | 9 | 53 |\\n| 2022 | 83 | 20 | 103 |\\n| 2023 | 76 | 18 | 94 |\\n| 2024 | 68 | 18 | 86 |\\n| 2025 | 60 | 12 | 72 |\\n| 2026 | 51 | 6 | 57 |\\n| Thereafter | 220 | 100 | 320 |\\n| Total undiscounted cash flows | $ | 602 | 183 | 785 |\\n| Less: Difference between undiscounted cash flows and discounted cash flows | 79 | 37 | 116 |\\n| Present value of lease liabilities | $ | 523 | 146 | 669 |\\n\\n98\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nThe following table presents the weighted-average remaining lease term and weighted-average discount rate as of:\\n| June 30,2021 | December 31,2020 |\\n| Weighted-average remaining lease term (years): |\\n| Operating leases | 9.09 | 9.06 |\\n| Finance leases | 14.42 | 12.93 |\\n| Weighted-average discount rate: |\\n| Operating leases | 2.95 | % | 3.05 |\\n| Finance leases | 2.58 | 2.39 |\\n\\nThe following table presents information related to lease transactions for the six months ended June 30:\\n| ($ in millions) | 2021 | 2020 |\\n| Cash paid for amounts included in the measurement of lease liabilities:(a) |\\n| Operating cash flows from operating leases | $ | 44 | 47 |\\n| Operating cash flows from finance leases | 2 | 1 |\\n| Financing cash flows from finance leases | 9 | 2 |\\n| Gains on sale-leaseback transactions | 2 | — |\\n\\n(a) The cash flows related to the short-term and variable lease payments are not included in the amounts in the table as they were not included in the measurement of lease liabilities.\\n10. Intangible Assets\\nIntangible assets consist of core deposit intangibles, customer relationships, operating leases, non-compete agreements, trade names and books of business. Intangible assets are amortized on either a straight-line or an accelerated basis over their estimated useful lives and, based on the type of intangible asset, the amortization expense may be recorded in either leasing business revenue or other noninterest expense in the Condensed Consolidated Statements of Income.\\nThe details of the Bancorp’s intangible assets are shown in the following table:\\n| ($ in millions) | Gross CarryingAmount | AccumulatedAmortization | Net CarryingAmount |\\n| As of June 30, 2021 |\\n| Core deposit intangibles | $ | 229 | ( 135 ) | 94 |\\n| Customer relationships | 24 | ( 6 ) | 18 |\\n| Operating leases | 14 | ( 11 ) | 3 |\\n| Other | 3 | ( 1 ) | 2 |\\n| Total intangible assets | $ | 270 | ( 153 ) | 117 |\\n| As of December 31, 2020 |\\n| Core deposit intangibles | $ | 229 | ( 116 ) | 113 |\\n| Customer relationships | 24 | ( 5 ) | 19 |\\n| Operating leases | 17 | ( 12 ) | 5 |\\n| Other | 3 | ( 1 ) | 2 |\\n| Total intangible assets | $ | 273 | ( 134 ) | 139 |\\n\\nAs of June 30, 2021, all of the Bancorp’s intangible assets were being amortized. Amortization expense recognized on intangible assets was $ 10 million and $ 13 million for the three months ended June 30, 2021 and 2020, respectively, and $ 22 million and $ 29 million for the six months ended June 30, 2021 and 2020, respectively. The Bancorp’s projections of amortization expense shown in the following table are based on existing asset balances as of June 30, 2021. Future amortization expense may vary from these projections.\\nEstimated amortization expense for the remainder of 2021 through 2025 is as follows:\\n| ($ in millions) | Total |\\n| Remainder of 2021 | $ | 20 |\\n| 2022 | 33 |\\n| 2023 | 24 |\\n| 2024 | 16 |\\n| 2025 | 9 |\\n\\n99\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n11. Variable Interest Entities\\nThe Bancorp, in the normal course of business, engages in a variety of activities that involve VIEs, which are legal entities that lack sufficient equity at risk to finance their activities without additional subordinated financial support or the equity investors of the entities as a group lack any of the characteristics of a controlling interest. The Bancorp evaluates its interest in certain entities to determine if these entities meet the definition of a VIE and whether the Bancorp is the primary beneficiary and should consolidate the entity based on the variable interests it held both at inception and when there is a change in circumstances that requires a reconsideration. If the Bancorp is determined to be the primary beneficiary of a VIE, it must account for the VIE as a consolidated subsidiary. If the Bancorp is determined not to be the primary beneficiary of a VIE but holds a variable interest in the entity, such variable interests are accounted for under the equity method of accounting or other accounting standards as appropriate.\\nConsolidated VIEs\\nThe Bancorp has consolidated VIEs related to certain automobile loan securitizations where it has determined that it is the primary beneficiary. The following table provides a summary of assets and liabilities carried on the Condensed Consolidated Balance Sheets for consolidated VIEs as of:\\n| ($ in millions) | June 30,2021 | December 31,2020 |\\n| Assets: |\\n| Other short-term investments | $ | 33 | 55 |\\n| Indirect secured consumer loans | 455 | 756 |\\n| ALLL | ( 3 ) | ( 7 ) |\\n| Other assets | 3 | 5 |\\n| Total assets | $ | 488 | 809 |\\n| Liabilities: |\\n| Other liabilities | $ | 1 | 2 |\\n| Long-term debt | 400 | 656 |\\n| Total liabilities | $ | 401 | 658 |\\n\\nThe Bancorp has previously completed securitization transactions in which the Bancorp transferred certain consumer automobile loans to bankruptcy remote trusts which were also deemed to be VIEs. In each of these securitization transactions, the primary purposes of the VIEs were to issue asset-backed securities with varying levels of credit subordination and payment priority, as well as residual interests, and to provide the Bancorp with access to liquidity for its originated loans. The Bancorp retained residual interests in the VIEs and, therefore, has an obligation to absorb losses and a right to receive benefits from the VIEs that could potentially be significant to the VIEs. In addition, the Bancorp retained servicing rights for the underlying loans and, therefore, holds the power to direct the activities of the VIEs that most significantly impact the economic performance of the VIEs. As a result, the Bancorp concluded that it is the primary beneficiary of the VIEs and has consolidated these VIEs. The assets of the VIEs are restricted to the settlement of the asset-backed securities and other obligations of the VIEs. The third-party holders of the asset-backed notes do not have recourse to the general assets of the Bancorp.\\nThe economic performance of the VIEs is most significantly impacted by the performance of the underlying loans. The principal risks to which the VIEs are exposed include credit risk and prepayment risk. The credit and prepayment risks are managed through credit enhancements in the form of reserve accounts, overcollateralization, excess interest on the loans and the subordination of certain classes of asset-backed securities to other classes.\\nNon-consolidated VIEs\\nThe following tables provide a summary of assets and liabilities carried on the Condensed Consolidated Balance Sheets related to non-consolidated VIEs for which the Bancorp holds an interest, but is not the primary beneficiary of the VIE, as well as the Bancorp’s maximum exposure to losses associated with its interests in the entities as of:\\n| June 30, 2021 ($ in millions) | TotalAssets | TotalLiabilities | MaximumExposure |\\n| CDC investments | $ | 1,668 | 519 | 1,668 |\\n| Private equity investments | 117 | — | 208 |\\n| Loans provided to VIEs | 2,872 | — | 4,268 |\\n| Lease pool entities | 75 | — | 75 |\\n\\n100\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n| December 31, 2020 ($ in millions) | TotalAssets | TotalLiabilities | MaximumExposure |\\n| CDC investments | $ | 1,546 | 478 | 1,546 |\\n| Private equity investments | 117 | — | 200 |\\n| Loans provided to VIEs | 2,420 | — | 3,649 |\\n| Lease pool entities | 73 | — | 73 |\\n\\nCDC investments\\nCDC, a wholly-owned indirect subsidiary of the Bancorp, was created to invest in projects to create affordable housing, revitalize business and residential areas and preserve historic landmarks. CDC generally co-invests with other unrelated companies and/or individuals and typically makes investments in a separate legal entity that owns the property under development. The entities are usually formed as limited partnerships and LLCs and CDC typically invests as a limited partner/investor member in the form of equity contributions. The economic performance of the VIEs is driven by the performance of their underlying investment projects as well as the VIEs’ ability to operate in compliance with the rules and regulations necessary for the qualification of tax credits generated by equity investments. The Bancorp has determined that it is not the primary beneficiary of these VIEs because it lacks the power to direct the activities that most significantly impact the economic performance of the underlying project or the VIEs’ ability to operate in compliance with the rules and regulations necessary for the qualification of tax credits generated by equity investments. This power is held by the managing members who exercise full and exclusive control of the operations of the VIEs. For information regarding the Bancorp’s accounting for these investments, refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\\nThe Bancorp’s funding requirements are limited to its invested capital and any additional unfunded commitments for future equity contributions. The Bancorp’s maximum exposure to loss as a result of its involvement with the VIEs is limited to the carrying amounts of the investments, including the unfunded commitments. The carrying amounts of these investments, which are included in other assets in the Condensed Consolidated Balance Sheets, and the liabilities related to the unfunded commitments, which are included in other liabilities in the Condensed Consolidated Balance Sheets, are included in the previous tables for all periods presented. The Bancorp has no other liquidity arrangements or obligations to purchase assets of the VIEs that would expose the Bancorp to a loss. In certain arrangements, the general partner/managing member of the VIE has guaranteed a level of projected tax credits to be received by the limited partners/investor members, thereby minimizing a portion of the Bancorp’s risk.\\nThe Bancorp’s CDC investments included $ 1.4 billion and $ 1.3 billion of investments in affordable housing tax credits recognized in other assets in the Condensed Consolidated Balance Sheets at June 30, 2021 and December 31, 2020, respectively. The unfunded commitments related to these investments were $ 514 million and $ 478 million at June 30, 2021 and December 31, 2020, respectively. The unfunded commitments as of June 30, 2021 are expected to be funded from 2021 to 2039 .\\nThe Bancorp has accounted for all of its qualifying LIHTC investments using the proportional amortization method of accounting. The following table summarizes the impact to the Condensed Consolidated Statements of Income related to these investments:\\n| Condensed ConsolidatedStatements of Income Caption(a) | For the three months ended June 30, | For the six months ended June 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Proportional amortization | Applicable income tax expense | $ | 43 | 27 | 87 | 32 |\\n| Tax credits and other benefits | Applicable income tax expense | ( 50 ) | ( 32 ) | ( 101 ) | ( 37 ) |\\n\\n(a)The Bancorp did no t recognize impairment losses resulting from the forfeiture or ineligibility of tax credits or other circumstances during both the three and six months ended June 30, 2021 and 2020.\\nPrivate equity investments\\nThe Bancorp invests as a limited partner in private equity investments which provide the Bancorp an opportunity to obtain higher rates of return on invested capital, while also creating cross-selling opportunities for the Bancorp’s commercial products. Each of the limited partnerships has an unrelated third-party general partner responsible for appointing the fund manager. The Bancorp has not been appointed fund manager for any of these private equity investments. The funds finance primarily all of their activities from the partners’ capital contributions and investment returns. The Bancorp has determined that it is not the primary beneficiary of the funds because it does not have the obligation to absorb the funds’ expected losses or the right to receive the funds’ expected residual returns that could potentially be significant to the funds and lacks the power to direct the activities that most significantly impact the economic performance of the funds. The Bancorp, as a limited partner, does not have substantive participating or substantive kick-out rights over the general partner. Therefore, the Bancorp accounts for its investments in these limited partnerships under the equity method of accounting.\\nThe Bancorp is exposed to losses arising from the negative performance of the underlying investments in the private equity investments. As a limited partner, the Bancorp’s maximum exposure to loss is limited to the carrying amounts of the investments plus unfunded commitments. The carrying amounts of these investments, which are included in other assets in the Condensed Consolidated Balance Sheets, are presented\\n101\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nin previous tables. Also, at June 30, 2021 and December 31, 2020, the Bancorp’s unfunded commitment amounts to the private equity funds were $ 91 million and $ 83 million, respectively. As part of previous commitments, the Bancorp made capital contributions to private equity investments of $ 6 million and $ 1 million during the three months ended June 30, 2021 and 2020, respectively, and $ 7 million and $ 5 million during the six months ended June 30, 2021 and 2020, respectively.\\nLoans provided to VIEs\\nThe Bancorp has provided funding to certain unconsolidated VIEs sponsored by third parties. These VIEs are generally established to finance certain consumer and small business loans originated by third parties. The entities are primarily funded through the issuance of a loan from the Bancorp or a syndication through which the Bancorp is involved. The sponsor/administrator of the entities is responsible for servicing the underlying assets in the VIEs. Because the sponsor/administrator, not the Bancorp, holds the servicing responsibilities, which include the establishment and employment of default mitigation policies and procedures, the Bancorp does not hold the power to direct the activities that most significantly impact the economic performance of the entity and, therefore, is not the primary beneficiary.\\nThe principal risk to which these entities are exposed is credit risk related to the underlying assets. The Bancorp’s maximum exposure to loss is equal to the carrying amounts of the loans and unfunded commitments to the VIEs. The Bancorp’s outstanding loans to these VIEs are included in commercial loans in Note 5. As of June 30, 2021 and December 31, 2020, the Bancorp’s unfunded commitments to these entities were $ 1.4 billion and $ 1.2 billion, respectively. The loans and unfunded commitments to these VIEs are included in the Bancorp’s overall analysis of the ALLL and reserve for unfunded commitments, respectively. The Bancorp does not provide any implicit or explicit liquidity guarantees or principal value guarantees to these VIEs.\\nLease pool entities\\nThe Bancorp is a co-investor with other unrelated leasing companies in three LLCs designed for the purpose of purchasing pools of residual interests in leases which have been originated or purchased by the other investing member. For each LLC, the leasing company is the managing member and has full authority over the day-to-day operations of the entity. While the Bancorp holds more than 50 % of the equity interests in each LLC, the operating agreements require both members to consent to significant corporate actions, such as liquidating the entity or removing the manager. In addition, the Bancorp has a preference with regards to distributions such that all of the Bancorp’s equity contribution for each pool must be distributed, plus a pre-defined rate of return, before the other member may receive distributions. The leasing company is also entitled to the return of its investment plus a pre-defined rate of return before any residual profits are distributed to the members.\\nThe lease pool entities are primarily subject to risk of losses on the lease residuals purchased. The Bancorp has determined that it is not the primary beneficiary of these VIEs because it does not have the power to direct the activities that most significantly impact the economic performance of the entities. This power is held by the leasing company, who as managing member controls the servicing of the leases and collection of the proceeds on the residual interests.\\n102\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n12. Sales of Receivables and Servicing Rights\\nResidential Mortgage Loan Sales\\nThe Bancorp sold fixed and adjustable-rate residential mortgage loans during the three and six months ended June 30, 2021 and 2020. In those sales, the Bancorp obtained servicing responsibilities and provided certain standard representations and warranties; however, the investors have no recourse to the Bancorp’s other assets for failure of debtors to pay when due. The Bancorp receives servicing fees based on a percentage of the outstanding balance. The Bancorp identifies classes of servicing assets based on financial asset type and interest rates.\\nInformation related to residential mortgage loan sales and the Bancorp’s mortgage banking activity, which is included in mortgage banking net revenue in the Condensed Consolidated Statements of Income, is as follows:\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Residential mortgage loan sales(a) | $ | 4,416 | 3,063 | 7,626 | 6,018 |\\n| Origination fees and gains on loan sales | 81 | 95 | 170 | 176 |\\n| Gross mortgage servicing fees | 59 | 63 | 117 | 130 |\\n\\n(a)Represents the unpaid principal balance at the time of the sale.\\nServicing Rights\\nThe Bancorp measures all of its servicing rights at fair value with changes in fair value reported in mortgage banking net revenue in the Condensed Consolidated Statements of Income.\\nThe following table presents changes in the servicing rights related to residential mortgage loans for the six months ended June 30:\\n| ($ in millions) | 2021 | 2020 |\\n| Balance, beginning of period | $ | 656 | 993 |\\n| Servicing rights originated | 103 | 101 |\\n| Servicing rights purchased | 109 | 30 |\\n| Changes in fair value: |\\n| Due to changes in inputs or assumptions(a) | 103 | ( 343 ) |\\n| Other changes in fair value(b) | ( 153 ) | ( 105 ) |\\n| Balance, end of period | $ | 818 | 676 |\\n\\n(a)Primarily reflects changes in prepayment speed and OAS assumptions which are updated based on market interest rates.\\n(b)Primarily reflects changes due to realized cash flows and the passage of time.\\nThe Bancorp maintains a non-qualifying hedging strategy to manage a portion of the risk associated with changes in the value of the MSR portfolio. This strategy may include the purchase of free-standing derivatives and various available-for-sale debt and trading debt securities. The interest income, mark-to-market adjustments and gain or loss from sale activities associated with these portfolios are expected to economically hedge a portion of the change in value of the MSR portfolio caused by fluctuating OAS, earnings rates and prepayment speeds. The fair value of the servicing asset is based on the present value of expected future cash flows.\\nThe following table presents activity related to valuations of the MSR portfolio and the impact of the non-qualifying hedging strategy:\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Securities (losses) gains, net – non-qualifying hedges on mortgage servicing rights | $ | 1 | — | ( 1 ) | 3 |\\n| Changes in fair value and settlement of free-standing derivatives purchased to economically hedge the MSR portfolio(a) | 46 | 11 | ( 88 ) | 361 |\\n| MSR fair value adjustment due to changes in inputs or assumptions(a) | ( 49 ) | ( 12 ) | 103 | ( 343 ) |\\n\\n(a)Included in mortgage banking net revenue in the Condensed Consolidated Statements of Income.\\n103\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nThe key economic assumptions used in measuring the servicing rights related to residential mortgage loans that continued to be held by the Bancorp at the date of sale, securitization or purchase resulting from transactions completed during the three months ended June 30, 2021 and 2020 were as follows:\\n| June 30, 2021 | June 30, 2020 |\\n| Weighted-Average Life(in years) | PrepaymentSpeed(annual) | OAS(bps) | Weighted-Average Life(in years) | PrepaymentSpeed(annual) | OAS(bps) |\\n| Fixed-rate | 5.9 | 12.3 | % | 610 | 5.8 | 12.4 | % | 777 |\\n| Adjustable-rate | — | — | — | 3.0 | 27.1 | 725 |\\n\\nBased on historical credit experience, expected credit losses for residential mortgage loan servicing rights have been deemed immaterial, as the Bancorp sold the majority of the underlying loans without recourse. At June 30, 2021 and December 31, 2020, the Bancorp serviced $ 71.5 billion and $ 68.8 billion, respectively, of residential mortgage loans for other investors. The value of MSRs that continue to be held by the Bancorp is subject to credit, prepayment and interest rate risks on the sold financial assets.\\nAt June 30, 2021, the sensitivity of the current fair value of residual cash flows to immediate 10%, 20% and 50% adverse changes in prepayment speed assumptions and immediate 10% and 20% adverse changes in OAS for servicing rights related to residential mortgage loans are as follows:\\n| PrepaymentSpeed Assumption | OASAssumption |\\n| Fair Value($ in millions)(a) | Weighted-Average Life(in years) | Impact of Adverse Changeon Fair Value | OAS(bps) | Impact of Adverse Change on Fair Value |\\n| Rate | 10% | 20% | 50% | 10% | 20% |\\n| Fixed-rate | $ | 812 | 5.0 | 14.5 | % | $ | ( 29 ) | ( 55 ) | ( 125 ) | 542 | $ | ( 16 ) | ( 32 ) |\\n| Adjustable-rate | 6 | 3.7 | 21.6 | — | ( 1 ) | ( 2 ) | 978 | — | — |\\n\\n(a)The impact of the weighted-average default rate on the current fair value of residual cash flows for all scenarios is immaterial.\\nThese sensitivities are hypothetical and should be used with caution. As the figures indicate, changes in fair value based on these variations in the assumptions typically cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. The Bancorp believes that variations of these levels are reasonably possible; however, there is the potential that adverse changes in key assumptions could be even greater. Also, in the previous table, the effect of a variation in a particular assumption on the fair value of the interests that continue to be held by the Bancorp is calculated without changing any other assumption; in reality, changes in one factor may result in changes in another (for example, increases in market interest rates may result in lower prepayments), which might magnify or counteract these sensitivities.\\n104\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n13. Derivative Financial Instruments\\nThe Bancorp maintains an overall risk management strategy that incorporates the use of derivative instruments to reduce certain risks related to interest rate, prepayment and foreign currency volatility. Additionally, the Bancorp holds derivative instruments for the benefit of its commercial customers and for other business purposes. The Bancorp does not enter into unhedged speculative derivative positions.\\nThe Bancorp’s interest rate risk management strategy involves modifying the repricing characteristics of certain financial instruments so that changes in interest rates do not adversely affect the Bancorp’s net interest margin and cash flows. Derivative instruments that the Bancorp may use as part of its interest rate risk management strategy include interest rate swaps, interest rate floors, interest rate caps, forward contracts, forward starting interest rate swaps, options, swaptions and TBA securities. Interest rate swap contracts are exchanges of interest payments, such as fixed-rate payments for floating-rate payments, based on a stated notional amount and maturity date. Interest rate floors protect against declining rates, while interest rate caps protect against rising interest rates. Forward contracts are contracts in which the buyer agrees to purchase, and the seller agrees to make delivery of, a specific financial instrument at a predetermined price or yield. Options provide the purchaser with the right, but not the obligation, to purchase or sell a contracted item during a specified period at an agreed-upon price. Swaptions are financial instruments granting the owner the right, but not the obligation, to enter into or cancel a swap.\\nPrepayment volatility arises mostly from changes in fair value of the largely fixed-rate MSR portfolio, mortgage loans and mortgage-backed securities. The Bancorp may enter into various free-standing derivatives (principal-only swaps, interest rate swaptions, interest rate floors, mortgage options, TBA securities and interest rate swaps) to economically hedge prepayment volatility. Principal-only swaps are total return swaps based on changes in the value of the underlying mortgage principal-only trust. TBA securities are a forward purchase agreement for a mortgage-backed securities trade whereby the terms of the security are undefined at the time the trade is made.\\nForeign currency volatility occurs as the Bancorp enters into certain loans denominated in foreign currencies. Derivative instruments that the Bancorp may use to economically hedge these foreign denominated loans include foreign exchange swaps and forward contracts.\\nThe Bancorp also enters into derivative contracts (including foreign exchange contracts, commodity contracts and interest rate contracts) for the benefit of commercial customers and other business purposes. The Bancorp economically hedges significant exposures related to these free-standing derivatives by entering into offsetting third-party contracts with approved, reputable and independent counterparties with substantially matching terms and currencies. Credit risk arises from the possible inability of counterparties to meet the terms of their contracts. The Bancorp’s exposure is limited to the replacement value of the contracts rather than the notional, principal or contract amounts. Credit risk is minimized through credit approvals, limits, counterparty collateral and monitoring procedures.\\nThe fair value of derivative instruments is presented on a gross basis, even when the derivative instruments are subject to master netting arrangements. Derivative instruments with a positive fair value are reported in other assets in the Condensed Consolidated Balance Sheets while derivative instruments with a negative fair value are reported in other liabilities in the Condensed Consolidated Balance Sheets. Cash collateral payables and receivables associated with the derivative instruments are not added to or netted against the fair value amounts with the exception of certain variation margin payments that are considered legal settlements of the derivative contracts. For derivative contracts cleared through certain central clearing parties who have modified their rules to treat variation margin payments as settlements, the variation margin payments are applied to net the fair value of the respective derivative contracts.\\nThe Bancorp’s derivative assets include certain contractual features in which the Bancorp requires the counterparties to provide collateral in the form of cash and securities to offset changes in the fair value of the derivatives, including changes in the fair value due to credit risk of the counterparty. As of June 30, 2021 and December 31, 2020, the balance of collateral held by the Bancorp for derivative assets was $ 1.1 billion and $ 1.0 billion, respectively. For derivative contracts cleared through certain central clearing parties whose rules treat variation margin payments as settlement of the derivative contract, the payments for variation margin of $ 898 million and $ 1.1 billion were applied to reduce the respective derivative contracts and were also not included in the total amount of collateral held as of June 30, 2021 and December 31, 2020, respectively. As of June 30, 2021 and December 31, 2020, the credit component negatively impacting the fair value of derivative assets associated with customer accommodation contracts was $ 26 million and $ 42 million, respectively.\\nIn measuring the fair value of derivative liabilities, the Bancorp considers its own credit risk, taking into consideration collateral maintenance requirements of certain derivative counterparties and the duration of instruments with counterparties that do not require collateral maintenance. When necessary, the Bancorp posts collateral primarily in the form of cash and securities to offset changes in fair value of the derivatives, including changes in fair value due to the Bancorp’s credit risk. As of June 30, 2021 and December 31, 2020, the balance of collateral posted by the Bancorp for derivative liabilities was $ 1.1 billion and $ 463 million, respectively. Additionally, as of June 30, 2021 and December 31, 2020, $ 768 million and $ 1.1 billion, respectively, of variation margin payments were applied to the respective derivative contracts to reduce the Bancorp’s derivative liabilities and were also not included in the total amount of collateral posted. Certain of the Bancorp’s derivative liabilities contain credit-risk related contingent features that could result in the requirement to post additional collateral upon the occurrence of specified events. As of both June 30, 2021 and December 31, 2020, the fair value of the additional collateral that could be required to be posted as a result of the credit-risk-related contingent features being triggered was immaterial to the Bancorp’s Condensed Consolidated Financial Statements. The posting of collateral has been determined to remove the need for further consideration of\\n105\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\ncredit risk. As a result, the Bancorp determined that the impact of the Bancorp’s credit risk to the valuation of its derivative liabilities was immaterial to the Bancorp’s Condensed Consolidated Financial Statements.\\nThe Bancorp holds certain derivative instruments that qualify for hedge accounting treatment and are designated as either fair value hedges or cash flow hedges. Derivative instruments that do not qualify for hedge accounting treatment, or for which hedge accounting is not established, are held as free-standing derivatives. All customer accommodation derivatives are held as free-standing derivatives.\\nThe following tables reflect the notional amounts and fair values for all derivative instruments included in the Condensed Consolidated Balance Sheets as of:\\n| Fair Value |\\n| June 30, 2021 ($ in millions) | NotionalAmount | DerivativeAssets | DerivativeLiabilities |\\n| Derivatives Designated as Qualifying Hedging Instruments: |\\n| Fair value hedges: |\\n| Interest rate swaps related to long-term debt | $ | 1,455 | 429 | — |\\n| Total fair value hedges | 429 | — |\\n| Cash flow hedges: |\\n| Interest rate floors related to C&I loans | 3,000 | 183 | — |\\n| Interest rate swaps related to C&I loans | 8,000 | — | 1 |\\n| Total cash flow hedges | 183 | 1 |\\n| Total derivatives designated as qualifying hedging instruments | 612 | 1 |\\n| Derivatives Not Designated as Qualifying Hedging Instruments: |\\n| Free-standing derivatives - risk management and other business purposes: |\\n| Interest rate contracts related to MSR portfolio | 6,310 | 146 | — |\\n| Forward contracts related to residential mortgage loans held for sale(b) | 3,395 | 1 | 8 |\\n| Swap associated with the sale of Visa, Inc. Class B Shares | 3,836 | — | 213 |\\n| Foreign exchange contracts | 208 | 5 | — |\\n| Interest rate contracts for collateral management | 12,000 | 5 | 5 |\\n| Interest rate contracts for LIBOR transition | 2,372 | — | — |\\n| Total free-standing derivatives – risk management and other business purposes | 157 | 226 |\\n| Free-standing derivatives – customer accommodation: |\\n| Interest rate contracts(a) | 80,338 | 879 | 225 |\\n| Interest rate lock commitments | 1,865 | 39 | — |\\n| Commodity contracts | 10,369 | 1,240 | 1,209 |\\n| TBA securities | 92 | — | — |\\n| Foreign exchange contracts | 19,778 | 281 | 246 |\\n| Total free-standing derivatives – customer accommodation | 2,439 | 1,680 |\\n| Total derivatives not designated as qualifying hedging instruments | 2,596 | 1,906 |\\n| Total | $ | 3,208 | 1,907 |\\n\\n(a)Derivative assets and liabilities are presented net of variation margin of $ 52 and $ 734 , respectively.\\n(b)Includes forward sale and forward purchase contracts which are utilized to manage market risk on residential mortgage loans held for sale and the related interest rate lock commitments.\\n106\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n| Fair Value |\\n| December 31, 2020 ($ in millions) | NotionalAmount | DerivativeAssets | DerivativeLiabilities |\\n| Derivatives Designated as Qualifying Hedging Instruments: |\\n| Fair value hedges: |\\n| Interest rate swaps related to long-term debt | $ | 1,955 | 528 | — |\\n| Total fair value hedges | 528 | — |\\n| Cash flow hedges: |\\n| Interest rate floors related to C&I loans | 3,000 | 244 | — |\\n| Interest rate swaps related to C&I loans | 8,000 | 16 | 2 |\\n| Total cash flow hedges | 260 | 2 |\\n| Total derivatives designated as qualifying hedging instruments | 788 | 2 |\\n| Derivatives Not Designated as Qualifying Hedging Instruments: |\\n| Free-standing derivatives – risk management and other business purposes: |\\n| Interest rate contracts related to MSR portfolio | 6,910 | 202 | 1 |\\n| Forward contracts related to residential mortgage loans held for sale | 2,903 | 1 | 16 |\\n| Swap associated with the sale of Visa, Inc. Class B Shares | 3,588 | — | 201 |\\n| Foreign exchange contracts | 204 | — | 3 |\\n| Interest rate contracts for collateral management | 12,000 | 3 | 1 |\\n| Interest rate contracts for LIBOR transition | 2,372 | — | — |\\n| Total free-standing derivatives – risk management and other business purposes | 206 | 222 |\\n| Free-standing derivatives – customer accommodation: |\\n| Interest rate contracts(a) | 77,806 | 1,238 | 265 |\\n| Interest rate lock commitments | 1,830 | 57 | — |\\n| Commodity contracts | 7,762 | 375 | 359 |\\n| Foreign exchange contracts | 14,587 | 255 | 224 |\\n| Total free-standing derivatives – customer accommodation | 1,925 | 848 |\\n| Total derivatives not designated as qualifying hedging instruments | 2,131 | 1,070 |\\n| Total | $ | 2,919 | 1,072 |\\n\\n(a)Derivative assets and liabilities are presented net of variation margin of $ 47 and $ 1,063 , respectively.\\nFair Value Hedges\\nThe Bancorp may enter into interest rate swaps to convert its fixed-rate funding to floating-rate. Decisions to convert fixed-rate funding to floating are made primarily through consideration of the asset/liability mix of the Bancorp, the desired asset/liability sensitivity and interest rate levels. As of June 30, 2021, certain interest rate swaps met the criteria required to qualify for the shortcut method of accounting that permits the assumption of perfect offset. For all designated fair value hedges of interest rate risk as of June 30, 2021 that were not accounted for under the shortcut method of accounting, the Bancorp performed an assessment of hedge effectiveness using regression analysis with changes in the fair value of the derivative instrument and changes in the fair value of the hedged asset or liability attributable to the hedged risk recorded in the same income statement line in current period net income.\\nThe following table reflects the change in fair value of interest rate contracts, designated as fair value hedges, as well as the change in fair value of the related hedged items attributable to the risk being hedged, included in the Condensed Consolidated Statements of Income:\\n| Condensed ConsolidatedStatements ofIncome Caption | For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Change in fair value of interest rate swaps hedging long- term debt | Interest on long-term debt | $ | 46 | ( 1 ) | ( 99 ) | 226 |\\n| Change in fair value of hedged long-term debt attributable to the risk being hedged | Interest on long-term debt | ( 46 ) | 2 | 99 | ( 225 ) |\\n\\n107\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nThe following amounts were recorded in the Condensed Consolidated Balance Sheets related to cumulative basis adjustments for fair value hedges as of:\\n| ($ in millions) | Condensed ConsolidatedBalance Sheets Caption | June 30,2021 | December 31,2020 |\\n| Carrying amount of the hedged items | Long-term debt | $ | 1,879 | 2,478 |\\n| Cumulative amount of fair value hedging adjustments included in the carrying amount of the hedged items | Long-term debt | 435 | 534 |\\n\\nCash Flow Hedges\\nThe Bancorp may enter into interest rate swaps to convert floating-rate assets and liabilities to fixed rates or to hedge certain forecasted transactions for the variability in cash flows attributable to the contractually specified interest rate. The assets or liabilities may be grouped in circumstances where they share the same risk exposure that the Bancorp desires to hedge. The Bancorp may also enter into interest rate caps and floors to limit cash flow variability of floating-rate assets and liabilities. As of June 30, 2021, all hedges designated as cash flow hedges were assessed for effectiveness using regression analysis. The entire change in the fair value of the interest rate swap included in the assessment of hedge effectiveness is recorded in AOCI and reclassified from AOCI to current period earnings when the hedged item affects earnings. As of June 30, 2021, the maximum length of time over which the Bancorp is hedging its exposure to the variability in future cash flows is 42 months.\\nReclassified gains and losses on interest rate contracts related to commercial and industrial loans are recorded within interest income in the Condensed Consolidated Statements of Income. As of June 30, 2021 and December 31, 2020, $ 548 million and $ 718 million, respectively, of net deferred gains, net of tax, on cash flow hedges were recorded in AOCI in the Condensed Consolidated Balance Sheets. As of June 30, 2021, $ 213 million in net unrealized gains, net of tax, recorded in AOCI are expected to be reclassified into earnings during the next 12 months. This amount could differ from amounts actually recognized due to changes in interest rates, hedge de-designations or the addition of other hedges subsequent to June 30, 2021.\\nDuring both the three and six months ended June 30, 2021 and 2020, there were no gains or losses reclassified from AOCI into earnings associated with the discontinuance of cash flow hedges because it was probable that the original forecasted transaction would no longer occur by the end of the originally specified time period or within the additional period of time as defined by U.S. GAAP.\\nThe following table presents the pre-tax net (losses) gains recorded in the Condensed Consolidated Statements of Income and in the Condensed Consolidated Statements of Comprehensive Income relating to derivative instruments designated as cash flow hedges:\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Amount of pre-tax net (losses) gains recognized in OCI | $ | 11 | 83 | ( 70 ) | 624 |\\n| Amount of pre-tax net gains reclassified from OCI into net income | 73 | 62 | 146 | 94 |\\n\\nFree-Standing Derivative Instruments – Risk Management and Other Business Purposes\\nAs part of its overall risk management strategy relative to its mortgage banking activity, the Bancorp may enter into various free-standing derivatives (principal-only swaps, interest rate swaptions, interest rate floors, mortgage options, TBA securities and interest rate swaps) to economically hedge changes in fair value of its largely fixed-rate MSR portfolio. Principal-only swaps hedge the spread between mortgage rates and LIBOR because these swaps appreciate in value as a result of tightening spreads. Principal-only swaps also provide prepayment protection by increasing in value when prepayment speeds increase, as opposed to MSRs that lose value in a faster prepayment environment. Receive fixed/pay floating interest rate swaps and swaptions increase in value when interest rates do not increase as quickly as expected.\\nThe Bancorp enters into forward contracts and mortgage options to economically hedge the change in fair value of certain residential mortgage loans held for sale due to changes in interest rates. IRLCs issued on residential mortgage loan commitments that will be held for sale are also considered free-standing derivative instruments and the interest rate exposure on these commitments is economically hedged primarily with forward contracts. Revaluation gains and losses from free-standing derivatives related to mortgage banking activity are recorded as a component of mortgage banking net revenue in the Condensed Consolidated Statements of Income.\\nIn conjunction with the sale of Visa, Inc. Class B Shares in 2009, the Bancorp entered into a total return swap in which the Bancorp will make or receive payments based on subsequent changes in the conversion rate of the Class B Shares into Class A Shares. This total return swap is accounted for as a free-standing derivative. Refer to Note 21 for further discussion of significant inputs and assumptions used in the valuation of this instrument.\\nThe Bancorp entered into certain interest rate swap contracts for the purpose of managing its collateral positions across two central clearing parties. These interest rate swaps were perfectly offsetting positions that allowed the Bancorp to lower the cash posted as required initial\\n108\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nmargin at the clearing parties, which reduced its credit exposure to the clearing parties. Given that all relevant terms for these interest rate swaps are offsetting, these trades create no additional market risk for the Bancorp.\\nAs part of the LIBOR to SOFR transition, the Bancorp received certain interest rate swap contracts from the two central clearing parties that are moving from an Effective Federal Funds Rate discounting curve to a SOFR discounting curve. The purpose of these interest rate swaps was to neutralize the impact on collateral requirements due to the change in discounting curves implemented by the central clearing parties.\\nThe net gains (losses) recorded in the Condensed Consolidated Statements of Income relating to free-standing derivative instruments used for risk management and other business purposes are summarized in the following table:\\n| Condensed ConsolidatedStatements ofIncome Caption | For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Interest rate contracts: |\\n| Forward contracts related to residential mortgage loans held for sale | Mortgage banking net revenue | $ | ( 58 ) | 47 | 9 | ( 11 ) |\\n| Interest rate contracts related to MSR portfolio | Mortgage banking net revenue | 46 | 11 | ( 88 ) | 361 |\\n| Foreign exchange contracts: |\\n| Foreign exchange contracts for risk management purposes | Other noninterest income | ( 3 ) | ( 6 ) | ( 5 ) | 8 |\\n| Equity contracts: |\\n| Swap associated with sale of Visa, Inc. Class B Shares | Other noninterest income | ( 37 ) | ( 29 ) | ( 50 ) | ( 51 ) |\\n\\nFree-Standing Derivative Instruments – Customer Accommodation\\nThe majority of the free-standing derivative instruments the Bancorp enters into are for the benefit of its commercial customers. These derivative contracts are not designated against specific assets or liabilities on the Condensed Consolidated Balance Sheets or to forecasted transactions and, therefore, do not qualify for hedge accounting. These instruments include foreign exchange derivative contracts entered into for the benefit of commercial customers involved in international trade to hedge their exposure to foreign currency fluctuations and commodity contracts to hedge such items as natural gas and various other derivative contracts. The Bancorp may economically hedge significant exposures related to these derivative contracts entered into for the benefit of customers by entering into offsetting contracts with approved, reputable, independent counterparties with substantially matching terms. The Bancorp hedges its interest rate exposure on commercial customer transactions by executing offsetting swap agreements with primary dealers. Revaluation gains and losses on interest rate, foreign exchange, commodity and other commercial customer derivative contracts are recorded as a component of commercial banking revenue or other noninterest income in the Condensed Consolidated Statements of Income.\\nThe Bancorp enters into risk participation agreements, under which the Bancorp assumes credit exposure relating to certain underlying interest rate derivative contracts. The Bancorp only enters into these risk participation agreements in instances in which the Bancorp has participated in the loan that the underlying interest rate derivative contract was designed to hedge. The Bancorp will make payments under these agreements if a customer defaults on its obligation to perform under the terms of the underlying interest rate derivative contract. The total notional amount of the risk participation agreements was $ 3.4 billion at both June 30, 2021 and December 31, 2020 and the fair value was a liability of $ 8 million at both June 30, 2021 and December 31, 2020, which is included in other liabilities in the Condensed Consolidated Balance Sheets. As of June 30, 2021, the risk participation agreements had a weighted-average remaining life of 3.2 years.\\nThe Bancorp’s maximum exposure in the risk participation agreements is contingent on the fair value of the underlying interest rate derivative contracts in an asset position at the time of default. The Bancorp monitors the credit risk associated with the underlying customers in the risk participation agreements through the same risk grading system currently utilized for establishing loss reserves in its loan and lease portfolio.\\nRisk ratings of the notional amount of risk participation agreements under this risk rating system are summarized in the following table as of:\\n| ($ in millions) | June 30,2021 | December 31,2020 |\\n| Pass | $ | 3,385 | 3,231 |\\n| Special mention | 14 | 113 |\\n| Substandard | 49 | 52 |\\n| Total | $ | 3,448 | 3,396 |\\n\\n109\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nThe net gains (losses) recorded in the Condensed Consolidated Statements of Income relating to free-standing derivative instruments used for customer accommodation are summarized in the following table:\\n| Condensed ConsolidatedStatements of Income Caption | For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Interest rate contracts: |\\n| Interest rate contracts for customers (contract revenue) | Commercial banking revenue | $ | 12 | 12 | 19 | 26 |\\n| Interest rate contracts for customers (credit portion of fair value adjustment) | Other noninterest expense | 1 | ( 1 ) | 16 | ( 34 ) |\\n| Interest rate lock commitments | Mortgage banking net revenue | 57 | 82 | 89 | 182 |\\n| Commodity contracts: |\\n| Commodity contracts for customers (contract revenue) | Commercial banking revenue | 6 | 4 | 11 | 7 |\\n| Commodity contracts for customers (credit portion of fair value adjustment) | Other noninterest expense | ( 1 ) | — | — | ( 1 ) |\\n| Commodity contracts for customers (credit losses) | Other noninterest expense | — | ( 1 ) | — | ( 1 ) |\\n| Foreign exchange contracts: |\\n| Foreign exchange contracts for customers (contract revenue) | Commercial banking revenue | 16 | 14 | 30 | 26 |\\n| Foreign exchange contracts for customers (contract revenue) | Other noninterest income | ( 2 ) | ( 3 ) | ( 1 ) | 3 |\\n| Foreign exchange contracts for customers (credit portion of fair value adjustment) | Other noninterest expense | — | 1 | — | ( 1 ) |\\n\\nOffsetting Derivative Financial Instruments\\nThe Bancorp’s derivative transactions are generally governed by ISDA Master Agreements and similar arrangements, which include provisions governing the setoff of assets and liabilities between the parties. When the Bancorp has more than one outstanding derivative transaction with a single counterparty, the setoff provisions contained within these agreements generally allow the non-defaulting party the right to reduce its liability to the defaulting party by amounts eligible for setoff, including the collateral received as well as eligible offsetting transactions with that counterparty, irrespective of the currency, place of payment or booking office. The Bancorp’s policy is to present its derivative assets and derivative liabilities on the Condensed Consolidated Balance Sheets on a gross basis, even when provisions allowing for setoff are in place. However, for derivative contracts cleared through certain central clearing parties who have modified their rules to treat variation margin payments as settlements, the fair value of the respective derivative contracts is reported net of the variation margin payments.\\nCollateral amounts included in the tables below consist primarily of cash and highly rated government-backed securities and do not include variation margin payments for derivative contracts with legal rights of setoff for both periods shown.\\nThe following tables provide a summary of offsetting derivative financial instruments:\\n| Gross AmountRecognized in theCondensed ConsolidatedBalance Sheets(a) | Gross Amounts Not Offset in theCondensed Consolidated Balance Sheets |\\n| Derivatives | Collateral(b) | Net Amount |\\n| As of June 30, 2021 |\\n| Derivative assets | $ | 3,169 | ( 742 ) | ( 632 ) | 1,795 |\\n| Derivative liabilities | 1,907 | ( 742 ) | ( 811 ) | 354 |\\n| As of December 31, 2020 |\\n| Derivative assets | $ | 2,862 | ( 621 ) | ( 755 ) | 1,486 |\\n| Derivative liabilities | 1,072 | ( 621 ) | ( 221 ) | 230 |\\n\\n(a)Amount does not include IRLCs because these instruments are not subject to master netting or similar arrangements.\\n(b)Amount of collateral received as an offset to asset positions or pledged as an offset to liability positions. Collateral values in excess of related derivative amounts recognized in the Condensed Consolidated Balance Sheets were excluded from this table.\\n110\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n14. Other Short-Term Borrowings\\nBorrowings with original maturities of one year or less are classified as short-term. The following table presents a summary of the Bancorp’s other short-term borrowings as of:\\n| ($ in millions) | June 30,2021 | December 31,2020 |\\n| Securities sold under repurchase agreements | $ | 533 | 679 |\\n| Derivative collateral | 596 | 474 |\\n| Other secured borrowings | 1 | 39 |\\n| Total other short-term borrowings | $ | 1,130 | 1,192 |\\n\\nThe Bancorp’s securities sold under repurchase agreements are accounted for as secured borrowings and are collateralized by securities included in available-for-sale debt and other securities in the Condensed Consolidated Balance Sheets. These securities are subject to changes in market value and, therefore, the Bancorp may increase or decrease the level of securities pledged as collateral based upon these movements in market value. As of both June 30, 2021 and December 31, 2020, all securities sold under repurchase agreements were secured by agency residential mortgage-backed securities and the repurchase agreements had an overnight remaining contractual maturity.\\nThe Bancorp’s other secured borrowings at December 31, 2020 primarily included obligations recognized by the Bancorp under ASC Topic 860 related to certain loans sold to GNMA and serviced by the Bancorp. Under ASC Topic 860, once the Bancorp has the unilateral right to repurchase the GNMA loans due to the borrower missing three consecutive payments, the Bancorp is considered to have regained effective control over the loan. As such, the Bancorp is required to recognize both the loan and the repurchase liability, regardless of the intent to repurchase the loans. The Bancorp repurchased these loans during the second quarter of 2021.\\n15. Capital Actions\\nAccelerated Share Repurchase Transactions\\nDuring the six months ended June 30, 2021, the Bancorp entered into and settled accelerated share repurchase transactions. As part of these transactions, the Bancorp entered into forward contracts in which the final number of shares delivered at settlement was based generally on a discount to the average daily volume weighted-average price of the Bancorp’s common stock during the term of these repurchase agreements. The accelerated share repurchases were treated as two separate transactions, (i) the repurchase of treasury shares on the repurchase date and (ii) a forward contract indexed to the Bancorp’s common stock.\\nThe following table presents a summary of the Bancorp’s accelerated share repurchase transactions that were entered into and settled during the six months ended June 30, 2021:\\n| Repurchase Date | Amount ($ in millions) | Shares Repurchased on Repurchase Date | Shares Received from Forward Contract Settlement | Total Shares Repurchased | Final Settlement Date |\\n| January 26, 2021 | $ | 180 | 4,951,456 | 366,939 | 5,318,395 | March 31, 2021 |\\n| April 23, 2021 | 347 | 7,894,807 | 675,295 | 8,570,102 | June 11, 2021 |\\n\\nFor further information on a subsequent event related to capital actions, refer to Note 23.\\n111\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n16. Commitments, Contingent Liabilities and Guarantees\\nThe Bancorp, in the normal course of business, enters into financial instruments and various agreements to meet the financing needs of its customers. The Bancorp also enters into certain transactions and agreements to manage its interest rate and prepayment risks, provide funding, equipment and locations for its operations and invest in its communities. These instruments and agreements involve, to varying degrees, elements of credit risk, counterparty risk and market risk in excess of the amounts recognized in the Condensed Consolidated Balance Sheets. The creditworthiness of counterparties for all instruments and agreements is evaluated on a case-by-case basis in accordance with the Bancorp’s credit policies. The Bancorp’s significant commitments, contingent liabilities and guarantees in excess of the amounts recognized in the Condensed Consolidated Balance Sheets are discussed in the following sections.\\nCommitments\\nThe Bancorp has certain commitments to make future payments under contracts. The following table reflects a summary of significant commitments as of:\\n| ($ in millions) | June 30,2021 | December 31,2020 |\\n| Commitments to extend credit | $ | 77,081 | 74,499 |\\n| Forward contracts related to residential mortgage loans held for sale | 3,395 | 2,903 |\\n| Letters of credit | 1,858 | 1,982 |\\n| Purchase obligations | 161 | 195 |\\n| Capital expenditures | 93 | 75 |\\n| Capital commitments for private equity investments | 91 | 83 |\\n\\nCommitments to extend credit\\nCommitments to extend credit are agreements to lend, typically having fixed expiration dates or other termination clauses that may require payment of a fee. Since many of the commitments to extend credit may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash flow requirements. The Bancorp is exposed to credit risk in the event of nonperformance by the counterparty for the amount of the contract. Fixed-rate commitments are also subject to market risk resulting from fluctuations in interest rates and the Bancorp’s exposure is limited to the replacement value of those commitments. As of June 30, 2021 and December 31, 2020, the Bancorp had a reserve for unfunded commitments, including letters of credit, totaling $ 189 million and $ 172 million, respectively, included in other liabilities in the Condensed Consolidated Balance Sheets. The Bancorp monitors the credit risk associated with commitments to extend credit using the same standard regulatory risk rating systems utilized for its loan and lease portfolio.\\nRisk ratings of outstanding commitments to extend credit under this risk rating system are summarized in the following table as of:\\n| ($ in millions) | June 30,2021 | December 31,2020 |\\n| Pass | $ | 74,230 | 71,386 |\\n| Special mention | 1,468 | 2,049 |\\n| Substandard | 1,383 | 1,063 |\\n| Doubtful | — | 1 |\\n| Total commitments to extend credit | $ | 77,081 | 74,499 |\\n\\nLetters of credit\\nStandby and commercial letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party and expire as summarized in the following table as of June 30, 2021:\\n| ($ in millions) |\\n| Less than 1 year(a) | $ | 999 |\\n| 1 - 5 years(a) | 856 |\\n| Over 5 years | 3 |\\n| Total letters of credit | $ | 1,858 |\\n\\n(a)Includes $ 14 and $ 3 issued on behalf of commercial customers to facilitate trade payments in U.S. dollars and foreign currencies which expire less than 1 year and between 1 -5 years, respectively.\\nStandby letters of credit accounted for approximately 99 % of total letters of credit at both June 30, 2021 and December 31, 2020, and are considered guarantees in accordance with U.S. GAAP. Approximately 72 % and 68 % of the total standby letters of credit were collateralized as of June 30, 2021 and December 31, 2020, respectively. In the event of nonperformance by the customers, the Bancorp has rights to the underlying collateral, which can include commercial real estate, physical plant and property, inventory, receivables, cash and marketable securities. The reserve related to these standby letters of credit, which was included in the total reserve for unfunded commitments, was $ 25\\n112\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nmillion and $ 27 million at June 30, 2021 and December 31, 2020, respectively. The Bancorp monitors the credit risk associated with letters of credit using the same standard regulatory risk rating systems utilized for its loan and lease portfolio.\\nRisk ratings of outstanding letters of credit under this risk rating system are summarized in the following table as of:\\n| ($ in millions) | June 30,2021 | December 31,2020 |\\n| Pass | $ | 1,632 | 1,739 |\\n| Special mention | 66 | 111 |\\n| Substandard | 160 | 132 |\\n| Total letters of credit | $ | 1,858 | 1,982 |\\n\\nAt June 30, 2021 and December 31, 2020, the Bancorp had outstanding letters of credit that were supporting certain securities issued as VRDNs. The Bancorp facilitates financing for its commercial customers, which consist of companies and municipalities, by marketing the VRDNs to investors. The VRDNs pay interest to holders at a rate of interest that fluctuates based upon market demand. The VRDNs generally have long-term maturity dates, but can be tendered by the holder for purchase at par value upon proper advance notice. When the VRDNs are tendered, a remarketing agent generally finds another investor to purchase the VRDNs to keep the securities outstanding in the market. As of June 30, 2021 and December 31, 2020, total VRDNs in which the Bancorp was the remarketing agent or that were supported by a Bancorp letter of credit were $ 485 million and $ 385 million, respectively, of which FTS acted as the remarketing agent to issuers on $ 485 million and $ 385 million, respectively. As remarketing agent, FTS is responsible for actively remarketing VRDNs to other investors when they have been tendered. If another investor is not identified, FTS may choose to purchase the VRDNs into inventory at its discretion while it continues to remarket them. If FTS purchases the VRDNs into inventory, it can subsequently tender back the VRDNs to the issuer’s trustee with proper advance notice. The Bancorp issued letters of credit, as a credit enhancement, to $ 138 million and $ 142 million of the VRDNs remarketed by FTS at June 30, 2021 and December 31, 2020, respectively. These letters of credit are included in the total letters of credit balance provided in the previous table. The Bancorp did no t hold any of these VRDNs in its portfolio at June 30, 2021 or December 31, 2020 but classifies them as trading debt securities when held.\\nForward contracts related to residential mortgage loans held for sale\\nThe Bancorp enters into forward contracts to economically hedge the change in fair value of certain residential mortgage loans held for sale due to changes in interest rates. The outstanding notional amounts of these forward contracts are included in the summary of significant commitments table for all periods presented.\\nOther commitments\\nThe Bancorp has entered into a limited number of agreements for work related to banking center construction and to purchase goods or services.\\nContingent Liabilities\\nLegal claims\\nThere are legal claims pending against the Bancorp and its subsidiaries that have arisen in the normal course of business. Refer to Note 17 for additional information regarding these proceedings.\\nGuarantees\\nThe Bancorp has performance obligations upon the occurrence of certain events under financial guarantees provided in certain contractual arrangements as discussed in the following sections.\\nResidential mortgage loans sold with representation and warranty provisions\\nConforming residential mortgage loans sold to unrelated third parties are generally sold with representation and warranty provisions. A contractual liability arises only in the event of a breach of these representations and warranties and, in general, only when a loss results from the breach. The Bancorp may be required to repurchase any previously sold loan, or indemnify or make whole the investor or insurer for which the representation or warranty of the Bancorp proves to be inaccurate, incomplete or misleading. For more information on how the Bancorp establishes the residential mortgage repurchase reserve, refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\\nAs of June 30, 2021 and December 31, 2020, the Bancorp maintained reserves related to loans sold with representation and warranty provisions totaling $ 9 million and $ 8 million, respectively, included in other liabilities in the Condensed Consolidated Balance Sheets.\\nThe Bancorp uses the best information available when estimating its mortgage representation and warranty reserve; however, the estimation process is inherently uncertain and imprecise and, accordingly, losses in excess of the amounts reserved as of June 30, 2021 are reasonably possible. The Bancorp currently estimates that it is reasonably possible that it could incur losses related to mortgage representation and warranty provisions in an amount up to approximately $ 11 million in excess of amounts reserved. This estimate was derived by modifying\\n113\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nthe key assumptions to reflect management’s judgment regarding reasonably possible adverse changes to those assumptions. The actual repurchase losses could vary significantly from the recorded mortgage representation and warranty reserve or this estimate of reasonably possible losses, depending on the outcome of various factors, including those previously discussed.\\nFor both the three months ended June 30, 2021 and 2020, the Bancorp paid an immaterial amount in the form of make-whole payments and repurchased $ 9 million and $ 7 million, respectively, in outstanding principal of loans to satisfy investor demands. For the six months ended June 30, 2021 and 2020, the Bancorp paid $ 1 million and an immaterial amount, respectively, in the form of make-whole payments and repurchased $ 19 million and $ 13 million, respectively, in outstanding principal of loans to satisfy investor demands. Total repurchase demand requests during the three months ended June 30, 2021 and 2020 were $ 18 million and $ 9 million, respectively. Total repurchase demand requests during the six months ended June 30, 2021 and 2020 were $ 28 million and $ 19 million, respectively. Total outstanding repurchase demand inventory was $ 11 million and $ 5 million at June 30, 2021 and December 31, 2020, respectively.\\nMargin accounts\\nFTS, an indirect wholly-owned subsidiary of the Bancorp, guarantees the collection of all margin account balances held by its brokerage clearing agent for the benefit of its customers. FTS is responsible for payment to its brokerage clearing agent for any loss, liability, damage, cost or expense incurred as a result of customers failing to comply with margin or margin maintenance calls on all margin accounts. The margin account balances held by the brokerage clearing agent were $ 27 million and $ 14 million at June 30, 2021 and December 31, 2020, respectively. In the event of any customer default, FTS has rights to the underlying collateral provided. Given the existence of the underlying collateral provided and negligible historical credit losses, the Bancorp does not maintain a loss reserve related to the margin accounts.\\nLong-term borrowing obligations\\nThe Bancorp had certain fully and unconditionally guaranteed long-term borrowing obligations issued by wholly-owned issuing trust entities of $ 62 million at both June 30, 2021 and December 31, 2020.\\nVisa litigation\\nThe Bancorp, as a member bank of Visa prior to Visa’s reorganization and IPO (the “IPO”) of its Class A common shares (the “Class A Shares”) in 2008, had certain indemnification obligations pursuant to Visa’s certificate of incorporation and bylaws and in accordance with its membership agreements. In accordance with Visa’s bylaws prior to the IPO, the Bancorp could have been required to indemnify Visa for the Bancorp’s proportional share of losses based on the pre-IPO membership interests. As part of its reorganization and IPO, the Bancorp’s indemnification obligation was modified to include only certain known or anticipated litigation (the “Covered Litigation”) as of the date of the restructuring. This modification triggered a requirement for the Bancorp to recognize a liability equal to the fair value of the indemnification liability.\\nIn conjunction with the IPO, the Bancorp received 10.1 million of Visa’s Class B common shares (the “Class B Shares”) based on the Bancorp’s membership percentage in Visa prior to the IPO. The Class B Shares are not transferable (other than to another member bank) until the later of the third anniversary of the IPO closing or the date on which the Covered Litigation has been resolved; therefore, the Bancorp’s Class B Shares were classified in other assets and accounted for at their carryover basis of $ 0 . Visa deposited $ 3 billion of the proceeds from the IPO into a litigation escrow account, established for the purpose of funding judgments in, or settlements of, the Covered Litigation. Since then, when Visa’s litigation committee determined that the escrow account was insufficient, Visa issued additional Class A Shares and deposited the proceeds from the sale of the Class A Shares into the litigation escrow account. When Visa funded the litigation escrow account, the Class B Shares were subjected to dilution through an adjustment in the conversion rate of Class B Shares into Class A Shares.\\nIn 2009, the Bancorp completed the sale of Visa, Inc. Class B Shares and entered into a total return swap in which the Bancorp will make or receive payments based on subsequent changes in the conversion rate of the Class B Shares into Class A Shares. The swap terminates on the later of the third anniversary of Visa’s IPO or the date on which the Covered Litigation is settled. Refer to Note 21 for additional information on the valuation of the swap. The counterparty to the swap as a result of its ownership of the Class B Shares will be impacted by dilutive adjustments to the conversion rate of the Class B Shares into Class A Shares caused by any Covered Litigation losses in excess of the litigation escrow account. If actual judgments in, or settlements of, the Covered Litigation significantly exceed current expectations, then additional funding by Visa of the litigation escrow account and the resulting dilution of the Class B Shares could result in a scenario where the Bancorp’s ultimate exposure associated with the Covered Litigation (the “Visa Litigation Exposure”) exceeds the value of the Class B Shares owned by the swap counterparty (the “Class B Value”). In the event the Bancorp concludes that it is probable that the Visa Litigation Exposure exceeds the Class B Value, the Bancorp would record a litigation reserve liability and a corresponding amount of other noninterest expense for the amount of the excess. Any such litigation reserve liability would be separate and distinct from the fair value derivative liability associated with the total return swap.\\nAs of the date of the Bancorp’s sale of the Visa Class B Shares and through June 30, 2021, the Bancorp has concluded that it is not probable that the Visa Litigation Exposure will exceed the Class B value. Based on this determination, upon the sale of Class B Shares, the Bancorp reversed its net Visa litigation reserve liability and recognized a free-standing derivative liability associated with the total return swap. The fair value of the swap liability was $ 213 million at June 30, 2021 and $ 201 million at December 31, 2020. Refer to Note 13 and Note 21 for further information.\\n114\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nAfter the Bancorp’s sale of the Class B Shares, Visa has funded additional amounts into the litigation escrow account which have resulted in further dilutive adjustments to the conversion of Class B Shares into Class A Shares, and along with other terms of the total return swap, required the Bancorp to make cash payments in varying amounts to the swap counterparty as follows:\\n| Period ($ in millions) | VisaFunding Amount | Bancorp CashPayment Amount |\\n| Q2 2010 | $ | 500 | 20 |\\n| Q4 2010 | 800 | 35 |\\n| Q2 2011 | 400 | 19 |\\n| Q1 2012 | 1,565 | 75 |\\n| Q3 2012 | 150 | 6 |\\n| Q3 2014 | 450 | 18 |\\n| Q2 2018 | 600 | 26 |\\n| Q3 2019 | 300 | 12 |\\n\\n115\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n17. Legal and Regulatory Proceedings\\nLitigation\\nVisa/MasterCard Merchant Interchange Litigation\\nIn April 2006, the Bancorp was added as a defendant in a consolidated antitrust class action lawsuit originally filed against Visa®, MasterCard® and several other major financial institutions in the United States District Court for the Eastern District of New York (In re: Payment Card Interchange Fee and Merchant Discount Antitrust Litigation, Case No. 5-MD-1720). The plaintiffs, merchants operating commercial businesses throughout the U.S. and trade associations, claimed that the interchange fees charged by card-issuing banks were unreasonable and sought injunctive relief and unspecified damages. In addition to being a named defendant, the Bancorp is currently also subject to a possible indemnification obligation of Visa as discussed in Note 16 and has also entered into judgment and loss sharing agreements with Visa, MasterCard and certain other named defendants. In October 2012, the parties to the litigation entered into a settlement agreement that was initially approved by the trial court but reversed by the U.S. Second Circuit Court of Appeals and remanded to the district court for further proceedings. Pursuant to the terms of the overturned settlement agreement, the Bancorp had previously paid $ 46 million into a class settlement escrow account. Approximately 8,000 merchants requested exclusion from the class settlement, and therefore, pursuant to the terms of the overturned settlement agreement, approximately 25 % of the funds paid into the class settlement escrow account had been already returned to the control of the defendants. The remaining settlement funds paid by the Bancorp have been maintained in the escrow account. More than 500 of the merchants who requested exclusion from the class filed separate federal lawsuits against Visa, MasterCard and certain other defendants alleging similar antitrust violations. These individual federal lawsuits were transferred to the United States District Court for the Eastern District of New York. While the Bancorp is only named as a defendant in one of the individual federal lawsuits, it may have obligations pursuant to indemnification arrangements and/or the judgment or loss sharing agreements noted above. On September 17, 2018, the defendants in the consolidated class action signed a second settlement agreement (the “Amended Settlement Agreement”) resolving the claims seeking monetary damages by the proposed plaintiffs’ class (the “Plaintiff Damages Class”) and superseding the original settlement agreement entered into in October 2012. The Amended Settlement Agreement included, among other terms, a release from participating class members for liability for claims that accrue no later than five years after the Amended Settlement Agreement becomes final. The Amended Settlement Agreement provided for a total payment by all defendants of approximately $ 6.24 billion, composed of approximately $ 5.34 billion held in escrow plus an additional $ 900 million in new funds. Pursuant to the terms of the Settlement Agreement, $ 700 million of the additional $ 900 million has been returned to the defendants due to the level of opt-outs from the class. The Bancorp’s allocated share of the settlement is within existing reserves, including funds maintained in escrow. On December 13, 2019, the Court entered an order granting final approval for the settlement. The settlement does not resolve the claims of the separate proposed plaintiffs’ class seeking injunctive relief or the claims of merchants who have opted out of the proposed class settlement and are pursuing, or may in the future decide to pursue, private lawsuits. The ultimate outcome in this matter, including the timing of resolution, therefore remains uncertain. Refer to Note 16 for further information.\\nKlopfenstein v. Fifth Third Bank\\nOn August 3, 2012, William Klopfenstein and Adam McKinney filed a lawsuit against Fifth Third Bank in the United States District Court for the Northern District of Ohio (Klopfenstein et al. v. Fifth Third Bank), alleging that the 120 % APR that Fifth Third disclosed on its Early Access program was misleading. Early Access is a deposit-advance program offered to eligible customers with checking accounts. The plaintiffs sought to represent a nationwide class of customers who used the Early Access program and repaid their cash advances within 30 days. On October 31, 2012, the case was transferred to the United States District Court for the Southern District of Ohio. In 2013, four similar putative class action lawsuits were filed against Fifth Third Bank in federal courts throughout the country (Lori and Danielle Laskaris v. Fifth Third Bank, Janet Fyock v. Fifth Third Bank, Jesse McQuillen v. Fifth Third Bank, and Brian Harrison v. Fifth Third Bank). Those four lawsuits were transferred to the Southern District of Ohio and consolidated with the original lawsuit as In re: Fifth Third Early Access Cash Advance Litigation (Case No. 1:12-CV-851). On behalf of a putative class, the plaintiffs sought unspecified monetary and statutory damages, injunctive relief, punitive damages, attorneys’ fees, and pre- and post-judgment interest. On March 30, 2015, the court dismissed all claims alleged in the consolidated lawsuit except a claim under the TILA. On May 28, 2019, the Sixth Circuit Court of Appeals reversed the dismissal of plaintiffs’ breach of contract claim and remanded for further proceedings. The plaintiffs’ claimed damages for the alleged breach of contract claim exceed $ 280 million. On March 26, 2021, the trial court granted plaintiffs’ motion for class certification. No trial date has been set.\\nHelton v. Fifth Third Bank\\nOn August 31, 2015, trust beneficiaries filed an action against Fifth Third Bank, as trustee, in the Probate Court for Hamilton County, Ohio (Helen Clarke Helton, et al. v. Fifth Third Bank, Case No. 2015003814). The plaintiffs alleged breach of the duty to diversify, breach of the duty of impartiality, breach of trust/fiduciary duty, and unjust enrichment, based on Fifth Third’s alleged failure to diversify assets held in two trusts for the plaintiffs’ benefit. The lawsuit sought over $ 800 million in alleged damages, attorneys’ fees, removal of Fifth Third as trustee, and injunctive relief. On April 20, 2018, the Court denied plaintiffs’ motion for summary judgment and granted summary judgment to Fifth Third, dismissing the case in its entirety. On December 18, 2019, the Ohio Court of Appeals affirmed the Probate Court’s dismissal of all of plaintiffs’ claims based upon allegations of Fifth Third’s alleged failure to diversify assets held in two trusts for plaintiffs’ benefit. The appeals court reversed summary judgment on one claim related to Fifth Third’s alleged unjust enrichment through its receipt of certain fees in managing the trusts. The Court of Appeals remanded the case to the Probate Court for further consideration of the lone surviving claim, which comprises a small fraction of the damages originally sought by plaintiffs in the lawsuit. Plaintiffs filed an appeal to the Ohio Supreme\\n116\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nCourt, seeking review of the decision from the Ohio Court of Appeals. On April 14, 2020, the Ohio Supreme Court announced its denial of plaintiffs’ request for review, and subsequently denied plaintiffs’ request for reconsideration. Thereafter, the case returned to the trial court for further adjudication of the lone surviving claim. On July 28, 2021 the trial court issued an order granting summary judgment to Fifth Third on a portion of plaintiffs’ unjust enrichment claim, leaving the remainder of the claim to be resolved at trial, currently scheduled for February 22, 2022.\\nBureau of Consumer Financial Protection v. Fifth Third Bank, National Association\\nOn March 9, 2020, the CFPB filed a lawsuit against Fifth Third in the United States District Court for the Northern District of Illinois entitled CFPB v. Fifth Third Bank, National Association, Case No. 1:20-CV-1683 (N.D. Ill.) (ABW), alleging violations of the Consumer Financial Protection Act, TILA, and Truth in Savings Act related to Fifth Third’s alleged opening of unspecified numbers of allegedly unauthorized credit card, savings, checking, online banking and early access accounts from 2010 through 2016. The CFPB seeks unspecified amounts of civil monetary penalties as well as unspecified customer remediation. On February 12, 2021, the court granted Fifth Third’s motion to transfer venue to the United States District Court for the Southern District of Ohio. The Bancorp is also subject to a consumer class action lawsuit related to the alleged opening of unauthorized accounts which has also been transferred to the United States District Court for the Southern District of Ohio (Zanni v. Fifth Third Bank, et al., Case No. 2020CH04022).\\nShareholder Litigation\\nOn April 7, 2020, Plaintiff Lee Christakis filed a putative class action lawsuit against Fifth Third Bancorp, Fifth Third Chairman and Chief Executive Officer Greg D. Carmichael, and former Fifth Third Chief Financial Officer Tayfun Tuzun in the U.S. District Court for the Northern District of Illinois entitled Lee Christakis, individually and on behalf of all others similarly situated v. Fifth Third Bancorp, et al., Case No. 1:20-cv-2176 (N.D. Ill). The case brings two claims for violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, alleging that the Defendants made material misstatements and omissions in connection with the alleged unauthorized opening of credit card, savings, checking, online banking and early access accounts from 2010 through 2016. The plaintiff seeks certification of a class, unspecified damages, attorneys’ fees and costs. On June 29, 2020, the Court appointed Heavy & General Laborers’ Local 472 & 172 Pension and Annuity Funds as lead plaintiff, and Robins Geller Rudman & Dowd LLP as lead counsel for the plaintiff. On September 14, 2020, the lead plaintiff filed its amended consolidated complaint. On April 27, 2021, the Court granted the defendants’ motion to dismiss and provided plaintiff with leave to amend to attempt to cure the deficiencies.\\nOn July 31, 2020, a second putative shareholder class action lawsuit captioned Dr. Steven Fox, individually and on behalf of all others similarly situated v. Fifth Third Bancorp, et al., Case No. 2020CH05219 was filed on behalf of former shareholders of MB Financial, Inc. in the Cook County, Illinois Circuit Court. The suit brings claims for violation of Sections 11 and 12(a)(2) of the Securities Act of 1933, alleging that the Bancorp and certain of its officers and directors made material misstatements and omissions regarding the alleged improper cross-selling strategy in filings made in connection with the Bancorp’s merger with MB Financial, Inc. On March 19, 2021, the trial court denied the defendants’ motion to dismiss.\\nIn addition, shareholder derivative lawsuits have been filed seeking monetary damages on behalf of the Bancorp alleging certain claims against various officers and directors relating to an alleged improper cross-selling strategy. Four lawsuits filed in the U.S. District Court for the Northern District of Illinois have been consolidated into a single action captioned In re Fifth Third Bancorp Derivative Litigation, Case No. 1:20-cv-04115. Those cases consist of: (1) Pemberton v. Carmichael, et al., Case No. 20-cv-4115 (filed July 13, 2020); (2) Meyer v. Carmichael, et al., Case No. 20-cv-4244 (filed July 17, 2020); (3) Cox v. Carmichael, et al., Case No. 20-cv-4660 (filed August 7, 2020); and (4) Hansen v. Carmichael, et al., Case No. 20-cv-5339 (filed September 10, 2020). Also pending are shareholder derivative matters Reese v. Carmichael, et al., Case No. 20-cv-866 pending in the U.S. District Court of the Southern District of Ohio (filed November 4, 2020), which was subsequently transferred to the Northern District of Illinois (Case No. 1:21-cv-01631) and Sandys v. Carmichael, et al., Case No. A2004539 pending in the Hamilton County, Ohio Court of Common Pleas (filed December 28, 2020).\\nThe Bancorp has also received several shareholder demands under Ohio Rev. Code § 1701.37(c) and lawsuits have been filed arising out of the same. Finally, the Bancorp has received shareholder demands that the Bancorp’s Board of Directors investigate and commence a civil action for failure to detect and/or prevent the alleged illegal cross-selling strategy. One of those shareholders subsequently filed the aforementioned Sandys v. Carmichael, et al. matter.\\nOther litigation\\nThe Bancorp and its subsidiaries are not parties to any other material litigation. However, there are other litigation matters that arise in the normal course of business. While it is impossible to ascertain the ultimate resolution or range of financial liability with respect to these contingent matters, management believes that the resulting liability, if any, from these other actions would not have a material effect upon the Bancorp’s consolidated financial position, results of operations or cash flows.\\nGovernmental Investigations and Proceedings\\nThe Bancorp and/or its affiliates are or may become involved in information-gathering requests, reviews, investigations and proceedings (both formal and informal) by various governmental regulatory agencies and law enforcement authorities, including but not limited to the FRB, OCC, CFPB, SEC, FINRA, U.S. Department of Justice, etc., as well as state and other governmental authorities and self-regulatory\\n117\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nbodies regarding their respective businesses. Additional matters will likely arise from time to time. Any of these matters may result in material adverse consequences or reputational harm to the Bancorp, its affiliates and/or their respective directors, officers and other personnel, including adverse judgments, findings, settlements, fines, penalties, orders, injunctions or other actions, amendments and/or restatements of the Bancorp’s SEC filings and/or financial statements, as applicable, and/or determinations of material weaknesses in our disclosure controls and procedures. Investigations by regulatory authorities may from time to time result in civil or criminal referrals to law enforcement. Additionally, in some cases, regulatory authorities may take supervisory actions that are considered to be confidential supervisory information which may not be publicly disclosed.\\nReasonably Possible Losses in Excess of Accruals\\nThe Bancorp and its subsidiaries are parties to numerous claims and lawsuits as well as threatened or potential actions or claims concerning matters arising from the conduct of its business activities. The outcome of claims or litigation and the timing of ultimate resolution are inherently difficult to predict. The following factors, among others, contribute to this lack of predictability: claims often include significant legal uncertainties, damages alleged by plaintiffs are often unspecified or overstated, discovery may not have started or may not be complete and material facts may be disputed or unsubstantiated. As a result of these factors, the Bancorp is not always able to provide an estimate of the range of reasonably possible outcomes for each claim. An accrual for a potential litigation loss is established when information related to the loss contingency indicates both that a loss is probable and that the amount of loss can be reasonably estimated. Any such accrual is adjusted from time to time thereafter as appropriate to reflect changes in circumstances. The Bancorp also determines, when possible (due to the uncertainties described above), estimates of reasonably possible losses or ranges of reasonably possible losses, in excess of amounts accrued. Under U.S. GAAP, an event is “reasonably possible” if “the chance of the future event or events occurring is more than remote but less than likely” and an event is “remote” if “the chance of the future event or events occurring is slight.” Thus, references to the upper end of the range of reasonably possible loss for cases in which the Bancorp is able to estimate a range of reasonably possible loss mean the upper end of the range of loss for cases for which the Bancorp believes the risk of loss is more than slight. For matters where the Bancorp is able to estimate such possible losses or ranges of possible losses, the Bancorp currently estimates that it is reasonably possible that it could incur losses related to legal and regulatory proceedings, in an aggregate amount up to approximately $ 49 million in excess of amounts accrued, with it also being reasonably possible that no losses will be incurred in these matters. The estimates included in this amount are based on the Bancorp’s analysis of currently available information, and as new information is obtained the Bancorp may change its estimates.\\nFor these matters and others where an unfavorable outcome is reasonably possible but not probable, there may be a range of possible losses in excess of the established accrual that cannot be estimated. Based on information currently available, advice of counsel, available insurance coverage and established accruals, the Bancorp believes that the eventual outcome of the actions against the Bancorp and/or its subsidiaries, including the matters described above, will not, individually or in the aggregate, have a material adverse effect on the Bancorp’s consolidated financial position. However, in the event of unexpected future developments, it is possible that the ultimate resolution of those matters, if unfavorable, may be material to the Bancorp’s results of operations for any particular period, depending, in part, upon the size of the loss or liability imposed and the operating results for the applicable period.\\n18. Income Taxes\\nThe applicable income tax expense was $ 202 million and $ 49 million for the three months ended June 30, 2021 and 2020, respectively, and $ 391 million and $ 61 million for the six months ended June 30, 2021 and 2020, respectively. The effective tax rates for the three months ended June 30, 2021 and 2020 were 22.1 % and 19.9 %, respectively, and 21.8 % and 20.4 % for the six months ended June 30, 2021 and 2020, respectively.\\nWhile it is reasonably possible that the amount of the unrecognized tax benefits with respect to certain of the Bancorp’s uncertain tax positions could increase or decrease during the next 12 months, the Bancorp believes it is unlikely that its unrecognized tax benefits will change by a material amount during the next 12 months.\\n118\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n19. Accumulated Other Comprehensive Income\\nThe tables below present the activity of the components of OCI and AOCI for the three months ended:\\n| Total OCI | Total AOCI |\\n| June 30, 2021 ($ in millions) | Pre-tax Activity | TaxEffect | NetActivity | Beginning Balance | NetActivity | EndingBalance |\\n| Unrealized holding gains on available-for-sale debt securities arising during period | $ | 306 | ( 71 ) | 235 |\\n| Reclassification adjustment for net gains on available-for-sale debt securities included in net income | ( 7 ) | 2 | ( 5 ) |\\n| Net unrealized gains on available-for-sale debt securities | 299 | ( 69 ) | 230 | 1,242 | 230 | 1,472 |\\n| Unrealized holding gains on cash flow hedge derivatives arising during period | 11 | ( 2 ) | 9 |\\n| Reclassification adjustment for net gains on cash flow hedge derivatives included in net income | ( 73 ) | 15 | ( 58 ) |\\n| Net unrealized gains on cash flow hedge derivatives | ( 62 ) | 13 | ( 49 ) | 597 | ( 49 ) | 548 |\\n| Net actuarial loss arising during the year | ( 1 ) | — | ( 1 ) |\\n| Reclassification of amounts to net periodic benefit costs | 3 | ( 1 ) | 2 |\\n| Defined benefit pension plans, net | 2 | ( 1 ) | 1 | ( 43 ) | 1 | ( 42 ) |\\n| Other | — | — | — | ( 4 ) | — | ( 4 ) |\\n| Total | $ | 239 | ( 57 ) | 182 | 1,792 | 182 | 1,974 |\\n\\n| Total OCI | Total AOCI |\\n| June 30, 2020 ($ in millions) | Pre-tax Activity | TaxEffect | NetActivity | Beginning Balance | NetActivity | EndingBalance |\\n| Unrealized holding gains on available-for-sale debt securities arising during period | $ | 602 | ( 146 ) | 456 |\\n| Net unrealized gains on available-for-sale debt securities | 602 | ( 146 ) | 456 | 1,694 | 456 | 2,150 |\\n| Unrealized holding gains on cash flow hedge derivatives arising during period | 83 | ( 17 ) | 66 |\\n| Reclassification adjustment for net gains on cash flow hedge derivatives included in net income | ( 62 ) | 13 | ( 49 ) |\\n| Net unrealized gains on cash flow hedge derivatives | 21 | ( 4 ) | 17 | 824 | 17 | 841 |\\n| Reclassification of amounts to net periodic benefit costs | 1 | — | 1 |\\n| Defined benefit pension plans, net | 1 | — | 1 | ( 41 ) | 1 | ( 40 ) |\\n| Total | $ | 624 | ( 150 ) | 474 | 2,477 | 474 | 2,951 |\\n\\n119\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nThe tables below present the activity of the components of OCI and AOCI for the six months ended:\\n| Total OCI | Total AOCI |\\n| June 30, 2021 ($ in millions) | Pre-tax Activity | Tax Effect | Net Activity | Beginning Balance | Net Activity | Ending Balance |\\n| Unrealized holding losses on available-for-sale debt securities arising during period | $ | ( 609 ) | 143 | ( 466 ) |\\n| Reclassification adjustment for net losses on available-for-sale debt securities included in net income | 9 | ( 2 ) | 7 |\\n| Net unrealized gains on available-for-sale debt securities | ( 600 ) | 141 | ( 459 ) | 1,931 | ( 459 ) | 1,472 |\\n| Unrealized holding losses on cash flow hedge derivatives arising during period | ( 70 ) | 15 | ( 55 ) |\\n| Reclassification adjustment for net gains on cash flow hedge derivatives included in net income | ( 146 ) | 31 | ( 115 ) |\\n| Net unrealized gains on cash flow hedge derivatives | ( 216 ) | 46 | ( 170 ) | 718 | ( 170 ) | 548 |\\n| Net actuarial loss arising during the year | ( 1 ) | — | ( 1 ) |\\n| Reclassification of amounts to net periodic benefit costs | 4 | ( 1 ) | 3 |\\n| Defined benefit pension plans, net | 3 | ( 1 ) | 2 | ( 44 ) | 2 | ( 42 ) |\\n| Other | — | — | — | ( 4 ) | — | ( 4 ) |\\n| Total | $ | ( 813 ) | 186 | ( 627 ) | 2,601 | ( 627 ) | 1,974 |\\n\\n| Total OCI | Total AOCI |\\n| June 30, 2020 ($ in millions) | Pre-tax Activity | Tax Effect | Net Activity | Beginning Balance | Net Activity | Ending Balance |\\n| Unrealized holding gains on available-for-sale debt securities arising during period | $ | 1,757 | ( 419 ) | 1,338 |\\n| Net unrealized gains on available-for-sale debt securities | 1,757 | ( 419 ) | 1,338 | 812 | 1,338 | 2,150 |\\n| Unrealized holding gains on cash flow hedge derivatives arising during period | 624 | ( 131 ) | 493 |\\n| Reclassification adjustment for net gains on cash flow hedge derivatives included in net income | ( 94 ) | 20 | ( 74 ) |\\n| Net unrealized gains on cash flow hedge derivatives | 530 | ( 111 ) | 419 | 422 | 419 | 841 |\\n| Reclassification of amounts to net periodic benefit costs | 3 | ( 1 ) | 2 |\\n| Defined benefit pension plans, net | 3 | ( 1 ) | 2 | ( 42 ) | 2 | ( 40 ) |\\n| Total | $ | 2,290 | ( 531 ) | 1,759 | 1,192 | 1,759 | 2,951 |\\n\\n120\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nThe table below presents reclassifications out of AOCI:\\n| Condensed Consolidated Statements ofIncome Caption | For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Net unrealized gains on available-for-sale debt securities:(b) |\\n| Net losses included in net income | Securities gains (losses), net | $ | 7 | — | ( 9 ) | — |\\n| Income before income taxes | 7 | — | ( 9 ) | — |\\n| Applicable income tax expense | ( 2 ) | — | 2 | — |\\n| Net income | 5 | — | ( 7 ) | — |\\n| Net unrealized gains on cash flow hedge derivatives:(b) |\\n| Interest rate contracts related to C&I loans | Interest and fees on loans and leases | 73 | 62 | 146 | 94 |\\n| Income before income taxes | 73 | 62 | 146 | 94 |\\n| Applicable income tax expense | ( 15 ) | ( 13 ) | ( 31 ) | ( 20 ) |\\n| Net income | 58 | 49 | 115 | 74 |\\n| Net periodic benefit costs:(b) |\\n| Amortization of net actuarial loss | Compensation and benefits(a) | ( 2 ) | ( 1 ) | ( 3 ) | ( 3 ) |\\n| Settlements | Compensation and benefits(a) | ( 1 ) | — | ( 1 ) | — |\\n| Income before income taxes | ( 3 ) | ( 1 ) | ( 4 ) | ( 3 ) |\\n| Applicable income tax expense | 1 | — | 1 | 1 |\\n| Net income | ( 2 ) | ( 1 ) | ( 3 ) | ( 2 ) |\\n| Total reclassifications for the period | Net income | $ | 61 | 48 | 105 | 72 |\\n\\n(a)This AOCI component is included in the computation of net periodic benefit cost. Refer to Note 23 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for further information.\\n(b)Amounts in parentheses indicate reductions to net income.\\n121\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n20. Earnings Per Share\\nThe following tables provide the calculation of earnings per share and the reconciliation of earnings per share and earnings per diluted share:\\n| 2021 | 2020 |\\n| For the three months ended June 30,(in millions, except per share data) | Income | AverageShares | Per ShareAmount | Income | AverageShares | Per ShareAmount |\\n| Earnings Per Share: |\\n| Net income available to common shareholders | $ | 674 | $ | 163 |\\n| Less: Income allocated to participating securities | 1 | 1 |\\n| Net income allocated to common shareholders | $ | 673 | 709 | $ | 0.95 | $ | 162 | 715 | $ | 0.23 |\\n| Earnings Per Diluted Share: |\\n| Net income available to common shareholders | $ | 674 | $ | 163 |\\n| Effect of dilutive securities: |\\n| Stock-based awards | — | 9 | — | 3 |\\n| Net income available to common shareholders plus assumed conversions | $ | 674 | $ | 163 |\\n| Less: Income allocated to participating securities | 1 | 1 |\\n| Net income allocated to common shareholders plus assumed conversions | $ | 673 | 718 | $ | 0.94 | $ | 162 | 718 | $ | 0.23 |\\n\\n| 2021 | 2020 |\\n| For the six months ended June 30,(in millions, except per share data) | Income | Average Shares | Per Share Amount | Income | Average Shares | Per Share Amount |\\n| Earnings Per Share: |\\n| Net income available to common shareholders | $ | 1,348 | $ | 193 |\\n| Less: Income allocated to participating securities | 4 | 2 |\\n| Net income allocated to common shareholders | $ | 1,344 | 712 | $ | 1.89 | $ | 191 | 714 | $ | 0.27 |\\n| Earnings Per Diluted Share: |\\n| Net income available to common shareholders | $ | 1,348 | $ | 193 |\\n| Effect of dilutive securities: |\\n| Stock-based awards | — | 9 | — | 5 |\\n| Net income available to common shareholders plus assumed conversions | $ | 1,348 | $ | 193 |\\n| Less: Income allocated to participating securities | 4 | 2 |\\n| Net income allocated to common shareholders plus assumed conversions | $ | 1,344 | 721 | $ | 1.87 | $ | 191 | 719 | $ | 0.27 |\\n\\nShares are excluded from the computation of earnings per diluted share when their inclusion has an anti-dilutive effect on earnings per share. The diluted earnings per share computation for both the three and six months ended June 30, 2021 excludes an immaterial amount of stock-based awards because their inclusion would have been anti-dilutive. The diluted earnings per share computation for the three and six months ended June 30, 2020 excludes 12 million and 9 million shares, respectively, of stock-based awards because their inclusion would have been anti-dilutive.\\n122\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n21. Fair Value Measurements\\nThe Bancorp measures certain financial assets and liabilities at fair value in accordance with U.S. GAAP, which defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. U.S. GAAP also establishes a fair value hierarchy, which prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the instrument’s fair value measurement. For more information regarding the fair value hierarchy, refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\\nAssets and Liabilities Measured at Fair Value on a Recurring Basis\\nThe following tables summarize assets and liabilities measured at fair value on a recurring basis as of:\\n| Fair Value Measurements Using |\\n| June 30, 2021 ($ in millions) | Level 1 | Level 2 | Level 3 | Total Fair Value |\\n| Assets: |\\n| Available-for-sale debt and other securities: |\\n| U.S. Treasury and federal agencies securities | $ | 107 | — | — | 107 |\\n| Obligations of states and political subdivisions securities | — | 18 | — | 18 |\\n| Mortgage-backed securities: |\\n| Agency residential mortgage-backed securities | — | 10,809 | — | 10,809 |\\n| Agency commercial mortgage-backed securities | — | 19,294 | — | 19,294 |\\n| Non-agency commercial mortgage-backed securities | — | 3,479 | — | 3,479 |\\n| Asset-backed securities and other debt securities | — | 3,785 | — | 3,785 |\\n| Available-for-sale debt and other securities(a) | 107 | 37,385 | — | 37,492 |\\n| Trading debt securities: |\\n| U.S. Treasury and federal agencies securities | 96 | — | — | 96 |\\n| Obligations of states and political subdivisions securities | — | 63 | — | 63 |\\n| Agency residential mortgage-backed securities | — | 69 | — | 69 |\\n| Asset-backed securities and other debt securities | — | 483 | — | 483 |\\n| Trading debt securities | 96 | 615 | — | 711 |\\n| Equity securities | 329 | 12 | — | 341 |\\n| Residential mortgage loans held for sale | — | 1,633 | — | 1,633 |\\n| Residential mortgage loans(b) | — | — | 151 | 151 |\\n| Servicing rights | — | — | 818 | 818 |\\n| Derivative assets: |\\n| Interest rate contracts | 1 | 1,642 | 39 | 1,682 |\\n| Foreign exchange contracts | — | 286 | — | 286 |\\n| Commodity contracts | 27 | 1,213 | — | 1,240 |\\n| Derivative assets(c) | 28 | 3,141 | 39 | 3,208 |\\n| Total assets | $ | 560 | 42,786 | 1,008 | 44,354 |\\n| Liabilities: |\\n| Derivative liabilities: |\\n| Interest rate contracts | $ | 8 | 223 | 8 | 239 |\\n| Foreign exchange contracts | — | 246 | — | 246 |\\n| Equity contracts | — | — | 213 | 213 |\\n| Commodity contracts | 397 | 812 | — | 1,209 |\\n| Derivative liabilities(d) | 405 | 1,281 | 221 | 1,907 |\\n| Short positions: |\\n| U.S. Treasury and federal agencies securities | 110 | — | — | 110 |\\n| Asset-backed securities and other debt securities | — | 417 | — | 417 |\\n| Short positions(d) | 110 | 417 | — | 527 |\\n| Total liabilities | $ | 515 | 1,698 | 221 | 2,434 |\\n\\n(a)Excludes FHLB, FRB and DTCC restricted stock holdings totaling $ 33 , $ 485 and $ 2 , respectively, at June 30, 2021.\\n(b)Includes residential mortgage loans originated as held for sale and subsequently transferred to held for investment.\\n(c)Included in other assets in the Condensed Consolidated Balance Sheets.\\n(d)Included in other liabilities in the Condensed Consolidated Balance Sheets.\\n123\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n| Fair Value Measurements Using |\\n| December 31, 2020 ($ in millions) | Level 1 | Level 2 | Level 3 | Total Fair Value |\\n| Assets: |\\n| Available-for-sale debt and other securities: |\\n| U.S. Treasury and federal agencies securities | $ | 78 | — | — | 78 |\\n| Obligations of states and political subdivisions securities | — | 17 | — | 17 |\\n| Mortgage-backed securities: |\\n| Agency residential mortgage-backed securities | — | 11,907 | — | 11,907 |\\n| Agency commercial mortgage-backed securities | — | 18,221 | — | 18,221 |\\n| Non-agency commercial mortgage-backed securities | — | 3,590 | — | 3,590 |\\n| Asset-backed securities and other debt securities | — | 3,176 | — | 3,176 |\\n| Available-for-sale debt and other securities(a) | 78 | 36,911 | — | 36,989 |\\n| Trading debt securities: |\\n| U.S. Treasury and federal agencies securities | 81 | — | — | 81 |\\n| Obligations of states and political subdivisions securities | — | 10 | — | 10 |\\n| Agency residential mortgage-backed securities | — | 30 | — | 30 |\\n| Asset-backed securities and other debt securities | — | 439 | — | 439 |\\n| Trading debt securities | 81 | 479 | — | 560 |\\n| Equity securities | 293 | 20 | — | 313 |\\n| Residential mortgage loans held for sale | — | 1,481 | — | 1,481 |\\n| Residential mortgage loans(b) | — | — | 161 | 161 |\\n| Servicing rights | — | — | 656 | 656 |\\n| Derivative assets: |\\n| Interest rate contracts | 1 | 2,227 | 61 | 2,289 |\\n| Foreign exchange contracts | — | 255 | — | 255 |\\n| Commodity contracts | 24 | 351 | — | 375 |\\n| Derivative assets(c) | 25 | 2,833 | 61 | 2,919 |\\n| Total assets | $ | 477 | 41,724 | 878 | 43,079 |\\n| Liabilities: |\\n| Derivative liabilities: |\\n| Interest rate contracts | $ | 16 | 261 | 8 | 285 |\\n| Foreign exchange contracts | — | 227 | — | 227 |\\n| Equity contracts | — | — | 201 | 201 |\\n| Commodity contracts | 55 | 304 | — | 359 |\\n| Derivative liabilities(d) | 71 | 792 | 209 | 1,072 |\\n| Short positions: |\\n| U.S. Treasury and federal agencies securities | 63 | — | — | 63 |\\n| Asset-backed securities and other debt securities | — | 392 | — | 392 |\\n| Short positions(d) | 63 | 392 | — | 455 |\\n| Total liabilities | $ | 134 | 1,184 | 209 | 1,527 |\\n\\n(a)Excludes FHLB, FRB and DTCC restricted stock holdings totaling $ 40 , $ 482 and $ 2 , respectively, at December 31, 2020.\\n(b)Includes residential mortgage loans originated as held for sale and subsequently transferred to held for investment.\\n(c)Included in other assets in the Condensed Consolidated Balance Sheets.\\n(d)Included in other liabilities in the Condensed Consolidated Balance Sheets.\\nThe following is a description of the valuation methodologies used for significant instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy.\\nAvailable-for-sale debt and other securities, trading debt securities and equity securities\\nWhere quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities include U.S. Treasury securities and equity securities. If quoted market prices are not available, then fair values are estimated using pricing models which primarily utilize quoted prices of securities with similar characteristics. Level 2 securities may include federal agencies securities, obligations of states and political subdivisions securities, agency residential mortgage-backed securities, agency and non-agency commercial mortgage-backed securities, asset-backed securities and other debt securities and equity securities. These securities are generally valued using a market approach based on observable prices of securities with similar characteristics.\\n124\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nResidential mortgage loans held for sale\\nFor residential mortgage loans held for sale for which the fair value election has been made, fair value is estimated based upon mortgage-backed securities prices and spreads to those prices or, for certain ARM loans, DCF models that may incorporate the anticipated portfolio composition, credit spreads of asset-backed securities with similar collateral and market conditions. The anticipated portfolio composition includes the effect of interest rate spreads and discount rates due to loan characteristics such as the state in which the loan was originated, the loan amount and the ARM margin. Residential mortgage loans held for sale that are valued based on mortgage-backed securities prices are classified within Level 2 of the valuation hierarchy as the valuation is based on external pricing for similar instruments. ARM loans classified as held for sale are also classified within Level 2 of the valuation hierarchy due to the use of observable inputs in the DCF model. These observable inputs include interest rate spreads from agency mortgage-backed securities market rates and observable discount rates.\\nResidential mortgage loans\\nResidential mortgage loans held for sale that are reclassified to held for investment are transferred from Level 2 to Level 3 of the fair value hierarchy. For residential mortgage loans for which the fair value election has been made, and that are reclassified from held for sale to held for investment, the fair value estimation is based on mortgage-backed securities prices, interest rate risk and an internally developed credit component. Therefore, these loans are classified within Level 3 of the valuation hierarchy. An adverse change in the loss rate or severity assumption would result in a decrease in fair value of the related loans.\\nServicing rights\\nMSRs do not trade in an active, open market with readily observable prices. While sales of MSRs do occur, the precise terms and conditions typically are not readily available. Accordingly, the Bancorp estimates the fair value of MSRs using internal OAS models with certain unobservable inputs, primarily prepayment speed assumptions, OAS and weighted-average lives, resulting in a classification within Level 3 of the valuation hierarchy. Refer to Note 12 for further information on the assumptions used in the valuation of the Bancorp’s MSRs.\\nDerivatives\\nExchange-traded derivatives valued using quoted prices and certain over-the-counter derivatives valued using active bids are classified within Level 1 of the valuation hierarchy. Most of the Bancorp’s derivative contracts are valued using DCF or other models that incorporate current market interest rates, credit spreads assigned to the derivative counterparties and other market parameters and, therefore, are classified within Level 2 of the valuation hierarchy. Such derivatives include basic and structured interest rate, foreign exchange and commodity swaps and options. Derivatives that are valued based upon models with significant unobservable market parameters are classified within Level 3 of the valuation hierarchy. At June 30, 2021 and December 31, 2020, derivatives classified as Level 3, which are valued using models containing unobservable inputs, consisted primarily of a total return swap associated with the Bancorp’s sale of Visa, Inc. Class B Shares as well as IRLCs, which utilize internally generated loan closing rate assumptions as a significant unobservable input in the valuation process.\\nUnder the terms of the total return swap, the Bancorp will make or receive payments based on subsequent changes in the conversion rate of the Visa, Inc. Class B Shares into Class A Shares. Additionally, the Bancorp will make a quarterly payment based on Visa’s stock price and the conversion rate of the Visa, Inc. Class B Shares into Class A Shares until the date on which the Covered Litigation is settled. The fair value of the total return swap was calculated using a DCF model based on unobservable inputs consisting of management’s estimate of the probability of certain litigation scenarios, the timing of the resolution of the Covered Litigation and Visa litigation loss estimates in excess, or shortfall, of the Bancorp’s proportional share of escrow funds.\\nAn increase in the loss estimate or a delay in the resolution of the Covered Litigation would result in an increase in the fair value of the derivative liability; conversely, a decrease in the loss estimate or an acceleration of the resolution of the Covered Litigation would result in a decrease in the fair value of the derivative liability. Refer to Note 16 for additional information on the Covered Litigation.\\nThe net asset fair value of the Bancorp’s IRLCs at June 30, 2021 was $ 39 million. Immediate decreases in current interest rates of 25 bps and 50 bps would result in increases in the fair value of the IRLCs of approximately $ 16 million and $ 29 million, respectively. Immediate increases of current interest rates of 25 bps and 50 bps would result in decreases in the fair value of the IRLCs of approximately $ 18 million and $ 37 million, respectively. The decrease in fair value of IRLCs due to immediate 10% and 20% adverse changes in the assumed loan closing rates would be approximately $ 4 million and $ 8 million, respectively, and the increase in fair value due to immediate 10% and 20% favorable changes in the assumed loan closing rates would be approximately $ 4 million and $ 8 million, respectively. These sensitivities are hypothetical and should be used with caution, as changes in fair value based on a variation in assumptions typically cannot be extrapolated because the relationship of the change in assumptions to the change in fair value may not be linear.\\nShort positions\\nWhere quoted prices are available in an active market, short positions are classified within Level 1 of the valuation hierarchy. Level 1 securities include U.S. Treasury securities. If quoted market prices are not available, then fair values are estimated using pricing models which primarily utilize quoted prices of securities with similar characteristics and therefore are classified within Level 2 of the valuation hierarchy. Level 2 securities include asset-backed and other debt securities.\\n125\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nThe following tables are a reconciliation of assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3):\\n| Fair Value Measurements Using Significant Unobservable Inputs (Level 3) |\\n| For the three months ended June 30, 2021 ($ in millions) | ResidentialMortgageLoans | ServicingRights | Interest RateDerivatives,Net(a) | EquityDerivatives | TotalFair Value |\\n| Balance, beginning of period | $ | 153 | 784 | 30 | ( 195 ) | 772 |\\n| Total (losses) gains (realized/unrealized):(b) |\\n| Included in earnings | — | ( 122 ) | 57 | ( 37 ) | ( 102 ) |\\n| Purchases/originations | — | 156 | — | — | 156 |\\n| Settlements | ( 12 ) | — | ( 56 ) | 19 | ( 49 ) |\\n| Transfers into Level 3(c) | 10 | — | — | — | 10 |\\n| Balance, end of period | $ | 151 | 818 | 31 | ( 213 ) | 787 |\\n| The amount of total (losses) gains for the period included in earnings attributable to the change in unrealized gains or losses relating to instruments still held at June 30, 2021 | $ | — | ( 56 ) | 37 | ( 37 ) | ( 56 ) |\\n\\n(a)Net interest rate derivatives include derivative assets and liabilities of $ 39 and $ 8 , respectively, as of June 30, 2021.\\n(b)There were no unrealized gains or losses for the period included in other comprehensive income for instruments still held at June 30, 2021.\\n(c)Includes certain residential mortgage loans originated as held for sale that were transferred to held for investment.\\n| Fair Value Measurements Using Significant Unobservable Inputs (Level 3) |\\n| For the three months ended June 30, 2020 ($ in millions) | ResidentialMortgageLoans | ServicingRights | Interest RateDerivatives,Net(a) | EquityDerivatives | TotalFair Value |\\n| Balance, beginning of period | $ | 185 | 685 | 61 | ( 171 ) | 760 |\\n| Total (losses) gains (realized/unrealized):(b) |\\n| Included in earnings | ( 2 ) | ( 70 ) | 83 | ( 29 ) | ( 18 ) |\\n| Purchases/originations | — | 61 | 5 | — | 66 |\\n| Settlements | ( 20 ) | — | ( 60 ) | 17 | ( 63 ) |\\n| Transfers into Level 3(c) | 22 | — | — | — | 22 |\\n| Balance, end of period | $ | 185 | 676 | 89 | ( 183 ) | 767 |\\n| The amount of total gains (losses) for the period included in earnings attributable to the change in unrealized gains or losses relating to instruments still held at June 30, 2020 | $ | ( 2 ) | ( 23 ) | 85 | ( 29 ) | 31 |\\n\\n(a)Net interest rate derivatives include derivative assets and liabilities of $ 98 and $ 9 , respectively, as of June 30, 2020.\\n(b)There were no unrealized gains or losses for the period included in other comprehensive income for instruments still held at June 30, 2020.\\n(c)Includes certain residential mortgage loans originated as held for sale that were transferred to held for investment.\\n| Fair Value Measurements Using Significant Unobservable Inputs (Level 3) |\\n| For the six months ended June 30, 2021 ($ in millions) | ResidentialMortgageLoans | ServicingRights | Interest RateDerivatives,Net(a) | EquityDerivatives | TotalFair Value |\\n| Balance, beginning of period | $ | 161 | 656 | 53 | ( 201 ) | 669 |\\n| Total (losses) gains (realized/unrealized):(b) |\\n| Included in earnings | ( 1 ) | ( 50 ) | 91 | ( 50 ) | ( 10 ) |\\n| Purchases/originations | — | 212 | ( 1 ) | — | 211 |\\n| Settlements | ( 29 ) | — | ( 112 ) | 38 | ( 103 ) |\\n| Transfers into Level 3(c) | 20 | — | — | — | 20 |\\n| Balance, end of period | $ | 151 | 818 | 31 | ( 213 ) | 787 |\\n| The amount of total gains (losses) for the period included in earnings attributable to the change in unrealized gains or losses relating to instruments still held at June 30, 2021 | $ | ( 1 ) | 69 | 40 | ( 50 ) | 58 |\\n\\n(a)Net interest rate derivatives include derivative assets and liabilities of $ 39 and $ 8 , respectively, as of June 30, 2021.\\n(b)There were no unrealized gains or losses for the period included in other comprehensive income for instruments still held at June 30, 2021.\\n(c)Includes certain residential mortgage loans originated as held for sale that were transferred to held for investment.\\n126\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n| Fair Value Measurements Using Significant Unobservable Inputs (Level 3) |\\n| For the six months ended June 30, 2020 ($ in millions) | ResidentialMortgageLoans | ServicingRights | Interest RateDerivatives,Net(a) | EquityDerivatives | TotalFair Value |\\n| Balance, beginning of period | $ | 183 | 993 | 10 | ( 163 ) | 1,023 |\\n| Total (losses) gains (realized/unrealized):(b) |\\n| Included in earnings | 2 | ( 448 ) | 186 | ( 51 ) | ( 311 ) |\\n| Purchases/originations | — | 131 | 4 | — | 135 |\\n| Settlements | ( 29 ) | — | ( 111 ) | 31 | ( 109 ) |\\n| Transfers into Level 3(c) | 29 | — | — | — | 29 |\\n| Balance, end of period | $ | 185 | 676 | 89 | ( 183 ) | 767 |\\n| The amount of total (losses) gains for the period included in earnings attributable to the change in unrealized gains or losses relating to instruments still held at June 30, 2020 | $ | 2 | ( 331 ) | 93 | ( 51 ) | ( 287 ) |\\n\\n(a)Net interest rate derivatives include derivative assets and liabilities of $ 98 and $ 9 , respectively, as of June 30, 2020.\\n(b)There were no unrealized gains or losses for the period included in other comprehensive income for instruments still held at June 30, 2020.\\n(c)Includes certain residential mortgage loans originated as held for sale that were transferred to held for investment.\\nThe total losses and gains included in earnings for assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) were recorded in the Condensed Consolidated Statements of Income as follows:\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Mortgage banking net revenue | $ | ( 66 ) | 10 | 39 | ( 261 ) |\\n| Commercial banking revenue | 1 | 1 | 1 | 1 |\\n| Other noninterest income | ( 37 ) | ( 29 ) | ( 50 ) | ( 51 ) |\\n| Total losses | $ | ( 102 ) | ( 18 ) | ( 10 ) | ( 311 ) |\\n\\nThe total gains and losses included in earnings attributable to changes in unrealized gains and losses related to Level 3 assets and liabilities still held at June 30, 2021 and 2020 were recorded in the Condensed Consolidated Statements of Income as follows:\\n| For the three months endedJune 30, | For the six months endedJune 30, |\\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\\n| Mortgage banking net revenue | $ | ( 20 ) | 59 | 107 | ( 237 ) |\\n| Commercial banking revenue | 1 | 1 | 1 | 1 |\\n| Other noninterest income | ( 37 ) | ( 29 ) | ( 50 ) | ( 51 ) |\\n| Total gains (losses) | $ | ( 56 ) | 31 | 58 | ( 287 ) |\\n\\n127\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nThe following tables present information as of June 30, 2021 and 2020 about significant unobservable inputs related to the Bancorp’s material categories of Level 3 financial assets and liabilities measured at fair value on a recurring basis:\\n| As of June 30, 2021 ($ in millions) |\\n| Financial Instrument | Fair Value | ValuationTechnique | SignificantUnobservable Inputs | Range of Inputs | Weighted-Average |\\n| Residential mortgage loans | $ | 151 | Loss rate model | Interest rate risk factor | ( 9.2 ) | - | 9.0 % | 1.1 | % | (a) |\\n| Credit risk factor | — | - | 24.8 % | 0.5 | % | (a) |\\n| (Fixed) | 14.5 | % | (b) |\\n| Servicing rights | 818 | DCF | Prepayment speed | — | - | 100.0 % | (Adjustable) | 21.6 | % | (b) |\\n| (Fixed) | 542 | (b) |\\n| OAS (bps) | 406 | - | 1,587 | (Adjustable) | 978 | (b) |\\n| IRLCs, net | 39 | DCF | Loan closing rates | 10.0 | - | 97.2 % | 76.5 | % | (c) |\\n| Swap associated with the sale of Visa, Inc. Class B Shares | ( 213 ) | DCF | Timing of the resolution of the Covered Litigation | Q1 2023 | - | Q1 2025 | Q4 2023 | (d) |\\n\\n(a)Unobservable inputs were weighted by the relative carrying value of the instruments.\\n(b)Unobservable inputs were weighted by the relative unpaid principal balance of the instruments.\\n(c)Unobservable inputs were weighted by the relative notional amount of the instruments.\\n(d)Unobservable inputs were weighted by the probability of the final funding date of the instruments.\\n| As of June 30, 2020 ($ in millions) |\\n| Financial Instrument | Fair Value | ValuationTechnique | SignificantUnobservable Inputs | Range of Inputs | Weighted-Average |\\n| Residential mortgage loans | $ | 185 | Loss rate model | Interest rate risk factor | ( 7.4 ) | - | 11.6 % | 0.7 | % | (a) |\\n| Credit risk factor | — | - | 26.4 % | 0.4 | % | (a) |\\n| (Fixed) | 20.1 | % | (b) |\\n| Servicing rights | 676 | DCF | Prepayment speed | 0.5 | - | 99.6 % | (Adjustable) | 23.4 | % | (b) |\\n| (Fixed) | 784 | (b) |\\n| OAS (bps) | 536 | - | 1,386 | (Adjustable) | 934 | (b) |\\n| IRLCs, net | 91 | DCF | Loan closing rates | 7.2 | - | 97.2 % | 65.7 | % | (c) |\\n| Swap associated with the sale of Visa, Inc. Class B Shares | ( 183 ) | DCF | Timing of the resolution of the Covered Litigation | Q3 2022 | - | Q2 2024 | Q1 2023 | (d) |\\n\\n(a)Unobservable inputs were weighted by the relative carrying value of the instruments.\\n(b)Unobservable inputs were weighted by the relative unpaid principal balance of the instruments.\\n(c)Unobservable inputs were weighted by the relative notional amount of the instruments.\\n(d)Unobservable inputs were weighted by the probability of the final funding date of the instruments.\\nAssets and Liabilities Measured at Fair Value on a Nonrecurring Basis\\nCertain assets and liabilities are measured at fair value on a nonrecurring basis. These assets and liabilities are not measured at fair value on an ongoing basis; however, they are subject to fair value adjustments in certain circumstances, such as when there is evidence of impairment.\\nThe following tables provide the fair value hierarchy and carrying amount of all assets that were held as of June 30, 2021 and 2020, and for which a nonrecurring fair value adjustment was recorded during the three and six months ended June 30, 2021 and 2020, and the related gains and losses from fair value adjustments on assets sold during the period as well as assets still held as of the end of the period.\\n| Fair Value Measurements Using | Total (Losses) Gains |\\n| As of June 30, 2021 ($ in millions) | Level 1 | Level 2 | Level 3 | Total | For the three months ended June 30, 2021 | For the six months ended June 30, 2021 |\\n| Commercial loans held for sale | $ | — | — | 2 | 2 | — | 1 |\\n| Commercial loans and leases | — | — | 313 | 313 | ( 39 ) | ( 44 ) |\\n| Consumer and residential mortgage loans | — | — | 140 | 140 | 1 | ( 1 ) |\\n| OREO | — | — | 6 | 6 | — | ( 6 ) |\\n| Bank premises and equipment | — | — | 7 | 7 | ( 1 ) | ( 2 ) |\\n| Operating lease equipment | — | — | 34 | 34 | — | ( 25 ) |\\n| Private equity investments | — | 1 | — | 1 | — | — |\\n| Total | $ | — | 1 | 502 | 503 | ( 39 ) | ( 77 ) |\\n\\n128\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n| Fair Value Measurements Using | Total (Losses) Gains |\\n| As of June 30, 2020 ($ in millions) | Level 1 | Level 2 | Level 3 | Total | For the three months ended June 30, 2020 | For the six months ended June 30, 2020 |\\n| Commercial loans held for sale | $ | — | 37 | 17 | 54 | ( 1 ) | ( 4 ) |\\n| Commercial loans and leases | — | — | 569 | 569 | ( 118 ) | ( 192 ) |\\n| Consumer and residential mortgage loans | — | — | 186 | 186 | 2 | 3 |\\n| OREO | — | — | 18 | 18 | ( 1 ) | ( 6 ) |\\n| Bank premises and equipment | — | — | 14 | 14 | ( 12 ) | ( 14 ) |\\n| Operating lease equipment | — | — | 10 | 10 | — | ( 3 ) |\\n| Private equity investments | — | — | 70 | 70 | — | ( 9 ) |\\n| Total | $ | — | 37 | 884 | 921 | ( 130 ) | ( 225 ) |\\n\\nThe following tables present information as of June 30, 2021 and 2020 about significant unobservable inputs related to the Bancorp’s material categories of Level 3 financial assets and liabilities measured on a nonrecurring basis:\\n| As of June 30, 2021 ($ in millions) |\\n| Financial Instrument | Fair Value | Valuation Technique | Significant Unobservable Inputs | Ranges ofInputs | Weighted-Average |\\n| Commercial loans held for sale | $ | 2 | Comparable company analysis | Market comparable transactions | NM | NM |\\n| Commercial loans and leases | 313 | Appraised value | Collateral value | NM | NM |\\n| Consumer and residential mortgage loans | 140 | Appraised value | Collateral value | NM | NM |\\n| OREO | 6 | Appraised value | Appraised value | NM | NM |\\n| Bank premises and equipment | 7 | Appraised value | Appraised value | NM | NM |\\n| Operating lease equipment | 34 | Appraised value | Appraised value | NM | NM |\\n\\n| As of June 30, 2020 ($ in millions) |\\n| Financial Instrument | Fair Value | Valuation Technique | Significant Unobservable Inputs | Ranges ofInputs | Weighted-Average |\\n| Commercial loans held for sale | $ | 16 | Comparable company analysis | Market comparable transactions | NM | NM |\\n| 1 | Appraised value | Appraised value | NM | NM |\\n| Commercial loans and leases | 569 | Appraised value | Collateral value | NM | NM |\\n| Consumer and residential mortgage loans | 186 | Appraised value | Collateral value | NM | NM |\\n| OREO | 18 | Appraised value | Appraised value | NM | NM |\\n| Bank premises and equipment | 14 | Appraised value | Appraised value | NM | NM |\\n| Operating lease equipment | 10 | Appraised value | Appraised value | NM | NM |\\n| Private equity investments | 70 | Comparable company analysis | Market comparable transactions | NM | NM |\\n\\nCommercial loans held for sale\\nThe Bancorp estimated the fair value of certain commercial loans held for sale during the six months ended June 30, 2021 and 2020, resulting in positive fair value adjustments of an immaterial amount during both the three and six months ended June 30, 2021, and negative fair value adjustments of $ 1 million and $ 4 million during the three and six months ended June 30, 2020, respectively. These valuations were based on quoted prices for similar assets in active markets (Level 2 of the valuation hierarchy), appraisals of the underlying collateral or by applying unobservable inputs such as an estimated market discount to the unpaid principal balance of the loans or the appraised values of the assets (Level 3 of the valuation hierarchy). The Bancorp recognized losses of an immaterial amount and gains of $ 1 million on the sale of certain commercial loans held for sale during the three and six months ended June 30, 2021, respectively, and gains of an immaterial amount during both the three and six months ended June 30, 2020.\\nPortfolio loans and leases\\nDuring the three and six months ended June 30, 2021 and 2020, the Bancorp recorded nonrecurring impairment adjustments to certain collateral-dependent portfolio loans and leases. When a loan is collateral-dependent, the fair value of the loan is generally based on the fair value less cost to sell of the underlying collateral supporting the loan and therefore these loans were classified within Level 3 of the valuation hierarchy. In cases where the carrying value exceeds the fair value, an impairment loss is recognized. The fair values and recognized impairment losses are reflected in the previous tables.\\nOREO\\nDuring the three and six months ended June 30, 2021 and 2020, the Bancorp recorded nonrecurring adjustments to certain commercial and residential real estate properties and branch-related real estate no longer intended to be used for banking purposes classified as OREO and\\n129\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nmeasured at the lower of carrying amount or fair value. These nonrecurring losses were primarily due to declines in real estate values of the properties recorded in OREO. These losses include an immaterial amount and $ 6 million in losses, respectively, recorded as charge-offs on new OREO properties transferred from loans, during the three and six months ended June 30, 2021 compared to an immaterial amount and $ 2 million in losses during the three and six months ended June 30, 2020, respectively. These losses also included an immaterial amount for both the three and six months ended June 30, 2021, and $ 1 million and $ 4 million for the three and six months ended June 30, 2020, respectively, recorded as negative fair value adjustments on OREO in other noninterest expense or other noninterest income in the Condensed Consolidated Statements of Income subsequent to their transfer into OREO. The fair value amounts are generally based on appraisals of the property values, resulting in a classification within Level 3 of the valuation hierarchy. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized. The previous tables reflect the fair value measurements of the properties before deducting the estimated costs to sell.\\nBank premises and equipment\\nThe Bancorp performs assessments of the recoverability of long-lived assets when events or changes in circumstances indicate that their carrying values may not be recoverable. These properties were written down to their lower of cost or market values. At least annually thereafter, the Bancorp will review these properties for market fluctuations. The fair value amounts were generally based on appraisals of the property values, resulting in a classification within Level 3 of the valuation hierarchy. For further information on bank premises and equipment, refer to Note 7.\\nOperating lease equipment\\nThe Bancorp performs assessments of the recoverability of long-lived assets when events or changes in circumstances indicate that their carrying values may not be recoverable. When evaluating whether an individual asset is impaired, the Bancorp considers the current fair value of the asset, the changes in overall market demand for the asset and the rate of change in advancements associated with technological improvements that impact the demand for the specific asset under review. As part of this ongoing assessment, the Bancorp determined that the carrying values of certain operating lease equipment were not recoverable and, as a result, the Bancorp recorded an impairment loss equal to the amount by which the carrying value of the assets exceeded the fair value. The fair value amounts were generally based on appraised values of the assets, resulting in a classification within Level 3 of the valuation hierarchy.\\nPrivate equity investments\\nThe Bancorp accounts for its private equity investments using the measurement alternative to fair value, except for those accounted for under the equity method of accounting. Under the measurement alternative, the Bancorp carries each investment at its cost basis minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for identical or similar investments of the same issuer. The Bancorp recognized an immaterial amount of gains resulting from observable price changes during both the three and six months ended June 30, 2021 and 2020. The carrying value of the Bancorp’s private equity investments still held as of June 30, 2021 includes a cumulative $ 70 million of positive adjustments as a result of observable price changes since January 1, 2018. Because these adjustments are based on observable transactions in inactive markets, they are classified in Level 2 of the fair value hierarchy.\\nFor private equity investments which are accounted for using the measurement alternative to fair value, the Bancorp qualitatively evaluates each investment quarterly to determine if impairment may exist. If necessary, the Bancorp then measures impairment by estimating the value of its investment and comparing that to the investment’s carrying value, whether or not the Bancorp considers the impairment to be temporary. These valuations are typically developed using a DCF method, but other methods may be used if more appropriate for the circumstances. These valuations are based on unobservable inputs and therefore are classified in Level 3 of the fair value hierarchy. The Bancorp recognized impairments of an immaterial amount for both the three and six months ended June 30, 2021 compared to zero and $ 9 million for the three and six months ended June 30, 2020, respectively. The carrying value of the Bancorp’s private equity investments still held as of June 30, 2021 includes a cumulative $ 21 million of impairment charges recognized since adoption of the measurement alternative to fair value on January 1, 2018.\\nFair Value Option\\nThe Bancorp elected to measure certain residential mortgage loans held for sale under the fair value option as allowed under U.S. GAAP. Electing to measure residential mortgage loans held for sale at fair value reduces certain timing differences and better matches changes in the value of these assets with changes in the value of derivatives used as economic hedges for these assets. Management’s intent to sell residential mortgage loans classified as held for sale may change over time due to such factors as changes in the overall liquidity in markets or changes in characteristics specific to certain loans held for sale. Consequently, these loans may be reclassified to loans held for investment and maintained in the Bancorp’s loan portfolio. In such cases, the loans will continue to be measured at fair value.\\nFair value changes recognized in earnings for residential mortgage loans held at June 30, 2021 and 2020 for which the fair value option was elected, as well as the changes in fair value of the underlying IRLCs, included gains of $ 59 million and $ 45 million, respectively. These gains are reported in mortgage banking net revenue in the Condensed Consolidated Statements of Income.\\n130\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nValuation adjustments related to instrument-specific credit risk for residential mortgage loans measured at fair value negatively impacted the fair value of those loans by $ 1 million at both June 30, 2021 and December 31, 2020. Interest on loans measured at fair value is accrued as it is earned using the effective interest method and is reported as interest income in the Condensed Consolidated Statements of Income.\\nThe following table summarizes the difference between the fair value and the unpaid principal balance for residential mortgage loans measured at fair value as of:\\n| June 30, 2021 ($ in millions) | AggregateFair Value | Aggregate UnpaidPrincipal Balance | Difference |\\n| Residential mortgage loans measured at fair value | $ | 1,784 | 1,725 | 59 |\\n| Past due loans of 90 days or more | 2 | 3 | ( 1 ) |\\n| Nonaccrual loans | — | — | — |\\n| December 31, 2020 |\\n| Residential mortgage loans measured at fair value | $ | 1,642 | 1,567 | 75 |\\n| Past due loans of 90 days or more | 3 | 3 | — |\\n| Nonaccrual loans | — | — | — |\\n\\nThe Bancorp invests in certain hybrid financial instruments with embedded derivatives that are not clearly and closely related to the host contracts. The Bancorp has elected to measure the entire instrument at fair value with changes in fair value recognized in earnings. The carrying value of these investments was $ 48 million as of June 30, 2021 and the investments are classified as trading debt securities on the Condensed Consolidated Balance Sheets. Fair value changes recognized in earnings included losses of $ 8 million and gains of $ 1 million for the three and six months ended June 30, 2021, respectively, reported in securities gains (losses), net in the Condensed Consolidated Statements of Income.\\nFair Value of Certain Financial Instruments\\nThe following tables summarize the carrying amounts and estimated fair values for certain financial instruments, excluding financial instruments measured at fair value on a recurring basis:\\n| Net CarryingAmount | Fair Value Measurements Using | TotalFair Value |\\n| As of June 30, 2021 ($ in millions) | Level 1 | Level 2 | Level 3 |\\n| Financial assets: |\\n| Cash and due from banks | $ | 3,285 | 3,285 | — | — | 3,285 |\\n| Other short-term investments | 32,409 | 32,409 | — | — | 32,409 |\\n| Other securities | 520 | — | 520 | — | 520 |\\n| Held-to-maturity securities | 10 | — | — | 10 | 10 |\\n| Loans and leases held for sale | 4,097 | — | — | 4,104 | 4,104 |\\n| Portfolio loans and leases: |\\n| Commercial loans and leases | 65,796 | — | — | 66,498 | 66,498 |\\n| Consumer and residential mortgage loans | 39,753 | — | — | 40,941 | 40,941 |\\n| Total portfolio loans and leases, net | $ | 105,549 | — | — | 107,439 | 107,439 |\\n| Financial liabilities: |\\n| Deposits | $ | 162,283 | — | 162,285 | — | 162,285 |\\n| Federal funds purchased | 338 | 338 | — | — | 338 |\\n| Other short-term borrowings | 1,130 | — | 1,130 | — | 1,130 |\\n| Long-term debt | 12,364 | 12,821 | 850 | — | 13,671 |\\n\\n131\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n| Net CarryingAmount | Fair Value Measurements Using | TotalFair Value |\\n| As of December 31, 2020 ($ in millions) | Level 1 | Level 2 | Level 3 |\\n| Financial assets: |\\n| Cash and due from banks | $ | 3,147 | 3,147 | — | — | 3,147 |\\n| Other short-term investments | 33,399 | 33,399 | — | — | 33,399 |\\n| Other securities | 524 | — | 524 | — | 524 |\\n| Held-to-maturity securities | 11 | — | — | 11 | 11 |\\n| Loans and leases held for sale | 3,260 | — | — | 3,269 | 3,269 |\\n| Portfolio loans and leases: |\\n| Commercial loans and leases | 67,541 | — | — | 67,810 | 67,810 |\\n| Consumer loans | 38,627 | — | — | 40,522 | 40,522 |\\n| Total portfolio loans and leases, net | $ | 106,168 | — | — | 108,332 | 108,332 |\\n| Financial liabilities: |\\n| Deposits | $ | 159,081 | — | 159,094 | — | 159,094 |\\n| Federal funds purchased | 300 | 300 | — | — | 300 |\\n| Other short-term borrowings | 1,192 | — | 1,192 | — | 1,192 |\\n| Long-term debt | 14,973 | 15,606 | 923 | — | 16,529 |\\n\\n132\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n22. Business Segments\\nThe Bancorp reports on four business segments: Commercial Banking, Branch Banking, Consumer Lending and Wealth and Asset Management. Results of the Bancorp’s business segments are presented based on its management structure and management accounting practices. The structure and accounting practices are specific to the Bancorp; therefore, the financial results of the Bancorp’s business segments are not necessarily comparable with similar information for other financial institutions. The Bancorp refines its methodologies from time to time as management’s accounting practices and businesses change.\\nThe Bancorp manages interest rate risk centrally at the corporate level. By employing an FTP methodology, the business segments are insulated from most benchmark interest rate volatility, enabling them to focus on serving customers through the origination of loans and acceptance of deposits. The FTP methodology assigns charge and credit rates to classes of assets and liabilities, respectively, based on the estimated amount and timing of the cash flows for each transaction. Assigning the FTP rate based on matching the duration of cash flows allocates interest income and interest expense to each business segment so its resulting net interest income is insulated from future changes in benchmark interest rates. The Bancorp’s FTP methodology also allocates the contribution to net interest income of the asset-generating and deposit-providing businesses on a duration-adjusted basis to better attribute the driver of the performance. As the asset and liability durations are not perfectly matched, the residual impact of the FTP methodology is captured in General Corporate and Other. The charge and credit rates are determined using the FTP rate curve, which is based on an estimate of Fifth Third’s marginal borrowing cost in the wholesale funding markets. The FTP curve is constructed using the U.S. swap curve, brokered CD pricing and unsecured debt pricing.\\nThe Bancorp adjusts the FTP charge and credit rates as dictated by changes in interest rates for various interest-earning assets and interest-bearing liabilities and by the review of behavioral assumptions, such as prepayment rates on interest-earning assets and the estimated durations for indeterminate-lived deposits. Key assumptions, including the credit rates provided for deposit accounts, are reviewed annually. Credit rates for deposit products and charge rates for loan products may be reset more frequently in response to changes in market conditions.\\nThe Bancorp’s methodology for allocating provision for credit losses expense to the business segments includes charges or benefits associated with changes in criticized commercial loan levels in addition to actual net charge-offs experienced by the loans and leases owned by each business segment. Provision for credit losses expense attributable to loan and lease growth and changes in ALLL factors is captured in General Corporate and Other. The financial results of the business segments include allocations for shared services and headquarters expenses. Additionally, the business segments form synergies by taking advantage of relationship depth opportunities and funding operations by accessing the capital markets as a collective unit.\\nThe following is a description of each of the Bancorp’s business segments and the products and services they provide to their respective client bases.\\nCommercial Banking offers credit intermediation, cash management and financial services to large and middle-market businesses and government and professional customers. In addition to the traditional lending and depository offerings, Commercial Banking products and services include global cash management, foreign exchange and international trade finance, derivatives and capital markets services, asset-based lending, real estate finance, public finance, commercial leasing and syndicated finance.\\nBranch Banking provides a full range of deposit and loan and lease products to individuals and small businesses through 1,096 full-service banking centers. Branch Banking offers depository and loan products, such as checking and savings accounts, home equity loans and lines of credit, credit cards and loans for automobiles and other personal financing needs, as well as products designed to meet the specific needs of small businesses, including cash management services.\\nConsumer Lending includes the Bancorp’s residential mortgage, automobile and other indirect lending activities. Residential mortgage activities within Consumer Lending include the origination, retention and servicing of residential mortgage loans, sales and securitizations of those loans and all associated hedging activities. Residential mortgages are primarily originated through a dedicated sales force and through third-party correspondent lenders. Automobile and other indirect lending activities include extending loans to consumers through automobile dealers, motorcycle dealers, powersport dealers, recreational vehicle dealers and marine dealers.\\nWealth and Asset Management provides a full range of wealth management services for individuals, companies and not-for-profit organizations. Wealth and Asset Management is made up of three main businesses: FTS, an indirect wholly-owned subsidiary of the Bancorp; Fifth Third Private Bank; and Fifth Third Institutional Services. FTS offers full service retail brokerage services to individual clients and broker-dealer services to the institutional marketplace. Fifth Third Private Bank offers wealth management strategies to high net worth and ultra-high net worth clients through wealth planning, investment management, banking, insurance, trust and estate services. Fifth Third Institutional Services provides advisory services for institutional clients, including middle market businesses, non-profits, states and municipalities.\\n133\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nThe following tables present the results of operations and assets by business segment for the three months ended:\\n| June 30, 2021 ($ in millions) | CommercialBanking | BranchBanking | ConsumerLending | Wealthand AssetManagement | GeneralCorporate and Other | Eliminations | Total |\\n| Net interest income | $ | 376 | 301 | 142 | 21 | 368 | — | 1,208 |\\n| (Benefit from) provision for credit losses | ( 151 ) | 25 | — | — | 11 | — | ( 115 ) |\\n| Net interest income after (benefit from) provision for credit losses | $ | 527 | 276 | 142 | 21 | 357 | — | 1,323 |\\n| Noninterest income: |\\n| Commercial banking revenue | $ | 156 | 3 | — | 1 | — | — | 160 |\\n| Service charges on deposits | 92 | 57 | — | — | — | — | 149 |\\n| Wealth and asset management revenue | 1 | 52 | — | 138 | — | ( 46 ) | (a) | 145 |\\n| Card and processing revenue | 15 | 84 | — | 1 | 2 | — | 102 |\\n| Mortgage banking net revenue | — | 3 | 60 | 1 | — | — | 64 |\\n| Leasing business revenue | 61 | — | — | — | — | — | 61 |\\n| Other noninterest income(b) | 30 | 25 | 2 | 2 | ( 10 ) | — | 49 |\\n| Securities gains, net | — | — | — | — | 10 | — | 10 |\\n| Securities gains, net – non-qualifying hedges on MSRs | — | — | 1 | — | — | — | 1 |\\n| Total noninterest income | $ | 355 | 224 | 63 | 143 | 2 | ( 46 ) | 741 |\\n| Noninterest expense: |\\n| Compensation and benefits | $ | 136 | 158 | 61 | 49 | 234 | — | 638 |\\n| Technology and communications | 4 | 1 | 3 | — | 86 | — | 94 |\\n| Net occupancy expense(c) | 8 | 49 | 3 | 4 | 13 | — | 77 |\\n| Equipment expense | 7 | 9 | — | — | 18 | — | 34 |\\n| Leasing business expense | 33 | — | — | — | — | — | 33 |\\n| Card and processing expense | 2 | 19 | — | — | ( 1 ) | — | 20 |\\n| Marketing expense | 2 | 7 | 1 | — | 10 | — | 20 |\\n| Other noninterest expense | 207 | 207 | 95 | 78 | ( 304 ) | ( 46 ) | 237 |\\n| Total noninterest expense | $ | 399 | 450 | 163 | 131 | 56 | ( 46 ) | 1,153 |\\n| Income before income taxes | $ | 483 | 50 | 42 | 33 | 303 | — | 911 |\\n| Applicable income tax expense | 90 | 10 | 9 | 7 | 86 | — | 202 |\\n| Net income | $ | 393 | 40 | 33 | 26 | 217 | — | 709 |\\n| Total goodwill | $ | 1,981 | 2,047 | — | 231 | — | — | 4,259 |\\n| Total assets | $ | 68,851 | 87,646 | 33,215 | 10,881 | 4,797 | (d) | — | 205,390 |\\n\\n(a)Revenue sharing agreements between wealth and asset management and branch banking are eliminated in the Condensed Consolidated Statements of Income.\\n(b)Includes impairment charges of $ 2 for branches and land recorded in Branch Banking. For more information, refer to Note 7 and Note 21.\\n(c)Includes impairment losses and termination charges of $ 2 for ROU assets related to certain operating leases. For more information refer to Note 9.\\n(d)Includes bank premises and equipment of $ 25 classified as held for sale. For more information, refer to Note 7.\\n134\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n| June 30, 2020 ($ in millions) | CommercialBanking | BranchBanking | ConsumerLending | Wealthand AssetManagement | GeneralCorporate and Other | Eliminations | Total |\\n| Net interest income | $ | 570 | 513 | 92 | 51 | ( 26 ) | — | 1,200 |\\n| Provision for (benefit from) credit losses | 457 | 52 | 10 | ( 1 ) | ( 33 ) | — | 485 |\\n| Net interest income after provision for (benefit from) credit losses | $ | 113 | 461 | 82 | 52 | 7 | — | 715 |\\n| Noninterest income: |\\n| Commercial banking revenue | $ | 136 | 1 | — | 1 | ( 1 ) | — | 137 |\\n| Service charges on deposits | 79 | 42 | — | — | 1 | — | 122 |\\n| Wealth and asset management revenue | 1 | 39 | — | 115 | — | ( 35 ) | (a) | 120 |\\n| Card and processing revenue | 11 | 68 | — | — | 3 | — | 82 |\\n| Mortgage banking net revenue | — | 2 | 96 | 1 | — | — | 99 |\\n| Leasing business revenue | 57 | — | — | — | — | — | 57 |\\n| Other noninterest income(b) | 10 | 15 | 2 | 4 | ( 19 ) | — | 12 |\\n| Securities gains, net | — | — | — | — | 21 | — | 21 |\\n| Securities gains, net – non-qualifying hedges on MSRs | — | — | — | — | — | — | — |\\n| Total noninterest income | $ | 294 | 167 | 98 | 121 | 5 | ( 35 ) | 650 |\\n| Noninterest expense: |\\n| Compensation and benefits | $ | 129 | 161 | 53 | 50 | 234 | — | 627 |\\n| Technology and communications | 3 | 1 | 2 | — | 84 | — | 90 |\\n| Net occupancy expense(c) | 8 | 44 | 2 | 3 | 25 | — | 82 |\\n| Equipment expense | 7 | 10 | — | — | 15 | — | 32 |\\n| Leasing business expense | 33 | — | — | — | — | — | 33 |\\n| Card and processing expense | 2 | 28 | — | — | ( 1 ) | — | 29 |\\n| Marketing expense | 2 | 5 | 1 | — | 12 | — | 20 |\\n| Other noninterest expense | 221 | 205 | 62 | 69 | ( 314 ) | ( 35 ) | 208 |\\n| Total noninterest expense | $ | 405 | 454 | 120 | 122 | 55 | ( 35 ) | 1,121 |\\n| Income (loss) before income taxes | $ | 2 | 174 | 60 | 51 | ( 43 ) | — | 244 |\\n| Applicable income tax expense (benefit) | ( 10 ) | 36 | 12 | 11 | — | — | 49 |\\n| Net income (loss) | $ | 12 | 138 | 48 | 40 | ( 43 ) | — | 195 |\\n| Total goodwill | $ | 1,961 | 2,047 | — | 253 | — | — | 4,261 |\\n| Total assets | $ | 76,437 | 77,219 | 26,451 | 11,680 | 11,119 | (d) | — | 202,906 |\\n\\n(a)Revenue sharing agreements between wealth and asset management and branch banking are eliminated in the Condensed Consolidated Statements of Income.\\n(b)Includes impairment charges of $ 4 and $ 8 for branches and land recorded in Branch Banking and General Corporate and Other, respectively. For more information, refer to Note 7 and Note 21.\\n(c)Includes impairment losses and termination charges of $ 3 for ROU assets related to certain operating leases. For more information refer to Note 9.\\n(d)Includes bank premises and equipment of $ 53 classified as held for sale. For more information, refer to Note 7.\\n135\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\nThe following tables present the results of operations and assets by business segment for the six months ended:\\n| June 30, 2021 ($ in millions) | CommercialBanking | BranchBanking | ConsumerLending | Wealthand AssetManagement | GeneralCorporate and Other | Eliminations | Total |\\n| Net interest income | $ | 741 | 596 | 269 | 42 | 737 | — | 2,385 |\\n| (Benefit from) provision for credit losses | ( 227 ) | 66 | 8 | ( 1 ) | ( 134 ) | — | ( 288 ) |\\n| Net interest income after (benefit from) provision for credit losses | $ | 968 | 530 | 261 | 43 | 871 | — | 2,673 |\\n| Noninterest income: |\\n| Commercial banking revenue | $ | 307 | 5 | — | 1 | — | — | 313 |\\n| Service charges on deposits | 181 | 111 | — | — | — | — | 292 |\\n| Wealth and asset management revenue | 1 | 102 | — | 274 | — | ( 89 ) | (a) | 288 |\\n| Card and processing revenue | 29 | 161 | — | 1 | 5 | — | 196 |\\n| Mortgage banking net revenue | — | 5 | 142 | 2 | — | — | 149 |\\n| Leasing business revenue | 148 | (c) | — | — | — | — | — | 148 |\\n| Other noninterest income(b) | 42 | 45 | 4 | 3 | ( 2 ) | — | 92 |\\n| Securities gains, net | 7 | — | — | — | 6 | — | 13 |\\n| Securities losses, net – non-qualifying hedges on MSRs | — | — | ( 1 ) | — | — | — | ( 1 ) |\\n| Total noninterest income | $ | 715 | 429 | 145 | 281 | 9 | ( 89 ) | 1,490 |\\n| Noninterest expense: |\\n| Compensation and benefits | $ | 292 | 328 | 127 | 103 | 493 | — | 1,343 |\\n| Technology and communications | 7 | 2 | 5 | — | 173 | — | 187 |\\n| Net occupancy expense(d) | 17 | 96 | 5 | 7 | 31 | — | 156 |\\n| Equipment expense | 13 | 19 | — | — | 36 | — | 68 |\\n| Leasing business expense | 68 | — | — | — | — | — | 68 |\\n| Card and processing expense | 3 | 49 | — | — | ( 2 ) | — | 50 |\\n| Marketing expense | 3 | 15 | 1 | 1 | 23 | — | 43 |\\n| Other noninterest expense | 416 | 430 | 186 | 156 | ( 645 ) | ( 89 ) | 454 |\\n| Total noninterest expense | $ | 819 | 939 | 324 | 267 | 109 | ( 89 ) | 2,369 |\\n| Income before income taxes | $ | 864 | 20 | 82 | 57 | 771 | — | 1,794 |\\n| Applicable income tax expense | 160 | 4 | 17 | 12 | 198 | — | 391 |\\n| Net income | $ | 704 | 16 | 65 | 45 | 573 | — | 1,403 |\\n| Total goodwill | $ | 1,981 | 2,047 | — | 231 | — | — | 4,259 |\\n| Total assets | $ | 68,851 | 87,646 | 33,215 | 10,881 | 4,797 | (e) | — | 205,390 |\\n\\n(a)Revenue sharing agreements between wealth and asset management and branch banking are eliminated in the Condensed Consolidated Statements of Income.\\n(b)Includes impairment charges of $ 3 and $ 1 for branches and land recorded in Branch Banking and General Corporate and Other, respectively. For more information, refer to Note 7 and Note 21.\\n(c)Includes impairment charges of $ 25 for operating lease equipment. For more information, refer to Note 8 and Note 21.\\n(d)Includes impairment losses and termination charges of $ 2 for ROU assets related to certain operating leases. For more information refer to Note 9.\\n(e)Includes bank premises and equipment of $ 25 classified as held for sale. For more information, refer to Note 7.\\n136\\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\\n\\n| June 30, 2020 ($ in millions) | CommercialBanking | BranchBanking | ConsumerLending | Wealthand AssetManagement | GeneralCorporate and Other | Eliminations | Total |\\n| Net interest income | $ | 1,078 | 1,017 | 181 | 88 | 65 | — | 2,429 |\\n| Provision for credit losses | 502 | 114 | 23 | — | 486 | — | 1,125 |\\n| Net interest income after provision for credit losses | $ | 576 | 903 | 158 | 88 | ( 421 ) | — | 1,304 |\\n| Noninterest income: |\\n| Commercial banking revenue | $ | 260 | 2 | — | 1 | ( 2 ) | — | 261 |\\n| Service charges on deposits | 162 | 107 | — | 1 | — | — | 270 |\\n| Wealth and asset management revenue | 2 | 84 | — | 244 | — | ( 75 ) | (a) | 255 |\\n| Card and processing revenue | 26 | 133 | — | 1 | 7 | — | 167 |\\n| Mortgage banking net revenue | — | 4 | 213 | 2 | — | — | 219 |\\n| Leasing business revenue | 131 | (c) | — | — | — | — | — | 131 |\\n| Other noninterest income(b) | ( 1 ) | 34 | 6 | 9 | ( 30 ) | — | 18 |\\n| Securities losses, net | — | — | — | — | ( 3 ) | — | ( 3 ) |\\n| Securities gains, net – non-qualifying hedges on MSRs | — | — | 3 | — | — | — | 3 |\\n| Total noninterest income | $ | 580 | 364 | 222 | 258 | ( 28 ) | ( 75 ) | 1,321 |\\n| Noninterest expense: |\\n| Compensation and benefits | $ | 278 | 330 | 104 | 112 | 450 | — | 1,274 |\\n| Technology and communications | 6 | 1 | 5 | — | 171 | — | 183 |\\n| Net occupancy expense(e) | 15 | 87 | 5 | 6 | 51 | — | 164 |\\n| Equipment expense | 14 | 21 | — | — | 29 | — | 64 |\\n| Leasing business expense | 68 | — | — | — | — | — | 68 |\\n| Card and processing expense | 4 | 58 | — | — | ( 2 ) | — | 60 |\\n| Marketing expense | 4 | 17 | 2 | 1 | 27 | — | 51 |\\n| Other noninterest expense | 495 | 426 | 128 | 147 | ( 664 ) | ( 75 ) | 457 |\\n| Total noninterest expense | $ | 884 | 940 | 244 | 266 | 62 | ( 75 ) | 2,321 |\\n| Income (loss) before income taxes | $ | 272 | 327 | 136 | 80 | ( 511 ) | — | 304 |\\n| Applicable income tax expense (benefit) | 35 | 69 | 29 | 16 | ( 88 ) | — | 61 |\\n| Net income (loss) | $ | 237 | 258 | 107 | 64 | ( 423 ) | — | 243 |\\n| Total goodwill | $ | 1,961 | 2,047 | — | 253 | — | — | 4,261 |\\n| Total assets | $ | 76,437 | 77,219 | 26,451 | 11,680 | 11,119 | (d) | — | 202,906 |\\n\\n(a)Revenue sharing agreements between wealth and asset management and branch banking are eliminated in the Condensed Consolidated Statements of Income.\\n(b)Includes impairment charges of $ 4 and $ 10 for branches and land recorded in Branch Banking and General Corporate and Other, respectively. For more information, refer to Note 7 and Note 21.\\n(c)Includes impairment charges of $ 3 for operating lease equipment. For more information, refer to Note 8 and Note 21.\\n(d)Includes bank premises and equipment of $ 53 classified as held for sale. For more information, refer to Note 7.\\n(e)Includes impairment losses of and termination charges of $ 5 for ROU assets related to certain operating leases. For more information, refer to Note 9.\\n23. Subsequent Event\\nOn July 23, 2021, the Bancorp entered into an accelerated share repurchase transaction with a counterparty pursuant to which the Bancorp paid $ 550 million on July 27, 2021 to repurchase shares of its outstanding common stock. The Bancorp is repurchasing the shares of its common stock as part of its Board-approved 100 million share repurchase program previously announced on June 18, 2019. The Bancorp expects the final settlement of the transaction to occur on or before September 29, 2021.\\n137\\nPART II. OTHER INFORMATION\\nLegal Proceedings (Item 1)\\nRefer to Note 17 of the Notes to Condensed Consolidated Financial Statements in Part I, Item 1 for information regarding legal proceedings.\\nRisk Factors (Item 1A)\\nThe following is a change to the risk factors as previously disclosed in Item 1A of the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2020. Other than as set forth below, there were no material changes to the risk factors disclosed in Item 1A of the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2020.\\nThe COVID-19 pandemic creates significant risks and uncertainties for Fifth Third’s business.\\nIn March 2020, the World Health Organization declared novel coronavirus disease 2019 (COVID-19) a global pandemic. The COVID-19 pandemic has negatively impacted the global economy, disrupted global supply chains, created significant volatility and disruption in financial markets and increased unemployment levels, all of which may become heightened concerns upon subsequent waves of infection or future developments. In addition, the pandemic resulted in temporary closures of many businesses and the institution of social distancing and sheltering in place requirements in many states and communities, including those in major markets in which the Bancorp is located or does business.\\nAs a result, the demand for the Bancorp’s products and services has been, and is expected to continue to be, significantly impacted. Furthermore, the pandemic could influence the recognition of credit losses in the Bancorp’s loan and lease portfolios and increase its allowance for credit losses as both businesses and consumers are negatively impacted by the economic downturn. In addition, governmental actions are meaningfully influencing the interest-rate environment, which could continue to adversely affect the Bancorp’s results of operations and financial condition. The business operations of subsidiaries of the Bancorp, such as Fifth Third Bank, National Association, have been, and may also be disrupted in the future, if significant portions of their workforce are unable to work effectively, including because of illness, quarantines, government actions, travel restrictions, technology limitations and/or disruptions or other restrictions in connection with the pandemic. Furthermore, the business operations of subsidiaries of the Bancorp have been, and may again in the future be, disrupted due to vendors and third party service providers being unable to work or provide services effectively, including because of illness, quarantines, government actions, or other restrictions in connection with the pandemic. An increase in the remote work force due to the COVID-19 pandemic and the potential for a long-term change in Fifth Third’s remote work strategy may also increase risks related to cybersecurity and information security.\\nIn response to the pandemic, the Bancorp provided financial hardship relief to borrowers that were negatively impacted by the pandemic and its related economic impacts. These programs included payment deferrals and forbearances for both commercial and retail borrowers. The Bancorp has also temporarily suspended all residential foreclosure activity. These actions are expected to negatively impact revenue and other results of operations of the Bancorp in the near term and, if not effective in mitigating the effects of the COVID-19 pandemic on the Bancorp’s customers, may adversely affect the Bancorp’s business and results of operations more substantially over a longer period of time.\\nGovernmental authorities have taken significant measures to provide economic assistance to households and businesses, to stabilize the markets and to support economic growth. For example, in response to the COVID-19 pandemic, the FRB and other U.S. state and federal financial regulatory agencies took action to mitigate the resulting disruptions to economic activity and financial stability by implementing a number of facilities to provide emergency liquidity to various segments of the U.S. economy and financial markets. Many of these facilities expired on or before December 31, 2020 or were extended for brief periods into 2021. The expiration of these facilities could have an adverse effect on U.S. economy and ultimately on the Bancorp’s business.\\nAmong other relief programs, the Bancorp is a participating lender in the SBA’s Paycheck Protection Program. Paycheck Protection Program loans are fixed, unsecured, low interest rate loans that are guaranteed by the SBA and subject to numerous other regulatory requirements, and a borrower may apply to have all or a portion of the loan forgiven. If Paycheck Protection Program borrowers fail to qualify for loan forgiveness, the Bancorp faces a heightened risk of holding these loans at unfavorable interest rates for an extended period of time. While the Paycheck Protection Program loans are guaranteed by the SBA, various regulatory requirements will apply to the Bancorp’s ability to seek recourse under the guarantees and the related procedures are currently subject to uncertainty. If a borrower defaults on a Paycheck Protection Program loan, these requirements and uncertainties may limit the Bancorp’s ability to fully recover against the loan guarantee or to seek full recourse against the borrower. These assistance efforts may adversely affect the Bancorp’s revenue and results of operations and may make the Bancorp’s results more difficult to forecast. Further, the timing and amount of forgiveness to which the Bancorp’s borrowers will be entitled cannot be predicted. The Paycheck Protection Program and other government programs in which the Bancorp may participate are complex and the Bancorp’s participation may lead to governmental and regulatory scrutiny, negative publicity and damage to the Bancorp’s reputation.\\nThe extent to which the COVID-19 pandemic impacts the Bancorp’s business, results of operations, and financial condition, as well as its regulatory capital and liquidity ratios, will depend on highly uncertain future developments, including the scope and duration of the pandemic (including the possibility of further surges of COVID-19 and any virus variants, which may or may not respond to available vaccinations), the timing and efficacy of the vaccination program in the U.S. and further actions taken by governmental authorities and other third parties in response to the pandemic. Government actions to mitigate the economic suffering caused by the COVID-19 pandemic may not be successful\\n138\\nor may result in increased pressure on the banking sector, which could adversely affect the Bancorp’s business, results of operations and financial condition more substantially over a longer period of time. In addition, the unique historical nature of the pandemic and the unprecedented level of governmental response may also significantly impact the Bancorp’s ability to effectively manage its business or predict future performance.\\nAs the COVID-19 pandemic subsides, the U.S. economy may require some time to fully recover from its effects, the length of which is unknown. The effects of the COVID-19 pandemic may heighten many of the other risks described in Item 1A. Risk Factors of the Bancorp’s Annual Report on Form 10-K and any subsequent Quarterly Report on Form 10-Q or Current Report on Form 8-K, including, but not limited to, risks of credit deterioration, interest rate changes, rating agency actions, governmental actions, market volatility, theft, fraud, security breaches and technology interruptions.\\nUnregistered Sales of Equity Securities and Use of Proceeds (Item 2)\\nRefer to the “Capital Management” section within Management’s Discussion and Analysis in Part I, Item 2 for information regarding purchases and sales of equity securities by the Bancorp during the second quarter of 2021.\\nDefaults Upon Senior Securities (Item 3)\\nNone.\\nMine Safety Disclosures (Item 4)\\nNot applicable.\\nOther Information (Item 5)\\nNone.\\n139\\nExhibits (Item 6)\\n| 3.1 | Amended Articles of Incorporation of Fifth Third Bancorp. Incorporated by reference to Exhibit 3.1 of the Registrant’s Quarterly Report on Form 10-Q filed on May 7, 2021. |\\n| 3.2 | Regulations of Fifth Third Bancorp as Amended as of March 23, 2020. Incorporated by reference to Exhibit 3.2 of the Registrant’s Current Report on Form 8-K filed on March 24, 2020. |\\n| 10.1 | Fifth Third Bancorp 2021 Incentive Compensation Plan. Incorporated by reference to Annex A to the Registrant’s Proxy Statement filed on March 2, 2021. |\\n| 10.2 | Supplemental Confirmation dated April 21, 2021, to Master Confirmation dated July 29, 2015, for accelerated share repurchase transaction between Fifth Third Bancorp and Morgan Stanley & Co. LLC* |\\n| 10.3 | 2021 Restricted Stock Unit Grant Agreement (for Directors). |\\n| 31(i) | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 by Chief Executive Officer. |\\n| 31(ii) | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 by Chief Financial Officer. |\\n| 32(i) | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Chief Executive Officer. |\\n| 32(ii) | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Chief Financial Officer. |\\n| 101.INS | Inline XBRL Instance Document. |\\n| 101.SCH | Inline XBRL Taxonomy Extension Schema. |\\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase. |\\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase. |\\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase. |\\n| 101.DEF | Inline XBRL Taxonomy Definition Linkbase. |\\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101). |\\n| * Selected portions of this exhibit have been omitted in accordance with Item 601(b)(10) of Regulation S-K. |\\n\\n140\\nSignature\\nPursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\n| Fifth Third Bancorp |\\n| Registrant |\\n\\nDate: August 6, 2021\\n| /s/ James C. Leonard |\\n| James C. Leonard |\\n| Executive Vice President and |\\n| Chief Financial Officer |\\n| (Duly Authorized Officer & Principal Financial Officer) |\\n\\n141\\n \\n\\nWhat is the adjusted Return on Average Tangible Common Equity (ROATCE) for the first half of the year 2021 in percent, considering net income available to common shareholders (U.S. GAAP), average tangible common equity, and attributable changes in net interest income due to volume and yield/rate?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 6.4492577269408615.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 64,\n \"input_length\": 153959\n}"}}},{"rowIdx":65,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nITEM 1.\nFinancial Statements\nNewpark Resources, Inc.Condensed Consolidated Balance Sheets(Unaudited)\n\n| (In thousands, except share data) | March 31, 2014 | December 31, 2013 |\n| ASSETS |\n| Cash and cash equivalents | $ | 130,187 | $ | 65,840 |\n| Receivables, net | 276,082 | 268,529 |\n| Inventories | 199,565 | 189,680 |\n| Deferred tax asset | 11,750 | 11,272 |\n| Prepaid expenses and other current assets | 15,034 | 11,016 |\n| Assets of discontinued operations | - | 13,103 |\n| Total current assets | 632,618 | 559,440 |\n| Property, plant and equipment, net | 227,050 | 217,010 |\n| Goodwill | 93,781 | 94,064 |\n| Other intangible assets, net | 23,870 | 25,900 |\n| Other assets | 9,813 | 6,086 |\n| Assets of discontinued operations | - | 65,917 |\n| Total assets | $ | 987,132 | $ | 968,417 |\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\n| Short-term debt | $ | 15,759 | $ | 12,867 |\n| Accounts payable | 88,328 | 88,586 |\n| Accrued liabilities | 65,196 | 46,341 |\n| Liabilities of discontinued operations | - | 5,957 |\n| Total current liabilities | 169,283 | 153,751 |\n| Long-term debt, less current portion | 172,771 | 172,786 |\n| Deferred tax liability | 26,235 | 27,060 |\n| Other noncurrent liabilities | 11,288 | 11,026 |\n| Liabilities of discontinued operations | - | 22,740 |\n| Total liabilities | 379,577 | 387,363 |\n| Commitments and contingencies (Note 9) |\n| Common stock, $0.01 par value, 200,000,000 shares authorized and 98,032,555 and 98,030,839 shares issued, respectively | 980 | 980 |\n| Paid-in capital | 507,820 | 504,675 |\n| Accumulated other comprehensive loss | (8,279 | ) | (9,484 | ) |\n| Retained earnings | 195,349 | 160,338 |\n| Treasury stock, at cost; 11,904,275 and 10,832,845 shares, respectively | (88,315 | ) | (75,455 | ) |\n| Total stockholders’ equity | 607,555 | 581,054 |\n| Total liabilities and stockholders' equity | $ | 987,132 | $ | 968,417 |\n\nSee Accompanying Notes to Unaudited Condensed Consolidated Financial Statements\n2\nNewpark Resources, Inc.Condensed Consolidated Statements of Operations(Unaudited)\n\n| Three Months Ended March 31, |\n| (In thousands, except per share data) | 2014 | 2013 |\n| Revenues | $ | 242,824 | $ | 267,923 |\n| Cost of revenues | 196,560 | 220,735 |\n| Selling, general and administrative expenses | 25,523 | 22,451 |\n| Other operating income, net | (16 | ) | (124 | ) |\n| Operating income | 20,757 | 24,861 |\n| Foreign currency exchange loss (gain) | 54 | (368 | ) |\n| Interest expense, net | 2,920 | 2,520 |\n| Income from continuing operations before income taxes | 17,783 | 22,709 |\n| Provision for income taxes | 6,041 | 7,842 |\n| Income from continuing operations | 11,742 | 14,867 |\n| Income from discontinued operations, net of tax | 1,152 | 2,508 |\n| Gain from disposal of discontinued operations, net of tax | 22,117 | - |\n| Net income | $ | 35,011 | $ | 17,375 |\n| Income per common share -basic: |\n| Income from continuing operations | $ | 0.14 | $ | 0.18 |\n| Income from discontinued operations | 0.27 | 0.03 |\n| Net income | $ | 0.41 | $ | 0.21 |\n| Income per common share -diluted: |\n| Income from continuing operations | $ | 0.13 | $ | 0.16 |\n| Income from discontinued operations | 0.23 | 0.02 |\n| Net income | $ | 0.36 | $ | 0.18 |\n\nSee Accompanying Notes to Unaudited Condensed Consolidated Financial Statements\n3\nNewpark Resources, Inc.Condensed Consolidated Statements of Comprehensive Income(Unaudited)\n\n| Three Months Ended March 31, |\n| (In thousands) | 2014 | 2013 |\n| Net income | $ | 35,011 | $ | 17,375 |\n| Foreign currency translation adjustments | 1,205 | (2,764 | ) |\n| Comprehensive income | $ | 36,216 | $ | 14,611 |\n\nSee Accompanying Notes to Unaudited Condensed Consolidated Financial Statements\n4\nNewpark Resources, Inc.Condensed Consolidated Statements of Cash Flows(Unaudited)\n\n| Three Months Ended March 31, |\n| (In thousands) | 2014 | 2013 |\n| Cash flows from operating activities: |\n| Net income | $ | 35,011 | $ | 17,375 |\n| Adjustments to reconcile net income to net cash provided by operations: |\n| Depreciation and amortization | 10,287 | 10,954 |\n| Stock-based compensation expense | 2,840 | 1,973 |\n| Provision for deferred income taxes | (13,108 | ) | 534 |\n| Net provision for doubtful accounts | 173 | 208 |\n| Gain on sale of a business | (33,974 | ) | - |\n| Gain on sale of assets | (362 | ) | (99 | ) |\n| Change in assets and liabilities: |\n| Increase in receivables | (1,080 | ) | (20,969 | ) |\n| Increase in inventories | (9,229 | ) | (1,280 | ) |\n| Increase in other assets | (3,858 | ) | (2,382 | ) |\n| (Decrease) increase in accounts payable | (1,248 | ) | 4,179 |\n| Increase in accrued liabilities and other | 18,142 | 4,747 |\n| Net cash provided by operating activities | 3,594 | 15,240 |\n| Cash flows from investing activities: |\n| Capital expenditures | (18,509 | ) | (16,127 | ) |\n| Proceeds from sale of property, plant and equipment | 754 | 213 |\n| Proceeds from sale of a business | 89,167 | - |\n| Net cash provided by (used in) investing activities | 71,412 | (15,914 | ) |\n| Cash flows from financing activities: |\n| Borrowings on lines of credit | 47,562 | 71,102 |\n| Payments on lines of credit | (45,113 | ) | (78,748 | ) |\n| Other financing activities | (13 | ) | (38 | ) |\n| Proceeds from employee stock plans | 34 | 3,808 |\n| Purchase of treasury stock | (13,123 | ) | - |\n| Net cash used in financing activities | (10,653 | ) | (3,876 | ) |\n| Effect of exchange rate changes on cash | (6 | ) | (586 | ) |\n| Net increase (decrease) in cash and cash equivalents | 64,347 | (5,136 | ) |\n| Cash and cash equivalents at beginning of year | 65,840 | 46,846 |\n| Cash and cash equivalents at end of period | $ | 130,187 | $ | 41,710 |\n| Cash paid for: |\n| Income taxes (net of refunds) | $ | 9,500 | $ | 4,294 |\n| Interest | $ | 667 | $ | 331 |\n\nSee Accompanying Notes to Unaudited Condensed Consolidated Financial Statements\n5\nNEWPARK RESOURCES, INC.\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\nNote 1 – Basis of Presentation and Significant Accounting Policies\nThe accompanying unaudited condensed consolidated financial statements of Newpark Resources, Inc. and our wholly-owned subsidiaries, which we refer to as “we,” “our” or “us,” have been prepared in accordance with Rule 10-01 of Regulation S-X for interim financial statements required to be filed with the Securities and Exchange Commission (“SEC”), and do not include all information and footnotes required by the accounting principles generally accepted in the United States (“U.S. GAAP”) for complete financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2013. Our fiscal year end is December 31 and our first quarter represents the three month period ended March 31. The results of operations for the first quarter of 2014 are not necessarily indicative of the results to be expected for the entire year. Unless otherwise stated, all currency amounts are stated in U.S. dollars.\nIn the opinion of management, the accompanying unaudited condensed consolidated financial statements reflect all adjustments necessary to present fairly our financial position as of March 31, 2014, the results of our operations for the first quarter of 2014 and 2013, and our cash flows for the first quarter of 2014 and 2013. All adjustments are of a normal recurring nature. Our balance sheet at December 31, 2013 is derived from the audited consolidated financial statements at that date.\nThe preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. For further information, see Note 1 in our Annual Report on Form 10-K for the year ended December 31, 2013.\nNew Accounting Standards\nIn April 2014, the Financial Accounting Standards Board (“FASB”) issued updated guidance that changes the criteria for reporting discontinued operations including enhanced disclosure requirements. Under the new guidance, only disposals representing a strategic shift in operations should be presented as discontinued operations. Those strategic shifts should have a major effect on the organization´s operations and financial results. The new guidance is effective for us in the first quarter of 2015, however we do not expect the adoption to have a material effect on our consolidated financial statements.\n6\nNote 2 – Discontinued Operations\nOn March 17, 2014, we completed the previously announced sale of our Environmental Services business for $100 million in cash, subject to adjustment based on actual working capital conveyed at closing. Cash proceeds from the sale were $89.2 million in the first quarter of 2014, net of transaction related expenses. In addition, $8 million of the sale price was withheld in escrow associated with transaction representations, warranties and indemnities, and is expected to be released over the next two years. As a result of the sale transaction, we recorded a gain on the disposal of the business of $34.0 million ($22.1 million after-tax). All assets, liabilities and results of operations for this business have been reclassified to discontinued operations for all periods presented.\nSummarized results of operations from discontinued operations are as follows:\n\n| Three Months Ended March 31, |\n| (In thousands) | 2014 | 2013 |\n| Revenues | $ | 11,744 | $ | 14,595 |\n| Income from discontinued operations before income taxes | 1,770 | 3,508 |\n| Income from discontinued operations, net of tax | 1,152 | 2,508 |\n| Gain from disposal of discontinued operations before income taxes | 33,974 | - |\n| Gain from disposal of discontinued operations, net of tax | 22,117 | - |\n\nAs of March 31, 2014, our reported accrued liabilities of $65.2 million, includes approximately $31 million of accrued income taxes payable, the majority of which is related to the sale of this business. Assets and liabilities of discontinued operations as of December 31, 2013 were as follows:\n\n| December 31, |\n| (In thousands) | 2013 |\n| Receivables, net | $ | 11,915 |\n| Prepaid expenses and other current assets | 1,188 |\n| Property, plant and equipment | 62,333 |\n| Other assets | 3,584 |\n| Assets of discontinued operations | $ | 79,020 |\n| Accounts payable | $ | 4,415 |\n| Other Accrued liabilities | 1,542 |\n| Deferred tax liability | 12,449 |\n| Other noncurrent liabilities | 10,291 |\n| Liabilities of discontinued operations | $ | 28,697 |\n\n7\nNote 3 – Earnings per Share\nThe following table presents the reconciliation of the numerator and denominator for calculating earnings per share from continuing operations:\n\n| First Quarter |\n| (In thousands, except per share data) | 2014 | 2013 |\n| Basic EPS: |\n| Income from continuing operations | $ | 11,742 | $ | 14,867 |\n| Weighted average number of common shares outstanding | 84,743 | 84,100 |\n| Basic income from continuing operations per common share | $ | 0.14 | $ | 0.18 |\n| Diluted EPS: |\n| Income from continuing operations | $ | 11,742 | $ | 14,867 |\n| Assumed conversions of Senior Notes | 1,261 | 1,250 |\n| Adjusted income from continuing operations | $ | 13,003 | $ | 16,117 |\n| Weighted average number of common shares outstanding-basic | 84,743 | 84,100 |\n| Add: Dilutive effect of stock options and restricted stock awards | 1,674 | 1,572 |\n| Dilutive effect of Senior Notes | 15,682 | 15,682 |\n| Diluted weighted average number of common shares outstanding | 102,099 | 101,354 |\n| Diluted income from continuing operations per common share | $ | 0.13 | $ | 0.16 |\n| Stock options excluded from calculation of diluted earnings per share because anti-dilutive for the period | 627 | 592 |\n\nFor the first quarter of 2014 and 2013, we had weighted average dilutive stock options and restricted stock outstanding of approximately 5.0 million shares and 5.5 million shares, respectively. The resulting net effect of stock options and restricted stock were used in calculating diluted earnings per share for the period.\nNote 4 – Acquisition\nIn December 2013, we completed the acquisition of Terrafirma Roadways (“Terrafirma”), a provider of temporary roadways and worksites based in the United Kingdom, for total cash consideration of $6.8 million, net of cash acquired. Additional consideration up to £1.0 million ($1.6 million) may be payable based on earnings of the business over the 18-month period following the acquisition. Prior to the acquisition, Terrafirma had been operating as a partner to the Company since 2008, developing a rental business with DURA-BASE® composite mats, primarily focused in the utility industry in the U.K.\n8\nThe transaction has been recorded using the acquisition method of accounting and accordingly, assets acquired and liabilities assumed were recorded at their fair values as of the acquisition date. The excess of the total consideration, including projected additional consideration, was recorded as goodwill and includes the value of the assembled workforce. While the initial purchase price allocation has been completed, the allocation of the purchase price is subject to change for a period of one year following the acquisition. The following table summarizes the amounts recognized for assets acquired and liabilities assumed as of the December 2013 acquisition date:\n\n| (In thousands) |\n| Receivables, net | $ | 2,155 |\n| Property, plant and equipment, net | 2,160 |\n| Goodwill | 4,544 |\n| Other intangibles, net | 4,528 |\n| Total assets acquired | 13,387 |\n| Accounts payable | 3,350 |\n| Short-term debt | 284 |\n| Accrued liabilities | 285 |\n| Deferred tax liability | 1,092 |\n| Other noncurrent liabilities | 1,600 |\n| Total liabilities assumed | 6,611 |\n| Total cash conveyed at closing | $ | 6,776 |\n\nPro forma results of operation for the acquired business have not been presented as the effect of this acquisition is not material to our consolidated financial statements.\nNote 5 – Treasury Stock\nIn April 2013, our Board of Directors approved a share repurchase program that authorizes the Company to purchase up to $50.0 million of its outstanding shares of common stock. In February 2014, our Board of Directors increased the total authorization of the program to $100.0 million, subject to completion of the Environmental Services divesture. These purchases are funded with a combination of cash generated from operations, the sale of the Environmental Services business and borrowings under the Company’s revolving credit facility. The repurchase program has no specific term. The Company may repurchase shares in the open market or as otherwise determined by management, subject to market conditions, business opportunities and other factors. As part of the share repurchase program, the Company’s management has been authorized to establish trading plans under Rule 10b5-1 of the Securities Exchange Act of 1934.\nDuring the first quarter of 2014, 1,095,413 shares were repurchased for an average price of approximately $11.84 per share, including commissions, leaving $80.3 million remaining under the program. All of the shares repurchased are held as treasury stock. We record treasury stock purchases under the cost method whereby the entire cost of the acquired stock is recorded as treasury stock.\n9\nNote 6 – Receivables\nReceivables - Receivables consist of the following:\n\n| March 31, | December 31, |\n| (In thousands) | 2014 | 2013 |\n| Gross trade receivables | $ | 254,376 | $ | 252,168 |\n| Allowance for doubtful accounts | (4,204 | ) | (4,142 | ) |\n| Net trade receivables | 250,172 | 248,026 |\n| Other receivables | 25,910 | 20,503 |\n| Total receivables, net | $ | 276,082 | $ | 268,529 |\n\nNote 7 – Inventories\nInventories- Inventories consist of the following:\n\n| (In thousands) | March 31, 2014 | December 31, 2013 |\n| Raw materials: |\n| Drilling fluids | $ | 173,393 | $ | 153,901 |\n| Mats | 914 | 790 |\n| Total raw materials | 174,307 | 154,691 |\n| Blended drilling fluids components | 23,914 | 34,075 |\n| Finished goods- mats | 1,344 | 914 |\n| Total | $ | 199,565 | $ | 189,680 |\n\nRaw materials consist primarily of barite, chemicals, and other additives that are consumed in the production of our drilling fluid systems. Our blended drilling fluids components consist of base drilling fluid systems that have been either mixed internally at our mixing plants or purchased from third party vendors. These base systems require raw materials to be added, as required to meet specified customer requirements.\nNote 8 – Financing Arrangements and Fair Value of Financial Instruments\nOur financing arrangements include $172.5 million of unsecured convertible senior notes (“Senior Notes”) and a $125.0 million revolving credit facility which can be increased by $75.0 million for a maximum $200.0 million of capacity. At March 31, 2014, we had no outstanding borrowings under the revolving credit facility. The Senior Notes bear interest at a rate of 4.0% per year, payable semi-annually in arrears on April 1 and October 1 of each year, beginning April 1, 2011. Holders may convert the Senior Notes at their option at any time prior to the close of business on the business day immediately preceding the October 1, 2017 maturity date. The conversion rate is initially 90.8893 shares of our common stock per $1,000 principal amount of Senior Notes (equivalent to an initial conversion price of $11.00 per share of common stock), subject to adjustment in certain circumstances. Upon conversion, the Senior Notes will be settled in shares of our common stock. We may not redeem the Senior Notes prior to their maturity date.\n10\nOur financial instruments include cash and cash equivalents, receivables, payables and debt. We believe the carrying values of these instruments, with the exception of our Senior Notes, approximated their fair values at March 31, 2014 and December 31, 2013. The estimated fair value of our Senior Notes is $219.1 million at March 31, 2014 and $231.2 million at December 31, 2013, based on quoted market prices at these respective dates.\nNote 9 – Commitments and Contingencies\nIn the ordinary course of conducting our business, we become involved in litigation and other claims from private party actions, as well as judicial and administrative proceedings involving governmental authorities at the federal, state and local levels. In the opinion of management, any liability in these matters should not have a material effect on our consolidated financial statements.\nNote 10 – Segment Data\nSummarized operating results for our reportable segments is shown in the following table (net of inter-segment transfers):\n\n| First Quarter |\n| (In thousands) | 2014 | 2013 |\n| Revenues |\n| Fluids systems | $ | 211,400 | $ | 247,339 |\n| Mats & integrated services | 31,424 | 20,584 |\n| Total Revenues | $ | 242,824 | $ | 267,923 |\n| Operating Income (loss) |\n| Fluids systems | $ | 15,740 | $ | 22,622 |\n| Mats & integrated services | 13,373 | 8,480 |\n| Corporate office | (8,356 | ) | (6,241 | ) |\n| Operating Income | $ | 20,757 | $ | 24,861 |\n\n11\n\n\nITEM 2.\nManagement's Discussion and Analysis of Financial Condition and Results of Operations\nThe following discussion of our financial condition, results of operations, liquidity and capital resources should be read together with our unaudited condensed consolidated financial statements and notes to unaudited condensed consolidated financial statements contained in this report as well as our Annual Report on Form 10-K for the year ended December 31, 2013. Our first quarter represents the three month period ended March 31, 2014. Unless otherwise stated, all currency amounts are stated in U.S. dollars.\nOverview\nWe are a diversified oil and gas industry supplier providing products and services primarily to the oil and gas exploration and production (“E&P”) industry. We operate our business through two reportable segments: Fluids Systems and Mats and Integrated Services.\nIn March 2014, we completed the sale of our Environmental Services business, which was historically reported as a third operating segment for $100 million in cash. The proceeds will be used for general corporate purposes, including investments in our core drilling fluids and mats segments, potential acquisitions, along with the continued share purchases under the current repurchase program. See Note 2 Discontinued Operations in our Notes to Unaudited Condensed Consolidated Financial Statements in Item 1 for additional information.\nOur Fluids Systems segment, which generated 87% of consolidated revenues in the first quarter of 2014, provides customized drilling fluids solutions to E&P customers globally, operating through four geographic regions: North America, Europe, the Middle East and Africa (“EMEA”), Latin America, and Asia Pacific.\nIn 2013, we announced several international contract awards, including two in the deepwater market. In Brazil, we were awarded a two-year contract from a subsidiary of Total S.A., to provide drilling fluids and related services for a series of wells planned in the Campos Basin. In our EMEA region, we were awarded a contract by another customer to provide drilling fluids and related services for a series of wells to be drilled in the Black Sea. In addition, we were awarded two contracts to provide drilling fluids and related services for land operations, including a five year contract by the Kuwait Oil Company and a four year contract by another customer in India. Work under the Brazil contract began in the first quarter of 2014, while work under the other three contracts is expected to begin later in 2014.\nWe are continuing the roll-out of Evolution®, our high performance water-based drilling fluid system launched in 2010, which we believe provides superior performance and environmental benefits to our customers, as compared to traditional fluids systems used in the industry. After completing the roll-out of the system into most major North American drilling basins in 2011 and 2012, we are seeking to further penetrate markets in North America, while expanding into key international markets. The system has now been used in our EMEA and Asia Pacific regions. Revenues from wells using the Evolution system were approximately $48 million in the first quarter of 2014, compared to $29 million in the first quarter of 2013.\nOur Mats and Integrated Services segment, which generated 13% of consolidated revenues through the first quarter of 2014, provides composite mat rentals, well site construction and related site services to oil and gas customers and mat rentals to the petrochemicals industry in the U.S. and the utility industry in the U.K. We also sell composite mats to E&P customers outside of the U.S., and to domestic customers outside of the oil and gas industry.\nIn October 2013, we announced plans to expand our mat manufacturing facility, located in Carencro, Louisiana. The $40 million expansion project is expected to be completed in early 2015. Upon completion, the project will significantly increase our production capacity and support expansion into new markets, both domestically and internationally. The new facility will also include a research and development center, intended to drive continued new product development efforts. Until this manufacturing facility expansion project is completed, we expect revenues from mat sales to continue to be limited by our manufacturing capacity limitations, along with our efforts to meet growing demand for mat rentals. During both the first quarters of 2014 and 2013, we allocated the majority of our composite mat production toward the expansion of our rental fleet, leaving fewer mats available for sale to customers.\n12\nIn December 2013 we completed the acquisition of Terrafirma Roadways (“Terrafirma”), a provider of temporary roadways and worksites based in the United Kingdom, for total cash consideration of $6.8 million, net of cash acquired. Prior to the acquisition, Terrafirma had been operating as a partner to the Company since 2008, developing a rental business with DURA-BASE® composite mats, primarily focused in the utility industry in the U.K.\nRig count data is the most widely accepted indicator of drilling activity. Average North American rig count data for the first quarter of 2014, as compared to the first quarter of 2013 is as follows:\n\n| First Quarter | 2014 vs 2013 |\n| 2014 | 2013 | Count | % |\n| U.S. Rig Count | 1,779 | 1,758 | 21 | 1 | % |\n| Canadian Rig Count | 525 | 531 | (6 | ) | (1 | %) |\n| North America | 2,304 | 2,289 | 15 | 1 | % |\n\nSource: Baker Hughes Incorporated\nFirst Quarter of 2014 Compared to First Quarter of 2013\nConsolidated Results of Operations\nSummarized results of operations for the first quarter of 2014 compared to the first quarter of 2013 are as follows:\n\n| First Quarter | 2014 vs 2013 |\n| (In thousands) | 2014 | 2013 | % |\n| Revenues | $ | 242,824 | $ | 267,923 | $ | (25,099 | ) | (9 | %) |\n| Cost of revenues | 196,560 | 220,735 | (24,175 | ) | (11 | %) |\n| Selling, general and administrative expenses | 25,523 | 22,451 | 3,072 | 14 | % |\n| Other operating income, net | (16 | ) | (124 | ) | 108 | (87 | %) |\n| Operating income | 20,757 | 24,861 | (4,104 | ) | (17 | %) |\n| Foreign currency exchange loss (gain) | 54 | (368 | ) | 422 | (115 | %) |\n| Interest expense, net | 2,920 | 2,520 | 400 | 16 | % |\n| Income from continuing operations before income taxes | 17,783 | 22,709 | (4,926 | ) | (22 | %) |\n| Provision for income taxes | 6,041 | 7,842 | (1,801 | ) | (23 | %) |\n| Income from continuing operations | 11,742 | 14,867 | (3,125 | ) | (21 | %) |\n| Income from discontinued operations, net of tax | 1,152 | 2,508 | (1,356 | ) | (54 | %) |\n| Gain from disposal of discontinued operations, net of tax | 22,117 | - | 22,117 | NM |\n| Net income | $ | 35,011 | $ | 17,375 | $ | 17,636 | 102 | % |\n| NM-Not meaningful |\n\n13\nRevenues\nRevenues decreased 9% to $242.8 million in the first quarter of 2014, compared to $267.9 million in the first quarter of 2013. This $25.1 million decrease includes a $22.1 million (11%) decrease in revenues in North America, including a $31.3 million decline in our Fluids Systems segment. Revenues from our international operations decreased by $3.0 million (4%), including declines in Asia Pacific and Brazil. Additional information regarding the change in revenues is provided within the operating segment results below.\nCost of revenues\nCost of revenues decreased 11% to $196.6 million in the first quarter of 2014, compared to $220.7 million in the first quarter of 2013. The decrease is primarily driven by the decrease in revenues. Additional information regarding the change in cost of revenues is provided within the operating segment results below.\nSelling, general and administrative expenses\nSelling, general and administrative expenses increased $3.1 million to $25.5 million in the first quarter of 2014 from $22.5 million in the first quarter of 2013. The increase is primarily attributable to a $1.7 million increase in spending related to strategic planning projects, including the development of our deepwater market penetration strategy and international treasury and tax planning projects.\nForeign currency exchange\nForeign currency exchange was a $0.1 million loss in the first quarter of 2014, compared to a $0.4 million gain in the first quarter of 2013, and primarily reflects the impact of currency translations on assets and liabilities held in our international operations that are denominated in currencies other than functional currencies.\nInterest expense, net\nInterest expense totaled $2.9 million for the first quarter of 2014 compared to $2.5 million for the first quarter of 2013. The $0.4 million increase primarily reflects the impact of increased borrowings in our Brazilian subsidiary.\nProvision for income taxes\nThe provision for income taxes for the first quarter of 2014 was $6.0 million, reflecting an effective tax rate of 34.0%, compared to $7.8 million in the first quarter of 2013, reflecting an effective tax rate of 34.5%.\nDiscontinued operations\nIncome from our discontinued Environmental Services operations was $1.2 million in the first quarter of 2014 compared to $2.5 million the first quarter of 2013. In addition, the first quarter of 2014 included a $22.1 million gain from the March 2014 sale of the business, described above. See Note 2 Discontinued Operations in our Notes to the unaudited condensed consolidated financial statements in Item 1.\n14\nOperating Segment Results\nSummarized financial information for our reportable segments is shown in the following table (net of inter-segment transfers):\n\n| First Quarter | 2014 vs 2013 |\n| (In thousands) | 2014 | 2013 | $ | % |\n| Revenues |\n| Fluids systems | $ | 211,400 | $ | 247,339 | $ | (35,939 | ) | (15 | %) |\n| Mats and integrated services | 31,424 | 20,584 | 10,840 | 53 | % |\n| Total revenues | $ | 242,824 | $ | 267,923 | $ | (25,099 | ) | (9 | %) |\n| Operating income (loss) |\n| Fluids systems | $ | 15,740 | $ | 22,622 | $ | (6,882 | ) |\n| Mats and integrated services | 13,373 | 8,480 | 4,893 |\n| Corporate office | (8,356 | ) | (6,241 | ) | (2,115 | ) |\n| Operating income | $ | 20,757 | $ | 24,861 | $ | (4,104 | ) |\n| Segment operating margin |\n| Fluids systems | 7.4 | % | 9.1 | % |\n| Mats and integrated services | 42.6 | % | 41.2 | % |\n\nFluids Systems\nRevenues\nTotal revenues for this segment consisted of the following:\n\n| First Quarter | 2014 vs 2013 |\n| (In thousands) | 2014 | 2013 | $ | % |\n| United States | $ | 124,776 | $ | 159,144 | $ | (34,368 | ) | (22 | %) |\n| Canada | 21,711 | 18,651 | 3,060 | 16 | % |\n| Total North America | 146,487 | 177,795 | (31,308 | ) | (18 | %) |\n| EMEA | 34,720 | 34,518 | 202 | 1 | % |\n| Latin America | 22,003 | 24,961 | (2,958 | ) | (12 | %) |\n| Asia Pacific | 8,190 | 10,065 | (1,875 | ) | (19 | %) |\n| Total | $ | 211,400 | $ | 247,339 | $ | (35,939 | ) | (15 | %) |\n\nNorth American revenues decreased 18% to $146.5 million in the first quarter of 2014, compared to $177.8 million in the first quarter of 2013. While the North American rig count improved by 1% over this period, the decrease is largely attributable to market share losses in South Texas, along with reduced drilling activity of a key customer in the U.S.\nInternationally, revenues were down 7% to $64.9 million in the first quarter of 2014, as compared to $69.5 million in first quarter 2013. This decrease is primarily attributable to decreased activity with Petrobras in Brazil, along with lower revenues for land drilling customers in Australia.\n15\nOperating Income\nOperating income decreased $6.9 million in the first quarter of 2014, as compared to the first quarter of 2013, largely attributable to the $35.9 million decline in revenues described above. The decline in operating income includes a $6.4 million decrease from North American operations, along with a $0.5 million decrease from international operations.\nIn recent quarters, the business environment in Brazil has become increasingly challenging, particularly as Petrobras, our primary customer in the region, has focused more efforts on well completions and less on drilling activities. Also, the lack of timely payment of Petrobras-related invoicing has caused increases in invested working capital associated with participation in this market. In response to these changes in the business environment, we are continuing to evaluate opportunities to reduce the cost structure of this operation. While the Brazilian deepwater drilling market remains an important component of our long-term strategy, the profitability of our business remains highly dependent on increasing levels of drilling activity by Petrobras and other E&P customers. In the absence of a longer-term increase in drilling activity, we may incur additional charges, as we seek to reduce our cost structure in country, which may negatively impact our future operating results.\nMats and Integrated Services\nRevenues\nTotal revenues for this segment consisted of the following:\n\n| First Quarter | 2014 vs 2013 |\n| (In thousands) | 2014 | 2013 | $ | % |\n| Mat rental and services | $ | 24,537 | $ | 14,778 | $ | 9,759 | 66 | % |\n| Mat sales | 6,887 | 5,806 | 1,081 | 19 | % |\n| Total | $ | 31,424 | $ | 20,584 | $ | 10,840 | 53 | % |\n\nMat rental and services revenues increased $9.8 million compared to the first quarter of 2013, primarily due to increasing demand for our composite mat products, particularly in the Northeast U.S. and Gulf Coast regions. In addition, the first quarter of 2014 benefitted from a $1.6 million increase from the U.K. rental operation, following the December 2013 Terrafirma acquisition, as described above. Mat sales increased by $1.1 million from the first quarter of 2013. As described above, quarterly revenues from mat sales typically fluctuate based on management’s allocation of plant capacity, along with the timing of mat orders from customers.\nOperating Income\nSegment operating income increased by $4.9 million, as compared to the first quarter of 2013, largely attributable to the $10.8 million increase in revenues described above. The segment operating margin continues to remain elevated, driven by high utilization of mats in our rental fleet, and high utilization of our production facility, which continues to run at maximum production capacity levels.\nThe levels of mats sales in a given quarter are determined by several factors, including customer demand, as well as our allocation of mat production between sales and deployment into our rental fleet. The allocation of our production between additions to our rental fleet and sales in any given quarter is driven by a number of factors including commitments to meeting customer schedules, ability of our customers to take delivery of mats, timing of large mat rental projects/events, and plant capacity/efficiencies. As noted above, in the first quarter of 2014, we allocated the majority of our composite mat production toward the expansion of our rental fleet, leaving fewer mats available for sale to customers. Based on the continuing strong demand for our mats in the rental fleet, we expect the majority of our production to continue to be dedicated toward the expansion of our rental fleet until completion of the new mat manufacturing facility, resulting in lower mat sales revenues and income.\n16\nCorporate Office\nCorporate office expenses increased $2.1 million to $8.4 million in the first quarter of 2014, compared to $6.2 million in the first quarter of 2013. The increase is primarily attributable to a $1.7 million increase in spending related to strategic planning projects, including the development of our deepwater market penetration strategy and international treasury and tax planning projects.\nLiquidity and Capital Resources\nNet cash provided by operating activities during the first quarter of 2014 totaled $3.6 million. During the first quarter of 2014, net cash provided by operating activities was negatively impacted by a $6.5 million reduction in accrued payroll and related costs, largely attributable to the first quarter payment of annual performance-based incentives, along with a $9.2 million increase in inventories, largely associated with the timing of receipts of barite ore purchased from China.\nNet cash provided by investing activities during the first quarter of 2014 was $71.4 million, primarily consisting of net proceeds from the sale of the Environmental Services business of $89.2 million offset by capital expenditures of $18.5 million. The first quarter of 2014 capital expenditures included $9.8 million in the Mats & Integrated Services segment, related to the deployment of produced mats into the rental fleet and the manufacturing plant expansion project described above.\nWe anticipate that our working capital requirements for our operations will decline in the near term due to continued efforts to reduce accounts receivable and inventory from the levels at March 31, 2014. We expect total 2014 capital expenditures to range between $65 million to $85 million. As of March 31, 2014, we had cash on-hand of $130.2 million of which $53.4 million resides within our foreign subsidiaries which we intend to leave permanently reinvested abroad. We expect our subsidiary cash on-hand, along with cash generated by operations and availability under our existing credit agreement to be adequate to fund our anticipated capital needs during the next 12 months.\nOur capitalization is as follows:\n\n| March 31, | December 31, |\n| (In thousands) | 2014 | 2013 |\n| Senior Notes | $ | 172,500 | $ | 172,500 |\n| Revolving credit facility | - | - |\n| Other | 16,030 | 13,153 |\n| Total | 188,530 | 185,653 |\n| Stockholder's equity | 607,555 | 581,054 |\n| Total capitalization | $ | 796,085 | $ | 766,707 |\n| Total debt to capitalization | 23.7 | % | 24.2 | % |\n\nOur financing arrangements include $172.5 million of Senior Notes and a $125.0 million revolving credit facility. The Senior Notes bear interest at a rate of 4.0% per year, payable semi-annually in arrears on April 1 and October 1 of each year, beginning April 1, 2011. Holders may convert the Senior Notes at their option at any time prior to the close of business on the business day immediately preceding the October 1, 2017 maturity date. The conversion rate is initially 90.8893 shares of our common stock per $1,000 principal amount of Senior Notes (equivalent to an initial conversion price of $11.00 per share of common stock), subject to adjustment in certain circumstances. Upon conversion, the Senior Notes will be settled in shares of our common stock. We may not redeem the Senior Notes prior to their maturity date.\n17\nOur revolving credit facility (the \"Credit Agreement\") provides for a $125.0 million revolving loan facility available for borrowings and letters of credit which expires in November 2016. The Credit Agreement can be increased by $75.0 million for a maximum $200.0 million of capacity. Under the terms of the Credit Agreement, we can elect to borrow at an interest rate either based on LIBOR plus a margin based on our consolidated leverage ratio, ranging from 175 to 300 basis points, or at an interest rate based on the greatest of: (a) prime rate, (b) the federal funds rate in effect plus 50 basis points, or (c) the Eurodollar rate for a Eurodollar Loan with a one-month interest period plus 100 basis points, in each case plus a margin ranging from 75 to 200 basis points. The applicable margin on LIBOR borrowings on March 31, 2014 was 200 basis points. In addition, we are required to pay a commitment fee on the unused portion of the Credit Agreement of 37.5 basis points. The Credit Agreement contains customary financial and operating covenants, including a consolidated leverage ratio, a senior secured leverage ratio and an interest coverage ratio. We were in compliance with these covenants as of March 31, 2014.\nAt March 31, 2014, we had letters of credit issued and outstanding under the Credit Agreement which totaled $31.4 million leaving $93.6 million of availability at March 31, 2014. Additionally, our foreign operations had $16.0 million outstanding under lines of credit and other borrowings, as well as $1.6 million outstanding in letters of credit.\nThe Credit Agreement is a senior secured obligation, secured by first liens on all of our U.S. tangible and intangible assets, including our accounts receivable and inventory. Additionally, a portion of the capital stock of our non-U.S. subsidiaries has also been pledged as collateral.\nCritical Accounting Estimates\nOur consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, which requires us to make assumptions, estimates and judgments that affect the amounts reported. We periodically evaluate our estimates and judgments related to uncollectible accounts and notes receivable, customer returns, reserves for obsolete and slow moving inventory, impairments of long-lived assets, including goodwill and other intangibles and our valuation allowance for deferred tax assets. Our estimates are based on historical experience and on our future expectations that we believe to be reasonable. The combination of these factors forms the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from our current estimates and those differences may be material.\nFor additional discussion of our critical accounting estimates and policies, see “Management's Discussion and Analysis of Financial Condition and Results of Operations” included in our Annual Report on Form 10-K for the year ended December 31, 2013. Our critical accounting policies have not changed materially since December 31, 2013.\n\n\nITEM 3.\nQuantitative and Qualitative Disclosures about Market Risk\nWe are exposed to market risk from changes in interest rates and changes in foreign currency rates. A discussion of our primary market risk exposure in financial instruments is presented below.\nInterest Rate Risk\nAt March 31, 2014, we had total debt outstanding of $188.5 million, including $172.5 million of Senior Notes, bearing interest at a fixed rate of 4.0%. Variable rate debt totaled $16.0 million which relates to our foreign operations under lines of credit and other borrowings. At the March 31, 2014 balance, a 200 basis point increase in market interest rates during 2014 would cause our annual interest expense to increase approximately $0.2 million.\n18\nForeign Currency\nOur principal foreign operations are conducted in certain areas of EMEA, Latin America, Asia Pacific, and Canada. We have foreign currency exchange risks associated with these operations, which are conducted principally in the foreign currency of the jurisdictions in which we operate which include European euros, Australian dollars, Canadian dollars, British pound and Brazilian reais. Historically, we have not used off-balance sheet financial hedging instruments to manage foreign currency risks when we enter into a transaction denominated in a currency other than our local currencies because the dollar amount of these transactions has not warranted our using hedging instruments.\n\n\nITEM 4.\nControls and Procedures\nEvaluation of disclosure controls and procedures\nBased on their evaluation of our disclosure controls and procedures as of the end of the period covered by this report, our Chief Executive Officer and Chief Financial Officer have concluded that the disclosure controls and procedures were effective as of March 31, 2014, the end of the period covered by this quarterly report.\nChanges in internal control over financial reporting\nThere has been no change in internal control over financial reporting during the quarter ended March 31, 2014 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\n\n| PART II | OTHER INFORMATION |\n\nITEM 1.\nLegal Proceedings\nThe information set forth in the legal proceedings section of “Note 9, Commitments and Contingencies,” to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q is incorporated by reference into this Item 1.\n\n\nITEM 1A.\nRisk Factors\nThere have been no material changes during the period ended March 31, 2014 in our “Risk Factors” as discussed in Item 1A to our Annual Report on Form 10-K for the year ended December 31, 2013.\n19\n\n\nITEM 2.\nUnregistered Sales of Equity Securities and Use of Proceeds\n\n| (a) | Not applicable |\n\n\n| (b) | Not applicable |\n\n\n| (c) | The following table details our repurchases of shares of our common stock, for the three months ended March 31, 2014: |\n\n\n| Total Number of | Maximum Approximate Dollar |\n| Shares Purchased as Part | Value of Shares that May Yet |\n| Total Number of | Average Price | of Publicly Announced | be Purchased Under |\n| Period | Shares Purchased | (1) | per Share | Plans or Programs | Plans or Programs |\n| January 1 - 31, 2014 | 876,820 | $ | 12.07 | 872,313 | $32.8 |\n| February 1 - 28, 2014 | - | - | - | $32.8 |\n| March 1 - 31, 2014 | 232,311 | 10.94 | 223,100 | $80.3 |\n| Total | 1,109,131 | $ | 11.83 | 1,095,413 |\n\n(1) During the three months ended March 31, 2014, we purchased an aggregate of 13,718 shares surrendered in lieu of taxes under vesting of restricted stock awards. In February 2014, the Company’s Board of Directors authorized an amendment to the $50.0 million repurchase program to increase the amount authorized to $100.0 million, subject to completion of the Environmental Services divesture which was completed in March 2014. Subsequent to quarter-end, we repurchased an additional 1,541,468 shares at an average cost of approximately $11.42 per share.\nITEM 3.\nDefaults Upon Senior Securities\nNot applicable.\n\n\nITEM 4.\nMine Safety Disclosures\nThe information concerning mine safety violations and other regulatory matters required by section 1503(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act and Item 104 of Regulation S-K is included in Exhibit 95.1 of this Quarterly Report on Form 10-Q, which is incorporated by reference.\n\n\nITEM 5.\nOther Information\nNone.\n20\n\n\nITEM 6.\nExhibits\n\n| *10.1 | Membership Interests Purchase Agreement dated as of February 10, 2014 by and among Newpark Resources, Inc., Newpark Drilling Fluids LLC and ecoserv, LLC. |\n\n\n| *31.1 | Certification of Paul L. Howes pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n\n\n| *31.2 | Certification of Gregg S. Piontek pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n\n\n| *32.1 | Certification of Paul L. Howes pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n\n\n| *32.2 | Certification of Gregg S. Piontek pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n\n*95.1 Reporting requirements under the Mine Safety and Health Administration.\n*101.INS XBRL Instance Document *101.SCH XBRL Schema Document *101.CAL XBRL Calculation Linkbase Document *101.LAB XBRL Label Linkbase Document *101.PRE XBRL Presentation Linkbase Document *101.DEF XBRL Definition Linkbase Document\n* Filed herewith.\n21\nNEWPARK RESOURCES, INC.\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\nDate: April 25, 2014\n\n| *95.1 | Reporting requirements under the Mine Safety and Health Administration. |\n\n\n| *101.INS | XBRL Instance Document |\n| *101.SCH | XBRL Schema Document |\n| *101.CAL | XBRL Calculation Linkbase Document |\n| *101.LAB | XBRL Label Linkbase Document |\n| *101.PRE | XBRL Presentation Linkbase Document |\n| *101.DEF | XBRL Definition Linkbase Document |\n\n22\nEXHIBIT INDEX\n\n| NEWPARK RESOURCES, INC. |\n| By: | /s/ Paul L. Howes |\n| Paul L. Howes, President and |\n| Chief Executive Officer |\n| (Principal Executive Officer) |\n\n\n| By: | /s/ Gregg S. Piontek |\n| Gregg S. Piontek, Vice President and |\n| Chief Financial Officer |\n| (Principal Financial and Accounting Officer) |\n\n\n| *10.1 | Membership Interests Purchase Agreement dated as of February 10, 2014 by and among Newpark Resources, Inc., Newpark Drilling Fluids LLC and ecoserv, LLC. |\n\n\n| *31.1 | Certification of Paul L. Howes pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n\n\n| *31.2 | Certification of Gregg S. Piontek pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n\n\n| *32.1 | Certification of Paul L. Howes pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n\n*101.INS XBRL Instance Document *101.SCH XBRL Schema Document *101.CAL XBRL Calculation Linkbase Document *101.LAB XBRL Label Linkbase Document *101.PRE XBRL Presentation Linkbase Document *101.DEF XBRL Definition Linkbase Document\n* Filed herewith.\n23\n \n\nWhat is the percentage change in net cash flow from December 2013 to March 2014 after factoring in the revenues from the sale of Environmental services, acquisition, and share repurchase program?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nITEM 1.\\nFinancial Statements\\nNewpark Resources, Inc.Condensed Consolidated Balance Sheets(Unaudited)\\n\\n| (In thousands, except share data) | March 31, 2014 | December 31, 2013 |\\n| ASSETS |\\n| Cash and cash equivalents | $ | 130,187 | $ | 65,840 |\\n| Receivables, net | 276,082 | 268,529 |\\n| Inventories | 199,565 | 189,680 |\\n| Deferred tax asset | 11,750 | 11,272 |\\n| Prepaid expenses and other current assets | 15,034 | 11,016 |\\n| Assets of discontinued operations | - | 13,103 |\\n| Total current assets | 632,618 | 559,440 |\\n| Property, plant and equipment, net | 227,050 | 217,010 |\\n| Goodwill | 93,781 | 94,064 |\\n| Other intangible assets, net | 23,870 | 25,900 |\\n| Other assets | 9,813 | 6,086 |\\n| Assets of discontinued operations | - | 65,917 |\\n| Total assets | $ | 987,132 | $ | 968,417 |\\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\\n| Short-term debt | $ | 15,759 | $ | 12,867 |\\n| Accounts payable | 88,328 | 88,586 |\\n| Accrued liabilities | 65,196 | 46,341 |\\n| Liabilities of discontinued operations | - | 5,957 |\\n| Total current liabilities | 169,283 | 153,751 |\\n| Long-term debt, less current portion | 172,771 | 172,786 |\\n| Deferred tax liability | 26,235 | 27,060 |\\n| Other noncurrent liabilities | 11,288 | 11,026 |\\n| Liabilities of discontinued operations | - | 22,740 |\\n| Total liabilities | 379,577 | 387,363 |\\n| Commitments and contingencies (Note 9) |\\n| Common stock, $0.01 par value, 200,000,000 shares authorized and 98,032,555 and 98,030,839 shares issued, respectively | 980 | 980 |\\n| Paid-in capital | 507,820 | 504,675 |\\n| Accumulated other comprehensive loss | (8,279 | ) | (9,484 | ) |\\n| Retained earnings | 195,349 | 160,338 |\\n| Treasury stock, at cost; 11,904,275 and 10,832,845 shares, respectively | (88,315 | ) | (75,455 | ) |\\n| Total stockholders’ equity | 607,555 | 581,054 |\\n| Total liabilities and stockholders' equity | $ | 987,132 | $ | 968,417 |\\n\\nSee Accompanying Notes to Unaudited Condensed Consolidated Financial Statements\\n2\\nNewpark Resources, Inc.Condensed Consolidated Statements of Operations(Unaudited)\\n\\n| Three Months Ended March 31, |\\n| (In thousands, except per share data) | 2014 | 2013 |\\n| Revenues | $ | 242,824 | $ | 267,923 |\\n| Cost of revenues | 196,560 | 220,735 |\\n| Selling, general and administrative expenses | 25,523 | 22,451 |\\n| Other operating income, net | (16 | ) | (124 | ) |\\n| Operating income | 20,757 | 24,861 |\\n| Foreign currency exchange loss (gain) | 54 | (368 | ) |\\n| Interest expense, net | 2,920 | 2,520 |\\n| Income from continuing operations before income taxes | 17,783 | 22,709 |\\n| Provision for income taxes | 6,041 | 7,842 |\\n| Income from continuing operations | 11,742 | 14,867 |\\n| Income from discontinued operations, net of tax | 1,152 | 2,508 |\\n| Gain from disposal of discontinued operations, net of tax | 22,117 | - |\\n| Net income | $ | 35,011 | $ | 17,375 |\\n| Income per common share -basic: |\\n| Income from continuing operations | $ | 0.14 | $ | 0.18 |\\n| Income from discontinued operations | 0.27 | 0.03 |\\n| Net income | $ | 0.41 | $ | 0.21 |\\n| Income per common share -diluted: |\\n| Income from continuing operations | $ | 0.13 | $ | 0.16 |\\n| Income from discontinued operations | 0.23 | 0.02 |\\n| Net income | $ | 0.36 | $ | 0.18 |\\n\\nSee Accompanying Notes to Unaudited Condensed Consolidated Financial Statements\\n3\\nNewpark Resources, Inc.Condensed Consolidated Statements of Comprehensive Income(Unaudited)\\n\\n| Three Months Ended March 31, |\\n| (In thousands) | 2014 | 2013 |\\n| Net income | $ | 35,011 | $ | 17,375 |\\n| Foreign currency translation adjustments | 1,205 | (2,764 | ) |\\n| Comprehensive income | $ | 36,216 | $ | 14,611 |\\n\\nSee Accompanying Notes to Unaudited Condensed Consolidated Financial Statements\\n4\\nNewpark Resources, Inc.Condensed Consolidated Statements of Cash Flows(Unaudited)\\n\\n| Three Months Ended March 31, |\\n| (In thousands) | 2014 | 2013 |\\n| Cash flows from operating activities: |\\n| Net income | $ | 35,011 | $ | 17,375 |\\n| Adjustments to reconcile net income to net cash provided by operations: |\\n| Depreciation and amortization | 10,287 | 10,954 |\\n| Stock-based compensation expense | 2,840 | 1,973 |\\n| Provision for deferred income taxes | (13,108 | ) | 534 |\\n| Net provision for doubtful accounts | 173 | 208 |\\n| Gain on sale of a business | (33,974 | ) | - |\\n| Gain on sale of assets | (362 | ) | (99 | ) |\\n| Change in assets and liabilities: |\\n| Increase in receivables | (1,080 | ) | (20,969 | ) |\\n| Increase in inventories | (9,229 | ) | (1,280 | ) |\\n| Increase in other assets | (3,858 | ) | (2,382 | ) |\\n| (Decrease) increase in accounts payable | (1,248 | ) | 4,179 |\\n| Increase in accrued liabilities and other | 18,142 | 4,747 |\\n| Net cash provided by operating activities | 3,594 | 15,240 |\\n| Cash flows from investing activities: |\\n| Capital expenditures | (18,509 | ) | (16,127 | ) |\\n| Proceeds from sale of property, plant and equipment | 754 | 213 |\\n| Proceeds from sale of a business | 89,167 | - |\\n| Net cash provided by (used in) investing activities | 71,412 | (15,914 | ) |\\n| Cash flows from financing activities: |\\n| Borrowings on lines of credit | 47,562 | 71,102 |\\n| Payments on lines of credit | (45,113 | ) | (78,748 | ) |\\n| Other financing activities | (13 | ) | (38 | ) |\\n| Proceeds from employee stock plans | 34 | 3,808 |\\n| Purchase of treasury stock | (13,123 | ) | - |\\n| Net cash used in financing activities | (10,653 | ) | (3,876 | ) |\\n| Effect of exchange rate changes on cash | (6 | ) | (586 | ) |\\n| Net increase (decrease) in cash and cash equivalents | 64,347 | (5,136 | ) |\\n| Cash and cash equivalents at beginning of year | 65,840 | 46,846 |\\n| Cash and cash equivalents at end of period | $ | 130,187 | $ | 41,710 |\\n| Cash paid for: |\\n| Income taxes (net of refunds) | $ | 9,500 | $ | 4,294 |\\n| Interest | $ | 667 | $ | 331 |\\n\\nSee Accompanying Notes to Unaudited Condensed Consolidated Financial Statements\\n5\\nNEWPARK RESOURCES, INC.\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\nNote 1 – Basis of Presentation and Significant Accounting Policies\\nThe accompanying unaudited condensed consolidated financial statements of Newpark Resources, Inc. and our wholly-owned subsidiaries, which we refer to as “we,” “our” or “us,” have been prepared in accordance with Rule 10-01 of Regulation S-X for interim financial statements required to be filed with the Securities and Exchange Commission (“SEC”), and do not include all information and footnotes required by the accounting principles generally accepted in the United States (“U.S. GAAP”) for complete financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2013. Our fiscal year end is December 31 and our first quarter represents the three month period ended March 31. The results of operations for the first quarter of 2014 are not necessarily indicative of the results to be expected for the entire year. Unless otherwise stated, all currency amounts are stated in U.S. dollars.\\nIn the opinion of management, the accompanying unaudited condensed consolidated financial statements reflect all adjustments necessary to present fairly our financial position as of March 31, 2014, the results of our operations for the first quarter of 2014 and 2013, and our cash flows for the first quarter of 2014 and 2013. All adjustments are of a normal recurring nature. Our balance sheet at December 31, 2013 is derived from the audited consolidated financial statements at that date.\\nThe preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. For further information, see Note 1 in our Annual Report on Form 10-K for the year ended December 31, 2013.\\nNew Accounting Standards\\nIn April 2014, the Financial Accounting Standards Board (“FASB”) issued updated guidance that changes the criteria for reporting discontinued operations including enhanced disclosure requirements. Under the new guidance, only disposals representing a strategic shift in operations should be presented as discontinued operations. Those strategic shifts should have a major effect on the organization´s operations and financial results. The new guidance is effective for us in the first quarter of 2015, however we do not expect the adoption to have a material effect on our consolidated financial statements.\\n6\\nNote 2 – Discontinued Operations\\nOn March 17, 2014, we completed the previously announced sale of our Environmental Services business for $100 million in cash, subject to adjustment based on actual working capital conveyed at closing. Cash proceeds from the sale were $89.2 million in the first quarter of 2014, net of transaction related expenses. In addition, $8 million of the sale price was withheld in escrow associated with transaction representations, warranties and indemnities, and is expected to be released over the next two years. As a result of the sale transaction, we recorded a gain on the disposal of the business of $34.0 million ($22.1 million after-tax). All assets, liabilities and results of operations for this business have been reclassified to discontinued operations for all periods presented.\\nSummarized results of operations from discontinued operations are as follows:\\n\\n| Three Months Ended March 31, |\\n| (In thousands) | 2014 | 2013 |\\n| Revenues | $ | 11,744 | $ | 14,595 |\\n| Income from discontinued operations before income taxes | 1,770 | 3,508 |\\n| Income from discontinued operations, net of tax | 1,152 | 2,508 |\\n| Gain from disposal of discontinued operations before income taxes | 33,974 | - |\\n| Gain from disposal of discontinued operations, net of tax | 22,117 | - |\\n\\nAs of March 31, 2014, our reported accrued liabilities of $65.2 million, includes approximately $31 million of accrued income taxes payable, the majority of which is related to the sale of this business. Assets and liabilities of discontinued operations as of December 31, 2013 were as follows:\\n\\n| December 31, |\\n| (In thousands) | 2013 |\\n| Receivables, net | $ | 11,915 |\\n| Prepaid expenses and other current assets | 1,188 |\\n| Property, plant and equipment | 62,333 |\\n| Other assets | 3,584 |\\n| Assets of discontinued operations | $ | 79,020 |\\n| Accounts payable | $ | 4,415 |\\n| Other Accrued liabilities | 1,542 |\\n| Deferred tax liability | 12,449 |\\n| Other noncurrent liabilities | 10,291 |\\n| Liabilities of discontinued operations | $ | 28,697 |\\n\\n7\\nNote 3 – Earnings per Share\\nThe following table presents the reconciliation of the numerator and denominator for calculating earnings per share from continuing operations:\\n\\n| First Quarter |\\n| (In thousands, except per share data) | 2014 | 2013 |\\n| Basic EPS: |\\n| Income from continuing operations | $ | 11,742 | $ | 14,867 |\\n| Weighted average number of common shares outstanding | 84,743 | 84,100 |\\n| Basic income from continuing operations per common share | $ | 0.14 | $ | 0.18 |\\n| Diluted EPS: |\\n| Income from continuing operations | $ | 11,742 | $ | 14,867 |\\n| Assumed conversions of Senior Notes | 1,261 | 1,250 |\\n| Adjusted income from continuing operations | $ | 13,003 | $ | 16,117 |\\n| Weighted average number of common shares outstanding-basic | 84,743 | 84,100 |\\n| Add: Dilutive effect of stock options and restricted stock awards | 1,674 | 1,572 |\\n| Dilutive effect of Senior Notes | 15,682 | 15,682 |\\n| Diluted weighted average number of common shares outstanding | 102,099 | 101,354 |\\n| Diluted income from continuing operations per common share | $ | 0.13 | $ | 0.16 |\\n| Stock options excluded from calculation of diluted earnings per share because anti-dilutive for the period | 627 | 592 |\\n\\nFor the first quarter of 2014 and 2013, we had weighted average dilutive stock options and restricted stock outstanding of approximately 5.0 million shares and 5.5 million shares, respectively. The resulting net effect of stock options and restricted stock were used in calculating diluted earnings per share for the period.\\nNote 4 – Acquisition\\nIn December 2013, we completed the acquisition of Terrafirma Roadways (“Terrafirma”), a provider of temporary roadways and worksites based in the United Kingdom, for total cash consideration of $6.8 million, net of cash acquired. Additional consideration up to £1.0 million ($1.6 million) may be payable based on earnings of the business over the 18-month period following the acquisition. Prior to the acquisition, Terrafirma had been operating as a partner to the Company since 2008, developing a rental business with DURA-BASE® composite mats, primarily focused in the utility industry in the U.K.\\n8\\nThe transaction has been recorded using the acquisition method of accounting and accordingly, assets acquired and liabilities assumed were recorded at their fair values as of the acquisition date. The excess of the total consideration, including projected additional consideration, was recorded as goodwill and includes the value of the assembled workforce. While the initial purchase price allocation has been completed, the allocation of the purchase price is subject to change for a period of one year following the acquisition. The following table summarizes the amounts recognized for assets acquired and liabilities assumed as of the December 2013 acquisition date:\\n\\n| (In thousands) |\\n| Receivables, net | $ | 2,155 |\\n| Property, plant and equipment, net | 2,160 |\\n| Goodwill | 4,544 |\\n| Other intangibles, net | 4,528 |\\n| Total assets acquired | 13,387 |\\n| Accounts payable | 3,350 |\\n| Short-term debt | 284 |\\n| Accrued liabilities | 285 |\\n| Deferred tax liability | 1,092 |\\n| Other noncurrent liabilities | 1,600 |\\n| Total liabilities assumed | 6,611 |\\n| Total cash conveyed at closing | $ | 6,776 |\\n\\nPro forma results of operation for the acquired business have not been presented as the effect of this acquisition is not material to our consolidated financial statements.\\nNote 5 – Treasury Stock\\nIn April 2013, our Board of Directors approved a share repurchase program that authorizes the Company to purchase up to $50.0 million of its outstanding shares of common stock. In February 2014, our Board of Directors increased the total authorization of the program to $100.0 million, subject to completion of the Environmental Services divesture. These purchases are funded with a combination of cash generated from operations, the sale of the Environmental Services business and borrowings under the Company’s revolving credit facility. The repurchase program has no specific term. The Company may repurchase shares in the open market or as otherwise determined by management, subject to market conditions, business opportunities and other factors. As part of the share repurchase program, the Company’s management has been authorized to establish trading plans under Rule 10b5-1 of the Securities Exchange Act of 1934.\\nDuring the first quarter of 2014, 1,095,413 shares were repurchased for an average price of approximately $11.84 per share, including commissions, leaving $80.3 million remaining under the program. All of the shares repurchased are held as treasury stock. We record treasury stock purchases under the cost method whereby the entire cost of the acquired stock is recorded as treasury stock.\\n9\\nNote 6 – Receivables\\nReceivables - Receivables consist of the following:\\n\\n| March 31, | December 31, |\\n| (In thousands) | 2014 | 2013 |\\n| Gross trade receivables | $ | 254,376 | $ | 252,168 |\\n| Allowance for doubtful accounts | (4,204 | ) | (4,142 | ) |\\n| Net trade receivables | 250,172 | 248,026 |\\n| Other receivables | 25,910 | 20,503 |\\n| Total receivables, net | $ | 276,082 | $ | 268,529 |\\n\\nNote 7 – Inventories\\nInventories- Inventories consist of the following:\\n\\n| (In thousands) | March 31, 2014 | December 31, 2013 |\\n| Raw materials: |\\n| Drilling fluids | $ | 173,393 | $ | 153,901 |\\n| Mats | 914 | 790 |\\n| Total raw materials | 174,307 | 154,691 |\\n| Blended drilling fluids components | 23,914 | 34,075 |\\n| Finished goods- mats | 1,344 | 914 |\\n| Total | $ | 199,565 | $ | 189,680 |\\n\\nRaw materials consist primarily of barite, chemicals, and other additives that are consumed in the production of our drilling fluid systems. Our blended drilling fluids components consist of base drilling fluid systems that have been either mixed internally at our mixing plants or purchased from third party vendors. These base systems require raw materials to be added, as required to meet specified customer requirements.\\nNote 8 – Financing Arrangements and Fair Value of Financial Instruments\\nOur financing arrangements include $172.5 million of unsecured convertible senior notes (“Senior Notes”) and a $125.0 million revolving credit facility which can be increased by $75.0 million for a maximum $200.0 million of capacity. At March 31, 2014, we had no outstanding borrowings under the revolving credit facility. The Senior Notes bear interest at a rate of 4.0% per year, payable semi-annually in arrears on April 1 and October 1 of each year, beginning April 1, 2011. Holders may convert the Senior Notes at their option at any time prior to the close of business on the business day immediately preceding the October 1, 2017 maturity date. The conversion rate is initially 90.8893 shares of our common stock per $1,000 principal amount of Senior Notes (equivalent to an initial conversion price of $11.00 per share of common stock), subject to adjustment in certain circumstances. Upon conversion, the Senior Notes will be settled in shares of our common stock. We may not redeem the Senior Notes prior to their maturity date.\\n10\\nOur financial instruments include cash and cash equivalents, receivables, payables and debt. We believe the carrying values of these instruments, with the exception of our Senior Notes, approximated their fair values at March 31, 2014 and December 31, 2013. The estimated fair value of our Senior Notes is $219.1 million at March 31, 2014 and $231.2 million at December 31, 2013, based on quoted market prices at these respective dates.\\nNote 9 – Commitments and Contingencies\\nIn the ordinary course of conducting our business, we become involved in litigation and other claims from private party actions, as well as judicial and administrative proceedings involving governmental authorities at the federal, state and local levels. In the opinion of management, any liability in these matters should not have a material effect on our consolidated financial statements.\\nNote 10 – Segment Data\\nSummarized operating results for our reportable segments is shown in the following table (net of inter-segment transfers):\\n\\n| First Quarter |\\n| (In thousands) | 2014 | 2013 |\\n| Revenues |\\n| Fluids systems | $ | 211,400 | $ | 247,339 |\\n| Mats & integrated services | 31,424 | 20,584 |\\n| Total Revenues | $ | 242,824 | $ | 267,923 |\\n| Operating Income (loss) |\\n| Fluids systems | $ | 15,740 | $ | 22,622 |\\n| Mats & integrated services | 13,373 | 8,480 |\\n| Corporate office | (8,356 | ) | (6,241 | ) |\\n| Operating Income | $ | 20,757 | $ | 24,861 |\\n\\n11\\n\\n\\nITEM 2.\\nManagement's Discussion and Analysis of Financial Condition and Results of Operations\\nThe following discussion of our financial condition, results of operations, liquidity and capital resources should be read together with our unaudited condensed consolidated financial statements and notes to unaudited condensed consolidated financial statements contained in this report as well as our Annual Report on Form 10-K for the year ended December 31, 2013. Our first quarter represents the three month period ended March 31, 2014. Unless otherwise stated, all currency amounts are stated in U.S. dollars.\\nOverview\\nWe are a diversified oil and gas industry supplier providing products and services primarily to the oil and gas exploration and production (“E&P”) industry. We operate our business through two reportable segments: Fluids Systems and Mats and Integrated Services.\\nIn March 2014, we completed the sale of our Environmental Services business, which was historically reported as a third operating segment for $100 million in cash. The proceeds will be used for general corporate purposes, including investments in our core drilling fluids and mats segments, potential acquisitions, along with the continued share purchases under the current repurchase program. See Note 2 Discontinued Operations in our Notes to Unaudited Condensed Consolidated Financial Statements in Item 1 for additional information.\\nOur Fluids Systems segment, which generated 87% of consolidated revenues in the first quarter of 2014, provides customized drilling fluids solutions to E&P customers globally, operating through four geographic regions: North America, Europe, the Middle East and Africa (“EMEA”), Latin America, and Asia Pacific.\\nIn 2013, we announced several international contract awards, including two in the deepwater market. In Brazil, we were awarded a two-year contract from a subsidiary of Total S.A., to provide drilling fluids and related services for a series of wells planned in the Campos Basin. In our EMEA region, we were awarded a contract by another customer to provide drilling fluids and related services for a series of wells to be drilled in the Black Sea. In addition, we were awarded two contracts to provide drilling fluids and related services for land operations, including a five year contract by the Kuwait Oil Company and a four year contract by another customer in India. Work under the Brazil contract began in the first quarter of 2014, while work under the other three contracts is expected to begin later in 2014.\\nWe are continuing the roll-out of Evolution®, our high performance water-based drilling fluid system launched in 2010, which we believe provides superior performance and environmental benefits to our customers, as compared to traditional fluids systems used in the industry. After completing the roll-out of the system into most major North American drilling basins in 2011 and 2012, we are seeking to further penetrate markets in North America, while expanding into key international markets. The system has now been used in our EMEA and Asia Pacific regions. Revenues from wells using the Evolution system were approximately $48 million in the first quarter of 2014, compared to $29 million in the first quarter of 2013.\\nOur Mats and Integrated Services segment, which generated 13% of consolidated revenues through the first quarter of 2014, provides composite mat rentals, well site construction and related site services to oil and gas customers and mat rentals to the petrochemicals industry in the U.S. and the utility industry in the U.K. We also sell composite mats to E&P customers outside of the U.S., and to domestic customers outside of the oil and gas industry.\\nIn October 2013, we announced plans to expand our mat manufacturing facility, located in Carencro, Louisiana. The $40 million expansion project is expected to be completed in early 2015. Upon completion, the project will significantly increase our production capacity and support expansion into new markets, both domestically and internationally. The new facility will also include a research and development center, intended to drive continued new product development efforts. Until this manufacturing facility expansion project is completed, we expect revenues from mat sales to continue to be limited by our manufacturing capacity limitations, along with our efforts to meet growing demand for mat rentals. During both the first quarters of 2014 and 2013, we allocated the majority of our composite mat production toward the expansion of our rental fleet, leaving fewer mats available for sale to customers.\\n12\\nIn December 2013 we completed the acquisition of Terrafirma Roadways (“Terrafirma”), a provider of temporary roadways and worksites based in the United Kingdom, for total cash consideration of $6.8 million, net of cash acquired. Prior to the acquisition, Terrafirma had been operating as a partner to the Company since 2008, developing a rental business with DURA-BASE® composite mats, primarily focused in the utility industry in the U.K.\\nRig count data is the most widely accepted indicator of drilling activity. Average North American rig count data for the first quarter of 2014, as compared to the first quarter of 2013 is as follows:\\n\\n| First Quarter | 2014 vs 2013 |\\n| 2014 | 2013 | Count | % |\\n| U.S. Rig Count | 1,779 | 1,758 | 21 | 1 | % |\\n| Canadian Rig Count | 525 | 531 | (6 | ) | (1 | %) |\\n| North America | 2,304 | 2,289 | 15 | 1 | % |\\n\\nSource: Baker Hughes Incorporated\\nFirst Quarter of 2014 Compared to First Quarter of 2013\\nConsolidated Results of Operations\\nSummarized results of operations for the first quarter of 2014 compared to the first quarter of 2013 are as follows:\\n\\n| First Quarter | 2014 vs 2013 |\\n| (In thousands) | 2014 | 2013 | % |\\n| Revenues | $ | 242,824 | $ | 267,923 | $ | (25,099 | ) | (9 | %) |\\n| Cost of revenues | 196,560 | 220,735 | (24,175 | ) | (11 | %) |\\n| Selling, general and administrative expenses | 25,523 | 22,451 | 3,072 | 14 | % |\\n| Other operating income, net | (16 | ) | (124 | ) | 108 | (87 | %) |\\n| Operating income | 20,757 | 24,861 | (4,104 | ) | (17 | %) |\\n| Foreign currency exchange loss (gain) | 54 | (368 | ) | 422 | (115 | %) |\\n| Interest expense, net | 2,920 | 2,520 | 400 | 16 | % |\\n| Income from continuing operations before income taxes | 17,783 | 22,709 | (4,926 | ) | (22 | %) |\\n| Provision for income taxes | 6,041 | 7,842 | (1,801 | ) | (23 | %) |\\n| Income from continuing operations | 11,742 | 14,867 | (3,125 | ) | (21 | %) |\\n| Income from discontinued operations, net of tax | 1,152 | 2,508 | (1,356 | ) | (54 | %) |\\n| Gain from disposal of discontinued operations, net of tax | 22,117 | - | 22,117 | NM |\\n| Net income | $ | 35,011 | $ | 17,375 | $ | 17,636 | 102 | % |\\n| NM-Not meaningful |\\n\\n13\\nRevenues\\nRevenues decreased 9% to $242.8 million in the first quarter of 2014, compared to $267.9 million in the first quarter of 2013. This $25.1 million decrease includes a $22.1 million (11%) decrease in revenues in North America, including a $31.3 million decline in our Fluids Systems segment. Revenues from our international operations decreased by $3.0 million (4%), including declines in Asia Pacific and Brazil. Additional information regarding the change in revenues is provided within the operating segment results below.\\nCost of revenues\\nCost of revenues decreased 11% to $196.6 million in the first quarter of 2014, compared to $220.7 million in the first quarter of 2013. The decrease is primarily driven by the decrease in revenues. Additional information regarding the change in cost of revenues is provided within the operating segment results below.\\nSelling, general and administrative expenses\\nSelling, general and administrative expenses increased $3.1 million to $25.5 million in the first quarter of 2014 from $22.5 million in the first quarter of 2013. The increase is primarily attributable to a $1.7 million increase in spending related to strategic planning projects, including the development of our deepwater market penetration strategy and international treasury and tax planning projects.\\nForeign currency exchange\\nForeign currency exchange was a $0.1 million loss in the first quarter of 2014, compared to a $0.4 million gain in the first quarter of 2013, and primarily reflects the impact of currency translations on assets and liabilities held in our international operations that are denominated in currencies other than functional currencies.\\nInterest expense, net\\nInterest expense totaled $2.9 million for the first quarter of 2014 compared to $2.5 million for the first quarter of 2013. The $0.4 million increase primarily reflects the impact of increased borrowings in our Brazilian subsidiary.\\nProvision for income taxes\\nThe provision for income taxes for the first quarter of 2014 was $6.0 million, reflecting an effective tax rate of 34.0%, compared to $7.8 million in the first quarter of 2013, reflecting an effective tax rate of 34.5%.\\nDiscontinued operations\\nIncome from our discontinued Environmental Services operations was $1.2 million in the first quarter of 2014 compared to $2.5 million the first quarter of 2013. In addition, the first quarter of 2014 included a $22.1 million gain from the March 2014 sale of the business, described above. See Note 2 Discontinued Operations in our Notes to the unaudited condensed consolidated financial statements in Item 1.\\n14\\nOperating Segment Results\\nSummarized financial information for our reportable segments is shown in the following table (net of inter-segment transfers):\\n\\n| First Quarter | 2014 vs 2013 |\\n| (In thousands) | 2014 | 2013 | $ | % |\\n| Revenues |\\n| Fluids systems | $ | 211,400 | $ | 247,339 | $ | (35,939 | ) | (15 | %) |\\n| Mats and integrated services | 31,424 | 20,584 | 10,840 | 53 | % |\\n| Total revenues | $ | 242,824 | $ | 267,923 | $ | (25,099 | ) | (9 | %) |\\n| Operating income (loss) |\\n| Fluids systems | $ | 15,740 | $ | 22,622 | $ | (6,882 | ) |\\n| Mats and integrated services | 13,373 | 8,480 | 4,893 |\\n| Corporate office | (8,356 | ) | (6,241 | ) | (2,115 | ) |\\n| Operating income | $ | 20,757 | $ | 24,861 | $ | (4,104 | ) |\\n| Segment operating margin |\\n| Fluids systems | 7.4 | % | 9.1 | % |\\n| Mats and integrated services | 42.6 | % | 41.2 | % |\\n\\nFluids Systems\\nRevenues\\nTotal revenues for this segment consisted of the following:\\n\\n| First Quarter | 2014 vs 2013 |\\n| (In thousands) | 2014 | 2013 | $ | % |\\n| United States | $ | 124,776 | $ | 159,144 | $ | (34,368 | ) | (22 | %) |\\n| Canada | 21,711 | 18,651 | 3,060 | 16 | % |\\n| Total North America | 146,487 | 177,795 | (31,308 | ) | (18 | %) |\\n| EMEA | 34,720 | 34,518 | 202 | 1 | % |\\n| Latin America | 22,003 | 24,961 | (2,958 | ) | (12 | %) |\\n| Asia Pacific | 8,190 | 10,065 | (1,875 | ) | (19 | %) |\\n| Total | $ | 211,400 | $ | 247,339 | $ | (35,939 | ) | (15 | %) |\\n\\nNorth American revenues decreased 18% to $146.5 million in the first quarter of 2014, compared to $177.8 million in the first quarter of 2013. While the North American rig count improved by 1% over this period, the decrease is largely attributable to market share losses in South Texas, along with reduced drilling activity of a key customer in the U.S.\\nInternationally, revenues were down 7% to $64.9 million in the first quarter of 2014, as compared to $69.5 million in first quarter 2013. This decrease is primarily attributable to decreased activity with Petrobras in Brazil, along with lower revenues for land drilling customers in Australia.\\n15\\nOperating Income\\nOperating income decreased $6.9 million in the first quarter of 2014, as compared to the first quarter of 2013, largely attributable to the $35.9 million decline in revenues described above. The decline in operating income includes a $6.4 million decrease from North American operations, along with a $0.5 million decrease from international operations.\\nIn recent quarters, the business environment in Brazil has become increasingly challenging, particularly as Petrobras, our primary customer in the region, has focused more efforts on well completions and less on drilling activities. Also, the lack of timely payment of Petrobras-related invoicing has caused increases in invested working capital associated with participation in this market. In response to these changes in the business environment, we are continuing to evaluate opportunities to reduce the cost structure of this operation. While the Brazilian deepwater drilling market remains an important component of our long-term strategy, the profitability of our business remains highly dependent on increasing levels of drilling activity by Petrobras and other E&P customers. In the absence of a longer-term increase in drilling activity, we may incur additional charges, as we seek to reduce our cost structure in country, which may negatively impact our future operating results.\\nMats and Integrated Services\\nRevenues\\nTotal revenues for this segment consisted of the following:\\n\\n| First Quarter | 2014 vs 2013 |\\n| (In thousands) | 2014 | 2013 | $ | % |\\n| Mat rental and services | $ | 24,537 | $ | 14,778 | $ | 9,759 | 66 | % |\\n| Mat sales | 6,887 | 5,806 | 1,081 | 19 | % |\\n| Total | $ | 31,424 | $ | 20,584 | $ | 10,840 | 53 | % |\\n\\nMat rental and services revenues increased $9.8 million compared to the first quarter of 2013, primarily due to increasing demand for our composite mat products, particularly in the Northeast U.S. and Gulf Coast regions. In addition, the first quarter of 2014 benefitted from a $1.6 million increase from the U.K. rental operation, following the December 2013 Terrafirma acquisition, as described above. Mat sales increased by $1.1 million from the first quarter of 2013. As described above, quarterly revenues from mat sales typically fluctuate based on management’s allocation of plant capacity, along with the timing of mat orders from customers.\\nOperating Income\\nSegment operating income increased by $4.9 million, as compared to the first quarter of 2013, largely attributable to the $10.8 million increase in revenues described above. The segment operating margin continues to remain elevated, driven by high utilization of mats in our rental fleet, and high utilization of our production facility, which continues to run at maximum production capacity levels.\\nThe levels of mats sales in a given quarter are determined by several factors, including customer demand, as well as our allocation of mat production between sales and deployment into our rental fleet. The allocation of our production between additions to our rental fleet and sales in any given quarter is driven by a number of factors including commitments to meeting customer schedules, ability of our customers to take delivery of mats, timing of large mat rental projects/events, and plant capacity/efficiencies. As noted above, in the first quarter of 2014, we allocated the majority of our composite mat production toward the expansion of our rental fleet, leaving fewer mats available for sale to customers. Based on the continuing strong demand for our mats in the rental fleet, we expect the majority of our production to continue to be dedicated toward the expansion of our rental fleet until completion of the new mat manufacturing facility, resulting in lower mat sales revenues and income.\\n16\\nCorporate Office\\nCorporate office expenses increased $2.1 million to $8.4 million in the first quarter of 2014, compared to $6.2 million in the first quarter of 2013. The increase is primarily attributable to a $1.7 million increase in spending related to strategic planning projects, including the development of our deepwater market penetration strategy and international treasury and tax planning projects.\\nLiquidity and Capital Resources\\nNet cash provided by operating activities during the first quarter of 2014 totaled $3.6 million. During the first quarter of 2014, net cash provided by operating activities was negatively impacted by a $6.5 million reduction in accrued payroll and related costs, largely attributable to the first quarter payment of annual performance-based incentives, along with a $9.2 million increase in inventories, largely associated with the timing of receipts of barite ore purchased from China.\\nNet cash provided by investing activities during the first quarter of 2014 was $71.4 million, primarily consisting of net proceeds from the sale of the Environmental Services business of $89.2 million offset by capital expenditures of $18.5 million. The first quarter of 2014 capital expenditures included $9.8 million in the Mats & Integrated Services segment, related to the deployment of produced mats into the rental fleet and the manufacturing plant expansion project described above.\\nWe anticipate that our working capital requirements for our operations will decline in the near term due to continued efforts to reduce accounts receivable and inventory from the levels at March 31, 2014. We expect total 2014 capital expenditures to range between $65 million to $85 million. As of March 31, 2014, we had cash on-hand of $130.2 million of which $53.4 million resides within our foreign subsidiaries which we intend to leave permanently reinvested abroad. We expect our subsidiary cash on-hand, along with cash generated by operations and availability under our existing credit agreement to be adequate to fund our anticipated capital needs during the next 12 months.\\nOur capitalization is as follows:\\n\\n| March 31, | December 31, |\\n| (In thousands) | 2014 | 2013 |\\n| Senior Notes | $ | 172,500 | $ | 172,500 |\\n| Revolving credit facility | - | - |\\n| Other | 16,030 | 13,153 |\\n| Total | 188,530 | 185,653 |\\n| Stockholder's equity | 607,555 | 581,054 |\\n| Total capitalization | $ | 796,085 | $ | 766,707 |\\n| Total debt to capitalization | 23.7 | % | 24.2 | % |\\n\\nOur financing arrangements include $172.5 million of Senior Notes and a $125.0 million revolving credit facility. The Senior Notes bear interest at a rate of 4.0% per year, payable semi-annually in arrears on April 1 and October 1 of each year, beginning April 1, 2011. Holders may convert the Senior Notes at their option at any time prior to the close of business on the business day immediately preceding the October 1, 2017 maturity date. The conversion rate is initially 90.8893 shares of our common stock per $1,000 principal amount of Senior Notes (equivalent to an initial conversion price of $11.00 per share of common stock), subject to adjustment in certain circumstances. Upon conversion, the Senior Notes will be settled in shares of our common stock. We may not redeem the Senior Notes prior to their maturity date.\\n17\\nOur revolving credit facility (the \\\"Credit Agreement\\\") provides for a $125.0 million revolving loan facility available for borrowings and letters of credit which expires in November 2016. The Credit Agreement can be increased by $75.0 million for a maximum $200.0 million of capacity. Under the terms of the Credit Agreement, we can elect to borrow at an interest rate either based on LIBOR plus a margin based on our consolidated leverage ratio, ranging from 175 to 300 basis points, or at an interest rate based on the greatest of: (a) prime rate, (b) the federal funds rate in effect plus 50 basis points, or (c) the Eurodollar rate for a Eurodollar Loan with a one-month interest period plus 100 basis points, in each case plus a margin ranging from 75 to 200 basis points. The applicable margin on LIBOR borrowings on March 31, 2014 was 200 basis points. In addition, we are required to pay a commitment fee on the unused portion of the Credit Agreement of 37.5 basis points. The Credit Agreement contains customary financial and operating covenants, including a consolidated leverage ratio, a senior secured leverage ratio and an interest coverage ratio. We were in compliance with these covenants as of March 31, 2014.\\nAt March 31, 2014, we had letters of credit issued and outstanding under the Credit Agreement which totaled $31.4 million leaving $93.6 million of availability at March 31, 2014. Additionally, our foreign operations had $16.0 million outstanding under lines of credit and other borrowings, as well as $1.6 million outstanding in letters of credit.\\nThe Credit Agreement is a senior secured obligation, secured by first liens on all of our U.S. tangible and intangible assets, including our accounts receivable and inventory. Additionally, a portion of the capital stock of our non-U.S. subsidiaries has also been pledged as collateral.\\nCritical Accounting Estimates\\nOur consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, which requires us to make assumptions, estimates and judgments that affect the amounts reported. We periodically evaluate our estimates and judgments related to uncollectible accounts and notes receivable, customer returns, reserves for obsolete and slow moving inventory, impairments of long-lived assets, including goodwill and other intangibles and our valuation allowance for deferred tax assets. Our estimates are based on historical experience and on our future expectations that we believe to be reasonable. The combination of these factors forms the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from our current estimates and those differences may be material.\\nFor additional discussion of our critical accounting estimates and policies, see “Management's Discussion and Analysis of Financial Condition and Results of Operations” included in our Annual Report on Form 10-K for the year ended December 31, 2013. Our critical accounting policies have not changed materially since December 31, 2013.\\n\\n\\nITEM 3.\\nQuantitative and Qualitative Disclosures about Market Risk\\nWe are exposed to market risk from changes in interest rates and changes in foreign currency rates. A discussion of our primary market risk exposure in financial instruments is presented below.\\nInterest Rate Risk\\nAt March 31, 2014, we had total debt outstanding of $188.5 million, including $172.5 million of Senior Notes, bearing interest at a fixed rate of 4.0%. Variable rate debt totaled $16.0 million which relates to our foreign operations under lines of credit and other borrowings. At the March 31, 2014 balance, a 200 basis point increase in market interest rates during 2014 would cause our annual interest expense to increase approximately $0.2 million.\\n18\\nForeign Currency\\nOur principal foreign operations are conducted in certain areas of EMEA, Latin America, Asia Pacific, and Canada. We have foreign currency exchange risks associated with these operations, which are conducted principally in the foreign currency of the jurisdictions in which we operate which include European euros, Australian dollars, Canadian dollars, British pound and Brazilian reais. Historically, we have not used off-balance sheet financial hedging instruments to manage foreign currency risks when we enter into a transaction denominated in a currency other than our local currencies because the dollar amount of these transactions has not warranted our using hedging instruments.\\n\\n\\nITEM 4.\\nControls and Procedures\\nEvaluation of disclosure controls and procedures\\nBased on their evaluation of our disclosure controls and procedures as of the end of the period covered by this report, our Chief Executive Officer and Chief Financial Officer have concluded that the disclosure controls and procedures were effective as of March 31, 2014, the end of the period covered by this quarterly report.\\nChanges in internal control over financial reporting\\nThere has been no change in internal control over financial reporting during the quarter ended March 31, 2014 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\\n\\n| PART II | OTHER INFORMATION |\\n\\nITEM 1.\\nLegal Proceedings\\nThe information set forth in the legal proceedings section of “Note 9, Commitments and Contingencies,” to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q is incorporated by reference into this Item 1.\\n\\n\\nITEM 1A.\\nRisk Factors\\nThere have been no material changes during the period ended March 31, 2014 in our “Risk Factors” as discussed in Item 1A to our Annual Report on Form 10-K for the year ended December 31, 2013.\\n19\\n\\n\\nITEM 2.\\nUnregistered Sales of Equity Securities and Use of Proceeds\\n\\n| (a) | Not applicable |\\n\\n\\n| (b) | Not applicable |\\n\\n\\n| (c) | The following table details our repurchases of shares of our common stock, for the three months ended March 31, 2014: |\\n\\n\\n| Total Number of | Maximum Approximate Dollar |\\n| Shares Purchased as Part | Value of Shares that May Yet |\\n| Total Number of | Average Price | of Publicly Announced | be Purchased Under |\\n| Period | Shares Purchased | (1) | per Share | Plans or Programs | Plans or Programs |\\n| January 1 - 31, 2014 | 876,820 | $ | 12.07 | 872,313 | $32.8 |\\n| February 1 - 28, 2014 | - | - | - | $32.8 |\\n| March 1 - 31, 2014 | 232,311 | 10.94 | 223,100 | $80.3 |\\n| Total | 1,109,131 | $ | 11.83 | 1,095,413 |\\n\\n(1) During the three months ended March 31, 2014, we purchased an aggregate of 13,718 shares surrendered in lieu of taxes under vesting of restricted stock awards. In February 2014, the Company’s Board of Directors authorized an amendment to the $50.0 million repurchase program to increase the amount authorized to $100.0 million, subject to completion of the Environmental Services divesture which was completed in March 2014. Subsequent to quarter-end, we repurchased an additional 1,541,468 shares at an average cost of approximately $11.42 per share.\\nITEM 3.\\nDefaults Upon Senior Securities\\nNot applicable.\\n\\n\\nITEM 4.\\nMine Safety Disclosures\\nThe information concerning mine safety violations and other regulatory matters required by section 1503(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act and Item 104 of Regulation S-K is included in Exhibit 95.1 of this Quarterly Report on Form 10-Q, which is incorporated by reference.\\n\\n\\nITEM 5.\\nOther Information\\nNone.\\n20\\n\\n\\nITEM 6.\\nExhibits\\n\\n| *10.1 | Membership Interests Purchase Agreement dated as of February 10, 2014 by and among Newpark Resources, Inc., Newpark Drilling Fluids LLC and ecoserv, LLC. |\\n\\n\\n| *31.1 | Certification of Paul L. Howes pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n\\n\\n| *31.2 | Certification of Gregg S. Piontek pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n\\n\\n| *32.1 | Certification of Paul L. Howes pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\\n\\n\\n| *32.2 | Certification of Gregg S. Piontek pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\\n\\n*95.1 Reporting requirements under the Mine Safety and Health Administration.\\n*101.INS XBRL Instance Document *101.SCH XBRL Schema Document *101.CAL XBRL Calculation Linkbase Document *101.LAB XBRL Label Linkbase Document *101.PRE XBRL Presentation Linkbase Document *101.DEF XBRL Definition Linkbase Document\\n* Filed herewith.\\n21\\nNEWPARK RESOURCES, INC.\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\nDate: April 25, 2014\\n\\n| *95.1 | Reporting requirements under the Mine Safety and Health Administration. |\\n\\n\\n| *101.INS | XBRL Instance Document |\\n| *101.SCH | XBRL Schema Document |\\n| *101.CAL | XBRL Calculation Linkbase Document |\\n| *101.LAB | XBRL Label Linkbase Document |\\n| *101.PRE | XBRL Presentation Linkbase Document |\\n| *101.DEF | XBRL Definition Linkbase Document |\\n\\n22\\nEXHIBIT INDEX\\n\\n| NEWPARK RESOURCES, INC. |\\n| By: | /s/ Paul L. Howes |\\n| Paul L. Howes, President and |\\n| Chief Executive Officer |\\n| (Principal Executive Officer) |\\n\\n\\n| By: | /s/ Gregg S. Piontek |\\n| Gregg S. Piontek, Vice President and |\\n| Chief Financial Officer |\\n| (Principal Financial and Accounting Officer) |\\n\\n\\n| *10.1 | Membership Interests Purchase Agreement dated as of February 10, 2014 by and among Newpark Resources, Inc., Newpark Drilling Fluids LLC and ecoserv, LLC. |\\n\\n\\n| *31.1 | Certification of Paul L. Howes pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n\\n\\n| *31.2 | Certification of Gregg S. Piontek pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n\\n\\n| *32.1 | Certification of Paul L. Howes pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\\n\\n*101.INS XBRL Instance Document *101.SCH XBRL Schema Document *101.CAL XBRL Calculation Linkbase Document *101.LAB XBRL Label Linkbase Document *101.PRE XBRL Presentation Linkbase Document *101.DEF XBRL Definition Linkbase Document\\n* Filed herewith.\\n23\\n \\n\\nWhat is the percentage change in net cash flow from December 2013 to March 2014 after factoring in the revenues from the sale of Environmental services, acquisition, and share repurchase program?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 146.9425880923451.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 65,\n \"input_length\": 13355\n}"}}},{"rowIdx":66,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nITEM 1. BUSINESS\nGeneral\nFLEETCOR is a leading global provider of commercial payment solutions. We help businesses of all sizes control, simplify and secure payment of various domestic and cross-border payables using specialized payment products. We serve businesses, merchants and partners in North America, Latin America, Europe, and Australasia. FLEETCOR’s predecessor company was organized in the United States in 1986, and FLEETCOR had its initial public offering in 2010 (NYSE: FLT).\nFLEETCOR has two reportable segments, North America and International. We report these two segments as they align with our senior executive organizational structure, reflect how we organize and manage our employees around the world, manage operating performance, contemplate the differing regulatory environments in North America versus other geographies, and help us isolate the impact of foreign exchange fluctuations on our financial results.\nOur payment solutions provide our customers with a payment method designed to be superior to and more robust and effective than what they use currently, whether they use a competitor’s product or another alternative method such as cash or check. Our solutions are comprised of payment products, networks and associated services.\nFLEETCOR payment products function like a charge card or prepaid card, and tend to be specialized for specific spend categories, such as fuel or lodging, and/or specific customer groups, such as long haul transportation. FLEETCOR’s five primary product lines are Fuel, Lodging, Tolls, Corporate Payments and Gift. Additionally, we provide other payment products including fleet maintenance, employee benefits and long haul transportation-related services. Our products are used in 56 countries around the world, with our primary geographies being the U.S., Brazil and the United Kingdom, which combined accounted for approximately 90% of our revenue in 2017.\nFLEETCOR uses both proprietary and third-party networks to deliver our payment solutions. FLEETCOR owns and operates proprietary networks with well-established brands throughout the world, bringing incremental sales and loyalty to affiliated merchants. Third-party networks are used to broaden payment product acceptance and use. In 2017, we processed approximately 3 billion transactions within these networks, of which approximately 1.4 billion were related to our Gift product line.\nFLEETCOR capitalizes on its products’ specialization with sales and marketing efforts by deploying product-dedicated sales forces to target specific customer segments. We market our products directly through multiple sales channels, including field sales, telesales and digital marketing, and indirectly through our partners, which include major oil companies, leasing companies, petroleum marketers, value-added resellers (VARs) and referral partners.\nWe believe that our size and scale, product breadth and specialization, geographic reach, proprietary networks, robust distribution capabilities and advanced technology contribute to our industry leading position.\nProducts and services\nWe offer specialized payment solutions predominately for commercial businesses. Our payment solutions are intended to provide our customers with a payment method superior to that which they formerly used, whether they used a competitor’s product or another alternative method such as cash or check. Our solutions are comprised of payment products, networks and associated services.\nOur payment products typically function like a charge card or prepaid card. FLEETCOR provides a variety of payment mechanisms such as a plastic card, electronic tag, or other form to the customer. We issue credit to the customer (or accept prepaid funds from the customer) to allow for purchases using the payment product. FLEETCOR then reports the purchases to the customer and invoices (or debits prepaid amounts) for payment of purchases made on the customer’s account.\nPayment networks are integral to our solutions, as they allow us to electronically connect to merchants and capture transaction data from the point of sale. We use both proprietary and third-party networks to deliver our payment solutions. For our proprietary networks, FLEETCOR provides merchant acquiring services, which may include affiliation, contract management, point-of-sale terminals, reporting and settlement. FLEETCOR owns and operates proprietary networks with well-established brands across 56 countries, bringing incremental sales and loyalty to affiliated merchants. Third-party networks include MasterCard in the U.S. and Visa in the U.K. and continental Europe, the retail outlets of various partners, and proprietary\n4\nnetworks owned and operated by other partners. We use these third-party networks in order to broaden our payment product acceptance and use. Through our proprietary and third-party networks, we capture detailed transaction data and can often enable advanced purchase controls at the point-of-sale.\nWe support our payment products with specialized issuing, processing and information services that enable us to manage customer accounts, facilitate the routing, authorization, clearing and settlement of transactions, and provide value-added functionality and data, including customizable user-level controls and productivity analysis tools. Our customers can use these data, controls and tools to lower their operating costs, and combat fraud and employee misuse and streamline expense administration.\nDepending on our customers’ and partners’ needs, we provide our products and services in a variety of combinations ranging from a comprehensive “end-to-end” solution (encompassing issuing, processing and network services) to limited back office processing services.\nOur solutions tend to be specialized for specific spend categories, such as fuel or lodging, and/or specific customer segments, such as long haul transportation. This specialization is manifested in the purchase controls, merchant network, and reporting applicable to the spend category or customer segment. For example, a fuel card could provide controls on the type of fuel purchased, be accepted only at gas stations for fuel purchases, and provide fuel usage and efficiency reports for a customer’s fleet of vehicles. The combination of these specialized attributes allows our payment products to compete well against less specialized products such as cash or general purpose credit cards when it comes to controlling purchases within certain spend categories.\nFLEETCOR’s five primary product lines are Fuel, Lodging, Tolls, Corporate Payments and Gift. Additionally, we provide other payment products including fleet maintenance, employee benefits and long haul transportation-related services.\nFuel payment product line\nOur fuel payment product line is our largest product category, representing approximately 49% of our revenue in 2017.\nFLEETCOR offers fuel payment solutions to businesses and government entities who operate vehicle fleets, as well as to major oil companies, leasing companies and fuel marketers. Our fuel payment products are most often in the form of plastic cards, but also include other forms such as electronic RFID tags and paper vouchers. While predominately used to purchase fuel, many of our fuel payment products have additional purchasing capabilities to allow customers to purchase non-fuel items such as oil, vehicle maintenance supplies and services and building supplies.\nOur fuel payment products, excluding paper vouchers, provide customers with tools and information to control their fuel and other fleet-related operating costs. Our proprietary processing and card management systems provide customers with customizable user-level controls, detailed transaction reporting, programmable alerts, configurable networks, contracted fuel price validation and audit, and vehicle efficiency analyses. Our customers can use these data, controls and tools to combat fraud and employee misuse, streamline expense administration and lower their vehicle fleets’ operating costs. The combination of these specialized attributes allows our fuel payment products to compete well against less specialized products such as cash or general purpose credit cards when it comes to controlling fuel purchases.\nFor major oil companies, leasing companies and petroleum marketers, we provide program management services which allow these partners to outsource the sales, marketing, credit, service, and system operations of their branded fuel card portfolios. Depending on our partners’ needs and internal capabilities, we provide our products and services in a variety of combinations ranging from a comprehensive “end-to-end” solution (encompassing issuing, processing and network services) to limited back office processing services. Our fuel payment product partners include British Petroleum (BP), its subsidiary Arco, Shell and Speedway, and over 775 fuel marketers of all sizes.\nWhile we refer to companies with whom we have strategic relationships as “partners,” our legal relationships with these companies are contractual, and do not constitute legal partnerships. Our contracts with our major oil company partners typically have initial terms of five to ten years with current remaining terms ranging from two to seven years. No single partner represented more than 10% of our consolidated revenue in any year during the last four years.\nWe use both proprietary and third-party networks to deliver our fuel payment solutions, including the following examples:\n5\nNorth America proprietary networks for fuel payment products\n\n| • | Fuelman network—our primary proprietary fleet card network in the U.S. We have negotiated card acceptance and settlement terms with approximately 11,000 individual merchants, providing the Fuelman network with approximately 59,000 fueling sites and approximately 28,000 maintenance sites across the country. |\n\n| • | Comdata network—our network of truck stops and fuel merchants for the over-the-road trucking industry. We have negotiated card acceptance and settlement terms at over 8,100 truck stops and fuel merchants across the U.S. and Canada. |\n\n| • | Commercial Fueling Network (CFN)—our “members only” fueling network in the U.S. and Canada composed of over 2,500 fueling sites owned by CFN members themselves. The majority of these fueling sites are unattended cardlock facilities located in commercial and industrial areas. |\n\n| • | Pacific Pride Fueling network—our \"franchise\" fueling network in the U.S. composed of over 1,100 fueling sites owned by more than 240 franchisees. The majority of these fueling sites are unattended cardlock facilities located in commercial and industrial areas. |\n\nInternational proprietary networks for fuel payment products\n\n| • | Allstar network—our proprietary fleet card network in the U.K. We have negotiated card acceptance and settlement terms with approximately 2,200 individual merchants, providing this network with over 7,300 fueling sites. |\n\n| • | Keyfuels network—our proprietary fleet card network in the U.K. We have negotiated card acceptance and settlement terms with more than 500 individual merchants, providing the Keyfuels network with approximately 2,800 fueling sites. |\n\n| • | CCS network—our primary proprietary fleet card network in the Czech Republic and Slovakia. We have negotiated card acceptance and settlement terms with several major oil companies on a brand-wide basis, including MOL, Benzina, OMV, Slovnaft and Shell, and with approximately 1,100 other merchants, providing the CCS network at over 2,600 fueling sites and 800 other sites accepting our cards. |\n\n| • | Petrol Plus Region (PPR) network—our primary proprietary fleet card network in Russia, Poland, Ukraine, Belarus, Kazakhstan and Moldova. We have negotiated card acceptance and settlement terms with over 700 individual merchants, providing the PPR network with approximately 13,500 fueling sites across the region. |\n\n| • | Efectivale network—our proprietary fuel card and voucher network in Mexico. We have negotiated acceptance and settlement terms individual merchants, providing the network with over 6,300 fueling sites. |\n\n| • | CTF network—our proprietary fuel controls network in Brazil, composed of over 1,700 highway fueling sites through our partners, BR Distribuidora (Petrobas) and Ipiranga Distribuidora. |\n\nThird-Party networks for fuel payments products\nIn addition to our proprietary “closed-loop” networks, we also utilize various third-party networks to deliver our payment programs and services. Examples of these networks include:\n\n| • | MasterCard network—In the U.S. and Canada, we issue co-branded MasterCard products which are accepted at over 175,000 fuel sites and 469,000 maintenance locations. These MasterCard products have additional purchasing capabilities which, when enabled, allow the cards to be accepted at approximately 10.9 million locations throughout the U.S. and Canada. |\n\n| • | Visa network—In the U.K., we issue products that utilize the Visa payment network, which includes over 8,400 fuel sites and 1,100 maintenance locations. These Visa products have additional purchasing capabilities which, when enabled, allow the cards to be accepted throughout the Visa network. |\n\n| • | Major oil and fuel marketer networks—The proprietary networks of branded locations owned by our major oil and fuel marketer partners in both North America and internationally are generally utilized to support the proprietary, branded card programs of these partners. |\n\n6\n| • | UTA network—UNION TANK Eckstein GmbH & Co. KG (UTA) operates a network of over 55,000 points of acceptance in 40 European countries, including more than 44,000 fueling sites. The UTA network is generally utilized by European transport companies that travel between multiple countries. |\n\n| • | DKV network—DKV operates a network of over 65,000 fleet card-accepting locations across more than 40 countries throughout Europe. The DKV network is generally utilized by European transport companies that travel between multiple countries. |\n\n| • | Carnet networks—A national debit network in Mexico, which includes over 11,500 fueling sites across the country. |\n\nWe distribute our fuel payment solutions through direct and indirect channels to businesses of all sizes. This includes businesses with small- to medium-sized fleets, which we believe represent an attractive segment of the global commercial fleet market given their relatively high use of less efficient payment products, such as cash and general purpose credit cards. We serve customers across numerous industry verticals and particularly those verticals with significant vehicle fueling needs such as trucking, construction, manufacturing, energy, and consumer products distribution.\nOur indirect channel includes our partners, such as major oil companies, leasing companies and fuel marketers. We generally provide our fuel payments solutions to our partners who offer our services under their own brands on a “white-label” basis. In turn, we leverage our partners’ brands, retail outlets, websites, and sales forces to help distribute our fuel payment products.\nIn Brazil, we have designed proprietary equipment which, when installed at the fueling site and on the vehicle and combined with our processing system, significantly reduces the likelihood of unauthorized and fraudulent transactions. We offer this product to over-the-road trucking fleets, shipping fleets and other operators of heavily industrialized equipment, including sea-going vessels, mining equipment, agricultural equipment, and locomotives. We generally co-brand this product with BR Distribuidora (Petrobas) or Ipiranga Distribuidora, depending on which fuel distributor provides fuel to our fleet clients via its retail and wholesale distribution operations.\nWith regard to our fuel payment products, we compete with independent fuel card issuers, major oil companies and petroleum marketers. Excluding major oil companies, our most significant competitors in this product category include WEX, U.S. Bank Voyager Fleet Systems, World Fuel Services, Edenred, Sodexo, Alelo, DKV, and Radius Payment Solutions.\nLodging payment product line\nWe offer lodging payment solutions to businesses in North America that have employees who travel overnight for work purposes. We offer two lodging payment products, a card-based solution for individual travelers and non-card based solution for crews. Our solutions can be customized to meet the specific needs of our customers, including access to a deeply discount hotel network and customer-specific rate negotiation, the ability to customize the network to fit customers’ specific travel needs and policies, enhanced controls and reporting, and audit and tax management services.\nOur lodging payment products operate on our proprietary CLC Lodging network, which includes over 16,700 hotels across the U.S. and Canada. We also can secure hotel rooms outside our proprietary network if required by our customers. The size, scale and nature of our lodging customer base enable us to negotiate lodging nightly rates lower than the rates most companies could negotiate directly and far below the rates available to the general public.\nOur customers can secure room nights with our solutions through our website or mobile app, by phone or email, or by walking into participating lodging properties and presenting their FLEETCOR lodging payment product credentials.\nFLEETCOR has developed data management and payment processing systems to manage client billings and reports which, combined with our discounted hotel network, provide clients with savings and increased visibility into their lodging costs.\nWe distribute our lodging payment solutions mostly through direct channels to businesses of all sizes and serve customers across a wide range of industries, including trucking, railroads, construction, telecom, energy, food service, retail distribution, and emergency response services such as FEMA and the American Red Cross. We provide our custom lodging solutions to large customers under contracts.\nOur lodging payment solutions compete with similar offerings from Travelliance, Egencia (Expedia), hotelengine.com, and in-house travel departments of large corporations.\n7\nToll payment product line\nIn Brazil, we offer an electronic toll and parking payments product to businesses and consumers in the form of RFID tags affixed to vehicles’ windshields. Our electronic toll and parking payments product operates on our proprietary Sem Parar network, which processed toll transactions for more than 3.2 million customers on 99% of the toll roads across Brazil. Our electronic tags may also be used to purchase fuel at select gas stations.\nElectronic tolling provides convenience and faster travel for customers, while also reducing manual labor and cash handling at merchants’ toll booths. At gas stations, payment via electronic tags is faster, safer and more secure for customers, which in turn increases loyalty and station throughput for merchants. Beyond these benefits, our electronic toll payment product also provides commercial customers with driver routing controls and fare auditing, mostly in the form of vehicle type and axle count configuration.\nFor certain commercial customers, we also offer prepaid paper vouchers as a means of payment on toll roads. We provide these vouchers to companies who contract with third-party drivers who do not have an electronic tag in their vehicles and for whom the companies are legally obligated to prepay tolls. Our paper toll vouchers are accepted for payment within our proprietary RODOCRED toll network, on behalf of more than 96,000 customers on all toll roads across Brazil.\nWe distribute our toll payment products through direct and indirect channels to customers of all sizes and across a broad number of industry verticals. To reach commercial customers, we utilize the same set of direct channels as our other commercially-focused product lines including field sales, telesales and digital marketing. To reach consumers, we also place proprietary manned kiosks and unmanned vending machines in areas with high consumer foot traffic, such as shopping malls.\nOur indirect channel includes a range of resellers and referral partners, including retail establishments with high consumer foot traffic such as grocery stores, pharmacies and gas stations. We provide our toll payment product to these partners under our brand and, in select cases, under the partner’s brand.\nOur electronic toll payment product competes with similar offerings such as Move Mais, ConectCar (Banco Itaú and Ipiranga), Veloe (Alelo), Repom (Edenred), and Visa Vale (Banco Bradesco).\nCorporate payments product line\nWe offer a broad suite of corporate payments solutions with vertical-specific applications, which enable our customers to manage and control electronic payments across their enterprise, optimize corporate spending and offer innovative services that increase employee efficiency and customer loyalty. Our primary corporate payments products include virtual cards, purchasing cards, travel & entertainment (T&E) cards, payroll cards and cross-border payment facilitation. These products are predominately marketed in North America, with cross-border payments also offered in the United Kingdom and Australia. This collection of comprehensive solutions positions us to enable automation and savings across a customer’s entire accounts payables (A/P) process, including both domestic and international payables.\nA virtual card provides a single-use card number for a specific amount within a defined timeframe and serves as a highly-effective replacement for check payments. Virtual cards provide enhanced security relative to checks while reducing payment costs for our customers. Full remittance data accompanies each virtual card payment, providing significant reconciliation advantages to ACH payments. We have integrated our virtual card offering into most leading ERP systems, providing a seamless experience for accounts payable personnel to select our virtual card as the payment mechanism of choice.\nFLEETCOR’s virtual card product operates on the Mastercard payment network. We have built a network of approximately 700,000 merchants that accept our virtual card payments, which has been growing at an average rate of 12,500 merchants per month. This network is managed with proprietary technology that allows us to continuously expand virtual card acceptance and optimize the amount of virtual card spend we can capture. This network, coupled with a best-in-class, in-house vendor enrollment service, is a major competitive advantage.\nOur purchasing and T&E cards operate on the MasterCard payment network and are accepted at approximately 10.7 million locations throughout the United States and Canada. These card products are generally sold in conjunction with our virtual card offering to augment our customers’ purchasing capabilities. FLEETCOR also provides full A/P outsourcing services for customers who send us their entire A/P file and allow us to execute payments across all modalities, including the aforementioned products as well as ACH, wires and checks. We also provide expense management software, which combines and leverages transaction data captured from our virtual, purchasing and T&E card products to help our customers analyze and control their corporate spending.\n8\nOur virtual, purchasing and T&E card products compete with similar offerings from large financial institutions such as Bank of America, Citibank, J.P. Morgan Chase, PNC Bank, U.S. Bank, Wells Fargo and American Express.\nFLEETCOR offers a payroll card product in the form of a reloadable stored value card, which operates on the MasterCard payment network and the All Point ATM network. These cards are distributed to our customers’ employees and are funded by our customers with their employees’ earned wages. As cardholders, the employees may present the payroll card as a form of payment for personal purchases, transfer funds to their bank account or withdraw funds from participating ATMs.\nOur payroll card product competes with similar offerings from First Data Corporation, Fidelity National Information Services, Global Cash Card, Green Dot Financial, Total System Services, Automatic Data Processing, Paychex and Heartland Payment Systems.\nFLEETCOR’s cross-border payment services are offered predominantly to commercial customers, who range from small businesses to mid-cap corporate entities. Customers generally use our cross-border payment services to pay international suppliers, foreign office and personnel expenses, capital expenditures, and profit repatriation and dividends. We administer foreign exchange trades and payment settlement with recipients through a global network of banks, enabling us to send payments to recipients in over 200 countries and in over 140 currencies. We employ rigorous compliance standards in all geographies where we are licensed. By using transaction monitoring and watch list screening systems, we ensure payments are safe, secure, and meet all applicable regulatory requirements.\nOur cross-border payment services compete with similar offerings from Western Union Business Solutions, Associated Foreign Exchange (AFEX), WorldFirst, Moneycorp, HiFX, Currencies Direct, GPS Capital Markets and large financial institutions.\nFLEETCOR’s corporate payment solutions are enabled by our technology and operations. Our ERP integrations, API capabilities, strategic vendor enrollment, and transaction management tools enable us to optimize our customers’ electronic payables programs.\nWe distribute our corporate payment solutions through direct and indirect channels to businesses of all sizes and types across a broad number of industry verticals. We serve customers across numerous industry verticals, such as retail, healthcare, construction, manufacturing, hospitality, energy, entertainment, insurance and trade finance. As FLEETCOR both issues and processes its virtual cards and commercial cards, we have the control and flexibility to meet the unique needs of customers in different verticals.\nWe generally provide our domestic corporate payment solutions under contracts with our customers. Pricing terms vary based on usage volumes, incentives and contract duration. When our corporate payment solutions include short term credit, our contracts for those solutions contain credit and collection terms.\nOur indirect channel includes a broad range of VARs and other referral partners that expand our reach into new customer segments, new industry verticals and new geographies faster and at a significantly lower cost. We provide our corporate payments solutions to these partners who offer our services under our brands or their own brands on a “white-label” basis. For example, we provide healthcare payment solutions through healthcare networks, corporate payment solutions through software and services providers and payroll card solutions through payroll service providers.\nGift payment product line\nWe provide fully integrated gift card product management and processing services in over 55 different countries around the world. These products come in the form of plastic and digital gift cards, carry our customers’ brands and are generally accepted exclusively within the retail network, websites, and mobile applications of each respective customer.\nOur services include card design, production and packaging, delivery and fulfillment, card and account management, transaction processing, promotion development and management, website design and hosting, program analytics, and card distribution channel management. The combination of our products and services provides a turnkey solution to our customers, who benefit in the form of brand promotion, cardholder loyalty, increased sales, interest income on prepaid balances, and breakage on abandoned card balances.\nWe distribute our gift payment products and services directly through a specialized, dedicated field sales force. We serve our commercial customers in numerous industry verticals, with a focus in restaurants, supermarkets, drugstores, airlines, hotels, apparel and other retail categories. We help our commercial customers manage distribution with omni-channel strategies which include card sales through the customers’ retail outlets, websites and mobile applications, as well as through third party\n9\nlocations, such as supermarkets and drug stores. This third party distribution is generally provided by other companies, such as Blackhawk and InComm, who are reliant on access to our systems to meet their distribution obligations.\nWe compete with a number of national companies in providing gift cards, the largest of which include First Data Corporation and Vantiv. We also compete with businesses that rely on in-house solutions.\nAdditional products\nFLEETCOR provides several other payment products that, due to their nature or size, are not considered primary product lines.\nFleet maintenance\nWe provide a vehicle maintenance service offering that helps fleet customers to manage their vehicle maintenance, service, and repair needs in the U.K. This product is provided through our proprietary 1link maintenance and repair network which processes transactions for fleet customers through approximately 9,400 service centers across the U.K. With regard to our fleet maintenance product, we compete with several companies including Ebbon-Dacs and Fleet on Demand.\nEmployee benefit payments\nIn Mexico, we offer prepaid food vouchers and cards that may be used as a form of payment in restaurants and grocery stores. These payment products operate on one of the following networks:\n| • | Efectivale network—also our proprietary food card and voucher network in Mexico. We have negotiated acceptance and settlement terms with over 56,700 individual merchants, providing the network with over 44,600 food locations and 5,800 restaurants. |\n\n| • | Carnet network—a national debit network in Mexico, which also includes over 47,400 food locations across the country. |\n\nIn Brazil, we offer prepaid transportation cards and vouchers that may be used as a form of payment on public transportation such as buses, subways and trains. Our proprietary VB Servicos, Comercio e Administracao LTDA (“VB”) distribution network distributes cards and vouchers to employees on behalf of approximately 26,000 customers and negotiates with more than 1,400 public transportation agencies across Brazil.\nWe provide these various payment products to businesses of all sizes and industry verticals and the businesses in turn offer the products to their employees as a form of benefit. With regard to our employee benefit payment products, we compete with numerous companies, the largest of which includes Edenred, Sodexo, Chèque Déjeuner, and Alelo.\nLong haul transportation services\nIn addition to, and often in conjunction with our fuel payment product, we provide trucking companies in North America with various products and services specifically relevant to their industry, including road tax compliance analysis and reporting, permit procurement, and cash movement and disbursement. We compete with several companies in providing these products and services, including EFS (WEX), Keller, and RTS Financial.\nCompetition\nWe face considerable competition in our business. The most significant competitive factors in our business are the breadth of product and service features, credit extension, payment terms, customer service and account management, and price. For certain payment-related products, we also compete on the respective size or nature (i.e., open versus closed loop) of each product’s acceptance network. For certain payment processing services, systems and technology are also significant competitive factors. We believe that we generally compete favorably with respect to each of these factors. However, we may experience competitive disadvantages with respect to each of these factors from time to time as potential customers prioritize or value these competitive factors differently. As a result, a specific offering of our products and service features, networks and pricing may serve as a competitive advantage with respect to one customer and a disadvantage for another based on the customers’ preferences. The companies with whom we compete often vary by product line and/or geography, and are therefore identified by name in the respective product line discussions.\n10\nSales and marketing\nWe market our products and services to prospective customers in North America and internationally through multiple channels including field sales, telesales, direct marketing, point-of-sale marketing and the internet. We also leverage the sales and marketing capabilities of our strategic relationships. Worldwide, our sales and marketing employees are focused on acquiring new customers and retaining existing customers for our different products. We also utilize tradeshows, advertising and other awareness campaigns to further market our products and services.\nWe utilize proprietary and third-party databases to develop our prospect universe and segment those prospects by various characteristics, including industry, geography, size, and credit score, to identify potential customers. We develop customized offers for different types of potential customers and work to deliver those offers through the most effective marketing channel. We actively manage prospects across our various marketing channels to optimize our results and avoid marketing channel conflicts.\nOur primary means of acquiring new customers include:\n| • | Field sales—Our field sales organizations are comprised of remote or local office-based sales representatives who conduct face-to-face sales presentations and product demonstrations with prospects, assist with post-sale program implementation and training, and provide in-person account management. Field sales representatives also attend and manage our marketing at tradeshows. Our field sales force is generally dedicated to specific products or service categories and tend to target larger prospects. |\n\n| • | Telesales—We have telesales representatives handling inbound and outbound sales calls. |\n\n| • | Our inbound call volume is primarily generated as a result of marketing activities, including direct marketing, point-of-sale marketing and the internet. |\n\n| • | Our outbound phone calls typically target prospects that have expressed an initial interest in our services or have been identified through database analysis as prospective customers. Our telesales teams are generally dedicated to a specific product or service category and tend to target smaller prospects. We also leverage our telesales channel to cross-sell additional products to existing customers. |\n\n| • | Digital marketing—We manage numerous marketing websites around the world which tend to fall into two categories: product-specific websites and marketing portals. |\n\n| • | Product-specific websites—Our product-specific websites, including fuelman.com, checkinncard.com, allstarcard.co.uk and semparar.com.br, focus on one or more specific products, provide the most in-depth information available online regarding those particular products, allow prospects to apply online (where appropriate) and allow customers to access and manage their accounts online. We manage product-specific websites for our own proprietary programs, as well as white labeled sites for our strategic relationships. |\n\n| • | Marketing portals—Our marketing portals, including fleetcardsUSA.com and fuelcards.co.uk, serve as information sources for fleet operators interested in fleet card products. In addition to providing helpful information on fleet management, including maintenance, tax reporting and fuel efficiency, these websites allow fleet operators to research card products, compare the features and benefits of multiple products, and identify the card product which best meets the fleet manager’s needs. |\n\nAs part of our digital marketing strategy, we monitor and modify our marketing websites to improve our search engine rankings and test our advertising keywords to optimize our banner advertising placement and costs and our pay-per-click advertising spend among the major internet search firms such as Google and Yahoo.\n| • | Direct marketing—We market directly to potential customers via mail and email. We test various program offers and promotions, and adopt the most successful features into subsequent direct marketing initiatives. We seek to enhance the sales conversion rates of our direct marketing efforts by coordinating timely follow-up calls by our telesales teams. |\n\n| • | Point-of-sale marketing—We provide marketing literature at the point-of-sale within our proprietary networks and those of our partner relationships. Literature may include “take-one” applications, pump-top advertising and in-store advertising. Our point-of-sale marketing leverages the branding and distribution reach of the physical merchant locations. |\n\n11\nAccount management\n\n| • | Customer service, account activation, account retention—We provide account management and customer service to our customers. Based in dedicated call centers across our key markets, these professionals handle transaction authorizations, billing questions and account changes. Customers also have the opportunity to self-service their accounts through interactive voice response and online tools. We monitor the quality of the service we provide to our customers by adhering to industry standard service levels with respect to abandon rates and answer times and through regular agent call monitoring. We also conduct regular customer surveys to ensure customers are satisfied with our products and services. In addition to our base customer service support, we provide the following specialized services: |\n\n| • | Implementation and activation—We have dedicated implementation teams that are responsible for establishing the system set-up for each customer account. These teams focus on successful activation and utilization of our new customers and provide training and education on the use of our products and services. Technical support resources are provided to support the accurate and timely set-up of technical integrations between our proprietary processing systems and customer systems (e.g., payroll, enterprise resource planning and point-of-sale). Larger accounts are provided dedicated program managers who are responsible for managing and coordinating customer activities for the duration of the implementation. These program managers are responsible for the successful set-up of accounts to meet stated customer objectives. |\n\n| • | Strategic account management—We assign designated account managers who serve as the single point of contact for our large accounts. Our account managers have in-depth knowledge of our programs and our customers’ operations and objectives. Our account managers train customer administrators and support them on the operation and optimal use of our programs, oversee account setup and activation, review online billing and create customized reports. Our account managers also prepare periodic account reviews, provide specific information on trends in their accounts and work together to identify and discuss major issues and emerging needs. |\n\n| • | Account retention—We have proprietary, proactive strategies to contact customers who may be at risk of terminating their relationship with us. Through these strategies we seek to address service concerns, enhance product structures and provide customized solutions to address customer issues. |\n\n| • | Customer service—Day-to-day servicing representatives are designated for customer accounts. These designated representatives are responsible for the daily service items and issue resolution of customers. These servicing representatives are familiar with the nuanced requirements and specifics of a customer’s program. Service representatives are responsible for customer training, fraud disputes, card orders, card maintenance, billing, etc. |\n\n| • | Cardholder support—We provide cardholder support for individuals utilizing our payment products. This support allows cardholders to activate cards, check balances, and resolve issues in a timely and effective fashion. Cardholder support is conducted 24 hours a day, seven days per week in multiple languages utilizing telephony, web and call center technologies to deliver comprehensive and cost effective servicing. We have rigorous operational metrics in place to increase cardholder responsiveness to corporate and customer objectives. |\n\n| • | Merchant network services—Our representatives work with merchants such as fuel, toll operators and vehicle maintenance providers to enroll them in one of our proprietary networks, install and test all network and terminal software and hardware and train them on the sale and transaction authorization process. In addition, our representatives provide transaction analysis and site reporting and address settlement issues. |\n\n| • | Call center program administrator—Off-hour call center support is provided to customers to handle time-sensitive requests and issues outside of normal business hours. |\n\n| • | Management tools—We offer a variety of online servicing tools that enable customers to identify and provide authority to program administrators to self-service their accounts. |\n\n\n| • | Credit underwriting and collections—We follow detailed application credit review, account management, and collections procedures for all customers of our payment solutions. We use multiple levers including billing frequency, payment terms, spending limits and security to manage risk in our portfolio. For the years ended December 31, 2017 and 2016, our bad debt expense was $44.9 million and $35.9 million, or 7 bps and 8 bps, respectively. |\n\n| • | New account underwriting—We use a combination of quantitative, third-party credit scoring models and judgmental underwriting to screen potential customers and establish appropriate credit terms and spend |\n\n12\nlimits. Our underwriting process provides additional scrutiny for large credit amounts and we utilize tiered credit approval authority among our management.\n| • | Prepaid and secured accounts—We also offer products and services on a prepaid or fully-secured basis. Prepaid customer accounts are funded with an initial deposit and subsequently debited for each purchase transacted on the cards issued to the customer. Fully-secured customer accounts are secured with cash deposits, letters of credit and/or insurance bonds. The security is held until such time as the customer either fails to pay the account or closes its account after paying outstanding amounts. Under either approach, our prepaid and fully-secured offerings allow us to market to a broader universe of prospects, including customers who might otherwise not meet our credit standards. |\n\n| • | Monitoring and account management—We use fraud detection programs, including both proprietary and third-party solutions, to monitor transactions and prevent misuse of our products. We monitor the credit quality of our portfolio periodically utilizing external credit scores and internal behavior data to identify high risk or deteriorating credit quality accounts. We conduct targeted strategies to minimize exposure to high risk accounts, including reducing spending limits and payment terms or requiring additional security. |\n\n| • | Collections—As accounts become delinquent, we may suspend future transactions based on our risk assessment of the account. Our collections strategy includes a combination of internal and outsourced resources which use both manual and dialer-based calling strategies. We use a segmented collection strategy which prioritizes higher risk and higher balance accounts. For severely delinquent, high balance accounts we may pursue legal remedies. |\n\nTechnology\nOur technology provides continuous authorization of transactions, processing of critical account and client information and settlement between merchants, issuing companies and individual commercial entities. We recognize the importance of state-of-the-art, secure, efficient and reliable technology in our business and have made significant investments in our applications and infrastructure. In 2017, we spent more than $185 million in capital and operating expenses to operate, protect and enhance our technology and expect to continue the build out of our proprietary processing platform in Europe and Asia, as well as the integration of our recently acquired businesses.\nOur technology function is based in the United States, Europe and Brazil and has expertise in the management of applications, transaction networks and infrastructure. We operate application development centers in the United States, United Kingdom, Netherlands, Russia, Czech Republic, Brazil and New Zealand. Our distributed application architecture allows us to maintain, administer and upgrade our systems in a cost-effective and flexible manner. We integrate our systems with third-party vendor applications for certain products, sales and customer relationship management and back-office support. Our technology organization has undertaken and successfully executed large scale projects to develop or consolidate new systems, convert oil company and petroleum marketer systems and integrate acquisitions while continuing to operate and enhance existing systems.\nOur technology infrastructure is supported by highly-secure data centers, with redundant locations. We operate our primary data centers, which are located in Atlanta, Georgia; Brentwood, Tennessee; Prague; Czech Republic; Las Vegas, Nevada; Lexington and Louisville, Kentucky; Sao Paulo, Brazil; Toronto, Canada and Moscow, Russia. We use only proven technology and have no foreseeable capacity limitations. Our systems align with industry standards for security with multiple industry certifications. Our network is configured with multiple layers of security to isolate our databases from unauthorized access. We use security protocols for communication among applications, and our employees access critical components on a need-only basis. As of December 31, 2017, we are not aware of any material breach of our data security systems. See Item 1A, “Risk Factors-We may not be able to adequately protect our systems or the data we collect from continually evolving cybersecurity risks or other technological risks, which could subject us to liability and damage our reputation” for a discussion of the potential data breach and cybersecurity risks facing the Company.\nWe maintain disaster recovery and business continuity plans. Our telecommunications and internet systems have multiple levels of redundancy to ensure reliability of network service. In 2017, we experienced 99.9% up-time for authorizations.\nProprietary processing systems\nWe operate several proprietary processing systems that provide features and functionality to run our card programs and product offerings, including our card issuing, processing and information services. Our processing systems also integrate with our proprietary networks, which provide brand awareness and connectivity to our acceptance locations that enables the “end-to-\n13\nend” card acceptance, data capture and transaction authorization capabilities of our card programs. Our proprietary processing systems and aggregation software are tailored to meet the unique needs of the individual markets they serve and enable us to create and deliver commercial payment solutions and stored value programs that serve each of our industry verticals and geographies. Our technology platforms are primarily comprised of four key components, which were primarily developed and are maintained in-house: (1) a core processing platform; (2) specialized software; (3) integrated network capabilities; and (4) a cloud based architecture with proprietary APIs.\nIntellectual property\nOur intellectual property is an important element of our business. We rely on trademark, copyright, trade secret, patent and other intellectual property laws, confidentiality agreements, contractual provisions and similar measures to protect our intellectual property. Our employees involved in technology development in some of the countries in which we operate, including the United States, are required to sign agreements acknowledging that all intellectual property created by them on our behalf is owned by us. We also have internal policies regarding the protection, disclosure and use of our confidential information. Confidentiality, license or similar agreements or clauses are generally used with our business partners and vendors to control access, use and distribution of our intellectual property. Unauthorized persons may attempt to obtain our intellectual property despite our efforts and others may develop similar intellectual property independently. We own trade names, service marks, trademarks and registered trademarks supporting a number of our brands, such as FLEETCOR, Fuelman, Comdata, and Comchek (among others) in the United States. We also own trademarks and registered trademarks in various foreign jurisdictions for a number of our brands, such as Keyfuels, AllStar, CTF, and Sem Parar (among others). We hold a number of patents and pending applications relating to payment cards and fuel tax returns.\nAcquisitions\nSince 2002, we have completed over 75 acquisitions of companies and commercial account portfolios, including the acquisition of Cambridge Global Payments in August 2017. Acquisitions have been an important part of our growth strategy, and it is our intention to continue to seek opportunities to increase our customer base and diversify our service offering through further strategic acquisitions. For a discussion of recent acquisitions, see “Management’s Discussion and Analysis of Financial Conditions and Results of Operations—Acquisitions”.\nRegulatory\nA substantial number of laws and regulations, both in the United States and in other jurisdictions, apply to businesses offering payment cards to customers or processing or servicing for payment cards and related accounts. These laws and regulations are often evolving and sometimes ambiguous or inconsistent, and the extent to which they apply to us is at times unclear. Failure to comply with regulations may result in the suspension or revocation of licenses or registrations, the limitation, suspension, or termination of services, and/or the imposition of civil and criminal penalties, including fines. Certain of our services are also subject to rules set by various payment networks, such as MasterCard, as more fully described below.\nThe following, while not exhaustive, is a description of several federal and state laws and regulations in the United States that are applicable to our business. The laws and regulations of other jurisdictions also affect us, and they may be more or less restrictive than those in the United States and may also impact different parts of our operations. In addition, the legal and regulatory framework governing our business is subject to ongoing revision, and changes in that framework could have a significant effect on us.\nMoney Transmission and Payment Instrument Licensing Regulations\nWe are subject to various U.S. laws and regulations governing money transmission and the issuance and sale of payment instruments relating to certain aspects of our business. In the United States, most states license money transmitters and issuers of payment instruments. Through our subsidiaries, we are licensed in all states where required for business. Many states exercise authority over the operations of our services related to money transmission and payment instruments and, as part of this authority, subject us to periodic examinations, which may include a review of our compliance practices, policies and procedures, financial position and related records, privacy and data security policies and procedures, and other matters related to our business. Some state agencies conduct periodic examinations and issue findings and recommendations as a result of which we make changes to our operations, such as improving our reporting processes, detailing our intercompany arrangements, and implementing new or revising existing policies and procedures such as our anti-money laundering and the U.S. Department of Treasury's Office of Foreign Assets Control (\"OFAC\") compliance program and complaints management process, and improvements to our documentation processes.\n14\nAs a licensee, we are subject to certain restrictions and requirements, including net worth and surety bond requirements, record keeping and reporting requirements, requirements for regulatory approval of controlling stockholders, and requirements to maintain certain levels of permissible investments in an amount equal to our outstanding payment obligations. Many states also require money transmitters and issuers of payment instruments to comply with federal and/or state anti-money laundering laws and regulations. Many states require prior approval for both direct and indirect changes of control of the licensee and certain other corporate events.\nGovernment agencies may impose new or additional requirements on money transmission and sales of payment instruments, and we expect that compliance costs will increase in the future for our regulated subsidiaries.\nPrivacy and Information Security Regulations\nWe provide services that may be subject to various state, federal, and foreign privacy laws and regulations, including, among others, the Financial Services Modernization Act of 1999, which we refer to as the Gramm-Leach-Bliley Act, and Directive 95/46/EC, and the Personal Information Protection and Electronic Documents Act in Canada. These laws and their implementing regulations restrict certain collection, processing, storage, use, and disclosure of personal information, require notice to individuals of privacy practices, and provide individuals with certain rights to prevent use and disclosure of protected information. These laws also impose requirements for the safeguarding and proper destruction of personal information through the issuance of data security standards or guidelines. Certain federal, state and foreign laws and regulations impose similar privacy obligations and, in certain circumstances, obligations to notify affected individuals, state officers or other governmental authorities, the media, and consumer reporting agencies, as well as businesses and governmental agencies, of security breaches affecting personal information. In addition, there are state and foreign laws restricting the ability to collect and utilize certain types of information such as Social Security and driver’s license numbers. In February 2013, the European Commission proposed additional European Union-wide legislation regarding cyber security in the form of the proposed NIS Directive. The NIS Directive was adopted by the European Parliament in July 2016 and entered into force in August 2016. The NIS Directive provides legal measures intended to boost the overall level of cybersecurity in the EU by ensuring: (1) Member States’ preparedness by requiring them to be appropriately equipped, for example, via a Computer Security Incident Response Team and a competent national NIS authority; (2) cooperation among all the Member States, by setting up a cooperation group, in order to support and facilitate strategic cooperation and the exchange of information among Member States; and (3) a culture of security across sectors vital to the EU’s economy and society, including banking, financial market infrastructures and digital infrastructure.\nAs a processor of personal data of EU data subjects, we are also subject to regulation and oversight in the applicable EU Member States with regard to data protection legislation. The existing Data Protection Directive, contains various obligations on the processing of personal data in the EU including restrictions on transferring personal data outside of the EU to countries which have not been recognized as having adequate data protection standards, unless specific conditions are met. Our EU operations are currently operating in accordance with these standards. In May 2018, a new European wide Regulation on data privacy will come into force. The General Data Protection Regulation (the “GDPR”) contains additional obligations on data controllers and data processors operating in the EU or offering services to consumers within the EU. While the core rules contained in the Data Protection Directive are retained in GDPR, there are significant enhancements with regard to the rights of data subjects (which include the right to be forgotten and the right of data portability), stricter regulation on obtaining consent to processing of personal data and sensitive personal data, stricter obligations with regard to the information to be included in privacy notices and significant enhanced requirements with regard to compliance, including a regime of “accountability” for processors and controllers and a requirement to embed compliance with GDPR into the fabric of an organization by developing appropriate policies and practices, to achieve a standard of data protection by “design and default.” The GDPR includes enhanced data security obligations (to run in parallel to those contained in NIS regulations), requiring data processors and controllers to take appropriate technical and organizational measures to protect the data they process and their systems. Organizations that process significant amounts of data may be required to appoint a Data Protection Officer responsible for reporting to highest level of management within the business. There are greatly enhanced sanctions under GDPR for failing to comply with the core principles of the GDPR or failing to secure data. We are working to prepare for the GDPR in readiness for its implementation in May 2018.\nIn addition, there are state laws restricting the ability to collect and utilize certain types of information such as Social Security and driver’s license numbers. Certain state laws impose similar privacy obligations as well as obligations to provide notification of security breaches of computer databases that contain personal information to affected individuals, state officers and consumer reporting agencies and businesses and governmental agencies that own data.\nCertain of our products that access payment networks require compliance with Payment Card Industry (“PCI”) standards. Our subsidiary, Comdata Inc., is PCI 3.2 compliant and its Attestation of Compliance is listed on MasterCard’s compliant\n15\nservice provider listing. Failure to maintain compliance with updates to PCI data security standards including having effective technical and administrative safeguards and policies and procedures could result in fines and assessments from payment networks and regulatory authorities, as well as litigation.\nFederal Trade Commission Act\nAll persons engaged in commerce, including, but not limited to, us and our bank sponsors and customers are subject to Section 5 of the Federal Trade Commission Act prohibiting unfair or deceptive acts or practices, and certain products are subject to the jurisdiction of the Consumer Financial Protection Bureau (\"CFPB\") regarding the prohibition of unfair, deceptive, or abusive acts and practices (both, collectively, UDAAP). Various federal and state regulatory enforcement agencies including the Federal Trade Commission (“FTC”), CFPB and the state attorneys general have authority to take action against businesses, merchants and financial institutions that engage in UDAAP or violate other laws, rules and regulations. If we violate such laws, rules and regulations, we may be subject to enforcement actions and as a result, may incur losses and liabilities that may impact our business. A number of state laws and regulations also prohibit unfair and deceptive business practices.\nTruth in Lending Act\nThe Truth in Lending Act, or TILA, was enacted as a consumer protection measure to increase consumer awareness of the cost of credit and to protect consumers from unauthorized charges or billing errors, and is implemented by Regulation Z. Most provisions of TILA and Regulation Z apply only to the extension of consumer credit, but a limited number of provisions apply to commercial cards as well. One example where TILA and Regulation Z are generally applicable is a limitation on liability for unauthorized use, although a business that acquires 10 or more credit cards for its personnel can agree to more expansive liability. Our cardholder agreements generally provide that these business customers waive, to the fullest extent possible, all limitations on liability for unauthorized card use.\nCredit Card Accountability, Responsibility, and Disclosure Act of 2009\nThe Credit Card Accountability, Responsibility, and Disclosure Act of 2009 is an act that, among other things, amended provisions of TILA that affect consumer credit and also directed the Federal Reserve Board to study the use of credit cards by small businesses and to make legislative recommendations. The report concluded that it is not clear whether the potential benefits outweigh the increased cost and reduced credit availability if the disclosure and substantive restrictions applicable to consumer cards were to be applied to small business cards. Legislation has been introduced, from time to time, to increase the protections afforded to small businesses that use payment cards. If legislation of this kind were enacted, our products and services for small businesses could be adversely impacted.\nEqual Credit Opportunity Act\nThe Equal Credit Opportunity Act, or ECOA, together with Regulation B prohibit creditors from discriminating on certain prohibited bases, such as an applicant’s sex, race, nationality, age and marital status, and further requires that creditors disclose the reasons for taking any adverse action against an applicant or a customer seeking credit.\nThe Fair Credit Reporting Act\nThe Fair Credit Reporting Act, or FCRA, regulates consumer reporting agencies and the disclosure and use of consumer reports. We may obtain consumer reports with respect to an individual who guarantees or otherwise is obligated on a commercial card.\nFACT Act\nThe Fair and Accurate Credit Transactions Act of 2003 amended FCRA and requires creditors to adopt identity theft prevention programs to detect, prevent and mitigate identity theft in connection with covered accounts, which can include business accounts for which there is a reasonably foreseeable risk of identity theft.\nAnti-Money Laundering and Counter Terrorist Regulations\nThe Currency and Foreign Transactions Reporting Act, which is also known as the Bank Secrecy Act (the \"BSA\") and which has been amended by the USA PATRIOT Act of 2001, contains a variety of provisions aimed at fighting terrorism and money laundering. Our business in Canada is also subject to Proceeds of Crime (Money Laundering) and Terrorist Financing Act, or the PCTFA, which is a corollary to the BSA. Among other things, the BSA and implementing regulations issued by the U.S. Treasury Department require financial-services providers to establish anti-money laundering programs, to not engage in terrorist financing, to report suspicious activity, and to maintain a number of related records.\nNon-banks that provide certain financial services are required to register with the Financial Crimes Enforcement Network of the U.S. Department of the Treasury (FinCEN) as “money services businesses” (MSBs). Through certain subsidiaries, we are\n16\nregistered as MSBs. As a result, we have established anti-money laundering compliance programs that include: (i) internal policies and controls; (ii) designation of a compliance officer; (iii) ongoing employee training; and (iv) an independent review function. We have developed and implemented compliance programs comprised of policies, procedures, systems and internal controls to monitor and address various legal requirements and developments.\nIn addition, provisions of the BSA known as the Prepaid Access Rule issued by FinCEN impose certain obligations, such as registration and collection of consumer information, on “providers” of certain prepaid access programs, including the stored value products issued by our sponsor banks for which we serve as program manager. FinCEN has taken the position that, where the issuing bank has principal oversight and control of such prepaid access programs, no other participant in the distribution chain would be required to register as a provider under the Prepaid Access Rule. Despite this position, we have opted to register as a provider of prepaid access through our subsidiary, Comdata Inc. We are also subject to certain economic and trade sanctions programs that are administered by the OFAC that prohibit or restrict transactions to or from or dealings with specified countries, their governments and, in certain circumstances, their nationals, narcotics traffickers, and terrorists or terrorist organizations.\nDodd-Frank Wall Street Reform and Consumer Protection Act\nThe Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, or the Dodd-Frank Act, effected comprehensive revisions to a wide array of federal laws governing financial institutions, financial services, and financial markets. Among its most notable provisions is the creation of the CFPB, which is charged with regulating consumer financial products or services and which is assuming much of the rulemaking authority under TILA, ECOA, FCRA, and other federal laws affecting the extension of credit. In addition to rulemaking authority over several enumerated federal consumer financial protection laws, the CFPB is authorized to issue rules prohibiting unfair, deceptive, and abusive acts and practices (UDAAP) by persons offering consumer financial products or services and their service providers, and has authority to enforce these consumer financial protection laws and CFPB rules. The CFPB has not defined what is a consumer financial product or service but has indicated informally that, in some instances, small businesses may be covered under consumer protection.\nAs a service provider to certain of our bank sponsors, we may be subject to direct supervision and examination by the CFPB, in connection with certain of our products and services. CFPB rules, examinations and enforcement actions may require us to adjust our activities and may increase our compliance costs.\nIn addition, the Durbin Amendment to the Dodd-Frank Act provided that interchange fees that a card issuer or payment network receives or charges for debit transactions will now be regulated by the Federal Reserve and must be “reasonable and proportional” to the cost incurred by the card issuer in authorizing, clearing and settling the transaction. Payment network fees may not be used directly or indirectly to compensate card issuers in circumvention of the interchange transaction fee restrictions. In July 2011, the Federal Reserve published the final rules governing debit interchange fees. Effective in October 2011, with certain exceptions, debit interchange rates are capped at $0.21 per transaction with an additional component of five basis points of the transaction’s value to reflect a portion of the issuer’s fraud losses plus, for qualifying issuing financial institutions, an additional $0.01 per transaction in debit interchange for fraud prevention costs. The cap on interchange fees is not expected to have a material direct impact on our results of operations because we qualify for an exemption for the majority of our debit transactions.\nThe implementation of the Dodd-Frank Act is ongoing, and as a result, its overall impact remains unclear. Its provisions, however, are sufficiently far reaching that it is possible that we could be further directly or indirectly impacted.\nAnti-Bribery Regulations\nThe FCPA prohibits the payment of bribes to foreign government officials and political figures and includes anti-bribery provisions enforced by the Department of Justice and accounting provisions enforced by the SEC. The statute has a broad reach, covering all U.S. companies and citizens doing business abroad, among others, and defining a foreign official to include not only those holding public office but also local citizens affiliated with foreign government-run or -owned organizations. The statute also requires maintenance of appropriate books and records and maintenance of adequate internal controls to prevent and detect possible FCPA violations.\nPayment Card Industry Rules\nBanks issuing payment cards bearing the MasterCard brand, and FLEETCOR to the extent that we provide certain services in connection with those cards and fleet customers acting as merchants accepting those cards, must comply with the bylaws, regulations and requirements that are promulgated by MasterCard and other applicable payment-card organizations, including the Payment Card Industry Data Security Standard developed by MasterCard and VISA, the MasterCard Site Data Protection Program and other applicable data-security program requirements. A breach of such payment card network rules could subject\n17\nus to a variety of fines or penalties that may be levied by the payment networks for certain acts or omissions. The payment networks routinely update and modify their requirements. Our failure to comply with the networks’ requirements or to pay the fines they impose could cause the termination of our registration and require us to stop processing transactions on their networks.\nWe are also subject to network operating rules promulgated by the National Automated Clearing House Association relating to payment transactions processed by us using the Automated Clearing House Network.\nEscheat Regulations\nWe may be subject to unclaimed or abandoned property (escheat) laws in the United States that require us to turn over to certain government authorities the property of others that we hold that has been unclaimed for a specified period of time such as payment instruments that have not been presented for payment and account balances that are due to a customer following discontinuation of our relationship. We may be subject to audit by individual U.S. states with regard to our escheatment practices.\nPrepaid Card Regulations\nPrepaid card programs managed by us are subject to various federal and state laws and regulations, in addition to those identified above, including the Credit Card Accountability Responsibility and Disclosure Act of 2009 and the Federal Reserve’s Regulation E, which impose requirements on general-use prepaid cards, store gift cards and electronic gift certificates. These laws and regulations are evolving, unclear and sometimes inconsistent and subject to judicial and regulatory challenge and interpretation, and therefore the extent to which these laws and rules have application to, and their impact on us, is in flux. At this time we are unable to determine the impact that the clarification of these laws and their potential application and future interpretations, as well as new laws, may have on us in a number of jurisdictions. On October 5, 2016, the Consumer Financial Protection Bureau issued a final rule amending Regulations E and Z to create comprehensive consumer protections for prepaid financial products, and on January 25, 2018, the CFPB released final amendments to the final rule, clarifying certain disclosure provisions and reducing potential liability with respect to cardholders who are not registered and verified. These changes include a delay of the final rule’s effective date until April 1, 2019. The extensive nature of these regulations and the implementation dates for this additional rulemaking may result in additional compliance obligations and expense for our business.\nState Usury Laws\nExtensions of credit under many of our card products may be treated as commercial loans. In some states, usury laws limit the interest rates that can be charged not only on consumer loans but on commercial loans as well. To the extent that these usury laws apply, we are limited in the amount of interest that we can charge and collect from our customers. Because we have substantial operations in multiple jurisdictions, we utilize choice of law provisions in our cardholder agreements as to the laws of which jurisdiction to apply. In addition, the interest rates on certain of our card products are set based upon the usury limit of the cardholder’s state. With respect to card products where we work with a partner or issuing bank, the partner bank may utilize the law of the jurisdiction applicable to the bank and “exports” the usury limit of that state in connection with cards issued to residents of other states or we may use our choice of law provisions.\nOther\nWe are subject to examination by our sponsor banks’ regulators, and must comply with certain regulations to which our sponsor banks are subject, as applicable. We are subject to audit by certain sponsor banks.\nThe Housing Assistance Tax Act of 2008 requires information returns to be made for each calendar year by merchants acquiring entities and third-party settlement organizations with respect to payments made in settlement of electronic payment transactions and third-party payment network transactions occurring in that calendar year. Reportable transactions are also subject to backup withholding requirements. We are required to comply with these requirements for the merchants in our Comdata network. We could be liable for penalties if our information return is not in compliance with these regulations.\nEmployees and labor relations\nAs of December 31, 2017, we employed approximately 7,890 employees, approximately 2,620 of whom were located in the United States. We consider our employee relations to be good and have never experienced a work stoppage.\nAdditional Information\nOur website address is www.fleetcor.com. You may obtain free electronic copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements and all related amendments required to be filed or\n18\nfurnished pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, at our website under the headings “Investor Relations—SEC Filings.” Information from our website is not incorporated by reference into this annual report on Form 10-K.\n19\nITEM X. EXECUTIVE OFFICERS OF THE REGISTRANT\nThe following table sets forth certain information regarding our executive officers, with their respective ages as of December 31, 2017. Our officers serve at the discretion of our board of directors. There are no family relationships between any of our directors or executive officers.\n| Name | Age | Position(s) |\n| Ronald F. Clarke | 62 | Chief Executive Officer and Chairman of the Board of Directors |\n| Eric R. Dey | 58 | Chief Financial Officer |\n| Kurt P. Adams | 48 | President—Comdata Corporate Payments |\n| Andrew R. Blazye | 59 | President—International Corporate Development |\n| John S. Coughlin | 50 | Executive Vice President—Global Corporate Development |\n| Pedro L. Donda | 64 | President-—Serviços e Tecnologia de Pagamentos S.A. (\"STP\") |\n| Charles R. Freund | 45 | Executive Vice President—Corporate Strategy |\n| Alexey P. Gavrilenya | 41 | President—Continental Europe |\n| Alan King | 41 | President—UK, Australia and New Zealand |\n| David D. Maxsimic | 58 | President—North America Partners |\n| Armando L. Netto | 49 | President—Brazil |\n| John A. Reed | 63 | Technology Executive Officer |\n| Gregory L. Secord | 55 | President—Comdata North America Trucking and CLC Lodging |\n\nRonald F. Clarke has been our Chief Executive Officer since August 2000 and was appointed Chairman of our board of directors in March 2003. From 1999 to 2000, Mr. Clarke served as President and Chief Operating Officer of AHL Services, Inc., a staffing firm. From 1990 to 1998, Mr. Clarke served as Chief Marketing Officer and later as a division president with Automatic Data Processing, Inc. (ADP), a computer services company. From 1987 to 1990, Mr. Clarke was a principal with Booz Allen Hamilton, a global management consulting firm. Earlier in his career, Mr. Clarke was a marketing manager for General Electric Company, a diversified technology, media, and financial services corporation.\nEric R. Dey has been our Chief Financial Officer since November 2002. From October 2000 to October 2002, Mr. Dey served as Chief Financial Officer of NCI Corporation, a call center company. From July 1999 to October 2000, Mr. Dey served as Chief Financial Officer of Leisure Time Technology, a software development/manufacturing company. From 1994 to 1999, Mr. Dey served as Corporate Controller with Excel Communications, a telecommunications service provider. From 1984 to 1994, Mr. Dey held a variety of financial and accounting positions with PepsiCo, Inc., a global beverage, snack and food company.\nKurt P. Adams joined us in September 2015 as our President—Comdata Corporate Payments. Prior to joining us, Mr. Adams was most recently President, Corporate Payments Solutions for U.S. Bancorp. Prior to that, Mr. Adams led strategy and planning for NOVA Information Systems (now Elavon – a U.S. Bancorp subsidiary) in Europe. Prior to his career in payments, Mr. Adams enjoyed a successful investment banking career with Piper Jaffray.\nAndrew R. Blazye has served as our President—International Corporate Development since 2012. From July 2007 to May 2012, Mr. Blazye served as our Chief Executive Officer—FLEETCOR Europe. From April 2006 to June 2007, Mr. Blazye was a Group Director for Dunnhumby Ltd., a research firm. From September 1980, to March 2006, Mr. Blazye held various positions with Shell International Ltd., a subsidiary of Royal Dutch Shell plc, a global energy company, including Global Payments General Manager.\nJohn S. Coughlin has served as our Executive Vice President—Global Corporate Development since September 2010. From 2007 to 2010, Mr. Coughlin served as a Managing Director at PCG Capital Partners, a private equity firm. From 2005 to 2006, Mr. Coughlin served as Chief Executive Officer of NCDR LLC, a private equity owned national dental practice management company. From 1994 to 2005, Mr. Coughlin was with The Parthenon Group, a strategic advisory and principal investment firm, where he was a Senior Partner and the founder and head of the firm’s San Francisco office. From 1990 to 1992, Mr. Coughlin was an investment banker with Credit Suisse First Boston.\nPedro L. Donda has served as our President—STP since our acquisition of the business in August 2016. Mr. Donda served in this role at STP, since 2006. From 2001 to 2003, Mr. Donda served as a Chief Executive Officer at IBOPE, a market research company in Brazil. Mr. Donda founded and led Americanas.com, a B2W Digital business in e-commerce. From 1990 to 1998, Mr. Donda founded and led Interchange, an electronic data interchange provider for banks, as well as specializing in logistics\n20\nand consumer packaged goods supply-chain. From 1980 to 1989, Mr. Donda, was an executive within Citibank N.A. Prior to this, Mr. Donda served in various technology positions.\nCharles R. Freund was named our Executive Vice President-Corporate Strategy in January 2017 and has been with us since 2000. During his tenure with FLEETCOR, Mr. Freund has held numerous roles including Executive Vice President-Global Sales, President-Emerging Markets, Senior Vice President-Corporate Strategy, Managing Director-The Fuelcard Company UK Limited, and Vice President of Business Development.\nAlexey P. Gavrilenya was named President—Continental Europe in February 2016, adding to his responsibilities as President—Central/Eastern Europe. Mr. Gavrilenya has been President, Eastern Europe since May 2011, where he has been responsible for PPR and NKT. From March 2009 to April 2011, Mr. Gavrilenya served as our Executive Vice President Strategy and Finance, Eastern Europe. Prior to joining us, Mr. Gavrilenya was Chief Financial Officer of Matarex, Ltd.\nAlan King joined us in August 2016 as our President—UK, Australia and New Zealand. Prior to joining us, Mr. King held various positions at MasterCard from 2005 to 2016, including Managing Director of MasterCard Prepaid Management Services, Group Head of Global Prepaid Solutions, Group General Manager for Market and Business Development in the UK and Ireland and General Manager of Global Accounts. Prior to MasterCard, Mr. King held leadership positions at VISA in the CEMEA region from 2003 to 2005 and at Citibank from 1998 to 2003, largely across commercial payments in international markets. Mr. King spent the early part of his career in the telecom and automotive industries, in various sales and marketing roles covering Europe.\nDavid D. Maxsimic was named President—North America Partners in November 2015 and in July 2017 assumed leadership of the U.S. sales shared services. Mr. Maxsimic joined us in January 2015 as our Group CEO—UK and Australasia. Prior to joining us, Mr. Maxsimic held various positions at WEX (also known as Wright Express) from 1997 to 2014, including President International, executive vice president of sales and marketing, senior vice president of sales, and vice president and general manager for Wright Express Direct Card. Prior to WEX, Mr. Maxsimic served as senior sales executive for several major fleet service companies, including U.S. Fleet Leasing, GE Capital Fleet Services, and PHH Fleet America. Mr. Maxsimic has over 25 years of experience in sales, marketing and managing customer relationships, in addition to managing and executing sales of complex financial services.\nArmando L. Netto joined us in June 2014 as our President—Brazil. Prior to joining us, Mr. Netto led IT Services for TIVIT, an IT and BPO services company, from 2006 to 2014, where he led the integration of functional areas into the business unit, focused on onboarding new clients and ensured service quality. Prior to TIVIT, Mr. Netto held various leadership roles with Unisys and McKinsey, where he gained international experience in Europe supporting clients in the UK, France, Austria, Portugal and the Netherlands.\nJohn A. Reed was named Technology Executive Officer effective January 2018, over system development and emerging technologies. Prior to this role, Mr. Reed served as our Global Chief Information Officer over product development and IT operations since 2013. From 2000 to 2009, Mr. Reed served various technology leadership roles at MBNA/Bank of America, Zurich Insurance and Unisys. From 1997 to 2000, Mr. Reed was the President and Managing Director for Business Innovations Inc., a financial services technology consulting company.\nGregory L. Secord joined us in July 2015 as our President—Comdata North America Trucking and in July 2017 assumed leadership of the U.S. operations shared services. Prior to joining us, Mr. Secord worked with ADP, where he was President—ADP Canada operations. Prior to his 20 year career with ADP, Mr. Secord held sales and marketing management roles with Canon and Xerox.\n21\nITEM 1A. RISK FACTORS\nYou should carefully consider the following risks applicable to us. If any of the following risks actually occur, our business, operating results, financial condition and the trading price of our common stock could be materially adversely affected. The risks discussed below also include forward-looking statements, and our actual results may differ substantially from those discussed in these forward-looking statements. See \"Note Regarding Forward-Looking Statements\" in this report.\nRisks related to our business\nA decline in retail fuel prices could adversely affect our revenue and operating results.\nOur fleet customers use our products and services primarily in connection with the purchase of fuel. Accordingly, our revenue is affected by fuel prices, which are subject to significant volatility. A decline in retail fuel prices could cause a decrease in our revenue from fees paid to us by merchants based on a percentage of each transaction purchase amount. We believe that in 2017, approximately 13% our consolidated revenue was directly influenced by the absolute price of fuel. Changes in the absolute price of fuel may also impact unpaid account balances and the late fees and charges based on these amounts. A decline in retail fuel prices could adversely affect our revenue and operating results.\nFuel prices are dependent on several factors, all of which are beyond our control. These factors include, among others:\n\n| • | supply and demand for oil and gas, and market expectations regarding supply and demand; |\n\n| • | actions by members of OPEC and other major oil-producing nations; |\n\n| • | new oil production being developed in the U.S. and elsewhere; |\n\n| • | political conditions in oil-producing and gas-producing nations, including insurgency, terrorism or war; |\n\n| • | oil refinery capacity; |\n\n| • | weather; |\n\n| • | the prices of foreign exports; |\n\n| • | speculative trading; |\n\n| • | the implementation of fuel efficiency standards and the adoption by our fleet customers of vehicles with greater fuel efficiency or alternative fuel sources; |\n\n| • | general worldwide economic conditions; and |\n\n| • | governmental regulations, taxes and tariffs. |\n\nA portion of our revenue is derived from fuel-price spreads. As a result, a contraction in fuel-price spreads could adversely affect our operating results.\nApproximately 10% of our consolidated revenue in 2017 was derived from transactions where our revenue is tied to fuel-price spreads. Fuel-price spreads equal the difference between the fuel price we charge to the fleet customer and the fuel price paid to the fuel merchant. In transactions where we derive revenue from fuel-price spreads, the fuel price paid to the fuel merchant is calculated as the merchant’s wholesale cost of fuel plus a commission. The merchant’s wholesale cost of fuel is dependent on several factors including, among others, the factors described above affecting fuel prices. The fuel price that we charge to our fleet customer is dependent on several factors including, among others, the fuel price paid to the fuel merchant, posted retail fuel prices and competitive fuel prices. We experience fuel-price spread contraction when the merchant’s wholesale cost of fuel increases at a faster rate than the fuel price we charge to our fleet customers, or the fuel price we charge to our fleet customers decreases at a faster rate than the merchant’s wholesale cost of fuel. Accordingly, when fuel-price spreads contract, we generate less revenue, which could adversely affect our operating results.\nIf we fail to adequately assess and monitor credit risks of our customers, we could experience an increase in credit loss.\nWe are subject to the credit risk of our customers which range in size from small sole proprietorships to large publicly traded companies. We use various methods to screen potential customers and establish appropriate credit limits, but these methods cannot eliminate all potential credit risks and may not always prevent us from approving customer applications that are not credit-worthy or are fraudulently completed. Changes in our industry, customer demand, and, in relation to our fleet customers, movement in fuel prices may result in periodic increases to customer credit limits and spending and, as a result, could lead to increased credit losses. We may also fail to detect changes to the credit risk of customers over time. Further, during a declining economic environment, we experience increased customer defaults and preference claims by bankrupt customers. If we fail to adequately manage our credit risks, our bad debt expense could be significantly higher than historic levels and adversely affect our business, operating results and financial condition. Our bad debt expense was $44.9 million in 2017 and $35.9 million in 2016, or 7 bps in 2017 and 8 bps in 2016, respectively.\n22\nWe derive a significant portion of our revenue from program fees and charges paid by the users of our cards. Any decrease in our receipt of such fees and charges, or limitations on our fees and charges, could adversely affect our business, results of operations and financial condition.\nOur card programs include a variety of fees and charges associated with transactions, cards, reports, optional services and late payments. Revenues for late fees and finance charges represent 6% of our consolidated revenue for the year ended December 31, 2017. If the users of our cards decrease their transaction activity, or the extent to which they use optional services or pay invoices late, our revenue could be materially adversely affected. In addition, several market factors can affect the amount of our fees and charges, including the market for similar charges for competitive card products and the availability of alternative payment methods such as cash or house accounts. Furthermore, regulators and Congress have scrutinized the electronic payments industry’s pricing, charges and other practices related to its customers. Any legislative or regulatory restrictions on our ability to price our products and services could materially and adversely affect our revenue. Any decrease in our revenue derived from these fees and charges could materially and adversely affect our business, operating results and financial condition.\nWe operate in a competitive business environment, and if we are unable to compete effectively, our business, operating results and financial condition would be adversely affected.\nThe market for our products and services is highly competitive, and competition could intensify in the future. Our competitors vary in size and in the scope and breadth of the products and services they offer. In the fleet card business, our primary competitors in North America are small regional and large independent fleet card providers, major oil companies and petroleum marketers that issue their own fleet cards, and major financial services companies that provide card services to major oil companies and petroleum marketers. In the commercial payments business, we face a variety of competitors, some of which have greater financial resources, name recognition and scope and breadth of products and services. Competitors in the hotel card business include travel agencies, online lodging discounters, internal corporate procurement and travel resources, and independent services companies. We also compete for customers with providers of alternative payment mechanisms, such as merchants offering house cash accounts or other forms of credit. Our primary competitors in Europe, Australia and New Zealand are independent fleet card providers, major oil companies and petroleum marketers that issue branded fleet cards, and providers of card outsourcing services to major oil companies and petroleum marketers. Our primary competitors in Latin America are independent providers of fleet cards and vouchers for food, fuel, tolls, and transportation and major oil companies and providers of card outsourcing services to major oil companies and petroleum marketers who offer commercial fleet cards.\nThe most significant competitive factors in our business are the breadth of product and service features, network acceptance size, customer service, account management, and price. We may experience competitive disadvantages with respect to any of these factors from time to time as potential customers prioritize or value these competitive factors differently. As a result, a specific offering of our products and service features, networks and pricing may serve as a competitive advantage with respect to one customer and a disadvantage for another based on the customers’ preferences.\nSome of our existing and potential competitors have longer operating histories, greater brand name recognition, larger customer bases, more extensive customer relationships or greater financial and technical resources than we do. In addition, our larger competitors may also have greater resources than we do to devote to the promotion and sale of their products and services and to pursue acquisitions. Many of our competitors provide additional and unrelated products and services to customers, such as treasury management, commercial lending and credit card processing. By providing these services that we do not provide, these competitors have an advantage of being able to bundle their products and services together and present them to existing customers with whom they have established relationships, sometimes at a discount. For example, in the commercial payments business, we compete with full service banks that are able to offer treasury management and commercial lending in addition to commercial payment solutions. If price competition continues to intensify, we may have to increase the incentives that we offer to our customers, decrease the prices of our products and services or lose customers, each of which could adversely affect our operating results. In the fleet card business, major oil companies and petroleum marketers and large financial institutions may choose to integrate fuel-card services as a complement to their existing card products and services, as well as offer add-on complementary services. As a result, they may be able to adapt more quickly to new or emerging technologies and changing opportunities, standards or customer requirements. To the extent that our competitors are regarded as leaders in specific categories, they may have an advantage over us as we attempt to further penetrate these categories.\nFuture mergers or consolidations among competitors, or acquisitions of our competitors by large companies may present competitive challenges to our business. Resulting combined entities could be at a competitive advantage if their fuel-card products and services are effectively integrated and bundled into sales packages with their widely utilized non-fuel-card-related products and services. Further, competitors may reduce the fees for their services, which could increase pricing pressure within our markets.\n23\nOverall, increased competition in our markets could result in intensified pricing pressure, reduced profit margins, increased sales and marketing expenses and a failure to increase, or a loss of, market share. We may not be able to maintain or improve our competitive position against our current or future competitors, which could adversely affect our business, operating results and financial condition.\nOur fleet card business is dependent on several key strategic relationships, the loss of which could adversely affect our operating results.\nWe intend to seek to expand our strategic relationships with major oil companies and to establish additional relationships with other petroleum marketers. We refer to the major oil companies and petroleum marketers with whom we have strategic relationships as our “partners.” We use this term in the business sense to refer to strategic business relationships formed through contracts such as Card Program Agreements, and not in the legal sense of operating under legal partnership arrangements created pursuant to laws such as the Uniform Partnership Act. During 2017, our top three strategic relationships with major oil companies accounted for less than 6% of our consolidated revenue. Our agreements with our major oil company partners typically have initial terms of five to ten years with current remaining terms ranging from about one to six years.\nThe success of our business is in part dependent on our ability to maintain these strategic relationships and enter into additional strategic relationships with major oil companies. In our relationships with these major oil companies, our services are marketed under our partners’ brands. If these partners fail to maintain their brands or decrease the size of their branded networks, our ability to grow our business may be adversely affected. Also, our inability to maintain or further develop these relationships or add additional strategic relationships could materially and adversely affect our business and operating results.\nTo enter into a new strategic relationship or renew an existing strategic relationship with a major oil company, we often must participate in a competitive bidding process, which may focus on a limited number of factors, including pricing. The bidding and negotiating processes generally occur over a protracted time period. The use of these processes may affect our ability to effectively compete for these relationships. Our competitors may be willing to bid for these contracts on pricing or other terms that we consider uneconomical in order to win business. The loss of our existing major oil company partners or the failure to contract or delays in contracting with additional partners could materially and adversely affect our business, operating results and financial condition.\nIn 2016, we received notice from an oil partner that they did not intend to renew our current contract when it expired at the end of 2017. Additionally, in 2017, we signed an agreement to extend the management of the commercial fuel card program for a strategic partner. We do not expect these contracts to have a material impact on our business and operating results.\nWe depend, in part, on our merchant relationships to grow our business. To grow our customer base in the closed loop fleet card and lodging card businesses, we must retain and add relationships with merchants who are located in areas where our customers purchase fuel, maintenance services and lodging. If we are unable to maintain and expand these relationships, our closed loop fleet card and lodging card businesses may be adversely affected.\nWith respect to the closed loop networks we utilize, a portion of our growth is derived from acquiring new merchant relationships to serve our customers, new and enhanced product and service offerings, and cross-selling our products and services through existing merchant relationships. We rely on the continuing growth of our merchant relationships and our distribution channels in order to expand our customer base. There can be no guarantee that this growth will continue. Similarly, our growth also will depend on our ability to retain and maintain existing merchant relationships that accept our proprietary closed-loop networks in areas where our customers purchase fuel and lodging. Our contractual agreements with fuel merchants and service garages typically have initial terms of one or two years and automatically renew on the same basis unless either party gives notice of termination. Our agreements with lodging providers typically have initial terms of one year and automatically renew on a month-to-month basis unless either party gives notice of termination. Furthermore, merchants with which we have relationships may experience bankruptcy, financial distress, or otherwise be forced to contract their operations. The loss of existing merchant relationships, failure to continue such relationships on similarly attractive economic terms, the contraction of our existing merchants’ operations or the inability to acquire new merchant relationships could adversely affect our ability to serve our customers and our business and operating results.\nWe depend on our relationships with major truck stop merchants to serve our over-the-road fuel card customers. We must maintain these relationships to effectively serve our customers that use these merchants. If we are unable to maintain these relationships, our over-the-road fuel card businesses may be adversely affected.\nWe have long standing relationships with major truck stop merchants to accept our over-the-road fuel cards. Over-the-road customers purchase a significant proportion of their fuel at major truck stop merchants. The loss of existing major truck stop\n24\nmerchant relationships or failure to continue such relationships on similar terms could adversely affect our ability to serve our over-the-road fuel card customers and our business and operating results.\nA decline in general economic conditions, and in particular, a decline in demand for fuel and other business related products and services would adversely affect our business, operating results and financial condition.\nOur operating results are materially affected by conditions in the economy generally, both in the U.S and internationally. We generate revenue based in part on the volume of purchase transactions we process. Our transaction volume is correlated with general economic conditions, particularly in the U.S., Europe, Russia, Latin America, Australia and New Zealand, and the amount of business activity in economies in which we operate. Downturns in these economies are generally characterized by reduced commercial activity and, consequently, reduced purchasing of fuel and other business related products and services by our customers. The commercial payments industry in general, and our commercial payment solutions business specifically, depends heavily upon the overall level of spending. Unfavorable changes in economic conditions, including declining consumer confidence, inflation, recession, political climate or other changes, may lead our corporate customers to reduce their spending, resulting in reduced demand for, or use of, our products and services. In addition, unfavorable changes in economic conditions, may lead our fleet card customers to demand less fuel, or lead our partners to reduce their use of our products and services. As a result, a sustained deterioration in general economic conditions in the U.S. or abroad could have a material adverse effect on our revenue and profitability.\nFurther, economic conditions also may impact the ability of our customers or partners to pay for fuel or other services they have purchased and, as a result, our reserve for credit losses and write-offs of accounts receivable could increase. A weakening economy could also force some retailers and merchants to close, resulting in exposure to potential credit losses and transaction declines. In addition, demand for fuel and other business related products and services may be reduced by other factors that are beyond our control, such as the development and use of vehicles with greater fuel efficiency and alternative fuel sources.\nWe are unable to predict the likely duration of current economic conditions in the U.S., Europe, Russia, Latin America, Australia and New Zealand. As a result, weaknesses in general economic conditions or increases in interest rates in key countries in which we operate could adversely affect our business and operating results.\nWe have expanded into new lines of business in the past and may do so in the future. If we are unable to successfully integrate these new businesses, our results of operations and financial condition may be adversely affected.\nWe have expanded our business to encompass new lines of business in the past. For example, we have entered into the corporate payments, stored value card, vehicle maintenance management and telematics business in the U.S. and Europe, and transaction processing, fuel, food, toll and transportation card and voucher businesses in Brazil and Mexico. We may continue to enter into new lines of business and offer new products and services in the future. There is no guarantee that we will be successful in integrating these new lines of business into our operations. If we are unable to do so, our operating results and financial condition may be adversely affected.\nIf we fail to develop and implement new technology, products and services, adapt our products and services to changes in technology, the marketplace requirements, or if our ongoing efforts to upgrade our technology, products and services are not successful, we could lose customers and partners.\nThe markets for our products and services are highly competitive and characterized by technological change, frequent introduction of new products and services and evolving industry standards. We must respond to the technological advances offered by our competitors and the requirements of our customers and partners, in order to maintain and improve upon our competitive position and fulfill contractual obligations. We may be unsuccessful in expanding our technological capabilities and developing, marketing or selling new products and services that meet these changing demands, which could jeopardize our competitive position. In addition, we engage in significant efforts to upgrade our products and services and the technology that supports these activities on a regular basis.\nThe products we deliver are designed to process complex transactions and provide reports and other information on those transactions, all at high volumes and processing speeds. Any failure to deliver an effective and secure product or service or any performance issue that arises with a new product or service could result in significant processing or reporting errors or other losses. We may rely on third parties to develop or co-develop our solutions or to incorporate our solutions into broader platforms for the commercial payments industry. We may not be able to enter into such relationships on attractive terms, or at all, and these relationships may not be successful. In addition, partners, some of whom may be our competitors or potential competitors, may choose to develop competing solutions on their own or with third parties. Even if we are successful in developing new services and technologies, these new services and technologies may not achieve broad acceptance due to a\n25\nvariety of factors, including a lack of industry-wide standards, competing products and services, or resistance to these changes from our customers. In addition, we may not be able to derive revenue from these efforts.\nIf we are unsuccessful in completing the migration of material technology, otherwise upgrading our products and services and supporting technology or completing or gaining market acceptance of new technology, products and services, it would have a material adverse effect on our ability to retain existing customers and attract new ones in the impacted business line.\nOur debt obligations, or our incurrence of additional debt obligations, could limit our flexibility in managing our business and could materially and adversely affect our financial performance.\nAt December 31, 2017, we had approximately $4.47 billion of debt outstanding under our Credit Facility and Securitization Facility. In addition, we are permitted under our credit agreement to incur additional indebtedness, subject to specified limitations. Our substantial indebtedness currently outstanding, or as may be outstanding if we incur additional indebtedness, could have important consequences, including the following:\n\n| • | we may have difficulty satisfying our obligations under our debt facilities and, if we fail to satisfy these obligations, an event of default could result; |\n\n| • | we may be required to dedicate a substantial portion of our cash flow from operations to required payments on our indebtedness, thereby reducing the availability of cash flow for acquisitions, working capital, capital expenditures and other general corporate activities. See \"Management’s Discussion and Analysis of Financial Condition and Results of Operations—Contractual Obligations,\" which sets forth our payment obligations with respect to our existing long-term debt; |\n\n| • | covenants relating to our debt may limit our ability to enter into certain contracts or to obtain additional financing for acquisitions, working capital, capital expenditures and other general corporate activities; |\n\n| • | covenants relating to our debt may limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate, including by restricting our ability to make strategic acquisitions; |\n\n| • | we may be more vulnerable than our competitors to the impact of economic downturns and adverse developments in the industry in which we operate; |\n\n| • | we are exposed to the risk of increased interest rates because certain of our borrowings are subject to variable rates of interest; |\n\n| • | although we have no current intention to pay any dividends, we may be unable to pay dividends or make other distributions with respect to your investment; and |\n\n| • | we may be placed at a competitive disadvantage against any less leveraged competitors. |\n\nThe occurrence of one or more of these potential consequences could have a material adverse effect on our business, financial condition, operating results, and ability to satisfy our obligations under our indebtedness.\nIn addition, we and our subsidiaries may incur substantial additional indebtedness in the future. Although our credit agreements contain restrictions on the incurrence of additional indebtedness, these restrictions are subject to a number of significant qualifications and exceptions, and under certain circumstances, the amount of additional indebtedness that could be incurred in compliance with these restrictions could be substantial. If new debt is added to our existing debt levels, the related risks that we will face would increase.\nWe meet a significant portion of our working capital needs through a securitization facility, which we must renew every three years.\nWe meet a significant portion of our working capital needs through a securitization facility, pursuant to which we sell accounts receivable to a special-purpose entity that in turn sells undivided participation interests in the accounts receivable to certain purchasers, who finance their purchases through the issuance of short-term commercial paper. The securitization facility has a three year term. Although we have been able to renew our Securitization Facility annually in the past, there can be no assurance that we will continue to be able to renew this facility in the future on terms acceptable to us. For example, the market for commercial paper experienced significant volatility during the financial crisis that began in 2008. Also, a significant rise in fuel prices could cause our accounts receivable to increase beyond the capacity of the securitization facility. There can be no\n26\nassurance that the size of the facility can be expanded to meet these increased working capital needs. Further, we may not be able to fund such increases in accounts receivable with our available cash resources. Our inability to meet working capital needs could adversely affect our financial condition and business, including our relationships with merchants, customers and partners. Further, we are exposed to the risk of increased interest rates because our borrowings under the Securitization Facility are subject to variable rates of interest. We renewed our Securitization Facility as of November 14, 2017, with an expiration date of November 14, 2020.\nWe are subject to risks related to volatility in foreign currency exchange rates, and restrictions on our ability to utilize revenue generated in foreign currencies.\nAs a result of our foreign operations, we are subject to risks related to changes in currency rates for revenue generated in currencies other than the U.S. dollar. For the year ended December 31, 2017, approximately 37% of our revenue was denominated in currencies other than the U.S. dollar (primarily, British pound, Brazilian real, Canadian dollar, Russian ruble, Mexican peso, Czech koruna, Euro, Australian dollar and New Zealand dollar). Revenue and profit generated by international operations may increase or decrease compared to prior periods as a result of changes in foreign currency exchange rates. Resulting exchange gains and losses are included in our net income. Volatility in foreign currency exchange rates may materially adversely affect our operating results and financial condition.\nFurthermore, we are subject to exchange control regulations that restrict or prohibit the conversion of more than a specified amount of our foreign currencies into U.S. dollars, and, as we continue to expand, we may become subject to further exchange control regulations that limit our ability to freely utilize and transfer currency in and out of particular jurisdictions. These restrictions may make it more difficult to effectively utilize the cash generated by our operations and may adversely affect our financial condition.\nWe expect to continue our expansion through acquisitions, which may divert our management’s attention and result in unexpected operating difficulties, increased costs and dilution to our stockholders. We also may never realize the anticipated benefits of the acquisitions.\nWe have been an active business acquirer in the U.S. and internationally, and, as part of our growth strategy, we expect to seek to acquire businesses, commercial account portfolios, technologies, services and products in the future. We have substantially expanded our overall business, customer base, headcount and operations through acquisitions. The acquisition and integration of each business involves a number of risks and may result in unforeseen operating difficulties and expenditures in assimilating or integrating the businesses, technologies, products, personnel or operations of the acquired business. Furthermore, acquisitions may:\n\n| • | involve our entry into geographic or business markets in which we have little or no prior experience; |\n\n| • | involve difficulties in retaining the customers of the acquired business; |\n\n| • | involve difficulties and expense associated with regulatory requirements, competition controls or investigations; |\n\n| • | result in a delay or reduction of sales for both us and the business we acquire; and |\n\n| • | disrupt our ongoing business, divert our resources and require significant management attention that would otherwise be available for ongoing development of our current business. |\n\nIn addition, international acquisitions often involve additional or increased risks including, for example:\n\n| • | difficulty managing geographically separated organizations, systems and facilities; |\n\n| • | difficulty integrating personnel with diverse business backgrounds, languages and organizational cultures; |\n\n| • | difficulty and expense introducing our corporate policies or controls; |\n\n| • | increased expense to comply with foreign regulatory requirements applicable to acquisitions; |\n\n| • | difficulty entering new foreign markets due to, among other things, lack of customer acceptance and a lack of business knowledge of these new markets; and |\n\n| • | political, social and economic instability. |\n\n27\nIn addition, the integration process following an acquisition requires significant management attention and resources. Integration of acquisitions could result in the distraction of our management, the disruption of our ongoing business or inconsistencies on our services, standards, controls, procedures and policies, any of which could affect our ability to achieve the anticipated benefits of an acquisition or otherwise adversely affect our business and financial results.\nTo complete future acquisitions, we may determine that it is necessary to use a substantial amount of our cash or engage in equity or debt financing. If we raise additional funds through further issuances of equity or convertible debt securities, our existing stockholders could suffer significant dilution, and any new equity securities we issue could have rights, preferences and privileges senior to those of holders of our common stock. Any debt financing obtained by us in the future could involve restrictive covenants relating to our capital-raising activities and other financial and operational matters that make it more difficult for us to obtain additional capital in the future and to pursue other business opportunities, including potential acquisitions. In addition, we may not be able to obtain additional financing on terms favorable to us, if at all, which could limit our ability to engage in acquisitions. Moreover, we can make no assurances that the anticipated benefits of any acquisition, such as operating improvements or anticipated cost savings, would be realized or that we would not be exposed to unexpected liabilities in connection with any acquisition.\nFurther, an acquisition may negatively affect our operating results because it may require us to incur charges and substantial debt or other liabilities, may cause adverse tax consequences, substantial depreciation and amortization or deferred compensation charges, may require the amortization, write-down or impairment of amounts related to deferred compensation, goodwill and other intangible assets, may include substantial contingent consideration payments or other compensation that reduce our earnings during the quarter in which incurred, or may not generate sufficient financial return to offset acquisition costs.\nWe conduct a significant portion of our business in foreign countries and we expect to expand our operations into additional foreign countries where we may be adversely affected by operational and political risks that are greater than in the U.S.\nWe have foreign operations in, or provide services for commercial card accounts in Australia, Austria, Azerbaijan, Belarus, Belgium, Brazil, Bulgaria, Canada, Croatia, Czech Republic, Denmark, Estonia, Finland, France, Georgia, Germany, Gibraltar, Greece, Hong Kong, Hungary, Ireland, Italy, Kazakhstan, Latvia, Lithuania, Luxembourg, Macau, Malaysia, Mexico, Moldova, Mongolia, the Netherlands, New Zealand, Norway, Pakistan, Papua New Guinea, Peru, Philippines, Poland, Portugal, Romania, Russia, Singapore, Slovakia, Slovenia, South Africa, South Korea, Spain, Sweden, Switzerland, Taiwan, Thailand, Turkey, Ukraine, United Arab Emirates and the United Kingdom. We also expect to seek to expand our operations into various countries in Asia, Europe and Latin America as part of our growth strategy.\nSome of the countries where we operate, and other countries where we will seek to operate, such as Russia, Brazil and Mexico, have undergone significant political, economic and social change in recent years, and the risk of unforeseen changes in these countries may be greater than in the U.S. For example, Russia and Ukraine are experiencing significant unrest, which could escalate into broader armed conflict and additional economic sanctions by the U.S., United Nations or other countries against Russia. In addition, political discourse in the U.S. may impact business practices in Mexico and other jurisdictions. In addition, changes in laws or regulations, including with respect to payment service providers, taxation, information technology, data transmission and the Internet, revenues from non-U.S. operations or in the interpretation of existing laws or regulations, whether caused by a change in government or otherwise, could materially adversely affect our business, operating results and financial condition.\nIn addition, conducting and expanding our international operations subjects us to other risks that we do not generally face in the U.S. These include:\n\n| • | difficulties in managing the staffing of our international operations, including hiring and retaining qualified employees; |\n\n| • | difficulties and increased expense introducing corporate policies and controls in our international operations; |\n\n| • | increased expense related to localization of our products and services, including language translation and the creation of localized agreements; |\n\n| • | potentially adverse tax consequences, including the complexities of foreign value added tax systems, restrictions on the repatriation of earnings and changes in tax rates; |\n\n28\n| • | increased expense to comply with foreign laws and legal standards, including laws that regulate pricing and promotion activities and the import and export of information technology, which can be difficult to monitor and are often subject to change; |\n\n| • | increased expense to comply with U.S. laws that apply to foreign operations, including the Foreign Corrupt Practices Act (the \"FCPA\") and OFAC regulations; |\n\n| • | increased expense to comply with U.K. laws that apply to foreign operations, including the U.K. Bribery Act; |\n\n| • | longer accounts receivable payment cycles and difficulties in collecting accounts receivable; |\n\n| • | increased financial accounting and reporting burdens and complexities; |\n\n| • | political, social and economic instability; |\n\n| • | terrorist attacks and security concerns in general; and |\n\n| • | reduced or varied protection for intellectual property rights and cultural norms in some geographies that are simply not respectful of intellectual property rights. |\n\nIn addition, in June 2016, voters in the United Kingdom approved an advisory referendum to withdraw from the European Union, commonly referred to as \"Brexit.\" This referendum has created political and economic uncertainty, particularly in the United Kingdom and the European Union, and this uncertainty may persist for years. A withdrawal could significantly disrupt the free movement of goods, services, and people between the United Kingdom and the European Union, and result in increased legal and regulatory complexities, as well as potential higher costs of conducting business in Europe. The United Kingdom's vote to exit the European Union could also result in similar referendums or votes in other European countries in which we do business. The uncertainty surrounding the terms of the United Kingdom's withdrawal and its consequences could adversely impact consumer and investor confidence, and the level of consumer purchases of discretionary items and retail products, including our products. Any of these effects, among others, could materially adversely affect our business, results of operations, and financial condition.\nThe occurrence of one or more of these events could negatively affect our international operations and, consequently, our operating results. Further, operating in international markets requires significant management attention and financial resources. Due to the additional uncertainties and risks of doing business in foreign jurisdictions, international acquisitions tend to entail risks and require additional oversight and management attention that are typically not attendant to acquisitions made within the U.S. We cannot be certain that the investment and additional resources required to establish, acquire or integrate operations in other countries will produce desired levels of revenue or profitability.\nWe are dependent on the efficient and uninterrupted operation of interconnected computer systems, telecommunications, data centers and call centers, including technology and network systems managed by multiple third parties, which could result in our inability to prevent disruptions in our services.\nOur ability to provide reliable service to customers, cardholders and other network participants depends upon uninterrupted operation of our data centers and call centers as well as third-party labor and services providers. Our business involves processing large numbers of transactions, the movement of large sums of money and the management of large amounts of data. We rely on the ability of our employees, contractors, suppliers, systems and processes to complete these transactions in a secure, uninterrupted and error-free manner.\nOur subsidiaries operate in various countries and country specific factors, such as power availability, telecommunications carrier redundancy, embargoes and regulation can adversely impact our information processing by or for our local subsidiaries.\nWe engage backup facilities for each of our processing centers for key systems and data. However, there could be material delays in fully activating backup facilities depending on the nature of the breakdown, security breach or catastrophic event (such as fire, explosion, flood, pandemic, natural disaster, power loss, telecommunications failure or physical break-in). We have controls and documented measures to mitigate these risks but these mitigating controls might not reduce the duration, scope or severity of an outage in time to avoid adverse effects.\n29\nWe may experience software defects, system errors, computer viruses and development delays, which could damage customer relationships, decrease our profitability and expose us to liability.\nOur business depends heavily on the reliability of proprietary and third-party processing systems. A system outage could adversely affect our business, financial condition or results of operations, including by damaging our reputation or exposing us to third-party liability. To successfully operate our business, we must be able to protect our processing and other systems from interruption, including from events that may be beyond our control. Events that could cause system interruptions include fire, natural disaster, unauthorized entry, power loss, telecommunications failure, computer viruses, terrorist acts and war. Although we have taken steps to protect against data loss and system failures, there is still risk that we may lose critical data or experience system failures.\nOur products and services are based on sophisticated software and computing systems that are constantly evolving. We often encounter delays and cost overruns in developing changes implemented to our systems. In addition, the underlying software may contain undetected errors, viruses or defects. Defects in our software products and errors or delays in our processing of electronic transactions could result in additional development costs, diversion of technical and other resources from our other development efforts, loss of credibility with current or potential customers, harm to our reputation or exposure to liability claims. In addition, we rely on technologies supplied to us by third parties that may also contain undetected errors, viruses or defects that could adversely affect our business, financial condition or results of operations. Although we attempt to limit our potential liability for warranty claims through disclaimers in our software documentation and limitation of liability provisions in our licenses and other agreements with our customers, we cannot assure that these measures will be successful in limiting our liability.\nWe may incur substantial losses due to fraudulent use of our payment cards or vouchers.\nUnder certain circumstances, when we fund customer transactions, we may bear the risk of substantial losses due to fraudulent use of our payment cards or vouchers. We do not maintain insurance to protect us against such losses. We bear similar risk relating to fraudulent acts of employees or contractors, for which we maintain insurance. However, the conditions or limits of coverage may be insufficient to protect us against such losses.\nCriminals are using increasingly sophisticated methods to engage in illegal activities involving financial products, such as skimming and counterfeiting payment cards and identity theft. A single significant incident of fraud, or increases in the overall level of fraud, involving our cards and other products and services, could result in reputational damage to us, which could reduce the use and acceptance of our cards and other products and services or lead to greater regulation that would increase our compliance costs. Fraudulent activity could also result in the imposition of regulatory sanctions, including significant monetary fines, which could have a material adverse effect on our business, financial condition and results of operations.\nWe may not be able to adequately protect our systems or the data we collect from continually evolving cybersecurity risks or other technological risks, which could subject us to liability and damage our reputation.\nWe electronically receive, process, store and transmit data and sensitive information about our customers and merchants, including bank account information, social security numbers, expense data, and credit card, debit card and checking account numbers. We endeavor to keep this information confidential; however, our websites, networks, information systems, services and technologies may be targeted for sabotage, disruption or misappropriation. The uninterrupted operation of our information systems and our ability to maintain the confidentiality of the customer and consumer information that resides on our systems are critical to the successful operation of our business. Unauthorized access to our networks and computer systems could result in the theft or publication of confidential information or the deletion or modification of records or could otherwise cause interruptions in our service and operations. Although we are not aware of any material breach of our or our associated third parties’ computer systems or material losses relating to cyber-attacks or other information security breaches, we and others in our industry are regularly the subject of attempts by bad actors to gain unauthorized access to these computer systems and data or to obtain, change or destroy confidential data (including personal consumer information of individuals) through a variety of means, including computer viruses, malware and phishing.\nBecause techniques used to sabotage or obtain unauthorized access to our systems and the data we collect change frequently and may not be recognized until launched against a target, we may be unable to anticipate these techniques or to implement adequate preventative measures. Threats to our systems and our associated third parties’ systems can derive from human error, fraud or malice on the part of employees or third parties, or may result from accidental technological failure. Computer viruses can be distributed and could infiltrate our systems or those of our associated third parties. In addition, denial of service or other attacks could be launched against us for a variety of purposes, including to interfere with our services or create a diversion for other malicious activities. Although we believe we have sufficient controls in place to prevent disruption and misappropriation\n30\nand to respond to such attacks, any inability to prevent security breaches could have a negative impact on our reputation, expose us to liability, decrease market acceptance of electronic transactions and cause our present and potential clients to choose another service provider. Any of these developments could have a material adverse effect on our business, operating results and financial condition.\nWe could also be subject to liability for claims relating to misuse of personal information, such as unauthorized marketing purposes and violation of data privacy laws. We cannot provide assurance that the contractual requirements related to security and privacy that we impose on our service providers who have access to customer and consumer data will be followed or will be adequate to prevent the unauthorized use or disclosure of data. In addition, we have agreed in certain agreements to take certain protective measures to ensure the confidentiality of customer data. The costs of systems and procedures associated with such protective measures may increase and could adversely affect our ability to compete effectively. Any failure to adequately enforce or provide these protective measures could result in liability, protracted and costly litigation, governmental and card network intervention and fines and, with respect to misuse of personal information of our customers, lost revenue and reputational harm.\nIn addition, under payment network rules, regulatory requirements, and related obligations, we may be responsible for the acts or failures to act of certain third parties, such as third party service providers, vendors, partners and others, which we refer to collectively as associated participants. The failure of our associated participants to safeguard cardholder data and other information in accordance with such rules, requirements and obligations could result in significant fines and sanctions and could harm our reputation and deter existing and prospective customers from using our services. We cannot assure you that there are written agreements in place with every associated participant or that such written agreements will ensure the adequate safeguarding of such data or information or allow us to seek reimbursement from associated participants. Any such unauthorized use or disclosure of data or information also could result in litigation that could result in a material adverse effect on our business, financial condition and results of operations.\nThe market for our commercial payment, fleet and stored value card services is evolving and may not continue to develop or grow.\nA substantial portion of our revenue is based on the volume of payment card transactions by our customers. If businesses do not continue to use, or increase their use of, credit, debit or stored value cards as a payment mechanism for their transactions, it could have a material adverse effect on our business, financial condition and results of operations. We believe that future growth in the use of credit, debit and stored value cards and other electronic payments will be driven by the cost, ease-of-use, and quality of services offered. In order for us to consistently increase and maintain profitability, businesses must continue to use and increase the use of electronic payment methods, including credit, debit and stored value cards. Moreover, if there is an adverse development in the payments industry in general, such as new legislation or regulation that makes it more difficult for customers to do business, or a well-publicized data security breach that undermines the confidence of the public in electronic payment systems, it could have a material adverse effect on our business, financial condition and results of operations.\nOur fleet card businesses rely on the acceptance and use of payment cards by businesses to purchase fuel for their vehicle fleets. If the use of fleet cards by businesses does not continue to grow, it could have a material adverse effect on our business, operating results and financial condition. In order to consistently increase and maintain our profitability, businesses and partners must continue to adopt our services. Similarly, growth in the acceptance and use of fleet cards will be impacted by the acceptance and use of electronic payment transactions generally.\nFurthermore, new technologies may displace credit, debit and/or stored value cards as payment mechanisms for purchase transactions by businesses. A decline in the acceptance and use of credit, debit and/or stored value cards, and electronic payment transactions generally, by businesses and merchants could have a material adverse effect on our business, operating results and financial condition. The market for our lodging cards, food vouchers and cards, transportation and toll road payments, telematics solutions and fleet maintenance management services is also evolving and those portions of our business are subject to similar risks.\nIf we fail to retain any of our stored value gift card customers, it will be difficult to find a replacement customer on a timely basis or at all, which will reduce our revenue.\nMost of our stored value gift card customers in the U.S. are national retailers. During 2017, a majority of our gift card revenue was derived from the design and purchase of gift card inventory, with the remaining portion of our 2017 gift card revenue derived primarily from processing fees. If we fail to retain any of these customers, it will be difficult to find a replacement customer on a timely basis or at all because there is a limited number of national retailers in the U.S. and nearly all of those\n31\nother national retailers already have a gift card solution in place, either in-house or with one of our competitors. As such, any loss of a stored value gift card customer would reduce our revenue.\nAdverse weather conditions across a geographic region can cause a decline in the number and amount of payment transactions we process, which could have a material adverse effect on our business, financial condition and results of operations.\nWhen travel is severely curtailed across a geographic region during adverse weather conditions, the number and amount of transactions we process can be significantly diminished, particularly in our fleet business, and revenue can materially decline. For example, during parts of January 2014, severe winter weather shut down a large portion of the eastern United States. Prolonged adverse weather events, especially those that impact regions in which we process a large number and amount of payment transactions, could have a material adverse effect on our business, financial condition and results of operations.\nOur fuel card, workforce payment solutions and gift card businesses’ results are subject to seasonality, which could result in fluctuations in our quarterly net income.\nOur fuel card and workforce payment solutions businesses have experienced in the past, and expect to continue to experience, seasonal fluctuations in revenues and profit, which are impacted during the first and fourth quarter each year by the weather, holidays in the U.S., Christmas being celebrated in Russia in January, and lower business levels in Brazil due to summer break and the Carnival celebration. Our gift card business has experienced in the past, and expects to continue to experience, seasonal fluctuations in revenues as a result of consumer spending patterns. Historically gift card business revenues have been strongest in the third and fourth quarters and weakest in the first and second quarters, as the retail industry has its highest level of activity during and leading up to the Christmas holiday season.\nOur balance sheet includes significant amounts of goodwill and intangible assets. The impairment of a significant portion of these assets would negatively affect our financial results.\nOur balance sheet includes goodwill and intangible assets that represent approximately 66% of our total assets at December 31, 2017. These assets consist primarily of goodwill and identified intangible assets associated with our acquisitions. We also expect to engage in additional acquisitions, which may result in our recognition of additional goodwill and intangible assets. Under current accounting standards, we are required to amortize certain intangible assets over the useful life of the asset, while goodwill and indefinite lived intangible assets are not amortized. On at least an annual basis, we assess whether there have been impairments in the carrying value of goodwill and indefinite lived intangible assets. If the carrying value of the asset is determined to be impaired, it is written down to fair value by a charge to operating earnings. An impairment of a significant portion of goodwill or intangible assets could materially negatively affect our operating results and financial condition.\nIf we are unable to protect our intellectual property rights and confidential information, our competitive position could be harmed and we could be required to incur significant expenses in order to enforce our rights.\nTo protect our proprietary technology, we rely on copyright, trade secret, patent and other intellectual property laws and confidentiality agreements with employees and third parties, all of which offer only limited protection. Despite our precautions, it may be possible for third parties to obtain and use without our consent confidential information or infringe on our intellectual property rights, and our ability to police that misappropriation or infringement is uncertain, particularly in countries outside of the U.S. In addition, our confidentiality agreements with employees, vendors, customers and other third parties may not effectively prevent disclosure or use of proprietary technology or confidential information and may not provide an adequate remedy in the event of such unauthorized use or disclosure.\nProtecting against the unauthorized use of our intellectual property and confidential information is expensive, difficult and not always possible. Litigation may be necessary in the future to enforce or defend our intellectual property rights, to protect our confidential information, including trade secrets, or to determine the validity and scope of the proprietary rights of others. This litigation could be costly and divert management resources, either of which could harm our business, operating results and financial condition. Accordingly, despite our efforts, we may not be able to prevent third parties from infringing upon or misappropriating our intellectual property and proprietary information.\nWe cannot be certain that the steps we have taken will prevent the unauthorized use or the reverse engineering of our proprietary technology. Moreover, others may independently develop technologies that are competitive to ours or infringe our intellectual property. The enforcement of our intellectual property rights also depends on our legal actions against these infringers being successful, and we cannot be sure these actions will be successful, even when our rights have been infringed.\n32\nFurthermore, effective patent, trademark, service mark, copyright and trade secret protection may not be available in every country in which we may offer our products and services.\nClaims by others that we or our customers infringe their intellectual property rights could harm our business.\nThird parties have in the past, and could in the future claim that our technologies and processes underlying our products and services infringe their intellectual property. In addition, to the extent that we gain greater visibility, market exposure, and add new products and services, we may face a higher risk of being the target of intellectual property infringement claims asserted by third parties. We may, in the future, receive notices alleging that we have misappropriated or infringed a third party’s intellectual property rights. There may be third-party intellectual property rights, including patents and pending patent applications that cover significant aspects of our technologies, processes or business methods. Any claims of infringement or misappropriation by a third party, even those without merit, could cause us to incur substantial defense costs and could distract our management from our business, and there can be no assurance that we will be able to prevail against such claims. Some of our competitors may have the capability to dedicate substantially greater resources to enforcing their intellectual property rights and to defending claims that may be brought against them than we do. Furthermore, a party making such a claim, if successful, could secure a judgment that requires us to pay substantial damages, potentially including treble damages if we are found to have willfully infringed a patent. A judgment could also include an injunction or other court order that could prevent us from offering our products and services. In addition, we might be required to seek a license for the use of a third party’s intellectual property, which may not be available on commercially reasonable terms or at all. Alternatively, we might be required to develop non-infringing technology, which could require significant effort and expense and might ultimately not be successful.\nThird parties may also assert infringement claims against our customers relating to their use of our technologies or processes. Any of these claims might require us to defend potentially protracted and costly litigation on their behalf, regardless of the merits of these claims, because under certain conditions we may agree to indemnify our customers from third-party claims of intellectual property infringement. If any of these claims succeed, we might be forced to pay damages on behalf of our customers, which could adversely affect our business, operating results and financial condition.\nFinally, we use open source software in connection with our technology and services. Companies that incorporate open source software into their products, from time to time, face claims challenging the ownership of open source software. As a result, we could be subject to suits by parties claiming ownership of what we believe to be open source software. Open source software is also provided without warranty, and may therefore include bugs, security vulnerabilities or other defects. Some open source software licenses require users of such software to publicly disclose all or part of the source code to their software and/or make available any derivative works of the open source code on unfavorable terms or at no cost. While we monitor the use of open source software in our technology and services and try to ensure that none is used in a manner that would require us to disclose the source code to the related technology or service, such use could inadvertently occur and any requirement to disclose our proprietary source code could be harmful to our business, financial condition and results of operations.\nOur success is dependent, in part, upon our executive officers and other key personnel, and the loss of key personnel could materially adversely affect our business.\nOur success depends, in part, on our executive officers and other key personnel. Our senior management team has significant industry experience and would be difficult to replace. The market for qualified individuals is competitive, and we may not be able to attract and retain qualified personnel or candidates to replace or succeed members of our senior management team or other key personnel. The loss of key personnel could materially adversely affect our business.\nChanges in laws, regulations and enforcement activities may adversely affect our products and services and the markets in which we operate.\nThe electronic payments industry is subject to increasing regulation in the U.S. and internationally. Domestic and foreign government regulations impose compliance obligations on us and restrictions on our operating activities, which can be difficult to administer because of their scope, mandates and varied requirements. We are subject to a number of government regulations, including, among others: interest rate and fee restrictions; credit access and disclosure requirements; collection and pricing regulations; compliance obligations; security and data breach requirements; identity theft avoidance programs; and anti-money laundering compliance programs. Government regulations can also include licensing or registration requirements. While a large portion of these regulations focuses on individual consumer protection, legislatures continue to consider whether to include business customers within the scope of these regulations. As a result, new or expanded regulation focusing on business customers or changes in interpretation or enforcement of regulations may have an adverse effect on our business and operating results, due to increased compliance costs and new restrictions affecting the terms under which we offer our products and services.\n33\nFor example, certain of our subsidiaries are currently licensed as money transmitters on the state level by the banking departments or other state agencies. Continued licensing by these states is subject to periodic examinations and ongoing satisfaction of compliance requirements regarding safety and soundness, including maintenance of certain levels of net worth, surety bonding, permissible investments in amounts sufficient to cover our outstanding payment obligations with respect to certain of our products subject to licensure, and record keeping and reporting. If our subsidiaries are unable to obtain, maintain or renew necessary licenses or comply with other relevant state regulations, they will not be able to operate as a money transmitter in those states or provide certain other services and products, which could have a material adverse effect on our business, financial condition and results of operations.\nIn addition, certain of our subsidiaries are subject to regulation by the Financial Crimes Enforcement Network, or FinCEN, and must comply with applicable anti-money laundering requirements, including implementation of an effective anti-money laundering program. Changes in this regulatory environment, including changing interpretations and the implementation of new or varying regulatory requirements by the government, may significantly affect or change the manner in which we currently conduct some aspects of our business.\nRegulatory changes may also restrict or eliminate present and future business opportunities available to certain of our subsidiaries. For example, the Durbin Amendment to the Dodd-Frank Act, which serves to limit interchange fees may restrict or otherwise impact the way our subsidiaries do business or limit their ability to charge certain fees to customers. The Consumer Financial Protection Bureau (\"CFPB\") is also engaged in rule making and regulation of the payments industry, in particular with respect to prepaid cards, and in October 2016, the CFPB issued a final rule amending Regulations E and Z to create comprehensive consumer protections for prepaid financial products. The extensive nature of these regulations and the implementation dates for this additional rulemaking may result in additional compliance obligations and expense for our business. The CFPB’s focus on the protection of consumers might also extend to many of our small business customers. As a service provider to certain of our bank sponsors, we are subject to direct supervision and examination by the CFPB, in connection with certain of our products and services. CFPB rules, examinations and enforcement actions may require us to adjust our activities and may increase our compliance costs. Changing regulations or standards in the area of privacy and data protection could also adversely impact us. In addition, certain of our bank partners are subject to regulation by federal and state authority and, as a result, could pass through some of those compliance obligations to us.\nOur business is subject to U.S. federal anti-money laundering laws and regulations, including the BSA. Our business in Canada is also subject to Proceeds of Crime (Money Laundering) and Terrorist Financing Act, or the PCTFA, which is a corollary to the BSA. The BSA, among other things, requires money services businesses (such as money transmitters, issuers of money orders and official checks and providers of prepaid access) to develop and implement risk-based anti-money laundering programs, report large cash transactions and suspicious activity and maintain transaction records. The PCTFA imposes similar requirements.\nMany of these laws and regulations are evolving, unclear and inconsistent across various jurisdictions, and ensuring compliance with them is difficult and costly. With increasing frequency, federal and state regulators are holding businesses like ours to higher standards of training, monitoring and compliance, including monitoring for possible violations of laws by our customers and people who do business with our customers while using our products. If we fail or are unable to comply with existing or changed government regulations in a timely and appropriate manner, we may be subject to injunctions, other sanctions and the payment of fines and penalties, and our reputation may be harmed, which could have a material adverse effect on our business, financial condition and results of operations.\nOur partner banks also operate in a highly regulated industry, which recently has been the subject of extensive structural reforms that are expected to negatively affect the conduct and scope of their businesses, their ability to maintain or expand offerings of products and services, and the costs of their operations. These legislative and regulatory changes could prompt our partner banks to alter the extent or the terms of their dealings with us in ways that may have adverse consequences for our business.\nIn addition, recently implemented and pending changes in accounting standards (for example, changes relating to revenue recognition for customer contracts that will become effective for fiscal 2018) may adversely affect our results of operations.\nFinally, we have endeavored to structure our businesses in accordance with existing tax laws and interpretations, including those related to state occupancy taxes, value added taxes in foreign jurisdictions, payroll taxes and restrictions on repatriation of funds or transfers of revenue between jurisdictions. Changes in tax laws, their interpretations or their enforcement could increase our tax liability, further limit our utilization of funds located in foreign jurisdictions and have a material adverse effect on our business and financial condition.\n34\nFor more information about laws, regulations and enforcement activities that may adversely affect our products and services and the markets in which we operate, see “Business- Regulatory.”\nDerivatives Regulations\nRules adopted under the Dodd-Frank Act by the Commodity Futures Trading Commission (the \"CFTC\"), as well as the provisions of the European Market Infrastructure Regulation and its technical standards, which are directly applicable in the member states of the European Union, have subjected certain of the foreign exchange derivative contracts we offer to our customers as part of Cambridge's business, to reporting, recordkeeping, and other requirements. Additionally, certain foreign exchange derivatives transactions we may enter into in the future may be subject to centralized clearing requirements, or may be subject to margin requirements in the United States and European Union. Other jurisdictions outside the United States and the European Union are considering, have implemented, or are implementing regulations similar to those described above. Derivatives regulations have added costs to our business and any additional requirements, such as future registration requirements and increased regulation of derivative contracts, may result in additional costs or impact the way we conduct our hedging activities, as well as impact how we conduct our business within our international payments provider operations. In particular, the CFTC has recently issued a proposed rule that, if adopted as proposed, would increase the likelihood that we will have to register one or more of our subsidiaries with the CFTC as swap dealers. Swap dealers are subject to a comprehensive regulatory framework and compliance with this framework will lead to additional costs, including costs relating to regulatory capital and margin requirements, and may impact how we conduct our hedging activities and derivatives business with customers. We are currently evaluating the impact the proposed rule, if adopted, would have on our hedging activities and operations.\nOur compliance with these requirements has resulted, and may continue to result, in additional costs to our business and may impact our international payments provider business operations. Furthermore, our failure to comply with these requirements could result in fines and other sanctions, as well as necessitate a temporary or permanent cessation to some or all of our derivative related activities. Any such fines, sanctions or limitations on our business could adversely affect our operations and financial results. Additionally, the regulatory regimes for derivatives in the United States and European Union, such as under the Dodd-Frank Act and the European Markets in Financial Instruments Directive known as \"MiFID II,\" are continuing to evolve and changes to such regimes, our designation under such regimes, or the implementation of new rules under such regimes, such as future registration requirements and increased regulation of derivative contracts, may result in additional costs to our business. Other jurisdictions outside the United States and the European Union are considering, have implemented, or are implementing regulations similar to those described above and these may result in greater costs to us as well.\nGovernmental regulations designed to protect or limit access to personal information could adversely affect our ability to effectively provide our services.\nGovernmental bodies in the U.S. and abroad have adopted, or are considering the adoption of, laws and regulations restricting the transfer of, and requiring safeguarding of, non-public personal information. For example, in the U.S., all financial institutions must undertake certain steps to help protect the privacy and security of consumer financial information. In connection with providing services to our clients, we are required by regulations and arrangements with payment networks, our sponsor bank and certain clients to provide assurances regarding the confidentiality and security of non-public consumer information. These arrangements require periodic audits by independent companies regarding our compliance with industry standards such as PCI standards and also allow for similar audits regarding best practices established by regulatory guidelines. The compliance standards relate to our infrastructure, components, and operational procedures designed to safeguard the confidentiality and security of non-public consumer personal information received from our customers. Our ability to maintain compliance with these standards and satisfy these audits will affect our ability to attract and maintain business in the future. If we fail to comply with these regulations, we could be exposed to suits for breach of contract or to governmental proceedings. In addition, our client relationships and reputation could be harmed, and we could be inhibited in our ability to obtain new clients. If more restrictive privacy laws or rules are adopted by authorities in the future on the federal or state level, our compliance costs may increase, our opportunities for growth may be curtailed by our compliance capabilities or reputational harm and our potential liability for security breaches may increase, all of which could have a material adverse effect on our business, financial condition and results of operations.\n35\nWe are subject to governmental regulation and other legal obligations, particularly related to privacy, data protection and information security, and we are subject to disparate consumer protection laws across different countries. Our actual or perceived failure to comply with such obligations could harm our business.\nIn the U.S., the European Union and in other jurisdictions around the world, we are subject to numerous and disparate consumer laws (including laws on disputed transactions) as well as regulations on eCommerce or similar legislation. If we are found to have breached any consumer, eCommerce or similar legislation in any country, we may be subject to enforcement actions that require us to change our business practices in a manner which may negatively impact revenue, as well as litigation, fines, penalties and adverse publicity that could cause our customers to lose trust in us, which could have an adverse effect on our reputation and business in a manner that harms our financial position.\nWe collect personally identifiable information and other data from our customers. Laws and regulations in several countries restrict certain collection, processing, storage, use, disclosure and security of personal information, require notice to individuals of privacy practices, and provide individuals with certain rights to prevent use and disclosure of protected information. Several foreign countries and governmental bodies, including the countries of the European Union and Canada, have laws and regulations which are often more restrictive than those in the United States. The data privacy regime in the EU includes certain directives which, among other things, require European Union member states to regulate the processing and movement of personal data, marketing and the use of cookies. Each European Union member state has transposed the requirements of these directives into its own national data privacy regime, and therefore the laws differ from jurisdiction to jurisdiction. These laws and regulations are subject to frequent revisions and differing interpretations, and have generally become more stringent over time.\nFuture restrictions on the collection, use, sharing or disclosure of personally identifiable information or additional requirements and liability for security and data integrity could require us to modify our solutions and features, possibly in a material manner, and could limit our ability to develop new services and features. For example, the EU-wide General Data Protection Regulation, or GDPR, which was passed by the European Union Parliament in the spring of 2016 and will become fully effective in May 2018, following a two-year implementation period, will replace the data protection laws of each European Union member state. The GDPR will implement more stringent operational requirements for processors and controllers of personal data, including, for example, increased requirements to erase an individual’s information upon request, mandatory data breach notification requirements and onerous new obligations on service providers. It also significantly increases penalties for non-compliance, including where we act as a service provider (e.g., data processor). If our privacy or data security measures fail to comply with applicable current or future laws and regulations, we may be subject to litigation, regulatory investigations, enforcement notices requiring us to change the way we use personal data or our marketing practices, fines, for example, of up to 20,000,000 Euros or up to 4% of the total worldwide annual turnover of the preceding financial year (whichever is higher) under the GDPR, or other liabilities, as well as negative publicity and a potential loss of business.\nIn February 2013, the European Commission proposed EU-wide legislation regarding cybersecurity in the form of the proposed Network and Information Security Directive, or the NIS Directive. The NIS Directive requires EU member states to impose cybersecurity obligations-including data breach notification requirements-to operators of “essential services” and to “digital service providers.” The NIS Directive and its implementing legislation if held to apply to us may lead to compliance obligations that require us to change one or more aspects of the way we operate our business, which could increase our operating costs, and failure to comply may result in governmental enforcement actions, litigation, fines, penalties and adverse publicity.\nUnfavorable resolution of tax contingencies or changes to enacted tax rates could adversely affect our tax expense and results of operations.\nOur tax returns and positions are subject to review and audit by federal, state, local, and international taxing authorities. An unfavorable outcome to a tax audit could result in higher tax expense, thereby negatively impacting our results of operations. We have established contingent liabilities for material known tax exposures relating to deductions, transactions and other matters involving some uncertainty as to the proper tax treatment of the item. These liabilities reflect what we believe to be reasonable assumptions as to the likely final resolution of each issue if raised by a taxing authority. There can be no assurance that, in all instances, an issue raised by a tax authority will be finally resolved at a financial cost less than any related liability. An unfavorable resolution, therefore, could negatively impact our financial position, operating results and cash flows in the current and/or future periods.\nOur acquisition documents include warranties, covenants and conditions regarding various tax matters that occurred prior to the acquisition, supported by indemnification and, in some cases, holdbacks or escrows from the sellers. The obligations of the\n36\nsellers are also generally subject to various limitations. In the event of a tax claim related to a pre-acquisition tax year, we would seek to recover costs and losses from the sellers under the acquisition agreement. However, there is no assurance that any indemnification, holdback or escrow would be sufficient or that we would recover such costs or losses, which could negatively impact our financial position, operating results and cash flows in the current and/or future periods.\nWe record deferred income taxes to reflect the impact of temporary differences between the amounts of assets and liabilities for financial accounting and income tax purposes. Deferred income taxes are determined using enacted tax rates. Changes in enacted tax rates may negatively impact our operating results.\nThe recently passed Tax Cuts and Jobs Act (the \"Tax Act\") act could adversely affect our business and financial condition.\nOn December 22, 2017, President Trump signed into law new legislation that significantly revises the Internal Revenue Code of 1986, as amended, or the Code. The newly enacted Tax Act among other things, contains significant changes to corporate taxation, including by reducing the corporate tax rate from a top marginal rate of 35% to a flat rate of 21%, significantly limiting the tax deduction for net interest expense, limiting the deduction for post-2017 net operating losses to 80% of current year taxable income and eliminating carrybacks of such net operating losses, imposing a one-time transition tax on offshore earnings regardless of whether they are repatriated, migrating from a “worldwide” system of taxation in the direction of a territorial system (subject to certain important exceptions), allowing immediate expensing of certain new investments instead of depreciating such investments over time, modifying or repealing many business deductions and credits, and requiring the accrual of certain income for U.S. federal income tax purposes no later than when such income is taken into account as revenue on our financial statements (subject to an exception for certain income that is already subject to a special method of accounting under the Code). We continue to examine the impact the new legislation may have on our business. Notwithstanding the reduction in the corporate income tax rate, the overall impact of the new federal tax law is uncertain, and our business and financial condition could be adversely affected. In addition, it is uncertain if and to what extent various states will conform to the newly enacted federal tax law. The impact of this tax reform on holders of our common stock is also uncertain and could be adverse.\nWe generate a portion of our revenue from our lodging card business, which is affected by conditions in the hotel industry generally and has a concentration of customers in the railroad and trucking industries.\nOur lodging card business earns revenue from customers purchasing lodging from the hotel industry and derives a significant portion of this revenue from end users in the railroad and trucking industries. Therefore, we are exposed to risks affecting each of these industries. For example, unfavorable economic conditions adversely impacting the hotel, railroad and trucking industries generally could cause a decrease in demand for our products and services in our lodging card business, resulting in decreased revenue, or increased credit risk and related losses, resulting in increased expenses. In addition, mergers or consolidations in these industries could reduce our customer and partnership base, resulting in a smaller market for our products and services.\nWe contract with government entities and are subject to risks related to our governmental contracts.\nIn the course of our business we contract with domestic and foreign government entities, including state and local government customers, as well as federal government agencies. As a result, we are subject to various laws and regulations that apply to companies doing business with federal, state and local governments. The laws relating to government contracts differ from other commercial contracting laws and our government contracts may contain pricing terms and conditions that are not common among commercial contracts. In addition, we may be subject to investigation from time to time concerning our compliance with the laws and regulations relating to our government contracts. Our failure to comply with these laws and regulations may result in suspension of these contracts or administrative or other penalties.\nLitigation and regulatory actions could subject us to significant fines, penalties or requirements resulting in significantly increased expenses, damage to our reputation and/or material adverse effects on our business.\nWe are subject to claims and a number of judicial and administrative proceedings considered normal in the course of our current and past operations, including employment-related disputes, contract disputes, intellectual property disputes, government audits and regulatory proceedings, customer disputes and tort claims. Responding to proceedings may be difficult and expensive, and we may not prevail. In some proceedings, the claimant seeks damages as well as other relief, which, if granted, would require expenditures on our part or changes in how we conduct business. There can be no certainty that we will not ultimately incur charges in excess of presently established or future financial accruals or insurance coverage, or that we will prevail with respect to such proceedings. Regardless of whether we prevail or not, such proceedings could have a material adverse effect on our business, reputation, financial condition and results of operations. From time to time, we have had, and expect to continue to receive, inquiries from regulatory bodies and administrative agencies relating to the operation of our\n37\nbusiness. Such inquiries have resulted in, and may continue to result in, various audits, reviews and investigations, which can be time consuming and expensive. These types of inquiries, audits, reviews, and investigations could result in the institution of administrative or civil proceedings, sanctions and the payment of fines and penalties, changes in personnel, and increased review and scrutiny by customers, regulatory authorities, the media and others, which could have a material adverse effect on our business, reputation, financial condition and results of operations. For more information about our judicial and other proceedings, see “Business—Legal Proceedings.”\nWe are named in a federal securities class action lawsuit and derivative complaint; if we are unable to resolve these matters favorably, then our business, operating results and financial condition may be adversely affected.\nIn June 2017, a shareholder filed a class action complaint in the Unites States District Court for the Northern District of Georgia against the Company and certain of its officers and directors on behalf of all persons who purchased or otherwise acquired the Company’s stock between February 5, 2016 and May 2, 2017. In July 2017, a shareholder derivative complaint was filed against certain of the Company’s directors and officers in the United States District Court for the Northern District of Georgia seeking recovery on behalf of the Company. See “Part II-Item 3 - Legal Proceedings” below for additional information about the lawsuit and the derivative complaint. We cannot at this time predict the outcome of these matters or reasonably determine the probability of a material adverse result or reasonably estimate range of potential exposure, if any, that these matters might have on us, our business, our financial condition or our results of operations, although such effects could be materially adverse. In addition, in the future, we may need to record litigation reserves with respect to these matters. Further, regardless of how these matters proceed, it could divert our management’s attention and other resources away from our business.\nOur revenues from MasterCard cards are dependent upon our continued MasterCard registration and financial institution sponsorship. If we fail to comply with the applicable requirements of MasterCard, it could seek to fine us, suspend us or terminate our registrations through our financial institution sponsors.\nA significant source of our revenue comes from processing transactions through the MasterCard networks. In order to offer MasterCard programs to our customers, one of our subsidiaries is registered as a member service provider with MasterCard through sponsorship by MasterCard member banks in both the U.S. and Canada. Registration as a service provider is dependent upon our being sponsored by member banks. If our sponsor banks should stop providing sponsorship for us or determine to provide sponsorship on materially less favorable terms, we would need to find other financial institutions to provide those services or we would need to become a MasterCard member, either of which could prove to be difficult and expensive. Even if we pursue sponsorship by alternative member banks, similar requirements and dependencies would likely still exist. In addition, MasterCard routinely updates and modifies its requirements. Changes in the requirements may make it significantly more expensive for us to provide these services. If we do not comply with MasterCard requirements, it could seek to fine us, suspend us or terminate our registration, which allows us to process transactions on its networks. The termination of our registration, or any changes in the payment network rules that would impair our registration, could require us to stop providing MasterCard payment processing services. If we are unable to find a replacement financial institution to provide sponsorship or become a member, we may no longer be able to provide such services to the affected customers, which would have a material adverse effect our business, financial condition and results of operations.\nChanges in MasterCard interchange fees could decrease our revenue.\nA portion of our revenue is generated by network processing fees charged to merchants, known as interchange fees, associated with transactions processed using our MasterCard-branded cards. Interchange fee amounts associated with our MasterCard network cards are affected by a number of factors, including regulatory limits in the United States and Europe and fee changes imposed by MasterCard. In addition, interchange fees are the subject of intense legal and regulatory scrutiny and competitive pressures in the electronic payments industry, which could result in lower interchange fees generally in the future. Temporary or permanent decreases in the interchange fees associated with our MasterCard network card transactions, could adversely affect our business and operating results.\nIf we are not able to maintain and enhance our brands, it could adversely affect our business, operating results and financial condition.\nWe believe that maintaining and enhancing our brands is critical to our customer relationships, and our ability to obtain partners and retain employees. The successful promotion of our brands will depend upon our marketing and public relations efforts, our ability to continue to offer high-quality products and services and our ability to successfully differentiate our services from those of our competitors. In addition, future extension of our brands to add new products or services different from our current offerings may dilute our brands, particularly if we fail to maintain our quality standards in these new areas. The promotion of\n38\nour brands will require us to make substantial expenditures, and we anticipate that the expenditures will increase as our markets become more competitive and we expand into new markets. To the extent that these activities yield increased revenues, this revenue may not offset the expenses we incur. There can be no assurance that our brand promotion activities will be successful.\nFailure to comply with the FCPA, anti-money laundering regulations, economic and trade sanctions regulations and similar laws and regulations associated with our international activities, could subject us to penalties and other adverse consequences.\nAs we continue to expand our business internationally, we may continue to expand into certain foreign countries, particularly those with developing economies, where companies often engage in business practices that are prohibited by U.S., U.K. and other foreign regulations, including the FCPA, the U.K. Bribery Act, the 2013 Brazilian Clean Companies Act and the 2013 Russian Law on Preventing Corruption. These laws and regulations generally prohibit us, our employees, consultants and agents from bribing, being bribed or making other prohibited payments to government officials or other persons to obtain or retain business or gain some other business advantage. We have implemented policies to discourage such practices; however, there can be no assurances that all of our employees, consultants and agents, including those that may be based in or from countries where practices that violate U.S. laws may be customary, will not take actions in violation of our policies, for which we may be ultimately responsible. Violations of the FCPA or similar laws may result in severe criminal or civil sanctions and, in the U.S., suspension or debarment from U.S. government contracting, which could negatively affect our business, operating results and financial condition.\nIn addition, we are subject to anti-money laundering laws and regulations, including the BSA. Among other things, the BSA requires money services businesses (such as money transmitters and providers of prepaid access) to develop and implement risk-based anti-money laundering programs, report large cash transactions and suspicious activity, and maintain transaction records.\nWe are also subject to certain economic and trade sanctions programs that are administered by OFAC, which prohibit or restrict transactions to or from or dealings with specified countries, their governments, and in certain circumstances, their nationals, and with individuals and entities that are specially-designated nationals of those countries, narcotics traffickers, and terrorists or terrorist organizations. Other group entities may be subject to additional foreign or local sanctions requirements in other relevant jurisdictions.\nSimilar anti-money laundering and counter-terrorist financing and proceeds of crime laws apply to movements of currency and payments through electronic transactions and to dealings with persons specified in lists maintained by the country equivalent to OFAC lists in several other countries and require specific data retention obligations to be observed by intermediaries in the payment process. Our businesses in those jurisdictions are subject to those data retention obligations.\nViolations of these laws and regulations may result in severe criminal or civil sanctions and, in the U.S., suspension or debarment from U.S. government contracting, which could negatively affect our business, operating results and financial condition. Likewise, any investigation of any potential violations of these laws and regulations by U.S. or foreign authorities could also have an adverse impact on our reputation, business, financial condition and operating results. In addition, we cannot predict the nature, scope or effect of future regulatory requirements to which our international operations might be subject or the manner in which existing laws and regulations might be administered or interpreted.\nGlobal economic downturns or slower growth or declines in the money transfer, payment service, and other markets in which we operate, including downturns or declines related to interruptions in migration patterns, and difficult conditions in global financial markets and financial market disruptions could adversely affect our business, financial condition, results of operations, and cash flows.\nThe global economy has experienced in recent years, and may experience, downturns, volatility and disruption, and we face certain risks relating to such events, including:\n| • | Our international payments provider business provides currency conversion and foreign exchange hedging services to our customers, exposing us to foreign currency exchange risk. In order to help mitigate these risks, we enter into derivative contracts. However, these contracts do not eliminate all of the risks related to fluctuating foreign currency rates. |\n\n| • | Our international payments provider business is heavily dependent on global trade. A downturn in global trade or the failure of long-term import growth rates to return to historic levels could have an adverse effect on our business, financial condition, results of operations, cash flows, and our cash management strategies. Additionally, as customer |\n\n39\nhedging activity in our international payments provider business generally varies with currency volatility, we have experienced and may experience in the future lower foreign exchange revenues in periods of lower currency volatility.\n| • | The counterparties to the derivative financial instruments that we use in our international payments provider business to reduce our exposure to various market risks, including changes in foreign exchange rates, may fail to honor their obligations, which could expose us to risks we had sought to mitigate. This includes the exposure generated when we write derivative contracts to our customers as part of our cross-currency payments business, and we typically hedge the net exposure through offsetting contracts with established financial institution counterparties. That failure could have an adverse effect on our financial condition, results of operations, and cash flows. |\n\nRisks associated with operations outside the U.S. and foreign currencies could adversely affect our business, financial condition, results of operations, and cash flows.\nWe have additional foreign exchange risk and associated foreign exchange risk management requirements due to the nature of our international payments provider business. The majority of this business' revenue is from exchanges of currency at spot rates, which enable customers to make cross-currency payments. Additionally, this business also writes foreign currency forward and option contracts for our customers. The duration of these derivative contracts at inception is generally less than one year. The credit risk associated with our derivative contracts increases when foreign currency exchange rates move against our customers, possibly impacting their ability to honor their obligations to deliver currency to us or to maintain appropriate collateral with us.\nOur international payments provider business aggregates its foreign exchange exposures arising from customer contracts, including the derivative contracts described above, and hedges the resulting net currency risks by entering into offsetting contracts with established financial institution counterparties. If we are unable to obtain offsetting positions, our business, financial condition, results of operations, and cash flows could be adversely affected.\nWe face credit, liquidity and fraud risks from our agents, consumers, businesses, and third-party processors that could adversely affect our business, financial condition, results of operations, and cash flows.\nWe are exposed to credit risk in our international payments provider business relating to: (a) derivatives written by us to our customers and (b) the extension of trade credit when transactions are paid to recipients prior to our receiving cleared funds from the sending customers. The credit risk associated with our derivative contracts increases when foreign currency exchange rates move against our customers, possibly impacting their ability to honor their obligations to deliver currency to us or\nto maintain appropriate collateral with us. If a customer becomes insolvent, files for bankruptcy, commits fraud or otherwise fails to pay us, we may be exposed to the value of an offsetting position with a financial institution counterparty for the derivatives or may bear financial risk for those receivables where we have offered trade credit.\nIf we are unable to maintain our relationships with banks needed to conduct our services, or fail to comply with our contract requirements, our business, financial condition, results of operations, and cash flows would be adversely affected.\nIn our international payments provider business, we facilitate payment and foreign exchange solutions, primarily cross-border, cross-currency transactions, for small and medium size enterprises and other organizations. Increased regulation and compliance requirements are impacting these businesses by making it more costly for us to provide our services or by making it more cumbersome for businesses to do business with us. We may also have difficulty establishing or maintaining banking relationships needed to conduct our services due to banks’ policies. If we are unable to maintain our current business or banking relationships or establish new relationships under terms consistent with those currently in place, our ability to continue to offer our services may be adversely impacted, which could have an adverse effect on our business, financial condition, results of operations, and cash flows.\nRisks related to ownership of our common stock\nOur stock price could be volatile and our stock could decline in value.\nThe market price of our common stock may fluctuate substantially as a result of many factors, some of which are beyond our control. Factors that could cause fluctuations in the market price of our common stock include the following:\n\n| • | quarterly variations in our results of operations; |\n\n| • | results of operations that vary from the expectations of securities analysts and investors; |\n\n| • | results of operations that vary from those of our competitors; |\n\n40\n| • | changes in expectations as to our future financial performance, including financial estimates by securities analysts and investors; |\n\n| • | announcements by us or our competitors of significant contracts, acquisitions, or capital commitments; |\n\n| • | announcements by third parties of significant claims or proceedings against us; |\n\n| • | regulatory developments in the U.S. and abroad; |\n\n| • | future sales of our common stock, and additions or departures of key personnel; and |\n\n| • | general domestic and international economic, market and currency factors and conditions unrelated to our performance. |\n\nIn addition, the stock market in general has experienced significant price and volume fluctuations that have often been unrelated or disproportionate to operating performance of individual companies. These broad market factors may seriously harm the market price of our common stock, regardless of our operating performance. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted. A securities class action suit against us could result in significant liabilities and, regardless of the outcome, could result in substantial costs and the diversion of our management’s attention and resources.\nOur disclosure controls and procedures may not prevent or detect all errors or acts of fraud.\nWe are subject to the periodic reporting requirements of the Securities Exchange Act of 1934, as amended, or the Exchange Act. Our disclosure controls and procedures are designed to reasonably ensure that information required to be disclosed by us in reports we file or submit under the Exchange Act is accumulated and communicated to management and recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission (the \"SEC\"). We believe that any disclosure controls and procedures or internal controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are and will be met. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by an unauthorized override of the controls. Accordingly, because of the inherent limitations in our control system, misstatements due to error or fraud may occur and not be detected.\nAnti-takeover provisions in our charter documents could discourage, delay or prevent a change in control of our company and may affect the trading price of our common stock.\nOur corporate documents and the Delaware General Corporation Law contain provisions that may enable our board of directors to resist a change in control of FLEETCOR even if a change in control were to be considered favorable by you and other stockholders. These provisions:\n| • | stagger the terms of our board of directors and require supermajority stockholder voting to remove directors; |\n\n| • | authorize our board of directors to issue preferred stock and to determine the rights and preferences of those shares, which may be senior to our common stock, without prior stockholder approval; |\n\n| • | establish advance notice requirements for nominating directors and proposing matters to be voted on by stockholders at stockholder meetings; |\n\n| • | prohibit our stockholders from calling a special meeting and prohibit stockholders from acting by written consent; and |\n\n| • | require super-majority stockholder voting to effect certain amendments to our certificate of incorporation and bylaws. |\n\nIn addition, Delaware law imposes some restrictions on mergers and other business combinations between any holder of 15% or more of our outstanding voting stock and us. These provisions could discourage, delay or prevent a transaction involving a change in control of FLEETCOR. These provisions could also discourage proxy contests and make it more difficult for you and other stockholders to elect directors of your choosing and cause us to take other corporate actions you desire.\nWe do not expect to pay any dividends on our common stock for the foreseeable future.\nWe currently expect to retain all future earnings, if any, for future operation, expansion and debt repayment and have no current plans to pay any cash dividends to holders of our common stock for the foreseeable future. Any decision to declare and pay\n41\ndividends in the future will be made at the discretion of our board of directors and will depend on, among other things, our operating results, financial condition, cash requirements, contractual restrictions and other factors that our board of directors may deem relevant. In addition, we must comply with the covenants in our credit agreements in order to be able to pay cash dividends, and our ability to pay dividends generally may be further limited by covenants of any existing and future outstanding indebtedness we or our subsidiaries incur.\nITEM 1B. UNRESOLVED STAFF COMMENTS\nWe have no unresolved written comments regarding our periodic or current reports from the staff of the SEC.\n42\nITEM 2. PROPERTIES\nWe lease all of the real property used in our business, except as noted below. The following table lists each of our material facilities and its location, use and approximate square footage, at December 31, 2017.\n| Facility | Use | Approximate size |\n| United States | Square Feet |\n| Norcross, Georgia | Corporate headquarters and operations | 98,000 |\n| Covington, Louisiana | Corporate accounting and treasury | 24,000 |\n| Houston, Texas | Credit and collections | 6,300 |\n| Concord, California | Customer support | 7,100 |\n| Wichita, Kansas | CLC operations and customer support | 38,000 |\n| Salem, Oregon | Pacific Pride sales, operations and customer support | 10,000 |\n| Brentwood, Tennessee | Comdata sales, operations and customer support | 135,000 |\n| Nashville, Tennessee | Comdata operations | 38,300 |\n| Louisville, Kentucky | SVS sales, operations and customer support | 66,000 |\n| Lexington, Kentucky | CLS operations | 60,100 |\n| Austin, Texas | Comdata operations | 4,300 |\n| New York, New York | Cambridge U.S. headquarters | 5,900 |\n| Bala Cynwyd, Pennsylvania | Cambridge global exchange division | 4,800 |\n| International |\n| Prague, Czech Republic | CCS headquarters and Shell Europe (Germany, Austria, Poland, Hungary, Switzerland, Czech Republic and Slovakia, France, Belgium, Netherlands and Luxembourg) operations, credit and collections, customer service, sales and finance | 38,400 |\n| Mexico City, Mexico(1) | FLEETCOR Mexico headquarters and operations | 27,500 |\n| Moscow, Russia | PPR and NKT headquarters, sales, customer support, operations, credit and collections | 16,300 |\n| Bryansk, Russia | Sales and marketing | 19,900 |\n| Ipswich, United Kingdom(1) | Operations, sales and customer support | 17,900 |\n| Knaresborough, United Kingdom | Operations, sales and customer support | 5,100 |\n| London, United Kingdom | Europe headquarters (including Cambridge Europe) | 7,540 |\n| Swindon, United Kingdom | Allstar operations, sales and customer support | 18,300 |\n| Walsall, United Kingdom | Operations, sales and customer support | 9,500 |\n| Birmingham, United Kingdom | EPYX headquarters, sales, operations and customer support | 14,800 |\n| Sao Paulo, Brazil | CTF and VB Servicios headquarters, sales, customer support and operations | 32,300 |\n| Osasco, Brazil | CTF and VB Servicios operations, STP and SemParar Headquarters, sales, operations and customer support | 59,900 |\n| Rio de Janeiro, Brazil | DB Trans and AExpresso headquarters, sales, operations and customer support | 15,300 |\n| Auckland, New Zealand | CardLink headquarters, sales, operations and customer support | 7,200 |\n| Nuremberg, Germany | Shell Europe sales | 6,900 |\n| Almere, Netherlands | Travelcard headquarters, sales, customer support, operations, credit and collections | 5,600 |\n| Rostov-on-Don, Russia | Gazprom headquarters and operations | 10,600 |\n| Toronto, Canada | Cambridge global headquarters | 27,600 |\n\n| (1) | We own these facilities. |\n\nWe also own approximately 1.5 acres of land in Nashville, Tennessee, for employee parking. Additionally, we lease a number of minor additional facilities, including local sales and operations offices less than 3,250 square feet, small storage facilities and a small number of service stations in the United Kingdom; which are not included in the above list. We believe our facilities are adequate for our needs for at least the next 12 months. We anticipate that suitable additional or alternative facilities will be available to accommodate foreseeable expansion of our operations.\n43\nITEM 3. LEGAL PROCEEDINGS\nIn the ordinary course of business, we are subject to various pending and potential legal actions, arbitration proceedings, claims, subpoenas, and matters relating to compliance with laws and regulations (collectively, legal proceedings). Based on our current knowledge, management presently does not believe that the liabilities arising from these legal proceedings will have a material adverse effect on our consolidated financial condition, results of operations or cash flows. However, it is possible that the ultimate resolution of these legal proceedings could have a material adverse effect on our results of operations and financial condition for any particular period.\nShareholder Class Action and Derivative Lawsuits\nOn June 14, 2017, a shareholder filed a class action complaint in the United States District Court for the Northern District of Georgia against the Company and certain of its officers and directors on behalf of all persons who purchased or otherwise acquired the Company’s stock between February 5, 2016 and May 2, 2017. On October 13, 2017, the shareholder filed an amended complaint asserting claims on behalf of a putative class of all persons who purchased or otherwise acquired the Company's common stock between February 4, 2016 and May 3, 2017. The complaint alleges that the defendants made false or misleading statements regarding fee charges and the reasons for its earnings and growth in certain press releases and other public statements in violation of the federal securities laws. Plaintiff seeks class certification, unspecified monetary damages, costs, and attorneys’ fees. The Company disputes the allegations in the complaint and intends to vigorously defend against the claims.\nOn July 10, 2017, a shareholder derivative complaint was filed against the Company and certain of the Company’s directors and officers in the United States District Court for the Northern District of Georgia seeking recovery on behalf of the Company. The derivative complaint alleges that the defendants issued a false and misleading proxy statement in violation of the federal securities laws; that defendants breached their fiduciary duties by causing or permitting the Company to make allegedly false and misleading public statements concerning the Company’s fee charges, and financial and business prospects; and that certain defendants breached their fiduciary duties through allegedly improper sales of stock. The complaint seeks unspecified monetary damages on behalf of the Company, corporate governance reforms, disgorgement of profits, benefits and compensation by the defendants, restitution, costs, and attorneys’ and experts’ fees. On August 18, 2017, the court entered an order deferring the case pending a ruling on the defendants' motion to dismiss the putative shareholder class action, or until otherwise agreed to by the parties. The defendants dispute the allegations in the complaint and intend to vigorously defend against the claims.\nEstimating an amount or range of possible losses resulting from litigation proceedings is inherently difficult and requires an extensive degree of judgment, particularly where the matters involve indeterminate claims for monetary damages, and are in the stages of the proceedings where key factual and legal issues have not been resolved. For these reasons, we are currently unable to predict the ultimate timing or outcome of, or reasonably estimate the possible losses or a range of possible losses resulting from the matters described above.\nITEM 4. MINE SAFETY DISCLOSURES\nNot applicable.\n44\nPART II\nITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER\nMATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES\nOur common stock is traded on the New York Stock Exchange (NYSE) under the symbol “FLT.” As of December 31, 2017, there were 146 holders of record of our common stock. The table set forth below provides the intra-day high and low sales prices per share of our common stock for the four quarters during 2017 and 2016.\n\n| High | Low |\n| 2017: |\n| First Quarter | $ | 171.78 | $ | 142.62 |\n| Second Quarter | 157.36 | 121.52 |\n| Third Quarter | 157.40 | 138.43 |\n| Fourth Quarter | 194.51 | 153.45 |\n| 2016: |\n| First Quarter | $ | 150.25 | $ | 107.56 |\n| Second Quarter | 156.58 | 133.64 |\n| Third Quarter | 174.84 | 137.26 |\n| Fourth Quarter | 176.42 | 140.75 |\n\nDIVIDENDS AND SHARE REPURCHASES\nWe currently expect to retain all future earnings, if any, for use in the operation and expansion of our business. We have never declared or paid any dividends on our common stock and do not anticipate paying cash dividends to holders of our common stock in the foreseeable future. In addition, our credit agreements restrict our ability to pay dividends. Any determination to pay dividends in the future will be at the discretion of our board of directors and will depend upon, among other factors, our results of operations, financial condition, capital requirements and covenants in our existing financing arrangements and any future financing arrangements.\nOn February 4, 2016, our Board of Directors approved a stock repurchase program (the \"Program\") under which we may begin purchasing up to an aggregate of $500 million of the outstanding common stock over the following 18 month period. On July 27, 2017, the Company's Board of Directors authorized an increase in the size of the Program by an additional $250 million and an extension of the Program by an additional 18 months. On November 1, 2017, the Company announced that its Board of Directors had authorized an increase in the size of the Program by an additional $350 million, resulting in total aggregate repurchases authorized under the Program of $1.1 billion. Since the beginning of the Program, 4,114,104 shares for an aggregate purchase price of $590 million have been repurchased.\nWe did not make any purchases of common stock during the three months ended December 31, 2017 as defined in Rule 10b-18(a)(3) under the Exchange Act.\n45\nPERFORMANCE GRAPH\nThe following graph assumes $100 invested on December 31, 2012, at the closing price ($53.65) of our common stock on that day, and compares (a) the percentage change of our cumulative total stockholder return on the common stock (as measured by dividing (i) the difference between our share price at the end and the beginning of the period presented by (ii) the share price at the beginning of the periods presented) with (b) (i) the Russell 2000 Index and (ii) the S&P 500® Data Processing & Outsourced Services.\n\n| Period Ending | FLEETCORTechnologies, Inc. | Russell 2000 | S&P DataProcessing andOutsourcedServices |\n| 12/31/2012 | $ | 100.00 | $ | 100.00 | $ | 100.00 |\n| 3/31/2013 | $ | 142.91 | $ | 112.03 | $ | 112.20 |\n| 6/30/2013 | $ | 151.54 | $ | 115.09 | $ | 118.85 |\n| 9/30/2013 | $ | 205.33 | $ | 126.42 | $ | 130.25 |\n| 12/31/2013 | $ | 218.40 | $ | 137.00 | $ | 151.76 |\n| 3/31/2014 | $ | 214.54 | $ | 138.11 | $ | 144.46 |\n| 6/30/2014 | $ | 245.67 | $ | 140.46 | $ | 144.86 |\n| 9/30/2014 | $ | 264.90 | $ | 129.71 | $ | 146.72 |\n| 12/31/2014 | $ | 277.19 | $ | 141.84 | $ | 170.19 |\n| 3/31/2015 | $ | 281.30 | $ | 147.50 | $ | 173.97 |\n| 6/30/2015 | $ | 290.89 | $ | 147.64 | $ | 175.73 |\n| 9/30/2015 | $ | 256.51 | $ | 129.59 | $ | 172.99 |\n| 12/31/2015 | $ | 266.41 | $ | 133.74 | $ | 188.13 |\n| 3/30/2016 | $ | 277.26 | $ | 131.16 | $ | 188.59 |\n| 6/30/2016 | $ | 266.78 | $ | 135.62 | $ | 185.00 |\n| 9/30/2016 | $ | 323.82 | $ | 147.37 | $ | 199.67 |\n| 12/31/2016 | $ | 263.78 | $ | 159.78 | $ | 199.15 |\n| 3/31/2017 | $ | 282.26 | $ | 163.17 | $ | 216.67 |\n| 6/30/2017 | $ | 268.80 | $ | 166.64 | $ | 232.21 |\n| 9/30/2017 | $ | 288.48 | $ | 175.53 | $ | 259.13 |\n| 12/31/2017 | $ | 358.68 | $ | 180.79 | $ | 280.89 |\n\n46\nRECENT SALES OF UNREGISTERED SECURITIES AND USE OF PROCEEDS\nNot Applicable.\n47\nITEM 6. SELECTED FINANCIAL DATA\nWe derived the consolidated statement of income and other financial data for the years ended December 31, 2017, 2016 and 2015 and the selected consolidated balance sheet data as of December 31, 2017 and 2016 from the audited consolidated financial statements included elsewhere in this report. We derived the selected historical financial data for the years ended December 31, 2014 and 2013 and the selected consolidated balance sheets as of December 31, 2015, 2014 and 2013 from our audited consolidated financial statements that are not included in this report.\nThe selected consolidated financial data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited consolidated financial statements and notes thereto included elsewhere in this report. Our historical results are not necessarily indicative of the results to be expected in any future period.\n\n| (in thousands, except per share data) | 2017 | 2016 | 2015 | 2014 | 2013 |\n| Consolidated statement of income data: |\n| Revenues, net | $ | 2,249,538 | $ | 1,831,546 | $ | 1,702,865 | $ | 1,199,390 | $ | 895,171 |\n| Expenses: |\n| Merchant commissions | 113,133 | 104,345 | 108,257 | 96,254 | 68,143 |\n| Processing | 429,613 | 355,414 | 331,073 | 173,337 | 134,030 |\n| Selling | 170,717 | 131,443 | 109,075 | 75,527 | 57,346 |\n| General and administrative | 387,694 | 283,625 | 297,715 | 205,963 | 142,283 |\n| Depreciation and amortization | 264,560 | 203,256 | 193,453 | 112,361 | 72,737 |\n| Other operating, net | 61 | (690 | ) | (4,242 | ) | (29,501 | ) | — |\n| Operating income | 883,760 | 754,153 | 667,534 | 565,449 | 420,632 |\n| Investment loss | 53,164 | 36,356 | 57,668 | 8,586 | — |\n| Other (income) expense, net | (173,436 | ) | 2,982 | 2,523 | (700 | ) | 602 |\n| Interest expense, net | 107,146 | 71,896 | 71,339 | 28,856 | 16,461 |\n| Loss on extinguishment of debt | 3,296 | — | — | 15,764 | — |\n| Total other (income) expense | (9,830 | ) | 111,234 | 131,530 | 52,506 | 17,063 |\n| Income before income taxes | 893,590 | 642,919 | 536,004 | 512,943 | 403,569 |\n| Provision for income taxes | 153,390 | 190,534 | 173,573 | 144,236 | 119,068 |\n| Net income | $ | 740,200 | $ | 452,385 | $ | 362,431 | $ | 368,707 | $ | 284,501 |\n| Earnings per share: |\n| Basic earnings per share | $ | 8.12 | $ | 4.89 | $ | 3.94 | $ | 4.37 | $ | 3.48 |\n| Diluted earnings per share | $ | 7.91 | $ | 4.75 | $ | 3.85 | $ | 4.24 | $ | 3.36 |\n| Weighted average shares outstanding: |\n| Basic shares | 91,129 | 92,597 | 92,023 | 84,317 | 81,793 |\n| Diluted shares | 93,594 | 95,213 | 94,139 | 86,982 | 84,655 |\n| As of December 31, |\n| (in thousands) | 2017 | 2016 | 2015 | 2014 | 2013 |\n| Consolidated balance sheet data: |\n| Cash and cash equivalents | $ | 913,595 | $ | 475,018 | $ | 447,152 | $ | 477,069 | $ | 338,105 |\n| Restricted cash(1) | 217,275 | 168,752 | 167,492 | 135,144 | 48,244 |\n| Total assets | 11,318,359 | 9,626,732 | 7,889,806 | 8,524,701 | 3,908,717 |\n| Total debt | 4,518,616 | 3,858,233 | 2,935,000 | 3,593,717 | 1,486,378 |\n| Total stockholders’ equity | 3,676,522 | 3,084,038 | 2,830,047 | 2,618,562 | 1,223,502 |\n\n(1) Restricted cash represents customer deposits repayable on demand, as well as collateral received from customers for cross-currency transactions.\n48\nITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND\nRESULTS OF OPERATIONS\nThe following discussion and analysis of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes appearing elsewhere in this report. In addition to historical information, this discussion contains forward-looking statements that involve risks, uncertainties and assumptions that could cause actual results to differ materially from management’s expectations. Factors that could cause such differences include, but are not limited to, those identified below and those described in Item 1A “Risk Factors” appearing elsewhere in this report. All foreign currency amounts that have been converted into U.S. dollars in this discussion are based on the exchange rate as reported by Oanda for the applicable periods.\nGeneral Business\nFLEETCOR is a leading global provider of commercial payment solutions. We help businesses of all sizes control, simplify and secure payment of various domestic and cross-border payables using specialized payment products. We serve businesses, merchants and partners in North America, Latin America, Europe, and Australasia. FLEETCOR’s predecessor company was organized in the United States in 1986, and FLEETCOR had its initial public offering in 2010 (NYSE: FLT).\nFLEETCOR has two reportable segments, North America and International. We report these two segments as they align with our senior executive organizational structure, reflect how we organize and manage our employees around the world, manage operating performance, contemplate the differing regulatory environments in North America versus other geographies, and help us isolate the impact of foreign exchange fluctuations on our financial results.\nOur payment solutions provide our customers with a payment method designed to be superior to and more robust and effective than what they use currently, whether they use a competitor’s product or another alternative method such as cash or check. Our solutions are comprised of payment products, networks and associated services.\nOur payment products function like a charge card or prepaid card and tend to be specialized for specific spend categories, such as fuel or lodging, and/or specific customer groups, such as long haul transportation. FLEETCOR’s five primary product lines are Fuel, Lodging, Tolls, Corporate Payments and Gift. Additionally, we provide other payment products including fleet maintenance, employee benefits and long haul transportation-related services. Our products are used in 56 countries around the world, with our primary geographies being the U.S., Brazil and the United Kingdom, which combined accounted for approximately 90% of our revenue in 2017.\nFLEETCOR uses both proprietary and third-party networks to deliver our payment solutions. FLEETCOR owns and operates proprietary networks with well-established brands throughout the world, bringing incremental sales and loyalty to affiliated merchants. Third-party networks are used to broaden payment product acceptance and use. In 2017, we processed approximately 3 billion transactions within these networks, of which approximately 1.4 billion were related to our Gift product line.\nFLEETCOR capitalizes on its products’ specialization with sales and marketing efforts by deploying product-dedicated sales forces to target specific customer segments. We market our products directly through multiple sales channels, including field sales, telesales and digital marketing, and indirectly through our partners, which include major oil companies, leasing companies, petroleum marketers, value-added resellers (VARs) and referral partners.\nWe believe that our size and scale, product breadth and specialization, geographic reach, proprietary networks, robust distribution capabilities and advanced technology contribute to our industry leading position.\nExecutive Overview\nWe operate in two segments, which we refer to as our North America and International segments. Our revenue is reported net of the wholesale cost for underlying products and services. In this report, we refer to this net revenue as “revenue\". See “Results of Operations” for additional segment information.\nWe report our results from Cambridge (acquired in the third quarter of 2017) and CLS (acquired in the fourth quarter of 2017) in our North America segment. The results of operations from the fuel card business acquired in Russia are included within our International segment. As part of our plan to exit the telematics business, on July 27, 2017, we sold NexTraq, a U.S. fleet telematics business, which has historically been included in our North America segment.\n49\nRevenues, net, by Segment. For the years ended December 31, 2017, 2016 and 2015, our North America and International segments generated the following revenue:\n| Year ended December 31, |\n| 2017 | 2016 | 2015 |\n| (in millions) | Revenues,net | % oftotalrevenues, net | Revenues,net | % oftotalrevenues, net | Revenues,net | % oftotalrevenues, net |\n| North America | $ | 1,429 | 63.5 | % | $ | 1,279 | 69.8 | % | $ | 1,232 | 72.3 | % |\n| International | 821 | 36.5 | % | 552 | 30.2 | % | 471 | 27.7 | % |\n| $ | 2,250 | 100.0 | % | $ | 1,832 | 100.0 | % | $ | 1,703 | 100.0 | % |\n\nRevenues, net, Net Income and Net Income Per Diluted Share. Set forth below are revenues, net, net income and net income per diluted share for the years ended December 31, 2017, 2016 and 2015.\n| Year ended December 31, |\n| (in millions, except per share amounts) | 2017 | 2016 | 2015 |\n| Revenues, net | $ | 2,250 | $ | 1,832 | $ | 1,703 |\n| Net income | $ | 740 | $ | 452 | $ | 362 |\n| Net income per diluted share | $ | 7.91 | $ | 4.75 | $ | 3.85 |\n\nAdjusted Revenues, Adjusted Net Income and Adjusted Net Income Per Diluted Share. Set forth below are adjusted revenues, adjusted net income and adjusted net income per diluted share for the years ended December 31, 2017, 2016 and 2015.\n| Year Ended December 31, |\n| 2017 | 2016 | 2015 |\n| (in millions, except per share amounts) |\n| Adjusted revenues | $ | 2,136 | $ | 1,727 | $ | 1,595 |\n| Adjusted net income | $ | 799 | $ | 659 | $ | 593 |\n| Adjusted net income per diluted share | $ | 8.54 | $ | 6.92 | $ | 6.30 |\n\nAdjusted revenues, adjusted net income and adjusted net income per diluted share are supplemental non-GAAP financial measures of operating performance. See the heading entitled “Management’s Use of Non-GAAP Financial Measures.” We use adjusted revenues as a basis to evaluate our revenues, net of the commissions that are paid to merchants that participate in certain of our card programs. The commissions paid to merchants can vary when market spreads fluctuate in much the same way as revenues are impacted when market spreads fluctuate. Thus, we believe this is a more effective way to evaluate our revenue performance on a consistent basis. We use adjusted net income and adjusted net income per diluted share to eliminate the effect of items that we do not consider indicative of our core operating performance on a consistent basis.\nSources of Revenue\nTransactions. In both of our segments, we derive revenue from transactions. A transaction is defined as a purchase by a customer utilizing one of our payment products at a participating merchant. The following diagram illustrates a typical transaction flow, which is representative of many, but not all, of our businesses.\n50\nIllustrative Transaction Flow\nThe revenue we derive from transactions is generated from both customers and merchants. Customers may include directly- and indirectly-sold commercial businesses as well as partners for whom we manage payment programs. Merchants may include those merchants affiliated with our proprietary networks or those participating in the third-party networks we utilize.\nFrom our customers and partners, we generate revenue through a variety of program fees, including transaction fees, card fees, network fees and charges. These fees may be charged as fixed amounts, costs plus a mark-up, or based on a percentage of the transaction purchase amounts. Our programs include other fees and charges associated with late payments and based on customer credit risk.\nFrom our merchants and third-party networks, we generate revenue mostly from the difference between the amount charged to a customer and the amount paid to the merchant or network for a given transaction, as well as network fees and charges in certain businesses. The amount paid to a merchant or network may be calculated as (i) the merchant’s wholesale product cost plus a markup; (ii) the transaction purchase amount less a percentage discount; or (iii) the transaction purchase amount less a fixed fee per unit. The following table provides illustrations of these three merchant payment models, which are representative of many, but not all, of our businesses.\nIllustrative Merchant Payment Models\n| i) Cost Plus Mark-up: | ii) Percentage Discount: | iii) Fixed Fee: |\n| Wholesale Cost | $ | 2.86 | Retail Price | $ | 3.00 | Retail Price | $ | 3.00 |\n| Mark-up | 0.05 | Discount (3%) | (0.09 | ) | Fixed Fee | (0.09 | ) |\n| Price Paid to Merchant | $ | 2.91 | Price Paid to Merchant | $ | 2.91 | Price Paid to Merchant | $ | 2.91 |\n\nFor a transaction involving the purchase of fuel where the amount paid to the merchant is calculated under the cost plus markup model, we refer to the difference between the amount charged to the customer and the amount paid to the merchant as merchant revenue tied to fuel-price spreads. In all other cases, we refer to the difference between the amount charged to the customer and the amount paid to the merchant for a given transaction as interchange revenue.\nRevenue per transaction. Set forth below is revenue per transaction by segment information for the years ended December 31, 2017, 2016 and 2015. Revenue per transactions by segment is affected by the mix of products and acquisitions, which may result in revenue per transaction by product providing more meaningful data for analysis.\n51\n| Year ended December 31, |\n| (Unaudited) | 2017 | 2016 | 2015 |\n| Transactions (in millions) |\n| North America | 1,842.4 | 1,714.6 | 1,667.5 |\n| International | 1,114.5 | 507.8 | 183.9 |\n| Total transactions | 2,956.9 | 2,222.4 | 1,851.4 |\n| Revenue per transaction |\n| North America | $ | 0.78 | $ | 0.75 | $ | 0.74 |\n| International | $ | 0.74 | $ | 1.09 | $ | 2.56 |\n| Consolidated revenue per transaction | $ | 0.76 | $ | 0.82 | $ | 0.92 |\n| Consolidated adjusted revenue per transaction | $ | 0.72 | $ | 0.78 | $ | 0.86 |\n\nThe following table provides a breakdown of revenue per transaction by product for the years ended December 31, 2017 and 2016 (in millions, except per transaction data):\n| As Reported | Pro Forma and Macro Adjusted2 |\n| Year Ended December 31, | Year Ended December 31, |\n| (Unaudited) | 2017 | 2016 | Change | % Change | 20173 | 20164 | Change | % Change |\n| Fuel Cards6 |\n| Transactions5 | 466 | 434 | 32 | 7 | % | 466 | 444 | 23 | 5 | % |\n| Revenues, net per transaction | $ | 2.35 | $ | 2.30 | $ | 0.05 | 2 | % | $ | 2.29 | $ | 2.25 | $ | 0.04 | 2 | % |\n| Revenues, net5 | $ | 1,096 | $ | 997 | $ | 99 | 10 | % | $ | 1,066 | $ | 998 | $ | 68 | 7 | % |\n| Corporate Payments |\n| Transactions | 42 | 39 | 3 | 7 | % | 42 | 39 | 3 | 6 | % |\n| Revenues, net per transaction | $ | 6.30 | $ | 4.64 | $ | 1.66 | 36 | % | $ | 6.26 | $ | 5.80 | $ | 0.46 | 8 | % |\n| Revenues, net | $ | 262 | $ | 180 | $ | 82 | 46 | % | $ | 260 | $ | 226 | $ | 34 | 15 | % |\n| Tolls |\n| Transactions | 916 | 327 | 589 | 180 | % | 916 | 894 | 22 | 2 | % |\n| Revenues, net per transaction | $ | 0.36 | $ | 0.31 | $ | 0.04 | 13 | % | $ | 0.33 | $ | 0.29 | $ | 0.04 | 14 | % |\n| Revenues, net | $ | 327 | $ | 103 | $ | 224 | 218 | % | $ | 302 | $ | 257 | $ | 45 | 18 | % |\n| Lodging |\n| Transactions | 17 | 13 | 4 | 30 | % | 17 | 14 | 3 | 22 | % |\n| Revenues, net per transaction | $ | 7.45 | $ | 7.58 | $ | (0.13 | ) | (2 | )% | $ | 7.45 | $ | 7.68 | (0.23 | ) | (3 | )% |\n| Revenues, net | $ | 127 | $ | 101 | $ | 26 | 26 | % | $ | 127 | 105 | $ | 22 | 21 | % |\n| Gift |\n| Transactions | 1,439 | 1,327 | 111 | 8 | % | 1,439 | 1,327 | 111 | 8 | % |\n| Revenues, net per transaction | $ | 0.13 | $0.14 | $0.00 | (3 | )% | $ | 0.13 | $ | 0.14 | $ | (0.01 | ) | (7 | )% |\n| Revenues, net | $ | 194 | $185 | $9 | 5 | % | $ | 194 | $ | 185 | $ | 9 | 5 | % |\n| Other1 |\n| Transactions5 | 77 | 82 | (5 | ) | (6 | )% | 77 | 82 | (4 | ) | (5 | )% |\n| Revenues, net per transaction | $ | 3.15 | $ | 3.23 | $ | (0.08 | ) | (2 | )% | $ | 3.14 | $ | 2.99 | $ | 0.15 | 5 | % |\n| Revenues, net5 | $ | 244 | $ | 266 | $ | (23 | ) | (8 | )% | $ | 243 | $ | 244 | $ | (1 | ) | — | % |\n| FLEETCOR CONSOLIDATED REVENUES |\n| ‑Transactions5 | 2,957 | 2,222 | 735 | 33 | % | 2,957 | 2,799 | 158 | 6 | % |\n| ‑Revenues, net per transaction | $ | 0.76 | $ | 0.82 | $ | (0.06 | ) | (7 | )% | $ | 0.74 | $ | 0.73 | $ | 0.02 | 2 | % |\n| ‑ Revenues, net | $ | 2,250 | $ | 1,832 | $ | 418 | 23 | % | $ | 2,193 | $ | 2,015 | $ | 178 | 9 | % |\n\n52\n\n| *Columns may not calculate due to rounding. |\n| 1Other includes telematics, maintenance, food, and transportation related businesses. |\n| 2 Pro forma and macro adjusted revenue is a non-GAAP financial measure defined as revenues, net adjusted for the impact of the macroeconomic environment and acquisitions and dispositions and other one-time items. We use pro forma and macro adjusted revenue as a basis to evaluate our organic growth. See the heading entitled “Management’s Use of Non-GAAP Financial Measures” for a reconciliation of pro forma and macro adjusted revenue by product, non-GAAP measures, to the GAAP equivalent. |\n| 32017 is adjusted to remove the impact of changes in the macroeconomic environment to be consistent with the same period of prior year, using constant fuel prices, fuel price spreads and foreign exchange rates. |\n| 42016 is pro forma to include acquisitions and exclude dispositions consistent with 2017 ownership. |\n| 52016 revenue and transactions reflect immaterial corrections from previously disclosed amounts for the prior period. |\n| 6Fuel Cards product category further refined to Fuel, to reflect different ways that fuel is paid for by our customers. |\n\nRevenue per transaction is derived from the various revenue types as discussed above and can vary based on geography, the relevant merchant relationship, the payment product utilized and the types of products or services purchased, the mix of which would be influenced by our acquisitions, organic growth in our business, and the overall macroeconomic environment, including fluctuations in foreign currency exchange rates, fuel prices and spreads. Revenue per transaction per customer changes as the level of services we provide to a customer increases or decreases, as macroeconomic factors change and as adjustments are made to merchant and customer rates. See “Results of Operations” for further discussion of transaction volumes and revenue per transaction.\nSources of Expense\nWe incur expenses in the following categories:\n\n| • | Merchant commissions—In certain of our card programs, we incur merchant commissions expense when we reimburse merchants with whom we have direct, contractual relationships for specific transactions where a customer purchases products or services from the merchant. In the card programs where it is paid, merchant commissions equal the difference between the price paid by us to the merchant and the merchant’s wholesale cost of the underlying products or services. |\n\n| • | Processing—Our processing expense consists of expenses related to processing transactions, servicing our customers and merchants, bad debt expense and cost of goods sold related to our hardware sales in certain businesses. |\n\n| • | Selling—Our selling expenses consist primarily of wages, benefits, sales commissions (other than merchant commissions) and related expenses for our sales, marketing and account management personnel and activities. |\n\n| • | General and administrative—Our general and administrative expenses include compensation and related expenses (including stock-based compensation) for our executive, finance and accounting, information technology, human resources, legal and other administrative personnel. Also included are facilities expenses, third-party professional services fees, travel and entertainment expenses, and other corporate-level expenses. |\n\n| • | Depreciation and amortization—Our depreciation expenses include depreciation of property and equipment, consisting of computer hardware and software (including proprietary software development amortization expense), card-reading equipment, furniture, fixtures, vehicles and buildings and leasehold improvements related to office space. Our amortization expenses include amortization of intangible assets related to customer and vendor relationships, trade names and trademarks and non-compete agreements. We also amortize intangible assets related to business acquisitions and certain private label contracts associated with the purchase of accounts receivable. |\n\n| • | Other operating, net—Our other operating, net includes other operating expenses and income items unusual to the period and presented separately. |\n\n| • | Investment loss (income)—Our investment results relate to our minority interest in Masternaut, a provider of telematics solutions to commercial fleets in Europe, which we historically accounted for using the equity method. On September 30, 2017, we entered into an amended Masternaut investment agreement that resulted in the loss of significant influence, and we began accounting for the Masternaut investment by applying the cost method. |\n\n| • | Other (income) expense, net—Our other (income) expense, net includes proceeds/costs from the sale of assets, foreign currency transaction gains or losses, and other miscellaneous operating costs and revenue. |\n\n53\n| • | Interest expense, net—Our interest expense, net includes interest income on our cash balances and interest expense on our outstanding debt and on our Securitization Facility. We have historically invested our cash primarily in short-term money market funds. |\n\n| • | Loss on extinguishment of debt—Loss on extinguishment of debt relates to our write-off of debt issuance costs associated with the refinancing of our existing Credit Facility. |\n\n| • | Provision for income taxes—The provision for income taxes consists primarily of corporate income taxes related to profits resulting from the sale of our products and services. Our worldwide effective tax rate is lower than the U.S. statutory rate of 35%, due primarily to the Tax Cuts and Job Act (\"Tax Act\") and lower rates in foreign jurisdictions and foreign-sourced non-taxable income. |\n\nFactors and Trends Impacting our Business\nWe believe that the following factors and trends are important in understanding our financial performance:\n\n| • | Global economic conditions—Our results of operations are materially affected by conditions in the economy generally, both in North America and internationally. Factors affected by the economy include our transaction volumes and the credit risk of our customers. These factors affected our businesses in both our North America and International segments. |\n\n| • | Foreign currency changes—Our results of operations are significantly impacted by changes in foreign currency rates; namely, by movements of the Australian dollar, Brazilian real, British pound, Canadian dollar, Czech koruna, Euro, Mexican peso, New Zealand dollar and Russian ruble, relative to the U.S. dollar. Approximately 62%, 70% and 72% of our revenue in 2017, 2016 and 2015, respectively, was derived in U.S. dollars and was not affected by foreign currency exchange rates. See “Results of Operations” for information related to foreign currency impact on our total revenue, net. |\n\n| • | Fuel prices—Our fleet customers use our products and services primarily in connection with the purchase of fuel. Accordingly, our revenue is affected by fuel prices, which are subject to significant volatility. A change in retail fuel prices could cause a decrease or increase in our revenue from several sources, including fees paid to us based on a percentage of each customer’s total purchase. Changes in the absolute price of fuel may also impact unpaid account balances and the finance fees and charges based on these amounts. See “Sources of Revenue” above for further information related to the absolute price of fuel. |\n\n| • | Fuel-price spread volatility—A portion of our revenue involves transactions where we derive revenue from fuel-price spreads, which is the difference between the price charged to a fleet customer for a transaction and the price paid to the merchant for the same transaction. In these transactions, the price paid to the merchant is based on the wholesale cost of fuel. The merchant’s wholesale cost of fuel is dependent on several factors including, among others, the factors described above affecting fuel prices. The fuel price that we charge to our customer is dependent on several factors including, among others, the fuel price paid to the merchant, posted retail fuel prices and competitive fuel prices. We experience fuel-price spread contraction when the merchant’s wholesale cost of fuel increases at a faster rate than the fuel price we charge to our customers, or the fuel price we charge to our customers decreases at a faster rate than the merchant’s wholesale cost of fuel. See “Sources of Revenue” above for further information related to fuel-price spreads. |\n\n| • | Acquisitions—Since 2002, we have completed over 75 acquisitions of companies and commercial account portfolios. Acquisitions have been an important part of our growth strategy, and it is our intention to continue to seek opportunities to increase our customer base and diversify our service offering through further strategic acquisitions. The impact of acquisitions has, and may continue to have, a significant impact on our results of operations and may make it difficult to compare our results between periods. |\n\n| • | Interest rates—Our results of operations are affected by interest rates. We are exposed to market risk changes in interest rates on our cash investments and debt. |\n\n| • | Expenses— Over the long term, we expect that our general and administrative expense will decrease as a percentage of revenue as our revenue increases. To support our expected revenue growth, we plan to continue to incur additional sales and marketing expense by investing in our direct marketing, third-party agents, internet marketing, telemarketing and field sales force. |\n\n54\nAcquisitions and Investments\nDuring 2017, the Company completed acquisitions with an aggregate purchase price of $720.8 million, net of cash acquired of $96.2 million. During 2017, the Company made investments in other businesses of $39 million.\n| • | On August 9, 2017, we acquired Cambridge, a leading business to business (B2B) international payments provider, for approximately $616.1 million in cash, net of cash acquired of $94.5 million and inclusive of a note payable of $23.8 million. Cambridge processes B2B cross-border payments, assisting business clients in making international payments. The purpose of this acquisition is to further expand our corporate payments footprint. |\n\n| • | On September 26, 2017, we acquired a fuel card provider in Russia. |\n\n| • | On October 13, 2017, we completed the acquisition of CLS, a small lodging tuck-in business, in the United States. |\n\nDuring 2016, we completed acquisitions with an aggregate purchase price of $1.3 billion, net of cash acquired of $51.3 million, which includes deferred payments made during the period related to prior acquisitions of $6.1 million.\n| • | In August 2016, we acquired all of the outstanding stock of Serviços e Tecnologia de Pagamentos S.A. (“STP”) for $1.23 billion, net of cash acquired of $40.2 million. STP is an electronic toll payments company in Brazil and provides cardless fuel payments at a number of Shell sites throughout Brazil. The purpose of this acquisition was to expand our presence in the toll market in Brazil. |\n\n| • | During 2016, we acquired additional fuel card portfolios in the U.S. and the United Kingdom, additional Shell fuel card markets in Europe and Travelcard in the Netherlands totaling $76.7 million, net of cash acquired of $11.1 million. |\n\n| • | During 2016, we made additional investments of $7.9 million related to our investment at Masternaut. We also received a $9.2 million return of our investment in Masternaut in 2016. |\n\nDuring 2015, we completed acquisitions of Shell portfolios related to our fuel card businesses in Europe, as well as a small acquisition internationally, with an aggregate purchase price of $46.3 million, each included within our International segment from the date of acquisition, and made additional investments of $8.4 million related to our equity method investment at Masternaut and deferred payments of $3.4 million related to acquisitions occurring in prior years.\nWe report our results from Cambridge and CLS acquired in the third and fourth quarters of 2017, respectively, in our North America segment, from the date of acquisition. The results of operations from the fuel card business in Russia acquired in the third quarter of 2017, are included within our International segment from the date of acquisition. The results of operations from the fuel card portfolio acquired in the U.S. are included within our North America segment, from the date of acquisition. The results of operations of STP, the fuel card portfolio in the United Kingdom, the additional Shell markets, the Travelcard business in the Netherlands and the small business in Brazil are included within our International segment, from the date of acquisition.\nAsset Dispositions\nTelematics Businesses\nAs part of our plan to exit the telematics business, on July 27, 2017, we sold NexTraq, a U.S. fleet telematics business, to Michelin Group for $316.5 million. We recorded a pre-tax gain on the disposal of NexTraq of $175.0 million during the third quarter of 2017, which is net of transaction closing costs. We recorded tax on the gain of disposal of $65.8 million. The gain on the disposal is included in other (income) expense, net in the accompanying Consolidated Statements of Income. NexTraq had historically been included in our North America segment.\nOn September 30, 2017, we entered into an amended Masternaut investment agreement that resulted in the loss of significant influence, and we began accounting for the Masternaut investment by applying the cost method.\nWe regularly evaluate the carrying value of our Masternaut investment and during the third quarter of 2017, we determined that the fair value of our 44% investment in Masternaut had declined as a result of our loss of significant influence and the operating results of Masternaut. As a result, we determined that the carrying value of our investment exceeded its fair value, and concluded that this decline in value was other than temporary. We recorded a $44.6 million impairment loss in the Masternaut investment that includes adjustment for $31.4 million of currency translation losses previously recognized in accumulated other comprehensive income, in the accompanying Consolidated Statements of Income.\n55\nResults of Operations\nYear ended December 31, 2017 compared to the year ended December 31, 2016\nThe following table sets forth selected consolidated statement of income and selected operational data for the years ended December 31, 2017 and 2016 (in millions, except percentages)*.\n| Year endedDecember 31,2017 | % of totalrevenue | Year endedDecember 31,2016 | % of totalrevenue | Increase(decrease) | % Change |\n| Revenues, net: |\n| North America | $ | 1,428.7 | 63.5 | % | $ | 1,279.1 | 69.8 | % | $ | 149.6 | 11.7 | % |\n| International | 820.8 | 36.5 | % | 552.4 | 30.2 | % | 268.4 | 48.6 | % |\n| Total revenues, net | 2,249.5 | 100.0 | % | 1,831.5 | 100.0 | % | 418.0 | 22.8 | % |\n| Consolidated operating expenses: |\n| Merchant commissions | 113.1 | 5.0 | % | 104.3 | 5.7 | % | 8.8 | 8.4 | % |\n| Processing | 429.6 | 19.1 | % | 355.4 | 19.4 | % | 74.2 | 20.9 | % |\n| Selling | 170.7 | 7.6 | % | 131.4 | 7.2 | % | 39.3 | 29.9 | % |\n| General and administrative | 387.7 | 17.2 | % | 283.6 | 15.5 | % | 104.1 | 36.7 | % |\n| Depreciation and amortization | 264.6 | 11.8 | % | 203.3 | 11.1 | % | 61.3 | 30.2 | % |\n| Other operating, net | 0.1 | — | % | (0.7 | ) | — | % | (0.8 | ) | (108.8 | )% |\n| Operating income | 883.8 | 39.3 | % | 754.2 | 41.2 | % | 129.6 | 17.2 | % |\n| Investment loss | 53.2 | 2.4 | % | 36.4 | 2.0 | % | 16.8 | 46.2 | % |\n| Other (income) expense, net | (173.4 | ) | (7.7 | )% | 3.0 | 0.2 | % | (176.4 | ) | NM |\n| Interest expense, net | 107.1 | 4.8 | % | 71.9 | 3.9 | % | 35.3 | 49.0 | % |\n| Loss on extinguishment of debt | 3.3 | 0.1 | % | — | — | % | 3.3 | — | % |\n| Provision for income taxes | 153.4 | 6.8 | % | 190.5 | 10.4 | % | (37.1 | ) | (19.5 | )% |\n| Net income | $ | 740.2 | 32.9 | % | $ | 452.4 | 24.7 | % | $ | 287.8 | 63.6 | % |\n| Operating income for segments: |\n| North America | $ | 541.6 | $ | 506.4 | $ | 35.2 | 6.9 | % |\n| International | 342.2 | 247.7 | 94.4 | 38.1 | % |\n| Operating income | $ | 883.8 | $ | 754.2 | $ | 129.6 | 17.2 | % |\n| Operating margin for segments: |\n| North America | 37.9 | % | 39.6 | % | (1.7 | )% |\n| International | 41.7 | % | 44.8 | % | (3.2 | )% |\n| Total | 39.3 | % | 41.2 | % | (1.9 | )% |\n\nNM = Not Meaningful\n*Columns may not calculate due to rounding.\nRevenues\nOur consolidated revenue increased from $1,831.5 million in 2016 to $2,249.5 million in 2017, an increase of $418.0 million, or 22.8%. The increase in our consolidated revenue was primarily due to:\n\n| • | The impact of acquisitions completed in 2016 and 2017, which contributed approximately $212 million in additional revenue. |\n\n| • | Organic growth of approximately 9% on a constant fuel price, fuel spread margin, foreign currency and pro forma basis, driven by increases in both volume and revenue per transaction in certain of our payment programs. |\n\n| • | Although we cannot precisely measure the impact of the macroeconomic environment, in total we believe it had a favorable impact on our consolidated revenue for 2017 over 2016 of approximately $33 million. We believe the favorable impact of higher fuel prices and fuel spread margins, primarily in the U.S., had a favorable impact on consolidated revenues in 2017 over in 2016 of approximately $30 million. Additionally, changes in foreign exchange |\n\n56\nrates had a favorable impact on consolidated revenues in 2017 over in 2016 of approximately $3 million, primarily due to favorable changes in foreign exchange rates in Brazil.\nThese increases were partially offset by the impact of the disposition of the NexTraq telematics business in July 2017 of $23 million.\nNorth America segment revenues. North America revenues increased from $1,279.1 million in 2016 to $1,428.7 million in 2017, an increase of $149.6 million, or 11.7%. The increase in our North America segment revenue was primarily due to:\n| • | The impact of our Cambridge and CLS acquisitions during the third and fourth quarters of 2017, respectively, which contributed approximately $51 million in additional revenue. |\n\n| • | Organic growth of approximately 8%, on a constant fuel price, fuel spread margin and pro forma basis, driven by increases in both volume and revenue per transaction in certain of our payment programs. |\n\n| • | Although we cannot precisely measure the impact of the macroeconomic environment, in total we believe it had a positive impact on our North America segment revenue in 2017 over in 2016 of approximately $26 million, primarily due to the favorable impact of changes in fuel prices and slightly higher fuel spread margins. |\n\nThese increases were partially offset by the impact of the disposition of the NexTraq business in July 2017 of $23 million.\nInternational segment revenue. International segment revenues increased from $552.4 million in 2016 to $820.8 million in 2017, an increase of $268.4 million, or 48.6%. The increase in our International segment revenue was primarily due to:\n\n| • | The impact of acquisitions during 2016 and 2017, which contributed approximately $161 million in additional revenue. |\n\n| • | Organic growth of approximately 11% on a constant macroeconomic and pro forma basis, driven by increases in both volume and revenue per transaction in certain of our payment programs. |\n\n| • | Although we cannot precisely measure the impact of the macroeconomic environment, in total we believe it had a positive impact on our International segment revenue for 2017 over 2016 of approximately $7 million, primarily due to favorable changes in foreign exchange rates in Brazil, as well as favorable impact of changes in fuel prices. |\n\nRevenues by geography, product and source. Set forth below are further breakdowns of revenue by geography, product and source for the years ended December 31, 2017 and 2016 (in millions), which we believe is useful in understanding the results of our business.\n| Year Ended December 31, |\n| (Unaudited) | 2017 | 2016 |\n| Revenue by Geography* | Revenues,net | % oftotalrevenues, net | Revenues,net | % oftotalrevenues, net |\n| United States | $ | 1,401 | 62 | % | $ | 1,279 | 70 | % |\n| United Kingdom | 237 | 11 | 229 | 13 |\n| Brazil | 395 | 18 | 168 | 9 |\n| Other | 218 | 10 | 156 | 8 |\n| Consolidated revenues, net | $ | 2,250 | 100 | % | $ | 1,832 | 100 | % |\n\n*Columns may not calculate due to rounding.\n57\n| Year Ended December 31, |\n| (Unaudited) | 2017 | 2016 |\n| Revenue by Product Category* | Revenues,net | % of total revenues, net | Revenues,net | % of totalrevenues, net |\n| Fuel cards1 | $ | 1,096 | 49 | % | $ | 997 | 54 | % |\n| Corporate payments | 262 | 12 | 180 | 10 |\n| Tolls | 327 | 15 | 103 | 6 |\n| Lodging | 127 | 6 | 101 | 5 |\n| Gift | 194 | 9 | 185 | 10 |\n| Other1 | 244 | 11 | 266 | 15 |\n| Consolidated revenues, net | $ | 2,250 | 100.0 | % | $ | 1,832 | 100 | % |\n\n*Columns may not calculate due to rounding.\n1 Amounts shown for 2016 reflect corrections in estimated allocation of revenue by source from previously disclosed amounts.\n| Year Ended December 31,8 |\n| (Unaudited) | 2017 | 2016 |\n| Major Sources of Revenue* | Revenues,net | % of totalrevenues, net | Revenues,net | % of totalrevenues, net |\n| Customer |\n| Processing and program revenue1 | $ | 1,093 | 49 | % | $ | 809 | 44 | % |\n| Late fees and finance charges2 | 141 | 6 | 118 | 6 |\n| Miscellaneous fees3 | 129 | 6 | 129 | 7 |\n| 1,363 | 61 | 1,057 | 58 |\n| Merchant |\n| Discount revenue (Fuel)4 | 303 | 13 | 260 | 14 |\n| Discount revenue (Nonfuel)5 | 175 | 8 | 157 | 9 |\n| Tied to fuel-price spreads6 | 220 | 10 | 194 | 11 |\n| Program revenue7 | 189 | 8 | 164 | 9 |\n| Consolidated revenues, net | $ | 2,250 | 100 | % | $ | 1,832 | 100 | % |\n\n1Includes revenue from customers based on accounts, cards, devices, transactions, load amounts, and/or purchase mounts, etc. for participation in our various fleet and workforce related programs; as well as, revenue from partners (e.g., major retailers, leasing companies, oil companies, petroleum marketers, etc.) for processing and network management services. Primarily represents revenue from North American trucking, lodging, prepaid benefits, telematics, gift cards and toll related businesses.\n2Fees for late payment and interest charges for carrying a balanced charged to a customer.\n3Non-standard fees charged to customers based on customer behavior or optional participation, primarily including high credit risk surcharges, over credit limit charges, minimum processing fees, printing and mailing fees, environmental fees, etc.\n4Interchange revenue directly influenced by the absolute price of fuel and other interchange related to fuel products.\n5Interchange revenue related to nonfuel products.\n6Revenue derived from the difference between the price charged to a fleet customer for a transaction and the price paid to the merchant for the same transaction.\n7Revenue derived primarily from the sales of equipment, software and related maintenance to merchants.\n8 Amounts shown for the years ended December 31, 2017 and 2016 reflect corrections in estimated allocation of revenue by source from previously disclosed amounts.\n* We may not be able to precisely calculate revenue by source, as certain estimates were made in these allocations. Columns may not calculate due to rounding. This table reflects how management views the sources of revenue and may not be consistent with prior disclosure.\n58\nConsolidated operating expenses\nMerchant commission. Merchant commissions increased from $104.3 million in 2016 to $113.1 million in 2017, an increase of $8.8 million or 8.4%. This increase was primarily due to the fluctuation of the margin between the wholesale cost and retail price of fuel and the impact of higher volume in certain revenue streams where merchant commissions are paid.\nProcessing. Processing expenses increased from $355.4 million in 2016 to $429.6 million in 2017, an increase of $74.2 million or 20.9%. Increases in processing expenses were primarily due to expenses related to acquisitions completed in 2016 and 2017 of approximately $62 million, as well as the impact of changes in foreign exchange rates, partially offset by the impact of negotiated lower vendor processing costs. The increase in bad debt was primarily due to bad debt inherent in the acquired STP business. These increases were partially offset by the impact of disposition of the NexTraq business of approximately $6 million.\nSelling. Selling expenses increased from $131.4 million in 2016 to $170.7 million in 2017, an increase of $39.3 million or 29.9%. Increases in spending were primarily due to ongoing expenses related to acquisitions completed in 2016 and 2017 of approximately $26 million and additional spending in certain lines of business. These increases were partially offset by the impact of disposition of the NexTraq business of approximately $2 million.\nGeneral and administrative. General and administrative expense increased from $283.6 million in 2016 to $387.7 million in 2017, an increase of $104.1 million or 36.7%. The increase was primarily due to ongoing expenses related to acquisitions completed in 2016 and 2017 of approximately $42 million, increased stock based compensation expense of approximately $30 million and increases in other professional and legal fees totaling approximately $22 million. These increases were partially offset by the impact of disposition of the NexTraq business of approximately $2 million.\nDepreciation and amortization. Depreciation and amortization increased from $203.3 million in 2016 to $264.6 million in 2017, an increase of $61.3 million or 30.2%. The increase was primarily due to amortization of intangible assets related to acquisitions completed in 2016 and 2017 of approximately $47 million and increased capital spending. These increases were partially offset by the impact of disposition of the NexTraq business of approximately $4 million.\nInvestment loss. Investment losses increased from $36.4 million in 2016 to $53.2 million in 2017. We regularly evaluate the carrying value of our Masternaut investment and during the third quarter of 2017, we determined that the fair value of our 44% investment in Masternaut had declined as a result of our loss of significant influence due to the amendment of the Masternaut investment agreement, executed September 30, 2017, and the operating results of Masternaut. As a result, we determined that the carrying value of our investment exceeded its fair value, and concluded that this decline in value was other than temporary. We recorded a $44.6 million impairment loss in the Masternaut investment that includes adjustment for $31.4 million of currency translation losses previously recognized in accumulated other comprehensive income.\nOther (income) expense, net. Other income, net was $173.4 million in 2017, compared to other expense, net of $3.0 million in 2016. The increase was due primarily to the pre-tax gain on the sale of our NexTraq business of $175 million in 2017.\nInterest expense, net. Interest expense increased from $71.9 million in 2016 to $107.1 million in 2017, an increase of $35.3 million or 49.0%. The increase in interest expense is primarily due to the impact of additional borrowings to finance the acquisitions in 2016 and 2017, share buybacks and increases in LIBOR. The following table sets forth the average interest rates paid on borrowings under our Credit Facility, excluding the related unused credit facility fees.\n| (Unaudited) | 2017 | 2016 |\n| Term loan A | 2.79 | % | 2.05 | % |\n| Term loan B | 3.28 | % | 3.75 | % |\n| Domestic Revolver A | 2.88 | % | 2.07 | % |\n| Foreign Revolver B | 2.05 | % | 1.84 | % |\n| Foreign Revolver B swing line | 2.01 | % | 1.84 | % |\n\nThe average unused credit facility fee for Domestic Revolver A was 0.35% and 0.31% in 2017 and 2016, respectively.\n59\nLoss on extinguishment of debt. Loss on extinguishment of debt of $3.3 million relates to our write-off of debt issuance costs associated with the refinancing of our existing credit facility during the third quarter of 2017.\nProvision for income taxes. The provision for income taxes decreased from $190.5 million in 2016 to $153.4 million in 2017, a decrease of $37.1 million or 19.5%, primarily driven by the impact of the enactment of the Tax Act, partially offset by the increase in pretax book income for 2017 as compared to 2016. On December 22, 2017, the U.S. government enacted tax legislation referred to as the Tax Act. The Tax Act makes broad and complex changes to the U.S. tax code, including, but not limited to reducing the U.S. federal corporate tax rate from 35% to 21% and requiring companies to pay a one-time transition tax on certain unrepatriated earnings of foreign subsidiaries. The transition tax can be paid over eight years.\nAlso, the SEC staff issued Staff Accounting Bulletin (\"SAB\") 118, which provides guidance on accounting for the tax effects of the Tax Act. In accordance with SAB 118, we have a one-year measurement period in which to complete our accounting for the Tax Act.\nWe have made an estimate of the effects on our existing deferred tax balances and the one-time transition tax, which resulted in a provisional net tax benefit of $128.2 million, which is included as a component of income tax expense from continuing operations. We remeasured certain deferred tax assets and liabilities after considering the U.S. federal income tax rate reduction to 21%. The one-time transition tax is based on our total post-1986 earnings and profits that we previously deferred from U.S. income taxes. In 2017, we recorded a provisional amount for the one-time transition tax expense of $81.8 million, net of foreign tax credits.\nNet income. For the reasons discussed above, our net income increased from $452.4 million in 2016 to $740.2 million in 2017, an increase of $287.8 million or 63.6%, primarily due to the impact of the enactment of the Tax Act on earnings of approximately $127.5 million and the gain on the disposition of NexTraq of $109.2 million, partially offset by incremental amortization expense, stock based compensation expense, impairment of our investment in Masternaut and legal fees during 2017.\nOperating income and operating margin\nConsolidated operating income. Operating income increased from $754.2 million in 2016 to $883.8 million in 2017, an increase of $129.6 million or 17.2%. Consolidated operating margin was 41.2% in 2016 and 39.3% in 2017. The increase in operating income was primarily due to acquisitions completed in 2016 and 2017, organic growth, as well as the positive impact of the macroeconomic environment of approximately $25 million, as previously discussed. These increases were partially offset by higher operating expenses related to acquisitions completed in 2016 and 2017 of approximately $178 million, additional stock based compensation of approximately $30 million, higher professional and legal fees totaling approximately $22 million and the disposition of the NexTraq business in July 2017 of approximately $8 million. The decrease in operating margin is driven by the items discussed above.\nFor the purpose of segment operating results, we calculate segment operating income by subtracting segment operating expenses from segment revenue. Segment operating margin is calculated by dividing segment operating income by segment revenue.\nNorth America segment operating income. North America operating income increased from $506.4 million in 2016 to $541.6 million in 2017, an increase of $35.2 million, or 6.9%. North America operating margin was 39.6% in 2016 and 37.9% in 2017. The increase in operating income was due primarily to organic growth and the positive impact of the macroeconomic environment of approximately $24 million, driven primarily by higher fuel prices. These increases were partially offset by additional stock based compensation of approximately $21 million, higher operating expenses related to acquisitions completed in 2017 of approximately $50 million, higher professional and legal fees totaling approximately $22 million and the disposition of the NexTraq business in July 2017 of approximately $8 million. The decrease in operating margin is driven by the items discussed above.\nInternational segment operating income. International operating income increased from $247.7 million in 2016 to $342.2 million in 2017, an increase of $94.4 million, or 38.1%. International operating margin was 44.8% in 2016 and 41.7% in 2017. The increase in operating income was due primarily to the impact of acquisitions completed in 2016 and 2017 and organic growth and the slightly positive impact of the macroeconomic environment. These increases were partially offset by higher operating expenses related to acquisitions completed in 2016 and 2017 of approximately $128 million and additional stock based compensation of approximately $9 million. The decrease in operating margin is driven by the items discussed above.\n60\nYear ended December 31, 2016 compared to the year ended December 31, 2015\nThe following table sets forth selected consolidated statement of income and selected operational data for the years ended December 31, 2016 and 2015 (in millions, except percentages).\n\n| Year endedDecember 31,2016 | % of totalrevenue | Year endedDecember 31,2015 | % of totalrevenue | Increase(decrease) | % Change |\n| North America | $ | 1,279.1 | 69.8 | % | $ | 1,232.0 | 72.3 | % | $ | 47.1 | 3.8 | % |\n| International | 552.4 | 30.2 | % | 470.9 | 27.7 | % | 81.5 | 17.3 | % |\n| Total revenues, net | 1,831.5 | 100.0 | % | 1,702.9 | 100.0 | % | 128.7 | 7.6 | % |\n| Consolidated operating expenses: |\n| Merchant commissions | 104.3 | 5.7 | % | 108.3 | 6.4 | % | (3.9 | ) | (3.6 | )% |\n| Processing | 355.4 | 19.4 | % | 331.1 | 19.4 | % | 24.3 | 7.4 | % |\n| Selling | 131.4 | 7.2 | % | 109.1 | 6.4 | % | 22.4 | 20.5 | % |\n| General and administrative | 283.6 | 15.5 | % | 297.7 | 17.5 | % | (14.1 | ) | (4.7 | )% |\n| Depreciation and amortization | 203.3 | 11.1 | % | 193.5 | 11.4 | % | 9.8 | 5.1 | % |\n| Other operating, net | (0.7 | ) | — | % | (4.2 | ) | 0.2 | % | (3.6 | ) | (83.7 | )% |\n| Operating income | 754.2 | 41.2 | % | 667.5 | 39.2 | % | 86.6 | 13.0 | % |\n| Investment loss | 36.4 | 2.0 | % | 57.7 | 3.4 | % | (21.3 | ) | (37.0 | )% |\n| Other expense, net | 3.0 | 0.2 | % | 2.5 | 0.1 | % | 0.5 | 18.2 | % |\n| Interest expense, net | 71.9 | 3.9 | % | 71.3 | 4.2 | % | 0.6 | 0.8 | % |\n| Provision for income taxes | 190.5 | 10.4 | % | 173.6 | 10.2 | % | 17.0 | 9.8 | % |\n| Net income | $ | 452.4 | 24.7 | % | $ | 362.4 | 21.3 | % | $ | 90.0 | 24.8 | % |\n| Operating income for segments: |\n| North America | $ | 506.4 | $ | 442.0 | $ | 64.4 | 14.6 | % |\n| International | 247.7 | 225.5 | 22.3 | 9.9 | % |\n| Operating income | $ | 754.2 | $ | 667.5 | $ | 86.6 | 13.0 | % |\n| Operating margin for segments: |\n| North America | 39.6 | % | 35.9 | % | 3.7 | % |\n| International | 44.8 | % | 47.9 | % | (3.0 | )% |\n| Total | 41.2 | % | 39.2 | % | 2.0 | % |\n\nNM = Not Meaningful\nRevenues\nOur consolidated revenue increased from $1,702.9 million in 2015 to $1,831.5 million in 2016, an increase of $128.7 million, or 7.6%. The increase in our consolidated revenue was primarily due to the following:\n| • | The impact of acquisitions completed in 2016, which contributed approximately $87 million in additional revenue. |\n\n| • | Organic growth in certain of our payment programs driven primarily by increases in both volume and revenue per transaction. |\n\n| • | Partially offsetting this growth was the negative impact of the macroeconomic environment. Although we cannot precisely measure the impact of the macroeconomic environment, in total we believe it had a negative impact on our consolidated revenue for 2016 over the comparable period in 2015 of approximately $109 million. We believe the impact of lower fuel prices, primarily in the U.S., and lower fuel spread margins, had an unfavorable impact on consolidated revenues of approximately $66 million. Additionally, changes in foreign exchange rates had an unfavorable impact on consolidated revenues of approximately $43 million due to unfavorable fluctuations in rates in most geographies in 2016 compared to 2015. |\n\n61\nNorth America segment revenues. North America revenue increased from $1,232.0 million in 2015 to $1,279.1 million in 2016, an increase of $47.1 million, or 3.8%. The increase in our North America revenue was primarily due to:\n| • | Organic growth in certain of our payment programs driven by increases in both volume and revenue per transaction. |\n\n| • | Partially offsetting the organic growth was the negative impact of macroeconomic environment. Although we cannot precisely measure the impact of the macroeconomic environment, in total we believe it had a negative impact on our North America segment revenue in 2016 over the comparable period in 2015 of approximately $65 million, primarily due to the impact of lower fuel prices and lower fuel spread margins. |\n\nInternational segment revenue. International segment revenues increased from $470.9 million in 2015 to $552.4 million in 2016, an increase of $81.5 million, or 17.3%. The increase in our International segment revenue was primarily due to:\n\n| • | The impact of acquisitions during 2016, which contributed approximately $87 million in additional revenue. |\n\n| • | Organic growth in certain of our payment programs driven by increases in both volume and revenue per transaction. |\n\n| • | Partially offsetting this growth was the negative impact of the macroeconomic environment. Although we cannot precisely measure the impact of the macroeconomic environment, in total we believe it had a negative impact on our International segment revenue for 2016 over the comparable period in 2015 of approximately $44 million, primarily due to unfavorable fluctuations in foreign exchange rates in most geographies where we do business and slightly lower fuel prices. |\n\nRevenues by geography and product. Set forth below are further breakdowns of revenue by geography and product for the years ended December 31, 2016 and 2015 (in millions), which we believe is useful in understanding the results of our business.\n| Year Ended December 31, |\n| (Unaudited) | 2016 | 2015 |\n| Revenue by Geography* | Revenues,net | % of totalrevenues, net | Revenues,net | % of totalrevenues, net |\n| United States | $ | 1,279 | 70 | % | $ | 1,232 | 72 | % |\n| United Kingdom | 229 | 13 | 248 | 15 | % |\n| Brazil | 168 | 9 | 85 | 5 | % |\n| Other | 156 | 8 | 138 | 8 | % |\n| Consolidated revenues, net | $ | 1,832 | 100 | % | $ | 1,703 | 100 | % |\n\n*Columns may not calculate due to rounding.\n| Year Ended December 31, |\n| (Unaudited) | 2016 | 2015 |\n| Revenue by Product Category* | Revenues,net | % of totalrevenues, net | Revenues,net | % of total revenues, net |\n| Fuel cards1 | $ | 997 | 54 | % | $ | 992 | 58 | % |\n| Corporate payments | 180 | 10 | 162 | 10 | % |\n| Tolls | 103 | 6 | 9 | 1 | % |\n| Lodging | 101 | 5 | 92 | 5 | % |\n| Gift | 185 | 10 | 170 | 10 | % |\n| Other1 | 266 | 15 | 278 | 16 | % |\n| Consolidated revenues, net | $ | 1,832 | 100 | % | $ | 1,703 | 100 | % |\n\n*Columns may not calculate due to rounding.\n1 Amounts shown for the years ended December 31, 2016 and 2015 reflect corrections in estimated allocation of revenue by product from previously disclosed amounts.\nConsolidated operating expenses\nMerchant commission. Merchant commissions decreased from $108.3 million in 2015 to $104.3 million in 2016, a decrease of$3.9 million, or 3.6%. This decrease was primarily due to the fluctuation of the margin between the wholesale cost and retail price of fuel, which impacted merchant commissions in certain card programs, as well as the impact of fluctuations in foreign exchange rates.\n62\nProcessing. Processing expenses increased from $331.1 million in 2015 to $355.4 million in 2016, an increase of $24.3 million, or 7.4%. Increases in processing expenses were primarily due to ongoing expenses related to acquisitions completed in 2016 and incremental bad debt expense, partially offset by the impact of fluctuations in foreign exchange rates and lower negotiated vendor processing costs.\nSelling. Selling expenses increased from $109.1 million in 2015 to $131.4 million in 2016, an increase of $22.4 million, or 20.5%. Increases in spending were primarily due to ongoing expenses related to acquisitions completed in 2016 as well as additional sales and marketing spending in certain markets, partially offset by the impact of fluctuations in foreign exchange rates.\nGeneral and administrative. General and administrative expense decreased from $297.7 million in 2015 to $283.6 million in 2016, a decrease of $14.1 million, or 4.7%. The decrease was primarily due to decreased stock based compensation of approximately $26 million from the comparable period in 2015 and the impact of fluctuations in foreign exchange rates, partially offset by ongoing expenses related to acquisitions completed in 2016 and an incremental $2 million in acquisition related expenses over 2015.\nDepreciation and amortization. Depreciation and amortization increased from $193.5 million in 2015 to $203.3 million in 2016, an increase of $9.8 million, or 5.1%. The increase was primarily due to ongoing expenses related to acquisitions completed in 2016, partially offset by movements in and adjustments from changes in foreign exchange rates of approximately $2 million.\nOther operating, net. Other operating, net decreased from $4.2 million in 2015 to $0.7 million in 2016. The decrease is due to favorable reversals of various contingent liabilities for tax indemnifications related to our acquisitions of DB Trans S.A. (\"DB\") and VB in Brazil in 2015.\nInvestment loss. Losses at our equity method investment decreased from $57.7 million in 2015 to $36.4 million in 2016. The decrease was primarily due to a non-recurring gain of $13.8 million during 2016, as well as less costs incurred to restructure the operations of the business and a smaller impairment of our investment, compared to 2015.\nWe regularly evaluate our investments, which are not carried at fair value, for other than temporary impairment in accordance with U. S. GAAP. During the fourth quarter of 2016, we determined that the performance improvement initiatives planned at Masternaut were more challenging to implement than we originally projected. As a result, we recorded a $36.1 million non-cash impairment charge in our equity method investment in 2016, compared to a $40 million charge in 2015.\nInterest expense, net. Interest expense was $71.3 million in 2015 compared to $71.9 million in 2016. The following table sets forth the average interest rates paid on borrowings under our Credit Facility, excluding the relevant unused credit facility fees.\n| (Unaudited) | 2016 | 2015 |\n| Term loan A | 2.05 | % | 1.94 | % |\n| Term loan B | 3.75 | % | 3.75 | % |\n| Domestic Revolver A | 2.07 | % | 1.95 | % |\n| Foreign Revolver B | 1.84 | % | 2.36 | % |\n| Foreign Revolver B swing line | 1.84 | % | 2.29 | % |\n\nThe average unused credit facility fee for Domestic Revolver A was 0.31% and 0.35% in 2016 and 2015, respectively.\nProvision for income taxes. The provision for income taxes increased from $173.6 million in 2015 to $190.5 million in 2016, an increase of $17.0 million, or 9.8%. The increase in income taxes from 2015 to 2016 was primarily driven by the increase in book earnings for 2016 as compared to 2015. The increase in taxes was partially offset by a decrease in our effective tax rate from 32.4% in 2015 to 29.7% in 2016. The decrease in our effective tax rate was primarily due to the adoption of ASU 2016-09, \"Compensation-Stock Compensation: Improvements to Employee Share-Based Payment Accounting\", which resulted in excess tax benefits being recorded as a reduction of income tax expense during 2016, rather than additional paid in capital as discussed in the summary of significant accounting policies footnote. We also had a non-recurring net gain recorded by our equity method investment, which favorably impacted pre-tax earnings but was not subject to U.S. income taxes and the impact of certain tax planning initiatives that were implemented during 2016. We pay taxes in many different taxing jurisdictions, including the U.S., most U.S. states and many non-U.S. jurisdictions. The tax rates in certain non-U.S. taxing jurisdictions are\n63\nlower than the U.S. tax rate. Consequently, as our earnings fluctuate between taxing jurisdictions, our effective tax rate fluctuates.\nNet income. For the reasons discussed above, our net income increased from $362.4 million in 2015 to $452.4 million in 2016, an increase of $90.0 million, or 24.8%.\nOperating income and operating margin\nConsolidated operating income. Operating income increased from $667.5 million in 2015 to $754.2 million in 2016, an increase of $86.6 million, or 13.0%. Consolidated operating margin was 39.2% in 2015 and 41.2% in 2016. The increase in operating income was primarily due to acquisitions completed in 2016, $26 million less stock based compensation expense compared to 2015 and organic growth in the business, partially offset by the negative impact of the macroeconomic environment of approximately $82 million, driven by lower fuel prices and spreads, and unfavorable fluctuations in foreign exchange rates.\nFor the purpose of segment operating results, we calculate segment operating income by subtracting segment operating expenses from segment revenue. Segment operating margin is calculated by dividing segment operating income by segment revenue.\nNorth America segment operating income. North America operating income increased from $442.0 million in 2015 to $506.4 million in 2016, an increase of $64.4 million, or 14.6%. North America operating margin was 35.9% in 2015 and 39.6% in 2016. The increase in operating income was due primarily to less stock based compensation expense compared to 2015 and organic growth in the business, partially offset by the negative impact of the macroeconomic environment of approximately $56 million, driven by lower fuel prices and lower fuel spread margins.\nInternational segment operating income. International operating income increased from $225.5 million in 2015 to $247.7 million in 2016, an increase of $22.3 million, or 9.9%. International operating margin was 47.9% in 2015 and 44.8% in 2016. The increase in operating income was due primarily to acquisitions completed in 2016 and organic growth in the business, partially offset by the approximately $26 million unfavorable impact of the macroeconomic environment, specifically unfavorable changes in foreign exchange rates, as well as the negative impact of fuel prices internationally. The impact of changes in fuel price spreads was negligible.\nLiquidity and capital resources\nOur principal liquidity requirements are to service and repay our indebtedness, make acquisitions of businesses and commercial account portfolios, repurchase shares of our common stock and meet working capital, tax and capital expenditure needs.\nSources of liquidity. At December 31, 2017, our cash balances totaled $1,130.9 million, with approximately $217.3 million restricted. Restricted cash represents customer deposits in the Czech Republic and in our Comdata business in the U.S., as well as collateral received from customers for cross-currency transactions in our Cambridge business, which are restricted from use other than to repay customer deposits, as well as secure and settle cross-currency transactions.\nAt December 31, 2017, cash and cash equivalents held in foreign subsidiaries where we have determined we are permanently reinvested was $556.1 million. All of the cash and cash equivalents held by our foreign subsidiaries, excluding restricted cash, are available for general corporate purposes. Our current intent is to permanently reinvest these funds outside of the U.S. Our current expectation for funds held in our foreign subsidiaries is to use the funds to finance foreign organic growth, to pay for potential future foreign acquisitions and to repay any foreign borrowings that may arise from time to time. We currently believe that funds generated from our U.S. operations, along with available borrowing capacity in the U.S. will be sufficient to fund our U.S. operations for the foreseeable future, and therefore do not foresee a need to repatriate cash held by our foreign subsidiaries to fund our U.S. operations.\nIn the fourth quarter of 2017, the U.S. enacted the Tax Act, which includes provisions for a tax on all previously undistributed earnings in foreign jurisdictions. We have provisionally recorded an $81.8 million charge on these undistributed earnings in 2017. As permitted by the Tax Act, we intend to pay the one-time transition tax in eight annual interest-free installments beginning in 2018. We are currently evaluating the remaining undistributed foreign earnings for which we have not provided deferred taxes for foreign withholding tax, as these earnings are considered to be indefinitely reinvested. The amount of these unrecorded deferred taxes is not expected to be material.\n64\nWe utilize an accounts receivable Securitization Facility to finance a majority of our domestic fuel card receivables, to lower our cost of borrowing and more efficiently use capital. We generate and record accounts receivable when a customer makes a purchase from a merchant using one of our card products and generally pay merchants before collecting the receivable. As a result, we utilize the Securitization Facility as a source of liquidity to provide the cash flow required to fund merchant payments while we collect customer balances. These balances are primarily composed of charge balances, which are typically billed to the customer on a weekly, semimonthly or monthly basis, and are generally required to be paid within 14 days of billing. We also consider the undrawn amounts under our Securitization Facility and Credit Facility as funds available for working capital purposes and acquisitions. At December 31, 2017, we had no additional liquidity under our Securitization Facility. At December 31, 2017, we had approximately $615 million available under our Credit Facility.\nBased on our current forecasts and anticipated market conditions, we believe that our current cash balances, our available borrowing capacity and our ability to generate cash from operations, will be sufficient to fund our liquidity needs for at least the next twelve months. However, we regularly evaluate our cash requirements for current operations, commitments, capital requirements and acquisitions, and we may elect to raise additional funds for these purposes in the future, either through the issuance of debt or equity securities. We may not be able to obtain additional financing on terms favorable to us, if at all.\nCash flows\nThe following table summarizes our cash flows for the years ended December 31, 2017, 2016 and 2015.\n\n| Year ended December 31, |\n| (in millions) | 2017 | 2016 | 2015 |\n| Net cash provided by operating activities | $ | 675.7 | $ | 705.9 | $ | 754.6 |\n| Net cash used in investing activities | (497.8 | ) | (1,389.6 | ) | (99.4 | ) |\n| Net cash provided by (used in) financing activities | 251.9 | 754.0 | (648.1 | ) |\n\nOperating activities. Net cash provided by operating activities decreased from $705.9 million in 2016 to $675.7 million in 2017. Operating cash flows were primarily affected by higher net income, the gain on the sale of our NexTraq business in 2017 (treated as an investing activity) and deferred income taxes resulting from enactment of the Tax Act. Also included in cash flows from operating activities were unfavorable working capital adjustments primarily due to the timing of cash receipts and payments in 2017 over the comparable period in 2016.\nNet cash provided by operating activities decreased from $754.6 million in 2015 to $705.9 million in 2016. The decrease was primarily due to changes in working capital driven by fluctuations in receivables and payables, largely due to timing of month end transactions and volume. Cash flow was favorably impacted by additional net income of $90 million during 2016 over the comparable period in 2015.\nInvesting activities. Net cash used in investing activities decreased from $1.4 billion in 2016 to $497.8 million in 2017. This decrease was primarily due to reduction in cash outlay for acquisitions and the proceeds received from the sale of our NexTraq business during the third quarter of 2017.\nNet cash used in investing activities increased from $99.4 million in 2015 to $1,389.6 million in 2016. This increase was primarily due to the increase in cash paid for our STP and Travelcard acquisitions completed in 2016.\nFinancing activities. Net cash provided by financing activities decreased from $754.0 million in 2016 to $251.9 million in 2017. The decrease is primarily due to additional repayments on our Credit Facility of $599.8 million in 2017 over 2016, and increased spending to repurchase our common stock of $214.7 million, partially offset by an increase in borrowings of $243 million on our Securitization Facility and an increase in borrowings of $55.5 million on our Credit Facility.\nNet cash from financing activities increased from net cash used of $648.1 million in 2015 to net cash provided of $754.0 million in 2016. The increase was primarily due to an increase in net borrowings on our revolving Credit Facility and term loans of $952.2 million and $585.0 million, respectively, to fund acquisitions during 2016.\n65\nCapital spending summary\nOur capital expenditures increased from $59.0 million in 2016 to $70.1 million in 2017, an increase of $11 million or 18.8%. This increase is primarily due to increased spending on strategic projects, including continued investment in our operating systems, as well as incremental spending related to acquisitions in 2016 and 2017.\nOur capital expenditures increased from $41.9 million in 2015 to $59.0 million in 2016, an increase of $17 million or 40.9%. This increase was primarily due to increased spending on strategic projects, including continued investment in our GFN application.\nCredit Facility\nFLEETCOR Technologies Operating Company, LLC, and certain of our domestic and foreign owned subsidiaries, as designated co-borrowers (the “Borrowers”), are parties to a $4.33 billion Credit Agreement (the \"Credit Agreement\"), with Bank of America, N.A., as administrative agent, swing line lender and local currency issuer, and a syndicate of financial institutions (the “Lenders”), which has been amended multiple times. The Credit Agreement provides for senior secured credit facilities consisting of a revolving A credit facility in the amount of $1.285 billion, a term loan A facility in the amount of $2.69 billion and a term loan B facility in the amount of $350.0 million as of December 31, 2017. The revolving credit facility consists of (a) a revolving A credit facility in the amount of $800 million, with sublimits for letters of credit and swing line loans, (b) a revolving B facility in the amount of $450 million for swing line loans and multi-currency borrowings and, (c) a revolving C facility in the amount of $35 million for multi-currency borrowings in Australian Dollars or New Zealand Dollars.\nOn January 20, 2017, we entered into the second amendment to the Credit Agreement, which established a new term B loan. Interest on the term B loan facility accrues based on the Eurocurrency Rate or the Base Rate at 2.25% for Eurocurrency Loans and at 1.25% for Base Rate Loans. Interest on amounts outstanding under the Credit Agreement (other than the term B loan) accrues based on the British Bankers Association LIBOR Rate (the Eurocurrency Rate), plus a margin based on a leverage ratio, or our option, the Base Rate (defined as the rate equal to the highest of (a) the Federal Funds Rate plus 0.50%, (b) the prime rate announced by Bank of America, N.A., or (c) the Eurocurrency Rate plus 1.00%) plus a margin based on a leverage ratio. In addition, the Company pays a quarterly commitment fee at a rate per annum ranging from 0.20% to 0.40% of the daily unused portion of the credit facility.\nOn August 2, 2017, we entered into the third amendment to the Credit Agreement, which increased the total facility by $708.7 million and extended the terms of the credit facilities. The stated maturity dates for the term A loan, revolving loans and letters of credit under the Credit Agreement is August 2, 2022 and August 2, 2024 for the term B loan. The term A and revolver pricing remains the same and the term B pricing was reduced by 25 basis points to LIBOR plus 200 basis points.\nAt December 31, 2017, the interest rate on the term A loan and the domestic revolving A facility was 3.32%, the interest rate on the foreign revolving B facility was 2.25%, the interest rate on the revolving B facility foreign swing line of credit was 2.22% and the interest rate on the term B loan was 3.57%. The unused credit facility was 0.35% for all revolving facilities at December 31, 2017.\nThe Credit Agreement also contains an accordion feature for borrowing an additional $750 million in term A, term B or revolver A debt. Proceeds from the Credit Facility may be used for working capital purposes, acquisitions, and other general corporate purposes.\nThe term loans are payable in quarterly installments and are due on the last business day of each March, June, September, and December with the final principal payment due on the respective maturity date. Borrowings on the revolving line of credit are repayable at our option of one, two, three or nine months after borrowing, depending on the term of the borrowing on the facility. Borrowings on the foreign swing line of credit are due no later than ten business days after such loan is made.\nThe Credit Facility contains representations, warranties and events of default, as well as certain affirmative and negative covenants, customary for financings of this nature. These covenants include limitations on the ability to pay dividends and make other restricted payments under certain circumstances and compliance with certain financial ratios.As of December 31, 2017, we were in compliance with each of the covenants under the Credit Facility.\nOur Credit Agreement contains a number of negative covenants restricting, among other things, limitations on liens (with exceptions for our Securitization Facility) and investments, incurrence or guarantees of indebtedness, mergers, acquisitions, dissolutions, liquidations and consolidations, dispositions, dividends and other restricted payments and prepayments of other indebtedness. In particular, we are not permitted to make any restricted payments (which includes any dividend or other distribution) except that the we may declare and make dividend payments or other distributions to our stockholders so long as (i) on a pro forma basis both before and after the distribution the consolidated leverage ratio is not greater than 3.25:1.00 and we are in compliance with the financial covenants and (ii) no default or event of default shall exist or result therefrom. The\n66\nCredit Agreement also contains customary events of default. The Credit Agreement includes financial covenants where the Company is required to maintain a consolidated leverage ratio to consolidated EBITDA of less than (i) 4.00 to 1.00 as of the end of any fiscal quarter provided that in connection with any Material Acquisition the leverage ratio may be increased to 4.25 to 1.00 for the quarter in which the Material Acquisition is consummated and the next three fiscal quarters; and a consolidated interest coverage ratio of no more than 4.00 to 1.0.\nThe obligations of the Borrowers under the Credit Agreement are secured by substantially all of the assets of FLEETCOR and its domestic subsidiaries, pursuant to a security agreement and includes a pledge of (i) 100% of the issued and outstanding equity interests owned by us of each Domestic Subsidiary and (2) 66% of the voting shares of the first-tier foreign subsidiaries, but excluding real property, personal property located outside of the U.S., accounts receivables and related assets subject to the Securitization Facility and certain investments required under money transmitter laws to be held free and clear of liens.\nAt December 31, 2017, we had $2.7 billion in borrowings outstanding on term A loan, excluding the related debt discount, $349.1 million in borrowings outstanding on term B loan, excluding the related debt discount, $635 million in borrowings outstanding on the domestic revolving A facility, $28.3 million in borrowings outstanding on the foreign revolving B facility and $6.9 million in borrowings outstanding on the foreign swing line revolving B facility. The Company has unamortized debt discounts of $6.0 million related to the term A facility and $0.7 million related to the term B facility and deferred financing costs of $5.1 million at December 31, 2017. In August 2017, the Company expensed $3.3 million and capitalized $10.6 million of debt issuance costs associated with the refinancing of its Credit Facility. The effective interest rate incurred on term loans was 2.69% and 2.57% during 2017 and 2016, respectively, related to the discount on debt.\nDuring 2017, we made principal payments of $423.2 million on the term loans, $930.0 million on the domestic revolving A facility, $101.7 million on the foreign revolving A facility and $52.7 million on the foreign swing line revolving B facility.\nSecuritization Facility\nWe are a party to a receivables purchase agreement among FleetCor Funding LLC, as seller, PNC Bank, National Association as administrator, and various purchaser agents, conduit purchasers and related committed purchasers parties thereto, which was amended and restated for the Fifth time as of November 14, 2014. We refer to this arrangement as the Securitization Facility. There have been several amendments to the Securitization Facility. The current purchase limit under the Securitization Facility is $950 million and the Securitization Facility expires on November 14, 2020. The Securitization Facility contains certain customary financial covenants.\nThere is a program fee equal to one month LIBOR plus 0.90% or the Commercial Paper Rate plus 0.80% as of December 31, 2017 and one month LIBOR or the Commercial Paper Rate plus 0.90% as of December 31, 2016. The program fee was 1.55% plus 0.86% as of December 31, 2017 and 0.85% plus 0.90% as of December 31, 2016. The unused facility fee is payable at a rate of 0.40% as of December 31, 2017 and 2016.\nUnder a related purchase and sale agreement, dated as of December 20, 2004, and most recently amended on November 14, 2014 to include Comdata as an originator, between FLEETCOR Funding LLC, as purchaser, and certain of our subsidiaries, as originators, the receivables generated by the originators are deemed to be sold to FLEETCOR Funding LLC immediately and without further action upon creation of such receivables. At the request of FLEETCOR Funding LLC, as seller, undivided percentage ownership interests in the receivables are ratably purchased by the purchasers in amounts not to exceed their respective commitments under the facility. Collections on receivables are required to be made pursuant to a written credit and collection policy and may be reinvested in other receivables, may be held in trust for the purchasers, or may be distributed. Fees are paid to each purchaser agent for the benefit of the purchasers and liquidity providers in the related purchaser group in accordance with the Securitization Facility and certain fee letter agreements.\nThe Securitization Facility provides for certain termination events, which includes nonpayment, upon the occurrence of which the administrator may declare the facility termination date to have occurred, may exercise certain enforcement rights with respect to the receivables, and may appoint a successor servicer, among other things.\nWe were in compliance with all financial and non-financial covenant requirements related to our Securitization Facility as of December 31, 2017.\nOther Liabilities\nIn connection with our acquisition of certain businesses, we owe final payments of $29.3 million, of which $3.6 million is payable in the next twelve months and $25.7 million in periods beyond a year.\n67\nStock Repurchase Program\nOn February 4, 2016, our Board of Directors approved a stock repurchase program (the \"Program\") under which we may purchase up to an aggregate of $500 million of our common stock over the following 18 months period. On July 27, 2017, our Board of Directors authorized an increase in the size of the Program by an additional $250 million and an extension of the Program by an additional 18 months. On November 1, 2017, we announced that our Board of Directors had authorized an additional increase in the size of the Program by an another $350 million, resulting in total aggregate repurchases authorized under the Program of $1.1 billion. With the increase and giving effect to $590.1 million of previous repurchases, we may repurchase up to $510 million in shares of our common stock at any time prior to February 1, 2019.\nAny stock repurchases may be made at times and in such amounts as deemed appropriate. The timing and amount of stock repurchases, if any, will depend on a variety of factors including the stock price, market conditions, corporate and regulatory requirements, and any additional constraints related to material inside information we may possess. Any repurchases have been and are expected to be funded by a combination of available cash flow from the business, working capital and debt.\nOn August 3, 2017, as part of the Program, we entered an Accelerated Share Repurchase agreement (\"ASR Agreement\") with a third-party financial institution to repurchase $250 million of our common stock. Pursuant to the ASR Agreement, we delivered $250 million in cash and received 1,491,647 shares based on a stock price of $142.46 on August 7, 2017. The ASR Agreement was completed on September 7, 2017, at which time the we received 263,012 additional shares based on a final weighted average per share purchase price during the repurchase period of $142.48.\nWe accounted for the ASR Agreement as two separate transactions: (i) as shares of reacquired common stock for the shares delivered to us upon effectiveness of the ASR Agreement and (ii) as a forward contract indexed to our common stock for the undelivered shares. The initial delivery of shares was included in treasury stock at cost and results in an immediate reduction of the outstanding shares used to calculate the weighted average common shares outstanding for basic and diluted earnings per share. The forward contracts indexed to our own common stock met the criteria for equity classification, and these amounts were initially recorded in additional paid-in capital and then reclassified to treasury stock upon completion of the ASR agreement.\nSince the beginning of the Program, 4,114,104 shares for an aggregate purchase price of $590.1 million have been repurchased. There were 2,854,959 common shares totaling $402.4 million repurchased under the Program during 2017.\nCritical accounting policies and estimates\nIn applying the accounting policies that we use to prepare our consolidated financial statements, we necessarily make accounting estimates that affect our reported amounts of assets, liabilities, revenue and expenses. Some of these estimates require us to make assumptions about matters that are highly uncertain at the time we make the accounting estimates. We base these assumptions and the resulting estimates on historical information and other factors that we believe to be reasonable under the circumstances, and we evaluate these assumptions and estimates on an ongoing basis. In many instances, however, we reasonably could have used different accounting estimates and, in other instances, changes in our accounting estimates could occur from period to period, with the result in each case being a material change in the financial statement presentation of our financial condition or results of operations. We refer to estimates of this type as critical accounting estimates. Our significant accounting policies are summarized in the consolidated financial statements contained elsewhere in this report. The critical accounting estimates that we discuss below are those that we believe are most important to an understanding of our consolidated financial statements.\nSee Footnote 2 to the Consolidated Financial Statements, Summary of Significant Accounting Policies.\nRevenue recognition and presentation. Revenue is derived from our merchant and network relationships, as well as from customers and partners. We recognize revenue on fees generated through services primarily to commercial fleets, commercial businesses, major oil companies, petroleum marketers and leasing companies and record revenue net of the wholesale cost of the underlying products and services based on the following: (i) we are not the primary obligor in the arrangement and we are not responsible for fulfillment and the acceptability of the product; (ii) we have no inventory risk, do not bear the risk of product loss and do not make any changes to the product or have any involvement in the product specifications; (iii) we do not have significant latitude with respect to establishing the price for the product and (iv) the amount we earn for our services is fixed, within a limited range. We recognize revenue from merchant and network relationships, processing and other arrangements when persuasive evidence of an arrangement exists, the services have been provided to the customer, the sales price is fixed or determinable and collectability is reasonably assured, as more fully described below.\n68\nThrough our merchant and network relationships we provide fuel, prepaid cards, vehicle maintenance, lodging, food, toll, and transportation related services to our customers. We derive revenue from our merchant and network relationships based on the difference between the price charged to a customer for a transaction and the price paid to the merchant or network for the same transaction. Our revenue consists of margin on sales and fees for technical support, processing, communications and reporting. The price paid to a merchant or network may be calculated as (i) the merchant’s wholesale cost of the product plus a markup; (ii) the transaction purchase price less a percentage discount; or (iii) the transaction purchase price less a fixed fee per unit. The difference between the price we pay to a merchant and the merchant’s wholesale cost for the underlying products and services is considered a merchant commission and is recognized as expense when the fuel purchase transaction is executed. We have entered into agreements with major oil companies, petroleum marketers and leasing companies, among others, that specify that a transaction is deemed to be captured when we have validated that the transaction has no errors and have accepted and posted the data to our records.\nWe also derive revenue from customers and partners from a variety of program fees including transaction fees, card fees, network fees, service fees, report fees and other transaction-based fees, which typically are calculated based on measures such as percentage of dollar volume processed, number of transactions processed, or some combination thereof. Such services are provided through proprietary networks or through the use of third-party networks. Transaction fees and other transaction-based fees generated from our proprietary networks and third-party networks are recognized at the time the transaction is captured. Card fees, network fees and program fees are recognized as we fulfill our contractual service obligations. In addition, we recognize revenue from late fees and finance charges, in jurisdictions where permitted under local regulations, primarily in the U.S. and Canada. Such fees are recognized net of a provision for estimated uncollectible amounts, at the time the fees and finance charges are assessed. The Company ceases billing and accruing for late fees and finance charges approximately 30-40 days after the customer’s balance becomes delinquent.\nWe also charge our customers transaction fees to load value onto prepaid fuel, food, toll and transportation vouchers and cards. We recognize fee revenue upon providing the activated fuel, food, toll and transportation vouchers and prepaid cards to the customer. Revenue is recognized on lodging and transportation management services when the lodging stay or transportation service is provided. Revenue is also derived from the sale of equipment and cards in certain of our businesses, which is recognized at the time the device is sold and the risks and rewards of ownership have passed. This revenue is recognized gross of the cost of sales related to the equipment in revenues, net within the Consolidated Statements of Income. The related cost of sales for the equipment is recorded within processing expenses in the Consolidated Statements of Income. We have recorded $96.8 million of expenses related to sales of equipment within the processing expenses line of the Consolidated Statements of Income in 2017. Sales commissions paid to personnel are expensed as incurred.\nWe deliver both stored value cards and card-based services primarily in the form of gift cards. For multiple-deliverable customer contracts, stored value cards and card-based services are separated into two units of accounting. Stored valued cards are generally recognized upon shipment to the customer. Card-based services are recognized when the card services are rendered.\nWe present taxes assessed by the government imposed concurrent with a revenue producing transaction between us and our customers (e.g. VAT) on a net basis within revenues, net.\nOur fiscal year ends on December 31. In certain of our U.K. businesses, we record the operating results using a 4-4-5 week accounting cycle with the fiscal year ending on the Friday on or immediately preceding December 31.\nAccounts receivable. As described above under the heading “Securitization facility,” we maintain a revolving trade accounts receivable Securitization Facility. The current purchase limit under the Securitization Facility is $950 million. Accounts receivable collateralized within our Securitization Facility relate to trade receivables resulting from charge card activity in the U.S. Pursuant to the terms of the Securitization Facility, we transfer certain of our domestic receivables, on a revolving basis, to FLEETCOR Funding LLC (Funding), a wholly-owned bankruptcy remote subsidiary. In turn, Funding sells, without recourse, on a revolving basis, up to $950 million of undivided ownership interests in this pool of accounts receivable to a multi-seller, asset-backed commercial paper conduit (Conduit). Funding maintains a subordinated interest, in the form of over collateralization, in a portion of the receivables sold to the Conduit. Purchases by the Conduit are financed with the sale of highly-rated commercial paper.\nWe utilize proceeds from the sale of our accounts receivable as an alternative to other forms of financing, to reduce our overall borrowing costs. We have agreed to continue servicing the sold receivables for the financial institution at market rates, which approximates our cost of servicing. We retain a residual interest in the accounts receivable sold as a form of credit\n69\nenhancement. The residual interest’s fair value approximates carrying value due to its short-term nature. Funding determines the level of funding achieved by the sale of trade accounts receivable, subject to a maximum amount.\nThe Company’s Consolidated Balance Sheets and Statements of Income reflect the activity related to securitized accounts receivable and the corresponding securitized debt, including interest income, fees generated from late payments, provision for losses on accounts receivable and interest expense. The cash flows from borrowings and repayments, associated with the securitized debt, are presented as cash flows from financing activities.\nForeign receivables are not included in our receivable securitization program. At December 31, 2017 and 2016, there was $811 million and $591 million, respectively, of short-term debt outstanding under our accounts receivable Securitization Facility.\nCredit risk and reserve for losses on receivables. We control credit risk by performing periodic credit evaluations of our customers. Payments from customers are generally due within 14 days or less of billing. We routinely review our accounts receivable balances and make provisions for probable doubtful accounts based primarily on the aging of those balances. Accounts receivable are deemed uncollectible once they age past 90 days and are deemed uncollectible from the customer. We also provide an allowance for receivables aged less than 90 days that we expect will be uncollectible based on historical collections experience including accounts that have filed for bankruptcy. At December 31, 2017, approximately 96% of outstanding accounts receivable were current. Accounts receivable deemed uncollectible are removed from accounts receivable and the allowance for doubtful accounts when internal collection efforts have been exhausted and accounts have been turned over to a third-party collection agency. Recoveries from the third-party collection agency are not significant.\nImpairment of long-lived assets, intangibles and investments. We test our long-lived assets for impairment in accordance with relevant authoritative guidance. We evaluate if impairment indicators related to our property, plant and equipment and other long-lived assets are present. These impairment indicators may include a significant decrease in the market price of a long-lived asset or asset group, a significant adverse change in the extent or manner in which a long-lived asset or asset group is being used or in its physical condition, or a current-period operating or cash flow loss combined with a history of operating or cash flow losses or a forecast that demonstrates continuing losses associated with the use of a long-lived asset or asset group. If impairment indicators are present, we estimate the future cash flows for the asset or asset group. The sum of the undiscounted future cash flows attributable to the asset or group of assets is compared to their carrying amount. The cash flows are estimated utilizing various projections of revenues and expenses, working capital and proceeds from asset disposals on a basis consistent with management’s intended actions. If the carrying amount exceeds the sum of the undiscounted future cash flows, we determine the assets’ fair value by discounting the future cash flows using a discount rate required for a similar investment of like risk and records an impairment charge as the difference between the fair value and the carrying value of the asset group. Generally, we perform our testing of the asset group at the business-line level, as this is the lowest level for which identifiable cash flows are available.\nWe complete an impairment test of goodwill at least annually or more frequently if facts or circumstances indicate that goodwill might be impaired. Goodwill is tested for impairment at the reporting unit level, and the impairment test consists of two steps, as well as a qualitative assessment, as appropriate. We have performed a qualitative assessment of certain of our reporting units. In this qualitative assessment we individually considered the following items for each reporting unit where we determined a qualitative analysis to be appropriate: the macroeconomic conditions, including any deterioration of general conditions, limitations on accessing capital, fluctuations in foreign exchange rates and other developments in equity and credit markets; industry and market conditions, including any deterioration in the environment where the reporting unit operates, increased competition, changes in the products/services and regulator and political developments; cost of doing business; overall financial performance, including any declining cash flows and performance in relation to planned revenues and earnings in past periods; other relevant reporting unit specific facts, such as changes in management or key personnel or pending litigation; events affecting the reporting unit, including changes in the\ncarrying value of net assets, likelihood of disposal and whether there were any other impairment considerations within the business; the overall performance of our share price in relation to the market and our peers; and a quantitative stress test of the previously completed step 1 test from the prior year, updated with current year results, weighted-average cost of capital rates and future projections.\nIn step 1 of the goodwill impairment test for reporting units, the reporting unit’s carrying amount, including goodwill, is compared to its fair value which is measured based upon, among other factors, a discounted cash flow analysis as well as market multiples for comparable companies. If the carrying amount of the reporting unit is greater than its fair value, goodwill is considered impaired and step two must be performed. Step two measures the impairment loss by comparing the implied fair value of reporting unit goodwill with the carrying amount of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit to all the assets and liabilities of that unit (including unrecognized intangibles) as\n70\nif the reporting unit had been acquired in a business combination. The excess of fair value over the amounts allocated to the assets and liabilities of the reporting unit is the implied fair value of goodwill. The excess of the carrying amount over the implied fair value is the impairment loss.\nWe estimated the fair value of our reporting units using a combination of the income approach and the market approach. The income approach utilizes a discounted cash flow model incorporating management’s expectations for future revenue, operating expenses, earnings before interest, taxes, depreciation and amortization, capital expenditures and an anticipated tax rate. We discounted the related cash flow forecasts using an estimated weighted-average cost of capital for each reporting unit at the date of valuation. The market approach utilizes comparative market multiples in the valuation estimate. Multiples are derived by relating the value of guideline companies, based on either the market price of publicly traded shares or the prices of companies being acquired in the marketplace, to various measures of their earnings and cash flow. Such multiples are then applied to the historical and projected earnings and cash flow of the reporting unit in developing the valuation estimate.\nPreparation of forecasts and the selection of the discount rates involve significant judgments about expected future business performance and general market conditions. Significant changes in forecasts, the discount rates selected or the weighting of the income and market approach could affect the estimated fair value of one or more of our reporting units and could result in a goodwill impairment charge in a future period.\nBased on the goodwill asset impairment analysis performed quantitatively on October 1, 2017, we determined that the fair value of each of our reporting units is in excess of the carrying value. No events or changes in circumstances have occurred since the date of our most recent annual impairment test that would more likely than not reduce the fair value of a reporting unit below its carrying amount.\nWe also evaluate indefinite-lived intangible assets (primarily trademarks and trade names) for impairment annually. We also test for impairment if events and circumstances indicate that it is more likely than not that the fair value of an indefinite-lived intangible asset is below its carrying amount. Estimates critical to our evaluation of indefinite-lived intangible assets for impairment include the discount rate, royalty rates used in our evaluation of trade names, projected average revenue growth and projected long-term growth rates in the determination of terminal values. An impairment charge is recorded if the carrying amount of an indefinite-lived intangible asset exceeds the estimated fair value on the measurement date.\nWe also regularly evaluate the carrying value of our investments, which are not carried at fair value, for other-than-temporary impairment. We estimate the fair value of our investments using a combination of the income approach and the market approach. The income approach utilizes a discounted cash flow model incorporating management’s expectations for future revenue, operating expenses, earnings before interest, taxes, depreciation and amortization, capital expenditures and an anticipated tax rate. We discount the related cash flow forecasts using an estimated weighted-average cost of capital for each reporting unit at the date of valuation. The market approach utilizes comparative market multiples in the valuation estimate. Multiples are derived by relating the value of guideline companies, based on either the market price of publicly traded shares or the prices of companies being acquired in the marketplace, to various measures of their earnings and cash flow. Such multiples are then applied to the historical and projected earnings and cash flow of our investments in developing the valuation estimate.\nOn September 30, 2017, we entered into an amended Masternaut Group Holdings Limited (\"Masternaut\") investment agreement that resulted in the loss of significant influence, and we began accounting for the Masternaut investment by applying the cost method. We regularly evaluate the carrying value of our investment and during the third quarter of 2017, we determined that the fair value of our 44% investment in Masternaut had declined as a result of our loss of significant influence. As a result, we determined that the carrying value of our investment exceeded its fair value, and concluded that this decline in value was other than temporary. We recorded a $44.6 million impairment loss in the Masternaut investment that includes adjustment for $31.4 million of currency losses previously recognized in accumulated other comprehensive income, in the year ended December 31, 2017, in the accompanying Consolidated Statements of Income. During the fourth quarters of 2016 and 2015, we determined that the performance improvement initiatives in our investment in Masternaut were taking longer to and were more challenging to implement than originally projected, based on revised cash flow projections provided by the business. As a result, we recorded a $36.1 million and $40 million non-cash impairment charge in its Masternaut investment for 2016 and 2015, respectively.\nIncome taxes. We account for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or\n71\nsettled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date.\nThe ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which the associated temporary differences become deductible. We evaluate on a quarterly basis, whether it is more likely than not that our deferred tax assets will be realized in the future and conclude whether a valuation allowance must be established.\nCurrent accounting guidance clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements and prescribes threshold and measurement attributes for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Under the relevant authoritative literature, the impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more likely than not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50 percent likelihood of being sustained. We include any estimated interest and penalties on tax related matters in income tax expense.\nIn the fourth quarter of 2017, the U.S. government enacted tax legislation referred to as the Tax Act. As a result of Tax Act, the U.S. federal corporate tax rate was reduced from 35% to 21%. The Tax Act also includes provisions for a tax on all previously undistributed earnings in foreign jurisdictions. We have provisionally recorded a $210 million deferred tax benefit for the benefit for the corporate rate reduction on our deferred tax assets and liabilities. Additionally, in 2017, We have provisionally recorded an $81.8 million charge on all previously undistributed earnings in foreign jurisdictions. We are currently evaluating the remaining undistributed foreign earnings for which we have not provided deferred taxes for foreign withholding tax, as these earnings are considered to be indefinitely reinvested. The amount of these unrecorded deferred taxes is not expected to be material. If in the future these earnings are repatriated to the U.S., or if we determine that the earnings will be remitted in the foreseeable future, additional tax provisions may be required. See Note 11 for further information regarding income taxes.\nBusiness combinations. Business combinations completed by us have been accounted for under the acquisition method of accounting. The acquisition method requires that the acquired assets and liabilities, including contingencies, be recorded at fair value determined as of the acquisition date and changes thereafter reflected in income. For significant acquisitions, we obtain independent third-party valuation studies for certain of the assets acquired and liabilities assumed to assist us in determining fair value. Goodwill represents the excess of the purchase price over the fair values of the tangible and intangible assets acquired and liabilities assumed. The results of the acquired businesses are included in our results of operations beginning from the completion date of the applicable transaction.\nEstimates of fair value are revised during an allocation period as necessary when, and if, information becomes available to further define and quantify the fair value of the assets acquired and liabilities assumed. Provisional estimates of the fair values of the assets acquired and liabilities assumed involves a number of estimates and assumptions that could differ materially from the final amounts recorded. The allocation period does not exceed one year from the date of the acquisition. To the extent additional information to refine the original allocation becomes available during the allocation period, the allocation of the purchase price is adjusted. Should information become available after the allocation period, those items are adjusted through operating results. The direct costs of the acquisition are recorded as operating expenses. Certain acquisitions include contingent consideration related to the performance of the acquired operations following the acquisition. Contingent consideration is recorded at estimated fair value at the date of the acquisition, and is remeasured each reporting period, with any changes in fair value recorded in the Consolidated Statements of Income. We estimate the fair value of the acquisition-related contingent consideration using various valuation approaches, as well as significant unobservable inputs, reflecting our assessment of the assumptions market participants would use to value these liabilities.\nStock-based compensation. We account for employee stock options and restricted stock in accordance with relevant authoritative literature. Stock options are granted with an exercise price estimated to be equal to the fair market value on the date of grant as authorized by our board of directors. Options granted have vesting provisions ranging from one to five years and vesting of the options is generally based on the passage of time or performance. Stock option grants are subject to forfeiture if employment terminates prior to vesting. We have selected the Black-Scholes option pricing model for estimating the grant date fair value of stock option awards granted. We have considered the retirement and forfeiture provisions of the options and utilized our historical experience to estimate the expected life of the options. Option forfeitures are accounted for upon occurrence. We base the risk-free interest rate on the yield of a zero coupon U.S. Treasury security with a maturity equal to the expected life of the option from the date of the grant. Stock-based compensation cost is measured at the grant date based on the\n72\nvalue of the award and is recognized as expense over the requisite service period based on the number of years for which the requisite service is expected to be rendered.\nAwards of restricted stock and restricted stock units are independent of stock option grants and are subject to forfeiture if employment terminates prior to vesting. The vesting of shares granted is generally based on the passage of time, performance or market conditions, or a combination of these. Shares vesting based on the passage of time have vesting provisions of one to three years. The fair value of restricted stock where the shares vest based on the passage of time or performance is based on the grant date fair value of our stock.\nFor performance-based restricted stock awards and performance based stock option awards, we must also make assumptions regarding the likelihood of achieving performance goals. If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations could be materially affected.\nDerivatives. With our acquisition of Cambridge in August 2017, we use derivatives to facilitate cross-currency corporate payments by writing derivatives to customers, which are not designated as hedging instruments. The majority of Cambridge's revenue is from exchanges of currency at spot rates, which enable customers to make cross-currency payments. In addition, Cambridge also writes foreign currency forward and option contracts for its customers to facilitate future payments. The duration of these derivative contracts at inception is generally less than one year. We aggregate our foreign exchange exposures arising from customer contracts, including forwards, options and spot exchanges of currency, and hedges (economic hedge) the resulting net currency risks by entering into offsetting contracts with established financial institution counterparties. The changes in fair value related to these contracts are recorded in revenues, net in the Consolidated Statements of Income.\nWe recognize all derivatives in \"prepaid expenses and other current assets\" and \"other current liabilities\" in the accompanying Consolidated Balance Sheets at their fair value. All cash flows associated with derivatives are included in cash flows from operating activities in the Consolidated Statements of Cash Flows.\nPending Adoption of Recently Issued Accounting Standards\nFrom time to time, new accounting pronouncements are issued by the FASB or other standards setting bodies that are adopted by the Company as of the specified effective date. Unless otherwise discussed, the Company’s management believes that the impact of recently issued standards that are not yet effective will not have a material impact on the Company’s consolidated financial statements upon adoption.\nTax Act. The SEC staff issued Staff Accounting Bulletin No. 118, \"Income Tax Accounting Implications of the Tax Cuts and Jobs Act\" (\"SAB 118\"), which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC 740. In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Act for which the accounting under ASC 740 is complete. To the extent that a company’s accounting for certain income tax effects of the Tax Act is incomplete but it is able to determine a reasonable estimate, it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax laws that were in effect immediately before the enactment of the Tax Act.\nRevenue Recognition. In May 2014, the FASB issued ASU 2014-09, \"Revenue from Contracts with Customers (Topic 606)\". The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 will replace most existing revenue recognition guidance in GAAP and permits the use of either the retrospective or modified retrospective transition method. The update requires significant additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments. ASU 2014-09, as amended by ASU 2015-14, \"Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date\", is effective for years beginning after December 15, 2017, including interim periods, with early adoption permitted for years beginning after December 15, 2016. Since the issuance of ASU 2014-09, the FASB has issued additional interpretive guidance, including new accounting standards updates, that clarifies certain points of the standard and modifies certain requirements.\nWe have performed a review of the requirements of the new revenue standard and we are monitoring the activity of the FASB and the transition resource group as it relates to specific interpretive guidance. We have established an implementation team to assess the effects of the new revenue standard in a multi-phase approach. In the first phase, we analyzed customer contracts for our most significant contract categories, applied the five-step model of Topic 606 to each contract category and comparing the\n73\nresults to our current accounting practices. The second phase, which includes quantifying the potential effects identified during the first phase, assessing additional contract categories and principal versus agent considerations, revising accounting policies and considering the effects on related disclosures and/or internal control over financial reporting is ongoing and expected to be concluded during the first quarter of 2018.\nTopic 606 could change the amount and timing of revenue and expenses to be recognized under certain of our arrangement types. In addition, it could also increase the administrative burden on our operations to account for customer contracts and provide the more expansive required disclosures. More judgment and estimates may be required within the process of applying the requirements of the new standard than are required under existing GAAP, such as identifying performance obligations in contracts, estimating the amount of variable consideration to include in transaction price, allocating transaction price to each separate performance obligation and estimating expected customer lives. We are in the process of finalizing our assessment and completing the quantification of the effect the new guidance will have on our consolidated financial statements, related disclosures and/or internal control over financial reporting. This conclusion will be made over the remainder of the first quarter of 2018 and will include finalizing our evaluation of the application of the principal vs. agent guidance, specifically as it relates to products where we utilize a third-party payment network and in certain businesses where we pay merchant commissions. However, our preliminary view is that the expected amount and timing of revenue to be recognized under Topic 606 for our most significant contract categories, fuel card payments, lodging payments, toll payments, corporate payments, and gift cards, will be similar to the amount and timing of revenue recognized under our current accounting practices, except as it relates to the presentation of certain costs where we may be determined to be an agent in the processing relationship under the new guidance, resulting in recording such costs as a reduction of revenue. We will be required to capitalize additional costs to obtain contracts with customers, and, in some cases, may be required to amortize these costs over a contractual time period. Finally, we expect disclosures about our revenues and related customer acquisition costs to be more extensive.\nWe plan to adopt Topic 606, as well as other clarifications and technical guidance issued by the FASB related to this new revenue standard, effective January 1, 2018. We will apply the modified retrospective transition method, which would result in an adjustment to retained earnings for the cumulative effect, if any, of applying the standard to contracts that are not completed at the date of initial application. Under this method, we would not restate the prior financial statements presented, therefore the new standard requires us to provide additional disclosures of the amount by which each financial statement line item is affected in the current reporting period during 2018, as compared to the guidance that was in effect before the change, and an explanation of the reasons for significant changes, if any.\nAccounting for Leases. In February 2016, the FASB issued ASU 2016-02, “Leases”, which requires lessees to recognize a right-of-use asset and a lease liability on the balance sheet for all leases with the exception of short-term leases. This ASU also requires disclosures to provide additional information about the amounts recorded in the financial statements. This ASU is effective for us for annual periods beginning after December 15, 2018 and interim periods therein. Early adoption is permitted. The new standard must be adopted using a modified retrospective transition and requires application of the new guidance for leases that exist or are entered into after the beginning of the earliest comparative period presented. We are currently evaluating the impact of ASU 2016-02 on our consolidated financial statements; however, we expect to recognize right of use assets and liabilities for operating leases in the Consolidated Balance Sheet upon adoption.\nAccounting for Breakage. In March 2016, the FASB issued ASU 2016-04, “Liabilities-Extinguishments of Liabilities: Recognition of Breakage for Certain Prepaid Stored-Value Products”, which requires entities that sell prepaid stored value products redeemable for goods, services or cash at third-party merchants to derecognize liabilities related to those products for breakage. This ASU is effective for the Company for reporting periods beginning after December 15, 2017. Early adoption is permitted. The ASU must be adopted using either a modified retrospective approach with a cumulative effect adjustment to retained earnings as of the beginning of the period of adoption or a full retrospective approach. Our adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows.\nCash Flow Classification. In August 2016, the FASB issued ASU 2016-15, \"Classification of Certain Cash Receipts and Cash Payments\", which amends the guidance in ASC 230, Statement of Cash Flows. This amended guidance reduces the diversity in practice that has resulted from the lack of consistent principles related to the classification of certain cash receipts and payments in the statement of cash flows. This ASU is effective for reporting periods beginning after December 15, 2017. Early adoption is permitted. Entities must apply the guidance retrospectively to all periods presented but may apply it prospectively from the earliest date practicable if retrospective application would be impracticable.Our adoption of this ASU is not expected to have a material impact on the results of operations or financial condition.\nIn November 2016, the FASB issued ASU 2016-18, \"Statement of Cash Flows (Topic 230): Restricted Cash\", which amends the guidance in ASC 230, Statement of Cash Flows, on the classification and presentation of restricted cash in the statement of cash flows. This ASU is effective for reporting periods beginning after December 15, 2017. Early adoption is permitted. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. The amendments in this ASU should be applied using a retrospective transition method to\n74\neach period presented. We do not believe the adoption of this ASU will impact the results of operations, financial condition, or cash flows.\nIntangibles - Goodwill and Other Impairment. In January 2017, the FASB issued ASU 2017-04, \"Simplifying the Test for Goodwill Impairment\", which eliminates the requirement to calculate the implied fair value of goodwill (i.e., Step 2 of the goodwill impairment test) to measure a goodwill impairment charge. Instead, entities will record an impairment charge based on the excess of a reporting unit’s carrying amount over its fair value (i.e., measure the charge based on Step 1). The standard has tiered effective dates, starting in 2020 for calendar-year public business entities that meet the definition of an SEC filer. Early adoption is permitted for interim and annual goodwill impairment testing dates after January 1, 2017. Our adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows, unless a goodwill impairment is identified.\nDefinition of a Business. In January 2017, the FASB issued ASU 2017-01, \"Clarifying the Definition of a Business\", which amends the definition of a business to assist entities with evaluating when a set of transferred assets and activities is a business. The guidance requires an entity to evaluate if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets. If so, the set of transferred assets and activities is not a business. The guidance also requires a business to include at least one substantive process and narrows the definition of outputs. The guidance is effective for the reporting periods beginning after December 15, 2017, and interim periods within those years. Early adoption is permitted. Our adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows, however it could result in accounting for acquisitions as asset acquisitions versus business combinations upon adoption.\nAccounting for Modifications to Stock-Based Compensation. In May 2017, the FASB issued ASU 2017-09, \"Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting\", which amends the scope of modification accounting for share-based payment arrangements. The ASU provides guidance on the types of changes to the terms or conditions of share-based payment awards to which an entity would be required to apply modification accounting under ASC 718. Specifically, an entity would not apply modification accounting if the fair value, vesting conditions and classification of the awards are the same immediately before and after the modification. The guidance is effective for reporting periods beginning after December 15, 2017, and interim periods within those years. Early adoption is permitted. Our adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows.\nAccounting for Derivative Financial Instruments. In August 2017, the FASB issued ASU 2017-12, \"Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities\", which amends the hedge accounting recognition and presentation requirements in ASC 815. The FASB issued accounting guidance to better align hedge accounting with a company’s risk management activities, simplify the application of hedge accounting and improve the disclosures of hedging arrangements. The guidance is effective for reporting periods beginning after December 15, 2018, and interim periods within those years. Early adoption is permitted. Our adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows.\nContractual obligations\nThe table below summarizes the estimated dollar amounts of payments under contractual obligations identified below as of December 31, 2017 for the periods specified:\n\n| Payments due by period(a) |\n| (in millions) | Total | Less than1 year | 1-3years | 3-5years | More than5 years |\n| Credit Facility | $ | 3,663.9 | $ | 805.5 | $ | 271.0 | $ | 2,256.2 | $ | 331.2 |\n| Securitization Facility | 811.0 | 811.0 | — | — | — |\n| Estimated interest payments- Credit Facility(b) | 534.1 | 119.5 | 330.8 | 77.0 | 6.8 |\n| Estimated interest payments- Securitization Facility(b) | 57.0 | 19.5 | 37.5 | — | — |\n| Operating leases | 92.0 | 19.3 | 26.5 | 20.9 | 25.3 |\n| Deferred purchase price(c) | 29.3 | 3.6 | 25.7 | — | — |\n| Other(c) | 18.1 | — | 13.5 | 1.4 | 3.2 |\n| Total | $ | 5,205.4 | $ | 1,778.5 | $ | 704.9 | $ | 2,355.4 | $ | 366.6 |\n\n______________________\n75\n| (a) | Deferred income tax liabilities as of December 31, 2017 were approximately $517.1 million. Refer to Note 11 to our audited consolidated financial statements. This amount is not included in the total contractual obligations table because we believe this presentation would not be meaningful. Deferred income tax liabilities are calculated based on temporary differences between the tax bases of assets and liabilities and their respective book bases, which will result in taxable amounts in future years when the liabilities are settled at their reported financial statement amounts. The results of these calculations do not have a direct connection with the amount of cash taxes to be paid in any future periods. As a result, scheduling deferred income tax liabilities as payments due by period could be misleading, as this scheduling would not relate to liquidity needs. At December 31, 2017, we had approximately $31.6 million of unrecognized income tax benefits related to uncertain tax positions. We cannot reasonably estimate when all of these unrecognized income tax benefits may be settled. We do not expect reductions to unrecognized income tax benefits within the next 12 months as a result of projected resolutions of income tax uncertainties. |\n\n| (b) | We draw upon and pay down on the revolver within our Credit Agreement and our Securitization Facility borrowings outside of a normal schedule, as excess cash is available. For our variable rate debt, we have assumed the December 31, 2017 interest rates to calculate the estimated interest payments, for all years presented. This analysis also assumes that outstanding principal is held constant at the December 31, 2017 balances for our Credit Agreement and Securitization Facility, except for mandatory pay downs on the term loans in accordance with the loan documents. We typically expect to settle such interest payments with cash flows from operating activities and/or other short-term borrowings. |\n\n| (c) | The long-term portion of contingent consideration agreements and deferred purchase price payments are included with ‘other debt’ in the detail of our debt instruments disclosed in Note 10 to our audited consolidated financial statements. To reconcile the amount of ‘other debt’ as disclosed in the footnote to the contractual obligations table above, the long-term portion of deferred purchase price payments should be combined with ‘Other’. |\n\nManagement’s Use of Non-GAAP Financial Measures\nWe have included in the discussion above certain financial measures that were not prepared in accordance with GAAP. Any analysis of non-GAAP financial measures should be used only in conjunction with results presented in accordance with GAAP. Below, we define the non-GAAP financial measures, provide a reconciliation of the non-GAAP financial measure to the most directly comparable financial measure calculated in accordance with GAAP, and discuss the reasons that we believe this information is useful to management and may be useful to investors.\nAdjusted revenues. We have defined the non-GAAP measure adjusted revenues as revenues, net less merchant commissions as reflected in our income statement.\nWe use adjusted revenues as a basis to evaluate our revenues, net of the commissions that are paid to merchants to participate in our card programs. The commissions paid to merchants can vary when market spreads fluctuate in much the same way as revenues are impacted when market spreads fluctuate. We believe that adjusted revenue is an appropriate supplemental measure of financial performance and may be useful to investors to understanding our revenue performance on a consistent basis. Adjusted revenues are not intended to be a substitute for GAAP financial measures and should not be used as such.\nSet forth below is a reconciliation of adjusted revenues to the most directly comparable GAAP measure, revenues, net (in millions):\n| Year Ended December 31, |\n| 2017 | 2016 | 2015 |\n| Revenues, net | $ | 2,250 | $ | 1,832 | $ | 1,703 |\n| Merchant commissions | 113 | 104 | 108 |\n| Total adjusted revenues | $ | 2,136 | $ | 1,727 | $ | 1,595 |\n\nPro forma and macro adjusted revenues. We have defined the non-GAAP measure pro forma and macro adjusted revenue as revenues, net adjusted for the impact of the macroeconomic environment, acquisitions and dispositions and other one-time items. We use pro forma and macro adjusted revenue as a basis to evaluate our organic growth.\nSet forth below is a reconciliation of pro forma and macro adjusted revenues to the most directly comparable GAAP measure, revenues, net (in millions):\n76\n| Year Ended December 31,* |\n| 2017 | 2016 |\n| (Unaudited) | Macro Adjusted1 | Pro forma2,3 |\n| FUEL CARDS |\n| Pro forma and macro adjusted | $ | 1,068 | $ | 996 |\n| Impact of acquisitions/dispositions | — | (7 | ) |\n| Impact of fuel prices/spread | 30 | — |\n| Impact of foreign exchange rates | — | — |\n| One-time items4 | (2 | ) | 8 |\n| As reported | $ | 1,096 | $ | 997 |\n| CORPORATE PAYMENTS |\n| Pro forma and macro adjusted | $ | 260 | $ | 226 |\n| Impact of acquisitions/dispositions | — | (47 | ) |\n| Impact of fuel prices/spread | 1 | — |\n| Impact of foreign exchange rates | 1 | — |\n| One-time items4 | — | — |\n| As reported | $ | 262 | $ | 180 |\n| TOLLS |\n| Pro forma and macro adjusted | $ | 302 | $ | 257 |\n| Impact of acquisitions/dispositions | — | (154 | ) |\n| Impact of fuel prices/spread | — | — |\n| Impact of foreign exchange rates | 25 | — |\n| One-time items4 | — | — |\n| As reported | $ | 327 | $ | 103 |\n| LODGING |\n| Pro forma and macro adjusted | $ | 127 | $ | 105 |\n| Impact of acquisitions/dispositions | — | (4 | ) |\n| Impact of fuel prices/spread | — | — |\n| Impact of foreign exchange rates | — | — |\n| One-time items4 | — | — |\n| As reported | $ | 127 | $ | 101 |\n| GIFT |\n| Pro forma and macro adjusted | $ | 194 | $ | 185 |\n| Impact of acquisitions/dispositions | — | — |\n| Impact of fuel prices/spread | — | — |\n| Impact of foreign exchange rates | — | — |\n| One-time items4 | — | — |\n| As reported | $ | 194 | $ | 185 |\n| OTHER5 |\n| Pro forma and macro adjusted | $ | 243 | $ | 244 |\n| Impact of acquisitions/dispositions | — | 23 |\n| Impact of fuel prices/spread | — | — |\n| Impact of foreign exchange rates | 1 | — |\n| One-time items4 | — | — |\n| As reported | $ | 244 | $ | 266 |\n\n77\n| FLEETCOR CONSOLIDATED REVENUES |\n| Pro forma and macro adjusted | $ | 2,194 | $ | 2,013 |\n| Impact of acquisitions/dispositions | — | (189 | ) |\n| Impact of fuel prices/spread | 30 | — |\n| Impact of foreign exchange rates | 27 | — |\n| One-time items4 | (2 | ) | 8 |\n| As reported | $ | 2,250 | $ | 1,832 |\n\n* Columns may not calculate due to rounding.\n1 Adjusted to remove the impact of changes in the macroeconomic environment to be consistent with the same period of prior year, using constant fuel prices, fuel price spreads and foreign exchange rates, as well as one-time items.\n2 Pro forma to include acquisitions and exclude dispositions and one-time items, consistent with previous period ownership.\n3 2016 reflects immaterial corrections in estimated allocation of revenue by product from previously disclosed amounts.\n4 Adjustments related to one-time items not representative of normal business operations.\n5 Other includes telematics, maintenance, food and transportation related businesses.\nAdjusted net income and adjusted net income per diluted share. We have defined the non-GAAP measure adjusted net income as net income as reflected in our statement of income, adjusted to eliminate (a) non-cash stock-based compensation expense related to share-based compensation awards, (b) amortization of deferred financing costs, discounts and intangible assets, amortization of the premium recognized on the purchase of receivables, and our proportionate share of amortization of intangible assets at our equity method investment, (c) a non-recurring net gain at equity method investment, (d) impairment of our equity method investment, (e) net gain on disposition of business, (f) loss on extinguishment of debt and, (g) other non-recurring items, including the impact of the Tax Act.\nWe have defined the non-GAAP measure adjusted net income per diluted share as the calculation previously noted divided by the weighted average diluted shares outstanding as reflected in our statement of income.\nWe use adjusted net income to eliminate the effect of items that we do not consider indicative of our core operating performance. We believe it is useful to exclude non-cash stock based compensation expense from adjusted net income because non-cash equity grants made at a certain price and point in time do not necessarily reflect how our business is performing at any particular time and stock based compensation expense is not a key measure of our core operating performance. We also believe that amortization expense can vary substantially from company to company and from period to period depending upon their financing and accounting methods, the fair value and average expected life of their acquired intangible assets, their capital structures and the method by which their assets were acquired. Therefore, we have excluded amortization expense from adjusted net income. We believe that adjusted net income and adjusted net income per diluted share are appropriate supplemental measures of financial performance and may be useful to investors to understanding our operating performance on a consistent basis. Adjusted net income and adjusted net income per diluted share are not intended to be a substitute for GAAP financial measures and should not be used as such.\n78\nSet forth below is a reconciliation of adjusted net income and adjusted net income per diluted share to the most directly comparable GAAP measure, net income and net income per diluted share (in thousands, except per share amounts):\n| Year Ended December 31,* |\n| (Unaudited) | 2017 | 20162 | 2015 |\n| Net income | $ | 740,200 | $ | 452,385 | $ | 362,431 |\n| Net income per diluted share | $ | 7.91 | $ | 4.75 | $ | 3.85 |\n| Stock based compensation | 93,297 | 63,946 | 90,122 |\n| Amortization of intangible assets, premium on receivables, deferred financing costs and discounts | 233,280 | 184,475 | 180,704 |\n| Impairment of investment | 44,600 | 36,065 | 40,000 |\n| Net gain on disposition of business | (109,205 | ) | — | — |\n| Loss on extinguishment of debt | 3,296 | — | — |\n| Non-recurring loss due to merger of entities | 2,028 | — | — |\n| Non-recurring net gain at equity method investment | — | (10,845 | ) | — |\n| Legal settlement | 11,000 | — | — |\n| Restructuring costs | 1,043 | — | — |\n| Total pre-tax adjustments | 279,339 | 273,641 | 310,826 |\n| Impact of 2017 Tax Act | (127,466 | ) | — | — |\n| Income tax impact of pre-tax adjustments at the effective tax rate1 | (93,164 | ) | (66,850 | ) | (80,632 | ) |\n| Adjusted net income | $ | 798,909 | $ | 659,176 | $ | 592,625 |\n| Adjusted net income per diluted share | $ | 8.54 | $ | 6.92 | $ | 6.30 |\n| Diluted shares | 93,594 | 95,213 | 94,139 |\n\n| *Columns may not calculate due to rounding. |\n| 1Excludes the results of our equity method investment on our effective tax rate, as results from our investment are reported within the Consolidated Income Statements on a post-tax basis and no tax-over-book outside basis differences related to our equity method investment. Also excludes the net gain realized upon our disposition of NexTraq, representing a pretax gain of $175.0 and tax on gain of $65.8. The tax on the gain is included in \"Net gain on disposition of business\". |\n| 2 Reflects the impact of the Company's adoption of Accounting Standards Update 2016-09, \"Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting\", to simplify several aspects of the accounting for share-based compensation, including the income tax consequences. |\n\n79\nITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nForeign currency risk\nForeign Earnings\nOur International segment exposes us to foreign currency exchange rate changes that can impact translations of foreign-denominated assets and liabilities into U.S. dollars and future earnings and cash flows from transactions denominated in different currencies. Revenue from our International segment was 36.5%, 30.2% and 27.7% of total revenue for the years ended December 31, 2017, 2016, and 2015, respectively. We measure foreign currency exchange risk based on changes in foreign currency exchange rates using a sensitivity analysis. The sensitivity analysis measures the potential change in earnings based on a hypothetical 10% change in currency exchange rates. Exchange rates and currency positions as of December 31, 2017 were used to perform the sensitivity analysis. Such analysis indicated that a hypothetical 10% change in foreign currency exchange rates would have increased or decreased consolidated operating income during the year ended December 31, 2017 by approximately $34.2 million had the U.S. dollar exchange rate increased or decreased relative to the currencies to which we had exposure. When exchange rates and currency positions as of December 31, 2016 and 2015 were used to perform this sensitivity analysis, the analysis indicated that a hypothetical 10% change in currency exchange rates would have increased or decreased consolidated operating income for the years ended December 31, 2016 and 2015 by approximately $24.8 million and $22.5 million, respectively.\nUnhedged Cross-Currency Risk\nWith the acquisition of Cambridge in August 2017, we have additional foreign exchange risk and associated foreign exchange risk management requirements due to the nature of our international payments provider business. The majority of Cambridge's revenue is from exchanges of currency at spot rates, which enable customers to make cross-currency payments. In addition, Cambridge also writes foreign currency forward and option contracts for customers to facilitate future payments. The duration of these derivative contracts at inception is generally less than one year. Cambridge aggregates its foreign exchange exposures arising from customer contracts, including the derivative contracts described above, and hedges (economic hedge) the resulting net currency risks by entering into offsetting contracts with established financial institution counterparties.\nInterest rate risk\nWe are exposed to changes in interest rates on our cash investments and debt. We invest our excess cash either to pay down our Securitization Facility debt or in securities that we believe are highly liquid and marketable in the short term. These investments are not held for trading or other speculative purposes. Under our $4.325 billion Credit Agreement, the Credit Agreement provides for senior secured credit facilities consisting of a revolving A credit facility in the amount of $1.285 billion, a term loan A facility in the amount of $2.690 billion and a term loan B facility in the amount of $350.0 million as of December 31, 2017. The revolving credit facility consists of (a) a revolving A credit facility in the amount of $800.0 million, with sublimits for letters of credit and swing line loans, (b) a revolving B facility in the amount of $450.0 million for swing line loans and multi-currency borrowings and, (c) a revolving C facility in the amount of $35.0 million for multi-currency borrowings in Australian Dollars or New Zealand Dollars.\nOn January 20, 2017, we entered into the second amendment to the Credit Agreement, which established a new term B loan. Interest on the term B loan facility accrues based on the Eurocurrency Rate or the Base Rate at 2.25% for Eurocurrency Loans and at 1.25% for Base Rate Loans. Interest on amounts outstanding under the Credit Agreement (other than the Term B loan) accrues based on the British Bankers Association LIBOR Rate (the Eurocurrency Rate), plus a margin based on a leverage ratio, or our option, the Base Rate (defined as the rate equal to the highest of (a) the Federal Funds Rate plus 0.50%, (b) the prime rate announced by Bank of America, N.A., or (c) the Eurocurrency Rate plus 1.00%) plus a margin based on a leverage ratio. In addition, the Company pays a quarterly commitment fee at a rate per annum ranging from 0.20% to 0.40% of the daily unused portion of the credit facility.\nBased on the amounts and mix of our fixed and floating rate debt (exclusive of our Securitization Facility) at December 31, 2017, 2016 and 2015, if market interest rates had increased or decreased an average of 100 basis points, our interest expense would have changed by approximately $34.7 million, $27.9 million and $26.2 million, respectively. We determined these amounts by considering the impact of the hypothetical interest rates on our borrowing costs. These analyses do not consider the effects of changes in the level of overall economic activity that could exist in such an environment.\nFuel price risk\n80\nOur fleet customers use our products and services primarily in connection with the purchase of fuel. Accordingly, our revenue is affected by fuel prices, which are subject to significant volatility. A decline in retail fuel prices could cause a change in our revenue from several sources, including fees paid to us based on a percentage of each customer’s total purchase. Changes in the absolute price of fuel may also impact unpaid account balances and the late fees and charges based on these amounts. The impact of changes in fuel price is somewhat mitigated by our agreements with certain merchants, where the price paid to the merchant is equal to the lesser of the merchant’s cost plus a markup or a percentage of the transaction purchase price. We do not enter into any fuel price derivative instruments.\nFuel-price spread risk\nFrom our merchant and network relationships, we derive revenue from the difference between the price charged to a fleet customer for a transaction and the price paid to the merchant or network for the same transaction. The price paid to a merchant or network is calculated as the merchant’s wholesale cost of fuel plus a markup. The merchant’s wholesale cost of fuel is dependent on several factors including, among others, the factors described above affecting fuel prices. The fuel price that we charge to our customer is dependent on several factors including, among others, the fuel price paid to the fuel merchant, posted retail fuel prices and competitive fuel prices. We experience fuel-price spread contraction when the merchant’s wholesale cost of fuel increases at a faster rate than the fuel price we charge to our customers, or the fuel price we charge to our customers decreases at a faster rate than the merchant’s wholesale cost of fuel. Accordingly, if fuel-price spreads contract, we may generate less revenue, which could adversely affect our operating results. The impact of volatility in fuel spreads is somewhat mitigated by our agreements with certain merchants, where the price paid to the merchant is equal to the lesser of the merchant’s cost plus a markup or a percentage of the transaction purchase price.\n81\nITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA\nINDEX TO CONSOLIDATED FINANCIAL STATEMENTS\n\n| Page |\n| Reports of Independent Registered Public Accounting Firm | 83 |\n| Consolidated Balance Sheets at December 31, 2017 and 2016 | 85 |\n| Consolidated Statements of Income for the Years Ended December 31, 2017, 2016 and 2015 | 86 |\n| Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2017, 2016 and 2015 | 87 |\n| Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2017, 2016 and 2015 | 88 |\n| Consolidated Statements of Cash Flows for the Years Ended December 31, 2017, 2016 and 2015 | 89 |\n| Notes to Consolidated Financial Statements | 90 |\n\n82\nReport of Independent Registered Public Accounting Firm\nTo the Shareholders and the Board of Directors of FleetCor Technologies, Inc. and Subsidiaries\nOpinion on the Financial Statements\nWe have audited the accompanying consolidated balance sheets of FleetCor Technologies, Inc. and subsidiaries (the Company) as of December 31, 2017 and 2016, the related consolidated statements of income, comprehensive income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2017, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2017, in conformity with U.S. generally accepted accounting principles.\nWe also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated March 1, 2018 expressed an unqualified opinion thereon.\nBasis for Opinion\nThese consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.\nWe conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.\n/s/ Ernst & Young LLP\nWe have served as the Company‘s auditor since 2002.\nAtlanta, Georgia\nMarch 1, 2018\n83\nReport of Independent Registered Public Accounting Firm\nTo the Shareholders and the Board of Directors of FLEETCOR Technologies, Inc. and Subsidiaries\nOpinion on Internal Control over Financial Reporting\nWe have audited FleetCor Technologies, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission 2013 framework (the COSO criteria). In our opinion, FleetCor and subsidiaries (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2017, based on the COSO criteria.\nAs indicated in the accompanying Management Report on Internal Control over Financial Reporting, management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of Cambridge Global Payments, Creative Lodging Solutions, and a fuel card provider in Russia (the “Acquired Entities”), which is included in the 2017 consolidated financial statements of the Company and constituted 11% of total assets as of December 31, 2017 and 3% of revenues for the year then ended. Our audit of internal control over financial reporting of the Company also did not include an evaluation of the internal control over financial reporting of the Acquired Entities.\nWe also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the FleetCor Technologies, Inc. and subsidiaries as of December 31, 2017 and 2016, the related consolidated statements of comprehensive income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2017, and the related notes and our report dated March 1, 2018 expressed an unqualified opinion thereon\nBasis for Opinion\nThe Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management Report on Internal Controls over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.\nWe conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.\nOur audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.\nDefinition and Limitations of Internal Control Over Financial Reporting\nA company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.\nBecause of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.\n/s/ Ernst & Young LLP\nAtlanta, Georgia\nMarch 1, 2018\n84\nFLEETCOR Technologies, Inc. and Subsidiaries\nConsolidated Balance Sheets\n| December 31, |\n| 2017 | 2016 |\n| Assets |\n| Current assets: |\n| Cash and cash equivalents | $ | 913,595 | $ | 475,018 |\n| Restricted cash | 217,275 | 168,752 |\n| Accounts and other receivables (less allowance for doubtful accounts of $46,031 and $32,506, respectively) | 1,420,011 | 1,202,009 |\n| Securitized accounts receivable—restricted for securitization investors | 811,000 | 591,000 |\n| Prepaid expenses and other current assets | 187,820 | 90,914 |\n| Total current assets | 3,549,701 | 2,527,693 |\n| Property and equipment, net | 180,057 | 142,504 |\n| Goodwill | 4,715,823 | 4,195,150 |\n| Other intangibles, net | 2,724,957 | 2,653,233 |\n| Investments | 32,859 | 36,200 |\n| Other assets | 114,962 | 71,952 |\n| Total assets | $ | 11,318,359 | $ | 9,626,732 |\n| Liabilities and stockholders’ equity |\n| Current liabilities: |\n| Accounts payable | $ | 1,437,314 | $ | 1,151,432 |\n| Accrued expenses | 238,472 | 238,812 |\n| Customer deposits | 732,171 | 530,787 |\n| Securitization facility | 811,000 | 591,000 |\n| Current portion of notes payable and lines of credit | 805,512 | 745,506 |\n| Other current liabilities | 71,033 | 38,781 |\n| Total current liabilities | 4,095,502 | 3,296,318 |\n| Notes payable and other obligations, less current portion | 2,902,104 | 2,521,727 |\n| Deferred income taxes | 518,912 | 668,580 |\n| Other noncurrent liabilities | 125,319 | 56,069 |\n| Total noncurrent liabilities | 3,546,335 | 3,246,376 |\n| Commitments and contingencies (Note 13) |\n| Stockholders’ equity: |\n| Common stock, $0.001 par value; 475,000,000 shares authorized; 122,083,059 shares issued and 89,803,982 shares outstanding at December 31, 2017; and 121,259,960 shares issued and 91,836,938 shares outstanding at December 31, 2016 | 122 | 121 |\n| Additional paid-in capital | 2,214,224 | 2,074,094 |\n| Retained earnings | 2,958,921 | 2,218,721 |\n| Accumulated other comprehensive loss | (551,857 | ) | (666,403 | ) |\n| Less treasury stock (32,279,077 shares at December 31, 2017; and 29,423,022 shares at December 31, 2016) | (944,888 | ) | (542,495 | ) |\n| Total stockholders’ equity | 3,676,522 | 3,084,038 |\n| Total liabilities and stockholders’ equity | $ | 11,318,359 | $ | 9,626,732 |\n\nSee accompanying notes.\n85\nFLEETCOR Technologies, Inc. and Subsidiaries\nConsolidated Statements of Income\n(In Thousands, Except Per Share Amounts)\n\n| Year Ended December 31, |\n| 2017 | 2016 | 2015 |\n| Revenues, net | $ | 2,249,538 | $ | 1,831,546 | $ | 1,702,865 |\n| Expenses: |\n| Merchant commissions | 113,133 | 104,345 | 108,257 |\n| Processing | 429,613 | 355,414 | 331,073 |\n| Selling | 170,717 | 131,443 | 109,075 |\n| General and administrative | 387,694 | 283,625 | 297,715 |\n| Depreciation and amortization | 264,560 | 203,256 | 193,453 |\n| Other operating, net | 61 | (690 | ) | (4,242 | ) |\n| Operating income | 883,760 | 754,153 | 667,534 |\n| Investment loss | 53,164 | 36,356 | 57,668 |\n| Other (income) expense, net | (173,436 | ) | 2,982 | 2,523 |\n| Interest expense, net | 107,146 | 71,896 | 71,339 |\n| Loss on extinguishment of debt | 3,296 | — | — |\n| Total other (income) expense | (9,830 | ) | 111,234 | 131,530 |\n| Income before income taxes | 893,590 | 642,919 | 536,004 |\n| Provision for income taxes | 153,390 | 190,534 | 173,573 |\n| Net income | $ | 740,200 | $ | 452,385 | $ | 362,431 |\n| Basic earnings per share | $ | 8.12 | $ | 4.89 | $ | 3.94 |\n| Diluted earnings per share | $ | 7.91 | $ | 4.75 | $ | 3.85 |\n| Weighted average shares outstanding: |\n| Basic shares | 91,129 | 92,597 | 92,023 |\n| Diluted shares | 93,594 | 95,213 | 94,139 |\n\nSee accompanying notes.\n86\nFLEETCOR Technologies, Inc. and Subsidiaries\nConsolidated Statements of Comprehensive Income\n(In Thousands)\n\n| Year Ended December 31, |\n| 2017 | 2016 | 2015 |\n| Net income | $ | 740,200 | $ | 452,385 | $ | 362,431 |\n| Other comprehensive income (loss): |\n| Foreign currency translation gains (losses), net of tax | 83,165 | (95,592 | ) | (279,303 | ) |\n| Reclassification of foreign currency translation loss to investment, net of tax | 31,381 | — | — |\n| Total other comprehensive income (loss) | 114,546 | (95,592 | ) | (279,303 | ) |\n| Total comprehensive income | $ | 854,746 | $ | 356,793 | $ | 83,128 |\n\nSee accompanying notes.\n87\nFLEETCOR Technologies, Inc. and Subsidiaries\nConsolidated Statements of Stockholders’ Equity\n(In Thousands)\n\n| CommonStock | AdditionalPaid-InCapital | RetainedEarnings | AccumulatedOtherComprehensiveLoss | TreasuryStock | Total |\n| Balance at December 31, 2014 | $ | 120 | $ | 1,852,442 | $ | 1,403,905 | $ | (291,508 | ) | $ | (346,397 | ) | $ | 2,618,562 |\n| Net income | — | — | 362,431 | — | — | 362,431 |\n| Other comprehensive loss, net of tax of $0 | — | — | — | (279,303 | ) | — | (279,303 | ) |\n| Acquisition of common stock | — | — | — | — | (8,119 | ) | (8,119 | ) |\n| Issuance of common stock | 1 | 136,475 | — | — | — | 136,476 |\n| Balance at December 31, 2015 | 121 | 1,988,917 | 1,766,336 | (570,811 | ) | (354,516 | ) | 2,830,047 |\n| Net income | — | — | 452,385 | — | — | 452,385 |\n| Other comprehensive loss, net of tax of $0 | — | — | — | (95,592 | ) | — | (95,592 | ) |\n| Acquisition/return of common stock | — | — | — | — | (187,979 | ) | (187,979 | ) |\n| Issuance of common stock | — | 85,177 | — | — | — | 85,177 |\n| Balance at December 31, 2016 | 121 | 2,074,094 | 2,218,721 | (666,403 | ) | (542,495 | ) | 3,084,038 |\n| Net income | — | — | 740,200 | — | — | 740,200 |\n| Other comprehensive income, net of tax of $0 | — | — | — | 114,546 | — | 114,546 |\n| Acquisition of common stock | — | — | — | — | (402,393 | ) | (402,393 | ) |\n| Issuance of common stock | 1 | 140,130 | — | — | — | 140,131 |\n| Balance at December 31, 2017 | $ | 122 | $ | 2,214,224 | $ | 2,958,921 | $ | (551,857 | ) | $ | (944,888 | ) | $ | 3,676,522 |\n\nSee accompanying notes.\n88\nFLEETCOR Technologies, Inc. and Subsidiaries\nConsolidated Statements of Cash Flows\n(In Thousands)\n| Year Ended Year Ended December 31, |\n| 2017 | 2016 | 2015 |\n| Operating activities |\n| Net income | $ | 740,200 | $ | 452,385 | $ | 362,431 |\n| Adjustments to reconcile net income to net cash provided by operating activities: |\n| Depreciation | 46,599 | 36,456 | 30,462 |\n| Stock-based compensation | 93,297 | 63,946 | 90,122 |\n| Provision for losses on accounts receivable | 44,857 | 35,885 | 24,629 |\n| Amortization of deferred financing costs and discounts | 6,952 | 7,582 | 7,049 |\n| Amortization of intangible assets | 211,849 | 161,635 | 159,740 |\n| Amortization of premium on receivables | 6,112 | 5,165 | 3,250 |\n| Loss on extinguishment of debt | 3,296 | — | — |\n| Deferred income taxes | (247,712 | ) | (28,681 | ) | 30,626 |\n| Investment loss | 53,164 | 36,356 | 57,668 |\n| Gain on disposition of business | (174,983 | ) | — | — |\n| Other non-cash operating income | (61 | ) | (690 | ) | (4,242 | ) |\n| Changes in operating assets and liabilities (net of acquisitions and disposition): |\n| Restricted cash | (4,335 | ) | (2,306 | ) | (35,676 | ) |\n| Accounts receivable and other receivables | (431,003 | ) | (338,796 | ) | 40,017 |\n| Prepaid expenses and other current assets | 26,102 | 5,301 | (12,564 | ) |\n| Other assets | (20,957 | ) | (20,345 | ) | (2,524 | ) |\n| Excess tax benefits related to stock-based compensation | — | — | (26,427 | ) |\n| Accounts payable, accrued expenses and customer deposits | 322,346 | 292,019 | 30,023 |\n| Net cash provided by operating activities | 675,723 | 705,912 | 754,584 |\n| Investing activities |\n| Acquisitions, net of cash acquired1 | (705,257 | ) | (1,331,985 | ) | (49,069 | ) |\n| Purchases of property and equipment | (70,093 | ) | (59,011 | ) | (41,875 | ) |\n| Proceeds from disposal of a business | 316,501 | — | — |\n| Other | (38,953 | ) | 1,411 | (8,470 | ) |\n| Net cash used in investing activities | (497,802 | ) | (1,389,585 | ) | (99,414 | ) |\n| Financing activities |\n| Excess tax benefits related to stock-based compensation | — | — | 26,427 |\n| Proceeds from issuance of common stock | 44,690 | 21,231 | 19,926 |\n| Borrowings (payments) on securitization facility, net | 220,000 | (23,000 | ) | (61,000 | ) |\n| Repurchase of common stock | (402,393 | ) | (187,678 | ) | — |\n| Deferred financing costs paid and debt discount | (12,908 | ) | (2,272 | ) | — |\n| Proceeds from issuance of notes payable | 780,656 | 600,000 | — |\n| Principal payments on notes payable | (423,156 | ) | (118,500 | ) | (103,500 | ) |\n| Borrowings from revolver | 1,100,000 | 1,225,107 | — |\n| Payments on revolver | (1,031,722 | ) | (786,849 | ) | (486,818 | ) |\n| Borrowings (payments) on swing line of credit, net | (23,686 | ) | 26,606 | (546 | ) |\n| Payment of contingent consideration | — | — | (42,177 | ) |\n| Other | 457 | (676 | ) | (377 | ) |\n| Net cash provided by (used in) financing activities | 251,938 | 753,969 | (648,065 | ) |\n| Effect of foreign currency exchange rates on cash | 8,718 | (42,430 | ) | (37,022 | ) |\n| Net increase (decrease) in cash | 438,577 | 27,866 | (29,917 | ) |\n| Cash and cash equivalents, beginning of year | 475,018 | 447,152 | 477,069 |\n| Cash and cash equivalents, end of year | $ | 913,595 | $ | 475,018 | $ | 447,152 |\n| Supplemental cash flow information |\n| Cash paid for interest | $ | 113,416 | $ | 70,339 | $ | 72,537 |\n| Cash paid for income taxes | $ | 392,192 | $ | 101,951 | $ | 83,380 |\n| Non cash investing activity, notes assumed in acquisitions | $ | 29,341 | $ | — | $ | — |\n| 1Amounts reported in acquisitions and investment, net of cash acquired, includes debt assumed and immediately repaid in acquisitions. |\n| See accompanying notes. |\n\n89\nFLEETCOR Technologies, Inc. and Subsidiaries\nNotes to Consolidated Financial Statements\nDecember 31, 2017\n1. Description of Business\nFLEETCOR Technologies, Inc. and its subsidiaries (the Company) is a leading global provider of commercial payment solutions. The Company helps businesses of all sizes control, simplify and secure payment of various domestic and cross-border payables using specialized payment products. The Company serves businesses, merchants and partners in North America, Latin America, Europe, and Australasia.\nThe Company has two reportable segments, North America and International. The Company reports these two segments as they align with its senior executive organizational structure, reflect how the Company organizes and manages its employees around the world, manages operating performance, contemplates the differing regulatory environments in North America versus other geographies, and helps the Company isolate the impact of foreign exchange fluctuations on its financial results.\nThe Company's payment solutions provide its customers with a payment method designed to be superior and more robust and effective than what they use currently, whether they use a competitor’s product or another alternative method such as cash or check. The Company's solutions are comprised of payment products, networks and associated services.\nThe Company's payment products function like a charge card or prepaid card and tend to be specialized for specific spend categories, such as fuel or lodging, and/or specific customer groups, such as long haul transportation. The Company's five primary product lines are Fuel, Lodging, Tolls, Corporate Payments and Gift. Additionally, the Company provides other payment products including fleet maintenance, employee benefits and long haul transportation-related services. The Company's products are used in 56 countries around the world, with its primary geographies being the U.S., Brazil and the United Kingdom, which combined accounted for approximately 90% of the Company's revenue in 2017.\nThe Company uses both proprietary and third-party networks to deliver its payment solutions. FLEETCOR owns and operates proprietary networks with brands throughout the world, bringing incremental sales and loyalty to affiliated merchants. Third-party networks are used to broaden payment product acceptance and use.\nThe Company markets its products directly through multiple sales channels, including field sales, telesales and digital marketing, and indirectly through its partners, which include major oil companies, leasing companies, petroleum marketers, value-added resellers (VARs) and referral partners.\n2. Summary of Significant Accounting Policies\nRevenue Recognition and Presentation\nRevenue is derived from the Company’s merchant and network relationships as well as from customers and partners. The Company recognizes revenue on fees generated through services primarily to commercial fleets, commercial businesses, major oil companies, petroleum marketers and leasing companies and records revenue net of the wholesale cost of the underlying products and services based on the following: (i) the Company is not the primary obligor in the arrangement and is not responsible for fulfillment and the acceptability of the product; (ii) the Company has no inventory risk, does not bear the risk of product loss and does not make any changes to the product or have any involvement in the product specifications; (iii) the Company does not have significant latitude with respect to establishing the price for the product; and (iv) the amount the Company earns for services is fixed, within a limited range. The Company recognizes revenue from merchant and network relationships, processing and other arrangements when persuasive evidence of an arrangement exists, the services have been provided to the customer, the sales price is fixed or determinable and collectability is reasonably assured, as more fully described below.\nThrough the Company’s merchant and network relationships the Company provides fuel, prepaid cards, vehicle maintenance, lodging, food, toll, and transportation related services to our customers. The Company derives revenue from its merchant and network relationships based on the difference between the price charged to a customer for a transaction and the price paid to the merchant or network for the same transaction. The Company’s revenue consists of margin on sales and fees for technical support, processing, communications and reporting. The price paid to a merchant or network may be calculated as (i) the merchant’s wholesale cost of the product plus a markup; (ii) the transaction purchase price less a percentage discount; or (iii) the transaction purchase price less a fixed fee per unit. The difference between the price the Company pays to a merchant and the merchant’s wholesale cost for the underlying products and services is considered a merchant commission and is recognized as expense when the fuel purchase transaction is executed. The Company has entered into agreements with major oil companies, petroleum marketers and leasing companies, among others, that specify that a transaction is deemed to be\n90\ncaptured when we have validated that the transaction has no errors and have accepted and posted the data to the Company’s records.\nThe Company also derives revenue from customers and partners from a variety of program fees including transaction fees, card fees, network fees, service fees, report fees and other transaction-based fees, which typically are calculated based on measures such as percentage of dollar volume processed, number of transactions processed, or some combination thereof. Such services are provided through proprietary networks or through the use of third-party networks. Transaction fees and other transaction-based fees generated from the Company’s proprietary networks and third-party networks are recognized at the time the transaction is captured. Card fees, network fees and program fees are recognized as the Company fulfills its contractual service obligations. In addition, the Company recognizes revenue from late fees and finance charges, in jurisdictions where permitted under local regulations, primarily in the U.S. and Canada. Such fees are recognized net of a provision for estimated uncollectible amounts, at the time the fees and finance charges are assessed and services are provided. The Company ceases billing and accruing for late fees and finance charges approximately 30-40 days after the customer’s balance becomes delinquent.\nThe Company also charges its customers transaction fees to load value onto prepaid fuel, food, toll and transportation vouchers and cards. The Company recognizes fee revenue upon providing the activated fuel, food, toll and transportation vouchers and prepaid cards to the customer. Revenue is recognized on lodging and transportation management services when the lodging stay or transportation service is completed. Revenue is also derived from the sale of equipment and cards in certain of the Company’s businesses, which is recognized at the time the device is sold and the risks and rewards of ownership have passed. This revenue is recognized gross of the cost of sales related to the equipment in revenues, net within the Consolidated Statements of Income. The related cost of sales for the equipment is recorded within processing expenses in the Consolidated Statements of Income. The Company has recorded $96.8 million, $91.6 million and $84.1 million of expenses related to sales of equipment within the processing expenses line of the Consolidated Statements of Income for the years ended December 31, 2017, 2016 and 2015, respectively. Sales commissions paid to personnel are expensed as incurred.\nThe Company delivers both stored value cards and card-based services primarily in the form of gift cards. For multiple-deliverable customer contracts, stored value cards and card-based services are separated into two units of accounting. Stored valued cards are generally recognized upon shipment to the customer. Card-based services are recognized when the card services are rendered.\nThe Company presents taxes assessed by the government imposed concurrent with a revenue producing transaction between us and our customers (e.g. VAT) on a net basis within revenues, net.\nUse of Estimates\nThe preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.\nPrinciples of Consolidation\nThe accompanying consolidated financial statements include the accounts of FLEETCOR Technologies, Inc. and all of its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated.\nThe Company’s fiscal year ends on December 31. In certain of the Company’s U.K. businesses, the Company records the operating results using a 4-4-5 week accounting cycle with the fiscal year ending on the Friday on or immediately preceding December 31. Fiscal years 2017, 2016 and 2015 include 52 weeks for the businesses reporting using a 4-4-5 accounting cycle.\nCredit Risk and Reserve for Losses on Receivables\nThe Company controls credit risk by performing periodic credit evaluations of its customers. Payments from customers are generally due within 14 days or less of billing. The Company routinely reviews its accounts receivable balances and makes provisions for probable doubtful accounts based primarily on the aging of those balances. Accounts receivable are deemed uncollectible once they age past 90 days and are deemed uncollectible from the customer. The Company also provides an allowance for receivables aged less than 90 days that it expects will be uncollectible based on historical collections experience including accounts that have filed for bankruptcy. At December 31, 2017 and 2016, approximately 96% and 95%, respectively, of outstanding accounts receivable were current. Accounts receivable deemed uncollectible are removed from accounts\n91\nreceivable and the allowance for doubtful accounts when internal collection efforts have been exhausted and accounts have been turned over to a third-party collection agency. Recoveries from the third-party collection agency are not significant.\nBusiness Combinations\nBusiness combinations completed by the Company have been accounted for under the acquisition method of accounting. The acquisition method requires that the acquired assets and liabilities, including contingencies, be recorded at fair value determined as of the acquisition date and changes thereafter reflected in income. For significant acquisitions, the Company obtains independent third-party valuation studies for certain of the assets acquired and liabilities assumed to assist the Company in determining fair value. Goodwill represents the excess of the purchase price over the fair values of the tangible and intangible assets acquired and liabilities assumed. The results of the acquired businesses are included in the Company’s results of operations beginning from the completion date of the applicable transaction.\nEstimates of fair value are revised during an allocation period as necessary when, and if, information becomes available to further define and quantify the fair value of the assets acquired and liabilities assumed. Provisional estimates of the fair values of the assets acquired and liabilities assumed involves a number of estimates and assumptions that could differ materially from the final amounts recorded. The allocation period does not exceed one year from the date of the acquisition. To the extent additional information to refine the original allocation becomes available during the allocation period, the allocation of the purchase price is adjusted. Should information become available after the allocation period, those items are adjusted through operating results. The direct costs of the acquisition are recorded as operating expenses. Certain acquisitions include contingent consideration related to the performance of the acquired operations following the acquisition. Contingent consideration is recorded at estimated fair value at the date of the acquisition, and is remeasured each reporting period, with any changes in fair value recorded in the Consolidated Statements of Income. The Company estimates the fair value of the acquisition-related contingent consideration using various valuation approaches, as well as significant unobservable inputs, reflecting the Company’s assessment of the assumptions market participants would use to value these liabilities.\nImpairment of Long-Lived Assets, Goodwill, Intangibles and Investments\nThe Company tests its long-lived assets for impairment in accordance with relevant authoritative guidance. The Company evaluates if impairment indicators related to its property, plant and equipment and other long-lived assets are present. These impairment indicators may include a significant decrease in the market price of a long-lived asset or asset group, a significant adverse change in the extent or manner in which a long-lived asset or asset group is being used or in its physical condition, or a current-period operating or cash flow loss combined with a history of operating or cash flow losses or a forecast that demonstrates continuing losses associated with the use of a long-lived asset or asset group. If impairment indicators are present, the Company estimates the future cash flows for the asset or asset group. The sum of the undiscounted future cash flows attributable to the asset or asset group is compared to its carrying amount. The cash flows are estimated utilizing various projections of revenues and expenses, working capital and proceeds from asset disposals on a basis consistent with management’s intended actions. If the carrying amount exceeds the sum of the undiscounted future cash flows, the Company determines the assets’ fair value by discounting the future cash flows using a discount rate required for a similar investment of like risk and records an impairment charge as the difference between the fair value and the carrying value of the asset group. Generally, the Company performs its testing of the asset group at the business-line level, as this is the lowest level for which identifiable cash flows are available.\nThe Company completes an impairment test of goodwill at least annually or more frequently if facts or circumstances indicate that goodwill might be impaired. Goodwill is tested for impairment at the reporting unit level, and the impairment test consists of two steps, as well as a qualitative assessment, as appropriate. The Company has performed a qualitative assessment of certain of its reporting units. In this qualitative assessment, the Company individually considered the following items for each reporting unit where the Company determined a qualitative analysis to be appropriate: the macroeconomic conditions, including any deterioration of general conditions, limitations on accessing capital, fluctuations in foreign exchange rates and other developments in equity and credit markets; industry and market conditions, including any deterioration in the environment where the reporting unit operates, increased competition, changes in the products/services and regulator and political developments; cost of doing business; overall financial performance, including any declining cash flows and performance in relation to planned revenues and earnings in past periods; other relevant reporting unit specific facts, such as changes in management or key personnel or pending litigation; events affecting the reporting unit, including changes in the carrying value of net assets, likelihood of disposal and whether there were any other impairment considerations within the business; the overall performance of our share price in relation to the market and our peers; and a quantitative stress test of the previously completed step 1 test from the prior year, updated with current year results, weighted-average cost of capital rates and future projections.\n92\nIn step 1 of the goodwill impairment test for reporting units, the reporting unit’s carrying amount, including goodwill, is compared to its fair value which is measured based upon, among other factors, a discounted cash flow analysis, as well as market multiples for comparable companies. If the carrying amount of the reporting unit is greater than its fair value, goodwill is considered impaired and step two must be performed. Step two measures the impairment loss by comparing the implied fair value of reporting unit goodwill with the carrying amount of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit to all the assets and liabilities of that unit (including unrecognized intangibles) as if the reporting unit had been acquired in a business combination. The excess of fair value over the amounts allocated to the assets and liabilities of the reporting unit is the implied fair value of goodwill. The excess of the carrying amount over the implied fair value is the impairment loss.\nThe Company estimated the fair value of its reporting units using a combination of the income approach and the market approach. The income approach utilizes a discounted cash flow model incorporating management’s expectations for future revenue, operating expenses, earnings before interest, taxes, depreciation and amortization, capital expenditures and an anticipated tax rate. The Company discounted the related cash flow forecasts using an estimated weighted-average cost of capital for each reporting unit at the date of valuation. The market approach utilizes comparative market multiples in the valuation estimate. Multiples are derived by relating the value of guideline companies, based on either the market price of publicly traded shares or the prices of companies being acquired in the marketplace, to various measures of their earnings and cash flow. Such multiples are then applied to the historical and projected earnings and cash flow of the reporting unit in developing the valuation estimate.\nPreparation of forecasts and the selection of the discount rates involve significant judgments about expected future business performance and general market conditions. Significant changes in forecasts, the discount rates selected or the weighting of the income and market approach could affect the estimated fair value of one or more of our reporting units and could result in a goodwill impairment charge in a future period.\nBased on the goodwill asset impairment analysis performed quantitatively on October 1, 2017, the Company determined that the fair value of each of its reporting units was in excess of the carrying value. No events or changes in circumstances have occurred since the date of this most recent annual impairment test that would more likely than not reduce the fair value of a reporting unit below its carrying amount.\nThe Company also evaluates indefinite-lived intangible assets (primarily trademarks and trade names) for impairment annually. The Company also tests for impairment if events and circumstances indicate that it is more likely than not that the fair value of an indefinite-lived intangible asset is below its carrying amount. Estimates critical to the Company’s evaluation of indefinite-lived intangible assets for impairment include the discount rate, royalty rates used in its evaluation of trade names, projected average revenue growth and projected long-term growth rates in the determination of terminal values. An impairment charge is recorded if the carrying amount of an indefinite-lived intangible asset exceeds the estimated fair value on the measurement date.\nThe Company regularly evaluates the carrying value of its investments, which are not carried at fair value, for other-than-temporary impairment. The Company estimates the fair value of its investments using a combination of the income approach and the market approach. The income approach utilizes a discounted cash flow model incorporating management’s expectations for future revenue, operating expenses, earnings before interest, taxes, depreciation and amortization, capital expenditures and an anticipated tax rate. The Company discounts the related cash flow forecasts using an estimated weighted-average cost of capital for each reporting unit at the date of valuation. The market approach utilizes comparative market multiples in the valuation estimate. Multiples are derived by relating the value of guideline companies, based on either the market price of publicly traded shares or the prices of companies being acquired in the marketplace, to various measures of their earnings and cash flow. Such multiples are then applied to the historical and projected earnings and cash flow of the Company's investments in developing the valuation estimate.\nOn September 30, 2017, the Company entered into an amended Masternaut Group Holdings Limited (\"Masternaut\") investment agreement that resulted in the loss of significant influence, and the Company began accounting for the Masternaut investment by applying the cost method. The Company regularly evaluates the carrying value of its investment and during the third quarter of 2017, the Company determined that the fair value of its 44% investment in Masternaut had declined as a result of the Company's loss of significant influence and the operating results of Masternaut. As a result, the Company determined that the carrying value of its investment exceeded its fair value, and concluded that this decline in value was other than temporary during the third quarter of 2017. The Company recorded a $44.6 million impairment loss in the Masternaut investment that includes adjustment for $31.4 million of currency losses previously recognized in accumulated other comprehensive income, in the year ended December 31, 2017, in the accompanying Consolidated Statements of Income. During the fourth quarters of 2016 and 2015, the Company determined that the performance improvement initiatives in its investment in Masternaut were\n93\ntaking longer to and were more challenging to implement than originally projected, based on revised cash flow projections provided by the business. As a result, the Company recorded a $36.1 million and $40 million non-cash impairment charge in its Masternaut investment for 2016 and 2015, respectively.\nProperty, Plant and Equipment and Definite-Lived Intangible Assets\nProperty, plant and equipment are stated at cost and depreciated on the straight-line basis. Definite-lived intangible assets, consisting primarily of customer relationships, are stated at fair value upon acquisition and are amortized over their estimated useful lives. Customer and merchant relationship useful lives are estimated using historical attrition rates.\nThe Company develops software that is used in providing processing and information management services to customers. A significant portion of the Company’s capital expenditures are devoted to the development of such internal-use computer software. Software development costs are capitalized once technological feasibility of the software has been established. Costs incurred prior to establishing technological feasibility are expensed as incurred. Technological feasibility is established when the Company has completed all planning, designing, coding and testing activities that are necessary to determine that the software can be produced to meet its design specifications, including functions, features and technical performance requirements. Capitalization of costs ceases when the software is ready for its intended use. Software development costs are amortized using the straight-line method over the estimated useful life of the software. The Company capitalized software costs of $37.4 million, $33.1 million and $23.4 million in 2017, 2016 and 2015, respectively. Amortization expense for software totaled $21.8 million, $17.7 million and $11.6 million in 2017, 2016 and 2015, respectively.\nIncome Taxes\nThe Company accounts for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date.\nThe ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which the associated temporary differences become deductible. The Company evaluates on a quarterly basis whether it is more likely than not that its deferred tax assets will be realized in the future and concludes whether a valuation allowance must be established.\nCurrent accounting guidance clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements and prescribes threshold and measurement attributes for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Under the relevant authoritative literature, the impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more likely than not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50 percent likelihood of being sustained. The Company includes any estimated interest and penalties on tax related matters in income tax expense.\nIn the fourth quarter of 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (“Tax Act”). As a result of Tax Act, the U.S. federal corporate tax rate was reduced from 35% to 21%. The Tax Act also includes provisions for a tax on all previously undistributed earnings in foreign jurisdictions. The Company has provisionally recorded a $210 million deferred tax benefit for the benefit for the corporate rate reduction on our deferred tax assets and liabilities. Additionally, in 2017, the Company has provisionally recorded an $81.8 million charge on all previously undistributed earnings in foreign jurisdictions. The Company is currently evaluating the remaining undistributed foreign earnings for which it has not provided deferred taxes for foreign withholding tax, as these earnings are considered to be indefinitely reinvested. The amount of these unrecorded deferred taxes is not expected to be material. If in the future these earnings are repatriated to the United States, or if we determine that the earnings will be remitted in the foreseeable future, additional tax provisions may be required. See Note 11 for further information regarding income taxes.\nCash Equivalents\nCash equivalents consist of cash on hand and highly liquid investments with original maturities of three months or less. Restricted cash represents customer deposits repayable on demand.\n94\nForeign Currency Translation\nAssets and liabilities of foreign subsidiaries are translated into U.S. dollars at the rates of exchange in effect at period-end. The related translation adjustments are made directly to accumulated other comprehensive income. Income and expenses are translated at the average monthly rates of exchange in effect during the year. Gains and losses from foreign currency transactions of these subsidiaries are included in net income. The Company recognized a foreign exchange loss of $0.2 million, $2.8 million and $2.4 million for the years ended December 31, 2017, 2016 and 2015 respectively, which are recorded within other expense, net in the Consolidated Statements of Income.\nDerivatives\nWith its acquisition of Cambridge Global Payments (\"Cambridge\") in August 2017, the Company uses derivatives to facilitate cross-currency corporate payments by writing derivatives to customers, which are not designated as hedging instruments. The majority of Cambridge's revenue is from exchanges of currency at spot rates, which enable customers to make cross-currency payments. In addition, Cambridge also writes foreign currency forward and option contracts for its customers to facilitate future payments. The duration of these derivative contracts at inception is generally less than one year. The Company aggregates its foreign exchange exposures arising from customer contracts, including forwards, options and spot exchanges of currency, and hedges (economic hedge) the resulting net currency risks by entering into offsetting contracts with established financial institution counterparties. The changes in fair value related to these contracts are recorded in revenues, net in the Consolidated Statements of Income.\nThe Company recognizes all derivatives in \"prepaid expenses and other current assets\" and \"other current liabilities\" in the accompanying Consolidated Balance Sheets at their fair value. All cash flows associated with derivatives are included in cash flows from operating activities in the Consolidated Statements of Cash Flows.\nStock-Based Compensation\nThe Company accounts for employee stock options and restricted stock in accordance with relevant authoritative literature. Stock options are granted with an exercise price estimated to be equal to the fair market value on the date of grant as authorized by the Company’s board of directors. Options granted have vesting provisions ranging from one to five years and vesting of the options is generally based on the passage of time or performance. Stock option grants are subject to forfeiture if employment terminates prior to vesting. The Company has selected the Black-Scholes option pricing model for estimating the grant date fair value of stock option awards granted. The Company has considered the retirement and forfeiture provisions of the options and utilized its historical experience to estimate the expected life of the options. Option forfeitures are accounted for upon occurrence. The Company bases the risk-free interest rate on the yield of a zero coupon U.S. Treasury security with a maturity equal to the expected life of the option from the date of the grant. Stock-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense over the requisite service period based on the number of years for which the requisite service is expected to be rendered.\nAwards of restricted stock and restricted stock units are independent of stock option grants and are subject to forfeiture if employment terminates prior to vesting. The vesting of shares granted is generally based on the passage of time, performance or market conditions, or a combination of these. Shares vesting based on the passage of time have vesting provisions of one to three years. The fair value of restricted stock where the shares vest based on the passage of time or performance is based on the grant date fair value of the Company’s stock.\nFor performance-based restricted stock awards and performance based stock option awards, the Company must also make assumptions regarding the likelihood of achieving performance goals. If actual results differ significantly from these estimates, stock-based compensation expense and the Company’s results of operations could be materially affected.\nDeferred Financing Costs/Debt Discounts\nCosts incurred to obtain financing, net of accumulated amortization, are amortized over the term of the related debt, using the effective interest method and are included within interest expense. The Company capitalized additional debt issuance costs of $12.9 million associated with refinancing its Credit Facility and Securitization Facility in 2017 and $2.3 million with refinancing its Credit Facility in 2016. At December 31, 2017 and 2016, the Company had net deferred financing costs of $16.3 million and $13.1 million, respectively.\n95\nComprehensive Income (Loss)\nComprehensive income (loss) is defined as the total of net income and all other changes in equity that result from transactions and other economic events of a reporting period other than transactions with owners.\nAccounts Receivable\nThe Company maintains a $950 million revolving trade accounts receivable Securitization Facility. Accounts receivable collateralized within our Securitization Facility relate to trade receivables resulting from charge card activity in the U.S. Pursuant to the terms of the Securitization Facility, the Company transfers certain of its domestic receivables, on a revolving basis, to FLEETCOR Funding LLC (Funding), a wholly-owned bankruptcy remote subsidiary. In turn, Funding sells, without recourse, on a revolving basis, up to $950 million of undivided ownership interests in this pool of accounts receivable to a multi-seller, asset-backed commercial paper conduit (Conduit). Funding maintains a subordinated interest, in the form of over-collateralization, in a portion of the receivables sold to the Conduit. Purchases by the Conduit are financed with the sale of highly-rated commercial paper.\nThe Company utilizes proceeds from the sale of its accounts receivable as an alternative to other forms of financing to reduce its overall borrowing costs. The Company has agreed to continue servicing the sold receivables for the financial institution at market rates, which approximates the Company’s cost of servicing. The Company retains a residual interest in the accounts receivable sold as a form of credit enhancement. The residual interest’s fair value approximates carrying value due to its short-term nature. Funding determines the level of funding achieved by the sale of trade accounts receivable, subject to a maximum amount.\nThe Company’s Consolidated Balance Sheets and Statements of Income reflect the activity related to securitized accounts receivable and the corresponding securitized debt, including interest income, fees generated from late payments, provision for losses on accounts receivable and interest expense. The cash flows from borrowings and repayments, associated with the securitized debt, are presented as cash flows from financing activities.\nOn November 14, 2017, the Company extended the term of its asset Securitization Facility to November 14, 2020. The Company capitalized $1.7 million in fees in connection with this extension.\nThe Company’s accounts receivable and securitized accounts receivable include the following at December 31 (in thousands):\n\n| 2017 | 2016 |\n| Gross domestic accounts receivables | $ | 661,677 | $ | 529,885 |\n| Gross domestic securitized accounts receivable | 811,000 | 591,000 |\n| Gross foreign receivables | 804,365 | 704,630 |\n| Total gross receivables | 2,277,042 | 1,825,515 |\n| Less allowance for doubtful accounts | (46,031 | ) | (32,506 | ) |\n| Net accounts and securitized accounts receivable | $ | 2,231,011 | $ | 1,793,009 |\n\nA rollforward of the Company’s allowance for doubtful accounts related to accounts receivable for the years ended December 31 is as follows (in thousands):\n\n| 2017 | 2016 | 2015 |\n| Allowance for doubtful accounts beginning of year | $ | 32,506 | $ | 21,903 | $ | 23,842 |\n| Provision for bad debts | 44,857 | 35,885 | 24,629 |\n| Write-offs | (31,332 | ) | (25,282 | ) | (26,568 | ) |\n| Allowance for doubtful accounts end of year | $ | 46,031 | $ | 32,506 | $ | 21,903 |\n\nAdvertising\nThe Company expenses advertising costs as incurred. Advertising expense was $26.1 million, $22.2 million and $19.9 million for the years ended December 31, 2017, 2016 and 2015, respectively.\n96\nEarnings Per Share\nThe Company reports basic and diluted earnings per share. Basic earnings per share is calculated using the weighted average of common stock and non-vested, non-forfeitable restricted shares outstanding, unadjusted for dilution, and net income attributable to common shareholders.\nDiluted earnings per share is calculated using the weighted average shares outstanding and contingently issuable shares less weighted average shares recognized during the period. The net outstanding shares have been adjusted for the dilutive effect of common stock equivalents, which consist of outstanding stock options and unvested forfeitable restricted stock units.\nPending Adoption of Recently Issued Accounting Standards\nFrom time to time, new accounting pronouncements are issued by the FASB or other standards setting bodies that are adopted by the Company as of the specified effective date. Unless otherwise discussed, the Company’s management believes that the impact of recently issued standards that are not yet effective will not have a material impact on the Company’s consolidated financial statements upon adoption.\nTax Act\nThe SEC staff issued Staff Accounting Bulletin No. 118, \"Income Tax Accounting Implications of the Tax Cuts and Jobs Act\" (\"SAB 118\"), which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC 740. In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Act for which the accounting under ASC 740 is complete. To the extent that a company’s accounting for certain income tax effects of the Tax Act is incomplete but it is able to determine a reasonable estimate, it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax laws that were in effect immediately before the enactment of the Tax Act.\nRevenue Recognition\nIn May 2014, the FASB issued ASU 2014-09, \"Revenue from Contracts with Customers (Topic 606)\". The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 will replace most existing revenue recognition guidance in GAAP and permits the use of either the retrospective or modified retrospective transition method. The update requires significant additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments. ASU 2014-09, as amended by ASU 2015-14, \"Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date\", is effective for years beginning after December 15, 2017, including interim periods, with early adoption permitted for years beginning after December 15, 2016. Since the issuance of ASU 2014-09, the FASB has issued additional interpretive guidance, including new accounting standards updates, that clarifies certain points of the standard and modifies certain requirements.\nThe Company has performed a review of the requirements of the new revenue standard and is monitoring the activity of the FASB and the transition resource group as it relates to specific interpretive guidance. The Company established an implementation team to assess the effects of the new revenue standard in a multi-phase approach. In the first phase, the Company analyzed customer contracts for its most significant contract categories, applied the five-step model of the new standard to each contract category and comparing the results to our current accounting practices. The second phase, which includes quantifying the potential effects identified during the first phase, assessing additional contract categories and principal versus agent considerations, revising accounting policies and considering the effects on related disclosures and/or internal control over financial reporting is ongoing and expected to be concluded during the first quarter of 2018.\nThe new standard could change the amount and timing of revenue and expenses to be recognized under certain of our arrangement types. In addition, it could also increase the administrative burden on our operations to account for customer contracts and provide the more expansive required disclosures. More judgment and estimates may be required within the process of applying the requirements of the new standard than are required under existing GAAP, such as identifying performance obligations in contracts, estimating the amount of variable consideration to include in transaction price, allocating transaction price to each separate performance obligation and estimating expected customer lives. The Company is in the process of finalizing its assessment and completing the quantification of the effect the new guidance will have on its consolidated financial statements, related disclosures and/or internal control over financial reporting. This conclusion will be made over the remainder of the first quarter of 2018 and will include finalizing its evaluation of the application of the principal\n97\nvs. agent guidance, specifically as it relates to products where we utilize a third-party payment network and in certain businesses where we pay merchant commissions. However, the Company's preliminary view is that the expected amount and timing of revenue to be recognized under ASU 2014-09 for our most significant contract categories, fuel card payments, lodging payments, toll payments, corporate payments, and gift cards, will be similar to the amount and timing of revenue recognized under its current accounting practices, except as it relates to the presentation of certain costs where the Company may be determined to be an agent in the processing relationship under the new guidance, resulting in recording such costs as a reduction of revenue. The Company will be required to capitalize additional costs to obtain contracts with customers, and, in some cases, may be required to amortize these costs over a contractual time period. Finally, the Company expects disclosures about its revenues and related customer acquisition costs to be more extensive.\nThe Company plans to adopt ASU 2014-09, as well as other clarifications and technical guidance issued by the FASB related to this new revenue standard, on January 1, 2018. The Company will apply the modified retrospective transition method, which would result in an adjustment to retained earnings for the cumulative effect, if any, of applying the standard to contracts that are not completed at the date of initial application. Under this method, the Company would not restate the prior financial statements presented, therefore the new standard requires the Company to provide additional disclosures of the amount by which each financial statement line item is affected in the current reporting period during 2018, as compared to the guidance that was in effect before the change, and an explanation of the reasons for significant changes, if any.\nAccounting for Leases\nIn February 2016, the FASB issued ASU 2016-02, “Leases”, which requires lessees to recognize a right-of-use asset and a lease liability on the balance sheet for all leases with the exception of short-term leases. This ASU also requires disclosures to provide additional information about the amounts recorded in the financial statements. This ASU is effective for the Company for annual periods beginning after December 15, 2018 and interim periods therein. Early adoption is permitted. The new standard must be adopted using a modified retrospective transition and requires application of the new guidance for leases that exist or are entered into after the beginning of the earliest comparative period presented. The Company is currently evaluating the impact of ASU 2016-02 on its consolidated financial statements; however, the Company expect to recognize right of use assets and liabilities for operating leases in the Consolidated Balance Sheet upon adoption.\nAccounting for Breakage\nIn March 2016, the FASB issued ASU 2016-04, “Liabilities-Extinguishments of Liabilities: Recognition of Breakage for Certain Prepaid Stored-Value Products”, which requires entities that sell prepaid stored value products redeemable for goods, services or cash at third-party merchants to derecognize liabilities related to those products for breakage. This ASU is effective for the Company for reporting periods beginning after December 15, 2017. Early adoption is permitted. The ASU must be adopted using either a modified retrospective approach with a cumulative effect adjustment to retained earnings as of the beginning of the period of adoption or a full retrospective approach. The Company’s adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows.\nCash Flow Classification\nIn August 2016, the FASB issued ASU 2016-15, \"Classification of Certain Cash Receipts and Cash Payments\", which amends the guidance in ASC 230, Statement of Cash Flows. This amended guidance reduces the diversity in practice that has resulted from the lack of consistent principles related to the classification of certain cash receipts and payments in the statement of cash flows. This ASU is effective for the Company for reporting periods beginning after December 15, 2017. Early adoption is permitted. Entities must apply the guidance retrospectively to all periods presented but may apply it prospectively from the earliest date practicable if retrospective application would be impracticable. The Company’s adoption of this ASU is not expected to have a material impact on the results of operations or financial condition.\nIn November 2016, the FASB issued ASU 2016-18, \"Statement of Cash Flows (Topic 230): Restricted Cash\", which amends the guidance in ASC 230, Statement of Cash Flows, on the classification and presentation of restricted cash in the statement of cash flows. This ASU is effective for the Company for reporting periods beginning after December 15, 2017. Early adoption is permitted. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. The amendments in this ASU should be applied using a retrospective transition method to each period presented. The Company is evaluating what impact, if any, the adoption of this ASU will have on the results of operations, financial condition, or cash flows.\nIntangibles - Goodwill and Other Impairment\nIn January 2017, the FASB issued ASU 2017-04, \"Simplifying the Test for Goodwill Impairment\", which eliminates the requirement to calculate the implied fair value of goodwill (i.e., Step 2 of the goodwill impairment test) to measure a goodwill impairment charge. Instead, entities will record an impairment charge based on the excess of a reporting unit’s carrying amount over its fair value (i.e., measure the charge based on Step 1). The standard has tiered effective dates, starting in 2020 for\n98\ncalendar-year public business entities that meet the definition of an SEC filer. Early adoption is permitted for interim and annual goodwill impairment testing dates after January 1, 2017. The Company’s adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows, unless a goodwill impairment is identified.\nDefinition of a Business\nIn January 2017, the FASB issued ASU 2017-01, \"Clarifying the Definition of a Business\", which amends the definition of a business to assist entities with evaluating when a set of transferred assets and activities is a business. The guidance requires an entity to evaluate if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets. If so, the set of transferred assets and activities is not a business. The guidance also requires a business to include at least one substantive process and narrows the definition of outputs. The guidance is effective for the Company for reporting periods beginning after December 15, 2017, and interim periods within those years. Early adoption is permitted. The Company’s adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows, however it could result in accounting for acquisitions as asset acquisitions versus business combinations upon adoption.\nAccounting for Modifications to Stock-Based Compensation\nIn May 2017, the FASB issued ASU 2017-09, \"Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting\", which amends the scope of modification accounting for share-based payment arrangements. The ASU provides guidance on the types of changes to the terms or conditions of share-based payment awards to which an entity would be required to apply modification accounting under ASC 718. Specifically, an entity would not apply modification accounting if the fair value, vesting conditions and classification of the awards are the same immediately before and after the modification. The guidance is effective for the Company for reporting periods beginning after December 15, 2017, and interim periods within those years. Early adoption is permitted. The Company's adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows.\nAccounting for Derivative Financial Instruments\nIn August 2017, the FASB issued ASU 2017-12, \"Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities\", which amends the hedge accounting recognition and presentation requirements in ASC 815. The FASB issued accounting guidance to better align hedge accounting with a company’s risk management activities, simplify the application of hedge accounting and improve the disclosures of hedging arrangements. The guidance is effective for the Company for reporting periods beginning after December 15, 2018, and interim periods within those years. Early adoption is permitted. The Company's adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows.\n3. Fair Value Measurements\nFair value is a market-based measurement that reflects assumptions that market participants would use in pricing an asset or liability. GAAP discusses valuation techniques, such as the market approach (comparable market prices), the income approach (present value of future income or cash flow), and the cost approach (cost to replace the service capacity of an asset or replacement cost). These valuation techniques are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions.\nAs the basis for evaluating such inputs, a three-tier value hierarchy prioritizes the inputs used in measuring fair value as follows:\n\n| • | Level 1: Observable inputs such as quoted prices for identical assets or liabilities in active markets. |\n\n| • | Level 2: Observable inputs other than quoted prices that are directly or indirectly observable for the asset or liability, including quoted prices for similar assets or liabilities in active markets; quoted prices for similar or identical assets or liabilities in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable. |\n\n| • | Level 3: Unobservable inputs for which there is little or no market data, which require the reporting entity to develop its own assumptions. The fair value hierarchy also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. |\n\n99\nThe following table presents the Company’s financial assets and liabilities which are measured at fair values on a recurring basis as of December 31, 2017 and 2016, (in thousands):\n\n| Fair Value | Level 1 | Level 2 | Level 3 |\n| December 31, 2017 |\n| Assets: |\n| Repurchase agreements | $ | 420,838 | $ | — | $ | 420,838 | $ | — |\n| Money market | 50,423 | — | 50,423 | — |\n| Certificates of deposit | 7,417 | — | 7,417 | — |\n| Foreign exchange contracts | 39,045 | 10 | 39,035 | — |\n| Total cash equivalents | $ | 517,723 | $ | 10 | $ | 517,713 | $ | — |\n| Cash collateral for foreign exchange contracts | $ | 12,540 | $ | — | $ | — | $ | — |\n| Liabilities: |\n| Foreign exchange contracts | $ | 26,888 | $ | 67 | $ | 26,821 | $ | — |\n| Total liabilities | $ | 26,888 | $ | 67 | $ | 26,821 | $ | — |\n| Cash collateral obligation for foreign exchange contracts | $ | 10,882 | $ | — | $ | — | $ | — |\n| December 31, 2016 |\n| Assets: |\n| Repurchase agreements | $ | 232,131 | $ | — | $ | 232,131 | $ | — |\n| Money market | 50,179 | — | 50,179 | — |\n| Certificates of deposit | 48 | — | 48 | — |\n| Total cash equivalents | $ | 282,358 | $ | — | $ | 282,358 | $ | — |\n\nThe Company has highly-liquid investments classified as cash equivalents, with original maturities of 90 days or less, included in our Consolidated Balance Sheets. The Company utilizes Level 2 fair value determinations derived from directly or indirectly observable (market based) information to determine the fair value of these highly liquid investments. The Company has certain cash and cash equivalents that are invested on an overnight basis in repurchase agreements, money markets and certificates of deposit. The value of overnight repurchase agreements is determined based upon the quoted market prices for the treasury securities associated with the repurchase agreements. The value of money market instruments is the financial institutions' month-end statement, as these instruments are not tradeable and must be settled directly by us with the respective financial institution. Certificates of deposit are valued at cost, plus interest accrued. Given the short-term nature of these instruments, the carrying value approximates fair value. Foreign exchange derivative contracts are carried at fair value, with changes in fair value recognized in the Consolidated Statements of Income. The fair value of the Company's derivatives is derived with reference to a valuation from a derivatives dealer operating in an active market, which the Company accepts as the fair value of these instruments. The fair value represents what would be received and or paid by the Company if the contracts were terminated as of the reporting date. Cash collateral received for foreign exchange derivatives is recorded within customer deposits in our Consolidated Balance Sheet at December 31, 2017. Cash collateral paid for foreign exchange derivatives is recorded within restricted cash in our Consolidated Balance Sheet at December 31, 2017.\nThe level within the fair value hierarchy and the measurement technique are reviewed quarterly. Transfers between levels are deemed to have occurred at the end of the quarter. There were no transfers between fair value levels during the periods presented for 2017 and 2016.\nThe Company’s assets that are measured at fair value on a nonrecurring basis and are evaluated with periodic testing for impairment include property, plant and equipment, investments, goodwill and other intangible assets. Estimates of the fair value of assets acquired and liabilities assumed in business combinations are generally developed using key inputs such as management’s projections of cash flows on a held-and-used basis (if applicable), discounted as appropriate, management’s projections of cash flows upon disposition and discount rates. Accordingly, these fair value measurements are in Level 3 of the fair value hierarchy. See footnote 2 for discussion of Masternaut's other than temporary decline in fair value during the year.\nThe fair value of the Company’s cash, accounts receivable, securitized accounts receivable and related facility, prepaid expenses and other current assets, accounts payable, accrued expenses, customer deposits and short-term borrowings approximate their respective carrying values due to the short-term maturities of the instruments. The carrying value of the\n100\nCompany’s debt obligations approximates fair value as the interest rates on the debt are variable market based interest rates that reset on a quarterly basis. These are each Level 2 fair value measurements, except for cash, which is a Level 1 fair value measurement.\n4. Stockholders' Equity\nOn February 4, 2016, the Company's Board of Directors approved a stock repurchase program (the \"Program\") under which the Company may purchase up to an aggregate of $500 million of its common stock over the following 18 months period. On July 27, 2017, the Company's Board of Directors authorized an increase in the size of the Program by an additional $250 million and an extension of the Program by an additional 18 months. On November 1, 2017, the Company announced that its Board of Directors had authorized an increase in the size of the Program by an additional $350 million, resulting in total aggregate repurchases authorized under the Program of $1.1 billion. With the increase and giving effect to the Company's $590.1 million of previous repurchases, the Company may repurchase up to $510 million in shares of its common stock at any time prior to February 1, 2019.\nAny stock repurchases may be made at times and in such amounts as deemed appropriate. The timing and amount of stock repurchases, if any, will depend on a variety of factors including the stock price, market conditions, corporate and regulatory requirements, and any additional constraints related to material inside information the Company may possess. Any repurchases have been and are expected to be funded by a combination of available cash flow from the business, working capital and debt.\nOn August 3, 2017, as part of the Program, the Company entered an Accelerated Share Repurchase agreement (\"ASR Agreement\") with a third-party financial institution to repurchase $250 million of its common stock. Pursuant to the ASR Agreement, the Company delivered $250 million in cash and received 1,491,647 shares based on a stock price of $142.46 on August 7, 2017. The ASR Agreement was completed on September 7, 2017, at which time the Company received 263,012 additional shares based on a final weighted average per share purchase price during the repurchase period of $142.48.\nThe Company accounted for the ASR Agreement as two separate transactions: (i) as shares of reacquired common stock for the shares delivered to the Company upon effectiveness of the ASR Agreement and (ii) as a forward contract indexed to the Company's common stock for the undelivered shares. The initial delivery of shares was included in treasury stock at cost and results in an immediate reduction of the outstanding shares used to calculate the weighted average common shares outstanding for basic and diluted earnings per share. The forward contracts indexed to the Company's own common stock met the criteria for equity classification, and these amounts were initially recorded in additional paid-in capital and then reclassified to treasury stock upon completion of the ASR agreement.\nSince the beginning of the Program, 4,114,104 shares for an aggregate purchase price of $590.1 million have been repurchased. There were 2,854,959 common shares totaling $402.4 million repurchased under the Program during 2017.\n5. Stock Based Compensation\nThe Company accounts for stock-based compensation pursuant to relevant authoritative guidance, which requires measurement of compensation cost for all stock awards at fair value on the date of grant and recognition of compensation, net of estimated forfeitures, over the requisite service period for awards expected to vest. The Company has Stock Incentive Plans (the Plans) pursuant to which the Company’s board of directors may grant stock options or restricted stock to employees. The Company is authorized to issue grants of restricted stock and stock options to purchase up to 26,963,150 shares for the years ended December 31, 2017, 2016 and 2015, respectively. On May 13, 2013, the Company’s stockholders authorized an increase of 6,500,000 shares of common stock available for grant pursuant to the 2010 Equity Compensation Plan. Giving effect to this increase, there were 277,821 additional shares remaining available for grant under the Plans at December 31, 2017.\nOn February 7, 2018, the stockholders of the Company approved the FleetCor Technologies, Inc. Amended and Restated 2010 Equity Incentive Plan (the \"Amended Plan\"). The Amended Plan was authorized and approved by the Company's Board of Directors on December 20, 2017, and Company's stockholders at a special meeting held on February 7, 2018. The Amended Plan amends the Registrant’s existing 2010 Equity Incentive Plan (as amended, the \"Prior Plan\") to, among other things, increase the number of shares of common stock available for issuance from 13,250,000 to 16,750,000 and make certain other amendments to the Prior Plan.\n101\nThe table below summarizes the expense recognized within general and administrative expenses in the Consolidated Statements of Income related to share-based payments recognized for the years ended December 31 (in thousands):\n| 2017 | 2016 | 2015 |\n| Stock options | $ | 56,400 | $ | 35,234 | $ | 44,260 |\n| Restricted stock | 36,897 | 28,712 | 45,862 |\n| Stock-based compensation | $ | 93,297 | $ | 63,946 | $ | 90,122 |\n\nThe tax benefits recorded on stock based compensation were $48.6 million, $35.0 million and $35.7 million for the years ended December 31, 2017, 2016 and 2015, respectively.\nThe following table summarizes the Company’s total unrecognized compensation cost related to stock-based compensation as of December 31, 2017 (cost in thousands):\n| UnrecognizedCompensationCost | Weighted AveragePeriod of ExpenseRecognition(in Years) |\n| Stock options | $ | 84,452 | 1.33 |\n| Restricted stock | 18,819 | 1.06 |\n| Total | $ | 103,271 |\n\nStock Options\nThe following summarizes the changes in the number of shares of common stock under option for the following periods (shares and aggregate intrinsic value in thousands):\n| Shares | WeightedAverageExercisePrice | OptionsExercisableat End ofYear | WeightedAverageExercisePrice ofExercisableOptions | WeightedAverage FairValue ofOptionsGranted Duringthe Year | AggregateIntrinsicValue |\n| Outstanding at December 31, 2014 | 5,131 | $ | 58.71 | 2,370 | $ | 21.75 | $ | 461,770 |\n| Granted | 654 | 154.56 | $ | 35.32 |\n| Exercised | (586 | ) | 33.97 | 63,863 |\n| Forfeited | (196 | ) | 95.16 |\n| Outstanding at December 31, 2015 | 5,003 | 72.72 | 2,545 | 26.82 | 351,277 |\n| Granted | 1,780 | 133.33 | $ | 28.61 |\n| Exercised | (500 | ) | 42.36 | 49,592 |\n| Forfeited | (137 | ) | 140.67 |\n| Outstanding at December 31, 2016 | 6,146 | 91.20 | 3,429 | 55.00 | 309,238 |\n| Granted | 2,885 | 145.35 | $ | 32.57 |\n| Exercised | (633 | ) | 71.43 | 76,546 |\n| Forfeited | (367 | ) | 144.51 |\n| Outstanding at December 31, 2017 | 8,031 | $ | 109.78 | 4,029 | $ | 75.80 | $ | 663,815 |\n| Expected to vest at December 31, 2017 | 8,031 | $ | 109.78 |\n\n102\nThe following table summarizes information about stock options outstanding at December 31, 2017 (shares in thousands):\n| Exercise Price | OptionsOutstanding | Weighted AverageRemaining VestingLife in Years | OptionsExercisable |\n| $10.00 – 58.02 | 2,218 | 0.00 | 2,218 |\n| 74.99 – 111.09 | 104 | 0.03 | 90 |\n| 114.90 – 138.47 | 2,029 | 0.77 | 577 |\n| 140.23-150.74 | 2,593 | 1.60 | 906 |\n| 151.16-158.24 | 618 | 1.48 | 195 |\n| 165.96-174.35 | 469 | 3.08 | 43 |\n| 8,031 | 4,029 |\n\nThe aggregate intrinsic value of stock options exercisable at December 31, 2017 was $469.8 million. The weighted average remaining contractual term of options exercisable at December 31, 2017 was 5.0 years.\nThe fair value of stock option awards granted was estimated using the Black-Scholes option pricing model with the following weighted-average assumptions for grants or modifications during the years ended December 31 as follows:\n\n| 2017 | 2016 | 2015 |\n| Risk-free interest rate | 1.65 | % | 1.08 | % | 1.47 | % |\n| Dividend yield | — | — | — |\n| Expected volatility | 28.00 | % | 27.29 | % | 27.77 | % |\n| Expected life (in years) | 3.4 | 3.5 | 4.5 |\n\nThe weighted-average remaining contractual life for options outstanding was 6.9 years at December 31, 2017.\nRestricted Stock\nThere were no restricted stock shares granted with market based vesting conditions in 2017, 2016 and 2015. The following table summarizes the changes in the number of shares of restricted stock and restricted stock units for the following periods (shares in thousands):\n| Shares | WeightedAverageGrant DateFair Value |\n| Outstanding at December 31, 2014 | 716 | $ | 121.38 |\n| Granted | 126 | 151.33 |\n| Cancelled | (52 | ) | 135.92 |\n| Issued | (293 | ) | 85.40 |\n| Outstanding at December 31, 2015 | 497 | 149.40 |\n| Granted | 152 | 128.90 |\n| Cancelled | (41 | ) | 145.25 |\n| Issued | (229 | ) | 151.72 |\n| Outstanding at December 31, 2016 | 379 | 140.39 |\n| Granted | 238 | 141.99 |\n| Cancelled | (48 | ) | 152.95 |\n| Issued | (204 | ) | 136.85 |\n| Outstanding at December 31, 2017 | 365 | $ | 155.58 |\n\n103\n6. Acquisitions\n2017 Acquisitions\nDuring 2017, the Company completed acquisitions with an aggregate purchase price of $720.8 million, net of cash acquired of $96.2 million and inclusive of notes payable of $29.3 million. During 2017, the Company made investments in other businesses of $39 million.\nCambridge Global Payments\nOn August 9, 2017, the Company acquired Cambridge, a leading business to business (B2B) international payments provider, for approximately $616.1 million in cash, net of cash acquired of $94.5 million and inclusive of a note payable of $23.8 million. Cambridge processes B2B cross-border payments, assisting business clients in making international payments. The purpose of this acquisition is to further expand the Company's corporate payments footprint. The Company financed the acquisition using a combination of existing cash and borrowings under its existing credit facility. The results from Cambridge are reported in its North America segment. The following table summarizes the preliminary acquisition accounting for Cambridge (in thousands):\n| Restricted cash | $ | 37,666 |\n| Trade and other receivables | 61,801 |\n| Prepaid expenses and other current assets | 15,190 |\n| Property and equipment | 7,106 |\n| Other long term assets | 10,025 |\n| Goodwill | 500,391 |\n| Customer relationships and other identifiable intangible assets | 271,793 |\n| Liabilities assumed | (194,552 | ) |\n| Deferred tax liabilities | (93,364 | ) |\n| Aggregate purchase price | $ | 616,056 |\n\nThe estimated fair value of intangible assets acquired and the related estimated useful lives consisted of the following (in thousands):\n| Useful Lives (in Years) | Value |\n| Banking relationships | 20 | $ | 705 |\n| Trade name and trademarks | Indefinite | 35,110 |\n| Technology | 5 | 16,039 |\n| Customer relationships - excluding Accounts Payable Solutions | 7-18 | 178,190 |\n| Customer relationships - Accounts Payable Solutions | 20 | 41,749 |\n| $ | 271,793 |\n\nAlong with the Company's acquisition of Cambridge, the Company signed noncompete agreements with certain parties with an estimated fair value of $5.8 million. Acquisition accounting for Cambridge is preliminary as the Company is still completing the valuation for goodwill, intangible assets, income taxes, certain acquired contingencies, derivatives and the working capital adjustment period remains open. Goodwill recorded is comprised primarily of expected synergies from combining the operations of the Company and Cambridge, as well as assembled workforce.\nOther\nDuring 2017, the Company acquired Creative Lodging Solutions (\"CLS\"), a small lodging tuck-in business, and a fuel card provider in Russia for approximately $104.7 million, net of cash acquired of $1.8 million and inclusive of a note payable of $5.5 million. The Company financed the acquisitions using a combination of existing cash and borrowings under its existing credit facility. The accounting for these acquisitions is preliminary as the Company is still completing the valuation of goodwill, intangible assets, income taxes and evaluation of acquired contingencies.\n104\nThe following table summarizes the preliminary acquisition accounting for the acquisitions (in thousands):\n| Trade and other receivables | $ | 37,986 |\n| Prepaid expenses and other | 1,426 |\n| Property and equipment | 5,745 |\n| Goodwill | 55,711 |\n| Other intangible assets | 53,259 |\n| Liabilities assumed | (32,202 | ) |\n| Deferred tax liabilities | (17,217 | ) |\n| Aggregate purchase prices | $ | 104,708 |\n\nThe estimated fair value of intangible assets acquired and the related estimated useful lives consisted of the following (in thousands):\n| Useful Lives (in Years) | Value |\n| Trade name and trademarks | 1 | $ | 180 |\n| Technology | 4 | 1,750 |\n| Customer relationships | 8 | 51,329 |\n| $ | 53,259 |\n\nAlong with the Company's acquisition of CLS, the Company signed noncompete agreements with certain parties with an estimated fair value of $4.5 million.\n2016 Acquisitions\nDuring 2016, the Company completed acquisitions with an aggregate purchase price of $1.3 billion, net of cash acquired of $51.3 million, which includes deferred payments made during the period related to prior acquisitions of $6.1 million.\nDuring 2016, the Company made additional investments of $7.9 million related to its equity method investment at Masternaut. The Company also received a $9.2 million return of its investment in Masternaut in 2016.\nSTP\nOn August 31, 2016, the Company acquired all of the outstanding stock of Serviços e Tecnologia de Pagamentos S.A. (“STP”), for approximately $1.23 billion, net of cash acquired of $40.2 million. STP is an electronic toll payments company in Brazil and provides cardless fuel payments at a number of Shell sites throughout Brazil. The purpose of this acquisition was to expand the Company's presence in the toll market in Brazil. The Company financed the acquisition using a combination of existing cash and borrowings under its existing credit facility. Results from the acquired business have been reported in the Company's international segment since the date of acquisition. The following table summarizes the acquisition accounting for STP (in thousands):\n\n| Trade and other receivables | $ | 243,157 |\n| Prepaid expenses and other | 5,757 |\n| Deferred tax assets | 20,644 |\n| Property and equipment | 44,226 |\n| Other long term assets | 14,280 |\n| Goodwill | 663,040 |\n| Customer relationships and other identifiable intangible assets | 548,682 |\n| Liabilities assumed | (312,297 | ) |\n| Aggregate purchase price | $ | 1,227,489 |\n\n105\nThe estimated fair value of intangible assets acquired and the related estimated useful lives consisted of the following (in thousands):\n| Useful Lives(in Years) | Value |\n| Customer relationships | 8.5-20 | $ | 348,414 |\n| Trade names and trademarks | Indefinite | 154,851 |\n| Technology | 6 | 45,417 |\n| $ | 548,682 |\n\nIn connection with the STP acquisition, the Company recorded contingent liabilities aggregating $15.1 million, recorded within other noncurrent liabilities and accrued expenses in the Consolidated Balance Sheet at the date of acquisition. A portion of these acquired liabilities have been indemnified by the respective sellers. As a result, an indemnification asset of $15.1 million was recorded within prepaid and other long term assets in the Consolidated Balance Sheet. Along with the Company's acquisition of STP, the Company signed noncompete agreements with certain parties with an estimated fair value of $23.2 million.\nGoodwill recognized is comprised primarily of expected synergies from combining the operations of the Company and STP, as well as the assembled workforce. The goodwill and definite lived intangibles acquired with STP will be deductible for tax purposes.\nOther\nDuring 2016, the Company acquired additional fuel card portfolios in the U.S. and the United Kingdom, additional Shell fuel card markets in Europe and Travelcard in the Netherlands totaling approximately $76.7 million, net of cash acquired of $11.1 million. The following table summarizes the acquisition accounting for these acquisitions (in thousands):\n| Trade and other receivables | $ | 27,810 |\n| Prepaid expenses and other | 5,097 |\n| Property and equipment | 992 |\n| Goodwill | 28,540 |\n| Other intangible assets | 61,823 |\n| Deferred tax asset | 146 |\n| Deferred tax liabilities | (5,123 | ) |\n| Liabilities assumed | (42,550 | ) |\n| Aggregate purchase prices | $ | 76,735 |\n\nThe estimated fair value of intangible assets acquired and the related estimated useful lives consisted of the following (in thousands):\n| Useful Lives(in Years) | Value |\n| Customer relationships and other identifiable intangible assets | 10-18 | $ | 61,823 |\n| $ | 61,823 |\n\n2015 Acquisitions\nDuring 2015, the Company completed acquisitions of Shell portfolios related to our fuel card businesses in Europe, as well as a small acquisition internationally, with an aggregate purchase price of $46.3 million, made additional investments of $8.4 million related to its equity method investment at Masternaut and deferred payments of $3.4 million related to acquisitions occurring in prior years.\n106\nThe following table summarizes the acquisition accounting for the acquisitions completed during 2015 (in thousands):\n\n| Trade and other receivables | $ | 521 |\n| Prepaid expenses and other | 996 |\n| Property and equipment | 197 |\n| Goodwill | 9,561 |\n| Other intangible assets | 39,791 |\n| Deferred tax liabilities | (2,437 | ) |\n| Liabilities assumed | (2,331 | ) |\n| Aggregate purchase prices | $ | 46,298 |\n\nThe final estimated fair value of intangible assets acquired and the related estimated useful lives consisted of the following (in thousands):\n| Useful Lives(in Years) | Value |\n| Customer relationships | 14-20 | $ | 39,791 |\n| $ | 39,791 |\n\n7. Goodwill and Other Intangible Assets\n| December 31, 2016 | Acquisitions | Dispositions | Acquisition AccountingAdjustments | ForeignCurrency | December 31, 2017 |\n| Segment |\n| North America | $ | 2,640,409 | $ | 534,777 | $ | (92,046 | ) | $ | — | $ | 983 | $ | 3,084,123 |\n| International | 1,554,741 | 21,325 | — | 3,752 | 51,882 | 1,631,700 |\n| $ | 4,195,150 | $ | 556,102 | $ | (92,046 | ) | $ | 3,752 | $ | 52,865 | $ | 4,715,823 |\n\n\n| December 31, 2015 | Acquisitions | Acquisition AccountingAdjustments | ForeignCurrency | December 31, 2016 |\n| Segment |\n| North America | $ | 2,640,409 | $ | — | $ | — | $ | — | $ | 2,640,409 |\n| International | 905,625 | 687,828 | (521 | ) | (38,191 | ) | 1,554,741 |\n| $ | 3,546,034 | $ | 687,828 | $ | (521 | ) | $ | (38,191 | ) | $ | 4,195,150 |\n\nAt December 31, 2017 and 2016, approximately $988.0 million and $362.6 million of the Company’s goodwill is deductible for tax purposes, respectively. Acquisition accounting adjustments recorded in 2017 and 2016 are a result of the Company completing its acquisition accounting and working capital adjustments for certain prior year acquisitions.\n107\nOther intangible assets consisted of the following at December 31 (in thousands):\n\n| 2017 | 2016 |\n| Weighted-Avg UsefulLife(Years) | GrossCarryingAmounts | AccumulatedAmortization | NetCarryingAmount | GrossCarryingAmounts | AccumulatedAmortization | NetCarryingAmount |\n| Customer and vendor agreements | 17.0 | $ | 2,698,428 | $ | (605,347 | ) | $ | 2,093,081 | $ | 2,449,389 | $ | (458,118 | ) | $ | 1,991,271 |\n| Trade names and trademarks—indefinite lived | N/A | 499,587 | — | 499,587 | 510,952 | — | 510,952 |\n| Trade names and trademarks—other | 13.8 | 2,986 | (2,207 | ) | 779 | 2,746 | (2,021 | ) | 725 |\n| Software | 6.0 | 219,019 | (116,654 | ) | 102,365 | 211,331 | (85,167 | ) | 126,164 |\n| Non-compete agreements | 4.5 | 48,221 | (19,076 | ) | 29,145 | 35,191 | (11,070 | ) | 24,121 |\n| Total other intangibles | $ | 3,468,241 | $ | (743,284 | ) | $ | 2,724,957 | $ | 3,209,609 | $ | (556,376 | ) | $ | 2,653,233 |\n\nChanges in foreign exchange rates resulted in a $24.2 million increase to the carrying values of other intangible assets in the year ended December 31, 2017. Amortization expense related to intangible assets for the years ended December 31, 2017, 2016 and 2015 was $211.8 million, $161.6 million and $159.7 million, respectively. As part of the Company's plan to exit the telematics business, on July 27, 2017, the Company sold NexTraq, a U.S. fleet telematics business, to Michelin Group, resulting in a $41.8 million reduction in the net carrying values of other intangible assets.\nThe future estimated amortization of intangibles at December 31, 2017 is as follows (in thousands):\n\n| 2018 | $ | 220,506 |\n| 2019 | 206,174 |\n| 2020 | 186,259 |\n| 2021 | 182,156 |\n| 2022 | 171,177 |\n| Thereafter | 1,259,098 |\n\n8. Property, Plant and Equipment\nProperty, plant and equipment, net consisted of the following at December 31 (in thousands):\n| EstimatedUseful Lives(in Years) | 2017 | 2016 |\n| Computer hardware and software | 3 to 5 | $ | 244,655 | $ | 197,958 |\n| Card-reading equipment | 4 to 6 | 25,462 | 25,553 |\n| Furniture, fixtures, and vehicles | 2 to 10 | 18,846 | 15,418 |\n| Buildings and improvements | 5 to 50 | 21,603 | 14,432 |\n| Property, plant and equipment, gross | 310,566 | 253,361 |\n| Less: accumulated depreciation | (130,509 | ) | (110,857 | ) |\n| Property, plant and equipment, net | $ | 180,057 | $ | 142,504 |\n\nDepreciation expense related to property and equipment for the years ended December 31, 2017, 2016 and 2015 was $46.6 million, $36.5 million and $30.5 million, respectively. Depreciation expense includes $21.8 million, $17.7 million and $11.6 million, for capitalized computer software costs for the years ended December 31, 2017, 2016 and 2015, respectively. At December 31, 2017 and 2016, the Company had unamortized computer software costs of $75.8 million and $60.2 million, respectively.\n108\n9. Accrued Expenses\nAccrued expenses consisted of the following at December 31 (in thousands):\n\n| 2017 | 2016 |\n| Accrued bonuses | $ | 15,119 | $ | 15,866 |\n| Accrued payroll and severance | 18,500 | 10,704 |\n| Accrued taxes | 63,698 | 104,623 |\n| Accrued commissions/rebates | 47,198 | 43,467 |\n| Other | 93,957 | 64,152 |\n| $ | 238,472 | $ | 238,812 |\n\n10. Debt\nThe Company’s debt instruments at December 31 consist primarily of term notes, revolving lines of credit and a Securitization Facility as follows (in thousands):\n| 2017 | 2016 |\n| Term notes payable—domestic(a), net of discounts | $ | 2,993,667 | $ | 2,639,279 |\n| Revolving line of credit A Facility—domestic(a) | 635,000 | 465,000 |\n| Revolving line of credit B Facility—foreign(a) | 28,334 | 123,412 |\n| Revolving line of credit B Facility—swing line(a) | 6,879 | 26,608 |\n| Other(c) | 43,736 | 12,934 |\n| Total notes payable and other obligations | 3,707,616 | 3,267,233 |\n| Securitization Facility(b) | 811,000 | 591,000 |\n| Total notes payable, credit agreements and Securitization Facility | $ | 4,518,616 | $ | 3,858,233 |\n| Current portion | $ | 1,616,512 | $ | 1,336,506 |\n| Long-term portion | 2,902,104 | 2,521,727 |\n| Total notes payable, credit agreements and Securitization Facility | $ | 4,518,616 | $ | 3,858,233 |\n\n_____________________\n| (a) | The Company has a Credit Agreement, which has been amended multiple times and provides for senior secured credit facilities consisting of a revolving A credit facility in the amount of $1.285 billion, a term loan A facility in the amount of $2.69 billion and a term loan B facility in the amount of $350 million as of December 31, 2017. The revolving credit facility consists of (a) a revolving A credit facility in the amount of $800 million, with sublimits for letters of credit and swing line loans, (b) a revolving B facility in the amount of $450 million for swing line loans and multi-currency borrowings and, (c) a revolving C facility in the amount of $35 million for multi-currency borrowings in Australian Dollars or New Zealand Dollars. The Credit Agreement also includes an accordion feature for borrowing an additional $750 million in term A, term B or revolver A debt. Proceeds from the credit facilities may be used for working capital purposes, acquisitions, and other general corporate purposes. On January 20, 2017, the Company entered into the second amendment to the Credit Agreement, which established a new term B loan. On August 2, 2017, the Company entered into the third amendment to the Credit Agreement, which increased the total facility by $708.7 million and extended the terms of the credit facilities to August 2, 2022 for the term A loan, revolving loans, and letters of credit under the Credit Agreement and August 2, 2024 for the term B loan. |\n\nInterest on amounts outstanding under the Credit Agreement (other than the term B loan) accrues based on the British Bankers Association LIBOR Rate (the Eurocurrency Rate), plus a margin based on a leverage ratio, or our option, the Base Rate (defined as the rate equal to the highest of (a) the Federal Funds Rate plus 0.50%, (b) the prime rate announced by Bank of America, N.A., or (c) the Eurocurrency Rate plus 1.00%) plus a margin based on a leverage ratio. Interest on the term B loan facility accrues based on the Eurocurrency Rate plus 2.00% for Eurocurrency Loans and at 1.00% for Base Rate Loans. In addition, the Company pays a quarterly commitment fee at a rate per annum ranging from 0.20% to 0.40% of the daily unused portion of the credit facility.\nAt December 31, 2017, the interest rate on the term A loan and the domestic revolving A facility was 3.32%, the interest rate on the foreign revolving B facility was 2.25%, the interest rate on the revolving B facility foreign swing line of\n109\ncredit was 2.22% and the interest rate on the term B loan was 3.57%. The unused credit facility was 0.35% for all revolving facilities at December 31, 2017.\nThe term loans are payable in quarterly installments and are due on the last business day of each March, June, September, and December with the final principal payment due on the respective maturity date. Borrowings on the revolving line of credit are repayable at the option of one, two, three or nine months after borrowing, depending on the term of the borrowing on the facility. Borrowings on the foreign swing line of credit are due no later than ten business days after such loan is made.\nAt December 31, 2017, the Company had $2.7 billion in borrowings outstanding on term A loan, excluding the related debt discount, $349.1 million in borrowings outstanding on term B loan, excluding the related debt discount, $635 million in borrowings outstanding on the domestic revolving A facility, $28.3 million in borrowings outstanding on the foreign revolving B facility and $6.9 million in borrowings outstanding on the foreign swing line revolving B facility. The Company has unamortized debt discounts of $6.0 million related to the term A facility and $0.7 million related to the term B facility and deferred financing costs of $5.1 million at December 31, 2017. In August 2017, the Company expensed $3.3 million and capitalized $10.6 million of debt issuance costs associated with the refinancing of its Credit Facility. The effective interest rate incurred on term loans was 2.69% and 2.57% during 2017 and 2016, respectively, related to the discount on debt. Principal payments of $423.2 million were made on the term loans during 2017.\n\n| (b) | The Company is party to a $950 million receivables purchase agreement (Securitization Facility) that was amended and restated on November 14, 2017. There is a program fee equal to one month LIBOR plus 0.90% or the Commercial Paper Rate plus 0.80% as of December 31, 2017 and one month LIBOR or the Commercial Paper Rate plus 0.90% as of December 31, 2016. The program fee was 1.55% plus 0.86% as of December 31, 2017 and 0.85% plus 0.90% as of December 31, 2016. The unused facility fee is payable at a rate of 0.40% as of December 31, 2017 and 2016. The Securitization Facility provides for certain termination events, which includes nonpayment, upon the occurrence of which the administrator may declare the facility termination date to have occurred, may exercise certain enforcement rights with respect to the receivables, and may appoint a successor servicer, among other things. |\n\n| (c) | Other includes the long term portion of contingent consideration and deferred payments associated with certain of our businesses. |\n\nThe Company was in compliance with all financial and non-financial covenants at December 31, 2017.\nThe contractual maturities of the Company’s notes payable and other obligations at December 31, 2017 are as follows (in thousands):\n\n| 2018 | $ | 805,512 |\n| 2019 | 173,927 |\n| 2020 | 136,197 |\n| 2021 | 136,337 |\n| 2022 | 2,121,177 |\n| Thereafter | 334,466 |\n\n11. Income Taxes\nOn December 22, 2017, the U.S. government enacted tax legislation referred to as the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act makes broad and complex changes to the U.S. tax code, including, but not limited to, (1) reducing the U.S. federal corporate tax rate from 35 percent to 21 percent; (2) requiring companies to pay a one-time Deemed Repatriation Transition Tax (“Transition Tax”) on certain unrepatriated earnings of foreign subsidiaries that can be paid over eight years; (3) a new provision designed to tax global intangible low-taxed income (GILTI), which allows for the possibility of using foreign tax credits (FTCs) and a deduction of up to 50 percent to offset the income tax liability (subject to some limitations); (4) the repeal of the domestic production activity deduction beginning January 1, 2018; (5) limitations on the deductibility of certain executive compensation; and (6) a new limitation on deductible interest expense beginning January 1, 2018.\nAt December 31, 2017, the Company has not completed its accounting for the tax effects of enactment of the Tax Act. However, as described below, the Company has made a reasonable estimate of the effects on its existing deferred tax balances and the one-time Transition Tax. In other cases, the Company has not been able to make a reasonable estimate and continue to\n110\naccount for those items based on its existing accounting under ASC 740 (\"Income Taxes\"), and the provisions of the tax laws that were in effect immediately prior to enactment. The Company was not able to make a reasonable estimate of the impact of the new limitations on the deductibility of certain executive compensation.\nFor those items for which it was able to determine a reasonable estimate, the Company recognized a provisional net tax benefit of $128.2 million, which is included as a component of income tax expense from continuing operations. In all cases, the Company will continue to make and refine its calculations as additional analysis is completed. In addition, it is anticipated that the U.S. Treasury Department will publish new regulations providing some clarity to many of the provisions included in the new act. As a result, the Company's estimates may also be affected as it gains a more thorough understanding of the Tax Act via new regulations and other guidance.\nThe SEC staff issued Staff Accounting Bulletin No. 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act (\"SAB 118\"), which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC 740. In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Act for which the accounting under ASC 740 is complete. To the extent that a company’s accounting for certain income tax effects of the Tax Act is incomplete but it is able to determine a reasonable estimate, it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax laws that were in effect immediately before the enactment of the Tax Act.\nIn connection with its initial analysis of the impact of the Tax Act, the Company has recorded a net tax benefit of $128.2 million in the period ending December 31, 2017. This net benefit primarily consists of a net benefit for the corporate rate reduction on the deferred tax assets and liabilities of $210 million and a net expense for the Transition Tax of $81.8 million. For various reasons that are discussed more fully below, the Company has not completed its accounting for the income tax effects of certain elements of the Tax Act. However, the Company was able to make reasonable estimates of the effects of the elements for which its analysis is not yet complete and recorded provisional adjustments.\nThe Company's accounting for the following elements of the Tax Act are incomplete. However, the Company was able to make reasonable estimates of certain effects and, therefore, recorded provisional adjustments.\nDeferred tax effects\nThe Tax Act reduces the corporate tax rate to 21 percent, effective January 1, 2018. For its deferred tax assets and deferred tax liabilities, the Company has recorded a provisional decrease of $210 million with a corresponding net adjustment to deferred tax benefit of $210 million for the year ended December 31, 2017. While the Company was able to make a reasonable estimate of the impact of the reduction in corporate rate, the impact may be affected by other analysis related to the Tax Act, including, but not limited to, FLEETCOR's calculation of deemed repatriation of deferred foreign income and the state tax effect of adjustments made to federal temporary differences.\nOne time transition tax\nThe Transition Tax is a tax on previously untaxed accumulated and current earnings and profits (\"E&P\") of certain of the Company's foreign subsidiaries. To determine the amount of the Transition Tax, the Company must determine, in addition to other factors, the amount of post-1986 E&P of the relevant subsidiaries, as well as the amount of non-U.S. income taxes paid on such earnings. The Company was able to make a reasonable estimate of the Transition Tax and recorded a provisional Transition Tax obligation of $81.8 million. However, the Company is continuing to gather additional information to more precisely compute the amount of the Transition Tax. Further, the Transition Tax is based in part on the amount of accumulated and current E&P held in cash and other specified assets. This amount may change when the Company finalizes the calculation of post-1986 foreign E&P previously deferred from U.S. federal taxation and finalize the amounts held in cash or other specified assets. Double tax relief is available for the pool of foreign tax credits attributed to the accumulated and current E&P. The amount of foreign tax credits claimed when the Company finalizes the calculation of the pool of foreign tax credits.\nNo additional income taxes have been provided for any remaining undistributed foreign earnings not subject to the Transition Tax, or any additional outside basis differences inherent in these entities, as these amounts continue to be indefinitely reinvested in foreign operations. The Company has not been able to make a reasonable estimate of the impact of the unrecognized deferred tax liability related to any remaining undistributed foreign earnings not subject to the Transition Tax or additional outside basis differences in these entities.\n111\nThe Company has also not been able to make a reasonable estimate of the impact of the new limitations on the deductibility of certain executive compensation and continues to account for that item based on its existing accounting under ASC 740 and the provisions of the tax laws that were in effect immediately prior to enactment.\nGlobal Intangible Low-Taxed Income\nThe Tax Act subjects a U.S. shareholder to current tax on global intangible low-taxed income (GILTI) earned by certain foreign subsidiaries. The FASB Staff Q&A, Topic 740 No. 5, \"Accounting for Global Intangible Low-Taxed Income\", states that an entity can make an accounting policy election to either recognize deferred taxes for temporary differences expected to reverse as GILTI in future years or provide for the tax expense related to GILTI in the year the tax is incurred. Based on the Company's preliminary assessment of the GILTI tax, the Company believes it will recognize tax on GILTI as a period expense.\nIncome before the provision for income taxes is attributable to the following jurisdictions for years ended December 31 (in thousands) :\n| 2017 | 2016 | 2015 |\n| United States | $ | 524,669 | $ | 383,427 | $ | 304,743 |\n| Foreign | 368,921 | 259,492 | 231,261 |\n| Total | $ | 893,590 | $ | 642,919 | $ | 536,004 |\n\nThe provision for income taxes for the years ended December 31 consists of the following (in thousands):\n\n| 2017 | 2016 | 2015 |\n| Current: |\n| Federal | $ | 303,514 | $ | 147,406 | $ | 82,926 |\n| State | 19,234 | 10,725 | 8,051 |\n| Foreign | 78,354 | 61,084 | 51,970 |\n| Total current | 401,102 | 219,215 | 142,947 |\n| Deferred: |\n| Federal | (255,188 | ) | (18,723 | ) | 36,723 |\n| State | 276 | 1,608 | 1,525 |\n| Foreign | 7,200 | (11,566 | ) | (7,622 | ) |\n| Total deferred | (247,712 | ) | (28,681 | ) | 30,626 |\n| Total provision | $ | 153,390 | $ | 190,534 | $ | 173,573 |\n\n112\nThe provision for income taxes differs from amounts computed by applying the U.S. federal tax rate of 35% to income before income taxes for the years ended December 31 due to the following (in thousands):\n\n| 2017 | 2016 | 2015 |\n| Computed “expected” tax expense | $ | 312,756 | 35.0 | % | $ | 225,022 | 35.0 | % | $ | 187,601 | 35.0 | % |\n| Changes resulting from: |\n| Change in valuation allowance | 18,289 | 2.0 | 11,952 | 1.9 | 20,243 | 3.8 |\n| Foreign income tax differential | (38,695 | ) | (4.3 | ) | (25,533 | ) | (4.0 | ) | (23,718 | ) | (4.4 | ) |\n| State taxes net of federal benefits | 12,884 | 1.4 | 9,439 | 1.5 | 6,711 | 1.2 |\n| Foreign-sourced nontaxable income | (8,836 | ) | (1.0 | ) | (13,659 | ) | (1.2 | ) | (10,573 | ) | (2.0 | ) |\n| IRC Section 199 deduction | (8,844 | ) | (1.0 | ) | (7,731 | ) | (1.2 | ) | (10,221 | ) | (1.9 | ) |\n| Excess tax benefits related to stock-based compensation | (18,058 | ) | (2.0 | ) | (11,974 | ) | (1.9 | ) | — | — |\n| Subpart F income/transition tax - federal only | 195,779 | 21.9 | — | — | — | — |\n| Foreign tax credit/transition tax - federal only | (113,955 | ) | (12.8 | ) | — | — | — | — |\n| Tax reform - federal rate reduction | (209,966 | ) | (23.5 | ) | — | — | — | — |\n| Other | 12,036 | 1.3 | 3,018 | (0.4 | ) | 3,530 | 0.7 |\n| Provision for income taxes | $ | 153,390 | 17.2 | % | $ | 190,534 | 29.7 | % | $ | 173,573 | 32.4 | % |\n\nThe tax effects of temporary differences that give rise to significant portions of the deferred tax assets and liabilities at December 31 are as follows (in thousands):\n\n| 2017 | 2016 |\n| Deferred tax assets: |\n| Accounts receivable, principally due to the allowance for doubtful accounts | $ | 6,752 | $ | 7,148 |\n| Accrued expenses not currently deductible for tax | 442 | 2,647 |\n| Stock based compensation | 37,274 | 41,415 |\n| Income tax credits | 376 | 376 |\n| Net operating loss carry forwards | 41,168 | 45,969 |\n| Investments | 37,804 | 53,379 |\n| Accrued escheat | 4,768 | 7,290 |\n| Fixed assets, intangibles and other | 12,604 | 15,622 |\n| Deferred tax assets before valuation allowance | 141,188 | 173,846 |\n| Valuation allowance | (59,349 | ) | (76,395 | ) |\n| Deferred tax assets, net | 81,839 | 97,451 |\n| Deferred tax liabilities: |\n| Intangibles—including goodwill | (508,958 | ) | (687,443 | ) |\n| Basis difference in investment in foreign subsidiaries | (39,287 | ) | (48,354 | ) |\n| Prepaid expenses | (1,605 | ) | (3,644 | ) |\n| Property and equipment, principally due to differences between book and tax depreciation, and other | (49,100 | ) | (24,157 | ) |\n| Deferred tax liabilities | (598,950 | ) | (763,598 | ) |\n| Net deferred tax liabilities | $ | (517,111 | ) | $ | (666,147 | ) |\n\n113\nThe Company’s deferred tax balances are classified in its balance sheets as of December 31 as follows (in thousands):\n\n| 2017 | 2016 |\n| Long term deferred tax assets and liabilities: |\n| Long term deferred tax assets | 1,801 | 2,433 |\n| Long term deferred tax liabilities | (518,912 | ) | (668,580 | ) |\n| Net long term deferred taxes | (517,111 | ) | (666,147 | ) |\n| Net deferred tax liabilities | $ | (517,111 | ) | $ | (666,147 | ) |\n\nThe valuation allowance for deferred tax assets at December 31, 2017 and 2016 was $59.3 million and $76.4 million, respectively. These valuation allowances related to basis differences in equity method investments, capital loss carryforwards, income tax credits, foreign net operating loss carryforwards and state net operating loss carryforwards. The net change in the total valuation allowance for the years ended December 31, 2017 and 2016 was a decrease of $17.0 million and an increase of $13.8 million, respectively. The valuation decrease from the prior year was due to the U.S. tax rate reduction that resulted from the Tax Act, which was offset by an increase in basis differences related to equity method investments completed in 2014. The increase in 2016 was primarily due to changes in the Company's deferred tax asset related to basis differences in an equity method investment.\n| Balances at December 31, 2014 | $ | 27,082 |\n| Additions | 35,523 |\n| Balance at December 31, 2015 | 62,605 |\n| Additions | 13,790 |\n| Balance at December 31, 2016 | 76,395 |\n| Additions | 5,332 |\n| Reduction in valuation allowance due to rate change from Tax Act | (22,378 | ) |\n| Balance at December 31, 2017 | $ | 59,349 |\n\nThe valuation allowances relate to basis differences in cost method investments, capital loss carryforwards, income tax credits, foreign net operating loss carryforwards and state net operating loss carryforwards. The net change in the total valuation allowance for the year ended December 31, 2017 was a decrease of $17.0 million. The valuation decrease from the prior year was due to the U.S. tax rate reduction that resulted from the Tax Act, which was partially offset by an increase in the basis differences related to cost method investments. The increase in 2015 and 2016 were primarily due to changes in the Company's deferred tax asset related to basis differences in a cost method investment.\nAs of December 31, 2017, the Company had a net operating loss carryforward for state income tax purposes of approximately $590.0 million that is available to offset future state taxable income through 2029. Additionally, the Company had $44.0 million net operating loss carryforwards for foreign income tax purposes that are available to offset future foreign taxable income. The foreign net operating loss carryforwards will not expire in future years.\nThe Company recognizes interest and penalties on unrecognized tax benefits (including interest and penalties calculated on uncertain tax positions on which the Company believes it will ultimately prevail) within the provision for income taxes on continuing operations in the consolidated financial statements. This policy is a continuation of the Company's policy prior to the adoption of the guidance regarding uncertain tax positions. During 2017 and 2016, the Company had recorded accrued interest and penalties related to the unrecognized tax benefits of $1.3 million and $5.9 million, respectively.\n114\nA reconciliation of the beginning and ending balances of the total amounts of gross unrecognized tax benefits including interest for the years ended December 31, 2017, 2016 and 2015 is as follows (in thousands):\n| Unrecognized tax benefits at December 31, 2014 | $ | 18,641 |\n| Additions based on tax provisions related to the current year | 9,079 |\n| Additions based on tax provisions related to the prior year | 477 |\n| Deductions based on settlement/expiration of prior year tax positions | (6,363 | ) |\n| Unrecognized tax benefits at December 31, 2015 | 21,834 |\n| Additions based on tax provisions related to the current year | 3,332 |\n| Additions based on tax provisions related to the prior year | 2,496 |\n| Deductions based on settlement/expiration of prior year tax positions | (1,507 | ) |\n| Unrecognized tax benefits at December 31, 2016 | 26,155 |\n| Additions based on tax provisions related to the current year | 4,143 |\n| Additions for tax positions due to acquisitions | 9,208 |\n| Additions based on tax provisions related to the prior year | 1,171 |\n| Deductions based on settlement/expiration of prior year tax positions | (9,119 | ) |\n| Unrecognized tax benefits at December 31, 2017 | $ | 31,558 |\n\nAs of December 31, 2017, the Company had total unrecognized tax benefits of $31.6 million of which $31.6 million, if recognized, would affect its effective tax rate. It is not anticipated that there are any unrecognized tax benefits that will significantly increase or decrease within the next twelve months.\nThe Company files numerous consolidated and separate income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions. The statute of limitations for the Company’s U.S. federal income tax returns has expired for years prior to 2014. The statute of limitations for the Company’s U.K. income tax returns has expired for years prior to 2015. The statute of limitations has expired for years prior to 2014 for the Company’s Czech Republic income tax returns, 2014 for the Company’s Russian income tax returns, 2012 for the Company’s Mexican income tax returns, 2012 for the Company’s Brazilian income tax returns, 2012 for the Company’s Luxembourg income tax returns, 2013 for the Company’s New Zealand income tax returns, and 2015 for the Company’s Australian income tax returns.\n12. Leases\nThe Company enters into noncancelable operating lease agreements for equipment, buildings and vehicles. The minimum lease payments for the noncancelable operating lease agreements are as follows (in thousands):\n\n| 2018 | $ | 19,343 |\n| 2019 | 14,362 |\n| 2020 | 12,132 |\n| 2021 | 10,661 |\n| 2022 | 10,195 |\n| Thereafter | 25,335 |\n\nRent expense for noncancelable operating leases approximated $18.4 million, $15.1 million and $14.1 million for the years ended December 31, 2017, 2016 and 2015, respectively. The leases are generally renewable at the Company’s option for periods of one to five years.\n13. Commitments and Contingencies\nIn the ordinary course of business, the Company is involved in various pending or threatened legal actions, arbitration proceedings, claims, subpoenas, and matters relating to compliance with laws and regulations (collectively, legal proceedings). Based on our current knowledge, management presently does not believe that the liabilities arising from these legal\n115\nproceedings will have a material adverse effect on our consolidated financial condition, results of operations or cash flows. However, it is possible that the ultimate resolution of these legal proceedings could have a material adverse effect on our results of operations and financial condition for any particular period.\nShareholder Class Action and Derivative Lawsuits\nOn June 14, 2017, a shareholder filed a class action complaint in the United States District Court for the Northern District of Georgia against the Company and certain of its officers and directors on behalf of all persons who purchased or otherwise acquired the Company’s stock between February 5, 2016 and May 2, 2017. On October 13, 2017, the shareholder filed an amended complaint asserting claims on behalf of a putative class of all persons who purchased or otherwise acquired the Company's common stock between February 4, 2016 and May 3, 2017. The complaint alleges that the defendants made false or misleading statements regarding fee charges and the reasons for its earnings and growth in certain press releases and other public statements in violation of the federal securities laws. Plaintiff seeks class certification, unspecified monetary damages, costs, and attorneys’ fees. The Company disputes the allegations in the complaint and intends to vigorously defend against the claims.\nOn July 10, 2017, a shareholder derivative complaint was filed against the Company and certain of the Company’s directors and officers in the United States District Court for the Northern District of Georgia seeking recovery on behalf of the Company. The derivative complaint alleges that the defendants issued a false and misleading proxy statement in violation of the federal securities laws; that defendants breached their fiduciary duties by causing or permitting the Company to make allegedly false and misleading public statements concerning the Company’s fee charges, and financial and business prospects; and that certain defendants breached their fiduciary duties through allegedly improper sales of stock. The complaint seeks unspecified monetary damages on behalf of the Company, corporate governance reforms, disgorgement of profits, benefits and compensation by the defendants, restitution, costs, and attorneys’ and experts’ fees. On August 18, 2017, the court entered an order deferring the case pending a ruling on the defendants' motion to dismiss the putative shareholder class action, or until otherwise agreed to by the parties. The defendants dispute the allegations in the complaint and intend to vigorously defend against the claims.\nEstimating an amount or range of possible losses resulting from litigation proceedings is inherently difficult and requires an extensive degree of judgment, particularly where the matters involve indeterminate claims for monetary damages, and are in the stages of the proceedings where key factual and legal issues have not been resolved. For these reasons, the Company is currently unable to predict the ultimate timing or outcome of, or reasonably estimate the possible losses or a range of possible losses resulting from the matters described above.\n14. Asset Dispositions\nTelematics Businesses\nAs part of the Company's plan to exit the telematics business, on July 27, 2017, the Company sold NexTraq, a U.S. fleet telematics business, to Michelin Group for $316.5 million. The Company recorded a pre-tax gain on the disposal of NexTraq of $175.0 million during the third quarter of 2017, which is net of transaction closing costs. The Company recorded tax on the gain of disposal of $65.8 million. The gain on the disposal is included in other (income) expense, net in the accompanying Consolidated Statements of Income. NexTraq had historically been included in the Company's North America segment.\n15. Derivative Financial Instruments\nAs a result of the Cambridge acquisition during 2017, the Company writes derivatives, primarily foreign currency forward contracts, option contracts, and swaps, mostly with small and medium size enterprises that are customers and derives a currency spread from this activity. Derivative transactions include:\n| • | Forward contracts, which are commitments to buy or sell at a future date a currency at a contract price and will be settled in cash. |\n\n| • | Option contracts, which gives the purchaser, the right, but not the obligation to buy or sell within a specified time a currency at a contracted price that may be settled in cash. |\n\n| • | Swap contracts, which are commitments to settlement in cash at a future date or dates, usually on an overnight basis. |\n\nThe credit risk inherent in derivative agreements represents the possibility that a loss may occur from the nonperformance of a counterparty to the agreements. The Company performs a review of the credit risk of these counterparties at the inception of\n116\nthe contract and on an ongoing basis. The Company also monitors the concentration of its contracts with any individual counterparty against limits at the individual counterparty level. The Company anticipates that the counterparties will be able to fully satisfy their obligations under the agreements, but takes action when doubt arises about the counterparties' ability to perform. These actions may include requiring customers to post or increase collateral, and for all counterparties, the possible termination of the related contracts. The Company does not designate any of its foreign exchange derivatives as hedging instruments in accordance with ASC 815.\nThe aggregate equivalent U.S. dollar notional amount of foreign exchange derivative customer contracts held by the Company as of December 31, 2017 (in millions) is presented in the table below. Notional amounts do not reflect the netting of offsetting trades, although these offsetting positions may result in minimal overall market risk. Aggregate derivative notional amounts can fluctuate from period to period in the normal course of business based on market conditions, levels of customer activity and other factors.\n| Net Notional |\n| Foreign exchange contracts: |\n| Swaps | $ | 515.4 |\n| Futures, forwards and spot | 3,274.5 |\n| Written options | 2,934.2 |\n| Purchased options | 2,314.1 |\n| Total | $ | 9,038.1 |\n\nThe majority of customer foreign exchange contracts are written in major currencies such as the U.S. Dollar, Canadian Dollar, British Pound, Euro and Australian Dollar.\nThe following table summarizes the fair value of derivatives reported in the Consolidated Balance Sheet as of December 31, 2017 (in millions):\n| Fair Value, Gross | Fair Value, Net |\n| Derivative Assets | Derivative Liabilities | Derivative Assets | Derivative Liabilities |\n| Derivatives - undesignated: |\n| Over the counter | $ | 80.4 | $ | 68.2 | $ | 39.0 | $ | 26.8 |\n| Exchange traded | — | 0.1 | — | 0.1 |\n| Foreign exchange contracts | 80.4 | 68.3 | 39.0 | 26.9 |\n| Cash collateral | 12.5 | 10.9 | 12.5 | 10.9 |\n| Total net derivative assets and liabilities | $ | 67.9 | $ | 57.4 | $ | 26.5 | $ | 16.0 |\n\nThe fair values of derivative assets and liabilities associated with contracts that include netting language that the Company believes to be enforceable have been netted to present the Company's net exposure with these counterparties. The Company recognizes all derivative assets, net in prepaid expense and other current assets and all derivative liabilities, net in other current liabilities, both net at the customer level as right of offset exists, in its Consolidated Balance Sheets at their fair value. The gain or loss on the fair value is recognized immediately within revenues, net in the Consolidated Statements of Income. The Company does not offset fair value amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral. At December 31, 2017, $39.0 million derivative assets and $26.9 million derivative liabilities were recorded in other current assets and other current liabilities, respectively, in the Consolidated Balance Sheet. The Company receives cash from customers as collateral for trade exposures, which is recorded within cash and cash equivalents and customer deposits in the Consolidated Balance Sheet. The customer has the right to recall their collateral in the event exposures move in their favor, they unwind all outstanding trades or they cease to do business with the Company.\n16. Earnings Per Share\nThe Company reports basic and diluted earnings per share. Basic earnings per share is computed by dividing net income attributable to shareholders of the Company by the weighted average number of common shares outstanding during the reported period. Diluted earnings per share reflect the potential dilution related to equity-based incentives using the treasury stock method.\n117\nThe calculation and reconciliation of basic and diluted earnings per share for the years ended December 31 (in thousands, except per share data) follows:\n\n| 2017 | 2016 | 2015 |\n| Net income | $ | 740,200 | $ | 452,385 | $ | 362,431 |\n| Denominator for basic earnings per share | 91,129 | 92,597 | 92,023 |\n| Dilutive securities | 2,465 | 2,616 | 2,116 |\n| Denominator for diluted earnings per share | 93,594 | 95,213 | 94,139 |\n| Basic earnings per share | $ | 8.12 | $ | 4.89 | $ | 3.94 |\n| Diluted earnings per share | 7.91 | 4.75 | 3.85 |\n\nThere were 0.1 million antidilutive shares for the year ended December 31, 2017. Diluted earnings per share for the years ended December 31, 2017, 2016 and 2015 excludes the effect of 0.1 million , 0.4 million and 1.4 million shares, respectively, of common stock that may be issued upon the exercise of employee stock options because such effect would be antidilutive. There were 0.1 million antidilutive shares for 2016. Diluted earnings per share also excludes the effect of 0.3 million, 0.2 million and 0.2 million shares of performance based restricted stock for which the performance criteria have not yet been achieved for the years ended December 31, 2017, 2016 and 2015, respectively.\n17. Segments\nThe Company reports information about its operating segments in accordance with the authoritative guidance related to segments. The Company’s reportable segments represent components of the business for which separate financial information is evaluated regularly by the chief operating decision maker in determining how to allocate resources and in assessing performance. The Company operates in two reportable segments, North America and International. The results from the Cambridge business acquired in the third quarter of 2017 and CLS business acquired in the fourth quarter of 2017 are reported in the Company's North America segment. The results from the Company's Russian business acquired in the fourth quarter of 2017 are reported in its International segment. There were no inter-segment sales.\nThe Company’s segment results are as follows as of and for the years ended December 31 (in thousands):\n\n| 2017 | 2016 | 2015 |\n| Revenues, net: |\n| North America | $ | 1,428,711 | $ | 1,279,102 | $ | 1,231,957 |\n| International | 820,827 | 552,444 | 470,908 |\n| $ | 2,249,538 | $ | 1,831,546 | $ | 1,702,865 |\n| Operating income: |\n| North America | $ | 541,598 | $ | 506,414 | $ | 442,052 |\n| International | 342,162 | 247,739 | 225,482 |\n| $ | 883,760 | $ | 754,153 | $ | 667,534 |\n| Depreciation and amortization: |\n| North America | $ | 139,418 | $ | 129,653 | $ | 127,863 |\n| International | 125,142 | 73,603 | 65,590 |\n| $ | 264,560 | $ | 203,256 | $ | 193,453 |\n| Capital expenditures: |\n| North America | $ | 40,747 | $ | 39,000 | $ | 19,883 |\n| International | 29,346 | 20,011 | 21,992 |\n| $ | 70,093 | $ | 59,011 | $ | 41,875 |\n| Long-lived assets (excluding goodwill): |\n| North America | $ | 1,888,599 | $ | 1,664,224 | $ | 1,719,639 |\n| International | 1,131,610 | 1,203,465 | 602,941 |\n| $ | 3,020,209 | $ | 2,867,689 | $ | 2,322,580 |\n\n118\nThe Company attributes revenues, net from external customers to individual countries based upon the country in which the related services were rendered. The table below presents certain financial information related to the Company’s significant operations as of and for the years ended December 31 (in thousands):\n| 2017 | 2016 | 2015 |\n| Revenues, net by location: |\n| United States (country of domicile) | $ | 1,400,801 | $ | 1,278,828 | $ | 1,231,641 |\n| Brazil | 394,550 | 167,769 | 85,124 |\n| United Kingdom | 236,550 | 229,125 | 248,598 |\n\nThe table below presents the Company's revenues, net from its primary product categories as of and for the years ended December 31 (in thousands).\n| Year Ended December 31, |\n| 2017 | 2016 | 2015 |\n| Revenue by Product Category | Revenues, net | Revenues, net | Revenues, net |\n| Fuel1 | $ | 1,096,153 | $ | 997,398 | $ | 1,115,570 |\n| Corporate payments | 261,822 | 179,557 | 162,283 |\n| Tolls | 326,977 | 102,740 | 9,337 |\n| Lodging | 126,657 | 100,664 | 91,751 |\n| Gift | 194,099 | 184,743 | 170,095 |\n| Other | 243,830 | 266,444 | 153,829 |\n| Consolidated revenues, net | $ | 2,249,538 | $ | 1,831,546 | $ | 1,702,865 |\n\n| 1Amounts shown for 2016 and 2015 from previously disclosed amounts conform to the current year's presentation. |\n\nThe table below presents the Company's long-lived assets (excluding goodwill) at December 31 (in thousands).\n| 2017 | 2016 |\n| Long-lived assets (excluding goodwill): |\n| United States (country of domicile) | $ | 1,808,043 | $ | 1,664,224 |\n| Brazil | 688,809 | 784,816 |\n| United Kingdom | 294,039 | 286,928 |\n\nNo single customer represented more than 10% of the Company’s consolidated revenue in 2017, 2016 and 2015.\n119\n18. Selected Quarterly Financial Data (Unaudited)\n\n| Fiscal Quarters Year Ended December 31, 2017 | First | Second | Third | Fourth |\n| Revenues, net | $ | 520,433 | $ | 541,237 | $ | 577,877 | $ | 609,991 |\n| Operating income | 195,068 | 216,043 | 232,637 | 240,012 |\n| Net income | 123,693 | 130,987 | 202,823 | 282,697 |\n| Basic earnings per share | $ | 1.34 | $ | 1.42 | $ | 2.23 | $ | 3.15 |\n| Diluted earnings per share | 1.31 | 1.39 | 2.18 | 3.05 |\n| Weighted average shares outstanding: |\n| Basic shares | 92,108 | 92,013 | 90,751 | 89,676 |\n| Diluted shares | 94,560 | 94,223 | 93,001 | 92,623 |\n\n\n| Fiscal Quarters Year Ended December 31, 2016* | First | Second | Third | Fourth |\n| Revenues, net | $ | 414,262 | $ | 417,905 | $ | 484,426 | $ | 514,953 |\n| Operating income | 175,955 | 171,168 | 191,055 | 215,975 |\n| Net income | 111,090 | 116,253 | 129,618 | 95,424 |\n| Earnings per share: |\n| Basic earnings per share | $ | 1.20 | $ | 1.25 | $ | 1.40 | $ | 1.03 |\n| Diluted earnings per share | 1.17 | 1.22 | 1.36 | 1.00 |\n| Weighted average shares outstanding: |\n| Basic shares | 92,516 | 92,665 | 92,631 | 92,574 |\n| Diluted shares | 95,030 | 95,279 | 95,307 | 95,235 |\n\n*2016 quarterly amounts reflect the impact of the Company's adoption of Accounting Standards Update 2016-09, Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payments Accounting, to simplify several aspects of the accounting for share-based compensation, including the income tax consequences.\nThe sum of the quarterly earnings per common share amounts for 2017 and 2016 may not equal the earnings per common share for the 2017 and 2016 due to rounding.\nThe fourth quarter of 2017 includes the provisional net tax benefit of $128.2 million as a result of the Tax Act and $11 million of incremental legal fees.\nThe fourth quarter of 2016 includes a $36.1 million impairment charge related to the Company’s minority investment in Masternaut, partially offset by a $31.8 million decrease in non-cash stock based compensation expense.\n120\nITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE\nNot applicable.\nITEM 9A. CONTROLS AND PROCEDURES\nEvaluation of Disclosure Controls and Procedures\nAs of December 31, 2017, management carried out, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2017, our disclosure controls and procedures were effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in applicable rules and forms and are designed to ensure that information required to be disclosed in those reports is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.\nManagement Report on Internal Control over Financial Reporting\nOur management team is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2017. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. As of December 31, 2017, management believes that the Company’s internal control over financial reporting is effective based on those criteria. Our independent registered public accounting firm has issued an audit report on our internal control over financial reporting, which is included in this annual report.\nIn connection with management's evaluation, our management team excluded from its assessment of the effectiveness of our internal control over financial reporting as of December 31, 2017, the internal controls related to three subsidiaries that we acquired during the year ended December 31, 2017, and for which financial results are included in our consolidated financial statements.\nOn August 9, 2017, we acquired Cambridge Global Payments (“Cambridge”), a leading business to business (B2B) international payments provider in Canada. On September 26, 2017, we acquired a fuel card provider in Russia. On October 13, 2017, we completed the acquisition of Creative Lodging Solutions (\"CLS\"), a lodging business, in the United States. Collectively we refer to these transactions as the Acquisitions. These Acquisitions constituted 11% of total assets, at December 31, 2017, and 3% of revenues, for the year then ended. This exclusion was in accordance with Securities and Exchange Commission guidance that an assessment of a recently acquired business may be omitted in management's report on internal control over financial reporting the year of acquisition.\nBecause of its inherent limitations, internal control over financial reporting may not prevent or detect all misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate. Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Due to such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, such risk.\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting during the quarter ended December 31, 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n121\nITEM 9B. OTHER INFORMATION\nNot applicable.\n122\nPART III\nITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE\nA list of our executive officers and biographical information appears in Part I, Item X of this Form 10-K. Information about our directors may be found under the caption “Nominees” and “Continuing Directors” in our Proxy Statement for the Annual Meeting of Shareholders to be held June 6, 2018 (the “Proxy Statement”). Information about our Audit Committee may be found under the caption “Board Committees” in the Proxy Statement. The foregoing information is incorporated herein by reference.\nThe information in the Proxy Statement set forth under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by reference.\nWe have adopted the FLEETCOR Code of Business Conduct and Ethics (the “code of ethics”), which applies to our Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer and Corporate Controller, and other finance organization employees. The code of ethics is publicly available on our website at www.fleetcor.com under Investor Relations. If we make any substantive amendments to the code of ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer, or Chief Accounting Officer, we will disclose the nature of the amendment or waiver on that website or in a report on Form 8-K.\nITEM 11. EXECUTIVE COMPENSATION\nThe information in the Proxy Statement set forth under the captions “Director Compensation,” “Named Executive Officer Compensation,” “Compensation Committee Report,” and “Compensation Committee Interlocks and Insider Participation” is incorporated herein by reference.\nITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT\nAND RELATED STOCKHOLDER MATTERS\nThe information in the Proxy Statement set forth under the captions “Securities Authorized for Issuance Under Equity Compensation Plans,” “Information Regarding Beneficial Ownership of Principal Shareholders, Directors, and Management” and “Equity Compensation Plan Information” is incorporated herein by reference.\nITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR\nINDEPENDENCE\nThe information set forth in the Proxy Statement under the captions “Director Independence” and “Certain Relationships and Related Transactions” is incorporated herein by reference.\nITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES\nInformation concerning principal accountant fees and services appears in the Proxy Statement under the headings “Fees Billed by Ernst & Young LLP” and “Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditor” and is incorporated herein by reference.\n123\nPART IV\nITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES\n(a) Financial Statements and Schedules\nThe financial statements are set forth under Item 8 of this Form 10-K, as indexed below. Financial statement schedules have been omitted since they either are not required, not applicable, or the information is otherwise included.\nIndex to Financial Statements\n| Page |\n| Reports of Independent Registered Public Accounting Firm | 83 |\n| Consolidated Balance Sheets at December 31, 2017 and 2016 | 85 |\n| Consolidated Statements of Income for the Years Ended December 31, 2017, 2016 and 2015 | 86 |\n| Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2017, 2016 and 2015 | 87 |\n| Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2017, 2016 and 2015 | 88 |\n| Consolidated Statements of Cash Flows for the Years Ended December 31, 2017, 2016 and 2015 | 89 |\n| Notes to Consolidated Financial Statements | 90 |\n\n(b) Exhibit Listing\n| Exhibit no. |\n| 2.1 | Stock Purchase Agreement, dated as of April 1, 2009, among FLEETCOR Technologies Operating Company, LLC, CLC Group, Inc., and the entities and individuals identified on the signature pages thereto (incorporated by reference to Exhibit No. 2.1 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\n| 2.2 | Share Purchase Agreement among Arval UK Group Limited, FLEETCOR UK Acquisition Limited and FLEETCOR Technologies, Inc. (incorporated by reference to exhibit No. 2.1 to the registrant’s Form 8-K, filed with the SEC on December 13, 2011) |\n| 2.3 | Agreement and Plan of Merger, dated August 12, 2014, by and among Comdata Inc., Ceridian LLC, FLEETCOR Technologies, Inc. and FCHC Project, Inc. (incorporated by reference to Exhibit No. 2.1 to the registrant’s Form 10-Q, filed with the SEC with the SEC on November 10, 2014) |\n| 2.4 | Amendment to Agreement and Plan of Merger, dated November 10, 2014, by and among Comdata Inc., Ceridian LLC, FLEETCOR Technologies, Inc. and FCHC Project, Inc. (incorporated by reference to Exhibit No. 10.2 to the registrant’s Form 8-K, filed with the SEC on November 17, 2014) |\n| 2.5 | Acquisition agreement to acquire Serviços e Tecnologia de Pagamentos S.A. (incorporated by reference to Exhibit 2.1 to the registrant’s Form 8-K, File No. 001-35004, filed with the Securities and Exchange Commission on March 18, 2016) |\n| 3.1 | Amended and Restated Certificate of Incorporation of FLEETCOR Technologies, Inc. (incorporated by reference to Exhibit 3.1 to the registrant’s Annual Report on Form 10-K, File No. 001-35004, filed with SEC on March 25, 2011) |\n| 3.2 | Amended and Restated Bylaws of FLEETCOR Technologies, Inc. (incorporated by reference to Exhibit 3.1 to the registrant’s Current Report on Form 8-K, filed with the SEC on January 29, 2018) |\n| 4.1 | Form of Stock Certificate for Common Stock (incorporated by reference to Exhibit 4.1 to Amendment No. 3 to the registrant’s Registration Statement on Form S-1, File No. 333-166092, filed with the SEC on June 29, 2010) |\n| 10.1* | Form of Indemnity Agreement entered into between FLEETCOR and its directors and executive officers (incorporated by reference to Exhibit 10.1 to Amendment No. 3 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on June 29, 2010) |\n\n124\n| 10.2* | FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.2 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\n| 10.3* | First Amendment to FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.3 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\n| 10.4* | Second Amendment to FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.4 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\n| 10.5* | Third Amendment to FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.5 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\n| 10.6* | Fourth Amendment to FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.6 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\n| 10.7* | Form of Incentive Stock Option Award Agreement pursuant to the FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.7 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\n| 10.8* | Form of Non-Qualified Stock Option Award Agreement pursuant to the FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.8 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\n| 10.9* | Form of Performance Share Restricted Stock Agreement pursuant to the FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.9 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\n| 10.10* | FLEETCOR Technologies, Inc. Annual Executive Bonus Program (incorporated by reference to Exhibit 10.11 to Amendment No. 2 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on June 8, 2010) |\n| 10.11* | Employee Noncompetition, Nondisclosure and Developments Agreement, dated September 25, 2000, between Fleetman, Inc. and Ronald F. Clarke (incorporated by reference to Exhibit 10.12 to Amendment No. 2 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on June 8, 2010) |\n| 10.12* | Offer Letter, dated September 20, 2002, between FLEETCOR Technologies, Inc. and Eric R. Dey (incorporated by reference to Exhibit 10.13 to Amendment No. 2 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on June 8, 2010) |\n| 10.13* | Service Agreement, dated July 9, 2007, between FLEETCOR Technologies, Inc. and Andrew R. Blazye (incorporated by reference to Exhibit 10.16 to Amendment No. 2 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on June 8, 2010) |\n| 10.14 | Sixth Amended and Restated Registration Rights Agreement, dated April 1, 2009, between FLEETCOR Technologies, Inc. and each of the stockholders party thereto (incorporated by reference to Exhibit 10.17 to Amendment No. 2 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on June 8, 2010) |\n| 10.15 | First Amendment to Sixth Amended and Restated Registration Rights Agreement (incorporated by reference to Exhibit No. 10.17 to the registrant’s form 10-K, filed with the SEC with the SEC on March 25, 2011) |\n| 10.16 | Form of Indemnity Agreement to be entered into between FLEETCOR and representatives of its major stockholders (incorporated by reference to Exhibit 10.37 to Amendment No. 3 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on June 29, 2010) |\n| 10.17 | Form of Director Restricted Stock Grant Agreement pursuant to the FLEETCOR Technologies, Inc. 2010 Equity Compensation Plan (incorporated by reference to Exhibit 10.38 to Amendment No. 6 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on November 30, 2010) |\n| 10.18* | Form of Employee Performance Share Restricted Stock Agreement pursuant to the FLEETCOR Technologies, Inc. 2010 Equity Compensation Plan (incorporated by reference to Exhibit 10.39 to Amendment No. 6 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on November 30, 2010) |\n\n125\n| 10.19* | Form of Employee Incentive Stock Option Award Agreement pursuant to the FLEETCOR Technologies, Inc. 2010 Equity Compensation Plan (incorporated by reference to Exhibit 10.40 to Amendment No. 6 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on November 30, 2010) |\n| 10.20* | Form of Employee Non-Qualified Stock Option Award Agreement pursuant to the FLEETCOR Technologies, Inc. 2010 Equity Compensation Plan (incorporated by reference to Exhibit 10.41 to Amendment No. 6 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on November 30, 2010) |\n| 10.21 | Form of Director Non-Qualified Stock Option Award Agreement pursuant to the FLEETCOR Technologies, Inc. 2010 Equity Compensation Plan (incorporated by reference to Exhibit 10.42 to Amendment No. 6 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on November 30, 2010) |\n| 10.22* | Amended and Restated Employee Noncompetition, Nondisclosure and Developments Agreement, dated November 29, 2010, between FLEETCOR Technologies, Inc. and Ronald F. Clarke (incorporated by reference to Exhibit No. 10.43 to Amendment No. 6 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on November 30, 2010) |\n| 10.23 | Arrangement Agreement Among FLEETCOR Luxembourg Holdings2 S.À.R.L, FLEETCOR Technologies, Inc. and CTF Technologies, Inc. (incorporated by reference to Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q, filed with the SEC on May 10, 2012) |\n| 10.24 | Repurchase Agreement, dated November 26, 2012, among the Company and the Repurchase Stockholders (incorporated by reference to Exhibit 10.1 to the registrant’s Form 8-K, filed with the SEC on November 27, 2012) |\n| 10.25* | FLEETCOR Technologies, Inc. 2010 Equity Compensation Plan, as amended and restated effective February 7, 2018 (incorporated by reference from Appendix A to Exhibit 10.1 to the registrant's Current Report on Form 8-K, filed with the SEC on February 12, 2018 ) |\n| 10.26 | FLEETCOR Technologies, Inc. Section 162(M) Performance—Based Program (incorporated by reference to Annex A to the registrant’s Proxy Statement, filed with the SEC on April 18, 2014) |\n| 10.27 | Credit Agreement, dated October 24, 2014, among FLEETCOR Technologies Operating Company, LLC, as Borrower, FLEETCOR Technologies, Inc., as Parent, FLEETCOR Technologies Operating Company, LLC, as a borrower and guarantor, certain of the our foreign subsidiaries as borrowers, Bank of America, N.A., as administrative agent, swing line lender and L/C issuer and a syndicate of financial institutions (incorporated by reference to Exhibit No. 10.4 to the registrant’s Form 10-Q filed with the SEC on November 10, 2014) |\n| 10.28 | Fifth Amended and Restated Receivables Purchase Agreement, dated November 14, 2014, by and among FLEETCOR Technologies, Inc. and PNC Bank, National Association, as administrator for a group of purchasers and purchaser agents, and certain other parties (incorporated by reference to Exhibit No. 10.1 to the registrant’s Form 8-K, filed with the SEC on November 17, 2014) |\n| 10.29 | Amended and Restated Performance Guaranty dated as of November 14, 2014 made by FLEETCOR Technologies, Inc. and FLEETCOR Technologies Operating Company, LLC, in favor of PNC Bank, National Association, as administrator under the Fifth Amended and Restated Receivables Purchase Agreement (incorporated by reference to Exhibit 10.32 to the registrant’s Form 10-K, file number 001-35004, filed with the SEC on March 2, 2015) |\n| 10.30 | Amended and Restated Purchase and Sale Agreement dated as of November 14, 2014, among various entities listed on Schedule I thereto, as originators, and FLEETCOR Funding LLC (incorporated by reference to Exhibit 10.33 to the registrant’s Form 10-K, file number 001-35004, filed with the SEC on March 2, 2015) |\n| 10.31 | Receivables Purchase and Sale Agreement dated as of November 14, 2014, among Comdata TN, Inc. and Comdata Network, Inc. of California, as the sellers, and Comdata Inc., as the buyer (incorporated by reference to Exhibit 10.34 to the registrant’s Form 10-K, file number 001-35004, filed with the SEC on March 2, 2015) |\n| 10.32 | Investor Rights Agreement, dated November 14, 2014, between FLEETCOR Technologies, Inc. and Ceridian LLC (incorporated by reference to Exhibit 10.35 to the registrant’s Form 10-K, file number 001-35004, filed with the SEC on March 2, 2015) |\n| 10.33* | Offer Letter, dated June 19, 2013, between FLEETCOR Technologies, Inc. and John A. Reed (incorporated by reference to Exhibit No. 10.3 to the registrant’s Form 10-Q, filed with the SEC on May 12, 2014) |\n| 10.34* | Offer Letter, dated July 29, 2014, between FLEETCOR Technologies, Inc. and Armando Lins Netto (incorporated by reference to Exhibit 10.1 to the registrant’s Form 10-Q, file number 001-35004, filed with the SEC on May 11, 2015) |\n\n126\n| 10.35 | First Amendment to the Fifth Amended and Restated Receivables Purchase Agreement, dated as of November 5, 2015, by and among FLEETCOR Funding LLC, FLEETCOR Technologies Operating Company, LLC and PNC Bank, National Association, as administrator for a group of purchasers and purchaser agents, and certain other parties (incorporated by reference to Exhibit 10.2 to the registrant’s Form 10-Q, file number 001-35004, filed with the SEC on November 9, 2015) |\n| 10.36* | Employee agreement on confidentiality, work product, non-competition, and non-solicitation (incorporated by reference to Exhibit 10.38 to the registrant's Form 10-K, file number 001-35004, filed with the SEC on February 29, 2016) |\n| 10.37 | Second Amendment to the Fifth Amended and Restated Receivables Purchase Agreement, dated as of December 1, 2015, by and among FLEETCOR Funding LLC, FLEETCOR Technologies Operating Company, LLC and PNC Bank, National Association, as administrator for a group of purchasers and purchaser agents, and certain other parties (incorporated by reference to Exhibit 10.39 to the registrant's Form 10-K, file number 001-35004, filed with the SEC on February 29, 2016) |\n| 10.40 | First Amendment to Credit Agreement and Lender Joiner Agreement, dated as of August 22, 2016, by and among FLEETCOR Funding LLC, FLEETCOR Technologies Operating Company, LLC and PNC Bank, National Association, as administrator for a group of purchasers and purchaser agents, and certain other parties (incorporated by reference to Exhibit 10.1 to the registrant’s Form 10-Q, filed with the SEC on November 9, 2016) |\n| 10.41 | Second Amendment to Credit Agreement, dated as of January 2017, among FLEETCOR Technologies Operating Company, LLC, as the Company, FLEETCOR Technologies, Inc., as the Parent, the designated borrowers party hereto, the other guarantors party hereto, Bank of America, N.A., as administrative agent, swing line lender and l/c issuer, and the other lenders party hereto and Merrill Lynch, Pierce, Fenner & Smith Incorporated, as sole lead arranger and sole bookrunner (incorporated by reference to Exhibit 10.41 to the registrant's Form 10-K, filed with the SEC on March 1, 2017) |\n| 10.42 | Third Amendment to Credit Agreement, dated as of August 2, 2017, among FLEETCOR Technologies Operating Company, LLC, as the Company, FLEETCOR Technologies, Inc., as the Parent, the designated borrowers party hereto, the other guarantors party hereto, Bank of America, N.A., as administrative agent, swing line lender and l/c issuer, and the other lenders party hereto, and Merrill Lynch, Pierce, Fenner & Smith Incorporated, as sole lead arranger and sole bookrunner (incorporated by reference to Exhibit 10.1 to the registrant’s Form 10-Q, filed with the SEC on August 8, 2017) |\n| 10.43 | Third Amendment to Fifth Amended and Restated Receivables Purchase Agreement, dated as of November 14, 2017, by and among FLEETCOR Funding LLC, FLEETCOR Technologies Operating Company, LLC, PNC Bank, National Association, as administrator for a group of purchasers and purchase agents, and certain other parties |\n| 11.1 | Statement of Computation of Share Earnings (See Note 16) |\n| 21.1 | List of subsidiaries of FLEETCOR Technologies, Inc. |\n| 23.1 | Consent of Independent Registered Public Accounting Firm |\n| 31.1 | Certification of Chief Executive Officer Pursuant to Section 302 |\n| 31.2 | Certification of Chief Financial Officer Pursuant to Section 302 |\n| 32.1 | Certification of Chief Executive Officer Pursuant to Section 906 |\n| 32.2 | Certification of Chief Financial Officer Pursuant to Section 906 |\n| 101 | The following financial information for the registrant formatted in XBRL (Extensible Business Reporting Language): (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income; (iv) the Consolidated Statements of Stockholders' Equity; (v) the Consolidated Statements of Cash Flows and (vi) the Notes to Consolidated Financial Statements |\n\n| * | Identifies management contract or compensatory plan or arrangement. |\n\n127\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned; thereunto duly authorized, in the City of Atlanta, State of Georgia, on March 1, 2018.\n\n| FLEETCOR Technologies, Inc. |\n| By: | /S/ RONALD F. CLARKE |\n| Ronald F. Clarke |\n| President and Chief Executive Officer |\n\nPursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of registrant and in the capacities indicated on March 1, 2018.\n\n| Signature | Title |\n| /S/ RONALD F. CLARKE | President, Chief Executive Officer and Chairman of the Board of Directors(Principal Executive Officer) |\n| Ronald F. Clarke |\n| /S/ ERIC R. DEY | Chief Financial Officer(Principal Financial Officer and Principal Accounting Officer) |\n| Eric R. Dey |\n| /s/ MICHAEL BUCKMAN | Director |\n| Michael Buckman |\n| /s/ JOSEPH W. FARRELLY | Director |\n| Joseph W. Farrelly |\n| /s/ THOMAS M. HAGERTY | Director |\n| Thomas M. Hagerty |\n| /s/ MARK A. JOHNSON | Director |\n| Mark A. Johnson |\n| /s/ RICHARD MACCHIA | Director |\n| Richard Macchia |\n| /s/ HALA G. MODDELMOG | Director |\n| Hala G. Moddelmog |\n| /s/ JEFFREY S. SLOAN | Director |\n| Jeffrey S. Sloan |\n| /s/ STEVEN T. STULL | Director |\n| Steven T. Stull |\n\n128\n \n\nWhat is the ratio per million locations of hotels under FLEETCOR's proprietary CLC Lodging network to the number of locations accepting FLEETCOR's purchasing and T&E cards in the United States and Canada?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nITEM 1. BUSINESS\\nGeneral\\nFLEETCOR is a leading global provider of commercial payment solutions. We help businesses of all sizes control, simplify and secure payment of various domestic and cross-border payables using specialized payment products. We serve businesses, merchants and partners in North America, Latin America, Europe, and Australasia. FLEETCOR’s predecessor company was organized in the United States in 1986, and FLEETCOR had its initial public offering in 2010 (NYSE: FLT).\\nFLEETCOR has two reportable segments, North America and International. We report these two segments as they align with our senior executive organizational structure, reflect how we organize and manage our employees around the world, manage operating performance, contemplate the differing regulatory environments in North America versus other geographies, and help us isolate the impact of foreign exchange fluctuations on our financial results.\\nOur payment solutions provide our customers with a payment method designed to be superior to and more robust and effective than what they use currently, whether they use a competitor’s product or another alternative method such as cash or check. Our solutions are comprised of payment products, networks and associated services.\\nFLEETCOR payment products function like a charge card or prepaid card, and tend to be specialized for specific spend categories, such as fuel or lodging, and/or specific customer groups, such as long haul transportation. FLEETCOR’s five primary product lines are Fuel, Lodging, Tolls, Corporate Payments and Gift. Additionally, we provide other payment products including fleet maintenance, employee benefits and long haul transportation-related services. Our products are used in 56 countries around the world, with our primary geographies being the U.S., Brazil and the United Kingdom, which combined accounted for approximately 90% of our revenue in 2017.\\nFLEETCOR uses both proprietary and third-party networks to deliver our payment solutions. FLEETCOR owns and operates proprietary networks with well-established brands throughout the world, bringing incremental sales and loyalty to affiliated merchants. Third-party networks are used to broaden payment product acceptance and use. In 2017, we processed approximately 3 billion transactions within these networks, of which approximately 1.4 billion were related to our Gift product line.\\nFLEETCOR capitalizes on its products’ specialization with sales and marketing efforts by deploying product-dedicated sales forces to target specific customer segments. We market our products directly through multiple sales channels, including field sales, telesales and digital marketing, and indirectly through our partners, which include major oil companies, leasing companies, petroleum marketers, value-added resellers (VARs) and referral partners.\\nWe believe that our size and scale, product breadth and specialization, geographic reach, proprietary networks, robust distribution capabilities and advanced technology contribute to our industry leading position.\\nProducts and services\\nWe offer specialized payment solutions predominately for commercial businesses. Our payment solutions are intended to provide our customers with a payment method superior to that which they formerly used, whether they used a competitor’s product or another alternative method such as cash or check. Our solutions are comprised of payment products, networks and associated services.\\nOur payment products typically function like a charge card or prepaid card. FLEETCOR provides a variety of payment mechanisms such as a plastic card, electronic tag, or other form to the customer. We issue credit to the customer (or accept prepaid funds from the customer) to allow for purchases using the payment product. FLEETCOR then reports the purchases to the customer and invoices (or debits prepaid amounts) for payment of purchases made on the customer’s account.\\nPayment networks are integral to our solutions, as they allow us to electronically connect to merchants and capture transaction data from the point of sale. We use both proprietary and third-party networks to deliver our payment solutions. For our proprietary networks, FLEETCOR provides merchant acquiring services, which may include affiliation, contract management, point-of-sale terminals, reporting and settlement. FLEETCOR owns and operates proprietary networks with well-established brands across 56 countries, bringing incremental sales and loyalty to affiliated merchants. Third-party networks include MasterCard in the U.S. and Visa in the U.K. and continental Europe, the retail outlets of various partners, and proprietary\\n4\\nnetworks owned and operated by other partners. We use these third-party networks in order to broaden our payment product acceptance and use. Through our proprietary and third-party networks, we capture detailed transaction data and can often enable advanced purchase controls at the point-of-sale.\\nWe support our payment products with specialized issuing, processing and information services that enable us to manage customer accounts, facilitate the routing, authorization, clearing and settlement of transactions, and provide value-added functionality and data, including customizable user-level controls and productivity analysis tools. Our customers can use these data, controls and tools to lower their operating costs, and combat fraud and employee misuse and streamline expense administration.\\nDepending on our customers’ and partners’ needs, we provide our products and services in a variety of combinations ranging from a comprehensive “end-to-end” solution (encompassing issuing, processing and network services) to limited back office processing services.\\nOur solutions tend to be specialized for specific spend categories, such as fuel or lodging, and/or specific customer segments, such as long haul transportation. This specialization is manifested in the purchase controls, merchant network, and reporting applicable to the spend category or customer segment. For example, a fuel card could provide controls on the type of fuel purchased, be accepted only at gas stations for fuel purchases, and provide fuel usage and efficiency reports for a customer’s fleet of vehicles. The combination of these specialized attributes allows our payment products to compete well against less specialized products such as cash or general purpose credit cards when it comes to controlling purchases within certain spend categories.\\nFLEETCOR’s five primary product lines are Fuel, Lodging, Tolls, Corporate Payments and Gift. Additionally, we provide other payment products including fleet maintenance, employee benefits and long haul transportation-related services.\\nFuel payment product line\\nOur fuel payment product line is our largest product category, representing approximately 49% of our revenue in 2017.\\nFLEETCOR offers fuel payment solutions to businesses and government entities who operate vehicle fleets, as well as to major oil companies, leasing companies and fuel marketers. Our fuel payment products are most often in the form of plastic cards, but also include other forms such as electronic RFID tags and paper vouchers. While predominately used to purchase fuel, many of our fuel payment products have additional purchasing capabilities to allow customers to purchase non-fuel items such as oil, vehicle maintenance supplies and services and building supplies.\\nOur fuel payment products, excluding paper vouchers, provide customers with tools and information to control their fuel and other fleet-related operating costs. Our proprietary processing and card management systems provide customers with customizable user-level controls, detailed transaction reporting, programmable alerts, configurable networks, contracted fuel price validation and audit, and vehicle efficiency analyses. Our customers can use these data, controls and tools to combat fraud and employee misuse, streamline expense administration and lower their vehicle fleets’ operating costs. The combination of these specialized attributes allows our fuel payment products to compete well against less specialized products such as cash or general purpose credit cards when it comes to controlling fuel purchases.\\nFor major oil companies, leasing companies and petroleum marketers, we provide program management services which allow these partners to outsource the sales, marketing, credit, service, and system operations of their branded fuel card portfolios. Depending on our partners’ needs and internal capabilities, we provide our products and services in a variety of combinations ranging from a comprehensive “end-to-end” solution (encompassing issuing, processing and network services) to limited back office processing services. Our fuel payment product partners include British Petroleum (BP), its subsidiary Arco, Shell and Speedway, and over 775 fuel marketers of all sizes.\\nWhile we refer to companies with whom we have strategic relationships as “partners,” our legal relationships with these companies are contractual, and do not constitute legal partnerships. Our contracts with our major oil company partners typically have initial terms of five to ten years with current remaining terms ranging from two to seven years. No single partner represented more than 10% of our consolidated revenue in any year during the last four years.\\nWe use both proprietary and third-party networks to deliver our fuel payment solutions, including the following examples:\\n5\\nNorth America proprietary networks for fuel payment products\\n\\n| • | Fuelman network—our primary proprietary fleet card network in the U.S. We have negotiated card acceptance and settlement terms with approximately 11,000 individual merchants, providing the Fuelman network with approximately 59,000 fueling sites and approximately 28,000 maintenance sites across the country. |\\n\\n| • | Comdata network—our network of truck stops and fuel merchants for the over-the-road trucking industry. We have negotiated card acceptance and settlement terms at over 8,100 truck stops and fuel merchants across the U.S. and Canada. |\\n\\n| • | Commercial Fueling Network (CFN)—our “members only” fueling network in the U.S. and Canada composed of over 2,500 fueling sites owned by CFN members themselves. The majority of these fueling sites are unattended cardlock facilities located in commercial and industrial areas. |\\n\\n| • | Pacific Pride Fueling network—our \\\"franchise\\\" fueling network in the U.S. composed of over 1,100 fueling sites owned by more than 240 franchisees. The majority of these fueling sites are unattended cardlock facilities located in commercial and industrial areas. |\\n\\nInternational proprietary networks for fuel payment products\\n\\n| • | Allstar network—our proprietary fleet card network in the U.K. We have negotiated card acceptance and settlement terms with approximately 2,200 individual merchants, providing this network with over 7,300 fueling sites. |\\n\\n| • | Keyfuels network—our proprietary fleet card network in the U.K. We have negotiated card acceptance and settlement terms with more than 500 individual merchants, providing the Keyfuels network with approximately 2,800 fueling sites. |\\n\\n| • | CCS network—our primary proprietary fleet card network in the Czech Republic and Slovakia. We have negotiated card acceptance and settlement terms with several major oil companies on a brand-wide basis, including MOL, Benzina, OMV, Slovnaft and Shell, and with approximately 1,100 other merchants, providing the CCS network at over 2,600 fueling sites and 800 other sites accepting our cards. |\\n\\n| • | Petrol Plus Region (PPR) network—our primary proprietary fleet card network in Russia, Poland, Ukraine, Belarus, Kazakhstan and Moldova. We have negotiated card acceptance and settlement terms with over 700 individual merchants, providing the PPR network with approximately 13,500 fueling sites across the region. |\\n\\n| • | Efectivale network—our proprietary fuel card and voucher network in Mexico. We have negotiated acceptance and settlement terms individual merchants, providing the network with over 6,300 fueling sites. |\\n\\n| • | CTF network—our proprietary fuel controls network in Brazil, composed of over 1,700 highway fueling sites through our partners, BR Distribuidora (Petrobas) and Ipiranga Distribuidora. |\\n\\nThird-Party networks for fuel payments products\\nIn addition to our proprietary “closed-loop” networks, we also utilize various third-party networks to deliver our payment programs and services. Examples of these networks include:\\n\\n| • | MasterCard network—In the U.S. and Canada, we issue co-branded MasterCard products which are accepted at over 175,000 fuel sites and 469,000 maintenance locations. These MasterCard products have additional purchasing capabilities which, when enabled, allow the cards to be accepted at approximately 10.9 million locations throughout the U.S. and Canada. |\\n\\n| • | Visa network—In the U.K., we issue products that utilize the Visa payment network, which includes over 8,400 fuel sites and 1,100 maintenance locations. These Visa products have additional purchasing capabilities which, when enabled, allow the cards to be accepted throughout the Visa network. |\\n\\n| • | Major oil and fuel marketer networks—The proprietary networks of branded locations owned by our major oil and fuel marketer partners in both North America and internationally are generally utilized to support the proprietary, branded card programs of these partners. |\\n\\n6\\n| • | UTA network—UNION TANK Eckstein GmbH & Co. KG (UTA) operates a network of over 55,000 points of acceptance in 40 European countries, including more than 44,000 fueling sites. The UTA network is generally utilized by European transport companies that travel between multiple countries. |\\n\\n| • | DKV network—DKV operates a network of over 65,000 fleet card-accepting locations across more than 40 countries throughout Europe. The DKV network is generally utilized by European transport companies that travel between multiple countries. |\\n\\n| • | Carnet networks—A national debit network in Mexico, which includes over 11,500 fueling sites across the country. |\\n\\nWe distribute our fuel payment solutions through direct and indirect channels to businesses of all sizes. This includes businesses with small- to medium-sized fleets, which we believe represent an attractive segment of the global commercial fleet market given their relatively high use of less efficient payment products, such as cash and general purpose credit cards. We serve customers across numerous industry verticals and particularly those verticals with significant vehicle fueling needs such as trucking, construction, manufacturing, energy, and consumer products distribution.\\nOur indirect channel includes our partners, such as major oil companies, leasing companies and fuel marketers. We generally provide our fuel payments solutions to our partners who offer our services under their own brands on a “white-label” basis. In turn, we leverage our partners’ brands, retail outlets, websites, and sales forces to help distribute our fuel payment products.\\nIn Brazil, we have designed proprietary equipment which, when installed at the fueling site and on the vehicle and combined with our processing system, significantly reduces the likelihood of unauthorized and fraudulent transactions. We offer this product to over-the-road trucking fleets, shipping fleets and other operators of heavily industrialized equipment, including sea-going vessels, mining equipment, agricultural equipment, and locomotives. We generally co-brand this product with BR Distribuidora (Petrobas) or Ipiranga Distribuidora, depending on which fuel distributor provides fuel to our fleet clients via its retail and wholesale distribution operations.\\nWith regard to our fuel payment products, we compete with independent fuel card issuers, major oil companies and petroleum marketers. Excluding major oil companies, our most significant competitors in this product category include WEX, U.S. Bank Voyager Fleet Systems, World Fuel Services, Edenred, Sodexo, Alelo, DKV, and Radius Payment Solutions.\\nLodging payment product line\\nWe offer lodging payment solutions to businesses in North America that have employees who travel overnight for work purposes. We offer two lodging payment products, a card-based solution for individual travelers and non-card based solution for crews. Our solutions can be customized to meet the specific needs of our customers, including access to a deeply discount hotel network and customer-specific rate negotiation, the ability to customize the network to fit customers’ specific travel needs and policies, enhanced controls and reporting, and audit and tax management services.\\nOur lodging payment products operate on our proprietary CLC Lodging network, which includes over 16,700 hotels across the U.S. and Canada. We also can secure hotel rooms outside our proprietary network if required by our customers. The size, scale and nature of our lodging customer base enable us to negotiate lodging nightly rates lower than the rates most companies could negotiate directly and far below the rates available to the general public.\\nOur customers can secure room nights with our solutions through our website or mobile app, by phone or email, or by walking into participating lodging properties and presenting their FLEETCOR lodging payment product credentials.\\nFLEETCOR has developed data management and payment processing systems to manage client billings and reports which, combined with our discounted hotel network, provide clients with savings and increased visibility into their lodging costs.\\nWe distribute our lodging payment solutions mostly through direct channels to businesses of all sizes and serve customers across a wide range of industries, including trucking, railroads, construction, telecom, energy, food service, retail distribution, and emergency response services such as FEMA and the American Red Cross. We provide our custom lodging solutions to large customers under contracts.\\nOur lodging payment solutions compete with similar offerings from Travelliance, Egencia (Expedia), hotelengine.com, and in-house travel departments of large corporations.\\n7\\nToll payment product line\\nIn Brazil, we offer an electronic toll and parking payments product to businesses and consumers in the form of RFID tags affixed to vehicles’ windshields. Our electronic toll and parking payments product operates on our proprietary Sem Parar network, which processed toll transactions for more than 3.2 million customers on 99% of the toll roads across Brazil. Our electronic tags may also be used to purchase fuel at select gas stations.\\nElectronic tolling provides convenience and faster travel for customers, while also reducing manual labor and cash handling at merchants’ toll booths. At gas stations, payment via electronic tags is faster, safer and more secure for customers, which in turn increases loyalty and station throughput for merchants. Beyond these benefits, our electronic toll payment product also provides commercial customers with driver routing controls and fare auditing, mostly in the form of vehicle type and axle count configuration.\\nFor certain commercial customers, we also offer prepaid paper vouchers as a means of payment on toll roads. We provide these vouchers to companies who contract with third-party drivers who do not have an electronic tag in their vehicles and for whom the companies are legally obligated to prepay tolls. Our paper toll vouchers are accepted for payment within our proprietary RODOCRED toll network, on behalf of more than 96,000 customers on all toll roads across Brazil.\\nWe distribute our toll payment products through direct and indirect channels to customers of all sizes and across a broad number of industry verticals. To reach commercial customers, we utilize the same set of direct channels as our other commercially-focused product lines including field sales, telesales and digital marketing. To reach consumers, we also place proprietary manned kiosks and unmanned vending machines in areas with high consumer foot traffic, such as shopping malls.\\nOur indirect channel includes a range of resellers and referral partners, including retail establishments with high consumer foot traffic such as grocery stores, pharmacies and gas stations. We provide our toll payment product to these partners under our brand and, in select cases, under the partner’s brand.\\nOur electronic toll payment product competes with similar offerings such as Move Mais, ConectCar (Banco Itaú and Ipiranga), Veloe (Alelo), Repom (Edenred), and Visa Vale (Banco Bradesco).\\nCorporate payments product line\\nWe offer a broad suite of corporate payments solutions with vertical-specific applications, which enable our customers to manage and control electronic payments across their enterprise, optimize corporate spending and offer innovative services that increase employee efficiency and customer loyalty. Our primary corporate payments products include virtual cards, purchasing cards, travel & entertainment (T&E) cards, payroll cards and cross-border payment facilitation. These products are predominately marketed in North America, with cross-border payments also offered in the United Kingdom and Australia. This collection of comprehensive solutions positions us to enable automation and savings across a customer’s entire accounts payables (A/P) process, including both domestic and international payables.\\nA virtual card provides a single-use card number for a specific amount within a defined timeframe and serves as a highly-effective replacement for check payments. Virtual cards provide enhanced security relative to checks while reducing payment costs for our customers. Full remittance data accompanies each virtual card payment, providing significant reconciliation advantages to ACH payments. We have integrated our virtual card offering into most leading ERP systems, providing a seamless experience for accounts payable personnel to select our virtual card as the payment mechanism of choice.\\nFLEETCOR’s virtual card product operates on the Mastercard payment network. We have built a network of approximately 700,000 merchants that accept our virtual card payments, which has been growing at an average rate of 12,500 merchants per month. This network is managed with proprietary technology that allows us to continuously expand virtual card acceptance and optimize the amount of virtual card spend we can capture. This network, coupled with a best-in-class, in-house vendor enrollment service, is a major competitive advantage.\\nOur purchasing and T&E cards operate on the MasterCard payment network and are accepted at approximately 10.7 million locations throughout the United States and Canada. These card products are generally sold in conjunction with our virtual card offering to augment our customers’ purchasing capabilities. FLEETCOR also provides full A/P outsourcing services for customers who send us their entire A/P file and allow us to execute payments across all modalities, including the aforementioned products as well as ACH, wires and checks. We also provide expense management software, which combines and leverages transaction data captured from our virtual, purchasing and T&E card products to help our customers analyze and control their corporate spending.\\n8\\nOur virtual, purchasing and T&E card products compete with similar offerings from large financial institutions such as Bank of America, Citibank, J.P. Morgan Chase, PNC Bank, U.S. Bank, Wells Fargo and American Express.\\nFLEETCOR offers a payroll card product in the form of a reloadable stored value card, which operates on the MasterCard payment network and the All Point ATM network. These cards are distributed to our customers’ employees and are funded by our customers with their employees’ earned wages. As cardholders, the employees may present the payroll card as a form of payment for personal purchases, transfer funds to their bank account or withdraw funds from participating ATMs.\\nOur payroll card product competes with similar offerings from First Data Corporation, Fidelity National Information Services, Global Cash Card, Green Dot Financial, Total System Services, Automatic Data Processing, Paychex and Heartland Payment Systems.\\nFLEETCOR’s cross-border payment services are offered predominantly to commercial customers, who range from small businesses to mid-cap corporate entities. Customers generally use our cross-border payment services to pay international suppliers, foreign office and personnel expenses, capital expenditures, and profit repatriation and dividends. We administer foreign exchange trades and payment settlement with recipients through a global network of banks, enabling us to send payments to recipients in over 200 countries and in over 140 currencies. We employ rigorous compliance standards in all geographies where we are licensed. By using transaction monitoring and watch list screening systems, we ensure payments are safe, secure, and meet all applicable regulatory requirements.\\nOur cross-border payment services compete with similar offerings from Western Union Business Solutions, Associated Foreign Exchange (AFEX), WorldFirst, Moneycorp, HiFX, Currencies Direct, GPS Capital Markets and large financial institutions.\\nFLEETCOR’s corporate payment solutions are enabled by our technology and operations. Our ERP integrations, API capabilities, strategic vendor enrollment, and transaction management tools enable us to optimize our customers’ electronic payables programs.\\nWe distribute our corporate payment solutions through direct and indirect channels to businesses of all sizes and types across a broad number of industry verticals. We serve customers across numerous industry verticals, such as retail, healthcare, construction, manufacturing, hospitality, energy, entertainment, insurance and trade finance. As FLEETCOR both issues and processes its virtual cards and commercial cards, we have the control and flexibility to meet the unique needs of customers in different verticals.\\nWe generally provide our domestic corporate payment solutions under contracts with our customers. Pricing terms vary based on usage volumes, incentives and contract duration. When our corporate payment solutions include short term credit, our contracts for those solutions contain credit and collection terms.\\nOur indirect channel includes a broad range of VARs and other referral partners that expand our reach into new customer segments, new industry verticals and new geographies faster and at a significantly lower cost. We provide our corporate payments solutions to these partners who offer our services under our brands or their own brands on a “white-label” basis. For example, we provide healthcare payment solutions through healthcare networks, corporate payment solutions through software and services providers and payroll card solutions through payroll service providers.\\nGift payment product line\\nWe provide fully integrated gift card product management and processing services in over 55 different countries around the world. These products come in the form of plastic and digital gift cards, carry our customers’ brands and are generally accepted exclusively within the retail network, websites, and mobile applications of each respective customer.\\nOur services include card design, production and packaging, delivery and fulfillment, card and account management, transaction processing, promotion development and management, website design and hosting, program analytics, and card distribution channel management. The combination of our products and services provides a turnkey solution to our customers, who benefit in the form of brand promotion, cardholder loyalty, increased sales, interest income on prepaid balances, and breakage on abandoned card balances.\\nWe distribute our gift payment products and services directly through a specialized, dedicated field sales force. We serve our commercial customers in numerous industry verticals, with a focus in restaurants, supermarkets, drugstores, airlines, hotels, apparel and other retail categories. We help our commercial customers manage distribution with omni-channel strategies which include card sales through the customers’ retail outlets, websites and mobile applications, as well as through third party\\n9\\nlocations, such as supermarkets and drug stores. This third party distribution is generally provided by other companies, such as Blackhawk and InComm, who are reliant on access to our systems to meet their distribution obligations.\\nWe compete with a number of national companies in providing gift cards, the largest of which include First Data Corporation and Vantiv. We also compete with businesses that rely on in-house solutions.\\nAdditional products\\nFLEETCOR provides several other payment products that, due to their nature or size, are not considered primary product lines.\\nFleet maintenance\\nWe provide a vehicle maintenance service offering that helps fleet customers to manage their vehicle maintenance, service, and repair needs in the U.K. This product is provided through our proprietary 1link maintenance and repair network which processes transactions for fleet customers through approximately 9,400 service centers across the U.K. With regard to our fleet maintenance product, we compete with several companies including Ebbon-Dacs and Fleet on Demand.\\nEmployee benefit payments\\nIn Mexico, we offer prepaid food vouchers and cards that may be used as a form of payment in restaurants and grocery stores. These payment products operate on one of the following networks:\\n| • | Efectivale network—also our proprietary food card and voucher network in Mexico. We have negotiated acceptance and settlement terms with over 56,700 individual merchants, providing the network with over 44,600 food locations and 5,800 restaurants. |\\n\\n| • | Carnet network—a national debit network in Mexico, which also includes over 47,400 food locations across the country. |\\n\\nIn Brazil, we offer prepaid transportation cards and vouchers that may be used as a form of payment on public transportation such as buses, subways and trains. Our proprietary VB Servicos, Comercio e Administracao LTDA (“VB”) distribution network distributes cards and vouchers to employees on behalf of approximately 26,000 customers and negotiates with more than 1,400 public transportation agencies across Brazil.\\nWe provide these various payment products to businesses of all sizes and industry verticals and the businesses in turn offer the products to their employees as a form of benefit. With regard to our employee benefit payment products, we compete with numerous companies, the largest of which includes Edenred, Sodexo, Chèque Déjeuner, and Alelo.\\nLong haul transportation services\\nIn addition to, and often in conjunction with our fuel payment product, we provide trucking companies in North America with various products and services specifically relevant to their industry, including road tax compliance analysis and reporting, permit procurement, and cash movement and disbursement. We compete with several companies in providing these products and services, including EFS (WEX), Keller, and RTS Financial.\\nCompetition\\nWe face considerable competition in our business. The most significant competitive factors in our business are the breadth of product and service features, credit extension, payment terms, customer service and account management, and price. For certain payment-related products, we also compete on the respective size or nature (i.e., open versus closed loop) of each product’s acceptance network. For certain payment processing services, systems and technology are also significant competitive factors. We believe that we generally compete favorably with respect to each of these factors. However, we may experience competitive disadvantages with respect to each of these factors from time to time as potential customers prioritize or value these competitive factors differently. As a result, a specific offering of our products and service features, networks and pricing may serve as a competitive advantage with respect to one customer and a disadvantage for another based on the customers’ preferences. The companies with whom we compete often vary by product line and/or geography, and are therefore identified by name in the respective product line discussions.\\n10\\nSales and marketing\\nWe market our products and services to prospective customers in North America and internationally through multiple channels including field sales, telesales, direct marketing, point-of-sale marketing and the internet. We also leverage the sales and marketing capabilities of our strategic relationships. Worldwide, our sales and marketing employees are focused on acquiring new customers and retaining existing customers for our different products. We also utilize tradeshows, advertising and other awareness campaigns to further market our products and services.\\nWe utilize proprietary and third-party databases to develop our prospect universe and segment those prospects by various characteristics, including industry, geography, size, and credit score, to identify potential customers. We develop customized offers for different types of potential customers and work to deliver those offers through the most effective marketing channel. We actively manage prospects across our various marketing channels to optimize our results and avoid marketing channel conflicts.\\nOur primary means of acquiring new customers include:\\n| • | Field sales—Our field sales organizations are comprised of remote or local office-based sales representatives who conduct face-to-face sales presentations and product demonstrations with prospects, assist with post-sale program implementation and training, and provide in-person account management. Field sales representatives also attend and manage our marketing at tradeshows. Our field sales force is generally dedicated to specific products or service categories and tend to target larger prospects. |\\n\\n| • | Telesales—We have telesales representatives handling inbound and outbound sales calls. |\\n\\n| • | Our inbound call volume is primarily generated as a result of marketing activities, including direct marketing, point-of-sale marketing and the internet. |\\n\\n| • | Our outbound phone calls typically target prospects that have expressed an initial interest in our services or have been identified through database analysis as prospective customers. Our telesales teams are generally dedicated to a specific product or service category and tend to target smaller prospects. We also leverage our telesales channel to cross-sell additional products to existing customers. |\\n\\n| • | Digital marketing—We manage numerous marketing websites around the world which tend to fall into two categories: product-specific websites and marketing portals. |\\n\\n| • | Product-specific websites—Our product-specific websites, including fuelman.com, checkinncard.com, allstarcard.co.uk and semparar.com.br, focus on one or more specific products, provide the most in-depth information available online regarding those particular products, allow prospects to apply online (where appropriate) and allow customers to access and manage their accounts online. We manage product-specific websites for our own proprietary programs, as well as white labeled sites for our strategic relationships. |\\n\\n| • | Marketing portals—Our marketing portals, including fleetcardsUSA.com and fuelcards.co.uk, serve as information sources for fleet operators interested in fleet card products. In addition to providing helpful information on fleet management, including maintenance, tax reporting and fuel efficiency, these websites allow fleet operators to research card products, compare the features and benefits of multiple products, and identify the card product which best meets the fleet manager’s needs. |\\n\\nAs part of our digital marketing strategy, we monitor and modify our marketing websites to improve our search engine rankings and test our advertising keywords to optimize our banner advertising placement and costs and our pay-per-click advertising spend among the major internet search firms such as Google and Yahoo.\\n| • | Direct marketing—We market directly to potential customers via mail and email. We test various program offers and promotions, and adopt the most successful features into subsequent direct marketing initiatives. We seek to enhance the sales conversion rates of our direct marketing efforts by coordinating timely follow-up calls by our telesales teams. |\\n\\n| • | Point-of-sale marketing—We provide marketing literature at the point-of-sale within our proprietary networks and those of our partner relationships. Literature may include “take-one” applications, pump-top advertising and in-store advertising. Our point-of-sale marketing leverages the branding and distribution reach of the physical merchant locations. |\\n\\n11\\nAccount management\\n\\n| • | Customer service, account activation, account retention—We provide account management and customer service to our customers. Based in dedicated call centers across our key markets, these professionals handle transaction authorizations, billing questions and account changes. Customers also have the opportunity to self-service their accounts through interactive voice response and online tools. We monitor the quality of the service we provide to our customers by adhering to industry standard service levels with respect to abandon rates and answer times and through regular agent call monitoring. We also conduct regular customer surveys to ensure customers are satisfied with our products and services. In addition to our base customer service support, we provide the following specialized services: |\\n\\n| • | Implementation and activation—We have dedicated implementation teams that are responsible for establishing the system set-up for each customer account. These teams focus on successful activation and utilization of our new customers and provide training and education on the use of our products and services. Technical support resources are provided to support the accurate and timely set-up of technical integrations between our proprietary processing systems and customer systems (e.g., payroll, enterprise resource planning and point-of-sale). Larger accounts are provided dedicated program managers who are responsible for managing and coordinating customer activities for the duration of the implementation. These program managers are responsible for the successful set-up of accounts to meet stated customer objectives. |\\n\\n| • | Strategic account management—We assign designated account managers who serve as the single point of contact for our large accounts. Our account managers have in-depth knowledge of our programs and our customers’ operations and objectives. Our account managers train customer administrators and support them on the operation and optimal use of our programs, oversee account setup and activation, review online billing and create customized reports. Our account managers also prepare periodic account reviews, provide specific information on trends in their accounts and work together to identify and discuss major issues and emerging needs. |\\n\\n| • | Account retention—We have proprietary, proactive strategies to contact customers who may be at risk of terminating their relationship with us. Through these strategies we seek to address service concerns, enhance product structures and provide customized solutions to address customer issues. |\\n\\n| • | Customer service—Day-to-day servicing representatives are designated for customer accounts. These designated representatives are responsible for the daily service items and issue resolution of customers. These servicing representatives are familiar with the nuanced requirements and specifics of a customer’s program. Service representatives are responsible for customer training, fraud disputes, card orders, card maintenance, billing, etc. |\\n\\n| • | Cardholder support—We provide cardholder support for individuals utilizing our payment products. This support allows cardholders to activate cards, check balances, and resolve issues in a timely and effective fashion. Cardholder support is conducted 24 hours a day, seven days per week in multiple languages utilizing telephony, web and call center technologies to deliver comprehensive and cost effective servicing. We have rigorous operational metrics in place to increase cardholder responsiveness to corporate and customer objectives. |\\n\\n| • | Merchant network services—Our representatives work with merchants such as fuel, toll operators and vehicle maintenance providers to enroll them in one of our proprietary networks, install and test all network and terminal software and hardware and train them on the sale and transaction authorization process. In addition, our representatives provide transaction analysis and site reporting and address settlement issues. |\\n\\n| • | Call center program administrator—Off-hour call center support is provided to customers to handle time-sensitive requests and issues outside of normal business hours. |\\n\\n| • | Management tools—We offer a variety of online servicing tools that enable customers to identify and provide authority to program administrators to self-service their accounts. |\\n\\n\\n| • | Credit underwriting and collections—We follow detailed application credit review, account management, and collections procedures for all customers of our payment solutions. We use multiple levers including billing frequency, payment terms, spending limits and security to manage risk in our portfolio. For the years ended December 31, 2017 and 2016, our bad debt expense was $44.9 million and $35.9 million, or 7 bps and 8 bps, respectively. |\\n\\n| • | New account underwriting—We use a combination of quantitative, third-party credit scoring models and judgmental underwriting to screen potential customers and establish appropriate credit terms and spend |\\n\\n12\\nlimits. Our underwriting process provides additional scrutiny for large credit amounts and we utilize tiered credit approval authority among our management.\\n| • | Prepaid and secured accounts—We also offer products and services on a prepaid or fully-secured basis. Prepaid customer accounts are funded with an initial deposit and subsequently debited for each purchase transacted on the cards issued to the customer. Fully-secured customer accounts are secured with cash deposits, letters of credit and/or insurance bonds. The security is held until such time as the customer either fails to pay the account or closes its account after paying outstanding amounts. Under either approach, our prepaid and fully-secured offerings allow us to market to a broader universe of prospects, including customers who might otherwise not meet our credit standards. |\\n\\n| • | Monitoring and account management—We use fraud detection programs, including both proprietary and third-party solutions, to monitor transactions and prevent misuse of our products. We monitor the credit quality of our portfolio periodically utilizing external credit scores and internal behavior data to identify high risk or deteriorating credit quality accounts. We conduct targeted strategies to minimize exposure to high risk accounts, including reducing spending limits and payment terms or requiring additional security. |\\n\\n| • | Collections—As accounts become delinquent, we may suspend future transactions based on our risk assessment of the account. Our collections strategy includes a combination of internal and outsourced resources which use both manual and dialer-based calling strategies. We use a segmented collection strategy which prioritizes higher risk and higher balance accounts. For severely delinquent, high balance accounts we may pursue legal remedies. |\\n\\nTechnology\\nOur technology provides continuous authorization of transactions, processing of critical account and client information and settlement between merchants, issuing companies and individual commercial entities. We recognize the importance of state-of-the-art, secure, efficient and reliable technology in our business and have made significant investments in our applications and infrastructure. In 2017, we spent more than $185 million in capital and operating expenses to operate, protect and enhance our technology and expect to continue the build out of our proprietary processing platform in Europe and Asia, as well as the integration of our recently acquired businesses.\\nOur technology function is based in the United States, Europe and Brazil and has expertise in the management of applications, transaction networks and infrastructure. We operate application development centers in the United States, United Kingdom, Netherlands, Russia, Czech Republic, Brazil and New Zealand. Our distributed application architecture allows us to maintain, administer and upgrade our systems in a cost-effective and flexible manner. We integrate our systems with third-party vendor applications for certain products, sales and customer relationship management and back-office support. Our technology organization has undertaken and successfully executed large scale projects to develop or consolidate new systems, convert oil company and petroleum marketer systems and integrate acquisitions while continuing to operate and enhance existing systems.\\nOur technology infrastructure is supported by highly-secure data centers, with redundant locations. We operate our primary data centers, which are located in Atlanta, Georgia; Brentwood, Tennessee; Prague; Czech Republic; Las Vegas, Nevada; Lexington and Louisville, Kentucky; Sao Paulo, Brazil; Toronto, Canada and Moscow, Russia. We use only proven technology and have no foreseeable capacity limitations. Our systems align with industry standards for security with multiple industry certifications. Our network is configured with multiple layers of security to isolate our databases from unauthorized access. We use security protocols for communication among applications, and our employees access critical components on a need-only basis. As of December 31, 2017, we are not aware of any material breach of our data security systems. See Item 1A, “Risk Factors-We may not be able to adequately protect our systems or the data we collect from continually evolving cybersecurity risks or other technological risks, which could subject us to liability and damage our reputation” for a discussion of the potential data breach and cybersecurity risks facing the Company.\\nWe maintain disaster recovery and business continuity plans. Our telecommunications and internet systems have multiple levels of redundancy to ensure reliability of network service. In 2017, we experienced 99.9% up-time for authorizations.\\nProprietary processing systems\\nWe operate several proprietary processing systems that provide features and functionality to run our card programs and product offerings, including our card issuing, processing and information services. Our processing systems also integrate with our proprietary networks, which provide brand awareness and connectivity to our acceptance locations that enables the “end-to-\\n13\\nend” card acceptance, data capture and transaction authorization capabilities of our card programs. Our proprietary processing systems and aggregation software are tailored to meet the unique needs of the individual markets they serve and enable us to create and deliver commercial payment solutions and stored value programs that serve each of our industry verticals and geographies. Our technology platforms are primarily comprised of four key components, which were primarily developed and are maintained in-house: (1) a core processing platform; (2) specialized software; (3) integrated network capabilities; and (4) a cloud based architecture with proprietary APIs.\\nIntellectual property\\nOur intellectual property is an important element of our business. We rely on trademark, copyright, trade secret, patent and other intellectual property laws, confidentiality agreements, contractual provisions and similar measures to protect our intellectual property. Our employees involved in technology development in some of the countries in which we operate, including the United States, are required to sign agreements acknowledging that all intellectual property created by them on our behalf is owned by us. We also have internal policies regarding the protection, disclosure and use of our confidential information. Confidentiality, license or similar agreements or clauses are generally used with our business partners and vendors to control access, use and distribution of our intellectual property. Unauthorized persons may attempt to obtain our intellectual property despite our efforts and others may develop similar intellectual property independently. We own trade names, service marks, trademarks and registered trademarks supporting a number of our brands, such as FLEETCOR, Fuelman, Comdata, and Comchek (among others) in the United States. We also own trademarks and registered trademarks in various foreign jurisdictions for a number of our brands, such as Keyfuels, AllStar, CTF, and Sem Parar (among others). We hold a number of patents and pending applications relating to payment cards and fuel tax returns.\\nAcquisitions\\nSince 2002, we have completed over 75 acquisitions of companies and commercial account portfolios, including the acquisition of Cambridge Global Payments in August 2017. Acquisitions have been an important part of our growth strategy, and it is our intention to continue to seek opportunities to increase our customer base and diversify our service offering through further strategic acquisitions. For a discussion of recent acquisitions, see “Management’s Discussion and Analysis of Financial Conditions and Results of Operations—Acquisitions”.\\nRegulatory\\nA substantial number of laws and regulations, both in the United States and in other jurisdictions, apply to businesses offering payment cards to customers or processing or servicing for payment cards and related accounts. These laws and regulations are often evolving and sometimes ambiguous or inconsistent, and the extent to which they apply to us is at times unclear. Failure to comply with regulations may result in the suspension or revocation of licenses or registrations, the limitation, suspension, or termination of services, and/or the imposition of civil and criminal penalties, including fines. Certain of our services are also subject to rules set by various payment networks, such as MasterCard, as more fully described below.\\nThe following, while not exhaustive, is a description of several federal and state laws and regulations in the United States that are applicable to our business. The laws and regulations of other jurisdictions also affect us, and they may be more or less restrictive than those in the United States and may also impact different parts of our operations. In addition, the legal and regulatory framework governing our business is subject to ongoing revision, and changes in that framework could have a significant effect on us.\\nMoney Transmission and Payment Instrument Licensing Regulations\\nWe are subject to various U.S. laws and regulations governing money transmission and the issuance and sale of payment instruments relating to certain aspects of our business. In the United States, most states license money transmitters and issuers of payment instruments. Through our subsidiaries, we are licensed in all states where required for business. Many states exercise authority over the operations of our services related to money transmission and payment instruments and, as part of this authority, subject us to periodic examinations, which may include a review of our compliance practices, policies and procedures, financial position and related records, privacy and data security policies and procedures, and other matters related to our business. Some state agencies conduct periodic examinations and issue findings and recommendations as a result of which we make changes to our operations, such as improving our reporting processes, detailing our intercompany arrangements, and implementing new or revising existing policies and procedures such as our anti-money laundering and the U.S. Department of Treasury's Office of Foreign Assets Control (\\\"OFAC\\\") compliance program and complaints management process, and improvements to our documentation processes.\\n14\\nAs a licensee, we are subject to certain restrictions and requirements, including net worth and surety bond requirements, record keeping and reporting requirements, requirements for regulatory approval of controlling stockholders, and requirements to maintain certain levels of permissible investments in an amount equal to our outstanding payment obligations. Many states also require money transmitters and issuers of payment instruments to comply with federal and/or state anti-money laundering laws and regulations. Many states require prior approval for both direct and indirect changes of control of the licensee and certain other corporate events.\\nGovernment agencies may impose new or additional requirements on money transmission and sales of payment instruments, and we expect that compliance costs will increase in the future for our regulated subsidiaries.\\nPrivacy and Information Security Regulations\\nWe provide services that may be subject to various state, federal, and foreign privacy laws and regulations, including, among others, the Financial Services Modernization Act of 1999, which we refer to as the Gramm-Leach-Bliley Act, and Directive 95/46/EC, and the Personal Information Protection and Electronic Documents Act in Canada. These laws and their implementing regulations restrict certain collection, processing, storage, use, and disclosure of personal information, require notice to individuals of privacy practices, and provide individuals with certain rights to prevent use and disclosure of protected information. These laws also impose requirements for the safeguarding and proper destruction of personal information through the issuance of data security standards or guidelines. Certain federal, state and foreign laws and regulations impose similar privacy obligations and, in certain circumstances, obligations to notify affected individuals, state officers or other governmental authorities, the media, and consumer reporting agencies, as well as businesses and governmental agencies, of security breaches affecting personal information. In addition, there are state and foreign laws restricting the ability to collect and utilize certain types of information such as Social Security and driver’s license numbers. In February 2013, the European Commission proposed additional European Union-wide legislation regarding cyber security in the form of the proposed NIS Directive. The NIS Directive was adopted by the European Parliament in July 2016 and entered into force in August 2016. The NIS Directive provides legal measures intended to boost the overall level of cybersecurity in the EU by ensuring: (1) Member States’ preparedness by requiring them to be appropriately equipped, for example, via a Computer Security Incident Response Team and a competent national NIS authority; (2) cooperation among all the Member States, by setting up a cooperation group, in order to support and facilitate strategic cooperation and the exchange of information among Member States; and (3) a culture of security across sectors vital to the EU’s economy and society, including banking, financial market infrastructures and digital infrastructure.\\nAs a processor of personal data of EU data subjects, we are also subject to regulation and oversight in the applicable EU Member States with regard to data protection legislation. The existing Data Protection Directive, contains various obligations on the processing of personal data in the EU including restrictions on transferring personal data outside of the EU to countries which have not been recognized as having adequate data protection standards, unless specific conditions are met. Our EU operations are currently operating in accordance with these standards. In May 2018, a new European wide Regulation on data privacy will come into force. The General Data Protection Regulation (the “GDPR”) contains additional obligations on data controllers and data processors operating in the EU or offering services to consumers within the EU. While the core rules contained in the Data Protection Directive are retained in GDPR, there are significant enhancements with regard to the rights of data subjects (which include the right to be forgotten and the right of data portability), stricter regulation on obtaining consent to processing of personal data and sensitive personal data, stricter obligations with regard to the information to be included in privacy notices and significant enhanced requirements with regard to compliance, including a regime of “accountability” for processors and controllers and a requirement to embed compliance with GDPR into the fabric of an organization by developing appropriate policies and practices, to achieve a standard of data protection by “design and default.” The GDPR includes enhanced data security obligations (to run in parallel to those contained in NIS regulations), requiring data processors and controllers to take appropriate technical and organizational measures to protect the data they process and their systems. Organizations that process significant amounts of data may be required to appoint a Data Protection Officer responsible for reporting to highest level of management within the business. There are greatly enhanced sanctions under GDPR for failing to comply with the core principles of the GDPR or failing to secure data. We are working to prepare for the GDPR in readiness for its implementation in May 2018.\\nIn addition, there are state laws restricting the ability to collect and utilize certain types of information such as Social Security and driver’s license numbers. Certain state laws impose similar privacy obligations as well as obligations to provide notification of security breaches of computer databases that contain personal information to affected individuals, state officers and consumer reporting agencies and businesses and governmental agencies that own data.\\nCertain of our products that access payment networks require compliance with Payment Card Industry (“PCI”) standards. Our subsidiary, Comdata Inc., is PCI 3.2 compliant and its Attestation of Compliance is listed on MasterCard’s compliant\\n15\\nservice provider listing. Failure to maintain compliance with updates to PCI data security standards including having effective technical and administrative safeguards and policies and procedures could result in fines and assessments from payment networks and regulatory authorities, as well as litigation.\\nFederal Trade Commission Act\\nAll persons engaged in commerce, including, but not limited to, us and our bank sponsors and customers are subject to Section 5 of the Federal Trade Commission Act prohibiting unfair or deceptive acts or practices, and certain products are subject to the jurisdiction of the Consumer Financial Protection Bureau (\\\"CFPB\\\") regarding the prohibition of unfair, deceptive, or abusive acts and practices (both, collectively, UDAAP). Various federal and state regulatory enforcement agencies including the Federal Trade Commission (“FTC”), CFPB and the state attorneys general have authority to take action against businesses, merchants and financial institutions that engage in UDAAP or violate other laws, rules and regulations. If we violate such laws, rules and regulations, we may be subject to enforcement actions and as a result, may incur losses and liabilities that may impact our business. A number of state laws and regulations also prohibit unfair and deceptive business practices.\\nTruth in Lending Act\\nThe Truth in Lending Act, or TILA, was enacted as a consumer protection measure to increase consumer awareness of the cost of credit and to protect consumers from unauthorized charges or billing errors, and is implemented by Regulation Z. Most provisions of TILA and Regulation Z apply only to the extension of consumer credit, but a limited number of provisions apply to commercial cards as well. One example where TILA and Regulation Z are generally applicable is a limitation on liability for unauthorized use, although a business that acquires 10 or more credit cards for its personnel can agree to more expansive liability. Our cardholder agreements generally provide that these business customers waive, to the fullest extent possible, all limitations on liability for unauthorized card use.\\nCredit Card Accountability, Responsibility, and Disclosure Act of 2009\\nThe Credit Card Accountability, Responsibility, and Disclosure Act of 2009 is an act that, among other things, amended provisions of TILA that affect consumer credit and also directed the Federal Reserve Board to study the use of credit cards by small businesses and to make legislative recommendations. The report concluded that it is not clear whether the potential benefits outweigh the increased cost and reduced credit availability if the disclosure and substantive restrictions applicable to consumer cards were to be applied to small business cards. Legislation has been introduced, from time to time, to increase the protections afforded to small businesses that use payment cards. If legislation of this kind were enacted, our products and services for small businesses could be adversely impacted.\\nEqual Credit Opportunity Act\\nThe Equal Credit Opportunity Act, or ECOA, together with Regulation B prohibit creditors from discriminating on certain prohibited bases, such as an applicant’s sex, race, nationality, age and marital status, and further requires that creditors disclose the reasons for taking any adverse action against an applicant or a customer seeking credit.\\nThe Fair Credit Reporting Act\\nThe Fair Credit Reporting Act, or FCRA, regulates consumer reporting agencies and the disclosure and use of consumer reports. We may obtain consumer reports with respect to an individual who guarantees or otherwise is obligated on a commercial card.\\nFACT Act\\nThe Fair and Accurate Credit Transactions Act of 2003 amended FCRA and requires creditors to adopt identity theft prevention programs to detect, prevent and mitigate identity theft in connection with covered accounts, which can include business accounts for which there is a reasonably foreseeable risk of identity theft.\\nAnti-Money Laundering and Counter Terrorist Regulations\\nThe Currency and Foreign Transactions Reporting Act, which is also known as the Bank Secrecy Act (the \\\"BSA\\\") and which has been amended by the USA PATRIOT Act of 2001, contains a variety of provisions aimed at fighting terrorism and money laundering. Our business in Canada is also subject to Proceeds of Crime (Money Laundering) and Terrorist Financing Act, or the PCTFA, which is a corollary to the BSA. Among other things, the BSA and implementing regulations issued by the U.S. Treasury Department require financial-services providers to establish anti-money laundering programs, to not engage in terrorist financing, to report suspicious activity, and to maintain a number of related records.\\nNon-banks that provide certain financial services are required to register with the Financial Crimes Enforcement Network of the U.S. Department of the Treasury (FinCEN) as “money services businesses” (MSBs). Through certain subsidiaries, we are\\n16\\nregistered as MSBs. As a result, we have established anti-money laundering compliance programs that include: (i) internal policies and controls; (ii) designation of a compliance officer; (iii) ongoing employee training; and (iv) an independent review function. We have developed and implemented compliance programs comprised of policies, procedures, systems and internal controls to monitor and address various legal requirements and developments.\\nIn addition, provisions of the BSA known as the Prepaid Access Rule issued by FinCEN impose certain obligations, such as registration and collection of consumer information, on “providers” of certain prepaid access programs, including the stored value products issued by our sponsor banks for which we serve as program manager. FinCEN has taken the position that, where the issuing bank has principal oversight and control of such prepaid access programs, no other participant in the distribution chain would be required to register as a provider under the Prepaid Access Rule. Despite this position, we have opted to register as a provider of prepaid access through our subsidiary, Comdata Inc. We are also subject to certain economic and trade sanctions programs that are administered by the OFAC that prohibit or restrict transactions to or from or dealings with specified countries, their governments and, in certain circumstances, their nationals, narcotics traffickers, and terrorists or terrorist organizations.\\nDodd-Frank Wall Street Reform and Consumer Protection Act\\nThe Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, or the Dodd-Frank Act, effected comprehensive revisions to a wide array of federal laws governing financial institutions, financial services, and financial markets. Among its most notable provisions is the creation of the CFPB, which is charged with regulating consumer financial products or services and which is assuming much of the rulemaking authority under TILA, ECOA, FCRA, and other federal laws affecting the extension of credit. In addition to rulemaking authority over several enumerated federal consumer financial protection laws, the CFPB is authorized to issue rules prohibiting unfair, deceptive, and abusive acts and practices (UDAAP) by persons offering consumer financial products or services and their service providers, and has authority to enforce these consumer financial protection laws and CFPB rules. The CFPB has not defined what is a consumer financial product or service but has indicated informally that, in some instances, small businesses may be covered under consumer protection.\\nAs a service provider to certain of our bank sponsors, we may be subject to direct supervision and examination by the CFPB, in connection with certain of our products and services. CFPB rules, examinations and enforcement actions may require us to adjust our activities and may increase our compliance costs.\\nIn addition, the Durbin Amendment to the Dodd-Frank Act provided that interchange fees that a card issuer or payment network receives or charges for debit transactions will now be regulated by the Federal Reserve and must be “reasonable and proportional” to the cost incurred by the card issuer in authorizing, clearing and settling the transaction. Payment network fees may not be used directly or indirectly to compensate card issuers in circumvention of the interchange transaction fee restrictions. In July 2011, the Federal Reserve published the final rules governing debit interchange fees. Effective in October 2011, with certain exceptions, debit interchange rates are capped at $0.21 per transaction with an additional component of five basis points of the transaction’s value to reflect a portion of the issuer’s fraud losses plus, for qualifying issuing financial institutions, an additional $0.01 per transaction in debit interchange for fraud prevention costs. The cap on interchange fees is not expected to have a material direct impact on our results of operations because we qualify for an exemption for the majority of our debit transactions.\\nThe implementation of the Dodd-Frank Act is ongoing, and as a result, its overall impact remains unclear. Its provisions, however, are sufficiently far reaching that it is possible that we could be further directly or indirectly impacted.\\nAnti-Bribery Regulations\\nThe FCPA prohibits the payment of bribes to foreign government officials and political figures and includes anti-bribery provisions enforced by the Department of Justice and accounting provisions enforced by the SEC. The statute has a broad reach, covering all U.S. companies and citizens doing business abroad, among others, and defining a foreign official to include not only those holding public office but also local citizens affiliated with foreign government-run or -owned organizations. The statute also requires maintenance of appropriate books and records and maintenance of adequate internal controls to prevent and detect possible FCPA violations.\\nPayment Card Industry Rules\\nBanks issuing payment cards bearing the MasterCard brand, and FLEETCOR to the extent that we provide certain services in connection with those cards and fleet customers acting as merchants accepting those cards, must comply with the bylaws, regulations and requirements that are promulgated by MasterCard and other applicable payment-card organizations, including the Payment Card Industry Data Security Standard developed by MasterCard and VISA, the MasterCard Site Data Protection Program and other applicable data-security program requirements. A breach of such payment card network rules could subject\\n17\\nus to a variety of fines or penalties that may be levied by the payment networks for certain acts or omissions. The payment networks routinely update and modify their requirements. Our failure to comply with the networks’ requirements or to pay the fines they impose could cause the termination of our registration and require us to stop processing transactions on their networks.\\nWe are also subject to network operating rules promulgated by the National Automated Clearing House Association relating to payment transactions processed by us using the Automated Clearing House Network.\\nEscheat Regulations\\nWe may be subject to unclaimed or abandoned property (escheat) laws in the United States that require us to turn over to certain government authorities the property of others that we hold that has been unclaimed for a specified period of time such as payment instruments that have not been presented for payment and account balances that are due to a customer following discontinuation of our relationship. We may be subject to audit by individual U.S. states with regard to our escheatment practices.\\nPrepaid Card Regulations\\nPrepaid card programs managed by us are subject to various federal and state laws and regulations, in addition to those identified above, including the Credit Card Accountability Responsibility and Disclosure Act of 2009 and the Federal Reserve’s Regulation E, which impose requirements on general-use prepaid cards, store gift cards and electronic gift certificates. These laws and regulations are evolving, unclear and sometimes inconsistent and subject to judicial and regulatory challenge and interpretation, and therefore the extent to which these laws and rules have application to, and their impact on us, is in flux. At this time we are unable to determine the impact that the clarification of these laws and their potential application and future interpretations, as well as new laws, may have on us in a number of jurisdictions. On October 5, 2016, the Consumer Financial Protection Bureau issued a final rule amending Regulations E and Z to create comprehensive consumer protections for prepaid financial products, and on January 25, 2018, the CFPB released final amendments to the final rule, clarifying certain disclosure provisions and reducing potential liability with respect to cardholders who are not registered and verified. These changes include a delay of the final rule’s effective date until April 1, 2019. The extensive nature of these regulations and the implementation dates for this additional rulemaking may result in additional compliance obligations and expense for our business.\\nState Usury Laws\\nExtensions of credit under many of our card products may be treated as commercial loans. In some states, usury laws limit the interest rates that can be charged not only on consumer loans but on commercial loans as well. To the extent that these usury laws apply, we are limited in the amount of interest that we can charge and collect from our customers. Because we have substantial operations in multiple jurisdictions, we utilize choice of law provisions in our cardholder agreements as to the laws of which jurisdiction to apply. In addition, the interest rates on certain of our card products are set based upon the usury limit of the cardholder’s state. With respect to card products where we work with a partner or issuing bank, the partner bank may utilize the law of the jurisdiction applicable to the bank and “exports” the usury limit of that state in connection with cards issued to residents of other states or we may use our choice of law provisions.\\nOther\\nWe are subject to examination by our sponsor banks’ regulators, and must comply with certain regulations to which our sponsor banks are subject, as applicable. We are subject to audit by certain sponsor banks.\\nThe Housing Assistance Tax Act of 2008 requires information returns to be made for each calendar year by merchants acquiring entities and third-party settlement organizations with respect to payments made in settlement of electronic payment transactions and third-party payment network transactions occurring in that calendar year. Reportable transactions are also subject to backup withholding requirements. We are required to comply with these requirements for the merchants in our Comdata network. We could be liable for penalties if our information return is not in compliance with these regulations.\\nEmployees and labor relations\\nAs of December 31, 2017, we employed approximately 7,890 employees, approximately 2,620 of whom were located in the United States. We consider our employee relations to be good and have never experienced a work stoppage.\\nAdditional Information\\nOur website address is www.fleetcor.com. You may obtain free electronic copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements and all related amendments required to be filed or\\n18\\nfurnished pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, at our website under the headings “Investor Relations—SEC Filings.” Information from our website is not incorporated by reference into this annual report on Form 10-K.\\n19\\nITEM X. EXECUTIVE OFFICERS OF THE REGISTRANT\\nThe following table sets forth certain information regarding our executive officers, with their respective ages as of December 31, 2017. Our officers serve at the discretion of our board of directors. There are no family relationships between any of our directors or executive officers.\\n| Name | Age | Position(s) |\\n| Ronald F. Clarke | 62 | Chief Executive Officer and Chairman of the Board of Directors |\\n| Eric R. Dey | 58 | Chief Financial Officer |\\n| Kurt P. Adams | 48 | President—Comdata Corporate Payments |\\n| Andrew R. Blazye | 59 | President—International Corporate Development |\\n| John S. Coughlin | 50 | Executive Vice President—Global Corporate Development |\\n| Pedro L. Donda | 64 | President-—Serviços e Tecnologia de Pagamentos S.A. (\\\"STP\\\") |\\n| Charles R. Freund | 45 | Executive Vice President—Corporate Strategy |\\n| Alexey P. Gavrilenya | 41 | President—Continental Europe |\\n| Alan King | 41 | President—UK, Australia and New Zealand |\\n| David D. Maxsimic | 58 | President—North America Partners |\\n| Armando L. Netto | 49 | President—Brazil |\\n| John A. Reed | 63 | Technology Executive Officer |\\n| Gregory L. Secord | 55 | President—Comdata North America Trucking and CLC Lodging |\\n\\nRonald F. Clarke has been our Chief Executive Officer since August 2000 and was appointed Chairman of our board of directors in March 2003. From 1999 to 2000, Mr. Clarke served as President and Chief Operating Officer of AHL Services, Inc., a staffing firm. From 1990 to 1998, Mr. Clarke served as Chief Marketing Officer and later as a division president with Automatic Data Processing, Inc. (ADP), a computer services company. From 1987 to 1990, Mr. Clarke was a principal with Booz Allen Hamilton, a global management consulting firm. Earlier in his career, Mr. Clarke was a marketing manager for General Electric Company, a diversified technology, media, and financial services corporation.\\nEric R. Dey has been our Chief Financial Officer since November 2002. From October 2000 to October 2002, Mr. Dey served as Chief Financial Officer of NCI Corporation, a call center company. From July 1999 to October 2000, Mr. Dey served as Chief Financial Officer of Leisure Time Technology, a software development/manufacturing company. From 1994 to 1999, Mr. Dey served as Corporate Controller with Excel Communications, a telecommunications service provider. From 1984 to 1994, Mr. Dey held a variety of financial and accounting positions with PepsiCo, Inc., a global beverage, snack and food company.\\nKurt P. Adams joined us in September 2015 as our President—Comdata Corporate Payments. Prior to joining us, Mr. Adams was most recently President, Corporate Payments Solutions for U.S. Bancorp. Prior to that, Mr. Adams led strategy and planning for NOVA Information Systems (now Elavon – a U.S. Bancorp subsidiary) in Europe. Prior to his career in payments, Mr. Adams enjoyed a successful investment banking career with Piper Jaffray.\\nAndrew R. Blazye has served as our President—International Corporate Development since 2012. From July 2007 to May 2012, Mr. Blazye served as our Chief Executive Officer—FLEETCOR Europe. From April 2006 to June 2007, Mr. Blazye was a Group Director for Dunnhumby Ltd., a research firm. From September 1980, to March 2006, Mr. Blazye held various positions with Shell International Ltd., a subsidiary of Royal Dutch Shell plc, a global energy company, including Global Payments General Manager.\\nJohn S. Coughlin has served as our Executive Vice President—Global Corporate Development since September 2010. From 2007 to 2010, Mr. Coughlin served as a Managing Director at PCG Capital Partners, a private equity firm. From 2005 to 2006, Mr. Coughlin served as Chief Executive Officer of NCDR LLC, a private equity owned national dental practice management company. From 1994 to 2005, Mr. Coughlin was with The Parthenon Group, a strategic advisory and principal investment firm, where he was a Senior Partner and the founder and head of the firm’s San Francisco office. From 1990 to 1992, Mr. Coughlin was an investment banker with Credit Suisse First Boston.\\nPedro L. Donda has served as our President—STP since our acquisition of the business in August 2016. Mr. Donda served in this role at STP, since 2006. From 2001 to 2003, Mr. Donda served as a Chief Executive Officer at IBOPE, a market research company in Brazil. Mr. Donda founded and led Americanas.com, a B2W Digital business in e-commerce. From 1990 to 1998, Mr. Donda founded and led Interchange, an electronic data interchange provider for banks, as well as specializing in logistics\\n20\\nand consumer packaged goods supply-chain. From 1980 to 1989, Mr. Donda, was an executive within Citibank N.A. Prior to this, Mr. Donda served in various technology positions.\\nCharles R. Freund was named our Executive Vice President-Corporate Strategy in January 2017 and has been with us since 2000. During his tenure with FLEETCOR, Mr. Freund has held numerous roles including Executive Vice President-Global Sales, President-Emerging Markets, Senior Vice President-Corporate Strategy, Managing Director-The Fuelcard Company UK Limited, and Vice President of Business Development.\\nAlexey P. Gavrilenya was named President—Continental Europe in February 2016, adding to his responsibilities as President—Central/Eastern Europe. Mr. Gavrilenya has been President, Eastern Europe since May 2011, where he has been responsible for PPR and NKT. From March 2009 to April 2011, Mr. Gavrilenya served as our Executive Vice President Strategy and Finance, Eastern Europe. Prior to joining us, Mr. Gavrilenya was Chief Financial Officer of Matarex, Ltd.\\nAlan King joined us in August 2016 as our President—UK, Australia and New Zealand. Prior to joining us, Mr. King held various positions at MasterCard from 2005 to 2016, including Managing Director of MasterCard Prepaid Management Services, Group Head of Global Prepaid Solutions, Group General Manager for Market and Business Development in the UK and Ireland and General Manager of Global Accounts. Prior to MasterCard, Mr. King held leadership positions at VISA in the CEMEA region from 2003 to 2005 and at Citibank from 1998 to 2003, largely across commercial payments in international markets. Mr. King spent the early part of his career in the telecom and automotive industries, in various sales and marketing roles covering Europe.\\nDavid D. Maxsimic was named President—North America Partners in November 2015 and in July 2017 assumed leadership of the U.S. sales shared services. Mr. Maxsimic joined us in January 2015 as our Group CEO—UK and Australasia. Prior to joining us, Mr. Maxsimic held various positions at WEX (also known as Wright Express) from 1997 to 2014, including President International, executive vice president of sales and marketing, senior vice president of sales, and vice president and general manager for Wright Express Direct Card. Prior to WEX, Mr. Maxsimic served as senior sales executive for several major fleet service companies, including U.S. Fleet Leasing, GE Capital Fleet Services, and PHH Fleet America. Mr. Maxsimic has over 25 years of experience in sales, marketing and managing customer relationships, in addition to managing and executing sales of complex financial services.\\nArmando L. Netto joined us in June 2014 as our President—Brazil. Prior to joining us, Mr. Netto led IT Services for TIVIT, an IT and BPO services company, from 2006 to 2014, where he led the integration of functional areas into the business unit, focused on onboarding new clients and ensured service quality. Prior to TIVIT, Mr. Netto held various leadership roles with Unisys and McKinsey, where he gained international experience in Europe supporting clients in the UK, France, Austria, Portugal and the Netherlands.\\nJohn A. Reed was named Technology Executive Officer effective January 2018, over system development and emerging technologies. Prior to this role, Mr. Reed served as our Global Chief Information Officer over product development and IT operations since 2013. From 2000 to 2009, Mr. Reed served various technology leadership roles at MBNA/Bank of America, Zurich Insurance and Unisys. From 1997 to 2000, Mr. Reed was the President and Managing Director for Business Innovations Inc., a financial services technology consulting company.\\nGregory L. Secord joined us in July 2015 as our President—Comdata North America Trucking and in July 2017 assumed leadership of the U.S. operations shared services. Prior to joining us, Mr. Secord worked with ADP, where he was President—ADP Canada operations. Prior to his 20 year career with ADP, Mr. Secord held sales and marketing management roles with Canon and Xerox.\\n21\\nITEM 1A. RISK FACTORS\\nYou should carefully consider the following risks applicable to us. If any of the following risks actually occur, our business, operating results, financial condition and the trading price of our common stock could be materially adversely affected. The risks discussed below also include forward-looking statements, and our actual results may differ substantially from those discussed in these forward-looking statements. See \\\"Note Regarding Forward-Looking Statements\\\" in this report.\\nRisks related to our business\\nA decline in retail fuel prices could adversely affect our revenue and operating results.\\nOur fleet customers use our products and services primarily in connection with the purchase of fuel. Accordingly, our revenue is affected by fuel prices, which are subject to significant volatility. A decline in retail fuel prices could cause a decrease in our revenue from fees paid to us by merchants based on a percentage of each transaction purchase amount. We believe that in 2017, approximately 13% our consolidated revenue was directly influenced by the absolute price of fuel. Changes in the absolute price of fuel may also impact unpaid account balances and the late fees and charges based on these amounts. A decline in retail fuel prices could adversely affect our revenue and operating results.\\nFuel prices are dependent on several factors, all of which are beyond our control. These factors include, among others:\\n\\n| • | supply and demand for oil and gas, and market expectations regarding supply and demand; |\\n\\n| • | actions by members of OPEC and other major oil-producing nations; |\\n\\n| • | new oil production being developed in the U.S. and elsewhere; |\\n\\n| • | political conditions in oil-producing and gas-producing nations, including insurgency, terrorism or war; |\\n\\n| • | oil refinery capacity; |\\n\\n| • | weather; |\\n\\n| • | the prices of foreign exports; |\\n\\n| • | speculative trading; |\\n\\n| • | the implementation of fuel efficiency standards and the adoption by our fleet customers of vehicles with greater fuel efficiency or alternative fuel sources; |\\n\\n| • | general worldwide economic conditions; and |\\n\\n| • | governmental regulations, taxes and tariffs. |\\n\\nA portion of our revenue is derived from fuel-price spreads. As a result, a contraction in fuel-price spreads could adversely affect our operating results.\\nApproximately 10% of our consolidated revenue in 2017 was derived from transactions where our revenue is tied to fuel-price spreads. Fuel-price spreads equal the difference between the fuel price we charge to the fleet customer and the fuel price paid to the fuel merchant. In transactions where we derive revenue from fuel-price spreads, the fuel price paid to the fuel merchant is calculated as the merchant’s wholesale cost of fuel plus a commission. The merchant’s wholesale cost of fuel is dependent on several factors including, among others, the factors described above affecting fuel prices. The fuel price that we charge to our fleet customer is dependent on several factors including, among others, the fuel price paid to the fuel merchant, posted retail fuel prices and competitive fuel prices. We experience fuel-price spread contraction when the merchant’s wholesale cost of fuel increases at a faster rate than the fuel price we charge to our fleet customers, or the fuel price we charge to our fleet customers decreases at a faster rate than the merchant’s wholesale cost of fuel. Accordingly, when fuel-price spreads contract, we generate less revenue, which could adversely affect our operating results.\\nIf we fail to adequately assess and monitor credit risks of our customers, we could experience an increase in credit loss.\\nWe are subject to the credit risk of our customers which range in size from small sole proprietorships to large publicly traded companies. We use various methods to screen potential customers and establish appropriate credit limits, but these methods cannot eliminate all potential credit risks and may not always prevent us from approving customer applications that are not credit-worthy or are fraudulently completed. Changes in our industry, customer demand, and, in relation to our fleet customers, movement in fuel prices may result in periodic increases to customer credit limits and spending and, as a result, could lead to increased credit losses. We may also fail to detect changes to the credit risk of customers over time. Further, during a declining economic environment, we experience increased customer defaults and preference claims by bankrupt customers. If we fail to adequately manage our credit risks, our bad debt expense could be significantly higher than historic levels and adversely affect our business, operating results and financial condition. Our bad debt expense was $44.9 million in 2017 and $35.9 million in 2016, or 7 bps in 2017 and 8 bps in 2016, respectively.\\n22\\nWe derive a significant portion of our revenue from program fees and charges paid by the users of our cards. Any decrease in our receipt of such fees and charges, or limitations on our fees and charges, could adversely affect our business, results of operations and financial condition.\\nOur card programs include a variety of fees and charges associated with transactions, cards, reports, optional services and late payments. Revenues for late fees and finance charges represent 6% of our consolidated revenue for the year ended December 31, 2017. If the users of our cards decrease their transaction activity, or the extent to which they use optional services or pay invoices late, our revenue could be materially adversely affected. In addition, several market factors can affect the amount of our fees and charges, including the market for similar charges for competitive card products and the availability of alternative payment methods such as cash or house accounts. Furthermore, regulators and Congress have scrutinized the electronic payments industry’s pricing, charges and other practices related to its customers. Any legislative or regulatory restrictions on our ability to price our products and services could materially and adversely affect our revenue. Any decrease in our revenue derived from these fees and charges could materially and adversely affect our business, operating results and financial condition.\\nWe operate in a competitive business environment, and if we are unable to compete effectively, our business, operating results and financial condition would be adversely affected.\\nThe market for our products and services is highly competitive, and competition could intensify in the future. Our competitors vary in size and in the scope and breadth of the products and services they offer. In the fleet card business, our primary competitors in North America are small regional and large independent fleet card providers, major oil companies and petroleum marketers that issue their own fleet cards, and major financial services companies that provide card services to major oil companies and petroleum marketers. In the commercial payments business, we face a variety of competitors, some of which have greater financial resources, name recognition and scope and breadth of products and services. Competitors in the hotel card business include travel agencies, online lodging discounters, internal corporate procurement and travel resources, and independent services companies. We also compete for customers with providers of alternative payment mechanisms, such as merchants offering house cash accounts or other forms of credit. Our primary competitors in Europe, Australia and New Zealand are independent fleet card providers, major oil companies and petroleum marketers that issue branded fleet cards, and providers of card outsourcing services to major oil companies and petroleum marketers. Our primary competitors in Latin America are independent providers of fleet cards and vouchers for food, fuel, tolls, and transportation and major oil companies and providers of card outsourcing services to major oil companies and petroleum marketers who offer commercial fleet cards.\\nThe most significant competitive factors in our business are the breadth of product and service features, network acceptance size, customer service, account management, and price. We may experience competitive disadvantages with respect to any of these factors from time to time as potential customers prioritize or value these competitive factors differently. As a result, a specific offering of our products and service features, networks and pricing may serve as a competitive advantage with respect to one customer and a disadvantage for another based on the customers’ preferences.\\nSome of our existing and potential competitors have longer operating histories, greater brand name recognition, larger customer bases, more extensive customer relationships or greater financial and technical resources than we do. In addition, our larger competitors may also have greater resources than we do to devote to the promotion and sale of their products and services and to pursue acquisitions. Many of our competitors provide additional and unrelated products and services to customers, such as treasury management, commercial lending and credit card processing. By providing these services that we do not provide, these competitors have an advantage of being able to bundle their products and services together and present them to existing customers with whom they have established relationships, sometimes at a discount. For example, in the commercial payments business, we compete with full service banks that are able to offer treasury management and commercial lending in addition to commercial payment solutions. If price competition continues to intensify, we may have to increase the incentives that we offer to our customers, decrease the prices of our products and services or lose customers, each of which could adversely affect our operating results. In the fleet card business, major oil companies and petroleum marketers and large financial institutions may choose to integrate fuel-card services as a complement to their existing card products and services, as well as offer add-on complementary services. As a result, they may be able to adapt more quickly to new or emerging technologies and changing opportunities, standards or customer requirements. To the extent that our competitors are regarded as leaders in specific categories, they may have an advantage over us as we attempt to further penetrate these categories.\\nFuture mergers or consolidations among competitors, or acquisitions of our competitors by large companies may present competitive challenges to our business. Resulting combined entities could be at a competitive advantage if their fuel-card products and services are effectively integrated and bundled into sales packages with their widely utilized non-fuel-card-related products and services. Further, competitors may reduce the fees for their services, which could increase pricing pressure within our markets.\\n23\\nOverall, increased competition in our markets could result in intensified pricing pressure, reduced profit margins, increased sales and marketing expenses and a failure to increase, or a loss of, market share. We may not be able to maintain or improve our competitive position against our current or future competitors, which could adversely affect our business, operating results and financial condition.\\nOur fleet card business is dependent on several key strategic relationships, the loss of which could adversely affect our operating results.\\nWe intend to seek to expand our strategic relationships with major oil companies and to establish additional relationships with other petroleum marketers. We refer to the major oil companies and petroleum marketers with whom we have strategic relationships as our “partners.” We use this term in the business sense to refer to strategic business relationships formed through contracts such as Card Program Agreements, and not in the legal sense of operating under legal partnership arrangements created pursuant to laws such as the Uniform Partnership Act. During 2017, our top three strategic relationships with major oil companies accounted for less than 6% of our consolidated revenue. Our agreements with our major oil company partners typically have initial terms of five to ten years with current remaining terms ranging from about one to six years.\\nThe success of our business is in part dependent on our ability to maintain these strategic relationships and enter into additional strategic relationships with major oil companies. In our relationships with these major oil companies, our services are marketed under our partners’ brands. If these partners fail to maintain their brands or decrease the size of their branded networks, our ability to grow our business may be adversely affected. Also, our inability to maintain or further develop these relationships or add additional strategic relationships could materially and adversely affect our business and operating results.\\nTo enter into a new strategic relationship or renew an existing strategic relationship with a major oil company, we often must participate in a competitive bidding process, which may focus on a limited number of factors, including pricing. The bidding and negotiating processes generally occur over a protracted time period. The use of these processes may affect our ability to effectively compete for these relationships. Our competitors may be willing to bid for these contracts on pricing or other terms that we consider uneconomical in order to win business. The loss of our existing major oil company partners or the failure to contract or delays in contracting with additional partners could materially and adversely affect our business, operating results and financial condition.\\nIn 2016, we received notice from an oil partner that they did not intend to renew our current contract when it expired at the end of 2017. Additionally, in 2017, we signed an agreement to extend the management of the commercial fuel card program for a strategic partner. We do not expect these contracts to have a material impact on our business and operating results.\\nWe depend, in part, on our merchant relationships to grow our business. To grow our customer base in the closed loop fleet card and lodging card businesses, we must retain and add relationships with merchants who are located in areas where our customers purchase fuel, maintenance services and lodging. If we are unable to maintain and expand these relationships, our closed loop fleet card and lodging card businesses may be adversely affected.\\nWith respect to the closed loop networks we utilize, a portion of our growth is derived from acquiring new merchant relationships to serve our customers, new and enhanced product and service offerings, and cross-selling our products and services through existing merchant relationships. We rely on the continuing growth of our merchant relationships and our distribution channels in order to expand our customer base. There can be no guarantee that this growth will continue. Similarly, our growth also will depend on our ability to retain and maintain existing merchant relationships that accept our proprietary closed-loop networks in areas where our customers purchase fuel and lodging. Our contractual agreements with fuel merchants and service garages typically have initial terms of one or two years and automatically renew on the same basis unless either party gives notice of termination. Our agreements with lodging providers typically have initial terms of one year and automatically renew on a month-to-month basis unless either party gives notice of termination. Furthermore, merchants with which we have relationships may experience bankruptcy, financial distress, or otherwise be forced to contract their operations. The loss of existing merchant relationships, failure to continue such relationships on similarly attractive economic terms, the contraction of our existing merchants’ operations or the inability to acquire new merchant relationships could adversely affect our ability to serve our customers and our business and operating results.\\nWe depend on our relationships with major truck stop merchants to serve our over-the-road fuel card customers. We must maintain these relationships to effectively serve our customers that use these merchants. If we are unable to maintain these relationships, our over-the-road fuel card businesses may be adversely affected.\\nWe have long standing relationships with major truck stop merchants to accept our over-the-road fuel cards. Over-the-road customers purchase a significant proportion of their fuel at major truck stop merchants. The loss of existing major truck stop\\n24\\nmerchant relationships or failure to continue such relationships on similar terms could adversely affect our ability to serve our over-the-road fuel card customers and our business and operating results.\\nA decline in general economic conditions, and in particular, a decline in demand for fuel and other business related products and services would adversely affect our business, operating results and financial condition.\\nOur operating results are materially affected by conditions in the economy generally, both in the U.S and internationally. We generate revenue based in part on the volume of purchase transactions we process. Our transaction volume is correlated with general economic conditions, particularly in the U.S., Europe, Russia, Latin America, Australia and New Zealand, and the amount of business activity in economies in which we operate. Downturns in these economies are generally characterized by reduced commercial activity and, consequently, reduced purchasing of fuel and other business related products and services by our customers. The commercial payments industry in general, and our commercial payment solutions business specifically, depends heavily upon the overall level of spending. Unfavorable changes in economic conditions, including declining consumer confidence, inflation, recession, political climate or other changes, may lead our corporate customers to reduce their spending, resulting in reduced demand for, or use of, our products and services. In addition, unfavorable changes in economic conditions, may lead our fleet card customers to demand less fuel, or lead our partners to reduce their use of our products and services. As a result, a sustained deterioration in general economic conditions in the U.S. or abroad could have a material adverse effect on our revenue and profitability.\\nFurther, economic conditions also may impact the ability of our customers or partners to pay for fuel or other services they have purchased and, as a result, our reserve for credit losses and write-offs of accounts receivable could increase. A weakening economy could also force some retailers and merchants to close, resulting in exposure to potential credit losses and transaction declines. In addition, demand for fuel and other business related products and services may be reduced by other factors that are beyond our control, such as the development and use of vehicles with greater fuel efficiency and alternative fuel sources.\\nWe are unable to predict the likely duration of current economic conditions in the U.S., Europe, Russia, Latin America, Australia and New Zealand. As a result, weaknesses in general economic conditions or increases in interest rates in key countries in which we operate could adversely affect our business and operating results.\\nWe have expanded into new lines of business in the past and may do so in the future. If we are unable to successfully integrate these new businesses, our results of operations and financial condition may be adversely affected.\\nWe have expanded our business to encompass new lines of business in the past. For example, we have entered into the corporate payments, stored value card, vehicle maintenance management and telematics business in the U.S. and Europe, and transaction processing, fuel, food, toll and transportation card and voucher businesses in Brazil and Mexico. We may continue to enter into new lines of business and offer new products and services in the future. There is no guarantee that we will be successful in integrating these new lines of business into our operations. If we are unable to do so, our operating results and financial condition may be adversely affected.\\nIf we fail to develop and implement new technology, products and services, adapt our products and services to changes in technology, the marketplace requirements, or if our ongoing efforts to upgrade our technology, products and services are not successful, we could lose customers and partners.\\nThe markets for our products and services are highly competitive and characterized by technological change, frequent introduction of new products and services and evolving industry standards. We must respond to the technological advances offered by our competitors and the requirements of our customers and partners, in order to maintain and improve upon our competitive position and fulfill contractual obligations. We may be unsuccessful in expanding our technological capabilities and developing, marketing or selling new products and services that meet these changing demands, which could jeopardize our competitive position. In addition, we engage in significant efforts to upgrade our products and services and the technology that supports these activities on a regular basis.\\nThe products we deliver are designed to process complex transactions and provide reports and other information on those transactions, all at high volumes and processing speeds. Any failure to deliver an effective and secure product or service or any performance issue that arises with a new product or service could result in significant processing or reporting errors or other losses. We may rely on third parties to develop or co-develop our solutions or to incorporate our solutions into broader platforms for the commercial payments industry. We may not be able to enter into such relationships on attractive terms, or at all, and these relationships may not be successful. In addition, partners, some of whom may be our competitors or potential competitors, may choose to develop competing solutions on their own or with third parties. Even if we are successful in developing new services and technologies, these new services and technologies may not achieve broad acceptance due to a\\n25\\nvariety of factors, including a lack of industry-wide standards, competing products and services, or resistance to these changes from our customers. In addition, we may not be able to derive revenue from these efforts.\\nIf we are unsuccessful in completing the migration of material technology, otherwise upgrading our products and services and supporting technology or completing or gaining market acceptance of new technology, products and services, it would have a material adverse effect on our ability to retain existing customers and attract new ones in the impacted business line.\\nOur debt obligations, or our incurrence of additional debt obligations, could limit our flexibility in managing our business and could materially and adversely affect our financial performance.\\nAt December 31, 2017, we had approximately $4.47 billion of debt outstanding under our Credit Facility and Securitization Facility. In addition, we are permitted under our credit agreement to incur additional indebtedness, subject to specified limitations. Our substantial indebtedness currently outstanding, or as may be outstanding if we incur additional indebtedness, could have important consequences, including the following:\\n\\n| • | we may have difficulty satisfying our obligations under our debt facilities and, if we fail to satisfy these obligations, an event of default could result; |\\n\\n| • | we may be required to dedicate a substantial portion of our cash flow from operations to required payments on our indebtedness, thereby reducing the availability of cash flow for acquisitions, working capital, capital expenditures and other general corporate activities. See \\\"Management’s Discussion and Analysis of Financial Condition and Results of Operations—Contractual Obligations,\\\" which sets forth our payment obligations with respect to our existing long-term debt; |\\n\\n| • | covenants relating to our debt may limit our ability to enter into certain contracts or to obtain additional financing for acquisitions, working capital, capital expenditures and other general corporate activities; |\\n\\n| • | covenants relating to our debt may limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate, including by restricting our ability to make strategic acquisitions; |\\n\\n| • | we may be more vulnerable than our competitors to the impact of economic downturns and adverse developments in the industry in which we operate; |\\n\\n| • | we are exposed to the risk of increased interest rates because certain of our borrowings are subject to variable rates of interest; |\\n\\n| • | although we have no current intention to pay any dividends, we may be unable to pay dividends or make other distributions with respect to your investment; and |\\n\\n| • | we may be placed at a competitive disadvantage against any less leveraged competitors. |\\n\\nThe occurrence of one or more of these potential consequences could have a material adverse effect on our business, financial condition, operating results, and ability to satisfy our obligations under our indebtedness.\\nIn addition, we and our subsidiaries may incur substantial additional indebtedness in the future. Although our credit agreements contain restrictions on the incurrence of additional indebtedness, these restrictions are subject to a number of significant qualifications and exceptions, and under certain circumstances, the amount of additional indebtedness that could be incurred in compliance with these restrictions could be substantial. If new debt is added to our existing debt levels, the related risks that we will face would increase.\\nWe meet a significant portion of our working capital needs through a securitization facility, which we must renew every three years.\\nWe meet a significant portion of our working capital needs through a securitization facility, pursuant to which we sell accounts receivable to a special-purpose entity that in turn sells undivided participation interests in the accounts receivable to certain purchasers, who finance their purchases through the issuance of short-term commercial paper. The securitization facility has a three year term. Although we have been able to renew our Securitization Facility annually in the past, there can be no assurance that we will continue to be able to renew this facility in the future on terms acceptable to us. For example, the market for commercial paper experienced significant volatility during the financial crisis that began in 2008. Also, a significant rise in fuel prices could cause our accounts receivable to increase beyond the capacity of the securitization facility. There can be no\\n26\\nassurance that the size of the facility can be expanded to meet these increased working capital needs. Further, we may not be able to fund such increases in accounts receivable with our available cash resources. Our inability to meet working capital needs could adversely affect our financial condition and business, including our relationships with merchants, customers and partners. Further, we are exposed to the risk of increased interest rates because our borrowings under the Securitization Facility are subject to variable rates of interest. We renewed our Securitization Facility as of November 14, 2017, with an expiration date of November 14, 2020.\\nWe are subject to risks related to volatility in foreign currency exchange rates, and restrictions on our ability to utilize revenue generated in foreign currencies.\\nAs a result of our foreign operations, we are subject to risks related to changes in currency rates for revenue generated in currencies other than the U.S. dollar. For the year ended December 31, 2017, approximately 37% of our revenue was denominated in currencies other than the U.S. dollar (primarily, British pound, Brazilian real, Canadian dollar, Russian ruble, Mexican peso, Czech koruna, Euro, Australian dollar and New Zealand dollar). Revenue and profit generated by international operations may increase or decrease compared to prior periods as a result of changes in foreign currency exchange rates. Resulting exchange gains and losses are included in our net income. Volatility in foreign currency exchange rates may materially adversely affect our operating results and financial condition.\\nFurthermore, we are subject to exchange control regulations that restrict or prohibit the conversion of more than a specified amount of our foreign currencies into U.S. dollars, and, as we continue to expand, we may become subject to further exchange control regulations that limit our ability to freely utilize and transfer currency in and out of particular jurisdictions. These restrictions may make it more difficult to effectively utilize the cash generated by our operations and may adversely affect our financial condition.\\nWe expect to continue our expansion through acquisitions, which may divert our management’s attention and result in unexpected operating difficulties, increased costs and dilution to our stockholders. We also may never realize the anticipated benefits of the acquisitions.\\nWe have been an active business acquirer in the U.S. and internationally, and, as part of our growth strategy, we expect to seek to acquire businesses, commercial account portfolios, technologies, services and products in the future. We have substantially expanded our overall business, customer base, headcount and operations through acquisitions. The acquisition and integration of each business involves a number of risks and may result in unforeseen operating difficulties and expenditures in assimilating or integrating the businesses, technologies, products, personnel or operations of the acquired business. Furthermore, acquisitions may:\\n\\n| • | involve our entry into geographic or business markets in which we have little or no prior experience; |\\n\\n| • | involve difficulties in retaining the customers of the acquired business; |\\n\\n| • | involve difficulties and expense associated with regulatory requirements, competition controls or investigations; |\\n\\n| • | result in a delay or reduction of sales for both us and the business we acquire; and |\\n\\n| • | disrupt our ongoing business, divert our resources and require significant management attention that would otherwise be available for ongoing development of our current business. |\\n\\nIn addition, international acquisitions often involve additional or increased risks including, for example:\\n\\n| • | difficulty managing geographically separated organizations, systems and facilities; |\\n\\n| • | difficulty integrating personnel with diverse business backgrounds, languages and organizational cultures; |\\n\\n| • | difficulty and expense introducing our corporate policies or controls; |\\n\\n| • | increased expense to comply with foreign regulatory requirements applicable to acquisitions; |\\n\\n| • | difficulty entering new foreign markets due to, among other things, lack of customer acceptance and a lack of business knowledge of these new markets; and |\\n\\n| • | political, social and economic instability. |\\n\\n27\\nIn addition, the integration process following an acquisition requires significant management attention and resources. Integration of acquisitions could result in the distraction of our management, the disruption of our ongoing business or inconsistencies on our services, standards, controls, procedures and policies, any of which could affect our ability to achieve the anticipated benefits of an acquisition or otherwise adversely affect our business and financial results.\\nTo complete future acquisitions, we may determine that it is necessary to use a substantial amount of our cash or engage in equity or debt financing. If we raise additional funds through further issuances of equity or convertible debt securities, our existing stockholders could suffer significant dilution, and any new equity securities we issue could have rights, preferences and privileges senior to those of holders of our common stock. Any debt financing obtained by us in the future could involve restrictive covenants relating to our capital-raising activities and other financial and operational matters that make it more difficult for us to obtain additional capital in the future and to pursue other business opportunities, including potential acquisitions. In addition, we may not be able to obtain additional financing on terms favorable to us, if at all, which could limit our ability to engage in acquisitions. Moreover, we can make no assurances that the anticipated benefits of any acquisition, such as operating improvements or anticipated cost savings, would be realized or that we would not be exposed to unexpected liabilities in connection with any acquisition.\\nFurther, an acquisition may negatively affect our operating results because it may require us to incur charges and substantial debt or other liabilities, may cause adverse tax consequences, substantial depreciation and amortization or deferred compensation charges, may require the amortization, write-down or impairment of amounts related to deferred compensation, goodwill and other intangible assets, may include substantial contingent consideration payments or other compensation that reduce our earnings during the quarter in which incurred, or may not generate sufficient financial return to offset acquisition costs.\\nWe conduct a significant portion of our business in foreign countries and we expect to expand our operations into additional foreign countries where we may be adversely affected by operational and political risks that are greater than in the U.S.\\nWe have foreign operations in, or provide services for commercial card accounts in Australia, Austria, Azerbaijan, Belarus, Belgium, Brazil, Bulgaria, Canada, Croatia, Czech Republic, Denmark, Estonia, Finland, France, Georgia, Germany, Gibraltar, Greece, Hong Kong, Hungary, Ireland, Italy, Kazakhstan, Latvia, Lithuania, Luxembourg, Macau, Malaysia, Mexico, Moldova, Mongolia, the Netherlands, New Zealand, Norway, Pakistan, Papua New Guinea, Peru, Philippines, Poland, Portugal, Romania, Russia, Singapore, Slovakia, Slovenia, South Africa, South Korea, Spain, Sweden, Switzerland, Taiwan, Thailand, Turkey, Ukraine, United Arab Emirates and the United Kingdom. We also expect to seek to expand our operations into various countries in Asia, Europe and Latin America as part of our growth strategy.\\nSome of the countries where we operate, and other countries where we will seek to operate, such as Russia, Brazil and Mexico, have undergone significant political, economic and social change in recent years, and the risk of unforeseen changes in these countries may be greater than in the U.S. For example, Russia and Ukraine are experiencing significant unrest, which could escalate into broader armed conflict and additional economic sanctions by the U.S., United Nations or other countries against Russia. In addition, political discourse in the U.S. may impact business practices in Mexico and other jurisdictions. In addition, changes in laws or regulations, including with respect to payment service providers, taxation, information technology, data transmission and the Internet, revenues from non-U.S. operations or in the interpretation of existing laws or regulations, whether caused by a change in government or otherwise, could materially adversely affect our business, operating results and financial condition.\\nIn addition, conducting and expanding our international operations subjects us to other risks that we do not generally face in the U.S. These include:\\n\\n| • | difficulties in managing the staffing of our international operations, including hiring and retaining qualified employees; |\\n\\n| • | difficulties and increased expense introducing corporate policies and controls in our international operations; |\\n\\n| • | increased expense related to localization of our products and services, including language translation and the creation of localized agreements; |\\n\\n| • | potentially adverse tax consequences, including the complexities of foreign value added tax systems, restrictions on the repatriation of earnings and changes in tax rates; |\\n\\n28\\n| • | increased expense to comply with foreign laws and legal standards, including laws that regulate pricing and promotion activities and the import and export of information technology, which can be difficult to monitor and are often subject to change; |\\n\\n| • | increased expense to comply with U.S. laws that apply to foreign operations, including the Foreign Corrupt Practices Act (the \\\"FCPA\\\") and OFAC regulations; |\\n\\n| • | increased expense to comply with U.K. laws that apply to foreign operations, including the U.K. Bribery Act; |\\n\\n| • | longer accounts receivable payment cycles and difficulties in collecting accounts receivable; |\\n\\n| • | increased financial accounting and reporting burdens and complexities; |\\n\\n| • | political, social and economic instability; |\\n\\n| • | terrorist attacks and security concerns in general; and |\\n\\n| • | reduced or varied protection for intellectual property rights and cultural norms in some geographies that are simply not respectful of intellectual property rights. |\\n\\nIn addition, in June 2016, voters in the United Kingdom approved an advisory referendum to withdraw from the European Union, commonly referred to as \\\"Brexit.\\\" This referendum has created political and economic uncertainty, particularly in the United Kingdom and the European Union, and this uncertainty may persist for years. A withdrawal could significantly disrupt the free movement of goods, services, and people between the United Kingdom and the European Union, and result in increased legal and regulatory complexities, as well as potential higher costs of conducting business in Europe. The United Kingdom's vote to exit the European Union could also result in similar referendums or votes in other European countries in which we do business. The uncertainty surrounding the terms of the United Kingdom's withdrawal and its consequences could adversely impact consumer and investor confidence, and the level of consumer purchases of discretionary items and retail products, including our products. Any of these effects, among others, could materially adversely affect our business, results of operations, and financial condition.\\nThe occurrence of one or more of these events could negatively affect our international operations and, consequently, our operating results. Further, operating in international markets requires significant management attention and financial resources. Due to the additional uncertainties and risks of doing business in foreign jurisdictions, international acquisitions tend to entail risks and require additional oversight and management attention that are typically not attendant to acquisitions made within the U.S. We cannot be certain that the investment and additional resources required to establish, acquire or integrate operations in other countries will produce desired levels of revenue or profitability.\\nWe are dependent on the efficient and uninterrupted operation of interconnected computer systems, telecommunications, data centers and call centers, including technology and network systems managed by multiple third parties, which could result in our inability to prevent disruptions in our services.\\nOur ability to provide reliable service to customers, cardholders and other network participants depends upon uninterrupted operation of our data centers and call centers as well as third-party labor and services providers. Our business involves processing large numbers of transactions, the movement of large sums of money and the management of large amounts of data. We rely on the ability of our employees, contractors, suppliers, systems and processes to complete these transactions in a secure, uninterrupted and error-free manner.\\nOur subsidiaries operate in various countries and country specific factors, such as power availability, telecommunications carrier redundancy, embargoes and regulation can adversely impact our information processing by or for our local subsidiaries.\\nWe engage backup facilities for each of our processing centers for key systems and data. However, there could be material delays in fully activating backup facilities depending on the nature of the breakdown, security breach or catastrophic event (such as fire, explosion, flood, pandemic, natural disaster, power loss, telecommunications failure or physical break-in). We have controls and documented measures to mitigate these risks but these mitigating controls might not reduce the duration, scope or severity of an outage in time to avoid adverse effects.\\n29\\nWe may experience software defects, system errors, computer viruses and development delays, which could damage customer relationships, decrease our profitability and expose us to liability.\\nOur business depends heavily on the reliability of proprietary and third-party processing systems. A system outage could adversely affect our business, financial condition or results of operations, including by damaging our reputation or exposing us to third-party liability. To successfully operate our business, we must be able to protect our processing and other systems from interruption, including from events that may be beyond our control. Events that could cause system interruptions include fire, natural disaster, unauthorized entry, power loss, telecommunications failure, computer viruses, terrorist acts and war. Although we have taken steps to protect against data loss and system failures, there is still risk that we may lose critical data or experience system failures.\\nOur products and services are based on sophisticated software and computing systems that are constantly evolving. We often encounter delays and cost overruns in developing changes implemented to our systems. In addition, the underlying software may contain undetected errors, viruses or defects. Defects in our software products and errors or delays in our processing of electronic transactions could result in additional development costs, diversion of technical and other resources from our other development efforts, loss of credibility with current or potential customers, harm to our reputation or exposure to liability claims. In addition, we rely on technologies supplied to us by third parties that may also contain undetected errors, viruses or defects that could adversely affect our business, financial condition or results of operations. Although we attempt to limit our potential liability for warranty claims through disclaimers in our software documentation and limitation of liability provisions in our licenses and other agreements with our customers, we cannot assure that these measures will be successful in limiting our liability.\\nWe may incur substantial losses due to fraudulent use of our payment cards or vouchers.\\nUnder certain circumstances, when we fund customer transactions, we may bear the risk of substantial losses due to fraudulent use of our payment cards or vouchers. We do not maintain insurance to protect us against such losses. We bear similar risk relating to fraudulent acts of employees or contractors, for which we maintain insurance. However, the conditions or limits of coverage may be insufficient to protect us against such losses.\\nCriminals are using increasingly sophisticated methods to engage in illegal activities involving financial products, such as skimming and counterfeiting payment cards and identity theft. A single significant incident of fraud, or increases in the overall level of fraud, involving our cards and other products and services, could result in reputational damage to us, which could reduce the use and acceptance of our cards and other products and services or lead to greater regulation that would increase our compliance costs. Fraudulent activity could also result in the imposition of regulatory sanctions, including significant monetary fines, which could have a material adverse effect on our business, financial condition and results of operations.\\nWe may not be able to adequately protect our systems or the data we collect from continually evolving cybersecurity risks or other technological risks, which could subject us to liability and damage our reputation.\\nWe electronically receive, process, store and transmit data and sensitive information about our customers and merchants, including bank account information, social security numbers, expense data, and credit card, debit card and checking account numbers. We endeavor to keep this information confidential; however, our websites, networks, information systems, services and technologies may be targeted for sabotage, disruption or misappropriation. The uninterrupted operation of our information systems and our ability to maintain the confidentiality of the customer and consumer information that resides on our systems are critical to the successful operation of our business. Unauthorized access to our networks and computer systems could result in the theft or publication of confidential information or the deletion or modification of records or could otherwise cause interruptions in our service and operations. Although we are not aware of any material breach of our or our associated third parties’ computer systems or material losses relating to cyber-attacks or other information security breaches, we and others in our industry are regularly the subject of attempts by bad actors to gain unauthorized access to these computer systems and data or to obtain, change or destroy confidential data (including personal consumer information of individuals) through a variety of means, including computer viruses, malware and phishing.\\nBecause techniques used to sabotage or obtain unauthorized access to our systems and the data we collect change frequently and may not be recognized until launched against a target, we may be unable to anticipate these techniques or to implement adequate preventative measures. Threats to our systems and our associated third parties’ systems can derive from human error, fraud or malice on the part of employees or third parties, or may result from accidental technological failure. Computer viruses can be distributed and could infiltrate our systems or those of our associated third parties. In addition, denial of service or other attacks could be launched against us for a variety of purposes, including to interfere with our services or create a diversion for other malicious activities. Although we believe we have sufficient controls in place to prevent disruption and misappropriation\\n30\\nand to respond to such attacks, any inability to prevent security breaches could have a negative impact on our reputation, expose us to liability, decrease market acceptance of electronic transactions and cause our present and potential clients to choose another service provider. Any of these developments could have a material adverse effect on our business, operating results and financial condition.\\nWe could also be subject to liability for claims relating to misuse of personal information, such as unauthorized marketing purposes and violation of data privacy laws. We cannot provide assurance that the contractual requirements related to security and privacy that we impose on our service providers who have access to customer and consumer data will be followed or will be adequate to prevent the unauthorized use or disclosure of data. In addition, we have agreed in certain agreements to take certain protective measures to ensure the confidentiality of customer data. The costs of systems and procedures associated with such protective measures may increase and could adversely affect our ability to compete effectively. Any failure to adequately enforce or provide these protective measures could result in liability, protracted and costly litigation, governmental and card network intervention and fines and, with respect to misuse of personal information of our customers, lost revenue and reputational harm.\\nIn addition, under payment network rules, regulatory requirements, and related obligations, we may be responsible for the acts or failures to act of certain third parties, such as third party service providers, vendors, partners and others, which we refer to collectively as associated participants. The failure of our associated participants to safeguard cardholder data and other information in accordance with such rules, requirements and obligations could result in significant fines and sanctions and could harm our reputation and deter existing and prospective customers from using our services. We cannot assure you that there are written agreements in place with every associated participant or that such written agreements will ensure the adequate safeguarding of such data or information or allow us to seek reimbursement from associated participants. Any such unauthorized use or disclosure of data or information also could result in litigation that could result in a material adverse effect on our business, financial condition and results of operations.\\nThe market for our commercial payment, fleet and stored value card services is evolving and may not continue to develop or grow.\\nA substantial portion of our revenue is based on the volume of payment card transactions by our customers. If businesses do not continue to use, or increase their use of, credit, debit or stored value cards as a payment mechanism for their transactions, it could have a material adverse effect on our business, financial condition and results of operations. We believe that future growth in the use of credit, debit and stored value cards and other electronic payments will be driven by the cost, ease-of-use, and quality of services offered. In order for us to consistently increase and maintain profitability, businesses must continue to use and increase the use of electronic payment methods, including credit, debit and stored value cards. Moreover, if there is an adverse development in the payments industry in general, such as new legislation or regulation that makes it more difficult for customers to do business, or a well-publicized data security breach that undermines the confidence of the public in electronic payment systems, it could have a material adverse effect on our business, financial condition and results of operations.\\nOur fleet card businesses rely on the acceptance and use of payment cards by businesses to purchase fuel for their vehicle fleets. If the use of fleet cards by businesses does not continue to grow, it could have a material adverse effect on our business, operating results and financial condition. In order to consistently increase and maintain our profitability, businesses and partners must continue to adopt our services. Similarly, growth in the acceptance and use of fleet cards will be impacted by the acceptance and use of electronic payment transactions generally.\\nFurthermore, new technologies may displace credit, debit and/or stored value cards as payment mechanisms for purchase transactions by businesses. A decline in the acceptance and use of credit, debit and/or stored value cards, and electronic payment transactions generally, by businesses and merchants could have a material adverse effect on our business, operating results and financial condition. The market for our lodging cards, food vouchers and cards, transportation and toll road payments, telematics solutions and fleet maintenance management services is also evolving and those portions of our business are subject to similar risks.\\nIf we fail to retain any of our stored value gift card customers, it will be difficult to find a replacement customer on a timely basis or at all, which will reduce our revenue.\\nMost of our stored value gift card customers in the U.S. are national retailers. During 2017, a majority of our gift card revenue was derived from the design and purchase of gift card inventory, with the remaining portion of our 2017 gift card revenue derived primarily from processing fees. If we fail to retain any of these customers, it will be difficult to find a replacement customer on a timely basis or at all because there is a limited number of national retailers in the U.S. and nearly all of those\\n31\\nother national retailers already have a gift card solution in place, either in-house or with one of our competitors. As such, any loss of a stored value gift card customer would reduce our revenue.\\nAdverse weather conditions across a geographic region can cause a decline in the number and amount of payment transactions we process, which could have a material adverse effect on our business, financial condition and results of operations.\\nWhen travel is severely curtailed across a geographic region during adverse weather conditions, the number and amount of transactions we process can be significantly diminished, particularly in our fleet business, and revenue can materially decline. For example, during parts of January 2014, severe winter weather shut down a large portion of the eastern United States. Prolonged adverse weather events, especially those that impact regions in which we process a large number and amount of payment transactions, could have a material adverse effect on our business, financial condition and results of operations.\\nOur fuel card, workforce payment solutions and gift card businesses’ results are subject to seasonality, which could result in fluctuations in our quarterly net income.\\nOur fuel card and workforce payment solutions businesses have experienced in the past, and expect to continue to experience, seasonal fluctuations in revenues and profit, which are impacted during the first and fourth quarter each year by the weather, holidays in the U.S., Christmas being celebrated in Russia in January, and lower business levels in Brazil due to summer break and the Carnival celebration. Our gift card business has experienced in the past, and expects to continue to experience, seasonal fluctuations in revenues as a result of consumer spending patterns. Historically gift card business revenues have been strongest in the third and fourth quarters and weakest in the first and second quarters, as the retail industry has its highest level of activity during and leading up to the Christmas holiday season.\\nOur balance sheet includes significant amounts of goodwill and intangible assets. The impairment of a significant portion of these assets would negatively affect our financial results.\\nOur balance sheet includes goodwill and intangible assets that represent approximately 66% of our total assets at December 31, 2017. These assets consist primarily of goodwill and identified intangible assets associated with our acquisitions. We also expect to engage in additional acquisitions, which may result in our recognition of additional goodwill and intangible assets. Under current accounting standards, we are required to amortize certain intangible assets over the useful life of the asset, while goodwill and indefinite lived intangible assets are not amortized. On at least an annual basis, we assess whether there have been impairments in the carrying value of goodwill and indefinite lived intangible assets. If the carrying value of the asset is determined to be impaired, it is written down to fair value by a charge to operating earnings. An impairment of a significant portion of goodwill or intangible assets could materially negatively affect our operating results and financial condition.\\nIf we are unable to protect our intellectual property rights and confidential information, our competitive position could be harmed and we could be required to incur significant expenses in order to enforce our rights.\\nTo protect our proprietary technology, we rely on copyright, trade secret, patent and other intellectual property laws and confidentiality agreements with employees and third parties, all of which offer only limited protection. Despite our precautions, it may be possible for third parties to obtain and use without our consent confidential information or infringe on our intellectual property rights, and our ability to police that misappropriation or infringement is uncertain, particularly in countries outside of the U.S. In addition, our confidentiality agreements with employees, vendors, customers and other third parties may not effectively prevent disclosure or use of proprietary technology or confidential information and may not provide an adequate remedy in the event of such unauthorized use or disclosure.\\nProtecting against the unauthorized use of our intellectual property and confidential information is expensive, difficult and not always possible. Litigation may be necessary in the future to enforce or defend our intellectual property rights, to protect our confidential information, including trade secrets, or to determine the validity and scope of the proprietary rights of others. This litigation could be costly and divert management resources, either of which could harm our business, operating results and financial condition. Accordingly, despite our efforts, we may not be able to prevent third parties from infringing upon or misappropriating our intellectual property and proprietary information.\\nWe cannot be certain that the steps we have taken will prevent the unauthorized use or the reverse engineering of our proprietary technology. Moreover, others may independently develop technologies that are competitive to ours or infringe our intellectual property. The enforcement of our intellectual property rights also depends on our legal actions against these infringers being successful, and we cannot be sure these actions will be successful, even when our rights have been infringed.\\n32\\nFurthermore, effective patent, trademark, service mark, copyright and trade secret protection may not be available in every country in which we may offer our products and services.\\nClaims by others that we or our customers infringe their intellectual property rights could harm our business.\\nThird parties have in the past, and could in the future claim that our technologies and processes underlying our products and services infringe their intellectual property. In addition, to the extent that we gain greater visibility, market exposure, and add new products and services, we may face a higher risk of being the target of intellectual property infringement claims asserted by third parties. We may, in the future, receive notices alleging that we have misappropriated or infringed a third party’s intellectual property rights. There may be third-party intellectual property rights, including patents and pending patent applications that cover significant aspects of our technologies, processes or business methods. Any claims of infringement or misappropriation by a third party, even those without merit, could cause us to incur substantial defense costs and could distract our management from our business, and there can be no assurance that we will be able to prevail against such claims. Some of our competitors may have the capability to dedicate substantially greater resources to enforcing their intellectual property rights and to defending claims that may be brought against them than we do. Furthermore, a party making such a claim, if successful, could secure a judgment that requires us to pay substantial damages, potentially including treble damages if we are found to have willfully infringed a patent. A judgment could also include an injunction or other court order that could prevent us from offering our products and services. In addition, we might be required to seek a license for the use of a third party’s intellectual property, which may not be available on commercially reasonable terms or at all. Alternatively, we might be required to develop non-infringing technology, which could require significant effort and expense and might ultimately not be successful.\\nThird parties may also assert infringement claims against our customers relating to their use of our technologies or processes. Any of these claims might require us to defend potentially protracted and costly litigation on their behalf, regardless of the merits of these claims, because under certain conditions we may agree to indemnify our customers from third-party claims of intellectual property infringement. If any of these claims succeed, we might be forced to pay damages on behalf of our customers, which could adversely affect our business, operating results and financial condition.\\nFinally, we use open source software in connection with our technology and services. Companies that incorporate open source software into their products, from time to time, face claims challenging the ownership of open source software. As a result, we could be subject to suits by parties claiming ownership of what we believe to be open source software. Open source software is also provided without warranty, and may therefore include bugs, security vulnerabilities or other defects. Some open source software licenses require users of such software to publicly disclose all or part of the source code to their software and/or make available any derivative works of the open source code on unfavorable terms or at no cost. While we monitor the use of open source software in our technology and services and try to ensure that none is used in a manner that would require us to disclose the source code to the related technology or service, such use could inadvertently occur and any requirement to disclose our proprietary source code could be harmful to our business, financial condition and results of operations.\\nOur success is dependent, in part, upon our executive officers and other key personnel, and the loss of key personnel could materially adversely affect our business.\\nOur success depends, in part, on our executive officers and other key personnel. Our senior management team has significant industry experience and would be difficult to replace. The market for qualified individuals is competitive, and we may not be able to attract and retain qualified personnel or candidates to replace or succeed members of our senior management team or other key personnel. The loss of key personnel could materially adversely affect our business.\\nChanges in laws, regulations and enforcement activities may adversely affect our products and services and the markets in which we operate.\\nThe electronic payments industry is subject to increasing regulation in the U.S. and internationally. Domestic and foreign government regulations impose compliance obligations on us and restrictions on our operating activities, which can be difficult to administer because of their scope, mandates and varied requirements. We are subject to a number of government regulations, including, among others: interest rate and fee restrictions; credit access and disclosure requirements; collection and pricing regulations; compliance obligations; security and data breach requirements; identity theft avoidance programs; and anti-money laundering compliance programs. Government regulations can also include licensing or registration requirements. While a large portion of these regulations focuses on individual consumer protection, legislatures continue to consider whether to include business customers within the scope of these regulations. As a result, new or expanded regulation focusing on business customers or changes in interpretation or enforcement of regulations may have an adverse effect on our business and operating results, due to increased compliance costs and new restrictions affecting the terms under which we offer our products and services.\\n33\\nFor example, certain of our subsidiaries are currently licensed as money transmitters on the state level by the banking departments or other state agencies. Continued licensing by these states is subject to periodic examinations and ongoing satisfaction of compliance requirements regarding safety and soundness, including maintenance of certain levels of net worth, surety bonding, permissible investments in amounts sufficient to cover our outstanding payment obligations with respect to certain of our products subject to licensure, and record keeping and reporting. If our subsidiaries are unable to obtain, maintain or renew necessary licenses or comply with other relevant state regulations, they will not be able to operate as a money transmitter in those states or provide certain other services and products, which could have a material adverse effect on our business, financial condition and results of operations.\\nIn addition, certain of our subsidiaries are subject to regulation by the Financial Crimes Enforcement Network, or FinCEN, and must comply with applicable anti-money laundering requirements, including implementation of an effective anti-money laundering program. Changes in this regulatory environment, including changing interpretations and the implementation of new or varying regulatory requirements by the government, may significantly affect or change the manner in which we currently conduct some aspects of our business.\\nRegulatory changes may also restrict or eliminate present and future business opportunities available to certain of our subsidiaries. For example, the Durbin Amendment to the Dodd-Frank Act, which serves to limit interchange fees may restrict or otherwise impact the way our subsidiaries do business or limit their ability to charge certain fees to customers. The Consumer Financial Protection Bureau (\\\"CFPB\\\") is also engaged in rule making and regulation of the payments industry, in particular with respect to prepaid cards, and in October 2016, the CFPB issued a final rule amending Regulations E and Z to create comprehensive consumer protections for prepaid financial products. The extensive nature of these regulations and the implementation dates for this additional rulemaking may result in additional compliance obligations and expense for our business. The CFPB’s focus on the protection of consumers might also extend to many of our small business customers. As a service provider to certain of our bank sponsors, we are subject to direct supervision and examination by the CFPB, in connection with certain of our products and services. CFPB rules, examinations and enforcement actions may require us to adjust our activities and may increase our compliance costs. Changing regulations or standards in the area of privacy and data protection could also adversely impact us. In addition, certain of our bank partners are subject to regulation by federal and state authority and, as a result, could pass through some of those compliance obligations to us.\\nOur business is subject to U.S. federal anti-money laundering laws and regulations, including the BSA. Our business in Canada is also subject to Proceeds of Crime (Money Laundering) and Terrorist Financing Act, or the PCTFA, which is a corollary to the BSA. The BSA, among other things, requires money services businesses (such as money transmitters, issuers of money orders and official checks and providers of prepaid access) to develop and implement risk-based anti-money laundering programs, report large cash transactions and suspicious activity and maintain transaction records. The PCTFA imposes similar requirements.\\nMany of these laws and regulations are evolving, unclear and inconsistent across various jurisdictions, and ensuring compliance with them is difficult and costly. With increasing frequency, federal and state regulators are holding businesses like ours to higher standards of training, monitoring and compliance, including monitoring for possible violations of laws by our customers and people who do business with our customers while using our products. If we fail or are unable to comply with existing or changed government regulations in a timely and appropriate manner, we may be subject to injunctions, other sanctions and the payment of fines and penalties, and our reputation may be harmed, which could have a material adverse effect on our business, financial condition and results of operations.\\nOur partner banks also operate in a highly regulated industry, which recently has been the subject of extensive structural reforms that are expected to negatively affect the conduct and scope of their businesses, their ability to maintain or expand offerings of products and services, and the costs of their operations. These legislative and regulatory changes could prompt our partner banks to alter the extent or the terms of their dealings with us in ways that may have adverse consequences for our business.\\nIn addition, recently implemented and pending changes in accounting standards (for example, changes relating to revenue recognition for customer contracts that will become effective for fiscal 2018) may adversely affect our results of operations.\\nFinally, we have endeavored to structure our businesses in accordance with existing tax laws and interpretations, including those related to state occupancy taxes, value added taxes in foreign jurisdictions, payroll taxes and restrictions on repatriation of funds or transfers of revenue between jurisdictions. Changes in tax laws, their interpretations or their enforcement could increase our tax liability, further limit our utilization of funds located in foreign jurisdictions and have a material adverse effect on our business and financial condition.\\n34\\nFor more information about laws, regulations and enforcement activities that may adversely affect our products and services and the markets in which we operate, see “Business- Regulatory.”\\nDerivatives Regulations\\nRules adopted under the Dodd-Frank Act by the Commodity Futures Trading Commission (the \\\"CFTC\\\"), as well as the provisions of the European Market Infrastructure Regulation and its technical standards, which are directly applicable in the member states of the European Union, have subjected certain of the foreign exchange derivative contracts we offer to our customers as part of Cambridge's business, to reporting, recordkeeping, and other requirements. Additionally, certain foreign exchange derivatives transactions we may enter into in the future may be subject to centralized clearing requirements, or may be subject to margin requirements in the United States and European Union. Other jurisdictions outside the United States and the European Union are considering, have implemented, or are implementing regulations similar to those described above. Derivatives regulations have added costs to our business and any additional requirements, such as future registration requirements and increased regulation of derivative contracts, may result in additional costs or impact the way we conduct our hedging activities, as well as impact how we conduct our business within our international payments provider operations. In particular, the CFTC has recently issued a proposed rule that, if adopted as proposed, would increase the likelihood that we will have to register one or more of our subsidiaries with the CFTC as swap dealers. Swap dealers are subject to a comprehensive regulatory framework and compliance with this framework will lead to additional costs, including costs relating to regulatory capital and margin requirements, and may impact how we conduct our hedging activities and derivatives business with customers. We are currently evaluating the impact the proposed rule, if adopted, would have on our hedging activities and operations.\\nOur compliance with these requirements has resulted, and may continue to result, in additional costs to our business and may impact our international payments provider business operations. Furthermore, our failure to comply with these requirements could result in fines and other sanctions, as well as necessitate a temporary or permanent cessation to some or all of our derivative related activities. Any such fines, sanctions or limitations on our business could adversely affect our operations and financial results. Additionally, the regulatory regimes for derivatives in the United States and European Union, such as under the Dodd-Frank Act and the European Markets in Financial Instruments Directive known as \\\"MiFID II,\\\" are continuing to evolve and changes to such regimes, our designation under such regimes, or the implementation of new rules under such regimes, such as future registration requirements and increased regulation of derivative contracts, may result in additional costs to our business. Other jurisdictions outside the United States and the European Union are considering, have implemented, or are implementing regulations similar to those described above and these may result in greater costs to us as well.\\nGovernmental regulations designed to protect or limit access to personal information could adversely affect our ability to effectively provide our services.\\nGovernmental bodies in the U.S. and abroad have adopted, or are considering the adoption of, laws and regulations restricting the transfer of, and requiring safeguarding of, non-public personal information. For example, in the U.S., all financial institutions must undertake certain steps to help protect the privacy and security of consumer financial information. In connection with providing services to our clients, we are required by regulations and arrangements with payment networks, our sponsor bank and certain clients to provide assurances regarding the confidentiality and security of non-public consumer information. These arrangements require periodic audits by independent companies regarding our compliance with industry standards such as PCI standards and also allow for similar audits regarding best practices established by regulatory guidelines. The compliance standards relate to our infrastructure, components, and operational procedures designed to safeguard the confidentiality and security of non-public consumer personal information received from our customers. Our ability to maintain compliance with these standards and satisfy these audits will affect our ability to attract and maintain business in the future. If we fail to comply with these regulations, we could be exposed to suits for breach of contract or to governmental proceedings. In addition, our client relationships and reputation could be harmed, and we could be inhibited in our ability to obtain new clients. If more restrictive privacy laws or rules are adopted by authorities in the future on the federal or state level, our compliance costs may increase, our opportunities for growth may be curtailed by our compliance capabilities or reputational harm and our potential liability for security breaches may increase, all of which could have a material adverse effect on our business, financial condition and results of operations.\\n35\\nWe are subject to governmental regulation and other legal obligations, particularly related to privacy, data protection and information security, and we are subject to disparate consumer protection laws across different countries. Our actual or perceived failure to comply with such obligations could harm our business.\\nIn the U.S., the European Union and in other jurisdictions around the world, we are subject to numerous and disparate consumer laws (including laws on disputed transactions) as well as regulations on eCommerce or similar legislation. If we are found to have breached any consumer, eCommerce or similar legislation in any country, we may be subject to enforcement actions that require us to change our business practices in a manner which may negatively impact revenue, as well as litigation, fines, penalties and adverse publicity that could cause our customers to lose trust in us, which could have an adverse effect on our reputation and business in a manner that harms our financial position.\\nWe collect personally identifiable information and other data from our customers. Laws and regulations in several countries restrict certain collection, processing, storage, use, disclosure and security of personal information, require notice to individuals of privacy practices, and provide individuals with certain rights to prevent use and disclosure of protected information. Several foreign countries and governmental bodies, including the countries of the European Union and Canada, have laws and regulations which are often more restrictive than those in the United States. The data privacy regime in the EU includes certain directives which, among other things, require European Union member states to regulate the processing and movement of personal data, marketing and the use of cookies. Each European Union member state has transposed the requirements of these directives into its own national data privacy regime, and therefore the laws differ from jurisdiction to jurisdiction. These laws and regulations are subject to frequent revisions and differing interpretations, and have generally become more stringent over time.\\nFuture restrictions on the collection, use, sharing or disclosure of personally identifiable information or additional requirements and liability for security and data integrity could require us to modify our solutions and features, possibly in a material manner, and could limit our ability to develop new services and features. For example, the EU-wide General Data Protection Regulation, or GDPR, which was passed by the European Union Parliament in the spring of 2016 and will become fully effective in May 2018, following a two-year implementation period, will replace the data protection laws of each European Union member state. The GDPR will implement more stringent operational requirements for processors and controllers of personal data, including, for example, increased requirements to erase an individual’s information upon request, mandatory data breach notification requirements and onerous new obligations on service providers. It also significantly increases penalties for non-compliance, including where we act as a service provider (e.g., data processor). If our privacy or data security measures fail to comply with applicable current or future laws and regulations, we may be subject to litigation, regulatory investigations, enforcement notices requiring us to change the way we use personal data or our marketing practices, fines, for example, of up to 20,000,000 Euros or up to 4% of the total worldwide annual turnover of the preceding financial year (whichever is higher) under the GDPR, or other liabilities, as well as negative publicity and a potential loss of business.\\nIn February 2013, the European Commission proposed EU-wide legislation regarding cybersecurity in the form of the proposed Network and Information Security Directive, or the NIS Directive. The NIS Directive requires EU member states to impose cybersecurity obligations-including data breach notification requirements-to operators of “essential services” and to “digital service providers.” The NIS Directive and its implementing legislation if held to apply to us may lead to compliance obligations that require us to change one or more aspects of the way we operate our business, which could increase our operating costs, and failure to comply may result in governmental enforcement actions, litigation, fines, penalties and adverse publicity.\\nUnfavorable resolution of tax contingencies or changes to enacted tax rates could adversely affect our tax expense and results of operations.\\nOur tax returns and positions are subject to review and audit by federal, state, local, and international taxing authorities. An unfavorable outcome to a tax audit could result in higher tax expense, thereby negatively impacting our results of operations. We have established contingent liabilities for material known tax exposures relating to deductions, transactions and other matters involving some uncertainty as to the proper tax treatment of the item. These liabilities reflect what we believe to be reasonable assumptions as to the likely final resolution of each issue if raised by a taxing authority. There can be no assurance that, in all instances, an issue raised by a tax authority will be finally resolved at a financial cost less than any related liability. An unfavorable resolution, therefore, could negatively impact our financial position, operating results and cash flows in the current and/or future periods.\\nOur acquisition documents include warranties, covenants and conditions regarding various tax matters that occurred prior to the acquisition, supported by indemnification and, in some cases, holdbacks or escrows from the sellers. The obligations of the\\n36\\nsellers are also generally subject to various limitations. In the event of a tax claim related to a pre-acquisition tax year, we would seek to recover costs and losses from the sellers under the acquisition agreement. However, there is no assurance that any indemnification, holdback or escrow would be sufficient or that we would recover such costs or losses, which could negatively impact our financial position, operating results and cash flows in the current and/or future periods.\\nWe record deferred income taxes to reflect the impact of temporary differences between the amounts of assets and liabilities for financial accounting and income tax purposes. Deferred income taxes are determined using enacted tax rates. Changes in enacted tax rates may negatively impact our operating results.\\nThe recently passed Tax Cuts and Jobs Act (the \\\"Tax Act\\\") act could adversely affect our business and financial condition.\\nOn December 22, 2017, President Trump signed into law new legislation that significantly revises the Internal Revenue Code of 1986, as amended, or the Code. The newly enacted Tax Act among other things, contains significant changes to corporate taxation, including by reducing the corporate tax rate from a top marginal rate of 35% to a flat rate of 21%, significantly limiting the tax deduction for net interest expense, limiting the deduction for post-2017 net operating losses to 80% of current year taxable income and eliminating carrybacks of such net operating losses, imposing a one-time transition tax on offshore earnings regardless of whether they are repatriated, migrating from a “worldwide” system of taxation in the direction of a territorial system (subject to certain important exceptions), allowing immediate expensing of certain new investments instead of depreciating such investments over time, modifying or repealing many business deductions and credits, and requiring the accrual of certain income for U.S. federal income tax purposes no later than when such income is taken into account as revenue on our financial statements (subject to an exception for certain income that is already subject to a special method of accounting under the Code). We continue to examine the impact the new legislation may have on our business. Notwithstanding the reduction in the corporate income tax rate, the overall impact of the new federal tax law is uncertain, and our business and financial condition could be adversely affected. In addition, it is uncertain if and to what extent various states will conform to the newly enacted federal tax law. The impact of this tax reform on holders of our common stock is also uncertain and could be adverse.\\nWe generate a portion of our revenue from our lodging card business, which is affected by conditions in the hotel industry generally and has a concentration of customers in the railroad and trucking industries.\\nOur lodging card business earns revenue from customers purchasing lodging from the hotel industry and derives a significant portion of this revenue from end users in the railroad and trucking industries. Therefore, we are exposed to risks affecting each of these industries. For example, unfavorable economic conditions adversely impacting the hotel, railroad and trucking industries generally could cause a decrease in demand for our products and services in our lodging card business, resulting in decreased revenue, or increased credit risk and related losses, resulting in increased expenses. In addition, mergers or consolidations in these industries could reduce our customer and partnership base, resulting in a smaller market for our products and services.\\nWe contract with government entities and are subject to risks related to our governmental contracts.\\nIn the course of our business we contract with domestic and foreign government entities, including state and local government customers, as well as federal government agencies. As a result, we are subject to various laws and regulations that apply to companies doing business with federal, state and local governments. The laws relating to government contracts differ from other commercial contracting laws and our government contracts may contain pricing terms and conditions that are not common among commercial contracts. In addition, we may be subject to investigation from time to time concerning our compliance with the laws and regulations relating to our government contracts. Our failure to comply with these laws and regulations may result in suspension of these contracts or administrative or other penalties.\\nLitigation and regulatory actions could subject us to significant fines, penalties or requirements resulting in significantly increased expenses, damage to our reputation and/or material adverse effects on our business.\\nWe are subject to claims and a number of judicial and administrative proceedings considered normal in the course of our current and past operations, including employment-related disputes, contract disputes, intellectual property disputes, government audits and regulatory proceedings, customer disputes and tort claims. Responding to proceedings may be difficult and expensive, and we may not prevail. In some proceedings, the claimant seeks damages as well as other relief, which, if granted, would require expenditures on our part or changes in how we conduct business. There can be no certainty that we will not ultimately incur charges in excess of presently established or future financial accruals or insurance coverage, or that we will prevail with respect to such proceedings. Regardless of whether we prevail or not, such proceedings could have a material adverse effect on our business, reputation, financial condition and results of operations. From time to time, we have had, and expect to continue to receive, inquiries from regulatory bodies and administrative agencies relating to the operation of our\\n37\\nbusiness. Such inquiries have resulted in, and may continue to result in, various audits, reviews and investigations, which can be time consuming and expensive. These types of inquiries, audits, reviews, and investigations could result in the institution of administrative or civil proceedings, sanctions and the payment of fines and penalties, changes in personnel, and increased review and scrutiny by customers, regulatory authorities, the media and others, which could have a material adverse effect on our business, reputation, financial condition and results of operations. For more information about our judicial and other proceedings, see “Business—Legal Proceedings.”\\nWe are named in a federal securities class action lawsuit and derivative complaint; if we are unable to resolve these matters favorably, then our business, operating results and financial condition may be adversely affected.\\nIn June 2017, a shareholder filed a class action complaint in the Unites States District Court for the Northern District of Georgia against the Company and certain of its officers and directors on behalf of all persons who purchased or otherwise acquired the Company’s stock between February 5, 2016 and May 2, 2017. In July 2017, a shareholder derivative complaint was filed against certain of the Company’s directors and officers in the United States District Court for the Northern District of Georgia seeking recovery on behalf of the Company. See “Part II-Item 3 - Legal Proceedings” below for additional information about the lawsuit and the derivative complaint. We cannot at this time predict the outcome of these matters or reasonably determine the probability of a material adverse result or reasonably estimate range of potential exposure, if any, that these matters might have on us, our business, our financial condition or our results of operations, although such effects could be materially adverse. In addition, in the future, we may need to record litigation reserves with respect to these matters. Further, regardless of how these matters proceed, it could divert our management’s attention and other resources away from our business.\\nOur revenues from MasterCard cards are dependent upon our continued MasterCard registration and financial institution sponsorship. If we fail to comply with the applicable requirements of MasterCard, it could seek to fine us, suspend us or terminate our registrations through our financial institution sponsors.\\nA significant source of our revenue comes from processing transactions through the MasterCard networks. In order to offer MasterCard programs to our customers, one of our subsidiaries is registered as a member service provider with MasterCard through sponsorship by MasterCard member banks in both the U.S. and Canada. Registration as a service provider is dependent upon our being sponsored by member banks. If our sponsor banks should stop providing sponsorship for us or determine to provide sponsorship on materially less favorable terms, we would need to find other financial institutions to provide those services or we would need to become a MasterCard member, either of which could prove to be difficult and expensive. Even if we pursue sponsorship by alternative member banks, similar requirements and dependencies would likely still exist. In addition, MasterCard routinely updates and modifies its requirements. Changes in the requirements may make it significantly more expensive for us to provide these services. If we do not comply with MasterCard requirements, it could seek to fine us, suspend us or terminate our registration, which allows us to process transactions on its networks. The termination of our registration, or any changes in the payment network rules that would impair our registration, could require us to stop providing MasterCard payment processing services. If we are unable to find a replacement financial institution to provide sponsorship or become a member, we may no longer be able to provide such services to the affected customers, which would have a material adverse effect our business, financial condition and results of operations.\\nChanges in MasterCard interchange fees could decrease our revenue.\\nA portion of our revenue is generated by network processing fees charged to merchants, known as interchange fees, associated with transactions processed using our MasterCard-branded cards. Interchange fee amounts associated with our MasterCard network cards are affected by a number of factors, including regulatory limits in the United States and Europe and fee changes imposed by MasterCard. In addition, interchange fees are the subject of intense legal and regulatory scrutiny and competitive pressures in the electronic payments industry, which could result in lower interchange fees generally in the future. Temporary or permanent decreases in the interchange fees associated with our MasterCard network card transactions, could adversely affect our business and operating results.\\nIf we are not able to maintain and enhance our brands, it could adversely affect our business, operating results and financial condition.\\nWe believe that maintaining and enhancing our brands is critical to our customer relationships, and our ability to obtain partners and retain employees. The successful promotion of our brands will depend upon our marketing and public relations efforts, our ability to continue to offer high-quality products and services and our ability to successfully differentiate our services from those of our competitors. In addition, future extension of our brands to add new products or services different from our current offerings may dilute our brands, particularly if we fail to maintain our quality standards in these new areas. The promotion of\\n38\\nour brands will require us to make substantial expenditures, and we anticipate that the expenditures will increase as our markets become more competitive and we expand into new markets. To the extent that these activities yield increased revenues, this revenue may not offset the expenses we incur. There can be no assurance that our brand promotion activities will be successful.\\nFailure to comply with the FCPA, anti-money laundering regulations, economic and trade sanctions regulations and similar laws and regulations associated with our international activities, could subject us to penalties and other adverse consequences.\\nAs we continue to expand our business internationally, we may continue to expand into certain foreign countries, particularly those with developing economies, where companies often engage in business practices that are prohibited by U.S., U.K. and other foreign regulations, including the FCPA, the U.K. Bribery Act, the 2013 Brazilian Clean Companies Act and the 2013 Russian Law on Preventing Corruption. These laws and regulations generally prohibit us, our employees, consultants and agents from bribing, being bribed or making other prohibited payments to government officials or other persons to obtain or retain business or gain some other business advantage. We have implemented policies to discourage such practices; however, there can be no assurances that all of our employees, consultants and agents, including those that may be based in or from countries where practices that violate U.S. laws may be customary, will not take actions in violation of our policies, for which we may be ultimately responsible. Violations of the FCPA or similar laws may result in severe criminal or civil sanctions and, in the U.S., suspension or debarment from U.S. government contracting, which could negatively affect our business, operating results and financial condition.\\nIn addition, we are subject to anti-money laundering laws and regulations, including the BSA. Among other things, the BSA requires money services businesses (such as money transmitters and providers of prepaid access) to develop and implement risk-based anti-money laundering programs, report large cash transactions and suspicious activity, and maintain transaction records.\\nWe are also subject to certain economic and trade sanctions programs that are administered by OFAC, which prohibit or restrict transactions to or from or dealings with specified countries, their governments, and in certain circumstances, their nationals, and with individuals and entities that are specially-designated nationals of those countries, narcotics traffickers, and terrorists or terrorist organizations. Other group entities may be subject to additional foreign or local sanctions requirements in other relevant jurisdictions.\\nSimilar anti-money laundering and counter-terrorist financing and proceeds of crime laws apply to movements of currency and payments through electronic transactions and to dealings with persons specified in lists maintained by the country equivalent to OFAC lists in several other countries and require specific data retention obligations to be observed by intermediaries in the payment process. Our businesses in those jurisdictions are subject to those data retention obligations.\\nViolations of these laws and regulations may result in severe criminal or civil sanctions and, in the U.S., suspension or debarment from U.S. government contracting, which could negatively affect our business, operating results and financial condition. Likewise, any investigation of any potential violations of these laws and regulations by U.S. or foreign authorities could also have an adverse impact on our reputation, business, financial condition and operating results. In addition, we cannot predict the nature, scope or effect of future regulatory requirements to which our international operations might be subject or the manner in which existing laws and regulations might be administered or interpreted.\\nGlobal economic downturns or slower growth or declines in the money transfer, payment service, and other markets in which we operate, including downturns or declines related to interruptions in migration patterns, and difficult conditions in global financial markets and financial market disruptions could adversely affect our business, financial condition, results of operations, and cash flows.\\nThe global economy has experienced in recent years, and may experience, downturns, volatility and disruption, and we face certain risks relating to such events, including:\\n| • | Our international payments provider business provides currency conversion and foreign exchange hedging services to our customers, exposing us to foreign currency exchange risk. In order to help mitigate these risks, we enter into derivative contracts. However, these contracts do not eliminate all of the risks related to fluctuating foreign currency rates. |\\n\\n| • | Our international payments provider business is heavily dependent on global trade. A downturn in global trade or the failure of long-term import growth rates to return to historic levels could have an adverse effect on our business, financial condition, results of operations, cash flows, and our cash management strategies. Additionally, as customer |\\n\\n39\\nhedging activity in our international payments provider business generally varies with currency volatility, we have experienced and may experience in the future lower foreign exchange revenues in periods of lower currency volatility.\\n| • | The counterparties to the derivative financial instruments that we use in our international payments provider business to reduce our exposure to various market risks, including changes in foreign exchange rates, may fail to honor their obligations, which could expose us to risks we had sought to mitigate. This includes the exposure generated when we write derivative contracts to our customers as part of our cross-currency payments business, and we typically hedge the net exposure through offsetting contracts with established financial institution counterparties. That failure could have an adverse effect on our financial condition, results of operations, and cash flows. |\\n\\nRisks associated with operations outside the U.S. and foreign currencies could adversely affect our business, financial condition, results of operations, and cash flows.\\nWe have additional foreign exchange risk and associated foreign exchange risk management requirements due to the nature of our international payments provider business. The majority of this business' revenue is from exchanges of currency at spot rates, which enable customers to make cross-currency payments. Additionally, this business also writes foreign currency forward and option contracts for our customers. The duration of these derivative contracts at inception is generally less than one year. The credit risk associated with our derivative contracts increases when foreign currency exchange rates move against our customers, possibly impacting their ability to honor their obligations to deliver currency to us or to maintain appropriate collateral with us.\\nOur international payments provider business aggregates its foreign exchange exposures arising from customer contracts, including the derivative contracts described above, and hedges the resulting net currency risks by entering into offsetting contracts with established financial institution counterparties. If we are unable to obtain offsetting positions, our business, financial condition, results of operations, and cash flows could be adversely affected.\\nWe face credit, liquidity and fraud risks from our agents, consumers, businesses, and third-party processors that could adversely affect our business, financial condition, results of operations, and cash flows.\\nWe are exposed to credit risk in our international payments provider business relating to: (a) derivatives written by us to our customers and (b) the extension of trade credit when transactions are paid to recipients prior to our receiving cleared funds from the sending customers. The credit risk associated with our derivative contracts increases when foreign currency exchange rates move against our customers, possibly impacting their ability to honor their obligations to deliver currency to us or\\nto maintain appropriate collateral with us. If a customer becomes insolvent, files for bankruptcy, commits fraud or otherwise fails to pay us, we may be exposed to the value of an offsetting position with a financial institution counterparty for the derivatives or may bear financial risk for those receivables where we have offered trade credit.\\nIf we are unable to maintain our relationships with banks needed to conduct our services, or fail to comply with our contract requirements, our business, financial condition, results of operations, and cash flows would be adversely affected.\\nIn our international payments provider business, we facilitate payment and foreign exchange solutions, primarily cross-border, cross-currency transactions, for small and medium size enterprises and other organizations. Increased regulation and compliance requirements are impacting these businesses by making it more costly for us to provide our services or by making it more cumbersome for businesses to do business with us. We may also have difficulty establishing or maintaining banking relationships needed to conduct our services due to banks’ policies. If we are unable to maintain our current business or banking relationships or establish new relationships under terms consistent with those currently in place, our ability to continue to offer our services may be adversely impacted, which could have an adverse effect on our business, financial condition, results of operations, and cash flows.\\nRisks related to ownership of our common stock\\nOur stock price could be volatile and our stock could decline in value.\\nThe market price of our common stock may fluctuate substantially as a result of many factors, some of which are beyond our control. Factors that could cause fluctuations in the market price of our common stock include the following:\\n\\n| • | quarterly variations in our results of operations; |\\n\\n| • | results of operations that vary from the expectations of securities analysts and investors; |\\n\\n| • | results of operations that vary from those of our competitors; |\\n\\n40\\n| • | changes in expectations as to our future financial performance, including financial estimates by securities analysts and investors; |\\n\\n| • | announcements by us or our competitors of significant contracts, acquisitions, or capital commitments; |\\n\\n| • | announcements by third parties of significant claims or proceedings against us; |\\n\\n| • | regulatory developments in the U.S. and abroad; |\\n\\n| • | future sales of our common stock, and additions or departures of key personnel; and |\\n\\n| • | general domestic and international economic, market and currency factors and conditions unrelated to our performance. |\\n\\nIn addition, the stock market in general has experienced significant price and volume fluctuations that have often been unrelated or disproportionate to operating performance of individual companies. These broad market factors may seriously harm the market price of our common stock, regardless of our operating performance. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted. A securities class action suit against us could result in significant liabilities and, regardless of the outcome, could result in substantial costs and the diversion of our management’s attention and resources.\\nOur disclosure controls and procedures may not prevent or detect all errors or acts of fraud.\\nWe are subject to the periodic reporting requirements of the Securities Exchange Act of 1934, as amended, or the Exchange Act. Our disclosure controls and procedures are designed to reasonably ensure that information required to be disclosed by us in reports we file or submit under the Exchange Act is accumulated and communicated to management and recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission (the \\\"SEC\\\"). We believe that any disclosure controls and procedures or internal controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are and will be met. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by an unauthorized override of the controls. Accordingly, because of the inherent limitations in our control system, misstatements due to error or fraud may occur and not be detected.\\nAnti-takeover provisions in our charter documents could discourage, delay or prevent a change in control of our company and may affect the trading price of our common stock.\\nOur corporate documents and the Delaware General Corporation Law contain provisions that may enable our board of directors to resist a change in control of FLEETCOR even if a change in control were to be considered favorable by you and other stockholders. These provisions:\\n| • | stagger the terms of our board of directors and require supermajority stockholder voting to remove directors; |\\n\\n| • | authorize our board of directors to issue preferred stock and to determine the rights and preferences of those shares, which may be senior to our common stock, without prior stockholder approval; |\\n\\n| • | establish advance notice requirements for nominating directors and proposing matters to be voted on by stockholders at stockholder meetings; |\\n\\n| • | prohibit our stockholders from calling a special meeting and prohibit stockholders from acting by written consent; and |\\n\\n| • | require super-majority stockholder voting to effect certain amendments to our certificate of incorporation and bylaws. |\\n\\nIn addition, Delaware law imposes some restrictions on mergers and other business combinations between any holder of 15% or more of our outstanding voting stock and us. These provisions could discourage, delay or prevent a transaction involving a change in control of FLEETCOR. These provisions could also discourage proxy contests and make it more difficult for you and other stockholders to elect directors of your choosing and cause us to take other corporate actions you desire.\\nWe do not expect to pay any dividends on our common stock for the foreseeable future.\\nWe currently expect to retain all future earnings, if any, for future operation, expansion and debt repayment and have no current plans to pay any cash dividends to holders of our common stock for the foreseeable future. Any decision to declare and pay\\n41\\ndividends in the future will be made at the discretion of our board of directors and will depend on, among other things, our operating results, financial condition, cash requirements, contractual restrictions and other factors that our board of directors may deem relevant. In addition, we must comply with the covenants in our credit agreements in order to be able to pay cash dividends, and our ability to pay dividends generally may be further limited by covenants of any existing and future outstanding indebtedness we or our subsidiaries incur.\\nITEM 1B. UNRESOLVED STAFF COMMENTS\\nWe have no unresolved written comments regarding our periodic or current reports from the staff of the SEC.\\n42\\nITEM 2. PROPERTIES\\nWe lease all of the real property used in our business, except as noted below. The following table lists each of our material facilities and its location, use and approximate square footage, at December 31, 2017.\\n| Facility | Use | Approximate size |\\n| United States | Square Feet |\\n| Norcross, Georgia | Corporate headquarters and operations | 98,000 |\\n| Covington, Louisiana | Corporate accounting and treasury | 24,000 |\\n| Houston, Texas | Credit and collections | 6,300 |\\n| Concord, California | Customer support | 7,100 |\\n| Wichita, Kansas | CLC operations and customer support | 38,000 |\\n| Salem, Oregon | Pacific Pride sales, operations and customer support | 10,000 |\\n| Brentwood, Tennessee | Comdata sales, operations and customer support | 135,000 |\\n| Nashville, Tennessee | Comdata operations | 38,300 |\\n| Louisville, Kentucky | SVS sales, operations and customer support | 66,000 |\\n| Lexington, Kentucky | CLS operations | 60,100 |\\n| Austin, Texas | Comdata operations | 4,300 |\\n| New York, New York | Cambridge U.S. headquarters | 5,900 |\\n| Bala Cynwyd, Pennsylvania | Cambridge global exchange division | 4,800 |\\n| International |\\n| Prague, Czech Republic | CCS headquarters and Shell Europe (Germany, Austria, Poland, Hungary, Switzerland, Czech Republic and Slovakia, France, Belgium, Netherlands and Luxembourg) operations, credit and collections, customer service, sales and finance | 38,400 |\\n| Mexico City, Mexico(1) | FLEETCOR Mexico headquarters and operations | 27,500 |\\n| Moscow, Russia | PPR and NKT headquarters, sales, customer support, operations, credit and collections | 16,300 |\\n| Bryansk, Russia | Sales and marketing | 19,900 |\\n| Ipswich, United Kingdom(1) | Operations, sales and customer support | 17,900 |\\n| Knaresborough, United Kingdom | Operations, sales and customer support | 5,100 |\\n| London, United Kingdom | Europe headquarters (including Cambridge Europe) | 7,540 |\\n| Swindon, United Kingdom | Allstar operations, sales and customer support | 18,300 |\\n| Walsall, United Kingdom | Operations, sales and customer support | 9,500 |\\n| Birmingham, United Kingdom | EPYX headquarters, sales, operations and customer support | 14,800 |\\n| Sao Paulo, Brazil | CTF and VB Servicios headquarters, sales, customer support and operations | 32,300 |\\n| Osasco, Brazil | CTF and VB Servicios operations, STP and SemParar Headquarters, sales, operations and customer support | 59,900 |\\n| Rio de Janeiro, Brazil | DB Trans and AExpresso headquarters, sales, operations and customer support | 15,300 |\\n| Auckland, New Zealand | CardLink headquarters, sales, operations and customer support | 7,200 |\\n| Nuremberg, Germany | Shell Europe sales | 6,900 |\\n| Almere, Netherlands | Travelcard headquarters, sales, customer support, operations, credit and collections | 5,600 |\\n| Rostov-on-Don, Russia | Gazprom headquarters and operations | 10,600 |\\n| Toronto, Canada | Cambridge global headquarters | 27,600 |\\n\\n| (1) | We own these facilities. |\\n\\nWe also own approximately 1.5 acres of land in Nashville, Tennessee, for employee parking. Additionally, we lease a number of minor additional facilities, including local sales and operations offices less than 3,250 square feet, small storage facilities and a small number of service stations in the United Kingdom; which are not included in the above list. We believe our facilities are adequate for our needs for at least the next 12 months. We anticipate that suitable additional or alternative facilities will be available to accommodate foreseeable expansion of our operations.\\n43\\nITEM 3. LEGAL PROCEEDINGS\\nIn the ordinary course of business, we are subject to various pending and potential legal actions, arbitration proceedings, claims, subpoenas, and matters relating to compliance with laws and regulations (collectively, legal proceedings). Based on our current knowledge, management presently does not believe that the liabilities arising from these legal proceedings will have a material adverse effect on our consolidated financial condition, results of operations or cash flows. However, it is possible that the ultimate resolution of these legal proceedings could have a material adverse effect on our results of operations and financial condition for any particular period.\\nShareholder Class Action and Derivative Lawsuits\\nOn June 14, 2017, a shareholder filed a class action complaint in the United States District Court for the Northern District of Georgia against the Company and certain of its officers and directors on behalf of all persons who purchased or otherwise acquired the Company’s stock between February 5, 2016 and May 2, 2017. On October 13, 2017, the shareholder filed an amended complaint asserting claims on behalf of a putative class of all persons who purchased or otherwise acquired the Company's common stock between February 4, 2016 and May 3, 2017. The complaint alleges that the defendants made false or misleading statements regarding fee charges and the reasons for its earnings and growth in certain press releases and other public statements in violation of the federal securities laws. Plaintiff seeks class certification, unspecified monetary damages, costs, and attorneys’ fees. The Company disputes the allegations in the complaint and intends to vigorously defend against the claims.\\nOn July 10, 2017, a shareholder derivative complaint was filed against the Company and certain of the Company’s directors and officers in the United States District Court for the Northern District of Georgia seeking recovery on behalf of the Company. The derivative complaint alleges that the defendants issued a false and misleading proxy statement in violation of the federal securities laws; that defendants breached their fiduciary duties by causing or permitting the Company to make allegedly false and misleading public statements concerning the Company’s fee charges, and financial and business prospects; and that certain defendants breached their fiduciary duties through allegedly improper sales of stock. The complaint seeks unspecified monetary damages on behalf of the Company, corporate governance reforms, disgorgement of profits, benefits and compensation by the defendants, restitution, costs, and attorneys’ and experts’ fees. On August 18, 2017, the court entered an order deferring the case pending a ruling on the defendants' motion to dismiss the putative shareholder class action, or until otherwise agreed to by the parties. The defendants dispute the allegations in the complaint and intend to vigorously defend against the claims.\\nEstimating an amount or range of possible losses resulting from litigation proceedings is inherently difficult and requires an extensive degree of judgment, particularly where the matters involve indeterminate claims for monetary damages, and are in the stages of the proceedings where key factual and legal issues have not been resolved. For these reasons, we are currently unable to predict the ultimate timing or outcome of, or reasonably estimate the possible losses or a range of possible losses resulting from the matters described above.\\nITEM 4. MINE SAFETY DISCLOSURES\\nNot applicable.\\n44\\nPART II\\nITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER\\nMATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES\\nOur common stock is traded on the New York Stock Exchange (NYSE) under the symbol “FLT.” As of December 31, 2017, there were 146 holders of record of our common stock. The table set forth below provides the intra-day high and low sales prices per share of our common stock for the four quarters during 2017 and 2016.\\n\\n| High | Low |\\n| 2017: |\\n| First Quarter | $ | 171.78 | $ | 142.62 |\\n| Second Quarter | 157.36 | 121.52 |\\n| Third Quarter | 157.40 | 138.43 |\\n| Fourth Quarter | 194.51 | 153.45 |\\n| 2016: |\\n| First Quarter | $ | 150.25 | $ | 107.56 |\\n| Second Quarter | 156.58 | 133.64 |\\n| Third Quarter | 174.84 | 137.26 |\\n| Fourth Quarter | 176.42 | 140.75 |\\n\\nDIVIDENDS AND SHARE REPURCHASES\\nWe currently expect to retain all future earnings, if any, for use in the operation and expansion of our business. We have never declared or paid any dividends on our common stock and do not anticipate paying cash dividends to holders of our common stock in the foreseeable future. In addition, our credit agreements restrict our ability to pay dividends. Any determination to pay dividends in the future will be at the discretion of our board of directors and will depend upon, among other factors, our results of operations, financial condition, capital requirements and covenants in our existing financing arrangements and any future financing arrangements.\\nOn February 4, 2016, our Board of Directors approved a stock repurchase program (the \\\"Program\\\") under which we may begin purchasing up to an aggregate of $500 million of the outstanding common stock over the following 18 month period. On July 27, 2017, the Company's Board of Directors authorized an increase in the size of the Program by an additional $250 million and an extension of the Program by an additional 18 months. On November 1, 2017, the Company announced that its Board of Directors had authorized an increase in the size of the Program by an additional $350 million, resulting in total aggregate repurchases authorized under the Program of $1.1 billion. Since the beginning of the Program, 4,114,104 shares for an aggregate purchase price of $590 million have been repurchased.\\nWe did not make any purchases of common stock during the three months ended December 31, 2017 as defined in Rule 10b-18(a)(3) under the Exchange Act.\\n45\\nPERFORMANCE GRAPH\\nThe following graph assumes $100 invested on December 31, 2012, at the closing price ($53.65) of our common stock on that day, and compares (a) the percentage change of our cumulative total stockholder return on the common stock (as measured by dividing (i) the difference between our share price at the end and the beginning of the period presented by (ii) the share price at the beginning of the periods presented) with (b) (i) the Russell 2000 Index and (ii) the S&P 500® Data Processing & Outsourced Services.\\n\\n| Period Ending | FLEETCORTechnologies, Inc. | Russell 2000 | S&P DataProcessing andOutsourcedServices |\\n| 12/31/2012 | $ | 100.00 | $ | 100.00 | $ | 100.00 |\\n| 3/31/2013 | $ | 142.91 | $ | 112.03 | $ | 112.20 |\\n| 6/30/2013 | $ | 151.54 | $ | 115.09 | $ | 118.85 |\\n| 9/30/2013 | $ | 205.33 | $ | 126.42 | $ | 130.25 |\\n| 12/31/2013 | $ | 218.40 | $ | 137.00 | $ | 151.76 |\\n| 3/31/2014 | $ | 214.54 | $ | 138.11 | $ | 144.46 |\\n| 6/30/2014 | $ | 245.67 | $ | 140.46 | $ | 144.86 |\\n| 9/30/2014 | $ | 264.90 | $ | 129.71 | $ | 146.72 |\\n| 12/31/2014 | $ | 277.19 | $ | 141.84 | $ | 170.19 |\\n| 3/31/2015 | $ | 281.30 | $ | 147.50 | $ | 173.97 |\\n| 6/30/2015 | $ | 290.89 | $ | 147.64 | $ | 175.73 |\\n| 9/30/2015 | $ | 256.51 | $ | 129.59 | $ | 172.99 |\\n| 12/31/2015 | $ | 266.41 | $ | 133.74 | $ | 188.13 |\\n| 3/30/2016 | $ | 277.26 | $ | 131.16 | $ | 188.59 |\\n| 6/30/2016 | $ | 266.78 | $ | 135.62 | $ | 185.00 |\\n| 9/30/2016 | $ | 323.82 | $ | 147.37 | $ | 199.67 |\\n| 12/31/2016 | $ | 263.78 | $ | 159.78 | $ | 199.15 |\\n| 3/31/2017 | $ | 282.26 | $ | 163.17 | $ | 216.67 |\\n| 6/30/2017 | $ | 268.80 | $ | 166.64 | $ | 232.21 |\\n| 9/30/2017 | $ | 288.48 | $ | 175.53 | $ | 259.13 |\\n| 12/31/2017 | $ | 358.68 | $ | 180.79 | $ | 280.89 |\\n\\n46\\nRECENT SALES OF UNREGISTERED SECURITIES AND USE OF PROCEEDS\\nNot Applicable.\\n47\\nITEM 6. SELECTED FINANCIAL DATA\\nWe derived the consolidated statement of income and other financial data for the years ended December 31, 2017, 2016 and 2015 and the selected consolidated balance sheet data as of December 31, 2017 and 2016 from the audited consolidated financial statements included elsewhere in this report. We derived the selected historical financial data for the years ended December 31, 2014 and 2013 and the selected consolidated balance sheets as of December 31, 2015, 2014 and 2013 from our audited consolidated financial statements that are not included in this report.\\nThe selected consolidated financial data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited consolidated financial statements and notes thereto included elsewhere in this report. Our historical results are not necessarily indicative of the results to be expected in any future period.\\n\\n| (in thousands, except per share data) | 2017 | 2016 | 2015 | 2014 | 2013 |\\n| Consolidated statement of income data: |\\n| Revenues, net | $ | 2,249,538 | $ | 1,831,546 | $ | 1,702,865 | $ | 1,199,390 | $ | 895,171 |\\n| Expenses: |\\n| Merchant commissions | 113,133 | 104,345 | 108,257 | 96,254 | 68,143 |\\n| Processing | 429,613 | 355,414 | 331,073 | 173,337 | 134,030 |\\n| Selling | 170,717 | 131,443 | 109,075 | 75,527 | 57,346 |\\n| General and administrative | 387,694 | 283,625 | 297,715 | 205,963 | 142,283 |\\n| Depreciation and amortization | 264,560 | 203,256 | 193,453 | 112,361 | 72,737 |\\n| Other operating, net | 61 | (690 | ) | (4,242 | ) | (29,501 | ) | — |\\n| Operating income | 883,760 | 754,153 | 667,534 | 565,449 | 420,632 |\\n| Investment loss | 53,164 | 36,356 | 57,668 | 8,586 | — |\\n| Other (income) expense, net | (173,436 | ) | 2,982 | 2,523 | (700 | ) | 602 |\\n| Interest expense, net | 107,146 | 71,896 | 71,339 | 28,856 | 16,461 |\\n| Loss on extinguishment of debt | 3,296 | — | — | 15,764 | — |\\n| Total other (income) expense | (9,830 | ) | 111,234 | 131,530 | 52,506 | 17,063 |\\n| Income before income taxes | 893,590 | 642,919 | 536,004 | 512,943 | 403,569 |\\n| Provision for income taxes | 153,390 | 190,534 | 173,573 | 144,236 | 119,068 |\\n| Net income | $ | 740,200 | $ | 452,385 | $ | 362,431 | $ | 368,707 | $ | 284,501 |\\n| Earnings per share: |\\n| Basic earnings per share | $ | 8.12 | $ | 4.89 | $ | 3.94 | $ | 4.37 | $ | 3.48 |\\n| Diluted earnings per share | $ | 7.91 | $ | 4.75 | $ | 3.85 | $ | 4.24 | $ | 3.36 |\\n| Weighted average shares outstanding: |\\n| Basic shares | 91,129 | 92,597 | 92,023 | 84,317 | 81,793 |\\n| Diluted shares | 93,594 | 95,213 | 94,139 | 86,982 | 84,655 |\\n| As of December 31, |\\n| (in thousands) | 2017 | 2016 | 2015 | 2014 | 2013 |\\n| Consolidated balance sheet data: |\\n| Cash and cash equivalents | $ | 913,595 | $ | 475,018 | $ | 447,152 | $ | 477,069 | $ | 338,105 |\\n| Restricted cash(1) | 217,275 | 168,752 | 167,492 | 135,144 | 48,244 |\\n| Total assets | 11,318,359 | 9,626,732 | 7,889,806 | 8,524,701 | 3,908,717 |\\n| Total debt | 4,518,616 | 3,858,233 | 2,935,000 | 3,593,717 | 1,486,378 |\\n| Total stockholders’ equity | 3,676,522 | 3,084,038 | 2,830,047 | 2,618,562 | 1,223,502 |\\n\\n(1) Restricted cash represents customer deposits repayable on demand, as well as collateral received from customers for cross-currency transactions.\\n48\\nITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND\\nRESULTS OF OPERATIONS\\nThe following discussion and analysis of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes appearing elsewhere in this report. In addition to historical information, this discussion contains forward-looking statements that involve risks, uncertainties and assumptions that could cause actual results to differ materially from management’s expectations. Factors that could cause such differences include, but are not limited to, those identified below and those described in Item 1A “Risk Factors” appearing elsewhere in this report. All foreign currency amounts that have been converted into U.S. dollars in this discussion are based on the exchange rate as reported by Oanda for the applicable periods.\\nGeneral Business\\nFLEETCOR is a leading global provider of commercial payment solutions. We help businesses of all sizes control, simplify and secure payment of various domestic and cross-border payables using specialized payment products. We serve businesses, merchants and partners in North America, Latin America, Europe, and Australasia. FLEETCOR’s predecessor company was organized in the United States in 1986, and FLEETCOR had its initial public offering in 2010 (NYSE: FLT).\\nFLEETCOR has two reportable segments, North America and International. We report these two segments as they align with our senior executive organizational structure, reflect how we organize and manage our employees around the world, manage operating performance, contemplate the differing regulatory environments in North America versus other geographies, and help us isolate the impact of foreign exchange fluctuations on our financial results.\\nOur payment solutions provide our customers with a payment method designed to be superior to and more robust and effective than what they use currently, whether they use a competitor’s product or another alternative method such as cash or check. Our solutions are comprised of payment products, networks and associated services.\\nOur payment products function like a charge card or prepaid card and tend to be specialized for specific spend categories, such as fuel or lodging, and/or specific customer groups, such as long haul transportation. FLEETCOR’s five primary product lines are Fuel, Lodging, Tolls, Corporate Payments and Gift. Additionally, we provide other payment products including fleet maintenance, employee benefits and long haul transportation-related services. Our products are used in 56 countries around the world, with our primary geographies being the U.S., Brazil and the United Kingdom, which combined accounted for approximately 90% of our revenue in 2017.\\nFLEETCOR uses both proprietary and third-party networks to deliver our payment solutions. FLEETCOR owns and operates proprietary networks with well-established brands throughout the world, bringing incremental sales and loyalty to affiliated merchants. Third-party networks are used to broaden payment product acceptance and use. In 2017, we processed approximately 3 billion transactions within these networks, of which approximately 1.4 billion were related to our Gift product line.\\nFLEETCOR capitalizes on its products’ specialization with sales and marketing efforts by deploying product-dedicated sales forces to target specific customer segments. We market our products directly through multiple sales channels, including field sales, telesales and digital marketing, and indirectly through our partners, which include major oil companies, leasing companies, petroleum marketers, value-added resellers (VARs) and referral partners.\\nWe believe that our size and scale, product breadth and specialization, geographic reach, proprietary networks, robust distribution capabilities and advanced technology contribute to our industry leading position.\\nExecutive Overview\\nWe operate in two segments, which we refer to as our North America and International segments. Our revenue is reported net of the wholesale cost for underlying products and services. In this report, we refer to this net revenue as “revenue\\\". See “Results of Operations” for additional segment information.\\nWe report our results from Cambridge (acquired in the third quarter of 2017) and CLS (acquired in the fourth quarter of 2017) in our North America segment. The results of operations from the fuel card business acquired in Russia are included within our International segment. As part of our plan to exit the telematics business, on July 27, 2017, we sold NexTraq, a U.S. fleet telematics business, which has historically been included in our North America segment.\\n49\\nRevenues, net, by Segment. For the years ended December 31, 2017, 2016 and 2015, our North America and International segments generated the following revenue:\\n| Year ended December 31, |\\n| 2017 | 2016 | 2015 |\\n| (in millions) | Revenues,net | % oftotalrevenues, net | Revenues,net | % oftotalrevenues, net | Revenues,net | % oftotalrevenues, net |\\n| North America | $ | 1,429 | 63.5 | % | $ | 1,279 | 69.8 | % | $ | 1,232 | 72.3 | % |\\n| International | 821 | 36.5 | % | 552 | 30.2 | % | 471 | 27.7 | % |\\n| $ | 2,250 | 100.0 | % | $ | 1,832 | 100.0 | % | $ | 1,703 | 100.0 | % |\\n\\nRevenues, net, Net Income and Net Income Per Diluted Share. Set forth below are revenues, net, net income and net income per diluted share for the years ended December 31, 2017, 2016 and 2015.\\n| Year ended December 31, |\\n| (in millions, except per share amounts) | 2017 | 2016 | 2015 |\\n| Revenues, net | $ | 2,250 | $ | 1,832 | $ | 1,703 |\\n| Net income | $ | 740 | $ | 452 | $ | 362 |\\n| Net income per diluted share | $ | 7.91 | $ | 4.75 | $ | 3.85 |\\n\\nAdjusted Revenues, Adjusted Net Income and Adjusted Net Income Per Diluted Share. Set forth below are adjusted revenues, adjusted net income and adjusted net income per diluted share for the years ended December 31, 2017, 2016 and 2015.\\n| Year Ended December 31, |\\n| 2017 | 2016 | 2015 |\\n| (in millions, except per share amounts) |\\n| Adjusted revenues | $ | 2,136 | $ | 1,727 | $ | 1,595 |\\n| Adjusted net income | $ | 799 | $ | 659 | $ | 593 |\\n| Adjusted net income per diluted share | $ | 8.54 | $ | 6.92 | $ | 6.30 |\\n\\nAdjusted revenues, adjusted net income and adjusted net income per diluted share are supplemental non-GAAP financial measures of operating performance. See the heading entitled “Management’s Use of Non-GAAP Financial Measures.” We use adjusted revenues as a basis to evaluate our revenues, net of the commissions that are paid to merchants that participate in certain of our card programs. The commissions paid to merchants can vary when market spreads fluctuate in much the same way as revenues are impacted when market spreads fluctuate. Thus, we believe this is a more effective way to evaluate our revenue performance on a consistent basis. We use adjusted net income and adjusted net income per diluted share to eliminate the effect of items that we do not consider indicative of our core operating performance on a consistent basis.\\nSources of Revenue\\nTransactions. In both of our segments, we derive revenue from transactions. A transaction is defined as a purchase by a customer utilizing one of our payment products at a participating merchant. The following diagram illustrates a typical transaction flow, which is representative of many, but not all, of our businesses.\\n50\\nIllustrative Transaction Flow\\nThe revenue we derive from transactions is generated from both customers and merchants. Customers may include directly- and indirectly-sold commercial businesses as well as partners for whom we manage payment programs. Merchants may include those merchants affiliated with our proprietary networks or those participating in the third-party networks we utilize.\\nFrom our customers and partners, we generate revenue through a variety of program fees, including transaction fees, card fees, network fees and charges. These fees may be charged as fixed amounts, costs plus a mark-up, or based on a percentage of the transaction purchase amounts. Our programs include other fees and charges associated with late payments and based on customer credit risk.\\nFrom our merchants and third-party networks, we generate revenue mostly from the difference between the amount charged to a customer and the amount paid to the merchant or network for a given transaction, as well as network fees and charges in certain businesses. The amount paid to a merchant or network may be calculated as (i) the merchant’s wholesale product cost plus a markup; (ii) the transaction purchase amount less a percentage discount; or (iii) the transaction purchase amount less a fixed fee per unit. The following table provides illustrations of these three merchant payment models, which are representative of many, but not all, of our businesses.\\nIllustrative Merchant Payment Models\\n| i) Cost Plus Mark-up: | ii) Percentage Discount: | iii) Fixed Fee: |\\n| Wholesale Cost | $ | 2.86 | Retail Price | $ | 3.00 | Retail Price | $ | 3.00 |\\n| Mark-up | 0.05 | Discount (3%) | (0.09 | ) | Fixed Fee | (0.09 | ) |\\n| Price Paid to Merchant | $ | 2.91 | Price Paid to Merchant | $ | 2.91 | Price Paid to Merchant | $ | 2.91 |\\n\\nFor a transaction involving the purchase of fuel where the amount paid to the merchant is calculated under the cost plus markup model, we refer to the difference between the amount charged to the customer and the amount paid to the merchant as merchant revenue tied to fuel-price spreads. In all other cases, we refer to the difference between the amount charged to the customer and the amount paid to the merchant for a given transaction as interchange revenue.\\nRevenue per transaction. Set forth below is revenue per transaction by segment information for the years ended December 31, 2017, 2016 and 2015. Revenue per transactions by segment is affected by the mix of products and acquisitions, which may result in revenue per transaction by product providing more meaningful data for analysis.\\n51\\n| Year ended December 31, |\\n| (Unaudited) | 2017 | 2016 | 2015 |\\n| Transactions (in millions) |\\n| North America | 1,842.4 | 1,714.6 | 1,667.5 |\\n| International | 1,114.5 | 507.8 | 183.9 |\\n| Total transactions | 2,956.9 | 2,222.4 | 1,851.4 |\\n| Revenue per transaction |\\n| North America | $ | 0.78 | $ | 0.75 | $ | 0.74 |\\n| International | $ | 0.74 | $ | 1.09 | $ | 2.56 |\\n| Consolidated revenue per transaction | $ | 0.76 | $ | 0.82 | $ | 0.92 |\\n| Consolidated adjusted revenue per transaction | $ | 0.72 | $ | 0.78 | $ | 0.86 |\\n\\nThe following table provides a breakdown of revenue per transaction by product for the years ended December 31, 2017 and 2016 (in millions, except per transaction data):\\n| As Reported | Pro Forma and Macro Adjusted2 |\\n| Year Ended December 31, | Year Ended December 31, |\\n| (Unaudited) | 2017 | 2016 | Change | % Change | 20173 | 20164 | Change | % Change |\\n| Fuel Cards6 |\\n| Transactions5 | 466 | 434 | 32 | 7 | % | 466 | 444 | 23 | 5 | % |\\n| Revenues, net per transaction | $ | 2.35 | $ | 2.30 | $ | 0.05 | 2 | % | $ | 2.29 | $ | 2.25 | $ | 0.04 | 2 | % |\\n| Revenues, net5 | $ | 1,096 | $ | 997 | $ | 99 | 10 | % | $ | 1,066 | $ | 998 | $ | 68 | 7 | % |\\n| Corporate Payments |\\n| Transactions | 42 | 39 | 3 | 7 | % | 42 | 39 | 3 | 6 | % |\\n| Revenues, net per transaction | $ | 6.30 | $ | 4.64 | $ | 1.66 | 36 | % | $ | 6.26 | $ | 5.80 | $ | 0.46 | 8 | % |\\n| Revenues, net | $ | 262 | $ | 180 | $ | 82 | 46 | % | $ | 260 | $ | 226 | $ | 34 | 15 | % |\\n| Tolls |\\n| Transactions | 916 | 327 | 589 | 180 | % | 916 | 894 | 22 | 2 | % |\\n| Revenues, net per transaction | $ | 0.36 | $ | 0.31 | $ | 0.04 | 13 | % | $ | 0.33 | $ | 0.29 | $ | 0.04 | 14 | % |\\n| Revenues, net | $ | 327 | $ | 103 | $ | 224 | 218 | % | $ | 302 | $ | 257 | $ | 45 | 18 | % |\\n| Lodging |\\n| Transactions | 17 | 13 | 4 | 30 | % | 17 | 14 | 3 | 22 | % |\\n| Revenues, net per transaction | $ | 7.45 | $ | 7.58 | $ | (0.13 | ) | (2 | )% | $ | 7.45 | $ | 7.68 | (0.23 | ) | (3 | )% |\\n| Revenues, net | $ | 127 | $ | 101 | $ | 26 | 26 | % | $ | 127 | 105 | $ | 22 | 21 | % |\\n| Gift |\\n| Transactions | 1,439 | 1,327 | 111 | 8 | % | 1,439 | 1,327 | 111 | 8 | % |\\n| Revenues, net per transaction | $ | 0.13 | $0.14 | $0.00 | (3 | )% | $ | 0.13 | $ | 0.14 | $ | (0.01 | ) | (7 | )% |\\n| Revenues, net | $ | 194 | $185 | $9 | 5 | % | $ | 194 | $ | 185 | $ | 9 | 5 | % |\\n| Other1 |\\n| Transactions5 | 77 | 82 | (5 | ) | (6 | )% | 77 | 82 | (4 | ) | (5 | )% |\\n| Revenues, net per transaction | $ | 3.15 | $ | 3.23 | $ | (0.08 | ) | (2 | )% | $ | 3.14 | $ | 2.99 | $ | 0.15 | 5 | % |\\n| Revenues, net5 | $ | 244 | $ | 266 | $ | (23 | ) | (8 | )% | $ | 243 | $ | 244 | $ | (1 | ) | — | % |\\n| FLEETCOR CONSOLIDATED REVENUES |\\n| ‑Transactions5 | 2,957 | 2,222 | 735 | 33 | % | 2,957 | 2,799 | 158 | 6 | % |\\n| ‑Revenues, net per transaction | $ | 0.76 | $ | 0.82 | $ | (0.06 | ) | (7 | )% | $ | 0.74 | $ | 0.73 | $ | 0.02 | 2 | % |\\n| ‑ Revenues, net | $ | 2,250 | $ | 1,832 | $ | 418 | 23 | % | $ | 2,193 | $ | 2,015 | $ | 178 | 9 | % |\\n\\n52\\n\\n| *Columns may not calculate due to rounding. |\\n| 1Other includes telematics, maintenance, food, and transportation related businesses. |\\n| 2 Pro forma and macro adjusted revenue is a non-GAAP financial measure defined as revenues, net adjusted for the impact of the macroeconomic environment and acquisitions and dispositions and other one-time items. We use pro forma and macro adjusted revenue as a basis to evaluate our organic growth. See the heading entitled “Management’s Use of Non-GAAP Financial Measures” for a reconciliation of pro forma and macro adjusted revenue by product, non-GAAP measures, to the GAAP equivalent. |\\n| 32017 is adjusted to remove the impact of changes in the macroeconomic environment to be consistent with the same period of prior year, using constant fuel prices, fuel price spreads and foreign exchange rates. |\\n| 42016 is pro forma to include acquisitions and exclude dispositions consistent with 2017 ownership. |\\n| 52016 revenue and transactions reflect immaterial corrections from previously disclosed amounts for the prior period. |\\n| 6Fuel Cards product category further refined to Fuel, to reflect different ways that fuel is paid for by our customers. |\\n\\nRevenue per transaction is derived from the various revenue types as discussed above and can vary based on geography, the relevant merchant relationship, the payment product utilized and the types of products or services purchased, the mix of which would be influenced by our acquisitions, organic growth in our business, and the overall macroeconomic environment, including fluctuations in foreign currency exchange rates, fuel prices and spreads. Revenue per transaction per customer changes as the level of services we provide to a customer increases or decreases, as macroeconomic factors change and as adjustments are made to merchant and customer rates. See “Results of Operations” for further discussion of transaction volumes and revenue per transaction.\\nSources of Expense\\nWe incur expenses in the following categories:\\n\\n| • | Merchant commissions—In certain of our card programs, we incur merchant commissions expense when we reimburse merchants with whom we have direct, contractual relationships for specific transactions where a customer purchases products or services from the merchant. In the card programs where it is paid, merchant commissions equal the difference between the price paid by us to the merchant and the merchant’s wholesale cost of the underlying products or services. |\\n\\n| • | Processing—Our processing expense consists of expenses related to processing transactions, servicing our customers and merchants, bad debt expense and cost of goods sold related to our hardware sales in certain businesses. |\\n\\n| • | Selling—Our selling expenses consist primarily of wages, benefits, sales commissions (other than merchant commissions) and related expenses for our sales, marketing and account management personnel and activities. |\\n\\n| • | General and administrative—Our general and administrative expenses include compensation and related expenses (including stock-based compensation) for our executive, finance and accounting, information technology, human resources, legal and other administrative personnel. Also included are facilities expenses, third-party professional services fees, travel and entertainment expenses, and other corporate-level expenses. |\\n\\n| • | Depreciation and amortization—Our depreciation expenses include depreciation of property and equipment, consisting of computer hardware and software (including proprietary software development amortization expense), card-reading equipment, furniture, fixtures, vehicles and buildings and leasehold improvements related to office space. Our amortization expenses include amortization of intangible assets related to customer and vendor relationships, trade names and trademarks and non-compete agreements. We also amortize intangible assets related to business acquisitions and certain private label contracts associated with the purchase of accounts receivable. |\\n\\n| • | Other operating, net—Our other operating, net includes other operating expenses and income items unusual to the period and presented separately. |\\n\\n| • | Investment loss (income)—Our investment results relate to our minority interest in Masternaut, a provider of telematics solutions to commercial fleets in Europe, which we historically accounted for using the equity method. On September 30, 2017, we entered into an amended Masternaut investment agreement that resulted in the loss of significant influence, and we began accounting for the Masternaut investment by applying the cost method. |\\n\\n| • | Other (income) expense, net—Our other (income) expense, net includes proceeds/costs from the sale of assets, foreign currency transaction gains or losses, and other miscellaneous operating costs and revenue. |\\n\\n53\\n| • | Interest expense, net—Our interest expense, net includes interest income on our cash balances and interest expense on our outstanding debt and on our Securitization Facility. We have historically invested our cash primarily in short-term money market funds. |\\n\\n| • | Loss on extinguishment of debt—Loss on extinguishment of debt relates to our write-off of debt issuance costs associated with the refinancing of our existing Credit Facility. |\\n\\n| • | Provision for income taxes—The provision for income taxes consists primarily of corporate income taxes related to profits resulting from the sale of our products and services. Our worldwide effective tax rate is lower than the U.S. statutory rate of 35%, due primarily to the Tax Cuts and Job Act (\\\"Tax Act\\\") and lower rates in foreign jurisdictions and foreign-sourced non-taxable income. |\\n\\nFactors and Trends Impacting our Business\\nWe believe that the following factors and trends are important in understanding our financial performance:\\n\\n| • | Global economic conditions—Our results of operations are materially affected by conditions in the economy generally, both in North America and internationally. Factors affected by the economy include our transaction volumes and the credit risk of our customers. These factors affected our businesses in both our North America and International segments. |\\n\\n| • | Foreign currency changes—Our results of operations are significantly impacted by changes in foreign currency rates; namely, by movements of the Australian dollar, Brazilian real, British pound, Canadian dollar, Czech koruna, Euro, Mexican peso, New Zealand dollar and Russian ruble, relative to the U.S. dollar. Approximately 62%, 70% and 72% of our revenue in 2017, 2016 and 2015, respectively, was derived in U.S. dollars and was not affected by foreign currency exchange rates. See “Results of Operations” for information related to foreign currency impact on our total revenue, net. |\\n\\n| • | Fuel prices—Our fleet customers use our products and services primarily in connection with the purchase of fuel. Accordingly, our revenue is affected by fuel prices, which are subject to significant volatility. A change in retail fuel prices could cause a decrease or increase in our revenue from several sources, including fees paid to us based on a percentage of each customer’s total purchase. Changes in the absolute price of fuel may also impact unpaid account balances and the finance fees and charges based on these amounts. See “Sources of Revenue” above for further information related to the absolute price of fuel. |\\n\\n| • | Fuel-price spread volatility—A portion of our revenue involves transactions where we derive revenue from fuel-price spreads, which is the difference between the price charged to a fleet customer for a transaction and the price paid to the merchant for the same transaction. In these transactions, the price paid to the merchant is based on the wholesale cost of fuel. The merchant’s wholesale cost of fuel is dependent on several factors including, among others, the factors described above affecting fuel prices. The fuel price that we charge to our customer is dependent on several factors including, among others, the fuel price paid to the merchant, posted retail fuel prices and competitive fuel prices. We experience fuel-price spread contraction when the merchant’s wholesale cost of fuel increases at a faster rate than the fuel price we charge to our customers, or the fuel price we charge to our customers decreases at a faster rate than the merchant’s wholesale cost of fuel. See “Sources of Revenue” above for further information related to fuel-price spreads. |\\n\\n| • | Acquisitions—Since 2002, we have completed over 75 acquisitions of companies and commercial account portfolios. Acquisitions have been an important part of our growth strategy, and it is our intention to continue to seek opportunities to increase our customer base and diversify our service offering through further strategic acquisitions. The impact of acquisitions has, and may continue to have, a significant impact on our results of operations and may make it difficult to compare our results between periods. |\\n\\n| • | Interest rates—Our results of operations are affected by interest rates. We are exposed to market risk changes in interest rates on our cash investments and debt. |\\n\\n| • | Expenses— Over the long term, we expect that our general and administrative expense will decrease as a percentage of revenue as our revenue increases. To support our expected revenue growth, we plan to continue to incur additional sales and marketing expense by investing in our direct marketing, third-party agents, internet marketing, telemarketing and field sales force. |\\n\\n54\\nAcquisitions and Investments\\nDuring 2017, the Company completed acquisitions with an aggregate purchase price of $720.8 million, net of cash acquired of $96.2 million. During 2017, the Company made investments in other businesses of $39 million.\\n| • | On August 9, 2017, we acquired Cambridge, a leading business to business (B2B) international payments provider, for approximately $616.1 million in cash, net of cash acquired of $94.5 million and inclusive of a note payable of $23.8 million. Cambridge processes B2B cross-border payments, assisting business clients in making international payments. The purpose of this acquisition is to further expand our corporate payments footprint. |\\n\\n| • | On September 26, 2017, we acquired a fuel card provider in Russia. |\\n\\n| • | On October 13, 2017, we completed the acquisition of CLS, a small lodging tuck-in business, in the United States. |\\n\\nDuring 2016, we completed acquisitions with an aggregate purchase price of $1.3 billion, net of cash acquired of $51.3 million, which includes deferred payments made during the period related to prior acquisitions of $6.1 million.\\n| • | In August 2016, we acquired all of the outstanding stock of Serviços e Tecnologia de Pagamentos S.A. (“STP”) for $1.23 billion, net of cash acquired of $40.2 million. STP is an electronic toll payments company in Brazil and provides cardless fuel payments at a number of Shell sites throughout Brazil. The purpose of this acquisition was to expand our presence in the toll market in Brazil. |\\n\\n| • | During 2016, we acquired additional fuel card portfolios in the U.S. and the United Kingdom, additional Shell fuel card markets in Europe and Travelcard in the Netherlands totaling $76.7 million, net of cash acquired of $11.1 million. |\\n\\n| • | During 2016, we made additional investments of $7.9 million related to our investment at Masternaut. We also received a $9.2 million return of our investment in Masternaut in 2016. |\\n\\nDuring 2015, we completed acquisitions of Shell portfolios related to our fuel card businesses in Europe, as well as a small acquisition internationally, with an aggregate purchase price of $46.3 million, each included within our International segment from the date of acquisition, and made additional investments of $8.4 million related to our equity method investment at Masternaut and deferred payments of $3.4 million related to acquisitions occurring in prior years.\\nWe report our results from Cambridge and CLS acquired in the third and fourth quarters of 2017, respectively, in our North America segment, from the date of acquisition. The results of operations from the fuel card business in Russia acquired in the third quarter of 2017, are included within our International segment from the date of acquisition. The results of operations from the fuel card portfolio acquired in the U.S. are included within our North America segment, from the date of acquisition. The results of operations of STP, the fuel card portfolio in the United Kingdom, the additional Shell markets, the Travelcard business in the Netherlands and the small business in Brazil are included within our International segment, from the date of acquisition.\\nAsset Dispositions\\nTelematics Businesses\\nAs part of our plan to exit the telematics business, on July 27, 2017, we sold NexTraq, a U.S. fleet telematics business, to Michelin Group for $316.5 million. We recorded a pre-tax gain on the disposal of NexTraq of $175.0 million during the third quarter of 2017, which is net of transaction closing costs. We recorded tax on the gain of disposal of $65.8 million. The gain on the disposal is included in other (income) expense, net in the accompanying Consolidated Statements of Income. NexTraq had historically been included in our North America segment.\\nOn September 30, 2017, we entered into an amended Masternaut investment agreement that resulted in the loss of significant influence, and we began accounting for the Masternaut investment by applying the cost method.\\nWe regularly evaluate the carrying value of our Masternaut investment and during the third quarter of 2017, we determined that the fair value of our 44% investment in Masternaut had declined as a result of our loss of significant influence and the operating results of Masternaut. As a result, we determined that the carrying value of our investment exceeded its fair value, and concluded that this decline in value was other than temporary. We recorded a $44.6 million impairment loss in the Masternaut investment that includes adjustment for $31.4 million of currency translation losses previously recognized in accumulated other comprehensive income, in the accompanying Consolidated Statements of Income.\\n55\\nResults of Operations\\nYear ended December 31, 2017 compared to the year ended December 31, 2016\\nThe following table sets forth selected consolidated statement of income and selected operational data for the years ended December 31, 2017 and 2016 (in millions, except percentages)*.\\n| Year endedDecember 31,2017 | % of totalrevenue | Year endedDecember 31,2016 | % of totalrevenue | Increase(decrease) | % Change |\\n| Revenues, net: |\\n| North America | $ | 1,428.7 | 63.5 | % | $ | 1,279.1 | 69.8 | % | $ | 149.6 | 11.7 | % |\\n| International | 820.8 | 36.5 | % | 552.4 | 30.2 | % | 268.4 | 48.6 | % |\\n| Total revenues, net | 2,249.5 | 100.0 | % | 1,831.5 | 100.0 | % | 418.0 | 22.8 | % |\\n| Consolidated operating expenses: |\\n| Merchant commissions | 113.1 | 5.0 | % | 104.3 | 5.7 | % | 8.8 | 8.4 | % |\\n| Processing | 429.6 | 19.1 | % | 355.4 | 19.4 | % | 74.2 | 20.9 | % |\\n| Selling | 170.7 | 7.6 | % | 131.4 | 7.2 | % | 39.3 | 29.9 | % |\\n| General and administrative | 387.7 | 17.2 | % | 283.6 | 15.5 | % | 104.1 | 36.7 | % |\\n| Depreciation and amortization | 264.6 | 11.8 | % | 203.3 | 11.1 | % | 61.3 | 30.2 | % |\\n| Other operating, net | 0.1 | — | % | (0.7 | ) | — | % | (0.8 | ) | (108.8 | )% |\\n| Operating income | 883.8 | 39.3 | % | 754.2 | 41.2 | % | 129.6 | 17.2 | % |\\n| Investment loss | 53.2 | 2.4 | % | 36.4 | 2.0 | % | 16.8 | 46.2 | % |\\n| Other (income) expense, net | (173.4 | ) | (7.7 | )% | 3.0 | 0.2 | % | (176.4 | ) | NM |\\n| Interest expense, net | 107.1 | 4.8 | % | 71.9 | 3.9 | % | 35.3 | 49.0 | % |\\n| Loss on extinguishment of debt | 3.3 | 0.1 | % | — | — | % | 3.3 | — | % |\\n| Provision for income taxes | 153.4 | 6.8 | % | 190.5 | 10.4 | % | (37.1 | ) | (19.5 | )% |\\n| Net income | $ | 740.2 | 32.9 | % | $ | 452.4 | 24.7 | % | $ | 287.8 | 63.6 | % |\\n| Operating income for segments: |\\n| North America | $ | 541.6 | $ | 506.4 | $ | 35.2 | 6.9 | % |\\n| International | 342.2 | 247.7 | 94.4 | 38.1 | % |\\n| Operating income | $ | 883.8 | $ | 754.2 | $ | 129.6 | 17.2 | % |\\n| Operating margin for segments: |\\n| North America | 37.9 | % | 39.6 | % | (1.7 | )% |\\n| International | 41.7 | % | 44.8 | % | (3.2 | )% |\\n| Total | 39.3 | % | 41.2 | % | (1.9 | )% |\\n\\nNM = Not Meaningful\\n*Columns may not calculate due to rounding.\\nRevenues\\nOur consolidated revenue increased from $1,831.5 million in 2016 to $2,249.5 million in 2017, an increase of $418.0 million, or 22.8%. The increase in our consolidated revenue was primarily due to:\\n\\n| • | The impact of acquisitions completed in 2016 and 2017, which contributed approximately $212 million in additional revenue. |\\n\\n| • | Organic growth of approximately 9% on a constant fuel price, fuel spread margin, foreign currency and pro forma basis, driven by increases in both volume and revenue per transaction in certain of our payment programs. |\\n\\n| • | Although we cannot precisely measure the impact of the macroeconomic environment, in total we believe it had a favorable impact on our consolidated revenue for 2017 over 2016 of approximately $33 million. We believe the favorable impact of higher fuel prices and fuel spread margins, primarily in the U.S., had a favorable impact on consolidated revenues in 2017 over in 2016 of approximately $30 million. Additionally, changes in foreign exchange |\\n\\n56\\nrates had a favorable impact on consolidated revenues in 2017 over in 2016 of approximately $3 million, primarily due to favorable changes in foreign exchange rates in Brazil.\\nThese increases were partially offset by the impact of the disposition of the NexTraq telematics business in July 2017 of $23 million.\\nNorth America segment revenues. North America revenues increased from $1,279.1 million in 2016 to $1,428.7 million in 2017, an increase of $149.6 million, or 11.7%. The increase in our North America segment revenue was primarily due to:\\n| • | The impact of our Cambridge and CLS acquisitions during the third and fourth quarters of 2017, respectively, which contributed approximately $51 million in additional revenue. |\\n\\n| • | Organic growth of approximately 8%, on a constant fuel price, fuel spread margin and pro forma basis, driven by increases in both volume and revenue per transaction in certain of our payment programs. |\\n\\n| • | Although we cannot precisely measure the impact of the macroeconomic environment, in total we believe it had a positive impact on our North America segment revenue in 2017 over in 2016 of approximately $26 million, primarily due to the favorable impact of changes in fuel prices and slightly higher fuel spread margins. |\\n\\nThese increases were partially offset by the impact of the disposition of the NexTraq business in July 2017 of $23 million.\\nInternational segment revenue. International segment revenues increased from $552.4 million in 2016 to $820.8 million in 2017, an increase of $268.4 million, or 48.6%. The increase in our International segment revenue was primarily due to:\\n\\n| • | The impact of acquisitions during 2016 and 2017, which contributed approximately $161 million in additional revenue. |\\n\\n| • | Organic growth of approximately 11% on a constant macroeconomic and pro forma basis, driven by increases in both volume and revenue per transaction in certain of our payment programs. |\\n\\n| • | Although we cannot precisely measure the impact of the macroeconomic environment, in total we believe it had a positive impact on our International segment revenue for 2017 over 2016 of approximately $7 million, primarily due to favorable changes in foreign exchange rates in Brazil, as well as favorable impact of changes in fuel prices. |\\n\\nRevenues by geography, product and source. Set forth below are further breakdowns of revenue by geography, product and source for the years ended December 31, 2017 and 2016 (in millions), which we believe is useful in understanding the results of our business.\\n| Year Ended December 31, |\\n| (Unaudited) | 2017 | 2016 |\\n| Revenue by Geography* | Revenues,net | % oftotalrevenues, net | Revenues,net | % oftotalrevenues, net |\\n| United States | $ | 1,401 | 62 | % | $ | 1,279 | 70 | % |\\n| United Kingdom | 237 | 11 | 229 | 13 |\\n| Brazil | 395 | 18 | 168 | 9 |\\n| Other | 218 | 10 | 156 | 8 |\\n| Consolidated revenues, net | $ | 2,250 | 100 | % | $ | 1,832 | 100 | % |\\n\\n*Columns may not calculate due to rounding.\\n57\\n| Year Ended December 31, |\\n| (Unaudited) | 2017 | 2016 |\\n| Revenue by Product Category* | Revenues,net | % of total revenues, net | Revenues,net | % of totalrevenues, net |\\n| Fuel cards1 | $ | 1,096 | 49 | % | $ | 997 | 54 | % |\\n| Corporate payments | 262 | 12 | 180 | 10 |\\n| Tolls | 327 | 15 | 103 | 6 |\\n| Lodging | 127 | 6 | 101 | 5 |\\n| Gift | 194 | 9 | 185 | 10 |\\n| Other1 | 244 | 11 | 266 | 15 |\\n| Consolidated revenues, net | $ | 2,250 | 100.0 | % | $ | 1,832 | 100 | % |\\n\\n*Columns may not calculate due to rounding.\\n1 Amounts shown for 2016 reflect corrections in estimated allocation of revenue by source from previously disclosed amounts.\\n| Year Ended December 31,8 |\\n| (Unaudited) | 2017 | 2016 |\\n| Major Sources of Revenue* | Revenues,net | % of totalrevenues, net | Revenues,net | % of totalrevenues, net |\\n| Customer |\\n| Processing and program revenue1 | $ | 1,093 | 49 | % | $ | 809 | 44 | % |\\n| Late fees and finance charges2 | 141 | 6 | 118 | 6 |\\n| Miscellaneous fees3 | 129 | 6 | 129 | 7 |\\n| 1,363 | 61 | 1,057 | 58 |\\n| Merchant |\\n| Discount revenue (Fuel)4 | 303 | 13 | 260 | 14 |\\n| Discount revenue (Nonfuel)5 | 175 | 8 | 157 | 9 |\\n| Tied to fuel-price spreads6 | 220 | 10 | 194 | 11 |\\n| Program revenue7 | 189 | 8 | 164 | 9 |\\n| Consolidated revenues, net | $ | 2,250 | 100 | % | $ | 1,832 | 100 | % |\\n\\n1Includes revenue from customers based on accounts, cards, devices, transactions, load amounts, and/or purchase mounts, etc. for participation in our various fleet and workforce related programs; as well as, revenue from partners (e.g., major retailers, leasing companies, oil companies, petroleum marketers, etc.) for processing and network management services. Primarily represents revenue from North American trucking, lodging, prepaid benefits, telematics, gift cards and toll related businesses.\\n2Fees for late payment and interest charges for carrying a balanced charged to a customer.\\n3Non-standard fees charged to customers based on customer behavior or optional participation, primarily including high credit risk surcharges, over credit limit charges, minimum processing fees, printing and mailing fees, environmental fees, etc.\\n4Interchange revenue directly influenced by the absolute price of fuel and other interchange related to fuel products.\\n5Interchange revenue related to nonfuel products.\\n6Revenue derived from the difference between the price charged to a fleet customer for a transaction and the price paid to the merchant for the same transaction.\\n7Revenue derived primarily from the sales of equipment, software and related maintenance to merchants.\\n8 Amounts shown for the years ended December 31, 2017 and 2016 reflect corrections in estimated allocation of revenue by source from previously disclosed amounts.\\n* We may not be able to precisely calculate revenue by source, as certain estimates were made in these allocations. Columns may not calculate due to rounding. This table reflects how management views the sources of revenue and may not be consistent with prior disclosure.\\n58\\nConsolidated operating expenses\\nMerchant commission. Merchant commissions increased from $104.3 million in 2016 to $113.1 million in 2017, an increase of $8.8 million or 8.4%. This increase was primarily due to the fluctuation of the margin between the wholesale cost and retail price of fuel and the impact of higher volume in certain revenue streams where merchant commissions are paid.\\nProcessing. Processing expenses increased from $355.4 million in 2016 to $429.6 million in 2017, an increase of $74.2 million or 20.9%. Increases in processing expenses were primarily due to expenses related to acquisitions completed in 2016 and 2017 of approximately $62 million, as well as the impact of changes in foreign exchange rates, partially offset by the impact of negotiated lower vendor processing costs. The increase in bad debt was primarily due to bad debt inherent in the acquired STP business. These increases were partially offset by the impact of disposition of the NexTraq business of approximately $6 million.\\nSelling. Selling expenses increased from $131.4 million in 2016 to $170.7 million in 2017, an increase of $39.3 million or 29.9%. Increases in spending were primarily due to ongoing expenses related to acquisitions completed in 2016 and 2017 of approximately $26 million and additional spending in certain lines of business. These increases were partially offset by the impact of disposition of the NexTraq business of approximately $2 million.\\nGeneral and administrative. General and administrative expense increased from $283.6 million in 2016 to $387.7 million in 2017, an increase of $104.1 million or 36.7%. The increase was primarily due to ongoing expenses related to acquisitions completed in 2016 and 2017 of approximately $42 million, increased stock based compensation expense of approximately $30 million and increases in other professional and legal fees totaling approximately $22 million. These increases were partially offset by the impact of disposition of the NexTraq business of approximately $2 million.\\nDepreciation and amortization. Depreciation and amortization increased from $203.3 million in 2016 to $264.6 million in 2017, an increase of $61.3 million or 30.2%. The increase was primarily due to amortization of intangible assets related to acquisitions completed in 2016 and 2017 of approximately $47 million and increased capital spending. These increases were partially offset by the impact of disposition of the NexTraq business of approximately $4 million.\\nInvestment loss. Investment losses increased from $36.4 million in 2016 to $53.2 million in 2017. We regularly evaluate the carrying value of our Masternaut investment and during the third quarter of 2017, we determined that the fair value of our 44% investment in Masternaut had declined as a result of our loss of significant influence due to the amendment of the Masternaut investment agreement, executed September 30, 2017, and the operating results of Masternaut. As a result, we determined that the carrying value of our investment exceeded its fair value, and concluded that this decline in value was other than temporary. We recorded a $44.6 million impairment loss in the Masternaut investment that includes adjustment for $31.4 million of currency translation losses previously recognized in accumulated other comprehensive income.\\nOther (income) expense, net. Other income, net was $173.4 million in 2017, compared to other expense, net of $3.0 million in 2016. The increase was due primarily to the pre-tax gain on the sale of our NexTraq business of $175 million in 2017.\\nInterest expense, net. Interest expense increased from $71.9 million in 2016 to $107.1 million in 2017, an increase of $35.3 million or 49.0%. The increase in interest expense is primarily due to the impact of additional borrowings to finance the acquisitions in 2016 and 2017, share buybacks and increases in LIBOR. The following table sets forth the average interest rates paid on borrowings under our Credit Facility, excluding the related unused credit facility fees.\\n| (Unaudited) | 2017 | 2016 |\\n| Term loan A | 2.79 | % | 2.05 | % |\\n| Term loan B | 3.28 | % | 3.75 | % |\\n| Domestic Revolver A | 2.88 | % | 2.07 | % |\\n| Foreign Revolver B | 2.05 | % | 1.84 | % |\\n| Foreign Revolver B swing line | 2.01 | % | 1.84 | % |\\n\\nThe average unused credit facility fee for Domestic Revolver A was 0.35% and 0.31% in 2017 and 2016, respectively.\\n59\\nLoss on extinguishment of debt. Loss on extinguishment of debt of $3.3 million relates to our write-off of debt issuance costs associated with the refinancing of our existing credit facility during the third quarter of 2017.\\nProvision for income taxes. The provision for income taxes decreased from $190.5 million in 2016 to $153.4 million in 2017, a decrease of $37.1 million or 19.5%, primarily driven by the impact of the enactment of the Tax Act, partially offset by the increase in pretax book income for 2017 as compared to 2016. On December 22, 2017, the U.S. government enacted tax legislation referred to as the Tax Act. The Tax Act makes broad and complex changes to the U.S. tax code, including, but not limited to reducing the U.S. federal corporate tax rate from 35% to 21% and requiring companies to pay a one-time transition tax on certain unrepatriated earnings of foreign subsidiaries. The transition tax can be paid over eight years.\\nAlso, the SEC staff issued Staff Accounting Bulletin (\\\"SAB\\\") 118, which provides guidance on accounting for the tax effects of the Tax Act. In accordance with SAB 118, we have a one-year measurement period in which to complete our accounting for the Tax Act.\\nWe have made an estimate of the effects on our existing deferred tax balances and the one-time transition tax, which resulted in a provisional net tax benefit of $128.2 million, which is included as a component of income tax expense from continuing operations. We remeasured certain deferred tax assets and liabilities after considering the U.S. federal income tax rate reduction to 21%. The one-time transition tax is based on our total post-1986 earnings and profits that we previously deferred from U.S. income taxes. In 2017, we recorded a provisional amount for the one-time transition tax expense of $81.8 million, net of foreign tax credits.\\nNet income. For the reasons discussed above, our net income increased from $452.4 million in 2016 to $740.2 million in 2017, an increase of $287.8 million or 63.6%, primarily due to the impact of the enactment of the Tax Act on earnings of approximately $127.5 million and the gain on the disposition of NexTraq of $109.2 million, partially offset by incremental amortization expense, stock based compensation expense, impairment of our investment in Masternaut and legal fees during 2017.\\nOperating income and operating margin\\nConsolidated operating income. Operating income increased from $754.2 million in 2016 to $883.8 million in 2017, an increase of $129.6 million or 17.2%. Consolidated operating margin was 41.2% in 2016 and 39.3% in 2017. The increase in operating income was primarily due to acquisitions completed in 2016 and 2017, organic growth, as well as the positive impact of the macroeconomic environment of approximately $25 million, as previously discussed. These increases were partially offset by higher operating expenses related to acquisitions completed in 2016 and 2017 of approximately $178 million, additional stock based compensation of approximately $30 million, higher professional and legal fees totaling approximately $22 million and the disposition of the NexTraq business in July 2017 of approximately $8 million. The decrease in operating margin is driven by the items discussed above.\\nFor the purpose of segment operating results, we calculate segment operating income by subtracting segment operating expenses from segment revenue. Segment operating margin is calculated by dividing segment operating income by segment revenue.\\nNorth America segment operating income. North America operating income increased from $506.4 million in 2016 to $541.6 million in 2017, an increase of $35.2 million, or 6.9%. North America operating margin was 39.6% in 2016 and 37.9% in 2017. The increase in operating income was due primarily to organic growth and the positive impact of the macroeconomic environment of approximately $24 million, driven primarily by higher fuel prices. These increases were partially offset by additional stock based compensation of approximately $21 million, higher operating expenses related to acquisitions completed in 2017 of approximately $50 million, higher professional and legal fees totaling approximately $22 million and the disposition of the NexTraq business in July 2017 of approximately $8 million. The decrease in operating margin is driven by the items discussed above.\\nInternational segment operating income. International operating income increased from $247.7 million in 2016 to $342.2 million in 2017, an increase of $94.4 million, or 38.1%. International operating margin was 44.8% in 2016 and 41.7% in 2017. The increase in operating income was due primarily to the impact of acquisitions completed in 2016 and 2017 and organic growth and the slightly positive impact of the macroeconomic environment. These increases were partially offset by higher operating expenses related to acquisitions completed in 2016 and 2017 of approximately $128 million and additional stock based compensation of approximately $9 million. The decrease in operating margin is driven by the items discussed above.\\n60\\nYear ended December 31, 2016 compared to the year ended December 31, 2015\\nThe following table sets forth selected consolidated statement of income and selected operational data for the years ended December 31, 2016 and 2015 (in millions, except percentages).\\n\\n| Year endedDecember 31,2016 | % of totalrevenue | Year endedDecember 31,2015 | % of totalrevenue | Increase(decrease) | % Change |\\n| North America | $ | 1,279.1 | 69.8 | % | $ | 1,232.0 | 72.3 | % | $ | 47.1 | 3.8 | % |\\n| International | 552.4 | 30.2 | % | 470.9 | 27.7 | % | 81.5 | 17.3 | % |\\n| Total revenues, net | 1,831.5 | 100.0 | % | 1,702.9 | 100.0 | % | 128.7 | 7.6 | % |\\n| Consolidated operating expenses: |\\n| Merchant commissions | 104.3 | 5.7 | % | 108.3 | 6.4 | % | (3.9 | ) | (3.6 | )% |\\n| Processing | 355.4 | 19.4 | % | 331.1 | 19.4 | % | 24.3 | 7.4 | % |\\n| Selling | 131.4 | 7.2 | % | 109.1 | 6.4 | % | 22.4 | 20.5 | % |\\n| General and administrative | 283.6 | 15.5 | % | 297.7 | 17.5 | % | (14.1 | ) | (4.7 | )% |\\n| Depreciation and amortization | 203.3 | 11.1 | % | 193.5 | 11.4 | % | 9.8 | 5.1 | % |\\n| Other operating, net | (0.7 | ) | — | % | (4.2 | ) | 0.2 | % | (3.6 | ) | (83.7 | )% |\\n| Operating income | 754.2 | 41.2 | % | 667.5 | 39.2 | % | 86.6 | 13.0 | % |\\n| Investment loss | 36.4 | 2.0 | % | 57.7 | 3.4 | % | (21.3 | ) | (37.0 | )% |\\n| Other expense, net | 3.0 | 0.2 | % | 2.5 | 0.1 | % | 0.5 | 18.2 | % |\\n| Interest expense, net | 71.9 | 3.9 | % | 71.3 | 4.2 | % | 0.6 | 0.8 | % |\\n| Provision for income taxes | 190.5 | 10.4 | % | 173.6 | 10.2 | % | 17.0 | 9.8 | % |\\n| Net income | $ | 452.4 | 24.7 | % | $ | 362.4 | 21.3 | % | $ | 90.0 | 24.8 | % |\\n| Operating income for segments: |\\n| North America | $ | 506.4 | $ | 442.0 | $ | 64.4 | 14.6 | % |\\n| International | 247.7 | 225.5 | 22.3 | 9.9 | % |\\n| Operating income | $ | 754.2 | $ | 667.5 | $ | 86.6 | 13.0 | % |\\n| Operating margin for segments: |\\n| North America | 39.6 | % | 35.9 | % | 3.7 | % |\\n| International | 44.8 | % | 47.9 | % | (3.0 | )% |\\n| Total | 41.2 | % | 39.2 | % | 2.0 | % |\\n\\nNM = Not Meaningful\\nRevenues\\nOur consolidated revenue increased from $1,702.9 million in 2015 to $1,831.5 million in 2016, an increase of $128.7 million, or 7.6%. The increase in our consolidated revenue was primarily due to the following:\\n| • | The impact of acquisitions completed in 2016, which contributed approximately $87 million in additional revenue. |\\n\\n| • | Organic growth in certain of our payment programs driven primarily by increases in both volume and revenue per transaction. |\\n\\n| • | Partially offsetting this growth was the negative impact of the macroeconomic environment. Although we cannot precisely measure the impact of the macroeconomic environment, in total we believe it had a negative impact on our consolidated revenue for 2016 over the comparable period in 2015 of approximately $109 million. We believe the impact of lower fuel prices, primarily in the U.S., and lower fuel spread margins, had an unfavorable impact on consolidated revenues of approximately $66 million. Additionally, changes in foreign exchange rates had an unfavorable impact on consolidated revenues of approximately $43 million due to unfavorable fluctuations in rates in most geographies in 2016 compared to 2015. |\\n\\n61\\nNorth America segment revenues. North America revenue increased from $1,232.0 million in 2015 to $1,279.1 million in 2016, an increase of $47.1 million, or 3.8%. The increase in our North America revenue was primarily due to:\\n| • | Organic growth in certain of our payment programs driven by increases in both volume and revenue per transaction. |\\n\\n| • | Partially offsetting the organic growth was the negative impact of macroeconomic environment. Although we cannot precisely measure the impact of the macroeconomic environment, in total we believe it had a negative impact on our North America segment revenue in 2016 over the comparable period in 2015 of approximately $65 million, primarily due to the impact of lower fuel prices and lower fuel spread margins. |\\n\\nInternational segment revenue. International segment revenues increased from $470.9 million in 2015 to $552.4 million in 2016, an increase of $81.5 million, or 17.3%. The increase in our International segment revenue was primarily due to:\\n\\n| • | The impact of acquisitions during 2016, which contributed approximately $87 million in additional revenue. |\\n\\n| • | Organic growth in certain of our payment programs driven by increases in both volume and revenue per transaction. |\\n\\n| • | Partially offsetting this growth was the negative impact of the macroeconomic environment. Although we cannot precisely measure the impact of the macroeconomic environment, in total we believe it had a negative impact on our International segment revenue for 2016 over the comparable period in 2015 of approximately $44 million, primarily due to unfavorable fluctuations in foreign exchange rates in most geographies where we do business and slightly lower fuel prices. |\\n\\nRevenues by geography and product. Set forth below are further breakdowns of revenue by geography and product for the years ended December 31, 2016 and 2015 (in millions), which we believe is useful in understanding the results of our business.\\n| Year Ended December 31, |\\n| (Unaudited) | 2016 | 2015 |\\n| Revenue by Geography* | Revenues,net | % of totalrevenues, net | Revenues,net | % of totalrevenues, net |\\n| United States | $ | 1,279 | 70 | % | $ | 1,232 | 72 | % |\\n| United Kingdom | 229 | 13 | 248 | 15 | % |\\n| Brazil | 168 | 9 | 85 | 5 | % |\\n| Other | 156 | 8 | 138 | 8 | % |\\n| Consolidated revenues, net | $ | 1,832 | 100 | % | $ | 1,703 | 100 | % |\\n\\n*Columns may not calculate due to rounding.\\n| Year Ended December 31, |\\n| (Unaudited) | 2016 | 2015 |\\n| Revenue by Product Category* | Revenues,net | % of totalrevenues, net | Revenues,net | % of total revenues, net |\\n| Fuel cards1 | $ | 997 | 54 | % | $ | 992 | 58 | % |\\n| Corporate payments | 180 | 10 | 162 | 10 | % |\\n| Tolls | 103 | 6 | 9 | 1 | % |\\n| Lodging | 101 | 5 | 92 | 5 | % |\\n| Gift | 185 | 10 | 170 | 10 | % |\\n| Other1 | 266 | 15 | 278 | 16 | % |\\n| Consolidated revenues, net | $ | 1,832 | 100 | % | $ | 1,703 | 100 | % |\\n\\n*Columns may not calculate due to rounding.\\n1 Amounts shown for the years ended December 31, 2016 and 2015 reflect corrections in estimated allocation of revenue by product from previously disclosed amounts.\\nConsolidated operating expenses\\nMerchant commission. Merchant commissions decreased from $108.3 million in 2015 to $104.3 million in 2016, a decrease of$3.9 million, or 3.6%. This decrease was primarily due to the fluctuation of the margin between the wholesale cost and retail price of fuel, which impacted merchant commissions in certain card programs, as well as the impact of fluctuations in foreign exchange rates.\\n62\\nProcessing. Processing expenses increased from $331.1 million in 2015 to $355.4 million in 2016, an increase of $24.3 million, or 7.4%. Increases in processing expenses were primarily due to ongoing expenses related to acquisitions completed in 2016 and incremental bad debt expense, partially offset by the impact of fluctuations in foreign exchange rates and lower negotiated vendor processing costs.\\nSelling. Selling expenses increased from $109.1 million in 2015 to $131.4 million in 2016, an increase of $22.4 million, or 20.5%. Increases in spending were primarily due to ongoing expenses related to acquisitions completed in 2016 as well as additional sales and marketing spending in certain markets, partially offset by the impact of fluctuations in foreign exchange rates.\\nGeneral and administrative. General and administrative expense decreased from $297.7 million in 2015 to $283.6 million in 2016, a decrease of $14.1 million, or 4.7%. The decrease was primarily due to decreased stock based compensation of approximately $26 million from the comparable period in 2015 and the impact of fluctuations in foreign exchange rates, partially offset by ongoing expenses related to acquisitions completed in 2016 and an incremental $2 million in acquisition related expenses over 2015.\\nDepreciation and amortization. Depreciation and amortization increased from $193.5 million in 2015 to $203.3 million in 2016, an increase of $9.8 million, or 5.1%. The increase was primarily due to ongoing expenses related to acquisitions completed in 2016, partially offset by movements in and adjustments from changes in foreign exchange rates of approximately $2 million.\\nOther operating, net. Other operating, net decreased from $4.2 million in 2015 to $0.7 million in 2016. The decrease is due to favorable reversals of various contingent liabilities for tax indemnifications related to our acquisitions of DB Trans S.A. (\\\"DB\\\") and VB in Brazil in 2015.\\nInvestment loss. Losses at our equity method investment decreased from $57.7 million in 2015 to $36.4 million in 2016. The decrease was primarily due to a non-recurring gain of $13.8 million during 2016, as well as less costs incurred to restructure the operations of the business and a smaller impairment of our investment, compared to 2015.\\nWe regularly evaluate our investments, which are not carried at fair value, for other than temporary impairment in accordance with U. S. GAAP. During the fourth quarter of 2016, we determined that the performance improvement initiatives planned at Masternaut were more challenging to implement than we originally projected. As a result, we recorded a $36.1 million non-cash impairment charge in our equity method investment in 2016, compared to a $40 million charge in 2015.\\nInterest expense, net. Interest expense was $71.3 million in 2015 compared to $71.9 million in 2016. The following table sets forth the average interest rates paid on borrowings under our Credit Facility, excluding the relevant unused credit facility fees.\\n| (Unaudited) | 2016 | 2015 |\\n| Term loan A | 2.05 | % | 1.94 | % |\\n| Term loan B | 3.75 | % | 3.75 | % |\\n| Domestic Revolver A | 2.07 | % | 1.95 | % |\\n| Foreign Revolver B | 1.84 | % | 2.36 | % |\\n| Foreign Revolver B swing line | 1.84 | % | 2.29 | % |\\n\\nThe average unused credit facility fee for Domestic Revolver A was 0.31% and 0.35% in 2016 and 2015, respectively.\\nProvision for income taxes. The provision for income taxes increased from $173.6 million in 2015 to $190.5 million in 2016, an increase of $17.0 million, or 9.8%. The increase in income taxes from 2015 to 2016 was primarily driven by the increase in book earnings for 2016 as compared to 2015. The increase in taxes was partially offset by a decrease in our effective tax rate from 32.4% in 2015 to 29.7% in 2016. The decrease in our effective tax rate was primarily due to the adoption of ASU 2016-09, \\\"Compensation-Stock Compensation: Improvements to Employee Share-Based Payment Accounting\\\", which resulted in excess tax benefits being recorded as a reduction of income tax expense during 2016, rather than additional paid in capital as discussed in the summary of significant accounting policies footnote. We also had a non-recurring net gain recorded by our equity method investment, which favorably impacted pre-tax earnings but was not subject to U.S. income taxes and the impact of certain tax planning initiatives that were implemented during 2016. We pay taxes in many different taxing jurisdictions, including the U.S., most U.S. states and many non-U.S. jurisdictions. The tax rates in certain non-U.S. taxing jurisdictions are\\n63\\nlower than the U.S. tax rate. Consequently, as our earnings fluctuate between taxing jurisdictions, our effective tax rate fluctuates.\\nNet income. For the reasons discussed above, our net income increased from $362.4 million in 2015 to $452.4 million in 2016, an increase of $90.0 million, or 24.8%.\\nOperating income and operating margin\\nConsolidated operating income. Operating income increased from $667.5 million in 2015 to $754.2 million in 2016, an increase of $86.6 million, or 13.0%. Consolidated operating margin was 39.2% in 2015 and 41.2% in 2016. The increase in operating income was primarily due to acquisitions completed in 2016, $26 million less stock based compensation expense compared to 2015 and organic growth in the business, partially offset by the negative impact of the macroeconomic environment of approximately $82 million, driven by lower fuel prices and spreads, and unfavorable fluctuations in foreign exchange rates.\\nFor the purpose of segment operating results, we calculate segment operating income by subtracting segment operating expenses from segment revenue. Segment operating margin is calculated by dividing segment operating income by segment revenue.\\nNorth America segment operating income. North America operating income increased from $442.0 million in 2015 to $506.4 million in 2016, an increase of $64.4 million, or 14.6%. North America operating margin was 35.9% in 2015 and 39.6% in 2016. The increase in operating income was due primarily to less stock based compensation expense compared to 2015 and organic growth in the business, partially offset by the negative impact of the macroeconomic environment of approximately $56 million, driven by lower fuel prices and lower fuel spread margins.\\nInternational segment operating income. International operating income increased from $225.5 million in 2015 to $247.7 million in 2016, an increase of $22.3 million, or 9.9%. International operating margin was 47.9% in 2015 and 44.8% in 2016. The increase in operating income was due primarily to acquisitions completed in 2016 and organic growth in the business, partially offset by the approximately $26 million unfavorable impact of the macroeconomic environment, specifically unfavorable changes in foreign exchange rates, as well as the negative impact of fuel prices internationally. The impact of changes in fuel price spreads was negligible.\\nLiquidity and capital resources\\nOur principal liquidity requirements are to service and repay our indebtedness, make acquisitions of businesses and commercial account portfolios, repurchase shares of our common stock and meet working capital, tax and capital expenditure needs.\\nSources of liquidity. At December 31, 2017, our cash balances totaled $1,130.9 million, with approximately $217.3 million restricted. Restricted cash represents customer deposits in the Czech Republic and in our Comdata business in the U.S., as well as collateral received from customers for cross-currency transactions in our Cambridge business, which are restricted from use other than to repay customer deposits, as well as secure and settle cross-currency transactions.\\nAt December 31, 2017, cash and cash equivalents held in foreign subsidiaries where we have determined we are permanently reinvested was $556.1 million. All of the cash and cash equivalents held by our foreign subsidiaries, excluding restricted cash, are available for general corporate purposes. Our current intent is to permanently reinvest these funds outside of the U.S. Our current expectation for funds held in our foreign subsidiaries is to use the funds to finance foreign organic growth, to pay for potential future foreign acquisitions and to repay any foreign borrowings that may arise from time to time. We currently believe that funds generated from our U.S. operations, along with available borrowing capacity in the U.S. will be sufficient to fund our U.S. operations for the foreseeable future, and therefore do not foresee a need to repatriate cash held by our foreign subsidiaries to fund our U.S. operations.\\nIn the fourth quarter of 2017, the U.S. enacted the Tax Act, which includes provisions for a tax on all previously undistributed earnings in foreign jurisdictions. We have provisionally recorded an $81.8 million charge on these undistributed earnings in 2017. As permitted by the Tax Act, we intend to pay the one-time transition tax in eight annual interest-free installments beginning in 2018. We are currently evaluating the remaining undistributed foreign earnings for which we have not provided deferred taxes for foreign withholding tax, as these earnings are considered to be indefinitely reinvested. The amount of these unrecorded deferred taxes is not expected to be material.\\n64\\nWe utilize an accounts receivable Securitization Facility to finance a majority of our domestic fuel card receivables, to lower our cost of borrowing and more efficiently use capital. We generate and record accounts receivable when a customer makes a purchase from a merchant using one of our card products and generally pay merchants before collecting the receivable. As a result, we utilize the Securitization Facility as a source of liquidity to provide the cash flow required to fund merchant payments while we collect customer balances. These balances are primarily composed of charge balances, which are typically billed to the customer on a weekly, semimonthly or monthly basis, and are generally required to be paid within 14 days of billing. We also consider the undrawn amounts under our Securitization Facility and Credit Facility as funds available for working capital purposes and acquisitions. At December 31, 2017, we had no additional liquidity under our Securitization Facility. At December 31, 2017, we had approximately $615 million available under our Credit Facility.\\nBased on our current forecasts and anticipated market conditions, we believe that our current cash balances, our available borrowing capacity and our ability to generate cash from operations, will be sufficient to fund our liquidity needs for at least the next twelve months. However, we regularly evaluate our cash requirements for current operations, commitments, capital requirements and acquisitions, and we may elect to raise additional funds for these purposes in the future, either through the issuance of debt or equity securities. We may not be able to obtain additional financing on terms favorable to us, if at all.\\nCash flows\\nThe following table summarizes our cash flows for the years ended December 31, 2017, 2016 and 2015.\\n\\n| Year ended December 31, |\\n| (in millions) | 2017 | 2016 | 2015 |\\n| Net cash provided by operating activities | $ | 675.7 | $ | 705.9 | $ | 754.6 |\\n| Net cash used in investing activities | (497.8 | ) | (1,389.6 | ) | (99.4 | ) |\\n| Net cash provided by (used in) financing activities | 251.9 | 754.0 | (648.1 | ) |\\n\\nOperating activities. Net cash provided by operating activities decreased from $705.9 million in 2016 to $675.7 million in 2017. Operating cash flows were primarily affected by higher net income, the gain on the sale of our NexTraq business in 2017 (treated as an investing activity) and deferred income taxes resulting from enactment of the Tax Act. Also included in cash flows from operating activities were unfavorable working capital adjustments primarily due to the timing of cash receipts and payments in 2017 over the comparable period in 2016.\\nNet cash provided by operating activities decreased from $754.6 million in 2015 to $705.9 million in 2016. The decrease was primarily due to changes in working capital driven by fluctuations in receivables and payables, largely due to timing of month end transactions and volume. Cash flow was favorably impacted by additional net income of $90 million during 2016 over the comparable period in 2015.\\nInvesting activities. Net cash used in investing activities decreased from $1.4 billion in 2016 to $497.8 million in 2017. This decrease was primarily due to reduction in cash outlay for acquisitions and the proceeds received from the sale of our NexTraq business during the third quarter of 2017.\\nNet cash used in investing activities increased from $99.4 million in 2015 to $1,389.6 million in 2016. This increase was primarily due to the increase in cash paid for our STP and Travelcard acquisitions completed in 2016.\\nFinancing activities. Net cash provided by financing activities decreased from $754.0 million in 2016 to $251.9 million in 2017. The decrease is primarily due to additional repayments on our Credit Facility of $599.8 million in 2017 over 2016, and increased spending to repurchase our common stock of $214.7 million, partially offset by an increase in borrowings of $243 million on our Securitization Facility and an increase in borrowings of $55.5 million on our Credit Facility.\\nNet cash from financing activities increased from net cash used of $648.1 million in 2015 to net cash provided of $754.0 million in 2016. The increase was primarily due to an increase in net borrowings on our revolving Credit Facility and term loans of $952.2 million and $585.0 million, respectively, to fund acquisitions during 2016.\\n65\\nCapital spending summary\\nOur capital expenditures increased from $59.0 million in 2016 to $70.1 million in 2017, an increase of $11 million or 18.8%. This increase is primarily due to increased spending on strategic projects, including continued investment in our operating systems, as well as incremental spending related to acquisitions in 2016 and 2017.\\nOur capital expenditures increased from $41.9 million in 2015 to $59.0 million in 2016, an increase of $17 million or 40.9%. This increase was primarily due to increased spending on strategic projects, including continued investment in our GFN application.\\nCredit Facility\\nFLEETCOR Technologies Operating Company, LLC, and certain of our domestic and foreign owned subsidiaries, as designated co-borrowers (the “Borrowers”), are parties to a $4.33 billion Credit Agreement (the \\\"Credit Agreement\\\"), with Bank of America, N.A., as administrative agent, swing line lender and local currency issuer, and a syndicate of financial institutions (the “Lenders”), which has been amended multiple times. The Credit Agreement provides for senior secured credit facilities consisting of a revolving A credit facility in the amount of $1.285 billion, a term loan A facility in the amount of $2.69 billion and a term loan B facility in the amount of $350.0 million as of December 31, 2017. The revolving credit facility consists of (a) a revolving A credit facility in the amount of $800 million, with sublimits for letters of credit and swing line loans, (b) a revolving B facility in the amount of $450 million for swing line loans and multi-currency borrowings and, (c) a revolving C facility in the amount of $35 million for multi-currency borrowings in Australian Dollars or New Zealand Dollars.\\nOn January 20, 2017, we entered into the second amendment to the Credit Agreement, which established a new term B loan. Interest on the term B loan facility accrues based on the Eurocurrency Rate or the Base Rate at 2.25% for Eurocurrency Loans and at 1.25% for Base Rate Loans. Interest on amounts outstanding under the Credit Agreement (other than the term B loan) accrues based on the British Bankers Association LIBOR Rate (the Eurocurrency Rate), plus a margin based on a leverage ratio, or our option, the Base Rate (defined as the rate equal to the highest of (a) the Federal Funds Rate plus 0.50%, (b) the prime rate announced by Bank of America, N.A., or (c) the Eurocurrency Rate plus 1.00%) plus a margin based on a leverage ratio. In addition, the Company pays a quarterly commitment fee at a rate per annum ranging from 0.20% to 0.40% of the daily unused portion of the credit facility.\\nOn August 2, 2017, we entered into the third amendment to the Credit Agreement, which increased the total facility by $708.7 million and extended the terms of the credit facilities. The stated maturity dates for the term A loan, revolving loans and letters of credit under the Credit Agreement is August 2, 2022 and August 2, 2024 for the term B loan. The term A and revolver pricing remains the same and the term B pricing was reduced by 25 basis points to LIBOR plus 200 basis points.\\nAt December 31, 2017, the interest rate on the term A loan and the domestic revolving A facility was 3.32%, the interest rate on the foreign revolving B facility was 2.25%, the interest rate on the revolving B facility foreign swing line of credit was 2.22% and the interest rate on the term B loan was 3.57%. The unused credit facility was 0.35% for all revolving facilities at December 31, 2017.\\nThe Credit Agreement also contains an accordion feature for borrowing an additional $750 million in term A, term B or revolver A debt. Proceeds from the Credit Facility may be used for working capital purposes, acquisitions, and other general corporate purposes.\\nThe term loans are payable in quarterly installments and are due on the last business day of each March, June, September, and December with the final principal payment due on the respective maturity date. Borrowings on the revolving line of credit are repayable at our option of one, two, three or nine months after borrowing, depending on the term of the borrowing on the facility. Borrowings on the foreign swing line of credit are due no later than ten business days after such loan is made.\\nThe Credit Facility contains representations, warranties and events of default, as well as certain affirmative and negative covenants, customary for financings of this nature. These covenants include limitations on the ability to pay dividends and make other restricted payments under certain circumstances and compliance with certain financial ratios.As of December 31, 2017, we were in compliance with each of the covenants under the Credit Facility.\\nOur Credit Agreement contains a number of negative covenants restricting, among other things, limitations on liens (with exceptions for our Securitization Facility) and investments, incurrence or guarantees of indebtedness, mergers, acquisitions, dissolutions, liquidations and consolidations, dispositions, dividends and other restricted payments and prepayments of other indebtedness. In particular, we are not permitted to make any restricted payments (which includes any dividend or other distribution) except that the we may declare and make dividend payments or other distributions to our stockholders so long as (i) on a pro forma basis both before and after the distribution the consolidated leverage ratio is not greater than 3.25:1.00 and we are in compliance with the financial covenants and (ii) no default or event of default shall exist or result therefrom. The\\n66\\nCredit Agreement also contains customary events of default. The Credit Agreement includes financial covenants where the Company is required to maintain a consolidated leverage ratio to consolidated EBITDA of less than (i) 4.00 to 1.00 as of the end of any fiscal quarter provided that in connection with any Material Acquisition the leverage ratio may be increased to 4.25 to 1.00 for the quarter in which the Material Acquisition is consummated and the next three fiscal quarters; and a consolidated interest coverage ratio of no more than 4.00 to 1.0.\\nThe obligations of the Borrowers under the Credit Agreement are secured by substantially all of the assets of FLEETCOR and its domestic subsidiaries, pursuant to a security agreement and includes a pledge of (i) 100% of the issued and outstanding equity interests owned by us of each Domestic Subsidiary and (2) 66% of the voting shares of the first-tier foreign subsidiaries, but excluding real property, personal property located outside of the U.S., accounts receivables and related assets subject to the Securitization Facility and certain investments required under money transmitter laws to be held free and clear of liens.\\nAt December 31, 2017, we had $2.7 billion in borrowings outstanding on term A loan, excluding the related debt discount, $349.1 million in borrowings outstanding on term B loan, excluding the related debt discount, $635 million in borrowings outstanding on the domestic revolving A facility, $28.3 million in borrowings outstanding on the foreign revolving B facility and $6.9 million in borrowings outstanding on the foreign swing line revolving B facility. The Company has unamortized debt discounts of $6.0 million related to the term A facility and $0.7 million related to the term B facility and deferred financing costs of $5.1 million at December 31, 2017. In August 2017, the Company expensed $3.3 million and capitalized $10.6 million of debt issuance costs associated with the refinancing of its Credit Facility. The effective interest rate incurred on term loans was 2.69% and 2.57% during 2017 and 2016, respectively, related to the discount on debt.\\nDuring 2017, we made principal payments of $423.2 million on the term loans, $930.0 million on the domestic revolving A facility, $101.7 million on the foreign revolving A facility and $52.7 million on the foreign swing line revolving B facility.\\nSecuritization Facility\\nWe are a party to a receivables purchase agreement among FleetCor Funding LLC, as seller, PNC Bank, National Association as administrator, and various purchaser agents, conduit purchasers and related committed purchasers parties thereto, which was amended and restated for the Fifth time as of November 14, 2014. We refer to this arrangement as the Securitization Facility. There have been several amendments to the Securitization Facility. The current purchase limit under the Securitization Facility is $950 million and the Securitization Facility expires on November 14, 2020. The Securitization Facility contains certain customary financial covenants.\\nThere is a program fee equal to one month LIBOR plus 0.90% or the Commercial Paper Rate plus 0.80% as of December 31, 2017 and one month LIBOR or the Commercial Paper Rate plus 0.90% as of December 31, 2016. The program fee was 1.55% plus 0.86% as of December 31, 2017 and 0.85% plus 0.90% as of December 31, 2016. The unused facility fee is payable at a rate of 0.40% as of December 31, 2017 and 2016.\\nUnder a related purchase and sale agreement, dated as of December 20, 2004, and most recently amended on November 14, 2014 to include Comdata as an originator, between FLEETCOR Funding LLC, as purchaser, and certain of our subsidiaries, as originators, the receivables generated by the originators are deemed to be sold to FLEETCOR Funding LLC immediately and without further action upon creation of such receivables. At the request of FLEETCOR Funding LLC, as seller, undivided percentage ownership interests in the receivables are ratably purchased by the purchasers in amounts not to exceed their respective commitments under the facility. Collections on receivables are required to be made pursuant to a written credit and collection policy and may be reinvested in other receivables, may be held in trust for the purchasers, or may be distributed. Fees are paid to each purchaser agent for the benefit of the purchasers and liquidity providers in the related purchaser group in accordance with the Securitization Facility and certain fee letter agreements.\\nThe Securitization Facility provides for certain termination events, which includes nonpayment, upon the occurrence of which the administrator may declare the facility termination date to have occurred, may exercise certain enforcement rights with respect to the receivables, and may appoint a successor servicer, among other things.\\nWe were in compliance with all financial and non-financial covenant requirements related to our Securitization Facility as of December 31, 2017.\\nOther Liabilities\\nIn connection with our acquisition of certain businesses, we owe final payments of $29.3 million, of which $3.6 million is payable in the next twelve months and $25.7 million in periods beyond a year.\\n67\\nStock Repurchase Program\\nOn February 4, 2016, our Board of Directors approved a stock repurchase program (the \\\"Program\\\") under which we may purchase up to an aggregate of $500 million of our common stock over the following 18 months period. On July 27, 2017, our Board of Directors authorized an increase in the size of the Program by an additional $250 million and an extension of the Program by an additional 18 months. On November 1, 2017, we announced that our Board of Directors had authorized an additional increase in the size of the Program by an another $350 million, resulting in total aggregate repurchases authorized under the Program of $1.1 billion. With the increase and giving effect to $590.1 million of previous repurchases, we may repurchase up to $510 million in shares of our common stock at any time prior to February 1, 2019.\\nAny stock repurchases may be made at times and in such amounts as deemed appropriate. The timing and amount of stock repurchases, if any, will depend on a variety of factors including the stock price, market conditions, corporate and regulatory requirements, and any additional constraints related to material inside information we may possess. Any repurchases have been and are expected to be funded by a combination of available cash flow from the business, working capital and debt.\\nOn August 3, 2017, as part of the Program, we entered an Accelerated Share Repurchase agreement (\\\"ASR Agreement\\\") with a third-party financial institution to repurchase $250 million of our common stock. Pursuant to the ASR Agreement, we delivered $250 million in cash and received 1,491,647 shares based on a stock price of $142.46 on August 7, 2017. The ASR Agreement was completed on September 7, 2017, at which time the we received 263,012 additional shares based on a final weighted average per share purchase price during the repurchase period of $142.48.\\nWe accounted for the ASR Agreement as two separate transactions: (i) as shares of reacquired common stock for the shares delivered to us upon effectiveness of the ASR Agreement and (ii) as a forward contract indexed to our common stock for the undelivered shares. The initial delivery of shares was included in treasury stock at cost and results in an immediate reduction of the outstanding shares used to calculate the weighted average common shares outstanding for basic and diluted earnings per share. The forward contracts indexed to our own common stock met the criteria for equity classification, and these amounts were initially recorded in additional paid-in capital and then reclassified to treasury stock upon completion of the ASR agreement.\\nSince the beginning of the Program, 4,114,104 shares for an aggregate purchase price of $590.1 million have been repurchased. There were 2,854,959 common shares totaling $402.4 million repurchased under the Program during 2017.\\nCritical accounting policies and estimates\\nIn applying the accounting policies that we use to prepare our consolidated financial statements, we necessarily make accounting estimates that affect our reported amounts of assets, liabilities, revenue and expenses. Some of these estimates require us to make assumptions about matters that are highly uncertain at the time we make the accounting estimates. We base these assumptions and the resulting estimates on historical information and other factors that we believe to be reasonable under the circumstances, and we evaluate these assumptions and estimates on an ongoing basis. In many instances, however, we reasonably could have used different accounting estimates and, in other instances, changes in our accounting estimates could occur from period to period, with the result in each case being a material change in the financial statement presentation of our financial condition or results of operations. We refer to estimates of this type as critical accounting estimates. Our significant accounting policies are summarized in the consolidated financial statements contained elsewhere in this report. The critical accounting estimates that we discuss below are those that we believe are most important to an understanding of our consolidated financial statements.\\nSee Footnote 2 to the Consolidated Financial Statements, Summary of Significant Accounting Policies.\\nRevenue recognition and presentation. Revenue is derived from our merchant and network relationships, as well as from customers and partners. We recognize revenue on fees generated through services primarily to commercial fleets, commercial businesses, major oil companies, petroleum marketers and leasing companies and record revenue net of the wholesale cost of the underlying products and services based on the following: (i) we are not the primary obligor in the arrangement and we are not responsible for fulfillment and the acceptability of the product; (ii) we have no inventory risk, do not bear the risk of product loss and do not make any changes to the product or have any involvement in the product specifications; (iii) we do not have significant latitude with respect to establishing the price for the product and (iv) the amount we earn for our services is fixed, within a limited range. We recognize revenue from merchant and network relationships, processing and other arrangements when persuasive evidence of an arrangement exists, the services have been provided to the customer, the sales price is fixed or determinable and collectability is reasonably assured, as more fully described below.\\n68\\nThrough our merchant and network relationships we provide fuel, prepaid cards, vehicle maintenance, lodging, food, toll, and transportation related services to our customers. We derive revenue from our merchant and network relationships based on the difference between the price charged to a customer for a transaction and the price paid to the merchant or network for the same transaction. Our revenue consists of margin on sales and fees for technical support, processing, communications and reporting. The price paid to a merchant or network may be calculated as (i) the merchant’s wholesale cost of the product plus a markup; (ii) the transaction purchase price less a percentage discount; or (iii) the transaction purchase price less a fixed fee per unit. The difference between the price we pay to a merchant and the merchant’s wholesale cost for the underlying products and services is considered a merchant commission and is recognized as expense when the fuel purchase transaction is executed. We have entered into agreements with major oil companies, petroleum marketers and leasing companies, among others, that specify that a transaction is deemed to be captured when we have validated that the transaction has no errors and have accepted and posted the data to our records.\\nWe also derive revenue from customers and partners from a variety of program fees including transaction fees, card fees, network fees, service fees, report fees and other transaction-based fees, which typically are calculated based on measures such as percentage of dollar volume processed, number of transactions processed, or some combination thereof. Such services are provided through proprietary networks or through the use of third-party networks. Transaction fees and other transaction-based fees generated from our proprietary networks and third-party networks are recognized at the time the transaction is captured. Card fees, network fees and program fees are recognized as we fulfill our contractual service obligations. In addition, we recognize revenue from late fees and finance charges, in jurisdictions where permitted under local regulations, primarily in the U.S. and Canada. Such fees are recognized net of a provision for estimated uncollectible amounts, at the time the fees and finance charges are assessed. The Company ceases billing and accruing for late fees and finance charges approximately 30-40 days after the customer’s balance becomes delinquent.\\nWe also charge our customers transaction fees to load value onto prepaid fuel, food, toll and transportation vouchers and cards. We recognize fee revenue upon providing the activated fuel, food, toll and transportation vouchers and prepaid cards to the customer. Revenue is recognized on lodging and transportation management services when the lodging stay or transportation service is provided. Revenue is also derived from the sale of equipment and cards in certain of our businesses, which is recognized at the time the device is sold and the risks and rewards of ownership have passed. This revenue is recognized gross of the cost of sales related to the equipment in revenues, net within the Consolidated Statements of Income. The related cost of sales for the equipment is recorded within processing expenses in the Consolidated Statements of Income. We have recorded $96.8 million of expenses related to sales of equipment within the processing expenses line of the Consolidated Statements of Income in 2017. Sales commissions paid to personnel are expensed as incurred.\\nWe deliver both stored value cards and card-based services primarily in the form of gift cards. For multiple-deliverable customer contracts, stored value cards and card-based services are separated into two units of accounting. Stored valued cards are generally recognized upon shipment to the customer. Card-based services are recognized when the card services are rendered.\\nWe present taxes assessed by the government imposed concurrent with a revenue producing transaction between us and our customers (e.g. VAT) on a net basis within revenues, net.\\nOur fiscal year ends on December 31. In certain of our U.K. businesses, we record the operating results using a 4-4-5 week accounting cycle with the fiscal year ending on the Friday on or immediately preceding December 31.\\nAccounts receivable. As described above under the heading “Securitization facility,” we maintain a revolving trade accounts receivable Securitization Facility. The current purchase limit under the Securitization Facility is $950 million. Accounts receivable collateralized within our Securitization Facility relate to trade receivables resulting from charge card activity in the U.S. Pursuant to the terms of the Securitization Facility, we transfer certain of our domestic receivables, on a revolving basis, to FLEETCOR Funding LLC (Funding), a wholly-owned bankruptcy remote subsidiary. In turn, Funding sells, without recourse, on a revolving basis, up to $950 million of undivided ownership interests in this pool of accounts receivable to a multi-seller, asset-backed commercial paper conduit (Conduit). Funding maintains a subordinated interest, in the form of over collateralization, in a portion of the receivables sold to the Conduit. Purchases by the Conduit are financed with the sale of highly-rated commercial paper.\\nWe utilize proceeds from the sale of our accounts receivable as an alternative to other forms of financing, to reduce our overall borrowing costs. We have agreed to continue servicing the sold receivables for the financial institution at market rates, which approximates our cost of servicing. We retain a residual interest in the accounts receivable sold as a form of credit\\n69\\nenhancement. The residual interest’s fair value approximates carrying value due to its short-term nature. Funding determines the level of funding achieved by the sale of trade accounts receivable, subject to a maximum amount.\\nThe Company’s Consolidated Balance Sheets and Statements of Income reflect the activity related to securitized accounts receivable and the corresponding securitized debt, including interest income, fees generated from late payments, provision for losses on accounts receivable and interest expense. The cash flows from borrowings and repayments, associated with the securitized debt, are presented as cash flows from financing activities.\\nForeign receivables are not included in our receivable securitization program. At December 31, 2017 and 2016, there was $811 million and $591 million, respectively, of short-term debt outstanding under our accounts receivable Securitization Facility.\\nCredit risk and reserve for losses on receivables. We control credit risk by performing periodic credit evaluations of our customers. Payments from customers are generally due within 14 days or less of billing. We routinely review our accounts receivable balances and make provisions for probable doubtful accounts based primarily on the aging of those balances. Accounts receivable are deemed uncollectible once they age past 90 days and are deemed uncollectible from the customer. We also provide an allowance for receivables aged less than 90 days that we expect will be uncollectible based on historical collections experience including accounts that have filed for bankruptcy. At December 31, 2017, approximately 96% of outstanding accounts receivable were current. Accounts receivable deemed uncollectible are removed from accounts receivable and the allowance for doubtful accounts when internal collection efforts have been exhausted and accounts have been turned over to a third-party collection agency. Recoveries from the third-party collection agency are not significant.\\nImpairment of long-lived assets, intangibles and investments. We test our long-lived assets for impairment in accordance with relevant authoritative guidance. We evaluate if impairment indicators related to our property, plant and equipment and other long-lived assets are present. These impairment indicators may include a significant decrease in the market price of a long-lived asset or asset group, a significant adverse change in the extent or manner in which a long-lived asset or asset group is being used or in its physical condition, or a current-period operating or cash flow loss combined with a history of operating or cash flow losses or a forecast that demonstrates continuing losses associated with the use of a long-lived asset or asset group. If impairment indicators are present, we estimate the future cash flows for the asset or asset group. The sum of the undiscounted future cash flows attributable to the asset or group of assets is compared to their carrying amount. The cash flows are estimated utilizing various projections of revenues and expenses, working capital and proceeds from asset disposals on a basis consistent with management’s intended actions. If the carrying amount exceeds the sum of the undiscounted future cash flows, we determine the assets’ fair value by discounting the future cash flows using a discount rate required for a similar investment of like risk and records an impairment charge as the difference between the fair value and the carrying value of the asset group. Generally, we perform our testing of the asset group at the business-line level, as this is the lowest level for which identifiable cash flows are available.\\nWe complete an impairment test of goodwill at least annually or more frequently if facts or circumstances indicate that goodwill might be impaired. Goodwill is tested for impairment at the reporting unit level, and the impairment test consists of two steps, as well as a qualitative assessment, as appropriate. We have performed a qualitative assessment of certain of our reporting units. In this qualitative assessment we individually considered the following items for each reporting unit where we determined a qualitative analysis to be appropriate: the macroeconomic conditions, including any deterioration of general conditions, limitations on accessing capital, fluctuations in foreign exchange rates and other developments in equity and credit markets; industry and market conditions, including any deterioration in the environment where the reporting unit operates, increased competition, changes in the products/services and regulator and political developments; cost of doing business; overall financial performance, including any declining cash flows and performance in relation to planned revenues and earnings in past periods; other relevant reporting unit specific facts, such as changes in management or key personnel or pending litigation; events affecting the reporting unit, including changes in the\\ncarrying value of net assets, likelihood of disposal and whether there were any other impairment considerations within the business; the overall performance of our share price in relation to the market and our peers; and a quantitative stress test of the previously completed step 1 test from the prior year, updated with current year results, weighted-average cost of capital rates and future projections.\\nIn step 1 of the goodwill impairment test for reporting units, the reporting unit’s carrying amount, including goodwill, is compared to its fair value which is measured based upon, among other factors, a discounted cash flow analysis as well as market multiples for comparable companies. If the carrying amount of the reporting unit is greater than its fair value, goodwill is considered impaired and step two must be performed. Step two measures the impairment loss by comparing the implied fair value of reporting unit goodwill with the carrying amount of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit to all the assets and liabilities of that unit (including unrecognized intangibles) as\\n70\\nif the reporting unit had been acquired in a business combination. The excess of fair value over the amounts allocated to the assets and liabilities of the reporting unit is the implied fair value of goodwill. The excess of the carrying amount over the implied fair value is the impairment loss.\\nWe estimated the fair value of our reporting units using a combination of the income approach and the market approach. The income approach utilizes a discounted cash flow model incorporating management’s expectations for future revenue, operating expenses, earnings before interest, taxes, depreciation and amortization, capital expenditures and an anticipated tax rate. We discounted the related cash flow forecasts using an estimated weighted-average cost of capital for each reporting unit at the date of valuation. The market approach utilizes comparative market multiples in the valuation estimate. Multiples are derived by relating the value of guideline companies, based on either the market price of publicly traded shares or the prices of companies being acquired in the marketplace, to various measures of their earnings and cash flow. Such multiples are then applied to the historical and projected earnings and cash flow of the reporting unit in developing the valuation estimate.\\nPreparation of forecasts and the selection of the discount rates involve significant judgments about expected future business performance and general market conditions. Significant changes in forecasts, the discount rates selected or the weighting of the income and market approach could affect the estimated fair value of one or more of our reporting units and could result in a goodwill impairment charge in a future period.\\nBased on the goodwill asset impairment analysis performed quantitatively on October 1, 2017, we determined that the fair value of each of our reporting units is in excess of the carrying value. No events or changes in circumstances have occurred since the date of our most recent annual impairment test that would more likely than not reduce the fair value of a reporting unit below its carrying amount.\\nWe also evaluate indefinite-lived intangible assets (primarily trademarks and trade names) for impairment annually. We also test for impairment if events and circumstances indicate that it is more likely than not that the fair value of an indefinite-lived intangible asset is below its carrying amount. Estimates critical to our evaluation of indefinite-lived intangible assets for impairment include the discount rate, royalty rates used in our evaluation of trade names, projected average revenue growth and projected long-term growth rates in the determination of terminal values. An impairment charge is recorded if the carrying amount of an indefinite-lived intangible asset exceeds the estimated fair value on the measurement date.\\nWe also regularly evaluate the carrying value of our investments, which are not carried at fair value, for other-than-temporary impairment. We estimate the fair value of our investments using a combination of the income approach and the market approach. The income approach utilizes a discounted cash flow model incorporating management’s expectations for future revenue, operating expenses, earnings before interest, taxes, depreciation and amortization, capital expenditures and an anticipated tax rate. We discount the related cash flow forecasts using an estimated weighted-average cost of capital for each reporting unit at the date of valuation. The market approach utilizes comparative market multiples in the valuation estimate. Multiples are derived by relating the value of guideline companies, based on either the market price of publicly traded shares or the prices of companies being acquired in the marketplace, to various measures of their earnings and cash flow. Such multiples are then applied to the historical and projected earnings and cash flow of our investments in developing the valuation estimate.\\nOn September 30, 2017, we entered into an amended Masternaut Group Holdings Limited (\\\"Masternaut\\\") investment agreement that resulted in the loss of significant influence, and we began accounting for the Masternaut investment by applying the cost method. We regularly evaluate the carrying value of our investment and during the third quarter of 2017, we determined that the fair value of our 44% investment in Masternaut had declined as a result of our loss of significant influence. As a result, we determined that the carrying value of our investment exceeded its fair value, and concluded that this decline in value was other than temporary. We recorded a $44.6 million impairment loss in the Masternaut investment that includes adjustment for $31.4 million of currency losses previously recognized in accumulated other comprehensive income, in the year ended December 31, 2017, in the accompanying Consolidated Statements of Income. During the fourth quarters of 2016 and 2015, we determined that the performance improvement initiatives in our investment in Masternaut were taking longer to and were more challenging to implement than originally projected, based on revised cash flow projections provided by the business. As a result, we recorded a $36.1 million and $40 million non-cash impairment charge in its Masternaut investment for 2016 and 2015, respectively.\\nIncome taxes. We account for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or\\n71\\nsettled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date.\\nThe ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which the associated temporary differences become deductible. We evaluate on a quarterly basis, whether it is more likely than not that our deferred tax assets will be realized in the future and conclude whether a valuation allowance must be established.\\nCurrent accounting guidance clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements and prescribes threshold and measurement attributes for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Under the relevant authoritative literature, the impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more likely than not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50 percent likelihood of being sustained. We include any estimated interest and penalties on tax related matters in income tax expense.\\nIn the fourth quarter of 2017, the U.S. government enacted tax legislation referred to as the Tax Act. As a result of Tax Act, the U.S. federal corporate tax rate was reduced from 35% to 21%. The Tax Act also includes provisions for a tax on all previously undistributed earnings in foreign jurisdictions. We have provisionally recorded a $210 million deferred tax benefit for the benefit for the corporate rate reduction on our deferred tax assets and liabilities. Additionally, in 2017, We have provisionally recorded an $81.8 million charge on all previously undistributed earnings in foreign jurisdictions. We are currently evaluating the remaining undistributed foreign earnings for which we have not provided deferred taxes for foreign withholding tax, as these earnings are considered to be indefinitely reinvested. The amount of these unrecorded deferred taxes is not expected to be material. If in the future these earnings are repatriated to the U.S., or if we determine that the earnings will be remitted in the foreseeable future, additional tax provisions may be required. See Note 11 for further information regarding income taxes.\\nBusiness combinations. Business combinations completed by us have been accounted for under the acquisition method of accounting. The acquisition method requires that the acquired assets and liabilities, including contingencies, be recorded at fair value determined as of the acquisition date and changes thereafter reflected in income. For significant acquisitions, we obtain independent third-party valuation studies for certain of the assets acquired and liabilities assumed to assist us in determining fair value. Goodwill represents the excess of the purchase price over the fair values of the tangible and intangible assets acquired and liabilities assumed. The results of the acquired businesses are included in our results of operations beginning from the completion date of the applicable transaction.\\nEstimates of fair value are revised during an allocation period as necessary when, and if, information becomes available to further define and quantify the fair value of the assets acquired and liabilities assumed. Provisional estimates of the fair values of the assets acquired and liabilities assumed involves a number of estimates and assumptions that could differ materially from the final amounts recorded. The allocation period does not exceed one year from the date of the acquisition. To the extent additional information to refine the original allocation becomes available during the allocation period, the allocation of the purchase price is adjusted. Should information become available after the allocation period, those items are adjusted through operating results. The direct costs of the acquisition are recorded as operating expenses. Certain acquisitions include contingent consideration related to the performance of the acquired operations following the acquisition. Contingent consideration is recorded at estimated fair value at the date of the acquisition, and is remeasured each reporting period, with any changes in fair value recorded in the Consolidated Statements of Income. We estimate the fair value of the acquisition-related contingent consideration using various valuation approaches, as well as significant unobservable inputs, reflecting our assessment of the assumptions market participants would use to value these liabilities.\\nStock-based compensation. We account for employee stock options and restricted stock in accordance with relevant authoritative literature. Stock options are granted with an exercise price estimated to be equal to the fair market value on the date of grant as authorized by our board of directors. Options granted have vesting provisions ranging from one to five years and vesting of the options is generally based on the passage of time or performance. Stock option grants are subject to forfeiture if employment terminates prior to vesting. We have selected the Black-Scholes option pricing model for estimating the grant date fair value of stock option awards granted. We have considered the retirement and forfeiture provisions of the options and utilized our historical experience to estimate the expected life of the options. Option forfeitures are accounted for upon occurrence. We base the risk-free interest rate on the yield of a zero coupon U.S. Treasury security with a maturity equal to the expected life of the option from the date of the grant. Stock-based compensation cost is measured at the grant date based on the\\n72\\nvalue of the award and is recognized as expense over the requisite service period based on the number of years for which the requisite service is expected to be rendered.\\nAwards of restricted stock and restricted stock units are independent of stock option grants and are subject to forfeiture if employment terminates prior to vesting. The vesting of shares granted is generally based on the passage of time, performance or market conditions, or a combination of these. Shares vesting based on the passage of time have vesting provisions of one to three years. The fair value of restricted stock where the shares vest based on the passage of time or performance is based on the grant date fair value of our stock.\\nFor performance-based restricted stock awards and performance based stock option awards, we must also make assumptions regarding the likelihood of achieving performance goals. If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations could be materially affected.\\nDerivatives. With our acquisition of Cambridge in August 2017, we use derivatives to facilitate cross-currency corporate payments by writing derivatives to customers, which are not designated as hedging instruments. The majority of Cambridge's revenue is from exchanges of currency at spot rates, which enable customers to make cross-currency payments. In addition, Cambridge also writes foreign currency forward and option contracts for its customers to facilitate future payments. The duration of these derivative contracts at inception is generally less than one year. We aggregate our foreign exchange exposures arising from customer contracts, including forwards, options and spot exchanges of currency, and hedges (economic hedge) the resulting net currency risks by entering into offsetting contracts with established financial institution counterparties. The changes in fair value related to these contracts are recorded in revenues, net in the Consolidated Statements of Income.\\nWe recognize all derivatives in \\\"prepaid expenses and other current assets\\\" and \\\"other current liabilities\\\" in the accompanying Consolidated Balance Sheets at their fair value. All cash flows associated with derivatives are included in cash flows from operating activities in the Consolidated Statements of Cash Flows.\\nPending Adoption of Recently Issued Accounting Standards\\nFrom time to time, new accounting pronouncements are issued by the FASB or other standards setting bodies that are adopted by the Company as of the specified effective date. Unless otherwise discussed, the Company’s management believes that the impact of recently issued standards that are not yet effective will not have a material impact on the Company’s consolidated financial statements upon adoption.\\nTax Act. The SEC staff issued Staff Accounting Bulletin No. 118, \\\"Income Tax Accounting Implications of the Tax Cuts and Jobs Act\\\" (\\\"SAB 118\\\"), which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC 740. In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Act for which the accounting under ASC 740 is complete. To the extent that a company’s accounting for certain income tax effects of the Tax Act is incomplete but it is able to determine a reasonable estimate, it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax laws that were in effect immediately before the enactment of the Tax Act.\\nRevenue Recognition. In May 2014, the FASB issued ASU 2014-09, \\\"Revenue from Contracts with Customers (Topic 606)\\\". The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 will replace most existing revenue recognition guidance in GAAP and permits the use of either the retrospective or modified retrospective transition method. The update requires significant additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments. ASU 2014-09, as amended by ASU 2015-14, \\\"Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date\\\", is effective for years beginning after December 15, 2017, including interim periods, with early adoption permitted for years beginning after December 15, 2016. Since the issuance of ASU 2014-09, the FASB has issued additional interpretive guidance, including new accounting standards updates, that clarifies certain points of the standard and modifies certain requirements.\\nWe have performed a review of the requirements of the new revenue standard and we are monitoring the activity of the FASB and the transition resource group as it relates to specific interpretive guidance. We have established an implementation team to assess the effects of the new revenue standard in a multi-phase approach. In the first phase, we analyzed customer contracts for our most significant contract categories, applied the five-step model of Topic 606 to each contract category and comparing the\\n73\\nresults to our current accounting practices. The second phase, which includes quantifying the potential effects identified during the first phase, assessing additional contract categories and principal versus agent considerations, revising accounting policies and considering the effects on related disclosures and/or internal control over financial reporting is ongoing and expected to be concluded during the first quarter of 2018.\\nTopic 606 could change the amount and timing of revenue and expenses to be recognized under certain of our arrangement types. In addition, it could also increase the administrative burden on our operations to account for customer contracts and provide the more expansive required disclosures. More judgment and estimates may be required within the process of applying the requirements of the new standard than are required under existing GAAP, such as identifying performance obligations in contracts, estimating the amount of variable consideration to include in transaction price, allocating transaction price to each separate performance obligation and estimating expected customer lives. We are in the process of finalizing our assessment and completing the quantification of the effect the new guidance will have on our consolidated financial statements, related disclosures and/or internal control over financial reporting. This conclusion will be made over the remainder of the first quarter of 2018 and will include finalizing our evaluation of the application of the principal vs. agent guidance, specifically as it relates to products where we utilize a third-party payment network and in certain businesses where we pay merchant commissions. However, our preliminary view is that the expected amount and timing of revenue to be recognized under Topic 606 for our most significant contract categories, fuel card payments, lodging payments, toll payments, corporate payments, and gift cards, will be similar to the amount and timing of revenue recognized under our current accounting practices, except as it relates to the presentation of certain costs where we may be determined to be an agent in the processing relationship under the new guidance, resulting in recording such costs as a reduction of revenue. We will be required to capitalize additional costs to obtain contracts with customers, and, in some cases, may be required to amortize these costs over a contractual time period. Finally, we expect disclosures about our revenues and related customer acquisition costs to be more extensive.\\nWe plan to adopt Topic 606, as well as other clarifications and technical guidance issued by the FASB related to this new revenue standard, effective January 1, 2018. We will apply the modified retrospective transition method, which would result in an adjustment to retained earnings for the cumulative effect, if any, of applying the standard to contracts that are not completed at the date of initial application. Under this method, we would not restate the prior financial statements presented, therefore the new standard requires us to provide additional disclosures of the amount by which each financial statement line item is affected in the current reporting period during 2018, as compared to the guidance that was in effect before the change, and an explanation of the reasons for significant changes, if any.\\nAccounting for Leases. In February 2016, the FASB issued ASU 2016-02, “Leases”, which requires lessees to recognize a right-of-use asset and a lease liability on the balance sheet for all leases with the exception of short-term leases. This ASU also requires disclosures to provide additional information about the amounts recorded in the financial statements. This ASU is effective for us for annual periods beginning after December 15, 2018 and interim periods therein. Early adoption is permitted. The new standard must be adopted using a modified retrospective transition and requires application of the new guidance for leases that exist or are entered into after the beginning of the earliest comparative period presented. We are currently evaluating the impact of ASU 2016-02 on our consolidated financial statements; however, we expect to recognize right of use assets and liabilities for operating leases in the Consolidated Balance Sheet upon adoption.\\nAccounting for Breakage. In March 2016, the FASB issued ASU 2016-04, “Liabilities-Extinguishments of Liabilities: Recognition of Breakage for Certain Prepaid Stored-Value Products”, which requires entities that sell prepaid stored value products redeemable for goods, services or cash at third-party merchants to derecognize liabilities related to those products for breakage. This ASU is effective for the Company for reporting periods beginning after December 15, 2017. Early adoption is permitted. The ASU must be adopted using either a modified retrospective approach with a cumulative effect adjustment to retained earnings as of the beginning of the period of adoption or a full retrospective approach. Our adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows.\\nCash Flow Classification. In August 2016, the FASB issued ASU 2016-15, \\\"Classification of Certain Cash Receipts and Cash Payments\\\", which amends the guidance in ASC 230, Statement of Cash Flows. This amended guidance reduces the diversity in practice that has resulted from the lack of consistent principles related to the classification of certain cash receipts and payments in the statement of cash flows. This ASU is effective for reporting periods beginning after December 15, 2017. Early adoption is permitted. Entities must apply the guidance retrospectively to all periods presented but may apply it prospectively from the earliest date practicable if retrospective application would be impracticable.Our adoption of this ASU is not expected to have a material impact on the results of operations or financial condition.\\nIn November 2016, the FASB issued ASU 2016-18, \\\"Statement of Cash Flows (Topic 230): Restricted Cash\\\", which amends the guidance in ASC 230, Statement of Cash Flows, on the classification and presentation of restricted cash in the statement of cash flows. This ASU is effective for reporting periods beginning after December 15, 2017. Early adoption is permitted. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. The amendments in this ASU should be applied using a retrospective transition method to\\n74\\neach period presented. We do not believe the adoption of this ASU will impact the results of operations, financial condition, or cash flows.\\nIntangibles - Goodwill and Other Impairment. In January 2017, the FASB issued ASU 2017-04, \\\"Simplifying the Test for Goodwill Impairment\\\", which eliminates the requirement to calculate the implied fair value of goodwill (i.e., Step 2 of the goodwill impairment test) to measure a goodwill impairment charge. Instead, entities will record an impairment charge based on the excess of a reporting unit’s carrying amount over its fair value (i.e., measure the charge based on Step 1). The standard has tiered effective dates, starting in 2020 for calendar-year public business entities that meet the definition of an SEC filer. Early adoption is permitted for interim and annual goodwill impairment testing dates after January 1, 2017. Our adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows, unless a goodwill impairment is identified.\\nDefinition of a Business. In January 2017, the FASB issued ASU 2017-01, \\\"Clarifying the Definition of a Business\\\", which amends the definition of a business to assist entities with evaluating when a set of transferred assets and activities is a business. The guidance requires an entity to evaluate if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets. If so, the set of transferred assets and activities is not a business. The guidance also requires a business to include at least one substantive process and narrows the definition of outputs. The guidance is effective for the reporting periods beginning after December 15, 2017, and interim periods within those years. Early adoption is permitted. Our adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows, however it could result in accounting for acquisitions as asset acquisitions versus business combinations upon adoption.\\nAccounting for Modifications to Stock-Based Compensation. In May 2017, the FASB issued ASU 2017-09, \\\"Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting\\\", which amends the scope of modification accounting for share-based payment arrangements. The ASU provides guidance on the types of changes to the terms or conditions of share-based payment awards to which an entity would be required to apply modification accounting under ASC 718. Specifically, an entity would not apply modification accounting if the fair value, vesting conditions and classification of the awards are the same immediately before and after the modification. The guidance is effective for reporting periods beginning after December 15, 2017, and interim periods within those years. Early adoption is permitted. Our adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows.\\nAccounting for Derivative Financial Instruments. In August 2017, the FASB issued ASU 2017-12, \\\"Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities\\\", which amends the hedge accounting recognition and presentation requirements in ASC 815. The FASB issued accounting guidance to better align hedge accounting with a company’s risk management activities, simplify the application of hedge accounting and improve the disclosures of hedging arrangements. The guidance is effective for reporting periods beginning after December 15, 2018, and interim periods within those years. Early adoption is permitted. Our adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows.\\nContractual obligations\\nThe table below summarizes the estimated dollar amounts of payments under contractual obligations identified below as of December 31, 2017 for the periods specified:\\n\\n| Payments due by period(a) |\\n| (in millions) | Total | Less than1 year | 1-3years | 3-5years | More than5 years |\\n| Credit Facility | $ | 3,663.9 | $ | 805.5 | $ | 271.0 | $ | 2,256.2 | $ | 331.2 |\\n| Securitization Facility | 811.0 | 811.0 | — | — | — |\\n| Estimated interest payments- Credit Facility(b) | 534.1 | 119.5 | 330.8 | 77.0 | 6.8 |\\n| Estimated interest payments- Securitization Facility(b) | 57.0 | 19.5 | 37.5 | — | — |\\n| Operating leases | 92.0 | 19.3 | 26.5 | 20.9 | 25.3 |\\n| Deferred purchase price(c) | 29.3 | 3.6 | 25.7 | — | — |\\n| Other(c) | 18.1 | — | 13.5 | 1.4 | 3.2 |\\n| Total | $ | 5,205.4 | $ | 1,778.5 | $ | 704.9 | $ | 2,355.4 | $ | 366.6 |\\n\\n______________________\\n75\\n| (a) | Deferred income tax liabilities as of December 31, 2017 were approximately $517.1 million. Refer to Note 11 to our audited consolidated financial statements. This amount is not included in the total contractual obligations table because we believe this presentation would not be meaningful. Deferred income tax liabilities are calculated based on temporary differences between the tax bases of assets and liabilities and their respective book bases, which will result in taxable amounts in future years when the liabilities are settled at their reported financial statement amounts. The results of these calculations do not have a direct connection with the amount of cash taxes to be paid in any future periods. As a result, scheduling deferred income tax liabilities as payments due by period could be misleading, as this scheduling would not relate to liquidity needs. At December 31, 2017, we had approximately $31.6 million of unrecognized income tax benefits related to uncertain tax positions. We cannot reasonably estimate when all of these unrecognized income tax benefits may be settled. We do not expect reductions to unrecognized income tax benefits within the next 12 months as a result of projected resolutions of income tax uncertainties. |\\n\\n| (b) | We draw upon and pay down on the revolver within our Credit Agreement and our Securitization Facility borrowings outside of a normal schedule, as excess cash is available. For our variable rate debt, we have assumed the December 31, 2017 interest rates to calculate the estimated interest payments, for all years presented. This analysis also assumes that outstanding principal is held constant at the December 31, 2017 balances for our Credit Agreement and Securitization Facility, except for mandatory pay downs on the term loans in accordance with the loan documents. We typically expect to settle such interest payments with cash flows from operating activities and/or other short-term borrowings. |\\n\\n| (c) | The long-term portion of contingent consideration agreements and deferred purchase price payments are included with ‘other debt’ in the detail of our debt instruments disclosed in Note 10 to our audited consolidated financial statements. To reconcile the amount of ‘other debt’ as disclosed in the footnote to the contractual obligations table above, the long-term portion of deferred purchase price payments should be combined with ‘Other’. |\\n\\nManagement’s Use of Non-GAAP Financial Measures\\nWe have included in the discussion above certain financial measures that were not prepared in accordance with GAAP. Any analysis of non-GAAP financial measures should be used only in conjunction with results presented in accordance with GAAP. Below, we define the non-GAAP financial measures, provide a reconciliation of the non-GAAP financial measure to the most directly comparable financial measure calculated in accordance with GAAP, and discuss the reasons that we believe this information is useful to management and may be useful to investors.\\nAdjusted revenues. We have defined the non-GAAP measure adjusted revenues as revenues, net less merchant commissions as reflected in our income statement.\\nWe use adjusted revenues as a basis to evaluate our revenues, net of the commissions that are paid to merchants to participate in our card programs. The commissions paid to merchants can vary when market spreads fluctuate in much the same way as revenues are impacted when market spreads fluctuate. We believe that adjusted revenue is an appropriate supplemental measure of financial performance and may be useful to investors to understanding our revenue performance on a consistent basis. Adjusted revenues are not intended to be a substitute for GAAP financial measures and should not be used as such.\\nSet forth below is a reconciliation of adjusted revenues to the most directly comparable GAAP measure, revenues, net (in millions):\\n| Year Ended December 31, |\\n| 2017 | 2016 | 2015 |\\n| Revenues, net | $ | 2,250 | $ | 1,832 | $ | 1,703 |\\n| Merchant commissions | 113 | 104 | 108 |\\n| Total adjusted revenues | $ | 2,136 | $ | 1,727 | $ | 1,595 |\\n\\nPro forma and macro adjusted revenues. We have defined the non-GAAP measure pro forma and macro adjusted revenue as revenues, net adjusted for the impact of the macroeconomic environment, acquisitions and dispositions and other one-time items. We use pro forma and macro adjusted revenue as a basis to evaluate our organic growth.\\nSet forth below is a reconciliation of pro forma and macro adjusted revenues to the most directly comparable GAAP measure, revenues, net (in millions):\\n76\\n| Year Ended December 31,* |\\n| 2017 | 2016 |\\n| (Unaudited) | Macro Adjusted1 | Pro forma2,3 |\\n| FUEL CARDS |\\n| Pro forma and macro adjusted | $ | 1,068 | $ | 996 |\\n| Impact of acquisitions/dispositions | — | (7 | ) |\\n| Impact of fuel prices/spread | 30 | — |\\n| Impact of foreign exchange rates | — | — |\\n| One-time items4 | (2 | ) | 8 |\\n| As reported | $ | 1,096 | $ | 997 |\\n| CORPORATE PAYMENTS |\\n| Pro forma and macro adjusted | $ | 260 | $ | 226 |\\n| Impact of acquisitions/dispositions | — | (47 | ) |\\n| Impact of fuel prices/spread | 1 | — |\\n| Impact of foreign exchange rates | 1 | — |\\n| One-time items4 | — | — |\\n| As reported | $ | 262 | $ | 180 |\\n| TOLLS |\\n| Pro forma and macro adjusted | $ | 302 | $ | 257 |\\n| Impact of acquisitions/dispositions | — | (154 | ) |\\n| Impact of fuel prices/spread | — | — |\\n| Impact of foreign exchange rates | 25 | — |\\n| One-time items4 | — | — |\\n| As reported | $ | 327 | $ | 103 |\\n| LODGING |\\n| Pro forma and macro adjusted | $ | 127 | $ | 105 |\\n| Impact of acquisitions/dispositions | — | (4 | ) |\\n| Impact of fuel prices/spread | — | — |\\n| Impact of foreign exchange rates | — | — |\\n| One-time items4 | — | — |\\n| As reported | $ | 127 | $ | 101 |\\n| GIFT |\\n| Pro forma and macro adjusted | $ | 194 | $ | 185 |\\n| Impact of acquisitions/dispositions | — | — |\\n| Impact of fuel prices/spread | — | — |\\n| Impact of foreign exchange rates | — | — |\\n| One-time items4 | — | — |\\n| As reported | $ | 194 | $ | 185 |\\n| OTHER5 |\\n| Pro forma and macro adjusted | $ | 243 | $ | 244 |\\n| Impact of acquisitions/dispositions | — | 23 |\\n| Impact of fuel prices/spread | — | — |\\n| Impact of foreign exchange rates | 1 | — |\\n| One-time items4 | — | — |\\n| As reported | $ | 244 | $ | 266 |\\n\\n77\\n| FLEETCOR CONSOLIDATED REVENUES |\\n| Pro forma and macro adjusted | $ | 2,194 | $ | 2,013 |\\n| Impact of acquisitions/dispositions | — | (189 | ) |\\n| Impact of fuel prices/spread | 30 | — |\\n| Impact of foreign exchange rates | 27 | — |\\n| One-time items4 | (2 | ) | 8 |\\n| As reported | $ | 2,250 | $ | 1,832 |\\n\\n* Columns may not calculate due to rounding.\\n1 Adjusted to remove the impact of changes in the macroeconomic environment to be consistent with the same period of prior year, using constant fuel prices, fuel price spreads and foreign exchange rates, as well as one-time items.\\n2 Pro forma to include acquisitions and exclude dispositions and one-time items, consistent with previous period ownership.\\n3 2016 reflects immaterial corrections in estimated allocation of revenue by product from previously disclosed amounts.\\n4 Adjustments related to one-time items not representative of normal business operations.\\n5 Other includes telematics, maintenance, food and transportation related businesses.\\nAdjusted net income and adjusted net income per diluted share. We have defined the non-GAAP measure adjusted net income as net income as reflected in our statement of income, adjusted to eliminate (a) non-cash stock-based compensation expense related to share-based compensation awards, (b) amortization of deferred financing costs, discounts and intangible assets, amortization of the premium recognized on the purchase of receivables, and our proportionate share of amortization of intangible assets at our equity method investment, (c) a non-recurring net gain at equity method investment, (d) impairment of our equity method investment, (e) net gain on disposition of business, (f) loss on extinguishment of debt and, (g) other non-recurring items, including the impact of the Tax Act.\\nWe have defined the non-GAAP measure adjusted net income per diluted share as the calculation previously noted divided by the weighted average diluted shares outstanding as reflected in our statement of income.\\nWe use adjusted net income to eliminate the effect of items that we do not consider indicative of our core operating performance. We believe it is useful to exclude non-cash stock based compensation expense from adjusted net income because non-cash equity grants made at a certain price and point in time do not necessarily reflect how our business is performing at any particular time and stock based compensation expense is not a key measure of our core operating performance. We also believe that amortization expense can vary substantially from company to company and from period to period depending upon their financing and accounting methods, the fair value and average expected life of their acquired intangible assets, their capital structures and the method by which their assets were acquired. Therefore, we have excluded amortization expense from adjusted net income. We believe that adjusted net income and adjusted net income per diluted share are appropriate supplemental measures of financial performance and may be useful to investors to understanding our operating performance on a consistent basis. Adjusted net income and adjusted net income per diluted share are not intended to be a substitute for GAAP financial measures and should not be used as such.\\n78\\nSet forth below is a reconciliation of adjusted net income and adjusted net income per diluted share to the most directly comparable GAAP measure, net income and net income per diluted share (in thousands, except per share amounts):\\n| Year Ended December 31,* |\\n| (Unaudited) | 2017 | 20162 | 2015 |\\n| Net income | $ | 740,200 | $ | 452,385 | $ | 362,431 |\\n| Net income per diluted share | $ | 7.91 | $ | 4.75 | $ | 3.85 |\\n| Stock based compensation | 93,297 | 63,946 | 90,122 |\\n| Amortization of intangible assets, premium on receivables, deferred financing costs and discounts | 233,280 | 184,475 | 180,704 |\\n| Impairment of investment | 44,600 | 36,065 | 40,000 |\\n| Net gain on disposition of business | (109,205 | ) | — | — |\\n| Loss on extinguishment of debt | 3,296 | — | — |\\n| Non-recurring loss due to merger of entities | 2,028 | — | — |\\n| Non-recurring net gain at equity method investment | — | (10,845 | ) | — |\\n| Legal settlement | 11,000 | — | — |\\n| Restructuring costs | 1,043 | — | — |\\n| Total pre-tax adjustments | 279,339 | 273,641 | 310,826 |\\n| Impact of 2017 Tax Act | (127,466 | ) | — | — |\\n| Income tax impact of pre-tax adjustments at the effective tax rate1 | (93,164 | ) | (66,850 | ) | (80,632 | ) |\\n| Adjusted net income | $ | 798,909 | $ | 659,176 | $ | 592,625 |\\n| Adjusted net income per diluted share | $ | 8.54 | $ | 6.92 | $ | 6.30 |\\n| Diluted shares | 93,594 | 95,213 | 94,139 |\\n\\n| *Columns may not calculate due to rounding. |\\n| 1Excludes the results of our equity method investment on our effective tax rate, as results from our investment are reported within the Consolidated Income Statements on a post-tax basis and no tax-over-book outside basis differences related to our equity method investment. Also excludes the net gain realized upon our disposition of NexTraq, representing a pretax gain of $175.0 and tax on gain of $65.8. The tax on the gain is included in \\\"Net gain on disposition of business\\\". |\\n| 2 Reflects the impact of the Company's adoption of Accounting Standards Update 2016-09, \\\"Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting\\\", to simplify several aspects of the accounting for share-based compensation, including the income tax consequences. |\\n\\n79\\nITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nForeign currency risk\\nForeign Earnings\\nOur International segment exposes us to foreign currency exchange rate changes that can impact translations of foreign-denominated assets and liabilities into U.S. dollars and future earnings and cash flows from transactions denominated in different currencies. Revenue from our International segment was 36.5%, 30.2% and 27.7% of total revenue for the years ended December 31, 2017, 2016, and 2015, respectively. We measure foreign currency exchange risk based on changes in foreign currency exchange rates using a sensitivity analysis. The sensitivity analysis measures the potential change in earnings based on a hypothetical 10% change in currency exchange rates. Exchange rates and currency positions as of December 31, 2017 were used to perform the sensitivity analysis. Such analysis indicated that a hypothetical 10% change in foreign currency exchange rates would have increased or decreased consolidated operating income during the year ended December 31, 2017 by approximately $34.2 million had the U.S. dollar exchange rate increased or decreased relative to the currencies to which we had exposure. When exchange rates and currency positions as of December 31, 2016 and 2015 were used to perform this sensitivity analysis, the analysis indicated that a hypothetical 10% change in currency exchange rates would have increased or decreased consolidated operating income for the years ended December 31, 2016 and 2015 by approximately $24.8 million and $22.5 million, respectively.\\nUnhedged Cross-Currency Risk\\nWith the acquisition of Cambridge in August 2017, we have additional foreign exchange risk and associated foreign exchange risk management requirements due to the nature of our international payments provider business. The majority of Cambridge's revenue is from exchanges of currency at spot rates, which enable customers to make cross-currency payments. In addition, Cambridge also writes foreign currency forward and option contracts for customers to facilitate future payments. The duration of these derivative contracts at inception is generally less than one year. Cambridge aggregates its foreign exchange exposures arising from customer contracts, including the derivative contracts described above, and hedges (economic hedge) the resulting net currency risks by entering into offsetting contracts with established financial institution counterparties.\\nInterest rate risk\\nWe are exposed to changes in interest rates on our cash investments and debt. We invest our excess cash either to pay down our Securitization Facility debt or in securities that we believe are highly liquid and marketable in the short term. These investments are not held for trading or other speculative purposes. Under our $4.325 billion Credit Agreement, the Credit Agreement provides for senior secured credit facilities consisting of a revolving A credit facility in the amount of $1.285 billion, a term loan A facility in the amount of $2.690 billion and a term loan B facility in the amount of $350.0 million as of December 31, 2017. The revolving credit facility consists of (a) a revolving A credit facility in the amount of $800.0 million, with sublimits for letters of credit and swing line loans, (b) a revolving B facility in the amount of $450.0 million for swing line loans and multi-currency borrowings and, (c) a revolving C facility in the amount of $35.0 million for multi-currency borrowings in Australian Dollars or New Zealand Dollars.\\nOn January 20, 2017, we entered into the second amendment to the Credit Agreement, which established a new term B loan. Interest on the term B loan facility accrues based on the Eurocurrency Rate or the Base Rate at 2.25% for Eurocurrency Loans and at 1.25% for Base Rate Loans. Interest on amounts outstanding under the Credit Agreement (other than the Term B loan) accrues based on the British Bankers Association LIBOR Rate (the Eurocurrency Rate), plus a margin based on a leverage ratio, or our option, the Base Rate (defined as the rate equal to the highest of (a) the Federal Funds Rate plus 0.50%, (b) the prime rate announced by Bank of America, N.A., or (c) the Eurocurrency Rate plus 1.00%) plus a margin based on a leverage ratio. In addition, the Company pays a quarterly commitment fee at a rate per annum ranging from 0.20% to 0.40% of the daily unused portion of the credit facility.\\nBased on the amounts and mix of our fixed and floating rate debt (exclusive of our Securitization Facility) at December 31, 2017, 2016 and 2015, if market interest rates had increased or decreased an average of 100 basis points, our interest expense would have changed by approximately $34.7 million, $27.9 million and $26.2 million, respectively. We determined these amounts by considering the impact of the hypothetical interest rates on our borrowing costs. These analyses do not consider the effects of changes in the level of overall economic activity that could exist in such an environment.\\nFuel price risk\\n80\\nOur fleet customers use our products and services primarily in connection with the purchase of fuel. Accordingly, our revenue is affected by fuel prices, which are subject to significant volatility. A decline in retail fuel prices could cause a change in our revenue from several sources, including fees paid to us based on a percentage of each customer’s total purchase. Changes in the absolute price of fuel may also impact unpaid account balances and the late fees and charges based on these amounts. The impact of changes in fuel price is somewhat mitigated by our agreements with certain merchants, where the price paid to the merchant is equal to the lesser of the merchant’s cost plus a markup or a percentage of the transaction purchase price. We do not enter into any fuel price derivative instruments.\\nFuel-price spread risk\\nFrom our merchant and network relationships, we derive revenue from the difference between the price charged to a fleet customer for a transaction and the price paid to the merchant or network for the same transaction. The price paid to a merchant or network is calculated as the merchant’s wholesale cost of fuel plus a markup. The merchant’s wholesale cost of fuel is dependent on several factors including, among others, the factors described above affecting fuel prices. The fuel price that we charge to our customer is dependent on several factors including, among others, the fuel price paid to the fuel merchant, posted retail fuel prices and competitive fuel prices. We experience fuel-price spread contraction when the merchant’s wholesale cost of fuel increases at a faster rate than the fuel price we charge to our customers, or the fuel price we charge to our customers decreases at a faster rate than the merchant’s wholesale cost of fuel. Accordingly, if fuel-price spreads contract, we may generate less revenue, which could adversely affect our operating results. The impact of volatility in fuel spreads is somewhat mitigated by our agreements with certain merchants, where the price paid to the merchant is equal to the lesser of the merchant’s cost plus a markup or a percentage of the transaction purchase price.\\n81\\nITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA\\nINDEX TO CONSOLIDATED FINANCIAL STATEMENTS\\n\\n| Page |\\n| Reports of Independent Registered Public Accounting Firm | 83 |\\n| Consolidated Balance Sheets at December 31, 2017 and 2016 | 85 |\\n| Consolidated Statements of Income for the Years Ended December 31, 2017, 2016 and 2015 | 86 |\\n| Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2017, 2016 and 2015 | 87 |\\n| Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2017, 2016 and 2015 | 88 |\\n| Consolidated Statements of Cash Flows for the Years Ended December 31, 2017, 2016 and 2015 | 89 |\\n| Notes to Consolidated Financial Statements | 90 |\\n\\n82\\nReport of Independent Registered Public Accounting Firm\\nTo the Shareholders and the Board of Directors of FleetCor Technologies, Inc. and Subsidiaries\\nOpinion on the Financial Statements\\nWe have audited the accompanying consolidated balance sheets of FleetCor Technologies, Inc. and subsidiaries (the Company) as of December 31, 2017 and 2016, the related consolidated statements of income, comprehensive income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2017, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2017, in conformity with U.S. generally accepted accounting principles.\\nWe also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated March 1, 2018 expressed an unqualified opinion thereon.\\nBasis for Opinion\\nThese consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.\\nWe conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.\\n/s/ Ernst & Young LLP\\nWe have served as the Company‘s auditor since 2002.\\nAtlanta, Georgia\\nMarch 1, 2018\\n83\\nReport of Independent Registered Public Accounting Firm\\nTo the Shareholders and the Board of Directors of FLEETCOR Technologies, Inc. and Subsidiaries\\nOpinion on Internal Control over Financial Reporting\\nWe have audited FleetCor Technologies, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission 2013 framework (the COSO criteria). In our opinion, FleetCor and subsidiaries (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2017, based on the COSO criteria.\\nAs indicated in the accompanying Management Report on Internal Control over Financial Reporting, management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of Cambridge Global Payments, Creative Lodging Solutions, and a fuel card provider in Russia (the “Acquired Entities”), which is included in the 2017 consolidated financial statements of the Company and constituted 11% of total assets as of December 31, 2017 and 3% of revenues for the year then ended. Our audit of internal control over financial reporting of the Company also did not include an evaluation of the internal control over financial reporting of the Acquired Entities.\\nWe also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the FleetCor Technologies, Inc. and subsidiaries as of December 31, 2017 and 2016, the related consolidated statements of comprehensive income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2017, and the related notes and our report dated March 1, 2018 expressed an unqualified opinion thereon\\nBasis for Opinion\\nThe Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management Report on Internal Controls over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.\\nWe conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.\\nOur audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.\\nDefinition and Limitations of Internal Control Over Financial Reporting\\nA company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.\\nBecause of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.\\n/s/ Ernst & Young LLP\\nAtlanta, Georgia\\nMarch 1, 2018\\n84\\nFLEETCOR Technologies, Inc. and Subsidiaries\\nConsolidated Balance Sheets\\n| December 31, |\\n| 2017 | 2016 |\\n| Assets |\\n| Current assets: |\\n| Cash and cash equivalents | $ | 913,595 | $ | 475,018 |\\n| Restricted cash | 217,275 | 168,752 |\\n| Accounts and other receivables (less allowance for doubtful accounts of $46,031 and $32,506, respectively) | 1,420,011 | 1,202,009 |\\n| Securitized accounts receivable—restricted for securitization investors | 811,000 | 591,000 |\\n| Prepaid expenses and other current assets | 187,820 | 90,914 |\\n| Total current assets | 3,549,701 | 2,527,693 |\\n| Property and equipment, net | 180,057 | 142,504 |\\n| Goodwill | 4,715,823 | 4,195,150 |\\n| Other intangibles, net | 2,724,957 | 2,653,233 |\\n| Investments | 32,859 | 36,200 |\\n| Other assets | 114,962 | 71,952 |\\n| Total assets | $ | 11,318,359 | $ | 9,626,732 |\\n| Liabilities and stockholders’ equity |\\n| Current liabilities: |\\n| Accounts payable | $ | 1,437,314 | $ | 1,151,432 |\\n| Accrued expenses | 238,472 | 238,812 |\\n| Customer deposits | 732,171 | 530,787 |\\n| Securitization facility | 811,000 | 591,000 |\\n| Current portion of notes payable and lines of credit | 805,512 | 745,506 |\\n| Other current liabilities | 71,033 | 38,781 |\\n| Total current liabilities | 4,095,502 | 3,296,318 |\\n| Notes payable and other obligations, less current portion | 2,902,104 | 2,521,727 |\\n| Deferred income taxes | 518,912 | 668,580 |\\n| Other noncurrent liabilities | 125,319 | 56,069 |\\n| Total noncurrent liabilities | 3,546,335 | 3,246,376 |\\n| Commitments and contingencies (Note 13) |\\n| Stockholders’ equity: |\\n| Common stock, $0.001 par value; 475,000,000 shares authorized; 122,083,059 shares issued and 89,803,982 shares outstanding at December 31, 2017; and 121,259,960 shares issued and 91,836,938 shares outstanding at December 31, 2016 | 122 | 121 |\\n| Additional paid-in capital | 2,214,224 | 2,074,094 |\\n| Retained earnings | 2,958,921 | 2,218,721 |\\n| Accumulated other comprehensive loss | (551,857 | ) | (666,403 | ) |\\n| Less treasury stock (32,279,077 shares at December 31, 2017; and 29,423,022 shares at December 31, 2016) | (944,888 | ) | (542,495 | ) |\\n| Total stockholders’ equity | 3,676,522 | 3,084,038 |\\n| Total liabilities and stockholders’ equity | $ | 11,318,359 | $ | 9,626,732 |\\n\\nSee accompanying notes.\\n85\\nFLEETCOR Technologies, Inc. and Subsidiaries\\nConsolidated Statements of Income\\n(In Thousands, Except Per Share Amounts)\\n\\n| Year Ended December 31, |\\n| 2017 | 2016 | 2015 |\\n| Revenues, net | $ | 2,249,538 | $ | 1,831,546 | $ | 1,702,865 |\\n| Expenses: |\\n| Merchant commissions | 113,133 | 104,345 | 108,257 |\\n| Processing | 429,613 | 355,414 | 331,073 |\\n| Selling | 170,717 | 131,443 | 109,075 |\\n| General and administrative | 387,694 | 283,625 | 297,715 |\\n| Depreciation and amortization | 264,560 | 203,256 | 193,453 |\\n| Other operating, net | 61 | (690 | ) | (4,242 | ) |\\n| Operating income | 883,760 | 754,153 | 667,534 |\\n| Investment loss | 53,164 | 36,356 | 57,668 |\\n| Other (income) expense, net | (173,436 | ) | 2,982 | 2,523 |\\n| Interest expense, net | 107,146 | 71,896 | 71,339 |\\n| Loss on extinguishment of debt | 3,296 | — | — |\\n| Total other (income) expense | (9,830 | ) | 111,234 | 131,530 |\\n| Income before income taxes | 893,590 | 642,919 | 536,004 |\\n| Provision for income taxes | 153,390 | 190,534 | 173,573 |\\n| Net income | $ | 740,200 | $ | 452,385 | $ | 362,431 |\\n| Basic earnings per share | $ | 8.12 | $ | 4.89 | $ | 3.94 |\\n| Diluted earnings per share | $ | 7.91 | $ | 4.75 | $ | 3.85 |\\n| Weighted average shares outstanding: |\\n| Basic shares | 91,129 | 92,597 | 92,023 |\\n| Diluted shares | 93,594 | 95,213 | 94,139 |\\n\\nSee accompanying notes.\\n86\\nFLEETCOR Technologies, Inc. and Subsidiaries\\nConsolidated Statements of Comprehensive Income\\n(In Thousands)\\n\\n| Year Ended December 31, |\\n| 2017 | 2016 | 2015 |\\n| Net income | $ | 740,200 | $ | 452,385 | $ | 362,431 |\\n| Other comprehensive income (loss): |\\n| Foreign currency translation gains (losses), net of tax | 83,165 | (95,592 | ) | (279,303 | ) |\\n| Reclassification of foreign currency translation loss to investment, net of tax | 31,381 | — | — |\\n| Total other comprehensive income (loss) | 114,546 | (95,592 | ) | (279,303 | ) |\\n| Total comprehensive income | $ | 854,746 | $ | 356,793 | $ | 83,128 |\\n\\nSee accompanying notes.\\n87\\nFLEETCOR Technologies, Inc. and Subsidiaries\\nConsolidated Statements of Stockholders’ Equity\\n(In Thousands)\\n\\n| CommonStock | AdditionalPaid-InCapital | RetainedEarnings | AccumulatedOtherComprehensiveLoss | TreasuryStock | Total |\\n| Balance at December 31, 2014 | $ | 120 | $ | 1,852,442 | $ | 1,403,905 | $ | (291,508 | ) | $ | (346,397 | ) | $ | 2,618,562 |\\n| Net income | — | — | 362,431 | — | — | 362,431 |\\n| Other comprehensive loss, net of tax of $0 | — | — | — | (279,303 | ) | — | (279,303 | ) |\\n| Acquisition of common stock | — | — | — | — | (8,119 | ) | (8,119 | ) |\\n| Issuance of common stock | 1 | 136,475 | — | — | — | 136,476 |\\n| Balance at December 31, 2015 | 121 | 1,988,917 | 1,766,336 | (570,811 | ) | (354,516 | ) | 2,830,047 |\\n| Net income | — | — | 452,385 | — | — | 452,385 |\\n| Other comprehensive loss, net of tax of $0 | — | — | — | (95,592 | ) | — | (95,592 | ) |\\n| Acquisition/return of common stock | — | — | — | — | (187,979 | ) | (187,979 | ) |\\n| Issuance of common stock | — | 85,177 | — | — | — | 85,177 |\\n| Balance at December 31, 2016 | 121 | 2,074,094 | 2,218,721 | (666,403 | ) | (542,495 | ) | 3,084,038 |\\n| Net income | — | — | 740,200 | — | — | 740,200 |\\n| Other comprehensive income, net of tax of $0 | — | — | — | 114,546 | — | 114,546 |\\n| Acquisition of common stock | — | — | — | — | (402,393 | ) | (402,393 | ) |\\n| Issuance of common stock | 1 | 140,130 | — | — | — | 140,131 |\\n| Balance at December 31, 2017 | $ | 122 | $ | 2,214,224 | $ | 2,958,921 | $ | (551,857 | ) | $ | (944,888 | ) | $ | 3,676,522 |\\n\\nSee accompanying notes.\\n88\\nFLEETCOR Technologies, Inc. and Subsidiaries\\nConsolidated Statements of Cash Flows\\n(In Thousands)\\n| Year Ended Year Ended December 31, |\\n| 2017 | 2016 | 2015 |\\n| Operating activities |\\n| Net income | $ | 740,200 | $ | 452,385 | $ | 362,431 |\\n| Adjustments to reconcile net income to net cash provided by operating activities: |\\n| Depreciation | 46,599 | 36,456 | 30,462 |\\n| Stock-based compensation | 93,297 | 63,946 | 90,122 |\\n| Provision for losses on accounts receivable | 44,857 | 35,885 | 24,629 |\\n| Amortization of deferred financing costs and discounts | 6,952 | 7,582 | 7,049 |\\n| Amortization of intangible assets | 211,849 | 161,635 | 159,740 |\\n| Amortization of premium on receivables | 6,112 | 5,165 | 3,250 |\\n| Loss on extinguishment of debt | 3,296 | — | — |\\n| Deferred income taxes | (247,712 | ) | (28,681 | ) | 30,626 |\\n| Investment loss | 53,164 | 36,356 | 57,668 |\\n| Gain on disposition of business | (174,983 | ) | — | — |\\n| Other non-cash operating income | (61 | ) | (690 | ) | (4,242 | ) |\\n| Changes in operating assets and liabilities (net of acquisitions and disposition): |\\n| Restricted cash | (4,335 | ) | (2,306 | ) | (35,676 | ) |\\n| Accounts receivable and other receivables | (431,003 | ) | (338,796 | ) | 40,017 |\\n| Prepaid expenses and other current assets | 26,102 | 5,301 | (12,564 | ) |\\n| Other assets | (20,957 | ) | (20,345 | ) | (2,524 | ) |\\n| Excess tax benefits related to stock-based compensation | — | — | (26,427 | ) |\\n| Accounts payable, accrued expenses and customer deposits | 322,346 | 292,019 | 30,023 |\\n| Net cash provided by operating activities | 675,723 | 705,912 | 754,584 |\\n| Investing activities |\\n| Acquisitions, net of cash acquired1 | (705,257 | ) | (1,331,985 | ) | (49,069 | ) |\\n| Purchases of property and equipment | (70,093 | ) | (59,011 | ) | (41,875 | ) |\\n| Proceeds from disposal of a business | 316,501 | — | — |\\n| Other | (38,953 | ) | 1,411 | (8,470 | ) |\\n| Net cash used in investing activities | (497,802 | ) | (1,389,585 | ) | (99,414 | ) |\\n| Financing activities |\\n| Excess tax benefits related to stock-based compensation | — | — | 26,427 |\\n| Proceeds from issuance of common stock | 44,690 | 21,231 | 19,926 |\\n| Borrowings (payments) on securitization facility, net | 220,000 | (23,000 | ) | (61,000 | ) |\\n| Repurchase of common stock | (402,393 | ) | (187,678 | ) | — |\\n| Deferred financing costs paid and debt discount | (12,908 | ) | (2,272 | ) | — |\\n| Proceeds from issuance of notes payable | 780,656 | 600,000 | — |\\n| Principal payments on notes payable | (423,156 | ) | (118,500 | ) | (103,500 | ) |\\n| Borrowings from revolver | 1,100,000 | 1,225,107 | — |\\n| Payments on revolver | (1,031,722 | ) | (786,849 | ) | (486,818 | ) |\\n| Borrowings (payments) on swing line of credit, net | (23,686 | ) | 26,606 | (546 | ) |\\n| Payment of contingent consideration | — | — | (42,177 | ) |\\n| Other | 457 | (676 | ) | (377 | ) |\\n| Net cash provided by (used in) financing activities | 251,938 | 753,969 | (648,065 | ) |\\n| Effect of foreign currency exchange rates on cash | 8,718 | (42,430 | ) | (37,022 | ) |\\n| Net increase (decrease) in cash | 438,577 | 27,866 | (29,917 | ) |\\n| Cash and cash equivalents, beginning of year | 475,018 | 447,152 | 477,069 |\\n| Cash and cash equivalents, end of year | $ | 913,595 | $ | 475,018 | $ | 447,152 |\\n| Supplemental cash flow information |\\n| Cash paid for interest | $ | 113,416 | $ | 70,339 | $ | 72,537 |\\n| Cash paid for income taxes | $ | 392,192 | $ | 101,951 | $ | 83,380 |\\n| Non cash investing activity, notes assumed in acquisitions | $ | 29,341 | $ | — | $ | — |\\n| 1Amounts reported in acquisitions and investment, net of cash acquired, includes debt assumed and immediately repaid in acquisitions. |\\n| See accompanying notes. |\\n\\n89\\nFLEETCOR Technologies, Inc. and Subsidiaries\\nNotes to Consolidated Financial Statements\\nDecember 31, 2017\\n1. Description of Business\\nFLEETCOR Technologies, Inc. and its subsidiaries (the Company) is a leading global provider of commercial payment solutions. The Company helps businesses of all sizes control, simplify and secure payment of various domestic and cross-border payables using specialized payment products. The Company serves businesses, merchants and partners in North America, Latin America, Europe, and Australasia.\\nThe Company has two reportable segments, North America and International. The Company reports these two segments as they align with its senior executive organizational structure, reflect how the Company organizes and manages its employees around the world, manages operating performance, contemplates the differing regulatory environments in North America versus other geographies, and helps the Company isolate the impact of foreign exchange fluctuations on its financial results.\\nThe Company's payment solutions provide its customers with a payment method designed to be superior and more robust and effective than what they use currently, whether they use a competitor’s product or another alternative method such as cash or check. The Company's solutions are comprised of payment products, networks and associated services.\\nThe Company's payment products function like a charge card or prepaid card and tend to be specialized for specific spend categories, such as fuel or lodging, and/or specific customer groups, such as long haul transportation. The Company's five primary product lines are Fuel, Lodging, Tolls, Corporate Payments and Gift. Additionally, the Company provides other payment products including fleet maintenance, employee benefits and long haul transportation-related services. The Company's products are used in 56 countries around the world, with its primary geographies being the U.S., Brazil and the United Kingdom, which combined accounted for approximately 90% of the Company's revenue in 2017.\\nThe Company uses both proprietary and third-party networks to deliver its payment solutions. FLEETCOR owns and operates proprietary networks with brands throughout the world, bringing incremental sales and loyalty to affiliated merchants. Third-party networks are used to broaden payment product acceptance and use.\\nThe Company markets its products directly through multiple sales channels, including field sales, telesales and digital marketing, and indirectly through its partners, which include major oil companies, leasing companies, petroleum marketers, value-added resellers (VARs) and referral partners.\\n2. Summary of Significant Accounting Policies\\nRevenue Recognition and Presentation\\nRevenue is derived from the Company’s merchant and network relationships as well as from customers and partners. The Company recognizes revenue on fees generated through services primarily to commercial fleets, commercial businesses, major oil companies, petroleum marketers and leasing companies and records revenue net of the wholesale cost of the underlying products and services based on the following: (i) the Company is not the primary obligor in the arrangement and is not responsible for fulfillment and the acceptability of the product; (ii) the Company has no inventory risk, does not bear the risk of product loss and does not make any changes to the product or have any involvement in the product specifications; (iii) the Company does not have significant latitude with respect to establishing the price for the product; and (iv) the amount the Company earns for services is fixed, within a limited range. The Company recognizes revenue from merchant and network relationships, processing and other arrangements when persuasive evidence of an arrangement exists, the services have been provided to the customer, the sales price is fixed or determinable and collectability is reasonably assured, as more fully described below.\\nThrough the Company’s merchant and network relationships the Company provides fuel, prepaid cards, vehicle maintenance, lodging, food, toll, and transportation related services to our customers. The Company derives revenue from its merchant and network relationships based on the difference between the price charged to a customer for a transaction and the price paid to the merchant or network for the same transaction. The Company’s revenue consists of margin on sales and fees for technical support, processing, communications and reporting. The price paid to a merchant or network may be calculated as (i) the merchant’s wholesale cost of the product plus a markup; (ii) the transaction purchase price less a percentage discount; or (iii) the transaction purchase price less a fixed fee per unit. The difference between the price the Company pays to a merchant and the merchant’s wholesale cost for the underlying products and services is considered a merchant commission and is recognized as expense when the fuel purchase transaction is executed. The Company has entered into agreements with major oil companies, petroleum marketers and leasing companies, among others, that specify that a transaction is deemed to be\\n90\\ncaptured when we have validated that the transaction has no errors and have accepted and posted the data to the Company’s records.\\nThe Company also derives revenue from customers and partners from a variety of program fees including transaction fees, card fees, network fees, service fees, report fees and other transaction-based fees, which typically are calculated based on measures such as percentage of dollar volume processed, number of transactions processed, or some combination thereof. Such services are provided through proprietary networks or through the use of third-party networks. Transaction fees and other transaction-based fees generated from the Company’s proprietary networks and third-party networks are recognized at the time the transaction is captured. Card fees, network fees and program fees are recognized as the Company fulfills its contractual service obligations. In addition, the Company recognizes revenue from late fees and finance charges, in jurisdictions where permitted under local regulations, primarily in the U.S. and Canada. Such fees are recognized net of a provision for estimated uncollectible amounts, at the time the fees and finance charges are assessed and services are provided. The Company ceases billing and accruing for late fees and finance charges approximately 30-40 days after the customer’s balance becomes delinquent.\\nThe Company also charges its customers transaction fees to load value onto prepaid fuel, food, toll and transportation vouchers and cards. The Company recognizes fee revenue upon providing the activated fuel, food, toll and transportation vouchers and prepaid cards to the customer. Revenue is recognized on lodging and transportation management services when the lodging stay or transportation service is completed. Revenue is also derived from the sale of equipment and cards in certain of the Company’s businesses, which is recognized at the time the device is sold and the risks and rewards of ownership have passed. This revenue is recognized gross of the cost of sales related to the equipment in revenues, net within the Consolidated Statements of Income. The related cost of sales for the equipment is recorded within processing expenses in the Consolidated Statements of Income. The Company has recorded $96.8 million, $91.6 million and $84.1 million of expenses related to sales of equipment within the processing expenses line of the Consolidated Statements of Income for the years ended December 31, 2017, 2016 and 2015, respectively. Sales commissions paid to personnel are expensed as incurred.\\nThe Company delivers both stored value cards and card-based services primarily in the form of gift cards. For multiple-deliverable customer contracts, stored value cards and card-based services are separated into two units of accounting. Stored valued cards are generally recognized upon shipment to the customer. Card-based services are recognized when the card services are rendered.\\nThe Company presents taxes assessed by the government imposed concurrent with a revenue producing transaction between us and our customers (e.g. VAT) on a net basis within revenues, net.\\nUse of Estimates\\nThe preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.\\nPrinciples of Consolidation\\nThe accompanying consolidated financial statements include the accounts of FLEETCOR Technologies, Inc. and all of its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated.\\nThe Company’s fiscal year ends on December 31. In certain of the Company’s U.K. businesses, the Company records the operating results using a 4-4-5 week accounting cycle with the fiscal year ending on the Friday on or immediately preceding December 31. Fiscal years 2017, 2016 and 2015 include 52 weeks for the businesses reporting using a 4-4-5 accounting cycle.\\nCredit Risk and Reserve for Losses on Receivables\\nThe Company controls credit risk by performing periodic credit evaluations of its customers. Payments from customers are generally due within 14 days or less of billing. The Company routinely reviews its accounts receivable balances and makes provisions for probable doubtful accounts based primarily on the aging of those balances. Accounts receivable are deemed uncollectible once they age past 90 days and are deemed uncollectible from the customer. The Company also provides an allowance for receivables aged less than 90 days that it expects will be uncollectible based on historical collections experience including accounts that have filed for bankruptcy. At December 31, 2017 and 2016, approximately 96% and 95%, respectively, of outstanding accounts receivable were current. Accounts receivable deemed uncollectible are removed from accounts\\n91\\nreceivable and the allowance for doubtful accounts when internal collection efforts have been exhausted and accounts have been turned over to a third-party collection agency. Recoveries from the third-party collection agency are not significant.\\nBusiness Combinations\\nBusiness combinations completed by the Company have been accounted for under the acquisition method of accounting. The acquisition method requires that the acquired assets and liabilities, including contingencies, be recorded at fair value determined as of the acquisition date and changes thereafter reflected in income. For significant acquisitions, the Company obtains independent third-party valuation studies for certain of the assets acquired and liabilities assumed to assist the Company in determining fair value. Goodwill represents the excess of the purchase price over the fair values of the tangible and intangible assets acquired and liabilities assumed. The results of the acquired businesses are included in the Company’s results of operations beginning from the completion date of the applicable transaction.\\nEstimates of fair value are revised during an allocation period as necessary when, and if, information becomes available to further define and quantify the fair value of the assets acquired and liabilities assumed. Provisional estimates of the fair values of the assets acquired and liabilities assumed involves a number of estimates and assumptions that could differ materially from the final amounts recorded. The allocation period does not exceed one year from the date of the acquisition. To the extent additional information to refine the original allocation becomes available during the allocation period, the allocation of the purchase price is adjusted. Should information become available after the allocation period, those items are adjusted through operating results. The direct costs of the acquisition are recorded as operating expenses. Certain acquisitions include contingent consideration related to the performance of the acquired operations following the acquisition. Contingent consideration is recorded at estimated fair value at the date of the acquisition, and is remeasured each reporting period, with any changes in fair value recorded in the Consolidated Statements of Income. The Company estimates the fair value of the acquisition-related contingent consideration using various valuation approaches, as well as significant unobservable inputs, reflecting the Company’s assessment of the assumptions market participants would use to value these liabilities.\\nImpairment of Long-Lived Assets, Goodwill, Intangibles and Investments\\nThe Company tests its long-lived assets for impairment in accordance with relevant authoritative guidance. The Company evaluates if impairment indicators related to its property, plant and equipment and other long-lived assets are present. These impairment indicators may include a significant decrease in the market price of a long-lived asset or asset group, a significant adverse change in the extent or manner in which a long-lived asset or asset group is being used or in its physical condition, or a current-period operating or cash flow loss combined with a history of operating or cash flow losses or a forecast that demonstrates continuing losses associated with the use of a long-lived asset or asset group. If impairment indicators are present, the Company estimates the future cash flows for the asset or asset group. The sum of the undiscounted future cash flows attributable to the asset or asset group is compared to its carrying amount. The cash flows are estimated utilizing various projections of revenues and expenses, working capital and proceeds from asset disposals on a basis consistent with management’s intended actions. If the carrying amount exceeds the sum of the undiscounted future cash flows, the Company determines the assets’ fair value by discounting the future cash flows using a discount rate required for a similar investment of like risk and records an impairment charge as the difference between the fair value and the carrying value of the asset group. Generally, the Company performs its testing of the asset group at the business-line level, as this is the lowest level for which identifiable cash flows are available.\\nThe Company completes an impairment test of goodwill at least annually or more frequently if facts or circumstances indicate that goodwill might be impaired. Goodwill is tested for impairment at the reporting unit level, and the impairment test consists of two steps, as well as a qualitative assessment, as appropriate. The Company has performed a qualitative assessment of certain of its reporting units. In this qualitative assessment, the Company individually considered the following items for each reporting unit where the Company determined a qualitative analysis to be appropriate: the macroeconomic conditions, including any deterioration of general conditions, limitations on accessing capital, fluctuations in foreign exchange rates and other developments in equity and credit markets; industry and market conditions, including any deterioration in the environment where the reporting unit operates, increased competition, changes in the products/services and regulator and political developments; cost of doing business; overall financial performance, including any declining cash flows and performance in relation to planned revenues and earnings in past periods; other relevant reporting unit specific facts, such as changes in management or key personnel or pending litigation; events affecting the reporting unit, including changes in the carrying value of net assets, likelihood of disposal and whether there were any other impairment considerations within the business; the overall performance of our share price in relation to the market and our peers; and a quantitative stress test of the previously completed step 1 test from the prior year, updated with current year results, weighted-average cost of capital rates and future projections.\\n92\\nIn step 1 of the goodwill impairment test for reporting units, the reporting unit’s carrying amount, including goodwill, is compared to its fair value which is measured based upon, among other factors, a discounted cash flow analysis, as well as market multiples for comparable companies. If the carrying amount of the reporting unit is greater than its fair value, goodwill is considered impaired and step two must be performed. Step two measures the impairment loss by comparing the implied fair value of reporting unit goodwill with the carrying amount of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit to all the assets and liabilities of that unit (including unrecognized intangibles) as if the reporting unit had been acquired in a business combination. The excess of fair value over the amounts allocated to the assets and liabilities of the reporting unit is the implied fair value of goodwill. The excess of the carrying amount over the implied fair value is the impairment loss.\\nThe Company estimated the fair value of its reporting units using a combination of the income approach and the market approach. The income approach utilizes a discounted cash flow model incorporating management’s expectations for future revenue, operating expenses, earnings before interest, taxes, depreciation and amortization, capital expenditures and an anticipated tax rate. The Company discounted the related cash flow forecasts using an estimated weighted-average cost of capital for each reporting unit at the date of valuation. The market approach utilizes comparative market multiples in the valuation estimate. Multiples are derived by relating the value of guideline companies, based on either the market price of publicly traded shares or the prices of companies being acquired in the marketplace, to various measures of their earnings and cash flow. Such multiples are then applied to the historical and projected earnings and cash flow of the reporting unit in developing the valuation estimate.\\nPreparation of forecasts and the selection of the discount rates involve significant judgments about expected future business performance and general market conditions. Significant changes in forecasts, the discount rates selected or the weighting of the income and market approach could affect the estimated fair value of one or more of our reporting units and could result in a goodwill impairment charge in a future period.\\nBased on the goodwill asset impairment analysis performed quantitatively on October 1, 2017, the Company determined that the fair value of each of its reporting units was in excess of the carrying value. No events or changes in circumstances have occurred since the date of this most recent annual impairment test that would more likely than not reduce the fair value of a reporting unit below its carrying amount.\\nThe Company also evaluates indefinite-lived intangible assets (primarily trademarks and trade names) for impairment annually. The Company also tests for impairment if events and circumstances indicate that it is more likely than not that the fair value of an indefinite-lived intangible asset is below its carrying amount. Estimates critical to the Company’s evaluation of indefinite-lived intangible assets for impairment include the discount rate, royalty rates used in its evaluation of trade names, projected average revenue growth and projected long-term growth rates in the determination of terminal values. An impairment charge is recorded if the carrying amount of an indefinite-lived intangible asset exceeds the estimated fair value on the measurement date.\\nThe Company regularly evaluates the carrying value of its investments, which are not carried at fair value, for other-than-temporary impairment. The Company estimates the fair value of its investments using a combination of the income approach and the market approach. The income approach utilizes a discounted cash flow model incorporating management’s expectations for future revenue, operating expenses, earnings before interest, taxes, depreciation and amortization, capital expenditures and an anticipated tax rate. The Company discounts the related cash flow forecasts using an estimated weighted-average cost of capital for each reporting unit at the date of valuation. The market approach utilizes comparative market multiples in the valuation estimate. Multiples are derived by relating the value of guideline companies, based on either the market price of publicly traded shares or the prices of companies being acquired in the marketplace, to various measures of their earnings and cash flow. Such multiples are then applied to the historical and projected earnings and cash flow of the Company's investments in developing the valuation estimate.\\nOn September 30, 2017, the Company entered into an amended Masternaut Group Holdings Limited (\\\"Masternaut\\\") investment agreement that resulted in the loss of significant influence, and the Company began accounting for the Masternaut investment by applying the cost method. The Company regularly evaluates the carrying value of its investment and during the third quarter of 2017, the Company determined that the fair value of its 44% investment in Masternaut had declined as a result of the Company's loss of significant influence and the operating results of Masternaut. As a result, the Company determined that the carrying value of its investment exceeded its fair value, and concluded that this decline in value was other than temporary during the third quarter of 2017. The Company recorded a $44.6 million impairment loss in the Masternaut investment that includes adjustment for $31.4 million of currency losses previously recognized in accumulated other comprehensive income, in the year ended December 31, 2017, in the accompanying Consolidated Statements of Income. During the fourth quarters of 2016 and 2015, the Company determined that the performance improvement initiatives in its investment in Masternaut were\\n93\\ntaking longer to and were more challenging to implement than originally projected, based on revised cash flow projections provided by the business. As a result, the Company recorded a $36.1 million and $40 million non-cash impairment charge in its Masternaut investment for 2016 and 2015, respectively.\\nProperty, Plant and Equipment and Definite-Lived Intangible Assets\\nProperty, plant and equipment are stated at cost and depreciated on the straight-line basis. Definite-lived intangible assets, consisting primarily of customer relationships, are stated at fair value upon acquisition and are amortized over their estimated useful lives. Customer and merchant relationship useful lives are estimated using historical attrition rates.\\nThe Company develops software that is used in providing processing and information management services to customers. A significant portion of the Company’s capital expenditures are devoted to the development of such internal-use computer software. Software development costs are capitalized once technological feasibility of the software has been established. Costs incurred prior to establishing technological feasibility are expensed as incurred. Technological feasibility is established when the Company has completed all planning, designing, coding and testing activities that are necessary to determine that the software can be produced to meet its design specifications, including functions, features and technical performance requirements. Capitalization of costs ceases when the software is ready for its intended use. Software development costs are amortized using the straight-line method over the estimated useful life of the software. The Company capitalized software costs of $37.4 million, $33.1 million and $23.4 million in 2017, 2016 and 2015, respectively. Amortization expense for software totaled $21.8 million, $17.7 million and $11.6 million in 2017, 2016 and 2015, respectively.\\nIncome Taxes\\nThe Company accounts for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date.\\nThe ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which the associated temporary differences become deductible. The Company evaluates on a quarterly basis whether it is more likely than not that its deferred tax assets will be realized in the future and concludes whether a valuation allowance must be established.\\nCurrent accounting guidance clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements and prescribes threshold and measurement attributes for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Under the relevant authoritative literature, the impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more likely than not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50 percent likelihood of being sustained. The Company includes any estimated interest and penalties on tax related matters in income tax expense.\\nIn the fourth quarter of 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (“Tax Act”). As a result of Tax Act, the U.S. federal corporate tax rate was reduced from 35% to 21%. The Tax Act also includes provisions for a tax on all previously undistributed earnings in foreign jurisdictions. The Company has provisionally recorded a $210 million deferred tax benefit for the benefit for the corporate rate reduction on our deferred tax assets and liabilities. Additionally, in 2017, the Company has provisionally recorded an $81.8 million charge on all previously undistributed earnings in foreign jurisdictions. The Company is currently evaluating the remaining undistributed foreign earnings for which it has not provided deferred taxes for foreign withholding tax, as these earnings are considered to be indefinitely reinvested. The amount of these unrecorded deferred taxes is not expected to be material. If in the future these earnings are repatriated to the United States, or if we determine that the earnings will be remitted in the foreseeable future, additional tax provisions may be required. See Note 11 for further information regarding income taxes.\\nCash Equivalents\\nCash equivalents consist of cash on hand and highly liquid investments with original maturities of three months or less. Restricted cash represents customer deposits repayable on demand.\\n94\\nForeign Currency Translation\\nAssets and liabilities of foreign subsidiaries are translated into U.S. dollars at the rates of exchange in effect at period-end. The related translation adjustments are made directly to accumulated other comprehensive income. Income and expenses are translated at the average monthly rates of exchange in effect during the year. Gains and losses from foreign currency transactions of these subsidiaries are included in net income. The Company recognized a foreign exchange loss of $0.2 million, $2.8 million and $2.4 million for the years ended December 31, 2017, 2016 and 2015 respectively, which are recorded within other expense, net in the Consolidated Statements of Income.\\nDerivatives\\nWith its acquisition of Cambridge Global Payments (\\\"Cambridge\\\") in August 2017, the Company uses derivatives to facilitate cross-currency corporate payments by writing derivatives to customers, which are not designated as hedging instruments. The majority of Cambridge's revenue is from exchanges of currency at spot rates, which enable customers to make cross-currency payments. In addition, Cambridge also writes foreign currency forward and option contracts for its customers to facilitate future payments. The duration of these derivative contracts at inception is generally less than one year. The Company aggregates its foreign exchange exposures arising from customer contracts, including forwards, options and spot exchanges of currency, and hedges (economic hedge) the resulting net currency risks by entering into offsetting contracts with established financial institution counterparties. The changes in fair value related to these contracts are recorded in revenues, net in the Consolidated Statements of Income.\\nThe Company recognizes all derivatives in \\\"prepaid expenses and other current assets\\\" and \\\"other current liabilities\\\" in the accompanying Consolidated Balance Sheets at their fair value. All cash flows associated with derivatives are included in cash flows from operating activities in the Consolidated Statements of Cash Flows.\\nStock-Based Compensation\\nThe Company accounts for employee stock options and restricted stock in accordance with relevant authoritative literature. Stock options are granted with an exercise price estimated to be equal to the fair market value on the date of grant as authorized by the Company’s board of directors. Options granted have vesting provisions ranging from one to five years and vesting of the options is generally based on the passage of time or performance. Stock option grants are subject to forfeiture if employment terminates prior to vesting. The Company has selected the Black-Scholes option pricing model for estimating the grant date fair value of stock option awards granted. The Company has considered the retirement and forfeiture provisions of the options and utilized its historical experience to estimate the expected life of the options. Option forfeitures are accounted for upon occurrence. The Company bases the risk-free interest rate on the yield of a zero coupon U.S. Treasury security with a maturity equal to the expected life of the option from the date of the grant. Stock-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense over the requisite service period based on the number of years for which the requisite service is expected to be rendered.\\nAwards of restricted stock and restricted stock units are independent of stock option grants and are subject to forfeiture if employment terminates prior to vesting. The vesting of shares granted is generally based on the passage of time, performance or market conditions, or a combination of these. Shares vesting based on the passage of time have vesting provisions of one to three years. The fair value of restricted stock where the shares vest based on the passage of time or performance is based on the grant date fair value of the Company’s stock.\\nFor performance-based restricted stock awards and performance based stock option awards, the Company must also make assumptions regarding the likelihood of achieving performance goals. If actual results differ significantly from these estimates, stock-based compensation expense and the Company’s results of operations could be materially affected.\\nDeferred Financing Costs/Debt Discounts\\nCosts incurred to obtain financing, net of accumulated amortization, are amortized over the term of the related debt, using the effective interest method and are included within interest expense. The Company capitalized additional debt issuance costs of $12.9 million associated with refinancing its Credit Facility and Securitization Facility in 2017 and $2.3 million with refinancing its Credit Facility in 2016. At December 31, 2017 and 2016, the Company had net deferred financing costs of $16.3 million and $13.1 million, respectively.\\n95\\nComprehensive Income (Loss)\\nComprehensive income (loss) is defined as the total of net income and all other changes in equity that result from transactions and other economic events of a reporting period other than transactions with owners.\\nAccounts Receivable\\nThe Company maintains a $950 million revolving trade accounts receivable Securitization Facility. Accounts receivable collateralized within our Securitization Facility relate to trade receivables resulting from charge card activity in the U.S. Pursuant to the terms of the Securitization Facility, the Company transfers certain of its domestic receivables, on a revolving basis, to FLEETCOR Funding LLC (Funding), a wholly-owned bankruptcy remote subsidiary. In turn, Funding sells, without recourse, on a revolving basis, up to $950 million of undivided ownership interests in this pool of accounts receivable to a multi-seller, asset-backed commercial paper conduit (Conduit). Funding maintains a subordinated interest, in the form of over-collateralization, in a portion of the receivables sold to the Conduit. Purchases by the Conduit are financed with the sale of highly-rated commercial paper.\\nThe Company utilizes proceeds from the sale of its accounts receivable as an alternative to other forms of financing to reduce its overall borrowing costs. The Company has agreed to continue servicing the sold receivables for the financial institution at market rates, which approximates the Company’s cost of servicing. The Company retains a residual interest in the accounts receivable sold as a form of credit enhancement. The residual interest’s fair value approximates carrying value due to its short-term nature. Funding determines the level of funding achieved by the sale of trade accounts receivable, subject to a maximum amount.\\nThe Company’s Consolidated Balance Sheets and Statements of Income reflect the activity related to securitized accounts receivable and the corresponding securitized debt, including interest income, fees generated from late payments, provision for losses on accounts receivable and interest expense. The cash flows from borrowings and repayments, associated with the securitized debt, are presented as cash flows from financing activities.\\nOn November 14, 2017, the Company extended the term of its asset Securitization Facility to November 14, 2020. The Company capitalized $1.7 million in fees in connection with this extension.\\nThe Company’s accounts receivable and securitized accounts receivable include the following at December 31 (in thousands):\\n\\n| 2017 | 2016 |\\n| Gross domestic accounts receivables | $ | 661,677 | $ | 529,885 |\\n| Gross domestic securitized accounts receivable | 811,000 | 591,000 |\\n| Gross foreign receivables | 804,365 | 704,630 |\\n| Total gross receivables | 2,277,042 | 1,825,515 |\\n| Less allowance for doubtful accounts | (46,031 | ) | (32,506 | ) |\\n| Net accounts and securitized accounts receivable | $ | 2,231,011 | $ | 1,793,009 |\\n\\nA rollforward of the Company’s allowance for doubtful accounts related to accounts receivable for the years ended December 31 is as follows (in thousands):\\n\\n| 2017 | 2016 | 2015 |\\n| Allowance for doubtful accounts beginning of year | $ | 32,506 | $ | 21,903 | $ | 23,842 |\\n| Provision for bad debts | 44,857 | 35,885 | 24,629 |\\n| Write-offs | (31,332 | ) | (25,282 | ) | (26,568 | ) |\\n| Allowance for doubtful accounts end of year | $ | 46,031 | $ | 32,506 | $ | 21,903 |\\n\\nAdvertising\\nThe Company expenses advertising costs as incurred. Advertising expense was $26.1 million, $22.2 million and $19.9 million for the years ended December 31, 2017, 2016 and 2015, respectively.\\n96\\nEarnings Per Share\\nThe Company reports basic and diluted earnings per share. Basic earnings per share is calculated using the weighted average of common stock and non-vested, non-forfeitable restricted shares outstanding, unadjusted for dilution, and net income attributable to common shareholders.\\nDiluted earnings per share is calculated using the weighted average shares outstanding and contingently issuable shares less weighted average shares recognized during the period. The net outstanding shares have been adjusted for the dilutive effect of common stock equivalents, which consist of outstanding stock options and unvested forfeitable restricted stock units.\\nPending Adoption of Recently Issued Accounting Standards\\nFrom time to time, new accounting pronouncements are issued by the FASB or other standards setting bodies that are adopted by the Company as of the specified effective date. Unless otherwise discussed, the Company’s management believes that the impact of recently issued standards that are not yet effective will not have a material impact on the Company’s consolidated financial statements upon adoption.\\nTax Act\\nThe SEC staff issued Staff Accounting Bulletin No. 118, \\\"Income Tax Accounting Implications of the Tax Cuts and Jobs Act\\\" (\\\"SAB 118\\\"), which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC 740. In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Act for which the accounting under ASC 740 is complete. To the extent that a company’s accounting for certain income tax effects of the Tax Act is incomplete but it is able to determine a reasonable estimate, it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax laws that were in effect immediately before the enactment of the Tax Act.\\nRevenue Recognition\\nIn May 2014, the FASB issued ASU 2014-09, \\\"Revenue from Contracts with Customers (Topic 606)\\\". The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 will replace most existing revenue recognition guidance in GAAP and permits the use of either the retrospective or modified retrospective transition method. The update requires significant additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments. ASU 2014-09, as amended by ASU 2015-14, \\\"Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date\\\", is effective for years beginning after December 15, 2017, including interim periods, with early adoption permitted for years beginning after December 15, 2016. Since the issuance of ASU 2014-09, the FASB has issued additional interpretive guidance, including new accounting standards updates, that clarifies certain points of the standard and modifies certain requirements.\\nThe Company has performed a review of the requirements of the new revenue standard and is monitoring the activity of the FASB and the transition resource group as it relates to specific interpretive guidance. The Company established an implementation team to assess the effects of the new revenue standard in a multi-phase approach. In the first phase, the Company analyzed customer contracts for its most significant contract categories, applied the five-step model of the new standard to each contract category and comparing the results to our current accounting practices. The second phase, which includes quantifying the potential effects identified during the first phase, assessing additional contract categories and principal versus agent considerations, revising accounting policies and considering the effects on related disclosures and/or internal control over financial reporting is ongoing and expected to be concluded during the first quarter of 2018.\\nThe new standard could change the amount and timing of revenue and expenses to be recognized under certain of our arrangement types. In addition, it could also increase the administrative burden on our operations to account for customer contracts and provide the more expansive required disclosures. More judgment and estimates may be required within the process of applying the requirements of the new standard than are required under existing GAAP, such as identifying performance obligations in contracts, estimating the amount of variable consideration to include in transaction price, allocating transaction price to each separate performance obligation and estimating expected customer lives. The Company is in the process of finalizing its assessment and completing the quantification of the effect the new guidance will have on its consolidated financial statements, related disclosures and/or internal control over financial reporting. This conclusion will be made over the remainder of the first quarter of 2018 and will include finalizing its evaluation of the application of the principal\\n97\\nvs. agent guidance, specifically as it relates to products where we utilize a third-party payment network and in certain businesses where we pay merchant commissions. However, the Company's preliminary view is that the expected amount and timing of revenue to be recognized under ASU 2014-09 for our most significant contract categories, fuel card payments, lodging payments, toll payments, corporate payments, and gift cards, will be similar to the amount and timing of revenue recognized under its current accounting practices, except as it relates to the presentation of certain costs where the Company may be determined to be an agent in the processing relationship under the new guidance, resulting in recording such costs as a reduction of revenue. The Company will be required to capitalize additional costs to obtain contracts with customers, and, in some cases, may be required to amortize these costs over a contractual time period. Finally, the Company expects disclosures about its revenues and related customer acquisition costs to be more extensive.\\nThe Company plans to adopt ASU 2014-09, as well as other clarifications and technical guidance issued by the FASB related to this new revenue standard, on January 1, 2018. The Company will apply the modified retrospective transition method, which would result in an adjustment to retained earnings for the cumulative effect, if any, of applying the standard to contracts that are not completed at the date of initial application. Under this method, the Company would not restate the prior financial statements presented, therefore the new standard requires the Company to provide additional disclosures of the amount by which each financial statement line item is affected in the current reporting period during 2018, as compared to the guidance that was in effect before the change, and an explanation of the reasons for significant changes, if any.\\nAccounting for Leases\\nIn February 2016, the FASB issued ASU 2016-02, “Leases”, which requires lessees to recognize a right-of-use asset and a lease liability on the balance sheet for all leases with the exception of short-term leases. This ASU also requires disclosures to provide additional information about the amounts recorded in the financial statements. This ASU is effective for the Company for annual periods beginning after December 15, 2018 and interim periods therein. Early adoption is permitted. The new standard must be adopted using a modified retrospective transition and requires application of the new guidance for leases that exist or are entered into after the beginning of the earliest comparative period presented. The Company is currently evaluating the impact of ASU 2016-02 on its consolidated financial statements; however, the Company expect to recognize right of use assets and liabilities for operating leases in the Consolidated Balance Sheet upon adoption.\\nAccounting for Breakage\\nIn March 2016, the FASB issued ASU 2016-04, “Liabilities-Extinguishments of Liabilities: Recognition of Breakage for Certain Prepaid Stored-Value Products”, which requires entities that sell prepaid stored value products redeemable for goods, services or cash at third-party merchants to derecognize liabilities related to those products for breakage. This ASU is effective for the Company for reporting periods beginning after December 15, 2017. Early adoption is permitted. The ASU must be adopted using either a modified retrospective approach with a cumulative effect adjustment to retained earnings as of the beginning of the period of adoption or a full retrospective approach. The Company’s adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows.\\nCash Flow Classification\\nIn August 2016, the FASB issued ASU 2016-15, \\\"Classification of Certain Cash Receipts and Cash Payments\\\", which amends the guidance in ASC 230, Statement of Cash Flows. This amended guidance reduces the diversity in practice that has resulted from the lack of consistent principles related to the classification of certain cash receipts and payments in the statement of cash flows. This ASU is effective for the Company for reporting periods beginning after December 15, 2017. Early adoption is permitted. Entities must apply the guidance retrospectively to all periods presented but may apply it prospectively from the earliest date practicable if retrospective application would be impracticable. The Company’s adoption of this ASU is not expected to have a material impact on the results of operations or financial condition.\\nIn November 2016, the FASB issued ASU 2016-18, \\\"Statement of Cash Flows (Topic 230): Restricted Cash\\\", which amends the guidance in ASC 230, Statement of Cash Flows, on the classification and presentation of restricted cash in the statement of cash flows. This ASU is effective for the Company for reporting periods beginning after December 15, 2017. Early adoption is permitted. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. The amendments in this ASU should be applied using a retrospective transition method to each period presented. The Company is evaluating what impact, if any, the adoption of this ASU will have on the results of operations, financial condition, or cash flows.\\nIntangibles - Goodwill and Other Impairment\\nIn January 2017, the FASB issued ASU 2017-04, \\\"Simplifying the Test for Goodwill Impairment\\\", which eliminates the requirement to calculate the implied fair value of goodwill (i.e., Step 2 of the goodwill impairment test) to measure a goodwill impairment charge. Instead, entities will record an impairment charge based on the excess of a reporting unit’s carrying amount over its fair value (i.e., measure the charge based on Step 1). The standard has tiered effective dates, starting in 2020 for\\n98\\ncalendar-year public business entities that meet the definition of an SEC filer. Early adoption is permitted for interim and annual goodwill impairment testing dates after January 1, 2017. The Company’s adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows, unless a goodwill impairment is identified.\\nDefinition of a Business\\nIn January 2017, the FASB issued ASU 2017-01, \\\"Clarifying the Definition of a Business\\\", which amends the definition of a business to assist entities with evaluating when a set of transferred assets and activities is a business. The guidance requires an entity to evaluate if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets. If so, the set of transferred assets and activities is not a business. The guidance also requires a business to include at least one substantive process and narrows the definition of outputs. The guidance is effective for the Company for reporting periods beginning after December 15, 2017, and interim periods within those years. Early adoption is permitted. The Company’s adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows, however it could result in accounting for acquisitions as asset acquisitions versus business combinations upon adoption.\\nAccounting for Modifications to Stock-Based Compensation\\nIn May 2017, the FASB issued ASU 2017-09, \\\"Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting\\\", which amends the scope of modification accounting for share-based payment arrangements. The ASU provides guidance on the types of changes to the terms or conditions of share-based payment awards to which an entity would be required to apply modification accounting under ASC 718. Specifically, an entity would not apply modification accounting if the fair value, vesting conditions and classification of the awards are the same immediately before and after the modification. The guidance is effective for the Company for reporting periods beginning after December 15, 2017, and interim periods within those years. Early adoption is permitted. The Company's adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows.\\nAccounting for Derivative Financial Instruments\\nIn August 2017, the FASB issued ASU 2017-12, \\\"Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities\\\", which amends the hedge accounting recognition and presentation requirements in ASC 815. The FASB issued accounting guidance to better align hedge accounting with a company’s risk management activities, simplify the application of hedge accounting and improve the disclosures of hedging arrangements. The guidance is effective for the Company for reporting periods beginning after December 15, 2018, and interim periods within those years. Early adoption is permitted. The Company's adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows.\\n3. Fair Value Measurements\\nFair value is a market-based measurement that reflects assumptions that market participants would use in pricing an asset or liability. GAAP discusses valuation techniques, such as the market approach (comparable market prices), the income approach (present value of future income or cash flow), and the cost approach (cost to replace the service capacity of an asset or replacement cost). These valuation techniques are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions.\\nAs the basis for evaluating such inputs, a three-tier value hierarchy prioritizes the inputs used in measuring fair value as follows:\\n\\n| • | Level 1: Observable inputs such as quoted prices for identical assets or liabilities in active markets. |\\n\\n| • | Level 2: Observable inputs other than quoted prices that are directly or indirectly observable for the asset or liability, including quoted prices for similar assets or liabilities in active markets; quoted prices for similar or identical assets or liabilities in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable. |\\n\\n| • | Level 3: Unobservable inputs for which there is little or no market data, which require the reporting entity to develop its own assumptions. The fair value hierarchy also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. |\\n\\n99\\nThe following table presents the Company’s financial assets and liabilities which are measured at fair values on a recurring basis as of December 31, 2017 and 2016, (in thousands):\\n\\n| Fair Value | Level 1 | Level 2 | Level 3 |\\n| December 31, 2017 |\\n| Assets: |\\n| Repurchase agreements | $ | 420,838 | $ | — | $ | 420,838 | $ | — |\\n| Money market | 50,423 | — | 50,423 | — |\\n| Certificates of deposit | 7,417 | — | 7,417 | — |\\n| Foreign exchange contracts | 39,045 | 10 | 39,035 | — |\\n| Total cash equivalents | $ | 517,723 | $ | 10 | $ | 517,713 | $ | — |\\n| Cash collateral for foreign exchange contracts | $ | 12,540 | $ | — | $ | — | $ | — |\\n| Liabilities: |\\n| Foreign exchange contracts | $ | 26,888 | $ | 67 | $ | 26,821 | $ | — |\\n| Total liabilities | $ | 26,888 | $ | 67 | $ | 26,821 | $ | — |\\n| Cash collateral obligation for foreign exchange contracts | $ | 10,882 | $ | — | $ | — | $ | — |\\n| December 31, 2016 |\\n| Assets: |\\n| Repurchase agreements | $ | 232,131 | $ | — | $ | 232,131 | $ | — |\\n| Money market | 50,179 | — | 50,179 | — |\\n| Certificates of deposit | 48 | — | 48 | — |\\n| Total cash equivalents | $ | 282,358 | $ | — | $ | 282,358 | $ | — |\\n\\nThe Company has highly-liquid investments classified as cash equivalents, with original maturities of 90 days or less, included in our Consolidated Balance Sheets. The Company utilizes Level 2 fair value determinations derived from directly or indirectly observable (market based) information to determine the fair value of these highly liquid investments. The Company has certain cash and cash equivalents that are invested on an overnight basis in repurchase agreements, money markets and certificates of deposit. The value of overnight repurchase agreements is determined based upon the quoted market prices for the treasury securities associated with the repurchase agreements. The value of money market instruments is the financial institutions' month-end statement, as these instruments are not tradeable and must be settled directly by us with the respective financial institution. Certificates of deposit are valued at cost, plus interest accrued. Given the short-term nature of these instruments, the carrying value approximates fair value. Foreign exchange derivative contracts are carried at fair value, with changes in fair value recognized in the Consolidated Statements of Income. The fair value of the Company's derivatives is derived with reference to a valuation from a derivatives dealer operating in an active market, which the Company accepts as the fair value of these instruments. The fair value represents what would be received and or paid by the Company if the contracts were terminated as of the reporting date. Cash collateral received for foreign exchange derivatives is recorded within customer deposits in our Consolidated Balance Sheet at December 31, 2017. Cash collateral paid for foreign exchange derivatives is recorded within restricted cash in our Consolidated Balance Sheet at December 31, 2017.\\nThe level within the fair value hierarchy and the measurement technique are reviewed quarterly. Transfers between levels are deemed to have occurred at the end of the quarter. There were no transfers between fair value levels during the periods presented for 2017 and 2016.\\nThe Company’s assets that are measured at fair value on a nonrecurring basis and are evaluated with periodic testing for impairment include property, plant and equipment, investments, goodwill and other intangible assets. Estimates of the fair value of assets acquired and liabilities assumed in business combinations are generally developed using key inputs such as management’s projections of cash flows on a held-and-used basis (if applicable), discounted as appropriate, management’s projections of cash flows upon disposition and discount rates. Accordingly, these fair value measurements are in Level 3 of the fair value hierarchy. See footnote 2 for discussion of Masternaut's other than temporary decline in fair value during the year.\\nThe fair value of the Company’s cash, accounts receivable, securitized accounts receivable and related facility, prepaid expenses and other current assets, accounts payable, accrued expenses, customer deposits and short-term borrowings approximate their respective carrying values due to the short-term maturities of the instruments. The carrying value of the\\n100\\nCompany’s debt obligations approximates fair value as the interest rates on the debt are variable market based interest rates that reset on a quarterly basis. These are each Level 2 fair value measurements, except for cash, which is a Level 1 fair value measurement.\\n4. Stockholders' Equity\\nOn February 4, 2016, the Company's Board of Directors approved a stock repurchase program (the \\\"Program\\\") under which the Company may purchase up to an aggregate of $500 million of its common stock over the following 18 months period. On July 27, 2017, the Company's Board of Directors authorized an increase in the size of the Program by an additional $250 million and an extension of the Program by an additional 18 months. On November 1, 2017, the Company announced that its Board of Directors had authorized an increase in the size of the Program by an additional $350 million, resulting in total aggregate repurchases authorized under the Program of $1.1 billion. With the increase and giving effect to the Company's $590.1 million of previous repurchases, the Company may repurchase up to $510 million in shares of its common stock at any time prior to February 1, 2019.\\nAny stock repurchases may be made at times and in such amounts as deemed appropriate. The timing and amount of stock repurchases, if any, will depend on a variety of factors including the stock price, market conditions, corporate and regulatory requirements, and any additional constraints related to material inside information the Company may possess. Any repurchases have been and are expected to be funded by a combination of available cash flow from the business, working capital and debt.\\nOn August 3, 2017, as part of the Program, the Company entered an Accelerated Share Repurchase agreement (\\\"ASR Agreement\\\") with a third-party financial institution to repurchase $250 million of its common stock. Pursuant to the ASR Agreement, the Company delivered $250 million in cash and received 1,491,647 shares based on a stock price of $142.46 on August 7, 2017. The ASR Agreement was completed on September 7, 2017, at which time the Company received 263,012 additional shares based on a final weighted average per share purchase price during the repurchase period of $142.48.\\nThe Company accounted for the ASR Agreement as two separate transactions: (i) as shares of reacquired common stock for the shares delivered to the Company upon effectiveness of the ASR Agreement and (ii) as a forward contract indexed to the Company's common stock for the undelivered shares. The initial delivery of shares was included in treasury stock at cost and results in an immediate reduction of the outstanding shares used to calculate the weighted average common shares outstanding for basic and diluted earnings per share. The forward contracts indexed to the Company's own common stock met the criteria for equity classification, and these amounts were initially recorded in additional paid-in capital and then reclassified to treasury stock upon completion of the ASR agreement.\\nSince the beginning of the Program, 4,114,104 shares for an aggregate purchase price of $590.1 million have been repurchased. There were 2,854,959 common shares totaling $402.4 million repurchased under the Program during 2017.\\n5. Stock Based Compensation\\nThe Company accounts for stock-based compensation pursuant to relevant authoritative guidance, which requires measurement of compensation cost for all stock awards at fair value on the date of grant and recognition of compensation, net of estimated forfeitures, over the requisite service period for awards expected to vest. The Company has Stock Incentive Plans (the Plans) pursuant to which the Company’s board of directors may grant stock options or restricted stock to employees. The Company is authorized to issue grants of restricted stock and stock options to purchase up to 26,963,150 shares for the years ended December 31, 2017, 2016 and 2015, respectively. On May 13, 2013, the Company’s stockholders authorized an increase of 6,500,000 shares of common stock available for grant pursuant to the 2010 Equity Compensation Plan. Giving effect to this increase, there were 277,821 additional shares remaining available for grant under the Plans at December 31, 2017.\\nOn February 7, 2018, the stockholders of the Company approved the FleetCor Technologies, Inc. Amended and Restated 2010 Equity Incentive Plan (the \\\"Amended Plan\\\"). The Amended Plan was authorized and approved by the Company's Board of Directors on December 20, 2017, and Company's stockholders at a special meeting held on February 7, 2018. The Amended Plan amends the Registrant’s existing 2010 Equity Incentive Plan (as amended, the \\\"Prior Plan\\\") to, among other things, increase the number of shares of common stock available for issuance from 13,250,000 to 16,750,000 and make certain other amendments to the Prior Plan.\\n101\\nThe table below summarizes the expense recognized within general and administrative expenses in the Consolidated Statements of Income related to share-based payments recognized for the years ended December 31 (in thousands):\\n| 2017 | 2016 | 2015 |\\n| Stock options | $ | 56,400 | $ | 35,234 | $ | 44,260 |\\n| Restricted stock | 36,897 | 28,712 | 45,862 |\\n| Stock-based compensation | $ | 93,297 | $ | 63,946 | $ | 90,122 |\\n\\nThe tax benefits recorded on stock based compensation were $48.6 million, $35.0 million and $35.7 million for the years ended December 31, 2017, 2016 and 2015, respectively.\\nThe following table summarizes the Company’s total unrecognized compensation cost related to stock-based compensation as of December 31, 2017 (cost in thousands):\\n| UnrecognizedCompensationCost | Weighted AveragePeriod of ExpenseRecognition(in Years) |\\n| Stock options | $ | 84,452 | 1.33 |\\n| Restricted stock | 18,819 | 1.06 |\\n| Total | $ | 103,271 |\\n\\nStock Options\\nThe following summarizes the changes in the number of shares of common stock under option for the following periods (shares and aggregate intrinsic value in thousands):\\n| Shares | WeightedAverageExercisePrice | OptionsExercisableat End ofYear | WeightedAverageExercisePrice ofExercisableOptions | WeightedAverage FairValue ofOptionsGranted Duringthe Year | AggregateIntrinsicValue |\\n| Outstanding at December 31, 2014 | 5,131 | $ | 58.71 | 2,370 | $ | 21.75 | $ | 461,770 |\\n| Granted | 654 | 154.56 | $ | 35.32 |\\n| Exercised | (586 | ) | 33.97 | 63,863 |\\n| Forfeited | (196 | ) | 95.16 |\\n| Outstanding at December 31, 2015 | 5,003 | 72.72 | 2,545 | 26.82 | 351,277 |\\n| Granted | 1,780 | 133.33 | $ | 28.61 |\\n| Exercised | (500 | ) | 42.36 | 49,592 |\\n| Forfeited | (137 | ) | 140.67 |\\n| Outstanding at December 31, 2016 | 6,146 | 91.20 | 3,429 | 55.00 | 309,238 |\\n| Granted | 2,885 | 145.35 | $ | 32.57 |\\n| Exercised | (633 | ) | 71.43 | 76,546 |\\n| Forfeited | (367 | ) | 144.51 |\\n| Outstanding at December 31, 2017 | 8,031 | $ | 109.78 | 4,029 | $ | 75.80 | $ | 663,815 |\\n| Expected to vest at December 31, 2017 | 8,031 | $ | 109.78 |\\n\\n102\\nThe following table summarizes information about stock options outstanding at December 31, 2017 (shares in thousands):\\n| Exercise Price | OptionsOutstanding | Weighted AverageRemaining VestingLife in Years | OptionsExercisable |\\n| $10.00 – 58.02 | 2,218 | 0.00 | 2,218 |\\n| 74.99 – 111.09 | 104 | 0.03 | 90 |\\n| 114.90 – 138.47 | 2,029 | 0.77 | 577 |\\n| 140.23-150.74 | 2,593 | 1.60 | 906 |\\n| 151.16-158.24 | 618 | 1.48 | 195 |\\n| 165.96-174.35 | 469 | 3.08 | 43 |\\n| 8,031 | 4,029 |\\n\\nThe aggregate intrinsic value of stock options exercisable at December 31, 2017 was $469.8 million. The weighted average remaining contractual term of options exercisable at December 31, 2017 was 5.0 years.\\nThe fair value of stock option awards granted was estimated using the Black-Scholes option pricing model with the following weighted-average assumptions for grants or modifications during the years ended December 31 as follows:\\n\\n| 2017 | 2016 | 2015 |\\n| Risk-free interest rate | 1.65 | % | 1.08 | % | 1.47 | % |\\n| Dividend yield | — | — | — |\\n| Expected volatility | 28.00 | % | 27.29 | % | 27.77 | % |\\n| Expected life (in years) | 3.4 | 3.5 | 4.5 |\\n\\nThe weighted-average remaining contractual life for options outstanding was 6.9 years at December 31, 2017.\\nRestricted Stock\\nThere were no restricted stock shares granted with market based vesting conditions in 2017, 2016 and 2015. The following table summarizes the changes in the number of shares of restricted stock and restricted stock units for the following periods (shares in thousands):\\n| Shares | WeightedAverageGrant DateFair Value |\\n| Outstanding at December 31, 2014 | 716 | $ | 121.38 |\\n| Granted | 126 | 151.33 |\\n| Cancelled | (52 | ) | 135.92 |\\n| Issued | (293 | ) | 85.40 |\\n| Outstanding at December 31, 2015 | 497 | 149.40 |\\n| Granted | 152 | 128.90 |\\n| Cancelled | (41 | ) | 145.25 |\\n| Issued | (229 | ) | 151.72 |\\n| Outstanding at December 31, 2016 | 379 | 140.39 |\\n| Granted | 238 | 141.99 |\\n| Cancelled | (48 | ) | 152.95 |\\n| Issued | (204 | ) | 136.85 |\\n| Outstanding at December 31, 2017 | 365 | $ | 155.58 |\\n\\n103\\n6. Acquisitions\\n2017 Acquisitions\\nDuring 2017, the Company completed acquisitions with an aggregate purchase price of $720.8 million, net of cash acquired of $96.2 million and inclusive of notes payable of $29.3 million. During 2017, the Company made investments in other businesses of $39 million.\\nCambridge Global Payments\\nOn August 9, 2017, the Company acquired Cambridge, a leading business to business (B2B) international payments provider, for approximately $616.1 million in cash, net of cash acquired of $94.5 million and inclusive of a note payable of $23.8 million. Cambridge processes B2B cross-border payments, assisting business clients in making international payments. The purpose of this acquisition is to further expand the Company's corporate payments footprint. The Company financed the acquisition using a combination of existing cash and borrowings under its existing credit facility. The results from Cambridge are reported in its North America segment. The following table summarizes the preliminary acquisition accounting for Cambridge (in thousands):\\n| Restricted cash | $ | 37,666 |\\n| Trade and other receivables | 61,801 |\\n| Prepaid expenses and other current assets | 15,190 |\\n| Property and equipment | 7,106 |\\n| Other long term assets | 10,025 |\\n| Goodwill | 500,391 |\\n| Customer relationships and other identifiable intangible assets | 271,793 |\\n| Liabilities assumed | (194,552 | ) |\\n| Deferred tax liabilities | (93,364 | ) |\\n| Aggregate purchase price | $ | 616,056 |\\n\\nThe estimated fair value of intangible assets acquired and the related estimated useful lives consisted of the following (in thousands):\\n| Useful Lives (in Years) | Value |\\n| Banking relationships | 20 | $ | 705 |\\n| Trade name and trademarks | Indefinite | 35,110 |\\n| Technology | 5 | 16,039 |\\n| Customer relationships - excluding Accounts Payable Solutions | 7-18 | 178,190 |\\n| Customer relationships - Accounts Payable Solutions | 20 | 41,749 |\\n| $ | 271,793 |\\n\\nAlong with the Company's acquisition of Cambridge, the Company signed noncompete agreements with certain parties with an estimated fair value of $5.8 million. Acquisition accounting for Cambridge is preliminary as the Company is still completing the valuation for goodwill, intangible assets, income taxes, certain acquired contingencies, derivatives and the working capital adjustment period remains open. Goodwill recorded is comprised primarily of expected synergies from combining the operations of the Company and Cambridge, as well as assembled workforce.\\nOther\\nDuring 2017, the Company acquired Creative Lodging Solutions (\\\"CLS\\\"), a small lodging tuck-in business, and a fuel card provider in Russia for approximately $104.7 million, net of cash acquired of $1.8 million and inclusive of a note payable of $5.5 million. The Company financed the acquisitions using a combination of existing cash and borrowings under its existing credit facility. The accounting for these acquisitions is preliminary as the Company is still completing the valuation of goodwill, intangible assets, income taxes and evaluation of acquired contingencies.\\n104\\nThe following table summarizes the preliminary acquisition accounting for the acquisitions (in thousands):\\n| Trade and other receivables | $ | 37,986 |\\n| Prepaid expenses and other | 1,426 |\\n| Property and equipment | 5,745 |\\n| Goodwill | 55,711 |\\n| Other intangible assets | 53,259 |\\n| Liabilities assumed | (32,202 | ) |\\n| Deferred tax liabilities | (17,217 | ) |\\n| Aggregate purchase prices | $ | 104,708 |\\n\\nThe estimated fair value of intangible assets acquired and the related estimated useful lives consisted of the following (in thousands):\\n| Useful Lives (in Years) | Value |\\n| Trade name and trademarks | 1 | $ | 180 |\\n| Technology | 4 | 1,750 |\\n| Customer relationships | 8 | 51,329 |\\n| $ | 53,259 |\\n\\nAlong with the Company's acquisition of CLS, the Company signed noncompete agreements with certain parties with an estimated fair value of $4.5 million.\\n2016 Acquisitions\\nDuring 2016, the Company completed acquisitions with an aggregate purchase price of $1.3 billion, net of cash acquired of $51.3 million, which includes deferred payments made during the period related to prior acquisitions of $6.1 million.\\nDuring 2016, the Company made additional investments of $7.9 million related to its equity method investment at Masternaut. The Company also received a $9.2 million return of its investment in Masternaut in 2016.\\nSTP\\nOn August 31, 2016, the Company acquired all of the outstanding stock of Serviços e Tecnologia de Pagamentos S.A. (“STP”), for approximately $1.23 billion, net of cash acquired of $40.2 million. STP is an electronic toll payments company in Brazil and provides cardless fuel payments at a number of Shell sites throughout Brazil. The purpose of this acquisition was to expand the Company's presence in the toll market in Brazil. The Company financed the acquisition using a combination of existing cash and borrowings under its existing credit facility. Results from the acquired business have been reported in the Company's international segment since the date of acquisition. The following table summarizes the acquisition accounting for STP (in thousands):\\n\\n| Trade and other receivables | $ | 243,157 |\\n| Prepaid expenses and other | 5,757 |\\n| Deferred tax assets | 20,644 |\\n| Property and equipment | 44,226 |\\n| Other long term assets | 14,280 |\\n| Goodwill | 663,040 |\\n| Customer relationships and other identifiable intangible assets | 548,682 |\\n| Liabilities assumed | (312,297 | ) |\\n| Aggregate purchase price | $ | 1,227,489 |\\n\\n105\\nThe estimated fair value of intangible assets acquired and the related estimated useful lives consisted of the following (in thousands):\\n| Useful Lives(in Years) | Value |\\n| Customer relationships | 8.5-20 | $ | 348,414 |\\n| Trade names and trademarks | Indefinite | 154,851 |\\n| Technology | 6 | 45,417 |\\n| $ | 548,682 |\\n\\nIn connection with the STP acquisition, the Company recorded contingent liabilities aggregating $15.1 million, recorded within other noncurrent liabilities and accrued expenses in the Consolidated Balance Sheet at the date of acquisition. A portion of these acquired liabilities have been indemnified by the respective sellers. As a result, an indemnification asset of $15.1 million was recorded within prepaid and other long term assets in the Consolidated Balance Sheet. Along with the Company's acquisition of STP, the Company signed noncompete agreements with certain parties with an estimated fair value of $23.2 million.\\nGoodwill recognized is comprised primarily of expected synergies from combining the operations of the Company and STP, as well as the assembled workforce. The goodwill and definite lived intangibles acquired with STP will be deductible for tax purposes.\\nOther\\nDuring 2016, the Company acquired additional fuel card portfolios in the U.S. and the United Kingdom, additional Shell fuel card markets in Europe and Travelcard in the Netherlands totaling approximately $76.7 million, net of cash acquired of $11.1 million. The following table summarizes the acquisition accounting for these acquisitions (in thousands):\\n| Trade and other receivables | $ | 27,810 |\\n| Prepaid expenses and other | 5,097 |\\n| Property and equipment | 992 |\\n| Goodwill | 28,540 |\\n| Other intangible assets | 61,823 |\\n| Deferred tax asset | 146 |\\n| Deferred tax liabilities | (5,123 | ) |\\n| Liabilities assumed | (42,550 | ) |\\n| Aggregate purchase prices | $ | 76,735 |\\n\\nThe estimated fair value of intangible assets acquired and the related estimated useful lives consisted of the following (in thousands):\\n| Useful Lives(in Years) | Value |\\n| Customer relationships and other identifiable intangible assets | 10-18 | $ | 61,823 |\\n| $ | 61,823 |\\n\\n2015 Acquisitions\\nDuring 2015, the Company completed acquisitions of Shell portfolios related to our fuel card businesses in Europe, as well as a small acquisition internationally, with an aggregate purchase price of $46.3 million, made additional investments of $8.4 million related to its equity method investment at Masternaut and deferred payments of $3.4 million related to acquisitions occurring in prior years.\\n106\\nThe following table summarizes the acquisition accounting for the acquisitions completed during 2015 (in thousands):\\n\\n| Trade and other receivables | $ | 521 |\\n| Prepaid expenses and other | 996 |\\n| Property and equipment | 197 |\\n| Goodwill | 9,561 |\\n| Other intangible assets | 39,791 |\\n| Deferred tax liabilities | (2,437 | ) |\\n| Liabilities assumed | (2,331 | ) |\\n| Aggregate purchase prices | $ | 46,298 |\\n\\nThe final estimated fair value of intangible assets acquired and the related estimated useful lives consisted of the following (in thousands):\\n| Useful Lives(in Years) | Value |\\n| Customer relationships | 14-20 | $ | 39,791 |\\n| $ | 39,791 |\\n\\n7. Goodwill and Other Intangible Assets\\n| December 31, 2016 | Acquisitions | Dispositions | Acquisition AccountingAdjustments | ForeignCurrency | December 31, 2017 |\\n| Segment |\\n| North America | $ | 2,640,409 | $ | 534,777 | $ | (92,046 | ) | $ | — | $ | 983 | $ | 3,084,123 |\\n| International | 1,554,741 | 21,325 | — | 3,752 | 51,882 | 1,631,700 |\\n| $ | 4,195,150 | $ | 556,102 | $ | (92,046 | ) | $ | 3,752 | $ | 52,865 | $ | 4,715,823 |\\n\\n\\n| December 31, 2015 | Acquisitions | Acquisition AccountingAdjustments | ForeignCurrency | December 31, 2016 |\\n| Segment |\\n| North America | $ | 2,640,409 | $ | — | $ | — | $ | — | $ | 2,640,409 |\\n| International | 905,625 | 687,828 | (521 | ) | (38,191 | ) | 1,554,741 |\\n| $ | 3,546,034 | $ | 687,828 | $ | (521 | ) | $ | (38,191 | ) | $ | 4,195,150 |\\n\\nAt December 31, 2017 and 2016, approximately $988.0 million and $362.6 million of the Company’s goodwill is deductible for tax purposes, respectively. Acquisition accounting adjustments recorded in 2017 and 2016 are a result of the Company completing its acquisition accounting and working capital adjustments for certain prior year acquisitions.\\n107\\nOther intangible assets consisted of the following at December 31 (in thousands):\\n\\n| 2017 | 2016 |\\n| Weighted-Avg UsefulLife(Years) | GrossCarryingAmounts | AccumulatedAmortization | NetCarryingAmount | GrossCarryingAmounts | AccumulatedAmortization | NetCarryingAmount |\\n| Customer and vendor agreements | 17.0 | $ | 2,698,428 | $ | (605,347 | ) | $ | 2,093,081 | $ | 2,449,389 | $ | (458,118 | ) | $ | 1,991,271 |\\n| Trade names and trademarks—indefinite lived | N/A | 499,587 | — | 499,587 | 510,952 | — | 510,952 |\\n| Trade names and trademarks—other | 13.8 | 2,986 | (2,207 | ) | 779 | 2,746 | (2,021 | ) | 725 |\\n| Software | 6.0 | 219,019 | (116,654 | ) | 102,365 | 211,331 | (85,167 | ) | 126,164 |\\n| Non-compete agreements | 4.5 | 48,221 | (19,076 | ) | 29,145 | 35,191 | (11,070 | ) | 24,121 |\\n| Total other intangibles | $ | 3,468,241 | $ | (743,284 | ) | $ | 2,724,957 | $ | 3,209,609 | $ | (556,376 | ) | $ | 2,653,233 |\\n\\nChanges in foreign exchange rates resulted in a $24.2 million increase to the carrying values of other intangible assets in the year ended December 31, 2017. Amortization expense related to intangible assets for the years ended December 31, 2017, 2016 and 2015 was $211.8 million, $161.6 million and $159.7 million, respectively. As part of the Company's plan to exit the telematics business, on July 27, 2017, the Company sold NexTraq, a U.S. fleet telematics business, to Michelin Group, resulting in a $41.8 million reduction in the net carrying values of other intangible assets.\\nThe future estimated amortization of intangibles at December 31, 2017 is as follows (in thousands):\\n\\n| 2018 | $ | 220,506 |\\n| 2019 | 206,174 |\\n| 2020 | 186,259 |\\n| 2021 | 182,156 |\\n| 2022 | 171,177 |\\n| Thereafter | 1,259,098 |\\n\\n8. Property, Plant and Equipment\\nProperty, plant and equipment, net consisted of the following at December 31 (in thousands):\\n| EstimatedUseful Lives(in Years) | 2017 | 2016 |\\n| Computer hardware and software | 3 to 5 | $ | 244,655 | $ | 197,958 |\\n| Card-reading equipment | 4 to 6 | 25,462 | 25,553 |\\n| Furniture, fixtures, and vehicles | 2 to 10 | 18,846 | 15,418 |\\n| Buildings and improvements | 5 to 50 | 21,603 | 14,432 |\\n| Property, plant and equipment, gross | 310,566 | 253,361 |\\n| Less: accumulated depreciation | (130,509 | ) | (110,857 | ) |\\n| Property, plant and equipment, net | $ | 180,057 | $ | 142,504 |\\n\\nDepreciation expense related to property and equipment for the years ended December 31, 2017, 2016 and 2015 was $46.6 million, $36.5 million and $30.5 million, respectively. Depreciation expense includes $21.8 million, $17.7 million and $11.6 million, for capitalized computer software costs for the years ended December 31, 2017, 2016 and 2015, respectively. At December 31, 2017 and 2016, the Company had unamortized computer software costs of $75.8 million and $60.2 million, respectively.\\n108\\n9. Accrued Expenses\\nAccrued expenses consisted of the following at December 31 (in thousands):\\n\\n| 2017 | 2016 |\\n| Accrued bonuses | $ | 15,119 | $ | 15,866 |\\n| Accrued payroll and severance | 18,500 | 10,704 |\\n| Accrued taxes | 63,698 | 104,623 |\\n| Accrued commissions/rebates | 47,198 | 43,467 |\\n| Other | 93,957 | 64,152 |\\n| $ | 238,472 | $ | 238,812 |\\n\\n10. Debt\\nThe Company’s debt instruments at December 31 consist primarily of term notes, revolving lines of credit and a Securitization Facility as follows (in thousands):\\n| 2017 | 2016 |\\n| Term notes payable—domestic(a), net of discounts | $ | 2,993,667 | $ | 2,639,279 |\\n| Revolving line of credit A Facility—domestic(a) | 635,000 | 465,000 |\\n| Revolving line of credit B Facility—foreign(a) | 28,334 | 123,412 |\\n| Revolving line of credit B Facility—swing line(a) | 6,879 | 26,608 |\\n| Other(c) | 43,736 | 12,934 |\\n| Total notes payable and other obligations | 3,707,616 | 3,267,233 |\\n| Securitization Facility(b) | 811,000 | 591,000 |\\n| Total notes payable, credit agreements and Securitization Facility | $ | 4,518,616 | $ | 3,858,233 |\\n| Current portion | $ | 1,616,512 | $ | 1,336,506 |\\n| Long-term portion | 2,902,104 | 2,521,727 |\\n| Total notes payable, credit agreements and Securitization Facility | $ | 4,518,616 | $ | 3,858,233 |\\n\\n_____________________\\n| (a) | The Company has a Credit Agreement, which has been amended multiple times and provides for senior secured credit facilities consisting of a revolving A credit facility in the amount of $1.285 billion, a term loan A facility in the amount of $2.69 billion and a term loan B facility in the amount of $350 million as of December 31, 2017. The revolving credit facility consists of (a) a revolving A credit facility in the amount of $800 million, with sublimits for letters of credit and swing line loans, (b) a revolving B facility in the amount of $450 million for swing line loans and multi-currency borrowings and, (c) a revolving C facility in the amount of $35 million for multi-currency borrowings in Australian Dollars or New Zealand Dollars. The Credit Agreement also includes an accordion feature for borrowing an additional $750 million in term A, term B or revolver A debt. Proceeds from the credit facilities may be used for working capital purposes, acquisitions, and other general corporate purposes. On January 20, 2017, the Company entered into the second amendment to the Credit Agreement, which established a new term B loan. On August 2, 2017, the Company entered into the third amendment to the Credit Agreement, which increased the total facility by $708.7 million and extended the terms of the credit facilities to August 2, 2022 for the term A loan, revolving loans, and letters of credit under the Credit Agreement and August 2, 2024 for the term B loan. |\\n\\nInterest on amounts outstanding under the Credit Agreement (other than the term B loan) accrues based on the British Bankers Association LIBOR Rate (the Eurocurrency Rate), plus a margin based on a leverage ratio, or our option, the Base Rate (defined as the rate equal to the highest of (a) the Federal Funds Rate plus 0.50%, (b) the prime rate announced by Bank of America, N.A., or (c) the Eurocurrency Rate plus 1.00%) plus a margin based on a leverage ratio. Interest on the term B loan facility accrues based on the Eurocurrency Rate plus 2.00% for Eurocurrency Loans and at 1.00% for Base Rate Loans. In addition, the Company pays a quarterly commitment fee at a rate per annum ranging from 0.20% to 0.40% of the daily unused portion of the credit facility.\\nAt December 31, 2017, the interest rate on the term A loan and the domestic revolving A facility was 3.32%, the interest rate on the foreign revolving B facility was 2.25%, the interest rate on the revolving B facility foreign swing line of\\n109\\ncredit was 2.22% and the interest rate on the term B loan was 3.57%. The unused credit facility was 0.35% for all revolving facilities at December 31, 2017.\\nThe term loans are payable in quarterly installments and are due on the last business day of each March, June, September, and December with the final principal payment due on the respective maturity date. Borrowings on the revolving line of credit are repayable at the option of one, two, three or nine months after borrowing, depending on the term of the borrowing on the facility. Borrowings on the foreign swing line of credit are due no later than ten business days after such loan is made.\\nAt December 31, 2017, the Company had $2.7 billion in borrowings outstanding on term A loan, excluding the related debt discount, $349.1 million in borrowings outstanding on term B loan, excluding the related debt discount, $635 million in borrowings outstanding on the domestic revolving A facility, $28.3 million in borrowings outstanding on the foreign revolving B facility and $6.9 million in borrowings outstanding on the foreign swing line revolving B facility. The Company has unamortized debt discounts of $6.0 million related to the term A facility and $0.7 million related to the term B facility and deferred financing costs of $5.1 million at December 31, 2017. In August 2017, the Company expensed $3.3 million and capitalized $10.6 million of debt issuance costs associated with the refinancing of its Credit Facility. The effective interest rate incurred on term loans was 2.69% and 2.57% during 2017 and 2016, respectively, related to the discount on debt. Principal payments of $423.2 million were made on the term loans during 2017.\\n\\n| (b) | The Company is party to a $950 million receivables purchase agreement (Securitization Facility) that was amended and restated on November 14, 2017. There is a program fee equal to one month LIBOR plus 0.90% or the Commercial Paper Rate plus 0.80% as of December 31, 2017 and one month LIBOR or the Commercial Paper Rate plus 0.90% as of December 31, 2016. The program fee was 1.55% plus 0.86% as of December 31, 2017 and 0.85% plus 0.90% as of December 31, 2016. The unused facility fee is payable at a rate of 0.40% as of December 31, 2017 and 2016. The Securitization Facility provides for certain termination events, which includes nonpayment, upon the occurrence of which the administrator may declare the facility termination date to have occurred, may exercise certain enforcement rights with respect to the receivables, and may appoint a successor servicer, among other things. |\\n\\n| (c) | Other includes the long term portion of contingent consideration and deferred payments associated with certain of our businesses. |\\n\\nThe Company was in compliance with all financial and non-financial covenants at December 31, 2017.\\nThe contractual maturities of the Company’s notes payable and other obligations at December 31, 2017 are as follows (in thousands):\\n\\n| 2018 | $ | 805,512 |\\n| 2019 | 173,927 |\\n| 2020 | 136,197 |\\n| 2021 | 136,337 |\\n| 2022 | 2,121,177 |\\n| Thereafter | 334,466 |\\n\\n11. Income Taxes\\nOn December 22, 2017, the U.S. government enacted tax legislation referred to as the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act makes broad and complex changes to the U.S. tax code, including, but not limited to, (1) reducing the U.S. federal corporate tax rate from 35 percent to 21 percent; (2) requiring companies to pay a one-time Deemed Repatriation Transition Tax (“Transition Tax”) on certain unrepatriated earnings of foreign subsidiaries that can be paid over eight years; (3) a new provision designed to tax global intangible low-taxed income (GILTI), which allows for the possibility of using foreign tax credits (FTCs) and a deduction of up to 50 percent to offset the income tax liability (subject to some limitations); (4) the repeal of the domestic production activity deduction beginning January 1, 2018; (5) limitations on the deductibility of certain executive compensation; and (6) a new limitation on deductible interest expense beginning January 1, 2018.\\nAt December 31, 2017, the Company has not completed its accounting for the tax effects of enactment of the Tax Act. However, as described below, the Company has made a reasonable estimate of the effects on its existing deferred tax balances and the one-time Transition Tax. In other cases, the Company has not been able to make a reasonable estimate and continue to\\n110\\naccount for those items based on its existing accounting under ASC 740 (\\\"Income Taxes\\\"), and the provisions of the tax laws that were in effect immediately prior to enactment. The Company was not able to make a reasonable estimate of the impact of the new limitations on the deductibility of certain executive compensation.\\nFor those items for which it was able to determine a reasonable estimate, the Company recognized a provisional net tax benefit of $128.2 million, which is included as a component of income tax expense from continuing operations. In all cases, the Company will continue to make and refine its calculations as additional analysis is completed. In addition, it is anticipated that the U.S. Treasury Department will publish new regulations providing some clarity to many of the provisions included in the new act. As a result, the Company's estimates may also be affected as it gains a more thorough understanding of the Tax Act via new regulations and other guidance.\\nThe SEC staff issued Staff Accounting Bulletin No. 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act (\\\"SAB 118\\\"), which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC 740. In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Act for which the accounting under ASC 740 is complete. To the extent that a company’s accounting for certain income tax effects of the Tax Act is incomplete but it is able to determine a reasonable estimate, it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax laws that were in effect immediately before the enactment of the Tax Act.\\nIn connection with its initial analysis of the impact of the Tax Act, the Company has recorded a net tax benefit of $128.2 million in the period ending December 31, 2017. This net benefit primarily consists of a net benefit for the corporate rate reduction on the deferred tax assets and liabilities of $210 million and a net expense for the Transition Tax of $81.8 million. For various reasons that are discussed more fully below, the Company has not completed its accounting for the income tax effects of certain elements of the Tax Act. However, the Company was able to make reasonable estimates of the effects of the elements for which its analysis is not yet complete and recorded provisional adjustments.\\nThe Company's accounting for the following elements of the Tax Act are incomplete. However, the Company was able to make reasonable estimates of certain effects and, therefore, recorded provisional adjustments.\\nDeferred tax effects\\nThe Tax Act reduces the corporate tax rate to 21 percent, effective January 1, 2018. For its deferred tax assets and deferred tax liabilities, the Company has recorded a provisional decrease of $210 million with a corresponding net adjustment to deferred tax benefit of $210 million for the year ended December 31, 2017. While the Company was able to make a reasonable estimate of the impact of the reduction in corporate rate, the impact may be affected by other analysis related to the Tax Act, including, but not limited to, FLEETCOR's calculation of deemed repatriation of deferred foreign income and the state tax effect of adjustments made to federal temporary differences.\\nOne time transition tax\\nThe Transition Tax is a tax on previously untaxed accumulated and current earnings and profits (\\\"E&P\\\") of certain of the Company's foreign subsidiaries. To determine the amount of the Transition Tax, the Company must determine, in addition to other factors, the amount of post-1986 E&P of the relevant subsidiaries, as well as the amount of non-U.S. income taxes paid on such earnings. The Company was able to make a reasonable estimate of the Transition Tax and recorded a provisional Transition Tax obligation of $81.8 million. However, the Company is continuing to gather additional information to more precisely compute the amount of the Transition Tax. Further, the Transition Tax is based in part on the amount of accumulated and current E&P held in cash and other specified assets. This amount may change when the Company finalizes the calculation of post-1986 foreign E&P previously deferred from U.S. federal taxation and finalize the amounts held in cash or other specified assets. Double tax relief is available for the pool of foreign tax credits attributed to the accumulated and current E&P. The amount of foreign tax credits claimed when the Company finalizes the calculation of the pool of foreign tax credits.\\nNo additional income taxes have been provided for any remaining undistributed foreign earnings not subject to the Transition Tax, or any additional outside basis differences inherent in these entities, as these amounts continue to be indefinitely reinvested in foreign operations. The Company has not been able to make a reasonable estimate of the impact of the unrecognized deferred tax liability related to any remaining undistributed foreign earnings not subject to the Transition Tax or additional outside basis differences in these entities.\\n111\\nThe Company has also not been able to make a reasonable estimate of the impact of the new limitations on the deductibility of certain executive compensation and continues to account for that item based on its existing accounting under ASC 740 and the provisions of the tax laws that were in effect immediately prior to enactment.\\nGlobal Intangible Low-Taxed Income\\nThe Tax Act subjects a U.S. shareholder to current tax on global intangible low-taxed income (GILTI) earned by certain foreign subsidiaries. The FASB Staff Q&A, Topic 740 No. 5, \\\"Accounting for Global Intangible Low-Taxed Income\\\", states that an entity can make an accounting policy election to either recognize deferred taxes for temporary differences expected to reverse as GILTI in future years or provide for the tax expense related to GILTI in the year the tax is incurred. Based on the Company's preliminary assessment of the GILTI tax, the Company believes it will recognize tax on GILTI as a period expense.\\nIncome before the provision for income taxes is attributable to the following jurisdictions for years ended December 31 (in thousands) :\\n| 2017 | 2016 | 2015 |\\n| United States | $ | 524,669 | $ | 383,427 | $ | 304,743 |\\n| Foreign | 368,921 | 259,492 | 231,261 |\\n| Total | $ | 893,590 | $ | 642,919 | $ | 536,004 |\\n\\nThe provision for income taxes for the years ended December 31 consists of the following (in thousands):\\n\\n| 2017 | 2016 | 2015 |\\n| Current: |\\n| Federal | $ | 303,514 | $ | 147,406 | $ | 82,926 |\\n| State | 19,234 | 10,725 | 8,051 |\\n| Foreign | 78,354 | 61,084 | 51,970 |\\n| Total current | 401,102 | 219,215 | 142,947 |\\n| Deferred: |\\n| Federal | (255,188 | ) | (18,723 | ) | 36,723 |\\n| State | 276 | 1,608 | 1,525 |\\n| Foreign | 7,200 | (11,566 | ) | (7,622 | ) |\\n| Total deferred | (247,712 | ) | (28,681 | ) | 30,626 |\\n| Total provision | $ | 153,390 | $ | 190,534 | $ | 173,573 |\\n\\n112\\nThe provision for income taxes differs from amounts computed by applying the U.S. federal tax rate of 35% to income before income taxes for the years ended December 31 due to the following (in thousands):\\n\\n| 2017 | 2016 | 2015 |\\n| Computed “expected” tax expense | $ | 312,756 | 35.0 | % | $ | 225,022 | 35.0 | % | $ | 187,601 | 35.0 | % |\\n| Changes resulting from: |\\n| Change in valuation allowance | 18,289 | 2.0 | 11,952 | 1.9 | 20,243 | 3.8 |\\n| Foreign income tax differential | (38,695 | ) | (4.3 | ) | (25,533 | ) | (4.0 | ) | (23,718 | ) | (4.4 | ) |\\n| State taxes net of federal benefits | 12,884 | 1.4 | 9,439 | 1.5 | 6,711 | 1.2 |\\n| Foreign-sourced nontaxable income | (8,836 | ) | (1.0 | ) | (13,659 | ) | (1.2 | ) | (10,573 | ) | (2.0 | ) |\\n| IRC Section 199 deduction | (8,844 | ) | (1.0 | ) | (7,731 | ) | (1.2 | ) | (10,221 | ) | (1.9 | ) |\\n| Excess tax benefits related to stock-based compensation | (18,058 | ) | (2.0 | ) | (11,974 | ) | (1.9 | ) | — | — |\\n| Subpart F income/transition tax - federal only | 195,779 | 21.9 | — | — | — | — |\\n| Foreign tax credit/transition tax - federal only | (113,955 | ) | (12.8 | ) | — | — | — | — |\\n| Tax reform - federal rate reduction | (209,966 | ) | (23.5 | ) | — | — | — | — |\\n| Other | 12,036 | 1.3 | 3,018 | (0.4 | ) | 3,530 | 0.7 |\\n| Provision for income taxes | $ | 153,390 | 17.2 | % | $ | 190,534 | 29.7 | % | $ | 173,573 | 32.4 | % |\\n\\nThe tax effects of temporary differences that give rise to significant portions of the deferred tax assets and liabilities at December 31 are as follows (in thousands):\\n\\n| 2017 | 2016 |\\n| Deferred tax assets: |\\n| Accounts receivable, principally due to the allowance for doubtful accounts | $ | 6,752 | $ | 7,148 |\\n| Accrued expenses not currently deductible for tax | 442 | 2,647 |\\n| Stock based compensation | 37,274 | 41,415 |\\n| Income tax credits | 376 | 376 |\\n| Net operating loss carry forwards | 41,168 | 45,969 |\\n| Investments | 37,804 | 53,379 |\\n| Accrued escheat | 4,768 | 7,290 |\\n| Fixed assets, intangibles and other | 12,604 | 15,622 |\\n| Deferred tax assets before valuation allowance | 141,188 | 173,846 |\\n| Valuation allowance | (59,349 | ) | (76,395 | ) |\\n| Deferred tax assets, net | 81,839 | 97,451 |\\n| Deferred tax liabilities: |\\n| Intangibles—including goodwill | (508,958 | ) | (687,443 | ) |\\n| Basis difference in investment in foreign subsidiaries | (39,287 | ) | (48,354 | ) |\\n| Prepaid expenses | (1,605 | ) | (3,644 | ) |\\n| Property and equipment, principally due to differences between book and tax depreciation, and other | (49,100 | ) | (24,157 | ) |\\n| Deferred tax liabilities | (598,950 | ) | (763,598 | ) |\\n| Net deferred tax liabilities | $ | (517,111 | ) | $ | (666,147 | ) |\\n\\n113\\nThe Company’s deferred tax balances are classified in its balance sheets as of December 31 as follows (in thousands):\\n\\n| 2017 | 2016 |\\n| Long term deferred tax assets and liabilities: |\\n| Long term deferred tax assets | 1,801 | 2,433 |\\n| Long term deferred tax liabilities | (518,912 | ) | (668,580 | ) |\\n| Net long term deferred taxes | (517,111 | ) | (666,147 | ) |\\n| Net deferred tax liabilities | $ | (517,111 | ) | $ | (666,147 | ) |\\n\\nThe valuation allowance for deferred tax assets at December 31, 2017 and 2016 was $59.3 million and $76.4 million, respectively. These valuation allowances related to basis differences in equity method investments, capital loss carryforwards, income tax credits, foreign net operating loss carryforwards and state net operating loss carryforwards. The net change in the total valuation allowance for the years ended December 31, 2017 and 2016 was a decrease of $17.0 million and an increase of $13.8 million, respectively. The valuation decrease from the prior year was due to the U.S. tax rate reduction that resulted from the Tax Act, which was offset by an increase in basis differences related to equity method investments completed in 2014. The increase in 2016 was primarily due to changes in the Company's deferred tax asset related to basis differences in an equity method investment.\\n| Balances at December 31, 2014 | $ | 27,082 |\\n| Additions | 35,523 |\\n| Balance at December 31, 2015 | 62,605 |\\n| Additions | 13,790 |\\n| Balance at December 31, 2016 | 76,395 |\\n| Additions | 5,332 |\\n| Reduction in valuation allowance due to rate change from Tax Act | (22,378 | ) |\\n| Balance at December 31, 2017 | $ | 59,349 |\\n\\nThe valuation allowances relate to basis differences in cost method investments, capital loss carryforwards, income tax credits, foreign net operating loss carryforwards and state net operating loss carryforwards. The net change in the total valuation allowance for the year ended December 31, 2017 was a decrease of $17.0 million. The valuation decrease from the prior year was due to the U.S. tax rate reduction that resulted from the Tax Act, which was partially offset by an increase in the basis differences related to cost method investments. The increase in 2015 and 2016 were primarily due to changes in the Company's deferred tax asset related to basis differences in a cost method investment.\\nAs of December 31, 2017, the Company had a net operating loss carryforward for state income tax purposes of approximately $590.0 million that is available to offset future state taxable income through 2029. Additionally, the Company had $44.0 million net operating loss carryforwards for foreign income tax purposes that are available to offset future foreign taxable income. The foreign net operating loss carryforwards will not expire in future years.\\nThe Company recognizes interest and penalties on unrecognized tax benefits (including interest and penalties calculated on uncertain tax positions on which the Company believes it will ultimately prevail) within the provision for income taxes on continuing operations in the consolidated financial statements. This policy is a continuation of the Company's policy prior to the adoption of the guidance regarding uncertain tax positions. During 2017 and 2016, the Company had recorded accrued interest and penalties related to the unrecognized tax benefits of $1.3 million and $5.9 million, respectively.\\n114\\nA reconciliation of the beginning and ending balances of the total amounts of gross unrecognized tax benefits including interest for the years ended December 31, 2017, 2016 and 2015 is as follows (in thousands):\\n| Unrecognized tax benefits at December 31, 2014 | $ | 18,641 |\\n| Additions based on tax provisions related to the current year | 9,079 |\\n| Additions based on tax provisions related to the prior year | 477 |\\n| Deductions based on settlement/expiration of prior year tax positions | (6,363 | ) |\\n| Unrecognized tax benefits at December 31, 2015 | 21,834 |\\n| Additions based on tax provisions related to the current year | 3,332 |\\n| Additions based on tax provisions related to the prior year | 2,496 |\\n| Deductions based on settlement/expiration of prior year tax positions | (1,507 | ) |\\n| Unrecognized tax benefits at December 31, 2016 | 26,155 |\\n| Additions based on tax provisions related to the current year | 4,143 |\\n| Additions for tax positions due to acquisitions | 9,208 |\\n| Additions based on tax provisions related to the prior year | 1,171 |\\n| Deductions based on settlement/expiration of prior year tax positions | (9,119 | ) |\\n| Unrecognized tax benefits at December 31, 2017 | $ | 31,558 |\\n\\nAs of December 31, 2017, the Company had total unrecognized tax benefits of $31.6 million of which $31.6 million, if recognized, would affect its effective tax rate. It is not anticipated that there are any unrecognized tax benefits that will significantly increase or decrease within the next twelve months.\\nThe Company files numerous consolidated and separate income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions. The statute of limitations for the Company’s U.S. federal income tax returns has expired for years prior to 2014. The statute of limitations for the Company’s U.K. income tax returns has expired for years prior to 2015. The statute of limitations has expired for years prior to 2014 for the Company’s Czech Republic income tax returns, 2014 for the Company’s Russian income tax returns, 2012 for the Company’s Mexican income tax returns, 2012 for the Company’s Brazilian income tax returns, 2012 for the Company’s Luxembourg income tax returns, 2013 for the Company’s New Zealand income tax returns, and 2015 for the Company’s Australian income tax returns.\\n12. Leases\\nThe Company enters into noncancelable operating lease agreements for equipment, buildings and vehicles. The minimum lease payments for the noncancelable operating lease agreements are as follows (in thousands):\\n\\n| 2018 | $ | 19,343 |\\n| 2019 | 14,362 |\\n| 2020 | 12,132 |\\n| 2021 | 10,661 |\\n| 2022 | 10,195 |\\n| Thereafter | 25,335 |\\n\\nRent expense for noncancelable operating leases approximated $18.4 million, $15.1 million and $14.1 million for the years ended December 31, 2017, 2016 and 2015, respectively. The leases are generally renewable at the Company’s option for periods of one to five years.\\n13. Commitments and Contingencies\\nIn the ordinary course of business, the Company is involved in various pending or threatened legal actions, arbitration proceedings, claims, subpoenas, and matters relating to compliance with laws and regulations (collectively, legal proceedings). Based on our current knowledge, management presently does not believe that the liabilities arising from these legal\\n115\\nproceedings will have a material adverse effect on our consolidated financial condition, results of operations or cash flows. However, it is possible that the ultimate resolution of these legal proceedings could have a material adverse effect on our results of operations and financial condition for any particular period.\\nShareholder Class Action and Derivative Lawsuits\\nOn June 14, 2017, a shareholder filed a class action complaint in the United States District Court for the Northern District of Georgia against the Company and certain of its officers and directors on behalf of all persons who purchased or otherwise acquired the Company’s stock between February 5, 2016 and May 2, 2017. On October 13, 2017, the shareholder filed an amended complaint asserting claims on behalf of a putative class of all persons who purchased or otherwise acquired the Company's common stock between February 4, 2016 and May 3, 2017. The complaint alleges that the defendants made false or misleading statements regarding fee charges and the reasons for its earnings and growth in certain press releases and other public statements in violation of the federal securities laws. Plaintiff seeks class certification, unspecified monetary damages, costs, and attorneys’ fees. The Company disputes the allegations in the complaint and intends to vigorously defend against the claims.\\nOn July 10, 2017, a shareholder derivative complaint was filed against the Company and certain of the Company’s directors and officers in the United States District Court for the Northern District of Georgia seeking recovery on behalf of the Company. The derivative complaint alleges that the defendants issued a false and misleading proxy statement in violation of the federal securities laws; that defendants breached their fiduciary duties by causing or permitting the Company to make allegedly false and misleading public statements concerning the Company’s fee charges, and financial and business prospects; and that certain defendants breached their fiduciary duties through allegedly improper sales of stock. The complaint seeks unspecified monetary damages on behalf of the Company, corporate governance reforms, disgorgement of profits, benefits and compensation by the defendants, restitution, costs, and attorneys’ and experts’ fees. On August 18, 2017, the court entered an order deferring the case pending a ruling on the defendants' motion to dismiss the putative shareholder class action, or until otherwise agreed to by the parties. The defendants dispute the allegations in the complaint and intend to vigorously defend against the claims.\\nEstimating an amount or range of possible losses resulting from litigation proceedings is inherently difficult and requires an extensive degree of judgment, particularly where the matters involve indeterminate claims for monetary damages, and are in the stages of the proceedings where key factual and legal issues have not been resolved. For these reasons, the Company is currently unable to predict the ultimate timing or outcome of, or reasonably estimate the possible losses or a range of possible losses resulting from the matters described above.\\n14. Asset Dispositions\\nTelematics Businesses\\nAs part of the Company's plan to exit the telematics business, on July 27, 2017, the Company sold NexTraq, a U.S. fleet telematics business, to Michelin Group for $316.5 million. The Company recorded a pre-tax gain on the disposal of NexTraq of $175.0 million during the third quarter of 2017, which is net of transaction closing costs. The Company recorded tax on the gain of disposal of $65.8 million. The gain on the disposal is included in other (income) expense, net in the accompanying Consolidated Statements of Income. NexTraq had historically been included in the Company's North America segment.\\n15. Derivative Financial Instruments\\nAs a result of the Cambridge acquisition during 2017, the Company writes derivatives, primarily foreign currency forward contracts, option contracts, and swaps, mostly with small and medium size enterprises that are customers and derives a currency spread from this activity. Derivative transactions include:\\n| • | Forward contracts, which are commitments to buy or sell at a future date a currency at a contract price and will be settled in cash. |\\n\\n| • | Option contracts, which gives the purchaser, the right, but not the obligation to buy or sell within a specified time a currency at a contracted price that may be settled in cash. |\\n\\n| • | Swap contracts, which are commitments to settlement in cash at a future date or dates, usually on an overnight basis. |\\n\\nThe credit risk inherent in derivative agreements represents the possibility that a loss may occur from the nonperformance of a counterparty to the agreements. The Company performs a review of the credit risk of these counterparties at the inception of\\n116\\nthe contract and on an ongoing basis. The Company also monitors the concentration of its contracts with any individual counterparty against limits at the individual counterparty level. The Company anticipates that the counterparties will be able to fully satisfy their obligations under the agreements, but takes action when doubt arises about the counterparties' ability to perform. These actions may include requiring customers to post or increase collateral, and for all counterparties, the possible termination of the related contracts. The Company does not designate any of its foreign exchange derivatives as hedging instruments in accordance with ASC 815.\\nThe aggregate equivalent U.S. dollar notional amount of foreign exchange derivative customer contracts held by the Company as of December 31, 2017 (in millions) is presented in the table below. Notional amounts do not reflect the netting of offsetting trades, although these offsetting positions may result in minimal overall market risk. Aggregate derivative notional amounts can fluctuate from period to period in the normal course of business based on market conditions, levels of customer activity and other factors.\\n| Net Notional |\\n| Foreign exchange contracts: |\\n| Swaps | $ | 515.4 |\\n| Futures, forwards and spot | 3,274.5 |\\n| Written options | 2,934.2 |\\n| Purchased options | 2,314.1 |\\n| Total | $ | 9,038.1 |\\n\\nThe majority of customer foreign exchange contracts are written in major currencies such as the U.S. Dollar, Canadian Dollar, British Pound, Euro and Australian Dollar.\\nThe following table summarizes the fair value of derivatives reported in the Consolidated Balance Sheet as of December 31, 2017 (in millions):\\n| Fair Value, Gross | Fair Value, Net |\\n| Derivative Assets | Derivative Liabilities | Derivative Assets | Derivative Liabilities |\\n| Derivatives - undesignated: |\\n| Over the counter | $ | 80.4 | $ | 68.2 | $ | 39.0 | $ | 26.8 |\\n| Exchange traded | — | 0.1 | — | 0.1 |\\n| Foreign exchange contracts | 80.4 | 68.3 | 39.0 | 26.9 |\\n| Cash collateral | 12.5 | 10.9 | 12.5 | 10.9 |\\n| Total net derivative assets and liabilities | $ | 67.9 | $ | 57.4 | $ | 26.5 | $ | 16.0 |\\n\\nThe fair values of derivative assets and liabilities associated with contracts that include netting language that the Company believes to be enforceable have been netted to present the Company's net exposure with these counterparties. The Company recognizes all derivative assets, net in prepaid expense and other current assets and all derivative liabilities, net in other current liabilities, both net at the customer level as right of offset exists, in its Consolidated Balance Sheets at their fair value. The gain or loss on the fair value is recognized immediately within revenues, net in the Consolidated Statements of Income. The Company does not offset fair value amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral. At December 31, 2017, $39.0 million derivative assets and $26.9 million derivative liabilities were recorded in other current assets and other current liabilities, respectively, in the Consolidated Balance Sheet. The Company receives cash from customers as collateral for trade exposures, which is recorded within cash and cash equivalents and customer deposits in the Consolidated Balance Sheet. The customer has the right to recall their collateral in the event exposures move in their favor, they unwind all outstanding trades or they cease to do business with the Company.\\n16. Earnings Per Share\\nThe Company reports basic and diluted earnings per share. Basic earnings per share is computed by dividing net income attributable to shareholders of the Company by the weighted average number of common shares outstanding during the reported period. Diluted earnings per share reflect the potential dilution related to equity-based incentives using the treasury stock method.\\n117\\nThe calculation and reconciliation of basic and diluted earnings per share for the years ended December 31 (in thousands, except per share data) follows:\\n\\n| 2017 | 2016 | 2015 |\\n| Net income | $ | 740,200 | $ | 452,385 | $ | 362,431 |\\n| Denominator for basic earnings per share | 91,129 | 92,597 | 92,023 |\\n| Dilutive securities | 2,465 | 2,616 | 2,116 |\\n| Denominator for diluted earnings per share | 93,594 | 95,213 | 94,139 |\\n| Basic earnings per share | $ | 8.12 | $ | 4.89 | $ | 3.94 |\\n| Diluted earnings per share | 7.91 | 4.75 | 3.85 |\\n\\nThere were 0.1 million antidilutive shares for the year ended December 31, 2017. Diluted earnings per share for the years ended December 31, 2017, 2016 and 2015 excludes the effect of 0.1 million , 0.4 million and 1.4 million shares, respectively, of common stock that may be issued upon the exercise of employee stock options because such effect would be antidilutive. There were 0.1 million antidilutive shares for 2016. Diluted earnings per share also excludes the effect of 0.3 million, 0.2 million and 0.2 million shares of performance based restricted stock for which the performance criteria have not yet been achieved for the years ended December 31, 2017, 2016 and 2015, respectively.\\n17. Segments\\nThe Company reports information about its operating segments in accordance with the authoritative guidance related to segments. The Company’s reportable segments represent components of the business for which separate financial information is evaluated regularly by the chief operating decision maker in determining how to allocate resources and in assessing performance. The Company operates in two reportable segments, North America and International. The results from the Cambridge business acquired in the third quarter of 2017 and CLS business acquired in the fourth quarter of 2017 are reported in the Company's North America segment. The results from the Company's Russian business acquired in the fourth quarter of 2017 are reported in its International segment. There were no inter-segment sales.\\nThe Company’s segment results are as follows as of and for the years ended December 31 (in thousands):\\n\\n| 2017 | 2016 | 2015 |\\n| Revenues, net: |\\n| North America | $ | 1,428,711 | $ | 1,279,102 | $ | 1,231,957 |\\n| International | 820,827 | 552,444 | 470,908 |\\n| $ | 2,249,538 | $ | 1,831,546 | $ | 1,702,865 |\\n| Operating income: |\\n| North America | $ | 541,598 | $ | 506,414 | $ | 442,052 |\\n| International | 342,162 | 247,739 | 225,482 |\\n| $ | 883,760 | $ | 754,153 | $ | 667,534 |\\n| Depreciation and amortization: |\\n| North America | $ | 139,418 | $ | 129,653 | $ | 127,863 |\\n| International | 125,142 | 73,603 | 65,590 |\\n| $ | 264,560 | $ | 203,256 | $ | 193,453 |\\n| Capital expenditures: |\\n| North America | $ | 40,747 | $ | 39,000 | $ | 19,883 |\\n| International | 29,346 | 20,011 | 21,992 |\\n| $ | 70,093 | $ | 59,011 | $ | 41,875 |\\n| Long-lived assets (excluding goodwill): |\\n| North America | $ | 1,888,599 | $ | 1,664,224 | $ | 1,719,639 |\\n| International | 1,131,610 | 1,203,465 | 602,941 |\\n| $ | 3,020,209 | $ | 2,867,689 | $ | 2,322,580 |\\n\\n118\\nThe Company attributes revenues, net from external customers to individual countries based upon the country in which the related services were rendered. The table below presents certain financial information related to the Company’s significant operations as of and for the years ended December 31 (in thousands):\\n| 2017 | 2016 | 2015 |\\n| Revenues, net by location: |\\n| United States (country of domicile) | $ | 1,400,801 | $ | 1,278,828 | $ | 1,231,641 |\\n| Brazil | 394,550 | 167,769 | 85,124 |\\n| United Kingdom | 236,550 | 229,125 | 248,598 |\\n\\nThe table below presents the Company's revenues, net from its primary product categories as of and for the years ended December 31 (in thousands).\\n| Year Ended December 31, |\\n| 2017 | 2016 | 2015 |\\n| Revenue by Product Category | Revenues, net | Revenues, net | Revenues, net |\\n| Fuel1 | $ | 1,096,153 | $ | 997,398 | $ | 1,115,570 |\\n| Corporate payments | 261,822 | 179,557 | 162,283 |\\n| Tolls | 326,977 | 102,740 | 9,337 |\\n| Lodging | 126,657 | 100,664 | 91,751 |\\n| Gift | 194,099 | 184,743 | 170,095 |\\n| Other | 243,830 | 266,444 | 153,829 |\\n| Consolidated revenues, net | $ | 2,249,538 | $ | 1,831,546 | $ | 1,702,865 |\\n\\n| 1Amounts shown for 2016 and 2015 from previously disclosed amounts conform to the current year's presentation. |\\n\\nThe table below presents the Company's long-lived assets (excluding goodwill) at December 31 (in thousands).\\n| 2017 | 2016 |\\n| Long-lived assets (excluding goodwill): |\\n| United States (country of domicile) | $ | 1,808,043 | $ | 1,664,224 |\\n| Brazil | 688,809 | 784,816 |\\n| United Kingdom | 294,039 | 286,928 |\\n\\nNo single customer represented more than 10% of the Company’s consolidated revenue in 2017, 2016 and 2015.\\n119\\n18. Selected Quarterly Financial Data (Unaudited)\\n\\n| Fiscal Quarters Year Ended December 31, 2017 | First | Second | Third | Fourth |\\n| Revenues, net | $ | 520,433 | $ | 541,237 | $ | 577,877 | $ | 609,991 |\\n| Operating income | 195,068 | 216,043 | 232,637 | 240,012 |\\n| Net income | 123,693 | 130,987 | 202,823 | 282,697 |\\n| Basic earnings per share | $ | 1.34 | $ | 1.42 | $ | 2.23 | $ | 3.15 |\\n| Diluted earnings per share | 1.31 | 1.39 | 2.18 | 3.05 |\\n| Weighted average shares outstanding: |\\n| Basic shares | 92,108 | 92,013 | 90,751 | 89,676 |\\n| Diluted shares | 94,560 | 94,223 | 93,001 | 92,623 |\\n\\n\\n| Fiscal Quarters Year Ended December 31, 2016* | First | Second | Third | Fourth |\\n| Revenues, net | $ | 414,262 | $ | 417,905 | $ | 484,426 | $ | 514,953 |\\n| Operating income | 175,955 | 171,168 | 191,055 | 215,975 |\\n| Net income | 111,090 | 116,253 | 129,618 | 95,424 |\\n| Earnings per share: |\\n| Basic earnings per share | $ | 1.20 | $ | 1.25 | $ | 1.40 | $ | 1.03 |\\n| Diluted earnings per share | 1.17 | 1.22 | 1.36 | 1.00 |\\n| Weighted average shares outstanding: |\\n| Basic shares | 92,516 | 92,665 | 92,631 | 92,574 |\\n| Diluted shares | 95,030 | 95,279 | 95,307 | 95,235 |\\n\\n*2016 quarterly amounts reflect the impact of the Company's adoption of Accounting Standards Update 2016-09, Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payments Accounting, to simplify several aspects of the accounting for share-based compensation, including the income tax consequences.\\nThe sum of the quarterly earnings per common share amounts for 2017 and 2016 may not equal the earnings per common share for the 2017 and 2016 due to rounding.\\nThe fourth quarter of 2017 includes the provisional net tax benefit of $128.2 million as a result of the Tax Act and $11 million of incremental legal fees.\\nThe fourth quarter of 2016 includes a $36.1 million impairment charge related to the Company’s minority investment in Masternaut, partially offset by a $31.8 million decrease in non-cash stock based compensation expense.\\n120\\nITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE\\nNot applicable.\\nITEM 9A. CONTROLS AND PROCEDURES\\nEvaluation of Disclosure Controls and Procedures\\nAs of December 31, 2017, management carried out, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2017, our disclosure controls and procedures were effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in applicable rules and forms and are designed to ensure that information required to be disclosed in those reports is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.\\nManagement Report on Internal Control over Financial Reporting\\nOur management team is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2017. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. As of December 31, 2017, management believes that the Company’s internal control over financial reporting is effective based on those criteria. Our independent registered public accounting firm has issued an audit report on our internal control over financial reporting, which is included in this annual report.\\nIn connection with management's evaluation, our management team excluded from its assessment of the effectiveness of our internal control over financial reporting as of December 31, 2017, the internal controls related to three subsidiaries that we acquired during the year ended December 31, 2017, and for which financial results are included in our consolidated financial statements.\\nOn August 9, 2017, we acquired Cambridge Global Payments (“Cambridge”), a leading business to business (B2B) international payments provider in Canada. On September 26, 2017, we acquired a fuel card provider in Russia. On October 13, 2017, we completed the acquisition of Creative Lodging Solutions (\\\"CLS\\\"), a lodging business, in the United States. Collectively we refer to these transactions as the Acquisitions. These Acquisitions constituted 11% of total assets, at December 31, 2017, and 3% of revenues, for the year then ended. This exclusion was in accordance with Securities and Exchange Commission guidance that an assessment of a recently acquired business may be omitted in management's report on internal control over financial reporting the year of acquisition.\\nBecause of its inherent limitations, internal control over financial reporting may not prevent or detect all misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate. Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Due to such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, such risk.\\nChanges in Internal Control over Financial Reporting\\nThere were no changes in our internal control over financial reporting during the quarter ended December 31, 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\n121\\nITEM 9B. OTHER INFORMATION\\nNot applicable.\\n122\\nPART III\\nITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE\\nA list of our executive officers and biographical information appears in Part I, Item X of this Form 10-K. Information about our directors may be found under the caption “Nominees” and “Continuing Directors” in our Proxy Statement for the Annual Meeting of Shareholders to be held June 6, 2018 (the “Proxy Statement”). Information about our Audit Committee may be found under the caption “Board Committees” in the Proxy Statement. The foregoing information is incorporated herein by reference.\\nThe information in the Proxy Statement set forth under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by reference.\\nWe have adopted the FLEETCOR Code of Business Conduct and Ethics (the “code of ethics”), which applies to our Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer and Corporate Controller, and other finance organization employees. The code of ethics is publicly available on our website at www.fleetcor.com under Investor Relations. If we make any substantive amendments to the code of ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer, or Chief Accounting Officer, we will disclose the nature of the amendment or waiver on that website or in a report on Form 8-K.\\nITEM 11. EXECUTIVE COMPENSATION\\nThe information in the Proxy Statement set forth under the captions “Director Compensation,” “Named Executive Officer Compensation,” “Compensation Committee Report,” and “Compensation Committee Interlocks and Insider Participation” is incorporated herein by reference.\\nITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT\\nAND RELATED STOCKHOLDER MATTERS\\nThe information in the Proxy Statement set forth under the captions “Securities Authorized for Issuance Under Equity Compensation Plans,” “Information Regarding Beneficial Ownership of Principal Shareholders, Directors, and Management” and “Equity Compensation Plan Information” is incorporated herein by reference.\\nITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR\\nINDEPENDENCE\\nThe information set forth in the Proxy Statement under the captions “Director Independence” and “Certain Relationships and Related Transactions” is incorporated herein by reference.\\nITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES\\nInformation concerning principal accountant fees and services appears in the Proxy Statement under the headings “Fees Billed by Ernst & Young LLP” and “Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditor” and is incorporated herein by reference.\\n123\\nPART IV\\nITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES\\n(a) Financial Statements and Schedules\\nThe financial statements are set forth under Item 8 of this Form 10-K, as indexed below. Financial statement schedules have been omitted since they either are not required, not applicable, or the information is otherwise included.\\nIndex to Financial Statements\\n| Page |\\n| Reports of Independent Registered Public Accounting Firm | 83 |\\n| Consolidated Balance Sheets at December 31, 2017 and 2016 | 85 |\\n| Consolidated Statements of Income for the Years Ended December 31, 2017, 2016 and 2015 | 86 |\\n| Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2017, 2016 and 2015 | 87 |\\n| Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2017, 2016 and 2015 | 88 |\\n| Consolidated Statements of Cash Flows for the Years Ended December 31, 2017, 2016 and 2015 | 89 |\\n| Notes to Consolidated Financial Statements | 90 |\\n\\n(b) Exhibit Listing\\n| Exhibit no. |\\n| 2.1 | Stock Purchase Agreement, dated as of April 1, 2009, among FLEETCOR Technologies Operating Company, LLC, CLC Group, Inc., and the entities and individuals identified on the signature pages thereto (incorporated by reference to Exhibit No. 2.1 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\\n| 2.2 | Share Purchase Agreement among Arval UK Group Limited, FLEETCOR UK Acquisition Limited and FLEETCOR Technologies, Inc. (incorporated by reference to exhibit No. 2.1 to the registrant’s Form 8-K, filed with the SEC on December 13, 2011) |\\n| 2.3 | Agreement and Plan of Merger, dated August 12, 2014, by and among Comdata Inc., Ceridian LLC, FLEETCOR Technologies, Inc. and FCHC Project, Inc. (incorporated by reference to Exhibit No. 2.1 to the registrant’s Form 10-Q, filed with the SEC with the SEC on November 10, 2014) |\\n| 2.4 | Amendment to Agreement and Plan of Merger, dated November 10, 2014, by and among Comdata Inc., Ceridian LLC, FLEETCOR Technologies, Inc. and FCHC Project, Inc. (incorporated by reference to Exhibit No. 10.2 to the registrant’s Form 8-K, filed with the SEC on November 17, 2014) |\\n| 2.5 | Acquisition agreement to acquire Serviços e Tecnologia de Pagamentos S.A. (incorporated by reference to Exhibit 2.1 to the registrant’s Form 8-K, File No. 001-35004, filed with the Securities and Exchange Commission on March 18, 2016) |\\n| 3.1 | Amended and Restated Certificate of Incorporation of FLEETCOR Technologies, Inc. (incorporated by reference to Exhibit 3.1 to the registrant’s Annual Report on Form 10-K, File No. 001-35004, filed with SEC on March 25, 2011) |\\n| 3.2 | Amended and Restated Bylaws of FLEETCOR Technologies, Inc. (incorporated by reference to Exhibit 3.1 to the registrant’s Current Report on Form 8-K, filed with the SEC on January 29, 2018) |\\n| 4.1 | Form of Stock Certificate for Common Stock (incorporated by reference to Exhibit 4.1 to Amendment No. 3 to the registrant’s Registration Statement on Form S-1, File No. 333-166092, filed with the SEC on June 29, 2010) |\\n| 10.1* | Form of Indemnity Agreement entered into between FLEETCOR and its directors and executive officers (incorporated by reference to Exhibit 10.1 to Amendment No. 3 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on June 29, 2010) |\\n\\n124\\n| 10.2* | FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.2 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\\n| 10.3* | First Amendment to FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.3 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\\n| 10.4* | Second Amendment to FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.4 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\\n| 10.5* | Third Amendment to FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.5 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\\n| 10.6* | Fourth Amendment to FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.6 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\\n| 10.7* | Form of Incentive Stock Option Award Agreement pursuant to the FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.7 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\\n| 10.8* | Form of Non-Qualified Stock Option Award Agreement pursuant to the FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.8 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\\n| 10.9* | Form of Performance Share Restricted Stock Agreement pursuant to the FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.9 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\\n| 10.10* | FLEETCOR Technologies, Inc. Annual Executive Bonus Program (incorporated by reference to Exhibit 10.11 to Amendment No. 2 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on June 8, 2010) |\\n| 10.11* | Employee Noncompetition, Nondisclosure and Developments Agreement, dated September 25, 2000, between Fleetman, Inc. and Ronald F. Clarke (incorporated by reference to Exhibit 10.12 to Amendment No. 2 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on June 8, 2010) |\\n| 10.12* | Offer Letter, dated September 20, 2002, between FLEETCOR Technologies, Inc. and Eric R. Dey (incorporated by reference to Exhibit 10.13 to Amendment No. 2 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on June 8, 2010) |\\n| 10.13* | Service Agreement, dated July 9, 2007, between FLEETCOR Technologies, Inc. and Andrew R. Blazye (incorporated by reference to Exhibit 10.16 to Amendment No. 2 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on June 8, 2010) |\\n| 10.14 | Sixth Amended and Restated Registration Rights Agreement, dated April 1, 2009, between FLEETCOR Technologies, Inc. and each of the stockholders party thereto (incorporated by reference to Exhibit 10.17 to Amendment No. 2 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on June 8, 2010) |\\n| 10.15 | First Amendment to Sixth Amended and Restated Registration Rights Agreement (incorporated by reference to Exhibit No. 10.17 to the registrant’s form 10-K, filed with the SEC with the SEC on March 25, 2011) |\\n| 10.16 | Form of Indemnity Agreement to be entered into between FLEETCOR and representatives of its major stockholders (incorporated by reference to Exhibit 10.37 to Amendment No. 3 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on June 29, 2010) |\\n| 10.17 | Form of Director Restricted Stock Grant Agreement pursuant to the FLEETCOR Technologies, Inc. 2010 Equity Compensation Plan (incorporated by reference to Exhibit 10.38 to Amendment No. 6 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on November 30, 2010) |\\n| 10.18* | Form of Employee Performance Share Restricted Stock Agreement pursuant to the FLEETCOR Technologies, Inc. 2010 Equity Compensation Plan (incorporated by reference to Exhibit 10.39 to Amendment No. 6 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on November 30, 2010) |\\n\\n125\\n| 10.19* | Form of Employee Incentive Stock Option Award Agreement pursuant to the FLEETCOR Technologies, Inc. 2010 Equity Compensation Plan (incorporated by reference to Exhibit 10.40 to Amendment No. 6 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on November 30, 2010) |\\n| 10.20* | Form of Employee Non-Qualified Stock Option Award Agreement pursuant to the FLEETCOR Technologies, Inc. 2010 Equity Compensation Plan (incorporated by reference to Exhibit 10.41 to Amendment No. 6 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on November 30, 2010) |\\n| 10.21 | Form of Director Non-Qualified Stock Option Award Agreement pursuant to the FLEETCOR Technologies, Inc. 2010 Equity Compensation Plan (incorporated by reference to Exhibit 10.42 to Amendment No. 6 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on November 30, 2010) |\\n| 10.22* | Amended and Restated Employee Noncompetition, Nondisclosure and Developments Agreement, dated November 29, 2010, between FLEETCOR Technologies, Inc. and Ronald F. Clarke (incorporated by reference to Exhibit No. 10.43 to Amendment No. 6 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on November 30, 2010) |\\n| 10.23 | Arrangement Agreement Among FLEETCOR Luxembourg Holdings2 S.À.R.L, FLEETCOR Technologies, Inc. and CTF Technologies, Inc. (incorporated by reference to Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q, filed with the SEC on May 10, 2012) |\\n| 10.24 | Repurchase Agreement, dated November 26, 2012, among the Company and the Repurchase Stockholders (incorporated by reference to Exhibit 10.1 to the registrant’s Form 8-K, filed with the SEC on November 27, 2012) |\\n| 10.25* | FLEETCOR Technologies, Inc. 2010 Equity Compensation Plan, as amended and restated effective February 7, 2018 (incorporated by reference from Appendix A to Exhibit 10.1 to the registrant's Current Report on Form 8-K, filed with the SEC on February 12, 2018 ) |\\n| 10.26 | FLEETCOR Technologies, Inc. Section 162(M) Performance—Based Program (incorporated by reference to Annex A to the registrant’s Proxy Statement, filed with the SEC on April 18, 2014) |\\n| 10.27 | Credit Agreement, dated October 24, 2014, among FLEETCOR Technologies Operating Company, LLC, as Borrower, FLEETCOR Technologies, Inc., as Parent, FLEETCOR Technologies Operating Company, LLC, as a borrower and guarantor, certain of the our foreign subsidiaries as borrowers, Bank of America, N.A., as administrative agent, swing line lender and L/C issuer and a syndicate of financial institutions (incorporated by reference to Exhibit No. 10.4 to the registrant’s Form 10-Q filed with the SEC on November 10, 2014) |\\n| 10.28 | Fifth Amended and Restated Receivables Purchase Agreement, dated November 14, 2014, by and among FLEETCOR Technologies, Inc. and PNC Bank, National Association, as administrator for a group of purchasers and purchaser agents, and certain other parties (incorporated by reference to Exhibit No. 10.1 to the registrant’s Form 8-K, filed with the SEC on November 17, 2014) |\\n| 10.29 | Amended and Restated Performance Guaranty dated as of November 14, 2014 made by FLEETCOR Technologies, Inc. and FLEETCOR Technologies Operating Company, LLC, in favor of PNC Bank, National Association, as administrator under the Fifth Amended and Restated Receivables Purchase Agreement (incorporated by reference to Exhibit 10.32 to the registrant’s Form 10-K, file number 001-35004, filed with the SEC on March 2, 2015) |\\n| 10.30 | Amended and Restated Purchase and Sale Agreement dated as of November 14, 2014, among various entities listed on Schedule I thereto, as originators, and FLEETCOR Funding LLC (incorporated by reference to Exhibit 10.33 to the registrant’s Form 10-K, file number 001-35004, filed with the SEC on March 2, 2015) |\\n| 10.31 | Receivables Purchase and Sale Agreement dated as of November 14, 2014, among Comdata TN, Inc. and Comdata Network, Inc. of California, as the sellers, and Comdata Inc., as the buyer (incorporated by reference to Exhibit 10.34 to the registrant’s Form 10-K, file number 001-35004, filed with the SEC on March 2, 2015) |\\n| 10.32 | Investor Rights Agreement, dated November 14, 2014, between FLEETCOR Technologies, Inc. and Ceridian LLC (incorporated by reference to Exhibit 10.35 to the registrant’s Form 10-K, file number 001-35004, filed with the SEC on March 2, 2015) |\\n| 10.33* | Offer Letter, dated June 19, 2013, between FLEETCOR Technologies, Inc. and John A. Reed (incorporated by reference to Exhibit No. 10.3 to the registrant’s Form 10-Q, filed with the SEC on May 12, 2014) |\\n| 10.34* | Offer Letter, dated July 29, 2014, between FLEETCOR Technologies, Inc. and Armando Lins Netto (incorporated by reference to Exhibit 10.1 to the registrant’s Form 10-Q, file number 001-35004, filed with the SEC on May 11, 2015) |\\n\\n126\\n| 10.35 | First Amendment to the Fifth Amended and Restated Receivables Purchase Agreement, dated as of November 5, 2015, by and among FLEETCOR Funding LLC, FLEETCOR Technologies Operating Company, LLC and PNC Bank, National Association, as administrator for a group of purchasers and purchaser agents, and certain other parties (incorporated by reference to Exhibit 10.2 to the registrant’s Form 10-Q, file number 001-35004, filed with the SEC on November 9, 2015) |\\n| 10.36* | Employee agreement on confidentiality, work product, non-competition, and non-solicitation (incorporated by reference to Exhibit 10.38 to the registrant's Form 10-K, file number 001-35004, filed with the SEC on February 29, 2016) |\\n| 10.37 | Second Amendment to the Fifth Amended and Restated Receivables Purchase Agreement, dated as of December 1, 2015, by and among FLEETCOR Funding LLC, FLEETCOR Technologies Operating Company, LLC and PNC Bank, National Association, as administrator for a group of purchasers and purchaser agents, and certain other parties (incorporated by reference to Exhibit 10.39 to the registrant's Form 10-K, file number 001-35004, filed with the SEC on February 29, 2016) |\\n| 10.40 | First Amendment to Credit Agreement and Lender Joiner Agreement, dated as of August 22, 2016, by and among FLEETCOR Funding LLC, FLEETCOR Technologies Operating Company, LLC and PNC Bank, National Association, as administrator for a group of purchasers and purchaser agents, and certain other parties (incorporated by reference to Exhibit 10.1 to the registrant’s Form 10-Q, filed with the SEC on November 9, 2016) |\\n| 10.41 | Second Amendment to Credit Agreement, dated as of January 2017, among FLEETCOR Technologies Operating Company, LLC, as the Company, FLEETCOR Technologies, Inc., as the Parent, the designated borrowers party hereto, the other guarantors party hereto, Bank of America, N.A., as administrative agent, swing line lender and l/c issuer, and the other lenders party hereto and Merrill Lynch, Pierce, Fenner & Smith Incorporated, as sole lead arranger and sole bookrunner (incorporated by reference to Exhibit 10.41 to the registrant's Form 10-K, filed with the SEC on March 1, 2017) |\\n| 10.42 | Third Amendment to Credit Agreement, dated as of August 2, 2017, among FLEETCOR Technologies Operating Company, LLC, as the Company, FLEETCOR Technologies, Inc., as the Parent, the designated borrowers party hereto, the other guarantors party hereto, Bank of America, N.A., as administrative agent, swing line lender and l/c issuer, and the other lenders party hereto, and Merrill Lynch, Pierce, Fenner & Smith Incorporated, as sole lead arranger and sole bookrunner (incorporated by reference to Exhibit 10.1 to the registrant’s Form 10-Q, filed with the SEC on August 8, 2017) |\\n| 10.43 | Third Amendment to Fifth Amended and Restated Receivables Purchase Agreement, dated as of November 14, 2017, by and among FLEETCOR Funding LLC, FLEETCOR Technologies Operating Company, LLC, PNC Bank, National Association, as administrator for a group of purchasers and purchase agents, and certain other parties |\\n| 11.1 | Statement of Computation of Share Earnings (See Note 16) |\\n| 21.1 | List of subsidiaries of FLEETCOR Technologies, Inc. |\\n| 23.1 | Consent of Independent Registered Public Accounting Firm |\\n| 31.1 | Certification of Chief Executive Officer Pursuant to Section 302 |\\n| 31.2 | Certification of Chief Financial Officer Pursuant to Section 302 |\\n| 32.1 | Certification of Chief Executive Officer Pursuant to Section 906 |\\n| 32.2 | Certification of Chief Financial Officer Pursuant to Section 906 |\\n| 101 | The following financial information for the registrant formatted in XBRL (Extensible Business Reporting Language): (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income; (iv) the Consolidated Statements of Stockholders' Equity; (v) the Consolidated Statements of Cash Flows and (vi) the Notes to Consolidated Financial Statements |\\n\\n| * | Identifies management contract or compensatory plan or arrangement. |\\n\\n127\\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned; thereunto duly authorized, in the City of Atlanta, State of Georgia, on March 1, 2018.\\n\\n| FLEETCOR Technologies, Inc. |\\n| By: | /S/ RONALD F. CLARKE |\\n| Ronald F. Clarke |\\n| President and Chief Executive Officer |\\n\\nPursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of registrant and in the capacities indicated on March 1, 2018.\\n\\n| Signature | Title |\\n| /S/ RONALD F. CLARKE | President, Chief Executive Officer and Chairman of the Board of Directors(Principal Executive Officer) |\\n| Ronald F. Clarke |\\n| /S/ ERIC R. DEY | Chief Financial Officer(Principal Financial Officer and Principal Accounting Officer) |\\n| Eric R. Dey |\\n| /s/ MICHAEL BUCKMAN | Director |\\n| Michael Buckman |\\n| /s/ JOSEPH W. FARRELLY | Director |\\n| Joseph W. Farrelly |\\n| /s/ THOMAS M. HAGERTY | Director |\\n| Thomas M. Hagerty |\\n| /s/ MARK A. JOHNSON | Director |\\n| Mark A. Johnson |\\n| /s/ RICHARD MACCHIA | Director |\\n| Richard Macchia |\\n| /s/ HALA G. MODDELMOG | Director |\\n| Hala G. Moddelmog |\\n| /s/ JEFFREY S. SLOAN | Director |\\n| Jeffrey S. Sloan |\\n| /s/ STEVEN T. STULL | Director |\\n| Steven T. Stull |\\n\\n128\\n \\n\\nWhat is the ratio per million locations of hotels under FLEETCOR's proprietary CLC Lodging network to the number of locations accepting FLEETCOR's purchasing and T&E cards in the United States and Canada?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 1560.747663551402.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 66,\n \"input_length\": 117094\n}"}}},{"rowIdx":67,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nITEM 1. FINANCIAL STATEMENTS\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\n| CONDENSED CONSOLIDATED BALANCE SHEETS |\n| (dollars in thousands) |\n| September 30, 2019 | December 31, 2018 |\n| (Unaudited) |\n| Assets |\n| Investments in: |\n| Excess mortgage servicing rights, at fair value | $ | 398,064 | $ | 447,860 |\n| Excess mortgage servicing rights, equity method investees, at fair value | 132,259 | 147,964 |\n| Mortgage servicing rights, at fair value | 3,431,968 | 2,884,100 |\n| Mortgage servicing rights financing receivables, at fair value | 1,811,261 | 1,644,504 |\n| Servicer advance investments, at fair value(A) | 600,547 | 735,846 |\n| Real estate and other securities, available-for-sale | 16,853,910 | 11,636,581 |\n| Residential mortgage loans, held-for-investment (includes $113,133 and $121,088 at fair value at September 30, 2019 and December 31, 2018, respectively)(A) | 613,657 | 735,329 |\n| Residential mortgage loans, held-for-sale | 1,349,997 | 932,480 |\n| Residential mortgage loans, held-for-sale, at fair value | 5,206,251 | 2,808,529 |\n| Consumer loans, held-for-investment(A) | 881,183 | 1,072,202 |\n| Cash and cash equivalents(A) | 738,219 | 251,058 |\n| Restricted cash | 163,148 | 164,020 |\n| Servicer advances receivable | 2,911,798 | 3,277,796 |\n| Trades receivable | 4,487,772 | 3,925,198 |\n| Deferred tax asset, net | 43,372 | 65,832 |\n| Other assets (includes $168,532 and $121,602 in residential mortgage loan subject to repurchase at September 30, 2019 and December 31,2018, respectively) | 1,724,519 | 961,714 |\n| $ | 41,347,925 | $ | 31,691,013 |\n| Liabilities and Equity |\n| Liabilities |\n| Repurchase agreements | $ | 23,110,359 | $ | 15,553,969 |\n| Notes and bonds payable (includes $474,309 and $117,048 at fair value at September 30, 2019 and December 31, 2018, respectively)(A) | 7,405,872 | 7,102,266 |\n| Trades payable | 2,536,188 | 2,048,348 |\n| Dividends payable | 213,098 | 184,552 |\n| Accrued expenses and other liabilities(A) (includes $168,532 and $121,602 in residential mortgage loans repurchase liabilities at September 30, 2019 and December 31,2018, respectively) | 820,291 | 713,583 |\n| 34,085,808 | 25,602,718 |\n| Commitments and Contingencies |\n| Equity |\n| Preferred Stock, par value of $0.01 per share, 23,000,000 shares authorized: |\n| 7.50% Series A Preferred Stock, $0.01 par value, 11,500,000 shares authorized, 6,210,000 and 0 issued and outstanding at September 30, 2019 and December 31, 2018, respectively | 150,026 | — |\n| 7.125% Series B Preferred Stock, $0.01 par value, 11,500,000 shares authorized, 11,300,000 and 0 issued and outstanding at September 30, 2019 and December 31, 2018, respectively | 273,418 | — |\n| Common Stock, $0.01 par value, 2,000,000,000 shares authorized, 415,520,780 and 369,104,429 issued and outstanding at September 30, 2019 and December 31, 2018, respectively | 4,156 | 3,692 |\n| Additional paid-in capital | 5,498,226 | 4,746,242 |\n| Retained earnings | 545,713 | 830,713 |\n| Accumulated other comprehensive income (loss) | 706,926 | 417,023 |\n| Total New Residential stockholders’ equity | 7,178,465 | 5,997,670 |\n| Noncontrolling interests in equity of consolidated subsidiaries | 83,652 | 90,625 |\n| Total Equity | 7,262,117 | 6,088,295 |\n| $ | 41,347,925 | $ | 31,691,013 |\n\n1\n| (A) | New Residential’s Condensed Consolidated Balance Sheets include the assets and liabilities of certain consolidated VIEs, Advance Purchaser LLC (the “Buyer”) (Note 6), the RPL Borrowers (defined in Note 8), Shellpoint Asset Funding Trust 2013-1 (“SAFT 2013-1”) and the Shelter retail mortgage origination joint ventures (“Shelter JVs”) (Note 8) and the Consumer Loan SPVs (Note 9), which primarily hold investments in Servicer Advance Investments, residential mortgage loans and consumer loans, respectively, financed with notes and bonds payable. The balance sheets of the Buyer, the RPL Borrowers, SAFT 2013-1, Shelter JVs and the Consumer Loan SPVs are included in Notes 6, 8 and 9, respectively. The creditors of the Buyer, the RPL Borrowers, SAFT 2013-1, Shelter JVs and the Consumer Loan SPVs do not have recourse to the general credit of New Residential and the assets of the Buyer, the RPL Borrowers, SAFT 2013-1, Shelter JVs and the Consumer Loan SPVs are not directly available to satisfy New Residential’s obligations. |\n\nSee notes to condensed consolidated financial statements.\n2\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\n| CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) |\n| (dollars in thousands, except per share data) |\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Interest income | $ | 448,127 | $ | 425,524 | $ | 1,303,041 | $ | 1,212,902 |\n| Interest expense | 245,902 | 162,806 | 686,738 | 421,109 |\n| Net Interest Income | 202,225 | 262,718 | 616,303 | 791,793 |\n| Impairment |\n| Other-than-temporary impairment (OTTI) on securities | 5,567 | 3,889 | 21,942 | 23,190 |\n| Valuation and loss provision (reversal) on loans and real estate owned (REO) | ( 10,690 | ) | 5,471 | 8,042 | 28,136 |\n| ( 5,123 | ) | 9,360 | 29,984 | 51,326 |\n| Net interest income after impairment | 207,348 | 253,358 | 586,319 | 740,467 |\n| Servicing revenue, net of change in fair value of $(228,405), $(26,741), $(619,914), and $35,118, respectively | 53,050 | 175,355 | 133,366 | 538,784 |\n| Gain on sale of originated mortgage loans, net | 100,541 | 45,732 | 194,029 | 45,732 |\n| Other Income |\n| Change in fair value of investments in excess mortgage servicing rights | 2,407 | ( 4,744 | ) | ( 1,421 | ) | ( 55,711 | ) |\n| Change in fair value of investments in excess mortgage servicing rights, equity method investees | 4,751 | 3,396 | 4,087 | 5,624 |\n| Change in fair value of investments in mortgage servicing rights financing receivables | ( 41,410 | ) | ( 88,345 | ) | ( 133,200 | ) | 63,628 |\n| Change in fair value of servicer advance investments | 6,641 | ( 5,353 | ) | 15,932 | ( 86,581 | ) |\n| Change in fair value of investments in residential mortgage loans | ( 19,037 | ) | 647 | 90,551 | 647 |\n| Change in fair value of derivative instruments | 58,508 | 24,299 | ( 1,988 | ) | 27,985 |\n| Gain (loss) on settlement of investments, net | 154,752 | ( 11,893 | ) | 157,013 | 106,064 |\n| Earnings from investments in consumer loans, equity method investees | ( 2,547 | ) | 4,555 | ( 890 | ) | 12,343 |\n| Other income (loss), net | ( 35,219 | ) | ( 5,860 | ) | ( 16,451 | ) | 10,415 |\n| 128,846 | ( 83,298 | ) | 113,633 | 84,414 |\n| Operating Expenses |\n| General and administrative expenses | 133,513 | 98,587 | 351,359 | 139,169 |\n| Management fee to affiliate | 20,678 | 15,464 | 58,261 | 46,027 |\n| Incentive compensation to affiliate | 36,307 | 23,848 | 49,265 | 65,169 |\n| Loan servicing expense | 7,192 | 11,060 | 26,167 | 33,609 |\n| Subservicing expense | 52,875 | 43,148 | 147,763 | 135,703 |\n| 250,565 | 192,107 | 632,815 | 419,677 |\n| Income (Loss) Before Income Taxes | 239,220 | 199,040 | 394,532 | 989,720 |\n| Income tax expense (benefit) | ( 5,440 | ) | 3,563 | 18,980 | ( 5,957 | ) |\n| Net Income (Loss) | $ | 244,660 | $ | 195,477 | $ | 375,552 | $ | 995,677 |\n| Noncontrolling Interests in Income of Consolidated Subsidiaries | $ | 14,738 | $ | 10,869 | $ | 31,979 | $ | 32,058 |\n| Dividends on Preferred Stock | $ | 5,338 | $ | — | $ | 5,338 | $ | — |\n| Net Income (Loss) Attributable to Common Stockholders | $ | 224,584 | $ | 184,608 | $ | 338,235 | $ | 963,619 |\n| Net Income (Loss) Per Share of Common Stock |\n| Basic | $ | 0.54 | $ | 0.54 | $ | 0.83 | $ | 2.87 |\n| Diluted | $ | 0.54 | $ | 0.54 | $ | 0.83 | $ | 2.86 |\n| Weighted Average Number of Shares of Common Stock Outstanding |\n| Basic | 415,520,780 | 340,044,440 | 406,521,273 | 335,615,566 |\n| Diluted | 415,588,238 | 340,868,403 | 406,671,972 | 337,078,824 |\n| Dividends Declared per Share of Common Stock | $ | 0.50 | $ | 0.50 | $ | 1.50 | $ | 1.50 |\n\nSee notes to condensed consolidated financial statements.\n3\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\n| CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED) |\n| (dollars in thousands) |\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Comprehensive income (loss), net of tax |\n| Net (loss) income | $ | 244,660 | $ | 195,477 | $ | 375,552 | $ | 995,677 |\n| Other comprehensive income (loss) |\n| Net unrealized gain (loss) on securities | 109,668 | ( 22,445 | ) | 469,183 | 14,600 |\n| Reclassification of net realized (gain) loss on securities into earnings | ( 89,436 | ) | 32,626 | ( 179,280 | ) | 89,885 |\n| 20,232 | 10,181 | 289,903 | 104,485 |\n| Total comprehensive income | $ | 264,892 | $ | 205,658 | $ | 665,455 | $ | 1,100,162 |\n| Comprehensive income attributable to noncontrolling interests | $ | 14,738 | $ | 10,869 | $ | 31,979 | $ | 32,058 |\n| Dividends on preferred stock | $ | 5,338 | $ | — | $ | 5,338 | $ | — |\n| Comprehensive income attributable to common stockholders | $ | 244,816 | $ | 194,789 | $ | 628,138 | $ | 1,068,104 |\n\nSee notes to condensed consolidated financial statements.\n4\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (UNAUDITED)\nFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2019 AND 2018\n| (dollars in thousands) |\n\n| Common Stock |\n| Preferred Stock | Shares | Amount | Additional Paid-in Capital | Retained Earnings | Accumulated Other Comprehensive Income | Total New Residential Stockholders’ Equity | Noncontrolling Interests in Equity of Consolidated Subsidiaries | Total Equity |\n| Equity - December 31, 2018 | $ | — | 369,104,429 | $ | 3,692 | $ | 4,746,242 | $ | 830,713 | $ | 417,023 | $ | 5,997,670 | $ | 90,625 | $ | 6,088,295 |\n| Dividends declared on common stock | — | — | — | — | ( 623,235 | ) | — | ( 623,235 | ) | — | ( 623,235 | ) |\n| Dividends declared on preferred stock | — | — | — | — | ( 5,338 | ) | — | ( 5,338 | ) | — | ( 5,338 | ) |\n| Capital contributions | — | — | — | — | — | — | — | — | — |\n| Capital distributions | — | — | — | — | — | — | — | ( 38,952 | ) | ( 38,952 | ) |\n| Issuance of common stock | — | 46,000,000 | 460 | 750,933 | — | — | 751,393 | — | 751,393 |\n| Issuance of preferred stock | 423,444 | — | — | — | — | — | 423,444 | — | 423,444 |\n| Option exercise | — | 348,613 | 3 | ( 3 | ) | — | — | — | — | — |\n| Purchase of noncontrolling interests in the Buyer | — | — | — | — | — | — | — | — | — |\n| Other dilution | — | — | — | — | — | — | — | — | — |\n| Director share grants | — | 67,738 | 1 | 1,054 | — | — | 1,055 | — | 1,055 |\n| Comprehensive income (loss) |\n| Net income (loss) | — | — | — | — | 343,573 | — | 343,573 | 31,979 | 375,552 |\n| Net unrealized gain (loss) on securities | — | — | — | — | — | 469,183 | 469,183 | — | 469,183 |\n| Reclassification of net realized (gain) loss on securities into earnings | — | — | — | — | — | ( 179,280 | ) | ( 179,280 | ) | — | ( 179,280 | ) |\n| Total comprehensive income (loss) | 633,476 | 31,979 | 665,455 |\n| Equity - September 30, 2019 | $ | 423,444 | 415,520,780 | $ | 4,156 | $ | 5,498,226 | $ | 545,713 | $ | 706,926 | $ | 7,178,465 | $ | 83,652 | $ | 7,262,117 |\n\n5\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (UNAUDITED), CONTINUED\nFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2019 AND 2018\n| (dollars in thousands) |\n\n| Common Stock |\n| Shares | Amount | Additional Paid-in Capital | Retained Earnings | Accumulated Other Comprehensive Income | Total New Residential Stockholders’ Equity | Noncontrolling Interests in Equity of Consolidated Subsidiaries | Total Equity |\n| Equity - December 31, 2017 | 307,361,309 | $ | 3,074 | $ | 3,763,188 | $ | 559,476 | $ | 364,467 | $ | 4,690,205 | $ | 105,957 | $ | 4,796,162 |\n| Dividends declared on common stock | — | — | — | ( 508,176 | ) | — | ( 508,176 | ) | — | ( 508,176 | ) |\n| Capital contributions | — | — | — | — | — | — | — | — |\n| Capital distributions | — | — | — | — | — | — | ( 51,735 | ) | ( 51,735 | ) |\n| Issuance of common stock | 29,241,659 | 292 | 491,312 | — | — | 491,604 | — | 491,604 |\n| Option exercise | 3,694,228 | 37 | ( 37 | ) | — | — | — | — | — |\n| Other dilution | — | — | ( 63 | ) | — | — | ( 63 | ) | — | ( 63 | ) |\n| Purchase of Noncontrolling Interests | — | — | 627 | — | — | 627 | 7,448 | 8,075 |\n| Director share grants | 57,233 | 1 | 1,018 | — | — | 1,019 | — | 1,019 |\n| Comprehensive income (loss) |\n| Net income (loss) | — | — | — | 963,619 | — | 963,619 | 32,058 | 995,677 |\n| Net unrealized gain (loss) on securities | — | — | — | — | 14,600 | 14,600 | — | 14,600 |\n| Reclassification of net realized (gain) loss on securities into earnings | — | — | — | — | 89,885 | 89,885 | — | 89,885 |\n| Total comprehensive income (loss) | 1,068,104 | 32,058 | 1,100,162 |\n| Equity - September 30, 2018 | 340,354,429 | $ | 3,404 | $ | 4,256,045 | $ | 1,014,919 | $ | 468,952 | $ | 5,743,320 | $ | 93,728 | $ | 5,837,048 |\n\nSee notes to condensed consolidated financial statements.\n6\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\n| CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) |\n| (dollars in thousands) |\n\n| Nine Months Ended September 30, |\n| 2019 | 2018 |\n| Cash Flows From Operating Activities |\n| Net income | $ | 375,552 | $ | 995,677 |\n| Adjustments to reconcile net income to net cash provided by (used in) operating activities: |\n| Change in fair value of investments in excess mortgage servicing rights | 1,421 | 55,711 |\n| Change in fair value of investments in excess mortgage servicing rights, equity method investees | ( 4,087 | ) | ( 5,624 | ) |\n| Change in fair value of investments in mortgage servicing rights financing receivables | 133,200 | ( 63,628 | ) |\n| Change in fair value of servicer advance investments | ( 15,932 | ) | 86,581 |\n| Change in fair value of residential mortgage loans, at fair value, and notes and bonds payable, at fair value | ( 85,303 | ) | 1,462 |\n| (Gain) / loss on settlement of investments (net) | ( 157,013 | ) | ( 106,064 | ) |\n| (Gain) / loss on sale of originated mortgage loans (net) | ( 194,029 | ) | ( 45,732 | ) |\n| Earnings from investments in consumer loans, equity method investees | 890 | ( 12,343 | ) |\n| Change in fair value of derivative instruments | 1,988 | ( 27,985 | ) |\n| Changes in fair value of contingent consideration | 7,430 | — |\n| Unrealized (gain) / loss on other ABS | ( 9,010 | ) | ( 12,001 | ) |\n| (Gain) / loss on transfer of loans to REO | ( 7,814 | ) | ( 16,609 | ) |\n| (Gain) / loss on transfer of loans to other assets | 378 | 1,648 |\n| (Gain) / loss on Excess MSR recapture agreements | ( 1,771 | ) | ( 5,257 | ) |\n| (Gain) / loss on Ocwen common stock | ( 3,134 | ) | ( 4,655 | ) |\n| Accretion and other amortization | ( 298,933 | ) | ( 528,981 | ) |\n| Other-than-temporary impairment | 21,942 | 23,190 |\n| Valuation and loss provision on loans and real estate owned | 8,042 | 28,136 |\n| Non-cash portions of servicing revenue, net | 619,914 | ( 35,118 | ) |\n| Non-cash directors’ compensation | 1,055 | 1,019 |\n| Deferred tax provision | 18,080 | ( 12,680 | ) |\n| Changes in: |\n| Servicer advances receivable | 366,426 | 441,351 |\n| Other assets | ( 516,107 | ) | ( 168,862 | ) |\n| Due to affiliates | ( 41,920 | ) | ( 14,826 | ) |\n| Accrued expenses and other liabilities | 263,420 | 161,246 |\n| Other operating cash flows: |\n| Interest received from excess mortgage servicing rights | 19,180 | 33,521 |\n| Interest received from servicer advance investments | 22,212 | 25,901 |\n| Interest received from Non-Agency RMBS | 203,309 | 156,420 |\n| Interest received from PCD residential mortgage loans, held-for-investment | 6,697 | 6,656 |\n| Interest received from PCD consumer loans, held-for-investment | 23,789 | 27,681 |\n| Distributions of earnings from excess mortgage servicing rights, equity method investees | 7,762 | 7,976 |\n| Distributions of earnings from consumer loan equity method investees | 1,178 | 6,176 |\n| Purchases of residential mortgage loans, held-for-sale | ( 6,002,975 | ) | ( 3,295,378 | ) |\n| Origination of residential mortgage loans, held-for-sale | ( 10,424,325 | ) | ( 1,678,606 | ) |\n| Proceeds from sales of purchased and originated residential mortgage loans, held-for-sale | 13,046,546 | 3,752,066 |\n| Principal repayments from purchased residential mortgage loans, held-for-sale | 295,584 | 146,170 |\n| Net cash provided by (used in) operating activities | ( 2,316,358 | ) | ( 75,761 | ) |\n\nContinued on next page.\n7\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\n| CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED), CONTINUED |\n| (dollars in thousands) |\n\n| Nine Months Ended September 30, |\n| 2019 | 2018 |\n| Cash Flows From Investing Activities |\n| Acquisition of Shellpoint, net of cash required | — | ( 118,285 | ) |\n| Purchase of servicer advance investments | ( 1,255,306 | ) | ( 1,790,635 | ) |\n| Purchase of MSRs, MSR financing receivables and servicer advances receivable | ( 1,365,333 | ) | ( 971,079 | ) |\n| Purchase of Agency RMBS | ( 25,212,307 | ) | ( 6,574,783 | ) |\n| Purchase of Non-Agency RMBS | ( 689,308 | ) | ( 2,714,991 | ) |\n| Purchase of residential mortgage loans | — | ( 85,778 | ) |\n| Purchase of real estate owned and other assets | ( 44,539 | ) | ( 26,807 | ) |\n| Purchase of investment in consumer loans, equity method investees | ( 63,969 | ) | ( 292,616 | ) |\n| Draws on revolving consumer loans | ( 42,231 | ) | ( 45,017 | ) |\n| Payments for settlement of derivatives | ( 283,037 | ) | ( 59,113 | ) |\n| Return of investments in excess mortgage servicing rights | 43,938 | 43,690 |\n| Return of investments in excess mortgage servicing rights, equity method investees | 12,030 | 14,474 |\n| Return of investments in consumer loans, equity method investees | 55,848 | 279,669 |\n| Principal repayments from servicer advance investments | 1,402,187 | 1,845,411 |\n| Principal repayments from Agency RMBS | 987,523 | 76,515 |\n| Principal repayments from Non-Agency RMBS | 996,396 | 565,460 |\n| Principal repayments from residential mortgage loans | 83,483 | 110,770 |\n| Proceeds from sale of residential mortgage loans | 41,308 | 21,278 |\n| Principal repayments from consumer loans | 203,607 | 237,129 |\n| Principal repayments from MSRs and MSR financing receivables | 21,306 | — |\n| Proceeds from sale of mortgage servicing rights | 1,047 | — |\n| Proceeds from sale of mortgage servicing rights financing receivables | 15,575 | — |\n| Proceeds from sale of excess mortgage servicing rights | 114 | — |\n| Proceeds from sale of Agency RMBS | 17,998,736 | 4,121,325 |\n| Proceeds from sale of Non-Agency RMBS | 1,664,017 | 81,325 |\n| Proceeds from settlement of derivatives | 74,724 | 146,146 |\n| Proceeds from sale of real estate owned | 103,258 | 111,459 |\n| Net cash provided by (used in) investing activities | ( 5,250,933 | ) | ( 5,024,453 | ) |\n\nContinued on next page.\n8\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\n| CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED), CONTINUED |\n| (dollars in thousands) |\n\n| Nine Months Ended September 30, |\n| 2019 | 2018 |\n| Cash Flows From Financing Activities |\n| Repayments of repurchase agreements | ( 144,545,608 | ) | ( 58,414,966 | ) |\n| Margin deposits under repurchase agreements and derivatives | ( 2,913,627 | ) | ( 1,374,374 | ) |\n| Repayments of notes and bonds payable | ( 7,306,541 | ) | ( 7,512,484 | ) |\n| Payment of deferred financing fees | ( 7,821 | ) | ( 12,838 | ) |\n| Common stock dividends paid | ( 600,027 | ) | ( 491,680 | ) |\n| Borrowings under repurchase agreements | 152,101,817 | 63,696,426 |\n| Return of margin deposits under repurchase agreements and derivatives | 2,589,160 | 1,263,220 |\n| Borrowings under notes and bonds payable | 7,600,342 | 7,547,541 |\n| Issuance of preferred stock | 423,444 | — |\n| Issuance of common stock | 752,217 | 492,285 |\n| Costs related to issuance of common stock | ( 824 | ) | ( 681 | ) |\n| Noncontrolling interest in equity of consolidated subsidiaries - contributions | — | — |\n| Noncontrolling interest in equity of consolidated subsidiaries - distributions | ( 38,952 | ) | ( 51,735 | ) |\n| Purchase of noncontrolling interests | — | ( 653 | ) |\n| Net cash provided by (used in) financing activities | 8,053,580 | 5,140,061 |\n| Net Increase (Decrease) in Cash, Cash Equivalents, and Restricted Cash | 486,289 | 39,847 |\n| Cash, Cash Equivalents, and Restricted Cash, Beginning of Period | 415,078 | 446,050 |\n| Cash, Cash Equivalents, and Restricted Cash, End of Period | $ | 901,367 | $ | 485,897 |\n| Supplemental Disclosure of Cash Flow Information |\n| Cash paid during the period for interest | $ | 643,349 | $ | 405,672 |\n| Cash paid during the period for income taxes | 1,208 | 3,176 |\n| Supplemental Schedule of Non-Cash Investing and Financing Activities |\n| Dividends declared but not paid | $ | 213,098 | $ | 170,177 |\n| Purchase of Agency and Non-Agency RMBS, settled after quarter end | 2,536,188 | 1,791,191 |\n| Sale of investments, primarily Agency RMBS, settled after quarter end | 4,487,772 | 3,424,865 |\n| Transfer from residential mortgage loans to real estate owned and other assets | 70,080 | 88,376 |\n| Transfer from residential mortgage loans, held-for-investment to residential mortgage loans, held-for-sale | 38,842 | — |\n| Non-cash distributions from LoanCo | 21,314 | 25,739 |\n| MSR purchase price holdback | 1,963 | 8,692 |\n| Shellpoint Acquisition purchase price holdback | — | 10,173 |\n| Shellpoint Acquisition contingent consideration | — | 42,770 |\n| Real estate securities retained from loan securitizations | 454,310 | 762,056 |\n| Residential mortgage loans subject to repurchase | 168,532 | 110,181 |\n| Ocwen transaction (Note 5) - excess mortgage servicing rights | — | 638,567 |\n| Ocwen transaction (Note 5) - servicer advance investments | — | 3,175,891 |\n| Ocwen transaction (Note 5) - mortgage servicing rights financing receivables, at fair value | — | 1,017,993 |\n\nSee notes to condensed consolidated financial statements.\n9\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| 1. | ORGANIZATION AND BASIS OF PRESENTATION |\n\nNew Residential Investment Corp. (together with its subsidiaries, “New Residential”) is a Delaware corporation that was formed as a limited liability company in September 2011 for the purpose of making real estate related investments and commenced operations on December 8, 2011. New Residential is an independent publicly traded real estate investment trust (“REIT”) primarily focused on investing in residential mortgage related assets. New Residential is listed on the New York Stock Exchange (“NYSE”) under the symbol “NRZ.”\nNew Residential has elected and intends to qualify to be taxed as a REIT for U.S. federal income tax purposes. As such, New Residential will generally not be subject to U.S. federal corporate income tax on that portion of its net income that is distributed to stockholders if it distributes at least 90% of its REIT taxable income to its stockholders by prescribed dates and complies with various other requirements. See Note 17 regarding New Residential’s taxable REIT subsidiaries.\nNew Residential, through its wholly-owned subsidiaries New Residential Mortgage LLC (“NRM”) and NewRez LLC (“NewRez”), is licensed or otherwise eligible to service residential mortgage loans in all states within the United States and the District of Columbia. NRM and NewRez perform servicing on behalf of investors, including the Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”) (collectively, Government Sponsored Enterprises or “GSEs”) and Government National Mortgage Association (“Ginnie Mae”), and on behalf of other servicers (subservicing).\nNewRez originates, sells and securitizes conventional (conforming to the underwriting standards of Fannie Mae or Freddie Mac; collectively referred to as “Agency” loans), government-insured (Federal Housing Administration (“FHA”) and Department of Veterans Affairs (“VA”)) and non-qualified (“Non-QM”) residential mortgage loans. The GSEs or Ginnie Mae guarantee securitizations completed under their applicable policies and guidelines. New Residential generally retains the right to service the underlying residential mortgage loans sold and securitized by NRM and NewRez. NRM and NewRez are required to conduct aspects of their operations in accordance with applicable policies and guidelines published by FHA, Fannie Mae and Freddie Mac in order to maintain those approvals.\nNew Residential has entered into a management agreement (the “Management Agreement”) with FIG LLC (the “Manager”), an affiliate of Fortress Investment Group LLC (“Fortress”), pursuant to which the Manager provides a management team and other professionals who are responsible for implementing New Residential’s business strategy, subject to the supervision of New Residential’s board of directors. For its services, the Manager is entitled to management fees and incentive compensation, both defined in, and in accordance with the terms of, the Management Agreement.\nAs of September 30, 2019, New Residential conducted its business through the following segments: (i) Servicing and Originations, (ii) Residential Securities and Loans, (iii) Consumer Loans and (iv) Corporate.\nApproximately 2.4 million shares of New Residential’s common stock were held by Fortress, through its affiliates, as of September 30, 2019. In addition, Fortress, through its affiliates, held options relating to approximately 10.5 million shares of New Residential’s common stock as of September 30, 2019.\nInterim Financial Statements\nThe accompanying condensed consolidated financial statements and related notes of New Residential have been prepared in accordance with accounting principles generally accepted in the United States for interim financial reporting and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, certain information and note disclosures normally included in financial statements prepared under U.S. generally accepted accounting principles have been condensed or omitted. In the opinion of management, all adjustments considered necessary for a fair presentation of New Residential’s financial position, results of operations and cash flows have been included and are of a normal and recurring nature. The operating results presented for interim periods are not necessarily indicative of the results that may be expected for any other interim period or for the entire year. These condensed consolidated financial statements should be read in conjunction with New Residential’s consolidated financial statements for the year ended December 31, 2018 and notes thereto included in New Residential’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (the “SEC”). Capitalized terms used herein, and not otherwise defined, are defined in\n10\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nNew Residential’s consolidated financial statements for the year ended December 31, 2018. Certain prior period amounts have been reclassified to conform to the current period’s presentation.\nRecent Accounting Pronouncements\nIn January 2016, the FASB issued ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10) - Recognition and Measurement of Financial Assets and Financial Liabilities. The standard: (i) requires that certain equity investments be measured at fair value, and modifies the assessment of impairment for certain other equity investments, (ii) changes certain disclosure requirements related to the fair value of financial instruments measured at amortized cost, (iii) changes certain disclosure requirements related to liabilities measured at fair value, (iv) requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset, and (v) clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets. ASU No. 2016-01 was effective for New Residential in the first quarter of 2018. The adoption of ASU No. 2016-01 did not have a material impact on the condensed consolidated financial statements.\nIn February 2016, the FASB issued ASU No. 2016-02, Leases. The standard requires that lessees recognize a right-of-use asset and corresponding lease liability on the balance sheet for most leases. The guidance applied by a lessor under ASU No. 2016-02 is substantially similar to existing GAAP. ASU No. 2016-02 was effective for New Residential in the first quarter of 2019. An entity should apply ASU No. 2016-02 by means of a modified retrospective transition method for all leases existing at, or entered into after, the date of initial application. The adoption of ASU No. 2016-02 did not have a material impact on the condensed consolidated financial statements (see Notes 2 and 14 for details).\nIn June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326) - Measurement of Credit Losses on Financial Instruments. The standard requires that a financial asset measured at amortized cost basis be presented at the net amount expected to be collected, net of an allowance for all expected (rather than incurred) credit losses. The measurement of expected credit losses is based on relevant information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectibility of the reported amount. The standard also changes the accounting for purchased credit deteriorated assets and available-for-sale securities, which will require the recognition of credit losses through a valuation allowance when fair value is less than amortized cost, regardless of whether the impairment is considered to be other-than-temporary. ASU No. 2016-13 is effective for New Residential in the first quarter of 2020. Early adoption is permitted beginning in 2019. An entity should apply ASU No. 2016-13 by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. New Residential is currently evaluating the new guidance to determine the impact it may have on its condensed consolidated financial statements. New Residential plans to elect the fair value option on Residential mortgage loans, held-for-investment and Consumer loans, held-for-investment.\nIn January 2017, the FASB issued ASU No. 2017-04, Simplifying the Test for Goodwill Impairment (Topic 805). The standard simplifies the accounting for goodwill impairment for all entities by requiring impairment charges to be based on the first step in the current two-step impairment test. Under the new guidance, an impairment charge, if triggered, is calculated as the difference between a reporting unit’s carrying value and fair value, but it is limited to the carrying value of goodwill. ASU No. 2017-04 is effective for New Residential in the first quarter of 2020 and early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The adoption of ASU No. 2017-04 is not expected to have a material impact on the condensed consolidated financial statements.\nIn August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (Topic 820). The standard: (i) adds incremental requirements for entities to disclose (a) the amount of total gains or losses for the period recognized in other comprehensive income that is attributable to fair value changes in assets and liabilities held as of the balance sheet date and categorized within Level 3 of the fair value hierarchy, (b) the range and weighted average used to develop significant unobservable inputs and (c) how the weighted average was calculated for fair value measurements categorized within Level 3 of the fair value hierarchy and (ii) eliminates disclosure requirements for (a) transfers between Level 1 and Level 2 and (b) valuation processes for Level 3 fair value measurements. ASU No. 2018-13 is effective for New Residential in the first quarter of 2020. The adoption of ASU No. 2018-13 is not expected to have a material impact on the condensed consolidated financial statements.\n11\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nAcquisition of Shellpoint Partners LLC\nOn November 29, 2017, NRM Acquisition LLC (the “Shellpoint Purchaser”), a Delaware limited liability company and a wholly owned subsidiary of New Residential, entered into a Securities Purchase Agreement (the “Shellpoint SPA”) to acquire Shellpoint Partners LLC, a Delaware limited liability company (“Shellpoint”).\nOn July 3, 2018, the Shellpoint Purchaser acquired 100 % of the outstanding equity interests of Shellpoint for a cash purchase price of $ 212.3 million (the “Shellpoint Acquisition”). As additional consideration for the Shellpoint Acquisition, the Shellpoint Purchaser may make up to three cash earnout payments, which will be calculated following each of the first three anniversaries of the Shellpoint closing as a percentage of the amount by which the pre-tax income of certain of Shellpoint’s businesses exceeds certain specified thresholds, up to an aggregate maximum amount of $ 60.0 million (the “Shellpoint Earnout Payments”). The Shellpoint Earnout Payments are classified as contingent consideration recorded at fair value at the acquisition date and included in the total consideration transferred for the Shellpoint Acquisition. The contingent consideration is subsequently measured at fair value on a quarterly basis with changes in fair value recorded in other income.\nShellpoint is a vertically integrated mortgage platform with established origination and servicing capabilities and provides New Residential with in-house servicing, asset origination and recapture capabilities. The results of Shellpoint’s operations have been included in the Company’s condensed consolidated statements of income for the nine months ended September 30, 2019 and represent $ 444.8 million and $ 97.2 million of revenue and net income, respectively.\nThe acquisition date fair value of the consideration transferred includes $ 212.3 million in cash consideration, $ 39.3 million in contingent consideration and $ 173.9 million in effective settlement of preexisting relationships. The total consideration is summarized as follows:\n| Total Consideration (in millions) | Amount |\n| Cash Consideration | $ | 212.3 |\n| Earnout Payment(A) | 39.3 |\n| Effective Settlement of Preexisting Relationships(B) | 173.9 |\n| Total Consideration | $ | 425.5 |\n\n| (A) | The range of outcomes for this contingent consideration is from $ 0 to $ 60.0 million, dependent on the performance of Shellpoint. New Residential derived a fair value of the remaining contingent consideration payment in three years of $ 39.3 million. This amount excludes contingent payments to the long-term employee incentive plans that require continuing employment and are recognized as compensation expense within General and Administrative expenses in the post-acquisition consolidated financial statements separate from New Residential’s acquisition of assets and assumption of liabilities in the business combination. On September 5, 2019, New Residential paid $ 10.0 million as the first of three potential earnout payments. As of September 30, 2019, the contingent consideration had a fair value of $ 38.3 million. |\n\n| (B) | Represents the effective settlement of preexisting relationships between New Residential and Shellpoint including 1) MSR acquisitions, 2) a note payable and 3) operating accounts receivable and payable existing prior to the acquisition date. The effective settlement of these preexisting relationships had no impact to New Residential’s condensed consolidated statements of income. |\n\n12\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nNew Residential has performed an allocation of the total consideration of $ 425.5 million to Shellpoint’s assets and liabilities, as set forth below. The final amount and allocation of total consideration reflects certain measurement period adjustments identified during the fourth quarter of 2018, including the effect on earnings that would have been recorded during the third quarter of 2018 had the accounting been completed at the acquisition date. Such measurement period adjustments included 1) a decrease of $ 3.5 million in the amount of contingent consideration based upon finalization of the internal valuation 2) a decrease of $ 6.4 million to consideration transferred for the effective settlement of existing relationships 3) an increase of $ 14.1 million to the fair value of identifiable intangible assets based upon receipt of the final valuation report from a third-party valuation firm and 4) an increase of $ 0.3 million to other assets due to a decrease in the fair value discount on certain servicing advance receivables. These measurement period adjustments resulted in a corresponding decrease to goodwill in the amount of $ 24.3 million.\n| Total Consideration ($ in millions) | $ | 425.5 |\n| Assets |\n| Cash and cash equivalents | $ | 79.2 |\n| Restricted cash | 9.9 |\n| Residential mortgage loans, held-for-sale, at fair value | 488.2 |\n| Mortgage servicing rights, at fair value(A) | 286.6 |\n| Residential mortgage loans, held-for-investment, at fair value | 125.3 |\n| Residential mortgage loans subject to repurchase | 121.4 |\n| Intangible assets(B) | 18.4 |\n| Other assets | 81.5 |\n| Total Assets Acquired | $ | 1,210.5 |\n| Liabilities |\n| Repurchase agreements | $ | 439.6 |\n| Notes and bonds payable | 20.7 |\n| Mortgage-backed securities issued, at fair value | 120.7 |\n| Residential mortgage loans repurchase liability | 121.4 |\n| Excess spread financing, at fair value | 48.3 |\n| Accrued expenses and other liabilities | 50.6 |\n| Total Liabilities Assumed | $ | 801.3 |\n| Noncontrolling Interest | $ | 8.3 |\n| Net Assets | $ | 400.9 |\n| Goodwill | $ | 24.6 |\n\n| (A) | Includes $ 135.3 million of Ginnie Mae MSRs where New Residential acquired the rights to the economic value of the servicing rights from Shellpoint prior to the acquisition date. |\n\n| (B) | Includes intangible assets in the form of mortgage origination and servicing licenses, internally developed software and a tradename. New Residential determined that mortgage origination and servicing licenses have an indefinite useful life and will be evaluated for impairment given no legal, regulatory, contractual, competitive or economic factors that would limit the useful life. Internally developed software will be amortized over a finite useful life of five years and tradenames were fully amortized over six months , respectively, based on the expected software development timeline and New Residential’s determination of the time to change a tradename with limited value. |\n\nThe goodwill of $ 24.6 million primarily includes the synergies and benefits expected to result from combining operations with Shellpoint and adding in-house servicing, asset origination and recapture capabilities. The full amount of goodwill for tax purposes of $ 24.6 million is expected to be deductible. New Residential will assess the goodwill annually on October 1 and in interim periods in case of events or circumstances make it more likely than not that an impairment may have occurred. Based on New Residential’s assessment performed, there were no indicators of impairment as of September 30, 2019.\n13\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nCertain transactions were recognized separately from New Residential’s acquisition of assets and assumption of liabilities in the business combination. These separately recognized transactions include 1) contingent payments to Shellpoint’s employees and 2) effective settlement of preexisting relationships discussed above.\nUnaudited Supplemental Pro Forma Financial Information — The following table presents unaudited pro forma combined Servicing and Originations Revenue, which is comprised of 1) servicing revenue, net and 2) gain on sale of originated mortgage loans, net, and Income Before Income Taxes for the three and nine months ended September 30, 2019 and 2018 prepared as if the Shellpoint Acquisition had been consummated on January 1, 2018.\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Pro Forma |\n| Servicing and Originations Revenue | $ | 153,591 | $ | 221,087 | $ | 327,395 | $ | 733,901 |\n| Income Before Income Taxes | 239,220 | 199,040 | 394,532 | 1,003,378 |\n\nThe unaudited supplemental pro forma financial information has not been adjusted for transactions other than the Shellpoint Acquisition, or for the conforming of accounting policies. The unaudited supplemental pro forma financial information does not include any anticipated synergies or other anticipated benefits of the Shellpoint Acquisition and, accordingly, the unaudited supplemental pro forma financial information is not necessarily indicative of either future results of operations or results that might have been achieved had the Shellpoint Acquisition occurred on January 1, 2018.\n| 2. | OTHER INCOME, GENERAL AND ADMINISTRATIVE, OTHER ASSETS AND LIABILITIES |\n\nGain (loss) on settlement of investments, net is comprised of the following:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Gain (loss) on sale of real estate securities, net | $ | 95,003 | $ | ( 28,737 | ) | $ | 201,222 | $ | ( 66,695 | ) |\n| Gain (loss) on sale of acquired residential mortgage loans, net | 43,648 | 4,065 | 53,405 | ( 1,358 | ) |\n| Gain (loss) on settlement of derivatives | ( 14,147 | ) | 19,459 | ( 152,424 | ) | 76,092 |\n| Gain (loss) on liquidated residential mortgage loans | ( 198 | ) | ( 1,113 | ) | ( 3,320 | ) | ( 2,267 | ) |\n| Gain (loss) on sale of REO | ( 3,169 | ) | ( 4,971 | ) | ( 9,445 | ) | ( 12,114 | ) |\n| Gains on settlement of investments in excess MSRs and servicer advance investments | — | — | — | 113,002 |\n| Gain (loss) on sale or securitization of originated mortgage loans(A) | 21,611 | — | 62,399 | — |\n| Other gains (losses) | 12,004 | ( 596 | ) | 5,176 | ( 596 | ) |\n| $ | 154,752 | $ | ( 11,893 | ) | $ | 157,013 | $ | 106,064 |\n\n| (A) | Represents gains on securitizations of Non-QM residential mortgage loans originated by NewRez. |\n\n14\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nOther income (loss), net, is comprised of the following:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Unrealized gain (loss) on other ABS | $ | ( 5,054 | ) | $ | 7,197 | $ | 9,010 | $ | 12,001 |\n| Unrealized gain (loss) on notes and bonds payable | ( 2,647 | ) | 900 | ( 5,248 | ) | 900 |\n| Unrealized gain (loss) on contingent consideration | ( 2,703 | ) | — | ( 7,430 | ) | — |\n| Gain (loss) on transfer of loans to REO | 1,230 | 6,119 | 7,814 | 16,609 |\n| Gain (loss) on transfer of loans to other assets | ( 101 | ) | ( 1,528 | ) | ( 378 | ) | ( 1,648 | ) |\n| Gain (loss) on Excess MSR recapture agreements | 529 | 987 | 1,771 | 5,257 |\n| Gain (loss) on Ocwen common stock | ( 1,103 | ) | ( 145 | ) | 3,134 | 4,655 |\n| Other income (loss) | ( 25,370 | ) | ( 19,390 | ) | ( 25,124 | ) | ( 27,359 | ) |\n| $ | ( 35,219 | ) | $ | ( 5,860 | ) | $ | ( 16,451 | ) | $ | 10,415 |\n\nGeneral and Administrative Expenses is comprised of the following:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Compensation and benefits expense, servicing | $ | 30,494 | $ | 22,498 | $ | 87,219 | $ | 22,498 |\n| Compensation and benefits expense, origination | 44,270 | 32,822 | 112,977 | 32,822 |\n| Legal and professional expense | 16,442 | 11,749 | 46,352 | 35,378 |\n| Loan origination expense | 17,882 | 7,801 | 42,349 | 7,801 |\n| Occupancy expense | 5,114 | 4,394 | 14,079 | 4,394 |\n| Other(A) | 19,311 | 19,323 | 48,383 | 36,276 |\n| $ | 133,513 | $ | 98,587 | $ | 351,359 | $ | 139,169 |\n\n| (A) | Represents miscellaneous general and administrative expenses. |\n\n15\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nOther assets and liabilities are comprised of the following:\n| Other Assets | Accrued Expenses and Other Liabilities |\n| September 30, 2019 | December 31, 2018 | September 30, 2019 | December 31, 2018 |\n| Margin receivable, net(A) | $ | 409,526 | $ | 145,857 | MSR purchase price holdback | $ | 102,556 | $ | 100,593 |\n| Servicing fee receivables | 144,550 | 105,563 | Accounts payable | 89,372 | 75,591 |\n| Due from servicers | 171,916 | 95,261 | Derivative liabilities (Note 10) | 1,842 | 29,389 |\n| Principal and interest receivable | 98,067 | 76,015 | Interest payable | 80,892 | 49,352 |\n| Equity investments(B) | 117,375 | 74,323 | Due to servicers | 144,156 | 95,419 |\n| Ditech deposit | 70,000 | — | Residential mortgage loan repurchase liability | 168,532 | 121,602 |\n| Other receivables | 103,933 | 23,723 | Due to affiliates | 59,551 | 101,471 |\n| Real Estate Owned | 105,968 | 113,410 | Contingent Consideration | 52,761 | 40,842 |\n| Residential mortgage loans subject to repurchase | 168,532 | 121,602 | Excess spread financing, at fair value | 30,377 | 39,304 |\n| Consumer loans, equity method investees (Note 9) | 23,033 | 38,294 | Operating lease liability | 24,532 | — |\n| Goodwill(C) | 41,986 | 24,645 | Reserve for sales recourse | 9,173 | 5,880 |\n| Receivable from government agency(D) | 20,505 | 20,795 | Other liabilities | 56,547 | 54,140 |\n| Intangible assets | 19,346 | 18,708 | $ | 820,291 | $ | 713,583 |\n| Prepaid expenses | 33,120 | 29,165 |\n| Operating lease right-of-use asset | 18,773 | — |\n| Derivative assets (Note 10) | 36,712 | 10,893 |\n| Ocwen common stock, at fair value | 10,912 | 7,778 |\n| Other assets | 130,265 | 55,682 |\n| $ | 1,724,519 | $ | 961,714 |\n\n| (A) | Represents collateral posted primarily as a result of changes in fair value of our 1) real estate securities securing our repurchase agreements and 2) derivative instruments. |\n\n| (B) | Represents equity investments in funds that invest in 1) a commercial redevelopment project and 2) operating companies in the single family housing industry. The indirect investments are accounted for at fair value based on the net asset value (“NAV”) of New Residential’s investment and as an equity method investment, respectively. |\n\n| (C) | Includes goodwill derived from the Shellpoint Acquisition (see Note 1 for details) and the Company’s acquisition of Guardian Asset Management, a leading national provider of field services and property management to government agencies, financial institutions and asset management firms. |\n\n| (D) | Represents claims receivable from the FHA on EBO and reverse mortgage loans for which foreclosure has been completed and for which New Residential has made or intends to make a claim on the FHA guarantee. |\n\n16\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nAs reflected on the Condensed Consolidated Statements of Cash Flows, accretion and other amortization is comprised of the following:\n| Nine Months Ended September 30, |\n| 2019 | 2018 |\n| Accretion of net discount on securities and loans(A) | $ | 266,467 | $ | 296,961 |\n| Accretion of servicer advances receivable discount and servicer advance investments | 18,290 | 207,428 |\n| Accretion of excess mortgage servicing rights income | 18,203 | 32,371 |\n| Amortization of deferred financing costs | ( 2,984 | ) | ( 6,180 | ) |\n| Amortization of discount on notes and bonds payable | ( 1,043 | ) | ( 1,599 | ) |\n| $ | 298,933 | $ | 528,981 |\n\n| (A) | Includes accretion of the accretable yield on PCD loans. |\n\n| 3. | SEGMENT REPORTING |\n\nNew Residential conducts its business through the following segments: (i) Servicing and Originations, (ii) Residential Securities and Loans, (iii) Consumer Loans and (iv) Corporate. The corporate segment consists primarily of (i) general and administrative expenses, (ii) the management fees and incentive compensation related to the Management Agreement and (iii) corporate cash and related interest income. Securities owned by New Residential (Note 7) that are collateralized by servicer advances and consumer loans are included in the Servicing and Originations and Consumer Loans segments, respectively. Secured corporate loans effectively collateralized by Excess MSRs are included in the Servicing and Originations segment.\nDuring the third quarter of 2018, New Residential changed the composition of its reportable segments primarily to reflect the (i) aggregation of the similar MSR, Excess MSR and Servicer Advance segments as the new Servicing and Originations segment and (ii) incorporation of the Shellpoint Acquisition. Segment information for prior periods has been restated to reflect this change.\nSummary financial data on New Residential’s segments is given below, together with a reconciliation to the same data for New Residential as a whole:\n| Residential Securities and Loans |\n| Servicing and Originations | Real Estate Securities | Residential Mortgage Loans | Consumer Loans | Corporate | Total |\n| Three Months Ended September 30, 2019 |\n| Interest income | $ | 135,892 | $ | 184,933 | $ | 86,971 | $ | 40,331 | $ | — | $ | 448,127 |\n| Interest expense | 69,679 | 123,023 | 45,707 | 7,493 | — | 245,902 |\n| Net interest income (expense) | 66,213 | 61,910 | 41,264 | 32,838 | — | 202,225 |\n| Impairment | — | 5,567 | ( 16,553 | ) | 5,863 | — | ( 5,123 | ) |\n| Servicing revenue, net | 53,050 | — | — | — | — | 53,050 |\n| Gain on sale of originated mortgage loans, net | 100,541 | — | — | — | — | 100,541 |\n| Other income (loss) | ( 38,547 | ) | 116,081 | 55,152 | ( 2,651 | ) | ( 1,189 | ) | 128,846 |\n| Operating expenses | 168,100 | 1,839 | 14,006 | 3,965 | 62,655 | 250,565 |\n| Income (Loss) Before Income Taxes | 13,157 | 170,585 | 98,963 | 20,359 | ( 63,844 | ) | 239,220 |\n| Income tax expense (benefit) | 10,749 | — | ( 15,546 | ) | ( 643 | ) | — | ( 5,440 | ) |\n| Net Income (Loss) | $ | 2,408 | $ | 170,585 | $ | 114,509 | $ | 21,002 | $ | ( 63,844 | ) | $ | 244,660 |\n| Noncontrolling interests in income (loss) of consolidated subsidiaries | $ | 4,141 | $ | — | $ | — | $ | 10,597 | $ | — | $ | 14,738 |\n| Dividends on Preferred Stock | $ | — | $ | — | $ | — | $ | — | $ | 5,338 | $ | 5,338 |\n| Net income (loss) attributable to common stockholders | $ | ( 1,733 | ) | $ | 170,585 | $ | 114,509 | $ | 10,405 | $ | ( 69,182 | ) | $ | 224,584 |\n\n17\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| Residential Securities and Loans |\n| Servicing and Originations | Real Estate Securities | Residential Mortgage Loans | Consumer Loans | Corporate | Total |\n| Nine Months Ended September 30, 2019 |\n| Interest income | $ | 396,662 | $ | 557,895 | $ | 219,909 | $ | 128,575 | $ | — | $ | 1,303,041 |\n| Interest expense | 203,940 | 330,992 | 126,288 | 25,518 | — | 686,738 |\n| Net interest income (expense) | 192,722 | 226,903 | 93,621 | 103,057 | — | 616,303 |\n| Impairment | — | 21,942 | ( 16,557 | ) | 24,599 | — | 29,984 |\n| Servicing revenue, net | 133,366 | — | — | — | — | 133,366 |\n| Gain on sale of originated mortgage loans, net | 194,029 | — | — | — | — | 194,029 |\n| Other income (loss) | ( 92,878 | ) | 31,677 | 180,643 | ( 10,324 | ) | 4,515 | 113,633 |\n| Operating expenses | 457,276 | 4,124 | 31,289 | 18,396 | 121,730 | 632,815 |\n| Income (Loss) Before Income Taxes | ( 30,037 | ) | 232,514 | 259,532 | 49,738 | ( 117,215 | ) | 394,532 |\n| Income tax expense (benefit) | 8,474 | — | 11,048 | ( 542 | ) | — | 18,980 |\n| Net Income (Loss) | $ | ( 38,511 | ) | $ | 232,514 | $ | 248,484 | $ | 50,280 | $ | ( 117,215 | ) | $ | 375,552 |\n| Noncontrolling interests in income (loss) of consolidated subsidiaries | $ | 8,873 | $ | — | $ | — | $ | 23,106 | $ | — | $ | 31,979 |\n| Dividends on Preferred Stock | $ | — | $ | — | $ | — | $ | — | $ | 5,338 | $ | 5,338 |\n| Net income (loss) attributable to common stockholders | $ | ( 47,384 | ) | $ | 232,514 | $ | 248,484 | $ | 27,174 | $ | ( 122,553 | ) | $ | 338,235 |\n\n| Residential Securities and Loans |\n| Servicing and Originations | Real Estate Securities | Residential Mortgage Loans | Consumer Loans | Corporate | Total |\n| September 30, 2019 |\n| Investments | $ | 6,374,099 | $ | 16,853,910 | $ | 7,444,405 | $ | 904,216 | $ | — | $ | 31,576,630 |\n| Cash and cash equivalents | 197,607 | 43,604 | 7,281 | 12,091 | 477,636 | 738,219 |\n| Restricted cash | 129,504 | — | — | 33,644 | — | 163,148 |\n| Other assets | 3,378,631 | 4,939,205 | 247,431 | 34,384 | 228,291 | 8,827,942 |\n| Goodwill | 41,986 | — | — | — | — | 41,986 |\n| Total assets | $ | 10,121,827 | $ | 21,836,719 | $ | 7,699,117 | $ | 984,335 | $ | 705,927 | $ | 41,347,925 |\n| Debt | $ | 6,192,811 | $ | 17,196,772 | $ | 6,248,142 | $ | 878,506 | $ | — | $ | 30,516,231 |\n| Other liabilities | 600,622 | 2,608,316 | 68,838 | 14,897 | 276,904 | 3,569,577 |\n| Total liabilities | 6,793,433 | 19,805,088 | 6,316,980 | 893,403 | 276,904 | 34,085,808 |\n| Total equity | 3,328,394 | 2,031,631 | 1,382,137 | 90,932 | 429,023 | 7,262,117 |\n| Noncontrolling interests in equity of consolidated subsidiaries | 61,132 | — | — | 22,520 | — | 83,652 |\n| Total New Residential stockholders’ equity | $ | 3,267,262 | $ | 2,031,631 | $ | 1,382,137 | $ | 68,412 | $ | 429,023 | $ | 7,178,465 |\n| Investments in equity method investees | $ | 249,134 | $ | — | $ | — | $ | 23,033 | $ | — | $ | 272,167 |\n\n18\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| Residential Securities and Loans |\n| Servicing and Originations | Real Estate Securities | Residential Mortgage Loans | Consumer Loans | Corporate | Total |\n| Three Months Ended September 30, 2018 |\n| Interest income | $ | 187,584 | $ | 138,197 | $ | 48,782 | $ | 50,961 | $ | — | $ | 425,524 |\n| Interest expense | 61,706 | 67,117 | 23,662 | 10,321 | — | 162,806 |\n| Net interest income (expense) | 125,878 | 71,080 | 25,120 | 40,640 | — | 262,718 |\n| Impairment | — | 3,889 | ( 4,436 | ) | 9,907 | — | 9,360 |\n| Servicing revenue, net | 175,355 | — | — | — | — | 175,355 |\n| Gain on sale of originated mortgage loans, net | 45,732 | — | — | — | — | 45,732 |\n| Other income (loss) | ( 92,243 | ) | 17,994 | ( 12,729 | ) | 3,795 | ( 115 | ) | ( 83,298 | ) |\n| Operating expenses | 132,542 | 63 | 6,436 | 8,467 | 44,599 | 192,107 |\n| Income (Loss) Before Income Taxes | 122,180 | 85,122 | 10,391 | 26,061 | ( 44,714 | ) | 199,040 |\n| Income tax expense (benefit) | 495 | — | 3,100 | ( 32 | ) | — | 3,563 |\n| Net Income (Loss) | $ | 121,685 | $ | 85,122 | $ | 7,291 | $ | 26,093 | $ | ( 44,714 | ) | $ | 195,477 |\n| Noncontrolling interests in income (loss) of consolidated subsidiaries | $ | 1,086 | $ | — | $ | — | $ | 9,783 | $ | — | $ | 10,869 |\n| Net income (loss) attributable to common stockholders | $ | 120,599 | $ | 85,122 | $ | 7,291 | $ | 16,310 | $ | ( 44,714 | ) | $ | 184,608 |\n\n| Residential Securities and Loans |\n| Servicing and Originations | Real Estate Securities | Residential Mortgage Loans | Consumer Loans | Corporate | Total |\n| Nine Months Ended September 30, 2018 |\n| Interest income | $ | 574,379 | $ | 354,922 | $ | 123,464 | $ | 158,631 | $ | 1,506 | $ | 1,212,902 |\n| Interest expense | 172,471 | 157,195 | 58,587 | 32,856 | — | 421,109 |\n| Net interest income (expense) | 401,908 | 197,727 | 64,877 | 125,775 | 1,506 | 791,793 |\n| Impairment | — | 23,190 | ( 8,683 | ) | 36,819 | — | 51,326 |\n| Servicing revenue, net | 538,784 | — | — | — | — | 538,784 |\n| Gain on sale of originated mortgage loans, net | 45,732 | — | — | — | — | 45,732 |\n| Other income (loss) | 48,128 | 45,346 | ( 27,219 | ) | 13,363 | 4,796 | 84,414 |\n| Operating expenses | 235,417 | 1,003 | 25,658 | 26,743 | 130,856 | 419,677 |\n| Income (Loss) Before Income Taxes | 799,135 | 218,880 | 20,683 | 75,576 | ( 124,554 | ) | 989,720 |\n| Income tax expense (benefit) | ( 6,458 | ) | — | 289 | 212 | — | ( 5,957 | ) |\n| Net Income (Loss) | $ | 805,593 | $ | 218,880 | $ | 20,394 | $ | 75,364 | $ | ( 124,554 | ) | $ | 995,677 |\n| Noncontrolling interests in income (loss) of consolidated subsidiaries | $ | 3,525 | $ | — | $ | — | $ | 28,533 | $ | — | $ | 32,058 |\n| Net income (loss) attributable to common stockholders | $ | 802,068 | $ | 218,880 | $ | 20,394 | $ | 46,831 | $ | ( 124,554 | ) | $ | 963,619 |\n\n19\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| 4. | INVESTMENTS IN EXCESS MORTGAGE SERVICING RIGHTS |\n\nThe following table presents activity related to the carrying value of New Residential’s direct investments in Excess MSRs:\n| Servicer |\n| Nationstar | SLS(A) | Total |\n| Balance as of December 31, 2018 | $ | 445,328 | $ | 2,532 | $ | 447,860 |\n| Purchases | — | — | — |\n| Interest income | 18,159 | 44 | 18,203 |\n| Other income | 2,092 | — | 2,092 |\n| Proceeds from repayments | ( 63,794 | ) | ( 295 | ) | ( 64,089 | ) |\n| Proceeds from sales | ( 4,581 | ) | — | ( 4,581 | ) |\n| Change in fair value | ( 1,258 | ) | ( 163 | ) | ( 1,421 | ) |\n| Balance as of September 30, 2019 | $ | 395,946 | $ | 2,118 | $ | 398,064 |\n\n| (A) | Specialized Loan Servicing LLC (“SLS”). |\n\nNationstar or SLS, as applicable, as servicer, performs all of the servicing and advancing functions, and retains the ancillary income, servicing obligations and liabilities as the servicer of the underlying loans in the portfolio.\nNew Residential has entered into a “recapture agreement” with respect to each of the Excess MSR investments serviced by Nationstar and SLS. Under such arrangements, New Residential is generally entitled to a pro rata interest in the Excess MSRs on any initial or subsequent refinancing by Nationstar of a loan in the original portfolio. These recapture agreements do not apply to New Residential’s Servicer Advance Investments (Note 6).\nNew Residential elected to record its investments in Excess MSRs at fair value pursuant to the fair value option for financial instruments in order to provide users of the financial statements with better information regarding the effects of prepayment risk and other market factors on the Excess MSRs.\nThe following is a summary of New Residential’s direct investments in Excess MSRs:\n| September 30, 2019 | December 31, 2018 |\n| UPB of Underlying Mortgages | Interest in Excess MSR | Weighted Average Life Years(A) | Amortized Cost Basis(B) | Carrying Value(C) | Carrying Value(C) |\n| New Residential(D) | Fortress-managed funds | Nationstar |\n| Agency | $ | 45,900,654 | 32.5% - 66.7% (53.3%) | 0.0% - 40.0% | 20.0% - 35.0% | 5.4 | $ | 183,064 | $ | 221,560 | $ | 257,387 |\n| Non-Agency(E) | $ | 47,124,536 | 33.3% - 100.0% (59.4%) | 0.0% - 50.0% | 0.0% - 33.3% | 6.5 | $ | 129,647 | $ | 176,504 | $ | 190,473 |\n| Total | $ | 93,025,190 | 5.9 | $ | 312,711 | $ | 398,064 | $ | 447,860 |\n\n\n| (A) | Weighted Average Life represents the weighted average expected timing of the receipt of expected cash flows for this investment. |\n\n| (B) | The amortized cost basis of the recapture agreements is determined based on the relative fair values of the recapture agreements and related Excess MSRs at the time they were acquired. |\n\n| (C) | Carrying Value represents the fair value of the pools or recapture agreements, as applicable. |\n\n| (D) | Amounts in parentheses represent weighted averages. |\n\n| (E) | Serviced by Nationstar and SLS, New Residential is also invested in related Servicer Advance Investments, including the basic fee component of the related MSR as of September 30, 2019 (Note 6) on $ 33.4 billion UPB underlying these Excess MSRs. |\n\n20\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nChanges in fair value recorded in other income is comprised of the following:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Original and Recaptured Pools | $ | 2,407 | $ | ( 4,744 | ) | $ | ( 1,421 | ) | $ | ( 55,711 | ) |\n\nAs of September 30, 2019, a weighted average discount rate of 7.8 % was used to value New Residential’s investments in Excess MSRs (directly and through equity method investees).\nNew Residential entered into investments in joint ventures (“Excess MSR joint ventures”) jointly controlled by New Residential and Fortress-managed funds investing in Excess MSRs. New Residential elected to record these investments at fair value pursuant to the fair value option for financial instruments to provide users of the financial statements with better information regarding the effects of prepayment risk and other market factors.\nThe following tables summarize the financial results of the Excess MSR joint ventures, accounted for as equity method investees, held by New Residential:\n| September 30, 2019 | December 31, 2018 |\n| Excess MSR assets | $ | 236,786 | $ | 269,203 |\n| Other assets | 28,418 | 27,411 |\n| Other liabilities | ( 687 | ) | ( 687 | ) |\n| Equity | $ | 264,517 | $ | 295,927 |\n| New Residential’s investment | $ | 132,259 | $ | 147,964 |\n| New Residential’s ownership | 50.0 | % | 50.0 | % |\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Interest income | $ | 7,990 | $ | 8,935 | $ | 12,251 | $ | 21,026 |\n| Other income (loss) | 1,528 | ( 2,143 | ) | ( 4,029 | ) | ( 9,778 | ) |\n| Expenses | ( 16 | ) | — | ( 48 | ) | — |\n| Net income (loss) | $ | 9,502 | $ | 6,792 | $ | 8,174 | $ | 11,248 |\n\nNew Residential’s investments in equity method investees changed during the nine months ended September 30, 2019 as follows:\n| Balance at December 31, 2018 | $ | 147,964 |\n| Contributions to equity method investees | — |\n| Distributions of earnings from equity method investees | ( 7,762 | ) |\n| Distributions of capital from equity method investees | ( 12,030 | ) |\n| Change in fair value of investments in equity method investees | 4,087 |\n| Balance at September 30, 2019 | $ | 132,259 |\n\n21\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nThe following is a summary of New Residential’s Excess MSR investments made through equity method investees:\n| September 30, 2019 |\n| Unpaid Principal Balance | Investee Interest in Excess MSR(A) | New Residential Interest in Investees | Amortized Cost Basis(B) | Carrying Value(C) | Weighted Average Life (Years)(D) |\n| Agency | $ | 35,632,429 | 66.7 | % | 50.0 | % | $ | 171,553 | $ | 236,786 | 5.3 |\n\n\n| (A) | The remaining interests are held by Nationstar. |\n\n| (B) | Represents the amortized cost basis of the equity method investees in which New Residential holds a 50 % interest. The amortized cost basis of the recapture agreements is determined based on the relative fair values of the recapture agreements and related Excess MSRs at the time they were acquired. |\n\n| (C) | Represents the carrying value of the Excess MSRs held in equity method investees, in which New Residential holds a 50 % interest. Carrying value represents the fair value of the pools or recapture agreements, as applicable. |\n\n| (D) | The weighted average life represents the weighted average expected timing of the receipt of cash flows of each investment. |\n\nSee Note 11 regarding the financing of Excess MSRs.\n5. INVESTMENTS IN MORTGAGE SERVICING RIGHTS AND MSR FINANCING RECEIVABLES\nA subsidiary of New Residential, New Residential Mortgage LLC (“NRM”), engages third party licensed mortgage servicers as subservicers to perform the operational servicing duties in connection with the MSRs it acquires, in exchange for a subservicing fee which is recorded as “Subservicing expense” on New Residential’s Condensed Consolidated Statements of Income. As of September 30, 2019, these subservicers include PHH Mortgage Corporation (“PHH”), Nationstar, LoanCare, LLC (“LoanCare”), AmeriHome Mortgage Company, LLC (“AmeriHome”), and Flagstar Bank, FSB (“Flagstar”), which subservice 26.9 %, 23.1 %, 19.2 %, 1.8 %, and 0.8 % of the underlying UPB of the related mortgages, respectively (includes both Mortgage Servicing Rights and MSR Financing Receivables). The remaining 28.2 % of the underlying UPB of the related mortgages is subserviced by a subsidiary of New Residential, Shellpoint Mortgage Servicing (Note 1).\nNew Residential has entered into recapture agreements with respect to each of its MSR investments subserviced by PHH, LoanCare, Flagstar, and Nationstar. Under the recapture agreements, New Residential is generally entitled to the MSRs on any initial or subsequent refinancing by PHH, Loancare, Flagstar or Nationstar of a loan in the original portfolios.\nIn certain cases, New Residential has legally purchased MSRs or the right to the economic interest in MSRs; however, New Residential has determined that the purchase agreement would not be treated as a sale under GAAP. Therefore, rather than recording an investment in MSRs, New Residential has recorded an investment in mortgage servicing rights financing receivables (“MSR Financing Receivables”). Income from these investments (net of subservicing fees) are recorded as interest income, and New Residential has elected to measure the investments at fair value, with changes in fair value flowing through change in fair value of investments in MSR financing receivables in the Condensed Consolidated Statements of Income.\nNew Residential records its investments in MSRs and MSR Financing Receivables at fair value at acquisition and has elected to subsequently measure at fair value pursuant to the fair value measurement method.\n22\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nThe following table presents activity related to the carrying value of New Residential’s investments in MSRs and MSR Financing Receivables:\n| MSRs | MSR Financing Receivables | Total |\n| Balance as of December 31, 2018 | $ | 2,884,100 | $ | 1,644,504 | $ | 4,528,604 |\n| Purchases, net(A) | 632,144 | 735,152 | 1,367,296 |\n| Transfers(B) | 367,121 | ( 367,121 | ) | — |\n| Other transfers(C) | ( 410 | ) | — | ( 410 | ) |\n| Originations(D) | 190,666 | — | 190,666 |\n| Prepayments(E) | ( 11,210 | ) | ( 52,499 | ) | ( 63,709 | ) |\n| Proceeds from sales | ( 1,047 | ) | ( 15,575 | ) | ( 16,622 | ) |\n| Amortization of servicing rights(F) | ( 351,867 | ) | ( 131,417 | ) | ( 483,284 | ) |\n| Change in valuation inputs and assumptions(G) | ( 279,758 | ) | 1,437 | ( 278,321 | ) |\n| (Gain)/loss on sales | 2,229 | ( 3,220 | ) | ( 991 | ) |\n| Balance as of September 30, 2019 | $ | 3,431,968 | $ | 1,811,261 | $ | 5,243,229 |\n\n| (A) | Net of purchase price adjustments. |\n\n| (B) | Represents MSRs previously accounted for as MSR Financing Receivables. As a result of the length of the initial term of the related subservicing agreement between NRM and PHH, although the MSRs were legally sold, solely for accounting purposes, the purchase agreement was not treated as a sale under GAAP through June 30, 2019. |\n\n| (C) | Represents Ginnie Mae MSRs repurchased. |\n\n| (D) | Represents MSRs retained on the sale of originated mortgage loans. |\n\n| (E) | Represents purchase price fully reimbursable from sellers as a result of prepayment protection. |\n\n| (F) | Based on the ratio of the current UPB of the underlying residential mortgage loans relative to the original UPB of the underlying residential mortgage loans. |\n\n| (G) | Change in valuation inputs and assumptions includes changes in inputs or assumptions used in the valuation model. |\n\nServicing revenue, net recognized by New Residential related to its investments in MSRs was comprised of the following:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Servicing fee revenue | $ | 222,966 | $ | 158,458 | $ | 602,241 | $ | 408,967 |\n| Ancillary and other fees | 58,489 | 43,638 | 151,039 | 94,699 |\n| Servicing fee revenue and fees | 281,455 | 202,096 | 753,280 | 503,666 |\n| Amortization of servicing rights | ( 168,776 | ) | ( 70,933 | ) | ( 346,772 | ) | ( 191,499 | ) |\n| Change in valuation inputs and assumptions(A) (B) | ( 61,858 | ) | 44,192 | ( 275,371 | ) | 226,617 |\n| (Gain)/loss on sales | 2,229 | — | 2,229 | — |\n| Servicing revenue, net | $ | 53,050 | $ | 175,355 | $ | 133,366 | $ | 538,784 |\n\n| (A) | Change in valuation inputs and assumptions includes changes in inputs or assumptions used in the valuation model. |\n\n| (B) | Includes $ 3.6 million and $ 4.4 million of fair value adjustment to Excess spread financing for the three and nine months ended September 30, 2019, respectively. |\n\n23\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nInterest income from investments in MSR Receivables was comprised of the following:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Servicing fee revenue | $ | 128,936 | $ | 181,495 | $ | 385,306 | $ | 575,909 |\n| Ancillary and other fees | 21,417 | 39,257 | 82,695 | 109,852 |\n| Less: subservicing expense | ( 40,410 | ) | ( 61,454 | ) | ( 145,649 | ) | ( 192,275 | ) |\n| Interest income, investments in mortgage servicing rights financing receivables | $ | 109,943 | $ | 159,298 | $ | 322,352 | $ | 493,486 |\n\nChange in fair value of investments in MSR Financing Receivables was comprised of the following:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Amortization of servicing rights | $ | ( 48,340 | ) | $ | ( 49,016 | ) | $ | ( 131,417 | ) | $ | ( 154,559 | ) |\n| Change in valuation inputs and assumptions(A) | 9,349 | ( 39,329 | ) | 1,437 | 218,187 |\n| (Gain)/loss on sales(B) | ( 2,419 | ) | — | ( 3,220 | ) | — |\n| Change in fair value of investments in mortgage servicing rights financing receivables | $ | ( 41,410 | ) | $ | ( 88,345 | ) | $ | ( 133,200 | ) | $ | 63,628 |\n\n| (A) | Change in valuation inputs and assumptions includes changes in inputs or assumptions used in the valuation model. |\n\n| (B) | Represents the realization of unrealized gain/(loss) as a result of sales. |\n\nThe following is a summary of New Residential’s investments in MSRs as of September 30, 2019:\n| UPB of Underlying Mortgages | Weighted Average Life (Years)(A) | Amortized Cost Basis | Carrying Value(B) |\n| MSRs: |\n| Agency | $ | 288,673,487 | 4.9 | $ | 2,968,392 | $ | 3,038,721 |\n| Non-Agency | 2,350,471 | 5.6 | 12,294 | 20,321 |\n| Ginnie Mae(C) | 28,903,327 | 4.0 | 383,454 | 372,926 |\n| MSR Financing Receivables: |\n| Agency | 61,162,569 | 4.3 | 659,950 | 597,990 |\n| Non-Agency | 79,360,666 | 7.7 | 840,279 | 1,213,271 |\n| Total | $ | 460,450,520 | 5.2 | $ | 4,864,369 | $ | 5,243,229 |\n\n| (A) | Weighted Average Life represents the weighted average expected timing of the receipt of expected cash flows for this investment. |\n\n| (B) | Carrying Value represents fair value. As of September 30, 2019, a weighted average discount rate of 7.5 % and 8.8 % was used to value New Residential’s investments in MSRs and MSR Financing Receivables, respectively. |\n\n| (C) | NewRez, as an approved issuer of Ginnie Mae MBS, originates, sells and securitizes government-insured residential mortgage loans into Ginnie Mae guaranteed securitizations and NewRez retains the right to service the underlying residential mortgage loans. As the servicer, NewRez holds an option to repurchase delinquent loans from the securitization at its discretion. As of September 30, 2019, New Residential holds approximately $ 168.5 million in residential mortgage loans subject to repurchase and residential mortgage loans repurchase liability on its condensed consolidated balance sheets. |\n\n24\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nOcwen MSR Financing Receivable Transactions\nOn July 23, 2017, Ocwen and New Residential entered into a Master Agreement (the “Ocwen Master Agreement”) and a Transfer Agreement (the “Ocwen Transfer Agreement”) pursuant to which Ocwen and New Residential agreed to undertake certain actions to facilitate the transfer from Ocwen to New Residential of Ocwen’s remaining interests in the mortgage servicing rights relating to loans with an aggregate unpaid principal balance of approximately $ 110.0 billion that are subject to the Original Ocwen Agreements (the “Ocwen Subject MSRs”) and with respect to which New Residential holds the Rights to MSRs (as defined in the Original Ocwen Agreements). New Residential and Ocwen concurrently entered into a subservicing agreement pursuant to which Ocwen will subservice the mortgage loans related to the Ocwen Subject MSRs that are transferred to New Residential pursuant to the Ocwen Master Agreement and Ocwen Transfer Agreement.\nOn January 18, 2018, New Residential entered into a new agreement regarding the rights to MSRs (the “New Ocwen RMSR Agreement”) including a servicing addendum thereto (the “Ocwen Servicing Addendum”), Amendment No. 1 to Transfer Agreement (the “New Ocwen Transfer Agreement”) and a Brokerage Services Agreement (the “Ocwen Brokerage Services Agreement” and, collectively, the “New Ocwen Agreements”) with Ocwen. The New Ocwen Agreements amend and supplement the arrangements among the parties set forth in the Original Ocwen Agreements, the Ocwen Master Agreement, the Ocwen Transfer Agreement, and the Ocwen Subservicing Agreement (together with the Original Ocwen Agreements, the Ocwen Master Agreement, and the Ocwen Transfer Agreement, the “Existing Ocwen Agreements”). NRM made a lump-sum “Fee Restructuring Payment” of $ 279.6 million to Ocwen on January 18, 2018, the date of the New Ocwen RMSR Agreement, with respect to such Existing Ocwen Subject MSRs.\nUnder the Existing Ocwen Agreements, Ocwen sold and transferred to New Residential certain “Rights to MSRs” and other assets related to mortgage servicing rights for loans with an unpaid principal balance of approximately $ 86.8 billion as of the opening balances in January 2018 (the “Existing Ocwen Subject MSRs”). The New Ocwen Agreements and NRM’s Fee Restructuring Payment resulted in a new investment structured as a transfer of the full interests and economics of the Ocwen subject MSRs.\nPursuant to the New Ocwen Agreements, Ocwen will continue to service the mortgage loans related to the Existing Ocwen Subject MSRs until the necessary third party consents are obtained in order to transfer the Existing Ocwen Subject MSRs in accordance with the New Ocwen Agreements.\nPursuant to the Ocwen Brokerage Services Agreement, Ocwen will engage NRZ Brokerage to perform brokerage and marketing services for all REO properties serviced by Ocwen pursuant to the Subject Servicing Agreements as defined in the New Ocwen RMSR Agreement. Such REO properties are subject to the Altisource Brokerage Agreement and Altisource Letter Agreement.\nAs of September 30, 2019, MSRs representing approximately $ 66.7 billion UPB of underlying loans have been transferred pursuant to the Ocwen Transaction. Economics related to the remaining MSRs subject to the Ocwen Transaction were transferred pursuant to the New Ocwen Agreements. As a result of the length of the initial term of the related subservicing agreement between NRM and Ocwen, although the MSRs transferred pursuant to the Ocwen Transaction were legally sold, solely for accounting purposes, New Residential determined that substantially all of the risks and rewards inherent in owning the MSRs had not been transferred to NRM, and that the purchase agreement would not be treated as a sale under GAAP.\nAs a part of the ongoing integration efforts related to the Ocwen and PHH merger completed on October 4, 2018, Ocwen now conducts its mortgage servicing business under the PHH tradename.\nNationstar MSR Financing Receivable Transaction\nOn February 28, 2019, NRM entered into an agreement with Nationstar to purchase the MSRs, and related servicer advance receivables, with respect to $ 9.5 billion in total UPB of seasoned Agency residential mortgage loans. The residential mortgage loans underlying the MSRs acquired by NRM are subserviced by Nationstar pursuant to an existing subservicing agreement with NRM. As a result of the length of the initial term of the related subservicing agreement between NRM and Nationstar, although the MSRs were legally sold, solely for accounting purposes, New Residential determined that substantially all of the risks and rewards inherent in owning the MSRs had not been transferred to NRM, and that the purchase agreement would not be treated as a sale under GAAP.\n25\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nUnited Shore MSR Financing Receivable Transactions\nOn April 2, 2019 and May 21, 2019, NRM entered into agreements with United Shore to purchase the MSRs, and related servicer advance receivables, with respect to $ 8.2 billion and $ 23.7 billion in total UPB of seasoned Agency residential mortgage loans, respectively. The residential mortgage loans underlying the MSRs acquired by NRM will be subserviced by NewRez, Nationstar and LoanCare pursuant to existing subservicing agreements with NRM. As a result of the length of term of prepayment protection provided to NRM, although the MSRs were legally sold, solely for accounting purposes, New Residential determined that the transferor retained more than minor protection provisions, and that the purchase agreement would not be treated as a sale under GAAP.\nQuicken MSR Financing Receivable Transaction\nOn August 6, 2019, NRM entered into an agreement with Quicken to purchase the MSRs, and related servicer advance receivables, with respect to $ 29.1 billion in total UPB of seasoned Agency residential mortgage loans. The residential mortgage loans underlying the MSRs acquired by NRM are subserviced by LoanCare pursuant to an existing subservicing agreement with NRM. As a result of the length of term of prepayment protection provided to NRM, although the MSRs were legally sold, solely for accounting purposes, New Residential determined that the transferor retained more than minor protection provisions, and that the purchase agreement would not be treated as a sale under GAAP.\nThe table below summarizes the geographic distribution of the underlying residential mortgage loans of the investments in MSRs and MSR Financing Receivables:\n| Percentage of Total Outstanding Unpaid Principal Amount |\n| State Concentration | September 30, 2019 | December 31, 2018 |\n| California | 23.0 | % | 21.7 | % |\n| Florida | 6.8 | % | 6.9 | % |\n| New York | 6.8 | % | 7.8 | % |\n| Texas | 5.2 | % | 5.3 | % |\n| New Jersey | 5.0 | % | 5.0 | % |\n| Illinois | 3.6 | % | 3.7 | % |\n| Washington | 3.5 | % | 2.3 | % |\n| Massachusetts | 3.3 | % | 3.5 | % |\n| Maryland | 3.1 | % | 3.4 | % |\n| Georgia | 3.0 | % | 3.0 | % |\n| Other U.S. | 36.7 | % | 37.4 | % |\n| 100.0 | % | 100.0 | % |\n\nGeographic concentrations of investments expose New Residential to the risk of economic downturns within the relevant states. Any such downturn in a state where New Residential holds significant investments could affect the underlying borrower’s ability to make mortgage payments and therefore could have a meaningful, negative impact on the MSRs.\nMortgage Subservicing\nNewRez performs servicing of residential mortgage loans for third parties under subservicing agreements. Mortgage subservicing does not meet the criteria to be recognized as a servicing right asset and, therefore, is not recognized on New Residential’s condensed consolidated balance sheets. The UPB of residential mortgage loans subserviced for others as of September 30, 2019 was $ 54.7 billion and subservicing revenue of $ 99.7 million for the nine months ended September 30, 2019 is included within servicing revenue, net in the Condensed Consolidated Statements of Income.\n26\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nServicer Advances Receivable\nIn connection with its investments in MSRs and MSR financing receivables, New Residential generally acquires any related outstanding servicer advances (not included in the purchase prices described above), which it records at fair value within servicer advances receivable upon acquisition.\nIn addition to receiving cash flows from the MSRs, NRM and NewRez, as servicers, have the obligation to fund future servicer advances on the underlying pool of mortgages (Note 14). These servicer advances are recorded when advanced and are included in servicer advances receivable.\nThe following types of advances are included in the Servicer Advances Receivable:\n| September 30, 2019 | December 31, 2018 |\n| Principal and interest advances | $ | 723,155 | $ | 793,790 |\n| Escrow advances (taxes and insurance advances) | 1,945,271 | 2,186,831 |\n| Foreclosure advances | 173,032 | 199,203 |\n| Total(A) (B) (C) | $ | 2,841,458 | $ | 3,179,824 |\n\n| (A) | Includes $ 243.0 million and $ 231.2 million of servicer advances receivable related to Agency MSRs, respectively, recoverable from the Agencies. |\n\n| (B) | Includes $ 62.7 million and $ 41.6 million of servicer advances receivable related to Ginnie Mae MSRs, respectively, recoverable from Ginnie Mae. Reserves for advances associated with Ginnie Mae loans in the MSR portfolio are considered in the MSR fair valuation through a nonreimbursable advance loss assumption. |\n\n| (C) | Net of $ 70.3 million and $ 98.0 million, respectively, in accrual for advance recoveries. |\n\nNew Residential’s Servicer Advances Receivable related to Non-Agency MSRs generally have the highest reimbursement priority (i.e., “top of the waterfall”) and New Residential is generally entitled to repayment from respective loan or REO liquidation proceeds before any interest or principal is paid on the bonds that were issued by the trust. In the majority of cases, advances in excess of respective loan or REO liquidation proceeds may be recovered from pool-level proceeds. Furthermore, to the extent that advances are not recoverable by New Residential as a result of the subservicer’s failure to comply with applicable requirements in the relevant servicing agreements, New Residential has a contractual right to be reimbursed by the subservicer. New Residential assesses the recoverability of Servicer Advance Receivables periodically and as of September 30, 2019 and December 31, 2018, expected full recovery of the Servicer Advance Receivables.\nSee Note 11 regarding the financing of MSRs.\n| 6. | SERVICER ADVANCE INVESTMENTS |\n\nAll of New Residential’s Servicer Advance Investments are comprised of outstanding servicer advances, the requirement to purchase all future servicer advances made with respect to a specified pool of residential mortgage loans, and the basic fee component of the related MSR. New Residential elected to record its Servicer Advance Investments, including the right to the basic fee component of the related MSRs, at fair value pursuant to the fair value option for financial instruments to provide users of the financial statements with better information regarding the effects of market factors.\nA taxable wholly-owned subsidiary of New Residential is the managing member of the Buyer and owned an approximately 73.2 % interest in the Buyer as of September 30, 2019. As of September 30, 2019, third-party co-investors, owning the remaining interest in the Buyer, have funded capital commitments to the Buyer of $ 389.6 million and New Residential has funded capital commitments to the Buyer of $ 312.7 million. The Buyer may call capital up to the commitment amount on unfunded commitments and recall capital to the extent the Buyer makes a distribution to the co-investors, including New Residential. As of September 30, 2019, the noncontrolling third-party co-investors and New Residential had previously funded their commitments, however the Buyer may recall $ 325.0 million and $ 297.6 million of capital distributed to the third-party co-investors and New Residential, respectively. Neither the third-party co-investors nor New Residential is obligated to fund amounts in excess of their respective capital commitments, regardless of the capital requirements of the Buyer.\n27\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nSee Note 5 regarding the New Ocwen Agreements. Subsequent to the New Ocwen Agreements, the Servicer Advance Investments serviced by Ocwen are accounted for as Servicer Advances Receivable, as described in Note 5.\nThe following is a summary of New Residential’s Servicer Advance Investments, including the right to the basic fee component of the related MSRs:\n| Amortized Cost Basis | Carrying Value(A) | Weighted Average Discount Rate | Weighted Average Yield | Weighted Average Life (Years)(B) |\n| September 30, 2019 |\n| Servicer Advance Investments | $ | 570,570 | $ | 600,547 | 5.1 | % | 5.7 | % | 6.3 |\n| As of December 31, 2018 |\n| Servicer Advance Investments | $ | 721,801 | $ | 735,846 | 5.9 | % | 5.8 | % | 5.7 |\n\n\n| (A) | Carrying value represents the fair value of the Servicer Advance Investments, including the basic fee component of the related MSRs. |\n\n| (B) | Weighted Average Life represents the weighted average expected timing of the receipt of expected net cash flows for this investment. |\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Change in Fair Value of Servicer Advance Investments | $ | 6,641 | $ | ( 5,353 | ) | $ | 15,932 | $ | ( 86,581 | ) |\n\nThe following is additional information regarding the Servicer Advance Investments and related financing:\n| Loan-to-Value (“LTV”)(A) | Cost of Funds(C) |\n| UPB of Underlying Residential Mortgage Loans | Outstanding Servicer Advances | Servicer Advances to UPB of Underlying Residential Mortgage Loans | Face Amount of Notes and Bonds Payable | Gross | Net(B) | Gross | Net |\n| September 30, 2019 |\n| Servicer Advance Investments(D) | $ | 33,406,320 | $ | 492,480 | 1.5 | % | $ | 449,731 | 87.3 | % | 86.1 | % | 3.8 | % | 3.1 | % |\n| December 31, 2018 |\n| Servicer Advance Investments(D) | $ | 40,096,998 | $ | 620,050 | 1.5 | % | $ | 574,117 | 88.3 | % | 87.2 | % | 3.7 | % | 3.1 | % |\n\n\n| (A) | Based on outstanding servicer advances, excluding purchased but unsettled servicer advances. |\n\n| (B) | Ratio of face amount of borrowings to par amount of servicer advance collateral, net of any general reserve. |\n\n| (C) | Annualized measure of the cost associated with borrowings. Gross Cost of Funds primarily includes interest expense and facility fees. Net Cost of Funds excludes facility fees. |\n\n| (D) | The following types of advances are included in the Servicer Advance Investments: |\n\n| September 30, 2019 | December 31, 2018 |\n| Principal and interest advances | $ | 82,999 | $ | 108,317 |\n| Escrow advances (taxes and insurance advances) | 185,774 | 238,349 |\n| Foreclosure advances | 223,707 | 273,384 |\n| Total | $ | 492,480 | $ | 620,050 |\n\n28\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nInterest income recognized by New Residential related to its Servicer Advance Investments was comprised of the following:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Interest income, gross of amounts attributable to servicer compensation | $ | 14,212 | $ | 21,183 | $ | 43,220 | $ | 63,731 |\n| Amounts attributable to base servicer compensation | ( 1,606 | ) | ( 2,347 | ) | ( 4,578 | ) | ( 6,354 | ) |\n| Amounts attributable to incentive servicer compensation | ( 7,273 | ) | ( 7,095 | ) | ( 20,780 | ) | ( 14,255 | ) |\n| Interest income from Servicer Advance Investments | $ | 5,333 | $ | 11,741 | $ | 17,862 | $ | 43,122 |\n\nNew Residential has determined that the Buyer is a VIE. The following table presents information on the assets and liabilities related to this consolidated VIE.\n| As of |\n| September 30, 2019 | December 31, 2018 |\n| Assets |\n| Servicer advance investments, at fair value | $ | 580,829 | $ | 713,239 |\n| Cash and cash equivalents | 36,457 | 29,833 |\n| All other assets | 8,662 | 10,223 |\n| Total assets(A) | $ | 625,948 | $ | 753,295 |\n| Liabilities |\n| Notes and bonds payable | $ | 435,935 | $ | 556,340 |\n| All other liabilities | 2,021 | 2,442 |\n| Total liabilities(A) | $ | 437,956 | $ | 558,782 |\n\n| (A) | The creditors of the Buyer do not have recourse to the general credit of New Residential and the assets of the Buyer are not directly available to satisfy New Residential’s obligations. |\n\nOthers’ interests in the equity of the Buyer is computed as follows:\n| September 30, 2019 | December 31, 2018 |\n| Total Advance Purchaser LLC equity | $ | 187,992 | $ | 194,513 |\n| Others’ ownership interest | 26.8 | % | 26.8 | % |\n| Others’ interest in equity of consolidated subsidiary | $ | 50,319 | $ | 52,066 |\n\nOthers’ interests in the Buyer’s net income is computed as follows:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Net Advance Purchaser LLC income | $ | 6,288 | $ | ( 299 | ) | $ | 16,678 | $ | 8,667 |\n| Others’ ownership interest as a percent of total | 26.8 | % | 27.1 | % | 26.8 | % | 27.2 | % |\n| Others’ interest in net income of consolidated subsidiaries | $ | 1,684 | $ | ( 81 | ) | $ | 4,466 | $ | 2,358 |\n\nSee Note 11 regarding the financing of Servicer Advance Investments.\n29\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| 7. | INVESTMENTS IN REAL ESTATE AND OTHER SECURITIES |\n\n“Agency” residential mortgage backed securities (“RMBS”) are RMBS issued by a government sponsored enterprise, such as the Federal National Mortgage Association (“Fannie Mae”) or the Federal Home Loan Mortgage Corporation (“Freddie Mac”). “Non-Agency” RMBS are issued by either public trusts or private label securitization entities.\nActivities related to New Residential’s investments in real estate and other securities were as follows:\n| Three Months Ended September 30, 2019 | Nine Months Ended September 30, 2019 |\n| (in millions) | (in millions) |\n| Agency | Non-Agency | Agency | Non-Agency |\n| Purchases |\n| Face | $ | 12,306.4 | $ | 3,324.9 | $ | 25,123.5 | $ | 7,899.1 |\n| Purchase Price | 12,610.9 | 247.0 | 25,700.0 | 1,164.9 |\n| Sales |\n| Face | $ | 6,073.4 | $ | 1,325.2 | $ | 17,898.5 | $ | 2,162.7 |\n| Amortized Cost | 6,233.5 | 832.4 | 18,339.1 | 1,571.0 |\n| Sale Price | 6,252.8 | 910.9 | 18,451.4 | 1,662.9 |\n| Gain (Loss) on Sale | 19.3 | 78.5 | 112.3 | 91.9 |\n\nAs of September 30, 2019, New Residential had sold and purchased $ 4.3 billion and $ 2.5 billion face amount of Agency RMBS for $ 4.4 billion and $ 2.5 billion, respectively, which had not yet been settled. These unsettled sales and purchases were recorded on the balance sheet on trade date as Trades Receivable and Trades Payable.\nNew Residential has exercised its call rights with respect to Non-Agency RMBS trusts and purchased performing and non-performing residential mortgage loans and REO contained in such trusts prior to their termination. In certain cases, New Residential sold portions of the purchased loans through securitizations, and retained bonds issued by such securitizations. In addition, New Residential received par on the securities issued by the called trusts which it owned prior to such trusts’ termination. Refer to Note 8 for further details on these transactions.\nThe following is a summary of New Residential’s real estate and other securities, all of which are classified as available-for-sale and are, therefore, reported at fair value with changes in fair value recorded in other comprehensive income, except for securities that are other-than-temporarily impaired and except for securities which New Residential elected to carry at fair value and record changes to valuation through the income statement.\n| September 30, 2019 | December 31, 2018 |\n| Gross Unrealized | Weighted Average |\n| Asset Type | Outstanding Face Amount | Amortized Cost Basis | Gains | Losses | Carrying Value(A) | Number of Securities | Rating(B) | Coupon(C) | Yield | Life (Years)(D) | Principal Subordination(E) | Carrying Value |\n| Agency RMBS(F) (G) | $ | 8,797,199 | $ | 8,950,763 | $ | 56,939 | $ | ( 9,636 | ) | $ | 8,998,066 | 39 | AAA | 3.66 | % | 3.06 | % | 4.6 | N/A | $ | 2,665,618 |\n| Non-Agency RMBS(H) (I) | 21,845,814 | 7,175,703 | 711,078 | ( 30,937 | ) | 7,855,844 | 950 | B+ | 3.03 | % | 4.84 | % | 6.3 | 10.6 | % | 8,970,963 |\n| Total/ Weighted Average | $ | 30,643,013 | $ | 16,126,466 | $ | 768,017 | $ | ( 40,573 | ) | $ | 16,853,910 | 989 | BBB+ | 3.35 | % | 3.85 | % | 5.3 | $ | 11,636,581 |\n\n\n| (A) | Fair value, which is equal to carrying value for all securities. See Note 12 regarding the estimation of fair value. |\n\n| (B) | Represents the weighted average of the ratings of all securities in each asset type, expressed as an S&P equivalent rating. This excludes the ratings of the collateral underlying 312 bonds with a carrying value of $ 1,064.1 million which either have never been rated or for which rating information is no longer provided. For each security rated by multiple rating agencies, the lowest rating is used. New Residential used an implied AAA rating for the Agency RMBS. Ratings provided were determined by third party rating agencies, and represent the most recent credit ratings available as of the reporting date and may not be current. |\n\n30\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| (C) | Excludes residual bonds, and certain other Non-Agency bonds, with a carrying value of $ 225.2 million and $ 3.5 million, respectively, for which no coupon payment is expected. |\n\n| (D) | The weighted average life is based on the timing of expected principal reduction on the assets. |\n\n| (E) | Percentage of the amortized cost basis of securities that is subordinate to New Residential’s investments, excluding fair value option securities. |\n\n| (F) | Includes securities issued or guaranteed by U.S. Government agencies such as Fannie Mae or Freddie Mac. |\n\n| (G) | The total outstanding face amount was $ 8.8 billion for fixed rate securities and $ 0.0 billion for floating rate securities as of September 30, 2019. |\n\n| (H) | The total outstanding face amount was $ 10.2 billion (including $ 7.9 billion of residual and fair value option notional amount) for fixed rate securities and $ 11.7 billion (including $ 4.9 billion of residual and fair value option notional amount) for floating rate securities as of September 30, 2019. |\n\n| (I) | Includes other asset backed securities (“ABS”) consisting primarily of (i) interest-only securities and servicing strips (fair value option securities) which New Residential elected to carry at fair value and record changes to valuation through the income statement, (ii) bonds backed by consumer loans, and (iii) corporate debt. |\n\n| Gross Unrealized | Weighted Average |\n| Asset Type | Outstanding Face Amount | Amortized Cost Basis | Gains | Losses | Carrying Value | Number of Securities | Rating | Coupon | Yield | Life (Years) | Principal Subordination |\n| Corporate debt | $ | 85,000 | $ | 85,000 | $ | — | $ | ( 7,013 | ) | $ | 77,987 | 1 | B- | 8.25 | % | 8.25 | % | 5.5 | N/A |\n| Consumer loan bonds | 30,945 | 29,990 | 566 | ( 5,073 | ) | 25,483 | 6 | N/A | N/A | 8.09 | % | 1.5 | N/A |\n| Fair Value Option Securities: |\n| Interest-only securities | 9,574,284 | 290,481 | 33,963 | ( 13,890 | ) | 310,554 | 111 | AA | 1.44 | % | 7.43 | % | 3.2 | N/A |\n| Servicing Strips | 2,568,427 | 32,216 | 4,306 | ( 3,178 | ) | 33,344 | 37 | N/A | 0.39 | % | 5.88 | % | 5.3 | N/A |\n\nUnrealized losses that are considered other-than-temporary and are attributable to credit losses are recognized currently in earnings. During the nine months ended September 30, 2019, New Residential recorded OTTI charges of $ 21.9 million with respect to real estate securities. Any remaining unrealized losses on New Residential’s securities were primarily the result of changes in market factors, rather than issue-specific credit impairment. New Residential performed analyses in relation to such securities, using its best estimate of their cash flows, which support its belief that the carrying values of such securities were fully recoverable over their expected holding period. New Residential has no intent to sell, and is not more likely than not to be required to sell, these securities.\nThe following table summarizes New Residential’s securities in an unrealized loss position as of September 30, 2019.\n| Amortized Cost Basis | Weighted Average |\n| Securities in an Unrealized Loss Position | Outstanding Face Amount | Before Impairment | Other-Than-Temporary Impairment(A) | After Impairment | Gross Unrealized Losses | Carrying Value | Number of Securities | Rating(B) | Coupon | Yield | Life(Years) |\n| Less than 12 Months | $ | 7,069,880 | $ | 2,162,118 | $ | ( 3,768 | ) | $ | 2,158,350 | $ | ( 20,406 | ) | $ | 2,137,944 | 77 | BBB | 4.27 | % | 4.24 | % | 6.4 |\n| 12 or More Months | 1,297,245 | 190,556 | ( 1,799 | ) | 188,757 | ( 20,167 | ) | 168,590 | 63 | BB | 4.58 | % | 5.74 | % | 5.1 |\n| Total/Weighted Average | $ | 8,367,125 | $ | 2,352,674 | $ | ( 5,567 | ) | $ | 2,347,107 | $ | ( 40,573 | ) | $ | 2,306,534 | 140 | BB+ | 4.29 | % | 4.36 | % | 6.3 |\n\n\n| (A) | This amount represents OTTI recorded on securities that are in an unrealized loss position as of September 30, 2019. |\n\n| (B) | The weighted average rating of securities in an unrealized loss position for less than 12 months excludes the rating of 43 bonds which either have never been rated or for which rating information is no longer provided. The weighted average rating of securities in an unrealized loss position for 12 or more months excludes the rating of 24 bonds which either have never been rated or for which rating information is no longer provided. |\n\n31\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nNew Residential performed an assessment of all of its debt securities that are in an unrealized loss position (an unrealized loss position exists when a security’s amortized cost basis, excluding the effect of OTTI, exceeds its fair value) and determined the following:\n| September 30, 2019 |\n| Gross Unrealized Losses |\n| Fair Value | Amortized Cost Basis After Impairment | Credit(A) | Non-Credit(B) |\n| Securities New Residential intends to sell(C) | $ | — | $ | — | $ | — | $ | — |\n| Securities New Residential is more likely than not to be required to sell(D) | — | — | — | N/A |\n| Securities New Residential has no intent to sell and is not more likely than not to be required to sell: |\n| Credit impaired securities | 159,172 | 165,780 | ( 5,567 | ) | ( 6,608 | ) |\n| Non-credit impaired securities | 2,147,362 | 2,181,327 | — | ( 33,965 | ) |\n| Total debt securities in an unrealized loss position | $ | 2,306,534 | $ | 2,347,107 | $ | ( 5,567 | ) | $ | ( 40,573 | ) |\n\n\n| (A) | This amount is required to be recorded as OTTI through earnings. In measuring the portion of credit losses, New Residential estimates the expected cash flow for each of the securities. This evaluation includes a review of the credit status and the performance of the collateral supporting those securities, including the credit of the issuer, key terms of the securities and the effect of local, industry and broader economic trends. Significant inputs in estimating the cash flows include New Residential’s expectations of prepayment rates, default rates and loss severities. Credit losses are measured as the decline in the present value of the expected future cash flows discounted at the investment’s effective interest rate. |\n\n| (B) | This amount represents unrealized losses on securities that are due to non-credit factors and recorded through other comprehensive income. |\n\n| (C) | A portion of securities New Residential intends to sell have a fair value equal to their amortized cost basis after impairment, and, therefore do no t have unrealized losses reflected in other comprehensive income as of September 30, 2019. |\n\n| (D) | New Residential may, at times, be more likely than not to be required to sell certain securities for liquidity purposes. While the amount of the securities to be sold may be an estimate, and the securities to be sold have not yet been identified, New Residential must make its best estimate, which is subject to significant judgment regarding future events, and may differ materially from actual future sales. |\n\nThe following table summarizes the activity related to credit losses on debt securities:\n| Nine Months Ended September 30, 2019 |\n| Beginning balance of credit losses on debt securities for which a portion of an OTTI was recognized in other comprehensive income | $ | 52,803 |\n| Increases to credit losses on securities for which an OTTI was previously recognized and a portion of an OTTI was recognized in other comprehensive income | 20,034 |\n| Additions for credit losses on securities for which an OTTI was not previously recognized | 1,908 |\n| Reductions for securities for which the amount previously recognized in other comprehensive income was recognized in earnings because the entity intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis | — |\n| Reduction for credit losses on securities for which no OTTI was recognized in other comprehensive income at the current measurement date | — |\n| Reduction for securities sold/paid off during the period | ( 18,431 | ) |\n| Ending balance of credit losses on debt securities for which a portion of an OTTI was recognized in other comprehensive income | $ | 56,314 |\n\n32\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nThe table below summarizes the geographic distribution of the collateral securing New Residential’s Non-Agency RMBS:\n| September 30, 2019 | December 31, 2018 |\n| Geographic Location(A) | Outstanding Face Amount | Percentage of Total Outstanding | Outstanding Face Amount | Percentage of Total Outstanding |\n| Western U.S. | $ | 8,348,465 | 38.4 | % | $ | 7,318,616 | 37.7 | % |\n| Southeastern U.S. | 5,232,919 | 24.1 | % | 4,613,314 | 23.8 | % |\n| Northeastern U.S. | 4,615,081 | 21.2 | % | 3,829,725 | 19.7 | % |\n| Midwestern U.S. | 2,134,577 | 9.8 | % | 2,063,263 | 10.6 | % |\n| Southwestern U.S. | 1,378,512 | 6.4 | % | 1,321,853 | 6.8 | % |\n| Other(B) | 20,315 | 0.1 | % | 250,833 | 1.4 | % |\n| $ | 21,729,869 | 100.0 | % | $ | 19,397,604 | 100.0 | % |\n\n\n| (A) | Excludes $ 30.9 million and $ 56.8 million face amount of bonds backed by consumer loans and $ 85.0 million and $ 85.0 million face amount of bonds backed by corporate debt as of September 30, 2019 and December 31, 2018, respectively. |\n\n| (B) | Represents collateral for which New Residential was unable to obtain geographic information. |\n\nNew Residential evaluates the credit quality of its real estate securities, as of the acquisition date, for evidence of credit quality deterioration. As a result, New Residential identified a population of real estate securities for which it was determined that it was probable that New Residential would be unable to collect all contractually required payments. For securities acquired during the nine months ended September 30, 2019, excluding residual and fair value option securities, the face amount of these real estate securities was $ 496.2 million, with total expected cash flows of $ 481.0 million and a fair value of $ 290.5 million on the dates that New Residential purchased the respective securities.\nThe following is the outstanding face amount and carrying value for securities, for which, as of the acquisition date, it was probable that New Residential would be unable to collect all contractually required payments, excluding residual and fair value option securities:\n| Outstanding Face Amount | Carrying Value |\n| September 30, 2019 | $ | 5,317,777 | $ | 3,641,142 |\n| December 31, 2018 | 6,385,306 | 4,217,242 |\n\nThe following is a summary of the changes in accretable yield for these securities:\n| Nine Months Ended September 30, 2019 |\n| Balance at December 31, 2018 | $ | 2,245,983 |\n| Additions | 190,482 |\n| Accretion | ( 191,559 | ) |\n| Reclassifications from (to) non-accretable difference | ( 430,080 | ) |\n| Disposals | ( 266,552 | ) |\n| Balance at September 30, 2019 | $ | 1,548,274 |\n\nSee Note 11 regarding the financing of real estate securities.\n| 8. | INVESTMENTS IN RESIDENTIAL MORTGAGE LOANS |\n\nNew Residential accumulated its residential mortgage loan portfolio through various bulk acquisitions and the execution of call rights. As a result of the Shellpoint Acquisition, New Residential, through its wholly owned subsidiary, NewRez, originates\n33\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nresidential mortgage loans for sale and securitization to third parties and generally retains the servicing rights on the underlying loans.\nLoans are accounted for based on New Residential’s strategy for the loan, and on whether the loan was credit-impaired at the date of acquisition. New Residential accounts for loans based on the following categories:\n| • | Loans Held-for-Investment (which may include PCD Loans) |\n\n| • | Loans Held-for-Investment, at fair value |\n\n| • | Loans Held-for-Sale, at lower of cost or fair value |\n\n| • | Loans Held-for-Sale, at fair value |\n\n| • | Real Estate Owned (“REO”) |\n\nThe following table presents certain information regarding New Residential’s residential mortgage loans outstanding by loan type, excluding REO:\n| September 30, 2019 | December 31, 2018 |\n| Outstanding Face Amount | Carrying Value | LoanCount | Weighted Average Yield | Weighted Average Life (Years)(A) | Floating Rate Loans as a % of Face Amount | Loan to Value Ratio (“LTV”)(B) | Weighted Avg. Delinquency(C) | Weighted Average FICO(D) | Carrying Value |\n| Loan Type |\n| Performing Loans(G) (J) | $ | 557,762 | $ | 524,387 | 7,695 | 7.8 | % | 4.6 | 20.2 | % | 72.3 | % | 10.2 | % | 647 | $ | 591,264 |\n| Purchased Credit Deteriorated Loans(H) | 124,238 | 89,270 | 1,106 | 7.9 | % | 3.2 | 19.3 | % | 88.1 | % | 60.7 | % | 590 | 144,065 |\n| Total Residential Mortgage Loans, held-for-investment | $ | 682,000 | $ | 613,657 | 8,801 | 7.8 | % | 4.4 | 20.1 | % | 75.2 | % | 19.4 | % | 636 | $ | 735,329 |\n| Reverse Mortgage Loans(E) (F) | $ | 13,032 | $ | 6,450 | 32 | 7.8 | % | 5.3 | 10.1 | % | 151.6 | % | 65.1 | % | N/A | $ | 6,557 |\n| Performing Loans(G) (I) | 709,867 | 726,935 | 10,798 | 4.3 | % | 4.0 | 62.4 | % | 54.3 | % | 5.9 | % | 688 | 413,883 |\n| Non-Performing Loans(H) (I) | 726,570 | 616,612 | 5,562 | 5.1 | % | 3.3 | 12.0 | % | 80.7 | % | 68.7 | % | 594 | 512,040 |\n| Total Residential Mortgage Loans, held-for-sale | $ | 1,449,469 | $ | 1,349,997 | 16,392 | 4.8 | % | 3.6 | 36.7 | % | 68.4 | % | 37.9 | % | 641 | $ | 932,480 |\n| Acquired Loans | $ | 4,024,252 | $ | 3,916,826 | 26,236 | 4.2 | % | 7.4 | 2.0 | % | 71.1 | % | 15.3 | % | 622 | $ | 2,153,269 |\n| Originated Loans | 1,248,711 | 1,289,425 | 4,465 | 4.0 | % | 28.6 | 4.0 | % | 77.6 | % | 29.2 | % | 672 | 655,260 |\n| Total Residential Mortgage Loans, held-for-sale, at fair value(K) | $ | 5,272,963 | $ | 5,206,251 | 30,701 | 4.1 | % | 12.5 | 2.5 | % | 72.7 | % | 18.6 | % | 634 | $ | 2,808,529 |\n\n| (A) | The weighted average life is based on the expected timing of the receipt of cash flows. |\n\n| (B) | LTV refers to the ratio comparing the loan’s unpaid principal balance to the value of the collateral property. |\n\n| (C) | Represents the percentage of the total principal balance that is 60+ days delinquent. |\n\n| (D) | The weighted average FICO score is based on the weighted average of information updated and provided by the loan servicer on a monthly basis. |\n\n| (E) | Represents a 70 % participation interest that New Residential holds in a portfolio of reverse mortgage loans. Nationstar holds the other 30 % interest and services the loans. The average loan balance outstanding based on total UPB was $ 0.6 million. Approximately 51 % of these loans have reached a termination event. As a result of the termination event, each such loan has matured and the borrower can no longer make draws on these loans. |\n\n| (F) | FICO scores are not used in determining how much a borrower can access via a reverse mortgage loan. |\n\n| (G) | Performing loans are generally placed on nonaccrual status when principal or interest is 120 days or more past due. |\n\n| (H) | Includes loans with evidence of credit deterioration since origination where it is probable that New Residential will not collect all contractually required principal and interest payments. As of September 30, 2019, New Residential has placed Non-Performing Loans, held-for-sale on nonaccrual status, except as described in (I) below. |\n\n| (I) | Includes $ 37.8 million and $ 27.7 million UPB of Ginnie Mae EBO performing and non-performing loans, respectively, on accrual status as contractual cash flows are guaranteed by the FHA. |\n\n| (J) | Includes $ 112.1 million UPB of non-agency mortgage loans underlying the SAFT 2013-1 securitization, which are carried at fair value based on New Residential’s election of the fair value option. Interest earned on loans measured at fair value are reported in other income. |\n\n| (K) | New Residential elected the fair value option to measure these loans at fair value on a recurring basis. Interest earned on loans measured at fair value are reported in other income. |\n\n34\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nNew Residential generally considers the delinquency status, loan-to-value ratios, and geographic area of residential mortgage loans as its credit quality indicators. Delinquency status is a primary credit quality indicator as loans that are more than 60 days past due provide an early warning of borrowers who may be experiencing financial difficulties. Current LTV ratio is an indicator of the potential loss severity in the event of default. Finally, the geographic distribution of the loan collateral also provides insight as to the credit quality of the portfolio, as factors such as the regional economy, home price changes and specific events will affect credit quality.\nThe table below summarizes the geographic distribution of the underlying residential mortgage loans:\n| Percentage of Total Outstanding Unpaid Principal Amount |\n| State Concentration | September 30, 2019 | December 31, 2018 |\n| California | 17.7 | % | 16.7 | % |\n| Florida | 9.0 | % | 8.8 | % |\n| New York | 9.9 | % | 11.7 | % |\n| New Jersey | 4.8 | % | 4.7 | % |\n| Texas | 4.6 | % | 5.3 | % |\n| Georgia | 4.3 | % | 2.7 | % |\n| Illinois | 3.9 | % | 4.0 | % |\n| Maryland | 3.7 | % | 3.1 | % |\n| Massachusetts | 3.3 | % | 3.1 | % |\n| Pennsylvania | 3.3 | % | 3.6 | % |\n| Other U.S. | 35.5 | % | 36.3 | % |\n| 100.0 | % | 100.0 | % |\n\nSee Note 11 regarding the financing of residential mortgage loans and related assets.\nCall Rights\nNew Residential has executed calls with respect to Non-Agency RMBS trusts and purchased performing and non-performing residential mortgage loans and REO assets contained in such trusts prior to their termination. In certain cases, New Residential sold portions of the purchased loans through securitizations, and retained bonds issued by such securitizations. In addition, New Residential received par on the securities issued by the called trusts which it owned prior to such trusts’ termination. For the nine months ended September 30, 2019, New Residential executed calls on a total of 97 trusts and recognized $ 45.3 million of interest income on securities held in the collapsed trusts and $ 54.2 million of gain on securitizations accounted for as sales.\nPerforming Loans\nThe following table provides past due information regarding New Residential’s Performing Loans, which is an important indicator of credit quality and the establishment of the allowance for loan losses:\n| September 30, 2019 |\n| Days Past Due | Delinquency Status(A) |\n| Current | 84.1 | % |\n| 30-59 | 8.2 | % |\n| 60-89 | 2.7 | % |\n| 90-119(B) | 0.7 | % |\n| 120+(C) | 4.3 | % |\n| 100.0 | % |\n\n| (A) | Represents the percentage of the total principal balance that corresponds to loans that are in each delinquency status. |\n\n35\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| (B) | Includes loans 90-119 days past due and still accruing interest because they are generally placed on nonaccrual status at 120 days or more past due. |\n\n| (C) | Represents nonaccrual loans. |\n\nActivities related to the carrying value of residential mortgage loans held-for-investment were as follows:\n| Performing Loans |\n| Balance at December 31, 2018 | $ | 591,253 |\n| Purchases/additional fundings | — |\n| Proceeds from repayments | ( 73,397 | ) |\n| Accretion of loan discount (premium) and other amortization(A) | 9,998 |\n| Provision for loan losses | ( 800 | ) |\n| Transfer of loans to other assets(B) | — |\n| Transfer of loans to real estate owned | ( 4,739 | ) |\n| Transfers of loans to held for sale | ( 168 | ) |\n| Fair value adjustment | 2,240 |\n| Balance at September 30, 2019 | $ | 524,387 |\n\n| (A) | Includes accelerated accretion of discount on loans paid in full and on loans transferred to other assets. |\n\n| (B) | Represents loans for which foreclosure has been completed and for which New Residential has made, or intends to make, a claim with the governmental agency that has guaranteed the loans that are now recognized as claims receivable in Other Assets (Note 2). |\n\nActivities related to the valuation and loss provision on reverse mortgage loans and allowance for loan losses on performing loans held-for-investment were as follows:\n| Performing Loans |\n| Balance at December 31, 2018 | $ | — |\n| Provision for loan losses(A) | 800 |\n| Charge-offs(B) | ( 800 | ) |\n| Balance at September 30, 2019 | $ | — |\n\n| (A) | Based on an analysis of collective borrower performance, credit ratings of borrowers, loan-to-value ratios, estimated value of the underlying collateral, key terms of the loans and historical and anticipated trends in defaults and loss severities at a pool level. |\n\n| (B) | Loans, other than PCD loans, are generally charged off or charged down to the net realizable value of the collateral (i.e., fair value less costs to sell), with an offset to the allowance for loan losses, when available information confirms that loans are uncollectible. |\n\nPurchased Credit Deteriorated Loans\nNew Residential determined at acquisition that the PCD loans acquired would be aggregated into pools based on common risk characteristics (FICO score, delinquency status, collateral type, loan-to-value ratio). Loans aggregated into pools are accounted for as if each pool were a single loan with a single composite interest rate and an aggregate expectation of cash flows, including consideration of involuntary prepayments.\n36\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nActivities related to the carrying value of PCD loans held-for-investment were as follows:\n| Balance at December 31, 2018 | $ | 144,065 |\n| Purchases/additional fundings | — |\n| Sales | — |\n| Proceeds from repayments | ( 13,935 | ) |\n| Accretion of loan discount and other amortization | 12,961 |\n| (Allowance) reversal for loan losses(A) | ( 2,332 | ) |\n| Transfer of loans to real estate owned | ( 12,815 | ) |\n| Transfer of loans to held-for-sale | ( 38,674 | ) |\n| Balance at September 30, 2019 | $ | 89,270 |\n\n| (A) | An allowance represents the present value of cash flows expected at acquisition that are no longer expected to be collected. A reversal results from an increase to expected cash flows that reverses a prior allowance. |\n\nThe following is a summary of the changes in accretable yield for these loans:\n| Balance at December 31, 2018 | $ | 68,632 |\n| Additions | — |\n| Accretion | ( 12,961 | ) |\n| Reclassifications from (to) non-accretable difference(A) | 8,188 |\n| Disposals(B) | ( 10,965 | ) |\n| Transfer of loans to held-for-sale(C) | ( 8,406 | ) |\n| Balance at September 30, 2019 | $ | 44,488 |\n\n| (A) | Represents a probable and significant increase (decrease) in cash flows previously expected to be uncollectible. |\n\n| (B) | Includes sales of loans or foreclosures, which result in removal of the loan from the PCD loan pool at its carrying amount. |\n\n| (C) | Represents loans not initially acquired with the intent to sell for which New Residential determined that it no longer has the intent to hold for the foreseeable future, or until maturity or payoff. |\n\nLoans Held-for-Sale, at Lower of Cost or Fair Value\nActivities related to the carrying value of loans held-for-sale, at lower of cost or fair value were as follows:\n| Balance at December 31, 2018 | $ | 932,480 |\n| Purchases(A) | 842,752 |\n| Transfer of loans from held-for-investment(B) | 38,842 |\n| Sales | ( 307,004 | ) |\n| Transfer of loans to other assets(C) | ( 8,564 | ) |\n| Transfer of loans to real estate owned | ( 35,326 | ) |\n| Proceeds from repayments | ( 133,279 | ) |\n| Valuation (provision) reversal on loans(D) | 20,096 |\n| Balance at September 30, 2019 | $ | 1,349,997 |\n\n| (A) | Represents loans acquired with the intent to sell. |\n\n| (B) | Represents loans not initially acquired with the intent to sell for which New Residential determined that it no longer has the intent to hold for the foreseeable future, or until maturity or payoff. |\n\n| (C) | Represents loans for which foreclosure has been completed and for which New Residential has made, or intends to make, a claim with the governmental agency that has guaranteed the loans that are now recognized as claims receivable in Other Assets (Note 2). |\n\n37\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| (D) | Represents the fair value adjustments to loans upon transfer to held-for-sale and provision recorded on certain purchased held-for-sale loans, including an aggregate of $ 4.8 million of provision related to the call transactions executed during the nine months ended September 30, 2019 . |\n\nLoans Held-for-Sale, at Fair Value\nActivities related to the carrying value of originated loans held-for-sale, at fair value were as follows:\n| Balance at December 31, 2018 | $ | 655,260 |\n| Originations | 10,427,690 |\n| Sales | ( 9,784,536 | ) |\n| Proceeds from repayments | ( 24,035 | ) |\n| Transfer of loans to other assets | ( 412 | ) |\n| Change in fair value | 15,458 |\n| Balance at September 30, 2019 | $ | 1,289,425 |\n\nActivities related to the carrying value of acquired loans held-for-sale, at fair value were as follows:\n| Balance at December 31, 2018 | $ | 2,153,269 |\n| Purchases(A) | 5,170,388 |\n| Sales | ( 3,338,140 | ) |\n| Proceeds from repayments | ( 141,109 | ) |\n| Transfer of loans to real estate owned | ( 435 | ) |\n| Accretion of loan discount and other amortization | — |\n| Change in fair value | 72,853 |\n| Balance at September 30, 2019 | $ | 3,916,826 |\n\n| (A) | Includes an acquisition date fair value adjustment increase of $ 10.2 million on loans acquired through call transactions executed during the nine months ended September 30, 2019. |\n\n38\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nNet Interest Income\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Interest Income: |\n| Acquired Residential Mortgage Loans, held-for-investment | $ | 14,532 | $ | 19,466 | $ | 47,167 | $ | 58,689 |\n| Acquired Residential Mortgage Loans, held-for-sale | 15,966 | 7,433 | 43,423 | 30,001 |\n| Acquired Residential Mortgage Loans, held-for-sale, at fair value | 43,288 | 15,453 | 96,393 | 28,344 |\n| Originated Residential Mortgage Loans, held-for-sale, at fair value | 13,185 | 6,430 | 32,926 | 6,430 |\n| Total Interest Income on Residential Mortgage Loans | 86,971 | 48,782 | 219,909 | 123,464 |\n| Interest Expense: |\n| Acquired Residential Mortgage Loans, held-for-investment | 3,953 | 6,537 | 15,717 | 17,447 |\n| Acquired Residential Mortgage Loans, held-for-sale | 9,357 | 8,306 | 26,873 | 26,264 |\n| Acquired Residential Mortgage Loans, held-for-sale, at fair value | 30,053 | 7,531 | 77,247 | 13,588 |\n| Originated Residential Mortgage Loans, held-for-sale,at fair value | 2,344 | 1,288 | 6,451 | 1,288 |\n| Total Interest Expense on Residential Mortgage Loans | 45,707 | 23,662 | 126,288 | 58,587 |\n| Total Net Interest Income on Residential Mortgage Loans | $ | 41,264 | $ | 25,120 | $ | 93,621 | $ | 64,877 |\n\nGain on Sale of Originated Mortgage Loans, Net\nNewRez, a wholly owned subsidiary of New Residential, originates conventional, government-insured and nonconforming residential mortgage loans for sale and securitization. The GSEs or Ginnie Mae guarantee conventional and government insured mortgage securitizations and mortgage investors issue nonconforming private label mortgage securitizations while NewRez generally retains the right to service the underlying residential mortgage loans. In connection with the transfer of loans to the GSEs or mortgage investors, New Residential reports gain on sale of originated mortgage loans, net in the condensed consolidated statements of income.\nGain on sale of originated mortgage loans, net is summarized below:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Gain on loans originated and sold(A) | $ | 24,312 | $ | 24,684 | $ | 36,413 | $ | 24,684 |\n| Gain (loss) on settlement of mortgage loan origination derivative instruments(B) | ( 32,138 | ) | ( 2,757 | ) | ( 61,879 | ) | ( 2,757 | ) |\n| MSRs retained on transfer of loans(C) | 96,317 | 17,282 | 190,666 | 17,282 |\n| Other(D) | 12,050 | 6,523 | 28,829 | 6,523 |\n| Gain on sale of originated mortgage loans, net | $ | 100,541 | $ | 45,732 | $ | 194,029 | $ | 45,732 |\n\n| (A) | Includes loan origination fees and direct loan origination costs. Other indirect costs related to loan origination are included within general and administrative expenses. |\n\n| (B) | Represents settlement of forward securities delivery commitments utilized as an economic hedge for mortgage loans not included within forward loan sale commitments. |\n\n| (C) | Represents the initial fair value of the capitalized mortgage servicing rights upon loan sales with servicing retained. |\n\n| (D) | Includes fees for services associated with the loan origination process. |\n\n39\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nReal estate owned (REO)\nNew Residential recognizes REO assets at the completion of the foreclosure process or upon execution of a deed in lieu of foreclosure with the borrower. REO assets are managed for prompt sale and disposition at the best possible economic value.\n| Real Estate Owned |\n| Balance at December 31, 2018 | $ | 113,410 |\n| Purchases | 44,539 |\n| Transfer of loans to real estate owned | 61,129 |\n| Sales | ( 112,703 | ) |\n| Valuation (provision) reversal on REO | ( 407 | ) |\n| Balance at September 30, 2019 | $ | 105,968 |\n\nAs of September 30, 2019, New Residential had residential mortgage loans that were in the process of foreclosure with an unpaid principal balance of $ 393.0 million.\nIn addition, New Residential has recognized $ 20.4 million in unpaid claims receivable from FHA on Ginnie Mae EBO loans and reverse mortgage loans for which foreclosure has been completed and for which New Residential has made, or intends to make, a claim.\nVariable Interest Entities\nDuring the first quarter of 2019, New Residential formed entities (the “RPL Borrowers”) that issued securitized debt collateralized by reperforming residential mortgage loans. New Residential determined that the RPL Borrowers should be evaluated for consolidation under the VIE model rather than the voting interest entity model as the equity holders as a group lack the characteristics of a controlling financial interest. Under the VIE model, New Residential’s consolidated subsidiaries had both 1) the power to direct the most significant activities of the RPL Borrowers and 2) significant variable interests in each of the RPL Borrowers, through their control of the related optional redemption feature and their ownership of certain notes issued by the RPL Borrowers and, therefore, met the primary beneficiary criterion and consolidated the RPL Borrowers. The following table presents information on the combined assets and liabilities related to these consolidated VIEs.\n| Three Months Ended September 30, |\n| 2019 |\n| Assets |\n| Residential mortgage loans | $ | 430,461 |\n| Other assets | — |\n| Total assets(A) | $ | 430,461 |\n| Liabilities |\n| Notes and bonds payable | $ | 364,380 |\n| Accounts payable and accrued expenses | 3,562 |\n| Total liabilities(A) | $ | 367,942 |\n\n| (A) | The creditors of the RPL Borrowers do not have recourse to the general credit of New Residential, and the assets of the RPL Borrowers are not directly available to satisfy New Residential’s obligations. |\n\nA wholly owned subsidiary of NewRez, Shelter Mortgage Company LLC (“Shelter”) is a mortgage originator specializing in retail origination. Shelter operates its business through a series of joint ventures and was deemed to be the primary beneficiary of the joint ventures as a result of its ability to direct activities that most significantly impact the economic performance of the entities and its ownership of a significant equity investment.\n40\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nThe following table presents information on the assets and liabilities of the Shelter JVs.\n| September 30, 2019 | December 31, 2018 |\n| Assets |\n| Cash and cash equivalents | $ | 21,604 | $ | 17,346 |\n| Property and equipment, net | 128 | 137 |\n| Intangible assets, net | 58 | 70 |\n| Prepaid expenses and other assets | 4,903 | 411 |\n| Total assets | $ | 26,693 | $ | 17,964 |\n| Liabilities |\n| Accounts payable and accrued expenses | $ | 3,065 | $ | 1,315 |\n| Reserve for sales recourse | 1,192 | 967 |\n| Total liabilities | $ | 4,257 | $ | 2,282 |\n\nNoncontrolling Interests\nNoncontrolling interests in the equity of the Shelter JVs is computed as follows:\n| September 30, 2019 | December 31, 2018 |\n| Total consolidated equity of JVs | $ | 22,436 | $ | 15,682 |\n| Noncontrolling ownership interest | 48.2 | % | 51.0 | % |\n| Noncontrolling equity interest in consolidated JVs | $ | 10,813 | $ | 7,998 |\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Total consolidated net income of JVs | $ | 5,098 | $ | 2,306 | $ | 9,144 | $ | 2,306 |\n| Noncontrolling ownership interest in net income | 48.2 | % | 50.6 | % | 48.2 | % | 50.6 | % |\n| Noncontrolling interest in net income of consolidated JVs | $ | 2,457 | $ | 1,167 | $ | 4,407 | $ | 1,167 |\n\nAs described in “Call Rights” above, New Residential has issued securitizations which were treated as sales under GAAP. New Residential has no obligation to repurchase any loans from these securitizations and its exposure to loss is limited to the carrying amount of its retained interests in the securitization entities. These securitizations are conducted through variable interest entities, of which New Residential is not the primary beneficiary.\n41\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nAdditionally, New Residential and NewRez, a wholly owned subsidiary of New Residential, were deemed to be the primary beneficiaries of the RPL Borrowers and SAFT 2013-1 securitization entity as a result of their ability to direct activities that most significantly impact the economic performance of the entities and their ownership of significant variable interests in the RPL Borrowers and SAFT 2013-1 securitization, respectively. The following table summarizes certain characteristics of the underlying residential mortgage loans, and related financing, in these securitizations as of September 30, 2019:\n| Residential mortgage loan UPB | $ | 11,183,024 |\n| Weighted average delinquency(A) | 1.97 | % |\n| Net credit losses for the nine months ended September 30, 2019 | $ | 5,738 |\n| Face amount of debt held by third parties(B) | $ | 10,074,690 |\n| Carrying value of bonds retained by New Residential(C) (D) | $ | 1,258,292 |\n| Cash flows received by New Residential on these bonds for the nine months ended September 30, 2019 | $ | 161,794 |\n\n| (A) | Represents the percentage of the UPB that is 60 + days delinquent. |\n\n| (B) | Excludes bonds retained by New Residential. |\n\n| (C) | Includes bonds retained pursuant to required risk retention regulations. |\n\n| (D) | Classified within Level 3 of the fair value hierarchy as the valuation is based on certain unobservable inputs including discount rate, prepayment rates and loss severity. See Note 12 for details on unobservable inputs. |\n\n| 9. | INVESTMENTS IN CONSUMER LOANS |\n\nNew Residential, through newly formed limited liability companies (together, the “Consumer Loan Companies”), has a co-investment in a portfolio of consumer loans. The portfolio includes personal unsecured loans and personal homeowner loans. OneMain is the servicer of the loans and provides all servicing and advancing functions for the portfolio. As of September 30, 2019, New Residential owns 53.5 % of the limited liability company interests in, and consolidates, the Consumer Loan Companies.\nOn June 4, 2019, the Consumer Loan Companies refinanced the outstanding asset-backed notes with an asset-backed securitization for approximately $ 938.7 million. The proceeds in excess of the refinanced debt of $ 13.4 million were distributed to the respective co-investors of which New Residential received approximately $ 7.8 million.\nNew Residential also purchased certain newly originated consumer loans from a third party (“Consumer Loan Seller”). These loans are not held in the Consumer Loan Companies and have been designated as performing consumer loans, held-for-investment. In addition, see “Equity Method Investees” below.\nThe following table summarizes the investment in consumer loans, held-for-investment held by New Residential:\n| Unpaid Principal Balance | Interest in Consumer Loans | Carrying Value | Weighted Average Coupon | Weighted Average Expected Life (Years)(A) | Weighted Average Delinquency(B) |\n| September 30, 2019 |\n| Consumer Loan Companies |\n| Performing Loans | $ | 684,064 | 53.5 | % | $ | 722,826 | 18.9 | % | 4.0 | 4.5 | % |\n| Purchased Credit Deteriorated Loans(C) | 182,171 | 53.5 | % | 147,059 | 15.6 | % | 3.5 | 10.0 | % |\n| Other - Performing Loans | 12,196 | 100.0 | % | 11,298 | 14.9 | % | 0.8 | 5.5 | % |\n| Total Consumer Loans, held-for-investment | $ | 878,431 | $ | 881,183 | 18.1 | % | 3.9 | 5.6 | % |\n| December 31, 2018 |\n| Consumer Loan Companies |\n| Performing Loans | $ | 815,341 | 53.5 | % | $ | 856,563 | 18.8 | % | 3.6 | 5.4 | % |\n| Purchased Credit Deteriorated Loans(C) | 221,910 | 53.5 | % | 182,917 | 16.0 | % | 3.4 | 11.6 | % |\n| Other - Performing Loans | 35,326 | 100.0 | % | 32,722 | 14.2 | % | 0.8 | 5.6 | % |\n| Total Consumer Loans, held-for-investment | $ | 1,072,577 | $ | 1,072,202 | 18.1 | % | 3.5 | 6.7 | % |\n\n42\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| (A) | Represents the weighted average expected timing of the receipt of expected cash flows for this investment. |\n\n| (B) | Represents the percentage of the total unpaid principal balance that is 30+ days delinquent. Delinquency status is the primary credit quality indicator as it provides early warning of borrowers who may be experiencing financial difficulties. |\n\n| (C) | Includes loans with evidence of credit deterioration since origination where it is probable that New Residential will not collect all contractually required principal and interest payments, which are accounted for as PCD loans. |\n\nSee Note 11 regarding the financing of consumer loans.\nPerforming Loans\nThe following table provides past due information regarding New Residential’s performing consumer loans, held-for-investment, which is an important indicator of credit quality and the establishment of the allowance for loan losses:\n| September 30, 2019 |\n| Days Past Due | Delinquency Status(A) |\n| Current | 95.5 | % |\n| 30-59 | 1.7 | % |\n| 60-89 | 1.0 | % |\n| 90-119(B) | 0.7 | % |\n| 120+(B) (C) | 1.1 | % |\n| 100.0 | % |\n\n| (A) | Represents the percentage of the total unpaid principal balance that corresponds to loans that are in each delinquency status. |\n\n| (B) | Includes loans more than 90 days past due and still accruing interest. |\n\n| (C) | Interest is accrued up to the date of charge-off at 180 days past due. |\n\nActivities related to the carrying value of performing consumer loans, held-for-investment were as follows:\n| Performing Loans |\n| Balance at December 31, 2018 | $ | 889,285 |\n| Purchases | — |\n| Additional fundings(A) | 42,231 |\n| Proceeds from repayments | ( 166,897 | ) |\n| Accretion of loan discount and premium amortization, net | 272 |\n| Gross charge-offs | ( 30,325 | ) |\n| Additions to the allowance for loan losses, net | ( 442 | ) |\n| Balance at September 30, 2019 | $ | 734,124 |\n\n| (A) | Represents draws on consumer loans with revolving privileges. |\n\nActivities related to the allowance for loan losses on performing consumer loans, held-for-investment were as follows:\n| Collectively Evaluated(A) | Individually Impaired(B) | Total |\n| Balance at December 31, 2018 | $ | 2,604 | $ | 2,064 | $ | 4,668 |\n| Provision (reversal) for loan losses | 23,966 | 442 | 24,408 |\n| Net charge-offs(C) | ( 25,672 | ) | — | ( 25,672 | ) |\n| Balance at September 30, 2019 | $ | 898 | $ | 2,506 | $ | 3,404 |\n\n43\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| (A) | Represents smaller-balance homogeneous loans that are not individually considered impaired and are evaluated based on an analysis of collective borrower performance, key terms of the loans and historical and anticipated trends in defaults and loss severities, and consideration of the unamortized acquisition discount. |\n\n| (B) | Represents consumer loan modifications considered to be troubled debt restructurings (“TDRs”) as they provide concessions to borrowers, primarily in the form of interest rate reductions, who are experiencing financial difficulty. As of September 30, 2019, there are $ 17.3 million in UPB and $ 15.5 million in carrying value of consumer loans classified as TDRs. |\n\n| (C) | Consumer loans, other than PCD loans, are charged off when available information confirms that loans are uncollectible, which is generally when they become 180 days past due. Charge-offs are presented net of $ 6.4 million in recoveries of previously charged-off UPB. |\n\nPurchased Credit Deteriorated Loans\nA portion of the consumer loans are considered PCD loans. Activities related to the carrying value of PCD consumer loans, held-for-investment were as follows:\n| Balance at December 31, 2018 | $ | 182,917 |\n| (Allowance) reversal for loan losses(A) | ( 40 | ) |\n| Proceeds from repayments | ( 60,499 | ) |\n| Accretion of loan discount and other amortization | 24,681 |\n| Balance at September 30, 2019 | $ | 147,059 |\n\n| (A) | An allowance represents the present value of cash flows expected at acquisition that are no longer expected to be collected. A reversal results from an increase to expected cash flows that reverses a prior allowance. |\n\nThe following is the unpaid principal balance and carrying value for consumer loans, for which, as of the acquisition date, it was probable that New Residential would be unable to collect all contractually required payments:\n| Unpaid Principal Balance | Carrying Value |\n| September 30, 2019 | $ | 182,171 | $ | 147,059 |\n| December 31, 2018 | 221,910 | 182,917 |\n\nThe following is a summary of the changes in accretable yield for these loans:\n| Balance at December 31, 2018 | $ | 126,518 |\n| Accretion | ( 24,681 | ) |\n| Reclassifications from (to) non-accretable difference(A) | 10,344 |\n| Balance at September 30, 2019 | $ | 112,181 |\n\n| (A) | Represents a probable and significant increase (decrease) in cash flows previously expected to be uncollectible. |\n\nNoncontrolling Interests\nOthers’ interests in the equity of the Consumer Loan Companies is computed as follows:\n| September 30, 2019 | December 31, 2018 |\n| Total Consumer Loan Companies equity | $ | 47,314 | $ | 66,105 |\n| Others’ ownership interest | 46.5 | % | 46.5 | % |\n| Others’ interests in equity of consolidated subsidiary | $ | 22,520 | $ | 30,561 |\n\n44\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nOthers’ interests in the Consumer Loan Companies’ net income (loss) is computed as follows:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Net Consumer Loan Companies income (loss) | $ | 22,790 | $ | 21,038 | $ | 49,690 | $ | 61,359 |\n| Others’ ownership interest as a percent of total | 46.5 | % | 46.5 | % | 46.5 | % | 46.5 | % |\n| Others’ interest in net income (loss) of consolidated subsidiaries | $ | 10,597 | $ | 9,783 | $ | 23,106 | $ | 28,533 |\n\nVariable Interest Entities\nThe Consumer Loan Companies consolidate certain entities that issued securitized debt collateralized by the consumer loans (the “Consumer Loan SPVs”). The Consumer Loan SPVs are VIEs of which the Consumer Loan Companies are the primary beneficiaries. The following table presents information on the combined assets and liabilities related to these consolidated VIEs.\n| As of |\n| September 30, 2019 | December 31, 2018 |\n| Assets |\n| Consumer loans, held-for-investment | $ | 869,885 | $ | 1,039,480 |\n| Restricted cash | 9,338 | 10,186 |\n| Accrued interest receivable | 13,148 | 15,627 |\n| Total assets(A) | $ | 892,371 | $ | 1,065,293 |\n| Liabilities |\n| Notes and bonds payable(B) | $ | 873,724 | $ | 1,030,096 |\n| Accounts payable and accrued expenses | 4,034 | 3,814 |\n| Total liabilities(A) | $ | 877,758 | $ | 1,033,910 |\n\n| (A) | The creditors of the Consumer Loan SPVs do not have recourse to the general credit of New Residential, and the assets of the Consumer Loan SPVs are not directly available to satisfy New Residential’s obligations. |\n\n| (B) | Includes $ 10.0 million face amount of bonds retained by New Residential issued by these VIEs. |\n\nEquity Method Investees\nIn February 2017, New Residential completed a co-investment, through a newly formed entity, PF LoanCo Funding LLC (“LoanCo”), to purchase up to $ 5.0 billion worth of newly originated consumer loans from Consumer Loan Seller over a two year term. New Residential, along with three co-investors, each acquired 25 % membership interests in LoanCo. New Residential accounts for its investment in LoanCo pursuant to the equity method of accounting because it can exercise significant influence over LoanCo but the requirements for consolidation are not met. New Residential’s investment in LoanCo is recorded as Investment in Consumer Loans, Equity Method Investees which is included within Other Assets (see Note 2 for details). LoanCo has elected to account for its investments in consumer loans at fair value. New Residential has elected to record LoanCo’s activity on a one month lag.\nIn addition, New Residential and the LoanCo co-investors agreed to purchase warrants to purchase up to 177.7 million shares of Series F convertible preferred stock in the Consumer Loan Seller’s parent company (“ParentCo”), which were valued at approximately $ 75.0 million in the aggregate as of February 2017, through a newly formed entity, PF WarrantCo Holdings, LP (“WarrantCo”). New Residential acquired a 23.57 % interest in WarrantCo, the remaining interest being acquired by three co-investors. WarrantCo has agreed to purchase a pro rata portion of the warrants each time LoanCo closes on a portion of its consumer loan purchase agreement from Consumer Loan Seller. The holder of the warrants has the option to purchase an equivalent number of shares of Series F convertible preferred stock in ParentCo at a price of $ 0.01 per share. WarrantCo is vested in the warrants to purchase an aggregate of 147.7 million Series F convertible preferred stock in ParentCo as of August 31, 2019, and New Residential and LoanCo co-investors are vested in the warrants to purchase an aggregate of 30.0 million Series F convertible preferred stock in ParentCo as of August 31, 2019. The Series F convertible preferred stock holders have the right to convert such preferred stock to common stock at any time, are entitled to the number of votes equal to the number of shares of common stock into which such\n45\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nshares of convertible preferred stock could be converted, and will have liquidation rights in the event of liquidation. New Residential accounts for its investment in WarrantCo pursuant to the equity method of accounting because it can exercise significant influence over WarrantCo but the requirements for consolidation are not met. New Residential’s investment in WarrantCo is recorded as Investment in Consumer Loans, Equity Method Investees which is included within Other Assets (see Note 2 for details). WarrantCo has elected to account for its investments in warrants at fair value. New Residential has elected to record WarrantCo’s activity on a one month lag.\nThe following tables summarize the investment in LoanCo and WarrantCo held by New Residential:\n| September 30, 2019(A) | December 31, 2018(A) |\n| Consumer loans, at fair value | $ | 1,632 | $ | 231,560 |\n| Warrants, at fair value | 106,378 | 103,067 |\n| Other assets | 1,685 | 25,971 |\n| Warehouse financing | — | ( 182,065 | ) |\n| Other liabilities | ( 118 | ) | ( 1,142 | ) |\n| Equity | $ | 109,577 | $ | 177,391 |\n| Undistributed retained earnings | $ | — | $ | — |\n| New Residential’s investment | $ | 25,875 | $ | 42,875 |\n| New Residential’s ownership | 23.6 | % | 24.2 | % |\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019(B) | 2018(B) | 2019(B) | 2018(B) |\n| Interest income | $ | 636 | $ | 16,513 | $ | 20,003 | $ | 38,032 |\n| Interest expense | — | ( 4,364 | ) | ( 6,487 | ) | ( 10,082 | ) |\n| Change in fair value of consumer loans and warrants | ( 2,933 | ) | 5,676 | ( 4,390 | ) | 24,750 |\n| Gain on sale of consumer loans(C) | ( 7,525 | ) | 2,379 | ( 9,193 | ) | 3,512 |\n| Other expenses | ( 576 | ) | ( 1,604 | ) | ( 3,494 | ) | ( 6,201 | ) |\n| Net income | $ | ( 10,398 | ) | $ | 18,600 | $ | ( 3,561 | ) | $ | 50,011 |\n| New Residential’s equity in net income | $ | ( 2,547 | ) | $ | 4,555 | $ | ( 890 | ) | $ | 12,343 |\n| New Residential’s ownership | 24.5 | % | 24.5 | % | 25.0 | % | 24.7 | % |\n\n| (A) | Data as of August 31, 2019 and November 30, 2018, respectively, as a result of the one month reporting lag. |\n\n| (B) | Data for the periods ended August 31, 2019 and 2018, respectively, as a result of the one month reporting lag. |\n\n| (C) | During the nine months ended September 30, 2019, LoanCo sold, through securitizations which were treated as sales for accounting purposes, $ 406.1 million in UPB of consumer loans. LoanCo retained $ 83.9 million of residual interest in the securitizations and distributed them to the LoanCo co-investors, including New Residential. |\n\nThe following is a summary of LoanCo’s consumer loan investments:\n| Unpaid Principal Balance | Interest in Consumer Loans | Carrying Value | Weighted Average Coupon | Weighted Average Expected Life (Years)(A) | Weighted Average Delinquency(B) |\n| September 30, 2019(C) | $ | 1,226 | 25.0 | % | $ | 1,632 | 18.7 | % | 1.0 | — | % |\n\n| (A) | Represents the weighted average expected timing of the receipt of expected cash flows for this investment. |\n\n| (B) | Represents the percentage of the total unpaid principal balance that is 30+ days delinquent. Delinquency status is the primary credit quality indicator as it provides early warning of borrowers who may be experiencing financial difficulties. |\n\n| (C) | Data as of August 31, 2019 as a result of the one month reporting lag. |\n\n46\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nNew Residential’s investment in LoanCo and WarrantCo changed as follows:\n| Balance at December 31, 2018 | $ | 38,294 |\n| Contributions to equity method investees | 63,969 |\n| Distributions of earnings from equity method investees | ( 1,178 | ) |\n| Distributions of capital from equity method investees | ( 77,162 | ) |\n| Earnings from investments in consumer loans, equity method investees | ( 890 | ) |\n| Balance at September 30, 2019 | $ | 23,033 |\n\n| 10. | DERIVATIVES |\n\nNew Residential uses interest rate swaps and interest rate caps as economic hedges to hedge a portion of its interest rate risk exposure. Interest rate risk is sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations, as well as other factors. New Residential’s credit risk with respect to economic hedges is the risk of default on New Residential’s investments that results from a borrower’s or counterparty’s inability or unwillingness to make contractually required payments.\nAs of September 30, 2019, New Residential held to-be-announced forward contract positions (“TBAs”) which were entered into as an economic hedge in order to mitigate New Residential’s interest rate risk on certain specified mortgage backed securities and any amounts or obligations owed by or to New Residential are subject to the right of set-off with the TBA counterparty. As part of executing these trades, New Residential has entered into agreements with its TBA counterparties that govern the transactions for the TBA purchases or sales made, including margin maintenance, payment and transfer, events of default, settlements, and various other provisions. New Residential has fulfilled all obligations and requirements entered into under these agreements.\nIn addition, as of September 30, 2019, New Residential held interest rate lock commitments (“IRLCs”), which represent a commitment to a particular interest rate provided the borrower is able to close the loan within a specified period, and forward loan sale and securities delivery commitments, which represent a commitment to sell specific mortgage loans at prices which are fixed as of the forward commitment date. New Residential enters into forward loan sale and securities delivery commitments in order to hedge the exposure related to IRLCs and mortgage loans that are not covered by mortgage loan sale commitments.\nNew Residential’s derivatives are recorded at fair value on the Condensed Consolidated Balance Sheets as follows:\n| Balance Sheet Location | September 30, 2019 | December 31, 2018 |\n| Derivative assets |\n| Interest Rate Caps | Other assets | $ | — | $ | 3 |\n| Interest Rate Lock Commitments | Other assets | 26,214 | 10,851 |\n| Forward Loan Sale Commitments | Other assets | — | 39 |\n| TBAs | Other assets | 10,498 | — |\n| $ | 36,712 | $ | 10,893 |\n| Derivative liabilities |\n| Interest Rate Swaps(A) | Accrued expenses and other liabilities | $ | 135 | $ | 5,245 |\n| Interest Rate Lock Commitments | Accrued expenses and other liabilities | 1,676 | 223 |\n| Forward Loan Sale Commitments | Accrued expenses and other liabilities | 31 |\n| TBAs | Accrued expenses and other liabilities | — | 23,921 |\n| $ | 1,842 | $ | 29,389 |\n\n| (A) | Net of $ 165.7 million of related variation margin accounts as of September 30, 2019. As of December 31, 2018, net of $ 106.1 million of related variation margin accounts existed. |\n\n47\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nThe following table summarizes notional amounts related to derivatives:\n| September 30, 2019 | December 31, 2018 |\n| Interest Rate Caps(A) | $ | 50,000 | $ | 50,000 |\n| Interest Rate Swaps(B) | 7,780,000 | 4,725,000 |\n| Interest Rate Lock Commitments | 2,735,387 | 823,187 |\n| Forward Loan Sale Commitments | 6,893 | 30,274 |\n| TBAs, short position(C) | 5,488,000 | 5,904,300 |\n| TBAs, long position(C) | 9,709,894 | 5,067,200 |\n\n| (A) | As of September 30, 2019, caps LIBOR at 4.00 % for $ 50.0 million of notional. The weighted average maturity of the interest rate caps as of September 30, 2019 was 14 months. |\n\n| (B) | Includes $ 4.5 billion notional of Receive LIBOR/Pay Fixed of 3.16 % and $ 3.3 billion notional of Receive Fixed of 1.51 %/Pay LIBOR with weighted average maturities of 43 months and 65 months, respectively, as of September 30, 2019. |\n\n| (C) | Represents the notional amount of Agency RMBS, classified as derivatives. |\n\nThe following table summarizes all income (losses) recorded in relation to derivatives:\n| For the Three Months Ended September 30, | For the Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Change in fair value of derivative instruments(A) |\n| Interest Rate Caps | $ | — | $ | ( 2 | ) | $ | ( 3 | ) | $ | 436 |\n| Interest Rate Swaps | 42,306 | 18,785 | ( 26,893 | ) | 19,668 |\n| Unrealized gains (losses) on Interest Rate Lock Commitments | 3,002 | ( 2,247 | ) | 13,911 | ( 2,247 | ) |\n| Forward Loan Sale Commitments | ( 272 | ) | ( 17 | ) | ( 70 | ) | ( 17 | ) |\n| TBAs | 13,472 | 7,780 | 11,067 | 10,145 |\n| 58,508 | 24,299 | ( 1,988 | ) | 27,985 |\n| Gain (loss) on settlement of investments, net |\n| Interest Rate Caps | — | — | — | ( 603 | ) |\n| Interest Rate Swaps | ( 10,338 | ) | ( 656 | ) | ( 32,529 | ) | 37,287 |\n| TBAs(B) | ( 3,809 | ) | 20,115 | ( 119,895 | ) | 39,408 |\n| ( 14,147 | ) | 19,459 | ( 152,424 | ) | 76,092 |\n| Total income (losses) | $ | 44,361 | $ | 43,758 | $ | ( 154,412 | ) | $ | 104,077 |\n\n| (A) | Represents unrealized gains (losses). |\n\n| (B) | Excludes $ 32.1 million and $ 61.9 million in loss on settlement included within gain on sale of originated mortgage loans, net (Note 8) for the three and nine months ended September 30, 2019, respectively. |\n\n48\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| 11. | DEBT OBLIGATIONS |\n\nThe following table presents certain information regarding New Residential’s debt obligations:\n| September 30, 2019 | December 31, 2018 |\n| Collateral |\n| Debt Obligations/Collateral | Outstanding Face Amount | Carrying Value(A) | Final Stated Maturity(B) | Weighted Average Funding Cost | Weighted Average Life (Years) | Outstanding Face | Amortized Cost Basis | Carrying Value | Weighted Average Life (Years) | Carrying Value(A) |\n| Repurchase Agreements(C) |\n| Agency RMBS(D) | $ | 10,733,236 | $ | 10,733,236 | Oct-19 to May-20 | 2.31 | % | 0.1 | $ | 10,611,553 | $ | 10,825,984 | $ | 10,886,787 | 2.4 | $ | 4,346,070 |\n| Non-Agency RMBS (E) | 7,144,329 | 7,144,329 | Oct-19 to Sep-20 | 3.08 | % | 0.1 | 21,021,981 | 7,113,471 | 7,786,425 | 6.3 | 7,434,785 |\n| Residential Mortgage Loans(F) | 5,165,150 | 5,164,159 | Oct-19 to May-21 | 3.74 | % | 0.6 | 5,960,958 | 6,025,596 | 5,805,242 | 13.9 | 3,678,246 |\n| Real Estate Owned(G)(H) | 68,651 | 68,635 | Oct-19 to May-21 | 3.85 | % | 0.4 | N/A | N/A | 95,410 | N/A | 94,868 |\n| Total Repurchase Agreements | 23,111,366 | 23,110,359 | 2.87 | % | 0.3 | 15,553,969 |\n| Notes and Bonds Payable |\n| Excess MSRs(I) | 269,759 | 269,759 | Feb-20 to Jul-22 | 4.95 | % | 1.9 | 103,514,484 | 315,847 | 416,899 | 5.8 | 297,563 |\n| MSRs(J) | 2,360,182 | 2,352,961 | Mar-20 to Jul-24 | 4.23 | % | 2.0 | 452,215,330 | 4,718,333 | 5,113,271 | 5.5 | 2,360,856 |\n| Servicer Advances(K) | 2,903,093 | 2,896,819 | Jan-20 to Aug-23 | 3.22 | % | 2.0 | 3,316,416 | 3,482,368 | 3,512,345 | 1.6 | 3,382,455 |\n| Residential Mortgage Loans(L) | 1,012,342 | 1,015,360 | Apr-20 to Jul-43 | 4.09 | % | 3.7 | 1,258,875 | 1,277,193 | 1,194,186 | 8.0 | 124,945 |\n| Consumer Loans(M) | 868,214 | 870,973 | Dec-21 to May-36 | 3.25 | % | 4.0 | 878,317 | 884,473 | 881,069 | 5.6 | 936,447 |\n| Total Notes and Bonds Payable | 7,413,590 | 7,405,872 | 3.73 | % | 2.5 | 7,102,266 |\n| Total/ Weighted Average | $ | 30,524,956 | $ | 30,516,231 | 3.08 | % | 0.8 | $ | 22,656,235 |\n\n| (A) | Net of deferred financing costs. |\n\n| (B) | All debt obligations with a stated maturity through October 31, 2019 were refinanced, extended or repaid. |\n\n| (C) | These repurchase agreements had approximately $ 77.8 million of associated accrued interest payable as of September 30, 2019. |\n\n| (D) | All of the Agency RMBS repurchase agreements have a fixed rate. Collateral amounts include approximately $ 4.4 billion of related trade and other receivables. |\n\n| (E) | $ 6,585.6 million face amount of the Non-Agency RMBS repurchase agreements have LIBOR-based floating interest rates while the remaining $ 558.8 million face amount of the Non-Agency RMBS repurchase agreements have a fixed rate. This also includes repurchase agreements of $ 7.5 million on retained servicer advance and consumer loan bonds and of $ 671.3 million on retained bonds collateralized by Agency MSRs. |\n\n| (F) | All of these repurchase agreements have LIBOR-based floating interest rates. |\n\n| (G) | All of these repurchase agreements have LIBOR-based floating interest rates. |\n\n| (H) | Includes financing collateralized by receivables including claims from FHA on Ginnie Mae EBO loans for which foreclosure has been completed and for which New Residential has made or intends to make a claim on the FHA guarantee. |\n\n| (I) | Includes $ 169.8 million of corporate loans which bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin of 3.00 %, and $ 100.0 million of corporate loans which bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin of 2.50 %. The outstanding face amount of the collateral represents the UPB of the residential mortgage loans underlying the interests in MSRs that secure these notes. |\n\n| (J) | Includes: $ 940.2 million of MSR notes which bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin ranging from 2.25 % to 2.75 %; and $ 1,419.9 million of public notes with fixed interest rates ranging from 3.55 % to 4.62 %. The outstanding face amount of the collateral represents the UPB of the residential mortgage loans underlying the MSRs and mortgage servicing rights financing receivables that secure these notes. |\n\n| (K) | $ 2.6 billion face amount of the notes have a fixed rate while the remaining notes bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR or a cost of funds rate, as applicable, and (ii) a margin ranging from 1.15 % to 1.99 %. Collateral includes Servicer Advance Investments, as well as servicer advances receivable related to the mortgage servicing rights and mortgage servicing rights financing receivables owned by NRM. |\n\n49\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| (L) | Represents: (i) a $ 6.0 million note payable to Nationstar which includes a $ 1.5 million receivable from government agency and bears interest equal to one-month LIBOR plus 2.88 %, (ii) $ 109.9 million fair value of SAFT 2013-1 mortgage-backed securities issued with fixed interest rates ranging from 3.50 % to 3.76 % (see Note 12 for details), (iii) $ 362.1 million of asset-backed notes held by third parties which bear interest equal to 4.59 % (see Note 12 for details), and (iv) $ 535.1 million of asset-backed notes held by third parties which include $ 1.3 million of REO and bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin of 1.25 %. |\n\n| (M) | Includes the SpringCastle debt, which is comprised of the following classes of asset-backed notes held by third parties: $ 787.9 million UPB of Class A notes with a coupon of 3.20 % and a stated maturity date in May 2036, $ 70.4 million UPB of Class B notes with a coupon of 3.58 % and a stated maturity date in May 2036, and $ 8.7 million UPB of Class C notes with a coupon of 5.06 % and a stated maturity date in May 2036. Also includes a $ 1.2 million face amount note which bears interest equal to 4.00 %. |\n\nAs of September 30, 2019, New Residential had no outstanding repurchase agreements where the amount at risk with any individual counterparty or group of related counterparties exceeded 10% of New Residential’s stockholders' equity. The amount at risk under repurchase agreements is defined as the excess of carrying amount (or market value, if higher than the carrying amount) of the securities or other assets sold under agreement to repurchase, including accrued interest plus any cash or other assets on deposit to secure the repurchase obligation, over the amount of the repurchase liability (adjusted for accrued interest).\nGeneral\nCertain of the debt obligations included above are obligations of New Residential’s consolidated subsidiaries, which own the related collateral. In some cases, such collateral is not available to other creditors of New Residential.\nNew Residential has margin exposure on $ 23.1 billion of repurchase agreements as of September 30, 2019. To the extent that the value of the collateral underlying these repurchase agreements declines, New Residential may be required to post margin, which could significantly impact its liquidity.\nActivities related to the carrying value of New Residential’s debt obligations were as follows:\n| Excess MSRs | MSRs | Servicer Advances(A) | Real Estate Securities | Residential Mortgage Loans and REO | Consumer Loans | Total |\n| Balance at December 31, 2018 | $ | 297,563 | $ | 2,360,856 | $ | 3,382,455 | $ | 11,780,855 | $ | 3,898,059 | $ | 936,447 | $ | 22,656,235 |\n| Repurchase Agreements: |\n| Borrowings | — | — | — | 131,684,478 | 20,417,339 | — | 152,101,817 |\n| Repayments | — | — | — | ( 125,587,933 | ) | ( 18,957,675 | ) | — | ( 144,545,608 | ) |\n| Capitalized deferred financing costs, net of amortization | — | — | — | 165 | 17 | — | 182 |\n| Notes and Bonds Payable: |\n| Borrowings | 300,000 | 2,039,949 | 3,419,265 | — | 912,445 | 928,683 | 7,600,342 |\n| Repayments | ( 328,000 | ) | ( 2,048,653 | ) | ( 3,902,406 | ) | — | ( 27,279 | ) | ( 1,000,203 | ) | ( 7,306,541 | ) |\n| Discount on borrowings, net of amortization | — | — | 29 | — | — | 6,046 | 6,075 |\n| Unrealized gain on notes, fair value | — | — | — | — | 5,248 | — | 5,248 |\n| Capitalized deferred financing costs, net of amortization | 196 | 809 | ( 2,524 | ) | — | — | — | ( 1,519 | ) |\n| Balance at September 30, 2019 | $ | 269,759 | $ | 2,352,961 | $ | 2,896,819 | $ | 17,877,565 | $ | 6,248,154 | $ | 870,973 | $ | 30,516,231 |\n\n| (A) | New Residential net settles daily borrowings and repayments of the Notes and Bonds Payable on its servicer advances. |\n\n50\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nMaturities\nNew Residential’s debt obligations as of September 30, 2019 had contractual maturities as follows:\n| Year | Nonrecourse | Recourse | Total |\n| October 1 through December 31, 2019 | $ | 1,978 | $ | 18,781,709 | $ | 18,783,687 |\n| 2020 | 615,733 | 5,480,786 | 6,096,519 |\n| 2021 | 1,088,623 | 1,034,034 | 2,122,657 |\n| 2022 | 1,162,067 | 169,759 | 1,331,826 |\n| 2023 | 400,000 | 403,433 | 803,433 |\n| 2024 and thereafter | 976,300 | 410,534 | 1,386,834 |\n| $ | 4,244,701 | $ | 26,280,255 | $ | 30,524,956 |\n\nBorrowing Capacity\nThe following table represents New Residential’s borrowing capacity as of September 30, 2019:\n| Debt Obligations / Collateral | Borrowing Capacity | Balance Outstanding | Available Financing |\n| Repurchase Agreements |\n| Residential mortgage loans and REO | $ | 9,112,297 | $ | 5,233,801 | $ | 3,878,496 |\n| Non-Agency RMBS | 650,000 | 558,756 | 91,244 |\n| Notes and Bonds Payable |\n| Excess MSRs | 150,000 | 100,000 | 50,000 |\n| MSRs | 1,375,000 | 940,188 | 434,812 |\n| Servicer advances(A) | 1,204,660 | 1,053,127 | 151,533 |\n| Residential Mortgage Loans | 650,000 | 535,063 | 114,937 |\n| Consumer loans | 150,000 | 1,228 | 148,772 |\n| $ | 13,291,957 | $ | 8,422,163 | $ | 4,869,794 |\n\n| (A) | New Residential’s unused borrowing capacity is available if New Residential has additional eligible collateral to pledge and meets other borrowing conditions as set forth in the applicable agreements, including any applicable advance rate. New Residential pays a 0.02 % fee on the unused borrowing capacity. |\n\nCertain of the debt obligations are subject to customary loan covenants and event of default provisions, including event of default provisions triggered by certain specified declines in New Residential’s equity or a failure to maintain a specified tangible net worth, liquidity, or indebtedness to tangible net worth ratio. New Residential was in compliance with all of its debt covenants as of September 30, 2019.\n51\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| 12. | FAIR VALUE MEASUREMENT |\n\nThe carrying values and fair values of New Residential’s assets and liabilities recorded at fair value on a recurring basis, as well as other financial instruments for which fair value is disclosed, as of September 30, 2019 were as follows:\n| Fair Value |\n| Principal Balance or Notional Amount | Carrying Value | Level 1 | Level 2 | Level 3 | Total |\n| Assets |\n| Investments in: |\n| Excess mortgage servicing rights, at fair value(A) | $ | 93,025,190 | $ | 398,064 | $ | — | $ | — | $ | 398,064 | $ | 398,064 |\n| Excess mortgage servicing rights, equity method investees, at fair value(A) | 35,632,429 | 132,259 | — | — | 132,259 | 132,259 |\n| Mortgage servicing rights, at fair value(A) | 319,927,285 | 3,431,968 | — | — | 3,431,968 | 3,431,968 |\n| Mortgage servicing rights financing receivables, at fair value | 140,523,235 | 1,811,261 | — | — | — | 1,811,261 | 1,811,261 |\n| Servicer advance investments, at fair value | 492,480 | 600,547 | — | — | 600,547 | 600,547 |\n| Real estate and other securities, available-for-sale | 30,643,013 | 16,853,910 | — | 8,998,066 | 7,855,844 | 16,853,910 |\n| Residential mortgage loans, held-for-investment | 569,888 | 500,524 | — | — | 495,424 | 495,424 |\n| Residential mortgage loans, held-for-sale | 1,449,469 | 1,349,997 | — | — | 1,365,262 | 1,365,262 |\n| Residential mortgage loans, held-for-sale, at fair value | 5,272,963 | 5,206,251 | — | 872,088 | 4,334,192 | 5,206,280 |\n| Residential mortgage loans, held-for-investment, at fair value | 112,112 | 113,133 | — | — | 113,133 | 113,133 |\n| Residential mortgage loans subject to repurchase | 168,532 | 168,532 | — | 168,532 | — | 168,532 |\n| Consumer loans, held-for-investment | 878,431 | 881,183 | — | — | 903,805 | 903,805 |\n| Derivative assets | 17,619,076 | 36,712 | — | 10,498 | 26,214 | 36,712 |\n| Cash and cash equivalents | 738,219 | 738,219 | 738,219 | — | — | 738,219 |\n| Restricted cash | 163,148 | 163,148 | 163,148 | — | — | 163,148 |\n| Other assets(B) | N/A | 25,187 | 10,912 | — | 14,275 | 25,187 |\n| $ | 32,410,895 | $ | 912,279 | $ | 10,049,184 | $ | 21,482,248 | $ | 32,443,711 |\n| Liabilities |\n| Repurchase agreements | $ | 23,111,366 | $ | 23,110,359 | $ | — | $ | 23,111,366 | $ | — | $ | 23,111,366 |\n| Notes and bonds payable(C) | 7,413,590 | 7,405,872 | — | — | 7,486,297 | 7,486,297 |\n| Residential mortgage loan repurchase liability | 168,532 | 168,532 | — | 168,532 | — | 168,532 |\n| Derivative liabilities | 8,151,098 | 1,842 | — | 166 | 1,676 | 1,842 |\n| Excess spread financing | 3,113,756 | 30,377 | — | — | 30,377 | 30,377 |\n| Contingent consideration | N/A | 52,761 | — | — | 52,761 | 52,761 |\n| $ | 30,769,743 | $ | — | $ | 23,280,064 | $ | 7,571,111 | $ | 30,851,175 |\n\n\n| (A) | The notional amount represents the total unpaid principal balance of the residential mortgage loans underlying the MSRs, MSR financing receivables and Excess MSRs. New Residential does not receive an excess mortgage servicing amount on non-performing loans in Agency portfolios. |\n\n| (B) | Excludes the indirect equity investment in a commercial redevelopment project that is accounted for at fair value on a recurring basis based on the NAV of New Residential’s investment. The investment had a fair value of $ 74.1 million as of September 30, 2019. |\n\n52\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| (C) | Includes the SAFT 2013-1 mortgage-backed securities and the 2019-RPL1 asset-backed notes issued for which the fair value option for financial instruments was elected and resulted in a fair value of $ 474.3 million as of September 30, 2019. |\n\nNew Residential’s assets measured at fair value on a recurring basis using Level 3 inputs changed as follows:\n| Level 3 |\n| Excess MSRs(A) | Excess MSRs in Equity Method Investees(A)(B) | MSRs(A) | Mortgage Servicing Rights Financing Receivable(A) | Servicer Advance Investments | Non-Agency RMBS | Derivatives(C) | Residential Mortgage Loans |\n| Agency | Non-Agency | Total |\n| Balance at December 31, 2018 | $ | 257,387 | $ | 190,473 | $ | 147,964 | $ | 2,884,100 | $ | 1,644,504 | $ | 735,846 | $ | 8,970,963 | $ | 10,628 | $ | 2,330,627 | $ | 17,172,492 |\n| Transfers(D) |\n| Transfers from Level 3 | — | — | — | — | — | — | — | — | ( 19,726 | ) | ( 19,726 | ) |\n| Transfers to Level 3 | — | — | — | — | — | — | — | — | 301,174 | 301,174 |\n| Shellpoint Acquisition (Note 1) | — | — | — | — | — | — | 805 | 805 |\n| Transfers from investments in mortgage servicing rights financing receivables to investments in mortgage servicing rights | — | — | — | 367,121 | ( 367,121 | ) | — | — | — | — | — |\n| Gains (losses) included in net income |\n| Included in other-than-temporary impairment on securities(E) | — | — | — | — | — | — | ( 21,942 | ) | — | — | ( 21,942 | ) |\n| Included in change in fair value of investments in excess mortgage servicing rights(E) | ( 946 | ) | ( 475 | ) | — | — | — | — | — | — | — | ( 1,421 | ) |\n| Included in change in fair value of investments in excess mortgage servicing rights, equity method investees(E) | — | — | 4,087 | — | — | — | — | — | — | 4,087 |\n| Included in servicing revenue, net(F) | — | — | — | ( 629,396 | ) | — | — | — | — | — | ( 629,396 | ) |\n| Included in change in fair value of investments in mortgage servicing rights financing receivables(E) | — | — | — | — | ( 133,200 | ) | — | — | — | — | ( 133,200 | ) |\n| Included in change in fair value of servicer advance investments | — | — | — | — | — | 15,932 | — | — | — | 15,932 |\n| Included in change in fair value of investments in residential mortgage loans | — | — | — | — | — | — | — | — | 82,559 | 82,559 |\n| Included in gain (loss) on settlement of investments, net | 231 | 90 | — | — | — | — | 91,895 | — | — | 92,216 |\n| Included in other income (loss), net(E) | 1,036 | 735 | — | — | — | — | 9,010 | 13,910 | — | 24,691 |\n| Gains (losses) included in other comprehensive income(G) | — | — | — | — | — | — | 254,044 | — | — | 254,044 |\n| Interest income | 4,452 | 13,751 | — | — | — | 17,862 | 243,538 | — | — | 279,603 |\n| Purchases, sales and repayments |\n| Purchases | — | — | — | 632,144 | 735,152 | 1,255,306 | 1,164,853 | — | 7,634,281 | 11,421,736 |\n| Proceeds from sales | ( 4,579 | ) | ( 2 | ) | — | ( 1,047 | ) | ( 15,575 | ) | ( 1,662,900 | ) | — | ( 6,559,120 | ) | ( 8,243,223 | ) |\n| Proceeds from repayments | ( 36,021 | ) | ( 28,068 | ) | ( 19,792 | ) | ( 11,210 | ) | ( 52,499 | ) | ( 1,424,399 | ) | ( 1,193,617 | ) | — | ( 170,668 | ) | ( 2,936,274 | ) |\n| Originations and other | — | — | — | 190,256 | — | — | — | — | 847,393 | 1,037,649 |\n| Balance at September 30, 2019 | $ | 221,560 | $ | 176,504 | $ | 132,259 | $ | 3,431,968 | $ | 1,811,261 | $ | 600,547 | $ | 7,855,844 | $ | 24,538 | $ | 4,447,325 | $ | 18,701,806 |\n\n\n| (A) | Includes the recapture agreement for each respective pool, as applicable. |\n\n| (B) | Amounts represent New Residential’s portion of the Excess MSRs held by the respective joint ventures in which New Residential has a 50 % interest. |\n\n| (C) | For the purpose of this table, the IRLC asset and liability positions are shown net. |\n\n| (D) | Transfers are assumed to occur at the beginning of the respective period. |\n\n| (E) | The gains (losses) recorded in earnings during the period are attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting dates and realized gains (losses) recorded during the period. |\n\n| (F) | The components of Servicing revenue, net are disclosed in Note 5. |\n\n| (G) | These gains (losses) were included in net unrealized gain (loss) on securities in the Condensed Consolidated Statements of Comprehensive Income. |\n\n53\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nNew Residential’s liabilities measured at fair value on a recurring basis using Level 3 inputs changed as follows:\n| Level 3 |\n| Excess Spread Financing | Mortgage-Backed Securities Issued | Contingent Consideration |\n| Total |\n| Balance at December 31, 2018 | $ | 39,304 | $ | 117,048 | $ | 40,842 | $ | 197,194 |\n| Transfers(A) |\n| Transfers from Level 3 | — | — | — | — |\n| Transfers to Level 3 | — | — | — | — |\n| Acquisition | — | — | 14,488 | 14,488 |\n| Gains (losses) included in net income |\n| Included in other-than-temporary impairment on securities(B) | — | — | — | — |\n| Included in change in fair value of investments in excess mortgage servicing rights | — | — | — | — |\n| Included in change in fair value of investments in excess mortgage servicing rights, equity method investees(B) | — | — | — | — |\n| Included in servicing revenue, net(C) | ( 9,482 | ) | — | — | ( 9,482 | ) |\n| Included in change in fair value of investments in notes receivable - rights to MSRs | — | — | — | — |\n| Included in change in fair value of servicer advance investments | — | — | — | — |\n| Included in change in fair value of investments in residential mortgage loans | — | — | — | — |\n| Included in gain (loss) on settlement of investments, net | — | — | — | — |\n| Included in other income(B) | — | 5,248 | 7,431 | 12,679 |\n| Gains (losses) included in other comprehensive income, net of tax(D) | — | — | — | — |\n| Interest income | — | — | — | — |\n| Purchases, sales and repayments |\n| Purchases | — | 378,569 | — | 378,569 |\n| Proceeds from sales | — | — | — | — |\n| Proceeds from repayments | — | ( 26,556 | ) | — | ( 26,556 | ) |\n| Other | 555 | — | ( 10,000 | ) | ( 9,445 | ) |\n| Balance at September 30, 2019 | $ | 30,377 | $ | 474,309 | $ | 52,761 | $ | 557,447 |\n\n| (A) | Transfers are assumed to occur at the beginning of the respective period. |\n\n| (B) | The gains (losses) recorded in earnings during the period are attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting dates and realized gains (losses) recorded during the period. |\n\n| (C) | The components of Servicing revenue, net are disclosed in Note 5. |\n\n| (D) | These gains (losses) were included in net unrealized gain (loss) on securities in the Condensed Consolidated Statements of Comprehensive Income. |\n\n54\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nInvestments in Excess MSRs, Excess MSRs Equity Method Investees, MSRs and MSR Financing Receivables Valuation\nThe following table summarizes certain information regarding the weighted average inputs used as of September 30, 2019:\n| Significant Inputs(A) |\n| Prepayment Rate(B) | Delinquency(C) | Recapture Rate(D) | Mortgage Servicing Amount or Excess Mortgage Servicing Amount (bps)(E) | Collateral Weighted Average Maturity (Years)(F) |\n| Excess MSRs Directly Held (Note 4) |\n| Agency |\n| Original Pools | 9.3 | % | 1.2 | % | 23.5 | % | 21 | 20 |\n| Recaptured Pools | 12.3 | % | 0.5 | % | 35.0 | % | 22 | 23 |\n| 10.0 | % | 1.0 | % | 26.3 | % | 21 | 21 |\n| Non-Agency(G) |\n| Nationstar and SLS Serviced: |\n| Original Pools | 9.9 | % | N/A | 17.5 | % | 15 | 24 |\n| Recaptured Pools | 8.6 | % | N/A | 20.9 | % | 24 | 24 |\n| 9.7 | % | N/A | 17.9 | % | 16 | 24 |\n| Total/Weighted Average--Excess MSRs Directly Held | 9.9 | % | 1.0 | % | 22.6 | % | 19 | 22 |\n| Excess MSRs Held through Equity Method Investees (Note 4) |\n| Agency |\n| Original Pools | 10.0 | % | 1.5 | % | 26.7 | % | 19 | 19 |\n| Recaptured Pools | 11.7 | % | 0.9 | % | 32.6 | % | 24 | 23 |\n| Total/Weighted Average--Excess MSRs Held through Investees | 10.7 | % | 1.2 | % | 29.3 | % | 21 | 21 |\n| Total/Weighted Average--Excess MSRs All Pools | 10.2 | % | 1.1 | % | 24.8 | % | 20 | 22 |\n| MSRs |\n| Agency |\n| Mortgage Servicing Rights(H) (I) | 13.7 | % | 0.7 | % | 27.1 | % | 27 | 22 |\n| MSR Financing Receivables | 17.6 | % | 0.3 | % | 14.9 | % | 27 | 25 |\n| Non-Agency |\n| Mortgage Servicing Rights | 12.4 | % | 0.2 | % | 24.6 | % | 26 | 26 |\n| MSR Financing Receivables | 8.3 | % | 14.1 | % | 10.2 | % | 47 | 26 |\n| Ginnie Mae |\n| Mortgage Servicing Rights(I) | 14.8 | % | 3.6 | % | 29.7 | % | 32 | 27 |\n\n| (A) | Weighted by fair value of the portfolio. |\n\n| (B) | Projected annualized weighted average lifetime voluntary and involuntary prepayment rate using a prepayment vector. |\n\n| (C) | Projected percentage of residential mortgage loans in the pool for which the borrower will miss its mortgage payments. |\n\n| (D) | Percentage of voluntarily prepaid loans that are expected to be refinanced by the related servicer or subservicer, as applicable. |\n\n| (E) | Weighted average total mortgage servicing amount, in excess of the basic fee as applicable, measured in basis points (bps). A weighted average cost of subservicing of $ 6.46 per loan per month was used to value the agency MSRs, including MSR Financing Receivables. A weighted average cost of subservicing of $ 11.23 per loan per month was used to value the non-agency MSRs, including MSR Financing Receivables. A weighted average cost of subservicing of $ 8.81 per loan per month was used to value the Ginnie Mae MSRs. |\n\n| (F) | Weighted average maturity of the underlying residential mortgage loans in the pool. |\n\n| (G) | For certain pools, the Excess MSR will be paid on the total UPB of the mortgage portfolio (including both performing and delinquent loans until REO). For these pools, no delinquency assumption is used. |\n\n55\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| (H) | For certain pools, recapture rate represents the expected recapture rate with the successor subservicer appointed by NRM. |\n\n| (I) | Includes valuation of the related Excess spread financing (Note 5). |\n\nWith respect to valuing the Ocwen-serviced mortgage servicing rights financing receivables, which include a significant servicer advances receivable component, the cost of financing servicer advances receivable is assumed to be LIBOR plus 0.9 %.\nAs of September 30, 2019, a weighted average discount rate of 7.8 % was used to value New Residential’s investments in Excess MSRs (directly and through equity method investees). As of September 30, 2019, a weighted average discount rate of 7.5 % was used to value New Residential’s investments in MSRs and a weighted average discount rate of 8.8 % was used to value New Residential’s investments in MSR financing receivables.\nServicer Advance Investments Valuation\nThe following table summarizes certain information regarding the inputs used in valuing the Servicer Advance Investments, including the basic fee component of the related MSRs:\n| Significant Inputs |\n| Weighted Average |\n| Outstanding Servicer Advances to UPB of Underlying Residential Mortgage Loans | Prepayment Rate(A) | Delinquency | Mortgage Servicing Amount(B) | Discount Rate | Collateral Weighted Average Maturity (Years)(C) |\n| September 30, 2019 | 1.4 | % | 10.6 | % | 16.1 | % | 19.6 | bps | 5.1 | % | 23.0 |\n\n| (A) | Projected annual weighted average lifetime voluntary and involuntary prepayment rate using a prepayment vector. |\n\n| (B) | Mortgage servicing amount is net of 10.2 bps which represents the amount New Residential paid its servicers as a monthly servicing fee. |\n\n| (C) | Weighted average maturity of the underlying residential mortgage loans in the pool. |\n\nReal Estate and Other Securities Valuation\nAs of September 30, 2019, New Residential’s securities valuation methodology and results are further detailed as follows:\n| Fair Value |\n| Asset Type | Outstanding Face Amount | Amortized Cost Basis | Multiple Quotes(A) | Single Quote(B) | Total | Level |\n| Agency RMBS | $ | 8,797,199 | $ | 8,950,763 | $ | 8,998,066 | $ | — | $ | 8,998,066 | 2 |\n| Non-Agency RMBS(C) | 21,845,814 | 7,175,703 | 7,853,955 | 1,889 | 7,855,844 | 3 |\n| Total | $ | 30,643,013 | $ | 16,126,466 | $ | 16,852,021 | $ | 1,889 | $ | 16,853,910 |\n\n\n| (A) | New Residential generally obtained pricing service quotations or broker quotations from two sources, one of which was generally the seller (the party that sold New Residential the security) for Non-Agency RMBS. New Residential evaluates quotes received and determines one as being most representative of fair value, and does not use an average of the quotes. Even if New Residential receives two or more quotes on a particular security that come from non-selling brokers or pricing services, it does not use an average because it believes using an actual quote more closely represents a transactable price for the security than an average level. Furthermore, in some cases, for non-agency RMBS, there is a wide disparity between the quotes New Residential receives. New Residential believes using an average of the quotes in these cases would not represent the fair value of the asset. Based on New Residential’s own fair value analysis, it selects one of the quotes which is believed to more accurately reflect fair value. New Residential has not adjusted any of the quotes received in the periods presented. These quotations are generally received via email and contain disclaimers which state that they are “indicative” and not “actionable” — meaning that the party giving the quotation is not bound to actually purchase |\n\n56\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nthe security at the quoted price. New Residential’s investments in Agency RMBS are classified within Level 2 of the fair value hierarchy because the market for these securities is very active and market prices are readily observable.\nThe third-party pricing services and brokers engaged by New Residential (collectively, “valuation providers”) use either the income approach or the market approach, or a combination of the two, in arriving at their estimated valuations of RMBS. Valuation providers using the market approach generally look at prices and other relevant information generated by market transactions involving identical or comparable assets. Valuation providers using the income approach create pricing models that generally incorporate such assumptions as discount rates, expected prepayment rates, expected default rates and expected loss severities. New Residential has reviewed the methodologies utilized by its valuation providers and has found them to be consistent with GAAP requirements. In addition to obtaining multiple quotations, when available, and reviewing the valuation methodologies of its valuation providers, New Residential creates its own internal pricing models for Level 3 securities and uses the outputs of these models as part of its process of evaluating the fair value estimates it receives from its valuation providers. These models incorporate the same types of assumptions as the models used by the valuation providers, but the assumptions are developed independently. These assumptions are regularly refined and updated at least quarterly by New Residential, and reviewed by its valuation group, which is separate from its investment acquisition and management group, to reflect market developments and actual performance.\nFor 67.0 % of New Residential’s Non-Agency RMBS, the ranges of assumptions used by New Residential’s valuation providers are summarized in the table below. The assumptions used by New Residential’s valuation providers with respect to the remainder of New Residential’s Non-Agency RMBS were not readily available.\n| Fair Value | Discount Rate | Prepayment Rate(a) | CDR(b) | Loss Severity(c) |\n| Non-Agency RMBS | $ | 5,262,801 | 1.03% to 27.44% | 0.5% to 23.00% | 0.25% to 7.00% | 5.0% to 100% |\n\n| (a) | Represents the annualized rate of the prepayments as a percentage of the total principal balance of the pool. |\n\n| (b) | Represents the annualized rate of the involuntary prepayments (defaults) as a percentage of the total principal balance of the pool. |\n\n| (c) | Represents the expected amount of future realized losses resulting from the ultimate liquidation of a particular loan, expressed as the net amount of loss relative to the outstanding balance. |\n\n| (B) | New Residential was unable to obtain quotations from more than one source on these securities. |\n\n| (C) | Includes New Residential’s investments in interest-only notes for which the fair value option for financial instruments was elected. |\n\nResidential Mortgage Loans Valuation\nNew Residential, through its wholly owned subsidiary, NewRez, originates mortgage loans that it intends to sell into Fannie Mae, Freddie Mac, and Ginnie Mae mortgage backed securitizations. Residential mortgage loans held-for-sale, at fair value are typically pooled together and sold into certain exit markets, depending upon underlying attributes of the loan, such as agency eligibility, product type, interest rate, and credit quality. Residential mortgage loans held-for-sale, at fair value are valued using a market approach by utilizing either: (i) the fair value of securities backed by similar mortgage loans, adjusted for certain factors to approximate the fair value of a whole mortgage loan, (ii) current commitments to purchase loans or (iii) recent observable market trades for similar loans, adjusted for credit risk and other individual loan characteristics. As these prices are derived from market observable inputs, New Residential classifies these valuations as Level 2 in the fair value hierarchy.\nResidential mortgage loans held-for-sale, at fair value also includes certain nonconforming mortgage loans originated for sale to private investors, which are valued using internal pricing models to forecast loan level cash flows based on a potential securitization exit using inputs such as default rates, prepayments speeds and discount rates. As the internal pricing model is based on certain unobservable inputs, New Residential classifies these valuations as Level 3 in the fair value hierarchy.\n57\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nThe following table summarizes certain information regarding the inputs used in valuing residential mortgage loans held-for-sale, at fair value classified as Level 3:\n| Fair Value | Discount Rate | Prepayment Rate | CDR | Loss Severity |\n| Acquired Loans | $ | 3,916,826 | 4.20 % | 7.4 % | 1.6 % | 28.5 % |\n| Originated Loans | 417,366 | 3.0-4.5% | 6.0-16.0% | 0.0-3.5% | 0.0% - 50.0% |\n| Residential Mortgage Loans Held-for-Sale, at Fair Value | $ | 4,334,192 |\n\nResidential mortgage loans held-for-investment, at fair value includes mortgage loans underlying the SAFT 2013-1 securitization, which are valued using internal pricing models using inputs such as default rates, prepayment speeds and discount rates. As the internal pricing model is based on certain unobservable inputs, New Residential classifies these valuations as Level 3 in the fair value hierarchy.\nThe following table summarizes certain information regarding the inputs used in valuing residential mortgage loans held-for-investment, at fair value classified as Level 3:\n| Fair Value | Discount Rate | Prepayment Rate | CDR | Loss Severity |\n| Residential Mortgage Loans Held-for-Investment, at Fair Value | $ | 113,133 | 3.75 % | 8.0 % | 0.5 % | 20.0 % |\n\nDerivative Valuation\nNew Residential enters into economic hedges including interest rate swaps, caps and TBAs, which are categorized as Level 2 in the valuation hierarchy. New Residential generally values such derivatives using quotations, similarly to the method of valuation used for New Residential’s other assets that are classified as Level 2 in the fair value hierarchy.\nAs a part of the mortgage loan origination business, New Residential enters into forward loan sale and securities delivery commitments, which are valued based on observed market pricing for similar instruments and therefore, are classified as Level 2. In addition, New Residential enters into IRLCs, which are valued using internal pricing models incorporating (i) market pricing for instruments with similar characteristics (ii) estimating the fair value of the servicing rights expected to be recorded at sale of the loan and (iii) adjusted for anticipated loan funding probability. Both the fair value of servicing rights expected to be recorded at the date of sale of the loan and anticipated loan funding probability are significant unobservable inputs and therefore, IRLCs are classified as Level 3 in the fair value hierarchy.\nThe following table summarizes certain information regarding the inputs used in valuing IRLCs:\n| Fair Value | Loan Funding Probability | Fair Value of initial servicing rights (bps) |\n| IRLCs | $ | 24,538 | 54% to 100% | 0 to 315 |\n\nMortgage-Backed Securities Issued\nNew Residential and NewRez, a wholly owned subsidiary of New Residential, were deemed to be the primary beneficiaries of the RPL Borrowers and SAFT 2013-1 securitization entity and therefore, New Residential’s condensed consolidated balance sheets include the mortgage-backed securities issued by the RPL Borrowers and SAFT 2013-1, respectively. New Residential elected the fair value option for these financial instruments and the mortgage-backed securities issued were valued consistently with New Residential’s Non-Agency RMBS described above.\n58\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nThe following table summarizes certain information regards the inputs used in valuing Mortgage-Backed Securities Issued:\n| Fair Value | Discount Rate | Prepayment Rate | CDR | Loss Severity |\n| Mortgage-Backed Securities Issued | $ | 474,309 | 3.05% - 6.75% | 7% - 15% | 0.1%-3.5% | 10%-25% |\n\nContingent Consideration Valuation\nNew Residential, as additional consideration for the Shellpoint Acquisition, may make up to three cash earnout payments, which will be calculated following each of the first three anniversaries of the Shellpoint Closing as a percentage of the amount by which the pre-tax income of certain of Shellpoint’s businesses exceeds certain specified thresholds, up to an aggregate maximum amount of $ 60.0 million (the “Shellpoint Earnout Payments”). On September 5, 2019, New Residential paid $ 10.0 million as the first of three potential earnout payments. In accordance with ASC 805, New Residential measures its contingent consideration at fair value on a recurring basis using a scenario-based method to weigh the probability of multiple outcomes to arrive at an expected payment cash flow and then discounts the expected cash flow. The inputs utilized in valuing the contingent consideration include a discount rate of 11 % and the application of probability weighting of income scenarios, which are significant unobservable inputs and therefore, contingent consideration is classified as Level 3 in the fair value hierarchy.\nAssets and Liabilities Measured at Fair Value on a Nonrecurring Basis\nCertain assets are measured at fair value on a nonrecurring basis; that is, they are not measured at fair value on an ongoing basis but are subject to fair value adjustments only in certain circumstances, such as when there is evidence of impairment. For residential mortgage loans held-for-sale and foreclosed real estate accounted for as REO, New Residential applies the lower of cost or fair value accounting and may be required, from time to time, to record a nonrecurring fair value adjustment.\nAt September 30, 2019, assets measured at fair value on a nonrecurring basis were $ 1.3 billion. The $ 1.3 billion of assets include approximately $ 1,236.5 million of residential mortgage loans held-for-sale and $ 51.8 million of REO. The fair value of New Residential’s residential mortgage loans, held-for-sale is estimated based on a discounted cash flow model analysis using internal pricing models and is categorized within Level 3 of the fair value hierarchy.\nThe following table summarizes the inputs used in valuing these residential mortgage loans as of September 30, 2019:\n| Fair Value and Carrying Value | Discount Rate | Weighted Average Life (Years)(A) | Prepayment Rate | CDR(B) | Loss Severity(C) |\n| Performing Loans | $ | 715,110 | 4.4 | % | 4.0 | 13.0 | % | 2.0 | % | 35.5 | % |\n| Non-Performing Loans | 521,435 | 5.5 | % | 3.1 | 3.0 | % | 2.9 | % | 30.0 | % |\n| Total/Weighted Average | $ | 1,236,545 | 4.9 | % | 3.6 | 8.8 | % | 2.4 | % | 33.2 | % |\n\n| (A) | The weighted average life is based on the expected timing of the receipt of cash flows. |\n\n| (B) | Represents the annualized rate of the involuntary prepayments (defaults) as a percentage of the total principal balance. |\n\n| (C) | Loss severity is the expected amount of future realized losses resulting from the ultimate liquidation of a particular loan, expressed as the net amount of loss relative to the outstanding loan balance. |\n\nThe fair value of REO is estimated using a broker’s price opinion discounted based upon New Residential’s experience with actual liquidation values and, therefore, is categorized within Level 3 of the fair value hierarchy. These discounts to the broker price opinion generally range from 10 % to 25 %, depending on the information available to the broker.\nThe total change in the recorded value of assets for which a fair value adjustment has been included in the Condensed Consolidated Statements of Income for the nine months ended September 30, 2019 consisted of a reversal of prior valuation allowance of $ 17.0 million for residential mortgage loans, offset by $ 0.4 million increased allowance for REO.\n59\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| 13. | EQUITY AND EARNINGS PER SHARE |\n\nEquity and Dividends\nIn February 2019, New Residential issued 46.0 million shares of its common stock in a public offering at a price to the public of $ 16.50 per share for net proceeds of approximately $ 751.7 million. To compensate the Manager for its successful efforts in raising capital for New Residential, in connection with this offering, New Residential granted options to the Manager relating to 4.6 million shares of New Residential’s common stock at the public offering price, which had a fair value of approximately $ 3.8 million as of the grant date. The assumptions used in valuing the options were: a 2.40 % risk-free rate, a 9.30 % dividend yield, 19.26 % volatility and a 10 -year term.\nOn July 2, 2019, in a public offering, New Residential issued 6.2 million shares of its 7.50 % Series A Fixed-to-Floating Rate Cumulative Redeemable Preferred Stock (“Preferred Series A”), par value $ 0.01 per share, with a liquidation preference of $ 25.00 per share for net proceeds of approximately $ 150.0 million. To compensate the Manager for its successful efforts in raising capital for New Residential, in connection with this offering, New Residential granted options to the Manager relating to 0.6 million shares of New Residential’s common stock at the closing price per share of common stock on the pricing date, which had a fair value of approximately $ 0.5 million as of the grant date. The assumptions used in valuing the options were: a 1.91 % risk-free rate, a 9.73 % dividend yield, 17.95 % volatility and 10 -year term.\nOn August 15, 2019, in a public offering, New Residential issued 11.3 million shares of its 7.125 % Series B Fixed-to-Floating Rate Cumulative Redeemable Preferred Stock (“Preferred Series B”), par value $ 0.01 per share, with a liquidation preference of $ 25.00 per share for net proceeds of approximately $ 273.4 million. To compensate the Manager for its successful efforts in raising capital for New Residential, in connection with this offering, New Residential granted options to the Manager relating to 1.1 million shares of New Residential’s common stock at the closing price per share of common stock on the pricing date, which had a fair value of approximately $ 0.7 million as of the grant date. The assumptions used in valuing the options were: a 1.56 % risk-free rate, a 11.2 % dividend yield, 18.23 % volatility and 10 -year term.\nOn September 23, 2019, New Residential’s board of directors declared a third quarter 2019 common dividend of $ 0.50 per common share or $ 207.8 million and preferred dividends of $ 0.69 per share of Preferred Series A and $ 0.45 per share of Preferred Series B, or $ 4.3 million and $ 5.0 million, respectively.\nApproximately 2.4 million shares of New Residential’s common stock were held by Fortress, through its affiliates, at September 30, 2019.\nOn August 20, 2019, New Residential announced that its board of directors had authorized the repurchase of up to $ 200.0 million of its common stock through December 31, 2020. Repurchases may be made from time to time through open market purchases or privately negotiated transactions, pursuant to one or more plans established pursuant to Rule 10b5-1 under the Securities Exchange Act of 1934 or by means of one or more tender offers, in each case, as permitted by securities laws and other legal requirements. The amount and timing of the purchases will depend on a number of factors including the price and availability of New Residential’s shares, trading volume, capital availability, New Residential’s performance and general economic and market conditions. No share repurchases have been made as of the date of issuance of these consolidated financial statements. The share repurchase program may be suspended or discontinued at any time.\nOption Plan\nAs of September 30, 2019, New Residential’s outstanding options were summarized as follows:\n| Held by the Manager | 10,511,167 |\n| Issued to the Manager and subsequently assigned to certain of the Manager’s employees | 2,290,749 |\n| Issued to the independent directors | 7,000 |\n| Total | 12,808,916 |\n\n60\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nThe following table summarizes New Residential’s outstanding options as of September 30, 2019. The last sales price on the New York Stock Exchange for New Residential’s common stock in the quarter ended September 30, 2019 was $ 15.68 per share.\n| Recipient | Date ofGrant/Exercise(A) | Number of UnexercisedOptions | OptionsExercisable as ofSeptember 30, 2019 | WeightedAverageExercisePrice(B) | Intrinsic Value of Exercisable Options as ofSeptember 30, 2019(millions) |\n| Directors | Various | 7,000 | 7,000 | $ | 13.61 | $ | — |\n| Manager(C) | 2017 | 1,130,916 | — | 14.09 | 1.8 |\n| Manager(C) | 2018 | 5,320,000 | 2,416,798 | 16.61 | — |\n| Manager(C) | 2019 | 6,351,000 | 1,152,400 | 16.43 | — |\n| Outstanding | 12,808,916 | 3,576,198 |\n\n\n| (A) | Options expire on the tenth anniversary from date of grant. |\n\n| (B) | The exercise prices are subject to adjustment in connection with return of capital dividends. A portion of New Residential’s 2018 dividends was deemed to be a return of capital and the exercise prices were adjusted accordingly. |\n\n| (C) | The Manager assigned certain of its options to its employees as follows: |\n\n| Date of Grant to Manager | Range of ExercisePrices | Total UnexercisedInception to Date |\n| 2017 | $ 14.09 | 1,130,916 |\n| 2018 | $16.48 to $17.73 | 1,159,833 |\n| Total | 2,290,749 |\n\nThe following table summarizes activity in New Residential’s outstanding options:\n| Amount | Weighted Average Exercise Price |\n| December 31, 2018 outstanding options | 8,498,138 |\n| Options granted | 6,352,000 | $ | 16.20 |\n| Options exercised | ( 2,041,222 | ) | $ | 13.88 |\n| Options expired unexercised | — |\n| September 30, 2019 outstanding options | 12,808,916 | See table above |\n\nIncome and Earnings Per Share\nNew Residential is required to present both basic and diluted earnings per share (“EPS”). Basic EPS is calculated by dividing net income by the weighted average number of shares of common stock outstanding. Diluted EPS is computed by dividing net income by the weighted average number of shares of common stock outstanding plus the additional dilutive effect, if any, of common stock equivalents during each period. New Residential’s common stock equivalents are its outstanding options. During the nine months ended September 30, 2019, based on the treasury stock method, New Residential had 150,699 dilutive common stock equivalents outstanding. During the nine months ended September 30, 2018, based on the treasury stock method, New Residential had 1,463,258 dilutive common stock equivalents outstanding.\nNoncontrolling Interests\nNoncontrolling interests is comprised of the interests held by third parties in consolidated entities that hold New Residential’s Servicer Advance Investments (Note 6), Shelter JVs (Note 8) and Consumer Loans (Note 9).\n| 14. | COMMITMENTS AND CONTINGENCIES |\n\nLitigation – New Residential is or may become, from time to time, involved in various disputes, litigation and regulatory inquiry and investigation matters that arise in the ordinary course of business. Given the inherent unpredictability of these types of proceedings, it is possible that future adverse outcomes could have a material adverse effect on its business, financial position or results of operations. New Residential is not aware of any unasserted claims that it believes are material and probable of assertion where the risk of loss is expected to be reasonably possible.\nNew Residential is, from time to time, subject to inquiries by government entities. New Residential currently does not believe any of these inquiries would result in a material adverse effect on New Residential’s business.\nIndemnifications – In the normal course of business, New Residential and its subsidiaries enter into contracts that contain a variety of representations and warranties and that provide general indemnifications. New Residential’s maximum exposure under these arrangements is unknown as this would involve future claims that may be made against New Residential that have not yet occurred. However, based on its experience, New Residential expects the risk of material loss to be remote.\nCapital Commitments — As of September 30, 2019, New Residential had outstanding capital commitments related to investments in the following investment types (also refer to Note 5 for MSR investment commitments and to Note 18 for additional capital commitments entered into subsequent to September 30, 2019, if any):\nMSRs and Servicer Advances — New Residential and, in some cases, third-party co-investors agreed to purchase future servicer advances related to certain Non-Agency mortgage loans. In addition, New Residential’s subsidiary, NRM, is generally obligated to fund future servicer advances related to the loans it is obligated to service. The actual amount of future advances purchased will be based on: (a) the credit and prepayment performance of the underlying loans, (b) the amount of advances recoverable prior to liquidation of the related collateral and (c) the percentage of the loans with respect to which no additional advance obligations are made. The actual amount of future advances is subject to significant uncertainty. See Notes 5 and 6 for information on New Residential’s investments in MSRs and Servicer Advance Investments, respectively.\nMortgage Origination Reserves — NewRez, a wholly owned subsidiary of New Residential, originates conventional, government-insured and nonconforming residential mortgage loans for sale and securitization. The GSEs or Ginnie Mae guarantee conventional and government insured mortgage securitizations and mortgage investors issue nonconforming private label mortgage securitizations while NewRez generally retains the right to service the underlying residential mortgage loans. In connection with the transfer of loans to the GSEs or mortgage investors, NewRez makes representations and warranties regarding certain attributes of the loans and, subsequent to the sale, if it is determined that a sold loan is in breach of these representations and warranties, NewRez generally has an obligation to cure the breach. If NewRez is unable to cure the breach, the purchaser may require NewRez to repurchase the loan.\nIn addition, for Ginnie Mae guaranteed securitizations, NewRez holds a Ginnie Mae Buy-Back Option to repurchase delinquent loans from the securitization at its discretion. While NewRez is not obligated to repurchase the delinquent loans, NewRez generally executes its option to repurchase that will result in an economic benefit. As of September 30, 2019, New Residential’s estimated liability associated with representations and warranties and Ginnie Mae repurchases was $ 9.2 million and $ 168.5 million, respectively. See Notes 5 and 8 for information on New Residential’s Ginnie Mae Buy-Back Option and mortgage origination, respectively.\nMortgage Origination Unfunded Commitments — As of September 30, 2019, NewRez was committed to fund approximately $ 2.7 billion of mortgage loans and had forward loan sale commitments of $ 7.0 million. The forward sales are expected to close during the fourth quarter of 2019.\nResidential Mortgage Loans — As part of its investment in residential mortgage loans, New Residential may be required to outlay capital. These capital outflows primarily consist of advance escrow and tax payments, residential maintenance and property disposition fees. The actual amount of these outflows is subject to significant uncertainty. See Note 8 for information on New Residential’s investments in residential mortgage loans.\nConsumer Loans — The Consumer Loan Companies have invested in loans with an aggregate of $ 279.4 million of unfunded and available revolving credit privileges as of September 30, 2019. However, under the terms of these loans, requests for draws may be denied and unfunded availability may be terminated at New Residential’s discretion.\n61\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nLeases — New Residential, through its wholly owned subsidiary, Shellpoint, has leases on office space expiring through 2025. Future commitments under non-cancelable leases are approximately $ 25.4 million.\nEnvironmental Costs — As a residential real estate owner, through its REO, New Residential is subject to potential environmental costs. At September 30, 2019, New Residential is not aware of any environmental concerns that would have a material adverse effect on its consolidated financial position or results of operations.\nDebt Covenants — New Residential’s debt obligations contain various customary loan covenants (Note 11).\nCertain Tax-Related Covenants — If New Residential is treated as a successor to Drive Shack Inc. (“Drive Shack”) under applicable U.S. federal income tax rules, and if Drive Shack failed to qualify as a REIT for a taxable year ending on or before December 31, 2014, New Residential could be prohibited from electing to be a REIT. Accordingly, in the separation and distribution agreement executed in connection with New Residential’s spin-off from Drive Shack, Drive Shack (i) represented that it had no knowledge of any fact or circumstance that would cause New Residential to fail to qualify as a REIT, (ii) covenanted to use commercially reasonable efforts to cooperate with New Residential as necessary to enable New Residential to qualify for taxation as a REIT and receive customary legal opinions concerning REIT status, including providing information and representations to New Residential and its tax counsel with respect to the composition of Drive Shack’s income and assets, the composition of its stockholders, and its operation as a REIT; and (iii) covenanted to use its reasonable best efforts to maintain its REIT status for each of Drive Shack’s taxable years ending on or before December 31, 2014 (unless Drive Shack obtains an opinion from a nationally recognized tax counsel or a private letter ruling from the U.S. Internal Revenue Service (“IRS”) to the effect that Drive Shack’s failure to maintain its REIT status will not cause New Residential to fail to qualify as a REIT under the successor REIT rule referred to above). Additionally, New Residential covenanted to use its reasonable best efforts to qualify for taxation as a REIT for its taxable year ended December 31, 2013.\n| 15. | TRANSACTIONS WITH AFFILIATES AND AFFILIATED ENTITIES |\n\nNew Residential is party to a Management Agreement with its Manager which provides for automatically renewing one-year terms subject to certain termination rights. The Manager’s performance is reviewed annually and the Management Agreement may be terminated by New Residential by payment of a termination fee, as defined in the Management Agreement, equal to the amount of management fees earned by the Manager during the 12 consecutive calendar months immediately preceding the termination, upon the affirmative vote of at least two-thirds of the independent directors, or by a majority vote of the holders of common stock. If the Management Agreement is terminated, the Manager may require New Residential to purchase from the Manager the right of the Manager to receive the Incentive Compensation. In exchange therefor, New Residential would be obligated to pay the Manager a cash purchase price equal to the amount of the Incentive Compensation that would be paid to the Manager if all of New Residential’s assets were sold for cash at their then current fair market value (taking into account, among other things, expected future performance of the underlying investments). Pursuant to the Management Agreement, the Manager, under the supervision of New Residential’s board of directors, formulates investment strategies, arranges for the acquisition of assets and associated financing, monitors the performance of New Residential’s assets and provides certain advisory, administrative and managerial services in connection with the operations of New Residential.\nThe Manager is entitled to receive a management fee in an amount equal to 1.5 % per annum of New Residential’s gross equity calculated and payable monthly in arrears in cash. Gross equity is generally (i) the equity transferred by Drive Shack, formerly Newcastle Investment Corp., which was the sole stockholder of New Residential until the spin-off of New Residential completed on May 15, 2013, on the date of the spin-off, (ii) plus total net proceeds from stock offerings, plus certain capital contributions to subsidiaries, less capital distributions and repurchases of common stock.\nIn addition, the Manager is entitled to receive annual incentive compensation in an amount equal to the product of (A) 25 % of the dollar amount by which (1) (a) New Residential’s funds from operations before the incentive compensation, excluding funds from operations from investments in the Consumer Loan Companies and any unrealized gains or losses from mark-to-market valuation changes on investments and debt (and any deferred tax impact thereof), per share of common stock, plus (b) earnings (or losses) from the Consumer Loan Companies computed on a level-yield basis (such that the loans are treated as if they qualified as loans acquired with a discount for credit quality as set forth in ASC No. 310-30, as such codification was in effect on June 30, 2013) as if the Consumer Loan Companies had been acquired at their GAAP basis on May 15, 2013, plus earnings (or losses) from equity method investees invested in Excess MSRs as if such equity method investees had not made a fair value election, plus gains (or losses) from debt restructuring and gains (or losses) from sales of property, and plus non-routine items, minus amortization of non-\n62\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nroutine items, in each case per share of common stock, exceed (2) an amount equal to (a) the weighted average of the book value per share of the equity transferred by Drive Shack on the date of the spin-off and the prices per share of New Residential’s common stock in any offerings (adjusted for prior capital dividends or capital distributions) multiplied by (b) a simple interest rate of 10 % per annum, multiplied by (B) the weighted average number of shares of common stock outstanding. “Funds from operations” means net income (computed in accordance with GAAP), excluding gains (or losses) from debt restructuring and gains (or losses) from sales of property, plus depreciation on real estate assets, and after adjustments for unconsolidated partnerships and joint ventures. Funds from operations will be computed on an unconsolidated basis. The computation of funds from operations may be adjusted at the direction of New Residential’s independent directors based on changes in, or certain applications of, GAAP. Funds from operations is determined from the date of the spin-off and without regard to Drive Shack’s prior performance.\nIn addition to the management fee and incentive compensation, New Residential is responsible for reimbursing the Manager for certain expenses paid by the Manager on behalf of New Residential.\nDue to affiliates is comprised of the following amounts:\n| September 30, 2019 | December 31, 2018 |\n| Management fees | $ | 7,076 | $ | 5,779 |\n| Incentive compensation | 49,265 | 94,900 |\n| Expense reimbursements and other | 3,210 | 792 |\n| Total | $ | 59,551 | $ | 101,471 |\n\nAffiliate expenses and fees were comprised of:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Management fees | $ | 20,678 | $ | 15,464 | $ | 58,261 | $ | 46,027 |\n| Incentive compensation | 36,307 | 23,848 | 49,265 | 65,169 |\n| Expense reimbursements(A) | 125 | 125 | 375 | 375 |\n| Total | $ | 57,110 | $ | 39,437 | $ | 107,901 | $ | 111,571 |\n\n\n| (A) | Included in General and Administrative Expenses in the Condensed Consolidated Statements of Income. |\n\nSee Note 4 regarding co-investments with Fortress-managed funds.\nSee Note 13 regarding options granted to the Manager.\n| 16. | RECLASSIFICATION FROM ACCUMULATED OTHER COMPREHENSIVE INCOME INTO NET INCOME |\n\nThe following table summarizes the amounts reclassified out of accumulated other comprehensive income into net income:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| Accumulated Other Comprehensive Income Components | Statement of Income Location | 2019 | 2018 | 2019 | 2018 |\n| Reclassification of net realized (gain) loss on securities into earnings | Gain (loss) on settlement of investments, net | $ | ( 95,003 | ) | $ | 28,737 | $ | ( 201,222 | ) | $ | 66,695 |\n| Reclassification of net realized (gain) loss on securities into earnings | Other-than-temporary impairment on securities | 5,567 | 3,889 | 21,942 | 23,190 |\n| Total reclassifications | $ | ( 89,436 | ) | $ | 32,626 | $ | ( 179,280 | ) | $ | 89,885 |\n\nNew Residential did not allocate any income tax expense or benefit to any component of other comprehensive income for any period presented, as no taxable subsidiary generated other comprehensive income.\n| 17. | INCOME TAXES |\n\nIncome tax expense (benefit) consists of the following:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Current: |\n| Federal | $ | 1,198 | $ | 5,691 | $ | 785 | $ | 6,299 |\n| State and Local | 14 | ( 263 | ) | 115 | 424 |\n| Total Current Income Tax Expense (Benefit) | 1,212 | 5,428 | 900 | 6,723 |\n| Deferred: |\n| Federal | ( 5,385 | ) | ( 1,201 | ) | 14,762 | ( 12,829 | ) |\n| State and Local | ( 1,267 | ) | ( 664 | ) | 3,318 | 149 |\n| Total Deferred Income Tax Expense (Benefit) | ( 6,652 | ) | ( 1,865 | ) | 18,080 | ( 12,680 | ) |\n| Total Income Tax Expense (Benefit) | $ | ( 5,440 | ) | $ | 3,563 | $ | 18,980 | $ | ( 5,957 | ) |\n\nNew Residential intends to qualify as a REIT for each of its tax years through December 31, 2019. A REIT is generally not subject to U.S. federal corporate income tax on that portion of its income that is distributed to stockholders if it distributes at least 90% of its REIT taxable income to its stockholders by prescribed dates and complies with various other requirements.\n63\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nNew Residential operates various securitization vehicles and has made certain investments, particularly its investments in MSRs (Note 5), Servicer Advance Investments (Note 6) and REO (Note 8), through taxable REIT subsidiaries (“TRSs”) that are subject to regular corporate income taxes which have been provided for in the provision for income taxes, as applicable.\nNew Residential has recorded a net deferred tax asset of approximately $ 43.4 million as of September 30, 2019 , primarily related to unrealized gains and discount accruals offset by net operating loss carry forwards.\n| 18. | SUBSEQUENT EVENTS |\n\nThese financial statements include a discussion of material events that have occurred subsequent to September 30, 2019 (referred to as “subsequent events”) through the issuance of these condensed consolidated financial statements. Events subsequent to that date have not been considered in these financial statements.\nCorporate Activities\nOn October 1, 2019, New Residential completed its purchase of Ditech’s forward Fannie Mae, Ginnie Mae and non-agency MSRs with an aggregate UPB of approximately $ 62.0 billion as of August 31, 2019, the servicer advance receivables relating to such MSRs and other assets core to the forward origination and servicing operations. Additionally, New Residential assumed certain Ditech office spaces and added approximately 1,100 Ditech employees to support the increase in volume to its existing origination and servicing operations. The approximate purchase price at the closing was $ 1.2 billion and the acquisition was financed via financing facilities and cash on hand.\nOn October 4, 2019, New Residential issued a securitization of approximately $ 1.73 billion UPB of reperforming residential mortgage loans for net proceeds of $ 1.67 billion.\n64\nITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nManagement’s discussion and analysis of financial condition and results of operations is intended to help the reader understand the results of operations and financial condition of New Residential. The following should be read in conjunction with the unaudited Condensed Consolidated Financial Statements and notes thereto included herein, and with “Risk Factors.”\nGENERAL\nNew Residential is a publicly traded REIT primarily focused on opportunistically investing in, and actively managing, investments related to residential real estate. We primarily target investments in mortgage servicing related assets and related opportunistic investments. We are externally managed by an affiliate of Fortress pursuant to the Management Agreement. Our goal is to drive strong risk-adjusted returns primarily through our investments, and our investment guidelines are purposefully broad to enable us to make investments in a wide array of assets in diverse markets, including non-real estate related assets such as consumer loans. We generally target assets that generate significant current cash flows and/or have the potential for meaningful capital appreciation.\nOur portfolio is currently composed of mortgage servicing related assets, Non-Agency RMBS (and associated call rights), residential mortgage loans and other opportunistic investments. Our asset allocation and target assets may change over time, depending on our investment decisions in light of prevailing market conditions. The assets in our portfolio are described in more detail below under “—Our Portfolio.”\nNew Residential, through its wholly-owned subsidiaries New Residential Mortgage LLC (“NRM”) and NewRez LLC (“NewRez”), is licensed or otherwise eligible to service residential mortgage loans in all states within the United States and the District of Columbia. NRM and NewRez perform servicing on behalf of investors, including the Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”) (collectively, Government Sponsored Enterprises or “GSEs”) and Government National Mortgage Association (“Ginnie Mae”), and on behalf of other servicers (subservicing).\nNewRez originates, sells and securitizes conventional (conforming to the underwriting standards of Fannie Mae or Freddie Mac; collectively referred to as “Agency” loans), government-insured (Federal Housing Administration (“FHA”) and Department of Veterans Affairs (“VA”)) and non-qualified (“Non-QM”) residential mortgage loans. The GSEs or Ginnie Mae guarantee securitizations completed under their applicable policies and guidelines. New Residential generally retains the right to service the underlying residential mortgage loans sold and securitized by NRM and NewRez. NRM and NewRez are required to conduct aspects of their operations in accordance with applicable policies and guidelines published by FHA, Fannie Mae and Freddie Mac in order to maintain those approvals.\nMARKET CONSIDERATIONS\nDevelopments in the U.S. Housing Market\nAs of the third quarter of 2019, the top 100 mortgage servicers serviced over 99% of the $10.9 trillion one-to-four family mortgage debt outstanding, according to Inside Mortgage Finance. Furthermore, according to Inside Mortgage Finance, as of the third quarter of 2019, approximately 66% of such outstanding mortgage debt was serviced by the top 25 mortgage servicers, of which 15 are non-banks. Given current market dynamics and an overall competitive servicing environment, we may expect additional market consolidation among non-bank servicers. As a result, we believe additional MSR sales will be likely for some period of time. These factors have resulted in increased opportunities for us to acquire interests in MSRs and to provide capital to non-bank servicers. In addition, approximately $1.64 trillion of new loans were originated in 2018 and another $1.86 trillion are forecasted for 2019, according to the Mortgage Bankers Association. We believe this creates an opportunity to enter into “flow arrangements,” whereby loan originators or servicers agree to sell MSRs or Excess MSRs on newly originated loans on a recurring basis (often monthly or quarterly). Recently, strong demand for mortgage assets in general has led to tighter spreads and lower required rates of return. This, in turn, creates a reach for yield and increased difficulty in sourcing accretive investments in the current investment landscape. These market conditions have driven prices higher, thereby also increasing the value of certain of our existing investments.\nInterest Rates and Prepayment Rates\nAs further described in “Quantitative and Qualitative Disclosures About Market Risk,” decreasing interest rates are generally associated with increasing prepayment rates for residential mortgage loans since they decrease the cost of borrowing for homeowners. Increasing prepayment rates, in turn, would generally be expected to decrease the value of our interests in Excess MSRs, MSRs and Servicer Advance Investments, which include the right to a portion of the related MSRs, because the duration\n65\nof the cash flows we are entitled to receive decreases and results in a reduction in current cash flows. Changes in interest rates will also directly impact our costs of borrowing either immediately (floating rate debt) or upon refinancing (fixed rate debt) and may also be associated with changes in credit spreads and/or the discount rates used in valuing investments. Increasing prepayment rates have a positive impact on the value of investments purchased at a significant discount since the recovery of that discount is accelerated.\nIn the third quarter of 2019, given mixed economic data, the Federal Reserve lowered borrowing costs twice and signaled that future rate cuts in 2019 were a possibility resulting in current interest rates moving lower, with the 10-year Treasury declining 34 bps during the quarter, to 1.67% as of September 30, 2019 from 2.01% as of June 30, 2019, and LIBOR declining 38 bps during the quarter to 2.01% as of September 30, 2019 from 2.39% as of June 30, 2019. Meanwhile, the primary mortgage rate decreased 11 bps during the quarter to 3.718% as of September 30, 2019 from 3.824% as of June 30, 2019. With respect to our Non-Agency RMBS, which are generally purchased at a significant discount to par, market interest rates decreased and market credit spreads increased, with the net result being a decrease in value of these investments during the quarter.\nThe value of our MSRs and Excess MSRs is subject to a variety of factors, as described in “Quantitative and Qualitative Disclosures About Market Risk” and in “Risk Factors.” In the third quarter of 2019, the fair value of our direct investments in Excess MSRs and our share of the fair value of the Excess MSRs held through equity method investees increased by approximately $3.2 million in the aggregate, primarily as a result of a decrease in discount rates. In addition, faster prepayment speeds partially offset by lower discount rates caused the fair value of our MSRs, including MSR financing receivables, to decrease by approximately $48.9 million during the period.\nChanges in interest rates did not have a meaningful impact on the net interest spread of our Agency and Non-Agency RMBS portfolios. Our RMBS are primarily floating rate or hybrid (i.e., fixed to floating rate) securities, which we generally finance with floating rate debt, or are economically hedged with respect to interest rates. Therefore, while decreasing interest rates will generally result in a lower cost of financing, they will also result in a lower coupon payable on the securities. The net interest spread on our Agency RMBS portfolio as of September 30, 2019 was 0.75%, compared to 0.55% as of June 30, 2019. The spread changed primarily as a result of increased funding costs. The net interest spread on our Non-Agency RMBS portfolio as of September 30, 2019 was 1.76%, compared to 1.61% as of June 30, 2019. This spread changed primarily as a result of lower funding costs.\nWe employ a variety of hedging strategies to reduce book value volatility. Both our diverse portfolio composition (inclusive of long and short duration instruments and various operating businesses) as well as specific hedging instruments (including Agency MBS, interest rate swaps etc.) mitigate book value volatility.\nGeneral U.S. Economy and Unemployment\nDuring the third quarter of 2019, the U.S. unemployment rate continued to decline slightly to 3.5% as of September 30, 2019, signaling a general improvement in the U.S. economy. In our view, an improvement in the economy, as demonstrated through such measure, generally improves the value of housing and the ability of borrowers to make payments on their loans, thereby decreasing delinquencies and defaults on residential mortgage loans, consumer loans and RMBS. This relationship generally held true, however, the third quarter of 2019 continued to show certain indications that the rate of home price increases across the U.S. has slowed. The Case Shiller U.S. National Home Price Index reported a 2.0% annual gain in July 2019, down from 4.3% in January 2019. In addition, according to CoreLogic, the total number of mortgaged residential properties with negative equity stood at 2.0 million, or 3.8%, as of the second quarter of 2019, down from 3.8% in the first quarter of 2019 and on a year-over-year basis, the number of mortgaged properties in negative equity fell 9.0%. While potentially slowing, this trend continues to help support the values of our residential mortgage loans, consumer loans and RMBS.\nCredit Spreads\nCorporate credit spreads, which generally have an impact on the value of yield driven financial instruments (e.g., RMBS and loan portfolios), continued to tighten during the third quarter of 2019. In addition, collateral performance, market liquidity, mortgage credit spreads and other factors related specifically to certain investments within our mortgage securities and loan portfolio caused an increase to the value of the portion of this portfolio that was owned for the entire quarter.\nFor more information regarding these and other market factors which impact our portfolio, see Item 3. “Quantitative and Qualitative Disclosures About Market Risk.”\n66\nOur Manager\nOn December 27, 2017, SoftBank Group Corp. (“SoftBank”) announced that it completed its previously announced acquisition of Fortress (the “SoftBank Merger”). In connection with the SoftBank Merger, Fortress operates within SoftBank as an independent business headquartered in New York.\nOUR PORTFOLIO\nOur portfolio is currently composed of mortgage servicing related assets, residential securities and loans and other investments, as described in more detail below. The assets in our portfolio are described in more detail below (dollars in thousands), as of September 30, 2019.\n| OutstandingFace Amount | AmortizedCost Basis | Percentage of Total Amortized Cost Basis | CarryingValue | WeightedAverageLife (years)(A) |\n| Investments in: |\n| Excess MSRs(B) | $ | 128,657,619 | $ | 398,488 | 1.3 | % | $ | 530,323 | 5.7 |\n| MSRs(B) | 319,927,285 | 3,364,140 | 11.2 | % | 3,431,968 | 4.8 |\n| MSR Financing Receivables(B) (C) | 140,523,235 | 1,500,229 | 5.0 | % | 1,811,261 | 6.2 |\n| Servicer Advance Investments(B) (D) | 492,480 | 570,570 | 1.7 | % | 600,547 | 6.3 |\n| Agency RMBS(E) | 8,797,199 | 8,950,763 | 29.9 | % | 8,998,066 | 4.6 |\n| Non-Agency RMBS(E) | 21,845,814 | 7,175,703 | 24.1 | % | 7,855,844 | 6.3 |\n| Residential Mortgage Loans | 7,404,432 | 7,067,812 | 23.7 | % | 7,169,905 | 10.0 |\n| Consumer Loans | 878,431 | 884,587 | 3.1 | % | 881,183 | 3.9 |\n| Total/Weighted Average | $ | 29,912,292 | 100.0 | % | $ | 31,279,097 | 6.4 |\n| Reconciliation to GAAP total assets: |\n| Cash and restricted cash | 901,367 |\n| Servicer advances receivable | 2,911,798 |\n| Trades receivable | 4,487,772 |\n| Deferred tax asset, net | 43,372 |\n| Other assets | 1,724,519 |\n| GAAP total assets | $ | 41,347,925 |\n\n\n| (A) | Weighted average life is based on the timing of expected principal reduction on the asset. |\n\n| (B) | The outstanding face amount of Excess MSRs, MSRs, MSR Financing Receivables, and Servicer Advance Investments is based on 100% of the face amount of the underlying residential mortgage loans and currently outstanding advances, as applicable. |\n\n| (C) | Includes certain MSRs where our subsidiary, NRM, is the named servicer. |\n\n| (D) | The value of our Servicer Advance Investments also includes the rights to a portion of the related MSR. |\n\n| (E) | Amortized cost basis is net of impairment. |\n\nServicing Related Assets\nMSRs and MSR Financing Receivables\nAs of September 30, 2019, we had $5.2 billion carrying value of MSRs and mortgage servicing rights financing receivables within our servicer subsidiary, NRM.\nNRM has contracted with certain subservicers to perform the related servicing duties on the residential mortgage loans underlying its MSRs. As of September 30, 2019, these subservicers include PHH, Nationstar, LoanCare, AmeriHome, and Flagstar, which subservice 26.9%, 23.1%, 19.2%, 1.8%, and 0.8% of the underlying UPB of the related mortgages, respectively (includes both Mortgage Servicing Rights and MSR Financing Receivables). The remaining 28.2% of the underlying UPB of the related mortgages is subserviced by our subsidiary, Shellpoint Mortgage Servicing (Note 1 to our Condensed Consolidated Financial Statements).\n67\nNRM has entered into agreements with PHH, LoanCare, Flagstar, and Nationstar whereby NRM is entitled to the MSR on any refinancing by such subservicer of a loan in the related original portfolio.\nThe table below summarizes our investments in MSRs and mortgage servicing rights financing receivables as of September 30, 2019.\n| Current UPB (bn) | Weighted Average MSR (bps) | Carrying Value (mm) |\n| Mortgage Servicing Rights |\n| Agency | $ | 288.7 | 27 | bps | $ | 3,038.7 |\n| Non-Agency | 2.3 | 26 | 20.3 |\n| Ginnie Mae | 28.9 | 32 | 372.9 |\n| MSR Financing Receivables |\n| Agency | 61.2 | 27 | 598.0 |\n| Non-Agency | 79.4 | 47 | 1,213.3 |\n| Total | $ | 460.5 | 31 | bps | $ | 5,243.2 |\n\nThe following table summarizes the collateral characteristics of the loans underlying our investments in MSRs and mortgage servicing rights financing receivables as of September 30, 2019 (dollars in thousands):\n| Collateral Characteristics |\n| Current Carrying Amount | Current Principal Balance | Number of Loans | WA FICO Score(A) | WA Coupon | WA Maturity (months) | Average Loan Age (months) | Adjustable Rate Mortgage %(B) | Three Month Average CPR(C) | Three Month Average CRR(D) | Three Month Average CDR(E) | Three Month Average Recapture Rate |\n| Mortgage Servicing Rights |\n| Agency | $ | 3,038,721 | $ | 288,673,487 | 1,820,794 | 749 | 4.3 | % | 263 | 66 | 2.8 | % | 14.6 | % | 14.4 | % | 0.2 | % | 10.1 | % |\n| Non-Agency | 20,321 | 2,350,471 | 5,656 | 743 | 4.0 | % | 308 | 34 | 3.8 | % | 14.1 | % | 14.1 | % | — | % | 5.8 | % |\n| Ginnie Mae | 372,926 | 28,903,327 | 137,168 | 681 | 3.8 | % | 319 | 36 | 5.6 | % | 17.6 | % | 17.0 | % | 0.7 | % | 24.1 | % |\n| MSR Financing Receivables |\n| Agency | 597,990 | 61,162,569 | 249,339 | 749 | 4.4 | % | 305 | 26 | 1.1 | % | 30.8 | % | 30.8 | % | — | % | 1.8 | % |\n| Non-Agency | 1,213,271 | 79,360,666 | 577,024 | 645 | 4.5 | % | 306 | 164 | 16.1 | % | 9.9 | % | 8.0 | % | 1.9 | % | 0.5 | % |\n| Total | $ | 5,243,229 | $ | 460,450,520 | 2,789,981 | 727 | 4.3 | % | 280 | 76 | 5.1 | % | 16.1 | % | 15.6 | % | 0.5 | % | 8.2 | % |\n\n| Collateral Characteristics |\n| Delinquency 30 Days(F) | Delinquency 60 Days(F) | Delinquency 90+ Days(F) | Loans in Foreclosure | Real Estate Owned | Loans in Bankruptcy |\n| Mortgage Servicing Rights |\n| Agency | 1.5 | % | 0.3 | % | 0.4 | % | 0.3 | % | — | % | 0.3 | % |\n| Non-Agency | 0.4 | % | 0.1 | % | 0.1 | % | 0.3 | % | 0.1 | % | 0.1 | % |\n| Ginnie Mae | 4.1 | % | 1.2 | % | 1.1 | % | 1.4 | % | 0.1 | % | 1.2 | % |\n| MSR Financing Receivables |\n| Agency | 1.6 | % | 0.1 | % | 0.1 | % | — | % | — | % | 0.1 | % |\n| Non-Agency | 9.5 | % | 4.9 | % | 4.2 | % | 7.7 | % | 1.9 | % | 2.9 | % |\n| Total | 3.1 | % | 1.1 | % | 1.1 | % | 1.6 | % | 0.3 | % | 0.8 | % |\n\n| (A) | The WA FICO score is based on the weighted average of information provided by the loan servicer on a monthly basis. The loan servicer generally updates the FICO score when loans are refinanced or become delinquent. |\n\n| (B) | Adjustable Rate Mortgage % represents the percentage of the total principal balance of the pool that corresponds to adjustable rate mortgages. |\n\n| (C) | Three Month Average CPR, or the constant prepayment rate, represents the annualized rate of the prepayments during the quarter as a percentage of the total principal balance of the pool. |\n\n| (D) | Three Month Average CRR, or the voluntary prepayment rate, represents the annualized rate of the voluntary prepayments during the quarter as a percentage of the total principal balance of the pool. |\n\n| (E) | Three Month Average CDR, or the involuntary prepayment rate, represents the annualized rate of the involuntary prepayments (defaults) during the quarter as a percentage of the total principal balance of the pool. |\n\n68\n| (F) | Delinquency 30 Days, Delinquency 60 Days and Delinquency 90+ Days represent the percentage of the total principal balance of the pool that corresponds to loans that are delinquent by 30–59 days, 60–89 days or 90 or more days, respectively. |\n\nExcess MSRs\nThe tables below summarize the terms of our investments in Excess MSRs completed as of September 30, 2019.\nSummary of Direct Excess MSR Investments as of September 30, 2019\n| MSR Component(A) | Excess MSR |\n| Current UPB (bn) | Weighted Average MSR (bps) | Weighted Average Excess MSR (bps) | Interest in Excess MSR (%) | Carrying Value (mm) |\n| Agency | $ | 45.9 | 29 | bps | 21 | bps | 32.5% - 66.7% | $ | 221.6 |\n| Non-Agency(B) | 47.1 | 35 | 15 | 33.3% - 100.0% | $ | 176.5 |\n| Total/Weighted Average | $ | 93.0 | 32 | bps | 18 | bps | $ | 398.1 |\n\n\n| (A) | The MSR is a weighted average as of September 30, 2019, and the Excess MSR represents the difference between the weighted average MSR and the basic fee (which fee remains constant). |\n\n| (B) | Serviced by Nationstar and SLS, we also invested in related Servicer Advance Investments, including the basic fee component of the related MSR (Note 6 to our Condensed Consolidated Financial Statements) on $33.4 billion UPB underlying these Excess MSRs. |\n\nSummary of Excess MSR Investments Through Equity Method Investees as of September 30, 2019\n| MSR Component(A) |\n| Current UPB (bn) | Weighted Average MSR (bps) | Weighted Average Excess MSR (bps) | New Residential Interest in Investee (%) | Investee Interest in Excess MSR (%) | New Residential Effective Ownership (%) | Investee Carrying Value (mm) |\n| Agency | $ | 35.6 | 33 | bps | 21 | bps | 50.0 | % | 66.7 | % | 33.3 | % | $ | 236.8 |\n\n\n| (A) | The MSR is a weighted average as of September 30, 2019, and the Excess MSR represents the difference between the weighted average MSR and the basic fee (which fee remains constant). |\n\nThe following table summarizes the collateral characteristics of the loans underlying our direct Excess MSR investments as of September 30, 2019 (dollars in thousands):\n| Collateral Characteristics |\n| Current Carrying Amount | Current Principal Balance | Number of Loans | WA FICO Score(A) | WA Coupon | WA Maturity (months) | Average Loan Age (months) | Adjustable Rate Mortgage %(B) | Three Month Average CPR(C) | Three Month Average CRR(D) | Three Month Average CDR(E) | Three Month Average Recapture Rate |\n| Agency |\n| Original Pools | $ | 168,463 | $ | 33,627,899 | 242,096 | 723 | 4.7 | % | 247 | 115 | 1.9 | % | 13.2 | % | 12.7 | % | 0.6 | % | 11.6 | % |\n| Recaptured Loans | 53,097 | 12,272,755 | 73,762 | 725 | 4.4 | % | 278 | 42 | 0.1 | % | 13.0 | % | 12.6 | % | 0.5 | % | 29.1 | % |\n| $ | 221,560 | $ | 45,900,654 | 315,858 | 724 | 4.6 | % | 256 | 93 | 1.5 | % | 13.2 | % | 12.6 | % | 0.6 | % | 16.2 | % |\n| Non-Agency(F) |\n| Nationstar and SLS Serviced: |\n| Original Pools | $ | 153,927 | $ | 43,127,383 | 242,478 | 672 | 4.8 | % | 281 | 162 | 10.1 | % | 14.4 | % | 11.6 | % | 3.2 | % | 8.8 | % |\n| Recaptured Loans | 22,577 | 3,997,153 | 18,203 | 739 | 4.3 | % | 285 | 29 | 0.1 | % | 13.2 | % | 13.2 | % | — | % | 25.5 | % |\n| $ | 176,504 | $ | 47,124,536 | 260,681 | 678 | 4.7 | % | 281 | 151 | 8.8 | % | 14.3 | % | 11.7 | % | 2.9 | % | 10.2 | % |\n| Total/Weighted Average(H) | $ | 398,064 | $ | 93,025,190 | 576,539 | 700 | 4.7 | % | 269 | 124 | 4.7 | % | 13.8 | % | 12.2 | % | 1.8 | % | 13.2 | % |\n\n69\n| Collateral Characteristics |\n| Delinquency 30 Days(G) | Delinquency 60 Days(G) | Delinquency 90+ Days(G) | Loans inForeclosure | RealEstateOwned | Loans inBankruptcy |\n| Agency |\n| Original Pools | 2.9 | % | 0.9 | % | 0.6 | % | 0.6 | % | 0.2 | % | 0.2 | % |\n| Recaptured Loans | 1.8 | % | 0.4 | % | 0.4 | % | 0.2 | % | 0.1 | % | — | % |\n| 2.6 | % | 0.7 | % | 0.5 | % | 0.5 | % | 0.2 | % | 0.1 | % |\n| Non-Agency(F) |\n| Nationstar and SLS Serviced: |\n| Original Pools | 10.8 | % | 3.2 | % | 2.3 | % | 5.4 | % | 1.1 | % | 2.0 | % |\n| Recaptured Loans | 1.5 | % | 0.3 | % | 0.1 | % | — | % | — | % | — | % |\n| 10.0 | % | 3.0 | % | 2.1 | % | 4.9 | % | 1.0 | % | 1.8 | % |\n| Total/Weighted Average(H) | 6.5 | % | 1.9 | % | 1.4 | % | 2.8 | % | 0.6 | % | 1.0 | % |\n\n\n| (A) | The WA FICO score is based on the weighted average of information provided by the loan servicer on a monthly basis. The loan servicer generally updates the FICO score when loans are refinanced or become delinquent. |\n\n| (B) | Adjustable Rate Mortgage % represents the percentage of the total principal balance of the pool that corresponds to adjustable rate mortgages. |\n\n| (C) | Three Month Average CPR, or the constant prepayment rate, represents the annualized rate of the prepayments during the quarter as a percentage of the total principal balance of the pool. |\n\n| (D) | Three Month Average CRR, or the voluntary prepayment rate, represents the annualized rate of the voluntary prepayments during the quarter as a percentage of the total principal balance of the pool. |\n\n| (E) | Three Month Average CDR, or the involuntary prepayment rate, represents the annualized rate of the involuntary prepayments (defaults) during the quarter as a percentage of the total principal balance of the pool. |\n\n| (F) | We also invested in related Servicer Advance Investments, including the basic fee component of the related MSR (Note 6 to our Condensed Consolidated Financial Statements) on $33.4 billion UPB underlying these Excess MSRs. |\n\n| (G) | Delinquency 30 Days, Delinquency 60 Days and Delinquency 90+ Days represent the percentage of the total principal balance of the pool that corresponds to loans that are delinquent by 30–59 days, 60–89 days or 90 or more days, respectively. |\n\n| (H) | Weighted averages exclude collateral information for which collateral data was not available as of the report date. |\n\nThe following table summarizes the collateral characteristics as of September 30, 2019 of the loans underlying Excess MSR investments made through joint ventures accounted for as equity method investees (dollars in thousands). For each of these pools, we own a 50% interest in an entity that invested in a 66.7% interest in the Excess MSRs.\n| Collateral Characteristics |\n| Current Carrying Amount | CurrentPrincipal Balance | New Residential Effective Ownership(%) | Numberof Loans | WA FICO Score(A) | WA Coupon | WA Maturity (months) | Average LoanAge (months) | Adjustable Rate Mortgage %(B) | Three Month Average CPR(C) | Three Month Average CRR(D) | Three Month Average CDR(E) | Three Month Average Recapture Rate |\n| Agency |\n| Original Pools | $ | 148,573 | $ | 21,303,865 | 33.3 | % | 216,012 | 703 | 5.2 | % | 239 | 134 | 1.5 | % | 14.4 | % | 13.3 | % | 1.3 | % | 16.8 | % |\n| Recaptured Loans | 88,213 | 14,328,564 | 33.3 | % | 102,067 | 710 | 4.3 | % | 272 | 49 | 0.1 | % | 12.7 | % | 11.8 | % | 1.0 | % | 35.6 | % |\n| Total/Weighted Average(G) | $ | 236,786 | $ | 35,632,429 | 318,079 | 706 | 4.9 | % | 252 | 101 | 1.5 | % | 13.7 | % | 12.7 | % | 1.2 | % | 24.2 | % |\n\n| Collateral Characteristics |\n| Delinquency 30 Days(F) | Delinquency 60 Days(F) | Delinquency 90+ Days(F) | Loans inForeclosure | RealEstateOwned | Loans inBankruptcy |\n| Agency |\n| Original Pools | 4.2 | % | 1.3 | % | 0.7 | % | 0.9 | % | 0.3 | % | 0.3 | % |\n| Recaptured Loans | 2.9 | % | 0.9 | % | 0.4 | % | 0.3 | % | 0.1 | % | 0.1 | % |\n| Total/Weighted Average(G) | 3.7 | % | 1.1 | % | 0.6 | % | 0.7 | % | 0.2 | % | 0.2 | % |\n\n\n| (A) | The WA FICO score is based on the weighted average of information provided by the loan servicer on a monthly basis. The loan servicer generally updates the FICO score on a monthly basis. |\n\n70\n| (B) | Adjustable Rate Mortgage % represents the percentage of the total principal balance of the pool that corresponds to adjustable rate mortgages. |\n\n| (C) | Three Month Average CPR, or the constant prepayment rate, represents the annualized rate of the prepayments during the quarter as a percentage of the total principal balance of the pool. |\n\n| (D) | Three Month Average CRR, or the voluntary prepayment rate, represents the annualized rate of the voluntary prepayments during the quarter as a percentage of the total principal balance of the pool. |\n\n| (E) | Three Month Average CDR, or the involuntary prepayment rate, represents the annualized rate of the involuntary prepayments (defaults) during the quarter as a percentage of the total principal balance of the pool. |\n\n| (F) | Delinquency 30 Days, Delinquency 60 Days and Delinquency 90+ Days represent the percentage of the total principal balance of the pool that corresponds to loans that are delinquent by 30-59 days, 60-89 days or 90 or more days, respectively. |\n\n| (G) | Weighted averages exclude collateral information for which collateral data was not available as of the report date. |\n\nServicer Advance Investments\nThe following is a summary of our Servicer Advance Investments, including the right to the basic fee component of the related MSRs (dollars in thousands):\n| September 30, 2019 |\n| Amortized Cost Basis | Carrying Value(A) | UPB of Underlying Residential Mortgage Loans | Outstanding Servicer Advances | Servicer Advances to UPB of Underlying Residential Mortgage Loans |\n| Servicer Advance Investments |\n| Nationstar and SLS serviced pools | $ | 570,570 | $ | 600,547 | $ | 33,406,320 | $ | 492,480 | 1.5 | % |\n\n\n| (A) | Carrying value represents the fair value of the Servicer Advance Investments, including the basic fee component of the related MSRs. |\n\nThe following is additional information regarding our Servicer Advance Investments, and related financing, as of and for the nine months ended, September 30, 2019 (dollars in thousands):\n| Nine Months Ended September 30, 2019 | Loan-to-Value (“LTV”)(A) | Cost of Funds(B) |\n| Weighted Average Discount Rate | Weighted Average Life (Years)(C) | Change in Fair Value Recorded in Other Income | Face Amount of Notes and Bonds Payable | Gross | Net(D) | Gross | Net |\n| Servicer Advance Investments(E) | 5.1 | % | 6.3 | $ | 15,932 | $ | 449,731 | 87.3 | % | 86.1 | % | 3.8 | % | 3.1 | % |\n\n\n| (A) | Based on outstanding servicer advances, excluding purchased but unsettled servicer advances. |\n\n| (B) | Annualized measure of the cost associated with borrowings. Gross Cost of Funds primarily includes interest expense and facility fees. Net Cost of Funds excludes facility fees. |\n\n| (C) | Weighted Average Life represents the weighted average expected timing of the receipt of expected net cash flows for this investment. |\n\n| (D) | Ratio of face amount of borrowings to par amount of servicer advance collateral, net of any general reserve. |\n\n| (E) | The following types of advances are included in Servicer Advance Investments: |\n\n| September 30, 2019 |\n| Principal and interest advances | $ | 82,999 |\n| Escrow advances (taxes and insurance advances) | 185,774 |\n| Foreclosure advances | 223,707 |\n| Total | $ | 492,480 |\n\nA discussion of the sensitivity of these incentive fees to changes in LIBOR is included below under “Quantitative and Qualitative Disclosures About Market Risk.”\n71\nOriginations\nNewRez, our wholly owned subsidiary, originates conventional, government-insured and nonconforming residential mortgage loans for sale and securitization. The GSEs or Ginnie Mae guarantee conventional and government insured mortgage securitizations and mortgage investors issue Nonconforming private label mortgage securitizations while NewRez generally retains the right to service the underlying residential mortgage loans. In connection with the transfer of loans to the GSEs or mortgage investors, we report gain on sale of originated mortgage loans, net in our condensed consolidated statements of income.\nDuring the third quarter of 2019, NewRez increased loan origination volume to $5.7 billion, which is a 49% increase quarter over quarter and approximately 200% increase year over year. Gain on sale of originated mortgage loans, net is summarized below:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Gain on loans originated and sold(A) | $ | 24,312 | $ | 24,684 | $ | 36,413 | $ | 24,684 |\n| Gain (loss) on settlement of mortgage loan origination derivative instruments(B) | (32,138 | ) | (2,757 | ) | (61,879 | ) | (2,757 | ) |\n| MSRs retained on transfer of loans(C) | 96,317 | 17,282 | 190,666 | 17,282 |\n| Other(D) | 12,050 | 6,523 | 28,829 | 6,523 |\n| Gain on sale of originated mortgage loans, net | $ | 100,541 | $ | 45,732 | $ | 194,029 | $ | 45,732 |\n\n| (A) | Includes loan origination fees and direct loan origination costs. Other indirect costs related to loan origination are included within general and administrative expenses. |\n\n| (B) | Represents settlement of forward securities delivery commitments utilized as an economic hedge for mortgage loans not included within forward loan sale commitments. |\n\n| (C) | Represents the initial fair value of the capitalized mortgage servicing rights upon loan sales with servicing retained. |\n\n| (D) | Includes fees for services associated with the loan origination process. |\n\nResidential Securities and Loans\nReal Estate Securities\nAgency RMBS\nThe following table summarizes our Agency RMBS portfolio as of September 30, 2019 (dollars in thousands):\n| Gross Unrealized |\n| Asset Type | Outstanding Face Amount | Amortized Cost Basis | Percentage of Total Amortized Cost Basis | Gains | Losses | CarryingValue(A) | Count | Weighted Average Life (Years) | 3-Month CPR | Outstanding Repurchase Agreements |\n| Agency Specified Pools | $ | 8,797,199 | $ | 8,950,763 | 100.0 | % | $ | 56,939 | $ | (9,636 | ) | $ | 8,998,066 | 39 | 4.6 | 0.3 | % | $ | 7,300,198 |\n\n\n| (A) | Fair value, which is equal to carrying value for all securities. |\n\nThe following table summarizes the net interest spread of our Agency RMBS portfolio as of September 30, 2019:\n| Net Interest Spread(A) |\n| Weighted Average Asset Yield | 3.06 | % |\n| Weighted Average Funding Cost | 2.31 | % |\n| Net Interest Spread | 0.75 | % |\n\n\n| (A) | The Agency RMBS portfolio consists of 100.0% fixed rate securities (based on amortized cost basis). |\n\n72\nNon-Agency RMBS\nThe following table summarizes our Non-Agency RMBS portfolio as of September 30, 2019 (dollars in thousands):\n| Gross Unrealized |\n| Asset Type | Outstanding Face Amount | Amortized Cost Basis | Gains | Losses | CarryingValue(A) | Outstanding Repurchase Agreements |\n| Non-Agency RMBS | $ | 21,845,814 | $ | 7,175,703 | $ | 711,078 | $ | (30,937 | ) | $ | 7,855,844 | $ | 7,142,351 |\n\n\n| (A) | Fair value, which is equal to carrying value for all securities. |\n\nThe following tables summarize the characteristics of our Non-Agency RMBS portfolio and of the collateral underlying our Non-Agency RMBS as of September 30, 2019 (dollars in thousands):\n| Non-Agency RMBS Characteristics(A) |\n| Vintage(B) | Average Minimum Rating(C) | Number of Securities | Outstanding Face Amount | Amortized Cost Basis | Percentage of Total Amortized Cost Basis | Carrying Value | Principal Subordination(D) | Excess Spread(E) | Weighted Average Life (Years) | Weighted Average Coupon(F) |\n| Pre 2006 | CCC- | 365 | $ | 1,956,007 | $ | 1,487,306 | 21.1 | % | $ | 1,663,069 | 14.2 | % | 0.8 | % | 6.8 | 3.4 | % |\n| 2006 | CC | 133 | 2,774,332 | 1,746,860 | 24.7 | % | 1,979,226 | 7.1 | % | 1.2 | % | 7.6 | 2.3 | % |\n| 2007 | CCC- | 82 | 2,224,528 | 1,348,788 | 19.1 | % | 1,520,709 | 5.2 | % | 0.9 | % | 7.1 | 2.5 | % |\n| 2008 and later | BBB | 363 | 14,775,002 | 2,477,759 | 35.1 | % | 2,589,370 | 14.0 | % | 0.1 | % | 4.8 | 3.5 | % |\n| Total/Weighted Average | B- | 943 | $ | 21,729,869 | $ | 7,060,713 | 100.0 | % | $ | 7,752,374 | 10.5 | % | 0.7 | % | 6.3 | 3.0 | % |\n\n\n| Collateral Characteristics(A) (G) |\n| Vintage(B) | Average Loan Age (years) | Collateral Factor(H) | 3-Month CPR(I) | Delinquency(J) | Cumulative Losses to Date |\n| Pre 2006 | 14.8 | 0.07 | 9.7 | % | 10.8 | % | 13.0 | % |\n| 2006 | 13.4 | 0.12 | 10.0 | % | 10.6 | % | 32.2 | % |\n| 2007 | 12.6 | 0.22 | 11.2 | % | 10.6 | % | 36.7 | % |\n| 2008 and later | 8.5 | 0.79 | 18.9 | % | 1.7 | % | 0.5 | % |\n| Total/Weighted Average | 11.8 | 0.36 | 13.3 | % | 7.5 | % | 17.9 | % |\n\n\n| (A) | Excludes $30.9 million face amount of bonds backed by consumer loans and $85.0 million face amount of bonds backed by corporate debt. |\n\n| (B) | The year in which the securities were issued. |\n\n| (C) | Ratings provided above were determined by third party rating agencies, represent the most recent credit ratings available as of the reporting date and may not be current. This excludes the ratings of the collateral underlying 312 bonds with a carrying value of $1,064.1 million, which either have never been rated or for which rating information is no longer provided. We had no assets that were on negative watch for possible downgrade by at least one rating agency as of September 30, 2019. |\n\n| (D) | The percentage of amortized cost basis of securities and residual interests that is subordinate to our investments. This excludes interest-only bonds. |\n\n| (E) | The current amount of interest received on the underlying loans in excess of the interest paid on the securities, as a percentage of the outstanding collateral balance for the quarter ended September 30, 2019. |\n\n| (F) | Excludes residual bonds, and certain other Non-Agency bonds, with a carrying value of $225.2 million and $3.5 million, respectively, for which no coupon payment is expected. |\n\n| (G) | The weighted average loan size of the underlying collateral is $204.0 thousand. |\n\n| (H) | The ratio of original UPB of loans still outstanding. |\n\n| (I) | Three month average constant prepayment rate and default rates. |\n\n| (J) | The percentage of underlying loans that are 90+ days delinquent, or in foreclosure or considered REO. |\n\n73\nThe following table summarizes the net interest spread of our Non-Agency RMBS portfolio as of September 30, 2019:\n| Net Interest Spread(A) |\n| Weighted Average Asset Yield | 4.84 | % |\n| Weighted Average Funding Cost | 3.08 | % |\n| Net Interest Spread | 1.76 | % |\n\n\n| (A) | The Non-Agency RMBS portfolio consists of 68.6% floating rate securities and 31.4% fixed rate securities (based on amortized cost basis). |\n\nCall Rights\nWe hold a limited right to cleanup call options with respect to certain securitization trusts serviced or master serviced by Nationstar whereby, when the UPB of the underlying residential mortgage loans falls below a pre-determined threshold, we can effectively purchase the underlying residential mortgage loans at par, plus unreimbursed servicer advances, resulting in the repayment of all of the outstanding securitization financing at par, in exchange for a fee of 0.75% of UPB paid to Nationstar at the time of exercise. We similarly hold a limited right to cleanup call options with respect to certain securitization trusts master serviced by SLS for no fee, and also with respect to certain securitization trusts serviced or master serviced by Ocwen subject to a fee of 0.5% of UPB on loans that are current or thirty (30) days or less delinquent, paid to Ocwen at the time of exercise. The aggregate UPB of the underlying residential mortgage loans within these various securitization trusts is approximately $101.0 billion.\nWe continue to evaluate the call rights we acquired from each of our servicers, and our ability to exercise such rights and realize the benefits therefrom are subject to a number of risks. See “Risk Factors—Risks Related to Our Business—Our ability to exercise our cleanup call rights may be limited or delayed if a third party also possessing such cleanup call rights exercises such rights, if the related securitization trustee refuses to permit the exercise of such rights, or if a related party is subject to bankruptcy proceedings.” The actual UPB of the residential mortgage loans on which we can successfully exercise call rights and realize the benefits therefrom may differ materially from our initial assumptions.\nWe have exercised our call rights with respect to Non-Agency RMBS trusts and purchased performing and non-performing residential mortgage loans and REO contained in such trusts prior to their termination. In certain cases, we sold portions of the purchased loans through securitizations, and retained bonds issued by such securitizations. In addition, we received par on the securities issued by the called trusts which we owned prior to such trusts’ termination. Refer to Note 8 in our Condensed Consolidated Financial Statements for further details on these transactions.\nResidential Mortgage Loans\nAs of September 30, 2019, we had approximately $7.4 billion outstanding face amount of residential mortgage loans. These investments were financed with repurchase agreements with an aggregate face amount of approximately $5.2 billion and notes and bonds payable with an aggregate face amount of approximately $1.0 billion. We acquired these loans through open market purchases, as well as through the exercise of call rights.\nThe following table presents the total residential mortgage loans outstanding by loan type at September 30, 2019 (dollars in thousands).\n| Outstanding Face Amount | Carrying Value | LoanCount | Weighted Average Yield | Weighted Average Life (Years)(A) | Floating Rate Loans as a % of Face Amount | LTV Ratio(B) | Weighted Avg. Delinquency(C) | Weighted Average FICO(D) |\n| Performing Loans(G) (J) | $ | 557,762 | $ | 524,387 | 7,695 | 7.8 | % | 4.6 | 20.2 | % | 72.3 | % | 10.2 | % | 647 |\n| Purchased Credit Deteriorated Loans(H) | 124,238 | 89,270 | 1,106 | 7.9 | % | 3.2 | 19.3 | % | 88.1 | % | 60.7 | % | 590 |\n| Total Residential Mortgage Loans, held-for-investment | $ | 682,000 | $ | 613,657 | 8,801 | 7.8 | % | 4.4 | 20.1 | % | 75.2 | % | 19.4 | % | 636 |\n| Reverse Mortgage Loans(E) (F) | $ | 13,032 | $ | 6,450 | 32 | 7.8 | % | 5.3 | 10.1 | % | 151.6 | % | 65.1 | % | N/A |\n| Performing Loans(G) (I) | 709,867 | 726,935 | 10,798 | 4.3 | % | 4.0 | 62.4 | % | 54.3 | % | 5.9 | % | 688 |\n| Non-Performing Loans(H) (I) | 726,570 | 616,612 | 5,562 | 5.1 | % | 3.3 | 12.0 | % | 80.7 | % | 68.7 | % | 594 |\n| Total Residential Mortgage Loans, held-for-sale | $ | 1,449,469 | $ | 1,349,997 | 16,392 | 4.8 | % | 3.6 | 36.7 | % | 68.4 | % | 37.9 | % | 641 |\n| Acquired Loans | $ | 4,024,252 | $ | 3,916,826 | 26,236 | 4.2 | % | 7.4 | 2.0 | % | 71.1 | % | 15.3 | % | 622 |\n| Originated Loans | 1,248,711 | 1,289,425 | 4,465 | 4.0 | % | 28.6 | 4.0 | % | 77.6 | % | 29.2 | % | 672 |\n| Total Residential Mortgage Loans, held-for-sale, at fair value(K) | $ | 5,272,963 | $ | 5,206,251 | 30,701 | 4.1 | % | 12.5 | 2.5 | % | 72.7 | % | 18.6 | % | 634 |\n\n74\n| (A) | The weighted average life is based on the expected timing of the receipt of cash flows. |\n\n| (B) | LTV refers to the ratio comparing the loan’s unpaid principal balance to the value of the collateral property. |\n\n| (C) | Represents the percentage of the total principal balance that is 60+ days delinquent. |\n\n| (D) | The weighted average FICO score is based on the weighted average of information updated and provided by the loan servicer on a monthly basis. |\n\n| (E) | Represents a 70% participation interest we hold in a portfolio of reverse mortgage loans. The average loan balance outstanding based on total UPB was $0.6 million. Approximately 51% of these loans outstanding have reached a termination event. As a result of the termination event, each such loan has matured and the borrower can no longer make draws on these loans. |\n\n| (F) | FICO scores are not used in determining how much a borrower can access via a reverse mortgage loan. |\n\n| (G) | Performing loans are generally placed on nonaccrual status when principal or interest is 120 days or more past due. |\n\n| (H) | Includes loans with evidence of credit deterioration since origination where it is probable that we will not collect all contractually required principal and interest payments. As of September 30, 2019, we have placed all Non-Performing Loans, held-for-sale on nonaccrual status, except as described in (I) below. |\n\n| (I) | Includes $37.8 million and $27.7 million UPB of Ginnie Mae EBO performing and non-performing loans, respectively, on accrual status as contractual cash flows are guaranteed by the FHA. |\n\n| (J) | Includes $112.1 million UPB of non-agency mortgage loans underlying the SAFT 2013-1 securitization, which are carried at fair value based on New Residential’s election of the fair value option. |\n\n| (K) | New Residential elected the fair value option to measure these loans at fair value on a recurring basis. |\n\nWe consider the delinquency status, loan-to-value ratios, and geographic area of residential mortgage loans as our credit quality indicators.\nOther\nConsumer Loans\nThe table below summarizes the collateral characteristics of the consumer loans, including those held in the Consumer Loan Companies and those acquired from the Consumer Loan Seller, as of September 30, 2019 (dollars in thousands):\n| Collateral Characteristics |\n| UPB | Personal Unsecured Loans % | Personal Homeowner Loans % | Number of Loans | Weighted Average Original FICO Score(A) | Weighted Average Coupon | Adjustable Rate Loan % | Average Loan Age (months) | Average Expected Life (Years) | Delinquency 30 Days(B) | Delinquency 60 Days(B) | Delinquency 90+ Days(B) | 12-Month CRR(C) | 12-Month CDR(D) |\n| Consumer loans, held-for-investment | $ | 878,431 | 59.6 | % | 40.4 | % | 117,312 | 675 | 18.3 | % | 12.0 | % | 172 | 3.9 | 1.7 | % | 1.0 | % | 1.8 | % | 16.4 | % | 5.0 | % |\n\n\n| (A) | Weighted average original FICO score represents the FICO score at the time the loan was originated. |\n\n| (B) | Delinquency 30 Days, Delinquency 60 Days and Delinquency 90+ Days represent the percentage of the total principal balance of the pool that corresponds to loans that are delinquent by 30-59 days, 60-89 days or 90 or more days, respectively. |\n\n| (C) | 12-Month CRR, or the voluntary prepayment rate, represents the annualized rate of the voluntary prepayments during the three months as a percentage of the total principal balance of the pool. |\n\n| (D) | 12-Month CDR, or the involuntary prepayment rate, represents the annualized rate of the involuntary prepayments (defaults) during the three months as a percentage of the total principal balance of the pool. |\n\nIn addition, as of September 30, 2019, we had a net investment of $23.0 million in LoanCo and WarrantCo. For further information, see Note 9 to our Condensed Consolidated Financial Statements.\nThe following is a summary of LoanCo’s consumer loan investments:\n| Unpaid Principal Balance | Interest in Consumer Loans | Carrying Value | Weighted Average Coupon | Weighted Average Expected Life (Years)(A) | Weighted Average Delinquency(B) |\n| September 30, 2019(C) | $ | 1,226 | 25.0 | % | $ | 1,632 | 18.7 | % | 1.0 | — | % |\n\n| (A) | Represents the weighted average expected timing of the receipt of expected cash flows for this investment. |\n\n| (B) | Represents the percentage of the total unpaid principal balance that is 30+ days delinquent. Delinquency status is the primary credit quality indicator as it provides early warning of borrowers who may be experiencing financial difficulties. |\n\n| (C) | Data as of August 31, 2019 as a result of the one month reporting lag. |\n\n75\nAPPLICATION OF CRITICAL ACCOUNTING POLICIES\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our Condensed Consolidated Financial Statements, which have been prepared in accordance with GAAP. The preparation of financial statements in conformity with GAAP requires the use of estimates and assumptions that could affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities and the reported amounts of revenue and expenses. Actual results could differ from these estimates. We believe that the estimates and assumptions utilized in the preparation of the Condensed Consolidated Financial Statements are prudent and reasonable. Actual results historically have generally been in line with our estimates and judgments used in applying each of the accounting policies described below, as modified periodically to reflect current market conditions.\nOur critical accounting policies as of September 30, 2019, which represent our accounting policies that are most affected by judgments, estimates and assumptions, included all of the critical accounting policies referred to in our annual report on Form 10-K for the year ended December 31, 2018.\nRecent Accounting Pronouncements\nSee Note 1 to our Condensed Consolidated Financial Statements.\nRESULTS OF OPERATIONS\nThe following table summarizes the changes in our results of operations for the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018 (dollars in thousands). Our results of operations are not necessarily indicative of future performance.\n| Three Months Ended September 30, | Increase (Decrease) | Nine Months Ended September 30, | Increase (Decrease) |\n| 2019 | 2018 | Amount | 2019 | 2018 | Amount |\n| Interest income | $ | 448,127 | $ | 425,524 | $ | 22,603 | $ | 1,303,041 | $ | 1,212,902 | $ | 90,139 |\n| Interest expense | 245,902 | 162,806 | 83,096 | 686,738 | 421,109 | 265,629 |\n| Net Interest Income | 202,225 | 262,718 | (60,493 | ) | 616,303 | 791,793 | (175,490 | ) |\n| Impairment |\n| Other-than-temporary impairment (OTTI) on securities | 5,567 | 3,889 | 1,678 | 21,942 | 23,190 | (1,248 | ) |\n| Valuation and loss provision (reversal) on loans and real estate owned (REO) | (10,690 | ) | 5,471 | (16,161 | ) | 8,042 | 28,136 | (20,094 | ) |\n| (5,123 | ) | 9,360 | (14,483 | ) | 29,984 | 51,326 | (21,342 | ) |\n| Net interest income after impairment | 207,348 | 253,358 | (46,010 | ) | 586,319 | 740,467 | (154,148 | ) |\n| Servicing revenue, net of change in fair value of $(228,405), $(26,741), $(619,914), and $35,118, respectively | 53,050 | 175,355 | (122,305 | ) | 133,366 | 538,784 | (405,418 | ) |\n| Gain on sale of originated mortgage loans, net | 100,541 | 45,732 | 54,809 | 194,029 | 45,732 | 148,297 |\n| Other Income |\n| Change in fair value of investments in excess mortgage servicing rights | 2,407 | (4,744 | ) | 7,151 | (1,421 | ) | (55,711 | ) | 54,290 |\n| Change in fair value of investments in excess mortgage servicing rights, equity method investees | 4,751 | 3,396 | 1,355 | 4,087 | 5,624 | (1,537 | ) |\n| Change in fair value of investments in mortgage servicing rights financing receivables | (41,410 | ) | (88,345 | ) | 46,935 | (133,200 | ) | 63,628 | (196,828 | ) |\n| Change in fair value of servicer advance investments | 6,641 | (5,353 | ) | 11,994 | 15,932 | (86,581 | ) | 102,513 |\n| Change in fair value of investments in residential mortgage loans | (19,037 | ) | 647 | (19,684 | ) | 90,551 | 647 | 89,904 |\n| Change in fair value of derivative instruments | 58,508 | 24,299 | 34,209 | (1,988 | ) | 27,985 | (29,973 | ) |\n| Gain (loss) on settlement of investments, net | 154,752 | (11,893 | ) | 166,645 | 157,013 | 106,064 | 50,949 |\n| Earnings from investments in consumer loans, equity method investees | (2,547 | ) | 4,555 | (7,102 | ) | (890 | ) | 12,343 | (13,233 | ) |\n| Other income (loss), net | (35,219 | ) | (5,860 | ) | (29,359 | ) | (16,451 | ) | 10,415 | (26,866 | ) |\n| 128,846 | (83,298 | ) | 212,144 | 113,633 | 84,414 | 29,219 |\n| Operating Expenses |\n| General and administrative expenses | 133,513 | 98,587 | 34,926 | 351,359 | 139,169 | 212,190 |\n| Management fee to affiliate | 20,678 | 15,464 | 5,214 | 58,261 | 46,027 | 12,234 |\n| Incentive compensation to affiliate | 36,307 | 23,848 | 12,459 | 49,265 | 65,169 | (15,904 | ) |\n| Loan servicing expense | 7,192 | 11,060 | (3,868 | ) | 26,167 | 33,609 | (7,442 | ) |\n| Subservicing expense | 52,875 | 43,148 | 9,727 | 147,763 | 135,703 | 12,060 |\n| 250,565 | 192,107 | 58,458 | 632,815 | 419,677 | 213,138 |\n| Income (Loss) Before Income Taxes | 239,220 | 199,040 | 40,180 | 394,532 | 989,720 | (595,188 | ) |\n| Income tax expense (benefit) | (5,440 | ) | 3,563 | (9,003 | ) | 18,980 | (5,957 | ) | 24,937 |\n| Net Income (Loss) | $ | 244,660 | $ | 195,477 | $ | 49,183 | $ | 375,552 | $ | 995,677 | $ | (620,125 | ) |\n| Noncontrolling Interests in Income (Loss) of Consolidated Subsidiaries | $ | 14,738 | $ | 10,869 | $ | 3,869 | $ | 31,979 | $ | 32,058 | $ | (79 | ) |\n| Dividends on Preferred Stock | $ | 5,338 | $ | — | $ | 5,338 | $ | 5,338 | $ | — | $ | 5,338 |\n| Net Income (Loss) Attributable to Common Stockholders | $ | 224,584 | $ | 184,608 | $ | 39,976 | $ | 338,235 | $ | 963,619 | $ | (625,384 | ) |\n\n76\nInterest Income\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nInterest income increased by $22.6 million, primarily attributable to incremental interest income of (i) $46.7 million from an increase in the size of the Real Estate Securities portfolio and (ii) $38.2 million from the Residential Mortgage Loans portfolio due to the acquisition of loans through purchases, originations, and the execution of calls. The increase was partially offset by (iii) a $39.2 million decrease from MSR Financing Receivable attributable to the drop in discount accretion income recognized on servicer advances related to the Ocwen Transaction subsequent to September 30, 2018, (iv) a $12.5 million decrease from Servicer Advance Investments and Excess Mortgage Servicing Rights driven by retrospective adjustments resulting from changes in valuation assumptions on September 30, 2019, and (v) a $10.6 million decrease from Consumer Loans attributable to lower unpaid principal balance.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nInterest income increased by $90.1 million, primarily attributable to incremental interest income of (i) $203.0 million from an increase in the size of the Real Estate Securities portfolio and accelerated accretion on Real Estate Securities owned in Non-Agency RMBS trusts that were terminated upon the execution of calls and (ii) $96.4 million from the Residential Mortgage Loans portfolio due to the acquisition of loans through purchases, originations, and the execution of calls. The increase was partially offset by (iii) a $137.5 million decrease from MSR Financing Receivable attributable to the drop in discount accretion income recognized on servicer advances related to the Ocwen Transaction subsequent to September 30, 2018, (iv) a $40.2 million decrease from Servicer Advance Investments and Excess Mortgage Servicing Rights driven by retrospective adjustments resulting from changes in valuation assumptions on September 30, 2019, and (v) a $30.1 million decrease from Consumer Loans attributable to lower unpaid principal balance.\nInterest Expense\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nInterest expense increased by $83.1 million primarily attributable to increases of (i) $55.9 million of interest expense on repurchase agreements financings on Real Estate Securities in which we made additional levered investments subsequent to September 30, 2018, (ii) $22.0 million on Residential Mortgage Loans due to an increase in the underlying principal balance of the portfolio levered with repurchase agreements, (iii) $7.4 million of interest expense on MSRs and related servicer advances financing obtained subsequent to September 30, 2018, and (iv) a $0.6 million increase in interest on debt collateralized by Excess MSRs as a result of draws subsequent to September 30, 2018. The increases were partially offset by (v) a $2.8 million decrease in interest expense on the Consumer Loan securitization notes due to a decrease in the principal balance outstanding and refinancing.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nInterest expense increased by $265.6 million primarily attributable to increases of (i) $173.8 million of interest expense on repurchase agreements financings on Real Estate Securities in which we made additional levered investments subsequent to September 30, 2018, (ii) $67.7 million on Residential Mortgage Loans due to an increase in the underlying principal balance of the portfolio levered with repurchase agreements, (iii) $31.1 million of interest expense on MSRs and related servicer advances financing obtained subsequent to September 30, 2018, and (iv) a $0.4 million increase in interest on debt collateralized by Excess MSRs as a result of draws subsequent to September 30, 2018. The increases were partially offset by (v) a $7.4 million decrease in interest expense on the Consumer Loan securitization notes due to a decrease in the principal balance outstanding and refinancing.\nOther-Than-Temporary Impairment on Securities\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nThe other-than-temporary impairment on securities increased by $1.7 million during the three months ended September 30, 2019 compared to the three months ended September 30, 2018, primarily resulting from a decline in fair values on a larger portion of our Non-Agency RMBS, which we purchased with existing credit impairment, below their amortized cost basis as of September 30, 2019.\n77\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nThe other-than-temporary impairment on securities decreased by $1.2 million during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018, primarily resulting from a decline in fair values on a smaller portion of our Non-Agency RMBS, which we purchased with existing credit impairment, below their amortized cost basis as of September 30, 2019.\nValuation and Loss Provision (Reversal) on Loans and Real Estate Owned\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nThe $16.2 million decrease in the valuation and loss provision (reversal) on loans and real estate owned resulted from (i) a $12.1 million in reversal of impairment on certain loans related to changes in interest rates and improved performance and certain REOs with an increase in home prices, and (ii) $4.1 million less provision due to a reduction in net charge-offs on the Consumer Loan Companies attributable to lower unpaid principal balance.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nThe $20.1 million decrease in the valuation and loss provision (reversal) on loans and real estate owned resulted from (i) a $7.9 million in reversal of impairment on certain loans related to changes in interest rates and improved performance, partially offset by additional impairment on certain REOs with an decrease in home prices, and (ii) $12.2 million less provision due to a reduction in net charge-offs on the Consumer Loan Companies attributable to lower unpaid principal balance.\nServicing Revenue, Net\nThe component of servicing revenue, net related to changes in valuation inputs and assumptions related to the following:\n| Three Months Ended September 30, | Increase (Decrease) | Nine Months Ended September 30, | Increase (Decrease) |\n| 2019 | 2018 | Amount | 2019 | 2018 | Amount |\n| Changes in interest rates and prepayment rates | $ | (149,413 | ) | $ | 38,546 | $ | (187,959 | ) | $ | (555,765 | ) | $ | 209,182 | $ | (764,947 | ) |\n| Changes in discount rates | 57,896 | (6,695 | ) | 64,591 | 127,314 | 46,264 | 81,050 |\n| Changes in other factors | 29,659 | 12,341 | 17,318 | 153,080 | (28,829 | ) | 181,909 |\n| Total | $ | (61,858 | ) | $ | 44,192 | $ | (106,050 | ) | $ | (275,371 | ) | $ | 226,617 | $ | (501,988 | ) |\n\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nServicing revenue, net decreased $122.3 million during the three months ended September 30, 2019 compared to the three months ended September 30, 2018, primarily driven by (i) a $106.1 million change from positive mark-to-market adjustments during the three months ended September 30, 2018 to negative mark-to-market adjustments during the three months ended September 30, 2019, and (ii) a $97.8 million increase in amortization as a result of MSR acquisitions by our licensed servicer subsidiary, NRM (Note 5 to our Condensed Consolidated Financial Statements) that closed subsequent to September 30, 2018. The negative mark-to-market adjustments during the three months ended September 30, 2019 was primarily driven by an increase in prepayment rates, partially offset by a decrease in discount rates. The decrease was partially offset by (iii) a $79.4 million increase in servicing fee revenue and fees as a result of MSR acquisitions that closed subsequent to September 30, 2018.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nServicing revenue, net decreased $405.4 million during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018, primarily driven by (i) a $502.0 million change from positive mark-to-market adjustments during the nine months ended September 30, 2018 to negative mark-to-market adjustments during the nine months ended September 30, 2019, and (ii) a $155.3 million increase in amortization as a result of MSR acquisitions by our licensed servicer subsidiary, NRM (Note 5 to our Condensed Consolidated Financial Statements), as well as the Shellpoint Acquisition (Note 1 to our Condensed Consolidated Financial Statements), which closed in July 2018. The negative mark-to-market adjustments during the nine months ended September 30, 2019 were primarily driven by an increase in prepayment rates, partially offset by a decrease in discount rates and costs of subservicing, and an increase in ancillary income. The decrease was partially offset by (iii) a $249.6 million increase in servicing fee revenue and fees as a result of MSR acquisitions and the Shellpoint Acquisition that closed in July 2018.\n78\nGain on Sale of Originated Mortgage Loans, Net\nAs a result of the Shellpoint Acquisition in July 2018 (Note 1 to our Condensed Consolidated Financial Statements), our wholly owned subsidiary, NewRez, originates conventional, government-insured and nonconforming residential mortgage loans for sale and securitization. The GSEs or Ginnie Mae guarantee conventional and government insured mortgage securitizations and private investors issue nonconforming private label mortgage securitizations while NewRez generally retains the right to service the underlying residential mortgage loans.\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nGain on sale of originated mortgage loans, net increased $54.8 million during the three months ended September 30, 2019 compared to the three months ended September 30, 2018, primarily driven by (i) $79.0 million higher value of MSRs retained on transfer of loans, and (ii) a $5.5 million increase in appraisal and other revenues earned in conjunction with the loan origination process, partially offset by (iii) a $29.4 million increase in loss on settlement of mortgage loan origination derivative instruments.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nGain on sale of originated mortgage loans, net increased $148.3 million during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018, primarily driven by (i) $173.4 million higher value of MSRs retained on transfer of loans, (ii) a $22.3 million increase in appraisal and other revenues earned in conjunction with the loan origination process, and (iii) an $11.7 million increase in gain on loans originated and sold. The increase was partially offset by (iv) a $59.1 million increase in loss on settlement of mortgage loan origination derivative instruments.\nChange in Fair Value of Investments in Excess Mortgage Servicing Rights\nChanges in the fair value of investments in Excess MSRs related to the following:\n| Three Months Ended September 30, | Increase (Decrease) | Nine Months Ended September 30, | Increase (Decrease) |\n| 2019 | 2018 | Amount | 2019 | 2018 | Amount |\n| Changes in interest rates and prepayment rates | $ | (2,566 | ) | $ | (9,872 | ) | $ | 7,306 | $ | (20,268 | ) | $ | (15,742 | ) | $ | (4,526 | ) |\n| Changes in discount rates | 4,167 | — | 4,167 | 13,446 | — | 13,446 |\n| Changes in other factors | 806 | 5,128 | (4,322 | ) | 5,401 | (39,969 | ) | 45,370 |\n| Total | $ | 2,407 | $ | (4,744 | ) | $ | 7,151 | $ | (1,421 | ) | $ | (55,711 | ) | $ | 54,290 |\n\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nThe positive mark-to-market adjustments during the three months ended September 30, 2019 were mainly driven by a decrease in discount rates, partially offset by changes in interest rates and prepayment rates. The negative mark-to-market adjustments during the three months ended September 30, 2018 were mainly driven by changes in interest rates and prepayment rates, as well as lower delinquency assumptions.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nThe negative mark-to-market adjustments during the nine months ended September 30, 2019 were mainly driven by changes in interest rates and prepayment rates, partially offset by a decrease in discount rates. The change between the mark-to-market adjustments during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018 were due to the realization of unrealized gains related to the Ocwen Transaction in 2018, which were reflected in Gain (Loss) on Settlement of Investments, Net.\n79\nChange in Fair Value of Investments in Excess Mortgage Servicing Rights, Equity Method Investees\nChanges in the fair value of investments in Excess MSRs, equity method investees related to the following:\n| Three Months Ended September 30, | Increase (Decrease) | Nine Months Ended September 30, | Increase (Decrease) |\n| 2019 | 2018 | Amount | 2019 | 2018 | Amount |\n| Changes in interest rates and prepayment rates | $ | (432 | ) | $ | (2,203 | ) | $ | 1,771 | $ | (7,897 | ) | $ | (3,711 | ) | $ | (4,186 | ) |\n| Changes in discount rates | 768 | — | 768 | 3,939 | — | 3,939 |\n| Changes in other factors | 4,415 | 5,599 | (1,184 | ) | 8,045 | 9,335 | (1,290 | ) |\n| Total | $ | 4,751 | $ | 3,396 | $ | 1,355 | $ | 4,087 | $ | 5,624 | $ | (1,537 | ) |\n\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nThe positive mark-to-market adjustments during the three months ended September 30, 2019 were mainly driven by interest income net of expenses recorded at the investee level, and a decrease in discount rates. Compared to the three months ended September 30, 2018 where the positive mark-to-market adjustments were mainly driven by interest income net of expenses recorded at the investee level, partially offset by changes in interest rates and prepayment rates.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nThe positive mark-to-market adjustments during the nine months ended September 30, 2019 were mainly driven by interest income net of expenses recorded at the investee level, and a decrease in discount rates, partially offset by changes in interest rates and prepayment rates. Compared to the nine months ended September 30, 2018 where the positive mark-to-market adjustments were mainly driven by interest income net of expenses recorded at the investee level and other market factors, partially offset by changes in interest rates and prepayment rates.\nChange in Fair Value of Investments in MSR Financing Receivables\nThe component of changes in the fair value of investments in mortgage servicing rights financing receivables related to changes in valuation inputs and assumptions related to the following:\n| Three Months Ended September 30, | Increase (Decrease) | Nine Months Ended September 30, | Increase (Decrease) |\n| 2019 | 2018 | Amount | 2019 | 2018 | Amount |\n| Changes in interest rates and prepayment rates | $ | (44,152 | ) | $ | (4,326 | ) | $ | (39,826 | ) | $ | (138,727 | ) | $ | (18,939 | ) | $ | (119,788 | ) |\n| Changes in discount rates | 60,273 | — | 60,273 | 99,674 | 212,273 | (112,599 | ) |\n| Changes in other factors | (6,772 | ) | (35,003 | ) | 28,231 | 40,490 | 24,853 | 15,637 |\n| Total | $ | 9,349 | $ | (39,329 | ) | $ | 48,678 | $ | 1,437 | $ | 218,187 | $ | (216,750 | ) |\n\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nThe change in fair value of investments in mortgage servicing rights financing receivable increased $46.9 million during the three months ended September 30, 2019 compared to the three months ended September 30, 2018. $48.7 million of the increase was related to changes in valuation inputs and assumptions, primarily due to decrease in discount rates and costs of subservicing, and an increase in ancillary income, partially offset by an increase in prepayment rates. The remaining increase was primarily due to $0.7 million decrease in amortization expense, attributable to lower unpaid principal balance.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nThe change in fair value of investments in mortgage servicing rights financing receivable decreased $196.8 million during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018. $216.8 million of the decrease was related to changes in valuation inputs and assumptions, primarily due to less decrease in discount rates and an increase in prepayment rates, partially offset by a decrease in costs of subservicing and an increase in ancillary income. The decrease was partially offset by $23.1 million decrease in amortization expense, attributable to lower unpaid principal balance.\n80\nChange in Fair Value of Servicer Advance Investments\nChanges in the fair value of Servicer Advance Investments related to the following:\n| Three Months Ended September 30, | Increase (Decrease) | Nine Months Ended September 30, | Increase (Decrease) |\n| 2019 | 2018 | Amount | 2019 | 2018 | Amount |\n| Changes in interest rates and prepayment rates | $ | (675 | ) | $ | 820 | $ | (1,495 | ) | $ | (2,379 | ) | $ | 2,357 | $ | (4,736 | ) |\n| Changes in discount rates | 8,419 | (4,173 | ) | 12,592 | 22,045 | (12,829 | ) | 34,874 |\n| Changes in other factors | (1,103 | ) | (2,000 | ) | 897 | (3,734 | ) | (76,109 | ) | 72,375 |\n| Total | $ | 6,641 | $ | (5,353 | ) | $ | 11,994 | $ | 15,932 | $ | (86,581 | ) | $ | 102,513 |\n\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nThe positive mark-to-market adjustments during the three months ended September 30, 2019 were mainly driven by a decrease in discount rates, compared to the three months ended September 30, 2018 where the negative mark-to-market adjustments were mainly driven by an increase in discount rates.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nThe positive mark-to-market adjustments during the nine months ended September 30, 2019 were mainly driven by a decrease in discount rates, compared to an increase in discount rates during the nine months ended September 30, 2018 resulting in negative mark-to-market adjustments. The change between the mark-to-market adjustments during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018 were due to the realization of unrealized gains related to the Ocwen Transaction in 2018, which were reflected in Gain (Loss) on Settlement of Investments, Net.\nChange in Fair Value of Investments in Residential Mortgage Loans\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nThe change in fair value of investments in Residential Mortgage Loans decreased $19.7 million during the three months ended September 30, 2019 compared to the three months ended September 30, 2018 was primarily due to (i) $36.0 million gain realized through securitizations, net of (ii) $16.1 million unrealized gains from changes in valuation assumptions and inputs.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nThe change in fair value of investments in Residential Mortgage Loans of increased $89.9 million during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018, primarily due to the election of the fair value option on certain Residential Mortgage Loans acquired beginning July 2018, coupled with a decrease in discount rates on loans acquired. Residential Mortgage Loans were held at lower of cost or market value, rather than fair value, during the six months ended June 30, 2018.\nChange in Fair Value of Derivative Instruments\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nChange in fair value of derivative instruments increased $34.2 million. The increase was primarily related to (i) a $23.5 million increase in unrealized gain on Interest Rate Swaps, (ii) a $5.7 million increase in unrealized gain on TBAs, and (iii) a $5.2 million change from unrealized loss to unrealized gain on Interest Rate Lock Commitments due to increase in market interest rates.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nChange in fair value of derivative instruments decreased $30.0 million. The decrease was primarily related to (i) a $46.6 million change from unrealized gain to unrealized loss on Interest Rate Swaps. The decrease was partially offset by (ii) a $16.2 million change from unrealized loss to unrealized gain on Interest Rate Lock Commitments, and (iii) $0.9 million increase in unrealized gain on TBAs due to increase in market interest rates.\n81\nGain (Loss) on Settlement of Investments, Net\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nGain (loss) on settlement of investments increased by $166.6 million from a loss to a gain, primarily related to (i) a $123.7 million change in loss on sale of real estate securities to gain on sale of real estate securities, (ii) a $39.6 million increase in gain on sale of residential mortgage loans, (iii) a $21.6 million increase in gain on sale or securitization of originated mortgage loans, (iv) a $11.5 million increase in gain on collapses due primarily to market interest rates and decreased delinquencies, (v) a $1.8 million decrease in loss on sale of REO, and (vi) a $0.6 million decrease in loss on extinguishment of debt related to debt restructuring. The increase was partially offset by (vii) a $33.6 million change in gain on settlement of derivatives to loss on settlement of derivatives related to TBAs and interest rate swaps, during the three months ended September 30, 2019 compared to the three months ended September 30, 2018.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nGain (loss) on settlement of investments increased by $50.9 million, primarily related to (i) a $267.9 million change in loss on sale of real estate securities to gain on sale of real estate securities, (ii) a $62.4 million increase in gain on sale or securitization of originated mortgage loans, (iii) a $54.8 million change from loss on sale of residential mortgage loans to gain on sale of residential mortgage loans, (iv) a $10.2 million increase in gain on collapses due primarily to market interest rates and decreased delinquencies, and (v) a $2.7 million decrease in loss on sale of REO. The increase was partially offset by (vi) a $228.5 million change in gain on settlement of derivatives to loss on settlement of derivatives related to TBAs and interest rate swaps, (vii) a $113.0 million decrease in gains on settlement of investments in excess MSRs and Servicer Advance Investments as a result of the Ocwen Transaction, and (viii) a $7.9 million increase in loss on extinguishment of debt related to debt restructuring, during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nEarnings from Investments in Consumer Loans, Equity Method Investees\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nEarnings from investments in Consumer Loans, Equity Method Investees decreased by $7.1 million as a result of a decrease in net earnings generated by our approximately 25% member interest in LoanCo and WarrantCo (Note 9 to our Condensed Consolidated Financial Statements), primarily as a result of declining portfolio and securitization, during the three months ended September 30, 2019 compared to the three months ended September 30, 2018.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nEarnings from investments in Consumer Loans, Equity Method Investees decreased by $13.2 million as a result of a decrease in net earnings generated by our approximately 25% member interest in LoanCo and WarrantCo (Note 9 to our Condensed Consolidated Financial Statements), primarily as a result of declining portfolio and securitization, during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nOther Income (Loss), Net\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nOther income (loss), net decreased by $29.4 million, primarily attributable to (i) a $14.4 million loss from uncollectible receivables, (ii) a $12.3 million change in unrealized gain on other ABS to unrealized loss on other ABS, (iii) a $4.9 million decrease in gain on transfer of loans to REO, (iv) a $3.5 million change in unrealized gain to unrealized loss on notes and bonds payable related to the SAFT bonds acquired in the Shellpoint Acquisition (Note 1 to our Condensed Consolidated Financial Statements), (v) a $2.7 million increase in unrealized loss on contingent consideration related to the Shellpoint Acquisition (Note 1 to our Condensed Consolidated Financial Statements). The decrease was partially offset by (vi) a $6.2 million decrease in servicer advance expenses, and (vii) a $1.4 million decrease in loss on transfer of loans to other assets.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nOther income (loss), net decreased by $26.9 million, primarily attributable to (i) a $14.4 million loss from uncollectible receivables,(ii) a $8.8 million decrease in gain on transfer of loans to REO, (iii) a $7.4 million increase in unrealized loss on contingent consideration related to the Shellpoint Acquisition (Note 1 to our Condensed Consolidated Financial Statements), (iv) a $6.1 million change in unrealized gain to unrealized loss on notes and bonds payable related to the SAFT bonds acquired in the Shellpoint\n82\nAcquisition (Note 1 to our Condensed Consolidated Financial Statements), (v) a $3.5 million decrease in positive mark-to-market adjustments for retained MSRs, and (vi) a $3.0 million decrease in unrealized gain on other ABS. The decrease was partially offset by (vii) a $7.1 million decrease in servicer advance expenses, (viii) a $4.3 million decrease in REO expenses, and (ix) a $3.7 million decrease in other losses related to residential mortgage loans.\nGeneral and Administrative Expenses\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nGeneral and administrative expenses increased by $34.9 million primarily attributable to (i) a $30.2 million increase in compensation and benefits expenses, loan origination expense, as well as rent, office, and other miscellaneous G&A expenses resulting from the Shellpoint Acquisition (Note 1 to our Condensed Consolidated Financial Statements), and (ii) a $4.7 million increase in securitization fees, and deal and other consulting expenses due to increased securitization, deal, and refinancing activity during the three months ended September 30, 2019 compared to the three months ended September 30, 2018.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nGeneral and administrative expenses increased by $212.2 million primarily attributable to (i) a $200.1 million increase in compensation and benefits expenses, loan origination expense, as well as rent, office, and other miscellaneous G&A expenses resulting from the Shellpoint Acquisition (Note 1 to our Condensed Consolidated Financial Statements), and (ii) an $11.0 million increase in securitization fees, and deal and other consulting expenses due to increased securitization, deal, and refinancing activity during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nManagement Fee to Affiliate\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nManagement fee to affiliate increased by $5.2 million as a result of increases to our gross equity subsequent to September 30, 2018.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nManagement fee to affiliate increased by $12.2 million as a result of increases to our gross equity subsequent to September 30, 2018.\nIncentive Compensation to Affiliate\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nIncentive compensation to affiliate increased by $12.5 million due to an increase in our incentive compensation earnings measure resulting from the changes in the income and expense items described above, excluding any unrealized gains or losses from mark-to-market valuation changes on investments and debt, during the three months ended September 30, 2019 compared to the three months ended September 30, 2018.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nIncentive compensation to affiliate decreased by $15.9 million due to a decrease in our incentive compensation earnings measure resulting from the changes in the income and expense items described above, excluding any unrealized gains or losses from mark-to-market valuation changes on investments and debt, during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nLoan Servicing Expense\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nLoan servicing expense decreased by $3.9 million primarily due to (i) a $4.5 million decrease of loan servicing expense on Consumer Loans, held for investment, attributable to lower unpaid principal balance, partially offset by (ii) a $0.6 million increase of loan servicing expense on Residential Mortgage Loans portfolio due to the acquisition of loans through the execution of calls.\n83\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nLoan servicing expense decreased by $7.4 million primarily due to (i) a $8.2 million decrease of loan servicing expense on Consumer Loans, held for investment, attributable to lower unpaid principal balance, partially offset by (ii) a $0.8 million increase of loan servicing expense on Residential Mortgage Loans portfolio due to the acquisition of loans through the execution of calls.\nSubservicing Expense\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nSubservicing expense increased $9.7 million during the three months ended September 30, 2019 compared to the three months ended September 30, 2018 as a result of an increase in subserviced loans due to transactions that closed subsequent to September 30, 2018 within our licensed servicer subsidiary, NRM (Note 5 to our Condensed Consolidated Financial Statements).\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nSubservicing expense increased $12.1 million during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018 as a result of an increase in subserviced loans due to transactions that closed subsequent to September 30, 2018 within our licensed servicer subsidiary, NRM (Note 5 to our Condensed Consolidated Financial Statements).\nIncome Tax Expense (Benefit)\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nIncome tax expense (benefit) changed by $9.0 million, as a result of an income tax benefit of $5.4 million during the three months ended September 30, 2019 compared to an income tax expense of $3.6 million during the three months ended September 30, 2018, primarily due to the deferred tax benefit generated by changes in the fair value of MSRs quarter over quarter.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nIncome tax expense (benefit) changed by $24.9 million, as a result of an income tax expense of $19.0 million during the nine months ended September 30, 2019 compared to an income tax benefit of $6.0 million during the nine months ended September 30, 2018, primarily due to the deferred tax expense generated by changes in the fair value of MSRs giving rise to an increase in taxable income in the TRS.\nNoncontrolling Interests in Income (Loss) of Consolidated Subsidiaries\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nNoncontrolling interests in income of consolidated subsidiaries increased by $3.9 million primarily due to (i) a $1.8 million increase in other’s interest in the net income of the Buyer as a result of a change from negative to positive mark-to-market adjustments in the fair value of the Buyer’s assets and lower interest expense, partially offset by a net decrease in interest income earned on the Buyer’s levered assets, (ii) a $1.3 million increase from the Shelter JVs, acquired as part of the Shellpoint Acquisition in the third quarter of 2018 (Note 1 to our Condensed Consolidated Financial Statements), and (iii) a $0.8 million increase from a net increase in income from the Consumer Loan Companies, which are 46.5% owned by third parties, during the three months ended September 30, 2019.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nNoncontrolling interests in income of consolidated subsidiaries decreased by $0.1 million primarily due to (i) a $5.4 million decrease from a net decrease in income from the Consumer Loan Companies, which are 46.5% owned by third parties, during the nine months ended September 30, 2019. The decrease was partially offset by (ii) a $3.2 million increase from the Shelter JVs, acquired as part of the Shellpoint Acquisition in the third quarter of 2018 (Note 1 to our Condensed Consolidated Financial Statements), and (iii) a $2.1 million increase in other’s interest in the net income of the Buyer as a result of a change from negative to positive mark-to-market adjustments in the fair value of the Buyer’s assets and lower interest expense, partially offset by a net decrease in interest income earned on the Buyer’s levered assets, during the nine months ended September 30, 2019.\n84\nDividends on Preferred Stock\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nDuring the three months ended September 30, 2019, in a public offering, we issued Preferred Series A and Preferred Series B (Note 13 to our Condensed Consolidated Financial Statements), and declared preferred dividends of $5.3 million.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nDuring the nine months ended September 30, 2019, in a public offering, we issued Preferred Series A and Preferred Series B (Note 13 to our Condensed Consolidated Financial Statements), and declared preferred dividends of $5.3 million.\nOther Comprehensive Income. See “—Accumulated Other Comprehensive Income (Loss)” below.\nLIQUIDITY AND CAPITAL RESOURCES\nLiquidity is a measurement of our ability to meet potential cash requirements, including ongoing commitments to repay borrowings, fund and maintain investments, and other general business needs. Additionally, to maintain our status as a REIT under the Internal Revenue Code, we must distribute annually at least 90% of our REIT taxable income. We note that a portion of this requirement may be able to be met in future years through stock dividends, rather than cash, subject to limitations based on the value of our stock.\nOur primary sources of funds for liquidity generally consist of cash provided by operating activities (primarily income from our investments in Excess MSRs, MSRs, Servicer Advance Investments, RMBS and loans), sales of and repayments from our investments, potential debt financing sources, including securitizations, and the issuance of equity securities, when feasible and appropriate. Our ability to utilize funds generated by the MSRs held in our servicer subsidiaries, NRM and NewRez, is subject to regulatory requirements regarding NRM’s and NewRez’s liquidity. As of September 30, 2019, approximately $454.3 million of our cash and cash equivalents was held at NRM and NewRez, of which $288.0 million was in excess of regulatory liquidity requirements and available for deployment. Our primary uses of funds are the payment of interest, management fees, incentive compensation, servicing and subservicing expenses, outstanding commitments (including margins and mortgage loan originations) and other operating expenses, and the repayment of borrowings and hedge obligations, as well as dividends. Although we have other sources of liquidity, such as sales of and repayments from our investments, potential debt financing sources and the issuance of equity securities, there can be no assurance that we will generate sufficient cash or achieve investment results that will allow us to make a specified level of cash distributions or year-to-year increases in cash distributions in the future. We have also committed to purchase certain future servicer advances. Currently, we expect that net recoveries of servicer advances will exceed net fundings for the foreseeable future. However, in the event of a significant economic downturn, net fundings could exceed net recoveries, which could have a materially adverse impact on our liquidity and could also result in additional expenses, primarily interest expense on any related financings of incremental advances.\nCurrently, our primary sources of financing are notes and bonds payable and repurchase agreements, although we have in the past and may in the future also pursue one or more other sources of financing such as securitizations and other secured and unsecured forms of borrowing. As of September 30, 2019, we had outstanding repurchase agreements with an aggregate face amount of approximately $23.1 billion to finance our investments. The financing of our entire RMBS portfolio, which generally has 30 to 90 day terms, is subject to margin calls. Under repurchase agreements, we sell a security to a counterparty and concurrently agree to repurchase the same security at a later date for a higher specified price. The sale price represents financing proceeds and the difference between the sale and repurchase prices represents interest on the financing. The price at which the security is sold generally represents the market value of the security less a discount or “haircut,” which can range broadly, for example from 2% - 5% for Agency RMBS, 4% - 60% for Non-Agency RMBS, and 6% - 55% for residential mortgage loans. During the term of the repurchase agreement, the counterparty holds the security as collateral. If the agreement is subject to margin calls, the counterparty monitors and calculates what it estimates to be the value of the collateral during the term of the agreement. If this value declines by more than a de minimis threshold, the counterparty could require us to post additional collateral (or “margin”) in order to maintain the initial haircut on the collateral. This margin is typically required to be posted in the form of cash and cash equivalents. Furthermore, we may, from time to time, be a party to derivative agreements or financing arrangements that may be subject to margin calls based on the value of such instruments. In addition, $2.6 billion face amount of our MSR and Excess MSR financing is subject to mandatory monthly repayment to the extent that the outstanding balance exceeds the market value (as defined in the related agreement) of the financed asset multiplied by the contractual maximum loan-to-value ratio. We seek to maintain adequate cash reserves and other sources of available liquidity to meet any margin calls or related requirements resulting from decreases in value related to a reasonably possible (in our opinion) change in interest rates.\n85\nOur ability to obtain borrowings and to raise future equity capital is dependent on our ability to access borrowings and the capital markets on attractive terms. We continually monitor market conditions for financing opportunities and at any given time may be entering or pursuing one or more of the transactions described above. Our Manager’s senior management team has extensive long-term relationships with investment banks, brokerage firms and commercial banks, which we believe will enhance our ability to source and finance asset acquisitions on attractive terms and access borrowings and the capital markets at attractive levels.\nWith respect to the next 12 months, we expect that our cash on hand combined with our cash flow provided by operations and our ability to roll our repurchase agreements and servicer advance financings will be sufficient to satisfy our anticipated liquidity needs with respect to our current investment portfolio, including related financings, potential margin calls, mortgage loan originations and operating expenses. Our ability to roll over short-term borrowings is critical to our liquidity outlook. While it is inherently more difficult to forecast beyond the next 12 months, we currently expect to meet our long-term liquidity requirements through our cash on hand and, if needed, additional borrowings, proceeds received from repurchase agreements and other financings, proceeds from equity offerings and the liquidation or refinancing of our assets.\nThese short-term and long-term expectations are forward-looking and subject to a number of uncertainties and assumptions, including those described under “—Market Considerations” as well as “Risk Factors.” If our assumptions about our liquidity prove to be incorrect, we could be subject to a shortfall in liquidity in the future, and such a shortfall may occur rapidly and with little or no notice, which could limit our ability to address the shortfall on a timely basis and could have a material adverse effect on our business.\nOur cash flow provided by operations differs from our net income due to these primary factors: (i) the difference between (a) accretion and amortization and unrealized gains and losses recorded with respect to our investments and (b) cash received therefrom, (ii) unrealized gains and losses on our derivatives, and recorded impairments, if any, (iii) deferred taxes, and (iv) principal cash flows related to held-for-sale loans, which are characterized as operating cash flows under GAAP.\nIn addition to the information referenced above, the following factors could affect our liquidity, access to capital resources and our capital obligations. As such, if their outcomes do not fall within our expectations, changes in these factors could negatively affect our liquidity.\n\n| • | Access to Financing from Counterparties – Decisions by investors, counterparties and lenders to enter into transactions with us will depend upon a number of factors, such as our historical and projected financial performance, compliance with the terms of our current credit arrangements, industry and market trends, the availability of capital and our investors’, counterparties’ and lenders’ policies and rates applicable thereto, and the relative attractiveness of alternative investment or lending opportunities. Our business strategy is dependent upon our ability to finance certain of our investments at rates that provide a positive net spread. |\n\n| • | Impact of Expected Repayment or Forecasted Sale on Cash Flows – The timing of and proceeds from the repayment or sale of certain investments may be different than expected or may not occur as expected. Proceeds from sales of assets are unpredictable and may vary materially from their estimated fair value and their carrying value. Further, the availability of investments that provide similar returns to those repaid or sold investments is unpredictable and returns on new investments may vary materially from those on existing investments. |\n\n86\nDebt Obligations\nThe following table presents certain information regarding our debt obligations (dollars in thousands):\n| September 30, 2019 |\n| Collateral |\n| Debt Obligations/Collateral | Outstanding Face Amount | Carrying Value(A) | Final Stated Maturity(B) | Weighted Average Funding Cost | Weighted Average Life (Years) | Outstanding Face | Amortized Cost Basis | Carrying Value | Weighted Average Life (Years) |\n| Repurchase Agreements(C) |\n| Agency RMBS(D) | $ | 10,733,236 | $ | 10,733,236 | Oct-19 to May-20 | 2.31 | % | 0.1 | $ | 10,611,553 | $ | 10,825,984 | $ | 10,886,787 | 2.4 |\n| Non-Agency RMBS (E) | 7,144,329 | 7,144,329 | Oct-19 to Sep-20 | 3.08 | % | 0.1 | 21,021,981 | 7,113,471 | 7,786,425 | 6.3 |\n| Residential Mortgage Loans(F) | 5,165,150 | 5,164,159 | Oct-19 to May-21 | 3.74 | % | 0.6 | 5,960,958 | 6,025,596 | 5,805,242 | 13.9 |\n| Real Estate Owned(G)(H) | 68,651 | 68,635 | Oct-19 to May-21 | 3.85 | % | 0.4 | N/A | N/A | 95,410 | N/A |\n| Total Repurchase Agreements | 23,111,366 | 23,110,359 | 2.87 | % | 0.3 |\n| Notes and Bonds Payable |\n| Excess MSRs(I) | 269,759 | 269,759 | Feb-20 to Jul-22 | 4.95 | % | 1.9 | 103,514,484 | 315,847 | 416,899 | 5.8 |\n| MSRs(J) | 2,360,182 | 2,352,961 | Mar-20 to Jul-24 | 4.23 | % | 2.0 | 452,215,330 | 4,718,333 | 5,113,271 | 5.5 |\n| Servicer Advances(K) | 2,903,093 | 2,896,819 | Jan-20 to Aug-23 | 3.22 | % | 2.0 | 3,316,416 | 3,482,368 | 3,512,345 | 1.6 |\n| Residential Mortgage Loans(L) | 1,012,342 | 1,015,360 | Apr-20 to Jul-43 | 4.09 | % | 3.7 | 1,258,875 | 1,277,193 | 1,194,186 | 8.0 |\n| Consumer Loans(M) | 868,214 | 870,973 | Dec-21 to May-36 | 3.25 | % | 4.0 | 878,317 | 884,473 | 881,069 | 5.6 |\n| Total Notes and Bonds Payable | 7,413,590 | 7,405,872 | 3.73 | % | 2.5 |\n| Total/ Weighted Average | $ | 30,524,956 | $ | 30,516,231 | 3.08 | % | 0.8 |\n\n\n| (A) | Net of deferred financing costs. |\n\n| (B) | All debt obligations with a stated maturity through October 31, 2019 were refinanced, extended or repaid. |\n\n| (C) | These repurchase agreements had approximately $77.8 million of associated accrued interest payable as of September 30, 2019. |\n\n| (D) | All of the Agency RMBS repurchase agreements have a fixed rate. Collateral amounts include approximately $4.4 billion of related trade and other receivables. |\n\n| (E) | $6,585.6 million face amount of the Non-Agency RMBS repurchase agreements have LIBOR-based floating interest rates while the remaining $558.8 million face amount of the Non-Agency RMBS repurchase agreements have a fixed rate. This also includes repurchase agreements of $7.5 million on retained servicer advance and consumer loan bonds and of $671.3 million on retained bonds collateralized by Agency MSRs. |\n\n| (F) | All of these repurchase agreements have LIBOR-based floating interest rates. |\n\n| (G) | All of these repurchase agreements have LIBOR-based floating interest rates. |\n\n| (H) | Includes financing collateralized by receivables including claims from FHA on Ginnie Mae EBO loans for which foreclosure has been completed and for which we have made or intend to make a claim on the FHA guarantee. |\n\n| (I) | Includes $169.8 million of corporate loans which bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin of 3.00%, and $100.0 million of corporate loans which bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin of 2.50%. The outstanding face amount of the collateral represents the UPB of our residential mortgage loans underlying our interests in MSRs that secure these notes. |\n\n| (J) | Includes: $940.2 million of MSR notes which bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin ranging from 2.25% to 2.75%; and $1,419.9 million of public notes with fixed interest rates ranging from 3.55% to 4.62%. The outstanding face amount of the collateral represents the UPB of the residential mortgage loans underlying the MSRs and mortgage servicing rights financing receivables that secure these notes. |\n\n| (K) | $2.6 billion face amount of the notes have a fixed rate while the remaining notes bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR or a cost of funds rate, as applicable, and (ii) a margin ranging from 1.15% to 1.99%. Collateral includes Servicer Advance Investments, as well as servicer advances receivable related to the mortgage servicing rights and mortgage servicing rights financing receivables owned by NRM. |\n\n| (L) | Represents: (i) a $6.0 million note payable to Nationstar which includes a $1.5 million receivable from government agency and bears interest equal to one-month LIBOR plus 2.88%, (ii) $109.9 million fair value of SAFT 2013-1 mortgage-backed securities issued with fixed interest rates ranging from 3.50% to 3.76% (see Note 12 for details), (iii) $362.1 million of asset-backed notes held by third parties which bear interest equal to 4.59% (see Note 12 for details), and (iv) |\n\n87\n$535.1 million of asset-backed notes held by third parties which include $1.3 million of REO and bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin of 1.25%.\n| (M) | Includes the SpringCastle debt, which is comprised of the following classes of asset-backed notes held by third parties: $787.9 million UPB of Class A notes with a coupon of 3.20% and a stated maturity date in May 2036, $70.4 million UPB of Class B notes with a coupon of 3.58% and a stated maturity date in May 2036, and $8.7 million UPB of Class C notes with a coupon of 5.06% and a stated maturity date in May 2036. Also includes a $1.2 million face amount note which bears interest equal to 4.00%. |\n\nCertain of the debt obligations included above are obligations of our consolidated subsidiaries, which own the related collateral. In some cases, such collateral is not available to other creditors of ours.\nWe have margin exposure on $23.1 billion of repurchase agreements. To the extent that the value of the collateral underlying these repurchase agreements declines, we may be required to post margin, which could significantly impact our liquidity.\nThe following table provides additional information regarding our short-term borrowings (dollars in thousands):\n| Nine Months Ended September 30, 2019 |\n| OutstandingBalance at September 30, 2019 | Average Daily Amount Outstanding(A) | Maximum Amount Outstanding | Weighted Average Daily Interest Rate |\n| Repurchase Agreements |\n| Agency RMBS | $ | 10,733,236 | $ | 7,604,281 | $ | 16,181,622 | 2.53 | % |\n| Non-Agency RMBS | 7,144,329 | 7,681,276 | 8,864,155 | 3.46 | % |\n| Residential mortgage loans | 4,742,824 | 2,403,677 | 5,155,161 | 4.24 | % |\n| Real estate owned | 63,831 | 65,768 | 101,153 | 4.40 | % |\n| Notes and Bonds Payable |\n| Excess MSRs | 100,000 | 71,062 | 100,000 | 4.87 | % |\n| MSRs | 940,188 | 728,119 | 1,256,040 | 4.71 | % |\n| Servicer advances | 615,733 | 357,863 | 773,968 | 3.15 | % |\n| Residential mortgage loans | 541,040 | 361,984 | 542,321 | 3.56 | % |\n| Total/Weighted Average | $ | 24,881,181 | $ | 19,274,030 | 3.26 | % |\n\n\n| (A) | Represents the average for the period the debt was outstanding. |\n\n| Average Daily Amount Outstanding(A) |\n| Three Months Ended |\n| December 31, 2018 | March 31, 2019 | June 30, 2019 | September 30, 2019 |\n| Repurchase Agreements |\n| Agency RMBS | $ | 3,428,226 | $ | 5,364,480 | $ | 6,846,716 | $ | 10,544,720 |\n| Non-Agency RMBS | 7,444,959 | 7,399,226 | 7,675,607 | 7,986,868 |\n| Residential mortgage loans | 1,675,353 | 2,155,752 | 2,681,220 | 3,432,062 |\n| Real estate owned | 68,416 | 91,025 | 48,247 | 58,390 |\n\n| (A) | Represents the average for the period the debt was outstanding. |\n\nFor additional information on our debt activities, see Note 11 to our Condensed Consolidated Financial Statements.\n88\nMaturities\nOur debt obligations as of September 30, 2019, as summarized in Note 11 to our Condensed Consolidated Financial Statements, had contractual maturities as follows (in thousands):\n| Year | Nonrecourse(A) | Recourse(B) | Total |\n| October 1 through December 31, 2019 | $ | 1,978 | $ | 18,781,709 | $ | 18,783,687 |\n| 2020 | 615,733 | 5,480,786 | 6,096,519 |\n| 2021 | 1,088,623 | 1,034,034 | 2,122,657 |\n| 2022 | 1,162,067 | 169,759 | 1,331,826 |\n| 2023 | 400,000 | 403,433 | 803,433 |\n| 2024 and thereafter | 976,300 | 410,534 | 1,386,834 |\n| $ | 4,244,701 | $ | 26,280,255 | $ | 30,524,956 |\n\n| (A) | Includes repurchase agreements and notes and bonds payable of $2.0 million and $4,242.7 million, respectively. |\n\n| (B) | Includes repurchase agreements and notes and bonds payable of $23,109.4 million and $3,170.9 million, respectively. |\n\nThe weighted average differences between the fair value of the assets and the face amount of available financing for the Agency RMBS repurchase agreements (including amounts related to Trades Receivable) and Non-Agency RMBS repurchase agreements were 1.4% and 8.2%, respectively, and for Residential Mortgage Loans and Real Estate Owned were 11.0% and 28.0%, respectively, during the nine months ended September 30, 2019.\nBorrowing Capacity\nThe following table represents our borrowing capacity as of September 30, 2019 (in thousands):\n| Debt Obligations/ Collateral | Borrowing Capacity | Balance Outstanding | Available Financing |\n| Repurchase Agreements |\n| Residential mortgage loans and REO | $ | 9,112,297 | $ | 5,233,801 | $ | 3,878,496 |\n| Non-Agency RMBS | 650,000 | 558,756 | 91,244 |\n| Notes and Bonds Payable |\n| Excess MSRs | 150,000 | 100,000 | 50,000 |\n| MSRs | 1,375,000 | 940,188 | 434,812 |\n| Servicer advances(A) | 1,204,660 | 1,053,127 | 151,533 |\n| Residential Mortgage Loans | 650,000 | 535,063 | 114,937 |\n| Consumer loans | 150,000 | 1,228 | 148,772 |\n| $ | 13,291,957 | $ | 8,422,163 | $ | 4,869,794 |\n\n\n| (A) | Our unused borrowing capacity is available to us if we have additional eligible collateral to pledge and meet other borrowing conditions as set forth in the applicable agreements, including any applicable advance rate. We pay a 0.02% fee on the unused borrowing capacity. |\n\nCovenants\nCertain of the debt obligations are subject to customary loan covenants and event of default provisions, including event of default provisions triggered by certain specified declines in our equity or failure to maintain a specified tangible net worth, liquidity, or indebtedness to tangible net worth ratio. We were in compliance with all of our debt covenants as of September 30, 2019.\n89\nStockholders’ Equity\nPreferred Stock\nPursuant to our certificate of incorporation, we are authorized to designate and issue up to 100.0 million shares of preferred stock, par value of $0.01 per share, in one or more classes or series.\nOn July 2, 2019, we issued 6.2 million shares of our Preferred Series A. To compensate the Manager for its successful efforts in raising capital for us, in connection with this offering, we granted options to the Manager relating to 0.6 million shares of our common stock at the closing price per share of common stock on the pricing date, which had a fair value of approximately $0.5 million as of the grant date.\nOn August 15, 2019, in a public offering, we issued 11.3 million shares of our Preferred Series B. To compensate the Manager for its successful efforts in raising capital for us, in connection with this offering, we granted options to the Manager relating to 1.1 million shares of our common stock at the closing price per share of common stock on the pricing date, which had a fair value of approximately $0.7 million as of the grant date.\nOur Preferred Series A and Preferred Series B rank senior to all classes or series of our common stock and to all other equity securities issued by us that expressly indicate are subordinated to the Preferred Series A and Preferred Series B with respect to rights to the payment of dividends and the distribution of assets upon our liquidation, dissolution or winding up. Our Preferred Series A and Preferred Series B have no stated maturity, are not subject to any sinking fund or mandatory redemption and rank on parity with each other. Under certain circumstances upon a change of control, our Preferred Series A and Preferred Series B are convertible to shares of our common stock.\nFrom and including, July 2, 2019 and August 15, 2019, but excluding, August 15, 2024, holders of shares of our Preferred Series A and Preferred Series B are entitled to receive cumulative cash dividends at a rate of 7.50% per annum and 7.125% of the $25.00 liquidation preference per share (equivalent to $1.875 and $1.781 per annum per share), respectively, and from and including August 15, 2024, at a floating rate per annum equal to the three-month LIBOR plus a spread of 5.802% and 5.640% per annum, respectively. Dividends are payable quarterly in arrears on or about the 15th day of each February, May, August and October.\nThe Preferred Series A and Preferred Series B will not be redeemable before August 15, 2024, except under certain limited circumstances intended to preserve the Company’s qualification as a REIT for U.S. federal income tax purposes and except upon the occurrence of a Change of Control (as defined in the Certificate of Designations). On or after August 15, 2024, we may, at our option, upon not less than 30 nor more than 60 days’ written notice, redeem the Series A and Series B Preferred Stock, in whole or in part, at any time or from time to time, for cash at a redemption price of $25.00 per share, plus any accumulated and unpaid dividends thereon (whether or not authorized or declared) to, but excluding, the redemption date, without interest.\nCommon Stock\nApproximately 2.4 million shares of our common stock were held by Fortress, through its affiliates, as of September 30, 2019.\nIn January 2018, New Residential issued 28.8 million shares of its common stock in a public offering at a price to the public of $17.10 per share for net proceeds of approximately $482.3 million. To compensate the Manager for its successful efforts in raising capital for New Residential, in connection with this offering, New Residential granted options to the Manager relating to 2.9 million shares of New Residential’s common stock at the public offering price, which had a fair value of approximately $3.8 million as of the grant date. The assumptions used in valuing the options were: a 2.58% risk-free rate, a 9.86% dividend yield, 23.16% volatility and a 10-year term.\nOn July 30, 2018, we entered into a Distribution Agreement to sell shares of its common stock, par value $0.01 per share (the “ATM Shares”), having an aggregate offering price of up to $500.0 million, from time to time, through an “at-the-market” equity offering program (the “ATM Program”). As of June 30, 2019, we had sold 0.5 million ATM Shares for aggregate proceeds of $9.1 million. In connection with the shares sold under the ATM program, we granted options to the Manager relating to 0.05 million shares of our common stock at the offering price, which had fair value of approximately $0.1 million as of the grant date.\nOn November 5, 2018, we issued 28.8 million shares of our common stock in a public offering at a price of $17.32 per share for net proceeds of approximately $489.2 million. To compensate the Manager for its successful efforts in raising capital for us, in connection with this offering, we granted options to the Manager relating to 2.9 million shares of our common stock at the public offering price, which had a fair value of approximately $3.8 million as of the grant date. The assumptions used in valuing the options were: a 3.25% risk-free rate, a 8.61% dividend yield, 17.50% volatility and a 10-year term.\n90\nIn February 2019, we issued 46.0 million shares of our common stock in a public offering at a price to the public of $16.50 per share for net proceeds of approximately $751.7 million. To compensate the Manager for its successful efforts in raising capital for us, in connection with this offering, we granted options to the Manager relating to 4.6 million shares of our common stock at the public offering price, which had a fair value of approximately $3.8 million as of the grant date. The assumptions used in valuing the options were: a 2.40% risk-free rate, a 9.30% dividend yield, 19.26% volatility and a 10-year term.\nOn August 20, 2019, we announced that our board of directors had authorized the repurchase of up to $200.0 million of our common stock through December 31, 2020. Repurchases may be made at any time and from time to time through open market purchases or privately negotiated transactions, pursuant to one or more plans established pursuant to Rule 10b5-1 under the Exchange Act, by means of one or more tender offers, or otherwise, in each case, as permitted by securities laws and other legal and contractual requirements. The amount and timing of the purchases will depend on a number of factors including the price and availability of our shares, trading volume, capital availability, our performance and general economic and market conditions. The share repurchase program may be suspended or discontinued at any time. No share repurchases have been made as of the filing of this report. Repurchases may impact our financial results, including fees paid to our Manager.\nAs of September 30, 2019, our outstanding options had a weighted average exercise price of $16.30. Our outstanding options as of September 30, 2019 were summarized as follows:\n| Held by the Manager | 10,511,167 |\n| Issued to the Manager and subsequently assigned to certain of the Manager’s employees | 2,290,749 |\n| Issued to the independent directors | 7,000 |\n| Total | 12,808,916 |\n\nAccumulated Other Comprehensive Income (Loss)\nDuring the nine months ended September 30, 2019, our accumulated other comprehensive income (loss) changed due to the following factors (in thousands):\n| Total Accumulated Other Comprehensive Income |\n| Accumulated other comprehensive income, December 31, 2018 | $ | 417,023 |\n| Net unrealized gain (loss) on securities | 469,183 |\n| Reclassification of net realized (gain) loss on securities into earnings | (179,280 | ) |\n| Accumulated other comprehensive income, September 30, 2019 | $ | 706,926 |\n\nOur GAAP equity changes as our real estate securities portfolio is marked to market each quarter, among other factors. The primary causes of mark to market changes are changes in interest rates and credit spreads. During the nine months ended September 30, 2019, we recorded unrealized gains on our real estate securities primarily caused by performance, liquidity and other factors related specifically to certain investments, coupled with a net tightening of mortgage credit spreads. We recorded OTTI charges of $21.9 million with respect to real estate securities and realized gains of $201.2 million on sales of real estate securities.\nSee “—Market Considerations” above for a further discussion of recent trends and events affecting our unrealized gains and losses, as well as our liquidity.\nCommon Dividends\nWe are organized and intend to conduct our operations to qualify as a REIT for U.S. federal income tax purposes. We intend to make regular quarterly distributions to holders of our common stock. U.S. federal income tax law generally requires that a REIT distribute annually at least 90% of its REIT taxable income, without regard to the deduction for dividends paid and excluding net capital gains, and that it pay tax at regular corporate rates to the extent that it annually distributes less than 100% of its taxable income. We intend to make regular quarterly distributions of our taxable income to holders of our common stock out of assets legally available for this purpose, if and to the extent authorized by our board of directors. Before we pay any dividend, whether for U.S. federal income tax purposes or otherwise, we must first meet both our operating requirements and debt service on our repurchase agreements and other debt payable. If our cash available for distribution is less than our taxable income, we could be\n91\nrequired to sell assets or raise capital to make cash distributions or we may make a portion of the required distribution in the form of a taxable stock distribution or distribution of debt securities.\nWe make distributions based on a number of factors, including an estimate of taxable earnings per common share. Dividends distributed and taxable and GAAP earnings will typically differ due to items such as fair value adjustments, differences in premium amortization and discount accretion, other differences in method of accounting, non-deductible general and administrative expenses, taxable income arising from certain modifications of debt instruments and investments held in TRSs. Our quarterly dividend per share may be substantially different than our quarterly taxable earnings and GAAP earnings per share.\n| Common Dividends Declared for the Period Ended | Paid/Payable | Amount Per Share |\n| September 30, 2018 | October 2018 | $ | 0.50 |\n| December 31, 2018 | January 2019 | $ | 0.50 |\n| March 31, 2019 | April 2019 | $ | 0.50 |\n| June 30, 2019 | July 2019 | $ | 0.50 |\n| September 30, 2019 | October 2019 | $ | 0.50 |\n\nCash Flow\nOperating Activities\nNet cash flows provided by operating activities increased approximately $2.2 billion for the nine months ended September 30, 2019 as compared to the nine months ended September 30, 2018. Operating cash flows for the nine months ended September 30, 2019 primarily consisted of proceeds from sales and principal repayments of purchased residential mortgage loans, held-for-sale of $13.3 billion, servicing fees received of $729.2 million, net recoveries of servicer advances receivable of $366.4 million, net interest income received of $702.3 million, and distributions of earnings from equity method investees of $8.9 million. Operating cash outflows primarily consisted of purchases of residential mortgage loans, held-for-sale of $6.0 billion, originations of $10.4 billion, incentive compensation and management fees paid to the Manager of $151.9 million, income taxes paid of $1.2 million, subservicing fees paid of $273.7 million and other outflows of approximately $611.3 million including general and administrative costs and loan servicing fees.\nInvesting Activities\nCash flows provided by (used in) investing activities were $(5.3) billion for the nine months ended September 30, 2019. Investing activities consisted primarily of the acquisition of MSRs, real estate securities, and the funding of servicer advances, net of principal repayments from Servicer Advance Investments, MSRs, real estate securities and loans as well as proceeds from the sale of real estate securities, loans and REO, and derivative cash flows.\nFinancing Activities\nCash flows provided by (used in) financing activities were approximately $8.1 billion during the nine months ended September 30, 2019. Financing activities consisted primarily of borrowings net of repayments under debt obligations, equity offerings, capital contributions net of distributions from noncontrolling interests in the equity of consolidated subsidiaries, and payment of dividends.\nINTEREST RATE, CREDIT AND SPREAD RISK\nWe are subject to interest rate, credit and spread risk with respect to our investments. These risks are further described in “Quantitative and Qualitative Disclosures About Market Risk.”\nOFF-BALANCE SHEET ARRANGEMENTS\nWe have material off-balance sheet arrangements related to our non-consolidated securitizations of residential mortgage loans treated as sales in which we retained certain interests. We believe that these off-balance sheet structures presented the most efficient and least expensive form of financing for these assets at the time they were entered and represented the most common market-accepted method for financing such assets. Our exposure to credit losses related to these non-recourse, off-balance sheet financings is limited to $1.3 billion. As of September 30, 2019, there was $11.2 billion in total outstanding unpaid principal balance of residential mortgage loans underlying such securitization trusts that represent off-balance sheet financings.\nWe have a co-investment in a portfolio of consumer loans held through an entity (“LoanCo”) which we account for under the equity method.\nWe did not have any other off-balance sheet arrangements as of September 30, 2019. We did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured investment vehicles, or special purpose or variable interest entities, established to facilitate off-balance sheet arrangements or other contractually narrow or limited purposes, other than the entities described above. Further, we have not guaranteed any obligations of unconsolidated entities or entered into any commitment and do not intend to provide additional funding to any such entities.\n92\nCONTRACTUAL OBLIGATIONS\nOur contractual obligations as of September 30, 2019 included all of the material contractual obligations referred to in our annual report on Form 10-K for the year ended December 31, 2018, excluding debt that was repaid as described in “—Liquidity and Capital Resources—Debt Obligations.”\nIn addition, we executed the following material contractual obligations during the nine months ended September 30, 2019:\n\n| • | Derivatives – as described in Note 10 to our Condensed Consolidated Financial Statements, we have altered the composition of our economic hedges during the period. |\n\n| • | Debt obligations – as described in Note 11 to our Condensed Consolidated Financial Statements, we borrowed additional amounts. |\n\nSee Notes 14 and 18 to our Condensed Consolidated Financial Statements included in this report for information regarding commitments and material contracts entered into subsequent to September 30, 2019, if any. As described in Note 14, we have committed to purchase certain future servicer advances. The actual amount of future advances is subject to significant uncertainty. However, we currently expect that net recoveries of servicer advances will exceed net fundings for the foreseeable future. This expectation is based on judgments, estimates and assumptions, all of which are subject to significant uncertainty, as further described in “—Application of Critical Accounting Policies—Servicer Advance Investments.” In addition, the Consumer Loan Companies have invested in loans with an aggregate of $279.4 million of unfunded and available revolving credit privileges as of September 30, 2019. However, under the terms of these loans, requests for draws may be denied and unfunded availability may be terminated at management’s discretion.\nINFLATION\nVirtually all of our assets and liabilities are financial in nature. As a result, interest rates and other factors affect our performance more so than inflation, although inflation rates can often have a meaningful influence over the direction of interest rates. Furthermore, our financial statements are prepared in accordance with GAAP and our distributions are determined by our board of directors primarily based on a number of factors, including taxable income, and, in each case, our activities and balance sheet are measured with reference to historical cost and/or fair market value without considering inflation. See “Quantitative and Qualitative Disclosures About Market Risk—Interest Rate Risk.”\nCORE EARNINGS\nWe have four primary variables that impact our operating performance: (i) the current yield earned on our investments, (ii) the interest expense under the debt incurred to finance our investments, (iii) our operating expenses and taxes and (iv) our realized and unrealized gains or losses, including any impairment, on our investments. “Core earnings” is a non-GAAP measure of our operating performance, excluding the fourth variable above and adjusts the earnings from the consumer loan investment to a level yield basis. Core earnings is used by management to evaluate our performance without taking into account: (i) realized and unrealized gains and losses, which although they represent a part of our recurring operations, are subject to significant variability and are generally limited to a potential indicator of future economic performance; (ii) incentive compensation paid to our Manager; (iii) non-capitalized transaction-related expenses; and (iv) deferred taxes, which are not representative of current operations.\nOur definition of core earnings includes accretion on held-for-sale loans as if they continued to be held-for-investment. Although we intend to sell such loans, there is no guarantee that such loans will be sold or that they will be sold within any expected timeframe. During the period prior to sale, we continue to receive cash flows from such loans and believe that it is appropriate to record a yield thereon. In addition, our definition of core earnings excludes all deferred taxes, rather than just deferred taxes related to unrealized gains or losses, because we believe deferred taxes are not representative of current operations. Our definition of core earnings also limits accreted interest income on RMBS where we receive par upon the exercise of associated call rights based on the estimated value of the underlying collateral, net of related costs including advances. We created this limit in order to be able\n93\nto accrete to the lower of par or the net value of the underlying collateral, in instances where the net value of the underlying collateral is lower than par. We believe this amount represents the amount of accretion we would have expected to earn on such bonds had the call rights not been exercised.\nOur investments in consumer loans are accounted for under ASC No. 310-20 and ASC No. 310-30, including certain non-performing consumer loans with revolving privileges that are explicitly excluded from being accounted for under ASC No. 310-30. Under ASC No. 310-20, the recognition of expected losses on these non-performing consumer loans is delayed in comparison to the level yield methodology under ASC No. 310-30, which recognizes income based on an expected cash flow model reflecting an investment’s lifetime expected losses. The purpose of the Core Earnings adjustment to adjust consumer loans to a level yield is to present income recognition across the consumer loan portfolio in the manner in which it is economically earned, avoid potential delays in loss recognition, and align it with our overall portfolio of mortgage-related assets which generally record income on a level yield basis. With respect to consumer loans classified as held-for-sale, the level yield is computed through the expected sale date. With respect to the gains recorded under GAAP in 2014 and 2016 as a result of a refinancing of, and the consolidation of, the Consumer Loan Companies, respectively, we continue to record a level yield on those assets based on their original purchase price.\nWhile incentive compensation paid to our Manager may be a material operating expense, we exclude it from core earnings because (i) from time to time, a component of the computation of this expense will relate to items (such as gains or losses) that are excluded from core earnings, and (ii) it is impractical to determine the portion of the expense related to core earnings and non-core earnings, and the type of earnings (loss) that created an excess (deficit) above or below, as applicable, the incentive compensation threshold. To illustrate why it is impractical to determine the portion of incentive compensation expense that should be allocated to core earnings, we note that, as an example, in a given period, we may have core earnings in excess of the incentive compensation threshold but incur losses (which are excluded from core earnings) that reduce total earnings below the incentive compensation threshold. In such case, we would either need to (a) allocate zero incentive compensation expense to core earnings, even though core earnings exceeded the incentive compensation threshold, or (b) assign a “pro forma” amount of incentive compensation expense to core earnings, even though no incentive compensation was actually incurred. We believe that neither of these allocation methodologies achieves a logical result. Accordingly, the exclusion of incentive compensation facilitates comparability between periods and avoids the distortion to our non-GAAP operating measure that would result from the inclusion of incentive compensation that relates to non-core earnings.\nWith regard to non-capitalized transaction-related expenses, management does not view these costs as part of our core operations, as they are considered by management to be similar to realized losses incurred at acquisition. Non-capitalized transaction-related expenses are generally legal and valuation service costs, as well as other professional service fees, incurred when we acquire certain investments, as well as costs associated with the acquisition and integration of acquired businesses.\nSince the third quarter of 2018, as a result of the Shellpoint Acquisition, the Company, through its wholly owned subsidiary, NewRez, originates conventional, government-insured and nonconforming residential mortgage loans for sale and securitization. In connection with the transfer of loans to the GSEs or mortgage investors, New Residential reports realized gains or losses on the sale of originated residential mortgage loans and retention of mortgage servicing rights, which we believe is an indicator of performance for the Servicing and Origination segment and therefore included in core earnings. Realized gains or losses on the sale of originated residential mortgage loans had no impact on core earnings in any prior period, but may impact core earnings in future periods.\nBeginning with the third quarter of 2019, as a result of the continued evaluation of how Shellpoint operates its business and its impact on our operating performance, core earnings includes Shellpoint’s GAAP net income with the exception of the unrealized gains or losses due to changes in valuation inputs and assumptions on MSRs owned by NewRez, and non-capitalized transaction-related expenses. This change was not material to core earnings for the quarter ended September 30, 2019.\nManagement believes that the adjustments to compute “core earnings” specified above allow investors and analysts to readily identify and track the operating performance of the assets that form the core of our activity, assist in comparing the core operating results between periods, and enable investors to evaluate our current core performance using the same measure that management uses to operate the business. Management also utilizes core earnings as a measure in its decision-making process relating to improvements to the underlying fundamental operations of our investments, as well as the allocation of resources between those investments, and management also relies on core earnings as an indicator of the results of such decisions. Core earnings excludes certain recurring items, such as gains and losses (including impairment as well as derivative activities) and non-capitalized transaction-related expenses, because they are not considered by management to be part of our core operations for the reasons described herein. As such, core earnings is not intended to reflect all of our activity and should be considered as only one of the factors used by management in assessing our performance, along with GAAP net income which is inclusive of all of our activities.\n94\nThe primary differences between core earnings and the measure we use to calculate incentive compensation relate to (i) realized gains and losses (including impairments), (ii) non-capitalized transaction-related expenses and (iii) deferred taxes (other than those related to unrealized gains and losses). Each are excluded from core earnings and included in our incentive compensation measure (either immediately or through amortization). In addition, our incentive compensation measure does not include accretion on held-for-sale loans and the timing of recognition of income from consumer loans is different. Unlike core earnings, our incentive compensation measure is intended to reflect all realized results of operations. The Gain on Remeasurement of Consumer Loans Investment was treated as an unrealized gain for the purposes of calculating incentive compensation and was therefore excluded from such calculation.\nCore earnings does not represent and should not be considered as a substitute for, or superior to, net income or as a substitute for, or superior to, cash flows from operating activities, each as determined in accordance with U.S. GAAP, and our calculation of this measure may not be comparable to similarly entitled measures reported by other companies. For a further description of the difference between cash flows provided by operations and net income, see “—Liquidity and Capital Resources” above. Set forth below is a reconciliation of core earnings to the most directly comparable GAAP financial measure (dollars in thousands):\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Net income (loss) attributable to common stockholders | $ | 224,584 | $ | 184,608 | $ | 338,235 | $ | 963,619 |\n| Adjustments for Non-Core Earnings: |\n| Impairment | (5,123 | ) | 9,360 | 29,984 | 51,326 |\n| Change in fair value of investments in mortgage servicing rights | 45,541 | (3,515 | ) | 272,259 | (394,717 | ) |\n| Change in fair value of servicer advance investments | (6,641 | ) | 5,353 | (15,932 | ) | 86,581 |\n| Change in fair value of investments in residential mortgage loans | 7,290 | (647 | ) | (102,298 | ) | (647 | ) |\n| Change in fair value of derivative instruments | (41,910 | ) | (24,299 | ) | 18,586 | (27,985 | ) |\n| (Gain) loss on settlement of investments, net (Note 2) | (135,935 | ) | 11,893 | (108,455 | ) | (106,064 | ) |\n| Other (income) loss (Note 2) | 35,271 | 5,860 | 16,503 | (10,415 | ) |\n| Other Income and Impairment attributable to non-controlling interests | (994 | ) | (4,633 | ) | (9,052 | ) | (17,088 | ) |\n| Gain (loss) on sale or securitization of originated mortgage loans (Note 2) | 21,611 | 2,757 | 62,399 | 2,757 |\n| Non-capitalized transaction-related expenses (Note 2) | 8,155 | 5,274 | 24,305 | 18,784 |\n| Incentive compensation to affiliate (Note 14) | 36,307 | 23,848 | 49,265 | 65,169 |\n| Preferred stock management fee to affiliate | 1,055 | — | 1,055 | — |\n| Deferred taxes (Note 17) | (6,652 | ) | (1,865 | ) | 18,080 | (12,680 | ) |\n| Interest income on residential mortgage loans, held-for-sale | 18,852 | 5,906 | 45,041 | 12,774 |\n| Limit on RMBS discount accretion related to called deals | (34 | ) | (2,914 | ) | (19,590 | ) | (13,108 | ) |\n| Adjust consumer loans to level yield | 1,922 | (6,760 | ) | 4,884 | (21,915 | ) |\n| Core earnings of equity method investees: |\n| Excess mortgage servicing rights (Note 4) | 3,987 | 4,468 | 6,102 | 10,514 |\n| Core Earnings | $ | 207,286 | $ | 214,694 | $ | 631,371 | $ | 606,905 |\n| Net Income Per Diluted Share | $ | 0.54 | $ | 0.54 | $ | 0.83 | $ | 2.86 |\n| Core Earnings Per Diluted Share | $ | 0.50 | $ | 0.63 | $ | 1.55 | $ | 1.80 |\n| Weighted Average Number of Shares of Common Stock Outstanding, Diluted | 415,588,238 | 340,868,403 | 406,671,972 | 337,078,824 |\n\n95\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nMarket risk is the exposure to loss resulting from changes in interest rates, credit spreads, foreign currency exchange rates, commodity prices, equity prices and other market based risks. The primary market risks that we are exposed to are interest rate risk, mortgage basis spread risk, prepayment rate risk and credit risk. These risks are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. All of our market risk sensitive assets, liabilities and derivative positions (other than TBAs) are for non-trading purposes only. For a further discussion of how market risk may affect our financial position or results of operations, please refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Application of Critical Accounting Policies.”\nBeginning with the third quarter of 2019, as a result of refinement of our risk management practices, including expansion of our hedging program, we have adjusted our sensitivity analysis. In prior periods, our sensitivity analysis reported the impact specific to changes in short term interest rates with no changes to discount rate spreads and yields. We have adjusted to report projected changes from a parallel shift in interest rates across all maturities along with corresponding changes in discount rates. In addition, based on management’s evaluation of the significance of each market risk exposure to our company, we have adjusted our sensitivity analysis to capture changes in mortgage basis spread risk and to remove credit spread risk. These changes resulted in a material impact to the results of our sensitivity analysis and therefore, we have provided summarized comparable information under the new sensitivity analysis for the prior period.\nInterest Rate Risk\nChanges in interest rates, including changes in expected interest rates or “yield curves,” affect our investments in various ways, the most significant of which are discussed below.\nFair Value Impact\nChanges in the level of interest rates also affect the yields required by the marketplace on interest rate instruments. Increasing interest rates would decrease the value of the fixed rate assets we hold at the time because higher required yields result in lower prices on existing fixed rate assets in order to adjust their yield upward to meet the market.\nChanges in unrealized gains or losses resulting from changes in market interest rates do not directly affect our cash flows, or our ability to pay a dividend, to the extent the related assets are expected to be held and continue to perform as expected, as their fair value is not relevant to their underlying cash flows. Changes in unrealized gains or losses would impact our ability to realize gains on existing investments if they were sold. Furthermore, with respect to changes in unrealized gains or losses on investments which are carried at fair value, changes in unrealized gains or losses would impact our net book value and, in certain cases, our net income.\nChanges in interest rates can also have ancillary impacts on our investments. Generally, in a declining interest rate environment, residential mortgage loan prepayment rates increase which in turn would cause the value of MSRs, mortgage servicing rights financing receivables, Excess MSRs and the rights to the basic fee components of MSRs to decrease, because the duration of the cash flows we are entitled to receive becomes shortened, and the value of loans and Non-Agency RMBS to increase, because we generally acquired these investments at a discount whose recovery would be accelerated. With respect to a significant portion of our investments in MSRs and Excess MSRs, we have recapture agreements, as described in Notes 4 and 5 to our Consolidated Financial Statements. These recapture agreements help to protect these investments from the impact of increasing prepayment rates. In addition, to the extent that the loans underlying our investments in MSRs, mortgage servicing rights financing receivables, Excess MSRs and the rights to the basic fee components of MSRs are well-seasoned with credit-impaired borrowers who may have limited refinancing options, we believe the impact of interest rates on prepayments would be reduced. Conversely, in an increasing interest rate environment, prepayment rates decrease which in turn would cause the value of MSRs, mortgage servicing rights financing receivables, Excess MSRs and the rights to the basic fee components of MSRs to increase and the value of loans and Non-Agency RMBS to decrease. To the extent we do not hedge against changes in interest rates, our balance sheet, results of operations and cash flows would be susceptible to significant volatility due to changes in the fair value of, or cash flows from, our investments as interest rates change. However, rising interest rates could result from more robust market conditions, which could reduce the credit risk associated with our investments. The effects of such a decrease in values on our financial position, results of operations and liquidity are discussed below under “—Prepayment Rate Exposure.”\nChanges in the value of our assets could affect our ability to borrow and access capital. Also, if the value of our assets subject to short-term financing were to decline, it could cause us to fund margin, or repay debt, and affect our ability to refinance such assets upon the maturity of the related financings, adversely impacting our rate of return on such investments.\n96\nWe are subject to margin calls on our repurchase agreements. Furthermore, we may, from time to time, be a party to derivative agreements or financing arrangements that are subject to margin calls, or mandatory repayment, based on the value of such instruments. We seek to maintain adequate cash reserves and other sources of available liquidity to meet any margin calls, or required repayments, resulting from decreases in value related to a reasonably possible (in our opinion) change in interest rates but there can be no assurance that our cash reserves will be sufficient.\nIn addition, changes in interest rates may impact our ability to exercise our call rights and to realize or maximize potential profits from them. A significant portion of the residential mortgage loans underlying our call rights bear fixed rates and may decline in value during a period of rising market interest rates. Furthermore, rising rates could cause prepayment rates on these loans to decline, which would delay our ability to exercise our call rights. These impacts could be at least partially offset by potential declines in the value of Non-Agency RMBS related to the call rights, which could then be acquired more cheaply, and in credit spreads, which could offset the impact of rising market interest rates on the value of fixed rate loans to some degree. Conversely, declining interest rates could increase the value of our call rights by increasing the value of the underlying loans.\nWe believe our consumer loan investments generally have limited interest rate sensitivity given that our portfolio is mostly composed of very seasoned loans with credit-impaired borrowers who are paying fixed rates, who we believe are relatively unlikely to change their prepayment patterns based on changes in interest rates.\nAs of September 30, 2019, an immediate 50 basis point increase in short term interest rates, based on a parallel shift in the yield curve (assuming an unchanged mortgage basis), would reduce our net book value by approximately $6.2 million, whereas a 50 basis point decrease in short term interest rates would increase our net book value by approximately $3.7 million, based on the present value of estimated cash flows on a static portfolio of investments. This includes changes in our book value resulting from potential related changes in discount rates.\nInterest rates are highly sensitive to many factors, including fiscal and monetary policies and domestic and international economic and political considerations, as well as other factors beyond our control.\nLIBOR and other indices which are deemed “benchmarks” are the subject of recent national, international, and other regulatory guidance and proposals for reform, and it appears likely that LIBOR will be phased out or the methodology for determining LIBOR will be modified by 2021. We currently have agreements that are indexed to LIBOR and are monitoring related reform proposals and evaluating the related risks; however, it is not possible to predict the effects of any of these developments, and any future initiatives to regulate, reform or change the manner of administration of LIBOR could result in adverse consequences to the rate of interest payable and receivable on, market value of and market liquidity for LIBOR-based financial instruments. The below table is comparative in order to show the prior period sensitivity analysis under our new methodology.\n| June 30, 2019 | September 30, 2019 |\n| Interest rate change (bps) | Estimated Change in Fair Value ($mm) | Estimated Change in Fair Value ($mm) |\n| +50bps | +$6.2mm | -$36.2mm |\n| +25bps | +$4.0mm | -$14.0mm |\n| -25bps | -$5.9mm | +$5.9mm |\n| -50bps | -$13.7mm | +$3.7mm |\n\nMortgage Basis Spread Risk\nMortgage basis measures the spread between the yield on current coupon mortgage backed securities and benchmark rates including treasuries and swaps. The level of mortgage basis is driven by demand and supply of mortgage backed instruments relative to other rate-sensitive assets. Changes in the mortgage basis have an impact on prepayment rates driven by the ability of borrowers underlying our portfolio to refinance. A lower mortgage basis would imply a lower mortgage rate which would increase prepayment speeds due to higher refinance activity and, therefore, lower fair value of our mortgage portfolio. As of September 30, 2019, an immediate 20 basis point increase in mortgage basis would increase our net book value by approximately $39.4 million, whereas a 20 basis point decrease in mortgage basis would decrease our net book value by approximately $40.6 million, based on the present value of estimated cash flows on a static portfolio of investments. The below table is comparative in order to show the prior period sensitivity analysis under our new methodology.\n97\n| June 30, 2019 | September 30, 2019 |\n| Mortgage Basis change (bps) | Estimated Change in Fair Value ($mm) | Estimated Change in Fair Value ($mm) |\n| +20bps | +$79.8mm | +$39.4mm |\n| +10bps | +$39.9mm | +$19.8mm |\n| -10bps | -$40.0mm | -$20.1mm |\n| -20bps | -$80.2mm | -$40.6mm |\n\nPrepayment Rate Exposure\nPrepayment rates significantly affect the value of MSRs, mortgage servicing rights financing receivables, Excess MSRs, the basic fee component of MSRs (which we own as part of our Servicer Advance Investments), Non-Agency RMBS and loans, including consumer loans. Prepayment rate is the measurement of how quickly borrowers pay down the UPB of their loans or how quickly loans are otherwise brought current, modified, liquidated or charged off. The price we pay to acquire certain investments will be based on, among other things, our projection of the cash flows from the related pool of loans. Our expectation of prepayment rates is a significant assumption underlying those cash flow projections. If the fair value of MSRs, mortgage servicing rights financing receivables, Excess MSRs or the basic fee component of MSRs decreases, we would be required to record a non-cash charge, which would have a negative impact on our financial results. Furthermore, a significant increase in prepayment rates could materially reduce the ultimate cash flows we receive from MSRs, mortgage servicing rights financing receivables, Excess MSRs or our right to the basic fee component of MSRs, and we could ultimately receive substantially less than what we paid for such assets. Conversely, a significant decrease in prepayment rates with respect to our loans or RMBS could delay our expected cash flows and reduce the yield on these investments.\nWe seek to reduce our exposure to prepayment through the structuring of our investments. For example, in our MSR and Excess MSR investments, we seek to enter into “recapture agreements” whereby our MSR or Excess MSR is retained if the applicable servicer or subservicer originates a new loan the proceeds of which are used to repay a loan underlying an MSR or Excess MSR in our portfolio. We seek to enter into such recapture agreements in order to protect our returns in the event of a rise in voluntary prepayment rates.\nPlease refer to the table in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Application of Critical Accounting Policies—Excess MSRs” for an analysis of the sensitivity of these investments to changes in certain market factors.\nCredit Risk\nWe are subject to varying degrees of credit risk in connection with our assets. Credit risk refers to the ability of each individual borrower underlying our investments in MSRs, mortgage servicing rights financing receivables, Excess MSRs, Servicer Advance Investments, securities and loans to make required interest and principal payments on the scheduled due dates. If delinquencies increase, then the amount of servicer advances we are required to make will also increase, as would our financing cost thereof. We may also invest in loans and Non-Agency RMBS which represent “first loss” pieces; in other words, they do not benefit from credit support although we believe they predominantly benefit from underlying collateral value in excess of their carrying amounts. Although we do not expect to encounter credit risk in our Agency RMBS, we do anticipate credit risk related to Non-Agency RMBS, residential mortgage loans and consumer loans.\nWe seek to reduce credit risk through prudent asset selection, actively monitoring our asset portfolio and the underlying credit quality of our holdings and, where appropriate and achievable, repositioning our investments to upgrade their credit quality. Our pre-acquisition due diligence and processes for monitoring performance include the evaluation of, among other things, credit and risk ratings, principal subordination, prepayment rates, delinquency and default rates, and vintage of collateral.\nFor our MSRs, mortgage servicing rights financing receivables, and Excess MSRs on Agency collateral and our Agency RMBS, delinquency and default rates have an effect similar to prepayment rates. Our Excess MSRs on Non-Agency portfolios are not directly affected by delinquency rates because the servicer continues to advance principal and interest until a default occurs on the applicable loan, so delinquencies decrease prepayments therefore having a positive impact on fair value, while increased defaults have an effect similar to increased prepayments. For our Non-Agency RMBS and loans, higher default rates can lead to greater loss of principal. For our call rights, higher delinquencies and defaults could reduce the value of the underlying loans, therefore reducing or eliminating the related potential profit.\n98\nMarket factors that could influence the degree of the impact of credit risk on our investments include (i) unemployment and the general economy, which impact borrowers’ ability to make payments on their loans, (ii) home prices, which impact the value of collateral underlying residential mortgage loans, (iii) the availability of credit, which impacts borrowers’ ability to refinance, and (iv) other factors, all of which are beyond our control.\nLiquidity Risk\nThe assets that comprise our asset portfolio are generally not publicly traded. A portion of these assets may be subject to legal and other restrictions on resale or otherwise be less liquid than publicly-traded securities. The illiquidity of our assets may make it difficult for us to sell such assets if the need or desire arises, including in response to changes in economic and other conditions.\nInvestment Specific Sensitivity Analyses\nExcess MSRs\nThe following table summarizes the estimated change in fair value of our interests in the Agency Excess MSRs owned directly as of September 30, 2019 given several parallel shifts in the discount rate, prepayment rate, delinquency rate and recapture rate (dollars in thousands):\n| Fair value at September 30, 2019 | $ | 221,560 |\n| Discount rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 233,576 | $ | 227,967 | $ | 215,552 | $ | 208,747 |\n| Change in estimated fair value: |\n| Amount | $ | 12,016 | $ | 6,407 | $ | (6,008 | ) | $ | (12,813 | ) |\n| % | 5.4 | % | 2.9 | % | (2.7 | )% | (5.8 | )% |\n| Prepayment rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 233,618 | $ | 228,908 | $ | 214,816 | $ | 211,680 |\n| Change in estimated fair value: |\n| Amount | $ | 12,058 | $ | 7,348 | $ | (6,744 | ) | $ | (9,880 | ) |\n| % | 5.4 | % | 3.3 | % | (3.0 | )% | (4.5 | )% |\n| Delinquency rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 221,913 | $ | 221,744 | $ | 221,404 | $ | 221,235 |\n| Change in estimated fair value: |\n| Amount | $ | 353 | $ | 184 | $ | (156 | ) | $ | (325 | ) |\n| % | 0.2 | % | 0.1 | % | (0.1 | )% | (0.1 | )% |\n| Recapture rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 214,864 | $ | 218,219 | $ | 224,929 | $ | 228,284 |\n| Change in estimated fair value: |\n| Amount | $ | (6,696 | ) | $ | (3,341 | ) | $ | 3,369 | $ | 6,724 |\n| % | (3.0 | )% | (1.5 | )% | 1.5 | % | 3.0 | % |\n\n99\nThe following table summarizes the estimated change in fair value of our interests in the Non-Agency Excess MSRs owned directly as of September 30, 2019 given several parallel shifts in the discount rate, prepayment rate, delinquency rate and recapture rate (dollars in thousands):\n| Fair value at September 30, 2019 | $ | 176,504 |\n| Discount rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 187,808 | $ | 182,601 | $ | 170,900 | $ | 164,407 |\n| Change in estimated fair value: |\n| Amount | $ | 11,304 | $ | 6,097 | $ | (5,604 | ) | $ | (12,097 | ) |\n| % | 6.4 | % | 3.5 | % | (3.2 | )% | (6.9 | )% |\n| Prepayment rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 190,121 | $ | 184,296 | $ | 169,440 | $ | 165,449 |\n| Change in estimated fair value: |\n| Amount | $ | 13,617 | $ | 7,792 | $ | (7,064 | ) | $ | (11,055 | ) |\n| % | 7.7 | % | 4.4 | % | (4.0 | )% | (6.3 | )% |\n| Delinquency rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 176,523 | $ | 176,521 | $ | 176,518 | $ | 176,516 |\n| Change in estimated fair value: |\n| Amount | $ | 19 | $ | 17 | $ | 14 | $ | 12 |\n| % | — | % | — | % | — | % | — | % |\n| Recapture rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 173,437 | $ | 174,978 | $ | 178,061 | $ | 179,602 |\n| Change in estimated fair value: |\n| Amount | $ | (3,067 | ) | $ | (1,526 | ) | $ | 1,557 | $ | 3,098 |\n| % | (1.7 | )% | (0.9 | )% | 0.9 | % | 1.8 | % |\n\nThe following table summarizes the estimated change in fair value of our interests in the Agency Excess MSRs owned through equity method investees as of September 30, 2019 given several parallel shifts in the discount rate, prepayment rate, delinquency rate and recapture rate (dollars in thousands):\n| Fair value at September 30, 2019 | $ | 132,259 |\n| Discount rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 138,805 | $ | 135,647 | $ | 128,986 | $ | 125,484 |\n| Change in estimated fair value: |\n| Amount | $ | 6,546 | $ | 3,388 | $ | (3,273 | ) | $ | (6,775 | ) |\n| % | 4.9 | % | 2.6 | % | (2.5 | )% | (5.1 | )% |\n| Prepayment rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 138,370 | $ | 135,993 | $ | 128,756 | $ | 127,242 |\n| Change in estimated fair value: |\n| Amount | $ | 6,111 | $ | 3,734 | $ | (3,503 | ) | $ | (5,017 | ) |\n| % | 4.6 | % | 2.8 | % | (2.6 | )% | (3.8 | )% |\n| Delinquency rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 132,487 | $ | 132,352 | $ | 132,083 | $ | 131,949 |\n| Change in estimated fair value: |\n| Amount | $ | 228 | $ | 93 | $ | (176 | ) | $ | (310 | ) |\n| % | 0.2 | % | 0.1 | % | (0.1 | )% | (0.2 | )% |\n| Recapture rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 128,488 | $ | 130,353 | $ | 134,082 | $ | 135,947 |\n| Change in estimated fair value: |\n| Amount | $ | (3,771 | ) | $ | (1,906 | ) | $ | 1,823 | $ | 3,688 |\n| % | (2.9 | )% | (1.4 | )% | 1.4 | % | 2.8 | % |\n\n100\nMSRs\nThe following table summarizes the estimated change in fair value of our interests in the Agency MSRs, including mortgage servicing rights financing receivables, owned as of September 30, 2019 given several parallel shifts in the discount rate, prepayment rate, delinquency rate and recapture rate (dollars in thousands):\n| Fair value at September 30, 2019 | $ | 3,636,711 |\n| Discount rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 3,819,885 | $ | 3,733,227 | $ | 3,545,124 | $ | 3,443,678 |\n| Change in estimated fair value: |\n| Amount | $ | 183,174 | $ | 96,516 | $ | (91,587 | ) | $ | (193,033 | ) |\n| % | 5.0 | % | 2.7 | % | (2.5 | )% | (5.3 | )% |\n| Prepayment rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 3,864,772 | $ | 3,743,884 | $ | 3,539,852 | $ | 3,452,425 |\n| Change in estimated fair value: |\n| Amount | $ | 228,061 | $ | 107,173 | $ | (96,859 | ) | $ | (184,286 | ) |\n| % | 6.3 | % | 2.9 | % | (2.7 | )% | (5.1 | )% |\n| Delinquency rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 3,650,369 | $ | 3,643,454 | $ | 3,629,626 | $ | 3,622,717 |\n| Change in estimated fair value: |\n| Amount | $ | 13,658 | $ | 6,743 | $ | (7,085 | ) | $ | (13,994 | ) |\n| % | 0.4 | % | 0.2 | % | (0.2 | )% | (0.4 | )% |\n| Recapture rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 3,511,603 | $ | 3,574,071 | $ | 3,699,008 | $ | 3,761,477 |\n| Change in estimated fair value: |\n| Amount | $ | (125,108 | ) | $ | (62,640 | ) | $ | 62,297 | $ | 124,766 |\n| % | (3.4 | )% | (1.7 | )% | 1.7 | % | 3.4 | % |\n\n101\nThe following table summarizes the estimated change in fair value of our interests in the Non-Agency MSRs, including mortgage servicing rights financing receivables, owned as of September 30, 2019 given several parallel shifts in the discount rate, prepayment rate, delinquency rate and recapture rate (dollars in thousands):\n| Fair value at September 30, 2019 | $ | 1,233,592 |\n| Discount rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 1,328,865 | $ | 1,287,146 | $ | 1,185,955 | $ | 1,126,483 |\n| Change in estimated fair value: |\n| Amount | $ | 95,273 | $ | 53,554 | $ | (47,637 | ) | $ | (107,109 | ) |\n| % | 7.7 | % | 4.3 | % | (3.9 | )% | (8.7 | )% |\n| Prepayment rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 1,286,886 | $ | 1,259,011 | $ | 1,213,398 | $ | 1,195,616 |\n| Change in estimated fair value: |\n| Amount | $ | 53,294 | $ | 25,419 | $ | (20,194 | ) | $ | (37,976 | ) |\n| % | 4.3 | % | 2.1 | % | (1.6 | )% | (3.1 | )% |\n| Delinquency rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 1,267,992 | $ | 1,245,516 | $ | 1,200,545 | $ | 1,178,053 |\n| Change in estimated fair value: |\n| Amount | $ | 34,400 | $ | 11,924 | $ | (33,047 | ) | $ | (55,539 | ) |\n| % | 2.8 | % | 1.0 | % | (2.7 | )% | (4.5 | )% |\n| Recapture rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 1,215,987 | $ | 1,225,223 | $ | 1,243,692 | $ | 1,252,927 |\n| Change in estimated fair value: |\n| Amount | $ | (17,605 | ) | $ | (8,369 | ) | $ | 10,100 | $ | 19,335 |\n| % | (1.4 | )% | (0.7 | )% | 0.8 | % | 1.6 | % |\n\nThe following table summarizes the estimated change in fair value of our interests in the Ginnie Mae MSRs, owned as of September 30, 2019 given several parallel shifts in the discount rate, prepayment rate, delinquency rate and recapture rate (dollars in thousands):\n| Fair value at September 30, 2019 | $ | 372,926 |\n| Discount rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 392,886 | $ | 382,305 | $ | 362,946 | $ | 354,169 |\n| Change in estimated fair value: |\n| Amount | $ | 19,960 | $ | 9,379 | $ | (9,980 | ) | $ | (18,757 | ) |\n| % | 5.4 | % | 2.5 | % | (2.7 | )% | (5.0 | )% |\n| Prepayment rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 398,886 | $ | 384,635 | $ | 361,543 | $ | 351,942 |\n| Change in estimated fair value: |\n| Amount | $ | 25,960 | $ | 11,709 | $ | (11,383 | ) | $ | (20,984 | ) |\n| % | 7.0 | % | 3.1 | % | (3.1 | )% | (5.6 | )% |\n| Delinquency rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 377,595 | $ | 374,961 | $ | 369,692 | $ | 367,058 |\n| Change in estimated fair value: |\n| Amount | $ | 4,669 | $ | 2,035 | $ | (3,234 | ) | $ | (5,868 | ) |\n| % | 1.3 | % | 0.5 | % | (0.9 | )% | (1.6 | )% |\n| Recapture rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 354,049 | $ | 363,187 | $ | 381,465 | $ | 390,603 |\n| Change in estimated fair value: |\n| Amount | $ | (18,877 | ) | $ | (9,739 | ) | $ | 8,539 | $ | 17,677 |\n| % | (5.1 | )% | (2.6 | )% | 2.3 | % | 4.7 | % |\n\n102\nEach of the preceding sensitivity analyses is hypothetical and should be used with caution. In particular, the results are calculated by stressing a particular economic assumption independent of changes in any other assumption; in practice, changes in one factor may result in changes in another, which might counteract or amplify the sensitivities. Also, changes in the fair value based on a 10% variation in an assumption generally may not be extrapolated because the relationship of the change in the assumption to the change in fair value may not be linear.\nITEM 4. CONTROLS AND PROCEDURES\nDisclosure Controls and Procedures\nThe Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. The Company’s disclosure controls and procedures are designed to provide reasonable assurance that information is recorded, processed, summarized and reported accurately and on a timely basis. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures were effective.\nChanges in Internal Control Over Financial Reporting\nThere have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\n103\nPART II. OTHER INFORMATION\n\nITEM 1. LEGAL PROCEEDINGS\nWe are or may become, from time to time, involved in various disputes, litigation and regulatory inquiry and investigation matters that arise in the ordinary course of business. Given the inherent unpredictability of these types of proceedings, it is possible that future adverse outcomes could have a material adverse effect on our business, financial position or results of operations.\nNew Residential is, from time to time, subject to inquiries by government entities. New Residential currently does not believe any of these inquiries would result in a material adverse effect on New Residential’s business.\nITEM 1A. RISK FACTORS\nInvesting in our stock involves a high degree of risk. You should carefully read and consider the following risk factors and all other information contained in this report. If any of the following risks, as well as additional risks and uncertainties not currently known to us or that we currently deem immaterial, occur, our business, financial condition or results of operations could be materially and adversely affected. The risk factors summarized below are categorized as follows: (i) Risks Related to Our Business, (ii) Risks Related to Our Manager, (iii) Risks Related to the Financial Markets, (iv) Risks Related to Our Taxation as a REIT and (v) Risks Related to Our Stock. However, these categories do overlap and should not be considered exclusive.\nRisks Related to Our Business\nWe may not be able to successfully operate our business strategy or generate sufficient revenue to make or sustain distributions to our stockholders.\nWe cannot assure you that we will be able to successfully operate our business or implement our operating policies and strategies. There can be no assurance that we will be able to generate sufficient returns to pay our operating expenses and make satisfactory distributions to our stockholders, or any distributions at all. Our results of operations and our ability to make or sustain distributions to our stockholders depend on several factors, including the availability of opportunities to acquire attractive assets, the level and volatility of interest rates, the availability of adequate short- and long-term financing, and conditions in the real estate market, the financial markets and economic conditions.\nThe value of our investments is based on various assumptions that could prove to be incorrect and could have a negative impact on our financial results.\nWhen we make investments, we base the price we pay and, in some cases, the rate of amortization of those investments on, among other things, our projection of the cash flows from the related pool of loans. We generally record such investments on our balance sheet at fair value, and we measure their fair value on a recurring basis. Our projections of the cash flow from our investments, and the determination of the fair value thereof, are based on assumptions about various factors, including, but not limited to:\n\n| • | rates of prepayment and repayment of the underlying loans; |\n\n| • | potential fluctuations in prevailing interest rates and credit spreads; |\n\n| • | rates of delinquencies and defaults, and related loss severities; |\n\n| • | costs of engaging a subservicer to service MSRs; |\n\n| • | market discount rates; |\n\n| • | in the case of MSRs and Excess MSRs, recapture rates; and |\n\n| • | in the case of Servicer Advance Investments and servicer advances receivable, the amount and timing of servicer advances and recoveries. |\n\nOur assumptions could differ materially from actual results. The use of different estimates or assumptions in connection with the valuation of these investments could produce materially different fair values for such investments, which could have a material adverse effect on our consolidated financial position and results of operations. The ultimate realization of the value of our investments may be materially different than the fair values of such investments as reflected in our Condensed Consolidated Financial Statements as of any particular date.\nWe refer to our MSRs, mortgage servicing rights financing receivables, Excess MSRs, and the base fee portion of the related MSRs included in our Servicer Advance Investments, collectively, as our interests in MSRs.\n104\nWith respect to our investments in interests in MSRs, residential mortgage loans and consumer loans, and a portion of our RMBS, when the related loans are prepaid as a result of a refinancing or otherwise, the related cash flows payable to us will either, in the case of interest-only RMBS, and/or interests in MSRs, cease (unless, in the case of our interests in MSRs, the loans are recaptured upon a refinancing), or we will cease to receive interest income on such investments, as applicable. Borrowers under residential mortgage loans and consumer loans are generally permitted to prepay their loans at any time without penalty. Our expectation of prepayment rates is a significant assumption underlying our cash flow projections. Prepayment rate is the measurement of how quickly borrowers pay down the UPB of their loans or how quickly loans are otherwise brought current, modified, liquidated or charged off. A significant increase in prepayment rates could materially reduce the ultimate cash flows and/or interest income, as applicable, we receive from our investments, and we could ultimately receive substantially less than what we paid for such assets, decreasing the fair value of our investments. If the fair value of our investment portfolio decreases, we would generally be required to record a non-cash charge, which would have a negative impact on our financial results. Consequently, the price we pay to acquire our investments may prove to be too high if there is a significant increase in prepayment rates.\nThe values of our investments are highly sensitive to changes in interest rates. Historically, the value of MSRs, which underpin the value of our investments, including interests in MSRs, has increased when interest rates rise and decreased when interest rates decline due to the effect of changes in interest rates on prepayment rates. Prepayment rates could increase as a result of a general economic recovery or other factors, which would reduce the value of our interests in MSRs.\nMoreover, delinquency rates have a significant impact on the value of our investments. When the UPB of mortgage loans cease to be a part of the aggregate UPB of the serviced loan pool (for example, when delinquent loans are foreclosed on or repurchased, or otherwise sold, from a securitized pool), the related cash flows payable to us, as the holder of an interest in the related MSR, cease. An increase in delinquencies will generally result in lower revenue because typically we will only collect on our interests in MSRs from GSEs or mortgage owners for performing loans. An increase in delinquencies with respect to the loans underlying our servicer advances could also result in a higher advance balance and the need to obtain additional financing, which we may not be able to do on favorable terms or at all. Additionally, in the case of residential mortgage loans, consumer loans and RMBS that we own, an increase in foreclosures could result in an acceleration of repayments, resulting in a decrease in interest income. Alternatively, increases in delinquencies and defaults could also adversely affect our investments in RMBS, residential mortgage loans and/or consumer loans if and to the extent that losses are suffered on residential mortgage loans, consumer loans or, in the case of RMBS, the residential mortgage loans underlying such RMBS. Accordingly, if delinquencies are significantly greater than expected, the estimated fair value of these investments could be diminished. As a result, we could suffer a loss, which would have a negative impact on our financial results.\nWe are party to several “recapture agreements” whereby our MSR or Excess MSR is retained if the applicable Servicing Partner originates a new loan the proceeds of which are used to repay a loan underlying an MSR or Excess MSR in our portfolio. We believe that such agreements will mitigate the impact on our returns in the event of a rise in voluntary prepayment rates, with respect to investments where we have such agreements. There are no assurances, however, that counterparties will enter into such arrangements with us in connection with any future investment in MSRs or Excess MSRs. We are not party to any such arrangements with respect to any of our investments other than MSRs and Excess MSRs.\nIf the applicable Servicing Partner does not meet anticipated recapture targets, the servicing cash flow on a given pool could be significantly lower than projected, which could have a material adverse effect on the value of our MSRs or Excess MSRs and consequently on our business, financial condition, results of operations and cash flows. Our recapture target for our current recapture agreements is stated in the table in Note 12 to our Condensed Consolidated Financial Statements.\nServicer advances may not be recoverable or may take longer to recover than we expect, which could cause us to fail to achieve our targeted return on our Servicer Advance Investments or MSRs.\nNRM is generally required to make servicer advances related to the pools of loans for which it is the named servicer. In addition, we have agreed (in the case of Nationstar, together with certain third-party investors) to purchase from certain of the servicers and subservicers that we engage, which we refer to as our “Servicing Partners,” all servicer advances related to certain loan pools, as a result of which we are entitled to amounts representing repayment for such advances. During any period in which a borrower is not making payments, a servicer is generally required under the applicable servicing agreement to advance its own funds to cover the principal and interest remittances due to investors in the loans, pay property taxes and insurance premiums to third parties, and to make payments for legal expenses and other protective advances. The servicer also advances funds to maintain, repair and market real estate properties on behalf of investors in the loans.\nRepayment of servicer advances and payment of deferred servicing fees are generally made from late payments and other collections and recoveries on the related residential mortgage loan (including liquidation, insurance and condemnation proceeds) or, if the related servicing agreement provides for a “general collections backstop,” from collections on other residential mortgage loans\n105\nto which such servicing agreement relates. The rate and timing of payments on servicer advances and deferred servicing fees are unpredictable for several reasons, including the following:\n\n| • | payments on the servicer advances and the deferred servicing fees depend on the source of repayment, and whether and when the related servicer receives such payment (certain servicer advances are reimbursable only out of late payments and other collections and recoveries on the related residential mortgage loan, while others are also reimbursable out of principal and interest collections with respect to all residential mortgage loans serviced under the related servicing agreement, and as a consequence, the timing of such reimbursement is highly uncertain); |\n\n| • | the length of time necessary to obtain liquidation proceeds may be affected by conditions in the real estate market or the financial markets generally, the availability of financing for the acquisition of the real estate and other factors, including, but not limited to, government intervention; |\n\n| • | the length of time necessary to effect a foreclosure may be affected by variations in the laws of the particular jurisdiction in which the related mortgaged property is located, including whether or not foreclosure requires judicial action; |\n\n| • | the requirements for judicial actions for foreclosure (which can result in substantial delays in reimbursement of servicer advances and payment of deferred servicing fees), which vary from time to time as a result of changes in applicable state law; and |\n\n| • | the ability of the related servicer to sell delinquent residential mortgage loans to third parties prior to a sale of the underlying real estate, resulting in the early reimbursement of outstanding unreimbursed servicer advances in respect of such residential mortgage loans. |\n\nAs home values change, the servicer may have to reconsider certain of the assumptions underlying its decisions to make advances. In certain situations, its contractual obligations may require the servicer to make certain advances for which it may not be reimbursed. In addition, when a residential mortgage loan defaults or becomes delinquent, the repayment of the advance may be delayed until the residential mortgage loan is repaid or refinanced, or a liquidation occurs. To the extent that one of our Servicing Partners fails to recover the servicer advances in which we have invested, or takes longer than we expect to recover such advances, the value of our investment could be adversely affected and we could fail to achieve our expected return and suffer losses.\nServicing agreements related to residential mortgage securitization transactions generally require a residential mortgage servicer to make servicer advances in respect of serviced residential mortgage loans unless the servicer determines in good faith that the servicer advance would not be ultimately recoverable from the proceeds of the related residential mortgage loan, mortgaged property or mortgagor. In many cases, if the servicer determines that a servicer advance previously made would not be recoverable from these sources, the servicer is entitled to withdraw funds from the related custodial account in respect of payments on the related pool of serviced mortgages to reimburse the related servicer advance. This is what is often referred to as a “general collections backstop.” The timing of when a servicer may utilize a general collections backstop can vary (some contracts require actual liquidation of the related loan first, while others do not), and contracts vary in terms of the types of servicer advances for which reimbursement from a general collections backstop is available. Accordingly, a servicer may not ultimately be reimbursed if both (i) the payments from related loan, property or mortgagor payments are insufficient for reimbursement, and (ii) a general collections backstop is not available or is insufficient. Also, if a servicer improperly makes a servicer advance, it would not be entitled to reimbursement. While we do not expect recovery rates to vary materially during the term of our investments, there can be no assurance regarding future recovery rates related to our portfolio.\nWe rely heavily on our Servicing Partners to achieve our investment objective and have no direct ability to influence their performance.\nThe value of substantially all of our investments is dependent on the satisfactory performance of servicing obligations by the related mortgage servicer or subservicer, as applicable. The duties and obligations of mortgage servicers are defined through contractual agreements, generally referred to as Servicing Guides in the case of GSEs, the MBS Guide in the case of Ginnie Mae or pooling agreements, securitization servicing agreements, pooling and servicing agreements or other similar agreements (collectively, “PSAs”) in the case of Non-Agency RMBS (collectively, the “Servicing Guidelines”). The duties of the subservicers we engage to service the loans underlying our MSRs are contained in subservicing agreements with our subservicers. The duties of a subservicer under a subservicing agreement may not be identical to the obligations of the servicer under Servicing Guidelines. Our interests in MSRs are subject to all of the terms and conditions of the applicable Servicing Guidelines. Servicing Guidelines generally provide for the possibility of termination of the contractual rights of the servicer in the absolute discretion of the owner of the mortgages being serviced (or the required bondholders in the case of Non-Agency RMBS). Under the Agency Servicing Guidelines, the servicer may be terminated by the applicable Agency for any reason, “with” or “without” cause, for all or any portion of the loans being serviced for such Agency. In the event mortgage owners (or bondholders) terminate the servicer (regardless of whether such servicer is a subsidiary of New Residential or one of its subservicers), the related interests in MSRs would under most circumstances lose all value on a going forward basis. If the servicer is terminated as servicer for any Agency pools, the servicer’s right to service the related mortgage loans will be extinguished and our interests in related MSRs will likely lose all of\n106\ntheir value. Any recovery in such circumstances, in the case of Non-Agency RMBS, will be highly conditioned and may require, among other things, a new servicer willing to pay for the right to service the applicable residential mortgage loans while assuming responsibility for the origination and prior servicing of the residential mortgage loans. In addition, in the case of Agency MSRs, any payment received from a successor servicer will be applied first to pay the applicable Agency for all of its claims and costs, including claims and costs against the servicer that do not relate to the residential mortgage loans for which we own interests in the MSRs. A termination could also result in an event of default under our related financings. It is expected that any termination of a servicer by mortgage owners (or bondholders) would take effect across all mortgages of such mortgage owners (or bondholders) and would not be limited to a particular vintage or other subset of mortgages. Therefore, it is possible that all investments with a given servicer would lose all their value in the event mortgage owners (or bondholders) terminate such servicer. See “—We have significant counterparty concentration risk in certain of our Servicing Partners, and are subject to other counterparty concentration and default risks.” As a result, we could be materially and adversely affected if one of our Servicing Partners is unable to adequately carry out its duties as a result of:\n\n| • | its failure to comply with applicable laws and regulations; |\n\n| • | its failure to comply with contractual and financing obligations and covenants; |\n\n| • | a downgrade in, or failure to maintain, any of its servicer ratings; |\n\n| • | its failure to maintain sufficient liquidity or access to sources of liquidity; |\n\n| • | its failure to perform its loss mitigation obligations; |\n\n| • | its failure to perform adequately in its external audits; |\n\n| • | a failure in or poor performance of its operational systems or infrastructure; |\n\n| • | regulatory or legal scrutiny or regulatory actions regarding any aspect of a servicer’s operations, including, but not limited to, servicing practices and foreclosure processes lengthening foreclosure timelines; |\n\n| • | an Agency’s or a whole-loan owner’s transfer of servicing to another party; or |\n\n| • | any other reason. |\n\nIn the ordinary course of business, our Servicing Partners are subject to numerous legal proceedings, federal, state or local governmental examinations, investigations or enforcement actions which could adversely affect their reputation and their liquidity, financial position and results of operations. Mortgage servicers, including certain of our Servicing Partners, have experienced heightened regulatory scrutiny and enforcement actions, and our Servicing Partners could be adversely affected by the market’s perception that they could experience, or continue to experience, regulatory issues. See “—Certain of our Servicing Partners have been and are subject to federal and state regulatory matters and other litigation, which may adversely impact us.”\nLoss mitigation techniques are intended to reduce the probability that borrowers will default on their loans and to minimize losses when defaults occur, and they may include the modification of mortgage loan rates, principal balances and maturities. If any of our Servicing Partners fail to adequately perform their loss mitigation obligations, we could be required to make or purchase, as applicable, servicer advances in excess of those that we might otherwise have had to make or purchase, and the time period for collecting servicer advances may extend. Any increase in servicer advances or material increase in the time to resolution of a defaulted loan could result in increased capital requirements and financing costs for us and our co-investors and could adversely affect our liquidity and net income. In the event that one of our servicers from which we are obligated to purchase servicer advances is required by the applicable Servicing Guidelines to make advances in excess of amounts that we or, in the case of Nationstar, the co-investors, are willing or able to fund, such servicer may not be able to fund these advance requests, which could result in a termination event under the applicable Servicing Guidelines, an event of default under our advance facilities and a breach of our purchase agreement with such servicer. As a result, we could experience a partial or total loss of the value of our Servicer Advance Investments.\nMSRs and servicer advances are subject to numerous federal, state and local laws and regulations and may be subject to various judicial and administrative decisions. If the Servicing Partner actually or allegedly failed to comply with applicable laws, rules or regulations, it could be terminated as the servicer, and could lead to civil and criminal liability, loss of licensing, damage to our reputation and litigation, which could have a material adverse effect on our business, financial condition, results of operations or cash flows. In addition, servicer advances that are improperly made may not be eligible for financing under our facilities and may not be reimbursable by the related securitization trust or other owner of the residential mortgage loan, which could cause us to suffer losses.\nFavorable servicer ratings from third-party rating agencies, such as S&P Global Ratings (“S&P”), Moody’s Investors Service (“Moody’s”) and Fitch Ratings (“Fitch”), are important to the conduct of a mortgage servicer’s loan servicing business, and a downgrade in a Servicing Partner’s servicer ratings could have an adverse effect on the value of our interests in MSRs and result in an event of default under our financings. Downgrades in a Servicing Partner’s servicer ratings could adversely affect our ability to finance our assets and maintain their status as an approved servicer by Fannie Mae and Freddie Mac. Downgrades in servicer ratings could also lead to the early termination of existing advance facilities and affect the terms and availability of financing that\n107\na Servicing Partner or we may seek in the future. A Servicing Partner’s failure to maintain favorable or specified ratings may cause their termination as a servicer and may impair their ability to consummate future servicing transactions, which could result in an event of default under our financing for servicer advances and have an adverse effect on the value of our investments because we will rely heavily on Servicing Partners to achieve our investment objectives and have no direct ability to influence their performance.\nFor additional information about the ways in which we may be affected by mortgage servicers, see “—The value of our interests in MSRs, servicer advances, residential mortgage loans and RMBS may be adversely affected by deficiencies in servicing and foreclosure practices, as well as related delays in the foreclosure process.”\nA number of lawsuits, including class-actions, have been filed against mortgage servicers alleging improper servicing in connection with residential non-agency mortgage securitizations. Investors in, and counterparties to, such securitizations may commence legal action against us and responding to such claims, and any related losses, could negatively impact our business.\nA number of lawsuits, including class actions, have been filed against mortgage servicers alleging improper servicing in connection with residential non-agency mortgage securitizations. Investors in, and counterparties to, such securitizations may commence legal action against us and responding to such claims, and any related losses, could negatively impact our business. The number of counterparties on behalf of which we service loans significantly increases as the size of our non-agency MSR portfolio increases and we may become subject to claims and legal proceedings, including purported class-actions, in the ordinary course of our business, challenging whether our loan servicing practices and other aspects of our business comply with applicable laws, agreements and regulatory requirements. We are unable to predict whether any such claims will be made, the ultimate outcome of any such claims, the possible loss, if any, associated with the resolution of such claims or the potential impact any such claims may have on us or our business and operations. Regardless of the merit of any such claims or lawsuits, defending any claims or lawsuits may be time consuming and costly and we may be required to expend significant internal resources and incur material expenses, and management time may be diverted from other aspects of our business, in connection therewith. Further, if our efforts to defend any such claims or lawsuits are not successful, our business could be materially and adversely affected. As a result of investor and other counterparty claims, we could also suffer reputational damage and trustees, lenders and other counterparties could cease wanting to do business with us.\nCertain of our Servicing Partners have been and are subject to federal and state regulatory matters and other litigation, which may adversely impact us.\nRegulatory actions or legal proceedings against certain of our Servicing Partners could increase our financing costs or operating expenses, reduce our revenues or otherwise materially adversely affect our business, financial condition, results of operations and liquidity. Such Servicing Partners may be subject to additional federal and state regulatory matters in the future that could materially and adversely affect the value of our investments to the extent we rely on them to achieve our investment objectives because we have no direct ability to influence their performance. Certain of our Servicing Partners have disclosed certain matters in their periodic reports filed with the SEC, and there can be no assurance that such events will not have a material adverse effect on them. We are currently evaluating the impact of such events and cannot assure you what impact these events may have or what actions we may take under our agreements with the servicer. In addition, any of our Servicing Partners could be removed as servicer by the related loan owner or certain other transaction counterparties, which could have a material adverse effect on our interests in the loans and MSRs serviced by such Servicing Partner.\nIn addition, certain of our Servicing Partners have been and continue to be subject to regulatory and governmental examinations, information requests and subpoenas, inquiries, investigations and threatened legal actions and proceedings. In connection with formal and informal inquiries, such Servicing Partners may receive numerous requests, subpoenas and orders for documents, testimony and information in connection with various aspects of their activities, including whether certain of their residential loan servicing and originations practices, bankruptcy practices and other aspects of their business comply with applicable laws and regulatory requirements. Such Servicing Partners cannot provide any assurance as to the outcome of any of the aforementioned actions, proceedings or inquiries, or that such outcomes will not have a material adverse effect on their reputation, business, prospects, results of operations, liquidity or financial condition.\nCompletion of certain pending transactions related to MSRs (the “MSR Transactions”) is subject to various closing conditions, involves significant costs, and we cannot assure you if, when or the terms on which such transactions will close. Failure to complete the pending MSR Transactions could adversely affect our future business and results of operations.\nWe have entered into an agreement for Ocwen to transfer its remaining interests in $110.0 billion of UPB of non-Agency MSRs to NRM (the “Ocwen Subject MSRs”). We currently hold certain interests in the Ocwen Subject MSRs (including all servicer advances) pursuant to existing agreements with Ocwen. The transfer of Ocwen’s interests in the Ocwen Subject MSRs is subject\n108\nto numerous consents of third parties and certain actions by rating agencies. While certain of the Ocwen Subject MSRs have previously transferred to our subsidiaries, there is no assurance that we will be able to obtain such consents in order to transfer Ocwen’s interests in the Ocwen Subject MSRs to our subsidiaries. We have spent considerable time and resources, and incurred substantial costs, in connection with the negotiation of such transaction and we will incur such costs even if the Ocwen Subject MSRs cannot be transferred to our subsidiaries. As of September 30, 2019, MSRs representing approximately $66.7 billion UPB of underlying loans have been transferred pursuant to the Ocwen Transaction. Economics related to the remaining MSRs subject to the Ocwen Transaction were transferred pursuant to the New Ocwen Agreements (Note 5 to our Condensed Consolidated Financial Statements).\nWe may be unable to become the named servicer in respect of certain Non-Agency MSRs. If we are unable to become the named servicer in respect of any of the Ocwen Subject MSRs in accordance with the Ocwen Transaction, Ocwen has the right, in certain circumstances, to purchase from us our interests in the related MSRs. In such a situation, we will be required to sell Ocwen those assets (and will cease to receive income on those investments) and/or may be required to refinance certain indebtedness on terms that are not favorable to us.\nOur ability to acquire MSRs may be subject to the approval of various third parties and such approvals may not be provided on a timely basis or at all, or may be subject to conditions, representations and warranties and indemnities.\nOur ability to acquire MSRs may be subject to the approval of various third parties and such approvals may not be provided on a timely basis or at all, or may be conditioned upon our satisfaction of significant conditions which could require material expenditures and the provision of significant representations, warranties and indemnities. Such third parties may include the Agencies and the Federal Housing Finance Agency (“FHFA”) with respect to agency MSRs, and securitization trustees, master servicers, depositors, rating agencies and insurers, among others, with respect to non-agency MSRs. The process of obtaining any such approvals required for a servicing transfer, especially with respect to non-agency MSRs, may be time consuming and costly and we may be required to expend significant internal resources and incur material expenses in connection with such transactions. Further, the parties from whom approval is necessary may require that we provide significant representations and warranties and broad indemnities as a condition to their consent, which such representations and warranties and indemnities, if given, may expose us to material risks in addition to those arising under the related servicing agreements. Consenting parties may also charge a material consent fee and may require that we reimburse them for the legal expenses they incur in connection with their approval of the servicing transfer, which such expenses may include costs relating to substantial contract due diligence and may be significant. No assurance can be given that we will be able to successfully obtain the consents required to acquire the MSRs that we have agreed to purchase.\nWe have significant counterparty concentration risk in certain of our Servicing Partners and are subject to other counterparty concentration and default risks.\nWe are not restricted from dealing with any particular counterparty or from concentrating any or all of our transactions with a few counterparties. Any loss suffered by us as a result of a counterparty defaulting, refusing to conduct business with us or imposing more onerous terms on us would also negatively affect our business, results of operations, cash flows and financial condition.\nOur interests in MSRs relate to loans serviced or subserviced, as applicable, by our Servicing Partners. As disclosed in Notes 4, 5, and 6 of our Condensed Consolidated Financial Statements, certain of our Servicing Partners service and/or subservice a substantial portion of our interests in MSRs. If any of these Servicing Partners is the named servicer of the related MSR and is terminated, its servicing performance deteriorates, or in the event that any of them files for bankruptcy, our expected returns on these investments could be severely impacted. In addition, a large portion of the loans underlying our Non-Agency RMBS are serviced by certain of our Servicing Partners. We closely monitor our Servicing Partners’ mortgage servicing performance and overall operating performance, financial condition and liquidity, as well as their compliance with applicable regulations and Servicing Guidelines. We have various information, access and inspection rights in our agreements with these Servicing Partners that enable us to monitor aspects of their financial and operating performance and credit quality, which we periodically evaluate and discuss with their management. However, we have no direct ability to influence our Servicing Partners’ performance, and our diligence cannot prevent, and may not even help us anticipate, the termination of any such Servicing Partners’ servicing agreement or a severe deterioration of any of our Servicing Partners’ servicing performance on our portfolio of interests in MSRs.\nFurthermore, certain of our Servicing Partners are subject to numerous legal proceedings, federal, state or local governmental examinations, investigations or enforcement actions, which could adversely affect their operations, reputation and liquidity, financial position and results of operations. See “—Certain of our Servicing Partners have been and are subject to federal and state regulatory matters and other litigation, which may adversely impact us” for more information.\nNone of our Servicing Partners has an obligation to offer us any future co-investment opportunity on the same terms as prior transactions, or at all, and we may not be able to find suitable counterparties from which to acquire interests in MSRs, which could\n109\nimpact our business strategy. See “—We rely heavily on our Servicing Partners to achieve our investment objective and have no direct ability to influence their performance.”\nRepayment of the outstanding amount of servicer advances (including payment with respect to deferred servicing fees) may be subject to delay, reduction or set-off in the event that the related Servicing Partner breaches any of its obligations under the Servicing Guidelines, including, without limitation, any failure of such Servicing Partner to perform its servicing and advancing functions in accordance with the terms of such Servicing Guidelines. If any applicable Servicing Partner is terminated or resigns as servicer and the applicable successor servicer does not purchase all outstanding servicer advances at the time of transfer, collection of the servicer advances will be dependent on the performance of such successor servicer and, if applicable, reliance on such successor servicer’s compliance with the “first-in, first-out” or “FIFO” provisions of the Servicing Guidelines. In addition, such successor servicers may not agree to purchase the outstanding advances on the same terms as our current purchase arrangements and may require, as a condition of their purchase, modification to such FIFO provisions, which could further delay our repayment and adversely affect the returns from our investment.\nWe are subject to substantial other operational risks associated with our Servicing Partners in connection with the financing of servicer advances. In our current financing facilities for servicer advances, the failure of our Servicing Partner to satisfy various covenants and tests can result in an amortization event and/or an event of default. We have no direct ability to control our Servicing Partners’ compliance with those covenants and tests. Failure of our Servicing Partners to satisfy any such covenants or tests could result in a partial or total loss on our investment.\nIn addition, our Servicing Partners are party to our servicer advance financing agreements, with respect to those advances where they service or subservice the loans underlying the related MSRs. Our ability to obtain financing for these assets is dependent on our Servicing Partners’ agreement to be a party to the related financing agreements. If our Servicing Partners do not agree to be a party to these financing agreements for any reason, we may not be able to obtain financing on favorable terms or at all. Our ability to obtain financing on such assets is dependent on our Servicing Partners’ ability to satisfy various tests under such financing arrangements. Breaches and other events with respect to our Servicing Partners (which may include, without limitation, failure of a Servicing Partner to satisfy certain financial tests) could cause certain or all of the relevant servicer advance financing to become due and payable prior to maturity.\nWe are dependent on our Servicing Partners as the servicer or subservicer of the residential mortgage loans with respect to which we hold interests in MSRs, and their servicing practices may impact the value of certain of our assets. We may be adversely impacted:\n| • | By regulatory actions taken against our Servicing Partners; |\n\n| • | By a default by one of our Servicing Partners under their debt agreements; |\n\n| • | By downgrades in our Servicing Partners’ servicer ratings; |\n\n| • | If our Servicing Partners fail to ensure their servicer advances comply with the terms of their Pooling and Servicing Agreements (“PSAs”); |\n\n| • | If our Servicing Partners were terminated as servicer under certain PSAs; |\n\n| • | If our Servicing Partners become subject to a bankruptcy proceeding; or |\n\n| • | If our Servicing Partners fail to meet their obligations or are deemed to be in default under the indenture governing notes issued under any servicer advance facility with respect to which such Servicing Partner is the servicer. |\n\nOur interests in MSRs relate to loans serviced or subserviced, as applicable, by our Servicing Partners. As disclosed in Notes 4, 5, and 6 of our Condensed Consolidated Financial Statements, certain of our Servicing Partners service and/or subservice a substantial portion of our interests in MSRs. In addition, Nationstar is currently the servicer for a significant portion of our loans, and the loans underlying our RMBS. If the servicing performance of one of our subservicers deteriorates, if one of our subservicers files for bankruptcy or if one of our subservicers is otherwise unwilling or unable to continue to subservice MSRs for us, our expected returns on these investments would be severely impacted. In addition, if a subservicer becomes subject to a regulatory consent order or similar enforcement proceeding, that regulatory action could adversely affect us in several ways. For example, the regulatory action could result in delays of transferring servicing from an interim subservicer to our designated successor subservicer or cause the subservicer’s performance to degrade. Any such development would negatively affect our expected returns on these investments, and such effect could be materially adverse to our business and results of operations. We closely monitor each subservicer’s mortgage servicing performance and overall operating performance, financial condition and liquidity, as well as its compliance with applicable regulations and GSE servicing guidelines. We have various information, access and inspection rights in our respective agreements with our subservicers that enable us to monitor their financial and operating performance and credit quality, which we periodically evaluate and discuss with each subservicer’s respective management. However, we have no direct ability to influence each subservicer’s performance, and our diligence cannot prevent, and may not even help us anticipate, a severe deterioration of each subservicer’s respective servicing performance on our MSR portfolio.\n110\nIn addition, a material portion of the consumer loans in which we have invested are serviced by OneMain. If OneMain is terminated as the servicer of some or all of these portfolios, or in the event that it files for bankruptcy or is otherwise unable to continue to service such loans, our expected returns on these investments could be severely impacted.\nMoreover, we are party to repurchase agreements with a limited number of counterparties. If any of our counterparties elected not to renew our repurchase agreements, we may not be able to find a replacement counterparty, which would have a material adverse effect on our financial condition.\nOur risk-management processes may not accurately anticipate the impact of market stress or counterparty financial condition, and as a result, we may not take sufficient action to reduce our risks effectively. Although we will monitor our credit exposures, default risk may arise from events or circumstances that are difficult to detect, foresee or evaluate. In addition, concerns about, or a default by, one large participant could lead to significant liquidity problems for other participants, which may in turn expose us to significant losses.\nIn the event of a counterparty default, particularly a default by a major investment bank or Servicing Partner, we could incur material losses rapidly, and the resulting market impact of a major counterparty default could seriously harm our business, results of operations, cash flows and financial condition. In the event that one of our counterparties becomes insolvent or files for bankruptcy, our ability to eventually recover any losses suffered as a result of that counterparty’s default may be limited by the liquidity of the counterparty or the applicable legal regime governing the bankruptcy proceeding.\nA bankruptcy of any of our Servicing Partners could materially and adversely affect us.\nIf any of our Servicing Partners becomes subject to a bankruptcy proceeding, we could be materially and adversely affected, and you could suffer losses, as discussed below.\nA sale of MSRs or interests in MSRs and servicer advances or other assets, including loans, could be re-characterized as a pledge of such assets in a bankruptcy proceeding.\nWe believe that a mortgage servicer’s transfer to us of MSRs or interests in MSRs and servicer advances or any other asset transferred pursuant to a related purchase agreement, including loans, constitutes a sale of such assets, in which case such assets would not be part of such servicer’s bankruptcy estate. The servicer (as debtor-in-possession in the bankruptcy proceeding), a bankruptcy trustee appointed in such servicer’s bankruptcy proceeding, or any other party in interest, however, might assert in a bankruptcy proceeding MSRs or interests in MSRs and servicer advances or any other assets transferred to us pursuant to the related purchase agreement were not sold to us but were instead pledged to us as security for such servicer’s obligation to repay amounts paid by us to the servicer pursuant to the related purchase agreement. We generally create and perfect security interests with respect to the MSRs that we acquire, though we do not do so in all instances. If such assertion were successful, all or part of the MSRs or interests in MSRs and servicer advances or any other asset transferred to us pursuant to the related purchase agreement would constitute property of the bankruptcy estate of such servicer, and our rights against the servicer could be those of a secured creditor with a lien on such present and future assets. Under such circumstances, cash proceeds generated from our collateral would constitute “cash collateral” under the provisions of the U.S. bankruptcy laws. Under U.S. bankruptcy laws, the servicer could not use our cash collateral without either (a) our consent or (b) approval by the bankruptcy court, subject to providing us with “adequate protection” under the U.S. bankruptcy laws. In addition, under such circumstances, an issue could arise as to whether certain of these assets generated after the commencement of the bankruptcy proceeding would constitute after-acquired property excluded from our entitlement pursuant to the U.S. bankruptcy laws.\nIf such a recharacterization occurs, the validity or priority of our security interest in the MSRs or interests in MSRs and servicer advances or other assets could be challenged in a bankruptcy proceeding of such servicer.\nIf the purchases pursuant to the related purchase agreement are recharacterized as secured financings as set forth above, we nevertheless created and perfected security interests with respect to the MSRs or interests in MSRs and servicer advances and other assets that we may have purchased from such servicer by including a pledge of collateral in the related purchase agreement and filing financing statements in appropriate jurisdictions. Nonetheless, to the extent we have created and perfected a security interest, our security interests may be challenged and ruled unenforceable, ineffective or subordinated by a bankruptcy court, and the amount of our claims may be disputed so as not to include all MSRs or interests in MSRs and servicer advances to be collected. If this were to occur, or if we have not created a security interest, then the servicer’s obligations to us with respect to purchased MSRs or interests in MSRs and servicer advances or other assets would be deemed unsecured obligations, payable from unencumbered assets to be shared among all of such servicer’s unsecured creditors. In addition, even if the security interests are found to be valid and enforceable, if a bankruptcy court determines that the value of the collateral is less than such servicer’s\n111\nunderlying obligations to us, the difference between such value and the total amount of such obligations will be deemed an unsecured “deficiency” claim and the same result will occur with respect to such unsecured claim. In addition, even if the security interest is found to be valid and enforceable, such servicer would have the right to use the proceeds of our collateral subject to either (a) our consent or (b) approval by the bankruptcy court, subject to providing us with “adequate protection” under U.S. bankruptcy laws. Such servicer also would have the ability to confirm a chapter 11 plan over our objections if the plan complied with the “cramdown” requirements under U.S. bankruptcy laws.\nPayments made by a servicer to us could be voided by a court under federal or state preference laws.\nIf one of our Servicing Partners were to file, or to become the subject of, a bankruptcy proceeding under the United States Bankruptcy Code or similar state insolvency laws, and our security interest (if any) is declared unenforceable, ineffective or subordinated, payments previously made by a servicer to us pursuant to the related purchase agreement may be recoverable on behalf of the bankruptcy estate as preferential transfers. Among other reasons, a payment could constitute a preferential transfer if a court were to find that the payment was a transfer of an interest of property of such servicer that:\n| • | Was made to or for the benefit of a creditor; |\n\n| • | Was for or on account of an antecedent debt owed by such servicer before that transfer was made; |\n\n| • | Was made while such servicer was insolvent (a company is presumed to have been insolvent on and during the 90 days preceding the date the company’s bankruptcy petition was filed); |\n\n| • | Was made on or within 90 days (or if we are determined to be a statutory insider, on or within one year) before such servicer’s bankruptcy filing; |\n\n| • | Permitted us to receive more than we would have received in a Chapter 7 liquidation case of such servicer under U.S. bankruptcy laws; and |\n\n| • | Was a payment as to which none of the statutory defenses to a preference action apply. |\n\nIf the court were to determine that any payments were avoidable as preferential transfers, we would be required to return such payments to such servicer’s bankruptcy estate and would have an unsecured claim against such servicer with respect to such returned amounts.\nPayments made to us by such servicer, or obligations incurred by it, could be voided by a court under federal or state fraudulent conveyance laws.\nThe mortgage servicer (as debtor-in-possession in the bankruptcy proceeding), a bankruptcy trustee appointed in such servicer’s bankruptcy proceeding, or another party in interest could also claim that such servicer’s transfer to us of MSRs or interests in MSRs and servicer advances or other assets or such servicer’s agreement to incur obligations to us under the related purchase agreement was a fraudulent conveyance. Under U.S. bankruptcy laws and similar state insolvency laws, transfers made or obligations incurred could be voided if, among other reasons, such servicer, at the time it made such transfers or incurred such obligations: (a) received less than reasonably equivalent value or fair consideration for such transfer or incurrence and (b) either (i) was insolvent at the time of, or was rendered insolvent by reason of, such transfer or incurrence; (ii) was engaged in, or was about to engage in, a business or transaction for which the assets remaining with such servicer were an unreasonably small capital; or (iii) intended to incur, or believed that it would incur, debts beyond its ability to pay such debts as they mature. If any transfer or incurrence is determined to be a fraudulent conveyance, our Servicing Partner, as applicable (as debtor-in-possession in the bankruptcy proceeding), or a bankruptcy trustee on such Servicing Partner’s behalf would be entitled to recover such transfer or to avoid the obligation previously incurred.\nAny purchase agreement pursuant to which we purchase interests in MSRs, servicer advances or other assets, including loans, or any subservicing agreement between us and a subservicer on our behalf could be rejected in a bankruptcy proceeding of one of our Servicing Partners or counterparties.\nA mortgage servicer (as debtor-in-possession in the bankruptcy proceeding) or a bankruptcy trustee appointed in such servicer’s or counterparty’s bankruptcy proceeding could seek to reject the related purchase agreement or subservicing agreement with a counterparty and thereby terminate such servicer’s or counterparty’s obligation to service the MSRs or interests in MSRs and servicer advances or any other asset transferred pursuant to such purchase agreement, and terminate our right to acquire additional assets under such purchase agreement and our right to require such servicer to use commercially reasonable efforts to transfer servicing. If the bankruptcy court approved the rejection, we would have a claim against such servicer or counterparty for any damages from the rejection, and the resulting transfer of our interests in MSRs or servicing of the MSRs relating to our Excess MSRs to another subservicer may result in significant cost and may negatively impact the value of our interests in MSRs.\n112\nA bankruptcy court could stay a transfer of servicing to another servicer.\nOur ability to terminate a subservicer or to require a mortgage servicer to use commercially reasonable efforts to transfer servicing rights to a new servicer would be subject to the automatic stay in such servicer’s bankruptcy proceeding. To enforce this right, we would have to seek relief from the bankruptcy court to lift such stay, and there is no assurance that the bankruptcy court would grant this relief.\nAny Subservicing Agreement could be rejected in a bankruptcy proceeding.\nIf one of our Servicing Partners were to file, or to become the subject of, a bankruptcy proceeding under the United States Bankruptcy Code or similar state insolvency laws, such Servicing Partner (as debtor-in-possession in the bankruptcy proceeding) or the bankruptcy trustee could reject its subservicing agreement with us and terminate such Servicing Partner’s obligation to service the MSRs, servicer advances or loans in which we have an investment. Any claim we have for damages arising from the rejection of a subservicing agreement would be treated as a general unsecured claim for purposes of distributions from such Servicing Partner’s bankruptcy estate.\nOur Servicing Partners could discontinue servicing.\nIf one of our Servicing Partners were to file, or to become the subject of, a bankruptcy proceeding under the United States Bankruptcy Code, such Servicing Partner could be terminated as servicer (with bankruptcy court approval) or could discontinue servicing, in which case there is no assurance that we would be able to continue receiving payments and transfers in respect of the interests in MSRs, servicer advances and other assets purchased under the related purchase agreement or subserviced under the related subservicing agreement. Even if we were able to obtain the servicing rights or terminate the related subservicer, we may need to engage an alternate subservicer (which may not be readily available on acceptable terms or at all) or negotiate a new subservicing agreement with such servicer, which presumably would be on less favorable terms to us. Any engagement of an alternate subservicer by us would require the approval of the related RMBS trustees or the Agencies, as applicable.\nAn automatic stay under the United States Bankruptcy Code may prevent the ongoing receipt of servicing fees or other amounts due.\nEven if we are successful in arguing that we own the interests in MSRs, servicer advances and other assets, including loans, purchased under the related purchase agreement, we may need to seek relief in the bankruptcy court to obtain turnover and payment of amounts relating to such assets, and there may be difficulty in recovering payments in respect of such assets that may have been commingled with other funds of such servicer.\nA bankruptcy of any of our Servicing Partners may default our MSR, Excess MSR and servicer advance financing facilities and negatively impact our ability to continue to purchase interests in MSRs.\nIf any of our Servicing Partners were to file for bankruptcy or become the subject of a bankruptcy proceeding, it could result in an event of default under certain of our financing facilities that would require the immediate paydown of such facilities. In this scenario, we may not be able to comply with our obligations to purchase interests in MSRs and servicer advances under the related purchase agreements. Notwithstanding this inability to purchase, the related seller may try to force us to continue making such purchases. If it is determined that we are in breach of our obligations under our purchase agreements, any claims that we may have against such related seller may be subject to offset against claims such seller may have against us by reason of this breach.\nCertain of our subsidiaries originate and service residential mortgage loans, which subject us to various operational risks that could have a negative impact on our financial results.\nAs a result of our previously disclosed acquisitions of Shellpoint Partners LLC and from Ditech, among others, certain subsidiaries of New Residential perform various mortgage and real estate related services, and have origination and servicing operations, which entail borrower-facing activities and employing personnel. Prior to such acquisitions, neither we nor any of our subsidiaries have previously originated or serviced loans directly, and owning entities that perform these and other operations could expose us to risks similar to those of our Servicing Partners, as well as various other risks, including, but not limited to those pertaining to:\n| • | risks related to compliance with applicable laws, regulations and other requirements; |\n\n| • | significant increases in delinquencies for the loans; |\n\n| • | compliance with the terms of related servicing agreements; |\n\n| • | financing related servicer advances and the origination business; |\n\n| • | expenses related to servicing high risk loans; |\n\n113\n| • | unrecovered or delayed recovery of servicing advances; |\n\n| • | a general risk in foreclosure rates, which may ultimately reduce the number of mortgages that we service (also see-“The residential mortgage loans underlying the securities we invest in and the loans we directly invest in are subject to delinquency, foreclosure and loss, which could result in losses to us.”); |\n\n| • | maintaining the size of the related servicing portfolio and the volume of the origination business; |\n\n| • | compliance with FHA underwriting guidelines; and |\n\n| • | termination of government mortgage refinancing programs. |\n\nAny of the foregoing risks, among others, could have a material adverse effect on our business, financial condition, results of operations and liquidity.\nOur subsidiaries that perform mortgage lending and servicing activities are subject to extensive regulation by federal, state and local governmental and regulatory authorities, and our subsidiaries' business results may be significantly impacted by the existing and future laws and regulations to which they are subject. If our subsidiaries performing mortgage lending and servicing activities fail to operate in compliance with both existing and future statutory, regulatory and other requirements, our business, financial condition, liquidity and/or results of operations could be materially and adversely affected.\nOur subsidiaries that perform mortgage lending and servicing activities are subject to extensive regulation by federal, state and local governmental and regulatory authorities, including the CFPB, the Federal Trade Commission, the U.S. Department of Housing and Urban Development (“HUD”), the U.S. Department of Veterans Affairs (“VA”), the SEC and various state agencies that license, audit, investigate and conduct examinations of such subsidiaries’ mortgage servicing, origination, debt collection, and other activities. In the current regulatory environment, the policies, laws, rules and regulations applicable to our subsidiaries’ mortgage origination and servicing businesses have been rapidly evolving. Federal, state or local governmental authorities may continue to enact laws, rules or regulations that will result in changes in our and our subsidiaries’ business practices and may materially increase the costs of compliance. We are unable to predict whether any such changes will adversely affect our business.\nWe and our subsidiaries must comply with a large number of federal, state and local consumer protection laws including, among others, the Dodd-Frank Act, the Gramm-Leach-Bliley Act, the Fair Debt Collection Practices Act, Real Estate Settlement Procedures Act, the Truth in Lending Act, the Fair Credit Reporting Act, the Servicemembers Civil Relief Act, the Homeowners Protection Act, the Federal Trade Commission Act, the Telephone Consumer Protection Act, the Equal Credit Opportunity Act, as well as individual state licensing and foreclosure laws and federal and local bankruptcy rules. These statutes apply to many facets of our subsidiaries’ businesses, including loan origination, default servicing and collections, use of credit reports, safeguarding of non-public personally identifiable information about customers, foreclosure and claims handling, investment of and interest payments on escrow balances and escrow payment features, and such statutes mandate certain disclosures and notices to borrowers. These requirements can and will change as statutes and regulations are enacted, promulgated, amended, interpreted and enforced.\nIn addition, the GSEs, Ginnie Mae and other business counterparties subject our subsidiaries’ mortgage origination and servicing businesses to periodic examinations, reviews and audits, and we routinely conduct our own internal examinations, reviews and audits. These various examinations, reviews and audits of our subsidiaries’ businesses and related activities may reveal deficiencies in such subsidiaries’ compliance with our policies and other requirements to which they are subject. While we strive to investigate and remediate such deficiencies, there can be no assurance that our internal investigations will reveal any deficiencies or that any remedial measures that we implement, which could involve material expense, will ensure compliance with applicable policies, laws, regulations and other requirements or be deemed sufficient by the GSEs, Ginnie Mae, federal and local governmental authorities or other interested parties.\nWe and our subsidiaries devote substantial resources to regulatory compliance and regulatory inquiries, and we incur, and expect to continue to incur, significant costs in connection therewith. Our business, financial condition, liquidity and/or results of operations could be materially and adversely affected by the substantial resources we devote to, and the significant compliance costs we incur in connection with, regulatory compliance and regulatory inquiries, including any fines, penalties, restitution or similar payments we may be required to make in connection with resolving such matters.\nThe actual or alleged failure of our mortgage origination and servicing subsidiaries to comply with applicable federal, state and local laws and regulations and GSE, Ginnie Mae and other business counterparty requirements, or to implement and adhere to adequate remedial measures designed to address any identified compliance deficiencies, could lead to:\n| • | the loss or suspension of licenses and approvals necessary to operate our or our subsidiaries’ business; |\n\n| • | limitations, restrictions or complete bans on our or our subsidiaries’ business or various segments of our business; |\n\n114\n| • | our or our subsidiaries’ disqualification from participation in governmental programs, including GSE, Ginnie Mae, and VA programs; |\n\n| • | breaches of covenants and representations under our servicing, debt, or other agreements; |\n\n| • | negative publicity and damage to our reputation; |\n\n| • | governmental investigations and enforcement actions; |\n\n| • | administrative fines and financial penalties; |\n\n| • | litigation, including class action lawsuits; |\n\n| • | civil and criminal liability; |\n\n| • | termination of our servicing and subservicing agreements or other contracts; |\n\n| • | demands for us to repurchase loans; |\n\n| • | loss of personnel who are targeted by prosecutions, investigations, enforcement actions or litigation; |\n\n| • | a significant increase in compliance costs; |\n\n| • | a significant increase in the resources we and our subsidiaries devote to regulatory compliance and regulatory inquiries; |\n\n| • | an inability to access new, or a default under or other loss of current, liquidity and funding sources necessary to operate our business; |\n\n| • | restrictions on our or our subsidiaries’ business activities; |\n\n| • | impairment of assets; and |\n\n| • | an inability to execute on our business strategy. |\n\nAny of these outcomes could materially and adversely affect our reputation, business, financial condition, prospects, liquidity and/or results of operations.\nWe cannot guarantee that any such scrutiny and investigations will not materially adversely affect us. Additionally, in recent years, the general trend among federal, state and local lawmakers and regulators has been toward increasing laws, regulations and investigative proceedings with regard to residential mortgage lenders and servicers. The CFPB continues to take an active role in supervising the mortgage industry, and its rule-making and regulatory agenda relating to loan servicing and originations continues to evolve. Individual states have also been increasingly active in supervising non-bank mortgage lenders and servicers such as NewRez, and certain regulators have communicated recommendations, expectations or demands with respect to areas such as corporate governance, safety and soundness, risk and compliance management, and cybersecurity, in addition to their focus on traditional licensing and examination matters.\nFollowing the 2018 Congressional elections, a level of heightened uncertainty exists with respect to the future of regulation of mortgage lending and servicing, including the future of the Dodd-Frank Act and CFPB. We cannot predict the specific legislative or executive actions that may result or what actions federal or state regulators might take in response to potential changes to the Dodd-Frank Act or to the federal regulatory environment generally. Such actions could impact the mortgage industry generally or us specifically, could impact our relationships with other regulators, and could adversely impact our business.\nThe CFPB and certain state regulators have increasingly focused on the use, and adequacy, of technology in the mortgage servicing industry. For example, in 2016, the CFPB issued a special edition supervision report that stressed the need for mortgage servicers to assess and make necessary improvements to their information technology systems in order to ensure compliance with the CFPB’s mortgage servicing requirements. The New York Department of Financial Services (“NY DFS”) also issued Cybersecurity Requirements for Financial Services Companies, effective in 2017, which requires banks, insurance companies, and other financial services institutions regulated by the NY DFS to establish and maintain a cybersecurity program designed to protect consumers and ensure the safety and soundness of New York State’s financial services industry. In addition, in June 2018, the State of California signed into law the California Consumer Privacy Act (“CCPA”), which will become effective in January 2020, will require businesses that maintain personal information of California residents, including certain mortgage lenders and servicers, to notify certain consumers when collecting their data, respond to consumer requests relating to the uses of their data, verify the identities of consumers who make requests, disclose details regarding transactions involving their data, and maintain records of consumer’ requests relating to their data, among various other obligations, and to create procedures designed to comply with CCPA requirements. The CCPA will become effective on January 1, 2020, and its implementing regulations are in the process of becoming finalized. The impact of the CCPA and its implementing regulations on our mortgage origination and servicing businesses remains uncertain, and may result in an increase in legal and compliance costs.\nNew regulatory and legislative measures, or changes in enforcement practices, including those related to the technology we use, could, either individually or in the aggregate, require significant changes to our business practices, impose additional costs on us, limit our product offerings, limit our ability to efficiently pursue business opportunities, negatively impact asset values or reduce our revenues. Accordingly, any of the foregoing could materially and adversely affect our business and our financial condition, liquidity and results of operations.\n115\nA failure to maintain minimum servicer ratings could have an adverse effect on our business, financing activities, financial condition or results of operations.\nS&P, Moody’s and Fitch rates Shellpoint Mortgage Servicing as a residential loan servicer, and a downgrade, or failure to maintain, any of our servicer ratings could:\n| • | adversely affect our ability to maintain our status as an approved servicer by Fannie Mae and Freddie Mac; |\n\n| • | adversely affect our ability to finance servicing advances and certain other assets; |\n\n| • | lead to the early termination of existing advance facilities and affect the terms and availability of advance facilities that we may seek in the future; |\n\n| • | cause our termination as servicer in our servicing agreements that require that we maintain specified servicer ratings; and |\n\n| • | further impair our ability to consummate future servicing transactions. |\n\nAny of the above could adversely affect our business, financial condition and results of operations.\nGSE initiatives and other actions, including changes to the minimum servicing amount for GSE loans, could occur at any time and could impact us in significantly negative ways that we are unable to predict or protect against.\nThe Federal Housing Finance Agency (“FHFA”) and other industry stakeholders or regulators may implement or require changes to current mortgage servicing practices and compensation that could have a material adverse effect on the economics or performance of our investments in MSRs.\nCurrently, when a loan is sold into the secondary market for Fannie Mae or Freddie Mac loans, the servicer is generally required to retain a minimum servicing amount (“MSA”) of 25 basis points of the UPB for fixed rate mortgages. As has been widely publicized, in September 2011, the FHFA announced that a Joint Initiative on Mortgage Servicing Compensation was seeking public comment on two alternative mortgage servicing compensation structures detailed in a discussion paper. Changes to the MSA structure could significantly impact our business in negative ways that we cannot predict or protect against. For example, the elimination of a MSA could radically change the mortgage servicing industry and could severely limit the supply of interests in MSRs available for sale. In addition, a removal of, or reduction in, the MSA could significantly reduce the recapture rate on the affected loan portfolio, which would negatively affect the investment return on our interests in MSRs. We cannot predict whether any changes to current MSA rules will occur or what impact any changes will have on our business, results of operations, liquidity or financial condition.\nOur interests in MSRs may involve complex or novel structures.\nInterests in MSRs may entail new types of transactions and may involve complex or novel structures. Accordingly, the risks associated with the transactions and structures are not fully known to buyers and sellers. In the case of interests in MSRs on Agency pools, Agencies may require that we submit to costly or burdensome conditions as a prerequisite to their consent to an investment in, or our financing of, interests in MSRs on Agency pools. Agency conditions, including capital requirements, may diminish or eliminate the investment potential of interests in MSRs on Agency pools by making such investments too expensive for us or by severely limiting the potential returns available from interests in MSRs on Agency pools.\nIt is possible that an Agency’s views on whether any such acquisition structure is appropriate or acceptable may not be known to us when we make an investment and may change from time to time for any reason or for no reason, even with respect to a completed investment. An Agency’s evolving posture toward an acquisition or disposition structure through which we invest in or dispose of interests in MSRs on Agency pools may cause such Agency to impose new conditions on our existing interests in MSRs on Agency pools, including the owner’s ability to hold such interests in MSRs on Agency pools directly or indirectly through a grantor trust or other means. Such new conditions may be costly or burdensome and may diminish or eliminate the investment potential of the interests in MSRs on Agency pools that are already owned by us. Moreover, obtaining such consent may require us or our co-investment counterparties to agree to material structural or economic changes, as well as agree to indemnification or other terms that expose us to risks to which we have not previously been exposed and that could negatively affect our returns from our investments.\nOur ability to finance the MSRs and servicer advances acquired in the MSR Transactions may depend on the related Servicing Partner’s cooperation with our financing sources and compliance with certain covenants.\nWe have in the past and intend to continue to finance some or all of the MSRs or servicer advances acquired in the MSR Transactions, and as a result, we will be subject to substantial operational risks associated with the related Servicing Partners. In our current financing facilities for interests in MSRs and servicer advances, the failure of the related Servicing Partner to satisfy various\n116\ncovenants and tests can result in an amortization event and/or an event of default. Our financing sources may require us to include similar provisions in any financing we obtain relating to the MSRs and servicer advances acquired in the MSR Transactions. If we decide to finance such assets, we will not have the direct ability to control any party’s compliance with any such covenants and tests and the failure of any party to satisfy any such covenants or tests could result in a partial or total loss on our investment. Some financing sources may be unwilling to finance any assets acquired in the MSR Transactions.\nIn addition, any financing for the MSRs and servicer advances acquired in the MSR Transactions may be subject to regulatory approval and the agreement of the relevant Servicing Partner to be party to such financing agreements. If we cannot get regulatory approval or these parties do not agree to be a party to such financing agreements, we may not be able to obtain financing on favorable terms or at all.\nMortgage servicing is heavily regulated at the U.S. federal, state and local levels, and each transfer of MSRs to our subservicer of such MSRs may not be approved by the requisite regulators.\nMortgage servicers must comply with U.S. federal, state and local laws and regulations. These laws and regulations cover topics such as licensing; allowable fees and loan terms; permissible servicing and debt collection practices; limitations on forced-placed insurance; special consumer protections in connection with default and foreclosure; and protection of confidential, nonpublic consumer information. The volume of new or modified laws and regulations has increased in recent years, and states and individual cities and counties continue to enact laws that either restrict or impose additional obligations in connection with certain loan origination, acquisition and servicing activities in those cities and counties. The laws and regulations are complex and vary greatly among the states and localities, and in some cases, these laws are in conflict with each other or with U.S. federal law. In connection with the MSR Transactions, there is no assurance that each transfer of MSRs to our selected subservicer will be approved by the requisite regulators. If regulatory approval for each such transfer is not obtained, we may incur additional costs and expenses in connection with the approval of another replacement subservicer.\nWe do not have legal title to the MSRs underlying our Excess MSRs or certain of our Servicer Advance Investments.\nWe do not have legal title to the MSRs underlying our Excess MSRs or certain of the MSRs related to the transactions contemplated by the purchase agreements pursuant to which we acquire Servicer Advance Investments or MSR financing receivables from Ocwen, SLS and Nationstar, and are subject to increased risks as a result of the related servicer continuing to own the mortgage servicing rights. The validity or priority of our interest in the underlying mortgage servicing could be challenged in a bankruptcy proceeding of the servicer, and the related purchase agreement could be rejected in such proceeding. Any of the foregoing events might have a material adverse effect on our business, financial condition, results of operations and liquidity. As part of the Ocwen Transaction, we and Ocwen have agreed to cooperate to obtain any third party consents required to transfer Ocwen’s remaining interest in the Ocwen Subject MSRs to us. As noted above, however, there is no assurance that we will be successful in obtaining those consents.\nMany of our investments may be illiquid, and this lack of liquidity could significantly impede our ability to vary our portfolio in response to changes in economic and other conditions or to realize the value at which such investments are carried if we are required to dispose of them.\nMany of our investments are illiquid. Illiquidity may result from the absence of an established market for the investments, as well as legal or contractual restrictions on their resale, refinancing or other disposition. Dispositions of investments may be subject to contractual and other limitations on transfer or other restrictions that would interfere with subsequent sales of such investments or adversely affect the terms that could be obtained upon any disposition thereof.\nInterests in MSRs are highly illiquid and may be subject to numerous restrictions on transfers, including without limitation the receipt of third-party consents. For example, the Servicing Guidelines of a mortgage owner may require that holders of Excess MSRs obtain the mortgage owner’s prior approval of any change of direct ownership of such Excess MSRs. Such approval may be withheld for any reason or no reason in the discretion of the mortgage owner. Moreover, we have not received and do not expect to receive any assurances from any GSEs that their conditions for the sale by us of any interests in MSRs will not change. Therefore, the potential costs, issues or restrictions associated with receiving such GSEs’ consent for any such dispositions by us cannot be determined with any certainty. Additionally, interests in MSRs may entail complex transaction structures and the risks associated with the transactions and structures are not fully known to buyers or sellers. As a result of the foregoing, we may be unable to locate a buyer at the time we wish to sell interests in MSRs. There is some risk that we will be required to dispose of interests in MSRs either through an in-kind distribution or other liquidation vehicle, which will, in either case, provide little or no economic benefit to us, or a sale to a co-investor in the interests in MSRs, which may be an affiliate. Accordingly, we cannot provide any assurance that we will obtain any return or any benefit of any kind from any disposition of interests in MSRs. We may not benefit\n117\nfrom the full term of the assets and for the aforementioned reasons may not receive any benefits from the disposition, if any, of such assets.\nIn addition, some of our real estate and other securities may not be registered under the relevant securities laws, resulting in a prohibition against their transfer, sale, pledge or other disposition except in a transaction that is exempt from the registration requirements of, or is otherwise in accordance with, those laws. There are also no established trading markets for a majority of our intended investments. Moreover, certain of our investments, including our investments in consumer loans and certain of our interests in MSRs, are made indirectly through a vehicle that owns the underlying assets. Our ability to sell our interest may be contractually limited or prohibited. As a result, our ability to vary our portfolio in response to changes in economic and other conditions may be limited.\nOur real estate and other securities have historically been valued based primarily on third-party quotations, which are subject to significant variability based on the liquidity and price transparency created by market trading activity. A disruption in these trading markets could reduce the trading for many real estate and other securities, resulting in less transparent prices for those securities, which would make selling such assets more difficult. Moreover, a decline in market demand for the types of assets that we hold would make it more difficult to sell our assets. If we are required to liquidate all or a portion of our illiquid investments quickly, we may realize significantly less than the amount at which we have previously valued these investments.\nMarket conditions could negatively impact our business, results of operations, cash flows and financial condition.\nThe market in which we operate is affected by a number of factors that are largely beyond our control but can nonetheless have a potentially significant, negative impact on us. These factors include, among other things:\n\n| • | interest rates and credit spreads; |\n\n| • | the availability of credit, including the price, terms and conditions under which it can be obtained; |\n\n| • | the quality, pricing and availability of suitable investments; |\n\n| • | the ability to obtain accurate market-based valuations; |\n\n| • | the ability of securities dealers to make markets in relevant securities and loans; |\n\n| • | loan values relative to the value of the underlying real estate assets; |\n\n| • | default rates on the loans underlying our investments and the amount of the related losses, and credit losses with respect to our investments; |\n\n| • | prepayment and repayment rates, delinquency rates and legislative/regulatory changes with respect to our investments, and the timing and amount of servicer advances; |\n\n| • | the availability and cost of quality Servicing Partners, and advance, recovery and recapture rates; |\n\n| • | competition; |\n\n| • | the actual and perceived state of the real estate markets, bond markets, market for dividend-paying stocks and public capital markets generally; |\n\n| • | unemployment rates; and |\n\n| • | the attractiveness of other types of investments relative to investments in real estate or REITs generally. |\n\nChanges in these factors are difficult to predict, and a change in one factor can affect other factors. For example, at various points in time, increased default rates in the subprime mortgage market played a role in causing credit spreads to widen, reducing availability of credit on favorable terms, reducing liquidity and price transparency of real estate related assets, resulting in difficulty in obtaining accurate mark-to-market valuations, and causing a negative perception of the state of the real estate markets and of REITs generally. Market conditions could be volatile or could deteriorate as a result of a variety of factors beyond our control with adverse effects to our financial condition.\nThe geographic distribution of the loans underlying, and collateral securing, certain of our investments subjects us to geographic real estate market risks, which could adversely affect the performance of our investments, our results of operations and financial condition.\nThe geographic distribution of the loans underlying, and collateral securing, our investments, including our interests in MSRs, servicer advances, Non-Agency RMBS and loans, exposes us to risks associated with the real estate and commercial lending industry in general within the states and regions in which we hold significant investments. These risks include, without limitation: possible declines in the value of real estate; risks related to general and local economic conditions; possible lack of availability of mortgage funds; overbuilding; extended vacancies of properties; increases in competition, property taxes and operating expenses; changes in zoning laws; increased energy costs; unemployment; costs resulting from the clean-up of, and liability to third parties for damages resulting from, environmental problems; casualty or condemnation losses; uninsured damages from floods, hurricanes, earthquakes or other natural disasters; and changes in interest rates.\n118\nAs of September 30, 2019, 24.9% and 23.0% of the total UPB of the residential mortgage loans underlying our Excess MSRs and MSRs, respectively, was secured by properties located in California, which are particularly susceptible to natural disasters such as fires, earthquakes and mudslides. 7.6% and 6.8% of the total UPB of the residential mortgage loans underlying our Excess MSRs and MSRs, respectively, was secured by properties located in Florida, which are particularly susceptible to natural disasters such as hurricanes and floods. As of September 30, 2019, 38.4% of the collateral securing our Non-Agency RMBS was located in the Western U.S., 24.1% was located in the Southeastern U.S., 21.2% was located in the Northeastern U.S., 9.8% was located in the Midwestern U.S. and 6.4% was located in the Southwestern U.S. We were unable to obtain geographical information for 0.1% of the collateral. As a result of this concentration, we may be more susceptible to adverse developments in those markets than if we owned a more geographically diverse portfolio. To the extent any of the foregoing risks arise in states and regions where we hold significant investments, the performance of our investments, our results of operations, cash flows and financial condition could suffer a material adverse effect.\nThe value of our interests in MSRs, servicer advances, residential mortgage loans and RMBS may be adversely affected by deficiencies in servicing and foreclosure practices, as well as related delays in the foreclosure process.\nAllegations of deficiencies in servicing and foreclosure practices among several large sellers and servicers of residential mortgage loans that surfaced in 2010 raised various concerns relating to such practices, including the improper execution of the documents used in foreclosure proceedings (so-called “robo signing”), inadequate documentation of transfers and registrations of mortgages and assignments of loans, improper modifications of loans, violations of representations and warranties at the date of securitization and failure to enforce put-backs.\nAs a result of alleged deficiencies in foreclosure practices, a number of servicers temporarily suspended foreclosure proceedings beginning in the second half of 2010 while they evaluated their foreclosure practices. In late 2010, a group of state attorneys general and state bank and mortgage regulators representing nearly all 50 states and the District of Columbia, along with the U.S. Justice Department and U.S. Department of Housing and Urban Development (“HUD”), began an investigation into foreclosure practices of banks and servicers. The investigations and lawsuits by several state attorneys general led to a settlement agreement in early February 2012 with five of the nation’s largest banks, pursuant to which the banks agreed to pay more than $25.0 billion to settle claims relating to improper foreclosure practices. The settlement does not prohibit the states, the federal government, individuals or investors from pursuing additional actions against the banks and servicers in the future.\nUnder the terms of the agreements governing our Servicer Advance Investments and MSRs, we (in certain cases, together with third-party co-investors) are required to make or purchase from certain of our Servicing Partners, servicer advances on certain loan pools. While a residential mortgage loan is in foreclosure, servicers are generally required to continue to advance delinquent principal and interest and to also make advances for delinquent taxes and insurance and foreclosure costs and the upkeep of vacant property in foreclosure to the extent it determines that such amounts are recoverable. Servicer advances are generally recovered when the delinquency is resolved.\nForeclosure moratoria or other actions that lengthen the foreclosure process increase the amount of servicer advances we or our Servicing Partners are required to make and we are required to purchase, lengthen the time it takes for us to be repaid for such advances and increase the costs incurred during the foreclosure process. In addition, servicer advance financing facilities contain provisions that modify the advance rates for, and limit the eligibility of, servicer advances to be financed based on the length of time that servicer advances are outstanding, and, as a result, an increase in foreclosure timelines could further increase the amount of servicer advances that we need to fund with our own capital. Such increases in foreclosure timelines could increase our need for capital to fund servicer advances (which do not bear interest), which would increase our interest expense, reduce the value of our investment and potentially reduce the cash that we have available to pay our operating expenses or to pay dividends.\nEven in states where servicers have not suspended foreclosure proceedings or have lifted (or will soon lift) any such delayed foreclosures, servicers, including our Servicing Partners, have faced, and may continue to face, increased delays and costs in the foreclosure process. For example, the current legislative and regulatory climate could lead borrowers to contest foreclosures that they would not otherwise have contested under ordinary circumstances, and servicers may incur increased litigation costs if the validity of a foreclosure action is challenged by a borrower. In general, regulatory developments with respect to foreclosure practices could result in increases in the amount of servicer advances and the length of time to recover servicer advances, fines or increases in operating expenses, and decreases in the advance rate and availability of financing for servicer advances. This would lead to increased borrowings, reduced cash and higher interest expense which could negatively impact our liquidity and profitability. Although the terms of our Servicer Advance Investments contain adjustment mechanisms that would reduce the amount of performance fees payable to the related Servicing Partner if servicer advances exceed pre-determined amounts, those fee reductions may not be sufficient to cover the expenses resulting from longer foreclosure timelines.\n119\nThe integrity of the servicing and foreclosure processes is critical to the value of the residential mortgage loans in which we invest and of the portfolios of loans underlying our interests in MSRs and RMBS, and our financial results could be adversely affected by deficiencies in the conduct of those processes. For example, delays in the foreclosure process that have resulted from investigations into improper servicing practices may adversely affect the values of, and result in losses on, these investments. Foreclosure delays may also increase the administrative expenses of the securitization trusts for the RMBS, thereby reducing the amount of funds available for distribution to investors.\nIn addition, the subordinate classes of securities issued by the securitization trusts may continue to receive interest payments while the defaulted loans remain in the trusts, rather than absorbing the default losses. This may reduce the amount of credit support available for senior classes of RMBS that we may own, thus possibly adversely affecting these securities. Additionally, a substantial portion of the $25.0 billion settlement is a “credit” to the banks and servicers for principal write-downs or reductions they may make to certain mortgages underlying RMBS. There remains uncertainty as to how these principal reductions will work and what effect they will have on the value of related RMBS. As a result, there can be no assurance that any such principal reductions will not adversely affect the value of our interests in MSRs and RMBS.\nWhile we believe that the sellers and servicers would be in violation of the applicable Servicing Guidelines to the extent that they have improperly serviced mortgage loans or improperly executed documents in foreclosure or bankruptcy proceedings, or do not comply with the terms of servicing contracts when deciding whether to apply principal reductions, it may be difficult, expensive, time consuming and, ultimately, uneconomic for us to enforce our contractual rights. While we cannot predict exactly how the servicing and foreclosure matters or the resulting litigation or settlement agreements will affect our business, there can be no assurance that these matters will not have an adverse impact on our results of operations, cash flows and financial condition.\nA failure by any or all of the members of Buyer to make capital contributions for amounts required to fund servicer advances could result in an event of default under our advance facilities and a complete loss of our investment.\nNew Residential and third-party co-investors, through a joint venture entity (Advance Purchaser LLC, the “Buyer”) have agreed to purchase all future arising servicer advances from Nationstar under certain residential mortgage servicing agreements. Buyer relies, in part, on its members to make committed capital contributions in order to pay the purchase price for future servicer advances. A failure by any or all of the members to make such capital contributions for amounts required to fund servicer advances could result in an event of default under our advance facilities and a complete loss of our investment.\nThe residential mortgage loans underlying the securities we invest in and the loans we directly invest in are subject to delinquency, foreclosure and loss, which could result in losses to us.\nThe ability of a borrower to repay a loan secured by a residential property is dependent upon the income or assets of the borrower. A number of factors may impair borrowers’ abilities to repay their loans, including, among other things, changes in the borrower’s employment status, changes in national, regional or local economic conditions, changes in interest rates or the availability of credit on favorable terms, changes in regional or local real estate values, changes in regional or local rental rates and changes in real estate taxes.\nOur mortgage backed securities are securities backed by mortgage loans. Many of the RMBS in which we invest are backed by collateral pools of subprime residential mortgage loans. “Subprime” mortgage loans refer to mortgage loans that have been originated using underwriting standards that are less restrictive than the underwriting requirements used as standards for other first and junior lien mortgage loan purchase programs, such as the programs of Fannie Mae and Freddie Mac. These lower standards include mortgage loans made to borrowers having imperfect or impaired credit histories (including outstanding judgments or prior bankruptcies), mortgage loans where the amount of the loan at origination is 80% or more of the value of the mortgage property, mortgage loans made to borrowers with low credit scores, mortgage loans made to borrowers who have other debt that represents a large portion of their income and mortgage loans made to borrowers whose income is not required to be disclosed or verified. Subprime mortgage loans may experience delinquency, foreclosure, bankruptcy and loss rates that are higher, and that may be substantially higher, than those experienced by mortgage loans underwritten in a more traditional manner. To the extent losses are realized on the loans underlying the securities in which we invest, we may not recover the amount invested in, or, in extreme cases, any of our investment in such securities.\nResidential mortgage loans, including manufactured housing loans and subprime mortgage loans are secured by single-family residential property and are also subject to risks of delinquency and foreclosure, and risks of loss. A significant portion of the residential mortgage loans that we acquire are, or may become, sub-performing loans, non-performing loans or REO assets where the borrower has failed to make timely payments of principal and/or interest. As part of the residential mortgage loan portfolios we purchase, we also may acquire performing loans that are or subsequently become sub-performing or non-performing, meaning the borrowers fail to timely pay some or all of the required payments of principal and/or interest. Under current market conditions,\n120\nit is likely that some of these loans will have current loan-to-value ratios in excess of 100%, meaning the amount owed on the loan exceeds the value of the underlying real estate.\nIn the event of default under a residential mortgage loan held directly by us, we will bear a risk of loss of principal to the extent of any deficiency between the value of the collateral and the outstanding principal and accrued but unpaid interest of the loan. Even though we typically pay less than the amount owed on these loans to acquire them, if actual results differ from our assumptions in determining the price we paid to acquire such loans, we may incur significant losses. In addition, we may acquire REO assets directly, which involves the same risks. Any loss we incur may be significant and could materially and adversely affect us.\nOur investments in real estate and other securities are subject to changes in credit spreads as well as available market liquidity, which could adversely affect our ability to realize gains on the sale of such investments.\nReal estate and other securities are subject to changes in credit spreads. Credit spreads measure the yield demanded on securities by the market based on their credit relative to a specific benchmark.\nFixed rate securities are valued based on a market credit spread over the rate payable on fixed rate U.S. Treasuries of like maturity. Floating rate securities are valued based on a market credit spread over LIBOR and are affected similarly by changes in LIBOR spreads. As of September 30, 2019, 68.6% of our Non-Agency RMBS Portfolio consisted of floating rate securities and 31.4% consisted of fixed rate securities, and 100.0% of our Agency RMBS portfolio consisted of fixed rate securities, based on the amortized cost basis of all securities (including the amortized cost basis of interest-only and residual classes). Excessive supply of these securities combined with reduced demand will generally cause the market to require a higher yield on these securities, resulting in the use of a higher, or “wider,” spread over the benchmark rate to value such securities. Under such conditions, the value of our real estate and other securities portfolios would tend to decline. Conversely, if the spread used to value such securities were to decrease, or “tighten,” the value of our real estate and other securities portfolio would tend to increase. Such changes in the market value of our real estate securities portfolios may affect our net equity, net income or cash flow directly through their impact on unrealized gains or losses on available-for-sale securities, and therefore our ability to realize gains on such securities, or indirectly through their impact on our ability to borrow and access capital. Widening credit spreads could cause the net unrealized gains on our securities and derivatives, recorded in accumulated other comprehensive income or retained earnings, and therefore our book value per share, to decrease and result in net losses.\nPrepayment rates on our residential mortgage loans and those underlying our real estate and other securities may adversely affect our profitability.\nIn general, residential mortgage loans may be prepaid at any time without penalty. Prepayments result when homeowners/mortgagors satisfy (i.e., pay off) the mortgage upon selling or refinancing their mortgaged property. When we acquire a particular loan or security, we anticipate that the loan or underlying residential mortgage loans will prepay at a projected rate which, together with expected coupon income, provides us with an expected yield on such investments. If we purchase assets at a premium to par value, and borrowers prepay their mortgage loans faster than expected, the corresponding prepayments on our assets may reduce the expected yield on such assets because we will have to amortize the related premium on an accelerated basis. Conversely, if we purchase assets at a discount to par value, when borrowers prepay their mortgage loans slower than expected, the decrease in corresponding prepayments on our assets may reduce the expected yield on such assets because we will not be able to accrete the related discount as quickly as originally anticipated.\nPrepayment rates on loans are influenced by changes in mortgage and market interest rates and a variety of economic, geographic, political and other factors, all of which are beyond our control. Consequently, such prepayment rates cannot be predicted with certainty and no strategy can completely insulate us from prepayment or other such risks. In periods of declining interest rates, prepayment rates on mortgage loans generally increase. If general interest rates decline at the same time, the proceeds of such prepayments received during such periods are likely to be reinvested by us in assets yielding less than the yields on the assets that were prepaid. In addition, the market value of our loans and real estate and other securities may, because of the risk of prepayment, benefit less than other fixed-income securities from declining interest rates.\nWe may purchase assets that have a higher or lower coupon rate than the prevailing market interest rates. In exchange for a higher coupon rate, we would then pay a premium over par value to acquire these securities. In accordance with GAAP, we would amortize the premiums over the life of the related assets. If the mortgage loans securing these assets prepay at a more rapid rate than anticipated, we would have to amortize our premiums on an accelerated basis which may adversely affect our profitability. As compensation for a lower coupon rate, we would then pay a discount to par value to acquire these assets. In accordance with GAAP, we would accrete any discounts over the life of the related assets. If the mortgage loans securing these assets prepay at a slower rate than anticipated, we would have to accrete our discounts on an extended basis which may adversely affect our\n121\nprofitability. Defaults on the mortgage loans underlying Agency RMBS typically have the same effect as prepayments because of the underlying Agency guarantee.\nPrepayments, which are the primary feature of mortgage backed securities that distinguish them from other types of bonds, are difficult to predict and can vary significantly over time. As the holder of the security, on a monthly basis, we receive a payment equal to a portion of our investment principal in a particular security as the underlying mortgages are prepaid. In general, on the date each month that principal prepayments are announced (i.e., factor day), the value of our real estate related security pledged as collateral under our repurchase agreements is reduced by the amount of the prepaid principal and, as a result, our lenders will typically initiate a margin call requiring the pledge of additional collateral or cash, in an amount equal to such prepaid principal, in order to re-establish the required ratio of borrowing to collateral value under such repurchase agreements. Accordingly, with respect to our Agency RMBS, the announcement on factor day of principal prepayments is in advance of our receipt of the related scheduled payment, thereby creating a short-term receivable for us in the amount of any such principal prepayments. However, under our repurchase agreements, we may receive a margin call relating to the related reduction in value of our Agency RMBS and, prior to receipt of this short-term receivable, be required to post additional collateral or cash in the amount of the principal prepayment on or about factor day, which would reduce our liquidity during the period in which the short-term receivable is outstanding. As a result, in order to meet any such margin calls, we could be forced to sell assets in order to maintain liquidity. Forced sales under adverse market conditions may result in lower sales prices than ordinary market sales made in the normal course of business. If our real estate and other securities were liquidated at prices below our amortized cost (i.e., the cost basis) of such assets, we would incur losses, which could adversely affect our earnings. In addition, in order to continue to earn a return on this prepaid principal, we must reinvest it in additional real estate and other securities or other assets; however, if interest rates decline, we may earn a lower return on our new investments as compared to the real estate and other securities that prepay.\nPrepayments may have a negative impact on our financial results, the effects of which depend on, among other things, the timing and amount of the prepayment delay on our Agency RMBS, the amount of unamortized premium or discount on our loans and real estate and other securities, the rate at which prepayments are made on our Non-Agency RMBS, the reinvestment lag and the availability of suitable reinvestment opportunities.\nOur investments in loans, REO and RMBS may be subject to significant impairment charges, which would adversely affect our results of operations.\nWe are required to periodically evaluate our investments for impairment indicators. The judgment regarding the existence of impairment indicators is based on a variety of factors depending upon the nature of the investment and the manner in which the income related to such investment was calculated for purposes of our financial statements. If we determine that an impairment has occurred, we are required to make an adjustment to the net carrying value of the investment, which would adversely affect our results of operations in the applicable period and thereby adversely affect our ability to pay dividends to our stockholders.\nThe lenders under our financing agreements may elect not to extend financing to us, which could quickly and seriously impair our liquidity.\nWe finance a meaningful portion of our investments with repurchase agreements and other short-term financing arrangements. Under the terms of repurchase agreements, we will sell an asset to the lending counterparty for a specified price and concurrently agree to repurchase the same asset from our counterparty at a later date for a higher specified price. During the term of the repurchase agreement—which can be as short as 30 days—the counterparty will make funds available to us and hold the asset as collateral. Our counterparties can also require us to post additional margin as collateral at any time during the term of the agreement. When the term of a repurchase agreement ends, we will be required to repurchase the asset for the specified repurchase price, with the difference between the sale and repurchase prices serving as the equivalent of paying interest to the counterparty in return for extending financing to us. If we want to continue to finance the asset with a repurchase agreement, we ask the counterparty to extend—or “roll”—the repurchase agreement for another term.\nOur counterparties are not required to roll our repurchase agreements or other financing agreements upon the expiration of their stated terms, which subjects us to a number of risks. Counterparties electing to roll our financing agreements may charge higher spread and impose more onerous terms upon us, including the requirement that we post additional margin as collateral. More significantly, if a financing agreement counterparty elects not to extend our financing, we would be required to pay the counterparty in full on the maturity date and find an alternate source of financing. Alternate sources of financing may be more expensive, contain more onerous terms or simply may not be available. If we were unable to pay the repurchase price for any asset financed with a repurchase agreement, the counterparty has the right to sell the asset being held as collateral and require us to compensate it for any shortfall between the value of our obligation to the counterparty and the amount for which the collateral was sold (which may be a significantly discounted price). Moreover, our financing agreement obligations are currently with a limited number of counterparties. If any of our counterparties elected not to roll our financing agreements, we may not be able to find a replacement\n122\ncounterparty in a timely manner. Finally, some of our financing agreements contain covenants and our failure to comply with such covenants could result in a loss of our investment.\nThe financing sources under our servicer advance financing facilities may elect not to extend financing to us or may have or take positions adverse to us, which could quickly and seriously impair our liquidity.\nWe finance a meaningful portion of our Servicer Advance Investments and servicer advances receivable with structured financing arrangements. These arrangements are commonly of a short-term nature. These arrangements are generally accomplished by having the named servicer, if the named servicer is a subsidiary of the Company, or the purchaser of such Servicer Advance Investments (which is a subsidiary of the Company) transfer our right to repayment for certain servicer advances that we have as servicer under the relevant Servicing Guidelines or that we have acquired from one of our Servicing Partners, as applicable, to one of our wholly owned bankruptcy remote subsidiaries (a “Depositor”). We are generally required to continue to transfer to the related Depositor all of our rights to repayment for any particular pool of servicer advances as they arise (and, if applicable, are transferred from one of our Servicing Partners) until the related financing arrangement is paid in full and is terminated. The related Depositor then transfers such rights to an “Issuer.” The Issuer then issues limited recourse notes to the financing sources backed by such rights to repayment.\nThe outstanding balance of servicer advances securing these arrangements is not likely to be repaid on or before the maturity date of such financing arrangements. Accordingly, we rely heavily on our financing sources to extend or refinance the terms of such financing arrangements. Our financing sources are not required to extend the arrangements upon the expiration of their stated terms, which subjects us to a number of risks. Financing sources electing to extend may charge higher interest rates and impose more onerous terms upon us, including without limitation, lowering the amount of financing that can be extended against any particular pool of servicer advances.\nIf a financing source is unable or unwilling to extend financing, including, but not limited to, due to legal or regulatory matters applicable to us or our Servicing Partners, the related Issuer will be required to repay the outstanding balance of the financing on the related maturity date. Additionally, there may be substantial increases in the interest rates under a financing arrangement if the related notes are not repaid, extended or refinanced prior to the expected repayment dated, which may be before the related maturity date. If an Issuer is unable to pay the outstanding balance of the notes, the financing sources generally have the right to foreclose on the servicer advances pledged as collateral.\nCurrently, certain of the notes issued under our structured servicer advance financing arrangements accrue interest at a floating rate of interest. Servicer advances are non-interest bearing assets. Accordingly, if there is an increase in prevailing interest rates and/or our financing sources increase the interest rate “margins” or “spreads.” the amount of financing that we could obtain against any particular pool of servicer advances may decrease substantially and/or we may be required to obtain interest rate hedging arrangements. There is no assurance that we will be able to obtain any such interest rate hedging arrangements.\nAlternate sources of financing may be more expensive, contain more onerous terms or simply may not be available. Moreover, our structured servicer advance financing arrangements are currently with a limited number of counterparties. If any of our sources are unable to or elected not to extend or refinance such arrangements, we may not be able to find a replacement counterparty in a timely manner.\nMany of our servicer advance financing arrangements are provided by financial institutions with whom we have substantial relationships. Some of our servicer advance financing arrangements entail the issuance of term notes to capital markets investors with whom we have little or no relationships or the identities of which we may not be aware and, therefore, we have no ability to control or monitor the identity of the holders of such term notes. Holders of such term notes may have or may take positions - for example, “short” positions in our stock or the stock of our servicers - that could be benefited by adverse events with respect to us or our Servicing Partners. If any holders of term notes allege or assert noncompliance by us or the related Servicing Partner under our servicer advance financing arrangements in order to realize such benefits, we or our Servicing Partners, or our ability to maintain servicer advance financing on favorable terms, could be materially and adversely affected.\nWe may not be able to finance our investments on attractive terms or at all, and financing for interests in MSRs or servicer advances may be particularly difficult to obtain.\nThe ability to finance investments with securitizations or other long-term non-recourse financing not subject to margin requirements has been challenging as a result of market conditions. These conditions may result in having to use less efficient forms of financing for any new investments, or the refinancing of current investments, which will likely require a larger portion of our cash flows to be put toward making the investment and thereby reduce the amount of cash available for distribution to our stockholders and funds available for operations and investments, and which will also likely require us to assume higher levels of risk when financing\n123\nour investments. In addition, there is a limited market for financing of interests in MSRs, and it is possible that one will not develop for a variety of reasons, such as the challenges with perfecting security interests in the underlying collateral.\nCertain of our advance facilities may mature in the short term, and there can be no assurance that we will be able to renew these facilities on favorable terms or at all. Moreover, an increase in delinquencies with respect to the loans underlying our servicer advances could result in the need for additional financing, which may not be available to us on favorable terms or at all. If we are not able to obtain adequate financing to purchase servicer advances from our Servicing Partners or fund servicer advances under our MSRs in accordance with the applicable Servicing Guidelines, we or any such Servicing Partner, as applicable, could default on its obligation to fund such advances, which could result in its termination of us or any applicable Servicing Partner, as applicable, as servicer under the applicable Servicing Guidelines, and a partial or total loss of our interests in MSRs and servicer advances, as applicable.\nThe non-recourse long-term financing structures we use expose us to risks, which could result in losses to us.\nWe use structured finance and other non-recourse long-term financing for our investments to the extent available and appropriate. In such structures, our financing sources typically have only a claim against the assets included in the securitizations rather than a general claim against us as an entity. Prior to any such financing, we would seek to finance our investments with relatively short-term facilities until a sufficient portfolio is accumulated. As a result, we would be subject to the risk that we would not be able to acquire, during the period that any short-term facilities are available, sufficient eligible assets or securities to maximize the efficiency of a securitization. We also bear the risk that we would not be able to obtain new short-term facilities or would not be able to renew any short-term facilities after they expire should we need more time to seek and acquire sufficient eligible assets or securities for a securitization. In addition, conditions in the capital markets may make the issuance of any such securitization less attractive to us even when we do have sufficient eligible assets or securities. While we would generally intend to retain a portion of the interests issued under such securitizations and, therefore, still have exposure to any investments included in such securitizations, our inability to enter into such securitizations may increase our overall exposure to risks associated with direct ownership of such investments, including the risk of default. Our inability to refinance any short-term facilities would also increase our risk because borrowings thereunder would likely be recourse to us as an entity. If we are unable to obtain and renew short-term facilities or to consummate securitizations to finance our investments on a long-term basis, we may be required to seek other forms of potentially less attractive financing or to liquidate assets at an inopportune time or price.\nThe final Basel FRTB Ruling, which raised capital charges for bank holders of ABS, CMBS and Non-Agency MBS beginning in 2019, could adversely impact available trading liquidity and access to financing.\nIn January 2006, the Basel Committee on Banking Supervision released a finalized framework for calculating minimum capital requirements for market risk, which became effective in January 2019. In the final proposal, capital requirements would overall be meaningfully higher than current requirements, but are less punitive than the previous December 2014 proposal. However, each country’s specific regulator may codify the rules differently. Under the framework, capital charges on a bond are calculated based on three components: default, market and residual risk. Implementation of the final proposal could impose meaningfully higher capital charges on dealers compared with current requirements, and could reduce liquidity in the securitized products market.\nRisks associated with our investment in the consumer loan sector could have a material adverse effect on our business and financial results.\nOur portfolio includes an investment in the consumer loan sector. Although many of the risks applicable to consumer loans are also applicable to residential mortgage loans, and thus the type of risks that we have experience managing, there are nevertheless substantial risks and uncertainties associated with engaging in a different category of investment.\nThe ability of borrowers to repay the consumer loans we invest in may be adversely affected by numerous personal factors, including unemployment, divorce, major medical expenses or personal bankruptcy. General factors, including an economic downturn, high energy costs or acts of God or terrorism, may also affect the financial stability of borrowers and impair their ability or willingness to repay the consumer loans in our investment portfolio. Furthermore, our returns on our consumer loan investments are dependent on the interest we receive exceeding any losses we may incur from defaults or delinquencies. The relatively higher interest rates paid by consumer loan borrowers could lead to increased delinquencies and defaults, or could lead to financially stronger borrowers prepaying their loans, thereby reducing the interest we receive from them, while financially weaker borrowers become delinquent or default, either of which would reduce the return on our investment or could cause losses.\nIn the event of any default under a loan in the consumer loan portfolio in which we have invested, we will bear a risk of loss of principal to the extent of any deficiency between the value of the collateral securing the loan, if any, and the principal and accrued interest of the loan. In addition, our investments in consumer loans may entail greater risk than our investments in residential\n124\nmortgage loans, particularly in the case of consumer loans that are unsecured or secured by assets that depreciate rapidly. In such cases, repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan and the remaining deficiency often does not warrant further substantial collection efforts against the borrower. Further, repossessing personal property securing a consumer loan can present additional challenges, including locating the collateral and taking possession of it. In addition, borrowers under consumer loans may have lower credit scores. There can be no guarantee that we will not suffer unexpected losses on our investments as a result of the factors set out above, which could have a negative impact on our financial results.\nIn addition, a portion of our investment in consumer loans is secured by second and third liens on real estate. When we hold the second or third lien, another creditor or creditors, as applicable, holds the first and/or second, as applicable, lien on the real estate that is the subject of the security. In these situations our second or third lien is subordinate in right of payment to the first and/or second, as applicable, holder’s right to receive payment. Moreover, as the servicer of the loans underlying our consumer loan portfolio is not able to track the default status of a senior lien loan in instances where we do not hold the related first mortgage, the value of the second or third lien loans in our portfolio may be lower than our estimates indicate.\nFinally, one of our consumer loan investments is held through LoanCo, in which we hold a minority, non-controlling interest. We do not control LoanCo and, as a result, LoanCo may make decisions, or take risks, that we would otherwise not make, and LoanCo may not have access to the same management and financing expertise that we have. Failure to successfully manage these risks could have a material adverse effect on our business and financial results.\nThe consumer loan investment sector is subject to various initiatives on the part of advocacy groups and extensive regulation and supervision under federal, state and local laws, ordinances and regulations, which could have a negative impact on our financial results.\nIn recent years consumer advocacy groups and some media reports have advocated governmental action to prohibit or place severe restrictions on the types of short-term consumer loans in which we have invested. Such consumer advocacy groups and media reports generally focus on the annual percentage rate to a consumer for this type of loan, which is compared unfavorably to the interest typically charged by banks to consumers with top-tier credit histories.\nThe fees charged on the consumer loans in the portfolio in which we have invested may be perceived as controversial by those who do not focus on the credit risk and high transaction costs typically associated with this type of investment. If the negative characterization of these types of loans becomes increasingly accepted by consumers, demand for the consumer loan products in which we have invested could significantly decrease. Additionally, if the negative characterization of these types of loans is accepted by legislators and regulators, we could become subject to more restrictive laws and regulations in the area.\nIn addition, we are, or may become, subject to federal, state and local laws, regulations, or regulatory policies and practices, including the Dodd-Frank Act (which, among other things, established the Consumer Financial Protection Bureau (the “CFPB”) with broad authority to regulate and examine financial institutions), which may, amongst other things, limit the amount of interest or fees allowed to be charged on the consumer loans we invest in, or the number of consumer loans that customers may receive or have outstanding. The operation of existing or future laws, ordinances and regulations could interfere with the focus of our investments which could have a negative impact on our financial results.\nCertain jurisdictions require licenses to purchase, hold, enforce or sell residential mortgage loans and/or MSRs, and we may not be able to obtain and/or maintain such licenses.\nCertain jurisdictions require a license to purchase, hold, enforce or sell residential mortgage loans and/or MSRs. In the event that any licensing requirement is applicable to us, and we do not hold such licenses, there can be no assurance that we will obtain such licenses or, if obtained, that we will be able to maintain them. Our failure to obtain or maintain such licenses could restrict our ability to invest in loans in these jurisdictions if such licensing requirements are applicable. With respect to mortgage loans, in lieu of obtaining such licenses, we may contribute our acquired residential mortgage loans to one or more wholly owned trusts whose trustee is a national bank, which may be exempt from state licensing requirements. We have formed one or more subsidiaries to apply for certain state licenses. If these subsidiaries obtain the required licenses, any trust holding loans in the applicable jurisdictions may transfer such loans to such subsidiaries, resulting in these loans being held by a state-licensed entity. There can be no assurance that we will be able to obtain the requisite licenses in a timely manner or at all or in all necessary jurisdictions, or that the use of the trusts will reduce the requirement for licensing. In addition, even if we obtain necessary licenses, we may not be able to maintain them. Any of these circumstances could limit our ability to invest in residential mortgage loans or MSRs in the future and have a material adverse effect on us.\n125\nOur determination of how much leverage to apply to our investments may adversely affect our return on our investments and may reduce cash available for distribution.\nWe leverage certain of our assets through a variety of borrowings. Our investment guidelines do not limit the amount of leverage we may incur with respect to any specific asset or pool of assets. The return we are able to earn on our investments and cash available for distribution to our stockholders may be significantly reduced due to changes in market conditions, which may cause the cost of our financing to increase relative to the income that can be derived from our assets.\nA significant portion of our investments are not match funded, which may increase the risks associated with these investments.\nWhen available, a match funding strategy mitigates the risk of not being able to refinance an investment on favorable terms or at all. However, our Manager may elect for us to bear a level of refinancing risk on a short-term or longer-term basis, as in the case of investments financed with repurchase agreements, when, based on its analysis, our Manager determines that bearing such risk is advisable or unavoidable. In addition, we may be unable, as a result of conditions in the credit markets, to match fund our investments. For example, non-recourse term financing not subject to margin requirements has been more difficult to obtain, which impairs our ability to match fund our investments. Moreover, we may not be able to enter into interest rate swaps. A decision not to, or the inability to, match fund certain investments exposes us to additional risks.\nFurthermore, we anticipate that, in most cases, for any period during which our floating rate assets are not match funded with respect to maturity, the income from such assets may respond more slowly to interest rate fluctuations than the cost of our borrowings. Because of this dynamic, interest income from such investments may rise more slowly than the related interest expense, with a consequent decrease in our net income. Interest rate fluctuations resulting in our interest expense exceeding interest income would result in operating losses for us from these investments.\nAccordingly, to the extent our investments are not match funded with respect to maturities and interest rates, we are exposed to the risk that we may not be able to finance or refinance our investments on economically favorable terms, or at all, or may have to liquidate assets at a loss.\nInterest rate fluctuations and shifts in the yield curve may cause losses.\nInterest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. Our primary interest rate exposures relate to our interests in MSRs, RMBS, loans, derivatives and any floating rate debt obligations that we may incur. Changes in interest rates, including changes in expected interest rates or “yield curves,” affect our business in a number of ways. Changes in the general level of interest rates can affect our net interest income, which is the difference between the interest income earned on our interest-earning assets and the interest expense incurred in connection with our interest-bearing liabilities and hedges. Changes in the level of interest rates also can affect, among other things, our ability to acquire real estate and other securities and loans at attractive prices, the value of our real estate and other securities, loans and derivatives and our ability to realize gains from the sale of such assets. We may wish to use hedging transactions to protect certain positions from interest rate fluctuations, but we may not be able to do so as a result of market conditions, REIT rules or other reasons. In such event, interest rate fluctuations could adversely affect our financial condition, cash flows and results of operations.\nRecently, the Federal Reserve has increased the benchmark interest rate and indicated that there may be further increases in the future. In the event of a significant rising interest rate environment and/or economic downturn, loan and collateral defaults may increase and result in credit losses that would adversely affect our liquidity and operating results.\nOur ability to execute our business strategy, particularly the growth of our investment portfolio, depends to a significant degree on our ability to obtain additional capital. Our financing strategy is dependent on our ability to place the debt we use to finance our investments at rates that provide a positive net spread. If spreads for such liabilities widen or if demand for such liabilities ceases to exist, then our ability to execute future financings will be severely restricted.\nInterest rate changes may also impact our net book value as most of our investments are marked to market each quarter. Debt obligations are not marked to market. Generally, as interest rates increase, the value of our fixed rate securities decreases, which will decrease the book value of our equity.\nFurthermore, shifts in the U.S. Treasury yield curve reflecting an increase in interest rates would also affect the yield required on our investments and therefore their value. For example, increasing interest rates would reduce the value of the fixed rate assets we hold at the time because the higher yields required by increased interest rates result in lower market prices on existing fixed\n126\nrate assets in order to adjust the yield upward to meet the market, and vice versa. This would have similar effects on our real estate and other securities and loan portfolio and our financial position and operations to a change in interest rates generally.\nChanges in banks’ inter-bank lending rate reporting practices or the method pursuant to which LIBOR is determined may adversely affect the value of the financial obligations to be held or issued by us that are linked to LIBOR.\nLIBOR and other indices which are deemed “benchmarks” are the subject of recent national, international, and other regulatory guidance and proposals for reform. Some of these reforms are already effective while others are still to be implemented. These reforms may cause such benchmarks to perform differently than in the past, or have other consequences which cannot be predicted. In particular, regulators and law enforcement agencies in the U.K. and elsewhere conducted criminal and civil investigations into whether the banks that contributed information to the British Bankers’ Association (“BBA”) in connection with the daily calculation of LIBOR may have been under-reporting or otherwise manipulating or attempting to manipulate LIBOR. A number of BBA member banks have entered into settlements with their regulators and law enforcement agencies with respect to this alleged manipulation of LIBOR. LIBOR is calculated by reference to a market for interbank lending that continues to shrink, as its based on increasingly fewer actual transactions. This increases the subjectivity of the LIBOR calculation process and increases the risk of manipulation. Actions by the regulators or law enforcement agencies, as well as ICE Benchmark Administration (the current administrator of LIBOR), may result in changes to the manner in which LIBOR is determined or the establishment of alternative reference rates. For example, on July 27, 2017, the U.K. Financial Conduct Authority announced that it intends to stop persuading or compelling banks to submit LIBOR rates after 2021.\nIt is likely that, over time, U.S. Dollar LIBOR will be replaced by the Secured Overnight Financing Rate (“SOFR”) published by the Federal Reserve Bank of New York. However, the manner and timing of this shift is currently unknown. SOFR is an overnight rate instead of a term rate, making SOFR an inexact replacement for LIBOR. There is currently no perfect way to create robust, forward-looking, SOFR term rates. Market participants are still considering how various types of financial instruments and securitization vehicles should react to a discontinuation of LIBOR. It is possible that not all of our assets and liabilities will transition away from LIBOR at the same time, and it is possible that not all of our assets and liabilities will transition to the same alternative reference rate, in each case increasing the difficulty of hedging. Switching existing financial instruments and hedging transactions from LIBOR to SOFR requires calculations of a spread. Industry organizations are attempting to structure the spread calculation in a manner that minimizes the possibility of value transfer between counterparties, borrowers, and lenders by virtue of the transition, but there is no assurance that the calculated spread will be fair and accurate or that all asset types and all types of securitization vehicles will use the same spread. We and other market participants have less experience understanding and modeling SOFR-based assets and liabilities than LIBOR-based assets and liabilities, increasing the difficulty of investing, hedging, and risk management. The process of transition involves operational risks. It is also possible that no transition will occur for many financial instruments, meaning that those instruments would continue to be subject to the weaknesses of the LIBOR calculation process. At this time, it is not possible to predict the effect of any such changes, any establishment of alternative reference rates or any other reforms to LIBOR that may be implemented. Uncertainty as to the nature of such potential changes, alternative reference rates or other reforms may adversely affect the market for or value of any securities on which the interest or dividend is determined by reference to LIBOR, loans, derivatives and other financial obligations or on our overall financial condition or results of operations. More generally, any of the above changes or any other consequential changes to LIBOR or any other “benchmark” as a result of international, national or other proposals for reform or other initiatives or investigations, or any further uncertainty in relation to the timing and manner of implementation of such changes, could have a material adverse effect on the value of and return on any securities based on or linked to a “benchmark.”\nAny hedging transactions that we enter into may limit our gains or result in losses.\nWe may use, when feasible and appropriate, derivatives to hedge a portion of our interest rate exposure, and this approach has certain risks, including the risk that losses on a hedge position will reduce the cash available for distribution to stockholders and that such losses may exceed the amount invested in such instruments. We have adopted a general policy with respect to the use of derivatives, which generally allows us to use derivatives where appropriate, but does not set forth specific policies and procedures or require that we hedge any specific amount of risk. From time to time, we may use derivative instruments, including forwards, futures, swaps and options, in our risk management strategy to limit the effects of changes in interest rates on our operations. A hedge may not be effective in eliminating all of the risks inherent in any particular position. Our profitability may be adversely affected during any period as a result of the use of derivatives.\nThere are limits to the ability of any hedging strategy to protect us completely against interest rate risks. When rates change, we expect the gain or loss on derivatives to be offset by a related but inverse change in the value of any items that we hedge. We cannot assure you, however, that our use of derivatives will offset the risks related to changes in interest rates. We cannot assure you that our hedging strategy and the derivatives that we use will adequately offset the risk of interest rate volatility or that our hedging transactions will not result in losses. In addition, our hedging strategy may limit our flexibility by causing us to refrain\n127\nfrom taking certain actions that would be potentially profitable but would cause adverse consequences under the terms of our hedging arrangements. The REIT provisions of the Internal Revenue Code limit our ability to hedge. In managing our hedge instruments, we consider the effect of the expected hedging income on the REIT qualification tests that limit the amount of gross income that a REIT may receive from hedging. We need to carefully monitor, and may have to limit, our hedging strategy to assure that we do not realize hedging income, or hold hedges having a value, in excess of the amounts that would cause us to fail the REIT gross income and asset tests. See “—Risks Related to Our Taxation as a REIT—Complying with the REIT requirements may limit our ability to hedge effectively.”\nAccounting for derivatives under GAAP is extremely complicated. Any failure by us to account for our derivatives properly in accordance with GAAP in our financial statements could adversely affect us. In addition, under applicable accounting standards, we may be required to treat some of our investments as derivatives, which could adversely affect our results of operations.\nCybersecurity incidents and technology disruptions or failures could damage our business operations and reputation, increase our costs and subject us to potential liability.\nAs our reliance on rapidly changing technology has increased, so have the risks that threaten the confidentiality, integrity or availability of our information systems, both internal and those provided to us by third-party service providers (including, but not limited to, our Servicing Partners). Cybersecurity incidents may involve gaining authorized or unauthorized access to our information systems for purposes of theft of certain personally identifiable information of consumers, misappropriating assets, stealing confidential information, corrupting data or causing operational disruption. Disruptions and failures of our systems or those of our third-party vendors could result from these incidents or be caused by fire, power outages, natural disasters and other similar events and may interrupt or delay our ability to provide services to our customers, expose us to remedial costs and reputational damage, and otherwise adversely affect our operations.\nDespite our efforts to ensure the integrity of our systems, there can be no assurance that any such cyber incidents will not occur or, if they do occur, that they will be adequately addressed. We also may not be able to anticipate or implement effective preventive measures against all security breaches, especially because the methods and sources of breaches change frequently or may not be immediately detected.\nIn addition, we are subject to various privacy and data protection laws and regulations, and any changes to laws or regulations, including new restrictions or requirements applicable to our business, could impose additional costs and liability on us and could limit our use and disclosure of such information. For example, the New York State Department of Financial Services requires certain financial services companies, such as NRM and NewRez, to establish a detailed cybersecurity program and comply with other requirements, and the California Consumer Privacy Act of 2018 creates new compliance regulations on businesses that collect information from California residents.\nAny of the foregoing events could result in violations of applicable privacy and other laws, financial loss to us or to our customers, loss of confidence in our security measures, customer dissatisfaction, additional regulatory scrutiny, significant litigation exposure and harm to our reputation, any of which could have a material adverse effect on our business, financial condition, liquidity and results of operations.\nWe depend on counterparties and vendors to provide certain services, which subjects us to various risks.\nWe have a number of counterparties and vendors, who provide us with financial, technology and other services that support our businesses. If our current counterparties and vendors were to stop providing services to us on acceptable terms, we may be unable to procure alternative services from other counterparties or vendors in a timely and efficient manner and on similarly acceptable terms, or at all. With respect to vendors engaged to perform certain servicing activities, we are required to assess their compliance with various regulations and establish procedures to provide reasonable assurance that the vendor’s activities comply in all material respects with such regulations. In the event that a vendor’s activities are not in compliance, it could negatively impact our relationships with our regulators, as well as our business and operations. Accordingly, we may incur significant costs to resolve any such disruptions in service which could have a material adverse effect on our business, financial condition, liquidity and results of operations.\nWe are subject to risks related to securitization of any loans originated and/or serviced by our subsidiaries.\nThe securitization of any loans that we originate and/or service subject us to various risks that may increase our compliance costs and adversely impact our financial results, including:\n| • | compliance with the terms of the agreements governing the securitized pools of loans, including any indemnification and repurchase provisions; |\n\n128\n| • | reliance on programs administered by Fannie Mae, Freddie Mac, and Ginnie Mae that facilitate the issuance of mortgage-backed securities in the secondary market and the effect of any changes or modifications thereto (see-“GSE initiatives and other actions, including changes to the minimum servicing amount for GSE loans, could occur at any time and could impact us in significantly negative ways that we are unable to predict or protect against” and -“The federal conservatorship of Fannie Mae and Freddie Mac and related efforts, along with any changes in laws and regulations affecting the relationship between these agencies and the U.S. government, may adversely affect our business”); and |\n\n| • | federal and state legislation in securitizations, such as the risk retention requirements under the Dodd-Frank Act, could result in higher costs of certain lending operations and impose on us additional compliance requirements to meet servicing and originations criteria for securitized mortgage loans. |\n\nMaintenance of our 1940 Act exclusion imposes limits on our operations.\nWe intend to continue to conduct our operations so that neither we nor any of our subsidiaries are required to register as an investment company under the 1940 Act. We believe we will not be considered an investment company under Section 3(a)(1)(A) of the 1940 Act because we will not engage primarily, or hold ourselves out as being engaged primarily, in the business of investing, reinvesting or trading in securities. However, under Section 3(a)(1)(C) of the 1940 Act, because we are a holding company that will conduct its businesses primarily through wholly owned and majority owned subsidiaries, the securities issued by our subsidiaries that are excluded from the definition of “investment company” under Section 3(c)(1) or Section 3(c)(7) of the 1940 Act, together with any other investment securities we may own, may not have a combined value in excess of 40% of the value of our total assets (exclusive of U.S. Government securities and cash items) on an unconsolidated basis, unless another exclusion from the definition of “investment company” is available to us. For purposes of the foregoing, we currently treat our interest in our SLS Servicer Advance Investment and our subsidiaries that hold consumer loans as investment securities because these subsidiaries presently rely on the exclusion provided by Section 3(c)(7) of the 1940 Act. The 40% test under Section 3(a)(1)(C) of the 1940 Act limits the types of businesses in which we may engage through our subsidiaries. In addition, the assets we and our subsidiaries may originate or acquire are limited by the provisions of the 1940 Act and the rules and regulations promulgated under the 1940 Act, which may adversely affect our business.\nIf the value of securities issued by our subsidiaries that are excluded from the definition of “investment company” by Section 3(c)(1) or 3(c)(7) of the 1940 Act, together with any other investment securities we own, exceeds the 40% test under Section 3(a)(1)(C) of the 1940 Act (e.g., the value of our interests in the taxable REIT subsidiaries that hold Servicer Advance Investments and are not excluded from the definition of “investment company” by Section 3(c)(5)(A), (B) or (C) of the 1940 Act increases significantly in proportion to the value of our other assets), or if one or more of such subsidiaries fail to maintain an exclusion or exception from the 1940 Act, we could, among other things, be required either (a) to substantially change the manner in which we conduct our operations to avoid being required to register as an investment company or (b) to register as an investment company under the 1940 Act, either of which could have an adverse effect on us and the market price of our securities. As discussed above, for purposes of the foregoing, we generally treat our interests in our SLS Servicer Advance Investment and our subsidiaries that hold consumer loans as investment securities because these subsidiaries presently rely on the exclusion provided by Section 3(c)(7) of the 1940 Act. If we or any of our subsidiaries were required to register as an investment company under the 1940 Act, the registered entity would become subject to substantial regulation with respect to capital structure (including the ability to use leverage), management, operations, transactions with affiliated persons (as defined in the 1940 Act), portfolio composition, including restrictions with respect to diversification and industry concentration, compliance with reporting, record keeping, voting, proxy disclosure and other rules and regulations that would significantly change our operations.\nFailure to maintain an exclusion would require us to significantly restructure our investment strategy. For example, because affiliate transactions are generally prohibited under the 1940 Act, we would not be able to enter into transactions with any of our affiliates if we are required to register as an investment company, and we might be required to terminate our Management Agreement and any other agreements with affiliates, which could have a material adverse effect on our ability to operate our business and pay distributions. If we were required to register us as an investment company but failed to do so, we would be prohibited from engaging in our business, and criminal and civil actions could be brought against us. In addition, our contracts would be unenforceable unless a court required enforcement, and a court could appoint a receiver to take control of us and liquidate our business.\nFor purposes of the foregoing, we treat our interests in certain of our wholly owned and majority owned subsidiaries, which constitute more than 60% of the value of our adjusted total assets on an unconsolidated basis, as non-investment securities because such subsidiaries qualify for exclusion from the definition of an investment company under the 1940 Act pursuant to Section 3(c)(5)(C) of the 1940 Act. The Section 3(c)(5)(C) exclusion is available for entities “primarily engaged” in the business of “purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” The Section 3(c)(5)(C) exclusion generally requires that at least 55% of these subsidiaries’ assets must comprise qualifying real estate assets and at least 80% of each of their portfolios must comprise qualifying real estate assets and real estate-related assets under the 1940 Act. We expect each of our subsidiaries relying on Section 3(c)(5)(C) to rely on guidance published by the SEC staff or on our analyses of such guidance to\n129\ndetermine which assets are qualifying real estate assets and real estate-related assets. However, the SEC’s guidance was issued in accordance with factual situations that may be substantially different from the factual situations each of our subsidiaries may face, and much of the guidance was issued more than 20 years ago. No assurance can be given that the SEC staff will concur with the classification of each of our subsidiaries’ assets. In addition, the SEC staff may, in the future, issue further guidance that may require us to re-classify some of our subsidiaries’ assets for purposes of qualifying for an exclusion from regulation under the 1940 Act. For example, the SEC and its staff have not published guidance with respect to the treatment of whole pool Non-Agency RMBS for purposes of the Section 3(c)(5)(C) exclusion. Accordingly, based on our own judgment and analysis of the guidance from the SEC and its staff identifying Agency whole pool certificates as qualifying real estate assets under Section 3(c)(5)(C), we treat whole pool Non-Agency RMBS issued with respect to an underlying pool of mortgage loans in which our subsidiary relying on Section 3(c)(5)(C) holds all of the certificates issued by the pool as qualifying real estate assets. Based on our own judgment and analysis of the guidance from the SEC and its staff with respect to analogous assets, we treat Excess MSRs for which we do not own the related servicing rights as real estate-related assets for purposes of satisfying the 80% test under the Section 3(c)(5)(C) exclusion. If we are required to re-classify any of our subsidiaries’ assets, including those subsidiaries holding whole pool Non-Agency RMBS and/or Excess MSRs, such subsidiaries may no longer be in compliance with the exclusion from the definition of an “investment company” provided by Section 3(c)(5)(C) of the 1940 Act, and in turn, we may not satisfy the requirements to avoid falling within the definition of an “investment company” provided by Section 3(a)(1)(C). To the extent that the SEC staff publishes new or different guidance or disagrees with our analysis with respect to any assets of our subsidiaries we have determined to be qualifying real estate assets or real estate-related assets, we may be required to adjust our strategy accordingly. In addition, we may be limited in our ability to make certain investments and these limitations could result in a subsidiary holding assets we might wish to sell or selling assets we might wish to hold.\nIn August 2011, the SEC issued a concept release soliciting public comments on a wide range of issues relating to companies engaged in the business of acquiring mortgages and mortgage-related instruments and that rely on Section 3(c)(5)(C) of the 1940 Act. Therefore, there can be no assurance that the laws and regulations governing the 1940 Act status of REITs, or guidance from the SEC or its staff regarding the Section 3(c)(5)(C) exclusion, will not change in a manner that adversely affects our operations. If we or our subsidiaries fail to maintain an exclusion or exception from the 1940 Act, we could, among other things, be required either to (a) change the manner in which we conduct our operations to avoid being required to register as an investment company, (b) effect sales of our assets in a manner that, or at a time when, we would not otherwise choose to do so, or (c) register as an investment company, any of which could negatively affect the value of our common stock, the sustainability of our business model, and our ability to make distributions. In addition, if we or any of our subsidiaries were required to register as an investment company under the 1940 Act, the registered entity would become subject to substantial regulation with respect to capital structure (including the ability to use leverage), management, operations, transactions with affiliated persons (as defined in the 1940 Act), portfolio composition, including restrictions with respect to diversification and industry concentration, compliance with reporting, record keeping, voting, proxy disclosure and other rules and regulations that would significantly change our operations.\nRapid changes in the values of our assets may make it more difficult for us to maintain our qualification as a REIT or our exclusion from the 1940 Act.\nIf the market value or income potential of qualifying assets for purposes of our qualification as a REIT or our exclusion from registration as an investment company under the 1940 Act declines as a result of increased interest rates, changes in prepayment rates or other factors, or the market value or income from non-qualifying assets increases, we may need to increase our investments in qualifying assets and/or liquidate our non-qualifying assets to maintain our REIT qualification or our exclusion from registration under the 1940 Act. If the change in market values or income occurs quickly, this may be especially difficult to accomplish. This difficulty may be exacerbated by the illiquid nature of any non-qualifying assets we may own. We may have to make investment decisions that we otherwise would not make absent the intent to maintain our qualification as a REIT and exclusion from registration under the 1940 Act.\nWe are subject to significant competition, and we may not compete successfully.\nWe are subject to significant competition in seeking investments. We compete with other companies, including other REITs, insurance companies and other investors, including funds and companies affiliated with our Manager. Some of our competitors have greater resources than we possess or have greater access to capital or various types of financing structures than are available to us, and we may not be able to compete successfully for investments or provide attractive investment returns relative to our competitors. These competitors may be willing to accept lower returns on their investments and, as a result, our profit margins could be adversely affected. Furthermore, competition for investments that are suitable for us, including, but not limited to, interests in MSRs, may lead to decreased availability, higher market prices and decreased returns available from such investments, which may further limit our ability to generate our desired returns. We cannot assure you that other companies will not be formed that compete with us for investments or otherwise pursue investment strategies similar to ours or that we will be able to compete successfully against any such companies.\n130\nOur business could suffer if we fail to attract and retain highly skilled personnel.\nOur future success will depend on our ability to identify, hire, develop, motivate and retain highly qualified personnel for all areas of the Company, in particular skilled managers, loan officers, underwriters, loan servicers, debt default specialists and other personnel specialized in finance, risk and compliance. Trained and experienced personnel are in high demand and may be in short supply in some areas. We may not be able to attract, develop and maintain an adequate skilled workforce necessary to operate our businesses and labor expenses may increase as a result of a shortage in the supply of qualified personnel. If we are unable to attract and retain such personnel, we may not be able to take advantage of acquisitions and other growth opportunities that may be presented to us and this could have a material adverse effect on our business, financial condition, liquidity and results of operations.\nThe valuations of our assets are subject to uncertainty because most of our assets are not traded in an active market.\nThere is not anticipated to be an active market for most of the assets in which we will invest. In the absence of market comparisons, we will use other pricing methodologies, including, for example, models based on assumptions regarding expected trends, historical trends following market conditions believed to be comparable to the then current market conditions and other factors believed at the time to be likely to influence the potential resale price of, or the potential cash flows derived from, an investment. Such methodologies may not prove to be accurate and any inability to accurately price assets may result in adverse consequences for us. A valuation is only an estimate of value and is not a precise measure of realizable value. Ultimate realization of the market value of a private asset depends to a great extent on economic and other conditions beyond our control. Further, valuations do not necessarily represent the price at which a private investment would sell since market prices of private investments can only be determined by negotiation between a willing buyer and seller. If we were to liquidate a particular private investment, the realized value may be more than or less than the valuation of such asset as carried on our books.\nChanges in accounting rules could occur at any time and could impact us in significantly negative ways that we are unable to predict or protect against.\nAs has been widely publicized, the SEC, the Financial Accounting Standards Board (the “FASB”) and other regulatory bodies that establish the accounting rules applicable to us have recently proposed or enacted a wide array of changes to accounting rules. Moreover, in the future these regulators may propose additional changes that we do not currently anticipate. Changes to accounting rules that apply to us could significantly impact our business or our reported financial performance in negative ways that we cannot predict or protect against. We cannot predict whether any changes to current accounting rules will occur or what impact any codified changes will have on our business, results of operations, liquidity or financial condition, directly or through their impact on our Servicing Partners or counterparties.\nA prolonged economic slowdown, a lengthy or severe recession, or declining real estate values could harm our operations.\nWe believe the risks associated with our business are more severe during periods in which an economic slowdown or recession is accompanied by declining real estate values, as was the case in 2008. Declining real estate values generally reduce the level of new mortgage loan originations, since borrowers often use increases in the value of their existing properties to support the purchase of, or investment in, additional properties. Borrowers may also be less able to pay principal and interest on our loans or the loans underlying our securities, interests in MSRs and servicer advances, if the real estate economy weakens. Further, declining real estate values significantly increase the likelihood that we will incur losses on our investments in the event of default because the value of our collateral may be insufficient to cover our basis. Any sustained period of increased payment delinquencies, foreclosures or losses could adversely affect our net interest income from the assets in our portfolio, which would significantly harm our revenues, results of operations, financial condition, liquidity, business prospects and our ability to make distributions to our stockholders.\nCompliance with changing regulation of corporate governance and public disclosure has and will continue to result in increased compliance costs and pose challenges for our management team.\nCertain aspects of the Dodd-Frank Act remain subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on us and, more generally, the financial services and mortgage industries. Additionally, we cannot predict whether there will be additional proposed laws or reforms that would affect us, whether or when such changes may be adopted, how such changes may be interpreted and enforced or how such changes may affect us. However, the costs of complying with any additional laws or regulations could have a material effect on our financial condition and results of operations.\n131\nWe have engaged and may in the future engage in a number of acquisitions and we may be unable to successfully integrate the acquired assets and assumed liabilities in connection with such acquisitions.\nAs part of our business strategy, we regularly evaluate acquisitions of what we believe are complementary assets. Identifying and achieving the anticipated benefits of such acquisitions is subject to a number of uncertainties, including, without limitation, whether we are able to acquire the assets, within our parameters, integrate the acquired assets and manage the assumed liabilities efficiently. It is possible that the integration process could take longer than anticipated and could result in additional and unforeseen expenses, the disruption of our ongoing business, processes and systems, or inconsistencies in standards, controls, procedures, practices and policies, any of which could adversely affect our ability to achieve the anticipated benefits of such acquisitions. There may be increased risk due to integrating the assets into our financial reporting and internal control systems. Difficulties in adding the assets into our business could also result in the loss of contract counterparties or other persons with whom we conduct business and potential disputes or litigation with contract counterparties or other persons with whom we or such counterparties conduct business. We could also be adversely affected by any issues attributable to the related seller’s operations that arise or are based on events or actions that occurred prior to the closing of such acquisitions. Completion of the integration process is subject to a number of uncertainties, and no assurance can be given that the anticipated benefits will be realized in their entirety or at all or, if realized, the timing of their realization. Failure to achieve these anticipated benefits could result in increased costs or decreases in the amount of expected revenues and could adversely affect our future business, financial condition, operating results and cash flows. Due to the costs of engaging in a number of acquisitions, we may also have difficulty completing more acquisitions in the future.\nThere may be difficulties with integrating the loans underlying MSR acquisitions involving servicing transfers into the successor servicer’s servicing platform, which could have a material adverse effect on our results of operations, financial condition and liquidity.\nIn connection with certain MSR acquisitions, servicing is transferred from the seller to a subservicer appointed by us. The ability to integrate and service the assets acquired will depend in large part on the success of our subservicer’s integration of expanded servicing capabilities with its current operations. We may fail to realize some or all of the anticipated benefits of these transactions if the integration process takes longer, or is more costly, than expected. Potential difficulties we may encounter during the integration process with the assets acquired in MSR acquisitions involving servicing transfers include, but are not limited to, the following:\n| • | the integration of the portfolio into our subservicer’s information technology platforms and servicing systems; |\n\n| • | the quality of servicing during any interim servicing period after we purchase the portfolio but before our subservicer assumes servicing obligations from the seller or its agents; |\n\n| • | the disruption to our ongoing businesses and distraction of our management teams from ongoing business concerns; |\n\n| • | incomplete or inaccurate files and records; |\n\n| • | the retention of existing customers; |\n\n| • | the creation of uniform standards, controls, procedures, policies and information systems; |\n\n| • | the occurrence of unanticipated expenses; and |\n\n| • | potential unknown liabilities associated with the transactions, including legal liability related to origination and servicing prior to the acquisition. |\n\nOur failure to meet the challenges involved in successfully integrating the assets acquired in MSR acquisitions involving servicing transfers with our current business could impair our operations. For example, it is possible that the data our subservicer acquires upon assuming the direct servicing obligations for the loans may not transfer from the seller’s platform to its systems properly. This may result in data being lost, key information not being locatable on our subservicer’s systems, or the complete failure of the transfer. If our employees are unable to access customer information easily, or is unable to produce originals or copies of documents or accurate information about the loans, collections could be affected significantly, and our subservicer may not be able to enforce its right to collect in some cases. Similarly, collections could be affected by any changes to our subservicer’s collections practices, the restructuring of any key servicing functions, transfer of files and other changes that occur as a result of the transfer of servicing obligations from the seller to our subservicer.\nWe are responsible for certain of HLSS’s contingent and other corporate liabilities.\nUnder the HLSS acquisition agreement, we have assumed and are responsible for the payment of HLSS’s contingent and other liabilities, including: (i) liabilities for litigation relating to, arising out of or resulting from certain lawsuits in which HLSS is named as the defendant, (ii) HLSS’s tax liabilities, (iii) HLSS’s corporate liabilities, (iv) generally any actions with respect to the HLSS Acquisition brought by any third party and (v) payments under contracts. We currently cannot estimate the amount we may ultimately be responsible for as a result of assuming substantially all of HLSS’s contingent and other corporate liabilities. The amount for which we are ultimately responsible may be material and have a material adverse effect on our business, financial condition, results of operations and liquidity. In addition, certain claims and lawsuits may require significant costs to defend and\n132\nresolve and may divert management’s attention away from other aspects of operating and managing our business, each of which could materially and adversely affect our business, financial condition, results of operations and liquidity.\nWe cannot guarantee that we will not receive further regulatory inquiries or be subject to litigation regarding the subject matter of the subpoenas or matters relating thereto, or that existing inquires, or, should they occur, any future regulatory inquiries or litigation, will not consume internal resources, result in additional legal and consulting costs or negatively impact our stock price.\nWe could be materially and adversely affected by past events, conditions or actions with respect to HLSS or Ocwen.\nHLSS acquired assets and assumed liabilities could be adversely affected as a result of events or conditions that occurred or existed before the closing of the HLSS Acquisition. Adverse changes in the assets or liabilities we have acquired or assumed, respectively, as part of the HLSS Acquisition, could occur or arise as a result of actions by HLSS or Ocwen, legal or regulatory developments, including the emergence or unfavorable resolution of pre-acquisition loss contingencies, deteriorating general business, market, industry or economic conditions, and other factors both within and beyond the control of HLSS or Ocwen. We are subject to a variety of risks as a result of our dependence on Servicing Partners, including, without limitation, the potential loss of all of the value of our Excess MSRs in the event that the servicer of the underlying loans is terminated by the mortgage loan owner or RMBS bondholders. A significant decline in the value of HLSS assets or a significant increase in HLSS liabilities we have acquired could adversely affect our future business, financial condition, cash flows and results of operations. HLSS is subject to a number of other risks and uncertainties, including regulatory investigations and legal proceedings against HLSS, and others with whom HLSS conducted business. Moreover, any insurance proceeds received with respect to such matters may be inadequate to cover the associated losses. Adverse developments at Ocwen, including liquidity issues, ratings downgrades, defaults under debt agreements, servicer rating downgrades, failure to comply with the terms of PSAs, termination under PSAs, Ocwen bankruptcy proceedings and additional regulatory issues and settlements, including those described above, could have a material adverse effect on us. See “—We rely heavily on our Servicing Partners to achieve our investment objective and have no direct ability to influence their performance.”\nOur ability to borrow may be adversely affected by the suspension or delay of the rating of the notes issued under certain of our financing facilities by the credit agency providing the ratings.\nCertain of our financing facilities are rated by one rating agency and we may sponsor financing facilities in the future that are rated by credit agencies. The related agency or rating agencies may suspend rating notes backed by servicer advances, MSRs, Excess MSRs and our other investments at any time. Rating agency delays may result in our inability to obtain timely ratings on new notes, or amend or modify other financing facilities which could adversely impact the availability of borrowings or the interest rates, advance rates or other financing terms and adversely affect our results of operations and liquidity. Further, if we are unable to secure ratings from other agencies, limited investor demand for unrated notes could result in further adverse changes to our liquidity and profitability.\nA downgrade of certain of the notes issued under our financing facilities could cause such notes to become due and payable prior to their expected repayment date/maturity date, which could have a material adverse effect on our business, financial condition, results of operations and liquidity.\nRegulatory scrutiny regarding foreclosure processes could lengthen foreclosure timelines, which could increase advances and materially and adversely affect our business, financial condition, results of operations and liquidity.\nWhen a residential mortgage loan is in foreclosure, the servicer is generally required to continue to advance delinquent principal and interest to the securitization trust and to also make advances for delinquent taxes and insurance and foreclosure costs and the upkeep of vacant property in foreclosure to the extent it determines that such amounts are recoverable. These servicer advances are generally recovered when the delinquency is resolved. Foreclosure moratoria or other actions that lengthen the foreclosure process increase the amount of servicer advances, lengthen the time it takes for reimbursement of such advances and increase the costs incurred during the foreclosure process. In addition, servicer advance financing facilities generally contain provisions that limit the eligibility of servicer advances to be financed based on the length of time that servicer advances are outstanding, and, as a result, an increase in foreclosure timelines could further increase the amount of servicer advances that need to be funded from the related servicer’s own capital. Such increases in foreclosure timelines could increase the need for capital to fund servicer advances, which would increase our interest expense, delay the collection of interest income or servicing revenue until the foreclosure has been resolved and, therefore, reduce the cash that we have available to pay our operating expenses or to pay dividends. For more information, see “—We could be materially and adversely affected by past events, conditions or actions with respect to HLSS or Ocwen” above.\n133\nCertain of our Servicing Partners have triggered termination events or events of default under some PSAs underlying the MSRs with respect to which we are entitled to the basic fee component or Excess MSRs.\nIn certain of these circumstances, the related Servicing Partner may be terminated without any right to compensation for its loss, other than the right to be reimbursed for any outstanding servicer advances as the related loans are brought current, modified, liquidated or charged off. So long as we are in compliance with our obligations under our servicing agreements and purchase agreements, if we or one of our Servicing Partners is terminated as servicer, we may have the right to receive an indemnification payment from the applicable Servicing Partner, even if such termination related to servicer termination events or events of default existing at the time of any transaction with such Servicing Partner. If one of our Servicing Partners is terminated as servicer under a PSA, we will lose any investment related to such Servicing Partner’s MSRs. If we or such Servicing Partner is terminated as servicer with respect to a PSA and we are unable to enforce our contractual rights against such Servicing Partner, or if such Servicing Partner is unable to make any resulting indemnification payments to us, if any such payment is due and payable, it may have a material adverse effect on our financial condition, results of operations, ability to make distributions, liquidity and financing arrangements, including our servicer advance financing facilities, and may make it more difficult for us to acquire additional interests in MSRs in the future.\nRepresentations and warranties made by us in our collateralized borrowings and loan sale agreements may subject us to liability.\nOur financing facilities require us to make certain representations and warranties regarding the assets that collateralize the borrowings. Although we perform due diligence on the assets that we acquire, certain representations and warranties that we make in respect of such assets may ultimately be determined to be inaccurate. In addition, our loan sale agreements require us to make representations and warranties to the purchaser regarding the loans that were sold. Such representations and warranties may include, but are not limited to, issues such as the validity of the lien; the absence of delinquent taxes or other liens; the loans’ compliance with all local, state and federal laws and the delivery of all documents required to perfect title to the lien.\nIn the event of a breach of a representation or warranty, we may be required to repurchase affected loans, make indemnification payments to certain indemnified parties or address any claims associated with such breach. Further, we may have limited or no recourse against the seller from whom we purchased the loans. Such recourse may be limited due to a variety of factors, including the absence of a representation or warranty from the seller corresponding to the representation provided by us or the contractual expiration thereof. A breach of a representation or warranty could adversely affect our results of operations and liquidity.\nOur ability to exercise our cleanup call rights may be limited or delayed if a third party contests our ability to exercise our cleanup call rights, if the related securitization trustee refuses to permit the exercise of such rights, or if a related party is subject to bankruptcy proceedings.\nCertain servicing contracts permit more than one party to exercise a cleanup call-meaning the right of a party to collapse a securitization trust by purchasing all of the remaining loans held by the securitization trust pursuant to the terms set forth in the applicable servicing agreement. While the servicers from which we acquired our cleanup call rights (or other servicers from which these servicers acquired MSRs) may be named as the party entitled to exercise such rights, certain third parties may also be permitted to exercise such rights. If any such third party exercises a cleanup call, we could lose our ability to exercise our cleanup call right and, as a result, lose the ability to generate positive returns with respect to the related securitization transaction. In addition, another party could impair our ability to exercise our cleanup call rights by contesting our rights (for example, by claiming that they hold the exclusive cleanup call right with respect to the applicable securitization trust). Moreover, because the ability to exercise a cleanup call right is governed by the terms of the applicable servicing agreement, any ambiguous or conflicting language regarding the exercise of such rights in the agreement may make it more difficult and costly to exercise a cleanup call right. Furthermore, certain servicing contracts provide cleanup call rights to a servicer currently subject to bankruptcy proceedings from which our servicers have acquired MSRs. While, notwithstanding the related bankruptcy proceedings, it is possible that we will be able to exercise the related cleanup calls within our desired time frame, our ability to exercise such rights may be significantly delayed or impaired by the applicable securitization trustee or bankruptcy estate or any additional steps required because of the bankruptcy process. Finally, many of our call rights are not currently exercisable and may not become exercisable for a period of years. As a result, our ability to realize the benefits from these rights will depend on a number of factors at the time they become exercisable many of which are outside our control, including interest rates, conditions in the capital markets and conditions in the residential mortgage market.\nThe exercise of cleanup calls could negatively impact our interests in MSRs.\nThe exercise of cleanup call rights results in the termination of the MSRs on the loans held within the related securitization trusts. To the extent we own interests in MSRs with respect to loans held within securitization trusts where cleanup call rights are exercised,\n134\nwhether they are exercised by us or a third party, the value of our interests in those MSRs will likely be reduced to zero and we could incur losses and reduced cash flows from any such interests.\nNew Residential’s subsidiary New Residential Mortgage LLC is or may become subject to significant state and federal regulations.\nA subsidiary of New Residential, New Residential Mortgage LLC (“NRM”), has obtained applicable qualifications, licenses and approvals to own Non-Agency and certain Agency MSRs in the United States and certain other jurisdictions. As a result of NRM’s current and expected approvals, NRM is subject to extensive and comprehensive regulation under federal, state and local laws in the United States. These laws and regulations do, and may in the future, significantly affect the way that NRM does business, and subject NRM and New Residential to additional costs and regulatory obligations, which could impact our financial results.\nNRM’s business may become subject to increasing regulatory oversight and scrutiny in the future as it continues seeking and obtaining additional approvals to hold MSRs, which may lead to regulatory investigations or enforcement, including both formal and informal inquiries, from various state and federal agencies as part of those agencies’ oversight of the mortgage servicing business. An adverse result in governmental investigations or examinations or private lawsuits, including purported class action lawsuits, may adversely affect NRM’s and our financial results or result in serious reputational harm. In addition, a number of participants in the mortgage servicing industry have been the subject of purported class action lawsuits and regulatory actions by state or federal regulators, and other industry participants have been the subject of actions by state Attorneys General.\nFailure of New Residential’s subsidiary, NRM, to obtain or maintain certain licenses and approvals required for NRM to purchase and own MSRs could prevent us from purchasing or owning MSRs, which could limit our potential business activities.\nState and federal laws require a business to hold certain state licenses prior to acquiring MSRs. NRM is currently licensed or otherwise eligible to hold MSRs in each applicable state. As a licensee in such states, NRM may become subject to administrative actions in those states for failing to satisfy ongoing license requirements or for other state law violations, the consequences of which could include fines or suspensions or revocations of NRM’s licenses by applicable state regulatory authorities, which could in turn result in NRM becoming ineligible to hold MSRs in the related jurisdictions. We could be delayed or prohibited from conducting certain business activities if we do not maintain necessary licenses in certain jurisdictions. We cannot assure you that we will be able to maintain all of the required state licenses.\nAdditionally, NRM has received approval from FHA to hold MSRs associated with FHA-insured mortgage loans, from Fannie Mae to hold MSRs associated with loans owned by Fannie Mae, and from Freddie Mac to hold MSRs associated with loans owned by Freddie Mac. NRM may seek approval from Ginnie Mae to become an approved Ginnie Mae Issuer, which would make NRM eligible to hold MSRs associated with Ginnie Mae securities. As an approved Fannie Mae Servicer, Freddie Mac Servicer and FHA Lender, NRM is required to conduct aspects of its operations in accordance with applicable policies and guidelines published by FHA, Fannie Mae and Freddie Mac in order to maintain those approvals. Should NRM fail to maintain FHA, Fannie Mae or Freddie Mac approval, or fail to obtain approval from Ginnie Mae, NRM may be unable to purchase certain types of MSRs, which could limit our potential business activities.\nNRM is currently subject to various, and may become subject to additional information reporting and other regulatory requirements, and there is no assurance that we will be able to satisfy those requirements or other ongoing requirements applicable to mortgage loan servicers under applicable state and federal laws. Any failure by NRM to comply with such state or federal regulatory requirements may expose us to administrative or enforcement actions, license or approval suspensions or revocations or other penalties that may restrict our business and investment options, any of which could restrict our business and investment options, adversely impact our business and financial results and damage our reputation.\nWe may become subject to fines or other penalties based on the conduct of mortgage loan originators and brokers that originate residential mortgage loans related to MSRs that we acquire, and the third-party servicers we may engage to subservice the loans underlying MSRs we acquire.\nWe have acquired MSRs and may in the future acquire additional MSRs from third-party mortgage loan originators, brokers or other sellers, and we therefore are or will become dependent on such third parties for the related mortgage loans’ compliance with applicable law, and on third-party mortgage servicers, including our Servicing Partners, to perform the day-to-day servicing on the mortgage loans underlying any such MSRs. Mortgage loan originators and brokers are subject to strict and evolving consumer protection laws and other legal obligations with respect to the origination of residential mortgage loans. These laws and regulations include the residential mortgage servicing standards, “ability-to-repay” and “qualified mortgage” regulations promulgated by the CFPB, which became effective in 2014. In addition, there are various other federal, state, and local laws and regulations that are\n135\nintended to discourage predatory lending practices by residential mortgage loan originators. These laws may be highly subjective and open to interpretation and, as a result, a regulator or court may determine that that there has been a violation where an originator or servicer of mortgage loans reasonably believed that the law or requirement had been satisfied. Failure or alleged failure by originators or servicers to comply with these laws and regulations could subject us to state or CFPB administrative proceedings, which could result in monetary penalties, license suspensions or revocations, or restrictions to our business, all of which could adversely impact our business and financial results and damage our reputation.\nThe final servicing rules promulgated by the CFPB to implement certain sections of the Dodd-Frank Act include provisions relating to, among other things, periodic billing statements and disclosures, responding to borrower inquiries and complaints, force-placed insurance, and adjustable rate mortgage interest rate adjustment notices. Further, the mortgage servicing rules require servicers to, among other things, make good faith early intervention efforts to notify delinquent borrowers of loss mitigation options, to implement specified loss mitigation procedures, and if feasible, exhaust all loss mitigation options before proceeding to foreclosure. Proposed updates to further refine these rules have been published and will likely lead to further changes in requirements applicable to servicing mortgage loans.\nIn addition to NewRez LLC d/b/a Shellpoint Mortgage Servicing, we engage third-party servicers to subservice mortgage loans relating to any MSRs we acquire. It is therefore possible that a third-party servicer’s failure to comply with the new and evolving servicing protocols could adversely affect the value of the MSRs we acquire. Additionally, we may become subject to fines, penalties or civil liability based upon the conduct of any third-party servicer who services mortgage loans related to MSRs that we have acquired or will acquire in the future.\nInvestments in MSRs may expose us to additional risks.\nWe hold investments in MSRs. Our investments in MSRs may subject us to certain additional risks, including the following:\n| • | We have limited experience acquiring MSRs and operating a servicer. Although ownership of MSRs and the operation of a servicer includes many of the same risks as our other target assets and business activities, including risks related to prepayments, borrower credit, defaults, interest rates, hedging, and regulatory changes, there can be no assurance that we will be able to successfully operate a servicer subsidiary and integrate MSR investments into our business operations. |\n\n| • | As of today, we rely on subservicers to subservice the mortgage loans underlying our MSRs on our behalf. We are generally responsible under the applicable Servicing Guidelines for any subservicer’s non-compliance with any such applicable Servicing Guideline. In addition, there is a risk that our current subservicers will be unwilling or unable to continue subservicing on our behalf on terms favorable to us in the future. In such a situation, we may be unable to locate a replacement subservicer on favorable terms. |\n\n| • | NRM’s existing approvals from government-related entities or federal agencies are subject to compliance with their respective servicing guidelines, minimum capital requirements, reporting requirements and other conditions that they may impose from time to time at their discretion. Failure to satisfy such guidelines or conditions could result in the unilateral termination of NRM’s existing approvals or pending applications by one or more entities or agencies. |\n\n| • | NRM is presently licensed or otherwise eligible to hold MSRs in all states within the United States and the District of Columbia. Such state licenses may be suspended or revoked by a state regulatory authority, and we may as a result lose the ability to own MSRs under the regulatory jurisdiction of such state regulatory authority. |\n\n| • | Changes in minimum servicing compensation for Agency loans could occur at any time and could negatively impact the value of the income derived from any MSRs that we hold or may acquire in the future. |\n\n| • | Investments in MSRs are highly illiquid and subject to numerous restrictions on transfer and, as a result, there is risk that we would be unable to locate a willing buyer or get approval to sell any MSRs in the future should we desire to do so. |\n\nOur business, results of operations, financial condition and reputation could be adversely impacted if we are not able to successfully manage these or other risks related to investing and managing MSR investments.\nRisks Related to Our Manager\nWe are dependent on our Manager and may not find a suitable replacement if our Manager terminates the Management Agreement.\nNone of our officers or other senior individuals who perform services for us (other than three part-time employees of NRM), is an employee of New Residential. Instead, these individuals are employees of our Manager. Accordingly, we are completely reliant on our Manager, which has significant discretion as to the implementation of our operating policies and strategies, to conduct our business. We are subject to the risk that our Manager will terminate the Management Agreement and that we will not be able to find a suitable replacement for our Manager in a timely manner, at a reasonable cost or at all. Furthermore, we are dependent on\n136\nthe services of certain key employees of our Manager whose compensation is partially or entirely dependent upon the amount of incentive or management compensation earned by our Manager and whose continued service is not guaranteed, and the loss of such services could adversely affect our operations.\nOn December 27, 2017, SoftBank announced that it completed the SoftBank Merger. In connection with the SoftBank Merger, Fortress operates within SoftBank as an independent business headquartered in New York. There can be no assurance that the SoftBank Merger will not have an impact on us or our relationship with the Manager.\nThere are conflicts of interest in our relationship with our Manager.\nOur Management Agreement with our Manager was not negotiated between unaffiliated parties, and its terms, including fees payable, although approved by the independent directors of New Residential as fair, may not be as favorable to us as if they had been negotiated with an unaffiliated third party.\nThere are conflicts of interest inherent in our relationship with our Manager insofar as our Manager and its affiliates—including investment funds, private investment funds, or businesses managed by our Manager invest in real estate and other securities and loans, consumer loans and interests in MSRs and whose investment objectives overlap with our investment objectives. Certain investments appropriate for us may also be appropriate for one or more of these other investment vehicles. Certain members of our board of directors and employees of our Manager who are our officers also serve as officers and/or directors of these other entities. Although we have the same Manager, we may compete with entities affiliated with our Manager or Fortress for certain target assets. From time to time, affiliates of Fortress focus on investments in assets with a similar profile as our target assets that we may seek to acquire. These affiliates may have meaningful purchasing capacity, which may change over time depending upon a variety of factors, including, but not limited to, available equity capital and debt financing, market conditions and cash on hand. Fortress has two funds primarily focused on investing in Excess MSRs with approximately $0.6 billion in investments in aggregate. We have broad investment guidelines, and we have co-invested and may co-invest with Fortress funds or portfolio companies of private equity funds managed by our Manager (or an affiliate thereof) in a variety of investments. We also may invest in securities that are senior or junior to securities owned by funds managed by our Manager. Fortress funds generally have a fee structure similar to ours, but the fees actually paid will vary depending on the size, terms and performance of each fund.\nOur Management Agreement with our Manager generally does not limit or restrict our Manager or its affiliates from engaging in any business or managing other pooled investment vehicles that invest in investments that meet our investment objectives. Our Manager intends to engage in additional real estate related management and real estate and other investment opportunities in the future, which may compete with us for investments or result in a change in our current investment strategy. In addition, our certificate of incorporation provides that if Fortress or an affiliate or any of their officers, directors or employees acquire knowledge of a potential transaction that could be a corporate opportunity, they have no duty, to the fullest extent permitted by law, to offer such corporate opportunity to us, our stockholders or our affiliates. In the event that any of our directors and officers who is also a director, officer or employee of Fortress or its affiliates acquires knowledge of a corporate opportunity or is offered a corporate opportunity, provided that this knowledge was not acquired solely in such person’s capacity as a director or officer of New Residential and such person acts in good faith, then to the fullest extent permitted by law such person is deemed to have fully satisfied such person’s fiduciary duties owed to us and is not liable to us if Fortress or its affiliates pursues or acquires the corporate opportunity or if such person did not present the corporate opportunity to us.\nThe ability of our Manager and its officers and employees to engage in other business activities, subject to the terms of our Management Agreement with our Manager, may reduce the amount of time our Manager, its officers or other employees spend managing us. In addition, we may engage (subject to our investment guidelines) in material transactions with our Manager or another entity managed by our Manager or one of its affiliates, which may include, but are not limited to, certain financing arrangements, purchases of debt, co-investments in interests in MSRs, consumer loans, and other assets that present an actual, potential or perceived conflict of interest. It is possible that actual, potential or perceived conflicts could give rise to investor dissatisfaction, litigation or regulatory enforcement actions. Appropriately dealing with conflicts of interest is complex and difficult, and our reputation could be damaged if we fail, or appear to fail, to deal appropriately with one or more potential, actual or perceived conflicts of interest. Regulatory scrutiny of, or litigation in connection with, conflicts of interest could have a material adverse effect on our reputation, which could materially adversely affect our business in a number of ways, including causing an inability to raise additional funds, a reluctance of counterparties to do business with us, a decrease in the prices of our equity securities and a resulting increased risk of litigation and regulatory enforcement actions.\nThe management compensation structure that we have agreed to with our Manager, as well as compensation arrangements that we may enter into with our Manager in the future (in connection with new lines of business or other activities), may incentivize our Manager to invest in high risk investments. In addition to its management fee, our Manager is currently entitled to receive incentive compensation. In evaluating investments and other management strategies, the opportunity to earn incentive\n137\ncompensation may lead our Manager to place undue emphasis on the maximization of earnings, including through the use of leverage, at the expense of other criteria, such as preservation of capital, in order to achieve higher incentive compensation. Investments with higher yield potential are generally riskier or more speculative than lower-yielding investments. Moreover, because our Manager receives compensation in the form of options in connection with the completion of our common equity offerings, our Manager may be incentivized to cause us to issue additional common stock, which could be dilutive to existing stockholders. In addition, our Manager’s management fee is not tied to our performance and may not sufficiently incentivize our Manager to generate attractive risk-adjusted returns for us.\nIt would be difficult and costly to terminate our Management Agreement with our Manager.\nIt would be difficult and costly for us to terminate our Management Agreement with our Manager. The Management Agreement may only be terminated annually upon (i) the affirmative vote of at least two-thirds of our independent directors, or by a vote of the holders of a simple majority of the outstanding shares of our common stock, that there has been unsatisfactory performance by our Manager that is materially detrimental to us or (ii) a determination by a simple majority of our independent directors that the management fee payable to our Manager is not fair, subject to our Manager’s right to prevent such a termination by accepting a mutually acceptable reduction of fees. Our Manager will be provided 60 days’ prior notice of any termination and will be paid a termination fee equal to the amount of the management fee earned by the Manager during the 12-month period preceding such termination. In addition, following any termination of the Management Agreement, our Manager may require us to purchase its right to receive incentive compensation at a price determined as if our assets were sold for their fair market value (as determined by an appraisal, taking into account, among other things, the expected future performance of the underlying investments) or otherwise we may continue to pay the incentive compensation to our Manager. These provisions may increase the effective cost to us of terminating the Management Agreement, thereby adversely affecting our ability to terminate our Manager without cause.\nOur directors have approved broad investment guidelines for our Manager and do not approve each investment decision made by our Manager. In addition, we may change our investment strategy without a stockholder vote, which may result in our making investments that are different, riskier or less profitable than our current investments.\nOur Manager is authorized to follow broad investment guidelines. Consequently, our Manager has great latitude in determining the types and categories of assets it may decide are proper investments for us, including the latitude to invest in types and categories of assets that may differ from those in which we currently invest. Our directors will periodically review our investment guidelines and our investment portfolio. However, our board does not review or pre-approve each proposed investment or our related financing arrangements. In addition, in conducting periodic reviews, the directors rely primarily on information provided to them by our Manager. Furthermore, transactions entered into by our Manager may be difficult or impossible to unwind by the time they are reviewed by the directors, even if the transactions contravene the terms of the Management Agreement. In addition, we may change our investment strategy, including our target asset classes, without a stockholder vote.\nOur investment strategy may evolve in light of existing market conditions and investment opportunities, and this evolution may involve additional risks depending upon the nature of the assets in which we invest and our ability to finance such assets on a short or long-term basis. Investment opportunities that present unattractive risk-return profiles relative to other available investment opportunities under particular market conditions may become relatively attractive under changed market conditions, and changes in market conditions may therefore result in changes in the investments we target. Decisions to make investments in new asset categories present risks that may be difficult for us to adequately assess and could therefore reduce our ability to pay dividends on our common stock or have adverse effects on our liquidity, results of operations or financial condition. A change in our investment strategy may also increase our exposure to interest rate, foreign currency, real estate market or credit market fluctuations and expose us to new legal and regulatory risks. In addition, a change in our investment strategy may increase our use of non-match-funded financing, increase the guarantee obligations we agree to incur or increase the number of transactions we enter into with affiliates. Our failure to accurately assess the risks inherent in new asset categories or the financing risks associated with such assets could adversely affect our results of operations, liquidity and financial condition.\nOur Manager will not be liable to us for any acts or omissions performed in accordance with the Management Agreement, including with respect to the performance of our investments.\nPursuant to our Management Agreement, our Manager will not assume any responsibility other than to render the services called for thereunder in good faith and will not be responsible for any action of our board of directors in following or declining to follow its advice or recommendations. Our Manager, its members, managers, officers and employees will not be liable to us or any of our subsidiaries, to our board of directors, or our or any subsidiary’s stockholders or partners for any acts or omissions by our Manager, its members, managers, officers or employees, except by reason of acts constituting bad faith, willful misconduct, gross negligence or reckless disregard of our Manager’s duties under our Management Agreement. We shall, to the full extent lawful, reimburse, indemnify and hold our Manager, its members, managers, officers and employees and each other person, if any,\n138\ncontrolling our Manager harmless of and from any and all expenses, losses, damages, liabilities, demands, charges and claims of any nature whatsoever (including attorneys’ fees) in respect of or arising from any acts or omissions of an indemnified party made in good faith in the performance of our Manager’s duties under our Management Agreement and not constituting such indemnified party’s bad faith, willful misconduct, gross negligence or reckless disregard of our Manager’s duties under our Management Agreement.\nOur Manager’s due diligence of investment opportunities or other transactions may not identify all pertinent risks, which could materially affect our business, financial condition, liquidity and results of operations.\nOur Manager intends to conduct due diligence with respect to each investment opportunity or other transaction it pursues. It is possible, however, that our Manager’s due diligence processes will not uncover all relevant facts, particularly with respect to any assets we acquire from third parties. In these cases, our Manager may be given limited access to information about the investment and will rely on information provided by the target of the investment. In addition, if investment opportunities are scarce, the process for selecting bidders is competitive, or the timeframe in which we are required to complete diligence is short, our ability to conduct a due diligence investigation may be limited, and we would be required to make investment decisions based upon a less thorough diligence process than would otherwise be the case. Accordingly, investments and other transactions that initially appear to be viable may prove not to be over time, due to the limitations of the due diligence process or other factors.\nThe ownership by our executive officers and directors of shares of common stock, options, or other equity awards of entities either owned by Fortress funds managed by affiliates of our Manager or managed by our Manager may create, or may create the appearance of, conflicts of interest.\nSome of our directors, officers and other employees of our Manager hold positions with entities either owned by Fortress funds managed by affiliates of our Manager or managed by our Manager and own such entities’ common stock, options to purchase such entities’ common stock or other equity awards. Such ownership may create, or may create the appearance of, conflicts of interest when these directors, officers and other employees are faced with decisions that could have different implications for such entities than they do for us.\nRisks Related to the Financial Markets\nThe impact of legislative and regulatory changes on our business, as well as the market and industry in which we operate, are uncertain and may adversely affect our business.\nThe Dodd-Frank Act was enacted in July 2010, which affects almost every aspect of the U.S. financial services industry, including certain aspects of the markets in which we operate, and imposes new regulations on us and how we conduct our business. As we describe in more detail below, it affects our business in many ways but it is difficult at this time to know exactly how or what the cumulative impact will be.\nGenerally, the Dodd-Frank Act strengthens the regulatory oversight of securities and capital markets activities by the SEC and established the CFPB to enforce laws and regulations for consumer financial products and services. It requires market participants to undertake additional record-keeping activities and imposes many additional disclosure requirements for public companies.\nMoreover, the Dodd-Frank Act contains a risk retention requirement for all asset-backed securities, which we issue. In October 2014, final rules were promulgated by a consortium of regulators implementing the final credit risk retention requirements of Section 941(b) of the Dodd-Frank Act. Under these “Risk Retention Rules,” sponsors of both public and private securitization transactions or one of their majority owned affiliates are required to retain at least 5% of the credit risk of the assets collateralizing such securitization transactions. These regulations generally prohibit the sponsor or its affiliate from directly or indirectly hedging or otherwise selling or transferring the retained interest for a specified period of time, depending on the type of asset that is securitized. Certain limited exemptions from these rules are available for certain types of assets, which may be of limited use under our current market practices. In any event, compliance with these new Risk Retention Rules has increased and will likely continue to increase the administrative and operational costs of asset securitization.\nFurther, the Dodd-Frank Act imposes mandatory clearing and exchange-trading requirements on many derivatives transactions (including formerly unregulated over-the-counter derivatives) in which we may engage. In addition, the Dodd-Frank Act is expected to increase the margin requirements for derivatives transactions that are not subject to mandatory clearing requirements, which may impact our activities. The Dodd-Frank Act also creates new categories of regulated market participants, such as “swap-dealers,” “security-based swap dealers,” “major swap participants” and “major security-based swap participants,” and subjects or may subject these regulated entities to significant new capital, registration, recordkeeping, reporting, disclosure, business conduct and other regulatory requirements that will give rise to new administrative costs.\n139\nAlso, under the Dodd-Frank Act, financial regulators belonging to the Financial Stability Oversight Council are authorized to designate nonbank financial institutions and financial activities as systemically important to the economy and therefore subject to closer regulatory supervision. Such systemically important financial institutions, or “SIFIs,” may be required to operate with greater safety margins, such as higher levels of capital, and may face further limitations on their activities. The determination of what constitutes a SIFI is evolving, and in time SIFIs may include large investment funds and even asset managers. There can be no assurance that we will not be deemed to be a SIFI or engage in activities later determined to be systemically important and thus subject to further regulation.\nEven new requirements that are not directly applicable to us may still increase our costs of entering into transactions with the parties to whom the requirements are directly applicable. For instance, if the exchange-trading and trade reporting requirements lead to reductions in the liquidity of derivative transactions we may experience higher pricing or reduced availability of derivatives, or the reduction of arbitrage opportunities for us, which could adversely affect the performance of certain of our trading strategies. Importantly, many key aspects of the changes imposed by the Dodd-Frank Act will continue to be established by various regulatory bodies and other groups over the next several years.\nIn addition, there is significant uncertainty regarding the legislative and regulatory outlook for the Dodd-Frank Act and related statutes governing financial services, which may include Dodd-Frank Act amendments, mortgage finance and housing policy in the U.S., and the future structure and responsibilities of regulatory agencies such as the CFPB and the FHFA. For example, in March 2018, the U.S. Senate approved banking reform legislation intended to ease some of the restrictions imposed by the Dodd-Frank Act. Due to this uncertainty, it is not possible for us to predict how future legislative or regulatory proposals by Congress and the Administration will affect us or the market and industry in which we operate, and there can be no assurance that the resulting changes will not have an adverse impact on our business, results of operations, or financial condition. It is possible that such regulatory changes could, among other things, increase our costs of operating as a public company, impose restrictions on our ability to securitize assets and reduce our investment returns on securitized assets.\nThe federal conservatorship of Fannie Mae and Freddie Mac and related efforts, along with any changes in laws and regulations affecting the relationship between these agencies and the U.S. government, may adversely affect our business.\nThe payments we receive on the Agency RMBS in which we invest depend upon a steady stream of payments by borrowers on the underlying mortgages and the fulfillment of guarantees by GSEs. Ginnie Mae is part of a U.S. Government agency and its guarantees are backed by the full faith and credit of the U.S. Fannie Mae and Freddie Mac are GSEs, but their guarantees are not backed by the full faith and credit of the U.S. Government.\nIn response to the deteriorating financial condition of Fannie Mae and Freddie Mac and the credit market disruption beginning in 2007, Congress and the U.S. Treasury undertook a series of actions to stabilize these GSEs and the financial markets, generally. The Housing and Economic Recovery Act of 2008 was signed into law on July 30, 2008, and established the FHFA, with enhanced regulatory authority over, among other things, the business activities of Fannie Mae and Freddie Mac and the size of their portfolio holdings. On September 7, 2008, FHFA placed Fannie Mae and Freddie Mac into federal conservatorship and, together with the U.S. Treasury, established a program designed to boost investor confidence in Fannie Mae’s and Freddie Mac’s debt and Agency RMBS.\nAs the conservator of Fannie Mae and Freddie Mac, the FHFA controls and directs the operations of Fannie Mae and Freddie Mac and may (1) take over the assets of and operate Fannie Mae and Freddie Mac with all the powers of the stockholders, the directors and the officers of Fannie Mae and Freddie Mac and conduct all business of Fannie Mae and Freddie Mac; (2) collect all obligations and money due to Fannie Mae and Freddie Mac; (3) perform all functions of Fannie Mae and Freddie Mac which are consistent with the conservator’s appointment; (4) preserve and conserve the assets and property of Fannie Mae and Freddie Mac; and (5) contract for assistance in fulfilling any function, activity, action or duty of the conservator.\nThose efforts resulted in significant U.S. Government financial support and increased control of the GSEs.\nThe U.S. Federal Reserve (the “Fed”) announced in November 2008 a program of large-scale purchases of Agency RMBS in an attempt to lower longer-term interest rates and contribute to an overall easing of adverse financial conditions. Subject to specified investment guidelines, the portfolios of Agency RMBS purchased through the programs established by the U.S. Treasury and the Fed may be held to maturity and, based on mortgage market conditions, adjustments may be made to these portfolios. This flexibility may adversely affect the pricing and availability of Agency RMBS that we seek to acquire during the remaining term of these portfolios.\n140\nThere can be no assurance that the U.S. Government’s intervention in Fannie Mae and Freddie Mac will be adequate for the longer-term viability of these GSEs. These uncertainties lead to questions about the availability of and trading market for, Agency RMBS. Accordingly, if these government actions are inadequate and the GSEs defaulted on their guaranteed obligations, suffered losses or ceased to exist, the value of our Agency RMBS and our business, operations and financial condition could be materially and adversely affected.\nAdditionally, because of the financial problems faced by Fannie Mae and Freddie Mac that led to their federal conservatorships, the Administration and Congress have been examining reform of the GSEs, including the value of a federal mortgage guarantee and the appropriate role for the U.S. government in providing liquidity for residential mortgage loans. The respective chairmen of the Congressional committees of jurisdiction, as well as the Secretary of the Treasury, has each stated that GSE reform, including a possible wind down of the GSEs, is a priority. However, the final details of any plans, policies or proposals with respect to the housing GSEs are unknown at this time. Other bills have been introduced that change the GSEs’ business charters and eliminate the entities or make other changes to the existing framework. We cannot predict whether or when such legislation may be enacted. If enacted, such legislation could materially and adversely affect the availability of, and trading market for, Agency RMBS and could, therefore, materially and adversely affect the value of our Agency RMBS and our business, operations and financial condition.\nLegislation that permits modifications to the terms of outstanding loans may negatively affect our business, financial condition, liquidity and results of operations.\nThe U.S. government has enacted legislation that enables government agencies to modify the terms of a significant number of residential and other loans to provide relief to borrowers without the applicable investor’s consent. These modifications allow for outstanding principal to be deferred, interest rates to be reduced, the term of the loan to be extended or other terms to be changed in ways that can permanently eliminate the cash flow (principal and interest) associated with a portion of the loan. These modifications are currently reducing, or in the future may reduce, the value of a number of our current or future investments, including investments in mortgage backed securities and interests in MSRs. As a result, such loan modifications are negatively affecting our business, results of operations, liquidity and financial condition. In addition, certain market participants propose reducing the amount of paperwork required by a borrower to modify a loan, which could increase the likelihood of fraudulent modifications and materially harm the U.S. mortgage market and investors that have exposure to this market. Additional legislation intended to provide relief to borrowers may be enacted and could further harm our business, results of operations and financial condition.\nRisks Related to Our Taxation as a REIT\nQualifying as a REIT involves highly technical and complex provisions of the Internal Revenue Code.\nQualification as a REIT involves the application of highly technical and complex Internal Revenue Code provisions for which only limited judicial and administrative authorities exist. Even a technical or inadvertent violation could jeopardize our REIT qualification. Our qualification as a REIT will depend on our satisfaction of certain asset, income, organizational, distribution, stockholder ownership and other requirements on a continuing basis. Compliance with these requirements must be carefully monitored on a continuing basis. Monitoring and managing our REIT compliance has become challenging due to the increased size and complexity of the assets in our portfolio, a meaningful portion of which are not qualifying REIT assets. There can be no assurance that our Manager’s personnel responsible for doing so will be able to successfully monitor our compliance or maintain our REIT status.\nOur failure to qualify as a REIT would result in higher taxes and reduced cash available for distribution to our stockholders.\nWe intend to operate in a manner intended to qualify us as a REIT for U.S. federal income tax purposes. Our ability to satisfy the asset tests depends upon our analysis of the fair market values of our assets, some of which are not susceptible to a precise determination, and for which we do not obtain independent appraisals. See “—Risks Related to our Business—The valuations of our assets are subject to uncertainty because most of our assets are not traded in an active market,” and “—Risks Related to Our Business—Rapid changes in the values of our assets may make it more difficult for us to maintain our qualification as a REIT or our exclusion from the 1940 Act.” Our compliance with the REIT income and quarterly asset requirements also depends upon our ability to successfully manage the composition of our income and assets on an ongoing basis. Moreover, the proper classification of one or more of our investments (such as TBAs) may be uncertain in some circumstances, which could affect the application of the REIT qualification requirements. Accordingly, there can be no assurance that the U.S. Internal Revenue Service (“IRS”) will not contend that our investments violate the REIT requirements.\nIf we were to fail to qualify as a REIT in any taxable year, we would be subject to U.S. federal income tax, including any applicable alternative minimum tax, on our taxable income at regular corporate rates, and distributions to stockholders would not be deductible\n141\nby us in computing our taxable income. Any such corporate tax liability could be substantial and would reduce the amount of cash available for distribution to our stockholders, which in turn could have an adverse impact on the value of, and market price for, our stock. See also “—Our failure to qualify as a REIT would cause our stock to be delisted from the NYSE.”\nUnless entitled to relief under certain provisions of the Internal Revenue Code, we also would be disqualified from taxation as a REIT for the four taxable years following the year during which we initially ceased to qualify as a REIT. The rule against re-electing REIT status following a loss of such status would also apply to us if Drive Shack failed to qualify as a REIT for any taxable year ended on or before December 31, 2014, and we were treated as a successor to Drive Shack for U.S. federal income tax purposes. Although Drive Shack (i) represented in the separation and distribution agreement that it entered into with us on April 26, 2013 (the “Separation and Distribution Agreement”) that it has no knowledge of any fact or circumstance that would cause us to fail to qualify as a REIT and (ii) covenanted in the Separation and Distribution Agreement to use its reasonable best efforts to maintain its REIT status for each of Drive Shack’s taxable years ended on or before December 31, 2014 (unless Drive Shack obtains an opinion from a nationally recognized tax counsel or a private letter ruling from the IRS to the effect that Drive Shack’s failure to maintain its REIT status will not cause us to fail to qualify as a REIT under the successor REIT rule referred to above), no assurance can be given that such representation and covenant would prevent us from failing to qualify as a REIT. Although, in the event of a breach, we may be able to seek damages from Drive Shack, there can be no assurance that such damages, if any, would appropriately compensate us. In addition, if Drive Shack were to fail to qualify as a REIT despite its reasonable best efforts, we would have no claim against Drive Shack.\nOur failure to qualify as a REIT would cause our stock to be delisted from the NYSE.\nThe NYSE requires, as a condition to the listing of our shares, that we maintain our REIT status. Consequently, if we fail to maintain our REIT status, our shares would promptly be delisted from the NYSE, which would decrease the trading activity of such shares. This could make it difficult to sell shares and would likely cause the market volume of the shares trading to decline.\nIf we were delisted as a result of losing our REIT status and desired to relist our shares on the NYSE, we would have to reapply to the NYSE to be listed as a domestic corporation. As the NYSE’s listing standards for REITs are less onerous than its standards for domestic corporations, it would be more difficult for us to become a listed company under these heightened standards. We might not be able to satisfy the NYSE’s listing standards for a domestic corporation. As a result, if we were delisted from the NYSE, we might not be able to relist as a domestic corporation, in which case our shares could not trade on the NYSE.\nThe failure of assets subject to repurchase agreements to qualify as real estate assets could adversely affect our ability to qualify as a REIT.\nWe enter into financing arrangements that are structured as sale and repurchase agreements pursuant to which we nominally sell certain of our assets to a counterparty and simultaneously enter into an agreement to repurchase these assets at a later date in exchange for a purchase price. Economically, these agreements are financings that are secured by the assets sold pursuant thereto. We believe that, for purposes of the REIT asset and income tests, we should be treated as the owner of the assets that are the subject of any such sale and repurchase agreement, notwithstanding that those agreements generally transfer record ownership of the assets to the counterparty during the term of the agreement. It is possible, however, that the IRS could assert that we did not own the assets during the term of the sale and repurchase agreement, in which case we might fail to qualify as a REIT.\nThe failure of our Excess MSRs to qualify as real estate assets or the income from our Excess MSRs to qualify as mortgage interest could adversely affect our ability to qualify as a REIT.\nWe have received from the IRS a private letter ruling substantially to the effect that our Excess MSRs represent interests in mortgages on real property and thus are qualifying “real estate assets” for purposes of the REIT asset test, which generate income that qualifies as interest on obligations secured by mortgages on real property for purposes of the REIT income test. The ruling is based on, among other things, certain assumptions as well as on the accuracy of certain factual representations and statements that we and Drive Shack have made to the IRS. If any of the representations or statements that we have made in connection with the private letter ruling, are, or become, inaccurate or incomplete in any material respect with respect to one or more Excess MSR investments, or if we acquire an Excess MSR investment with terms that are not consistent with the terms of the Excess MSR investments described in the private letter ruling, then we will not be able to rely on the private letter ruling. If we are unable to rely on the private letter ruling with respect to an Excess MSR investment, the IRS could assert that such Excess MSR investments do not qualify under the REIT asset and income tests, and if successful, we might fail to qualify as a REIT.\n142\nDividends payable by REITs do not qualify for the reduced tax rates available for some “qualified dividends.”\nDividends payable to domestic stockholders that are individuals, trusts, and estates are generally taxed at reduced tax rates applicable to “qualified dividends.” Dividends payable by REITs, however, generally are not eligible for those reduced rates. The more favorable rates applicable to regular corporate dividends could cause investors who are individuals, trusts and estates to perceive investments in REITs to be relatively less attractive than investments in the stocks of non-REIT corporations that pay dividends, which could adversely affect the value of the stock of REITs, including our common stock. In addition, the relative attractiveness of real estate in general may be adversely affected by the favorable tax treatment given to non-REIT corporate dividends, which could affect the value of our real estate assets negatively.\nREIT distribution requirements could adversely affect our liquidity and our ability to execute our business plan.\nWe generally must distribute annually at least 90% of our REIT taxable income, excluding any net capital gain, in order for corporate income tax not to apply to earnings that we distribute. We intend to make distributions to our stockholders to comply with the REIT requirements of the Internal Revenue Code. However, differences in timing between the recognition of taxable income and the actual receipt of cash could require us to sell assets or borrow funds on a short-term or long-term basis to meet the 90% distribution requirement of the Internal Revenue Code. Certain of our assets, such as our investment in consumer loans, generate substantial mismatches between taxable income and available cash. As a result, the requirement to distribute a substantial portion of our net taxable income could cause us to: (i) sell assets in adverse market conditions; (ii) borrow on unfavorable terms; (iii) distribute amounts that would otherwise be invested in future acquisitions, capital expenditures or repayment of debt; or (iv) make taxable distributions of our capital stock or debt securities in order to comply with REIT requirements. Further, amounts distributed will not be available to fund investment activities. If we fail to obtain debt or equity capital in the future, it could limit our ability to satisfy our liquidity needs, which could adversely affect the value of our common stock.\nWe may be required to report taxable income for certain investments in excess of the economic income we ultimately realize from them.\nBased on IRS guidance concerning the classification of Excess MSRs, we intend to treat our Excess MSRs as ownership interests in the interest payments made on the underlying residential mortgage loans, akin to an “interest only” strip. Under this treatment, for purposes of determining the amount and timing of taxable income, each Excess MSR is treated as a bond that was issued with original issue discount on the date we acquired such Excess MSR. In general, we will be required to accrue original issue discount based on the constant yield to maturity of each Excess MSR, and to treat such original issue discount as taxable income in accordance with the applicable U.S. federal income tax rules. The constant yield of an Excess MSR will be determined, and we will be taxed, based on a prepayment assumption regarding future payments due on the residential mortgage loans underlying the Excess MSR. If the residential mortgage loans underlying an Excess MSR prepay at a rate different than that under the prepayment assumption, our recognition of original issue discount will be either increased or decreased depending on the circumstances. Thus, in a particular taxable year, we may be required to accrue an amount of income in respect of an Excess MSR that exceeds the amount of cash collected in respect of that Excess MSR. Furthermore, it is possible that, over the life of the investment in an Excess MSR, the total amount we pay for, and accrue with respect to, the Excess MSR may exceed the total amount we collect on such Excess MSR. No assurance can be given that we will be entitled to a deduction for such excess, meaning that we may be required to recognize “phantom income” over the life of an Excess MSR.\nOther debt instruments that we may acquire, including consumer loans, may be issued with, or treated as issued with, original issue discount. Those instruments would be subject to the original issue discount accrual and income computations that are described above with regard to Excess MSRs.\nUnder the Tax Cuts and Jobs Act (“TCJA”) enacted in late 2017, we generally will be required to take certain amounts into income no later than the time such amounts are reflected on certain financial statements. The application of this rule may require the accrual of, among other categories of income, income with respect to certain debt instruments or mortgage-backed securities, such as original issue discount, earlier than would be the case under the general tax rules, although the precise application of this rule is unclear at this time.\nWe may acquire debt instruments in the secondary market for less than their face amount. The discount at which such debt instruments are acquired may reflect doubts about their ultimate collectability rather than current market interest rates. The amount of such discount will nevertheless generally be treated as “market discount” for U.S. federal income tax purposes. Accrued market discount is reported as income when, and to the extent that, any payment of principal of the debt instrument is made. If we collect less on the debt instrument than our purchase price plus the market discount we had previously reported as income, we may not be able to benefit from any offsetting loss deductions.\n143\nIn addition, we may acquire debt instruments that are subsequently modified by agreement with the borrower. If the amendments to the outstanding instrument are “significant modifications” under the applicable U.S. Treasury regulations, the modified instrument will be considered to have been reissued to us in a debt-for-debt exchange with the borrower. In that event, we may be required to recognize taxable gain to the extent the principal amount of the modified instrument exceeds our adjusted tax basis in the unmodified instrument, even if the value of the instrument or the payment expectations have not changed. Following such a taxable modification, we would hold the modified loan with a cost basis equal to its principal amount for U.S. federal tax purposes.\nFinally, in the event that any debt instruments acquired by us are delinquent as to mandatory principal and interest payments, or in the event payments with respect to a particular instrument are not made when due, we may nonetheless be required to continue to recognize the unpaid interest as taxable income as it accrues, despite doubt as to its ultimate collectability. Similarly, we may be required to accrue interest income with respect to debt instruments at the stated rate regardless of whether corresponding cash payments are received or are ultimately collectible. In each case, while we would in general ultimately have an offsetting loss deduction available to us when such interest was determined to be uncollectible, the utility of that deduction could depend on our having taxable income of an appropriate character in that later year or thereafter.\nIn any event, if our investments generate more taxable income than cash in any given year, we may have difficulty satisfying our annual REIT distribution requirement.\nWe may be unable to generate sufficient cash from operations to pay our operating expenses and to pay distributions to our stockholders.\nAs a REIT, we are generally required to distribute at least 90% of our REIT taxable income (determined without regard to the dividends paid deduction and not including net capital gains) each year to our stockholders. To qualify for the tax benefits accorded to REITs, we intend to make distributions to our stockholders in amounts such that we distribute all or substantially all of our net taxable income, subject to certain adjustments, although there can be no assurance that our operations will generate sufficient cash to make such distributions. Moreover, our ability to make distributions may be adversely affected by the risk factors described herein. See also “—Risks Related to our Stock—We have not established a minimum distribution payment level, and we cannot assure you of our ability to pay distributions in the future.”\nThe stock ownership limit imposed by the Internal Revenue Code for REITs and our certificate of incorporation may inhibit market activity in our stock and restrict our business combination opportunities.\nIn order for us to maintain our qualification as a REIT under the Internal Revenue Code, not more than 50% in value of our outstanding stock may be owned, directly or indirectly, by five or fewer individuals (as defined in the Internal Revenue Code to include certain entities) at any time during the last half of each taxable year after our first taxable year. Our certificate of incorporation, with certain exceptions, authorizes our board of directors to take the actions that are necessary and desirable to preserve our qualification as a REIT. Stockholders are generally restricted from owning more than 9.8% by value or number of shares, whichever is more restrictive, of our outstanding shares of common stock, or 9.8% by value or number of shares, whichever is more restrictive, of our outstanding shares of capital stock. Our board may grant an exemption in its sole discretion, subject to such conditions, representations and undertakings as it may determine in its sole discretion. These ownership limits could delay or prevent a transaction or a change in our control that might involve a premium price for our common stock or otherwise be in the best interest of our stockholders.\nEven if we remain qualified as a REIT, we may face other tax liabilities that reduce our cash flow.\nEven if we remain qualified for taxation as a REIT, we may be subject to certain federal, state and local taxes on our income and assets, including taxes on any undistributed income, tax on income from some activities conducted as a result of a foreclosure, and state or local income, property and transfer taxes. Moreover, if a REIT distributes less than 85% of its ordinary income and 95% of its capital gain net income plus any undistributed shortfall from the prior year (the “Required Distribution”) to its stockholders during any calendar year (including any distributions declared by the last day of the calendar year but paid in the subsequent year), then it is required to pay an excise tax on 4% of any shortfall between the Required Distribution and the amount that was actually distributed. Any of these taxes would decrease cash available for distribution to our stockholders. In addition, in order to meet the REIT qualification requirements, or to avert the imposition of a 100% tax that applies to certain gains derived by a REIT from dealer property or inventory, we may hold some of our assets through TRSs. Such subsidiaries generally will be subject to corporate level income tax at regular rates and the payment of such taxes would reduce our return on the applicable investment. Currently, we hold some of our investments in TRSs, including Servicer Advance Investments and MSRs, and we may contribute other non-qualifying investments, such as our investment in consumer loans, to a TRS in the future.\n144\nComplying with the REIT requirements may negatively impact our investment returns or cause us to forgo otherwise attractive opportunities, liquidate assets or contribute assets to a TRS.\nTo qualify as a REIT for U.S. federal income tax purposes, we must continually satisfy tests concerning, among other things, the sources of our income, the nature and diversification of our assets, the amounts we distribute to our stockholders and the ownership of our stock. As a result of these tests, we may be required to make distributions to stockholders at disadvantageous times or when we do not have funds readily available for distribution, forgo otherwise attractive investment opportunities, liquidate assets in adverse market conditions or contribute assets to a TRS that is subject to regular corporate federal income tax. Our ability to acquire and hold MSRs, interests in consumer loans, Servicer Advance Investments and other investments is subject to the applicable REIT qualification tests, and we may have to hold these interests through TRSs, which would negatively impact our returns from these assets. In general, compliance with the REIT requirements may hinder our ability to make and retain certain attractive investments.\nComplying with the REIT requirements may limit our ability to hedge effectively.\nThe existing REIT provisions of the Internal Revenue Code may substantially limit our ability to hedge our operations because a significant amount of the income from those hedging transactions is likely to be treated as non-qualifying income for purposes of both REIT gross income tests. In addition, we must limit our aggregate income from non-qualified hedging transactions, from our provision of services and from other non-qualifying sources, to less than 5% of our annual gross income (determined without regard to gross income from qualified hedging transactions).\nAs a result, we may have to limit our use of certain hedging techniques or implement those hedges through TRSs. This could result in greater risks associated with changes in interest rates than we would otherwise want to incur or could increase the cost of our hedging activities. If we fail to comply with these limitations, we could lose our REIT qualification for U.S. federal income tax purposes, unless our failure was due to reasonable cause, and not due to willful neglect, and we meet certain other technical requirements. Even if our failure were due to reasonable cause, we might incur a penalty tax. See also “—Risks Related to Our Business—Any hedging transactions that we enter into may limit our gains or result in losses.”\nDistributions to tax-exempt investors may be classified as unrelated business taxable income.\nNeither ordinary nor capital gain distributions with respect to our stock nor gain from the sale of stock should generally constitute unrelated business taxable income to a tax-exempt investor. However, there are certain exceptions to this rule. In particular:\n\n| • | part of the income and gain recognized by certain qualified employee pension trusts with respect to our stock may be treated as unrelated business taxable income if shares of our stock are predominantly held by qualified employee pension trusts, and we are required to rely on a special look-through rule for purposes of meeting one of the REIT ownership tests, and we are not operated in a manner to avoid treatment of such income or gain as unrelated business taxable income; |\n\n| • | part of the income and gain recognized by a tax-exempt investor with respect to our stock would constitute unrelated business taxable income if the investor incurs debt in order to acquire the stock; and |\n\n| • | to the extent that we are (or a part of us, or a disregarded subsidiary of ours, is) a “taxable mortgage pool,” or if we hold residual interests in a real estate mortgage investment conduit (“REMIC”), a portion of the distributions paid to a tax exempt stockholder that is allocable to excess inclusion income may be treated as unrelated business taxable income. |\n\nThe “taxable mortgage pool” rules may increase the taxes that we or our stockholders may incur, and may limit the manner in which we effect future securitizations.\nWe may enter into securitization or other financing transactions that result in the creation of taxable mortgage pools for U.S. federal income tax purposes. As a REIT, so long as we own 100% of the equity interests in a taxable mortgage pool, we would generally not be adversely affected by the characterization of a securitization as a taxable mortgage pool. Certain categories of stockholders, however, such as foreign stockholders eligible for treaty or other benefits, stockholders with net operating losses, and certain tax exempt stockholders that are subject to unrelated business income tax, could be subject to increased taxes on a portion of their dividend income from us that is attributable to the taxable mortgage pool. In addition, to the extent that our stock is owned by tax exempt “disqualified organizations,” such as certain government-related entities and charitable remainder trusts that are not subject to tax on unrelated business income, we could incur a corporate level tax on a portion of our income from the taxable mortgage pool. In that case, we might reduce the amount of our distributions to any disqualified organization whose stock ownership gave rise to the tax. Moreover, we may be precluded from selling equity interests in these securitizations to outside investors, or selling any debt securities issued in connection with these securitizations that might be considered to be equity interests for tax purposes. These limitations may prevent us from using certain techniques to maximize our returns from securitization transactions.\n145\nUncertainty exists with respect to the treatment of TBAs for purposes of the REIT asset and income tests, and the failure of TBAs to be qualifying assets or of income/gains from TBAs to be qualifying income could adversely affect our ability to qualify as a REIT.\nWe purchase and sell Agency RMBS through TBAs and recognize income or gains from the disposition of those TBAs, through dollar roll transactions or otherwise. In a dollar roll transaction, we exchange an existing TBA for another TBA with a different settlement date. There is no direct authority with respect to the qualification of TBAs as real estate assets or U.S. Government securities for purposes of the 75% asset test or the qualification of income or gains from dispositions of TBAs as gains from the sale of real property (including interests in real property and interests in mortgages on real property) or other qualifying income for purposes of the 75% gross income test. For a particular taxable year, we would treat such TBAs as qualifying assets for purposes of the REIT asset tests, and income and gains from such TBAs as qualifying income for purposes of the 75% gross income test, to the extent set forth in an opinion from Skadden, Arps, Slate, Meagher & Flom LLP substantially to the effect that (i) for purposes of the REIT asset tests, our ownership of a TBA should be treated as ownership of the underlying Agency RMBS, and (ii) for purposes of the 75% REIT gross income test, any gain recognized by us in connection with the settlement of such TBAs should be treated as gain from the sale or disposition of the underlying Agency RMBS. Opinions of counsel are not binding on the IRS, and no assurance can be given that the IRS would not successfully challenge the conclusions set forth in such opinions. In addition, it must be emphasized that any opinion of Skadden, Arps, Slate, Meagher & Flom LLP would be based on various assumptions relating to any TBAs that we enter into and would be conditioned upon fact-based representations and covenants made by our management regarding such TBAs. No assurance can be given that the IRS would not assert that such assets or income are not qualifying assets or income. If the IRS were to successfully challenge any conclusions of Skadden, Arps, Slate, Meagher & Flom LLP, we could be subject to a penalty tax or we could fail to qualify as a REIT if a sufficient portion of our assets consists of TBAs or a sufficient portion of our income consists of income or gains from the disposition of TBAs.\nThe tax on prohibited transactions will limit our ability to engage in transactions that would be treated as prohibited transactions for U.S. federal income tax purposes.\nNet income that we derive from a “prohibited transaction” is subject to a 100% tax. The term “prohibited transaction” generally includes a sale or other disposition of property (including mortgage loans, but other than foreclosure property, as discussed below) that is held primarily for sale to customers in the ordinary course of our trade or business. We might be subject to this tax if we were to dispose of or securitize loans or Excess MSRs in a manner that was treated as a prohibited transaction for U.S. federal income tax purposes.\nWe intend to conduct our operations so that no asset that we own (or are treated as owning) will be treated as, or as having been, held-for-sale to customers, and that a sale of any such asset will not be treated as having been in the ordinary course of our business. As a result, we may choose not to engage in certain sales of loans or Excess MSRs at the REIT level, and may limit the structures we utilize for our securitization transactions, even though the sales or structures might otherwise be beneficial to us. In addition, whether property is held “primarily for sale to customers in the ordinary course of a trade or business” depends on the particular facts and circumstances. No assurance can be given that any property that we sell will not be treated as property held-for-sale to customers, or that we can comply with certain safe-harbor provisions of the Internal Revenue Code that would prevent such treatment. The 100% prohibited transaction tax does not apply to gains from the sale of property that is held through a TRS or other taxable corporation, although such income will be subject to tax in the hands of the corporation at regular corporate rates. We intend to structure our activities to prevent prohibited transaction characterization.\nLiquidation of assets may jeopardize our REIT qualification or create additional tax liability for us.\nTo qualify as a REIT, we must comply with requirements regarding the composition of our assets and our sources of income. If we are compelled to liquidate our investments to repay obligations to our lenders, we may be unable to comply with these requirements, ultimately jeopardizing our qualification as a REIT, or we may be subject to a 100% tax on any resultant gain if we sell assets that are treated as dealer property or inventory.\nChanges to U.S. federal income tax laws could materially and adversely affect us and our stockholders.\nThe present U.S. federal income tax treatment of REITs and their shareholders may be modified, possibly with retroactive effect, by legislative, judicial or administrative action at any time, which could affect the U.S. federal income tax treatment of an investment in our shares. The U.S. federal income tax rules, including those dealing with REITs, are constantly under review by persons involved in the legislative process, the IRS and the U.S. Treasury Department, which results in statutory changes as well as frequent revisions to regulations and interpretations.\n146\nThe TCJA, which was enacted in 2017, made substantial changes to the Internal Revenue Code. Among those changes are a significant permanent reduction in the generally applicable corporate tax rate, changes in the taxation of individuals and other non-corporate taxpayers that generally but not universally reduce their taxes on a temporary basis subject to “sunset” provisions, the elimination or modification of various currently allowed deductions (including substantial limitations on the deductibility of interest and, in the case of individuals, the deduction for personal state and local taxes), certain additional limitations on the deduction of net operating losses, and preferential rates of taxation on most ordinary REIT dividends and certain business income derived by non-corporate taxpayers in comparison to other ordinary income recognized by such taxpayers. The effect of these, and the many other, changes made in the TCJA remains uncertain, both in terms of their direct effect on the taxation of an investment in our common stock and their indirect effect on the value of our assets or market conditions generally. Furthermore, many of the provisions of the TCJA still require guidance through the issuance of Treasury regulations in order to assess their effect. There may be a substantial delay before such regulations are promulgated, increasing the uncertainty as to the ultimate effect of the statutory amendments on us. There also may be technical corrections legislation proposed with respect to the TCJA, the effect of which cannot be predicted and may be adverse to us or our stockholders.\nRisks Related to our Stock\nThere can be no assurance that the market for our stock will provide you with adequate liquidity.\nOur common stock began trading on the NYSE in May 2013, and our preferred stock began trading on the NYSE in July 2019. There can be no assurance that an active trading market for our common and preferred stock will be sustained in the future, and the market price of our common and preferred stock may fluctuate widely, depending upon many factors, some of which may be beyond our control. These factors include, without limitation:\n\n| • | a shift in our investor base; |\n\n| • | our quarterly or annual earnings and cash flows, or those of other comparable companies; |\n\n| • | actual or anticipated fluctuations in our operating results; |\n\n| • | changes in accounting standards, policies, guidance, interpretations or principles; |\n\n| • | announcements by us or our competitors of significant investments, acquisitions or dispositions; |\n\n| • | the failure of securities analysts to cover our common stock; |\n\n| • | changes in earnings estimates by securities analysts or our ability to meet those estimates; |\n\n| • | market performance of affiliates and other counterparties with whom we conduct business; |\n\n| • | the operating and stock price performance of other comparable companies; |\n\n| • | our failure to qualify as a REIT, maintain our exemption under the 1940 Act or satisfy the NYSE listing requirements; |\n\n| • | negative public perception of us, our competitors or industry; |\n\n| • | overall market fluctuations; and |\n\n| • | general economic conditions. |\n\nStock markets in general have experienced volatility that has often been unrelated to the operating performance of a particular company. These broad market fluctuations may adversely affect the market price of our common and preferred stock.\nSales or issuances of shares of our common stock could adversely affect the market price of our common stock.\nSales or issuances of substantial amounts of shares of our common stock, or the perception that such sales or issuances might occur, could adversely affect the market price of our common stock. The issuance of our common stock in connection with property, portfolio or business acquisitions or the exercise of outstanding options or otherwise could also have an adverse effect on the market price of our common stock. We have an effective registration statement on file to sell common stock or convertible securities in public offerings.\nFailure to maintain effective internal control over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act of 2002 could have a material adverse effect on our business and stock price.\nAs a public company, we are required to maintain effective internal control over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act of 2002. Internal control over financial reporting is complex and may be revised over time to adapt to changes in our business, or changes in applicable accounting rules. We have made investments through joint ventures, such as our investment in consumer loans, and accounting for such investments can increase the complexity of maintaining effective internal control over financial reporting. We cannot assure you that our internal control over financial reporting will be effective in the future or that a material weakness will not be discovered with respect to a prior period for which we had previously believed that our internal control over financial reporting was effective. If we are not able to maintain or document effective internal control over financial reporting, our independent registered public accounting firm will not be able to certify as to the effectiveness of our\n147\ninternal control over financial reporting. Matters impacting our internal control over financial reporting may cause us to be unable to report our financial information on a timely basis, or may cause us to restate previously issued financial information, and thereby subject us to adverse regulatory consequences, including sanctions or investigations by the SEC, or violations of applicable stock exchange listing rules. There could also be a negative reaction in the financial markets due to a loss of investor confidence in us and the reliability of our financial statements. Confidence in the reliability of our financial statements is also likely to suffer if we or our independent registered public accounting firm reports a material weakness in the effectiveness of our internal control over financial reporting. This could materially adversely affect us by, for example, leading to a decline in our stock price and impairing our ability to raise capital.\nYour percentage ownership in us may be diluted in the future.\nYour percentage ownership in us may be diluted in the future because of equity awards that we expect will be granted to our Manager, to the directors, officers and employees of our Manager who perform services for us, and to our directors, officers and employees, as well as other equity instruments such as debt and equity financing. We have adopted a Nonqualified Stock Option and Incentive Award Plan, as amended (the “Plan”), which provides for the grant of equity-based awards, including restricted stock, options, stock appreciation rights, performance awards, tandem awards and other equity-based and non-equity based awards, in each case to our Manager, to the directors, officers, employees, service providers, consultants and advisor of our Manager who perform services for us, and to our directors, officers, employees, service providers, consultants and advisors. We reserved 15 million shares of our common stock for issuance under the Plan. The term of the Plan expires in 2023. On the first day of each fiscal year beginning during the term of the Plan, that number will be increased by a number of shares of our common stock equal to 10% of the number of shares of our common stock newly issued by us during the immediately preceding fiscal year. In connection with any offering of our common or preferred stock, we will issue to our Manager options relating to shares of our common stock, representing 10% of the number of shares being offered. Our board of directors may also determine to issue options to the Manager that are not subject to the Plan, provided that the number of shares relating to any options granted to the Manager in connection with an offering of our common stock would not exceed 10% of the shares sold in such offering and would be subject to NYSE rules.\nWe may incur or issue debt or issue equity, which may negatively affect the market price of our common stock.\nWe may in the future incur or issue debt or issue equity or equity-related securities. In the event of our liquidation, lenders and holders of our debt and holders of our preferred stock (if any) would receive a distribution of our available assets before common stockholders. Any future incurrence or issuance of debt would increase our interest cost and could adversely affect our results of operations and cash flows. We are not required to offer any additional equity securities to existing common stockholders on a preemptive basis. Therefore, additional issuances of common stock, directly or through convertible or exchangeable securities, warrants or options, will dilute the holdings of our existing common stockholders and such issuances, or the perception of such issuances, may reduce the market price of our common stock. Our preferred stock has, and any additional preferred stock issued by us would likely have, a preference on distribution payments, periodically or upon liquidation, which could eliminate or otherwise limit our ability to make distributions to common stockholders. Because our decision to incur or issue debt or issue equity or equity-related securities in the future will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing, nature or success of our future capital raising efforts. Thus, common stockholders bear the risk that our future incurrence or issuance of debt or issuance of equity or equity-related securities will adversely affect the market price of our common stock.\nWe have not established a minimum distribution payment level for our common stock, and we cannot assure you of our ability to pay distributions in the future.\nWe intend to make quarterly distributions of our REIT taxable income to holders of our common stock out of assets legally available therefor. We have not established a minimum distribution payment level and our ability to pay distributions may be adversely affected by a number of factors, including the risk factors described in this report. Any distributions will be authorized by our board of directors and declared by us based upon a number of factors, including our actual and anticipated results of operations, liquidity and financial condition, restrictions under Delaware law or applicable financing covenants, our REIT taxable income, the annual distribution requirements under the REIT provisions of the Internal Revenue Code, our operating expenses and other factors our directors deem relevant.\nOur board of directors approved two increases in our quarterly dividends during 2017, which has resulted in reduced cash flows and we will begin making distributions on our preferred stock issued in July 2019, beginning in November 2019, which will further reduce our cash flows. Although we have other sources of liquidity, such as sales of and repayments from our investments, potential debt financing sources and the issuance of equity securities, there can be no assurance that we will generate sufficient cash or\n148\nachieve investment results that will allow us to make a specified level of cash distributions or year-to-year increases in cash distributions in the future.\nFurthermore, while we are required to make distributions in order to maintain our REIT status (as described above under “—Risks Related to our Taxation as a REIT—We may be unable to generate sufficient cash from operations to pay our operating expenses and to pay distributions to our stockholders”), we may elect not to maintain our REIT status, in which case we would no longer be required to make such distributions. Moreover, even if we do elect to maintain our REIT status, we may elect to comply with the applicable requirements by, after completing various procedural steps, distributing, under certain circumstances, a portion of the required amount in the form of shares of our common stock in lieu of cash. If we elect not to maintain our REIT status or to satisfy any required distributions in shares of common stock in lieu of cash, such action could negatively and materially affect our business, results of operations, liquidity and financial condition as well as the market price of our common stock. No assurance can be given that we will make any distributions on shares of our common stock in the future.\nWe may in the future choose to make distributions in our own stock, in which case you could be required to pay income taxes in excess of any cash distributions you receive.\nWe may in the future make taxable distributions that are payable in cash and shares of our common stock at the election of each stockholder. Taxable stockholders receiving such distributions will be required to include the full amount of the distribution as ordinary income to the extent of our current and accumulated earnings and profits for federal income tax purposes. As a result, stockholders may be required to pay income taxes with respect to such distributions in excess of the cash distributions received. If a U.S. stockholder sells the stock that it receives as a distribution in order to pay this tax, the sale proceeds may be less than the amount included in income with respect to the distribution, depending on the market price of our stock at the time of the sale. Furthermore, with respect to certain non-U.S. stockholders, we may be required to withhold U.S. tax with respect to such distributions, including in respect of all or a portion of such distribution that is payable in stock. In addition, if a significant number of our stockholders determine to sell shares of our common stock in order to pay taxes owed on distributions, it may put downward pressure on the market price of our common stock.\nIn August 2017, the IRS issued guidance authorizing elective cash/stock dividends to be made by public REITs where there is a minimum (of at least 20%) amount of cash that may be paid as part of the dividend, provided that certain requirements are met. It is unclear whether and to what extent we would be able to or choose to pay taxable distributions in cash and stock. In addition, no assurance can be given that the IRS will not impose additional requirements in the future with respect to taxable cash/stock distributions, including on a retroactive basis, or assert that the requirements for such taxable cash/stock distributions have not been met.\nAn increase in market interest rates may have an adverse effect on the market price of our common stock.\nOne of the factors that investors may consider in deciding whether to buy or sell shares of our common stock is our distribution rate as a percentage of our stock price relative to market interest rates. If the market price of our common stock is based primarily on the earnings and return that we derive from our investments and income with respect to our investments and our related distributions to stockholders, and not from the market value of the investments themselves, then interest rate fluctuations and capital market conditions will likely affect the market price of our common stock. For instance, if market interest rates rise without an increase in our distribution rate, the market price of our common stock could decrease, as potential investors may require a higher distribution yield on our common stock or seek other securities paying higher distributions or interest. In addition, rising interest rates would result in increased interest expense on our outstanding and future (variable and fixed) rate debt, thereby adversely affecting cash flow and our ability to service our indebtedness and pay distributions.\nProvisions in our certificate of incorporation and bylaws and of Delaware law may prevent or delay an acquisition of our company, which could decrease the market price of our common stock.\nOur certificate of incorporation, bylaws and Delaware law contain provisions that are intended to deter coercive takeover practices and inadequate takeover bids by making such practices or bids unacceptably expensive to the raider and to encourage prospective acquirers to negotiate with our board of directors rather than to attempt a hostile takeover. These provisions include, among others:\n\n| • | a classified board of directors with staggered three-year terms; |\n\n| • | provisions regarding the election of directors, classes of directors, the term of office of directors, the filling of director vacancies and the resignation and removal of directors for cause only upon the affirmative vote of at least 80% of the then issued and outstanding shares of our capital stock entitled to vote thereon; |\n\n| • | provisions regarding corporate opportunity only upon the affirmative vote of at least 80% of the then issued and outstanding shares of our capital stock entitled to vote thereon; |\n\n149\n| • | removal of directors only for cause and only with the affirmative vote of at least 80% of the then issued and outstanding shares of our capital stock entitled to vote in the election of directors; |\n\n| • | our board of directors to determine the powers, preferences and rights of our preferred stock and to issue such preferred stock without stockholder approval; |\n\n| • | advance notice requirements applicable to stockholders for director nominations and actions to be taken at annual meetings; |\n\n| • | a prohibition, in our certificate of incorporation, stating that no holder of shares of our common stock will have cumulative voting rights in the election of directors, which means that the holders of a majority of the issued and outstanding shares of common stock can elect all the directors standing for election; and |\n\n| • | a requirement in our bylaws specifically denying the ability of our stockholders to consent in writing to take any action in lieu of taking such action at a duly called annual or special meeting of our stockholders. |\n\nPublic stockholders who might desire to participate in these types of transactions may not have an opportunity to do so, even if the transaction is considered favorable to stockholders. These anti-takeover provisions could substantially impede the ability of public stockholders to benefit from a change in control or a change in our management and board of directors and, as a result, may adversely affect the market price of our common stock and your ability to realize any potential change of control premium.\nERISA may restrict investments by plans in our common stock.\nA plan fiduciary considering an investment in our common stock should consider, among other things, whether such an investment is consistent with the fiduciary obligations under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), including whether such investment might constitute or give rise to a prohibited transaction under ERISA, the Internal Revenue Code or any substantially similar federal, state or local law and, if so, whether an exemption from such prohibited transaction rules is available.\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nNone.\nITEM 3. DEFAULTS UPON SENIOR SECURITIES\nNone.\n\nITEM 4. MINE SAFETY DISCLOSURES\nNot Applicable.\n\nITEM 5. OTHER INFORMATION\nMr. David Schneider, the Chief Accounting Officer of the Company, has resigned as an officer of the Company effective as of October 31, 2019. The board of directors of the Company has appointed Mr. Nicola Santoro, Jr. as Chief Accounting Officer effective as of October 31, 2019. Mr. Santoro has been actively involved with New Residential since 2015 and is also the Company’s Chief Financial Officer and Treasurer.\n150\nITEM 6. EXHIBITS\n| Exhibit Number | Exhibit Description |\n| 2.1† | Separation and Distribution Agreement, dated as of April 26, 2013, by and between New Residential Investment Corp. and Newcastle Investment Corp. (incorporated by reference to Exhibit 2.1 to Amendment No. 6 of New Residential Investment Corp.’s Registration Statement on Form 10, filed April 29, 2013) |\n| 2.2† | Purchase Agreement, dated as of March 5, 2013, by and among the Sellers listed therein, HSBC Finance Corporation and SpringCastle Acquisition LLC (incorporated by reference to Exhibit 99.1 to Drive Shack Inc.’s Current Report on Form 8-K, filed March 11, 2013) |\n| 2.3† | Master Servicing Rights Purchase Agreement, dated as of December 17, 2013, by and between Nationstar Mortgage LLC and Advance Purchaser LLC (incorporated by reference to Exhibit 2.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed December 23, 2013) |\n| 2.4† | Sale Supplement (Shuttle 1), dated as of December 17, 2013, by and between Nationstar Mortgage LLC and Advance Purchaser LLC (incorporated by reference to Exhibit 2.2 to New Residential Investment Corp.’s Current Report on Form 8-K, filed December 23, 2013) |\n| 2.5† | Sale Supplement (Shuttle 2), dated as of December 17, 2013, by and between Nationstar Mortgage LLC and Advance Purchaser LLC (incorporated by reference to Exhibit 2.3 to New Residential Investment Corp.’s Current Report on Form 8-K, filed December 23, 2013) |\n| 2.6† | Sale Supplement (First Tennessee), dated as of December 17, 2013, by and between Nationstar Mortgage LLC and Advance Purchaser LLC (incorporated by reference to Exhibit 2.4 to New Residential Investment Corp.’s Current Report on Form 8-K, filed December 23, 2013) |\n| 2.7† | Purchase Agreement, dated as of March 31, 2016, by and among SpringCastle Holdings, LLC, Springleaf Acquisition Corporation, Springleaf Finance, Inc., NRZ Consumer LLC, NRZ SC America LLC, NRZ SC Credit Limited, NRZ SC Finance I LLC, NRZ SC Finance II LLC, NRZ SC Finance III LLC, NRZ SC Finance IV LLC, NRZ SC Finance V LLC, BTO Willow Holdings II, L.P. and Blackstone Family Tactical Opportunities Investment Partnership - NQ - ESC L.P., and solely with respect to Section 11(a) and Section 11(g), NRZ SC America Trust 2015-1, NRZ SC Credit Trust 2015-1, NRZ SC Finance Trust 2015-1, and BTO Willow Holdings, L.P. (incorporated by reference to Exhibit 2.10 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2016, filed on May 4, 2016) |\n| 2.8† | Securities Purchase Agreement, dated as of November 29, 2017, by and among NRM Acquisition LLC, Shellpoint Partners LLC, the Sellers party thereto and Shellpoint Services LLC, as original representative of the Seller (incorporated by reference to Exhibit 2.8 to New Residential Investment Corp.’s Annual Report on Form 10-K for the year ended December 31, 2017, filed on February 15, 2018) |\n| 2.9† | Amendment No. 1 to the Securities Purchase Agreement, dated as of July 3, 2018, by and among NRM Acquisition LLC, Shellpoint Partners LLC, the Sellers party thereto and Shellpoint Representative LLC, as replacement representative of the Sellers (incorporated by reference to Exhibit 2.9 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2018) |\n| 2.10 | Asset Purchase Agreement among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company, dated June 17, 2019 (incorporated by reference to Exhibit 2.10 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2019) |\n| 2.11 | Amendment No. 1 to the Asset Purchase Agreement, dated as of July 9, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\n| 2.12 | Amendment No. 2 to the Asset Purchase Agreement, dated as of August 30, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\n| 2.13 | Amendment No. 3 to the Asset Purchase Agreement, dated as of September 4, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\n| 2.14 | Amendment No. 4 to the Asset Purchase Agreement, dated as of September 5, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\n| 2.15 | Amendment No. 5 to the Asset Purchase Agreement, dated as of September 6, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\n\n151\n| Exhibit Number | Exhibit Description |\n| 2.16 | Amendment No. 6 to the Asset Purchase Agreement, dated as of September 9, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\n| 2.17 | Amendment No. 7 to the Asset Purchase Agreement, dated as of September 17, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\n| 2.18 | Amendment No. 8 to the Asset Purchase Agreement, dated as of September 30, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\n| 3.1 | Amended and Restated Certificate of Incorporation of New Residential Investment Corp. (incorporated by reference to Exhibit 3.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed May 3, 2013) |\n| 3.2 | Amended and Restated Bylaws of New Residential Investment Corp. (incorporated by reference to Exhibit 3.2 to New Residential Investment Corp.’s Current Report on Form 8-K, filed May 3, 2013) |\n| 3.3 | Certificate of Amendment to the Amended and Restated Certificate of Incorporation of New Residential Investment Corp. (incorporated by reference to Exhibit 3.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed October 17, 2014) |\n| 3.4 | Certificate of Designations of New Residential Investment Corp., designating the Company’s 7.50% Series A Fixed-to-Floating Rate Cumulative Redeemable Preferred Stock, par value $0.01 per share (incorporated by reference to Exhibit 3.4 to New Residential Investment Corp.’s Form 8-A, filed July 2, 2019) |\n| 3.5 | Certificate of Designations of New Residential Investment Corp., designating the Company’s 7.125% Series B Fixed-to-Floating Rate Cumulative Redeemable Preferred Stock, par value $0.01 per share (incorporated by reference to Exhibit 3.5 to New Residential Investment Corp.’s Form 8-A, filed August 15, 2019) |\n| 4.1 | Specimen Series A Preferred Stock Certificate (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Form 8-A filed July 2, 2019) |\n| 4.2 | Specimen Series B Preferred Stock Certificate of New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Form 8-A, filed August 15, 2019) |\n| 4.3 | Second Amended and Restated Indenture, dated as of September 7, 2018, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, New Residential Mortgage LLC, New Penn Financial, LLC, d/b/a Shellpoint Mortgage Servicing and Credit Suisse AG, New York Branch (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed September 7, 2018) |\n| 4.4 | Omnibus Amendment to Term Note Indenture Supplements, dated as of August 17, 2017, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, New Residential Mortgage LLC, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.2 to New Residential Investment Corp.’s Current Report on Form 8-K, filed August 22, 2017) |\n| 4.5 | Series 2016-T2 Indenture Supplement, dated as of October 25, 2016, to the Indenture, dated as of August 28, 2015, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed October 31, 2016) |\n| 4.6 | Series 2016-T3 Indenture Supplement, dated as of October 25, 2016, to the Indenture, dated as of August 28, 2015, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.2 to New Residential Investment Corp.’s Current Report on Form 8-K, filed October 31, 2016) |\n| 4.7 | Series 2016-T4 Indenture Supplement, dated as of December 15, 2016, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed December 16, 2016) |\n\n152\n| Exhibit Number | Exhibit Description |\n| 4.8 | Series 2016-T5 Indenture Supplement, dated as of December 15, 2016, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.2 to New Residential Investment Corp.’s Current Report on Form 8-K, filed December 16, 2016) |\n| 4.9 | Series 2017-T1 Indenture Supplement, dated as of February 7, 2017, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Current Report on Form 8-K filed February 7, 2017) |\n| 4.10 | Series 2018-VF1 Indenture Supplement, dated as of March 22, 2018, to the Amended and Restated Indenture, dated as of August 17, 2017, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, New Residential Mortgage LLC, JPMorgan Chase Bank, N.A. and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.'s Current Report on Form 8-K, filed March 28, 2018) |\n| 4.11 | Omnibus Amendment to Certain Agreements Relating to the NRZ Advance Receivables Trust 2015-ON1, dated as of September 7, 2018, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, New Residential Mortgage LLC, Credit Suisse AG, New York Branch, New Penn Financial, LLC, d/b/a Shellpoint Mortgage Servicing and New Residential Investment Corp. (incorporated by reference to Exhibit 4.2 to New Residential Investment Corp.’s Current Report on Form 8-K, filed September 7, 2018) |\n| 4.12 | Amendment No. 1 to Series 2018-VF1 Indenture Supplement, dated as of September 7, 2018, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, New Residential Mortgage LLC, New Penn Financial, LLC, d/b/a Shellpoint Mortgage Servicing, JPMorgan Chase Bank, N.A. and New Residential Investment Corp. (incorporated by reference to Exhibit 4.3 to New Residential Investment Corp.’s Current Report on Form 8-K, filed September 7, 2018) |\n| 4.13 | Amendment No. 2 to Series 2018-VF1 Indenture Supplement, dated as of September 28, 2018, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, New Residential Mortgage LLC, New Penn Financial, LLC, d/b/a Shellpoint Mortgage Servicing, JPMorgan Chase Bank, N.A. and New Residential Investment Corp. (incorporated by reference to Exhibit 4.11 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q, filed May 2, 2019) |\n| 4.14 | Amendment No. 3 to Series 2018-VF1 Indenture Supplement, dated as of March 11, 2019, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, New Residential Mortgage LLC, NewRez LLC d/b/a Shellpoint Mortgage Servicing, JPMorgan Chase Bank, N.A. and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed March 15, 2019) |\n| 4.15 | Third Amended and Restated Indenture, dated as of July 25, 2019, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, PHH Mortgage Corporation, HLSS Holdings, LLC, New Residential Mortgage LLC, NewRez LLC, d/b/a Shellpoint Mortgage Servicing and Credit Suisse AG, New York Branch (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Form 8-K, filed July 26, 2019) |\n| 4.16 | Series 2019-T1 Indenture Supplement, dated as of July 25, 2019, to the Third Amended and Restated Indenture, dated as of July 25, 2019, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, PHH Mortgage Corporation, HLSS Holdings, LLC, New Residential Mortgage LLC, NewRez LLC d/b/a Shellpoint Mortgage Servicing, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.2 to New Residential Investment Corp.’s Form 8-K, filed July 26, 2019) |\n| 4.17 | Series 2019-T2 Indenture Supplement, dated as of August 15, 2019, to the Third Amended and Restated Indenture, dated as of July 25, 2019, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, PHH Mortgage Corporation, HLSS Holdings, LLC, New Residential Mortgage LLC, NewRez LLC d/b/a Shellpoint Mortgage Servicing, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Form 8-K, filed August 16, 2019) |\n| 4.18 | Series 2019-T3 Indenture Supplement, dated as of September 20, 2019, to the Third Amended and Restated Indenture, dated as of July 25, 2019, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, PHH Mortgage Corporation, HLSS Holdings, LLC, New Residential Mortgage LLC, NewRez LLC d/b/a Shellpoint Mortgage Servicing, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Form 8-K, filed September 20, 2019) |\n\n153\n| Exhibit Number | Exhibit Description |\n| 4.19 | Series 2019-T4 Indenture Supplement, dated as of October 15, 2019, to the Third Amended and Restated Indenture, dated as of July 25, 2019, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, PHH Mortgage Corporation, HLSS Holdings, LLC, New Residential Mortgage LLC, NewRez LLC d/b/a Shellpoint Mortgage Servicing, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Form 8-K, filed October 18, 2019) |\n| 4.20 | Form of Debt Securities Indenture (including Form of Debt Security) (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Registration Statement on Form S-3, filed May 16, 2014) |\n| 10.1 | Third Amended and Restated Management and Advisory Agreement, dated as of May 7, 2015, by and between New Residential Investment Corp. and FIG LLC (incorporated by reference to Exhibit 10.4 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2015) |\n| 10.2 | Form of Indemnification Agreement by and between New Residential Investment Corp. and its directors and officers (incorporated by reference to Exhibit 10.2 to Amendment No. 3 to New Residential Investment Corp.’s Registration Statement on Form 10, filed March 27, 2013) |\n| 10.3 | New Residential Investment Corp. Nonqualified Stock Option and Incentive Award Plan, adopted as of April 29, 2013 (incorporated by reference to Exhibit 10.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed May 3, 2013) |\n| 10.4 | Amended and Restated New Residential Investment Corp. Nonqualified Stock Option and Incentive Plan, adopted as of November 4, 2014 (incorporated by reference to Exhibit 10.6 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2014) |\n| 10.5 | Investment Guidelines (incorporated by reference to Exhibit 10.4 to Amendment No. 4 to New Residential Investment Corp.’s Registration Statement on Form 10, filed April 9, 2013) |\n| 10.6 | Excess Servicing Spread Sale and Assignment Agreement, dated as of December 8, 2011, by and between Nationstar Mortgage LLC and NIC MSR I LLC (incorporated by reference to Exhibit 10.5 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2011) |\n| 10.7 | Excess Spread Refinanced Loan Replacement Agreement, dated as of December 8, 2011, by and between Nationstar Mortgage LLC and NIC MSR I LLC (incorporated by reference to Exhibit 10.6 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2011) |\n| 10.8 | Future Spread Agreement for FHLMC Mortgage Loans, dated as of May 13, 2012, by and between Nationstar Mortgage LLC and NIC MSR IV LLC (incorporated by reference to Exhibit 10.4 to Drive Shack Inc.’s Current Report on Form 8-K, filed May 15, 2012) |\n| 10.9 | Future Spread Agreement for FNMA Mortgage Loans, dated as of May 13, 2012, by and between Nationstar Mortgage LLC and NIC MSR V LLC (incorporated by reference to Exhibit 10.2 to Drive Shack Inc.’s Current Report on Form 8-K, filed May 15, 2012) |\n| 10.10 | Future Spread Agreement for Non-Agency Mortgage Loans, dated as of May 13, 2012, by and between Nationstar Mortgage LLC and NIC MSR VI LLC (incorporated by reference to Exhibit 10.6 to Drive Shack Inc.’s Current Report on Form 8-K, filed May 15, 2012) |\n| 10.11 | Future Spread Agreement for GNMA Mortgage Loans, dated as of May 13, 2012, by and between Nationstar Mortgage LLC and NIC MSR VII, LLC (incorporated by reference to Exhibit 10.8 to Drive Shack Inc.’s Current Report on Form 8-K, filed May 15, 2012) |\n| 10.12 | Current Excess Servicing Spread Acquisition Agreement for FHLMC Mortgage Loans, dated as of May 31, 2012, by and between Nationstar Mortgage LLC and NIC MSR III LLC (incorporated by reference to Exhibit 10.1 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 6, 2012) |\n| 10.13 | Future Spread Agreement for FHLMC Mortgage Loans, dated as of May 31, 2012, by and between Nationstar Mortgage LLC and NIC MSR III LLC (incorporated by reference to Exhibit 10.2 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 6, 2012) |\n| 10.14 | Amended and Restated Current Excess Servicing Spread Acquisition Agreement for FNMA Mortgage Loans, dated as of June 7, 2012, by and between Nationstar Mortgage LLC and NIC MSR II LLC (incorporated by reference to Exhibit 10.1 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 7, 2012) |\n| 10.15 | Amended and Restated Future Spread Agreement for FNMA Mortgage Loans, dated as of June 7, 2012, by and between Nationstar Mortgage LLC and NIC MSR II LLC (incorporated by reference to Exhibit 10.2 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 7, 2012) |\n\n154\n| Exhibit Number | Exhibit Description |\n| 10.16 | Amended and Restated Current Excess Servicing Spread Acquisition Agreement for FHLMC Mortgage Loans, dated as of June 7, 2012, by and between Nationstar Mortgage LLC and NIC MSR II LLC (incorporated by reference to Exhibit 10.3 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 7, 2012) |\n| 10.17 | Amended and Restated Future Spread Agreement for FHLMC Mortgage Loans, dated as of June 7, 2012, by and between Nationstar Mortgage LLC and NIC MSR II LLC (incorporated by reference to Exhibit 10.4 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 7, 2012) |\n| 10.18 | Amended and Restated Current Excess Servicing Spread Acquisition Agreement for Non-Agency Mortgage Loans, dated as of June 7, 2012, by and between Nationstar Mortgage LLC and NIC MSR II LLC (incorporated by reference to Exhibit 10.5 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 7, 2012) |\n| 10.19 | Amended and Restated Future Spread Agreement for Non-Agency Mortgage Loans, dated as of June 7, 2012, by and between Nationstar Mortgage LLC and NIC MSR II LLC (incorporated by reference to Exhibit 10.6 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 7, 2012) |\n| 10.20 | Amended and Restated Current Excess Servicing Spread Acquisition Agreement for FNMA Mortgage Loans, dated as of June 28, 2012, by and between Nationstar Mortgage LLC and NIC MSR V LLC (incorporated by reference to Exhibit 10.1 to Drive Shack Inc.’s Current Report on Form 8-K, filed July 5, 2012) |\n| 10.21 | Amended and Restated Current Excess Servicing Spread Acquisition Agreement for FHLMC Mortgage Loans, dated as of June 28, 2012, by and between Nationstar Mortgage LLC and NIC MSR IV LLC (incorporated by reference to Exhibit 10.2 to Drive Shack Inc.’s Current Report on Form 8-K, filed July 5, 2012) |\n| 10.22 | Amended and Restated Current Excess Servicing Spread Acquisition Agreement for Non-Agency Mortgage Loans, dated as of June 28, 2012, by and between Nationstar Mortgage LLC and NIC MSR VI LLC (incorporated by reference to Exhibit 10.3 to Drive Shack Inc.’s Current Report on Form 8-K, filed July 5, 2012) |\n| 10.23 | Amended and Restated Current Excess Servicing Spread Acquisition Agreement for GNMA Mortgage Loans, dated as of June 28, 2012, by and between Nationstar Mortgage LLC and NIC MSR VII LLC (incorporated by reference to Exhibit 10.4 to Drive Shack Inc.’s Current Report on Form 8-K, filed July 5, 2012) |\n| 10.24 | Current Excess Servicing Spread Acquisition Agreement for GNMA Mortgage Loans, dated as of December 31, 2012, by and between Nationstar Mortgage LLC and MSR VIII LLC (incorporated by reference to Exhibit 10.35 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n| 10.25 | Future Spread Agreement for GNMA Mortgage Loans, dated as of December 31, 2012, by and between Nationstar Mortgage LLC and MSR VIII LLC (incorporated by reference to Exhibit 10.36 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n| 10.26 | Current Excess Servicing Spread Acquisition Agreement for FHLMC Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR IX LLC (incorporated by reference to Exhibit 10.37 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n| 10.27 | Future Spread Agreement for FHLMC Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR IX LLC (incorporated by reference to Exhibit 10.38 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n| 10.28 | Current Excess Servicing Spread Acquisition Agreement for FNMA Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR X LLC (incorporated by reference to Exhibit 10.39 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n| 10.29 | Future Spread Agreement for FNMA Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR X LLC (incorporated by reference to Exhibit 10.40 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n| 10.30 | Current Excess Servicing Spread Acquisition Agreement for GNMA Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR XI LLC (incorporated by reference to Exhibit 10.41 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n| 10.31 | Future Spread Agreement for GNMA Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR XI LLC (incorporated by reference to Exhibit 10.42 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n| 10.32 | Current Excess Servicing Spread Acquisition Agreement for Non-Agency Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR XII LLC (incorporated by reference to Exhibit 10.43 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n\n155\n| Exhibit Number | Exhibit Description |\n| 10.33 | Future Spread Agreement for Non-Agency Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR XII LLC (incorporated by reference to Exhibit 10.44 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n| 10.34 | Current Excess Servicing Spread Acquisition Agreement for Non-Agency Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR XIII LLC (incorporated by reference to Exhibit 10.45 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n| 10.35 | Future Spread Agreement for Non-Agency Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR XIII LLC (incorporated by reference to Exhibit 10.46 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n| 10.36 | Interim Servicing Agreement, dated as of April 1, 2013, by and among the Interim Servicers listed therein, HSBC Finance Corporation, as Interim Servicer Representative, HSBC Bank USA, National Association, SpringCastle America, LLC, SpringCastle Credit, LLC, SpringCastle Finance, LLC, Wilmington Trust, National Association, as Loan Trustee, and SpringCastle Finance LLC, as Owner Representative (incorporated by reference to Exhibit 10.35 to Amendment No. 4 to New Residential Investment Corp.’s Registration Statement on Form 10, filed April 9, 2013) |\n| 10.37 | Second Amended and Restated Limited Liability Company Agreement of SpringCastle Acquisition LLC, dated as of March 31, 2016 (incorporated by reference to Exhibit 10.37 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2016) |\n| 10.38 | Services Agreement, dated as of April 6, 2015, by and between HLSS Advances Acquisition Corp. and Home Loan Servicing Solutions, Ltd. (incorporated by reference to Exhibit 2.4 to New Residential Investment Corp.’s Current Report on Form 8-K, filed April 10, 2015) |\n| 10.39 | Receivables Sale Agreement, dated as of August 28, 2015, by and among Ocwen Loan Servicing, LLC, HLSS Holdings, LLC and NRZ Advance Facility Transferor 2015-ON1 LLC (incorporated by reference to Exhibit 10.47 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2015) |\n| 10.40 | Receivables Pooling Agreement, dated as of August 28, 2015, by and between NRZ Advance Facility Transferor 2015-ON1 LLC and NRZ Advance Receivables Trust 2015-ON1 (incorporated by reference to Exhibit 10.48 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2015) |\n| 10.41# | Master Agreement, dated as July 23, 2017, by and among Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, HLSS MSR - EBO Acquisition LLC and New Residential Mortgage LLC (incorporated by reference to Exhibit 10.41 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2017) |\n| 10.42 | Amendment No. 1 to Master Agreement, dated as of October 12, 2017, by and among Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, HLSS MSR - EBO Acquisition LLC and New Residential Mortgage LLC (incorporated by reference to Exhibit 10.42 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2017) |\n| 10.43# | Transfer Agreement, dated as of July 23, 2017, by and among Ocwen Loan Servicing, LLC, New Residential Mortgage LLC, Ocwen Financial Corporation and New Residential Investment Corp. (incorporated by reference to Exhibit 10.43 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2017) |\n| 10.44# | Amendment No. 1 to the Transfer Agreement, dated January 18, 2018, by and among Ocwen Loan Servicing, LLC, New Residential Mortgage LLC, Ocwen Financial Corporation and New Residential Investment Corp. (incorporated by reference to Exhibit 10.44 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2018) |\n| 10.45# | Subservicing Agreement, dated as of July 23, 2017, by and between New Residential Mortgage LLC and Ocwen Loan Servicing, LLC (incorporated by reference to Exhibit 10.44 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2017) |\n| 10.46# | Amendment No. 1 to Subservicing Agreement, dated as of August 17, 2018, by and between New Residential Mortgage LLC and Ocwen Loan Servicing, LLC (incorporated by reference to Exhibit 10.46 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2018) |\n| 10.47# | Cooperative Brokerage Agreement, dated as of August 28, 2017, by and among REALHome Services and Solutions, Inc., REALHome Services and Solutions - CT, Inc. and New Residential Sales Corp. (incorporated by reference to Exhibit 10.45 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2017) |\n\n156\n| Exhibit Number | Exhibit Description |\n| 10.48# | First Amendment to Cooperative Brokerage Agreement, dated as of November 16, 2017, by and among REALHome Services and Solutions, Inc., REALHome Services and Solutions - CT, Inc. and New Residential Sales Corp. (incorporated by reference to Exhibit 10.46 to New Residential Investment Corp.’s Annual Report on Form 10-K for the year ended December 31, 2017, filed on February 14, 2018) |\n| 10.49# | Second Amendment to Cooperative Brokerage Agreement, dated as of January 18, 2018, by and among REALHome Services and Solutions, Inc., REALHome Services and Solutions - CT, Inc. and New Residential Sales Corp. (incorporated by reference to Exhibit 10.47 to New Residential Investment Corp.’s Annual Report on Form 10-K for the year ended December 31, 2017, filed on February 14, 2018) |\n| 10.50 | Third Amendment to Cooperative Brokerage Agreement, dated as of March 23, 2018, by and among REALHome Services and Solutions, Inc., REALHome Services and Solutions - CT, Inc. and New Residential Sales Corp. (incorporated by reference to Exhibit 10.49 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2018) |\n| 10.51 | Fourth Amendment to Cooperative Brokerage Agreement, dated as of September 11, 2018, by and among REALHome Services and Solutions, Inc., REALHome Services and Solutions - CT, Inc. and New Residential Sales Corp. (incorporated by reference to Exhibit 10.51 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2018) |\n| 10.52# | Letter Agreement, dated as of August 28, 2017, by and among New Residential Investment Corp., New Residential Mortgage LLC, REALHome Services and Solutions, Inc., REALHome Services and Solutions - CT, Inc. and Altisource Solutions S.a.r.l. (incorporated by reference to Exhibit 10.46 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2017) |\n| 10.53# | New RMSR Agreement, dated as of January 18, 2018, by and among Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, HLSS MSR - EBO Acquisition LLC, and New Residential Mortgage LLC (incorporated by reference to Exhibit 10.51 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2018) |\n| 10.54# | Amendment No. 1 to New RMSR Agreement, dated as of August 17, 2018, by and among Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, HLSS MSR - EBO Acquisition LLC, and New Residential Mortgage LLC (incorporated by reference to Exhibit 10.54 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2018) |\n| 10.55# | Subservicing Agreement, dated as of August 17, 2018, by and between New Penn Financial, LLC, d/b/a Shellpoint Mortgage Servicing New Residential Mortgage LLC and Ocwen Loan Servicing, LLC (incorporated by reference to Exhibit 10.55 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2018) |\n| 31.1 | Certification of Chief Executive Officer as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2 | Certification of Chief Financial Officer as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101 | The following financial information from the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2019, formatted in iXBRL (Inline Extensible Business Reporting Language): (i) Condensed Consolidated Balance Sheets; (ii) Condensed Consolidated Statements of Comprehensive Income; (iii) Condensed Consolidated Statements of Changes in Stockholders’ Equity; (iv) Condensed Consolidated Statements of Cash Flows; and (v) Notes to Condensed Consolidated Financial Statements |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\n\n| # | Portions of this exhibit have been omitted pursuant to a request for confidential treatment. |\n| * | Portions of this exhibit have been omitted. |\n\n157\nThe following second amended and restated limited liability company agreements of the Consumer Loan Companies are substantially identical in all material respects, except as to the parties thereto and the initial capital contributions required under each agreement, to the Second Amended and Restated Limited Liability Company Agreement of SpringCastle Acquisition LLC that is filed as Exhibit 10.37 hereto and are being omitted in reliance on Instruction 2 to Item 601 of Regulation S-K:\n\n| • | Second Amended and Restated Limited Liability Company Agreement of SpringCastle America, LLC, dated as of March 31, 2016. |\n\n| • | Second Amended and Restated Limited Liability Company Agreement of SpringCastle Credit, LLC, dated as of March 31, 2016. |\n\n| • | Second Amended and Restated Limited Liability Company Agreement of SpringCastle Finance, LLC, dated as of March 31, 2016. |\n\n158\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized:\n\n| NEW RESIDENTIAL INVESTMENT CORP. |\n| By: | /s/ Michael Nierenberg |\n| Michael Nierenberg |\n| Chief Executive Officer and President |\n| (Principal Executive Officer) |\n| October 28, 2019 |\n| By: | /s/ Nicola Santoro, Jr. |\n| Nicola Santoro, Jr. |\n| Chief Financial Officer and Treasurer |\n| (Principal Financial Officer) |\n| October 28, 2019 |\n| By: | /s/ David Schneider |\n| David Schneider |\n| Chief Accounting Officer |\n| (Principal Accounting Officer) |\n| October 28, 2019 |\n\n159\n \n\nWhat is the net income ratio of the Real Estate Securities segment considering the interest income and net income for the three months ended September 30, 2019 in percentages?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nITEM 1. FINANCIAL STATEMENTS\\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\\n| CONDENSED CONSOLIDATED BALANCE SHEETS |\\n| (dollars in thousands) |\\n| September 30, 2019 | December 31, 2018 |\\n| (Unaudited) |\\n| Assets |\\n| Investments in: |\\n| Excess mortgage servicing rights, at fair value | $ | 398,064 | $ | 447,860 |\\n| Excess mortgage servicing rights, equity method investees, at fair value | 132,259 | 147,964 |\\n| Mortgage servicing rights, at fair value | 3,431,968 | 2,884,100 |\\n| Mortgage servicing rights financing receivables, at fair value | 1,811,261 | 1,644,504 |\\n| Servicer advance investments, at fair value(A) | 600,547 | 735,846 |\\n| Real estate and other securities, available-for-sale | 16,853,910 | 11,636,581 |\\n| Residential mortgage loans, held-for-investment (includes $113,133 and $121,088 at fair value at September 30, 2019 and December 31, 2018, respectively)(A) | 613,657 | 735,329 |\\n| Residential mortgage loans, held-for-sale | 1,349,997 | 932,480 |\\n| Residential mortgage loans, held-for-sale, at fair value | 5,206,251 | 2,808,529 |\\n| Consumer loans, held-for-investment(A) | 881,183 | 1,072,202 |\\n| Cash and cash equivalents(A) | 738,219 | 251,058 |\\n| Restricted cash | 163,148 | 164,020 |\\n| Servicer advances receivable | 2,911,798 | 3,277,796 |\\n| Trades receivable | 4,487,772 | 3,925,198 |\\n| Deferred tax asset, net | 43,372 | 65,832 |\\n| Other assets (includes $168,532 and $121,602 in residential mortgage loan subject to repurchase at September 30, 2019 and December 31,2018, respectively) | 1,724,519 | 961,714 |\\n| $ | 41,347,925 | $ | 31,691,013 |\\n| Liabilities and Equity |\\n| Liabilities |\\n| Repurchase agreements | $ | 23,110,359 | $ | 15,553,969 |\\n| Notes and bonds payable (includes $474,309 and $117,048 at fair value at September 30, 2019 and December 31, 2018, respectively)(A) | 7,405,872 | 7,102,266 |\\n| Trades payable | 2,536,188 | 2,048,348 |\\n| Dividends payable | 213,098 | 184,552 |\\n| Accrued expenses and other liabilities(A) (includes $168,532 and $121,602 in residential mortgage loans repurchase liabilities at September 30, 2019 and December 31,2018, respectively) | 820,291 | 713,583 |\\n| 34,085,808 | 25,602,718 |\\n| Commitments and Contingencies |\\n| Equity |\\n| Preferred Stock, par value of $0.01 per share, 23,000,000 shares authorized: |\\n| 7.50% Series A Preferred Stock, $0.01 par value, 11,500,000 shares authorized, 6,210,000 and 0 issued and outstanding at September 30, 2019 and December 31, 2018, respectively | 150,026 | — |\\n| 7.125% Series B Preferred Stock, $0.01 par value, 11,500,000 shares authorized, 11,300,000 and 0 issued and outstanding at September 30, 2019 and December 31, 2018, respectively | 273,418 | — |\\n| Common Stock, $0.01 par value, 2,000,000,000 shares authorized, 415,520,780 and 369,104,429 issued and outstanding at September 30, 2019 and December 31, 2018, respectively | 4,156 | 3,692 |\\n| Additional paid-in capital | 5,498,226 | 4,746,242 |\\n| Retained earnings | 545,713 | 830,713 |\\n| Accumulated other comprehensive income (loss) | 706,926 | 417,023 |\\n| Total New Residential stockholders’ equity | 7,178,465 | 5,997,670 |\\n| Noncontrolling interests in equity of consolidated subsidiaries | 83,652 | 90,625 |\\n| Total Equity | 7,262,117 | 6,088,295 |\\n| $ | 41,347,925 | $ | 31,691,013 |\\n\\n1\\n| (A) | New Residential’s Condensed Consolidated Balance Sheets include the assets and liabilities of certain consolidated VIEs, Advance Purchaser LLC (the “Buyer”) (Note 6), the RPL Borrowers (defined in Note 8), Shellpoint Asset Funding Trust 2013-1 (“SAFT 2013-1”) and the Shelter retail mortgage origination joint ventures (“Shelter JVs”) (Note 8) and the Consumer Loan SPVs (Note 9), which primarily hold investments in Servicer Advance Investments, residential mortgage loans and consumer loans, respectively, financed with notes and bonds payable. The balance sheets of the Buyer, the RPL Borrowers, SAFT 2013-1, Shelter JVs and the Consumer Loan SPVs are included in Notes 6, 8 and 9, respectively. The creditors of the Buyer, the RPL Borrowers, SAFT 2013-1, Shelter JVs and the Consumer Loan SPVs do not have recourse to the general credit of New Residential and the assets of the Buyer, the RPL Borrowers, SAFT 2013-1, Shelter JVs and the Consumer Loan SPVs are not directly available to satisfy New Residential’s obligations. |\\n\\nSee notes to condensed consolidated financial statements.\\n2\\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\\n| CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) |\\n| (dollars in thousands, except per share data) |\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Interest income | $ | 448,127 | $ | 425,524 | $ | 1,303,041 | $ | 1,212,902 |\\n| Interest expense | 245,902 | 162,806 | 686,738 | 421,109 |\\n| Net Interest Income | 202,225 | 262,718 | 616,303 | 791,793 |\\n| Impairment |\\n| Other-than-temporary impairment (OTTI) on securities | 5,567 | 3,889 | 21,942 | 23,190 |\\n| Valuation and loss provision (reversal) on loans and real estate owned (REO) | ( 10,690 | ) | 5,471 | 8,042 | 28,136 |\\n| ( 5,123 | ) | 9,360 | 29,984 | 51,326 |\\n| Net interest income after impairment | 207,348 | 253,358 | 586,319 | 740,467 |\\n| Servicing revenue, net of change in fair value of $(228,405), $(26,741), $(619,914), and $35,118, respectively | 53,050 | 175,355 | 133,366 | 538,784 |\\n| Gain on sale of originated mortgage loans, net | 100,541 | 45,732 | 194,029 | 45,732 |\\n| Other Income |\\n| Change in fair value of investments in excess mortgage servicing rights | 2,407 | ( 4,744 | ) | ( 1,421 | ) | ( 55,711 | ) |\\n| Change in fair value of investments in excess mortgage servicing rights, equity method investees | 4,751 | 3,396 | 4,087 | 5,624 |\\n| Change in fair value of investments in mortgage servicing rights financing receivables | ( 41,410 | ) | ( 88,345 | ) | ( 133,200 | ) | 63,628 |\\n| Change in fair value of servicer advance investments | 6,641 | ( 5,353 | ) | 15,932 | ( 86,581 | ) |\\n| Change in fair value of investments in residential mortgage loans | ( 19,037 | ) | 647 | 90,551 | 647 |\\n| Change in fair value of derivative instruments | 58,508 | 24,299 | ( 1,988 | ) | 27,985 |\\n| Gain (loss) on settlement of investments, net | 154,752 | ( 11,893 | ) | 157,013 | 106,064 |\\n| Earnings from investments in consumer loans, equity method investees | ( 2,547 | ) | 4,555 | ( 890 | ) | 12,343 |\\n| Other income (loss), net | ( 35,219 | ) | ( 5,860 | ) | ( 16,451 | ) | 10,415 |\\n| 128,846 | ( 83,298 | ) | 113,633 | 84,414 |\\n| Operating Expenses |\\n| General and administrative expenses | 133,513 | 98,587 | 351,359 | 139,169 |\\n| Management fee to affiliate | 20,678 | 15,464 | 58,261 | 46,027 |\\n| Incentive compensation to affiliate | 36,307 | 23,848 | 49,265 | 65,169 |\\n| Loan servicing expense | 7,192 | 11,060 | 26,167 | 33,609 |\\n| Subservicing expense | 52,875 | 43,148 | 147,763 | 135,703 |\\n| 250,565 | 192,107 | 632,815 | 419,677 |\\n| Income (Loss) Before Income Taxes | 239,220 | 199,040 | 394,532 | 989,720 |\\n| Income tax expense (benefit) | ( 5,440 | ) | 3,563 | 18,980 | ( 5,957 | ) |\\n| Net Income (Loss) | $ | 244,660 | $ | 195,477 | $ | 375,552 | $ | 995,677 |\\n| Noncontrolling Interests in Income of Consolidated Subsidiaries | $ | 14,738 | $ | 10,869 | $ | 31,979 | $ | 32,058 |\\n| Dividends on Preferred Stock | $ | 5,338 | $ | — | $ | 5,338 | $ | — |\\n| Net Income (Loss) Attributable to Common Stockholders | $ | 224,584 | $ | 184,608 | $ | 338,235 | $ | 963,619 |\\n| Net Income (Loss) Per Share of Common Stock |\\n| Basic | $ | 0.54 | $ | 0.54 | $ | 0.83 | $ | 2.87 |\\n| Diluted | $ | 0.54 | $ | 0.54 | $ | 0.83 | $ | 2.86 |\\n| Weighted Average Number of Shares of Common Stock Outstanding |\\n| Basic | 415,520,780 | 340,044,440 | 406,521,273 | 335,615,566 |\\n| Diluted | 415,588,238 | 340,868,403 | 406,671,972 | 337,078,824 |\\n| Dividends Declared per Share of Common Stock | $ | 0.50 | $ | 0.50 | $ | 1.50 | $ | 1.50 |\\n\\nSee notes to condensed consolidated financial statements.\\n3\\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\\n| CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED) |\\n| (dollars in thousands) |\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Comprehensive income (loss), net of tax |\\n| Net (loss) income | $ | 244,660 | $ | 195,477 | $ | 375,552 | $ | 995,677 |\\n| Other comprehensive income (loss) |\\n| Net unrealized gain (loss) on securities | 109,668 | ( 22,445 | ) | 469,183 | 14,600 |\\n| Reclassification of net realized (gain) loss on securities into earnings | ( 89,436 | ) | 32,626 | ( 179,280 | ) | 89,885 |\\n| 20,232 | 10,181 | 289,903 | 104,485 |\\n| Total comprehensive income | $ | 264,892 | $ | 205,658 | $ | 665,455 | $ | 1,100,162 |\\n| Comprehensive income attributable to noncontrolling interests | $ | 14,738 | $ | 10,869 | $ | 31,979 | $ | 32,058 |\\n| Dividends on preferred stock | $ | 5,338 | $ | — | $ | 5,338 | $ | — |\\n| Comprehensive income attributable to common stockholders | $ | 244,816 | $ | 194,789 | $ | 628,138 | $ | 1,068,104 |\\n\\nSee notes to condensed consolidated financial statements.\\n4\\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\\nCONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (UNAUDITED)\\nFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2019 AND 2018\\n| (dollars in thousands) |\\n\\n| Common Stock |\\n| Preferred Stock | Shares | Amount | Additional Paid-in Capital | Retained Earnings | Accumulated Other Comprehensive Income | Total New Residential Stockholders’ Equity | Noncontrolling Interests in Equity of Consolidated Subsidiaries | Total Equity |\\n| Equity - December 31, 2018 | $ | — | 369,104,429 | $ | 3,692 | $ | 4,746,242 | $ | 830,713 | $ | 417,023 | $ | 5,997,670 | $ | 90,625 | $ | 6,088,295 |\\n| Dividends declared on common stock | — | — | — | — | ( 623,235 | ) | — | ( 623,235 | ) | — | ( 623,235 | ) |\\n| Dividends declared on preferred stock | — | — | — | — | ( 5,338 | ) | — | ( 5,338 | ) | — | ( 5,338 | ) |\\n| Capital contributions | — | — | — | — | — | — | — | — | — |\\n| Capital distributions | — | — | — | — | — | — | — | ( 38,952 | ) | ( 38,952 | ) |\\n| Issuance of common stock | — | 46,000,000 | 460 | 750,933 | — | — | 751,393 | — | 751,393 |\\n| Issuance of preferred stock | 423,444 | — | — | — | — | — | 423,444 | — | 423,444 |\\n| Option exercise | — | 348,613 | 3 | ( 3 | ) | — | — | — | — | — |\\n| Purchase of noncontrolling interests in the Buyer | — | — | — | — | — | — | — | — | — |\\n| Other dilution | — | — | — | — | — | — | — | — | — |\\n| Director share grants | — | 67,738 | 1 | 1,054 | — | — | 1,055 | — | 1,055 |\\n| Comprehensive income (loss) |\\n| Net income (loss) | — | — | — | — | 343,573 | — | 343,573 | 31,979 | 375,552 |\\n| Net unrealized gain (loss) on securities | — | — | — | — | — | 469,183 | 469,183 | — | 469,183 |\\n| Reclassification of net realized (gain) loss on securities into earnings | — | — | — | — | — | ( 179,280 | ) | ( 179,280 | ) | — | ( 179,280 | ) |\\n| Total comprehensive income (loss) | 633,476 | 31,979 | 665,455 |\\n| Equity - September 30, 2019 | $ | 423,444 | 415,520,780 | $ | 4,156 | $ | 5,498,226 | $ | 545,713 | $ | 706,926 | $ | 7,178,465 | $ | 83,652 | $ | 7,262,117 |\\n\\n5\\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\\nCONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (UNAUDITED), CONTINUED\\nFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2019 AND 2018\\n| (dollars in thousands) |\\n\\n| Common Stock |\\n| Shares | Amount | Additional Paid-in Capital | Retained Earnings | Accumulated Other Comprehensive Income | Total New Residential Stockholders’ Equity | Noncontrolling Interests in Equity of Consolidated Subsidiaries | Total Equity |\\n| Equity - December 31, 2017 | 307,361,309 | $ | 3,074 | $ | 3,763,188 | $ | 559,476 | $ | 364,467 | $ | 4,690,205 | $ | 105,957 | $ | 4,796,162 |\\n| Dividends declared on common stock | — | — | — | ( 508,176 | ) | — | ( 508,176 | ) | — | ( 508,176 | ) |\\n| Capital contributions | — | — | — | — | — | — | — | — |\\n| Capital distributions | — | — | — | — | — | — | ( 51,735 | ) | ( 51,735 | ) |\\n| Issuance of common stock | 29,241,659 | 292 | 491,312 | — | — | 491,604 | — | 491,604 |\\n| Option exercise | 3,694,228 | 37 | ( 37 | ) | — | — | — | — | — |\\n| Other dilution | — | — | ( 63 | ) | — | — | ( 63 | ) | — | ( 63 | ) |\\n| Purchase of Noncontrolling Interests | — | — | 627 | — | — | 627 | 7,448 | 8,075 |\\n| Director share grants | 57,233 | 1 | 1,018 | — | — | 1,019 | — | 1,019 |\\n| Comprehensive income (loss) |\\n| Net income (loss) | — | — | — | 963,619 | — | 963,619 | 32,058 | 995,677 |\\n| Net unrealized gain (loss) on securities | — | — | — | — | 14,600 | 14,600 | — | 14,600 |\\n| Reclassification of net realized (gain) loss on securities into earnings | — | — | — | — | 89,885 | 89,885 | — | 89,885 |\\n| Total comprehensive income (loss) | 1,068,104 | 32,058 | 1,100,162 |\\n| Equity - September 30, 2018 | 340,354,429 | $ | 3,404 | $ | 4,256,045 | $ | 1,014,919 | $ | 468,952 | $ | 5,743,320 | $ | 93,728 | $ | 5,837,048 |\\n\\nSee notes to condensed consolidated financial statements.\\n6\\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\\n| CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) |\\n| (dollars in thousands) |\\n\\n| Nine Months Ended September 30, |\\n| 2019 | 2018 |\\n| Cash Flows From Operating Activities |\\n| Net income | $ | 375,552 | $ | 995,677 |\\n| Adjustments to reconcile net income to net cash provided by (used in) operating activities: |\\n| Change in fair value of investments in excess mortgage servicing rights | 1,421 | 55,711 |\\n| Change in fair value of investments in excess mortgage servicing rights, equity method investees | ( 4,087 | ) | ( 5,624 | ) |\\n| Change in fair value of investments in mortgage servicing rights financing receivables | 133,200 | ( 63,628 | ) |\\n| Change in fair value of servicer advance investments | ( 15,932 | ) | 86,581 |\\n| Change in fair value of residential mortgage loans, at fair value, and notes and bonds payable, at fair value | ( 85,303 | ) | 1,462 |\\n| (Gain) / loss on settlement of investments (net) | ( 157,013 | ) | ( 106,064 | ) |\\n| (Gain) / loss on sale of originated mortgage loans (net) | ( 194,029 | ) | ( 45,732 | ) |\\n| Earnings from investments in consumer loans, equity method investees | 890 | ( 12,343 | ) |\\n| Change in fair value of derivative instruments | 1,988 | ( 27,985 | ) |\\n| Changes in fair value of contingent consideration | 7,430 | — |\\n| Unrealized (gain) / loss on other ABS | ( 9,010 | ) | ( 12,001 | ) |\\n| (Gain) / loss on transfer of loans to REO | ( 7,814 | ) | ( 16,609 | ) |\\n| (Gain) / loss on transfer of loans to other assets | 378 | 1,648 |\\n| (Gain) / loss on Excess MSR recapture agreements | ( 1,771 | ) | ( 5,257 | ) |\\n| (Gain) / loss on Ocwen common stock | ( 3,134 | ) | ( 4,655 | ) |\\n| Accretion and other amortization | ( 298,933 | ) | ( 528,981 | ) |\\n| Other-than-temporary impairment | 21,942 | 23,190 |\\n| Valuation and loss provision on loans and real estate owned | 8,042 | 28,136 |\\n| Non-cash portions of servicing revenue, net | 619,914 | ( 35,118 | ) |\\n| Non-cash directors’ compensation | 1,055 | 1,019 |\\n| Deferred tax provision | 18,080 | ( 12,680 | ) |\\n| Changes in: |\\n| Servicer advances receivable | 366,426 | 441,351 |\\n| Other assets | ( 516,107 | ) | ( 168,862 | ) |\\n| Due to affiliates | ( 41,920 | ) | ( 14,826 | ) |\\n| Accrued expenses and other liabilities | 263,420 | 161,246 |\\n| Other operating cash flows: |\\n| Interest received from excess mortgage servicing rights | 19,180 | 33,521 |\\n| Interest received from servicer advance investments | 22,212 | 25,901 |\\n| Interest received from Non-Agency RMBS | 203,309 | 156,420 |\\n| Interest received from PCD residential mortgage loans, held-for-investment | 6,697 | 6,656 |\\n| Interest received from PCD consumer loans, held-for-investment | 23,789 | 27,681 |\\n| Distributions of earnings from excess mortgage servicing rights, equity method investees | 7,762 | 7,976 |\\n| Distributions of earnings from consumer loan equity method investees | 1,178 | 6,176 |\\n| Purchases of residential mortgage loans, held-for-sale | ( 6,002,975 | ) | ( 3,295,378 | ) |\\n| Origination of residential mortgage loans, held-for-sale | ( 10,424,325 | ) | ( 1,678,606 | ) |\\n| Proceeds from sales of purchased and originated residential mortgage loans, held-for-sale | 13,046,546 | 3,752,066 |\\n| Principal repayments from purchased residential mortgage loans, held-for-sale | 295,584 | 146,170 |\\n| Net cash provided by (used in) operating activities | ( 2,316,358 | ) | ( 75,761 | ) |\\n\\nContinued on next page.\\n7\\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\\n| CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED), CONTINUED |\\n| (dollars in thousands) |\\n\\n| Nine Months Ended September 30, |\\n| 2019 | 2018 |\\n| Cash Flows From Investing Activities |\\n| Acquisition of Shellpoint, net of cash required | — | ( 118,285 | ) |\\n| Purchase of servicer advance investments | ( 1,255,306 | ) | ( 1,790,635 | ) |\\n| Purchase of MSRs, MSR financing receivables and servicer advances receivable | ( 1,365,333 | ) | ( 971,079 | ) |\\n| Purchase of Agency RMBS | ( 25,212,307 | ) | ( 6,574,783 | ) |\\n| Purchase of Non-Agency RMBS | ( 689,308 | ) | ( 2,714,991 | ) |\\n| Purchase of residential mortgage loans | — | ( 85,778 | ) |\\n| Purchase of real estate owned and other assets | ( 44,539 | ) | ( 26,807 | ) |\\n| Purchase of investment in consumer loans, equity method investees | ( 63,969 | ) | ( 292,616 | ) |\\n| Draws on revolving consumer loans | ( 42,231 | ) | ( 45,017 | ) |\\n| Payments for settlement of derivatives | ( 283,037 | ) | ( 59,113 | ) |\\n| Return of investments in excess mortgage servicing rights | 43,938 | 43,690 |\\n| Return of investments in excess mortgage servicing rights, equity method investees | 12,030 | 14,474 |\\n| Return of investments in consumer loans, equity method investees | 55,848 | 279,669 |\\n| Principal repayments from servicer advance investments | 1,402,187 | 1,845,411 |\\n| Principal repayments from Agency RMBS | 987,523 | 76,515 |\\n| Principal repayments from Non-Agency RMBS | 996,396 | 565,460 |\\n| Principal repayments from residential mortgage loans | 83,483 | 110,770 |\\n| Proceeds from sale of residential mortgage loans | 41,308 | 21,278 |\\n| Principal repayments from consumer loans | 203,607 | 237,129 |\\n| Principal repayments from MSRs and MSR financing receivables | 21,306 | — |\\n| Proceeds from sale of mortgage servicing rights | 1,047 | — |\\n| Proceeds from sale of mortgage servicing rights financing receivables | 15,575 | — |\\n| Proceeds from sale of excess mortgage servicing rights | 114 | — |\\n| Proceeds from sale of Agency RMBS | 17,998,736 | 4,121,325 |\\n| Proceeds from sale of Non-Agency RMBS | 1,664,017 | 81,325 |\\n| Proceeds from settlement of derivatives | 74,724 | 146,146 |\\n| Proceeds from sale of real estate owned | 103,258 | 111,459 |\\n| Net cash provided by (used in) investing activities | ( 5,250,933 | ) | ( 5,024,453 | ) |\\n\\nContinued on next page.\\n8\\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\\n| CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED), CONTINUED |\\n| (dollars in thousands) |\\n\\n| Nine Months Ended September 30, |\\n| 2019 | 2018 |\\n| Cash Flows From Financing Activities |\\n| Repayments of repurchase agreements | ( 144,545,608 | ) | ( 58,414,966 | ) |\\n| Margin deposits under repurchase agreements and derivatives | ( 2,913,627 | ) | ( 1,374,374 | ) |\\n| Repayments of notes and bonds payable | ( 7,306,541 | ) | ( 7,512,484 | ) |\\n| Payment of deferred financing fees | ( 7,821 | ) | ( 12,838 | ) |\\n| Common stock dividends paid | ( 600,027 | ) | ( 491,680 | ) |\\n| Borrowings under repurchase agreements | 152,101,817 | 63,696,426 |\\n| Return of margin deposits under repurchase agreements and derivatives | 2,589,160 | 1,263,220 |\\n| Borrowings under notes and bonds payable | 7,600,342 | 7,547,541 |\\n| Issuance of preferred stock | 423,444 | — |\\n| Issuance of common stock | 752,217 | 492,285 |\\n| Costs related to issuance of common stock | ( 824 | ) | ( 681 | ) |\\n| Noncontrolling interest in equity of consolidated subsidiaries - contributions | — | — |\\n| Noncontrolling interest in equity of consolidated subsidiaries - distributions | ( 38,952 | ) | ( 51,735 | ) |\\n| Purchase of noncontrolling interests | — | ( 653 | ) |\\n| Net cash provided by (used in) financing activities | 8,053,580 | 5,140,061 |\\n| Net Increase (Decrease) in Cash, Cash Equivalents, and Restricted Cash | 486,289 | 39,847 |\\n| Cash, Cash Equivalents, and Restricted Cash, Beginning of Period | 415,078 | 446,050 |\\n| Cash, Cash Equivalents, and Restricted Cash, End of Period | $ | 901,367 | $ | 485,897 |\\n| Supplemental Disclosure of Cash Flow Information |\\n| Cash paid during the period for interest | $ | 643,349 | $ | 405,672 |\\n| Cash paid during the period for income taxes | 1,208 | 3,176 |\\n| Supplemental Schedule of Non-Cash Investing and Financing Activities |\\n| Dividends declared but not paid | $ | 213,098 | $ | 170,177 |\\n| Purchase of Agency and Non-Agency RMBS, settled after quarter end | 2,536,188 | 1,791,191 |\\n| Sale of investments, primarily Agency RMBS, settled after quarter end | 4,487,772 | 3,424,865 |\\n| Transfer from residential mortgage loans to real estate owned and other assets | 70,080 | 88,376 |\\n| Transfer from residential mortgage loans, held-for-investment to residential mortgage loans, held-for-sale | 38,842 | — |\\n| Non-cash distributions from LoanCo | 21,314 | 25,739 |\\n| MSR purchase price holdback | 1,963 | 8,692 |\\n| Shellpoint Acquisition purchase price holdback | — | 10,173 |\\n| Shellpoint Acquisition contingent consideration | — | 42,770 |\\n| Real estate securities retained from loan securitizations | 454,310 | 762,056 |\\n| Residential mortgage loans subject to repurchase | 168,532 | 110,181 |\\n| Ocwen transaction (Note 5) - excess mortgage servicing rights | — | 638,567 |\\n| Ocwen transaction (Note 5) - servicer advance investments | — | 3,175,891 |\\n| Ocwen transaction (Note 5) - mortgage servicing rights financing receivables, at fair value | — | 1,017,993 |\\n\\nSee notes to condensed consolidated financial statements.\\n9\\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\n| 1. | ORGANIZATION AND BASIS OF PRESENTATION |\\n\\nNew Residential Investment Corp. (together with its subsidiaries, “New Residential”) is a Delaware corporation that was formed as a limited liability company in September 2011 for the purpose of making real estate related investments and commenced operations on December 8, 2011. New Residential is an independent publicly traded real estate investment trust (“REIT”) primarily focused on investing in residential mortgage related assets. New Residential is listed on the New York Stock Exchange (“NYSE”) under the symbol “NRZ.”\\nNew Residential has elected and intends to qualify to be taxed as a REIT for U.S. federal income tax purposes. As such, New Residential will generally not be subject to U.S. federal corporate income tax on that portion of its net income that is distributed to stockholders if it distributes at least 90% of its REIT taxable income to its stockholders by prescribed dates and complies with various other requirements. See Note 17 regarding New Residential’s taxable REIT subsidiaries.\\nNew Residential, through its wholly-owned subsidiaries New Residential Mortgage LLC (“NRM”) and NewRez LLC (“NewRez”), is licensed or otherwise eligible to service residential mortgage loans in all states within the United States and the District of Columbia. NRM and NewRez perform servicing on behalf of investors, including the Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”) (collectively, Government Sponsored Enterprises or “GSEs”) and Government National Mortgage Association (“Ginnie Mae”), and on behalf of other servicers (subservicing).\\nNewRez originates, sells and securitizes conventional (conforming to the underwriting standards of Fannie Mae or Freddie Mac; collectively referred to as “Agency” loans), government-insured (Federal Housing Administration (“FHA”) and Department of Veterans Affairs (“VA”)) and non-qualified (“Non-QM”) residential mortgage loans. The GSEs or Ginnie Mae guarantee securitizations completed under their applicable policies and guidelines. New Residential generally retains the right to service the underlying residential mortgage loans sold and securitized by NRM and NewRez. NRM and NewRez are required to conduct aspects of their operations in accordance with applicable policies and guidelines published by FHA, Fannie Mae and Freddie Mac in order to maintain those approvals.\\nNew Residential has entered into a management agreement (the “Management Agreement”) with FIG LLC (the “Manager”), an affiliate of Fortress Investment Group LLC (“Fortress”), pursuant to which the Manager provides a management team and other professionals who are responsible for implementing New Residential’s business strategy, subject to the supervision of New Residential’s board of directors. For its services, the Manager is entitled to management fees and incentive compensation, both defined in, and in accordance with the terms of, the Management Agreement.\\nAs of September 30, 2019, New Residential conducted its business through the following segments: (i) Servicing and Originations, (ii) Residential Securities and Loans, (iii) Consumer Loans and (iv) Corporate.\\nApproximately 2.4 million shares of New Residential’s common stock were held by Fortress, through its affiliates, as of September 30, 2019. In addition, Fortress, through its affiliates, held options relating to approximately 10.5 million shares of New Residential’s common stock as of September 30, 2019.\\nInterim Financial Statements\\nThe accompanying condensed consolidated financial statements and related notes of New Residential have been prepared in accordance with accounting principles generally accepted in the United States for interim financial reporting and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, certain information and note disclosures normally included in financial statements prepared under U.S. generally accepted accounting principles have been condensed or omitted. In the opinion of management, all adjustments considered necessary for a fair presentation of New Residential’s financial position, results of operations and cash flows have been included and are of a normal and recurring nature. The operating results presented for interim periods are not necessarily indicative of the results that may be expected for any other interim period or for the entire year. These condensed consolidated financial statements should be read in conjunction with New Residential’s consolidated financial statements for the year ended December 31, 2018 and notes thereto included in New Residential’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (the “SEC”). Capitalized terms used herein, and not otherwise defined, are defined in\\n10\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nNew Residential’s consolidated financial statements for the year ended December 31, 2018. Certain prior period amounts have been reclassified to conform to the current period’s presentation.\\nRecent Accounting Pronouncements\\nIn January 2016, the FASB issued ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10) - Recognition and Measurement of Financial Assets and Financial Liabilities. The standard: (i) requires that certain equity investments be measured at fair value, and modifies the assessment of impairment for certain other equity investments, (ii) changes certain disclosure requirements related to the fair value of financial instruments measured at amortized cost, (iii) changes certain disclosure requirements related to liabilities measured at fair value, (iv) requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset, and (v) clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets. ASU No. 2016-01 was effective for New Residential in the first quarter of 2018. The adoption of ASU No. 2016-01 did not have a material impact on the condensed consolidated financial statements.\\nIn February 2016, the FASB issued ASU No. 2016-02, Leases. The standard requires that lessees recognize a right-of-use asset and corresponding lease liability on the balance sheet for most leases. The guidance applied by a lessor under ASU No. 2016-02 is substantially similar to existing GAAP. ASU No. 2016-02 was effective for New Residential in the first quarter of 2019. An entity should apply ASU No. 2016-02 by means of a modified retrospective transition method for all leases existing at, or entered into after, the date of initial application. The adoption of ASU No. 2016-02 did not have a material impact on the condensed consolidated financial statements (see Notes 2 and 14 for details).\\nIn June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326) - Measurement of Credit Losses on Financial Instruments. The standard requires that a financial asset measured at amortized cost basis be presented at the net amount expected to be collected, net of an allowance for all expected (rather than incurred) credit losses. The measurement of expected credit losses is based on relevant information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectibility of the reported amount. The standard also changes the accounting for purchased credit deteriorated assets and available-for-sale securities, which will require the recognition of credit losses through a valuation allowance when fair value is less than amortized cost, regardless of whether the impairment is considered to be other-than-temporary. ASU No. 2016-13 is effective for New Residential in the first quarter of 2020. Early adoption is permitted beginning in 2019. An entity should apply ASU No. 2016-13 by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. New Residential is currently evaluating the new guidance to determine the impact it may have on its condensed consolidated financial statements. New Residential plans to elect the fair value option on Residential mortgage loans, held-for-investment and Consumer loans, held-for-investment.\\nIn January 2017, the FASB issued ASU No. 2017-04, Simplifying the Test for Goodwill Impairment (Topic 805). The standard simplifies the accounting for goodwill impairment for all entities by requiring impairment charges to be based on the first step in the current two-step impairment test. Under the new guidance, an impairment charge, if triggered, is calculated as the difference between a reporting unit’s carrying value and fair value, but it is limited to the carrying value of goodwill. ASU No. 2017-04 is effective for New Residential in the first quarter of 2020 and early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The adoption of ASU No. 2017-04 is not expected to have a material impact on the condensed consolidated financial statements.\\nIn August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (Topic 820). The standard: (i) adds incremental requirements for entities to disclose (a) the amount of total gains or losses for the period recognized in other comprehensive income that is attributable to fair value changes in assets and liabilities held as of the balance sheet date and categorized within Level 3 of the fair value hierarchy, (b) the range and weighted average used to develop significant unobservable inputs and (c) how the weighted average was calculated for fair value measurements categorized within Level 3 of the fair value hierarchy and (ii) eliminates disclosure requirements for (a) transfers between Level 1 and Level 2 and (b) valuation processes for Level 3 fair value measurements. ASU No. 2018-13 is effective for New Residential in the first quarter of 2020. The adoption of ASU No. 2018-13 is not expected to have a material impact on the condensed consolidated financial statements.\\n11\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nAcquisition of Shellpoint Partners LLC\\nOn November 29, 2017, NRM Acquisition LLC (the “Shellpoint Purchaser”), a Delaware limited liability company and a wholly owned subsidiary of New Residential, entered into a Securities Purchase Agreement (the “Shellpoint SPA”) to acquire Shellpoint Partners LLC, a Delaware limited liability company (“Shellpoint”).\\nOn July 3, 2018, the Shellpoint Purchaser acquired 100 % of the outstanding equity interests of Shellpoint for a cash purchase price of $ 212.3 million (the “Shellpoint Acquisition”). As additional consideration for the Shellpoint Acquisition, the Shellpoint Purchaser may make up to three cash earnout payments, which will be calculated following each of the first three anniversaries of the Shellpoint closing as a percentage of the amount by which the pre-tax income of certain of Shellpoint’s businesses exceeds certain specified thresholds, up to an aggregate maximum amount of $ 60.0 million (the “Shellpoint Earnout Payments”). The Shellpoint Earnout Payments are classified as contingent consideration recorded at fair value at the acquisition date and included in the total consideration transferred for the Shellpoint Acquisition. The contingent consideration is subsequently measured at fair value on a quarterly basis with changes in fair value recorded in other income.\\nShellpoint is a vertically integrated mortgage platform with established origination and servicing capabilities and provides New Residential with in-house servicing, asset origination and recapture capabilities. The results of Shellpoint’s operations have been included in the Company’s condensed consolidated statements of income for the nine months ended September 30, 2019 and represent $ 444.8 million and $ 97.2 million of revenue and net income, respectively.\\nThe acquisition date fair value of the consideration transferred includes $ 212.3 million in cash consideration, $ 39.3 million in contingent consideration and $ 173.9 million in effective settlement of preexisting relationships. The total consideration is summarized as follows:\\n| Total Consideration (in millions) | Amount |\\n| Cash Consideration | $ | 212.3 |\\n| Earnout Payment(A) | 39.3 |\\n| Effective Settlement of Preexisting Relationships(B) | 173.9 |\\n| Total Consideration | $ | 425.5 |\\n\\n| (A) | The range of outcomes for this contingent consideration is from $ 0 to $ 60.0 million, dependent on the performance of Shellpoint. New Residential derived a fair value of the remaining contingent consideration payment in three years of $ 39.3 million. This amount excludes contingent payments to the long-term employee incentive plans that require continuing employment and are recognized as compensation expense within General and Administrative expenses in the post-acquisition consolidated financial statements separate from New Residential’s acquisition of assets and assumption of liabilities in the business combination. On September 5, 2019, New Residential paid $ 10.0 million as the first of three potential earnout payments. As of September 30, 2019, the contingent consideration had a fair value of $ 38.3 million. |\\n\\n| (B) | Represents the effective settlement of preexisting relationships between New Residential and Shellpoint including 1) MSR acquisitions, 2) a note payable and 3) operating accounts receivable and payable existing prior to the acquisition date. The effective settlement of these preexisting relationships had no impact to New Residential’s condensed consolidated statements of income. |\\n\\n12\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nNew Residential has performed an allocation of the total consideration of $ 425.5 million to Shellpoint’s assets and liabilities, as set forth below. The final amount and allocation of total consideration reflects certain measurement period adjustments identified during the fourth quarter of 2018, including the effect on earnings that would have been recorded during the third quarter of 2018 had the accounting been completed at the acquisition date. Such measurement period adjustments included 1) a decrease of $ 3.5 million in the amount of contingent consideration based upon finalization of the internal valuation 2) a decrease of $ 6.4 million to consideration transferred for the effective settlement of existing relationships 3) an increase of $ 14.1 million to the fair value of identifiable intangible assets based upon receipt of the final valuation report from a third-party valuation firm and 4) an increase of $ 0.3 million to other assets due to a decrease in the fair value discount on certain servicing advance receivables. These measurement period adjustments resulted in a corresponding decrease to goodwill in the amount of $ 24.3 million.\\n| Total Consideration ($ in millions) | $ | 425.5 |\\n| Assets |\\n| Cash and cash equivalents | $ | 79.2 |\\n| Restricted cash | 9.9 |\\n| Residential mortgage loans, held-for-sale, at fair value | 488.2 |\\n| Mortgage servicing rights, at fair value(A) | 286.6 |\\n| Residential mortgage loans, held-for-investment, at fair value | 125.3 |\\n| Residential mortgage loans subject to repurchase | 121.4 |\\n| Intangible assets(B) | 18.4 |\\n| Other assets | 81.5 |\\n| Total Assets Acquired | $ | 1,210.5 |\\n| Liabilities |\\n| Repurchase agreements | $ | 439.6 |\\n| Notes and bonds payable | 20.7 |\\n| Mortgage-backed securities issued, at fair value | 120.7 |\\n| Residential mortgage loans repurchase liability | 121.4 |\\n| Excess spread financing, at fair value | 48.3 |\\n| Accrued expenses and other liabilities | 50.6 |\\n| Total Liabilities Assumed | $ | 801.3 |\\n| Noncontrolling Interest | $ | 8.3 |\\n| Net Assets | $ | 400.9 |\\n| Goodwill | $ | 24.6 |\\n\\n| (A) | Includes $ 135.3 million of Ginnie Mae MSRs where New Residential acquired the rights to the economic value of the servicing rights from Shellpoint prior to the acquisition date. |\\n\\n| (B) | Includes intangible assets in the form of mortgage origination and servicing licenses, internally developed software and a tradename. New Residential determined that mortgage origination and servicing licenses have an indefinite useful life and will be evaluated for impairment given no legal, regulatory, contractual, competitive or economic factors that would limit the useful life. Internally developed software will be amortized over a finite useful life of five years and tradenames were fully amortized over six months , respectively, based on the expected software development timeline and New Residential’s determination of the time to change a tradename with limited value. |\\n\\nThe goodwill of $ 24.6 million primarily includes the synergies and benefits expected to result from combining operations with Shellpoint and adding in-house servicing, asset origination and recapture capabilities. The full amount of goodwill for tax purposes of $ 24.6 million is expected to be deductible. New Residential will assess the goodwill annually on October 1 and in interim periods in case of events or circumstances make it more likely than not that an impairment may have occurred. Based on New Residential’s assessment performed, there were no indicators of impairment as of September 30, 2019.\\n13\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nCertain transactions were recognized separately from New Residential’s acquisition of assets and assumption of liabilities in the business combination. These separately recognized transactions include 1) contingent payments to Shellpoint’s employees and 2) effective settlement of preexisting relationships discussed above.\\nUnaudited Supplemental Pro Forma Financial Information — The following table presents unaudited pro forma combined Servicing and Originations Revenue, which is comprised of 1) servicing revenue, net and 2) gain on sale of originated mortgage loans, net, and Income Before Income Taxes for the three and nine months ended September 30, 2019 and 2018 prepared as if the Shellpoint Acquisition had been consummated on January 1, 2018.\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Pro Forma |\\n| Servicing and Originations Revenue | $ | 153,591 | $ | 221,087 | $ | 327,395 | $ | 733,901 |\\n| Income Before Income Taxes | 239,220 | 199,040 | 394,532 | 1,003,378 |\\n\\nThe unaudited supplemental pro forma financial information has not been adjusted for transactions other than the Shellpoint Acquisition, or for the conforming of accounting policies. The unaudited supplemental pro forma financial information does not include any anticipated synergies or other anticipated benefits of the Shellpoint Acquisition and, accordingly, the unaudited supplemental pro forma financial information is not necessarily indicative of either future results of operations or results that might have been achieved had the Shellpoint Acquisition occurred on January 1, 2018.\\n| 2. | OTHER INCOME, GENERAL AND ADMINISTRATIVE, OTHER ASSETS AND LIABILITIES |\\n\\nGain (loss) on settlement of investments, net is comprised of the following:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Gain (loss) on sale of real estate securities, net | $ | 95,003 | $ | ( 28,737 | ) | $ | 201,222 | $ | ( 66,695 | ) |\\n| Gain (loss) on sale of acquired residential mortgage loans, net | 43,648 | 4,065 | 53,405 | ( 1,358 | ) |\\n| Gain (loss) on settlement of derivatives | ( 14,147 | ) | 19,459 | ( 152,424 | ) | 76,092 |\\n| Gain (loss) on liquidated residential mortgage loans | ( 198 | ) | ( 1,113 | ) | ( 3,320 | ) | ( 2,267 | ) |\\n| Gain (loss) on sale of REO | ( 3,169 | ) | ( 4,971 | ) | ( 9,445 | ) | ( 12,114 | ) |\\n| Gains on settlement of investments in excess MSRs and servicer advance investments | — | — | — | 113,002 |\\n| Gain (loss) on sale or securitization of originated mortgage loans(A) | 21,611 | — | 62,399 | — |\\n| Other gains (losses) | 12,004 | ( 596 | ) | 5,176 | ( 596 | ) |\\n| $ | 154,752 | $ | ( 11,893 | ) | $ | 157,013 | $ | 106,064 |\\n\\n| (A) | Represents gains on securitizations of Non-QM residential mortgage loans originated by NewRez. |\\n\\n14\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nOther income (loss), net, is comprised of the following:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Unrealized gain (loss) on other ABS | $ | ( 5,054 | ) | $ | 7,197 | $ | 9,010 | $ | 12,001 |\\n| Unrealized gain (loss) on notes and bonds payable | ( 2,647 | ) | 900 | ( 5,248 | ) | 900 |\\n| Unrealized gain (loss) on contingent consideration | ( 2,703 | ) | — | ( 7,430 | ) | — |\\n| Gain (loss) on transfer of loans to REO | 1,230 | 6,119 | 7,814 | 16,609 |\\n| Gain (loss) on transfer of loans to other assets | ( 101 | ) | ( 1,528 | ) | ( 378 | ) | ( 1,648 | ) |\\n| Gain (loss) on Excess MSR recapture agreements | 529 | 987 | 1,771 | 5,257 |\\n| Gain (loss) on Ocwen common stock | ( 1,103 | ) | ( 145 | ) | 3,134 | 4,655 |\\n| Other income (loss) | ( 25,370 | ) | ( 19,390 | ) | ( 25,124 | ) | ( 27,359 | ) |\\n| $ | ( 35,219 | ) | $ | ( 5,860 | ) | $ | ( 16,451 | ) | $ | 10,415 |\\n\\nGeneral and Administrative Expenses is comprised of the following:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Compensation and benefits expense, servicing | $ | 30,494 | $ | 22,498 | $ | 87,219 | $ | 22,498 |\\n| Compensation and benefits expense, origination | 44,270 | 32,822 | 112,977 | 32,822 |\\n| Legal and professional expense | 16,442 | 11,749 | 46,352 | 35,378 |\\n| Loan origination expense | 17,882 | 7,801 | 42,349 | 7,801 |\\n| Occupancy expense | 5,114 | 4,394 | 14,079 | 4,394 |\\n| Other(A) | 19,311 | 19,323 | 48,383 | 36,276 |\\n| $ | 133,513 | $ | 98,587 | $ | 351,359 | $ | 139,169 |\\n\\n| (A) | Represents miscellaneous general and administrative expenses. |\\n\\n15\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nOther assets and liabilities are comprised of the following:\\n| Other Assets | Accrued Expenses and Other Liabilities |\\n| September 30, 2019 | December 31, 2018 | September 30, 2019 | December 31, 2018 |\\n| Margin receivable, net(A) | $ | 409,526 | $ | 145,857 | MSR purchase price holdback | $ | 102,556 | $ | 100,593 |\\n| Servicing fee receivables | 144,550 | 105,563 | Accounts payable | 89,372 | 75,591 |\\n| Due from servicers | 171,916 | 95,261 | Derivative liabilities (Note 10) | 1,842 | 29,389 |\\n| Principal and interest receivable | 98,067 | 76,015 | Interest payable | 80,892 | 49,352 |\\n| Equity investments(B) | 117,375 | 74,323 | Due to servicers | 144,156 | 95,419 |\\n| Ditech deposit | 70,000 | — | Residential mortgage loan repurchase liability | 168,532 | 121,602 |\\n| Other receivables | 103,933 | 23,723 | Due to affiliates | 59,551 | 101,471 |\\n| Real Estate Owned | 105,968 | 113,410 | Contingent Consideration | 52,761 | 40,842 |\\n| Residential mortgage loans subject to repurchase | 168,532 | 121,602 | Excess spread financing, at fair value | 30,377 | 39,304 |\\n| Consumer loans, equity method investees (Note 9) | 23,033 | 38,294 | Operating lease liability | 24,532 | — |\\n| Goodwill(C) | 41,986 | 24,645 | Reserve for sales recourse | 9,173 | 5,880 |\\n| Receivable from government agency(D) | 20,505 | 20,795 | Other liabilities | 56,547 | 54,140 |\\n| Intangible assets | 19,346 | 18,708 | $ | 820,291 | $ | 713,583 |\\n| Prepaid expenses | 33,120 | 29,165 |\\n| Operating lease right-of-use asset | 18,773 | — |\\n| Derivative assets (Note 10) | 36,712 | 10,893 |\\n| Ocwen common stock, at fair value | 10,912 | 7,778 |\\n| Other assets | 130,265 | 55,682 |\\n| $ | 1,724,519 | $ | 961,714 |\\n\\n| (A) | Represents collateral posted primarily as a result of changes in fair value of our 1) real estate securities securing our repurchase agreements and 2) derivative instruments. |\\n\\n| (B) | Represents equity investments in funds that invest in 1) a commercial redevelopment project and 2) operating companies in the single family housing industry. The indirect investments are accounted for at fair value based on the net asset value (“NAV”) of New Residential’s investment and as an equity method investment, respectively. |\\n\\n| (C) | Includes goodwill derived from the Shellpoint Acquisition (see Note 1 for details) and the Company’s acquisition of Guardian Asset Management, a leading national provider of field services and property management to government agencies, financial institutions and asset management firms. |\\n\\n| (D) | Represents claims receivable from the FHA on EBO and reverse mortgage loans for which foreclosure has been completed and for which New Residential has made or intends to make a claim on the FHA guarantee. |\\n\\n16\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nAs reflected on the Condensed Consolidated Statements of Cash Flows, accretion and other amortization is comprised of the following:\\n| Nine Months Ended September 30, |\\n| 2019 | 2018 |\\n| Accretion of net discount on securities and loans(A) | $ | 266,467 | $ | 296,961 |\\n| Accretion of servicer advances receivable discount and servicer advance investments | 18,290 | 207,428 |\\n| Accretion of excess mortgage servicing rights income | 18,203 | 32,371 |\\n| Amortization of deferred financing costs | ( 2,984 | ) | ( 6,180 | ) |\\n| Amortization of discount on notes and bonds payable | ( 1,043 | ) | ( 1,599 | ) |\\n| $ | 298,933 | $ | 528,981 |\\n\\n| (A) | Includes accretion of the accretable yield on PCD loans. |\\n\\n| 3. | SEGMENT REPORTING |\\n\\nNew Residential conducts its business through the following segments: (i) Servicing and Originations, (ii) Residential Securities and Loans, (iii) Consumer Loans and (iv) Corporate. The corporate segment consists primarily of (i) general and administrative expenses, (ii) the management fees and incentive compensation related to the Management Agreement and (iii) corporate cash and related interest income. Securities owned by New Residential (Note 7) that are collateralized by servicer advances and consumer loans are included in the Servicing and Originations and Consumer Loans segments, respectively. Secured corporate loans effectively collateralized by Excess MSRs are included in the Servicing and Originations segment.\\nDuring the third quarter of 2018, New Residential changed the composition of its reportable segments primarily to reflect the (i) aggregation of the similar MSR, Excess MSR and Servicer Advance segments as the new Servicing and Originations segment and (ii) incorporation of the Shellpoint Acquisition. Segment information for prior periods has been restated to reflect this change.\\nSummary financial data on New Residential’s segments is given below, together with a reconciliation to the same data for New Residential as a whole:\\n| Residential Securities and Loans |\\n| Servicing and Originations | Real Estate Securities | Residential Mortgage Loans | Consumer Loans | Corporate | Total |\\n| Three Months Ended September 30, 2019 |\\n| Interest income | $ | 135,892 | $ | 184,933 | $ | 86,971 | $ | 40,331 | $ | — | $ | 448,127 |\\n| Interest expense | 69,679 | 123,023 | 45,707 | 7,493 | — | 245,902 |\\n| Net interest income (expense) | 66,213 | 61,910 | 41,264 | 32,838 | — | 202,225 |\\n| Impairment | — | 5,567 | ( 16,553 | ) | 5,863 | — | ( 5,123 | ) |\\n| Servicing revenue, net | 53,050 | — | — | — | — | 53,050 |\\n| Gain on sale of originated mortgage loans, net | 100,541 | — | — | — | — | 100,541 |\\n| Other income (loss) | ( 38,547 | ) | 116,081 | 55,152 | ( 2,651 | ) | ( 1,189 | ) | 128,846 |\\n| Operating expenses | 168,100 | 1,839 | 14,006 | 3,965 | 62,655 | 250,565 |\\n| Income (Loss) Before Income Taxes | 13,157 | 170,585 | 98,963 | 20,359 | ( 63,844 | ) | 239,220 |\\n| Income tax expense (benefit) | 10,749 | — | ( 15,546 | ) | ( 643 | ) | — | ( 5,440 | ) |\\n| Net Income (Loss) | $ | 2,408 | $ | 170,585 | $ | 114,509 | $ | 21,002 | $ | ( 63,844 | ) | $ | 244,660 |\\n| Noncontrolling interests in income (loss) of consolidated subsidiaries | $ | 4,141 | $ | — | $ | — | $ | 10,597 | $ | — | $ | 14,738 |\\n| Dividends on Preferred Stock | $ | — | $ | — | $ | — | $ | — | $ | 5,338 | $ | 5,338 |\\n| Net income (loss) attributable to common stockholders | $ | ( 1,733 | ) | $ | 170,585 | $ | 114,509 | $ | 10,405 | $ | ( 69,182 | ) | $ | 224,584 |\\n\\n17\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\n| Residential Securities and Loans |\\n| Servicing and Originations | Real Estate Securities | Residential Mortgage Loans | Consumer Loans | Corporate | Total |\\n| Nine Months Ended September 30, 2019 |\\n| Interest income | $ | 396,662 | $ | 557,895 | $ | 219,909 | $ | 128,575 | $ | — | $ | 1,303,041 |\\n| Interest expense | 203,940 | 330,992 | 126,288 | 25,518 | — | 686,738 |\\n| Net interest income (expense) | 192,722 | 226,903 | 93,621 | 103,057 | — | 616,303 |\\n| Impairment | — | 21,942 | ( 16,557 | ) | 24,599 | — | 29,984 |\\n| Servicing revenue, net | 133,366 | — | — | — | — | 133,366 |\\n| Gain on sale of originated mortgage loans, net | 194,029 | — | — | — | — | 194,029 |\\n| Other income (loss) | ( 92,878 | ) | 31,677 | 180,643 | ( 10,324 | ) | 4,515 | 113,633 |\\n| Operating expenses | 457,276 | 4,124 | 31,289 | 18,396 | 121,730 | 632,815 |\\n| Income (Loss) Before Income Taxes | ( 30,037 | ) | 232,514 | 259,532 | 49,738 | ( 117,215 | ) | 394,532 |\\n| Income tax expense (benefit) | 8,474 | — | 11,048 | ( 542 | ) | — | 18,980 |\\n| Net Income (Loss) | $ | ( 38,511 | ) | $ | 232,514 | $ | 248,484 | $ | 50,280 | $ | ( 117,215 | ) | $ | 375,552 |\\n| Noncontrolling interests in income (loss) of consolidated subsidiaries | $ | 8,873 | $ | — | $ | — | $ | 23,106 | $ | — | $ | 31,979 |\\n| Dividends on Preferred Stock | $ | — | $ | — | $ | — | $ | — | $ | 5,338 | $ | 5,338 |\\n| Net income (loss) attributable to common stockholders | $ | ( 47,384 | ) | $ | 232,514 | $ | 248,484 | $ | 27,174 | $ | ( 122,553 | ) | $ | 338,235 |\\n\\n| Residential Securities and Loans |\\n| Servicing and Originations | Real Estate Securities | Residential Mortgage Loans | Consumer Loans | Corporate | Total |\\n| September 30, 2019 |\\n| Investments | $ | 6,374,099 | $ | 16,853,910 | $ | 7,444,405 | $ | 904,216 | $ | — | $ | 31,576,630 |\\n| Cash and cash equivalents | 197,607 | 43,604 | 7,281 | 12,091 | 477,636 | 738,219 |\\n| Restricted cash | 129,504 | — | — | 33,644 | — | 163,148 |\\n| Other assets | 3,378,631 | 4,939,205 | 247,431 | 34,384 | 228,291 | 8,827,942 |\\n| Goodwill | 41,986 | — | — | — | — | 41,986 |\\n| Total assets | $ | 10,121,827 | $ | 21,836,719 | $ | 7,699,117 | $ | 984,335 | $ | 705,927 | $ | 41,347,925 |\\n| Debt | $ | 6,192,811 | $ | 17,196,772 | $ | 6,248,142 | $ | 878,506 | $ | — | $ | 30,516,231 |\\n| Other liabilities | 600,622 | 2,608,316 | 68,838 | 14,897 | 276,904 | 3,569,577 |\\n| Total liabilities | 6,793,433 | 19,805,088 | 6,316,980 | 893,403 | 276,904 | 34,085,808 |\\n| Total equity | 3,328,394 | 2,031,631 | 1,382,137 | 90,932 | 429,023 | 7,262,117 |\\n| Noncontrolling interests in equity of consolidated subsidiaries | 61,132 | — | — | 22,520 | — | 83,652 |\\n| Total New Residential stockholders’ equity | $ | 3,267,262 | $ | 2,031,631 | $ | 1,382,137 | $ | 68,412 | $ | 429,023 | $ | 7,178,465 |\\n| Investments in equity method investees | $ | 249,134 | $ | — | $ | — | $ | 23,033 | $ | — | $ | 272,167 |\\n\\n18\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\n| Residential Securities and Loans |\\n| Servicing and Originations | Real Estate Securities | Residential Mortgage Loans | Consumer Loans | Corporate | Total |\\n| Three Months Ended September 30, 2018 |\\n| Interest income | $ | 187,584 | $ | 138,197 | $ | 48,782 | $ | 50,961 | $ | — | $ | 425,524 |\\n| Interest expense | 61,706 | 67,117 | 23,662 | 10,321 | — | 162,806 |\\n| Net interest income (expense) | 125,878 | 71,080 | 25,120 | 40,640 | — | 262,718 |\\n| Impairment | — | 3,889 | ( 4,436 | ) | 9,907 | — | 9,360 |\\n| Servicing revenue, net | 175,355 | — | — | — | — | 175,355 |\\n| Gain on sale of originated mortgage loans, net | 45,732 | — | — | — | — | 45,732 |\\n| Other income (loss) | ( 92,243 | ) | 17,994 | ( 12,729 | ) | 3,795 | ( 115 | ) | ( 83,298 | ) |\\n| Operating expenses | 132,542 | 63 | 6,436 | 8,467 | 44,599 | 192,107 |\\n| Income (Loss) Before Income Taxes | 122,180 | 85,122 | 10,391 | 26,061 | ( 44,714 | ) | 199,040 |\\n| Income tax expense (benefit) | 495 | — | 3,100 | ( 32 | ) | — | 3,563 |\\n| Net Income (Loss) | $ | 121,685 | $ | 85,122 | $ | 7,291 | $ | 26,093 | $ | ( 44,714 | ) | $ | 195,477 |\\n| Noncontrolling interests in income (loss) of consolidated subsidiaries | $ | 1,086 | $ | — | $ | — | $ | 9,783 | $ | — | $ | 10,869 |\\n| Net income (loss) attributable to common stockholders | $ | 120,599 | $ | 85,122 | $ | 7,291 | $ | 16,310 | $ | ( 44,714 | ) | $ | 184,608 |\\n\\n| Residential Securities and Loans |\\n| Servicing and Originations | Real Estate Securities | Residential Mortgage Loans | Consumer Loans | Corporate | Total |\\n| Nine Months Ended September 30, 2018 |\\n| Interest income | $ | 574,379 | $ | 354,922 | $ | 123,464 | $ | 158,631 | $ | 1,506 | $ | 1,212,902 |\\n| Interest expense | 172,471 | 157,195 | 58,587 | 32,856 | — | 421,109 |\\n| Net interest income (expense) | 401,908 | 197,727 | 64,877 | 125,775 | 1,506 | 791,793 |\\n| Impairment | — | 23,190 | ( 8,683 | ) | 36,819 | — | 51,326 |\\n| Servicing revenue, net | 538,784 | — | — | — | — | 538,784 |\\n| Gain on sale of originated mortgage loans, net | 45,732 | — | — | — | — | 45,732 |\\n| Other income (loss) | 48,128 | 45,346 | ( 27,219 | ) | 13,363 | 4,796 | 84,414 |\\n| Operating expenses | 235,417 | 1,003 | 25,658 | 26,743 | 130,856 | 419,677 |\\n| Income (Loss) Before Income Taxes | 799,135 | 218,880 | 20,683 | 75,576 | ( 124,554 | ) | 989,720 |\\n| Income tax expense (benefit) | ( 6,458 | ) | — | 289 | 212 | — | ( 5,957 | ) |\\n| Net Income (Loss) | $ | 805,593 | $ | 218,880 | $ | 20,394 | $ | 75,364 | $ | ( 124,554 | ) | $ | 995,677 |\\n| Noncontrolling interests in income (loss) of consolidated subsidiaries | $ | 3,525 | $ | — | $ | — | $ | 28,533 | $ | — | $ | 32,058 |\\n| Net income (loss) attributable to common stockholders | $ | 802,068 | $ | 218,880 | $ | 20,394 | $ | 46,831 | $ | ( 124,554 | ) | $ | 963,619 |\\n\\n19\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\n| 4. | INVESTMENTS IN EXCESS MORTGAGE SERVICING RIGHTS |\\n\\nThe following table presents activity related to the carrying value of New Residential’s direct investments in Excess MSRs:\\n| Servicer |\\n| Nationstar | SLS(A) | Total |\\n| Balance as of December 31, 2018 | $ | 445,328 | $ | 2,532 | $ | 447,860 |\\n| Purchases | — | — | — |\\n| Interest income | 18,159 | 44 | 18,203 |\\n| Other income | 2,092 | — | 2,092 |\\n| Proceeds from repayments | ( 63,794 | ) | ( 295 | ) | ( 64,089 | ) |\\n| Proceeds from sales | ( 4,581 | ) | — | ( 4,581 | ) |\\n| Change in fair value | ( 1,258 | ) | ( 163 | ) | ( 1,421 | ) |\\n| Balance as of September 30, 2019 | $ | 395,946 | $ | 2,118 | $ | 398,064 |\\n\\n| (A) | Specialized Loan Servicing LLC (“SLS”). |\\n\\nNationstar or SLS, as applicable, as servicer, performs all of the servicing and advancing functions, and retains the ancillary income, servicing obligations and liabilities as the servicer of the underlying loans in the portfolio.\\nNew Residential has entered into a “recapture agreement” with respect to each of the Excess MSR investments serviced by Nationstar and SLS. Under such arrangements, New Residential is generally entitled to a pro rata interest in the Excess MSRs on any initial or subsequent refinancing by Nationstar of a loan in the original portfolio. These recapture agreements do not apply to New Residential’s Servicer Advance Investments (Note 6).\\nNew Residential elected to record its investments in Excess MSRs at fair value pursuant to the fair value option for financial instruments in order to provide users of the financial statements with better information regarding the effects of prepayment risk and other market factors on the Excess MSRs.\\nThe following is a summary of New Residential’s direct investments in Excess MSRs:\\n| September 30, 2019 | December 31, 2018 |\\n| UPB of Underlying Mortgages | Interest in Excess MSR | Weighted Average Life Years(A) | Amortized Cost Basis(B) | Carrying Value(C) | Carrying Value(C) |\\n| New Residential(D) | Fortress-managed funds | Nationstar |\\n| Agency | $ | 45,900,654 | 32.5% - 66.7% (53.3%) | 0.0% - 40.0% | 20.0% - 35.0% | 5.4 | $ | 183,064 | $ | 221,560 | $ | 257,387 |\\n| Non-Agency(E) | $ | 47,124,536 | 33.3% - 100.0% (59.4%) | 0.0% - 50.0% | 0.0% - 33.3% | 6.5 | $ | 129,647 | $ | 176,504 | $ | 190,473 |\\n| Total | $ | 93,025,190 | 5.9 | $ | 312,711 | $ | 398,064 | $ | 447,860 |\\n\\n\\n| (A) | Weighted Average Life represents the weighted average expected timing of the receipt of expected cash flows for this investment. |\\n\\n| (B) | The amortized cost basis of the recapture agreements is determined based on the relative fair values of the recapture agreements and related Excess MSRs at the time they were acquired. |\\n\\n| (C) | Carrying Value represents the fair value of the pools or recapture agreements, as applicable. |\\n\\n| (D) | Amounts in parentheses represent weighted averages. |\\n\\n| (E) | Serviced by Nationstar and SLS, New Residential is also invested in related Servicer Advance Investments, including the basic fee component of the related MSR as of September 30, 2019 (Note 6) on $ 33.4 billion UPB underlying these Excess MSRs. |\\n\\n20\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nChanges in fair value recorded in other income is comprised of the following:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Original and Recaptured Pools | $ | 2,407 | $ | ( 4,744 | ) | $ | ( 1,421 | ) | $ | ( 55,711 | ) |\\n\\nAs of September 30, 2019, a weighted average discount rate of 7.8 % was used to value New Residential’s investments in Excess MSRs (directly and through equity method investees).\\nNew Residential entered into investments in joint ventures (“Excess MSR joint ventures”) jointly controlled by New Residential and Fortress-managed funds investing in Excess MSRs. New Residential elected to record these investments at fair value pursuant to the fair value option for financial instruments to provide users of the financial statements with better information regarding the effects of prepayment risk and other market factors.\\nThe following tables summarize the financial results of the Excess MSR joint ventures, accounted for as equity method investees, held by New Residential:\\n| September 30, 2019 | December 31, 2018 |\\n| Excess MSR assets | $ | 236,786 | $ | 269,203 |\\n| Other assets | 28,418 | 27,411 |\\n| Other liabilities | ( 687 | ) | ( 687 | ) |\\n| Equity | $ | 264,517 | $ | 295,927 |\\n| New Residential’s investment | $ | 132,259 | $ | 147,964 |\\n| New Residential’s ownership | 50.0 | % | 50.0 | % |\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Interest income | $ | 7,990 | $ | 8,935 | $ | 12,251 | $ | 21,026 |\\n| Other income (loss) | 1,528 | ( 2,143 | ) | ( 4,029 | ) | ( 9,778 | ) |\\n| Expenses | ( 16 | ) | — | ( 48 | ) | — |\\n| Net income (loss) | $ | 9,502 | $ | 6,792 | $ | 8,174 | $ | 11,248 |\\n\\nNew Residential’s investments in equity method investees changed during the nine months ended September 30, 2019 as follows:\\n| Balance at December 31, 2018 | $ | 147,964 |\\n| Contributions to equity method investees | — |\\n| Distributions of earnings from equity method investees | ( 7,762 | ) |\\n| Distributions of capital from equity method investees | ( 12,030 | ) |\\n| Change in fair value of investments in equity method investees | 4,087 |\\n| Balance at September 30, 2019 | $ | 132,259 |\\n\\n21\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nThe following is a summary of New Residential’s Excess MSR investments made through equity method investees:\\n| September 30, 2019 |\\n| Unpaid Principal Balance | Investee Interest in Excess MSR(A) | New Residential Interest in Investees | Amortized Cost Basis(B) | Carrying Value(C) | Weighted Average Life (Years)(D) |\\n| Agency | $ | 35,632,429 | 66.7 | % | 50.0 | % | $ | 171,553 | $ | 236,786 | 5.3 |\\n\\n\\n| (A) | The remaining interests are held by Nationstar. |\\n\\n| (B) | Represents the amortized cost basis of the equity method investees in which New Residential holds a 50 % interest. The amortized cost basis of the recapture agreements is determined based on the relative fair values of the recapture agreements and related Excess MSRs at the time they were acquired. |\\n\\n| (C) | Represents the carrying value of the Excess MSRs held in equity method investees, in which New Residential holds a 50 % interest. Carrying value represents the fair value of the pools or recapture agreements, as applicable. |\\n\\n| (D) | The weighted average life represents the weighted average expected timing of the receipt of cash flows of each investment. |\\n\\nSee Note 11 regarding the financing of Excess MSRs.\\n5. INVESTMENTS IN MORTGAGE SERVICING RIGHTS AND MSR FINANCING RECEIVABLES\\nA subsidiary of New Residential, New Residential Mortgage LLC (“NRM”), engages third party licensed mortgage servicers as subservicers to perform the operational servicing duties in connection with the MSRs it acquires, in exchange for a subservicing fee which is recorded as “Subservicing expense” on New Residential’s Condensed Consolidated Statements of Income. As of September 30, 2019, these subservicers include PHH Mortgage Corporation (“PHH”), Nationstar, LoanCare, LLC (“LoanCare”), AmeriHome Mortgage Company, LLC (“AmeriHome”), and Flagstar Bank, FSB (“Flagstar”), which subservice 26.9 %, 23.1 %, 19.2 %, 1.8 %, and 0.8 % of the underlying UPB of the related mortgages, respectively (includes both Mortgage Servicing Rights and MSR Financing Receivables). The remaining 28.2 % of the underlying UPB of the related mortgages is subserviced by a subsidiary of New Residential, Shellpoint Mortgage Servicing (Note 1).\\nNew Residential has entered into recapture agreements with respect to each of its MSR investments subserviced by PHH, LoanCare, Flagstar, and Nationstar. Under the recapture agreements, New Residential is generally entitled to the MSRs on any initial or subsequent refinancing by PHH, Loancare, Flagstar or Nationstar of a loan in the original portfolios.\\nIn certain cases, New Residential has legally purchased MSRs or the right to the economic interest in MSRs; however, New Residential has determined that the purchase agreement would not be treated as a sale under GAAP. Therefore, rather than recording an investment in MSRs, New Residential has recorded an investment in mortgage servicing rights financing receivables (“MSR Financing Receivables”). Income from these investments (net of subservicing fees) are recorded as interest income, and New Residential has elected to measure the investments at fair value, with changes in fair value flowing through change in fair value of investments in MSR financing receivables in the Condensed Consolidated Statements of Income.\\nNew Residential records its investments in MSRs and MSR Financing Receivables at fair value at acquisition and has elected to subsequently measure at fair value pursuant to the fair value measurement method.\\n22\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nThe following table presents activity related to the carrying value of New Residential’s investments in MSRs and MSR Financing Receivables:\\n| MSRs | MSR Financing Receivables | Total |\\n| Balance as of December 31, 2018 | $ | 2,884,100 | $ | 1,644,504 | $ | 4,528,604 |\\n| Purchases, net(A) | 632,144 | 735,152 | 1,367,296 |\\n| Transfers(B) | 367,121 | ( 367,121 | ) | — |\\n| Other transfers(C) | ( 410 | ) | — | ( 410 | ) |\\n| Originations(D) | 190,666 | — | 190,666 |\\n| Prepayments(E) | ( 11,210 | ) | ( 52,499 | ) | ( 63,709 | ) |\\n| Proceeds from sales | ( 1,047 | ) | ( 15,575 | ) | ( 16,622 | ) |\\n| Amortization of servicing rights(F) | ( 351,867 | ) | ( 131,417 | ) | ( 483,284 | ) |\\n| Change in valuation inputs and assumptions(G) | ( 279,758 | ) | 1,437 | ( 278,321 | ) |\\n| (Gain)/loss on sales | 2,229 | ( 3,220 | ) | ( 991 | ) |\\n| Balance as of September 30, 2019 | $ | 3,431,968 | $ | 1,811,261 | $ | 5,243,229 |\\n\\n| (A) | Net of purchase price adjustments. |\\n\\n| (B) | Represents MSRs previously accounted for as MSR Financing Receivables. As a result of the length of the initial term of the related subservicing agreement between NRM and PHH, although the MSRs were legally sold, solely for accounting purposes, the purchase agreement was not treated as a sale under GAAP through June 30, 2019. |\\n\\n| (C) | Represents Ginnie Mae MSRs repurchased. |\\n\\n| (D) | Represents MSRs retained on the sale of originated mortgage loans. |\\n\\n| (E) | Represents purchase price fully reimbursable from sellers as a result of prepayment protection. |\\n\\n| (F) | Based on the ratio of the current UPB of the underlying residential mortgage loans relative to the original UPB of the underlying residential mortgage loans. |\\n\\n| (G) | Change in valuation inputs and assumptions includes changes in inputs or assumptions used in the valuation model. |\\n\\nServicing revenue, net recognized by New Residential related to its investments in MSRs was comprised of the following:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Servicing fee revenue | $ | 222,966 | $ | 158,458 | $ | 602,241 | $ | 408,967 |\\n| Ancillary and other fees | 58,489 | 43,638 | 151,039 | 94,699 |\\n| Servicing fee revenue and fees | 281,455 | 202,096 | 753,280 | 503,666 |\\n| Amortization of servicing rights | ( 168,776 | ) | ( 70,933 | ) | ( 346,772 | ) | ( 191,499 | ) |\\n| Change in valuation inputs and assumptions(A) (B) | ( 61,858 | ) | 44,192 | ( 275,371 | ) | 226,617 |\\n| (Gain)/loss on sales | 2,229 | — | 2,229 | — |\\n| Servicing revenue, net | $ | 53,050 | $ | 175,355 | $ | 133,366 | $ | 538,784 |\\n\\n| (A) | Change in valuation inputs and assumptions includes changes in inputs or assumptions used in the valuation model. |\\n\\n| (B) | Includes $ 3.6 million and $ 4.4 million of fair value adjustment to Excess spread financing for the three and nine months ended September 30, 2019, respectively. |\\n\\n23\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nInterest income from investments in MSR Receivables was comprised of the following:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Servicing fee revenue | $ | 128,936 | $ | 181,495 | $ | 385,306 | $ | 575,909 |\\n| Ancillary and other fees | 21,417 | 39,257 | 82,695 | 109,852 |\\n| Less: subservicing expense | ( 40,410 | ) | ( 61,454 | ) | ( 145,649 | ) | ( 192,275 | ) |\\n| Interest income, investments in mortgage servicing rights financing receivables | $ | 109,943 | $ | 159,298 | $ | 322,352 | $ | 493,486 |\\n\\nChange in fair value of investments in MSR Financing Receivables was comprised of the following:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Amortization of servicing rights | $ | ( 48,340 | ) | $ | ( 49,016 | ) | $ | ( 131,417 | ) | $ | ( 154,559 | ) |\\n| Change in valuation inputs and assumptions(A) | 9,349 | ( 39,329 | ) | 1,437 | 218,187 |\\n| (Gain)/loss on sales(B) | ( 2,419 | ) | — | ( 3,220 | ) | — |\\n| Change in fair value of investments in mortgage servicing rights financing receivables | $ | ( 41,410 | ) | $ | ( 88,345 | ) | $ | ( 133,200 | ) | $ | 63,628 |\\n\\n| (A) | Change in valuation inputs and assumptions includes changes in inputs or assumptions used in the valuation model. |\\n\\n| (B) | Represents the realization of unrealized gain/(loss) as a result of sales. |\\n\\nThe following is a summary of New Residential’s investments in MSRs as of September 30, 2019:\\n| UPB of Underlying Mortgages | Weighted Average Life (Years)(A) | Amortized Cost Basis | Carrying Value(B) |\\n| MSRs: |\\n| Agency | $ | 288,673,487 | 4.9 | $ | 2,968,392 | $ | 3,038,721 |\\n| Non-Agency | 2,350,471 | 5.6 | 12,294 | 20,321 |\\n| Ginnie Mae(C) | 28,903,327 | 4.0 | 383,454 | 372,926 |\\n| MSR Financing Receivables: |\\n| Agency | 61,162,569 | 4.3 | 659,950 | 597,990 |\\n| Non-Agency | 79,360,666 | 7.7 | 840,279 | 1,213,271 |\\n| Total | $ | 460,450,520 | 5.2 | $ | 4,864,369 | $ | 5,243,229 |\\n\\n| (A) | Weighted Average Life represents the weighted average expected timing of the receipt of expected cash flows for this investment. |\\n\\n| (B) | Carrying Value represents fair value. As of September 30, 2019, a weighted average discount rate of 7.5 % and 8.8 % was used to value New Residential’s investments in MSRs and MSR Financing Receivables, respectively. |\\n\\n| (C) | NewRez, as an approved issuer of Ginnie Mae MBS, originates, sells and securitizes government-insured residential mortgage loans into Ginnie Mae guaranteed securitizations and NewRez retains the right to service the underlying residential mortgage loans. As the servicer, NewRez holds an option to repurchase delinquent loans from the securitization at its discretion. As of September 30, 2019, New Residential holds approximately $ 168.5 million in residential mortgage loans subject to repurchase and residential mortgage loans repurchase liability on its condensed consolidated balance sheets. |\\n\\n24\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nOcwen MSR Financing Receivable Transactions\\nOn July 23, 2017, Ocwen and New Residential entered into a Master Agreement (the “Ocwen Master Agreement”) and a Transfer Agreement (the “Ocwen Transfer Agreement”) pursuant to which Ocwen and New Residential agreed to undertake certain actions to facilitate the transfer from Ocwen to New Residential of Ocwen’s remaining interests in the mortgage servicing rights relating to loans with an aggregate unpaid principal balance of approximately $ 110.0 billion that are subject to the Original Ocwen Agreements (the “Ocwen Subject MSRs”) and with respect to which New Residential holds the Rights to MSRs (as defined in the Original Ocwen Agreements). New Residential and Ocwen concurrently entered into a subservicing agreement pursuant to which Ocwen will subservice the mortgage loans related to the Ocwen Subject MSRs that are transferred to New Residential pursuant to the Ocwen Master Agreement and Ocwen Transfer Agreement.\\nOn January 18, 2018, New Residential entered into a new agreement regarding the rights to MSRs (the “New Ocwen RMSR Agreement”) including a servicing addendum thereto (the “Ocwen Servicing Addendum”), Amendment No. 1 to Transfer Agreement (the “New Ocwen Transfer Agreement”) and a Brokerage Services Agreement (the “Ocwen Brokerage Services Agreement” and, collectively, the “New Ocwen Agreements”) with Ocwen. The New Ocwen Agreements amend and supplement the arrangements among the parties set forth in the Original Ocwen Agreements, the Ocwen Master Agreement, the Ocwen Transfer Agreement, and the Ocwen Subservicing Agreement (together with the Original Ocwen Agreements, the Ocwen Master Agreement, and the Ocwen Transfer Agreement, the “Existing Ocwen Agreements”). NRM made a lump-sum “Fee Restructuring Payment” of $ 279.6 million to Ocwen on January 18, 2018, the date of the New Ocwen RMSR Agreement, with respect to such Existing Ocwen Subject MSRs.\\nUnder the Existing Ocwen Agreements, Ocwen sold and transferred to New Residential certain “Rights to MSRs” and other assets related to mortgage servicing rights for loans with an unpaid principal balance of approximately $ 86.8 billion as of the opening balances in January 2018 (the “Existing Ocwen Subject MSRs”). The New Ocwen Agreements and NRM’s Fee Restructuring Payment resulted in a new investment structured as a transfer of the full interests and economics of the Ocwen subject MSRs.\\nPursuant to the New Ocwen Agreements, Ocwen will continue to service the mortgage loans related to the Existing Ocwen Subject MSRs until the necessary third party consents are obtained in order to transfer the Existing Ocwen Subject MSRs in accordance with the New Ocwen Agreements.\\nPursuant to the Ocwen Brokerage Services Agreement, Ocwen will engage NRZ Brokerage to perform brokerage and marketing services for all REO properties serviced by Ocwen pursuant to the Subject Servicing Agreements as defined in the New Ocwen RMSR Agreement. Such REO properties are subject to the Altisource Brokerage Agreement and Altisource Letter Agreement.\\nAs of September 30, 2019, MSRs representing approximately $ 66.7 billion UPB of underlying loans have been transferred pursuant to the Ocwen Transaction. Economics related to the remaining MSRs subject to the Ocwen Transaction were transferred pursuant to the New Ocwen Agreements. As a result of the length of the initial term of the related subservicing agreement between NRM and Ocwen, although the MSRs transferred pursuant to the Ocwen Transaction were legally sold, solely for accounting purposes, New Residential determined that substantially all of the risks and rewards inherent in owning the MSRs had not been transferred to NRM, and that the purchase agreement would not be treated as a sale under GAAP.\\nAs a part of the ongoing integration efforts related to the Ocwen and PHH merger completed on October 4, 2018, Ocwen now conducts its mortgage servicing business under the PHH tradename.\\nNationstar MSR Financing Receivable Transaction\\nOn February 28, 2019, NRM entered into an agreement with Nationstar to purchase the MSRs, and related servicer advance receivables, with respect to $ 9.5 billion in total UPB of seasoned Agency residential mortgage loans. The residential mortgage loans underlying the MSRs acquired by NRM are subserviced by Nationstar pursuant to an existing subservicing agreement with NRM. As a result of the length of the initial term of the related subservicing agreement between NRM and Nationstar, although the MSRs were legally sold, solely for accounting purposes, New Residential determined that substantially all of the risks and rewards inherent in owning the MSRs had not been transferred to NRM, and that the purchase agreement would not be treated as a sale under GAAP.\\n25\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nUnited Shore MSR Financing Receivable Transactions\\nOn April 2, 2019 and May 21, 2019, NRM entered into agreements with United Shore to purchase the MSRs, and related servicer advance receivables, with respect to $ 8.2 billion and $ 23.7 billion in total UPB of seasoned Agency residential mortgage loans, respectively. The residential mortgage loans underlying the MSRs acquired by NRM will be subserviced by NewRez, Nationstar and LoanCare pursuant to existing subservicing agreements with NRM. As a result of the length of term of prepayment protection provided to NRM, although the MSRs were legally sold, solely for accounting purposes, New Residential determined that the transferor retained more than minor protection provisions, and that the purchase agreement would not be treated as a sale under GAAP.\\nQuicken MSR Financing Receivable Transaction\\nOn August 6, 2019, NRM entered into an agreement with Quicken to purchase the MSRs, and related servicer advance receivables, with respect to $ 29.1 billion in total UPB of seasoned Agency residential mortgage loans. The residential mortgage loans underlying the MSRs acquired by NRM are subserviced by LoanCare pursuant to an existing subservicing agreement with NRM. As a result of the length of term of prepayment protection provided to NRM, although the MSRs were legally sold, solely for accounting purposes, New Residential determined that the transferor retained more than minor protection provisions, and that the purchase agreement would not be treated as a sale under GAAP.\\nThe table below summarizes the geographic distribution of the underlying residential mortgage loans of the investments in MSRs and MSR Financing Receivables:\\n| Percentage of Total Outstanding Unpaid Principal Amount |\\n| State Concentration | September 30, 2019 | December 31, 2018 |\\n| California | 23.0 | % | 21.7 | % |\\n| Florida | 6.8 | % | 6.9 | % |\\n| New York | 6.8 | % | 7.8 | % |\\n| Texas | 5.2 | % | 5.3 | % |\\n| New Jersey | 5.0 | % | 5.0 | % |\\n| Illinois | 3.6 | % | 3.7 | % |\\n| Washington | 3.5 | % | 2.3 | % |\\n| Massachusetts | 3.3 | % | 3.5 | % |\\n| Maryland | 3.1 | % | 3.4 | % |\\n| Georgia | 3.0 | % | 3.0 | % |\\n| Other U.S. | 36.7 | % | 37.4 | % |\\n| 100.0 | % | 100.0 | % |\\n\\nGeographic concentrations of investments expose New Residential to the risk of economic downturns within the relevant states. Any such downturn in a state where New Residential holds significant investments could affect the underlying borrower’s ability to make mortgage payments and therefore could have a meaningful, negative impact on the MSRs.\\nMortgage Subservicing\\nNewRez performs servicing of residential mortgage loans for third parties under subservicing agreements. Mortgage subservicing does not meet the criteria to be recognized as a servicing right asset and, therefore, is not recognized on New Residential’s condensed consolidated balance sheets. The UPB of residential mortgage loans subserviced for others as of September 30, 2019 was $ 54.7 billion and subservicing revenue of $ 99.7 million for the nine months ended September 30, 2019 is included within servicing revenue, net in the Condensed Consolidated Statements of Income.\\n26\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nServicer Advances Receivable\\nIn connection with its investments in MSRs and MSR financing receivables, New Residential generally acquires any related outstanding servicer advances (not included in the purchase prices described above), which it records at fair value within servicer advances receivable upon acquisition.\\nIn addition to receiving cash flows from the MSRs, NRM and NewRez, as servicers, have the obligation to fund future servicer advances on the underlying pool of mortgages (Note 14). These servicer advances are recorded when advanced and are included in servicer advances receivable.\\nThe following types of advances are included in the Servicer Advances Receivable:\\n| September 30, 2019 | December 31, 2018 |\\n| Principal and interest advances | $ | 723,155 | $ | 793,790 |\\n| Escrow advances (taxes and insurance advances) | 1,945,271 | 2,186,831 |\\n| Foreclosure advances | 173,032 | 199,203 |\\n| Total(A) (B) (C) | $ | 2,841,458 | $ | 3,179,824 |\\n\\n| (A) | Includes $ 243.0 million and $ 231.2 million of servicer advances receivable related to Agency MSRs, respectively, recoverable from the Agencies. |\\n\\n| (B) | Includes $ 62.7 million and $ 41.6 million of servicer advances receivable related to Ginnie Mae MSRs, respectively, recoverable from Ginnie Mae. Reserves for advances associated with Ginnie Mae loans in the MSR portfolio are considered in the MSR fair valuation through a nonreimbursable advance loss assumption. |\\n\\n| (C) | Net of $ 70.3 million and $ 98.0 million, respectively, in accrual for advance recoveries. |\\n\\nNew Residential’s Servicer Advances Receivable related to Non-Agency MSRs generally have the highest reimbursement priority (i.e., “top of the waterfall”) and New Residential is generally entitled to repayment from respective loan or REO liquidation proceeds before any interest or principal is paid on the bonds that were issued by the trust. In the majority of cases, advances in excess of respective loan or REO liquidation proceeds may be recovered from pool-level proceeds. Furthermore, to the extent that advances are not recoverable by New Residential as a result of the subservicer’s failure to comply with applicable requirements in the relevant servicing agreements, New Residential has a contractual right to be reimbursed by the subservicer. New Residential assesses the recoverability of Servicer Advance Receivables periodically and as of September 30, 2019 and December 31, 2018, expected full recovery of the Servicer Advance Receivables.\\nSee Note 11 regarding the financing of MSRs.\\n| 6. | SERVICER ADVANCE INVESTMENTS |\\n\\nAll of New Residential’s Servicer Advance Investments are comprised of outstanding servicer advances, the requirement to purchase all future servicer advances made with respect to a specified pool of residential mortgage loans, and the basic fee component of the related MSR. New Residential elected to record its Servicer Advance Investments, including the right to the basic fee component of the related MSRs, at fair value pursuant to the fair value option for financial instruments to provide users of the financial statements with better information regarding the effects of market factors.\\nA taxable wholly-owned subsidiary of New Residential is the managing member of the Buyer and owned an approximately 73.2 % interest in the Buyer as of September 30, 2019. As of September 30, 2019, third-party co-investors, owning the remaining interest in the Buyer, have funded capital commitments to the Buyer of $ 389.6 million and New Residential has funded capital commitments to the Buyer of $ 312.7 million. The Buyer may call capital up to the commitment amount on unfunded commitments and recall capital to the extent the Buyer makes a distribution to the co-investors, including New Residential. As of September 30, 2019, the noncontrolling third-party co-investors and New Residential had previously funded their commitments, however the Buyer may recall $ 325.0 million and $ 297.6 million of capital distributed to the third-party co-investors and New Residential, respectively. Neither the third-party co-investors nor New Residential is obligated to fund amounts in excess of their respective capital commitments, regardless of the capital requirements of the Buyer.\\n27\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nSee Note 5 regarding the New Ocwen Agreements. Subsequent to the New Ocwen Agreements, the Servicer Advance Investments serviced by Ocwen are accounted for as Servicer Advances Receivable, as described in Note 5.\\nThe following is a summary of New Residential’s Servicer Advance Investments, including the right to the basic fee component of the related MSRs:\\n| Amortized Cost Basis | Carrying Value(A) | Weighted Average Discount Rate | Weighted Average Yield | Weighted Average Life (Years)(B) |\\n| September 30, 2019 |\\n| Servicer Advance Investments | $ | 570,570 | $ | 600,547 | 5.1 | % | 5.7 | % | 6.3 |\\n| As of December 31, 2018 |\\n| Servicer Advance Investments | $ | 721,801 | $ | 735,846 | 5.9 | % | 5.8 | % | 5.7 |\\n\\n\\n| (A) | Carrying value represents the fair value of the Servicer Advance Investments, including the basic fee component of the related MSRs. |\\n\\n| (B) | Weighted Average Life represents the weighted average expected timing of the receipt of expected net cash flows for this investment. |\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Change in Fair Value of Servicer Advance Investments | $ | 6,641 | $ | ( 5,353 | ) | $ | 15,932 | $ | ( 86,581 | ) |\\n\\nThe following is additional information regarding the Servicer Advance Investments and related financing:\\n| Loan-to-Value (“LTV”)(A) | Cost of Funds(C) |\\n| UPB of Underlying Residential Mortgage Loans | Outstanding Servicer Advances | Servicer Advances to UPB of Underlying Residential Mortgage Loans | Face Amount of Notes and Bonds Payable | Gross | Net(B) | Gross | Net |\\n| September 30, 2019 |\\n| Servicer Advance Investments(D) | $ | 33,406,320 | $ | 492,480 | 1.5 | % | $ | 449,731 | 87.3 | % | 86.1 | % | 3.8 | % | 3.1 | % |\\n| December 31, 2018 |\\n| Servicer Advance Investments(D) | $ | 40,096,998 | $ | 620,050 | 1.5 | % | $ | 574,117 | 88.3 | % | 87.2 | % | 3.7 | % | 3.1 | % |\\n\\n\\n| (A) | Based on outstanding servicer advances, excluding purchased but unsettled servicer advances. |\\n\\n| (B) | Ratio of face amount of borrowings to par amount of servicer advance collateral, net of any general reserve. |\\n\\n| (C) | Annualized measure of the cost associated with borrowings. Gross Cost of Funds primarily includes interest expense and facility fees. Net Cost of Funds excludes facility fees. |\\n\\n| (D) | The following types of advances are included in the Servicer Advance Investments: |\\n\\n| September 30, 2019 | December 31, 2018 |\\n| Principal and interest advances | $ | 82,999 | $ | 108,317 |\\n| Escrow advances (taxes and insurance advances) | 185,774 | 238,349 |\\n| Foreclosure advances | 223,707 | 273,384 |\\n| Total | $ | 492,480 | $ | 620,050 |\\n\\n28\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nInterest income recognized by New Residential related to its Servicer Advance Investments was comprised of the following:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Interest income, gross of amounts attributable to servicer compensation | $ | 14,212 | $ | 21,183 | $ | 43,220 | $ | 63,731 |\\n| Amounts attributable to base servicer compensation | ( 1,606 | ) | ( 2,347 | ) | ( 4,578 | ) | ( 6,354 | ) |\\n| Amounts attributable to incentive servicer compensation | ( 7,273 | ) | ( 7,095 | ) | ( 20,780 | ) | ( 14,255 | ) |\\n| Interest income from Servicer Advance Investments | $ | 5,333 | $ | 11,741 | $ | 17,862 | $ | 43,122 |\\n\\nNew Residential has determined that the Buyer is a VIE. The following table presents information on the assets and liabilities related to this consolidated VIE.\\n| As of |\\n| September 30, 2019 | December 31, 2018 |\\n| Assets |\\n| Servicer advance investments, at fair value | $ | 580,829 | $ | 713,239 |\\n| Cash and cash equivalents | 36,457 | 29,833 |\\n| All other assets | 8,662 | 10,223 |\\n| Total assets(A) | $ | 625,948 | $ | 753,295 |\\n| Liabilities |\\n| Notes and bonds payable | $ | 435,935 | $ | 556,340 |\\n| All other liabilities | 2,021 | 2,442 |\\n| Total liabilities(A) | $ | 437,956 | $ | 558,782 |\\n\\n| (A) | The creditors of the Buyer do not have recourse to the general credit of New Residential and the assets of the Buyer are not directly available to satisfy New Residential’s obligations. |\\n\\nOthers’ interests in the equity of the Buyer is computed as follows:\\n| September 30, 2019 | December 31, 2018 |\\n| Total Advance Purchaser LLC equity | $ | 187,992 | $ | 194,513 |\\n| Others’ ownership interest | 26.8 | % | 26.8 | % |\\n| Others’ interest in equity of consolidated subsidiary | $ | 50,319 | $ | 52,066 |\\n\\nOthers’ interests in the Buyer’s net income is computed as follows:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Net Advance Purchaser LLC income | $ | 6,288 | $ | ( 299 | ) | $ | 16,678 | $ | 8,667 |\\n| Others’ ownership interest as a percent of total | 26.8 | % | 27.1 | % | 26.8 | % | 27.2 | % |\\n| Others’ interest in net income of consolidated subsidiaries | $ | 1,684 | $ | ( 81 | ) | $ | 4,466 | $ | 2,358 |\\n\\nSee Note 11 regarding the financing of Servicer Advance Investments.\\n29\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\n| 7. | INVESTMENTS IN REAL ESTATE AND OTHER SECURITIES |\\n\\n“Agency” residential mortgage backed securities (“RMBS”) are RMBS issued by a government sponsored enterprise, such as the Federal National Mortgage Association (“Fannie Mae”) or the Federal Home Loan Mortgage Corporation (“Freddie Mac”). “Non-Agency” RMBS are issued by either public trusts or private label securitization entities.\\nActivities related to New Residential’s investments in real estate and other securities were as follows:\\n| Three Months Ended September 30, 2019 | Nine Months Ended September 30, 2019 |\\n| (in millions) | (in millions) |\\n| Agency | Non-Agency | Agency | Non-Agency |\\n| Purchases |\\n| Face | $ | 12,306.4 | $ | 3,324.9 | $ | 25,123.5 | $ | 7,899.1 |\\n| Purchase Price | 12,610.9 | 247.0 | 25,700.0 | 1,164.9 |\\n| Sales |\\n| Face | $ | 6,073.4 | $ | 1,325.2 | $ | 17,898.5 | $ | 2,162.7 |\\n| Amortized Cost | 6,233.5 | 832.4 | 18,339.1 | 1,571.0 |\\n| Sale Price | 6,252.8 | 910.9 | 18,451.4 | 1,662.9 |\\n| Gain (Loss) on Sale | 19.3 | 78.5 | 112.3 | 91.9 |\\n\\nAs of September 30, 2019, New Residential had sold and purchased $ 4.3 billion and $ 2.5 billion face amount of Agency RMBS for $ 4.4 billion and $ 2.5 billion, respectively, which had not yet been settled. These unsettled sales and purchases were recorded on the balance sheet on trade date as Trades Receivable and Trades Payable.\\nNew Residential has exercised its call rights with respect to Non-Agency RMBS trusts and purchased performing and non-performing residential mortgage loans and REO contained in such trusts prior to their termination. In certain cases, New Residential sold portions of the purchased loans through securitizations, and retained bonds issued by such securitizations. In addition, New Residential received par on the securities issued by the called trusts which it owned prior to such trusts’ termination. Refer to Note 8 for further details on these transactions.\\nThe following is a summary of New Residential’s real estate and other securities, all of which are classified as available-for-sale and are, therefore, reported at fair value with changes in fair value recorded in other comprehensive income, except for securities that are other-than-temporarily impaired and except for securities which New Residential elected to carry at fair value and record changes to valuation through the income statement.\\n| September 30, 2019 | December 31, 2018 |\\n| Gross Unrealized | Weighted Average |\\n| Asset Type | Outstanding Face Amount | Amortized Cost Basis | Gains | Losses | Carrying Value(A) | Number of Securities | Rating(B) | Coupon(C) | Yield | Life (Years)(D) | Principal Subordination(E) | Carrying Value |\\n| Agency RMBS(F) (G) | $ | 8,797,199 | $ | 8,950,763 | $ | 56,939 | $ | ( 9,636 | ) | $ | 8,998,066 | 39 | AAA | 3.66 | % | 3.06 | % | 4.6 | N/A | $ | 2,665,618 |\\n| Non-Agency RMBS(H) (I) | 21,845,814 | 7,175,703 | 711,078 | ( 30,937 | ) | 7,855,844 | 950 | B+ | 3.03 | % | 4.84 | % | 6.3 | 10.6 | % | 8,970,963 |\\n| Total/ Weighted Average | $ | 30,643,013 | $ | 16,126,466 | $ | 768,017 | $ | ( 40,573 | ) | $ | 16,853,910 | 989 | BBB+ | 3.35 | % | 3.85 | % | 5.3 | $ | 11,636,581 |\\n\\n\\n| (A) | Fair value, which is equal to carrying value for all securities. See Note 12 regarding the estimation of fair value. |\\n\\n| (B) | Represents the weighted average of the ratings of all securities in each asset type, expressed as an S&P equivalent rating. This excludes the ratings of the collateral underlying 312 bonds with a carrying value of $ 1,064.1 million which either have never been rated or for which rating information is no longer provided. For each security rated by multiple rating agencies, the lowest rating is used. New Residential used an implied AAA rating for the Agency RMBS. Ratings provided were determined by third party rating agencies, and represent the most recent credit ratings available as of the reporting date and may not be current. |\\n\\n30\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\n| (C) | Excludes residual bonds, and certain other Non-Agency bonds, with a carrying value of $ 225.2 million and $ 3.5 million, respectively, for which no coupon payment is expected. |\\n\\n| (D) | The weighted average life is based on the timing of expected principal reduction on the assets. |\\n\\n| (E) | Percentage of the amortized cost basis of securities that is subordinate to New Residential’s investments, excluding fair value option securities. |\\n\\n| (F) | Includes securities issued or guaranteed by U.S. Government agencies such as Fannie Mae or Freddie Mac. |\\n\\n| (G) | The total outstanding face amount was $ 8.8 billion for fixed rate securities and $ 0.0 billion for floating rate securities as of September 30, 2019. |\\n\\n| (H) | The total outstanding face amount was $ 10.2 billion (including $ 7.9 billion of residual and fair value option notional amount) for fixed rate securities and $ 11.7 billion (including $ 4.9 billion of residual and fair value option notional amount) for floating rate securities as of September 30, 2019. |\\n\\n| (I) | Includes other asset backed securities (“ABS”) consisting primarily of (i) interest-only securities and servicing strips (fair value option securities) which New Residential elected to carry at fair value and record changes to valuation through the income statement, (ii) bonds backed by consumer loans, and (iii) corporate debt. |\\n\\n| Gross Unrealized | Weighted Average |\\n| Asset Type | Outstanding Face Amount | Amortized Cost Basis | Gains | Losses | Carrying Value | Number of Securities | Rating | Coupon | Yield | Life (Years) | Principal Subordination |\\n| Corporate debt | $ | 85,000 | $ | 85,000 | $ | — | $ | ( 7,013 | ) | $ | 77,987 | 1 | B- | 8.25 | % | 8.25 | % | 5.5 | N/A |\\n| Consumer loan bonds | 30,945 | 29,990 | 566 | ( 5,073 | ) | 25,483 | 6 | N/A | N/A | 8.09 | % | 1.5 | N/A |\\n| Fair Value Option Securities: |\\n| Interest-only securities | 9,574,284 | 290,481 | 33,963 | ( 13,890 | ) | 310,554 | 111 | AA | 1.44 | % | 7.43 | % | 3.2 | N/A |\\n| Servicing Strips | 2,568,427 | 32,216 | 4,306 | ( 3,178 | ) | 33,344 | 37 | N/A | 0.39 | % | 5.88 | % | 5.3 | N/A |\\n\\nUnrealized losses that are considered other-than-temporary and are attributable to credit losses are recognized currently in earnings. During the nine months ended September 30, 2019, New Residential recorded OTTI charges of $ 21.9 million with respect to real estate securities. Any remaining unrealized losses on New Residential’s securities were primarily the result of changes in market factors, rather than issue-specific credit impairment. New Residential performed analyses in relation to such securities, using its best estimate of their cash flows, which support its belief that the carrying values of such securities were fully recoverable over their expected holding period. New Residential has no intent to sell, and is not more likely than not to be required to sell, these securities.\\nThe following table summarizes New Residential’s securities in an unrealized loss position as of September 30, 2019.\\n| Amortized Cost Basis | Weighted Average |\\n| Securities in an Unrealized Loss Position | Outstanding Face Amount | Before Impairment | Other-Than-Temporary Impairment(A) | After Impairment | Gross Unrealized Losses | Carrying Value | Number of Securities | Rating(B) | Coupon | Yield | Life(Years) |\\n| Less than 12 Months | $ | 7,069,880 | $ | 2,162,118 | $ | ( 3,768 | ) | $ | 2,158,350 | $ | ( 20,406 | ) | $ | 2,137,944 | 77 | BBB | 4.27 | % | 4.24 | % | 6.4 |\\n| 12 or More Months | 1,297,245 | 190,556 | ( 1,799 | ) | 188,757 | ( 20,167 | ) | 168,590 | 63 | BB | 4.58 | % | 5.74 | % | 5.1 |\\n| Total/Weighted Average | $ | 8,367,125 | $ | 2,352,674 | $ | ( 5,567 | ) | $ | 2,347,107 | $ | ( 40,573 | ) | $ | 2,306,534 | 140 | BB+ | 4.29 | % | 4.36 | % | 6.3 |\\n\\n\\n| (A) | This amount represents OTTI recorded on securities that are in an unrealized loss position as of September 30, 2019. |\\n\\n| (B) | The weighted average rating of securities in an unrealized loss position for less than 12 months excludes the rating of 43 bonds which either have never been rated or for which rating information is no longer provided. The weighted average rating of securities in an unrealized loss position for 12 or more months excludes the rating of 24 bonds which either have never been rated or for which rating information is no longer provided. |\\n\\n31\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nNew Residential performed an assessment of all of its debt securities that are in an unrealized loss position (an unrealized loss position exists when a security’s amortized cost basis, excluding the effect of OTTI, exceeds its fair value) and determined the following:\\n| September 30, 2019 |\\n| Gross Unrealized Losses |\\n| Fair Value | Amortized Cost Basis After Impairment | Credit(A) | Non-Credit(B) |\\n| Securities New Residential intends to sell(C) | $ | — | $ | — | $ | — | $ | — |\\n| Securities New Residential is more likely than not to be required to sell(D) | — | — | — | N/A |\\n| Securities New Residential has no intent to sell and is not more likely than not to be required to sell: |\\n| Credit impaired securities | 159,172 | 165,780 | ( 5,567 | ) | ( 6,608 | ) |\\n| Non-credit impaired securities | 2,147,362 | 2,181,327 | — | ( 33,965 | ) |\\n| Total debt securities in an unrealized loss position | $ | 2,306,534 | $ | 2,347,107 | $ | ( 5,567 | ) | $ | ( 40,573 | ) |\\n\\n\\n| (A) | This amount is required to be recorded as OTTI through earnings. In measuring the portion of credit losses, New Residential estimates the expected cash flow for each of the securities. This evaluation includes a review of the credit status and the performance of the collateral supporting those securities, including the credit of the issuer, key terms of the securities and the effect of local, industry and broader economic trends. Significant inputs in estimating the cash flows include New Residential’s expectations of prepayment rates, default rates and loss severities. Credit losses are measured as the decline in the present value of the expected future cash flows discounted at the investment’s effective interest rate. |\\n\\n| (B) | This amount represents unrealized losses on securities that are due to non-credit factors and recorded through other comprehensive income. |\\n\\n| (C) | A portion of securities New Residential intends to sell have a fair value equal to their amortized cost basis after impairment, and, therefore do no t have unrealized losses reflected in other comprehensive income as of September 30, 2019. |\\n\\n| (D) | New Residential may, at times, be more likely than not to be required to sell certain securities for liquidity purposes. While the amount of the securities to be sold may be an estimate, and the securities to be sold have not yet been identified, New Residential must make its best estimate, which is subject to significant judgment regarding future events, and may differ materially from actual future sales. |\\n\\nThe following table summarizes the activity related to credit losses on debt securities:\\n| Nine Months Ended September 30, 2019 |\\n| Beginning balance of credit losses on debt securities for which a portion of an OTTI was recognized in other comprehensive income | $ | 52,803 |\\n| Increases to credit losses on securities for which an OTTI was previously recognized and a portion of an OTTI was recognized in other comprehensive income | 20,034 |\\n| Additions for credit losses on securities for which an OTTI was not previously recognized | 1,908 |\\n| Reductions for securities for which the amount previously recognized in other comprehensive income was recognized in earnings because the entity intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis | — |\\n| Reduction for credit losses on securities for which no OTTI was recognized in other comprehensive income at the current measurement date | — |\\n| Reduction for securities sold/paid off during the period | ( 18,431 | ) |\\n| Ending balance of credit losses on debt securities for which a portion of an OTTI was recognized in other comprehensive income | $ | 56,314 |\\n\\n32\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nThe table below summarizes the geographic distribution of the collateral securing New Residential’s Non-Agency RMBS:\\n| September 30, 2019 | December 31, 2018 |\\n| Geographic Location(A) | Outstanding Face Amount | Percentage of Total Outstanding | Outstanding Face Amount | Percentage of Total Outstanding |\\n| Western U.S. | $ | 8,348,465 | 38.4 | % | $ | 7,318,616 | 37.7 | % |\\n| Southeastern U.S. | 5,232,919 | 24.1 | % | 4,613,314 | 23.8 | % |\\n| Northeastern U.S. | 4,615,081 | 21.2 | % | 3,829,725 | 19.7 | % |\\n| Midwestern U.S. | 2,134,577 | 9.8 | % | 2,063,263 | 10.6 | % |\\n| Southwestern U.S. | 1,378,512 | 6.4 | % | 1,321,853 | 6.8 | % |\\n| Other(B) | 20,315 | 0.1 | % | 250,833 | 1.4 | % |\\n| $ | 21,729,869 | 100.0 | % | $ | 19,397,604 | 100.0 | % |\\n\\n\\n| (A) | Excludes $ 30.9 million and $ 56.8 million face amount of bonds backed by consumer loans and $ 85.0 million and $ 85.0 million face amount of bonds backed by corporate debt as of September 30, 2019 and December 31, 2018, respectively. |\\n\\n| (B) | Represents collateral for which New Residential was unable to obtain geographic information. |\\n\\nNew Residential evaluates the credit quality of its real estate securities, as of the acquisition date, for evidence of credit quality deterioration. As a result, New Residential identified a population of real estate securities for which it was determined that it was probable that New Residential would be unable to collect all contractually required payments. For securities acquired during the nine months ended September 30, 2019, excluding residual and fair value option securities, the face amount of these real estate securities was $ 496.2 million, with total expected cash flows of $ 481.0 million and a fair value of $ 290.5 million on the dates that New Residential purchased the respective securities.\\nThe following is the outstanding face amount and carrying value for securities, for which, as of the acquisition date, it was probable that New Residential would be unable to collect all contractually required payments, excluding residual and fair value option securities:\\n| Outstanding Face Amount | Carrying Value |\\n| September 30, 2019 | $ | 5,317,777 | $ | 3,641,142 |\\n| December 31, 2018 | 6,385,306 | 4,217,242 |\\n\\nThe following is a summary of the changes in accretable yield for these securities:\\n| Nine Months Ended September 30, 2019 |\\n| Balance at December 31, 2018 | $ | 2,245,983 |\\n| Additions | 190,482 |\\n| Accretion | ( 191,559 | ) |\\n| Reclassifications from (to) non-accretable difference | ( 430,080 | ) |\\n| Disposals | ( 266,552 | ) |\\n| Balance at September 30, 2019 | $ | 1,548,274 |\\n\\nSee Note 11 regarding the financing of real estate securities.\\n| 8. | INVESTMENTS IN RESIDENTIAL MORTGAGE LOANS |\\n\\nNew Residential accumulated its residential mortgage loan portfolio through various bulk acquisitions and the execution of call rights. As a result of the Shellpoint Acquisition, New Residential, through its wholly owned subsidiary, NewRez, originates\\n33\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nresidential mortgage loans for sale and securitization to third parties and generally retains the servicing rights on the underlying loans.\\nLoans are accounted for based on New Residential’s strategy for the loan, and on whether the loan was credit-impaired at the date of acquisition. New Residential accounts for loans based on the following categories:\\n| • | Loans Held-for-Investment (which may include PCD Loans) |\\n\\n| • | Loans Held-for-Investment, at fair value |\\n\\n| • | Loans Held-for-Sale, at lower of cost or fair value |\\n\\n| • | Loans Held-for-Sale, at fair value |\\n\\n| • | Real Estate Owned (“REO”) |\\n\\nThe following table presents certain information regarding New Residential’s residential mortgage loans outstanding by loan type, excluding REO:\\n| September 30, 2019 | December 31, 2018 |\\n| Outstanding Face Amount | Carrying Value | LoanCount | Weighted Average Yield | Weighted Average Life (Years)(A) | Floating Rate Loans as a % of Face Amount | Loan to Value Ratio (“LTV”)(B) | Weighted Avg. Delinquency(C) | Weighted Average FICO(D) | Carrying Value |\\n| Loan Type |\\n| Performing Loans(G) (J) | $ | 557,762 | $ | 524,387 | 7,695 | 7.8 | % | 4.6 | 20.2 | % | 72.3 | % | 10.2 | % | 647 | $ | 591,264 |\\n| Purchased Credit Deteriorated Loans(H) | 124,238 | 89,270 | 1,106 | 7.9 | % | 3.2 | 19.3 | % | 88.1 | % | 60.7 | % | 590 | 144,065 |\\n| Total Residential Mortgage Loans, held-for-investment | $ | 682,000 | $ | 613,657 | 8,801 | 7.8 | % | 4.4 | 20.1 | % | 75.2 | % | 19.4 | % | 636 | $ | 735,329 |\\n| Reverse Mortgage Loans(E) (F) | $ | 13,032 | $ | 6,450 | 32 | 7.8 | % | 5.3 | 10.1 | % | 151.6 | % | 65.1 | % | N/A | $ | 6,557 |\\n| Performing Loans(G) (I) | 709,867 | 726,935 | 10,798 | 4.3 | % | 4.0 | 62.4 | % | 54.3 | % | 5.9 | % | 688 | 413,883 |\\n| Non-Performing Loans(H) (I) | 726,570 | 616,612 | 5,562 | 5.1 | % | 3.3 | 12.0 | % | 80.7 | % | 68.7 | % | 594 | 512,040 |\\n| Total Residential Mortgage Loans, held-for-sale | $ | 1,449,469 | $ | 1,349,997 | 16,392 | 4.8 | % | 3.6 | 36.7 | % | 68.4 | % | 37.9 | % | 641 | $ | 932,480 |\\n| Acquired Loans | $ | 4,024,252 | $ | 3,916,826 | 26,236 | 4.2 | % | 7.4 | 2.0 | % | 71.1 | % | 15.3 | % | 622 | $ | 2,153,269 |\\n| Originated Loans | 1,248,711 | 1,289,425 | 4,465 | 4.0 | % | 28.6 | 4.0 | % | 77.6 | % | 29.2 | % | 672 | 655,260 |\\n| Total Residential Mortgage Loans, held-for-sale, at fair value(K) | $ | 5,272,963 | $ | 5,206,251 | 30,701 | 4.1 | % | 12.5 | 2.5 | % | 72.7 | % | 18.6 | % | 634 | $ | 2,808,529 |\\n\\n| (A) | The weighted average life is based on the expected timing of the receipt of cash flows. |\\n\\n| (B) | LTV refers to the ratio comparing the loan’s unpaid principal balance to the value of the collateral property. |\\n\\n| (C) | Represents the percentage of the total principal balance that is 60+ days delinquent. |\\n\\n| (D) | The weighted average FICO score is based on the weighted average of information updated and provided by the loan servicer on a monthly basis. |\\n\\n| (E) | Represents a 70 % participation interest that New Residential holds in a portfolio of reverse mortgage loans. Nationstar holds the other 30 % interest and services the loans. The average loan balance outstanding based on total UPB was $ 0.6 million. Approximately 51 % of these loans have reached a termination event. As a result of the termination event, each such loan has matured and the borrower can no longer make draws on these loans. |\\n\\n| (F) | FICO scores are not used in determining how much a borrower can access via a reverse mortgage loan. |\\n\\n| (G) | Performing loans are generally placed on nonaccrual status when principal or interest is 120 days or more past due. |\\n\\n| (H) | Includes loans with evidence of credit deterioration since origination where it is probable that New Residential will not collect all contractually required principal and interest payments. As of September 30, 2019, New Residential has placed Non-Performing Loans, held-for-sale on nonaccrual status, except as described in (I) below. |\\n\\n| (I) | Includes $ 37.8 million and $ 27.7 million UPB of Ginnie Mae EBO performing and non-performing loans, respectively, on accrual status as contractual cash flows are guaranteed by the FHA. |\\n\\n| (J) | Includes $ 112.1 million UPB of non-agency mortgage loans underlying the SAFT 2013-1 securitization, which are carried at fair value based on New Residential’s election of the fair value option. Interest earned on loans measured at fair value are reported in other income. |\\n\\n| (K) | New Residential elected the fair value option to measure these loans at fair value on a recurring basis. Interest earned on loans measured at fair value are reported in other income. |\\n\\n34\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nNew Residential generally considers the delinquency status, loan-to-value ratios, and geographic area of residential mortgage loans as its credit quality indicators. Delinquency status is a primary credit quality indicator as loans that are more than 60 days past due provide an early warning of borrowers who may be experiencing financial difficulties. Current LTV ratio is an indicator of the potential loss severity in the event of default. Finally, the geographic distribution of the loan collateral also provides insight as to the credit quality of the portfolio, as factors such as the regional economy, home price changes and specific events will affect credit quality.\\nThe table below summarizes the geographic distribution of the underlying residential mortgage loans:\\n| Percentage of Total Outstanding Unpaid Principal Amount |\\n| State Concentration | September 30, 2019 | December 31, 2018 |\\n| California | 17.7 | % | 16.7 | % |\\n| Florida | 9.0 | % | 8.8 | % |\\n| New York | 9.9 | % | 11.7 | % |\\n| New Jersey | 4.8 | % | 4.7 | % |\\n| Texas | 4.6 | % | 5.3 | % |\\n| Georgia | 4.3 | % | 2.7 | % |\\n| Illinois | 3.9 | % | 4.0 | % |\\n| Maryland | 3.7 | % | 3.1 | % |\\n| Massachusetts | 3.3 | % | 3.1 | % |\\n| Pennsylvania | 3.3 | % | 3.6 | % |\\n| Other U.S. | 35.5 | % | 36.3 | % |\\n| 100.0 | % | 100.0 | % |\\n\\nSee Note 11 regarding the financing of residential mortgage loans and related assets.\\nCall Rights\\nNew Residential has executed calls with respect to Non-Agency RMBS trusts and purchased performing and non-performing residential mortgage loans and REO assets contained in such trusts prior to their termination. In certain cases, New Residential sold portions of the purchased loans through securitizations, and retained bonds issued by such securitizations. In addition, New Residential received par on the securities issued by the called trusts which it owned prior to such trusts’ termination. For the nine months ended September 30, 2019, New Residential executed calls on a total of 97 trusts and recognized $ 45.3 million of interest income on securities held in the collapsed trusts and $ 54.2 million of gain on securitizations accounted for as sales.\\nPerforming Loans\\nThe following table provides past due information regarding New Residential’s Performing Loans, which is an important indicator of credit quality and the establishment of the allowance for loan losses:\\n| September 30, 2019 |\\n| Days Past Due | Delinquency Status(A) |\\n| Current | 84.1 | % |\\n| 30-59 | 8.2 | % |\\n| 60-89 | 2.7 | % |\\n| 90-119(B) | 0.7 | % |\\n| 120+(C) | 4.3 | % |\\n| 100.0 | % |\\n\\n| (A) | Represents the percentage of the total principal balance that corresponds to loans that are in each delinquency status. |\\n\\n35\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\n| (B) | Includes loans 90-119 days past due and still accruing interest because they are generally placed on nonaccrual status at 120 days or more past due. |\\n\\n| (C) | Represents nonaccrual loans. |\\n\\nActivities related to the carrying value of residential mortgage loans held-for-investment were as follows:\\n| Performing Loans |\\n| Balance at December 31, 2018 | $ | 591,253 |\\n| Purchases/additional fundings | — |\\n| Proceeds from repayments | ( 73,397 | ) |\\n| Accretion of loan discount (premium) and other amortization(A) | 9,998 |\\n| Provision for loan losses | ( 800 | ) |\\n| Transfer of loans to other assets(B) | — |\\n| Transfer of loans to real estate owned | ( 4,739 | ) |\\n| Transfers of loans to held for sale | ( 168 | ) |\\n| Fair value adjustment | 2,240 |\\n| Balance at September 30, 2019 | $ | 524,387 |\\n\\n| (A) | Includes accelerated accretion of discount on loans paid in full and on loans transferred to other assets. |\\n\\n| (B) | Represents loans for which foreclosure has been completed and for which New Residential has made, or intends to make, a claim with the governmental agency that has guaranteed the loans that are now recognized as claims receivable in Other Assets (Note 2). |\\n\\nActivities related to the valuation and loss provision on reverse mortgage loans and allowance for loan losses on performing loans held-for-investment were as follows:\\n| Performing Loans |\\n| Balance at December 31, 2018 | $ | — |\\n| Provision for loan losses(A) | 800 |\\n| Charge-offs(B) | ( 800 | ) |\\n| Balance at September 30, 2019 | $ | — |\\n\\n| (A) | Based on an analysis of collective borrower performance, credit ratings of borrowers, loan-to-value ratios, estimated value of the underlying collateral, key terms of the loans and historical and anticipated trends in defaults and loss severities at a pool level. |\\n\\n| (B) | Loans, other than PCD loans, are generally charged off or charged down to the net realizable value of the collateral (i.e., fair value less costs to sell), with an offset to the allowance for loan losses, when available information confirms that loans are uncollectible. |\\n\\nPurchased Credit Deteriorated Loans\\nNew Residential determined at acquisition that the PCD loans acquired would be aggregated into pools based on common risk characteristics (FICO score, delinquency status, collateral type, loan-to-value ratio). Loans aggregated into pools are accounted for as if each pool were a single loan with a single composite interest rate and an aggregate expectation of cash flows, including consideration of involuntary prepayments.\\n36\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nActivities related to the carrying value of PCD loans held-for-investment were as follows:\\n| Balance at December 31, 2018 | $ | 144,065 |\\n| Purchases/additional fundings | — |\\n| Sales | — |\\n| Proceeds from repayments | ( 13,935 | ) |\\n| Accretion of loan discount and other amortization | 12,961 |\\n| (Allowance) reversal for loan losses(A) | ( 2,332 | ) |\\n| Transfer of loans to real estate owned | ( 12,815 | ) |\\n| Transfer of loans to held-for-sale | ( 38,674 | ) |\\n| Balance at September 30, 2019 | $ | 89,270 |\\n\\n| (A) | An allowance represents the present value of cash flows expected at acquisition that are no longer expected to be collected. A reversal results from an increase to expected cash flows that reverses a prior allowance. |\\n\\nThe following is a summary of the changes in accretable yield for these loans:\\n| Balance at December 31, 2018 | $ | 68,632 |\\n| Additions | — |\\n| Accretion | ( 12,961 | ) |\\n| Reclassifications from (to) non-accretable difference(A) | 8,188 |\\n| Disposals(B) | ( 10,965 | ) |\\n| Transfer of loans to held-for-sale(C) | ( 8,406 | ) |\\n| Balance at September 30, 2019 | $ | 44,488 |\\n\\n| (A) | Represents a probable and significant increase (decrease) in cash flows previously expected to be uncollectible. |\\n\\n| (B) | Includes sales of loans or foreclosures, which result in removal of the loan from the PCD loan pool at its carrying amount. |\\n\\n| (C) | Represents loans not initially acquired with the intent to sell for which New Residential determined that it no longer has the intent to hold for the foreseeable future, or until maturity or payoff. |\\n\\nLoans Held-for-Sale, at Lower of Cost or Fair Value\\nActivities related to the carrying value of loans held-for-sale, at lower of cost or fair value were as follows:\\n| Balance at December 31, 2018 | $ | 932,480 |\\n| Purchases(A) | 842,752 |\\n| Transfer of loans from held-for-investment(B) | 38,842 |\\n| Sales | ( 307,004 | ) |\\n| Transfer of loans to other assets(C) | ( 8,564 | ) |\\n| Transfer of loans to real estate owned | ( 35,326 | ) |\\n| Proceeds from repayments | ( 133,279 | ) |\\n| Valuation (provision) reversal on loans(D) | 20,096 |\\n| Balance at September 30, 2019 | $ | 1,349,997 |\\n\\n| (A) | Represents loans acquired with the intent to sell. |\\n\\n| (B) | Represents loans not initially acquired with the intent to sell for which New Residential determined that it no longer has the intent to hold for the foreseeable future, or until maturity or payoff. |\\n\\n| (C) | Represents loans for which foreclosure has been completed and for which New Residential has made, or intends to make, a claim with the governmental agency that has guaranteed the loans that are now recognized as claims receivable in Other Assets (Note 2). |\\n\\n37\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\n| (D) | Represents the fair value adjustments to loans upon transfer to held-for-sale and provision recorded on certain purchased held-for-sale loans, including an aggregate of $ 4.8 million of provision related to the call transactions executed during the nine months ended September 30, 2019 . |\\n\\nLoans Held-for-Sale, at Fair Value\\nActivities related to the carrying value of originated loans held-for-sale, at fair value were as follows:\\n| Balance at December 31, 2018 | $ | 655,260 |\\n| Originations | 10,427,690 |\\n| Sales | ( 9,784,536 | ) |\\n| Proceeds from repayments | ( 24,035 | ) |\\n| Transfer of loans to other assets | ( 412 | ) |\\n| Change in fair value | 15,458 |\\n| Balance at September 30, 2019 | $ | 1,289,425 |\\n\\nActivities related to the carrying value of acquired loans held-for-sale, at fair value were as follows:\\n| Balance at December 31, 2018 | $ | 2,153,269 |\\n| Purchases(A) | 5,170,388 |\\n| Sales | ( 3,338,140 | ) |\\n| Proceeds from repayments | ( 141,109 | ) |\\n| Transfer of loans to real estate owned | ( 435 | ) |\\n| Accretion of loan discount and other amortization | — |\\n| Change in fair value | 72,853 |\\n| Balance at September 30, 2019 | $ | 3,916,826 |\\n\\n| (A) | Includes an acquisition date fair value adjustment increase of $ 10.2 million on loans acquired through call transactions executed during the nine months ended September 30, 2019. |\\n\\n38\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nNet Interest Income\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Interest Income: |\\n| Acquired Residential Mortgage Loans, held-for-investment | $ | 14,532 | $ | 19,466 | $ | 47,167 | $ | 58,689 |\\n| Acquired Residential Mortgage Loans, held-for-sale | 15,966 | 7,433 | 43,423 | 30,001 |\\n| Acquired Residential Mortgage Loans, held-for-sale, at fair value | 43,288 | 15,453 | 96,393 | 28,344 |\\n| Originated Residential Mortgage Loans, held-for-sale, at fair value | 13,185 | 6,430 | 32,926 | 6,430 |\\n| Total Interest Income on Residential Mortgage Loans | 86,971 | 48,782 | 219,909 | 123,464 |\\n| Interest Expense: |\\n| Acquired Residential Mortgage Loans, held-for-investment | 3,953 | 6,537 | 15,717 | 17,447 |\\n| Acquired Residential Mortgage Loans, held-for-sale | 9,357 | 8,306 | 26,873 | 26,264 |\\n| Acquired Residential Mortgage Loans, held-for-sale, at fair value | 30,053 | 7,531 | 77,247 | 13,588 |\\n| Originated Residential Mortgage Loans, held-for-sale,at fair value | 2,344 | 1,288 | 6,451 | 1,288 |\\n| Total Interest Expense on Residential Mortgage Loans | 45,707 | 23,662 | 126,288 | 58,587 |\\n| Total Net Interest Income on Residential Mortgage Loans | $ | 41,264 | $ | 25,120 | $ | 93,621 | $ | 64,877 |\\n\\nGain on Sale of Originated Mortgage Loans, Net\\nNewRez, a wholly owned subsidiary of New Residential, originates conventional, government-insured and nonconforming residential mortgage loans for sale and securitization. The GSEs or Ginnie Mae guarantee conventional and government insured mortgage securitizations and mortgage investors issue nonconforming private label mortgage securitizations while NewRez generally retains the right to service the underlying residential mortgage loans. In connection with the transfer of loans to the GSEs or mortgage investors, New Residential reports gain on sale of originated mortgage loans, net in the condensed consolidated statements of income.\\nGain on sale of originated mortgage loans, net is summarized below:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Gain on loans originated and sold(A) | $ | 24,312 | $ | 24,684 | $ | 36,413 | $ | 24,684 |\\n| Gain (loss) on settlement of mortgage loan origination derivative instruments(B) | ( 32,138 | ) | ( 2,757 | ) | ( 61,879 | ) | ( 2,757 | ) |\\n| MSRs retained on transfer of loans(C) | 96,317 | 17,282 | 190,666 | 17,282 |\\n| Other(D) | 12,050 | 6,523 | 28,829 | 6,523 |\\n| Gain on sale of originated mortgage loans, net | $ | 100,541 | $ | 45,732 | $ | 194,029 | $ | 45,732 |\\n\\n| (A) | Includes loan origination fees and direct loan origination costs. Other indirect costs related to loan origination are included within general and administrative expenses. |\\n\\n| (B) | Represents settlement of forward securities delivery commitments utilized as an economic hedge for mortgage loans not included within forward loan sale commitments. |\\n\\n| (C) | Represents the initial fair value of the capitalized mortgage servicing rights upon loan sales with servicing retained. |\\n\\n| (D) | Includes fees for services associated with the loan origination process. |\\n\\n39\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nReal estate owned (REO)\\nNew Residential recognizes REO assets at the completion of the foreclosure process or upon execution of a deed in lieu of foreclosure with the borrower. REO assets are managed for prompt sale and disposition at the best possible economic value.\\n| Real Estate Owned |\\n| Balance at December 31, 2018 | $ | 113,410 |\\n| Purchases | 44,539 |\\n| Transfer of loans to real estate owned | 61,129 |\\n| Sales | ( 112,703 | ) |\\n| Valuation (provision) reversal on REO | ( 407 | ) |\\n| Balance at September 30, 2019 | $ | 105,968 |\\n\\nAs of September 30, 2019, New Residential had residential mortgage loans that were in the process of foreclosure with an unpaid principal balance of $ 393.0 million.\\nIn addition, New Residential has recognized $ 20.4 million in unpaid claims receivable from FHA on Ginnie Mae EBO loans and reverse mortgage loans for which foreclosure has been completed and for which New Residential has made, or intends to make, a claim.\\nVariable Interest Entities\\nDuring the first quarter of 2019, New Residential formed entities (the “RPL Borrowers”) that issued securitized debt collateralized by reperforming residential mortgage loans. New Residential determined that the RPL Borrowers should be evaluated for consolidation under the VIE model rather than the voting interest entity model as the equity holders as a group lack the characteristics of a controlling financial interest. Under the VIE model, New Residential’s consolidated subsidiaries had both 1) the power to direct the most significant activities of the RPL Borrowers and 2) significant variable interests in each of the RPL Borrowers, through their control of the related optional redemption feature and their ownership of certain notes issued by the RPL Borrowers and, therefore, met the primary beneficiary criterion and consolidated the RPL Borrowers. The following table presents information on the combined assets and liabilities related to these consolidated VIEs.\\n| Three Months Ended September 30, |\\n| 2019 |\\n| Assets |\\n| Residential mortgage loans | $ | 430,461 |\\n| Other assets | — |\\n| Total assets(A) | $ | 430,461 |\\n| Liabilities |\\n| Notes and bonds payable | $ | 364,380 |\\n| Accounts payable and accrued expenses | 3,562 |\\n| Total liabilities(A) | $ | 367,942 |\\n\\n| (A) | The creditors of the RPL Borrowers do not have recourse to the general credit of New Residential, and the assets of the RPL Borrowers are not directly available to satisfy New Residential’s obligations. |\\n\\nA wholly owned subsidiary of NewRez, Shelter Mortgage Company LLC (“Shelter”) is a mortgage originator specializing in retail origination. Shelter operates its business through a series of joint ventures and was deemed to be the primary beneficiary of the joint ventures as a result of its ability to direct activities that most significantly impact the economic performance of the entities and its ownership of a significant equity investment.\\n40\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nThe following table presents information on the assets and liabilities of the Shelter JVs.\\n| September 30, 2019 | December 31, 2018 |\\n| Assets |\\n| Cash and cash equivalents | $ | 21,604 | $ | 17,346 |\\n| Property and equipment, net | 128 | 137 |\\n| Intangible assets, net | 58 | 70 |\\n| Prepaid expenses and other assets | 4,903 | 411 |\\n| Total assets | $ | 26,693 | $ | 17,964 |\\n| Liabilities |\\n| Accounts payable and accrued expenses | $ | 3,065 | $ | 1,315 |\\n| Reserve for sales recourse | 1,192 | 967 |\\n| Total liabilities | $ | 4,257 | $ | 2,282 |\\n\\nNoncontrolling Interests\\nNoncontrolling interests in the equity of the Shelter JVs is computed as follows:\\n| September 30, 2019 | December 31, 2018 |\\n| Total consolidated equity of JVs | $ | 22,436 | $ | 15,682 |\\n| Noncontrolling ownership interest | 48.2 | % | 51.0 | % |\\n| Noncontrolling equity interest in consolidated JVs | $ | 10,813 | $ | 7,998 |\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Total consolidated net income of JVs | $ | 5,098 | $ | 2,306 | $ | 9,144 | $ | 2,306 |\\n| Noncontrolling ownership interest in net income | 48.2 | % | 50.6 | % | 48.2 | % | 50.6 | % |\\n| Noncontrolling interest in net income of consolidated JVs | $ | 2,457 | $ | 1,167 | $ | 4,407 | $ | 1,167 |\\n\\nAs described in “Call Rights” above, New Residential has issued securitizations which were treated as sales under GAAP. New Residential has no obligation to repurchase any loans from these securitizations and its exposure to loss is limited to the carrying amount of its retained interests in the securitization entities. These securitizations are conducted through variable interest entities, of which New Residential is not the primary beneficiary.\\n41\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nAdditionally, New Residential and NewRez, a wholly owned subsidiary of New Residential, were deemed to be the primary beneficiaries of the RPL Borrowers and SAFT 2013-1 securitization entity as a result of their ability to direct activities that most significantly impact the economic performance of the entities and their ownership of significant variable interests in the RPL Borrowers and SAFT 2013-1 securitization, respectively. The following table summarizes certain characteristics of the underlying residential mortgage loans, and related financing, in these securitizations as of September 30, 2019:\\n| Residential mortgage loan UPB | $ | 11,183,024 |\\n| Weighted average delinquency(A) | 1.97 | % |\\n| Net credit losses for the nine months ended September 30, 2019 | $ | 5,738 |\\n| Face amount of debt held by third parties(B) | $ | 10,074,690 |\\n| Carrying value of bonds retained by New Residential(C) (D) | $ | 1,258,292 |\\n| Cash flows received by New Residential on these bonds for the nine months ended September 30, 2019 | $ | 161,794 |\\n\\n| (A) | Represents the percentage of the UPB that is 60 + days delinquent. |\\n\\n| (B) | Excludes bonds retained by New Residential. |\\n\\n| (C) | Includes bonds retained pursuant to required risk retention regulations. |\\n\\n| (D) | Classified within Level 3 of the fair value hierarchy as the valuation is based on certain unobservable inputs including discount rate, prepayment rates and loss severity. See Note 12 for details on unobservable inputs. |\\n\\n| 9. | INVESTMENTS IN CONSUMER LOANS |\\n\\nNew Residential, through newly formed limited liability companies (together, the “Consumer Loan Companies”), has a co-investment in a portfolio of consumer loans. The portfolio includes personal unsecured loans and personal homeowner loans. OneMain is the servicer of the loans and provides all servicing and advancing functions for the portfolio. As of September 30, 2019, New Residential owns 53.5 % of the limited liability company interests in, and consolidates, the Consumer Loan Companies.\\nOn June 4, 2019, the Consumer Loan Companies refinanced the outstanding asset-backed notes with an asset-backed securitization for approximately $ 938.7 million. The proceeds in excess of the refinanced debt of $ 13.4 million were distributed to the respective co-investors of which New Residential received approximately $ 7.8 million.\\nNew Residential also purchased certain newly originated consumer loans from a third party (“Consumer Loan Seller”). These loans are not held in the Consumer Loan Companies and have been designated as performing consumer loans, held-for-investment. In addition, see “Equity Method Investees” below.\\nThe following table summarizes the investment in consumer loans, held-for-investment held by New Residential:\\n| Unpaid Principal Balance | Interest in Consumer Loans | Carrying Value | Weighted Average Coupon | Weighted Average Expected Life (Years)(A) | Weighted Average Delinquency(B) |\\n| September 30, 2019 |\\n| Consumer Loan Companies |\\n| Performing Loans | $ | 684,064 | 53.5 | % | $ | 722,826 | 18.9 | % | 4.0 | 4.5 | % |\\n| Purchased Credit Deteriorated Loans(C) | 182,171 | 53.5 | % | 147,059 | 15.6 | % | 3.5 | 10.0 | % |\\n| Other - Performing Loans | 12,196 | 100.0 | % | 11,298 | 14.9 | % | 0.8 | 5.5 | % |\\n| Total Consumer Loans, held-for-investment | $ | 878,431 | $ | 881,183 | 18.1 | % | 3.9 | 5.6 | % |\\n| December 31, 2018 |\\n| Consumer Loan Companies |\\n| Performing Loans | $ | 815,341 | 53.5 | % | $ | 856,563 | 18.8 | % | 3.6 | 5.4 | % |\\n| Purchased Credit Deteriorated Loans(C) | 221,910 | 53.5 | % | 182,917 | 16.0 | % | 3.4 | 11.6 | % |\\n| Other - Performing Loans | 35,326 | 100.0 | % | 32,722 | 14.2 | % | 0.8 | 5.6 | % |\\n| Total Consumer Loans, held-for-investment | $ | 1,072,577 | $ | 1,072,202 | 18.1 | % | 3.5 | 6.7 | % |\\n\\n42\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\n| (A) | Represents the weighted average expected timing of the receipt of expected cash flows for this investment. |\\n\\n| (B) | Represents the percentage of the total unpaid principal balance that is 30+ days delinquent. Delinquency status is the primary credit quality indicator as it provides early warning of borrowers who may be experiencing financial difficulties. |\\n\\n| (C) | Includes loans with evidence of credit deterioration since origination where it is probable that New Residential will not collect all contractually required principal and interest payments, which are accounted for as PCD loans. |\\n\\nSee Note 11 regarding the financing of consumer loans.\\nPerforming Loans\\nThe following table provides past due information regarding New Residential’s performing consumer loans, held-for-investment, which is an important indicator of credit quality and the establishment of the allowance for loan losses:\\n| September 30, 2019 |\\n| Days Past Due | Delinquency Status(A) |\\n| Current | 95.5 | % |\\n| 30-59 | 1.7 | % |\\n| 60-89 | 1.0 | % |\\n| 90-119(B) | 0.7 | % |\\n| 120+(B) (C) | 1.1 | % |\\n| 100.0 | % |\\n\\n| (A) | Represents the percentage of the total unpaid principal balance that corresponds to loans that are in each delinquency status. |\\n\\n| (B) | Includes loans more than 90 days past due and still accruing interest. |\\n\\n| (C) | Interest is accrued up to the date of charge-off at 180 days past due. |\\n\\nActivities related to the carrying value of performing consumer loans, held-for-investment were as follows:\\n| Performing Loans |\\n| Balance at December 31, 2018 | $ | 889,285 |\\n| Purchases | — |\\n| Additional fundings(A) | 42,231 |\\n| Proceeds from repayments | ( 166,897 | ) |\\n| Accretion of loan discount and premium amortization, net | 272 |\\n| Gross charge-offs | ( 30,325 | ) |\\n| Additions to the allowance for loan losses, net | ( 442 | ) |\\n| Balance at September 30, 2019 | $ | 734,124 |\\n\\n| (A) | Represents draws on consumer loans with revolving privileges. |\\n\\nActivities related to the allowance for loan losses on performing consumer loans, held-for-investment were as follows:\\n| Collectively Evaluated(A) | Individually Impaired(B) | Total |\\n| Balance at December 31, 2018 | $ | 2,604 | $ | 2,064 | $ | 4,668 |\\n| Provision (reversal) for loan losses | 23,966 | 442 | 24,408 |\\n| Net charge-offs(C) | ( 25,672 | ) | — | ( 25,672 | ) |\\n| Balance at September 30, 2019 | $ | 898 | $ | 2,506 | $ | 3,404 |\\n\\n43\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\n| (A) | Represents smaller-balance homogeneous loans that are not individually considered impaired and are evaluated based on an analysis of collective borrower performance, key terms of the loans and historical and anticipated trends in defaults and loss severities, and consideration of the unamortized acquisition discount. |\\n\\n| (B) | Represents consumer loan modifications considered to be troubled debt restructurings (“TDRs”) as they provide concessions to borrowers, primarily in the form of interest rate reductions, who are experiencing financial difficulty. As of September 30, 2019, there are $ 17.3 million in UPB and $ 15.5 million in carrying value of consumer loans classified as TDRs. |\\n\\n| (C) | Consumer loans, other than PCD loans, are charged off when available information confirms that loans are uncollectible, which is generally when they become 180 days past due. Charge-offs are presented net of $ 6.4 million in recoveries of previously charged-off UPB. |\\n\\nPurchased Credit Deteriorated Loans\\nA portion of the consumer loans are considered PCD loans. Activities related to the carrying value of PCD consumer loans, held-for-investment were as follows:\\n| Balance at December 31, 2018 | $ | 182,917 |\\n| (Allowance) reversal for loan losses(A) | ( 40 | ) |\\n| Proceeds from repayments | ( 60,499 | ) |\\n| Accretion of loan discount and other amortization | 24,681 |\\n| Balance at September 30, 2019 | $ | 147,059 |\\n\\n| (A) | An allowance represents the present value of cash flows expected at acquisition that are no longer expected to be collected. A reversal results from an increase to expected cash flows that reverses a prior allowance. |\\n\\nThe following is the unpaid principal balance and carrying value for consumer loans, for which, as of the acquisition date, it was probable that New Residential would be unable to collect all contractually required payments:\\n| Unpaid Principal Balance | Carrying Value |\\n| September 30, 2019 | $ | 182,171 | $ | 147,059 |\\n| December 31, 2018 | 221,910 | 182,917 |\\n\\nThe following is a summary of the changes in accretable yield for these loans:\\n| Balance at December 31, 2018 | $ | 126,518 |\\n| Accretion | ( 24,681 | ) |\\n| Reclassifications from (to) non-accretable difference(A) | 10,344 |\\n| Balance at September 30, 2019 | $ | 112,181 |\\n\\n| (A) | Represents a probable and significant increase (decrease) in cash flows previously expected to be uncollectible. |\\n\\nNoncontrolling Interests\\nOthers’ interests in the equity of the Consumer Loan Companies is computed as follows:\\n| September 30, 2019 | December 31, 2018 |\\n| Total Consumer Loan Companies equity | $ | 47,314 | $ | 66,105 |\\n| Others’ ownership interest | 46.5 | % | 46.5 | % |\\n| Others’ interests in equity of consolidated subsidiary | $ | 22,520 | $ | 30,561 |\\n\\n44\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nOthers’ interests in the Consumer Loan Companies’ net income (loss) is computed as follows:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Net Consumer Loan Companies income (loss) | $ | 22,790 | $ | 21,038 | $ | 49,690 | $ | 61,359 |\\n| Others’ ownership interest as a percent of total | 46.5 | % | 46.5 | % | 46.5 | % | 46.5 | % |\\n| Others’ interest in net income (loss) of consolidated subsidiaries | $ | 10,597 | $ | 9,783 | $ | 23,106 | $ | 28,533 |\\n\\nVariable Interest Entities\\nThe Consumer Loan Companies consolidate certain entities that issued securitized debt collateralized by the consumer loans (the “Consumer Loan SPVs”). The Consumer Loan SPVs are VIEs of which the Consumer Loan Companies are the primary beneficiaries. The following table presents information on the combined assets and liabilities related to these consolidated VIEs.\\n| As of |\\n| September 30, 2019 | December 31, 2018 |\\n| Assets |\\n| Consumer loans, held-for-investment | $ | 869,885 | $ | 1,039,480 |\\n| Restricted cash | 9,338 | 10,186 |\\n| Accrued interest receivable | 13,148 | 15,627 |\\n| Total assets(A) | $ | 892,371 | $ | 1,065,293 |\\n| Liabilities |\\n| Notes and bonds payable(B) | $ | 873,724 | $ | 1,030,096 |\\n| Accounts payable and accrued expenses | 4,034 | 3,814 |\\n| Total liabilities(A) | $ | 877,758 | $ | 1,033,910 |\\n\\n| (A) | The creditors of the Consumer Loan SPVs do not have recourse to the general credit of New Residential, and the assets of the Consumer Loan SPVs are not directly available to satisfy New Residential’s obligations. |\\n\\n| (B) | Includes $ 10.0 million face amount of bonds retained by New Residential issued by these VIEs. |\\n\\nEquity Method Investees\\nIn February 2017, New Residential completed a co-investment, through a newly formed entity, PF LoanCo Funding LLC (“LoanCo”), to purchase up to $ 5.0 billion worth of newly originated consumer loans from Consumer Loan Seller over a two year term. New Residential, along with three co-investors, each acquired 25 % membership interests in LoanCo. New Residential accounts for its investment in LoanCo pursuant to the equity method of accounting because it can exercise significant influence over LoanCo but the requirements for consolidation are not met. New Residential’s investment in LoanCo is recorded as Investment in Consumer Loans, Equity Method Investees which is included within Other Assets (see Note 2 for details). LoanCo has elected to account for its investments in consumer loans at fair value. New Residential has elected to record LoanCo’s activity on a one month lag.\\nIn addition, New Residential and the LoanCo co-investors agreed to purchase warrants to purchase up to 177.7 million shares of Series F convertible preferred stock in the Consumer Loan Seller’s parent company (“ParentCo”), which were valued at approximately $ 75.0 million in the aggregate as of February 2017, through a newly formed entity, PF WarrantCo Holdings, LP (“WarrantCo”). New Residential acquired a 23.57 % interest in WarrantCo, the remaining interest being acquired by three co-investors. WarrantCo has agreed to purchase a pro rata portion of the warrants each time LoanCo closes on a portion of its consumer loan purchase agreement from Consumer Loan Seller. The holder of the warrants has the option to purchase an equivalent number of shares of Series F convertible preferred stock in ParentCo at a price of $ 0.01 per share. WarrantCo is vested in the warrants to purchase an aggregate of 147.7 million Series F convertible preferred stock in ParentCo as of August 31, 2019, and New Residential and LoanCo co-investors are vested in the warrants to purchase an aggregate of 30.0 million Series F convertible preferred stock in ParentCo as of August 31, 2019. The Series F convertible preferred stock holders have the right to convert such preferred stock to common stock at any time, are entitled to the number of votes equal to the number of shares of common stock into which such\\n45\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nshares of convertible preferred stock could be converted, and will have liquidation rights in the event of liquidation. New Residential accounts for its investment in WarrantCo pursuant to the equity method of accounting because it can exercise significant influence over WarrantCo but the requirements for consolidation are not met. New Residential’s investment in WarrantCo is recorded as Investment in Consumer Loans, Equity Method Investees which is included within Other Assets (see Note 2 for details). WarrantCo has elected to account for its investments in warrants at fair value. New Residential has elected to record WarrantCo’s activity on a one month lag.\\nThe following tables summarize the investment in LoanCo and WarrantCo held by New Residential:\\n| September 30, 2019(A) | December 31, 2018(A) |\\n| Consumer loans, at fair value | $ | 1,632 | $ | 231,560 |\\n| Warrants, at fair value | 106,378 | 103,067 |\\n| Other assets | 1,685 | 25,971 |\\n| Warehouse financing | — | ( 182,065 | ) |\\n| Other liabilities | ( 118 | ) | ( 1,142 | ) |\\n| Equity | $ | 109,577 | $ | 177,391 |\\n| Undistributed retained earnings | $ | — | $ | — |\\n| New Residential’s investment | $ | 25,875 | $ | 42,875 |\\n| New Residential’s ownership | 23.6 | % | 24.2 | % |\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019(B) | 2018(B) | 2019(B) | 2018(B) |\\n| Interest income | $ | 636 | $ | 16,513 | $ | 20,003 | $ | 38,032 |\\n| Interest expense | — | ( 4,364 | ) | ( 6,487 | ) | ( 10,082 | ) |\\n| Change in fair value of consumer loans and warrants | ( 2,933 | ) | 5,676 | ( 4,390 | ) | 24,750 |\\n| Gain on sale of consumer loans(C) | ( 7,525 | ) | 2,379 | ( 9,193 | ) | 3,512 |\\n| Other expenses | ( 576 | ) | ( 1,604 | ) | ( 3,494 | ) | ( 6,201 | ) |\\n| Net income | $ | ( 10,398 | ) | $ | 18,600 | $ | ( 3,561 | ) | $ | 50,011 |\\n| New Residential’s equity in net income | $ | ( 2,547 | ) | $ | 4,555 | $ | ( 890 | ) | $ | 12,343 |\\n| New Residential’s ownership | 24.5 | % | 24.5 | % | 25.0 | % | 24.7 | % |\\n\\n| (A) | Data as of August 31, 2019 and November 30, 2018, respectively, as a result of the one month reporting lag. |\\n\\n| (B) | Data for the periods ended August 31, 2019 and 2018, respectively, as a result of the one month reporting lag. |\\n\\n| (C) | During the nine months ended September 30, 2019, LoanCo sold, through securitizations which were treated as sales for accounting purposes, $ 406.1 million in UPB of consumer loans. LoanCo retained $ 83.9 million of residual interest in the securitizations and distributed them to the LoanCo co-investors, including New Residential. |\\n\\nThe following is a summary of LoanCo’s consumer loan investments:\\n| Unpaid Principal Balance | Interest in Consumer Loans | Carrying Value | Weighted Average Coupon | Weighted Average Expected Life (Years)(A) | Weighted Average Delinquency(B) |\\n| September 30, 2019(C) | $ | 1,226 | 25.0 | % | $ | 1,632 | 18.7 | % | 1.0 | — | % |\\n\\n| (A) | Represents the weighted average expected timing of the receipt of expected cash flows for this investment. |\\n\\n| (B) | Represents the percentage of the total unpaid principal balance that is 30+ days delinquent. Delinquency status is the primary credit quality indicator as it provides early warning of borrowers who may be experiencing financial difficulties. |\\n\\n| (C) | Data as of August 31, 2019 as a result of the one month reporting lag. |\\n\\n46\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nNew Residential’s investment in LoanCo and WarrantCo changed as follows:\\n| Balance at December 31, 2018 | $ | 38,294 |\\n| Contributions to equity method investees | 63,969 |\\n| Distributions of earnings from equity method investees | ( 1,178 | ) |\\n| Distributions of capital from equity method investees | ( 77,162 | ) |\\n| Earnings from investments in consumer loans, equity method investees | ( 890 | ) |\\n| Balance at September 30, 2019 | $ | 23,033 |\\n\\n| 10. | DERIVATIVES |\\n\\nNew Residential uses interest rate swaps and interest rate caps as economic hedges to hedge a portion of its interest rate risk exposure. Interest rate risk is sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations, as well as other factors. New Residential’s credit risk with respect to economic hedges is the risk of default on New Residential’s investments that results from a borrower’s or counterparty’s inability or unwillingness to make contractually required payments.\\nAs of September 30, 2019, New Residential held to-be-announced forward contract positions (“TBAs”) which were entered into as an economic hedge in order to mitigate New Residential’s interest rate risk on certain specified mortgage backed securities and any amounts or obligations owed by or to New Residential are subject to the right of set-off with the TBA counterparty. As part of executing these trades, New Residential has entered into agreements with its TBA counterparties that govern the transactions for the TBA purchases or sales made, including margin maintenance, payment and transfer, events of default, settlements, and various other provisions. New Residential has fulfilled all obligations and requirements entered into under these agreements.\\nIn addition, as of September 30, 2019, New Residential held interest rate lock commitments (“IRLCs”), which represent a commitment to a particular interest rate provided the borrower is able to close the loan within a specified period, and forward loan sale and securities delivery commitments, which represent a commitment to sell specific mortgage loans at prices which are fixed as of the forward commitment date. New Residential enters into forward loan sale and securities delivery commitments in order to hedge the exposure related to IRLCs and mortgage loans that are not covered by mortgage loan sale commitments.\\nNew Residential’s derivatives are recorded at fair value on the Condensed Consolidated Balance Sheets as follows:\\n| Balance Sheet Location | September 30, 2019 | December 31, 2018 |\\n| Derivative assets |\\n| Interest Rate Caps | Other assets | $ | — | $ | 3 |\\n| Interest Rate Lock Commitments | Other assets | 26,214 | 10,851 |\\n| Forward Loan Sale Commitments | Other assets | — | 39 |\\n| TBAs | Other assets | 10,498 | — |\\n| $ | 36,712 | $ | 10,893 |\\n| Derivative liabilities |\\n| Interest Rate Swaps(A) | Accrued expenses and other liabilities | $ | 135 | $ | 5,245 |\\n| Interest Rate Lock Commitments | Accrued expenses and other liabilities | 1,676 | 223 |\\n| Forward Loan Sale Commitments | Accrued expenses and other liabilities | 31 |\\n| TBAs | Accrued expenses and other liabilities | — | 23,921 |\\n| $ | 1,842 | $ | 29,389 |\\n\\n| (A) | Net of $ 165.7 million of related variation margin accounts as of September 30, 2019. As of December 31, 2018, net of $ 106.1 million of related variation margin accounts existed. |\\n\\n47\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nThe following table summarizes notional amounts related to derivatives:\\n| September 30, 2019 | December 31, 2018 |\\n| Interest Rate Caps(A) | $ | 50,000 | $ | 50,000 |\\n| Interest Rate Swaps(B) | 7,780,000 | 4,725,000 |\\n| Interest Rate Lock Commitments | 2,735,387 | 823,187 |\\n| Forward Loan Sale Commitments | 6,893 | 30,274 |\\n| TBAs, short position(C) | 5,488,000 | 5,904,300 |\\n| TBAs, long position(C) | 9,709,894 | 5,067,200 |\\n\\n| (A) | As of September 30, 2019, caps LIBOR at 4.00 % for $ 50.0 million of notional. The weighted average maturity of the interest rate caps as of September 30, 2019 was 14 months. |\\n\\n| (B) | Includes $ 4.5 billion notional of Receive LIBOR/Pay Fixed of 3.16 % and $ 3.3 billion notional of Receive Fixed of 1.51 %/Pay LIBOR with weighted average maturities of 43 months and 65 months, respectively, as of September 30, 2019. |\\n\\n| (C) | Represents the notional amount of Agency RMBS, classified as derivatives. |\\n\\nThe following table summarizes all income (losses) recorded in relation to derivatives:\\n| For the Three Months Ended September 30, | For the Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Change in fair value of derivative instruments(A) |\\n| Interest Rate Caps | $ | — | $ | ( 2 | ) | $ | ( 3 | ) | $ | 436 |\\n| Interest Rate Swaps | 42,306 | 18,785 | ( 26,893 | ) | 19,668 |\\n| Unrealized gains (losses) on Interest Rate Lock Commitments | 3,002 | ( 2,247 | ) | 13,911 | ( 2,247 | ) |\\n| Forward Loan Sale Commitments | ( 272 | ) | ( 17 | ) | ( 70 | ) | ( 17 | ) |\\n| TBAs | 13,472 | 7,780 | 11,067 | 10,145 |\\n| 58,508 | 24,299 | ( 1,988 | ) | 27,985 |\\n| Gain (loss) on settlement of investments, net |\\n| Interest Rate Caps | — | — | — | ( 603 | ) |\\n| Interest Rate Swaps | ( 10,338 | ) | ( 656 | ) | ( 32,529 | ) | 37,287 |\\n| TBAs(B) | ( 3,809 | ) | 20,115 | ( 119,895 | ) | 39,408 |\\n| ( 14,147 | ) | 19,459 | ( 152,424 | ) | 76,092 |\\n| Total income (losses) | $ | 44,361 | $ | 43,758 | $ | ( 154,412 | ) | $ | 104,077 |\\n\\n| (A) | Represents unrealized gains (losses). |\\n\\n| (B) | Excludes $ 32.1 million and $ 61.9 million in loss on settlement included within gain on sale of originated mortgage loans, net (Note 8) for the three and nine months ended September 30, 2019, respectively. |\\n\\n48\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\n| 11. | DEBT OBLIGATIONS |\\n\\nThe following table presents certain information regarding New Residential’s debt obligations:\\n| September 30, 2019 | December 31, 2018 |\\n| Collateral |\\n| Debt Obligations/Collateral | Outstanding Face Amount | Carrying Value(A) | Final Stated Maturity(B) | Weighted Average Funding Cost | Weighted Average Life (Years) | Outstanding Face | Amortized Cost Basis | Carrying Value | Weighted Average Life (Years) | Carrying Value(A) |\\n| Repurchase Agreements(C) |\\n| Agency RMBS(D) | $ | 10,733,236 | $ | 10,733,236 | Oct-19 to May-20 | 2.31 | % | 0.1 | $ | 10,611,553 | $ | 10,825,984 | $ | 10,886,787 | 2.4 | $ | 4,346,070 |\\n| Non-Agency RMBS (E) | 7,144,329 | 7,144,329 | Oct-19 to Sep-20 | 3.08 | % | 0.1 | 21,021,981 | 7,113,471 | 7,786,425 | 6.3 | 7,434,785 |\\n| Residential Mortgage Loans(F) | 5,165,150 | 5,164,159 | Oct-19 to May-21 | 3.74 | % | 0.6 | 5,960,958 | 6,025,596 | 5,805,242 | 13.9 | 3,678,246 |\\n| Real Estate Owned(G)(H) | 68,651 | 68,635 | Oct-19 to May-21 | 3.85 | % | 0.4 | N/A | N/A | 95,410 | N/A | 94,868 |\\n| Total Repurchase Agreements | 23,111,366 | 23,110,359 | 2.87 | % | 0.3 | 15,553,969 |\\n| Notes and Bonds Payable |\\n| Excess MSRs(I) | 269,759 | 269,759 | Feb-20 to Jul-22 | 4.95 | % | 1.9 | 103,514,484 | 315,847 | 416,899 | 5.8 | 297,563 |\\n| MSRs(J) | 2,360,182 | 2,352,961 | Mar-20 to Jul-24 | 4.23 | % | 2.0 | 452,215,330 | 4,718,333 | 5,113,271 | 5.5 | 2,360,856 |\\n| Servicer Advances(K) | 2,903,093 | 2,896,819 | Jan-20 to Aug-23 | 3.22 | % | 2.0 | 3,316,416 | 3,482,368 | 3,512,345 | 1.6 | 3,382,455 |\\n| Residential Mortgage Loans(L) | 1,012,342 | 1,015,360 | Apr-20 to Jul-43 | 4.09 | % | 3.7 | 1,258,875 | 1,277,193 | 1,194,186 | 8.0 | 124,945 |\\n| Consumer Loans(M) | 868,214 | 870,973 | Dec-21 to May-36 | 3.25 | % | 4.0 | 878,317 | 884,473 | 881,069 | 5.6 | 936,447 |\\n| Total Notes and Bonds Payable | 7,413,590 | 7,405,872 | 3.73 | % | 2.5 | 7,102,266 |\\n| Total/ Weighted Average | $ | 30,524,956 | $ | 30,516,231 | 3.08 | % | 0.8 | $ | 22,656,235 |\\n\\n| (A) | Net of deferred financing costs. |\\n\\n| (B) | All debt obligations with a stated maturity through October 31, 2019 were refinanced, extended or repaid. |\\n\\n| (C) | These repurchase agreements had approximately $ 77.8 million of associated accrued interest payable as of September 30, 2019. |\\n\\n| (D) | All of the Agency RMBS repurchase agreements have a fixed rate. Collateral amounts include approximately $ 4.4 billion of related trade and other receivables. |\\n\\n| (E) | $ 6,585.6 million face amount of the Non-Agency RMBS repurchase agreements have LIBOR-based floating interest rates while the remaining $ 558.8 million face amount of the Non-Agency RMBS repurchase agreements have a fixed rate. This also includes repurchase agreements of $ 7.5 million on retained servicer advance and consumer loan bonds and of $ 671.3 million on retained bonds collateralized by Agency MSRs. |\\n\\n| (F) | All of these repurchase agreements have LIBOR-based floating interest rates. |\\n\\n| (G) | All of these repurchase agreements have LIBOR-based floating interest rates. |\\n\\n| (H) | Includes financing collateralized by receivables including claims from FHA on Ginnie Mae EBO loans for which foreclosure has been completed and for which New Residential has made or intends to make a claim on the FHA guarantee. |\\n\\n| (I) | Includes $ 169.8 million of corporate loans which bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin of 3.00 %, and $ 100.0 million of corporate loans which bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin of 2.50 %. The outstanding face amount of the collateral represents the UPB of the residential mortgage loans underlying the interests in MSRs that secure these notes. |\\n\\n| (J) | Includes: $ 940.2 million of MSR notes which bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin ranging from 2.25 % to 2.75 %; and $ 1,419.9 million of public notes with fixed interest rates ranging from 3.55 % to 4.62 %. The outstanding face amount of the collateral represents the UPB of the residential mortgage loans underlying the MSRs and mortgage servicing rights financing receivables that secure these notes. |\\n\\n| (K) | $ 2.6 billion face amount of the notes have a fixed rate while the remaining notes bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR or a cost of funds rate, as applicable, and (ii) a margin ranging from 1.15 % to 1.99 %. Collateral includes Servicer Advance Investments, as well as servicer advances receivable related to the mortgage servicing rights and mortgage servicing rights financing receivables owned by NRM. |\\n\\n49\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\n| (L) | Represents: (i) a $ 6.0 million note payable to Nationstar which includes a $ 1.5 million receivable from government agency and bears interest equal to one-month LIBOR plus 2.88 %, (ii) $ 109.9 million fair value of SAFT 2013-1 mortgage-backed securities issued with fixed interest rates ranging from 3.50 % to 3.76 % (see Note 12 for details), (iii) $ 362.1 million of asset-backed notes held by third parties which bear interest equal to 4.59 % (see Note 12 for details), and (iv) $ 535.1 million of asset-backed notes held by third parties which include $ 1.3 million of REO and bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin of 1.25 %. |\\n\\n| (M) | Includes the SpringCastle debt, which is comprised of the following classes of asset-backed notes held by third parties: $ 787.9 million UPB of Class A notes with a coupon of 3.20 % and a stated maturity date in May 2036, $ 70.4 million UPB of Class B notes with a coupon of 3.58 % and a stated maturity date in May 2036, and $ 8.7 million UPB of Class C notes with a coupon of 5.06 % and a stated maturity date in May 2036. Also includes a $ 1.2 million face amount note which bears interest equal to 4.00 %. |\\n\\nAs of September 30, 2019, New Residential had no outstanding repurchase agreements where the amount at risk with any individual counterparty or group of related counterparties exceeded 10% of New Residential’s stockholders' equity. The amount at risk under repurchase agreements is defined as the excess of carrying amount (or market value, if higher than the carrying amount) of the securities or other assets sold under agreement to repurchase, including accrued interest plus any cash or other assets on deposit to secure the repurchase obligation, over the amount of the repurchase liability (adjusted for accrued interest).\\nGeneral\\nCertain of the debt obligations included above are obligations of New Residential’s consolidated subsidiaries, which own the related collateral. In some cases, such collateral is not available to other creditors of New Residential.\\nNew Residential has margin exposure on $ 23.1 billion of repurchase agreements as of September 30, 2019. To the extent that the value of the collateral underlying these repurchase agreements declines, New Residential may be required to post margin, which could significantly impact its liquidity.\\nActivities related to the carrying value of New Residential’s debt obligations were as follows:\\n| Excess MSRs | MSRs | Servicer Advances(A) | Real Estate Securities | Residential Mortgage Loans and REO | Consumer Loans | Total |\\n| Balance at December 31, 2018 | $ | 297,563 | $ | 2,360,856 | $ | 3,382,455 | $ | 11,780,855 | $ | 3,898,059 | $ | 936,447 | $ | 22,656,235 |\\n| Repurchase Agreements: |\\n| Borrowings | — | — | — | 131,684,478 | 20,417,339 | — | 152,101,817 |\\n| Repayments | — | — | — | ( 125,587,933 | ) | ( 18,957,675 | ) | — | ( 144,545,608 | ) |\\n| Capitalized deferred financing costs, net of amortization | — | — | — | 165 | 17 | — | 182 |\\n| Notes and Bonds Payable: |\\n| Borrowings | 300,000 | 2,039,949 | 3,419,265 | — | 912,445 | 928,683 | 7,600,342 |\\n| Repayments | ( 328,000 | ) | ( 2,048,653 | ) | ( 3,902,406 | ) | — | ( 27,279 | ) | ( 1,000,203 | ) | ( 7,306,541 | ) |\\n| Discount on borrowings, net of amortization | — | — | 29 | — | — | 6,046 | 6,075 |\\n| Unrealized gain on notes, fair value | — | — | — | — | 5,248 | — | 5,248 |\\n| Capitalized deferred financing costs, net of amortization | 196 | 809 | ( 2,524 | ) | — | — | — | ( 1,519 | ) |\\n| Balance at September 30, 2019 | $ | 269,759 | $ | 2,352,961 | $ | 2,896,819 | $ | 17,877,565 | $ | 6,248,154 | $ | 870,973 | $ | 30,516,231 |\\n\\n| (A) | New Residential net settles daily borrowings and repayments of the Notes and Bonds Payable on its servicer advances. |\\n\\n50\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nMaturities\\nNew Residential’s debt obligations as of September 30, 2019 had contractual maturities as follows:\\n| Year | Nonrecourse | Recourse | Total |\\n| October 1 through December 31, 2019 | $ | 1,978 | $ | 18,781,709 | $ | 18,783,687 |\\n| 2020 | 615,733 | 5,480,786 | 6,096,519 |\\n| 2021 | 1,088,623 | 1,034,034 | 2,122,657 |\\n| 2022 | 1,162,067 | 169,759 | 1,331,826 |\\n| 2023 | 400,000 | 403,433 | 803,433 |\\n| 2024 and thereafter | 976,300 | 410,534 | 1,386,834 |\\n| $ | 4,244,701 | $ | 26,280,255 | $ | 30,524,956 |\\n\\nBorrowing Capacity\\nThe following table represents New Residential’s borrowing capacity as of September 30, 2019:\\n| Debt Obligations / Collateral | Borrowing Capacity | Balance Outstanding | Available Financing |\\n| Repurchase Agreements |\\n| Residential mortgage loans and REO | $ | 9,112,297 | $ | 5,233,801 | $ | 3,878,496 |\\n| Non-Agency RMBS | 650,000 | 558,756 | 91,244 |\\n| Notes and Bonds Payable |\\n| Excess MSRs | 150,000 | 100,000 | 50,000 |\\n| MSRs | 1,375,000 | 940,188 | 434,812 |\\n| Servicer advances(A) | 1,204,660 | 1,053,127 | 151,533 |\\n| Residential Mortgage Loans | 650,000 | 535,063 | 114,937 |\\n| Consumer loans | 150,000 | 1,228 | 148,772 |\\n| $ | 13,291,957 | $ | 8,422,163 | $ | 4,869,794 |\\n\\n| (A) | New Residential’s unused borrowing capacity is available if New Residential has additional eligible collateral to pledge and meets other borrowing conditions as set forth in the applicable agreements, including any applicable advance rate. New Residential pays a 0.02 % fee on the unused borrowing capacity. |\\n\\nCertain of the debt obligations are subject to customary loan covenants and event of default provisions, including event of default provisions triggered by certain specified declines in New Residential’s equity or a failure to maintain a specified tangible net worth, liquidity, or indebtedness to tangible net worth ratio. New Residential was in compliance with all of its debt covenants as of September 30, 2019.\\n51\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\n| 12. | FAIR VALUE MEASUREMENT |\\n\\nThe carrying values and fair values of New Residential’s assets and liabilities recorded at fair value on a recurring basis, as well as other financial instruments for which fair value is disclosed, as of September 30, 2019 were as follows:\\n| Fair Value |\\n| Principal Balance or Notional Amount | Carrying Value | Level 1 | Level 2 | Level 3 | Total |\\n| Assets |\\n| Investments in: |\\n| Excess mortgage servicing rights, at fair value(A) | $ | 93,025,190 | $ | 398,064 | $ | — | $ | — | $ | 398,064 | $ | 398,064 |\\n| Excess mortgage servicing rights, equity method investees, at fair value(A) | 35,632,429 | 132,259 | — | — | 132,259 | 132,259 |\\n| Mortgage servicing rights, at fair value(A) | 319,927,285 | 3,431,968 | — | — | 3,431,968 | 3,431,968 |\\n| Mortgage servicing rights financing receivables, at fair value | 140,523,235 | 1,811,261 | — | — | — | 1,811,261 | 1,811,261 |\\n| Servicer advance investments, at fair value | 492,480 | 600,547 | — | — | 600,547 | 600,547 |\\n| Real estate and other securities, available-for-sale | 30,643,013 | 16,853,910 | — | 8,998,066 | 7,855,844 | 16,853,910 |\\n| Residential mortgage loans, held-for-investment | 569,888 | 500,524 | — | — | 495,424 | 495,424 |\\n| Residential mortgage loans, held-for-sale | 1,449,469 | 1,349,997 | — | — | 1,365,262 | 1,365,262 |\\n| Residential mortgage loans, held-for-sale, at fair value | 5,272,963 | 5,206,251 | — | 872,088 | 4,334,192 | 5,206,280 |\\n| Residential mortgage loans, held-for-investment, at fair value | 112,112 | 113,133 | — | — | 113,133 | 113,133 |\\n| Residential mortgage loans subject to repurchase | 168,532 | 168,532 | — | 168,532 | — | 168,532 |\\n| Consumer loans, held-for-investment | 878,431 | 881,183 | — | — | 903,805 | 903,805 |\\n| Derivative assets | 17,619,076 | 36,712 | — | 10,498 | 26,214 | 36,712 |\\n| Cash and cash equivalents | 738,219 | 738,219 | 738,219 | — | — | 738,219 |\\n| Restricted cash | 163,148 | 163,148 | 163,148 | — | — | 163,148 |\\n| Other assets(B) | N/A | 25,187 | 10,912 | — | 14,275 | 25,187 |\\n| $ | 32,410,895 | $ | 912,279 | $ | 10,049,184 | $ | 21,482,248 | $ | 32,443,711 |\\n| Liabilities |\\n| Repurchase agreements | $ | 23,111,366 | $ | 23,110,359 | $ | — | $ | 23,111,366 | $ | — | $ | 23,111,366 |\\n| Notes and bonds payable(C) | 7,413,590 | 7,405,872 | — | — | 7,486,297 | 7,486,297 |\\n| Residential mortgage loan repurchase liability | 168,532 | 168,532 | — | 168,532 | — | 168,532 |\\n| Derivative liabilities | 8,151,098 | 1,842 | — | 166 | 1,676 | 1,842 |\\n| Excess spread financing | 3,113,756 | 30,377 | — | — | 30,377 | 30,377 |\\n| Contingent consideration | N/A | 52,761 | — | — | 52,761 | 52,761 |\\n| $ | 30,769,743 | $ | — | $ | 23,280,064 | $ | 7,571,111 | $ | 30,851,175 |\\n\\n\\n| (A) | The notional amount represents the total unpaid principal balance of the residential mortgage loans underlying the MSRs, MSR financing receivables and Excess MSRs. New Residential does not receive an excess mortgage servicing amount on non-performing loans in Agency portfolios. |\\n\\n| (B) | Excludes the indirect equity investment in a commercial redevelopment project that is accounted for at fair value on a recurring basis based on the NAV of New Residential’s investment. The investment had a fair value of $ 74.1 million as of September 30, 2019. |\\n\\n52\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\n| (C) | Includes the SAFT 2013-1 mortgage-backed securities and the 2019-RPL1 asset-backed notes issued for which the fair value option for financial instruments was elected and resulted in a fair value of $ 474.3 million as of September 30, 2019. |\\n\\nNew Residential’s assets measured at fair value on a recurring basis using Level 3 inputs changed as follows:\\n| Level 3 |\\n| Excess MSRs(A) | Excess MSRs in Equity Method Investees(A)(B) | MSRs(A) | Mortgage Servicing Rights Financing Receivable(A) | Servicer Advance Investments | Non-Agency RMBS | Derivatives(C) | Residential Mortgage Loans |\\n| Agency | Non-Agency | Total |\\n| Balance at December 31, 2018 | $ | 257,387 | $ | 190,473 | $ | 147,964 | $ | 2,884,100 | $ | 1,644,504 | $ | 735,846 | $ | 8,970,963 | $ | 10,628 | $ | 2,330,627 | $ | 17,172,492 |\\n| Transfers(D) |\\n| Transfers from Level 3 | — | — | — | — | — | — | — | — | ( 19,726 | ) | ( 19,726 | ) |\\n| Transfers to Level 3 | — | — | — | — | — | — | — | — | 301,174 | 301,174 |\\n| Shellpoint Acquisition (Note 1) | — | — | — | — | — | — | 805 | 805 |\\n| Transfers from investments in mortgage servicing rights financing receivables to investments in mortgage servicing rights | — | — | — | 367,121 | ( 367,121 | ) | — | — | — | — | — |\\n| Gains (losses) included in net income |\\n| Included in other-than-temporary impairment on securities(E) | — | — | — | — | — | — | ( 21,942 | ) | — | — | ( 21,942 | ) |\\n| Included in change in fair value of investments in excess mortgage servicing rights(E) | ( 946 | ) | ( 475 | ) | — | — | — | — | — | — | — | ( 1,421 | ) |\\n| Included in change in fair value of investments in excess mortgage servicing rights, equity method investees(E) | — | — | 4,087 | — | — | — | — | — | — | 4,087 |\\n| Included in servicing revenue, net(F) | — | — | — | ( 629,396 | ) | — | — | — | — | — | ( 629,396 | ) |\\n| Included in change in fair value of investments in mortgage servicing rights financing receivables(E) | — | — | — | — | ( 133,200 | ) | — | — | — | — | ( 133,200 | ) |\\n| Included in change in fair value of servicer advance investments | — | — | — | — | — | 15,932 | — | — | — | 15,932 |\\n| Included in change in fair value of investments in residential mortgage loans | — | — | — | — | — | — | — | — | 82,559 | 82,559 |\\n| Included in gain (loss) on settlement of investments, net | 231 | 90 | — | — | — | — | 91,895 | — | — | 92,216 |\\n| Included in other income (loss), net(E) | 1,036 | 735 | — | — | — | — | 9,010 | 13,910 | — | 24,691 |\\n| Gains (losses) included in other comprehensive income(G) | — | — | — | — | — | — | 254,044 | — | — | 254,044 |\\n| Interest income | 4,452 | 13,751 | — | — | — | 17,862 | 243,538 | — | — | 279,603 |\\n| Purchases, sales and repayments |\\n| Purchases | — | — | — | 632,144 | 735,152 | 1,255,306 | 1,164,853 | — | 7,634,281 | 11,421,736 |\\n| Proceeds from sales | ( 4,579 | ) | ( 2 | ) | — | ( 1,047 | ) | ( 15,575 | ) | ( 1,662,900 | ) | — | ( 6,559,120 | ) | ( 8,243,223 | ) |\\n| Proceeds from repayments | ( 36,021 | ) | ( 28,068 | ) | ( 19,792 | ) | ( 11,210 | ) | ( 52,499 | ) | ( 1,424,399 | ) | ( 1,193,617 | ) | — | ( 170,668 | ) | ( 2,936,274 | ) |\\n| Originations and other | — | — | — | 190,256 | — | — | — | — | 847,393 | 1,037,649 |\\n| Balance at September 30, 2019 | $ | 221,560 | $ | 176,504 | $ | 132,259 | $ | 3,431,968 | $ | 1,811,261 | $ | 600,547 | $ | 7,855,844 | $ | 24,538 | $ | 4,447,325 | $ | 18,701,806 |\\n\\n\\n| (A) | Includes the recapture agreement for each respective pool, as applicable. |\\n\\n| (B) | Amounts represent New Residential’s portion of the Excess MSRs held by the respective joint ventures in which New Residential has a 50 % interest. |\\n\\n| (C) | For the purpose of this table, the IRLC asset and liability positions are shown net. |\\n\\n| (D) | Transfers are assumed to occur at the beginning of the respective period. |\\n\\n| (E) | The gains (losses) recorded in earnings during the period are attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting dates and realized gains (losses) recorded during the period. |\\n\\n| (F) | The components of Servicing revenue, net are disclosed in Note 5. |\\n\\n| (G) | These gains (losses) were included in net unrealized gain (loss) on securities in the Condensed Consolidated Statements of Comprehensive Income. |\\n\\n53\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nNew Residential’s liabilities measured at fair value on a recurring basis using Level 3 inputs changed as follows:\\n| Level 3 |\\n| Excess Spread Financing | Mortgage-Backed Securities Issued | Contingent Consideration |\\n| Total |\\n| Balance at December 31, 2018 | $ | 39,304 | $ | 117,048 | $ | 40,842 | $ | 197,194 |\\n| Transfers(A) |\\n| Transfers from Level 3 | — | — | — | — |\\n| Transfers to Level 3 | — | — | — | — |\\n| Acquisition | — | — | 14,488 | 14,488 |\\n| Gains (losses) included in net income |\\n| Included in other-than-temporary impairment on securities(B) | — | — | — | — |\\n| Included in change in fair value of investments in excess mortgage servicing rights | — | — | — | — |\\n| Included in change in fair value of investments in excess mortgage servicing rights, equity method investees(B) | — | — | — | — |\\n| Included in servicing revenue, net(C) | ( 9,482 | ) | — | — | ( 9,482 | ) |\\n| Included in change in fair value of investments in notes receivable - rights to MSRs | — | — | — | — |\\n| Included in change in fair value of servicer advance investments | — | — | — | — |\\n| Included in change in fair value of investments in residential mortgage loans | — | — | — | — |\\n| Included in gain (loss) on settlement of investments, net | — | — | — | — |\\n| Included in other income(B) | — | 5,248 | 7,431 | 12,679 |\\n| Gains (losses) included in other comprehensive income, net of tax(D) | — | — | — | — |\\n| Interest income | — | — | — | — |\\n| Purchases, sales and repayments |\\n| Purchases | — | 378,569 | — | 378,569 |\\n| Proceeds from sales | — | — | — | — |\\n| Proceeds from repayments | — | ( 26,556 | ) | — | ( 26,556 | ) |\\n| Other | 555 | — | ( 10,000 | ) | ( 9,445 | ) |\\n| Balance at September 30, 2019 | $ | 30,377 | $ | 474,309 | $ | 52,761 | $ | 557,447 |\\n\\n| (A) | Transfers are assumed to occur at the beginning of the respective period. |\\n\\n| (B) | The gains (losses) recorded in earnings during the period are attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting dates and realized gains (losses) recorded during the period. |\\n\\n| (C) | The components of Servicing revenue, net are disclosed in Note 5. |\\n\\n| (D) | These gains (losses) were included in net unrealized gain (loss) on securities in the Condensed Consolidated Statements of Comprehensive Income. |\\n\\n54\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nInvestments in Excess MSRs, Excess MSRs Equity Method Investees, MSRs and MSR Financing Receivables Valuation\\nThe following table summarizes certain information regarding the weighted average inputs used as of September 30, 2019:\\n| Significant Inputs(A) |\\n| Prepayment Rate(B) | Delinquency(C) | Recapture Rate(D) | Mortgage Servicing Amount or Excess Mortgage Servicing Amount (bps)(E) | Collateral Weighted Average Maturity (Years)(F) |\\n| Excess MSRs Directly Held (Note 4) |\\n| Agency |\\n| Original Pools | 9.3 | % | 1.2 | % | 23.5 | % | 21 | 20 |\\n| Recaptured Pools | 12.3 | % | 0.5 | % | 35.0 | % | 22 | 23 |\\n| 10.0 | % | 1.0 | % | 26.3 | % | 21 | 21 |\\n| Non-Agency(G) |\\n| Nationstar and SLS Serviced: |\\n| Original Pools | 9.9 | % | N/A | 17.5 | % | 15 | 24 |\\n| Recaptured Pools | 8.6 | % | N/A | 20.9 | % | 24 | 24 |\\n| 9.7 | % | N/A | 17.9 | % | 16 | 24 |\\n| Total/Weighted Average--Excess MSRs Directly Held | 9.9 | % | 1.0 | % | 22.6 | % | 19 | 22 |\\n| Excess MSRs Held through Equity Method Investees (Note 4) |\\n| Agency |\\n| Original Pools | 10.0 | % | 1.5 | % | 26.7 | % | 19 | 19 |\\n| Recaptured Pools | 11.7 | % | 0.9 | % | 32.6 | % | 24 | 23 |\\n| Total/Weighted Average--Excess MSRs Held through Investees | 10.7 | % | 1.2 | % | 29.3 | % | 21 | 21 |\\n| Total/Weighted Average--Excess MSRs All Pools | 10.2 | % | 1.1 | % | 24.8 | % | 20 | 22 |\\n| MSRs |\\n| Agency |\\n| Mortgage Servicing Rights(H) (I) | 13.7 | % | 0.7 | % | 27.1 | % | 27 | 22 |\\n| MSR Financing Receivables | 17.6 | % | 0.3 | % | 14.9 | % | 27 | 25 |\\n| Non-Agency |\\n| Mortgage Servicing Rights | 12.4 | % | 0.2 | % | 24.6 | % | 26 | 26 |\\n| MSR Financing Receivables | 8.3 | % | 14.1 | % | 10.2 | % | 47 | 26 |\\n| Ginnie Mae |\\n| Mortgage Servicing Rights(I) | 14.8 | % | 3.6 | % | 29.7 | % | 32 | 27 |\\n\\n| (A) | Weighted by fair value of the portfolio. |\\n\\n| (B) | Projected annualized weighted average lifetime voluntary and involuntary prepayment rate using a prepayment vector. |\\n\\n| (C) | Projected percentage of residential mortgage loans in the pool for which the borrower will miss its mortgage payments. |\\n\\n| (D) | Percentage of voluntarily prepaid loans that are expected to be refinanced by the related servicer or subservicer, as applicable. |\\n\\n| (E) | Weighted average total mortgage servicing amount, in excess of the basic fee as applicable, measured in basis points (bps). A weighted average cost of subservicing of $ 6.46 per loan per month was used to value the agency MSRs, including MSR Financing Receivables. A weighted average cost of subservicing of $ 11.23 per loan per month was used to value the non-agency MSRs, including MSR Financing Receivables. A weighted average cost of subservicing of $ 8.81 per loan per month was used to value the Ginnie Mae MSRs. |\\n\\n| (F) | Weighted average maturity of the underlying residential mortgage loans in the pool. |\\n\\n| (G) | For certain pools, the Excess MSR will be paid on the total UPB of the mortgage portfolio (including both performing and delinquent loans until REO). For these pools, no delinquency assumption is used. |\\n\\n55\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\n| (H) | For certain pools, recapture rate represents the expected recapture rate with the successor subservicer appointed by NRM. |\\n\\n| (I) | Includes valuation of the related Excess spread financing (Note 5). |\\n\\nWith respect to valuing the Ocwen-serviced mortgage servicing rights financing receivables, which include a significant servicer advances receivable component, the cost of financing servicer advances receivable is assumed to be LIBOR plus 0.9 %.\\nAs of September 30, 2019, a weighted average discount rate of 7.8 % was used to value New Residential’s investments in Excess MSRs (directly and through equity method investees). As of September 30, 2019, a weighted average discount rate of 7.5 % was used to value New Residential’s investments in MSRs and a weighted average discount rate of 8.8 % was used to value New Residential’s investments in MSR financing receivables.\\nServicer Advance Investments Valuation\\nThe following table summarizes certain information regarding the inputs used in valuing the Servicer Advance Investments, including the basic fee component of the related MSRs:\\n| Significant Inputs |\\n| Weighted Average |\\n| Outstanding Servicer Advances to UPB of Underlying Residential Mortgage Loans | Prepayment Rate(A) | Delinquency | Mortgage Servicing Amount(B) | Discount Rate | Collateral Weighted Average Maturity (Years)(C) |\\n| September 30, 2019 | 1.4 | % | 10.6 | % | 16.1 | % | 19.6 | bps | 5.1 | % | 23.0 |\\n\\n| (A) | Projected annual weighted average lifetime voluntary and involuntary prepayment rate using a prepayment vector. |\\n\\n| (B) | Mortgage servicing amount is net of 10.2 bps which represents the amount New Residential paid its servicers as a monthly servicing fee. |\\n\\n| (C) | Weighted average maturity of the underlying residential mortgage loans in the pool. |\\n\\nReal Estate and Other Securities Valuation\\nAs of September 30, 2019, New Residential’s securities valuation methodology and results are further detailed as follows:\\n| Fair Value |\\n| Asset Type | Outstanding Face Amount | Amortized Cost Basis | Multiple Quotes(A) | Single Quote(B) | Total | Level |\\n| Agency RMBS | $ | 8,797,199 | $ | 8,950,763 | $ | 8,998,066 | $ | — | $ | 8,998,066 | 2 |\\n| Non-Agency RMBS(C) | 21,845,814 | 7,175,703 | 7,853,955 | 1,889 | 7,855,844 | 3 |\\n| Total | $ | 30,643,013 | $ | 16,126,466 | $ | 16,852,021 | $ | 1,889 | $ | 16,853,910 |\\n\\n\\n| (A) | New Residential generally obtained pricing service quotations or broker quotations from two sources, one of which was generally the seller (the party that sold New Residential the security) for Non-Agency RMBS. New Residential evaluates quotes received and determines one as being most representative of fair value, and does not use an average of the quotes. Even if New Residential receives two or more quotes on a particular security that come from non-selling brokers or pricing services, it does not use an average because it believes using an actual quote more closely represents a transactable price for the security than an average level. Furthermore, in some cases, for non-agency RMBS, there is a wide disparity between the quotes New Residential receives. New Residential believes using an average of the quotes in these cases would not represent the fair value of the asset. Based on New Residential’s own fair value analysis, it selects one of the quotes which is believed to more accurately reflect fair value. New Residential has not adjusted any of the quotes received in the periods presented. These quotations are generally received via email and contain disclaimers which state that they are “indicative” and not “actionable” — meaning that the party giving the quotation is not bound to actually purchase |\\n\\n56\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nthe security at the quoted price. New Residential’s investments in Agency RMBS are classified within Level 2 of the fair value hierarchy because the market for these securities is very active and market prices are readily observable.\\nThe third-party pricing services and brokers engaged by New Residential (collectively, “valuation providers”) use either the income approach or the market approach, or a combination of the two, in arriving at their estimated valuations of RMBS. Valuation providers using the market approach generally look at prices and other relevant information generated by market transactions involving identical or comparable assets. Valuation providers using the income approach create pricing models that generally incorporate such assumptions as discount rates, expected prepayment rates, expected default rates and expected loss severities. New Residential has reviewed the methodologies utilized by its valuation providers and has found them to be consistent with GAAP requirements. In addition to obtaining multiple quotations, when available, and reviewing the valuation methodologies of its valuation providers, New Residential creates its own internal pricing models for Level 3 securities and uses the outputs of these models as part of its process of evaluating the fair value estimates it receives from its valuation providers. These models incorporate the same types of assumptions as the models used by the valuation providers, but the assumptions are developed independently. These assumptions are regularly refined and updated at least quarterly by New Residential, and reviewed by its valuation group, which is separate from its investment acquisition and management group, to reflect market developments and actual performance.\\nFor 67.0 % of New Residential’s Non-Agency RMBS, the ranges of assumptions used by New Residential’s valuation providers are summarized in the table below. The assumptions used by New Residential’s valuation providers with respect to the remainder of New Residential’s Non-Agency RMBS were not readily available.\\n| Fair Value | Discount Rate | Prepayment Rate(a) | CDR(b) | Loss Severity(c) |\\n| Non-Agency RMBS | $ | 5,262,801 | 1.03% to 27.44% | 0.5% to 23.00% | 0.25% to 7.00% | 5.0% to 100% |\\n\\n| (a) | Represents the annualized rate of the prepayments as a percentage of the total principal balance of the pool. |\\n\\n| (b) | Represents the annualized rate of the involuntary prepayments (defaults) as a percentage of the total principal balance of the pool. |\\n\\n| (c) | Represents the expected amount of future realized losses resulting from the ultimate liquidation of a particular loan, expressed as the net amount of loss relative to the outstanding balance. |\\n\\n| (B) | New Residential was unable to obtain quotations from more than one source on these securities. |\\n\\n| (C) | Includes New Residential’s investments in interest-only notes for which the fair value option for financial instruments was elected. |\\n\\nResidential Mortgage Loans Valuation\\nNew Residential, through its wholly owned subsidiary, NewRez, originates mortgage loans that it intends to sell into Fannie Mae, Freddie Mac, and Ginnie Mae mortgage backed securitizations. Residential mortgage loans held-for-sale, at fair value are typically pooled together and sold into certain exit markets, depending upon underlying attributes of the loan, such as agency eligibility, product type, interest rate, and credit quality. Residential mortgage loans held-for-sale, at fair value are valued using a market approach by utilizing either: (i) the fair value of securities backed by similar mortgage loans, adjusted for certain factors to approximate the fair value of a whole mortgage loan, (ii) current commitments to purchase loans or (iii) recent observable market trades for similar loans, adjusted for credit risk and other individual loan characteristics. As these prices are derived from market observable inputs, New Residential classifies these valuations as Level 2 in the fair value hierarchy.\\nResidential mortgage loans held-for-sale, at fair value also includes certain nonconforming mortgage loans originated for sale to private investors, which are valued using internal pricing models to forecast loan level cash flows based on a potential securitization exit using inputs such as default rates, prepayments speeds and discount rates. As the internal pricing model is based on certain unobservable inputs, New Residential classifies these valuations as Level 3 in the fair value hierarchy.\\n57\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nThe following table summarizes certain information regarding the inputs used in valuing residential mortgage loans held-for-sale, at fair value classified as Level 3:\\n| Fair Value | Discount Rate | Prepayment Rate | CDR | Loss Severity |\\n| Acquired Loans | $ | 3,916,826 | 4.20 % | 7.4 % | 1.6 % | 28.5 % |\\n| Originated Loans | 417,366 | 3.0-4.5% | 6.0-16.0% | 0.0-3.5% | 0.0% - 50.0% |\\n| Residential Mortgage Loans Held-for-Sale, at Fair Value | $ | 4,334,192 |\\n\\nResidential mortgage loans held-for-investment, at fair value includes mortgage loans underlying the SAFT 2013-1 securitization, which are valued using internal pricing models using inputs such as default rates, prepayment speeds and discount rates. As the internal pricing model is based on certain unobservable inputs, New Residential classifies these valuations as Level 3 in the fair value hierarchy.\\nThe following table summarizes certain information regarding the inputs used in valuing residential mortgage loans held-for-investment, at fair value classified as Level 3:\\n| Fair Value | Discount Rate | Prepayment Rate | CDR | Loss Severity |\\n| Residential Mortgage Loans Held-for-Investment, at Fair Value | $ | 113,133 | 3.75 % | 8.0 % | 0.5 % | 20.0 % |\\n\\nDerivative Valuation\\nNew Residential enters into economic hedges including interest rate swaps, caps and TBAs, which are categorized as Level 2 in the valuation hierarchy. New Residential generally values such derivatives using quotations, similarly to the method of valuation used for New Residential’s other assets that are classified as Level 2 in the fair value hierarchy.\\nAs a part of the mortgage loan origination business, New Residential enters into forward loan sale and securities delivery commitments, which are valued based on observed market pricing for similar instruments and therefore, are classified as Level 2. In addition, New Residential enters into IRLCs, which are valued using internal pricing models incorporating (i) market pricing for instruments with similar characteristics (ii) estimating the fair value of the servicing rights expected to be recorded at sale of the loan and (iii) adjusted for anticipated loan funding probability. Both the fair value of servicing rights expected to be recorded at the date of sale of the loan and anticipated loan funding probability are significant unobservable inputs and therefore, IRLCs are classified as Level 3 in the fair value hierarchy.\\nThe following table summarizes certain information regarding the inputs used in valuing IRLCs:\\n| Fair Value | Loan Funding Probability | Fair Value of initial servicing rights (bps) |\\n| IRLCs | $ | 24,538 | 54% to 100% | 0 to 315 |\\n\\nMortgage-Backed Securities Issued\\nNew Residential and NewRez, a wholly owned subsidiary of New Residential, were deemed to be the primary beneficiaries of the RPL Borrowers and SAFT 2013-1 securitization entity and therefore, New Residential’s condensed consolidated balance sheets include the mortgage-backed securities issued by the RPL Borrowers and SAFT 2013-1, respectively. New Residential elected the fair value option for these financial instruments and the mortgage-backed securities issued were valued consistently with New Residential’s Non-Agency RMBS described above.\\n58\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nThe following table summarizes certain information regards the inputs used in valuing Mortgage-Backed Securities Issued:\\n| Fair Value | Discount Rate | Prepayment Rate | CDR | Loss Severity |\\n| Mortgage-Backed Securities Issued | $ | 474,309 | 3.05% - 6.75% | 7% - 15% | 0.1%-3.5% | 10%-25% |\\n\\nContingent Consideration Valuation\\nNew Residential, as additional consideration for the Shellpoint Acquisition, may make up to three cash earnout payments, which will be calculated following each of the first three anniversaries of the Shellpoint Closing as a percentage of the amount by which the pre-tax income of certain of Shellpoint’s businesses exceeds certain specified thresholds, up to an aggregate maximum amount of $ 60.0 million (the “Shellpoint Earnout Payments”). On September 5, 2019, New Residential paid $ 10.0 million as the first of three potential earnout payments. In accordance with ASC 805, New Residential measures its contingent consideration at fair value on a recurring basis using a scenario-based method to weigh the probability of multiple outcomes to arrive at an expected payment cash flow and then discounts the expected cash flow. The inputs utilized in valuing the contingent consideration include a discount rate of 11 % and the application of probability weighting of income scenarios, which are significant unobservable inputs and therefore, contingent consideration is classified as Level 3 in the fair value hierarchy.\\nAssets and Liabilities Measured at Fair Value on a Nonrecurring Basis\\nCertain assets are measured at fair value on a nonrecurring basis; that is, they are not measured at fair value on an ongoing basis but are subject to fair value adjustments only in certain circumstances, such as when there is evidence of impairment. For residential mortgage loans held-for-sale and foreclosed real estate accounted for as REO, New Residential applies the lower of cost or fair value accounting and may be required, from time to time, to record a nonrecurring fair value adjustment.\\nAt September 30, 2019, assets measured at fair value on a nonrecurring basis were $ 1.3 billion. The $ 1.3 billion of assets include approximately $ 1,236.5 million of residential mortgage loans held-for-sale and $ 51.8 million of REO. The fair value of New Residential’s residential mortgage loans, held-for-sale is estimated based on a discounted cash flow model analysis using internal pricing models and is categorized within Level 3 of the fair value hierarchy.\\nThe following table summarizes the inputs used in valuing these residential mortgage loans as of September 30, 2019:\\n| Fair Value and Carrying Value | Discount Rate | Weighted Average Life (Years)(A) | Prepayment Rate | CDR(B) | Loss Severity(C) |\\n| Performing Loans | $ | 715,110 | 4.4 | % | 4.0 | 13.0 | % | 2.0 | % | 35.5 | % |\\n| Non-Performing Loans | 521,435 | 5.5 | % | 3.1 | 3.0 | % | 2.9 | % | 30.0 | % |\\n| Total/Weighted Average | $ | 1,236,545 | 4.9 | % | 3.6 | 8.8 | % | 2.4 | % | 33.2 | % |\\n\\n| (A) | The weighted average life is based on the expected timing of the receipt of cash flows. |\\n\\n| (B) | Represents the annualized rate of the involuntary prepayments (defaults) as a percentage of the total principal balance. |\\n\\n| (C) | Loss severity is the expected amount of future realized losses resulting from the ultimate liquidation of a particular loan, expressed as the net amount of loss relative to the outstanding loan balance. |\\n\\nThe fair value of REO is estimated using a broker’s price opinion discounted based upon New Residential’s experience with actual liquidation values and, therefore, is categorized within Level 3 of the fair value hierarchy. These discounts to the broker price opinion generally range from 10 % to 25 %, depending on the information available to the broker.\\nThe total change in the recorded value of assets for which a fair value adjustment has been included in the Condensed Consolidated Statements of Income for the nine months ended September 30, 2019 consisted of a reversal of prior valuation allowance of $ 17.0 million for residential mortgage loans, offset by $ 0.4 million increased allowance for REO.\\n59\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\n| 13. | EQUITY AND EARNINGS PER SHARE |\\n\\nEquity and Dividends\\nIn February 2019, New Residential issued 46.0 million shares of its common stock in a public offering at a price to the public of $ 16.50 per share for net proceeds of approximately $ 751.7 million. To compensate the Manager for its successful efforts in raising capital for New Residential, in connection with this offering, New Residential granted options to the Manager relating to 4.6 million shares of New Residential’s common stock at the public offering price, which had a fair value of approximately $ 3.8 million as of the grant date. The assumptions used in valuing the options were: a 2.40 % risk-free rate, a 9.30 % dividend yield, 19.26 % volatility and a 10 -year term.\\nOn July 2, 2019, in a public offering, New Residential issued 6.2 million shares of its 7.50 % Series A Fixed-to-Floating Rate Cumulative Redeemable Preferred Stock (“Preferred Series A”), par value $ 0.01 per share, with a liquidation preference of $ 25.00 per share for net proceeds of approximately $ 150.0 million. To compensate the Manager for its successful efforts in raising capital for New Residential, in connection with this offering, New Residential granted options to the Manager relating to 0.6 million shares of New Residential’s common stock at the closing price per share of common stock on the pricing date, which had a fair value of approximately $ 0.5 million as of the grant date. The assumptions used in valuing the options were: a 1.91 % risk-free rate, a 9.73 % dividend yield, 17.95 % volatility and 10 -year term.\\nOn August 15, 2019, in a public offering, New Residential issued 11.3 million shares of its 7.125 % Series B Fixed-to-Floating Rate Cumulative Redeemable Preferred Stock (“Preferred Series B”), par value $ 0.01 per share, with a liquidation preference of $ 25.00 per share for net proceeds of approximately $ 273.4 million. To compensate the Manager for its successful efforts in raising capital for New Residential, in connection with this offering, New Residential granted options to the Manager relating to 1.1 million shares of New Residential’s common stock at the closing price per share of common stock on the pricing date, which had a fair value of approximately $ 0.7 million as of the grant date. The assumptions used in valuing the options were: a 1.56 % risk-free rate, a 11.2 % dividend yield, 18.23 % volatility and 10 -year term.\\nOn September 23, 2019, New Residential’s board of directors declared a third quarter 2019 common dividend of $ 0.50 per common share or $ 207.8 million and preferred dividends of $ 0.69 per share of Preferred Series A and $ 0.45 per share of Preferred Series B, or $ 4.3 million and $ 5.0 million, respectively.\\nApproximately 2.4 million shares of New Residential’s common stock were held by Fortress, through its affiliates, at September 30, 2019.\\nOn August 20, 2019, New Residential announced that its board of directors had authorized the repurchase of up to $ 200.0 million of its common stock through December 31, 2020. Repurchases may be made from time to time through open market purchases or privately negotiated transactions, pursuant to one or more plans established pursuant to Rule 10b5-1 under the Securities Exchange Act of 1934 or by means of one or more tender offers, in each case, as permitted by securities laws and other legal requirements. The amount and timing of the purchases will depend on a number of factors including the price and availability of New Residential’s shares, trading volume, capital availability, New Residential’s performance and general economic and market conditions. No share repurchases have been made as of the date of issuance of these consolidated financial statements. The share repurchase program may be suspended or discontinued at any time.\\nOption Plan\\nAs of September 30, 2019, New Residential’s outstanding options were summarized as follows:\\n| Held by the Manager | 10,511,167 |\\n| Issued to the Manager and subsequently assigned to certain of the Manager’s employees | 2,290,749 |\\n| Issued to the independent directors | 7,000 |\\n| Total | 12,808,916 |\\n\\n60\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nThe following table summarizes New Residential’s outstanding options as of September 30, 2019. The last sales price on the New York Stock Exchange for New Residential’s common stock in the quarter ended September 30, 2019 was $ 15.68 per share.\\n| Recipient | Date ofGrant/Exercise(A) | Number of UnexercisedOptions | OptionsExercisable as ofSeptember 30, 2019 | WeightedAverageExercisePrice(B) | Intrinsic Value of Exercisable Options as ofSeptember 30, 2019(millions) |\\n| Directors | Various | 7,000 | 7,000 | $ | 13.61 | $ | — |\\n| Manager(C) | 2017 | 1,130,916 | — | 14.09 | 1.8 |\\n| Manager(C) | 2018 | 5,320,000 | 2,416,798 | 16.61 | — |\\n| Manager(C) | 2019 | 6,351,000 | 1,152,400 | 16.43 | — |\\n| Outstanding | 12,808,916 | 3,576,198 |\\n\\n\\n| (A) | Options expire on the tenth anniversary from date of grant. |\\n\\n| (B) | The exercise prices are subject to adjustment in connection with return of capital dividends. A portion of New Residential’s 2018 dividends was deemed to be a return of capital and the exercise prices were adjusted accordingly. |\\n\\n| (C) | The Manager assigned certain of its options to its employees as follows: |\\n\\n| Date of Grant to Manager | Range of ExercisePrices | Total UnexercisedInception to Date |\\n| 2017 | $ 14.09 | 1,130,916 |\\n| 2018 | $16.48 to $17.73 | 1,159,833 |\\n| Total | 2,290,749 |\\n\\nThe following table summarizes activity in New Residential’s outstanding options:\\n| Amount | Weighted Average Exercise Price |\\n| December 31, 2018 outstanding options | 8,498,138 |\\n| Options granted | 6,352,000 | $ | 16.20 |\\n| Options exercised | ( 2,041,222 | ) | $ | 13.88 |\\n| Options expired unexercised | — |\\n| September 30, 2019 outstanding options | 12,808,916 | See table above |\\n\\nIncome and Earnings Per Share\\nNew Residential is required to present both basic and diluted earnings per share (“EPS”). Basic EPS is calculated by dividing net income by the weighted average number of shares of common stock outstanding. Diluted EPS is computed by dividing net income by the weighted average number of shares of common stock outstanding plus the additional dilutive effect, if any, of common stock equivalents during each period. New Residential’s common stock equivalents are its outstanding options. During the nine months ended September 30, 2019, based on the treasury stock method, New Residential had 150,699 dilutive common stock equivalents outstanding. During the nine months ended September 30, 2018, based on the treasury stock method, New Residential had 1,463,258 dilutive common stock equivalents outstanding.\\nNoncontrolling Interests\\nNoncontrolling interests is comprised of the interests held by third parties in consolidated entities that hold New Residential’s Servicer Advance Investments (Note 6), Shelter JVs (Note 8) and Consumer Loans (Note 9).\\n| 14. | COMMITMENTS AND CONTINGENCIES |\\n\\nLitigation – New Residential is or may become, from time to time, involved in various disputes, litigation and regulatory inquiry and investigation matters that arise in the ordinary course of business. Given the inherent unpredictability of these types of proceedings, it is possible that future adverse outcomes could have a material adverse effect on its business, financial position or results of operations. New Residential is not aware of any unasserted claims that it believes are material and probable of assertion where the risk of loss is expected to be reasonably possible.\\nNew Residential is, from time to time, subject to inquiries by government entities. New Residential currently does not believe any of these inquiries would result in a material adverse effect on New Residential’s business.\\nIndemnifications – In the normal course of business, New Residential and its subsidiaries enter into contracts that contain a variety of representations and warranties and that provide general indemnifications. New Residential’s maximum exposure under these arrangements is unknown as this would involve future claims that may be made against New Residential that have not yet occurred. However, based on its experience, New Residential expects the risk of material loss to be remote.\\nCapital Commitments — As of September 30, 2019, New Residential had outstanding capital commitments related to investments in the following investment types (also refer to Note 5 for MSR investment commitments and to Note 18 for additional capital commitments entered into subsequent to September 30, 2019, if any):\\nMSRs and Servicer Advances — New Residential and, in some cases, third-party co-investors agreed to purchase future servicer advances related to certain Non-Agency mortgage loans. In addition, New Residential’s subsidiary, NRM, is generally obligated to fund future servicer advances related to the loans it is obligated to service. The actual amount of future advances purchased will be based on: (a) the credit and prepayment performance of the underlying loans, (b) the amount of advances recoverable prior to liquidation of the related collateral and (c) the percentage of the loans with respect to which no additional advance obligations are made. The actual amount of future advances is subject to significant uncertainty. See Notes 5 and 6 for information on New Residential’s investments in MSRs and Servicer Advance Investments, respectively.\\nMortgage Origination Reserves — NewRez, a wholly owned subsidiary of New Residential, originates conventional, government-insured and nonconforming residential mortgage loans for sale and securitization. The GSEs or Ginnie Mae guarantee conventional and government insured mortgage securitizations and mortgage investors issue nonconforming private label mortgage securitizations while NewRez generally retains the right to service the underlying residential mortgage loans. In connection with the transfer of loans to the GSEs or mortgage investors, NewRez makes representations and warranties regarding certain attributes of the loans and, subsequent to the sale, if it is determined that a sold loan is in breach of these representations and warranties, NewRez generally has an obligation to cure the breach. If NewRez is unable to cure the breach, the purchaser may require NewRez to repurchase the loan.\\nIn addition, for Ginnie Mae guaranteed securitizations, NewRez holds a Ginnie Mae Buy-Back Option to repurchase delinquent loans from the securitization at its discretion. While NewRez is not obligated to repurchase the delinquent loans, NewRez generally executes its option to repurchase that will result in an economic benefit. As of September 30, 2019, New Residential’s estimated liability associated with representations and warranties and Ginnie Mae repurchases was $ 9.2 million and $ 168.5 million, respectively. See Notes 5 and 8 for information on New Residential’s Ginnie Mae Buy-Back Option and mortgage origination, respectively.\\nMortgage Origination Unfunded Commitments — As of September 30, 2019, NewRez was committed to fund approximately $ 2.7 billion of mortgage loans and had forward loan sale commitments of $ 7.0 million. The forward sales are expected to close during the fourth quarter of 2019.\\nResidential Mortgage Loans — As part of its investment in residential mortgage loans, New Residential may be required to outlay capital. These capital outflows primarily consist of advance escrow and tax payments, residential maintenance and property disposition fees. The actual amount of these outflows is subject to significant uncertainty. See Note 8 for information on New Residential’s investments in residential mortgage loans.\\nConsumer Loans — The Consumer Loan Companies have invested in loans with an aggregate of $ 279.4 million of unfunded and available revolving credit privileges as of September 30, 2019. However, under the terms of these loans, requests for draws may be denied and unfunded availability may be terminated at New Residential’s discretion.\\n61\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nLeases — New Residential, through its wholly owned subsidiary, Shellpoint, has leases on office space expiring through 2025. Future commitments under non-cancelable leases are approximately $ 25.4 million.\\nEnvironmental Costs — As a residential real estate owner, through its REO, New Residential is subject to potential environmental costs. At September 30, 2019, New Residential is not aware of any environmental concerns that would have a material adverse effect on its consolidated financial position or results of operations.\\nDebt Covenants — New Residential’s debt obligations contain various customary loan covenants (Note 11).\\nCertain Tax-Related Covenants — If New Residential is treated as a successor to Drive Shack Inc. (“Drive Shack”) under applicable U.S. federal income tax rules, and if Drive Shack failed to qualify as a REIT for a taxable year ending on or before December 31, 2014, New Residential could be prohibited from electing to be a REIT. Accordingly, in the separation and distribution agreement executed in connection with New Residential’s spin-off from Drive Shack, Drive Shack (i) represented that it had no knowledge of any fact or circumstance that would cause New Residential to fail to qualify as a REIT, (ii) covenanted to use commercially reasonable efforts to cooperate with New Residential as necessary to enable New Residential to qualify for taxation as a REIT and receive customary legal opinions concerning REIT status, including providing information and representations to New Residential and its tax counsel with respect to the composition of Drive Shack’s income and assets, the composition of its stockholders, and its operation as a REIT; and (iii) covenanted to use its reasonable best efforts to maintain its REIT status for each of Drive Shack’s taxable years ending on or before December 31, 2014 (unless Drive Shack obtains an opinion from a nationally recognized tax counsel or a private letter ruling from the U.S. Internal Revenue Service (“IRS”) to the effect that Drive Shack’s failure to maintain its REIT status will not cause New Residential to fail to qualify as a REIT under the successor REIT rule referred to above). Additionally, New Residential covenanted to use its reasonable best efforts to qualify for taxation as a REIT for its taxable year ended December 31, 2013.\\n| 15. | TRANSACTIONS WITH AFFILIATES AND AFFILIATED ENTITIES |\\n\\nNew Residential is party to a Management Agreement with its Manager which provides for automatically renewing one-year terms subject to certain termination rights. The Manager’s performance is reviewed annually and the Management Agreement may be terminated by New Residential by payment of a termination fee, as defined in the Management Agreement, equal to the amount of management fees earned by the Manager during the 12 consecutive calendar months immediately preceding the termination, upon the affirmative vote of at least two-thirds of the independent directors, or by a majority vote of the holders of common stock. If the Management Agreement is terminated, the Manager may require New Residential to purchase from the Manager the right of the Manager to receive the Incentive Compensation. In exchange therefor, New Residential would be obligated to pay the Manager a cash purchase price equal to the amount of the Incentive Compensation that would be paid to the Manager if all of New Residential’s assets were sold for cash at their then current fair market value (taking into account, among other things, expected future performance of the underlying investments). Pursuant to the Management Agreement, the Manager, under the supervision of New Residential’s board of directors, formulates investment strategies, arranges for the acquisition of assets and associated financing, monitors the performance of New Residential’s assets and provides certain advisory, administrative and managerial services in connection with the operations of New Residential.\\nThe Manager is entitled to receive a management fee in an amount equal to 1.5 % per annum of New Residential’s gross equity calculated and payable monthly in arrears in cash. Gross equity is generally (i) the equity transferred by Drive Shack, formerly Newcastle Investment Corp., which was the sole stockholder of New Residential until the spin-off of New Residential completed on May 15, 2013, on the date of the spin-off, (ii) plus total net proceeds from stock offerings, plus certain capital contributions to subsidiaries, less capital distributions and repurchases of common stock.\\nIn addition, the Manager is entitled to receive annual incentive compensation in an amount equal to the product of (A) 25 % of the dollar amount by which (1) (a) New Residential’s funds from operations before the incentive compensation, excluding funds from operations from investments in the Consumer Loan Companies and any unrealized gains or losses from mark-to-market valuation changes on investments and debt (and any deferred tax impact thereof), per share of common stock, plus (b) earnings (or losses) from the Consumer Loan Companies computed on a level-yield basis (such that the loans are treated as if they qualified as loans acquired with a discount for credit quality as set forth in ASC No. 310-30, as such codification was in effect on June 30, 2013) as if the Consumer Loan Companies had been acquired at their GAAP basis on May 15, 2013, plus earnings (or losses) from equity method investees invested in Excess MSRs as if such equity method investees had not made a fair value election, plus gains (or losses) from debt restructuring and gains (or losses) from sales of property, and plus non-routine items, minus amortization of non-\\n62\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nroutine items, in each case per share of common stock, exceed (2) an amount equal to (a) the weighted average of the book value per share of the equity transferred by Drive Shack on the date of the spin-off and the prices per share of New Residential’s common stock in any offerings (adjusted for prior capital dividends or capital distributions) multiplied by (b) a simple interest rate of 10 % per annum, multiplied by (B) the weighted average number of shares of common stock outstanding. “Funds from operations” means net income (computed in accordance with GAAP), excluding gains (or losses) from debt restructuring and gains (or losses) from sales of property, plus depreciation on real estate assets, and after adjustments for unconsolidated partnerships and joint ventures. Funds from operations will be computed on an unconsolidated basis. The computation of funds from operations may be adjusted at the direction of New Residential’s independent directors based on changes in, or certain applications of, GAAP. Funds from operations is determined from the date of the spin-off and without regard to Drive Shack’s prior performance.\\nIn addition to the management fee and incentive compensation, New Residential is responsible for reimbursing the Manager for certain expenses paid by the Manager on behalf of New Residential.\\nDue to affiliates is comprised of the following amounts:\\n| September 30, 2019 | December 31, 2018 |\\n| Management fees | $ | 7,076 | $ | 5,779 |\\n| Incentive compensation | 49,265 | 94,900 |\\n| Expense reimbursements and other | 3,210 | 792 |\\n| Total | $ | 59,551 | $ | 101,471 |\\n\\nAffiliate expenses and fees were comprised of:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Management fees | $ | 20,678 | $ | 15,464 | $ | 58,261 | $ | 46,027 |\\n| Incentive compensation | 36,307 | 23,848 | 49,265 | 65,169 |\\n| Expense reimbursements(A) | 125 | 125 | 375 | 375 |\\n| Total | $ | 57,110 | $ | 39,437 | $ | 107,901 | $ | 111,571 |\\n\\n\\n| (A) | Included in General and Administrative Expenses in the Condensed Consolidated Statements of Income. |\\n\\nSee Note 4 regarding co-investments with Fortress-managed funds.\\nSee Note 13 regarding options granted to the Manager.\\n| 16. | RECLASSIFICATION FROM ACCUMULATED OTHER COMPREHENSIVE INCOME INTO NET INCOME |\\n\\nThe following table summarizes the amounts reclassified out of accumulated other comprehensive income into net income:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| Accumulated Other Comprehensive Income Components | Statement of Income Location | 2019 | 2018 | 2019 | 2018 |\\n| Reclassification of net realized (gain) loss on securities into earnings | Gain (loss) on settlement of investments, net | $ | ( 95,003 | ) | $ | 28,737 | $ | ( 201,222 | ) | $ | 66,695 |\\n| Reclassification of net realized (gain) loss on securities into earnings | Other-than-temporary impairment on securities | 5,567 | 3,889 | 21,942 | 23,190 |\\n| Total reclassifications | $ | ( 89,436 | ) | $ | 32,626 | $ | ( 179,280 | ) | $ | 89,885 |\\n\\nNew Residential did not allocate any income tax expense or benefit to any component of other comprehensive income for any period presented, as no taxable subsidiary generated other comprehensive income.\\n| 17. | INCOME TAXES |\\n\\nIncome tax expense (benefit) consists of the following:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Current: |\\n| Federal | $ | 1,198 | $ | 5,691 | $ | 785 | $ | 6,299 |\\n| State and Local | 14 | ( 263 | ) | 115 | 424 |\\n| Total Current Income Tax Expense (Benefit) | 1,212 | 5,428 | 900 | 6,723 |\\n| Deferred: |\\n| Federal | ( 5,385 | ) | ( 1,201 | ) | 14,762 | ( 12,829 | ) |\\n| State and Local | ( 1,267 | ) | ( 664 | ) | 3,318 | 149 |\\n| Total Deferred Income Tax Expense (Benefit) | ( 6,652 | ) | ( 1,865 | ) | 18,080 | ( 12,680 | ) |\\n| Total Income Tax Expense (Benefit) | $ | ( 5,440 | ) | $ | 3,563 | $ | 18,980 | $ | ( 5,957 | ) |\\n\\nNew Residential intends to qualify as a REIT for each of its tax years through December 31, 2019. A REIT is generally not subject to U.S. federal corporate income tax on that portion of its income that is distributed to stockholders if it distributes at least 90% of its REIT taxable income to its stockholders by prescribed dates and complies with various other requirements.\\n63\\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\\n| September 30, 2019 |\\n| (dollars in tables in thousands, except share data) |\\n\\nNew Residential operates various securitization vehicles and has made certain investments, particularly its investments in MSRs (Note 5), Servicer Advance Investments (Note 6) and REO (Note 8), through taxable REIT subsidiaries (“TRSs”) that are subject to regular corporate income taxes which have been provided for in the provision for income taxes, as applicable.\\nNew Residential has recorded a net deferred tax asset of approximately $ 43.4 million as of September 30, 2019 , primarily related to unrealized gains and discount accruals offset by net operating loss carry forwards.\\n| 18. | SUBSEQUENT EVENTS |\\n\\nThese financial statements include a discussion of material events that have occurred subsequent to September 30, 2019 (referred to as “subsequent events”) through the issuance of these condensed consolidated financial statements. Events subsequent to that date have not been considered in these financial statements.\\nCorporate Activities\\nOn October 1, 2019, New Residential completed its purchase of Ditech’s forward Fannie Mae, Ginnie Mae and non-agency MSRs with an aggregate UPB of approximately $ 62.0 billion as of August 31, 2019, the servicer advance receivables relating to such MSRs and other assets core to the forward origination and servicing operations. Additionally, New Residential assumed certain Ditech office spaces and added approximately 1,100 Ditech employees to support the increase in volume to its existing origination and servicing operations. The approximate purchase price at the closing was $ 1.2 billion and the acquisition was financed via financing facilities and cash on hand.\\nOn October 4, 2019, New Residential issued a securitization of approximately $ 1.73 billion UPB of reperforming residential mortgage loans for net proceeds of $ 1.67 billion.\\n64\\nITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\\nManagement’s discussion and analysis of financial condition and results of operations is intended to help the reader understand the results of operations and financial condition of New Residential. The following should be read in conjunction with the unaudited Condensed Consolidated Financial Statements and notes thereto included herein, and with “Risk Factors.”\\nGENERAL\\nNew Residential is a publicly traded REIT primarily focused on opportunistically investing in, and actively managing, investments related to residential real estate. We primarily target investments in mortgage servicing related assets and related opportunistic investments. We are externally managed by an affiliate of Fortress pursuant to the Management Agreement. Our goal is to drive strong risk-adjusted returns primarily through our investments, and our investment guidelines are purposefully broad to enable us to make investments in a wide array of assets in diverse markets, including non-real estate related assets such as consumer loans. We generally target assets that generate significant current cash flows and/or have the potential for meaningful capital appreciation.\\nOur portfolio is currently composed of mortgage servicing related assets, Non-Agency RMBS (and associated call rights), residential mortgage loans and other opportunistic investments. Our asset allocation and target assets may change over time, depending on our investment decisions in light of prevailing market conditions. The assets in our portfolio are described in more detail below under “—Our Portfolio.”\\nNew Residential, through its wholly-owned subsidiaries New Residential Mortgage LLC (“NRM”) and NewRez LLC (“NewRez”), is licensed or otherwise eligible to service residential mortgage loans in all states within the United States and the District of Columbia. NRM and NewRez perform servicing on behalf of investors, including the Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”) (collectively, Government Sponsored Enterprises or “GSEs”) and Government National Mortgage Association (“Ginnie Mae”), and on behalf of other servicers (subservicing).\\nNewRez originates, sells and securitizes conventional (conforming to the underwriting standards of Fannie Mae or Freddie Mac; collectively referred to as “Agency” loans), government-insured (Federal Housing Administration (“FHA”) and Department of Veterans Affairs (“VA”)) and non-qualified (“Non-QM”) residential mortgage loans. The GSEs or Ginnie Mae guarantee securitizations completed under their applicable policies and guidelines. New Residential generally retains the right to service the underlying residential mortgage loans sold and securitized by NRM and NewRez. NRM and NewRez are required to conduct aspects of their operations in accordance with applicable policies and guidelines published by FHA, Fannie Mae and Freddie Mac in order to maintain those approvals.\\nMARKET CONSIDERATIONS\\nDevelopments in the U.S. Housing Market\\nAs of the third quarter of 2019, the top 100 mortgage servicers serviced over 99% of the $10.9 trillion one-to-four family mortgage debt outstanding, according to Inside Mortgage Finance. Furthermore, according to Inside Mortgage Finance, as of the third quarter of 2019, approximately 66% of such outstanding mortgage debt was serviced by the top 25 mortgage servicers, of which 15 are non-banks. Given current market dynamics and an overall competitive servicing environment, we may expect additional market consolidation among non-bank servicers. As a result, we believe additional MSR sales will be likely for some period of time. These factors have resulted in increased opportunities for us to acquire interests in MSRs and to provide capital to non-bank servicers. In addition, approximately $1.64 trillion of new loans were originated in 2018 and another $1.86 trillion are forecasted for 2019, according to the Mortgage Bankers Association. We believe this creates an opportunity to enter into “flow arrangements,” whereby loan originators or servicers agree to sell MSRs or Excess MSRs on newly originated loans on a recurring basis (often monthly or quarterly). Recently, strong demand for mortgage assets in general has led to tighter spreads and lower required rates of return. This, in turn, creates a reach for yield and increased difficulty in sourcing accretive investments in the current investment landscape. These market conditions have driven prices higher, thereby also increasing the value of certain of our existing investments.\\nInterest Rates and Prepayment Rates\\nAs further described in “Quantitative and Qualitative Disclosures About Market Risk,” decreasing interest rates are generally associated with increasing prepayment rates for residential mortgage loans since they decrease the cost of borrowing for homeowners. Increasing prepayment rates, in turn, would generally be expected to decrease the value of our interests in Excess MSRs, MSRs and Servicer Advance Investments, which include the right to a portion of the related MSRs, because the duration\\n65\\nof the cash flows we are entitled to receive decreases and results in a reduction in current cash flows. Changes in interest rates will also directly impact our costs of borrowing either immediately (floating rate debt) or upon refinancing (fixed rate debt) and may also be associated with changes in credit spreads and/or the discount rates used in valuing investments. Increasing prepayment rates have a positive impact on the value of investments purchased at a significant discount since the recovery of that discount is accelerated.\\nIn the third quarter of 2019, given mixed economic data, the Federal Reserve lowered borrowing costs twice and signaled that future rate cuts in 2019 were a possibility resulting in current interest rates moving lower, with the 10-year Treasury declining 34 bps during the quarter, to 1.67% as of September 30, 2019 from 2.01% as of June 30, 2019, and LIBOR declining 38 bps during the quarter to 2.01% as of September 30, 2019 from 2.39% as of June 30, 2019. Meanwhile, the primary mortgage rate decreased 11 bps during the quarter to 3.718% as of September 30, 2019 from 3.824% as of June 30, 2019. With respect to our Non-Agency RMBS, which are generally purchased at a significant discount to par, market interest rates decreased and market credit spreads increased, with the net result being a decrease in value of these investments during the quarter.\\nThe value of our MSRs and Excess MSRs is subject to a variety of factors, as described in “Quantitative and Qualitative Disclosures About Market Risk” and in “Risk Factors.” In the third quarter of 2019, the fair value of our direct investments in Excess MSRs and our share of the fair value of the Excess MSRs held through equity method investees increased by approximately $3.2 million in the aggregate, primarily as a result of a decrease in discount rates. In addition, faster prepayment speeds partially offset by lower discount rates caused the fair value of our MSRs, including MSR financing receivables, to decrease by approximately $48.9 million during the period.\\nChanges in interest rates did not have a meaningful impact on the net interest spread of our Agency and Non-Agency RMBS portfolios. Our RMBS are primarily floating rate or hybrid (i.e., fixed to floating rate) securities, which we generally finance with floating rate debt, or are economically hedged with respect to interest rates. Therefore, while decreasing interest rates will generally result in a lower cost of financing, they will also result in a lower coupon payable on the securities. The net interest spread on our Agency RMBS portfolio as of September 30, 2019 was 0.75%, compared to 0.55% as of June 30, 2019. The spread changed primarily as a result of increased funding costs. The net interest spread on our Non-Agency RMBS portfolio as of September 30, 2019 was 1.76%, compared to 1.61% as of June 30, 2019. This spread changed primarily as a result of lower funding costs.\\nWe employ a variety of hedging strategies to reduce book value volatility. Both our diverse portfolio composition (inclusive of long and short duration instruments and various operating businesses) as well as specific hedging instruments (including Agency MBS, interest rate swaps etc.) mitigate book value volatility.\\nGeneral U.S. Economy and Unemployment\\nDuring the third quarter of 2019, the U.S. unemployment rate continued to decline slightly to 3.5% as of September 30, 2019, signaling a general improvement in the U.S. economy. In our view, an improvement in the economy, as demonstrated through such measure, generally improves the value of housing and the ability of borrowers to make payments on their loans, thereby decreasing delinquencies and defaults on residential mortgage loans, consumer loans and RMBS. This relationship generally held true, however, the third quarter of 2019 continued to show certain indications that the rate of home price increases across the U.S. has slowed. The Case Shiller U.S. National Home Price Index reported a 2.0% annual gain in July 2019, down from 4.3% in January 2019. In addition, according to CoreLogic, the total number of mortgaged residential properties with negative equity stood at 2.0 million, or 3.8%, as of the second quarter of 2019, down from 3.8% in the first quarter of 2019 and on a year-over-year basis, the number of mortgaged properties in negative equity fell 9.0%. While potentially slowing, this trend continues to help support the values of our residential mortgage loans, consumer loans and RMBS.\\nCredit Spreads\\nCorporate credit spreads, which generally have an impact on the value of yield driven financial instruments (e.g., RMBS and loan portfolios), continued to tighten during the third quarter of 2019. In addition, collateral performance, market liquidity, mortgage credit spreads and other factors related specifically to certain investments within our mortgage securities and loan portfolio caused an increase to the value of the portion of this portfolio that was owned for the entire quarter.\\nFor more information regarding these and other market factors which impact our portfolio, see Item 3. “Quantitative and Qualitative Disclosures About Market Risk.”\\n66\\nOur Manager\\nOn December 27, 2017, SoftBank Group Corp. (“SoftBank”) announced that it completed its previously announced acquisition of Fortress (the “SoftBank Merger”). In connection with the SoftBank Merger, Fortress operates within SoftBank as an independent business headquartered in New York.\\nOUR PORTFOLIO\\nOur portfolio is currently composed of mortgage servicing related assets, residential securities and loans and other investments, as described in more detail below. The assets in our portfolio are described in more detail below (dollars in thousands), as of September 30, 2019.\\n| OutstandingFace Amount | AmortizedCost Basis | Percentage of Total Amortized Cost Basis | CarryingValue | WeightedAverageLife (years)(A) |\\n| Investments in: |\\n| Excess MSRs(B) | $ | 128,657,619 | $ | 398,488 | 1.3 | % | $ | 530,323 | 5.7 |\\n| MSRs(B) | 319,927,285 | 3,364,140 | 11.2 | % | 3,431,968 | 4.8 |\\n| MSR Financing Receivables(B) (C) | 140,523,235 | 1,500,229 | 5.0 | % | 1,811,261 | 6.2 |\\n| Servicer Advance Investments(B) (D) | 492,480 | 570,570 | 1.7 | % | 600,547 | 6.3 |\\n| Agency RMBS(E) | 8,797,199 | 8,950,763 | 29.9 | % | 8,998,066 | 4.6 |\\n| Non-Agency RMBS(E) | 21,845,814 | 7,175,703 | 24.1 | % | 7,855,844 | 6.3 |\\n| Residential Mortgage Loans | 7,404,432 | 7,067,812 | 23.7 | % | 7,169,905 | 10.0 |\\n| Consumer Loans | 878,431 | 884,587 | 3.1 | % | 881,183 | 3.9 |\\n| Total/Weighted Average | $ | 29,912,292 | 100.0 | % | $ | 31,279,097 | 6.4 |\\n| Reconciliation to GAAP total assets: |\\n| Cash and restricted cash | 901,367 |\\n| Servicer advances receivable | 2,911,798 |\\n| Trades receivable | 4,487,772 |\\n| Deferred tax asset, net | 43,372 |\\n| Other assets | 1,724,519 |\\n| GAAP total assets | $ | 41,347,925 |\\n\\n\\n| (A) | Weighted average life is based on the timing of expected principal reduction on the asset. |\\n\\n| (B) | The outstanding face amount of Excess MSRs, MSRs, MSR Financing Receivables, and Servicer Advance Investments is based on 100% of the face amount of the underlying residential mortgage loans and currently outstanding advances, as applicable. |\\n\\n| (C) | Includes certain MSRs where our subsidiary, NRM, is the named servicer. |\\n\\n| (D) | The value of our Servicer Advance Investments also includes the rights to a portion of the related MSR. |\\n\\n| (E) | Amortized cost basis is net of impairment. |\\n\\nServicing Related Assets\\nMSRs and MSR Financing Receivables\\nAs of September 30, 2019, we had $5.2 billion carrying value of MSRs and mortgage servicing rights financing receivables within our servicer subsidiary, NRM.\\nNRM has contracted with certain subservicers to perform the related servicing duties on the residential mortgage loans underlying its MSRs. As of September 30, 2019, these subservicers include PHH, Nationstar, LoanCare, AmeriHome, and Flagstar, which subservice 26.9%, 23.1%, 19.2%, 1.8%, and 0.8% of the underlying UPB of the related mortgages, respectively (includes both Mortgage Servicing Rights and MSR Financing Receivables). The remaining 28.2% of the underlying UPB of the related mortgages is subserviced by our subsidiary, Shellpoint Mortgage Servicing (Note 1 to our Condensed Consolidated Financial Statements).\\n67\\nNRM has entered into agreements with PHH, LoanCare, Flagstar, and Nationstar whereby NRM is entitled to the MSR on any refinancing by such subservicer of a loan in the related original portfolio.\\nThe table below summarizes our investments in MSRs and mortgage servicing rights financing receivables as of September 30, 2019.\\n| Current UPB (bn) | Weighted Average MSR (bps) | Carrying Value (mm) |\\n| Mortgage Servicing Rights |\\n| Agency | $ | 288.7 | 27 | bps | $ | 3,038.7 |\\n| Non-Agency | 2.3 | 26 | 20.3 |\\n| Ginnie Mae | 28.9 | 32 | 372.9 |\\n| MSR Financing Receivables |\\n| Agency | 61.2 | 27 | 598.0 |\\n| Non-Agency | 79.4 | 47 | 1,213.3 |\\n| Total | $ | 460.5 | 31 | bps | $ | 5,243.2 |\\n\\nThe following table summarizes the collateral characteristics of the loans underlying our investments in MSRs and mortgage servicing rights financing receivables as of September 30, 2019 (dollars in thousands):\\n| Collateral Characteristics |\\n| Current Carrying Amount | Current Principal Balance | Number of Loans | WA FICO Score(A) | WA Coupon | WA Maturity (months) | Average Loan Age (months) | Adjustable Rate Mortgage %(B) | Three Month Average CPR(C) | Three Month Average CRR(D) | Three Month Average CDR(E) | Three Month Average Recapture Rate |\\n| Mortgage Servicing Rights |\\n| Agency | $ | 3,038,721 | $ | 288,673,487 | 1,820,794 | 749 | 4.3 | % | 263 | 66 | 2.8 | % | 14.6 | % | 14.4 | % | 0.2 | % | 10.1 | % |\\n| Non-Agency | 20,321 | 2,350,471 | 5,656 | 743 | 4.0 | % | 308 | 34 | 3.8 | % | 14.1 | % | 14.1 | % | — | % | 5.8 | % |\\n| Ginnie Mae | 372,926 | 28,903,327 | 137,168 | 681 | 3.8 | % | 319 | 36 | 5.6 | % | 17.6 | % | 17.0 | % | 0.7 | % | 24.1 | % |\\n| MSR Financing Receivables |\\n| Agency | 597,990 | 61,162,569 | 249,339 | 749 | 4.4 | % | 305 | 26 | 1.1 | % | 30.8 | % | 30.8 | % | — | % | 1.8 | % |\\n| Non-Agency | 1,213,271 | 79,360,666 | 577,024 | 645 | 4.5 | % | 306 | 164 | 16.1 | % | 9.9 | % | 8.0 | % | 1.9 | % | 0.5 | % |\\n| Total | $ | 5,243,229 | $ | 460,450,520 | 2,789,981 | 727 | 4.3 | % | 280 | 76 | 5.1 | % | 16.1 | % | 15.6 | % | 0.5 | % | 8.2 | % |\\n\\n| Collateral Characteristics |\\n| Delinquency 30 Days(F) | Delinquency 60 Days(F) | Delinquency 90+ Days(F) | Loans in Foreclosure | Real Estate Owned | Loans in Bankruptcy |\\n| Mortgage Servicing Rights |\\n| Agency | 1.5 | % | 0.3 | % | 0.4 | % | 0.3 | % | — | % | 0.3 | % |\\n| Non-Agency | 0.4 | % | 0.1 | % | 0.1 | % | 0.3 | % | 0.1 | % | 0.1 | % |\\n| Ginnie Mae | 4.1 | % | 1.2 | % | 1.1 | % | 1.4 | % | 0.1 | % | 1.2 | % |\\n| MSR Financing Receivables |\\n| Agency | 1.6 | % | 0.1 | % | 0.1 | % | — | % | — | % | 0.1 | % |\\n| Non-Agency | 9.5 | % | 4.9 | % | 4.2 | % | 7.7 | % | 1.9 | % | 2.9 | % |\\n| Total | 3.1 | % | 1.1 | % | 1.1 | % | 1.6 | % | 0.3 | % | 0.8 | % |\\n\\n| (A) | The WA FICO score is based on the weighted average of information provided by the loan servicer on a monthly basis. The loan servicer generally updates the FICO score when loans are refinanced or become delinquent. |\\n\\n| (B) | Adjustable Rate Mortgage % represents the percentage of the total principal balance of the pool that corresponds to adjustable rate mortgages. |\\n\\n| (C) | Three Month Average CPR, or the constant prepayment rate, represents the annualized rate of the prepayments during the quarter as a percentage of the total principal balance of the pool. |\\n\\n| (D) | Three Month Average CRR, or the voluntary prepayment rate, represents the annualized rate of the voluntary prepayments during the quarter as a percentage of the total principal balance of the pool. |\\n\\n| (E) | Three Month Average CDR, or the involuntary prepayment rate, represents the annualized rate of the involuntary prepayments (defaults) during the quarter as a percentage of the total principal balance of the pool. |\\n\\n68\\n| (F) | Delinquency 30 Days, Delinquency 60 Days and Delinquency 90+ Days represent the percentage of the total principal balance of the pool that corresponds to loans that are delinquent by 30–59 days, 60–89 days or 90 or more days, respectively. |\\n\\nExcess MSRs\\nThe tables below summarize the terms of our investments in Excess MSRs completed as of September 30, 2019.\\nSummary of Direct Excess MSR Investments as of September 30, 2019\\n| MSR Component(A) | Excess MSR |\\n| Current UPB (bn) | Weighted Average MSR (bps) | Weighted Average Excess MSR (bps) | Interest in Excess MSR (%) | Carrying Value (mm) |\\n| Agency | $ | 45.9 | 29 | bps | 21 | bps | 32.5% - 66.7% | $ | 221.6 |\\n| Non-Agency(B) | 47.1 | 35 | 15 | 33.3% - 100.0% | $ | 176.5 |\\n| Total/Weighted Average | $ | 93.0 | 32 | bps | 18 | bps | $ | 398.1 |\\n\\n\\n| (A) | The MSR is a weighted average as of September 30, 2019, and the Excess MSR represents the difference between the weighted average MSR and the basic fee (which fee remains constant). |\\n\\n| (B) | Serviced by Nationstar and SLS, we also invested in related Servicer Advance Investments, including the basic fee component of the related MSR (Note 6 to our Condensed Consolidated Financial Statements) on $33.4 billion UPB underlying these Excess MSRs. |\\n\\nSummary of Excess MSR Investments Through Equity Method Investees as of September 30, 2019\\n| MSR Component(A) |\\n| Current UPB (bn) | Weighted Average MSR (bps) | Weighted Average Excess MSR (bps) | New Residential Interest in Investee (%) | Investee Interest in Excess MSR (%) | New Residential Effective Ownership (%) | Investee Carrying Value (mm) |\\n| Agency | $ | 35.6 | 33 | bps | 21 | bps | 50.0 | % | 66.7 | % | 33.3 | % | $ | 236.8 |\\n\\n\\n| (A) | The MSR is a weighted average as of September 30, 2019, and the Excess MSR represents the difference between the weighted average MSR and the basic fee (which fee remains constant). |\\n\\nThe following table summarizes the collateral characteristics of the loans underlying our direct Excess MSR investments as of September 30, 2019 (dollars in thousands):\\n| Collateral Characteristics |\\n| Current Carrying Amount | Current Principal Balance | Number of Loans | WA FICO Score(A) | WA Coupon | WA Maturity (months) | Average Loan Age (months) | Adjustable Rate Mortgage %(B) | Three Month Average CPR(C) | Three Month Average CRR(D) | Three Month Average CDR(E) | Three Month Average Recapture Rate |\\n| Agency |\\n| Original Pools | $ | 168,463 | $ | 33,627,899 | 242,096 | 723 | 4.7 | % | 247 | 115 | 1.9 | % | 13.2 | % | 12.7 | % | 0.6 | % | 11.6 | % |\\n| Recaptured Loans | 53,097 | 12,272,755 | 73,762 | 725 | 4.4 | % | 278 | 42 | 0.1 | % | 13.0 | % | 12.6 | % | 0.5 | % | 29.1 | % |\\n| $ | 221,560 | $ | 45,900,654 | 315,858 | 724 | 4.6 | % | 256 | 93 | 1.5 | % | 13.2 | % | 12.6 | % | 0.6 | % | 16.2 | % |\\n| Non-Agency(F) |\\n| Nationstar and SLS Serviced: |\\n| Original Pools | $ | 153,927 | $ | 43,127,383 | 242,478 | 672 | 4.8 | % | 281 | 162 | 10.1 | % | 14.4 | % | 11.6 | % | 3.2 | % | 8.8 | % |\\n| Recaptured Loans | 22,577 | 3,997,153 | 18,203 | 739 | 4.3 | % | 285 | 29 | 0.1 | % | 13.2 | % | 13.2 | % | — | % | 25.5 | % |\\n| $ | 176,504 | $ | 47,124,536 | 260,681 | 678 | 4.7 | % | 281 | 151 | 8.8 | % | 14.3 | % | 11.7 | % | 2.9 | % | 10.2 | % |\\n| Total/Weighted Average(H) | $ | 398,064 | $ | 93,025,190 | 576,539 | 700 | 4.7 | % | 269 | 124 | 4.7 | % | 13.8 | % | 12.2 | % | 1.8 | % | 13.2 | % |\\n\\n69\\n| Collateral Characteristics |\\n| Delinquency 30 Days(G) | Delinquency 60 Days(G) | Delinquency 90+ Days(G) | Loans inForeclosure | RealEstateOwned | Loans inBankruptcy |\\n| Agency |\\n| Original Pools | 2.9 | % | 0.9 | % | 0.6 | % | 0.6 | % | 0.2 | % | 0.2 | % |\\n| Recaptured Loans | 1.8 | % | 0.4 | % | 0.4 | % | 0.2 | % | 0.1 | % | — | % |\\n| 2.6 | % | 0.7 | % | 0.5 | % | 0.5 | % | 0.2 | % | 0.1 | % |\\n| Non-Agency(F) |\\n| Nationstar and SLS Serviced: |\\n| Original Pools | 10.8 | % | 3.2 | % | 2.3 | % | 5.4 | % | 1.1 | % | 2.0 | % |\\n| Recaptured Loans | 1.5 | % | 0.3 | % | 0.1 | % | — | % | — | % | — | % |\\n| 10.0 | % | 3.0 | % | 2.1 | % | 4.9 | % | 1.0 | % | 1.8 | % |\\n| Total/Weighted Average(H) | 6.5 | % | 1.9 | % | 1.4 | % | 2.8 | % | 0.6 | % | 1.0 | % |\\n\\n\\n| (A) | The WA FICO score is based on the weighted average of information provided by the loan servicer on a monthly basis. The loan servicer generally updates the FICO score when loans are refinanced or become delinquent. |\\n\\n| (B) | Adjustable Rate Mortgage % represents the percentage of the total principal balance of the pool that corresponds to adjustable rate mortgages. |\\n\\n| (C) | Three Month Average CPR, or the constant prepayment rate, represents the annualized rate of the prepayments during the quarter as a percentage of the total principal balance of the pool. |\\n\\n| (D) | Three Month Average CRR, or the voluntary prepayment rate, represents the annualized rate of the voluntary prepayments during the quarter as a percentage of the total principal balance of the pool. |\\n\\n| (E) | Three Month Average CDR, or the involuntary prepayment rate, represents the annualized rate of the involuntary prepayments (defaults) during the quarter as a percentage of the total principal balance of the pool. |\\n\\n| (F) | We also invested in related Servicer Advance Investments, including the basic fee component of the related MSR (Note 6 to our Condensed Consolidated Financial Statements) on $33.4 billion UPB underlying these Excess MSRs. |\\n\\n| (G) | Delinquency 30 Days, Delinquency 60 Days and Delinquency 90+ Days represent the percentage of the total principal balance of the pool that corresponds to loans that are delinquent by 30–59 days, 60–89 days or 90 or more days, respectively. |\\n\\n| (H) | Weighted averages exclude collateral information for which collateral data was not available as of the report date. |\\n\\nThe following table summarizes the collateral characteristics as of September 30, 2019 of the loans underlying Excess MSR investments made through joint ventures accounted for as equity method investees (dollars in thousands). For each of these pools, we own a 50% interest in an entity that invested in a 66.7% interest in the Excess MSRs.\\n| Collateral Characteristics |\\n| Current Carrying Amount | CurrentPrincipal Balance | New Residential Effective Ownership(%) | Numberof Loans | WA FICO Score(A) | WA Coupon | WA Maturity (months) | Average LoanAge (months) | Adjustable Rate Mortgage %(B) | Three Month Average CPR(C) | Three Month Average CRR(D) | Three Month Average CDR(E) | Three Month Average Recapture Rate |\\n| Agency |\\n| Original Pools | $ | 148,573 | $ | 21,303,865 | 33.3 | % | 216,012 | 703 | 5.2 | % | 239 | 134 | 1.5 | % | 14.4 | % | 13.3 | % | 1.3 | % | 16.8 | % |\\n| Recaptured Loans | 88,213 | 14,328,564 | 33.3 | % | 102,067 | 710 | 4.3 | % | 272 | 49 | 0.1 | % | 12.7 | % | 11.8 | % | 1.0 | % | 35.6 | % |\\n| Total/Weighted Average(G) | $ | 236,786 | $ | 35,632,429 | 318,079 | 706 | 4.9 | % | 252 | 101 | 1.5 | % | 13.7 | % | 12.7 | % | 1.2 | % | 24.2 | % |\\n\\n| Collateral Characteristics |\\n| Delinquency 30 Days(F) | Delinquency 60 Days(F) | Delinquency 90+ Days(F) | Loans inForeclosure | RealEstateOwned | Loans inBankruptcy |\\n| Agency |\\n| Original Pools | 4.2 | % | 1.3 | % | 0.7 | % | 0.9 | % | 0.3 | % | 0.3 | % |\\n| Recaptured Loans | 2.9 | % | 0.9 | % | 0.4 | % | 0.3 | % | 0.1 | % | 0.1 | % |\\n| Total/Weighted Average(G) | 3.7 | % | 1.1 | % | 0.6 | % | 0.7 | % | 0.2 | % | 0.2 | % |\\n\\n\\n| (A) | The WA FICO score is based on the weighted average of information provided by the loan servicer on a monthly basis. The loan servicer generally updates the FICO score on a monthly basis. |\\n\\n70\\n| (B) | Adjustable Rate Mortgage % represents the percentage of the total principal balance of the pool that corresponds to adjustable rate mortgages. |\\n\\n| (C) | Three Month Average CPR, or the constant prepayment rate, represents the annualized rate of the prepayments during the quarter as a percentage of the total principal balance of the pool. |\\n\\n| (D) | Three Month Average CRR, or the voluntary prepayment rate, represents the annualized rate of the voluntary prepayments during the quarter as a percentage of the total principal balance of the pool. |\\n\\n| (E) | Three Month Average CDR, or the involuntary prepayment rate, represents the annualized rate of the involuntary prepayments (defaults) during the quarter as a percentage of the total principal balance of the pool. |\\n\\n| (F) | Delinquency 30 Days, Delinquency 60 Days and Delinquency 90+ Days represent the percentage of the total principal balance of the pool that corresponds to loans that are delinquent by 30-59 days, 60-89 days or 90 or more days, respectively. |\\n\\n| (G) | Weighted averages exclude collateral information for which collateral data was not available as of the report date. |\\n\\nServicer Advance Investments\\nThe following is a summary of our Servicer Advance Investments, including the right to the basic fee component of the related MSRs (dollars in thousands):\\n| September 30, 2019 |\\n| Amortized Cost Basis | Carrying Value(A) | UPB of Underlying Residential Mortgage Loans | Outstanding Servicer Advances | Servicer Advances to UPB of Underlying Residential Mortgage Loans |\\n| Servicer Advance Investments |\\n| Nationstar and SLS serviced pools | $ | 570,570 | $ | 600,547 | $ | 33,406,320 | $ | 492,480 | 1.5 | % |\\n\\n\\n| (A) | Carrying value represents the fair value of the Servicer Advance Investments, including the basic fee component of the related MSRs. |\\n\\nThe following is additional information regarding our Servicer Advance Investments, and related financing, as of and for the nine months ended, September 30, 2019 (dollars in thousands):\\n| Nine Months Ended September 30, 2019 | Loan-to-Value (“LTV”)(A) | Cost of Funds(B) |\\n| Weighted Average Discount Rate | Weighted Average Life (Years)(C) | Change in Fair Value Recorded in Other Income | Face Amount of Notes and Bonds Payable | Gross | Net(D) | Gross | Net |\\n| Servicer Advance Investments(E) | 5.1 | % | 6.3 | $ | 15,932 | $ | 449,731 | 87.3 | % | 86.1 | % | 3.8 | % | 3.1 | % |\\n\\n\\n| (A) | Based on outstanding servicer advances, excluding purchased but unsettled servicer advances. |\\n\\n| (B) | Annualized measure of the cost associated with borrowings. Gross Cost of Funds primarily includes interest expense and facility fees. Net Cost of Funds excludes facility fees. |\\n\\n| (C) | Weighted Average Life represents the weighted average expected timing of the receipt of expected net cash flows for this investment. |\\n\\n| (D) | Ratio of face amount of borrowings to par amount of servicer advance collateral, net of any general reserve. |\\n\\n| (E) | The following types of advances are included in Servicer Advance Investments: |\\n\\n| September 30, 2019 |\\n| Principal and interest advances | $ | 82,999 |\\n| Escrow advances (taxes and insurance advances) | 185,774 |\\n| Foreclosure advances | 223,707 |\\n| Total | $ | 492,480 |\\n\\nA discussion of the sensitivity of these incentive fees to changes in LIBOR is included below under “Quantitative and Qualitative Disclosures About Market Risk.”\\n71\\nOriginations\\nNewRez, our wholly owned subsidiary, originates conventional, government-insured and nonconforming residential mortgage loans for sale and securitization. The GSEs or Ginnie Mae guarantee conventional and government insured mortgage securitizations and mortgage investors issue Nonconforming private label mortgage securitizations while NewRez generally retains the right to service the underlying residential mortgage loans. In connection with the transfer of loans to the GSEs or mortgage investors, we report gain on sale of originated mortgage loans, net in our condensed consolidated statements of income.\\nDuring the third quarter of 2019, NewRez increased loan origination volume to $5.7 billion, which is a 49% increase quarter over quarter and approximately 200% increase year over year. Gain on sale of originated mortgage loans, net is summarized below:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Gain on loans originated and sold(A) | $ | 24,312 | $ | 24,684 | $ | 36,413 | $ | 24,684 |\\n| Gain (loss) on settlement of mortgage loan origination derivative instruments(B) | (32,138 | ) | (2,757 | ) | (61,879 | ) | (2,757 | ) |\\n| MSRs retained on transfer of loans(C) | 96,317 | 17,282 | 190,666 | 17,282 |\\n| Other(D) | 12,050 | 6,523 | 28,829 | 6,523 |\\n| Gain on sale of originated mortgage loans, net | $ | 100,541 | $ | 45,732 | $ | 194,029 | $ | 45,732 |\\n\\n| (A) | Includes loan origination fees and direct loan origination costs. Other indirect costs related to loan origination are included within general and administrative expenses. |\\n\\n| (B) | Represents settlement of forward securities delivery commitments utilized as an economic hedge for mortgage loans not included within forward loan sale commitments. |\\n\\n| (C) | Represents the initial fair value of the capitalized mortgage servicing rights upon loan sales with servicing retained. |\\n\\n| (D) | Includes fees for services associated with the loan origination process. |\\n\\nResidential Securities and Loans\\nReal Estate Securities\\nAgency RMBS\\nThe following table summarizes our Agency RMBS portfolio as of September 30, 2019 (dollars in thousands):\\n| Gross Unrealized |\\n| Asset Type | Outstanding Face Amount | Amortized Cost Basis | Percentage of Total Amortized Cost Basis | Gains | Losses | CarryingValue(A) | Count | Weighted Average Life (Years) | 3-Month CPR | Outstanding Repurchase Agreements |\\n| Agency Specified Pools | $ | 8,797,199 | $ | 8,950,763 | 100.0 | % | $ | 56,939 | $ | (9,636 | ) | $ | 8,998,066 | 39 | 4.6 | 0.3 | % | $ | 7,300,198 |\\n\\n\\n| (A) | Fair value, which is equal to carrying value for all securities. |\\n\\nThe following table summarizes the net interest spread of our Agency RMBS portfolio as of September 30, 2019:\\n| Net Interest Spread(A) |\\n| Weighted Average Asset Yield | 3.06 | % |\\n| Weighted Average Funding Cost | 2.31 | % |\\n| Net Interest Spread | 0.75 | % |\\n\\n\\n| (A) | The Agency RMBS portfolio consists of 100.0% fixed rate securities (based on amortized cost basis). |\\n\\n72\\nNon-Agency RMBS\\nThe following table summarizes our Non-Agency RMBS portfolio as of September 30, 2019 (dollars in thousands):\\n| Gross Unrealized |\\n| Asset Type | Outstanding Face Amount | Amortized Cost Basis | Gains | Losses | CarryingValue(A) | Outstanding Repurchase Agreements |\\n| Non-Agency RMBS | $ | 21,845,814 | $ | 7,175,703 | $ | 711,078 | $ | (30,937 | ) | $ | 7,855,844 | $ | 7,142,351 |\\n\\n\\n| (A) | Fair value, which is equal to carrying value for all securities. |\\n\\nThe following tables summarize the characteristics of our Non-Agency RMBS portfolio and of the collateral underlying our Non-Agency RMBS as of September 30, 2019 (dollars in thousands):\\n| Non-Agency RMBS Characteristics(A) |\\n| Vintage(B) | Average Minimum Rating(C) | Number of Securities | Outstanding Face Amount | Amortized Cost Basis | Percentage of Total Amortized Cost Basis | Carrying Value | Principal Subordination(D) | Excess Spread(E) | Weighted Average Life (Years) | Weighted Average Coupon(F) |\\n| Pre 2006 | CCC- | 365 | $ | 1,956,007 | $ | 1,487,306 | 21.1 | % | $ | 1,663,069 | 14.2 | % | 0.8 | % | 6.8 | 3.4 | % |\\n| 2006 | CC | 133 | 2,774,332 | 1,746,860 | 24.7 | % | 1,979,226 | 7.1 | % | 1.2 | % | 7.6 | 2.3 | % |\\n| 2007 | CCC- | 82 | 2,224,528 | 1,348,788 | 19.1 | % | 1,520,709 | 5.2 | % | 0.9 | % | 7.1 | 2.5 | % |\\n| 2008 and later | BBB | 363 | 14,775,002 | 2,477,759 | 35.1 | % | 2,589,370 | 14.0 | % | 0.1 | % | 4.8 | 3.5 | % |\\n| Total/Weighted Average | B- | 943 | $ | 21,729,869 | $ | 7,060,713 | 100.0 | % | $ | 7,752,374 | 10.5 | % | 0.7 | % | 6.3 | 3.0 | % |\\n\\n\\n| Collateral Characteristics(A) (G) |\\n| Vintage(B) | Average Loan Age (years) | Collateral Factor(H) | 3-Month CPR(I) | Delinquency(J) | Cumulative Losses to Date |\\n| Pre 2006 | 14.8 | 0.07 | 9.7 | % | 10.8 | % | 13.0 | % |\\n| 2006 | 13.4 | 0.12 | 10.0 | % | 10.6 | % | 32.2 | % |\\n| 2007 | 12.6 | 0.22 | 11.2 | % | 10.6 | % | 36.7 | % |\\n| 2008 and later | 8.5 | 0.79 | 18.9 | % | 1.7 | % | 0.5 | % |\\n| Total/Weighted Average | 11.8 | 0.36 | 13.3 | % | 7.5 | % | 17.9 | % |\\n\\n\\n| (A) | Excludes $30.9 million face amount of bonds backed by consumer loans and $85.0 million face amount of bonds backed by corporate debt. |\\n\\n| (B) | The year in which the securities were issued. |\\n\\n| (C) | Ratings provided above were determined by third party rating agencies, represent the most recent credit ratings available as of the reporting date and may not be current. This excludes the ratings of the collateral underlying 312 bonds with a carrying value of $1,064.1 million, which either have never been rated or for which rating information is no longer provided. We had no assets that were on negative watch for possible downgrade by at least one rating agency as of September 30, 2019. |\\n\\n| (D) | The percentage of amortized cost basis of securities and residual interests that is subordinate to our investments. This excludes interest-only bonds. |\\n\\n| (E) | The current amount of interest received on the underlying loans in excess of the interest paid on the securities, as a percentage of the outstanding collateral balance for the quarter ended September 30, 2019. |\\n\\n| (F) | Excludes residual bonds, and certain other Non-Agency bonds, with a carrying value of $225.2 million and $3.5 million, respectively, for which no coupon payment is expected. |\\n\\n| (G) | The weighted average loan size of the underlying collateral is $204.0 thousand. |\\n\\n| (H) | The ratio of original UPB of loans still outstanding. |\\n\\n| (I) | Three month average constant prepayment rate and default rates. |\\n\\n| (J) | The percentage of underlying loans that are 90+ days delinquent, or in foreclosure or considered REO. |\\n\\n73\\nThe following table summarizes the net interest spread of our Non-Agency RMBS portfolio as of September 30, 2019:\\n| Net Interest Spread(A) |\\n| Weighted Average Asset Yield | 4.84 | % |\\n| Weighted Average Funding Cost | 3.08 | % |\\n| Net Interest Spread | 1.76 | % |\\n\\n\\n| (A) | The Non-Agency RMBS portfolio consists of 68.6% floating rate securities and 31.4% fixed rate securities (based on amortized cost basis). |\\n\\nCall Rights\\nWe hold a limited right to cleanup call options with respect to certain securitization trusts serviced or master serviced by Nationstar whereby, when the UPB of the underlying residential mortgage loans falls below a pre-determined threshold, we can effectively purchase the underlying residential mortgage loans at par, plus unreimbursed servicer advances, resulting in the repayment of all of the outstanding securitization financing at par, in exchange for a fee of 0.75% of UPB paid to Nationstar at the time of exercise. We similarly hold a limited right to cleanup call options with respect to certain securitization trusts master serviced by SLS for no fee, and also with respect to certain securitization trusts serviced or master serviced by Ocwen subject to a fee of 0.5% of UPB on loans that are current or thirty (30) days or less delinquent, paid to Ocwen at the time of exercise. The aggregate UPB of the underlying residential mortgage loans within these various securitization trusts is approximately $101.0 billion.\\nWe continue to evaluate the call rights we acquired from each of our servicers, and our ability to exercise such rights and realize the benefits therefrom are subject to a number of risks. See “Risk Factors—Risks Related to Our Business—Our ability to exercise our cleanup call rights may be limited or delayed if a third party also possessing such cleanup call rights exercises such rights, if the related securitization trustee refuses to permit the exercise of such rights, or if a related party is subject to bankruptcy proceedings.” The actual UPB of the residential mortgage loans on which we can successfully exercise call rights and realize the benefits therefrom may differ materially from our initial assumptions.\\nWe have exercised our call rights with respect to Non-Agency RMBS trusts and purchased performing and non-performing residential mortgage loans and REO contained in such trusts prior to their termination. In certain cases, we sold portions of the purchased loans through securitizations, and retained bonds issued by such securitizations. In addition, we received par on the securities issued by the called trusts which we owned prior to such trusts’ termination. Refer to Note 8 in our Condensed Consolidated Financial Statements for further details on these transactions.\\nResidential Mortgage Loans\\nAs of September 30, 2019, we had approximately $7.4 billion outstanding face amount of residential mortgage loans. These investments were financed with repurchase agreements with an aggregate face amount of approximately $5.2 billion and notes and bonds payable with an aggregate face amount of approximately $1.0 billion. We acquired these loans through open market purchases, as well as through the exercise of call rights.\\nThe following table presents the total residential mortgage loans outstanding by loan type at September 30, 2019 (dollars in thousands).\\n| Outstanding Face Amount | Carrying Value | LoanCount | Weighted Average Yield | Weighted Average Life (Years)(A) | Floating Rate Loans as a % of Face Amount | LTV Ratio(B) | Weighted Avg. Delinquency(C) | Weighted Average FICO(D) |\\n| Performing Loans(G) (J) | $ | 557,762 | $ | 524,387 | 7,695 | 7.8 | % | 4.6 | 20.2 | % | 72.3 | % | 10.2 | % | 647 |\\n| Purchased Credit Deteriorated Loans(H) | 124,238 | 89,270 | 1,106 | 7.9 | % | 3.2 | 19.3 | % | 88.1 | % | 60.7 | % | 590 |\\n| Total Residential Mortgage Loans, held-for-investment | $ | 682,000 | $ | 613,657 | 8,801 | 7.8 | % | 4.4 | 20.1 | % | 75.2 | % | 19.4 | % | 636 |\\n| Reverse Mortgage Loans(E) (F) | $ | 13,032 | $ | 6,450 | 32 | 7.8 | % | 5.3 | 10.1 | % | 151.6 | % | 65.1 | % | N/A |\\n| Performing Loans(G) (I) | 709,867 | 726,935 | 10,798 | 4.3 | % | 4.0 | 62.4 | % | 54.3 | % | 5.9 | % | 688 |\\n| Non-Performing Loans(H) (I) | 726,570 | 616,612 | 5,562 | 5.1 | % | 3.3 | 12.0 | % | 80.7 | % | 68.7 | % | 594 |\\n| Total Residential Mortgage Loans, held-for-sale | $ | 1,449,469 | $ | 1,349,997 | 16,392 | 4.8 | % | 3.6 | 36.7 | % | 68.4 | % | 37.9 | % | 641 |\\n| Acquired Loans | $ | 4,024,252 | $ | 3,916,826 | 26,236 | 4.2 | % | 7.4 | 2.0 | % | 71.1 | % | 15.3 | % | 622 |\\n| Originated Loans | 1,248,711 | 1,289,425 | 4,465 | 4.0 | % | 28.6 | 4.0 | % | 77.6 | % | 29.2 | % | 672 |\\n| Total Residential Mortgage Loans, held-for-sale, at fair value(K) | $ | 5,272,963 | $ | 5,206,251 | 30,701 | 4.1 | % | 12.5 | 2.5 | % | 72.7 | % | 18.6 | % | 634 |\\n\\n74\\n| (A) | The weighted average life is based on the expected timing of the receipt of cash flows. |\\n\\n| (B) | LTV refers to the ratio comparing the loan’s unpaid principal balance to the value of the collateral property. |\\n\\n| (C) | Represents the percentage of the total principal balance that is 60+ days delinquent. |\\n\\n| (D) | The weighted average FICO score is based on the weighted average of information updated and provided by the loan servicer on a monthly basis. |\\n\\n| (E) | Represents a 70% participation interest we hold in a portfolio of reverse mortgage loans. The average loan balance outstanding based on total UPB was $0.6 million. Approximately 51% of these loans outstanding have reached a termination event. As a result of the termination event, each such loan has matured and the borrower can no longer make draws on these loans. |\\n\\n| (F) | FICO scores are not used in determining how much a borrower can access via a reverse mortgage loan. |\\n\\n| (G) | Performing loans are generally placed on nonaccrual status when principal or interest is 120 days or more past due. |\\n\\n| (H) | Includes loans with evidence of credit deterioration since origination where it is probable that we will not collect all contractually required principal and interest payments. As of September 30, 2019, we have placed all Non-Performing Loans, held-for-sale on nonaccrual status, except as described in (I) below. |\\n\\n| (I) | Includes $37.8 million and $27.7 million UPB of Ginnie Mae EBO performing and non-performing loans, respectively, on accrual status as contractual cash flows are guaranteed by the FHA. |\\n\\n| (J) | Includes $112.1 million UPB of non-agency mortgage loans underlying the SAFT 2013-1 securitization, which are carried at fair value based on New Residential’s election of the fair value option. |\\n\\n| (K) | New Residential elected the fair value option to measure these loans at fair value on a recurring basis. |\\n\\nWe consider the delinquency status, loan-to-value ratios, and geographic area of residential mortgage loans as our credit quality indicators.\\nOther\\nConsumer Loans\\nThe table below summarizes the collateral characteristics of the consumer loans, including those held in the Consumer Loan Companies and those acquired from the Consumer Loan Seller, as of September 30, 2019 (dollars in thousands):\\n| Collateral Characteristics |\\n| UPB | Personal Unsecured Loans % | Personal Homeowner Loans % | Number of Loans | Weighted Average Original FICO Score(A) | Weighted Average Coupon | Adjustable Rate Loan % | Average Loan Age (months) | Average Expected Life (Years) | Delinquency 30 Days(B) | Delinquency 60 Days(B) | Delinquency 90+ Days(B) | 12-Month CRR(C) | 12-Month CDR(D) |\\n| Consumer loans, held-for-investment | $ | 878,431 | 59.6 | % | 40.4 | % | 117,312 | 675 | 18.3 | % | 12.0 | % | 172 | 3.9 | 1.7 | % | 1.0 | % | 1.8 | % | 16.4 | % | 5.0 | % |\\n\\n\\n| (A) | Weighted average original FICO score represents the FICO score at the time the loan was originated. |\\n\\n| (B) | Delinquency 30 Days, Delinquency 60 Days and Delinquency 90+ Days represent the percentage of the total principal balance of the pool that corresponds to loans that are delinquent by 30-59 days, 60-89 days or 90 or more days, respectively. |\\n\\n| (C) | 12-Month CRR, or the voluntary prepayment rate, represents the annualized rate of the voluntary prepayments during the three months as a percentage of the total principal balance of the pool. |\\n\\n| (D) | 12-Month CDR, or the involuntary prepayment rate, represents the annualized rate of the involuntary prepayments (defaults) during the three months as a percentage of the total principal balance of the pool. |\\n\\nIn addition, as of September 30, 2019, we had a net investment of $23.0 million in LoanCo and WarrantCo. For further information, see Note 9 to our Condensed Consolidated Financial Statements.\\nThe following is a summary of LoanCo’s consumer loan investments:\\n| Unpaid Principal Balance | Interest in Consumer Loans | Carrying Value | Weighted Average Coupon | Weighted Average Expected Life (Years)(A) | Weighted Average Delinquency(B) |\\n| September 30, 2019(C) | $ | 1,226 | 25.0 | % | $ | 1,632 | 18.7 | % | 1.0 | — | % |\\n\\n| (A) | Represents the weighted average expected timing of the receipt of expected cash flows for this investment. |\\n\\n| (B) | Represents the percentage of the total unpaid principal balance that is 30+ days delinquent. Delinquency status is the primary credit quality indicator as it provides early warning of borrowers who may be experiencing financial difficulties. |\\n\\n| (C) | Data as of August 31, 2019 as a result of the one month reporting lag. |\\n\\n75\\nAPPLICATION OF CRITICAL ACCOUNTING POLICIES\\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our Condensed Consolidated Financial Statements, which have been prepared in accordance with GAAP. The preparation of financial statements in conformity with GAAP requires the use of estimates and assumptions that could affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities and the reported amounts of revenue and expenses. Actual results could differ from these estimates. We believe that the estimates and assumptions utilized in the preparation of the Condensed Consolidated Financial Statements are prudent and reasonable. Actual results historically have generally been in line with our estimates and judgments used in applying each of the accounting policies described below, as modified periodically to reflect current market conditions.\\nOur critical accounting policies as of September 30, 2019, which represent our accounting policies that are most affected by judgments, estimates and assumptions, included all of the critical accounting policies referred to in our annual report on Form 10-K for the year ended December 31, 2018.\\nRecent Accounting Pronouncements\\nSee Note 1 to our Condensed Consolidated Financial Statements.\\nRESULTS OF OPERATIONS\\nThe following table summarizes the changes in our results of operations for the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018 (dollars in thousands). Our results of operations are not necessarily indicative of future performance.\\n| Three Months Ended September 30, | Increase (Decrease) | Nine Months Ended September 30, | Increase (Decrease) |\\n| 2019 | 2018 | Amount | 2019 | 2018 | Amount |\\n| Interest income | $ | 448,127 | $ | 425,524 | $ | 22,603 | $ | 1,303,041 | $ | 1,212,902 | $ | 90,139 |\\n| Interest expense | 245,902 | 162,806 | 83,096 | 686,738 | 421,109 | 265,629 |\\n| Net Interest Income | 202,225 | 262,718 | (60,493 | ) | 616,303 | 791,793 | (175,490 | ) |\\n| Impairment |\\n| Other-than-temporary impairment (OTTI) on securities | 5,567 | 3,889 | 1,678 | 21,942 | 23,190 | (1,248 | ) |\\n| Valuation and loss provision (reversal) on loans and real estate owned (REO) | (10,690 | ) | 5,471 | (16,161 | ) | 8,042 | 28,136 | (20,094 | ) |\\n| (5,123 | ) | 9,360 | (14,483 | ) | 29,984 | 51,326 | (21,342 | ) |\\n| Net interest income after impairment | 207,348 | 253,358 | (46,010 | ) | 586,319 | 740,467 | (154,148 | ) |\\n| Servicing revenue, net of change in fair value of $(228,405), $(26,741), $(619,914), and $35,118, respectively | 53,050 | 175,355 | (122,305 | ) | 133,366 | 538,784 | (405,418 | ) |\\n| Gain on sale of originated mortgage loans, net | 100,541 | 45,732 | 54,809 | 194,029 | 45,732 | 148,297 |\\n| Other Income |\\n| Change in fair value of investments in excess mortgage servicing rights | 2,407 | (4,744 | ) | 7,151 | (1,421 | ) | (55,711 | ) | 54,290 |\\n| Change in fair value of investments in excess mortgage servicing rights, equity method investees | 4,751 | 3,396 | 1,355 | 4,087 | 5,624 | (1,537 | ) |\\n| Change in fair value of investments in mortgage servicing rights financing receivables | (41,410 | ) | (88,345 | ) | 46,935 | (133,200 | ) | 63,628 | (196,828 | ) |\\n| Change in fair value of servicer advance investments | 6,641 | (5,353 | ) | 11,994 | 15,932 | (86,581 | ) | 102,513 |\\n| Change in fair value of investments in residential mortgage loans | (19,037 | ) | 647 | (19,684 | ) | 90,551 | 647 | 89,904 |\\n| Change in fair value of derivative instruments | 58,508 | 24,299 | 34,209 | (1,988 | ) | 27,985 | (29,973 | ) |\\n| Gain (loss) on settlement of investments, net | 154,752 | (11,893 | ) | 166,645 | 157,013 | 106,064 | 50,949 |\\n| Earnings from investments in consumer loans, equity method investees | (2,547 | ) | 4,555 | (7,102 | ) | (890 | ) | 12,343 | (13,233 | ) |\\n| Other income (loss), net | (35,219 | ) | (5,860 | ) | (29,359 | ) | (16,451 | ) | 10,415 | (26,866 | ) |\\n| 128,846 | (83,298 | ) | 212,144 | 113,633 | 84,414 | 29,219 |\\n| Operating Expenses |\\n| General and administrative expenses | 133,513 | 98,587 | 34,926 | 351,359 | 139,169 | 212,190 |\\n| Management fee to affiliate | 20,678 | 15,464 | 5,214 | 58,261 | 46,027 | 12,234 |\\n| Incentive compensation to affiliate | 36,307 | 23,848 | 12,459 | 49,265 | 65,169 | (15,904 | ) |\\n| Loan servicing expense | 7,192 | 11,060 | (3,868 | ) | 26,167 | 33,609 | (7,442 | ) |\\n| Subservicing expense | 52,875 | 43,148 | 9,727 | 147,763 | 135,703 | 12,060 |\\n| 250,565 | 192,107 | 58,458 | 632,815 | 419,677 | 213,138 |\\n| Income (Loss) Before Income Taxes | 239,220 | 199,040 | 40,180 | 394,532 | 989,720 | (595,188 | ) |\\n| Income tax expense (benefit) | (5,440 | ) | 3,563 | (9,003 | ) | 18,980 | (5,957 | ) | 24,937 |\\n| Net Income (Loss) | $ | 244,660 | $ | 195,477 | $ | 49,183 | $ | 375,552 | $ | 995,677 | $ | (620,125 | ) |\\n| Noncontrolling Interests in Income (Loss) of Consolidated Subsidiaries | $ | 14,738 | $ | 10,869 | $ | 3,869 | $ | 31,979 | $ | 32,058 | $ | (79 | ) |\\n| Dividends on Preferred Stock | $ | 5,338 | $ | — | $ | 5,338 | $ | 5,338 | $ | — | $ | 5,338 |\\n| Net Income (Loss) Attributable to Common Stockholders | $ | 224,584 | $ | 184,608 | $ | 39,976 | $ | 338,235 | $ | 963,619 | $ | (625,384 | ) |\\n\\n76\\nInterest Income\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nInterest income increased by $22.6 million, primarily attributable to incremental interest income of (i) $46.7 million from an increase in the size of the Real Estate Securities portfolio and (ii) $38.2 million from the Residential Mortgage Loans portfolio due to the acquisition of loans through purchases, originations, and the execution of calls. The increase was partially offset by (iii) a $39.2 million decrease from MSR Financing Receivable attributable to the drop in discount accretion income recognized on servicer advances related to the Ocwen Transaction subsequent to September 30, 2018, (iv) a $12.5 million decrease from Servicer Advance Investments and Excess Mortgage Servicing Rights driven by retrospective adjustments resulting from changes in valuation assumptions on September 30, 2019, and (v) a $10.6 million decrease from Consumer Loans attributable to lower unpaid principal balance.\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nInterest income increased by $90.1 million, primarily attributable to incremental interest income of (i) $203.0 million from an increase in the size of the Real Estate Securities portfolio and accelerated accretion on Real Estate Securities owned in Non-Agency RMBS trusts that were terminated upon the execution of calls and (ii) $96.4 million from the Residential Mortgage Loans portfolio due to the acquisition of loans through purchases, originations, and the execution of calls. The increase was partially offset by (iii) a $137.5 million decrease from MSR Financing Receivable attributable to the drop in discount accretion income recognized on servicer advances related to the Ocwen Transaction subsequent to September 30, 2018, (iv) a $40.2 million decrease from Servicer Advance Investments and Excess Mortgage Servicing Rights driven by retrospective adjustments resulting from changes in valuation assumptions on September 30, 2019, and (v) a $30.1 million decrease from Consumer Loans attributable to lower unpaid principal balance.\\nInterest Expense\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nInterest expense increased by $83.1 million primarily attributable to increases of (i) $55.9 million of interest expense on repurchase agreements financings on Real Estate Securities in which we made additional levered investments subsequent to September 30, 2018, (ii) $22.0 million on Residential Mortgage Loans due to an increase in the underlying principal balance of the portfolio levered with repurchase agreements, (iii) $7.4 million of interest expense on MSRs and related servicer advances financing obtained subsequent to September 30, 2018, and (iv) a $0.6 million increase in interest on debt collateralized by Excess MSRs as a result of draws subsequent to September 30, 2018. The increases were partially offset by (v) a $2.8 million decrease in interest expense on the Consumer Loan securitization notes due to a decrease in the principal balance outstanding and refinancing.\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nInterest expense increased by $265.6 million primarily attributable to increases of (i) $173.8 million of interest expense on repurchase agreements financings on Real Estate Securities in which we made additional levered investments subsequent to September 30, 2018, (ii) $67.7 million on Residential Mortgage Loans due to an increase in the underlying principal balance of the portfolio levered with repurchase agreements, (iii) $31.1 million of interest expense on MSRs and related servicer advances financing obtained subsequent to September 30, 2018, and (iv) a $0.4 million increase in interest on debt collateralized by Excess MSRs as a result of draws subsequent to September 30, 2018. The increases were partially offset by (v) a $7.4 million decrease in interest expense on the Consumer Loan securitization notes due to a decrease in the principal balance outstanding and refinancing.\\nOther-Than-Temporary Impairment on Securities\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nThe other-than-temporary impairment on securities increased by $1.7 million during the three months ended September 30, 2019 compared to the three months ended September 30, 2018, primarily resulting from a decline in fair values on a larger portion of our Non-Agency RMBS, which we purchased with existing credit impairment, below their amortized cost basis as of September 30, 2019.\\n77\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nThe other-than-temporary impairment on securities decreased by $1.2 million during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018, primarily resulting from a decline in fair values on a smaller portion of our Non-Agency RMBS, which we purchased with existing credit impairment, below their amortized cost basis as of September 30, 2019.\\nValuation and Loss Provision (Reversal) on Loans and Real Estate Owned\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nThe $16.2 million decrease in the valuation and loss provision (reversal) on loans and real estate owned resulted from (i) a $12.1 million in reversal of impairment on certain loans related to changes in interest rates and improved performance and certain REOs with an increase in home prices, and (ii) $4.1 million less provision due to a reduction in net charge-offs on the Consumer Loan Companies attributable to lower unpaid principal balance.\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nThe $20.1 million decrease in the valuation and loss provision (reversal) on loans and real estate owned resulted from (i) a $7.9 million in reversal of impairment on certain loans related to changes in interest rates and improved performance, partially offset by additional impairment on certain REOs with an decrease in home prices, and (ii) $12.2 million less provision due to a reduction in net charge-offs on the Consumer Loan Companies attributable to lower unpaid principal balance.\\nServicing Revenue, Net\\nThe component of servicing revenue, net related to changes in valuation inputs and assumptions related to the following:\\n| Three Months Ended September 30, | Increase (Decrease) | Nine Months Ended September 30, | Increase (Decrease) |\\n| 2019 | 2018 | Amount | 2019 | 2018 | Amount |\\n| Changes in interest rates and prepayment rates | $ | (149,413 | ) | $ | 38,546 | $ | (187,959 | ) | $ | (555,765 | ) | $ | 209,182 | $ | (764,947 | ) |\\n| Changes in discount rates | 57,896 | (6,695 | ) | 64,591 | 127,314 | 46,264 | 81,050 |\\n| Changes in other factors | 29,659 | 12,341 | 17,318 | 153,080 | (28,829 | ) | 181,909 |\\n| Total | $ | (61,858 | ) | $ | 44,192 | $ | (106,050 | ) | $ | (275,371 | ) | $ | 226,617 | $ | (501,988 | ) |\\n\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nServicing revenue, net decreased $122.3 million during the three months ended September 30, 2019 compared to the three months ended September 30, 2018, primarily driven by (i) a $106.1 million change from positive mark-to-market adjustments during the three months ended September 30, 2018 to negative mark-to-market adjustments during the three months ended September 30, 2019, and (ii) a $97.8 million increase in amortization as a result of MSR acquisitions by our licensed servicer subsidiary, NRM (Note 5 to our Condensed Consolidated Financial Statements) that closed subsequent to September 30, 2018. The negative mark-to-market adjustments during the three months ended September 30, 2019 was primarily driven by an increase in prepayment rates, partially offset by a decrease in discount rates. The decrease was partially offset by (iii) a $79.4 million increase in servicing fee revenue and fees as a result of MSR acquisitions that closed subsequent to September 30, 2018.\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nServicing revenue, net decreased $405.4 million during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018, primarily driven by (i) a $502.0 million change from positive mark-to-market adjustments during the nine months ended September 30, 2018 to negative mark-to-market adjustments during the nine months ended September 30, 2019, and (ii) a $155.3 million increase in amortization as a result of MSR acquisitions by our licensed servicer subsidiary, NRM (Note 5 to our Condensed Consolidated Financial Statements), as well as the Shellpoint Acquisition (Note 1 to our Condensed Consolidated Financial Statements), which closed in July 2018. The negative mark-to-market adjustments during the nine months ended September 30, 2019 were primarily driven by an increase in prepayment rates, partially offset by a decrease in discount rates and costs of subservicing, and an increase in ancillary income. The decrease was partially offset by (iii) a $249.6 million increase in servicing fee revenue and fees as a result of MSR acquisitions and the Shellpoint Acquisition that closed in July 2018.\\n78\\nGain on Sale of Originated Mortgage Loans, Net\\nAs a result of the Shellpoint Acquisition in July 2018 (Note 1 to our Condensed Consolidated Financial Statements), our wholly owned subsidiary, NewRez, originates conventional, government-insured and nonconforming residential mortgage loans for sale and securitization. The GSEs or Ginnie Mae guarantee conventional and government insured mortgage securitizations and private investors issue nonconforming private label mortgage securitizations while NewRez generally retains the right to service the underlying residential mortgage loans.\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nGain on sale of originated mortgage loans, net increased $54.8 million during the three months ended September 30, 2019 compared to the three months ended September 30, 2018, primarily driven by (i) $79.0 million higher value of MSRs retained on transfer of loans, and (ii) a $5.5 million increase in appraisal and other revenues earned in conjunction with the loan origination process, partially offset by (iii) a $29.4 million increase in loss on settlement of mortgage loan origination derivative instruments.\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nGain on sale of originated mortgage loans, net increased $148.3 million during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018, primarily driven by (i) $173.4 million higher value of MSRs retained on transfer of loans, (ii) a $22.3 million increase in appraisal and other revenues earned in conjunction with the loan origination process, and (iii) an $11.7 million increase in gain on loans originated and sold. The increase was partially offset by (iv) a $59.1 million increase in loss on settlement of mortgage loan origination derivative instruments.\\nChange in Fair Value of Investments in Excess Mortgage Servicing Rights\\nChanges in the fair value of investments in Excess MSRs related to the following:\\n| Three Months Ended September 30, | Increase (Decrease) | Nine Months Ended September 30, | Increase (Decrease) |\\n| 2019 | 2018 | Amount | 2019 | 2018 | Amount |\\n| Changes in interest rates and prepayment rates | $ | (2,566 | ) | $ | (9,872 | ) | $ | 7,306 | $ | (20,268 | ) | $ | (15,742 | ) | $ | (4,526 | ) |\\n| Changes in discount rates | 4,167 | — | 4,167 | 13,446 | — | 13,446 |\\n| Changes in other factors | 806 | 5,128 | (4,322 | ) | 5,401 | (39,969 | ) | 45,370 |\\n| Total | $ | 2,407 | $ | (4,744 | ) | $ | 7,151 | $ | (1,421 | ) | $ | (55,711 | ) | $ | 54,290 |\\n\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nThe positive mark-to-market adjustments during the three months ended September 30, 2019 were mainly driven by a decrease in discount rates, partially offset by changes in interest rates and prepayment rates. The negative mark-to-market adjustments during the three months ended September 30, 2018 were mainly driven by changes in interest rates and prepayment rates, as well as lower delinquency assumptions.\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nThe negative mark-to-market adjustments during the nine months ended September 30, 2019 were mainly driven by changes in interest rates and prepayment rates, partially offset by a decrease in discount rates. The change between the mark-to-market adjustments during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018 were due to the realization of unrealized gains related to the Ocwen Transaction in 2018, which were reflected in Gain (Loss) on Settlement of Investments, Net.\\n79\\nChange in Fair Value of Investments in Excess Mortgage Servicing Rights, Equity Method Investees\\nChanges in the fair value of investments in Excess MSRs, equity method investees related to the following:\\n| Three Months Ended September 30, | Increase (Decrease) | Nine Months Ended September 30, | Increase (Decrease) |\\n| 2019 | 2018 | Amount | 2019 | 2018 | Amount |\\n| Changes in interest rates and prepayment rates | $ | (432 | ) | $ | (2,203 | ) | $ | 1,771 | $ | (7,897 | ) | $ | (3,711 | ) | $ | (4,186 | ) |\\n| Changes in discount rates | 768 | — | 768 | 3,939 | — | 3,939 |\\n| Changes in other factors | 4,415 | 5,599 | (1,184 | ) | 8,045 | 9,335 | (1,290 | ) |\\n| Total | $ | 4,751 | $ | 3,396 | $ | 1,355 | $ | 4,087 | $ | 5,624 | $ | (1,537 | ) |\\n\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nThe positive mark-to-market adjustments during the three months ended September 30, 2019 were mainly driven by interest income net of expenses recorded at the investee level, and a decrease in discount rates. Compared to the three months ended September 30, 2018 where the positive mark-to-market adjustments were mainly driven by interest income net of expenses recorded at the investee level, partially offset by changes in interest rates and prepayment rates.\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nThe positive mark-to-market adjustments during the nine months ended September 30, 2019 were mainly driven by interest income net of expenses recorded at the investee level, and a decrease in discount rates, partially offset by changes in interest rates and prepayment rates. Compared to the nine months ended September 30, 2018 where the positive mark-to-market adjustments were mainly driven by interest income net of expenses recorded at the investee level and other market factors, partially offset by changes in interest rates and prepayment rates.\\nChange in Fair Value of Investments in MSR Financing Receivables\\nThe component of changes in the fair value of investments in mortgage servicing rights financing receivables related to changes in valuation inputs and assumptions related to the following:\\n| Three Months Ended September 30, | Increase (Decrease) | Nine Months Ended September 30, | Increase (Decrease) |\\n| 2019 | 2018 | Amount | 2019 | 2018 | Amount |\\n| Changes in interest rates and prepayment rates | $ | (44,152 | ) | $ | (4,326 | ) | $ | (39,826 | ) | $ | (138,727 | ) | $ | (18,939 | ) | $ | (119,788 | ) |\\n| Changes in discount rates | 60,273 | — | 60,273 | 99,674 | 212,273 | (112,599 | ) |\\n| Changes in other factors | (6,772 | ) | (35,003 | ) | 28,231 | 40,490 | 24,853 | 15,637 |\\n| Total | $ | 9,349 | $ | (39,329 | ) | $ | 48,678 | $ | 1,437 | $ | 218,187 | $ | (216,750 | ) |\\n\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nThe change in fair value of investments in mortgage servicing rights financing receivable increased $46.9 million during the three months ended September 30, 2019 compared to the three months ended September 30, 2018. $48.7 million of the increase was related to changes in valuation inputs and assumptions, primarily due to decrease in discount rates and costs of subservicing, and an increase in ancillary income, partially offset by an increase in prepayment rates. The remaining increase was primarily due to $0.7 million decrease in amortization expense, attributable to lower unpaid principal balance.\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nThe change in fair value of investments in mortgage servicing rights financing receivable decreased $196.8 million during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018. $216.8 million of the decrease was related to changes in valuation inputs and assumptions, primarily due to less decrease in discount rates and an increase in prepayment rates, partially offset by a decrease in costs of subservicing and an increase in ancillary income. The decrease was partially offset by $23.1 million decrease in amortization expense, attributable to lower unpaid principal balance.\\n80\\nChange in Fair Value of Servicer Advance Investments\\nChanges in the fair value of Servicer Advance Investments related to the following:\\n| Three Months Ended September 30, | Increase (Decrease) | Nine Months Ended September 30, | Increase (Decrease) |\\n| 2019 | 2018 | Amount | 2019 | 2018 | Amount |\\n| Changes in interest rates and prepayment rates | $ | (675 | ) | $ | 820 | $ | (1,495 | ) | $ | (2,379 | ) | $ | 2,357 | $ | (4,736 | ) |\\n| Changes in discount rates | 8,419 | (4,173 | ) | 12,592 | 22,045 | (12,829 | ) | 34,874 |\\n| Changes in other factors | (1,103 | ) | (2,000 | ) | 897 | (3,734 | ) | (76,109 | ) | 72,375 |\\n| Total | $ | 6,641 | $ | (5,353 | ) | $ | 11,994 | $ | 15,932 | $ | (86,581 | ) | $ | 102,513 |\\n\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nThe positive mark-to-market adjustments during the three months ended September 30, 2019 were mainly driven by a decrease in discount rates, compared to the three months ended September 30, 2018 where the negative mark-to-market adjustments were mainly driven by an increase in discount rates.\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nThe positive mark-to-market adjustments during the nine months ended September 30, 2019 were mainly driven by a decrease in discount rates, compared to an increase in discount rates during the nine months ended September 30, 2018 resulting in negative mark-to-market adjustments. The change between the mark-to-market adjustments during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018 were due to the realization of unrealized gains related to the Ocwen Transaction in 2018, which were reflected in Gain (Loss) on Settlement of Investments, Net.\\nChange in Fair Value of Investments in Residential Mortgage Loans\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nThe change in fair value of investments in Residential Mortgage Loans decreased $19.7 million during the three months ended September 30, 2019 compared to the three months ended September 30, 2018 was primarily due to (i) $36.0 million gain realized through securitizations, net of (ii) $16.1 million unrealized gains from changes in valuation assumptions and inputs.\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nThe change in fair value of investments in Residential Mortgage Loans of increased $89.9 million during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018, primarily due to the election of the fair value option on certain Residential Mortgage Loans acquired beginning July 2018, coupled with a decrease in discount rates on loans acquired. Residential Mortgage Loans were held at lower of cost or market value, rather than fair value, during the six months ended June 30, 2018.\\nChange in Fair Value of Derivative Instruments\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nChange in fair value of derivative instruments increased $34.2 million. The increase was primarily related to (i) a $23.5 million increase in unrealized gain on Interest Rate Swaps, (ii) a $5.7 million increase in unrealized gain on TBAs, and (iii) a $5.2 million change from unrealized loss to unrealized gain on Interest Rate Lock Commitments due to increase in market interest rates.\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nChange in fair value of derivative instruments decreased $30.0 million. The decrease was primarily related to (i) a $46.6 million change from unrealized gain to unrealized loss on Interest Rate Swaps. The decrease was partially offset by (ii) a $16.2 million change from unrealized loss to unrealized gain on Interest Rate Lock Commitments, and (iii) $0.9 million increase in unrealized gain on TBAs due to increase in market interest rates.\\n81\\nGain (Loss) on Settlement of Investments, Net\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nGain (loss) on settlement of investments increased by $166.6 million from a loss to a gain, primarily related to (i) a $123.7 million change in loss on sale of real estate securities to gain on sale of real estate securities, (ii) a $39.6 million increase in gain on sale of residential mortgage loans, (iii) a $21.6 million increase in gain on sale or securitization of originated mortgage loans, (iv) a $11.5 million increase in gain on collapses due primarily to market interest rates and decreased delinquencies, (v) a $1.8 million decrease in loss on sale of REO, and (vi) a $0.6 million decrease in loss on extinguishment of debt related to debt restructuring. The increase was partially offset by (vii) a $33.6 million change in gain on settlement of derivatives to loss on settlement of derivatives related to TBAs and interest rate swaps, during the three months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nGain (loss) on settlement of investments increased by $50.9 million, primarily related to (i) a $267.9 million change in loss on sale of real estate securities to gain on sale of real estate securities, (ii) a $62.4 million increase in gain on sale or securitization of originated mortgage loans, (iii) a $54.8 million change from loss on sale of residential mortgage loans to gain on sale of residential mortgage loans, (iv) a $10.2 million increase in gain on collapses due primarily to market interest rates and decreased delinquencies, and (v) a $2.7 million decrease in loss on sale of REO. The increase was partially offset by (vi) a $228.5 million change in gain on settlement of derivatives to loss on settlement of derivatives related to TBAs and interest rate swaps, (vii) a $113.0 million decrease in gains on settlement of investments in excess MSRs and Servicer Advance Investments as a result of the Ocwen Transaction, and (viii) a $7.9 million increase in loss on extinguishment of debt related to debt restructuring, during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nEarnings from Investments in Consumer Loans, Equity Method Investees\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nEarnings from investments in Consumer Loans, Equity Method Investees decreased by $7.1 million as a result of a decrease in net earnings generated by our approximately 25% member interest in LoanCo and WarrantCo (Note 9 to our Condensed Consolidated Financial Statements), primarily as a result of declining portfolio and securitization, during the three months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nEarnings from investments in Consumer Loans, Equity Method Investees decreased by $13.2 million as a result of a decrease in net earnings generated by our approximately 25% member interest in LoanCo and WarrantCo (Note 9 to our Condensed Consolidated Financial Statements), primarily as a result of declining portfolio and securitization, during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nOther Income (Loss), Net\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nOther income (loss), net decreased by $29.4 million, primarily attributable to (i) a $14.4 million loss from uncollectible receivables, (ii) a $12.3 million change in unrealized gain on other ABS to unrealized loss on other ABS, (iii) a $4.9 million decrease in gain on transfer of loans to REO, (iv) a $3.5 million change in unrealized gain to unrealized loss on notes and bonds payable related to the SAFT bonds acquired in the Shellpoint Acquisition (Note 1 to our Condensed Consolidated Financial Statements), (v) a $2.7 million increase in unrealized loss on contingent consideration related to the Shellpoint Acquisition (Note 1 to our Condensed Consolidated Financial Statements). The decrease was partially offset by (vi) a $6.2 million decrease in servicer advance expenses, and (vii) a $1.4 million decrease in loss on transfer of loans to other assets.\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nOther income (loss), net decreased by $26.9 million, primarily attributable to (i) a $14.4 million loss from uncollectible receivables,(ii) a $8.8 million decrease in gain on transfer of loans to REO, (iii) a $7.4 million increase in unrealized loss on contingent consideration related to the Shellpoint Acquisition (Note 1 to our Condensed Consolidated Financial Statements), (iv) a $6.1 million change in unrealized gain to unrealized loss on notes and bonds payable related to the SAFT bonds acquired in the Shellpoint\\n82\\nAcquisition (Note 1 to our Condensed Consolidated Financial Statements), (v) a $3.5 million decrease in positive mark-to-market adjustments for retained MSRs, and (vi) a $3.0 million decrease in unrealized gain on other ABS. The decrease was partially offset by (vii) a $7.1 million decrease in servicer advance expenses, (viii) a $4.3 million decrease in REO expenses, and (ix) a $3.7 million decrease in other losses related to residential mortgage loans.\\nGeneral and Administrative Expenses\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nGeneral and administrative expenses increased by $34.9 million primarily attributable to (i) a $30.2 million increase in compensation and benefits expenses, loan origination expense, as well as rent, office, and other miscellaneous G&A expenses resulting from the Shellpoint Acquisition (Note 1 to our Condensed Consolidated Financial Statements), and (ii) a $4.7 million increase in securitization fees, and deal and other consulting expenses due to increased securitization, deal, and refinancing activity during the three months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nGeneral and administrative expenses increased by $212.2 million primarily attributable to (i) a $200.1 million increase in compensation and benefits expenses, loan origination expense, as well as rent, office, and other miscellaneous G&A expenses resulting from the Shellpoint Acquisition (Note 1 to our Condensed Consolidated Financial Statements), and (ii) an $11.0 million increase in securitization fees, and deal and other consulting expenses due to increased securitization, deal, and refinancing activity during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nManagement Fee to Affiliate\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nManagement fee to affiliate increased by $5.2 million as a result of increases to our gross equity subsequent to September 30, 2018.\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nManagement fee to affiliate increased by $12.2 million as a result of increases to our gross equity subsequent to September 30, 2018.\\nIncentive Compensation to Affiliate\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nIncentive compensation to affiliate increased by $12.5 million due to an increase in our incentive compensation earnings measure resulting from the changes in the income and expense items described above, excluding any unrealized gains or losses from mark-to-market valuation changes on investments and debt, during the three months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nIncentive compensation to affiliate decreased by $15.9 million due to a decrease in our incentive compensation earnings measure resulting from the changes in the income and expense items described above, excluding any unrealized gains or losses from mark-to-market valuation changes on investments and debt, during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nLoan Servicing Expense\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nLoan servicing expense decreased by $3.9 million primarily due to (i) a $4.5 million decrease of loan servicing expense on Consumer Loans, held for investment, attributable to lower unpaid principal balance, partially offset by (ii) a $0.6 million increase of loan servicing expense on Residential Mortgage Loans portfolio due to the acquisition of loans through the execution of calls.\\n83\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nLoan servicing expense decreased by $7.4 million primarily due to (i) a $8.2 million decrease of loan servicing expense on Consumer Loans, held for investment, attributable to lower unpaid principal balance, partially offset by (ii) a $0.8 million increase of loan servicing expense on Residential Mortgage Loans portfolio due to the acquisition of loans through the execution of calls.\\nSubservicing Expense\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nSubservicing expense increased $9.7 million during the three months ended September 30, 2019 compared to the three months ended September 30, 2018 as a result of an increase in subserviced loans due to transactions that closed subsequent to September 30, 2018 within our licensed servicer subsidiary, NRM (Note 5 to our Condensed Consolidated Financial Statements).\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nSubservicing expense increased $12.1 million during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018 as a result of an increase in subserviced loans due to transactions that closed subsequent to September 30, 2018 within our licensed servicer subsidiary, NRM (Note 5 to our Condensed Consolidated Financial Statements).\\nIncome Tax Expense (Benefit)\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nIncome tax expense (benefit) changed by $9.0 million, as a result of an income tax benefit of $5.4 million during the three months ended September 30, 2019 compared to an income tax expense of $3.6 million during the three months ended September 30, 2018, primarily due to the deferred tax benefit generated by changes in the fair value of MSRs quarter over quarter.\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nIncome tax expense (benefit) changed by $24.9 million, as a result of an income tax expense of $19.0 million during the nine months ended September 30, 2019 compared to an income tax benefit of $6.0 million during the nine months ended September 30, 2018, primarily due to the deferred tax expense generated by changes in the fair value of MSRs giving rise to an increase in taxable income in the TRS.\\nNoncontrolling Interests in Income (Loss) of Consolidated Subsidiaries\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nNoncontrolling interests in income of consolidated subsidiaries increased by $3.9 million primarily due to (i) a $1.8 million increase in other’s interest in the net income of the Buyer as a result of a change from negative to positive mark-to-market adjustments in the fair value of the Buyer’s assets and lower interest expense, partially offset by a net decrease in interest income earned on the Buyer’s levered assets, (ii) a $1.3 million increase from the Shelter JVs, acquired as part of the Shellpoint Acquisition in the third quarter of 2018 (Note 1 to our Condensed Consolidated Financial Statements), and (iii) a $0.8 million increase from a net increase in income from the Consumer Loan Companies, which are 46.5% owned by third parties, during the three months ended September 30, 2019.\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nNoncontrolling interests in income of consolidated subsidiaries decreased by $0.1 million primarily due to (i) a $5.4 million decrease from a net decrease in income from the Consumer Loan Companies, which are 46.5% owned by third parties, during the nine months ended September 30, 2019. The decrease was partially offset by (ii) a $3.2 million increase from the Shelter JVs, acquired as part of the Shellpoint Acquisition in the third quarter of 2018 (Note 1 to our Condensed Consolidated Financial Statements), and (iii) a $2.1 million increase in other’s interest in the net income of the Buyer as a result of a change from negative to positive mark-to-market adjustments in the fair value of the Buyer’s assets and lower interest expense, partially offset by a net decrease in interest income earned on the Buyer’s levered assets, during the nine months ended September 30, 2019.\\n84\\nDividends on Preferred Stock\\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\\nDuring the three months ended September 30, 2019, in a public offering, we issued Preferred Series A and Preferred Series B (Note 13 to our Condensed Consolidated Financial Statements), and declared preferred dividends of $5.3 million.\\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\\nDuring the nine months ended September 30, 2019, in a public offering, we issued Preferred Series A and Preferred Series B (Note 13 to our Condensed Consolidated Financial Statements), and declared preferred dividends of $5.3 million.\\nOther Comprehensive Income. See “—Accumulated Other Comprehensive Income (Loss)” below.\\nLIQUIDITY AND CAPITAL RESOURCES\\nLiquidity is a measurement of our ability to meet potential cash requirements, including ongoing commitments to repay borrowings, fund and maintain investments, and other general business needs. Additionally, to maintain our status as a REIT under the Internal Revenue Code, we must distribute annually at least 90% of our REIT taxable income. We note that a portion of this requirement may be able to be met in future years through stock dividends, rather than cash, subject to limitations based on the value of our stock.\\nOur primary sources of funds for liquidity generally consist of cash provided by operating activities (primarily income from our investments in Excess MSRs, MSRs, Servicer Advance Investments, RMBS and loans), sales of and repayments from our investments, potential debt financing sources, including securitizations, and the issuance of equity securities, when feasible and appropriate. Our ability to utilize funds generated by the MSRs held in our servicer subsidiaries, NRM and NewRez, is subject to regulatory requirements regarding NRM’s and NewRez’s liquidity. As of September 30, 2019, approximately $454.3 million of our cash and cash equivalents was held at NRM and NewRez, of which $288.0 million was in excess of regulatory liquidity requirements and available for deployment. Our primary uses of funds are the payment of interest, management fees, incentive compensation, servicing and subservicing expenses, outstanding commitments (including margins and mortgage loan originations) and other operating expenses, and the repayment of borrowings and hedge obligations, as well as dividends. Although we have other sources of liquidity, such as sales of and repayments from our investments, potential debt financing sources and the issuance of equity securities, there can be no assurance that we will generate sufficient cash or achieve investment results that will allow us to make a specified level of cash distributions or year-to-year increases in cash distributions in the future. We have also committed to purchase certain future servicer advances. Currently, we expect that net recoveries of servicer advances will exceed net fundings for the foreseeable future. However, in the event of a significant economic downturn, net fundings could exceed net recoveries, which could have a materially adverse impact on our liquidity and could also result in additional expenses, primarily interest expense on any related financings of incremental advances.\\nCurrently, our primary sources of financing are notes and bonds payable and repurchase agreements, although we have in the past and may in the future also pursue one or more other sources of financing such as securitizations and other secured and unsecured forms of borrowing. As of September 30, 2019, we had outstanding repurchase agreements with an aggregate face amount of approximately $23.1 billion to finance our investments. The financing of our entire RMBS portfolio, which generally has 30 to 90 day terms, is subject to margin calls. Under repurchase agreements, we sell a security to a counterparty and concurrently agree to repurchase the same security at a later date for a higher specified price. The sale price represents financing proceeds and the difference between the sale and repurchase prices represents interest on the financing. The price at which the security is sold generally represents the market value of the security less a discount or “haircut,” which can range broadly, for example from 2% - 5% for Agency RMBS, 4% - 60% for Non-Agency RMBS, and 6% - 55% for residential mortgage loans. During the term of the repurchase agreement, the counterparty holds the security as collateral. If the agreement is subject to margin calls, the counterparty monitors and calculates what it estimates to be the value of the collateral during the term of the agreement. If this value declines by more than a de minimis threshold, the counterparty could require us to post additional collateral (or “margin”) in order to maintain the initial haircut on the collateral. This margin is typically required to be posted in the form of cash and cash equivalents. Furthermore, we may, from time to time, be a party to derivative agreements or financing arrangements that may be subject to margin calls based on the value of such instruments. In addition, $2.6 billion face amount of our MSR and Excess MSR financing is subject to mandatory monthly repayment to the extent that the outstanding balance exceeds the market value (as defined in the related agreement) of the financed asset multiplied by the contractual maximum loan-to-value ratio. We seek to maintain adequate cash reserves and other sources of available liquidity to meet any margin calls or related requirements resulting from decreases in value related to a reasonably possible (in our opinion) change in interest rates.\\n85\\nOur ability to obtain borrowings and to raise future equity capital is dependent on our ability to access borrowings and the capital markets on attractive terms. We continually monitor market conditions for financing opportunities and at any given time may be entering or pursuing one or more of the transactions described above. Our Manager’s senior management team has extensive long-term relationships with investment banks, brokerage firms and commercial banks, which we believe will enhance our ability to source and finance asset acquisitions on attractive terms and access borrowings and the capital markets at attractive levels.\\nWith respect to the next 12 months, we expect that our cash on hand combined with our cash flow provided by operations and our ability to roll our repurchase agreements and servicer advance financings will be sufficient to satisfy our anticipated liquidity needs with respect to our current investment portfolio, including related financings, potential margin calls, mortgage loan originations and operating expenses. Our ability to roll over short-term borrowings is critical to our liquidity outlook. While it is inherently more difficult to forecast beyond the next 12 months, we currently expect to meet our long-term liquidity requirements through our cash on hand and, if needed, additional borrowings, proceeds received from repurchase agreements and other financings, proceeds from equity offerings and the liquidation or refinancing of our assets.\\nThese short-term and long-term expectations are forward-looking and subject to a number of uncertainties and assumptions, including those described under “—Market Considerations” as well as “Risk Factors.” If our assumptions about our liquidity prove to be incorrect, we could be subject to a shortfall in liquidity in the future, and such a shortfall may occur rapidly and with little or no notice, which could limit our ability to address the shortfall on a timely basis and could have a material adverse effect on our business.\\nOur cash flow provided by operations differs from our net income due to these primary factors: (i) the difference between (a) accretion and amortization and unrealized gains and losses recorded with respect to our investments and (b) cash received therefrom, (ii) unrealized gains and losses on our derivatives, and recorded impairments, if any, (iii) deferred taxes, and (iv) principal cash flows related to held-for-sale loans, which are characterized as operating cash flows under GAAP.\\nIn addition to the information referenced above, the following factors could affect our liquidity, access to capital resources and our capital obligations. As such, if their outcomes do not fall within our expectations, changes in these factors could negatively affect our liquidity.\\n\\n| • | Access to Financing from Counterparties – Decisions by investors, counterparties and lenders to enter into transactions with us will depend upon a number of factors, such as our historical and projected financial performance, compliance with the terms of our current credit arrangements, industry and market trends, the availability of capital and our investors’, counterparties’ and lenders’ policies and rates applicable thereto, and the relative attractiveness of alternative investment or lending opportunities. Our business strategy is dependent upon our ability to finance certain of our investments at rates that provide a positive net spread. |\\n\\n| • | Impact of Expected Repayment or Forecasted Sale on Cash Flows – The timing of and proceeds from the repayment or sale of certain investments may be different than expected or may not occur as expected. Proceeds from sales of assets are unpredictable and may vary materially from their estimated fair value and their carrying value. Further, the availability of investments that provide similar returns to those repaid or sold investments is unpredictable and returns on new investments may vary materially from those on existing investments. |\\n\\n86\\nDebt Obligations\\nThe following table presents certain information regarding our debt obligations (dollars in thousands):\\n| September 30, 2019 |\\n| Collateral |\\n| Debt Obligations/Collateral | Outstanding Face Amount | Carrying Value(A) | Final Stated Maturity(B) | Weighted Average Funding Cost | Weighted Average Life (Years) | Outstanding Face | Amortized Cost Basis | Carrying Value | Weighted Average Life (Years) |\\n| Repurchase Agreements(C) |\\n| Agency RMBS(D) | $ | 10,733,236 | $ | 10,733,236 | Oct-19 to May-20 | 2.31 | % | 0.1 | $ | 10,611,553 | $ | 10,825,984 | $ | 10,886,787 | 2.4 |\\n| Non-Agency RMBS (E) | 7,144,329 | 7,144,329 | Oct-19 to Sep-20 | 3.08 | % | 0.1 | 21,021,981 | 7,113,471 | 7,786,425 | 6.3 |\\n| Residential Mortgage Loans(F) | 5,165,150 | 5,164,159 | Oct-19 to May-21 | 3.74 | % | 0.6 | 5,960,958 | 6,025,596 | 5,805,242 | 13.9 |\\n| Real Estate Owned(G)(H) | 68,651 | 68,635 | Oct-19 to May-21 | 3.85 | % | 0.4 | N/A | N/A | 95,410 | N/A |\\n| Total Repurchase Agreements | 23,111,366 | 23,110,359 | 2.87 | % | 0.3 |\\n| Notes and Bonds Payable |\\n| Excess MSRs(I) | 269,759 | 269,759 | Feb-20 to Jul-22 | 4.95 | % | 1.9 | 103,514,484 | 315,847 | 416,899 | 5.8 |\\n| MSRs(J) | 2,360,182 | 2,352,961 | Mar-20 to Jul-24 | 4.23 | % | 2.0 | 452,215,330 | 4,718,333 | 5,113,271 | 5.5 |\\n| Servicer Advances(K) | 2,903,093 | 2,896,819 | Jan-20 to Aug-23 | 3.22 | % | 2.0 | 3,316,416 | 3,482,368 | 3,512,345 | 1.6 |\\n| Residential Mortgage Loans(L) | 1,012,342 | 1,015,360 | Apr-20 to Jul-43 | 4.09 | % | 3.7 | 1,258,875 | 1,277,193 | 1,194,186 | 8.0 |\\n| Consumer Loans(M) | 868,214 | 870,973 | Dec-21 to May-36 | 3.25 | % | 4.0 | 878,317 | 884,473 | 881,069 | 5.6 |\\n| Total Notes and Bonds Payable | 7,413,590 | 7,405,872 | 3.73 | % | 2.5 |\\n| Total/ Weighted Average | $ | 30,524,956 | $ | 30,516,231 | 3.08 | % | 0.8 |\\n\\n\\n| (A) | Net of deferred financing costs. |\\n\\n| (B) | All debt obligations with a stated maturity through October 31, 2019 were refinanced, extended or repaid. |\\n\\n| (C) | These repurchase agreements had approximately $77.8 million of associated accrued interest payable as of September 30, 2019. |\\n\\n| (D) | All of the Agency RMBS repurchase agreements have a fixed rate. Collateral amounts include approximately $4.4 billion of related trade and other receivables. |\\n\\n| (E) | $6,585.6 million face amount of the Non-Agency RMBS repurchase agreements have LIBOR-based floating interest rates while the remaining $558.8 million face amount of the Non-Agency RMBS repurchase agreements have a fixed rate. This also includes repurchase agreements of $7.5 million on retained servicer advance and consumer loan bonds and of $671.3 million on retained bonds collateralized by Agency MSRs. |\\n\\n| (F) | All of these repurchase agreements have LIBOR-based floating interest rates. |\\n\\n| (G) | All of these repurchase agreements have LIBOR-based floating interest rates. |\\n\\n| (H) | Includes financing collateralized by receivables including claims from FHA on Ginnie Mae EBO loans for which foreclosure has been completed and for which we have made or intend to make a claim on the FHA guarantee. |\\n\\n| (I) | Includes $169.8 million of corporate loans which bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin of 3.00%, and $100.0 million of corporate loans which bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin of 2.50%. The outstanding face amount of the collateral represents the UPB of our residential mortgage loans underlying our interests in MSRs that secure these notes. |\\n\\n| (J) | Includes: $940.2 million of MSR notes which bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin ranging from 2.25% to 2.75%; and $1,419.9 million of public notes with fixed interest rates ranging from 3.55% to 4.62%. The outstanding face amount of the collateral represents the UPB of the residential mortgage loans underlying the MSRs and mortgage servicing rights financing receivables that secure these notes. |\\n\\n| (K) | $2.6 billion face amount of the notes have a fixed rate while the remaining notes bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR or a cost of funds rate, as applicable, and (ii) a margin ranging from 1.15% to 1.99%. Collateral includes Servicer Advance Investments, as well as servicer advances receivable related to the mortgage servicing rights and mortgage servicing rights financing receivables owned by NRM. |\\n\\n| (L) | Represents: (i) a $6.0 million note payable to Nationstar which includes a $1.5 million receivable from government agency and bears interest equal to one-month LIBOR plus 2.88%, (ii) $109.9 million fair value of SAFT 2013-1 mortgage-backed securities issued with fixed interest rates ranging from 3.50% to 3.76% (see Note 12 for details), (iii) $362.1 million of asset-backed notes held by third parties which bear interest equal to 4.59% (see Note 12 for details), and (iv) |\\n\\n87\\n$535.1 million of asset-backed notes held by third parties which include $1.3 million of REO and bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin of 1.25%.\\n| (M) | Includes the SpringCastle debt, which is comprised of the following classes of asset-backed notes held by third parties: $787.9 million UPB of Class A notes with a coupon of 3.20% and a stated maturity date in May 2036, $70.4 million UPB of Class B notes with a coupon of 3.58% and a stated maturity date in May 2036, and $8.7 million UPB of Class C notes with a coupon of 5.06% and a stated maturity date in May 2036. Also includes a $1.2 million face amount note which bears interest equal to 4.00%. |\\n\\nCertain of the debt obligations included above are obligations of our consolidated subsidiaries, which own the related collateral. In some cases, such collateral is not available to other creditors of ours.\\nWe have margin exposure on $23.1 billion of repurchase agreements. To the extent that the value of the collateral underlying these repurchase agreements declines, we may be required to post margin, which could significantly impact our liquidity.\\nThe following table provides additional information regarding our short-term borrowings (dollars in thousands):\\n| Nine Months Ended September 30, 2019 |\\n| OutstandingBalance at September 30, 2019 | Average Daily Amount Outstanding(A) | Maximum Amount Outstanding | Weighted Average Daily Interest Rate |\\n| Repurchase Agreements |\\n| Agency RMBS | $ | 10,733,236 | $ | 7,604,281 | $ | 16,181,622 | 2.53 | % |\\n| Non-Agency RMBS | 7,144,329 | 7,681,276 | 8,864,155 | 3.46 | % |\\n| Residential mortgage loans | 4,742,824 | 2,403,677 | 5,155,161 | 4.24 | % |\\n| Real estate owned | 63,831 | 65,768 | 101,153 | 4.40 | % |\\n| Notes and Bonds Payable |\\n| Excess MSRs | 100,000 | 71,062 | 100,000 | 4.87 | % |\\n| MSRs | 940,188 | 728,119 | 1,256,040 | 4.71 | % |\\n| Servicer advances | 615,733 | 357,863 | 773,968 | 3.15 | % |\\n| Residential mortgage loans | 541,040 | 361,984 | 542,321 | 3.56 | % |\\n| Total/Weighted Average | $ | 24,881,181 | $ | 19,274,030 | 3.26 | % |\\n\\n\\n| (A) | Represents the average for the period the debt was outstanding. |\\n\\n| Average Daily Amount Outstanding(A) |\\n| Three Months Ended |\\n| December 31, 2018 | March 31, 2019 | June 30, 2019 | September 30, 2019 |\\n| Repurchase Agreements |\\n| Agency RMBS | $ | 3,428,226 | $ | 5,364,480 | $ | 6,846,716 | $ | 10,544,720 |\\n| Non-Agency RMBS | 7,444,959 | 7,399,226 | 7,675,607 | 7,986,868 |\\n| Residential mortgage loans | 1,675,353 | 2,155,752 | 2,681,220 | 3,432,062 |\\n| Real estate owned | 68,416 | 91,025 | 48,247 | 58,390 |\\n\\n| (A) | Represents the average for the period the debt was outstanding. |\\n\\nFor additional information on our debt activities, see Note 11 to our Condensed Consolidated Financial Statements.\\n88\\nMaturities\\nOur debt obligations as of September 30, 2019, as summarized in Note 11 to our Condensed Consolidated Financial Statements, had contractual maturities as follows (in thousands):\\n| Year | Nonrecourse(A) | Recourse(B) | Total |\\n| October 1 through December 31, 2019 | $ | 1,978 | $ | 18,781,709 | $ | 18,783,687 |\\n| 2020 | 615,733 | 5,480,786 | 6,096,519 |\\n| 2021 | 1,088,623 | 1,034,034 | 2,122,657 |\\n| 2022 | 1,162,067 | 169,759 | 1,331,826 |\\n| 2023 | 400,000 | 403,433 | 803,433 |\\n| 2024 and thereafter | 976,300 | 410,534 | 1,386,834 |\\n| $ | 4,244,701 | $ | 26,280,255 | $ | 30,524,956 |\\n\\n| (A) | Includes repurchase agreements and notes and bonds payable of $2.0 million and $4,242.7 million, respectively. |\\n\\n| (B) | Includes repurchase agreements and notes and bonds payable of $23,109.4 million and $3,170.9 million, respectively. |\\n\\nThe weighted average differences between the fair value of the assets and the face amount of available financing for the Agency RMBS repurchase agreements (including amounts related to Trades Receivable) and Non-Agency RMBS repurchase agreements were 1.4% and 8.2%, respectively, and for Residential Mortgage Loans and Real Estate Owned were 11.0% and 28.0%, respectively, during the nine months ended September 30, 2019.\\nBorrowing Capacity\\nThe following table represents our borrowing capacity as of September 30, 2019 (in thousands):\\n| Debt Obligations/ Collateral | Borrowing Capacity | Balance Outstanding | Available Financing |\\n| Repurchase Agreements |\\n| Residential mortgage loans and REO | $ | 9,112,297 | $ | 5,233,801 | $ | 3,878,496 |\\n| Non-Agency RMBS | 650,000 | 558,756 | 91,244 |\\n| Notes and Bonds Payable |\\n| Excess MSRs | 150,000 | 100,000 | 50,000 |\\n| MSRs | 1,375,000 | 940,188 | 434,812 |\\n| Servicer advances(A) | 1,204,660 | 1,053,127 | 151,533 |\\n| Residential Mortgage Loans | 650,000 | 535,063 | 114,937 |\\n| Consumer loans | 150,000 | 1,228 | 148,772 |\\n| $ | 13,291,957 | $ | 8,422,163 | $ | 4,869,794 |\\n\\n\\n| (A) | Our unused borrowing capacity is available to us if we have additional eligible collateral to pledge and meet other borrowing conditions as set forth in the applicable agreements, including any applicable advance rate. We pay a 0.02% fee on the unused borrowing capacity. |\\n\\nCovenants\\nCertain of the debt obligations are subject to customary loan covenants and event of default provisions, including event of default provisions triggered by certain specified declines in our equity or failure to maintain a specified tangible net worth, liquidity, or indebtedness to tangible net worth ratio. We were in compliance with all of our debt covenants as of September 30, 2019.\\n89\\nStockholders’ Equity\\nPreferred Stock\\nPursuant to our certificate of incorporation, we are authorized to designate and issue up to 100.0 million shares of preferred stock, par value of $0.01 per share, in one or more classes or series.\\nOn July 2, 2019, we issued 6.2 million shares of our Preferred Series A. To compensate the Manager for its successful efforts in raising capital for us, in connection with this offering, we granted options to the Manager relating to 0.6 million shares of our common stock at the closing price per share of common stock on the pricing date, which had a fair value of approximately $0.5 million as of the grant date.\\nOn August 15, 2019, in a public offering, we issued 11.3 million shares of our Preferred Series B. To compensate the Manager for its successful efforts in raising capital for us, in connection with this offering, we granted options to the Manager relating to 1.1 million shares of our common stock at the closing price per share of common stock on the pricing date, which had a fair value of approximately $0.7 million as of the grant date.\\nOur Preferred Series A and Preferred Series B rank senior to all classes or series of our common stock and to all other equity securities issued by us that expressly indicate are subordinated to the Preferred Series A and Preferred Series B with respect to rights to the payment of dividends and the distribution of assets upon our liquidation, dissolution or winding up. Our Preferred Series A and Preferred Series B have no stated maturity, are not subject to any sinking fund or mandatory redemption and rank on parity with each other. Under certain circumstances upon a change of control, our Preferred Series A and Preferred Series B are convertible to shares of our common stock.\\nFrom and including, July 2, 2019 and August 15, 2019, but excluding, August 15, 2024, holders of shares of our Preferred Series A and Preferred Series B are entitled to receive cumulative cash dividends at a rate of 7.50% per annum and 7.125% of the $25.00 liquidation preference per share (equivalent to $1.875 and $1.781 per annum per share), respectively, and from and including August 15, 2024, at a floating rate per annum equal to the three-month LIBOR plus a spread of 5.802% and 5.640% per annum, respectively. Dividends are payable quarterly in arrears on or about the 15th day of each February, May, August and October.\\nThe Preferred Series A and Preferred Series B will not be redeemable before August 15, 2024, except under certain limited circumstances intended to preserve the Company’s qualification as a REIT for U.S. federal income tax purposes and except upon the occurrence of a Change of Control (as defined in the Certificate of Designations). On or after August 15, 2024, we may, at our option, upon not less than 30 nor more than 60 days’ written notice, redeem the Series A and Series B Preferred Stock, in whole or in part, at any time or from time to time, for cash at a redemption price of $25.00 per share, plus any accumulated and unpaid dividends thereon (whether or not authorized or declared) to, but excluding, the redemption date, without interest.\\nCommon Stock\\nApproximately 2.4 million shares of our common stock were held by Fortress, through its affiliates, as of September 30, 2019.\\nIn January 2018, New Residential issued 28.8 million shares of its common stock in a public offering at a price to the public of $17.10 per share for net proceeds of approximately $482.3 million. To compensate the Manager for its successful efforts in raising capital for New Residential, in connection with this offering, New Residential granted options to the Manager relating to 2.9 million shares of New Residential’s common stock at the public offering price, which had a fair value of approximately $3.8 million as of the grant date. The assumptions used in valuing the options were: a 2.58% risk-free rate, a 9.86% dividend yield, 23.16% volatility and a 10-year term.\\nOn July 30, 2018, we entered into a Distribution Agreement to sell shares of its common stock, par value $0.01 per share (the “ATM Shares”), having an aggregate offering price of up to $500.0 million, from time to time, through an “at-the-market” equity offering program (the “ATM Program”). As of June 30, 2019, we had sold 0.5 million ATM Shares for aggregate proceeds of $9.1 million. In connection with the shares sold under the ATM program, we granted options to the Manager relating to 0.05 million shares of our common stock at the offering price, which had fair value of approximately $0.1 million as of the grant date.\\nOn November 5, 2018, we issued 28.8 million shares of our common stock in a public offering at a price of $17.32 per share for net proceeds of approximately $489.2 million. To compensate the Manager for its successful efforts in raising capital for us, in connection with this offering, we granted options to the Manager relating to 2.9 million shares of our common stock at the public offering price, which had a fair value of approximately $3.8 million as of the grant date. The assumptions used in valuing the options were: a 3.25% risk-free rate, a 8.61% dividend yield, 17.50% volatility and a 10-year term.\\n90\\nIn February 2019, we issued 46.0 million shares of our common stock in a public offering at a price to the public of $16.50 per share for net proceeds of approximately $751.7 million. To compensate the Manager for its successful efforts in raising capital for us, in connection with this offering, we granted options to the Manager relating to 4.6 million shares of our common stock at the public offering price, which had a fair value of approximately $3.8 million as of the grant date. The assumptions used in valuing the options were: a 2.40% risk-free rate, a 9.30% dividend yield, 19.26% volatility and a 10-year term.\\nOn August 20, 2019, we announced that our board of directors had authorized the repurchase of up to $200.0 million of our common stock through December 31, 2020. Repurchases may be made at any time and from time to time through open market purchases or privately negotiated transactions, pursuant to one or more plans established pursuant to Rule 10b5-1 under the Exchange Act, by means of one or more tender offers, or otherwise, in each case, as permitted by securities laws and other legal and contractual requirements. The amount and timing of the purchases will depend on a number of factors including the price and availability of our shares, trading volume, capital availability, our performance and general economic and market conditions. The share repurchase program may be suspended or discontinued at any time. No share repurchases have been made as of the filing of this report. Repurchases may impact our financial results, including fees paid to our Manager.\\nAs of September 30, 2019, our outstanding options had a weighted average exercise price of $16.30. Our outstanding options as of September 30, 2019 were summarized as follows:\\n| Held by the Manager | 10,511,167 |\\n| Issued to the Manager and subsequently assigned to certain of the Manager’s employees | 2,290,749 |\\n| Issued to the independent directors | 7,000 |\\n| Total | 12,808,916 |\\n\\nAccumulated Other Comprehensive Income (Loss)\\nDuring the nine months ended September 30, 2019, our accumulated other comprehensive income (loss) changed due to the following factors (in thousands):\\n| Total Accumulated Other Comprehensive Income |\\n| Accumulated other comprehensive income, December 31, 2018 | $ | 417,023 |\\n| Net unrealized gain (loss) on securities | 469,183 |\\n| Reclassification of net realized (gain) loss on securities into earnings | (179,280 | ) |\\n| Accumulated other comprehensive income, September 30, 2019 | $ | 706,926 |\\n\\nOur GAAP equity changes as our real estate securities portfolio is marked to market each quarter, among other factors. The primary causes of mark to market changes are changes in interest rates and credit spreads. During the nine months ended September 30, 2019, we recorded unrealized gains on our real estate securities primarily caused by performance, liquidity and other factors related specifically to certain investments, coupled with a net tightening of mortgage credit spreads. We recorded OTTI charges of $21.9 million with respect to real estate securities and realized gains of $201.2 million on sales of real estate securities.\\nSee “—Market Considerations” above for a further discussion of recent trends and events affecting our unrealized gains and losses, as well as our liquidity.\\nCommon Dividends\\nWe are organized and intend to conduct our operations to qualify as a REIT for U.S. federal income tax purposes. We intend to make regular quarterly distributions to holders of our common stock. U.S. federal income tax law generally requires that a REIT distribute annually at least 90% of its REIT taxable income, without regard to the deduction for dividends paid and excluding net capital gains, and that it pay tax at regular corporate rates to the extent that it annually distributes less than 100% of its taxable income. We intend to make regular quarterly distributions of our taxable income to holders of our common stock out of assets legally available for this purpose, if and to the extent authorized by our board of directors. Before we pay any dividend, whether for U.S. federal income tax purposes or otherwise, we must first meet both our operating requirements and debt service on our repurchase agreements and other debt payable. If our cash available for distribution is less than our taxable income, we could be\\n91\\nrequired to sell assets or raise capital to make cash distributions or we may make a portion of the required distribution in the form of a taxable stock distribution or distribution of debt securities.\\nWe make distributions based on a number of factors, including an estimate of taxable earnings per common share. Dividends distributed and taxable and GAAP earnings will typically differ due to items such as fair value adjustments, differences in premium amortization and discount accretion, other differences in method of accounting, non-deductible general and administrative expenses, taxable income arising from certain modifications of debt instruments and investments held in TRSs. Our quarterly dividend per share may be substantially different than our quarterly taxable earnings and GAAP earnings per share.\\n| Common Dividends Declared for the Period Ended | Paid/Payable | Amount Per Share |\\n| September 30, 2018 | October 2018 | $ | 0.50 |\\n| December 31, 2018 | January 2019 | $ | 0.50 |\\n| March 31, 2019 | April 2019 | $ | 0.50 |\\n| June 30, 2019 | July 2019 | $ | 0.50 |\\n| September 30, 2019 | October 2019 | $ | 0.50 |\\n\\nCash Flow\\nOperating Activities\\nNet cash flows provided by operating activities increased approximately $2.2 billion for the nine months ended September 30, 2019 as compared to the nine months ended September 30, 2018. Operating cash flows for the nine months ended September 30, 2019 primarily consisted of proceeds from sales and principal repayments of purchased residential mortgage loans, held-for-sale of $13.3 billion, servicing fees received of $729.2 million, net recoveries of servicer advances receivable of $366.4 million, net interest income received of $702.3 million, and distributions of earnings from equity method investees of $8.9 million. Operating cash outflows primarily consisted of purchases of residential mortgage loans, held-for-sale of $6.0 billion, originations of $10.4 billion, incentive compensation and management fees paid to the Manager of $151.9 million, income taxes paid of $1.2 million, subservicing fees paid of $273.7 million and other outflows of approximately $611.3 million including general and administrative costs and loan servicing fees.\\nInvesting Activities\\nCash flows provided by (used in) investing activities were $(5.3) billion for the nine months ended September 30, 2019. Investing activities consisted primarily of the acquisition of MSRs, real estate securities, and the funding of servicer advances, net of principal repayments from Servicer Advance Investments, MSRs, real estate securities and loans as well as proceeds from the sale of real estate securities, loans and REO, and derivative cash flows.\\nFinancing Activities\\nCash flows provided by (used in) financing activities were approximately $8.1 billion during the nine months ended September 30, 2019. Financing activities consisted primarily of borrowings net of repayments under debt obligations, equity offerings, capital contributions net of distributions from noncontrolling interests in the equity of consolidated subsidiaries, and payment of dividends.\\nINTEREST RATE, CREDIT AND SPREAD RISK\\nWe are subject to interest rate, credit and spread risk with respect to our investments. These risks are further described in “Quantitative and Qualitative Disclosures About Market Risk.”\\nOFF-BALANCE SHEET ARRANGEMENTS\\nWe have material off-balance sheet arrangements related to our non-consolidated securitizations of residential mortgage loans treated as sales in which we retained certain interests. We believe that these off-balance sheet structures presented the most efficient and least expensive form of financing for these assets at the time they were entered and represented the most common market-accepted method for financing such assets. Our exposure to credit losses related to these non-recourse, off-balance sheet financings is limited to $1.3 billion. As of September 30, 2019, there was $11.2 billion in total outstanding unpaid principal balance of residential mortgage loans underlying such securitization trusts that represent off-balance sheet financings.\\nWe have a co-investment in a portfolio of consumer loans held through an entity (“LoanCo”) which we account for under the equity method.\\nWe did not have any other off-balance sheet arrangements as of September 30, 2019. We did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured investment vehicles, or special purpose or variable interest entities, established to facilitate off-balance sheet arrangements or other contractually narrow or limited purposes, other than the entities described above. Further, we have not guaranteed any obligations of unconsolidated entities or entered into any commitment and do not intend to provide additional funding to any such entities.\\n92\\nCONTRACTUAL OBLIGATIONS\\nOur contractual obligations as of September 30, 2019 included all of the material contractual obligations referred to in our annual report on Form 10-K for the year ended December 31, 2018, excluding debt that was repaid as described in “—Liquidity and Capital Resources—Debt Obligations.”\\nIn addition, we executed the following material contractual obligations during the nine months ended September 30, 2019:\\n\\n| • | Derivatives – as described in Note 10 to our Condensed Consolidated Financial Statements, we have altered the composition of our economic hedges during the period. |\\n\\n| • | Debt obligations – as described in Note 11 to our Condensed Consolidated Financial Statements, we borrowed additional amounts. |\\n\\nSee Notes 14 and 18 to our Condensed Consolidated Financial Statements included in this report for information regarding commitments and material contracts entered into subsequent to September 30, 2019, if any. As described in Note 14, we have committed to purchase certain future servicer advances. The actual amount of future advances is subject to significant uncertainty. However, we currently expect that net recoveries of servicer advances will exceed net fundings for the foreseeable future. This expectation is based on judgments, estimates and assumptions, all of which are subject to significant uncertainty, as further described in “—Application of Critical Accounting Policies—Servicer Advance Investments.” In addition, the Consumer Loan Companies have invested in loans with an aggregate of $279.4 million of unfunded and available revolving credit privileges as of September 30, 2019. However, under the terms of these loans, requests for draws may be denied and unfunded availability may be terminated at management’s discretion.\\nINFLATION\\nVirtually all of our assets and liabilities are financial in nature. As a result, interest rates and other factors affect our performance more so than inflation, although inflation rates can often have a meaningful influence over the direction of interest rates. Furthermore, our financial statements are prepared in accordance with GAAP and our distributions are determined by our board of directors primarily based on a number of factors, including taxable income, and, in each case, our activities and balance sheet are measured with reference to historical cost and/or fair market value without considering inflation. See “Quantitative and Qualitative Disclosures About Market Risk—Interest Rate Risk.”\\nCORE EARNINGS\\nWe have four primary variables that impact our operating performance: (i) the current yield earned on our investments, (ii) the interest expense under the debt incurred to finance our investments, (iii) our operating expenses and taxes and (iv) our realized and unrealized gains or losses, including any impairment, on our investments. “Core earnings” is a non-GAAP measure of our operating performance, excluding the fourth variable above and adjusts the earnings from the consumer loan investment to a level yield basis. Core earnings is used by management to evaluate our performance without taking into account: (i) realized and unrealized gains and losses, which although they represent a part of our recurring operations, are subject to significant variability and are generally limited to a potential indicator of future economic performance; (ii) incentive compensation paid to our Manager; (iii) non-capitalized transaction-related expenses; and (iv) deferred taxes, which are not representative of current operations.\\nOur definition of core earnings includes accretion on held-for-sale loans as if they continued to be held-for-investment. Although we intend to sell such loans, there is no guarantee that such loans will be sold or that they will be sold within any expected timeframe. During the period prior to sale, we continue to receive cash flows from such loans and believe that it is appropriate to record a yield thereon. In addition, our definition of core earnings excludes all deferred taxes, rather than just deferred taxes related to unrealized gains or losses, because we believe deferred taxes are not representative of current operations. Our definition of core earnings also limits accreted interest income on RMBS where we receive par upon the exercise of associated call rights based on the estimated value of the underlying collateral, net of related costs including advances. We created this limit in order to be able\\n93\\nto accrete to the lower of par or the net value of the underlying collateral, in instances where the net value of the underlying collateral is lower than par. We believe this amount represents the amount of accretion we would have expected to earn on such bonds had the call rights not been exercised.\\nOur investments in consumer loans are accounted for under ASC No. 310-20 and ASC No. 310-30, including certain non-performing consumer loans with revolving privileges that are explicitly excluded from being accounted for under ASC No. 310-30. Under ASC No. 310-20, the recognition of expected losses on these non-performing consumer loans is delayed in comparison to the level yield methodology under ASC No. 310-30, which recognizes income based on an expected cash flow model reflecting an investment’s lifetime expected losses. The purpose of the Core Earnings adjustment to adjust consumer loans to a level yield is to present income recognition across the consumer loan portfolio in the manner in which it is economically earned, avoid potential delays in loss recognition, and align it with our overall portfolio of mortgage-related assets which generally record income on a level yield basis. With respect to consumer loans classified as held-for-sale, the level yield is computed through the expected sale date. With respect to the gains recorded under GAAP in 2014 and 2016 as a result of a refinancing of, and the consolidation of, the Consumer Loan Companies, respectively, we continue to record a level yield on those assets based on their original purchase price.\\nWhile incentive compensation paid to our Manager may be a material operating expense, we exclude it from core earnings because (i) from time to time, a component of the computation of this expense will relate to items (such as gains or losses) that are excluded from core earnings, and (ii) it is impractical to determine the portion of the expense related to core earnings and non-core earnings, and the type of earnings (loss) that created an excess (deficit) above or below, as applicable, the incentive compensation threshold. To illustrate why it is impractical to determine the portion of incentive compensation expense that should be allocated to core earnings, we note that, as an example, in a given period, we may have core earnings in excess of the incentive compensation threshold but incur losses (which are excluded from core earnings) that reduce total earnings below the incentive compensation threshold. In such case, we would either need to (a) allocate zero incentive compensation expense to core earnings, even though core earnings exceeded the incentive compensation threshold, or (b) assign a “pro forma” amount of incentive compensation expense to core earnings, even though no incentive compensation was actually incurred. We believe that neither of these allocation methodologies achieves a logical result. Accordingly, the exclusion of incentive compensation facilitates comparability between periods and avoids the distortion to our non-GAAP operating measure that would result from the inclusion of incentive compensation that relates to non-core earnings.\\nWith regard to non-capitalized transaction-related expenses, management does not view these costs as part of our core operations, as they are considered by management to be similar to realized losses incurred at acquisition. Non-capitalized transaction-related expenses are generally legal and valuation service costs, as well as other professional service fees, incurred when we acquire certain investments, as well as costs associated with the acquisition and integration of acquired businesses.\\nSince the third quarter of 2018, as a result of the Shellpoint Acquisition, the Company, through its wholly owned subsidiary, NewRez, originates conventional, government-insured and nonconforming residential mortgage loans for sale and securitization. In connection with the transfer of loans to the GSEs or mortgage investors, New Residential reports realized gains or losses on the sale of originated residential mortgage loans and retention of mortgage servicing rights, which we believe is an indicator of performance for the Servicing and Origination segment and therefore included in core earnings. Realized gains or losses on the sale of originated residential mortgage loans had no impact on core earnings in any prior period, but may impact core earnings in future periods.\\nBeginning with the third quarter of 2019, as a result of the continued evaluation of how Shellpoint operates its business and its impact on our operating performance, core earnings includes Shellpoint’s GAAP net income with the exception of the unrealized gains or losses due to changes in valuation inputs and assumptions on MSRs owned by NewRez, and non-capitalized transaction-related expenses. This change was not material to core earnings for the quarter ended September 30, 2019.\\nManagement believes that the adjustments to compute “core earnings” specified above allow investors and analysts to readily identify and track the operating performance of the assets that form the core of our activity, assist in comparing the core operating results between periods, and enable investors to evaluate our current core performance using the same measure that management uses to operate the business. Management also utilizes core earnings as a measure in its decision-making process relating to improvements to the underlying fundamental operations of our investments, as well as the allocation of resources between those investments, and management also relies on core earnings as an indicator of the results of such decisions. Core earnings excludes certain recurring items, such as gains and losses (including impairment as well as derivative activities) and non-capitalized transaction-related expenses, because they are not considered by management to be part of our core operations for the reasons described herein. As such, core earnings is not intended to reflect all of our activity and should be considered as only one of the factors used by management in assessing our performance, along with GAAP net income which is inclusive of all of our activities.\\n94\\nThe primary differences between core earnings and the measure we use to calculate incentive compensation relate to (i) realized gains and losses (including impairments), (ii) non-capitalized transaction-related expenses and (iii) deferred taxes (other than those related to unrealized gains and losses). Each are excluded from core earnings and included in our incentive compensation measure (either immediately or through amortization). In addition, our incentive compensation measure does not include accretion on held-for-sale loans and the timing of recognition of income from consumer loans is different. Unlike core earnings, our incentive compensation measure is intended to reflect all realized results of operations. The Gain on Remeasurement of Consumer Loans Investment was treated as an unrealized gain for the purposes of calculating incentive compensation and was therefore excluded from such calculation.\\nCore earnings does not represent and should not be considered as a substitute for, or superior to, net income or as a substitute for, or superior to, cash flows from operating activities, each as determined in accordance with U.S. GAAP, and our calculation of this measure may not be comparable to similarly entitled measures reported by other companies. For a further description of the difference between cash flows provided by operations and net income, see “—Liquidity and Capital Resources” above. Set forth below is a reconciliation of core earnings to the most directly comparable GAAP financial measure (dollars in thousands):\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2019 | 2018 | 2019 | 2018 |\\n| Net income (loss) attributable to common stockholders | $ | 224,584 | $ | 184,608 | $ | 338,235 | $ | 963,619 |\\n| Adjustments for Non-Core Earnings: |\\n| Impairment | (5,123 | ) | 9,360 | 29,984 | 51,326 |\\n| Change in fair value of investments in mortgage servicing rights | 45,541 | (3,515 | ) | 272,259 | (394,717 | ) |\\n| Change in fair value of servicer advance investments | (6,641 | ) | 5,353 | (15,932 | ) | 86,581 |\\n| Change in fair value of investments in residential mortgage loans | 7,290 | (647 | ) | (102,298 | ) | (647 | ) |\\n| Change in fair value of derivative instruments | (41,910 | ) | (24,299 | ) | 18,586 | (27,985 | ) |\\n| (Gain) loss on settlement of investments, net (Note 2) | (135,935 | ) | 11,893 | (108,455 | ) | (106,064 | ) |\\n| Other (income) loss (Note 2) | 35,271 | 5,860 | 16,503 | (10,415 | ) |\\n| Other Income and Impairment attributable to non-controlling interests | (994 | ) | (4,633 | ) | (9,052 | ) | (17,088 | ) |\\n| Gain (loss) on sale or securitization of originated mortgage loans (Note 2) | 21,611 | 2,757 | 62,399 | 2,757 |\\n| Non-capitalized transaction-related expenses (Note 2) | 8,155 | 5,274 | 24,305 | 18,784 |\\n| Incentive compensation to affiliate (Note 14) | 36,307 | 23,848 | 49,265 | 65,169 |\\n| Preferred stock management fee to affiliate | 1,055 | — | 1,055 | — |\\n| Deferred taxes (Note 17) | (6,652 | ) | (1,865 | ) | 18,080 | (12,680 | ) |\\n| Interest income on residential mortgage loans, held-for-sale | 18,852 | 5,906 | 45,041 | 12,774 |\\n| Limit on RMBS discount accretion related to called deals | (34 | ) | (2,914 | ) | (19,590 | ) | (13,108 | ) |\\n| Adjust consumer loans to level yield | 1,922 | (6,760 | ) | 4,884 | (21,915 | ) |\\n| Core earnings of equity method investees: |\\n| Excess mortgage servicing rights (Note 4) | 3,987 | 4,468 | 6,102 | 10,514 |\\n| Core Earnings | $ | 207,286 | $ | 214,694 | $ | 631,371 | $ | 606,905 |\\n| Net Income Per Diluted Share | $ | 0.54 | $ | 0.54 | $ | 0.83 | $ | 2.86 |\\n| Core Earnings Per Diluted Share | $ | 0.50 | $ | 0.63 | $ | 1.55 | $ | 1.80 |\\n| Weighted Average Number of Shares of Common Stock Outstanding, Diluted | 415,588,238 | 340,868,403 | 406,671,972 | 337,078,824 |\\n\\n95\\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nMarket risk is the exposure to loss resulting from changes in interest rates, credit spreads, foreign currency exchange rates, commodity prices, equity prices and other market based risks. The primary market risks that we are exposed to are interest rate risk, mortgage basis spread risk, prepayment rate risk and credit risk. These risks are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. All of our market risk sensitive assets, liabilities and derivative positions (other than TBAs) are for non-trading purposes only. For a further discussion of how market risk may affect our financial position or results of operations, please refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Application of Critical Accounting Policies.”\\nBeginning with the third quarter of 2019, as a result of refinement of our risk management practices, including expansion of our hedging program, we have adjusted our sensitivity analysis. In prior periods, our sensitivity analysis reported the impact specific to changes in short term interest rates with no changes to discount rate spreads and yields. We have adjusted to report projected changes from a parallel shift in interest rates across all maturities along with corresponding changes in discount rates. In addition, based on management’s evaluation of the significance of each market risk exposure to our company, we have adjusted our sensitivity analysis to capture changes in mortgage basis spread risk and to remove credit spread risk. These changes resulted in a material impact to the results of our sensitivity analysis and therefore, we have provided summarized comparable information under the new sensitivity analysis for the prior period.\\nInterest Rate Risk\\nChanges in interest rates, including changes in expected interest rates or “yield curves,” affect our investments in various ways, the most significant of which are discussed below.\\nFair Value Impact\\nChanges in the level of interest rates also affect the yields required by the marketplace on interest rate instruments. Increasing interest rates would decrease the value of the fixed rate assets we hold at the time because higher required yields result in lower prices on existing fixed rate assets in order to adjust their yield upward to meet the market.\\nChanges in unrealized gains or losses resulting from changes in market interest rates do not directly affect our cash flows, or our ability to pay a dividend, to the extent the related assets are expected to be held and continue to perform as expected, as their fair value is not relevant to their underlying cash flows. Changes in unrealized gains or losses would impact our ability to realize gains on existing investments if they were sold. Furthermore, with respect to changes in unrealized gains or losses on investments which are carried at fair value, changes in unrealized gains or losses would impact our net book value and, in certain cases, our net income.\\nChanges in interest rates can also have ancillary impacts on our investments. Generally, in a declining interest rate environment, residential mortgage loan prepayment rates increase which in turn would cause the value of MSRs, mortgage servicing rights financing receivables, Excess MSRs and the rights to the basic fee components of MSRs to decrease, because the duration of the cash flows we are entitled to receive becomes shortened, and the value of loans and Non-Agency RMBS to increase, because we generally acquired these investments at a discount whose recovery would be accelerated. With respect to a significant portion of our investments in MSRs and Excess MSRs, we have recapture agreements, as described in Notes 4 and 5 to our Consolidated Financial Statements. These recapture agreements help to protect these investments from the impact of increasing prepayment rates. In addition, to the extent that the loans underlying our investments in MSRs, mortgage servicing rights financing receivables, Excess MSRs and the rights to the basic fee components of MSRs are well-seasoned with credit-impaired borrowers who may have limited refinancing options, we believe the impact of interest rates on prepayments would be reduced. Conversely, in an increasing interest rate environment, prepayment rates decrease which in turn would cause the value of MSRs, mortgage servicing rights financing receivables, Excess MSRs and the rights to the basic fee components of MSRs to increase and the value of loans and Non-Agency RMBS to decrease. To the extent we do not hedge against changes in interest rates, our balance sheet, results of operations and cash flows would be susceptible to significant volatility due to changes in the fair value of, or cash flows from, our investments as interest rates change. However, rising interest rates could result from more robust market conditions, which could reduce the credit risk associated with our investments. The effects of such a decrease in values on our financial position, results of operations and liquidity are discussed below under “—Prepayment Rate Exposure.”\\nChanges in the value of our assets could affect our ability to borrow and access capital. Also, if the value of our assets subject to short-term financing were to decline, it could cause us to fund margin, or repay debt, and affect our ability to refinance such assets upon the maturity of the related financings, adversely impacting our rate of return on such investments.\\n96\\nWe are subject to margin calls on our repurchase agreements. Furthermore, we may, from time to time, be a party to derivative agreements or financing arrangements that are subject to margin calls, or mandatory repayment, based on the value of such instruments. We seek to maintain adequate cash reserves and other sources of available liquidity to meet any margin calls, or required repayments, resulting from decreases in value related to a reasonably possible (in our opinion) change in interest rates but there can be no assurance that our cash reserves will be sufficient.\\nIn addition, changes in interest rates may impact our ability to exercise our call rights and to realize or maximize potential profits from them. A significant portion of the residential mortgage loans underlying our call rights bear fixed rates and may decline in value during a period of rising market interest rates. Furthermore, rising rates could cause prepayment rates on these loans to decline, which would delay our ability to exercise our call rights. These impacts could be at least partially offset by potential declines in the value of Non-Agency RMBS related to the call rights, which could then be acquired more cheaply, and in credit spreads, which could offset the impact of rising market interest rates on the value of fixed rate loans to some degree. Conversely, declining interest rates could increase the value of our call rights by increasing the value of the underlying loans.\\nWe believe our consumer loan investments generally have limited interest rate sensitivity given that our portfolio is mostly composed of very seasoned loans with credit-impaired borrowers who are paying fixed rates, who we believe are relatively unlikely to change their prepayment patterns based on changes in interest rates.\\nAs of September 30, 2019, an immediate 50 basis point increase in short term interest rates, based on a parallel shift in the yield curve (assuming an unchanged mortgage basis), would reduce our net book value by approximately $6.2 million, whereas a 50 basis point decrease in short term interest rates would increase our net book value by approximately $3.7 million, based on the present value of estimated cash flows on a static portfolio of investments. This includes changes in our book value resulting from potential related changes in discount rates.\\nInterest rates are highly sensitive to many factors, including fiscal and monetary policies and domestic and international economic and political considerations, as well as other factors beyond our control.\\nLIBOR and other indices which are deemed “benchmarks” are the subject of recent national, international, and other regulatory guidance and proposals for reform, and it appears likely that LIBOR will be phased out or the methodology for determining LIBOR will be modified by 2021. We currently have agreements that are indexed to LIBOR and are monitoring related reform proposals and evaluating the related risks; however, it is not possible to predict the effects of any of these developments, and any future initiatives to regulate, reform or change the manner of administration of LIBOR could result in adverse consequences to the rate of interest payable and receivable on, market value of and market liquidity for LIBOR-based financial instruments. The below table is comparative in order to show the prior period sensitivity analysis under our new methodology.\\n| June 30, 2019 | September 30, 2019 |\\n| Interest rate change (bps) | Estimated Change in Fair Value ($mm) | Estimated Change in Fair Value ($mm) |\\n| +50bps | +$6.2mm | -$36.2mm |\\n| +25bps | +$4.0mm | -$14.0mm |\\n| -25bps | -$5.9mm | +$5.9mm |\\n| -50bps | -$13.7mm | +$3.7mm |\\n\\nMortgage Basis Spread Risk\\nMortgage basis measures the spread between the yield on current coupon mortgage backed securities and benchmark rates including treasuries and swaps. The level of mortgage basis is driven by demand and supply of mortgage backed instruments relative to other rate-sensitive assets. Changes in the mortgage basis have an impact on prepayment rates driven by the ability of borrowers underlying our portfolio to refinance. A lower mortgage basis would imply a lower mortgage rate which would increase prepayment speeds due to higher refinance activity and, therefore, lower fair value of our mortgage portfolio. As of September 30, 2019, an immediate 20 basis point increase in mortgage basis would increase our net book value by approximately $39.4 million, whereas a 20 basis point decrease in mortgage basis would decrease our net book value by approximately $40.6 million, based on the present value of estimated cash flows on a static portfolio of investments. The below table is comparative in order to show the prior period sensitivity analysis under our new methodology.\\n97\\n| June 30, 2019 | September 30, 2019 |\\n| Mortgage Basis change (bps) | Estimated Change in Fair Value ($mm) | Estimated Change in Fair Value ($mm) |\\n| +20bps | +$79.8mm | +$39.4mm |\\n| +10bps | +$39.9mm | +$19.8mm |\\n| -10bps | -$40.0mm | -$20.1mm |\\n| -20bps | -$80.2mm | -$40.6mm |\\n\\nPrepayment Rate Exposure\\nPrepayment rates significantly affect the value of MSRs, mortgage servicing rights financing receivables, Excess MSRs, the basic fee component of MSRs (which we own as part of our Servicer Advance Investments), Non-Agency RMBS and loans, including consumer loans. Prepayment rate is the measurement of how quickly borrowers pay down the UPB of their loans or how quickly loans are otherwise brought current, modified, liquidated or charged off. The price we pay to acquire certain investments will be based on, among other things, our projection of the cash flows from the related pool of loans. Our expectation of prepayment rates is a significant assumption underlying those cash flow projections. If the fair value of MSRs, mortgage servicing rights financing receivables, Excess MSRs or the basic fee component of MSRs decreases, we would be required to record a non-cash charge, which would have a negative impact on our financial results. Furthermore, a significant increase in prepayment rates could materially reduce the ultimate cash flows we receive from MSRs, mortgage servicing rights financing receivables, Excess MSRs or our right to the basic fee component of MSRs, and we could ultimately receive substantially less than what we paid for such assets. Conversely, a significant decrease in prepayment rates with respect to our loans or RMBS could delay our expected cash flows and reduce the yield on these investments.\\nWe seek to reduce our exposure to prepayment through the structuring of our investments. For example, in our MSR and Excess MSR investments, we seek to enter into “recapture agreements” whereby our MSR or Excess MSR is retained if the applicable servicer or subservicer originates a new loan the proceeds of which are used to repay a loan underlying an MSR or Excess MSR in our portfolio. We seek to enter into such recapture agreements in order to protect our returns in the event of a rise in voluntary prepayment rates.\\nPlease refer to the table in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Application of Critical Accounting Policies—Excess MSRs” for an analysis of the sensitivity of these investments to changes in certain market factors.\\nCredit Risk\\nWe are subject to varying degrees of credit risk in connection with our assets. Credit risk refers to the ability of each individual borrower underlying our investments in MSRs, mortgage servicing rights financing receivables, Excess MSRs, Servicer Advance Investments, securities and loans to make required interest and principal payments on the scheduled due dates. If delinquencies increase, then the amount of servicer advances we are required to make will also increase, as would our financing cost thereof. We may also invest in loans and Non-Agency RMBS which represent “first loss” pieces; in other words, they do not benefit from credit support although we believe they predominantly benefit from underlying collateral value in excess of their carrying amounts. Although we do not expect to encounter credit risk in our Agency RMBS, we do anticipate credit risk related to Non-Agency RMBS, residential mortgage loans and consumer loans.\\nWe seek to reduce credit risk through prudent asset selection, actively monitoring our asset portfolio and the underlying credit quality of our holdings and, where appropriate and achievable, repositioning our investments to upgrade their credit quality. Our pre-acquisition due diligence and processes for monitoring performance include the evaluation of, among other things, credit and risk ratings, principal subordination, prepayment rates, delinquency and default rates, and vintage of collateral.\\nFor our MSRs, mortgage servicing rights financing receivables, and Excess MSRs on Agency collateral and our Agency RMBS, delinquency and default rates have an effect similar to prepayment rates. Our Excess MSRs on Non-Agency portfolios are not directly affected by delinquency rates because the servicer continues to advance principal and interest until a default occurs on the applicable loan, so delinquencies decrease prepayments therefore having a positive impact on fair value, while increased defaults have an effect similar to increased prepayments. For our Non-Agency RMBS and loans, higher default rates can lead to greater loss of principal. For our call rights, higher delinquencies and defaults could reduce the value of the underlying loans, therefore reducing or eliminating the related potential profit.\\n98\\nMarket factors that could influence the degree of the impact of credit risk on our investments include (i) unemployment and the general economy, which impact borrowers’ ability to make payments on their loans, (ii) home prices, which impact the value of collateral underlying residential mortgage loans, (iii) the availability of credit, which impacts borrowers’ ability to refinance, and (iv) other factors, all of which are beyond our control.\\nLiquidity Risk\\nThe assets that comprise our asset portfolio are generally not publicly traded. A portion of these assets may be subject to legal and other restrictions on resale or otherwise be less liquid than publicly-traded securities. The illiquidity of our assets may make it difficult for us to sell such assets if the need or desire arises, including in response to changes in economic and other conditions.\\nInvestment Specific Sensitivity Analyses\\nExcess MSRs\\nThe following table summarizes the estimated change in fair value of our interests in the Agency Excess MSRs owned directly as of September 30, 2019 given several parallel shifts in the discount rate, prepayment rate, delinquency rate and recapture rate (dollars in thousands):\\n| Fair value at September 30, 2019 | $ | 221,560 |\\n| Discount rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 233,576 | $ | 227,967 | $ | 215,552 | $ | 208,747 |\\n| Change in estimated fair value: |\\n| Amount | $ | 12,016 | $ | 6,407 | $ | (6,008 | ) | $ | (12,813 | ) |\\n| % | 5.4 | % | 2.9 | % | (2.7 | )% | (5.8 | )% |\\n| Prepayment rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 233,618 | $ | 228,908 | $ | 214,816 | $ | 211,680 |\\n| Change in estimated fair value: |\\n| Amount | $ | 12,058 | $ | 7,348 | $ | (6,744 | ) | $ | (9,880 | ) |\\n| % | 5.4 | % | 3.3 | % | (3.0 | )% | (4.5 | )% |\\n| Delinquency rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 221,913 | $ | 221,744 | $ | 221,404 | $ | 221,235 |\\n| Change in estimated fair value: |\\n| Amount | $ | 353 | $ | 184 | $ | (156 | ) | $ | (325 | ) |\\n| % | 0.2 | % | 0.1 | % | (0.1 | )% | (0.1 | )% |\\n| Recapture rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 214,864 | $ | 218,219 | $ | 224,929 | $ | 228,284 |\\n| Change in estimated fair value: |\\n| Amount | $ | (6,696 | ) | $ | (3,341 | ) | $ | 3,369 | $ | 6,724 |\\n| % | (3.0 | )% | (1.5 | )% | 1.5 | % | 3.0 | % |\\n\\n99\\nThe following table summarizes the estimated change in fair value of our interests in the Non-Agency Excess MSRs owned directly as of September 30, 2019 given several parallel shifts in the discount rate, prepayment rate, delinquency rate and recapture rate (dollars in thousands):\\n| Fair value at September 30, 2019 | $ | 176,504 |\\n| Discount rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 187,808 | $ | 182,601 | $ | 170,900 | $ | 164,407 |\\n| Change in estimated fair value: |\\n| Amount | $ | 11,304 | $ | 6,097 | $ | (5,604 | ) | $ | (12,097 | ) |\\n| % | 6.4 | % | 3.5 | % | (3.2 | )% | (6.9 | )% |\\n| Prepayment rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 190,121 | $ | 184,296 | $ | 169,440 | $ | 165,449 |\\n| Change in estimated fair value: |\\n| Amount | $ | 13,617 | $ | 7,792 | $ | (7,064 | ) | $ | (11,055 | ) |\\n| % | 7.7 | % | 4.4 | % | (4.0 | )% | (6.3 | )% |\\n| Delinquency rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 176,523 | $ | 176,521 | $ | 176,518 | $ | 176,516 |\\n| Change in estimated fair value: |\\n| Amount | $ | 19 | $ | 17 | $ | 14 | $ | 12 |\\n| % | — | % | — | % | — | % | — | % |\\n| Recapture rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 173,437 | $ | 174,978 | $ | 178,061 | $ | 179,602 |\\n| Change in estimated fair value: |\\n| Amount | $ | (3,067 | ) | $ | (1,526 | ) | $ | 1,557 | $ | 3,098 |\\n| % | (1.7 | )% | (0.9 | )% | 0.9 | % | 1.8 | % |\\n\\nThe following table summarizes the estimated change in fair value of our interests in the Agency Excess MSRs owned through equity method investees as of September 30, 2019 given several parallel shifts in the discount rate, prepayment rate, delinquency rate and recapture rate (dollars in thousands):\\n| Fair value at September 30, 2019 | $ | 132,259 |\\n| Discount rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 138,805 | $ | 135,647 | $ | 128,986 | $ | 125,484 |\\n| Change in estimated fair value: |\\n| Amount | $ | 6,546 | $ | 3,388 | $ | (3,273 | ) | $ | (6,775 | ) |\\n| % | 4.9 | % | 2.6 | % | (2.5 | )% | (5.1 | )% |\\n| Prepayment rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 138,370 | $ | 135,993 | $ | 128,756 | $ | 127,242 |\\n| Change in estimated fair value: |\\n| Amount | $ | 6,111 | $ | 3,734 | $ | (3,503 | ) | $ | (5,017 | ) |\\n| % | 4.6 | % | 2.8 | % | (2.6 | )% | (3.8 | )% |\\n| Delinquency rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 132,487 | $ | 132,352 | $ | 132,083 | $ | 131,949 |\\n| Change in estimated fair value: |\\n| Amount | $ | 228 | $ | 93 | $ | (176 | ) | $ | (310 | ) |\\n| % | 0.2 | % | 0.1 | % | (0.1 | )% | (0.2 | )% |\\n| Recapture rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 128,488 | $ | 130,353 | $ | 134,082 | $ | 135,947 |\\n| Change in estimated fair value: |\\n| Amount | $ | (3,771 | ) | $ | (1,906 | ) | $ | 1,823 | $ | 3,688 |\\n| % | (2.9 | )% | (1.4 | )% | 1.4 | % | 2.8 | % |\\n\\n100\\nMSRs\\nThe following table summarizes the estimated change in fair value of our interests in the Agency MSRs, including mortgage servicing rights financing receivables, owned as of September 30, 2019 given several parallel shifts in the discount rate, prepayment rate, delinquency rate and recapture rate (dollars in thousands):\\n| Fair value at September 30, 2019 | $ | 3,636,711 |\\n| Discount rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 3,819,885 | $ | 3,733,227 | $ | 3,545,124 | $ | 3,443,678 |\\n| Change in estimated fair value: |\\n| Amount | $ | 183,174 | $ | 96,516 | $ | (91,587 | ) | $ | (193,033 | ) |\\n| % | 5.0 | % | 2.7 | % | (2.5 | )% | (5.3 | )% |\\n| Prepayment rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 3,864,772 | $ | 3,743,884 | $ | 3,539,852 | $ | 3,452,425 |\\n| Change in estimated fair value: |\\n| Amount | $ | 228,061 | $ | 107,173 | $ | (96,859 | ) | $ | (184,286 | ) |\\n| % | 6.3 | % | 2.9 | % | (2.7 | )% | (5.1 | )% |\\n| Delinquency rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 3,650,369 | $ | 3,643,454 | $ | 3,629,626 | $ | 3,622,717 |\\n| Change in estimated fair value: |\\n| Amount | $ | 13,658 | $ | 6,743 | $ | (7,085 | ) | $ | (13,994 | ) |\\n| % | 0.4 | % | 0.2 | % | (0.2 | )% | (0.4 | )% |\\n| Recapture rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 3,511,603 | $ | 3,574,071 | $ | 3,699,008 | $ | 3,761,477 |\\n| Change in estimated fair value: |\\n| Amount | $ | (125,108 | ) | $ | (62,640 | ) | $ | 62,297 | $ | 124,766 |\\n| % | (3.4 | )% | (1.7 | )% | 1.7 | % | 3.4 | % |\\n\\n101\\nThe following table summarizes the estimated change in fair value of our interests in the Non-Agency MSRs, including mortgage servicing rights financing receivables, owned as of September 30, 2019 given several parallel shifts in the discount rate, prepayment rate, delinquency rate and recapture rate (dollars in thousands):\\n| Fair value at September 30, 2019 | $ | 1,233,592 |\\n| Discount rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 1,328,865 | $ | 1,287,146 | $ | 1,185,955 | $ | 1,126,483 |\\n| Change in estimated fair value: |\\n| Amount | $ | 95,273 | $ | 53,554 | $ | (47,637 | ) | $ | (107,109 | ) |\\n| % | 7.7 | % | 4.3 | % | (3.9 | )% | (8.7 | )% |\\n| Prepayment rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 1,286,886 | $ | 1,259,011 | $ | 1,213,398 | $ | 1,195,616 |\\n| Change in estimated fair value: |\\n| Amount | $ | 53,294 | $ | 25,419 | $ | (20,194 | ) | $ | (37,976 | ) |\\n| % | 4.3 | % | 2.1 | % | (1.6 | )% | (3.1 | )% |\\n| Delinquency rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 1,267,992 | $ | 1,245,516 | $ | 1,200,545 | $ | 1,178,053 |\\n| Change in estimated fair value: |\\n| Amount | $ | 34,400 | $ | 11,924 | $ | (33,047 | ) | $ | (55,539 | ) |\\n| % | 2.8 | % | 1.0 | % | (2.7 | )% | (4.5 | )% |\\n| Recapture rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 1,215,987 | $ | 1,225,223 | $ | 1,243,692 | $ | 1,252,927 |\\n| Change in estimated fair value: |\\n| Amount | $ | (17,605 | ) | $ | (8,369 | ) | $ | 10,100 | $ | 19,335 |\\n| % | (1.4 | )% | (0.7 | )% | 0.8 | % | 1.6 | % |\\n\\nThe following table summarizes the estimated change in fair value of our interests in the Ginnie Mae MSRs, owned as of September 30, 2019 given several parallel shifts in the discount rate, prepayment rate, delinquency rate and recapture rate (dollars in thousands):\\n| Fair value at September 30, 2019 | $ | 372,926 |\\n| Discount rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 392,886 | $ | 382,305 | $ | 362,946 | $ | 354,169 |\\n| Change in estimated fair value: |\\n| Amount | $ | 19,960 | $ | 9,379 | $ | (9,980 | ) | $ | (18,757 | ) |\\n| % | 5.4 | % | 2.5 | % | (2.7 | )% | (5.0 | )% |\\n| Prepayment rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 398,886 | $ | 384,635 | $ | 361,543 | $ | 351,942 |\\n| Change in estimated fair value: |\\n| Amount | $ | 25,960 | $ | 11,709 | $ | (11,383 | ) | $ | (20,984 | ) |\\n| % | 7.0 | % | 3.1 | % | (3.1 | )% | (5.6 | )% |\\n| Delinquency rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 377,595 | $ | 374,961 | $ | 369,692 | $ | 367,058 |\\n| Change in estimated fair value: |\\n| Amount | $ | 4,669 | $ | 2,035 | $ | (3,234 | ) | $ | (5,868 | ) |\\n| % | 1.3 | % | 0.5 | % | (0.9 | )% | (1.6 | )% |\\n| Recapture rate shift in % | -20% | -10% | 10% | 20% |\\n| Estimated fair value | $ | 354,049 | $ | 363,187 | $ | 381,465 | $ | 390,603 |\\n| Change in estimated fair value: |\\n| Amount | $ | (18,877 | ) | $ | (9,739 | ) | $ | 8,539 | $ | 17,677 |\\n| % | (5.1 | )% | (2.6 | )% | 2.3 | % | 4.7 | % |\\n\\n102\\nEach of the preceding sensitivity analyses is hypothetical and should be used with caution. In particular, the results are calculated by stressing a particular economic assumption independent of changes in any other assumption; in practice, changes in one factor may result in changes in another, which might counteract or amplify the sensitivities. Also, changes in the fair value based on a 10% variation in an assumption generally may not be extrapolated because the relationship of the change in the assumption to the change in fair value may not be linear.\\nITEM 4. CONTROLS AND PROCEDURES\\nDisclosure Controls and Procedures\\nThe Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. The Company’s disclosure controls and procedures are designed to provide reasonable assurance that information is recorded, processed, summarized and reported accurately and on a timely basis. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures were effective.\\nChanges in Internal Control Over Financial Reporting\\nThere have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\\n103\\nPART II. OTHER INFORMATION\\n\\nITEM 1. LEGAL PROCEEDINGS\\nWe are or may become, from time to time, involved in various disputes, litigation and regulatory inquiry and investigation matters that arise in the ordinary course of business. Given the inherent unpredictability of these types of proceedings, it is possible that future adverse outcomes could have a material adverse effect on our business, financial position or results of operations.\\nNew Residential is, from time to time, subject to inquiries by government entities. New Residential currently does not believe any of these inquiries would result in a material adverse effect on New Residential’s business.\\nITEM 1A. RISK FACTORS\\nInvesting in our stock involves a high degree of risk. You should carefully read and consider the following risk factors and all other information contained in this report. If any of the following risks, as well as additional risks and uncertainties not currently known to us or that we currently deem immaterial, occur, our business, financial condition or results of operations could be materially and adversely affected. The risk factors summarized below are categorized as follows: (i) Risks Related to Our Business, (ii) Risks Related to Our Manager, (iii) Risks Related to the Financial Markets, (iv) Risks Related to Our Taxation as a REIT and (v) Risks Related to Our Stock. However, these categories do overlap and should not be considered exclusive.\\nRisks Related to Our Business\\nWe may not be able to successfully operate our business strategy or generate sufficient revenue to make or sustain distributions to our stockholders.\\nWe cannot assure you that we will be able to successfully operate our business or implement our operating policies and strategies. There can be no assurance that we will be able to generate sufficient returns to pay our operating expenses and make satisfactory distributions to our stockholders, or any distributions at all. Our results of operations and our ability to make or sustain distributions to our stockholders depend on several factors, including the availability of opportunities to acquire attractive assets, the level and volatility of interest rates, the availability of adequate short- and long-term financing, and conditions in the real estate market, the financial markets and economic conditions.\\nThe value of our investments is based on various assumptions that could prove to be incorrect and could have a negative impact on our financial results.\\nWhen we make investments, we base the price we pay and, in some cases, the rate of amortization of those investments on, among other things, our projection of the cash flows from the related pool of loans. We generally record such investments on our balance sheet at fair value, and we measure their fair value on a recurring basis. Our projections of the cash flow from our investments, and the determination of the fair value thereof, are based on assumptions about various factors, including, but not limited to:\\n\\n| • | rates of prepayment and repayment of the underlying loans; |\\n\\n| • | potential fluctuations in prevailing interest rates and credit spreads; |\\n\\n| • | rates of delinquencies and defaults, and related loss severities; |\\n\\n| • | costs of engaging a subservicer to service MSRs; |\\n\\n| • | market discount rates; |\\n\\n| • | in the case of MSRs and Excess MSRs, recapture rates; and |\\n\\n| • | in the case of Servicer Advance Investments and servicer advances receivable, the amount and timing of servicer advances and recoveries. |\\n\\nOur assumptions could differ materially from actual results. The use of different estimates or assumptions in connection with the valuation of these investments could produce materially different fair values for such investments, which could have a material adverse effect on our consolidated financial position and results of operations. The ultimate realization of the value of our investments may be materially different than the fair values of such investments as reflected in our Condensed Consolidated Financial Statements as of any particular date.\\nWe refer to our MSRs, mortgage servicing rights financing receivables, Excess MSRs, and the base fee portion of the related MSRs included in our Servicer Advance Investments, collectively, as our interests in MSRs.\\n104\\nWith respect to our investments in interests in MSRs, residential mortgage loans and consumer loans, and a portion of our RMBS, when the related loans are prepaid as a result of a refinancing or otherwise, the related cash flows payable to us will either, in the case of interest-only RMBS, and/or interests in MSRs, cease (unless, in the case of our interests in MSRs, the loans are recaptured upon a refinancing), or we will cease to receive interest income on such investments, as applicable. Borrowers under residential mortgage loans and consumer loans are generally permitted to prepay their loans at any time without penalty. Our expectation of prepayment rates is a significant assumption underlying our cash flow projections. Prepayment rate is the measurement of how quickly borrowers pay down the UPB of their loans or how quickly loans are otherwise brought current, modified, liquidated or charged off. A significant increase in prepayment rates could materially reduce the ultimate cash flows and/or interest income, as applicable, we receive from our investments, and we could ultimately receive substantially less than what we paid for such assets, decreasing the fair value of our investments. If the fair value of our investment portfolio decreases, we would generally be required to record a non-cash charge, which would have a negative impact on our financial results. Consequently, the price we pay to acquire our investments may prove to be too high if there is a significant increase in prepayment rates.\\nThe values of our investments are highly sensitive to changes in interest rates. Historically, the value of MSRs, which underpin the value of our investments, including interests in MSRs, has increased when interest rates rise and decreased when interest rates decline due to the effect of changes in interest rates on prepayment rates. Prepayment rates could increase as a result of a general economic recovery or other factors, which would reduce the value of our interests in MSRs.\\nMoreover, delinquency rates have a significant impact on the value of our investments. When the UPB of mortgage loans cease to be a part of the aggregate UPB of the serviced loan pool (for example, when delinquent loans are foreclosed on or repurchased, or otherwise sold, from a securitized pool), the related cash flows payable to us, as the holder of an interest in the related MSR, cease. An increase in delinquencies will generally result in lower revenue because typically we will only collect on our interests in MSRs from GSEs or mortgage owners for performing loans. An increase in delinquencies with respect to the loans underlying our servicer advances could also result in a higher advance balance and the need to obtain additional financing, which we may not be able to do on favorable terms or at all. Additionally, in the case of residential mortgage loans, consumer loans and RMBS that we own, an increase in foreclosures could result in an acceleration of repayments, resulting in a decrease in interest income. Alternatively, increases in delinquencies and defaults could also adversely affect our investments in RMBS, residential mortgage loans and/or consumer loans if and to the extent that losses are suffered on residential mortgage loans, consumer loans or, in the case of RMBS, the residential mortgage loans underlying such RMBS. Accordingly, if delinquencies are significantly greater than expected, the estimated fair value of these investments could be diminished. As a result, we could suffer a loss, which would have a negative impact on our financial results.\\nWe are party to several “recapture agreements” whereby our MSR or Excess MSR is retained if the applicable Servicing Partner originates a new loan the proceeds of which are used to repay a loan underlying an MSR or Excess MSR in our portfolio. We believe that such agreements will mitigate the impact on our returns in the event of a rise in voluntary prepayment rates, with respect to investments where we have such agreements. There are no assurances, however, that counterparties will enter into such arrangements with us in connection with any future investment in MSRs or Excess MSRs. We are not party to any such arrangements with respect to any of our investments other than MSRs and Excess MSRs.\\nIf the applicable Servicing Partner does not meet anticipated recapture targets, the servicing cash flow on a given pool could be significantly lower than projected, which could have a material adverse effect on the value of our MSRs or Excess MSRs and consequently on our business, financial condition, results of operations and cash flows. Our recapture target for our current recapture agreements is stated in the table in Note 12 to our Condensed Consolidated Financial Statements.\\nServicer advances may not be recoverable or may take longer to recover than we expect, which could cause us to fail to achieve our targeted return on our Servicer Advance Investments or MSRs.\\nNRM is generally required to make servicer advances related to the pools of loans for which it is the named servicer. In addition, we have agreed (in the case of Nationstar, together with certain third-party investors) to purchase from certain of the servicers and subservicers that we engage, which we refer to as our “Servicing Partners,” all servicer advances related to certain loan pools, as a result of which we are entitled to amounts representing repayment for such advances. During any period in which a borrower is not making payments, a servicer is generally required under the applicable servicing agreement to advance its own funds to cover the principal and interest remittances due to investors in the loans, pay property taxes and insurance premiums to third parties, and to make payments for legal expenses and other protective advances. The servicer also advances funds to maintain, repair and market real estate properties on behalf of investors in the loans.\\nRepayment of servicer advances and payment of deferred servicing fees are generally made from late payments and other collections and recoveries on the related residential mortgage loan (including liquidation, insurance and condemnation proceeds) or, if the related servicing agreement provides for a “general collections backstop,” from collections on other residential mortgage loans\\n105\\nto which such servicing agreement relates. The rate and timing of payments on servicer advances and deferred servicing fees are unpredictable for several reasons, including the following:\\n\\n| • | payments on the servicer advances and the deferred servicing fees depend on the source of repayment, and whether and when the related servicer receives such payment (certain servicer advances are reimbursable only out of late payments and other collections and recoveries on the related residential mortgage loan, while others are also reimbursable out of principal and interest collections with respect to all residential mortgage loans serviced under the related servicing agreement, and as a consequence, the timing of such reimbursement is highly uncertain); |\\n\\n| • | the length of time necessary to obtain liquidation proceeds may be affected by conditions in the real estate market or the financial markets generally, the availability of financing for the acquisition of the real estate and other factors, including, but not limited to, government intervention; |\\n\\n| • | the length of time necessary to effect a foreclosure may be affected by variations in the laws of the particular jurisdiction in which the related mortgaged property is located, including whether or not foreclosure requires judicial action; |\\n\\n| • | the requirements for judicial actions for foreclosure (which can result in substantial delays in reimbursement of servicer advances and payment of deferred servicing fees), which vary from time to time as a result of changes in applicable state law; and |\\n\\n| • | the ability of the related servicer to sell delinquent residential mortgage loans to third parties prior to a sale of the underlying real estate, resulting in the early reimbursement of outstanding unreimbursed servicer advances in respect of such residential mortgage loans. |\\n\\nAs home values change, the servicer may have to reconsider certain of the assumptions underlying its decisions to make advances. In certain situations, its contractual obligations may require the servicer to make certain advances for which it may not be reimbursed. In addition, when a residential mortgage loan defaults or becomes delinquent, the repayment of the advance may be delayed until the residential mortgage loan is repaid or refinanced, or a liquidation occurs. To the extent that one of our Servicing Partners fails to recover the servicer advances in which we have invested, or takes longer than we expect to recover such advances, the value of our investment could be adversely affected and we could fail to achieve our expected return and suffer losses.\\nServicing agreements related to residential mortgage securitization transactions generally require a residential mortgage servicer to make servicer advances in respect of serviced residential mortgage loans unless the servicer determines in good faith that the servicer advance would not be ultimately recoverable from the proceeds of the related residential mortgage loan, mortgaged property or mortgagor. In many cases, if the servicer determines that a servicer advance previously made would not be recoverable from these sources, the servicer is entitled to withdraw funds from the related custodial account in respect of payments on the related pool of serviced mortgages to reimburse the related servicer advance. This is what is often referred to as a “general collections backstop.” The timing of when a servicer may utilize a general collections backstop can vary (some contracts require actual liquidation of the related loan first, while others do not), and contracts vary in terms of the types of servicer advances for which reimbursement from a general collections backstop is available. Accordingly, a servicer may not ultimately be reimbursed if both (i) the payments from related loan, property or mortgagor payments are insufficient for reimbursement, and (ii) a general collections backstop is not available or is insufficient. Also, if a servicer improperly makes a servicer advance, it would not be entitled to reimbursement. While we do not expect recovery rates to vary materially during the term of our investments, there can be no assurance regarding future recovery rates related to our portfolio.\\nWe rely heavily on our Servicing Partners to achieve our investment objective and have no direct ability to influence their performance.\\nThe value of substantially all of our investments is dependent on the satisfactory performance of servicing obligations by the related mortgage servicer or subservicer, as applicable. The duties and obligations of mortgage servicers are defined through contractual agreements, generally referred to as Servicing Guides in the case of GSEs, the MBS Guide in the case of Ginnie Mae or pooling agreements, securitization servicing agreements, pooling and servicing agreements or other similar agreements (collectively, “PSAs”) in the case of Non-Agency RMBS (collectively, the “Servicing Guidelines”). The duties of the subservicers we engage to service the loans underlying our MSRs are contained in subservicing agreements with our subservicers. The duties of a subservicer under a subservicing agreement may not be identical to the obligations of the servicer under Servicing Guidelines. Our interests in MSRs are subject to all of the terms and conditions of the applicable Servicing Guidelines. Servicing Guidelines generally provide for the possibility of termination of the contractual rights of the servicer in the absolute discretion of the owner of the mortgages being serviced (or the required bondholders in the case of Non-Agency RMBS). Under the Agency Servicing Guidelines, the servicer may be terminated by the applicable Agency for any reason, “with” or “without” cause, for all or any portion of the loans being serviced for such Agency. In the event mortgage owners (or bondholders) terminate the servicer (regardless of whether such servicer is a subsidiary of New Residential or one of its subservicers), the related interests in MSRs would under most circumstances lose all value on a going forward basis. If the servicer is terminated as servicer for any Agency pools, the servicer’s right to service the related mortgage loans will be extinguished and our interests in related MSRs will likely lose all of\\n106\\ntheir value. Any recovery in such circumstances, in the case of Non-Agency RMBS, will be highly conditioned and may require, among other things, a new servicer willing to pay for the right to service the applicable residential mortgage loans while assuming responsibility for the origination and prior servicing of the residential mortgage loans. In addition, in the case of Agency MSRs, any payment received from a successor servicer will be applied first to pay the applicable Agency for all of its claims and costs, including claims and costs against the servicer that do not relate to the residential mortgage loans for which we own interests in the MSRs. A termination could also result in an event of default under our related financings. It is expected that any termination of a servicer by mortgage owners (or bondholders) would take effect across all mortgages of such mortgage owners (or bondholders) and would not be limited to a particular vintage or other subset of mortgages. Therefore, it is possible that all investments with a given servicer would lose all their value in the event mortgage owners (or bondholders) terminate such servicer. See “—We have significant counterparty concentration risk in certain of our Servicing Partners, and are subject to other counterparty concentration and default risks.” As a result, we could be materially and adversely affected if one of our Servicing Partners is unable to adequately carry out its duties as a result of:\\n\\n| • | its failure to comply with applicable laws and regulations; |\\n\\n| • | its failure to comply with contractual and financing obligations and covenants; |\\n\\n| • | a downgrade in, or failure to maintain, any of its servicer ratings; |\\n\\n| • | its failure to maintain sufficient liquidity or access to sources of liquidity; |\\n\\n| • | its failure to perform its loss mitigation obligations; |\\n\\n| • | its failure to perform adequately in its external audits; |\\n\\n| • | a failure in or poor performance of its operational systems or infrastructure; |\\n\\n| • | regulatory or legal scrutiny or regulatory actions regarding any aspect of a servicer’s operations, including, but not limited to, servicing practices and foreclosure processes lengthening foreclosure timelines; |\\n\\n| • | an Agency’s or a whole-loan owner’s transfer of servicing to another party; or |\\n\\n| • | any other reason. |\\n\\nIn the ordinary course of business, our Servicing Partners are subject to numerous legal proceedings, federal, state or local governmental examinations, investigations or enforcement actions which could adversely affect their reputation and their liquidity, financial position and results of operations. Mortgage servicers, including certain of our Servicing Partners, have experienced heightened regulatory scrutiny and enforcement actions, and our Servicing Partners could be adversely affected by the market’s perception that they could experience, or continue to experience, regulatory issues. See “—Certain of our Servicing Partners have been and are subject to federal and state regulatory matters and other litigation, which may adversely impact us.”\\nLoss mitigation techniques are intended to reduce the probability that borrowers will default on their loans and to minimize losses when defaults occur, and they may include the modification of mortgage loan rates, principal balances and maturities. If any of our Servicing Partners fail to adequately perform their loss mitigation obligations, we could be required to make or purchase, as applicable, servicer advances in excess of those that we might otherwise have had to make or purchase, and the time period for collecting servicer advances may extend. Any increase in servicer advances or material increase in the time to resolution of a defaulted loan could result in increased capital requirements and financing costs for us and our co-investors and could adversely affect our liquidity and net income. In the event that one of our servicers from which we are obligated to purchase servicer advances is required by the applicable Servicing Guidelines to make advances in excess of amounts that we or, in the case of Nationstar, the co-investors, are willing or able to fund, such servicer may not be able to fund these advance requests, which could result in a termination event under the applicable Servicing Guidelines, an event of default under our advance facilities and a breach of our purchase agreement with such servicer. As a result, we could experience a partial or total loss of the value of our Servicer Advance Investments.\\nMSRs and servicer advances are subject to numerous federal, state and local laws and regulations and may be subject to various judicial and administrative decisions. If the Servicing Partner actually or allegedly failed to comply with applicable laws, rules or regulations, it could be terminated as the servicer, and could lead to civil and criminal liability, loss of licensing, damage to our reputation and litigation, which could have a material adverse effect on our business, financial condition, results of operations or cash flows. In addition, servicer advances that are improperly made may not be eligible for financing under our facilities and may not be reimbursable by the related securitization trust or other owner of the residential mortgage loan, which could cause us to suffer losses.\\nFavorable servicer ratings from third-party rating agencies, such as S&P Global Ratings (“S&P”), Moody’s Investors Service (“Moody’s”) and Fitch Ratings (“Fitch”), are important to the conduct of a mortgage servicer’s loan servicing business, and a downgrade in a Servicing Partner’s servicer ratings could have an adverse effect on the value of our interests in MSRs and result in an event of default under our financings. Downgrades in a Servicing Partner’s servicer ratings could adversely affect our ability to finance our assets and maintain their status as an approved servicer by Fannie Mae and Freddie Mac. Downgrades in servicer ratings could also lead to the early termination of existing advance facilities and affect the terms and availability of financing that\\n107\\na Servicing Partner or we may seek in the future. A Servicing Partner’s failure to maintain favorable or specified ratings may cause their termination as a servicer and may impair their ability to consummate future servicing transactions, which could result in an event of default under our financing for servicer advances and have an adverse effect on the value of our investments because we will rely heavily on Servicing Partners to achieve our investment objectives and have no direct ability to influence their performance.\\nFor additional information about the ways in which we may be affected by mortgage servicers, see “—The value of our interests in MSRs, servicer advances, residential mortgage loans and RMBS may be adversely affected by deficiencies in servicing and foreclosure practices, as well as related delays in the foreclosure process.”\\nA number of lawsuits, including class-actions, have been filed against mortgage servicers alleging improper servicing in connection with residential non-agency mortgage securitizations. Investors in, and counterparties to, such securitizations may commence legal action against us and responding to such claims, and any related losses, could negatively impact our business.\\nA number of lawsuits, including class actions, have been filed against mortgage servicers alleging improper servicing in connection with residential non-agency mortgage securitizations. Investors in, and counterparties to, such securitizations may commence legal action against us and responding to such claims, and any related losses, could negatively impact our business. The number of counterparties on behalf of which we service loans significantly increases as the size of our non-agency MSR portfolio increases and we may become subject to claims and legal proceedings, including purported class-actions, in the ordinary course of our business, challenging whether our loan servicing practices and other aspects of our business comply with applicable laws, agreements and regulatory requirements. We are unable to predict whether any such claims will be made, the ultimate outcome of any such claims, the possible loss, if any, associated with the resolution of such claims or the potential impact any such claims may have on us or our business and operations. Regardless of the merit of any such claims or lawsuits, defending any claims or lawsuits may be time consuming and costly and we may be required to expend significant internal resources and incur material expenses, and management time may be diverted from other aspects of our business, in connection therewith. Further, if our efforts to defend any such claims or lawsuits are not successful, our business could be materially and adversely affected. As a result of investor and other counterparty claims, we could also suffer reputational damage and trustees, lenders and other counterparties could cease wanting to do business with us.\\nCertain of our Servicing Partners have been and are subject to federal and state regulatory matters and other litigation, which may adversely impact us.\\nRegulatory actions or legal proceedings against certain of our Servicing Partners could increase our financing costs or operating expenses, reduce our revenues or otherwise materially adversely affect our business, financial condition, results of operations and liquidity. Such Servicing Partners may be subject to additional federal and state regulatory matters in the future that could materially and adversely affect the value of our investments to the extent we rely on them to achieve our investment objectives because we have no direct ability to influence their performance. Certain of our Servicing Partners have disclosed certain matters in their periodic reports filed with the SEC, and there can be no assurance that such events will not have a material adverse effect on them. We are currently evaluating the impact of such events and cannot assure you what impact these events may have or what actions we may take under our agreements with the servicer. In addition, any of our Servicing Partners could be removed as servicer by the related loan owner or certain other transaction counterparties, which could have a material adverse effect on our interests in the loans and MSRs serviced by such Servicing Partner.\\nIn addition, certain of our Servicing Partners have been and continue to be subject to regulatory and governmental examinations, information requests and subpoenas, inquiries, investigations and threatened legal actions and proceedings. In connection with formal and informal inquiries, such Servicing Partners may receive numerous requests, subpoenas and orders for documents, testimony and information in connection with various aspects of their activities, including whether certain of their residential loan servicing and originations practices, bankruptcy practices and other aspects of their business comply with applicable laws and regulatory requirements. Such Servicing Partners cannot provide any assurance as to the outcome of any of the aforementioned actions, proceedings or inquiries, or that such outcomes will not have a material adverse effect on their reputation, business, prospects, results of operations, liquidity or financial condition.\\nCompletion of certain pending transactions related to MSRs (the “MSR Transactions”) is subject to various closing conditions, involves significant costs, and we cannot assure you if, when or the terms on which such transactions will close. Failure to complete the pending MSR Transactions could adversely affect our future business and results of operations.\\nWe have entered into an agreement for Ocwen to transfer its remaining interests in $110.0 billion of UPB of non-Agency MSRs to NRM (the “Ocwen Subject MSRs”). We currently hold certain interests in the Ocwen Subject MSRs (including all servicer advances) pursuant to existing agreements with Ocwen. The transfer of Ocwen’s interests in the Ocwen Subject MSRs is subject\\n108\\nto numerous consents of third parties and certain actions by rating agencies. While certain of the Ocwen Subject MSRs have previously transferred to our subsidiaries, there is no assurance that we will be able to obtain such consents in order to transfer Ocwen’s interests in the Ocwen Subject MSRs to our subsidiaries. We have spent considerable time and resources, and incurred substantial costs, in connection with the negotiation of such transaction and we will incur such costs even if the Ocwen Subject MSRs cannot be transferred to our subsidiaries. As of September 30, 2019, MSRs representing approximately $66.7 billion UPB of underlying loans have been transferred pursuant to the Ocwen Transaction. Economics related to the remaining MSRs subject to the Ocwen Transaction were transferred pursuant to the New Ocwen Agreements (Note 5 to our Condensed Consolidated Financial Statements).\\nWe may be unable to become the named servicer in respect of certain Non-Agency MSRs. If we are unable to become the named servicer in respect of any of the Ocwen Subject MSRs in accordance with the Ocwen Transaction, Ocwen has the right, in certain circumstances, to purchase from us our interests in the related MSRs. In such a situation, we will be required to sell Ocwen those assets (and will cease to receive income on those investments) and/or may be required to refinance certain indebtedness on terms that are not favorable to us.\\nOur ability to acquire MSRs may be subject to the approval of various third parties and such approvals may not be provided on a timely basis or at all, or may be subject to conditions, representations and warranties and indemnities.\\nOur ability to acquire MSRs may be subject to the approval of various third parties and such approvals may not be provided on a timely basis or at all, or may be conditioned upon our satisfaction of significant conditions which could require material expenditures and the provision of significant representations, warranties and indemnities. Such third parties may include the Agencies and the Federal Housing Finance Agency (“FHFA”) with respect to agency MSRs, and securitization trustees, master servicers, depositors, rating agencies and insurers, among others, with respect to non-agency MSRs. The process of obtaining any such approvals required for a servicing transfer, especially with respect to non-agency MSRs, may be time consuming and costly and we may be required to expend significant internal resources and incur material expenses in connection with such transactions. Further, the parties from whom approval is necessary may require that we provide significant representations and warranties and broad indemnities as a condition to their consent, which such representations and warranties and indemnities, if given, may expose us to material risks in addition to those arising under the related servicing agreements. Consenting parties may also charge a material consent fee and may require that we reimburse them for the legal expenses they incur in connection with their approval of the servicing transfer, which such expenses may include costs relating to substantial contract due diligence and may be significant. No assurance can be given that we will be able to successfully obtain the consents required to acquire the MSRs that we have agreed to purchase.\\nWe have significant counterparty concentration risk in certain of our Servicing Partners and are subject to other counterparty concentration and default risks.\\nWe are not restricted from dealing with any particular counterparty or from concentrating any or all of our transactions with a few counterparties. Any loss suffered by us as a result of a counterparty defaulting, refusing to conduct business with us or imposing more onerous terms on us would also negatively affect our business, results of operations, cash flows and financial condition.\\nOur interests in MSRs relate to loans serviced or subserviced, as applicable, by our Servicing Partners. As disclosed in Notes 4, 5, and 6 of our Condensed Consolidated Financial Statements, certain of our Servicing Partners service and/or subservice a substantial portion of our interests in MSRs. If any of these Servicing Partners is the named servicer of the related MSR and is terminated, its servicing performance deteriorates, or in the event that any of them files for bankruptcy, our expected returns on these investments could be severely impacted. In addition, a large portion of the loans underlying our Non-Agency RMBS are serviced by certain of our Servicing Partners. We closely monitor our Servicing Partners’ mortgage servicing performance and overall operating performance, financial condition and liquidity, as well as their compliance with applicable regulations and Servicing Guidelines. We have various information, access and inspection rights in our agreements with these Servicing Partners that enable us to monitor aspects of their financial and operating performance and credit quality, which we periodically evaluate and discuss with their management. However, we have no direct ability to influence our Servicing Partners’ performance, and our diligence cannot prevent, and may not even help us anticipate, the termination of any such Servicing Partners’ servicing agreement or a severe deterioration of any of our Servicing Partners’ servicing performance on our portfolio of interests in MSRs.\\nFurthermore, certain of our Servicing Partners are subject to numerous legal proceedings, federal, state or local governmental examinations, investigations or enforcement actions, which could adversely affect their operations, reputation and liquidity, financial position and results of operations. See “—Certain of our Servicing Partners have been and are subject to federal and state regulatory matters and other litigation, which may adversely impact us” for more information.\\nNone of our Servicing Partners has an obligation to offer us any future co-investment opportunity on the same terms as prior transactions, or at all, and we may not be able to find suitable counterparties from which to acquire interests in MSRs, which could\\n109\\nimpact our business strategy. See “—We rely heavily on our Servicing Partners to achieve our investment objective and have no direct ability to influence their performance.”\\nRepayment of the outstanding amount of servicer advances (including payment with respect to deferred servicing fees) may be subject to delay, reduction or set-off in the event that the related Servicing Partner breaches any of its obligations under the Servicing Guidelines, including, without limitation, any failure of such Servicing Partner to perform its servicing and advancing functions in accordance with the terms of such Servicing Guidelines. If any applicable Servicing Partner is terminated or resigns as servicer and the applicable successor servicer does not purchase all outstanding servicer advances at the time of transfer, collection of the servicer advances will be dependent on the performance of such successor servicer and, if applicable, reliance on such successor servicer’s compliance with the “first-in, first-out” or “FIFO” provisions of the Servicing Guidelines. In addition, such successor servicers may not agree to purchase the outstanding advances on the same terms as our current purchase arrangements and may require, as a condition of their purchase, modification to such FIFO provisions, which could further delay our repayment and adversely affect the returns from our investment.\\nWe are subject to substantial other operational risks associated with our Servicing Partners in connection with the financing of servicer advances. In our current financing facilities for servicer advances, the failure of our Servicing Partner to satisfy various covenants and tests can result in an amortization event and/or an event of default. We have no direct ability to control our Servicing Partners’ compliance with those covenants and tests. Failure of our Servicing Partners to satisfy any such covenants or tests could result in a partial or total loss on our investment.\\nIn addition, our Servicing Partners are party to our servicer advance financing agreements, with respect to those advances where they service or subservice the loans underlying the related MSRs. Our ability to obtain financing for these assets is dependent on our Servicing Partners’ agreement to be a party to the related financing agreements. If our Servicing Partners do not agree to be a party to these financing agreements for any reason, we may not be able to obtain financing on favorable terms or at all. Our ability to obtain financing on such assets is dependent on our Servicing Partners’ ability to satisfy various tests under such financing arrangements. Breaches and other events with respect to our Servicing Partners (which may include, without limitation, failure of a Servicing Partner to satisfy certain financial tests) could cause certain or all of the relevant servicer advance financing to become due and payable prior to maturity.\\nWe are dependent on our Servicing Partners as the servicer or subservicer of the residential mortgage loans with respect to which we hold interests in MSRs, and their servicing practices may impact the value of certain of our assets. We may be adversely impacted:\\n| • | By regulatory actions taken against our Servicing Partners; |\\n\\n| • | By a default by one of our Servicing Partners under their debt agreements; |\\n\\n| • | By downgrades in our Servicing Partners’ servicer ratings; |\\n\\n| • | If our Servicing Partners fail to ensure their servicer advances comply with the terms of their Pooling and Servicing Agreements (“PSAs”); |\\n\\n| • | If our Servicing Partners were terminated as servicer under certain PSAs; |\\n\\n| • | If our Servicing Partners become subject to a bankruptcy proceeding; or |\\n\\n| • | If our Servicing Partners fail to meet their obligations or are deemed to be in default under the indenture governing notes issued under any servicer advance facility with respect to which such Servicing Partner is the servicer. |\\n\\nOur interests in MSRs relate to loans serviced or subserviced, as applicable, by our Servicing Partners. As disclosed in Notes 4, 5, and 6 of our Condensed Consolidated Financial Statements, certain of our Servicing Partners service and/or subservice a substantial portion of our interests in MSRs. In addition, Nationstar is currently the servicer for a significant portion of our loans, and the loans underlying our RMBS. If the servicing performance of one of our subservicers deteriorates, if one of our subservicers files for bankruptcy or if one of our subservicers is otherwise unwilling or unable to continue to subservice MSRs for us, our expected returns on these investments would be severely impacted. In addition, if a subservicer becomes subject to a regulatory consent order or similar enforcement proceeding, that regulatory action could adversely affect us in several ways. For example, the regulatory action could result in delays of transferring servicing from an interim subservicer to our designated successor subservicer or cause the subservicer’s performance to degrade. Any such development would negatively affect our expected returns on these investments, and such effect could be materially adverse to our business and results of operations. We closely monitor each subservicer’s mortgage servicing performance and overall operating performance, financial condition and liquidity, as well as its compliance with applicable regulations and GSE servicing guidelines. We have various information, access and inspection rights in our respective agreements with our subservicers that enable us to monitor their financial and operating performance and credit quality, which we periodically evaluate and discuss with each subservicer’s respective management. However, we have no direct ability to influence each subservicer’s performance, and our diligence cannot prevent, and may not even help us anticipate, a severe deterioration of each subservicer’s respective servicing performance on our MSR portfolio.\\n110\\nIn addition, a material portion of the consumer loans in which we have invested are serviced by OneMain. If OneMain is terminated as the servicer of some or all of these portfolios, or in the event that it files for bankruptcy or is otherwise unable to continue to service such loans, our expected returns on these investments could be severely impacted.\\nMoreover, we are party to repurchase agreements with a limited number of counterparties. If any of our counterparties elected not to renew our repurchase agreements, we may not be able to find a replacement counterparty, which would have a material adverse effect on our financial condition.\\nOur risk-management processes may not accurately anticipate the impact of market stress or counterparty financial condition, and as a result, we may not take sufficient action to reduce our risks effectively. Although we will monitor our credit exposures, default risk may arise from events or circumstances that are difficult to detect, foresee or evaluate. In addition, concerns about, or a default by, one large participant could lead to significant liquidity problems for other participants, which may in turn expose us to significant losses.\\nIn the event of a counterparty default, particularly a default by a major investment bank or Servicing Partner, we could incur material losses rapidly, and the resulting market impact of a major counterparty default could seriously harm our business, results of operations, cash flows and financial condition. In the event that one of our counterparties becomes insolvent or files for bankruptcy, our ability to eventually recover any losses suffered as a result of that counterparty’s default may be limited by the liquidity of the counterparty or the applicable legal regime governing the bankruptcy proceeding.\\nA bankruptcy of any of our Servicing Partners could materially and adversely affect us.\\nIf any of our Servicing Partners becomes subject to a bankruptcy proceeding, we could be materially and adversely affected, and you could suffer losses, as discussed below.\\nA sale of MSRs or interests in MSRs and servicer advances or other assets, including loans, could be re-characterized as a pledge of such assets in a bankruptcy proceeding.\\nWe believe that a mortgage servicer’s transfer to us of MSRs or interests in MSRs and servicer advances or any other asset transferred pursuant to a related purchase agreement, including loans, constitutes a sale of such assets, in which case such assets would not be part of such servicer’s bankruptcy estate. The servicer (as debtor-in-possession in the bankruptcy proceeding), a bankruptcy trustee appointed in such servicer’s bankruptcy proceeding, or any other party in interest, however, might assert in a bankruptcy proceeding MSRs or interests in MSRs and servicer advances or any other assets transferred to us pursuant to the related purchase agreement were not sold to us but were instead pledged to us as security for such servicer’s obligation to repay amounts paid by us to the servicer pursuant to the related purchase agreement. We generally create and perfect security interests with respect to the MSRs that we acquire, though we do not do so in all instances. If such assertion were successful, all or part of the MSRs or interests in MSRs and servicer advances or any other asset transferred to us pursuant to the related purchase agreement would constitute property of the bankruptcy estate of such servicer, and our rights against the servicer could be those of a secured creditor with a lien on such present and future assets. Under such circumstances, cash proceeds generated from our collateral would constitute “cash collateral” under the provisions of the U.S. bankruptcy laws. Under U.S. bankruptcy laws, the servicer could not use our cash collateral without either (a) our consent or (b) approval by the bankruptcy court, subject to providing us with “adequate protection” under the U.S. bankruptcy laws. In addition, under such circumstances, an issue could arise as to whether certain of these assets generated after the commencement of the bankruptcy proceeding would constitute after-acquired property excluded from our entitlement pursuant to the U.S. bankruptcy laws.\\nIf such a recharacterization occurs, the validity or priority of our security interest in the MSRs or interests in MSRs and servicer advances or other assets could be challenged in a bankruptcy proceeding of such servicer.\\nIf the purchases pursuant to the related purchase agreement are recharacterized as secured financings as set forth above, we nevertheless created and perfected security interests with respect to the MSRs or interests in MSRs and servicer advances and other assets that we may have purchased from such servicer by including a pledge of collateral in the related purchase agreement and filing financing statements in appropriate jurisdictions. Nonetheless, to the extent we have created and perfected a security interest, our security interests may be challenged and ruled unenforceable, ineffective or subordinated by a bankruptcy court, and the amount of our claims may be disputed so as not to include all MSRs or interests in MSRs and servicer advances to be collected. If this were to occur, or if we have not created a security interest, then the servicer’s obligations to us with respect to purchased MSRs or interests in MSRs and servicer advances or other assets would be deemed unsecured obligations, payable from unencumbered assets to be shared among all of such servicer’s unsecured creditors. In addition, even if the security interests are found to be valid and enforceable, if a bankruptcy court determines that the value of the collateral is less than such servicer’s\\n111\\nunderlying obligations to us, the difference between such value and the total amount of such obligations will be deemed an unsecured “deficiency” claim and the same result will occur with respect to such unsecured claim. In addition, even if the security interest is found to be valid and enforceable, such servicer would have the right to use the proceeds of our collateral subject to either (a) our consent or (b) approval by the bankruptcy court, subject to providing us with “adequate protection” under U.S. bankruptcy laws. Such servicer also would have the ability to confirm a chapter 11 plan over our objections if the plan complied with the “cramdown” requirements under U.S. bankruptcy laws.\\nPayments made by a servicer to us could be voided by a court under federal or state preference laws.\\nIf one of our Servicing Partners were to file, or to become the subject of, a bankruptcy proceeding under the United States Bankruptcy Code or similar state insolvency laws, and our security interest (if any) is declared unenforceable, ineffective or subordinated, payments previously made by a servicer to us pursuant to the related purchase agreement may be recoverable on behalf of the bankruptcy estate as preferential transfers. Among other reasons, a payment could constitute a preferential transfer if a court were to find that the payment was a transfer of an interest of property of such servicer that:\\n| • | Was made to or for the benefit of a creditor; |\\n\\n| • | Was for or on account of an antecedent debt owed by such servicer before that transfer was made; |\\n\\n| • | Was made while such servicer was insolvent (a company is presumed to have been insolvent on and during the 90 days preceding the date the company’s bankruptcy petition was filed); |\\n\\n| • | Was made on or within 90 days (or if we are determined to be a statutory insider, on or within one year) before such servicer’s bankruptcy filing; |\\n\\n| • | Permitted us to receive more than we would have received in a Chapter 7 liquidation case of such servicer under U.S. bankruptcy laws; and |\\n\\n| • | Was a payment as to which none of the statutory defenses to a preference action apply. |\\n\\nIf the court were to determine that any payments were avoidable as preferential transfers, we would be required to return such payments to such servicer’s bankruptcy estate and would have an unsecured claim against such servicer with respect to such returned amounts.\\nPayments made to us by such servicer, or obligations incurred by it, could be voided by a court under federal or state fraudulent conveyance laws.\\nThe mortgage servicer (as debtor-in-possession in the bankruptcy proceeding), a bankruptcy trustee appointed in such servicer’s bankruptcy proceeding, or another party in interest could also claim that such servicer’s transfer to us of MSRs or interests in MSRs and servicer advances or other assets or such servicer’s agreement to incur obligations to us under the related purchase agreement was a fraudulent conveyance. Under U.S. bankruptcy laws and similar state insolvency laws, transfers made or obligations incurred could be voided if, among other reasons, such servicer, at the time it made such transfers or incurred such obligations: (a) received less than reasonably equivalent value or fair consideration for such transfer or incurrence and (b) either (i) was insolvent at the time of, or was rendered insolvent by reason of, such transfer or incurrence; (ii) was engaged in, or was about to engage in, a business or transaction for which the assets remaining with such servicer were an unreasonably small capital; or (iii) intended to incur, or believed that it would incur, debts beyond its ability to pay such debts as they mature. If any transfer or incurrence is determined to be a fraudulent conveyance, our Servicing Partner, as applicable (as debtor-in-possession in the bankruptcy proceeding), or a bankruptcy trustee on such Servicing Partner’s behalf would be entitled to recover such transfer or to avoid the obligation previously incurred.\\nAny purchase agreement pursuant to which we purchase interests in MSRs, servicer advances or other assets, including loans, or any subservicing agreement between us and a subservicer on our behalf could be rejected in a bankruptcy proceeding of one of our Servicing Partners or counterparties.\\nA mortgage servicer (as debtor-in-possession in the bankruptcy proceeding) or a bankruptcy trustee appointed in such servicer’s or counterparty’s bankruptcy proceeding could seek to reject the related purchase agreement or subservicing agreement with a counterparty and thereby terminate such servicer’s or counterparty’s obligation to service the MSRs or interests in MSRs and servicer advances or any other asset transferred pursuant to such purchase agreement, and terminate our right to acquire additional assets under such purchase agreement and our right to require such servicer to use commercially reasonable efforts to transfer servicing. If the bankruptcy court approved the rejection, we would have a claim against such servicer or counterparty for any damages from the rejection, and the resulting transfer of our interests in MSRs or servicing of the MSRs relating to our Excess MSRs to another subservicer may result in significant cost and may negatively impact the value of our interests in MSRs.\\n112\\nA bankruptcy court could stay a transfer of servicing to another servicer.\\nOur ability to terminate a subservicer or to require a mortgage servicer to use commercially reasonable efforts to transfer servicing rights to a new servicer would be subject to the automatic stay in such servicer’s bankruptcy proceeding. To enforce this right, we would have to seek relief from the bankruptcy court to lift such stay, and there is no assurance that the bankruptcy court would grant this relief.\\nAny Subservicing Agreement could be rejected in a bankruptcy proceeding.\\nIf one of our Servicing Partners were to file, or to become the subject of, a bankruptcy proceeding under the United States Bankruptcy Code or similar state insolvency laws, such Servicing Partner (as debtor-in-possession in the bankruptcy proceeding) or the bankruptcy trustee could reject its subservicing agreement with us and terminate such Servicing Partner’s obligation to service the MSRs, servicer advances or loans in which we have an investment. Any claim we have for damages arising from the rejection of a subservicing agreement would be treated as a general unsecured claim for purposes of distributions from such Servicing Partner’s bankruptcy estate.\\nOur Servicing Partners could discontinue servicing.\\nIf one of our Servicing Partners were to file, or to become the subject of, a bankruptcy proceeding under the United States Bankruptcy Code, such Servicing Partner could be terminated as servicer (with bankruptcy court approval) or could discontinue servicing, in which case there is no assurance that we would be able to continue receiving payments and transfers in respect of the interests in MSRs, servicer advances and other assets purchased under the related purchase agreement or subserviced under the related subservicing agreement. Even if we were able to obtain the servicing rights or terminate the related subservicer, we may need to engage an alternate subservicer (which may not be readily available on acceptable terms or at all) or negotiate a new subservicing agreement with such servicer, which presumably would be on less favorable terms to us. Any engagement of an alternate subservicer by us would require the approval of the related RMBS trustees or the Agencies, as applicable.\\nAn automatic stay under the United States Bankruptcy Code may prevent the ongoing receipt of servicing fees or other amounts due.\\nEven if we are successful in arguing that we own the interests in MSRs, servicer advances and other assets, including loans, purchased under the related purchase agreement, we may need to seek relief in the bankruptcy court to obtain turnover and payment of amounts relating to such assets, and there may be difficulty in recovering payments in respect of such assets that may have been commingled with other funds of such servicer.\\nA bankruptcy of any of our Servicing Partners may default our MSR, Excess MSR and servicer advance financing facilities and negatively impact our ability to continue to purchase interests in MSRs.\\nIf any of our Servicing Partners were to file for bankruptcy or become the subject of a bankruptcy proceeding, it could result in an event of default under certain of our financing facilities that would require the immediate paydown of such facilities. In this scenario, we may not be able to comply with our obligations to purchase interests in MSRs and servicer advances under the related purchase agreements. Notwithstanding this inability to purchase, the related seller may try to force us to continue making such purchases. If it is determined that we are in breach of our obligations under our purchase agreements, any claims that we may have against such related seller may be subject to offset against claims such seller may have against us by reason of this breach.\\nCertain of our subsidiaries originate and service residential mortgage loans, which subject us to various operational risks that could have a negative impact on our financial results.\\nAs a result of our previously disclosed acquisitions of Shellpoint Partners LLC and from Ditech, among others, certain subsidiaries of New Residential perform various mortgage and real estate related services, and have origination and servicing operations, which entail borrower-facing activities and employing personnel. Prior to such acquisitions, neither we nor any of our subsidiaries have previously originated or serviced loans directly, and owning entities that perform these and other operations could expose us to risks similar to those of our Servicing Partners, as well as various other risks, including, but not limited to those pertaining to:\\n| • | risks related to compliance with applicable laws, regulations and other requirements; |\\n\\n| • | significant increases in delinquencies for the loans; |\\n\\n| • | compliance with the terms of related servicing agreements; |\\n\\n| • | financing related servicer advances and the origination business; |\\n\\n| • | expenses related to servicing high risk loans; |\\n\\n113\\n| • | unrecovered or delayed recovery of servicing advances; |\\n\\n| • | a general risk in foreclosure rates, which may ultimately reduce the number of mortgages that we service (also see-“The residential mortgage loans underlying the securities we invest in and the loans we directly invest in are subject to delinquency, foreclosure and loss, which could result in losses to us.”); |\\n\\n| • | maintaining the size of the related servicing portfolio and the volume of the origination business; |\\n\\n| • | compliance with FHA underwriting guidelines; and |\\n\\n| • | termination of government mortgage refinancing programs. |\\n\\nAny of the foregoing risks, among others, could have a material adverse effect on our business, financial condition, results of operations and liquidity.\\nOur subsidiaries that perform mortgage lending and servicing activities are subject to extensive regulation by federal, state and local governmental and regulatory authorities, and our subsidiaries' business results may be significantly impacted by the existing and future laws and regulations to which they are subject. If our subsidiaries performing mortgage lending and servicing activities fail to operate in compliance with both existing and future statutory, regulatory and other requirements, our business, financial condition, liquidity and/or results of operations could be materially and adversely affected.\\nOur subsidiaries that perform mortgage lending and servicing activities are subject to extensive regulation by federal, state and local governmental and regulatory authorities, including the CFPB, the Federal Trade Commission, the U.S. Department of Housing and Urban Development (“HUD”), the U.S. Department of Veterans Affairs (“VA”), the SEC and various state agencies that license, audit, investigate and conduct examinations of such subsidiaries’ mortgage servicing, origination, debt collection, and other activities. In the current regulatory environment, the policies, laws, rules and regulations applicable to our subsidiaries’ mortgage origination and servicing businesses have been rapidly evolving. Federal, state or local governmental authorities may continue to enact laws, rules or regulations that will result in changes in our and our subsidiaries’ business practices and may materially increase the costs of compliance. We are unable to predict whether any such changes will adversely affect our business.\\nWe and our subsidiaries must comply with a large number of federal, state and local consumer protection laws including, among others, the Dodd-Frank Act, the Gramm-Leach-Bliley Act, the Fair Debt Collection Practices Act, Real Estate Settlement Procedures Act, the Truth in Lending Act, the Fair Credit Reporting Act, the Servicemembers Civil Relief Act, the Homeowners Protection Act, the Federal Trade Commission Act, the Telephone Consumer Protection Act, the Equal Credit Opportunity Act, as well as individual state licensing and foreclosure laws and federal and local bankruptcy rules. These statutes apply to many facets of our subsidiaries’ businesses, including loan origination, default servicing and collections, use of credit reports, safeguarding of non-public personally identifiable information about customers, foreclosure and claims handling, investment of and interest payments on escrow balances and escrow payment features, and such statutes mandate certain disclosures and notices to borrowers. These requirements can and will change as statutes and regulations are enacted, promulgated, amended, interpreted and enforced.\\nIn addition, the GSEs, Ginnie Mae and other business counterparties subject our subsidiaries’ mortgage origination and servicing businesses to periodic examinations, reviews and audits, and we routinely conduct our own internal examinations, reviews and audits. These various examinations, reviews and audits of our subsidiaries’ businesses and related activities may reveal deficiencies in such subsidiaries’ compliance with our policies and other requirements to which they are subject. While we strive to investigate and remediate such deficiencies, there can be no assurance that our internal investigations will reveal any deficiencies or that any remedial measures that we implement, which could involve material expense, will ensure compliance with applicable policies, laws, regulations and other requirements or be deemed sufficient by the GSEs, Ginnie Mae, federal and local governmental authorities or other interested parties.\\nWe and our subsidiaries devote substantial resources to regulatory compliance and regulatory inquiries, and we incur, and expect to continue to incur, significant costs in connection therewith. Our business, financial condition, liquidity and/or results of operations could be materially and adversely affected by the substantial resources we devote to, and the significant compliance costs we incur in connection with, regulatory compliance and regulatory inquiries, including any fines, penalties, restitution or similar payments we may be required to make in connection with resolving such matters.\\nThe actual or alleged failure of our mortgage origination and servicing subsidiaries to comply with applicable federal, state and local laws and regulations and GSE, Ginnie Mae and other business counterparty requirements, or to implement and adhere to adequate remedial measures designed to address any identified compliance deficiencies, could lead to:\\n| • | the loss or suspension of licenses and approvals necessary to operate our or our subsidiaries’ business; |\\n\\n| • | limitations, restrictions or complete bans on our or our subsidiaries’ business or various segments of our business; |\\n\\n114\\n| • | our or our subsidiaries’ disqualification from participation in governmental programs, including GSE, Ginnie Mae, and VA programs; |\\n\\n| • | breaches of covenants and representations under our servicing, debt, or other agreements; |\\n\\n| • | negative publicity and damage to our reputation; |\\n\\n| • | governmental investigations and enforcement actions; |\\n\\n| • | administrative fines and financial penalties; |\\n\\n| • | litigation, including class action lawsuits; |\\n\\n| • | civil and criminal liability; |\\n\\n| • | termination of our servicing and subservicing agreements or other contracts; |\\n\\n| • | demands for us to repurchase loans; |\\n\\n| • | loss of personnel who are targeted by prosecutions, investigations, enforcement actions or litigation; |\\n\\n| • | a significant increase in compliance costs; |\\n\\n| • | a significant increase in the resources we and our subsidiaries devote to regulatory compliance and regulatory inquiries; |\\n\\n| • | an inability to access new, or a default under or other loss of current, liquidity and funding sources necessary to operate our business; |\\n\\n| • | restrictions on our or our subsidiaries’ business activities; |\\n\\n| • | impairment of assets; and |\\n\\n| • | an inability to execute on our business strategy. |\\n\\nAny of these outcomes could materially and adversely affect our reputation, business, financial condition, prospects, liquidity and/or results of operations.\\nWe cannot guarantee that any such scrutiny and investigations will not materially adversely affect us. Additionally, in recent years, the general trend among federal, state and local lawmakers and regulators has been toward increasing laws, regulations and investigative proceedings with regard to residential mortgage lenders and servicers. The CFPB continues to take an active role in supervising the mortgage industry, and its rule-making and regulatory agenda relating to loan servicing and originations continues to evolve. Individual states have also been increasingly active in supervising non-bank mortgage lenders and servicers such as NewRez, and certain regulators have communicated recommendations, expectations or demands with respect to areas such as corporate governance, safety and soundness, risk and compliance management, and cybersecurity, in addition to their focus on traditional licensing and examination matters.\\nFollowing the 2018 Congressional elections, a level of heightened uncertainty exists with respect to the future of regulation of mortgage lending and servicing, including the future of the Dodd-Frank Act and CFPB. We cannot predict the specific legislative or executive actions that may result or what actions federal or state regulators might take in response to potential changes to the Dodd-Frank Act or to the federal regulatory environment generally. Such actions could impact the mortgage industry generally or us specifically, could impact our relationships with other regulators, and could adversely impact our business.\\nThe CFPB and certain state regulators have increasingly focused on the use, and adequacy, of technology in the mortgage servicing industry. For example, in 2016, the CFPB issued a special edition supervision report that stressed the need for mortgage servicers to assess and make necessary improvements to their information technology systems in order to ensure compliance with the CFPB’s mortgage servicing requirements. The New York Department of Financial Services (“NY DFS”) also issued Cybersecurity Requirements for Financial Services Companies, effective in 2017, which requires banks, insurance companies, and other financial services institutions regulated by the NY DFS to establish and maintain a cybersecurity program designed to protect consumers and ensure the safety and soundness of New York State’s financial services industry. In addition, in June 2018, the State of California signed into law the California Consumer Privacy Act (“CCPA”), which will become effective in January 2020, will require businesses that maintain personal information of California residents, including certain mortgage lenders and servicers, to notify certain consumers when collecting their data, respond to consumer requests relating to the uses of their data, verify the identities of consumers who make requests, disclose details regarding transactions involving their data, and maintain records of consumer’ requests relating to their data, among various other obligations, and to create procedures designed to comply with CCPA requirements. The CCPA will become effective on January 1, 2020, and its implementing regulations are in the process of becoming finalized. The impact of the CCPA and its implementing regulations on our mortgage origination and servicing businesses remains uncertain, and may result in an increase in legal and compliance costs.\\nNew regulatory and legislative measures, or changes in enforcement practices, including those related to the technology we use, could, either individually or in the aggregate, require significant changes to our business practices, impose additional costs on us, limit our product offerings, limit our ability to efficiently pursue business opportunities, negatively impact asset values or reduce our revenues. Accordingly, any of the foregoing could materially and adversely affect our business and our financial condition, liquidity and results of operations.\\n115\\nA failure to maintain minimum servicer ratings could have an adverse effect on our business, financing activities, financial condition or results of operations.\\nS&P, Moody’s and Fitch rates Shellpoint Mortgage Servicing as a residential loan servicer, and a downgrade, or failure to maintain, any of our servicer ratings could:\\n| • | adversely affect our ability to maintain our status as an approved servicer by Fannie Mae and Freddie Mac; |\\n\\n| • | adversely affect our ability to finance servicing advances and certain other assets; |\\n\\n| • | lead to the early termination of existing advance facilities and affect the terms and availability of advance facilities that we may seek in the future; |\\n\\n| • | cause our termination as servicer in our servicing agreements that require that we maintain specified servicer ratings; and |\\n\\n| • | further impair our ability to consummate future servicing transactions. |\\n\\nAny of the above could adversely affect our business, financial condition and results of operations.\\nGSE initiatives and other actions, including changes to the minimum servicing amount for GSE loans, could occur at any time and could impact us in significantly negative ways that we are unable to predict or protect against.\\nThe Federal Housing Finance Agency (“FHFA”) and other industry stakeholders or regulators may implement or require changes to current mortgage servicing practices and compensation that could have a material adverse effect on the economics or performance of our investments in MSRs.\\nCurrently, when a loan is sold into the secondary market for Fannie Mae or Freddie Mac loans, the servicer is generally required to retain a minimum servicing amount (“MSA”) of 25 basis points of the UPB for fixed rate mortgages. As has been widely publicized, in September 2011, the FHFA announced that a Joint Initiative on Mortgage Servicing Compensation was seeking public comment on two alternative mortgage servicing compensation structures detailed in a discussion paper. Changes to the MSA structure could significantly impact our business in negative ways that we cannot predict or protect against. For example, the elimination of a MSA could radically change the mortgage servicing industry and could severely limit the supply of interests in MSRs available for sale. In addition, a removal of, or reduction in, the MSA could significantly reduce the recapture rate on the affected loan portfolio, which would negatively affect the investment return on our interests in MSRs. We cannot predict whether any changes to current MSA rules will occur or what impact any changes will have on our business, results of operations, liquidity or financial condition.\\nOur interests in MSRs may involve complex or novel structures.\\nInterests in MSRs may entail new types of transactions and may involve complex or novel structures. Accordingly, the risks associated with the transactions and structures are not fully known to buyers and sellers. In the case of interests in MSRs on Agency pools, Agencies may require that we submit to costly or burdensome conditions as a prerequisite to their consent to an investment in, or our financing of, interests in MSRs on Agency pools. Agency conditions, including capital requirements, may diminish or eliminate the investment potential of interests in MSRs on Agency pools by making such investments too expensive for us or by severely limiting the potential returns available from interests in MSRs on Agency pools.\\nIt is possible that an Agency’s views on whether any such acquisition structure is appropriate or acceptable may not be known to us when we make an investment and may change from time to time for any reason or for no reason, even with respect to a completed investment. An Agency’s evolving posture toward an acquisition or disposition structure through which we invest in or dispose of interests in MSRs on Agency pools may cause such Agency to impose new conditions on our existing interests in MSRs on Agency pools, including the owner’s ability to hold such interests in MSRs on Agency pools directly or indirectly through a grantor trust or other means. Such new conditions may be costly or burdensome and may diminish or eliminate the investment potential of the interests in MSRs on Agency pools that are already owned by us. Moreover, obtaining such consent may require us or our co-investment counterparties to agree to material structural or economic changes, as well as agree to indemnification or other terms that expose us to risks to which we have not previously been exposed and that could negatively affect our returns from our investments.\\nOur ability to finance the MSRs and servicer advances acquired in the MSR Transactions may depend on the related Servicing Partner’s cooperation with our financing sources and compliance with certain covenants.\\nWe have in the past and intend to continue to finance some or all of the MSRs or servicer advances acquired in the MSR Transactions, and as a result, we will be subject to substantial operational risks associated with the related Servicing Partners. In our current financing facilities for interests in MSRs and servicer advances, the failure of the related Servicing Partner to satisfy various\\n116\\ncovenants and tests can result in an amortization event and/or an event of default. Our financing sources may require us to include similar provisions in any financing we obtain relating to the MSRs and servicer advances acquired in the MSR Transactions. If we decide to finance such assets, we will not have the direct ability to control any party’s compliance with any such covenants and tests and the failure of any party to satisfy any such covenants or tests could result in a partial or total loss on our investment. Some financing sources may be unwilling to finance any assets acquired in the MSR Transactions.\\nIn addition, any financing for the MSRs and servicer advances acquired in the MSR Transactions may be subject to regulatory approval and the agreement of the relevant Servicing Partner to be party to such financing agreements. If we cannot get regulatory approval or these parties do not agree to be a party to such financing agreements, we may not be able to obtain financing on favorable terms or at all.\\nMortgage servicing is heavily regulated at the U.S. federal, state and local levels, and each transfer of MSRs to our subservicer of such MSRs may not be approved by the requisite regulators.\\nMortgage servicers must comply with U.S. federal, state and local laws and regulations. These laws and regulations cover topics such as licensing; allowable fees and loan terms; permissible servicing and debt collection practices; limitations on forced-placed insurance; special consumer protections in connection with default and foreclosure; and protection of confidential, nonpublic consumer information. The volume of new or modified laws and regulations has increased in recent years, and states and individual cities and counties continue to enact laws that either restrict or impose additional obligations in connection with certain loan origination, acquisition and servicing activities in those cities and counties. The laws and regulations are complex and vary greatly among the states and localities, and in some cases, these laws are in conflict with each other or with U.S. federal law. In connection with the MSR Transactions, there is no assurance that each transfer of MSRs to our selected subservicer will be approved by the requisite regulators. If regulatory approval for each such transfer is not obtained, we may incur additional costs and expenses in connection with the approval of another replacement subservicer.\\nWe do not have legal title to the MSRs underlying our Excess MSRs or certain of our Servicer Advance Investments.\\nWe do not have legal title to the MSRs underlying our Excess MSRs or certain of the MSRs related to the transactions contemplated by the purchase agreements pursuant to which we acquire Servicer Advance Investments or MSR financing receivables from Ocwen, SLS and Nationstar, and are subject to increased risks as a result of the related servicer continuing to own the mortgage servicing rights. The validity or priority of our interest in the underlying mortgage servicing could be challenged in a bankruptcy proceeding of the servicer, and the related purchase agreement could be rejected in such proceeding. Any of the foregoing events might have a material adverse effect on our business, financial condition, results of operations and liquidity. As part of the Ocwen Transaction, we and Ocwen have agreed to cooperate to obtain any third party consents required to transfer Ocwen’s remaining interest in the Ocwen Subject MSRs to us. As noted above, however, there is no assurance that we will be successful in obtaining those consents.\\nMany of our investments may be illiquid, and this lack of liquidity could significantly impede our ability to vary our portfolio in response to changes in economic and other conditions or to realize the value at which such investments are carried if we are required to dispose of them.\\nMany of our investments are illiquid. Illiquidity may result from the absence of an established market for the investments, as well as legal or contractual restrictions on their resale, refinancing or other disposition. Dispositions of investments may be subject to contractual and other limitations on transfer or other restrictions that would interfere with subsequent sales of such investments or adversely affect the terms that could be obtained upon any disposition thereof.\\nInterests in MSRs are highly illiquid and may be subject to numerous restrictions on transfers, including without limitation the receipt of third-party consents. For example, the Servicing Guidelines of a mortgage owner may require that holders of Excess MSRs obtain the mortgage owner’s prior approval of any change of direct ownership of such Excess MSRs. Such approval may be withheld for any reason or no reason in the discretion of the mortgage owner. Moreover, we have not received and do not expect to receive any assurances from any GSEs that their conditions for the sale by us of any interests in MSRs will not change. Therefore, the potential costs, issues or restrictions associated with receiving such GSEs’ consent for any such dispositions by us cannot be determined with any certainty. Additionally, interests in MSRs may entail complex transaction structures and the risks associated with the transactions and structures are not fully known to buyers or sellers. As a result of the foregoing, we may be unable to locate a buyer at the time we wish to sell interests in MSRs. There is some risk that we will be required to dispose of interests in MSRs either through an in-kind distribution or other liquidation vehicle, which will, in either case, provide little or no economic benefit to us, or a sale to a co-investor in the interests in MSRs, which may be an affiliate. Accordingly, we cannot provide any assurance that we will obtain any return or any benefit of any kind from any disposition of interests in MSRs. We may not benefit\\n117\\nfrom the full term of the assets and for the aforementioned reasons may not receive any benefits from the disposition, if any, of such assets.\\nIn addition, some of our real estate and other securities may not be registered under the relevant securities laws, resulting in a prohibition against their transfer, sale, pledge or other disposition except in a transaction that is exempt from the registration requirements of, or is otherwise in accordance with, those laws. There are also no established trading markets for a majority of our intended investments. Moreover, certain of our investments, including our investments in consumer loans and certain of our interests in MSRs, are made indirectly through a vehicle that owns the underlying assets. Our ability to sell our interest may be contractually limited or prohibited. As a result, our ability to vary our portfolio in response to changes in economic and other conditions may be limited.\\nOur real estate and other securities have historically been valued based primarily on third-party quotations, which are subject to significant variability based on the liquidity and price transparency created by market trading activity. A disruption in these trading markets could reduce the trading for many real estate and other securities, resulting in less transparent prices for those securities, which would make selling such assets more difficult. Moreover, a decline in market demand for the types of assets that we hold would make it more difficult to sell our assets. If we are required to liquidate all or a portion of our illiquid investments quickly, we may realize significantly less than the amount at which we have previously valued these investments.\\nMarket conditions could negatively impact our business, results of operations, cash flows and financial condition.\\nThe market in which we operate is affected by a number of factors that are largely beyond our control but can nonetheless have a potentially significant, negative impact on us. These factors include, among other things:\\n\\n| • | interest rates and credit spreads; |\\n\\n| • | the availability of credit, including the price, terms and conditions under which it can be obtained; |\\n\\n| • | the quality, pricing and availability of suitable investments; |\\n\\n| • | the ability to obtain accurate market-based valuations; |\\n\\n| • | the ability of securities dealers to make markets in relevant securities and loans; |\\n\\n| • | loan values relative to the value of the underlying real estate assets; |\\n\\n| • | default rates on the loans underlying our investments and the amount of the related losses, and credit losses with respect to our investments; |\\n\\n| • | prepayment and repayment rates, delinquency rates and legislative/regulatory changes with respect to our investments, and the timing and amount of servicer advances; |\\n\\n| • | the availability and cost of quality Servicing Partners, and advance, recovery and recapture rates; |\\n\\n| • | competition; |\\n\\n| • | the actual and perceived state of the real estate markets, bond markets, market for dividend-paying stocks and public capital markets generally; |\\n\\n| • | unemployment rates; and |\\n\\n| • | the attractiveness of other types of investments relative to investments in real estate or REITs generally. |\\n\\nChanges in these factors are difficult to predict, and a change in one factor can affect other factors. For example, at various points in time, increased default rates in the subprime mortgage market played a role in causing credit spreads to widen, reducing availability of credit on favorable terms, reducing liquidity and price transparency of real estate related assets, resulting in difficulty in obtaining accurate mark-to-market valuations, and causing a negative perception of the state of the real estate markets and of REITs generally. Market conditions could be volatile or could deteriorate as a result of a variety of factors beyond our control with adverse effects to our financial condition.\\nThe geographic distribution of the loans underlying, and collateral securing, certain of our investments subjects us to geographic real estate market risks, which could adversely affect the performance of our investments, our results of operations and financial condition.\\nThe geographic distribution of the loans underlying, and collateral securing, our investments, including our interests in MSRs, servicer advances, Non-Agency RMBS and loans, exposes us to risks associated with the real estate and commercial lending industry in general within the states and regions in which we hold significant investments. These risks include, without limitation: possible declines in the value of real estate; risks related to general and local economic conditions; possible lack of availability of mortgage funds; overbuilding; extended vacancies of properties; increases in competition, property taxes and operating expenses; changes in zoning laws; increased energy costs; unemployment; costs resulting from the clean-up of, and liability to third parties for damages resulting from, environmental problems; casualty or condemnation losses; uninsured damages from floods, hurricanes, earthquakes or other natural disasters; and changes in interest rates.\\n118\\nAs of September 30, 2019, 24.9% and 23.0% of the total UPB of the residential mortgage loans underlying our Excess MSRs and MSRs, respectively, was secured by properties located in California, which are particularly susceptible to natural disasters such as fires, earthquakes and mudslides. 7.6% and 6.8% of the total UPB of the residential mortgage loans underlying our Excess MSRs and MSRs, respectively, was secured by properties located in Florida, which are particularly susceptible to natural disasters such as hurricanes and floods. As of September 30, 2019, 38.4% of the collateral securing our Non-Agency RMBS was located in the Western U.S., 24.1% was located in the Southeastern U.S., 21.2% was located in the Northeastern U.S., 9.8% was located in the Midwestern U.S. and 6.4% was located in the Southwestern U.S. We were unable to obtain geographical information for 0.1% of the collateral. As a result of this concentration, we may be more susceptible to adverse developments in those markets than if we owned a more geographically diverse portfolio. To the extent any of the foregoing risks arise in states and regions where we hold significant investments, the performance of our investments, our results of operations, cash flows and financial condition could suffer a material adverse effect.\\nThe value of our interests in MSRs, servicer advances, residential mortgage loans and RMBS may be adversely affected by deficiencies in servicing and foreclosure practices, as well as related delays in the foreclosure process.\\nAllegations of deficiencies in servicing and foreclosure practices among several large sellers and servicers of residential mortgage loans that surfaced in 2010 raised various concerns relating to such practices, including the improper execution of the documents used in foreclosure proceedings (so-called “robo signing”), inadequate documentation of transfers and registrations of mortgages and assignments of loans, improper modifications of loans, violations of representations and warranties at the date of securitization and failure to enforce put-backs.\\nAs a result of alleged deficiencies in foreclosure practices, a number of servicers temporarily suspended foreclosure proceedings beginning in the second half of 2010 while they evaluated their foreclosure practices. In late 2010, a group of state attorneys general and state bank and mortgage regulators representing nearly all 50 states and the District of Columbia, along with the U.S. Justice Department and U.S. Department of Housing and Urban Development (“HUD”), began an investigation into foreclosure practices of banks and servicers. The investigations and lawsuits by several state attorneys general led to a settlement agreement in early February 2012 with five of the nation’s largest banks, pursuant to which the banks agreed to pay more than $25.0 billion to settle claims relating to improper foreclosure practices. The settlement does not prohibit the states, the federal government, individuals or investors from pursuing additional actions against the banks and servicers in the future.\\nUnder the terms of the agreements governing our Servicer Advance Investments and MSRs, we (in certain cases, together with third-party co-investors) are required to make or purchase from certain of our Servicing Partners, servicer advances on certain loan pools. While a residential mortgage loan is in foreclosure, servicers are generally required to continue to advance delinquent principal and interest and to also make advances for delinquent taxes and insurance and foreclosure costs and the upkeep of vacant property in foreclosure to the extent it determines that such amounts are recoverable. Servicer advances are generally recovered when the delinquency is resolved.\\nForeclosure moratoria or other actions that lengthen the foreclosure process increase the amount of servicer advances we or our Servicing Partners are required to make and we are required to purchase, lengthen the time it takes for us to be repaid for such advances and increase the costs incurred during the foreclosure process. In addition, servicer advance financing facilities contain provisions that modify the advance rates for, and limit the eligibility of, servicer advances to be financed based on the length of time that servicer advances are outstanding, and, as a result, an increase in foreclosure timelines could further increase the amount of servicer advances that we need to fund with our own capital. Such increases in foreclosure timelines could increase our need for capital to fund servicer advances (which do not bear interest), which would increase our interest expense, reduce the value of our investment and potentially reduce the cash that we have available to pay our operating expenses or to pay dividends.\\nEven in states where servicers have not suspended foreclosure proceedings or have lifted (or will soon lift) any such delayed foreclosures, servicers, including our Servicing Partners, have faced, and may continue to face, increased delays and costs in the foreclosure process. For example, the current legislative and regulatory climate could lead borrowers to contest foreclosures that they would not otherwise have contested under ordinary circumstances, and servicers may incur increased litigation costs if the validity of a foreclosure action is challenged by a borrower. In general, regulatory developments with respect to foreclosure practices could result in increases in the amount of servicer advances and the length of time to recover servicer advances, fines or increases in operating expenses, and decreases in the advance rate and availability of financing for servicer advances. This would lead to increased borrowings, reduced cash and higher interest expense which could negatively impact our liquidity and profitability. Although the terms of our Servicer Advance Investments contain adjustment mechanisms that would reduce the amount of performance fees payable to the related Servicing Partner if servicer advances exceed pre-determined amounts, those fee reductions may not be sufficient to cover the expenses resulting from longer foreclosure timelines.\\n119\\nThe integrity of the servicing and foreclosure processes is critical to the value of the residential mortgage loans in which we invest and of the portfolios of loans underlying our interests in MSRs and RMBS, and our financial results could be adversely affected by deficiencies in the conduct of those processes. For example, delays in the foreclosure process that have resulted from investigations into improper servicing practices may adversely affect the values of, and result in losses on, these investments. Foreclosure delays may also increase the administrative expenses of the securitization trusts for the RMBS, thereby reducing the amount of funds available for distribution to investors.\\nIn addition, the subordinate classes of securities issued by the securitization trusts may continue to receive interest payments while the defaulted loans remain in the trusts, rather than absorbing the default losses. This may reduce the amount of credit support available for senior classes of RMBS that we may own, thus possibly adversely affecting these securities. Additionally, a substantial portion of the $25.0 billion settlement is a “credit” to the banks and servicers for principal write-downs or reductions they may make to certain mortgages underlying RMBS. There remains uncertainty as to how these principal reductions will work and what effect they will have on the value of related RMBS. As a result, there can be no assurance that any such principal reductions will not adversely affect the value of our interests in MSRs and RMBS.\\nWhile we believe that the sellers and servicers would be in violation of the applicable Servicing Guidelines to the extent that they have improperly serviced mortgage loans or improperly executed documents in foreclosure or bankruptcy proceedings, or do not comply with the terms of servicing contracts when deciding whether to apply principal reductions, it may be difficult, expensive, time consuming and, ultimately, uneconomic for us to enforce our contractual rights. While we cannot predict exactly how the servicing and foreclosure matters or the resulting litigation or settlement agreements will affect our business, there can be no assurance that these matters will not have an adverse impact on our results of operations, cash flows and financial condition.\\nA failure by any or all of the members of Buyer to make capital contributions for amounts required to fund servicer advances could result in an event of default under our advance facilities and a complete loss of our investment.\\nNew Residential and third-party co-investors, through a joint venture entity (Advance Purchaser LLC, the “Buyer”) have agreed to purchase all future arising servicer advances from Nationstar under certain residential mortgage servicing agreements. Buyer relies, in part, on its members to make committed capital contributions in order to pay the purchase price for future servicer advances. A failure by any or all of the members to make such capital contributions for amounts required to fund servicer advances could result in an event of default under our advance facilities and a complete loss of our investment.\\nThe residential mortgage loans underlying the securities we invest in and the loans we directly invest in are subject to delinquency, foreclosure and loss, which could result in losses to us.\\nThe ability of a borrower to repay a loan secured by a residential property is dependent upon the income or assets of the borrower. A number of factors may impair borrowers’ abilities to repay their loans, including, among other things, changes in the borrower’s employment status, changes in national, regional or local economic conditions, changes in interest rates or the availability of credit on favorable terms, changes in regional or local real estate values, changes in regional or local rental rates and changes in real estate taxes.\\nOur mortgage backed securities are securities backed by mortgage loans. Many of the RMBS in which we invest are backed by collateral pools of subprime residential mortgage loans. “Subprime” mortgage loans refer to mortgage loans that have been originated using underwriting standards that are less restrictive than the underwriting requirements used as standards for other first and junior lien mortgage loan purchase programs, such as the programs of Fannie Mae and Freddie Mac. These lower standards include mortgage loans made to borrowers having imperfect or impaired credit histories (including outstanding judgments or prior bankruptcies), mortgage loans where the amount of the loan at origination is 80% or more of the value of the mortgage property, mortgage loans made to borrowers with low credit scores, mortgage loans made to borrowers who have other debt that represents a large portion of their income and mortgage loans made to borrowers whose income is not required to be disclosed or verified. Subprime mortgage loans may experience delinquency, foreclosure, bankruptcy and loss rates that are higher, and that may be substantially higher, than those experienced by mortgage loans underwritten in a more traditional manner. To the extent losses are realized on the loans underlying the securities in which we invest, we may not recover the amount invested in, or, in extreme cases, any of our investment in such securities.\\nResidential mortgage loans, including manufactured housing loans and subprime mortgage loans are secured by single-family residential property and are also subject to risks of delinquency and foreclosure, and risks of loss. A significant portion of the residential mortgage loans that we acquire are, or may become, sub-performing loans, non-performing loans or REO assets where the borrower has failed to make timely payments of principal and/or interest. As part of the residential mortgage loan portfolios we purchase, we also may acquire performing loans that are or subsequently become sub-performing or non-performing, meaning the borrowers fail to timely pay some or all of the required payments of principal and/or interest. Under current market conditions,\\n120\\nit is likely that some of these loans will have current loan-to-value ratios in excess of 100%, meaning the amount owed on the loan exceeds the value of the underlying real estate.\\nIn the event of default under a residential mortgage loan held directly by us, we will bear a risk of loss of principal to the extent of any deficiency between the value of the collateral and the outstanding principal and accrued but unpaid interest of the loan. Even though we typically pay less than the amount owed on these loans to acquire them, if actual results differ from our assumptions in determining the price we paid to acquire such loans, we may incur significant losses. In addition, we may acquire REO assets directly, which involves the same risks. Any loss we incur may be significant and could materially and adversely affect us.\\nOur investments in real estate and other securities are subject to changes in credit spreads as well as available market liquidity, which could adversely affect our ability to realize gains on the sale of such investments.\\nReal estate and other securities are subject to changes in credit spreads. Credit spreads measure the yield demanded on securities by the market based on their credit relative to a specific benchmark.\\nFixed rate securities are valued based on a market credit spread over the rate payable on fixed rate U.S. Treasuries of like maturity. Floating rate securities are valued based on a market credit spread over LIBOR and are affected similarly by changes in LIBOR spreads. As of September 30, 2019, 68.6% of our Non-Agency RMBS Portfolio consisted of floating rate securities and 31.4% consisted of fixed rate securities, and 100.0% of our Agency RMBS portfolio consisted of fixed rate securities, based on the amortized cost basis of all securities (including the amortized cost basis of interest-only and residual classes). Excessive supply of these securities combined with reduced demand will generally cause the market to require a higher yield on these securities, resulting in the use of a higher, or “wider,” spread over the benchmark rate to value such securities. Under such conditions, the value of our real estate and other securities portfolios would tend to decline. Conversely, if the spread used to value such securities were to decrease, or “tighten,” the value of our real estate and other securities portfolio would tend to increase. Such changes in the market value of our real estate securities portfolios may affect our net equity, net income or cash flow directly through their impact on unrealized gains or losses on available-for-sale securities, and therefore our ability to realize gains on such securities, or indirectly through their impact on our ability to borrow and access capital. Widening credit spreads could cause the net unrealized gains on our securities and derivatives, recorded in accumulated other comprehensive income or retained earnings, and therefore our book value per share, to decrease and result in net losses.\\nPrepayment rates on our residential mortgage loans and those underlying our real estate and other securities may adversely affect our profitability.\\nIn general, residential mortgage loans may be prepaid at any time without penalty. Prepayments result when homeowners/mortgagors satisfy (i.e., pay off) the mortgage upon selling or refinancing their mortgaged property. When we acquire a particular loan or security, we anticipate that the loan or underlying residential mortgage loans will prepay at a projected rate which, together with expected coupon income, provides us with an expected yield on such investments. If we purchase assets at a premium to par value, and borrowers prepay their mortgage loans faster than expected, the corresponding prepayments on our assets may reduce the expected yield on such assets because we will have to amortize the related premium on an accelerated basis. Conversely, if we purchase assets at a discount to par value, when borrowers prepay their mortgage loans slower than expected, the decrease in corresponding prepayments on our assets may reduce the expected yield on such assets because we will not be able to accrete the related discount as quickly as originally anticipated.\\nPrepayment rates on loans are influenced by changes in mortgage and market interest rates and a variety of economic, geographic, political and other factors, all of which are beyond our control. Consequently, such prepayment rates cannot be predicted with certainty and no strategy can completely insulate us from prepayment or other such risks. In periods of declining interest rates, prepayment rates on mortgage loans generally increase. If general interest rates decline at the same time, the proceeds of such prepayments received during such periods are likely to be reinvested by us in assets yielding less than the yields on the assets that were prepaid. In addition, the market value of our loans and real estate and other securities may, because of the risk of prepayment, benefit less than other fixed-income securities from declining interest rates.\\nWe may purchase assets that have a higher or lower coupon rate than the prevailing market interest rates. In exchange for a higher coupon rate, we would then pay a premium over par value to acquire these securities. In accordance with GAAP, we would amortize the premiums over the life of the related assets. If the mortgage loans securing these assets prepay at a more rapid rate than anticipated, we would have to amortize our premiums on an accelerated basis which may adversely affect our profitability. As compensation for a lower coupon rate, we would then pay a discount to par value to acquire these assets. In accordance with GAAP, we would accrete any discounts over the life of the related assets. If the mortgage loans securing these assets prepay at a slower rate than anticipated, we would have to accrete our discounts on an extended basis which may adversely affect our\\n121\\nprofitability. Defaults on the mortgage loans underlying Agency RMBS typically have the same effect as prepayments because of the underlying Agency guarantee.\\nPrepayments, which are the primary feature of mortgage backed securities that distinguish them from other types of bonds, are difficult to predict and can vary significantly over time. As the holder of the security, on a monthly basis, we receive a payment equal to a portion of our investment principal in a particular security as the underlying mortgages are prepaid. In general, on the date each month that principal prepayments are announced (i.e., factor day), the value of our real estate related security pledged as collateral under our repurchase agreements is reduced by the amount of the prepaid principal and, as a result, our lenders will typically initiate a margin call requiring the pledge of additional collateral or cash, in an amount equal to such prepaid principal, in order to re-establish the required ratio of borrowing to collateral value under such repurchase agreements. Accordingly, with respect to our Agency RMBS, the announcement on factor day of principal prepayments is in advance of our receipt of the related scheduled payment, thereby creating a short-term receivable for us in the amount of any such principal prepayments. However, under our repurchase agreements, we may receive a margin call relating to the related reduction in value of our Agency RMBS and, prior to receipt of this short-term receivable, be required to post additional collateral or cash in the amount of the principal prepayment on or about factor day, which would reduce our liquidity during the period in which the short-term receivable is outstanding. As a result, in order to meet any such margin calls, we could be forced to sell assets in order to maintain liquidity. Forced sales under adverse market conditions may result in lower sales prices than ordinary market sales made in the normal course of business. If our real estate and other securities were liquidated at prices below our amortized cost (i.e., the cost basis) of such assets, we would incur losses, which could adversely affect our earnings. In addition, in order to continue to earn a return on this prepaid principal, we must reinvest it in additional real estate and other securities or other assets; however, if interest rates decline, we may earn a lower return on our new investments as compared to the real estate and other securities that prepay.\\nPrepayments may have a negative impact on our financial results, the effects of which depend on, among other things, the timing and amount of the prepayment delay on our Agency RMBS, the amount of unamortized premium or discount on our loans and real estate and other securities, the rate at which prepayments are made on our Non-Agency RMBS, the reinvestment lag and the availability of suitable reinvestment opportunities.\\nOur investments in loans, REO and RMBS may be subject to significant impairment charges, which would adversely affect our results of operations.\\nWe are required to periodically evaluate our investments for impairment indicators. The judgment regarding the existence of impairment indicators is based on a variety of factors depending upon the nature of the investment and the manner in which the income related to such investment was calculated for purposes of our financial statements. If we determine that an impairment has occurred, we are required to make an adjustment to the net carrying value of the investment, which would adversely affect our results of operations in the applicable period and thereby adversely affect our ability to pay dividends to our stockholders.\\nThe lenders under our financing agreements may elect not to extend financing to us, which could quickly and seriously impair our liquidity.\\nWe finance a meaningful portion of our investments with repurchase agreements and other short-term financing arrangements. Under the terms of repurchase agreements, we will sell an asset to the lending counterparty for a specified price and concurrently agree to repurchase the same asset from our counterparty at a later date for a higher specified price. During the term of the repurchase agreement—which can be as short as 30 days—the counterparty will make funds available to us and hold the asset as collateral. Our counterparties can also require us to post additional margin as collateral at any time during the term of the agreement. When the term of a repurchase agreement ends, we will be required to repurchase the asset for the specified repurchase price, with the difference between the sale and repurchase prices serving as the equivalent of paying interest to the counterparty in return for extending financing to us. If we want to continue to finance the asset with a repurchase agreement, we ask the counterparty to extend—or “roll”—the repurchase agreement for another term.\\nOur counterparties are not required to roll our repurchase agreements or other financing agreements upon the expiration of their stated terms, which subjects us to a number of risks. Counterparties electing to roll our financing agreements may charge higher spread and impose more onerous terms upon us, including the requirement that we post additional margin as collateral. More significantly, if a financing agreement counterparty elects not to extend our financing, we would be required to pay the counterparty in full on the maturity date and find an alternate source of financing. Alternate sources of financing may be more expensive, contain more onerous terms or simply may not be available. If we were unable to pay the repurchase price for any asset financed with a repurchase agreement, the counterparty has the right to sell the asset being held as collateral and require us to compensate it for any shortfall between the value of our obligation to the counterparty and the amount for which the collateral was sold (which may be a significantly discounted price). Moreover, our financing agreement obligations are currently with a limited number of counterparties. If any of our counterparties elected not to roll our financing agreements, we may not be able to find a replacement\\n122\\ncounterparty in a timely manner. Finally, some of our financing agreements contain covenants and our failure to comply with such covenants could result in a loss of our investment.\\nThe financing sources under our servicer advance financing facilities may elect not to extend financing to us or may have or take positions adverse to us, which could quickly and seriously impair our liquidity.\\nWe finance a meaningful portion of our Servicer Advance Investments and servicer advances receivable with structured financing arrangements. These arrangements are commonly of a short-term nature. These arrangements are generally accomplished by having the named servicer, if the named servicer is a subsidiary of the Company, or the purchaser of such Servicer Advance Investments (which is a subsidiary of the Company) transfer our right to repayment for certain servicer advances that we have as servicer under the relevant Servicing Guidelines or that we have acquired from one of our Servicing Partners, as applicable, to one of our wholly owned bankruptcy remote subsidiaries (a “Depositor”). We are generally required to continue to transfer to the related Depositor all of our rights to repayment for any particular pool of servicer advances as they arise (and, if applicable, are transferred from one of our Servicing Partners) until the related financing arrangement is paid in full and is terminated. The related Depositor then transfers such rights to an “Issuer.” The Issuer then issues limited recourse notes to the financing sources backed by such rights to repayment.\\nThe outstanding balance of servicer advances securing these arrangements is not likely to be repaid on or before the maturity date of such financing arrangements. Accordingly, we rely heavily on our financing sources to extend or refinance the terms of such financing arrangements. Our financing sources are not required to extend the arrangements upon the expiration of their stated terms, which subjects us to a number of risks. Financing sources electing to extend may charge higher interest rates and impose more onerous terms upon us, including without limitation, lowering the amount of financing that can be extended against any particular pool of servicer advances.\\nIf a financing source is unable or unwilling to extend financing, including, but not limited to, due to legal or regulatory matters applicable to us or our Servicing Partners, the related Issuer will be required to repay the outstanding balance of the financing on the related maturity date. Additionally, there may be substantial increases in the interest rates under a financing arrangement if the related notes are not repaid, extended or refinanced prior to the expected repayment dated, which may be before the related maturity date. If an Issuer is unable to pay the outstanding balance of the notes, the financing sources generally have the right to foreclose on the servicer advances pledged as collateral.\\nCurrently, certain of the notes issued under our structured servicer advance financing arrangements accrue interest at a floating rate of interest. Servicer advances are non-interest bearing assets. Accordingly, if there is an increase in prevailing interest rates and/or our financing sources increase the interest rate “margins” or “spreads.” the amount of financing that we could obtain against any particular pool of servicer advances may decrease substantially and/or we may be required to obtain interest rate hedging arrangements. There is no assurance that we will be able to obtain any such interest rate hedging arrangements.\\nAlternate sources of financing may be more expensive, contain more onerous terms or simply may not be available. Moreover, our structured servicer advance financing arrangements are currently with a limited number of counterparties. If any of our sources are unable to or elected not to extend or refinance such arrangements, we may not be able to find a replacement counterparty in a timely manner.\\nMany of our servicer advance financing arrangements are provided by financial institutions with whom we have substantial relationships. Some of our servicer advance financing arrangements entail the issuance of term notes to capital markets investors with whom we have little or no relationships or the identities of which we may not be aware and, therefore, we have no ability to control or monitor the identity of the holders of such term notes. Holders of such term notes may have or may take positions - for example, “short” positions in our stock or the stock of our servicers - that could be benefited by adverse events with respect to us or our Servicing Partners. If any holders of term notes allege or assert noncompliance by us or the related Servicing Partner under our servicer advance financing arrangements in order to realize such benefits, we or our Servicing Partners, or our ability to maintain servicer advance financing on favorable terms, could be materially and adversely affected.\\nWe may not be able to finance our investments on attractive terms or at all, and financing for interests in MSRs or servicer advances may be particularly difficult to obtain.\\nThe ability to finance investments with securitizations or other long-term non-recourse financing not subject to margin requirements has been challenging as a result of market conditions. These conditions may result in having to use less efficient forms of financing for any new investments, or the refinancing of current investments, which will likely require a larger portion of our cash flows to be put toward making the investment and thereby reduce the amount of cash available for distribution to our stockholders and funds available for operations and investments, and which will also likely require us to assume higher levels of risk when financing\\n123\\nour investments. In addition, there is a limited market for financing of interests in MSRs, and it is possible that one will not develop for a variety of reasons, such as the challenges with perfecting security interests in the underlying collateral.\\nCertain of our advance facilities may mature in the short term, and there can be no assurance that we will be able to renew these facilities on favorable terms or at all. Moreover, an increase in delinquencies with respect to the loans underlying our servicer advances could result in the need for additional financing, which may not be available to us on favorable terms or at all. If we are not able to obtain adequate financing to purchase servicer advances from our Servicing Partners or fund servicer advances under our MSRs in accordance with the applicable Servicing Guidelines, we or any such Servicing Partner, as applicable, could default on its obligation to fund such advances, which could result in its termination of us or any applicable Servicing Partner, as applicable, as servicer under the applicable Servicing Guidelines, and a partial or total loss of our interests in MSRs and servicer advances, as applicable.\\nThe non-recourse long-term financing structures we use expose us to risks, which could result in losses to us.\\nWe use structured finance and other non-recourse long-term financing for our investments to the extent available and appropriate. In such structures, our financing sources typically have only a claim against the assets included in the securitizations rather than a general claim against us as an entity. Prior to any such financing, we would seek to finance our investments with relatively short-term facilities until a sufficient portfolio is accumulated. As a result, we would be subject to the risk that we would not be able to acquire, during the period that any short-term facilities are available, sufficient eligible assets or securities to maximize the efficiency of a securitization. We also bear the risk that we would not be able to obtain new short-term facilities or would not be able to renew any short-term facilities after they expire should we need more time to seek and acquire sufficient eligible assets or securities for a securitization. In addition, conditions in the capital markets may make the issuance of any such securitization less attractive to us even when we do have sufficient eligible assets or securities. While we would generally intend to retain a portion of the interests issued under such securitizations and, therefore, still have exposure to any investments included in such securitizations, our inability to enter into such securitizations may increase our overall exposure to risks associated with direct ownership of such investments, including the risk of default. Our inability to refinance any short-term facilities would also increase our risk because borrowings thereunder would likely be recourse to us as an entity. If we are unable to obtain and renew short-term facilities or to consummate securitizations to finance our investments on a long-term basis, we may be required to seek other forms of potentially less attractive financing or to liquidate assets at an inopportune time or price.\\nThe final Basel FRTB Ruling, which raised capital charges for bank holders of ABS, CMBS and Non-Agency MBS beginning in 2019, could adversely impact available trading liquidity and access to financing.\\nIn January 2006, the Basel Committee on Banking Supervision released a finalized framework for calculating minimum capital requirements for market risk, which became effective in January 2019. In the final proposal, capital requirements would overall be meaningfully higher than current requirements, but are less punitive than the previous December 2014 proposal. However, each country’s specific regulator may codify the rules differently. Under the framework, capital charges on a bond are calculated based on three components: default, market and residual risk. Implementation of the final proposal could impose meaningfully higher capital charges on dealers compared with current requirements, and could reduce liquidity in the securitized products market.\\nRisks associated with our investment in the consumer loan sector could have a material adverse effect on our business and financial results.\\nOur portfolio includes an investment in the consumer loan sector. Although many of the risks applicable to consumer loans are also applicable to residential mortgage loans, and thus the type of risks that we have experience managing, there are nevertheless substantial risks and uncertainties associated with engaging in a different category of investment.\\nThe ability of borrowers to repay the consumer loans we invest in may be adversely affected by numerous personal factors, including unemployment, divorce, major medical expenses or personal bankruptcy. General factors, including an economic downturn, high energy costs or acts of God or terrorism, may also affect the financial stability of borrowers and impair their ability or willingness to repay the consumer loans in our investment portfolio. Furthermore, our returns on our consumer loan investments are dependent on the interest we receive exceeding any losses we may incur from defaults or delinquencies. The relatively higher interest rates paid by consumer loan borrowers could lead to increased delinquencies and defaults, or could lead to financially stronger borrowers prepaying their loans, thereby reducing the interest we receive from them, while financially weaker borrowers become delinquent or default, either of which would reduce the return on our investment or could cause losses.\\nIn the event of any default under a loan in the consumer loan portfolio in which we have invested, we will bear a risk of loss of principal to the extent of any deficiency between the value of the collateral securing the loan, if any, and the principal and accrued interest of the loan. In addition, our investments in consumer loans may entail greater risk than our investments in residential\\n124\\nmortgage loans, particularly in the case of consumer loans that are unsecured or secured by assets that depreciate rapidly. In such cases, repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan and the remaining deficiency often does not warrant further substantial collection efforts against the borrower. Further, repossessing personal property securing a consumer loan can present additional challenges, including locating the collateral and taking possession of it. In addition, borrowers under consumer loans may have lower credit scores. There can be no guarantee that we will not suffer unexpected losses on our investments as a result of the factors set out above, which could have a negative impact on our financial results.\\nIn addition, a portion of our investment in consumer loans is secured by second and third liens on real estate. When we hold the second or third lien, another creditor or creditors, as applicable, holds the first and/or second, as applicable, lien on the real estate that is the subject of the security. In these situations our second or third lien is subordinate in right of payment to the first and/or second, as applicable, holder’s right to receive payment. Moreover, as the servicer of the loans underlying our consumer loan portfolio is not able to track the default status of a senior lien loan in instances where we do not hold the related first mortgage, the value of the second or third lien loans in our portfolio may be lower than our estimates indicate.\\nFinally, one of our consumer loan investments is held through LoanCo, in which we hold a minority, non-controlling interest. We do not control LoanCo and, as a result, LoanCo may make decisions, or take risks, that we would otherwise not make, and LoanCo may not have access to the same management and financing expertise that we have. Failure to successfully manage these risks could have a material adverse effect on our business and financial results.\\nThe consumer loan investment sector is subject to various initiatives on the part of advocacy groups and extensive regulation and supervision under federal, state and local laws, ordinances and regulations, which could have a negative impact on our financial results.\\nIn recent years consumer advocacy groups and some media reports have advocated governmental action to prohibit or place severe restrictions on the types of short-term consumer loans in which we have invested. Such consumer advocacy groups and media reports generally focus on the annual percentage rate to a consumer for this type of loan, which is compared unfavorably to the interest typically charged by banks to consumers with top-tier credit histories.\\nThe fees charged on the consumer loans in the portfolio in which we have invested may be perceived as controversial by those who do not focus on the credit risk and high transaction costs typically associated with this type of investment. If the negative characterization of these types of loans becomes increasingly accepted by consumers, demand for the consumer loan products in which we have invested could significantly decrease. Additionally, if the negative characterization of these types of loans is accepted by legislators and regulators, we could become subject to more restrictive laws and regulations in the area.\\nIn addition, we are, or may become, subject to federal, state and local laws, regulations, or regulatory policies and practices, including the Dodd-Frank Act (which, among other things, established the Consumer Financial Protection Bureau (the “CFPB”) with broad authority to regulate and examine financial institutions), which may, amongst other things, limit the amount of interest or fees allowed to be charged on the consumer loans we invest in, or the number of consumer loans that customers may receive or have outstanding. The operation of existing or future laws, ordinances and regulations could interfere with the focus of our investments which could have a negative impact on our financial results.\\nCertain jurisdictions require licenses to purchase, hold, enforce or sell residential mortgage loans and/or MSRs, and we may not be able to obtain and/or maintain such licenses.\\nCertain jurisdictions require a license to purchase, hold, enforce or sell residential mortgage loans and/or MSRs. In the event that any licensing requirement is applicable to us, and we do not hold such licenses, there can be no assurance that we will obtain such licenses or, if obtained, that we will be able to maintain them. Our failure to obtain or maintain such licenses could restrict our ability to invest in loans in these jurisdictions if such licensing requirements are applicable. With respect to mortgage loans, in lieu of obtaining such licenses, we may contribute our acquired residential mortgage loans to one or more wholly owned trusts whose trustee is a national bank, which may be exempt from state licensing requirements. We have formed one or more subsidiaries to apply for certain state licenses. If these subsidiaries obtain the required licenses, any trust holding loans in the applicable jurisdictions may transfer such loans to such subsidiaries, resulting in these loans being held by a state-licensed entity. There can be no assurance that we will be able to obtain the requisite licenses in a timely manner or at all or in all necessary jurisdictions, or that the use of the trusts will reduce the requirement for licensing. In addition, even if we obtain necessary licenses, we may not be able to maintain them. Any of these circumstances could limit our ability to invest in residential mortgage loans or MSRs in the future and have a material adverse effect on us.\\n125\\nOur determination of how much leverage to apply to our investments may adversely affect our return on our investments and may reduce cash available for distribution.\\nWe leverage certain of our assets through a variety of borrowings. Our investment guidelines do not limit the amount of leverage we may incur with respect to any specific asset or pool of assets. The return we are able to earn on our investments and cash available for distribution to our stockholders may be significantly reduced due to changes in market conditions, which may cause the cost of our financing to increase relative to the income that can be derived from our assets.\\nA significant portion of our investments are not match funded, which may increase the risks associated with these investments.\\nWhen available, a match funding strategy mitigates the risk of not being able to refinance an investment on favorable terms or at all. However, our Manager may elect for us to bear a level of refinancing risk on a short-term or longer-term basis, as in the case of investments financed with repurchase agreements, when, based on its analysis, our Manager determines that bearing such risk is advisable or unavoidable. In addition, we may be unable, as a result of conditions in the credit markets, to match fund our investments. For example, non-recourse term financing not subject to margin requirements has been more difficult to obtain, which impairs our ability to match fund our investments. Moreover, we may not be able to enter into interest rate swaps. A decision not to, or the inability to, match fund certain investments exposes us to additional risks.\\nFurthermore, we anticipate that, in most cases, for any period during which our floating rate assets are not match funded with respect to maturity, the income from such assets may respond more slowly to interest rate fluctuations than the cost of our borrowings. Because of this dynamic, interest income from such investments may rise more slowly than the related interest expense, with a consequent decrease in our net income. Interest rate fluctuations resulting in our interest expense exceeding interest income would result in operating losses for us from these investments.\\nAccordingly, to the extent our investments are not match funded with respect to maturities and interest rates, we are exposed to the risk that we may not be able to finance or refinance our investments on economically favorable terms, or at all, or may have to liquidate assets at a loss.\\nInterest rate fluctuations and shifts in the yield curve may cause losses.\\nInterest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. Our primary interest rate exposures relate to our interests in MSRs, RMBS, loans, derivatives and any floating rate debt obligations that we may incur. Changes in interest rates, including changes in expected interest rates or “yield curves,” affect our business in a number of ways. Changes in the general level of interest rates can affect our net interest income, which is the difference between the interest income earned on our interest-earning assets and the interest expense incurred in connection with our interest-bearing liabilities and hedges. Changes in the level of interest rates also can affect, among other things, our ability to acquire real estate and other securities and loans at attractive prices, the value of our real estate and other securities, loans and derivatives and our ability to realize gains from the sale of such assets. We may wish to use hedging transactions to protect certain positions from interest rate fluctuations, but we may not be able to do so as a result of market conditions, REIT rules or other reasons. In such event, interest rate fluctuations could adversely affect our financial condition, cash flows and results of operations.\\nRecently, the Federal Reserve has increased the benchmark interest rate and indicated that there may be further increases in the future. In the event of a significant rising interest rate environment and/or economic downturn, loan and collateral defaults may increase and result in credit losses that would adversely affect our liquidity and operating results.\\nOur ability to execute our business strategy, particularly the growth of our investment portfolio, depends to a significant degree on our ability to obtain additional capital. Our financing strategy is dependent on our ability to place the debt we use to finance our investments at rates that provide a positive net spread. If spreads for such liabilities widen or if demand for such liabilities ceases to exist, then our ability to execute future financings will be severely restricted.\\nInterest rate changes may also impact our net book value as most of our investments are marked to market each quarter. Debt obligations are not marked to market. Generally, as interest rates increase, the value of our fixed rate securities decreases, which will decrease the book value of our equity.\\nFurthermore, shifts in the U.S. Treasury yield curve reflecting an increase in interest rates would also affect the yield required on our investments and therefore their value. For example, increasing interest rates would reduce the value of the fixed rate assets we hold at the time because the higher yields required by increased interest rates result in lower market prices on existing fixed\\n126\\nrate assets in order to adjust the yield upward to meet the market, and vice versa. This would have similar effects on our real estate and other securities and loan portfolio and our financial position and operations to a change in interest rates generally.\\nChanges in banks’ inter-bank lending rate reporting practices or the method pursuant to which LIBOR is determined may adversely affect the value of the financial obligations to be held or issued by us that are linked to LIBOR.\\nLIBOR and other indices which are deemed “benchmarks” are the subject of recent national, international, and other regulatory guidance and proposals for reform. Some of these reforms are already effective while others are still to be implemented. These reforms may cause such benchmarks to perform differently than in the past, or have other consequences which cannot be predicted. In particular, regulators and law enforcement agencies in the U.K. and elsewhere conducted criminal and civil investigations into whether the banks that contributed information to the British Bankers’ Association (“BBA”) in connection with the daily calculation of LIBOR may have been under-reporting or otherwise manipulating or attempting to manipulate LIBOR. A number of BBA member banks have entered into settlements with their regulators and law enforcement agencies with respect to this alleged manipulation of LIBOR. LIBOR is calculated by reference to a market for interbank lending that continues to shrink, as its based on increasingly fewer actual transactions. This increases the subjectivity of the LIBOR calculation process and increases the risk of manipulation. Actions by the regulators or law enforcement agencies, as well as ICE Benchmark Administration (the current administrator of LIBOR), may result in changes to the manner in which LIBOR is determined or the establishment of alternative reference rates. For example, on July 27, 2017, the U.K. Financial Conduct Authority announced that it intends to stop persuading or compelling banks to submit LIBOR rates after 2021.\\nIt is likely that, over time, U.S. Dollar LIBOR will be replaced by the Secured Overnight Financing Rate (“SOFR”) published by the Federal Reserve Bank of New York. However, the manner and timing of this shift is currently unknown. SOFR is an overnight rate instead of a term rate, making SOFR an inexact replacement for LIBOR. There is currently no perfect way to create robust, forward-looking, SOFR term rates. Market participants are still considering how various types of financial instruments and securitization vehicles should react to a discontinuation of LIBOR. It is possible that not all of our assets and liabilities will transition away from LIBOR at the same time, and it is possible that not all of our assets and liabilities will transition to the same alternative reference rate, in each case increasing the difficulty of hedging. Switching existing financial instruments and hedging transactions from LIBOR to SOFR requires calculations of a spread. Industry organizations are attempting to structure the spread calculation in a manner that minimizes the possibility of value transfer between counterparties, borrowers, and lenders by virtue of the transition, but there is no assurance that the calculated spread will be fair and accurate or that all asset types and all types of securitization vehicles will use the same spread. We and other market participants have less experience understanding and modeling SOFR-based assets and liabilities than LIBOR-based assets and liabilities, increasing the difficulty of investing, hedging, and risk management. The process of transition involves operational risks. It is also possible that no transition will occur for many financial instruments, meaning that those instruments would continue to be subject to the weaknesses of the LIBOR calculation process. At this time, it is not possible to predict the effect of any such changes, any establishment of alternative reference rates or any other reforms to LIBOR that may be implemented. Uncertainty as to the nature of such potential changes, alternative reference rates or other reforms may adversely affect the market for or value of any securities on which the interest or dividend is determined by reference to LIBOR, loans, derivatives and other financial obligations or on our overall financial condition or results of operations. More generally, any of the above changes or any other consequential changes to LIBOR or any other “benchmark” as a result of international, national or other proposals for reform or other initiatives or investigations, or any further uncertainty in relation to the timing and manner of implementation of such changes, could have a material adverse effect on the value of and return on any securities based on or linked to a “benchmark.”\\nAny hedging transactions that we enter into may limit our gains or result in losses.\\nWe may use, when feasible and appropriate, derivatives to hedge a portion of our interest rate exposure, and this approach has certain risks, including the risk that losses on a hedge position will reduce the cash available for distribution to stockholders and that such losses may exceed the amount invested in such instruments. We have adopted a general policy with respect to the use of derivatives, which generally allows us to use derivatives where appropriate, but does not set forth specific policies and procedures or require that we hedge any specific amount of risk. From time to time, we may use derivative instruments, including forwards, futures, swaps and options, in our risk management strategy to limit the effects of changes in interest rates on our operations. A hedge may not be effective in eliminating all of the risks inherent in any particular position. Our profitability may be adversely affected during any period as a result of the use of derivatives.\\nThere are limits to the ability of any hedging strategy to protect us completely against interest rate risks. When rates change, we expect the gain or loss on derivatives to be offset by a related but inverse change in the value of any items that we hedge. We cannot assure you, however, that our use of derivatives will offset the risks related to changes in interest rates. We cannot assure you that our hedging strategy and the derivatives that we use will adequately offset the risk of interest rate volatility or that our hedging transactions will not result in losses. In addition, our hedging strategy may limit our flexibility by causing us to refrain\\n127\\nfrom taking certain actions that would be potentially profitable but would cause adverse consequences under the terms of our hedging arrangements. The REIT provisions of the Internal Revenue Code limit our ability to hedge. In managing our hedge instruments, we consider the effect of the expected hedging income on the REIT qualification tests that limit the amount of gross income that a REIT may receive from hedging. We need to carefully monitor, and may have to limit, our hedging strategy to assure that we do not realize hedging income, or hold hedges having a value, in excess of the amounts that would cause us to fail the REIT gross income and asset tests. See “—Risks Related to Our Taxation as a REIT—Complying with the REIT requirements may limit our ability to hedge effectively.”\\nAccounting for derivatives under GAAP is extremely complicated. Any failure by us to account for our derivatives properly in accordance with GAAP in our financial statements could adversely affect us. In addition, under applicable accounting standards, we may be required to treat some of our investments as derivatives, which could adversely affect our results of operations.\\nCybersecurity incidents and technology disruptions or failures could damage our business operations and reputation, increase our costs and subject us to potential liability.\\nAs our reliance on rapidly changing technology has increased, so have the risks that threaten the confidentiality, integrity or availability of our information systems, both internal and those provided to us by third-party service providers (including, but not limited to, our Servicing Partners). Cybersecurity incidents may involve gaining authorized or unauthorized access to our information systems for purposes of theft of certain personally identifiable information of consumers, misappropriating assets, stealing confidential information, corrupting data or causing operational disruption. Disruptions and failures of our systems or those of our third-party vendors could result from these incidents or be caused by fire, power outages, natural disasters and other similar events and may interrupt or delay our ability to provide services to our customers, expose us to remedial costs and reputational damage, and otherwise adversely affect our operations.\\nDespite our efforts to ensure the integrity of our systems, there can be no assurance that any such cyber incidents will not occur or, if they do occur, that they will be adequately addressed. We also may not be able to anticipate or implement effective preventive measures against all security breaches, especially because the methods and sources of breaches change frequently or may not be immediately detected.\\nIn addition, we are subject to various privacy and data protection laws and regulations, and any changes to laws or regulations, including new restrictions or requirements applicable to our business, could impose additional costs and liability on us and could limit our use and disclosure of such information. For example, the New York State Department of Financial Services requires certain financial services companies, such as NRM and NewRez, to establish a detailed cybersecurity program and comply with other requirements, and the California Consumer Privacy Act of 2018 creates new compliance regulations on businesses that collect information from California residents.\\nAny of the foregoing events could result in violations of applicable privacy and other laws, financial loss to us or to our customers, loss of confidence in our security measures, customer dissatisfaction, additional regulatory scrutiny, significant litigation exposure and harm to our reputation, any of which could have a material adverse effect on our business, financial condition, liquidity and results of operations.\\nWe depend on counterparties and vendors to provide certain services, which subjects us to various risks.\\nWe have a number of counterparties and vendors, who provide us with financial, technology and other services that support our businesses. If our current counterparties and vendors were to stop providing services to us on acceptable terms, we may be unable to procure alternative services from other counterparties or vendors in a timely and efficient manner and on similarly acceptable terms, or at all. With respect to vendors engaged to perform certain servicing activities, we are required to assess their compliance with various regulations and establish procedures to provide reasonable assurance that the vendor’s activities comply in all material respects with such regulations. In the event that a vendor’s activities are not in compliance, it could negatively impact our relationships with our regulators, as well as our business and operations. Accordingly, we may incur significant costs to resolve any such disruptions in service which could have a material adverse effect on our business, financial condition, liquidity and results of operations.\\nWe are subject to risks related to securitization of any loans originated and/or serviced by our subsidiaries.\\nThe securitization of any loans that we originate and/or service subject us to various risks that may increase our compliance costs and adversely impact our financial results, including:\\n| • | compliance with the terms of the agreements governing the securitized pools of loans, including any indemnification and repurchase provisions; |\\n\\n128\\n| • | reliance on programs administered by Fannie Mae, Freddie Mac, and Ginnie Mae that facilitate the issuance of mortgage-backed securities in the secondary market and the effect of any changes or modifications thereto (see-“GSE initiatives and other actions, including changes to the minimum servicing amount for GSE loans, could occur at any time and could impact us in significantly negative ways that we are unable to predict or protect against” and -“The federal conservatorship of Fannie Mae and Freddie Mac and related efforts, along with any changes in laws and regulations affecting the relationship between these agencies and the U.S. government, may adversely affect our business”); and |\\n\\n| • | federal and state legislation in securitizations, such as the risk retention requirements under the Dodd-Frank Act, could result in higher costs of certain lending operations and impose on us additional compliance requirements to meet servicing and originations criteria for securitized mortgage loans. |\\n\\nMaintenance of our 1940 Act exclusion imposes limits on our operations.\\nWe intend to continue to conduct our operations so that neither we nor any of our subsidiaries are required to register as an investment company under the 1940 Act. We believe we will not be considered an investment company under Section 3(a)(1)(A) of the 1940 Act because we will not engage primarily, or hold ourselves out as being engaged primarily, in the business of investing, reinvesting or trading in securities. However, under Section 3(a)(1)(C) of the 1940 Act, because we are a holding company that will conduct its businesses primarily through wholly owned and majority owned subsidiaries, the securities issued by our subsidiaries that are excluded from the definition of “investment company” under Section 3(c)(1) or Section 3(c)(7) of the 1940 Act, together with any other investment securities we may own, may not have a combined value in excess of 40% of the value of our total assets (exclusive of U.S. Government securities and cash items) on an unconsolidated basis, unless another exclusion from the definition of “investment company” is available to us. For purposes of the foregoing, we currently treat our interest in our SLS Servicer Advance Investment and our subsidiaries that hold consumer loans as investment securities because these subsidiaries presently rely on the exclusion provided by Section 3(c)(7) of the 1940 Act. The 40% test under Section 3(a)(1)(C) of the 1940 Act limits the types of businesses in which we may engage through our subsidiaries. In addition, the assets we and our subsidiaries may originate or acquire are limited by the provisions of the 1940 Act and the rules and regulations promulgated under the 1940 Act, which may adversely affect our business.\\nIf the value of securities issued by our subsidiaries that are excluded from the definition of “investment company” by Section 3(c)(1) or 3(c)(7) of the 1940 Act, together with any other investment securities we own, exceeds the 40% test under Section 3(a)(1)(C) of the 1940 Act (e.g., the value of our interests in the taxable REIT subsidiaries that hold Servicer Advance Investments and are not excluded from the definition of “investment company” by Section 3(c)(5)(A), (B) or (C) of the 1940 Act increases significantly in proportion to the value of our other assets), or if one or more of such subsidiaries fail to maintain an exclusion or exception from the 1940 Act, we could, among other things, be required either (a) to substantially change the manner in which we conduct our operations to avoid being required to register as an investment company or (b) to register as an investment company under the 1940 Act, either of which could have an adverse effect on us and the market price of our securities. As discussed above, for purposes of the foregoing, we generally treat our interests in our SLS Servicer Advance Investment and our subsidiaries that hold consumer loans as investment securities because these subsidiaries presently rely on the exclusion provided by Section 3(c)(7) of the 1940 Act. If we or any of our subsidiaries were required to register as an investment company under the 1940 Act, the registered entity would become subject to substantial regulation with respect to capital structure (including the ability to use leverage), management, operations, transactions with affiliated persons (as defined in the 1940 Act), portfolio composition, including restrictions with respect to diversification and industry concentration, compliance with reporting, record keeping, voting, proxy disclosure and other rules and regulations that would significantly change our operations.\\nFailure to maintain an exclusion would require us to significantly restructure our investment strategy. For example, because affiliate transactions are generally prohibited under the 1940 Act, we would not be able to enter into transactions with any of our affiliates if we are required to register as an investment company, and we might be required to terminate our Management Agreement and any other agreements with affiliates, which could have a material adverse effect on our ability to operate our business and pay distributions. If we were required to register us as an investment company but failed to do so, we would be prohibited from engaging in our business, and criminal and civil actions could be brought against us. In addition, our contracts would be unenforceable unless a court required enforcement, and a court could appoint a receiver to take control of us and liquidate our business.\\nFor purposes of the foregoing, we treat our interests in certain of our wholly owned and majority owned subsidiaries, which constitute more than 60% of the value of our adjusted total assets on an unconsolidated basis, as non-investment securities because such subsidiaries qualify for exclusion from the definition of an investment company under the 1940 Act pursuant to Section 3(c)(5)(C) of the 1940 Act. The Section 3(c)(5)(C) exclusion is available for entities “primarily engaged” in the business of “purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” The Section 3(c)(5)(C) exclusion generally requires that at least 55% of these subsidiaries’ assets must comprise qualifying real estate assets and at least 80% of each of their portfolios must comprise qualifying real estate assets and real estate-related assets under the 1940 Act. We expect each of our subsidiaries relying on Section 3(c)(5)(C) to rely on guidance published by the SEC staff or on our analyses of such guidance to\\n129\\ndetermine which assets are qualifying real estate assets and real estate-related assets. However, the SEC’s guidance was issued in accordance with factual situations that may be substantially different from the factual situations each of our subsidiaries may face, and much of the guidance was issued more than 20 years ago. No assurance can be given that the SEC staff will concur with the classification of each of our subsidiaries’ assets. In addition, the SEC staff may, in the future, issue further guidance that may require us to re-classify some of our subsidiaries’ assets for purposes of qualifying for an exclusion from regulation under the 1940 Act. For example, the SEC and its staff have not published guidance with respect to the treatment of whole pool Non-Agency RMBS for purposes of the Section 3(c)(5)(C) exclusion. Accordingly, based on our own judgment and analysis of the guidance from the SEC and its staff identifying Agency whole pool certificates as qualifying real estate assets under Section 3(c)(5)(C), we treat whole pool Non-Agency RMBS issued with respect to an underlying pool of mortgage loans in which our subsidiary relying on Section 3(c)(5)(C) holds all of the certificates issued by the pool as qualifying real estate assets. Based on our own judgment and analysis of the guidance from the SEC and its staff with respect to analogous assets, we treat Excess MSRs for which we do not own the related servicing rights as real estate-related assets for purposes of satisfying the 80% test under the Section 3(c)(5)(C) exclusion. If we are required to re-classify any of our subsidiaries’ assets, including those subsidiaries holding whole pool Non-Agency RMBS and/or Excess MSRs, such subsidiaries may no longer be in compliance with the exclusion from the definition of an “investment company” provided by Section 3(c)(5)(C) of the 1940 Act, and in turn, we may not satisfy the requirements to avoid falling within the definition of an “investment company” provided by Section 3(a)(1)(C). To the extent that the SEC staff publishes new or different guidance or disagrees with our analysis with respect to any assets of our subsidiaries we have determined to be qualifying real estate assets or real estate-related assets, we may be required to adjust our strategy accordingly. In addition, we may be limited in our ability to make certain investments and these limitations could result in a subsidiary holding assets we might wish to sell or selling assets we might wish to hold.\\nIn August 2011, the SEC issued a concept release soliciting public comments on a wide range of issues relating to companies engaged in the business of acquiring mortgages and mortgage-related instruments and that rely on Section 3(c)(5)(C) of the 1940 Act. Therefore, there can be no assurance that the laws and regulations governing the 1940 Act status of REITs, or guidance from the SEC or its staff regarding the Section 3(c)(5)(C) exclusion, will not change in a manner that adversely affects our operations. If we or our subsidiaries fail to maintain an exclusion or exception from the 1940 Act, we could, among other things, be required either to (a) change the manner in which we conduct our operations to avoid being required to register as an investment company, (b) effect sales of our assets in a manner that, or at a time when, we would not otherwise choose to do so, or (c) register as an investment company, any of which could negatively affect the value of our common stock, the sustainability of our business model, and our ability to make distributions. In addition, if we or any of our subsidiaries were required to register as an investment company under the 1940 Act, the registered entity would become subject to substantial regulation with respect to capital structure (including the ability to use leverage), management, operations, transactions with affiliated persons (as defined in the 1940 Act), portfolio composition, including restrictions with respect to diversification and industry concentration, compliance with reporting, record keeping, voting, proxy disclosure and other rules and regulations that would significantly change our operations.\\nRapid changes in the values of our assets may make it more difficult for us to maintain our qualification as a REIT or our exclusion from the 1940 Act.\\nIf the market value or income potential of qualifying assets for purposes of our qualification as a REIT or our exclusion from registration as an investment company under the 1940 Act declines as a result of increased interest rates, changes in prepayment rates or other factors, or the market value or income from non-qualifying assets increases, we may need to increase our investments in qualifying assets and/or liquidate our non-qualifying assets to maintain our REIT qualification or our exclusion from registration under the 1940 Act. If the change in market values or income occurs quickly, this may be especially difficult to accomplish. This difficulty may be exacerbated by the illiquid nature of any non-qualifying assets we may own. We may have to make investment decisions that we otherwise would not make absent the intent to maintain our qualification as a REIT and exclusion from registration under the 1940 Act.\\nWe are subject to significant competition, and we may not compete successfully.\\nWe are subject to significant competition in seeking investments. We compete with other companies, including other REITs, insurance companies and other investors, including funds and companies affiliated with our Manager. Some of our competitors have greater resources than we possess or have greater access to capital or various types of financing structures than are available to us, and we may not be able to compete successfully for investments or provide attractive investment returns relative to our competitors. These competitors may be willing to accept lower returns on their investments and, as a result, our profit margins could be adversely affected. Furthermore, competition for investments that are suitable for us, including, but not limited to, interests in MSRs, may lead to decreased availability, higher market prices and decreased returns available from such investments, which may further limit our ability to generate our desired returns. We cannot assure you that other companies will not be formed that compete with us for investments or otherwise pursue investment strategies similar to ours or that we will be able to compete successfully against any such companies.\\n130\\nOur business could suffer if we fail to attract and retain highly skilled personnel.\\nOur future success will depend on our ability to identify, hire, develop, motivate and retain highly qualified personnel for all areas of the Company, in particular skilled managers, loan officers, underwriters, loan servicers, debt default specialists and other personnel specialized in finance, risk and compliance. Trained and experienced personnel are in high demand and may be in short supply in some areas. We may not be able to attract, develop and maintain an adequate skilled workforce necessary to operate our businesses and labor expenses may increase as a result of a shortage in the supply of qualified personnel. If we are unable to attract and retain such personnel, we may not be able to take advantage of acquisitions and other growth opportunities that may be presented to us and this could have a material adverse effect on our business, financial condition, liquidity and results of operations.\\nThe valuations of our assets are subject to uncertainty because most of our assets are not traded in an active market.\\nThere is not anticipated to be an active market for most of the assets in which we will invest. In the absence of market comparisons, we will use other pricing methodologies, including, for example, models based on assumptions regarding expected trends, historical trends following market conditions believed to be comparable to the then current market conditions and other factors believed at the time to be likely to influence the potential resale price of, or the potential cash flows derived from, an investment. Such methodologies may not prove to be accurate and any inability to accurately price assets may result in adverse consequences for us. A valuation is only an estimate of value and is not a precise measure of realizable value. Ultimate realization of the market value of a private asset depends to a great extent on economic and other conditions beyond our control. Further, valuations do not necessarily represent the price at which a private investment would sell since market prices of private investments can only be determined by negotiation between a willing buyer and seller. If we were to liquidate a particular private investment, the realized value may be more than or less than the valuation of such asset as carried on our books.\\nChanges in accounting rules could occur at any time and could impact us in significantly negative ways that we are unable to predict or protect against.\\nAs has been widely publicized, the SEC, the Financial Accounting Standards Board (the “FASB”) and other regulatory bodies that establish the accounting rules applicable to us have recently proposed or enacted a wide array of changes to accounting rules. Moreover, in the future these regulators may propose additional changes that we do not currently anticipate. Changes to accounting rules that apply to us could significantly impact our business or our reported financial performance in negative ways that we cannot predict or protect against. We cannot predict whether any changes to current accounting rules will occur or what impact any codified changes will have on our business, results of operations, liquidity or financial condition, directly or through their impact on our Servicing Partners or counterparties.\\nA prolonged economic slowdown, a lengthy or severe recession, or declining real estate values could harm our operations.\\nWe believe the risks associated with our business are more severe during periods in which an economic slowdown or recession is accompanied by declining real estate values, as was the case in 2008. Declining real estate values generally reduce the level of new mortgage loan originations, since borrowers often use increases in the value of their existing properties to support the purchase of, or investment in, additional properties. Borrowers may also be less able to pay principal and interest on our loans or the loans underlying our securities, interests in MSRs and servicer advances, if the real estate economy weakens. Further, declining real estate values significantly increase the likelihood that we will incur losses on our investments in the event of default because the value of our collateral may be insufficient to cover our basis. Any sustained period of increased payment delinquencies, foreclosures or losses could adversely affect our net interest income from the assets in our portfolio, which would significantly harm our revenues, results of operations, financial condition, liquidity, business prospects and our ability to make distributions to our stockholders.\\nCompliance with changing regulation of corporate governance and public disclosure has and will continue to result in increased compliance costs and pose challenges for our management team.\\nCertain aspects of the Dodd-Frank Act remain subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on us and, more generally, the financial services and mortgage industries. Additionally, we cannot predict whether there will be additional proposed laws or reforms that would affect us, whether or when such changes may be adopted, how such changes may be interpreted and enforced or how such changes may affect us. However, the costs of complying with any additional laws or regulations could have a material effect on our financial condition and results of operations.\\n131\\nWe have engaged and may in the future engage in a number of acquisitions and we may be unable to successfully integrate the acquired assets and assumed liabilities in connection with such acquisitions.\\nAs part of our business strategy, we regularly evaluate acquisitions of what we believe are complementary assets. Identifying and achieving the anticipated benefits of such acquisitions is subject to a number of uncertainties, including, without limitation, whether we are able to acquire the assets, within our parameters, integrate the acquired assets and manage the assumed liabilities efficiently. It is possible that the integration process could take longer than anticipated and could result in additional and unforeseen expenses, the disruption of our ongoing business, processes and systems, or inconsistencies in standards, controls, procedures, practices and policies, any of which could adversely affect our ability to achieve the anticipated benefits of such acquisitions. There may be increased risk due to integrating the assets into our financial reporting and internal control systems. Difficulties in adding the assets into our business could also result in the loss of contract counterparties or other persons with whom we conduct business and potential disputes or litigation with contract counterparties or other persons with whom we or such counterparties conduct business. We could also be adversely affected by any issues attributable to the related seller’s operations that arise or are based on events or actions that occurred prior to the closing of such acquisitions. Completion of the integration process is subject to a number of uncertainties, and no assurance can be given that the anticipated benefits will be realized in their entirety or at all or, if realized, the timing of their realization. Failure to achieve these anticipated benefits could result in increased costs or decreases in the amount of expected revenues and could adversely affect our future business, financial condition, operating results and cash flows. Due to the costs of engaging in a number of acquisitions, we may also have difficulty completing more acquisitions in the future.\\nThere may be difficulties with integrating the loans underlying MSR acquisitions involving servicing transfers into the successor servicer’s servicing platform, which could have a material adverse effect on our results of operations, financial condition and liquidity.\\nIn connection with certain MSR acquisitions, servicing is transferred from the seller to a subservicer appointed by us. The ability to integrate and service the assets acquired will depend in large part on the success of our subservicer’s integration of expanded servicing capabilities with its current operations. We may fail to realize some or all of the anticipated benefits of these transactions if the integration process takes longer, or is more costly, than expected. Potential difficulties we may encounter during the integration process with the assets acquired in MSR acquisitions involving servicing transfers include, but are not limited to, the following:\\n| • | the integration of the portfolio into our subservicer’s information technology platforms and servicing systems; |\\n\\n| • | the quality of servicing during any interim servicing period after we purchase the portfolio but before our subservicer assumes servicing obligations from the seller or its agents; |\\n\\n| • | the disruption to our ongoing businesses and distraction of our management teams from ongoing business concerns; |\\n\\n| • | incomplete or inaccurate files and records; |\\n\\n| • | the retention of existing customers; |\\n\\n| • | the creation of uniform standards, controls, procedures, policies and information systems; |\\n\\n| • | the occurrence of unanticipated expenses; and |\\n\\n| • | potential unknown liabilities associated with the transactions, including legal liability related to origination and servicing prior to the acquisition. |\\n\\nOur failure to meet the challenges involved in successfully integrating the assets acquired in MSR acquisitions involving servicing transfers with our current business could impair our operations. For example, it is possible that the data our subservicer acquires upon assuming the direct servicing obligations for the loans may not transfer from the seller’s platform to its systems properly. This may result in data being lost, key information not being locatable on our subservicer’s systems, or the complete failure of the transfer. If our employees are unable to access customer information easily, or is unable to produce originals or copies of documents or accurate information about the loans, collections could be affected significantly, and our subservicer may not be able to enforce its right to collect in some cases. Similarly, collections could be affected by any changes to our subservicer’s collections practices, the restructuring of any key servicing functions, transfer of files and other changes that occur as a result of the transfer of servicing obligations from the seller to our subservicer.\\nWe are responsible for certain of HLSS’s contingent and other corporate liabilities.\\nUnder the HLSS acquisition agreement, we have assumed and are responsible for the payment of HLSS’s contingent and other liabilities, including: (i) liabilities for litigation relating to, arising out of or resulting from certain lawsuits in which HLSS is named as the defendant, (ii) HLSS’s tax liabilities, (iii) HLSS’s corporate liabilities, (iv) generally any actions with respect to the HLSS Acquisition brought by any third party and (v) payments under contracts. We currently cannot estimate the amount we may ultimately be responsible for as a result of assuming substantially all of HLSS’s contingent and other corporate liabilities. The amount for which we are ultimately responsible may be material and have a material adverse effect on our business, financial condition, results of operations and liquidity. In addition, certain claims and lawsuits may require significant costs to defend and\\n132\\nresolve and may divert management’s attention away from other aspects of operating and managing our business, each of which could materially and adversely affect our business, financial condition, results of operations and liquidity.\\nWe cannot guarantee that we will not receive further regulatory inquiries or be subject to litigation regarding the subject matter of the subpoenas or matters relating thereto, or that existing inquires, or, should they occur, any future regulatory inquiries or litigation, will not consume internal resources, result in additional legal and consulting costs or negatively impact our stock price.\\nWe could be materially and adversely affected by past events, conditions or actions with respect to HLSS or Ocwen.\\nHLSS acquired assets and assumed liabilities could be adversely affected as a result of events or conditions that occurred or existed before the closing of the HLSS Acquisition. Adverse changes in the assets or liabilities we have acquired or assumed, respectively, as part of the HLSS Acquisition, could occur or arise as a result of actions by HLSS or Ocwen, legal or regulatory developments, including the emergence or unfavorable resolution of pre-acquisition loss contingencies, deteriorating general business, market, industry or economic conditions, and other factors both within and beyond the control of HLSS or Ocwen. We are subject to a variety of risks as a result of our dependence on Servicing Partners, including, without limitation, the potential loss of all of the value of our Excess MSRs in the event that the servicer of the underlying loans is terminated by the mortgage loan owner or RMBS bondholders. A significant decline in the value of HLSS assets or a significant increase in HLSS liabilities we have acquired could adversely affect our future business, financial condition, cash flows and results of operations. HLSS is subject to a number of other risks and uncertainties, including regulatory investigations and legal proceedings against HLSS, and others with whom HLSS conducted business. Moreover, any insurance proceeds received with respect to such matters may be inadequate to cover the associated losses. Adverse developments at Ocwen, including liquidity issues, ratings downgrades, defaults under debt agreements, servicer rating downgrades, failure to comply with the terms of PSAs, termination under PSAs, Ocwen bankruptcy proceedings and additional regulatory issues and settlements, including those described above, could have a material adverse effect on us. See “—We rely heavily on our Servicing Partners to achieve our investment objective and have no direct ability to influence their performance.”\\nOur ability to borrow may be adversely affected by the suspension or delay of the rating of the notes issued under certain of our financing facilities by the credit agency providing the ratings.\\nCertain of our financing facilities are rated by one rating agency and we may sponsor financing facilities in the future that are rated by credit agencies. The related agency or rating agencies may suspend rating notes backed by servicer advances, MSRs, Excess MSRs and our other investments at any time. Rating agency delays may result in our inability to obtain timely ratings on new notes, or amend or modify other financing facilities which could adversely impact the availability of borrowings or the interest rates, advance rates or other financing terms and adversely affect our results of operations and liquidity. Further, if we are unable to secure ratings from other agencies, limited investor demand for unrated notes could result in further adverse changes to our liquidity and profitability.\\nA downgrade of certain of the notes issued under our financing facilities could cause such notes to become due and payable prior to their expected repayment date/maturity date, which could have a material adverse effect on our business, financial condition, results of operations and liquidity.\\nRegulatory scrutiny regarding foreclosure processes could lengthen foreclosure timelines, which could increase advances and materially and adversely affect our business, financial condition, results of operations and liquidity.\\nWhen a residential mortgage loan is in foreclosure, the servicer is generally required to continue to advance delinquent principal and interest to the securitization trust and to also make advances for delinquent taxes and insurance and foreclosure costs and the upkeep of vacant property in foreclosure to the extent it determines that such amounts are recoverable. These servicer advances are generally recovered when the delinquency is resolved. Foreclosure moratoria or other actions that lengthen the foreclosure process increase the amount of servicer advances, lengthen the time it takes for reimbursement of such advances and increase the costs incurred during the foreclosure process. In addition, servicer advance financing facilities generally contain provisions that limit the eligibility of servicer advances to be financed based on the length of time that servicer advances are outstanding, and, as a result, an increase in foreclosure timelines could further increase the amount of servicer advances that need to be funded from the related servicer’s own capital. Such increases in foreclosure timelines could increase the need for capital to fund servicer advances, which would increase our interest expense, delay the collection of interest income or servicing revenue until the foreclosure has been resolved and, therefore, reduce the cash that we have available to pay our operating expenses or to pay dividends. For more information, see “—We could be materially and adversely affected by past events, conditions or actions with respect to HLSS or Ocwen” above.\\n133\\nCertain of our Servicing Partners have triggered termination events or events of default under some PSAs underlying the MSRs with respect to which we are entitled to the basic fee component or Excess MSRs.\\nIn certain of these circumstances, the related Servicing Partner may be terminated without any right to compensation for its loss, other than the right to be reimbursed for any outstanding servicer advances as the related loans are brought current, modified, liquidated or charged off. So long as we are in compliance with our obligations under our servicing agreements and purchase agreements, if we or one of our Servicing Partners is terminated as servicer, we may have the right to receive an indemnification payment from the applicable Servicing Partner, even if such termination related to servicer termination events or events of default existing at the time of any transaction with such Servicing Partner. If one of our Servicing Partners is terminated as servicer under a PSA, we will lose any investment related to such Servicing Partner’s MSRs. If we or such Servicing Partner is terminated as servicer with respect to a PSA and we are unable to enforce our contractual rights against such Servicing Partner, or if such Servicing Partner is unable to make any resulting indemnification payments to us, if any such payment is due and payable, it may have a material adverse effect on our financial condition, results of operations, ability to make distributions, liquidity and financing arrangements, including our servicer advance financing facilities, and may make it more difficult for us to acquire additional interests in MSRs in the future.\\nRepresentations and warranties made by us in our collateralized borrowings and loan sale agreements may subject us to liability.\\nOur financing facilities require us to make certain representations and warranties regarding the assets that collateralize the borrowings. Although we perform due diligence on the assets that we acquire, certain representations and warranties that we make in respect of such assets may ultimately be determined to be inaccurate. In addition, our loan sale agreements require us to make representations and warranties to the purchaser regarding the loans that were sold. Such representations and warranties may include, but are not limited to, issues such as the validity of the lien; the absence of delinquent taxes or other liens; the loans’ compliance with all local, state and federal laws and the delivery of all documents required to perfect title to the lien.\\nIn the event of a breach of a representation or warranty, we may be required to repurchase affected loans, make indemnification payments to certain indemnified parties or address any claims associated with such breach. Further, we may have limited or no recourse against the seller from whom we purchased the loans. Such recourse may be limited due to a variety of factors, including the absence of a representation or warranty from the seller corresponding to the representation provided by us or the contractual expiration thereof. A breach of a representation or warranty could adversely affect our results of operations and liquidity.\\nOur ability to exercise our cleanup call rights may be limited or delayed if a third party contests our ability to exercise our cleanup call rights, if the related securitization trustee refuses to permit the exercise of such rights, or if a related party is subject to bankruptcy proceedings.\\nCertain servicing contracts permit more than one party to exercise a cleanup call-meaning the right of a party to collapse a securitization trust by purchasing all of the remaining loans held by the securitization trust pursuant to the terms set forth in the applicable servicing agreement. While the servicers from which we acquired our cleanup call rights (or other servicers from which these servicers acquired MSRs) may be named as the party entitled to exercise such rights, certain third parties may also be permitted to exercise such rights. If any such third party exercises a cleanup call, we could lose our ability to exercise our cleanup call right and, as a result, lose the ability to generate positive returns with respect to the related securitization transaction. In addition, another party could impair our ability to exercise our cleanup call rights by contesting our rights (for example, by claiming that they hold the exclusive cleanup call right with respect to the applicable securitization trust). Moreover, because the ability to exercise a cleanup call right is governed by the terms of the applicable servicing agreement, any ambiguous or conflicting language regarding the exercise of such rights in the agreement may make it more difficult and costly to exercise a cleanup call right. Furthermore, certain servicing contracts provide cleanup call rights to a servicer currently subject to bankruptcy proceedings from which our servicers have acquired MSRs. While, notwithstanding the related bankruptcy proceedings, it is possible that we will be able to exercise the related cleanup calls within our desired time frame, our ability to exercise such rights may be significantly delayed or impaired by the applicable securitization trustee or bankruptcy estate or any additional steps required because of the bankruptcy process. Finally, many of our call rights are not currently exercisable and may not become exercisable for a period of years. As a result, our ability to realize the benefits from these rights will depend on a number of factors at the time they become exercisable many of which are outside our control, including interest rates, conditions in the capital markets and conditions in the residential mortgage market.\\nThe exercise of cleanup calls could negatively impact our interests in MSRs.\\nThe exercise of cleanup call rights results in the termination of the MSRs on the loans held within the related securitization trusts. To the extent we own interests in MSRs with respect to loans held within securitization trusts where cleanup call rights are exercised,\\n134\\nwhether they are exercised by us or a third party, the value of our interests in those MSRs will likely be reduced to zero and we could incur losses and reduced cash flows from any such interests.\\nNew Residential’s subsidiary New Residential Mortgage LLC is or may become subject to significant state and federal regulations.\\nA subsidiary of New Residential, New Residential Mortgage LLC (“NRM”), has obtained applicable qualifications, licenses and approvals to own Non-Agency and certain Agency MSRs in the United States and certain other jurisdictions. As a result of NRM’s current and expected approvals, NRM is subject to extensive and comprehensive regulation under federal, state and local laws in the United States. These laws and regulations do, and may in the future, significantly affect the way that NRM does business, and subject NRM and New Residential to additional costs and regulatory obligations, which could impact our financial results.\\nNRM’s business may become subject to increasing regulatory oversight and scrutiny in the future as it continues seeking and obtaining additional approvals to hold MSRs, which may lead to regulatory investigations or enforcement, including both formal and informal inquiries, from various state and federal agencies as part of those agencies’ oversight of the mortgage servicing business. An adverse result in governmental investigations or examinations or private lawsuits, including purported class action lawsuits, may adversely affect NRM’s and our financial results or result in serious reputational harm. In addition, a number of participants in the mortgage servicing industry have been the subject of purported class action lawsuits and regulatory actions by state or federal regulators, and other industry participants have been the subject of actions by state Attorneys General.\\nFailure of New Residential’s subsidiary, NRM, to obtain or maintain certain licenses and approvals required for NRM to purchase and own MSRs could prevent us from purchasing or owning MSRs, which could limit our potential business activities.\\nState and federal laws require a business to hold certain state licenses prior to acquiring MSRs. NRM is currently licensed or otherwise eligible to hold MSRs in each applicable state. As a licensee in such states, NRM may become subject to administrative actions in those states for failing to satisfy ongoing license requirements or for other state law violations, the consequences of which could include fines or suspensions or revocations of NRM’s licenses by applicable state regulatory authorities, which could in turn result in NRM becoming ineligible to hold MSRs in the related jurisdictions. We could be delayed or prohibited from conducting certain business activities if we do not maintain necessary licenses in certain jurisdictions. We cannot assure you that we will be able to maintain all of the required state licenses.\\nAdditionally, NRM has received approval from FHA to hold MSRs associated with FHA-insured mortgage loans, from Fannie Mae to hold MSRs associated with loans owned by Fannie Mae, and from Freddie Mac to hold MSRs associated with loans owned by Freddie Mac. NRM may seek approval from Ginnie Mae to become an approved Ginnie Mae Issuer, which would make NRM eligible to hold MSRs associated with Ginnie Mae securities. As an approved Fannie Mae Servicer, Freddie Mac Servicer and FHA Lender, NRM is required to conduct aspects of its operations in accordance with applicable policies and guidelines published by FHA, Fannie Mae and Freddie Mac in order to maintain those approvals. Should NRM fail to maintain FHA, Fannie Mae or Freddie Mac approval, or fail to obtain approval from Ginnie Mae, NRM may be unable to purchase certain types of MSRs, which could limit our potential business activities.\\nNRM is currently subject to various, and may become subject to additional information reporting and other regulatory requirements, and there is no assurance that we will be able to satisfy those requirements or other ongoing requirements applicable to mortgage loan servicers under applicable state and federal laws. Any failure by NRM to comply with such state or federal regulatory requirements may expose us to administrative or enforcement actions, license or approval suspensions or revocations or other penalties that may restrict our business and investment options, any of which could restrict our business and investment options, adversely impact our business and financial results and damage our reputation.\\nWe may become subject to fines or other penalties based on the conduct of mortgage loan originators and brokers that originate residential mortgage loans related to MSRs that we acquire, and the third-party servicers we may engage to subservice the loans underlying MSRs we acquire.\\nWe have acquired MSRs and may in the future acquire additional MSRs from third-party mortgage loan originators, brokers or other sellers, and we therefore are or will become dependent on such third parties for the related mortgage loans’ compliance with applicable law, and on third-party mortgage servicers, including our Servicing Partners, to perform the day-to-day servicing on the mortgage loans underlying any such MSRs. Mortgage loan originators and brokers are subject to strict and evolving consumer protection laws and other legal obligations with respect to the origination of residential mortgage loans. These laws and regulations include the residential mortgage servicing standards, “ability-to-repay” and “qualified mortgage” regulations promulgated by the CFPB, which became effective in 2014. In addition, there are various other federal, state, and local laws and regulations that are\\n135\\nintended to discourage predatory lending practices by residential mortgage loan originators. These laws may be highly subjective and open to interpretation and, as a result, a regulator or court may determine that that there has been a violation where an originator or servicer of mortgage loans reasonably believed that the law or requirement had been satisfied. Failure or alleged failure by originators or servicers to comply with these laws and regulations could subject us to state or CFPB administrative proceedings, which could result in monetary penalties, license suspensions or revocations, or restrictions to our business, all of which could adversely impact our business and financial results and damage our reputation.\\nThe final servicing rules promulgated by the CFPB to implement certain sections of the Dodd-Frank Act include provisions relating to, among other things, periodic billing statements and disclosures, responding to borrower inquiries and complaints, force-placed insurance, and adjustable rate mortgage interest rate adjustment notices. Further, the mortgage servicing rules require servicers to, among other things, make good faith early intervention efforts to notify delinquent borrowers of loss mitigation options, to implement specified loss mitigation procedures, and if feasible, exhaust all loss mitigation options before proceeding to foreclosure. Proposed updates to further refine these rules have been published and will likely lead to further changes in requirements applicable to servicing mortgage loans.\\nIn addition to NewRez LLC d/b/a Shellpoint Mortgage Servicing, we engage third-party servicers to subservice mortgage loans relating to any MSRs we acquire. It is therefore possible that a third-party servicer’s failure to comply with the new and evolving servicing protocols could adversely affect the value of the MSRs we acquire. Additionally, we may become subject to fines, penalties or civil liability based upon the conduct of any third-party servicer who services mortgage loans related to MSRs that we have acquired or will acquire in the future.\\nInvestments in MSRs may expose us to additional risks.\\nWe hold investments in MSRs. Our investments in MSRs may subject us to certain additional risks, including the following:\\n| • | We have limited experience acquiring MSRs and operating a servicer. Although ownership of MSRs and the operation of a servicer includes many of the same risks as our other target assets and business activities, including risks related to prepayments, borrower credit, defaults, interest rates, hedging, and regulatory changes, there can be no assurance that we will be able to successfully operate a servicer subsidiary and integrate MSR investments into our business operations. |\\n\\n| • | As of today, we rely on subservicers to subservice the mortgage loans underlying our MSRs on our behalf. We are generally responsible under the applicable Servicing Guidelines for any subservicer’s non-compliance with any such applicable Servicing Guideline. In addition, there is a risk that our current subservicers will be unwilling or unable to continue subservicing on our behalf on terms favorable to us in the future. In such a situation, we may be unable to locate a replacement subservicer on favorable terms. |\\n\\n| • | NRM’s existing approvals from government-related entities or federal agencies are subject to compliance with their respective servicing guidelines, minimum capital requirements, reporting requirements and other conditions that they may impose from time to time at their discretion. Failure to satisfy such guidelines or conditions could result in the unilateral termination of NRM’s existing approvals or pending applications by one or more entities or agencies. |\\n\\n| • | NRM is presently licensed or otherwise eligible to hold MSRs in all states within the United States and the District of Columbia. Such state licenses may be suspended or revoked by a state regulatory authority, and we may as a result lose the ability to own MSRs under the regulatory jurisdiction of such state regulatory authority. |\\n\\n| • | Changes in minimum servicing compensation for Agency loans could occur at any time and could negatively impact the value of the income derived from any MSRs that we hold or may acquire in the future. |\\n\\n| • | Investments in MSRs are highly illiquid and subject to numerous restrictions on transfer and, as a result, there is risk that we would be unable to locate a willing buyer or get approval to sell any MSRs in the future should we desire to do so. |\\n\\nOur business, results of operations, financial condition and reputation could be adversely impacted if we are not able to successfully manage these or other risks related to investing and managing MSR investments.\\nRisks Related to Our Manager\\nWe are dependent on our Manager and may not find a suitable replacement if our Manager terminates the Management Agreement.\\nNone of our officers or other senior individuals who perform services for us (other than three part-time employees of NRM), is an employee of New Residential. Instead, these individuals are employees of our Manager. Accordingly, we are completely reliant on our Manager, which has significant discretion as to the implementation of our operating policies and strategies, to conduct our business. We are subject to the risk that our Manager will terminate the Management Agreement and that we will not be able to find a suitable replacement for our Manager in a timely manner, at a reasonable cost or at all. Furthermore, we are dependent on\\n136\\nthe services of certain key employees of our Manager whose compensation is partially or entirely dependent upon the amount of incentive or management compensation earned by our Manager and whose continued service is not guaranteed, and the loss of such services could adversely affect our operations.\\nOn December 27, 2017, SoftBank announced that it completed the SoftBank Merger. In connection with the SoftBank Merger, Fortress operates within SoftBank as an independent business headquartered in New York. There can be no assurance that the SoftBank Merger will not have an impact on us or our relationship with the Manager.\\nThere are conflicts of interest in our relationship with our Manager.\\nOur Management Agreement with our Manager was not negotiated between unaffiliated parties, and its terms, including fees payable, although approved by the independent directors of New Residential as fair, may not be as favorable to us as if they had been negotiated with an unaffiliated third party.\\nThere are conflicts of interest inherent in our relationship with our Manager insofar as our Manager and its affiliates—including investment funds, private investment funds, or businesses managed by our Manager invest in real estate and other securities and loans, consumer loans and interests in MSRs and whose investment objectives overlap with our investment objectives. Certain investments appropriate for us may also be appropriate for one or more of these other investment vehicles. Certain members of our board of directors and employees of our Manager who are our officers also serve as officers and/or directors of these other entities. Although we have the same Manager, we may compete with entities affiliated with our Manager or Fortress for certain target assets. From time to time, affiliates of Fortress focus on investments in assets with a similar profile as our target assets that we may seek to acquire. These affiliates may have meaningful purchasing capacity, which may change over time depending upon a variety of factors, including, but not limited to, available equity capital and debt financing, market conditions and cash on hand. Fortress has two funds primarily focused on investing in Excess MSRs with approximately $0.6 billion in investments in aggregate. We have broad investment guidelines, and we have co-invested and may co-invest with Fortress funds or portfolio companies of private equity funds managed by our Manager (or an affiliate thereof) in a variety of investments. We also may invest in securities that are senior or junior to securities owned by funds managed by our Manager. Fortress funds generally have a fee structure similar to ours, but the fees actually paid will vary depending on the size, terms and performance of each fund.\\nOur Management Agreement with our Manager generally does not limit or restrict our Manager or its affiliates from engaging in any business or managing other pooled investment vehicles that invest in investments that meet our investment objectives. Our Manager intends to engage in additional real estate related management and real estate and other investment opportunities in the future, which may compete with us for investments or result in a change in our current investment strategy. In addition, our certificate of incorporation provides that if Fortress or an affiliate or any of their officers, directors or employees acquire knowledge of a potential transaction that could be a corporate opportunity, they have no duty, to the fullest extent permitted by law, to offer such corporate opportunity to us, our stockholders or our affiliates. In the event that any of our directors and officers who is also a director, officer or employee of Fortress or its affiliates acquires knowledge of a corporate opportunity or is offered a corporate opportunity, provided that this knowledge was not acquired solely in such person’s capacity as a director or officer of New Residential and such person acts in good faith, then to the fullest extent permitted by law such person is deemed to have fully satisfied such person’s fiduciary duties owed to us and is not liable to us if Fortress or its affiliates pursues or acquires the corporate opportunity or if such person did not present the corporate opportunity to us.\\nThe ability of our Manager and its officers and employees to engage in other business activities, subject to the terms of our Management Agreement with our Manager, may reduce the amount of time our Manager, its officers or other employees spend managing us. In addition, we may engage (subject to our investment guidelines) in material transactions with our Manager or another entity managed by our Manager or one of its affiliates, which may include, but are not limited to, certain financing arrangements, purchases of debt, co-investments in interests in MSRs, consumer loans, and other assets that present an actual, potential or perceived conflict of interest. It is possible that actual, potential or perceived conflicts could give rise to investor dissatisfaction, litigation or regulatory enforcement actions. Appropriately dealing with conflicts of interest is complex and difficult, and our reputation could be damaged if we fail, or appear to fail, to deal appropriately with one or more potential, actual or perceived conflicts of interest. Regulatory scrutiny of, or litigation in connection with, conflicts of interest could have a material adverse effect on our reputation, which could materially adversely affect our business in a number of ways, including causing an inability to raise additional funds, a reluctance of counterparties to do business with us, a decrease in the prices of our equity securities and a resulting increased risk of litigation and regulatory enforcement actions.\\nThe management compensation structure that we have agreed to with our Manager, as well as compensation arrangements that we may enter into with our Manager in the future (in connection with new lines of business or other activities), may incentivize our Manager to invest in high risk investments. In addition to its management fee, our Manager is currently entitled to receive incentive compensation. In evaluating investments and other management strategies, the opportunity to earn incentive\\n137\\ncompensation may lead our Manager to place undue emphasis on the maximization of earnings, including through the use of leverage, at the expense of other criteria, such as preservation of capital, in order to achieve higher incentive compensation. Investments with higher yield potential are generally riskier or more speculative than lower-yielding investments. Moreover, because our Manager receives compensation in the form of options in connection with the completion of our common equity offerings, our Manager may be incentivized to cause us to issue additional common stock, which could be dilutive to existing stockholders. In addition, our Manager’s management fee is not tied to our performance and may not sufficiently incentivize our Manager to generate attractive risk-adjusted returns for us.\\nIt would be difficult and costly to terminate our Management Agreement with our Manager.\\nIt would be difficult and costly for us to terminate our Management Agreement with our Manager. The Management Agreement may only be terminated annually upon (i) the affirmative vote of at least two-thirds of our independent directors, or by a vote of the holders of a simple majority of the outstanding shares of our common stock, that there has been unsatisfactory performance by our Manager that is materially detrimental to us or (ii) a determination by a simple majority of our independent directors that the management fee payable to our Manager is not fair, subject to our Manager’s right to prevent such a termination by accepting a mutually acceptable reduction of fees. Our Manager will be provided 60 days’ prior notice of any termination and will be paid a termination fee equal to the amount of the management fee earned by the Manager during the 12-month period preceding such termination. In addition, following any termination of the Management Agreement, our Manager may require us to purchase its right to receive incentive compensation at a price determined as if our assets were sold for their fair market value (as determined by an appraisal, taking into account, among other things, the expected future performance of the underlying investments) or otherwise we may continue to pay the incentive compensation to our Manager. These provisions may increase the effective cost to us of terminating the Management Agreement, thereby adversely affecting our ability to terminate our Manager without cause.\\nOur directors have approved broad investment guidelines for our Manager and do not approve each investment decision made by our Manager. In addition, we may change our investment strategy without a stockholder vote, which may result in our making investments that are different, riskier or less profitable than our current investments.\\nOur Manager is authorized to follow broad investment guidelines. Consequently, our Manager has great latitude in determining the types and categories of assets it may decide are proper investments for us, including the latitude to invest in types and categories of assets that may differ from those in which we currently invest. Our directors will periodically review our investment guidelines and our investment portfolio. However, our board does not review or pre-approve each proposed investment or our related financing arrangements. In addition, in conducting periodic reviews, the directors rely primarily on information provided to them by our Manager. Furthermore, transactions entered into by our Manager may be difficult or impossible to unwind by the time they are reviewed by the directors, even if the transactions contravene the terms of the Management Agreement. In addition, we may change our investment strategy, including our target asset classes, without a stockholder vote.\\nOur investment strategy may evolve in light of existing market conditions and investment opportunities, and this evolution may involve additional risks depending upon the nature of the assets in which we invest and our ability to finance such assets on a short or long-term basis. Investment opportunities that present unattractive risk-return profiles relative to other available investment opportunities under particular market conditions may become relatively attractive under changed market conditions, and changes in market conditions may therefore result in changes in the investments we target. Decisions to make investments in new asset categories present risks that may be difficult for us to adequately assess and could therefore reduce our ability to pay dividends on our common stock or have adverse effects on our liquidity, results of operations or financial condition. A change in our investment strategy may also increase our exposure to interest rate, foreign currency, real estate market or credit market fluctuations and expose us to new legal and regulatory risks. In addition, a change in our investment strategy may increase our use of non-match-funded financing, increase the guarantee obligations we agree to incur or increase the number of transactions we enter into with affiliates. Our failure to accurately assess the risks inherent in new asset categories or the financing risks associated with such assets could adversely affect our results of operations, liquidity and financial condition.\\nOur Manager will not be liable to us for any acts or omissions performed in accordance with the Management Agreement, including with respect to the performance of our investments.\\nPursuant to our Management Agreement, our Manager will not assume any responsibility other than to render the services called for thereunder in good faith and will not be responsible for any action of our board of directors in following or declining to follow its advice or recommendations. Our Manager, its members, managers, officers and employees will not be liable to us or any of our subsidiaries, to our board of directors, or our or any subsidiary’s stockholders or partners for any acts or omissions by our Manager, its members, managers, officers or employees, except by reason of acts constituting bad faith, willful misconduct, gross negligence or reckless disregard of our Manager’s duties under our Management Agreement. We shall, to the full extent lawful, reimburse, indemnify and hold our Manager, its members, managers, officers and employees and each other person, if any,\\n138\\ncontrolling our Manager harmless of and from any and all expenses, losses, damages, liabilities, demands, charges and claims of any nature whatsoever (including attorneys’ fees) in respect of or arising from any acts or omissions of an indemnified party made in good faith in the performance of our Manager’s duties under our Management Agreement and not constituting such indemnified party’s bad faith, willful misconduct, gross negligence or reckless disregard of our Manager’s duties under our Management Agreement.\\nOur Manager’s due diligence of investment opportunities or other transactions may not identify all pertinent risks, which could materially affect our business, financial condition, liquidity and results of operations.\\nOur Manager intends to conduct due diligence with respect to each investment opportunity or other transaction it pursues. It is possible, however, that our Manager’s due diligence processes will not uncover all relevant facts, particularly with respect to any assets we acquire from third parties. In these cases, our Manager may be given limited access to information about the investment and will rely on information provided by the target of the investment. In addition, if investment opportunities are scarce, the process for selecting bidders is competitive, or the timeframe in which we are required to complete diligence is short, our ability to conduct a due diligence investigation may be limited, and we would be required to make investment decisions based upon a less thorough diligence process than would otherwise be the case. Accordingly, investments and other transactions that initially appear to be viable may prove not to be over time, due to the limitations of the due diligence process or other factors.\\nThe ownership by our executive officers and directors of shares of common stock, options, or other equity awards of entities either owned by Fortress funds managed by affiliates of our Manager or managed by our Manager may create, or may create the appearance of, conflicts of interest.\\nSome of our directors, officers and other employees of our Manager hold positions with entities either owned by Fortress funds managed by affiliates of our Manager or managed by our Manager and own such entities’ common stock, options to purchase such entities’ common stock or other equity awards. Such ownership may create, or may create the appearance of, conflicts of interest when these directors, officers and other employees are faced with decisions that could have different implications for such entities than they do for us.\\nRisks Related to the Financial Markets\\nThe impact of legislative and regulatory changes on our business, as well as the market and industry in which we operate, are uncertain and may adversely affect our business.\\nThe Dodd-Frank Act was enacted in July 2010, which affects almost every aspect of the U.S. financial services industry, including certain aspects of the markets in which we operate, and imposes new regulations on us and how we conduct our business. As we describe in more detail below, it affects our business in many ways but it is difficult at this time to know exactly how or what the cumulative impact will be.\\nGenerally, the Dodd-Frank Act strengthens the regulatory oversight of securities and capital markets activities by the SEC and established the CFPB to enforce laws and regulations for consumer financial products and services. It requires market participants to undertake additional record-keeping activities and imposes many additional disclosure requirements for public companies.\\nMoreover, the Dodd-Frank Act contains a risk retention requirement for all asset-backed securities, which we issue. In October 2014, final rules were promulgated by a consortium of regulators implementing the final credit risk retention requirements of Section 941(b) of the Dodd-Frank Act. Under these “Risk Retention Rules,” sponsors of both public and private securitization transactions or one of their majority owned affiliates are required to retain at least 5% of the credit risk of the assets collateralizing such securitization transactions. These regulations generally prohibit the sponsor or its affiliate from directly or indirectly hedging or otherwise selling or transferring the retained interest for a specified period of time, depending on the type of asset that is securitized. Certain limited exemptions from these rules are available for certain types of assets, which may be of limited use under our current market practices. In any event, compliance with these new Risk Retention Rules has increased and will likely continue to increase the administrative and operational costs of asset securitization.\\nFurther, the Dodd-Frank Act imposes mandatory clearing and exchange-trading requirements on many derivatives transactions (including formerly unregulated over-the-counter derivatives) in which we may engage. In addition, the Dodd-Frank Act is expected to increase the margin requirements for derivatives transactions that are not subject to mandatory clearing requirements, which may impact our activities. The Dodd-Frank Act also creates new categories of regulated market participants, such as “swap-dealers,” “security-based swap dealers,” “major swap participants” and “major security-based swap participants,” and subjects or may subject these regulated entities to significant new capital, registration, recordkeeping, reporting, disclosure, business conduct and other regulatory requirements that will give rise to new administrative costs.\\n139\\nAlso, under the Dodd-Frank Act, financial regulators belonging to the Financial Stability Oversight Council are authorized to designate nonbank financial institutions and financial activities as systemically important to the economy and therefore subject to closer regulatory supervision. Such systemically important financial institutions, or “SIFIs,” may be required to operate with greater safety margins, such as higher levels of capital, and may face further limitations on their activities. The determination of what constitutes a SIFI is evolving, and in time SIFIs may include large investment funds and even asset managers. There can be no assurance that we will not be deemed to be a SIFI or engage in activities later determined to be systemically important and thus subject to further regulation.\\nEven new requirements that are not directly applicable to us may still increase our costs of entering into transactions with the parties to whom the requirements are directly applicable. For instance, if the exchange-trading and trade reporting requirements lead to reductions in the liquidity of derivative transactions we may experience higher pricing or reduced availability of derivatives, or the reduction of arbitrage opportunities for us, which could adversely affect the performance of certain of our trading strategies. Importantly, many key aspects of the changes imposed by the Dodd-Frank Act will continue to be established by various regulatory bodies and other groups over the next several years.\\nIn addition, there is significant uncertainty regarding the legislative and regulatory outlook for the Dodd-Frank Act and related statutes governing financial services, which may include Dodd-Frank Act amendments, mortgage finance and housing policy in the U.S., and the future structure and responsibilities of regulatory agencies such as the CFPB and the FHFA. For example, in March 2018, the U.S. Senate approved banking reform legislation intended to ease some of the restrictions imposed by the Dodd-Frank Act. Due to this uncertainty, it is not possible for us to predict how future legislative or regulatory proposals by Congress and the Administration will affect us or the market and industry in which we operate, and there can be no assurance that the resulting changes will not have an adverse impact on our business, results of operations, or financial condition. It is possible that such regulatory changes could, among other things, increase our costs of operating as a public company, impose restrictions on our ability to securitize assets and reduce our investment returns on securitized assets.\\nThe federal conservatorship of Fannie Mae and Freddie Mac and related efforts, along with any changes in laws and regulations affecting the relationship between these agencies and the U.S. government, may adversely affect our business.\\nThe payments we receive on the Agency RMBS in which we invest depend upon a steady stream of payments by borrowers on the underlying mortgages and the fulfillment of guarantees by GSEs. Ginnie Mae is part of a U.S. Government agency and its guarantees are backed by the full faith and credit of the U.S. Fannie Mae and Freddie Mac are GSEs, but their guarantees are not backed by the full faith and credit of the U.S. Government.\\nIn response to the deteriorating financial condition of Fannie Mae and Freddie Mac and the credit market disruption beginning in 2007, Congress and the U.S. Treasury undertook a series of actions to stabilize these GSEs and the financial markets, generally. The Housing and Economic Recovery Act of 2008 was signed into law on July 30, 2008, and established the FHFA, with enhanced regulatory authority over, among other things, the business activities of Fannie Mae and Freddie Mac and the size of their portfolio holdings. On September 7, 2008, FHFA placed Fannie Mae and Freddie Mac into federal conservatorship and, together with the U.S. Treasury, established a program designed to boost investor confidence in Fannie Mae’s and Freddie Mac’s debt and Agency RMBS.\\nAs the conservator of Fannie Mae and Freddie Mac, the FHFA controls and directs the operations of Fannie Mae and Freddie Mac and may (1) take over the assets of and operate Fannie Mae and Freddie Mac with all the powers of the stockholders, the directors and the officers of Fannie Mae and Freddie Mac and conduct all business of Fannie Mae and Freddie Mac; (2) collect all obligations and money due to Fannie Mae and Freddie Mac; (3) perform all functions of Fannie Mae and Freddie Mac which are consistent with the conservator’s appointment; (4) preserve and conserve the assets and property of Fannie Mae and Freddie Mac; and (5) contract for assistance in fulfilling any function, activity, action or duty of the conservator.\\nThose efforts resulted in significant U.S. Government financial support and increased control of the GSEs.\\nThe U.S. Federal Reserve (the “Fed”) announced in November 2008 a program of large-scale purchases of Agency RMBS in an attempt to lower longer-term interest rates and contribute to an overall easing of adverse financial conditions. Subject to specified investment guidelines, the portfolios of Agency RMBS purchased through the programs established by the U.S. Treasury and the Fed may be held to maturity and, based on mortgage market conditions, adjustments may be made to these portfolios. This flexibility may adversely affect the pricing and availability of Agency RMBS that we seek to acquire during the remaining term of these portfolios.\\n140\\nThere can be no assurance that the U.S. Government’s intervention in Fannie Mae and Freddie Mac will be adequate for the longer-term viability of these GSEs. These uncertainties lead to questions about the availability of and trading market for, Agency RMBS. Accordingly, if these government actions are inadequate and the GSEs defaulted on their guaranteed obligations, suffered losses or ceased to exist, the value of our Agency RMBS and our business, operations and financial condition could be materially and adversely affected.\\nAdditionally, because of the financial problems faced by Fannie Mae and Freddie Mac that led to their federal conservatorships, the Administration and Congress have been examining reform of the GSEs, including the value of a federal mortgage guarantee and the appropriate role for the U.S. government in providing liquidity for residential mortgage loans. The respective chairmen of the Congressional committees of jurisdiction, as well as the Secretary of the Treasury, has each stated that GSE reform, including a possible wind down of the GSEs, is a priority. However, the final details of any plans, policies or proposals with respect to the housing GSEs are unknown at this time. Other bills have been introduced that change the GSEs’ business charters and eliminate the entities or make other changes to the existing framework. We cannot predict whether or when such legislation may be enacted. If enacted, such legislation could materially and adversely affect the availability of, and trading market for, Agency RMBS and could, therefore, materially and adversely affect the value of our Agency RMBS and our business, operations and financial condition.\\nLegislation that permits modifications to the terms of outstanding loans may negatively affect our business, financial condition, liquidity and results of operations.\\nThe U.S. government has enacted legislation that enables government agencies to modify the terms of a significant number of residential and other loans to provide relief to borrowers without the applicable investor’s consent. These modifications allow for outstanding principal to be deferred, interest rates to be reduced, the term of the loan to be extended or other terms to be changed in ways that can permanently eliminate the cash flow (principal and interest) associated with a portion of the loan. These modifications are currently reducing, or in the future may reduce, the value of a number of our current or future investments, including investments in mortgage backed securities and interests in MSRs. As a result, such loan modifications are negatively affecting our business, results of operations, liquidity and financial condition. In addition, certain market participants propose reducing the amount of paperwork required by a borrower to modify a loan, which could increase the likelihood of fraudulent modifications and materially harm the U.S. mortgage market and investors that have exposure to this market. Additional legislation intended to provide relief to borrowers may be enacted and could further harm our business, results of operations and financial condition.\\nRisks Related to Our Taxation as a REIT\\nQualifying as a REIT involves highly technical and complex provisions of the Internal Revenue Code.\\nQualification as a REIT involves the application of highly technical and complex Internal Revenue Code provisions for which only limited judicial and administrative authorities exist. Even a technical or inadvertent violation could jeopardize our REIT qualification. Our qualification as a REIT will depend on our satisfaction of certain asset, income, organizational, distribution, stockholder ownership and other requirements on a continuing basis. Compliance with these requirements must be carefully monitored on a continuing basis. Monitoring and managing our REIT compliance has become challenging due to the increased size and complexity of the assets in our portfolio, a meaningful portion of which are not qualifying REIT assets. There can be no assurance that our Manager’s personnel responsible for doing so will be able to successfully monitor our compliance or maintain our REIT status.\\nOur failure to qualify as a REIT would result in higher taxes and reduced cash available for distribution to our stockholders.\\nWe intend to operate in a manner intended to qualify us as a REIT for U.S. federal income tax purposes. Our ability to satisfy the asset tests depends upon our analysis of the fair market values of our assets, some of which are not susceptible to a precise determination, and for which we do not obtain independent appraisals. See “—Risks Related to our Business—The valuations of our assets are subject to uncertainty because most of our assets are not traded in an active market,” and “—Risks Related to Our Business—Rapid changes in the values of our assets may make it more difficult for us to maintain our qualification as a REIT or our exclusion from the 1940 Act.” Our compliance with the REIT income and quarterly asset requirements also depends upon our ability to successfully manage the composition of our income and assets on an ongoing basis. Moreover, the proper classification of one or more of our investments (such as TBAs) may be uncertain in some circumstances, which could affect the application of the REIT qualification requirements. Accordingly, there can be no assurance that the U.S. Internal Revenue Service (“IRS”) will not contend that our investments violate the REIT requirements.\\nIf we were to fail to qualify as a REIT in any taxable year, we would be subject to U.S. federal income tax, including any applicable alternative minimum tax, on our taxable income at regular corporate rates, and distributions to stockholders would not be deductible\\n141\\nby us in computing our taxable income. Any such corporate tax liability could be substantial and would reduce the amount of cash available for distribution to our stockholders, which in turn could have an adverse impact on the value of, and market price for, our stock. See also “—Our failure to qualify as a REIT would cause our stock to be delisted from the NYSE.”\\nUnless entitled to relief under certain provisions of the Internal Revenue Code, we also would be disqualified from taxation as a REIT for the four taxable years following the year during which we initially ceased to qualify as a REIT. The rule against re-electing REIT status following a loss of such status would also apply to us if Drive Shack failed to qualify as a REIT for any taxable year ended on or before December 31, 2014, and we were treated as a successor to Drive Shack for U.S. federal income tax purposes. Although Drive Shack (i) represented in the separation and distribution agreement that it entered into with us on April 26, 2013 (the “Separation and Distribution Agreement”) that it has no knowledge of any fact or circumstance that would cause us to fail to qualify as a REIT and (ii) covenanted in the Separation and Distribution Agreement to use its reasonable best efforts to maintain its REIT status for each of Drive Shack’s taxable years ended on or before December 31, 2014 (unless Drive Shack obtains an opinion from a nationally recognized tax counsel or a private letter ruling from the IRS to the effect that Drive Shack’s failure to maintain its REIT status will not cause us to fail to qualify as a REIT under the successor REIT rule referred to above), no assurance can be given that such representation and covenant would prevent us from failing to qualify as a REIT. Although, in the event of a breach, we may be able to seek damages from Drive Shack, there can be no assurance that such damages, if any, would appropriately compensate us. In addition, if Drive Shack were to fail to qualify as a REIT despite its reasonable best efforts, we would have no claim against Drive Shack.\\nOur failure to qualify as a REIT would cause our stock to be delisted from the NYSE.\\nThe NYSE requires, as a condition to the listing of our shares, that we maintain our REIT status. Consequently, if we fail to maintain our REIT status, our shares would promptly be delisted from the NYSE, which would decrease the trading activity of such shares. This could make it difficult to sell shares and would likely cause the market volume of the shares trading to decline.\\nIf we were delisted as a result of losing our REIT status and desired to relist our shares on the NYSE, we would have to reapply to the NYSE to be listed as a domestic corporation. As the NYSE’s listing standards for REITs are less onerous than its standards for domestic corporations, it would be more difficult for us to become a listed company under these heightened standards. We might not be able to satisfy the NYSE’s listing standards for a domestic corporation. As a result, if we were delisted from the NYSE, we might not be able to relist as a domestic corporation, in which case our shares could not trade on the NYSE.\\nThe failure of assets subject to repurchase agreements to qualify as real estate assets could adversely affect our ability to qualify as a REIT.\\nWe enter into financing arrangements that are structured as sale and repurchase agreements pursuant to which we nominally sell certain of our assets to a counterparty and simultaneously enter into an agreement to repurchase these assets at a later date in exchange for a purchase price. Economically, these agreements are financings that are secured by the assets sold pursuant thereto. We believe that, for purposes of the REIT asset and income tests, we should be treated as the owner of the assets that are the subject of any such sale and repurchase agreement, notwithstanding that those agreements generally transfer record ownership of the assets to the counterparty during the term of the agreement. It is possible, however, that the IRS could assert that we did not own the assets during the term of the sale and repurchase agreement, in which case we might fail to qualify as a REIT.\\nThe failure of our Excess MSRs to qualify as real estate assets or the income from our Excess MSRs to qualify as mortgage interest could adversely affect our ability to qualify as a REIT.\\nWe have received from the IRS a private letter ruling substantially to the effect that our Excess MSRs represent interests in mortgages on real property and thus are qualifying “real estate assets” for purposes of the REIT asset test, which generate income that qualifies as interest on obligations secured by mortgages on real property for purposes of the REIT income test. The ruling is based on, among other things, certain assumptions as well as on the accuracy of certain factual representations and statements that we and Drive Shack have made to the IRS. If any of the representations or statements that we have made in connection with the private letter ruling, are, or become, inaccurate or incomplete in any material respect with respect to one or more Excess MSR investments, or if we acquire an Excess MSR investment with terms that are not consistent with the terms of the Excess MSR investments described in the private letter ruling, then we will not be able to rely on the private letter ruling. If we are unable to rely on the private letter ruling with respect to an Excess MSR investment, the IRS could assert that such Excess MSR investments do not qualify under the REIT asset and income tests, and if successful, we might fail to qualify as a REIT.\\n142\\nDividends payable by REITs do not qualify for the reduced tax rates available for some “qualified dividends.”\\nDividends payable to domestic stockholders that are individuals, trusts, and estates are generally taxed at reduced tax rates applicable to “qualified dividends.” Dividends payable by REITs, however, generally are not eligible for those reduced rates. The more favorable rates applicable to regular corporate dividends could cause investors who are individuals, trusts and estates to perceive investments in REITs to be relatively less attractive than investments in the stocks of non-REIT corporations that pay dividends, which could adversely affect the value of the stock of REITs, including our common stock. In addition, the relative attractiveness of real estate in general may be adversely affected by the favorable tax treatment given to non-REIT corporate dividends, which could affect the value of our real estate assets negatively.\\nREIT distribution requirements could adversely affect our liquidity and our ability to execute our business plan.\\nWe generally must distribute annually at least 90% of our REIT taxable income, excluding any net capital gain, in order for corporate income tax not to apply to earnings that we distribute. We intend to make distributions to our stockholders to comply with the REIT requirements of the Internal Revenue Code. However, differences in timing between the recognition of taxable income and the actual receipt of cash could require us to sell assets or borrow funds on a short-term or long-term basis to meet the 90% distribution requirement of the Internal Revenue Code. Certain of our assets, such as our investment in consumer loans, generate substantial mismatches between taxable income and available cash. As a result, the requirement to distribute a substantial portion of our net taxable income could cause us to: (i) sell assets in adverse market conditions; (ii) borrow on unfavorable terms; (iii) distribute amounts that would otherwise be invested in future acquisitions, capital expenditures or repayment of debt; or (iv) make taxable distributions of our capital stock or debt securities in order to comply with REIT requirements. Further, amounts distributed will not be available to fund investment activities. If we fail to obtain debt or equity capital in the future, it could limit our ability to satisfy our liquidity needs, which could adversely affect the value of our common stock.\\nWe may be required to report taxable income for certain investments in excess of the economic income we ultimately realize from them.\\nBased on IRS guidance concerning the classification of Excess MSRs, we intend to treat our Excess MSRs as ownership interests in the interest payments made on the underlying residential mortgage loans, akin to an “interest only” strip. Under this treatment, for purposes of determining the amount and timing of taxable income, each Excess MSR is treated as a bond that was issued with original issue discount on the date we acquired such Excess MSR. In general, we will be required to accrue original issue discount based on the constant yield to maturity of each Excess MSR, and to treat such original issue discount as taxable income in accordance with the applicable U.S. federal income tax rules. The constant yield of an Excess MSR will be determined, and we will be taxed, based on a prepayment assumption regarding future payments due on the residential mortgage loans underlying the Excess MSR. If the residential mortgage loans underlying an Excess MSR prepay at a rate different than that under the prepayment assumption, our recognition of original issue discount will be either increased or decreased depending on the circumstances. Thus, in a particular taxable year, we may be required to accrue an amount of income in respect of an Excess MSR that exceeds the amount of cash collected in respect of that Excess MSR. Furthermore, it is possible that, over the life of the investment in an Excess MSR, the total amount we pay for, and accrue with respect to, the Excess MSR may exceed the total amount we collect on such Excess MSR. No assurance can be given that we will be entitled to a deduction for such excess, meaning that we may be required to recognize “phantom income” over the life of an Excess MSR.\\nOther debt instruments that we may acquire, including consumer loans, may be issued with, or treated as issued with, original issue discount. Those instruments would be subject to the original issue discount accrual and income computations that are described above with regard to Excess MSRs.\\nUnder the Tax Cuts and Jobs Act (“TCJA”) enacted in late 2017, we generally will be required to take certain amounts into income no later than the time such amounts are reflected on certain financial statements. The application of this rule may require the accrual of, among other categories of income, income with respect to certain debt instruments or mortgage-backed securities, such as original issue discount, earlier than would be the case under the general tax rules, although the precise application of this rule is unclear at this time.\\nWe may acquire debt instruments in the secondary market for less than their face amount. The discount at which such debt instruments are acquired may reflect doubts about their ultimate collectability rather than current market interest rates. The amount of such discount will nevertheless generally be treated as “market discount” for U.S. federal income tax purposes. Accrued market discount is reported as income when, and to the extent that, any payment of principal of the debt instrument is made. If we collect less on the debt instrument than our purchase price plus the market discount we had previously reported as income, we may not be able to benefit from any offsetting loss deductions.\\n143\\nIn addition, we may acquire debt instruments that are subsequently modified by agreement with the borrower. If the amendments to the outstanding instrument are “significant modifications” under the applicable U.S. Treasury regulations, the modified instrument will be considered to have been reissued to us in a debt-for-debt exchange with the borrower. In that event, we may be required to recognize taxable gain to the extent the principal amount of the modified instrument exceeds our adjusted tax basis in the unmodified instrument, even if the value of the instrument or the payment expectations have not changed. Following such a taxable modification, we would hold the modified loan with a cost basis equal to its principal amount for U.S. federal tax purposes.\\nFinally, in the event that any debt instruments acquired by us are delinquent as to mandatory principal and interest payments, or in the event payments with respect to a particular instrument are not made when due, we may nonetheless be required to continue to recognize the unpaid interest as taxable income as it accrues, despite doubt as to its ultimate collectability. Similarly, we may be required to accrue interest income with respect to debt instruments at the stated rate regardless of whether corresponding cash payments are received or are ultimately collectible. In each case, while we would in general ultimately have an offsetting loss deduction available to us when such interest was determined to be uncollectible, the utility of that deduction could depend on our having taxable income of an appropriate character in that later year or thereafter.\\nIn any event, if our investments generate more taxable income than cash in any given year, we may have difficulty satisfying our annual REIT distribution requirement.\\nWe may be unable to generate sufficient cash from operations to pay our operating expenses and to pay distributions to our stockholders.\\nAs a REIT, we are generally required to distribute at least 90% of our REIT taxable income (determined without regard to the dividends paid deduction and not including net capital gains) each year to our stockholders. To qualify for the tax benefits accorded to REITs, we intend to make distributions to our stockholders in amounts such that we distribute all or substantially all of our net taxable income, subject to certain adjustments, although there can be no assurance that our operations will generate sufficient cash to make such distributions. Moreover, our ability to make distributions may be adversely affected by the risk factors described herein. See also “—Risks Related to our Stock—We have not established a minimum distribution payment level, and we cannot assure you of our ability to pay distributions in the future.”\\nThe stock ownership limit imposed by the Internal Revenue Code for REITs and our certificate of incorporation may inhibit market activity in our stock and restrict our business combination opportunities.\\nIn order for us to maintain our qualification as a REIT under the Internal Revenue Code, not more than 50% in value of our outstanding stock may be owned, directly or indirectly, by five or fewer individuals (as defined in the Internal Revenue Code to include certain entities) at any time during the last half of each taxable year after our first taxable year. Our certificate of incorporation, with certain exceptions, authorizes our board of directors to take the actions that are necessary and desirable to preserve our qualification as a REIT. Stockholders are generally restricted from owning more than 9.8% by value or number of shares, whichever is more restrictive, of our outstanding shares of common stock, or 9.8% by value or number of shares, whichever is more restrictive, of our outstanding shares of capital stock. Our board may grant an exemption in its sole discretion, subject to such conditions, representations and undertakings as it may determine in its sole discretion. These ownership limits could delay or prevent a transaction or a change in our control that might involve a premium price for our common stock or otherwise be in the best interest of our stockholders.\\nEven if we remain qualified as a REIT, we may face other tax liabilities that reduce our cash flow.\\nEven if we remain qualified for taxation as a REIT, we may be subject to certain federal, state and local taxes on our income and assets, including taxes on any undistributed income, tax on income from some activities conducted as a result of a foreclosure, and state or local income, property and transfer taxes. Moreover, if a REIT distributes less than 85% of its ordinary income and 95% of its capital gain net income plus any undistributed shortfall from the prior year (the “Required Distribution”) to its stockholders during any calendar year (including any distributions declared by the last day of the calendar year but paid in the subsequent year), then it is required to pay an excise tax on 4% of any shortfall between the Required Distribution and the amount that was actually distributed. Any of these taxes would decrease cash available for distribution to our stockholders. In addition, in order to meet the REIT qualification requirements, or to avert the imposition of a 100% tax that applies to certain gains derived by a REIT from dealer property or inventory, we may hold some of our assets through TRSs. Such subsidiaries generally will be subject to corporate level income tax at regular rates and the payment of such taxes would reduce our return on the applicable investment. Currently, we hold some of our investments in TRSs, including Servicer Advance Investments and MSRs, and we may contribute other non-qualifying investments, such as our investment in consumer loans, to a TRS in the future.\\n144\\nComplying with the REIT requirements may negatively impact our investment returns or cause us to forgo otherwise attractive opportunities, liquidate assets or contribute assets to a TRS.\\nTo qualify as a REIT for U.S. federal income tax purposes, we must continually satisfy tests concerning, among other things, the sources of our income, the nature and diversification of our assets, the amounts we distribute to our stockholders and the ownership of our stock. As a result of these tests, we may be required to make distributions to stockholders at disadvantageous times or when we do not have funds readily available for distribution, forgo otherwise attractive investment opportunities, liquidate assets in adverse market conditions or contribute assets to a TRS that is subject to regular corporate federal income tax. Our ability to acquire and hold MSRs, interests in consumer loans, Servicer Advance Investments and other investments is subject to the applicable REIT qualification tests, and we may have to hold these interests through TRSs, which would negatively impact our returns from these assets. In general, compliance with the REIT requirements may hinder our ability to make and retain certain attractive investments.\\nComplying with the REIT requirements may limit our ability to hedge effectively.\\nThe existing REIT provisions of the Internal Revenue Code may substantially limit our ability to hedge our operations because a significant amount of the income from those hedging transactions is likely to be treated as non-qualifying income for purposes of both REIT gross income tests. In addition, we must limit our aggregate income from non-qualified hedging transactions, from our provision of services and from other non-qualifying sources, to less than 5% of our annual gross income (determined without regard to gross income from qualified hedging transactions).\\nAs a result, we may have to limit our use of certain hedging techniques or implement those hedges through TRSs. This could result in greater risks associated with changes in interest rates than we would otherwise want to incur or could increase the cost of our hedging activities. If we fail to comply with these limitations, we could lose our REIT qualification for U.S. federal income tax purposes, unless our failure was due to reasonable cause, and not due to willful neglect, and we meet certain other technical requirements. Even if our failure were due to reasonable cause, we might incur a penalty tax. See also “—Risks Related to Our Business—Any hedging transactions that we enter into may limit our gains or result in losses.”\\nDistributions to tax-exempt investors may be classified as unrelated business taxable income.\\nNeither ordinary nor capital gain distributions with respect to our stock nor gain from the sale of stock should generally constitute unrelated business taxable income to a tax-exempt investor. However, there are certain exceptions to this rule. In particular:\\n\\n| • | part of the income and gain recognized by certain qualified employee pension trusts with respect to our stock may be treated as unrelated business taxable income if shares of our stock are predominantly held by qualified employee pension trusts, and we are required to rely on a special look-through rule for purposes of meeting one of the REIT ownership tests, and we are not operated in a manner to avoid treatment of such income or gain as unrelated business taxable income; |\\n\\n| • | part of the income and gain recognized by a tax-exempt investor with respect to our stock would constitute unrelated business taxable income if the investor incurs debt in order to acquire the stock; and |\\n\\n| • | to the extent that we are (or a part of us, or a disregarded subsidiary of ours, is) a “taxable mortgage pool,” or if we hold residual interests in a real estate mortgage investment conduit (“REMIC”), a portion of the distributions paid to a tax exempt stockholder that is allocable to excess inclusion income may be treated as unrelated business taxable income. |\\n\\nThe “taxable mortgage pool” rules may increase the taxes that we or our stockholders may incur, and may limit the manner in which we effect future securitizations.\\nWe may enter into securitization or other financing transactions that result in the creation of taxable mortgage pools for U.S. federal income tax purposes. As a REIT, so long as we own 100% of the equity interests in a taxable mortgage pool, we would generally not be adversely affected by the characterization of a securitization as a taxable mortgage pool. Certain categories of stockholders, however, such as foreign stockholders eligible for treaty or other benefits, stockholders with net operating losses, and certain tax exempt stockholders that are subject to unrelated business income tax, could be subject to increased taxes on a portion of their dividend income from us that is attributable to the taxable mortgage pool. In addition, to the extent that our stock is owned by tax exempt “disqualified organizations,” such as certain government-related entities and charitable remainder trusts that are not subject to tax on unrelated business income, we could incur a corporate level tax on a portion of our income from the taxable mortgage pool. In that case, we might reduce the amount of our distributions to any disqualified organization whose stock ownership gave rise to the tax. Moreover, we may be precluded from selling equity interests in these securitizations to outside investors, or selling any debt securities issued in connection with these securitizations that might be considered to be equity interests for tax purposes. These limitations may prevent us from using certain techniques to maximize our returns from securitization transactions.\\n145\\nUncertainty exists with respect to the treatment of TBAs for purposes of the REIT asset and income tests, and the failure of TBAs to be qualifying assets or of income/gains from TBAs to be qualifying income could adversely affect our ability to qualify as a REIT.\\nWe purchase and sell Agency RMBS through TBAs and recognize income or gains from the disposition of those TBAs, through dollar roll transactions or otherwise. In a dollar roll transaction, we exchange an existing TBA for another TBA with a different settlement date. There is no direct authority with respect to the qualification of TBAs as real estate assets or U.S. Government securities for purposes of the 75% asset test or the qualification of income or gains from dispositions of TBAs as gains from the sale of real property (including interests in real property and interests in mortgages on real property) or other qualifying income for purposes of the 75% gross income test. For a particular taxable year, we would treat such TBAs as qualifying assets for purposes of the REIT asset tests, and income and gains from such TBAs as qualifying income for purposes of the 75% gross income test, to the extent set forth in an opinion from Skadden, Arps, Slate, Meagher & Flom LLP substantially to the effect that (i) for purposes of the REIT asset tests, our ownership of a TBA should be treated as ownership of the underlying Agency RMBS, and (ii) for purposes of the 75% REIT gross income test, any gain recognized by us in connection with the settlement of such TBAs should be treated as gain from the sale or disposition of the underlying Agency RMBS. Opinions of counsel are not binding on the IRS, and no assurance can be given that the IRS would not successfully challenge the conclusions set forth in such opinions. In addition, it must be emphasized that any opinion of Skadden, Arps, Slate, Meagher & Flom LLP would be based on various assumptions relating to any TBAs that we enter into and would be conditioned upon fact-based representations and covenants made by our management regarding such TBAs. No assurance can be given that the IRS would not assert that such assets or income are not qualifying assets or income. If the IRS were to successfully challenge any conclusions of Skadden, Arps, Slate, Meagher & Flom LLP, we could be subject to a penalty tax or we could fail to qualify as a REIT if a sufficient portion of our assets consists of TBAs or a sufficient portion of our income consists of income or gains from the disposition of TBAs.\\nThe tax on prohibited transactions will limit our ability to engage in transactions that would be treated as prohibited transactions for U.S. federal income tax purposes.\\nNet income that we derive from a “prohibited transaction” is subject to a 100% tax. The term “prohibited transaction” generally includes a sale or other disposition of property (including mortgage loans, but other than foreclosure property, as discussed below) that is held primarily for sale to customers in the ordinary course of our trade or business. We might be subject to this tax if we were to dispose of or securitize loans or Excess MSRs in a manner that was treated as a prohibited transaction for U.S. federal income tax purposes.\\nWe intend to conduct our operations so that no asset that we own (or are treated as owning) will be treated as, or as having been, held-for-sale to customers, and that a sale of any such asset will not be treated as having been in the ordinary course of our business. As a result, we may choose not to engage in certain sales of loans or Excess MSRs at the REIT level, and may limit the structures we utilize for our securitization transactions, even though the sales or structures might otherwise be beneficial to us. In addition, whether property is held “primarily for sale to customers in the ordinary course of a trade or business” depends on the particular facts and circumstances. No assurance can be given that any property that we sell will not be treated as property held-for-sale to customers, or that we can comply with certain safe-harbor provisions of the Internal Revenue Code that would prevent such treatment. The 100% prohibited transaction tax does not apply to gains from the sale of property that is held through a TRS or other taxable corporation, although such income will be subject to tax in the hands of the corporation at regular corporate rates. We intend to structure our activities to prevent prohibited transaction characterization.\\nLiquidation of assets may jeopardize our REIT qualification or create additional tax liability for us.\\nTo qualify as a REIT, we must comply with requirements regarding the composition of our assets and our sources of income. If we are compelled to liquidate our investments to repay obligations to our lenders, we may be unable to comply with these requirements, ultimately jeopardizing our qualification as a REIT, or we may be subject to a 100% tax on any resultant gain if we sell assets that are treated as dealer property or inventory.\\nChanges to U.S. federal income tax laws could materially and adversely affect us and our stockholders.\\nThe present U.S. federal income tax treatment of REITs and their shareholders may be modified, possibly with retroactive effect, by legislative, judicial or administrative action at any time, which could affect the U.S. federal income tax treatment of an investment in our shares. The U.S. federal income tax rules, including those dealing with REITs, are constantly under review by persons involved in the legislative process, the IRS and the U.S. Treasury Department, which results in statutory changes as well as frequent revisions to regulations and interpretations.\\n146\\nThe TCJA, which was enacted in 2017, made substantial changes to the Internal Revenue Code. Among those changes are a significant permanent reduction in the generally applicable corporate tax rate, changes in the taxation of individuals and other non-corporate taxpayers that generally but not universally reduce their taxes on a temporary basis subject to “sunset” provisions, the elimination or modification of various currently allowed deductions (including substantial limitations on the deductibility of interest and, in the case of individuals, the deduction for personal state and local taxes), certain additional limitations on the deduction of net operating losses, and preferential rates of taxation on most ordinary REIT dividends and certain business income derived by non-corporate taxpayers in comparison to other ordinary income recognized by such taxpayers. The effect of these, and the many other, changes made in the TCJA remains uncertain, both in terms of their direct effect on the taxation of an investment in our common stock and their indirect effect on the value of our assets or market conditions generally. Furthermore, many of the provisions of the TCJA still require guidance through the issuance of Treasury regulations in order to assess their effect. There may be a substantial delay before such regulations are promulgated, increasing the uncertainty as to the ultimate effect of the statutory amendments on us. There also may be technical corrections legislation proposed with respect to the TCJA, the effect of which cannot be predicted and may be adverse to us or our stockholders.\\nRisks Related to our Stock\\nThere can be no assurance that the market for our stock will provide you with adequate liquidity.\\nOur common stock began trading on the NYSE in May 2013, and our preferred stock began trading on the NYSE in July 2019. There can be no assurance that an active trading market for our common and preferred stock will be sustained in the future, and the market price of our common and preferred stock may fluctuate widely, depending upon many factors, some of which may be beyond our control. These factors include, without limitation:\\n\\n| • | a shift in our investor base; |\\n\\n| • | our quarterly or annual earnings and cash flows, or those of other comparable companies; |\\n\\n| • | actual or anticipated fluctuations in our operating results; |\\n\\n| • | changes in accounting standards, policies, guidance, interpretations or principles; |\\n\\n| • | announcements by us or our competitors of significant investments, acquisitions or dispositions; |\\n\\n| • | the failure of securities analysts to cover our common stock; |\\n\\n| • | changes in earnings estimates by securities analysts or our ability to meet those estimates; |\\n\\n| • | market performance of affiliates and other counterparties with whom we conduct business; |\\n\\n| • | the operating and stock price performance of other comparable companies; |\\n\\n| • | our failure to qualify as a REIT, maintain our exemption under the 1940 Act or satisfy the NYSE listing requirements; |\\n\\n| • | negative public perception of us, our competitors or industry; |\\n\\n| • | overall market fluctuations; and |\\n\\n| • | general economic conditions. |\\n\\nStock markets in general have experienced volatility that has often been unrelated to the operating performance of a particular company. These broad market fluctuations may adversely affect the market price of our common and preferred stock.\\nSales or issuances of shares of our common stock could adversely affect the market price of our common stock.\\nSales or issuances of substantial amounts of shares of our common stock, or the perception that such sales or issuances might occur, could adversely affect the market price of our common stock. The issuance of our common stock in connection with property, portfolio or business acquisitions or the exercise of outstanding options or otherwise could also have an adverse effect on the market price of our common stock. We have an effective registration statement on file to sell common stock or convertible securities in public offerings.\\nFailure to maintain effective internal control over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act of 2002 could have a material adverse effect on our business and stock price.\\nAs a public company, we are required to maintain effective internal control over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act of 2002. Internal control over financial reporting is complex and may be revised over time to adapt to changes in our business, or changes in applicable accounting rules. We have made investments through joint ventures, such as our investment in consumer loans, and accounting for such investments can increase the complexity of maintaining effective internal control over financial reporting. We cannot assure you that our internal control over financial reporting will be effective in the future or that a material weakness will not be discovered with respect to a prior period for which we had previously believed that our internal control over financial reporting was effective. If we are not able to maintain or document effective internal control over financial reporting, our independent registered public accounting firm will not be able to certify as to the effectiveness of our\\n147\\ninternal control over financial reporting. Matters impacting our internal control over financial reporting may cause us to be unable to report our financial information on a timely basis, or may cause us to restate previously issued financial information, and thereby subject us to adverse regulatory consequences, including sanctions or investigations by the SEC, or violations of applicable stock exchange listing rules. There could also be a negative reaction in the financial markets due to a loss of investor confidence in us and the reliability of our financial statements. Confidence in the reliability of our financial statements is also likely to suffer if we or our independent registered public accounting firm reports a material weakness in the effectiveness of our internal control over financial reporting. This could materially adversely affect us by, for example, leading to a decline in our stock price and impairing our ability to raise capital.\\nYour percentage ownership in us may be diluted in the future.\\nYour percentage ownership in us may be diluted in the future because of equity awards that we expect will be granted to our Manager, to the directors, officers and employees of our Manager who perform services for us, and to our directors, officers and employees, as well as other equity instruments such as debt and equity financing. We have adopted a Nonqualified Stock Option and Incentive Award Plan, as amended (the “Plan”), which provides for the grant of equity-based awards, including restricted stock, options, stock appreciation rights, performance awards, tandem awards and other equity-based and non-equity based awards, in each case to our Manager, to the directors, officers, employees, service providers, consultants and advisor of our Manager who perform services for us, and to our directors, officers, employees, service providers, consultants and advisors. We reserved 15 million shares of our common stock for issuance under the Plan. The term of the Plan expires in 2023. On the first day of each fiscal year beginning during the term of the Plan, that number will be increased by a number of shares of our common stock equal to 10% of the number of shares of our common stock newly issued by us during the immediately preceding fiscal year. In connection with any offering of our common or preferred stock, we will issue to our Manager options relating to shares of our common stock, representing 10% of the number of shares being offered. Our board of directors may also determine to issue options to the Manager that are not subject to the Plan, provided that the number of shares relating to any options granted to the Manager in connection with an offering of our common stock would not exceed 10% of the shares sold in such offering and would be subject to NYSE rules.\\nWe may incur or issue debt or issue equity, which may negatively affect the market price of our common stock.\\nWe may in the future incur or issue debt or issue equity or equity-related securities. In the event of our liquidation, lenders and holders of our debt and holders of our preferred stock (if any) would receive a distribution of our available assets before common stockholders. Any future incurrence or issuance of debt would increase our interest cost and could adversely affect our results of operations and cash flows. We are not required to offer any additional equity securities to existing common stockholders on a preemptive basis. Therefore, additional issuances of common stock, directly or through convertible or exchangeable securities, warrants or options, will dilute the holdings of our existing common stockholders and such issuances, or the perception of such issuances, may reduce the market price of our common stock. Our preferred stock has, and any additional preferred stock issued by us would likely have, a preference on distribution payments, periodically or upon liquidation, which could eliminate or otherwise limit our ability to make distributions to common stockholders. Because our decision to incur or issue debt or issue equity or equity-related securities in the future will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing, nature or success of our future capital raising efforts. Thus, common stockholders bear the risk that our future incurrence or issuance of debt or issuance of equity or equity-related securities will adversely affect the market price of our common stock.\\nWe have not established a minimum distribution payment level for our common stock, and we cannot assure you of our ability to pay distributions in the future.\\nWe intend to make quarterly distributions of our REIT taxable income to holders of our common stock out of assets legally available therefor. We have not established a minimum distribution payment level and our ability to pay distributions may be adversely affected by a number of factors, including the risk factors described in this report. Any distributions will be authorized by our board of directors and declared by us based upon a number of factors, including our actual and anticipated results of operations, liquidity and financial condition, restrictions under Delaware law or applicable financing covenants, our REIT taxable income, the annual distribution requirements under the REIT provisions of the Internal Revenue Code, our operating expenses and other factors our directors deem relevant.\\nOur board of directors approved two increases in our quarterly dividends during 2017, which has resulted in reduced cash flows and we will begin making distributions on our preferred stock issued in July 2019, beginning in November 2019, which will further reduce our cash flows. Although we have other sources of liquidity, such as sales of and repayments from our investments, potential debt financing sources and the issuance of equity securities, there can be no assurance that we will generate sufficient cash or\\n148\\nachieve investment results that will allow us to make a specified level of cash distributions or year-to-year increases in cash distributions in the future.\\nFurthermore, while we are required to make distributions in order to maintain our REIT status (as described above under “—Risks Related to our Taxation as a REIT—We may be unable to generate sufficient cash from operations to pay our operating expenses and to pay distributions to our stockholders”), we may elect not to maintain our REIT status, in which case we would no longer be required to make such distributions. Moreover, even if we do elect to maintain our REIT status, we may elect to comply with the applicable requirements by, after completing various procedural steps, distributing, under certain circumstances, a portion of the required amount in the form of shares of our common stock in lieu of cash. If we elect not to maintain our REIT status or to satisfy any required distributions in shares of common stock in lieu of cash, such action could negatively and materially affect our business, results of operations, liquidity and financial condition as well as the market price of our common stock. No assurance can be given that we will make any distributions on shares of our common stock in the future.\\nWe may in the future choose to make distributions in our own stock, in which case you could be required to pay income taxes in excess of any cash distributions you receive.\\nWe may in the future make taxable distributions that are payable in cash and shares of our common stock at the election of each stockholder. Taxable stockholders receiving such distributions will be required to include the full amount of the distribution as ordinary income to the extent of our current and accumulated earnings and profits for federal income tax purposes. As a result, stockholders may be required to pay income taxes with respect to such distributions in excess of the cash distributions received. If a U.S. stockholder sells the stock that it receives as a distribution in order to pay this tax, the sale proceeds may be less than the amount included in income with respect to the distribution, depending on the market price of our stock at the time of the sale. Furthermore, with respect to certain non-U.S. stockholders, we may be required to withhold U.S. tax with respect to such distributions, including in respect of all or a portion of such distribution that is payable in stock. In addition, if a significant number of our stockholders determine to sell shares of our common stock in order to pay taxes owed on distributions, it may put downward pressure on the market price of our common stock.\\nIn August 2017, the IRS issued guidance authorizing elective cash/stock dividends to be made by public REITs where there is a minimum (of at least 20%) amount of cash that may be paid as part of the dividend, provided that certain requirements are met. It is unclear whether and to what extent we would be able to or choose to pay taxable distributions in cash and stock. In addition, no assurance can be given that the IRS will not impose additional requirements in the future with respect to taxable cash/stock distributions, including on a retroactive basis, or assert that the requirements for such taxable cash/stock distributions have not been met.\\nAn increase in market interest rates may have an adverse effect on the market price of our common stock.\\nOne of the factors that investors may consider in deciding whether to buy or sell shares of our common stock is our distribution rate as a percentage of our stock price relative to market interest rates. If the market price of our common stock is based primarily on the earnings and return that we derive from our investments and income with respect to our investments and our related distributions to stockholders, and not from the market value of the investments themselves, then interest rate fluctuations and capital market conditions will likely affect the market price of our common stock. For instance, if market interest rates rise without an increase in our distribution rate, the market price of our common stock could decrease, as potential investors may require a higher distribution yield on our common stock or seek other securities paying higher distributions or interest. In addition, rising interest rates would result in increased interest expense on our outstanding and future (variable and fixed) rate debt, thereby adversely affecting cash flow and our ability to service our indebtedness and pay distributions.\\nProvisions in our certificate of incorporation and bylaws and of Delaware law may prevent or delay an acquisition of our company, which could decrease the market price of our common stock.\\nOur certificate of incorporation, bylaws and Delaware law contain provisions that are intended to deter coercive takeover practices and inadequate takeover bids by making such practices or bids unacceptably expensive to the raider and to encourage prospective acquirers to negotiate with our board of directors rather than to attempt a hostile takeover. These provisions include, among others:\\n\\n| • | a classified board of directors with staggered three-year terms; |\\n\\n| • | provisions regarding the election of directors, classes of directors, the term of office of directors, the filling of director vacancies and the resignation and removal of directors for cause only upon the affirmative vote of at least 80% of the then issued and outstanding shares of our capital stock entitled to vote thereon; |\\n\\n| • | provisions regarding corporate opportunity only upon the affirmative vote of at least 80% of the then issued and outstanding shares of our capital stock entitled to vote thereon; |\\n\\n149\\n| • | removal of directors only for cause and only with the affirmative vote of at least 80% of the then issued and outstanding shares of our capital stock entitled to vote in the election of directors; |\\n\\n| • | our board of directors to determine the powers, preferences and rights of our preferred stock and to issue such preferred stock without stockholder approval; |\\n\\n| • | advance notice requirements applicable to stockholders for director nominations and actions to be taken at annual meetings; |\\n\\n| • | a prohibition, in our certificate of incorporation, stating that no holder of shares of our common stock will have cumulative voting rights in the election of directors, which means that the holders of a majority of the issued and outstanding shares of common stock can elect all the directors standing for election; and |\\n\\n| • | a requirement in our bylaws specifically denying the ability of our stockholders to consent in writing to take any action in lieu of taking such action at a duly called annual or special meeting of our stockholders. |\\n\\nPublic stockholders who might desire to participate in these types of transactions may not have an opportunity to do so, even if the transaction is considered favorable to stockholders. These anti-takeover provisions could substantially impede the ability of public stockholders to benefit from a change in control or a change in our management and board of directors and, as a result, may adversely affect the market price of our common stock and your ability to realize any potential change of control premium.\\nERISA may restrict investments by plans in our common stock.\\nA plan fiduciary considering an investment in our common stock should consider, among other things, whether such an investment is consistent with the fiduciary obligations under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), including whether such investment might constitute or give rise to a prohibited transaction under ERISA, the Internal Revenue Code or any substantially similar federal, state or local law and, if so, whether an exemption from such prohibited transaction rules is available.\\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\\nNone.\\nITEM 3. DEFAULTS UPON SENIOR SECURITIES\\nNone.\\n\\nITEM 4. MINE SAFETY DISCLOSURES\\nNot Applicable.\\n\\nITEM 5. OTHER INFORMATION\\nMr. David Schneider, the Chief Accounting Officer of the Company, has resigned as an officer of the Company effective as of October 31, 2019. The board of directors of the Company has appointed Mr. Nicola Santoro, Jr. as Chief Accounting Officer effective as of October 31, 2019. Mr. Santoro has been actively involved with New Residential since 2015 and is also the Company’s Chief Financial Officer and Treasurer.\\n150\\nITEM 6. EXHIBITS\\n| Exhibit Number | Exhibit Description |\\n| 2.1† | Separation and Distribution Agreement, dated as of April 26, 2013, by and between New Residential Investment Corp. and Newcastle Investment Corp. (incorporated by reference to Exhibit 2.1 to Amendment No. 6 of New Residential Investment Corp.’s Registration Statement on Form 10, filed April 29, 2013) |\\n| 2.2† | Purchase Agreement, dated as of March 5, 2013, by and among the Sellers listed therein, HSBC Finance Corporation and SpringCastle Acquisition LLC (incorporated by reference to Exhibit 99.1 to Drive Shack Inc.’s Current Report on Form 8-K, filed March 11, 2013) |\\n| 2.3† | Master Servicing Rights Purchase Agreement, dated as of December 17, 2013, by and between Nationstar Mortgage LLC and Advance Purchaser LLC (incorporated by reference to Exhibit 2.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed December 23, 2013) |\\n| 2.4† | Sale Supplement (Shuttle 1), dated as of December 17, 2013, by and between Nationstar Mortgage LLC and Advance Purchaser LLC (incorporated by reference to Exhibit 2.2 to New Residential Investment Corp.’s Current Report on Form 8-K, filed December 23, 2013) |\\n| 2.5† | Sale Supplement (Shuttle 2), dated as of December 17, 2013, by and between Nationstar Mortgage LLC and Advance Purchaser LLC (incorporated by reference to Exhibit 2.3 to New Residential Investment Corp.’s Current Report on Form 8-K, filed December 23, 2013) |\\n| 2.6† | Sale Supplement (First Tennessee), dated as of December 17, 2013, by and between Nationstar Mortgage LLC and Advance Purchaser LLC (incorporated by reference to Exhibit 2.4 to New Residential Investment Corp.’s Current Report on Form 8-K, filed December 23, 2013) |\\n| 2.7† | Purchase Agreement, dated as of March 31, 2016, by and among SpringCastle Holdings, LLC, Springleaf Acquisition Corporation, Springleaf Finance, Inc., NRZ Consumer LLC, NRZ SC America LLC, NRZ SC Credit Limited, NRZ SC Finance I LLC, NRZ SC Finance II LLC, NRZ SC Finance III LLC, NRZ SC Finance IV LLC, NRZ SC Finance V LLC, BTO Willow Holdings II, L.P. and Blackstone Family Tactical Opportunities Investment Partnership - NQ - ESC L.P., and solely with respect to Section 11(a) and Section 11(g), NRZ SC America Trust 2015-1, NRZ SC Credit Trust 2015-1, NRZ SC Finance Trust 2015-1, and BTO Willow Holdings, L.P. (incorporated by reference to Exhibit 2.10 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2016, filed on May 4, 2016) |\\n| 2.8† | Securities Purchase Agreement, dated as of November 29, 2017, by and among NRM Acquisition LLC, Shellpoint Partners LLC, the Sellers party thereto and Shellpoint Services LLC, as original representative of the Seller (incorporated by reference to Exhibit 2.8 to New Residential Investment Corp.’s Annual Report on Form 10-K for the year ended December 31, 2017, filed on February 15, 2018) |\\n| 2.9† | Amendment No. 1 to the Securities Purchase Agreement, dated as of July 3, 2018, by and among NRM Acquisition LLC, Shellpoint Partners LLC, the Sellers party thereto and Shellpoint Representative LLC, as replacement representative of the Sellers (incorporated by reference to Exhibit 2.9 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2018) |\\n| 2.10 | Asset Purchase Agreement among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company, dated June 17, 2019 (incorporated by reference to Exhibit 2.10 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2019) |\\n| 2.11 | Amendment No. 1 to the Asset Purchase Agreement, dated as of July 9, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\\n| 2.12 | Amendment No. 2 to the Asset Purchase Agreement, dated as of August 30, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\\n| 2.13 | Amendment No. 3 to the Asset Purchase Agreement, dated as of September 4, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\\n| 2.14 | Amendment No. 4 to the Asset Purchase Agreement, dated as of September 5, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\\n| 2.15 | Amendment No. 5 to the Asset Purchase Agreement, dated as of September 6, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\\n\\n151\\n| Exhibit Number | Exhibit Description |\\n| 2.16 | Amendment No. 6 to the Asset Purchase Agreement, dated as of September 9, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\\n| 2.17 | Amendment No. 7 to the Asset Purchase Agreement, dated as of September 17, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\\n| 2.18 | Amendment No. 8 to the Asset Purchase Agreement, dated as of September 30, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\\n| 3.1 | Amended and Restated Certificate of Incorporation of New Residential Investment Corp. (incorporated by reference to Exhibit 3.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed May 3, 2013) |\\n| 3.2 | Amended and Restated Bylaws of New Residential Investment Corp. (incorporated by reference to Exhibit 3.2 to New Residential Investment Corp.’s Current Report on Form 8-K, filed May 3, 2013) |\\n| 3.3 | Certificate of Amendment to the Amended and Restated Certificate of Incorporation of New Residential Investment Corp. (incorporated by reference to Exhibit 3.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed October 17, 2014) |\\n| 3.4 | Certificate of Designations of New Residential Investment Corp., designating the Company’s 7.50% Series A Fixed-to-Floating Rate Cumulative Redeemable Preferred Stock, par value $0.01 per share (incorporated by reference to Exhibit 3.4 to New Residential Investment Corp.’s Form 8-A, filed July 2, 2019) |\\n| 3.5 | Certificate of Designations of New Residential Investment Corp., designating the Company’s 7.125% Series B Fixed-to-Floating Rate Cumulative Redeemable Preferred Stock, par value $0.01 per share (incorporated by reference to Exhibit 3.5 to New Residential Investment Corp.’s Form 8-A, filed August 15, 2019) |\\n| 4.1 | Specimen Series A Preferred Stock Certificate (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Form 8-A filed July 2, 2019) |\\n| 4.2 | Specimen Series B Preferred Stock Certificate of New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Form 8-A, filed August 15, 2019) |\\n| 4.3 | Second Amended and Restated Indenture, dated as of September 7, 2018, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, New Residential Mortgage LLC, New Penn Financial, LLC, d/b/a Shellpoint Mortgage Servicing and Credit Suisse AG, New York Branch (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed September 7, 2018) |\\n| 4.4 | Omnibus Amendment to Term Note Indenture Supplements, dated as of August 17, 2017, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, New Residential Mortgage LLC, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.2 to New Residential Investment Corp.’s Current Report on Form 8-K, filed August 22, 2017) |\\n| 4.5 | Series 2016-T2 Indenture Supplement, dated as of October 25, 2016, to the Indenture, dated as of August 28, 2015, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed October 31, 2016) |\\n| 4.6 | Series 2016-T3 Indenture Supplement, dated as of October 25, 2016, to the Indenture, dated as of August 28, 2015, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.2 to New Residential Investment Corp.’s Current Report on Form 8-K, filed October 31, 2016) |\\n| 4.7 | Series 2016-T4 Indenture Supplement, dated as of December 15, 2016, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed December 16, 2016) |\\n\\n152\\n| Exhibit Number | Exhibit Description |\\n| 4.8 | Series 2016-T5 Indenture Supplement, dated as of December 15, 2016, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.2 to New Residential Investment Corp.’s Current Report on Form 8-K, filed December 16, 2016) |\\n| 4.9 | Series 2017-T1 Indenture Supplement, dated as of February 7, 2017, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Current Report on Form 8-K filed February 7, 2017) |\\n| 4.10 | Series 2018-VF1 Indenture Supplement, dated as of March 22, 2018, to the Amended and Restated Indenture, dated as of August 17, 2017, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, New Residential Mortgage LLC, JPMorgan Chase Bank, N.A. and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.'s Current Report on Form 8-K, filed March 28, 2018) |\\n| 4.11 | Omnibus Amendment to Certain Agreements Relating to the NRZ Advance Receivables Trust 2015-ON1, dated as of September 7, 2018, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, New Residential Mortgage LLC, Credit Suisse AG, New York Branch, New Penn Financial, LLC, d/b/a Shellpoint Mortgage Servicing and New Residential Investment Corp. (incorporated by reference to Exhibit 4.2 to New Residential Investment Corp.’s Current Report on Form 8-K, filed September 7, 2018) |\\n| 4.12 | Amendment No. 1 to Series 2018-VF1 Indenture Supplement, dated as of September 7, 2018, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, New Residential Mortgage LLC, New Penn Financial, LLC, d/b/a Shellpoint Mortgage Servicing, JPMorgan Chase Bank, N.A. and New Residential Investment Corp. (incorporated by reference to Exhibit 4.3 to New Residential Investment Corp.’s Current Report on Form 8-K, filed September 7, 2018) |\\n| 4.13 | Amendment No. 2 to Series 2018-VF1 Indenture Supplement, dated as of September 28, 2018, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, New Residential Mortgage LLC, New Penn Financial, LLC, d/b/a Shellpoint Mortgage Servicing, JPMorgan Chase Bank, N.A. and New Residential Investment Corp. (incorporated by reference to Exhibit 4.11 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q, filed May 2, 2019) |\\n| 4.14 | Amendment No. 3 to Series 2018-VF1 Indenture Supplement, dated as of March 11, 2019, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, New Residential Mortgage LLC, NewRez LLC d/b/a Shellpoint Mortgage Servicing, JPMorgan Chase Bank, N.A. and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed March 15, 2019) |\\n| 4.15 | Third Amended and Restated Indenture, dated as of July 25, 2019, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, PHH Mortgage Corporation, HLSS Holdings, LLC, New Residential Mortgage LLC, NewRez LLC, d/b/a Shellpoint Mortgage Servicing and Credit Suisse AG, New York Branch (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Form 8-K, filed July 26, 2019) |\\n| 4.16 | Series 2019-T1 Indenture Supplement, dated as of July 25, 2019, to the Third Amended and Restated Indenture, dated as of July 25, 2019, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, PHH Mortgage Corporation, HLSS Holdings, LLC, New Residential Mortgage LLC, NewRez LLC d/b/a Shellpoint Mortgage Servicing, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.2 to New Residential Investment Corp.’s Form 8-K, filed July 26, 2019) |\\n| 4.17 | Series 2019-T2 Indenture Supplement, dated as of August 15, 2019, to the Third Amended and Restated Indenture, dated as of July 25, 2019, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, PHH Mortgage Corporation, HLSS Holdings, LLC, New Residential Mortgage LLC, NewRez LLC d/b/a Shellpoint Mortgage Servicing, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Form 8-K, filed August 16, 2019) |\\n| 4.18 | Series 2019-T3 Indenture Supplement, dated as of September 20, 2019, to the Third Amended and Restated Indenture, dated as of July 25, 2019, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, PHH Mortgage Corporation, HLSS Holdings, LLC, New Residential Mortgage LLC, NewRez LLC d/b/a Shellpoint Mortgage Servicing, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Form 8-K, filed September 20, 2019) |\\n\\n153\\n| Exhibit Number | Exhibit Description |\\n| 4.19 | Series 2019-T4 Indenture Supplement, dated as of October 15, 2019, to the Third Amended and Restated Indenture, dated as of July 25, 2019, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, PHH Mortgage Corporation, HLSS Holdings, LLC, New Residential Mortgage LLC, NewRez LLC d/b/a Shellpoint Mortgage Servicing, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Form 8-K, filed October 18, 2019) |\\n| 4.20 | Form of Debt Securities Indenture (including Form of Debt Security) (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Registration Statement on Form S-3, filed May 16, 2014) |\\n| 10.1 | Third Amended and Restated Management and Advisory Agreement, dated as of May 7, 2015, by and between New Residential Investment Corp. and FIG LLC (incorporated by reference to Exhibit 10.4 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2015) |\\n| 10.2 | Form of Indemnification Agreement by and between New Residential Investment Corp. and its directors and officers (incorporated by reference to Exhibit 10.2 to Amendment No. 3 to New Residential Investment Corp.’s Registration Statement on Form 10, filed March 27, 2013) |\\n| 10.3 | New Residential Investment Corp. Nonqualified Stock Option and Incentive Award Plan, adopted as of April 29, 2013 (incorporated by reference to Exhibit 10.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed May 3, 2013) |\\n| 10.4 | Amended and Restated New Residential Investment Corp. Nonqualified Stock Option and Incentive Plan, adopted as of November 4, 2014 (incorporated by reference to Exhibit 10.6 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2014) |\\n| 10.5 | Investment Guidelines (incorporated by reference to Exhibit 10.4 to Amendment No. 4 to New Residential Investment Corp.’s Registration Statement on Form 10, filed April 9, 2013) |\\n| 10.6 | Excess Servicing Spread Sale and Assignment Agreement, dated as of December 8, 2011, by and between Nationstar Mortgage LLC and NIC MSR I LLC (incorporated by reference to Exhibit 10.5 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2011) |\\n| 10.7 | Excess Spread Refinanced Loan Replacement Agreement, dated as of December 8, 2011, by and between Nationstar Mortgage LLC and NIC MSR I LLC (incorporated by reference to Exhibit 10.6 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2011) |\\n| 10.8 | Future Spread Agreement for FHLMC Mortgage Loans, dated as of May 13, 2012, by and between Nationstar Mortgage LLC and NIC MSR IV LLC (incorporated by reference to Exhibit 10.4 to Drive Shack Inc.’s Current Report on Form 8-K, filed May 15, 2012) |\\n| 10.9 | Future Spread Agreement for FNMA Mortgage Loans, dated as of May 13, 2012, by and between Nationstar Mortgage LLC and NIC MSR V LLC (incorporated by reference to Exhibit 10.2 to Drive Shack Inc.’s Current Report on Form 8-K, filed May 15, 2012) |\\n| 10.10 | Future Spread Agreement for Non-Agency Mortgage Loans, dated as of May 13, 2012, by and between Nationstar Mortgage LLC and NIC MSR VI LLC (incorporated by reference to Exhibit 10.6 to Drive Shack Inc.’s Current Report on Form 8-K, filed May 15, 2012) |\\n| 10.11 | Future Spread Agreement for GNMA Mortgage Loans, dated as of May 13, 2012, by and between Nationstar Mortgage LLC and NIC MSR VII, LLC (incorporated by reference to Exhibit 10.8 to Drive Shack Inc.’s Current Report on Form 8-K, filed May 15, 2012) |\\n| 10.12 | Current Excess Servicing Spread Acquisition Agreement for FHLMC Mortgage Loans, dated as of May 31, 2012, by and between Nationstar Mortgage LLC and NIC MSR III LLC (incorporated by reference to Exhibit 10.1 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 6, 2012) |\\n| 10.13 | Future Spread Agreement for FHLMC Mortgage Loans, dated as of May 31, 2012, by and between Nationstar Mortgage LLC and NIC MSR III LLC (incorporated by reference to Exhibit 10.2 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 6, 2012) |\\n| 10.14 | Amended and Restated Current Excess Servicing Spread Acquisition Agreement for FNMA Mortgage Loans, dated as of June 7, 2012, by and between Nationstar Mortgage LLC and NIC MSR II LLC (incorporated by reference to Exhibit 10.1 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 7, 2012) |\\n| 10.15 | Amended and Restated Future Spread Agreement for FNMA Mortgage Loans, dated as of June 7, 2012, by and between Nationstar Mortgage LLC and NIC MSR II LLC (incorporated by reference to Exhibit 10.2 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 7, 2012) |\\n\\n154\\n| Exhibit Number | Exhibit Description |\\n| 10.16 | Amended and Restated Current Excess Servicing Spread Acquisition Agreement for FHLMC Mortgage Loans, dated as of June 7, 2012, by and between Nationstar Mortgage LLC and NIC MSR II LLC (incorporated by reference to Exhibit 10.3 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 7, 2012) |\\n| 10.17 | Amended and Restated Future Spread Agreement for FHLMC Mortgage Loans, dated as of June 7, 2012, by and between Nationstar Mortgage LLC and NIC MSR II LLC (incorporated by reference to Exhibit 10.4 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 7, 2012) |\\n| 10.18 | Amended and Restated Current Excess Servicing Spread Acquisition Agreement for Non-Agency Mortgage Loans, dated as of June 7, 2012, by and between Nationstar Mortgage LLC and NIC MSR II LLC (incorporated by reference to Exhibit 10.5 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 7, 2012) |\\n| 10.19 | Amended and Restated Future Spread Agreement for Non-Agency Mortgage Loans, dated as of June 7, 2012, by and between Nationstar Mortgage LLC and NIC MSR II LLC (incorporated by reference to Exhibit 10.6 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 7, 2012) |\\n| 10.20 | Amended and Restated Current Excess Servicing Spread Acquisition Agreement for FNMA Mortgage Loans, dated as of June 28, 2012, by and between Nationstar Mortgage LLC and NIC MSR V LLC (incorporated by reference to Exhibit 10.1 to Drive Shack Inc.’s Current Report on Form 8-K, filed July 5, 2012) |\\n| 10.21 | Amended and Restated Current Excess Servicing Spread Acquisition Agreement for FHLMC Mortgage Loans, dated as of June 28, 2012, by and between Nationstar Mortgage LLC and NIC MSR IV LLC (incorporated by reference to Exhibit 10.2 to Drive Shack Inc.’s Current Report on Form 8-K, filed July 5, 2012) |\\n| 10.22 | Amended and Restated Current Excess Servicing Spread Acquisition Agreement for Non-Agency Mortgage Loans, dated as of June 28, 2012, by and between Nationstar Mortgage LLC and NIC MSR VI LLC (incorporated by reference to Exhibit 10.3 to Drive Shack Inc.’s Current Report on Form 8-K, filed July 5, 2012) |\\n| 10.23 | Amended and Restated Current Excess Servicing Spread Acquisition Agreement for GNMA Mortgage Loans, dated as of June 28, 2012, by and between Nationstar Mortgage LLC and NIC MSR VII LLC (incorporated by reference to Exhibit 10.4 to Drive Shack Inc.’s Current Report on Form 8-K, filed July 5, 2012) |\\n| 10.24 | Current Excess Servicing Spread Acquisition Agreement for GNMA Mortgage Loans, dated as of December 31, 2012, by and between Nationstar Mortgage LLC and MSR VIII LLC (incorporated by reference to Exhibit 10.35 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\\n| 10.25 | Future Spread Agreement for GNMA Mortgage Loans, dated as of December 31, 2012, by and between Nationstar Mortgage LLC and MSR VIII LLC (incorporated by reference to Exhibit 10.36 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\\n| 10.26 | Current Excess Servicing Spread Acquisition Agreement for FHLMC Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR IX LLC (incorporated by reference to Exhibit 10.37 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\\n| 10.27 | Future Spread Agreement for FHLMC Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR IX LLC (incorporated by reference to Exhibit 10.38 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\\n| 10.28 | Current Excess Servicing Spread Acquisition Agreement for FNMA Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR X LLC (incorporated by reference to Exhibit 10.39 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\\n| 10.29 | Future Spread Agreement for FNMA Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR X LLC (incorporated by reference to Exhibit 10.40 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\\n| 10.30 | Current Excess Servicing Spread Acquisition Agreement for GNMA Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR XI LLC (incorporated by reference to Exhibit 10.41 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\\n| 10.31 | Future Spread Agreement for GNMA Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR XI LLC (incorporated by reference to Exhibit 10.42 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\\n| 10.32 | Current Excess Servicing Spread Acquisition Agreement for Non-Agency Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR XII LLC (incorporated by reference to Exhibit 10.43 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\\n\\n155\\n| Exhibit Number | Exhibit Description |\\n| 10.33 | Future Spread Agreement for Non-Agency Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR XII LLC (incorporated by reference to Exhibit 10.44 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\\n| 10.34 | Current Excess Servicing Spread Acquisition Agreement for Non-Agency Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR XIII LLC (incorporated by reference to Exhibit 10.45 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\\n| 10.35 | Future Spread Agreement for Non-Agency Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR XIII LLC (incorporated by reference to Exhibit 10.46 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\\n| 10.36 | Interim Servicing Agreement, dated as of April 1, 2013, by and among the Interim Servicers listed therein, HSBC Finance Corporation, as Interim Servicer Representative, HSBC Bank USA, National Association, SpringCastle America, LLC, SpringCastle Credit, LLC, SpringCastle Finance, LLC, Wilmington Trust, National Association, as Loan Trustee, and SpringCastle Finance LLC, as Owner Representative (incorporated by reference to Exhibit 10.35 to Amendment No. 4 to New Residential Investment Corp.’s Registration Statement on Form 10, filed April 9, 2013) |\\n| 10.37 | Second Amended and Restated Limited Liability Company Agreement of SpringCastle Acquisition LLC, dated as of March 31, 2016 (incorporated by reference to Exhibit 10.37 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2016) |\\n| 10.38 | Services Agreement, dated as of April 6, 2015, by and between HLSS Advances Acquisition Corp. and Home Loan Servicing Solutions, Ltd. (incorporated by reference to Exhibit 2.4 to New Residential Investment Corp.’s Current Report on Form 8-K, filed April 10, 2015) |\\n| 10.39 | Receivables Sale Agreement, dated as of August 28, 2015, by and among Ocwen Loan Servicing, LLC, HLSS Holdings, LLC and NRZ Advance Facility Transferor 2015-ON1 LLC (incorporated by reference to Exhibit 10.47 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2015) |\\n| 10.40 | Receivables Pooling Agreement, dated as of August 28, 2015, by and between NRZ Advance Facility Transferor 2015-ON1 LLC and NRZ Advance Receivables Trust 2015-ON1 (incorporated by reference to Exhibit 10.48 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2015) |\\n| 10.41# | Master Agreement, dated as July 23, 2017, by and among Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, HLSS MSR - EBO Acquisition LLC and New Residential Mortgage LLC (incorporated by reference to Exhibit 10.41 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2017) |\\n| 10.42 | Amendment No. 1 to Master Agreement, dated as of October 12, 2017, by and among Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, HLSS MSR - EBO Acquisition LLC and New Residential Mortgage LLC (incorporated by reference to Exhibit 10.42 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2017) |\\n| 10.43# | Transfer Agreement, dated as of July 23, 2017, by and among Ocwen Loan Servicing, LLC, New Residential Mortgage LLC, Ocwen Financial Corporation and New Residential Investment Corp. (incorporated by reference to Exhibit 10.43 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2017) |\\n| 10.44# | Amendment No. 1 to the Transfer Agreement, dated January 18, 2018, by and among Ocwen Loan Servicing, LLC, New Residential Mortgage LLC, Ocwen Financial Corporation and New Residential Investment Corp. (incorporated by reference to Exhibit 10.44 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2018) |\\n| 10.45# | Subservicing Agreement, dated as of July 23, 2017, by and between New Residential Mortgage LLC and Ocwen Loan Servicing, LLC (incorporated by reference to Exhibit 10.44 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2017) |\\n| 10.46# | Amendment No. 1 to Subservicing Agreement, dated as of August 17, 2018, by and between New Residential Mortgage LLC and Ocwen Loan Servicing, LLC (incorporated by reference to Exhibit 10.46 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2018) |\\n| 10.47# | Cooperative Brokerage Agreement, dated as of August 28, 2017, by and among REALHome Services and Solutions, Inc., REALHome Services and Solutions - CT, Inc. and New Residential Sales Corp. (incorporated by reference to Exhibit 10.45 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2017) |\\n\\n156\\n| Exhibit Number | Exhibit Description |\\n| 10.48# | First Amendment to Cooperative Brokerage Agreement, dated as of November 16, 2017, by and among REALHome Services and Solutions, Inc., REALHome Services and Solutions - CT, Inc. and New Residential Sales Corp. (incorporated by reference to Exhibit 10.46 to New Residential Investment Corp.’s Annual Report on Form 10-K for the year ended December 31, 2017, filed on February 14, 2018) |\\n| 10.49# | Second Amendment to Cooperative Brokerage Agreement, dated as of January 18, 2018, by and among REALHome Services and Solutions, Inc., REALHome Services and Solutions - CT, Inc. and New Residential Sales Corp. (incorporated by reference to Exhibit 10.47 to New Residential Investment Corp.’s Annual Report on Form 10-K for the year ended December 31, 2017, filed on February 14, 2018) |\\n| 10.50 | Third Amendment to Cooperative Brokerage Agreement, dated as of March 23, 2018, by and among REALHome Services and Solutions, Inc., REALHome Services and Solutions - CT, Inc. and New Residential Sales Corp. (incorporated by reference to Exhibit 10.49 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2018) |\\n| 10.51 | Fourth Amendment to Cooperative Brokerage Agreement, dated as of September 11, 2018, by and among REALHome Services and Solutions, Inc., REALHome Services and Solutions - CT, Inc. and New Residential Sales Corp. (incorporated by reference to Exhibit 10.51 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2018) |\\n| 10.52# | Letter Agreement, dated as of August 28, 2017, by and among New Residential Investment Corp., New Residential Mortgage LLC, REALHome Services and Solutions, Inc., REALHome Services and Solutions - CT, Inc. and Altisource Solutions S.a.r.l. (incorporated by reference to Exhibit 10.46 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2017) |\\n| 10.53# | New RMSR Agreement, dated as of January 18, 2018, by and among Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, HLSS MSR - EBO Acquisition LLC, and New Residential Mortgage LLC (incorporated by reference to Exhibit 10.51 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2018) |\\n| 10.54# | Amendment No. 1 to New RMSR Agreement, dated as of August 17, 2018, by and among Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, HLSS MSR - EBO Acquisition LLC, and New Residential Mortgage LLC (incorporated by reference to Exhibit 10.54 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2018) |\\n| 10.55# | Subservicing Agreement, dated as of August 17, 2018, by and between New Penn Financial, LLC, d/b/a Shellpoint Mortgage Servicing New Residential Mortgage LLC and Ocwen Loan Servicing, LLC (incorporated by reference to Exhibit 10.55 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2018) |\\n| 31.1 | Certification of Chief Executive Officer as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 31.2 | Certification of Chief Financial Officer as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 32.2 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 101 | The following financial information from the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2019, formatted in iXBRL (Inline Extensible Business Reporting Language): (i) Condensed Consolidated Balance Sheets; (ii) Condensed Consolidated Statements of Comprehensive Income; (iii) Condensed Consolidated Statements of Changes in Stockholders’ Equity; (iv) Condensed Consolidated Statements of Cash Flows; and (v) Notes to Condensed Consolidated Financial Statements |\\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\\n\\n| # | Portions of this exhibit have been omitted pursuant to a request for confidential treatment. |\\n| * | Portions of this exhibit have been omitted. |\\n\\n157\\nThe following second amended and restated limited liability company agreements of the Consumer Loan Companies are substantially identical in all material respects, except as to the parties thereto and the initial capital contributions required under each agreement, to the Second Amended and Restated Limited Liability Company Agreement of SpringCastle Acquisition LLC that is filed as Exhibit 10.37 hereto and are being omitted in reliance on Instruction 2 to Item 601 of Regulation S-K:\\n\\n| • | Second Amended and Restated Limited Liability Company Agreement of SpringCastle America, LLC, dated as of March 31, 2016. |\\n\\n| • | Second Amended and Restated Limited Liability Company Agreement of SpringCastle Credit, LLC, dated as of March 31, 2016. |\\n\\n| • | Second Amended and Restated Limited Liability Company Agreement of SpringCastle Finance, LLC, dated as of March 31, 2016. |\\n\\n158\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized:\\n\\n| NEW RESIDENTIAL INVESTMENT CORP. |\\n| By: | /s/ Michael Nierenberg |\\n| Michael Nierenberg |\\n| Chief Executive Officer and President |\\n| (Principal Executive Officer) |\\n| October 28, 2019 |\\n| By: | /s/ Nicola Santoro, Jr. |\\n| Nicola Santoro, Jr. |\\n| Chief Financial Officer and Treasurer |\\n| (Principal Financial Officer) |\\n| October 28, 2019 |\\n| By: | /s/ David Schneider |\\n| David Schneider |\\n| Chief Accounting Officer |\\n| (Principal Accounting Officer) |\\n| October 28, 2019 |\\n\\n159\\n \\n\\nWhat is the net income ratio of the Real Estate Securities segment considering the interest income and net income for the three months ended September 30, 2019 in percentages?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 92.24151449443852.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 67,\n \"input_length\": 176286\n}"}}},{"rowIdx":68,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nItem 1. Financial Statements\nINDEPENDENT BANK CORP.\nCONSOLIDATED BALANCE SHEETS\n(Unaudited—Dollars in thousands)\n\n| September 302022 | December 312021 |\n| Assets |\n| Cash and due from banks | $ | 172,615 | $ | 141,581 |\n| Interest-earning deposits with banks | 763,681 | 2,099,103 |\n| Securities |\n| Trading | 3,538 | 3,720 |\n| Equity | 20,439 | 23,173 |\n| Available for sale (amortized cost $ 1,605,913 and $ 1,583,736 ) | 1,425,511 | 1,571,148 |\n| Held to maturity (fair value $ 1,509,985 and $ 1,064,133 ) | 1,697,635 | 1,066,818 |\n| Total securities | 3,147,123 | 2,664,859 |\n| Loans held for sale (at fair value) | 5,100 | 24,679 |\n| Loans |\n| Commercial and industrial | 1,548,349 | 1,563,279 |\n| Commercial real estate | 7,677,917 | 7,992,344 |\n| Commercial construction | 1,185,157 | 1,165,457 |\n| Small business | 209,567 | 193,189 |\n| Residential real estate | 1,959,254 | 1,604,686 |\n| Home equity - first position | 578,405 | 589,550 |\n| Home equity - subordinate positions | 508,765 | 450,061 |\n| Other consumer | 32,936 | 28,720 |\n| Total loans | 13,700,350 | 13,587,286 |\n| Less: allowance for credit losses | ( 147,313 ) | ( 146,922 ) |\n| Net loans | 13,553,037 | 13,440,364 |\n| Federal Home Loan Bank stock | 5,218 | 11,407 |\n| Bank premises and equipment, net | 198,408 | 195,590 |\n| Goodwill | 985,072 | 985,072 |\n| Other intangible assets | 26,934 | 32,772 |\n| Cash surrender value of life insurance policies | 293,126 | 289,304 |\n| Other assets | 552,955 | 538,674 |\n| Total assets | $ | 19,703,269 | $ | 20,423,405 |\n| Liabilities and Stockholders' Equity |\n| Deposits |\n| Noninterest-bearing demand deposits | $ | 5,622,260 | $ | 5,479,503 |\n| Savings and interest checking accounts | 6,094,493 | 6,350,016 |\n| Money market | 3,443,622 | 3,556,375 |\n| Time certificates of deposit | 1,178,619 | 1,531,150 |\n| Total deposits | 16,338,994 | 16,917,044 |\n| Borrowings |\n| Federal Home Loan Bank borrowings | 643 | 25,667 |\n| Long-term borrowings | — | 14,063 |\n| Junior subordinated debentures (less unamortized debt issuance costs of $ 33 and $ 35 ) | 62,855 | 62,853 |\n\n5\n| Subordinated debentures (less unamortized debt issuance costs of $ 138 and $ 209 ) | 49,862 | 49,791 |\n| Total borrowings | 113,360 | 152,374 |\n| Other liabilities | 433,714 | 335,538 |\n| Total liabilities | 16,886,068 | 17,404,956 |\n| Commitments and contingencies | — | — |\n| Stockholders' equity |\n| Preferred stock, $ 0.01 par value, authorized: 1,000,000 shares, outstanding: none | — | — |\n| Common stock, $ 0.01 par value, authorized: 75,000,000 shares,issued and outstanding: 45,634,626 shares at September 30, 2022 and 47,349,778 shares at December 31, 2021 (includes 136,904 and 135,273 shares of unvested participating restricted stock awards, respectively) | 454 | 472 |\n| Value of shares held in rabbi trust at cost: 82,617 shares at September 30, 2022 and 82,565 shares at December 31, 2021 | ( 3,239 ) | ( 3,146 ) |\n| Deferred compensation and other retirement benefit obligations | 3,239 | 3,146 |\n| Additional paid in capital | 2,113,313 | 2,249,078 |\n| Retained earnings | 882,503 | 766,716 |\n| Accumulated other comprehensive income (loss), net of tax | ( 179,069 ) | 2,183 |\n| Total stockholders’ equity | 2,817,201 | 3,018,449 |\n| Total liabilities and stockholders' equity | $ | 19,703,269 | $ | 20,423,405 |\n\nThe accompanying notes are an integral part of these unaudited consolidated financial statements.\n6\nINDEPENDENT BANK CORP.\nCONSOLIDATED STATEMENTS OF INCOME\n(Unaudited—Dollars in thousands, except per share data)\n| Three Months Ended | Nine Months Ended |\n| September 30 | September 30 |\n| 2022 | 2021 | 2022 | 2021 |\n| Interest income |\n| Interest and fees on loans | $ | 150,157 | $ | 84,212 | $ | 413,770 | $ | 265,409 |\n| Taxable interest and dividends on securities | 13,243 | 7,792 | 34,567 | 21,603 |\n| Nontaxable interest and dividends on securities | 1 | 4 | 4 | 14 |\n| Interest on loans held for sale | 51 | 193 | 150 | 675 |\n| Interest on federal funds sold and short-term investments | 6,519 | 815 | 10,222 | 1,654 |\n| Total interest and dividend income | 169,971 | 93,016 | 458,713 | 289,355 |\n| Interest expense |\n| Interest on deposits | 6,109 | 1,633 | 10,327 | 6,361 |\n| Interest on borrowings | 1,261 | 1,292 | 3,492 | 3,965 |\n| Total interest expense | 7,370 | 2,925 | 13,819 | 10,326 |\n| Net interest income | 162,601 | 90,091 | 444,894 | 279,029 |\n| Provision for (release of) credit losses | 3,000 | ( 10,000 ) | 1,000 | ( 17,500 ) |\n| Net interest income after provision for credit losses | 159,601 | 100,091 | 443,894 | 296,529 |\n| Noninterest income |\n| Deposit account fees | 6,261 | 4,298 | 17,582 | 11,704 |\n| Interchange and ATM fees | 4,331 | 3,441 | 11,967 | 9,229 |\n| Investment management | 8,436 | 9,174 | 26,438 | 26,350 |\n| Mortgage banking income | 585 | 2,825 | 2,989 | 11,270 |\n| Increase in cash surrender value of life insurance policies | 1,883 | 1,596 | 5,549 | 4,508 |\n| Gain on life insurance benefits | 477 | — | 600 | 258 |\n| Loan level derivative income | 471 | 586 | 1,511 | 875 |\n| Other noninterest income | 5,751 | 4,537 | 15,729 | 12,476 |\n| Total noninterest income | 28,195 | 26,457 | 82,365 | 76,670 |\n| Noninterest expenses |\n| Salaries and employee benefits | 52,708 | 42,235 | 150,957 | 124,759 |\n| Occupancy and equipment expenses | 12,316 | 8,564 | 37,255 | 26,543 |\n| Data processing and facilities management | 2,259 | 1,673 | 6,878 | 5,024 |\n| Consulting expense | 2,547 | 1,560 | 7,057 | 5,443 |\n| Software maintenance | 2,497 | 2,018 | 7,706 | 5,903 |\n| Debit card expense | 1,936 | 1,347 | 5,562 | 3,693 |\n| Amortization of intangible assets | 1,898 | 1,310 | 5,801 | 4,037 |\n| FDIC assessment | 1,677 | 980 | 5,225 | 2,805 |\n| Merger and acquisition expense | — | 1,943 | 7,100 | 3,674 |\n| Other noninterest expenses | 14,890 | 10,789 | 45,249 | 33,522 |\n| Total noninterest expenses | 92,728 | 72,419 | 278,790 | 215,403 |\n| Income before income taxes | 95,068 | 54,129 | 247,469 | 157,796 |\n| Provision for income taxes | 23,171 | 14,122 | 60,699 | 38,506 |\n| Net income | $ | 71,897 | $ | 40,007 | $ | 186,770 | $ | 119,290 |\n| Basic earnings per share | $ | 1.57 | $ | 1.21 | $ | 4.01 | $ | 3.61 |\n| Diluted earnings per share | $ | 1.57 | $ | 1.21 | $ | 4.00 | $ | 3.61 |\n| Weighted average common shares (basic) | 45,839,555 | 33,043,716 | 46,618,209 | 33,024,386 |\n| Common share equivalents | 16,856 | 15,554 | 17,221 | 18,238 |\n| Weighted average common shares (diluted) | 45,856,411 | 33,059,270 | 46,635,430 | 33,042,624 |\n| Cash dividends declared per common share | $ | 0.51 | $ | 0.48 | $ | 1.53 | $ | 1.44 |\n\nThe accompanying notes are an integral part of these unaudited consolidated financial statements.\n7\nINDEPENDENT BANK CORP.\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME\n(Unaudited—Dollars in thousands)\n\n| Three Months Ended | Nine Months Ended |\n| September 30 | September 30 |\n| 2022 | 2021 | 2022 | 2021 |\n| Net income | $ | 71,897 | $ | 40,007 | $ | 186,770 | $ | 119,290 |\n| Other comprehensive income (loss), net of tax |\n| Net change in fair value of securities available for sale | ( 42,582 ) | ( 7,897 ) | ( 128,872 ) | ( 11,878 ) |\n| Net change in fair value of cash flow hedges | ( 27,144 ) | ( 3,383 ) | ( 52,743 ) | ( 11,559 ) |\n| Net change in other comprehensive income for defined benefit postretirement plans | 121 | 280 | 363 | 1,309 |\n| Total other comprehensive loss | ( 69,605 ) | ( 11,000 ) | ( 181,252 ) | ( 22,128 ) |\n| Total comprehensive income | $ | 2,292 | $ | 29,007 | $ | 5,518 | $ | 97,162 |\n\nThe accompanying notes are an integral part of these unaudited consolidated financial statements.\n8\nINDEPENDENT BANK CORP.\nCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\nThree Months Ended September 30, 2022 and 2021\n(Unaudited—Dollars in thousands, except per share data)\n| Common Stock Outstanding | Common Stock | Value of Shares Held in Rabbi Trust at Cost | Deferred Compensation Obligation | Additional Paid in Capital | Retained Earnings | Accumulated OtherComprehensive Income (Loss) | Total |\n| Balance June 30, 2022 | 46,069,761 | $ | 459 | $ | ( 3,196 ) | $ | 3,196 | $ | 2,146,333 | $ | 833,857 | $ | ( 109,464 ) | $ | 2,871,185 |\n| Net income | — | — | — | — | — | 71,897 | — | 71,897 |\n| Other comprehensive loss | — | — | — | — | — | — | ( 69,605 ) | ( 69,605 ) |\n| Common dividend declared ($ 0.51 per share) | — | — | — | — | — | ( 23,251 ) | — | ( 23,251 ) |\n| Stock based compensation | — | — | — | — | 1,017 | — | — | 1,017 |\n| Restricted stock awards issued, net of awards surrendered | 296 | — | — | — | — | — | — | — |\n| Shares issued under direct stock purchase plan | 7,541 | — | — | — | 606 | — | — | 606 |\n| Shares repurchased under share repurchase program | ( 442,972 ) | ( 5 ) | — | — | ( 34,643 ) | — | — | ( 34,648 ) |\n| Deferred compensation and other retirement benefit obligations | — | — | ( 43 ) | 43 | — | — | — | — |\n| Balance September 30, 2022 | 45,634,626 | $ | 454 | $ | ( 3,239 ) | $ | 3,239 | $ | 2,113,313 | $ | 882,503 | $ | ( 179,069 ) | $ | 2,817,201 |\n| Balance June 30, 2021 | 33,037,859 | $ | 329 | $ | ( 3,116 ) | $ | 3,116 | $ | 948,130 | $ | 763,596 | $ | 29,567 | $ | 1,741,622 |\n| Net income | — | — | — | — | — | 40,007 | — | 40,007 |\n| Other comprehensive loss | — | — | — | — | — | — | ( 11,000 ) | ( 11,000 ) |\n| Common dividend declared ($ 0.48 per share) | — | — | — | — | — | ( 15,861 ) | — | ( 15,861 ) |\n| Stock based compensation | — | — | — | — | 707 | — | — | 707 |\n| Restricted stock awards issued, net of awards surrendered | ( 763 ) | — | — | — | ( 3 ) | — | — | ( 3 ) |\n| Shares issued under direct stock purchase plan | 6,716 | — | — | — | 482 | — | — | 482 |\n| Deferred compensation and other retirement benefit obligations | — | — | ( 41 ) | 41 | — | — | — | — |\n| Balance September 30, 2021 | 33,043,812 | $ | 329 | $ | ( 3,157 ) | $ | 3,157 | $ | 949,316 | $ | 787,742 | $ | 18,567 | $ | 1,755,954 |\n\n9\nINDEPENDENT BANK CORP.\nCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\nNine Months Ended September 30, 2022 and 2021\n(Unaudited—Dollars in thousands, except per share data)\n| Common Stock Outstanding | Common Stock | Value of Shares Held in Rabbi Trust at Cost | Deferred Compensation Obligation | Additional Paid in Capital | Retained Earnings | Accumulated OtherComprehensive Income (Loss) | Total |\n| Balance December 31, 2021 | 47,349,778 | $ | 472 | $ | ( 3,146 ) | $ | 3,146 | $ | 2,249,078 | $ | 766,716 | $ | 2,183 | $ | 3,018,449 |\n| Net income | — | — | — | — | — | 186,770 | — | 186,770 |\n| Other comprehensive loss | — | — | — | — | — | — | ( 181,252 ) | ( 181,252 ) |\n| Common dividend declared ($ 1.53 per share) | — | — | — | — | — | ( 70,983 ) | — | ( 70,983 ) |\n| Stock based compensation | — | — | — | — | 3,483 | — | — | 3,483 |\n| Restricted stock awards issued, net of awards surrendered | 50,096 | — | — | — | ( 1,085 ) | — | — | ( 1,085 ) |\n| Shares issued under direct stock purchase plan | 21,717 | — | — | — | 1,765 | — | — | 1,765 |\n| Shares repurchased under share repurchase program | ( 1,786,965 ) | ( 18 ) | — | — | ( 139,928 ) | — | — | ( 139,946 ) |\n| Deferred compensation and other retirement benefit obligations | — | — | ( 93 ) | 93 | — | — | — | — |\n| Balance September 30, 2022 | 45,634,626 | $ | 454 | $ | ( 3,239 ) | $ | 3,239 | $ | 2,113,313 | $ | 882,503 | $ | ( 179,069 ) | $ | 2,817,201 |\n| Balance December 31, 2020 | 32,965,692 | $ | 328 | $ | ( 3,066 ) | $ | 3,066 | $ | 945,638 | $ | 716,024 | $ | 40,695 | $ | 1,702,685 |\n| Net income | — | — | — | — | — | 119,290 | — | 119,290 |\n| Other comprehensive loss | — | — | — | — | — | — | ( 22,128 ) | ( 22,128 ) |\n| Common dividend declared ($ 1.44 per share) | — | — | — | — | — | ( 47,572 ) | — | ( 47,572 ) |\n| Proceeds from exercise of stock options, net of cash paid | 4,744 | — | — | — | ( 57 ) | — | — | ( 57 ) |\n| Stock based compensation | — | — | — | — | 3,467 | — | — | 3,467 |\n| Restricted stock awards issued, net of awards surrendered | 53,795 | 1 | — | — | ( 1,247 ) | — | — | ( 1,246 ) |\n| Shares issued under direct stock purchase plan | 19,581 | — | — | — | 1,515 | — | — | 1,515 |\n| Deferred compensation and other retirement benefit obligations | — | — | ( 91 ) | 91 | — | — | — | — |\n| Balance September 30, 2021 | 33,043,812 | $ | 329 | $ | ( 3,157 ) | $ | 3,157 | $ | 949,316 | $ | 787,742 | $ | 18,567 | $ | 1,755,954 |\n\nThe accompanying notes are an integral part of these unaudited consolidated financial statements.\n10\nINDEPENDENT BANK CORP.\nCONSOLIDATED STATEMENTS OF CASH FLOWS\n(Unaudited—Dollars in thousands)\n\n| Nine Months Ended |\n| September 30 |\n| 2022 | 2021 |\n| Cash flow from operating activities |\n| Net income | $ | 186,770 | $ | 119,290 |\n| Adjustments to reconcile net income to net cash provided by operating activities |\n| Depreciation and amortization | 29,528 | 24,586 |\n| Change in unamortized net loan costs and premiums | ( 6,397 ) | ( 17,217 ) |\n| Accretion of fair value mark of acquired loans | ( 65 ) | ( 5,349 ) |\n| Provision for (release of) credit losses | 1,000 | ( 17,500 ) |\n| Deferred income tax expense | 271 | 271 |\n| Net loss (gain) on equity securities | 2,819 | ( 695 ) |\n| Net loss on bank premises and equipment | 217 | 32 |\n| Realized gain on sale leaseback transaction | ( 433 ) | ( 433 ) |\n| Stock based compensation | 3,483 | 3,467 |\n| Increase in cash surrender value of life insurance policies | ( 5,549 ) | ( 4,508 ) |\n| Gain on life insurance benefits | ( 600 ) | ( 258 ) |\n| Operating lease payments | ( 15,867 ) | ( 8,993 ) |\n| Operating lease termination payments | — | ( 4,750 ) |\n| Change in fair value on loans held for sale | 620 | 1,534 |\n| Net change in: |\n| Trading assets | 182 | ( 666 ) |\n| Loans held for sale | 18,959 | 23,017 |\n| Other assets | 32,252 | 16,700 |\n| Other liabilities | 58,669 | 28,267 |\n| Total adjustments | 119,089 | 37,505 |\n| Net cash provided by operating activities | 305,859 | 156,795 |\n| Cash flows used in investing activities |\n| Proceeds from sales of equity securities | 30 | 1,164 |\n| Purchases of equity securities | ( 471 ) | ( 1,522 ) |\n| Proceeds from maturities and principal repayments of securities available for sale | 100,790 | 75,442 |\n| Purchases of securities available for sale | ( 123,289 ) | ( 1,106,079 ) |\n| Proceeds from maturities and principal repayments of securities held to maturity | 132,997 | 199,304 |\n| Purchases of securities held to maturity | ( 763,987 ) | ( 340,713 ) |\n| Net redemption of Federal Home Loan Bank stock | 6,189 | 1,584 |\n| Investments in low income housing projects | ( 14,896 ) | ( 19,236 ) |\n| Purchases of life insurance policies | ( 115 ) | ( 40,116 ) |\n| Proceeds from life insurance policies | 2,273 | 576 |\n| Net (increase) decrease in loans | ( 107,211 ) | 603,773 |\n| Purchases of bank premises and equipment | ( 18,019 ) | ( 16,114 ) |\n| Proceeds from the sale of bank premises and equipment | 1,228 | 78 |\n| Net cash used in investing activities | ( 784,481 ) | ( 641,859 ) |\n| Cash flows (used in) provided by financing activities |\n| Net decrease in time deposits | ( 351,458 ) | ( 165,052 ) |\n\n11\n| Net (decrease) increase in other deposits | ( 225,519 ) | 1,432,037 |\n| Repayments of short-term Federal Home Loan Bank borrowings | ( 25,000 ) | — |\n| Repayments of long-term Federal Home Loan Bank borrowings | — | ( 10,000 ) |\n| Repayments of long-term debt, net of issuance costs | ( 14,063 ) | ( 14,063 ) |\n| Net payments for exercise of stock options | — | ( 57 ) |\n| Restricted stock awards issued, net of awards surrendered | ( 1,085 ) | ( 1,246 ) |\n| Proceeds from shares issued under direct stock purchase plan | 1,765 | 1,515 |\n| Payments for shares repurchased under share repurchase program | ( 139,946 ) | — |\n| Common dividends paid | ( 70,460 ) | ( 46,875 ) |\n| Net cash (used in) provided by financing activities | ( 825,766 ) | 1,196,259 |\n| Net (decrease) increase in cash and cash equivalents | ( 1,304,388 ) | 711,195 |\n| Cash and cash equivalents at beginning of year | 2,240,684 | 1,296,636 |\n| Cash and cash equivalents at end of period | $ | 936,296 | $ | 2,007,831 |\n| Supplemental schedule of noncash activities |\n| Net increase in capital commitments relating to low income housing project investments | $ | 4,408 | $ | 34,127 |\n| Right-of-use assets obtained in exchange for new lease obligations | $ | 14,124 | $ | 5,888 |\n\nThe accompanying notes are an integral part of these unaudited consolidated financial statements.\n12\nNOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS\nNOTE 1 - BASIS OF PRESENTATION\nIndependent Bank Corp. (the “Company”) is a state chartered, federally registered bank holding company, incorporated in 1985. The Company is the sole stockholder of Rockland Trust Company (“Rockland Trust” or the “Bank”), a Massachusetts trust company chartered in 1907.\nAll material intercompany balances and transactions have been eliminated in consolidation. Certain previously reported amounts have been reclassified to conform to the current year’s presentation.\nThe accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (\"GAAP\") for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation of the financial statements, primarily consisting of normal recurring adjustments, have been included. Results for the nine months ended September 30, 2022 are not necessarily indicative of the results that may be expected for the year ending December 31, 2022 or any other interim period.\nFor further information, refer to the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2021, filed with the Securities and Exchange Commission (the \"2021 Form 10-K\").\nNOTE 2 - RECENT ACCOUNTING STANDARDS UPDATES\nFinancial Accounting Standards Board (\"FASB\") Accounting Standards Codification (\"ASC\") Topic 848 \"Reference Rate Reform\" Update No. 2020-04. Update No. 2020-04 was issued in March 2020 to provide optional expedients and exceptions for applying GAAP to certain contracts, hedging relationships, and other transactions affected by reference rate reform if certain criteria are met. The amendments in this update apply only to contracts, hedging relationships, and other transactions that reference the London Interbank Offered Rate (\"LIBOR\") or another reference rate expected to be discontinued because of reference rate reform. The amendments will not apply to contract modifications made and hedging relationships entered into or evaluated after December 31, 2022, except for hedging relationships existing as of December 31, 2022 for which an entity has elected certain optional expedients that are retained through the end of the hedging relationship. The amendments in this update are effective for all entities as of March 12, 2020 through December 31, 2022 and do not apply to contract modifications made after December 31, 2022. FASB ASC Topic 848 \"Reference Rate Reform\" Update No. 2021-01 was subsequently issued in January 2021 and expanded application of the optional expedients to derivative transactions affected by the discounting transition. The Company has not yet adopted the amendments in these updates, but has established a working group to guide the Company’s transition from LIBOR and has begun efforts to transition off the LIBOR index consistent with industry timelines. The working group has identified its products that utilize LIBOR and has implemented fallback language to facilitate the transition to alternative rates. The Company is also evaluating existing platforms and systems as well as alternative indices in its preparation to offer new products tied to the alternative indices. The Company does not anticipate that the adoption of these updates will have a material impact on the Company's financial statements.\nFASB ASC Topic 260 \"Earnings Per Share\" Update No. 2020-06. In August 2020, the FASB issued update No. 2020-06 (\"ASU 2020-06\"). ASU 2020-06 included amendments to ASC 260 related to the earnings per share calculation, which were designed to simplify and improve consistency of the diluted earnings per share calculation. ASU 2020-06 is effective for public entities for annual periods beginning after December 15, 2021 and interim periods therein. Accordingly, the Company adopted ASU 2020-06 effective January 1, 2022 and the adoption did not have a material impact on the Company's financial statements.\nFASB ASC Topic 815 \"Derivatives and Hedging\" Update No. 2022-01. Update No. 2022-01 was issued in March 2022 and its amendments allow for nonprepayable financial assets to also be included in a closed portfolio hedged using the portfolio layer method. The expanded scope permits an entity to apply the same portfolio hedging method to both prepayable and nonprepayable financial assets resulting in more consistent accounting for similar hedges. All amendments in this update are effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. The Company is currently assessing the impact of the adoption of this standard on the Company's financial statements.\nFASB ASC Topic 326 \"Financial Instruments - Credit Losses\" Update No. 2022-02. Update No. 2022-02 was issued in March 2022 and applies to public entities that have adopted ASU Topic 326. The amendments in this update eliminate the existing accounting guidance for troubled debt restructures (\"TDRs\") by creditors in Subtopic 310-40, Receivables - Troubled Debt Restructurings by Creditors and instead requires that an entity evaluate whether a modification\n13\nrepresents a new loan or a continuation of an existing loan. The amendments also enhance disclosure requirements for certain loan refinancing and restructuring by creditors when a borrower is experiencing financial difficulty. ASU 2022-02 also requires additional disclosure of current period gross write-offs by year of origination for financing receivables to be included in the entity's vintage disclosure, as currently required under Topic 326. All amendments in this update are effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. The Company is currently assessing the impact of the adoption of this standard on the Company's financial statements.\n14\nNOTE 3 - SECURITIES\nTrading Securities\nThe Company had trading securities of $ 3.5 million and $ 3.7 million as of September 30, 2022 and December 31, 2021, respectively. These securities are held in a rabbi trust and will be used for future payments associated with the Company’s non-qualified 401(k) Restoration Plan and Non-qualified Deferred Compensation Plan.\nEquity Securities\nThe Company had equity securities of $ 20.4 million and $ 23.2 million as of September 30, 2022 and December 31, 2021, respectively. These securities consist primarily of mutual funds held in a rabbi trust and will be used for future payments associated with the Company’s supplemental executive retirement plans.\nThe following table represents a summary of the gains and losses recognized within non-interest income and non-interest expense within the consolidated statements of income that relate to equity securities for the periods indicated:\n| Three Months Ended | Nine Months Ended |\n| September 30 | September 30 |\n| 2022 | 2021 | 2022 | 2021 |\n| Dollars in thousands |\n| Net gains (losses) recognized during the period on equity securities | $ | ( 742 ) | $ | ( 169 ) | ( 2,819 ) | 695 |\n| Less: net gains recognized during the period on equity securities sold during the period | — | 50 | 8 | 191 |\n| Unrealized gains (losses) recognized during the reporting period on equity securities still held at the reporting date | $ | ( 742 ) | $ | ( 219 ) | $ | ( 2,827 ) | $ | 504 |\n\nAvailable for Sale Securities\nThe following table summarizes the amortized cost, allowance for credit losses, and fair value of available for sale securities and the corresponding amounts of gross unrealized gains and losses recognized in accumulated other comprehensive income (loss) as of the dates indicated:\n| September 30, 2022 | December 31, 2021 |\n| AmortizedCost | GrossUnrealizedGains | Gross UnrealizedLosses | Allowance for credit losses | FairValue | AmortizedCost | GrossUnrealizedGains | Gross UnrealizedLosses | Allowance for credit losses | FairValue |\n| (Dollars in thousands) |\n| Available for sale securities |\n| U.S. government agency securities | $ | 231,122 | $ | — | $ | ( 31,180 ) | $ | — | $ | 199,942 | $ | 217,393 | $ | 990 | $ | ( 2,901 ) | $ | — | $ | 215,482 |\n| U.S. treasury securities | 873,891 | — | ( 89,433 ) | — | 784,458 | 873,467 | 172 | ( 12,191 ) | — | 861,448 |\n| Agency mortgage-backed securities | 393,296 | 50 | ( 49,193 ) | — | 344,153 | 364,955 | 4,512 | ( 5,534 ) | — | 363,933 |\n| Agency collateralized mortgage obligations | 43,672 | 5 | ( 2,890 ) | — | 40,787 | 78,966 | 1,282 | ( 571 ) | — | 79,677 |\n| State, county, and municipal securities | 193 | — | ( 6 ) | — | 187 | 192 | 11 | — | — | 203 |\n| Single issuer trust preferred securities issued by banks | 489 | — | — | — | 489 | 489 | 2 | — | — | 491 |\n| Pooled trust preferred securities issued by banks and insurers | 1,202 | — | ( 203 ) | — | 999 | 1,199 | — | ( 199 ) | — | 1,000 |\n| Small business administration pooled securities | 62,048 | — | ( 7,552 ) | — | 54,496 | 47,075 | 1,839 | — | — | 48,914 |\n| Total available for sale securities | $ | 1,605,913 | $ | 55 | $ | ( 180,457 ) | $ | — | $ | 1,425,511 | $ | 1,583,736 | $ | 8,808 | $ | ( 21,396 ) | $ | — | $ | 1,571,148 |\n\nExcluded from the table above is accrued interest on available for sale securities of $ 3.3 million and $ 3.0 million as of September 30, 2022 and December 31, 2021, respectively, which is included within other assets on the consolidated balance sheets. Additionally, the Company did not record any write-offs of accrued interest income on available for sale securities during the three and nine months ended September 30, 2022 and 2021. Furthermore, no securities held by the Company were\n15\ndelinquent on contractual payments nor were any securities placed on non-accrual status as of September 30, 2022 and December 31, 2021.\nWhen securities are sold, the adjusted cost of the specific security sold is used to compute the gain or loss on the sale. The Company had no sales of securities available for sale during the three and nine months ended September 30, 2022 and 2021, and therefore no gains or losses were realized during the periods presented.\nThe following tables show the gross unrealized losses and fair value of the Company’s available for sale securities in an unrealized loss position, and for which the Company has not recorded a provision for credit losses, as of the dates indicated. These available for sale securities are aggregated by major security type and length of time that individual securities have been in a continuous unrealized loss position:\n| September 30, 2022 |\n| Less than 12 months | 12 months or longer | Total |\n| # of holdings | FairValue | UnrealizedLosses | FairValue | UnrealizedLosses | FairValue | UnrealizedLosses |\n| (Dollars in thousands) |\n| U.S. government agency securities | 9 | $ | 80,353 | $ | ( 11,483 ) | $ | 119,589 | $ | ( 19,697 ) | $ | 199,942 | $ | ( 31,180 ) |\n| U.S. treasury securities | 18 | 86,592 | ( 12,426 ) | 697,866 | ( 77,007 ) | 784,458 | ( 89,433 ) |\n| Agency mortgage-backed securities | 142 | 263,358 | ( 29,512 ) | 79,167 | ( 19,681 ) | 342,525 | ( 49,193 ) |\n| Agency collateralized mortgage obligations | 11 | 39,291 | ( 2,890 ) | — | — | 39,291 | ( 2,890 ) |\n| State, county, and municipal securities | 1 | 187 | ( 6 ) | — | — | 187 | ( 6 ) |\n| Pooled trust preferred securities issued by banks and insurers | 1 | — | — | 999 | ( 203 ) | 999 | ( 203 ) |\n| Small business administration pooled securities | 8 | 36,885 | ( 3,768 ) | 17,611 | ( 3,784 ) | 54,496 | ( 7,552 ) |\n| Total impaired available for sale securities | 190 | $ | 506,666 | $ | ( 60,085 ) | $ | 915,232 | $ | ( 120,372 ) | $ | 1,421,898 | $ | ( 180,457 ) |\n| December 31, 2021 |\n| Less than 12 months | 12 months or longer | Total |\n| # of holdings | FairValue | UnrealizedLosses | FairValue | UnrealizedLosses | FairValue | UnrealizedLosses |\n| (Dollars in thousands) |\n| U.S. government agency securities | 6 | $ | 160,913 | $ | ( 2,901 ) | $ | — | $ | — | $ | 160,913 | $ | ( 2,901 ) |\n| U.S. treasury securities | 17 | 811,993 | ( 12,191 ) | — | — | 811,993 | ( 12,191 ) |\n| Agency mortgage-backed securities | 12 | 214,678 | ( 5,534 ) | — | — | 214,678 | ( 5,534 ) |\n| Agency collateralized mortgage obligations | 1 | 22,960 | ( 571 ) | — | — | 22,960 | ( 571 ) |\n| Pooled trust preferred securities issued by banks and insurers | 1 | — | — | 1,000 | ( 199 ) | 1,000 | ( 199 ) |\n| Total impaired available for sale securities | 37 | $ | 1,210,544 | $ | ( 21,197 ) | $ | 1,000 | $ | ( 199 ) | $ | 1,211,544 | $ | ( 21,396 ) |\n\nThe Company does not intend to sell these investments and has determined, based upon available evidence, that it is more likely than not that the Company will not be required to sell each security before the recovery of its amortized cost basis. In addition, management does not believe that any of the securities are impaired due to reasons of credit quality. As a result, the Company did not recognize a provision for credit losses on these investments during the three and nine months ended September 30, 2022 and 2021, respectively. The Company made this determination by reviewing various qualitative and quantitative factors regarding each investment category, such as current market conditions, extent and nature of changes in fair value, issuer rating changes and trends, volatility of earnings, and current analysts’ evaluations.\n16\nAs a result of the Company’s review of these qualitative and quantitative factors, the causes of the impairments listed in the table above by category were as follows at September 30, 2022:\n•U.S. Government Agency Securities, U.S. Treasury Securities, Agency Mortgage-Backed Securities, Agency Collateralized Mortgage Obligations and Small Business Administration Pooled Securities: These portfolios have contractual terms that generally do not permit the issuer to settle the securities at a price less than the current par value of the investment. The decline in market value of these securities is attributable to changes in interest rates and not credit quality. Additionally, these securities are implicitly guaranteed by the U.S. Government or one of its agencies.\n•State, County and Municipal Securities: This portfolio has contractual terms that generally do not permit the issuer to settle the securities at a price less than the current par value of the investment. The decline in market value of these securities is attributable to changes in interest rates and not credit quality.\n•Pooled Trust Preferred Securities: This portfolio consists of one below investment grade security which is performing. The unrealized loss on this security is attributable to the illiquid nature of the trust preferred market in the current economic and regulatory environment. Management evaluates collateral credit and instrument structure, including current and expected deferral and default rates and timing. In addition, discount rates are determined by evaluating comparable spreads observed currently in the market for similar instruments.\nHeld to Maturity Securities\nThe following table summarizes the amortized cost, fair value and allowance for credit losses of held to maturity securities and the corresponding amounts of gross unrealized gains and losses recognized in accumulated other comprehensive income (loss) as of the dates indicated:\n| September 30, 2022 | December 31, 2021 |\n| AmortizedCost | GrossUnrealizedGains | Gross UnrealizedLosses | Allowance for credit losses | FairValue | AmortizedCost | GrossUnrealizedGains | Gross UnrealizedLosses | Allowance for credit losses | FairValue |\n| (Dollars in thousands) |\n| U.S. government agency securities | $ | 31,696 | $ | — | $ | ( 2,393 ) | $ | — | $ | 29,303 | $ | 32,987 | $ | — | $ | ( 441 ) | $ | — | $ | 32,546 |\n| U.S. treasury securities | 100,615 | — | ( 12,623 ) | — | 87,992 | 102,560 | 6 | ( 324 ) | — | 102,242 |\n| Agency mortgage-backed securities | 892,102 | 149 | ( 90,158 ) | — | 802,093 | 493,012 | 8,495 | ( 4,271 ) | — | 497,236 |\n| Agency collateralized mortgage obligations | 553,995 | — | ( 77,025 ) | — | 476,970 | 415,736 | 3,232 | ( 10,123 ) | — | 408,845 |\n| Single issuer trust preferred securities issued by banks | 1,500 | 8 | — | — | 1,508 | 1,500 | 8 | — | — | 1,508 |\n| Small business administration pooled securities | 117,727 | 12 | ( 5,620 ) | — | 112,119 | 21,023 | 733 | — | — | 21,756 |\n| Total held to maturity securities | $ | 1,697,635 | $ | 169 | $ | ( 187,819 ) | $ | — | $ | 1,509,985 | $ | 1,066,818 | $ | 12,474 | $ | ( 15,159 ) | $ | — | $ | 1,064,133 |\n\nSubstantially all held to maturity securities held by the Company are guaranteed by the U.S. federal government or other government sponsored agencies and have a long history of no credit losses. As a result, management has determined these securities to have a zero loss expectation and therefore the Company did not record a provision for estimated credit losses on any held to maturity securities during the three and nine months ended September 30, 2022 and 2021, respectively. Excluded from the table above is accrued interest on held to maturity securities of $ 4.3 million and $ 2.0 million as of September 30, 2022 and December 31, 2021, respectively, which is included within other assets on the consolidated balance sheets. Additionally, the Company did not record any write-offs of accrued interest income on held to maturity securities during the three and nine months ended September 30, 2022 and 2021. Furthermore, no securities held by the Company were delinquent on contractual payments nor were any securities placed on non-accrual status as of September 30, 2022 and December 31, 2021.\nWhen securities are sold, the adjusted cost of the specific security sold is used to compute the gain or loss on the sale. The Company had no sales of held to maturity securities during the three and nine months ended September 30, 2022 and 2021, respectively, and therefore no gains or losses were realized during the periods presented.\nThe Company monitors the credit quality of held to maturity securities through the use of credit ratings. Credit ratings are monitored by the Company on at least a quarterly basis. As of September 30, 2022, all held to maturity securities held by the Company were rated investment grade or higher.\n17\nThe actual maturities of certain available for sale or held to maturity securities may differ from the contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. A schedule of the contractual maturities of available for sale and held to maturity securities as of September 30, 2022 is presented below:\n| Due in one year or less | Due after one year to five years | Due after five to ten years | Due after ten years | Total |\n| AmortizedCost | FairValue | AmortizedCost | FairValue | AmortizedCost | FairValue | AmortizedCost | FairValue | AmortizedCost | FairValue |\n| (Dollars in thousands) |\n| Available for sale securities |\n| U.S. government agency securities | $ | — | $ | — | $ | 68,007 | $ | 60,786 | $ | 163,115 | $ | 139,156 | $ | — | $ | — | $ | 231,122 | $ | 199,942 |\n| U.S. treasury securities | — | — | 691,691 | 627,786 | 182,200 | 156,672 | — | — | 873,891 | 784,458 |\n| Agency mortgage-backed securities | 19,658 | 19,617 | 70,984 | 66,817 | 148,475 | 126,625 | 154,179 | 131,094 | 393,296 | 344,153 |\n| Agency collateralized mortgage obligations | — | — | — | — | — | — | 43,672 | 40,787 | 43,672 | 40,787 |\n| State, county, and municipal securities | — | — | 193 | 187 | — | — | — | — | 193 | 187 |\n| Single issuer trust preferred securities issued by banks | — | — | — | — | — | — | 489 | 489 | 489 | 489 |\n| Pooled trust preferred securities issued by banks and insurers | — | — | — | — | — | — | 1,202 | 999 | 1,202 | 999 |\n| Small business administration pooled securities | — | — | — | — | — | — | 62,048 | 54,496 | 62,048 | 54,496 |\n| Total available for sale securities | $ | 19,658 | $ | 19,617 | $ | 830,875 | $ | 755,576 | $ | 493,790 | $ | 422,453 | $ | 261,590 | $ | 227,865 | $ | 1,605,913 | $ | 1,425,511 |\n| Held to maturity securities |\n| U.S. government agency securities | $ | — | $ | — | $ | 31,696 | $ | 29,303 | $ | — | $ | — | $ | — | $ | — | $ | 31,696 | $ | 29,303 |\n| U.S. treasury securities | — | — | 49,766 | 44,047 | 50,849 | 43,945 | — | — | 100,615 | 87,992 |\n| Agency mortgage-backed securities | 228 | 226 | 190,333 | 182,141 | 478,115 | 415,833 | 223,426 | 203,893 | 892,102 | 802,093 |\n| Agency collateralized mortgage obligations | — | — | 29,998 | 28,550 | 36,791 | 31,784 | 487,206 | 416,636 | 553,995 | 476,970 |\n| Single issuer trust preferred securities issued by banks | — | — | — | — | 1,500 | 1,508 | — | — | 1,500 | 1,508 |\n| Small business administration pooled securities | — | — | — | — | — | — | 117,727 | 112,119 | 117,727 | 112,119 |\n| Total held to maturity securities | $ | 228 | $ | 226 | $ | 301,793 | $ | 284,041 | $ | 567,255 | $ | 493,070 | $ | 828,359 | $ | 732,648 | $ | 1,697,635 | $ | 1,509,985 |\n| Total | $ | 19,886 | $ | 19,843 | $ | 1,132,668 | $ | 1,039,617 | $ | 1,061,045 | $ | 915,523 | $ | 1,089,949 | $ | 960,513 | $ | 3,303,548 | $ | 2,935,496 |\n\nIncluded in the table above are $ 24.8 million of callable securities at September 30, 2022.\nThe carrying value of securities pledged to secure public funds, trust deposits, and for other purposes, as required or permitted by law, was $ 963.9 million and $ 740.6 million at September 30, 2022 and December 31, 2021, respectively.\nAt September 30, 2022 and December 31, 2021, the Company had no investments in obligations of individual states, counties, or municipalities which exceeded 10% of consolidated stockholders’ equity.\n18\nNOTE 4 - LOANS, ALLOWANCE FOR CREDIT LOSSES AND CREDIT QUALITY\nLoans Held for Investment and Allowance for Credit Losses\nThe following table summarizes the change in allowance for credit losses by loan category, and bifurcates the amount of loans allocated to each loan category for the period indicated:\n| Three Months Ended September 30, 2022 |\n| (Dollars in thousands) |\n| Commercial andIndustrial | CommercialReal Estate | CommercialConstruction | SmallBusiness | ResidentialReal Estate | Home Equity | Other Consumer | Total |\n| Allowance for credit losses |\n| Beginning balance | $ | 14,107 | $ | 83,456 | $ | 11,710 | $ | 2,784 | $ | 19,750 | $ | 11,740 | $ | 772 | $ | 144,319 |\n| Charge-offs | — | ( 62 ) | — | — | — | — | ( 679 ) | ( 741 ) |\n| Recoveries | 2 | 330 | — | 88 | — | 65 | 251 | 735 |\n| Provision for (release of) credit losses | 6,060 | ( 3,688 ) | ( 291 ) | ( 248 ) | 852 | ( 154 ) | 469 | 3,000 |\n| Ending balance (1) | $ | 20,169 | $ | 80,036 | $ | 11,419 | $ | 2,624 | $ | 20,602 | $ | 11,651 | $ | 812 | $ | 147,313 |\n| Three Months Ended September 30, 2021 |\n| (Dollars in thousands) |\n| Commercial andIndustrial | CommercialReal Estate | CommercialConstruction | SmallBusiness | ResidentialReal Estate | Home Equity | Other Consumer | Total |\n| Allowance for credit losses |\n| Beginning balance | $ | 17,032 | $ | 44,325 | $ | 4,865 | $ | 3,612 | $ | 12,014 | $ | 20,087 | $ | 422 | $ | 102,357 |\n| Charge-offs | ( 1 ) | — | — | ( 83 ) | — | — | ( 248 ) | ( 332 ) |\n| Recoveries | 1 | — | — | 50 | — | 49 | 121 | 221 |\n| Provision for (release of) credit losses | ( 1,018 ) | ( 6,527 ) | ( 397 ) | 88 | ( 967 ) | ( 1,268 ) | 89 | ( 10,000 ) |\n| Ending balance (1) | $ | 16,014 | $ | 37,798 | $ | 4,468 | $ | 3,667 | $ | 11,047 | $ | 18,868 | $ | 384 | $ | 92,246 |\n| Nine Months Ended September 30, 2022 |\n| (Dollars in thousands) |\n| Commercial andIndustrial | CommercialReal Estate | CommercialConstruction | SmallBusiness | ResidentialReal Estate | Home Equity | Other Consumer | Total |\n| Allowance for credit losses |\n| Beginning balance | $ | 14,402 | $ | 83,486 | $ | 12,316 | $ | 3,508 | $ | 14,484 | $ | 17,986 | $ | 740 | $ | 146,922 |\n| Charge-offs | — | ( 62 ) | — | ( 59 ) | — | ( 122 ) | ( 1,749 ) | ( 1,992 ) |\n| Recoveries | 44 | 333 | — | 147 | — | 105 | 754 | 1,383 |\n| Provision for (release of) credit losses | 5,723 | ( 3,721 ) | ( 897 ) | ( 972 ) | 6,118 | ( 6,318 ) | 1,067 | 1,000 |\n| Ending balance (1) | $ | 20,169 | $ | 80,036 | $ | 11,419 | $ | 2,624 | $ | 20,602 | $ | 11,651 | $ | 812 | $ | 147,313 |\n| Nine Months Ended September 30, 2021 |\n| (Dollars in thousands) |\n| Commercial andIndustrial | CommercialReal Estate | CommercialConstruction | SmallBusiness | ResidentialReal Estate | Home Equity | Other Consumer | Total |\n| Allowance for credit losses |\n| Beginning balance | $ | 21,086 | $ | 45,009 | $ | 5,397 | $ | 5,095 | $ | 14,275 | $ | 22,060 | $ | 470 | $ | 113,392 |\n| Charge-offs | ( 3,474 ) | — | — | ( 184 ) | — | ( 69 ) | ( 772 ) | ( 4,499 ) |\n| Recoveries | 100 | 57 | — | 65 | 1 | 107 | 523 | 853 |\n| Provision for (release of) credit losses | ( 1,698 ) | ( 7,268 ) | ( 929 ) | ( 1,309 ) | ( 3,229 ) | ( 3,230 ) | 163 | ( 17,500 ) |\n| Ending balance (1) | $ | 16,014 | $ | 37,798 | $ | 4,468 | $ | 3,667 | $ | 11,047 | $ | 18,868 | $ | 384 | $ | 92,246 |\n\n(1) Balances of accrued interest receivable excluded from amortized cost and the calculation of allowance for credit losses amounted to $ 42.7 million and $ 36.7 million as of September 30, 2022 and September 30, 2021, respectively.\n19\nThe balance of allowance for credit losses of $ 147.3 million as of September 30, 2022 remained relatively flat compared to $ 146.9 million at December 31, 2021. The nominal change in the Company's allowance for credit losses for the nine months ended September 30, 2022 primarily reflects increased reserves attributable to category shifts on nonperforming loans and net loan growth, offset by a stabilized credit environment and continued strong asset quality metrics.\nFor the purpose of estimating the allowance for credit losses, management segregated the loan portfolio into the portfolio segments detailed in the above tables. Each of these loan categories possesses unique risk characteristics that are considered when determining the appropriate level of allowance for each segment. Some of the characteristics unique to each loan category include:\nCommercial Portfolio\n•Commercial and Industrial: Loans in this category consist of revolving and term loan obligations extended to business and corporate enterprises for the purpose of financing working capital and/or capital investment. Collateral generally consists of pledges of business assets including, but not limited to: accounts receivable, inventory, plant and equipment, or real estate, if applicable. Repayment sources consist of primarily, operating cash flow, and secondarily, liquidation of assets.\n•Commercial Real Estate: Loans in this category consist of mortgage loans to finance investment in real property such as multi-family residential, commercial/retail, office, industrial, hotels, educational and healthcare facilities and other specific use properties. Loans are typically written with amortizing payment structures. Collateral values are determined based upon third party appraisals and evaluations. Loan to value ratios at origination are governed by established policy and regulatory guidelines. Repayment sources consist of, primarily, cash flow from operating leases and rents and, secondarily, liquidation of assets.\n•Commercial Construction: Loans in this category consist of short-term construction loans, revolving and nonrevolving credit lines and construction/permanent loans to finance the acquisition, development and construction or rehabilitation of real property. Project types include residential land development, one-to-four family, condominium, and multi-family home construction, commercial/retail, office, industrial, hotels, educational and healthcare facilities and other specific use properties. Loans may be written with nonamortizing or hybrid payment structures depending upon the type of project. Collateral values are determined based upon third party appraisals and evaluations. Loan to value ratios at origination are governed by established policy and regulatory guidelines. Repayment sources vary depending upon the type of project and may consist of sale or lease of units, operating cash flows or liquidation of other assets.\n•Small Business: Loans in this category consist of revolving, term loan and mortgage obligations extended to sole proprietors and small businesses for purposes of financing working capital and/or capital investment. Collateral generally consists of pledges of business assets including, but not limited to, accounts receivable, inventory, plant and equipment, or real estate if applicable. Repayment sources consist primarily of operating cash flows and, secondarily, liquidation of assets.\nFor the commercial portfolio it is the Company’s policy to obtain personal guarantees for payment from individuals holding material ownership interests in the borrowing entities.\nConsumer Portfolio\n•Residential Real Estate: Residential mortgage loans held in the Company’s portfolio are made to borrowers who demonstrate the ability to make scheduled payments with full consideration to underwriting factors such as current and expected income, employment status, current assets, other financial resources, credit history and the value of the collateral. Collateral consists of mortgage liens on one-to-four family residential properties. Residential mortgage loans also include loans to construct owner-occupied one-to-four family residential properties.\n•Home Equity: Home equity loans and credit lines are made to qualified individuals and are primarily secured by senior or junior mortgage liens on owner-occupied one-to-four family homes, condominiums or vacation homes. Each home equity loan has a fixed rate and is billed in equal payments comprised of principal and interest. The majority of home equity lines of credit have a variable rate and are billed in interest-only payments during the draw period. At the end of the draw period, the home equity line of credit is billed as a percentage of the then outstanding principal balance plus all accrued interest over a predetermined repayment period, as set forth in the note. Additionally, the Company has the option of renewing each line of credit for additional draw periods. Borrower qualifications include favorable credit history combined with supportive income requirements and combined loan to value ratios within established policy guidelines.\n•Other Consumer: Other consumer loan products include personal lines of credit and amortizing loans made to qualified individuals for various purposes such as debt consolidation, personal expenses or overdraft protection. Borrower qualifications include favorable credit history combined with supportive income and collateral requirements within established policy guidelines. These loans may be secured or unsecured.\n20\nCredit Quality\nThe Company continually monitors the asset quality of the loan portfolio using all available information. Based on this information, loans demonstrating certain payment issues or other weaknesses may be categorized as adversely risk-rated, delinquent, nonperforming and/or put on nonaccrual status. Additionally, in the course of resolving such loans, the Company may choose to restructure the contractual terms of certain loans to match the borrower’s ability to repay the loan based on their current financial condition.\nThe Company reviews numerous credit quality indicators when assessing the risk in its loan portfolio. For the commercial portfolio, the Company utilizes a 10-point credit risk-rating system, which assigns a risk-grade to each loan obligation based on a number of quantitative and qualitative factors associated with a commercial or small business loan transaction. Factors considered include industry and market conditions, position within the industry, earnings trends, operating cash flow, asset/liability values, debt capacity, guarantor strength, management and controls, financial reporting, collateral, and other considerations. The risk-rating categories for the commercial portfolio are defined as follows:\n•Pass: Risk-rating “1” through “6” comprises of loans ranging from ‘Substantially Risk Free’ which indicates borrowers are of unquestioned credit standing and the pinnacle of credit quality, well established companies with a very strong financial condition, and loans fully secured by cash collateral, through ‘Acceptable Risk’, which indicates borrowers may exhibit declining earnings, strained cash flow, increasing or above average leverage and/or weakening market fundamentals that indicate below average asset quality, margins and market share. Collateral coverage is protective.\n•Potential Weakness: Borrowers exhibit potential credit weaknesses or downward trends deserving management’s close attention. If not checked or corrected, these trends will weaken the Company’s asset and position. While potentially weak, currently these borrowers are marginally acceptable; no loss of principal or interest is envisioned.\n•Definite Weakness Loss Unlikely: Borrowers exhibit well defined weaknesses that jeopardize the orderly liquidation of debt. Loans may be inadequately protected by the current net worth and paying capacity of the obligor or by the collateral pledged, if any. Normal repayment from the borrower is in jeopardy, although no loss of principal is envisioned. However, there is a distinct possibility that a partial loss of interest and/or principal will occur if the deficiencies are not corrected. Collateral coverage may be inadequate to cover the principal obligation.\n•Partial Loss Probable: Borrowers exhibit well defined weaknesses that jeopardize the orderly liquidation of debt with the added provision that the weaknesses make collection of the debt in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Serious problems exist to the point where partial loss of principal is likely.\n•Definite Loss: Borrowers deemed incapable of repayment. Loans to such borrowers are considered uncollectible and of such little value that continuation as active assets of the Company is not warranted.\nThe Company utilizes a comprehensive, continuous strategy for evaluating and monitoring commercial credit quality. Initially, credit quality is determined at loan origination and is re-evaluated when subsequent actions, such as renewals, modifications or reviews, occur. Actively managed commercial borrowers are required to provide updated financial information at least annually which is carefully evaluated for any changes in credit quality. Larger loan relationships are subject to a full annual credit review by experienced credit professionals, while continuous portfolio monitoring techniques are employed to evaluate changes in credit quality for smaller loan relationships. Any changes in credit quality are reflected in risk-rating changes. Additionally, the Company retains an independent loan review firm to evaluate the credit quality of the commercial loan portfolio. The independent loan review process achieves significant penetration into the commercial loan portfolio and reports the results of these reviews to the Audit Committee of the Board of Directors on a quarterly basis. Commercial loan modifications granted by the Company allowing payment deferrals for qualifying borrowers in accordance with the Coronavirus Aid, Relief and Economic Security Act (\"CARES Act\") were assessed for potential downgrades of risk ratings.\nFor the Company’s consumer portfolio, the quality of the loan is best indicated by the repayment performance of an individual borrower. As a result, for this portfolio the Company utilizes a pass/default risk-rating system, based on an age analysis (i.e., days past due) associated with each consumer loan. Under this structure, consumer loans less than 90 days past due are assigned a \"pass\" rating, while any consumer loans 90 days or more past due are assigned a \"default\" rating.\nThe following table details the amortized cost balances of the Company's loan portfolios, presented by credit quality indicator and origination year as of the dates indicated below:\n21\n| September 30, 2022 |\n| 2022 | 2021 | 2020 | 2019 | 2018 | Prior | Revolving Loans | Revolving converted to Term | Total (1) |\n| (Dollars in thousands) |\n| Commercial andindustrial |\n| Pass (2) | $ | 292,601 | $ | 149,588 | $ | 122,752 | $ | 67,591 | $ | 82,911 | $ | 22,943 | $ | 759,390 | $ | 3,362 | $ | 1,501,138 |\n| Potential weakness | 1,540 | 973 | 1,038 | 1,844 | 3,955 | 715 | 6,557 | — | 16,622 |\n| Definite weakness - loss unlikely | 2,485 | 935 | — | 39 | — | 111 | 27,019 | — | 30,589 |\n| Partial loss probable | — | — | — | — | — | — | — | — | — |\n| Definite loss | — | — | — | — | — | — | — | — | — |\n| Total commercial and industrial | $ | 296,626 | $ | 151,496 | $ | 123,790 | $ | 69,474 | $ | 86,866 | $ | 23,769 | $ | 792,966 | $ | 3,362 | $ | 1,548,349 |\n| Commercial real estate |\n| Pass | $ | 922,772 | $ | 1,467,370 | $ | 1,265,711 | $ | 773,102 | $ | 733,621 | $ | 1,976,282 | $ | 47,317 | $ | 1,070 | $ | 7,187,245 |\n| Potential weakness | 32,579 | 53,096 | 41,164 | 14,147 | 68,298 | 205,234 | — | — | 414,518 |\n| Definite weakness - loss unlikely | 26,684 | 2,224 | 4,722 | 2,585 | 17,928 | 21,836 | — | — | 75,979 |\n| Partial loss probable | — | — | — | — | — | 175 | — | — | 175 |\n| Definite loss | — | — | — | — | — | — | — | — | — |\n| Total commercial real estate | $ | 982,035 | $ | 1,522,690 | $ | 1,311,597 | $ | 789,834 | $ | 819,847 | $ | 2,203,527 | $ | 47,317 | $ | 1,070 | $ | 7,677,917 |\n| Commercial construction |\n| Pass | $ | 388,627 | $ | 392,229 | $ | 231,336 | $ | 57,768 | $ | 26,263 | $ | 7,844 | $ | 21,457 | $ | 632 | $ | 1,126,156 |\n| Potential weakness | 40,631 | — | 3,387 | — | — | — | — | — | 44,018 |\n| Definite weakness - loss unlikely | 2,138 | 12,845 | — | — | — | — | — | — | 14,983 |\n| Partial loss probable | — | — | — | — | — | — | — | — | — |\n| Definite loss | — | — | — | — | — | — | — | — | — |\n| Total commercial construction | $ | 431,396 | $ | 405,074 | $ | 234,723 | $ | 57,768 | $ | 26,263 | $ | 7,844 | $ | 21,457 | $ | 632 | $ | 1,185,157 |\n| Small business |\n| Pass | $ | 41,923 | $ | 46,581 | $ | 31,968 | $ | 17,536 | $ | 10,454 | $ | 20,227 | $ | 37,455 | $ | — | $ | 206,144 |\n| Potential weakness | — | 163 | 394 | 369 | 193 | 129 | 697 | — | 1,945 |\n| Definite weakness - loss unlikely | 194 | — | 442 | 7 | 20 | 224 | 591 | — | 1,478 |\n| Partial loss probable | — | — | — | — | — | — | — | — | — |\n| Definite loss | — | — | — | — | — | — | — | — | — |\n| Total small business | $ | 42,117 | $ | 46,744 | $ | 32,804 | $ | 17,912 | $ | 10,667 | $ | 20,580 | $ | 38,743 | $ | — | $ | 209,567 |\n| Residential real estate |\n| Pass | $ | 557,643 | $ | 426,721 | $ | 196,538 | $ | 95,689 | $ | 96,828 | $ | 582,830 | $ | — | $ | — | $ | 1,956,249 |\n| Default | — | — | 676 | 466 | 376 | 1,487 | — | — | 3,005 |\n| Total residential real estate | $ | 557,643 | $ | 426,721 | $ | 197,214 | $ | 96,155 | $ | 97,204 | $ | 584,317 | $ | — | $ | — | $ | 1,959,254 |\n| Home equity |\n| Pass | $ | 37,298 | $ | 61,898 | $ | 56,262 | $ | 32,761 | $ | 27,906 | $ | 124,325 | $ | 741,952 | $ | 3,190 | $ | 1,085,592 |\n| Default | — | — | — | 122 | — | 285 | 1,171 | — | 1,578 |\n| Total home equity | $ | 37,298 | $ | 61,898 | $ | 56,262 | $ | 32,883 | $ | 27,906 | $ | 124,610 | $ | 743,123 | $ | 3,190 | $ | 1,087,170 |\n| Other consumer |\n| Pass | $ | 383 | $ | 2,498 | $ | 1,969 | $ | 1,370 | $ | 380 | $ | 3,630 | $ | 22,680 | $ | — | $ | 32,910 |\n| Default | — | 14 | — | — | — | 11 | 1 | — | 26 |\n| Total other consumer | $ | 383 | $ | 2,512 | $ | 1,969 | $ | 1,370 | $ | 380 | $ | 3,641 | $ | 22,681 | $ | — | $ | 32,936 |\n| Total | $ | 2,347,498 | $ | 2,617,135 | $ | 1,958,359 | $ | 1,065,396 | $ | 1,069,133 | $ | 2,968,288 | $ | 1,666,287 | $ | 8,254 | $ | 13,700,350 |\n\n22\n| September 30, 2021 |\n| 2021 | 2020 | 2019 | 2018 | 2017 | Prior | Revolving Loans | Revolving converted to Term | Total (1) |\n| (Dollars in thousands) |\n| Commercial andindustrial |\n| Pass (2) | $ | 590,532 | $ | 185,706 | $ | 97,095 | $ | 74,381 | $ | 15,175 | $ | 16,731 | $ | 605,718 | $ | 66 | $ | 1,585,404 |\n| Potential weakness | 1,338 | 9,035 | 3,286 | 1,672 | 980 | 1,632 | 10,262 | — | 28,205 |\n| Definite weakness - loss unlikely | 16,597 | 332 | 793 | 1,034 | 2,678 | 214 | 5,452 | — | 27,100 |\n| Partial loss probable | — | — | — | — | — | — | — | — | — |\n| Definite loss | — | — | — | — | — | — | — | — | — |\n| Total commercial and industrial | $ | 608,467 | $ | 195,073 | $ | 101,174 | $ | 77,087 | $ | 18,833 | $ | 18,577 | $ | 621,432 | $ | 66 | $ | 1,640,709 |\n| Commercial real estate |\n| Pass | $ | 699,565 | $ | 1,019,453 | $ | 606,645 | $ | 347,874 | $ | 442,306 | $ | 794,263 | $ | 17,068 | $ | — | $ | 3,927,174 |\n| Potential weakness | 22,106 | 29,091 | 51,976 | 14,628 | 21,350 | 82,655 | 13,615 | — | 235,421 |\n| Definite weakness - loss unlikely | 9,331 | 16,336 | 3,399 | 13,657 | 9,762 | 6,179 | — | — | 58,664 |\n| Partial loss probable | — | — | — | — | — | — | — | — | — |\n| Definite loss | — | — | — | — | — | — | — | — | — |\n| Total commercial real estate | $ | 731,002 | $ | 1,064,880 | $ | 662,020 | $ | 376,159 | $ | 473,418 | $ | 883,097 | $ | 30,683 | $ | — | $ | 4,221,259 |\n| Commercial construction |\n| Pass | $ | 127,945 | $ | 216,573 | $ | 82,559 | $ | 22,851 | $ | 22,873 | $ | 6,505 | $ | 16,424 | $ | 2,134 | $ | 497,864 |\n| Potential weakness | — | 12,991 | — | — | — | — | — | — | 12,991 |\n| Definite weakness - loss unlikely | — | 4,560 | — | — | — | — | — | — | 4,560 |\n| Partial loss probable | — | — | — | — | — | — | — | — | — |\n| Definite loss | — | — | — | — | — | — | — | — | — |\n| Total commercial construction | $ | 127,945 | $ | 234,124 | $ | 82,559 | $ | 22,851 | $ | 22,873 | $ | 6,505 | $ | 16,424 | $ | 2,134 | $ | 515,415 |\n| Small business |\n| Pass | $ | 40,736 | $ | 38,804 | $ | 22,075 | $ | 14,241 | $ | 10,675 | $ | 21,809 | $ | 32,679 | $ | — | $ | 181,019 |\n| Potential weakness | 14 | — | 383 | 200 | 5 | 174 | 627 | — | 1,403 |\n| Definite weakness - loss unlikely | 138 | 637 | 41 | 26 | 10 | 284 | 580 | — | 1,716 |\n| Partial loss probable | — | — | — | — | — | — | — | — | — |\n| Definite loss | — | — | — | — | — | — | — | — | — |\n| Total small business | $ | 40,888 | $ | 39,441 | $ | 22,499 | $ | 14,467 | $ | 10,690 | $ | 22,267 | $ | 33,886 | $ | — | $ | 184,138 |\n| Residential real estate |\n| Pass | $ | 277,949 | $ | 184,974 | $ | 92,723 | $ | 97,915 | $ | 102,581 | $ | 463,397 | $ | — | $ | — | $ | 1,219,539 |\n| Default | — | 123 | — | 1,024 | — | 2,163 | — | — | 3,310 |\n| Total residential real estate | $ | 277,949 | $ | 185,097 | $ | 92,723 | $ | 98,939 | $ | 102,581 | $ | 465,560 | $ | — | $ | — | $ | 1,222,849 |\n| Home equity |\n| Pass | $ | 58,897 | $ | 68,629 | $ | 42,083 | $ | 37,644 | $ | 41,792 | $ | 117,488 | $ | 628,575 | $ | 3,575 | $ | 998,683 |\n| Default | — | — | — | — | — | 33 | 1,717 | 35 | 1,785 |\n| Total home equity | $ | 58,897 | $ | 68,629 | $ | 42,083 | $ | 37,644 | $ | 41,792 | $ | 117,521 | $ | 630,292 | $ | 3,610 | $ | 1,000,468 |\n| Other consumer |\n| Pass | $ | 307 | $ | 347 | $ | 244 | $ | 78 | $ | 500 | $ | 5,338 | $ | 16,359 | $ | — | $ | 23,173 |\n| Default | — | — | — | — | — | — | 2 | — | 2 |\n| Total other consumer | $ | 307 | $ | 347 | $ | 244 | $ | 78 | $ | 500 | $ | 5,338 | $ | 16,361 | $ | — | $ | 23,175 |\n| Total | $ | 1,845,455 | $ | 1,787,591 | $ | 1,003,302 | $ | 627,225 | $ | 670,687 | $ | 1,518,865 | $ | 1,349,078 | $ | 5,810 | $ | 8,808,013 |\n\n23\n(1) Loan origination dates in the tables above reflect the original origination date, or the date of a material modification of a previously originated loan.\n(2) Loans originated as part of the Paycheck Protection Program (\"PPP\") established by the CARES Act are included within commercial and industrial under the 2021 and 2020 vintage year and \"pass\" category as these loans are 100% guaranteed by the U.S. Government. Outstanding PPP loans totaled $ 11.1 million and $ 383.6 million as of September 30, 2022 and 2021, respectively.\nFor the Company’s consumer portfolio, the quality of the loan is best indicated by the repayment performance of an individual borrower. However, the Company does supplement performance data with current Fair Isaac Corporation (“FICO”) scores and Loan to Value (“LTV”) estimates. Current FICO data is purchased and appended to all consumer loans on a regular basis. In addition, automated valuation services and broker opinions of value are used to supplement original value data for the residential real estate and home equity portfolios, periodically. The following table shows the weighted average FICO scores and the weighted average combined LTV ratios at the dates indicated below:\n| September 302022 | December 312021 |\n| Residential real estate portfolio |\n| FICO score (re-scored)(1) | 753 | 749 |\n| LTV (re-valued)(2) | 54.8 | % | 54.4 | % |\n| Home equity portfolio |\n| FICO score (re-scored)(1) | 771 | 772 |\n| LTV (re-valued)(2)(3) | 40.9 | % | 42.4 | % |\n\n(1) The average FICO scores at September 30, 2022 are based upon rescores from June 2022, as available for previously originated loans, or origination score data for loans booked since June 2022. The average FICO scores at December 31, 2021 were based upon rescores available from December 2021, as available for previously originated loans, or origination score data for loans booked in December 2021.\n(2) The combined LTV ratios for September 30, 2022 are based upon updated automated valuations as of August 2022, when available, and/or the most current valuation data available. The combined LTV ratios for December 31, 2021 were based upon updated automated valuations as of November 2021, when available, and/or the most current valuation data available as of such date. The updated automated valuations provide new information on loans that may be available since the previous valuation was obtained. If no new information is available, the valuation will default to the previously obtained data or most recent appraisal.\n(3) For home equity loans and lines in a subordinate lien, the LTV data represents a combined LTV, taking into account the senior lien data for loans and lines.\nUnfunded Commitments\nManagement evaluates the need for a reserve on unfunded lending commitments in a manner consistent with loans held for investment. At September 30, 2022 and December 31, 2021, the Company's estimated reserve for unfunded commitments amounted to $ 1.3 million and $ 1.5 million, respectively.\nAsset Quality\nThe Company’s philosophy toward managing its loan portfolios is predicated upon careful monitoring, which stresses early detection and response to delinquent and default situations. Delinquent loans are managed by a team of collection specialists and the Company seeks to make arrangements to resolve any delinquent or default situation over the shortest possible time frame. As a general rule, loans 90 days or more past due with respect to principal or interest are classified as nonaccrual loans. The Company also may use discretion regarding other loans 90 days or more delinquent if the loan is well secured and/or in process of collection.\nIn response to the COVID-19 pandemic, the Company has granted loan modifications to allow deferral of payments for borrowers negatively impacted by the pandemic. The balance of loans with active deferrals as of September 30, 2022 and December 31, 2021 was $ 193.3 million and $ 383.1 million, respectively. The majority of these loans with active deferrals as of September 30, 2022 continue to be characterized as current loans. In accordance with regulatory guidance, these modifications are not considered to be troubled debt restructures (\"TDRs\") if they were performing as of December 31, 2019. Additionally, a majority of these modified loans are characterized as current and therefore are not impacting nonaccrual or delinquency totals as of September 30, 2022 and December 31, 2021. The Company does, however, consider all active deferrals when estimating loss reserves. As loans reach their deferral maturity date, consideration of TDR and delinquency status will resume in accordance with the Company's accounting policy.\n24\nThe following table shows information regarding nonaccrual loans as of the dates indicated:\n| Nonaccrual Balances |\n| September 30, 2022 | December 31, 2021 |\n| With Allowance for Credit Losses | Without Allowance for Credit Losses | Total | With Allowance for Credit Losses | Without Allowance for Credit Losses | Total |\n| (Dollars in thousands) |\n| Commercial and industrial | $ | 27,374 | $ | 19 | $ | 27,393 | $ | 3,420 | $ | 19 | $ | 3,439 |\n| Commercial real estate | 15,982 | — | 15,982 | 10,870 | — | 10,870 |\n| Small business | 50 | — | 50 | 44 | — | 44 |\n| Residential real estate | 8,891 | — | 8,891 | 8,580 | 602 | 9,182 |\n| Home equity | 3,485 | — | 3,485 | 3,781 | — | 3,781 |\n| Other consumer | 216 | — | 216 | 504 | — | 504 |\n| Total nonaccrual loans (1) | $ | 55,998 | $ | 19 | $ | 56,017 | $ | 27,199 | $ | 621 | $ | 27,820 |\n\n(1) Included in these amounts were $ 1.5 million and $ 2.0 million of nonaccruing TDRs at September 30, 2022 and December 31, 2021, respectively.\nIt is the Company's policy to reverse any accrued interest when a loan is put on nonaccrual status, and, as such, the Company did not record any interest income on nonaccrual loans during the nine months ended September 30, 2022 and 2021.\nThe following table shows information regarding foreclosed residential real estate property at the dates indicated:\n| September 30, 2022 | December 31, 2021 |\n| (Dollars in thousands) |\n| Foreclosed residential real estate property held by the creditor | $ | — | $ | — |\n| Recorded investment in mortgage loans collateralized by residential real estate property that are in the process of foreclosure | $ | 1,871 | $ | 1,426 |\n\nThe following tables show the age analysis of past due financing receivables as of the dates indicated:\n| September 30, 2022 |\n| 30-59 days | 60-89 days | 90 days or more | Total Past Due | TotalFinancingReceivables | Amortized Cost>90 Daysand Accruing |\n| Numberof Loans | PrincipalBalance | Numberof Loans | PrincipalBalance | Numberof Loans | PrincipalBalance | Numberof Loans | PrincipalBalance | Current |\n| (Dollars in thousands) |\n| Loan Portfolio |\n| Commercial and industrial | 10 | $ | 322 | 1 | $ | 182 | 3 | $ | 558 | 14 | $ | 1,062 | $ | 1,547,287 | $ | 1,548,349 | $ | — |\n| Commercial real estate | 9 | 5,419 | 5 | 4,491 | 2 | 208 | 16 | 10,118 | 7,667,799 | 7,677,917 | — |\n| Commercial construction | — | — | 1 | 1,661 | — | — | 1 | 1,661 | 1,183,496 | 1,185,157 | — |\n| Small business | 7 | 233 | 3 | 15 | 6 | 29 | 16 | 277 | 209,290 | 209,567 | — |\n| Residential real estate | 15 | 3,146 | 6 | 1,202 | 19 | 1,804 | 40 | 6,152 | 1,953,102 | 1,959,254 | — |\n| Home equity | 14 | 534 | 8 | 775 | 19 | 1,577 | 41 | 2,886 | 1,084,284 | 1,087,170 | — |\n| Other consumer (1) | 504 | 510 | 36 | 245 | 8 | 26 | 548 | 781 | 32,155 | 32,936 | — |\n| Total | 559 | $ | 10,164 | 60 | $ | 8,571 | 57 | $ | 4,202 | 676 | $ | 22,937 | $ | 13,677,413 | $ | 13,700,350 | $ | — |\n\n25\n| December 31, 2021 |\n| 30-59 days | 60-89 days | 90 days or more | Total Past Due | TotalFinancingReceivables | RecordedInvestment>90 Daysand Accruing |\n| Numberof Loans | PrincipalBalance | Numberof Loans | PrincipalBalance | Numberof Loans | PrincipalBalance | Numberof Loans | PrincipalBalance | Current |\n| (Dollars in thousands) |\n| Loan Portfolio |\n| Commercial and industrial | 7 | $ | 143 | 2 | $ | 252 | 2 | $ | 24 | 11 | $ | 419 | $ | 1,562,860 | $ | 1,563,279 | $ | — |\n| Commercial real estate | 15 | 32,845 | — | — | 4 | 1,339 | 19 | 34,184 | 7,958,160 | 7,992,344 | — |\n| Commercial construction | — | — | — | — | — | — | — | — | 1,165,457 | 1,165,457 | — |\n| Small business | 11 | 136 | 6 | 53 | 4 | 24 | 21 | 213 | 192,976 | 193,189 | — |\n| Residential real estate | 12 | 2,709 | 5 | 714 | 76 | 3,922 | 93 | 7,345 | 1,597,341 | 1,604,686 | — |\n| Home equity | 15 | 1,375 | 6 | 381 | 21 | 1,671 | 42 | 3,427 | 1,036,184 | 1,039,611 | — |\n| Other consumer (1) | 458 | 719 | 41 | 277 | 16 | 112 | 515 | 1,108 | 27,612 | 28,720 | — |\n| Total | 518 | $ | 37,927 | 60 | $ | 1,677 | 123 | $ | 7,092 | 701 | $ | 46,696 | $ | 13,540,590 | $ | 13,587,286 | $ | — |\n\n(1) Other consumer portfolio is inclusive of deposit account overdrafts recorded as loan balances.\nTroubled Debt Restructurings\nIn the course of resolving nonperforming loans, the Bank may choose to restructure the contractual terms of certain loans. The Bank attempts to work out an alternative payment schedule with the borrower in order to avoid foreclosure actions. Exclusive of loans modified under provisions of the CARES Act, any loans that are modified are reviewed by the Bank to identify if a TDR has occurred, which is when, for economic or legal reasons related to a borrower’s financial difficulties, the Bank grants a concession to the borrower that it would not otherwise consider. Terms may be modified to fit the ability of the borrower to repay in line with its current financial status and the restructuring of the loan may include the transfer of assets from the borrower to satisfy the debt, a modification of loan terms, or a combination of the two.\nThe following table shows the Company’s total TDRs and other pertinent information as of the dates indicated:\n| September 30, 2022 | December 31, 2021 |\n| (Dollars in thousands) |\n| TDRs on accrual status | $ | 11,549 | $ | 14,635 |\n| TDRs on nonaccrual | 1,538 | 1,993 |\n| Total TDRs | $ | 13,087 | $ | 16,628 |\n| Additional commitments to lend to a borrower who has been a party to a TDR | $ | 137 | $ | 190 |\n\nThe Company’s policy is to have any restructured loan which is on nonaccrual status prior to being modified remain on nonaccrual status for six months subsequent to being modified before management considers its return to accrual status. If the restructured loan is on accrual status prior to being modified, it is reviewed to determine if the modified loan should remain on accrual status. Additionally, loans classified as TDRs are adjusted to reflect the changes in value of the recorded investment in the loan, if any, resulting from the granting of a concession. For all residential loan modifications, the borrower must perform during a 90 day trial period before the modification is finalized.\n26\nThe following table shows the TDRs which occurred during the periods indicated and the change in the recorded investment subsequent to the modifications occurring:\n| Three Months Ended | Nine Months Ended |\n| September 30, 2022 | September 30, 2022 |\n| Number ofContracts | Pre-ModificationOutstandingRecordedInvestment | Post-ModificationOutstandingRecordedInvestment | Number ofContracts | Pre-ModificationOutstandingRecordedInvestment | Post-ModificationOutstandingRecordedInvestment |\n| (Dollars in thousands) | (Dollars in thousands) |\n| Troubled debt restructurings |\n| Commercial and industrial | 1 | $ | 68 | $ | 67 | 1 | 68 | 67 |\n| Total (1) | 1 | $ | 68 | $ | 67 | 1 | 68 | 67 |\n| Three Months Ended | Nine Months Ended |\n| September 30, 2021 | September 30, 2021 |\n| Number ofContracts | Pre-ModificationOutstandingRecordedInvestment | Post-ModificationOutstandingRecordedInvestment | Number ofContracts | Pre-ModificationOutstandingRecordedInvestment | Post-ModificationOutstandingRecordedInvestment |\n| (Dollars in thousands) |\n| Troubled debt restructurings |\n| Commercial and industrial | — | $ | — | $ | — | 1 | $ | 14,148 | $ | 14,148 |\n| Commercial real estate | — | — | — | 5 | 3,964 | 3,964 |\n| Small business | — | — | — | 2 | 189 | 189 |\n| Total (1) | — | $ | — | $ | — | 8 | $ | 18,301 | $ | 18,301 |\n\n(1) The pre-modification and post-modification balances represent the legal principal balance of the loan. Activity presented in the table above includes $ 14.3 million of modifications on existing TDRs occurring during the nine months ended September 30, 2021.\nThe following table shows the Company’s post-modification balance of TDRs listed by type of modification for the periods indicated:\n| Three Months Ended | Nine Months Ended |\n| September 30 | September 30 |\n| 2022 | 2021 | 2022 | 2021 |\n| (Dollars in thousands) |\n| Combination rate and maturity | — | — | — | 14,148 |\n| Extended maturity | 67 | — | 67 | 4,153 |\n| Total | 67 | — | $ | 67 | $ | 18,301 |\n\nThe Company considers a loan to have defaulted when it reaches 90 days past due. During the nine months ended September 30, 2022 and September 30, 2021, there were no loans modified during the prior twelve months that subsequently defaulted during the respective periods. The Company determines the amount of allowance on TDRs in accordance with CECL methodology using a discounted cash flow approach, or a fair value of collateral approach if the loan is determined to be individually evaluated.\n27\nNOTE 5 - STOCK BASED COMPENSATION\nDuring the nine months ended September 30, 2022, the Company had the following activity related to stock based compensation:\nTime Vested Restricted Stock Awards\nThe Company made the following awards of time vested restricted stock:\n| Date | Shares Granted | Plan | Grant Date Fair Value Per Share | Vesting Period |\n| 2/17/2022 | 52,100 | 2005 Employee Stock Plan | $ | 84.70 | Ratably over 5 years from grant date |\n| 5/24/2022 | 8,099 | 2018 Non-Employee Director Stock Plan | $ | 80.39 | Shares vested immediately |\n| 9/15/2022 | 646 | 2005 Employee Stock Plan | $ | 77.44 | Ratably over 5 years from grant date |\n\nPerformance-Based Restricted Stock Awards\nOn February 17, 2022, the Company granted 20,700 performance-based restricted stock awards, representing the maximum number of shares that may be earned under the awards, to certain executive level employees. These performance-based restricted stock awards were issued from the 2005 Employee Stock Plan and were determined to have a grant date fair value per share of $ 84.70 . The number of shares to be vested are contingent upon the Company's attainment of certain performance criteria to be measured at the end of a three year performance period, ending December 31, 2024. The awards will vest upon the earlier of the date on which it is determined if the performance goal is achieved subsequent to the performance period or March 31, 2025.\nOn March 10, 2022, the performance-based restricted stock awards that were awarded on February 21, 2019 vested at 50 % of the maximum target shares awarded, or 7,450 shares.\n28\nNOTE 6 - DERIVATIVE AND HEDGING ACTIVITIES\nThe Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally to manage the Company’s interest rate risk. Additionally, the Company enters into interest rate derivatives, foreign exchange contracts and risk participation agreements to accommodate the business requirements of its customers (“customer related positions”). The Company minimizes the market and liquidity risks of customer related positions by entering into similar offsetting positions with broker-dealers. Derivative instruments are carried at fair value in the Company's financial statements. The accounting for changes in the fair value of a derivative instrument is dependent upon whether or not it qualifies as a hedge for accounting purposes, and further, by the type of hedging relationship.\nThe Company does not enter into proprietary trading positions for any derivatives.\nThe Company is subject to over-the-counter derivative clearing requirements which require certain derivatives to be cleared through central clearing houses. Accordingly, the Company clears certain derivative transactions through the Chicago Mercantile Exchange Clearing House (\"CME\"). This clearing house requires the Company to post initial and variation margin to mitigate the risk of non-payment, the latter of which is received or paid daily based on the net asset or liability position of the contracts.\nInterest Rate Positions\nThe Company may utilize various interest rate derivatives as hedging instruments against interest rate risk associated with the Company’s borrowings and loan portfolios. An interest rate derivative is an agreement whereby one party agrees to pay a floating rate of interest on a notional principal amount in exchange for receiving a fixed rate of interest on the same notional amount, for a predetermined period of time, from a second party. The amounts relating to the notional principal amount are not actually exchanged.\n29\nThe following tables reflect the Company's derivative positions as of the dates indicated below for interest rate derivatives which qualify as cash flow hedges for accounting purposes:\n| September 30, 2022 |\n| Weighted Average Rate |\n| Notional Amount | Average Maturity | Current Rate Paid | Receive Fixed Swap Rate | Fair Value |\n| (in thousands) | (in years) | (in thousands) |\n| Interest rate swaps on loans | $ | 1,050,000 | 3.23 | 2.72 | % | 2.66 | % | $ | ( 43,365 ) |\n| Current Rate Paid | Receive Fixed Swap Rate Cap - Floor |\n| Interest rate collars on loans | 400,000 | 2.52 | 2.69 | % | 3.09 % - 2.19 % | ( 10,375 ) |\n| Total | $ | 1,450,000 | $ | ( 53,740 ) |\n| December 31, 2021 |\n| Weighted Average Rate |\n| Notional Amount | Average Maturity | CurrentRateReceived | Pay FixedSwap Rate | Fair Value |\n| (in thousands) | (in years) | (in thousands) |\n| Interest rate swaps on borrowings | $ | 25,000 | 0.62 | 0.16 | % | 1.88 | % | $ | ( 294 ) |\n| Current Rate Paid | Receive Fixed Swap Rate |\n| Interest rate swaps on loans | 550,000 | 2.58 | 0.11 | % | 2.16 | % | 11,830 |\n| Current Rate Paid | Receive Fixed Swap Rate Cap - Floor |\n| Interest rate collars on loans | 400,000 | 1.66 | 0.11 | % | 2.73 % - 2.20 % | 9,383 |\n| Total | $ | 975,000 | $ | 20,919 |\n\nThe maximum length of time over which the Company is currently hedging its exposure to the variability in future cash flows for forecasted transactions related to the payment of variable interest on existing financial instruments is 6.5 years.\nFor derivative instruments that are designated and qualify as cash flow hedging instruments, the effective portion of the gains or losses is reported as a component of other comprehensive income (\"OCI\"), and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. The Company expects approximately $ 22.5 million (pre-tax) to be reclassified as an increase to interest expense, from OCI related to the Company’s cash flow hedges in the twelve months following September 30, 2022. This reclassification is due to anticipated payments that will be made and/or received on the swaps based upon the forward curve as of September 30, 2022.\nThe Company had no fair value hedges as of September 30, 2022 or December 31, 2021.\nCustomer Related Positions\nLoan level derivatives, primarily interest rate swaps, offered to commercial borrowers through the Company’s loan level derivative program do not qualify as hedges for accounting purposes. The Company believes that its exposure to commercial customer derivatives is limited because these contracts are simultaneously matched at inception with an offsetting dealer transaction. Derivatives with dealer counterparties are then either cleared through a clearinghouse or settled directly with a single counterparty. The commercial customer derivative program allows the Company to retain variable-rate commercial loans while allowing the customer to synthetically fix the loan rate by entering into a variable-to-fixed interest rate swap. The amounts relating to the notional principal amount are not actually exchanged.\n30\nForeign exchange contracts offered to commercial borrowers through the Company’s derivative program do not qualify as hedges for accounting purposes. The Company acts as a seller and buyer of foreign exchange contracts to accommodate its customers. To mitigate the market and liquidity risk associated with these derivatives, the Company enters into similar offsetting positions. The amounts relating to the notional principal amount are exchanged.\nThe Company has entered into risk participation agreements with other dealer banks in commercial loan agreements. Participating banks guarantee the performance on borrower-related interest rate swap contracts. These derivatives are not designated as hedges and, therefore, changes in fair value are recognized in earnings. Under a risk participation-out agreement, a derivative asset, the Company participates out a portion of the credit risk associated with the interest rate swap position executed with the commercial borrower for a fee paid to the participating bank. Under a risk participation-in agreement, a derivative liability, the Company assumes, or participates in, a portion of the credit risk associated with the interest rate swap position with the commercial borrower for a fee received from the other bank.\n31\nThe following table reflects the Company’s customer related derivative positions as of the dates indicated below for those derivatives not designated as hedging:\n| Notional Amount Maturing |\n| Number of Positions (1) | Less than 1 year | Less than 2 years | Less than 3 years | Less than 4 years | Thereafter | Total | Fair Value |\n| September 30, 2022 |\n| (Dollars in thousands) |\n| Loan level swaps |\n| Receive fixed, pay variable | 285 | $ | 82,932 | $ | 98,409 | $ | 259,419 | $ | 173,197 | $ | 953,915 | $ | 1,567,872 | $ | ( 127,611 ) |\n| Pay fixed, receive variable | 285 | 82,932 | 98,409 | 259,419 | 173,197 | 953,915 | 1,567,872 | 127,609 |\n| Foreign exchange contracts |\n| Buys foreign currency, sells U.S. currency | 62 | 162,094 | 13,013 | — | — | — | 175,107 | ( 15,992 ) |\n| Buys U.S. currency, sells foreign currency | 62 | 162,094 | 13,013 | — | — | — | 175,107 | 16,079 |\n| Risk participation agreements |\n| Participation out | 11 | 2,605 | — | 24,538 | — | 72,045 | 99,188 | 64 |\n| Participation in | 7 | 22,802 | 16,329 | — | — | 25,944 | 65,075 | ( 15 ) |\n| Notional Amount Maturing |\n| Number of Positions (1) | Less than 1 year | Less than 2 years | Less than 3 years | Less than 4 years | Thereafter | Total | Fair Value |\n| December 31, 2021 |\n| (Dollars in thousands) |\n| Loan level swaps |\n| Receive fixed, pay variable | 296 | $ | 37,589 | $ | 139,844 | $ | 123,507 | $ | 260,953 | $ | 1,060,276 | $ | 1,622,169 | $ | 55,984 |\n| Pay fixed, receive variable | 296 | 37,589 | 139,844 | 123,507 | 260,953 | 1,060,276 | 1,622,169 | ( 55,982 ) |\n| Foreign exchange contracts |\n| Buys foreign currency, sells U.S. currency | 52 | 149,588 | 8,784 | — | — | — | 158,372 | 5,734 |\n| Buys U.S. currency, sells foreign currency | 52 | 149,588 | 8,784 | — | — | — | 158,372 | ( 5,734 ) |\n| Risk participation agreements |\n| Participation out | 11 | — | 2,635 | 7,138 | 24,539 | 68,408 | 102,720 | 279 |\n| Participation in | 7 | 29,972 | 28,235 | — | — | 8,339 | 66,546 | ( 55 ) |\n\n(1) The Company may enter into one dealer swap agreement which offsets multiple commercial borrower swap agreements.\n32\nMortgage Derivatives\nThe Company enters into commitments to fund residential mortgage loans at specified rates and times in the future, with the intention that loans may be sold subsequently in the secondary market. Mortgage loan commitments are referred to as derivative loan commitments if the loan that will result from exercise of the commitment will be held for sale upon funding. These commitments are recognized at fair value on the consolidated balance sheet in other assets and other liabilities with changes in their fair values recorded within mortgage banking income. In addition, the Company has elected the fair value option to carry loans held for sale at fair value. The change in fair value of loans held for sale is recorded in current period earnings as a component of mortgage banking income in accordance with the Company's fair value election. The fair value of loans held for sale decreased by $ 194,000 and $ 75,000 for the three months ended September 30, 2022 and 2021, respectively. The fair value of loans held for sale decreased by $ 620,000 and $ 1.5 million for the nine months ended September 30, 2022 and 2021, respectively. These amounts were offset in earnings by the change in the fair value of mortgage derivatives.\nOutstanding loan commitments expose the Company to the risk that the price of the loans arising from exercise of the loan commitment might change from inception of the rate lock to funding of the loan due to changes in mortgage interest rates. If interest rates increase, the value of these loan commitments decreases. Conversely, if interest rates decrease, the value of these loan commitments increases. To protect against the price risk inherent in derivative loan commitments, the Company utilizes both \"mandatory delivery\" and \"best efforts\" forward loan sale commitments to mitigate the risk of potential decreases in the values of loans that would result from the exercise of the derivative loan commitments. Mandatory delivery contracts are accounted for as derivative instruments. Included in the mandatory delivery forward commitments are To Be Announced securities (\"TBAs\"). Certain assumptions, including pull through rates and rate lock periods, are used in managing the existing and future hedges. The accuracy of underlying assumptions will impact the ultimate effectiveness of any hedging strategies.\nWith mandatory delivery contracts, the Company commits to deliver a certain principal amount of mortgage loans to an investor at a specified price on or before a specified date. If the Company fails to deliver the amount of mortgages necessary to fulfill the commitment by the specified date, it is obligated to pay a \"pair-off\" fee, based on then-current market prices, to the investor/counterparty to compensate the investor for the shortfall. Generally, the Company makes this type of commitment once mortgage loans have been funded and are held for sale, in order to minimize the risk of failure to deliver the requisite volume of loans to the investor and paying pair-off fees as a result. The Company also sells TBA securities to offset potential changes in the fair value of derivative loan commitments. Generally, the Company sells TBA securities by entering into derivative loan commitments for settlement in 30 to 90 days. The Company expects that mandatory delivery contracts, including TBA securities, will experience changes in fair value opposite to the changes in the fair value of derivative loan commitments.\nWith best effort contracts, the Company commits to deliver an individual mortgage loan of a specified principal amount and quality to an investor if the loan to the underlying borrower closes. Generally, best efforts cash contracts have no pair off risk regardless of market movement. The price the investor will pay the seller for an individual loan is specified prior to the loan being funded (e.g., on the same day the lender commits to lend funds to a potential borrower). The Company expects that these best efforts forward loan sale commitments will experience a net neutral shift in fair value with related derivative loan commitments.\nThe aggregate amount of net realized gains on sales of such loans included within mortgage banking income was $ 229,000 and $ 4.9 million for the three months ended September 30, 2022 and 2021, respectively, and $ 550,000 and $ 17.2 million for the nine months ended September 30, 2022 and 2021, respectively.\nBalance Sheet Offsetting\nThe Company does not offset fair value amounts recognized for derivative instruments. The Company does net the amount recognized for the right to reclaim cash collateral against the obligation to return cash collateral arising from derivative instruments executed with the same counterparty under a master netting arrangement. Collateral legally required to be maintained at dealer banks by the Company is monitored and adjusted as necessary.\nA daily settlement occurs through the CME for changes in the fair value of centrally cleared derivatives. Not all of the derivatives are required to be cleared through the daily clearing agent. As a result, the total fair values of loan level derivative assets and liabilities recognized on the Company's financial statements are not equal and offsetting.\n33\nThe table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the balance sheet and the potential effect of netting arrangements on its financial position, at the dates indicated:\n| Asset Derivatives (1) | Liability Derivatives (2) |\n| Fair Value at | Fair Value at | Fair Value at | Fair Value at |\n| September 302022 | December 312021 | September 302022 | December 312021 |\n| (Dollars in thousands) |\n| Derivatives designated as hedges |\n| Interest rate derivatives | $ | — | $ | 21,951 | (3) | $ | 53,740 | (4) | $ | 1,032 | (4) |\n| Derivatives not designated as hedges |\n| Customer Related Positions |\n| Loan level derivatives | 127,625 | (3) | 68,726 | (3) | 127,627 | (4) | 68,724 | (4) |\n| Foreign exchange contracts | 16,520 | 6,147 | 16,433 | 6,147 |\n| Risk participation agreements | 64 | 279 | 15 | 55 |\n| Mortgage Derivatives |\n| Interest rate lock commitments | 6 | 753 | 16 | — |\n| Forward sale loan commitments | 86 | 56 | — | — |\n| Forward sale hedge commitments | 73 | — | — | 57 |\n| Total derivatives not designated as hedges | 144,374 | 75,961 | 144,091 | 74,983 |\n| Total | 144,374 | 97,912 | 197,831 | 76,015 |\n| Netting Adjustments (5) | ( 62,614 ) | ( 5,727 ) | 35,293 | 6,769 |\n| Net Derivatives on the Balance Sheet | 81,760 | 92,185 | 162,538 | 69,246 |\n| Financial instruments (6) | 17,744 | 22,378 | 17,744 | 22,378 |\n| Cash collateral pledged (received) | — | — | — | 33,838 |\n| Net Derivative Amounts | $ | 64,016 | $ | 69,807 | $ | 144,794 | $ | 13,030 |\n\n(1) All asset derivatives are reflected in other assets on the balance sheet.\n(2) All liability derivatives are reflected in other liabilities on the balance sheet.\n(3) Approximately $ 660,000 of accrued interest receivable is included in the fair value of the loan level derivative assets at September 30, 2022, in comparison to accrued interest receivable of approximately $ 1.2 million and $ 1.5 million in included in the fair value of interest rate and loan level derivative assets, respectively, at December 31, 2021.\n(4) Approximately $ 36,000 and $ 660,000 of accrued interest payable is included in the fair value of interest rate and loan level derivative liabilities, respectively, at September 30, 2022. Accrued interest payable of approximately $ 5,000 and $ 1.5 million is included in the fair value of the interest rate and loan level derivative liabilities, respectively, at December 31, 2021.\n(5) Netting adjustments represent the amounts recorded to convert derivative assets and liabilities cleared through CME from a gross basis to a net basis, inclusive of the variation margin payments, in accordance with applicable accounting guidance. As displayed in the table above, derivatives that cleared through the CME were either in a net asset position or a net liability position at September 30, 2022.\n(6) Reflects offsetting derivative positions with the same counterparty that are not netted on the balance sheet.\n34\nThe table below presents the effect of the Company’s derivative financial instruments included in OCI and current earnings for the periods indicated:\n| Three Months Ended | Nine Months Ended |\n| September 30 | September 30 |\n| 2022 | 2021 | 2022 | 2021 |\n| (Dollars in thousands) |\n| Derivatives designated as hedges |\n| Loss in OCI on derivatives (effective portion), net of tax | $ | ( 27,144 ) | $ | ( 3,383 ) | $ | ( 52,743 ) | $ | ( 11,559 ) |\n| Gain reclassified from OCI into interest income or interest expense (effective portion) | $ | 407 | $ | 4,791 | $ | 8,427 | $ | 13,869 |\n| Derivatives not designated as hedges |\n| Changes in fair value of customer related positions |\n| Other income | $ | 26 | $ | 54 | $ | 147 | $ | 137 |\n| Other expense | ( 67 ) | ( 80 ) | ( 239 ) | ( 374 ) |\n| Changes in fair value of mortgage derivatives |\n| Mortgage banking income | 41 | ( 213 ) | ( 603 ) | ( 3,840 ) |\n| Total | $ | — | $ | ( 239 ) | $ | ( 695 ) | $ | ( 4,077 ) |\n\nThe Company's derivative agreements with institutional counterparties contain various credit-risk related contingent provisions, such as requiring the Company to maintain a well-capitalized capital position. If the Company fails to meet these conditions, the counterparties could request the Company make immediate payment or demand that the Company provide immediate and ongoing full collateralization on derivative positions in net liability positions. All derivative instruments with credit-risk contingent features were in a net asset position at September 30, 2022. At December 31, 2021, the aggregate fair value of all derivative instruments with credit-risk related contingent features that were in a net liability position was $ 34.8 million. Although none of the contingency provisions have applied as of September 30, 2022 and December 31, 2021, the Company posted collateral to offset the net liability exposure with institutional counterparties at December 31, 2021.\nBy using derivatives, the Company is exposed to credit risk to the extent that counterparties to the derivative contracts do not perform as required. Should a counterparty fail to perform under the terms of a derivative contract, the Company's credit exposure on interest rate swaps is limited to the net positive fair value and accrued interest of all swaps with each counterparty. The Company seeks to minimize counterparty credit risk through credit approvals, limits, monitoring procedures, and obtaining collateral, where appropriate. Institutional counterparties must have an investment grade credit rating and be approved by the Company's Board of Directors. As such, management believes the risk of incurring credit losses on derivative contracts with institutional counterparties is remote. The Company's exposure relating to institutional counterparties was $ 127.6 million and $ 28.3 million at September 30, 2022 and December 31, 2021, respectively. The Company’s exposure relating to customer counterparties was approximately $ 8,000 and $ 62.4 million at September 30, 2022 and December 31, 2021, respectively. Credit exposure may be reduced by the value of collateral pledged by the counterparty.\nNOTE 7 - FAIR VALUE MEASUREMENTS\nFair value is a market-based measure considered from the perspective of a market participant rather than an entity-specific measure. Therefore, even when market assumptions are not readily available, the assumptions applied by the Company when determining fair value reflect those that the Company determines market participants would use to price the asset or liability at the measurement date. If there has been a significant decrease in the volume and level of activity for the asset or liability, regardless of the valuation technique(s) used, the objective of a fair value measurement remains the same. Fair value is the price that would be received if the asset were to be sold or that would be or paid if the liability were to be transferred in an orderly market transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. When determining fair value, the Company considers pricing information and other inputs that are current as of the measurement date. In periods of market dislocation, the observability of prices and other inputs may be reduced for certain instruments, or not available at all. The unavailability or reduced availability of pricing or other input information could cause an instrument to be reclassified from one level to another.\nThe Fair Value Measurements and Disclosures Topic of the FASB ASC defines fair value and establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to\n35\nunobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy under the Fair Value Measurements and Disclosures Topic of the FASB ASC are described below:\nLevel 1 – Inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.\nLevel 2 – Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly.\nLevel 3 – Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable.\nTo the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Accordingly, the degree of judgment exercised by the Company in determining fair value is greatest for instruments categorized in Level 3. A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement.\nValuation Techniques\nThere have been no changes in the valuation techniques used during the nine months ended September 30, 2022.\nSecurities\nTrading and Equity Securities\nThese equity securities are valued based on market quoted prices. These securities are categorized in Level 1 as they are actively traded and no valuation adjustments have been applied.\nU.S. Government Agency and U.S. Treasury Securities\nFair value is estimated using either multi-dimensional spread tables or benchmarks. The inputs used include benchmark yields, reported trades, and broker/dealer quotes. These securities are classified as Level 2.\nAgency Mortgage-Backed Securities\nFair value is estimated using either a matrix or benchmarks. The inputs used include benchmark yields, reported trades, broker/dealer quotes, and issuer spreads. These securities are categorized as Level 2.\nAgency Collateralized Mortgage Obligations and Small Business Administration Pooled Securities\nThe valuation model for these securities is volatility-driven and ratings based, and uses multi-dimensional spread tables. The inputs used include benchmark yields, reported trades, new issue data, broker dealer quotes, and collateral performance. If there is at least one significant model assumption or input that is not observable, these securities are categorized as Level 3 within the fair value hierarchy; otherwise, they are classified as Level 2.\nState, County, and Municipal Securities\nThe fair value is estimated using a valuation matrix with inputs including bond interest rate tables, recent transactions, and yield relationships. These securities are categorized as Level 2.\nSingle and Pooled Issuer Trust Preferred Securities\nThe fair value of trust preferred securities, including pooled and single issuer preferred securities, is estimated using external pricing models, discounted cash flow methodologies or similar techniques. The inputs used in these valuations include benchmark yields, reported trades, new issue data, broker dealer quotes, and collateral performance. If there is at least one significant model assumption or input that is not observable, these securities are classified as Level 3 within the fair value hierarchy; otherwise, they are classified as Level 2.\nLoans Held for Sale\nThe Company has elected the fair value option to account for originated closed loans intended for sale. The fair value is measured on an individual loan basis using quoted market prices and when not available, comparable market value or discounted cash flow analysis may be utilized. These assets are typically classified as Level 2.\n36\nDerivative Instruments\nDerivatives\nThe valuation of these instruments is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilizes. The Company incorporates credit valuation adjustments to appropriately reflect nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral postings. Additionally, in conjunction with fair value measurement guidance, the Company has made an accounting policy election to measure the credit risk of its derivative financial instruments that are subject to master netting agreements on a net basis by counterparty portfolio. Although the Company has determined that the majority of the inputs used to value its interest rate derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its interest rate derivatives and risk participation agreements may also utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by the Company and its counterparties. However, as of September 30, 2022 and December 31, 2021, the Company has assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and has determined that the credit valuation adjustments are not significant to the overall valuation of its derivatives. As a result, the Company has determined that its derivative valuations in their entirety are properly classified as Level 2.\nMortgage Derivatives\nThe fair value of mortgage derivatives is determined based on current market prices for similar assets in the secondary market and, therefore, classified as Level 2 within the fair value hierarchy.\nIndividually Assessed Collateral Dependent Loans\nIn accordance with the CECL standard, expected credit losses on individually assessed loans deemed to be collateral dependent are valued based upon the lower of amortized cost or fair value of the underlying collateral less costs to sell. The inputs used in the appraisals of the collateral are not always observable, and in such cases the loans may be classified as Level 3 within the fair value hierarchy; otherwise, they are classified as Level 2.\nOther Real Estate Owned and Other Foreclosed Assets\nOther Real Estate Owned (\"OREO\") and Other Foreclosed Assets are valued at the lower of cost or fair value of the property, less estimated costs to sell. The fair values are generally estimated based upon recent appraisal values of the property less costs to sell the property. Certain inputs used in appraisals are not always observable, and therefore OREO and Other Foreclosed Assets may be classified as Level 3 within the fair value hierarchy.\nGoodwill and Other Intangible Assets\nGoodwill and other intangible assets are subject to impairment testing. The Company conducts an annual impairment test of goodwill in the third quarter of each year, or more frequently if necessary. Other intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. To estimate the fair value of goodwill and, if necessary, other intangible assets, the Company utilizes both a comparable analysis of relevant price multiples in recent market transactions and a discounted cash flow analysis. Both valuation models require a significant degree of management judgment. In the event the fair value as determined by the valuation model is less than the carrying value, the intangibles may be impaired. If the impairment testing resulted in impairment, the Company would classify the impaired goodwill and other intangible assets subjected to nonrecurring fair value adjustments as Level 3.\n37\nAssets and liabilities measured at fair value on a recurring and nonrecurring basis were as follows at the dates indicated:\n| Fair Value Measurements at Reporting Date Using |\n| Balance | Quoted Pricesin ActiveMarkets forIdenticalAssets(Level 1) | SignificantOtherObservableInputs(Level 2) | SignificantUnobservableInputs(Level 3) |\n| September 30, 2022 |\n| (Dollars in thousands) |\n| Recurring fair value measurements |\n| Assets |\n| Trading securities | $ | 3,538 | $ | 3,538 | $ | — | $ | — |\n| Equity securities | 20,439 | 20,439 | — | — |\n| Securities available for sale |\n| U.S. government agency securities | 199,942 | — | 199,942 | — |\n| U.S. treasury securities | 784,458 | — | 784,458 | — |\n| Agency mortgage-backed securities | 344,153 | — | 344,153 | — |\n| Agency collateralized mortgage obligations | 40,787 | — | 40,787 | — |\n| State, county, and municipal securities | 187 | — | 187 | — |\n| Single issuer trust preferred securities issued by banks and insurers | 489 | — | 489 | — |\n| Pooled trust preferred securities issued by banks and insurers | 999 | — | 999 | — |\n| Small business administration pooled securities | 54,496 | — | 54,496 | — |\n| Loans held for sale | 5,100 | — | 5,100 | — |\n| Derivative instruments | 144,374 | — | 144,374 | — |\n| Liabilities |\n| Derivative instruments | 197,831 | — | 197,831 | — |\n| Total recurring fair value measurements | $ | 1,401,131 | $ | 23,977 | $ | 1,377,154 | $ | — |\n| Nonrecurring fair value measurements |\n| Assets |\n| Individually assessed collateral dependent loans (1) | $ | 13,020 | $ | — | $ | — | $ | 13,020 |\n| Total nonrecurring fair value measurements | $ | 13,020 | $ | — | $ | — | $ | 13,020 |\n\n38\n| Fair Value Measurements at Reporting Date Using |\n| Balance | Quoted Pricesin ActiveMarkets forIdenticalAssets(Level 1) | SignificantOtherObservableInputs(Level 2) | SignificantUnobservableInputs(Level 3) |\n| December 31, 2021 |\n| (Dollars in thousands) |\n| Recurring fair value measurements |\n| Assets |\n| Trading securities | $ | 3,720 | $ | 3,720 | $ | — | $ | — |\n| Equity securities | 23,173 | 23,173 | — | — |\n| Securities available for sale |\n| U.S. government agency securities | 215,482 | — | 215,482 | — |\n| U.S. treasury securities | 861,448 | — | 861,448 | — |\n| Agency mortgage-backed securities | 363,933 | — | 363,933 | — |\n| Agency collateralized mortgage obligations | 79,677 | — | 79,677 | — |\n| State, county, and municipal securities | 203 | — | 203 | — |\n| Single issuer trust preferred securities issued by banks and insurers | 491 | — | 491 | — |\n| Pooled trust preferred securities issued by banks and insurers | 1,000 | — | 1,000 | — |\n| Small business administration pooled securities | 48,914 | — | 48,914 | — |\n| Loans held for sale | 24,679 | — | 24,679 | — |\n| Derivative instruments | 97,912 | — | 97,912 | — |\n| Liabilities |\n| Derivative instruments | 76,015 | — | 76,015 | — |\n| Total recurring fair value measurements | $ | 1,644,617 | $ | 26,893 | $ | 1,617,724 | $ | — |\n| Nonrecurring fair value measurements |\n| Assets |\n| Individually assessed collateral dependent loans (1) | $ | 1,174 | $ | — | $ | — | $ | 1,174 |\n| Total nonrecurring fair value measurements | $ | 1,174 | $ | — | $ | — | $ | 1,174 |\n\n(1) The carrying value of individually assessed collateral dependent loans is based on the lower of amortized cost or fair value of the underlying collateral less costs to sell. The fair value of the underlying collateral is generally determined through independent appraisals, which generally include various Level 3 inputs which are not identifiable. Appraisals may be adjusted by management for qualitative factors such as economic factors and estimated liquidation expenses. The range of these possible adjustments may vary.\n39\nThe estimated fair values and related carrying amounts for assets and liabilities for which fair value is only disclosed are shown below at the dates indicated:\n| Fair Value Measurements at Reporting Date Using |\n| CarryingValue | FairValue | Quoted Pricesin ActiveMarkets forIdenticalAssets(Level 1) | SignificantOtherObservableInputs(Level 2) | SignificantUnobservableInputs(Level 3) |\n| September 30, 2022 |\n| (Dollars in thousands) |\n| Financial assets |\n| Securities held to maturity (a) |\n| U.S. government agency securities | $ | 31,696 | $ | 29,303 | $ | — | $ | 29,303 | $ | — |\n| U.S. treasury securities | 100,615 | 87,992 | — | 87,992 | — |\n| Agency mortgage-backed securities | 892,102 | 802,093 | — | 802,093 | — |\n| Agency collateralized mortgage obligations | 553,995 | 476,970 | — | 476,970 | — |\n| Single issuer trust preferred securities issued by banks | 1,500 | 1,508 | — | 1,508 | — |\n| Small business administration pooled securities | 117,727 | 112,119 | — | 112,119 | — |\n| Loans, net of allowance for credit losses (b) | 13,540,017 | 13,208,966 | — | — | 13,208,966 |\n| Federal Home Loan Bank stock (c) | 5,218 | 5,218 | — | 5,218 | — |\n| Cash surrender value of life insurance policies (d) | 293,126 | 293,126 | — | 293,126 | — |\n| Financial liabilities |\n| Deposit liabilities, other than time deposits (e) | $ | 15,160,375 | $ | 15,160,375 | $ | — | $ | 15,160,375 | $ | — |\n| Time certificates of deposits (f) | 1,178,619 | 1,147,506 | — | 1,147,506 | — |\n| Federal Home Loan Bank borrowings (f) | 643 | 571 | — | 571 | — |\n| Junior subordinated debentures (g) | 62,855 | 59,770 | — | 59,770 | — |\n| Subordinated debentures (f) | 49,862 | 44,066 | — | — | 44,066 |\n\n40\n| Fair Value Measurements at Reporting Date Using |\n| Carrying Value | FairValue | Quoted Pricesin ActiveMarkets forIdenticalAssets(Level 1) | SignificantOtherObservableInputs(Level 2) | SignificantUnobservableInputs(Level 3) |\n| December 31, 2021 |\n| (Dollars in thousands) |\n| Financial assets |\n| Securities held to maturity (a) |\n| U.S. government agency securities | $ | 32,987 | $ | 32,546 | $ | — | $ | 32,546 | $ | — |\n| U.S. treasury securities | 102,560 | 102,242 | — | 102,242 | — |\n| Agency mortgage-backed securities | 493,012 | 497,236 | — | 497,236 | — |\n| Agency collateralized mortgage obligations | 415,736 | 408,845 | — | 408,845 | — |\n| Single issuer trust preferred securities issued by banks | 1,500 | 1,508 | — | 1,508 | — |\n| Small business administration pooled securities | 21,023 | 21,756 | — | 21,756 | — |\n| Loans, net of allowance for credit losses (b) | 13,439,190 | 13,389,515 | — | — | 13,389,515 |\n| Federal Home Loan Bank stock (c) | 11,407 | 11,407 | — | 11,407 | — |\n| Cash surrender value of life insurance policies (d) | 289,304 | 289,304 | — | 289,304 | — |\n| Financial liabilities |\n| Deposit liabilities, other than time deposits (e) | $ | 15,385,894 | $ | 15,385,894 | $ | — | $ | 15,385,894 | $ | — |\n| Time certificates of deposits (f) | 1,531,150 | 1,529,857 | — | 1,529,857 | — |\n| Federal Home Loan Bank borrowings (f) | 25,667 | 25,663 | — | 25,663 | — |\n| Long-term borrowings (f) | 14,063 | 13,989 | — | 13,989 | — |\n| Junior subordinated debentures (g) | 62,853 | 67,019 | — | 67,019 | — |\n| Subordinated debentures (f) | 49,791 | 45,532 | — | — | 45,532 |\n\n(a) The fair values presented are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments and/or discounted cash flow analysis.\n(b) Fair value of loans is measured using the exit price valuation method, determined primarily by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities or cash flows, while incorporating liquidity and credit assumptions. Additionally, this amount excludes individually assessed collateral dependent loans, which are deemed to be marked to fair value on a nonrecurring basis.\n(c) Federal Home Loan Bank stock has no quoted market value and is carried at cost; therefore, the carrying amount approximates fair value.\n(d) Cash surrender value of life insurance policies is recorded at its cash surrender value (or the amount that can be realized upon surrender of the policy), therefore, carrying amount approximates fair value.\n(e) Fair value of demand deposits, savings and interest checking accounts and money market deposits is the amount payable on demand at the reporting date.\n(f) Fair value was determined by discounting anticipated future cash payments using rates currently available for instruments with similar remaining maturities.\n(g) Fair value was determined based upon market prices of securities with similar terms and maturities.\nThis summary excludes certain financial assets and liabilities for which the carrying value approximates fair value. For financial assets, these may include cash and due from banks, federal funds sold and short-term investments. For financial liabilities, these may include federal funds purchased. These instruments would all be considered to be classified as Level 1 within the fair value hierarchy. Also excluded from the summary are financial instruments measured at fair value on a recurring and nonrecurring basis, as previously described.\nThe Company considers its current use of financial instruments to be the highest and best use of the instruments.\n41\nNOTE 8 - REVENUE RECOGNITION\nA portion of the Company's noninterest income is derived from contracts with customers, and as such, the revenue recognized depicts the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The Company considers the terms of the contract and all relevant facts and circumstances when applying this guidance. To ensure its alignment with this core principle, the Company measures revenue and the timing of recognition by applying the following five steps:\n1.Identify the contract(s) with customers\n2.Identify the performance obligations\n3.Determine the transaction price\n4.Allocate the transaction price to the performance obligations\n5.Recognize revenue when (or as) the entity satisfies a performance obligation\nThe Company has disaggregated its revenue from contracts with customers into categories that depict how the nature, amount, timing, and uncertainty of revenue and cash flows are affected by economic factors. The following table presents the revenue streams that the Company has disaggregated as of the periods indicated:\n| Three Months Ended | Nine Months Ended |\n| September 302022 | September 302021 | September 302022 | September 302021 |\n| (Dollars in thousands) |\n| Deposit account fees (inclusive of cash management fees) | $ | 6,261 | $ | 4,298 | $ | 17,582 | $ | 11,704 |\n| Interchange fees | 2,833 | 2,223 | 8,043 | 6,267 |\n| ATM fees | 1,066 | 817 | 2,900 | 2,177 |\n| Investment management - wealth management and advisory services | 7,834 | 8,147 | 23,563 | 23,576 |\n| Investment management - retail investments and insurance revenue | 602 | 1,027 | 2,875 | 2,774 |\n| Merchant processing income | 412 | 365 | 1,140 | 1,024 |\n| Credit card income | 495 | 334 | 1,341 | 883 |\n| Other noninterest income | 1,782 | 1,362 | 4,650 | 3,732 |\n| Total noninterest income in-scope of ASC 606 | 21,285 | 18,573 | 62,094 | 52,137 |\n| Total noninterest income out-of-scope of ASC 606 | 6,910 | 7,884 | 20,271 | 24,533 |\n| Total noninterest income | $ | 28,195 | $ | 26,457 | $ | 82,365 | $ | 76,670 |\n\nIn each of the revenue streams identified above, there were no significant judgments made in determining or allocating the transaction price, as the consideration and service requirements are generally explicitly identified in the associated contracts. Additional information related to each of the revenue streams is further noted below.\nDeposit Account Fees\nThe Company offers various deposit account products to its customers governed by specific deposit agreements applicable to either personal customers or business customers. These agreements identify the general conditions and obligations of both parties, and include standard information regarding deposit account related fees.\nDeposit account services include providing access to deposit accounts as well as access to the various deposit transactional services of the Company. These transactional services are primarily those that are identified in the standard fee schedule, and include, but are not limited to, services such as overdraft protection, wire transfer, and check collection. Revenue is recognized in conjunction with the various services being provided. For example, the Company may assess monthly fixed service fees associated with the customer having access to a deposit account, which can vary depending on the account type and daily account balance. In addition, the Company may also assess separate fixed fees associated with and at the time specific transactions are entered into by the customer. As such, the Company considers its performance obligations to be met concurrently with providing the account access or completing the requested deposit transaction.\n42\nCash Management\nCash management services are a subset of the deposit account fees revenue stream. These services primarily include ACH transaction processing, positive pay and remote deposit services. These services are also governed by separate agreements entered into with the customer. The fee arrangement for these services is structured to assess fees under one of two scenarios, either a per transaction fee arrangement or an earnings credit analysis arrangement. Under the per transaction fee arrangement, fixed fees are assessed concurrently with customers executing the transactions, and as such, the Company considers its performance obligations to be met concurrently with completing the requested transaction. Under the earnings credit analysis arrangement, the Company provides a monthly earnings credit to the customer that is negotiated and determined based on various factors. The credit is then available to absorb the per transaction fees that are assessed on the customer's deposit account activity for the month. Any amount of the transactional fees in excess of the earnings credit is recognized as revenue in that month.\nInterchange Fees\nThe Company earns interchange revenue from its issuance of credit and debit cards granted through its membership in various card payment networks. The Company provides credit cards and debit cards to its customers which are authorized and settled through these payment networks, and in exchange, the Company earns revenue as determined by each payment network's interchange program. The revenue is recognized concurrently with the settlement of card transactions within each network.\nATM Fees\nThe Company deploys automated teller machines (ATMs) as part of its overall branch network. Certain transactions performed at the ATMs require customers to acknowledge and pay a fee for the requested service. Certain ATM fees are disclosed in the deposit account agreement fee schedules, whereas those assessed to non-Rockland Trust deposit holders are solely determined during the transaction at the machine.\nThe ATM fee is a fixed dollar per transaction amount, and as such, is recognized concurrently with the overall daily processing and settlement of the ATM activity.\nInvestment Management - Wealth Management and Advisory Services\nThe Company offers investment management and trust services to individuals, institutions, small businesses and charitable institutions. Each investment management product is governed by its own contract along with a separate identifiable fee schedule unique to that product. The Company also offers additional services, such as estate settlement, financial planning, tax services and other special services quoted at the client's request.\nThe asset management and/or custody fees are based upon a percentage of the monthly valuation of the principal assets in the customer's account, whereas fees for additional or special services are fixed in nature and are charged as services are rendered. As the fees are dependent on assets under management, which are susceptible to market factors outside of the Company's control, this variable consideration is constrained and therefore no revenue is estimated at contract initiation. As such, all revenue is recognized in correlation to the monthly management fee determinations or as transactional services are provided. Due to the fact that payments are primarily made subsequent to the valuation period, the Company records a receivable for revenue earned but not received. The following table provides the amount of investment management revenue earned but not received as of the dates indicated:\n| September 30, 2022 | December 31, 2021 |\n| (Dollars in thousands) |\n| Receivables, included in other assets | $ | 4,401 | $ | 5,385 |\n\nInvestment Management - Retail Investments and Insurance Revenue\nThe Company offers the sale of mutual fund shares, unit investment trust shares, general securities, fixed and variable annuities and life insurance products through registered representatives who are both employed by the Company and licensed and contracted with various broker general agents to offer these products to the Company’s customer base. As such, the Company performs these services as an agent and earns a fixed commission on the sales of these products and services. To a lesser degree, production bonus commissions can also be earned based upon the Company meeting certain volume thresholds.\n43\nIn general, the Company recognizes commission revenue at the point of sale, and for certain insurance products, may also earn and recognize annual residual commissions commensurate with annual premiums being paid.\nMerchant Processing Income\nThe Company refers customers to third party merchant processing partners in exchange for commission and fee income. The income earned is comprised of multiple components, including a fixed referral fee per each referred customer, a rebate amount determined primarily as a percentage of net revenue earned by the third party from services provided to each referred customer, and overall production bonus commissions if certain new account production thresholds are met. Merchant processing income is recognized in conjunction with either completing the referral to earn the fixed fee amount or as the merchant activity is processed to derive the Company's rebate and/or production bonus amounts.\nCredit Card Income\nThe Company provides consumer and business credit card solutions to its customers by soliciting new accounts on behalf of a third party credit card provider in exchange for a fee. The income earned is comprised of new account incentive payments as well as a percentage of interchange income earned by the third party provider offering the consumer and business purpose revolving credit accounts. The credit card income is recognized in conjunction with the establishment of each new credit card member or as the interchange is earned by the third party in connection with net purchase transactions made by the credit card member.\nOther Noninterest Income\nThe Company earns various types of other noninterest income that fall within the scope of the new revenue recognition rules, and have been aggregated into one general revenue stream in the table noted above. This amount includes, but is not limited to, the following types of revenue with customers:\nSafe Deposit Rent\nThe Company rents out the use of safe deposit boxes to its customers, which can be accessed when the bank is open for business. The safe deposit box rental fee is paid upfront and is recognized as revenue ratably over the annual term of the contract.\n1031 Exchange Fee Revenue\nThe Company provides like-kind exchange services pursuant to Section 1031 of the Internal Revenue Code. Fee income is recognized in conjunction with completing the exchange transactions.\nForeign Currency\nThe Company earns fee income associated with various transactions related to foreign currency product offerings, including foreign currency bank notes and drafts and foreign currency wires. The majority of this income is derived from commissions earned related to customers executing the above mentioned foreign currency transactions through arrangements with third party correspondents.\n44\nNOTE 9 - OTHER COMPREHENSIVE INCOME (LOSS)\nThe following tables present a reconciliation of the changes in the components of other comprehensive income (loss) for the periods indicated, including the amount of income tax (expense) benefit allocated to each component of other comprehensive income (loss):\n| Three Months EndedSeptember 30, 2022 | Nine Months EndedSeptember 30, 2022 |\n| Pre-TaxAmount | Tax (Expense)Benefit | After TaxAmount | Pre-TaxAmount | Tax (Expense)Benefit | After TaxAmount |\n| (Dollars in thousands) |\n| Change in fair value of securities available for sale | $ | ( 55,461 ) | $ | 12,879 | $ | ( 42,582 ) | $ | ( 167,814 ) | $ | 38,942 | $ | ( 128,872 ) |\n| Less: net security losses reclassified into other noninterest expense | — | — | — | — | — | — |\n| Net change in fair value of securities available for sale | ( 55,461 ) | 12,879 | ( 42,582 ) | ( 167,814 ) | 38,942 | ( 128,872 ) |\n| Change in fair value of cash flow hedges | ( 37,357 ) | 10,505 | ( 26,852 ) | ( 64,963 ) | 18,277 | ( 46,686 ) |\n| Less: net cash flow hedge gains reclassified into interest income or interest expense | 407 | ( 115 ) | 292 | 8,427 | ( 2,370 ) | 6,057 |\n| Net change in fair value of cash flow hedges | ( 37,764 ) | 10,620 | ( 27,144 ) | ( 73,390 ) | 20,647 | ( 52,743 ) |\n| Amortization of net actuarial losses | 159 | ( 45 ) | 114 | 476 | ( 134 ) | 342 |\n| Amortization of net prior service costs | 10 | ( 3 ) | 7 | 29 | ( 8 ) | 21 |\n| Net change in other comprehensive income for defined benefit postretirement plans (1) | 169 | ( 48 ) | 121 | 505 | ( 142 ) | 363 |\n| Total other comprehensive loss | $ | ( 93,056 ) | $ | 23,451 | $ | ( 69,605 ) | $ | ( 240,699 ) | $ | 59,447 | $ | ( 181,252 ) |\n\n\n| Three Months EndedSeptember 30, 2021 | Nine Months EndedSeptember 30, 2021 |\n| Pre-TaxAmount | Tax (Expense)Benefit | After TaxAmount | Pre-TaxAmount | Tax (Expense)Benefit | After TaxAmount |\n| (Dollars in thousands) |\n| Change in fair value of securities available for sale | $ | ( 10,337 ) | $ | 2,440 | $ | ( 7,897 ) | $ | ( 15,589 ) | $ | 3,711 | $ | ( 11,878 ) |\n| Less: net security losses reclassified into other noninterest expense | — | — | — | — | — | — |\n| Net change in fair value of securities available for sale | ( 10,337 ) | 2,440 | ( 7,897 ) | ( 15,589 ) | 3,711 | ( 11,878 ) |\n| Change in fair value of cash flow hedges | 84 | ( 23 ) | 61 | ( 2,214 ) | 624 | ( 1,590 ) |\n| Less: net cash flow hedge gains reclassified into interest income or interest expense | 4,791 | ( 1,347 ) | 3,444 | 13,869 | ( 3,900 ) | 9,969 |\n| Net change in fair value of cash flow hedges | ( 4,707 ) | 1,324 | ( 3,383 ) | ( 16,083 ) | 4,524 | ( 11,559 ) |\n| Net unamortized gain related to defined benefit pension and other postretirement adjustments arising during the period | — | — | — | 653 | ( 184 ) | 469 |\n| Amortization of net actuarial losses | 346 | ( 97 ) | 249 | 1,037 | ( 291 ) | 746 |\n| Amortization of net prior service costs | 44 | ( 13 ) | 31 | 131 | ( 37 ) | 94 |\n| Net change in other comprehensive income for defined benefit postretirement plans (1) | 390 | ( 110 ) | 280 | 1,821 | ( 512 ) | 1,309 |\n| Total other comprehensive loss | $ | ( 14,654 ) | $ | 3,654 | $ | ( 11,000 ) | $ | ( 29,851 ) | $ | 7,723 | $ | ( 22,128 ) |\n\n(1) The amortization of prior service costs is included in the computation of net periodic pension cost as disclosed in Note 14 \"Employee Benefit Plans\" within the Notes to the Consolidated Financial Statements included in Item 8 of the Company's 2021 Form 10-K.\n45\nInformation on the Company’s accumulated other comprehensive income (loss), net of tax, is comprised of the following components as of the dates indicated:\n| Unrealized Gain (Loss) on Securities | Unrealized Gain (Loss) on Cash Flow Hedge | Defined Benefit Postretirement Plans | Accumulated Other Comprehensive Income (Loss) |\n| (Dollars in thousands) |\n| 2022 |\n| Beginning balance: January 1, 2022 | $ | ( 9,667 ) | $ | 14,137 | $ | ( 2,287 ) | $ | 2,183 |\n| Net change in other comprehensive income (loss) | ( 128,872 ) | ( 52,743 ) | 363 | ( 181,252 ) |\n| Ending balance: September 30, 2022 | $ | ( 138,539 ) | $ | ( 38,606 ) | $ | ( 1,924 ) | $ | ( 179,069 ) |\n| 2021 |\n| Beginning balance: January 1, 2021 | $ | 13,255 | $ | 33,276 | $ | ( 5,836 ) | $ | 40,695 |\n| Net change in other comprehensive income (loss) | ( 11,878 ) | ( 11,559 ) | 1,309 | ( 22,128 ) |\n| Ending balance: September 30, 2021 | $ | 1,377 | $ | 21,717 | $ | ( 4,527 ) | $ | 18,567 |\n\nNOTE 10 - COMMITMENTS AND CONTINGENCIES\nFinancial Instruments with Off-Balance Sheet Risk\nIn the normal course of business, the Company enters into various transactions to meet the financing needs of its customers, which, in accordance with GAAP, are not included in its consolidated balance sheets. These transactions include commitments to extend credit and standby letters of credit, and loan exposures with recourse, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. The Company minimizes its exposure to loss under these commitments by subjecting them to credit approval and monitoring procedures.\nThe Company enters into contractual commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Substantially all of these commitments to extend credit are contingent upon customers maintaining specific credit standards at the time of loan funding.\nThe Company has certain loan exposures for which there is recourse. These loan relationships could require the Company to repurchase or cover certain losses per agreements for certain loans that are either sold or referred to third parties.\nStandby letters of credit are written conditional commitments issued to guarantee the performance of a customer to a third party. In the event the customer does not perform in accordance with the terms of the agreement with the third party, the Company would be required to fund the commitment. The maximum potential amount of future payments the Company could be required to make is represented by the contractual amount of the commitment. If the commitment were funded, the Company would be entitled to seek recovery from the customer. The Company’s policies generally require that standby letter of credit arrangements contain security and debt covenants similar to those contained in loan agreements.\nThe fees collected in connection with the issuance of standby letters of credit are representative of the fair value of the Company's obligation undertaken in issuing the guarantee. In accordance with applicable accounting standards related to guarantees, fees collected in connection with the issuance of standby letters of credit are deferred. The fees are then recognized in income proportionately over the life of the standby letter of credit agreement. The deferred standby letter of credit fees represent the fair value of the Company's potential obligations under the standby letter of credit guarantees.\nThe following table summarizes the above financial instruments at the dates indicated:\n| September 30, 2022 | December 31, 2021 |\n| (Dollars in thousands) |\n| Commitments to extend credit | $ | 4,552,576 | $ | 4,535,895 |\n| Standby letters of credit | 25,565 | 24,412 |\n| Deferred standby letter of credit fees | 187 | 124 |\n| Loan exposures sold with recourse | 171,437 | 202,717 |\n\n46\nLease Commitments\nThe Company leases office space, space for ATM locations, and certain branch locations under noncancellable operating leases. Several of these leases contain renewal options to extend lease terms for a period of 1 to 20 years. During the first quarter of 2022, the Company recognized approximately $ 4.4 million in costs associated with several terminated leased locations acquired from Meridian that were subsequently exited. These costs are reflected within merger and acquisition expense in the Consolidated Statement of Income.\nThere has been no significant change in the future minimum lease payments payable by the Company since December 31, 2021. See the Company's 2021 Form 10-K for information regarding leases and other commitments.\nOther Contingencies\nAt September 30, 2022, the Bank was involved in pending lawsuits that arose in the ordinary course of business. Management has reviewed these pending lawsuits with legal counsel and has taken into consideration the view of counsel as to their outcome. In the opinion of management, the final disposition of pending lawsuits is not expected to have a material adverse effect on the Company’s financial position or results of operations.\n47\nNOTE 11 - LOW INCOME HOUSING PROJECT INVESTMENTS\nThe Company has invested in low income housing projects that generate Low Income Housing Tax Credits which provide the Company with tax credits and operating loss tax benefits over a period of approximately 15 years. None of the original investment is expected to be repaid.\nThe following table presents certain information related to the Company's investments in low income housing projects as of the dates indicated:\n| September 302022 | December 312021 |\n| (Dollars in thousands) |\n| Original investment value | $ | 183,889 | $ | 179,481 |\n| Current recorded investment | 129,875 | 135,497 |\n| Unfunded liability obligation | 63,014 | 73,336 |\n| Tax credits and benefits | 16,679 | (1) | 14,198 |\n| Amortization of investments | 13,375 | (1) | 11,892 |\n| Net income tax benefit | 3,304 | (1) | 2,306 |\n\n(1) Amounts shown represent the estimated full year impact for the year ended December 31 , 2022.\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nThe following discussion should be read in conjunction with the consolidated financial statements, notes and tables included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2021, filed with the Securities and Exchange Commission (the \"2021 Form 10-K\").\nCautionary Statement Regarding Forward-Looking Statements\nThis Quarterly Report on Form 10-Q (this \"Report\"), in Management's Discussion and Analysis of Financial Condition and Results of Operations and elsewhere, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are not historical facts and include expressions about management’s confidence and strategies and management’s expectations about new and existing programs and products, acquisitions, relationships, opportunities, taxation, technology, market conditions and economic expectations. These statements may be identified by forward-looking terminology such as “should,” “could,” “will,” “may,” “expect,” “believe,” “forecast,” “view,” “opportunity,” “allow,” “continues,” “reflects,” “typically,” “usually,” “anticipate,” “estimate,” “intend,” or similar statements or variations of such terms. Such forward-looking statements involve certain risks and uncertainties and our actual results may differ materially from such forward-looking statements. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements, in addition to those risk factors listed under the “Risk Factors” section of the 2021 Form 10-K, include but are not limited to:\n•further weakening in the United States economy in general and the regional and local economies within the New England region and the Company’s market area, including any future weakening caused by the COVID-19 pandemic and any uncertainty regarding the length and extent of economic contraction as a result of the pandemic;\n•the potential effects of inflationary pressures, labor market shortages and supply chain issues;\n•the instability or volatility in financial markets and unfavorable general economic or business conditions, globally, nationally or regionally, caused by geopolitical concerns, including as a result of the conflict between Russia and Ukraine;\n•unanticipated loan delinquencies, loss of collateral, decreased service revenues, and other potential negative effects on our business caused by severe weather, pandemics or other external events;\n•adverse changes or volatility in the local real estate market;\n•adverse changes in asset quality and any unanticipated credit deterioration in our loan portfolio including those related to one or more large commercial relationships;\n•acquisitions may not produce results at levels or within time frames originally anticipated and may result in unforeseen integration issues or impairment of goodwill and/or other intangibles;\n•additional regulatory oversight and related compliance costs;\n•changes in trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System;\n48\n•higher than expected tax expense, resulting from failure to comply with general tax laws and changes in tax laws;\n•changes in market interest rates for interest earning assets and/or interest bearing liabilities and changes related to the phase-out of LIBOR;\n•increased competition in the Company’s market areas;\n•adverse weather, changes in climate, natural disasters, geopolitical concerns, including those arising from the conflict between Russia and Ukraine;\n•the emergence of widespread health emergencies or pandemics, including the magnitude and duration of the COVID-19 pandemic, any further resurgences or variants of the COVID-19 virus, the efficacy and availability of vaccines, boosters or other treatments, actions taken by governmental authorities in response thereto, other public health crises or man-made events, and their impact on the Company's local economies or the Company's operations;\n•a deterioration in the conditions of the securities markets;\n•a deterioration of the credit rating for U.S. long-term sovereign debt;\n•inability to adapt to changes in information technology, including changes to industry accepted delivery models driven by a migration to the internet as a means of service delivery;\n•electronic fraudulent activity within the financial services industry, especially in the commercial banking sector;\n•adverse changes in consumer spending and savings habits;\n•the effect of laws and regulations regarding the financial services industry;\n•changes in laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) generally applicable to the Company’s business;\n•the Company's potential judgments, claims, damages, penalties, fines and reputational damage resulting from pending or future litigation and regulatory and government actions, including as a result of our participation in and execution of government programs related to the COVID-19 pandemic;\n•changes in accounting policies, practices and standards, as may be adopted by the regulatory agencies as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board, and other accounting standard setters including, but not limited to, changes to how the Company accounts for credit losses;\n•cyber security attacks or intrusions that could adversely impact our businesses; and\n•other unexpected material adverse changes in our operations or earnings.\nExcept as required by law, the Company disclaims any intent or obligation to update publicly any such forward-looking statements, whether in response to new information, future events or otherwise. Any public statements or disclosures by the Company following this Report which modify or impact any of the forward-looking statements contained in this Report will be deemed to modify or supersede such statements in this Report.\n49\nSelected Quarterly Financial Data\nThe selected consolidated financial and other data of the Company set forth below does not purport to be complete and should be read in conjunction with, and is qualified in its entirety by, the more detailed information, including the Consolidated Financial Statements and related notes, appearing elsewhere in this Report.\n| Three Months Ended |\n| September 302022 | June 302022 | March 312022 | December 312021 | September 302021 |\n| (Dollars in thousands, except per share data) |\n| Financial condition data |\n| Securities | $ | 3,147,123 | $ | 2,934,956 | $ | 2,861,739 | $ | 2,664,859 | $ | 2,318,757 |\n| Loans | 13,700,350 | 13,675,764 | 13,580,027 | 13,587,286 | 8,808,013 |\n| Allowance for credit losses | (147,313) | (144,319) | (144,518) | (146,922) | (92,246) |\n| Goodwill and other intangible assets | 1,012,006 | 1,013,917 | 1,015,831 | 1,017,844 | 525,261 |\n| Total assets | 19,703,269 | 19,982,450 | 20,159,178 | 20,423,405 | 14,533,311 |\n| Total deposits | 16,338,994 | 16,639,548 | 16,763,392 | 16,917,044 | 12,260,140 |\n| Total borrowings | 113,360 | 138,344 | 138,328 | 152,374 | 157,045 |\n| Stockholders’ equity | 2,817,201 | 2,871,185 | 2,965,439 | 3,018,449 | 1,755,954 |\n| Nonperforming loans | 56,017 | 55,915 | 56,618 | 27,820 | 45,810 |\n| Nonperforming assets | 56,017 | 55,915 | 56,618 | 27,820 | 45,810 |\n| Income statement |\n| Interest income | $ | 169,971 | $ | 148,123 | $ | 140,619 | $ | 125,921 | $ | 93,016 |\n| Interest expense | 7,370 | 3,262 | 3,187 | 3,391 | 2,925 |\n| Net interest income | 162,601 | 144,861 | 137,432 | 122,530 | 90,091 |\n| Provision for (release of) credit losses | 3,000 | — | (2,000) | 35,705 | (10,000) |\n| Noninterest income | 28,195 | 27,898 | 26,272 | 29,180 | 26,457 |\n| Noninterest expenses | 92,728 | 90,562 | 95,500 | 117,126 | 72,419 |\n| Net income | 71,897 | 61,776 | 53,097 | 1,702 | 40,007 |\n| Per share data |\n| Net income—basic | $ | 1.57 | $ | 1.32 | $ | 1.12 | $ | 0.04 | $ | 1.21 |\n| Net income—diluted | 1.57 | 1.32 | 1.12 | 0.04 | 1.21 |\n| Cash dividends declared | 0.51 | 0.51 | 0.51 | 0.48 | 0.48 |\n| Book value per share | 61.73 | 62.32 | 62.59 | 63.75 | 53.14 |\n| Tangible book value per share (1) | 39.56 | 40.31 | 41.15 | 42.25 | 37.24 |\n| Performance ratios |\n| Return on average assets | 1.43 | % | 1.24 | % | 1.06 | % | 0.04 | % | 1.11 | % |\n| Return on average common equity | 9.90 | % | 8.49 | % | 7.16 | % | 0.28 | % | 9.04 | % |\n| Net interest margin (on a fully tax equivalent basis) | 3.64 | % | 3.27 | % | 3.09 | % | 3.05 | % | 2.78 | % |\n| Dividend payout ratio | 32.78 | % | 39.11 | % | 42.80 | % | 931.90 | % | 39.64 | % |\n| Asset Quality Ratios |\n| Nonperforming loans as a percent of gross loans | 0.41 | % | 0.41 | % | 0.42 | % | 0.20 | % | 0.52 | % |\n| Nonperforming assets as a percent of total assets | 0.28 | % | 0.28 | % | 0.28 | % | 0.14 | % | 0.32 | % |\n| Allowance for credit losses as a percent of total loans | 1.08 | % | 1.06 | % | 1.06 | % | 1.08 | % | 1.05 | % |\n| Allowance for credit losses as a percent of nonperforming loans | 262.98 | % | 258.10 | % | 255.25 | % | 528.12 | % | 201.37 | % |\n| Capital ratios |\n\n50\n| Equity to assets | 14.30 | % | 14.37 | % | 14.71 | % | 14.78 | % | 12.08 | % |\n| Tangible equity to tangible assets (1) | 9.66 | % | 9.79 | % | 10.18 | % | 10.31 | % | 8.79 | % |\n| Tier 1 leverage capital ratio | 10.51 | % | 10.42 | % | 10.62 | % | 12.03 | % | 9.36 | % |\n| Common equity tier 1 capital ratio | 13.98 | % | 13.90 | % | 14.45 | % | 14.30 | % | 13.53 | % |\n| Tier 1 risk-based capital ratio | 13.98 | % | 13.90 | % | 14.45 | % | 14.30 | % | 14.21 | % |\n| Total risk-based capital ratio | 15.71 | % | 15.62 | % | 16.18 | % | 16.04 | % | 15.78 | % |\n\n(1) Represents a non-GAAP measure. For reconciliation to GAAP book value per share, see Item 2 \"Management's Discussion and Analysis of Financial Condition and Results of Operations - Executive Level Overview - Non-GAAP Measures\" below.\n51\nExecutive Level Overview\nManagement evaluates the Company's operating results and financial condition using measures that include net income, earnings per share, return on assets and equity, return on tangible common equity, net interest margin, tangible book value per share, asset quality indicators, and many others. These metrics are used by management to make key decisions regarding the Company's balance sheet, liquidity, interest rate sensitivity, and capital resources and assist with identifying opportunities for improving the Company's financial position or operating results. The Company maintains an asset-sensitive profile and, accordingly, has benefited from recent interest rate increases. While asset quality remains very strong, management is closely monitoring the economic environment, including elevated inflationary pressures, supply chain issues, and labor shortages being experienced in the current operating environment across various industries. The Company focuses on organic growth, but will also consider growth through acquisition. Any potential acquisition opportunities are evaluated for the potential to provide a satisfactory financial return as well as other criteria (ease of integration, synergies, geographical location). Recent acquisitions include Meridian Bancorp, Inc. (\"Meridian\") and its subsidiary, East Boston Savings Bank (\"EBSB\"), which closed in the fourth quarter of 2021.\nThird Quarter 2022 Results\nNet income for the three months ended September 30, 2022 was $71.9 million, or $1.57 on a diluted earnings per share basis, as compared to $40.0 million, or $1.21 on a diluted earnings per share basis, for the three months ended September 30, 2021, or an increase of 79.7% and 29.8%, respectively. Net income for the nine months ended September 30, 2022 was $186.8 million, or $4.00 on a diluted earnings per share basis, as compared to $119.3 million, or $3.61 on a diluted earnings per share basis, for the nine months ended September 30, 2021, or an increase of 56.6% and 10.8%, respectively. The nine months ended September 30, 2022 results reflect merger and acquisition-related costs of $7.1 million, pre-tax, associated with the Meridian acquisition, as compared to $3.7 million of merger-related costs during the same prior year period. Excluding these merger and acquisition costs, operating net income was $191.9 million, or $4.11 on a diluted per share basis, for the nine months ended September 30, 2022, as compared to $121.9 million, or $3.69 on a diluted per share basis for the nine months ended September 30, 2021. See \"Non-GAAP Measures\" below for a reconciliation of non-GAAP measures.\nThird quarter 2022 results reflected the following key drivers:\n•Improved net interest margin for the quarter;\n•1.3% annualized net loan growth, excluding Paycheck Protection Program (\"PPP\") runoff;\n•Continued modest cash deployment into the securities portfolio;\n•Strong core deposit account openings and low cost of deposits;\n•Modest provision for credit loss; nonperforming assets remained flat;\n•Strong fee income;\n•49% efficiency ratio for the quarter;\n•443,000 shares repurchased, completing the Company's share repurchase program announced in January 2022.\n52\nInterest-Earning Assets\nThe results depicted in the following table reflect the trend of the Company's interest-earning assets over the past five quarters, inclusive of the Company's acquisition of Meridian during the fourth quarter of 2021. Changes over the five quarter period reflect measured deployment of excess cash balances into the securities portfolio, combined with a longer term overall strategy that typically emphasizes loan growth commensurate with overall economic growth. The following table summarizes the Company's interest-earning assets as of the periods indicated:\nManagement strives to be disciplined about loan pricing and considers interest rate sensitivity when generating loan assets. In addition, management takes a disciplined approach to credit underwriting, seeking to avoid undue credit risk and credit losses.\n53\nFunding and Net Interest Margin\nThe Company's overall sources of funding reflect strong business and retail deposit growth with a management strategy of relying upon core deposit growth to fund loans. The following chart shows sources of funding and percentage of core deposits to total deposits for the trailing five quarters:\nThe following table shows the net interest margin and cost of deposits trends for the trailing five quarters:\n54\nNoninterest Income\nNoninterest income is primarily comprised of deposit account fees, interchange and ATM fees, investment management fees and mortgage banking income. The following chart shows trends in the components of noninterest income over the past five quarters:\nExpense Control\nManagement seeks to take a balanced approach to noninterest expense control by monitoring ongoing operating expenses while making needed capital expenditures and prudently investing in growth initiatives. The Company’s primary expenses arise from Rockland Trust’s employee salaries and benefits, as well as expenses associated with buildings and equipment.\nThe following chart depicts the Company's efficiency ratio on a GAAP basis (calculated by dividing noninterest expense by the sum of noninterest income and net interest income), as well as the Company's efficiency ratio on a non-GAAP operating basis, if applicable (calculated by dividing noninterest expense, excluding certain noncore items, by the sum of noninterest income, excluding certain noncore items, and net interest income), over the past five quarters:\n55\n*See \"Non-GAAP Measures\" below for a reconciliation to GAAP financial measures.\nCapital\nThe Company's approach with respect to revenue and expense is designed to promote long-term earnings growth, which in turn contributes to capital growth. Strong earnings retention has contributed to capital growth, both on an absolute level and per share basis, which has been offset in the last two quarters by share repurchases and other comprehensive losses. The following chart shows the Company's book value and tangible book value per share over the past five quarters:\n*See \"Non-GAAP Measures\" below for a reconciliation to GAAP financial measures.\nThe Company declared a quarterly cash dividend of $0.51 per share for each of the first three quarters of 2022, representing an increase of 6.3% from the 2021 quarterly dividend rate of $0.48 per share. During the third quarter of 2022, the Company repurchased approximately 443,000 shares of common stock under the Company's stock repurchase program announced in January 2022. In total, the Company repurchased 1.8 million shares of its common stock during the nine months ended September 30, 2022 at an average price of $78.32 under the January 2022 program which ended in the third quarter. In consideration of the Company's strong current capital position, on October 20, 2022 the Company announced a new stock repurchase plan, which authorizes repurchases by the Company of up to $120 million in common stock. The new plan will be in effect through October 19, 2023.\n56\nNon-GAAP Measures\nWhen management assesses the Company’s financial performance for purposes of making day-to-day and strategic decisions, it does so based upon the performance of its core banking business, which is derived from the combination of net interest income and noninterest or fee income, reduced by operating expenses, the provision for credit losses, and the impact of income taxes and other noncore items. There are items that impact the Company's results that management believes are unrelated to its core banking business such as gains or losses on the sales of securities, merger and acquisition expenses, provision for credit losses on acquired portfolios, loss on extinguishment of debt, impairment, and other items, such as one-time adjustments as a result of changes in laws and regulations. Management excludes items management considers to be noncore when computing the Company’s non-GAAP operating earnings and operating EPS, noninterest income on an operating basis and efficiency ratio on an operating basis. Management believes excluding these items facilitates greater visibility into the Company’s core banking business and underlying trends.\nManagement also supplements its evaluation of financial performance with analysis of tangible book value per share (which is computed by dividing stockholders' equity less goodwill and identifiable intangible assets, which is referred to as tangible common equity, by common shares outstanding) and tangible common equity ratio (which is computed by dividing tangible common equity by tangible assets), both of which are non-GAAP measures. The Company reports these ratios because management believes that investors may find it useful to have access to the same analytical tools used by management to assess performance and identify trends. The Company has recognized goodwill and other intangible assets in conjunction with merger and acquisition activities. Management believes providing information excluding the impact of goodwill and other intangibles facilitates comparison of the capital adequacy of the Company to other companies in the financial services industry.\nThese non-GAAP measures should not be viewed as a substitute for financial results determined in accordance with GAAP. An item which management deems to be noncore and excludes when computing these non-GAAP measures can be of substantial importance to the Company’s results for any particular period. The Company’s non-GAAP performance measures are not necessarily comparable to similarly named non-GAAP performance measures which may be presented by other companies.\nThe following tables summarize adjustments for noncore items for the periods indicated below and shows the reconciliation of non-GAAP measures:\n57\n| Three Months Ended September 30 |\n| Net Income | DilutedEarnings Per Share |\n| 2022 | 2021 | 2022 | 2021 |\n| (Dollars in thousands, except per share data) |\n| Net income available to common shareholders (GAAP) | $ | 71,897 | $ | 40,007 | $ | 1.57 | $ | 1.21 |\n| Non-GAAP adjustments |\n| Noninterest expense components |\n| Add: merger and acquisition expenses | — | 1,943 | — | 0.06 |\n| Noncore increases to income before taxes | — | 1,943 | — | 0.06 |\n| Net tax benefit associated with noncore items (1) | — | (546) | — | (0.02) |\n| Noncore increases to net income | — | 1,397 | — | 0.04 |\n| Operating net income (Non-GAAP) | $ | 71,897 | $ | 41,404 | $ | 1.57 | $ | 1.25 |\n| Nine Months Ended September 30 |\n| Net Income | DilutedEarnings Per Share |\n| 2022 | 2021 | 2022 | 2021 |\n| (Dollars in thousands, except per share data) |\n| Net income available to common shareholders (GAAP) | $ | 186,770 | $ | 119,290 | $ | 4.00 | $ | 3.61 |\n| Non-GAAP adjustments |\n| Noninterest expense components |\n| Add: merger and acquisition expenses | 7,100 | 3,674 | 0.15 | 0.11 |\n| Noncore increases to income before taxes | 7,100 | 3,674 | 0.15 | 0.11 |\n| Net tax benefit associated with noncore items (1) | (1,995) | (1,033) | (0.04) | (0.03) |\n| Noncore increases to net income | 5,105 | 2,641 | 0.11 | 0.08 |\n| Operating net income (Non-GAAP) | $ | 191,875 | $ | 121,931 | $ | 4.11 | $ | 3.69 |\n\n(1)The net tax benefit associated with noncore items is determined by assessing whether each noncore item is included or excluded from net taxable income and applying the Company's combined marginal tax rate to only those items included in net taxable income.\n58\n\n| Three Months Ended |\n| September 302022 | June 302022 | March 312022 | December 312021 | September 302021 |\n| (Dollars in thousands) |\n| Net interest income (GAAP) | $ | 162,601 | $ | 144,861 | $ | 137,432 | $ | 122,530 | $ | 90,091 | (a) |\n| Noninterest income (GAAP) | $ | 28,195 | $ | 27,898 | $ | 26,272 | $ | 29,180 | $ | 26,457 | (b) |\n| Noninterest expense (GAAP) | $ | 92,728 | $ | 90,562 | $ | 95,500 | $ | 117,126 | $ | 72,419 | (c) |\n| Less: |\n| Merger and acquisition expense | — | — | 7,100 | 37,166 | 1,943 |\n| Noninterest expense on an operating basis (Non-GAAP) | $ | 92,728 | $ | 90,562 | $ | 88,400 | $ | 79,960 | $ | 70,476 | (d) |\n| Total revenue (GAAP) | $ | 190,796 | $ | 172,759 | $ | 163,704 | $ | 151,710 | $ | 116,548 | (a+b) |\n| Ratios |\n| Noninterest income as a % of revenue (GAAP based) | 14.78 | % | 16.15 | % | 16.05 | % | 19.23 | % | 22.70 | % | (b/(a+b)) |\n| Efficiency ratio (GAAP based) | 48.60 | % | 52.42 | % | 58.34 | % | 77.20 | % | 62.14 | % | (c/(a+b)) |\n| Efficiency ratio on an operating basis (Non-GAAP) | 48.60 | % | 52.42 | % | 54.00 | % | 52.71 | % | 60.47 | % | (d/(a+b)) |\n\n59\nThe following table summarizes the calculation of tangible common equity to tangible assets ratio and tangible book value per share and shows the reconciliation of non-GAAP measures:\n| September 302022 | June 302022 | March 312022 | December 312021 | September 302021 |\n| (Dollars in thousands, except per share data) |\n| Tangible common equity |\n| Stockholders' equity (GAAP) | $ | 2,817,201 | $ | 2,871,185 | $ | 2,965,439 | $ | 3,018,449 | $ | 1,755,954 | (a) |\n| Less: Goodwill and other intangibles | 1,012,006 | 1,013,917 | 1,015,831 | 1,017,844 | 525,261 |\n| Tangible common equity (Non-GAAP) | 1,805,195 | 1,857,268 | 1,949,608 | 2,000,605 | 1,230,693 | (b) |\n| Tangible assets |\n| Assets (GAAP) | 19,703,269 | 19,982,450 | 20,159,178 | 20,423,405 | 14,533,311 | (c) |\n| Less: Goodwill and other intangibles | 1,012,006 | 1,013,917 | 1,015,831 | 1,017,844 | 525,261 |\n| Tangible assets (Non-GAAP) | $ | 18,691,263 | $ | 18,968,533 | $ | 19,143,347 | $ | 19,405,561 | $ | 14,008,050 | (d) |\n| Common shares | 45,634,626 | 46,069,761 | 47,377,125 | 47,349,778 | 33,043,812 | (e) |\n| Common equity to assets ratio (GAAP) | 14.30 | % | 14.37 | % | 14.71 | % | 14.78 | % | 12.08 | % | (a/c) |\n| Tangible common equity to tangible assets ratio (Non-GAAP) | 9.66 | % | 9.79 | % | 10.18 | % | 10.31 | % | 8.79 | % | (b/d) |\n| Book value per share (GAAP) | $ | 61.73 | $ | 62.32 | $ | 62.59 | $ | 63.75 | $ | 53.14 | (a/e) |\n| Tangible book value per share (Non-GAAP) | $ | 39.56 | $ | 40.31 | $ | 41.15 | $ | 42.25 | $ | 37.24 | (b/e) |\n\nCritical Accounting Policies\nCritical accounting policies are those that are reflective of significant management judgments and uncertainties, and could potentially result in materially different results under different assumptions and conditions. The Company believes that the most critical accounting policies are those that are both most important to the portrayal of the Company’s financial condition and results and require management's most difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain.\nThere have been no material changes in critical accounting policies during the first nine months of 2022. Refer to \"Critical Accounting Policies and Estimates\" in Item 7. \"Management's Discussion and Analysis of Financial Condition and Results of Operations\" in the Company's 2021 Form 10-K for a complete listing of critical accounting policies.\nFINANCIAL POSITION\nSecurities Portfolio The Company’s securities portfolio consists of trading securities, equity securities, securities available for sale, and securities which management intends to hold until maturity. Securities increased by $482.3 million, or 18.1%, at September 30, 2022 as compared to December 31, 2021, primarily reflecting $887.3 million of purchases, partially offset by unrealized losses of $167.8 million related to the available for sale portfolio, as well as paydowns, calls, and maturities. The ratio of securities to total assets increased to 16.0% at September 30, 2022 compared to 13.0% at December 31, 2021, which reflects the ongoing strategy to deploy excess liquidity into increased investment security purchases. The Company estimates expected credit losses for its available for sale and held to maturity securities in accordance with the current expected credit loss (\"CECL\") methodology. Further details regarding the Company's measurement of expected credit losses on securities can be found in Note 3 “Securities” within the Notes to Consolidated Financial Statements included in Part I. Item 1 of this Report.\n60\nResidential Mortgage Loan Sales The Company’s primary loan sale activity arises from the sale of government sponsored enterprise eligible residential mortgage loans. The Company originates residential loans with the intention of either selling them in the secondary market or holding them in the Company's residential real estate portfolio. When a loan is sold, the Company enters into agreements that contain representations and warranties about the characteristics of the loans sold and their origination. The Company may be required to either repurchase mortgage loans or to indemnify the purchaser from losses if representations and warranties are found to be not accurate in all material respects. The Company incurred no material losses related to residential mortgage repurchases during the three and nine months ended September 30, 2022 and 2021, respectively.\nThe following table shows the total residential real estate loans closed and the breakdown of amounts held in portfolio or sold (or held for sale) in the secondary market during the periods indicated:\nTable 1 - Closed Residential Real Estate Loans\n| Three Months Ended September 30 | Nine Months Ended September 30 |\n| 2022 | 2021 | 2022 | 2021 |\n| (Dollars in thousands) |\n| Held in portfolio | $ | 165,065 | $ | 65,832 | $ | 571,115 | $ | 279,176 |\n| Sold or held for sale in the secondary market | 21,325 | 183,794 | 77,309 | 611,795 |\n| Total closed loans | $ | 186,390 | $ | 249,626 | $ | 648,424 | $ | 890,971 |\n\nThe Company experienced a lower volume of residential real estate loans sales for the three and nine months ended September 30, 2022 compared to the same prior year periods, driven primarily by reduced customer demand in the rising interest rate environment. In addition, the volume of closed residential real estate loans held in portfolio increased during the three and nine months ended September 30, 2022.\nThe table below reflects additional information related to the loans sold during the periods indicated:\nTable 2 - Residential Mortgage Loan Sales\n| Three Months Ended September 30 | Nine Months Ended September 30 |\n| 2022 | 2021 | 2022 | 2021 |\n| (Dollars in thousands) |\n| Sold with servicing rights released | $ | 18,206 | $ | 171,256 | $ | 94,006 | $ | 618,171 |\n| Sold with servicing rights retained (1) | 182 | 3,029 | 863 | 11,116 |\n| Total loans sold | $ | 18,388 | $ | 174,285 | $ | 94,869 | $ | 629,287 |\n\n(1)All loans sold with servicing rights retained during the three and nine months ended September 30, 2022 and 2021, respectively, were sold without recourse.\nWhen a loan is sold, the Company may decide to also sell the servicing of sold loans for a servicing release premium, simultaneously with the sale of the loan, or the Company may opt to sell the loan and retain the servicing. In the event of a sale with servicing rights retained, a mortgage servicing asset is established, which represents the then current estimated fair value based on market prices for comparable mortgage servicing contracts, when available, or alternatively is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses. Servicing rights are recorded in other assets in the Consolidated Balance Sheets, are amortized in proportion to and over the period of estimated net servicing income, and are assessed for impairment based on fair value at each reporting date. Impairment is determined by stratifying the rights based on predominant characteristics, such as interest rate, loan type and investor type. Impairment is recognized through a valuation allowance, to the extent that fair value is less than the capitalized amount. If the Company later determines that all or a portion of the impairment no longer exists, a reduction of the allowance may be recorded as an increase to income. The principal balance of loans serviced by the Bank on behalf of investors was $336.2 million, $382.6 million and $342.3 million at September 30, 2022, December 31, 2021, and September 30, 2021, respectively.\n61\nThe following table shows the adjusted cost of the servicing rights associated with these loans and the changes for the periods indicated:\nTable 3 - Mortgage Servicing Asset\n| Three Months Ended September 30 | Nine Months Ended September 30 |\n| 2022 | 2021 | 2022 | 2021 |\n| (Dollars in thousands) |\n| Balance at beginning of period | $ | 2,993 | $ | 2,295 | $ | 2,627 | $ | 2,365 |\n| Additions | 2 | 30 | 8 | 95 |\n| Amortization | (153) | (244) | (510) | (769) |\n| Change in valuation allowance | 103 | 122 | 820 | 512 |\n| Balance at end of period | $ | 2,945 | $ | 2,203 | $ | 2,945 | $ | 2,203 |\n\nSee Note 6, “Derivative and Hedging Activities” within the Notes to Consolidated Financial Statements included in Part I. Item 1 of this Report for more information on mortgage activity and mortgage related derivatives.\nLoan Portfolio Total loans at September 30, 2022 increased by $113.1 million, or 0.8%, when compared to December 31, 2021. Excluding $205.1 million of net paydowns associated with PPP loans during the nine months ended September 30, 2022, the loan portfolio increased by $318.1 million, or 2.4% (3.2% on an annualized basis), compared to December 31, 2021. Organic loan growth was driven primarily by strong consumer loan activity, as the majority of residential real estate loan closings were retained on the balance sheet, while increased demand and line utilization fueled growth in home equity balances. Excluding the net reduction in PPP loans, the commercial portfolio decreased 0.82% at September 30, 2022 in comparison to December 31, 2021, primarily driven by continued elevated levels of attrition within the commercial real estate portfolio, which were partially offset by increased line utilization and higher closing volumes within the commercial and industrial category, which grew by $190.1 million, or 14.1% (18.9% on an annualized basis), as compared to December 31, 2021.\n62\nThe Company's commercial loan portfolio is comprised primarily of commercial and industrial loans as well as commercial real estate loans. Management considers the Company’s commercial and industrial portfolio to be well-diversified with loans to various types of industries. The following pie chart shows the diversification of the commercial and industrial portfolio as of September 30, 2022:\n\n| (Dollars in thousands) |\n| Average loan size (excluding floor plan tranches) | $ | 388 |\n| Largest individual commercial and industrial loan outstanding | $ | 37,650 |\n| Commercial and industrial nonperforming loans/commercial and industrial loans | 1.77 | % |\n\nThe Company’s commercial real estate loan portfolio, inclusive of commercial construction, is the Company’s largest loan type concentration. The Company believes that this portfolio is also well-diversified with loans secured by a variety of property types, such as owner-occupied and nonowner-occupied commercial, retail, office, industrial, warehouse, and other special purpose properties, such as hotels, motels, nursing homes, restaurants, churches, recreational facilities, marinas, and golf courses. Commercial real estate also includes loans secured by certain residential-related property types, including multi-family apartment buildings, residential development tracts and condominiums. The following pie chart shows the diversification of the commercial real estate loan portfolio as of September 30, 2022:\n63\n| (Dollars in thousands) |\n| Average loan size | $ | 1,573 |\n| Largest individual commercial real estate mortgage outstanding | $ | 63,435 |\n| Commercial real estate nonperforming loans/commercial real estate loans | 0.18 | % |\n| Owner occupied commercial real estate loans/commercial real estate loans | 12.0 | % |\n\n64\nThe Company's consumer portfolio primarily consists of both fixed-rate and adjustable-rate residential real estate loans as well as residential construction lending related to single-home residential development within the Company's market area. The Company also provides home equity loans and lines of credit that may be made as a fixed-rate term loan or under a variable rate revolving line of credit secured by a first or junior mortgage on the borrower's residence or second home. Additionally, the Company makes loans for a wide variety of other personal needs. Other consumer loans primarily consist of installment loans and overdraft protections. The residential real estate, home equity and other consumer portfolios totaled $3.1 billion at September 30, 2022, as noted below:\n| (Dollars in thousands) |\n| Average loan size | $ | 165 |\n| Largest individual consumer loan outstanding | $ | 5,181 |\n| Consumer nonperforming loans/consumer loans | 0.41 | % |\n\nAsset Quality The Company continually monitors the asset quality of the loan portfolio using all available information. Based on this assessment, loans demonstrating certain payment issues or other weaknesses may be categorized as delinquent, nonperforming and/or put on nonaccrual status. In the course of resolving such loans, the Company may choose to restructure the contractual terms of certain loans to match the borrower’s ability to repay the loan based on their current financial condition. If a restructured loan meets certain criteria, it may be categorized as a troubled debt restructuring (\"TDR\"). In addition, the Company has offered need-based payment relief options for commercial and small business loans, residential mortgages, and home equity loans and lines of credit in response to the COVID-19 pandemic. In accordance with the Coronavirus Aid, Relief and Economic Security Act (\"CARES Act\"), these modifications are not accounted for as TDRs or reflected as delinquent or non-accrual loans if the borrower was in compliance with the loan terms as of December 31, 2019.\nDelinquency The Company’s philosophy toward managing its loan portfolios is predicated upon careful monitoring, which stresses early detection and response to delinquent and default situations. The Company seeks to make arrangements to resolve any delinquent or default situation over the shortest possible time frame. Generally, the Company requires that a delinquency notice be mailed to a borrower upon expiration of a grace period (typically no longer than 15 days beyond the due date). Reminder notices may be sent and telephone calls may be made prior to the expiration of the grace period. If the delinquent status is not resolved within a reasonable time frame following the mailing of a delinquency notice, the Bank’s personnel charged with managing its loan portfolios contacts the borrower to ascertain the reasons for delinquency and the prospects for payment. Any subsequent actions taken to resolve the delinquency will depend upon the nature of the loan and\n65\nthe length of time that the loan has been delinquent. The borrower’s needs are considered as much as reasonably possible without jeopardizing the Bank’s position. A late charge is usually assessed on loans upon expiration of the grace period.\nNonaccrual Loans As a general rule, loans 90 days or more past due with respect to principal or interest are classified as nonaccrual loans. However, certain loans that are 90 days or more past due may be kept on an accruing status if the loans are well secured and in the process of collection. Income accruals are suspended on all nonaccrual loans and all previously accrued and uncollected interest is reversed against current income. A loan remains on nonaccrual status until it becomes current with respect to principal and interest (and in certain instances remains current for up to six months), the loan is liquidated, or when the loan is determined to be uncollectible and is charged-off against the allowance for credit losses.\nTroubled Debt Restructurings In the course of resolving problem loans, the Company may choose to restructure the contractual terms of certain loans. The Company attempts to work out an alternative payment schedule with the borrower in order to avoid or cure a default. Loans that are modified are reviewed by the Company to identify if a TDR has occurred, which is when, for economic or legal reasons related to a borrower’s financial difficulties, the Bank grants a concession to the borrower that it would not otherwise consider. Terms may be modified to fit the ability of the borrower to repay in line with its current financial status and the restructuring of the loan may include adjustments to interest rates, extensions of maturity, consumer loans where the borrower's obligations have been effectively discharged through Chapter 7 Bankruptcy and the borrower has not reaffirmed the debt to the Bank, and other actions intended to minimize economic loss and avoid foreclosure or repossession of collateral. If such efforts by the Bank do not result in satisfactory performance, the loan is referred to legal counsel, at which time foreclosure proceedings are initiated. At any time prior to a sale of the property at foreclosure, the Bank may terminate foreclosure proceedings if the borrower is able to work out a satisfactory payment plan.\nIt is the Company’s policy to have any restructured loans which are on nonaccrual status prior to being modified remain on nonaccrual status for six months, subsequent to being modified, before management considers their return to accrual status. If the restructured loan is on accrual status prior to being modified, it is reviewed to determine if the modified loan should remain on accrual status. Loans that are considered TDRs are classified as performing, unless they are on nonaccrual status or are delinquent for 90 days or more. Loans classified as TDRs remain classified as such for the life of the loan, except in limited circumstances, when it may be determined that the borrower is performing under modified terms and the restructuring agreement specified an interest rate greater than or equal to an acceptable market rate for a comparable new loan at the time of the restructuring.\nPurchased Credit Deteriorated Loans Purchased Credit Deteriorated (\"PCD\") loans are acquired loans which have shown a more-than-insignificant deterioration in credit quality since origination. PCD loans are recorded at amortized cost with an allowance for credit losses recorded upon purchase.\nNonperforming Assets Nonperforming assets are typically comprised of nonperforming loans and other real estate owned. Nonperforming loans consist of nonaccrual loans and loans that are 90 days or more past due but still accruing interest.\nThe following table sets forth information regarding nonperforming assets held by the Company at the dates indicated:\nTable 4 - Nonperforming Assets\n| September 302022 | December 312021 | September 302021 |\n| (Dollars in thousands) |\n| Loans accounted for on a nonaccrual basis |\n| Commercial and industrial | $ | 27,393 | $ | 3,439 | $ | 19,275 |\n| Commercial real estate | 15,982 | 10,870 | 11,788 |\n| Small business | 50 | 44 | 46 |\n| Residential real estate | 8,891 | 9,182 | 10,872 |\n| Home equity | 3,485 | 3,781 | 3,746 |\n| Other consumer | 216 | 504 | 83 |\n| Total nonperforming assets (1) | $ | 56,017 | $ | 27,820 | $ | 45,810 |\n| Nonperforming loans as a percent of gross loans | 0.41 | % | 0.20 | % | 0.52 | % |\n| Nonperforming assets as a percent of total assets | 0.28 | % | 0.14 | % | 0.32 | % |\n\n(1)Inclusive of TDRs on nonaccrual status of $1.5 million at September 30, 2022, $2.0 million at December 31, 2021, and $21.1 million at September 30, 2021.\nThe following table summarizes the changes in nonperforming assets for the periods indicated:\nTable 5 - Activity in Nonperforming Assets\n| 2022 | 2021 |\n| Three Months Ended | Nine Months Ended |\n| September 302022 | September 302021 | September 302022 | September 302021 |\n| (Dollars in thousands) |\n| Nonperforming assets beginning balance | $ | 55,915 | $ | 47,818 | $ | 27,820 | $ | 66,861 |\n| New to nonperforming | 30,650 | 4,613 | 67,226 | 9,205 |\n| Loans charged-off | (741) | (332) | (1,992) | (4,499) |\n| Loans paid-off | (29,450) | (3,488) | (33,174) | (17,877) |\n| Loans restored to performing status | (366) | (2,813) | (3,806) | (8,143) |\n| Other | 9 | 12 | (57) | 263 |\n| Nonperforming assets ending balance | $ | 56,017 | $ | 45,810 | $ | 56,017 | $ | 45,810 |\n\n67\nThe following table sets forth information regarding troubled debt restructured loans as of the dates indicated:\nTable 6 - Troubled Debt Restructurings\n| September 302022 | December 312021 | September 302021 |\n| (Dollars in thousands) |\n| Performing troubled debt restructurings | $ | 11,549 | $ | 14,635 | $ | 15,950 |\n| Nonaccrual troubled debt restructurings | 1,538 | 1,993 | 21,104 |\n| Total | $ | 13,087 | $ | 16,628 | $ | 37,054 |\n| Performing troubled debt restructurings as a % of total loans | 0.09 | % | 0.11 | % | 0.18 | % |\n| Nonaccrual troubled debt restructurings as a % of total loans | 0.01 | % | 0.01 | % | 0.24 | % |\n| Total troubled debt restructurings as a % of total loans | 0.10 | % | 0.12 | % | 0.42 | % |\n\nThe following table summarizes changes in TDRs for the periods indicated:\nTable 7 - Activity in Troubled Debt Restructurings\n| Three Months Ended | Nine Months Ended |\n| September 302022 | September 302021 | September 302022 | September 302021 |\n| (Dollars in thousands) |\n| TDRs beginning balance | $ | 13,411 | $ | 39,707 | $ | 16,628 | $ | 39,192 |\n| New to TDR status | 62 | — | 62 | 3,918 |\n| Paydowns | (386) | (2,637) | (3,603) | (6,040) |\n| Charge-offs | — | (16) | — | (16) |\n| TDRs ending balance | $ | 13,087 | $ | 37,054 | $ | 13,087 | $ | 37,054 |\n\nIncome accruals are suspended on all nonaccrual loans and all previously accrued and uncollected interest is reversed against current income. The table below shows interest income that was recognized or collected on all nonaccrual loans and TDRs for the periods indicated:\nTable 8 - Interest Income - Nonaccrual Loans and Troubled Debt Restructurings\n\n| Three Months Ended | Nine Months Ended |\n| September 302022 | September 302021 | September 302022 | September 302021 |\n| (Dollars in thousands) |\n| The amount of incremental gross interest income that would have been recorded if nonaccrual loans had been current in accordance with their original terms | $ | 1,802 | $ | 678 | $ | 4,666 | $ | 2,289 |\n| The amount of interest income on nonaccrual loans and performing TDRs that was included in net income | $ | 1,817 | $ | 257 | $ | 2,443 | $ | 673 |\n\nPotential problem loans are any loans which are not included in nonaccrual or nonperforming loans, where known information about possible credit problems of the borrowers causes management to have concerns as to the ability of such borrowers to comply with present loan repayment terms. At September 30, 2022, there were 51 relationships, with an aggregate balance of $173.5 million, deemed to be potential problem loans. These potential problem loans continued to perform with respect to payments. Management actively monitors these loans and strives to minimize any possible adverse impact to the Company.\n68\nAs previously noted, the Company has offered need-based payment relief options to its customers in response to the COVID-19 pandemic, primarily in the form of payment deferrals, all of which were granted prior to December 31, 2020. Loans that were modified are not accounted for as TDRs or reflected as delinquent or nonaccrual loans if the borrower was in compliance with their loan terms as of December 31, 2019. The Company held $193.3 million of loans with active deferrals at September 30, 2022, of which $137.7 million is scheduled to mature during the fourth quarter of 2022.\nAllowance for Credit Losses The allowance for credit losses is maintained at a level that management considers appropriate to provide for the Company's current estimate of expected lifetime credit losses on loans measured at amortized cost. The allowance is increased by providing for credit losses through a charge to expense and by credits for recoveries of loans previously charged-off and is reduced by loans being charged-off.\nIn accordance with the CECL methodology, the Company estimates credit losses for financial assets on a collective basis for loans sharing similar risk characteristics using a quantitative model combined with an assessment of certain qualitative factors designed to address forecast risk and model risk inherent in the quantitative model output. The model estimates expected credit losses using loan level data over the contractual life of the exposure, considering the effect of prepayments. Economic forecasts are incorporated into the estimate over a reasonable and supportable forecast period of one year, beyond which is a reversion to the Company's historical long-run average for a period of six months. The Company's qualitative assessment is structured based upon nine environmental factors impacting the expected risk of loss within the loan portfolio. Loans that do not share similar risk characteristics with any pools of assets are subject to individual assessment and are removed from the collectively assessed pools to avoid double counting. For the loans that will be individually assessed, the Company uses either a discounted cash flow (“DCF”) approach or a fair value of collateral approach. The latter approach is used for loans deemed to be collateral dependent or when foreclosure is probable.\nThe balance of allowance for credit losses of $147.3 million at September 30, 2022 remained relatively flat compared to $146.9 million at December 31, 2021. The net change in the Company's allowance for credit losses for the nine months ended September 30, 2022 primarily reflects elevated balances of nonperforming loans at September 30, 2022 compared to December 31, 2021, offset by attrition of existing loans and continued strong asset quality metrics. Despite the increase in nonperforming loans, net charge-offs recorded for the three and nine months ended September 30, 2022 were minimal.\nThe aforementioned increase in nonperforming loans contributed to an overall higher quantitative allowance at September 30, 2022 compared to December 31, 2021. Management's forecast anticipates that the federal funds rates will rise in the near term, that supply chain issues will persist, inflation will remain elevated, and the military conflict between Russia and Ukraine will persist for the foreseeable future, potentially impacting global oil supplies and the supply chain more generally. The forecast used by management also anticipates that the U.S. economy will fall into a recession during the fourth quarter of 2022 and that the recession will persist for the short term. Additionally, the allowance for credit losses is qualitatively adjusted on a quarterly basis in order to ensure coverage for relationships that are deemed to be more at risk within certain industries, specific collateral types, or other specific characteristics that may be highly impacted by the current economic environment.\n69\nThe following table summarizes the ratio of net charge-offs to average loans outstanding within each major loan category for the periods presented:\nTable 9 - Summary Net Charge-Offs to Average Loans Outstanding\n| Net Charge-Offs (Recoveries) | Average Loans Outstanding | Ratio of Annualized Net Charge-Offs/(Recoveries) to Average Loans | Net Charge-Offs (Recoveries) | Average Loans Outstanding | Ratio of Annualized Net Charge-Offs/(Recoveries) to Average Loans |\n| (Dollars in thousands) |\n| Three Months Ended September 30, 2022 | Nine Months Ended September 30, 2022 |\n| Commercial and industrial | $ | (2) | $ | 1,520,924 | — | % | $ | (44) | $ | 1,531,421 | — | % |\n| Commercial real estate | (268) | 7,760,470 | (0.01) | % | (271) | 7,832,534 | — | % |\n| Commercial construction | — | 1,157,876 | — | % | — | 1,180,509 | — | % |\n| Small business | (88) | 207,546 | (0.17) | % | (88) | 202,151 | (0.06) | % |\n| Residential real estate | — | 1,909,066 | — | % | — | 1,774,355 | — | % |\n| Home equity | (65) | 1,076,040 | (0.02) | % | 17 | 1,051,921 | — | % |\n| Other consumer | 429 | 31,883 | 5.34 | % | 995 | 31,092 | 4.28 | % |\n| Total | $ | 6 | $ | 13,663,805 | — | % | $ | 609 | $ | 13,603,983 | 0.01 | % |\n| Net Charge-Offs (Recoveries) | Average Loans Outstanding | Ratio of Annualized Net Charge-Offs/(Recoveries) to Average Loans | Net Charge-Offs (Recoveries) | Average Loans Outstanding | Ratio of Annualized Net Charge-Offs/(Recoveries) to Average Loans |\n| (Dollars in thousands) |\n| Three Months Ended September 30, 2021 | Nine Months Ended September 30, 2021 |\n| Commercial and industrial | $ | — | $ | 1,640,422 | — | % | $ | 3,374 | $ | 1,898,100 | 0.24 | % |\n| Commercial real estate | — | 4,232,575 | — | % | (57) | 4,195,200 | — | % |\n| Commercial construction | — | 507,393 | — | % | — | 525,652 | — | % |\n| Small business | 33 | 181,953 | 0.07 | % | 119 | 178,294 | 0.09 | % |\n| Residential real estate | — | 1,231,606 | — | % | (1) | 1,242,991 | — | % |\n| Home equity | (49) | 1,007,371 | (0.02) | % | (38) | 1,027,311 | — | % |\n| Other consumer | 127 | 25,929 | 1.94 | % | 249 | 23,382 | 1.42 | % |\n| Total | $ | 111 | $ | 8,827,249 | — | % | $ | 3,646 | $ | 9,090,930 | 0.05 | % |\n\n70\nFor purposes of the allowance for credit losses, management segregates the loan portfolio into the portfolio segments detailed in the table below. The allocation of the allowance for credit losses is made to each loan category using the analytical techniques and estimation methods described in this Report. While these amounts represent management’s best estimate of credit losses at the evaluation dates, they are not necessarily indicative of either the categories in which actual losses may occur or the extent of such actual losses that may be recognized within each category. Each of these loan categories possess unique risk characteristics that are considered when determining the appropriate level of allowance for each segment. The total allowance is available to absorb losses from any segment of the loan portfolio.\nThe following table sets forth the allocation of the allowance for credit losses by loan category at the dates indicated:\nTable 10 - Summary of Allocation of Allowance for Credit Losses\n\n| September 302022 | December 312021 |\n| AllowanceAmount | Percent ofLoansIn CategoryTo Total Loans | AllowanceAmount | Percent ofLoansIn CategoryTo Total Loans |\n| (Dollars in thousands) |\n| Commercial and industrial (1) | $ | 20,169 | 11.3 | % | $ | 14,402 | 11.5 | % |\n| Commercial real estate | 80,036 | 56.1 | % | 83,486 | 58.8 | % |\n| Commercial construction | 11,419 | 8.7 | % | 12,316 | 8.6 | % |\n| Small business | 2,624 | 1.5 | % | 3,508 | 1.4 | % |\n| Residential real estate | 20,602 | 14.3 | % | 14,484 | 11.8 | % |\n| Home equity | 11,651 | 7.9 | % | 17,986 | 7.7 | % |\n| Other consumer | 812 | 0.2 | % | 740 | 0.2 | % |\n| Total allowance for credit losses | $ | 147,313 | 100.0 | % | $ | 146,922 | 100.0 | % |\n\n(1)Total loans in this category are inclusive of $11.1 million and $216.2 million in loans at September 30, 2022 and December 31, 2021, respectively, which were originated as part of the PPP established by the CARES Act. These loans have been excluded from the credit loss calculations as these loans are 100% guaranteed by the U.S. Government.\nTo determine if a loan should be charged-off, all possible sources of repayment are analyzed. Possible sources of repayment include the potential for future cash flows, the value of the Bank’s collateral, and the strength of co-makers or guarantors. When available information confirms that specific loans or portions thereof are uncollectible, these amounts are promptly charged-off against the allowance for credit losses and any recoveries of such previously charged-off amounts are credited to the allowance.\nRegardless of whether a loan is unsecured or collateralized, the Company charges off the amount of any confirmed loan loss in the period when the loans, or portions of loans, are deemed uncollectible. For troubled, collateral-dependent loans, loss-confirming events may include an appraisal or other valuation that reflects a shortfall between the value of the collateral and the carrying value of the loan or receivable, or a deficiency balance following the sale of the collateral.\nFor additional information regarding the Company’s allowance for credit losses, see Note 4 \"Loans, Allowance for Credit Losses and Credit Quality\" within the Notes to Consolidated Financial Statements included in Part I. Item 1 of this Report.\nFederal Home Loan Bank Stock The FHLB is a cooperative that provides services to its member banking institutions. The primary reason for the FHLB of Boston membership is to gain access to a reliable source of wholesale funding as a tool to manage liquidity and interest rate risk. The purchase of stock in the FHLB is a requirement for a member to gain access to funding. The Company either purchases additional FHLB stock or is subject to redemption of FHLB stock proportional to the volume of funding received. The Company views the holdings as a necessary long-term investment for the purpose of balance sheet liquidity and not for investment return. The Bank held investments in FHLB of Boston stock of $5.2 million and $11.4 million at September 30, 2022 and December 31, 2021, respectively, reflecting redemption activity occurring during 2022.\nGoodwill and Other Intangible Assets Goodwill and other intangible assets were $1.0 billion at both September 30, 2022 and December 31, 2021.\n71\nThe Company typically performs its annual goodwill impairment testing during the third quarter of the year, unless certain indicators suggest earlier testing to be warranted. Accordingly, the Company performed its annual goodwill impairment testing during the third quarter of 2022 and determined that the Company's goodwill was not impaired as of September 30, 2022. Other intangible assets are also reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. There were no events or changes during the third quarter of 2022 that indicated impairment of goodwill and other intangible assets.\nCash Surrender Value of Life Insurance Policies The Bank holds life insurance policies for the purpose of offsetting its future obligations to its employees under its retirement and benefits plans. The cash surrender value of life insurance policies was $293.1 million at September 30, 2022 compared to $289.3 million at December 31, 2021, representing an increase of $3.8 million, or 1.3%, primarily due to income earned on the policies.\nThe Company recorded tax exempt income from life insurance policies of $1.9 million and $1.6 million for the three months ended September 30, 2022 and 2021, respectively, and $5.5 million and $4.5 million for the nine months ended September 30, 2022 and 2021, respectively. The Company recorded gains on life insurance benefits of $477,000 for three months ended September 30, 2022 and no such gains for the three months ended September 30, 2021, respectively, and $600,000 and $258,000 for the nine months ended September 30, 2022 and September 30, 2021, respectively.\nDeposits As of September 30, 2022, total deposits were $16.3 billion, representing a $578.1 million, or 3.4%, decrease from December 31, 2021, primarily attributable to continued runoff in higher-cost time deposits and certain rate sensitive deposits. The total cost of deposits was 0.15% and 0.05% for the three months ended September 30, 2022 and 2021, respectively, and 0.08% and 0.07% for the nine months ended September 30, 2022 and 2021, respectively. Core deposits increased to 87.8% of total deposits as of September 30, 2022 from 84.5% at December 31, 2021.\nThe Company also participates in the IntraFi Network, allowing the Bank to provide easy access to multi-million dollar Federal Deposit Insurance Corporation (\"FDIC\") deposit insurance protection on certificate of deposit and money market investments for consumers, businesses and public entities. This channel allows the Company to seek additional funding in potentially large quantities by attracting deposits from outside the Bank’s core market, and amounted to $751.1 million and $998.1 million at September 30, 2022 and December 31, 2021, respectively. In addition, the Company may occasionally raise funds through the use of brokered deposits outside of the IntraFi Network, which amounted to $102.6 million and $141.6 million at September 30, 2022 and December 31, 2021, respectively.\nBorrowings The Company's borrowings consist of both short-term and long-term borrowings and provide the Bank with one of its primary sources of funding. Maintaining available borrowing capacity provides the Bank with a contingent source of liquidity. Borrowings were $113.4 million at September 30, 2022, a decrease of $39.0 million, or 25.6%, as compared to December 31, 2021, due primarily to the re-payment of a revolving loan credit facility during the first quarter of 2022 and the maturity of a short term Federal Home Loan Bank borrowing during the third quarter of 2022.\nAdditionally, the Bank had $4.3 billion and $4.2 billion of assets pledged as collateral against borrowings at September 30, 2022 and December 31, 2021, respectively. These assets are primarily pledged to the FHLB of Boston and the Federal Reserve Bank of Boston.\n72\nCapital Resources On September 15, 2022 the Company’s Board of Directors declared a cash dividend of $0.51 per share to shareholders of record as of the close of business on September 26, 2022. This dividend was paid on October 7, 2022.\nThe Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company’s and the Bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.\nQuantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of Total, Tier 1 Capital and Common Equity Tier 1 Capital (as defined for regulatory purposes) to risk weighted assets (as defined for regulatory purposes) and Tier 1 Capital to average assets (as defined for regulatory purposes). At September 30, 2022 and December 31, 2021, the Company and the Bank exceeded the minimum requirements for all applicable ratios that were in effect during the respective periods. The Company’s and the Bank’s capital amounts and ratios are presented in the following table, along with the applicable minimum requirements as of each date indicated:\nTable 11 - Company and Bank's Capital Amounts and Ratios\n| Actual | For Capital Adequacy Purposes | To Be Well Capitalized Under PromptCorrective Action Provisions |\n| Amount | Ratio | Amount | Ratio | Amount | Ratio |\n| September 30, 2022 |\n| (Dollars in thousands) |\n| Company (consolidated) |\n| Total capital (to risk weighted assets) | $ | 2,250,741 | 15.71 | % | $ | 1,146,074 | ≥ | 8.0 | % | N/A | N/A |\n| Common equity tier 1 capital (to risk weighted assets) | 2,002,105 | 13.98 | % | 644,666 | ≥ | 4.5 | % | N/A | N/A |\n| Tier 1 capital (to risk weighted assets) | 2,002,105 | 13.98 | % | 859,555 | ≥ | 6.0 | % | N/A | N/A |\n| Tier 1 capital (to average assets) | 2,002,105 | 10.51 | % | 761,820 | ≥ | 4.0 | % | N/A | N/A |\n| Bank |\n| Total capital (to risk weighted assets) | $ | 2,142,284 | 14.95 | % | $ | 1,146,046 | ≥ | 8.0 | % | $ | 1,432,558 | ≥ | 10.0 | % |\n| Common equity tier 1 capital(to risk weighted assets) | 2,004,510 | 13.99 | % | 644,651 | ≥ | 4.5 | % | 931,163 | ≥ | 6.5 | % |\n| Tier 1 capital (to risk weighted assets) | 2,004,510 | 13.99 | % | 859,535 | ≥ | 6.0 | % | 1,146,046 | ≥ | 8.0 | % |\n| Tier 1 capital (to average assets) | 2,004,510 | 10.52 | % | 801,528 | ≥ | 4.0 | % | 1,001,911 | ≥ | 5.0 | % |\n| December 31, 2021 |\n| (Dollars in thousands) |\n| Company (consolidated) |\n| Total capital (to risk weighted assets) | $ | 2,262,740 | 16.04 | % | $ | 1,128,900 | ≥ | 8.0 | % | N/A | N/A |\n| Common equity tier 1 capital (to risk weighted assets) | 2,017,497 | 14.30 | % | 635,006 | ≥ | 4.5 | % | N/A | N/A |\n| Tier 1 capital (to risk weighted assets) | 2,017,497 | 14.30 | % | 846,675 | ≥ | 6.0 | % | N/A | N/A |\n| Tier 1 capital (to average assets) | 2,017,497 | 12.03 | % | 670,659 | ≥ | 4.0 | % | N/A | N/A |\n| Bank |\n| Total capital (to risk weighted assets) | $ | 2,083,689 | 14.77 | % | $ | 1,128,536 | ≥ | 8.0 | % | $ | 1,410,670 | ≥ | 10.0 | % |\n| Common equity tier 1 capital(to risk weighted assets) | 1,949,237 | 13.82 | % | 634,801 | ≥ | 4.5 | % | 916,935 | ≥ | 6.5 | % |\n| Tier 1 capital (to risk weighted assets) | 1,949,237 | 13.82 | % | 846,402 | ≥ | 6.0 | % | 1,128,536 | ≥ | 8.0 | % |\n| Tier 1 capital (to average assets) | 1,949,237 | 11.62 | % | 670,827 | ≥ | 4.0 | % | 838,534 | ≥ | 5.0 | % |\n\n73\nIn addition to the minimum risk-based capital requirements outlined in the table above, the Company is required to maintain a minimum capital conservation buffer, in the form of common equity, in order to avoid restrictions on capital distributions and discretionary bonuses. The required amount of the capital conservation buffer is 2.5%. At September 30, 2022, the Company's capital levels exceeded the buffer.\nDividend Restrictions The Company is subject to capital and dividend requirements administered by federal and state bank regulators, and the Company will not declare a cash dividend that would cause the Company to violate regulatory requirements. The Company is, in the ordinary course of business, dependent upon the receipt of cash dividends from the Bank to pay cash dividends to shareholders and satisfy the Company’s other cash needs. Federal and state law impose limits on capital distributions by the Bank. Massachusetts-chartered banks, such as the Bank, may declare from net profits cash dividends not more frequently than quarterly and non-cash dividends at any time. No dividends may be declared, credited, or paid if the Bank’s capital stock would be impaired. Massachusetts Bank Commissioner approval is required if the total of all dividends declared by the Bank in any calendar year would exceed the total of its net profits for that year combined with its retained net profits of the preceding two years, less any required transfer to surplus or a fund for the retirement of any preferred stock. Dividends paid by the Bank to the Company totaled $64.5 million and $33.9 million for the three months ended September 30, 2022 and 2021, respectively and totaled $142.7 million and $38.9 million for the nine months ended September 30, 2022 and 2021, respectively.\nTrust Preferred Securities In accordance with the applicable accounting standard related to variable interest entities, the common stock of trusts which have issued trust preferred securities has not been included in the consolidated financial statements of the Company. At each of September 30, 2022 and December 31, 2021 there were $61.0 million in trust preferred securities included in the Tier 2 capital of the Company for regulatory reporting purposes pursuant to the Federal Reserve's capital adequacy guidelines.\nInvestment Management The following table presents total assets under administration and number of accounts held by the Rockland Trust Investment Management Group at the following dates:\nTable 12 - Assets Under Administration\n| September 302022 | December 312021 | September 302021 |\n| (Dollars in thousands) |\n| Assets under administration | $ | 5,091,592 | $ | 5,726,368 | $ | 5,434,971 |\n| Number of trust, fiduciary and agency accounts | 6,487 | 6,379 | 6,368 |\n\nDespite strong new asset inflows, assets under administration at September 30, 2022 decreased compared to December 31, 2021, driven primarily by depressed market valuations experienced during the first nine months of 2022. Included in these amounts as of September 30, 2022 and December 31, 2021 are assets under administration of $361.0 million and $447.4 million, respectively, relating to the Company’s registered investment advisor, Bright Rock Capital Management, LLC, which provides institutional quality investment management services to institutional and high net worth clients. Revenue from the Investment Management Group was $7.8 million and $8.1 million for the three months ended September 30, 2022 and 2021, respectively, and $23.6 million for the nine months ended September 30, 2022 and 2021.\nThe administration of trust and fiduciary accounts is monitored by the Trust Committee of the Bank’s Board of Directors. The Trust Committee has delegated administrative responsibilities to three committees, one for investments, one for administration, and one for operations, all of which are comprised of Investment Management Group officers who meet no less than quarterly.\nThe Bank has an agreement with LPL Financial (\"LPL\") and its affiliates and their insurance subsidiary, LPL Insurance Associates, Inc., to offer the sale of mutual fund shares, unit investment trust shares, general securities, fixed and variable annuities and life insurance. Registered representatives who are both employed by the Bank and licensed and contracted with LPL are onsite to offer these products to the Bank’s customer base. These same agents are also approved and appointed with various other Broker General Agents for the purposes of processing insurance solutions for clients. Retail investments and insurance revenue was $601,000 and $1.0 million for the three months ended September 30, 2022 and 2021, respectively, and $2.9 million and $2.8 million for the nine months ended September 30, 2022 and 2021, respectively.\n74\nRESULTS OF OPERATIONS\nThe following table provides a summary of results of operations for the three and nine months ended September 30, 2022 and 2021:\nTable 13 - Summary of Results of Operations\n\n| Three Months Ended September 30 | Nine Months Ended September 30 |\n| 2022 | 2021 | 2022 | 2021 |\n| (Dollars in thousands, except per share data) |\n| Net income | $ | 71,897 | $ | 40,007 | $ | 186,770 | $ | 119,290 |\n| Diluted earnings per share | $ | 1.57 | $ | 1.21 | $ | 4.00 | $ | 3.61 |\n| Return on average assets | 1.43 | % | 1.11 | % | 1.25 | % | 1.15 | % |\n| Return on average equity | 9.90 | % | 9.04 | % | 8.51 | % | 9.20 | % |\n| Net interest margin | 3.64 | % | 2.78 | % | 3.33 | % | 3.00 | % |\n\nNet Interest Income The amount of net interest income is affected by changes in interest rates and by the volume, mix, and interest rate sensitivity of interest-earning assets and interest-bearing liabilities.\nOn a fully tax equivalent basis (\"FTE\"), net interest income for the third quarter of 2022 was $163.6 million, representing an increase of $73.3 million, or 81.2%, when compared to the third quarter of 2021. For the nine months ended September 30, 2022, the net interest income on a FTE basis was $447.9 million, representing an increase of $168.2 million, or 60.1%, when compared to the year ago period. The year-over-year increases in net interest income are primarily attributable to the Meridian acquisition which closed during the fourth quarter of 2021, as well as the positive impact of asset repricing in the rising rate environment and relatively stable funding costs experienced through September 30, 2022, partially offset by reduced PPP fee income.\n75\nThe following tables present the Company’s average balances, net interest income, interest rate spread, and net interest margin for the three and nine months ended September 30, 2022 and 2021. Nontaxable income from loans and securities is presented on a FTE basis by adjusting tax-exempt income upward by an amount equivalent to the prevailing income tax rate that would have been paid if the income had been fully taxable.\nTable 14 - Average Balance, Interest Earned/Paid & Average Yields Quarter-to-Date\n| Three Months Ended September 30 |\n| 2022 | 2021 |\n| AverageBalance | InterestEarned/Paid | Yield/Rate | AverageBalance | InterestEarned/Paid | Yield/Rate |\n| (Dollars in thousands) |\n| Interest-earning assets |\n| Interest-earning deposits with banks, federal funds sold, and short term investments | $ | 1,156,143 | $ | 6,519 | 2.24 | % | $ | 2,135,031 | $ | 815 | 0.15 | % |\n| Securities |\n| Securities - trading | 3,730 | — | — | % | 3,498 | — | — | % |\n| Securities - taxable investments | 3,024,802 | 13,243 | 1.74 | % | 1,880,863 | 7,792 | 1.64 | % |\n| Securities - nontaxable investments (1) | 196 | 1 | 2.02 | % | 468 | 5 | 4.24 | % |\n| Total securities | $ | 3,028,728 | $ | 13,244 | 1.73 | % | $ | 1,884,829 | $ | 7,797 | 1.64 | % |\n| Loans held for sale | 4,263 | 51 | 4.75 | % | 30,143 | 193 | 2.54 | % |\n| Loans (2) |\n| Commercial and industrial (1) | 1,520,924 | 19,289 | 5.03 | % | 1,640,422 | 15,309 | 3.70 | % |\n| Commercial real estate (1) | 7,760,470 | 85,284 | 4.36 | % | 4,232,575 | 41,469 | 3.89 | % |\n| Commercial construction | 1,157,876 | 14,875 | 5.10 | % | 507,393 | 4,916 | 3.84 | % |\n| Small business | 207,546 | 2,819 | 5.39 | % | 181,953 | 2,341 | 5.10 | % |\n| Total commercial | 10,646,816 | 122,267 | 4.56 | % | 6,562,343 | 64,035 | 3.87 | % |\n| Residential real estate | 1,909,066 | 16,533 | 3.44 | % | 1,231,606 | 10,955 | 3.53 | % |\n| Home equity | 1,076,040 | 11,869 | 4.38 | % | 1,007,371 | 9,043 | 3.56 | % |\n| Total consumer real estate | 2,985,106 | 28,402 | 3.77 | % | 2,238,977 | 19,998 | 3.54 | % |\n| Other consumer | 31,883 | 523 | 6.51 | % | 25,929 | 398 | 6.09 | % |\n| Total loans | $ | 13,663,805 | $ | 151,192 | 4.39 | % | $ | 8,827,249 | $ | 84,431 | 3.79 | % |\n| Total interest-earning assets | $ | 17,852,939 | $ | 171,006 | 3.80 | % | $ | 12,877,252 | $ | 93,236 | 2.87 | % |\n| Cash and due from banks | 192,003 | 144,556 |\n| Federal Home Loan Bank stock | 5,745 | 8,904 |\n| Other assets | 1,854,870 | 1,268,199 |\n| Total assets | $ | 19,905,557 | $ | 14,298,911 |\n| Interest-bearing liabilities |\n| Deposits |\n| Savings and interest checking accounts | $ | 6,224,690 | $ | 2,110 | 0.13 | % | $ | 4,426,106 | $ | 338 | 0.03 | % |\n| Money market | 3,459,212 | 3,025 | 0.35 | % | 2,375,492 | 443 | 0.07 | % |\n| Time deposits | 1,246,841 | 974 | 0.31 | % | 795,943 | 852 | 0.42 | % |\n| Total interest-bearing deposits | $ | 10,930,743 | $ | 6,109 | 0.22 | % | $ | 7,597,541 | $ | 1,633 | 0.09 | % |\n| Borrowings |\n| Federal Home Loan Bank borrowings | $ | 12,876 | $ | 55 | 1.69 | % | $ | 31,118 | $ | 165 | 2.10 | % |\n| Long-term borrowings | — | — | — | % | 18,742 | 77 | 1.63 | % |\n| Junior subordinated debentures | 62,854 | 589 | 3.72 | % | 62,852 | 432 | 2.73 | % |\n| Subordinated debentures | 49,847 | 617 | 4.91 | % | 49,753 | 617 | 4.92 | % |\n\n76\n| Total borrowings | $ | 125,577 | $ | 1,261 | 3.98 | % | $ | 162,465 | $ | 1,291 | 3.15 | % |\n| Total interest-bearing liabilities | $ | 11,056,320 | $ | 7,370 | 0.26 | % | $ | 7,760,006 | $ | 2,924 | 0.15 | % |\n| Noninterest bearing demand deposits | 5,641,742 | 4,502,045 |\n| Other liabilities | 325,507 | 280,754 |\n| Total liabilities | $ | 17,023,569 | $ | 12,542,805 |\n| Stockholders' equity | 2,881,988 | 1,756,106 |\n| Total liabilities and stockholders' equity | $ | 19,905,557 | $ | 14,298,911 |\n| Net interest income (1) | $ | 163,636 | $ | 90,312 |\n| Interest rate spread (3) | 3.54 | % | 2.72 | % |\n| Net interest margin (4) | 3.64 | % | 2.78 | % |\n| Supplemental information |\n| Total deposits, including demand deposits | $ | 16,572,485 | $ | 6,109 | $ | 12,099,586 | $ | 1,633 |\n| Cost of total deposits | 0.15 | % | 0.05 | % |\n| Total funding liabilities, including demand deposits | $ | 16,698,062 | $ | 7,370 | $ | 12,262,051 | $ | 2,924 |\n| Cost of total funding liabilities | 0.18 | % | 0.09 | % |\n\n(1)The total amount of adjustment to interest income and yield on a FTE basis was $1.0 million and $220,000 for the three months ended September 30, 2022 and 2021, respectively. The FTE adjustment relates to tax exempt income relating to securities with average balances of $196,000 and $468,000 and tax exempt income relating to loans with average balances of $414.4 million and $61.2 million, for the three months ended September 30, 2022 and 2021, respectively.\n(2)Includes average nonaccruing loans.\n(3)Interest rate spread represents the difference between the weighted average yield on interest-earning assets and the weighted average cost of interest-bearing liabilities.\n(4)Net interest margin represents annualized net interest income as a percentage of average interest-earning assets.\n77\nTable 15 - Average Balance, Interest Earned/Paid & Average Yields Year-to-Date\n| Nine Months Ended September 30 |\n| 2022 | 2021 |\n| AverageBalance | InterestEarned/Paid | Yield/Rate | AverageBalance | InterestEarned/Paid | Yield/Rate |\n| (Dollars in thousands) |\n| Interest-earning assets |\n| Interest-earning deposits with banks, federal funds sold, and short-term investments | $ | 1,477,117 | $ | 10,222 | 0.93 | % | $ | 1,782,463 | $ | 1,654 | 0.12 | % |\n| Securities |\n| Securities - trading | 3,775 | — | — | % | 3,267 | — | — | % |\n| Securities - taxable investments | 2,881,203 | 34,567 | 1.60 | % | 1,550,859 | 21,603 | 1.86 | % |\n| Securities - nontaxable investments (1) | 198 | 5 | 3.38 | % | 555 | 17 | 4.10 | % |\n| Total securities | $ | 2,885,176 | $ | 34,572 | 1.60 | % | $ | 1,554,681 | $ | 21,620 | 1.86 | % |\n| Loans held for sale | 5,841 | 150 | 3.43 | % | 35,953 | 675 | 2.51 | % |\n| Loans (2) |\n| Commercial and industrial (1) | 1,531,421 | 53,816 | 4.70 | % | 1,898,100 | 58,706 | 4.14 | % |\n| Commercial real estate (1) | 7,832,534 | 238,085 | 4.06 | % | 4,195,200 | 123,377 | 3.93 | % |\n| Commercial construction | 1,180,509 | 40,599 | 4.60 | % | 525,652 | 14,976 | 3.81 | % |\n| Small business | 202,151 | 7,891 | 5.22 | % | 178,294 | 6,924 | 5.19 | % |\n| Total commercial | 10,746,615 | 340,391 | 4.23 | % | 6,797,246 | 203,983 | 4.01 | % |\n| Residential real estate | 1,774,355 | 45,109 | 3.40 | % | 1,242,991 | 34,449 | 3.71 | % |\n| Home equity | 1,051,921 | 29,709 | 3.78 | % | 1,027,311 | 26,391 | 3.43 | % |\n| Total consumer real estate | 2,826,276 | 74,818 | 3.54 | % | 2,270,302 | 60,840 | 3.58 | % |\n| Other consumer | 31,092 | 1,519 | 6.53 | % | 23,382 | 1,241 | 7.10 | % |\n| Total loans | $ | 13,603,983 | $ | 416,728 | 4.10 | % | $ | 9,090,930 | $ | 266,064 | 3.91 | % |\n| Total interest-earning assets | $ | 17,972,117 | $ | 461,672 | 3.43 | % | $ | 12,464,027 | $ | 290,013 | 3.11 | % |\n| Cash and due from banks | 184,754 | 147,269 |\n| Federal Home Loan Bank stock | 7,780 | 9,516 |\n| Other assets | 1,853,818 | 1,256,066 |\n| Total assets | $ | 20,018,469 | $ | 13,876,878 |\n| Interest-bearing liabilities |\n| Deposits |\n| Savings and interest checking accounts | $ | 6,224,317 | $ | 3,418 | 0.07 | % | $ | 4,292,992 | $ | 1,145 | 0.04 | % |\n| Money market | 3,517,459 | 4,191 | 0.16 | % | 2,337,445 | 1,393 | 0.08 | % |\n| Time deposits | 1,355,861 | 2,718 | 0.27 | % | 848,143 | 3,823 | 0.60 | % |\n| Total interest-bearing deposits | $ | 11,097,637 | $ | 10,327 | 0.12 | % | $ | 7,478,580 | $ | 6,361 | 0.11 | % |\n| Borrowings |\n| Federal Home Loan Bank borrowings | $ | 21,361 | $ | 311 | 1.95 | % | $ | 34,185 | $ | 544 | 2.13 | % |\n| Long-term borrowings | 2,988 | 31 | 1.39 | % | 23,434 | 282 | 1.61 | % |\n| Junior subordinated debentures | 62,854 | 1,298 | 2.76 | % | 62,852 | 1,287 | 2.74 | % |\n| Subordinated debentures | 49,824 | 1,852 | 4.97 | % | 49,729 | 1,852 | 4.98 | % |\n| Total borrowings | $ | 137,027 | $ | 3,492 | 3.41 | % | $ | 170,200 | $ | 3,965 | 3.11 | % |\n| Total interest-bearing liabilities | $ | 11,234,664 | $ | 13,819 | 0.16 | % | $ | 7,648,780 | $ | 10,326 | 0.18 | % |\n| Noninterest bearing demand deposits | 5,544,476 | 4,213,764 |\n| Other liabilities | 303,308 | 280,002 |\n\n78\n| Total liabilities | $ | 17,082,448 | $ | 12,142,546 |\n| Stockholders' equity | 2,936,021 | 1,734,332 |\n| Total liabilities and stockholders' equity | $ | 20,018,469 | $ | 13,876,878 |\n| Net interest income (1) | $ | 447,853 | $ | 279,687 |\n| Interest rate spread (3) | 3.27 | % | 2.93 | % |\n| Net interest margin (4) | 3.33 | % | 3.00 | % |\n| Supplemental information |\n| Total deposit, including demand deposits | $ | 16,642,113 | $ | 10,327 | $ | 11,692,344 | $ | 6,361 |\n| Cost of total deposits | 0.08 | % | 0.07 | % |\n| Total funding liabilities, including demand deposits | $ | 16,779,140 | $ | 13,819 | $ | 11,862,544 | $ | 10,326 |\n| Cost of total funding liabilities | 0.11 | % | 0.12 | % |\n\n(1)The total amount of adjustment to present interest income and yield on a FTE basis was $3.0 million and $658,000 for the nine months ended September 30, 2022 and 2021, respectively. The FTE adjustment relates to nontaxable investment securities with average balances of $198,000 and $555,000 and tax exempt income relating to loans with average balances of $411.9 million and $63.9 million for the nine months ended September 30, 2022 and 2021, respectively.\n(2)Includes average nonaccruing loans.\n(3)Interest rate spread represents the difference between the weighted average yield on interest-earning assets and the weighted average cost of interest-bearing liabilities.\n(4)Net interest margin represents annualized net interest income as a percentage of average interest-earning assets.\n79\nThe following table presents certain information on a FTE basis regarding changes in the Company’s interest income and interest expense for the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided with respect to changes attributable to: (1) changes in rate (change in rate multiplied by prior period volume), (2) changes in volume (change in volume multiplied by old rate), and (3) changes in volume/rate (change in volume multiplied by change in rate) which is allocated to the change due to rate column:\nTable 16 - Volume Rate Analysis\n| Three Months Ended September 30 | Nine Months Ended September 30 |\n| 2022 Compared To 2021 | 2022 Compared To 2021 |\n| ChangeDue toRate | ChangeDue toVolume | Total Change | ChangeDue toRate | ChangeDue toVolume | Total Change |\n| (Dollars in thousands) |\n| Income on interest-earning assets |\n| Interest earning deposits, federal funds sold and short term investments | $ | 6,078 | $ | (374) | $ | 5,704 | $ | 8,851 | $ | (283) | $ | 8,568 |\n| Securities |\n| Securities - taxable investments | 712 | 4,739 | 5,451 | (5,567) | 18,531 | 12,964 |\n| Securities - nontaxable investments (1) | (1) | (3) | (4) | (1) | (11) | (12) |\n| Total securities | 5,447 | 12,952 |\n| Loans held for sale | 24 | (166) | (142) | 40 | (565) | (525) |\n| Loans |\n| Commercial and industrial (1) | 5,095 | (1,115) | 3,980 | 6,451 | (11,341) | (4,890) |\n| Commercial real estate (1) | 9,250 | 34,565 | 43,815 | 7,737 | 106,971 | 114,708 |\n| Commercial construction | 3,657 | 6,302 | 9,959 | 6,966 | 18,657 | 25,623 |\n| Small business | 149 | 329 | 478 | 41 | 926 | 967 |\n| Total commercial | 58,232 | 136,408 |\n| Residential real estate | (448) | 6,026 | 5,578 | (4,067) | 14,727 | 10,660 |\n| Home equity | 2,210 | 616 | 2,826 | 2,686 | 632 | 3,318 |\n| Total consumer real estate | 8,404 | 13,978 |\n| Other consumer | 34 | 91 | 125 | (131) | 409 | 278 |\n| Total loans (1)(2) | 66,761 | 150,664 |\n| Total income of interest-earning assets | $ | 77,770 | $ | 171,659 |\n| Expense of interest-bearing liabilities |\n| Deposits |\n| Savings and interest checking accounts | $ | 1,635 | $ | 137 | $ | 1,772 | $ | 1,758 | $ | 515 | $ | 2,273 |\n| Money market | 2,380 | 202 | 2,582 | 2,095 | 703 | 2,798 |\n| Time certificates of deposits | (361) | 483 | 122 | (3,394) | 2,289 | (1,105) |\n| Total interest bearing deposits | 4,476 | 3,966 |\n| Borrowings |\n| Federal Home Loan Bank borrowings | (13) | (97) | (110) | (29) | (204) | (233) |\n| Line of Credit | — | — | — | — |\n| Long-term borrowings | — | (77) | (77) | (5) | (246) | (251) |\n| Junior subordinated debentures | 157 | — | 157 | 11 | — | 11 |\n| Subordinated debentures | (1) | 1 | — | (4) | 4 | — |\n| Total borrowings | (30) | (473) |\n| Total expense of interest-bearing liabilities | 4,446 | 3,493 |\n| Change in net interest income | $ | 73,324 | $ | 168,166 |\n\n(1)Reflects income determined on a FTE basis. See footnote (1) to Table 14 and 15 in this Report for the related adjustments.\n(2)Loans include portfolio loans and nonaccrual loans; however, unpaid interest on nonaccrual loans has not been included for purposes of determining interest income.\n80\nProvision For Credit Losses The provision for credit losses represents the charge to expense that is required to maintain an appropriate level of allowance for credit losses. The Company recorded a $3.0 million and a $1.0 million provision for credit losses for the three and nine months ended September 30, 2022, respectively, as compared to releases of provision for credit losses of $10.0 million and $17.5 million for the three and nine months ended September 30, 2021, respectively. The Company’s allowance for credit losses, as a percentage of total loans, was 1.08% at both September 30, 2022 and December 31, 2021, and 1.05% at September 30, 2021. The Company recorded net charge-offs of $6,000 and $609,000 for the three and nine months ended September 30, 2022, respectively, as compared to net charge-offs of $111,000 and $3.6 million for the three and nine months ended September 30, 2021, respectively. Refer to Note 4 \"Loans, Allowance for Credit Losses and Credit Quality\" within the Note to Consolidated Financial Statements included in Part I. Item 1 of this Report, for further details surrounding the primary drivers of the provision for credit losses for the period.\nNoninterest Income The following table sets forth information regarding noninterest income for the periods shown:\nTable 17 - Noninterest Income\n| Three Months Ended |\n| September 30 | Change |\n| 2022 | 2021 | Amount | % |\n| (Dollars in thousands) |\n| Deposit account fees | $ | 6,261 | $ | 4,298 | $ | 1,963 | 45.67 | % |\n| Interchange and ATM fees | 4,331 | 3,441 | 890 | 25.86 | % |\n| Investment management | 8,436 | 9,174 | (738) | (8.04) | % |\n| Mortgage banking income | 585 | 2,825 | (2,240) | (79.29) | % |\n| Gain on life insurance benefits | 477 | — | 477 | 100.00% |\n| Increase in cash surrender value of life insurance policies | 1,883 | 1,596 | 287 | 17.98 | % |\n| Loan level derivative income | 471 | 586 | (115) | (19.62) | % |\n| Other noninterest income | 5,751 | 4,537 | 1,214 | 26.76 | % |\n| Total | $ | 28,195 | $ | 26,457 | $ | 1,738 | 6.57 | % |\n| Nine Months Ended |\n| September 30 | Change |\n| 2022 | 2021 | Amount | % |\n| (Dollars in thousands) |\n| Deposit account fees | $ | 17,582 | $ | 11,704 | $ | 5,878 | 50.22 | % |\n| Interchange and ATM fees | 11,967 | 9,229 | 2,738 | 29.67 | % |\n| Investment management | 26,438 | 26,350 | 88 | 0.33 | % |\n| Mortgage banking income | 2,989 | 11,270 | (8,281) | (73.48) | % |\n| Gain on life insurance benefits | 600 | 258 | 342 | 132.56 | % |\n| Increase in cash surrender value of life insurance policies | 5,549 | 4,508 | 1,041 | 23.09 | % |\n| Loan level derivative income | 1,511 | 875 | 636 | 72.69 | % |\n| Other noninterest income | 15,729 | 12,476 | 3,253 | 26.07 | % |\n| Total | $ | 82,365 | $ | 76,670 | $ | 5,695 | 7.43 | % |\n\nThe primary reasons for the variances in the noninterest income categories for the three and nine months ended September 30, 2022 as compared to the respective prior year periods shown in the preceding table include:\n•Deposit account fees and interchange and ATM fees increased for the three and nine months ended September 30, 2022 in comparison to the same prior year periods driven primarily by increased transaction volume attributable to the larger customer base as a result of the Meridian acquisition.\n81\n•Investment management income decreased for the three months ended September 30, 2022, driven primarily by a decline in overall asset valuations and was consistent for the nine months ended September 30, 2022, as compared to the prior year period, primarily due to a higher volume of new asset inflows, which were offset by depressed market valuations.\n•Mortgage banking income decreased for the three and nine months ended September 30, 2022 in comparison to the prior year periods, due primarily to overall reduced activity resulting from increased interest rates and a greater portion of new originations being retained in the Company's portfolio versus being sold in the secondary market during 2022.\n•The cash surrender value of life insurance policies increased primarily due to the impact of policies acquired from Meridian.\n•The changes in loan level derivative income primarily reflect customer demand during the respective periods.\n•Other noninterest income increased for the three and nine months ended September 30, 2022, primarily attributable to increases in rental income from equipment leases, foreign currency exchange fees, credit card fee income, discounted purchases of Massachusetts historical tax credits, and a gain on the sale of a vacated office space recently acquired during the Meridian acquisition, partially offset by decreases in loan fees and income from like-kind exchanges.\n82\nNoninterest Expense The following table sets forth information regarding non-interest expense for the periods shown:\nTable 18 - Noninterest Expense\n| Three Months Ended |\n| September 30 | Change |\n| 2022 | 2021 | Amount | % |\n| (Dollars in thousands) |\n| Salaries and employee benefits | $ | 52,708 | $ | 42,235 | $ | 10,473 | 24.80 | % |\n| Occupancy and equipment expenses | 12,316 | 8,564 | 3,752 | 43.81 | % |\n| Data processing & facilities management | 2,259 | 1,673 | 586 | 35.03 | % |\n| Consulting expense | 2,547 | 1,560 | 987 | 63.27 | % |\n| Software maintenance | 2,497 | 2,018 | 479 | 23.74 | % |\n| Amortization of intangible assets | 1,898 | 1,310 | 588 | 44.89 | % |\n| Debit card expense | 1,936 | 1,347 | 589 | 43.73 | % |\n| FDIC assessment | 1,677 | 980 | 697 | 71.12 | % |\n| Merger and acquisition expenses | — | 1,943 | (1,943) | (100.00) | % |\n| Other noninterest expenses | 14,890 | 10,789 | 4,101 | 38.01 | % |\n| Total | $ | 92,728 | $ | 72,419 | $ | 20,309 | 28.04 | % |\n| Nine Months Ended |\n| September 30 | Change |\n| 2022 | 2021 | Amount | % |\n| (Dollars in thousands) |\n| Salaries and employee benefits | $ | 150,957 | $ | 124,759 | $ | 26,198 | 21.00 | % |\n| Occupancy and equipment expenses | 37,255 | 26,543 | 10,712 | 40.36 | % |\n| Data processing & facilities management | 6,878 | 5,024 | 1,854 | 36.90 | % |\n| Merger and acquisition expenses | 7,100 | 3,674 | 3,426 | 93.25 | % |\n| Software maintenance | 7,706 | 5,903 | 1,803 | 30.54 | % |\n| Consulting expense | 7,057 | 5,443 | 1,614 | 29.65 | % |\n| Amortization of intangible assets | 5,801 | 4,037 | 1,764 | 43.70 | % |\n| Debit card expense | 5,562 | 3,693 | 1,869 | 50.61 | % |\n| FDIC assessment | 5,225 | 2,805 | 2,420 | 86.27 | % |\n| Other noninterest expenses | 45,249 | 33,522 | 11,727 | 34.98 | % |\n| Total | $ | 278,790 | $ | 215,403 | $ | 63,387 | 29.43 | % |\n\nThe primary reasons for the variances in the noninterest expense categories for the three and nine months ended September 30, 2022 as compared to the respective prior year periods shown in the preceding table include:\n•The increase in salaries and employee benefits was primarily attributable to the Company's increased workforce base following the Meridian acquisition.\n•Occupancy and equipment expenses increased year-over-year, primarily driven by costs associated with the Company's expanded branch network, real estate and other fixed assets resulting from the Meridian acquisition, as well as increased depreciation expense on leased equipment.\n•Data processing and facilities management expenses increased primarily due to the timing of certain initiatives and general increases associated with higher transaction volumes.\n•The Company incurred merger and acquisition costs related to the Meridian acquisition of $7.1 million during the first quarter of 2022, primarily related to lease terminations associated with exited branch locations, along with\n83\nadditional integration costs and professional fees. Meridian related merger and acquisition costs were also incurred, to a lesser extent, during the nine months ended September 30, 2021, leading up to deal close during the fourth quarter of 2021.\n•Software maintenance increased primarily due to the Company's continued investment in its technology infrastructure.\n•FDIC assessment increased primarily due to an increased assessment base resulting from the Meridian acquisition.\n•Consulting expense increased for the three and nine months ended September 30, 2022, primarily due to rollout of strategic initiatives during such periods.\n•Other noninterest expense increased for the three and nine months ended September 30, 2022, primarily due to three full quarters of general increases associated with the Meridian acquisition, elevated unrealized losses on equity securities, and increased marketing and public relations costs.\nIncome Taxes The tax effect of all income and expense transactions is recognized by the Company in each year’s consolidated statements of income, regardless of the year in which the transactions are reported for income tax purposes. The following table sets forth information regarding the Company’s tax provision and applicable tax rates for the periods indicated:\nTable 19 - Tax Provision and Applicable Tax Rates\n| Three Months Ended | Nine Months Ended |\n| September 30 | September 30 |\n| 2022 | 2021 | 2022 | 2021 |\n| (Dollars in thousands) |\n| Combined federal and state income tax provision | $ | 23,171 | $ | 14,122 | $ | 60,699 | $ | 38,506 |\n| Effective income tax rate | 24.37 | % | 26.09 | % | 24.53 | % | 24.40 | % |\n| Blended statutory tax rate | 27.11 | % | 27.92 | % | 27.11 | % | 27.92 | % |\n\nThe Company’s effective tax rate in 2022 thus far is higher as compared to the year ago period primarily due to higher pre-tax income, as well as the impact of discrete items, including tax benefits related to low income housing tax credits and equity compensation. The effective tax rates in the table above are lower than the blended statutory tax rates due to the aforementioned discrete items as well as certain tax preference assets such as life insurance policies, tax exempt bonds, and federal tax credits.\nThe Company invests in various low income housing projects, which are real estate limited partnerships that acquire, develop, own and operate low and moderate-income housing developments. As a limited partner in these operating partnerships, the Company will receive tax credits and tax deductions for losses incurred by the underlying properties. The investments are accounted for using the proportional amortization method and will be amortized over various periods through 2039, which represents the period that the tax credits and other tax benefits will be utilized. The total committed investment in these partnerships is $183.9 million, of which $120.9 million had been funded as of September 30, 2022. It is expected that the limited partnership investments will generate a net tax benefit of approximately $3.3 million for the fiscal year 2022 and a total of $23.7 million over the remaining life of the investments from the combination of the tax credits and operating losses.\nRisk Management\nThe Board of Directors has approved an Enterprise Risk Management Policy and Risk Appetite Statement to state the Company’s goals and objectives in identifying, measuring, and managing the risks associated with the Company’s current and near future anticipated size and complexity. Management is responsible for comprehensive enterprise risk management, and continually strives to adopt and implement practices that strike an appropriate balance between risk and reward and permit the achievement of strategic goals in a controlled environment.\nThe Company has implemented the “three lines of defense” enterprise risk management model. The first line of defense are the executives in charge of business units, operational areas, and corporate functions who, sometimes assisted by management committees, teams, and working groups, own and manage risks. The second line of defense is the Chief Risk Officer and the risk department, who monitor and provide advice with respect to first line risk management. The third line of\n84\ndefense is independent assurance performed by the Chief Internal Auditor, who reports to the Audit Committee of the Company's Board of Directors, and by the Company's internal audit department.\nThe Board of Directors, with the assistance of its Risk Committee, oversees management’s enterprise risk management practices. As risks must be taken to create value, the Board of Directors has defined the acceptable residual risk tolerances for the Company and the eight major risk types identified as having the potential to create significant adverse impacts on the Company, such as financial losses, reputational damage, legal or regulatory actions, nonachievement of strategic objectives, diminished customer experience, and/or cultural erosion. The eight major risk types identified by the Company and addressed in the Risk Appetite Statement are strategic risk, culture risk, credit risk, liquidity risk, interest rate risk, operational risk, technology risk, and reputation risk, each of which is discussed below.\nStrategic Risk Strategic risk is the risk arising from adverse strategic or business decisions, misalignment of strategic direction with the Company’s mission and values, failure to execute strategies or tactics, or an inadequate adaptation or lack of responsiveness to industry and/or operating environment changes. Management seeks to mitigate strategic risk through strategic planning, frequent executive review of strategic plan progress, monitoring of competitors and technology, assessment of new products, new branches, and new business initiatives, customer advocacy, and crisis management planning.\nCulture Risk Culture risk is the risk arising from failed leadership and/or ineffective colleague engagement and workplace management that causes the Company to lose sight of core values and, through acts or omissions, damage the relationship-based culture which has been one of the foundations of the Company’s consistent success. Management mitigates culture risk through effective employee relations, leadership that encourages continuous improvement, cultural development and reinforcement of core values, communication of clear ethical and behavioral standards, consistent enforcement of policies and programs, discipline of misbehavior, alignment of incentives and compensation, and by promoting diversity, equity, and inclusion.\nCredit Risk Credit risk is the risk arising from the failure of a borrower or a counterparty to a contract to make payments as agreed, and includes the risks arising from inadequate collateral and mismanagement of loan concentrations. While the collateral securing loans may be sufficient in some cases to recover the amount due, in other cases the Company may experience significant credit losses which could have an adverse effect on its operating results. The Company makes assumptions and judgments about the collectability of its loan portfolio, including the creditworthiness of its borrowers and counterparties and the value of collateral for the repayment of loans. For further discussion regarding the credit risk and the credit quality of the Company’s loan portfolio, see Note 4, “Loans, Allowance for Credit Losses and Credit Quality” within the Notes to Consolidated Financial Statements included in Part I. Item 1 of this Report.\nLiquidity Risk Liquidity risk is the risk arising from the Company being unable to meet obligations when due. Liquidity risk includes the inability to access funding sources or manage fluctuations in available funding levels. Liquidity risk also results from a failure to recognize or address market condition changes that affect the ability to liquidate assets quickly with minimal value loss.\nThe Company’s primary sources of funds are deposits, borrowings, and the amortization, prepayment, and maturities of loans and securities. The Bank utilizes its extensive branch network to access retail customers who provide a base of in-market core deposits. These funds are principally comprised of demand deposits, interest checking accounts, savings accounts, and money market accounts. Deposit levels are greatly influenced by interest rates, economic conditions, and competitive factors.\nThe Company’s primary measure of short-term liquidity is the Total Basic Surplus/Deficit as a percentage of assets. This ratio, which is an analysis of the relationship between liquid assets plus available Federal Home Loan Bank funding, less short-term liabilities relative to total assets, was within policy limits at September 30, 2022. The Total Basic Surplus/Deficit measure is affected primarily by changes in deposits, securities and short-term investments, loans, and borrowings. An increase in deposits, without a corresponding increase in nonliquid assets, will improve the Total Basic Surplus/Deficit measure, whereas, an increase in loans, with no increase in deposits, will decrease the measure. Other factors affecting the Total Basic Surplus/Deficit include Federal Home Loan Bank collateral requirements, securities portfolio changes, and the mix of deposits.\nThe Company seeks to increase deposits without adversely impacting its weighted average funding cost. The Company also maintains a variety of liquidity sources, including Federal Home Loan Bank advances, Federal Reserve borrowing capacity, and repurchase agreement lines. These funding sources serve as a contingent source of liquidity and, when profitable lending and investment opportunities exist, the Company may access them to provide the liquidity needed to grow the balance sheet. The amount and type of assets that the Company has available to pledge impacts the Company's Federal Home Loan Bank and Federal Reserve borrowing capacity. For example, a prime one-to-four family residential loan may provide 75 cents of borrowing capacity for every $1.00 pledged, whereas a pledged commercial loan may increase borrowing capacity in a lower amount. The Company’s lending decisions, therefore, can also affect its liquidity position.\n85\nThe Company can also raise additional funds through the issuance of equity or unsecured debt privately or publicly and has done so in the past. Additionally, the Company is able to enter into repurchase agreements or acquire brokered deposits at its discretion. The availability and cost of equity or debt on an unsecured basis is dependent on many factors, including the Company’s financial position, the market environment, and the Company’s credit rating. The Company monitors the factors that could impact its ability to raise liquidity through these channels.\nThe following table depicts current and unused liquidity capacity from various sources as of the dates indicated:\nTable 20 - Liquidity Sources\n| September 30, 2022 | December 31, 2021 |\n| Outstanding | AdditionalBorrowingCapacity | Outstanding | AdditionalBorrowing Capacity |\n| (Dollars in thousands) |\n| Federal Home Loan Bank of Boston (1) | $ | 643 | $ | 1,739,262 | $ | 25,667 | $ | 1,622,494 |\n| Federal Reserve Bank of Boston (2) | — | 1,206,651 | — | 1,176,486 |\n| Unpledged Securities | — | 2,159,018 | — | 1,897,148 |\n| Line of Credit | — | 85,000 | — | 85,000 |\n| Long-term borrowing (3) | — | — | 14,063 | — |\n| Junior subordinated debentures (3) | 62,855 | — | 62,853 | — |\n| Subordinated debt (3) | 49,862 | — | 49,791 | — |\n| Reciprocal deposits (3) | 751,133 | — | 998,121 | — |\n| Brokered deposits (3) | 102,610 | — | 141,572 | — |\n| $ | 967,103 | $ | 5,189,931 | $ | 1,292,067 | $ | 4,781,128 |\n\n(1)Loans with a carrying value of $2.6 billion and $2.3 billion at September 30, 2022 and December 31, 2021, respectively, were pledged to the Federal Home Loan Bank of Boston resulting in this additional unused borrowing capacity.\n(2)Loans with a carrying value of $1.7 billion and $1.8 billion at September 30, 2022 and December 31, 2021, respectively, were pledged to the Federal Reserve Bank of Boston resulting in this additional unused borrowing capacity.\n(3)The additional borrowing capacity has not been assessed for these categories.\nIn addition to customary operational liquidity practices, the Board of Directors and management recognize the need to establish reasonable guidelines to manage a heightened liquidity risk environment. Catalysts for elevated liquidity risk can be Company-specific issues and/or systemic industry-wide events. It is therefore the responsibility of management to institute systems and controls designed to provide advanced detection of potentially significant funding shortages, establish methods for assessing and monitoring risk levels, and institute responses that may alleviate or circumvent a potential liquidity crisis. Management has established a Liquidity Contingency Plan to provide a framework to detect potential liquidity problems and appropriately address them in a timely manner. In a period of perceived heightened liquidity risk, the Liquidity Contingency Plan provides for the establishment of a Liquidity Crisis Task Force to monitor the potential for a liquidity crisis and establish and execute an appropriate response.\nInterest Rate Risk Interest rate risk is the risk arising from changes in interest rates and the value of investments due to market conditions or other external factors or events. Interest rate risk includes market risk. The Company’s primary market risk exposure is interest rate risk.\nInterest rate risk is the sensitivity of income to changes in interest rates. Interest rate changes, as well as fluctuations in the level and duration of assets and liabilities, affect net interest income, the Company’s primary source of revenue. Interest rate risk arises directly from the Company’s core banking activities. In addition to directly impacting net interest income, changes in the level of interest rates can also affect the amount of loans originated, the timing of cash flows on loans and securities, and the fair value of securities and derivatives, and have other effects.\nManagement strives to control interest rate risk within limits approved by the Board of Directors that reflect the Company’s tolerance for interest rate risk over short-term and long-term horizons. The Company attempts to manage interest rate risk by identifying, quantifying, and, where appropriate, hedging exposure. If assets and liabilities do not re-price simultaneously and in equal volume, the potential for interest rate exposure exists. It is the Company's objective to maintain stability in the growth of net interest income through the maintenance of an appropriate mix of interest-earning assets and\n86\ninterest-bearing liabilities and, when necessary within limits management deems prudent, through the use of off-balance sheet hedging instruments such as interest rate swaps, floors, and caps.\nThe Company quantifies its interest rate exposures using net interest income simulation models, as well as simpler gap analysis, and an Economic Value of Equity analysis. Key assumptions in these analyses relate to behavior of interest rates and behavior of the Company’s deposit and loan customers. The most material assumptions relate to the prepayment of mortgage assets (including mortgage loans and mortgage-backed securities) and the life and sensitivity of non-maturity deposits (e.g., demand deposit, negotiable order of withdrawal, savings, and money market accounts). In the case of prepayment of mortgage assets, assumptions are derived from published dealer median prepayment estimates for comparable mortgage loans. The risk of prepayment tends to increase when interest rates fall. Since future prepayment behavior of loan customers is uncertain, interest rate sensitivity of loans cannot be determined with precision and actual behavior may differ from assumptions to a significant degree.\nBased upon the net interest income simulation models, the Company currently forecasts that assets are anticipated to re-price faster than liabilities. As a result, net interest income will be positively impacted as market rates increase and negatively impacted if market rates decrease. The Company runs several scenarios to quantify and effectively assist in managing interest rate risk, including instantaneous parallel shifts in market rates as well as gradual (12-24 months) shifts in market rates, and may also include other alternative scenarios as management deems necessary given the interest rate environment. The Company measures the annual income from each scenario and then compares it against the current year base case scenario.\nThe relative results of all scenarios and the impact to net interest income as they compare to the year 1 base scenario are outlined in the table below:\nTable 21 - Interest Rate Sensitivity\n| September 30 |\n| 2022 | 2021 |\n| Year 1 | Year 2 | Year 1 | Year 2 |\n| Parallel rate shocks (basis points) |\n| -300 | (15.2) | % | (21.8) | % | n/a | n/a |\n| -200 | (9.8) | % | (11.3) | % | n/a | n/a |\n| -100 | (3.4) | % | 0.5 | % | (3.4) | % | (9.8) | % |\n| +100 | 2.4 | % | 14.0 | % | 8.4 | % | 9.6 | % |\n| +200 | 4.0 | % | 18.1 | % | 18.0 | % | 22.8 | % |\n| +300 | 6.4 | % | 24.0 | % | 27.9 | % | 36.4 | % |\n| +400 | 8.7 | % | 29.9 | % | 37.5 | % | 49.5 | % |\n| Gradual rate shifts (basis points) |\n| -200 over 12 months | (3.9) | % | (8.2) | % | n/a | n/a |\n| -100 over 12 months | (1.5) | % | 1.6 | % | (1.4) | % | (8.0) | % |\n| +200 over 12 months | 2.3 | % | 17.5 | % | 8.6 | % | 20.3 | % |\n| +400 over 24 months | 2.3 | % | 20.8 | % | 8.6 | % | 31.6 | % |\n| Alternative scenarios |\n| Flat up 200 basis points scenario | n/a | n/a | 8.0 | % | 17.8 | % |\n\nThe results depicted in the table above are dependent on material assumptions. For instance, asymmetrical rate behavior can have a material impact on the simulation results. If competition for deposits prompts the Company to raise rates on those liabilities more quickly than is assumed in the simulation analysis without a corresponding increase in asset yields, net interest income would be negatively impacted. Alternatively, if the Company is able to lag increases in deposit rates as loans re-price upward, net interest income would be positively impacted.\nThe most significant market factors affecting the Company’s net interest income during the nine months ended September 30, 2022 were the shape of the U.S. Government securities and interest rate swap yield curve, the U.S. prime interest\n87\nrate, LIBOR rates, the secured overnight financing rates (\"SOFR\"), and the interest rates being offered on long-term fixed rate loans.\nThe Company manages the interest rate risk inherent in both its loan and borrowing portfolios by using interest rate swap agreements and interest rate caps and floors. An interest rate swap is an agreement in which one party agrees to pay a floating rate of interest on a notional principal amount in exchange for receiving a fixed rate of interest on the same notional amount for a predetermined period of time from the other party. Interest rate caps and floors are agreements where one party agrees to pay a floating rate of interest on a notional principal amount for a predetermined period of time to a second party if certain market interest rate thresholds are realized. While interest is paid or received in swap, cap, and floors agreements, the notional principal amount is not actually exchanged. The Company may also manage the interest rate risk inherent in its mortgage banking operations by entering into forward sales contracts under which the Company agrees to deliver whole mortgage loans to various investors. See Note 6, “Derivative and Hedging Activities” within the Notes to Consolidated Financial Statements included in Part I. Item 1 of this Report for additional information regarding the Company’s derivative financial instruments.\nThe Company’s earnings are not directly or materially impacted by movements in foreign currency rates or commodity prices. Movements in equity prices may have a modest impact on earnings by affecting the volume of activity or the amount of fees from investment-related business lines. See Note 3, “Securities” within the Notes to Consolidated Financial Statements included in Part I. Item 1 of this Report.\nOperational Risk Operational risk is the risk arising from human error or misconduct, transaction errors or delays, inadequate or failed internal systems or processes, data unavailability, loss, or poor quality, or adverse external events. Operational risk includes business resiliency risk, consumer compliance risk, data governance risk, fraud risk, legal risk, model risk, regulatory compliance risk, and third party vendor risk. Potential operational risk exposure exists throughout the Company. The continued effectiveness of colleagues, technical systems, operational infrastructure, and relationships with key third party service providers are integral to mitigating operational risk, and any shortcomings subject the Company to risks that vary in size, scale and scope. Operational risks include operational failures, unlawful tampering, terrorist activities, ineffectiveness or exposure due to interruption in third party support, as well as the loss of key individuals or a failure of key individuals to perform properly.\nTechnology Risk Technology risk is the risk of losses or other impacts arising from the failure of technology systems to function in accordance with expectations and business requirements. Technology risk includes information technology risk, information security risk, and cyber security.\nReputation Risk Reputational risk is the risk arising from negative public opinion of the Company and the Bank. Management seeks to mitigate reputation risk through actions that include a structured process of customer complaint resolution and ongoing reputational monitoring.\nContractual Obligations, Commitments, Contingencies, and Off-Balance Sheet Financial Information\nOff-Balance Sheet Arrangements There were no material changes in off-balance sheet financial instruments during the three months ended September 30, 2022.\nSee Note 6, \"Derivative and Hedging Activities\" and Note 10, \"Commitments and Contingencies\" within the Notes to Consolidated Financial Statements included in Part I. Item 1 of this Report for more information relating to the Company's other off-balance sheet financial instruments.\nContractual Obligations, Commitments, and Contingencies There were no material changes in contractual obligations, commitments, or contingencies during the three months ended September 30, 2022.\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\nInformation required by this Item 3 is included in the \"Risk Management\" section of Part I. Item 2 \"Management's Discussion and Analysis of Financial Condition and Results of Operations\" of this Report and is incorporated herein by reference.\n88\nItem 4. Controls and Procedures\nConclusion Regarding the Effectiveness of Disclosure Controls and Procedures. The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer along with the Company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as such term is defined under Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Based upon that evaluation, the Company’s Chief Executive Officer along with the Company’s Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.\nChanges in Internal Control over Financial Reporting. There were no changes in the Company's internal control over financial reporting that occurred during the third quarter of 2022 that have materially affected or are reasonably likely to materially affect the Company’s internal control over financial reporting.\nPART II. OTHER INFORMATION\nItem 1. Legal Proceedings\nAt September 30, 2022, the Bank was involved in pending lawsuits that arose in the ordinary course of business. Management has reviewed these pending lawsuits with legal counsel and has taken into consideration the view of counsel as to their outcome. In the opinion of management, the final disposition of pending lawsuits is not expected to have a material adverse effect on the Company’s financial position or results of operations.\nItem 1A. Risk Factors\nThe section titled Risk Factors in Part I, Item 1A of the 2021 Form 10-K includes a discussion of the material risks and uncertainties the Company faces, any one or more of which could have a material adverse effect on the Company's business, results of operations, or financial condition (including capital and liquidity). As of the date of this Report, there have been no material changes with regard to the Risk Factors disclosed in Item 1A of the 2021 Form 10-K which are incorporated herein by reference.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\n(a) Not applicable.\n(b) Not applicable.\n(c) The following table sets forth information regarding the Company’s repurchases of its common stock during the three months ended September 30, 2022:\n| Issuer Purchases of Equity Securities |\n| Total Number of Shares Purchased (1) | Average Price Paid Per Share | Total Number ofShares Purchased asPart of PubliclyAnnounced Plan orProgram (2) | Maximum Number of Shares (or Approximate Dollar Value) That May Yet Be Purchased Under the Plan or Program (2) |\n| Period |\n| July 1 to July 31, 2022 | 177,327 | $ | 79.25 | 177,327 | $ | 20,648,057 |\n| August 1 to August 31, 2022 | 111,433 | $ | 78.98 | 111,433 | $ | 11,847,362 |\n| September 1 to September 30, 2022 | 154,212 | $ | 76.48 | 154,212 | $ | — |\n| Total | 442,972 | $ | 78.22 | 442,972 |\n\n(1)Of these shares, none were surrendered in connection with the exercise and/or vesting of equity compensation grants to satisfy related tax withholding obligations.\n(2)On January 20, 2022, the Company announced that its Board of Directors authorized a share repurchase program of up to $140 million in shares of the Company's common stock. The 154,212 shares repurchased under the program in September 2022 represented the balance of the $140 million in shares repurchased, completing the program.\nOn October 20, 2022, the Company announced the commencement of a new stock repurchase plan which authorizes repurchases by the Company of up to $120 million in common stock. Repurchases under the new plan may be made from time to time on the open market and in privately negotiated transactions, including through the use of trading plans intended to qualify under Rule 10b5-1 under the Exchange Act. The extent to which the Company repurchases shares and the size and timing of these repurchases will depend on a variety of factors, including pricing, market and economic conditions, the Company’s capital position and amount of retained earnings and legal and contractual requirements. The\n89\nrepurchase plan is scheduled to expire October 19, 2023 and may be modified, suspended or discontinued without prior notice at any time.\nItem 3. Defaults Upon Senior Securities -\nNone.\nItem 4. Mine Safety Disclosures -\nNot Applicable.\nItem 5. Other Information -\nNone.\nItem 6. Exhibits\nExhibit Index\n\n| No. | Exhibit |\n\n| 31.1 | Section 302 Certification of Sarbanes-Oxley Act of 2002 is attached hereto.* |\n| 31.2 | Section 302 Certification of Sarbanes-Oxley Act of 2002 is attached hereto.* |\n| 32.1 | Section 906 Certification of Sarbanes-Oxley Act of 2002 is attached hereto.+ |\n| 32.2 | Section 906 Certification of Sarbanes-Oxley Act of 2002 is attached hereto.+ |\n| 101 | The instance document does not appear in the interactive data file because its XBRL tags are embedded within the inline XBRL document.* |\n| 104 | Cover page interactive data file (formatted as inline XBRL and contained in Exhibit 101).* |\n\n| * | Filed herewith |\n\n| + | Furnished herewith |\n\n90\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\nINDEPENDENT BANK CORP.\n(registrant)\n\n| November 3, 2022 | /s/ Christopher Oddleifson |\n| Christopher OddleifsonPresident andChief Executive Officer(Principal Executive Officer) |\n\n\n| November 3, 2022 | /s/ Mark J. Ruggiero |\n| Mark J. RuggieroChief Financial Officer (Principal Financial Officer) |\n\n91\n \n\nWhat is the percentage increase of the net income after provision for credit losses for the three months ended September 30, from 2021 to 2022?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nItem 1. Financial Statements\\nINDEPENDENT BANK CORP.\\nCONSOLIDATED BALANCE SHEETS\\n(Unaudited—Dollars in thousands)\\n\\n| September 302022 | December 312021 |\\n| Assets |\\n| Cash and due from banks | $ | 172,615 | $ | 141,581 |\\n| Interest-earning deposits with banks | 763,681 | 2,099,103 |\\n| Securities |\\n| Trading | 3,538 | 3,720 |\\n| Equity | 20,439 | 23,173 |\\n| Available for sale (amortized cost $ 1,605,913 and $ 1,583,736 ) | 1,425,511 | 1,571,148 |\\n| Held to maturity (fair value $ 1,509,985 and $ 1,064,133 ) | 1,697,635 | 1,066,818 |\\n| Total securities | 3,147,123 | 2,664,859 |\\n| Loans held for sale (at fair value) | 5,100 | 24,679 |\\n| Loans |\\n| Commercial and industrial | 1,548,349 | 1,563,279 |\\n| Commercial real estate | 7,677,917 | 7,992,344 |\\n| Commercial construction | 1,185,157 | 1,165,457 |\\n| Small business | 209,567 | 193,189 |\\n| Residential real estate | 1,959,254 | 1,604,686 |\\n| Home equity - first position | 578,405 | 589,550 |\\n| Home equity - subordinate positions | 508,765 | 450,061 |\\n| Other consumer | 32,936 | 28,720 |\\n| Total loans | 13,700,350 | 13,587,286 |\\n| Less: allowance for credit losses | ( 147,313 ) | ( 146,922 ) |\\n| Net loans | 13,553,037 | 13,440,364 |\\n| Federal Home Loan Bank stock | 5,218 | 11,407 |\\n| Bank premises and equipment, net | 198,408 | 195,590 |\\n| Goodwill | 985,072 | 985,072 |\\n| Other intangible assets | 26,934 | 32,772 |\\n| Cash surrender value of life insurance policies | 293,126 | 289,304 |\\n| Other assets | 552,955 | 538,674 |\\n| Total assets | $ | 19,703,269 | $ | 20,423,405 |\\n| Liabilities and Stockholders' Equity |\\n| Deposits |\\n| Noninterest-bearing demand deposits | $ | 5,622,260 | $ | 5,479,503 |\\n| Savings and interest checking accounts | 6,094,493 | 6,350,016 |\\n| Money market | 3,443,622 | 3,556,375 |\\n| Time certificates of deposit | 1,178,619 | 1,531,150 |\\n| Total deposits | 16,338,994 | 16,917,044 |\\n| Borrowings |\\n| Federal Home Loan Bank borrowings | 643 | 25,667 |\\n| Long-term borrowings | — | 14,063 |\\n| Junior subordinated debentures (less unamortized debt issuance costs of $ 33 and $ 35 ) | 62,855 | 62,853 |\\n\\n5\\n| Subordinated debentures (less unamortized debt issuance costs of $ 138 and $ 209 ) | 49,862 | 49,791 |\\n| Total borrowings | 113,360 | 152,374 |\\n| Other liabilities | 433,714 | 335,538 |\\n| Total liabilities | 16,886,068 | 17,404,956 |\\n| Commitments and contingencies | — | — |\\n| Stockholders' equity |\\n| Preferred stock, $ 0.01 par value, authorized: 1,000,000 shares, outstanding: none | — | — |\\n| Common stock, $ 0.01 par value, authorized: 75,000,000 shares,issued and outstanding: 45,634,626 shares at September 30, 2022 and 47,349,778 shares at December 31, 2021 (includes 136,904 and 135,273 shares of unvested participating restricted stock awards, respectively) | 454 | 472 |\\n| Value of shares held in rabbi trust at cost: 82,617 shares at September 30, 2022 and 82,565 shares at December 31, 2021 | ( 3,239 ) | ( 3,146 ) |\\n| Deferred compensation and other retirement benefit obligations | 3,239 | 3,146 |\\n| Additional paid in capital | 2,113,313 | 2,249,078 |\\n| Retained earnings | 882,503 | 766,716 |\\n| Accumulated other comprehensive income (loss), net of tax | ( 179,069 ) | 2,183 |\\n| Total stockholders’ equity | 2,817,201 | 3,018,449 |\\n| Total liabilities and stockholders' equity | $ | 19,703,269 | $ | 20,423,405 |\\n\\nThe accompanying notes are an integral part of these unaudited consolidated financial statements.\\n6\\nINDEPENDENT BANK CORP.\\nCONSOLIDATED STATEMENTS OF INCOME\\n(Unaudited—Dollars in thousands, except per share data)\\n| Three Months Ended | Nine Months Ended |\\n| September 30 | September 30 |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Interest income |\\n| Interest and fees on loans | $ | 150,157 | $ | 84,212 | $ | 413,770 | $ | 265,409 |\\n| Taxable interest and dividends on securities | 13,243 | 7,792 | 34,567 | 21,603 |\\n| Nontaxable interest and dividends on securities | 1 | 4 | 4 | 14 |\\n| Interest on loans held for sale | 51 | 193 | 150 | 675 |\\n| Interest on federal funds sold and short-term investments | 6,519 | 815 | 10,222 | 1,654 |\\n| Total interest and dividend income | 169,971 | 93,016 | 458,713 | 289,355 |\\n| Interest expense |\\n| Interest on deposits | 6,109 | 1,633 | 10,327 | 6,361 |\\n| Interest on borrowings | 1,261 | 1,292 | 3,492 | 3,965 |\\n| Total interest expense | 7,370 | 2,925 | 13,819 | 10,326 |\\n| Net interest income | 162,601 | 90,091 | 444,894 | 279,029 |\\n| Provision for (release of) credit losses | 3,000 | ( 10,000 ) | 1,000 | ( 17,500 ) |\\n| Net interest income after provision for credit losses | 159,601 | 100,091 | 443,894 | 296,529 |\\n| Noninterest income |\\n| Deposit account fees | 6,261 | 4,298 | 17,582 | 11,704 |\\n| Interchange and ATM fees | 4,331 | 3,441 | 11,967 | 9,229 |\\n| Investment management | 8,436 | 9,174 | 26,438 | 26,350 |\\n| Mortgage banking income | 585 | 2,825 | 2,989 | 11,270 |\\n| Increase in cash surrender value of life insurance policies | 1,883 | 1,596 | 5,549 | 4,508 |\\n| Gain on life insurance benefits | 477 | — | 600 | 258 |\\n| Loan level derivative income | 471 | 586 | 1,511 | 875 |\\n| Other noninterest income | 5,751 | 4,537 | 15,729 | 12,476 |\\n| Total noninterest income | 28,195 | 26,457 | 82,365 | 76,670 |\\n| Noninterest expenses |\\n| Salaries and employee benefits | 52,708 | 42,235 | 150,957 | 124,759 |\\n| Occupancy and equipment expenses | 12,316 | 8,564 | 37,255 | 26,543 |\\n| Data processing and facilities management | 2,259 | 1,673 | 6,878 | 5,024 |\\n| Consulting expense | 2,547 | 1,560 | 7,057 | 5,443 |\\n| Software maintenance | 2,497 | 2,018 | 7,706 | 5,903 |\\n| Debit card expense | 1,936 | 1,347 | 5,562 | 3,693 |\\n| Amortization of intangible assets | 1,898 | 1,310 | 5,801 | 4,037 |\\n| FDIC assessment | 1,677 | 980 | 5,225 | 2,805 |\\n| Merger and acquisition expense | — | 1,943 | 7,100 | 3,674 |\\n| Other noninterest expenses | 14,890 | 10,789 | 45,249 | 33,522 |\\n| Total noninterest expenses | 92,728 | 72,419 | 278,790 | 215,403 |\\n| Income before income taxes | 95,068 | 54,129 | 247,469 | 157,796 |\\n| Provision for income taxes | 23,171 | 14,122 | 60,699 | 38,506 |\\n| Net income | $ | 71,897 | $ | 40,007 | $ | 186,770 | $ | 119,290 |\\n| Basic earnings per share | $ | 1.57 | $ | 1.21 | $ | 4.01 | $ | 3.61 |\\n| Diluted earnings per share | $ | 1.57 | $ | 1.21 | $ | 4.00 | $ | 3.61 |\\n| Weighted average common shares (basic) | 45,839,555 | 33,043,716 | 46,618,209 | 33,024,386 |\\n| Common share equivalents | 16,856 | 15,554 | 17,221 | 18,238 |\\n| Weighted average common shares (diluted) | 45,856,411 | 33,059,270 | 46,635,430 | 33,042,624 |\\n| Cash dividends declared per common share | $ | 0.51 | $ | 0.48 | $ | 1.53 | $ | 1.44 |\\n\\nThe accompanying notes are an integral part of these unaudited consolidated financial statements.\\n7\\nINDEPENDENT BANK CORP.\\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME\\n(Unaudited—Dollars in thousands)\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30 | September 30 |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Net income | $ | 71,897 | $ | 40,007 | $ | 186,770 | $ | 119,290 |\\n| Other comprehensive income (loss), net of tax |\\n| Net change in fair value of securities available for sale | ( 42,582 ) | ( 7,897 ) | ( 128,872 ) | ( 11,878 ) |\\n| Net change in fair value of cash flow hedges | ( 27,144 ) | ( 3,383 ) | ( 52,743 ) | ( 11,559 ) |\\n| Net change in other comprehensive income for defined benefit postretirement plans | 121 | 280 | 363 | 1,309 |\\n| Total other comprehensive loss | ( 69,605 ) | ( 11,000 ) | ( 181,252 ) | ( 22,128 ) |\\n| Total comprehensive income | $ | 2,292 | $ | 29,007 | $ | 5,518 | $ | 97,162 |\\n\\nThe accompanying notes are an integral part of these unaudited consolidated financial statements.\\n8\\nINDEPENDENT BANK CORP.\\nCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\\nThree Months Ended September 30, 2022 and 2021\\n(Unaudited—Dollars in thousands, except per share data)\\n| Common Stock Outstanding | Common Stock | Value of Shares Held in Rabbi Trust at Cost | Deferred Compensation Obligation | Additional Paid in Capital | Retained Earnings | Accumulated OtherComprehensive Income (Loss) | Total |\\n| Balance June 30, 2022 | 46,069,761 | $ | 459 | $ | ( 3,196 ) | $ | 3,196 | $ | 2,146,333 | $ | 833,857 | $ | ( 109,464 ) | $ | 2,871,185 |\\n| Net income | — | — | — | — | — | 71,897 | — | 71,897 |\\n| Other comprehensive loss | — | — | — | — | — | — | ( 69,605 ) | ( 69,605 ) |\\n| Common dividend declared ($ 0.51 per share) | — | — | — | — | — | ( 23,251 ) | — | ( 23,251 ) |\\n| Stock based compensation | — | — | — | — | 1,017 | — | — | 1,017 |\\n| Restricted stock awards issued, net of awards surrendered | 296 | — | — | — | — | — | — | — |\\n| Shares issued under direct stock purchase plan | 7,541 | — | — | — | 606 | — | — | 606 |\\n| Shares repurchased under share repurchase program | ( 442,972 ) | ( 5 ) | — | — | ( 34,643 ) | — | — | ( 34,648 ) |\\n| Deferred compensation and other retirement benefit obligations | — | — | ( 43 ) | 43 | — | — | — | — |\\n| Balance September 30, 2022 | 45,634,626 | $ | 454 | $ | ( 3,239 ) | $ | 3,239 | $ | 2,113,313 | $ | 882,503 | $ | ( 179,069 ) | $ | 2,817,201 |\\n| Balance June 30, 2021 | 33,037,859 | $ | 329 | $ | ( 3,116 ) | $ | 3,116 | $ | 948,130 | $ | 763,596 | $ | 29,567 | $ | 1,741,622 |\\n| Net income | — | — | — | — | — | 40,007 | — | 40,007 |\\n| Other comprehensive loss | — | — | — | — | — | — | ( 11,000 ) | ( 11,000 ) |\\n| Common dividend declared ($ 0.48 per share) | — | — | — | — | — | ( 15,861 ) | — | ( 15,861 ) |\\n| Stock based compensation | — | — | — | — | 707 | — | — | 707 |\\n| Restricted stock awards issued, net of awards surrendered | ( 763 ) | — | — | — | ( 3 ) | — | — | ( 3 ) |\\n| Shares issued under direct stock purchase plan | 6,716 | — | — | — | 482 | — | — | 482 |\\n| Deferred compensation and other retirement benefit obligations | — | — | ( 41 ) | 41 | — | — | — | — |\\n| Balance September 30, 2021 | 33,043,812 | $ | 329 | $ | ( 3,157 ) | $ | 3,157 | $ | 949,316 | $ | 787,742 | $ | 18,567 | $ | 1,755,954 |\\n\\n9\\nINDEPENDENT BANK CORP.\\nCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\\nNine Months Ended September 30, 2022 and 2021\\n(Unaudited—Dollars in thousands, except per share data)\\n| Common Stock Outstanding | Common Stock | Value of Shares Held in Rabbi Trust at Cost | Deferred Compensation Obligation | Additional Paid in Capital | Retained Earnings | Accumulated OtherComprehensive Income (Loss) | Total |\\n| Balance December 31, 2021 | 47,349,778 | $ | 472 | $ | ( 3,146 ) | $ | 3,146 | $ | 2,249,078 | $ | 766,716 | $ | 2,183 | $ | 3,018,449 |\\n| Net income | — | — | — | — | — | 186,770 | — | 186,770 |\\n| Other comprehensive loss | — | — | — | — | — | — | ( 181,252 ) | ( 181,252 ) |\\n| Common dividend declared ($ 1.53 per share) | — | — | — | — | — | ( 70,983 ) | — | ( 70,983 ) |\\n| Stock based compensation | — | — | — | — | 3,483 | — | — | 3,483 |\\n| Restricted stock awards issued, net of awards surrendered | 50,096 | — | — | — | ( 1,085 ) | — | — | ( 1,085 ) |\\n| Shares issued under direct stock purchase plan | 21,717 | — | — | — | 1,765 | — | — | 1,765 |\\n| Shares repurchased under share repurchase program | ( 1,786,965 ) | ( 18 ) | — | — | ( 139,928 ) | — | — | ( 139,946 ) |\\n| Deferred compensation and other retirement benefit obligations | — | — | ( 93 ) | 93 | — | — | — | — |\\n| Balance September 30, 2022 | 45,634,626 | $ | 454 | $ | ( 3,239 ) | $ | 3,239 | $ | 2,113,313 | $ | 882,503 | $ | ( 179,069 ) | $ | 2,817,201 |\\n| Balance December 31, 2020 | 32,965,692 | $ | 328 | $ | ( 3,066 ) | $ | 3,066 | $ | 945,638 | $ | 716,024 | $ | 40,695 | $ | 1,702,685 |\\n| Net income | — | — | — | — | — | 119,290 | — | 119,290 |\\n| Other comprehensive loss | — | — | — | — | — | — | ( 22,128 ) | ( 22,128 ) |\\n| Common dividend declared ($ 1.44 per share) | — | — | — | — | — | ( 47,572 ) | — | ( 47,572 ) |\\n| Proceeds from exercise of stock options, net of cash paid | 4,744 | — | — | — | ( 57 ) | — | — | ( 57 ) |\\n| Stock based compensation | — | — | — | — | 3,467 | — | — | 3,467 |\\n| Restricted stock awards issued, net of awards surrendered | 53,795 | 1 | — | — | ( 1,247 ) | — | — | ( 1,246 ) |\\n| Shares issued under direct stock purchase plan | 19,581 | — | — | — | 1,515 | — | — | 1,515 |\\n| Deferred compensation and other retirement benefit obligations | — | — | ( 91 ) | 91 | — | — | — | — |\\n| Balance September 30, 2021 | 33,043,812 | $ | 329 | $ | ( 3,157 ) | $ | 3,157 | $ | 949,316 | $ | 787,742 | $ | 18,567 | $ | 1,755,954 |\\n\\nThe accompanying notes are an integral part of these unaudited consolidated financial statements.\\n10\\nINDEPENDENT BANK CORP.\\nCONSOLIDATED STATEMENTS OF CASH FLOWS\\n(Unaudited—Dollars in thousands)\\n\\n| Nine Months Ended |\\n| September 30 |\\n| 2022 | 2021 |\\n| Cash flow from operating activities |\\n| Net income | $ | 186,770 | $ | 119,290 |\\n| Adjustments to reconcile net income to net cash provided by operating activities |\\n| Depreciation and amortization | 29,528 | 24,586 |\\n| Change in unamortized net loan costs and premiums | ( 6,397 ) | ( 17,217 ) |\\n| Accretion of fair value mark of acquired loans | ( 65 ) | ( 5,349 ) |\\n| Provision for (release of) credit losses | 1,000 | ( 17,500 ) |\\n| Deferred income tax expense | 271 | 271 |\\n| Net loss (gain) on equity securities | 2,819 | ( 695 ) |\\n| Net loss on bank premises and equipment | 217 | 32 |\\n| Realized gain on sale leaseback transaction | ( 433 ) | ( 433 ) |\\n| Stock based compensation | 3,483 | 3,467 |\\n| Increase in cash surrender value of life insurance policies | ( 5,549 ) | ( 4,508 ) |\\n| Gain on life insurance benefits | ( 600 ) | ( 258 ) |\\n| Operating lease payments | ( 15,867 ) | ( 8,993 ) |\\n| Operating lease termination payments | — | ( 4,750 ) |\\n| Change in fair value on loans held for sale | 620 | 1,534 |\\n| Net change in: |\\n| Trading assets | 182 | ( 666 ) |\\n| Loans held for sale | 18,959 | 23,017 |\\n| Other assets | 32,252 | 16,700 |\\n| Other liabilities | 58,669 | 28,267 |\\n| Total adjustments | 119,089 | 37,505 |\\n| Net cash provided by operating activities | 305,859 | 156,795 |\\n| Cash flows used in investing activities |\\n| Proceeds from sales of equity securities | 30 | 1,164 |\\n| Purchases of equity securities | ( 471 ) | ( 1,522 ) |\\n| Proceeds from maturities and principal repayments of securities available for sale | 100,790 | 75,442 |\\n| Purchases of securities available for sale | ( 123,289 ) | ( 1,106,079 ) |\\n| Proceeds from maturities and principal repayments of securities held to maturity | 132,997 | 199,304 |\\n| Purchases of securities held to maturity | ( 763,987 ) | ( 340,713 ) |\\n| Net redemption of Federal Home Loan Bank stock | 6,189 | 1,584 |\\n| Investments in low income housing projects | ( 14,896 ) | ( 19,236 ) |\\n| Purchases of life insurance policies | ( 115 ) | ( 40,116 ) |\\n| Proceeds from life insurance policies | 2,273 | 576 |\\n| Net (increase) decrease in loans | ( 107,211 ) | 603,773 |\\n| Purchases of bank premises and equipment | ( 18,019 ) | ( 16,114 ) |\\n| Proceeds from the sale of bank premises and equipment | 1,228 | 78 |\\n| Net cash used in investing activities | ( 784,481 ) | ( 641,859 ) |\\n| Cash flows (used in) provided by financing activities |\\n| Net decrease in time deposits | ( 351,458 ) | ( 165,052 ) |\\n\\n11\\n| Net (decrease) increase in other deposits | ( 225,519 ) | 1,432,037 |\\n| Repayments of short-term Federal Home Loan Bank borrowings | ( 25,000 ) | — |\\n| Repayments of long-term Federal Home Loan Bank borrowings | — | ( 10,000 ) |\\n| Repayments of long-term debt, net of issuance costs | ( 14,063 ) | ( 14,063 ) |\\n| Net payments for exercise of stock options | — | ( 57 ) |\\n| Restricted stock awards issued, net of awards surrendered | ( 1,085 ) | ( 1,246 ) |\\n| Proceeds from shares issued under direct stock purchase plan | 1,765 | 1,515 |\\n| Payments for shares repurchased under share repurchase program | ( 139,946 ) | — |\\n| Common dividends paid | ( 70,460 ) | ( 46,875 ) |\\n| Net cash (used in) provided by financing activities | ( 825,766 ) | 1,196,259 |\\n| Net (decrease) increase in cash and cash equivalents | ( 1,304,388 ) | 711,195 |\\n| Cash and cash equivalents at beginning of year | 2,240,684 | 1,296,636 |\\n| Cash and cash equivalents at end of period | $ | 936,296 | $ | 2,007,831 |\\n| Supplemental schedule of noncash activities |\\n| Net increase in capital commitments relating to low income housing project investments | $ | 4,408 | $ | 34,127 |\\n| Right-of-use assets obtained in exchange for new lease obligations | $ | 14,124 | $ | 5,888 |\\n\\nThe accompanying notes are an integral part of these unaudited consolidated financial statements.\\n12\\nNOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS\\nNOTE 1 - BASIS OF PRESENTATION\\nIndependent Bank Corp. (the “Company”) is a state chartered, federally registered bank holding company, incorporated in 1985. The Company is the sole stockholder of Rockland Trust Company (“Rockland Trust” or the “Bank”), a Massachusetts trust company chartered in 1907.\\nAll material intercompany balances and transactions have been eliminated in consolidation. Certain previously reported amounts have been reclassified to conform to the current year’s presentation.\\nThe accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (\\\"GAAP\\\") for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation of the financial statements, primarily consisting of normal recurring adjustments, have been included. Results for the nine months ended September 30, 2022 are not necessarily indicative of the results that may be expected for the year ending December 31, 2022 or any other interim period.\\nFor further information, refer to the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2021, filed with the Securities and Exchange Commission (the \\\"2021 Form 10-K\\\").\\nNOTE 2 - RECENT ACCOUNTING STANDARDS UPDATES\\nFinancial Accounting Standards Board (\\\"FASB\\\") Accounting Standards Codification (\\\"ASC\\\") Topic 848 \\\"Reference Rate Reform\\\" Update No. 2020-04. Update No. 2020-04 was issued in March 2020 to provide optional expedients and exceptions for applying GAAP to certain contracts, hedging relationships, and other transactions affected by reference rate reform if certain criteria are met. The amendments in this update apply only to contracts, hedging relationships, and other transactions that reference the London Interbank Offered Rate (\\\"LIBOR\\\") or another reference rate expected to be discontinued because of reference rate reform. The amendments will not apply to contract modifications made and hedging relationships entered into or evaluated after December 31, 2022, except for hedging relationships existing as of December 31, 2022 for which an entity has elected certain optional expedients that are retained through the end of the hedging relationship. The amendments in this update are effective for all entities as of March 12, 2020 through December 31, 2022 and do not apply to contract modifications made after December 31, 2022. FASB ASC Topic 848 \\\"Reference Rate Reform\\\" Update No. 2021-01 was subsequently issued in January 2021 and expanded application of the optional expedients to derivative transactions affected by the discounting transition. The Company has not yet adopted the amendments in these updates, but has established a working group to guide the Company’s transition from LIBOR and has begun efforts to transition off the LIBOR index consistent with industry timelines. The working group has identified its products that utilize LIBOR and has implemented fallback language to facilitate the transition to alternative rates. The Company is also evaluating existing platforms and systems as well as alternative indices in its preparation to offer new products tied to the alternative indices. The Company does not anticipate that the adoption of these updates will have a material impact on the Company's financial statements.\\nFASB ASC Topic 260 \\\"Earnings Per Share\\\" Update No. 2020-06. In August 2020, the FASB issued update No. 2020-06 (\\\"ASU 2020-06\\\"). ASU 2020-06 included amendments to ASC 260 related to the earnings per share calculation, which were designed to simplify and improve consistency of the diluted earnings per share calculation. ASU 2020-06 is effective for public entities for annual periods beginning after December 15, 2021 and interim periods therein. Accordingly, the Company adopted ASU 2020-06 effective January 1, 2022 and the adoption did not have a material impact on the Company's financial statements.\\nFASB ASC Topic 815 \\\"Derivatives and Hedging\\\" Update No. 2022-01. Update No. 2022-01 was issued in March 2022 and its amendments allow for nonprepayable financial assets to also be included in a closed portfolio hedged using the portfolio layer method. The expanded scope permits an entity to apply the same portfolio hedging method to both prepayable and nonprepayable financial assets resulting in more consistent accounting for similar hedges. All amendments in this update are effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. The Company is currently assessing the impact of the adoption of this standard on the Company's financial statements.\\nFASB ASC Topic 326 \\\"Financial Instruments - Credit Losses\\\" Update No. 2022-02. Update No. 2022-02 was issued in March 2022 and applies to public entities that have adopted ASU Topic 326. The amendments in this update eliminate the existing accounting guidance for troubled debt restructures (\\\"TDRs\\\") by creditors in Subtopic 310-40, Receivables - Troubled Debt Restructurings by Creditors and instead requires that an entity evaluate whether a modification\\n13\\nrepresents a new loan or a continuation of an existing loan. The amendments also enhance disclosure requirements for certain loan refinancing and restructuring by creditors when a borrower is experiencing financial difficulty. ASU 2022-02 also requires additional disclosure of current period gross write-offs by year of origination for financing receivables to be included in the entity's vintage disclosure, as currently required under Topic 326. All amendments in this update are effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. The Company is currently assessing the impact of the adoption of this standard on the Company's financial statements.\\n14\\nNOTE 3 - SECURITIES\\nTrading Securities\\nThe Company had trading securities of $ 3.5 million and $ 3.7 million as of September 30, 2022 and December 31, 2021, respectively. These securities are held in a rabbi trust and will be used for future payments associated with the Company’s non-qualified 401(k) Restoration Plan and Non-qualified Deferred Compensation Plan.\\nEquity Securities\\nThe Company had equity securities of $ 20.4 million and $ 23.2 million as of September 30, 2022 and December 31, 2021, respectively. These securities consist primarily of mutual funds held in a rabbi trust and will be used for future payments associated with the Company’s supplemental executive retirement plans.\\nThe following table represents a summary of the gains and losses recognized within non-interest income and non-interest expense within the consolidated statements of income that relate to equity securities for the periods indicated:\\n| Three Months Ended | Nine Months Ended |\\n| September 30 | September 30 |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Dollars in thousands |\\n| Net gains (losses) recognized during the period on equity securities | $ | ( 742 ) | $ | ( 169 ) | ( 2,819 ) | 695 |\\n| Less: net gains recognized during the period on equity securities sold during the period | — | 50 | 8 | 191 |\\n| Unrealized gains (losses) recognized during the reporting period on equity securities still held at the reporting date | $ | ( 742 ) | $ | ( 219 ) | $ | ( 2,827 ) | $ | 504 |\\n\\nAvailable for Sale Securities\\nThe following table summarizes the amortized cost, allowance for credit losses, and fair value of available for sale securities and the corresponding amounts of gross unrealized gains and losses recognized in accumulated other comprehensive income (loss) as of the dates indicated:\\n| September 30, 2022 | December 31, 2021 |\\n| AmortizedCost | GrossUnrealizedGains | Gross UnrealizedLosses | Allowance for credit losses | FairValue | AmortizedCost | GrossUnrealizedGains | Gross UnrealizedLosses | Allowance for credit losses | FairValue |\\n| (Dollars in thousands) |\\n| Available for sale securities |\\n| U.S. government agency securities | $ | 231,122 | $ | — | $ | ( 31,180 ) | $ | — | $ | 199,942 | $ | 217,393 | $ | 990 | $ | ( 2,901 ) | $ | — | $ | 215,482 |\\n| U.S. treasury securities | 873,891 | — | ( 89,433 ) | — | 784,458 | 873,467 | 172 | ( 12,191 ) | — | 861,448 |\\n| Agency mortgage-backed securities | 393,296 | 50 | ( 49,193 ) | — | 344,153 | 364,955 | 4,512 | ( 5,534 ) | — | 363,933 |\\n| Agency collateralized mortgage obligations | 43,672 | 5 | ( 2,890 ) | — | 40,787 | 78,966 | 1,282 | ( 571 ) | — | 79,677 |\\n| State, county, and municipal securities | 193 | — | ( 6 ) | — | 187 | 192 | 11 | — | — | 203 |\\n| Single issuer trust preferred securities issued by banks | 489 | — | — | — | 489 | 489 | 2 | — | — | 491 |\\n| Pooled trust preferred securities issued by banks and insurers | 1,202 | — | ( 203 ) | — | 999 | 1,199 | — | ( 199 ) | — | 1,000 |\\n| Small business administration pooled securities | 62,048 | — | ( 7,552 ) | — | 54,496 | 47,075 | 1,839 | — | — | 48,914 |\\n| Total available for sale securities | $ | 1,605,913 | $ | 55 | $ | ( 180,457 ) | $ | — | $ | 1,425,511 | $ | 1,583,736 | $ | 8,808 | $ | ( 21,396 ) | $ | — | $ | 1,571,148 |\\n\\nExcluded from the table above is accrued interest on available for sale securities of $ 3.3 million and $ 3.0 million as of September 30, 2022 and December 31, 2021, respectively, which is included within other assets on the consolidated balance sheets. Additionally, the Company did not record any write-offs of accrued interest income on available for sale securities during the three and nine months ended September 30, 2022 and 2021. Furthermore, no securities held by the Company were\\n15\\ndelinquent on contractual payments nor were any securities placed on non-accrual status as of September 30, 2022 and December 31, 2021.\\nWhen securities are sold, the adjusted cost of the specific security sold is used to compute the gain or loss on the sale. The Company had no sales of securities available for sale during the three and nine months ended September 30, 2022 and 2021, and therefore no gains or losses were realized during the periods presented.\\nThe following tables show the gross unrealized losses and fair value of the Company’s available for sale securities in an unrealized loss position, and for which the Company has not recorded a provision for credit losses, as of the dates indicated. These available for sale securities are aggregated by major security type and length of time that individual securities have been in a continuous unrealized loss position:\\n| September 30, 2022 |\\n| Less than 12 months | 12 months or longer | Total |\\n| # of holdings | FairValue | UnrealizedLosses | FairValue | UnrealizedLosses | FairValue | UnrealizedLosses |\\n| (Dollars in thousands) |\\n| U.S. government agency securities | 9 | $ | 80,353 | $ | ( 11,483 ) | $ | 119,589 | $ | ( 19,697 ) | $ | 199,942 | $ | ( 31,180 ) |\\n| U.S. treasury securities | 18 | 86,592 | ( 12,426 ) | 697,866 | ( 77,007 ) | 784,458 | ( 89,433 ) |\\n| Agency mortgage-backed securities | 142 | 263,358 | ( 29,512 ) | 79,167 | ( 19,681 ) | 342,525 | ( 49,193 ) |\\n| Agency collateralized mortgage obligations | 11 | 39,291 | ( 2,890 ) | — | — | 39,291 | ( 2,890 ) |\\n| State, county, and municipal securities | 1 | 187 | ( 6 ) | — | — | 187 | ( 6 ) |\\n| Pooled trust preferred securities issued by banks and insurers | 1 | — | — | 999 | ( 203 ) | 999 | ( 203 ) |\\n| Small business administration pooled securities | 8 | 36,885 | ( 3,768 ) | 17,611 | ( 3,784 ) | 54,496 | ( 7,552 ) |\\n| Total impaired available for sale securities | 190 | $ | 506,666 | $ | ( 60,085 ) | $ | 915,232 | $ | ( 120,372 ) | $ | 1,421,898 | $ | ( 180,457 ) |\\n| December 31, 2021 |\\n| Less than 12 months | 12 months or longer | Total |\\n| # of holdings | FairValue | UnrealizedLosses | FairValue | UnrealizedLosses | FairValue | UnrealizedLosses |\\n| (Dollars in thousands) |\\n| U.S. government agency securities | 6 | $ | 160,913 | $ | ( 2,901 ) | $ | — | $ | — | $ | 160,913 | $ | ( 2,901 ) |\\n| U.S. treasury securities | 17 | 811,993 | ( 12,191 ) | — | — | 811,993 | ( 12,191 ) |\\n| Agency mortgage-backed securities | 12 | 214,678 | ( 5,534 ) | — | — | 214,678 | ( 5,534 ) |\\n| Agency collateralized mortgage obligations | 1 | 22,960 | ( 571 ) | — | — | 22,960 | ( 571 ) |\\n| Pooled trust preferred securities issued by banks and insurers | 1 | — | — | 1,000 | ( 199 ) | 1,000 | ( 199 ) |\\n| Total impaired available for sale securities | 37 | $ | 1,210,544 | $ | ( 21,197 ) | $ | 1,000 | $ | ( 199 ) | $ | 1,211,544 | $ | ( 21,396 ) |\\n\\nThe Company does not intend to sell these investments and has determined, based upon available evidence, that it is more likely than not that the Company will not be required to sell each security before the recovery of its amortized cost basis. In addition, management does not believe that any of the securities are impaired due to reasons of credit quality. As a result, the Company did not recognize a provision for credit losses on these investments during the three and nine months ended September 30, 2022 and 2021, respectively. The Company made this determination by reviewing various qualitative and quantitative factors regarding each investment category, such as current market conditions, extent and nature of changes in fair value, issuer rating changes and trends, volatility of earnings, and current analysts’ evaluations.\\n16\\nAs a result of the Company’s review of these qualitative and quantitative factors, the causes of the impairments listed in the table above by category were as follows at September 30, 2022:\\n•U.S. Government Agency Securities, U.S. Treasury Securities, Agency Mortgage-Backed Securities, Agency Collateralized Mortgage Obligations and Small Business Administration Pooled Securities: These portfolios have contractual terms that generally do not permit the issuer to settle the securities at a price less than the current par value of the investment. The decline in market value of these securities is attributable to changes in interest rates and not credit quality. Additionally, these securities are implicitly guaranteed by the U.S. Government or one of its agencies.\\n•State, County and Municipal Securities: This portfolio has contractual terms that generally do not permit the issuer to settle the securities at a price less than the current par value of the investment. The decline in market value of these securities is attributable to changes in interest rates and not credit quality.\\n•Pooled Trust Preferred Securities: This portfolio consists of one below investment grade security which is performing. The unrealized loss on this security is attributable to the illiquid nature of the trust preferred market in the current economic and regulatory environment. Management evaluates collateral credit and instrument structure, including current and expected deferral and default rates and timing. In addition, discount rates are determined by evaluating comparable spreads observed currently in the market for similar instruments.\\nHeld to Maturity Securities\\nThe following table summarizes the amortized cost, fair value and allowance for credit losses of held to maturity securities and the corresponding amounts of gross unrealized gains and losses recognized in accumulated other comprehensive income (loss) as of the dates indicated:\\n| September 30, 2022 | December 31, 2021 |\\n| AmortizedCost | GrossUnrealizedGains | Gross UnrealizedLosses | Allowance for credit losses | FairValue | AmortizedCost | GrossUnrealizedGains | Gross UnrealizedLosses | Allowance for credit losses | FairValue |\\n| (Dollars in thousands) |\\n| U.S. government agency securities | $ | 31,696 | $ | — | $ | ( 2,393 ) | $ | — | $ | 29,303 | $ | 32,987 | $ | — | $ | ( 441 ) | $ | — | $ | 32,546 |\\n| U.S. treasury securities | 100,615 | — | ( 12,623 ) | — | 87,992 | 102,560 | 6 | ( 324 ) | — | 102,242 |\\n| Agency mortgage-backed securities | 892,102 | 149 | ( 90,158 ) | — | 802,093 | 493,012 | 8,495 | ( 4,271 ) | — | 497,236 |\\n| Agency collateralized mortgage obligations | 553,995 | — | ( 77,025 ) | — | 476,970 | 415,736 | 3,232 | ( 10,123 ) | — | 408,845 |\\n| Single issuer trust preferred securities issued by banks | 1,500 | 8 | — | — | 1,508 | 1,500 | 8 | — | — | 1,508 |\\n| Small business administration pooled securities | 117,727 | 12 | ( 5,620 ) | — | 112,119 | 21,023 | 733 | — | — | 21,756 |\\n| Total held to maturity securities | $ | 1,697,635 | $ | 169 | $ | ( 187,819 ) | $ | — | $ | 1,509,985 | $ | 1,066,818 | $ | 12,474 | $ | ( 15,159 ) | $ | — | $ | 1,064,133 |\\n\\nSubstantially all held to maturity securities held by the Company are guaranteed by the U.S. federal government or other government sponsored agencies and have a long history of no credit losses. As a result, management has determined these securities to have a zero loss expectation and therefore the Company did not record a provision for estimated credit losses on any held to maturity securities during the three and nine months ended September 30, 2022 and 2021, respectively. Excluded from the table above is accrued interest on held to maturity securities of $ 4.3 million and $ 2.0 million as of September 30, 2022 and December 31, 2021, respectively, which is included within other assets on the consolidated balance sheets. Additionally, the Company did not record any write-offs of accrued interest income on held to maturity securities during the three and nine months ended September 30, 2022 and 2021. Furthermore, no securities held by the Company were delinquent on contractual payments nor were any securities placed on non-accrual status as of September 30, 2022 and December 31, 2021.\\nWhen securities are sold, the adjusted cost of the specific security sold is used to compute the gain or loss on the sale. The Company had no sales of held to maturity securities during the three and nine months ended September 30, 2022 and 2021, respectively, and therefore no gains or losses were realized during the periods presented.\\nThe Company monitors the credit quality of held to maturity securities through the use of credit ratings. Credit ratings are monitored by the Company on at least a quarterly basis. As of September 30, 2022, all held to maturity securities held by the Company were rated investment grade or higher.\\n17\\nThe actual maturities of certain available for sale or held to maturity securities may differ from the contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. A schedule of the contractual maturities of available for sale and held to maturity securities as of September 30, 2022 is presented below:\\n| Due in one year or less | Due after one year to five years | Due after five to ten years | Due after ten years | Total |\\n| AmortizedCost | FairValue | AmortizedCost | FairValue | AmortizedCost | FairValue | AmortizedCost | FairValue | AmortizedCost | FairValue |\\n| (Dollars in thousands) |\\n| Available for sale securities |\\n| U.S. government agency securities | $ | — | $ | — | $ | 68,007 | $ | 60,786 | $ | 163,115 | $ | 139,156 | $ | — | $ | — | $ | 231,122 | $ | 199,942 |\\n| U.S. treasury securities | — | — | 691,691 | 627,786 | 182,200 | 156,672 | — | — | 873,891 | 784,458 |\\n| Agency mortgage-backed securities | 19,658 | 19,617 | 70,984 | 66,817 | 148,475 | 126,625 | 154,179 | 131,094 | 393,296 | 344,153 |\\n| Agency collateralized mortgage obligations | — | — | — | — | — | — | 43,672 | 40,787 | 43,672 | 40,787 |\\n| State, county, and municipal securities | — | — | 193 | 187 | — | — | — | — | 193 | 187 |\\n| Single issuer trust preferred securities issued by banks | — | — | — | — | — | — | 489 | 489 | 489 | 489 |\\n| Pooled trust preferred securities issued by banks and insurers | — | — | — | — | — | — | 1,202 | 999 | 1,202 | 999 |\\n| Small business administration pooled securities | — | — | — | — | — | — | 62,048 | 54,496 | 62,048 | 54,496 |\\n| Total available for sale securities | $ | 19,658 | $ | 19,617 | $ | 830,875 | $ | 755,576 | $ | 493,790 | $ | 422,453 | $ | 261,590 | $ | 227,865 | $ | 1,605,913 | $ | 1,425,511 |\\n| Held to maturity securities |\\n| U.S. government agency securities | $ | — | $ | — | $ | 31,696 | $ | 29,303 | $ | — | $ | — | $ | — | $ | — | $ | 31,696 | $ | 29,303 |\\n| U.S. treasury securities | — | — | 49,766 | 44,047 | 50,849 | 43,945 | — | — | 100,615 | 87,992 |\\n| Agency mortgage-backed securities | 228 | 226 | 190,333 | 182,141 | 478,115 | 415,833 | 223,426 | 203,893 | 892,102 | 802,093 |\\n| Agency collateralized mortgage obligations | — | — | 29,998 | 28,550 | 36,791 | 31,784 | 487,206 | 416,636 | 553,995 | 476,970 |\\n| Single issuer trust preferred securities issued by banks | — | — | — | — | 1,500 | 1,508 | — | — | 1,500 | 1,508 |\\n| Small business administration pooled securities | — | — | — | — | — | — | 117,727 | 112,119 | 117,727 | 112,119 |\\n| Total held to maturity securities | $ | 228 | $ | 226 | $ | 301,793 | $ | 284,041 | $ | 567,255 | $ | 493,070 | $ | 828,359 | $ | 732,648 | $ | 1,697,635 | $ | 1,509,985 |\\n| Total | $ | 19,886 | $ | 19,843 | $ | 1,132,668 | $ | 1,039,617 | $ | 1,061,045 | $ | 915,523 | $ | 1,089,949 | $ | 960,513 | $ | 3,303,548 | $ | 2,935,496 |\\n\\nIncluded in the table above are $ 24.8 million of callable securities at September 30, 2022.\\nThe carrying value of securities pledged to secure public funds, trust deposits, and for other purposes, as required or permitted by law, was $ 963.9 million and $ 740.6 million at September 30, 2022 and December 31, 2021, respectively.\\nAt September 30, 2022 and December 31, 2021, the Company had no investments in obligations of individual states, counties, or municipalities which exceeded 10% of consolidated stockholders’ equity.\\n18\\nNOTE 4 - LOANS, ALLOWANCE FOR CREDIT LOSSES AND CREDIT QUALITY\\nLoans Held for Investment and Allowance for Credit Losses\\nThe following table summarizes the change in allowance for credit losses by loan category, and bifurcates the amount of loans allocated to each loan category for the period indicated:\\n| Three Months Ended September 30, 2022 |\\n| (Dollars in thousands) |\\n| Commercial andIndustrial | CommercialReal Estate | CommercialConstruction | SmallBusiness | ResidentialReal Estate | Home Equity | Other Consumer | Total |\\n| Allowance for credit losses |\\n| Beginning balance | $ | 14,107 | $ | 83,456 | $ | 11,710 | $ | 2,784 | $ | 19,750 | $ | 11,740 | $ | 772 | $ | 144,319 |\\n| Charge-offs | — | ( 62 ) | — | — | — | — | ( 679 ) | ( 741 ) |\\n| Recoveries | 2 | 330 | — | 88 | — | 65 | 251 | 735 |\\n| Provision for (release of) credit losses | 6,060 | ( 3,688 ) | ( 291 ) | ( 248 ) | 852 | ( 154 ) | 469 | 3,000 |\\n| Ending balance (1) | $ | 20,169 | $ | 80,036 | $ | 11,419 | $ | 2,624 | $ | 20,602 | $ | 11,651 | $ | 812 | $ | 147,313 |\\n| Three Months Ended September 30, 2021 |\\n| (Dollars in thousands) |\\n| Commercial andIndustrial | CommercialReal Estate | CommercialConstruction | SmallBusiness | ResidentialReal Estate | Home Equity | Other Consumer | Total |\\n| Allowance for credit losses |\\n| Beginning balance | $ | 17,032 | $ | 44,325 | $ | 4,865 | $ | 3,612 | $ | 12,014 | $ | 20,087 | $ | 422 | $ | 102,357 |\\n| Charge-offs | ( 1 ) | — | — | ( 83 ) | — | — | ( 248 ) | ( 332 ) |\\n| Recoveries | 1 | — | — | 50 | — | 49 | 121 | 221 |\\n| Provision for (release of) credit losses | ( 1,018 ) | ( 6,527 ) | ( 397 ) | 88 | ( 967 ) | ( 1,268 ) | 89 | ( 10,000 ) |\\n| Ending balance (1) | $ | 16,014 | $ | 37,798 | $ | 4,468 | $ | 3,667 | $ | 11,047 | $ | 18,868 | $ | 384 | $ | 92,246 |\\n| Nine Months Ended September 30, 2022 |\\n| (Dollars in thousands) |\\n| Commercial andIndustrial | CommercialReal Estate | CommercialConstruction | SmallBusiness | ResidentialReal Estate | Home Equity | Other Consumer | Total |\\n| Allowance for credit losses |\\n| Beginning balance | $ | 14,402 | $ | 83,486 | $ | 12,316 | $ | 3,508 | $ | 14,484 | $ | 17,986 | $ | 740 | $ | 146,922 |\\n| Charge-offs | — | ( 62 ) | — | ( 59 ) | — | ( 122 ) | ( 1,749 ) | ( 1,992 ) |\\n| Recoveries | 44 | 333 | — | 147 | — | 105 | 754 | 1,383 |\\n| Provision for (release of) credit losses | 5,723 | ( 3,721 ) | ( 897 ) | ( 972 ) | 6,118 | ( 6,318 ) | 1,067 | 1,000 |\\n| Ending balance (1) | $ | 20,169 | $ | 80,036 | $ | 11,419 | $ | 2,624 | $ | 20,602 | $ | 11,651 | $ | 812 | $ | 147,313 |\\n| Nine Months Ended September 30, 2021 |\\n| (Dollars in thousands) |\\n| Commercial andIndustrial | CommercialReal Estate | CommercialConstruction | SmallBusiness | ResidentialReal Estate | Home Equity | Other Consumer | Total |\\n| Allowance for credit losses |\\n| Beginning balance | $ | 21,086 | $ | 45,009 | $ | 5,397 | $ | 5,095 | $ | 14,275 | $ | 22,060 | $ | 470 | $ | 113,392 |\\n| Charge-offs | ( 3,474 ) | — | — | ( 184 ) | — | ( 69 ) | ( 772 ) | ( 4,499 ) |\\n| Recoveries | 100 | 57 | — | 65 | 1 | 107 | 523 | 853 |\\n| Provision for (release of) credit losses | ( 1,698 ) | ( 7,268 ) | ( 929 ) | ( 1,309 ) | ( 3,229 ) | ( 3,230 ) | 163 | ( 17,500 ) |\\n| Ending balance (1) | $ | 16,014 | $ | 37,798 | $ | 4,468 | $ | 3,667 | $ | 11,047 | $ | 18,868 | $ | 384 | $ | 92,246 |\\n\\n(1) Balances of accrued interest receivable excluded from amortized cost and the calculation of allowance for credit losses amounted to $ 42.7 million and $ 36.7 million as of September 30, 2022 and September 30, 2021, respectively.\\n19\\nThe balance of allowance for credit losses of $ 147.3 million as of September 30, 2022 remained relatively flat compared to $ 146.9 million at December 31, 2021. The nominal change in the Company's allowance for credit losses for the nine months ended September 30, 2022 primarily reflects increased reserves attributable to category shifts on nonperforming loans and net loan growth, offset by a stabilized credit environment and continued strong asset quality metrics.\\nFor the purpose of estimating the allowance for credit losses, management segregated the loan portfolio into the portfolio segments detailed in the above tables. Each of these loan categories possesses unique risk characteristics that are considered when determining the appropriate level of allowance for each segment. Some of the characteristics unique to each loan category include:\\nCommercial Portfolio\\n•Commercial and Industrial: Loans in this category consist of revolving and term loan obligations extended to business and corporate enterprises for the purpose of financing working capital and/or capital investment. Collateral generally consists of pledges of business assets including, but not limited to: accounts receivable, inventory, plant and equipment, or real estate, if applicable. Repayment sources consist of primarily, operating cash flow, and secondarily, liquidation of assets.\\n•Commercial Real Estate: Loans in this category consist of mortgage loans to finance investment in real property such as multi-family residential, commercial/retail, office, industrial, hotels, educational and healthcare facilities and other specific use properties. Loans are typically written with amortizing payment structures. Collateral values are determined based upon third party appraisals and evaluations. Loan to value ratios at origination are governed by established policy and regulatory guidelines. Repayment sources consist of, primarily, cash flow from operating leases and rents and, secondarily, liquidation of assets.\\n•Commercial Construction: Loans in this category consist of short-term construction loans, revolving and nonrevolving credit lines and construction/permanent loans to finance the acquisition, development and construction or rehabilitation of real property. Project types include residential land development, one-to-four family, condominium, and multi-family home construction, commercial/retail, office, industrial, hotels, educational and healthcare facilities and other specific use properties. Loans may be written with nonamortizing or hybrid payment structures depending upon the type of project. Collateral values are determined based upon third party appraisals and evaluations. Loan to value ratios at origination are governed by established policy and regulatory guidelines. Repayment sources vary depending upon the type of project and may consist of sale or lease of units, operating cash flows or liquidation of other assets.\\n•Small Business: Loans in this category consist of revolving, term loan and mortgage obligations extended to sole proprietors and small businesses for purposes of financing working capital and/or capital investment. Collateral generally consists of pledges of business assets including, but not limited to, accounts receivable, inventory, plant and equipment, or real estate if applicable. Repayment sources consist primarily of operating cash flows and, secondarily, liquidation of assets.\\nFor the commercial portfolio it is the Company’s policy to obtain personal guarantees for payment from individuals holding material ownership interests in the borrowing entities.\\nConsumer Portfolio\\n•Residential Real Estate: Residential mortgage loans held in the Company’s portfolio are made to borrowers who demonstrate the ability to make scheduled payments with full consideration to underwriting factors such as current and expected income, employment status, current assets, other financial resources, credit history and the value of the collateral. Collateral consists of mortgage liens on one-to-four family residential properties. Residential mortgage loans also include loans to construct owner-occupied one-to-four family residential properties.\\n•Home Equity: Home equity loans and credit lines are made to qualified individuals and are primarily secured by senior or junior mortgage liens on owner-occupied one-to-four family homes, condominiums or vacation homes. Each home equity loan has a fixed rate and is billed in equal payments comprised of principal and interest. The majority of home equity lines of credit have a variable rate and are billed in interest-only payments during the draw period. At the end of the draw period, the home equity line of credit is billed as a percentage of the then outstanding principal balance plus all accrued interest over a predetermined repayment period, as set forth in the note. Additionally, the Company has the option of renewing each line of credit for additional draw periods. Borrower qualifications include favorable credit history combined with supportive income requirements and combined loan to value ratios within established policy guidelines.\\n•Other Consumer: Other consumer loan products include personal lines of credit and amortizing loans made to qualified individuals for various purposes such as debt consolidation, personal expenses or overdraft protection. Borrower qualifications include favorable credit history combined with supportive income and collateral requirements within established policy guidelines. These loans may be secured or unsecured.\\n20\\nCredit Quality\\nThe Company continually monitors the asset quality of the loan portfolio using all available information. Based on this information, loans demonstrating certain payment issues or other weaknesses may be categorized as adversely risk-rated, delinquent, nonperforming and/or put on nonaccrual status. Additionally, in the course of resolving such loans, the Company may choose to restructure the contractual terms of certain loans to match the borrower’s ability to repay the loan based on their current financial condition.\\nThe Company reviews numerous credit quality indicators when assessing the risk in its loan portfolio. For the commercial portfolio, the Company utilizes a 10-point credit risk-rating system, which assigns a risk-grade to each loan obligation based on a number of quantitative and qualitative factors associated with a commercial or small business loan transaction. Factors considered include industry and market conditions, position within the industry, earnings trends, operating cash flow, asset/liability values, debt capacity, guarantor strength, management and controls, financial reporting, collateral, and other considerations. The risk-rating categories for the commercial portfolio are defined as follows:\\n•Pass: Risk-rating “1” through “6” comprises of loans ranging from ‘Substantially Risk Free’ which indicates borrowers are of unquestioned credit standing and the pinnacle of credit quality, well established companies with a very strong financial condition, and loans fully secured by cash collateral, through ‘Acceptable Risk’, which indicates borrowers may exhibit declining earnings, strained cash flow, increasing or above average leverage and/or weakening market fundamentals that indicate below average asset quality, margins and market share. Collateral coverage is protective.\\n•Potential Weakness: Borrowers exhibit potential credit weaknesses or downward trends deserving management’s close attention. If not checked or corrected, these trends will weaken the Company’s asset and position. While potentially weak, currently these borrowers are marginally acceptable; no loss of principal or interest is envisioned.\\n•Definite Weakness Loss Unlikely: Borrowers exhibit well defined weaknesses that jeopardize the orderly liquidation of debt. Loans may be inadequately protected by the current net worth and paying capacity of the obligor or by the collateral pledged, if any. Normal repayment from the borrower is in jeopardy, although no loss of principal is envisioned. However, there is a distinct possibility that a partial loss of interest and/or principal will occur if the deficiencies are not corrected. Collateral coverage may be inadequate to cover the principal obligation.\\n•Partial Loss Probable: Borrowers exhibit well defined weaknesses that jeopardize the orderly liquidation of debt with the added provision that the weaknesses make collection of the debt in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Serious problems exist to the point where partial loss of principal is likely.\\n•Definite Loss: Borrowers deemed incapable of repayment. Loans to such borrowers are considered uncollectible and of such little value that continuation as active assets of the Company is not warranted.\\nThe Company utilizes a comprehensive, continuous strategy for evaluating and monitoring commercial credit quality. Initially, credit quality is determined at loan origination and is re-evaluated when subsequent actions, such as renewals, modifications or reviews, occur. Actively managed commercial borrowers are required to provide updated financial information at least annually which is carefully evaluated for any changes in credit quality. Larger loan relationships are subject to a full annual credit review by experienced credit professionals, while continuous portfolio monitoring techniques are employed to evaluate changes in credit quality for smaller loan relationships. Any changes in credit quality are reflected in risk-rating changes. Additionally, the Company retains an independent loan review firm to evaluate the credit quality of the commercial loan portfolio. The independent loan review process achieves significant penetration into the commercial loan portfolio and reports the results of these reviews to the Audit Committee of the Board of Directors on a quarterly basis. Commercial loan modifications granted by the Company allowing payment deferrals for qualifying borrowers in accordance with the Coronavirus Aid, Relief and Economic Security Act (\\\"CARES Act\\\") were assessed for potential downgrades of risk ratings.\\nFor the Company’s consumer portfolio, the quality of the loan is best indicated by the repayment performance of an individual borrower. As a result, for this portfolio the Company utilizes a pass/default risk-rating system, based on an age analysis (i.e., days past due) associated with each consumer loan. Under this structure, consumer loans less than 90 days past due are assigned a \\\"pass\\\" rating, while any consumer loans 90 days or more past due are assigned a \\\"default\\\" rating.\\nThe following table details the amortized cost balances of the Company's loan portfolios, presented by credit quality indicator and origination year as of the dates indicated below:\\n21\\n| September 30, 2022 |\\n| 2022 | 2021 | 2020 | 2019 | 2018 | Prior | Revolving Loans | Revolving converted to Term | Total (1) |\\n| (Dollars in thousands) |\\n| Commercial andindustrial |\\n| Pass (2) | $ | 292,601 | $ | 149,588 | $ | 122,752 | $ | 67,591 | $ | 82,911 | $ | 22,943 | $ | 759,390 | $ | 3,362 | $ | 1,501,138 |\\n| Potential weakness | 1,540 | 973 | 1,038 | 1,844 | 3,955 | 715 | 6,557 | — | 16,622 |\\n| Definite weakness - loss unlikely | 2,485 | 935 | — | 39 | — | 111 | 27,019 | — | 30,589 |\\n| Partial loss probable | — | — | — | — | — | — | — | — | — |\\n| Definite loss | — | — | — | — | — | — | — | — | — |\\n| Total commercial and industrial | $ | 296,626 | $ | 151,496 | $ | 123,790 | $ | 69,474 | $ | 86,866 | $ | 23,769 | $ | 792,966 | $ | 3,362 | $ | 1,548,349 |\\n| Commercial real estate |\\n| Pass | $ | 922,772 | $ | 1,467,370 | $ | 1,265,711 | $ | 773,102 | $ | 733,621 | $ | 1,976,282 | $ | 47,317 | $ | 1,070 | $ | 7,187,245 |\\n| Potential weakness | 32,579 | 53,096 | 41,164 | 14,147 | 68,298 | 205,234 | — | — | 414,518 |\\n| Definite weakness - loss unlikely | 26,684 | 2,224 | 4,722 | 2,585 | 17,928 | 21,836 | — | — | 75,979 |\\n| Partial loss probable | — | — | — | — | — | 175 | — | — | 175 |\\n| Definite loss | — | — | — | — | — | — | — | — | — |\\n| Total commercial real estate | $ | 982,035 | $ | 1,522,690 | $ | 1,311,597 | $ | 789,834 | $ | 819,847 | $ | 2,203,527 | $ | 47,317 | $ | 1,070 | $ | 7,677,917 |\\n| Commercial construction |\\n| Pass | $ | 388,627 | $ | 392,229 | $ | 231,336 | $ | 57,768 | $ | 26,263 | $ | 7,844 | $ | 21,457 | $ | 632 | $ | 1,126,156 |\\n| Potential weakness | 40,631 | — | 3,387 | — | — | — | — | — | 44,018 |\\n| Definite weakness - loss unlikely | 2,138 | 12,845 | — | — | — | — | — | — | 14,983 |\\n| Partial loss probable | — | — | — | — | — | — | — | — | — |\\n| Definite loss | — | — | — | — | — | — | — | — | — |\\n| Total commercial construction | $ | 431,396 | $ | 405,074 | $ | 234,723 | $ | 57,768 | $ | 26,263 | $ | 7,844 | $ | 21,457 | $ | 632 | $ | 1,185,157 |\\n| Small business |\\n| Pass | $ | 41,923 | $ | 46,581 | $ | 31,968 | $ | 17,536 | $ | 10,454 | $ | 20,227 | $ | 37,455 | $ | — | $ | 206,144 |\\n| Potential weakness | — | 163 | 394 | 369 | 193 | 129 | 697 | — | 1,945 |\\n| Definite weakness - loss unlikely | 194 | — | 442 | 7 | 20 | 224 | 591 | — | 1,478 |\\n| Partial loss probable | — | — | — | — | — | — | — | — | — |\\n| Definite loss | — | — | — | — | — | — | — | — | — |\\n| Total small business | $ | 42,117 | $ | 46,744 | $ | 32,804 | $ | 17,912 | $ | 10,667 | $ | 20,580 | $ | 38,743 | $ | — | $ | 209,567 |\\n| Residential real estate |\\n| Pass | $ | 557,643 | $ | 426,721 | $ | 196,538 | $ | 95,689 | $ | 96,828 | $ | 582,830 | $ | — | $ | — | $ | 1,956,249 |\\n| Default | — | — | 676 | 466 | 376 | 1,487 | — | — | 3,005 |\\n| Total residential real estate | $ | 557,643 | $ | 426,721 | $ | 197,214 | $ | 96,155 | $ | 97,204 | $ | 584,317 | $ | — | $ | — | $ | 1,959,254 |\\n| Home equity |\\n| Pass | $ | 37,298 | $ | 61,898 | $ | 56,262 | $ | 32,761 | $ | 27,906 | $ | 124,325 | $ | 741,952 | $ | 3,190 | $ | 1,085,592 |\\n| Default | — | — | — | 122 | — | 285 | 1,171 | — | 1,578 |\\n| Total home equity | $ | 37,298 | $ | 61,898 | $ | 56,262 | $ | 32,883 | $ | 27,906 | $ | 124,610 | $ | 743,123 | $ | 3,190 | $ | 1,087,170 |\\n| Other consumer |\\n| Pass | $ | 383 | $ | 2,498 | $ | 1,969 | $ | 1,370 | $ | 380 | $ | 3,630 | $ | 22,680 | $ | — | $ | 32,910 |\\n| Default | — | 14 | — | — | — | 11 | 1 | — | 26 |\\n| Total other consumer | $ | 383 | $ | 2,512 | $ | 1,969 | $ | 1,370 | $ | 380 | $ | 3,641 | $ | 22,681 | $ | — | $ | 32,936 |\\n| Total | $ | 2,347,498 | $ | 2,617,135 | $ | 1,958,359 | $ | 1,065,396 | $ | 1,069,133 | $ | 2,968,288 | $ | 1,666,287 | $ | 8,254 | $ | 13,700,350 |\\n\\n22\\n| September 30, 2021 |\\n| 2021 | 2020 | 2019 | 2018 | 2017 | Prior | Revolving Loans | Revolving converted to Term | Total (1) |\\n| (Dollars in thousands) |\\n| Commercial andindustrial |\\n| Pass (2) | $ | 590,532 | $ | 185,706 | $ | 97,095 | $ | 74,381 | $ | 15,175 | $ | 16,731 | $ | 605,718 | $ | 66 | $ | 1,585,404 |\\n| Potential weakness | 1,338 | 9,035 | 3,286 | 1,672 | 980 | 1,632 | 10,262 | — | 28,205 |\\n| Definite weakness - loss unlikely | 16,597 | 332 | 793 | 1,034 | 2,678 | 214 | 5,452 | — | 27,100 |\\n| Partial loss probable | — | — | — | — | — | — | — | — | — |\\n| Definite loss | — | — | — | — | — | — | — | — | — |\\n| Total commercial and industrial | $ | 608,467 | $ | 195,073 | $ | 101,174 | $ | 77,087 | $ | 18,833 | $ | 18,577 | $ | 621,432 | $ | 66 | $ | 1,640,709 |\\n| Commercial real estate |\\n| Pass | $ | 699,565 | $ | 1,019,453 | $ | 606,645 | $ | 347,874 | $ | 442,306 | $ | 794,263 | $ | 17,068 | $ | — | $ | 3,927,174 |\\n| Potential weakness | 22,106 | 29,091 | 51,976 | 14,628 | 21,350 | 82,655 | 13,615 | — | 235,421 |\\n| Definite weakness - loss unlikely | 9,331 | 16,336 | 3,399 | 13,657 | 9,762 | 6,179 | — | — | 58,664 |\\n| Partial loss probable | — | — | — | — | — | — | — | — | — |\\n| Definite loss | — | — | — | — | — | — | — | — | — |\\n| Total commercial real estate | $ | 731,002 | $ | 1,064,880 | $ | 662,020 | $ | 376,159 | $ | 473,418 | $ | 883,097 | $ | 30,683 | $ | — | $ | 4,221,259 |\\n| Commercial construction |\\n| Pass | $ | 127,945 | $ | 216,573 | $ | 82,559 | $ | 22,851 | $ | 22,873 | $ | 6,505 | $ | 16,424 | $ | 2,134 | $ | 497,864 |\\n| Potential weakness | — | 12,991 | — | — | — | — | — | — | 12,991 |\\n| Definite weakness - loss unlikely | — | 4,560 | — | — | — | — | — | — | 4,560 |\\n| Partial loss probable | — | — | — | — | — | — | — | — | — |\\n| Definite loss | — | — | — | — | — | — | — | — | — |\\n| Total commercial construction | $ | 127,945 | $ | 234,124 | $ | 82,559 | $ | 22,851 | $ | 22,873 | $ | 6,505 | $ | 16,424 | $ | 2,134 | $ | 515,415 |\\n| Small business |\\n| Pass | $ | 40,736 | $ | 38,804 | $ | 22,075 | $ | 14,241 | $ | 10,675 | $ | 21,809 | $ | 32,679 | $ | — | $ | 181,019 |\\n| Potential weakness | 14 | — | 383 | 200 | 5 | 174 | 627 | — | 1,403 |\\n| Definite weakness - loss unlikely | 138 | 637 | 41 | 26 | 10 | 284 | 580 | — | 1,716 |\\n| Partial loss probable | — | — | — | — | — | — | — | — | — |\\n| Definite loss | — | — | — | — | — | — | — | — | — |\\n| Total small business | $ | 40,888 | $ | 39,441 | $ | 22,499 | $ | 14,467 | $ | 10,690 | $ | 22,267 | $ | 33,886 | $ | — | $ | 184,138 |\\n| Residential real estate |\\n| Pass | $ | 277,949 | $ | 184,974 | $ | 92,723 | $ | 97,915 | $ | 102,581 | $ | 463,397 | $ | — | $ | — | $ | 1,219,539 |\\n| Default | — | 123 | — | 1,024 | — | 2,163 | — | — | 3,310 |\\n| Total residential real estate | $ | 277,949 | $ | 185,097 | $ | 92,723 | $ | 98,939 | $ | 102,581 | $ | 465,560 | $ | — | $ | — | $ | 1,222,849 |\\n| Home equity |\\n| Pass | $ | 58,897 | $ | 68,629 | $ | 42,083 | $ | 37,644 | $ | 41,792 | $ | 117,488 | $ | 628,575 | $ | 3,575 | $ | 998,683 |\\n| Default | — | — | — | — | — | 33 | 1,717 | 35 | 1,785 |\\n| Total home equity | $ | 58,897 | $ | 68,629 | $ | 42,083 | $ | 37,644 | $ | 41,792 | $ | 117,521 | $ | 630,292 | $ | 3,610 | $ | 1,000,468 |\\n| Other consumer |\\n| Pass | $ | 307 | $ | 347 | $ | 244 | $ | 78 | $ | 500 | $ | 5,338 | $ | 16,359 | $ | — | $ | 23,173 |\\n| Default | — | — | — | — | — | — | 2 | — | 2 |\\n| Total other consumer | $ | 307 | $ | 347 | $ | 244 | $ | 78 | $ | 500 | $ | 5,338 | $ | 16,361 | $ | — | $ | 23,175 |\\n| Total | $ | 1,845,455 | $ | 1,787,591 | $ | 1,003,302 | $ | 627,225 | $ | 670,687 | $ | 1,518,865 | $ | 1,349,078 | $ | 5,810 | $ | 8,808,013 |\\n\\n23\\n(1) Loan origination dates in the tables above reflect the original origination date, or the date of a material modification of a previously originated loan.\\n(2) Loans originated as part of the Paycheck Protection Program (\\\"PPP\\\") established by the CARES Act are included within commercial and industrial under the 2021 and 2020 vintage year and \\\"pass\\\" category as these loans are 100% guaranteed by the U.S. Government. Outstanding PPP loans totaled $ 11.1 million and $ 383.6 million as of September 30, 2022 and 2021, respectively.\\nFor the Company’s consumer portfolio, the quality of the loan is best indicated by the repayment performance of an individual borrower. However, the Company does supplement performance data with current Fair Isaac Corporation (“FICO”) scores and Loan to Value (“LTV”) estimates. Current FICO data is purchased and appended to all consumer loans on a regular basis. In addition, automated valuation services and broker opinions of value are used to supplement original value data for the residential real estate and home equity portfolios, periodically. The following table shows the weighted average FICO scores and the weighted average combined LTV ratios at the dates indicated below:\\n| September 302022 | December 312021 |\\n| Residential real estate portfolio |\\n| FICO score (re-scored)(1) | 753 | 749 |\\n| LTV (re-valued)(2) | 54.8 | % | 54.4 | % |\\n| Home equity portfolio |\\n| FICO score (re-scored)(1) | 771 | 772 |\\n| LTV (re-valued)(2)(3) | 40.9 | % | 42.4 | % |\\n\\n(1) The average FICO scores at September 30, 2022 are based upon rescores from June 2022, as available for previously originated loans, or origination score data for loans booked since June 2022. The average FICO scores at December 31, 2021 were based upon rescores available from December 2021, as available for previously originated loans, or origination score data for loans booked in December 2021.\\n(2) The combined LTV ratios for September 30, 2022 are based upon updated automated valuations as of August 2022, when available, and/or the most current valuation data available. The combined LTV ratios for December 31, 2021 were based upon updated automated valuations as of November 2021, when available, and/or the most current valuation data available as of such date. The updated automated valuations provide new information on loans that may be available since the previous valuation was obtained. If no new information is available, the valuation will default to the previously obtained data or most recent appraisal.\\n(3) For home equity loans and lines in a subordinate lien, the LTV data represents a combined LTV, taking into account the senior lien data for loans and lines.\\nUnfunded Commitments\\nManagement evaluates the need for a reserve on unfunded lending commitments in a manner consistent with loans held for investment. At September 30, 2022 and December 31, 2021, the Company's estimated reserve for unfunded commitments amounted to $ 1.3 million and $ 1.5 million, respectively.\\nAsset Quality\\nThe Company’s philosophy toward managing its loan portfolios is predicated upon careful monitoring, which stresses early detection and response to delinquent and default situations. Delinquent loans are managed by a team of collection specialists and the Company seeks to make arrangements to resolve any delinquent or default situation over the shortest possible time frame. As a general rule, loans 90 days or more past due with respect to principal or interest are classified as nonaccrual loans. The Company also may use discretion regarding other loans 90 days or more delinquent if the loan is well secured and/or in process of collection.\\nIn response to the COVID-19 pandemic, the Company has granted loan modifications to allow deferral of payments for borrowers negatively impacted by the pandemic. The balance of loans with active deferrals as of September 30, 2022 and December 31, 2021 was $ 193.3 million and $ 383.1 million, respectively. The majority of these loans with active deferrals as of September 30, 2022 continue to be characterized as current loans. In accordance with regulatory guidance, these modifications are not considered to be troubled debt restructures (\\\"TDRs\\\") if they were performing as of December 31, 2019. Additionally, a majority of these modified loans are characterized as current and therefore are not impacting nonaccrual or delinquency totals as of September 30, 2022 and December 31, 2021. The Company does, however, consider all active deferrals when estimating loss reserves. As loans reach their deferral maturity date, consideration of TDR and delinquency status will resume in accordance with the Company's accounting policy.\\n24\\nThe following table shows information regarding nonaccrual loans as of the dates indicated:\\n| Nonaccrual Balances |\\n| September 30, 2022 | December 31, 2021 |\\n| With Allowance for Credit Losses | Without Allowance for Credit Losses | Total | With Allowance for Credit Losses | Without Allowance for Credit Losses | Total |\\n| (Dollars in thousands) |\\n| Commercial and industrial | $ | 27,374 | $ | 19 | $ | 27,393 | $ | 3,420 | $ | 19 | $ | 3,439 |\\n| Commercial real estate | 15,982 | — | 15,982 | 10,870 | — | 10,870 |\\n| Small business | 50 | — | 50 | 44 | — | 44 |\\n| Residential real estate | 8,891 | — | 8,891 | 8,580 | 602 | 9,182 |\\n| Home equity | 3,485 | — | 3,485 | 3,781 | — | 3,781 |\\n| Other consumer | 216 | — | 216 | 504 | — | 504 |\\n| Total nonaccrual loans (1) | $ | 55,998 | $ | 19 | $ | 56,017 | $ | 27,199 | $ | 621 | $ | 27,820 |\\n\\n(1) Included in these amounts were $ 1.5 million and $ 2.0 million of nonaccruing TDRs at September 30, 2022 and December 31, 2021, respectively.\\nIt is the Company's policy to reverse any accrued interest when a loan is put on nonaccrual status, and, as such, the Company did not record any interest income on nonaccrual loans during the nine months ended September 30, 2022 and 2021.\\nThe following table shows information regarding foreclosed residential real estate property at the dates indicated:\\n| September 30, 2022 | December 31, 2021 |\\n| (Dollars in thousands) |\\n| Foreclosed residential real estate property held by the creditor | $ | — | $ | — |\\n| Recorded investment in mortgage loans collateralized by residential real estate property that are in the process of foreclosure | $ | 1,871 | $ | 1,426 |\\n\\nThe following tables show the age analysis of past due financing receivables as of the dates indicated:\\n| September 30, 2022 |\\n| 30-59 days | 60-89 days | 90 days or more | Total Past Due | TotalFinancingReceivables | Amortized Cost>90 Daysand Accruing |\\n| Numberof Loans | PrincipalBalance | Numberof Loans | PrincipalBalance | Numberof Loans | PrincipalBalance | Numberof Loans | PrincipalBalance | Current |\\n| (Dollars in thousands) |\\n| Loan Portfolio |\\n| Commercial and industrial | 10 | $ | 322 | 1 | $ | 182 | 3 | $ | 558 | 14 | $ | 1,062 | $ | 1,547,287 | $ | 1,548,349 | $ | — |\\n| Commercial real estate | 9 | 5,419 | 5 | 4,491 | 2 | 208 | 16 | 10,118 | 7,667,799 | 7,677,917 | — |\\n| Commercial construction | — | — | 1 | 1,661 | — | — | 1 | 1,661 | 1,183,496 | 1,185,157 | — |\\n| Small business | 7 | 233 | 3 | 15 | 6 | 29 | 16 | 277 | 209,290 | 209,567 | — |\\n| Residential real estate | 15 | 3,146 | 6 | 1,202 | 19 | 1,804 | 40 | 6,152 | 1,953,102 | 1,959,254 | — |\\n| Home equity | 14 | 534 | 8 | 775 | 19 | 1,577 | 41 | 2,886 | 1,084,284 | 1,087,170 | — |\\n| Other consumer (1) | 504 | 510 | 36 | 245 | 8 | 26 | 548 | 781 | 32,155 | 32,936 | — |\\n| Total | 559 | $ | 10,164 | 60 | $ | 8,571 | 57 | $ | 4,202 | 676 | $ | 22,937 | $ | 13,677,413 | $ | 13,700,350 | $ | — |\\n\\n25\\n| December 31, 2021 |\\n| 30-59 days | 60-89 days | 90 days or more | Total Past Due | TotalFinancingReceivables | RecordedInvestment>90 Daysand Accruing |\\n| Numberof Loans | PrincipalBalance | Numberof Loans | PrincipalBalance | Numberof Loans | PrincipalBalance | Numberof Loans | PrincipalBalance | Current |\\n| (Dollars in thousands) |\\n| Loan Portfolio |\\n| Commercial and industrial | 7 | $ | 143 | 2 | $ | 252 | 2 | $ | 24 | 11 | $ | 419 | $ | 1,562,860 | $ | 1,563,279 | $ | — |\\n| Commercial real estate | 15 | 32,845 | — | — | 4 | 1,339 | 19 | 34,184 | 7,958,160 | 7,992,344 | — |\\n| Commercial construction | — | — | — | — | — | — | — | — | 1,165,457 | 1,165,457 | — |\\n| Small business | 11 | 136 | 6 | 53 | 4 | 24 | 21 | 213 | 192,976 | 193,189 | — |\\n| Residential real estate | 12 | 2,709 | 5 | 714 | 76 | 3,922 | 93 | 7,345 | 1,597,341 | 1,604,686 | — |\\n| Home equity | 15 | 1,375 | 6 | 381 | 21 | 1,671 | 42 | 3,427 | 1,036,184 | 1,039,611 | — |\\n| Other consumer (1) | 458 | 719 | 41 | 277 | 16 | 112 | 515 | 1,108 | 27,612 | 28,720 | — |\\n| Total | 518 | $ | 37,927 | 60 | $ | 1,677 | 123 | $ | 7,092 | 701 | $ | 46,696 | $ | 13,540,590 | $ | 13,587,286 | $ | — |\\n\\n(1) Other consumer portfolio is inclusive of deposit account overdrafts recorded as loan balances.\\nTroubled Debt Restructurings\\nIn the course of resolving nonperforming loans, the Bank may choose to restructure the contractual terms of certain loans. The Bank attempts to work out an alternative payment schedule with the borrower in order to avoid foreclosure actions. Exclusive of loans modified under provisions of the CARES Act, any loans that are modified are reviewed by the Bank to identify if a TDR has occurred, which is when, for economic or legal reasons related to a borrower’s financial difficulties, the Bank grants a concession to the borrower that it would not otherwise consider. Terms may be modified to fit the ability of the borrower to repay in line with its current financial status and the restructuring of the loan may include the transfer of assets from the borrower to satisfy the debt, a modification of loan terms, or a combination of the two.\\nThe following table shows the Company’s total TDRs and other pertinent information as of the dates indicated:\\n| September 30, 2022 | December 31, 2021 |\\n| (Dollars in thousands) |\\n| TDRs on accrual status | $ | 11,549 | $ | 14,635 |\\n| TDRs on nonaccrual | 1,538 | 1,993 |\\n| Total TDRs | $ | 13,087 | $ | 16,628 |\\n| Additional commitments to lend to a borrower who has been a party to a TDR | $ | 137 | $ | 190 |\\n\\nThe Company’s policy is to have any restructured loan which is on nonaccrual status prior to being modified remain on nonaccrual status for six months subsequent to being modified before management considers its return to accrual status. If the restructured loan is on accrual status prior to being modified, it is reviewed to determine if the modified loan should remain on accrual status. Additionally, loans classified as TDRs are adjusted to reflect the changes in value of the recorded investment in the loan, if any, resulting from the granting of a concession. For all residential loan modifications, the borrower must perform during a 90 day trial period before the modification is finalized.\\n26\\nThe following table shows the TDRs which occurred during the periods indicated and the change in the recorded investment subsequent to the modifications occurring:\\n| Three Months Ended | Nine Months Ended |\\n| September 30, 2022 | September 30, 2022 |\\n| Number ofContracts | Pre-ModificationOutstandingRecordedInvestment | Post-ModificationOutstandingRecordedInvestment | Number ofContracts | Pre-ModificationOutstandingRecordedInvestment | Post-ModificationOutstandingRecordedInvestment |\\n| (Dollars in thousands) | (Dollars in thousands) |\\n| Troubled debt restructurings |\\n| Commercial and industrial | 1 | $ | 68 | $ | 67 | 1 | 68 | 67 |\\n| Total (1) | 1 | $ | 68 | $ | 67 | 1 | 68 | 67 |\\n| Three Months Ended | Nine Months Ended |\\n| September 30, 2021 | September 30, 2021 |\\n| Number ofContracts | Pre-ModificationOutstandingRecordedInvestment | Post-ModificationOutstandingRecordedInvestment | Number ofContracts | Pre-ModificationOutstandingRecordedInvestment | Post-ModificationOutstandingRecordedInvestment |\\n| (Dollars in thousands) |\\n| Troubled debt restructurings |\\n| Commercial and industrial | — | $ | — | $ | — | 1 | $ | 14,148 | $ | 14,148 |\\n| Commercial real estate | — | — | — | 5 | 3,964 | 3,964 |\\n| Small business | — | — | — | 2 | 189 | 189 |\\n| Total (1) | — | $ | — | $ | — | 8 | $ | 18,301 | $ | 18,301 |\\n\\n(1) The pre-modification and post-modification balances represent the legal principal balance of the loan. Activity presented in the table above includes $ 14.3 million of modifications on existing TDRs occurring during the nine months ended September 30, 2021.\\nThe following table shows the Company’s post-modification balance of TDRs listed by type of modification for the periods indicated:\\n| Three Months Ended | Nine Months Ended |\\n| September 30 | September 30 |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (Dollars in thousands) |\\n| Combination rate and maturity | — | — | — | 14,148 |\\n| Extended maturity | 67 | — | 67 | 4,153 |\\n| Total | 67 | — | $ | 67 | $ | 18,301 |\\n\\nThe Company considers a loan to have defaulted when it reaches 90 days past due. During the nine months ended September 30, 2022 and September 30, 2021, there were no loans modified during the prior twelve months that subsequently defaulted during the respective periods. The Company determines the amount of allowance on TDRs in accordance with CECL methodology using a discounted cash flow approach, or a fair value of collateral approach if the loan is determined to be individually evaluated.\\n27\\nNOTE 5 - STOCK BASED COMPENSATION\\nDuring the nine months ended September 30, 2022, the Company had the following activity related to stock based compensation:\\nTime Vested Restricted Stock Awards\\nThe Company made the following awards of time vested restricted stock:\\n| Date | Shares Granted | Plan | Grant Date Fair Value Per Share | Vesting Period |\\n| 2/17/2022 | 52,100 | 2005 Employee Stock Plan | $ | 84.70 | Ratably over 5 years from grant date |\\n| 5/24/2022 | 8,099 | 2018 Non-Employee Director Stock Plan | $ | 80.39 | Shares vested immediately |\\n| 9/15/2022 | 646 | 2005 Employee Stock Plan | $ | 77.44 | Ratably over 5 years from grant date |\\n\\nPerformance-Based Restricted Stock Awards\\nOn February 17, 2022, the Company granted 20,700 performance-based restricted stock awards, representing the maximum number of shares that may be earned under the awards, to certain executive level employees. These performance-based restricted stock awards were issued from the 2005 Employee Stock Plan and were determined to have a grant date fair value per share of $ 84.70 . The number of shares to be vested are contingent upon the Company's attainment of certain performance criteria to be measured at the end of a three year performance period, ending December 31, 2024. The awards will vest upon the earlier of the date on which it is determined if the performance goal is achieved subsequent to the performance period or March 31, 2025.\\nOn March 10, 2022, the performance-based restricted stock awards that were awarded on February 21, 2019 vested at 50 % of the maximum target shares awarded, or 7,450 shares.\\n28\\nNOTE 6 - DERIVATIVE AND HEDGING ACTIVITIES\\nThe Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally to manage the Company’s interest rate risk. Additionally, the Company enters into interest rate derivatives, foreign exchange contracts and risk participation agreements to accommodate the business requirements of its customers (“customer related positions”). The Company minimizes the market and liquidity risks of customer related positions by entering into similar offsetting positions with broker-dealers. Derivative instruments are carried at fair value in the Company's financial statements. The accounting for changes in the fair value of a derivative instrument is dependent upon whether or not it qualifies as a hedge for accounting purposes, and further, by the type of hedging relationship.\\nThe Company does not enter into proprietary trading positions for any derivatives.\\nThe Company is subject to over-the-counter derivative clearing requirements which require certain derivatives to be cleared through central clearing houses. Accordingly, the Company clears certain derivative transactions through the Chicago Mercantile Exchange Clearing House (\\\"CME\\\"). This clearing house requires the Company to post initial and variation margin to mitigate the risk of non-payment, the latter of which is received or paid daily based on the net asset or liability position of the contracts.\\nInterest Rate Positions\\nThe Company may utilize various interest rate derivatives as hedging instruments against interest rate risk associated with the Company’s borrowings and loan portfolios. An interest rate derivative is an agreement whereby one party agrees to pay a floating rate of interest on a notional principal amount in exchange for receiving a fixed rate of interest on the same notional amount, for a predetermined period of time, from a second party. The amounts relating to the notional principal amount are not actually exchanged.\\n29\\nThe following tables reflect the Company's derivative positions as of the dates indicated below for interest rate derivatives which qualify as cash flow hedges for accounting purposes:\\n| September 30, 2022 |\\n| Weighted Average Rate |\\n| Notional Amount | Average Maturity | Current Rate Paid | Receive Fixed Swap Rate | Fair Value |\\n| (in thousands) | (in years) | (in thousands) |\\n| Interest rate swaps on loans | $ | 1,050,000 | 3.23 | 2.72 | % | 2.66 | % | $ | ( 43,365 ) |\\n| Current Rate Paid | Receive Fixed Swap Rate Cap - Floor |\\n| Interest rate collars on loans | 400,000 | 2.52 | 2.69 | % | 3.09 % - 2.19 % | ( 10,375 ) |\\n| Total | $ | 1,450,000 | $ | ( 53,740 ) |\\n| December 31, 2021 |\\n| Weighted Average Rate |\\n| Notional Amount | Average Maturity | CurrentRateReceived | Pay FixedSwap Rate | Fair Value |\\n| (in thousands) | (in years) | (in thousands) |\\n| Interest rate swaps on borrowings | $ | 25,000 | 0.62 | 0.16 | % | 1.88 | % | $ | ( 294 ) |\\n| Current Rate Paid | Receive Fixed Swap Rate |\\n| Interest rate swaps on loans | 550,000 | 2.58 | 0.11 | % | 2.16 | % | 11,830 |\\n| Current Rate Paid | Receive Fixed Swap Rate Cap - Floor |\\n| Interest rate collars on loans | 400,000 | 1.66 | 0.11 | % | 2.73 % - 2.20 % | 9,383 |\\n| Total | $ | 975,000 | $ | 20,919 |\\n\\nThe maximum length of time over which the Company is currently hedging its exposure to the variability in future cash flows for forecasted transactions related to the payment of variable interest on existing financial instruments is 6.5 years.\\nFor derivative instruments that are designated and qualify as cash flow hedging instruments, the effective portion of the gains or losses is reported as a component of other comprehensive income (\\\"OCI\\\"), and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. The Company expects approximately $ 22.5 million (pre-tax) to be reclassified as an increase to interest expense, from OCI related to the Company’s cash flow hedges in the twelve months following September 30, 2022. This reclassification is due to anticipated payments that will be made and/or received on the swaps based upon the forward curve as of September 30, 2022.\\nThe Company had no fair value hedges as of September 30, 2022 or December 31, 2021.\\nCustomer Related Positions\\nLoan level derivatives, primarily interest rate swaps, offered to commercial borrowers through the Company’s loan level derivative program do not qualify as hedges for accounting purposes. The Company believes that its exposure to commercial customer derivatives is limited because these contracts are simultaneously matched at inception with an offsetting dealer transaction. Derivatives with dealer counterparties are then either cleared through a clearinghouse or settled directly with a single counterparty. The commercial customer derivative program allows the Company to retain variable-rate commercial loans while allowing the customer to synthetically fix the loan rate by entering into a variable-to-fixed interest rate swap. The amounts relating to the notional principal amount are not actually exchanged.\\n30\\nForeign exchange contracts offered to commercial borrowers through the Company’s derivative program do not qualify as hedges for accounting purposes. The Company acts as a seller and buyer of foreign exchange contracts to accommodate its customers. To mitigate the market and liquidity risk associated with these derivatives, the Company enters into similar offsetting positions. The amounts relating to the notional principal amount are exchanged.\\nThe Company has entered into risk participation agreements with other dealer banks in commercial loan agreements. Participating banks guarantee the performance on borrower-related interest rate swap contracts. These derivatives are not designated as hedges and, therefore, changes in fair value are recognized in earnings. Under a risk participation-out agreement, a derivative asset, the Company participates out a portion of the credit risk associated with the interest rate swap position executed with the commercial borrower for a fee paid to the participating bank. Under a risk participation-in agreement, a derivative liability, the Company assumes, or participates in, a portion of the credit risk associated with the interest rate swap position with the commercial borrower for a fee received from the other bank.\\n31\\nThe following table reflects the Company’s customer related derivative positions as of the dates indicated below for those derivatives not designated as hedging:\\n| Notional Amount Maturing |\\n| Number of Positions (1) | Less than 1 year | Less than 2 years | Less than 3 years | Less than 4 years | Thereafter | Total | Fair Value |\\n| September 30, 2022 |\\n| (Dollars in thousands) |\\n| Loan level swaps |\\n| Receive fixed, pay variable | 285 | $ | 82,932 | $ | 98,409 | $ | 259,419 | $ | 173,197 | $ | 953,915 | $ | 1,567,872 | $ | ( 127,611 ) |\\n| Pay fixed, receive variable | 285 | 82,932 | 98,409 | 259,419 | 173,197 | 953,915 | 1,567,872 | 127,609 |\\n| Foreign exchange contracts |\\n| Buys foreign currency, sells U.S. currency | 62 | 162,094 | 13,013 | — | — | — | 175,107 | ( 15,992 ) |\\n| Buys U.S. currency, sells foreign currency | 62 | 162,094 | 13,013 | — | — | — | 175,107 | 16,079 |\\n| Risk participation agreements |\\n| Participation out | 11 | 2,605 | — | 24,538 | — | 72,045 | 99,188 | 64 |\\n| Participation in | 7 | 22,802 | 16,329 | — | — | 25,944 | 65,075 | ( 15 ) |\\n| Notional Amount Maturing |\\n| Number of Positions (1) | Less than 1 year | Less than 2 years | Less than 3 years | Less than 4 years | Thereafter | Total | Fair Value |\\n| December 31, 2021 |\\n| (Dollars in thousands) |\\n| Loan level swaps |\\n| Receive fixed, pay variable | 296 | $ | 37,589 | $ | 139,844 | $ | 123,507 | $ | 260,953 | $ | 1,060,276 | $ | 1,622,169 | $ | 55,984 |\\n| Pay fixed, receive variable | 296 | 37,589 | 139,844 | 123,507 | 260,953 | 1,060,276 | 1,622,169 | ( 55,982 ) |\\n| Foreign exchange contracts |\\n| Buys foreign currency, sells U.S. currency | 52 | 149,588 | 8,784 | — | — | — | 158,372 | 5,734 |\\n| Buys U.S. currency, sells foreign currency | 52 | 149,588 | 8,784 | — | — | — | 158,372 | ( 5,734 ) |\\n| Risk participation agreements |\\n| Participation out | 11 | — | 2,635 | 7,138 | 24,539 | 68,408 | 102,720 | 279 |\\n| Participation in | 7 | 29,972 | 28,235 | — | — | 8,339 | 66,546 | ( 55 ) |\\n\\n(1) The Company may enter into one dealer swap agreement which offsets multiple commercial borrower swap agreements.\\n32\\nMortgage Derivatives\\nThe Company enters into commitments to fund residential mortgage loans at specified rates and times in the future, with the intention that loans may be sold subsequently in the secondary market. Mortgage loan commitments are referred to as derivative loan commitments if the loan that will result from exercise of the commitment will be held for sale upon funding. These commitments are recognized at fair value on the consolidated balance sheet in other assets and other liabilities with changes in their fair values recorded within mortgage banking income. In addition, the Company has elected the fair value option to carry loans held for sale at fair value. The change in fair value of loans held for sale is recorded in current period earnings as a component of mortgage banking income in accordance with the Company's fair value election. The fair value of loans held for sale decreased by $ 194,000 and $ 75,000 for the three months ended September 30, 2022 and 2021, respectively. The fair value of loans held for sale decreased by $ 620,000 and $ 1.5 million for the nine months ended September 30, 2022 and 2021, respectively. These amounts were offset in earnings by the change in the fair value of mortgage derivatives.\\nOutstanding loan commitments expose the Company to the risk that the price of the loans arising from exercise of the loan commitment might change from inception of the rate lock to funding of the loan due to changes in mortgage interest rates. If interest rates increase, the value of these loan commitments decreases. Conversely, if interest rates decrease, the value of these loan commitments increases. To protect against the price risk inherent in derivative loan commitments, the Company utilizes both \\\"mandatory delivery\\\" and \\\"best efforts\\\" forward loan sale commitments to mitigate the risk of potential decreases in the values of loans that would result from the exercise of the derivative loan commitments. Mandatory delivery contracts are accounted for as derivative instruments. Included in the mandatory delivery forward commitments are To Be Announced securities (\\\"TBAs\\\"). Certain assumptions, including pull through rates and rate lock periods, are used in managing the existing and future hedges. The accuracy of underlying assumptions will impact the ultimate effectiveness of any hedging strategies.\\nWith mandatory delivery contracts, the Company commits to deliver a certain principal amount of mortgage loans to an investor at a specified price on or before a specified date. If the Company fails to deliver the amount of mortgages necessary to fulfill the commitment by the specified date, it is obligated to pay a \\\"pair-off\\\" fee, based on then-current market prices, to the investor/counterparty to compensate the investor for the shortfall. Generally, the Company makes this type of commitment once mortgage loans have been funded and are held for sale, in order to minimize the risk of failure to deliver the requisite volume of loans to the investor and paying pair-off fees as a result. The Company also sells TBA securities to offset potential changes in the fair value of derivative loan commitments. Generally, the Company sells TBA securities by entering into derivative loan commitments for settlement in 30 to 90 days. The Company expects that mandatory delivery contracts, including TBA securities, will experience changes in fair value opposite to the changes in the fair value of derivative loan commitments.\\nWith best effort contracts, the Company commits to deliver an individual mortgage loan of a specified principal amount and quality to an investor if the loan to the underlying borrower closes. Generally, best efforts cash contracts have no pair off risk regardless of market movement. The price the investor will pay the seller for an individual loan is specified prior to the loan being funded (e.g., on the same day the lender commits to lend funds to a potential borrower). The Company expects that these best efforts forward loan sale commitments will experience a net neutral shift in fair value with related derivative loan commitments.\\nThe aggregate amount of net realized gains on sales of such loans included within mortgage banking income was $ 229,000 and $ 4.9 million for the three months ended September 30, 2022 and 2021, respectively, and $ 550,000 and $ 17.2 million for the nine months ended September 30, 2022 and 2021, respectively.\\nBalance Sheet Offsetting\\nThe Company does not offset fair value amounts recognized for derivative instruments. The Company does net the amount recognized for the right to reclaim cash collateral against the obligation to return cash collateral arising from derivative instruments executed with the same counterparty under a master netting arrangement. Collateral legally required to be maintained at dealer banks by the Company is monitored and adjusted as necessary.\\nA daily settlement occurs through the CME for changes in the fair value of centrally cleared derivatives. Not all of the derivatives are required to be cleared through the daily clearing agent. As a result, the total fair values of loan level derivative assets and liabilities recognized on the Company's financial statements are not equal and offsetting.\\n33\\nThe table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the balance sheet and the potential effect of netting arrangements on its financial position, at the dates indicated:\\n| Asset Derivatives (1) | Liability Derivatives (2) |\\n| Fair Value at | Fair Value at | Fair Value at | Fair Value at |\\n| September 302022 | December 312021 | September 302022 | December 312021 |\\n| (Dollars in thousands) |\\n| Derivatives designated as hedges |\\n| Interest rate derivatives | $ | — | $ | 21,951 | (3) | $ | 53,740 | (4) | $ | 1,032 | (4) |\\n| Derivatives not designated as hedges |\\n| Customer Related Positions |\\n| Loan level derivatives | 127,625 | (3) | 68,726 | (3) | 127,627 | (4) | 68,724 | (4) |\\n| Foreign exchange contracts | 16,520 | 6,147 | 16,433 | 6,147 |\\n| Risk participation agreements | 64 | 279 | 15 | 55 |\\n| Mortgage Derivatives |\\n| Interest rate lock commitments | 6 | 753 | 16 | — |\\n| Forward sale loan commitments | 86 | 56 | — | — |\\n| Forward sale hedge commitments | 73 | — | — | 57 |\\n| Total derivatives not designated as hedges | 144,374 | 75,961 | 144,091 | 74,983 |\\n| Total | 144,374 | 97,912 | 197,831 | 76,015 |\\n| Netting Adjustments (5) | ( 62,614 ) | ( 5,727 ) | 35,293 | 6,769 |\\n| Net Derivatives on the Balance Sheet | 81,760 | 92,185 | 162,538 | 69,246 |\\n| Financial instruments (6) | 17,744 | 22,378 | 17,744 | 22,378 |\\n| Cash collateral pledged (received) | — | — | — | 33,838 |\\n| Net Derivative Amounts | $ | 64,016 | $ | 69,807 | $ | 144,794 | $ | 13,030 |\\n\\n(1) All asset derivatives are reflected in other assets on the balance sheet.\\n(2) All liability derivatives are reflected in other liabilities on the balance sheet.\\n(3) Approximately $ 660,000 of accrued interest receivable is included in the fair value of the loan level derivative assets at September 30, 2022, in comparison to accrued interest receivable of approximately $ 1.2 million and $ 1.5 million in included in the fair value of interest rate and loan level derivative assets, respectively, at December 31, 2021.\\n(4) Approximately $ 36,000 and $ 660,000 of accrued interest payable is included in the fair value of interest rate and loan level derivative liabilities, respectively, at September 30, 2022. Accrued interest payable of approximately $ 5,000 and $ 1.5 million is included in the fair value of the interest rate and loan level derivative liabilities, respectively, at December 31, 2021.\\n(5) Netting adjustments represent the amounts recorded to convert derivative assets and liabilities cleared through CME from a gross basis to a net basis, inclusive of the variation margin payments, in accordance with applicable accounting guidance. As displayed in the table above, derivatives that cleared through the CME were either in a net asset position or a net liability position at September 30, 2022.\\n(6) Reflects offsetting derivative positions with the same counterparty that are not netted on the balance sheet.\\n34\\nThe table below presents the effect of the Company’s derivative financial instruments included in OCI and current earnings for the periods indicated:\\n| Three Months Ended | Nine Months Ended |\\n| September 30 | September 30 |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (Dollars in thousands) |\\n| Derivatives designated as hedges |\\n| Loss in OCI on derivatives (effective portion), net of tax | $ | ( 27,144 ) | $ | ( 3,383 ) | $ | ( 52,743 ) | $ | ( 11,559 ) |\\n| Gain reclassified from OCI into interest income or interest expense (effective portion) | $ | 407 | $ | 4,791 | $ | 8,427 | $ | 13,869 |\\n| Derivatives not designated as hedges |\\n| Changes in fair value of customer related positions |\\n| Other income | $ | 26 | $ | 54 | $ | 147 | $ | 137 |\\n| Other expense | ( 67 ) | ( 80 ) | ( 239 ) | ( 374 ) |\\n| Changes in fair value of mortgage derivatives |\\n| Mortgage banking income | 41 | ( 213 ) | ( 603 ) | ( 3,840 ) |\\n| Total | $ | — | $ | ( 239 ) | $ | ( 695 ) | $ | ( 4,077 ) |\\n\\nThe Company's derivative agreements with institutional counterparties contain various credit-risk related contingent provisions, such as requiring the Company to maintain a well-capitalized capital position. If the Company fails to meet these conditions, the counterparties could request the Company make immediate payment or demand that the Company provide immediate and ongoing full collateralization on derivative positions in net liability positions. All derivative instruments with credit-risk contingent features were in a net asset position at September 30, 2022. At December 31, 2021, the aggregate fair value of all derivative instruments with credit-risk related contingent features that were in a net liability position was $ 34.8 million. Although none of the contingency provisions have applied as of September 30, 2022 and December 31, 2021, the Company posted collateral to offset the net liability exposure with institutional counterparties at December 31, 2021.\\nBy using derivatives, the Company is exposed to credit risk to the extent that counterparties to the derivative contracts do not perform as required. Should a counterparty fail to perform under the terms of a derivative contract, the Company's credit exposure on interest rate swaps is limited to the net positive fair value and accrued interest of all swaps with each counterparty. The Company seeks to minimize counterparty credit risk through credit approvals, limits, monitoring procedures, and obtaining collateral, where appropriate. Institutional counterparties must have an investment grade credit rating and be approved by the Company's Board of Directors. As such, management believes the risk of incurring credit losses on derivative contracts with institutional counterparties is remote. The Company's exposure relating to institutional counterparties was $ 127.6 million and $ 28.3 million at September 30, 2022 and December 31, 2021, respectively. The Company’s exposure relating to customer counterparties was approximately $ 8,000 and $ 62.4 million at September 30, 2022 and December 31, 2021, respectively. Credit exposure may be reduced by the value of collateral pledged by the counterparty.\\nNOTE 7 - FAIR VALUE MEASUREMENTS\\nFair value is a market-based measure considered from the perspective of a market participant rather than an entity-specific measure. Therefore, even when market assumptions are not readily available, the assumptions applied by the Company when determining fair value reflect those that the Company determines market participants would use to price the asset or liability at the measurement date. If there has been a significant decrease in the volume and level of activity for the asset or liability, regardless of the valuation technique(s) used, the objective of a fair value measurement remains the same. Fair value is the price that would be received if the asset were to be sold or that would be or paid if the liability were to be transferred in an orderly market transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. When determining fair value, the Company considers pricing information and other inputs that are current as of the measurement date. In periods of market dislocation, the observability of prices and other inputs may be reduced for certain instruments, or not available at all. The unavailability or reduced availability of pricing or other input information could cause an instrument to be reclassified from one level to another.\\nThe Fair Value Measurements and Disclosures Topic of the FASB ASC defines fair value and establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to\\n35\\nunobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy under the Fair Value Measurements and Disclosures Topic of the FASB ASC are described below:\\nLevel 1 – Inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.\\nLevel 2 – Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly.\\nLevel 3 – Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable.\\nTo the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Accordingly, the degree of judgment exercised by the Company in determining fair value is greatest for instruments categorized in Level 3. A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement.\\nValuation Techniques\\nThere have been no changes in the valuation techniques used during the nine months ended September 30, 2022.\\nSecurities\\nTrading and Equity Securities\\nThese equity securities are valued based on market quoted prices. These securities are categorized in Level 1 as they are actively traded and no valuation adjustments have been applied.\\nU.S. Government Agency and U.S. Treasury Securities\\nFair value is estimated using either multi-dimensional spread tables or benchmarks. The inputs used include benchmark yields, reported trades, and broker/dealer quotes. These securities are classified as Level 2.\\nAgency Mortgage-Backed Securities\\nFair value is estimated using either a matrix or benchmarks. The inputs used include benchmark yields, reported trades, broker/dealer quotes, and issuer spreads. These securities are categorized as Level 2.\\nAgency Collateralized Mortgage Obligations and Small Business Administration Pooled Securities\\nThe valuation model for these securities is volatility-driven and ratings based, and uses multi-dimensional spread tables. The inputs used include benchmark yields, reported trades, new issue data, broker dealer quotes, and collateral performance. If there is at least one significant model assumption or input that is not observable, these securities are categorized as Level 3 within the fair value hierarchy; otherwise, they are classified as Level 2.\\nState, County, and Municipal Securities\\nThe fair value is estimated using a valuation matrix with inputs including bond interest rate tables, recent transactions, and yield relationships. These securities are categorized as Level 2.\\nSingle and Pooled Issuer Trust Preferred Securities\\nThe fair value of trust preferred securities, including pooled and single issuer preferred securities, is estimated using external pricing models, discounted cash flow methodologies or similar techniques. The inputs used in these valuations include benchmark yields, reported trades, new issue data, broker dealer quotes, and collateral performance. If there is at least one significant model assumption or input that is not observable, these securities are classified as Level 3 within the fair value hierarchy; otherwise, they are classified as Level 2.\\nLoans Held for Sale\\nThe Company has elected the fair value option to account for originated closed loans intended for sale. The fair value is measured on an individual loan basis using quoted market prices and when not available, comparable market value or discounted cash flow analysis may be utilized. These assets are typically classified as Level 2.\\n36\\nDerivative Instruments\\nDerivatives\\nThe valuation of these instruments is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilizes. The Company incorporates credit valuation adjustments to appropriately reflect nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral postings. Additionally, in conjunction with fair value measurement guidance, the Company has made an accounting policy election to measure the credit risk of its derivative financial instruments that are subject to master netting agreements on a net basis by counterparty portfolio. Although the Company has determined that the majority of the inputs used to value its interest rate derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its interest rate derivatives and risk participation agreements may also utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by the Company and its counterparties. However, as of September 30, 2022 and December 31, 2021, the Company has assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and has determined that the credit valuation adjustments are not significant to the overall valuation of its derivatives. As a result, the Company has determined that its derivative valuations in their entirety are properly classified as Level 2.\\nMortgage Derivatives\\nThe fair value of mortgage derivatives is determined based on current market prices for similar assets in the secondary market and, therefore, classified as Level 2 within the fair value hierarchy.\\nIndividually Assessed Collateral Dependent Loans\\nIn accordance with the CECL standard, expected credit losses on individually assessed loans deemed to be collateral dependent are valued based upon the lower of amortized cost or fair value of the underlying collateral less costs to sell. The inputs used in the appraisals of the collateral are not always observable, and in such cases the loans may be classified as Level 3 within the fair value hierarchy; otherwise, they are classified as Level 2.\\nOther Real Estate Owned and Other Foreclosed Assets\\nOther Real Estate Owned (\\\"OREO\\\") and Other Foreclosed Assets are valued at the lower of cost or fair value of the property, less estimated costs to sell. The fair values are generally estimated based upon recent appraisal values of the property less costs to sell the property. Certain inputs used in appraisals are not always observable, and therefore OREO and Other Foreclosed Assets may be classified as Level 3 within the fair value hierarchy.\\nGoodwill and Other Intangible Assets\\nGoodwill and other intangible assets are subject to impairment testing. The Company conducts an annual impairment test of goodwill in the third quarter of each year, or more frequently if necessary. Other intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. To estimate the fair value of goodwill and, if necessary, other intangible assets, the Company utilizes both a comparable analysis of relevant price multiples in recent market transactions and a discounted cash flow analysis. Both valuation models require a significant degree of management judgment. In the event the fair value as determined by the valuation model is less than the carrying value, the intangibles may be impaired. If the impairment testing resulted in impairment, the Company would classify the impaired goodwill and other intangible assets subjected to nonrecurring fair value adjustments as Level 3.\\n37\\nAssets and liabilities measured at fair value on a recurring and nonrecurring basis were as follows at the dates indicated:\\n| Fair Value Measurements at Reporting Date Using |\\n| Balance | Quoted Pricesin ActiveMarkets forIdenticalAssets(Level 1) | SignificantOtherObservableInputs(Level 2) | SignificantUnobservableInputs(Level 3) |\\n| September 30, 2022 |\\n| (Dollars in thousands) |\\n| Recurring fair value measurements |\\n| Assets |\\n| Trading securities | $ | 3,538 | $ | 3,538 | $ | — | $ | — |\\n| Equity securities | 20,439 | 20,439 | — | — |\\n| Securities available for sale |\\n| U.S. government agency securities | 199,942 | — | 199,942 | — |\\n| U.S. treasury securities | 784,458 | — | 784,458 | — |\\n| Agency mortgage-backed securities | 344,153 | — | 344,153 | — |\\n| Agency collateralized mortgage obligations | 40,787 | — | 40,787 | — |\\n| State, county, and municipal securities | 187 | — | 187 | — |\\n| Single issuer trust preferred securities issued by banks and insurers | 489 | — | 489 | — |\\n| Pooled trust preferred securities issued by banks and insurers | 999 | — | 999 | — |\\n| Small business administration pooled securities | 54,496 | — | 54,496 | — |\\n| Loans held for sale | 5,100 | — | 5,100 | — |\\n| Derivative instruments | 144,374 | — | 144,374 | — |\\n| Liabilities |\\n| Derivative instruments | 197,831 | — | 197,831 | — |\\n| Total recurring fair value measurements | $ | 1,401,131 | $ | 23,977 | $ | 1,377,154 | $ | — |\\n| Nonrecurring fair value measurements |\\n| Assets |\\n| Individually assessed collateral dependent loans (1) | $ | 13,020 | $ | — | $ | — | $ | 13,020 |\\n| Total nonrecurring fair value measurements | $ | 13,020 | $ | — | $ | — | $ | 13,020 |\\n\\n38\\n| Fair Value Measurements at Reporting Date Using |\\n| Balance | Quoted Pricesin ActiveMarkets forIdenticalAssets(Level 1) | SignificantOtherObservableInputs(Level 2) | SignificantUnobservableInputs(Level 3) |\\n| December 31, 2021 |\\n| (Dollars in thousands) |\\n| Recurring fair value measurements |\\n| Assets |\\n| Trading securities | $ | 3,720 | $ | 3,720 | $ | — | $ | — |\\n| Equity securities | 23,173 | 23,173 | — | — |\\n| Securities available for sale |\\n| U.S. government agency securities | 215,482 | — | 215,482 | — |\\n| U.S. treasury securities | 861,448 | — | 861,448 | — |\\n| Agency mortgage-backed securities | 363,933 | — | 363,933 | — |\\n| Agency collateralized mortgage obligations | 79,677 | — | 79,677 | — |\\n| State, county, and municipal securities | 203 | — | 203 | — |\\n| Single issuer trust preferred securities issued by banks and insurers | 491 | — | 491 | — |\\n| Pooled trust preferred securities issued by banks and insurers | 1,000 | — | 1,000 | — |\\n| Small business administration pooled securities | 48,914 | — | 48,914 | — |\\n| Loans held for sale | 24,679 | — | 24,679 | — |\\n| Derivative instruments | 97,912 | — | 97,912 | — |\\n| Liabilities |\\n| Derivative instruments | 76,015 | — | 76,015 | — |\\n| Total recurring fair value measurements | $ | 1,644,617 | $ | 26,893 | $ | 1,617,724 | $ | — |\\n| Nonrecurring fair value measurements |\\n| Assets |\\n| Individually assessed collateral dependent loans (1) | $ | 1,174 | $ | — | $ | — | $ | 1,174 |\\n| Total nonrecurring fair value measurements | $ | 1,174 | $ | — | $ | — | $ | 1,174 |\\n\\n(1) The carrying value of individually assessed collateral dependent loans is based on the lower of amortized cost or fair value of the underlying collateral less costs to sell. The fair value of the underlying collateral is generally determined through independent appraisals, which generally include various Level 3 inputs which are not identifiable. Appraisals may be adjusted by management for qualitative factors such as economic factors and estimated liquidation expenses. The range of these possible adjustments may vary.\\n39\\nThe estimated fair values and related carrying amounts for assets and liabilities for which fair value is only disclosed are shown below at the dates indicated:\\n| Fair Value Measurements at Reporting Date Using |\\n| CarryingValue | FairValue | Quoted Pricesin ActiveMarkets forIdenticalAssets(Level 1) | SignificantOtherObservableInputs(Level 2) | SignificantUnobservableInputs(Level 3) |\\n| September 30, 2022 |\\n| (Dollars in thousands) |\\n| Financial assets |\\n| Securities held to maturity (a) |\\n| U.S. government agency securities | $ | 31,696 | $ | 29,303 | $ | — | $ | 29,303 | $ | — |\\n| U.S. treasury securities | 100,615 | 87,992 | — | 87,992 | — |\\n| Agency mortgage-backed securities | 892,102 | 802,093 | — | 802,093 | — |\\n| Agency collateralized mortgage obligations | 553,995 | 476,970 | — | 476,970 | — |\\n| Single issuer trust preferred securities issued by banks | 1,500 | 1,508 | — | 1,508 | — |\\n| Small business administration pooled securities | 117,727 | 112,119 | — | 112,119 | — |\\n| Loans, net of allowance for credit losses (b) | 13,540,017 | 13,208,966 | — | — | 13,208,966 |\\n| Federal Home Loan Bank stock (c) | 5,218 | 5,218 | — | 5,218 | — |\\n| Cash surrender value of life insurance policies (d) | 293,126 | 293,126 | — | 293,126 | — |\\n| Financial liabilities |\\n| Deposit liabilities, other than time deposits (e) | $ | 15,160,375 | $ | 15,160,375 | $ | — | $ | 15,160,375 | $ | — |\\n| Time certificates of deposits (f) | 1,178,619 | 1,147,506 | — | 1,147,506 | — |\\n| Federal Home Loan Bank borrowings (f) | 643 | 571 | — | 571 | — |\\n| Junior subordinated debentures (g) | 62,855 | 59,770 | — | 59,770 | — |\\n| Subordinated debentures (f) | 49,862 | 44,066 | — | — | 44,066 |\\n\\n40\\n| Fair Value Measurements at Reporting Date Using |\\n| Carrying Value | FairValue | Quoted Pricesin ActiveMarkets forIdenticalAssets(Level 1) | SignificantOtherObservableInputs(Level 2) | SignificantUnobservableInputs(Level 3) |\\n| December 31, 2021 |\\n| (Dollars in thousands) |\\n| Financial assets |\\n| Securities held to maturity (a) |\\n| U.S. government agency securities | $ | 32,987 | $ | 32,546 | $ | — | $ | 32,546 | $ | — |\\n| U.S. treasury securities | 102,560 | 102,242 | — | 102,242 | — |\\n| Agency mortgage-backed securities | 493,012 | 497,236 | — | 497,236 | — |\\n| Agency collateralized mortgage obligations | 415,736 | 408,845 | — | 408,845 | — |\\n| Single issuer trust preferred securities issued by banks | 1,500 | 1,508 | — | 1,508 | — |\\n| Small business administration pooled securities | 21,023 | 21,756 | — | 21,756 | — |\\n| Loans, net of allowance for credit losses (b) | 13,439,190 | 13,389,515 | — | — | 13,389,515 |\\n| Federal Home Loan Bank stock (c) | 11,407 | 11,407 | — | 11,407 | — |\\n| Cash surrender value of life insurance policies (d) | 289,304 | 289,304 | — | 289,304 | — |\\n| Financial liabilities |\\n| Deposit liabilities, other than time deposits (e) | $ | 15,385,894 | $ | 15,385,894 | $ | — | $ | 15,385,894 | $ | — |\\n| Time certificates of deposits (f) | 1,531,150 | 1,529,857 | — | 1,529,857 | — |\\n| Federal Home Loan Bank borrowings (f) | 25,667 | 25,663 | — | 25,663 | — |\\n| Long-term borrowings (f) | 14,063 | 13,989 | — | 13,989 | — |\\n| Junior subordinated debentures (g) | 62,853 | 67,019 | — | 67,019 | — |\\n| Subordinated debentures (f) | 49,791 | 45,532 | — | — | 45,532 |\\n\\n(a) The fair values presented are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments and/or discounted cash flow analysis.\\n(b) Fair value of loans is measured using the exit price valuation method, determined primarily by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities or cash flows, while incorporating liquidity and credit assumptions. Additionally, this amount excludes individually assessed collateral dependent loans, which are deemed to be marked to fair value on a nonrecurring basis.\\n(c) Federal Home Loan Bank stock has no quoted market value and is carried at cost; therefore, the carrying amount approximates fair value.\\n(d) Cash surrender value of life insurance policies is recorded at its cash surrender value (or the amount that can be realized upon surrender of the policy), therefore, carrying amount approximates fair value.\\n(e) Fair value of demand deposits, savings and interest checking accounts and money market deposits is the amount payable on demand at the reporting date.\\n(f) Fair value was determined by discounting anticipated future cash payments using rates currently available for instruments with similar remaining maturities.\\n(g) Fair value was determined based upon market prices of securities with similar terms and maturities.\\nThis summary excludes certain financial assets and liabilities for which the carrying value approximates fair value. For financial assets, these may include cash and due from banks, federal funds sold and short-term investments. For financial liabilities, these may include federal funds purchased. These instruments would all be considered to be classified as Level 1 within the fair value hierarchy. Also excluded from the summary are financial instruments measured at fair value on a recurring and nonrecurring basis, as previously described.\\nThe Company considers its current use of financial instruments to be the highest and best use of the instruments.\\n41\\nNOTE 8 - REVENUE RECOGNITION\\nA portion of the Company's noninterest income is derived from contracts with customers, and as such, the revenue recognized depicts the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The Company considers the terms of the contract and all relevant facts and circumstances when applying this guidance. To ensure its alignment with this core principle, the Company measures revenue and the timing of recognition by applying the following five steps:\\n1.Identify the contract(s) with customers\\n2.Identify the performance obligations\\n3.Determine the transaction price\\n4.Allocate the transaction price to the performance obligations\\n5.Recognize revenue when (or as) the entity satisfies a performance obligation\\nThe Company has disaggregated its revenue from contracts with customers into categories that depict how the nature, amount, timing, and uncertainty of revenue and cash flows are affected by economic factors. The following table presents the revenue streams that the Company has disaggregated as of the periods indicated:\\n| Three Months Ended | Nine Months Ended |\\n| September 302022 | September 302021 | September 302022 | September 302021 |\\n| (Dollars in thousands) |\\n| Deposit account fees (inclusive of cash management fees) | $ | 6,261 | $ | 4,298 | $ | 17,582 | $ | 11,704 |\\n| Interchange fees | 2,833 | 2,223 | 8,043 | 6,267 |\\n| ATM fees | 1,066 | 817 | 2,900 | 2,177 |\\n| Investment management - wealth management and advisory services | 7,834 | 8,147 | 23,563 | 23,576 |\\n| Investment management - retail investments and insurance revenue | 602 | 1,027 | 2,875 | 2,774 |\\n| Merchant processing income | 412 | 365 | 1,140 | 1,024 |\\n| Credit card income | 495 | 334 | 1,341 | 883 |\\n| Other noninterest income | 1,782 | 1,362 | 4,650 | 3,732 |\\n| Total noninterest income in-scope of ASC 606 | 21,285 | 18,573 | 62,094 | 52,137 |\\n| Total noninterest income out-of-scope of ASC 606 | 6,910 | 7,884 | 20,271 | 24,533 |\\n| Total noninterest income | $ | 28,195 | $ | 26,457 | $ | 82,365 | $ | 76,670 |\\n\\nIn each of the revenue streams identified above, there were no significant judgments made in determining or allocating the transaction price, as the consideration and service requirements are generally explicitly identified in the associated contracts. Additional information related to each of the revenue streams is further noted below.\\nDeposit Account Fees\\nThe Company offers various deposit account products to its customers governed by specific deposit agreements applicable to either personal customers or business customers. These agreements identify the general conditions and obligations of both parties, and include standard information regarding deposit account related fees.\\nDeposit account services include providing access to deposit accounts as well as access to the various deposit transactional services of the Company. These transactional services are primarily those that are identified in the standard fee schedule, and include, but are not limited to, services such as overdraft protection, wire transfer, and check collection. Revenue is recognized in conjunction with the various services being provided. For example, the Company may assess monthly fixed service fees associated with the customer having access to a deposit account, which can vary depending on the account type and daily account balance. In addition, the Company may also assess separate fixed fees associated with and at the time specific transactions are entered into by the customer. As such, the Company considers its performance obligations to be met concurrently with providing the account access or completing the requested deposit transaction.\\n42\\nCash Management\\nCash management services are a subset of the deposit account fees revenue stream. These services primarily include ACH transaction processing, positive pay and remote deposit services. These services are also governed by separate agreements entered into with the customer. The fee arrangement for these services is structured to assess fees under one of two scenarios, either a per transaction fee arrangement or an earnings credit analysis arrangement. Under the per transaction fee arrangement, fixed fees are assessed concurrently with customers executing the transactions, and as such, the Company considers its performance obligations to be met concurrently with completing the requested transaction. Under the earnings credit analysis arrangement, the Company provides a monthly earnings credit to the customer that is negotiated and determined based on various factors. The credit is then available to absorb the per transaction fees that are assessed on the customer's deposit account activity for the month. Any amount of the transactional fees in excess of the earnings credit is recognized as revenue in that month.\\nInterchange Fees\\nThe Company earns interchange revenue from its issuance of credit and debit cards granted through its membership in various card payment networks. The Company provides credit cards and debit cards to its customers which are authorized and settled through these payment networks, and in exchange, the Company earns revenue as determined by each payment network's interchange program. The revenue is recognized concurrently with the settlement of card transactions within each network.\\nATM Fees\\nThe Company deploys automated teller machines (ATMs) as part of its overall branch network. Certain transactions performed at the ATMs require customers to acknowledge and pay a fee for the requested service. Certain ATM fees are disclosed in the deposit account agreement fee schedules, whereas those assessed to non-Rockland Trust deposit holders are solely determined during the transaction at the machine.\\nThe ATM fee is a fixed dollar per transaction amount, and as such, is recognized concurrently with the overall daily processing and settlement of the ATM activity.\\nInvestment Management - Wealth Management and Advisory Services\\nThe Company offers investment management and trust services to individuals, institutions, small businesses and charitable institutions. Each investment management product is governed by its own contract along with a separate identifiable fee schedule unique to that product. The Company also offers additional services, such as estate settlement, financial planning, tax services and other special services quoted at the client's request.\\nThe asset management and/or custody fees are based upon a percentage of the monthly valuation of the principal assets in the customer's account, whereas fees for additional or special services are fixed in nature and are charged as services are rendered. As the fees are dependent on assets under management, which are susceptible to market factors outside of the Company's control, this variable consideration is constrained and therefore no revenue is estimated at contract initiation. As such, all revenue is recognized in correlation to the monthly management fee determinations or as transactional services are provided. Due to the fact that payments are primarily made subsequent to the valuation period, the Company records a receivable for revenue earned but not received. The following table provides the amount of investment management revenue earned but not received as of the dates indicated:\\n| September 30, 2022 | December 31, 2021 |\\n| (Dollars in thousands) |\\n| Receivables, included in other assets | $ | 4,401 | $ | 5,385 |\\n\\nInvestment Management - Retail Investments and Insurance Revenue\\nThe Company offers the sale of mutual fund shares, unit investment trust shares, general securities, fixed and variable annuities and life insurance products through registered representatives who are both employed by the Company and licensed and contracted with various broker general agents to offer these products to the Company’s customer base. As such, the Company performs these services as an agent and earns a fixed commission on the sales of these products and services. To a lesser degree, production bonus commissions can also be earned based upon the Company meeting certain volume thresholds.\\n43\\nIn general, the Company recognizes commission revenue at the point of sale, and for certain insurance products, may also earn and recognize annual residual commissions commensurate with annual premiums being paid.\\nMerchant Processing Income\\nThe Company refers customers to third party merchant processing partners in exchange for commission and fee income. The income earned is comprised of multiple components, including a fixed referral fee per each referred customer, a rebate amount determined primarily as a percentage of net revenue earned by the third party from services provided to each referred customer, and overall production bonus commissions if certain new account production thresholds are met. Merchant processing income is recognized in conjunction with either completing the referral to earn the fixed fee amount or as the merchant activity is processed to derive the Company's rebate and/or production bonus amounts.\\nCredit Card Income\\nThe Company provides consumer and business credit card solutions to its customers by soliciting new accounts on behalf of a third party credit card provider in exchange for a fee. The income earned is comprised of new account incentive payments as well as a percentage of interchange income earned by the third party provider offering the consumer and business purpose revolving credit accounts. The credit card income is recognized in conjunction with the establishment of each new credit card member or as the interchange is earned by the third party in connection with net purchase transactions made by the credit card member.\\nOther Noninterest Income\\nThe Company earns various types of other noninterest income that fall within the scope of the new revenue recognition rules, and have been aggregated into one general revenue stream in the table noted above. This amount includes, but is not limited to, the following types of revenue with customers:\\nSafe Deposit Rent\\nThe Company rents out the use of safe deposit boxes to its customers, which can be accessed when the bank is open for business. The safe deposit box rental fee is paid upfront and is recognized as revenue ratably over the annual term of the contract.\\n1031 Exchange Fee Revenue\\nThe Company provides like-kind exchange services pursuant to Section 1031 of the Internal Revenue Code. Fee income is recognized in conjunction with completing the exchange transactions.\\nForeign Currency\\nThe Company earns fee income associated with various transactions related to foreign currency product offerings, including foreign currency bank notes and drafts and foreign currency wires. The majority of this income is derived from commissions earned related to customers executing the above mentioned foreign currency transactions through arrangements with third party correspondents.\\n44\\nNOTE 9 - OTHER COMPREHENSIVE INCOME (LOSS)\\nThe following tables present a reconciliation of the changes in the components of other comprehensive income (loss) for the periods indicated, including the amount of income tax (expense) benefit allocated to each component of other comprehensive income (loss):\\n| Three Months EndedSeptember 30, 2022 | Nine Months EndedSeptember 30, 2022 |\\n| Pre-TaxAmount | Tax (Expense)Benefit | After TaxAmount | Pre-TaxAmount | Tax (Expense)Benefit | After TaxAmount |\\n| (Dollars in thousands) |\\n| Change in fair value of securities available for sale | $ | ( 55,461 ) | $ | 12,879 | $ | ( 42,582 ) | $ | ( 167,814 ) | $ | 38,942 | $ | ( 128,872 ) |\\n| Less: net security losses reclassified into other noninterest expense | — | — | — | — | — | — |\\n| Net change in fair value of securities available for sale | ( 55,461 ) | 12,879 | ( 42,582 ) | ( 167,814 ) | 38,942 | ( 128,872 ) |\\n| Change in fair value of cash flow hedges | ( 37,357 ) | 10,505 | ( 26,852 ) | ( 64,963 ) | 18,277 | ( 46,686 ) |\\n| Less: net cash flow hedge gains reclassified into interest income or interest expense | 407 | ( 115 ) | 292 | 8,427 | ( 2,370 ) | 6,057 |\\n| Net change in fair value of cash flow hedges | ( 37,764 ) | 10,620 | ( 27,144 ) | ( 73,390 ) | 20,647 | ( 52,743 ) |\\n| Amortization of net actuarial losses | 159 | ( 45 ) | 114 | 476 | ( 134 ) | 342 |\\n| Amortization of net prior service costs | 10 | ( 3 ) | 7 | 29 | ( 8 ) | 21 |\\n| Net change in other comprehensive income for defined benefit postretirement plans (1) | 169 | ( 48 ) | 121 | 505 | ( 142 ) | 363 |\\n| Total other comprehensive loss | $ | ( 93,056 ) | $ | 23,451 | $ | ( 69,605 ) | $ | ( 240,699 ) | $ | 59,447 | $ | ( 181,252 ) |\\n\\n\\n| Three Months EndedSeptember 30, 2021 | Nine Months EndedSeptember 30, 2021 |\\n| Pre-TaxAmount | Tax (Expense)Benefit | After TaxAmount | Pre-TaxAmount | Tax (Expense)Benefit | After TaxAmount |\\n| (Dollars in thousands) |\\n| Change in fair value of securities available for sale | $ | ( 10,337 ) | $ | 2,440 | $ | ( 7,897 ) | $ | ( 15,589 ) | $ | 3,711 | $ | ( 11,878 ) |\\n| Less: net security losses reclassified into other noninterest expense | — | — | — | — | — | — |\\n| Net change in fair value of securities available for sale | ( 10,337 ) | 2,440 | ( 7,897 ) | ( 15,589 ) | 3,711 | ( 11,878 ) |\\n| Change in fair value of cash flow hedges | 84 | ( 23 ) | 61 | ( 2,214 ) | 624 | ( 1,590 ) |\\n| Less: net cash flow hedge gains reclassified into interest income or interest expense | 4,791 | ( 1,347 ) | 3,444 | 13,869 | ( 3,900 ) | 9,969 |\\n| Net change in fair value of cash flow hedges | ( 4,707 ) | 1,324 | ( 3,383 ) | ( 16,083 ) | 4,524 | ( 11,559 ) |\\n| Net unamortized gain related to defined benefit pension and other postretirement adjustments arising during the period | — | — | — | 653 | ( 184 ) | 469 |\\n| Amortization of net actuarial losses | 346 | ( 97 ) | 249 | 1,037 | ( 291 ) | 746 |\\n| Amortization of net prior service costs | 44 | ( 13 ) | 31 | 131 | ( 37 ) | 94 |\\n| Net change in other comprehensive income for defined benefit postretirement plans (1) | 390 | ( 110 ) | 280 | 1,821 | ( 512 ) | 1,309 |\\n| Total other comprehensive loss | $ | ( 14,654 ) | $ | 3,654 | $ | ( 11,000 ) | $ | ( 29,851 ) | $ | 7,723 | $ | ( 22,128 ) |\\n\\n(1) The amortization of prior service costs is included in the computation of net periodic pension cost as disclosed in Note 14 \\\"Employee Benefit Plans\\\" within the Notes to the Consolidated Financial Statements included in Item 8 of the Company's 2021 Form 10-K.\\n45\\nInformation on the Company’s accumulated other comprehensive income (loss), net of tax, is comprised of the following components as of the dates indicated:\\n| Unrealized Gain (Loss) on Securities | Unrealized Gain (Loss) on Cash Flow Hedge | Defined Benefit Postretirement Plans | Accumulated Other Comprehensive Income (Loss) |\\n| (Dollars in thousands) |\\n| 2022 |\\n| Beginning balance: January 1, 2022 | $ | ( 9,667 ) | $ | 14,137 | $ | ( 2,287 ) | $ | 2,183 |\\n| Net change in other comprehensive income (loss) | ( 128,872 ) | ( 52,743 ) | 363 | ( 181,252 ) |\\n| Ending balance: September 30, 2022 | $ | ( 138,539 ) | $ | ( 38,606 ) | $ | ( 1,924 ) | $ | ( 179,069 ) |\\n| 2021 |\\n| Beginning balance: January 1, 2021 | $ | 13,255 | $ | 33,276 | $ | ( 5,836 ) | $ | 40,695 |\\n| Net change in other comprehensive income (loss) | ( 11,878 ) | ( 11,559 ) | 1,309 | ( 22,128 ) |\\n| Ending balance: September 30, 2021 | $ | 1,377 | $ | 21,717 | $ | ( 4,527 ) | $ | 18,567 |\\n\\nNOTE 10 - COMMITMENTS AND CONTINGENCIES\\nFinancial Instruments with Off-Balance Sheet Risk\\nIn the normal course of business, the Company enters into various transactions to meet the financing needs of its customers, which, in accordance with GAAP, are not included in its consolidated balance sheets. These transactions include commitments to extend credit and standby letters of credit, and loan exposures with recourse, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. The Company minimizes its exposure to loss under these commitments by subjecting them to credit approval and monitoring procedures.\\nThe Company enters into contractual commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Substantially all of these commitments to extend credit are contingent upon customers maintaining specific credit standards at the time of loan funding.\\nThe Company has certain loan exposures for which there is recourse. These loan relationships could require the Company to repurchase or cover certain losses per agreements for certain loans that are either sold or referred to third parties.\\nStandby letters of credit are written conditional commitments issued to guarantee the performance of a customer to a third party. In the event the customer does not perform in accordance with the terms of the agreement with the third party, the Company would be required to fund the commitment. The maximum potential amount of future payments the Company could be required to make is represented by the contractual amount of the commitment. If the commitment were funded, the Company would be entitled to seek recovery from the customer. The Company’s policies generally require that standby letter of credit arrangements contain security and debt covenants similar to those contained in loan agreements.\\nThe fees collected in connection with the issuance of standby letters of credit are representative of the fair value of the Company's obligation undertaken in issuing the guarantee. In accordance with applicable accounting standards related to guarantees, fees collected in connection with the issuance of standby letters of credit are deferred. The fees are then recognized in income proportionately over the life of the standby letter of credit agreement. The deferred standby letter of credit fees represent the fair value of the Company's potential obligations under the standby letter of credit guarantees.\\nThe following table summarizes the above financial instruments at the dates indicated:\\n| September 30, 2022 | December 31, 2021 |\\n| (Dollars in thousands) |\\n| Commitments to extend credit | $ | 4,552,576 | $ | 4,535,895 |\\n| Standby letters of credit | 25,565 | 24,412 |\\n| Deferred standby letter of credit fees | 187 | 124 |\\n| Loan exposures sold with recourse | 171,437 | 202,717 |\\n\\n46\\nLease Commitments\\nThe Company leases office space, space for ATM locations, and certain branch locations under noncancellable operating leases. Several of these leases contain renewal options to extend lease terms for a period of 1 to 20 years. During the first quarter of 2022, the Company recognized approximately $ 4.4 million in costs associated with several terminated leased locations acquired from Meridian that were subsequently exited. These costs are reflected within merger and acquisition expense in the Consolidated Statement of Income.\\nThere has been no significant change in the future minimum lease payments payable by the Company since December 31, 2021. See the Company's 2021 Form 10-K for information regarding leases and other commitments.\\nOther Contingencies\\nAt September 30, 2022, the Bank was involved in pending lawsuits that arose in the ordinary course of business. Management has reviewed these pending lawsuits with legal counsel and has taken into consideration the view of counsel as to their outcome. In the opinion of management, the final disposition of pending lawsuits is not expected to have a material adverse effect on the Company’s financial position or results of operations.\\n47\\nNOTE 11 - LOW INCOME HOUSING PROJECT INVESTMENTS\\nThe Company has invested in low income housing projects that generate Low Income Housing Tax Credits which provide the Company with tax credits and operating loss tax benefits over a period of approximately 15 years. None of the original investment is expected to be repaid.\\nThe following table presents certain information related to the Company's investments in low income housing projects as of the dates indicated:\\n| September 302022 | December 312021 |\\n| (Dollars in thousands) |\\n| Original investment value | $ | 183,889 | $ | 179,481 |\\n| Current recorded investment | 129,875 | 135,497 |\\n| Unfunded liability obligation | 63,014 | 73,336 |\\n| Tax credits and benefits | 16,679 | (1) | 14,198 |\\n| Amortization of investments | 13,375 | (1) | 11,892 |\\n| Net income tax benefit | 3,304 | (1) | 2,306 |\\n\\n(1) Amounts shown represent the estimated full year impact for the year ended December 31 , 2022.\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\\nThe following discussion should be read in conjunction with the consolidated financial statements, notes and tables included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2021, filed with the Securities and Exchange Commission (the \\\"2021 Form 10-K\\\").\\nCautionary Statement Regarding Forward-Looking Statements\\nThis Quarterly Report on Form 10-Q (this \\\"Report\\\"), in Management's Discussion and Analysis of Financial Condition and Results of Operations and elsewhere, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are not historical facts and include expressions about management’s confidence and strategies and management’s expectations about new and existing programs and products, acquisitions, relationships, opportunities, taxation, technology, market conditions and economic expectations. These statements may be identified by forward-looking terminology such as “should,” “could,” “will,” “may,” “expect,” “believe,” “forecast,” “view,” “opportunity,” “allow,” “continues,” “reflects,” “typically,” “usually,” “anticipate,” “estimate,” “intend,” or similar statements or variations of such terms. Such forward-looking statements involve certain risks and uncertainties and our actual results may differ materially from such forward-looking statements. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements, in addition to those risk factors listed under the “Risk Factors” section of the 2021 Form 10-K, include but are not limited to:\\n•further weakening in the United States economy in general and the regional and local economies within the New England region and the Company’s market area, including any future weakening caused by the COVID-19 pandemic and any uncertainty regarding the length and extent of economic contraction as a result of the pandemic;\\n•the potential effects of inflationary pressures, labor market shortages and supply chain issues;\\n•the instability or volatility in financial markets and unfavorable general economic or business conditions, globally, nationally or regionally, caused by geopolitical concerns, including as a result of the conflict between Russia and Ukraine;\\n•unanticipated loan delinquencies, loss of collateral, decreased service revenues, and other potential negative effects on our business caused by severe weather, pandemics or other external events;\\n•adverse changes or volatility in the local real estate market;\\n•adverse changes in asset quality and any unanticipated credit deterioration in our loan portfolio including those related to one or more large commercial relationships;\\n•acquisitions may not produce results at levels or within time frames originally anticipated and may result in unforeseen integration issues or impairment of goodwill and/or other intangibles;\\n•additional regulatory oversight and related compliance costs;\\n•changes in trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System;\\n48\\n•higher than expected tax expense, resulting from failure to comply with general tax laws and changes in tax laws;\\n•changes in market interest rates for interest earning assets and/or interest bearing liabilities and changes related to the phase-out of LIBOR;\\n•increased competition in the Company’s market areas;\\n•adverse weather, changes in climate, natural disasters, geopolitical concerns, including those arising from the conflict between Russia and Ukraine;\\n•the emergence of widespread health emergencies or pandemics, including the magnitude and duration of the COVID-19 pandemic, any further resurgences or variants of the COVID-19 virus, the efficacy and availability of vaccines, boosters or other treatments, actions taken by governmental authorities in response thereto, other public health crises or man-made events, and their impact on the Company's local economies or the Company's operations;\\n•a deterioration in the conditions of the securities markets;\\n•a deterioration of the credit rating for U.S. long-term sovereign debt;\\n•inability to adapt to changes in information technology, including changes to industry accepted delivery models driven by a migration to the internet as a means of service delivery;\\n•electronic fraudulent activity within the financial services industry, especially in the commercial banking sector;\\n•adverse changes in consumer spending and savings habits;\\n•the effect of laws and regulations regarding the financial services industry;\\n•changes in laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) generally applicable to the Company’s business;\\n•the Company's potential judgments, claims, damages, penalties, fines and reputational damage resulting from pending or future litigation and regulatory and government actions, including as a result of our participation in and execution of government programs related to the COVID-19 pandemic;\\n•changes in accounting policies, practices and standards, as may be adopted by the regulatory agencies as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board, and other accounting standard setters including, but not limited to, changes to how the Company accounts for credit losses;\\n•cyber security attacks or intrusions that could adversely impact our businesses; and\\n•other unexpected material adverse changes in our operations or earnings.\\nExcept as required by law, the Company disclaims any intent or obligation to update publicly any such forward-looking statements, whether in response to new information, future events or otherwise. Any public statements or disclosures by the Company following this Report which modify or impact any of the forward-looking statements contained in this Report will be deemed to modify or supersede such statements in this Report.\\n49\\nSelected Quarterly Financial Data\\nThe selected consolidated financial and other data of the Company set forth below does not purport to be complete and should be read in conjunction with, and is qualified in its entirety by, the more detailed information, including the Consolidated Financial Statements and related notes, appearing elsewhere in this Report.\\n| Three Months Ended |\\n| September 302022 | June 302022 | March 312022 | December 312021 | September 302021 |\\n| (Dollars in thousands, except per share data) |\\n| Financial condition data |\\n| Securities | $ | 3,147,123 | $ | 2,934,956 | $ | 2,861,739 | $ | 2,664,859 | $ | 2,318,757 |\\n| Loans | 13,700,350 | 13,675,764 | 13,580,027 | 13,587,286 | 8,808,013 |\\n| Allowance for credit losses | (147,313) | (144,319) | (144,518) | (146,922) | (92,246) |\\n| Goodwill and other intangible assets | 1,012,006 | 1,013,917 | 1,015,831 | 1,017,844 | 525,261 |\\n| Total assets | 19,703,269 | 19,982,450 | 20,159,178 | 20,423,405 | 14,533,311 |\\n| Total deposits | 16,338,994 | 16,639,548 | 16,763,392 | 16,917,044 | 12,260,140 |\\n| Total borrowings | 113,360 | 138,344 | 138,328 | 152,374 | 157,045 |\\n| Stockholders’ equity | 2,817,201 | 2,871,185 | 2,965,439 | 3,018,449 | 1,755,954 |\\n| Nonperforming loans | 56,017 | 55,915 | 56,618 | 27,820 | 45,810 |\\n| Nonperforming assets | 56,017 | 55,915 | 56,618 | 27,820 | 45,810 |\\n| Income statement |\\n| Interest income | $ | 169,971 | $ | 148,123 | $ | 140,619 | $ | 125,921 | $ | 93,016 |\\n| Interest expense | 7,370 | 3,262 | 3,187 | 3,391 | 2,925 |\\n| Net interest income | 162,601 | 144,861 | 137,432 | 122,530 | 90,091 |\\n| Provision for (release of) credit losses | 3,000 | — | (2,000) | 35,705 | (10,000) |\\n| Noninterest income | 28,195 | 27,898 | 26,272 | 29,180 | 26,457 |\\n| Noninterest expenses | 92,728 | 90,562 | 95,500 | 117,126 | 72,419 |\\n| Net income | 71,897 | 61,776 | 53,097 | 1,702 | 40,007 |\\n| Per share data |\\n| Net income—basic | $ | 1.57 | $ | 1.32 | $ | 1.12 | $ | 0.04 | $ | 1.21 |\\n| Net income—diluted | 1.57 | 1.32 | 1.12 | 0.04 | 1.21 |\\n| Cash dividends declared | 0.51 | 0.51 | 0.51 | 0.48 | 0.48 |\\n| Book value per share | 61.73 | 62.32 | 62.59 | 63.75 | 53.14 |\\n| Tangible book value per share (1) | 39.56 | 40.31 | 41.15 | 42.25 | 37.24 |\\n| Performance ratios |\\n| Return on average assets | 1.43 | % | 1.24 | % | 1.06 | % | 0.04 | % | 1.11 | % |\\n| Return on average common equity | 9.90 | % | 8.49 | % | 7.16 | % | 0.28 | % | 9.04 | % |\\n| Net interest margin (on a fully tax equivalent basis) | 3.64 | % | 3.27 | % | 3.09 | % | 3.05 | % | 2.78 | % |\\n| Dividend payout ratio | 32.78 | % | 39.11 | % | 42.80 | % | 931.90 | % | 39.64 | % |\\n| Asset Quality Ratios |\\n| Nonperforming loans as a percent of gross loans | 0.41 | % | 0.41 | % | 0.42 | % | 0.20 | % | 0.52 | % |\\n| Nonperforming assets as a percent of total assets | 0.28 | % | 0.28 | % | 0.28 | % | 0.14 | % | 0.32 | % |\\n| Allowance for credit losses as a percent of total loans | 1.08 | % | 1.06 | % | 1.06 | % | 1.08 | % | 1.05 | % |\\n| Allowance for credit losses as a percent of nonperforming loans | 262.98 | % | 258.10 | % | 255.25 | % | 528.12 | % | 201.37 | % |\\n| Capital ratios |\\n\\n50\\n| Equity to assets | 14.30 | % | 14.37 | % | 14.71 | % | 14.78 | % | 12.08 | % |\\n| Tangible equity to tangible assets (1) | 9.66 | % | 9.79 | % | 10.18 | % | 10.31 | % | 8.79 | % |\\n| Tier 1 leverage capital ratio | 10.51 | % | 10.42 | % | 10.62 | % | 12.03 | % | 9.36 | % |\\n| Common equity tier 1 capital ratio | 13.98 | % | 13.90 | % | 14.45 | % | 14.30 | % | 13.53 | % |\\n| Tier 1 risk-based capital ratio | 13.98 | % | 13.90 | % | 14.45 | % | 14.30 | % | 14.21 | % |\\n| Total risk-based capital ratio | 15.71 | % | 15.62 | % | 16.18 | % | 16.04 | % | 15.78 | % |\\n\\n(1) Represents a non-GAAP measure. For reconciliation to GAAP book value per share, see Item 2 \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations - Executive Level Overview - Non-GAAP Measures\\\" below.\\n51\\nExecutive Level Overview\\nManagement evaluates the Company's operating results and financial condition using measures that include net income, earnings per share, return on assets and equity, return on tangible common equity, net interest margin, tangible book value per share, asset quality indicators, and many others. These metrics are used by management to make key decisions regarding the Company's balance sheet, liquidity, interest rate sensitivity, and capital resources and assist with identifying opportunities for improving the Company's financial position or operating results. The Company maintains an asset-sensitive profile and, accordingly, has benefited from recent interest rate increases. While asset quality remains very strong, management is closely monitoring the economic environment, including elevated inflationary pressures, supply chain issues, and labor shortages being experienced in the current operating environment across various industries. The Company focuses on organic growth, but will also consider growth through acquisition. Any potential acquisition opportunities are evaluated for the potential to provide a satisfactory financial return as well as other criteria (ease of integration, synergies, geographical location). Recent acquisitions include Meridian Bancorp, Inc. (\\\"Meridian\\\") and its subsidiary, East Boston Savings Bank (\\\"EBSB\\\"), which closed in the fourth quarter of 2021.\\nThird Quarter 2022 Results\\nNet income for the three months ended September 30, 2022 was $71.9 million, or $1.57 on a diluted earnings per share basis, as compared to $40.0 million, or $1.21 on a diluted earnings per share basis, for the three months ended September 30, 2021, or an increase of 79.7% and 29.8%, respectively. Net income for the nine months ended September 30, 2022 was $186.8 million, or $4.00 on a diluted earnings per share basis, as compared to $119.3 million, or $3.61 on a diluted earnings per share basis, for the nine months ended September 30, 2021, or an increase of 56.6% and 10.8%, respectively. The nine months ended September 30, 2022 results reflect merger and acquisition-related costs of $7.1 million, pre-tax, associated with the Meridian acquisition, as compared to $3.7 million of merger-related costs during the same prior year period. Excluding these merger and acquisition costs, operating net income was $191.9 million, or $4.11 on a diluted per share basis, for the nine months ended September 30, 2022, as compared to $121.9 million, or $3.69 on a diluted per share basis for the nine months ended September 30, 2021. See \\\"Non-GAAP Measures\\\" below for a reconciliation of non-GAAP measures.\\nThird quarter 2022 results reflected the following key drivers:\\n•Improved net interest margin for the quarter;\\n•1.3% annualized net loan growth, excluding Paycheck Protection Program (\\\"PPP\\\") runoff;\\n•Continued modest cash deployment into the securities portfolio;\\n•Strong core deposit account openings and low cost of deposits;\\n•Modest provision for credit loss; nonperforming assets remained flat;\\n•Strong fee income;\\n•49% efficiency ratio for the quarter;\\n•443,000 shares repurchased, completing the Company's share repurchase program announced in January 2022.\\n52\\nInterest-Earning Assets\\nThe results depicted in the following table reflect the trend of the Company's interest-earning assets over the past five quarters, inclusive of the Company's acquisition of Meridian during the fourth quarter of 2021. Changes over the five quarter period reflect measured deployment of excess cash balances into the securities portfolio, combined with a longer term overall strategy that typically emphasizes loan growth commensurate with overall economic growth. The following table summarizes the Company's interest-earning assets as of the periods indicated:\\nManagement strives to be disciplined about loan pricing and considers interest rate sensitivity when generating loan assets. In addition, management takes a disciplined approach to credit underwriting, seeking to avoid undue credit risk and credit losses.\\n53\\nFunding and Net Interest Margin\\nThe Company's overall sources of funding reflect strong business and retail deposit growth with a management strategy of relying upon core deposit growth to fund loans. The following chart shows sources of funding and percentage of core deposits to total deposits for the trailing five quarters:\\nThe following table shows the net interest margin and cost of deposits trends for the trailing five quarters:\\n54\\nNoninterest Income\\nNoninterest income is primarily comprised of deposit account fees, interchange and ATM fees, investment management fees and mortgage banking income. The following chart shows trends in the components of noninterest income over the past five quarters:\\nExpense Control\\nManagement seeks to take a balanced approach to noninterest expense control by monitoring ongoing operating expenses while making needed capital expenditures and prudently investing in growth initiatives. The Company’s primary expenses arise from Rockland Trust’s employee salaries and benefits, as well as expenses associated with buildings and equipment.\\nThe following chart depicts the Company's efficiency ratio on a GAAP basis (calculated by dividing noninterest expense by the sum of noninterest income and net interest income), as well as the Company's efficiency ratio on a non-GAAP operating basis, if applicable (calculated by dividing noninterest expense, excluding certain noncore items, by the sum of noninterest income, excluding certain noncore items, and net interest income), over the past five quarters:\\n55\\n*See \\\"Non-GAAP Measures\\\" below for a reconciliation to GAAP financial measures.\\nCapital\\nThe Company's approach with respect to revenue and expense is designed to promote long-term earnings growth, which in turn contributes to capital growth. Strong earnings retention has contributed to capital growth, both on an absolute level and per share basis, which has been offset in the last two quarters by share repurchases and other comprehensive losses. The following chart shows the Company's book value and tangible book value per share over the past five quarters:\\n*See \\\"Non-GAAP Measures\\\" below for a reconciliation to GAAP financial measures.\\nThe Company declared a quarterly cash dividend of $0.51 per share for each of the first three quarters of 2022, representing an increase of 6.3% from the 2021 quarterly dividend rate of $0.48 per share. During the third quarter of 2022, the Company repurchased approximately 443,000 shares of common stock under the Company's stock repurchase program announced in January 2022. In total, the Company repurchased 1.8 million shares of its common stock during the nine months ended September 30, 2022 at an average price of $78.32 under the January 2022 program which ended in the third quarter. In consideration of the Company's strong current capital position, on October 20, 2022 the Company announced a new stock repurchase plan, which authorizes repurchases by the Company of up to $120 million in common stock. The new plan will be in effect through October 19, 2023.\\n56\\nNon-GAAP Measures\\nWhen management assesses the Company’s financial performance for purposes of making day-to-day and strategic decisions, it does so based upon the performance of its core banking business, which is derived from the combination of net interest income and noninterest or fee income, reduced by operating expenses, the provision for credit losses, and the impact of income taxes and other noncore items. There are items that impact the Company's results that management believes are unrelated to its core banking business such as gains or losses on the sales of securities, merger and acquisition expenses, provision for credit losses on acquired portfolios, loss on extinguishment of debt, impairment, and other items, such as one-time adjustments as a result of changes in laws and regulations. Management excludes items management considers to be noncore when computing the Company’s non-GAAP operating earnings and operating EPS, noninterest income on an operating basis and efficiency ratio on an operating basis. Management believes excluding these items facilitates greater visibility into the Company’s core banking business and underlying trends.\\nManagement also supplements its evaluation of financial performance with analysis of tangible book value per share (which is computed by dividing stockholders' equity less goodwill and identifiable intangible assets, which is referred to as tangible common equity, by common shares outstanding) and tangible common equity ratio (which is computed by dividing tangible common equity by tangible assets), both of which are non-GAAP measures. The Company reports these ratios because management believes that investors may find it useful to have access to the same analytical tools used by management to assess performance and identify trends. The Company has recognized goodwill and other intangible assets in conjunction with merger and acquisition activities. Management believes providing information excluding the impact of goodwill and other intangibles facilitates comparison of the capital adequacy of the Company to other companies in the financial services industry.\\nThese non-GAAP measures should not be viewed as a substitute for financial results determined in accordance with GAAP. An item which management deems to be noncore and excludes when computing these non-GAAP measures can be of substantial importance to the Company’s results for any particular period. The Company’s non-GAAP performance measures are not necessarily comparable to similarly named non-GAAP performance measures which may be presented by other companies.\\nThe following tables summarize adjustments for noncore items for the periods indicated below and shows the reconciliation of non-GAAP measures:\\n57\\n| Three Months Ended September 30 |\\n| Net Income | DilutedEarnings Per Share |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (Dollars in thousands, except per share data) |\\n| Net income available to common shareholders (GAAP) | $ | 71,897 | $ | 40,007 | $ | 1.57 | $ | 1.21 |\\n| Non-GAAP adjustments |\\n| Noninterest expense components |\\n| Add: merger and acquisition expenses | — | 1,943 | — | 0.06 |\\n| Noncore increases to income before taxes | — | 1,943 | — | 0.06 |\\n| Net tax benefit associated with noncore items (1) | — | (546) | — | (0.02) |\\n| Noncore increases to net income | — | 1,397 | — | 0.04 |\\n| Operating net income (Non-GAAP) | $ | 71,897 | $ | 41,404 | $ | 1.57 | $ | 1.25 |\\n| Nine Months Ended September 30 |\\n| Net Income | DilutedEarnings Per Share |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (Dollars in thousands, except per share data) |\\n| Net income available to common shareholders (GAAP) | $ | 186,770 | $ | 119,290 | $ | 4.00 | $ | 3.61 |\\n| Non-GAAP adjustments |\\n| Noninterest expense components |\\n| Add: merger and acquisition expenses | 7,100 | 3,674 | 0.15 | 0.11 |\\n| Noncore increases to income before taxes | 7,100 | 3,674 | 0.15 | 0.11 |\\n| Net tax benefit associated with noncore items (1) | (1,995) | (1,033) | (0.04) | (0.03) |\\n| Noncore increases to net income | 5,105 | 2,641 | 0.11 | 0.08 |\\n| Operating net income (Non-GAAP) | $ | 191,875 | $ | 121,931 | $ | 4.11 | $ | 3.69 |\\n\\n(1)The net tax benefit associated with noncore items is determined by assessing whether each noncore item is included or excluded from net taxable income and applying the Company's combined marginal tax rate to only those items included in net taxable income.\\n58\\n\\n| Three Months Ended |\\n| September 302022 | June 302022 | March 312022 | December 312021 | September 302021 |\\n| (Dollars in thousands) |\\n| Net interest income (GAAP) | $ | 162,601 | $ | 144,861 | $ | 137,432 | $ | 122,530 | $ | 90,091 | (a) |\\n| Noninterest income (GAAP) | $ | 28,195 | $ | 27,898 | $ | 26,272 | $ | 29,180 | $ | 26,457 | (b) |\\n| Noninterest expense (GAAP) | $ | 92,728 | $ | 90,562 | $ | 95,500 | $ | 117,126 | $ | 72,419 | (c) |\\n| Less: |\\n| Merger and acquisition expense | — | — | 7,100 | 37,166 | 1,943 |\\n| Noninterest expense on an operating basis (Non-GAAP) | $ | 92,728 | $ | 90,562 | $ | 88,400 | $ | 79,960 | $ | 70,476 | (d) |\\n| Total revenue (GAAP) | $ | 190,796 | $ | 172,759 | $ | 163,704 | $ | 151,710 | $ | 116,548 | (a+b) |\\n| Ratios |\\n| Noninterest income as a % of revenue (GAAP based) | 14.78 | % | 16.15 | % | 16.05 | % | 19.23 | % | 22.70 | % | (b/(a+b)) |\\n| Efficiency ratio (GAAP based) | 48.60 | % | 52.42 | % | 58.34 | % | 77.20 | % | 62.14 | % | (c/(a+b)) |\\n| Efficiency ratio on an operating basis (Non-GAAP) | 48.60 | % | 52.42 | % | 54.00 | % | 52.71 | % | 60.47 | % | (d/(a+b)) |\\n\\n59\\nThe following table summarizes the calculation of tangible common equity to tangible assets ratio and tangible book value per share and shows the reconciliation of non-GAAP measures:\\n| September 302022 | June 302022 | March 312022 | December 312021 | September 302021 |\\n| (Dollars in thousands, except per share data) |\\n| Tangible common equity |\\n| Stockholders' equity (GAAP) | $ | 2,817,201 | $ | 2,871,185 | $ | 2,965,439 | $ | 3,018,449 | $ | 1,755,954 | (a) |\\n| Less: Goodwill and other intangibles | 1,012,006 | 1,013,917 | 1,015,831 | 1,017,844 | 525,261 |\\n| Tangible common equity (Non-GAAP) | 1,805,195 | 1,857,268 | 1,949,608 | 2,000,605 | 1,230,693 | (b) |\\n| Tangible assets |\\n| Assets (GAAP) | 19,703,269 | 19,982,450 | 20,159,178 | 20,423,405 | 14,533,311 | (c) |\\n| Less: Goodwill and other intangibles | 1,012,006 | 1,013,917 | 1,015,831 | 1,017,844 | 525,261 |\\n| Tangible assets (Non-GAAP) | $ | 18,691,263 | $ | 18,968,533 | $ | 19,143,347 | $ | 19,405,561 | $ | 14,008,050 | (d) |\\n| Common shares | 45,634,626 | 46,069,761 | 47,377,125 | 47,349,778 | 33,043,812 | (e) |\\n| Common equity to assets ratio (GAAP) | 14.30 | % | 14.37 | % | 14.71 | % | 14.78 | % | 12.08 | % | (a/c) |\\n| Tangible common equity to tangible assets ratio (Non-GAAP) | 9.66 | % | 9.79 | % | 10.18 | % | 10.31 | % | 8.79 | % | (b/d) |\\n| Book value per share (GAAP) | $ | 61.73 | $ | 62.32 | $ | 62.59 | $ | 63.75 | $ | 53.14 | (a/e) |\\n| Tangible book value per share (Non-GAAP) | $ | 39.56 | $ | 40.31 | $ | 41.15 | $ | 42.25 | $ | 37.24 | (b/e) |\\n\\nCritical Accounting Policies\\nCritical accounting policies are those that are reflective of significant management judgments and uncertainties, and could potentially result in materially different results under different assumptions and conditions. The Company believes that the most critical accounting policies are those that are both most important to the portrayal of the Company’s financial condition and results and require management's most difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain.\\nThere have been no material changes in critical accounting policies during the first nine months of 2022. Refer to \\\"Critical Accounting Policies and Estimates\\\" in Item 7. \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations\\\" in the Company's 2021 Form 10-K for a complete listing of critical accounting policies.\\nFINANCIAL POSITION\\nSecurities Portfolio The Company’s securities portfolio consists of trading securities, equity securities, securities available for sale, and securities which management intends to hold until maturity. Securities increased by $482.3 million, or 18.1%, at September 30, 2022 as compared to December 31, 2021, primarily reflecting $887.3 million of purchases, partially offset by unrealized losses of $167.8 million related to the available for sale portfolio, as well as paydowns, calls, and maturities. The ratio of securities to total assets increased to 16.0% at September 30, 2022 compared to 13.0% at December 31, 2021, which reflects the ongoing strategy to deploy excess liquidity into increased investment security purchases. The Company estimates expected credit losses for its available for sale and held to maturity securities in accordance with the current expected credit loss (\\\"CECL\\\") methodology. Further details regarding the Company's measurement of expected credit losses on securities can be found in Note 3 “Securities” within the Notes to Consolidated Financial Statements included in Part I. Item 1 of this Report.\\n60\\nResidential Mortgage Loan Sales The Company’s primary loan sale activity arises from the sale of government sponsored enterprise eligible residential mortgage loans. The Company originates residential loans with the intention of either selling them in the secondary market or holding them in the Company's residential real estate portfolio. When a loan is sold, the Company enters into agreements that contain representations and warranties about the characteristics of the loans sold and their origination. The Company may be required to either repurchase mortgage loans or to indemnify the purchaser from losses if representations and warranties are found to be not accurate in all material respects. The Company incurred no material losses related to residential mortgage repurchases during the three and nine months ended September 30, 2022 and 2021, respectively.\\nThe following table shows the total residential real estate loans closed and the breakdown of amounts held in portfolio or sold (or held for sale) in the secondary market during the periods indicated:\\nTable 1 - Closed Residential Real Estate Loans\\n| Three Months Ended September 30 | Nine Months Ended September 30 |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (Dollars in thousands) |\\n| Held in portfolio | $ | 165,065 | $ | 65,832 | $ | 571,115 | $ | 279,176 |\\n| Sold or held for sale in the secondary market | 21,325 | 183,794 | 77,309 | 611,795 |\\n| Total closed loans | $ | 186,390 | $ | 249,626 | $ | 648,424 | $ | 890,971 |\\n\\nThe Company experienced a lower volume of residential real estate loans sales for the three and nine months ended September 30, 2022 compared to the same prior year periods, driven primarily by reduced customer demand in the rising interest rate environment. In addition, the volume of closed residential real estate loans held in portfolio increased during the three and nine months ended September 30, 2022.\\nThe table below reflects additional information related to the loans sold during the periods indicated:\\nTable 2 - Residential Mortgage Loan Sales\\n| Three Months Ended September 30 | Nine Months Ended September 30 |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (Dollars in thousands) |\\n| Sold with servicing rights released | $ | 18,206 | $ | 171,256 | $ | 94,006 | $ | 618,171 |\\n| Sold with servicing rights retained (1) | 182 | 3,029 | 863 | 11,116 |\\n| Total loans sold | $ | 18,388 | $ | 174,285 | $ | 94,869 | $ | 629,287 |\\n\\n(1)All loans sold with servicing rights retained during the three and nine months ended September 30, 2022 and 2021, respectively, were sold without recourse.\\nWhen a loan is sold, the Company may decide to also sell the servicing of sold loans for a servicing release premium, simultaneously with the sale of the loan, or the Company may opt to sell the loan and retain the servicing. In the event of a sale with servicing rights retained, a mortgage servicing asset is established, which represents the then current estimated fair value based on market prices for comparable mortgage servicing contracts, when available, or alternatively is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses. Servicing rights are recorded in other assets in the Consolidated Balance Sheets, are amortized in proportion to and over the period of estimated net servicing income, and are assessed for impairment based on fair value at each reporting date. Impairment is determined by stratifying the rights based on predominant characteristics, such as interest rate, loan type and investor type. Impairment is recognized through a valuation allowance, to the extent that fair value is less than the capitalized amount. If the Company later determines that all or a portion of the impairment no longer exists, a reduction of the allowance may be recorded as an increase to income. The principal balance of loans serviced by the Bank on behalf of investors was $336.2 million, $382.6 million and $342.3 million at September 30, 2022, December 31, 2021, and September 30, 2021, respectively.\\n61\\nThe following table shows the adjusted cost of the servicing rights associated with these loans and the changes for the periods indicated:\\nTable 3 - Mortgage Servicing Asset\\n| Three Months Ended September 30 | Nine Months Ended September 30 |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (Dollars in thousands) |\\n| Balance at beginning of period | $ | 2,993 | $ | 2,295 | $ | 2,627 | $ | 2,365 |\\n| Additions | 2 | 30 | 8 | 95 |\\n| Amortization | (153) | (244) | (510) | (769) |\\n| Change in valuation allowance | 103 | 122 | 820 | 512 |\\n| Balance at end of period | $ | 2,945 | $ | 2,203 | $ | 2,945 | $ | 2,203 |\\n\\nSee Note 6, “Derivative and Hedging Activities” within the Notes to Consolidated Financial Statements included in Part I. Item 1 of this Report for more information on mortgage activity and mortgage related derivatives.\\nLoan Portfolio Total loans at September 30, 2022 increased by $113.1 million, or 0.8%, when compared to December 31, 2021. Excluding $205.1 million of net paydowns associated with PPP loans during the nine months ended September 30, 2022, the loan portfolio increased by $318.1 million, or 2.4% (3.2% on an annualized basis), compared to December 31, 2021. Organic loan growth was driven primarily by strong consumer loan activity, as the majority of residential real estate loan closings were retained on the balance sheet, while increased demand and line utilization fueled growth in home equity balances. Excluding the net reduction in PPP loans, the commercial portfolio decreased 0.82% at September 30, 2022 in comparison to December 31, 2021, primarily driven by continued elevated levels of attrition within the commercial real estate portfolio, which were partially offset by increased line utilization and higher closing volumes within the commercial and industrial category, which grew by $190.1 million, or 14.1% (18.9% on an annualized basis), as compared to December 31, 2021.\\n62\\nThe Company's commercial loan portfolio is comprised primarily of commercial and industrial loans as well as commercial real estate loans. Management considers the Company’s commercial and industrial portfolio to be well-diversified with loans to various types of industries. The following pie chart shows the diversification of the commercial and industrial portfolio as of September 30, 2022:\\n\\n| (Dollars in thousands) |\\n| Average loan size (excluding floor plan tranches) | $ | 388 |\\n| Largest individual commercial and industrial loan outstanding | $ | 37,650 |\\n| Commercial and industrial nonperforming loans/commercial and industrial loans | 1.77 | % |\\n\\nThe Company’s commercial real estate loan portfolio, inclusive of commercial construction, is the Company’s largest loan type concentration. The Company believes that this portfolio is also well-diversified with loans secured by a variety of property types, such as owner-occupied and nonowner-occupied commercial, retail, office, industrial, warehouse, and other special purpose properties, such as hotels, motels, nursing homes, restaurants, churches, recreational facilities, marinas, and golf courses. Commercial real estate also includes loans secured by certain residential-related property types, including multi-family apartment buildings, residential development tracts and condominiums. The following pie chart shows the diversification of the commercial real estate loan portfolio as of September 30, 2022:\\n63\\n| (Dollars in thousands) |\\n| Average loan size | $ | 1,573 |\\n| Largest individual commercial real estate mortgage outstanding | $ | 63,435 |\\n| Commercial real estate nonperforming loans/commercial real estate loans | 0.18 | % |\\n| Owner occupied commercial real estate loans/commercial real estate loans | 12.0 | % |\\n\\n64\\nThe Company's consumer portfolio primarily consists of both fixed-rate and adjustable-rate residential real estate loans as well as residential construction lending related to single-home residential development within the Company's market area. The Company also provides home equity loans and lines of credit that may be made as a fixed-rate term loan or under a variable rate revolving line of credit secured by a first or junior mortgage on the borrower's residence or second home. Additionally, the Company makes loans for a wide variety of other personal needs. Other consumer loans primarily consist of installment loans and overdraft protections. The residential real estate, home equity and other consumer portfolios totaled $3.1 billion at September 30, 2022, as noted below:\\n| (Dollars in thousands) |\\n| Average loan size | $ | 165 |\\n| Largest individual consumer loan outstanding | $ | 5,181 |\\n| Consumer nonperforming loans/consumer loans | 0.41 | % |\\n\\nAsset Quality The Company continually monitors the asset quality of the loan portfolio using all available information. Based on this assessment, loans demonstrating certain payment issues or other weaknesses may be categorized as delinquent, nonperforming and/or put on nonaccrual status. In the course of resolving such loans, the Company may choose to restructure the contractual terms of certain loans to match the borrower’s ability to repay the loan based on their current financial condition. If a restructured loan meets certain criteria, it may be categorized as a troubled debt restructuring (\\\"TDR\\\"). In addition, the Company has offered need-based payment relief options for commercial and small business loans, residential mortgages, and home equity loans and lines of credit in response to the COVID-19 pandemic. In accordance with the Coronavirus Aid, Relief and Economic Security Act (\\\"CARES Act\\\"), these modifications are not accounted for as TDRs or reflected as delinquent or non-accrual loans if the borrower was in compliance with the loan terms as of December 31, 2019.\\nDelinquency The Company’s philosophy toward managing its loan portfolios is predicated upon careful monitoring, which stresses early detection and response to delinquent and default situations. The Company seeks to make arrangements to resolve any delinquent or default situation over the shortest possible time frame. Generally, the Company requires that a delinquency notice be mailed to a borrower upon expiration of a grace period (typically no longer than 15 days beyond the due date). Reminder notices may be sent and telephone calls may be made prior to the expiration of the grace period. If the delinquent status is not resolved within a reasonable time frame following the mailing of a delinquency notice, the Bank’s personnel charged with managing its loan portfolios contacts the borrower to ascertain the reasons for delinquency and the prospects for payment. Any subsequent actions taken to resolve the delinquency will depend upon the nature of the loan and\\n65\\nthe length of time that the loan has been delinquent. The borrower’s needs are considered as much as reasonably possible without jeopardizing the Bank’s position. A late charge is usually assessed on loans upon expiration of the grace period.\\nNonaccrual Loans As a general rule, loans 90 days or more past due with respect to principal or interest are classified as nonaccrual loans. However, certain loans that are 90 days or more past due may be kept on an accruing status if the loans are well secured and in the process of collection. Income accruals are suspended on all nonaccrual loans and all previously accrued and uncollected interest is reversed against current income. A loan remains on nonaccrual status until it becomes current with respect to principal and interest (and in certain instances remains current for up to six months), the loan is liquidated, or when the loan is determined to be uncollectible and is charged-off against the allowance for credit losses.\\nTroubled Debt Restructurings In the course of resolving problem loans, the Company may choose to restructure the contractual terms of certain loans. The Company attempts to work out an alternative payment schedule with the borrower in order to avoid or cure a default. Loans that are modified are reviewed by the Company to identify if a TDR has occurred, which is when, for economic or legal reasons related to a borrower’s financial difficulties, the Bank grants a concession to the borrower that it would not otherwise consider. Terms may be modified to fit the ability of the borrower to repay in line with its current financial status and the restructuring of the loan may include adjustments to interest rates, extensions of maturity, consumer loans where the borrower's obligations have been effectively discharged through Chapter 7 Bankruptcy and the borrower has not reaffirmed the debt to the Bank, and other actions intended to minimize economic loss and avoid foreclosure or repossession of collateral. If such efforts by the Bank do not result in satisfactory performance, the loan is referred to legal counsel, at which time foreclosure proceedings are initiated. At any time prior to a sale of the property at foreclosure, the Bank may terminate foreclosure proceedings if the borrower is able to work out a satisfactory payment plan.\\nIt is the Company’s policy to have any restructured loans which are on nonaccrual status prior to being modified remain on nonaccrual status for six months, subsequent to being modified, before management considers their return to accrual status. If the restructured loan is on accrual status prior to being modified, it is reviewed to determine if the modified loan should remain on accrual status. Loans that are considered TDRs are classified as performing, unless they are on nonaccrual status or are delinquent for 90 days or more. Loans classified as TDRs remain classified as such for the life of the loan, except in limited circumstances, when it may be determined that the borrower is performing under modified terms and the restructuring agreement specified an interest rate greater than or equal to an acceptable market rate for a comparable new loan at the time of the restructuring.\\nPurchased Credit Deteriorated Loans Purchased Credit Deteriorated (\\\"PCD\\\") loans are acquired loans which have shown a more-than-insignificant deterioration in credit quality since origination. PCD loans are recorded at amortized cost with an allowance for credit losses recorded upon purchase.\\nNonperforming Assets Nonperforming assets are typically comprised of nonperforming loans and other real estate owned. Nonperforming loans consist of nonaccrual loans and loans that are 90 days or more past due but still accruing interest.\\nThe following table sets forth information regarding nonperforming assets held by the Company at the dates indicated:\\nTable 4 - Nonperforming Assets\\n| September 302022 | December 312021 | September 302021 |\\n| (Dollars in thousands) |\\n| Loans accounted for on a nonaccrual basis |\\n| Commercial and industrial | $ | 27,393 | $ | 3,439 | $ | 19,275 |\\n| Commercial real estate | 15,982 | 10,870 | 11,788 |\\n| Small business | 50 | 44 | 46 |\\n| Residential real estate | 8,891 | 9,182 | 10,872 |\\n| Home equity | 3,485 | 3,781 | 3,746 |\\n| Other consumer | 216 | 504 | 83 |\\n| Total nonperforming assets (1) | $ | 56,017 | $ | 27,820 | $ | 45,810 |\\n| Nonperforming loans as a percent of gross loans | 0.41 | % | 0.20 | % | 0.52 | % |\\n| Nonperforming assets as a percent of total assets | 0.28 | % | 0.14 | % | 0.32 | % |\\n\\n(1)Inclusive of TDRs on nonaccrual status of $1.5 million at September 30, 2022, $2.0 million at December 31, 2021, and $21.1 million at September 30, 2021.\\nThe following table summarizes the changes in nonperforming assets for the periods indicated:\\nTable 5 - Activity in Nonperforming Assets\\n| 2022 | 2021 |\\n| Three Months Ended | Nine Months Ended |\\n| September 302022 | September 302021 | September 302022 | September 302021 |\\n| (Dollars in thousands) |\\n| Nonperforming assets beginning balance | $ | 55,915 | $ | 47,818 | $ | 27,820 | $ | 66,861 |\\n| New to nonperforming | 30,650 | 4,613 | 67,226 | 9,205 |\\n| Loans charged-off | (741) | (332) | (1,992) | (4,499) |\\n| Loans paid-off | (29,450) | (3,488) | (33,174) | (17,877) |\\n| Loans restored to performing status | (366) | (2,813) | (3,806) | (8,143) |\\n| Other | 9 | 12 | (57) | 263 |\\n| Nonperforming assets ending balance | $ | 56,017 | $ | 45,810 | $ | 56,017 | $ | 45,810 |\\n\\n67\\nThe following table sets forth information regarding troubled debt restructured loans as of the dates indicated:\\nTable 6 - Troubled Debt Restructurings\\n| September 302022 | December 312021 | September 302021 |\\n| (Dollars in thousands) |\\n| Performing troubled debt restructurings | $ | 11,549 | $ | 14,635 | $ | 15,950 |\\n| Nonaccrual troubled debt restructurings | 1,538 | 1,993 | 21,104 |\\n| Total | $ | 13,087 | $ | 16,628 | $ | 37,054 |\\n| Performing troubled debt restructurings as a % of total loans | 0.09 | % | 0.11 | % | 0.18 | % |\\n| Nonaccrual troubled debt restructurings as a % of total loans | 0.01 | % | 0.01 | % | 0.24 | % |\\n| Total troubled debt restructurings as a % of total loans | 0.10 | % | 0.12 | % | 0.42 | % |\\n\\nThe following table summarizes changes in TDRs for the periods indicated:\\nTable 7 - Activity in Troubled Debt Restructurings\\n| Three Months Ended | Nine Months Ended |\\n| September 302022 | September 302021 | September 302022 | September 302021 |\\n| (Dollars in thousands) |\\n| TDRs beginning balance | $ | 13,411 | $ | 39,707 | $ | 16,628 | $ | 39,192 |\\n| New to TDR status | 62 | — | 62 | 3,918 |\\n| Paydowns | (386) | (2,637) | (3,603) | (6,040) |\\n| Charge-offs | — | (16) | — | (16) |\\n| TDRs ending balance | $ | 13,087 | $ | 37,054 | $ | 13,087 | $ | 37,054 |\\n\\nIncome accruals are suspended on all nonaccrual loans and all previously accrued and uncollected interest is reversed against current income. The table below shows interest income that was recognized or collected on all nonaccrual loans and TDRs for the periods indicated:\\nTable 8 - Interest Income - Nonaccrual Loans and Troubled Debt Restructurings\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 302022 | September 302021 | September 302022 | September 302021 |\\n| (Dollars in thousands) |\\n| The amount of incremental gross interest income that would have been recorded if nonaccrual loans had been current in accordance with their original terms | $ | 1,802 | $ | 678 | $ | 4,666 | $ | 2,289 |\\n| The amount of interest income on nonaccrual loans and performing TDRs that was included in net income | $ | 1,817 | $ | 257 | $ | 2,443 | $ | 673 |\\n\\nPotential problem loans are any loans which are not included in nonaccrual or nonperforming loans, where known information about possible credit problems of the borrowers causes management to have concerns as to the ability of such borrowers to comply with present loan repayment terms. At September 30, 2022, there were 51 relationships, with an aggregate balance of $173.5 million, deemed to be potential problem loans. These potential problem loans continued to perform with respect to payments. Management actively monitors these loans and strives to minimize any possible adverse impact to the Company.\\n68\\nAs previously noted, the Company has offered need-based payment relief options to its customers in response to the COVID-19 pandemic, primarily in the form of payment deferrals, all of which were granted prior to December 31, 2020. Loans that were modified are not accounted for as TDRs or reflected as delinquent or nonaccrual loans if the borrower was in compliance with their loan terms as of December 31, 2019. The Company held $193.3 million of loans with active deferrals at September 30, 2022, of which $137.7 million is scheduled to mature during the fourth quarter of 2022.\\nAllowance for Credit Losses The allowance for credit losses is maintained at a level that management considers appropriate to provide for the Company's current estimate of expected lifetime credit losses on loans measured at amortized cost. The allowance is increased by providing for credit losses through a charge to expense and by credits for recoveries of loans previously charged-off and is reduced by loans being charged-off.\\nIn accordance with the CECL methodology, the Company estimates credit losses for financial assets on a collective basis for loans sharing similar risk characteristics using a quantitative model combined with an assessment of certain qualitative factors designed to address forecast risk and model risk inherent in the quantitative model output. The model estimates expected credit losses using loan level data over the contractual life of the exposure, considering the effect of prepayments. Economic forecasts are incorporated into the estimate over a reasonable and supportable forecast period of one year, beyond which is a reversion to the Company's historical long-run average for a period of six months. The Company's qualitative assessment is structured based upon nine environmental factors impacting the expected risk of loss within the loan portfolio. Loans that do not share similar risk characteristics with any pools of assets are subject to individual assessment and are removed from the collectively assessed pools to avoid double counting. For the loans that will be individually assessed, the Company uses either a discounted cash flow (“DCF”) approach or a fair value of collateral approach. The latter approach is used for loans deemed to be collateral dependent or when foreclosure is probable.\\nThe balance of allowance for credit losses of $147.3 million at September 30, 2022 remained relatively flat compared to $146.9 million at December 31, 2021. The net change in the Company's allowance for credit losses for the nine months ended September 30, 2022 primarily reflects elevated balances of nonperforming loans at September 30, 2022 compared to December 31, 2021, offset by attrition of existing loans and continued strong asset quality metrics. Despite the increase in nonperforming loans, net charge-offs recorded for the three and nine months ended September 30, 2022 were minimal.\\nThe aforementioned increase in nonperforming loans contributed to an overall higher quantitative allowance at September 30, 2022 compared to December 31, 2021. Management's forecast anticipates that the federal funds rates will rise in the near term, that supply chain issues will persist, inflation will remain elevated, and the military conflict between Russia and Ukraine will persist for the foreseeable future, potentially impacting global oil supplies and the supply chain more generally. The forecast used by management also anticipates that the U.S. economy will fall into a recession during the fourth quarter of 2022 and that the recession will persist for the short term. Additionally, the allowance for credit losses is qualitatively adjusted on a quarterly basis in order to ensure coverage for relationships that are deemed to be more at risk within certain industries, specific collateral types, or other specific characteristics that may be highly impacted by the current economic environment.\\n69\\nThe following table summarizes the ratio of net charge-offs to average loans outstanding within each major loan category for the periods presented:\\nTable 9 - Summary Net Charge-Offs to Average Loans Outstanding\\n| Net Charge-Offs (Recoveries) | Average Loans Outstanding | Ratio of Annualized Net Charge-Offs/(Recoveries) to Average Loans | Net Charge-Offs (Recoveries) | Average Loans Outstanding | Ratio of Annualized Net Charge-Offs/(Recoveries) to Average Loans |\\n| (Dollars in thousands) |\\n| Three Months Ended September 30, 2022 | Nine Months Ended September 30, 2022 |\\n| Commercial and industrial | $ | (2) | $ | 1,520,924 | — | % | $ | (44) | $ | 1,531,421 | — | % |\\n| Commercial real estate | (268) | 7,760,470 | (0.01) | % | (271) | 7,832,534 | — | % |\\n| Commercial construction | — | 1,157,876 | — | % | — | 1,180,509 | — | % |\\n| Small business | (88) | 207,546 | (0.17) | % | (88) | 202,151 | (0.06) | % |\\n| Residential real estate | — | 1,909,066 | — | % | — | 1,774,355 | — | % |\\n| Home equity | (65) | 1,076,040 | (0.02) | % | 17 | 1,051,921 | — | % |\\n| Other consumer | 429 | 31,883 | 5.34 | % | 995 | 31,092 | 4.28 | % |\\n| Total | $ | 6 | $ | 13,663,805 | — | % | $ | 609 | $ | 13,603,983 | 0.01 | % |\\n| Net Charge-Offs (Recoveries) | Average Loans Outstanding | Ratio of Annualized Net Charge-Offs/(Recoveries) to Average Loans | Net Charge-Offs (Recoveries) | Average Loans Outstanding | Ratio of Annualized Net Charge-Offs/(Recoveries) to Average Loans |\\n| (Dollars in thousands) |\\n| Three Months Ended September 30, 2021 | Nine Months Ended September 30, 2021 |\\n| Commercial and industrial | $ | — | $ | 1,640,422 | — | % | $ | 3,374 | $ | 1,898,100 | 0.24 | % |\\n| Commercial real estate | — | 4,232,575 | — | % | (57) | 4,195,200 | — | % |\\n| Commercial construction | — | 507,393 | — | % | — | 525,652 | — | % |\\n| Small business | 33 | 181,953 | 0.07 | % | 119 | 178,294 | 0.09 | % |\\n| Residential real estate | — | 1,231,606 | — | % | (1) | 1,242,991 | — | % |\\n| Home equity | (49) | 1,007,371 | (0.02) | % | (38) | 1,027,311 | — | % |\\n| Other consumer | 127 | 25,929 | 1.94 | % | 249 | 23,382 | 1.42 | % |\\n| Total | $ | 111 | $ | 8,827,249 | — | % | $ | 3,646 | $ | 9,090,930 | 0.05 | % |\\n\\n70\\nFor purposes of the allowance for credit losses, management segregates the loan portfolio into the portfolio segments detailed in the table below. The allocation of the allowance for credit losses is made to each loan category using the analytical techniques and estimation methods described in this Report. While these amounts represent management’s best estimate of credit losses at the evaluation dates, they are not necessarily indicative of either the categories in which actual losses may occur or the extent of such actual losses that may be recognized within each category. Each of these loan categories possess unique risk characteristics that are considered when determining the appropriate level of allowance for each segment. The total allowance is available to absorb losses from any segment of the loan portfolio.\\nThe following table sets forth the allocation of the allowance for credit losses by loan category at the dates indicated:\\nTable 10 - Summary of Allocation of Allowance for Credit Losses\\n\\n| September 302022 | December 312021 |\\n| AllowanceAmount | Percent ofLoansIn CategoryTo Total Loans | AllowanceAmount | Percent ofLoansIn CategoryTo Total Loans |\\n| (Dollars in thousands) |\\n| Commercial and industrial (1) | $ | 20,169 | 11.3 | % | $ | 14,402 | 11.5 | % |\\n| Commercial real estate | 80,036 | 56.1 | % | 83,486 | 58.8 | % |\\n| Commercial construction | 11,419 | 8.7 | % | 12,316 | 8.6 | % |\\n| Small business | 2,624 | 1.5 | % | 3,508 | 1.4 | % |\\n| Residential real estate | 20,602 | 14.3 | % | 14,484 | 11.8 | % |\\n| Home equity | 11,651 | 7.9 | % | 17,986 | 7.7 | % |\\n| Other consumer | 812 | 0.2 | % | 740 | 0.2 | % |\\n| Total allowance for credit losses | $ | 147,313 | 100.0 | % | $ | 146,922 | 100.0 | % |\\n\\n(1)Total loans in this category are inclusive of $11.1 million and $216.2 million in loans at September 30, 2022 and December 31, 2021, respectively, which were originated as part of the PPP established by the CARES Act. These loans have been excluded from the credit loss calculations as these loans are 100% guaranteed by the U.S. Government.\\nTo determine if a loan should be charged-off, all possible sources of repayment are analyzed. Possible sources of repayment include the potential for future cash flows, the value of the Bank’s collateral, and the strength of co-makers or guarantors. When available information confirms that specific loans or portions thereof are uncollectible, these amounts are promptly charged-off against the allowance for credit losses and any recoveries of such previously charged-off amounts are credited to the allowance.\\nRegardless of whether a loan is unsecured or collateralized, the Company charges off the amount of any confirmed loan loss in the period when the loans, or portions of loans, are deemed uncollectible. For troubled, collateral-dependent loans, loss-confirming events may include an appraisal or other valuation that reflects a shortfall between the value of the collateral and the carrying value of the loan or receivable, or a deficiency balance following the sale of the collateral.\\nFor additional information regarding the Company’s allowance for credit losses, see Note 4 \\\"Loans, Allowance for Credit Losses and Credit Quality\\\" within the Notes to Consolidated Financial Statements included in Part I. Item 1 of this Report.\\nFederal Home Loan Bank Stock The FHLB is a cooperative that provides services to its member banking institutions. The primary reason for the FHLB of Boston membership is to gain access to a reliable source of wholesale funding as a tool to manage liquidity and interest rate risk. The purchase of stock in the FHLB is a requirement for a member to gain access to funding. The Company either purchases additional FHLB stock or is subject to redemption of FHLB stock proportional to the volume of funding received. The Company views the holdings as a necessary long-term investment for the purpose of balance sheet liquidity and not for investment return. The Bank held investments in FHLB of Boston stock of $5.2 million and $11.4 million at September 30, 2022 and December 31, 2021, respectively, reflecting redemption activity occurring during 2022.\\nGoodwill and Other Intangible Assets Goodwill and other intangible assets were $1.0 billion at both September 30, 2022 and December 31, 2021.\\n71\\nThe Company typically performs its annual goodwill impairment testing during the third quarter of the year, unless certain indicators suggest earlier testing to be warranted. Accordingly, the Company performed its annual goodwill impairment testing during the third quarter of 2022 and determined that the Company's goodwill was not impaired as of September 30, 2022. Other intangible assets are also reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. There were no events or changes during the third quarter of 2022 that indicated impairment of goodwill and other intangible assets.\\nCash Surrender Value of Life Insurance Policies The Bank holds life insurance policies for the purpose of offsetting its future obligations to its employees under its retirement and benefits plans. The cash surrender value of life insurance policies was $293.1 million at September 30, 2022 compared to $289.3 million at December 31, 2021, representing an increase of $3.8 million, or 1.3%, primarily due to income earned on the policies.\\nThe Company recorded tax exempt income from life insurance policies of $1.9 million and $1.6 million for the three months ended September 30, 2022 and 2021, respectively, and $5.5 million and $4.5 million for the nine months ended September 30, 2022 and 2021, respectively. The Company recorded gains on life insurance benefits of $477,000 for three months ended September 30, 2022 and no such gains for the three months ended September 30, 2021, respectively, and $600,000 and $258,000 for the nine months ended September 30, 2022 and September 30, 2021, respectively.\\nDeposits As of September 30, 2022, total deposits were $16.3 billion, representing a $578.1 million, or 3.4%, decrease from December 31, 2021, primarily attributable to continued runoff in higher-cost time deposits and certain rate sensitive deposits. The total cost of deposits was 0.15% and 0.05% for the three months ended September 30, 2022 and 2021, respectively, and 0.08% and 0.07% for the nine months ended September 30, 2022 and 2021, respectively. Core deposits increased to 87.8% of total deposits as of September 30, 2022 from 84.5% at December 31, 2021.\\nThe Company also participates in the IntraFi Network, allowing the Bank to provide easy access to multi-million dollar Federal Deposit Insurance Corporation (\\\"FDIC\\\") deposit insurance protection on certificate of deposit and money market investments for consumers, businesses and public entities. This channel allows the Company to seek additional funding in potentially large quantities by attracting deposits from outside the Bank’s core market, and amounted to $751.1 million and $998.1 million at September 30, 2022 and December 31, 2021, respectively. In addition, the Company may occasionally raise funds through the use of brokered deposits outside of the IntraFi Network, which amounted to $102.6 million and $141.6 million at September 30, 2022 and December 31, 2021, respectively.\\nBorrowings The Company's borrowings consist of both short-term and long-term borrowings and provide the Bank with one of its primary sources of funding. Maintaining available borrowing capacity provides the Bank with a contingent source of liquidity. Borrowings were $113.4 million at September 30, 2022, a decrease of $39.0 million, or 25.6%, as compared to December 31, 2021, due primarily to the re-payment of a revolving loan credit facility during the first quarter of 2022 and the maturity of a short term Federal Home Loan Bank borrowing during the third quarter of 2022.\\nAdditionally, the Bank had $4.3 billion and $4.2 billion of assets pledged as collateral against borrowings at September 30, 2022 and December 31, 2021, respectively. These assets are primarily pledged to the FHLB of Boston and the Federal Reserve Bank of Boston.\\n72\\nCapital Resources On September 15, 2022 the Company’s Board of Directors declared a cash dividend of $0.51 per share to shareholders of record as of the close of business on September 26, 2022. This dividend was paid on October 7, 2022.\\nThe Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company’s and the Bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.\\nQuantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of Total, Tier 1 Capital and Common Equity Tier 1 Capital (as defined for regulatory purposes) to risk weighted assets (as defined for regulatory purposes) and Tier 1 Capital to average assets (as defined for regulatory purposes). At September 30, 2022 and December 31, 2021, the Company and the Bank exceeded the minimum requirements for all applicable ratios that were in effect during the respective periods. The Company’s and the Bank’s capital amounts and ratios are presented in the following table, along with the applicable minimum requirements as of each date indicated:\\nTable 11 - Company and Bank's Capital Amounts and Ratios\\n| Actual | For Capital Adequacy Purposes | To Be Well Capitalized Under PromptCorrective Action Provisions |\\n| Amount | Ratio | Amount | Ratio | Amount | Ratio |\\n| September 30, 2022 |\\n| (Dollars in thousands) |\\n| Company (consolidated) |\\n| Total capital (to risk weighted assets) | $ | 2,250,741 | 15.71 | % | $ | 1,146,074 | ≥ | 8.0 | % | N/A | N/A |\\n| Common equity tier 1 capital (to risk weighted assets) | 2,002,105 | 13.98 | % | 644,666 | ≥ | 4.5 | % | N/A | N/A |\\n| Tier 1 capital (to risk weighted assets) | 2,002,105 | 13.98 | % | 859,555 | ≥ | 6.0 | % | N/A | N/A |\\n| Tier 1 capital (to average assets) | 2,002,105 | 10.51 | % | 761,820 | ≥ | 4.0 | % | N/A | N/A |\\n| Bank |\\n| Total capital (to risk weighted assets) | $ | 2,142,284 | 14.95 | % | $ | 1,146,046 | ≥ | 8.0 | % | $ | 1,432,558 | ≥ | 10.0 | % |\\n| Common equity tier 1 capital(to risk weighted assets) | 2,004,510 | 13.99 | % | 644,651 | ≥ | 4.5 | % | 931,163 | ≥ | 6.5 | % |\\n| Tier 1 capital (to risk weighted assets) | 2,004,510 | 13.99 | % | 859,535 | ≥ | 6.0 | % | 1,146,046 | ≥ | 8.0 | % |\\n| Tier 1 capital (to average assets) | 2,004,510 | 10.52 | % | 801,528 | ≥ | 4.0 | % | 1,001,911 | ≥ | 5.0 | % |\\n| December 31, 2021 |\\n| (Dollars in thousands) |\\n| Company (consolidated) |\\n| Total capital (to risk weighted assets) | $ | 2,262,740 | 16.04 | % | $ | 1,128,900 | ≥ | 8.0 | % | N/A | N/A |\\n| Common equity tier 1 capital (to risk weighted assets) | 2,017,497 | 14.30 | % | 635,006 | ≥ | 4.5 | % | N/A | N/A |\\n| Tier 1 capital (to risk weighted assets) | 2,017,497 | 14.30 | % | 846,675 | ≥ | 6.0 | % | N/A | N/A |\\n| Tier 1 capital (to average assets) | 2,017,497 | 12.03 | % | 670,659 | ≥ | 4.0 | % | N/A | N/A |\\n| Bank |\\n| Total capital (to risk weighted assets) | $ | 2,083,689 | 14.77 | % | $ | 1,128,536 | ≥ | 8.0 | % | $ | 1,410,670 | ≥ | 10.0 | % |\\n| Common equity tier 1 capital(to risk weighted assets) | 1,949,237 | 13.82 | % | 634,801 | ≥ | 4.5 | % | 916,935 | ≥ | 6.5 | % |\\n| Tier 1 capital (to risk weighted assets) | 1,949,237 | 13.82 | % | 846,402 | ≥ | 6.0 | % | 1,128,536 | ≥ | 8.0 | % |\\n| Tier 1 capital (to average assets) | 1,949,237 | 11.62 | % | 670,827 | ≥ | 4.0 | % | 838,534 | ≥ | 5.0 | % |\\n\\n73\\nIn addition to the minimum risk-based capital requirements outlined in the table above, the Company is required to maintain a minimum capital conservation buffer, in the form of common equity, in order to avoid restrictions on capital distributions and discretionary bonuses. The required amount of the capital conservation buffer is 2.5%. At September 30, 2022, the Company's capital levels exceeded the buffer.\\nDividend Restrictions The Company is subject to capital and dividend requirements administered by federal and state bank regulators, and the Company will not declare a cash dividend that would cause the Company to violate regulatory requirements. The Company is, in the ordinary course of business, dependent upon the receipt of cash dividends from the Bank to pay cash dividends to shareholders and satisfy the Company’s other cash needs. Federal and state law impose limits on capital distributions by the Bank. Massachusetts-chartered banks, such as the Bank, may declare from net profits cash dividends not more frequently than quarterly and non-cash dividends at any time. No dividends may be declared, credited, or paid if the Bank’s capital stock would be impaired. Massachusetts Bank Commissioner approval is required if the total of all dividends declared by the Bank in any calendar year would exceed the total of its net profits for that year combined with its retained net profits of the preceding two years, less any required transfer to surplus or a fund for the retirement of any preferred stock. Dividends paid by the Bank to the Company totaled $64.5 million and $33.9 million for the three months ended September 30, 2022 and 2021, respectively and totaled $142.7 million and $38.9 million for the nine months ended September 30, 2022 and 2021, respectively.\\nTrust Preferred Securities In accordance with the applicable accounting standard related to variable interest entities, the common stock of trusts which have issued trust preferred securities has not been included in the consolidated financial statements of the Company. At each of September 30, 2022 and December 31, 2021 there were $61.0 million in trust preferred securities included in the Tier 2 capital of the Company for regulatory reporting purposes pursuant to the Federal Reserve's capital adequacy guidelines.\\nInvestment Management The following table presents total assets under administration and number of accounts held by the Rockland Trust Investment Management Group at the following dates:\\nTable 12 - Assets Under Administration\\n| September 302022 | December 312021 | September 302021 |\\n| (Dollars in thousands) |\\n| Assets under administration | $ | 5,091,592 | $ | 5,726,368 | $ | 5,434,971 |\\n| Number of trust, fiduciary and agency accounts | 6,487 | 6,379 | 6,368 |\\n\\nDespite strong new asset inflows, assets under administration at September 30, 2022 decreased compared to December 31, 2021, driven primarily by depressed market valuations experienced during the first nine months of 2022. Included in these amounts as of September 30, 2022 and December 31, 2021 are assets under administration of $361.0 million and $447.4 million, respectively, relating to the Company’s registered investment advisor, Bright Rock Capital Management, LLC, which provides institutional quality investment management services to institutional and high net worth clients. Revenue from the Investment Management Group was $7.8 million and $8.1 million for the three months ended September 30, 2022 and 2021, respectively, and $23.6 million for the nine months ended September 30, 2022 and 2021.\\nThe administration of trust and fiduciary accounts is monitored by the Trust Committee of the Bank’s Board of Directors. The Trust Committee has delegated administrative responsibilities to three committees, one for investments, one for administration, and one for operations, all of which are comprised of Investment Management Group officers who meet no less than quarterly.\\nThe Bank has an agreement with LPL Financial (\\\"LPL\\\") and its affiliates and their insurance subsidiary, LPL Insurance Associates, Inc., to offer the sale of mutual fund shares, unit investment trust shares, general securities, fixed and variable annuities and life insurance. Registered representatives who are both employed by the Bank and licensed and contracted with LPL are onsite to offer these products to the Bank’s customer base. These same agents are also approved and appointed with various other Broker General Agents for the purposes of processing insurance solutions for clients. Retail investments and insurance revenue was $601,000 and $1.0 million for the three months ended September 30, 2022 and 2021, respectively, and $2.9 million and $2.8 million for the nine months ended September 30, 2022 and 2021, respectively.\\n74\\nRESULTS OF OPERATIONS\\nThe following table provides a summary of results of operations for the three and nine months ended September 30, 2022 and 2021:\\nTable 13 - Summary of Results of Operations\\n\\n| Three Months Ended September 30 | Nine Months Ended September 30 |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (Dollars in thousands, except per share data) |\\n| Net income | $ | 71,897 | $ | 40,007 | $ | 186,770 | $ | 119,290 |\\n| Diluted earnings per share | $ | 1.57 | $ | 1.21 | $ | 4.00 | $ | 3.61 |\\n| Return on average assets | 1.43 | % | 1.11 | % | 1.25 | % | 1.15 | % |\\n| Return on average equity | 9.90 | % | 9.04 | % | 8.51 | % | 9.20 | % |\\n| Net interest margin | 3.64 | % | 2.78 | % | 3.33 | % | 3.00 | % |\\n\\nNet Interest Income The amount of net interest income is affected by changes in interest rates and by the volume, mix, and interest rate sensitivity of interest-earning assets and interest-bearing liabilities.\\nOn a fully tax equivalent basis (\\\"FTE\\\"), net interest income for the third quarter of 2022 was $163.6 million, representing an increase of $73.3 million, or 81.2%, when compared to the third quarter of 2021. For the nine months ended September 30, 2022, the net interest income on a FTE basis was $447.9 million, representing an increase of $168.2 million, or 60.1%, when compared to the year ago period. The year-over-year increases in net interest income are primarily attributable to the Meridian acquisition which closed during the fourth quarter of 2021, as well as the positive impact of asset repricing in the rising rate environment and relatively stable funding costs experienced through September 30, 2022, partially offset by reduced PPP fee income.\\n75\\nThe following tables present the Company’s average balances, net interest income, interest rate spread, and net interest margin for the three and nine months ended September 30, 2022 and 2021. Nontaxable income from loans and securities is presented on a FTE basis by adjusting tax-exempt income upward by an amount equivalent to the prevailing income tax rate that would have been paid if the income had been fully taxable.\\nTable 14 - Average Balance, Interest Earned/Paid & Average Yields Quarter-to-Date\\n| Three Months Ended September 30 |\\n| 2022 | 2021 |\\n| AverageBalance | InterestEarned/Paid | Yield/Rate | AverageBalance | InterestEarned/Paid | Yield/Rate |\\n| (Dollars in thousands) |\\n| Interest-earning assets |\\n| Interest-earning deposits with banks, federal funds sold, and short term investments | $ | 1,156,143 | $ | 6,519 | 2.24 | % | $ | 2,135,031 | $ | 815 | 0.15 | % |\\n| Securities |\\n| Securities - trading | 3,730 | — | — | % | 3,498 | — | — | % |\\n| Securities - taxable investments | 3,024,802 | 13,243 | 1.74 | % | 1,880,863 | 7,792 | 1.64 | % |\\n| Securities - nontaxable investments (1) | 196 | 1 | 2.02 | % | 468 | 5 | 4.24 | % |\\n| Total securities | $ | 3,028,728 | $ | 13,244 | 1.73 | % | $ | 1,884,829 | $ | 7,797 | 1.64 | % |\\n| Loans held for sale | 4,263 | 51 | 4.75 | % | 30,143 | 193 | 2.54 | % |\\n| Loans (2) |\\n| Commercial and industrial (1) | 1,520,924 | 19,289 | 5.03 | % | 1,640,422 | 15,309 | 3.70 | % |\\n| Commercial real estate (1) | 7,760,470 | 85,284 | 4.36 | % | 4,232,575 | 41,469 | 3.89 | % |\\n| Commercial construction | 1,157,876 | 14,875 | 5.10 | % | 507,393 | 4,916 | 3.84 | % |\\n| Small business | 207,546 | 2,819 | 5.39 | % | 181,953 | 2,341 | 5.10 | % |\\n| Total commercial | 10,646,816 | 122,267 | 4.56 | % | 6,562,343 | 64,035 | 3.87 | % |\\n| Residential real estate | 1,909,066 | 16,533 | 3.44 | % | 1,231,606 | 10,955 | 3.53 | % |\\n| Home equity | 1,076,040 | 11,869 | 4.38 | % | 1,007,371 | 9,043 | 3.56 | % |\\n| Total consumer real estate | 2,985,106 | 28,402 | 3.77 | % | 2,238,977 | 19,998 | 3.54 | % |\\n| Other consumer | 31,883 | 523 | 6.51 | % | 25,929 | 398 | 6.09 | % |\\n| Total loans | $ | 13,663,805 | $ | 151,192 | 4.39 | % | $ | 8,827,249 | $ | 84,431 | 3.79 | % |\\n| Total interest-earning assets | $ | 17,852,939 | $ | 171,006 | 3.80 | % | $ | 12,877,252 | $ | 93,236 | 2.87 | % |\\n| Cash and due from banks | 192,003 | 144,556 |\\n| Federal Home Loan Bank stock | 5,745 | 8,904 |\\n| Other assets | 1,854,870 | 1,268,199 |\\n| Total assets | $ | 19,905,557 | $ | 14,298,911 |\\n| Interest-bearing liabilities |\\n| Deposits |\\n| Savings and interest checking accounts | $ | 6,224,690 | $ | 2,110 | 0.13 | % | $ | 4,426,106 | $ | 338 | 0.03 | % |\\n| Money market | 3,459,212 | 3,025 | 0.35 | % | 2,375,492 | 443 | 0.07 | % |\\n| Time deposits | 1,246,841 | 974 | 0.31 | % | 795,943 | 852 | 0.42 | % |\\n| Total interest-bearing deposits | $ | 10,930,743 | $ | 6,109 | 0.22 | % | $ | 7,597,541 | $ | 1,633 | 0.09 | % |\\n| Borrowings |\\n| Federal Home Loan Bank borrowings | $ | 12,876 | $ | 55 | 1.69 | % | $ | 31,118 | $ | 165 | 2.10 | % |\\n| Long-term borrowings | — | — | — | % | 18,742 | 77 | 1.63 | % |\\n| Junior subordinated debentures | 62,854 | 589 | 3.72 | % | 62,852 | 432 | 2.73 | % |\\n| Subordinated debentures | 49,847 | 617 | 4.91 | % | 49,753 | 617 | 4.92 | % |\\n\\n76\\n| Total borrowings | $ | 125,577 | $ | 1,261 | 3.98 | % | $ | 162,465 | $ | 1,291 | 3.15 | % |\\n| Total interest-bearing liabilities | $ | 11,056,320 | $ | 7,370 | 0.26 | % | $ | 7,760,006 | $ | 2,924 | 0.15 | % |\\n| Noninterest bearing demand deposits | 5,641,742 | 4,502,045 |\\n| Other liabilities | 325,507 | 280,754 |\\n| Total liabilities | $ | 17,023,569 | $ | 12,542,805 |\\n| Stockholders' equity | 2,881,988 | 1,756,106 |\\n| Total liabilities and stockholders' equity | $ | 19,905,557 | $ | 14,298,911 |\\n| Net interest income (1) | $ | 163,636 | $ | 90,312 |\\n| Interest rate spread (3) | 3.54 | % | 2.72 | % |\\n| Net interest margin (4) | 3.64 | % | 2.78 | % |\\n| Supplemental information |\\n| Total deposits, including demand deposits | $ | 16,572,485 | $ | 6,109 | $ | 12,099,586 | $ | 1,633 |\\n| Cost of total deposits | 0.15 | % | 0.05 | % |\\n| Total funding liabilities, including demand deposits | $ | 16,698,062 | $ | 7,370 | $ | 12,262,051 | $ | 2,924 |\\n| Cost of total funding liabilities | 0.18 | % | 0.09 | % |\\n\\n(1)The total amount of adjustment to interest income and yield on a FTE basis was $1.0 million and $220,000 for the three months ended September 30, 2022 and 2021, respectively. The FTE adjustment relates to tax exempt income relating to securities with average balances of $196,000 and $468,000 and tax exempt income relating to loans with average balances of $414.4 million and $61.2 million, for the three months ended September 30, 2022 and 2021, respectively.\\n(2)Includes average nonaccruing loans.\\n(3)Interest rate spread represents the difference between the weighted average yield on interest-earning assets and the weighted average cost of interest-bearing liabilities.\\n(4)Net interest margin represents annualized net interest income as a percentage of average interest-earning assets.\\n77\\nTable 15 - Average Balance, Interest Earned/Paid & Average Yields Year-to-Date\\n| Nine Months Ended September 30 |\\n| 2022 | 2021 |\\n| AverageBalance | InterestEarned/Paid | Yield/Rate | AverageBalance | InterestEarned/Paid | Yield/Rate |\\n| (Dollars in thousands) |\\n| Interest-earning assets |\\n| Interest-earning deposits with banks, federal funds sold, and short-term investments | $ | 1,477,117 | $ | 10,222 | 0.93 | % | $ | 1,782,463 | $ | 1,654 | 0.12 | % |\\n| Securities |\\n| Securities - trading | 3,775 | — | — | % | 3,267 | — | — | % |\\n| Securities - taxable investments | 2,881,203 | 34,567 | 1.60 | % | 1,550,859 | 21,603 | 1.86 | % |\\n| Securities - nontaxable investments (1) | 198 | 5 | 3.38 | % | 555 | 17 | 4.10 | % |\\n| Total securities | $ | 2,885,176 | $ | 34,572 | 1.60 | % | $ | 1,554,681 | $ | 21,620 | 1.86 | % |\\n| Loans held for sale | 5,841 | 150 | 3.43 | % | 35,953 | 675 | 2.51 | % |\\n| Loans (2) |\\n| Commercial and industrial (1) | 1,531,421 | 53,816 | 4.70 | % | 1,898,100 | 58,706 | 4.14 | % |\\n| Commercial real estate (1) | 7,832,534 | 238,085 | 4.06 | % | 4,195,200 | 123,377 | 3.93 | % |\\n| Commercial construction | 1,180,509 | 40,599 | 4.60 | % | 525,652 | 14,976 | 3.81 | % |\\n| Small business | 202,151 | 7,891 | 5.22 | % | 178,294 | 6,924 | 5.19 | % |\\n| Total commercial | 10,746,615 | 340,391 | 4.23 | % | 6,797,246 | 203,983 | 4.01 | % |\\n| Residential real estate | 1,774,355 | 45,109 | 3.40 | % | 1,242,991 | 34,449 | 3.71 | % |\\n| Home equity | 1,051,921 | 29,709 | 3.78 | % | 1,027,311 | 26,391 | 3.43 | % |\\n| Total consumer real estate | 2,826,276 | 74,818 | 3.54 | % | 2,270,302 | 60,840 | 3.58 | % |\\n| Other consumer | 31,092 | 1,519 | 6.53 | % | 23,382 | 1,241 | 7.10 | % |\\n| Total loans | $ | 13,603,983 | $ | 416,728 | 4.10 | % | $ | 9,090,930 | $ | 266,064 | 3.91 | % |\\n| Total interest-earning assets | $ | 17,972,117 | $ | 461,672 | 3.43 | % | $ | 12,464,027 | $ | 290,013 | 3.11 | % |\\n| Cash and due from banks | 184,754 | 147,269 |\\n| Federal Home Loan Bank stock | 7,780 | 9,516 |\\n| Other assets | 1,853,818 | 1,256,066 |\\n| Total assets | $ | 20,018,469 | $ | 13,876,878 |\\n| Interest-bearing liabilities |\\n| Deposits |\\n| Savings and interest checking accounts | $ | 6,224,317 | $ | 3,418 | 0.07 | % | $ | 4,292,992 | $ | 1,145 | 0.04 | % |\\n| Money market | 3,517,459 | 4,191 | 0.16 | % | 2,337,445 | 1,393 | 0.08 | % |\\n| Time deposits | 1,355,861 | 2,718 | 0.27 | % | 848,143 | 3,823 | 0.60 | % |\\n| Total interest-bearing deposits | $ | 11,097,637 | $ | 10,327 | 0.12 | % | $ | 7,478,580 | $ | 6,361 | 0.11 | % |\\n| Borrowings |\\n| Federal Home Loan Bank borrowings | $ | 21,361 | $ | 311 | 1.95 | % | $ | 34,185 | $ | 544 | 2.13 | % |\\n| Long-term borrowings | 2,988 | 31 | 1.39 | % | 23,434 | 282 | 1.61 | % |\\n| Junior subordinated debentures | 62,854 | 1,298 | 2.76 | % | 62,852 | 1,287 | 2.74 | % |\\n| Subordinated debentures | 49,824 | 1,852 | 4.97 | % | 49,729 | 1,852 | 4.98 | % |\\n| Total borrowings | $ | 137,027 | $ | 3,492 | 3.41 | % | $ | 170,200 | $ | 3,965 | 3.11 | % |\\n| Total interest-bearing liabilities | $ | 11,234,664 | $ | 13,819 | 0.16 | % | $ | 7,648,780 | $ | 10,326 | 0.18 | % |\\n| Noninterest bearing demand deposits | 5,544,476 | 4,213,764 |\\n| Other liabilities | 303,308 | 280,002 |\\n\\n78\\n| Total liabilities | $ | 17,082,448 | $ | 12,142,546 |\\n| Stockholders' equity | 2,936,021 | 1,734,332 |\\n| Total liabilities and stockholders' equity | $ | 20,018,469 | $ | 13,876,878 |\\n| Net interest income (1) | $ | 447,853 | $ | 279,687 |\\n| Interest rate spread (3) | 3.27 | % | 2.93 | % |\\n| Net interest margin (4) | 3.33 | % | 3.00 | % |\\n| Supplemental information |\\n| Total deposit, including demand deposits | $ | 16,642,113 | $ | 10,327 | $ | 11,692,344 | $ | 6,361 |\\n| Cost of total deposits | 0.08 | % | 0.07 | % |\\n| Total funding liabilities, including demand deposits | $ | 16,779,140 | $ | 13,819 | $ | 11,862,544 | $ | 10,326 |\\n| Cost of total funding liabilities | 0.11 | % | 0.12 | % |\\n\\n(1)The total amount of adjustment to present interest income and yield on a FTE basis was $3.0 million and $658,000 for the nine months ended September 30, 2022 and 2021, respectively. The FTE adjustment relates to nontaxable investment securities with average balances of $198,000 and $555,000 and tax exempt income relating to loans with average balances of $411.9 million and $63.9 million for the nine months ended September 30, 2022 and 2021, respectively.\\n(2)Includes average nonaccruing loans.\\n(3)Interest rate spread represents the difference between the weighted average yield on interest-earning assets and the weighted average cost of interest-bearing liabilities.\\n(4)Net interest margin represents annualized net interest income as a percentage of average interest-earning assets.\\n79\\nThe following table presents certain information on a FTE basis regarding changes in the Company’s interest income and interest expense for the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided with respect to changes attributable to: (1) changes in rate (change in rate multiplied by prior period volume), (2) changes in volume (change in volume multiplied by old rate), and (3) changes in volume/rate (change in volume multiplied by change in rate) which is allocated to the change due to rate column:\\nTable 16 - Volume Rate Analysis\\n| Three Months Ended September 30 | Nine Months Ended September 30 |\\n| 2022 Compared To 2021 | 2022 Compared To 2021 |\\n| ChangeDue toRate | ChangeDue toVolume | Total Change | ChangeDue toRate | ChangeDue toVolume | Total Change |\\n| (Dollars in thousands) |\\n| Income on interest-earning assets |\\n| Interest earning deposits, federal funds sold and short term investments | $ | 6,078 | $ | (374) | $ | 5,704 | $ | 8,851 | $ | (283) | $ | 8,568 |\\n| Securities |\\n| Securities - taxable investments | 712 | 4,739 | 5,451 | (5,567) | 18,531 | 12,964 |\\n| Securities - nontaxable investments (1) | (1) | (3) | (4) | (1) | (11) | (12) |\\n| Total securities | 5,447 | 12,952 |\\n| Loans held for sale | 24 | (166) | (142) | 40 | (565) | (525) |\\n| Loans |\\n| Commercial and industrial (1) | 5,095 | (1,115) | 3,980 | 6,451 | (11,341) | (4,890) |\\n| Commercial real estate (1) | 9,250 | 34,565 | 43,815 | 7,737 | 106,971 | 114,708 |\\n| Commercial construction | 3,657 | 6,302 | 9,959 | 6,966 | 18,657 | 25,623 |\\n| Small business | 149 | 329 | 478 | 41 | 926 | 967 |\\n| Total commercial | 58,232 | 136,408 |\\n| Residential real estate | (448) | 6,026 | 5,578 | (4,067) | 14,727 | 10,660 |\\n| Home equity | 2,210 | 616 | 2,826 | 2,686 | 632 | 3,318 |\\n| Total consumer real estate | 8,404 | 13,978 |\\n| Other consumer | 34 | 91 | 125 | (131) | 409 | 278 |\\n| Total loans (1)(2) | 66,761 | 150,664 |\\n| Total income of interest-earning assets | $ | 77,770 | $ | 171,659 |\\n| Expense of interest-bearing liabilities |\\n| Deposits |\\n| Savings and interest checking accounts | $ | 1,635 | $ | 137 | $ | 1,772 | $ | 1,758 | $ | 515 | $ | 2,273 |\\n| Money market | 2,380 | 202 | 2,582 | 2,095 | 703 | 2,798 |\\n| Time certificates of deposits | (361) | 483 | 122 | (3,394) | 2,289 | (1,105) |\\n| Total interest bearing deposits | 4,476 | 3,966 |\\n| Borrowings |\\n| Federal Home Loan Bank borrowings | (13) | (97) | (110) | (29) | (204) | (233) |\\n| Line of Credit | — | — | — | — |\\n| Long-term borrowings | — | (77) | (77) | (5) | (246) | (251) |\\n| Junior subordinated debentures | 157 | — | 157 | 11 | — | 11 |\\n| Subordinated debentures | (1) | 1 | — | (4) | 4 | — |\\n| Total borrowings | (30) | (473) |\\n| Total expense of interest-bearing liabilities | 4,446 | 3,493 |\\n| Change in net interest income | $ | 73,324 | $ | 168,166 |\\n\\n(1)Reflects income determined on a FTE basis. See footnote (1) to Table 14 and 15 in this Report for the related adjustments.\\n(2)Loans include portfolio loans and nonaccrual loans; however, unpaid interest on nonaccrual loans has not been included for purposes of determining interest income.\\n80\\nProvision For Credit Losses The provision for credit losses represents the charge to expense that is required to maintain an appropriate level of allowance for credit losses. The Company recorded a $3.0 million and a $1.0 million provision for credit losses for the three and nine months ended September 30, 2022, respectively, as compared to releases of provision for credit losses of $10.0 million and $17.5 million for the three and nine months ended September 30, 2021, respectively. The Company’s allowance for credit losses, as a percentage of total loans, was 1.08% at both September 30, 2022 and December 31, 2021, and 1.05% at September 30, 2021. The Company recorded net charge-offs of $6,000 and $609,000 for the three and nine months ended September 30, 2022, respectively, as compared to net charge-offs of $111,000 and $3.6 million for the three and nine months ended September 30, 2021, respectively. Refer to Note 4 \\\"Loans, Allowance for Credit Losses and Credit Quality\\\" within the Note to Consolidated Financial Statements included in Part I. Item 1 of this Report, for further details surrounding the primary drivers of the provision for credit losses for the period.\\nNoninterest Income The following table sets forth information regarding noninterest income for the periods shown:\\nTable 17 - Noninterest Income\\n| Three Months Ended |\\n| September 30 | Change |\\n| 2022 | 2021 | Amount | % |\\n| (Dollars in thousands) |\\n| Deposit account fees | $ | 6,261 | $ | 4,298 | $ | 1,963 | 45.67 | % |\\n| Interchange and ATM fees | 4,331 | 3,441 | 890 | 25.86 | % |\\n| Investment management | 8,436 | 9,174 | (738) | (8.04) | % |\\n| Mortgage banking income | 585 | 2,825 | (2,240) | (79.29) | % |\\n| Gain on life insurance benefits | 477 | — | 477 | 100.00% |\\n| Increase in cash surrender value of life insurance policies | 1,883 | 1,596 | 287 | 17.98 | % |\\n| Loan level derivative income | 471 | 586 | (115) | (19.62) | % |\\n| Other noninterest income | 5,751 | 4,537 | 1,214 | 26.76 | % |\\n| Total | $ | 28,195 | $ | 26,457 | $ | 1,738 | 6.57 | % |\\n| Nine Months Ended |\\n| September 30 | Change |\\n| 2022 | 2021 | Amount | % |\\n| (Dollars in thousands) |\\n| Deposit account fees | $ | 17,582 | $ | 11,704 | $ | 5,878 | 50.22 | % |\\n| Interchange and ATM fees | 11,967 | 9,229 | 2,738 | 29.67 | % |\\n| Investment management | 26,438 | 26,350 | 88 | 0.33 | % |\\n| Mortgage banking income | 2,989 | 11,270 | (8,281) | (73.48) | % |\\n| Gain on life insurance benefits | 600 | 258 | 342 | 132.56 | % |\\n| Increase in cash surrender value of life insurance policies | 5,549 | 4,508 | 1,041 | 23.09 | % |\\n| Loan level derivative income | 1,511 | 875 | 636 | 72.69 | % |\\n| Other noninterest income | 15,729 | 12,476 | 3,253 | 26.07 | % |\\n| Total | $ | 82,365 | $ | 76,670 | $ | 5,695 | 7.43 | % |\\n\\nThe primary reasons for the variances in the noninterest income categories for the three and nine months ended September 30, 2022 as compared to the respective prior year periods shown in the preceding table include:\\n•Deposit account fees and interchange and ATM fees increased for the three and nine months ended September 30, 2022 in comparison to the same prior year periods driven primarily by increased transaction volume attributable to the larger customer base as a result of the Meridian acquisition.\\n81\\n•Investment management income decreased for the three months ended September 30, 2022, driven primarily by a decline in overall asset valuations and was consistent for the nine months ended September 30, 2022, as compared to the prior year period, primarily due to a higher volume of new asset inflows, which were offset by depressed market valuations.\\n•Mortgage banking income decreased for the three and nine months ended September 30, 2022 in comparison to the prior year periods, due primarily to overall reduced activity resulting from increased interest rates and a greater portion of new originations being retained in the Company's portfolio versus being sold in the secondary market during 2022.\\n•The cash surrender value of life insurance policies increased primarily due to the impact of policies acquired from Meridian.\\n•The changes in loan level derivative income primarily reflect customer demand during the respective periods.\\n•Other noninterest income increased for the three and nine months ended September 30, 2022, primarily attributable to increases in rental income from equipment leases, foreign currency exchange fees, credit card fee income, discounted purchases of Massachusetts historical tax credits, and a gain on the sale of a vacated office space recently acquired during the Meridian acquisition, partially offset by decreases in loan fees and income from like-kind exchanges.\\n82\\nNoninterest Expense The following table sets forth information regarding non-interest expense for the periods shown:\\nTable 18 - Noninterest Expense\\n| Three Months Ended |\\n| September 30 | Change |\\n| 2022 | 2021 | Amount | % |\\n| (Dollars in thousands) |\\n| Salaries and employee benefits | $ | 52,708 | $ | 42,235 | $ | 10,473 | 24.80 | % |\\n| Occupancy and equipment expenses | 12,316 | 8,564 | 3,752 | 43.81 | % |\\n| Data processing & facilities management | 2,259 | 1,673 | 586 | 35.03 | % |\\n| Consulting expense | 2,547 | 1,560 | 987 | 63.27 | % |\\n| Software maintenance | 2,497 | 2,018 | 479 | 23.74 | % |\\n| Amortization of intangible assets | 1,898 | 1,310 | 588 | 44.89 | % |\\n| Debit card expense | 1,936 | 1,347 | 589 | 43.73 | % |\\n| FDIC assessment | 1,677 | 980 | 697 | 71.12 | % |\\n| Merger and acquisition expenses | — | 1,943 | (1,943) | (100.00) | % |\\n| Other noninterest expenses | 14,890 | 10,789 | 4,101 | 38.01 | % |\\n| Total | $ | 92,728 | $ | 72,419 | $ | 20,309 | 28.04 | % |\\n| Nine Months Ended |\\n| September 30 | Change |\\n| 2022 | 2021 | Amount | % |\\n| (Dollars in thousands) |\\n| Salaries and employee benefits | $ | 150,957 | $ | 124,759 | $ | 26,198 | 21.00 | % |\\n| Occupancy and equipment expenses | 37,255 | 26,543 | 10,712 | 40.36 | % |\\n| Data processing & facilities management | 6,878 | 5,024 | 1,854 | 36.90 | % |\\n| Merger and acquisition expenses | 7,100 | 3,674 | 3,426 | 93.25 | % |\\n| Software maintenance | 7,706 | 5,903 | 1,803 | 30.54 | % |\\n| Consulting expense | 7,057 | 5,443 | 1,614 | 29.65 | % |\\n| Amortization of intangible assets | 5,801 | 4,037 | 1,764 | 43.70 | % |\\n| Debit card expense | 5,562 | 3,693 | 1,869 | 50.61 | % |\\n| FDIC assessment | 5,225 | 2,805 | 2,420 | 86.27 | % |\\n| Other noninterest expenses | 45,249 | 33,522 | 11,727 | 34.98 | % |\\n| Total | $ | 278,790 | $ | 215,403 | $ | 63,387 | 29.43 | % |\\n\\nThe primary reasons for the variances in the noninterest expense categories for the three and nine months ended September 30, 2022 as compared to the respective prior year periods shown in the preceding table include:\\n•The increase in salaries and employee benefits was primarily attributable to the Company's increased workforce base following the Meridian acquisition.\\n•Occupancy and equipment expenses increased year-over-year, primarily driven by costs associated with the Company's expanded branch network, real estate and other fixed assets resulting from the Meridian acquisition, as well as increased depreciation expense on leased equipment.\\n•Data processing and facilities management expenses increased primarily due to the timing of certain initiatives and general increases associated with higher transaction volumes.\\n•The Company incurred merger and acquisition costs related to the Meridian acquisition of $7.1 million during the first quarter of 2022, primarily related to lease terminations associated with exited branch locations, along with\\n83\\nadditional integration costs and professional fees. Meridian related merger and acquisition costs were also incurred, to a lesser extent, during the nine months ended September 30, 2021, leading up to deal close during the fourth quarter of 2021.\\n•Software maintenance increased primarily due to the Company's continued investment in its technology infrastructure.\\n•FDIC assessment increased primarily due to an increased assessment base resulting from the Meridian acquisition.\\n•Consulting expense increased for the three and nine months ended September 30, 2022, primarily due to rollout of strategic initiatives during such periods.\\n•Other noninterest expense increased for the three and nine months ended September 30, 2022, primarily due to three full quarters of general increases associated with the Meridian acquisition, elevated unrealized losses on equity securities, and increased marketing and public relations costs.\\nIncome Taxes The tax effect of all income and expense transactions is recognized by the Company in each year’s consolidated statements of income, regardless of the year in which the transactions are reported for income tax purposes. The following table sets forth information regarding the Company’s tax provision and applicable tax rates for the periods indicated:\\nTable 19 - Tax Provision and Applicable Tax Rates\\n| Three Months Ended | Nine Months Ended |\\n| September 30 | September 30 |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (Dollars in thousands) |\\n| Combined federal and state income tax provision | $ | 23,171 | $ | 14,122 | $ | 60,699 | $ | 38,506 |\\n| Effective income tax rate | 24.37 | % | 26.09 | % | 24.53 | % | 24.40 | % |\\n| Blended statutory tax rate | 27.11 | % | 27.92 | % | 27.11 | % | 27.92 | % |\\n\\nThe Company’s effective tax rate in 2022 thus far is higher as compared to the year ago period primarily due to higher pre-tax income, as well as the impact of discrete items, including tax benefits related to low income housing tax credits and equity compensation. The effective tax rates in the table above are lower than the blended statutory tax rates due to the aforementioned discrete items as well as certain tax preference assets such as life insurance policies, tax exempt bonds, and federal tax credits.\\nThe Company invests in various low income housing projects, which are real estate limited partnerships that acquire, develop, own and operate low and moderate-income housing developments. As a limited partner in these operating partnerships, the Company will receive tax credits and tax deductions for losses incurred by the underlying properties. The investments are accounted for using the proportional amortization method and will be amortized over various periods through 2039, which represents the period that the tax credits and other tax benefits will be utilized. The total committed investment in these partnerships is $183.9 million, of which $120.9 million had been funded as of September 30, 2022. It is expected that the limited partnership investments will generate a net tax benefit of approximately $3.3 million for the fiscal year 2022 and a total of $23.7 million over the remaining life of the investments from the combination of the tax credits and operating losses.\\nRisk Management\\nThe Board of Directors has approved an Enterprise Risk Management Policy and Risk Appetite Statement to state the Company’s goals and objectives in identifying, measuring, and managing the risks associated with the Company’s current and near future anticipated size and complexity. Management is responsible for comprehensive enterprise risk management, and continually strives to adopt and implement practices that strike an appropriate balance between risk and reward and permit the achievement of strategic goals in a controlled environment.\\nThe Company has implemented the “three lines of defense” enterprise risk management model. The first line of defense are the executives in charge of business units, operational areas, and corporate functions who, sometimes assisted by management committees, teams, and working groups, own and manage risks. The second line of defense is the Chief Risk Officer and the risk department, who monitor and provide advice with respect to first line risk management. The third line of\\n84\\ndefense is independent assurance performed by the Chief Internal Auditor, who reports to the Audit Committee of the Company's Board of Directors, and by the Company's internal audit department.\\nThe Board of Directors, with the assistance of its Risk Committee, oversees management’s enterprise risk management practices. As risks must be taken to create value, the Board of Directors has defined the acceptable residual risk tolerances for the Company and the eight major risk types identified as having the potential to create significant adverse impacts on the Company, such as financial losses, reputational damage, legal or regulatory actions, nonachievement of strategic objectives, diminished customer experience, and/or cultural erosion. The eight major risk types identified by the Company and addressed in the Risk Appetite Statement are strategic risk, culture risk, credit risk, liquidity risk, interest rate risk, operational risk, technology risk, and reputation risk, each of which is discussed below.\\nStrategic Risk Strategic risk is the risk arising from adverse strategic or business decisions, misalignment of strategic direction with the Company’s mission and values, failure to execute strategies or tactics, or an inadequate adaptation or lack of responsiveness to industry and/or operating environment changes. Management seeks to mitigate strategic risk through strategic planning, frequent executive review of strategic plan progress, monitoring of competitors and technology, assessment of new products, new branches, and new business initiatives, customer advocacy, and crisis management planning.\\nCulture Risk Culture risk is the risk arising from failed leadership and/or ineffective colleague engagement and workplace management that causes the Company to lose sight of core values and, through acts or omissions, damage the relationship-based culture which has been one of the foundations of the Company’s consistent success. Management mitigates culture risk through effective employee relations, leadership that encourages continuous improvement, cultural development and reinforcement of core values, communication of clear ethical and behavioral standards, consistent enforcement of policies and programs, discipline of misbehavior, alignment of incentives and compensation, and by promoting diversity, equity, and inclusion.\\nCredit Risk Credit risk is the risk arising from the failure of a borrower or a counterparty to a contract to make payments as agreed, and includes the risks arising from inadequate collateral and mismanagement of loan concentrations. While the collateral securing loans may be sufficient in some cases to recover the amount due, in other cases the Company may experience significant credit losses which could have an adverse effect on its operating results. The Company makes assumptions and judgments about the collectability of its loan portfolio, including the creditworthiness of its borrowers and counterparties and the value of collateral for the repayment of loans. For further discussion regarding the credit risk and the credit quality of the Company’s loan portfolio, see Note 4, “Loans, Allowance for Credit Losses and Credit Quality” within the Notes to Consolidated Financial Statements included in Part I. Item 1 of this Report.\\nLiquidity Risk Liquidity risk is the risk arising from the Company being unable to meet obligations when due. Liquidity risk includes the inability to access funding sources or manage fluctuations in available funding levels. Liquidity risk also results from a failure to recognize or address market condition changes that affect the ability to liquidate assets quickly with minimal value loss.\\nThe Company’s primary sources of funds are deposits, borrowings, and the amortization, prepayment, and maturities of loans and securities. The Bank utilizes its extensive branch network to access retail customers who provide a base of in-market core deposits. These funds are principally comprised of demand deposits, interest checking accounts, savings accounts, and money market accounts. Deposit levels are greatly influenced by interest rates, economic conditions, and competitive factors.\\nThe Company’s primary measure of short-term liquidity is the Total Basic Surplus/Deficit as a percentage of assets. This ratio, which is an analysis of the relationship between liquid assets plus available Federal Home Loan Bank funding, less short-term liabilities relative to total assets, was within policy limits at September 30, 2022. The Total Basic Surplus/Deficit measure is affected primarily by changes in deposits, securities and short-term investments, loans, and borrowings. An increase in deposits, without a corresponding increase in nonliquid assets, will improve the Total Basic Surplus/Deficit measure, whereas, an increase in loans, with no increase in deposits, will decrease the measure. Other factors affecting the Total Basic Surplus/Deficit include Federal Home Loan Bank collateral requirements, securities portfolio changes, and the mix of deposits.\\nThe Company seeks to increase deposits without adversely impacting its weighted average funding cost. The Company also maintains a variety of liquidity sources, including Federal Home Loan Bank advances, Federal Reserve borrowing capacity, and repurchase agreement lines. These funding sources serve as a contingent source of liquidity and, when profitable lending and investment opportunities exist, the Company may access them to provide the liquidity needed to grow the balance sheet. The amount and type of assets that the Company has available to pledge impacts the Company's Federal Home Loan Bank and Federal Reserve borrowing capacity. For example, a prime one-to-four family residential loan may provide 75 cents of borrowing capacity for every $1.00 pledged, whereas a pledged commercial loan may increase borrowing capacity in a lower amount. The Company’s lending decisions, therefore, can also affect its liquidity position.\\n85\\nThe Company can also raise additional funds through the issuance of equity or unsecured debt privately or publicly and has done so in the past. Additionally, the Company is able to enter into repurchase agreements or acquire brokered deposits at its discretion. The availability and cost of equity or debt on an unsecured basis is dependent on many factors, including the Company’s financial position, the market environment, and the Company’s credit rating. The Company monitors the factors that could impact its ability to raise liquidity through these channels.\\nThe following table depicts current and unused liquidity capacity from various sources as of the dates indicated:\\nTable 20 - Liquidity Sources\\n| September 30, 2022 | December 31, 2021 |\\n| Outstanding | AdditionalBorrowingCapacity | Outstanding | AdditionalBorrowing Capacity |\\n| (Dollars in thousands) |\\n| Federal Home Loan Bank of Boston (1) | $ | 643 | $ | 1,739,262 | $ | 25,667 | $ | 1,622,494 |\\n| Federal Reserve Bank of Boston (2) | — | 1,206,651 | — | 1,176,486 |\\n| Unpledged Securities | — | 2,159,018 | — | 1,897,148 |\\n| Line of Credit | — | 85,000 | — | 85,000 |\\n| Long-term borrowing (3) | — | — | 14,063 | — |\\n| Junior subordinated debentures (3) | 62,855 | — | 62,853 | — |\\n| Subordinated debt (3) | 49,862 | — | 49,791 | — |\\n| Reciprocal deposits (3) | 751,133 | — | 998,121 | — |\\n| Brokered deposits (3) | 102,610 | — | 141,572 | — |\\n| $ | 967,103 | $ | 5,189,931 | $ | 1,292,067 | $ | 4,781,128 |\\n\\n(1)Loans with a carrying value of $2.6 billion and $2.3 billion at September 30, 2022 and December 31, 2021, respectively, were pledged to the Federal Home Loan Bank of Boston resulting in this additional unused borrowing capacity.\\n(2)Loans with a carrying value of $1.7 billion and $1.8 billion at September 30, 2022 and December 31, 2021, respectively, were pledged to the Federal Reserve Bank of Boston resulting in this additional unused borrowing capacity.\\n(3)The additional borrowing capacity has not been assessed for these categories.\\nIn addition to customary operational liquidity practices, the Board of Directors and management recognize the need to establish reasonable guidelines to manage a heightened liquidity risk environment. Catalysts for elevated liquidity risk can be Company-specific issues and/or systemic industry-wide events. It is therefore the responsibility of management to institute systems and controls designed to provide advanced detection of potentially significant funding shortages, establish methods for assessing and monitoring risk levels, and institute responses that may alleviate or circumvent a potential liquidity crisis. Management has established a Liquidity Contingency Plan to provide a framework to detect potential liquidity problems and appropriately address them in a timely manner. In a period of perceived heightened liquidity risk, the Liquidity Contingency Plan provides for the establishment of a Liquidity Crisis Task Force to monitor the potential for a liquidity crisis and establish and execute an appropriate response.\\nInterest Rate Risk Interest rate risk is the risk arising from changes in interest rates and the value of investments due to market conditions or other external factors or events. Interest rate risk includes market risk. The Company’s primary market risk exposure is interest rate risk.\\nInterest rate risk is the sensitivity of income to changes in interest rates. Interest rate changes, as well as fluctuations in the level and duration of assets and liabilities, affect net interest income, the Company’s primary source of revenue. Interest rate risk arises directly from the Company’s core banking activities. In addition to directly impacting net interest income, changes in the level of interest rates can also affect the amount of loans originated, the timing of cash flows on loans and securities, and the fair value of securities and derivatives, and have other effects.\\nManagement strives to control interest rate risk within limits approved by the Board of Directors that reflect the Company’s tolerance for interest rate risk over short-term and long-term horizons. The Company attempts to manage interest rate risk by identifying, quantifying, and, where appropriate, hedging exposure. If assets and liabilities do not re-price simultaneously and in equal volume, the potential for interest rate exposure exists. It is the Company's objective to maintain stability in the growth of net interest income through the maintenance of an appropriate mix of interest-earning assets and\\n86\\ninterest-bearing liabilities and, when necessary within limits management deems prudent, through the use of off-balance sheet hedging instruments such as interest rate swaps, floors, and caps.\\nThe Company quantifies its interest rate exposures using net interest income simulation models, as well as simpler gap analysis, and an Economic Value of Equity analysis. Key assumptions in these analyses relate to behavior of interest rates and behavior of the Company’s deposit and loan customers. The most material assumptions relate to the prepayment of mortgage assets (including mortgage loans and mortgage-backed securities) and the life and sensitivity of non-maturity deposits (e.g., demand deposit, negotiable order of withdrawal, savings, and money market accounts). In the case of prepayment of mortgage assets, assumptions are derived from published dealer median prepayment estimates for comparable mortgage loans. The risk of prepayment tends to increase when interest rates fall. Since future prepayment behavior of loan customers is uncertain, interest rate sensitivity of loans cannot be determined with precision and actual behavior may differ from assumptions to a significant degree.\\nBased upon the net interest income simulation models, the Company currently forecasts that assets are anticipated to re-price faster than liabilities. As a result, net interest income will be positively impacted as market rates increase and negatively impacted if market rates decrease. The Company runs several scenarios to quantify and effectively assist in managing interest rate risk, including instantaneous parallel shifts in market rates as well as gradual (12-24 months) shifts in market rates, and may also include other alternative scenarios as management deems necessary given the interest rate environment. The Company measures the annual income from each scenario and then compares it against the current year base case scenario.\\nThe relative results of all scenarios and the impact to net interest income as they compare to the year 1 base scenario are outlined in the table below:\\nTable 21 - Interest Rate Sensitivity\\n| September 30 |\\n| 2022 | 2021 |\\n| Year 1 | Year 2 | Year 1 | Year 2 |\\n| Parallel rate shocks (basis points) |\\n| -300 | (15.2) | % | (21.8) | % | n/a | n/a |\\n| -200 | (9.8) | % | (11.3) | % | n/a | n/a |\\n| -100 | (3.4) | % | 0.5 | % | (3.4) | % | (9.8) | % |\\n| +100 | 2.4 | % | 14.0 | % | 8.4 | % | 9.6 | % |\\n| +200 | 4.0 | % | 18.1 | % | 18.0 | % | 22.8 | % |\\n| +300 | 6.4 | % | 24.0 | % | 27.9 | % | 36.4 | % |\\n| +400 | 8.7 | % | 29.9 | % | 37.5 | % | 49.5 | % |\\n| Gradual rate shifts (basis points) |\\n| -200 over 12 months | (3.9) | % | (8.2) | % | n/a | n/a |\\n| -100 over 12 months | (1.5) | % | 1.6 | % | (1.4) | % | (8.0) | % |\\n| +200 over 12 months | 2.3 | % | 17.5 | % | 8.6 | % | 20.3 | % |\\n| +400 over 24 months | 2.3 | % | 20.8 | % | 8.6 | % | 31.6 | % |\\n| Alternative scenarios |\\n| Flat up 200 basis points scenario | n/a | n/a | 8.0 | % | 17.8 | % |\\n\\nThe results depicted in the table above are dependent on material assumptions. For instance, asymmetrical rate behavior can have a material impact on the simulation results. If competition for deposits prompts the Company to raise rates on those liabilities more quickly than is assumed in the simulation analysis without a corresponding increase in asset yields, net interest income would be negatively impacted. Alternatively, if the Company is able to lag increases in deposit rates as loans re-price upward, net interest income would be positively impacted.\\nThe most significant market factors affecting the Company’s net interest income during the nine months ended September 30, 2022 were the shape of the U.S. Government securities and interest rate swap yield curve, the U.S. prime interest\\n87\\nrate, LIBOR rates, the secured overnight financing rates (\\\"SOFR\\\"), and the interest rates being offered on long-term fixed rate loans.\\nThe Company manages the interest rate risk inherent in both its loan and borrowing portfolios by using interest rate swap agreements and interest rate caps and floors. An interest rate swap is an agreement in which one party agrees to pay a floating rate of interest on a notional principal amount in exchange for receiving a fixed rate of interest on the same notional amount for a predetermined period of time from the other party. Interest rate caps and floors are agreements where one party agrees to pay a floating rate of interest on a notional principal amount for a predetermined period of time to a second party if certain market interest rate thresholds are realized. While interest is paid or received in swap, cap, and floors agreements, the notional principal amount is not actually exchanged. The Company may also manage the interest rate risk inherent in its mortgage banking operations by entering into forward sales contracts under which the Company agrees to deliver whole mortgage loans to various investors. See Note 6, “Derivative and Hedging Activities” within the Notes to Consolidated Financial Statements included in Part I. Item 1 of this Report for additional information regarding the Company’s derivative financial instruments.\\nThe Company’s earnings are not directly or materially impacted by movements in foreign currency rates or commodity prices. Movements in equity prices may have a modest impact on earnings by affecting the volume of activity or the amount of fees from investment-related business lines. See Note 3, “Securities” within the Notes to Consolidated Financial Statements included in Part I. Item 1 of this Report.\\nOperational Risk Operational risk is the risk arising from human error or misconduct, transaction errors or delays, inadequate or failed internal systems or processes, data unavailability, loss, or poor quality, or adverse external events. Operational risk includes business resiliency risk, consumer compliance risk, data governance risk, fraud risk, legal risk, model risk, regulatory compliance risk, and third party vendor risk. Potential operational risk exposure exists throughout the Company. The continued effectiveness of colleagues, technical systems, operational infrastructure, and relationships with key third party service providers are integral to mitigating operational risk, and any shortcomings subject the Company to risks that vary in size, scale and scope. Operational risks include operational failures, unlawful tampering, terrorist activities, ineffectiveness or exposure due to interruption in third party support, as well as the loss of key individuals or a failure of key individuals to perform properly.\\nTechnology Risk Technology risk is the risk of losses or other impacts arising from the failure of technology systems to function in accordance with expectations and business requirements. Technology risk includes information technology risk, information security risk, and cyber security.\\nReputation Risk Reputational risk is the risk arising from negative public opinion of the Company and the Bank. Management seeks to mitigate reputation risk through actions that include a structured process of customer complaint resolution and ongoing reputational monitoring.\\nContractual Obligations, Commitments, Contingencies, and Off-Balance Sheet Financial Information\\nOff-Balance Sheet Arrangements There were no material changes in off-balance sheet financial instruments during the three months ended September 30, 2022.\\nSee Note 6, \\\"Derivative and Hedging Activities\\\" and Note 10, \\\"Commitments and Contingencies\\\" within the Notes to Consolidated Financial Statements included in Part I. Item 1 of this Report for more information relating to the Company's other off-balance sheet financial instruments.\\nContractual Obligations, Commitments, and Contingencies There were no material changes in contractual obligations, commitments, or contingencies during the three months ended September 30, 2022.\\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\\nInformation required by this Item 3 is included in the \\\"Risk Management\\\" section of Part I. Item 2 \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations\\\" of this Report and is incorporated herein by reference.\\n88\\nItem 4. Controls and Procedures\\nConclusion Regarding the Effectiveness of Disclosure Controls and Procedures. The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer along with the Company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as such term is defined under Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Based upon that evaluation, the Company’s Chief Executive Officer along with the Company’s Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.\\nChanges in Internal Control over Financial Reporting. There were no changes in the Company's internal control over financial reporting that occurred during the third quarter of 2022 that have materially affected or are reasonably likely to materially affect the Company’s internal control over financial reporting.\\nPART II. OTHER INFORMATION\\nItem 1. Legal Proceedings\\nAt September 30, 2022, the Bank was involved in pending lawsuits that arose in the ordinary course of business. Management has reviewed these pending lawsuits with legal counsel and has taken into consideration the view of counsel as to their outcome. In the opinion of management, the final disposition of pending lawsuits is not expected to have a material adverse effect on the Company’s financial position or results of operations.\\nItem 1A. Risk Factors\\nThe section titled Risk Factors in Part I, Item 1A of the 2021 Form 10-K includes a discussion of the material risks and uncertainties the Company faces, any one or more of which could have a material adverse effect on the Company's business, results of operations, or financial condition (including capital and liquidity). As of the date of this Report, there have been no material changes with regard to the Risk Factors disclosed in Item 1A of the 2021 Form 10-K which are incorporated herein by reference.\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\\n(a) Not applicable.\\n(b) Not applicable.\\n(c) The following table sets forth information regarding the Company’s repurchases of its common stock during the three months ended September 30, 2022:\\n| Issuer Purchases of Equity Securities |\\n| Total Number of Shares Purchased (1) | Average Price Paid Per Share | Total Number ofShares Purchased asPart of PubliclyAnnounced Plan orProgram (2) | Maximum Number of Shares (or Approximate Dollar Value) That May Yet Be Purchased Under the Plan or Program (2) |\\n| Period |\\n| July 1 to July 31, 2022 | 177,327 | $ | 79.25 | 177,327 | $ | 20,648,057 |\\n| August 1 to August 31, 2022 | 111,433 | $ | 78.98 | 111,433 | $ | 11,847,362 |\\n| September 1 to September 30, 2022 | 154,212 | $ | 76.48 | 154,212 | $ | — |\\n| Total | 442,972 | $ | 78.22 | 442,972 |\\n\\n(1)Of these shares, none were surrendered in connection with the exercise and/or vesting of equity compensation grants to satisfy related tax withholding obligations.\\n(2)On January 20, 2022, the Company announced that its Board of Directors authorized a share repurchase program of up to $140 million in shares of the Company's common stock. The 154,212 shares repurchased under the program in September 2022 represented the balance of the $140 million in shares repurchased, completing the program.\\nOn October 20, 2022, the Company announced the commencement of a new stock repurchase plan which authorizes repurchases by the Company of up to $120 million in common stock. Repurchases under the new plan may be made from time to time on the open market and in privately negotiated transactions, including through the use of trading plans intended to qualify under Rule 10b5-1 under the Exchange Act. The extent to which the Company repurchases shares and the size and timing of these repurchases will depend on a variety of factors, including pricing, market and economic conditions, the Company’s capital position and amount of retained earnings and legal and contractual requirements. The\\n89\\nrepurchase plan is scheduled to expire October 19, 2023 and may be modified, suspended or discontinued without prior notice at any time.\\nItem 3. Defaults Upon Senior Securities -\\nNone.\\nItem 4. Mine Safety Disclosures -\\nNot Applicable.\\nItem 5. Other Information -\\nNone.\\nItem 6. Exhibits\\nExhibit Index\\n\\n| No. | Exhibit |\\n\\n| 31.1 | Section 302 Certification of Sarbanes-Oxley Act of 2002 is attached hereto.* |\\n| 31.2 | Section 302 Certification of Sarbanes-Oxley Act of 2002 is attached hereto.* |\\n| 32.1 | Section 906 Certification of Sarbanes-Oxley Act of 2002 is attached hereto.+ |\\n| 32.2 | Section 906 Certification of Sarbanes-Oxley Act of 2002 is attached hereto.+ |\\n| 101 | The instance document does not appear in the interactive data file because its XBRL tags are embedded within the inline XBRL document.* |\\n| 104 | Cover page interactive data file (formatted as inline XBRL and contained in Exhibit 101).* |\\n\\n| * | Filed herewith |\\n\\n| + | Furnished herewith |\\n\\n90\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\nINDEPENDENT BANK CORP.\\n(registrant)\\n\\n| November 3, 2022 | /s/ Christopher Oddleifson |\\n| Christopher OddleifsonPresident andChief Executive Officer(Principal Executive Officer) |\\n\\n\\n| November 3, 2022 | /s/ Mark J. Ruggiero |\\n| Mark J. RuggieroChief Financial Officer (Principal Financial Officer) |\\n\\n91\\n \\n\\nWhat is the percentage increase of the net income after provision for credit losses for the three months ended September 30, from 2021 to 2022?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 59.455895135426765.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 68,\n \"input_length\": 77042\n}"}}},{"rowIdx":69,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nPART I—FINANCIAL INFORMATION\nItem 1. Financial Statements.\nTALKSPACE, INC.\nCONDENSED CONSOLIDATED BALANCE SHEETS\n\n| June 30, 2023 | December 31, 2022 |\n| (U.S. dollars in thousands, except share and per share data) | (Unaudited) |\n| ASSETS | |\n| CURRENT ASSETS: | | |\n| Cash and cash equivalents | $ | 126,104 | $ | 138,545 |\n| Accounts receivable, net | 8,420 | 9,640 |\n| Other current assets | 2,920 | 4,372 |\n| Total current assets | 137,444 | 152,557 |\n| Property and equipment, net | 456 | 677 |\n| Intangible assets, net | 2,157 | 2,529 |\n| Other long-term assets | 464 | 491 |\n| Total assets | $ | 140,521 | $ | 156,254 |\n| LIABILITIES AND STOCKHOLDERS’ EQUITY | | |\n| CURRENT LIABILITIES: | | |\n| Accounts payable | $ | 5,484 | $ | 6,461 |\n| Deferred revenues | 3,683 | 4,355 |\n| Accrued expenses and other current liabilities | 10,444 | 16,502 |\n| Total current liabilities | 19,611 | 27,318 |\n| Warrant liabilities | 820 | 939 |\n| Other long-term liabilities | 295 | 461 |\n| Total liabilities | 20,726 | 28,718 |\n| Commitments and contingencies (Note 5) |\n| STOCKHOLDERS’ EQUITY: | | |\n| Common stock of $ 0.0001 par value — Authorized: 1,000,000,000 shares at June 30, 2023 and December 31, 2022; Issued and outstanding: 166,204,295 and 161,155,030 shares at June 30, 2023 and December 31, 2022, respectively | 16 | 16 |\n| Additional paid-in capital | 384,443 | 378,722 |\n| Accumulated deficit | ( 264,664 | ) | ( 251,202 | ) |\n| Total stockholders’ equity | 119,795 | 127,536 |\n| Total liabilities and stockholders’ equity | $ | 140,521 | $ | 156,254 |\n\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\n3\nTALKSPACE, INC.\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\n(Unaudited)\n\n| Three Months Ended | Six Months Ended |\n| June 30, | June 30, |\n| (U.S. dollars in thousands, except share and per share data) | 2023 | 2022 | 2023 | 2022 |\n| Revenues | $ | 35,645 | $ | 29,844 | $ | 68,981 | $ | 59,994 |\n| Cost of revenues | 17,833 | 15,297 | 34,421 | 30,426 |\n| Gross profit | 17,812 | 14,547 | 34,560 | 29,568 |\n| Operating expenses: |\n| Research and development, net | 4,171 | 5,576 | 9,524 | 10,611 |\n| Clinical operations, net | 1,675 | 2,316 | 3,276 | 4,092 |\n| Sales and marketing | 13,045 | 18,931 | 26,514 | 40,339 |\n| General and administrative | 5,329 | 8,792 | 10,693 | 16,802 |\n| Total operating expenses | 24,220 | 35,615 | 50,007 | 71,844 |\n| Operating loss | ( 6,408 | ) | ( 21,068 | ) | ( 15,447 | ) | ( 42,276 | ) |\n| Financial (income) expense, net | ( 1,712 | ) | 1,865 | ( 2,136 | ) | 996 |\n| Loss before taxes on income | ( 4,696 | ) | ( 22,933 | ) | ( 13,311 | ) | ( 43,272 | ) |\n| Taxes on income | 8 | 89 | 151 | 110 |\n| Net loss | $ | ( 4,704 | ) | $ | ( 23,022 | ) | $ | ( 13,462 | ) | $ | ( 43,382 | ) |\n| Net loss per share: |\n| Basic and Diluted | $ | ( 0.03 | ) | $ | ( 0.15 | ) | $ | ( 0.08 | ) | $ | ( 0.28 | ) |\n| Weighted average number of common shares used in computing basic and diluted net loss per share: |\n| Basic and Diluted | 164,195,697 | 155,709,901 | 163,003,363 | 154,901,165 |\n\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\n4\nTALKSPACE, INC.\nCONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY\n(Unaudited)\n\n| (U.S. dollars in thousands, except share data) | Common Stock |\n| Three and Six Months Ended June 30, 2023 | Number of SharesOutstanding | Amount | Additional paid-incapital | Accumulateddeficit | Total |\n| Balance as of December 31, 2022 | 161,155,030 | $ | 16 | $ | 378,722 | $ | ( 251,202 | ) | $ | 127,536 |\n| Exercise of stock options | 1,739,265 | *) | 621 | — | 621 |\n| Restricted stock units vested, net of tax | 225,050 | *) | ( 65 | ) | — | ( 65 | ) |\n| Stock-based compensation | — | — | 2,303 | — | 2,303 |\n| Net loss | — | — | — | ( 8,758 | ) | ( 8,758 | ) |\n| Balance as of March 31, 2023 (unaudited) | 163,119,345 | $ | 16 | $ | 381,581 | $ | ( 259,960 | ) | $ | 121,637 |\n| Exercise of stock options | 1,837,734 | *) | 869 | — | 869 |\n| Restricted stock units vested, net of tax | 1,247,216 | *) | ( 136 | ) | — | ( 136 | ) |\n| Stock-based compensation | — | — | 2,129 | — | 2,129 |\n| Net loss | — | — | — | ( 4,704 | ) | ( 4,704 | ) |\n| Balance as of June 30, 2023 (unaudited) | 166,204,295 | $ | 16 | $ | 384,443 | $ | ( 264,664 | ) | $ | 119,795 |\n| Common Stock |\n| Three and Six Months Ended June 30, 2022 | Number of SharesOutstanding | Amount | Additional paid-incapital | Accumulateddeficit | Total |\n| Balance as of December 31, 2021 | 152,862,447 | $ | 15 | $ | 363,788 | $ | ( 171,530 | ) | $ | 192,273 |\n| Exercise of stock options | 2,164,870 | *) | 2,063 | — | 2,063 |\n| Restricted stock units vested, net of tax | 77,338 | *) | ( 67 | ) | — | ( 67 | ) |\n| Stock-based compensation | — | — | 2,368 | — | 2,368 |\n| Net loss | — | — | — | ( 20,360 | ) | ( 20,360 | ) |\n| Balance as of March 31, 2022 (unaudited) | 155,104,655 | $ | 15 | $ | 368,152 | $ | ( 191,890 | ) | $ | 176,277 |\n| Exercise of stock options | 1,092,515 | *) | 286 | — | 286 |\n| Restricted stock units vested, net of tax | 1,175,446 | *) | ( 126 | ) | — | ( 126 | ) |\n| Stock-based compensation | — | — | 3,839 | — | 3,839 |\n| Net loss | — | — | — | ( 23,022 | ) | ( 23,022 | ) |\n| Balance as of June 30, 2022 (unaudited) | 157,372,616 | $ | 15 | $ | 372,151 | $ | ( 214,912 | ) | $ | 157,254 |\n\n*) Represents an amount lower than $1\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\n5\nTALKSPACE, INC.\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(Unaudited)\n\n| Six Months EndedJune 30, |\n| (U.S. dollars in thousands) | 2023 | 2022 |\n| Cash flows from operating activities: |\n| Net loss | $ | ( 13,462 | ) | $ | ( 43,382 | ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: |\n| Depreciation and amortization | 608 | 697 |\n| Stock-based compensation | 4,432 | 6,207 |\n| Remeasurement of warrant liabilities | ( 119 | ) | 1,217 |\n| Decrease (increase) in accounts receivable | 1,220 | ( 1,650 | ) |\n| Decrease in other current assets | 1,452 | 5,622 |\n| (Decrease) increase in accounts payable | ( 977 | ) | 381 |\n| Decrease in deferred revenues | ( 672 | ) | ( 1,236 | ) |\n| Decrease in accrued expenses and other current liabilities | ( 6,058 | ) | ( 1,145 | ) |\n| Other | ( 172 | ) | 178 |\n| Net cash used in operating activities | ( 13,748 | ) | ( 33,111 | ) |\n| Cash flows from investing activities: |\n| Purchase of property and equipment | ( 10 | ) | ( 160 | ) |\n| Proceeds from sale of property and equipment | 28 | — |\n| Net cash provided by (used in) investing activities | 18 | ( 160 | ) |\n| Cash flows from financing activities: |\n| Proceeds from exercise of stock options | 1,490 | 2,349 |\n| Payments for employee taxes withheld related to vested stock-based awards | ( 201 | ) | ( 67 | ) |\n| (Payments) proceeds from reverse capitalization, net of transaction costs | — | ( 645 | ) |\n| Net cash provided by financing activities | 1,289 | 1,637 |\n| Net decrease in cash and cash equivalents | ( 12,441 | ) | ( 31,634 | ) |\n| Cash and cash equivalents at the beginning of the period | 138,545 | 198,256 |\n| Cash and cash equivalents at the end of the period | $ | 126,104 | $ | 166,622 |\n| Supplemental cash flow data: |\n| Cash paid during the period for income taxes | $ | 176 | $ | 97 |\n\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\n6\nTALKSPACE, INC.\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(Unaudited)\nNOTE 1. DESCRIPTION OF ORGANIZATION AND BUSINESS OPERATIONS Talkspace, Inc. (together with its consolidated subsidiaries, the “Company” or “Talkspace”) is a leading behavioral healthcare company enabled by a purpose-built technology platform. Talkspace provides individuals and licensed therapists, psychologists and psychiatrists with an online platform for one-on-one therapy delivered via messaging, audio and video. The Company offers convenient and affordable access to a fully credentialed network of highly qualified providers. Since its inception, the Company has connected millions of patients with licensed behavioral health providers across a wide and growing spectrum of care through virtual counseling, psychotherapy, and psychiatry. The Company's principal executive office is located in New York, NY. The Company has three wholly owned subsidiaries, Talkspace LLC, Talkspace Network LLC and Groop Internet Platform LTD. In addition, the Company holds a variable interest in one professional association and six professional corporations, which have been established pursuant to the requirements of their respective domestic jurisdiction governing the corporate practice of medicine. See Note 10, “Variable Interest Entities,” in these notes to the condensed consolidated financial statements for further details.\nNOTE 2. SIGNIFICANT ACCOUNTING POLICIES Basis of presentationThe unaudited condensed consolidated financial statements and accompanying notes have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”). In management’s opinion, the unaudited condensed consolidated financial statements reflect all adjustments of a normal recurring nature that are necessary for a fair presentation of the results for the interim periods presented. The Company’s interim period results do not necessarily indicate the results that may be expected for any other interim period or for the full fiscal year. These condensed consolidated financial statements should be read in conjuction with the consolidated financial statements as of and for the year ended December 31, 2022 included in the Company's Annual Report on Form 10-K for the year ended December 31, 2022. The significant accounting policies applied in the annual consolidated financial statements of the Company as of December 31, 2022, have been applied consistently in these unaudited condensed consolidated financial statements, unless otherwise stated. Intercompany transactions and balances have been eliminated in the preparation of the condensed consolidated financial statements. Use of estimatesThe preparation of financial statements in conformity with U.S. GAAP requires management to make estimates, judgments, and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, together with amounts disclosed in the related notes to the condensed consolidated financial statements. The Company’s significant estimates and assumptions used in these condensed consolidated financial statements include, but are not limited to, the recognition and disclosure of contingent liabilities, revenue recognition, stock-based compensation awards and the fair value of warrant liabilities. The Company bases its estimates on historical factors, current circumstances and the experience and judgment of management. The Company evaluates its assumptions on an ongoing basis. The Company’s management believes that the estimates, judgments, and assumptions used are reasonable based on information available at the time they are made. Estimates, by their nature, are based on judgment and available information, therefore, actual results could be materially different from these estimates. Reclassification Certain prior year amounts have been reclassified to conform to current year presentation . Recently Issued and Adopted Accounting PronouncementsThe Company has reviewed recent accounting pronouncements and concluded that they are either not applicable to its business or that no material effect is expected on the condensed consolidated financial statements as a result of their future adoption.\n7\n| Unaudited | Three Months Ended June 30, | | Six Months Ended June 30, |\n| (in thousands) | 2023 | 2022 | 2023 | 2022 |\n| Revenues from sales to unaffiliated customers: | |\n| Payor revenue | $ | 18,539 | $ | 7,880 | $ | 33,350 | $ | 15,990 |\n| DTE revenue | 8,039 | 6,685 | 16,715 | 12,346 |\n| Total B2B revenue | 26,578 | 14,565 | 50,065 | 28,336 |\n| Consumer revenue | 9,067 | 15,279 | | 18,916 | 31,658 |\n| Total revenue | $ | 35,645 | $ | 29,844 | | $ | 68,981 | $ | 59,994 |\n\n| Level 3 Liabilities (unaudited) |\n| For the Three Months Ended June 30, 2023 |\n| (in thousands) | Beginning Balance | Change in Fair Value | Ending Balance |\n| Private Placement Warrants | $ | 1,128 | $ | ( 308 | ) | $ | 820 |\n| For the Six Months Ended June 30, 2023 |\n| (in thousands) | Beginning Balance | Change in Fair Value | Ending Balance |\n| Private Placement Warrants | $ | 939 | $ | ( 119 | ) | $ | 820 |\n| Level 3 Liabilities (unaudited) |\n| For the Three Months Ended June 30, 2022 |\n| (in thousands) | Beginning Balance | Change in Fair Value | Ending Balance |\n| Private Placement Warrants | $ | 3,195 | $ | 2,092 | $ | 5,287 |\n| For the Six Months Ended June 30, 2022 |\n| (in thousands) | Beginning Balance | Change in Fair Value | Ending Balance |\n| Private Placement Warrants | $ | 4,070 | $ | 1,217 | $ | 5,287 |\n\n9\nNOTE 5. COMMITMENTS AND CONTINGENT LIABILITIES LitigationIn January 2022, the Company and certain of its current and former officers and directors were named as defendants in securities class action complaints filed in the United States District Court for the Southern District of New York under the case headings: (1) Baron v. Talkspace et al., No. 22-cv-00163 (S.D.N.Y.) and (2) Valdez v. Talkspace et al., No. 22-cv-00840 (S.D.N.Y.), which were subsequently consolidated under the caption In re Talkspace, Inc. Securities Litigation, No. 22-cv-00163 (S.D.N.Y) (the “Securities Action”). The Securities Action asserts violations of sections 10(b), 14(a) and 20(a) of the Securities Exchange Act of 1934 and SEC Rules 10b-5 and 14a-9 promulgated thereunder. These actions generally relate to public disclosures and statements by the Company in connection with its merger with Hudson Executive Investment Corp. (“HEIC”). In December 2022, the Company’s subsidiary Tailwind Merger Sub II, LLC, certain of the Company’s current and former directors and officers, and others were named as defendants in a putative class action complaint filed in the Delaware Court of Chancery under the case caption Valdez v. Braunstein, et al., C.A. No. 2022-1148 (Del. Ch.) (the “Delaware Action”). The Delaware Action asserts claims for breach of fiduciary duty and aiding and abetting breach of fiduciary duty relating to the merger with HEIC, among other things, based on many of the same facts at issue in the Securities Action. The complaint seeks, among other things damages on behalf of putative class members who did not redeem their shares in connection with the Company’s merger with HEIC. In February 2023, the Company resolved the Securities Action and the Delaware Action through mediation. The settlement resolves these litigations with respect to all named defendants. The settlement will have to be approved by the court, which the Company expects will occur in the third quarter of 2023. In June and July 2022, two individuals filed stockholder derivative lawsuits on behalf of Talkspace in the United States District Court for the Southern District of New York under the case captions: (1) Odsvall v. Oren Frank et al., No. 22-cv-05016 (S.D.N.Y.) and (2) Nayman v. Berg, et al., No. 22-cv-06258 (S.D.N.Y.), which were subsequently consolidated under the caption In re Talkspace Stockholder Derivative Litigation, No. 22-cv-05016 (S.D.N.Y.) in September 2022 (the “Derivative Action”). The Derivative Action named certain of the Company’s current and former officers and directors as defendants and the Company as a nominal defendant. The Derivative Action asserted claims for violations of federal securities laws, breach of fiduciary duty, and aiding and abetting breaches of fiduciary duty relating to the merger with HEIC, among other things, based on many of the same facts at issue in the Securities Action. In February 2023 the parties reached an agreement in principle to resolve the Derivative Action with respect to all named defendants in exchange for certain changes to the Company’s Corporate Governance environment, including the declassification of the Company’s board of directors, creation of a management-level disclosure committee, enhancements to the responsibilities and duties of the Company’s Audit Committee, the addition of independent directors, enhancements to employee compliance training and retention of an internal controls consultant. In addition, the Company agreed to pay or cause to be paid $ 550,000 in attorney’s fees and expenses. On May 18, 2023, the parties entered into a Stipulation of Settlement and Release Agreement (the “Stipulation”) that sets forth the terms and conditions for the proposed settlement and dismissal with prejudice of the Derivative Action (the “Settlement”). On June 30, 2023, the court entered an order preliminarily approving the Stipulation and proposed Settlement of the Derivative Action and scheduling a hearing for August 16, 2023 to determine whether to give final approval to the Settlement. The defendants have not admitted any liability or wrongdoing in connection with the Settlement and have entered into the Settlement solely to avoid the costs, risks, distraction, and uncertainties of continued litigation of the Derivative Action. In addition to the foregoing, the Company may in the future be involved in various legal proceedings, claims and litigation that arise in the normal course of business. The Company accrues for estimated loss contingencies related to legal matters when available information indicates that it is probable a liability had been incurred and the Company can reasonably estimate the amount of that loss. In many proceedings, however, it is inherently difficult to determine whether any loss is probable or even possible or to estimate the amount of any loss. In addition, even where a loss is possible or an exposure to loss exists in excess of the liability already accrued with respect to a previously recognized loss contingency, it is often not possible to reasonably estimate the size of the possible loss or range of loss or possible additional losses or range of additional losses. 10 Warranties and IndemnificationThe Company’s arrangements generally include certain provisions for indemnifying clients against liabilities if there is a breach of a client’s data or if the Company’s service infringes a third party’s intellectual property rights. To date, the Company has not incurred any material costs as a result of such indemnifications.The Company has also agreed to indemnify its directors and executive officers for costs associated with any fees, expenses, judgments, fines and settlement amounts incurred by any of these persons in any action or proceeding to which any of those persons is, or is threatened to be, made a party by reason of the person’s service as a director or officer, including any action by the Company, arising out of that person’s services as a director or officer or that person’s services provided to any other company or enterprise at the Company’s request. The Company maintains director and officer liability insurance coverage that would generally enable it to recover a portion of any future amounts paid. The Company may also be subject to indemnification obligations by law with respect to the actions of its employees under certain circumstances and in certain jurisdictions.\nNOTE 6. CAPITAL STOCK As of June 30, 2023 and December 31, 2022 there were outstanding 12,780,000 Private Placement Warrants and 21,350,000 Public Warrants to purchase the Company’s common stock at an exercise price of $ 11.50 per share. As of June 30, 2023 and December 31, 2022, no shares of preferred stock were issued or outstanding.\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| Unaudited | 2023 | 2022 | 2023 | 2022 |\n| (in thousands) |\n| Research and development, net | $ | 546 | $ | 662 | $ | 1,220 | $ | 1,208 |\n| Clinical operations, net | 126 | 79 | 246 | 201 |\n| Sales and marketing | 445 | 816 | 836 | 1,593 |\n| General and administrative | 1,012 | 2,282 | 2,130 | 3,205 |\n| Total stock-based compensation expense | $ | 2,129 | $ | 3,839 | $ | 4,432 | $ | 6,207 |\n\n11\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| Unaudited | 2023 | 2022 | 2023 | 2022 |\n| (in thousands, except share and per share data) |\n| Net loss | $ | ( 4,704 | ) | $ | ( 23,022 | ) | $ | ( 13,462 | ) | $ | ( 43,382 | ) |\n| Weighted-average shares used to compute net loss per share: |\n| Basic and Diluted | 164,195,697 | 155,709,901 | 163,003,363 | 154,901,165 |\n| Net loss per share: |\n| Basic and Diluted | $ | ( 0.03 | ) | $ | ( 0.15 | ) | $ | ( 0.08 | ) | $ | ( 0.28 | ) |\n\n| June 30, 2023 | December 31, 2022 |\n| (in thousands) | Unaudited |\n| Employee compensation | $ | 3,821 | $ | 5,290 |\n| User acquisition | 1,913 | 2,256 |\n| Litigation costs | 750 | 5,500 |\n| Professional fees | 576 | 543 |\n| Other | 3,384 | 2,913 |\n| Accrued expenses and other current liabilities | $ | 10,444 | $ | 16,502 |\n\n12\n| (in thousands) | June 30, 2023 | December 31, 2022 |\n| ASSETS | Unaudited |\n| Cash and cash equivalents | $ | 497 | $ | 883 |\n| Accounts receivable | 6,159 | 1,716 |\n| Other assets | — | 4,813 |\n| Total Assets | $ | 6,656 | $ | 7,412 |\n| LIABILITIES |\n| Accrued expenses and other current liabilities | 3,802 | 3,758 |\n| Total Liabilities | $ | 3,802 | $ | 3,758 |\n\n13\nItem 2\n. Management’s Discussion and Analysis of Financial Condition and Results of Operations.\nUnless the context otherwise requires, all references in this section as to “Talkspace,” the “Company,” “we,” “us” or “our” refer to the business of Talkspace, Inc. and its consolidated subsidiaries.\nThe following discussion and analysis of our financial condition and results of operations should be read together with the financial statements and the related notes contained in this Quarterly Report and the financial statements and related notes contained in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2022. This discussion contains forward-looking statements that reflect our plans, estimates, and beliefs that involve risks and uncertainties. As a result of many factors, such as those discussed in Part I, Item 1A, “Risk Factors” of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2022 and “Forward-Looking Statements” sections and elsewhere in this Quarterly Report, our actual results may differ materially from those anticipated in these forward-looking statements.\nThe purpose of this section is to discuss and analyze our consolidated financial condition, liquidity and capital resources and results of operations for the three and six months ended June 30, 2023 and 2022.\nOverview\nTalkspace is a healthcare company offering its members convenient and affordable access to a fully-credentialed network of highly qualified providers. We are a leading virtual behavioral health company and, since Talkspace’s founding in 2012, we have connected millions of patients with licensed mental health providers across a wide and growing spectrum of care through virtual counseling, psychotherapy and psychiatry. We created a purpose-built platform to address the vast, unmet and growing demand for mental health services of our members, serving our business-to-business (“B2B”) channel, comprised of large health plans and employee assistance programs (“Payors”) such as Aetna, Cigna, Premera and Optum and large enterprise clients (“DTE”) such as Google and Expedia (collectively, our “clients”), who offer their insured members and employees access to our platform at in-network reimbursement rates, or while their employer is under an active contract with Talkspace, where applicable, and our business-to-consumer (“Consumer”) channel, comprised of individual consumers who subscribe directly to our platform.\nAs of June 30, 2023, we had approximately 110 million B2B eligible lives and approximately 13,700 consumer active members compared to 77 million B2B eligible lives and 20,100 consumer active members as of June 30, 2022. For the three and six months ended June 30, 2023, our clinicians completed 200,500 and 372,200 B2B sessions, respectively, related to members covered under our health plan clients, as compared to 96,000 and 186,600 completed B2B sessions for the three and six months ended June 30, 2022. Please refer to the “Key Business Metrics” section below for a description of active members and B2B eligible lives.\nOperating Segments\nThe Company operates as a single segment and as one reporting unit, which is how the chief operating decision maker (who is the chief executive officer) reviews financial performance and allocates resources.\nKey Business Metrics\nWe monitor the following key metrics to help us evaluate our business, identify trends affecting our business, formulate business plans and make strategic decisions. We believe the following metrics are useful in evaluating our business:\n\n| Unaudited | Six Months EndedJune 30, |\n| (in thousands except number of health plan and enterprise clients or otherwise indicated) | 2023 | 2022 |\n| Number of B2B eligible lives at period end (in millions) | 110 | 77 |\n| Number of completed B2B sessions during the period | 372.2 | 186.6 |\n| Number of health plan clients at period end | 20 | 16 |\n| Number of enterprise clients at period end | 217 | 205 |\n| Number of Consumer active members at period end | 13.7 | 20.1 |\n\n14\nB2B Eligible Lives: We consider B2B lives “eligible” if such persons are eligible to receive treatment on the Talkspace platform, in the case of our health plan clients, at an agreed upon reimbursement rate through insurance under an employee assistance program or other network behavioral health paid benefit program. There may be instances where a person may be covered through multiple solutions, typically through behavioral health plans and employee assistance programs. In these instances, the person is counted each time they are covered in the B2B eligible lives calculation, which may cause this amount to reflect a higher number of B2B eligible lives than we actually serve.\nActive Members: We consider members “active”, in the case of our Consumer members, commencing on the date such member initiates contact with a provider on our platform until the term of their monthly, quarterly or bi-annual subscription plan expires, unless terminated early.\nComponents of Results of Operations\nRevenues\nWe contract with health insurance plans, employee assistance organizations and enterprises to provide services to individuals who are qualified to receive access to the Company’s services through the Company’s commercial arrangements. We generate revenues from payments from insured members and claims paid by their respective insurance companies and from contracted platform access fees paid to us by our enterprise clients for the delivery of therapy services to their members or employees. We recognize revenues from services provided to insured members at a point in time, as virtual therapy or psychiatry session is rendered. We recognize revenue from our enterprise clients ratably over the contractual term based primarily on a per-member-per month access fee model.\nWe also generate revenues from the sale of monthly, quarterly, bi-annual and annual membership subscriptions to the Company's therapy platform as well as supplementary a la carte offerings directly to individual consumers through a subscription plan. We recognize member subscription revenues ratably over the subscription period, beginning when therapy services commence. We recognize revenues from supplementary a la carte offerings at a point in time, as virtual therapy session is rendered. Members may cancel their subscription at any time and will receive a pro-rata refund for the subscription price.\nRevenue growth is generated from increasing our eligible covered lives through contracting with health plans, increasing utilization within eligible covered lives, expanding enterprise clients, and increasing membership subscriptions.\nCost of Revenues\nCost of revenues is comprised primarily of therapist payments. Cost of revenues is largely driven by number of sessions and the size of our provider network that is required to service the growth of our health plan and enterprise clients, in addition to the growth of our customer base.\nWe designed our business model and our provider network to be scalable and to leverage a hybrid model of both employee providers and independently contracted providers to support multiple growth scenarios. The compensation paid to our independently contracted providers is variable, and the amount paid to a provider is generally based on the amount of time committed by such provider to our members. In addition, our network supervisors have authority to approve the payment of incentive bonuses to providers with certain licenses during periods of higher demand for providers with such licenses. For our employee providers, they receive a fixed-salary and discretionary bonuses, where applicable, all of which is included in cost of revenues.\nWhile we expect to make increased investments to support accelerated growth and the required investment to scale our provider network, we also expect increased efficiencies and economies of scale. Our cost of revenues as a percentage of revenues is expected to fluctuate from period to period depending on the interplay of these factors as well as pricing fluctuations.\n15\nOperating Expenses\nOperating expenses consist of research and development, clinical operations, sales and marketing, and general and administrative expenses.\nResearch and Development Expenses\nResearch and development expenses include personnel and related expenses for software development and engineering, information technology infrastructure, security, privacy compliance and product development (inclusive of stock-based compensation for our research and development employees), third-party services and contractors related to research and development, information technology and software-related costs.\nClinical Operations Expenses\nClinical operations expenses are associated with the management of our network of therapists. This item is comprised of costs related to recruiting, onboarding, credentialing, training and ongoing quality assurance activities (inclusive of stock-based compensation for our clinical operations employees), costs of third-party services and contractors related to recruiting and training and software-related costs.\nSales and Marketing Expenses\nSales expenses consist primarily of employee-related expenses, including salaries, benefits, commissions, travel and stock-based compensation costs for our employees engaged in sales and account management.\nMarketing expenses consist primarily of advertising and marketing expenses for member acquisition and engagement, as well as personnel costs, including salaries, benefits, bonuses, stock-based compensation expense for marketing employees, third-party services and contractors. Marketing expenses also include third-party software subscription services, third-party independent research, participation in trade shows, brand messaging and costs of communications materials that are produced for our clients to generate greater awareness and utilization of our platform among our health plan and enterprise clients.\nGeneral and Administrative Expenses\nGeneral and administrative expenses consist primarily of personnel costs, including salaries, benefits, bonuses and stock-based compensation expense for certain executives, finance, accounting, legal and human resources functions, as well as professional fees, occupancy costs, and other general overhead costs.\nFinancial income, net\nFinancial income, net includes the impact from (i) non-cash changes in the fair value of our warrant liabilities, (ii) interest earned on cash equivalents deposited in our money market accounts and (iii) other financial expenses in connection with bank charges.\nTaxes on income\nOur taxes on income consists primarily of foreign income taxes related to income generated by our subsidiary organized under the laws of Israel.\nWe have a full valuation allowance for our U.S. deferred tax assets, including federal and state NOLs. We expect to maintain this valuation allowance until it becomes more likely than not that the benefit of our federal and state deferred tax assets will be realized through expected future taxable income in the United States.\n16\nResults of Operations\nThe following table presents our results of operations for the three and six months ended June 30, 2023 and 2022 and the dollar and percentage change between the respective periods:\n\n| (in thousands, except percentages) | Three Months EndedJune 30, | Variance | Six Months EndedJune 30, | Variance |\n| Unaudited | 2023 | 2022 | $ | % | 2023 | 2022 | $ | % |\n| Revenue: |\n| Payor revenue | $18,539 | $7,880 | 10,659 | 135.3 | $33,350 | $15,990 | 17,360 | 108.6 |\n| DTE revenue | 8,039 | 6,685 | 1,354 | 20.3 | 16,715 | 12,346 | 4,369 | 35.4 |\n| Total B2B revenue | 26,578 | 14,565 | 12,013 | 82.5 | 50,065 | 28,336 | 21,729 | 76.7 |\n| Consumer revenue | 9,067 | 15,279 | (6,212) | (40.7) | 18,916 | 31,658 | (12,742) | (40.2) |\n| Total revenue | 35,645 | 29,844 | 5,801 | 19.4 | 68,981 | 59,994 | 8,987 | 15.0 |\n| Cost of revenue | 17,833 | 15,297 | 2,536 | 16.6 | 34,421 | 30,426 | 3,995 | 13.1 |\n| Gross profit | 17,812 | 14,547 | 3,265 | 22.4 | 34,560 | 29,568 | 4,992 | 16.9 |\n| Operating expenses: |\n| Research and development, net | 4,171 | 5,576 | (1,405) | (25.2) | 9,524 | 10,611 | (1,087) | (10.2) |\n| Clinical operations, net | 1,675 | 2,316 | (641) | (27.7) | 3,276 | 4,092 | (816) | (19.9) |\n| Sales and marketing | 13,045 | 18,931 | (5,886) | (31.1) | 26,514 | 40,339 | (13,825) | (34.3) |\n| General and administrative | 5,329 | 8,792 | (3,463) | (39.4) | 10,693 | 16,802 | (6,109) | (36.4) |\n| Total operating expenses | 24,220 | 35,615 | (11,395) | (32.0) | 50,007 | 71,844 | (21,837) | (30.4) |\n| Operating loss | (6,408) | (21,068) | 14,660 | 69.6 | (15,447) | (42,276) | 26,829 | 63.5 |\n| Financial (income) expense, net | (1,712) | 1,865 | (3,577) | * | (2,136) | 996 | (3,132) | * |\n| Loss before taxes on income | (4,696) | (22,933) | 18,237 | 79.5 | (13,311) | (43,272) | 29,961 | 69.2 |\n| Taxes on income | 8 | 89 | (81) | (91.0) | 151 | 110 | 41 | 37.3 |\n| Net loss | $(4,704) | $(23,022) | $18,318 | 79.6 | $(13,462) | $(43,382) | $29,920 | 69.0 |\n\n* Percentage not meaningful\nRevenues. Revenues increased by $5.8 million, or 19.4% to $35.6 million for the three months ended June 30, 2023 from $29.8 million for the three months ended June 30, 2022. The increase was principally due to a 82.5% growth in B2B revenue driven by a higher number of completed B2B sessions and an increase in covered lives from health plan clients (\"Payors\") and new enterprise clients (\"DTE\"), partially offset by a 40.7% decline in consumer subscription revenue. Revenue from our health plan clients increased by $10.7 million, or 135.3%, to $18.5 million for the three months ended June 30, 2023 from $7.9 million for the three months ended June 30, 2022. Enterprise client contracts increased by 12 clients, or 5.9%, to 217 clients as of June 30, 2023 from 205 clients as of June 30, 2022. This increase in the number of enterprise clients drove DTE revenue to increase by $1.4 million, or 20.3% to $8.0 million for the three months ended June 30, 2023 from $6.7 million for the three months ended June 30, 2022. Consumer subscriptions revenue decreased by $6.2 million, or 40.7%, to $9.1 million for the three months ended June 30, 2023 from $15.3 million for the three months ended June 30, 2022, due to the Company's intentional and strategic decision to reduce marketing spend related to this service.\nRevenues increased by $9.0 million, or 15.0% to $69.0 million for the six months ended June 30, 2023 from $60.0 million for the six months ended June 30, 2022. The increase was principally due to a 76.7% growth in B2B revenue driven by a higher number of completed B2B sessions and an increase in covered lives from Payors and new DTE clients, partially offset by a 40.2% decline in consumer subscription revenue. Revenue from our health plan clients increased by $17.4 million, or 108.6%, to $33.4 million for the six months ended June 30, 2023 from $16.0 million for the six months ended June 30, 2022. Enterprise client contracts increased by 12 clients, or 5.9%, to 217 clients as of June 30, 2023 from 205 clients as of June 30, 2022. This increase in the number of enterprise clients drove DTE revenue to increase by $4.4 million, or 35.4% to $16.7 million for the six months ended June 30, 2023 from $12.3 million for the six months ended June 30, 2022. Consumer subscriptions revenue decreased by $12.7 million, or 40.2%, to $18.9 million for the six months ended June 30, 2023 from $31.7 million for the six months ended June 30, 2022, due to the Company's intentional and strategic decision to reduce marketing spend related to this service.\nCosts of revenues. Cost of revenues increased by $2.5 million, or 16.6%, to $17.8 million for the three months ended June 30, 2023 from $15.3 million for the three months ended June 30, 2022, and increased by $4.0 million, or 13.1%, to $34.4 million for the six months ended June 30, 2023 from $30.4 million for the six months ended June 30, 2022. The increase in cost of revenues for the three and six months ended June 30, 2023, was primarily due to increased hours worked by therapists to meet strong customer engagement.\n17\nGross profit. Gross profit increased by $3.3 million, or 22.4%, to $17.8 million for the three months ended June 30, 2023 from $14.5 million for the three months ended June 30, 2022. Gross profit increased by $5.0 million, or 16.9%, to $34.6 million for the six months ended June 30, 2023 from $29.6 million for the six months ended June 30, 2022. The increase in gross profit for the three and six months ended June 30, 2023 was primarily driven by higher revenue and provider network productivity.\nGross margin was 50.0% for the three months ended June 30, 2023, compared to 48.7% during the three months ended June 30, 2022. Gross margin was 50.1% for the six months ended June 30, 2023, compared to 49.3% during the six months ended June 30, 2022. The increase in gross margin for the three and six months ended June 30, 2023 was primarily due to higher revenue and provider network productivity, partially offset by the revenue shift mix towards B2B revenue.\nOperating expenses\nOverall, our operating expenses for the three and six months ended June 30, 2023 have decreased due to our efficiency initiatives in order to optimize for profitability.\nResearch and development expenses. Research and development expenses decreased by $1.4 million, or 25.2% to $4.2 million for the three months ended June 30, 2023 from $5.6 million for the three months ended June 30, 2022, and decreased by $1.1 million, or 10.2% to $9.5 million for the six months ended June 30, 2023 from $10.6 million for the six months ended June 30, 2022. The decrease in research and development expenses for the three and six months ended June 30, 2023 was primarily due to a decrease in employee-related costs, inclusive of non-cash stock compensation expense.\nClinical operations expenses. Clinical operations expenses decreased by $0.6 million, or 27.7% to $1.7 million for the three months ended June 30, 2023 from $2.3 million for the three months ended June 30, 2022, and decreased by $0.8 million, or 19.9% to $3.3 million for the six months ended June 30, 2023 from $4.1 million for the six months ended June 30, 2022. The decrease in clinical operations expenses for the three and six months ended June 30, 2023 was primarily due to lower provider recruitment costs.\nSales and marketing expenses. Sales and marketing expenses decreased by $5.9 million, or 31.1%, to $13.0 million for the three months ended June 30, 2023 from $18.9 million for the three months ended June 30, 2022, and decreased by $13.8 million, or 34.3%, to $26.5 million for the six months ended June 30, 2023 from $40.3 million for the six months ended June 30, 2022. The decrease in sales and marketing expenses for the three and six months ended June 30, 2023 was primarily driven by a decrease in direct marketing and promotional costs.\nGeneral and administrative expenses. General and administrative expenses decreased by $3.5 million, or 39.4%, to $5.3 million for the three months ended June 30, 2023 from $8.8 million for the three months ended June 30, 2022, and decreased by $6.1 million, or 36.4%, to $10.7 million for the six months ended June 30, 2023 from $16.8 million for the six months ended June 30, 2022. The decrease in general and administrative expenses for the three and six months ended June 30, 2023 was primarily due to a decrease in professional fees, subcontractor costs and employee-related costs, inclusive of non-cash stock compensation expense.\nFinancial income, net. Financial income, net was $1.7 million for the three months ended June 30, 2023, compared to financial expense, net of $1.9 million for the three months ended June 30, 2022. For the three months ended June 30, 2023 financial income, net was primarily driven by interest income earned on our money market accounts of $1.5 million and $0.3 million in non-cash gains resulting from the remeasurement of warrant liabilities. For the three months ended June 30, 2022 financial expense, net primarily consisted of $2.1 million in non-cash losses resulting from the remeasurement of warrant liabilities.\nFinancial income, net was $2.1 million for the six months ended June 30, 2023, compared to financial expense, net of $1.0 million for the six months ended June 30, 2022. For the six months ended June 30, 2023 financial income, net was primarily driven by interest income earned on our money market accounts of $2.1 million. For the six months ended June 30, 2022 financial expense, net was primarily driven by $1.2 million of non-cash losses resulting from the remeasurement of warrant liabilities.\nTaxes on income. Taxes on income consists primarily of foreign income taxes related to income generated by our subsidiary organized under the laws of Israel.\n18\nNon-GAAP Financial Measures\nIn addition to our financial results determined in accordance with GAAP, we believe adjusted EBITDA, a non-GAAP measure, is useful in evaluating our operating performance and is a key performance measure that our management uses to assess our operating performance. Because adjusted EBITDA facilitates internal comparisons of our historical operating performance on a more consistent basis, we use this measure for business planning purposes and in evaluating acquisition opportunities. We also use adjusted EBITDA to evaluate our ongoing operations and for internal planning and forecasting purposes. We believe that this non-GAAP financial measure, when taken together with the corresponding GAAP financial measures, provides meaningful supplemental information regarding our performance by excluding certain items that may not be indicative of our business, results of operations or outlook. We believe that the use of adjusted EBITDA is helpful to our investors as it is a metric used by management in assessing the health of our business and our operating performance. However, non-GAAP financial information is presented for supplemental informational purposes only, has limitations as an analytical tool and should not be considered in isolation or as a substitute for financial information presented in accordance with GAAP.\nSome of the limitations of adjusted EBITDA include (i) adjusted EBITDA does not necessarily reflect capital commitments to be paid in the future and (ii) although depreciation and amortization are non-cash charges, the underlying assets may need to be replaced and adjusted EBITDA does not reflect these requirements. In evaluating adjusted EBITDA, you should be aware that in the future we will incur expenses similar to the adjustments described herein. Our presentation of adjusted EBITDA should not be construed as an inference that our future results will be unaffected by these expenses or any unusual or non-recurring items. Our adjusted EBITDA may not be comparable to similarly titled measures of other companies because they may not calculate adjusted EBITDA in the same manner as we calculate the measure, limiting its usefulness as a comparative measure. Adjusted EBITDA should not be considered as an alternative to loss before income taxes, net loss, loss per share, or any other performance measures derived in accordance with U.S. GAAP. When evaluating our performance, you should consider adjusted EBITDA alongside other financial performance measures, including our net loss and other GAAP results.\nA reconciliation is provided below for adjusted EBITDA to net loss, the most directly comparable financial measure stated in accordance with GAAP. Investors are encouraged to review our financial statements prepared in accordance with GAAP and the reconciliation of our non-GAAP financial measure to its most directly comparable GAAP financial measure, and not to rely on any single financial measure to evaluate our business.\nWe calculate adjusted EBITDA as net loss income adjusted to exclude (i) depreciation and amortization, (ii) interest and other expenses (income), net, (iii) tax benefit and expense, and (iv) stock-based compensation expense.\nThe following table presents a reconciliation of adjusted EBITDA from the most comparable GAAP measure, net loss for the three and six months ended June 30, 2023 and 2022:\n\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\n| Unaudited | 2023 | 2022 | 2023 | 2022 |\n| (in thousands) |\n| Net loss | $ | (4,704 | ) | $ | (23,022 | ) | $ | (13,462 | ) | $ | (43,382 | ) |\n| Add: |\n| Depreciation and amortization | 302 | 268 | 608 | 697 |\n| Financial (income) expense, net (1) | (1,712 | ) | 1,865 | (2,136 | ) | 996 |\n| Taxes on income | 8 | 89 | 151 | 110 |\n| Stock-based compensation | 2,129 | 3,839 | 4,432 | 6,207 |\n| Adjusted EBITDA | $ | (3,977 | ) | $ | (16,961 | ) | $ | (10,407 | ) | $ | (35,372 | ) |\n\n(1) For the three months ended June 30, 2023, financial (income), net, primarily consisted of $1.5 million of interest income from our money market accounts and $0.3 million in gains resulting from the remeasurement of warrant liabilities. For the six months ended June 30, 2023, financial (income), net, primarily consisted of $2.1 million of interest income from our money market accounts. For the three and six months ended June 30, 2022, financial expense, net primarily consisted of $2.1 million and $1.2 million, respectively, in losses resulting from the remeasurement of warrant liabilities.\n19\nLiquidity and Capital Resources\nAs of June 30, 2023, we had $126.1 million of cash and cash equivalents ($138.5 million as of December 31, 2022), which we use to finance our operations and support a variety of growth initiatives and investments. We had no debt as of June 30, 2023.\nOur primary cash needs are to fund operating activities. Our future capital requirements will depend on many factors including our growth rate, contract renewal activity, the timing and extent of investments to support product development efforts, our expansion of sales and marketing activities, the introduction of new and enhanced service offerings, and the continuing market acceptance of virtual behavioral services. Additionally, we may in the future enter into arrangements to acquire or invest in complementary businesses, services and technologies.\nWe currently anticipate to be able to fund our cash needs for at least the next 12 months and thereafter for the foreseeable future using available cash and cash equivalent balances as of June 30, 2023. However, in the future we may require additional capital to respond to technological advancements, competitive dynamics, customer demands, business and investment opportunities, acquisitions or unforeseen circumstances and we may determine to engage in equity or debt financings for other reasons. We may not be able to timely secure additional debt or equity financing on favorable terms, or at all. If we raise additional funds through the issuance of equity or convertible debt or other equity-linked securities, our existing stockholders could experience significant dilution. Any debt financing obtained by us in the future could involve restrictive covenants relating to our capital raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities, including potential acquisitions. If we cannot raise capital when needed, we may be forced to undertake asset sales or similar measures to ensure adequate liquidity.\nCash Flows from Operating, Investing and Financing Activities\nThe following table presents the summary condensed consolidated cash flow information for the periods presented:\nCash Flows\n\n| Unaudited | Six Months EndedJune 30, |\n| (in thousands) | 2023 | 2022 |\n| Net cash used in operating activities | $ | (13,748 | ) | $ | (33,111 | ) |\n| Net cash provided by (used in) investing activities | 18 | (160 | ) |\n| Net cash provided by financing activities | 1,289 | 1,637 |\n| Net decrease in cash and cash equivalents | $ | (12,441 | ) | $ | (31,634 | ) |\n\nOperating Activities\nThe decrease in net cash used in operating activities was driven primarily by the positive impact of lower operating expenses, favorable timing of collections on receivables and an increase in interest income from our money market accounts offset by unfavorable timing of payments of account payables and accrued expenses.\nInvesting Activities\nThe increase in net cash provided by investing activities was driven primarily by an increase in the proceeds from the sale of computer equipment and a decrease in the purchases of computer equipment and software.\nFinancing Activities\nThe decrease in net cash provided by financing activities was primarily driven by a decrease in the proceeds from the exercise of stock options.\nContractual Obligations, Commitments and Contingencies\nAs of June 30, 2023, we did not have any short-term or long-term debt, or significant long-term liabilities.\nAs of June 30, 2023, we have a non-material long-term operating lease for our office space in New York, NY.\nA settlement was reached in February 2023 for certain class action lawsuits ending an ongoing litigation, see Note 5, “Commitments and Contingent Liabilities” in the notes to the condensed consolidated financial statements for further details.\n20\nIn addition, we may in the future be involved in various legal proceedings, claims and litigation that arise in the normal course of business. We accrue for estimated loss contingencies related to legal matters when available information indicates that it is probable a liability had been incurred and we can reasonably estimate the amount of that loss. In many proceedings, however, it is inherently difficult to determine whether any loss is probable or even possible or to estimate the amount of any loss. In addition, even where a loss is possible or an exposure to loss exists in excess of the liability already accrued with respect to a previously recognized loss contingency, it is often not possible to reasonably estimate the size of the possible loss or range of loss or possible additional losses or range of additional losses. Should any of our estimates and assumptions change or prove to be incorrect, it could have a material impact on our results of operations, financial position, and cash flows. See Note 5, “Commitments and Contingent Liabilities” in the notes to the condensed consolidated financial statements for further details.\nOur commercial contract arrangements generally include certain provisions requiring us to indemnify clients against liabilities if there is a breach of a client’s data or if our service infringes a third party’s intellectual property rights. To date, we have not incurred any material costs as a result of such indemnifications.\nWe have also agreed to indemnify our officers and directors for costs associated with any fees, expenses, judgments, fines and settlement amounts incurred by any of these persons in any action or proceeding to which any of those persons is, or is threatened to be, made a party by reason of the person’s service as a director or officer, including any action by us, arising out of that person’s services as our director or officer or that person’s services provided to any other company or enterprise at our request. We maintain director and officer liability insurance coverage that would generally enable us to recover a portion of any future amounts paid. We may also be subject to indemnification obligations by law with respect to the actions of our employees under certain circumstances and in certain jurisdictions.\nOff-Balance Sheet Arrangements\nWe do not invest in any off-balance sheet vehicles that provide liquidity, capital resources, market or credit risk support, or engage in any activities that expose us to any liability that is not reflected in our condensed consolidated financial statements.\nInflation Risk\nWe do not believe that inflation has had a material effect on our business, financial condition or results of operations. If our costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could harm our business, financial condition or results of operations.\nCritical Accounting Policies and Estimates\nThe Company’s condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. Reference is also made to the Company’s consolidated financial statements and notes thereto found in its Annual Report on Form 10-K for the year ended December 31, 2022.\nThe Company’s accounting policies are essential to understanding and interpreting the financial results reported on the condensed consolidated financial statements. The significant accounting policies used in the preparation of the Company’s consolidated financial statements are summarized in Note 2 to those financial statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2022. Certain of those policies are considered to be particularly important to the presentation of the Company's financial results because they require management to make difficult, complex or subjective judgments, often as a result of matters that are inherently uncertain.\nDuring the six months ended June 30, 2023, there were no material changes to matters discussed under the heading “Critical Accounting Policies and Estimates” in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2022.\nRecent Accounting Pronouncements\nInformation regarding recent accounting developments and their impact on our results can be found in Note 2, “Summary of Significant Accounting Policies and Estimates” in the audited consolidated financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2022 and in Note 2, “Significant Accounting Policies” in the notes to the condensed consolidated financial statements of this Quarterly Report on Form 10-Q.\n21\nFORWARD-LOOKING STATEMENTS\nThis Quarterly Report on Form 10-Q (the “Quarterly Report”) contains forward-looking statements. We intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). All statements other than statements of historical facts contained in this Quarterly Report may be forward-looking statements. In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “could,” “intends,” “targets,” “projects,” “contemplates,” “believes,” “estimates,” “forecasts,” “predicts,” “potential” or “continue” or the negative of these terms or other similar expressions. Forward-looking statements contained in this Quarterly Report include, but are not limited to, statements regarding our future results of operations and financial position, industry and business trends, stock-based compensation, revenue recognition, business strategy, plans and market growth.\nThe forward-looking statements in this Quarterly Report and other such statements we publicly make from time-to-time are only predictions. We base these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our business, financial condition, and results of operations. Forward-looking statements involve known and unknown risks, uncertainties and other important factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements, including, but not limited to, the important factors discussed in Part I, Item 1A, “Risk Factors” of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2022. The forward-looking statements in this Quarterly Report are based upon information available to us as of the date of this Quarterly, and while we believe such information forms a reasonable basis for such statements, such information may be limited or incomplete, and our statements should not be read to indicate that we have conducted an exhaustive inquiry into, or review of, all potentially available relevant information. These statements are inherently uncertain and investors are cautioned not to unduly rely upon these statements.\nYou should read this Quarterly Report and the risk factors discussed in Part I, Item 1A, “Risk Factors” of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2022 with the understanding that our actual future results, levels of activity, performance and achievements may be materially different from what we expect. We qualify all of our forward-looking statements by these cautionary statements. These forward-looking statements speak only as of the date of this Quarterly Report. Except as required by applicable law, we do not plan to publicly update or revise any forward-looking statements contained in this Quarterly Report on Form 10-Q or any forward-looking statements we may publicly make from time-to-time, whether as a result of any new information, future events or otherwise.\nItem 3\n. Quantitative and Qualitative Disclosures About Market Risk.\nDuring the six months ended June 30, 2023, there were no material changes to the information contained in Part II, Item 7A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2022.\n22\n\nItem 4\n. Controls and Procedures.\nIn connection with the preparation of this report, an evaluation was carried out under the supervision, and with the participation of, our management including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act of 1934, as amended (the “Act”)) as of June 30, 2023. Based upon the evaluation and although management has made significant progress in the design and implementation of IT and business process controls, our CEO and CFO concluded our disclosure controls and procedures are not effective as of such date solely due to material weaknesses in internal controls over financial reporting that were disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2022 and are discussed below.\nAs previously described in Part II, Item 9A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2022, we concluded that our internal control over financial reporting was not effective solely due to the existence of the following material weaknesses described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2022:\n1.Management was able to complete the design and establish effective information technology general controls (ITGCs) for the majority of tested ITGCs; however, some ineffective ITGC controls existed at December 31, 2022. As a result, business process controls (automated and IT-dependent manual controls) that are dependent on the ineffective ITGCs, or that use data produced from systems impacted by the ineffective ITGCs were deemed ineffective; and\n2.Management did not have an adequate process in place to monitor and provide oversight over the completion of its testing and assessment of the design and operating effectiveness of internal control over financial reporting in a timely manner.\nThe material weaknesses did not result in any identified misstatements to the financial statements, and there were no changes to previously released financial results.\nRemediation Plan for the Material Weakness\nManagement is committed to the remediation of the material weakness described above, as well as the continued improvement of the Company’s internal control over financial reporting. Management has implemented and continues to implement measures designed to ensure that control deficiencies contributing to the material weakness are remediated, such that these controls are designed, implemented and operating effectively.\nRemediation efforts include but are not limited to, (a) hiring additional personnel with appropriate technical skill sets, (b) developing an execution plan and resources to test controls and providing timely feedback of any deficiencies noted to complete remediation (c) establishing a training program for the entire organization to support ongoing execution of internal controls and adherence to control activities and (d) actively monitoring corrective actions and providing status reporting to leadership on the progress.\nManagement will test and evaluate the implementation of internal controls and revised processes to ascertain whether they are designed and operating effectively to provide reasonable assurance that they will prevent or detect a material error in our financial statements.\nWe believe that once these actions have been completed, it will remediate the material weakness. The material weakness will not be considered remediated, however, until the applicable controls operate for a sufficient period of time and management has concluded, through testing, that controls are operating effectively.\nChanges in Internal Control Over Financial Reporting\nThere have been no changes in the Company’s internal control over financial reporting during the six months ended June 30, 2023 which have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\nIn order to enhance the Company's internal control over financial reporting, management has (a) hired additional personnel with appropriate technical skill sets, (b) developed an execution plan and engaged resources to test controls and provide timely feedback of any deficiencies noted, (c) provided training to the organization to support ongoing execution of internal controls and adherence to control activities, and (d) implemented status reporting to leadership on the progress of the assessment of the design and operating effectiveness of internal control over financial reporting.\n23\nPART II—OTHER INFORMATION\nItem 1\n. Legal Proceedings.\nThe Company reached settlements for certain class action lawsuits in February 2023 ending on going securities and derivatives suits. The settlements for these lawsuits have received preliminary court approval and are expected to receive final court approval in the third quarter of 2023. See Note 5, “Commitments and Contingent Liabilities” in the notes to the condensed consolidated financial statements for further details.\nIn addition to the foregoing, the Company may in the future be involved in various legal proceedings, claims and litigation that arise in the normal course of business. The Company accrues for estimated loss contingencies related to legal matters when available information indicates that it is probable a liability had been incurred and the Company can reasonably estimate the amount of that loss. In many proceedings, however, it is inherently difficult to determine whether any loss is probable or even possible or to estimate the amount of any loss. In addition, even where a loss is possible or an exposure to loss exists in excess of the liability already accrued with respect to a previously recognized loss contingency, it is often not possible to reasonably estimate the size of the possible loss or range of loss or possible additional losses or range of additional losses.\nI\nte\nm\n1a. R\nisk Factors.\nIn addition to the other information set forth in this Quarterly Report, you should carefully consider the factors discussed under Part I, Item 1A. “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2022. These factors could materially adversely affect our business, financial condition, liquidity, results of operations and capital position, and could cause our actual results to differ materially from our historical results or the results contemplated by any forward-looking statements contained in this Quarterly Report. During the six months ended June 30, 2023, there were no material changes to the information contained in Part I, Item 1A of the Company's Annual Report on Form 10-K for the year ended December 31, 2022.\nItem 2\n. Unregistered Sales of Equity Securities and Use of Proceeds.\nNot applicable.\nItem 3\n. Defaults Upon Senior Securities.\nNone.\nItem 4\n. Mine Safety Disclosures.\nNot applicable.\nItem 5\n. Other Information.\nNone.\n24\n\nItem 6\n. Exhibits.\n\n| Filed/ |\n| ExhibitNumber | Exhibit Description | FurnishedHerewith |\n| 31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a). | * |\n| 31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a). | * |\n| 32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350. | ** |\n| 32.2 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350. | ** |\n| 101.INS | Inline XBRL Instance Document - the instance document does not appear in the Interactive Data file because its XBRL tags are embedded within the Inline XBRL document. | * |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document. | * |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document. | * |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document. | * |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document. | * |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document. | * |\n| 104 | Cover Page Interactive Data File (as formatted as Inline XBRL and contained in Exhibit 101). | * |\n\n* Filed herewith.\n** Furnished herewith.\n25\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| Talkspace, Inc. |\n| Date: August 2, 2023 | By: | /s/ Jon Cohen |\n| Jon Cohen |\n| Chief Executive Officer |\n| Date: August 2, 2023 | By: | /s/ Jennifer Fulk |\n| Jennifer Fulk |\n| Chief Financial Officer |\n\n26\n \n\nWhat is the percentage change for Adjusted EBITDA year on year for two consecutive periods ending June 30, 2023 and 2022?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nPART I—FINANCIAL INFORMATION\\nItem 1. Financial Statements.\\nTALKSPACE, INC.\\nCONDENSED CONSOLIDATED BALANCE SHEETS\\n\\n| June 30, 2023 | December 31, 2022 |\\n| (U.S. dollars in thousands, except share and per share data) | (Unaudited) |\\n| ASSETS | |\\n| CURRENT ASSETS: | | |\\n| Cash and cash equivalents | $ | 126,104 | $ | 138,545 |\\n| Accounts receivable, net | 8,420 | 9,640 |\\n| Other current assets | 2,920 | 4,372 |\\n| Total current assets | 137,444 | 152,557 |\\n| Property and equipment, net | 456 | 677 |\\n| Intangible assets, net | 2,157 | 2,529 |\\n| Other long-term assets | 464 | 491 |\\n| Total assets | $ | 140,521 | $ | 156,254 |\\n| LIABILITIES AND STOCKHOLDERS’ EQUITY | | |\\n| CURRENT LIABILITIES: | | |\\n| Accounts payable | $ | 5,484 | $ | 6,461 |\\n| Deferred revenues | 3,683 | 4,355 |\\n| Accrued expenses and other current liabilities | 10,444 | 16,502 |\\n| Total current liabilities | 19,611 | 27,318 |\\n| Warrant liabilities | 820 | 939 |\\n| Other long-term liabilities | 295 | 461 |\\n| Total liabilities | 20,726 | 28,718 |\\n| Commitments and contingencies (Note 5) |\\n| STOCKHOLDERS’ EQUITY: | | |\\n| Common stock of $ 0.0001 par value — Authorized: 1,000,000,000 shares at June 30, 2023 and December 31, 2022; Issued and outstanding: 166,204,295 and 161,155,030 shares at June 30, 2023 and December 31, 2022, respectively | 16 | 16 |\\n| Additional paid-in capital | 384,443 | 378,722 |\\n| Accumulated deficit | ( 264,664 | ) | ( 251,202 | ) |\\n| Total stockholders’ equity | 119,795 | 127,536 |\\n| Total liabilities and stockholders’ equity | $ | 140,521 | $ | 156,254 |\\n\\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\\n3\\nTALKSPACE, INC.\\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\\n(Unaudited)\\n\\n| Three Months Ended | Six Months Ended |\\n| June 30, | June 30, |\\n| (U.S. dollars in thousands, except share and per share data) | 2023 | 2022 | 2023 | 2022 |\\n| Revenues | $ | 35,645 | $ | 29,844 | $ | 68,981 | $ | 59,994 |\\n| Cost of revenues | 17,833 | 15,297 | 34,421 | 30,426 |\\n| Gross profit | 17,812 | 14,547 | 34,560 | 29,568 |\\n| Operating expenses: |\\n| Research and development, net | 4,171 | 5,576 | 9,524 | 10,611 |\\n| Clinical operations, net | 1,675 | 2,316 | 3,276 | 4,092 |\\n| Sales and marketing | 13,045 | 18,931 | 26,514 | 40,339 |\\n| General and administrative | 5,329 | 8,792 | 10,693 | 16,802 |\\n| Total operating expenses | 24,220 | 35,615 | 50,007 | 71,844 |\\n| Operating loss | ( 6,408 | ) | ( 21,068 | ) | ( 15,447 | ) | ( 42,276 | ) |\\n| Financial (income) expense, net | ( 1,712 | ) | 1,865 | ( 2,136 | ) | 996 |\\n| Loss before taxes on income | ( 4,696 | ) | ( 22,933 | ) | ( 13,311 | ) | ( 43,272 | ) |\\n| Taxes on income | 8 | 89 | 151 | 110 |\\n| Net loss | $ | ( 4,704 | ) | $ | ( 23,022 | ) | $ | ( 13,462 | ) | $ | ( 43,382 | ) |\\n| Net loss per share: |\\n| Basic and Diluted | $ | ( 0.03 | ) | $ | ( 0.15 | ) | $ | ( 0.08 | ) | $ | ( 0.28 | ) |\\n| Weighted average number of common shares used in computing basic and diluted net loss per share: |\\n| Basic and Diluted | 164,195,697 | 155,709,901 | 163,003,363 | 154,901,165 |\\n\\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\\n4\\nTALKSPACE, INC.\\nCONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY\\n(Unaudited)\\n\\n| (U.S. dollars in thousands, except share data) | Common Stock |\\n| Three and Six Months Ended June 30, 2023 | Number of SharesOutstanding | Amount | Additional paid-incapital | Accumulateddeficit | Total |\\n| Balance as of December 31, 2022 | 161,155,030 | $ | 16 | $ | 378,722 | $ | ( 251,202 | ) | $ | 127,536 |\\n| Exercise of stock options | 1,739,265 | *) | 621 | — | 621 |\\n| Restricted stock units vested, net of tax | 225,050 | *) | ( 65 | ) | — | ( 65 | ) |\\n| Stock-based compensation | — | — | 2,303 | — | 2,303 |\\n| Net loss | — | — | — | ( 8,758 | ) | ( 8,758 | ) |\\n| Balance as of March 31, 2023 (unaudited) | 163,119,345 | $ | 16 | $ | 381,581 | $ | ( 259,960 | ) | $ | 121,637 |\\n| Exercise of stock options | 1,837,734 | *) | 869 | — | 869 |\\n| Restricted stock units vested, net of tax | 1,247,216 | *) | ( 136 | ) | — | ( 136 | ) |\\n| Stock-based compensation | — | — | 2,129 | — | 2,129 |\\n| Net loss | — | — | — | ( 4,704 | ) | ( 4,704 | ) |\\n| Balance as of June 30, 2023 (unaudited) | 166,204,295 | $ | 16 | $ | 384,443 | $ | ( 264,664 | ) | $ | 119,795 |\\n| Common Stock |\\n| Three and Six Months Ended June 30, 2022 | Number of SharesOutstanding | Amount | Additional paid-incapital | Accumulateddeficit | Total |\\n| Balance as of December 31, 2021 | 152,862,447 | $ | 15 | $ | 363,788 | $ | ( 171,530 | ) | $ | 192,273 |\\n| Exercise of stock options | 2,164,870 | *) | 2,063 | — | 2,063 |\\n| Restricted stock units vested, net of tax | 77,338 | *) | ( 67 | ) | — | ( 67 | ) |\\n| Stock-based compensation | — | — | 2,368 | — | 2,368 |\\n| Net loss | — | — | — | ( 20,360 | ) | ( 20,360 | ) |\\n| Balance as of March 31, 2022 (unaudited) | 155,104,655 | $ | 15 | $ | 368,152 | $ | ( 191,890 | ) | $ | 176,277 |\\n| Exercise of stock options | 1,092,515 | *) | 286 | — | 286 |\\n| Restricted stock units vested, net of tax | 1,175,446 | *) | ( 126 | ) | — | ( 126 | ) |\\n| Stock-based compensation | — | — | 3,839 | — | 3,839 |\\n| Net loss | — | — | — | ( 23,022 | ) | ( 23,022 | ) |\\n| Balance as of June 30, 2022 (unaudited) | 157,372,616 | $ | 15 | $ | 372,151 | $ | ( 214,912 | ) | $ | 157,254 |\\n\\n*) Represents an amount lower than $1\\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\\n5\\nTALKSPACE, INC.\\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\\n(Unaudited)\\n\\n| Six Months EndedJune 30, |\\n| (U.S. dollars in thousands) | 2023 | 2022 |\\n| Cash flows from operating activities: |\\n| Net loss | $ | ( 13,462 | ) | $ | ( 43,382 | ) |\\n| Adjustments to reconcile net loss to net cash used in operating activities: |\\n| Depreciation and amortization | 608 | 697 |\\n| Stock-based compensation | 4,432 | 6,207 |\\n| Remeasurement of warrant liabilities | ( 119 | ) | 1,217 |\\n| Decrease (increase) in accounts receivable | 1,220 | ( 1,650 | ) |\\n| Decrease in other current assets | 1,452 | 5,622 |\\n| (Decrease) increase in accounts payable | ( 977 | ) | 381 |\\n| Decrease in deferred revenues | ( 672 | ) | ( 1,236 | ) |\\n| Decrease in accrued expenses and other current liabilities | ( 6,058 | ) | ( 1,145 | ) |\\n| Other | ( 172 | ) | 178 |\\n| Net cash used in operating activities | ( 13,748 | ) | ( 33,111 | ) |\\n| Cash flows from investing activities: |\\n| Purchase of property and equipment | ( 10 | ) | ( 160 | ) |\\n| Proceeds from sale of property and equipment | 28 | — |\\n| Net cash provided by (used in) investing activities | 18 | ( 160 | ) |\\n| Cash flows from financing activities: |\\n| Proceeds from exercise of stock options | 1,490 | 2,349 |\\n| Payments for employee taxes withheld related to vested stock-based awards | ( 201 | ) | ( 67 | ) |\\n| (Payments) proceeds from reverse capitalization, net of transaction costs | — | ( 645 | ) |\\n| Net cash provided by financing activities | 1,289 | 1,637 |\\n| Net decrease in cash and cash equivalents | ( 12,441 | ) | ( 31,634 | ) |\\n| Cash and cash equivalents at the beginning of the period | 138,545 | 198,256 |\\n| Cash and cash equivalents at the end of the period | $ | 126,104 | $ | 166,622 |\\n| Supplemental cash flow data: |\\n| Cash paid during the period for income taxes | $ | 176 | $ | 97 |\\n\\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\\n6\\nTALKSPACE, INC.\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(Unaudited)\\nNOTE 1. DESCRIPTION OF ORGANIZATION AND BUSINESS OPERATIONS Talkspace, Inc. (together with its consolidated subsidiaries, the “Company” or “Talkspace”) is a leading behavioral healthcare company enabled by a purpose-built technology platform. Talkspace provides individuals and licensed therapists, psychologists and psychiatrists with an online platform for one-on-one therapy delivered via messaging, audio and video. The Company offers convenient and affordable access to a fully credentialed network of highly qualified providers. Since its inception, the Company has connected millions of patients with licensed behavioral health providers across a wide and growing spectrum of care through virtual counseling, psychotherapy, and psychiatry. The Company's principal executive office is located in New York, NY. The Company has three wholly owned subsidiaries, Talkspace LLC, Talkspace Network LLC and Groop Internet Platform LTD. In addition, the Company holds a variable interest in one professional association and six professional corporations, which have been established pursuant to the requirements of their respective domestic jurisdiction governing the corporate practice of medicine. See Note 10, “Variable Interest Entities,” in these notes to the condensed consolidated financial statements for further details.\\nNOTE 2. SIGNIFICANT ACCOUNTING POLICIES Basis of presentationThe unaudited condensed consolidated financial statements and accompanying notes have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”). In management’s opinion, the unaudited condensed consolidated financial statements reflect all adjustments of a normal recurring nature that are necessary for a fair presentation of the results for the interim periods presented. The Company’s interim period results do not necessarily indicate the results that may be expected for any other interim period or for the full fiscal year. These condensed consolidated financial statements should be read in conjuction with the consolidated financial statements as of and for the year ended December 31, 2022 included in the Company's Annual Report on Form 10-K for the year ended December 31, 2022. The significant accounting policies applied in the annual consolidated financial statements of the Company as of December 31, 2022, have been applied consistently in these unaudited condensed consolidated financial statements, unless otherwise stated. Intercompany transactions and balances have been eliminated in the preparation of the condensed consolidated financial statements. Use of estimatesThe preparation of financial statements in conformity with U.S. GAAP requires management to make estimates, judgments, and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, together with amounts disclosed in the related notes to the condensed consolidated financial statements. The Company’s significant estimates and assumptions used in these condensed consolidated financial statements include, but are not limited to, the recognition and disclosure of contingent liabilities, revenue recognition, stock-based compensation awards and the fair value of warrant liabilities. The Company bases its estimates on historical factors, current circumstances and the experience and judgment of management. The Company evaluates its assumptions on an ongoing basis. The Company’s management believes that the estimates, judgments, and assumptions used are reasonable based on information available at the time they are made. Estimates, by their nature, are based on judgment and available information, therefore, actual results could be materially different from these estimates. Reclassification Certain prior year amounts have been reclassified to conform to current year presentation . Recently Issued and Adopted Accounting PronouncementsThe Company has reviewed recent accounting pronouncements and concluded that they are either not applicable to its business or that no material effect is expected on the condensed consolidated financial statements as a result of their future adoption.\\n7\\n| Unaudited | Three Months Ended June 30, | | Six Months Ended June 30, |\\n| (in thousands) | 2023 | 2022 | 2023 | 2022 |\\n| Revenues from sales to unaffiliated customers: | |\\n| Payor revenue | $ | 18,539 | $ | 7,880 | $ | 33,350 | $ | 15,990 |\\n| DTE revenue | 8,039 | 6,685 | 16,715 | 12,346 |\\n| Total B2B revenue | 26,578 | 14,565 | 50,065 | 28,336 |\\n| Consumer revenue | 9,067 | 15,279 | | 18,916 | 31,658 |\\n| Total revenue | $ | 35,645 | $ | 29,844 | | $ | 68,981 | $ | 59,994 |\\n\\n| Level 3 Liabilities (unaudited) |\\n| For the Three Months Ended June 30, 2023 |\\n| (in thousands) | Beginning Balance | Change in Fair Value | Ending Balance |\\n| Private Placement Warrants | $ | 1,128 | $ | ( 308 | ) | $ | 820 |\\n| For the Six Months Ended June 30, 2023 |\\n| (in thousands) | Beginning Balance | Change in Fair Value | Ending Balance |\\n| Private Placement Warrants | $ | 939 | $ | ( 119 | ) | $ | 820 |\\n| Level 3 Liabilities (unaudited) |\\n| For the Three Months Ended June 30, 2022 |\\n| (in thousands) | Beginning Balance | Change in Fair Value | Ending Balance |\\n| Private Placement Warrants | $ | 3,195 | $ | 2,092 | $ | 5,287 |\\n| For the Six Months Ended June 30, 2022 |\\n| (in thousands) | Beginning Balance | Change in Fair Value | Ending Balance |\\n| Private Placement Warrants | $ | 4,070 | $ | 1,217 | $ | 5,287 |\\n\\n9\\nNOTE 5. COMMITMENTS AND CONTINGENT LIABILITIES LitigationIn January 2022, the Company and certain of its current and former officers and directors were named as defendants in securities class action complaints filed in the United States District Court for the Southern District of New York under the case headings: (1) Baron v. Talkspace et al., No. 22-cv-00163 (S.D.N.Y.) and (2) Valdez v. Talkspace et al., No. 22-cv-00840 (S.D.N.Y.), which were subsequently consolidated under the caption In re Talkspace, Inc. Securities Litigation, No. 22-cv-00163 (S.D.N.Y) (the “Securities Action”). The Securities Action asserts violations of sections 10(b), 14(a) and 20(a) of the Securities Exchange Act of 1934 and SEC Rules 10b-5 and 14a-9 promulgated thereunder. These actions generally relate to public disclosures and statements by the Company in connection with its merger with Hudson Executive Investment Corp. (“HEIC”). In December 2022, the Company’s subsidiary Tailwind Merger Sub II, LLC, certain of the Company’s current and former directors and officers, and others were named as defendants in a putative class action complaint filed in the Delaware Court of Chancery under the case caption Valdez v. Braunstein, et al., C.A. No. 2022-1148 (Del. Ch.) (the “Delaware Action”). The Delaware Action asserts claims for breach of fiduciary duty and aiding and abetting breach of fiduciary duty relating to the merger with HEIC, among other things, based on many of the same facts at issue in the Securities Action. The complaint seeks, among other things damages on behalf of putative class members who did not redeem their shares in connection with the Company’s merger with HEIC. In February 2023, the Company resolved the Securities Action and the Delaware Action through mediation. The settlement resolves these litigations with respect to all named defendants. The settlement will have to be approved by the court, which the Company expects will occur in the third quarter of 2023. In June and July 2022, two individuals filed stockholder derivative lawsuits on behalf of Talkspace in the United States District Court for the Southern District of New York under the case captions: (1) Odsvall v. Oren Frank et al., No. 22-cv-05016 (S.D.N.Y.) and (2) Nayman v. Berg, et al., No. 22-cv-06258 (S.D.N.Y.), which were subsequently consolidated under the caption In re Talkspace Stockholder Derivative Litigation, No. 22-cv-05016 (S.D.N.Y.) in September 2022 (the “Derivative Action”). The Derivative Action named certain of the Company’s current and former officers and directors as defendants and the Company as a nominal defendant. The Derivative Action asserted claims for violations of federal securities laws, breach of fiduciary duty, and aiding and abetting breaches of fiduciary duty relating to the merger with HEIC, among other things, based on many of the same facts at issue in the Securities Action. In February 2023 the parties reached an agreement in principle to resolve the Derivative Action with respect to all named defendants in exchange for certain changes to the Company’s Corporate Governance environment, including the declassification of the Company’s board of directors, creation of a management-level disclosure committee, enhancements to the responsibilities and duties of the Company’s Audit Committee, the addition of independent directors, enhancements to employee compliance training and retention of an internal controls consultant. In addition, the Company agreed to pay or cause to be paid $ 550,000 in attorney’s fees and expenses. On May 18, 2023, the parties entered into a Stipulation of Settlement and Release Agreement (the “Stipulation”) that sets forth the terms and conditions for the proposed settlement and dismissal with prejudice of the Derivative Action (the “Settlement”). On June 30, 2023, the court entered an order preliminarily approving the Stipulation and proposed Settlement of the Derivative Action and scheduling a hearing for August 16, 2023 to determine whether to give final approval to the Settlement. The defendants have not admitted any liability or wrongdoing in connection with the Settlement and have entered into the Settlement solely to avoid the costs, risks, distraction, and uncertainties of continued litigation of the Derivative Action. In addition to the foregoing, the Company may in the future be involved in various legal proceedings, claims and litigation that arise in the normal course of business. The Company accrues for estimated loss contingencies related to legal matters when available information indicates that it is probable a liability had been incurred and the Company can reasonably estimate the amount of that loss. In many proceedings, however, it is inherently difficult to determine whether any loss is probable or even possible or to estimate the amount of any loss. In addition, even where a loss is possible or an exposure to loss exists in excess of the liability already accrued with respect to a previously recognized loss contingency, it is often not possible to reasonably estimate the size of the possible loss or range of loss or possible additional losses or range of additional losses. 10 Warranties and IndemnificationThe Company’s arrangements generally include certain provisions for indemnifying clients against liabilities if there is a breach of a client’s data or if the Company’s service infringes a third party’s intellectual property rights. To date, the Company has not incurred any material costs as a result of such indemnifications.The Company has also agreed to indemnify its directors and executive officers for costs associated with any fees, expenses, judgments, fines and settlement amounts incurred by any of these persons in any action or proceeding to which any of those persons is, or is threatened to be, made a party by reason of the person’s service as a director or officer, including any action by the Company, arising out of that person’s services as a director or officer or that person’s services provided to any other company or enterprise at the Company’s request. The Company maintains director and officer liability insurance coverage that would generally enable it to recover a portion of any future amounts paid. The Company may also be subject to indemnification obligations by law with respect to the actions of its employees under certain circumstances and in certain jurisdictions.\\nNOTE 6. CAPITAL STOCK As of June 30, 2023 and December 31, 2022 there were outstanding 12,780,000 Private Placement Warrants and 21,350,000 Public Warrants to purchase the Company’s common stock at an exercise price of $ 11.50 per share. As of June 30, 2023 and December 31, 2022, no shares of preferred stock were issued or outstanding.\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| Unaudited | 2023 | 2022 | 2023 | 2022 |\\n| (in thousands) |\\n| Research and development, net | $ | 546 | $ | 662 | $ | 1,220 | $ | 1,208 |\\n| Clinical operations, net | 126 | 79 | 246 | 201 |\\n| Sales and marketing | 445 | 816 | 836 | 1,593 |\\n| General and administrative | 1,012 | 2,282 | 2,130 | 3,205 |\\n| Total stock-based compensation expense | $ | 2,129 | $ | 3,839 | $ | 4,432 | $ | 6,207 |\\n\\n11\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| Unaudited | 2023 | 2022 | 2023 | 2022 |\\n| (in thousands, except share and per share data) |\\n| Net loss | $ | ( 4,704 | ) | $ | ( 23,022 | ) | $ | ( 13,462 | ) | $ | ( 43,382 | ) |\\n| Weighted-average shares used to compute net loss per share: |\\n| Basic and Diluted | 164,195,697 | 155,709,901 | 163,003,363 | 154,901,165 |\\n| Net loss per share: |\\n| Basic and Diluted | $ | ( 0.03 | ) | $ | ( 0.15 | ) | $ | ( 0.08 | ) | $ | ( 0.28 | ) |\\n\\n| June 30, 2023 | December 31, 2022 |\\n| (in thousands) | Unaudited |\\n| Employee compensation | $ | 3,821 | $ | 5,290 |\\n| User acquisition | 1,913 | 2,256 |\\n| Litigation costs | 750 | 5,500 |\\n| Professional fees | 576 | 543 |\\n| Other | 3,384 | 2,913 |\\n| Accrued expenses and other current liabilities | $ | 10,444 | $ | 16,502 |\\n\\n12\\n| (in thousands) | June 30, 2023 | December 31, 2022 |\\n| ASSETS | Unaudited |\\n| Cash and cash equivalents | $ | 497 | $ | 883 |\\n| Accounts receivable | 6,159 | 1,716 |\\n| Other assets | — | 4,813 |\\n| Total Assets | $ | 6,656 | $ | 7,412 |\\n| LIABILITIES |\\n| Accrued expenses and other current liabilities | 3,802 | 3,758 |\\n| Total Liabilities | $ | 3,802 | $ | 3,758 |\\n\\n13\\nItem 2\\n. Management’s Discussion and Analysis of Financial Condition and Results of Operations.\\nUnless the context otherwise requires, all references in this section as to “Talkspace,” the “Company,” “we,” “us” or “our” refer to the business of Talkspace, Inc. and its consolidated subsidiaries.\\nThe following discussion and analysis of our financial condition and results of operations should be read together with the financial statements and the related notes contained in this Quarterly Report and the financial statements and related notes contained in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2022. This discussion contains forward-looking statements that reflect our plans, estimates, and beliefs that involve risks and uncertainties. As a result of many factors, such as those discussed in Part I, Item 1A, “Risk Factors” of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2022 and “Forward-Looking Statements” sections and elsewhere in this Quarterly Report, our actual results may differ materially from those anticipated in these forward-looking statements.\\nThe purpose of this section is to discuss and analyze our consolidated financial condition, liquidity and capital resources and results of operations for the three and six months ended June 30, 2023 and 2022.\\nOverview\\nTalkspace is a healthcare company offering its members convenient and affordable access to a fully-credentialed network of highly qualified providers. We are a leading virtual behavioral health company and, since Talkspace’s founding in 2012, we have connected millions of patients with licensed mental health providers across a wide and growing spectrum of care through virtual counseling, psychotherapy and psychiatry. We created a purpose-built platform to address the vast, unmet and growing demand for mental health services of our members, serving our business-to-business (“B2B”) channel, comprised of large health plans and employee assistance programs (“Payors”) such as Aetna, Cigna, Premera and Optum and large enterprise clients (“DTE”) such as Google and Expedia (collectively, our “clients”), who offer their insured members and employees access to our platform at in-network reimbursement rates, or while their employer is under an active contract with Talkspace, where applicable, and our business-to-consumer (“Consumer”) channel, comprised of individual consumers who subscribe directly to our platform.\\nAs of June 30, 2023, we had approximately 110 million B2B eligible lives and approximately 13,700 consumer active members compared to 77 million B2B eligible lives and 20,100 consumer active members as of June 30, 2022. For the three and six months ended June 30, 2023, our clinicians completed 200,500 and 372,200 B2B sessions, respectively, related to members covered under our health plan clients, as compared to 96,000 and 186,600 completed B2B sessions for the three and six months ended June 30, 2022. Please refer to the “Key Business Metrics” section below for a description of active members and B2B eligible lives.\\nOperating Segments\\nThe Company operates as a single segment and as one reporting unit, which is how the chief operating decision maker (who is the chief executive officer) reviews financial performance and allocates resources.\\nKey Business Metrics\\nWe monitor the following key metrics to help us evaluate our business, identify trends affecting our business, formulate business plans and make strategic decisions. We believe the following metrics are useful in evaluating our business:\\n\\n| Unaudited | Six Months EndedJune 30, |\\n| (in thousands except number of health plan and enterprise clients or otherwise indicated) | 2023 | 2022 |\\n| Number of B2B eligible lives at period end (in millions) | 110 | 77 |\\n| Number of completed B2B sessions during the period | 372.2 | 186.6 |\\n| Number of health plan clients at period end | 20 | 16 |\\n| Number of enterprise clients at period end | 217 | 205 |\\n| Number of Consumer active members at period end | 13.7 | 20.1 |\\n\\n14\\nB2B Eligible Lives: We consider B2B lives “eligible” if such persons are eligible to receive treatment on the Talkspace platform, in the case of our health plan clients, at an agreed upon reimbursement rate through insurance under an employee assistance program or other network behavioral health paid benefit program. There may be instances where a person may be covered through multiple solutions, typically through behavioral health plans and employee assistance programs. In these instances, the person is counted each time they are covered in the B2B eligible lives calculation, which may cause this amount to reflect a higher number of B2B eligible lives than we actually serve.\\nActive Members: We consider members “active”, in the case of our Consumer members, commencing on the date such member initiates contact with a provider on our platform until the term of their monthly, quarterly or bi-annual subscription plan expires, unless terminated early.\\nComponents of Results of Operations\\nRevenues\\nWe contract with health insurance plans, employee assistance organizations and enterprises to provide services to individuals who are qualified to receive access to the Company’s services through the Company’s commercial arrangements. We generate revenues from payments from insured members and claims paid by their respective insurance companies and from contracted platform access fees paid to us by our enterprise clients for the delivery of therapy services to their members or employees. We recognize revenues from services provided to insured members at a point in time, as virtual therapy or psychiatry session is rendered. We recognize revenue from our enterprise clients ratably over the contractual term based primarily on a per-member-per month access fee model.\\nWe also generate revenues from the sale of monthly, quarterly, bi-annual and annual membership subscriptions to the Company's therapy platform as well as supplementary a la carte offerings directly to individual consumers through a subscription plan. We recognize member subscription revenues ratably over the subscription period, beginning when therapy services commence. We recognize revenues from supplementary a la carte offerings at a point in time, as virtual therapy session is rendered. Members may cancel their subscription at any time and will receive a pro-rata refund for the subscription price.\\nRevenue growth is generated from increasing our eligible covered lives through contracting with health plans, increasing utilization within eligible covered lives, expanding enterprise clients, and increasing membership subscriptions.\\nCost of Revenues\\nCost of revenues is comprised primarily of therapist payments. Cost of revenues is largely driven by number of sessions and the size of our provider network that is required to service the growth of our health plan and enterprise clients, in addition to the growth of our customer base.\\nWe designed our business model and our provider network to be scalable and to leverage a hybrid model of both employee providers and independently contracted providers to support multiple growth scenarios. The compensation paid to our independently contracted providers is variable, and the amount paid to a provider is generally based on the amount of time committed by such provider to our members. In addition, our network supervisors have authority to approve the payment of incentive bonuses to providers with certain licenses during periods of higher demand for providers with such licenses. For our employee providers, they receive a fixed-salary and discretionary bonuses, where applicable, all of which is included in cost of revenues.\\nWhile we expect to make increased investments to support accelerated growth and the required investment to scale our provider network, we also expect increased efficiencies and economies of scale. Our cost of revenues as a percentage of revenues is expected to fluctuate from period to period depending on the interplay of these factors as well as pricing fluctuations.\\n15\\nOperating Expenses\\nOperating expenses consist of research and development, clinical operations, sales and marketing, and general and administrative expenses.\\nResearch and Development Expenses\\nResearch and development expenses include personnel and related expenses for software development and engineering, information technology infrastructure, security, privacy compliance and product development (inclusive of stock-based compensation for our research and development employees), third-party services and contractors related to research and development, information technology and software-related costs.\\nClinical Operations Expenses\\nClinical operations expenses are associated with the management of our network of therapists. This item is comprised of costs related to recruiting, onboarding, credentialing, training and ongoing quality assurance activities (inclusive of stock-based compensation for our clinical operations employees), costs of third-party services and contractors related to recruiting and training and software-related costs.\\nSales and Marketing Expenses\\nSales expenses consist primarily of employee-related expenses, including salaries, benefits, commissions, travel and stock-based compensation costs for our employees engaged in sales and account management.\\nMarketing expenses consist primarily of advertising and marketing expenses for member acquisition and engagement, as well as personnel costs, including salaries, benefits, bonuses, stock-based compensation expense for marketing employees, third-party services and contractors. Marketing expenses also include third-party software subscription services, third-party independent research, participation in trade shows, brand messaging and costs of communications materials that are produced for our clients to generate greater awareness and utilization of our platform among our health plan and enterprise clients.\\nGeneral and Administrative Expenses\\nGeneral and administrative expenses consist primarily of personnel costs, including salaries, benefits, bonuses and stock-based compensation expense for certain executives, finance, accounting, legal and human resources functions, as well as professional fees, occupancy costs, and other general overhead costs.\\nFinancial income, net\\nFinancial income, net includes the impact from (i) non-cash changes in the fair value of our warrant liabilities, (ii) interest earned on cash equivalents deposited in our money market accounts and (iii) other financial expenses in connection with bank charges.\\nTaxes on income\\nOur taxes on income consists primarily of foreign income taxes related to income generated by our subsidiary organized under the laws of Israel.\\nWe have a full valuation allowance for our U.S. deferred tax assets, including federal and state NOLs. We expect to maintain this valuation allowance until it becomes more likely than not that the benefit of our federal and state deferred tax assets will be realized through expected future taxable income in the United States.\\n16\\nResults of Operations\\nThe following table presents our results of operations for the three and six months ended June 30, 2023 and 2022 and the dollar and percentage change between the respective periods:\\n\\n| (in thousands, except percentages) | Three Months EndedJune 30, | Variance | Six Months EndedJune 30, | Variance |\\n| Unaudited | 2023 | 2022 | $ | % | 2023 | 2022 | $ | % |\\n| Revenue: |\\n| Payor revenue | $18,539 | $7,880 | 10,659 | 135.3 | $33,350 | $15,990 | 17,360 | 108.6 |\\n| DTE revenue | 8,039 | 6,685 | 1,354 | 20.3 | 16,715 | 12,346 | 4,369 | 35.4 |\\n| Total B2B revenue | 26,578 | 14,565 | 12,013 | 82.5 | 50,065 | 28,336 | 21,729 | 76.7 |\\n| Consumer revenue | 9,067 | 15,279 | (6,212) | (40.7) | 18,916 | 31,658 | (12,742) | (40.2) |\\n| Total revenue | 35,645 | 29,844 | 5,801 | 19.4 | 68,981 | 59,994 | 8,987 | 15.0 |\\n| Cost of revenue | 17,833 | 15,297 | 2,536 | 16.6 | 34,421 | 30,426 | 3,995 | 13.1 |\\n| Gross profit | 17,812 | 14,547 | 3,265 | 22.4 | 34,560 | 29,568 | 4,992 | 16.9 |\\n| Operating expenses: |\\n| Research and development, net | 4,171 | 5,576 | (1,405) | (25.2) | 9,524 | 10,611 | (1,087) | (10.2) |\\n| Clinical operations, net | 1,675 | 2,316 | (641) | (27.7) | 3,276 | 4,092 | (816) | (19.9) |\\n| Sales and marketing | 13,045 | 18,931 | (5,886) | (31.1) | 26,514 | 40,339 | (13,825) | (34.3) |\\n| General and administrative | 5,329 | 8,792 | (3,463) | (39.4) | 10,693 | 16,802 | (6,109) | (36.4) |\\n| Total operating expenses | 24,220 | 35,615 | (11,395) | (32.0) | 50,007 | 71,844 | (21,837) | (30.4) |\\n| Operating loss | (6,408) | (21,068) | 14,660 | 69.6 | (15,447) | (42,276) | 26,829 | 63.5 |\\n| Financial (income) expense, net | (1,712) | 1,865 | (3,577) | * | (2,136) | 996 | (3,132) | * |\\n| Loss before taxes on income | (4,696) | (22,933) | 18,237 | 79.5 | (13,311) | (43,272) | 29,961 | 69.2 |\\n| Taxes on income | 8 | 89 | (81) | (91.0) | 151 | 110 | 41 | 37.3 |\\n| Net loss | $(4,704) | $(23,022) | $18,318 | 79.6 | $(13,462) | $(43,382) | $29,920 | 69.0 |\\n\\n* Percentage not meaningful\\nRevenues. Revenues increased by $5.8 million, or 19.4% to $35.6 million for the three months ended June 30, 2023 from $29.8 million for the three months ended June 30, 2022. The increase was principally due to a 82.5% growth in B2B revenue driven by a higher number of completed B2B sessions and an increase in covered lives from health plan clients (\\\"Payors\\\") and new enterprise clients (\\\"DTE\\\"), partially offset by a 40.7% decline in consumer subscription revenue. Revenue from our health plan clients increased by $10.7 million, or 135.3%, to $18.5 million for the three months ended June 30, 2023 from $7.9 million for the three months ended June 30, 2022. Enterprise client contracts increased by 12 clients, or 5.9%, to 217 clients as of June 30, 2023 from 205 clients as of June 30, 2022. This increase in the number of enterprise clients drove DTE revenue to increase by $1.4 million, or 20.3% to $8.0 million for the three months ended June 30, 2023 from $6.7 million for the three months ended June 30, 2022. Consumer subscriptions revenue decreased by $6.2 million, or 40.7%, to $9.1 million for the three months ended June 30, 2023 from $15.3 million for the three months ended June 30, 2022, due to the Company's intentional and strategic decision to reduce marketing spend related to this service.\\nRevenues increased by $9.0 million, or 15.0% to $69.0 million for the six months ended June 30, 2023 from $60.0 million for the six months ended June 30, 2022. The increase was principally due to a 76.7% growth in B2B revenue driven by a higher number of completed B2B sessions and an increase in covered lives from Payors and new DTE clients, partially offset by a 40.2% decline in consumer subscription revenue. Revenue from our health plan clients increased by $17.4 million, or 108.6%, to $33.4 million for the six months ended June 30, 2023 from $16.0 million for the six months ended June 30, 2022. Enterprise client contracts increased by 12 clients, or 5.9%, to 217 clients as of June 30, 2023 from 205 clients as of June 30, 2022. This increase in the number of enterprise clients drove DTE revenue to increase by $4.4 million, or 35.4% to $16.7 million for the six months ended June 30, 2023 from $12.3 million for the six months ended June 30, 2022. Consumer subscriptions revenue decreased by $12.7 million, or 40.2%, to $18.9 million for the six months ended June 30, 2023 from $31.7 million for the six months ended June 30, 2022, due to the Company's intentional and strategic decision to reduce marketing spend related to this service.\\nCosts of revenues. Cost of revenues increased by $2.5 million, or 16.6%, to $17.8 million for the three months ended June 30, 2023 from $15.3 million for the three months ended June 30, 2022, and increased by $4.0 million, or 13.1%, to $34.4 million for the six months ended June 30, 2023 from $30.4 million for the six months ended June 30, 2022. The increase in cost of revenues for the three and six months ended June 30, 2023, was primarily due to increased hours worked by therapists to meet strong customer engagement.\\n17\\nGross profit. Gross profit increased by $3.3 million, or 22.4%, to $17.8 million for the three months ended June 30, 2023 from $14.5 million for the three months ended June 30, 2022. Gross profit increased by $5.0 million, or 16.9%, to $34.6 million for the six months ended June 30, 2023 from $29.6 million for the six months ended June 30, 2022. The increase in gross profit for the three and six months ended June 30, 2023 was primarily driven by higher revenue and provider network productivity.\\nGross margin was 50.0% for the three months ended June 30, 2023, compared to 48.7% during the three months ended June 30, 2022. Gross margin was 50.1% for the six months ended June 30, 2023, compared to 49.3% during the six months ended June 30, 2022. The increase in gross margin for the three and six months ended June 30, 2023 was primarily due to higher revenue and provider network productivity, partially offset by the revenue shift mix towards B2B revenue.\\nOperating expenses\\nOverall, our operating expenses for the three and six months ended June 30, 2023 have decreased due to our efficiency initiatives in order to optimize for profitability.\\nResearch and development expenses. Research and development expenses decreased by $1.4 million, or 25.2% to $4.2 million for the three months ended June 30, 2023 from $5.6 million for the three months ended June 30, 2022, and decreased by $1.1 million, or 10.2% to $9.5 million for the six months ended June 30, 2023 from $10.6 million for the six months ended June 30, 2022. The decrease in research and development expenses for the three and six months ended June 30, 2023 was primarily due to a decrease in employee-related costs, inclusive of non-cash stock compensation expense.\\nClinical operations expenses. Clinical operations expenses decreased by $0.6 million, or 27.7% to $1.7 million for the three months ended June 30, 2023 from $2.3 million for the three months ended June 30, 2022, and decreased by $0.8 million, or 19.9% to $3.3 million for the six months ended June 30, 2023 from $4.1 million for the six months ended June 30, 2022. The decrease in clinical operations expenses for the three and six months ended June 30, 2023 was primarily due to lower provider recruitment costs.\\nSales and marketing expenses. Sales and marketing expenses decreased by $5.9 million, or 31.1%, to $13.0 million for the three months ended June 30, 2023 from $18.9 million for the three months ended June 30, 2022, and decreased by $13.8 million, or 34.3%, to $26.5 million for the six months ended June 30, 2023 from $40.3 million for the six months ended June 30, 2022. The decrease in sales and marketing expenses for the three and six months ended June 30, 2023 was primarily driven by a decrease in direct marketing and promotional costs.\\nGeneral and administrative expenses. General and administrative expenses decreased by $3.5 million, or 39.4%, to $5.3 million for the three months ended June 30, 2023 from $8.8 million for the three months ended June 30, 2022, and decreased by $6.1 million, or 36.4%, to $10.7 million for the six months ended June 30, 2023 from $16.8 million for the six months ended June 30, 2022. The decrease in general and administrative expenses for the three and six months ended June 30, 2023 was primarily due to a decrease in professional fees, subcontractor costs and employee-related costs, inclusive of non-cash stock compensation expense.\\nFinancial income, net. Financial income, net was $1.7 million for the three months ended June 30, 2023, compared to financial expense, net of $1.9 million for the three months ended June 30, 2022. For the three months ended June 30, 2023 financial income, net was primarily driven by interest income earned on our money market accounts of $1.5 million and $0.3 million in non-cash gains resulting from the remeasurement of warrant liabilities. For the three months ended June 30, 2022 financial expense, net primarily consisted of $2.1 million in non-cash losses resulting from the remeasurement of warrant liabilities.\\nFinancial income, net was $2.1 million for the six months ended June 30, 2023, compared to financial expense, net of $1.0 million for the six months ended June 30, 2022. For the six months ended June 30, 2023 financial income, net was primarily driven by interest income earned on our money market accounts of $2.1 million. For the six months ended June 30, 2022 financial expense, net was primarily driven by $1.2 million of non-cash losses resulting from the remeasurement of warrant liabilities.\\nTaxes on income. Taxes on income consists primarily of foreign income taxes related to income generated by our subsidiary organized under the laws of Israel.\\n18\\nNon-GAAP Financial Measures\\nIn addition to our financial results determined in accordance with GAAP, we believe adjusted EBITDA, a non-GAAP measure, is useful in evaluating our operating performance and is a key performance measure that our management uses to assess our operating performance. Because adjusted EBITDA facilitates internal comparisons of our historical operating performance on a more consistent basis, we use this measure for business planning purposes and in evaluating acquisition opportunities. We also use adjusted EBITDA to evaluate our ongoing operations and for internal planning and forecasting purposes. We believe that this non-GAAP financial measure, when taken together with the corresponding GAAP financial measures, provides meaningful supplemental information regarding our performance by excluding certain items that may not be indicative of our business, results of operations or outlook. We believe that the use of adjusted EBITDA is helpful to our investors as it is a metric used by management in assessing the health of our business and our operating performance. However, non-GAAP financial information is presented for supplemental informational purposes only, has limitations as an analytical tool and should not be considered in isolation or as a substitute for financial information presented in accordance with GAAP.\\nSome of the limitations of adjusted EBITDA include (i) adjusted EBITDA does not necessarily reflect capital commitments to be paid in the future and (ii) although depreciation and amortization are non-cash charges, the underlying assets may need to be replaced and adjusted EBITDA does not reflect these requirements. In evaluating adjusted EBITDA, you should be aware that in the future we will incur expenses similar to the adjustments described herein. Our presentation of adjusted EBITDA should not be construed as an inference that our future results will be unaffected by these expenses or any unusual or non-recurring items. Our adjusted EBITDA may not be comparable to similarly titled measures of other companies because they may not calculate adjusted EBITDA in the same manner as we calculate the measure, limiting its usefulness as a comparative measure. Adjusted EBITDA should not be considered as an alternative to loss before income taxes, net loss, loss per share, or any other performance measures derived in accordance with U.S. GAAP. When evaluating our performance, you should consider adjusted EBITDA alongside other financial performance measures, including our net loss and other GAAP results.\\nA reconciliation is provided below for adjusted EBITDA to net loss, the most directly comparable financial measure stated in accordance with GAAP. Investors are encouraged to review our financial statements prepared in accordance with GAAP and the reconciliation of our non-GAAP financial measure to its most directly comparable GAAP financial measure, and not to rely on any single financial measure to evaluate our business.\\nWe calculate adjusted EBITDA as net loss income adjusted to exclude (i) depreciation and amortization, (ii) interest and other expenses (income), net, (iii) tax benefit and expense, and (iv) stock-based compensation expense.\\nThe following table presents a reconciliation of adjusted EBITDA from the most comparable GAAP measure, net loss for the three and six months ended June 30, 2023 and 2022:\\n\\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\\n| Unaudited | 2023 | 2022 | 2023 | 2022 |\\n| (in thousands) |\\n| Net loss | $ | (4,704 | ) | $ | (23,022 | ) | $ | (13,462 | ) | $ | (43,382 | ) |\\n| Add: |\\n| Depreciation and amortization | 302 | 268 | 608 | 697 |\\n| Financial (income) expense, net (1) | (1,712 | ) | 1,865 | (2,136 | ) | 996 |\\n| Taxes on income | 8 | 89 | 151 | 110 |\\n| Stock-based compensation | 2,129 | 3,839 | 4,432 | 6,207 |\\n| Adjusted EBITDA | $ | (3,977 | ) | $ | (16,961 | ) | $ | (10,407 | ) | $ | (35,372 | ) |\\n\\n(1) For the three months ended June 30, 2023, financial (income), net, primarily consisted of $1.5 million of interest income from our money market accounts and $0.3 million in gains resulting from the remeasurement of warrant liabilities. For the six months ended June 30, 2023, financial (income), net, primarily consisted of $2.1 million of interest income from our money market accounts. For the three and six months ended June 30, 2022, financial expense, net primarily consisted of $2.1 million and $1.2 million, respectively, in losses resulting from the remeasurement of warrant liabilities.\\n19\\nLiquidity and Capital Resources\\nAs of June 30, 2023, we had $126.1 million of cash and cash equivalents ($138.5 million as of December 31, 2022), which we use to finance our operations and support a variety of growth initiatives and investments. We had no debt as of June 30, 2023.\\nOur primary cash needs are to fund operating activities. Our future capital requirements will depend on many factors including our growth rate, contract renewal activity, the timing and extent of investments to support product development efforts, our expansion of sales and marketing activities, the introduction of new and enhanced service offerings, and the continuing market acceptance of virtual behavioral services. Additionally, we may in the future enter into arrangements to acquire or invest in complementary businesses, services and technologies.\\nWe currently anticipate to be able to fund our cash needs for at least the next 12 months and thereafter for the foreseeable future using available cash and cash equivalent balances as of June 30, 2023. However, in the future we may require additional capital to respond to technological advancements, competitive dynamics, customer demands, business and investment opportunities, acquisitions or unforeseen circumstances and we may determine to engage in equity or debt financings for other reasons. We may not be able to timely secure additional debt or equity financing on favorable terms, or at all. If we raise additional funds through the issuance of equity or convertible debt or other equity-linked securities, our existing stockholders could experience significant dilution. Any debt financing obtained by us in the future could involve restrictive covenants relating to our capital raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities, including potential acquisitions. If we cannot raise capital when needed, we may be forced to undertake asset sales or similar measures to ensure adequate liquidity.\\nCash Flows from Operating, Investing and Financing Activities\\nThe following table presents the summary condensed consolidated cash flow information for the periods presented:\\nCash Flows\\n\\n| Unaudited | Six Months EndedJune 30, |\\n| (in thousands) | 2023 | 2022 |\\n| Net cash used in operating activities | $ | (13,748 | ) | $ | (33,111 | ) |\\n| Net cash provided by (used in) investing activities | 18 | (160 | ) |\\n| Net cash provided by financing activities | 1,289 | 1,637 |\\n| Net decrease in cash and cash equivalents | $ | (12,441 | ) | $ | (31,634 | ) |\\n\\nOperating Activities\\nThe decrease in net cash used in operating activities was driven primarily by the positive impact of lower operating expenses, favorable timing of collections on receivables and an increase in interest income from our money market accounts offset by unfavorable timing of payments of account payables and accrued expenses.\\nInvesting Activities\\nThe increase in net cash provided by investing activities was driven primarily by an increase in the proceeds from the sale of computer equipment and a decrease in the purchases of computer equipment and software.\\nFinancing Activities\\nThe decrease in net cash provided by financing activities was primarily driven by a decrease in the proceeds from the exercise of stock options.\\nContractual Obligations, Commitments and Contingencies\\nAs of June 30, 2023, we did not have any short-term or long-term debt, or significant long-term liabilities.\\nAs of June 30, 2023, we have a non-material long-term operating lease for our office space in New York, NY.\\nA settlement was reached in February 2023 for certain class action lawsuits ending an ongoing litigation, see Note 5, “Commitments and Contingent Liabilities” in the notes to the condensed consolidated financial statements for further details.\\n20\\nIn addition, we may in the future be involved in various legal proceedings, claims and litigation that arise in the normal course of business. We accrue for estimated loss contingencies related to legal matters when available information indicates that it is probable a liability had been incurred and we can reasonably estimate the amount of that loss. In many proceedings, however, it is inherently difficult to determine whether any loss is probable or even possible or to estimate the amount of any loss. In addition, even where a loss is possible or an exposure to loss exists in excess of the liability already accrued with respect to a previously recognized loss contingency, it is often not possible to reasonably estimate the size of the possible loss or range of loss or possible additional losses or range of additional losses. Should any of our estimates and assumptions change or prove to be incorrect, it could have a material impact on our results of operations, financial position, and cash flows. See Note 5, “Commitments and Contingent Liabilities” in the notes to the condensed consolidated financial statements for further details.\\nOur commercial contract arrangements generally include certain provisions requiring us to indemnify clients against liabilities if there is a breach of a client’s data or if our service infringes a third party’s intellectual property rights. To date, we have not incurred any material costs as a result of such indemnifications.\\nWe have also agreed to indemnify our officers and directors for costs associated with any fees, expenses, judgments, fines and settlement amounts incurred by any of these persons in any action or proceeding to which any of those persons is, or is threatened to be, made a party by reason of the person’s service as a director or officer, including any action by us, arising out of that person’s services as our director or officer or that person’s services provided to any other company or enterprise at our request. We maintain director and officer liability insurance coverage that would generally enable us to recover a portion of any future amounts paid. We may also be subject to indemnification obligations by law with respect to the actions of our employees under certain circumstances and in certain jurisdictions.\\nOff-Balance Sheet Arrangements\\nWe do not invest in any off-balance sheet vehicles that provide liquidity, capital resources, market or credit risk support, or engage in any activities that expose us to any liability that is not reflected in our condensed consolidated financial statements.\\nInflation Risk\\nWe do not believe that inflation has had a material effect on our business, financial condition or results of operations. If our costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could harm our business, financial condition or results of operations.\\nCritical Accounting Policies and Estimates\\nThe Company’s condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. Reference is also made to the Company’s consolidated financial statements and notes thereto found in its Annual Report on Form 10-K for the year ended December 31, 2022.\\nThe Company’s accounting policies are essential to understanding and interpreting the financial results reported on the condensed consolidated financial statements. The significant accounting policies used in the preparation of the Company’s consolidated financial statements are summarized in Note 2 to those financial statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2022. Certain of those policies are considered to be particularly important to the presentation of the Company's financial results because they require management to make difficult, complex or subjective judgments, often as a result of matters that are inherently uncertain.\\nDuring the six months ended June 30, 2023, there were no material changes to matters discussed under the heading “Critical Accounting Policies and Estimates” in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2022.\\nRecent Accounting Pronouncements\\nInformation regarding recent accounting developments and their impact on our results can be found in Note 2, “Summary of Significant Accounting Policies and Estimates” in the audited consolidated financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2022 and in Note 2, “Significant Accounting Policies” in the notes to the condensed consolidated financial statements of this Quarterly Report on Form 10-Q.\\n21\\nFORWARD-LOOKING STATEMENTS\\nThis Quarterly Report on Form 10-Q (the “Quarterly Report”) contains forward-looking statements. We intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). All statements other than statements of historical facts contained in this Quarterly Report may be forward-looking statements. In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “could,” “intends,” “targets,” “projects,” “contemplates,” “believes,” “estimates,” “forecasts,” “predicts,” “potential” or “continue” or the negative of these terms or other similar expressions. Forward-looking statements contained in this Quarterly Report include, but are not limited to, statements regarding our future results of operations and financial position, industry and business trends, stock-based compensation, revenue recognition, business strategy, plans and market growth.\\nThe forward-looking statements in this Quarterly Report and other such statements we publicly make from time-to-time are only predictions. We base these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our business, financial condition, and results of operations. Forward-looking statements involve known and unknown risks, uncertainties and other important factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements, including, but not limited to, the important factors discussed in Part I, Item 1A, “Risk Factors” of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2022. The forward-looking statements in this Quarterly Report are based upon information available to us as of the date of this Quarterly, and while we believe such information forms a reasonable basis for such statements, such information may be limited or incomplete, and our statements should not be read to indicate that we have conducted an exhaustive inquiry into, or review of, all potentially available relevant information. These statements are inherently uncertain and investors are cautioned not to unduly rely upon these statements.\\nYou should read this Quarterly Report and the risk factors discussed in Part I, Item 1A, “Risk Factors” of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2022 with the understanding that our actual future results, levels of activity, performance and achievements may be materially different from what we expect. We qualify all of our forward-looking statements by these cautionary statements. These forward-looking statements speak only as of the date of this Quarterly Report. Except as required by applicable law, we do not plan to publicly update or revise any forward-looking statements contained in this Quarterly Report on Form 10-Q or any forward-looking statements we may publicly make from time-to-time, whether as a result of any new information, future events or otherwise.\\nItem 3\\n. Quantitative and Qualitative Disclosures About Market Risk.\\nDuring the six months ended June 30, 2023, there were no material changes to the information contained in Part II, Item 7A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2022.\\n22\\n\\nItem 4\\n. Controls and Procedures.\\nIn connection with the preparation of this report, an evaluation was carried out under the supervision, and with the participation of, our management including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act of 1934, as amended (the “Act”)) as of June 30, 2023. Based upon the evaluation and although management has made significant progress in the design and implementation of IT and business process controls, our CEO and CFO concluded our disclosure controls and procedures are not effective as of such date solely due to material weaknesses in internal controls over financial reporting that were disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2022 and are discussed below.\\nAs previously described in Part II, Item 9A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2022, we concluded that our internal control over financial reporting was not effective solely due to the existence of the following material weaknesses described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2022:\\n1.Management was able to complete the design and establish effective information technology general controls (ITGCs) for the majority of tested ITGCs; however, some ineffective ITGC controls existed at December 31, 2022. As a result, business process controls (automated and IT-dependent manual controls) that are dependent on the ineffective ITGCs, or that use data produced from systems impacted by the ineffective ITGCs were deemed ineffective; and\\n2.Management did not have an adequate process in place to monitor and provide oversight over the completion of its testing and assessment of the design and operating effectiveness of internal control over financial reporting in a timely manner.\\nThe material weaknesses did not result in any identified misstatements to the financial statements, and there were no changes to previously released financial results.\\nRemediation Plan for the Material Weakness\\nManagement is committed to the remediation of the material weakness described above, as well as the continued improvement of the Company’s internal control over financial reporting. Management has implemented and continues to implement measures designed to ensure that control deficiencies contributing to the material weakness are remediated, such that these controls are designed, implemented and operating effectively.\\nRemediation efforts include but are not limited to, (a) hiring additional personnel with appropriate technical skill sets, (b) developing an execution plan and resources to test controls and providing timely feedback of any deficiencies noted to complete remediation (c) establishing a training program for the entire organization to support ongoing execution of internal controls and adherence to control activities and (d) actively monitoring corrective actions and providing status reporting to leadership on the progress.\\nManagement will test and evaluate the implementation of internal controls and revised processes to ascertain whether they are designed and operating effectively to provide reasonable assurance that they will prevent or detect a material error in our financial statements.\\nWe believe that once these actions have been completed, it will remediate the material weakness. The material weakness will not be considered remediated, however, until the applicable controls operate for a sufficient period of time and management has concluded, through testing, that controls are operating effectively.\\nChanges in Internal Control Over Financial Reporting\\nThere have been no changes in the Company’s internal control over financial reporting during the six months ended June 30, 2023 which have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\\nIn order to enhance the Company's internal control over financial reporting, management has (a) hired additional personnel with appropriate technical skill sets, (b) developed an execution plan and engaged resources to test controls and provide timely feedback of any deficiencies noted, (c) provided training to the organization to support ongoing execution of internal controls and adherence to control activities, and (d) implemented status reporting to leadership on the progress of the assessment of the design and operating effectiveness of internal control over financial reporting.\\n23\\nPART II—OTHER INFORMATION\\nItem 1\\n. Legal Proceedings.\\nThe Company reached settlements for certain class action lawsuits in February 2023 ending on going securities and derivatives suits. The settlements for these lawsuits have received preliminary court approval and are expected to receive final court approval in the third quarter of 2023. See Note 5, “Commitments and Contingent Liabilities” in the notes to the condensed consolidated financial statements for further details.\\nIn addition to the foregoing, the Company may in the future be involved in various legal proceedings, claims and litigation that arise in the normal course of business. The Company accrues for estimated loss contingencies related to legal matters when available information indicates that it is probable a liability had been incurred and the Company can reasonably estimate the amount of that loss. In many proceedings, however, it is inherently difficult to determine whether any loss is probable or even possible or to estimate the amount of any loss. In addition, even where a loss is possible or an exposure to loss exists in excess of the liability already accrued with respect to a previously recognized loss contingency, it is often not possible to reasonably estimate the size of the possible loss or range of loss or possible additional losses or range of additional losses.\\nI\\nte\\nm\\n1a. R\\nisk Factors.\\nIn addition to the other information set forth in this Quarterly Report, you should carefully consider the factors discussed under Part I, Item 1A. “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2022. These factors could materially adversely affect our business, financial condition, liquidity, results of operations and capital position, and could cause our actual results to differ materially from our historical results or the results contemplated by any forward-looking statements contained in this Quarterly Report. During the six months ended June 30, 2023, there were no material changes to the information contained in Part I, Item 1A of the Company's Annual Report on Form 10-K for the year ended December 31, 2022.\\nItem 2\\n. Unregistered Sales of Equity Securities and Use of Proceeds.\\nNot applicable.\\nItem 3\\n. Defaults Upon Senior Securities.\\nNone.\\nItem 4\\n. Mine Safety Disclosures.\\nNot applicable.\\nItem 5\\n. Other Information.\\nNone.\\n24\\n\\nItem 6\\n. Exhibits.\\n\\n| Filed/ |\\n| ExhibitNumber | Exhibit Description | FurnishedHerewith |\\n| 31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a). | * |\\n| 31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a). | * |\\n| 32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350. | ** |\\n| 32.2 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350. | ** |\\n| 101.INS | Inline XBRL Instance Document - the instance document does not appear in the Interactive Data file because its XBRL tags are embedded within the Inline XBRL document. | * |\\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document. | * |\\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document. | * |\\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document. | * |\\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document. | * |\\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document. | * |\\n| 104 | Cover Page Interactive Data File (as formatted as Inline XBRL and contained in Exhibit 101). | * |\\n\\n* Filed herewith.\\n** Furnished herewith.\\n25\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n\\n| Talkspace, Inc. |\\n| Date: August 2, 2023 | By: | /s/ Jon Cohen |\\n| Jon Cohen |\\n| Chief Executive Officer |\\n| Date: August 2, 2023 | By: | /s/ Jennifer Fulk |\\n| Jennifer Fulk |\\n| Chief Financial Officer |\\n\\n26\\n \\n\\nWhat is the percentage change for Adjusted EBITDA year on year for two consecutive periods ending June 30, 2023 and 2022?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 76.55209008902777.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 69,\n \"input_length\": 17927\n}"}}},{"rowIdx":70,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nITEM 1. FINANCIAL STATEMENTS\nLIVENT CORPORATION\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| (in Millions, Except Per Share Data) | (unaudited) |\n| Revenue | $ | 103.6 | $ | 72.6 | $ | 297.5 | $ | 206.0 |\n| Cost of sales | 85.3 | 69.8 | 245.5 | 178.4 |\n| Gross margin | 18.3 | 2.8 | 52.0 | 27.6 |\n| Selling, general and administrative expenses | 11.8 | 10.0 | 34.2 | 31.1 |\n| Research and development expenses | 0.8 | 1.0 | 2.2 | 2.8 |\n| Restructuring and other charges | 1.1 | 4.4 | 3.4 | 10.1 |\n| Separation-related costs | 0.8 | 0.6 | 1.3 | 0.8 |\n| Total costs and expenses | 99.8 | 85.8 | 286.6 | 223.2 |\n| Income/(loss) from operations before loss on debt extinguishment, equity in net loss of unconsolidated affiliates and interest expense, net | 3.8 | ( 13.2 ) | 10.9 | ( 17.2 ) |\n| Loss on debt extinguishment | — | — | — | 0.1 |\n| Equity in net loss of unconsolidated affiliates | 1.0 | 0.1 | 3.7 | 0.4 |\n| Interest expense, net | — | 0.3 | 0.3 | 0.3 |\n| Income/(loss) from operations before income taxes | 2.8 | ( 13.6 ) | 6.9 | ( 18.0 ) |\n| Income tax expense/(benefit) | 15.4 | ( 3.1 ) | 13.8 | ( 5.4 ) |\n| Net loss | $ | ( 12.6 ) | $ | ( 10.5 ) | $ | ( 6.9 ) | $ | ( 12.6 ) |\n| Net loss per weighted average share - basic and diluted | $ | ( 0.08 ) | $ | ( 0.07 ) | $ | ( 0.05 ) | $ | ( 0.09 ) |\n| Weighted average common shares outstanding - basic and diluted | 161.6 | 146.3 | 152.3 | 146.2 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n4\nLIVENT CORPORATION\nCONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| (in Millions) | (unaudited) |\n| Net loss | $ | ( 12.6 ) | $ | ( 10.5 ) | $ | ( 6.9 ) | $ | ( 12.6 ) |\n| Other comprehensive (loss)/income, net of tax: |\n| Foreign currency adjustments: |\n| Foreign currency translation (loss)/gain arising during the period | ( 1.1 ) | 3.0 | ( 0.2 ) | 1.4 |\n| Total foreign currency translation adjustments | ( 1.1 ) | 3.0 | ( 0.2 ) | 1.4 |\n| Derivative instruments: |\n| Unrealized hedging losses, net of tax of less than $ 0.1 | ( 0.1 ) | — | — | ( 0.2 ) |\n| Total derivative instruments loss, net of tax of less than $ 0.1 | ( 0.1 ) | — | — | ( 0.2 ) |\n| Other comprehensive (loss)/income, net of tax | ( 1.2 ) | 3.0 | ( 0.2 ) | 1.2 |\n| Comprehensive loss | $ | ( 13.8 ) | $ | ( 7.5 ) | $ | ( 7.1 ) | $ | ( 11.4 ) |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n5\nLIVENT CORPORATION\nCONDENSED CONSOLIDATED BALANCE SHEETS\n| (in Millions, Except Share and Par Value Data) | September 30, 2021 | December 31, 2020 |\n| ASSETS | (unaudited) |\n| Current assets |\n| Cash and cash equivalents | $ | 195.3 | $ | 11.6 |\n| Trade receivables, net of allowance of $ 0.3 and $ 0.4 , respectively | 83.0 | 76.3 |\n| Inventories, net | 110.2 | 105.6 |\n| Prepaid and other current assets | 43.8 | 56.3 |\n| Total current assets | 432.3 | 249.8 |\n| Investments | 23.2 | 23.8 |\n| Property, plant and equipment, net of accumulated depreciation of $ 238.3 and $ 222.4 , respectively | 605.3 | 545.3 |\n| Deferred income taxes | 2.2 | 13.4 |\n| Right of use assets - operating leases, net | 6.4 | 16.1 |\n| Other assets | 81.6 | 88.4 |\n| Total assets | $ | 1,151.0 | $ | 936.8 |\n| LIABILITIES AND EQUITY |\n| Current liabilities |\n| Accounts payable, trade and other | $ | 49.7 | $ | 43.9 |\n| Accrued customer rebates | — | 0.3 |\n| Accrued and other current liabilities | 35.7 | 36.7 |\n| Operating lease liabilities - current | 1.0 | 1.4 |\n| Income taxes | 2.3 | — |\n| Total current liabilities | 88.7 | 82.3 |\n| Long-term debt | 240.1 | 274.6 |\n| Operating lease liabilities - long-term | 5.5 | 14.8 |\n| Environmental liabilities | 6.2 | 6.1 |\n| Deferred income taxes | 7.8 | 5.6 |\n| Other long-term liabilities | 18.2 | 17.2 |\n| Commitments and contingent liabilities (Note 13) |\n| Total current and long-term liabilities | 366.5 | 400.6 |\n| Equity |\n| Common stock; $ 0.001 par value; 2 billion shares authorized in 2018; 161,676,147 and 146,461,249 shares issued; 161,575,016 and 146,361,981 outstanding at September 30, 2021 and December 31, 2020, respectively | 0.1 | 0.1 |\n| Capital in excess of par value of common stock | 776.4 | 520.9 |\n| Retained earnings | 53.4 | 60.3 |\n| Accumulated other comprehensive loss | ( 44.6 ) | ( 44.4 ) |\n| Treasury stock, common; 101,131 and 99,268 shares at September 30, 2021 and December 31, 2020, respectively | ( 0.8 ) | ( 0.7 ) |\n| Total equity | 784.5 | 536.2 |\n| Total liabilities and equity | $ | 1,151.0 | $ | 936.8 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n6\nLIVENT CORPORATION\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n| Nine Months Ended September 30, |\n| 2021 | 2020 |\n| (in Millions) | (unaudited) |\n| Cash provided by operating activities: |\n| Net loss | $ | ( 6.9 ) | $ | ( 12.6 ) |\n| Adjustments to reconcile net loss to cash provided by operating activities: |\n| Depreciation and amortization | 18.7 | 17.7 |\n| Restructuring and other charges | ( 0.8 ) | 4.3 |\n| Deferred income taxes | 11.2 | ( 5.7 ) |\n| Separation-related costs | — | 0.1 |\n| Share-based compensation | 4.0 | 3.4 |\n| Change in investments in trust fund securities | 0.4 | 0.1 |\n| Loss on debt extinguishment | — | 0.1 |\n| Deferred financing fees amortization | 0.3 | 0.3 |\n| Equity in net loss of unconsolidated affiliates | 3.7 | 0.4 |\n| Changes in operating assets and liabilities: |\n| Trade receivables, net | ( 6.2 ) | 17.5 |\n| Inventories | ( 4.2 ) | ( 0.1 ) |\n| Accounts payable, trade and other | 5.5 | ( 40.9 ) |\n| Change in deferred compensation | 1.2 | 0.4 |\n| Income taxes | 2.3 | ( 0.9 ) |\n| Change in prepaid and other current assets and other assets | 16.6 | ( 5.5 ) |\n| Change in accrued and other current liabilities and other long-term liabilities | ( 4.8 ) | 22.9 |\n| Cash provided by operating activities | 41.0 | 1.5 |\n| Cash used in investing activities: |\n| Capital expenditures(1) | ( 69.4 ) | ( 110.0 ) |\n| Investments in trust fund securities | ( 1.2 ) | ( 0.4 ) |\n| Investment in unconsolidated affiliate | ( 2.5 ) | — |\n| Other investing activities | ( 1.2 ) | ( 1.4 ) |\n| Cash used in investing activities | ( 74.3 ) | ( 111.8 ) |\n| Cash provided by financing activities: |\n| Proceeds from Revolving Credit Facility | 39.5 | 147.0 |\n| Repayments of Revolving Credit Facility | ( 75.1 ) | ( 276.5 ) |\n| Proceeds from 2025 Notes | — | 245.7 |\n| Payments of financing fees | — | ( 8.4 ) |\n| Proceeds from Offering | 261.6 | — |\n| Payments of underwriting fees and expenses - Offering | ( 9.4 ) | — |\n| Proceeds of issuance of common stock - incentive plans | 0.3 | 0.4 |\n| Cash provided by financing activities | 216.9 | 108.2 |\n| Effect of exchange rate changes on cash and cash equivalents | 0.1 | 0.1 |\n| Increase/(decrease) in cash and cash equivalents | 183.7 | ( 2.0 ) |\n| Cash and cash equivalents, beginning of period | 11.6 | 16.8 |\n| Cash and cash equivalents, end of period | $ | 195.3 | $ | 14.8 |\n\n7\nLIVENT CORPORATION\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)\n| Nine Months Ended September 30, |\n| 2021 | 2020 |\n| Supplemental Disclosure for Cash Flow: | (unaudited) |\n| Cash payments for income taxes, net (2) | $ | 0.5 | $ | 2.8 |\n| Cash payments for interest, net (1) | $ | 12.9 | $ | 4.8 |\n| Cash payments for Restructuring and other charges | $ | 4.2 | $ | 5.8 |\n| Cash payments for Separation-related charges | $ | 1.4 | $ | 0.7 |\n| Accrued capital expenditures | $ | 17.8 | $ | 7.8 |\n| Operating lease right-of-use assets and lease liabilities recorded for ASC 842 | $ | 2.1 | $ | 0.8 |\n\n____________________\n1. For the nine months ended September 30, 2021, and 2020 $ 11.5 million and $ 8.1 million of interest expense was capitalized, respectively.\n2.Nine months ended September 30, 2021 includes $ 1.7 million of refunds relating to U.S. state taxes and foreign taxes. Nine months ended September 30, 2020 includes $ 1.9 million refund from FMC related to the Company's 2018 federal income tax return.\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n8\nLIVENT CORPORATION\nCONDENSED CONSOLIDATED STATEMENTS OF EQUITY\n(UNAUDITED)\n| (in Millions Except Per Share Data) | Common Stock, $ 0.001 Per Share Par Value | Capital In Excess of Par | Retained Earnings | Accumulated Other Comprehensive Loss | Treasury Stock | Total |\n| Balance, December 31, 2019 | $ | 0.1 | $ | 516.4 | $ | 76.6 | $ | ( 48.3 ) | $ | ( 0.8 ) | $ | 544.0 |\n| Net loss | — | — | ( 1.9 ) | — | — | ( 1.9 ) |\n| Stock compensation plans | — | 1.2 | — | — | — | 1.2 |\n| Shares withheld for taxes - common stock issuances | — | ( 0.7 ) | — | — | — | ( 0.7 ) |\n| Foreign currency translation adjustments | — | — | — | ( 1.8 ) | — | ( 1.8 ) |\n| Balance, March 31, 2020 | $ | 0.1 | $ | 516.9 | $ | 74.7 | $ | ( 50.1 ) | $ | ( 0.8 ) | $ | 540.8 |\n| Net loss | — | — | ( 0.2 ) | — | — | ( 0.2 ) |\n| Stock compensation plans | — | 1.0 | — | — | — | 1.0 |\n| Net hedging losses, net of income tax | — | — | — | ( 0.2 ) | — | ( 0.2 ) |\n| Foreign currency translation adjustments | — | — | — | 0.2 | — | 0.2 |\n| Exercise of stock options | — | 0.1 | — | — | — | 0.1 |\n| Balance, June 30, 2020 | $ | 0.1 | $ | 518.0 | $ | 74.5 | $ | ( 50.1 ) | $ | ( 0.8 ) | $ | 541.7 |\n| Net loss | — | — | ( 10.5 ) | — | — | ( 10.5 ) |\n| Stock compensation plans | — | 1.2 | — | — | — | 1.2 |\n| Exercise of stock options | — | 0.3 | — | — | — | 0.3 |\n| Foreign currency translation adjustments | — | — | 3.0 | — | 3.0 |\n| Balance, September 30, 2020 | $ | 0.1 | $ | 519.5 | $ | 64.0 | $ | ( 47.1 ) | $ | ( 0.8 ) | $ | 535.7 |\n| Balance, December 31, 2020 | $ | 0.1 | $ | 520.9 | $ | 60.3 | $ | ( 44.4 ) | $ | ( 0.7 ) | $ | 536.2 |\n| Net loss | — | — | ( 0.8 ) | — | — | ( 0.8 ) |\n| Stock compensation plans | — | 1.2 | — | — | — | 1.2 |\n| Exercise of stock options | — | 0.2 | — | — | — | 0.2 |\n| Shares withheld for taxes - common stock issuances | — | ( 0.8 ) | — | — | — | ( 0.8 ) |\n| Net purchases of treasury stock - nonqualified plan | — | — | — | — | ( 0.1 ) | ( 0.1 ) |\n| Foreign currency translation adjustments | — | — | — | ( 0.3 ) | — | ( 0.3 ) |\n| Balance, March 31, 2021 | $ | 0.1 | $ | 521.5 | $ | 59.5 | $ | ( 44.7 ) | $ | ( 0.8 ) | $ | 535.6 |\n| Net income | — | — | 6.5 | — | — | 6.5 |\n| Stock compensation plans | — | 1.4 | — | — | — | 1.4 |\n| Net hedging gains, net of income tax | — | — | — | 0.1 | — | 0.1 |\n| Issuance of common stock - Offering | — | 252.3 | — | — | — | 252.3 |\n| Foreign currency translation adjustments | — | — | — | 1.2 | — | 1.2 |\n| Balance, June 30, 2021 | $ | 0.1 | $ | 775.2 | $ | 66.0 | $ | ( 43.4 ) | $ | ( 0.8 ) | $ | 797.1 |\n| Net loss | — | — | ( 12.6 ) | — | — | ( 12.6 ) |\n| Stock compensation plans | — | 1.4 | — | — | — | 1.4 |\n| Issuance of common stock - Offering | — | ( 0.1 ) | — | — | — | ( 0.1 ) |\n| Shares withheld for taxes - common stock issuances | — | ( 0.2 ) | — | — | — | ( 0.2 ) |\n| Net hedging losses, net of income tax | — | — | — | ( 0.1 ) | — | ( 0.1 ) |\n| Exercise of stock options | — | 0.1 | — | — | — | 0.1 |\n| Foreign currency translation adjustments | — | — | — | ( 1.1 ) | — | ( 1.1 ) |\n| Balance, September 30, 2021 | $ | 0.1 | $ | 776.4 | $ | 53.4 | $ | ( 44.6 ) | $ | ( 0.8 ) | $ | 784.5 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n9\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited)\nNote 1: Description of the Business\nBackground and Nature of Operations\nLivent Corporation (“Livent”, “we”, “us”, \"company\" or “our”) manufactures lithium for use in a wide range of lithium products, which are used primarily in lithium-based batteries, specialty polymers and chemical synthesis applications. We serve a diverse group of markets. Our product offerings generally have few cost-effective substitutes. A major growth driver for lithium in the future will be the rate of adoption of electric vehicles.\nMost markets for lithium chemicals are global with significant growth occurring in Asia, Europe and North America, primarily driven by the development and manufacturing of lithium-ion batteries. We are one of the few leading global producers of performance lithium compounds.\nNote 2: Principal Accounting Policies and Related Financial Information\nThe accompanying condensed consolidated financial statements were prepared in accordance with the requirements of the Securities and Exchange Commission (“SEC”) for interim reporting. As permitted under those rules, certain notes or other financial information that are normally required by U.S. GAAP have been condensed or omitted from these interim financial statements. The financial statements included in this report reflect all normal and recurring adjustments which, in the opinion of management, are necessary for a fair presentation of our condensed consolidated financial position as of September 30, 2021 and December 31, 2020, the condensed consolidated results of operations for the three and nine months ended September 30, 2021 and 2020, and the condensed consolidated cash flows for the nine months ended September 30, 2021 and 2020. The unaudited results of operations for the interim periods reported are not necessarily indicative of results to be expected for the full year. These statements, therefore, should be read in conjunction with the annual consolidated and combined financial statements and related notes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2020 (the \"2020 Annual Report on Form 10-K\").\nEstimates and assumptions\nIn preparing the financial statements in conformity with U.S. GAAP, we are required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period.\nDue to the current coronavirus (\"COVID-19\") pandemic, there has been uncertainty and disruption in the global economy and financial markets. The estimates used for, but not limited to, the collectability of trade receivables, fair value of long-lived assets, income taxes, inventory valuation and fair value of financial instruments could be impacted. We have assessed the impact and are not aware of any specific events or circumstances that required an update to our estimates and assumptions or materially affected the carrying value of our assets or liabilities as of the date of issuance of this Quarterly Report on Form 10-Q. These estimates may change as new events occur and additional information is obtained. Actual results could differ materially from these estimates under different assumptions or conditions.\n4.125 % Convertible Senior Notes due 2025 (the “2025 Notes”)\nWe account for our 2025 Notes under Accounting Standards Update (\"ASU\") No. 2020-06, Debt - Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging - Contracts in Entity's Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity's Own Equity (\"ASU 2020-06\"), which we early adopted January 1, 2021 under the full retrospective method. See Note 3 and Note 9 for details.\nThere were no other significant changes to our accounting policies that are set forth in detail in Note 2 to our annual consolidated and combined financial statements in Part II, Item 8 of our 2020 Annual Report on Form 10-K.\nNote 3: Recently Issued and Adopted Accounting Pronouncements and Regulatory Items\nNew accounting guidance and regulatory items\nIn April 2020, the Financial Accounting Standard Board (\"FASB\") issued ASU No. 2020-04, Reference Rate Reform (Topic 848). The amendments in this ASU provide optional expedients and exceptions for applying U.S. GAAP to contracts, hedging relationships, and other transactions affected by reference rate reform if certain criteria are met. An entity may optionally elect to apply the amendments effective in the first interim period that includes or is subsequent to March 12, 2020 through December 31, 2022. We are evaluating the effect the guidance will have on our condensed consolidated financial statements.\n10\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nRecently adopted accounting guidance\nIn August 2020, FASB issued ASU 2020-06. The ASU reduces the number of accounting models for convertible debt instruments by eliminating the cash conversion model. As compared with current U.S. GAAP, more convertible debt instruments will be reported as a single liability instrument and the interest rate of more convertible debt instruments will be closer to the coupon interest rate. The ASU also aligns the consistency of diluted Earnings Per Share (\"EPS\") calculations for convertible instruments by requiring that (1) an entity use the if-converted method and (2) share settlement be included in the diluted EPS calculation for both convertible instruments and equity contracts when those contracts include an option of cash settlement or share settlement. The ASU is effective for fiscal years beginning after December 15, 2021, including interim periods within those fiscal years. Early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. The FASB has specified that an entity should adopt the guidance as of the beginning of its annual fiscal year. We elected to early adopt ASU 2020-06 on January 1, 2021, using the full retrospective method. Prior to adoption, under Accounting Standards Codification 470-20, Debt with Conversion and Other Options (\"ASC 470-20\"), we had separately accounted for the liability and equity components of our 2025 Notes, which may be settled entirely or partially in cash upon conversion, in a manner that reflected the issuer’s economic interest cost. The effect of ASC 470-20 on the accounting for the 2025 Notes was that the equity component was required to be included in the additional paid-in capital section of stockholders’ equity on our consolidated balance sheet, and the value of the equity component was treated as original issue discount for purposes of accounting for the debt component of the 2025 Notes. As a result, prior to the adoption of ASU 2020-06, we were required to record a greater amount of non-cash interest expense as a result of the amortization of the discounted carrying value of the 2025 Notes to their face amount over the term of the 2025 Notes. Because we intend to settle in cash the principal outstanding under our 2025 Notes, we previously used the treasury stock method when calculating their potential dilutive effect, if any. ASU 2020-06 now requires us to use the if-converted method for EPS. For the full retrospective method of adoption, the accounting change was recognized as an adjustment to the balance of retained earnings, additional paid-in capital, long-term debt and deferred income taxes in our consolidated balance sheet as of December 31, 2020, the year in which the 2025 Notes were issued. See Note 9 and Note 11 for further details.\nIn December 2019, FASB issued ASU No. 2019-12, Simplifying the Accounting for Income Taxes (Topic 740). The amendments in this ASU simplified the accounting for income taxes by removing certain exceptions to the general principle in Topic 740. The amendments also contain improvements and clarifications of certain guidance in Topic 740. The new amendments are effective for fiscal years beginning after December 15, 2020 (i.e. a January 1, 2021 effective date), with early adoption permitted. We adopted the amendments as of January 1, 2021 and the adoption did not have a material impact on our condensed consolidated financial statements.\nNote 4: Revenue Recognition\nDisaggregation of revenue\nWe disaggregate revenue from contracts with customers by geographical areas and by product categories. The following table provides information about disaggregated revenue by major geographical region:\n| (in Millions) | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| North America (1) | $ | 20.0 | $ | 11.0 | $ | 63.4 | $ | 40.5 |\n| Latin America | — | — | — | 0.1 |\n| Europe, Middle East & Africa | 14.2 | 9.8 | 46.0 | 32.3 |\n| Asia Pacific (1) | 69.4 | 51.8 | 188.1 | 133.1 |\n| Total Revenue | $ | 103.6 | $ | 72.6 | $ | 297.5 | $ | 206.0 |\n\n1.During the three months ended September 30, 2021, countries with sales in excess of 10% of combined revenue consisted of Japan, the United States, and China. Sales for the three months ended September 30, 2021 for Japan, the United States, and China totaled $ 24.5 million, $ 19.7 million, $ 36.6 million, respectively. During the nine months ended September 30, 2021, countries with sales in excess of 10% of combined revenue consisted of Japan, the United States, and China. Sales for the nine months ended September 30, 2021 for Japan, the United States, and China totaled $ 65.1 million, $ 62.7 million, $ 89.9 million, respectively. During the three months ended September 30, 2020, countries with sales in excess of 10% of combined revenue consisted of Japan, the United States and China. Sales for the three months ended September 30, 2020 for Japan, the United States and China totaled $ 23.5 million, $ 11.0 million, and $ 19.0 million, respectively. During the nine months ended September 30, 2020, countries with sales in excess of 10% of combined\n11\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nrevenue consisted of Japan, the United States and China. Sales for the nine months ended September 30, 2020 for Japan, the United States and China totaled $ 81.1 million, $ 40.0 million, and $ 29.1 million, respectively.\nFor the three months ended September 30, 2021, one customer accounted for approximately 35 % of total revenue and our 10 largest customers accounted in aggregate for approximately 69 % of total revenue. For the three months ended September 30, 2020, two customers accounted for approximately 34 % and 10 % of total revenue, respectively, and our 10 largest customers accounted in aggregate for approximately 68 % of total revenue. For the nine months ended September 30, 2021, one customer accounted for approximately 36 % of total revenue and our 10 largest customers accounted in aggregate for approximately 68 % of total revenue. For the nine months ended September 30, 2020, one customer accounted for approximately 35 % of total revenue and our 10 largest customers accounted in aggregate for approximately 64 % of total revenue. A loss of any material customer could have a material adverse effect on our business, financial condition and results of operations.\nThe following table provides information about disaggregated revenue by major product category:\n| (in Millions) | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Lithium Hydroxide | $ | 50.7 | $ | 43.9 | $ | 160.5 | $ | 115.4 |\n| Butyllithium | 27.4 | 19.6 | 76.1 | 62.4 |\n| High Purity Lithium Metal and Other Specialty Compounds | 9.8 | 7.1 | 27.6 | 23.0 |\n| Lithium Carbonate and Lithium Chloride | 15.7 | 2.0 | 33.3 | 5.2 |\n| Total Revenue | $ | 103.6 | $ | 72.6 | $ | 297.5 | $ | 206.0 |\n\nContract asset and contract liability balances\nThe following table presents the opening and closing balances of our receivables, net of allowances. As of September 30, 2021 and December 31, 2020, there were no contract liabilities from contracts with customers.\n| (in Millions) | Balance as of September 30, 2021 | Balance as of December 31, 2020 | Increase (Decrease) |\n| Receivables from contracts with customers, net of allowances | $ | 83.0 | $ | 76.3 | $ | 6.7 |\n\nThe balance of receivables from contracts with customers listed in the table above represents the current trade receivables, net of allowance for doubtful accounts. The allowance for receivables represents our best estimate of the probable losses associated with potential customer defaults. We determine the allowance based on historical experience, current collection trends, and external business factors such as economic factors, including regional bankruptcy rates, and political factors.\nPerformance obligations\nOccasionally, we may enter into multi-year take or pay supply agreements with customers. The aggregate amount of revenue expected to be recognized related to these contracts’ performance obligations that are unsatisfied or partially unsatisfied is approximately $ 10 million for the remainder of 2021 and $ 68 million in 2022 and 2023, respectively. T hese approximate revenues do not include amounts of variable consideration attributable to contract renewals or contract contingencies. Based on our past experience with the customers under these arrangements, we expect to continue recognizing revenue in accordance with the contracts as we transfer control of the product to the customer. However, in the case a shortfall of volume purchases occurs, we will recognize the amount payable by the customer over the remaining performance obligations in the contract.\nNote 5: Inventories, Net\nInventories consisted of the following:\n| (in Millions) | September 30, 2021 | December 31, 2020 |\n| Finished goods | $ | 35.0 | $ | 36.1 |\n| Semi-finished goods | 41.3 | 46.2 |\n| Raw materials, supplies and other | 33.9 | 23.3 |\n| Inventory, net | $ | 110.2 | $ | 105.6 |\n\n12\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nNote 6: Investments\nIn 2020, Livent entered into an agreement with The Pallinghurst Group relating to Québec Lithium Partners (\"QLP\"), a joint venture owned equally by The Pallinghurst Group and Livent, and the conduct of certain business operations and oversight, previously conducted solely by Nemaska Lithium Inc. for the development of a fully integrated lithium chemical asset located in Québec, Canada that is not yet in commercial production. QLP owns a 50 % equity interest in the Nemaska Project. The Company accounts for the investment in QLP as an equity method investment on a one-quarter lag basis and is included in Investments in our condensed consolidated balance sheets. For the three and nine months ended September 30, 2021, we recorded a $ 1.0 million and $ 3.7 million loss, respectively, related to our 50 % equity interest in QLP to Equity in net loss of unconsolidated affiliates in our condensed consolidated statement of operations. The carrying amount of our 50 % equity interest in QLP was $ 20.1 million and $ 21.2 million as of September 30, 2021 and December 31, 2020, respectively.\nNote 7: Restructuring and Other Charges\nThe following table shows other charges included in \"Restructuring and other charges\" in the condensed consolidated statements of operations:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (in Millions) | 2021 | 2020 | 2021 | 2020 |\n| Restructuring charges |\n| Severance-related and exit costs (1) | $ | 0.1 | $ | 0.9 | $ | 0.2 | $ | 5.8 |\n| Other charges |\n| Environmental remediation (2) | 0.1 | 0.1 | 0.3 | 0.4 |\n| Other (3) | 0.9 | 3.4 | 2.9 | 3.9 |\n| Total Restructuring and other charges | $ | 1.1 | $ | 4.4 | $ | 3.4 | $ | 10.1 |\n\n___________________\n1.Three and nine months ended September 30, 2020 includes severance costs for management changes at certain operating and administrative facilities and exit costs of $ 1.6 million for the closing of leased office space.\n2.There is one environmental remediation site in Bessemer City, North Carolina.\n3.Three and nine months ended September 30, 2021 consists primarily of transaction-related legal fees and miscellaneous nonrecurring transactions. Three and nine months ended September 30, 2020 consists primarily of legal fees related to IPO securities litigation including a settlement accrual, net of insurance reimbursement, of $ 2.5 million in the third quarter. The IPO litigation settlement was finalized in the second quarter of 2021.\n13\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nNote 8: Income Taxes\nWe determine our interim tax provision using an estimated annual effective tax rate methodology (“EAETR”) in accordance with U.S. GAAP. The EAETR is applied to the year-to-date ordinary income, exclusive of discrete items. The tax effects of discrete items are then included to arrive at the total reported interim tax provision.\nThe determination of the EAETR is based upon a number of estimates, including the estimated annual pretax ordinary income in each tax jurisdiction in which we operate. As our projections of ordinary income change throughout the year, the EAETR will change period-to-period. The tax effects of discrete items are recognized in the tax provision in the period they occur in accordance with U.S. GAAP. Depending on various factors, such as the item’s significance in relation to total income and the rate of tax applicable in the jurisdiction to which it relates, discrete items in any quarter can materially impact the reported effective tax rate. As a global enterprise, our tax expense can be impacted by changes in tax rates or laws, the finalization of tax audits and reviews, as well as other factors. As a result, there can be significant volatility in interim tax provisions.\nProvision for income taxes for the three and nine months ended September 30, 2021 was an expense of $ 15.4 million and $ 13.8 million resulting in an effective tax rate of 540.5 % and 198.7 %, respectively. Provision for income taxes for the three and nine months ended September 30, 2020 was a benefit of $ 3.1 million and $ 5.4 million resulting in an effective tax rate of 22.8 % and 30.0 %, respectively.\nNote 9: Debt\nLong-term debt\nLong-term debt consists of the following:\n| Interest RatePercentage | MaturityDate | September 30, 2021 | December 31, 2020 |\n| (in Millions) | LIBOR borrowings | Base rate borrowings |\n| Revolving Credit Facility (1) | 2.3 % | 4.5 % | 2023 | $ | — | $ | 35.6 |\n| 4.125 % Convertible Senior Notes due 2025 | 4.125 % | 2025 | 245.8 | 245.8 |\n| Transaction costs - 2025 Notes | ( 5.7 ) | ( 6.8 ) |\n| Total long-term debt (2) | $ | 240.1 | $ | 274.6 |\n\n______________________________\n1.As of September 30, 2021 and December 31, 2020, there were $ 14.4 million in letters of credit outstanding under our Revolving Credit Facility and $ 385.6 million and $ 275.0 million available funds as of September 30, 2021 and December 31, 2020, respectively. Fund availability is subject to the Company meeting its debt covenants.\n2. As of September 30, 2021 and December 31, 2020, the Company had no debt maturing within one year.\nOn January 1, 2021, the Company elected to early adopt ASU 2020-06 under the full retrospective method, that is, the accounting change was recognized as an adjustment to the balance of retained earnings, additional paid-in capital, long-term debt and deferred income taxes in our consolidated balance sheet as of December 31, 2020, the year in which the 2025 Notes were issued. The ASU reduces the number of accounting models for convertible debt instruments by eliminating the cash conversion model. Our 2025 Notes are now reported as a single liability instrument net of transaction costs with an interest rate closer to the coupon interest rate.\nThe comparative financial statements of prior years have been adjusted to apply the adopted guidance retrospectively.\n14\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\n| Statement of operations |\n| (in Millions, except per share amounts) |\n| Three months ended September 30, 2021 | As computed under ASC 470-20 | As reported under ASU 2020-06 | Effect of change |\n| Interest expense/(income) | $ | 1.8 | $ | — | $ | ( 1.8 ) |\n| Income from operations before income taxes | 1.0 | 2.8 | 1.8 |\n| Income tax expense | 15.0 | 15.4 | 0.4 |\n| Net (loss)/income | $ | ( 14.0 ) | $ | ( 12.6 ) | $ | 1.4 |\n| Net (loss)/income per weighted average share - basic and diluted | $ | ( 0.09 ) | $ | ( 0.08 ) | $ | 0.01 |\n| Nine months ended September 30, 2021 | As computed under ASC 470-20 | As reported under ASU 2020-06 | Effect of change |\n| Interest expense/(income) | $ | 5.5 | $ | 0.3 | $ | ( 5.2 ) |\n| Income from operations before income taxes | 1.7 | 6.9 | 5.2 |\n| Income tax expense | 12.7 | 13.8 | 1.1 |\n| Net (loss)/income | $ | ( 11.0 ) | $ | ( 6.9 ) | $ | 4.1 |\n| Net (loss)/income per weighted average share - basic and diluted | $ | ( 0.07 ) | $ | ( 0.05 ) | $ | 0.02 |\n| Three months ended September 30, 2020 | As originally reported | As adjusted | Effect of change |\n| Interest expense/(income) | $ | 2.0 | $ | 0.3 | $ | ( 1.7 ) |\n| (Loss)/income from operations before income taxes | ( 15.3 ) | ( 13.6 ) | 1.7 |\n| Income tax (benefit)/expense | ( 3.5 ) | ( 3.1 ) | 0.4 |\n| Net (loss)/income | $ | ( 11.8 ) | $ | ( 10.5 ) | $ | 1.3 |\n| Net (loss)/income per weighted average share - basic and diluted | $ | ( 0.08 ) | $ | ( 0.07 ) | $ | 0.01 |\n| Nine months ended September 30, 2020 | As originally reported | As adjusted | Effect of change |\n| Interest expense/(income) | $ | 2.0 | $ | 0.3 | $ | ( 1.7 ) |\n| (Loss)/Income from operations before income taxes | ( 19.7 ) | ( 18.0 ) | 1.7 |\n| Income tax (benefit)/expense | ( 5.8 ) | ( 5.4 ) | 0.4 |\n| Net (loss)/income | $ | ( 13.9 ) | $ | ( 12.6 ) | $ | 1.3 |\n| Net (loss)/income per weighted average share - basic and diluted | $ | ( 0.10 ) | $ | ( 0.09 ) | $ | 0.01 |\n\n15\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\n| Balance Sheet |\n| (in Millions, except per share amounts) |\n| September 30, 2021 | As computed under ASC 470-20 | As reported under ASU 2020-06 | Effect of change |\n| Deferred income taxes | $ | 15.0 | 7.8 | $ | ( 7.2 ) |\n| Long-term debt | 207.4 | 240.1 | 32.7 |\n| Total liabilities | $ | 222.4 | $ | 247.9 | $ | 25.5 |\n| Common stock, $ 0.001 per share par value | 0.1 | 0.1 | — |\n| Capital in excess of par value of common stock | 808.6 | 776.4 | ( 32.2 ) |\n| Retained earnings | 46.7 | 53.4 | 6.7 |\n| Accumulated other comprehensive loss | ( 44.6 ) | ( 44.6 ) | — |\n| Treasury stock | ( 0.8 ) | ( 0.8 ) | — |\n| Total equity | 810.0 | 784.5 | ( 25.5 ) |\n| Total liabilities and equity | $ | 1,032.4 | $ | 1,032.4 | $ | — |\n| December 31, 2020 | As originally reported | As adjusted | Effect of change |\n| Deferred income taxes | $ | 13.9 | $ | 5.6 | $ | ( 8.3 ) |\n| Long-term debt | 236.7 | 274.6 | 37.9 |\n| Total liabilities | $ | 250.6 | $ | 280.2 | $ | 29.6 |\n| Common stock | 0.1 | 0.1 | — |\n| Capital in excess of par value of common stock | 553.1 | 520.9 | ( 32.2 ) |\n| Retained earnings | 57.7 | 60.3 | 2.6 |\n| Accumulated other comprehensive loss | ( 44.4 ) | ( 44.4 ) | — |\n| Treasury stock, common, at cost | ( 0.7 ) | ( 0.7 ) | — |\n| Total equity | 565.8 | 536.2 | ( 29.6 ) |\n| Total liabilities and equity | $ | 816.4 | $ | 816.4 | $ | — |\n\n| Statement of cash flows |\n| (in Millions) |\n| Nine months ended September 30, 2021 | As computed under ASC 470-20 | As reported under ASU 2020-06 | Effect of change |\n| Net (loss)/income | $ | ( 11.0 ) | $ | ( 6.9 ) | $ | 4.1 |\n| Adjustments to reconcile net (loss)/income to cash provided by operating activities: |\n| Deferred income taxes | 10.1 | 11.2 | 1.1 |\n| Deferred financing fee amortization | 5.5 | 0.3 | ( 5.2 ) |\n| Net cash provided by operating activities | 4.6 | 4.6 | — |\n| Net increase in cash and cash equivalents | 183.7 | 183.7 | — |\n| Cash and cash equivalents, beginning of period | 11.6 | 11.6 | — |\n| Cash and cash equivalents, end of period | $ | 195.3 | $ | 195.3 | $ | — |\n| Nine months ended September 30, 2020 | As originally reported | As adjusted | Effect of change |\n| Net (loss)/income | $ | ( 13.9 ) | $ | ( 12.6 ) | $ | 1.3 |\n| Adjustments to reconcile net (loss)/income to cash required by operating activities: |\n| Deferred income taxes | ( 6.1 ) | ( 5.7 ) | 0.4 |\n| Deferred financing fee amortization | 2.0 | 0.3 | ( 1.7 ) |\n| Net cash required by operating activities | ( 18.0 ) | ( 18.0 ) | — |\n| Net decrease in cash and cash equivalents | ( 2.0 ) | ( 2.0 ) | — |\n| Cash and cash equivalents, beginning of period | 16.8 | 16.8 | — |\n| Cash and cash equivalents, end of period | $ | 14.8 | $ | 14.8 | $ | — |\n\n16\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\n2025 Notes\nIn the fourth quarter of 2021, the holders of the 2025 Notes were notified that the last reported sale price of our common stock for at least 20 trading days (whether or not consecutive) during the period of 30 consecutive trading days ending on, and including, September 30, 2021 was greater than or equal to 130 % of the conversion price on each trading day, and as a result, the holders have the option to convert all or any portion of their 2025 Notes through December 31, 2021. The 2025 Notes are classified as long-term debt.\nThe Company recognized noncash interest related to the amortization of transaction costs of $ 0.4 million and $ 1.1 million for the three and nine months ended September 30, 2021, respectively; $ 0.4 million and $ 0.8 million of which was capitalized for the three and nine months ended September 30, 2021, respectively. The Company recorded $ 2.5 million and $ 7.6 million of accrued interest expense related to the principal amount for the three and nine months ended September 30, 2021, respectively.\nRevolving Credit Facility\nThe carrying value of our deferred financing costs was $ 1.7 million as of September 30, 2021. In June 2021, we used a portion of the net proceeds from the Offering to repay all amounts outstanding under our Revolving Credit Facility.\nCovenants\nThe Credit Agreement contains certain affirmative and negative covenants that are binding on us and our subsidiary, FMC Lithium USA Corp., as borrowers (the \"Borrowers\") and their subsidiaries, including, among others, restrictions (subject to exceptions and qualifications) on the ability of the Borrowers and their subsidiaries to create liens, to undertake fundamental changes, to incur debt, to sell or dispose of assets, to make investments, to make restricted payments such as dividends, distributions or equity repurchases, to change the nature of their businesses, to enter into transactions with affiliates and to enter into certain burdensome agreements. Furthermore, the Borrowers are subject to financial covenants regarding leverage (measured as the ratio of debt to adjusted earnings) and interest coverage (measured as the ratio of adjusted earnings to interest expense). Our maximum allowable first lien leverage ratio is 3.5 as of September 30, 2021. Our minimum allowable interest coverage ratio is 3.5 . We were in compliance with all requirements of the covenants at September 30, 2021.\n17\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nNote 10: Equity\nAs of September 30, 2021 and December 31, 2020, we had 2 billion shares of common stock authorized. The following is a summary of Livent's common stock issued and outstanding:\n| Issued | Treasury | Outstanding |\n| Balance at December 31, 2020 | 146,461,249 | ( 99,268 ) | 146,361,981 |\n| Adjusted FMC RSU awards (1) | 120,986 | — | 120,986 |\n| Livent RSU awards | 102,505 | — | 102,505 |\n| Livent stock option awards | 41,407 | — | 41,407 |\n| Net purchases of treasury stock - deferred compensation plan | — | ( 1,863 ) | ( 1,863 ) |\n| Issuance of common stock | 14,950,000 | — | 14,950,000 |\n| Balance at September 30, 2021 | 161,676,147 | ( 101,131 ) | 161,575,016 |\n\n1.See Note 12 to our consolidated and combined financial statements in Part II, Item 8 of our 2020 Annual Report on Form 10-K for more information on Adjusted FMC RSU awards held by FMC employees.\nI n June 15, 2021, the Company closed on the issuance of 14,950,000 shares of its common stock, par value $ 0.001 per share, at a public offering price of $ 17.50 per share, in an underwritten public offering (the \"Offering\"), including 1,950,000 shares purchased under a 30 -day underwriters' option exercised in full by the underwriters on June 11, 2021. Total net proceeds from the Offering, including from the exercise of the underwriters’ option, were $ 252.2 million, after deducting the underwriters’ fees and offering expenses payable by the Company of $ 9.4 million. The total net proceeds were recorded to paid-in capital in the condensed consolidated balance sheet. In the third quarter of 2021, we purchased $ 140.0 million in limited risk investments with maturities of 90 days or less with a portion of the Offering net proceeds. The investments were recorded to Cash and cash equivalents in our condensed consolidated balance sheet in the third quarter of 2021.\nSummarized below is the roll forward of accumulated other comprehensive loss, net of tax.\n| (in Millions) | Foreign currency adjustments | Derivative Instruments (1) | Total |\n| Accumulated other comprehensive loss, net of tax at December 31, 2020 | $ | ( 44.4 ) | — | $ | ( 44.4 ) |\n| Other comprehensive losses before reclassifications | ( 0.2 ) | — | ( 0.2 ) |\n| Accumulated other comprehensive loss, net of tax at September 30, 2021 | $ | ( 44.6 ) | $ | — | $ | ( 44.6 ) |\n\n| (in Millions) | Foreign currency adjustments | Derivative Instruments (1) | Total |\n| Accumulated other comprehensive loss, net of tax at December 31, 2019 | $ | ( 48.3 ) | $ | — | $ | ( 48.3 ) |\n| Other comprehensive gains/(losses) before reclassifications | 1.4 | ( 0.2 ) | 1.2 |\n| Accumulated other comprehensive loss, net of tax at September 30, 2020 | $ | ( 46.9 ) | $ | ( 0.2 ) | $ | ( 47.1 ) |\n\n1.See Note 12 for more information.\n18\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nReclassifications of accumulated other comprehensive loss\nThe table below provides details about the reclassifications from accumulated other comprehensive loss and the affected line items in the condensed consolidated statements of operations for the period presented. No amounts were reclassified from accumulated other comprehensive loss for the three and nine months ended September 30, 2021.\n| Details about Accumulated Other Comprehensive Loss Components | Amounts Reclassified from Accumulated Other Comprehensive Loss (1) | Affected Line Item in the Condensed Consolidated Statements of Operations |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (in Millions) | 2021 | 2020 | 2021 | 2020 |\n| Derivative instruments |\n| Foreign currency contracts | $ | — | $ | ( 0.2 ) | $ | — | $ | ( 0.2 ) | Costs of sales and services |\n| Total before tax | — | ( 0.2 ) | — | ( 0.2 ) |\n| Amount included in net income (1) | $ | — | $ | ( 0.2 ) | $ | — | $ | ( 0.2 ) |\n\n(1) Provision for income taxes related to the reclassification was less than $ 0.1 million.\nDividends\nFor the three and nine months ended September 30, 2021 and 2020, we paid no dividends. We do not expect to pay any dividends in the foreseeable future.\nNote 11: Loss Per Share\nLoss per common share is computed by dividing net loss by the weighted average number of common shares outstanding during the period on a basic and diluted basis.\nOur potentially dilutive securities include potential common shares related to our stock options and restricted stock units (\"RSU\") granted in connection with the Livent Plan and FMC Plan. See Note 12 to our consolidated and combined financial statements in Part II, Item 8 of our 2020 Annual Report on Form 10-K for more information. Diluted loss per share (“Diluted EPS”) considers the impact of potentially dilutive securities except in periods in which there is a loss because the inclusion of the potential common shares would have an anti-dilutive effect. Diluted EPS excludes the impact of potential common shares related to our stock options in periods in which the option exercise price is greater than the average market price of our common stock for the period. We use the if-converted method when calculating the potential dilutive effect, if any, of our 2025 Notes.\nL oss applicable to common stock and common stock shares used in the calculation of basic and diluted loss per share are as follows:\n| (in Millions, Except Share and Per Share Data) | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Numerator: |\n| Net loss | $ | ( 12.6 ) | $ | ( 10.5 ) | $ | ( 6.9 ) | $ | ( 12.6 ) |\n| Denominator: |\n| Weighted average common shares outstanding - basic and diluted | 161.6 | 146.3 | 152.3 | 146.2 |\n| Basic and diluted loss per common share: |\n| Net loss per weighted average share - basic and diluted | $ | ( 0.08 ) | $ | ( 0.07 ) | $ | ( 0.05 ) | $ | ( 0.09 ) |\n\n19\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nThe following table presents weighted average share equivalents associated with share-based plans and the 2025 Notes that were excluded from the diluted shares outstanding calculation because the result would have been antidilutive. The 2025 Notes are further discussed in Note 9.\n| (in Millions) | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Share equivalents from share-based plans | 1.5 | 0.6 | 1.4 | 0.6 |\n| Share equivalents from 2025 Notes | 45.3 | 28.1 | 44.0 | 10.1 |\n| Total antidilutive weighted average share equivalents | 46.8 | 28.7 | 45.4 | 10.7 |\n\nAnti-dilutive stock options\nFor the three months ended September 30, 2021, none of the outstanding options to purchase shares of our common stock were anti-dilutive. For the nine months ended September 30, 2021, options to purchase 542,760 shares of our common stock at an average exercise price of $ 20.35 per share were anti-dilutive and not included in the computation of diluted loss per share because the exercise price of the options was greater than the average market price of the common stock for the nine months ended September 30, 2021. For the three and nine months ended September 30, 2020, options to purchase 1,835,476 and 1,904,010 shares of our common stock at an average exercise price of $ 12.59 and $ 12.58 per share, respectively, were anti-dilutive and not included in the computation of diluted loss per share because the exercise price of the options was greater than the average market price of the common stock for the three and nine months ended September 30, 2020.\nNote 12: Financial Instruments, Risk Management and Fair Value Measurements\nOur financial instruments include cash and cash equivalents, trade receivables, other current assets, investments held in trust fund, accounts payable, and amounts included in investments and accruals meeting the definition of financial instruments. Investments in the Livent NQSP deferred compensation plan trust fund are considered Level 1 investments based on readily available quoted prices in active markets for identical assets. The carrying value of cash and cash equivalents, trade receivables, other current assets, and accounts payable approximates their fair value and are considered Level 1 investments. Our other financial instruments include the following:\n| Financial Instrument | Valuation Method |\n| Foreign exchange forward contracts | Estimated amounts that would be received or paid to terminate the contracts at the reporting date based on current market prices for applicable currencies. |\n\nThe estimated fair value of our foreign exchange forward contracts have been determined using standard pricing models which take into account the present value of expected future cash flows discounted to the balance sheet date. These standard pricing models utilize inputs derived from, or corroborated by, observable market data such as interest rate yield curves and currency and commodity spot and forward rates. In addition, we test a subset of our valuations against valuations received from the transaction's counterparty to validate the accuracy of our standard pricing models. Accordingly, the estimates presented may not be indicative of the amounts that we would realize in a market exchange at settlement date and do not represent potential gains or losses on these agreements.\nFair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). The inputs used to measure fair value are classified into the following hierarchy:\nLevel 1 - Unadjusted quoted prices in active markets for identical assets or liabilities.\nLevel 2 - Unadjusted quoted prices in active markets for similar assets or liabilities, or unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability.\nLevel 3 - Unobservable inputs for the asset or liability.\n20\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nThe estimated fair value and the carrying amount of debt was $ 292.0 million and $ 240.1 million, respectively, as of September 30, 2021. Our 2025 Notes are classified as Level 2 in the fair value hierarchy. The estimated fair value and carrying amount of debt was $ 267.6 million and $ 274.6 million as of December 31, 2020.\nUse of Derivative Financial Instruments to Manage Risk\nWe mitigate certain financial exposures connected to currency risk through a program of risk management that includes the use of derivative financial instruments. We enter into foreign exchange forward contracts to reduce the effects of fluctuating foreign currency exchange rates.\nWe formally document all relationships between hedging instruments and hedged items, as well as the risk management objective and strategy for undertaking various hedge transactions. This process includes relating derivatives that are designated as fair value or cash flow hedges to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions. We also assess both at the inception of the hedge and on an ongoing basis, whether each derivative is highly effective in offsetting changes in fair values or cash flows of the hedged item. If we determine that a derivative is not highly effective as a hedge, or if a derivative ceases to be a highly effective hedge, we discontinue hedge accounting with respect to that derivative prospectively.\nForeign Currency Exchange Risk Management\nWe conduct business in many foreign countries, exposing earnings, cash flows, and our financial position to foreign currency risks. The majority of these risks arise as a result of foreign currency transactions. The primary currencies for which we have exchange rate exposure are the Euro, the British pound, the Chinese yuan, the Argentine peso, and the Japanese yen. We currently do not hedge foreign currency risks associated with the Argentine peso due to the limited availability and the high cost of suitable derivative instruments. Our policy is to minimize exposure to adverse changes in currency exchange rates. This is accomplished through a controlled program of risk management that could include the use of foreign currency debt and forward foreign exchange contracts. We also use forward foreign exchange contracts to hedge firm and highly anticipated foreign currency cash flows, with an objective of balancing currency risk to provide adequate protection from significant fluctuations in the currency markets.\nConcentration of Credit Risk\nOur counterparties to derivative contracts are primarily major financial institutions. We limit the dollar amount of contracts entered into with any one financial institution and monitor counterparties’ credit ratings. We also enter into master netting agreements with each financial institution, where possible, which helps mitigate the credit risk associated with our financial instruments. While we may be exposed to credit losses due to the nonperformance of counterparties, we consider this risk remote.\nAccounting for Derivative Instruments and Hedging Activities\nCash Flow Hedges\nWe recognize all derivatives on the balance sheet at fair value. On the date we enter into the derivative instrument, we generally designate the derivative as a hedge of the variability of cash flows to be received or paid related to a forecasted transaction (cash flow hedge). We record in accumulated other comprehensive loss (\"AOCL\") changes in the fair value of derivatives that are designated as and meet all the required criteria for, a cash flow hedge. We then reclassify these amounts into earnings as the underlying hedged item affects earnings. In contrast we immediately record in earnings changes in the fair value of derivatives that are not designated as cash flow hedges. As of September 30, 2021, we had open foreign currency forward contracts in AOCL in a net after-tax gain position of less than $ 0.1 million designated as cash flow hedges of underlying forecasted sales and purchases. As of September 30, 2021 we had open forward contracts with various expiration dates to buy, sell or exchange foreign currencies with a U.S. dollar equivalent of approximately $ 5.6 million.\nLess than $ 0.1 million of net after-tax gain, representing open foreign currency exchange contracts, will be realized in earnings during the three months ending December 31, 2021 if spot rates in the future are consistent with market rates as of September 30, 2021. The actual effect on earnings will be dependent on the actual spot rates when the forecasted transactions occur. We recognize derivative gains and losses in the “Costs of sales and services” line in the condensed consolidated statements of operations.\n21\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nDerivatives Not Designated As Cash Flow Hedging Instruments\nWe hold certain forward contracts that have not been designated as cash flow hedging instruments for accounting purposes. Contracts used to hedge the exposure to foreign currency fluctuations associated with certain monetary assets and liabilities are not designated as cash flow hedging instruments and changes in the fair value of these items are recorded in earnings.\nWe had open forward contracts not designated as cash flow hedging instruments for accounting purposes with various expiration dates to buy, sell or exchange foreign currencies with a U.S. dollar equivalent of approximately $ 30.9 million at September 30, 2021.\nFair Value of Derivative Instruments.\nAs of September 30, 2021, we had open derivative cash flow hedge contracts in a net gain fair value position of less than $ 0.1 million. The Company had no open derivative cash flow hedge contracts as of December 31, 2020.\nDerivatives in Cash Flow Hedging Relationships\n| (in Millions) | Total Foreign Exchange Contracts |\n| Accumulated other comprehensive loss, net of tax at March 31, 2021 | $ | — |\n| Unrealized hedging gains, net of tax | 0.1 |\n| Total derivatives instruments impact on comprehensive income, net of tax | 0.1 |\n| Accumulated other comprehensive gain, net of tax at June 30, 2021 | $ | 0.1 |\n| Unrealized hedging losses, net of tax | ( 0.1 ) |\n| Total derivatives instruments impact on comprehensive income, net of tax | ( 0.1 ) |\n| Accumulated other comprehensive gain, net of tax at September 30, 2021 | $ | — |\n\n22\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\n| (in Millions) | Total Foreign Exchange Contracts |\n| Accumulated other comprehensive loss, net of tax at March 31, 2020 | $ | — |\n| Unrealized hedging loses, net of tax | ( 0.2 ) |\n| Total derivatives instruments impact on comprehensive income, net of tax | ( 0.2 ) |\n| Accumulated other comprehensive loss, net of tax at June 30, 2020 | $ | ( 0.2 ) |\n| Unrealized hedging gains, net of tax | 0.2 |\n| Reclassification of deferred hedging gains, net of tax (1) | ( 0.2 ) |\n| Accumulated other comprehensive loss, net of tax at September 30, 2020 | $ | ( 0.2 ) |\n\n1.Amounts are included in \"Cost of sales and services\" on the condensed consolidated statements of operations\nDerivatives Not Designated as Cash Flow Hedging Instruments\n| Location of LossRecognized in Income on Derivatives | Amount of Pre-tax Loss Recognized in Income on Derivatives (1) |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (in Millions) | 2021 | 2020 | 2021 | 2020 |\n| Foreign Exchange contracts | Cost of Sales and Services (2) | $ | ( 0.2 ) | $ | ( 0.8 ) | $ | ( 1.1 ) | $ | ( 1.9 ) |\n| Total | $ | ( 0.2 ) | $ | ( 0.8 ) | $ | ( 1.1 ) | $ | ( 1.9 ) |\n\n____________________\n1.Amounts represent the gain or loss on the derivative instrument offset by the gain or loss on the hedged item.\n2.A loss of $ 0.1 million and $ 0.2 million related to intercompany loan hedges is included in Restructuring and other charges in the consolidated statement of operations for the three and nine months ended September 30, 2021, respectively. A loss of $ 0.1 million related to intercompany loan hedges is included in Restructuring and other charges in the consolidated statement of operations for the three and nine months ended September 30, 2020.\nFair Value Measurements\nFair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Market participants are defined as buyers or sellers in the principle or most advantageous market for the asset or liability that are independent of the reporting entity, knowledgeable and able and willing to transact for the asset or liability.\nFair Value Hierarchy\nWe have categorized our assets and liabilities that are recorded at fair value, based on the priority of the inputs to the valuation technique, into a three-level fair-value hierarchy. The fair-value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure the assets and liabilities fall within different levels of the hierarchy, the categorization is based on the lowest level input that is significant to the fair-value measurement of the instrument.\n23\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nRecurring Fair Value Measurements\nThe following tables present our fair-value hierarchy for those assets and liabilities measured at fair-value on a recurring basis in our condensed consolidated balance sheets.\n| (in Millions) | September 30, 2021 | Quoted Prices in Active Markets for Identical Assets(Level 1) | Significant Other Observable Inputs(Level 2) | Significant Unobservable Inputs(Level 3) |\n| Assets |\n| Investments in deferred compensation plan (1) | $ | 3.1 | $ | 3.1 | $ | — | $ | — |\n| Total Assets | $ | 3.1 | $ | 3.1 | $ | — | $ | — |\n| Liabilities |\n| Deferred compensation plan obligation (2) | $ | 5.5 | $ | 5.5 | $ | — | $ | — |\n| Total Liabilities | $ | 5.5 | $ | 5.5 | $ | — | $ | — |\n\n\n| (in Millions) | December 31, 2020 | Quoted Prices in Active Markets for Identical Assets(Level 1) | Significant Other Observable Inputs(Level 2) | Significant Unobservable Inputs(Level 3) |\n| Assets |\n| Investments in deferred compensation plan (1) | $ | 2.6 | $ | 2.6 | $ | — | $ | — |\n| Total Assets | $ | 2.6 | $ | 2.6 | $ | — | $ | — |\n| Liabilities |\n| Deferred compensation plan obligation (2) | $ | 4.5 | $ | 4.5 | $ | — | $ | — |\n| Total Liabilities | $ | 4.5 | $ | 4.5 | $ | — | $ | — |\n\n____________________\n1.Balance is included in “Investments” in the condensed consolidated balance sheets. Livent NQSP investments in Livent common stock are recorded as \"Treasury stock\" in the condensed consolidated balance sheets and carried at historical cost. A mark-to-market loss of $ 0.4 million was recorded for the three and nine months ended September 30, 2021, related to the Livent common stock. The mark-to-market gains were recorded in \"Selling, general and administrative expense\" in the condensed consolidated statement of operations, with a corresponding offset to the deferred compensation plan obligation in the condensed consolidated balance sheets.\n2.Balance is included in “Other long-term liabilities” in the condensed consolidated balance sheets.\nNote 13: Commitments and Contingencies\nContingencies\nWe are a party to various legal proceedings, including those noted in this section. Livent records reserves for estimated losses from contingencies when information available indicates that a loss is probable and the amount of the loss, or range of loss, can be reasonably estimated. As additional information becomes available, management adjusts its assessments and estimates. Legal costs are expensed as incurred.\nIn addition to the legal proceedings noted below, we have certain contingent liabilities arising in the ordinary course of business. Some of these contingencies are known but are so preliminary that the merits cannot be determined, or if more advanced, are not deemed material based on current knowledge; and some are unknown - for example, claims with respect to which we have no notice or claims which may arise in the future from products sold, guarantees or warranties made, or indemnities provided. Therefore, we are unable to develop a reasonable estimate of our potential exposure of loss for these contingencies, either individually or in the aggregate, at this time. There can be no assurance that the outcome of these contingencies will be favorable, and adverse results in certain of these contingencies could have a material adverse effect on the consolidated financial position, results of operations in any one reporting period, or liquidity.\n24\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nArgentine Customs Authority\nOn July 31, 2020, we received notice from the Argentine Customs Authority that it was conducting an audit of Minera del Altiplano SA, our subsidiary in Argentina (“MdA”). The audit relates to the export of Lithium Carbonate from Argentina for the period January 10, 2015 through December 31, 2017. Although this relates to a period of time when MdA was a subsidiary of FMC, the Company agreed to bear any possible liability for this matter under the terms of the Tax Matters Agreement that it entered into with FMC in connection with the Separation. A range of reasonably possible liabilities, if any, cannot be currently currently estimated by the Company.\nLeases\nAll of our leases are operating leases as of September 30, 2021 and December 31, 2020. We have operating leases for corporate offices, manufacturing facilities, and land. Our leases have remaining lease terms of 1 year to 14 years. Quantitative disclosures about our leases are summarized in the table below.\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (in Millions, except for weighted-average amounts) | 2021 | 2020 | 2021 | 2020 |\n| Lease Cost |\n| Operating lease cost | $ | 0.4 | $ | 0.6 | $ | 1.0 | $ | 1.6 |\n| Short-term lease cost | 0.3 | — | 1.0 | 0.3 |\n| Variable lease cost (1) | — | — | 0.1 | 0.1 |\n| Total lease cost (1) | $ | 0.7 | $ | 0.6 | $ | 2.1 | $ | 2.0 |\n| Other information |\n| Cash paid for amounts included in the measurement of lease liabilities: |\n| Cash paid for operating leases | $ | 0.5 | $ | 0.5 | $ | 1.6 | $ | 1.5 |\n\n__________________________\n1. Short term lease cost for the three months ended September 30, 2020 was less than $ 0.1 million. Variable lease cost for the three months ended September 30, 2020 and 2021 was less than $ 0.1 million. Lease expense is classified as \"Selling, general and administrative expenses\" in our consolidated statements of operations.\nAs of September 30, 2021 and December 31, 2020, our operating leases had a weighted average remaining lease term of 8.6 years and 11.7 years, respectively. As of September 30, 2021 and December 31, 2020, our operating leases had a weighted average discount rate of 4.9 % and 4.4 %, respectively.\nThe table below presents a maturity analysis of our operating lease liabilities for each of the next five years and a total of the amounts for the remaining years.\n| (in Millions) | Undiscounted cash flows |\n| Remainder of 2021 | $ | 0.4 |\n| 2022 | 1.3 |\n| 2023 | 1.1 |\n| 2024 | 1.1 |\n| 2025 | 1.1 |\n| Thereafter | 3.0 |\n| Total future minimum lease payments | 8.0 |\n| Less: Imputed interest | ( 1.5 ) |\n| Total | $ | 6.5 |\n\n25\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nIn the first quarter of 2021, we terminated our existing sublease with FMC for approximately twenty-five thousand square feet of office space used for our corporate headquarters in Philadelphia, Pennsylvania and removed the related right-of-use (\"ROU\") asset and lease liability of approximately $ 10.9 million from our condensed consolidated balance sheets. On April 13, 2021 we executed a new five-year sublease agreement with a different counterparty for approximately thirteen thousand square feet of office space for our corporate headquarters in Philadelphia, Pennsylvania and recorded a $ 2.1 million ROU asset and lease liability in the second quarter of 2021 related thereto.\n26\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nNote 14: Supplemental Information\nThe following tables present details of prepaid and other current assets, other assets, accrued and other current liabilities, and other long-term liabilities as presented on the condensed consolidated balance sheets:\n| (in Millions) | September 30, 2021 | December 31, 2020 |\n| Prepaid and other current assets |\n| Argentina government receivable (1) | $ | 11.8 | $ | 10.8 |\n| Tax related items | 15.4 | 15.7 |\n| Other receivables | 3.0 | 8.6 |\n| Prepaid expenses | 7.6 | 8.2 |\n| Bank Acceptance Drafts (2) | — | 0.2 |\n| Other current assets (3) | 6.0 | 12.8 |\n| Total | $ | 43.8 | $ | 56.3 |\n\n| (in Millions) | September 30, 2021 | December 31, 2020 |\n| Other assets |\n| Argentina government receivable (1) | $ | 51.0 | $ | 55.8 |\n| Advance to contract manufacturers (4) | 15.6 | 16.3 |\n| Capitalized software, net | 1.5 | 1.8 |\n| Tax related items | 2.5 | 2.7 |\n| Other assets | 11.0 | 11.8 |\n| Total | $ | 81.6 | $ | 88.4 |\n\n_________________\n1.We have various subsidiaries that conduct business in Argentina. As of September 30, 2021 and December 31, 2020, $ 38.3 million and $ 39.5 million, respectively, of outstanding receivables due from the Argentina government, which primarily represent export tax and export rebate receivables, was denominated in U.S. dollars. As with all outstanding receivable balances, we continually review recoverability by analyzing historical experience, current collection trends and regional business and political factors among other factors.\n2.Bank Acceptance Drafts are a common Chinese finance note used to settle trade transactions. Livent accepts these notes from Chinese customers based on criteria intended to ensure collectability and limit working capital usage.\n3.The December 31, 2020 balance includes a $ 5.4 million receivable for insurance reimbursement related to the IPO litigation settlement which was netted with the IPO litigation settlement accrual. The IPO litigation settlement was finalized in the second quarter of 2021. See Note 7 for details.\n4.We record deferred charges for certain contract manufacturing agreements which we amortize over the term of the underlying contract.\n27\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\n| (in Millions) | September 30, 2021 | December 31, 2020 |\n| Accrued and other current liabilities |\n| Plant restructuring reserves | $ | 3.2 | $ | 3.2 |\n| Retirement liability - 401K | 0.6 | 2.6 |\n| Accrued payroll | 11.5 | 12.5 |\n| Severance related | 0.2 | 2.5 |\n| Environmental reserves, current | 0.5 | 0.6 |\n| Other accrued and other current liabilities (1) | 19.7 | 15.3 |\n| Total | $ | 35.7 | $ | 36.7 |\n\n| (in Millions) | September 30, 2021 | December 31, 2020 |\n| Other long-term liabilities |\n| Accrued investment in unconsolidated affiliate | $ | 6.2 | $ | 6.2 |\n| Asset retirement obligations | 0.3 | 0.3 |\n| Contingencies related to uncertain tax positions (2) | 3.6 | 3.4 |\n| Deferred compensation plan obligation | 5.5 | 4.5 |\n| Self-insurance reserves | 1.5 | 1.5 |\n| Other long-term liabilities | 1.1 | 1.3 |\n| Total | $ | 18.2 | $ | 17.2 |\n\n____________________\n1.Amounts primarily include accrued capital expenditures related to our expansion projects. December 31, 2020 includes a $ 7.4 million settlement accrual related to IPO litigation recorded in the third quarter of 2020. The IPO litigation settlement was finalized in the second quarter of 2021.\n2.As of September 30, 2021, we have recorded a liability for uncertain tax positions of $ 3.2 million and a $ 0.4 million indemnification liability to FMC for assets held by the Company where the offsetting liability for uncertain tax positions rests with FMC. The Company agreed to bear any possible liability for this matter under the terms of the Tax Matters Agreement that it entered into with FMC in connection with the Separation.\n28\nITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nSPECIAL NOTE REGARDING FORWARD-LOOKING INFORMATION\nStatement under the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995: We and our representatives may from time to time make written or oral statements that are “forward-looking” and provide other than historical information, including statements contained in Item 2 of this Quarterly Report on Form 10-Q, in our other filings with the SEC, or in reports to our stockholders.\nIn some cases, we have identified forward-looking statements by such words or phrases as “will likely result,” “is confident that,” “expect,” “expects,” “should,” “could,” “may,” “will continue to,” “believe,” “believes,” “anticipates,” “predicts,” “forecasts,” “estimates,” “projects,” “potential,” “intends” or similar expressions identifying “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, including the negative of those words and phrases. Such forward-looking statements are based on our current views and assumptions regarding future events, future business conditions and the outlook for the company based on currently available information. These forward-looking statements may include projections of our future financial performance, our anticipated growth strategies and anticipated trends in our business. These statements are only predictions based on our current expectations and projections about future events. These statements involve known and unknown risks, uncertainties and other factors that may cause actual results to be materially different from any results, levels of activity, performance or achievements expressed or implied by any forward-looking statement.\nCurrently, one of the most significant factors is the potential adverse effect of the current COVID-19 pandemic on the financial condition, results of operations, cash flows and performance of the Company, which is substantially influenced by the potential adverse effect of the pandemic on Livent’s customers and suppliers, the global economy and financial markets and costs of implementing COVID-19 safety protocols. The extent to which COVID-19 impacts us will depend on future developments, which are highly uncertain and cannot be predicted with confidence, including the scope, severity and duration of the pandemic, the development of more contagious variants of the virus, such as the Delta variant, the actions taken to contain the pandemic or mitigate its impact, and the direct and indirect economic effects of the pandemic and containment measures, among others.\nAdditional factors include, among other things:\n•a decline in the growth in demand for electric vehicles with high performance lithium compounds;\n•supply chain disruptions in the electric vehicle manufacturing industry, such as shortages, congestion at ports, and rolling electricity blackouts in China, resulting in delays in customer orders for our high performance lithium compounds;\n•reduced customer demand, or delays in growth of customer demand, for higher performance lithium compounds;\n•volatility in the price for performance lithium compounds;\n•adverse global economic and weather conditions that may result in adverse impact on supply chains and customer demand;\n•competition;\n•quarterly and annual fluctuations of our operating results;\n•risks relating to Livent’s capacity expansion efforts and current production;\n•potential development and adoption of battery technologies that do not rely on performance lithium compounds as an input, or that require a lesser amount of performance lithium compounds;\n•difficulty accessing global capital and credit markets;\n•the conditional conversion feature of the 2025 Notes;\n•the lack of sufficient cash flow from our business to pay our debt;\n•the success of Livent’s research and development efforts;\n•future acquisitions that may be difficult to integrate or are otherwise unsuccessful;\n•risks inherent in international operations and sales, including political, financial and operational risks specific to Argentina, China and other countries where Livent has active operations;\n•customer concentration and the possible loss of, or significant reduction in orders from, large customers;\n•failure to satisfy customer qualification processes and customer and government quality standards;\n29\n•fluctuations in the price of energy and certain raw materials;\n•employee attraction and retention, especially in relation to our capacity expansion efforts;\n•union relations;\n•cybersecurity breaches;\n•our ability to protect our intellectual property rights;\n•ESG matters;\n•the lack of proven lithium reserves;\n•legal and regulatory proceedings, including any shareholder lawsuits;\n•compliance with environmental, health and safety laws;\n•changes in tax laws;\n•risks related to our separation from FMC Corporation;\n•potential conflicts of interests among officers and directors who may own equity in, and/or may have otherwise served as employees of, FMC Corporation;\n•risks related to ownership of our common stock, including price fluctuations;\n•provisions under Delaware law and our charter documents that may deter third parties from acquiring us; and\n•the lack of cash dividends at this time.\nMoreover, investors are cautioned to interpret many of these factors as being heightened as a result of the ongoing and numerous adverse impacts of COVID-19. You should carefully consider the risk factors discussed in Part I, Item 1A of our 2020 Annual Report on Form 10-K.\nAlthough we believe the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, level of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of any of these forward-looking statements. We wish to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made. We are under no duty to and specifically decline to undertake any obligation to publicly revise or update any of these forward-looking statements after the date of this Quarterly Report on Form 10-Q to conform our prior statements to actual results, revised expectations or to reflect the occurrence of anticipated or unanticipated events.\nAPPLICATION OF CRITICAL ACCOUNTING POLICIES\nOur condensed consolidated financial statements are prepared in conformity with U.S. GAAP. The preparation of our financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. We have described our accounting policies in Note 2 to our consolidated and combined financial statements included in Part II, Item 8 of our 2020 Annual Report on Form 10-K.\nWe have reviewed these accounting policies, identifying those that we believe to be critical to the preparation and understanding of our condensed consolidated financial statements. We have reviewed these critical accounting policies with the Audit Committee of our Board of Directors. Critical accounting policies are central to our presentation of results of operations and financial condition and require management to make estimates and judgments on certain matters. We base our estimates and judgments on historical experience, current conditions and other reasonable factors.\nThe following is a list of those accounting policies that we have deemed most critical to the presentation and understanding of our results of operations and financial condition. See the \"Critical Accounting Policies\" section included within \"Management's Discussion and Analysis of Financial Condition and Results of Operations\" within Part II, Item 7 of our 2020 Annual Report on Form 10-K for a detailed description of these policies and their potential effects on our results of operations and financial condition.\n•Revenue recognition and trade receivables\n•Impairment and valuation of long-lived assets\n•Income taxes\nDue to the COVID-19 pandemic, there has been uncertainty and disruption in the global economy and financial markets. The estimates used for, but not limited to, revenue recognition and the collectability of trade receivables, impairment and valuation of long-lived assets, and income taxes could be impacted. We have assessed the impact and are not aware of any specific events or circumstances that required an update to our estimates and assumptions or materially affected the carrying value of our assets\n30\nor liabilities as of the date of issuance of this Quarterly Report on Form 10-Q. These estimates may change as new events occur and additional information is obtained. Actual results could differ materially from these estimates under different assumptions or conditions.\nRECENTLY ISSUED AND ADOPTED ACCOUNTING PRONOUNCEMENTS AND REGULATORY ITEMS\nSee Note 3 to these condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for a discussion of recently adopted accounting guidance and other new accounting guidance.\nOVERVIEW\nWe are a pure-play, fully integrated lithium company, with a long, proven history of producing performance lithium compounds. Our primary products, namely battery-grade lithium hydroxide, lithium carbonate, butyllithium and high purity lithium metal are critical inputs used in various performance applications. Our strategy is to focus on supplying high performance lithium compounds to the fast growing Electric Vehicle (“EV”) battery market, while continuing to maintain our position as a leading global producer of butyllithium and high purity lithium metal. With extensive global capabilities, nearly 80 years of continuous production experience, applications and technical expertise, long standing customer relationships, and a favorable sustainability profile, we believe we are well positioned to capitalize on the accelerating trend of vehicle electrification and renewable energy adoption.\nWe produce lithium compounds for use in applications that have specific and constantly changing performance requirements, including battery-grade lithium hydroxide for use in high performance lithium-ion batteries. We believe the demand for our compounds will continue to grow as the electrification of transportation accelerates, and as the use of high nickel content cathode materials increases in the next generation of battery technology products. We also supply butyllithium, which is used in the production of polymers and pharmaceutical products, as well as a range of specialty lithium compounds including high purity lithium metal, which is used in non-rechargeable batteries and in the production of lightweight materials for aerospace applications and non-rechargeable batteries. It is in these applications that we have established a differentiated position in the market through our ability to consistently produce and deliver performance lithium compounds.\nThird Quarter 2021 Highlights\nThe following are the more significant developments in our business during the three months ended September 30, 2021:\n•Revenue of $103.6 million for the three months ended September 30, 2021 increased $31.0 million, or approximately 43%, compared to $72.6 million for the three months ended September 30, 2020, primarily due to higher lithium hydroxide, lithium carbonate and butyllithium sales volumes, driven by an increase in customer demand.\n•Net loss of $(12.6) million for the three months ended September 30, 2021 compared to net loss of $(10.5) million for the three months ended September 30, 2020 was primarily due to an increase in the Argentina tax expense from inflationary tax adjustments, higher logistics, raw material and other operating costs, and $1.0 million Equity in net loss of unconsolidated affiliates partially offset by higher lithium hydroxide, lithium carbonate and butyllithium sales volumes and lower Restructuring and other charges.\n•Adjusted EBITDA of $14.9 million for the three months ended September 30, 2021 increased $14.0 million compared to $0.9 million for the three months ended September 30, 2020, primarily due to higher lithium hydroxide, lithium carbonate and butyllithium sales volumes partially offset by higher logistics, raw material and other operating costs.\nCOVID-19 Impacts\nBusiness and Operations\nDuring the three months ended September 30, 2021, the COVID-19 pandemic continued to negatively impact our business, operations and financial performance. Worldwide government and private sector efforts to contain the spread and mitigate the impact of COVID-19 continued. We still face operational challenges and uncertainties related to the unprecedented global COVID-19 pandemic. The disruptions and duration may be impacted by the actions that governments, businesses and individuals take in relation to the pandemic, the Delta variant and other new variants of the virus, vaccine safety concerns, vaccine resistance, vaccine availability, delays in vaccine distribution and the willingness of individuals to be vaccinated.\nWe have manufacturing operations in the United States, Argentina, China, the United Kingdom, and India, general operations in Singapore, and sales offices in the United States, China, the United Kingdom, India, and Japan. All of these countries have been affected by the COVID-19 pandemic to varying degrees. Each has adopted measures to contain it, and each may adopt different and/or even stricter measures in the future. The government of Argentina, where the Company’s primary lithium brine resource is located, continues to enact new emergency measures to stem the spread of COVID-19 and modify existing ones. While regional curfews and lockdowns are being lifted and businesses and schools are being allowed to reopen, travel and\n31\nimmigration restrictions and workforce retention rules remain in place. In India, regional governments have imposed testing requirements, curfews and travel restrictions. We expect government measures and restrictions globally to continue to have a negative impact on demand for certain of our products and a negative impact on the efficient operation of our facilities, supply chains and logistics. Disruptions and delays within our supply chain and logistics operations included problems and congestion at ports, difficulties with scheduling cargo ships, higher shipment and freight costs, additional warehouse costs due to shipment delays, lack of driver availability and fewer transportation options, and the restriction of movements by trucks within and between countries. The severity of these problems and issues has varied in different geographic locations over the course of the COVID-19 pandemic and continues to remain a challenge in all of the countries where we operate.\nCustomer demand for certain types of our products improved during the third quarter of 2021. However, customers continue to protect their interests by diversifying among multiple suppliers. They continue to actively manage their own inventory levels in the current uncertain market environment. In addition, customers in the fast-growing EV manufacturing industry are currently experiencing their own supply chain constraints, including semiconductors shortages, congestion at ports, and rolling electricity blackouts in China. The semiconductor chip shortage is expected to continue and may adversely impact our business. This, and similar supply chain disruptions experienced by our customers, could cause delays in their demand for our high performance lithium compounds, further adversely impacting our business and growth plans.\nThe continuing spread and effects of COVID-19, including health and safety protocols and supply and logistics disruptions in China and elsewhere, are impacting our expansion work in Argentina and the United States. There can be no assurance that such impacts will not turn into long-term or continuing delays, cause us to decide to suspend our capital expansion work, or otherwise negatively impact our capital expansion. Any significant delay in our capital expansion work in Argentina or the United States could have a material adverse effect on our business, financial condition and results of operations. In addition to delays, there have been increased costs due to slowdown of availability of materials for construction.\nWe have not faced any material issues with employee morale or attrition. Likewise, we have not faced any material issues with our ability to recruit new employees or in talent management of existing employees. However, certain of our employees may resign, and we may be unable to attract certain talent, if we were to impose any vaccine mandate. Broadly, we are observing tightness in the local labor markets where we operate in both the United States and Argentina (e.g., fewer applicants and higher wages). This may impact us and our expansion efforts, our customers and suppliers in the future.\nThe material operational challenges that management and our Board of Directors are monitoring are the health and safety of our employees, vaccine availability and distribution, travel restrictions, COVID-19 mitigation measures, the relaxation of work from home requirements, the restriction of movements within and between countries, and supply chain and logistics issues. Furthermore, our Board of Directors is monitoring the additional expected and unexpected impacts that COVID-19 is having on the economies in the countries where we operate, such as Argentina where inflation remains high and economic instability persists, and China where economic growth has led to shortages of electricity and temporary shutdowns of third party providers to the Company.\nLiquidity and Financial Resources\nThe rapid and global spread of COVID-19 continues to disrupt the businesses of certain customers, contract manufacturers and suppliers. Several of our customers and contract manufacturers have experienced disruptions in their business due to the COVID-19 pandemic. Certain customers have canceled, postponed or delayed orders.\nOur uses of cash were impacted by the effects of COVID-19 during the nine months ended September 30, 2021. We continue to face logistical supply disruptions, such as higher truck, freight and sea shipping costs, along with the need to use air freight from time to time. We expect this to continue. We also continue to use cash to purchase additional COVID-19 testing, personal protective equipment for our employees, such as masks and gloves, and for increased cleaning and disinfectant costs, additional medical personnel at our facilities, and increased personnel transportation costs due to social distancing guidelines.\nCorporate Efforts\nWe have responded to the COVID-19 pandemic in a number of ways. We formed a Global Pandemic Response Team, regional COVID-19 Response Teams, and a Vaccine subcommittee. The Vaccine subcommittee is tasked with monitoring vaccine developments and encouraging our employees to be vaccinated. Our regional COVID-19 Response Teams continue to keep Executive Leadership informed of local matters such as government policies and regulations. Our Enterprise Risk Management processes have worked as designed.\nWe continue to identify potential new suppliers and logistics providers for our operations as supply chain challenges continue. This includes potential new suppliers of chemicals and packaging, and air freight companies when required. We have altered global production schedules to meet changes in customer demand, supply and logistics challenges. Future efforts will continue along these lines and be dictated by the particulars of the COVID-19 pandemic. We continue to plan for a return to more normalized business operations once the COVID-19 pandemic subsides. This may include a relaxation of COVID-19 protocols, more business travel and customer contacts, and hybrid work arrangements.\n32\nHealth & Safety\nWe are working diligently to protect the health and well-being of our employees, customers and other key stakeholders. As an essential business under the rules of the governments in the countries where we operate, our plant personnel continue to remain on the job at their respective facilities. We have instituted numerous safety procedures to protect the health of these plant personnel. Protocols include screening of personnel prior to facility entry, the use of masks and gloves, social distancing measures, and quarantine of close contacts with suspected or confirmed COVID-19 cases. Much of our non-plant personnel continue to work from home, and business travel has been substantially reduced, which has limited our ability to meet with customers, suppliers and fellow employees. Communications relating to all of these policies and COVID-19 preventative measures are regularly distributed to our employees, as there can be significant variation with respect to the COVID-19 pandemic situation in different geographic regions at any one time.\nWe base our health and safety protocols on the advice provided by the White House, the Centers for Disease Control and Prevention, the World Health Organization, and the local government authorities in the countries and regions where we operate.\nIn the United States, we previously implemented the paid sick leave policies that were required under the Families First Coronavirus Response Act and had supplemented them with our own paid sick and other leave policies. Currently, in the United States, we are providing paid sick leave for qualified absences due to COVID-19. In other geographic locations, we are providing our customary local sick leave benefits and any other leave and benefits that may be required by local governmental authorities. We have not experienced any material employee absences as a result of COVID-19. However, social distancing measures and other health and safety protocols have led to reduced workforce numbers in certain locations, such as with our expansion project in Argentina. If a significant number of our employees at any one location were to require leave as a result of COVID-19, this could pose a risk to the continued operation of the particular facility and could potentially disrupt our broader operations.\nGovernment Programs\nWe continue to evaluate government support and tax relief programs in the countries where we operate. This includes support grants, loans, tax deferrals, and tax credits.\nOverall, the impact of the COVID-19 pandemic is fluid and continues to evolve, and therefore, we cannot predict the extent to which our business, results of operations, financial condition or liquidity will ultimately be impacted.\nBusiness Outlook\nWe expect higher volumes across our lithium products and slightly higher average pricing in 2021 versus the prior year. We also expect lower unit costs versus the prior year, driven in part by higher operating rates and the reduced impact of third-party purchased lithium carbonate usage. However, we expect this to be partially offset by cost increases in logistics, solvents and other raw materials.\n33\nRESULTS OF OPERATIONS\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| (in Millions) | (unaudited) |\n| Revenue | $ | 103.6 | $ | 72.6 | $ | 297.5 | $ | 206.0 |\n| Cost of sales | 85.3 | 69.8 | 245.5 | 178.4 |\n| Gross margin | 18.3 | 2.8 | 52.0 | 27.6 |\n| Selling, general and administrative expenses | 11.8 | 10.0 | 34.2 | 31.1 |\n| Research and development expenses | 0.8 | 1.0 | 2.2 | 2.8 |\n| Restructuring and other charges | 1.1 | 4.4 | 3.4 | 10.1 |\n| Separation-related costs | 0.8 | 0.6 | 1.3 | 0.8 |\n| Total costs and expenses | 99.8 | 85.8 | 286.6 | 223.2 |\n| Income/(loss) from operations before loss on debt extinguishment, equity in net loss of unconsolidated affiliates and interest expense, net | 3.8 | (13.2) | 10.9 | (17.2) |\n| Loss on debt extinguishment | — | — | — | 0.1 |\n| Equity in net loss of unconsolidated affiliates | 1.0 | 0.1 | 3.7 | 0.4 |\n| Interest expense, net | — | 0.3 | 0.3 | 0.3 |\n| Income/(loss) from operations before income taxes | 2.8 | (13.6) | 6.9 | (18.0) |\n| Income tax expense/(benefit) | 15.4 | (3.1) | 13.8 | (5.4) |\n| Net loss | $ | (12.6) | $ | (10.5) | $ | (6.9) | $ | (12.6) |\n\nIn addition to net income, as determined in accordance with U.S. GAAP, we evaluate operating performance using certain non-GAAP measures such as EBITDA, which we define as net income plus interest expense, net, income tax expense/(benefit), and depreciation and amortization, and Adjusted EBITDA, which we define as EBITDA adjusted for restructuring and other charges/(income), separation-related costs and certain other losses/(gains). Management believes the use of these non-GAAP measures allows management and investors to compare more easily the financial performance of its underlying business from period to period. The non-GAAP information provided may not be comparable to similar measures disclosed by other companies because of differing methods used by other companies in calculating EBITDA and Adjusted EBITDA. These measures should not be considered as a substitute for net income or other measures of performance or liquidity reported in accordance with U.S. GAAP. The following table reconciles EBITDA and Adjusted EBITDA from net income.\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (in Millions) | 2021 | 2020 | 2021 | 2020 |\n| Net loss (GAAP) | $ | (12.6) | $ | (10.5) | $ | (6.9) | $ | (12.6) |\n| Add back: |\n| Interest expense, net | — | 0.3 | 0.3 | 0.3 |\n| Income tax expense/(benefit) | 15.4 | (3.1) | 13.8 | (5.4) |\n| Depreciation and amortization | 6.2 | 6.1 | 18.7 | 17.7 |\n| EBITDA (Non-GAAP) | 9.0 | (7.2) | 25.9 | — |\n| Add back: |\n| Certain Argentina remeasurement losses (a) | 0.9 | 1.5 | 4.2 | 4.4 |\n| Restructuring and other charges (b) | 1.1 | 4.4 | 3.4 | 10.1 |\n| Separation-related costs (c) | 0.8 | 0.6 | 1.3 | 0.8 |\n| COVID-19 related costs (d) | 1.9 | 1.7 | 4.2 | 1.7 |\n| Loss on debt extinguishment (e) | — | — | — | 0.1 |\n| Other gain/(loss) (f) | 1.2 | (0.1) | 3.0 | (0.4) |\n| Adjusted EBITDA (Non-GAAP) | $ | 14.9 | $ | 0.9 | $ | 42.0 | $ | 16.7 |\n\n___________________\na.Represents impact of currency fluctuations on tax assets and liabilities and on long-term monetary assets associated with our capital expansion as well as significant currency devaluations. The remeasurement gains/(losses) are included within \"Cost of sales\" in our condensed consolidated statement of operations but are excluded from our calculation of Adjusted EBITDA because of: i.) their nature as income tax related; ii.) their association with long-term capital projects which will not be operational until future periods; or iii.) the severity of the devaluations and their immediate impact on our operations in the country.\nb.We continually perform strategic reviews and assess the return on our business. This sometimes results in management changes or in a plan to restructure the operations of our business. As part of these restructuring plans, demolition costs and write-downs of long-lived assets may occur. Also includes transaction related legal fees and miscellaneous nonrecurring transactions. Three and nine months\n34\nended September 30, 2020 consists primarily of legal fees related to IPO securities litigation including a settlement accrual, net of insurance reimbursement, of $2.5 million in the third quarter. The IPO litigation settlement was finalized in the second quarter of 2021.\nc.Represents legal, professional, transaction-related fees and other separation-related activity.\nd.Represents incremental costs associated with COVID-19 recorded in \"Cost of sales\" in the condensed consolidated statement of operations, including but not limited to, incremental quarantine related absenteeism, incremental facility cleaning costs, COVID-19 testing, pandemic-related supplies and personal protective equipment for employees, among other costs; offset by economic relief provided by foreign governments.\ne.Represents the partial write off of deferred financing costs for the temporary reduction in borrowing capacity related to the First Amendment excluded from our calculation of Adjusted EBITDA because the loss is nonrecurring.\nf.Three and nine months ended September 30, 2021 represents our 25% indirect interest in transaction costs incurred for the Nemaska Transaction, certain project-related costs and interest expense, all included in Equity in net loss of unconsolidated affiliates in our condensed consolidated statement of operations. Three and nine months ended September 30, 2020 represents a portion of our nonrefundable prepaid research and development costs advanced to an unconsolidated affiliate in the fourth quarter 2019 and excluded from our calculation of Adjusted EBITDA in the same period because the costs represent research and development activities of the affiliate that had not occurred as of December 31, 2019. These costs were included with our calculation of Adjusted EBITDA for the three and nine months ended September 30, 2020 when the costs were incurred at the unconsolidated affiliate.\nThree Months Ended September 30, 2021 vs. 2020\nRevenue\nRevenue of $103.6 million for the three months ended September 30, 2021 (the \"2021 Quarter\") increased by approximately 43%, or $31 million, compared to $72.6 million for the three months ended September 30, 2020 (the \"2020 Quarter\") primarily due to higher lithium hydroxide, lithium carbonate and butyllithium sales volumes, driven by an increase in customer demand.\nGross margin\nGross margin of $18.3 million for the 2021 Quarter increased by $15.5 million, or approximately 554%, versus $2.8 million for the 2020 Quarter. The increase in gross margin was primarily due to higher lithium hydroxide, lithium carbonate and butyllithium sales volumes, partially offset by higher logistics, raw material and other operating costs.\nRestructuring and other charges\nRestructuring and other charges of $1.1 million for the 2021 Quarter decreased by $3.3 million versus $4.4 million for the 2020 Quarter. Restructuring and other charges for the 2020 Quarter consisted primarily of severance-related costs of $0.9 million, and legal fees related to IPO securities litigation including a settlement accrual, net of insurance reimbursement, of $2.5 million in the 2020 Quarter. The IPO litigation settlement was finalized in the second quarter of 2021. 2021 Quarter Restructuring and other charges consisted primarily of transaction related legal fees and miscellaneous nonrecurring transactions (see Note 7 for details).\nEquity in net loss of unconsolidated affiliates\nEquity in net loss of unconsolidated affiliates of $1.0 million for the 2021 Quarter arises out of our 25% interest in the Nemaska Project.\nInterest expense, net\nInterest expense of $0.3 million for the 2020 Quarter is noncash amortization of transaction costs related to the 2025 Notes which represents the excess interest over the amount of interest capitalized in accordance with U.S. GAAP for the 2020 Quarter. Interest of $3.8 million and $3.4 million for the 2021 Quarter and the 2020 Quarter, respectively was capitalized.\nIncome tax expense/(benefit)\nThe increase in income tax expense to $15.4 million for the 2021 Quarter compared to the income tax benefit of $(3.1) million for the 2020 Quarter, was primarily due to the fluctuations in foreign currency impacts in Argentina of $12.7 million and $(2.6) million for the three months ended September 30, 2021 and 2020, respectively. Within foreign currency impacts, Argentina tax law annually requires an increase to taxable income for inflationary adjustments in the period when the consumer price index fluctuates over a specific threshold, which was met in Q3 of 2021. Additionally, the increase in income tax expense was the result of an increase in income from operations.\nNet loss\nNet loss of $(12.6) million for the 2021 Quarter compared to net loss of $(10.5) million for the 2020 Quarter was primarily due to the an increase in the Argentina tax expense from inflationary tax adjustments, higher logistics, raw material and other\n35\noperating costs, and $1.0 million Equity in net loss of unconsolidated affiliates partially offset by higher lithium hydroxide, lithium carbonate and butyllithium sales volumes and lower Restructuring and other charges.\n36\nNine Months Ended September 30, 2021 vs. 2020\nRevenue\nRevenue of $297.5 million for the nine months ended September 30, 2021 (the \"2021 YTD\") increased by approximately 44%, or $91.5 million, compared to $206.0 million for the nine months ended September 30, 2020 (the \"2020 YTD\") primarily due to higher lithium hydroxide, lithium carbonate and butyllithium sales volumes, driven by an increase in customer demand.\nGross margin\nGross margin of $52.0 million for the 2021 YTD increased by $24.4 million, or approximately 88%, versus $27.6 million for the 2020 YTD. The increase in gross margin was primarily due higher lithium hydroxide, lithium carbonate and butyllithium sales volumes partially offset by COVID-19 costs to implement safety protocols and higher logistics, raw material and other operating costs.\nRestructuring and other charges\nRestructuring and other charges of $3.4 million for the 2021 YTD decreased by $6.7 million versus $10.1 million for the 2020 YTD. Restructuring and other charges for the 2020 YTD consisted of severance-related costs for management changes at certain operating and administrative facilities, exit costs of $1.6 million for the closing of leased office space and legal fees related to IPO securities litigation, including a settlement accrual, net of insurance reimbursement, of $2.5 million in the third quarter of 2020. The IPO litigation settlement was finalized in the second quarter of 2021. 2021 YTD Restructuring and other charges consisted primarily of environmental remediation, transaction related legal fees and miscellaneous nonrecurring costs (see Note 7 for details).\nEquity in net loss of unconsolidated affiliates\nEquity in net loss of unconsolidated affiliates of $3.7 million for the 2021 YTD arises out of our 25% interest in the Nemaska Project and includes $1.6 million of nonrecurring transaction costs incurred for the Nemaska Transaction by an unconsolidated affiliate.\nInterest expense, net\nInterest expense of $0.3 million for the 2021 YTD and 2020 YTD is noncash amortization of transaction costs related to the 2025 Notes which represents the excess interest over the amount of interest capitalized in accordance with U.S. GAAP for the 2021 YTD. Interest expense of $11.5 million and $8.1 million was capitalized in the 2021 YTD and 2020 YTD, respectively.\nIncome tax expense/(benefit)\nThe increase in income tax expense to $13.8 million for the 2021 YTD compared to the income tax benefit of $(5.4) million for the 2020 YTD, was primarily due to the fluctuations in foreign currency impacts in Argentina of $10.8 million and $(7.1) million for the nine months ended September 30, 2021 and 2020, respectively. Within foreign currency impacts, Argentina tax law annually requires an increase to taxable income for inflationary adjustments in the period when the consumer price index fluctuates over a specific threshold, which was met in Q3 of 2021. Additionally, the increase in tax expense was due to an increase in income from operations. The increase in income tax expense was partially offset by an Argentina income tax law, which was amended on June 16, 2021 to introduce new progressive corporate income tax rates from 25% to 35%. This change resulted in a tax benefit of $(2.2) million for the revaluation of Argentina net deferred tax assets for the nine months ended September 30, 2021.\nNet loss\nNet loss of $(6.9) million for the 2021 YTD compared to net loss of $(12.6) million for the 2020 YTD was primarily due to higher lithium hydroxide, lithium carbonate and butyllithium sales volumes and lower Restructuring and other charges, offset by an increase in the Argentina tax expense from inflationary tax adjustments, incremental COVID-19 costs to implement safety protocols, higher logistics, raw material and other operating costs and $3.7 million Equity in net loss of unconsolidated affiliates.\n37\nLIQUIDITY AND CAPITAL RESOURCES\nCash and cash equivalents at September 30, 2021 and December 31, 2020, were $195.3 million and $11.6 million, respectively. Of the cash and cash equivalents balance at September 30, 2021, $12.5 million were held by our foreign subsidiaries. The cash held by foreign subsidiaries for permanent reinvestment is generally used to finance the subsidiaries’ operating activities and future foreign investments. We have not provided additional income taxes for any additional outside basis differences inherent in our investments in subsidiaries because the investments are essentially permanent in duration or we have concluded that no additional tax liability will arise upon disposal. See Note 9, Part II, Item 8 of our 2020 Annual Report on Form 10-K for more information.\nRevolving Credit Facility\nThe Credit Agreement provides for a $400 million senior secured Revolving Credit Facility, $50 million of which is available for the issuance of letters of credit, with an option, subject to certain conditions and limitations, to increase the aggregate amount of the revolving credit commitments to $600 million. The issuance of letters of credit and the proceeds of revolving credit loans made pursuant to the Revolving Credit Facility are available, and will be used, for general corporate purposes, including capital expenditures and permitted acquisitions, See Note 10, Part II, Item 8 of our 2020 Annual Report on Form 10-K for more information.\nWe had $245.8 million and $281.4 million debt outstanding as of September 30, 2021 and December 31, 2020, respectively. Our September 30, 2021 debt outstanding was comprised solely of our 2025 Notes because in June 2021 we used a portion of the net proceeds from the Offering to repay all amounts outstanding under our Revolving Credit Facility. Among other restrictions, our Revolving Credit Facility contains financial covenants applicable to Livent and its consolidated subsidiaries related to leverage (measured as the ratio of debt to adjusted earnings) and interest coverage (measured as the ratio of adjusted earnings to interest expense). Our maximum allowable first lien leverage ratio is 3.5 as of September 30, 2021. Our minimum allowable interest coverage ratio is 3.5. We were in compliance with all covenants at September 30, 2021.\nStatement of Cash Flows\nCash provided by operating activities was $41.0 million and $1.5 million for the nine months ended September 30, 2021 and 2020, respectively.\nThe cash provided by operating activities for the 2021 YTD as compared to the cash provided by operating activities for the 2020 YTD was primarily driven by higher net income in the 2021 YTD and a decrease in payments of accounts payables in the 2021 YTD compared to the 2020 YTD.\nCash used in investing activities was $(74.3) million and $(111.8) million for the nine months ended September 30, 2021 and 2020, respectively.\nThe decrease in cash used in investing activities for the 2021 YTD compared to the 2020 YTD is primarily due to the Company's election to suspend all capital expansion work globally from March 2020 to the second quarter of 2021. The time lag of slowing down and subsequently ramping back up capital spending, resulted in decreased capital expenditures for capacity expansion of lithium carbonate and hydroxide during the nine months ended September 30, 2021.\nCash provided by financing activities was $216.9 million and $108.2 million for the nine months ended September 30, 2021 and 2020, respectively.\nNet cash proceeds for financing activities increased in the 2021 YTD compared to the 2020 YTD and was provided primarily by net proceeds of $252.2 million from the Offering, partially offset by the repayment of the outstanding balance of our Revolving Credit Facility in June 2021.\nOther potential liquidity needs\nWe plan to meet our liquidity needs through available cash, cash generated from operations, borrowings under the committed Revolving Credit Facility, and other potential financing strategies that may be available to us. At September 30, 2021, our remaining borrowing capacity under our Revolving Credit Facility, subject to meeting our debt covenants, is $385.6 million, including letters of credit utilization. Our overall borrowing capacity under the Revolving Credit Facility is $400 million as of September 30, 2021.\nWe expect the COVID-19 pandemic uncertainties, and lithium market challenges to continue in 2021. Our net leverage ratio is determined, in large part, by our ability to manage the timing and amount of our capital expenditures, which is within our\n38\ncontrol. It is also determined by our ability to achieve forecasted operating results and to pursue other working capital financing strategies that may be available to us, which is less certain and outside our control. In the first quarter of 2020, because of the significant practical constraints resulting from actions being taken by authorities around the word in response to the COVID-19 pandemic, the Company elected to suspend all capital expansion work globally. As of the second quarter of 2021, supported by partially reduced COVID-19 related constraints, additional commitments from customers and improved market conditions, Livent resumed its capital expansion work in Argentina and the United States. Based on this resumption, the Company estimates 2021 total capital spending to be $125 million.\nThe company remains focused on maintaining its financial flexibility and will continue to manage its cash flow and capital allocation decisions to navigate through this challenging environment.\nWe believe that our available cash and cash from operations, together with our borrowing availability under the Revolving Credit Facility and other potential financing strategies that may be available to us, will provide adequate liquidity for the next 12 months. Access to capital and the availability of financing on acceptable terms in the future will be affected by many factors, including our credit rating, economic conditions, the COVID-19 pandemic and the overall liquidity of capital markets and cannot be guaranteed.\n39\nCommitments and Contingencies\nSee Note 13 to these condensed consolidated financial statements included in this Quarterly Report on Form 10-Q.\nContractual Commitments\nInformation related to our contractual commitments at December 31, 2020 can be found in a table included within Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations within our 2020 Annual Report on Form 10-K. There have been no significant changes to our contractual commitments during the period ended September 30, 2021.\nClimate Change\nA detailed discussion related to climate change can be found in Part II, Item 7 of our 2020 Annual Report on Form 10-K.\nOff-Balance Sheet Arrangements\nWe do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.\nDERIVATIVE FINANCIAL INSTRUMENTS AND MARKET RISKS\nOur earnings, cash flows and financial position are exposed to market risks relating to fluctuations in commodity prices, interest rates and foreign currency exchange rates. Our policy is to minimize exposure to our cash flow over time caused by changes in interest and currency exchange rates. To accomplish this, we have implemented a controlled program of risk management consisting of appropriate derivative contracts entered into with major financial institutions.\nThe analysis below presents the sensitivity of the market value of our financial instruments to selected changes in market rates and prices. The range of changes chosen reflects our view of changes that are reasonably possible over a one-year period. Market value estimates are based on the present value of projected future cash flows considering the market rates and prices chosen.\nIn the second quarter of 2021, we placed foreign currency hedges for 2021 projected exposure.\nForeign Currency Exchange Rate Risk\nOur worldwide operations expose us to currency risk from sales, purchases, expenses and intercompany loans denominated in currencies other than the U.S. dollar, our functional currency. The primary currencies for which we have exchange rate exposure are the Euro, the British pound, the Chinese yuan, the Argentine peso, and the Japanese yen. Foreign currency debt and foreign exchange forward contracts are used in countries where we do business, thereby reducing our net asset exposure. Foreign exchange forward contracts are also used to hedge firm and highly anticipated foreign currency cash flows. We currently do not hedge foreign currency risks associated with the Argentine peso due to the limited availability and the high cost of suitable derivative instruments.\nTo analyze the effects of changing foreign currency rates, we have performed a sensitivity analysis in which we assume an instantaneous 10% change in the foreign currency exchange rates from their levels at the balance sheet date with all other variables (including interest rates) held constant. As of December 31, 2020, we had no open derivative cash flow hedge contracts.\n| Hedged Currency vs. Functional Currency |\n| (in Millions) | Net asset position on consolidated balance sheets | Net liability position with 10% strengthening | Net asset position with 10% weakening |\n| Net asset/(liability) position as of September 30, 2021 | $ | 0.1 | $ | (0.6) | $ | 0.6 |\n\nInterest Rate Risk\nOne of the strategies that we can use to manage interest rate exposure is to enter into interest rate swap agreements. In these agreements, we agree to exchange, at specified intervals, the difference between fixed and variable interest amounts calculated on an agreed-upon notional principal amount. As of September 30, 2021, we had no interest rate swap agreements.\nOur debt portfolio at September 30, 2021 is composed of fixed-rate and variable-rate debt; consisting of borrowings under our 2025 Notes and Revolving Credit Facility. Changes in interest rates affect different portions of our variable-rate debt portfolio in different ways. Based on the variable-rate debt in our debt portfolio at September 30, 2021, a one percentage point increase or decrease in interest rates would have increased or decreased, respectively, gross interest expense by $0.2 million for the nine months ended September 30, 2021.\n40\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nThe information required by this item is provided in “Derivative Financial Instruments and Market Risks,” under Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations.\nITEM 4. CONTROLS AND PROCEDURES\n(a) Evaluation of disclosure controls and procedures. Based on management’s evaluation (with the participation of the company’s Chief Executive Officer and Chief Financial Officer), the Chief Executive Officer and Chief Financial Officer have concluded that, as of September 30, 2021, the company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) are effective to provide reasonable assurance that information required to be disclosed by the Company in reports filed or submitted under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and is accumulated and communicated to management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.\n(b) Change in Internal Controls. There have been no changes in internal control over financial reporting that occurred during the quarter ended September 30, 2021, that materially affected or are reasonably likely to materially affect, our internal control over financial reporting.\n41\nPART II - OTHER INFORMATION\n\nITEM 1. LEGAL PROCEEDINGS\nWe are involved in legal proceedings from time to time in the ordinary course of our business, including with respect to workers’ compensation matters. Based on information currently available and established reserves, we have no reason to believe that the ultimate resolution of any known legal proceeding will have a material adverse effect on our financial position, liquidity or results of operations. However, there can be no assurance that the outcome of any such legal proceeding will be favorable, and adverse results in certain of these legal proceedings could have a material adverse effect on our financial position, results of operations in any one reporting period, or liquidity. Except as set forth in Note 13 to our financial statements, which is incorporated herein by reference to the extent applicable, there are no material changes from the legal proceedings previously disclosed in our 2020 Annual Report on Form 10-K.\nITEM 1A. RISK FACTORS\nIn addition to the other information set forth in this Quarterly Report on Form 10-Q, you should carefully consider the risk factors discussed in Part I, Item 1A of our 2020 Annual Report on Form 10-K, which is available at www.sec.gov and on our website at www.livent.com. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may adversely affect our business, financial condition or future results.\nForward-Looking Information\nWe wish to caution readers not to place undue reliance on any forward-looking statements contained herein, which speak only as of the date made. We specifically decline to undertake any obligation to publicly revise any forward-looking statements that have been made to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nRepurchases of Common Shares\nA summary of our repurchases of Livent's common stock for the three months ended September 30, 2021 is as follows:\n| ISSUER PURCHASES OF EQUITY SECURITIES |\n| Period | Total Number of Shares Purchased (1) | Average Price Paid Per Share | Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs (2) | Maximum Number of Shares That May Yet Be Purchased Under the Plans or Programs (2) |\n| July 1 through July 31, 2021 | 206 | $ | 19.52 | $ | — | $ | — |\n| August 1 through August 31, 2021 | 187 | $ | 24.22 | — | — |\n| September 1 through September 30, 2021 | 172 | $ | 24.64 | — | — |\n| Total Q3 2021 | 565 | $ | 22.64 | $ | — | $ | — |\n\n(1) The trustee of the Livent NQSP reacquires shares of Livent common stock from time to time through open-market purchases relating to investments by employees in our common stock, one of the investment options available under the Livent NQSP. Such shares are held in a trust fund and recorded to Treasury stock in our condensed consolidated balance sheets.\n(2) We have no publicly announced stock repurchase programs.\n42\nITEM 6. EXHIBITS\n| 31.1 | Certifying Statement of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2 | Certifying Statement of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1 | Certifying Statement of the Chief Executive Officer pursuant to Section 1350 of Title 18 of the United States Code |\n| 32.2 | Certifying Statement of the Chief Financial Officer pursuant to Section 1350 of Title 18 of the United States Code |\n| 101 | Interactive Data File |\n| 104 | The cover page from Livent Corporation’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2021, formatted in Inline XBRL. |\n\n43\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n| LIVENT CORPORATION(Registrant) |\n| By: | /s/ GILBERTO ANTONIAZZI |\n| Gilberto Antoniazzi,Vice President and Chief Financial Officer |\n\nDate: November 4, 2021\n44\n \n\nWhat is the percentage change in operating cash flow to net loss ratio from the year 2020 to 2021?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nITEM 1. FINANCIAL STATEMENTS\\nLIVENT CORPORATION\\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| (in Millions, Except Per Share Data) | (unaudited) |\\n| Revenue | $ | 103.6 | $ | 72.6 | $ | 297.5 | $ | 206.0 |\\n| Cost of sales | 85.3 | 69.8 | 245.5 | 178.4 |\\n| Gross margin | 18.3 | 2.8 | 52.0 | 27.6 |\\n| Selling, general and administrative expenses | 11.8 | 10.0 | 34.2 | 31.1 |\\n| Research and development expenses | 0.8 | 1.0 | 2.2 | 2.8 |\\n| Restructuring and other charges | 1.1 | 4.4 | 3.4 | 10.1 |\\n| Separation-related costs | 0.8 | 0.6 | 1.3 | 0.8 |\\n| Total costs and expenses | 99.8 | 85.8 | 286.6 | 223.2 |\\n| Income/(loss) from operations before loss on debt extinguishment, equity in net loss of unconsolidated affiliates and interest expense, net | 3.8 | ( 13.2 ) | 10.9 | ( 17.2 ) |\\n| Loss on debt extinguishment | — | — | — | 0.1 |\\n| Equity in net loss of unconsolidated affiliates | 1.0 | 0.1 | 3.7 | 0.4 |\\n| Interest expense, net | — | 0.3 | 0.3 | 0.3 |\\n| Income/(loss) from operations before income taxes | 2.8 | ( 13.6 ) | 6.9 | ( 18.0 ) |\\n| Income tax expense/(benefit) | 15.4 | ( 3.1 ) | 13.8 | ( 5.4 ) |\\n| Net loss | $ | ( 12.6 ) | $ | ( 10.5 ) | $ | ( 6.9 ) | $ | ( 12.6 ) |\\n| Net loss per weighted average share - basic and diluted | $ | ( 0.08 ) | $ | ( 0.07 ) | $ | ( 0.05 ) | $ | ( 0.09 ) |\\n| Weighted average common shares outstanding - basic and diluted | 161.6 | 146.3 | 152.3 | 146.2 |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n4\\nLIVENT CORPORATION\\nCONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| (in Millions) | (unaudited) |\\n| Net loss | $ | ( 12.6 ) | $ | ( 10.5 ) | $ | ( 6.9 ) | $ | ( 12.6 ) |\\n| Other comprehensive (loss)/income, net of tax: |\\n| Foreign currency adjustments: |\\n| Foreign currency translation (loss)/gain arising during the period | ( 1.1 ) | 3.0 | ( 0.2 ) | 1.4 |\\n| Total foreign currency translation adjustments | ( 1.1 ) | 3.0 | ( 0.2 ) | 1.4 |\\n| Derivative instruments: |\\n| Unrealized hedging losses, net of tax of less than $ 0.1 | ( 0.1 ) | — | — | ( 0.2 ) |\\n| Total derivative instruments loss, net of tax of less than $ 0.1 | ( 0.1 ) | — | — | ( 0.2 ) |\\n| Other comprehensive (loss)/income, net of tax | ( 1.2 ) | 3.0 | ( 0.2 ) | 1.2 |\\n| Comprehensive loss | $ | ( 13.8 ) | $ | ( 7.5 ) | $ | ( 7.1 ) | $ | ( 11.4 ) |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n5\\nLIVENT CORPORATION\\nCONDENSED CONSOLIDATED BALANCE SHEETS\\n| (in Millions, Except Share and Par Value Data) | September 30, 2021 | December 31, 2020 |\\n| ASSETS | (unaudited) |\\n| Current assets |\\n| Cash and cash equivalents | $ | 195.3 | $ | 11.6 |\\n| Trade receivables, net of allowance of $ 0.3 and $ 0.4 , respectively | 83.0 | 76.3 |\\n| Inventories, net | 110.2 | 105.6 |\\n| Prepaid and other current assets | 43.8 | 56.3 |\\n| Total current assets | 432.3 | 249.8 |\\n| Investments | 23.2 | 23.8 |\\n| Property, plant and equipment, net of accumulated depreciation of $ 238.3 and $ 222.4 , respectively | 605.3 | 545.3 |\\n| Deferred income taxes | 2.2 | 13.4 |\\n| Right of use assets - operating leases, net | 6.4 | 16.1 |\\n| Other assets | 81.6 | 88.4 |\\n| Total assets | $ | 1,151.0 | $ | 936.8 |\\n| LIABILITIES AND EQUITY |\\n| Current liabilities |\\n| Accounts payable, trade and other | $ | 49.7 | $ | 43.9 |\\n| Accrued customer rebates | — | 0.3 |\\n| Accrued and other current liabilities | 35.7 | 36.7 |\\n| Operating lease liabilities - current | 1.0 | 1.4 |\\n| Income taxes | 2.3 | — |\\n| Total current liabilities | 88.7 | 82.3 |\\n| Long-term debt | 240.1 | 274.6 |\\n| Operating lease liabilities - long-term | 5.5 | 14.8 |\\n| Environmental liabilities | 6.2 | 6.1 |\\n| Deferred income taxes | 7.8 | 5.6 |\\n| Other long-term liabilities | 18.2 | 17.2 |\\n| Commitments and contingent liabilities (Note 13) |\\n| Total current and long-term liabilities | 366.5 | 400.6 |\\n| Equity |\\n| Common stock; $ 0.001 par value; 2 billion shares authorized in 2018; 161,676,147 and 146,461,249 shares issued; 161,575,016 and 146,361,981 outstanding at September 30, 2021 and December 31, 2020, respectively | 0.1 | 0.1 |\\n| Capital in excess of par value of common stock | 776.4 | 520.9 |\\n| Retained earnings | 53.4 | 60.3 |\\n| Accumulated other comprehensive loss | ( 44.6 ) | ( 44.4 ) |\\n| Treasury stock, common; 101,131 and 99,268 shares at September 30, 2021 and December 31, 2020, respectively | ( 0.8 ) | ( 0.7 ) |\\n| Total equity | 784.5 | 536.2 |\\n| Total liabilities and equity | $ | 1,151.0 | $ | 936.8 |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n6\\nLIVENT CORPORATION\\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\\n| Nine Months Ended September 30, |\\n| 2021 | 2020 |\\n| (in Millions) | (unaudited) |\\n| Cash provided by operating activities: |\\n| Net loss | $ | ( 6.9 ) | $ | ( 12.6 ) |\\n| Adjustments to reconcile net loss to cash provided by operating activities: |\\n| Depreciation and amortization | 18.7 | 17.7 |\\n| Restructuring and other charges | ( 0.8 ) | 4.3 |\\n| Deferred income taxes | 11.2 | ( 5.7 ) |\\n| Separation-related costs | — | 0.1 |\\n| Share-based compensation | 4.0 | 3.4 |\\n| Change in investments in trust fund securities | 0.4 | 0.1 |\\n| Loss on debt extinguishment | — | 0.1 |\\n| Deferred financing fees amortization | 0.3 | 0.3 |\\n| Equity in net loss of unconsolidated affiliates | 3.7 | 0.4 |\\n| Changes in operating assets and liabilities: |\\n| Trade receivables, net | ( 6.2 ) | 17.5 |\\n| Inventories | ( 4.2 ) | ( 0.1 ) |\\n| Accounts payable, trade and other | 5.5 | ( 40.9 ) |\\n| Change in deferred compensation | 1.2 | 0.4 |\\n| Income taxes | 2.3 | ( 0.9 ) |\\n| Change in prepaid and other current assets and other assets | 16.6 | ( 5.5 ) |\\n| Change in accrued and other current liabilities and other long-term liabilities | ( 4.8 ) | 22.9 |\\n| Cash provided by operating activities | 41.0 | 1.5 |\\n| Cash used in investing activities: |\\n| Capital expenditures(1) | ( 69.4 ) | ( 110.0 ) |\\n| Investments in trust fund securities | ( 1.2 ) | ( 0.4 ) |\\n| Investment in unconsolidated affiliate | ( 2.5 ) | — |\\n| Other investing activities | ( 1.2 ) | ( 1.4 ) |\\n| Cash used in investing activities | ( 74.3 ) | ( 111.8 ) |\\n| Cash provided by financing activities: |\\n| Proceeds from Revolving Credit Facility | 39.5 | 147.0 |\\n| Repayments of Revolving Credit Facility | ( 75.1 ) | ( 276.5 ) |\\n| Proceeds from 2025 Notes | — | 245.7 |\\n| Payments of financing fees | — | ( 8.4 ) |\\n| Proceeds from Offering | 261.6 | — |\\n| Payments of underwriting fees and expenses - Offering | ( 9.4 ) | — |\\n| Proceeds of issuance of common stock - incentive plans | 0.3 | 0.4 |\\n| Cash provided by financing activities | 216.9 | 108.2 |\\n| Effect of exchange rate changes on cash and cash equivalents | 0.1 | 0.1 |\\n| Increase/(decrease) in cash and cash equivalents | 183.7 | ( 2.0 ) |\\n| Cash and cash equivalents, beginning of period | 11.6 | 16.8 |\\n| Cash and cash equivalents, end of period | $ | 195.3 | $ | 14.8 |\\n\\n7\\nLIVENT CORPORATION\\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)\\n| Nine Months Ended September 30, |\\n| 2021 | 2020 |\\n| Supplemental Disclosure for Cash Flow: | (unaudited) |\\n| Cash payments for income taxes, net (2) | $ | 0.5 | $ | 2.8 |\\n| Cash payments for interest, net (1) | $ | 12.9 | $ | 4.8 |\\n| Cash payments for Restructuring and other charges | $ | 4.2 | $ | 5.8 |\\n| Cash payments for Separation-related charges | $ | 1.4 | $ | 0.7 |\\n| Accrued capital expenditures | $ | 17.8 | $ | 7.8 |\\n| Operating lease right-of-use assets and lease liabilities recorded for ASC 842 | $ | 2.1 | $ | 0.8 |\\n\\n____________________\\n1. For the nine months ended September 30, 2021, and 2020 $ 11.5 million and $ 8.1 million of interest expense was capitalized, respectively.\\n2.Nine months ended September 30, 2021 includes $ 1.7 million of refunds relating to U.S. state taxes and foreign taxes. Nine months ended September 30, 2020 includes $ 1.9 million refund from FMC related to the Company's 2018 federal income tax return.\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n8\\nLIVENT CORPORATION\\nCONDENSED CONSOLIDATED STATEMENTS OF EQUITY\\n(UNAUDITED)\\n| (in Millions Except Per Share Data) | Common Stock, $ 0.001 Per Share Par Value | Capital In Excess of Par | Retained Earnings | Accumulated Other Comprehensive Loss | Treasury Stock | Total |\\n| Balance, December 31, 2019 | $ | 0.1 | $ | 516.4 | $ | 76.6 | $ | ( 48.3 ) | $ | ( 0.8 ) | $ | 544.0 |\\n| Net loss | — | — | ( 1.9 ) | — | — | ( 1.9 ) |\\n| Stock compensation plans | — | 1.2 | — | — | — | 1.2 |\\n| Shares withheld for taxes - common stock issuances | — | ( 0.7 ) | — | — | — | ( 0.7 ) |\\n| Foreign currency translation adjustments | — | — | — | ( 1.8 ) | — | ( 1.8 ) |\\n| Balance, March 31, 2020 | $ | 0.1 | $ | 516.9 | $ | 74.7 | $ | ( 50.1 ) | $ | ( 0.8 ) | $ | 540.8 |\\n| Net loss | — | — | ( 0.2 ) | — | — | ( 0.2 ) |\\n| Stock compensation plans | — | 1.0 | — | — | — | 1.0 |\\n| Net hedging losses, net of income tax | — | — | — | ( 0.2 ) | — | ( 0.2 ) |\\n| Foreign currency translation adjustments | — | — | — | 0.2 | — | 0.2 |\\n| Exercise of stock options | — | 0.1 | — | — | — | 0.1 |\\n| Balance, June 30, 2020 | $ | 0.1 | $ | 518.0 | $ | 74.5 | $ | ( 50.1 ) | $ | ( 0.8 ) | $ | 541.7 |\\n| Net loss | — | — | ( 10.5 ) | — | — | ( 10.5 ) |\\n| Stock compensation plans | — | 1.2 | — | — | — | 1.2 |\\n| Exercise of stock options | — | 0.3 | — | — | — | 0.3 |\\n| Foreign currency translation adjustments | — | — | 3.0 | — | 3.0 |\\n| Balance, September 30, 2020 | $ | 0.1 | $ | 519.5 | $ | 64.0 | $ | ( 47.1 ) | $ | ( 0.8 ) | $ | 535.7 |\\n| Balance, December 31, 2020 | $ | 0.1 | $ | 520.9 | $ | 60.3 | $ | ( 44.4 ) | $ | ( 0.7 ) | $ | 536.2 |\\n| Net loss | — | — | ( 0.8 ) | — | — | ( 0.8 ) |\\n| Stock compensation plans | — | 1.2 | — | — | — | 1.2 |\\n| Exercise of stock options | — | 0.2 | — | — | — | 0.2 |\\n| Shares withheld for taxes - common stock issuances | — | ( 0.8 ) | — | — | — | ( 0.8 ) |\\n| Net purchases of treasury stock - nonqualified plan | — | — | — | — | ( 0.1 ) | ( 0.1 ) |\\n| Foreign currency translation adjustments | — | — | — | ( 0.3 ) | — | ( 0.3 ) |\\n| Balance, March 31, 2021 | $ | 0.1 | $ | 521.5 | $ | 59.5 | $ | ( 44.7 ) | $ | ( 0.8 ) | $ | 535.6 |\\n| Net income | — | — | 6.5 | — | — | 6.5 |\\n| Stock compensation plans | — | 1.4 | — | — | — | 1.4 |\\n| Net hedging gains, net of income tax | — | — | — | 0.1 | — | 0.1 |\\n| Issuance of common stock - Offering | — | 252.3 | — | — | — | 252.3 |\\n| Foreign currency translation adjustments | — | — | — | 1.2 | — | 1.2 |\\n| Balance, June 30, 2021 | $ | 0.1 | $ | 775.2 | $ | 66.0 | $ | ( 43.4 ) | $ | ( 0.8 ) | $ | 797.1 |\\n| Net loss | — | — | ( 12.6 ) | — | — | ( 12.6 ) |\\n| Stock compensation plans | — | 1.4 | — | — | — | 1.4 |\\n| Issuance of common stock - Offering | — | ( 0.1 ) | — | — | — | ( 0.1 ) |\\n| Shares withheld for taxes - common stock issuances | — | ( 0.2 ) | — | — | — | ( 0.2 ) |\\n| Net hedging losses, net of income tax | — | — | — | ( 0.1 ) | — | ( 0.1 ) |\\n| Exercise of stock options | — | 0.1 | — | — | — | 0.1 |\\n| Foreign currency translation adjustments | — | — | — | ( 1.1 ) | — | ( 1.1 ) |\\n| Balance, September 30, 2021 | $ | 0.1 | $ | 776.4 | $ | 53.4 | $ | ( 44.6 ) | $ | ( 0.8 ) | $ | 784.5 |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n9\\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited)\\nNote 1: Description of the Business\\nBackground and Nature of Operations\\nLivent Corporation (“Livent”, “we”, “us”, \\\"company\\\" or “our”) manufactures lithium for use in a wide range of lithium products, which are used primarily in lithium-based batteries, specialty polymers and chemical synthesis applications. We serve a diverse group of markets. Our product offerings generally have few cost-effective substitutes. A major growth driver for lithium in the future will be the rate of adoption of electric vehicles.\\nMost markets for lithium chemicals are global with significant growth occurring in Asia, Europe and North America, primarily driven by the development and manufacturing of lithium-ion batteries. We are one of the few leading global producers of performance lithium compounds.\\nNote 2: Principal Accounting Policies and Related Financial Information\\nThe accompanying condensed consolidated financial statements were prepared in accordance with the requirements of the Securities and Exchange Commission (“SEC”) for interim reporting. As permitted under those rules, certain notes or other financial information that are normally required by U.S. GAAP have been condensed or omitted from these interim financial statements. The financial statements included in this report reflect all normal and recurring adjustments which, in the opinion of management, are necessary for a fair presentation of our condensed consolidated financial position as of September 30, 2021 and December 31, 2020, the condensed consolidated results of operations for the three and nine months ended September 30, 2021 and 2020, and the condensed consolidated cash flows for the nine months ended September 30, 2021 and 2020. The unaudited results of operations for the interim periods reported are not necessarily indicative of results to be expected for the full year. These statements, therefore, should be read in conjunction with the annual consolidated and combined financial statements and related notes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2020 (the \\\"2020 Annual Report on Form 10-K\\\").\\nEstimates and assumptions\\nIn preparing the financial statements in conformity with U.S. GAAP, we are required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period.\\nDue to the current coronavirus (\\\"COVID-19\\\") pandemic, there has been uncertainty and disruption in the global economy and financial markets. The estimates used for, but not limited to, the collectability of trade receivables, fair value of long-lived assets, income taxes, inventory valuation and fair value of financial instruments could be impacted. We have assessed the impact and are not aware of any specific events or circumstances that required an update to our estimates and assumptions or materially affected the carrying value of our assets or liabilities as of the date of issuance of this Quarterly Report on Form 10-Q. These estimates may change as new events occur and additional information is obtained. Actual results could differ materially from these estimates under different assumptions or conditions.\\n4.125 % Convertible Senior Notes due 2025 (the “2025 Notes”)\\nWe account for our 2025 Notes under Accounting Standards Update (\\\"ASU\\\") No. 2020-06, Debt - Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging - Contracts in Entity's Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity's Own Equity (\\\"ASU 2020-06\\\"), which we early adopted January 1, 2021 under the full retrospective method. See Note 3 and Note 9 for details.\\nThere were no other significant changes to our accounting policies that are set forth in detail in Note 2 to our annual consolidated and combined financial statements in Part II, Item 8 of our 2020 Annual Report on Form 10-K.\\nNote 3: Recently Issued and Adopted Accounting Pronouncements and Regulatory Items\\nNew accounting guidance and regulatory items\\nIn April 2020, the Financial Accounting Standard Board (\\\"FASB\\\") issued ASU No. 2020-04, Reference Rate Reform (Topic 848). The amendments in this ASU provide optional expedients and exceptions for applying U.S. GAAP to contracts, hedging relationships, and other transactions affected by reference rate reform if certain criteria are met. An entity may optionally elect to apply the amendments effective in the first interim period that includes or is subsequent to March 12, 2020 through December 31, 2022. We are evaluating the effect the guidance will have on our condensed consolidated financial statements.\\n10\\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\\nRecently adopted accounting guidance\\nIn August 2020, FASB issued ASU 2020-06. The ASU reduces the number of accounting models for convertible debt instruments by eliminating the cash conversion model. As compared with current U.S. GAAP, more convertible debt instruments will be reported as a single liability instrument and the interest rate of more convertible debt instruments will be closer to the coupon interest rate. The ASU also aligns the consistency of diluted Earnings Per Share (\\\"EPS\\\") calculations for convertible instruments by requiring that (1) an entity use the if-converted method and (2) share settlement be included in the diluted EPS calculation for both convertible instruments and equity contracts when those contracts include an option of cash settlement or share settlement. The ASU is effective for fiscal years beginning after December 15, 2021, including interim periods within those fiscal years. Early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. The FASB has specified that an entity should adopt the guidance as of the beginning of its annual fiscal year. We elected to early adopt ASU 2020-06 on January 1, 2021, using the full retrospective method. Prior to adoption, under Accounting Standards Codification 470-20, Debt with Conversion and Other Options (\\\"ASC 470-20\\\"), we had separately accounted for the liability and equity components of our 2025 Notes, which may be settled entirely or partially in cash upon conversion, in a manner that reflected the issuer’s economic interest cost. The effect of ASC 470-20 on the accounting for the 2025 Notes was that the equity component was required to be included in the additional paid-in capital section of stockholders’ equity on our consolidated balance sheet, and the value of the equity component was treated as original issue discount for purposes of accounting for the debt component of the 2025 Notes. As a result, prior to the adoption of ASU 2020-06, we were required to record a greater amount of non-cash interest expense as a result of the amortization of the discounted carrying value of the 2025 Notes to their face amount over the term of the 2025 Notes. Because we intend to settle in cash the principal outstanding under our 2025 Notes, we previously used the treasury stock method when calculating their potential dilutive effect, if any. ASU 2020-06 now requires us to use the if-converted method for EPS. For the full retrospective method of adoption, the accounting change was recognized as an adjustment to the balance of retained earnings, additional paid-in capital, long-term debt and deferred income taxes in our consolidated balance sheet as of December 31, 2020, the year in which the 2025 Notes were issued. See Note 9 and Note 11 for further details.\\nIn December 2019, FASB issued ASU No. 2019-12, Simplifying the Accounting for Income Taxes (Topic 740). The amendments in this ASU simplified the accounting for income taxes by removing certain exceptions to the general principle in Topic 740. The amendments also contain improvements and clarifications of certain guidance in Topic 740. The new amendments are effective for fiscal years beginning after December 15, 2020 (i.e. a January 1, 2021 effective date), with early adoption permitted. We adopted the amendments as of January 1, 2021 and the adoption did not have a material impact on our condensed consolidated financial statements.\\nNote 4: Revenue Recognition\\nDisaggregation of revenue\\nWe disaggregate revenue from contracts with customers by geographical areas and by product categories. The following table provides information about disaggregated revenue by major geographical region:\\n| (in Millions) | Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| North America (1) | $ | 20.0 | $ | 11.0 | $ | 63.4 | $ | 40.5 |\\n| Latin America | — | — | — | 0.1 |\\n| Europe, Middle East & Africa | 14.2 | 9.8 | 46.0 | 32.3 |\\n| Asia Pacific (1) | 69.4 | 51.8 | 188.1 | 133.1 |\\n| Total Revenue | $ | 103.6 | $ | 72.6 | $ | 297.5 | $ | 206.0 |\\n\\n1.During the three months ended September 30, 2021, countries with sales in excess of 10% of combined revenue consisted of Japan, the United States, and China. Sales for the three months ended September 30, 2021 for Japan, the United States, and China totaled $ 24.5 million, $ 19.7 million, $ 36.6 million, respectively. During the nine months ended September 30, 2021, countries with sales in excess of 10% of combined revenue consisted of Japan, the United States, and China. Sales for the nine months ended September 30, 2021 for Japan, the United States, and China totaled $ 65.1 million, $ 62.7 million, $ 89.9 million, respectively. During the three months ended September 30, 2020, countries with sales in excess of 10% of combined revenue consisted of Japan, the United States and China. Sales for the three months ended September 30, 2020 for Japan, the United States and China totaled $ 23.5 million, $ 11.0 million, and $ 19.0 million, respectively. During the nine months ended September 30, 2020, countries with sales in excess of 10% of combined\\n11\\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\\nrevenue consisted of Japan, the United States and China. Sales for the nine months ended September 30, 2020 for Japan, the United States and China totaled $ 81.1 million, $ 40.0 million, and $ 29.1 million, respectively.\\nFor the three months ended September 30, 2021, one customer accounted for approximately 35 % of total revenue and our 10 largest customers accounted in aggregate for approximately 69 % of total revenue. For the three months ended September 30, 2020, two customers accounted for approximately 34 % and 10 % of total revenue, respectively, and our 10 largest customers accounted in aggregate for approximately 68 % of total revenue. For the nine months ended September 30, 2021, one customer accounted for approximately 36 % of total revenue and our 10 largest customers accounted in aggregate for approximately 68 % of total revenue. For the nine months ended September 30, 2020, one customer accounted for approximately 35 % of total revenue and our 10 largest customers accounted in aggregate for approximately 64 % of total revenue. A loss of any material customer could have a material adverse effect on our business, financial condition and results of operations.\\nThe following table provides information about disaggregated revenue by major product category:\\n| (in Millions) | Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Lithium Hydroxide | $ | 50.7 | $ | 43.9 | $ | 160.5 | $ | 115.4 |\\n| Butyllithium | 27.4 | 19.6 | 76.1 | 62.4 |\\n| High Purity Lithium Metal and Other Specialty Compounds | 9.8 | 7.1 | 27.6 | 23.0 |\\n| Lithium Carbonate and Lithium Chloride | 15.7 | 2.0 | 33.3 | 5.2 |\\n| Total Revenue | $ | 103.6 | $ | 72.6 | $ | 297.5 | $ | 206.0 |\\n\\nContract asset and contract liability balances\\nThe following table presents the opening and closing balances of our receivables, net of allowances. As of September 30, 2021 and December 31, 2020, there were no contract liabilities from contracts with customers.\\n| (in Millions) | Balance as of September 30, 2021 | Balance as of December 31, 2020 | Increase (Decrease) |\\n| Receivables from contracts with customers, net of allowances | $ | 83.0 | $ | 76.3 | $ | 6.7 |\\n\\nThe balance of receivables from contracts with customers listed in the table above represents the current trade receivables, net of allowance for doubtful accounts. The allowance for receivables represents our best estimate of the probable losses associated with potential customer defaults. We determine the allowance based on historical experience, current collection trends, and external business factors such as economic factors, including regional bankruptcy rates, and political factors.\\nPerformance obligations\\nOccasionally, we may enter into multi-year take or pay supply agreements with customers. The aggregate amount of revenue expected to be recognized related to these contracts’ performance obligations that are unsatisfied or partially unsatisfied is approximately $ 10 million for the remainder of 2021 and $ 68 million in 2022 and 2023, respectively. T hese approximate revenues do not include amounts of variable consideration attributable to contract renewals or contract contingencies. Based on our past experience with the customers under these arrangements, we expect to continue recognizing revenue in accordance with the contracts as we transfer control of the product to the customer. However, in the case a shortfall of volume purchases occurs, we will recognize the amount payable by the customer over the remaining performance obligations in the contract.\\nNote 5: Inventories, Net\\nInventories consisted of the following:\\n| (in Millions) | September 30, 2021 | December 31, 2020 |\\n| Finished goods | $ | 35.0 | $ | 36.1 |\\n| Semi-finished goods | 41.3 | 46.2 |\\n| Raw materials, supplies and other | 33.9 | 23.3 |\\n| Inventory, net | $ | 110.2 | $ | 105.6 |\\n\\n12\\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\\nNote 6: Investments\\nIn 2020, Livent entered into an agreement with The Pallinghurst Group relating to Québec Lithium Partners (\\\"QLP\\\"), a joint venture owned equally by The Pallinghurst Group and Livent, and the conduct of certain business operations and oversight, previously conducted solely by Nemaska Lithium Inc. for the development of a fully integrated lithium chemical asset located in Québec, Canada that is not yet in commercial production. QLP owns a 50 % equity interest in the Nemaska Project. The Company accounts for the investment in QLP as an equity method investment on a one-quarter lag basis and is included in Investments in our condensed consolidated balance sheets. For the three and nine months ended September 30, 2021, we recorded a $ 1.0 million and $ 3.7 million loss, respectively, related to our 50 % equity interest in QLP to Equity in net loss of unconsolidated affiliates in our condensed consolidated statement of operations. The carrying amount of our 50 % equity interest in QLP was $ 20.1 million and $ 21.2 million as of September 30, 2021 and December 31, 2020, respectively.\\nNote 7: Restructuring and Other Charges\\nThe following table shows other charges included in \\\"Restructuring and other charges\\\" in the condensed consolidated statements of operations:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (in Millions) | 2021 | 2020 | 2021 | 2020 |\\n| Restructuring charges |\\n| Severance-related and exit costs (1) | $ | 0.1 | $ | 0.9 | $ | 0.2 | $ | 5.8 |\\n| Other charges |\\n| Environmental remediation (2) | 0.1 | 0.1 | 0.3 | 0.4 |\\n| Other (3) | 0.9 | 3.4 | 2.9 | 3.9 |\\n| Total Restructuring and other charges | $ | 1.1 | $ | 4.4 | $ | 3.4 | $ | 10.1 |\\n\\n___________________\\n1.Three and nine months ended September 30, 2020 includes severance costs for management changes at certain operating and administrative facilities and exit costs of $ 1.6 million for the closing of leased office space.\\n2.There is one environmental remediation site in Bessemer City, North Carolina.\\n3.Three and nine months ended September 30, 2021 consists primarily of transaction-related legal fees and miscellaneous nonrecurring transactions. Three and nine months ended September 30, 2020 consists primarily of legal fees related to IPO securities litigation including a settlement accrual, net of insurance reimbursement, of $ 2.5 million in the third quarter. The IPO litigation settlement was finalized in the second quarter of 2021.\\n13\\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\\nNote 8: Income Taxes\\nWe determine our interim tax provision using an estimated annual effective tax rate methodology (“EAETR”) in accordance with U.S. GAAP. The EAETR is applied to the year-to-date ordinary income, exclusive of discrete items. The tax effects of discrete items are then included to arrive at the total reported interim tax provision.\\nThe determination of the EAETR is based upon a number of estimates, including the estimated annual pretax ordinary income in each tax jurisdiction in which we operate. As our projections of ordinary income change throughout the year, the EAETR will change period-to-period. The tax effects of discrete items are recognized in the tax provision in the period they occur in accordance with U.S. GAAP. Depending on various factors, such as the item’s significance in relation to total income and the rate of tax applicable in the jurisdiction to which it relates, discrete items in any quarter can materially impact the reported effective tax rate. As a global enterprise, our tax expense can be impacted by changes in tax rates or laws, the finalization of tax audits and reviews, as well as other factors. As a result, there can be significant volatility in interim tax provisions.\\nProvision for income taxes for the three and nine months ended September 30, 2021 was an expense of $ 15.4 million and $ 13.8 million resulting in an effective tax rate of 540.5 % and 198.7 %, respectively. Provision for income taxes for the three and nine months ended September 30, 2020 was a benefit of $ 3.1 million and $ 5.4 million resulting in an effective tax rate of 22.8 % and 30.0 %, respectively.\\nNote 9: Debt\\nLong-term debt\\nLong-term debt consists of the following:\\n| Interest RatePercentage | MaturityDate | September 30, 2021 | December 31, 2020 |\\n| (in Millions) | LIBOR borrowings | Base rate borrowings |\\n| Revolving Credit Facility (1) | 2.3 % | 4.5 % | 2023 | $ | — | $ | 35.6 |\\n| 4.125 % Convertible Senior Notes due 2025 | 4.125 % | 2025 | 245.8 | 245.8 |\\n| Transaction costs - 2025 Notes | ( 5.7 ) | ( 6.8 ) |\\n| Total long-term debt (2) | $ | 240.1 | $ | 274.6 |\\n\\n______________________________\\n1.As of September 30, 2021 and December 31, 2020, there were $ 14.4 million in letters of credit outstanding under our Revolving Credit Facility and $ 385.6 million and $ 275.0 million available funds as of September 30, 2021 and December 31, 2020, respectively. Fund availability is subject to the Company meeting its debt covenants.\\n2. As of September 30, 2021 and December 31, 2020, the Company had no debt maturing within one year.\\nOn January 1, 2021, the Company elected to early adopt ASU 2020-06 under the full retrospective method, that is, the accounting change was recognized as an adjustment to the balance of retained earnings, additional paid-in capital, long-term debt and deferred income taxes in our consolidated balance sheet as of December 31, 2020, the year in which the 2025 Notes were issued. The ASU reduces the number of accounting models for convertible debt instruments by eliminating the cash conversion model. Our 2025 Notes are now reported as a single liability instrument net of transaction costs with an interest rate closer to the coupon interest rate.\\nThe comparative financial statements of prior years have been adjusted to apply the adopted guidance retrospectively.\\n14\\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\\n| Statement of operations |\\n| (in Millions, except per share amounts) |\\n| Three months ended September 30, 2021 | As computed under ASC 470-20 | As reported under ASU 2020-06 | Effect of change |\\n| Interest expense/(income) | $ | 1.8 | $ | — | $ | ( 1.8 ) |\\n| Income from operations before income taxes | 1.0 | 2.8 | 1.8 |\\n| Income tax expense | 15.0 | 15.4 | 0.4 |\\n| Net (loss)/income | $ | ( 14.0 ) | $ | ( 12.6 ) | $ | 1.4 |\\n| Net (loss)/income per weighted average share - basic and diluted | $ | ( 0.09 ) | $ | ( 0.08 ) | $ | 0.01 |\\n| Nine months ended September 30, 2021 | As computed under ASC 470-20 | As reported under ASU 2020-06 | Effect of change |\\n| Interest expense/(income) | $ | 5.5 | $ | 0.3 | $ | ( 5.2 ) |\\n| Income from operations before income taxes | 1.7 | 6.9 | 5.2 |\\n| Income tax expense | 12.7 | 13.8 | 1.1 |\\n| Net (loss)/income | $ | ( 11.0 ) | $ | ( 6.9 ) | $ | 4.1 |\\n| Net (loss)/income per weighted average share - basic and diluted | $ | ( 0.07 ) | $ | ( 0.05 ) | $ | 0.02 |\\n| Three months ended September 30, 2020 | As originally reported | As adjusted | Effect of change |\\n| Interest expense/(income) | $ | 2.0 | $ | 0.3 | $ | ( 1.7 ) |\\n| (Loss)/income from operations before income taxes | ( 15.3 ) | ( 13.6 ) | 1.7 |\\n| Income tax (benefit)/expense | ( 3.5 ) | ( 3.1 ) | 0.4 |\\n| Net (loss)/income | $ | ( 11.8 ) | $ | ( 10.5 ) | $ | 1.3 |\\n| Net (loss)/income per weighted average share - basic and diluted | $ | ( 0.08 ) | $ | ( 0.07 ) | $ | 0.01 |\\n| Nine months ended September 30, 2020 | As originally reported | As adjusted | Effect of change |\\n| Interest expense/(income) | $ | 2.0 | $ | 0.3 | $ | ( 1.7 ) |\\n| (Loss)/Income from operations before income taxes | ( 19.7 ) | ( 18.0 ) | 1.7 |\\n| Income tax (benefit)/expense | ( 5.8 ) | ( 5.4 ) | 0.4 |\\n| Net (loss)/income | $ | ( 13.9 ) | $ | ( 12.6 ) | $ | 1.3 |\\n| Net (loss)/income per weighted average share - basic and diluted | $ | ( 0.10 ) | $ | ( 0.09 ) | $ | 0.01 |\\n\\n15\\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\\n| Balance Sheet |\\n| (in Millions, except per share amounts) |\\n| September 30, 2021 | As computed under ASC 470-20 | As reported under ASU 2020-06 | Effect of change |\\n| Deferred income taxes | $ | 15.0 | 7.8 | $ | ( 7.2 ) |\\n| Long-term debt | 207.4 | 240.1 | 32.7 |\\n| Total liabilities | $ | 222.4 | $ | 247.9 | $ | 25.5 |\\n| Common stock, $ 0.001 per share par value | 0.1 | 0.1 | — |\\n| Capital in excess of par value of common stock | 808.6 | 776.4 | ( 32.2 ) |\\n| Retained earnings | 46.7 | 53.4 | 6.7 |\\n| Accumulated other comprehensive loss | ( 44.6 ) | ( 44.6 ) | — |\\n| Treasury stock | ( 0.8 ) | ( 0.8 ) | — |\\n| Total equity | 810.0 | 784.5 | ( 25.5 ) |\\n| Total liabilities and equity | $ | 1,032.4 | $ | 1,032.4 | $ | — |\\n| December 31, 2020 | As originally reported | As adjusted | Effect of change |\\n| Deferred income taxes | $ | 13.9 | $ | 5.6 | $ | ( 8.3 ) |\\n| Long-term debt | 236.7 | 274.6 | 37.9 |\\n| Total liabilities | $ | 250.6 | $ | 280.2 | $ | 29.6 |\\n| Common stock | 0.1 | 0.1 | — |\\n| Capital in excess of par value of common stock | 553.1 | 520.9 | ( 32.2 ) |\\n| Retained earnings | 57.7 | 60.3 | 2.6 |\\n| Accumulated other comprehensive loss | ( 44.4 ) | ( 44.4 ) | — |\\n| Treasury stock, common, at cost | ( 0.7 ) | ( 0.7 ) | — |\\n| Total equity | 565.8 | 536.2 | ( 29.6 ) |\\n| Total liabilities and equity | $ | 816.4 | $ | 816.4 | $ | — |\\n\\n| Statement of cash flows |\\n| (in Millions) |\\n| Nine months ended September 30, 2021 | As computed under ASC 470-20 | As reported under ASU 2020-06 | Effect of change |\\n| Net (loss)/income | $ | ( 11.0 ) | $ | ( 6.9 ) | $ | 4.1 |\\n| Adjustments to reconcile net (loss)/income to cash provided by operating activities: |\\n| Deferred income taxes | 10.1 | 11.2 | 1.1 |\\n| Deferred financing fee amortization | 5.5 | 0.3 | ( 5.2 ) |\\n| Net cash provided by operating activities | 4.6 | 4.6 | — |\\n| Net increase in cash and cash equivalents | 183.7 | 183.7 | — |\\n| Cash and cash equivalents, beginning of period | 11.6 | 11.6 | — |\\n| Cash and cash equivalents, end of period | $ | 195.3 | $ | 195.3 | $ | — |\\n| Nine months ended September 30, 2020 | As originally reported | As adjusted | Effect of change |\\n| Net (loss)/income | $ | ( 13.9 ) | $ | ( 12.6 ) | $ | 1.3 |\\n| Adjustments to reconcile net (loss)/income to cash required by operating activities: |\\n| Deferred income taxes | ( 6.1 ) | ( 5.7 ) | 0.4 |\\n| Deferred financing fee amortization | 2.0 | 0.3 | ( 1.7 ) |\\n| Net cash required by operating activities | ( 18.0 ) | ( 18.0 ) | — |\\n| Net decrease in cash and cash equivalents | ( 2.0 ) | ( 2.0 ) | — |\\n| Cash and cash equivalents, beginning of period | 16.8 | 16.8 | — |\\n| Cash and cash equivalents, end of period | $ | 14.8 | $ | 14.8 | $ | — |\\n\\n16\\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\\n2025 Notes\\nIn the fourth quarter of 2021, the holders of the 2025 Notes were notified that the last reported sale price of our common stock for at least 20 trading days (whether or not consecutive) during the period of 30 consecutive trading days ending on, and including, September 30, 2021 was greater than or equal to 130 % of the conversion price on each trading day, and as a result, the holders have the option to convert all or any portion of their 2025 Notes through December 31, 2021. The 2025 Notes are classified as long-term debt.\\nThe Company recognized noncash interest related to the amortization of transaction costs of $ 0.4 million and $ 1.1 million for the three and nine months ended September 30, 2021, respectively; $ 0.4 million and $ 0.8 million of which was capitalized for the three and nine months ended September 30, 2021, respectively. The Company recorded $ 2.5 million and $ 7.6 million of accrued interest expense related to the principal amount for the three and nine months ended September 30, 2021, respectively.\\nRevolving Credit Facility\\nThe carrying value of our deferred financing costs was $ 1.7 million as of September 30, 2021. In June 2021, we used a portion of the net proceeds from the Offering to repay all amounts outstanding under our Revolving Credit Facility.\\nCovenants\\nThe Credit Agreement contains certain affirmative and negative covenants that are binding on us and our subsidiary, FMC Lithium USA Corp., as borrowers (the \\\"Borrowers\\\") and their subsidiaries, including, among others, restrictions (subject to exceptions and qualifications) on the ability of the Borrowers and their subsidiaries to create liens, to undertake fundamental changes, to incur debt, to sell or dispose of assets, to make investments, to make restricted payments such as dividends, distributions or equity repurchases, to change the nature of their businesses, to enter into transactions with affiliates and to enter into certain burdensome agreements. Furthermore, the Borrowers are subject to financial covenants regarding leverage (measured as the ratio of debt to adjusted earnings) and interest coverage (measured as the ratio of adjusted earnings to interest expense). Our maximum allowable first lien leverage ratio is 3.5 as of September 30, 2021. Our minimum allowable interest coverage ratio is 3.5 . We were in compliance with all requirements of the covenants at September 30, 2021.\\n17\\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\\nNote 10: Equity\\nAs of September 30, 2021 and December 31, 2020, we had 2 billion shares of common stock authorized. The following is a summary of Livent's common stock issued and outstanding:\\n| Issued | Treasury | Outstanding |\\n| Balance at December 31, 2020 | 146,461,249 | ( 99,268 ) | 146,361,981 |\\n| Adjusted FMC RSU awards (1) | 120,986 | — | 120,986 |\\n| Livent RSU awards | 102,505 | — | 102,505 |\\n| Livent stock option awards | 41,407 | — | 41,407 |\\n| Net purchases of treasury stock - deferred compensation plan | — | ( 1,863 ) | ( 1,863 ) |\\n| Issuance of common stock | 14,950,000 | — | 14,950,000 |\\n| Balance at September 30, 2021 | 161,676,147 | ( 101,131 ) | 161,575,016 |\\n\\n1.See Note 12 to our consolidated and combined financial statements in Part II, Item 8 of our 2020 Annual Report on Form 10-K for more information on Adjusted FMC RSU awards held by FMC employees.\\nI n June 15, 2021, the Company closed on the issuance of 14,950,000 shares of its common stock, par value $ 0.001 per share, at a public offering price of $ 17.50 per share, in an underwritten public offering (the \\\"Offering\\\"), including 1,950,000 shares purchased under a 30 -day underwriters' option exercised in full by the underwriters on June 11, 2021. Total net proceeds from the Offering, including from the exercise of the underwriters’ option, were $ 252.2 million, after deducting the underwriters’ fees and offering expenses payable by the Company of $ 9.4 million. The total net proceeds were recorded to paid-in capital in the condensed consolidated balance sheet. In the third quarter of 2021, we purchased $ 140.0 million in limited risk investments with maturities of 90 days or less with a portion of the Offering net proceeds. The investments were recorded to Cash and cash equivalents in our condensed consolidated balance sheet in the third quarter of 2021.\\nSummarized below is the roll forward of accumulated other comprehensive loss, net of tax.\\n| (in Millions) | Foreign currency adjustments | Derivative Instruments (1) | Total |\\n| Accumulated other comprehensive loss, net of tax at December 31, 2020 | $ | ( 44.4 ) | — | $ | ( 44.4 ) |\\n| Other comprehensive losses before reclassifications | ( 0.2 ) | — | ( 0.2 ) |\\n| Accumulated other comprehensive loss, net of tax at September 30, 2021 | $ | ( 44.6 ) | $ | — | $ | ( 44.6 ) |\\n\\n| (in Millions) | Foreign currency adjustments | Derivative Instruments (1) | Total |\\n| Accumulated other comprehensive loss, net of tax at December 31, 2019 | $ | ( 48.3 ) | $ | — | $ | ( 48.3 ) |\\n| Other comprehensive gains/(losses) before reclassifications | 1.4 | ( 0.2 ) | 1.2 |\\n| Accumulated other comprehensive loss, net of tax at September 30, 2020 | $ | ( 46.9 ) | $ | ( 0.2 ) | $ | ( 47.1 ) |\\n\\n1.See Note 12 for more information.\\n18\\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\\nReclassifications of accumulated other comprehensive loss\\nThe table below provides details about the reclassifications from accumulated other comprehensive loss and the affected line items in the condensed consolidated statements of operations for the period presented. No amounts were reclassified from accumulated other comprehensive loss for the three and nine months ended September 30, 2021.\\n| Details about Accumulated Other Comprehensive Loss Components | Amounts Reclassified from Accumulated Other Comprehensive Loss (1) | Affected Line Item in the Condensed Consolidated Statements of Operations |\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (in Millions) | 2021 | 2020 | 2021 | 2020 |\\n| Derivative instruments |\\n| Foreign currency contracts | $ | — | $ | ( 0.2 ) | $ | — | $ | ( 0.2 ) | Costs of sales and services |\\n| Total before tax | — | ( 0.2 ) | — | ( 0.2 ) |\\n| Amount included in net income (1) | $ | — | $ | ( 0.2 ) | $ | — | $ | ( 0.2 ) |\\n\\n(1) Provision for income taxes related to the reclassification was less than $ 0.1 million.\\nDividends\\nFor the three and nine months ended September 30, 2021 and 2020, we paid no dividends. We do not expect to pay any dividends in the foreseeable future.\\nNote 11: Loss Per Share\\nLoss per common share is computed by dividing net loss by the weighted average number of common shares outstanding during the period on a basic and diluted basis.\\nOur potentially dilutive securities include potential common shares related to our stock options and restricted stock units (\\\"RSU\\\") granted in connection with the Livent Plan and FMC Plan. See Note 12 to our consolidated and combined financial statements in Part II, Item 8 of our 2020 Annual Report on Form 10-K for more information. Diluted loss per share (“Diluted EPS”) considers the impact of potentially dilutive securities except in periods in which there is a loss because the inclusion of the potential common shares would have an anti-dilutive effect. Diluted EPS excludes the impact of potential common shares related to our stock options in periods in which the option exercise price is greater than the average market price of our common stock for the period. We use the if-converted method when calculating the potential dilutive effect, if any, of our 2025 Notes.\\nL oss applicable to common stock and common stock shares used in the calculation of basic and diluted loss per share are as follows:\\n| (in Millions, Except Share and Per Share Data) | Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Numerator: |\\n| Net loss | $ | ( 12.6 ) | $ | ( 10.5 ) | $ | ( 6.9 ) | $ | ( 12.6 ) |\\n| Denominator: |\\n| Weighted average common shares outstanding - basic and diluted | 161.6 | 146.3 | 152.3 | 146.2 |\\n| Basic and diluted loss per common share: |\\n| Net loss per weighted average share - basic and diluted | $ | ( 0.08 ) | $ | ( 0.07 ) | $ | ( 0.05 ) | $ | ( 0.09 ) |\\n\\n19\\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\\nThe following table presents weighted average share equivalents associated with share-based plans and the 2025 Notes that were excluded from the diluted shares outstanding calculation because the result would have been antidilutive. The 2025 Notes are further discussed in Note 9.\\n| (in Millions) | Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Share equivalents from share-based plans | 1.5 | 0.6 | 1.4 | 0.6 |\\n| Share equivalents from 2025 Notes | 45.3 | 28.1 | 44.0 | 10.1 |\\n| Total antidilutive weighted average share equivalents | 46.8 | 28.7 | 45.4 | 10.7 |\\n\\nAnti-dilutive stock options\\nFor the three months ended September 30, 2021, none of the outstanding options to purchase shares of our common stock were anti-dilutive. For the nine months ended September 30, 2021, options to purchase 542,760 shares of our common stock at an average exercise price of $ 20.35 per share were anti-dilutive and not included in the computation of diluted loss per share because the exercise price of the options was greater than the average market price of the common stock for the nine months ended September 30, 2021. For the three and nine months ended September 30, 2020, options to purchase 1,835,476 and 1,904,010 shares of our common stock at an average exercise price of $ 12.59 and $ 12.58 per share, respectively, were anti-dilutive and not included in the computation of diluted loss per share because the exercise price of the options was greater than the average market price of the common stock for the three and nine months ended September 30, 2020.\\nNote 12: Financial Instruments, Risk Management and Fair Value Measurements\\nOur financial instruments include cash and cash equivalents, trade receivables, other current assets, investments held in trust fund, accounts payable, and amounts included in investments and accruals meeting the definition of financial instruments. Investments in the Livent NQSP deferred compensation plan trust fund are considered Level 1 investments based on readily available quoted prices in active markets for identical assets. The carrying value of cash and cash equivalents, trade receivables, other current assets, and accounts payable approximates their fair value and are considered Level 1 investments. Our other financial instruments include the following:\\n| Financial Instrument | Valuation Method |\\n| Foreign exchange forward contracts | Estimated amounts that would be received or paid to terminate the contracts at the reporting date based on current market prices for applicable currencies. |\\n\\nThe estimated fair value of our foreign exchange forward contracts have been determined using standard pricing models which take into account the present value of expected future cash flows discounted to the balance sheet date. These standard pricing models utilize inputs derived from, or corroborated by, observable market data such as interest rate yield curves and currency and commodity spot and forward rates. In addition, we test a subset of our valuations against valuations received from the transaction's counterparty to validate the accuracy of our standard pricing models. Accordingly, the estimates presented may not be indicative of the amounts that we would realize in a market exchange at settlement date and do not represent potential gains or losses on these agreements.\\nFair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). The inputs used to measure fair value are classified into the following hierarchy:\\nLevel 1 - Unadjusted quoted prices in active markets for identical assets or liabilities.\\nLevel 2 - Unadjusted quoted prices in active markets for similar assets or liabilities, or unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability.\\nLevel 3 - Unobservable inputs for the asset or liability.\\n20\\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\\nThe estimated fair value and the carrying amount of debt was $ 292.0 million and $ 240.1 million, respectively, as of September 30, 2021. Our 2025 Notes are classified as Level 2 in the fair value hierarchy. The estimated fair value and carrying amount of debt was $ 267.6 million and $ 274.6 million as of December 31, 2020.\\nUse of Derivative Financial Instruments to Manage Risk\\nWe mitigate certain financial exposures connected to currency risk through a program of risk management that includes the use of derivative financial instruments. We enter into foreign exchange forward contracts to reduce the effects of fluctuating foreign currency exchange rates.\\nWe formally document all relationships between hedging instruments and hedged items, as well as the risk management objective and strategy for undertaking various hedge transactions. This process includes relating derivatives that are designated as fair value or cash flow hedges to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions. We also assess both at the inception of the hedge and on an ongoing basis, whether each derivative is highly effective in offsetting changes in fair values or cash flows of the hedged item. If we determine that a derivative is not highly effective as a hedge, or if a derivative ceases to be a highly effective hedge, we discontinue hedge accounting with respect to that derivative prospectively.\\nForeign Currency Exchange Risk Management\\nWe conduct business in many foreign countries, exposing earnings, cash flows, and our financial position to foreign currency risks. The majority of these risks arise as a result of foreign currency transactions. The primary currencies for which we have exchange rate exposure are the Euro, the British pound, the Chinese yuan, the Argentine peso, and the Japanese yen. We currently do not hedge foreign currency risks associated with the Argentine peso due to the limited availability and the high cost of suitable derivative instruments. Our policy is to minimize exposure to adverse changes in currency exchange rates. This is accomplished through a controlled program of risk management that could include the use of foreign currency debt and forward foreign exchange contracts. We also use forward foreign exchange contracts to hedge firm and highly anticipated foreign currency cash flows, with an objective of balancing currency risk to provide adequate protection from significant fluctuations in the currency markets.\\nConcentration of Credit Risk\\nOur counterparties to derivative contracts are primarily major financial institutions. We limit the dollar amount of contracts entered into with any one financial institution and monitor counterparties’ credit ratings. We also enter into master netting agreements with each financial institution, where possible, which helps mitigate the credit risk associated with our financial instruments. While we may be exposed to credit losses due to the nonperformance of counterparties, we consider this risk remote.\\nAccounting for Derivative Instruments and Hedging Activities\\nCash Flow Hedges\\nWe recognize all derivatives on the balance sheet at fair value. On the date we enter into the derivative instrument, we generally designate the derivative as a hedge of the variability of cash flows to be received or paid related to a forecasted transaction (cash flow hedge). We record in accumulated other comprehensive loss (\\\"AOCL\\\") changes in the fair value of derivatives that are designated as and meet all the required criteria for, a cash flow hedge. We then reclassify these amounts into earnings as the underlying hedged item affects earnings. In contrast we immediately record in earnings changes in the fair value of derivatives that are not designated as cash flow hedges. As of September 30, 2021, we had open foreign currency forward contracts in AOCL in a net after-tax gain position of less than $ 0.1 million designated as cash flow hedges of underlying forecasted sales and purchases. As of September 30, 2021 we had open forward contracts with various expiration dates to buy, sell or exchange foreign currencies with a U.S. dollar equivalent of approximately $ 5.6 million.\\nLess than $ 0.1 million of net after-tax gain, representing open foreign currency exchange contracts, will be realized in earnings during the three months ending December 31, 2021 if spot rates in the future are consistent with market rates as of September 30, 2021. The actual effect on earnings will be dependent on the actual spot rates when the forecasted transactions occur. We recognize derivative gains and losses in the “Costs of sales and services” line in the condensed consolidated statements of operations.\\n21\\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\\nDerivatives Not Designated As Cash Flow Hedging Instruments\\nWe hold certain forward contracts that have not been designated as cash flow hedging instruments for accounting purposes. Contracts used to hedge the exposure to foreign currency fluctuations associated with certain monetary assets and liabilities are not designated as cash flow hedging instruments and changes in the fair value of these items are recorded in earnings.\\nWe had open forward contracts not designated as cash flow hedging instruments for accounting purposes with various expiration dates to buy, sell or exchange foreign currencies with a U.S. dollar equivalent of approximately $ 30.9 million at September 30, 2021.\\nFair Value of Derivative Instruments.\\nAs of September 30, 2021, we had open derivative cash flow hedge contracts in a net gain fair value position of less than $ 0.1 million. The Company had no open derivative cash flow hedge contracts as of December 31, 2020.\\nDerivatives in Cash Flow Hedging Relationships\\n| (in Millions) | Total Foreign Exchange Contracts |\\n| Accumulated other comprehensive loss, net of tax at March 31, 2021 | $ | — |\\n| Unrealized hedging gains, net of tax | 0.1 |\\n| Total derivatives instruments impact on comprehensive income, net of tax | 0.1 |\\n| Accumulated other comprehensive gain, net of tax at June 30, 2021 | $ | 0.1 |\\n| Unrealized hedging losses, net of tax | ( 0.1 ) |\\n| Total derivatives instruments impact on comprehensive income, net of tax | ( 0.1 ) |\\n| Accumulated other comprehensive gain, net of tax at September 30, 2021 | $ | — |\\n\\n22\\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\\n| (in Millions) | Total Foreign Exchange Contracts |\\n| Accumulated other comprehensive loss, net of tax at March 31, 2020 | $ | — |\\n| Unrealized hedging loses, net of tax | ( 0.2 ) |\\n| Total derivatives instruments impact on comprehensive income, net of tax | ( 0.2 ) |\\n| Accumulated other comprehensive loss, net of tax at June 30, 2020 | $ | ( 0.2 ) |\\n| Unrealized hedging gains, net of tax | 0.2 |\\n| Reclassification of deferred hedging gains, net of tax (1) | ( 0.2 ) |\\n| Accumulated other comprehensive loss, net of tax at September 30, 2020 | $ | ( 0.2 ) |\\n\\n1.Amounts are included in \\\"Cost of sales and services\\\" on the condensed consolidated statements of operations\\nDerivatives Not Designated as Cash Flow Hedging Instruments\\n| Location of LossRecognized in Income on Derivatives | Amount of Pre-tax Loss Recognized in Income on Derivatives (1) |\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (in Millions) | 2021 | 2020 | 2021 | 2020 |\\n| Foreign Exchange contracts | Cost of Sales and Services (2) | $ | ( 0.2 ) | $ | ( 0.8 ) | $ | ( 1.1 ) | $ | ( 1.9 ) |\\n| Total | $ | ( 0.2 ) | $ | ( 0.8 ) | $ | ( 1.1 ) | $ | ( 1.9 ) |\\n\\n____________________\\n1.Amounts represent the gain or loss on the derivative instrument offset by the gain or loss on the hedged item.\\n2.A loss of $ 0.1 million and $ 0.2 million related to intercompany loan hedges is included in Restructuring and other charges in the consolidated statement of operations for the three and nine months ended September 30, 2021, respectively. A loss of $ 0.1 million related to intercompany loan hedges is included in Restructuring and other charges in the consolidated statement of operations for the three and nine months ended September 30, 2020.\\nFair Value Measurements\\nFair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Market participants are defined as buyers or sellers in the principle or most advantageous market for the asset or liability that are independent of the reporting entity, knowledgeable and able and willing to transact for the asset or liability.\\nFair Value Hierarchy\\nWe have categorized our assets and liabilities that are recorded at fair value, based on the priority of the inputs to the valuation technique, into a three-level fair-value hierarchy. The fair-value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure the assets and liabilities fall within different levels of the hierarchy, the categorization is based on the lowest level input that is significant to the fair-value measurement of the instrument.\\n23\\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\\nRecurring Fair Value Measurements\\nThe following tables present our fair-value hierarchy for those assets and liabilities measured at fair-value on a recurring basis in our condensed consolidated balance sheets.\\n| (in Millions) | September 30, 2021 | Quoted Prices in Active Markets for Identical Assets(Level 1) | Significant Other Observable Inputs(Level 2) | Significant Unobservable Inputs(Level 3) |\\n| Assets |\\n| Investments in deferred compensation plan (1) | $ | 3.1 | $ | 3.1 | $ | — | $ | — |\\n| Total Assets | $ | 3.1 | $ | 3.1 | $ | — | $ | — |\\n| Liabilities |\\n| Deferred compensation plan obligation (2) | $ | 5.5 | $ | 5.5 | $ | — | $ | — |\\n| Total Liabilities | $ | 5.5 | $ | 5.5 | $ | — | $ | — |\\n\\n\\n| (in Millions) | December 31, 2020 | Quoted Prices in Active Markets for Identical Assets(Level 1) | Significant Other Observable Inputs(Level 2) | Significant Unobservable Inputs(Level 3) |\\n| Assets |\\n| Investments in deferred compensation plan (1) | $ | 2.6 | $ | 2.6 | $ | — | $ | — |\\n| Total Assets | $ | 2.6 | $ | 2.6 | $ | — | $ | — |\\n| Liabilities |\\n| Deferred compensation plan obligation (2) | $ | 4.5 | $ | 4.5 | $ | — | $ | — |\\n| Total Liabilities | $ | 4.5 | $ | 4.5 | $ | — | $ | — |\\n\\n____________________\\n1.Balance is included in “Investments” in the condensed consolidated balance sheets. Livent NQSP investments in Livent common stock are recorded as \\\"Treasury stock\\\" in the condensed consolidated balance sheets and carried at historical cost. A mark-to-market loss of $ 0.4 million was recorded for the three and nine months ended September 30, 2021, related to the Livent common stock. The mark-to-market gains were recorded in \\\"Selling, general and administrative expense\\\" in the condensed consolidated statement of operations, with a corresponding offset to the deferred compensation plan obligation in the condensed consolidated balance sheets.\\n2.Balance is included in “Other long-term liabilities” in the condensed consolidated balance sheets.\\nNote 13: Commitments and Contingencies\\nContingencies\\nWe are a party to various legal proceedings, including those noted in this section. Livent records reserves for estimated losses from contingencies when information available indicates that a loss is probable and the amount of the loss, or range of loss, can be reasonably estimated. As additional information becomes available, management adjusts its assessments and estimates. Legal costs are expensed as incurred.\\nIn addition to the legal proceedings noted below, we have certain contingent liabilities arising in the ordinary course of business. Some of these contingencies are known but are so preliminary that the merits cannot be determined, or if more advanced, are not deemed material based on current knowledge; and some are unknown - for example, claims with respect to which we have no notice or claims which may arise in the future from products sold, guarantees or warranties made, or indemnities provided. Therefore, we are unable to develop a reasonable estimate of our potential exposure of loss for these contingencies, either individually or in the aggregate, at this time. There can be no assurance that the outcome of these contingencies will be favorable, and adverse results in certain of these contingencies could have a material adverse effect on the consolidated financial position, results of operations in any one reporting period, or liquidity.\\n24\\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\\nArgentine Customs Authority\\nOn July 31, 2020, we received notice from the Argentine Customs Authority that it was conducting an audit of Minera del Altiplano SA, our subsidiary in Argentina (“MdA”). The audit relates to the export of Lithium Carbonate from Argentina for the period January 10, 2015 through December 31, 2017. Although this relates to a period of time when MdA was a subsidiary of FMC, the Company agreed to bear any possible liability for this matter under the terms of the Tax Matters Agreement that it entered into with FMC in connection with the Separation. A range of reasonably possible liabilities, if any, cannot be currently currently estimated by the Company.\\nLeases\\nAll of our leases are operating leases as of September 30, 2021 and December 31, 2020. We have operating leases for corporate offices, manufacturing facilities, and land. Our leases have remaining lease terms of 1 year to 14 years. Quantitative disclosures about our leases are summarized in the table below.\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (in Millions, except for weighted-average amounts) | 2021 | 2020 | 2021 | 2020 |\\n| Lease Cost |\\n| Operating lease cost | $ | 0.4 | $ | 0.6 | $ | 1.0 | $ | 1.6 |\\n| Short-term lease cost | 0.3 | — | 1.0 | 0.3 |\\n| Variable lease cost (1) | — | — | 0.1 | 0.1 |\\n| Total lease cost (1) | $ | 0.7 | $ | 0.6 | $ | 2.1 | $ | 2.0 |\\n| Other information |\\n| Cash paid for amounts included in the measurement of lease liabilities: |\\n| Cash paid for operating leases | $ | 0.5 | $ | 0.5 | $ | 1.6 | $ | 1.5 |\\n\\n__________________________\\n1. Short term lease cost for the three months ended September 30, 2020 was less than $ 0.1 million. Variable lease cost for the three months ended September 30, 2020 and 2021 was less than $ 0.1 million. Lease expense is classified as \\\"Selling, general and administrative expenses\\\" in our consolidated statements of operations.\\nAs of September 30, 2021 and December 31, 2020, our operating leases had a weighted average remaining lease term of 8.6 years and 11.7 years, respectively. As of September 30, 2021 and December 31, 2020, our operating leases had a weighted average discount rate of 4.9 % and 4.4 %, respectively.\\nThe table below presents a maturity analysis of our operating lease liabilities for each of the next five years and a total of the amounts for the remaining years.\\n| (in Millions) | Undiscounted cash flows |\\n| Remainder of 2021 | $ | 0.4 |\\n| 2022 | 1.3 |\\n| 2023 | 1.1 |\\n| 2024 | 1.1 |\\n| 2025 | 1.1 |\\n| Thereafter | 3.0 |\\n| Total future minimum lease payments | 8.0 |\\n| Less: Imputed interest | ( 1.5 ) |\\n| Total | $ | 6.5 |\\n\\n25\\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\\nIn the first quarter of 2021, we terminated our existing sublease with FMC for approximately twenty-five thousand square feet of office space used for our corporate headquarters in Philadelphia, Pennsylvania and removed the related right-of-use (\\\"ROU\\\") asset and lease liability of approximately $ 10.9 million from our condensed consolidated balance sheets. On April 13, 2021 we executed a new five-year sublease agreement with a different counterparty for approximately thirteen thousand square feet of office space for our corporate headquarters in Philadelphia, Pennsylvania and recorded a $ 2.1 million ROU asset and lease liability in the second quarter of 2021 related thereto.\\n26\\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\\nNote 14: Supplemental Information\\nThe following tables present details of prepaid and other current assets, other assets, accrued and other current liabilities, and other long-term liabilities as presented on the condensed consolidated balance sheets:\\n| (in Millions) | September 30, 2021 | December 31, 2020 |\\n| Prepaid and other current assets |\\n| Argentina government receivable (1) | $ | 11.8 | $ | 10.8 |\\n| Tax related items | 15.4 | 15.7 |\\n| Other receivables | 3.0 | 8.6 |\\n| Prepaid expenses | 7.6 | 8.2 |\\n| Bank Acceptance Drafts (2) | — | 0.2 |\\n| Other current assets (3) | 6.0 | 12.8 |\\n| Total | $ | 43.8 | $ | 56.3 |\\n\\n| (in Millions) | September 30, 2021 | December 31, 2020 |\\n| Other assets |\\n| Argentina government receivable (1) | $ | 51.0 | $ | 55.8 |\\n| Advance to contract manufacturers (4) | 15.6 | 16.3 |\\n| Capitalized software, net | 1.5 | 1.8 |\\n| Tax related items | 2.5 | 2.7 |\\n| Other assets | 11.0 | 11.8 |\\n| Total | $ | 81.6 | $ | 88.4 |\\n\\n_________________\\n1.We have various subsidiaries that conduct business in Argentina. As of September 30, 2021 and December 31, 2020, $ 38.3 million and $ 39.5 million, respectively, of outstanding receivables due from the Argentina government, which primarily represent export tax and export rebate receivables, was denominated in U.S. dollars. As with all outstanding receivable balances, we continually review recoverability by analyzing historical experience, current collection trends and regional business and political factors among other factors.\\n2.Bank Acceptance Drafts are a common Chinese finance note used to settle trade transactions. Livent accepts these notes from Chinese customers based on criteria intended to ensure collectability and limit working capital usage.\\n3.The December 31, 2020 balance includes a $ 5.4 million receivable for insurance reimbursement related to the IPO litigation settlement which was netted with the IPO litigation settlement accrual. The IPO litigation settlement was finalized in the second quarter of 2021. See Note 7 for details.\\n4.We record deferred charges for certain contract manufacturing agreements which we amortize over the term of the underlying contract.\\n27\\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\\n| (in Millions) | September 30, 2021 | December 31, 2020 |\\n| Accrued and other current liabilities |\\n| Plant restructuring reserves | $ | 3.2 | $ | 3.2 |\\n| Retirement liability - 401K | 0.6 | 2.6 |\\n| Accrued payroll | 11.5 | 12.5 |\\n| Severance related | 0.2 | 2.5 |\\n| Environmental reserves, current | 0.5 | 0.6 |\\n| Other accrued and other current liabilities (1) | 19.7 | 15.3 |\\n| Total | $ | 35.7 | $ | 36.7 |\\n\\n| (in Millions) | September 30, 2021 | December 31, 2020 |\\n| Other long-term liabilities |\\n| Accrued investment in unconsolidated affiliate | $ | 6.2 | $ | 6.2 |\\n| Asset retirement obligations | 0.3 | 0.3 |\\n| Contingencies related to uncertain tax positions (2) | 3.6 | 3.4 |\\n| Deferred compensation plan obligation | 5.5 | 4.5 |\\n| Self-insurance reserves | 1.5 | 1.5 |\\n| Other long-term liabilities | 1.1 | 1.3 |\\n| Total | $ | 18.2 | $ | 17.2 |\\n\\n____________________\\n1.Amounts primarily include accrued capital expenditures related to our expansion projects. December 31, 2020 includes a $ 7.4 million settlement accrual related to IPO litigation recorded in the third quarter of 2020. The IPO litigation settlement was finalized in the second quarter of 2021.\\n2.As of September 30, 2021, we have recorded a liability for uncertain tax positions of $ 3.2 million and a $ 0.4 million indemnification liability to FMC for assets held by the Company where the offsetting liability for uncertain tax positions rests with FMC. The Company agreed to bear any possible liability for this matter under the terms of the Tax Matters Agreement that it entered into with FMC in connection with the Separation.\\n28\\nITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\\nSPECIAL NOTE REGARDING FORWARD-LOOKING INFORMATION\\nStatement under the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995: We and our representatives may from time to time make written or oral statements that are “forward-looking” and provide other than historical information, including statements contained in Item 2 of this Quarterly Report on Form 10-Q, in our other filings with the SEC, or in reports to our stockholders.\\nIn some cases, we have identified forward-looking statements by such words or phrases as “will likely result,” “is confident that,” “expect,” “expects,” “should,” “could,” “may,” “will continue to,” “believe,” “believes,” “anticipates,” “predicts,” “forecasts,” “estimates,” “projects,” “potential,” “intends” or similar expressions identifying “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, including the negative of those words and phrases. Such forward-looking statements are based on our current views and assumptions regarding future events, future business conditions and the outlook for the company based on currently available information. These forward-looking statements may include projections of our future financial performance, our anticipated growth strategies and anticipated trends in our business. These statements are only predictions based on our current expectations and projections about future events. These statements involve known and unknown risks, uncertainties and other factors that may cause actual results to be materially different from any results, levels of activity, performance or achievements expressed or implied by any forward-looking statement.\\nCurrently, one of the most significant factors is the potential adverse effect of the current COVID-19 pandemic on the financial condition, results of operations, cash flows and performance of the Company, which is substantially influenced by the potential adverse effect of the pandemic on Livent’s customers and suppliers, the global economy and financial markets and costs of implementing COVID-19 safety protocols. The extent to which COVID-19 impacts us will depend on future developments, which are highly uncertain and cannot be predicted with confidence, including the scope, severity and duration of the pandemic, the development of more contagious variants of the virus, such as the Delta variant, the actions taken to contain the pandemic or mitigate its impact, and the direct and indirect economic effects of the pandemic and containment measures, among others.\\nAdditional factors include, among other things:\\n•a decline in the growth in demand for electric vehicles with high performance lithium compounds;\\n•supply chain disruptions in the electric vehicle manufacturing industry, such as shortages, congestion at ports, and rolling electricity blackouts in China, resulting in delays in customer orders for our high performance lithium compounds;\\n•reduced customer demand, or delays in growth of customer demand, for higher performance lithium compounds;\\n•volatility in the price for performance lithium compounds;\\n•adverse global economic and weather conditions that may result in adverse impact on supply chains and customer demand;\\n•competition;\\n•quarterly and annual fluctuations of our operating results;\\n•risks relating to Livent’s capacity expansion efforts and current production;\\n•potential development and adoption of battery technologies that do not rely on performance lithium compounds as an input, or that require a lesser amount of performance lithium compounds;\\n•difficulty accessing global capital and credit markets;\\n•the conditional conversion feature of the 2025 Notes;\\n•the lack of sufficient cash flow from our business to pay our debt;\\n•the success of Livent’s research and development efforts;\\n•future acquisitions that may be difficult to integrate or are otherwise unsuccessful;\\n•risks inherent in international operations and sales, including political, financial and operational risks specific to Argentina, China and other countries where Livent has active operations;\\n•customer concentration and the possible loss of, or significant reduction in orders from, large customers;\\n•failure to satisfy customer qualification processes and customer and government quality standards;\\n29\\n•fluctuations in the price of energy and certain raw materials;\\n•employee attraction and retention, especially in relation to our capacity expansion efforts;\\n•union relations;\\n•cybersecurity breaches;\\n•our ability to protect our intellectual property rights;\\n•ESG matters;\\n•the lack of proven lithium reserves;\\n•legal and regulatory proceedings, including any shareholder lawsuits;\\n•compliance with environmental, health and safety laws;\\n•changes in tax laws;\\n•risks related to our separation from FMC Corporation;\\n•potential conflicts of interests among officers and directors who may own equity in, and/or may have otherwise served as employees of, FMC Corporation;\\n•risks related to ownership of our common stock, including price fluctuations;\\n•provisions under Delaware law and our charter documents that may deter third parties from acquiring us; and\\n•the lack of cash dividends at this time.\\nMoreover, investors are cautioned to interpret many of these factors as being heightened as a result of the ongoing and numerous adverse impacts of COVID-19. You should carefully consider the risk factors discussed in Part I, Item 1A of our 2020 Annual Report on Form 10-K.\\nAlthough we believe the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, level of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of any of these forward-looking statements. We wish to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made. We are under no duty to and specifically decline to undertake any obligation to publicly revise or update any of these forward-looking statements after the date of this Quarterly Report on Form 10-Q to conform our prior statements to actual results, revised expectations or to reflect the occurrence of anticipated or unanticipated events.\\nAPPLICATION OF CRITICAL ACCOUNTING POLICIES\\nOur condensed consolidated financial statements are prepared in conformity with U.S. GAAP. The preparation of our financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. We have described our accounting policies in Note 2 to our consolidated and combined financial statements included in Part II, Item 8 of our 2020 Annual Report on Form 10-K.\\nWe have reviewed these accounting policies, identifying those that we believe to be critical to the preparation and understanding of our condensed consolidated financial statements. We have reviewed these critical accounting policies with the Audit Committee of our Board of Directors. Critical accounting policies are central to our presentation of results of operations and financial condition and require management to make estimates and judgments on certain matters. We base our estimates and judgments on historical experience, current conditions and other reasonable factors.\\nThe following is a list of those accounting policies that we have deemed most critical to the presentation and understanding of our results of operations and financial condition. See the \\\"Critical Accounting Policies\\\" section included within \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations\\\" within Part II, Item 7 of our 2020 Annual Report on Form 10-K for a detailed description of these policies and their potential effects on our results of operations and financial condition.\\n•Revenue recognition and trade receivables\\n•Impairment and valuation of long-lived assets\\n•Income taxes\\nDue to the COVID-19 pandemic, there has been uncertainty and disruption in the global economy and financial markets. The estimates used for, but not limited to, revenue recognition and the collectability of trade receivables, impairment and valuation of long-lived assets, and income taxes could be impacted. We have assessed the impact and are not aware of any specific events or circumstances that required an update to our estimates and assumptions or materially affected the carrying value of our assets\\n30\\nor liabilities as of the date of issuance of this Quarterly Report on Form 10-Q. These estimates may change as new events occur and additional information is obtained. Actual results could differ materially from these estimates under different assumptions or conditions.\\nRECENTLY ISSUED AND ADOPTED ACCOUNTING PRONOUNCEMENTS AND REGULATORY ITEMS\\nSee Note 3 to these condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for a discussion of recently adopted accounting guidance and other new accounting guidance.\\nOVERVIEW\\nWe are a pure-play, fully integrated lithium company, with a long, proven history of producing performance lithium compounds. Our primary products, namely battery-grade lithium hydroxide, lithium carbonate, butyllithium and high purity lithium metal are critical inputs used in various performance applications. Our strategy is to focus on supplying high performance lithium compounds to the fast growing Electric Vehicle (“EV”) battery market, while continuing to maintain our position as a leading global producer of butyllithium and high purity lithium metal. With extensive global capabilities, nearly 80 years of continuous production experience, applications and technical expertise, long standing customer relationships, and a favorable sustainability profile, we believe we are well positioned to capitalize on the accelerating trend of vehicle electrification and renewable energy adoption.\\nWe produce lithium compounds for use in applications that have specific and constantly changing performance requirements, including battery-grade lithium hydroxide for use in high performance lithium-ion batteries. We believe the demand for our compounds will continue to grow as the electrification of transportation accelerates, and as the use of high nickel content cathode materials increases in the next generation of battery technology products. We also supply butyllithium, which is used in the production of polymers and pharmaceutical products, as well as a range of specialty lithium compounds including high purity lithium metal, which is used in non-rechargeable batteries and in the production of lightweight materials for aerospace applications and non-rechargeable batteries. It is in these applications that we have established a differentiated position in the market through our ability to consistently produce and deliver performance lithium compounds.\\nThird Quarter 2021 Highlights\\nThe following are the more significant developments in our business during the three months ended September 30, 2021:\\n•Revenue of $103.6 million for the three months ended September 30, 2021 increased $31.0 million, or approximately 43%, compared to $72.6 million for the three months ended September 30, 2020, primarily due to higher lithium hydroxide, lithium carbonate and butyllithium sales volumes, driven by an increase in customer demand.\\n•Net loss of $(12.6) million for the three months ended September 30, 2021 compared to net loss of $(10.5) million for the three months ended September 30, 2020 was primarily due to an increase in the Argentina tax expense from inflationary tax adjustments, higher logistics, raw material and other operating costs, and $1.0 million Equity in net loss of unconsolidated affiliates partially offset by higher lithium hydroxide, lithium carbonate and butyllithium sales volumes and lower Restructuring and other charges.\\n•Adjusted EBITDA of $14.9 million for the three months ended September 30, 2021 increased $14.0 million compared to $0.9 million for the three months ended September 30, 2020, primarily due to higher lithium hydroxide, lithium carbonate and butyllithium sales volumes partially offset by higher logistics, raw material and other operating costs.\\nCOVID-19 Impacts\\nBusiness and Operations\\nDuring the three months ended September 30, 2021, the COVID-19 pandemic continued to negatively impact our business, operations and financial performance. Worldwide government and private sector efforts to contain the spread and mitigate the impact of COVID-19 continued. We still face operational challenges and uncertainties related to the unprecedented global COVID-19 pandemic. The disruptions and duration may be impacted by the actions that governments, businesses and individuals take in relation to the pandemic, the Delta variant and other new variants of the virus, vaccine safety concerns, vaccine resistance, vaccine availability, delays in vaccine distribution and the willingness of individuals to be vaccinated.\\nWe have manufacturing operations in the United States, Argentina, China, the United Kingdom, and India, general operations in Singapore, and sales offices in the United States, China, the United Kingdom, India, and Japan. All of these countries have been affected by the COVID-19 pandemic to varying degrees. Each has adopted measures to contain it, and each may adopt different and/or even stricter measures in the future. The government of Argentina, where the Company’s primary lithium brine resource is located, continues to enact new emergency measures to stem the spread of COVID-19 and modify existing ones. While regional curfews and lockdowns are being lifted and businesses and schools are being allowed to reopen, travel and\\n31\\nimmigration restrictions and workforce retention rules remain in place. In India, regional governments have imposed testing requirements, curfews and travel restrictions. We expect government measures and restrictions globally to continue to have a negative impact on demand for certain of our products and a negative impact on the efficient operation of our facilities, supply chains and logistics. Disruptions and delays within our supply chain and logistics operations included problems and congestion at ports, difficulties with scheduling cargo ships, higher shipment and freight costs, additional warehouse costs due to shipment delays, lack of driver availability and fewer transportation options, and the restriction of movements by trucks within and between countries. The severity of these problems and issues has varied in different geographic locations over the course of the COVID-19 pandemic and continues to remain a challenge in all of the countries where we operate.\\nCustomer demand for certain types of our products improved during the third quarter of 2021. However, customers continue to protect their interests by diversifying among multiple suppliers. They continue to actively manage their own inventory levels in the current uncertain market environment. In addition, customers in the fast-growing EV manufacturing industry are currently experiencing their own supply chain constraints, including semiconductors shortages, congestion at ports, and rolling electricity blackouts in China. The semiconductor chip shortage is expected to continue and may adversely impact our business. This, and similar supply chain disruptions experienced by our customers, could cause delays in their demand for our high performance lithium compounds, further adversely impacting our business and growth plans.\\nThe continuing spread and effects of COVID-19, including health and safety protocols and supply and logistics disruptions in China and elsewhere, are impacting our expansion work in Argentina and the United States. There can be no assurance that such impacts will not turn into long-term or continuing delays, cause us to decide to suspend our capital expansion work, or otherwise negatively impact our capital expansion. Any significant delay in our capital expansion work in Argentina or the United States could have a material adverse effect on our business, financial condition and results of operations. In addition to delays, there have been increased costs due to slowdown of availability of materials for construction.\\nWe have not faced any material issues with employee morale or attrition. Likewise, we have not faced any material issues with our ability to recruit new employees or in talent management of existing employees. However, certain of our employees may resign, and we may be unable to attract certain talent, if we were to impose any vaccine mandate. Broadly, we are observing tightness in the local labor markets where we operate in both the United States and Argentina (e.g., fewer applicants and higher wages). This may impact us and our expansion efforts, our customers and suppliers in the future.\\nThe material operational challenges that management and our Board of Directors are monitoring are the health and safety of our employees, vaccine availability and distribution, travel restrictions, COVID-19 mitigation measures, the relaxation of work from home requirements, the restriction of movements within and between countries, and supply chain and logistics issues. Furthermore, our Board of Directors is monitoring the additional expected and unexpected impacts that COVID-19 is having on the economies in the countries where we operate, such as Argentina where inflation remains high and economic instability persists, and China where economic growth has led to shortages of electricity and temporary shutdowns of third party providers to the Company.\\nLiquidity and Financial Resources\\nThe rapid and global spread of COVID-19 continues to disrupt the businesses of certain customers, contract manufacturers and suppliers. Several of our customers and contract manufacturers have experienced disruptions in their business due to the COVID-19 pandemic. Certain customers have canceled, postponed or delayed orders.\\nOur uses of cash were impacted by the effects of COVID-19 during the nine months ended September 30, 2021. We continue to face logistical supply disruptions, such as higher truck, freight and sea shipping costs, along with the need to use air freight from time to time. We expect this to continue. We also continue to use cash to purchase additional COVID-19 testing, personal protective equipment for our employees, such as masks and gloves, and for increased cleaning and disinfectant costs, additional medical personnel at our facilities, and increased personnel transportation costs due to social distancing guidelines.\\nCorporate Efforts\\nWe have responded to the COVID-19 pandemic in a number of ways. We formed a Global Pandemic Response Team, regional COVID-19 Response Teams, and a Vaccine subcommittee. The Vaccine subcommittee is tasked with monitoring vaccine developments and encouraging our employees to be vaccinated. Our regional COVID-19 Response Teams continue to keep Executive Leadership informed of local matters such as government policies and regulations. Our Enterprise Risk Management processes have worked as designed.\\nWe continue to identify potential new suppliers and logistics providers for our operations as supply chain challenges continue. This includes potential new suppliers of chemicals and packaging, and air freight companies when required. We have altered global production schedules to meet changes in customer demand, supply and logistics challenges. Future efforts will continue along these lines and be dictated by the particulars of the COVID-19 pandemic. We continue to plan for a return to more normalized business operations once the COVID-19 pandemic subsides. This may include a relaxation of COVID-19 protocols, more business travel and customer contacts, and hybrid work arrangements.\\n32\\nHealth & Safety\\nWe are working diligently to protect the health and well-being of our employees, customers and other key stakeholders. As an essential business under the rules of the governments in the countries where we operate, our plant personnel continue to remain on the job at their respective facilities. We have instituted numerous safety procedures to protect the health of these plant personnel. Protocols include screening of personnel prior to facility entry, the use of masks and gloves, social distancing measures, and quarantine of close contacts with suspected or confirmed COVID-19 cases. Much of our non-plant personnel continue to work from home, and business travel has been substantially reduced, which has limited our ability to meet with customers, suppliers and fellow employees. Communications relating to all of these policies and COVID-19 preventative measures are regularly distributed to our employees, as there can be significant variation with respect to the COVID-19 pandemic situation in different geographic regions at any one time.\\nWe base our health and safety protocols on the advice provided by the White House, the Centers for Disease Control and Prevention, the World Health Organization, and the local government authorities in the countries and regions where we operate.\\nIn the United States, we previously implemented the paid sick leave policies that were required under the Families First Coronavirus Response Act and had supplemented them with our own paid sick and other leave policies. Currently, in the United States, we are providing paid sick leave for qualified absences due to COVID-19. In other geographic locations, we are providing our customary local sick leave benefits and any other leave and benefits that may be required by local governmental authorities. We have not experienced any material employee absences as a result of COVID-19. However, social distancing measures and other health and safety protocols have led to reduced workforce numbers in certain locations, such as with our expansion project in Argentina. If a significant number of our employees at any one location were to require leave as a result of COVID-19, this could pose a risk to the continued operation of the particular facility and could potentially disrupt our broader operations.\\nGovernment Programs\\nWe continue to evaluate government support and tax relief programs in the countries where we operate. This includes support grants, loans, tax deferrals, and tax credits.\\nOverall, the impact of the COVID-19 pandemic is fluid and continues to evolve, and therefore, we cannot predict the extent to which our business, results of operations, financial condition or liquidity will ultimately be impacted.\\nBusiness Outlook\\nWe expect higher volumes across our lithium products and slightly higher average pricing in 2021 versus the prior year. We also expect lower unit costs versus the prior year, driven in part by higher operating rates and the reduced impact of third-party purchased lithium carbonate usage. However, we expect this to be partially offset by cost increases in logistics, solvents and other raw materials.\\n33\\nRESULTS OF OPERATIONS\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| (in Millions) | (unaudited) |\\n| Revenue | $ | 103.6 | $ | 72.6 | $ | 297.5 | $ | 206.0 |\\n| Cost of sales | 85.3 | 69.8 | 245.5 | 178.4 |\\n| Gross margin | 18.3 | 2.8 | 52.0 | 27.6 |\\n| Selling, general and administrative expenses | 11.8 | 10.0 | 34.2 | 31.1 |\\n| Research and development expenses | 0.8 | 1.0 | 2.2 | 2.8 |\\n| Restructuring and other charges | 1.1 | 4.4 | 3.4 | 10.1 |\\n| Separation-related costs | 0.8 | 0.6 | 1.3 | 0.8 |\\n| Total costs and expenses | 99.8 | 85.8 | 286.6 | 223.2 |\\n| Income/(loss) from operations before loss on debt extinguishment, equity in net loss of unconsolidated affiliates and interest expense, net | 3.8 | (13.2) | 10.9 | (17.2) |\\n| Loss on debt extinguishment | — | — | — | 0.1 |\\n| Equity in net loss of unconsolidated affiliates | 1.0 | 0.1 | 3.7 | 0.4 |\\n| Interest expense, net | — | 0.3 | 0.3 | 0.3 |\\n| Income/(loss) from operations before income taxes | 2.8 | (13.6) | 6.9 | (18.0) |\\n| Income tax expense/(benefit) | 15.4 | (3.1) | 13.8 | (5.4) |\\n| Net loss | $ | (12.6) | $ | (10.5) | $ | (6.9) | $ | (12.6) |\\n\\nIn addition to net income, as determined in accordance with U.S. GAAP, we evaluate operating performance using certain non-GAAP measures such as EBITDA, which we define as net income plus interest expense, net, income tax expense/(benefit), and depreciation and amortization, and Adjusted EBITDA, which we define as EBITDA adjusted for restructuring and other charges/(income), separation-related costs and certain other losses/(gains). Management believes the use of these non-GAAP measures allows management and investors to compare more easily the financial performance of its underlying business from period to period. The non-GAAP information provided may not be comparable to similar measures disclosed by other companies because of differing methods used by other companies in calculating EBITDA and Adjusted EBITDA. These measures should not be considered as a substitute for net income or other measures of performance or liquidity reported in accordance with U.S. GAAP. The following table reconciles EBITDA and Adjusted EBITDA from net income.\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (in Millions) | 2021 | 2020 | 2021 | 2020 |\\n| Net loss (GAAP) | $ | (12.6) | $ | (10.5) | $ | (6.9) | $ | (12.6) |\\n| Add back: |\\n| Interest expense, net | — | 0.3 | 0.3 | 0.3 |\\n| Income tax expense/(benefit) | 15.4 | (3.1) | 13.8 | (5.4) |\\n| Depreciation and amortization | 6.2 | 6.1 | 18.7 | 17.7 |\\n| EBITDA (Non-GAAP) | 9.0 | (7.2) | 25.9 | — |\\n| Add back: |\\n| Certain Argentina remeasurement losses (a) | 0.9 | 1.5 | 4.2 | 4.4 |\\n| Restructuring and other charges (b) | 1.1 | 4.4 | 3.4 | 10.1 |\\n| Separation-related costs (c) | 0.8 | 0.6 | 1.3 | 0.8 |\\n| COVID-19 related costs (d) | 1.9 | 1.7 | 4.2 | 1.7 |\\n| Loss on debt extinguishment (e) | — | — | — | 0.1 |\\n| Other gain/(loss) (f) | 1.2 | (0.1) | 3.0 | (0.4) |\\n| Adjusted EBITDA (Non-GAAP) | $ | 14.9 | $ | 0.9 | $ | 42.0 | $ | 16.7 |\\n\\n___________________\\na.Represents impact of currency fluctuations on tax assets and liabilities and on long-term monetary assets associated with our capital expansion as well as significant currency devaluations. The remeasurement gains/(losses) are included within \\\"Cost of sales\\\" in our condensed consolidated statement of operations but are excluded from our calculation of Adjusted EBITDA because of: i.) their nature as income tax related; ii.) their association with long-term capital projects which will not be operational until future periods; or iii.) the severity of the devaluations and their immediate impact on our operations in the country.\\nb.We continually perform strategic reviews and assess the return on our business. This sometimes results in management changes or in a plan to restructure the operations of our business. As part of these restructuring plans, demolition costs and write-downs of long-lived assets may occur. Also includes transaction related legal fees and miscellaneous nonrecurring transactions. Three and nine months\\n34\\nended September 30, 2020 consists primarily of legal fees related to IPO securities litigation including a settlement accrual, net of insurance reimbursement, of $2.5 million in the third quarter. The IPO litigation settlement was finalized in the second quarter of 2021.\\nc.Represents legal, professional, transaction-related fees and other separation-related activity.\\nd.Represents incremental costs associated with COVID-19 recorded in \\\"Cost of sales\\\" in the condensed consolidated statement of operations, including but not limited to, incremental quarantine related absenteeism, incremental facility cleaning costs, COVID-19 testing, pandemic-related supplies and personal protective equipment for employees, among other costs; offset by economic relief provided by foreign governments.\\ne.Represents the partial write off of deferred financing costs for the temporary reduction in borrowing capacity related to the First Amendment excluded from our calculation of Adjusted EBITDA because the loss is nonrecurring.\\nf.Three and nine months ended September 30, 2021 represents our 25% indirect interest in transaction costs incurred for the Nemaska Transaction, certain project-related costs and interest expense, all included in Equity in net loss of unconsolidated affiliates in our condensed consolidated statement of operations. Three and nine months ended September 30, 2020 represents a portion of our nonrefundable prepaid research and development costs advanced to an unconsolidated affiliate in the fourth quarter 2019 and excluded from our calculation of Adjusted EBITDA in the same period because the costs represent research and development activities of the affiliate that had not occurred as of December 31, 2019. These costs were included with our calculation of Adjusted EBITDA for the three and nine months ended September 30, 2020 when the costs were incurred at the unconsolidated affiliate.\\nThree Months Ended September 30, 2021 vs. 2020\\nRevenue\\nRevenue of $103.6 million for the three months ended September 30, 2021 (the \\\"2021 Quarter\\\") increased by approximately 43%, or $31 million, compared to $72.6 million for the three months ended September 30, 2020 (the \\\"2020 Quarter\\\") primarily due to higher lithium hydroxide, lithium carbonate and butyllithium sales volumes, driven by an increase in customer demand.\\nGross margin\\nGross margin of $18.3 million for the 2021 Quarter increased by $15.5 million, or approximately 554%, versus $2.8 million for the 2020 Quarter. The increase in gross margin was primarily due to higher lithium hydroxide, lithium carbonate and butyllithium sales volumes, partially offset by higher logistics, raw material and other operating costs.\\nRestructuring and other charges\\nRestructuring and other charges of $1.1 million for the 2021 Quarter decreased by $3.3 million versus $4.4 million for the 2020 Quarter. Restructuring and other charges for the 2020 Quarter consisted primarily of severance-related costs of $0.9 million, and legal fees related to IPO securities litigation including a settlement accrual, net of insurance reimbursement, of $2.5 million in the 2020 Quarter. The IPO litigation settlement was finalized in the second quarter of 2021. 2021 Quarter Restructuring and other charges consisted primarily of transaction related legal fees and miscellaneous nonrecurring transactions (see Note 7 for details).\\nEquity in net loss of unconsolidated affiliates\\nEquity in net loss of unconsolidated affiliates of $1.0 million for the 2021 Quarter arises out of our 25% interest in the Nemaska Project.\\nInterest expense, net\\nInterest expense of $0.3 million for the 2020 Quarter is noncash amortization of transaction costs related to the 2025 Notes which represents the excess interest over the amount of interest capitalized in accordance with U.S. GAAP for the 2020 Quarter. Interest of $3.8 million and $3.4 million for the 2021 Quarter and the 2020 Quarter, respectively was capitalized.\\nIncome tax expense/(benefit)\\nThe increase in income tax expense to $15.4 million for the 2021 Quarter compared to the income tax benefit of $(3.1) million for the 2020 Quarter, was primarily due to the fluctuations in foreign currency impacts in Argentina of $12.7 million and $(2.6) million for the three months ended September 30, 2021 and 2020, respectively. Within foreign currency impacts, Argentina tax law annually requires an increase to taxable income for inflationary adjustments in the period when the consumer price index fluctuates over a specific threshold, which was met in Q3 of 2021. Additionally, the increase in income tax expense was the result of an increase in income from operations.\\nNet loss\\nNet loss of $(12.6) million for the 2021 Quarter compared to net loss of $(10.5) million for the 2020 Quarter was primarily due to the an increase in the Argentina tax expense from inflationary tax adjustments, higher logistics, raw material and other\\n35\\noperating costs, and $1.0 million Equity in net loss of unconsolidated affiliates partially offset by higher lithium hydroxide, lithium carbonate and butyllithium sales volumes and lower Restructuring and other charges.\\n36\\nNine Months Ended September 30, 2021 vs. 2020\\nRevenue\\nRevenue of $297.5 million for the nine months ended September 30, 2021 (the \\\"2021 YTD\\\") increased by approximately 44%, or $91.5 million, compared to $206.0 million for the nine months ended September 30, 2020 (the \\\"2020 YTD\\\") primarily due to higher lithium hydroxide, lithium carbonate and butyllithium sales volumes, driven by an increase in customer demand.\\nGross margin\\nGross margin of $52.0 million for the 2021 YTD increased by $24.4 million, or approximately 88%, versus $27.6 million for the 2020 YTD. The increase in gross margin was primarily due higher lithium hydroxide, lithium carbonate and butyllithium sales volumes partially offset by COVID-19 costs to implement safety protocols and higher logistics, raw material and other operating costs.\\nRestructuring and other charges\\nRestructuring and other charges of $3.4 million for the 2021 YTD decreased by $6.7 million versus $10.1 million for the 2020 YTD. Restructuring and other charges for the 2020 YTD consisted of severance-related costs for management changes at certain operating and administrative facilities, exit costs of $1.6 million for the closing of leased office space and legal fees related to IPO securities litigation, including a settlement accrual, net of insurance reimbursement, of $2.5 million in the third quarter of 2020. The IPO litigation settlement was finalized in the second quarter of 2021. 2021 YTD Restructuring and other charges consisted primarily of environmental remediation, transaction related legal fees and miscellaneous nonrecurring costs (see Note 7 for details).\\nEquity in net loss of unconsolidated affiliates\\nEquity in net loss of unconsolidated affiliates of $3.7 million for the 2021 YTD arises out of our 25% interest in the Nemaska Project and includes $1.6 million of nonrecurring transaction costs incurred for the Nemaska Transaction by an unconsolidated affiliate.\\nInterest expense, net\\nInterest expense of $0.3 million for the 2021 YTD and 2020 YTD is noncash amortization of transaction costs related to the 2025 Notes which represents the excess interest over the amount of interest capitalized in accordance with U.S. GAAP for the 2021 YTD. Interest expense of $11.5 million and $8.1 million was capitalized in the 2021 YTD and 2020 YTD, respectively.\\nIncome tax expense/(benefit)\\nThe increase in income tax expense to $13.8 million for the 2021 YTD compared to the income tax benefit of $(5.4) million for the 2020 YTD, was primarily due to the fluctuations in foreign currency impacts in Argentina of $10.8 million and $(7.1) million for the nine months ended September 30, 2021 and 2020, respectively. Within foreign currency impacts, Argentina tax law annually requires an increase to taxable income for inflationary adjustments in the period when the consumer price index fluctuates over a specific threshold, which was met in Q3 of 2021. Additionally, the increase in tax expense was due to an increase in income from operations. The increase in income tax expense was partially offset by an Argentina income tax law, which was amended on June 16, 2021 to introduce new progressive corporate income tax rates from 25% to 35%. This change resulted in a tax benefit of $(2.2) million for the revaluation of Argentina net deferred tax assets for the nine months ended September 30, 2021.\\nNet loss\\nNet loss of $(6.9) million for the 2021 YTD compared to net loss of $(12.6) million for the 2020 YTD was primarily due to higher lithium hydroxide, lithium carbonate and butyllithium sales volumes and lower Restructuring and other charges, offset by an increase in the Argentina tax expense from inflationary tax adjustments, incremental COVID-19 costs to implement safety protocols, higher logistics, raw material and other operating costs and $3.7 million Equity in net loss of unconsolidated affiliates.\\n37\\nLIQUIDITY AND CAPITAL RESOURCES\\nCash and cash equivalents at September 30, 2021 and December 31, 2020, were $195.3 million and $11.6 million, respectively. Of the cash and cash equivalents balance at September 30, 2021, $12.5 million were held by our foreign subsidiaries. The cash held by foreign subsidiaries for permanent reinvestment is generally used to finance the subsidiaries’ operating activities and future foreign investments. We have not provided additional income taxes for any additional outside basis differences inherent in our investments in subsidiaries because the investments are essentially permanent in duration or we have concluded that no additional tax liability will arise upon disposal. See Note 9, Part II, Item 8 of our 2020 Annual Report on Form 10-K for more information.\\nRevolving Credit Facility\\nThe Credit Agreement provides for a $400 million senior secured Revolving Credit Facility, $50 million of which is available for the issuance of letters of credit, with an option, subject to certain conditions and limitations, to increase the aggregate amount of the revolving credit commitments to $600 million. The issuance of letters of credit and the proceeds of revolving credit loans made pursuant to the Revolving Credit Facility are available, and will be used, for general corporate purposes, including capital expenditures and permitted acquisitions, See Note 10, Part II, Item 8 of our 2020 Annual Report on Form 10-K for more information.\\nWe had $245.8 million and $281.4 million debt outstanding as of September 30, 2021 and December 31, 2020, respectively. Our September 30, 2021 debt outstanding was comprised solely of our 2025 Notes because in June 2021 we used a portion of the net proceeds from the Offering to repay all amounts outstanding under our Revolving Credit Facility. Among other restrictions, our Revolving Credit Facility contains financial covenants applicable to Livent and its consolidated subsidiaries related to leverage (measured as the ratio of debt to adjusted earnings) and interest coverage (measured as the ratio of adjusted earnings to interest expense). Our maximum allowable first lien leverage ratio is 3.5 as of September 30, 2021. Our minimum allowable interest coverage ratio is 3.5. We were in compliance with all covenants at September 30, 2021.\\nStatement of Cash Flows\\nCash provided by operating activities was $41.0 million and $1.5 million for the nine months ended September 30, 2021 and 2020, respectively.\\nThe cash provided by operating activities for the 2021 YTD as compared to the cash provided by operating activities for the 2020 YTD was primarily driven by higher net income in the 2021 YTD and a decrease in payments of accounts payables in the 2021 YTD compared to the 2020 YTD.\\nCash used in investing activities was $(74.3) million and $(111.8) million for the nine months ended September 30, 2021 and 2020, respectively.\\nThe decrease in cash used in investing activities for the 2021 YTD compared to the 2020 YTD is primarily due to the Company's election to suspend all capital expansion work globally from March 2020 to the second quarter of 2021. The time lag of slowing down and subsequently ramping back up capital spending, resulted in decreased capital expenditures for capacity expansion of lithium carbonate and hydroxide during the nine months ended September 30, 2021.\\nCash provided by financing activities was $216.9 million and $108.2 million for the nine months ended September 30, 2021 and 2020, respectively.\\nNet cash proceeds for financing activities increased in the 2021 YTD compared to the 2020 YTD and was provided primarily by net proceeds of $252.2 million from the Offering, partially offset by the repayment of the outstanding balance of our Revolving Credit Facility in June 2021.\\nOther potential liquidity needs\\nWe plan to meet our liquidity needs through available cash, cash generated from operations, borrowings under the committed Revolving Credit Facility, and other potential financing strategies that may be available to us. At September 30, 2021, our remaining borrowing capacity under our Revolving Credit Facility, subject to meeting our debt covenants, is $385.6 million, including letters of credit utilization. Our overall borrowing capacity under the Revolving Credit Facility is $400 million as of September 30, 2021.\\nWe expect the COVID-19 pandemic uncertainties, and lithium market challenges to continue in 2021. Our net leverage ratio is determined, in large part, by our ability to manage the timing and amount of our capital expenditures, which is within our\\n38\\ncontrol. It is also determined by our ability to achieve forecasted operating results and to pursue other working capital financing strategies that may be available to us, which is less certain and outside our control. In the first quarter of 2020, because of the significant practical constraints resulting from actions being taken by authorities around the word in response to the COVID-19 pandemic, the Company elected to suspend all capital expansion work globally. As of the second quarter of 2021, supported by partially reduced COVID-19 related constraints, additional commitments from customers and improved market conditions, Livent resumed its capital expansion work in Argentina and the United States. Based on this resumption, the Company estimates 2021 total capital spending to be $125 million.\\nThe company remains focused on maintaining its financial flexibility and will continue to manage its cash flow and capital allocation decisions to navigate through this challenging environment.\\nWe believe that our available cash and cash from operations, together with our borrowing availability under the Revolving Credit Facility and other potential financing strategies that may be available to us, will provide adequate liquidity for the next 12 months. Access to capital and the availability of financing on acceptable terms in the future will be affected by many factors, including our credit rating, economic conditions, the COVID-19 pandemic and the overall liquidity of capital markets and cannot be guaranteed.\\n39\\nCommitments and Contingencies\\nSee Note 13 to these condensed consolidated financial statements included in this Quarterly Report on Form 10-Q.\\nContractual Commitments\\nInformation related to our contractual commitments at December 31, 2020 can be found in a table included within Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations within our 2020 Annual Report on Form 10-K. There have been no significant changes to our contractual commitments during the period ended September 30, 2021.\\nClimate Change\\nA detailed discussion related to climate change can be found in Part II, Item 7 of our 2020 Annual Report on Form 10-K.\\nOff-Balance Sheet Arrangements\\nWe do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.\\nDERIVATIVE FINANCIAL INSTRUMENTS AND MARKET RISKS\\nOur earnings, cash flows and financial position are exposed to market risks relating to fluctuations in commodity prices, interest rates and foreign currency exchange rates. Our policy is to minimize exposure to our cash flow over time caused by changes in interest and currency exchange rates. To accomplish this, we have implemented a controlled program of risk management consisting of appropriate derivative contracts entered into with major financial institutions.\\nThe analysis below presents the sensitivity of the market value of our financial instruments to selected changes in market rates and prices. The range of changes chosen reflects our view of changes that are reasonably possible over a one-year period. Market value estimates are based on the present value of projected future cash flows considering the market rates and prices chosen.\\nIn the second quarter of 2021, we placed foreign currency hedges for 2021 projected exposure.\\nForeign Currency Exchange Rate Risk\\nOur worldwide operations expose us to currency risk from sales, purchases, expenses and intercompany loans denominated in currencies other than the U.S. dollar, our functional currency. The primary currencies for which we have exchange rate exposure are the Euro, the British pound, the Chinese yuan, the Argentine peso, and the Japanese yen. Foreign currency debt and foreign exchange forward contracts are used in countries where we do business, thereby reducing our net asset exposure. Foreign exchange forward contracts are also used to hedge firm and highly anticipated foreign currency cash flows. We currently do not hedge foreign currency risks associated with the Argentine peso due to the limited availability and the high cost of suitable derivative instruments.\\nTo analyze the effects of changing foreign currency rates, we have performed a sensitivity analysis in which we assume an instantaneous 10% change in the foreign currency exchange rates from their levels at the balance sheet date with all other variables (including interest rates) held constant. As of December 31, 2020, we had no open derivative cash flow hedge contracts.\\n| Hedged Currency vs. Functional Currency |\\n| (in Millions) | Net asset position on consolidated balance sheets | Net liability position with 10% strengthening | Net asset position with 10% weakening |\\n| Net asset/(liability) position as of September 30, 2021 | $ | 0.1 | $ | (0.6) | $ | 0.6 |\\n\\nInterest Rate Risk\\nOne of the strategies that we can use to manage interest rate exposure is to enter into interest rate swap agreements. In these agreements, we agree to exchange, at specified intervals, the difference between fixed and variable interest amounts calculated on an agreed-upon notional principal amount. As of September 30, 2021, we had no interest rate swap agreements.\\nOur debt portfolio at September 30, 2021 is composed of fixed-rate and variable-rate debt; consisting of borrowings under our 2025 Notes and Revolving Credit Facility. Changes in interest rates affect different portions of our variable-rate debt portfolio in different ways. Based on the variable-rate debt in our debt portfolio at September 30, 2021, a one percentage point increase or decrease in interest rates would have increased or decreased, respectively, gross interest expense by $0.2 million for the nine months ended September 30, 2021.\\n40\\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nThe information required by this item is provided in “Derivative Financial Instruments and Market Risks,” under Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations.\\nITEM 4. CONTROLS AND PROCEDURES\\n(a) Evaluation of disclosure controls and procedures. Based on management’s evaluation (with the participation of the company’s Chief Executive Officer and Chief Financial Officer), the Chief Executive Officer and Chief Financial Officer have concluded that, as of September 30, 2021, the company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) are effective to provide reasonable assurance that information required to be disclosed by the Company in reports filed or submitted under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and is accumulated and communicated to management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.\\n(b) Change in Internal Controls. There have been no changes in internal control over financial reporting that occurred during the quarter ended September 30, 2021, that materially affected or are reasonably likely to materially affect, our internal control over financial reporting.\\n41\\nPART II - OTHER INFORMATION\\n\\nITEM 1. LEGAL PROCEEDINGS\\nWe are involved in legal proceedings from time to time in the ordinary course of our business, including with respect to workers’ compensation matters. Based on information currently available and established reserves, we have no reason to believe that the ultimate resolution of any known legal proceeding will have a material adverse effect on our financial position, liquidity or results of operations. However, there can be no assurance that the outcome of any such legal proceeding will be favorable, and adverse results in certain of these legal proceedings could have a material adverse effect on our financial position, results of operations in any one reporting period, or liquidity. Except as set forth in Note 13 to our financial statements, which is incorporated herein by reference to the extent applicable, there are no material changes from the legal proceedings previously disclosed in our 2020 Annual Report on Form 10-K.\\nITEM 1A. RISK FACTORS\\nIn addition to the other information set forth in this Quarterly Report on Form 10-Q, you should carefully consider the risk factors discussed in Part I, Item 1A of our 2020 Annual Report on Form 10-K, which is available at www.sec.gov and on our website at www.livent.com. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may adversely affect our business, financial condition or future results.\\nForward-Looking Information\\nWe wish to caution readers not to place undue reliance on any forward-looking statements contained herein, which speak only as of the date made. We specifically decline to undertake any obligation to publicly revise any forward-looking statements that have been made to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.\\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\\nRepurchases of Common Shares\\nA summary of our repurchases of Livent's common stock for the three months ended September 30, 2021 is as follows:\\n| ISSUER PURCHASES OF EQUITY SECURITIES |\\n| Period | Total Number of Shares Purchased (1) | Average Price Paid Per Share | Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs (2) | Maximum Number of Shares That May Yet Be Purchased Under the Plans or Programs (2) |\\n| July 1 through July 31, 2021 | 206 | $ | 19.52 | $ | — | $ | — |\\n| August 1 through August 31, 2021 | 187 | $ | 24.22 | — | — |\\n| September 1 through September 30, 2021 | 172 | $ | 24.64 | — | — |\\n| Total Q3 2021 | 565 | $ | 22.64 | $ | — | $ | — |\\n\\n(1) The trustee of the Livent NQSP reacquires shares of Livent common stock from time to time through open-market purchases relating to investments by employees in our common stock, one of the investment options available under the Livent NQSP. Such shares are held in a trust fund and recorded to Treasury stock in our condensed consolidated balance sheets.\\n(2) We have no publicly announced stock repurchase programs.\\n42\\nITEM 6. EXHIBITS\\n| 31.1 | Certifying Statement of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 31.2 | Certifying Statement of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 32.1 | Certifying Statement of the Chief Executive Officer pursuant to Section 1350 of Title 18 of the United States Code |\\n| 32.2 | Certifying Statement of the Chief Financial Officer pursuant to Section 1350 of Title 18 of the United States Code |\\n| 101 | Interactive Data File |\\n| 104 | The cover page from Livent Corporation’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2021, formatted in Inline XBRL. |\\n\\n43\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n| LIVENT CORPORATION(Registrant) |\\n| By: | /s/ GILBERTO ANTONIAZZI |\\n| Gilberto Antoniazzi,Vice President and Chief Financial Officer |\\n\\nDate: November 4, 2021\\n44\\n \\n\\nWhat is the percentage change in operating cash flow to net loss ratio from the year 2020 to 2021?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 4891.304347826087.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 70,\n \"input_length\": 31441\n}"}}},{"rowIdx":71,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nItem 1.\nFinancial Statements\nUnaudited Condensed Balance Sheets 1\nUnaudited Condensed Statements of Operations 2\nUnaudited Condensed Statements of Changes in Shareholders’ Deficit 3\nUnaudited Condensed Statements of Cash Flows 4\nNotes to Unaudited Condensed Financial Statements 5\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 18\nItem 3. Quantitative and Qualitative Disclosures about Market Risk 22\nItem 4. Control and Procedures 22\nPART II – OTHER INFORMATION\nItem 1. Legal Proceedings 23\nItem 1A. Risk Factors 23\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds 23\nItem 3. Defaults Upon Senior Securities 24\nItem 4. Mine Safety Disclosures 24\nItem 5. Other Information 24\nItem 6. Exhibits 24\nSIGNATURES 25\ni\nPART I – FINANCIAL INFORMATION\nINCEPTION GROWTH ACQUISITION LIMITED\nUNAUDITED CONDENSED BALANCE SHEETS\n(Currency expressed in United States Dollars (“US$”), except for number of shares)\n\n| June 30, 2022 | December 31, 2021 |\n| (Audited) |\n| ASSETS |\n| Current assets: |\n| Cash | $ | 787,449 | $ | 1,365,181 |\n| Prepayments | 313,083 | 404,762 |\n| Total current assets | 1,100,532 | 1,769,943 |\n| Cash and investments held in trust account | 104,710,586 | 104,535,351 |\n| TOTAL ASSETS | $ | 105,811,118 | $ | 106,305,294 |\n| LIABILITIES, TEMPORARY EQUITY AND SHAREHOLDERS’ DEFICIT |\n| Current liabilities: |\n| Accrued liabilities | $ | 97,106 | $ | 475,948 |\n| Advances from a related party | 118,267 | 10,253 |\n| Total current liabilities | 215,373 | 486,201 |\n| Deferred underwriting compensation | 2,587,500 | 2,587,500 |\n| TOTAL LIABILITIES | 2,802,873 | 3,073,701 |\n| Commitments and contingencies |\n| Common stock, subject to possible redemption: 10,350,000 shares (at redemption value of $ 10.12 and $ 10.10 per share) | 104,710,586 | 104,535,000 |\n| Shareholders’ deficit: |\n| Common stock, $ 0.0001 par value; 26,000,000 shares authorized; 2,637,500 shares issued and outstanding (excluding 10,350,000 shares subject to possible redemption) | 264 | 264 |\n| Accumulated other comprehensive income | 158,483 | - |\n| Accumulated deficit | ( 1,861,088 | ) | ( 1,303,671 | ) |\n| Total shareholders’ deficit | ( 1,702,341 | ) | ( 1,303,407 | ) |\n| TOTAL LIABILITIES, TEMPORARY EQUITY AND SHAREHOLDERS’ DEFICIT | $ | 105,811,118 | $ | 106,305,294 |\n\nSee accompanying notes to unaudited condensed financial statements.\n1\nINCEPTION GROWTH ACQUISITION LIMITED\nUNAUDITED CONDENSED STATEMENT OF OPERATIONS\n(Currency expressed in United States Dollars (“US$”), except for number of shares)\n\n| Three months ended June 30, 2022 | Three months ended June 30, 2021 | Six months ended June 30, 2022 | From March 4, 2021 (date of inception) to June 30, 2021 |\n| Formation, general and administrative expenses | $ | ( 170,157 | ) | $ | ( 52,524 | ) | $ | ( 398,583 | ) | $ | ( 52,524 | ) |\n| Other income: |\n| Dividend income | 6,225 | - | 16,752 | - |\n| Total other income, net | 6,225 | - | 16,752 | - |\n| Loss before income taxes | ( 163,932 | ) | ( 52,524 | ) | ( 381,831 | ) | ( 52,524 | ) |\n| Income taxes | - | - | - | - |\n| NET LOSS | $ | ( 163,932 | ) | $ | ( 52,524 | ) | $ | ( 381,831 | ) | $ | ( 52,524 | ) |\n| Other comprehensive income |\n| Unrealized gain on available-for-sale securities | 158,483 | - | 158,483 | - |\n| COMPREHENSIVE LOSS | $ | ( 5,449 | ) | $ | ( 52,524 | ) | $ | ( 223,348 | ) | $ | ( 52,524 | ) |\n| Basic and diluted weighted average shares outstanding, common stock subject to possible redemption | 10,035,000 | - | 10,035,000 | - |\n| Basic and diluted net loss per share, common stock subject to possible redemption | $ | ( 0.01 | ) | $ | - | $ | ( 0.03 | ) | $ | - |\n| Basic and diluted weighted average shares outstanding, common stock attributable to Inception Growth Acquisition Limited | 2,637,500 | 2,250,000 | 2,637,500 | $ | 2,250,000 |\n| Basic and diluted net loss per share, common stock attributable to Inception Growth Acquisition Limited | $ | ( 0.03 | ) | $ | ( 0.02 | ) | $ | ( 0.04 | ) | $ | ( 0.02 | ) |\n\nSee accompanying notes to unaudited condensed financial statements.\n2\nINCEPTION GROWTH ACQUISITION LIMITED\nUNAUDITED CONDENSED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY (DEFICIT)\n(Currency expressed in United States Dollars (“US$”), except for number of shares)\n\n| Ordinary shares | Accumulated other | Total |\n| No. of shares | Amount | comprehensive income | Accumulated deficit | shareholders’ deficit |\n| Balance as of January 1, 2022 | 2,637,500 | $ | 264 | $ | - | $ | ( 1,303,671 | ) | $ | ( 1,303,407 | ) |\n| Accretion of carrying value to redemption value | - | - | - | ( 10,878 | ) | ( 10,878 | ) |\n| Net loss | - | - | - | ( 217,899 | ) | ( 217,899 | ) |\n| Balance as of March 31, 2022 | 2,637,500 | 264 | - | ( 1,532,448 | ) | ( 1,532,184 | ) |\n| Accretion of carrying value to redemption value | - | - | - | ( 164,708 | ) | ( 164,708 | ) |\n| Unrealized gain on available-for-sale securities | - | - | 158,483 | - | 158,483 |\n| Net loss | - | - | - | ( 163,932 | ) | ( 163,932 | ) |\n| Balance as of June 30, 2022 | 2,637,500 | $ | 264 | $ | 158,483 | $ | ( 1,861,088 | ) | $ | ( 1,702,341 | ) |\n\n\n| Ordinary shares | Additional | Total |\n| No. of shares | Amount | paid-in capital | Accumulated deficit | shareholders’ deficit |\n| Balance as of March 4, 2021 (inception) | - | $ | - | $ | - | $ | - | $ | - |\n| Issuance of common stock to founders | 2,587,500 | 259 | 24,741 | - | 25,000 |\n| Balance as of March 31, 2021 | 2,587,500 | 259 | 24,741 | - | 25,000 |\n| Net loss | - | - | - | ( 52,524 | ) | ( 52,524 | ) |\n| Balance as of June 30, 2021 | 2,587,500 | $ | 259 | $ | 24,741 | $ | ( 52,524 | ) | $ | ( 27,524 | ) |\n\nSee accompanying notes to unaudited condensed financial statements.\n3\nINCEPTION GROWTH ACQUISITION LIMITED\nUNAUDITED CONDENSED STATEMENT OF CASH FLOWS\n(Currency expressed in United States Dollars (“US$”))\n\n| Six months ended June 30, 2022 | March 4, 2021 (date of inception) to June 30, 2021 |\n| Cash flows from operating activities |\n| Net loss | $ | ( 381,831 | ) | ( 52,524 | ) |\n| Adjustments to reconcile net loss to net cash used in operating activities |\n| Interest income and dividend income earned in cash and investments income held in trust account | ( 16,752 | ) | - |\n| Change in operating assets and liabilities: |\n| Decrease in prepayment | 91,679 | - |\n| Increase (decrease) in accrued liabilities | ( 378,842 | ) | - |\n| Net cash used in operating activities | ( 685,746 | ) | ( 52,524 | ) |\n| Cash flows from financing activities |\n| Proceed from issuance of common stock | - | 25,000 |\n| Advance from a related party | 108,014 | 27,524 |\n| Net cash provided by financing activities | 108,014 | 52,524 |\n| NET CHANGE IN CASH | ( 577,732 | ) | - |\n| Cash, beginning of period | 1,365,181 | - |\n| Cash, end of period | $ | 787,449 | $ | - |\n| SUPPLEMENTAL DISCLOSURE OF NON-CASH FINANCING ACTIVITIES: |\n| Accretion of carrying value to redemption value | $ | ( 175,586 | ) | $ | - |\n| Deferred offering costs paid by a related party | $ | - | $ | 190,000 |\n\nSee accompanying notes to unaudited condensed financial statements.\n4\nINCEPTION GROWTH ACQUISITION LIMITED\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\n(Currency expressed in United States Dollars (“US$”), except for number of shares)\nNOTE 1 – ORGANIZATION AND BUSINESS BACKGROUND\nInception Growth Acquisition Limited (the “Company”) is a newly organized blank check company incorporated on March 4, 2021, under the laws of the State of Delaware for the purpose of acquiring, engaging in a share exchange, share reconstruction and amalgamation, purchasing all or substantially all of the assets of, entering into contractual arrangements, or engaging in any other similar business combination with one or more businesses or entities (“Business Combination”).\nAlthough the Company is not limited to a particular industry or geographic region for purposes of consummating a Business Combination, the Company intends to focus on businesses that have a connection to the Asian market and shall not undertake an initial business combination with any entity with its principal business operations in China (including Hong Kong and Macau). The Company is an early stage and emerging growth company and, as such, the Company is subject to all of the risks associated with early stage and emerging growth companies. The Company has selected December 31 as its fiscal year end.\nAt June 30, 2022, the Company had not yet commenced any operations. All activities through December 13, 2021 relate to the Company’s formation and the initial public offering (the “Initial Public Offering”). Since the Initial Public Offering, the Company’s activity has been limited to the evaluation of business combination candidates. The Company will not generate any operating revenues until after the completion of a Business Combination, at the earliest. The Company will generate non-operating income in the form of interest income from the proceeds derived from the Initial Public Offering.\nFinancing\nThe registration statement for the Company’s Initial Public Offering became effective on December 8, 2021. On December 13, 2021, the Company consummated the Initial Public Offering of 10,350,000 ordinary units (the “Public Units”), which includes the full exercise by the underwriter of its over-allotment option in the amount of 1,350,000 Public Units, at $ 10.00 per Public Unit, generating gross proceeds of $ 103,500,000 which is described in Note 4.\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the sale of 4,721,250 Warrants (the “Private Warrants”) at a price of $ 1.00 per warrant in a private placement to Soul Venture Partners LLC (the “Sponsor”), generating gross proceeds of $ 4,721,250 , which is described in Note 5.\nTransaction costs amounted to $ 4,832,697 , consisting of $ 1,811,250 of underwriting fees, $ 2,587,500 of deferred underwriting fees and $ 433,947 of other offering costs. In addition, at December 13, 2021, cash of $ 1,498,937 were held outside of the Trust Account (as defined below) and is available for the payment of offering costs and for working capital purposes net with $ 104,535,000 transferred to the Trust Account on December 13, 2021.\nTrust Account\nFollowing the closing of the Initial Public Offering and exercise of the over-allotment option on December 13, 2021, the aggregate amount of 104,535,000 ($ 10.10 per Public Unit) held in Trust Account was invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, with a maturity of 185 days or less, or in any open-ended investment company that holds itself out as a money market fund meeting certain conditions of Rule 2a-7 of the Investment Company Act, as determined by the Company, until the earlier of: (i) the completion of a Business Combination and (ii) the distribution of the funds in the Trust Account to the Company’s stockholders, as described below, except that interest earned on the Trust Account can be released to the Company to pay its tax obligations.\nBusiness Combination\nThe Company’s management has broad discretion with respect to the specific application of the net proceeds of the Initial Public Offering and sale of the Private Warrants, although substantially all of the net proceeds are intended to be applied generally toward consummating a Business Combination. NASDAQ rules provide that the Business Combination must be with one or more target businesses that together have a fair market value equal to at least 80 % of the balance in the Trust Account (as defined below) (less any deferred underwriting commissions and taxes payable on interest earned) at the time of the signing of an agreement to enter into a Business Combination. The Company will only complete a Business Combination if the post-Business Combination company owns or acquires 50 % or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act of 1940, as amended (the “Investment Company Act”). There is no assurance that the Company will be able to successfully effect a Business Combination.\n5\nThe Company will provide its stockholders with the opportunity to redeem all or a portion of their Public Shares upon the completion of a Business Combination either (i) in connection with a stockholder meeting called to approve the Business Combination or (ii) by means of a tender offer. In connection with an Initial Business Combination, the Company may seek stockholder approval of a Business Combination at a meeting called for such purpose at which stockholders may seek to redeem their shares, regardless of whether they vote for or against a Business Combination. The Company will proceed with a Business Combination only if the Company has net tangible assets of at least $ 5,000,001 upon such consummation of a Business Combination and, if the Company seeks stockholder approval, a majority of the outstanding shares voted are voted in favor of the Business Combination.\nNotwithstanding the foregoing, if the Company seeks stockholder approval of a Business Combination and it does not conduct redemptions pursuant to the tender offer rules, the Company’s Amended and Restated Memorandum and Articles of Association provides that a public stockholder, together with any affiliate of such stockholder or any other person with whom such stockholder is acting in concert or as a “group” (as defined under Section 13 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), will be restricted from seeking redemption rights with respect to 15 % or more of the Public Shares without the Company’s prior written consent.\nIf a stockholder vote is not required and the Company does not decide to hold a stockholder vote for business or other legal reasons, the Company will, pursuant to its Amended and Restated Memorandum and Articles of Association, offer such redemption pursuant to the tender offer rules of the Securities and Exchange Commission (“SEC”), and file tender offer documents containing substantially the same information as would be included in a proxy statement with the SEC prior to completing a Business Combination.\nThe stockholders will be entitled to redeem their Public Shares for a pro rata portion of the amount then in the Trust Account (initially $ 10.10 per Public Share, subject to increase of up to an additional $ 0.30 per Public Share in the event that the Sponsor elects to extend the period of time to consummate a Business Combination (see below), plus any pro rata interest earned on the funds held in the Trust Account and not previously released to the Company to pay its tax obligations). The per-share amount to be distributed to stockholders who redeem their Public Shares will not be reduced by the deferred underwriting commissions the Company will pay to the underwriter (as discussed in Note 9). There will be no redemption rights upon the completion of a Business Combination with respect to the Company’s rights or warrants. The common stock will be recorded at redemption value and classified as temporary equity upon the completion of the Initial Public Offering, in accordance with Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity” (“ASC 480”).\nThe Company will proceed with a Business Combination if the Company has net tangible assets of at least $ 5,000,001 upon such consummation of a Business Combination and, if the Company seeks stockholder approval, a majority of the outstanding shares voted are voted in favor of the Business Combination. If a stockholder vote is not required and the Company does not decide to hold a stockholder vote for business or other legal reasons, the Company will, pursuant to its Amended and Restated Certificate of Incorporation, offer such redemption pursuant to the tender offer rules of the Securities and Exchange Commission (“SEC”), and file tender offer documents containing substantially the same information as would be included in a proxy statement with the SEC prior to completing a Business Combination.\nThe Sponsor and any of the Company’s officers or directors that may hold Founder Shares (as defined in Note 7) (the “stockholders”) and the underwriters will agree (a) to vote their Founder Shares, the common stock included in the Private Units (the “Private Shares”) and any Public Shares purchased during or after the Initial Public Offering in favor of a Business Combination, (b) not to propose an amendment to the Company’s Amended and Restated Memorandum and Articles of Association with respect to the Company’s pre-Business Combination activities prior to the consummation of a Business Combination unless the Company provides dissenting public stockholders with the opportunity to redeem their Public Shares in conjunction with any such amendment; (c) not to redeem any shares (including the Founder Shares) and Private Shares into the right to receive cash from the Trust Account in connection with a stockholder vote to approve a Business Combination (or to sell any shares in a tender offer in connection with a Business Combination if the Company does not seek stockholder approval in connection therewith) or a vote to amend the provisions of the Amended and Restated Memorandum and Articles of Association relating to stockholders’ rights of pre-Business Combination activity and (d) that the Founder Shares and Private Shares shall not participate in any liquidating distributions upon winding up if a Business Combination is not consummated. However, the stockholders will be entitled to liquidating distributions from the Trust Account with respect to any Public Shares purchased during or after the Initial Public Offering if the Company fails to complete its Business Combination.\n6\nThe Company will have until March 13, 2023 to consummate a Business Combination. However, if the Company anticipates that it may not be able to consummate a Business Combination within 15 months, the Company may extend the period of time to consummate a Business Combination up to two times, each by an additional three months each time (for a total of 21 months to complete a Business Combination (the “Combination Period”). In order to extend the time available for the Company to consummate a Business Combination, the Sponsor or its affiliate or designees must deposit into the Trust Account $ 1,035,000 (approximately $ 0.1 per Public Share), on or prior to the date of the applicable deadline, for each three months extension. Any funds which may be provided to extend the time frame will be in the form of a loan to us from the sponsor. The terms of any such loan have not been definitely negotiated, provided, however, any loan will be interest free and will be repayable only if we compete a business combination.\nLiquidation\nIf the Company is unable to complete a Business Combination within the Combination Period, the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but no more than ten business days thereafter, redeem 100% of the outstanding Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including interest earned (net of taxes payable and less interest to pay dissolution expenses up to $50,000), divided by the number of then outstanding Public Shares, which redemption will completely extinguish public stockholders’ rights as stockholders (including the right to receive further liquidation distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the remaining stockholders and the Company’s board of directors, proceed to commence a voluntary liquidation and thereby a formal dissolution of the Company, subject in each case to its obligations to provide for claims of creditors and the requirements of applicable law. The underwriter has agreed to waive its rights to the deferred underwriting commission held in the Trust Account in the event the Company does not complete a Business Combination within the Combination Period and, in such event, such amounts will be included with the funds held in the Trust Account that will be available to fund the redemption of the Public Shares. In the event of such distribution, it is possible that the per share value of the assets remaining available for distribution will be less than the Initial Public Offering price per Unit ($ 10.00 ).\nThe Sponsor has agreed that it will be liable to the Company, if and to the extent any claims by a vendor for services rendered or products sold to the Company, or a prospective target business with which the Company has discussed entering into a transaction agreement, reduce the amounts in the Trust Account to below (i) $ 10.10 per share or (ii) such lesser amount per Public Share held in the Trust Account as of the date of the liquidation of the Trust Account due to reductions in the value of the trust assets, except as to any claims by a third party who executed a waiver of any and all rights to seek access to the Trust Account and except as to any claims under the Company’s indemnity of the underwriters of the Initial Public Offering against certain liabilities, including liabilities under the Securities Act of 1933, as amended (the “Securities Act”). In the event that an executed waiver is deemed to be unenforceable against a third party, the Sponsor will not be responsible to the extent of any liability for such third-party claims. The Company will seek to reduce the possibility that the Sponsor will have to indemnify the Trust Account due to claims of creditors by endeavoring to have all vendors, service providers, prospective target businesses or other entities with which the Company does business, execute agreements with the Company waiving any right, title, interest or claim of any kind in or to monies held in the Trust Account.\nLiquidity and capital resources\nFollowing the closing of the Initial Public Offering on December 13, 2021, a total of $ 103,500,000 was placed in the Trust Account, and the Company had $ 1,498,937 of cash held outside of the Trust Account, after payment of costs related to the Initial Public Offering, and available for working capital purposes. As of June 30, 2022, the Company had a working capital equity of $ 885,159 . The Company has incurred and expects to continue to incur significant costs in pursuit of its acquisition plans. Based on the foregoing, the Company believes it will have sufficient cash to meet its needs to execute its intended initial Business Combination in the next twelve months from the date of the issuance of the accompanying unaudited condensed consolidated financial statements.\nIf the Company is unable to raise additional capital, it may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, and reducing overhead expenses. The Company cannot provide any assurance that new financing will be available to it on commercially acceptable terms, if at all. These conditions raise substantial doubt about the Company’s ability to continue as a going concern through one year from the date of these unaudited condensed consolidated financial statements if a Business Combination is not consummated. These unaudited condensed consolidated financial statements do not include any adjustments relating to the recovery of the recorded assets or the classification of the liabilities that might be necessary should the Company be unable to continue as a going concern.\nNOTE 2 – SIGNIFICANT ACCOUNTING POLICIES\n\n| ● | Basis of presentation |\n\nThese accompanying unaudited condensed financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”) and pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). The interim financial information provided is unaudited, but includes all adjustments which management considers necessary for the fair presentation of the results for these periods. Operating results for the interim period ended June 30, 2022 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2022. The information included in this Form 10-Q should be read in conjunction with Management’s Discussion and Analysis, and the audited financial statements and notes thereto included in the Company’s Form 10-K for the fiscal year ended December 31, 2021, filed with the SEC on March 31, 2022.\n7\n\n| ● | Emerging growth company |\n\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the independent registered public accounting firm attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\n\n| ● | Use of estimates |\n\nIn preparing these unaudited condensed financial statements in conformity with U.S. GAAP, management makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited condensed financial statements and the reported expenses during the reporting period.\nMaking estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the unaudited condensed financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. Accordingly, Actual results may differ from these estimates.\n\n| ● | Cash |\n\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did not have any cash equivalents as of June 30, 2022 and December 31, 2021.\n\n| ● | Cash and investment held in trust account |\n\nAt June 30, 2022, the assets held in the Trust Account are held in cash and US Treasury securities. Investment securities in the Company’s Trust Account consisted of $ 104,699,165 in United States Treasury Bills and $ 11,421 in cash. At December 31, 2021, investment securities in the Company’s Trust Account consisted of $ 104,535,263 in United States Treasury Bills and $ 88 in cash.\nThe Company classifies marketable securities as available-for-sale at the time of purchase and reevaluates such classification as of each balance sheet date. All marketable securities are recorded at their estimated fair value. Unrealized gains and losses for available-for-sale securities are recorded in other comprehensive income. The Company evaluates its investments to assess whether those with unrealized loss positions are other than temporarily impaired. Impairments are considered other than temporary if they are related to deterioration in credit risk or if it is likely the Company will sell the securities before the recovery of the cost basis. Realized gains and losses and declines in value determined to be other than temporary are determined based on the specific identification method and are reported in other income (expense), net in the statements of operations.\n8\n\n| ● | Deferred offering costs |\n\nDeferred offering costs consist of underwriting, legal, accounting and other expenses incurred through the balance sheet date that are directly related to the Initial public Offering and that were charged to shareholders’ equity upon the completion of the Initial Public Offering.\n\n| ● | Warrant accounting |\n\nThe Company accounts for warrants as either equity-classified or liability-classified instruments based on an assessment of the warrant’s specific terms and applicable authoritative guidance in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 480, “Distinguishing Liabilities from Equity” (“ASC 480”) and ASC 815, “Derivatives and Hedging” (“ASC 815”). The assessment considers whether the warrants are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and whether the warrants meet all of the requirements for equity classification under ASC 815, including whether the warrants are indexed to the Company’s own common stock and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of the Company’s control, among other conditions for equity classification. This assessment, which requires the use of professional judgment, is conducted at the time of warrant issuance and as of each subsequent quarterly period end date while the warrants are outstanding.\nFor issued or modified warrants that meet all of the criteria for equity classification, the warrants are required to be recorded as a component of equity at the time of issuance. For issued or modified warrants that do not meet all the criteria for equity classification, the warrants are required to be recorded as liabilities at their initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of the warrants are recognized as a non-cash gain or loss on the statements of operations.\nAs the warrants issued upon the IPO and private placements meet the criteria for equity classification under ASC 480, therefore, the warrants are classified as equity.\n\n| ● | Common stock subject to possible redemption |\n\nThe Company accounts for its common stock subject to possible redemption in accordance with the guidance in ASC Topic 480. Common stocks subject to mandatory redemption (if any) are classified as a liability instrument and are measured at fair value. Conditionally redeemable common stocks (including common stocks that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) are classified as temporary equity. At all other times, common stocks are classified as shareholders’ equity. The Company’s common stocks feature certain redemption rights that are subject to the occurrence of uncertain future events and considered to be outside of the Company’s control. Accordingly, at June 30, 2022 and December 31, 2021, 10,350,000 shares of common stock subject to possible redemption, respectively, are presented as temporary equity, outside of the shareholders’ equity section of the Company’s balance sheet.\n\n| ● | Offering costs |\n\nThe Company complies with the requirements of the ASC 340-10-S99-1 and SEC Staff Accounting Bulletin (“SAB”) Topic 5A – “Expenses of Offering”. Offering costs consist principally of professional and registration fees incurred through the balance sheet date that are related to the Public Offering and that were charged to shareholders’ equity upon the completion of the Public Offering.\n\n| ● | Fair value of financial instruments |\n\nASC Topic 820 “Fair Value Measurements and Disclosures” (“ASC 820”) defines fair value, the methods used to measure fair value and the expanded disclosures about fair value measurements. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between the buyer and the seller at the measurement date. In determining fair value, the valuation techniques consistent with the market approach, income approach and cost approach shall be used to measure fair value. ASC 820 establishes a fair value hierarchy for inputs, which represents the assumptions used by the buyer and seller in pricing the asset or liability. These inputs are further defined as observable and unobservable inputs. Observable inputs are those that buyer and seller would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs reflect the Company’s assumptions about the inputs that the buyer and seller would use in pricing the asset or liability developed based on the best information available in the circumstances.\n9\nThe fair value hierarchy is categorized into three levels based on the inputs as follows:\nLevel 1 — Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access. Valuation adjustments and block discounts are not being applied. Since valuations are based on quoted prices that are readily and regularly available in an active market, the valuation of these securities does not entail a significant degree of judgment.\nLevel 2 — Valuations based on (i) quoted prices in active markets for similar assets and liabilities, (ii) quoted prices in markets that are not active for identical or similar assets, (iii) inputs other than quoted prices for the assets or liabilities, or (iv) inputs that are derived principally from or corroborated by the market through correlation or other means.\nLevel 3 — Valuations based on inputs that are unobservable and significant to the overall fair value measurement.\nThe fair value of the Company’s certain assets and liabilities, which qualify as financial instruments under ASC 820, “Fair Value Measurements and Disclosures,” approximates the carrying amounts represented in the balance sheet. The fair values of cash and cash equivalents, and other current assets, accrued expenses, due to the sponsor are estimated to approximate the carrying values as of June 30, 2022 due to the short maturities of such instruments. See Note 8 for the disclosure of the Company’s assets and liabilities that were measured at fair value on a recurring basis.\n\n| ● | Income taxes |\n\nThe Company complies with the accounting and reporting requirements of ASC Topic 740, “Income Taxes” (“ASC 740), which requires an asset and liability approach to financial accounting and reporting for income taxes. Deferred income tax assets and liabilities are computed for differences between the financial statement and tax bases of assets and liabilities that will result in future taxable or deductible amounts, based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.\nASC 740 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of June 30, 2022 and December 31, 2021. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position.\nThe Company may be subject to potential examination by federal, state and city taxing authorities in the areas of income taxes. These potential examinations may include questioning the timing and amount of deductions, the nexus of income among various tax jurisdictions and compliance with federal, state and city tax laws. The Company’s management does not expect that the total amount of unrecognized tax benefits will materially change over the next twelve months.\nThe provision for annual franchise taxes, based on the number of shares of our common stock authorized and outstanding after the completion of the IPO for the six months ended June 30, 2022 and 2021 were $ 48,535 and $ 0 , respectively.\nThe provision for income taxes was deemed to be immaterial for the six months ended June 30, 2022 and 2021.\n10\n\n| ● | Net loss per share |\n\nThe Company calculates net loss per share in accordance with ASC Topic 260, “Earnings per Share.” In order to determine the net income (loss) attributable to both the redeemable shares and non-redeemable shares, the Company first considered the undistributed income (loss) allocable to both the redeemable common stock and non-redeemable common stock and the undistributed income (loss) is calculated using the total net loss less any dividends paid. The Company then allocated the undistributed income (loss) ratably based on the weighted average number of shares outstanding between the redeemable and non-redeemable common stock. Any remeasurement of the accretion to the redemption value of the common stock subject to possible redemption was considered to be dividends paid to the public stockholders. As of June 30, 2022, the Company has not considered the effect of the warrants sold in the Initial Public Offering and private warrants to purchase an aggregate of 9,896,250 shares in the calculation of diluted net loss per share, since the exercise of the warrants is contingent upon the occurrence of future events and the inclusion of such warrants would be anti-dilutive and the Company did not have any other dilutive securities and other contracts that could, potentially, be exercised or converted into common stock and then share in the earnings of the Company. As a result, diluted loss per share is the same as basic loss per share for the period presented.\nThe net income (loss) per share presented in the statement of operations is based on the following:\n\n| For the Three Months Ended | For the Three Months Ended |\n| June 30, 2022 | June 30, 2021 |\n| Net loss | $ | ( 163,932 | ) | $ | ( 52,524 | ) |\n| Accretion of carrying value to redemption value | ( 164,708 | ) | - |\n| Net loss including accretion of carrying value to redemption value | $ | ( 328,640 | ) | $ | ( 52,524 | ) |\n\n\n| For the Six Months Ended | From March 4, 2021 (date of inception) to |\n| June 30, 2022 | June 30, 2021 |\n| Net loss | $ | ( 381,831 | ) | $ | ( 52,524 | ) |\n| Accretion of carrying value to redemption value | ( 175,586 | ) | - |\n| Net loss including accretion of carrying value to redemption value | $ | ( 557,417 | ) | $ | ( 52,524 | ) |\n\n\n| For the six months ended June 30, 2022 | For the six months ended June 30, 2021 |\n| Redeemable ordinary shares | Non- Redeemable ordinary shares | Redeemable ordinary shares | Non-Redeemable ordinary shares |\n| Basic and diluted net loss per share: |\n| Numerators: |\n| Allocation of net loss including carrying value to redemption value | $ | ( 444,217 | ) | $ | ( 113,200 | ) | $ | - | $ | ( 52,524 | ) |\n| Accretion of carrying value to redemption value | 175,586 | - | - | - |\n| Allocation of net loss | $ | ( 268,631 | ) | $ | ( 113,200 | ) | $ | - | $ | ( 52,524 | ) |\n| Denominators: |\n| Weighted-average shares outstanding | 10,350,000 | 2,637,500 | - | 2,250,000 |\n| Basic and diluted net loss per share | $ | ( 0.03 | ) | $ | ( 0.04 | ) | $ | - | $ | ( 0.00 | ) |\n\n11\n\n| For the three months ended June 30, 2022 | For the three months ended June 30, 2021 |\n| Redeemable ordinary shares | Non- Redeemable ordinary shares | Redeemable ordinary shares | Non-Redeemable ordinary shares |\n| Basic and diluted net loss per share: |\n| Numerators: |\n| Allocation of net loss including carrying value to redemption value | $ | ( 261,900 | ) | $ | ( 66,740 | ) | $ | - | $ | ( 52,524 | ) |\n| Accretion of carrying value to redemption value | 164,708 | - | - | - |\n| Allocation of net loss | $ | ( 97,192 | ) | $ | ( 66,740 | ) | $ | - | $ | ( 52,524 | ) |\n| Denominators: |\n| Weighted-average shares outstanding | 10,350,000 | 2,637,500 | - | 2,250,000 |\n| Basic and diluted net loss per share | $ | ( 0.01 | ) | $ | ( 0.03 | ) | $ | - | $ | ( 0.00 | ) |\n\n\n| ● | Related parties |\n\nParties, which can be a corporation or individual, are considered to be related if the Company has the ability, directly or indirectly, to control the other party or exercise significant influence over the other party in making financial and operational decisions. Companies are also considered to be related if they are subject to common control or common significant influence.\n\n| ● | Concentration of credit risk |\n\nFinancial instruments that potentially subject the Company to concentration of credit risk consist of a cash account in a financial institution. The Company has not experienced losses on this account and management believes the Company is not exposed to significant risks on such account.\n\n| ● | Recent accounting pronouncements |\n\nThe Company has considered all new accounting pronouncements and has concluded that there are no new pronouncements that may have a material impact on the results of operations, financial condition, or cash flows, based on the current information.\nNOTE 3 – CASH AND INVESTMENT HELD IN TRUST ACCOUNT\nAs of June 30, 2022, investment securities in the Company’s Trust Account consisted of $ 104,699,165 in United States Treasury Bills and $ 11,421 in cash. The Company classifies its United States Treasury securities as available-for-sale. Available-for-sale marketable securities are recorded at their estimated fair value on the accompanying June 30, 2022 balance sheet. The carrying value, including gross unrealized holding gain as other comprehensive income and fair value of held to marketable securities on June 30, 2022 and December 31, 2021 is as follows:\n\n| Carrying Value as of June 30, 2022 (Unaudited) | Gross Unrealized Holding Gain | Fair Value as of June 30, 2022 (Unaudited) |\n| Available-for-sale marketable securities: |\n| U.S. Treasury Securities | $ | 104,540,682 | $ | 158,483 | $ | 104,699,165 |\n\n\n| Carrying Value as of December 31, 2021 (Audited) | Gross Unrealized Holding Gain | Fair Value as of December 31, 2021 |\n| Available-for-sale marketable securities: |\n| U.S. Treasury Securities | $ | 104,535,263 | $ | - | $ | 104,535,263 |\n\n12\nNOTE 4 – INITIAL PUBLIC OFFERING\nPursuant to the Initial Public Offering, the Company sold 9,000,000 Units, which includes a full exercise by the underwriters of their over-allotment option in the amount of 1,350,000 Public Units, at a purchase price of $ 10.00 per Unit. Each Unit consists of one share of common stock, one-half (1/2) of one redeemable warrant (“Public Warrant”) and one right (“Public Right”) to receive one-tenth (1/10) of one share of common stock. Each Public Warrant will entitle the holder to purchase one share of common stock at an exercise price of $ 11.50 per whole share.\nAll of the 10,350,000 (including over-allotment shares) Public Shares sold as part of the Public Units in the IPO contain a redemption feature which allows for the redemption of such Public Shares if there is a stockholder vote or tender offer in connection with the Business Combination and in connection with certain amendments to the Company’s amended and restated certificate of incorporation, or in connection with the Company’s liquidation. In accordance with the SEC and its staff’s guidance on redeemable equity instruments, which has been codified in ASC 480-10-S99, redemption provisions not solely within the control of the Company require common stocks subject to redemption to be classified outside of permanent equity.\nThe Company’s redeemable common stock is subject to SEC and its staff’s guidance on redeemable equity instruments, which has been codified in ASC 480-10-S99. If it is probable that the equity instrument will become redeemable, the Company has the option to either accrete changes in the redemption value over the period from the date of issuance (or from the date that it becomes probable that the instrument will become redeemable, if later) to the earliest redemption date of the instrument or to recognize changes in the redemption value immediately as they occur and adjust the carrying amount of the instrument to equal the redemption value at the end of each reporting period. The Company has elected to recognize the changes immediately. The accretion or remeasurement is treated as a deemed dividend (i.e., a reduction to retained earnings, or in absence of retained earnings, additional paid-in capital).\nAs of June 30, 2022 and December 31, 2021, the shares of common stock reflected on the balance sheet are reconciled in the following table.\n\n| June 30, | December 31, |\n| 2022 | 2021 |\n| Gross proceeds | $ | 103,500,000 | $ | 103,500,000 |\n| Less: |\n| Proceeds allocated Public Warrants | ( 2,572,990 | ) | ( 2,572,990 | ) |\n| Proceeds allocated Public Rights | ( 7,418,984 | ) | ( 7,418,984 | ) |\n| Offering costs of Public Shares | ( 2,511,906 | ) | ( 2,511,906 | ) |\n| Plus: |\n| Accretion of carrying value to redemption value - 2021 | 13,538,880 | 13,538,880 |\n| Accretion of carrying value to redemption value - 2022 | 175,586 | - |\n| Common stock subject to possible redemption | $ | 104,710,586 | $ | 104,535,000 |\n\nNOTE 5 – PRIVATE PLACEMENT\nSimultaneously with the closing of the Initial Public Offering, the Sponsor and the underwriters purchased an aggregate of 4,721,250 Warrants at a price of $ 1.00 per Warrant, ($ 4,721,250 in the aggregate), in each case, in a private warrant that will occur simultaneously with the closing of the Initial Public Offering (the “Private Warrants”). Each Private Warrant is exercisable to purchase one share of common stock at a price of $ 11.50 per whole share. The Private Warrants may only be exercised for a whole number of shares. The proceeds from the sale of the Private Placement Warrants will be added to the net proceeds from the Initial Public Offering held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the proceeds from the sale of the Private Warrants will be used to fund the redemption of the Public Shares (subject to the requirements of applicable law) and the Private Warrants will expire worthless.\n13\nNOTE 6 – RELATED PARTY TRANSACTIONS\nFounder Shares\nOn March 4, 2021, the Company issued an aggregate of 2,587,500 founder shares to the initial shareholder for an aggregate purchase price of $ 25,000 .\nOn December 13, 2021, the Company issued an aggregate of 50,000 representative shares to the underwriter.\nAs of June 30, 2022 and December 31, 2021, 2,637,500 shares of common stock were issued and outstanding, excluding 10,350,000 shares of common stock are subject to possible conversion.\nAdvance from a Related Party\nOn April 1, 2021, the Company issued an unsecured promissory note to the Sponsor, pursuant to which the Company may borrow up to an aggregate principal amount of $ 1,000,000 (the “Promissory Note”). The Promissory Note is non-interest bearing and payable on the earlier of (i) April 30, 2021 or (ii) the date on which the Company determines not to conduct an initial public offering. As of December 13, 2021, the Company drew $ 134,885 against the promissory note and the entire balance was repaid on December 16, 2021.\nAs of June 30, 2022 and December 31, 2021, the Company had a temporary advance of $ 118,267 and $ 10,253 from the Sponsor, respectively. The balance is unsecured, interest-free and has no fixed terms of repayment.\nAdministrative Services Agreement\nThe Company is obligated, commencing from March 4, 2021, to pay Soul Venture Partners LLC a monthly fee of $ 10,000 for general and administrative services. This agreement will terminate upon completion of the Company’s Business Combination or the liquidation of the trust account to public shareholders.\nNOTE 7 – SHAREHOLDER’S EQUITY\nCommon stocks\nThe Company is authorized to issue 26,000,000 shares of common stock at par value $ 0.0001 . Holders of the Company’s common stocks are entitled to one vote for each share. As of June 30, 2022 and December 31, 2021, 2,637,500 shares of common stocks were issued and outstanding, excluding 10,350,000 shares of common stock subject to possible redemption.\nRights\nEach holder of a right will receive one-tenth (1/10) of one share of common stock upon consummation of a Business Combination, even if the holder of such right redeemed all shares held by it in connection with a Business Combination. No fractional shares will be issued upon exchange of the rights. No additional consideration will be required to be paid by a holder of rights in order to receive its additional shares upon consummation of a Business Combination as the consideration related thereto has been included in the Unit purchase price paid for by investors in the Initial Public Offering. If the Company enters into a definitive agreement for a Business Combination in which the Company will not be the surviving entity, the definitive agreement will provide for the holders of rights to receive the same per share consideration the holders of the common stock will receive in the transaction on an as-converted into common stock basis and each holder of a right will be required to affirmatively convert its rights in order to receive 1/10 share underlying each right (without paying additional consideration). The shares issuable upon exchange of the rights will be freely tradable (except to the extent held by affiliates of the Company).\nIf the Company is unable to complete a Business Combination within the Combination Period and the Company liquidates the funds held in the Trust Account, holders of rights will not receive any of such funds with respect to their rights, nor will they receive any distribution from the Company’s assets held outside of the Trust Account with respect to such rights, and the rights will expire worthless. Further, there are no contractual penalties for failure to deliver securities to the holders of the rights upon consummation of a Business Combination. Additionally, in no event will the Company be required to net cash settle the rights. Accordingly, the rights may expire worthless.\n14\nWarrants\nThe Public Warrants will become exercisable on the later of (a) the completion of a Business Combination or (b) 15 months (or up to 21 months, if we extend the time to complete a business combination) from the closing of this Initial Public Offering. No Public Warrants will be exercisable for cash unless the Company has an effective and current registration statement covering the common stock issuable upon exercise of the Public Warrants and a current prospectus relating to such common stock. Notwithstanding the foregoing, if a registration statement covering the common stock issuable upon the exercise of the Public Warrants is not effective within 52 business days from the consummation of a Business Combination, the holders may, until such time as there is an effective registration statement and during any period when the Company shall have failed to maintain an effective registration statement, exercise the Public Warrants on a cashless basis pursuant to the exemption from registration provided by Section 3(a)(9) of the Securities Act provided that such exemption is available. If an exemption from registration is not available, holders will not be able to exercise their Public Warrants on a cashless basis. The Public Warrants will expire five years after the completion of the Business Combination, at 5:00 p.m., New York City time, or earlier upon redemption or liquidation.\nThe Company may call the warrants for redemption (excluding the Private Warrants), in whole and not in part, at a price of $0.01 per warrant:\n\n| ● | at any time while the Public Warrants are exercisable, |\n\n\n| ● | upon not less than 30 days’ prior written notice of redemption to each Public Warrant holder, |\n\n\n| ● | if, and only if, the reported last sale price of the ordinary shares equals or exceeds $18 per share, for any 30 trading days within a 30 trading day period ending on the third trading day prior to the notice of redemption to Public Warrant holders, and |\n\n\n| ● | if, and only if, there is a current registration statement in effect with respect to the issuance of the ordinary shares underlying such warrants at the time of redemption and for the entire 30-day trading period referred to above and continuing each day thereafter until the date of redemption. |\n\nThe Private Warrants will be identical to the Public Warrants underlying the Units being sold in the Proposed Public Offering, except that the Private Warrants and the common stock issuable upon the exercise of the Private Warrants will not be transferable, assignable or salable until after the completion of a Business Combination, subject to certain limited exceptions. Additionally, the Private Warrants will be exercisable on a cashless basis and will be non-redeemable so long as they are held by the initial purchasers or their permitted transferees. If the Private Warrants are held by someone other than the initial purchasers or their permitted transferees, the Private Warrants will be redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants.\nIf the Company calls the Public Warrants for redemption, management will have the option to require all holders that wish to exercise the Public Warrants to do so on a “cashless basis,” as described in the warrant agreement. The exercise price and number of common stock issuable upon exercise of the warrants may be adjusted in certain circumstances including in the event of a share dividend, extraordinary dividend or recapitalization, reorganization, merger or consolidation. However, the warrants will not be adjusted for issuances of common stock at a price below its exercise price. Additionally, in no event will the Company be required to net cash settle the warrants. If the Company is unable to complete a Business Combination within the Combination Period and the Company liquidates the funds held in the Trust Account, holders of warrants will not receive any of such funds with respect to their warrants, nor will they receive any distribution from the Company’s assets held outside of the Trust Account with respect to such warrants. Accordingly, the warrants may expire worthless.\n15\nNOTE 8 – FAIR VALUE MEASUREMENTS\nThe fair value of the Company’s financial assets and liabilities reflects management’s estimate of amounts that the Company would have received in connection with the sale of the assets or paid in connection with the transfer of the liabilities in an orderly transaction between market participants at the measurement date. In connection with measuring the fair value of its assets and liabilities, the Company seeks to maximize the use of observable inputs (market data obtained from independent sources) and to minimize the use of unobservable inputs (internal assumptions about how market participants would price assets and liabilities). The following fair value hierarchy is used to classify assets and liabilities based on the observable inputs and unobservable inputs used in order to value the assets and liabilities:\nLevel 1: Quoted prices in active markets for identical assets or liabilities. An active market for an asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis.\nLevel 2: Observable inputs other than Level 1 inputs. Examples of Level 2 inputs include quoted prices in active markets for similar assets or liabilities and quoted prices for identical assets or liabilities in markets that are not active.\nLevel 3: Unobservable inputs based on the assessment of the assumptions that market participants would use in pricing the asset or liability.\nThe following table presents information about the Company’s assets and liabilities that were measured at fair value on a recurring basis as of June 30, 2022 and December 31, 2021, and indicates the fair value hierarchy of the valuation techniques the Company utilized to determine such fair value.\n\n| June 30, 2022 | Quoted Prices In Active Markets | Significant Other Observable Inputs | Significant Other Unobservable Inputs |\n| Description | (Unaudited) | (Level 1) | (Level 2) | (Level 3) |\n| Assets: |\n| U.S. Treasury Securities held in Trust Account* | $ | 104,699,165 | $ | 104,699,165 | $ | - | $ | - |\n\n\n| December 31, | Quoted Prices In Active Markets | Significant Other Observable Inputs | Significant Other Unobservable Inputs |\n| Description | 2021 | (Level 1) | (Level 2) | (Level 3) |\n| (Audited) |\n| Assets: |\n| U.S. Treasury Securities held in Trust Account* | $ | 104,535,263 | $ | 104,535,263 | $ | - | $ | - |\n\n\n| * | included in cash and investments held in trust account on the Company’s balance sheets. |\n\nNOTE 9 – COMMITMENTS AND CONTINGENCIES\nRisks and Uncertainties\nManagement is currently evaluating the impact of the COVID-19 pandemic on the industry and has concluded that while it is reasonably possible that the virus could have a negative effect on the Company’s financial position, results of its operations and/or search for a target company, the specific impact is not readily determinable as of the date of these unaudited condensed financial statements. The unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty.\n16\nRegistration Rights\nPursuant to a registration rights agreement entered into on December 13, 2021 the holders of the Founder Shares, Private Warrants (and their underlying securities) and any securities of the Company’s initial stockholders, officers, directors or their affiliates may be issued in payment of working capital loans made to us, will be entitled to registration rights pursuant to an agreement to be signed prior to or on the effective date of this Proposed Public Offering. The holders of the majority of the founder shares can elect to exercise these registration rights at any time commencing three months prior to the date on which these shares of common stock are to be released from escrow. The holders of a majority of the Private Warrants (and underlying securities) and securities issued in payment of working capital loans (or underlying securities) or loans to extend the life can elect to exercise these registration rights at any time after the Company consummates a Business Combination. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the consummation of a Business Combination. The Company will bear the expenses incurred in connection with the filing of any such registration statements.\nUnderwriter Agreement\nThe underwriter is entitled to a cash underwriting discount of 1.75% of the gross proceeds of the Proposed Public Offering, or $1,811,250 until the closing of the Business Combination. In addition, the underwriter will be entitled to a deferred fee ranged between $1,000,000 and $2,250,000. The deferred fee should equal to the greater of 1) $1,000,000; and 2) 2.5% of the cash remaining in the Trust Fund with a maximum amount of $2,250,000. The deferred fee can be paid in cash.\nNOTE 10 – SUBSEQUENT EVENTS\nIn accordance with ASC Topic 855, “Subsequent Events”, which establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before this unaudited condensed financial statements are issued, the Company has evaluated all events or transactions that occurred after the balance sheet date, up through August 12, 2022 was the Company issued the unaudited condensed financial statements. During the period, the Company did not have any material subsequent events other than disclosed above.\n17\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nReferences in this report (the “Quarterly Report”) to “we,” “us” or the “Company” refer to Inception Growth Acquisition Limited. References to our “management” or our “management team” refer to our officers and directors, references to the “Sponsor” refer to Soul Venture Partners LLC. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Quarterly Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\nSpecial Note Regarding Forward-Looking Statements\nThis Quarterly Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Exchange Act that are not historical facts, and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. All statements, other than statements of historical fact included in this Form 10-Q including, without limitation, statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. Words such as “expect,” “believe,” “anticipate,” “intend,” “estimate,” “seek” and variations and similar words and expressions are intended to identify such forward-looking statements. Such forward-looking statements relate to future events or future performance, but reflect management’s current beliefs, based on information currently available. A number of factors could cause actual events, performance or results to differ materially from the events, performance and results discussed in the forward-looking statements. For information identifying important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements, please refer to the Risk Factors section of the Company’s registration statement on Form S-1 filed with the U.S. Securities and Exchange Commission (the “SEC”). The Company’s securities filings can be accessed on the EDGAR section of the SEC’s website at sec.report. Except as expressly required by applicable securities law, the Company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.\nOverview\nWe are a blank check company incorporated as a Delaware corporation on March 4, 2021 and formed for the purpose of entering into a merger, share exchange, asset acquisition, share purchase, recapitalization, reorganization or similar business combination with one or more businesses or entities. We intend to effectuate our initial business combination using cash from the proceeds of the initial public offering and the sale of the Private Warrants, our capital stock, debt or a combination of cash, stock and debt.\nWe presently have no revenue, have had losses since inception from incurring formation costs and have had no operations other than the active solicitation of a target business with which to complete a business combination. We have relied upon the sale of our securities and loans from our officers and directors to fund our operations.\nOn December 13, 2021, we consummated our initial public offering (“IPO”) of 9,000,000 units (the “Units”), each Unit consisting of one share of common stock of the Company, par value $0.0001 per share (the “Common Stock”), one-half of one redeemable warrant (the “Warrant”), each whole Warrant entitling the holder thereof to purchase one share of Common Stock for $11.50 per share, and one right (the “Right”) to receive one-tenth (1/10) of a share of Common Stock upon consummation of an initial business combination. The Units were sold at a price of $10.00 per Unit, generating aggregate gross proceeds to the Company of $90,000,000. On December 9, 2021, the underwriters of the IPO fully exercised their over-allotment option, and the closing and sale of an additional 1,350,000 Units (the “Over-Allotment Units”) occurred on December 13, 2021. The issuance by the Company of the Over-Allotment Units at a price of $10.00 per Unit resulted in total gross proceeds of $13,500,000.\nSimultaneously with the closing of the IPO and the sale of the over-allotment units on December 13, 2021, the Company consummated the private placement (“Private Placement”) with the Sponsor of 4,721,250 warrants (the “Private Warrants”) at a price of $1.00 per Private Warrant, generating total proceeds of $4,721,250. These securities (other than our IPO securities) were issued pursuant to an exemption from registration under the Securities Act of 1933, as amended pursuant to Section 4(2) of the securities Act.\n18\nThe Private Warrants are identical to the warrants sold in the IPO except that the Private Warrants will be non-redeemable and the shares of common stock issuable upon exercise thereof are entitled to registration rights pursuant to the Registration Rights Agreement, in each case so long as they continue to be held by the Sponsor or their permitted transferees. Additionally, our Sponsor has agreed not to transfer, assign, or sell any of the Private Warrants or underlying securities (except in limited circumstances, as described in the Registration Statement) until 30 days after the Company completes its initial business combination.\nOur management has broad discretion with respect to the specific application of the net proceeds of the initial business combination and the Private Placement, although substantially all of the net proceeds are intended to be applied generally towards consummating a business combination.\nResults of Operations\nOur entire activity from inception up to December 13, 2021 was in preparation for the initial public offering. Since the initial public offering, our activity has been limited to the evaluation of business combination candidates, and we will not be generating any operating revenues until the closing and completion of our initial business combination. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. We expect our expenses to increase substantially after this period.\nFor the three and six months ended June 30, 2022 we had a net loss of $163,932 and $381,831, respectively, which was comprised of general and administrative expenses, dividend income and interest income.\nFor the three and six months ended June 30, 2021 we had a net loss of $52,524 and $52,524, respectively, which was comprised of general and administrative expenses.\nFor the six months ended June 30, 2022, cash used in operating activities was $685,746, consisting primarily of a net loss of $381,831 and changes in our operating assets and liabilities used cash of $287,163.\nFor the six months ended June 30, 2021, cash used in operating activities was $52,524, consisting primarily of a net loss of $52,524.\nLiquidity and Capital Resources\nAs of June 30, 2022, we had cash of $787,449. Until the consummation of the initial public offering, the only source of liquidity was an initial purchase of common stock by our Sponsor, monies loaned by the Sponsor under a certain unsecured promissory note and advances from our Sponsor.\nOn December 13, 2021, we consummated the Initial Public Offering of 10,350,000 units (the “Public Units”), which includes the full exercise by the underwriter of its over-allotment option in the amount of 1,350,000 Public Units, at $10.00 per Public Unit, generating gross proceeds of $103,500,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of 4,721,250 Warrants (the “Private Warrants”) at a price of $1.00 per warrant in a private placement to Soul Venture Partners LLC (the “Sponsor”), generating gross proceeds of $4,721,250.\nTransaction costs amounted to $4,832,697, consisting of $1,811,250 of underwriting fees, $2,587,500 of deferred underwriting fees and $433,947 of other offering costs. In addition, at December 13, 2021, cash of $1,498,937 were held outside of the Trust Account and is available for the payment of offering costs and for working capital purposes net with $104,535,000 transferred to the Trust Account on December 13, 2021.\n19\nWe intend to use substantially all of the funds held in the trust account, including any amounts representing interest earned on the trust account to complete our initial business combination (less deferred underwriting commissions). We may withdraw interest to pay taxes. We estimate our annual franchise tax obligations, based on the number of shares of our common stock authorized and outstanding after the completion of this offering, to be $200,000, which is the maximum amount of annual franchise taxes payable by us as a Delaware corporation per annum, which we may pay from funds from this offering held outside of the trust account or from interest earned on the funds held in our trust account and released to us for this purpose. Our annual income tax obligations will depend on the amount of interest and other income earned on the amounts held in the trust account. We expect the interest earned on the amount in the trust account will be sufficient to pay our income and franchise taxes. To the extent that our capital stock or debt is used, in whole or in part, as consideration to complete our initial business combination, the remaining proceeds held in the trust account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies.\nPrior to the completion of our initial business combination, we will have available to us the approximately $1,100,000 (the amount will remain the same if the over-allotment option is exercised in full) of proceeds held outside the trust account. We will use these funds to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, and structure, negotiate and complete an initial business combination.\nWe do not believe we will need to raise additional funds following the offering in order to meet the expenditures required for operating our business. However, if our estimates of the costs of identifying a target business, undertaking in-depth due diligence and negotiating an initial business combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our initial business combination. Moreover, we may need to obtain additional financing either to complete our initial business combination or because we become obligated to redeem a significant number of our public shares upon completion of our initial business combination, in which case we may issue additional securities or incur debt in connection with such business combination. In addition, we intend to target businesses larger than we could acquire with the net proceeds of this offering and the sale of the private warrants, and may as a result be required to seek additional financing to complete such proposed initial business combination. Subject to compliance with applicable securities laws, we would only complete such financing simultaneously with the completion of our initial business combination. If we are unable to complete our initial business combination because we do not have sufficient funds available to us, we will be forced to cease operations and liquidate the trust account. In addition, following our initial business combination, if cash on hand is insufficient, we may need to obtain additional financing in order to meet our obligations.\nOff-balance Sheet Financing Arrangements\nWe have no obligations, assets or liabilities which would be considered off-balance sheet arrangements as of June 30, 2022. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets.\nContractual Obligations\nWe do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities other than an agreement to pay our Sponsor a monthly fee of $10,000 for general and administrative services, including office space, utilities and administrative services to us. We began incurring these fees on March 4, 2021 and will continue to incur these fees monthly until the earlier of the completion of the business combination and our liquidation. Also, we are committed to the below:\nRegistration Rights\nThe holders of the Founder Shares, the Private Placement Warrants (and their underlying securities) and the warrants that may be issued upon conversion of the Working Capital Loans (and their underlying securities) are entitled to registration rights pursuant to a registration rights agreement signed on the effective date of the Public Offering. The holders of a majority of these securities are entitled to make up to two demands that we register such securities. The holders of the majority of the Founder Shares can elect to exercise these registration rights at any time commencing three months prior to the date on which these shares are to be released from escrow. The holders of a majority of the Private Placement Warrants and warrants issued in payment of Working Capital Loans made to us (or underlying securities) can elect to exercise these registration rights at any time after we consummate a Business Combination. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the completion of a Business Combination. We will bear the expenses incurred in connection with the filing of any such registration statements.\nUnderwriting Agreement\nWe are committed to pay the Deferred Fee ranged between $1,000,000 to $2,250,000, which should equal to the greater of 1) $1,000,000 and 2) 2.5% of the cash remaining in the Trust Fund with a maximum amount of $2,250,000. The deferred fee can be paid in cash.\n20\nCritical Accounting Policies\nThe preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have not identified any significant accounting policies.\n\n| ● | Warrant accounting |\n\nWe account for warrants as either equity-classified or liability-classified instruments based on an assessment of the warrant’s specific terms and applicable authoritative guidance in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 480, “Distinguishing Liabilities from Equity” (“ASC 480”) and ASC 815, “Derivatives and Hedging” (“ASC 815”). The assessment considers whether the warrants are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and whether the warrants meet all of the requirements for equity classification under ASC 815, including whether the warrants are indexed to our own common stock and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of our control, among other conditions for equity classification. This assessment, which requires the use of professional judgment, is conducted at the time of warrant issuance and as of each subsequent quarterly period end date while the warrants are outstanding.\nFor issued or modified warrants that meet all of the criteria for equity classification, the warrants are required to be recorded as a component of equity at the time of issuance. For issued or modified warrants that do not meet all the criteria for equity classification, the warrants are required to be recorded as liabilities at their initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of the warrants are recognized as a non-cash gain or loss on the statements of operations.\nAs the warrants issued upon the IPO and private placements meet the criteria for equity classification under ASC 480, therefore, the warrants are classified as equity.\n\n| ● | Common stock subject to possible redemption |\n\nWe account for its common stock subject to possible redemption in accordance with the guidance in ASC Topic 480 “Distinguishing Liabilities from Equity.” Common stocks subject to mandatory redemption (if any) are classified as a liability instrument and are measured at fair value. Conditionally redeemable common stocks (including common stocks that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, common stocks are classified as shareholders’ equity. Our common stocks feature certain redemption rights that are subject to the occurrence of uncertain future events and considered to be outside of our control. Accordingly, at June 30, 2022, 10,350,000 shares of common stock subject to possible redemption, respectively, are presented as temporary equity, outside of the shareholders’ equity section of our balance sheet.\n\n| ● | Offering costs |\n\nWe comply with the requirements of the ASC 340-10-S99-1 and SEC Staff Accounting Bulletin (“SAB”) Topic 5A – “Expenses of Offering”. Offering costs consist principally of professional and registration fees incurred through the balance sheet date that are related to the Public Offering and that were charged to shareholders’ equity upon the completion of the Public Offering.\n\n| ● | Net loss per share |\n\nWe calculate net loss per share in accordance with ASC Topic 260, “Earnings per Share.” In order to determine the net income (loss) attributable to both the redeemable shares and non-redeemable shares, we first considered the undistributed income (loss) allocable to both the redeemable common stock and non-redeemable common stock and the undistributed income (loss) is calculated using the total net loss less any dividends paid. We then allocated the undistributed income (loss) ratably based on the weighted average number of shares outstanding between the redeemable and non-redeemable common stock. Any remeasurement of the accretion to the redemption value of the common stock subject to possible redemption was considered to be dividends paid to the public stockholders. As of June 30, 2022, we have not considered the effect of the warrants sold in the Initial Public Offering and private warrants to purchase an aggregate of 9,896,250 shares in the calculation of diluted net loss per share, since the exercise of the warrants is contingent upon the occurrence of future events and the inclusion of such warrants would be anti-dilutive and we did not have any other dilutive securities and other contracts that could, potentially, be exercised or converted into common stock and then share in our earnings. As a result, diluted loss per share is the same as basic loss per share for the period presented.\n21\n\nItem 3. Quantitative and Qualitative Disclosures about Market Risk\nThe net proceeds of the IPO held in the trust account may be invested in U.S. government treasury bills, notes or bonds with a maturity of 180 days or less or in certain money market funds that invest solely in US treasuries. Due to the short-term nature of these investments, we believe there will be no associated material exposure to interest rate risk.\n\nItem 4. Controls and Procedures\nEvaluation of Disclosure Controls and Procedures\nDisclosure controls and procedures are designed to ensure that information required to be disclosed by us in our Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.\nUnder the supervision and with the participation of our management, including our principal executive officer and principal financial and accounting officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures as of the end of the fiscal quarter ended June 30, 2022, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act. Based on this evaluation, our principal executive officer and principal financial and accounting officer have concluded that during the period covered by this report, our disclosure controls and procedures were effective at a reasonable assurance level and, accordingly, provided reasonable assurance that the information required to be disclosed by us in reports filed under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.\nChanges in Internal Control over Financial Reporting\nThere was no change in our internal control over financial reporting that occurred during the fiscal quarter of June 30, 2022 covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\n22\nPART II - OTHER INFORMATION\n\nItem 1 Legal Proceedings\nThe Company is not party to any legal proceedings as of the filing date of this Form 10-Q.\n\nItem 1A. Risk Factors.\nFactors that could cause our actual results to differ materially from those in this Quarterly Report are any of the risks described in our final prospectus for our Initial Public Offering filed with the SEC on December 8, 2021. Any of these factors could result in a significant or material adverse effect on our results of operations or financial condition. Additional risk factors not presently known to us or that we currently deem immaterial may also impair our business or results of operations. As of the date of this Quarterly Report, there have been no material changes to the risk factors disclosed in our final prospectus dated December 8, 2021 other than as stated below.\n\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\nOn December 13, 2021, we consummated our initial public offering (“IPO”)of 9,000,000 units (the “Units”), each Unit consisting of one share of common stock of the Company, par value $0.0001 per share (the “Common Stock”), one-half of one redeemable warrant (the “Warrant”), each whole Warrant entitling the holder thereof to purchase one share of Common Stock for $11.50 per share, and one right (the “Right”) to receive one-tenth (1/10) of a share of Common Stock upon consummation of an initial business combination. The Units were sold at a price of $10.00 per Unit, generating aggregate gross proceeds to the Company of $90,000,000. On December 9, 2021, the underwriters of the IPO fully exercised their over-allotment option, and the closing and sale of an additional 1,350,000 Units (the “Over-Allotment Units”) occurred on December 13, 2021. The issuance by the Company of the Over-Allotment Units at a price of $10.00 per Unit resulted in total gross proceeds of $13,500,000.\nSimultaneously with the closing of the IPO and the sale of the over-allotment units on December 13, 2021, the Company consummated the private placement (“Private Placement”) with the Sponsor of 4,721,250 warrants (the “Private Warrants”) at a price of $1.00 per Private Warrant, generating total proceeds of $4,721,250. These securities (other than our IPO securities) were issued pursuant to an exemption from registration under the Securities Act of 1933, as amended pursuant to Section 4(2) of the securities Act.\n23\nThe Private Warrants are identical to the warrants sold in the IPO except that the Private Warrants will be non-redeemable and the shares of common stock issuable upon exercise thereof are entitled to registration rights pursuant to the Registration Rights Agreement, in each case so long as they continue to be held by the Sponsor or their permitted transferees. Additionally, our Sponsor has agreed not to transfer, assign, or sell any of the Private Warrants or underlying securities (except in limited circumstances, as described in the Registration Statement) until 30 days after the Company completes its initial business combination.\nAs of December 31, 2021, a total of $104,535,351 was held in a trust account established for the benefit of the Company’s public stockholders, which included $103,500,000 of the net proceeds from the IPO (including the exercise of the over-allotment option) and $4,721,250 of the Private Placements and subsequent interest income.\nWe paid a total of $1,811,250 in underwriting discounts and commissions (not including the deferred underwriting commission payable at the consummation of initial business combination) and approximately $433,947 for other costs and expenses related to our formation and the initial public offering.\n\nItem 3. Defaults Upon Senior Securities.\nNone.\n\nItem 4. Mine Safety Disclosures.\nNot Applicable.\n\nItem 5. Other Information.\nNone.\n\nItem 6. Exhibits\nThe following exhibits are filed as part of, or incorporated by reference into, this Quarterly Report on Form 10-Q.\n\n| 31.1 | Certification of Principal Executive Officer Pursuant to Securities Exchange Act Rules 13a-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2 | Certification of Principal Financial Officer Pursuant to Securities Exchange Act Rules 13a-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1 | Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2 | Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS | Inline XBRL Instance Document. |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document. |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document. |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document. |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document. |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document. |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101). |\n\n24\nSIGNATURES\nIn accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| INCEPTION GROWTH ACQUISITION LIMITED |\n| Date: August 12, 2022 | By: | /s/ Paige E. Craig |\n| Name: | Paige E. Craig |\n| Title: | Chief Executive Officer |\n| (Principal Executive Officer) |\n\n25\n\n \n\nWhat is the growth rate of total liabilities from December 31, 2021, to June 30, 2022?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nItem 1.\\nFinancial Statements\\nUnaudited Condensed Balance Sheets 1\\nUnaudited Condensed Statements of Operations 2\\nUnaudited Condensed Statements of Changes in Shareholders’ Deficit 3\\nUnaudited Condensed Statements of Cash Flows 4\\nNotes to Unaudited Condensed Financial Statements 5\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 18\\nItem 3. Quantitative and Qualitative Disclosures about Market Risk 22\\nItem 4. Control and Procedures 22\\nPART II – OTHER INFORMATION\\nItem 1. Legal Proceedings 23\\nItem 1A. Risk Factors 23\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds 23\\nItem 3. Defaults Upon Senior Securities 24\\nItem 4. Mine Safety Disclosures 24\\nItem 5. Other Information 24\\nItem 6. Exhibits 24\\nSIGNATURES 25\\ni\\nPART I – FINANCIAL INFORMATION\\nINCEPTION GROWTH ACQUISITION LIMITED\\nUNAUDITED CONDENSED BALANCE SHEETS\\n(Currency expressed in United States Dollars (“US$”), except for number of shares)\\n\\n| June 30, 2022 | December 31, 2021 |\\n| (Audited) |\\n| ASSETS |\\n| Current assets: |\\n| Cash | $ | 787,449 | $ | 1,365,181 |\\n| Prepayments | 313,083 | 404,762 |\\n| Total current assets | 1,100,532 | 1,769,943 |\\n| Cash and investments held in trust account | 104,710,586 | 104,535,351 |\\n| TOTAL ASSETS | $ | 105,811,118 | $ | 106,305,294 |\\n| LIABILITIES, TEMPORARY EQUITY AND SHAREHOLDERS’ DEFICIT |\\n| Current liabilities: |\\n| Accrued liabilities | $ | 97,106 | $ | 475,948 |\\n| Advances from a related party | 118,267 | 10,253 |\\n| Total current liabilities | 215,373 | 486,201 |\\n| Deferred underwriting compensation | 2,587,500 | 2,587,500 |\\n| TOTAL LIABILITIES | 2,802,873 | 3,073,701 |\\n| Commitments and contingencies |\\n| Common stock, subject to possible redemption: 10,350,000 shares (at redemption value of $ 10.12 and $ 10.10 per share) | 104,710,586 | 104,535,000 |\\n| Shareholders’ deficit: |\\n| Common stock, $ 0.0001 par value; 26,000,000 shares authorized; 2,637,500 shares issued and outstanding (excluding 10,350,000 shares subject to possible redemption) | 264 | 264 |\\n| Accumulated other comprehensive income | 158,483 | - |\\n| Accumulated deficit | ( 1,861,088 | ) | ( 1,303,671 | ) |\\n| Total shareholders’ deficit | ( 1,702,341 | ) | ( 1,303,407 | ) |\\n| TOTAL LIABILITIES, TEMPORARY EQUITY AND SHAREHOLDERS’ DEFICIT | $ | 105,811,118 | $ | 106,305,294 |\\n\\nSee accompanying notes to unaudited condensed financial statements.\\n1\\nINCEPTION GROWTH ACQUISITION LIMITED\\nUNAUDITED CONDENSED STATEMENT OF OPERATIONS\\n(Currency expressed in United States Dollars (“US$”), except for number of shares)\\n\\n| Three months ended June 30, 2022 | Three months ended June 30, 2021 | Six months ended June 30, 2022 | From March 4, 2021 (date of inception) to June 30, 2021 |\\n| Formation, general and administrative expenses | $ | ( 170,157 | ) | $ | ( 52,524 | ) | $ | ( 398,583 | ) | $ | ( 52,524 | ) |\\n| Other income: |\\n| Dividend income | 6,225 | - | 16,752 | - |\\n| Total other income, net | 6,225 | - | 16,752 | - |\\n| Loss before income taxes | ( 163,932 | ) | ( 52,524 | ) | ( 381,831 | ) | ( 52,524 | ) |\\n| Income taxes | - | - | - | - |\\n| NET LOSS | $ | ( 163,932 | ) | $ | ( 52,524 | ) | $ | ( 381,831 | ) | $ | ( 52,524 | ) |\\n| Other comprehensive income |\\n| Unrealized gain on available-for-sale securities | 158,483 | - | 158,483 | - |\\n| COMPREHENSIVE LOSS | $ | ( 5,449 | ) | $ | ( 52,524 | ) | $ | ( 223,348 | ) | $ | ( 52,524 | ) |\\n| Basic and diluted weighted average shares outstanding, common stock subject to possible redemption | 10,035,000 | - | 10,035,000 | - |\\n| Basic and diluted net loss per share, common stock subject to possible redemption | $ | ( 0.01 | ) | $ | - | $ | ( 0.03 | ) | $ | - |\\n| Basic and diluted weighted average shares outstanding, common stock attributable to Inception Growth Acquisition Limited | 2,637,500 | 2,250,000 | 2,637,500 | $ | 2,250,000 |\\n| Basic and diluted net loss per share, common stock attributable to Inception Growth Acquisition Limited | $ | ( 0.03 | ) | $ | ( 0.02 | ) | $ | ( 0.04 | ) | $ | ( 0.02 | ) |\\n\\nSee accompanying notes to unaudited condensed financial statements.\\n2\\nINCEPTION GROWTH ACQUISITION LIMITED\\nUNAUDITED CONDENSED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY (DEFICIT)\\n(Currency expressed in United States Dollars (“US$”), except for number of shares)\\n\\n| Ordinary shares | Accumulated other | Total |\\n| No. of shares | Amount | comprehensive income | Accumulated deficit | shareholders’ deficit |\\n| Balance as of January 1, 2022 | 2,637,500 | $ | 264 | $ | - | $ | ( 1,303,671 | ) | $ | ( 1,303,407 | ) |\\n| Accretion of carrying value to redemption value | - | - | - | ( 10,878 | ) | ( 10,878 | ) |\\n| Net loss | - | - | - | ( 217,899 | ) | ( 217,899 | ) |\\n| Balance as of March 31, 2022 | 2,637,500 | 264 | - | ( 1,532,448 | ) | ( 1,532,184 | ) |\\n| Accretion of carrying value to redemption value | - | - | - | ( 164,708 | ) | ( 164,708 | ) |\\n| Unrealized gain on available-for-sale securities | - | - | 158,483 | - | 158,483 |\\n| Net loss | - | - | - | ( 163,932 | ) | ( 163,932 | ) |\\n| Balance as of June 30, 2022 | 2,637,500 | $ | 264 | $ | 158,483 | $ | ( 1,861,088 | ) | $ | ( 1,702,341 | ) |\\n\\n\\n| Ordinary shares | Additional | Total |\\n| No. of shares | Amount | paid-in capital | Accumulated deficit | shareholders’ deficit |\\n| Balance as of March 4, 2021 (inception) | - | $ | - | $ | - | $ | - | $ | - |\\n| Issuance of common stock to founders | 2,587,500 | 259 | 24,741 | - | 25,000 |\\n| Balance as of March 31, 2021 | 2,587,500 | 259 | 24,741 | - | 25,000 |\\n| Net loss | - | - | - | ( 52,524 | ) | ( 52,524 | ) |\\n| Balance as of June 30, 2021 | 2,587,500 | $ | 259 | $ | 24,741 | $ | ( 52,524 | ) | $ | ( 27,524 | ) |\\n\\nSee accompanying notes to unaudited condensed financial statements.\\n3\\nINCEPTION GROWTH ACQUISITION LIMITED\\nUNAUDITED CONDENSED STATEMENT OF CASH FLOWS\\n(Currency expressed in United States Dollars (“US$”))\\n\\n| Six months ended June 30, 2022 | March 4, 2021 (date of inception) to June 30, 2021 |\\n| Cash flows from operating activities |\\n| Net loss | $ | ( 381,831 | ) | ( 52,524 | ) |\\n| Adjustments to reconcile net loss to net cash used in operating activities |\\n| Interest income and dividend income earned in cash and investments income held in trust account | ( 16,752 | ) | - |\\n| Change in operating assets and liabilities: |\\n| Decrease in prepayment | 91,679 | - |\\n| Increase (decrease) in accrued liabilities | ( 378,842 | ) | - |\\n| Net cash used in operating activities | ( 685,746 | ) | ( 52,524 | ) |\\n| Cash flows from financing activities |\\n| Proceed from issuance of common stock | - | 25,000 |\\n| Advance from a related party | 108,014 | 27,524 |\\n| Net cash provided by financing activities | 108,014 | 52,524 |\\n| NET CHANGE IN CASH | ( 577,732 | ) | - |\\n| Cash, beginning of period | 1,365,181 | - |\\n| Cash, end of period | $ | 787,449 | $ | - |\\n| SUPPLEMENTAL DISCLOSURE OF NON-CASH FINANCING ACTIVITIES: |\\n| Accretion of carrying value to redemption value | $ | ( 175,586 | ) | $ | - |\\n| Deferred offering costs paid by a related party | $ | - | $ | 190,000 |\\n\\nSee accompanying notes to unaudited condensed financial statements.\\n4\\nINCEPTION GROWTH ACQUISITION LIMITED\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\n(Currency expressed in United States Dollars (“US$”), except for number of shares)\\nNOTE 1 – ORGANIZATION AND BUSINESS BACKGROUND\\nInception Growth Acquisition Limited (the “Company”) is a newly organized blank check company incorporated on March 4, 2021, under the laws of the State of Delaware for the purpose of acquiring, engaging in a share exchange, share reconstruction and amalgamation, purchasing all or substantially all of the assets of, entering into contractual arrangements, or engaging in any other similar business combination with one or more businesses or entities (“Business Combination”).\\nAlthough the Company is not limited to a particular industry or geographic region for purposes of consummating a Business Combination, the Company intends to focus on businesses that have a connection to the Asian market and shall not undertake an initial business combination with any entity with its principal business operations in China (including Hong Kong and Macau). The Company is an early stage and emerging growth company and, as such, the Company is subject to all of the risks associated with early stage and emerging growth companies. The Company has selected December 31 as its fiscal year end.\\nAt June 30, 2022, the Company had not yet commenced any operations. All activities through December 13, 2021 relate to the Company’s formation and the initial public offering (the “Initial Public Offering”). Since the Initial Public Offering, the Company’s activity has been limited to the evaluation of business combination candidates. The Company will not generate any operating revenues until after the completion of a Business Combination, at the earliest. The Company will generate non-operating income in the form of interest income from the proceeds derived from the Initial Public Offering.\\nFinancing\\nThe registration statement for the Company’s Initial Public Offering became effective on December 8, 2021. On December 13, 2021, the Company consummated the Initial Public Offering of 10,350,000 ordinary units (the “Public Units”), which includes the full exercise by the underwriter of its over-allotment option in the amount of 1,350,000 Public Units, at $ 10.00 per Public Unit, generating gross proceeds of $ 103,500,000 which is described in Note 4.\\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the sale of 4,721,250 Warrants (the “Private Warrants”) at a price of $ 1.00 per warrant in a private placement to Soul Venture Partners LLC (the “Sponsor”), generating gross proceeds of $ 4,721,250 , which is described in Note 5.\\nTransaction costs amounted to $ 4,832,697 , consisting of $ 1,811,250 of underwriting fees, $ 2,587,500 of deferred underwriting fees and $ 433,947 of other offering costs. In addition, at December 13, 2021, cash of $ 1,498,937 were held outside of the Trust Account (as defined below) and is available for the payment of offering costs and for working capital purposes net with $ 104,535,000 transferred to the Trust Account on December 13, 2021.\\nTrust Account\\nFollowing the closing of the Initial Public Offering and exercise of the over-allotment option on December 13, 2021, the aggregate amount of 104,535,000 ($ 10.10 per Public Unit) held in Trust Account was invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, with a maturity of 185 days or less, or in any open-ended investment company that holds itself out as a money market fund meeting certain conditions of Rule 2a-7 of the Investment Company Act, as determined by the Company, until the earlier of: (i) the completion of a Business Combination and (ii) the distribution of the funds in the Trust Account to the Company’s stockholders, as described below, except that interest earned on the Trust Account can be released to the Company to pay its tax obligations.\\nBusiness Combination\\nThe Company’s management has broad discretion with respect to the specific application of the net proceeds of the Initial Public Offering and sale of the Private Warrants, although substantially all of the net proceeds are intended to be applied generally toward consummating a Business Combination. NASDAQ rules provide that the Business Combination must be with one or more target businesses that together have a fair market value equal to at least 80 % of the balance in the Trust Account (as defined below) (less any deferred underwriting commissions and taxes payable on interest earned) at the time of the signing of an agreement to enter into a Business Combination. The Company will only complete a Business Combination if the post-Business Combination company owns or acquires 50 % or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act of 1940, as amended (the “Investment Company Act”). There is no assurance that the Company will be able to successfully effect a Business Combination.\\n5\\nThe Company will provide its stockholders with the opportunity to redeem all or a portion of their Public Shares upon the completion of a Business Combination either (i) in connection with a stockholder meeting called to approve the Business Combination or (ii) by means of a tender offer. In connection with an Initial Business Combination, the Company may seek stockholder approval of a Business Combination at a meeting called for such purpose at which stockholders may seek to redeem their shares, regardless of whether they vote for or against a Business Combination. The Company will proceed with a Business Combination only if the Company has net tangible assets of at least $ 5,000,001 upon such consummation of a Business Combination and, if the Company seeks stockholder approval, a majority of the outstanding shares voted are voted in favor of the Business Combination.\\nNotwithstanding the foregoing, if the Company seeks stockholder approval of a Business Combination and it does not conduct redemptions pursuant to the tender offer rules, the Company’s Amended and Restated Memorandum and Articles of Association provides that a public stockholder, together with any affiliate of such stockholder or any other person with whom such stockholder is acting in concert or as a “group” (as defined under Section 13 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), will be restricted from seeking redemption rights with respect to 15 % or more of the Public Shares without the Company’s prior written consent.\\nIf a stockholder vote is not required and the Company does not decide to hold a stockholder vote for business or other legal reasons, the Company will, pursuant to its Amended and Restated Memorandum and Articles of Association, offer such redemption pursuant to the tender offer rules of the Securities and Exchange Commission (“SEC”), and file tender offer documents containing substantially the same information as would be included in a proxy statement with the SEC prior to completing a Business Combination.\\nThe stockholders will be entitled to redeem their Public Shares for a pro rata portion of the amount then in the Trust Account (initially $ 10.10 per Public Share, subject to increase of up to an additional $ 0.30 per Public Share in the event that the Sponsor elects to extend the period of time to consummate a Business Combination (see below), plus any pro rata interest earned on the funds held in the Trust Account and not previously released to the Company to pay its tax obligations). The per-share amount to be distributed to stockholders who redeem their Public Shares will not be reduced by the deferred underwriting commissions the Company will pay to the underwriter (as discussed in Note 9). There will be no redemption rights upon the completion of a Business Combination with respect to the Company’s rights or warrants. The common stock will be recorded at redemption value and classified as temporary equity upon the completion of the Initial Public Offering, in accordance with Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity” (“ASC 480”).\\nThe Company will proceed with a Business Combination if the Company has net tangible assets of at least $ 5,000,001 upon such consummation of a Business Combination and, if the Company seeks stockholder approval, a majority of the outstanding shares voted are voted in favor of the Business Combination. If a stockholder vote is not required and the Company does not decide to hold a stockholder vote for business or other legal reasons, the Company will, pursuant to its Amended and Restated Certificate of Incorporation, offer such redemption pursuant to the tender offer rules of the Securities and Exchange Commission (“SEC”), and file tender offer documents containing substantially the same information as would be included in a proxy statement with the SEC prior to completing a Business Combination.\\nThe Sponsor and any of the Company’s officers or directors that may hold Founder Shares (as defined in Note 7) (the “stockholders”) and the underwriters will agree (a) to vote their Founder Shares, the common stock included in the Private Units (the “Private Shares”) and any Public Shares purchased during or after the Initial Public Offering in favor of a Business Combination, (b) not to propose an amendment to the Company’s Amended and Restated Memorandum and Articles of Association with respect to the Company’s pre-Business Combination activities prior to the consummation of a Business Combination unless the Company provides dissenting public stockholders with the opportunity to redeem their Public Shares in conjunction with any such amendment; (c) not to redeem any shares (including the Founder Shares) and Private Shares into the right to receive cash from the Trust Account in connection with a stockholder vote to approve a Business Combination (or to sell any shares in a tender offer in connection with a Business Combination if the Company does not seek stockholder approval in connection therewith) or a vote to amend the provisions of the Amended and Restated Memorandum and Articles of Association relating to stockholders’ rights of pre-Business Combination activity and (d) that the Founder Shares and Private Shares shall not participate in any liquidating distributions upon winding up if a Business Combination is not consummated. However, the stockholders will be entitled to liquidating distributions from the Trust Account with respect to any Public Shares purchased during or after the Initial Public Offering if the Company fails to complete its Business Combination.\\n6\\nThe Company will have until March 13, 2023 to consummate a Business Combination. However, if the Company anticipates that it may not be able to consummate a Business Combination within 15 months, the Company may extend the period of time to consummate a Business Combination up to two times, each by an additional three months each time (for a total of 21 months to complete a Business Combination (the “Combination Period”). In order to extend the time available for the Company to consummate a Business Combination, the Sponsor or its affiliate or designees must deposit into the Trust Account $ 1,035,000 (approximately $ 0.1 per Public Share), on or prior to the date of the applicable deadline, for each three months extension. Any funds which may be provided to extend the time frame will be in the form of a loan to us from the sponsor. The terms of any such loan have not been definitely negotiated, provided, however, any loan will be interest free and will be repayable only if we compete a business combination.\\nLiquidation\\nIf the Company is unable to complete a Business Combination within the Combination Period, the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but no more than ten business days thereafter, redeem 100% of the outstanding Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including interest earned (net of taxes payable and less interest to pay dissolution expenses up to $50,000), divided by the number of then outstanding Public Shares, which redemption will completely extinguish public stockholders’ rights as stockholders (including the right to receive further liquidation distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the remaining stockholders and the Company’s board of directors, proceed to commence a voluntary liquidation and thereby a formal dissolution of the Company, subject in each case to its obligations to provide for claims of creditors and the requirements of applicable law. The underwriter has agreed to waive its rights to the deferred underwriting commission held in the Trust Account in the event the Company does not complete a Business Combination within the Combination Period and, in such event, such amounts will be included with the funds held in the Trust Account that will be available to fund the redemption of the Public Shares. In the event of such distribution, it is possible that the per share value of the assets remaining available for distribution will be less than the Initial Public Offering price per Unit ($ 10.00 ).\\nThe Sponsor has agreed that it will be liable to the Company, if and to the extent any claims by a vendor for services rendered or products sold to the Company, or a prospective target business with which the Company has discussed entering into a transaction agreement, reduce the amounts in the Trust Account to below (i) $ 10.10 per share or (ii) such lesser amount per Public Share held in the Trust Account as of the date of the liquidation of the Trust Account due to reductions in the value of the trust assets, except as to any claims by a third party who executed a waiver of any and all rights to seek access to the Trust Account and except as to any claims under the Company’s indemnity of the underwriters of the Initial Public Offering against certain liabilities, including liabilities under the Securities Act of 1933, as amended (the “Securities Act”). In the event that an executed waiver is deemed to be unenforceable against a third party, the Sponsor will not be responsible to the extent of any liability for such third-party claims. The Company will seek to reduce the possibility that the Sponsor will have to indemnify the Trust Account due to claims of creditors by endeavoring to have all vendors, service providers, prospective target businesses or other entities with which the Company does business, execute agreements with the Company waiving any right, title, interest or claim of any kind in or to monies held in the Trust Account.\\nLiquidity and capital resources\\nFollowing the closing of the Initial Public Offering on December 13, 2021, a total of $ 103,500,000 was placed in the Trust Account, and the Company had $ 1,498,937 of cash held outside of the Trust Account, after payment of costs related to the Initial Public Offering, and available for working capital purposes. As of June 30, 2022, the Company had a working capital equity of $ 885,159 . The Company has incurred and expects to continue to incur significant costs in pursuit of its acquisition plans. Based on the foregoing, the Company believes it will have sufficient cash to meet its needs to execute its intended initial Business Combination in the next twelve months from the date of the issuance of the accompanying unaudited condensed consolidated financial statements.\\nIf the Company is unable to raise additional capital, it may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, and reducing overhead expenses. The Company cannot provide any assurance that new financing will be available to it on commercially acceptable terms, if at all. These conditions raise substantial doubt about the Company’s ability to continue as a going concern through one year from the date of these unaudited condensed consolidated financial statements if a Business Combination is not consummated. These unaudited condensed consolidated financial statements do not include any adjustments relating to the recovery of the recorded assets or the classification of the liabilities that might be necessary should the Company be unable to continue as a going concern.\\nNOTE 2 – SIGNIFICANT ACCOUNTING POLICIES\\n\\n| ● | Basis of presentation |\\n\\nThese accompanying unaudited condensed financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”) and pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). The interim financial information provided is unaudited, but includes all adjustments which management considers necessary for the fair presentation of the results for these periods. Operating results for the interim period ended June 30, 2022 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2022. The information included in this Form 10-Q should be read in conjunction with Management’s Discussion and Analysis, and the audited financial statements and notes thereto included in the Company’s Form 10-K for the fiscal year ended December 31, 2021, filed with the SEC on March 31, 2022.\\n7\\n\\n| ● | Emerging growth company |\\n\\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the independent registered public accounting firm attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\\n\\n| ● | Use of estimates |\\n\\nIn preparing these unaudited condensed financial statements in conformity with U.S. GAAP, management makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited condensed financial statements and the reported expenses during the reporting period.\\nMaking estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the unaudited condensed financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. Accordingly, Actual results may differ from these estimates.\\n\\n| ● | Cash |\\n\\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did not have any cash equivalents as of June 30, 2022 and December 31, 2021.\\n\\n| ● | Cash and investment held in trust account |\\n\\nAt June 30, 2022, the assets held in the Trust Account are held in cash and US Treasury securities. Investment securities in the Company’s Trust Account consisted of $ 104,699,165 in United States Treasury Bills and $ 11,421 in cash. At December 31, 2021, investment securities in the Company’s Trust Account consisted of $ 104,535,263 in United States Treasury Bills and $ 88 in cash.\\nThe Company classifies marketable securities as available-for-sale at the time of purchase and reevaluates such classification as of each balance sheet date. All marketable securities are recorded at their estimated fair value. Unrealized gains and losses for available-for-sale securities are recorded in other comprehensive income. The Company evaluates its investments to assess whether those with unrealized loss positions are other than temporarily impaired. Impairments are considered other than temporary if they are related to deterioration in credit risk or if it is likely the Company will sell the securities before the recovery of the cost basis. Realized gains and losses and declines in value determined to be other than temporary are determined based on the specific identification method and are reported in other income (expense), net in the statements of operations.\\n8\\n\\n| ● | Deferred offering costs |\\n\\nDeferred offering costs consist of underwriting, legal, accounting and other expenses incurred through the balance sheet date that are directly related to the Initial public Offering and that were charged to shareholders’ equity upon the completion of the Initial Public Offering.\\n\\n| ● | Warrant accounting |\\n\\nThe Company accounts for warrants as either equity-classified or liability-classified instruments based on an assessment of the warrant’s specific terms and applicable authoritative guidance in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 480, “Distinguishing Liabilities from Equity” (“ASC 480”) and ASC 815, “Derivatives and Hedging” (“ASC 815”). The assessment considers whether the warrants are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and whether the warrants meet all of the requirements for equity classification under ASC 815, including whether the warrants are indexed to the Company’s own common stock and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of the Company’s control, among other conditions for equity classification. This assessment, which requires the use of professional judgment, is conducted at the time of warrant issuance and as of each subsequent quarterly period end date while the warrants are outstanding.\\nFor issued or modified warrants that meet all of the criteria for equity classification, the warrants are required to be recorded as a component of equity at the time of issuance. For issued or modified warrants that do not meet all the criteria for equity classification, the warrants are required to be recorded as liabilities at their initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of the warrants are recognized as a non-cash gain or loss on the statements of operations.\\nAs the warrants issued upon the IPO and private placements meet the criteria for equity classification under ASC 480, therefore, the warrants are classified as equity.\\n\\n| ● | Common stock subject to possible redemption |\\n\\nThe Company accounts for its common stock subject to possible redemption in accordance with the guidance in ASC Topic 480. Common stocks subject to mandatory redemption (if any) are classified as a liability instrument and are measured at fair value. Conditionally redeemable common stocks (including common stocks that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) are classified as temporary equity. At all other times, common stocks are classified as shareholders’ equity. The Company’s common stocks feature certain redemption rights that are subject to the occurrence of uncertain future events and considered to be outside of the Company’s control. Accordingly, at June 30, 2022 and December 31, 2021, 10,350,000 shares of common stock subject to possible redemption, respectively, are presented as temporary equity, outside of the shareholders’ equity section of the Company’s balance sheet.\\n\\n| ● | Offering costs |\\n\\nThe Company complies with the requirements of the ASC 340-10-S99-1 and SEC Staff Accounting Bulletin (“SAB”) Topic 5A – “Expenses of Offering”. Offering costs consist principally of professional and registration fees incurred through the balance sheet date that are related to the Public Offering and that were charged to shareholders’ equity upon the completion of the Public Offering.\\n\\n| ● | Fair value of financial instruments |\\n\\nASC Topic 820 “Fair Value Measurements and Disclosures” (“ASC 820”) defines fair value, the methods used to measure fair value and the expanded disclosures about fair value measurements. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between the buyer and the seller at the measurement date. In determining fair value, the valuation techniques consistent with the market approach, income approach and cost approach shall be used to measure fair value. ASC 820 establishes a fair value hierarchy for inputs, which represents the assumptions used by the buyer and seller in pricing the asset or liability. These inputs are further defined as observable and unobservable inputs. Observable inputs are those that buyer and seller would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs reflect the Company’s assumptions about the inputs that the buyer and seller would use in pricing the asset or liability developed based on the best information available in the circumstances.\\n9\\nThe fair value hierarchy is categorized into three levels based on the inputs as follows:\\nLevel 1 — Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access. Valuation adjustments and block discounts are not being applied. Since valuations are based on quoted prices that are readily and regularly available in an active market, the valuation of these securities does not entail a significant degree of judgment.\\nLevel 2 — Valuations based on (i) quoted prices in active markets for similar assets and liabilities, (ii) quoted prices in markets that are not active for identical or similar assets, (iii) inputs other than quoted prices for the assets or liabilities, or (iv) inputs that are derived principally from or corroborated by the market through correlation or other means.\\nLevel 3 — Valuations based on inputs that are unobservable and significant to the overall fair value measurement.\\nThe fair value of the Company’s certain assets and liabilities, which qualify as financial instruments under ASC 820, “Fair Value Measurements and Disclosures,” approximates the carrying amounts represented in the balance sheet. The fair values of cash and cash equivalents, and other current assets, accrued expenses, due to the sponsor are estimated to approximate the carrying values as of June 30, 2022 due to the short maturities of such instruments. See Note 8 for the disclosure of the Company’s assets and liabilities that were measured at fair value on a recurring basis.\\n\\n| ● | Income taxes |\\n\\nThe Company complies with the accounting and reporting requirements of ASC Topic 740, “Income Taxes” (“ASC 740), which requires an asset and liability approach to financial accounting and reporting for income taxes. Deferred income tax assets and liabilities are computed for differences between the financial statement and tax bases of assets and liabilities that will result in future taxable or deductible amounts, based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.\\nASC 740 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of June 30, 2022 and December 31, 2021. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position.\\nThe Company may be subject to potential examination by federal, state and city taxing authorities in the areas of income taxes. These potential examinations may include questioning the timing and amount of deductions, the nexus of income among various tax jurisdictions and compliance with federal, state and city tax laws. The Company’s management does not expect that the total amount of unrecognized tax benefits will materially change over the next twelve months.\\nThe provision for annual franchise taxes, based on the number of shares of our common stock authorized and outstanding after the completion of the IPO for the six months ended June 30, 2022 and 2021 were $ 48,535 and $ 0 , respectively.\\nThe provision for income taxes was deemed to be immaterial for the six months ended June 30, 2022 and 2021.\\n10\\n\\n| ● | Net loss per share |\\n\\nThe Company calculates net loss per share in accordance with ASC Topic 260, “Earnings per Share.” In order to determine the net income (loss) attributable to both the redeemable shares and non-redeemable shares, the Company first considered the undistributed income (loss) allocable to both the redeemable common stock and non-redeemable common stock and the undistributed income (loss) is calculated using the total net loss less any dividends paid. The Company then allocated the undistributed income (loss) ratably based on the weighted average number of shares outstanding between the redeemable and non-redeemable common stock. Any remeasurement of the accretion to the redemption value of the common stock subject to possible redemption was considered to be dividends paid to the public stockholders. As of June 30, 2022, the Company has not considered the effect of the warrants sold in the Initial Public Offering and private warrants to purchase an aggregate of 9,896,250 shares in the calculation of diluted net loss per share, since the exercise of the warrants is contingent upon the occurrence of future events and the inclusion of such warrants would be anti-dilutive and the Company did not have any other dilutive securities and other contracts that could, potentially, be exercised or converted into common stock and then share in the earnings of the Company. As a result, diluted loss per share is the same as basic loss per share for the period presented.\\nThe net income (loss) per share presented in the statement of operations is based on the following:\\n\\n| For the Three Months Ended | For the Three Months Ended |\\n| June 30, 2022 | June 30, 2021 |\\n| Net loss | $ | ( 163,932 | ) | $ | ( 52,524 | ) |\\n| Accretion of carrying value to redemption value | ( 164,708 | ) | - |\\n| Net loss including accretion of carrying value to redemption value | $ | ( 328,640 | ) | $ | ( 52,524 | ) |\\n\\n\\n| For the Six Months Ended | From March 4, 2021 (date of inception) to |\\n| June 30, 2022 | June 30, 2021 |\\n| Net loss | $ | ( 381,831 | ) | $ | ( 52,524 | ) |\\n| Accretion of carrying value to redemption value | ( 175,586 | ) | - |\\n| Net loss including accretion of carrying value to redemption value | $ | ( 557,417 | ) | $ | ( 52,524 | ) |\\n\\n\\n| For the six months ended June 30, 2022 | For the six months ended June 30, 2021 |\\n| Redeemable ordinary shares | Non- Redeemable ordinary shares | Redeemable ordinary shares | Non-Redeemable ordinary shares |\\n| Basic and diluted net loss per share: |\\n| Numerators: |\\n| Allocation of net loss including carrying value to redemption value | $ | ( 444,217 | ) | $ | ( 113,200 | ) | $ | - | $ | ( 52,524 | ) |\\n| Accretion of carrying value to redemption value | 175,586 | - | - | - |\\n| Allocation of net loss | $ | ( 268,631 | ) | $ | ( 113,200 | ) | $ | - | $ | ( 52,524 | ) |\\n| Denominators: |\\n| Weighted-average shares outstanding | 10,350,000 | 2,637,500 | - | 2,250,000 |\\n| Basic and diluted net loss per share | $ | ( 0.03 | ) | $ | ( 0.04 | ) | $ | - | $ | ( 0.00 | ) |\\n\\n11\\n\\n| For the three months ended June 30, 2022 | For the three months ended June 30, 2021 |\\n| Redeemable ordinary shares | Non- Redeemable ordinary shares | Redeemable ordinary shares | Non-Redeemable ordinary shares |\\n| Basic and diluted net loss per share: |\\n| Numerators: |\\n| Allocation of net loss including carrying value to redemption value | $ | ( 261,900 | ) | $ | ( 66,740 | ) | $ | - | $ | ( 52,524 | ) |\\n| Accretion of carrying value to redemption value | 164,708 | - | - | - |\\n| Allocation of net loss | $ | ( 97,192 | ) | $ | ( 66,740 | ) | $ | - | $ | ( 52,524 | ) |\\n| Denominators: |\\n| Weighted-average shares outstanding | 10,350,000 | 2,637,500 | - | 2,250,000 |\\n| Basic and diluted net loss per share | $ | ( 0.01 | ) | $ | ( 0.03 | ) | $ | - | $ | ( 0.00 | ) |\\n\\n\\n| ● | Related parties |\\n\\nParties, which can be a corporation or individual, are considered to be related if the Company has the ability, directly or indirectly, to control the other party or exercise significant influence over the other party in making financial and operational decisions. Companies are also considered to be related if they are subject to common control or common significant influence.\\n\\n| ● | Concentration of credit risk |\\n\\nFinancial instruments that potentially subject the Company to concentration of credit risk consist of a cash account in a financial institution. The Company has not experienced losses on this account and management believes the Company is not exposed to significant risks on such account.\\n\\n| ● | Recent accounting pronouncements |\\n\\nThe Company has considered all new accounting pronouncements and has concluded that there are no new pronouncements that may have a material impact on the results of operations, financial condition, or cash flows, based on the current information.\\nNOTE 3 – CASH AND INVESTMENT HELD IN TRUST ACCOUNT\\nAs of June 30, 2022, investment securities in the Company’s Trust Account consisted of $ 104,699,165 in United States Treasury Bills and $ 11,421 in cash. The Company classifies its United States Treasury securities as available-for-sale. Available-for-sale marketable securities are recorded at their estimated fair value on the accompanying June 30, 2022 balance sheet. The carrying value, including gross unrealized holding gain as other comprehensive income and fair value of held to marketable securities on June 30, 2022 and December 31, 2021 is as follows:\\n\\n| Carrying Value as of June 30, 2022 (Unaudited) | Gross Unrealized Holding Gain | Fair Value as of June 30, 2022 (Unaudited) |\\n| Available-for-sale marketable securities: |\\n| U.S. Treasury Securities | $ | 104,540,682 | $ | 158,483 | $ | 104,699,165 |\\n\\n\\n| Carrying Value as of December 31, 2021 (Audited) | Gross Unrealized Holding Gain | Fair Value as of December 31, 2021 |\\n| Available-for-sale marketable securities: |\\n| U.S. Treasury Securities | $ | 104,535,263 | $ | - | $ | 104,535,263 |\\n\\n12\\nNOTE 4 – INITIAL PUBLIC OFFERING\\nPursuant to the Initial Public Offering, the Company sold 9,000,000 Units, which includes a full exercise by the underwriters of their over-allotment option in the amount of 1,350,000 Public Units, at a purchase price of $ 10.00 per Unit. Each Unit consists of one share of common stock, one-half (1/2) of one redeemable warrant (“Public Warrant”) and one right (“Public Right”) to receive one-tenth (1/10) of one share of common stock. Each Public Warrant will entitle the holder to purchase one share of common stock at an exercise price of $ 11.50 per whole share.\\nAll of the 10,350,000 (including over-allotment shares) Public Shares sold as part of the Public Units in the IPO contain a redemption feature which allows for the redemption of such Public Shares if there is a stockholder vote or tender offer in connection with the Business Combination and in connection with certain amendments to the Company’s amended and restated certificate of incorporation, or in connection with the Company’s liquidation. In accordance with the SEC and its staff’s guidance on redeemable equity instruments, which has been codified in ASC 480-10-S99, redemption provisions not solely within the control of the Company require common stocks subject to redemption to be classified outside of permanent equity.\\nThe Company’s redeemable common stock is subject to SEC and its staff’s guidance on redeemable equity instruments, which has been codified in ASC 480-10-S99. If it is probable that the equity instrument will become redeemable, the Company has the option to either accrete changes in the redemption value over the period from the date of issuance (or from the date that it becomes probable that the instrument will become redeemable, if later) to the earliest redemption date of the instrument or to recognize changes in the redemption value immediately as they occur and adjust the carrying amount of the instrument to equal the redemption value at the end of each reporting period. The Company has elected to recognize the changes immediately. The accretion or remeasurement is treated as a deemed dividend (i.e., a reduction to retained earnings, or in absence of retained earnings, additional paid-in capital).\\nAs of June 30, 2022 and December 31, 2021, the shares of common stock reflected on the balance sheet are reconciled in the following table.\\n\\n| June 30, | December 31, |\\n| 2022 | 2021 |\\n| Gross proceeds | $ | 103,500,000 | $ | 103,500,000 |\\n| Less: |\\n| Proceeds allocated Public Warrants | ( 2,572,990 | ) | ( 2,572,990 | ) |\\n| Proceeds allocated Public Rights | ( 7,418,984 | ) | ( 7,418,984 | ) |\\n| Offering costs of Public Shares | ( 2,511,906 | ) | ( 2,511,906 | ) |\\n| Plus: |\\n| Accretion of carrying value to redemption value - 2021 | 13,538,880 | 13,538,880 |\\n| Accretion of carrying value to redemption value - 2022 | 175,586 | - |\\n| Common stock subject to possible redemption | $ | 104,710,586 | $ | 104,535,000 |\\n\\nNOTE 5 – PRIVATE PLACEMENT\\nSimultaneously with the closing of the Initial Public Offering, the Sponsor and the underwriters purchased an aggregate of 4,721,250 Warrants at a price of $ 1.00 per Warrant, ($ 4,721,250 in the aggregate), in each case, in a private warrant that will occur simultaneously with the closing of the Initial Public Offering (the “Private Warrants”). Each Private Warrant is exercisable to purchase one share of common stock at a price of $ 11.50 per whole share. The Private Warrants may only be exercised for a whole number of shares. The proceeds from the sale of the Private Placement Warrants will be added to the net proceeds from the Initial Public Offering held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the proceeds from the sale of the Private Warrants will be used to fund the redemption of the Public Shares (subject to the requirements of applicable law) and the Private Warrants will expire worthless.\\n13\\nNOTE 6 – RELATED PARTY TRANSACTIONS\\nFounder Shares\\nOn March 4, 2021, the Company issued an aggregate of 2,587,500 founder shares to the initial shareholder for an aggregate purchase price of $ 25,000 .\\nOn December 13, 2021, the Company issued an aggregate of 50,000 representative shares to the underwriter.\\nAs of June 30, 2022 and December 31, 2021, 2,637,500 shares of common stock were issued and outstanding, excluding 10,350,000 shares of common stock are subject to possible conversion.\\nAdvance from a Related Party\\nOn April 1, 2021, the Company issued an unsecured promissory note to the Sponsor, pursuant to which the Company may borrow up to an aggregate principal amount of $ 1,000,000 (the “Promissory Note”). The Promissory Note is non-interest bearing and payable on the earlier of (i) April 30, 2021 or (ii) the date on which the Company determines not to conduct an initial public offering. As of December 13, 2021, the Company drew $ 134,885 against the promissory note and the entire balance was repaid on December 16, 2021.\\nAs of June 30, 2022 and December 31, 2021, the Company had a temporary advance of $ 118,267 and $ 10,253 from the Sponsor, respectively. The balance is unsecured, interest-free and has no fixed terms of repayment.\\nAdministrative Services Agreement\\nThe Company is obligated, commencing from March 4, 2021, to pay Soul Venture Partners LLC a monthly fee of $ 10,000 for general and administrative services. This agreement will terminate upon completion of the Company’s Business Combination or the liquidation of the trust account to public shareholders.\\nNOTE 7 – SHAREHOLDER’S EQUITY\\nCommon stocks\\nThe Company is authorized to issue 26,000,000 shares of common stock at par value $ 0.0001 . Holders of the Company’s common stocks are entitled to one vote for each share. As of June 30, 2022 and December 31, 2021, 2,637,500 shares of common stocks were issued and outstanding, excluding 10,350,000 shares of common stock subject to possible redemption.\\nRights\\nEach holder of a right will receive one-tenth (1/10) of one share of common stock upon consummation of a Business Combination, even if the holder of such right redeemed all shares held by it in connection with a Business Combination. No fractional shares will be issued upon exchange of the rights. No additional consideration will be required to be paid by a holder of rights in order to receive its additional shares upon consummation of a Business Combination as the consideration related thereto has been included in the Unit purchase price paid for by investors in the Initial Public Offering. If the Company enters into a definitive agreement for a Business Combination in which the Company will not be the surviving entity, the definitive agreement will provide for the holders of rights to receive the same per share consideration the holders of the common stock will receive in the transaction on an as-converted into common stock basis and each holder of a right will be required to affirmatively convert its rights in order to receive 1/10 share underlying each right (without paying additional consideration). The shares issuable upon exchange of the rights will be freely tradable (except to the extent held by affiliates of the Company).\\nIf the Company is unable to complete a Business Combination within the Combination Period and the Company liquidates the funds held in the Trust Account, holders of rights will not receive any of such funds with respect to their rights, nor will they receive any distribution from the Company’s assets held outside of the Trust Account with respect to such rights, and the rights will expire worthless. Further, there are no contractual penalties for failure to deliver securities to the holders of the rights upon consummation of a Business Combination. Additionally, in no event will the Company be required to net cash settle the rights. Accordingly, the rights may expire worthless.\\n14\\nWarrants\\nThe Public Warrants will become exercisable on the later of (a) the completion of a Business Combination or (b) 15 months (or up to 21 months, if we extend the time to complete a business combination) from the closing of this Initial Public Offering. No Public Warrants will be exercisable for cash unless the Company has an effective and current registration statement covering the common stock issuable upon exercise of the Public Warrants and a current prospectus relating to such common stock. Notwithstanding the foregoing, if a registration statement covering the common stock issuable upon the exercise of the Public Warrants is not effective within 52 business days from the consummation of a Business Combination, the holders may, until such time as there is an effective registration statement and during any period when the Company shall have failed to maintain an effective registration statement, exercise the Public Warrants on a cashless basis pursuant to the exemption from registration provided by Section 3(a)(9) of the Securities Act provided that such exemption is available. If an exemption from registration is not available, holders will not be able to exercise their Public Warrants on a cashless basis. The Public Warrants will expire five years after the completion of the Business Combination, at 5:00 p.m., New York City time, or earlier upon redemption or liquidation.\\nThe Company may call the warrants for redemption (excluding the Private Warrants), in whole and not in part, at a price of $0.01 per warrant:\\n\\n| ● | at any time while the Public Warrants are exercisable, |\\n\\n\\n| ● | upon not less than 30 days’ prior written notice of redemption to each Public Warrant holder, |\\n\\n\\n| ● | if, and only if, the reported last sale price of the ordinary shares equals or exceeds $18 per share, for any 30 trading days within a 30 trading day period ending on the third trading day prior to the notice of redemption to Public Warrant holders, and |\\n\\n\\n| ● | if, and only if, there is a current registration statement in effect with respect to the issuance of the ordinary shares underlying such warrants at the time of redemption and for the entire 30-day trading period referred to above and continuing each day thereafter until the date of redemption. |\\n\\nThe Private Warrants will be identical to the Public Warrants underlying the Units being sold in the Proposed Public Offering, except that the Private Warrants and the common stock issuable upon the exercise of the Private Warrants will not be transferable, assignable or salable until after the completion of a Business Combination, subject to certain limited exceptions. Additionally, the Private Warrants will be exercisable on a cashless basis and will be non-redeemable so long as they are held by the initial purchasers or their permitted transferees. If the Private Warrants are held by someone other than the initial purchasers or their permitted transferees, the Private Warrants will be redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants.\\nIf the Company calls the Public Warrants for redemption, management will have the option to require all holders that wish to exercise the Public Warrants to do so on a “cashless basis,” as described in the warrant agreement. The exercise price and number of common stock issuable upon exercise of the warrants may be adjusted in certain circumstances including in the event of a share dividend, extraordinary dividend or recapitalization, reorganization, merger or consolidation. However, the warrants will not be adjusted for issuances of common stock at a price below its exercise price. Additionally, in no event will the Company be required to net cash settle the warrants. If the Company is unable to complete a Business Combination within the Combination Period and the Company liquidates the funds held in the Trust Account, holders of warrants will not receive any of such funds with respect to their warrants, nor will they receive any distribution from the Company’s assets held outside of the Trust Account with respect to such warrants. Accordingly, the warrants may expire worthless.\\n15\\nNOTE 8 – FAIR VALUE MEASUREMENTS\\nThe fair value of the Company’s financial assets and liabilities reflects management’s estimate of amounts that the Company would have received in connection with the sale of the assets or paid in connection with the transfer of the liabilities in an orderly transaction between market participants at the measurement date. In connection with measuring the fair value of its assets and liabilities, the Company seeks to maximize the use of observable inputs (market data obtained from independent sources) and to minimize the use of unobservable inputs (internal assumptions about how market participants would price assets and liabilities). The following fair value hierarchy is used to classify assets and liabilities based on the observable inputs and unobservable inputs used in order to value the assets and liabilities:\\nLevel 1: Quoted prices in active markets for identical assets or liabilities. An active market for an asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis.\\nLevel 2: Observable inputs other than Level 1 inputs. Examples of Level 2 inputs include quoted prices in active markets for similar assets or liabilities and quoted prices for identical assets or liabilities in markets that are not active.\\nLevel 3: Unobservable inputs based on the assessment of the assumptions that market participants would use in pricing the asset or liability.\\nThe following table presents information about the Company’s assets and liabilities that were measured at fair value on a recurring basis as of June 30, 2022 and December 31, 2021, and indicates the fair value hierarchy of the valuation techniques the Company utilized to determine such fair value.\\n\\n| June 30, 2022 | Quoted Prices In Active Markets | Significant Other Observable Inputs | Significant Other Unobservable Inputs |\\n| Description | (Unaudited) | (Level 1) | (Level 2) | (Level 3) |\\n| Assets: |\\n| U.S. Treasury Securities held in Trust Account* | $ | 104,699,165 | $ | 104,699,165 | $ | - | $ | - |\\n\\n\\n| December 31, | Quoted Prices In Active Markets | Significant Other Observable Inputs | Significant Other Unobservable Inputs |\\n| Description | 2021 | (Level 1) | (Level 2) | (Level 3) |\\n| (Audited) |\\n| Assets: |\\n| U.S. Treasury Securities held in Trust Account* | $ | 104,535,263 | $ | 104,535,263 | $ | - | $ | - |\\n\\n\\n| * | included in cash and investments held in trust account on the Company’s balance sheets. |\\n\\nNOTE 9 – COMMITMENTS AND CONTINGENCIES\\nRisks and Uncertainties\\nManagement is currently evaluating the impact of the COVID-19 pandemic on the industry and has concluded that while it is reasonably possible that the virus could have a negative effect on the Company’s financial position, results of its operations and/or search for a target company, the specific impact is not readily determinable as of the date of these unaudited condensed financial statements. The unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty.\\n16\\nRegistration Rights\\nPursuant to a registration rights agreement entered into on December 13, 2021 the holders of the Founder Shares, Private Warrants (and their underlying securities) and any securities of the Company’s initial stockholders, officers, directors or their affiliates may be issued in payment of working capital loans made to us, will be entitled to registration rights pursuant to an agreement to be signed prior to or on the effective date of this Proposed Public Offering. The holders of the majority of the founder shares can elect to exercise these registration rights at any time commencing three months prior to the date on which these shares of common stock are to be released from escrow. The holders of a majority of the Private Warrants (and underlying securities) and securities issued in payment of working capital loans (or underlying securities) or loans to extend the life can elect to exercise these registration rights at any time after the Company consummates a Business Combination. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the consummation of a Business Combination. The Company will bear the expenses incurred in connection with the filing of any such registration statements.\\nUnderwriter Agreement\\nThe underwriter is entitled to a cash underwriting discount of 1.75% of the gross proceeds of the Proposed Public Offering, or $1,811,250 until the closing of the Business Combination. In addition, the underwriter will be entitled to a deferred fee ranged between $1,000,000 and $2,250,000. The deferred fee should equal to the greater of 1) $1,000,000; and 2) 2.5% of the cash remaining in the Trust Fund with a maximum amount of $2,250,000. The deferred fee can be paid in cash.\\nNOTE 10 – SUBSEQUENT EVENTS\\nIn accordance with ASC Topic 855, “Subsequent Events”, which establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before this unaudited condensed financial statements are issued, the Company has evaluated all events or transactions that occurred after the balance sheet date, up through August 12, 2022 was the Company issued the unaudited condensed financial statements. During the period, the Company did not have any material subsequent events other than disclosed above.\\n17\\n\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\\nReferences in this report (the “Quarterly Report”) to “we,” “us” or the “Company” refer to Inception Growth Acquisition Limited. References to our “management” or our “management team” refer to our officers and directors, references to the “Sponsor” refer to Soul Venture Partners LLC. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Quarterly Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\\nSpecial Note Regarding Forward-Looking Statements\\nThis Quarterly Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Exchange Act that are not historical facts, and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. All statements, other than statements of historical fact included in this Form 10-Q including, without limitation, statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. Words such as “expect,” “believe,” “anticipate,” “intend,” “estimate,” “seek” and variations and similar words and expressions are intended to identify such forward-looking statements. Such forward-looking statements relate to future events or future performance, but reflect management’s current beliefs, based on information currently available. A number of factors could cause actual events, performance or results to differ materially from the events, performance and results discussed in the forward-looking statements. For information identifying important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements, please refer to the Risk Factors section of the Company’s registration statement on Form S-1 filed with the U.S. Securities and Exchange Commission (the “SEC”). The Company’s securities filings can be accessed on the EDGAR section of the SEC’s website at sec.report. Except as expressly required by applicable securities law, the Company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.\\nOverview\\nWe are a blank check company incorporated as a Delaware corporation on March 4, 2021 and formed for the purpose of entering into a merger, share exchange, asset acquisition, share purchase, recapitalization, reorganization or similar business combination with one or more businesses or entities. We intend to effectuate our initial business combination using cash from the proceeds of the initial public offering and the sale of the Private Warrants, our capital stock, debt or a combination of cash, stock and debt.\\nWe presently have no revenue, have had losses since inception from incurring formation costs and have had no operations other than the active solicitation of a target business with which to complete a business combination. We have relied upon the sale of our securities and loans from our officers and directors to fund our operations.\\nOn December 13, 2021, we consummated our initial public offering (“IPO”) of 9,000,000 units (the “Units”), each Unit consisting of one share of common stock of the Company, par value $0.0001 per share (the “Common Stock”), one-half of one redeemable warrant (the “Warrant”), each whole Warrant entitling the holder thereof to purchase one share of Common Stock for $11.50 per share, and one right (the “Right”) to receive one-tenth (1/10) of a share of Common Stock upon consummation of an initial business combination. The Units were sold at a price of $10.00 per Unit, generating aggregate gross proceeds to the Company of $90,000,000. On December 9, 2021, the underwriters of the IPO fully exercised their over-allotment option, and the closing and sale of an additional 1,350,000 Units (the “Over-Allotment Units”) occurred on December 13, 2021. The issuance by the Company of the Over-Allotment Units at a price of $10.00 per Unit resulted in total gross proceeds of $13,500,000.\\nSimultaneously with the closing of the IPO and the sale of the over-allotment units on December 13, 2021, the Company consummated the private placement (“Private Placement”) with the Sponsor of 4,721,250 warrants (the “Private Warrants”) at a price of $1.00 per Private Warrant, generating total proceeds of $4,721,250. These securities (other than our IPO securities) were issued pursuant to an exemption from registration under the Securities Act of 1933, as amended pursuant to Section 4(2) of the securities Act.\\n18\\nThe Private Warrants are identical to the warrants sold in the IPO except that the Private Warrants will be non-redeemable and the shares of common stock issuable upon exercise thereof are entitled to registration rights pursuant to the Registration Rights Agreement, in each case so long as they continue to be held by the Sponsor or their permitted transferees. Additionally, our Sponsor has agreed not to transfer, assign, or sell any of the Private Warrants or underlying securities (except in limited circumstances, as described in the Registration Statement) until 30 days after the Company completes its initial business combination.\\nOur management has broad discretion with respect to the specific application of the net proceeds of the initial business combination and the Private Placement, although substantially all of the net proceeds are intended to be applied generally towards consummating a business combination.\\nResults of Operations\\nOur entire activity from inception up to December 13, 2021 was in preparation for the initial public offering. Since the initial public offering, our activity has been limited to the evaluation of business combination candidates, and we will not be generating any operating revenues until the closing and completion of our initial business combination. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. We expect our expenses to increase substantially after this period.\\nFor the three and six months ended June 30, 2022 we had a net loss of $163,932 and $381,831, respectively, which was comprised of general and administrative expenses, dividend income and interest income.\\nFor the three and six months ended June 30, 2021 we had a net loss of $52,524 and $52,524, respectively, which was comprised of general and administrative expenses.\\nFor the six months ended June 30, 2022, cash used in operating activities was $685,746, consisting primarily of a net loss of $381,831 and changes in our operating assets and liabilities used cash of $287,163.\\nFor the six months ended June 30, 2021, cash used in operating activities was $52,524, consisting primarily of a net loss of $52,524.\\nLiquidity and Capital Resources\\nAs of June 30, 2022, we had cash of $787,449. Until the consummation of the initial public offering, the only source of liquidity was an initial purchase of common stock by our Sponsor, monies loaned by the Sponsor under a certain unsecured promissory note and advances from our Sponsor.\\nOn December 13, 2021, we consummated the Initial Public Offering of 10,350,000 units (the “Public Units”), which includes the full exercise by the underwriter of its over-allotment option in the amount of 1,350,000 Public Units, at $10.00 per Public Unit, generating gross proceeds of $103,500,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of 4,721,250 Warrants (the “Private Warrants”) at a price of $1.00 per warrant in a private placement to Soul Venture Partners LLC (the “Sponsor”), generating gross proceeds of $4,721,250.\\nTransaction costs amounted to $4,832,697, consisting of $1,811,250 of underwriting fees, $2,587,500 of deferred underwriting fees and $433,947 of other offering costs. In addition, at December 13, 2021, cash of $1,498,937 were held outside of the Trust Account and is available for the payment of offering costs and for working capital purposes net with $104,535,000 transferred to the Trust Account on December 13, 2021.\\n19\\nWe intend to use substantially all of the funds held in the trust account, including any amounts representing interest earned on the trust account to complete our initial business combination (less deferred underwriting commissions). We may withdraw interest to pay taxes. We estimate our annual franchise tax obligations, based on the number of shares of our common stock authorized and outstanding after the completion of this offering, to be $200,000, which is the maximum amount of annual franchise taxes payable by us as a Delaware corporation per annum, which we may pay from funds from this offering held outside of the trust account or from interest earned on the funds held in our trust account and released to us for this purpose. Our annual income tax obligations will depend on the amount of interest and other income earned on the amounts held in the trust account. We expect the interest earned on the amount in the trust account will be sufficient to pay our income and franchise taxes. To the extent that our capital stock or debt is used, in whole or in part, as consideration to complete our initial business combination, the remaining proceeds held in the trust account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies.\\nPrior to the completion of our initial business combination, we will have available to us the approximately $1,100,000 (the amount will remain the same if the over-allotment option is exercised in full) of proceeds held outside the trust account. We will use these funds to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, and structure, negotiate and complete an initial business combination.\\nWe do not believe we will need to raise additional funds following the offering in order to meet the expenditures required for operating our business. However, if our estimates of the costs of identifying a target business, undertaking in-depth due diligence and negotiating an initial business combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our initial business combination. Moreover, we may need to obtain additional financing either to complete our initial business combination or because we become obligated to redeem a significant number of our public shares upon completion of our initial business combination, in which case we may issue additional securities or incur debt in connection with such business combination. In addition, we intend to target businesses larger than we could acquire with the net proceeds of this offering and the sale of the private warrants, and may as a result be required to seek additional financing to complete such proposed initial business combination. Subject to compliance with applicable securities laws, we would only complete such financing simultaneously with the completion of our initial business combination. If we are unable to complete our initial business combination because we do not have sufficient funds available to us, we will be forced to cease operations and liquidate the trust account. In addition, following our initial business combination, if cash on hand is insufficient, we may need to obtain additional financing in order to meet our obligations.\\nOff-balance Sheet Financing Arrangements\\nWe have no obligations, assets or liabilities which would be considered off-balance sheet arrangements as of June 30, 2022. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets.\\nContractual Obligations\\nWe do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities other than an agreement to pay our Sponsor a monthly fee of $10,000 for general and administrative services, including office space, utilities and administrative services to us. We began incurring these fees on March 4, 2021 and will continue to incur these fees monthly until the earlier of the completion of the business combination and our liquidation. Also, we are committed to the below:\\nRegistration Rights\\nThe holders of the Founder Shares, the Private Placement Warrants (and their underlying securities) and the warrants that may be issued upon conversion of the Working Capital Loans (and their underlying securities) are entitled to registration rights pursuant to a registration rights agreement signed on the effective date of the Public Offering. The holders of a majority of these securities are entitled to make up to two demands that we register such securities. The holders of the majority of the Founder Shares can elect to exercise these registration rights at any time commencing three months prior to the date on which these shares are to be released from escrow. The holders of a majority of the Private Placement Warrants and warrants issued in payment of Working Capital Loans made to us (or underlying securities) can elect to exercise these registration rights at any time after we consummate a Business Combination. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the completion of a Business Combination. We will bear the expenses incurred in connection with the filing of any such registration statements.\\nUnderwriting Agreement\\nWe are committed to pay the Deferred Fee ranged between $1,000,000 to $2,250,000, which should equal to the greater of 1) $1,000,000 and 2) 2.5% of the cash remaining in the Trust Fund with a maximum amount of $2,250,000. The deferred fee can be paid in cash.\\n20\\nCritical Accounting Policies\\nThe preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have not identified any significant accounting policies.\\n\\n| ● | Warrant accounting |\\n\\nWe account for warrants as either equity-classified or liability-classified instruments based on an assessment of the warrant’s specific terms and applicable authoritative guidance in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 480, “Distinguishing Liabilities from Equity” (“ASC 480”) and ASC 815, “Derivatives and Hedging” (“ASC 815”). The assessment considers whether the warrants are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and whether the warrants meet all of the requirements for equity classification under ASC 815, including whether the warrants are indexed to our own common stock and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of our control, among other conditions for equity classification. This assessment, which requires the use of professional judgment, is conducted at the time of warrant issuance and as of each subsequent quarterly period end date while the warrants are outstanding.\\nFor issued or modified warrants that meet all of the criteria for equity classification, the warrants are required to be recorded as a component of equity at the time of issuance. For issued or modified warrants that do not meet all the criteria for equity classification, the warrants are required to be recorded as liabilities at their initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of the warrants are recognized as a non-cash gain or loss on the statements of operations.\\nAs the warrants issued upon the IPO and private placements meet the criteria for equity classification under ASC 480, therefore, the warrants are classified as equity.\\n\\n| ● | Common stock subject to possible redemption |\\n\\nWe account for its common stock subject to possible redemption in accordance with the guidance in ASC Topic 480 “Distinguishing Liabilities from Equity.” Common stocks subject to mandatory redemption (if any) are classified as a liability instrument and are measured at fair value. Conditionally redeemable common stocks (including common stocks that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, common stocks are classified as shareholders’ equity. Our common stocks feature certain redemption rights that are subject to the occurrence of uncertain future events and considered to be outside of our control. Accordingly, at June 30, 2022, 10,350,000 shares of common stock subject to possible redemption, respectively, are presented as temporary equity, outside of the shareholders’ equity section of our balance sheet.\\n\\n| ● | Offering costs |\\n\\nWe comply with the requirements of the ASC 340-10-S99-1 and SEC Staff Accounting Bulletin (“SAB”) Topic 5A – “Expenses of Offering”. Offering costs consist principally of professional and registration fees incurred through the balance sheet date that are related to the Public Offering and that were charged to shareholders’ equity upon the completion of the Public Offering.\\n\\n| ● | Net loss per share |\\n\\nWe calculate net loss per share in accordance with ASC Topic 260, “Earnings per Share.” In order to determine the net income (loss) attributable to both the redeemable shares and non-redeemable shares, we first considered the undistributed income (loss) allocable to both the redeemable common stock and non-redeemable common stock and the undistributed income (loss) is calculated using the total net loss less any dividends paid. We then allocated the undistributed income (loss) ratably based on the weighted average number of shares outstanding between the redeemable and non-redeemable common stock. Any remeasurement of the accretion to the redemption value of the common stock subject to possible redemption was considered to be dividends paid to the public stockholders. As of June 30, 2022, we have not considered the effect of the warrants sold in the Initial Public Offering and private warrants to purchase an aggregate of 9,896,250 shares in the calculation of diluted net loss per share, since the exercise of the warrants is contingent upon the occurrence of future events and the inclusion of such warrants would be anti-dilutive and we did not have any other dilutive securities and other contracts that could, potentially, be exercised or converted into common stock and then share in our earnings. As a result, diluted loss per share is the same as basic loss per share for the period presented.\\n21\\n\\nItem 3. Quantitative and Qualitative Disclosures about Market Risk\\nThe net proceeds of the IPO held in the trust account may be invested in U.S. government treasury bills, notes or bonds with a maturity of 180 days or less or in certain money market funds that invest solely in US treasuries. Due to the short-term nature of these investments, we believe there will be no associated material exposure to interest rate risk.\\n\\nItem 4. Controls and Procedures\\nEvaluation of Disclosure Controls and Procedures\\nDisclosure controls and procedures are designed to ensure that information required to be disclosed by us in our Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.\\nUnder the supervision and with the participation of our management, including our principal executive officer and principal financial and accounting officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures as of the end of the fiscal quarter ended June 30, 2022, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act. Based on this evaluation, our principal executive officer and principal financial and accounting officer have concluded that during the period covered by this report, our disclosure controls and procedures were effective at a reasonable assurance level and, accordingly, provided reasonable assurance that the information required to be disclosed by us in reports filed under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.\\nChanges in Internal Control over Financial Reporting\\nThere was no change in our internal control over financial reporting that occurred during the fiscal quarter of June 30, 2022 covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\\n22\\nPART II - OTHER INFORMATION\\n\\nItem 1 Legal Proceedings\\nThe Company is not party to any legal proceedings as of the filing date of this Form 10-Q.\\n\\nItem 1A. Risk Factors.\\nFactors that could cause our actual results to differ materially from those in this Quarterly Report are any of the risks described in our final prospectus for our Initial Public Offering filed with the SEC on December 8, 2021. Any of these factors could result in a significant or material adverse effect on our results of operations or financial condition. Additional risk factors not presently known to us or that we currently deem immaterial may also impair our business or results of operations. As of the date of this Quarterly Report, there have been no material changes to the risk factors disclosed in our final prospectus dated December 8, 2021 other than as stated below.\\n\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\\nOn December 13, 2021, we consummated our initial public offering (“IPO”)of 9,000,000 units (the “Units”), each Unit consisting of one share of common stock of the Company, par value $0.0001 per share (the “Common Stock”), one-half of one redeemable warrant (the “Warrant”), each whole Warrant entitling the holder thereof to purchase one share of Common Stock for $11.50 per share, and one right (the “Right”) to receive one-tenth (1/10) of a share of Common Stock upon consummation of an initial business combination. The Units were sold at a price of $10.00 per Unit, generating aggregate gross proceeds to the Company of $90,000,000. On December 9, 2021, the underwriters of the IPO fully exercised their over-allotment option, and the closing and sale of an additional 1,350,000 Units (the “Over-Allotment Units”) occurred on December 13, 2021. The issuance by the Company of the Over-Allotment Units at a price of $10.00 per Unit resulted in total gross proceeds of $13,500,000.\\nSimultaneously with the closing of the IPO and the sale of the over-allotment units on December 13, 2021, the Company consummated the private placement (“Private Placement”) with the Sponsor of 4,721,250 warrants (the “Private Warrants”) at a price of $1.00 per Private Warrant, generating total proceeds of $4,721,250. These securities (other than our IPO securities) were issued pursuant to an exemption from registration under the Securities Act of 1933, as amended pursuant to Section 4(2) of the securities Act.\\n23\\nThe Private Warrants are identical to the warrants sold in the IPO except that the Private Warrants will be non-redeemable and the shares of common stock issuable upon exercise thereof are entitled to registration rights pursuant to the Registration Rights Agreement, in each case so long as they continue to be held by the Sponsor or their permitted transferees. Additionally, our Sponsor has agreed not to transfer, assign, or sell any of the Private Warrants or underlying securities (except in limited circumstances, as described in the Registration Statement) until 30 days after the Company completes its initial business combination.\\nAs of December 31, 2021, a total of $104,535,351 was held in a trust account established for the benefit of the Company’s public stockholders, which included $103,500,000 of the net proceeds from the IPO (including the exercise of the over-allotment option) and $4,721,250 of the Private Placements and subsequent interest income.\\nWe paid a total of $1,811,250 in underwriting discounts and commissions (not including the deferred underwriting commission payable at the consummation of initial business combination) and approximately $433,947 for other costs and expenses related to our formation and the initial public offering.\\n\\nItem 3. Defaults Upon Senior Securities.\\nNone.\\n\\nItem 4. Mine Safety Disclosures.\\nNot Applicable.\\n\\nItem 5. Other Information.\\nNone.\\n\\nItem 6. Exhibits\\nThe following exhibits are filed as part of, or incorporated by reference into, this Quarterly Report on Form 10-Q.\\n\\n| 31.1 | Certification of Principal Executive Officer Pursuant to Securities Exchange Act Rules 13a-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 31.2 | Certification of Principal Financial Officer Pursuant to Securities Exchange Act Rules 13a-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 32.1 | Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 32.2 | Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 101.INS | Inline XBRL Instance Document. |\\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document. |\\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document. |\\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document. |\\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document. |\\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document. |\\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101). |\\n\\n24\\nSIGNATURES\\nIn accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\n\\n| INCEPTION GROWTH ACQUISITION LIMITED |\\n| Date: August 12, 2022 | By: | /s/ Paige E. Craig |\\n| Name: | Paige E. Craig |\\n| Title: | Chief Executive Officer |\\n| (Principal Executive Officer) |\\n\\n25\\n\\n \\n\\nWhat is the growth rate of total liabilities from December 31, 2021, to June 30, 2022?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is -8.811136802180823.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 71,\n \"input_length\": 21004\n}"}}},{"rowIdx":72,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nITEM 1.\nBUSINESS\nOur Company\nAlign Technology, Inc (“We”, “Our”, “Align”) designs, manufactures and markets a system of clear aligner therapy, intraoral scanners and CAD/CAM (computer-aided design and computer-aided manufacturing) digital services used in dentistry, orthodontics, and dental records storage. Align Technology was founded in March 1997 and incorporated in Delaware in April 1997. Our headquarters is located at 2560 Orchard Parkway, San Jose, California 95131, and our telephone number is 408-470-1000. Our internet address is www.aligntech.com. Our international headquarters is located in Amsterdam, the Netherlands.\nWe have two operating segments: (1) Clear Aligner and (2) Scanners and Services (\"Scanner\"). For the year ended December 31, 2016, Clear Aligner revenues represent approximately 89% of worldwide revenue, while Scanner represent the remaining 11% of worldwide revenues. We distribute the vast majority of our products directly to our customers: orthodontists and general practitioner dentists (\"GPs\"), as well as to restorative dentists, including prosthodontists, periodontists, and oral surgeons. We also supply clear aligners to SmileDirectClub, LLC (\"SDC\") who sells them directly to consumers, with a doctor’s approved prescription.\nWe received 510(k) clearance from the United States Food and Drug Administration (“FDA”) to market the Invisalign System in 1998. The Invisalign System is regulated by the FDA as a Class II medical device. In order to provide Invisalign treatment to their patients, orthodontists and GPs must initially complete an Invisalign training course. The Invisalign System is primarily sold through a direct sales force in the United States (\"U.S.\"), Canada, Europe, certain Asia Pacific countries, Latin America and Middle East and Africa including Australia, New Zealand, China and Japan. We use a distributor model for the sale of our products in non-core country markets in the Asia Pacific (\"APAC\"), Europe, Middle East and Africa (\"EMEA\"), and Latin America regions.\nOur iTero scanner is used by dental professionals and/or labs and services for restorative and orthodontic digital procedures as well as Invisalign digital impression submission. We received 501(k) clearance from the FDA to market iTero software for expanded indications in 2013. Scanners and CAD/CAM Services are primarily sold through our direct sales force in North America, Europe and certain Asia Pacific countries including Taiwan, Singapore, Korea, Australia, New Zealand, and through distribution partners in Thailand, Scandinavia and Russia.\n3\nOur Products and Services\nOur net revenues are generated from the sale of the following product offerings:\n| Fiscal Year |\n| Percentage of Net Revenues by Product | 2016 | 2015 | 2014 |\n| Clear Aligner Segment |\n| Comprehensive Products | 72 | % | 78 | % | 77 | % |\n| Non-Comprehensive Products | 11 | 11 | 11 |\n| Non-Case Products | 6 | 6 | 6 |\n| Total Clear Aligner Segment | 89 | 95 | 94 |\n| Scanners and Services Segment | 11 | 5 | 6 |\n| Total Net Revenues | 100 | % | 100 | % | 100 | % |\n\nClear Aligner Segment\nMalocclusion and Traditional Orthodontic Treatment\nMalocclusion, or the misalignment of teeth, is one of the most prevalent clinical dental conditions, affecting billions of people, or approximately 60% to 75% of the population. Annually, approximately 10 million people in major developed countries elect treatment by orthodontists worldwide, of which approximately 50% or 5 million have mild to moderate malocclusion and are applicable to Invisalign treatment - our served market. In addition, approximately 100 million people with malocclusion want to straighten their teeth; however, they will not seek orthodontic treatment in a doctor's office and would instead elect to receive clear aligner treatment in the convenience of their own home - referred to as the doctor-directed at home market.\nIn the U.S., orthodontists and GPs treat malocclusion primarily with metal arch wires and brackets, referred to as braces, and they may augment braces with elastics, metal expanders, headgear or functional appliances, and other ancillary devices as needed. Available options for improving treatment aesthetics include the use of ceramic, tooth-colored brackets or bonding brackets on the inside, or lingual surface, of the patient’s teeth. The average treatment takes approximately 12 to 24 months to complete and requires several hours of direct dental professional involvement, known in the industry as “chair time,” including the initial diagnosis, creation of an appropriate treatment plan and bonding of the brackets to the patient’s teeth, and attachment of arch wires to the brackets. Subsequent visits involve tightening or otherwise adjusting the braces approximately every six weeks until the final visit when the dental professional removes each bracket and residual bonding agent from the patient’s teeth. Upon completion of the treatment, the dental professional may, at his or her discretion, have the patient use a retainer. GPs, may also combine orthodontic treatment with restorative treatment. Many times the dental professional may need to move certain teeth or roots out of the way to create more space for implant placement, or move teeth to create space for restorations of missing teeth. In addition, GPs may need to move or adjust teeth or spaces to be able to place better restorations. The orthodontic portion of treatment generally comes before the restorative portion.\nThe Invisalign System\nThe Invisalign System is a proprietary method for treating malocclusion based on a series of doctor-prescribed, custom manufactured, clear plastic, removable orthodontic aligners. The Invisalign System offers a range of treatment options, specialized services, and proprietary software for treatment visualization and is comprised of the following phases:\nOrthodontic diagnosis and transmission of treatment data to us. The Invisalign-trained dental professional prepares and sends us a patient’s treatment data package which consists of a prescription form, a polyvinyl-siloxane, (or \"PVS\") impression of the relevant dental arches, photographs of the patient and, at the dental professional’s election, x-rays of the patient’s dentition. The Invisalign-trained dental professional can also submit an intraoral digital scan instead of a physical PVS impression through either Align's iTero scanner or several third-party scanners. See \"Third Party Scanners.\"\nPreparation of computer-simulated treatment plan. Upon receipt, we use the treatment data package to construct digital models of the patient’s dentition. In cases where a PVS impression has been submitted, we use computed tomography, known as CT scanning to develop a digital, three-dimensional computer model of the patient’s current dentition. In cases where the dental professional submits a digital scan, this step in the process is eliminated. We transform this initial digital model into a proposed custom, three-dimensional treatment plan, called a ClinCheck treatment plan. The ClinCheck treatment plan simulates\n4\nappropriate tooth movement broken down into a series of increments and details timing and placement of any attachments that will be used during treatment. Attachments are tooth-colored “buttons” that are sometimes used to increase the biomechanical force on a specific tooth or teeth in order to effect the desired movement.\nReview and approval of the treatment plan by an Invisalign provider. The patient’s ClinCheck treatment plan is then made available to the prescribing dental professional via the Invisalign Doctor Site which enables the dental professional to project tooth movement with a level of accuracy not previously possible with metal arch wires and brackets. By reviewing, modifying as needed and approving the treatment plan, the dental professional retains control over the treatment plan.\nManufacture of custom aligners. Upon the dental professional’s approval of the ClinCheck treatment plan, we use the data underlying the simulation, in conjunction with stereolithography technology (a form of 3D printing technology), to construct a series of molds depicting the future position of the patient’s teeth. Each mold is a replica of the patient’s teeth at each stage of the simulated course of treatment. From these molds, aligners are fabricated by pressure-forming polymeric sheets over each mold. Aligners are thin, clear plastic, removable dental appliances that are custom manufactured in a series to correspond to each stage of the ClinCheck treatment plan.\nShipment to the dental professional and patient aligner wear. All the aligners for a patient are shipped directly to the dental professional, who then dispenses them to the patient at regular check-up intervals throughout the treatment. Aligners are generally worn for consecutive two-week periods or less which correspond to the approved ClinCheck treatment plan. The patient replaces the aligners with the next pair in the series when prescribed, advancing tooth movement with each aligner stage. Throughout treatment, the doctor may place attachments or use other auxiliaries to achieve desired tooth movements, per the doctor’s original prescription and resulting ClinCheck treatment plan. In October 2016, we introduced one-week aligner wear. At the treating doctor’s discretion, we recommend changing from two-week aligner wear to one-week aligner wear for Invisalign treatments with Invisalign Full, Invisalign Teen and Invisalign Assist products, thereby reducing treatment time by up to 50%. Align’s recommendation is based on clinical analysis of more than 200 in-progress Invisalign cases (data on file) and the experiences of numerous Invisalign providers.\nTreatment progress and request for additional aligners. Should the dental professional determine that the treatment is not tracking for various reasons, such as patient compliance, certain teeth not tracking to plan, or they need to extend the treatment a few stages further to achieve their treatment goals, the dental professional can request additional aligners at no charge at any point during the treatment, subject to certain requirements.\nClear Aligner Products\nComprehensive Products:\nInvisalign Full. Used for a wide range of malocclusion, the Invisalign Full treatment consists of the number of aligners necessary to achieve the doctor’s treatment goals. Invisalign Full treatment aligners are manufactured and then delivered to the dental professionals in a single shipment. Invisalign Full is sold in the U.S., Canada and our international regions.\nInvisalign Teen. The Invisalign Teen treatment includes all the features of Invisalign Full treatment, plus additional features that address the orthodontic needs of teenage patients such as compliance indicators, compensation for tooth eruption and six free single arch replacement aligners. This product is predominantly marketed to orthodontists who treat the vast majority of malocclusion in teenage patients. Invisalign Teen treatment aligners (other than the replacement aligners) are manufactured and then delivered to the dental professionals in a single shipment. Invisalign Teen is sold in the U.S., Canada and our international regions.\nInvisalign Assist. Used for anterior alignment and aesthetically-oriented cases, the Invisalign Assist treatment offers added support to our dental practitioners throughout the treatment process, including progress tracking that allows the dental professional to submit new impressions every nine stages. When the progress tracking feature is selected, aligners are shipped to the dental professional after every nine stages thereby helping to achieve successful treatment outcomes. Predominantly marketed to GPs, Invisalign Assist is intended to make it easier to select appropriate cases for their experience level or treatment approach, submit cases more efficiently and manage appointments with suggested tasks. Invisalign Assist is sold in the U.S. and Canada.\n5\nNon-Comprehensive Products:\nInvisalign Express (10 and 5) and Invisalign Lite/i7. Invisalign Express treatments, Invisalign Lite treatment and Invisalign i7 treatment are lower-cost solutions for less complex orthodontic cases, non-comprehensive treatment relapse cases, or straightening prior to restorative or cosmetic treatments such as veneers. Invisalign Express 10 and Invisalign Express 5, which are sold in the U.S. and Canada, use up to 10 and 5 sets of aligners, respectively, and are also available as a single arch option. Invisalign Lite and Invisalign i7, sold in our international regions, use up to 14 and 7 sets of aligners, respectively. For Invisalign Express/Lite/i7, aligners are manufactured and then delivered to the dental professionals in a single shipment.\nInvisalign Go. A simplified and streamlined solution designed for GP dentists to more easily identify and treat patients with mild malocclusion. Invisalign Go combines case assessment support, a simplified ClinCheck treatment plan and a progress assessment feature for case monitoring. Invisalign Go was launched in core European markets in the fourth quarter of 2016 and is expected to launch in North America in the first quarter of 2017.\nSmileDirectClub Aligners. On July 25, 2016, we entered into a supply agreement with SmileDirectClub, LLC (\"SDC\") to manufacture non-Invisalign clear aligners for SDC's doctor-led, at-home program for simple teeth straightening. In October 2016, we became SDC's exclusive third-party supplier and began supplying aligners directly to SDC. SDC aligners include up to 20 stages without attachments or interproximal reduction (\"IPR\"). Align manufactures the aligners per SDC’s specifications for minor tooth movement using EX-30 aligner material.\nNon-Case Products:\nClear Aligner non-case products include retention products, Invisalign training fees and sales of ancillary products, such as cleaning material and adjusting tools used by dental professionals during the course of treatment.\nRetention. We offer two products for post treatment retention. The first is a single set of custom clear aligner retainers. The second is offered as a set of four custom clear aligners called Vivera Retainers made with proprietary material strong enough to maintain tooth position and correct minor relapse if necessary. A shipment of four sets are available to both Invisalign and non-Invisalign patients.\nFeature Enhancements\nWe have consistently introduced enhanced features across the Invisalign System over the past several years, such as Invisalign G3 (launched in October 2010), Invisalign G4 (launched in November 2011), Invisalign G5 (launched in February 2014) and Invisalign G6 (launched in March 2015). In October 2016, we launched Invisalign G7, a set of features designed to deliver greater control of tooth movements and improved treatment outcomes.\nInvisalign G5 innovations for deep bite is engineered to improve clinical outcomes in deep bite treatment with Invisalign treatment. Comprehensive features dedicated to deep bite treatment include new SmartForce® features that are designed to level the curve of spee by improving control of anterior intrusion and premolar extrusion for more predictable deep bite treatments, and precision bite ramps that are designed to disocclude the posterior teeth for improved efficiency in deep bite treatments.\nInvisalign G6 clinical innovations for first premolar extraction is engineered to improve clinical outcomes for orthodontic treatment of severe crowding and bimaxillary protrusion. Feature enhancements include new SmartStage programmed tooth movements that optimize the progression of tooth movements and provide aligner activation, engineered to eliminate unwanted tipping and unwanted anterior extrusion during retraction and new SmartForce features that are designed to deliver the force systems necessary to achieve predictable tooth movements.\nInvisalign G7 builds on earlier Invisalign G-series releases with new features to fine-tune certain tooth movements and deliver treatment outcome quality that Invisalign providers expect, particularly with teenage patients. Powered by Invisalign SmartStage technology that optimizes the staging and sequence of tooth movements and aligner activation for greater predictability, Invisalign G7 delivers better upper lateral control, improved root control, and features to address prevention of posterior open bites.\nSmartTrack™ Aligner Material\nSmartTrack is a proprietary, custom-engineered Invisalign clear aligner material that delivers gentle, more constant force considered ideal for orthodontic tooth movements. Conventional aligner materials relax and lose a substantial percent of energy in the initial days of aligner wear, but SmartTrack maintains more constant force over the period of time the patient wears the\n6\naligners. The flexible SmartTrack material also more precisely conforms to tooth morphology, attachments and interproximal spaces to improve control of tooth movement throughout treatment.\nScanner Segment\nIntraoral scanning is an emerging technology that we believe will have substantial impact on the future of dentistry. By enabling the dental practitioner to create a 3D image of the patient's teeth (digital scan) using a handheld intraoral scanner inside the mouth, digital scanning is more efficient and precise and more comfortable for patients, compared to the mess, discomfort and subjective nature of taking physical impressions. The digitally scanned model is more accurate than a physical impression and substantially reduces the rate of restoration \"remakes\" so patients are recalled less often and the appointment time for the restoration is shorter because of fewer adjustments which results in greater overall patient satisfaction. The digital model file can be used for various procedures and services including fabrication of physical dental models for use by labs to create restorative units such as veneers, inlays, onlays, crowns, bridges and implant abutments; digital records storage; orthodontic diagnosis; orthodontic retainers and appliances; and Invisalign digital impression submission.\niTero Scanner. The iTero scanner is available as a single hardware platform with software options for restorative or orthodontic procedures. In March 2015, we announced our next generation iTero Element Intraoral Scanner which features a more compact footprint, enhanced wand and multi-touch display and is engineered to enable faster scan speeds for more efficient, real-time clinical evaluation. We began shipping the iTero Element Intraoral Scanner in September 2015. We market and sell the iTero Element in North America and in select international markets. The iTero scanner is interoperable with our Invisalign treatment such that a full arch digital scan can be submitted as part of the Invisalign case submission process. In addition, the Invisalign Outcome Simulator and features are exclusive to the iTero scanner.\nRestorative software for iTero. Software designed for GPs, prosthodontists, periodontists, and oral surgeons which includes features for restorative procedures commonly performed in their practices such as veneers, inlays, onlays, crowns, bridges and implants. The iTero restorative software provides the ability to scan quadrants and full arches, and allows simple powder-free capture of digital impressions for single-unit cases as well as more complex restorative and implant treatment plans. The iTero software also contains Invisalign interoperability to support clear aligner orthodontic treatment.\nOrthodontic software for iTero. Software designed for orthodontists for digital records storage, orthodontic diagnosis, Invisalign digital impression submission, and for the fabrication of printed models and retainers. The iTero orthodontic software digitally captures the contours of the dentition and the gingival structures, providing an accurate, powder-free digital orthodontic scan in just minutes. This digital impression procedure ensures a more comfortable patient experience and produces a precise scan that can be seamlessly integrated with Invisalign treatment, OrthoCAD iCast, and OrthoCAD iRecord which allows a doctor to utilize sophisticated measurement and treatment planning tools.\nCAD/CAM Services\niTero Models and Dies. An accurate physical model and dies are manufactured based on the digital scan and sent to the laboratory of the dentist’s choice for completion of the needed restoration. The laboratory also has the option to export the digital file for immediate production of coping and full-contour restorations on their laboratory CAD/CAM systems. The laboratory conducts then completes the ceramic buildup or staining and glazing and delivers the end result - a precisely fitting restoration. iTero prosthetics have a near-zero remake rate.\nOrthoCAD iCast. iCast provides a digital alternative to traditional stone cast models which allows for simplified storage and digital record retrieval. The iCast digital model contains a full American Board of Orthodontics (\"ABO\") base and is available from an iTero scan or from a traditional alginate impression.\nOrthoCAD iRecord. iRecord scans provide a digital alternative to traditional stone cast models which allows for simplified storage and digital record retrieval. iRecord scan data may also be exported to orthodontic laboratories for the fabrication of retainers, orthodontic appliances, and hard model fabrication.\nThird Party Scanners and Digital scans for Invisalign treatment submission. We support an open systems approach to digital scans and other intraoral scanning companies interested in qualifying their scanners to submit a digital impression in place of a traditional PVS impression as part of the Invisalign case submission process. We have qualified several scanners for digital scan submission including 3M™ True Definition scanner (January 2014), the Sirona CEREC Omnicam scanner (March 2015) and certain TRIOS scanners (October 2016).\n7\nChair Side Applications\nInvisalign Outcome Simulator. The Invisalign Outcome Simulator is an exclusive chair-side and cloud-based application for the iTero scanner that allows doctors to help patients visualize how their teeth may look at the end of Invisalign treatment through a dual view layout that shows a prospective patient an image of his/her own current dentition next to his/her simulated final position after Invisalign treatment. Using a full arch digital scan, the Invisalign Outcome Simulator takes a few minutes to run and may be viewed chair-side, on the scanner, or from a computer using MyAlignTech.com. Intuitive tools allow doctors to make real-time adjustments to individual teeth during consultations that increase patient education and the likelihood of patient acceptance. In October 2016, we introduced the following new features in the 4.0 upgrade:\n| • | 3D Progress Tracking - Ability to compare a patient’s new scan with a specific stage of their ClinCheck treatment plan to visually assess and communicate Invisalign treatment progress with an easy to read, color-coded tooth movement report that allows the doctor to know how each tooth is tracking. |\n\n| • | Patient Simulation Sharing - Ability to easily share the patient’s 3D simulated Invisalign treatment outcome through a protected patient portal which can be viewed on smartphones, tablets and computers. |\n\nOur iTero scanner includes orthodontic software and/or restorative software and the Invisalign Outcome Simulator. The orthodontic or restorative software may also be purchased subsequently for an upgrade fee. The Invisalign Outcome Simulator is not available for sale separately.\nOther proprietary software mentioned in this Annual Report on Form 10-K such as ClinCheck and ClinCheck Pro software, the Invisalign Doctor Site, and enhanced feature solutions such as Invisalign G7 are included as part of the Invisalign System and are not sold separately nor do they contribute as individual items of revenue.\nBusiness Strategy\nOur goal is to establish Invisalign clear aligners as the standard method for treating malocclusion and to establish the iTero intraoral scanner as the preferred scanning protocol for 3D digital scans, ultimately driving increased product adoption by dental professionals. We intend to achieve this by continued focus and execution of our strategic growth drivers: International, Orthodontists Utilization, GP Dentists Treat & Refer and Patient Demand & Conversion\n| 1. | International Expansion. We expect to continue to grow and expand our business by investing in resources, infrastructure, and initiatives that will drive Invisalign treatment growth in our current and new international markets. As our core countries within the EMEA and APAC regions continue to grow in both number of new Invisalign providers and utilization, we strive to make sure we can support that growth through investments such as headcount, clinical support, education and advertising. Additionally, we are expanding our presence and entering new markets, such as India and Korea, by establishing a solid base of key opinion leaders and early adopters who can help build clinical confidence in the orthodontic community and create strong brand preference for Invisalign treatment among consumers. We have also transitioned most of our indirect smaller country markets to a direct sales model, and, while we do not expect a material impact from these countries for some time, in the near term, we will leverage our existing infrastructure in adjacent country markets as we build local sales organizations to drive long-term market penetration. |\n\n| 2. | Orthodontist Utilization. We want all of our orthodontist providers to have the confidence and motivation to lead with Invisalign for every patient that walks into their practice. We strive to achieve this by increasing the product applicability and predictability for a wide range of complex cases within adults, teenagers and younger aged patients. As an example, in 2015, we launched Invisalign G6 clinical innovations for first premolar extractions. The nature of malocclusion that requires first premolar tooth extraction is an orthodontic problem that affects more than 50% of people in Asia, 20% in Europe and 12% in North America. In October 2016, we launched Invisalign G7, which builds on earlier Invisalign G-series releases with new features to fine-tune certain tooth movements and deliver treatment outcome quality that Invisalign providers expect, particularly with teenage patients. We also continue to make improvements to our Invisalign treatment software, ClinCheck Pro, designed to deliver an exceptional user experience and increase treatment control to help our doctors achieve their treatment goals. |\n\n| 3. | GP Dentist Treat & Refer. We want to make it easier for GPs to identify the cases that they can treat and refer the cases that are too complex over to orthodontists. Although GPs have a larger pool of potential patients, which can expand the market for Invisalign treatment, overall, we need to provide them with tools to help them quickly identify cases they can treat, monitor patient progress or if needed, help refer them more easily to an orthodontist. The iTero scanner is an important component to that customer experience. In October 2016, we introduced a 3D progress tracking feature in the |\n\n8\nInvisalign Outcome Simulator application that provides our customers with the ability to compare a patient’s new scan with a specific stage of their ClinCheck treatment plan to visually assess and communicate Invisalign treatment progress.\n| 4. | Patient Demand & Conversion. Our goal is to make Invisalign a highly recognized name brand worldwide by creating awareness for Invisalign treatment among consumers and motiving potential patients to seek treatment from an Invisalign provider. In support of this objective, we invest in initiatives designed to strengthen our global brand name recognition, drive patient demand and covert that interest into Invisalign treatment case starts. We accomplish this objective through an integrated consumer marketing strategy that includes television, media, social networking and event marketing as well as educating patients on treatment options and directing them to high volume Invisalign providers. |\n\nSupply Agreement with SmileDirectClub, LLC\nOn July 28, 2016, we announced a supply agreement with SmileDirectClub, LLC (\"SDC\") to manufacture non-Invisalign clear aligners for SDC’s doctor-led, at-home program for affordable, cosmetic teeth straightening. The agreement brings our manufacturing and production expertise to a new and growing segment of the adult treatment market, one that provides new treatment choices to consumers and new business opportunities to Invisalign providers.\nBeginning October 2016, we became SDC’s exclusive third-party supplier for its minor tooth movement aligner program. Specifically, we provide a case setup through SDC’s SmileCheck viewer portal and upon review and approval by a participating licensed orthodontist or general dentist in SDC’s network, we manufacture clear aligners and ship them directly to SDC.\nSDC aligners include up to 20 stages without attachments or interproximal reduction (IPR). We manufacture the aligners per SDC’s specifications for minor tooth movement using EX-30 aligner material. The Invisalign brand and system of clear aligners continue to be available exclusively for in office treatment with Invisalign-trained orthodontists and general dentists.\nIn addition, under the agreement, Align and SDC created a new Invisalign doctor referral program similar to the Invisalign Doc Locator, that systematically refers the approximately 30% of SDC’s SmileCheck case assessments that are too complex for their minor tooth movement product, to Invisalign providers in the patient’s local area. The goal of the agreement is to help expand the market and opportunity for our Invisalign doctors, while supporting SDC’s efforts to provide consumers with access to more choices in treating simple cases from the convenience of their own home.\nManufacturing and Suppliers\nOur manufacturing facilities are located in Juarez, Mexico, where we conduct our aligner fabrication, distribute and repair our scanners and perform our CAD/CAM services, and in Or Yehuda, Israel where we produce our handheld intraoral scanner wand. The final assembly of our iTero scanner is performed by a third party manufacturer located in Israel. Our Invisalign digital treatment planning and interpretation for iTero restorative cases are conducted primarily at our facility located in San Jose, Costa Rica. Information regarding risks associated with our manufacturing process and foreign operations may be found in Item 1A of this Annual Report on Form 10-K under the heading “Risk Factors.”\nOur quality system is required to be in compliance with the Quality System regulations enforced by the FDA, and similar regulations enforced by other worldwide regulatory authorities. We are certified to EN ISO 13485:2003, an internationally recognized standard for medical device manufacturing. We have a formal, documented quality system by which quality objectives are defined, understood and achieved. Systems, processes and procedures are implemented to ensure high levels of product and service quality. We monitor the effectiveness of the quality system based on internal data and direct customer feedback and strive to continually improve our systems and processes, taking corrective action, as needed.\nSince the manufacturing process of our products requires substantial and varied technical expertise, we believe that our manufacturing capabilities are important to our success. In order to produce our highly customized, highly precise, medical quality products in volume, we have developed a number of proprietary processes and technologies. These technologies include complex software algorithms and solutions, CT scanning, stereolithography and automated aligner fabrication. To increase the efficiency of our manufacturing processes, we continue to focus our efforts on software development and the improvement of rate-limiting processes or bottlenecks. We continuously upgrade our proprietary, three-dimensional treatment planning software to enhance computer analysis of treatment data and to reduce time spent on manual and judgmental tasks for each case, thereby increasing the efficiency of our technicians in Costa Rica. In addition, to improve efficiency and increase the scale of our operations, we continue to invest in the development of automated systems for the fabrication and packaging of aligners.\nWe are highly dependent on manufacturers of specialized scanning equipment, rapid prototyping machines, resin and other advanced materials for our aligners, as well as the optics, electronic and other mechanical components of our intraoral scanners. We\n9\nmaintain single supply relationships for many of these machines and materials technologies. In particular, our CT scanning and stereolithography equipment used in our aligner manufacturing and many of the critical components for the optics of our intraoral scanners are provided by single suppliers. We are also committed to purchasing all of our resin and polymer, the primary raw materials used in our manufacturing process for clear aligners, from a single source. The need to replace one of our single source suppliers could cause a disruption in our ability to timely deliver certain of our products or increase costs. See Item 1A Risk Factors — “We maintain single supply relationships for certain of our key machines and materials technologies, and our business and operating results could be harmed if supply is restricted or ends or the price of raw materials used in our manufacturing process increases.”\nSales and Marketing\nOur sales efforts are focused primarily on the Invisalign System and continuing to increase adoption and utilization by orthodontists and GPs worldwide. In North America, Europe and certain Asia Pacific country markets, and more recently in Brazil and certain regions in the Middle East and Africa, we have direct sales and support organizations, which includes quota carrying sales representatives, sales management and sales administration. We also have distribution partners that sell the Invisalign System in smaller non-core country markets outside of North America. We continued to expand in our existing markets through targeted investments in sales coverage, professional marketing and education programs, along with consumer marketing in selected country markets.\nFor the iTero scanner, we have a small team of direct sales representatives in North America. Our intraoral scanner sales team leverages leads generated by our Invisalign sales and marketing resources, including customer events and industry trade-shows. We sell the iTero scanner in select country markets internationally and will expand to additional markets over time to grow the scanner business.\nWe provide training, marketing and clinical support to orthodontists and GPs. In 2016, we had approximately 54,480 active Invisalign providers.\nResearch and Development\nWe are committed to investing in world-class technology development, which we believe is critical to achieving our goal of establishing the Invisalign System as the standard method for treating malocclusion and our intraoral scanning platform as the preferred scanning protocol for digital scans. Our research and development expenses were $75.7 million, $61.2 million and $52.8 million for the year ended December 31, 2016, 2015 and 2014, respectively.\nOur research and development activities are directed toward developing the technology innovations that we believe will deliver our next generation of products and platforms. These activities range from accelerating product and clinical innovation to developing manufacturing process improvements to researching future technologies and products.\nIn an effort to demonstrate Invisalign’s broad treatment capabilities, various clinical case studies and articles have been published that highlight the clinical applicability of Invisalign to malocclusion cases, including those of severe complexity. We undertake pre-commercialization trials and testing of our technological improvements to the product and manufacturing process.\nIntellectual Property\nWe believe our intellectual property position represents a substantial business advantage. As of December 31, 2016, we had issued 425 U.S. patents, 370 foreign issued patents, and 386 pending global patent applications.\nWe continue to pursue further intellectual property protection through U.S. and foreign patent applications and non-disclosure agreements. Our issued U.S. patents expire between 2017 and 2035. In addition, corresponding foreign patents will start to expire in 2018. When patents expire, we lose the protection and competitive advantages they provided to us, which could negatively impact our operating results; however, we continue to pursue further intellectual property protection through U.S. and foreign patent applications and non-disclosure agreements. We also seek to protect our software, documentation and other written materials under trade secret and copyright laws. We cannot be certain that patents will be issued as a result of any patent application or that patents that have been issued to us or that may be issued in the future will be found to be valid and enforceable and sufficient to protect our technology or products. Our intellectual property rights may not be successfully asserted in the future or may be invalidated, circumvented or challenged. In addition, the laws of various foreign countries do not protect our intellectual property rights to the same extent as U.S. laws. Our inability to protect our proprietary information could harm our business. Information regarding risks associated with failing to protect our proprietary technology and our intellectual property rights may be found in Item 1A of this Annual Report on Form 10-K under the heading “Risk Factors.”\n10\nSeasonal Fluctuations\nGeneral economic conditions impact our business and financial results, and we experience seasonal trends related to our two operating segments, customer channels and the geographic locations that we serve. For example, European sales of Invisalign treatment are often weaker in the summer months due to our customers and their patients being on holiday. In North America, summer is typically the busiest season for orthodontists with practices that have a high percentage of adolescent and teenage patients as many parents want to get their teenagers started in treatment before the start of the school year; however, many GPs are on vacation during this time and therefore tend to start fewer cases. For our Scanner segment, capital equipment sales are often stronger in the fourth calendar quarter. Consequently, these seasonal trends have caused and may continue to cause, fluctuations in our quarterly results, including fluctuations in sequential revenue growth rates.\nBacklog\nDue to the individualized nature of an Invisalign treatment which is prescribed by a doctor, no two cases are alike, thus we maintain relatively low levels of backlog. The period from which a treatment data package (or “a case”) is received until the acceptance of the digital ClinCheck treatment plan is dependent on the dental professional’s discretion to modify, accept or cancel the treatment plan. Therefore, we consider the case a firm order to manufacture aligners once the dental professional has approved the ClinCheck treatment plan. Our Invisalign backlog consists of ClinCheck treatment plans that have been accepted but not yet shipped. Because aligners are shipped shortly after the ClinCheck treatment plan has been accepted, we believe that backlog is not a good indicator of future Invisalign sales. Our quarterly Invisalign revenues can be impacted by the timing of the ClinCheck treatment plan acceptances and our ability to ship those cases in the same quarter. We define our intraoral scanner backlog as orders where payment is reasonably assured and credit and financing is approved but the scanner has not yet shipped. Our intraoral scanner backlog as of December 31, 2016 was not material.\nCompetition\nWe operate in a highly competitive market and we encounter a wide variety of competitors, including larger companies or divisions of larger companies with substantial sales, marketing, research and financial capabilities. We also face competition from early stage companies. Although the number of competitors varies by segment, currently our products compete directly against products manufactured and distributed by various companies, both within and outside the U.S., including Danaher Corporation, Sirona Dental Systems, Inc., Dentsply International, Inc., 3M Company and other private competitors. In addition, the expiration of certain of our key patents commencing in 2017, may result in additional competition. Information regarding risks associated with increased competition may be found in Item 1A of this Annual Report on Form 10-K under the heading “Risk Factors.”\nKey competitive factors include:\n| • | effectiveness of treatment; |\n\n| • | price; |\n\n| • | software features; |\n\n| • | aesthetic appeal of the treatment method; |\n\n| • | customer support; |\n\n| • | customer online interface; |\n\n| • | brand awareness; |\n\n| • | innovation; |\n\n| • | distribution network; |\n\n| • | comfort associated with the treatment method; |\n\n| • | oral hygiene; |\n\n| • | ease of use; and |\n\n| • | dental professionals’ chair time. |\n\nWe believe that our products compare favorably with our competitors’ products with respect to each of these factors.\n11\nGovernment Regulation\nIn order for us to market our products, we must obtain regulatory authorization and comply with extensive product and quality system regulations both within and outside the U.S. These regulations, including the requirements for approvals or clearance and the time required for regulatory review, vary from country to country. Failure to obtain regulatory approval and to meet all local requirements including language and specific safety standards in any country in which we currently market or plan to market our products could prevent us from marketing products in such countries or subject us to sanctions and fines. The approval by government authorities is unpredictable and uncertain and may not be granted on a timely basis, if at all. Delays in receipt of, or a failure to receive, such approvals or clearances, or the loss of any previously received approvals or clearances, could have a material adverse effect on our business, financial condition, and results of operations.\nCertain of our products are classified as medical devices under the United States Food, Drug, and Cosmetic Act (the “FD&CA”). The FD&CA requires these products, when sold in the U.S., to be safe and effective for their intended use and to comply with the regulations administered by the United States FDA. Our products may also be regulated by comparable agencies in non-U.S. countries in which they are produced or sold. In the European Union (\"EU\"), our products are subject to the medical devices laws of the various member states, which are based on a Directive of the European Commission. Such laws generally regulate the safety of the products in a similar way to the FDA regulations.\nWe believe we are in compliance with all FDA, federal and state laws and International regulatory requirements that are applicable to our products and manufacturing operations.\nWe are also subject to various laws inside and outside the U.S. concerning our relationships with healthcare professionals and government officials, price reporting and regulation, the promotion, sales and marketing of our products and services, the importation and exportation of our products, the operation of our facilities and distribution of our products. As a global company, we are subject to varying degrees of government regulation in the various countries in which we do business, and the general trend is toward increasingly stringent oversight and enforcement. Initiatives sponsored by government agencies, legislative bodies, and the private sector to limit the growth of healthcare expenses generally are ongoing in markets where we do business. It is not possible to predict at this time the long-term impact of such cost containment measures on our future business.\nOur customers are healthcare providers that may be reimbursed by federally funded programs such as Medicaid or a foreign national healthcare program, each of which may offer some degree of oversight. Many government agencies, both domestic and foreign, have increased their enforcement activities with respect to healthcare providers and companies in recent years. Enforcement actions and associated defense can be expensive, and any resulting findings carry the risk of significant civil and criminal penalties. For example, the U.S. Federal Physician Payment Sunshine Act went into effect in 2014 which requires public transparency of transfers of value to physicians.\nIn addition, we must comply with numerous data protection requirements that span from individual state and national laws in the U.S. to multinational requirements in the EU. In the U.S., final regulations implementing amendments to the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) became effective in the latter part of 2013 with the HIPAA Omnibus Rule. The EU is currently considering a proposal to enact legislation governing data protection which would transform the current mix of European countries’ laws to one overarching multinational law. Meanwhile, the Asia Pacific region has also seen rapid development of privacy laws, including in Singapore, Hong Kong, and Australia. We believe we have designed our product and service offerings to be compliant with the requirements of applicable data protection laws and regulations. Maintaining systems that are compliant with these laws and regulations is costly and could require complex changes in the way we do business or provide services to our customers and their patients. Additionally, our success may be dependent on the success of healthcare providers in managing data protection requirements.\nEmployees\nAs of December 31, 2016, we had approximately 6,060 employees, including 3,970 in manufacturing and operations, 1,270 in sales and marketing which includes customer care, 430 in research and development and 390 in general and administrative functions.\n12\nAvailable Information\nOur website is www.aligntech.com, and our investor relations website is http://investor.aligntech.com. The information on or accessible through our websites is not part of this Annual Report on Form 10-K. Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, our proxy statement on Schedule 14A for our annual stockholders’ meeting and amendments to such reports are available, free of charge, on our investor relations website as soon as reasonably practicable after we electronically file or furnish such material with the SEC. Further, a copy of this Annual Report on Form 10-K is located at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Information on the operation of the Public Reference Room can be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains an internet site that contains reports, proxy and information statements and other information regarding our filings at www.sec.gov.\nExecutive Officers of the Registrant\nThe following table sets forth certain information regarding our executive officers as of February 28, 2017:\n\n| Name | Age | Position |\n| Joseph M. Hogan | 59 | President and Chief Executive Officer |\n| John F. Morici | 50 | Chief Financial Officer |\n| Simon Beard | 50 | Vice President and Managing Director, EMEA |\n| Roger E. George | 51 | Vice President, Corporate and Legal Affairs and General Counsel |\n| Stuart Hockridge | 45 | Vice President, Global Human Resources |\n| Sreelakshmi Kolli | 42 | Vice President, Information Technology |\n| Jennifer Olson | 39 | Vice President and Managing Director, Doctor Directed Consumer Channel |\n| Raphael Pascaud | 45 | Chief Marketing Portfolio and Business Development Officer, and Vice President iTero Scanner and Services |\n| Lynn Pendergrass | 56 | Vice President and Managing Director, Americas |\n| Christopher C. Puco | 56 | Vice President and Managing Director, North America |\n| Zelko Relic | 52 | Vice President, Research & Development |\n| Julie Tay | 50 | Vice President and Managing Director, Asia Pacific |\n| Emory M. Wright | 47 | Vice President, Operations |\n\nJoseph M. Hogan has served as our President and Chief Executive Officer and as a member of our Board of Directors since June 2015. Prior to joining us, Mr. Hogan was Chief Executive Officer of ABB Ltd., a global power and automation technologies company based in Zurich, Switzerland from 2008 to 2013. Prior to working in ABB, Mr. Hogan worked at General Electric Company (GE) in a variety of executive and management roles from 1985 to 2008, including eight years as Chief Executive Officer of GE Healthcare from 2000 to 2008.\nJohn F. Morici has served as our Chief Financial Officer since November 2016. Prior to joining us, Mr. Morici was at NBC Universal from 2007 to 2016 where he held several senior management positions in their Universal Pictures Home Entertainment U.S. and Canadian business, including Chief Financial Officer, Chief Operating Officer, and most recently, Executive Vice President and Managing Director from 2014 to 2016. Prior to NBC Universal, Mr. Morici was in various senior financial management positions at GE Healthcare from 1999 to 2007, including Chief Financial Officer for its Diagnostic Imaging and Global Products units from 2002 to 2003.\nSimon Beard has served as our Vice President and Managing Director, EMEA since October 2015. Prior to joining us, from 2012 to 2014, Mr. Beard was Regional Director for the South East Asia business of Smith & Nephew, a multinational medical equipment manufacturing company. From 2006 to 2012, Mr. Beard was Director & General Manager for UK and Ireland for Smith & Nephew's Advanced Woundcare business. Prior to Smith & Nephew, Mr. Beard held multiple commercial, strategic, and general management positions in companies such as DePuy International (Johnson & Johnson), Sankyo Pharmaceutical and Sanofi Aventis.\nRoger E. George has served as our Vice President, Corporate and Legal Affairs and General Counsel since July 2002. Prior to joining us, Mr. George was the Chief Financial Officer, Vice President of Finance and Legal Affairs and General Counsel of SkyStream Networks, a privately held broadband and broadcast network equipment company. Prior to SkyStream, Mr. George was a partner at Wilson Sonsini Goodrich & Rosati, P.C. in Palo Alto, California.\n13\nStuart Hockridge has served as our Vice President, Global Human Resources since May 2016. Prior to joining us, Mr. Hockridge was Senior Vice President of Talent at Visa Inc. from 2013 to 2016 where he led all aspects of talent delivery for the company including executive development, succession planning, employee engagement, learning and development, and talent acquisition. Prior to Visa, Mr. Hockridge held a number of human resource management positions at GE Healthcare from 2002 to 2012 leading HR processes both globally and for various divisions.\nSreelakshmi Kolli has served as our Vice President, Information Technology since December 2012. Ms. Kolli joined us in June 2003 and has held positions leading business operations and engineering for customer-facing applications. Before joining us, she held technical lead positions with Sword CT Space and Accenture.\nJennifer Olson has served as our Vice President and Managing Director, Doctor-Directed Consumer Channel since August 2016. Ms. Olson joined us in 2002 and has held multiple roles in sales, marketing, and business development. Most recently, she was Area Sales Director for the North America region where she led all sales activities in Western Canada and the Western region of the U.S. Prior to joining Align, Ms. Olson was with technology companies including Extreme Networks and PWI Technologies.\nRaphael Pascaud has served as our Chief Marketing, Portfolio and Business Development Officer, and Vice President, iTero Scanner and Services since July 2015. He joined Align in 2010 as Vice President and Managing Director for the EMEA and was promoted in January 2014 to Vice President, International. Prior to Align, Mr. Pascaud spent 14 years in various management positions within DePuy, a Johnson & Johnson family of companies, including Vice President Orthopedics of EMEA and Vice President Marketing of International.\nLynn Pendergrass has served as our Vice President and Managing Director, Americas since February 2017. Prior to joining us, Ms. Pendergrass was president of Sears Holdings Corporation's hardlines division from 2015 to 2016. Prior to Sears, Ms. Pendergrass served as Worldwide Chairman for Johnson & Johnson Consumer from 2013 to 2014, and as Americas Senior Vice President for Hewlett-Packard's Printing & Personal Systems and its Imaging & Printing Group from 2008 to 2012. Ms. Pendergrass also spent 22 years at General Electric in various operating and commercial roles and held several executive management positions in sales and marketing for its Consumer & Industrial division.\nChristopher C. Puco has served as our Vice President and Managing Director, North America since February 2017. He joined us in 2006 as a sales director and in 2008 became senior director for the U.S. Eastern sales area. He served as Vice President of North America from December 2012 to February 2017. Mr. Puco has more than 20 years of experience in the medical device industry holding sales management positions in both starts-ups and established corporate environments. Prior to joining us, he was with United States Surgical Corporation, General Surgical Innovations, Baxter BioSurgery and Fusion Medical Technologies.\nZelko Relic was appointed Vice President, Research & Development in December 2013. Prior to joining us, Mr. Relic was Vice President, Engineering for Datalogic Automation, a global leader in automatic data capture and industrial automation markets from 2012. Mr. Relic was previously Vice President, Engineering at Danaher Corporation, Accu-Sort Systems business from 2010 to 2012 before it was acquired by Datalogic Automation. From 2005 to 2010, he was at Siemens Medical Solutions USA, most recent as Vice President, and from 2002 to 2004, he held senior management positions in engineering at Kulicke & Soffa Industries, designers and manufactures of semiconductor products. He also held management positions at KLA-Tencor from 1994 to 2000.\nJulie Tay was appointed Vice President and Managing Director, Asia Pacific in March 2013. Prior to joining us, Ms. Tay was regional head of Bayer Healthcare (Diabetes Care) overseeing operations across Asia from 2010 to 2013. From 2006 to 2010, Ms. Tay served as director of marketing and corporate accounts at Sealed Air Corporation (formerly Johnson Diversey), a global provider of food safety and security, facility hygiene and product protection. Prior to that, Ms. Tay spent 15 years with Johnson & Johnson Medical.\nEmory M. Wright has served as our Vice President, Operations since December 2007. He has been with us since March 2000 predominantly in manufacturing and operations roles including Vice President, Manufacturing and was General Manager of New Product Development. Prior to joining Align, Mr. Wright was Senior Manufacturing Manager at Metrika, Inc. a medical device manufacturer from 1999 to 2000. From 1994 to 1999, Mr. Wright served as Manager of Manufacturing and Process Development for Metra Biosystems Inc.\n14\nITEM 1A.\nRISK FACTORS\nWe depend on the sale of the Invisalign system for the vast majority of our net revenues, and any decline in sales of Invisalign treatment for any reason, or a decline in average selling prices would adversely affect net revenues, gross margin and net income.\nWe expect that net revenues from the sale of the Invisalign System, primarily Invisalign Full and Invisalign Teen, will continue to account for the vast majority of our total net revenues for the foreseeable future. Continued and widespread market acceptance of Invisalign by orthodontists, GPs and consumers is critical to our future success. If orthodontists and GPs experience a reduction in consumer demand for orthodontic services, if consumers prove unwilling to adopt Invisalign as rapidly as we anticipate or in the volume that we anticipate, if orthodontists or GPs choose to use a competitive product rather than Invisalign or if the average selling price of our product declines, our operating results would be harmed.\nCompetition in the markets for our products is intense and we expect aggressive competition from existing competitors and other companies that may introduce new technologies in the future.\nCurrently, our products compete directly against products manufactured and distributed by various companies, both within and outside the U.S. Many of these manufacturers, including Danaher Corporation, Sirona Dental Systems, Inc., Dentsply International, Inc. and 3M, have substantially greater financial resources and manufacturing and marketing experience than we do. In addition, as a result of the expiration of certain key patents owned by us, commencing in 2017, we expect that these existing competitors as well as new entrants into the clear aligner market will begin offering an orthodontic system more similar to ours in the near future. Several of these competitors will likely have greater resources as well as the ability to leverage their existing channels in the dental market to compete directly with us, and therefore our share of the clear aligner market could decline which would likely have a material adverse effect on our business, results of operation and financial condition. In addition, corresponding foreign patents will start to expire in 2018 which will likely result in increased competition in some of the markets outside the U.S. large consumer product companies may also enter the orthodontic supply market. Furthermore, we also face competition for companies that now offer clear aligner therapy directly to the consumer eliminating the need for the consumer to visit a dental office. In addition, we may also face competition in the future from new companies that may introduce new technologies. We may be unable to compete with these competitors and one or more of these competitors may render our technology obsolete or economically unattractive. If we are unable to compete effectively with existing products or respond effectively to any products developed by new or existing competitors, our business could be harmed. Increased competition has resulted in the past and may in the future result in volume discounting and price reductions, reduced gross margins, reduced profitability and loss of market share, and reduce dental professionals’ efforts and commitment to expand their use of our products, any of which could have a material adverse effect on our net revenues, volume growth, net income and stock price. We cannot assure that we will be able to compete successfully against our current or future competitors or that competitive pressures will not have a material adverse effect on our business, results of operations and financial condition.\nWe are dependent on our international operations, which exposes us to foreign operational, political and other risks that may harm our business.\nOur key production steps are performed in operations located outside of the U.S. At our facility in San Jose, Costa Rica, technicians use a sophisticated, internally developed computer-modeling program to prepare digital treatment plans, which are then transmitted electronically to Juarez, Mexico. These digital files form the basis of the ClinCheck treatment plan and are used to manufacture aligner molds. Our order acquisition, aligner fabrication and shipping operations are conducted in Juarez, Mexico and starting in July 2016, we transitioned order acquisition for EMEA region to our facility in Amsterdam, the Netherlands. In addition to the research and development efforts conducted in our North America facilities, we also carry out research and development in Moscow, Russia. We also have customer-care, accounts receivable, credit and collections, customer event registration and accounts payable organizations located at our facility in San Jose, Costa Rica. In addition, we have operations in Israel where the design and wand assembly and our intraoral scanner are manufactured. Our reliance on international operations exposes us to risks and uncertainties that may affect our business or results of operation, including:\n| • | difficulties in hiring and retaining employees generally, as well as difficulties in hiring and retaining employees with the necessary skills to perform the more technical aspects of our operations; |\n\n| • | difficulties in managing international operations, including any travel restrictions to or from our facilities located in Russia, Israel and other countries; |\n\n| • | fluctuations in currency exchange rates; |\n\n| • | increased income taxes, and other restrictions and limitations, if we were to decide to repatriate any of our foreign cash balances back to the U.S.; |\n\n15\n| • | import and export license requirements and restrictions; |\n\n| • | controlling production volume and quality of the manufacturing process; |\n\n| • | political, social and economic instability, including as a result of increased levels of violence in Juarez, Mexico or the Middle East. We cannot predict the effect on us of any future armed conflict, political instability or violence in these regions. In addition, some of our employees in Israel are obligated to perform annual reserve duty in the Israeli military and are subject to being called for additional active duty under emergency circumstances. We cannot predict the full impact of these conditions on us in the future, particularly if emergency circumstances or an escalation in the political situation occurs. If many of our employees are called for active duty, our operations in Israel and our business may not be able to function at full capacity; |\n\n| • | acts of terrorism and acts of war; |\n\n| • | general geopolitical instability and the responses to it, such as the possibility of additional sanctions against Russia which continue to bring uncertainty to this region; |\n\n| • | interruptions and limitations in telecommunication services; |\n\n| • | product or material transportation delays or disruption, including as a result of increased levels of violence, acts of terrorism, acts of war or health epidemics restricting travel to and from our international locations or as a result of natural disasters, such as earthquakes or volcanic eruptions; |\n\n| • | burdens of complying with a wide variety of local country and regional laws, including the risks associated with the Foreign Corrupt Practices Act and local anti-bribery compliance; |\n\n| • | trade restrictions and changes in tariffs; and |\n\n| • | potential adverse tax consequences. |\n\nIf any of these risks materialize in the future, we could experience production delays and lost or delayed revenue.\nIn addition, President Donald Trump and his administration have made recent statements regarding the possibility of changing the way in which the international operations of U.S. companies are taxed, including through the implementation of a border tax, tariff or increase in custom duties on products manufactured in countries outside of the U.S., such as Mexico, and imported into the U.S. In the event such taxes, tariffs, increased custom duties or other measures are implemented, they could have a materially adverse effect on our business and or operating results, and we may have to consider relocating some of our international operations.\nWe earn an increasingly larger portion of our total revenues from international sales and face risks attendant to those operations.\nWe earn an increasingly larger portion of our total revenues from international sales generated through our foreign direct and indirect operations. Since our growth strategy depends in part on our ability to further penetrate markets outside the U.S. and increase the localization of our products and services, we expect to continue to increase our sales and presence outside the U.S., particularly in the high-growth markets. Our international operations are subject to risks that are customarily encountered in non-U.S. operations, including:\n| • | local political and economic instability; |\n\n| • | the engagement of activities by our employees, contractors, partners and agents, especially in countries with developing economies, that are prohibited by international and local trade and labor laws and other laws prohibiting corrupt payments to government officials, including the Foreign Corrupt Practices Act, the UK Bribery Act of 2010 and export control laws, in spite of our policies and procedures designed to ensure compliance with these laws; |\n\n| • | although it is our intention to indefinitely reinvest earnings outside the U.S., restrictions on the transfer of funds held by our foreign subsidiaries, including with respect to restrictions on our ability to repatriate foreign cash to the U.S at favorable tax rates; |\n\n| • | fluctuations in currency exchange rates; and |\n\n| • | increased expense of developing, testing and making localized versions of our products. |\n\n16\nAny of these factors, either individually or in combination, could materially impact our international operations and adversely affect our business as a whole.\nWe face risks related to our international sales, including the need to obtain necessary foreign regulatory clearance or approvals.\nOutside of North America, we currently sell our products in Europe, Asia Pacific, Latin America and the Middle East and may expand into other countries from time to time. For sales of our products outside the U.S., we are subject to foreign regulatory requirements that vary widely from country to country. The time required to obtain clearances or approvals required by other countries may be longer than that required for FDA clearance or approval, and requirements for such approvals may differ from FDA requirements. We may be unable to obtain regulatory approvals in one or more of the other countries in which we do business or in which we may do business in the future. We may also incur significant costs in attempting to obtain and maintain foreign regulatory approvals. If we experience delays in receipt of approvals to market our products outside of the U.S., or if we fail to receive these approvals, we may be unable to market our products or enhancements in international markets in a timely manner, if at all, which could materially impact our international operations and adversely affect our business as a whole.\nDemand for our products may not increase as rapidly as we anticipate due to a variety of factors including a weakness in general economic conditions.\nConsumer spending habits are affected by, among other things, prevailing economic conditions, levels of employment, salaries and wage rates, gas prices, consumer confidence and consumer perception of economic conditions. A general slowdown in the U.S. economy and certain international economies or an uncertain economic outlook would adversely affect consumer spending habits which may, among other things, result in a decrease in the number of overall orthodontic case starts, reduced patient traffic in dentists’ offices, reduction in consumer spending on higher value procedures or a reduction in the demand for dental services generally, each of which would have a material adverse effect on our sales and operating results. Weakness in the global economy results in a challenging environment for selling dental technologies and dentists may postpone investments in capital equipment, such as intraoral scanners. In addition, Invisalign treatment, which currently accounts for the vast majority of our net revenues, represents a significant change from traditional orthodontic treatment, and customers and consumers may be reluctant to accept it or may not find it preferable to traditional treatment. We have generally received positive feedback from orthodontists, GPs and consumers regarding Invisalign treatment as both an alternative to braces and as a clinical method for the treatment of malocclusion, but a number of dental professionals believe that the Invisalign treatment is appropriate for only a limited percentage of their patients. Increased market acceptance of all of our products will depend in part upon the recommendations of dental professionals, as well as other factors including effectiveness, safety, ease of use, reliability, aesthetics, and price compared to competing products.\nThe frequency of use of the Invisalign system by orthodontists or GPs may not increase at the rate that we anticipate or at all.\nOne of our key objectives is to continue to increase utilization, or the adoption and frequency of use, of the Invisalign System by new and existing customers. If utilization of the Invisalign System by our existing and newly trained orthodontists or GPs does not occur or does not occur as quickly as we anticipate, our operating results could be harmed.\nWe may experience declines in average selling prices of our products which may decrease our net revenues.\nWe provide volume based discount programs to our doctors. In addition, we sell a number of products at different list prices. If we introduce any price reductions or consumer rebate programs; if we expand our discount programs in the future or participation in these programs increases; or if our product mix shifts to lower priced products or products that have a higher percentage of deferred revenue, our average selling prices would be adversely affected and our net revenues, gross profit, gross margin and net income may be reduced. In July 2015, we launched a new product policy called \"Additional Aligners at No Charge\" that addresses one of our customer's top complaints. With this product policy change, we no longer distinguish between mid-course correction and case refinements and allow doctors to order additional aligners to address either treatment need at no charge, subject to certain requirements. Based on this product policy, beginning in the third quarter of 2015, we deferred more revenue as a result of providing free additional aligners for eligible treatments. Additionally, as we grandfathered over 1 million open cases, we will recognize lower revenues as additional aligners are shipped for at least the following two years until these cases complete.\nWe are exposed to fluctuations in currency exchange rates, which could negatively affect our financial condition and results of operations.\nAlthough the U.S. dollar is our reporting currency, a portion of our net revenues and net income are generated in foreign currencies. Net revenues and net income generated by subsidiaries operating outside of the U.S. are translated into U.S. dollars\n17\nusing exchange rates effective during the respective period and are affected by changes in exchange rates. As a result, negative movements in currency exchange rates against the U.S. dollar will adversely affect our net revenues and net income in our consolidated financial statements. The exchange rate between the U.S. dollar and foreign currencies has fluctuated substantially in recent years and may continue to fluctuate substantially in the future. We have in the past and may in the future enter into currency hedging transactions in an effort to cover some of our exposure to foreign currency exchange fluctuations. These transactions may not operate to fully or effectively hedge our exposure to currency fluctuations, and, under certain circumstances, these transactions could have an adverse effect on our financial condition.\nAs we continue to grow, we are subject to growth related risks, including risks related to excess or constrained capacity at our existing facilities.\nWe are subject to growth related risks, including excess or constrained capacity and pressure on our internal systems and personnel. In order to manage current operations and future growth effectively, we will need to continue to implement and improve our operational, financial and management information systems and to hire, train, motivate, manage and retain employees. We may be unable to manage such growth effectively. Any such failure could have a material adverse impact on our business, operations and prospects. In the near term, we intend to establish additional order acquisition and treatment planning facilities closer to our international customers in order to improve our operational efficiency and provide doctors with a better experience to further improve their confidence in using Invisalign to treat more patients, more often. Our ability to plan, construct and equip additional order acquisition, treatment planning and manufacturing facilities is subject to significant risk and uncertainty, including risks inherent in the establishment of a facility, such as hiring and retaining employees and delays and cost overruns as a result of a number of factors, any of which may be out of our control. If the transition into this additional facility is significantly delayed or demand for our product exceeds our current expectations, we may not be able to fulfill orders timely, which may negatively impact our financial results and overall business. In addition, because we cannot immediately adapt our production capacity and related cost structures to changing market conditions, our facility capacity may at times exceed or fall short of our production requirements. In addition, if product demand decreases or we fail to forecast demand accurately, we could be required to write off inventory or record excess capacity charges, which would lower our gross margin. Production of our intraoral scanners may also be limited by capacity constraints due to a variety of factors, including our dependency on third party vendors for key components in addition to limited production yields. Any or all of these problems could result in the loss of customers, provide an opportunity for competing products to gain market acceptance and otherwise harm our business and financial results.\nIf we fail to sustain or increase profitability or revenue growth in future periods, the market price for our common stock may decline.\nIf we are to sustain or increase profitability in future periods, we will need to continue to increase our net revenues, while controlling our expenses. Because our business is evolving, it is difficult to predict our future operating results or levels of growth, and we have not in the past and may not in the future be able to sustain our historical growth rates. If we do not increase profitability or revenue growth or otherwise meet the expectations of securities analysts or investors, the market price of our common stock will likely decline.\nOur financial results have fluctuated in the past and may fluctuate in the future which may cause volatility in our stock price.\nOur operating results have fluctuated in the past and we expect our future quarterly and annual operating results to fluctuate as we focus on increasing doctor and consumer demand for our products. These fluctuations could cause our stock price to decline or significantly fluctuate. Some of the factors that could cause our operating results to fluctuate include:\n| • | limited visibility into and difficulty predicting the level of activity in our customers’ practices from quarter to quarter; |\n\n| • | weakness in consumer spending as a result of the slowdown in the U.S. economy and global economies; |\n\n| • | changes in relationships with our distributors; |\n\n| • | changes in the timing of receipt of Invisalign case product orders during a given quarter which, given our cycle time and the delay between case receipts and case shipments, could have an impact on which quarter revenue can be recognized; |\n\n| • | fluctuations in currency exchange rates against the U.S. dollar; |\n\n| • | changes in product mix; |\n\n| • | our inability to scale production of our iTero Element scanner to meet customer demand; |\n\n| • | if participation in our customer rebate or discount programs increases our average selling price will be adversely affected; |\n\n18\n| • | seasonal fluctuations in the number of doctors in their offices and their availability to take appointments; |\n\n| • | success of or changes to our marketing programs from quarter to quarter; |\n\n| • | our reliance on our contract manufacturers for the production of sub-assemblies for our intraoral scanners; |\n\n| • | timing of industry tradeshows; |\n\n| • | changes in the timing of when revenue is recognized, including as a result of the introduction of new products or promotions, modifications to our terms and conditions or as a result of changes to critical accounting estimates or new accounting pronouncements; |\n\n| • | changes to our effective tax rate; |\n\n| • | unanticipated delays in production caused by insufficient capacity or availability of raw materials; |\n\n| • | any disruptions in the manufacturing process, including unexpected turnover in the labor force or the introduction of new production processes, power outages or natural or other disasters beyond our control; |\n\n| • | the development and marketing of directly competitive products by existing and new competitors; |\n\n| • | disruptions to our business as a result of our agreement to manufacture clear aligners for SmileDirectClub, LLC (\"SDC\"), including, market acceptance of the SDC business model and product, possible adverse customer reaction and negative publicity about us and our products; |\n\n| • | impairments in the value of our strategic investments in SDC and other privately held companies could be material; |\n\n| • | major changes in available technology or the preferences of customers may cause our current product offerings to become less competitive or obsolete; |\n\n| • | aggressive price competition from competitors; |\n\n| • | costs and expenditures in connection with litigation; |\n\n| • | the timing of new product introductions by us and our competitors, as well as customer order deferrals in anticipation of enhancements or new products; |\n\n| • | unanticipated delays in our receipt of patient records made through an intraoral scanner for any reason; |\n\n| • | disruptions to our business due to political, economic or other social instability, including the impact of an epidemic any of which results in changes in consumer spending habits, consumers unable or unwilling to visit the orthodontist or general practitioners office, as well as any impact on workforce absenteeism; |\n\n| • | inaccurate forecasting of net revenues, production and other operating costs, |\n\n| • | investments in research and development to develop new products and enhancements; |\n\n| • | changes in accounting rules; and |\n\n| • | our ability to successfully hedge against a portion of our foreign currency-denominated assets and liabilities. |\n\nTo respond to these and other factors, we may need to make business decisions that could adversely affect our operating results such as modifications to our pricing policy, business structure or operations. Most of our expenses, such as employee compensation and lease payment obligations, are relatively fixed in the short term. Moreover, our expense levels are based, in part, on our expectations regarding future revenue levels. As a result, if our net revenues for a particular period fall below our expectations, whether caused by changes in consumer spending, consumer preferences, weakness in the U.S. or global economies, changes in customer behavior related to advertising and prescribing our product or other factors, we may be unable to adjust spending quickly enough to offset any shortfall in net revenues. Due to these and other factors, we believe that quarter-to-quarter comparisons of our operating results may not be meaningful. You should not rely on our results for any one quarter as an indication of our future performance.\n19\nOur future success may depend on our ability to develop, successfully introduce and achieve market acceptance of new products.\nOur future success may depend on our ability to develop, manufacture, market and obtain regulatory approval or clearance of new products. There can be no assurance that we will be able to successfully develop, sell and achieve market acceptance of these and other new products and applications and enhanced versions of our existing product or software. The extent of, and rate at which, market acceptance and penetration are achieved by future products is a function of many variables, which include, among other things, our ability to:\n| • | correctly identify customer needs and preferences and predict future needs and preferences; |\n\n| • | include functionality and features that address customer requirements; |\n\n| • | ensure compatibility of our computer operating systems and hardware configurations with those of our customers; |\n\n| • | allocate our research and development funding to products with higher growth prospects; |\n\n| • | anticipate and respond to our competitors’ development of new products and technological innovations; |\n\n| • | differentiate our offerings from our competitors’ offerings; |\n\n| • | innovate and develop new technologies and applications; |\n\n| • | the availability of third-party reimbursement of procedures using our products; |\n\n| • | obtain adequate intellectual property rights; and |\n\n| • | encourage customers to adopt new technologies. |\n\nIf we fail to accurately predict customer needs and preferences or fail to produce viable technologies, we may invest heavily in research and development of products that do not lead to significant revenue. Even if we successfully innovate and develop new products and produce enhancements, we may incur substantial costs in doing so and our profitability may suffer. In addition, even if our new products are successfully introduced, it is unlikely that they will rapidly gain market share and acceptance primarily due to the relatively long period of time it takes to successfully treat a patient with Invisalign. Since it takes approximately 12 to 24 months to treat a patient, our customers may be unwilling to rapidly adopt our new products until they successfully complete at least one case or until more historical clinical results are available.\nOur ability to market and sell new products may also be subject to government regulation, including approval or clearance by the FDA and foreign government agencies. Any failure in our ability to successfully develop and introduce or achieve market acceptance of our new products or enhanced versions of existing products could have a material adverse effect on our operating results and could cause our net revenues to decline.\nA disruption in the operations of our primary freight carrier or higher shipping costs could cause a decline in our net revenues or a reduction in our earnings.\nWe are dependent on commercial freight carriers, primarily UPS, to deliver our products to our customers. If the operations of these carriers are disrupted for any reason, we may be unable to deliver our products to our customers on a timely basis. If we cannot deliver our products in an efficient and timely manner, our customers may reduce their orders from us and our net revenues and operating profits could materially decline. In a rising fuel cost environment, our freight costs will increase. If freight costs materially increase and we are unable to pass that increase along to our customers for any reason or otherwise offset such increases in our cost of net revenues, our gross margin and financial results could be adversely affected.\nIf we are unable to accurately predict our volume growth, and fail to hire a sufficient number of technicians in advance of such demand, the delivery time of our products could be delayed which could adversely affect our results of operations.\nTreatment planning is a key step leading to our manufacturing process which relies on sophisticated computer technology requiring new technicians to undergo a relatively long training process. Training production technicians takes approximately 90 to 120 days. As a result, if we are unable to accurately predict our volume growth, we may not have a sufficient number of trained technicians to deliver our products within the timeframe our customers expect. Such a delay could cause us to lose existing customers or fail to attract new customers. This could cause a decline in our net revenues and net income and could adversely affect our results of operations.\n20\nOur headquarters, digital dental modeling processes, and other manufacturing processes are principally located in regions that are subject to earthquakes and other natural disasters.\nOur digital dental modeling is processed in our facility located in San Jose, Costa Rica. The operations team in Costa Rica creates ClinCheck treatment plans using sophisticated computer software. In addition, our customer facing operations are located in Costa Rica. Our aligner molds and finished aligners are fabricated in Juarez, Mexico. Both locations in Costa Rica and Mexico are in earthquake zones and may be subject to other natural disasters. If there is a major earthquake or any other natural disaster in a region where one of these facilities is located, our ability to create ClinCheck treatment plans, respond to customer inquiries or manufacture and ship our aligners could be compromised which could result in our customers experiencing a significant delay in receiving their completed aligners and a decrease in service levels for a period of time. In addition, our corporate headquarters facility in California is located in the San Francisco Bay Area. An earthquake or other natural disaster in this region could result in a disruption in our operations. Any such business interruption could materially and adversely affect our business, financial condition and results of operations.\nOur information technology systems are critical to our business. System integration and implementation issues and system security risks could disrupt our operations, which could have a material adverse impact on our business and operating results.\nWe rely on the efficient and uninterrupted operation of complex information technology systems. All information technology systems are vulnerable to damage or interruption from a variety of sources. As our business has grown in size and complexity, the growth has placed, and will continue to place, significant demands on our information technology systems. To effectively manage this growth, our information systems and applications require an ongoing commitment of significant resources to maintain, protect and enhance existing systems and develop new systems to keep pace with continuing changes in information processing technology, evolving industry and regulatory standards and changing customer preferences. We are in a multi-year, company-wide program to transform certain business processes or extend established processes which includes the transition to a new enterprise resource planning (\"ERP\") software system. We implemented the first phase of our ERP on July 1, 2016 and, while we believe we are past any potential significant business disruption, we are still monitoring and troubleshooting potential issues. The implementation of additional functionality in the ERP system entails certain risks, including difficulties with changes in business processes that could disrupt our operations, such as our ability to track orders and timely ship products, manage our supply chain and aggregate financial and operational data. Additionally, this implementation may not achieve the anticipated benefits and may divert management's attention from other operational activities, negatively affect employee morale, or have other unintended consequences. Additionally, if we are not able to accurately forecast expenses related to the project, this may have an adverse impact on our financial condition and operating results.\nIf the information we rely upon to run our businesses were to be found to be inaccurate or unreliable, if we fail to properly maintain our information systems and data integrity, or if we fail to develop new capabilities to meet our business needs in a timely manner, we could have operational disruptions, have customer disputes, lose our ability to produce timely and accurate reports, have regulatory or other legal problems, have increases in operating and administrative expenses, lose existing customers, have difficulty in attracting new customers or in implementing our growth strategies, or suffer other adverse consequences. In addition, experienced computer programmers and hackers may be able to penetrate our network security or our cloud-based software servers hosted by third party and misappropriate our confidential information or that of third parties, create system disruptions or cause shutdowns. Furthermore, sophisticated hardware and operating system software and applications that we either internally develop or procure from third parties which we depend upon may contain defects in design and manufacture, including “bugs” and other problems that can unexpectedly interfere with the operation of the system. The costs to eliminate or alleviate security problems, viruses and bugs could be significant, and the efforts to address these problems could result in interruptions that may have a material adverse impact on our operations, net revenues and operating results.\nSystem upgrades and enhancements require significant expenditures and allocation of valuable employee resources. Delays in integration or disruptions to our business from implementation of these new or upgraded systems could have a material adverse impact on our financial condition and operating results.\nAdditionally, we continuously upgrade our customer facing software applications, specifically the ClinCheck and MyAligntech software. Software applications frequently contain errors or defects, especially when they are first introduced or when new versions are released. The discovery of a defect or error or the incompatibility with the computer operating system and hardware configurations of customers in a new upgraded version or the failure of our primary information systems may result in the following consequences, among others: loss of revenue or delay in market acceptance, damage to our reputation or increased service costs, any of which could have a material adverse effect on our business, financial condition or results of operations.\nFurthermore, our business requires the secure transmission of confidential information over public networks. Because of the confidential health information we store and transmit, security breaches could expose us to a risk of regulatory action, litigation,\n21\npossible liability and loss. Our security measures may be inadequate to prevent security breaches, and our business operations and profitability would be adversely affected by, among other things, loss of customers and potential criminal and civil sanctions if they are not prevented.\nThere can be no assurance that our process of improving existing systems, developing new systems to support our expanding operations, integrating new systems, protecting confidential patient information, and improving service levels will not be delayed or that additional systems issues will not arise in the future. Failure to adequately protect and maintain the integrity of our information systems and data may result in a material adverse effect on our financial position, results of operations and cash flows.\nIf the security of our customer and patient information is compromised, patient care could suffer, and we could be liable for related damages, and our reputation could be impaired.\nWe retain confidential customer and patient information in our processing centers. Therefore, it is critical that our facilities and infrastructure remain secure and that our facilities and infrastructure are perceived by the marketplace and our customers to be secure. Despite the implementation of security measures, our infrastructure may be vulnerable to physical break-ins, computer viruses, programming errors, attacks by third parties or similar disruptive problems. If we fail to meet our clients’ expectations regarding the security of healthcare information, we could be liable for damages and our reputation could be impaired. In addition, patient care could suffer, and we could be liable if our systems fail to deliver correct information in a timely manner. Our insurance may not protect us from this risk.\nOur success depends in part on our proprietary technology, and if we are unable to successfully enforce our intellectual property rights, our competitive position may be harmed. Litigating claims of this type is costly and could distract our management and cause a decline in our results of operations and stock price.\nOur success will depend in part on our ability to maintain existing intellectual property and to obtain and maintain further intellectual property protection for our products, both in the U.S. and in other countries. Our inability to do so could harm our competitive position. As of December 31, 2016, we had issued 425 U.S. patents, 370 foreign issued patents, and 386 pending global patent applications.\nWe intend to rely on our portfolio of issued and pending patent applications in the U.S. and in other countries to protect a large part of our intellectual property and our competitive position; however, our currently pending or future patent filings may not result in the issuance of patents. Additionally, any patents issued to us may be challenged, invalidated, held unenforceable, circumvented, or may not be sufficiently broad to prevent third parties from producing competing products similar in design to our products. In addition, any protection afforded by foreign patents may be more limited than that provided under U.S. patents and intellectual property laws. We also rely on protection of our copyrights, trade secrets, know-how and proprietary information. We generally enter into confidentiality agreements with our employees, consultants and our collaborative partners upon commencement of a relationship with us; however, these agreements may not provide meaningful protection against the unauthorized use or disclosure of our trade secrets or other confidential information, and adequate remedies may not exist if unauthorized use or disclosure were to occur. Our inability to maintain the proprietary nature of our technology through patents, copyrights or trade secrets would impair our competitive advantages and could have a material adverse effect on our operating results, financial condition and future growth prospects. In particular, a failure to protect our proprietary rights might allow competitors to copy our technology, which could adversely affect our pricing and market share. In addition, in an effort to protect our intellectual property we have in the past been and may in the future be involved in litigation. The potential effects on our business operations resulting from litigation that we may participate in the future, whether or not ultimately determined in our favor or settled by us, are costly and divert the efforts and attention of our management and technical personnel from normal business operations.\nLitigation, interferences, oppositions, inter partes reviews or other proceedings are, have been and may in the future be necessary in some instances to determine the validity and scope of certain of our proprietary rights, and in other instances to determine the validity, scope or non-infringement of certain patent rights claimed by third parties to be pertinent to the manufacture, use or sale of our products. Litigation, interference, oppositions, inter partes reviews, administrative challenges or other similar types of proceedings are unpredictable and may be protracted, expensive and distracting to management. The outcome of such proceedings could adversely affect the validity and scope of our patent or other proprietary rights, hinder our ability to manufacture and market our products, require us to seek a license for the infringed product or technology or result in the assessment of significant monetary damages. An unfavorable ruling could include monetary damages or, in cases where injunctive relief is sought, an injunction prohibiting us from selling our products. Any of these results from our litigation could adversely affect our results of operations and stock price.\n22\nWhile we believe we currently have adequate internal control over financial reporting, we are required to assess our internal control over financial reporting on an annual basis and any future adverse results from such assessment could result in a loss of investor confidence in our financial reports and have an adverse effect on our stock price.\nPursuant to the Sarbanes-Oxley Act of 2002 and the rules and regulations promulgated by the SEC, we are required to furnish in our Form 10-K a report by our management regarding the effectiveness of our internal control over financial reporting. The report includes, among other things, an assessment of the effectiveness of our internal control over financial reporting as of the end of our fiscal year, including a statement as to whether or not our internal control over financial reporting is effective. This assessment must include disclosure of any material weaknesses in our internal control over financial reporting identified by management. While we believe our internal control over financial reporting is currently effective, the effectiveness of our internal controls in future periods is subject to the risk that our controls may become inadequate because of changes in conditions including our transition to a new ERP software system, and, as a result, the degree of compliance of our internal control over financial reporting with the existing policies or procedures may become ineffective. Establishing, testing and maintaining an effective system of internal control over financial reporting requires significant resources and time commitments on the part of our management and our finance staff, may require additional staffing and infrastructure investments and would increase our costs of doing business. If we are unable to assert that our internal control over financial reporting is effective in any future period (or if our auditors are unable to express an opinion on the effectiveness of our internal controls or conclude that our internal controls are ineffective), we could lose investor confidence in the accuracy and completeness of our financial reports, which could have an adverse effect on our stock price.\nIf we lose our key personnel or are unable to attract and retain key personnel, we may be unable to pursue business opportunities or develop our products.\nWe are highly dependent on the key employees in our clinical engineering, technology development, sales, training and marketing personnel and management teams. The loss of the services provided by those individuals may significantly delay or prevent the achievement of our product development and other business objectives and could harm our business. Our future success will also depend on our ability to identify, recruit, train and retain additional qualified personnel, including orthodontists. Few orthodontists are accustomed to working in a manufacturing environment since they are generally trained to work in private practices, universities and other research institutions. Thus, we may be unable to attract and retain personnel with the advanced qualifications necessary for the further development of our business. Furthermore, we may not be successful in retaining our key personnel or their services. If we are unable to attract and retain key personnel, our business could be materially harmed.\nIf we infringe the patents or proprietary rights of other parties or are subject to a patent infringement claim, our ability to grow our business may be severely limited.\nExtensive litigation over patents and other intellectual property rights is common in the medical device industry. We have been sued for infringement of third party’s patents in the past and we may be the subject of patent or other litigation in the future. From time to time, we have received and may in the future receive letters from third parties drawing our attention to their patent rights. While we do not believe that we infringe upon any valid and enforceable rights that have been brought to our attention, there may be other more pertinent rights of which we are presently unaware. The defense and prosecution of intellectual property suits, interference proceedings and related legal and administrative proceedings could result in substantial expense to us and significant diversion of effort by our technical and management personnel. An adverse determination of any litigation or interference proceeding to which we may become a party could subject us to significant liabilities. An adverse determination of this nature could also put our patents at risk of being invalidated or interpreted narrowly or require us to seek licenses from third parties. Licenses may not be available on commercially reasonable terms or at all, in which event, our business would be materially adversely affected.\n23\nWe maintain single supply relationships for certain of our key machines and materials technologies, and our business and operating results could be harmed if supply is restricted or ends or the price of raw materials used in our manufacturing process increases.\nWe are highly dependent on manufacturers of specialized scanning equipment, rapid prototyping machines, resin and other advanced materials, as well as the optics, electronic and other mechanical components of our intraoral scanners. We maintain single supply relationships for many of these machines and materials technologies. In particular, our CT scanning and stereolithography equipment used in our aligner manufacturing and many of the critical components for the optics of our scanners are provided by single suppliers. We are also committed to purchasing the vast majority of our resin and polymer, the primary raw materials used in our manufacturing process for clear aligners, from a single source. If these or other suppliers encounter financial, operating or other difficulties or if our relationship with them changes, we might not be able to quickly establish or qualify replacement sources of supply and could face production interruptions, delays and inefficiencies. In addition, technology changes by our vendors could disrupt access to required manufacturing capacity or require expensive, time consuming development efforts to adapt and integrate new equipment or processes. Our growth may exceed the capacity of one or more of these manufacturers to produce the needed equipment and materials in sufficient quantities to support our growth. Conversely, in order to secure supplies for production of products, we sometimes enter into non-cancelable purchase commitments with vendors, which could impact our ability to adjust our inventory to reflect declining market demands. If demand for our products is less than we expect, we may experience additional excess and obsolete inventories and be forced to incur additional charges and our profitability may suffer. In the event of technology changes, delivery delays, or shortages of or increases in price for these items, our business and growth prospects may be harmed.\nWe depend on a single contract manufacturer and supplier of parts used in our iTero scanner and any disruption in this relationship may cause us to fail to meet the demands of our customers and damage our customer relationships.\nWe rely on a third party manufacturer to supply key sub-assemblies for our iTero Element scanner. As a result, if this third party manufacturer fails to deliver its components, if we lose its services or if we fail to negotiate acceptable terms, we may be unable to deliver our products in a timely manner and our business may be harmed. Any difficulties encountered by the third party manufacturer with respect to hiring personnel and maintaining acceptable manufacturing standards, controls, procedures and policies could disrupt our ability to deliver our products in a timely manner. Finding a substitute manufacturer may be expensive, time-consuming or impossible and could result in a significant interruption in the supply of our intraoral scanning products. Any failure by our contract manufacturer that results in delays in our fulfillment of customer orders may cause us to lose revenues and suffer damage to our customer relationships.\nWe primarily rely on our direct sales force to sell our products, and any failure to maintain our direct sales force could harm our business.\nOur ability to sell our products and generate revenues primarily depends upon our direct sales force within our North American and international markets. We do not have any long-term employment contracts with the members of our direct sales force. The loss of the services provided by these key personnel may harm our business. If we are unable to retain our direct sales force personnel or replace them with individuals of equivalent technical expertise and qualifications, or if we are unable to successfully instill such technical expertise or if we fail to establish and maintain strong relationships with our customers within a relatively short period of time, our net revenues and our ability to maintain market share could be materially harmed. In addition, due to our large and fragmented customer base, we may not be able to provide all of our customers with product support immediately upon the launch of a new product. As a result, adoption of new products by our customers may be slower than anticipated and our ability to grow market share and increase our net revenues may be harmed.\nIf our distributor relationships are not successful, our ability to market and sell our products would be harmed and our financial performance will be adversely affected.\nWe depend on relationships with distributors for the marketing and sales of our products in various geographic regions, and we have a limited ability to influence their efforts. Relying on distributors for our sales and marketing could harm our business for various reasons, including:\n24\n| • | agreements with distributors may terminate prematurely due to disagreements or may result in litigation between the partners; |\n\n| • | we may not be able to renew existing distributor agreements on acceptable terms; |\n\n| • | our distributors may not devote sufficient resources to the sale of products; |\n\n| • | our distributors may be unsuccessful in marketing our products; |\n\n| • | our existing relationships with distributors may preclude us from entering into additional future arrangements with other distributors; and |\n\n| • | we may not be able to negotiate future distributor agreements on acceptable terms. |\n\nComplying with regulations enforced by the FDA and other regulatory authorities is an expensive and time-consuming process, and any failure to comply could result in substantial penalties.\nOur products are considered medical devices and are subject to extensive regulation in the U.S. and internationally. FDA regulations are wide ranging and govern, among other things:\n| • | product design, development, manufacturing and testing; |\n\n| • | product labeling; |\n\n| • | product storage; |\n\n| • | pre-market clearance or approval; |\n\n| • | complaint handling and corrective actions; |\n\n| • | advertising and promotion; and |\n\n| • | product sales and distribution. |\n\nOur failure to comply with applicable regulatory requirements could result in enforcement action by the FDA or state agencies, which may include any of the following sanctions:\n| • | warning letters, fines, injunctions, consent decrees and civil penalties; |\n\n| • | repair, replacement, refunds, recall or seizure of our products; |\n\n| • | operating restrictions or partial suspension or total shutdown of production; |\n\n| • | refusing our requests for 510(k) clearance or pre-market approval of new products, new intended uses, or modifications to existing products; |\n\n| • | withdrawing clearance or pre-market approvals that have already been granted; and |\n\n| • | criminal prosecution. |\n\nIf any of these events were to occur, they could harm our business. We must comply with facility registration and product listing requirements of the FDA and adhere to applicable Quality System regulations. The FDA enforces its Quality System regulations through periodic unannounced inspections. Our failure to take satisfactory corrective action in response to an adverse inspection or the failure to comply with applicable manufacturing regulations could result in enforcement action, and we may be required to find alternative manufacturers, which could be a long and costly process. Any FDA enforcement action could have a material adverse effect on us.\nBefore we can sell a new medical device in the U.S., or market a new use of or claim for an existing product, we must obtain FDA clearance or approval unless an exemption applies. Obtaining regulatory clearances or approvals can be a lengthy and time-consuming process. Even though the devices we market have obtained the necessary clearances from the FDA, we may be unable to maintain such clearances in the future. Furthermore, we may be unable to obtain the necessary clearances for new devices that\n25\nwe intend to market in the future. Our inability to maintain or obtain regulatory clearances or approvals could materially harm our business.\nIn addition, as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC adopted disclosure requirements regarding the use of certain minerals, known as conflict minerals, which are mined from the Democratic Republic of Congo and adjoining countries, as well as procedures regarding a manufacturer's efforts to identify and discourage the sourcing of such minerals and metals produced from those minerals. Additional reporting obligations are being proposed by the European Union. The U.S. requirements and any additional requirements in Europe could affect the sourcing and availability of metals used in the manufacture of a limited number of parts (if any) contained in our products. For example, the implementation of these disclosure requirements may decrease the number of suppliers capable of supplying our needs for certain metals, thereby negatively affecting our ability to obtain products in sufficient quantities or at competitive prices. Our material sourcing is broad based and multi-tiered, and we may be unable to conclusively verify the origins for all metals used in our products. We may suffer financial and reputational harm if customers require, and we are unable to deliver, certification that our products are conflict free. Regardless, we will incur additional costs associated with compliance with these disclosure requirements, including time-consuming and costly efforts to determine the source of any conflict minerals used in our products.\nIf compliance with healthcare regulations becomes costly and difficult for our customers or for us, we may not be able to grow our business.\nParticipants in the healthcare industry are subject to extensive and frequently changing regulations under numerous laws administered by governmental entities at the federal, state and local levels, some of which are, and others of which may be, applicable to our business. In response to perceived increases in health care costs in recent years, Congress passed health care reform legislation that was signed into law in March 2010. This legislation contains many provisions designed to generate the revenues necessary to fund the coverage expansions. The most relevant of these provisions are those that impose fees or taxes on certain health-related industries, including medical device manufacturers.\nFurthermore, our healthcare provider customers are also subject to a wide variety of laws and regulations that could affect the nature and scope of their relationships with us. The healthcare market itself is highly regulated and subject to changing political, economic and regulatory influences. Regulations implemented pursuant to the Health Insurance Portability and Accountability Act (\"HIPAA\"), including regulations affecting the security and privacy of patient healthcare information held by healthcare providers and their business associates may require us to make significant and unplanned enhancements of software applications or services, result in delays or cancellations of orders, or result in the revocation of endorsement of our products and services by healthcare participants. The effect of HIPAA and newly enforced regulations on our business is difficult to predict, and there can be no assurance that we will adequately address the business risks created by HIPAA and its implementation or that we will be able to take advantage of any resulting business opportunities.\nExtensive and changing government regulation of the healthcare industry may be expensive to comply with and exposes us to the risk of substantial government penalties.\nIn addition to medical device laws and regulations, numerous state and federal healthcare-related laws regulate our business, covering areas such as:\n| • | storage, transmission and disclosure of medical information and healthcare records; |\n\n| • | prohibitions against the offer, payment or receipt of remuneration to induce referrals to entities providing healthcare services or goods or to induce the order, purchase or recommendation of our products; and |\n\n| • | the marketing and advertising of our products. |\n\nComplying with these laws and regulations could be expensive and time-consuming, and could increase our operating costs or reduce or eliminate certain of our sales and marketing activities or our revenues.\nOur business exposes us to potential product liability claims, and we may incur substantial expenses if we are subject to product liability claims or litigation.\nMedical devices involve an inherent risk of product liability claims and associated adverse publicity. We may be held liable if any product we develop or any product that uses or incorporates any of our technologies causes injury or is otherwise found unsuitable. Although we intend to continue to maintain product liability insurance, adequate insurance may not be available on acceptable terms, if at all, and may not provide adequate coverage against potential liabilities. A product liability claim, regardless\n26\nof its merit or eventual outcome, could result in significant legal defense costs. These costs would have the effect of increasing our expenses and diverting management’s attention away from the operation of our business, and could harm our business.\nHistorically, the market price for our common stock has been volatile.\nThe market price of our common stock could be subject to wide price fluctuations in response to various factors, many of which are beyond our control. The factors include:\n| • | quarterly variations in our results of operations and liquidity; |\n\n| • | changes in recommendations by the investment community or in their estimates of our net revenues or operating results; |\n\n| • | speculation in the press or investment community concerning our business and results of operations; |\n\n| • | strategic actions by our competitors, such as product announcements or acquisitions; |\n\n| • | announcements of technological innovations or new products by us, our customers or competitors; and |\n\n| • | general economic market conditions. |\n\nIn addition, the stock market, in general and the market for technology and medical device companies, in particular, have experienced extreme price and volume fluctuations that have often been unrelated to or disproportionate to the operating performance of those companies. These broad market and industry factors may seriously harm the market price of our common stock, regardless of our operating performance. Historically, class action litigation is often brought against an issuing company following periods of volatility in the market price of a company’s securities.\nFuture sales of significant amounts of our common stock may depress our stock price.\nA large percentage of our outstanding common stock is currently owned by a small number of significant stockholders. These stockholders have sold in the past, and may sell in the future, large amounts of common stock over relatively short periods of time. Sales of substantial amounts of our common stock in the public market by our existing stockholders may adversely affect the market price of our common stock. Such sales could create public perception of difficulties or problems with our business and may depress our stock price.\nWe are subject to risks associated with our strategic investments. Impairments in the value of our investments could negatively impact our financial results.\nWe have invested in SmileDirectClub, LLC (\"SDC\") and other privately held companies for strategic reasons and to support key business initiatives, and we may not realize a return on our strategic investments. Many of such companies generate net losses and the market for their products, services or technologies may be slow to develop. Further, valuations of privately held companies are inherently complex due to the lack of readily available market data. If we determine that our investments in SDC or other privately held companies have experienced a decline in value, we may be required to record impairments, which could be material and could have an adverse impact on our financial results.\nIf our goodwill or long-lived assets become impaired, we may be required to record a significant charge to earnings.\nUnder Generally Accepted Accounting Principles in the United States (“U.S. GAAP”), we review our goodwill and long-lived asset group for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. Additionally, goodwill is required to be tested for impairment at least annually. The qualitative and quantitative analysis used to test goodwill are dependent upon various assumptions and reflect management’s best estimates. Changes in certain assumptions including revenue growth rates, discount rates, earnings multiples and future cash flows may cause a change in circumstances indicating that the carrying value of goodwill or the asset group may be impaired. We may be required to record a significant charge to earnings in the financial statements during the period in which any impairment of goodwill or asset group are determined.\nChanges in, or interpretations of, accounting rules and regulations, could result in unfavorable accounting charges.\nWe prepare our consolidated financial statements in conformity with U.S. GAAP. These principles are subject to interpretation by the SEC and various bodies formed to interpret and create appropriate accounting policies. A change in these policies can have a significant effect on our reported results and may even retroactively affect previously reported transactions. Our accounting\n27\npolicies that recently have been, or may be affected by changes in the accounting rules relate to stock-based compensation, revenue recognition and leases.\nIf we fail to manage our exposure to global financial and securities market risk successfully, our operating results and financial statements could be materially impacted.\nThe primary objective of our investment activities is to preserve principal. To achieve this objective, a majority of our marketable investments are investment grade, liquid, fixed-income securities and money market instruments denominated in U.S. dollars. If the carrying value of our investments exceeds the fair value, and the decline in fair value is deemed to be other-than-temporary, we will be required to write down the value of our investments, which could materially harm our results of operations and financial condition. Moreover, the performance of certain securities in our investment portfolio correlates with the credit condition of the U.S. financial sector. In a current unstable credit environment, we might incur significant realized, unrealized or impairment losses associated with these investments.\nOn July 1, 2016, we changed our corporate structure; however, if we are unable to maintain this structure or if it is challenged by U.S. or foreign tax authorities, we may be unable to realize tax savings which could materially and adversely affect our operating results.\nWe implemented a new international corporate structure on July 1, 2016. This corporate structure may reduce our overall effective tax rate over time through changes in the structure of our international procurement and sales operations, as well as realignment of the ownership and use of intellectual property among our wholly-owned subsidiaries.\nThe structure includes legal entities located in jurisdictions with income tax rates lower than the U.S. federal statutory tax rate. Such intercompany arrangements would be designed to result in income earned by such entities in accordance with arm’s-length principles and commensurate with functions performed, risks assumed and ownership of valuable corporate assets. We believe that income taxed in certain foreign jurisdictions at a lower rate relative to the U.S. federal statutory rate will have a beneficial impact on our worldwide effective tax rate over the medium to long term.\nIf the structure is challenged by U.S. or foreign tax authorities, if changes in domestic and international tax laws negatively impact the structure, including proposed legislation to reform U.S. taxation of international business activities, or if we do not operate our business in a manner consistent with the structure and applicable regulatory provisions, we may fail to achieve the financial and operational efficiencies that we anticipate as a result of the structure, and our business, financial condition and operating results may be materially and adversely affected.\nOur effective tax rate may vary significantly from period to period.\nVarious internal and external factors may have favorable or unfavorable effects on our future effective tax rate. These factors include, but are not limited to, changes in tax laws, regulations and/or rates, new or changes to accounting pronouncements, non-deductible goodwill impairments, changing interpretations of existing tax laws or regulations, changes in the relative proportions of revenues and income before taxes in the various jurisdictions in which we operate that have differing statutory tax rates, the future levels of tax benefits of stock-based compensation, settlement of income tax audits, and changes in overall levels of pretax earnings.\nIn addition, our tax rate may be impacted by tax holidays or incentives. In June 2009, the Costa Rica Ministry of Foreign Trade, an agency of the Government of Costa Rica, granted a twelve year extension of certain income tax incentives, which were previously granted in 2002. The incentive tax rates will expire in various years beginning in 2017. We intend to seek a renewal of these income tax incentives before they expire. Under these incentives, all of the income in Costa Rica during these twelve year incentive periods is subject to a reduced tax rate. In order to receive the benefit of these incentives, we must hire specified numbers of employees and maintain certain minimum levels of fixed asset investment in Costa Rica. If we do not fulfill these conditions for any reason, our incentive could lapse, and our income in Costa Rica would be subject to taxation at higher rates, which could have a negative impact on our operating results. The Costa Rica corporate income tax rate that would apply, absent the incentives, is 30% for 2016, 2015 and 2014. As a result of these incentives, income taxes were reduced by $19.1 million, $32.7 million and $32.5 million in the year ended December 31, 2016, 2015 and 2014, respectively. The benefit of the tax holiday on diluted net income per share was $0.23 in the year ended December 31, 2016 and $0.40 in each of the year ended December 31, 2015 and 2014. Our subsidiary in Israel is under audit by the local tax authorities for calendar years 2006 through 2013.\n28\nChanges in tax laws or tax rulings could negatively impact our income tax provision and net income.\nAs a U.S. multinational corporation, we are subject to changing tax laws both within and outside of the U.S. Changes in tax laws or tax rulings, or changes in interpretations of existing tax laws, could affect our income tax provision and net income or require us to change the manner in which we operate our business. Many countries in Europe, as well as a number of other countries and organizations, have recently proposed or recommended changes to existing tax laws or have enacted new laws. For example, the Organization for Economic Cooperation and Development (\"OECD\") has been working on a \"Base Erosion and Profit Shifting Project,\" which is focused on a number of issues, including the shifting of profits between affiliated entities in different tax jurisdictions. The OECD issued in 2015, and is expected to continue to issue, guidelines and proposals that may change various aspects of the existing framework under which our tax obligations are determined in many of the countries in which we do business. In addition, the current U.S. administration and key members of Congress have made public statements indicating that tax reform is a priority. Certain changes to U.S. tax laws, including limitations on the ability to defer U.S. taxation on earnings outside of the United States until those earnings are repatriated to the United States, could affect the tax treatment of our foreign earnings.\nITEM 1B.\nUNRESOLVED STAFF COMMENTS\nNone.\nITEM 2.\nPROPERTIES\nWe occupy several leased and owned facilities with total office and manufacturing area of over 987,000 square feet. At December 31, 2016, the significant facilities were occupied as follows:\n\n| Location | Lease/Own | Primary Use | Expiration of Lease |\n| San Jose, California (1) | Lease | Office for corporate headquarters, research & development and administrative personnel | August 2017 |\n| Juarez, Mexico | Own | Manufacturing and office facilities for manufacturing and administrative personnel | N/A |\n| San Jose, Costa Rica | Lease | Office for administrative personnel, treatment personnel, and customer care | October 2018 |\n| Or Yehuda, Israel | Lease | Manufacturing and office for manufacturing, administrative personnel, and research & development | February 2022 |\n| Amsterdam, The Netherlands | Lease | Office for international headquarters, sales and marketing and administrative personnel | March 2020 |\n| Moscow, Russia | Lease | Office for research & development | July 2023 |\n| Raleigh, North Carolina | Lease | Office for research & development and administrative personnel | October 2024 |\n\n(1) Refer to Note 8 \"Commitments and Contingencies\" of the Notes of Consolidated Financial Statements for information on our corporate headquarters office Purchase Agreement in December 2016.\n29\nITEM 3.\nLEGAL PROCEEDINGS\nSecurities Class Action Lawsuit\nOn November 28, 2012, plaintiff City of Dearborn Heights Act 345 Police & Fire Retirement System filed a lawsuit against Align, Thomas M. Prescott (“Mr. Prescott”), Align’s former President and Chief Executive Officer, and Kenneth B. Arola (“Mr. Arola”), Align’s former Vice President, Finance and Chief Financial Officer, in the United States District Court for the Northern District of California on behalf of a purported class of purchasers of our common stock (the “Securities Action”). On July 11, 2013, an amended complaint was filed, which named the same defendants, on behalf of a purported class of purchasers of our common stock between January 31, 2012 and October 17, 2012. The amended complaint alleged that Align, Mr. Prescott and Mr. Arola violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, and that Mr. Prescott and Mr. Arola violated Section 20(a) of the Securities Exchange Act of 1934. Specifically, the amended complaint alleged that during the purported class period defendants failed to take an appropriate goodwill impairment charge related to the April 29, 2011 acquisition of Cadent Holdings, Inc. in the fourth quarter of 2011, the first quarter of 2012 or the second quarter of 2012, which rendered our financial statements and projections of future earnings materially false and misleading and in violation of U.S. GAAP. The amended complaint sought monetary damages in an unspecified amount, costs and attorneys’ fees. On December 9, 2013, the court granted defendants’ motion to dismiss with leave for plaintiff to file a second amended complaint. Plaintiff filed a second amended complaint on January 8, 2014 on behalf of the same purported class. The second amended complaint states the same claims as the amended complaint. On August 22, 2014, the court granted our motion to dismiss without leave to amend. On September 22, 2014, Plaintiff filed a notice of appeal to the Ninth Circuit Court of Appeals. Briefing for the appeal was completed in May 2015 and the Ninth Circuit held oral arguments in October 2016. Align intends to vigorously defend itself against these allegations. Align is currently unable to predict the outcome of this amended complaint and therefore cannot determine the likelihood of loss nor estimate a range of possible loss, if any.\nShareholder Derivative Lawsuit\nOn February 1, 2013, plaintiff Gary Udis filed a shareholder derivative lawsuit against several of Align’s current and former officers and directors in the Superior Court of California, County of Santa Clara. The complaint alleges that our reported income and earnings were materially overstated because of a failure to timely write down goodwill related to the April 29, 2011 acquisition of Cadent Holdings, Inc., and that defendants made allegedly false statements concerning our forecasts. The complaint asserts various state law causes of action, including claims of breach of fiduciary duty, unjust enrichment, and insider trading, among others. The complaint seeks unspecified damages on behalf of Align, which is named solely as nominal defendant against whom no recovery is sought. The complaint also seeks an order directing Align to reform and improve its corporate governance and internal procedures, and seeks restitution in an unspecified amount, costs, and attorneys’ fees. On July 8, 2013, an Order was entered staying this derivative lawsuit until an initial ruling on our first motion to dismiss the Securities Action. On January 15, 2014, an Order was entered staying this derivative lawsuit until an initial ruling on our second motion to dismiss the Securities Action. On October 14, 2014, an Order was entered staying this derivative lawsuit until a ruling by the Ninth Circuit in the Securities Action discussed above. Align is currently unable to predict the outcome of this complaint and therefore cannot determine the likelihood of loss nor estimate a range of possible losses, if any.\nIn addition, in the course of Align's operations, Align is involved in a variety of claims, suits, investigations, and proceedings, including actions with respect to intellectual property claims, patent infringement claims, government investigations, labor and employment claims, breach of contract claims, tax, and other matters. Regardless of the outcome, these proceedings can have an adverse impact on us because of defense costs, diversion of management resources, and other factors. Although the results of complex legal proceedings are difficult to predict and Align's view of these matters may change in the future as litigation and events related thereto unfold; Align currently does not believe that these matters, individually or in the aggregate, will materially affect Align's financial position, results of operations or cash flows.\nITEM 4.\nMINE SAFETY DISCLOSURES\nNot applicable.\n30\nPART II\n\nITEM 5.\nMARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES\nPrice Range of Common Stock\nOur common stock is quoted on the NASDAQ Global Select Market under the symbol “ALGN.” The following table sets forth the range of high and low per share sales prices as reported for each period indicated:\n| High | Low |\n| Year Ended December 31, 2016: |\n| Fourth quarter | $ | 102.10 | $ | 83.27 |\n| Third quarter | $ | 96.90 | $ | 80.30 |\n| Second quarter | $ | 81.98 | $ | 70.03 |\n| First quarter | $ | 73.55 | $ | 57.31 |\n| Year Ended December 31, 2015: |\n| Fourth quarter | $ | 68.48 | $ | 54.69 |\n| Third quarter | $ | 66.53 | $ | 52.01 |\n| Second quarter | $ | 64.99 | $ | 51.65 |\n| First quarter | $ | 64.75 | $ | 51.77 |\n\nOn February 21, 2017, the closing price of our common stock on the NASDAQ Global Market was $101.86 per share. As of February 21, 2017, there were approximately 96 holders of record of our common stock. Because the majority of our shares of outstanding common stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders.\nWe have never declared or paid any cash dividends on our common stock. We currently intend to retain any future earnings to fund the development and growth of our business and do not anticipate paying any cash dividends in the foreseeable future.\nPerformance Graph\nNotwithstanding any statement to the contrary in any of our previous or future filings with the SEC, the following information relating to the price performance of our common stock shall not be deemed “filed” with the SEC or “Soliciting Material” under the Securities Exchange Act of 1934, as amended, or subject to Regulation 14A or 14C, or to liabilities of Section 18 of the Exchange Act except to the extent we specifically request that such information be treated as soliciting material or to the extent we specifically incorporate this information by reference.\nThe graph below matches our cumulative 5-year total shareholder return on common stock with the cumulative total returns of the NASDAQ Composite index, and the S&P 1500 Composite Health Care Equipment & Supplies index. The graph tracks the performance of a $100 investment in our common stock, in the peer group, and the index (with the reinvestment of all dividends) from December 31, 2011 to December 31, 2016.\n31\nUNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nFollowing is a summary of stock repurchases for the three months ended December 31, 2016:\n| Period | Total Number of Shares Repurchased | Average Price Paid per Share | Total Number of Shares Repurchased as Part of Publicly Announced Program | Approximate Dollar Value of Shares that May Yet Be Repurchased Under the Program (1) |\n| October 1, 2016 through October 31, 2016 | 179,500 | $ | 89.28 | 179,500 | $ | 325,777,042 |\n| November 1, 2016 through November 30, 2016 | 126,000 | $ | 92.36 | 126,000 | $ | 314,139,921 |\n| December 1, 2016 through December 31, 2016 | 106,000 | $ | 97.92 | 106,000 | $ | 303,760,487 |\n\n(1) Stock Repurchase Programs\n| ◦ | April 2014 Repurchase Program. In 2016, we repurchased $50.0 million of our common stock through an accelerated stock repurchase agreement and $46.2 million of stock repurchase in the open market. |\n\n| ◦ | April 2016 Repurchase Program. On April 28, 2016, we announced that our Board of Directors had authorized a plan to repurchase up to $300.0 million of our stock. |\n\n| ◦ | Remaining Available Repurchases. As of December 31, 2016, we have approximately $3.8 million remaining available under the April 2014 Repurchase Program and $300.0 million under the April 2016 Repurchase Plan (Refer to Note 10 \"Common Stock Repurchase Program\" of the Notes to Consolidated Financial Statements for details on common stock repurchase). |\n\n32\nITEM 6.\nSELECTED CONSOLIDATED FINANCIAL DATA\nThe following tables set forth the selected consolidated financial data for each of the years in the five-year period ended December 31, 2016. The selected consolidated financial data should be read in conjunction with the consolidated financial statements and accompanying notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations. We have derived the statements of operations data for the year ended December 31, 2016, 2015 and 2014 and the balance sheet data as of December 31, 2016 and 2015 from the consolidated audited financial statements included elsewhere in this Annual Report on Form 10-K. The statements of operations data for the year ended December 31, 2013 and 2012 and the balance sheet data as of December 31, 2014, 2013 and 2012 were derived from the consolidated audited financial statements that are not included in this Annual Report on Form 10-K.\nSELECTED CONSOLIDATED FINANCIAL DATA\n(in thousands, except per share data)\n\n| Year Ended December 31, |\n| 2016 | 2015 | 2014 | 2013 | 2012 |\n| Consolidated Statements of Operations Data: |\n| Net revenues | $ | 1,079,874 | $ | 845,486 | $ | 761,653 | $ | 660,206 | $ | 560,041 |\n| Gross profit (1) | $ | 815,294 | $ | 640,110 | $ | 578,443 | $ | 498,106 | $ | 416,388 |\n| Income from operations (2) | 248,921 | 188,634 | 193,576 | 94,212 | 85,592 |\n| Interest and other income (expense), net | (6,355 | ) | (2,533 | ) | (3,207 | ) | (1,073 | ) | (1,296 | ) |\n| Net income before provision for income taxes and equity in losses of investee (2) | 242,566 | 186,101 | 190,369 | 93,139 | 84,296 |\n| Provision for income taxes (3) | 51,200 | 42,081 | 44,537 | 28,844 | 25,605 |\n| Equity in losses of investee, net of tax | 1,684 | — | — | — | — |\n| Net income | $ | 189,682 | $ | 144,020 | $ | 145,832 | $ | 64,295 | $ | 58,691 |\n| Net income per share: |\n| Basic | $ | 2.38 | $ | 1.80 | $ | 1.81 | $ | 0.80 | $ | 0.73 |\n| Diluted | $ | 2.33 | $ | 1.77 | $ | 1.77 | $ | 0.78 | $ | 0.71 |\n| Shares used in computing net income per share: |\n| Basic | 79,856 | 79,998 | 80,754 | 80,551 | 80,529 |\n| Diluted | 81,484 | 81,521 | 82,283 | 82,589 | 83,040 |\n| December 31, |\n| 2016 | 2015 | 2014 | 2013 | 2012 |\n| Consolidated Balance Sheet Data: |\n| Working capital (4) | $ | 598,643 | $ | 460,338 | $ | 455,349 | $ | 369,338 | $ | 330,022 |\n| Total assets | 1,396,151 | 1,158,633 | 987,997 | 832,147 | 756,312 |\n| Total long-term liabilities | 46,427 | 39,035 | 33,415 | 22,839 | 19,224 |\n| Stockholders’ equity | $ | 995,389 | $ | 847,926 | $ | 752,771 | $ | 633,970 | $ | 581,317 |\n\n| (1) | Gross profit includes: |\n\n| • | $1.7 million out of period adjustment in 2013 |\n\n| • | $0.2 million acquisition and integration related costs, $0.9 million amortization of intangible assets, and $0.5 million of exit costs in 2012 |\n\n33\n(2) Income from operations and net income before provision for income taxes and equity in losses of investee include:\n| • | $40.7 million and $26.3 million of goodwill and long-lived asset impairment, respectively, in 2013 |\n\n| • | $1.9 million, net of tax, out of period adjustment in 2013 |\n\n| • | $36.6 million of goodwill impairment, $1.3 million acquisition and integration related costs, $4.5 million of amortization of intangible assets, and $0.8 million of exit costs in 2012 |\n\n| (3) | Provision for income taxes includes: |\n\n| • | $1.8 million out of period income tax adjustment in 2014 (Refer to Note 1 \"Summary of Significant Accounting Policies\" of the Notes to Consolidated Financial Statements) |\n\n| (4) | Working capital is calculated as the difference between total current assets and total current liabilities. |\n\n34\nITEM 7.\nMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nThe following discussion and analysis of our financial condition and results of operations should be read together with “Selected Consolidated Financial Data” and our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K.\nOverview\nOur goal is to establish Invisalign clear aligners as the standard method for treating malocclusion and to establish the iTero intraoral scanner as the preferred scanning device for 3D digital scans, ultimately driving increased product adoption by dental professionals. We intend to achieve this by continued focus and execution of our strategic growth drivers set forth in the Business Strategy section in our Annual Report on Form 10-K.\nThe successful execution of our business strategy in 2017 and beyond may be affected by a number of other factors including:\n| • | New Products, Feature Enhancements and Technology Innovation. Product innovation drives greater treatment predictability and clinical applicability and ease of use for our customers which supports adoption of Invisalign in their practices. Increasing applicability and treating more complex cases requires that we move away from individual features to more comprehensive solutions so that Invisalign providers can more predictably treat the whole case, such as with our Invisalign \"G-Series\" of product innovations, including our most recent October 2016 release of Invisalign G7. Invisalign G7 delivers better upper lateral control, improved root control and features to address prevention of posterior open bites. Concurrently, we also announced ClinCheck Pro 5.0, which has new features designed to deliver an improved and user friendly experience and increased control to Invisalign providers. Since the iTero Element began shipping in September 2015, the use of iTero scanners for Invisalign case submissions in place of Polyvinyl-siloxane (\"PVS\") impressions has gradually increased to a record 51.3% of cases from North America and 24.9% of cases from international doctors as of the fourth quarter of 2016. We believe that over the long-term, clinical solutions and treatment tools will increase adoption of Invisalign and increase sales of our intraoral scanners; however, it is difficult to predict the rate of adoption which may vary by region and channel. |\n\n| • | Invisalign Adoption. Our goal is to establish Invisalign as the treatment of choice for treating malocclusion ultimately driving increased product adoption and frequency of use by dental professionals, also known as \"utilization rates.\" Our quarterly utilization rates for the last 9 quarters are as follows: |\n\n* Invisalign Utilization Rates = # of cases shipped divided by # of doctors cases were shipped to\n35\n| ◦ | Total utilization in the fourth quarter of 2016 increased to 5.2 cases per doctor compared to 4.9 in the fourth quarter of 2015. |\n\n| ▪ | North America: Utilization among our North American orthodontist customers reached an all time high of 11.3 cases per doctor in the fourth quarter of 2016 compared to 9.9 in the fourth quarter of 2015. The increase in North America orthodontist utilization reflects improvements in product and technology which continues to strengthen our doctors’ clinical confidence in the use of Invisalign such that they now utilize Invisalign more often and on more complex cases, including their teenage patients. |\n\n| ▪ | International: International doctor utilization of 5.0 cases per doctor in the fourth quarter of 2016 was flat compared with the fourth quarter of 2015. The International utilization reflects growth in both the Europe, Middle East and Africa (\"EMEA\") and Asia Pacific (\"APAC\") regions due to increasing adoption of the product and its ability to treat more complex cases; however, utilization remained flat primarily due to the expansion of our customer base, particularly in APAC. |\n\nWe expect that over the long-term our utilization rates will gradually improve as a result of advancements in product and technology, which continue to strengthen our doctors’ clinical confidence in the use of Invisalign; however, we expect that our utilization rates may fluctuate from period to period due to a variety of factors, including seasonal trends in our business along with adoption rates of new products and features.\n| • | Number of New Invisalign Doctors Trained. We continue to expand our Invisalign customer base through the training of new doctors. In 2016, Invisalign growth was driven primarily by increased utilization across all regions as well as by the continued expansion of our customer base as we trained a total of 11,680 new Invisalign doctors, of which 60% were trained internationally. |\n\n| • | International Invisalign Growth. We will continue to focus our efforts towards increasing Invisalign adoption by dental professionals in our direct international markets. On a year over year basis, international Invisalign volume increased 32.4% driven primarily by strong performance in our APAC and in Europe regions. In 2017, we are continuing to expand in our existing markets through targeted investments in sales coverage and professional marketing and education programs, along with consumer marketing in selected country markets. We expect international Invisalign revenues to continue to grow at a faster rate than North America for the foreseeable future due to our continued investment in international market expansion, the size of the market opportunity, and our relatively low market penetration in this region (Refer to Item 1A Risk Factors - “We are exposed to fluctuations in currency exchange rates, which could negatively affect our financial condition and results of operations.” for information on related risk factors). |\n\n| • | Establish Regional Order Acquisition and Treatment Planning Facilities: We intend to establish additional order acquisition and treatment planning facilities closer to our international customers in order to improve our operational efficiency and provide doctors with a great experience to further improve their confidence in using Invisalign to treat more patients and more often (Refer to Item 1A Risk Factors - “As we continue to grow, we are subject to growth related risks, including risks related to excess or constrained capacity at our existing facilities.” for information on related risk factors). |\n\n| • | Operating Expenses. We expect operating expenses to increase in 2017 due in part to: |\n\n| ◦ | investments in international expansion in new country markets particularly in the APAC region; |\n\n| ◦ | investments in manufacturing to enhance our regional capabilities; |\n\n| ◦ | increases in legal expenses primarily related to the continued protection of our intellectual property rights, including our patents; |\n\n| ◦ | increases in sales and customer support resources; |\n\n| ◦ | increases in expenses related to the purchase of our new corporate headquarters in San Jose, California; and |\n\n| ◦ | product and technology innovation to address such things as treatment times, indications unique to teens and predictability. |\n\nWe believe that these investments will position us to increase our revenue and continue to grow our market share.\n36\n| • | Stock Repurchases: |\n\n| ◦ | April 2014 Repurchase Program. In 2016, we repurchased $50.0 million of our common stock through an accelerated stock repurchase agreement and $46.2 million of stock repurchase in the open market. |\n\n| ◦ | April 2016 Repurchase Program. On April 28, 2016, we announced that our Board of Directors had authorized a plan to repurchase up to $300.0 million of our stock. |\n\n| ◦ | Remaining Available Repurchases. As of December 31, 2016, we have $3.8 million remaining under the April 2014 Repurchase Program and $300.0 million under the April 2016 Repurchase Plan (Refer to Note 10 \"Common Stock Repurchase Program\" of the Notes to Consolidated Financial Statements for details on stock repurchase program). |\n\n| • | SmileDirectClub. On July 25, 2016, we entered into a supply agreement with SmileDirectClub, LLC (\"SDC\") to manufacture clear aligners for SDC's doctor-led, at-home program for simple teeth straightening. In October 2016, we became SDC's exclusive third-party supplier and commercial supplying aligners for its minor tooth movement aligner program. As part of the transaction, we acquired a 17% equity interest in SDC for $46.7 million. We also provided a revolving line of credit to SDC of up to $15.0 million to fund their working capital and general corporate needs (Refer to Note 4 \"Equity Method Investments\" of the Notes to Consolidated Financial Statements for details on accounting treatment). |\n\nWe expect the supply agreement to be incremental to revenue growth in 2017.\n| • | New Corporate Headquarters Office Purchase Agreement. On December 19, 2016, we entered into a Purchase and Sale Agreement (the \"Purchase Agreement\") with LBA RIV-COMPANY XXX, LLC (\"Seller\") to purchase the real property located in San Jose, California (the \"Property\") for the purchase price of $44.1 million. We closed the Purchase Agreement on January 26, 2017 (Refer to Note 8 \"Commitments and Contingencies\" of the Notes of Consolidated Financial Statements for more information on the Purchase Agreement). |\n\nResults of Operations\nNet Revenues by Reportable Segment Comparison for Year Ended December 31, 2016, 2015 and 2014:\nWe group our operations into two reportable segments: Clear Aligner segment and Scanner segment\n| • | Our Clear Aligner segment consists of our Invisalign system which includes Invisalign Full, Teen and Assist (\"Comprehensive Products\"), Express/Lite (\"Non-Comprehensive Products\"), Vivera retainers, along with our training and ancillary products for treating malocclusion (\"Non-Case\"). Clear Aligner segment also include the sale of aligners to SDC under our supply agreement which commenced in the fourth quarter of 2016. SDC revenue is recorded after eliminating outstanding intercompany transactions. |\n\n| • | Our Scanner segment consists of intraoral scanning systems and additional services available with the intraoral scanners that provide digital alternatives to the traditional cast models. This segment includes our iTero scanner and OrthoCAD services. |\n\nNet revenues for our Clear Aligner segment and Scanner segment by region for the year ended December 31, 2016, 2015 and 2014 are as follows (in millions):\n37\n| Year Ended | Year Ended |\n| Net Revenues | December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\n| Clear Aligner Revenues: |\n| North America | $ | 568.7 | $ | 498.7 | $ | 70.0 | 14.0 | % | $ | 498.7 | $ | 446.6 | $ | 52.1 | 11.7 | % |\n| International | 326.6 | 250.1 | 76.5 | 30.6 | % | 250.1 | 219.7 | 30.4 | 13.8 | % |\n| Non-Case | 63.0 | 51.4 | 11.6 | 22.6 | % | 51.4 | 46.2 | 5.2 | 11.3 | % |\n| Total Clear Aligner net revenues | $ | 958.3 | $ | 800.2 | $ | 158.1 | 19.8 | % | $ | 800.2 | $ | 712.5 | $ | 87.7 | 12.3 | % |\n| Scanner net revenues | $ | 121.5 | $ | 45.3 | $ | 76.2 | 168.2 | % | $ | 45.3 | $ | 49.1 | $ | (3.8 | ) | (7.7 | )% |\n| Total net revenues | $ | 1,079.8 | $ | 845.5 | $ | 234.3 | 27.7 | % | $ | 845.5 | $ | 761.6 | $ | 83.9 | 11.0 | % |\n\nChanges and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.\nClear Aligner Case Volume by Region\nCase volume data which represents Clear Aligner case shipments by region, for the year ended December 31, 2016, 2015 and 2014 is as follows (in millions):\n| Year Ended | Year Ended |\n| Region | December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\n| North America | 464.5 | 398.4 | 66.1 | 16.6 | % | 398.4 | 338.5 | 59.9 | 17.7 | % |\n| International | 244.7 | 184.8 | 59.9 | 32.4 | % | 184.8 | 139.5 | 45.3 | 32.5 | % |\n| Total case volume | 709.2 | 583.2 | 126.0 | 21.6 | % | 583.2 | 478.0 | 105.2 | 22.0 | % |\n\nChanges and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.\nFiscal Year 2016 compared to Fiscal Year 2015\nTotal net revenues increased by $234.3 million in 2016 as compared to 2015 primarily as a result of case volume growth across all regions and products as well as increased non-case revenue.\nClear Aligner - North America\nNorth America net revenues increased by $70.0 million in 2016 compared to 2015 primarily due to case volume growth across all channels and products which increased net revenues by $82.7 million. This increase was offset in part by lower average selling price (\"ASP\") which decreased net revenues by $12.7 million. ASP declined in 2016 compared to 2015 as a result of higher promotional discounts of $21.9 million as well as an increase in net deferrals of $7.7 million primarily related to the full year effect of our new additional aligners product policy launched in July 2015. These declines were partially offset by price increases on our Comprehensive Products effective April 1, 2016 which contributed $17.7 million to net revenues.\nClear Aligner - International\nInternational net revenues increased by $76.5 million in 2016 compared to 2015 primarily driven by case volume growth across all channels and products which increased net revenues by $80.9 million. This increase was offset in part by lower ASP which decreased net revenues by $4.4 million. ASP declined in 2016 compared to 2015 as a result of higher promotional discounts of $6.9 million as well as the unfavorable impact of changes in foreign exchange rates of $6.8 million. These declines were partially offset by the price increases on our Comprehensive products effective April 1, 2016 which contributed $5.7 million to net revenues, as well as an increase in additional aligner revenue of $3.5 million.\nClear Aligner - Non-Case\nNon-case net revenues, consisting of training fees and ancillary product revenues, increased by $11.6 million in 2016 compared to 2015 primarily due to increased Vivera volume both in North America and International.\n38\nScanner\nScanner net revenues increased by $76.2 million in 2016 compared to 2015 primarily as a result of an increase in the number of scanners recognized as we began shipping our next generation iTero Element scanner in September 2015, and, to a lesser extent, an increase in ASP.\nFiscal Year 2015 compared to Fiscal Year 2014\nTotal net revenues increased by $83.9 million in 2015 compared to 2014 primarily as a result of case volume growth across all regions and products as well as increased non-case revenue.\nClear Aligner - North America\nNorth America net revenues increased by $52.1 million in 2015 compared to 2014 primarily due to case volume growth across all channels and products which increased net revenues by approximately $79.0 million. These increases were offset in part by lower ASP, which decreased net revenues by $26.9 million. The decrease in ASP was primarily as a result of higher net revenue deferrals of $16.0 million, which includes the impact of our new additional aligner product policy launched in July 2015 of $8.9 million and the impact of higher promotional discounts in 2015 as compared to 2014 of $11.7 million. These decreases in ASP were offset in part by the price increase, effective April 1, 2015 on our Comprehensive Products.\nClear Aligner - International\nInternational net revenues increased by $30.4 million in 2015 compared to 2014 primarily driven by case volume growth across all products of $71.5 million. This was partially offset by lower ASP which decreased net revenues by approximately $41.1 million. The decrease in ASP was primarily as a result of the unfavorable impact from changes in foreign exchange rates primarily due to the weakening of the Euro compared to the U.S. dollar in 2015 compared to 2014 of $34.5 million, and, to a lesser extent, higher net revenue deferrals of $7.8 million which includes the impact of our new additional aligner product policy launched in July 2015 of $4.7 million, as well as higher promotional discounts of $6.3 million in 2015 compared to 2014. These decreases were partially offset by an increase in ASP as we transitioned to direct sales in certain APAC countries and EMEA regions, as well as the price increase on our Comprehensive Products effective July 1, 2015.\nClear Aligner - Non-Case\nNon-case net revenues, consisting of training fees and ancillary product revenues, increased by $5.2 million in 2015 as compared to 2014 primarily due to increased Vivera volume both in North America and International.\nScanner\nScanner net revenues decreased by $3.8 million in 2015 compared to 2014 primarily due to a decrease in scanner revenue, offset in part by a slight increase in services revenue. In March 2015, we announced our next generation scanner and began shipping the iTero Element scanner in September 2015. Scanner revenues declined in 2015 primarily due to fewer scanners recognized and permanent price reductions on our previous generation scanner. The increase in services revenue was primarily due to an increase in the volume of CAD/CAM services resulting from a larger installed base of scanners.\n39\nCost of net revenues and gross profit (in millions):\n\n| Year Ended | Year Ended |\n| December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\n| Clear Aligner |\n| Cost of net revenues | $ | 210.8 | $ | 172.0 | $ | 38.8 | $ | 172.0 | $ | 149.7 | $ | 22.3 |\n| % of net segment revenues | 22.0 | % | 21.5 | % | 21.5 | % | 21.0 | % |\n| Gross profit | $ | 747.5 | $ | 628.2 | $ | 119.3 | $ | 628.2 | $ | 562.9 | $ | 65.3 |\n| Gross margin % | 78.0 | % | 78.5 | % | 78.5 | % | 79.0 | % |\n| Scanner |\n| Cost of net revenues | $ | 53.7 | $ | 33.4 | $ | 20.3 | $ | 33.4 | $ | 33.6 | $ | (0.2 | ) |\n| % of net segment revenues | 44.2 | % | 73.7 | % | 73.7 | % | 68.3 | % |\n| Gross profit | $ | 67.8 | $ | 11.9 | $ | 55.9 | $ | 11.9 | $ | 15.6 | $ | (3.7 | ) |\n| Gross margin % | 55.8 | % | 26.3 | % | 26.3 | % | 31.7 | % |\n| Total cost of net revenues | $ | 264.6 | $ | 205.4 | $ | 59.2 | $ | 205.4 | $ | 183.2 | $ | 22.2 |\n| % of net revenues | 24.5 | % | 24.3 | % | 24.3 | % | 24.1 | % |\n| Gross profit | $ | 815.3 | $ | 640.1 | $ | 175.2 | $ | 640.1 | $ | 578.4 | $ | 61.7 |\n| Gross margin % | 75.5 | % | 75.7 | % | 75.7 | % | 75.9 | % |\n\nChanges and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.\nCost of net revenues for our Clear Aligner and Scanner segments includes salaries for staff involved in the production process, the cost of materials, packaging, shipping costs, depreciation on capital equipment and facilities used in the production process, amortization of acquired intangible assets from training costs and stock-based compensation.\nFiscal Year 2016 compared to Fiscal Year 2015\nClear Aligner\nThe gross margin percentage declined in 2016 compared to 2015 primarily driven by a higher number of aligners per case and lower ASP which was partially offset by higher absorption as a result of increased production volumes.\nScanner\nThe gross margin percentage increased in 2016 compared to 2015 due to a product mix shift to our iTero Element scanner which has a higher ASP along with lower costs per unit.\nFiscal Year 2015 compared to Fiscal Year 2014\nClear Aligner\nThe gross margin percentage declined in 2015 compared to 2014 due to lower ASP which was partially offset by higher absorption as a result of increased production volumes.\nScanner\nThe gross margin percentage decreased in 2015 compared to 2014 due to lower ASP from permanent price reductions on our previous generation scanner, higher manufacturing costs from lower production volumes and higher inventory reserves. This was partially offset by a product mix shift to the lower cost Element scanner which commenced shipping in September 2015.\n40\nSelling, general and administrative (in millions):\n| Year Ended | Year Ended |\n| December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\n| Selling, general and administrative | $ | 490.7 | $ | 390.2 | $ | 100.5 | $ | 390.2 | $ | 332.1 | $ | 58.1 |\n| % of net revenues | 45.4 | % | 46.2 | % | 46.2 | % | 43.6 | % |\n\nChanges and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.\nSelling, general and administrative expense includes personnel-related costs including payroll, commissions and stock-based compensation for our sales force, marketing and administration in addition to media and advertising expenses, clinical education, trade shows and industry events, product marketing, outside consulting services, legal expenses, depreciation and amortization expense, the medical device excise tax (\"MDET\") and allocations of corporate overhead expenses including facilities and IT.\nSelling, general and administrative expense increased in 2016 compared to 2015 primarily due to higher compensation related costs of $47.1 million as a result of increased headcount, resulting in higher salaries expense, incentive bonuses and fringe benefits. We also incurred higher expenses from advertising and marketing of $16.5 million, outside services costs of $12.2 million, equipment and material costs of $6.8 million, travel and related costs of $6.0 million and credit card processing fees of $4.2 million. In addition, during the first quarter of 2015, there was a refund of MDET taxes paid in 2014 of $6.8 million as our aligners are no longer subject to the excise tax.\nSelling, general and administrative expense increased in 2015 compared to 2014 primarily due to higher compensation related costs of $50.1 million as a result of increased headcount, which led to higher salaries, stock based compensation and commissions. In addition, consulting costs increased by $9.7 million primarily due to our enterprise resource planning (\"ERP\") project. Partially offsetting these increases was the MDET refund of $6.8 million received in the first quarter of 2015.\nResearch and development (in millions):\n| Year Ended | Year Ended |\n| December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\n| Research and development | $ | 75.7 | $ | 61.2 | $ | 14.5 | $ | 61.2 | $ | 52.8 | $ | 8.4 |\n| % of net revenues | 7.0 | % | 7.2 | % | 7.2 | % | 6.9 | % |\n\nChanges and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.\nResearch and development expense includes the personnel-related costs including stock-based compensation and outside consulting expenses associated with the research and development of new products and enhancements to existing products and allocations of corporate overhead expenses including facilities and IT.\nResearch and development expense increased in 2016 compared to 2015 due to higher compensation costs as a result of increased headcount along with annual salary increases.\nResearch and development expense increased in 2015 compared to 2014 primarily as a result of our investment in obstructive sleep apnea which was terminated in the third quarter of 2015.\n41\nIncome from operations (in millions):\n| Year Ended | Year Ended |\n| December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\n| Clear Aligner |\n| Income from operations | $ | 411.8 | $ | 371.1 | $ | 40.7 | $ | 371.1 | $ | 341.1 | $ | 30.0 |\n| Operating margin % | 43.0 | % | 46.4 | % | 46.4 | % | 47.9 | % |\n| Scanner |\n| Income (loss) from operations | $ | 37.5 | $ | (12.3 | ) | $ | 49.8 | $ | (12.3 | ) | $ | (8.5 | ) | $ | (3.8 | ) |\n| Operating margin % | 30.9 | % | (27.2 | )% | (27.2 | )% | (17.3 | )% |\n| Total income from operations(1) | $ | 248.9 | $ | 188.6 | $ | 60.3 | $ | 188.6 | $ | 193.6 | $ | (5.0 | ) |\n| Operating margin % | 23.1 | % | 22.3 | % | 22.3 | % | 25.4 | % |\n\nChanges and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.\n(1) Refer to Note 15 \"Segments and Geographical Information\" of the Notes to Consolidated Financial Statements for details on unallocated corporate expenses and the reconciliation to total income from operations.\nFiscal Year 2016 compared to Fiscal Year 2015\nClear Aligner\nOperating margin percentage declined in 2016 compared to 2015 primarily due to higher compensation costs as a result of increased headcount, higher number of aligners manufactured per case and lower ASP.\nScanner\nOperating margin percentage increased in 2016 compared to 2015 due to a product mix shift to our iTero Element scanner resulting in a higher ASP and lower costs per unit. We also incurred lower operating expenses as a percentage of revenues as we leveraged our operating expenses on higher revenues.\nFiscal Year 2015 compared to Fiscal Year 2014\nClear Aligner\nOperating margin percentage declined in 2015 compared to 2014 due to higher compensation costs as a result of increased headcount, higher research and development expenses due to our investment in obstructive sleep apnea and lower ASP.\nScanner\nOperating margin percentage decreased in 2015 compared to 2014 due to lower ASP, higher manufacturing costs, higher inventory reserves and increased compensation related costs.\nInterest and other income (expense), net (in millions):\n| Year Ended | Year Ended |\n| December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\n| Interest and other income (expense), net | $ | (6.4 | ) | $ | (2.5 | ) | $ | (3.9 | ) | $ | (2.5 | ) | $ | (3.2 | ) | $ | 0.7 |\n\nInterest and other income (expense), net, includes foreign currency revaluation gains and losses, interest income earned on cash, cash equivalents and investment balances, gains and losses on foreign currency forward contracts and other miscellaneous charges.\n42\nInterest and other income (expense), net, decreased in 2016 compared to 2015 mainly due to higher foreign exchange losses as a result of weakening of the Euro to the U.S. dollar.\nInterest and other income (expense), net, increased in 2015 compared to 2014 mainly due to higher interest income on higher balances of cash, cash equivalents and investments offset in part by higher foreign exchange losses primarily due to the strengthening of the U.S. dollar to the Euro and Australian dollar.\nEquity in losses of investee, net of tax (in millions):\n| Year Ended | Year Ended |\n| December 31, 2016 | December 31, 2015 | Change | December 31, 2015 | December 31, 2014 | Change |\n| Equity in losses, net of tax | $ | 1.7 | — | $ | 1.7 | — | — | — |\n\nWe invested $46.7 million in SDC on July 25, 2016 and we account for this investment based on the equity method of accounting. In 2016, we recorded a $1.7 million charge representing our share of losses attributable to equity method investments (Refer to Note 4 \"Equity Method Investments\" of the Notes to Consolidated Financial Statements for details on equity method investments).\nProvision for income taxes (in millions):\n| Year Ended | Year Ended |\n| December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\n| Provision for income taxes | $ | 51.2 | $ | 42.1 | $ | 9.1 | $ | 42.1 | $ | 44.5 | $ | (2.4 | ) |\n| Effective tax rates | 21.1 | % | 22.6 | % | 22.6 | % | 23.4 | % |\n\nChanges and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.\nOur provision for income taxes was $51.2 million, $42.1 million and $44.5 million for the year ended December 31, 2016, 2015 and 2014, respectively, representing effective tax rates of 21.1%, 22.6% and 23.4%, respectively. Our effective tax rate differs from the statutory federal income tax rate of 35% due to certain foreign earnings, primarily in Costa Rica and the Netherlands, which are subject to lower tax rates and the impacts from our new international corporate structure in 2016, partially offset by the tax impact of certain stock-based compensation charges and unrecognized tax benefits. The decrease in the effective tax rate in 2016 compared to 2015 was primarily related to our international corporate restructuring as explained below. The decrease in the effective rate for the year ended December 31, 2015 compared to 2014 is mainly due to a $1.8 million tax adjustment recorded in 2014 which related to prior periods.\nOur total gross unrecognized tax benefits, excluding interest and penalties, was $46.4 million and $39.4 million as of December 31, 2016 and 2015, respectively, all of which would impact our effective tax rate if recognized. We have elected to recognize interest and penalties related to unrecognized tax benefits as a component of income taxes. For the year ended December 31, 2016 and 2015, interest and penalties included in tax expense was $1.4 million and $0.7 million, respectively. Our total interest and penalties accrued as of December 31, 2016 was $2.1 million. We do not expect any significant changes to the amount of unrecognized tax benefit within the next twelve months.\nWe file U.S. federal, U.S. state, and non-U.S. income tax returns. Our major tax jurisdictions are U.S. federal and the State of California. For U.S. federal and state tax returns, we are no longer subject to tax examinations for years before 2000. With few exceptions, we are no longer subject to examination by foreign tax authorities for years before 2007. Our subsidiary in Israel is under audit by the local tax authorities for calendar years 2006 through 2013.\nOn July 1, 2016, we implemented a new international corporate structure. This changes the structure of our international procurement and sales operations, as well as realigns the ownership and use of intellectual property among our wholly-owned subsidiaries. We continue to anticipate that an increasing percentage of our consolidated pre-tax income will be derived from, and reinvested in our foreign operations. We believe that income taxed in certain foreign jurisdictions at a lower rate relative to the U.S. federal statutory rate will have a beneficial impact on our worldwide effective tax rate over time. Although the license of intellectual property rights between consolidated entities did not result in any gain in the consolidated financial statements, the Company generated taxable income in certain jurisdictions in 2016 resulting in a tax expense of $34.3 million. Additionally, as a result of the restructuring, we reassessed the need for a valuation allowance against our deferred tax assets considering all available evidence. Given the current earnings and anticipated future earnings of our subsidiary in Israel, we concluded that we have sufficient\n43\npositive evidence to release the valuation allowance against our Israel operating loss carryforwards of $31.4 million, which resulted in an income tax benefit in this period of the same amount.\nAs of December 31, 2016, our remaining valuation allowance was not material.\nIn June 2009, the Costa Rica Ministry of Foreign Trade, an agency of the Government of Costa Rica, granted a twelve year extension of certain income tax incentives, which were previously granted in 2002. The incentive tax rates will expire in various years beginning in 2017. We intend to seek a renewal of these income tax incentives before they expire. Under these incentives, all of the income in Costa Rica during these twelve year incentive periods is subject to a reduced tax rate. In order to receive the benefit of these incentives, we must hire specified numbers of employees and maintain certain minimum levels of fixed asset investment in Costa Rica. If we do not fulfill these conditions for any reason, our incentive could lapse, and our income in Costa Rica would be subject to taxation at higher rates, which could have a negative impact on our operating results. The Costa Rica corporate income tax rate that would apply, absent the incentives, is 30% for 2016, 2015 and 2014. As a result of these incentives, our income taxes were reduced by $19.1 million, $32.7 million and $32.5 million in the year ended December 31, 2016, 2015 and 2014, respectively, representing a benefit to diluted net income per share of $0.23 in the year ended December 31, 2016 and $0.40 for both the year ended December 31, 2015 and 2014.\nAs of December 31, 2016, approximately $438.0 million of undistributed earnings from non-U.S. operations held by our foreign subsidiaries are designated as indefinitely reinvested outside the U.S. We maintain sufficient cash reserves in the U.S. and do not intend to repatriate our foreign earnings. As a result, U.S. income taxes and foreign withholding taxes have not been provided on these foreign earnings. If these earnings were distributed in the form of dividends or otherwise, or if the shares of the relevant foreign subsidiaries were sold or otherwise transferred, we would be subject to additional U.S. income taxes subject to an adjustment for foreign tax credits and foreign withholding taxes. We intend to use the undistributed earnings for local operating expansions and to meet local operating working capital needs. In addition, a significant amount of the cash earned by foreign subsidiaries has been and will continue to be utilized to affect the new international corporate structure described above.\nLiquidity and Capital Resources\nWe fund our operations from product sales. As of December 31, 2016 and 2015, we had the following cash and cash equivalents, and short-term and long-term marketable securities (in thousands):\n| Year Ended December 31, |\n| 2016 | 2015 |\n| Cash and cash equivalents | $ | 389,275 | $ | 167,714 |\n| Short-term marketable securities | 250,981 | 359,581 |\n| Long-term marketable securities | 59,783 | 151,370 |\n| Total | $ | 700,039 | $ | 678,665 |\n\nCash flows (in thousands):\n| Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| Net cash flow provided by (used in): |\n| Operating activities | $ | 247,654 | $ | 237,997 | $ | 226,899 |\n| Investing activities | 72,848 | (166,361 | ) | (201,627 | ) |\n| Financing activities | (95,524 | ) | (100,786 | ) | (66,420 | ) |\n| Effects of exchange rate changes on cash and cash equivalents | (3,417 | ) | (3,007 | ) | (1,934 | ) |\n| Net increase (decrease) in cash and cash equivalents | $ | 221,561 | $ | (32,157 | ) | $ | (43,082 | ) |\n\nAs of December 31, 2016, we had $700.0 million in cash, cash equivalents, and short-term and long-term marketable securities. Cash equivalents and marketable securities are comprised of money market funds and highly liquid debt instruments which primarily include commercial paper, corporate bonds, U.S. dollar denominated foreign corporate bonds, U.S. government agency bonds, U.S. government treasury bonds, municipal securities, asset-backed securities and certificates of deposit.\nAs of December 31, 2016, approximately $459.0 million of cash, cash equivalents and short-term and long-term marketable securities was held by our foreign subsidiaries. Amounts held by foreign subsidiaries are generally subject to U.S. income taxation on repatriation to the U.S. The costs to repatriate our foreign earnings to the U.S. would likely be material; however, our intent is\n44\nto permanently reinvest our earnings from foreign operations, and our current plans do not require us to repatriate them to fund our U.S. operations as we generate sufficient domestic operating cash flow and have access to external funding under our current revolving line of credit.\nOperating Activities\nFor the year ended December 31, 2016, cash flows from operations of $247.7 million resulted primarily from our net income of approximately $189.7 million as well as the following:\nSignificant non-cash activities\n| • | Stock-based compensation was $54.1 million related to equity incentive compensation granted to employees and directors, |\n\n| • | Depreciation and amortization of $24.0 million related to our fixed assets and acquired and purchased intangible assets, |\n\n| • | Excess tax benefits from our share-based compensation arrangements of $16.8 million, |\n\n| • | Net change in deferred tax assets of $16.4 million, and |\n\n| • | Net tax benefits from stock based compensation of $15.9 million. |\n\nSignificant changes in working capital\n| • | Increase of $94.4 million in accounts receivable which is a result of the increase in net revenues, |\n\n| • | Increase of $60.7 million in deferred revenues corresponding to the increases in case shipments and full year effect of our additional aligner product policy effective in July 2015, and |\n\n| • | Increase of $37.6 million in accrued and other long-term liabilities due to timing of payments and activities. |\n\nFor the year ended December 31, 2015, cash flows from operations of $238.0 million resulted primarily from our net income of approximately $144.0 million as well as the following:\nSignificant non-cash activities\n| • | Stock-based compensation was $52.9 million related to our equity incentive compensation granted to employees and directors, |\n\n| • | Depreciation and amortization of $18.0 million related to our fixed assets and acquired intangible assets, and |\n\n| • | Excess tax benefits from our share-based compensation arrangements of $10.4 million. |\n\nSignificant changes in working capital\n| • | Increase of $41.9 million in deferred revenues corresponding to higher product sales along with the increased deferrals as a result of the change to our new additional aligner product policy in July 2015, |\n\n| • | Increase of $40.8 million in accounts receivable which is a result of the increase in net revenues, and |\n\n| • | Increase of $19.5 million in accrued and other long-term liabilities primarily due to an increase in income tax payable along with other accruals due to timing of payment. |\n\nFor the year ended December 31, 2014, cash flows from operations of $226.9 million resulted primarily from our net income of approximately $145.8 million as well as the following:\n45\nSignificant non-cash activities\n| • | Stock-based compensation was $39.8 million related to our equity incentive compensation granted to employees and directors, |\n\n| • | Excess tax benefits from our share-based compensation arrangements of $21.4 million, and |\n\n| • | Depreciation and amortization of $17.9 million related to our fixed assets and acquired intangible assets. |\n\nSignificant changes in working capital\n| • | Increase of $27.2 million in accounts receivable which is a result of the increase in net revenues, |\n\n| • | Increase of $22.7 million in accrued and other long-term liabilities primarily due to an increase in income tax payable along with other accruals due to timing of payment, and |\n\n| • | Increase of $15.8 million in deferred revenues corresponding to the increases in revenues. |\n\nInvesting Activities\nNet cash provided by investing activities was $72.8 million for the year ended December 31, 2016, which primarily consisted of maturities and sales of our marketable securities of $604.0 million. These inflows were partially offset by purchases of marketable securities of $405.6 million, property, plant and equipment purchases of $70.6 million including the implementation of our new ERP system and $46.7 million related to our equity interest investment in SmileDirectClub, LLC (\"SDC\").\nFor 2017, we expect to invest $220.0 million to $250.0 million on capital expenditures primarily for our purchase of a new corporate headquarters office, new order acquisition facility in Singapore and other additional manufacturing and capacity to support our international expansion. Although we believe our current investment portfolio has little risk of impairment, we cannot predict future market conditions or market liquidity and can provide no assurance that our investment portfolio will remain unimpaired.\nNet cash used in investing activities was $166.4 million for the year ended December 31, 2015, which primarily consisted of purchases of marketable securities of $447.1 million and property, plant and equipment purchases of $53.5 million for additional manufacturing capacity and infrastructure including the project to implement a new ERP system which we started in late 2014. These uses were partially offset by $334.1 million of maturities and sales of our marketable securities.\nNet cash used in investing activities was $201.6 million for the year ended December 31, 2014, which primarily consisted of purchases of marketable securities of $437.2 million and property, plant and equipment purchases of $24.1 million. These uses were partially offset by $259.8 million of maturities and sales of our marketable securities.\nFinancing Activities\nNet cash used by financing activities was $95.5 million for the year ended December 31, 2016 primarily resulting from a common stock repurchase of $96.2 million (Refer to Note 10 \"Common Stock Repurchase Program\" of the Notes to Consolidated Financial Statements for details on the stock repurchase program) and $29.9 million of payroll taxes paid for vesting of restricted stock units (\"RSUs\") through share withholdings, partially offset by excess tax benefit from our share-based compensation arrangements of $16.8 million and proceeds from issuance of common stock of $13.8 million.\nNet cash used by financing activities was $100.8 million for the year ended December 31, 2015 resulting from repurchases of our common stock of $101.8 million and $20.7 million of payroll taxes paid for our employees' vesting of RSUs through share withholdings, partially off-set by proceeds from issuance of common stock of $11.3 million and $10.4 million from excess tax benefit from our share-based compensation arrangements.\nNet cash used by financing activities was $66.4 million for the year ended December 31, 2014 resulting from repurchases of our common stock of $98.2 million and $7.6 million of payroll taxes paid for our employees' vesting of RSUs through share withholdings, partially off-set by proceeds from issuance of common stock of $18.0 million and $21.4 million from excess tax benefit from our share-based compensation arrangements.\nAs restricted stock units are taxable to the individuals when they vest, the number of shares we issue to each of our employees will be net of applicable withholding taxes which will be paid by us on their behalf. During 2016, 2015 and 2014, we paid $29.9 million, $20.7 million and $7.6 million, respectively, for taxes related to RSUs that vested during the periods. The cash paid for\n46\ntaxes related to RSUs in 2016 and 2015 increased in comparison to 2014 due to the Company changing its policy in mid 2014 to pay for employees' payroll taxes related to their vesting RSUs instead of requiring employees to sell to cover for their payroll taxes.\nStock Repurchases\nRefer to Note 10 \"Common Stock Repurchase Program\" of the Notes to Consolidated Financial Statements for details on stock repurchase program.\n| ◦ | April 2014 Repurchase Program. In 2016, we repurchased $50.0 million of our common stock through an accelerated stock repurchase agreement and $46.2 million of stock repurchase in the open market. |\n\n| ◦ | April 2016 Repurchase Program. On April 28, 2016, we announced that our Board of Directors had authorized a plan to repurchase up to $300.0 million of our stock. |\n\n| ◦ | Remaining Available Repurchases. As of December 31, 2016, we have $3.8 million remaining under the April 2014 Repurchase Program and $300.0 million under the April 2016 Repurchase Plan. |\n\nWe believe that our current cash and cash equivalents and marketable securities combined with our positive cash flows from operations will be sufficient to fund our operations and stock repurchases for at least the next 12 months. If we are unable to generate adequate operating cash flows, we may need to suspend our stock repurchase program or seek additional sources of capital through equity or debt financing, collaborative or other arrangements with other companies, bank financing and other sources in order to realize our objectives and to continue our operations. There can be no assurance that we will be able to obtain additional debt or equity financing on terms acceptable to us, or at all. If adequate funds are not available, we may need to make business decisions that could adversely affect our operating results such as modifications to our pricing policy, business structure or operations. Accordingly, the failure to obtain sufficient funds on acceptable terms when needed could have a material adverse effect on our business, results of operations and financial condition.\nCredit Facility\nOn March 22, 2013, we entered into a credit facility for a $50.0 million revolving line of credit, with a $10.0 million letter of credit sublimit, and has a maturity date on March 22, 2018 (Refer to Note 7 \"Credit Facility\" of the Notes to Consolidated Financial Statements for details of the credit facility).\nContractual Obligations/Off Balance Sheet Arrangements\nThe impact that our contractual obligations as of December 31, 2016 are expected to have on our liquidity and cash flows in future periods is as follows (in thousands):\n| Payments Due by Period |\n| Total | Less than1 Year | 1-3Years | 3-5Years | More than5 Years |\n| Operating lease obligations | $ | 53,921 | $ | 12,880 | $ | 18,804 | $ | 13,096 | $ | 9,141 |\n| Unconditional purchase obligations | 163,688 | — | — | — | — |\n| Total contractual cash obligations | $ | 217,609 | $ | 12,880 | $ | 18,804 | $ | 13,096 | $ | 9,141 |\n\nOur contractual obligations table above excludes approximately $45.1 million of non-current uncertain tax benefits which are included in other long-term obligations and deferred tax assets on our balance sheet as of December 31, 2016. We have not included this amount because we cannot make a reasonably reliable estimate regarding the timing of settlements with taxing authorities, if any.\nWe had no off-balance sheet arrangements as defined in Regulation S-K Item 303(a) (4) as of December 31, 2016.\n47\nIndemnification Provisions\nIn the normal course of business to facilitate transactions in our services and products, we indemnify customers, vendors, lessors, and other parties with respect to certain matters, including, but not limited to, services to be provided by us and intellectual property infringement claims made by third parties. In addition, we have entered into indemnification agreements with our directors and certain of our officers that will require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors or officers. Several of these agreements limit the time within which an indemnification claim can be made and the amount of the claim.\nIt is not possible to make a reasonable estimate of the maximum potential amount under these indemnification agreements due to the unique facts and circumstances involved in each particular agreement. Additionally, we have a limited history of prior indemnification claims and the payments we have made under such agreements have not had a material adverse effect on our results of operations, cash flows, or financial position. However, to the extent that valid indemnification claims arise in the future, future payments by us could be significant and could have a material adverse effect on our results of operations or cash flows in a particular period. As of December 31, 2016, we did not have any material indemnification claims that were probable or reasonably possible.\nCritical Accounting Policies and Estimates\nManagement’s discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses and disclosures at the date of the financial statements. We evaluate our estimates on an on-going basis, including those related to revenue recognition, stock-based compensation, goodwill and finite-lived assets and related impairment, and income taxes. We use authoritative pronouncements, historical experience and other assumptions as the basis for making estimates. Actual results could differ from those estimates.\nWe believe the following critical accounting policies and estimates affect our more significant judgments used in the preparation of our consolidated financial statements. For further information on all of our significant accounting policies, see Note 1 \"Summary of Significant Accounting Policies\" of the Notes to Consolidated Financial Statements under Item 8.\nRevenue Recognition\nWe enter into sales arrangements that may consist of multiple deliverables of our products and services where certain elements of the sales arrangement are not delivered in one reporting period. We measure and allocate revenue according to the accounting guidance for multiple-deliverable revenue arrangements in Accounting Standards Update (“ASU”) 2009-13, Multiple-Deliverable Revenue Arrangements-a consensus of the Financial Accounting Standard Board (“FASB”) Emerging Issues Task Force.\nEach element within a multiple-element arrangement is accounted for as a separate unit of accounting provided the following criteria are met: the delivered products or services have value to the customer on a standalone basis; and for an arrangement that includes a general right of return relative to the delivered products or services, delivery or performance of the undelivered product or service is considered probable and is substantially controlled by us. We consider a deliverable to have standalone value if the product or service is sold separately by us or another vendor or could be resold by the customer. Further, our revenue arrangements generally do not include a general right of return relative to the delivered products. The arrangement consideration is allocated to each element, delivered or undelivered, based on the relative selling price of each unit of accounting based first on vendor-specific objective evidence (“VSOE”) if it exists, second on third-party evidence (“TPE”) if it exists, or on best estimated selling price (“BESP”) if neither VSOE nor TPE exist (a description as to how we determine VSOE, TPE and BESP is provided below).\n| • | VSOE - In most instances, this applies to products and services that are sold separately in stand-alone arrangements. We determine VSOE based on pricing and discounting practices for the specific product or service when sold separately, considering geographical, customer, and other economic or marketing variables, as well as renewal rates or stand-alone prices for the service element(s). |\n\n| • | TPE - If we cannot establish VSOE of selling price for a specific product or service included in a multiple-element arrangement, we use third-party evidence of selling price. We determine TPE based on sales of comparable amount of similar products or service offered by multiple third parties considering the degree of customization and similarity of product or service sold. |\n\n| • | BESP - The best estimated selling price represents the price at which we would sell a product or service if it were sold on a stand-alone basis. When VSOE or TPE does not exist for all elements, we determine BESP for the arrangement element based on sales, cost and margin analysis, as well as other inputs based on our pricing practices. Adjustments for |\n\n48\nother market and company specific factors are made as deemed necessary in determining BESP. We regularly review our estimates of selling price and maintain internal controls over the establishment and update of these estimates.\nJudgment is required to properly identify the accounting units of the multiple deliverable transactions, to determine the best estimated selling price for each accounting unit, and to determine the manner in which revenue should be allocated among the accounting units. Further, while changes in the allocation of the best estimated selling price between the accounting units will not affect the amount of total revenue recognized for a particular arrangement, any material changes in these allocations could impact the timing of revenue recognition, which could have a material effect on our financial position and results of operations.\nClear Aligner\nWe enter into arrangements (“treatment plans”) that involve multiple future product deliverables. Invisalign Full, Invisalign Teen, and Invisalign Assist products (\"Comprehensive Products\") include optional additional aligners at no charge for a period of up to five years after initial shipment. Invisalign Teen also includes up to six optional replacement aligners in the price of the product and may be ordered by the dental professional any time throughout treatment. Invisalign Lite (\"Non-Comprehensive Products\") includes one optional case refinement in the price of the product. Case refinement is a finishing tool used to adjust a patient's teeth to the desired final position and may be elected by the dental professional at any time during treatment; however, it is generally ordered in the last stages of orthodontic treatment.\nWe determined that our treatment plans, except Invisalign Assist with progress tracking, comprise the following deliverables which also represent separate units of accounting: initial aligners, additional aligners, case refinement, and replacement aligners. We allocate revenue for each treatment plan based on each unit's relative selling price based on BESP and recognize the revenue upon shipment of each unit in the treatment plan.\nFor Invisalign Assist with the progress tracking feature, aligners and services are provided to the dental professional every nine stages (“a batch”). We are able to reliably estimate the number of batches which are expected to be shipped for each case based upon our historical experience. The amounts allocated to this deliverable are recognized on a prorated basis as each batch is shipped.\nScanners and Services\nWe sell intraoral scanners and CAD/CAM services through both our direct sales force and distribution partners. The intraoral scanner sales price includes one year of warranty, and unlimited scanning services. The customer may, for additional fees, also select extended warranty and unlimited scanning services for periods beyond the initial year. When intraoral scanners are sold with an unlimited scanning service agreement and/or extended warranty, we allocate revenue based on each element's relative selling price. We estimate the selling price of each element, as if it is sold on a stand-alone basis, taking into consideration historical prices as well as our discounting strategies.\nStock-Based Compensation Expense\nWe recognize stock-based compensation cost for only those shares ultimately expected to vest on a straight-line basis over the requisite service period of the award. We use the Black-Scholes option pricing model to determine the fair value of stock options and employee stock purchase plan shares. We estimate the fair value of market-performance based restricted stock units using a Monte Carlo simulation model which requires the input of assumptions, including expected term, stock price volatility and the risk-free rate of return. In addition, judgment is required in estimating the number of stock-based awards that are expected to be forfeited. Forfeitures are estimated based on historical experience at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management’s judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future.\nGoodwill and Finite-Lived Acquired Intangible Assets\nGoodwill represents the excess of the purchase price paid over the fair value of tangible and identifiable intangible net assets acquired in business combinations and is allocated to the respective reporting units based on relative synergies generated. For the year ended December 31, 2016 and 2015, all goodwill is attributed to our Clear Aligner reporting unit.\n49\nOur intangible assets primarily consist of intangible assets acquired as part of acquisitions and are amortized using the straight-line method over their estimated useful lives, reflecting the period in which the economic benefits of the assets are expected to be realized.\nImpairment of Goodwill, Finite-Lived Acquired Intangible Assets and Long-Lived assets\nGoodwill\nWe evaluate goodwill for impairment at least annually on November 30th or more frequently if indicators are present, an event occurs or circumstances changes that suggest an impairment may exist and that it would more likely than not reduce the fair value of a reporting unit below its carrying amount. The allocation of goodwill to the respective reporting unit is based on relative synergies generated as a result of an acquisition.\nWe perform an initial assessment of qualitative factors to determine whether the existence of events and circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. In performing the qualitative assessment, we identify and consider the significance of relevant key factors, events, and circumstances that affect the fair value of our reporting units. These factors include external factors such as macroeconomic, industry, and market conditions, as well as entity-specific factors, such as our actual and planned financial performance. We also give consideration to the difference between the reporting unit fair value and carrying value as of the most recent date a fair value measurement was performed. If, after assessing the totality of relevant events and circumstances, we determine that it is more likely than not that the fair value of the reporting unit exceeds its carrying value and there is no indication of impairment, no further testing is performed; however, if we conclude otherwise, the first step of the two-step impairment test is performed by estimating the fair value of the reporting unit and comparing it with its carrying value, including goodwill. Refer to Note 5 \"Goodwill and Intangible Assets\" of Notes to Consolidated Financial Statements for details on intangible long-lived assets.\nFinite-Lived Intangible Assets and Long-Lived Assets\nWe evaluate long-lived assets (including finite-lived intangible assets) for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. An asset or asset group is considered impaired if its carrying amount exceeds the future undiscounted net cash flows the asset or asset group is expected to generate. If an asset or asset group is considered to be impaired, the impairment to be recognized is calculated as the amount by which the carrying amount of the asset or asset group exceeds its fair market value. Our estimates of future cash flows attributable to our long-lived assets require significant judgment based on our historical and anticipated results and are subject to many factors. Factors we consider important which could trigger an impairment review include significant negative industry or economic trends, significant loss of customers and changes in the competitive environment. The estimation of fair value utilizing a discounted cash flow approach includes numerous uncertainties which require our significant judgment when making assumptions of expected growth rates and the selection of discount rates, as well as assumptions regarding general economic and business conditions, and the structure that would yield the highest economic value, among other factors. Refer to Note 5 \"Goodwill and Intangible Assets\" of Notes to Consolidated Financial Statements for details of the impairment analysis.\nAccounting for Income Taxes\nWe make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of certain tax assets and liabilities, which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes.\nAs part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves us estimating our current tax exposure under the applicable tax laws and assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our Consolidated Balance Sheets.\nWe account for uncertainty in income taxes pursuant to authoritative guidance based on a two-step approach to recognize and measure uncertain tax positions taken or expected to be taken in a tax return. The first step is to determine if the weight of available evidence indicates that it is more likely than not that the tax position will be sustained on audit based on its technical merits, including resolution of any related appeals or litigation processes. The second step is to measure the tax benefit as the largest amount that is more than 50% likely to be realized upon ultimate settlement. We adjust reserves for our uncertain tax positions due to changing facts and circumstances, such as the closing of a tax audit, or refinement of estimates due to new\n50\ninformation. To the extent that the final outcome of these matters is different than the amounts recorded, such differences will impact our tax provision in our Consolidated Statements of Operations in the period in which such determination is made.\nWe assess the likelihood that we will be able to realize our deferred tax assets. Should there be a change in our ability to realize our deferred tax assets, our tax provision would increase in the period in which we determine that it is more likely than not that we cannot realize our deferred tax assets. We consider all available evidence, both positive and negative, including historical levels of income, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance. If it is more likely than not that we will not realize our deferred tax assets, we will increase our provision for taxes by recording a valuation allowance against the deferred tax assets that we estimate will not ultimately be realized.\nRecent Accounting Pronouncements\nSee Note 1 “Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements in Item 8 for a full description of recent accounting pronouncements, including the expected dates of adoption and estimated effects on results of operations and financial condition, which is incorporated herein.\n51\nITEM 7A.\nQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nIn the normal course of business, we are exposed to foreign currency exchange rate and interest rate risks that could impact our financial position and results of operations.\nInterest Rate Risk\nChanges in interest rates could impact our anticipated interest income on our cash equivalents and investments in marketable securities. Our cash equivalents and investments are fixed-rate short-term and long-term securities. Fixed-rate securities may have their fair market value adversely impacted due to a rise in interest rates, and as a result, our future investment income may fall short of expectations due to changes in interest rates or we may suffer losses in principal if forced to sell securities which have declined in market value due to changes in interest rates. As of December 31, 2016, we had approximately $310.8 million invested in available-for-sale marketable securities. An immediate 10% change in interest rates would not have a material adverse impact on our future operating results and cash flows.\nWe do not have interest bearing liabilities as of December 31, 2016, and, therefore, we are not subject to risks from immediate interest rate increases.\nCurrency Rate Risk\nAs a result of our international business activities, including the impact of our new international corporate structure in 2016, our financial results could be affected by factors such as changes in foreign currency exchange rates or economic conditions in foreign markets, and there is no assurance that exchange rate fluctuations will not harm our business in the future. We generally sell our products in the local currency of the respective countries. This provides some natural hedging because most of the subsidiaries’ operating expenses are generally denominated in their local currencies as discussed further below. Regardless of this natural hedging, our results of operations may be adversely impacted by exchange rate fluctuations. For the year ended December 31, 2016 and 2015, we had foreign currency net losses of $8.0 million and $4.0 million, respectively.\nIn September 2015, we started to enter into foreign currency forward contracts to minimize the short-term impact of foreign currency exchange rate fluctuations on cash and certain trade and intercompany receivables and payables. These forward contracts are not designated as hedging instruments and do not subject us to material balance sheet risk due to fluctuations in foreign currency exchange rates. The gains and losses on these forward contracts are intended to offset the gains and losses in the underlying foreign currency denominated monetary assets and liabilities being economically hedged. These instruments are marked to market through earnings every period and generally are one month in original maturity. We do not enter into foreign currency forward contracts for trading or speculative purposes. As our international operations grow, we will continue to reassess our approach to managing the risks relating to fluctuations in currency rates. It is difficult to predict the impact hedging activities could have on our results of operations. As of December 31, 2016, we did not have any outstanding foreign exchange forward contracts.\nAlthough we will continue to monitor our exposure to currency fluctuations, and, where appropriate, may use financial hedging techniques in the future to minimize the effect of these fluctuations, the impact of an aggregate change of 10% in foreign currency exchange rates relative to the U.S. dollar on our results of operations and financial position could be material.\n52\nITEM 8.\nCONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA\nQuarterly Results of Operations\n| Three Months Ended |\n| 2016 | 2015 |\n| December 31, 2016 | September 30, 2016 | June 30, 2016 | March 31, 2016 | December 31, 2015 | September 30, 2015 | June 30, 2015 | March 31, 2015 |\n| (in thousands, except per share data)(unaudited ) |\n| Net revenues | $ | 293,203 | $ | 278,589 | $ | 269,362 | $ | 238,720 | $ | 230,276 | $ | 207,636 | $ | 209,488 | $ | 198,086 |\n| Gross profit | 220,249 | 209,202 | 205,216 | 180,627 | 172,810 | 157,576 | 158,634 | 151,090 |\n| Income from operations | 68,372 | 62,079 | 65,136 | 53,334 | 59,339 | 38,046 | 42,325 | 48,924 |\n| Net income | 47,621 | 51,367 | 50,148 | 40,546 | 48,877 | 27,616 | 31,350 | 36,177 |\n| Net income per share: |\n| Basic | $ | 0.60 | $ | 0.64 | $ | 0.63 | $ | 0.51 | $ | 0.61 | $ | 0.35 | $ | 0.39 | $ | 0.45 |\n| Diluted | $ | 0.59 | $ | 0.63 | $ | 0.62 | $ | 0.50 | $ | 0.60 | $ | 0.34 | $ | 0.39 | $ | 0.44 |\n| Shares used in computing net income per share: |\n| Basic | 79,667 | 79,977 | 79,951 | 79,831 | 79,481 | 79,808 | 80,257 | 80,459 |\n| Diluted | 81,248 | 81,466 | 81,281 | 81,320 | 81,051 | 81,092 | 81,394 | 81,824 |\n\n53\nINDEX TO CONSOLIDATED FINANCIAL STATEMENTS\n\n| Page |\n| Report of Management on Internal Control over Financial Reporting | 55 |\n| Report of Independent Registered Public Accounting Firm | 56 |\n| Consolidated Statements of Operations | 57 |\n| Consolidated Statements of Comprehensive Income | 58 |\n| Consolidated Balance Sheets | 59 |\n| Consolidated Statements of Stockholders’ Equity | 60 |\n| Consolidated Statements of Cash Flows | 61 |\n| Notes to Consolidated Financial Statements | 62 |\n\n54\nREPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING\nManagement of Align is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Our internal control over financial reporting is designed by, or under supervision of, our CEO and CFO, and effected by the board of directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that:\n| • | pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of Align; |\n\n| • | provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of Align are being made only in accordance with authorizations of management and directors of Align; and |\n\n| • | provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of Align's assets that could have a material effect on the financial statements. |\n\nBecause of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. In addition, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.\nManagement assessed the effectiveness of our internal control over financial reporting as of December 31, 2016. In making this assessment, management used the criteria set forth in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).\nBased on its assessment, management has concluded that, as of December 31, 2016, our internal control over financial reporting was effective based on criteria in Internal Control - Integrated Framework (2013) issued by the COSO.\nThe effectiveness of our internal control over financial reporting as of December 31, 2016 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which is included herein.\n| /S/ JOSEPH M. HOGAN |\n| Joseph M. Hogan |\n| President and Chief Executive Officer |\n| February 28, 2017 |\n| /S/ JOHN F. MORICI |\n| John F. Morici |\n| Chief Financial Officer |\n| February 28, 2017 |\n\n55\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\nTo the Stockholders and Board of Directors of Align Technology, Inc.:\nIn our opinion, the consolidated financial statements listed in the index appearing under Item 15(a) (1) present fairly, in all material respects, the financial position of Align Technology, Inc. and its subsidiaries at December 31, 2016 and December 31, 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control over Financial Reporting. Our responsibility is to express opinions on these financial statements, on the financial statement schedule, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.\nA company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.\nBecause of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.\n/s/ PricewaterhouseCoopers LLP\nSan Jose, California\nFebruary 28, 2017\n56\nALIGN TECHNOLOGY, INC. AND SUBSIDIARIES\nCONSOLIDATED STATEMENTS OF OPERATIONS\n(in thousands, except per share data)\n\n| Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| Net revenues | $ | 1,079,874 | $ | 845,486 | $ | 761,653 |\n| Cost of net revenues | 264,580 | 205,376 | 183,210 |\n| Gross profit | 815,294 | 640,110 | 578,443 |\n| Operating expenses: |\n| Selling, general and administrative | 490,653 | 390,239 | 332,068 |\n| Research and development | 75,720 | 61,237 | 52,799 |\n| Total operating expenses | 566,373 | 451,476 | 384,867 |\n| Income from operations | 248,921 | 188,634 | 193,576 |\n| Interest and other income (expense), net | (6,355 | ) | (2,533 | ) | (3,207 | ) |\n| Net income before provision for income taxes and equity in losses of investee | 242,566 | 186,101 | 190,369 |\n| Provision for income taxes | 51,200 | 42,081 | 44,537 |\n| Equity in losses of investee, net of tax | 1,684 | — | — |\n| Net income | $ | 189,682 | $ | 144,020 | $ | 145,832 |\n| Net income per share: |\n| Basic | $ | 2.38 | $ | 1.80 | $ | 1.81 |\n| Diluted | $ | 2.33 | $ | 1.77 | $ | 1.77 |\n| Shares used in computing net income per share: |\n| Basic | 79,856 | 79,998 | 80,754 |\n| Diluted | 81,484 | 81,521 | 82,283 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n57\nALIGN TECHNOLOGY, INC. AND SUBSIDIARIES\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME\n(in thousands)\n| Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| Net income | $ | 189,682 | $ | 144,020 | $ | 145,832 |\n| Net change in foreign currency translation adjustment | (670 | ) | (154 | ) | (196 | ) |\n| Change in unrealized gains (losses) on investments, net of tax | 712 | (686 | ) | (238 | ) |\n| Other comprehensive income (loss) | 42 | (840 | ) | (434 | ) |\n| Comprehensive income | $ | 189,724 | $ | 143,180 | $ | 145,398 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n58\nALIGN TECHNOLOGY, INC. AND SUBSIDIARIES\nCONSOLIDATED BALANCE SHEETS\n(in thousands, except per share data)\n\n| December 31, |\n| 2016 | 2015 |\n| ASSETS |\n| Current assets: |\n| Cash and cash equivalents | $ | 389,275 | $ | 167,714 |\n| Marketable securities, short-term | 250,981 | 359,581 |\n| Accounts receivable, net of allowance for doubtful accounts and returns of $4,310 and $2,472, respectively | 247,415 | 158,550 |\n| Inventories | 27,131 | 19,465 |\n| Prepaid expenses and other current assets | 38,176 | 26,700 |\n| Total current assets | 952,978 | 732,010 |\n| Marketable securities, long-term | 59,783 | 151,370 |\n| Property, plant and equipment, net | 175,167 | 136,473 |\n| Equity method investments | 45,061 | — |\n| Goodwill and intangible assets, net | 81,998 | 79,162 |\n| Deferred tax assets | 67,844 | 51,416 |\n| Other assets | 13,320 | 8,202 |\n| Total assets | $ | 1,396,151 | $ | 1,158,633 |\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\n| Current liabilities: |\n| Accounts payable | $ | 28,596 | $ | 34,354 |\n| Accrued liabilities | 134,332 | 107,765 |\n| Deferred revenues | 191,407 | 129,553 |\n| Total current liabilities | 354,335 | 271,672 |\n| Income tax payable | 45,133 | 37,512 |\n| Other long-term liabilities | 1,294 | 1,523 |\n| Total liabilities | 400,762 | 310,707 |\n| Commitments and contingencies (Notes 6 and 8) |\n| Stockholders’ equity: |\n| Preferred stock, $0.0001 par value (5,000 shares authorized; none issued) | — | — |\n| Common stock, $0.0001 par value (200,000 shares authorized; 79,553 and 79,500 issued and outstanding, respectively) | 8 | 8 |\n| Additional paid-in capital | 864,871 | 821,507 |\n| Accumulated other comprehensive income (loss), net | (938 | ) | (980 | ) |\n| Retained earnings | 131,448 | 27,391 |\n| Total stockholders’ equity | 995,389 | 847,926 |\n| Total liabilities and stockholders’ equity | $ | 1,396,151 | $ | 1,158,633 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n59\nALIGN TECHNOLOGY, INC. AND SUBSIDIARIES\nCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\n(in thousands)\n\n| Common Stock | AdditionalPaid-InCapital | AccumulatedOtherComprehensiveIncome (Loss), Net | Retained Earnings (Deficit) | Total |\n| Shares | Amount |\n| Balances at December 31, 2013 | 80,583 | $ | 8 | $ | 729,578 | $ | 294 | $ | (95,910 | ) | $ | 633,970 |\n| Net income | — | — | — | — | 145,832 | 145,832 |\n| Net change in unrealized gains (losses) from investments | — | — | — | (238 | ) | — | (238 | ) |\n| Net change in foreign currency translation adjustment | — | — | — | (196 | ) | — | (196 | ) |\n| Issuance of common stock relating to employee equity compensation plans | 1,536 | — | 18,028 | — | — | 18,028 |\n| Tax withholdings related to net share settlement of restricted stock units | — | — | (7,608 | ) | — | — | (7,608 | ) |\n| Common stock repurchased and retired | (1,914 | ) | — | (17,804 | ) | — | (80,429 | ) | (98,233 | ) |\n| Net tax benefits from stock-based awards | — | — | 21,393 | — | — | 21,393 |\n| Stock-based compensation | — | — | 39,823 | — | — | 39,823 |\n| Balances at December 31, 2014 | 80,205 | 8 | 783,410 | (140 | ) | (30,507 | ) | 752,771 |\n| Net income | — | — | — | — | 144,020 | 144,020 |\n| Net change in unrealized gains (losses) from investments | — | — | — | (686 | ) | — | (686 | ) |\n| Net change in foreign currency translation adjustment | — | — | (10 | ) | (154 | ) | — | (164 | ) |\n| Issuance of common stock relating to employee equity compensation plans | 991 | — | 11,325 | — | — | 11,325 |\n| Tax withholdings related to net share settlements of restricted stock units | — | — | (20,716 | ) | — | — | (20,716 | ) |\n| Common stock repurchased and retired | (1,696 | ) | — | (15,669 | ) | — | (86,122 | ) | (101,791 | ) |\n| Net tax benefits from stock-based awards | — | — | 10,224 | — | — | 10,224 |\n| Stock-based compensation | — | — | 52,943 | — | — | 52,943 |\n| Balances at December 31, 2015 | 79,500 | 8 | 821,507 | (980 | ) | 27,391 | 847,926 |\n| Net income | — | — | — | — | 189,682 | 189,682 |\n| Net change in unrealized gains (losses) from investments | — | — | — | 712 | — | 712 |\n| Net change in foreign currency translation adjustment | — | — | — | (670 | ) | — | (670 | ) |\n| Issuance of common stock relating to employee equity compensation plans | 1,163 | — | 13,778 | — | — | 13,778 |\n| Tax withholdings related to net share settlements of restricted stock units | — | — | (29,857 | ) | — | — | (29,857 | ) |\n| Common stock repurchased and retired | (1,110 | ) | — | (10,593 | ) | — | (85,625 | ) | (96,218 | ) |\n| Net tax benefits from stock-based awards | — | — | 15,888 | — | — | 15,888 |\n| Stock-based compensation | — | — | 54,148 | — | — | 54,148 |\n| Balances at December 31, 2016 | 79,553 | $ | 8 | $ | 864,871 | $ | (938 | ) | $ | 131,448 | $ | 995,389 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n60\nALIGN TECHNOLOGY, INC. AND SUBSIDIARIES\nCONSOLIDATED STATEMENTS OF CASH FLOWS\n(in thousands)\n\n| Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| CASH FLOWS FROM OPERATING ACTIVITIES: |\n| Net income | $ | 189,682 | $ | 144,020 | $ | 145,832 |\n| Adjustments to reconcile net income to net cash provided by operating activities: |\n| Deferred taxes | (16,401 | ) | (11,424 | ) | 4,088 |\n| Depreciation and amortization | 24,002 | 18,004 | 17,856 |\n| Stock-based compensation | 54,148 | 52,943 | 39,823 |\n| Net tax benefits from stock-based awards | 15,888 | 10,224 | 21,393 |\n| Excess tax benefit from share-based payment arrangements | (16,773 | ) | (10,396 | ) | (21,393 | ) |\n| Equity in losses of investee | 1,684 | — | — |\n| Other non-cash operating activities | 12,031 | 13,799 | 10,106 |\n| Changes in assets and liabilities: |\n| Accounts receivable | (94,444 | ) | (40,775 | ) | (27,229 | ) |\n| Inventories | (7,663 | ) | (3,563 | ) | (1,999 | ) |\n| Prepaid expenses and other assets | (9,390 | ) | (3,726 | ) | (2,924 | ) |\n| Accounts payable | (3,395 | ) | 7,575 | 2,887 |\n| Accrued and other long-term liabilities | 37,629 | 19,462 | 22,692 |\n| Deferred revenues | 60,656 | 41,854 | 15,767 |\n| Net cash provided by operating activities | 247,654 | 237,997 | 226,899 |\n| CASH FLOWS FROM INVESTING ACTIVITIES: |\n| Purchase of property, plant and equipment | (70,576 | ) | (53,451 | ) | (24,092 | ) |\n| Purchase of marketable securities | (405,612 | ) | (447,092 | ) | (437,152 | ) |\n| Proceeds from maturities of marketable securities | 387,873 | 304,125 | 176,810 |\n| Purchase of equity method investments | (46,745 | ) | — | — |\n| Proceeds from sales of marketable securities | 216,119 | 30,011 | 82,990 |\n| Other investing activities | (8,211 | ) | 46 | (183 | ) |\n| Net cash provided by (used in) investing activities | 72,848 | (166,361 | ) | (201,627 | ) |\n| CASH FLOWS FROM FINANCING ACTIVITIES: |\n| Proceeds from issuance of common stock | 13,778 | 11,325 | 18,028 |\n| Common stock repurchases | (96,218 | ) | (101,791 | ) | (98,233 | ) |\n| Excess tax benefit from share-based payment arrangements | 16,773 | 10,396 | 21,393 |\n| Employees’ taxes paid upon the vesting of restricted stock units | (29,857 | ) | (20,716 | ) | (7,608 | ) |\n| Net cash used in financing activities | (95,524 | ) | (100,786 | ) | (66,420 | ) |\n| Effect of foreign exchange rate changes on cash and cash equivalents | (3,417 | ) | (3,007 | ) | (1,934 | ) |\n| Net increase (decrease) in cash and cash equivalents | 221,561 | (32,157 | ) | (43,082 | ) |\n| Cash and cash equivalents, beginning of year | 167,714 | 199,871 | 242,953 |\n| Cash and cash equivalents, end of year | $ | 389,275 | $ | 167,714 | $ | 199,871 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n61\nALIGN TECHNOLOGY, INC. AND SUBSIDIARIES\nNOTES TO CONSOLIDATED FINANCIAL STATEMENTS\nNote 1. Summary of Significant Accounting Policies\nBusiness Description\nAlign Technology, Inc. (“We”, “Our”, or “Align”) was incorporated in April 1997 in Delaware and focuses on designing, manufacturing and marketing innovative, technology-rich products to help dental professionals achieve the clinical results they expect and deliver effective, convenient cutting-edge dental treatment options to their patients. We are headquartered in San Jose, California with offices worldwide. Our international headquarters is located in Amsterdam, the Netherlands. We have two operating segments: (1) Clear Aligner, known as the Invisalign System, and (2) Scanners and Services (\"Scanner\"), known as the iTero intraoral scanner and OrthoCAD services.\nBasis of Presentation and Preparation\nThe consolidated financial statements include the accounts of Align and our wholly-owned subsidiaries after elimination of intercompany transactions and balances.\nIn connection with the preparation of the consolidated financial statements, we evaluated events subsequent to the balance sheet date through the financial statement issuance date and determined that all material transactions have been recorded and disclosed properly.\nOut of Period Adjustment\nIn 2014, we recorded an out of period correction that resulted in an increase in the provision for income taxes of $1.8 million. We do not believe the decrease to net income related to the out of period adjustment is material to the consolidated financial statements for the fiscal year ended December 31, 2014 or to any prior years' consolidated financial statements.\nUse of Estimates\nThe preparation of financial statements in conformity with generally accepted accounting principles (\"GAAP\") in the United States of America (“U.S.”) requires our management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates. On an ongoing basis, we evaluate our estimates, including those related to the fair values of financial instruments, long-lived assets and goodwill, equity method investments, useful lives of intangible assets and property and equipment, revenue recognition, stock-based compensation, equity losses of investee, income taxes and contingent liabilities, among others. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities.\nFair Value of Financial Instruments\nWe measure our cash equivalents, marketable securities, Israeli fund and long-term notes receivable at fair value. Fair value is the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is estimated by applying the following hierarchy, which prioritizes the inputs used to measure fair value into three levels and bases the categorization within the hierarchy upon the lowest level of input that is available and significant to the fair value measurement:\nLevel 1 – Quoted (unadjusted) prices in active markets for identical assets or liabilities.\nLevel 2 – Observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the asset or liability.\nLevel 3 – Inputs that are generally unobservable and typically reflect management’s estimate of assumptions that market participants would use in pricing the asset or liability.\n62\nCash and Cash Equivalents\nWe consider currency on hand, demand deposits, time deposits, and all highly liquid investments with an original or remaining maturity of three months or less at the date of purchase to be cash and cash equivalents. Cash and cash equivalents are held in various financial institutions in the U.S. and internationally.\nRestricted Cash\nOur restricted cash balance as of December 31, 2016 was $3.7 million, of which $3.3 million was classified as a long-term asset and $0.4 million as a current asset. Our restricted cash balance as of December 31, 2015 was $3.5 million, of which $3.3 million was classified as a long-term asset and $0.2 million as a current asset. The restricted cash primarily consisted of funds reserved for legal requirements.\nMarketable Securities\nWe invest primarily in money market funds, commercial paper, corporate bonds, U.S. government agency bonds, asset-backed securities, municipal securities, U.S. government treasury bonds and certificates of deposits.\nMarketable securities are classified as available-for-sale and are carried at fair value. Marketable securities classified as current assets have maturities of less than one year. Unrealized gains or losses on such securities are included in accumulated other comprehensive income (loss), net in stockholders’ equity. Realized gains and losses from maturities of all such securities are reported in earnings and computed using the specific identification cost method. Realized gains or losses and charges for other-than-temporary declines in value, if any, on available-for-sale securities are reported in interest and other income (expense), net as incurred. We periodically evaluate these investments for other-than-temporary impairment.\nVariable Interest Entities\nWe have interests in entities determined to be variable interest entity (“VIE”). If we determine we are the primary beneficiary of a VIE, we would consolidate the VIE into our financial statements. In determining if we are the primary beneficiary, we evaluate whether we have the power to direct the activities that most significantly impact the VIE's economic performance and the obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE. Our evaluation includes identification of significant activities and an assessment of our ability to direct those activities based on governance provisions and arrangements to provide or receive product and process technology, product supply, operations services, equity funding, financing, and other applicable agreements and circumstances. Our assessments of whether we are the primary beneficiary of a VIE require significant assumptions and judgments. We have concluded that we are not the primary beneficiary of our VIE investments; therefore, we do not consolidate their results into our consolidated financials.\nInvestments in Privately Held Companies\nInvestments in privately held companies in which we can exercise significant influence but do not own a majority equity interest or otherwise control, are accounted for under the equity method of accounting. Equity method investments are reported on our balance sheet as a single amount, and we record our share of their operating results within equity in losses of investee, net of tax in our Consolidated Statement of Operations.\nDerivative Financial Instruments\nWe may enter into foreign currency forward contracts to minimize the short-term impact of foreign currency exchange rate fluctuations associated with certain assets and liabilities. These forward contracts are not designated as hedging instruments and do not subject us to material balance sheet risk due to fluctuations in foreign currency exchange rates. The gains and losses on these forward contracts are intended to offset the gains and losses in the underlying foreign currency denominated monetary assets and liabilities being economically hedged. We do not enter into foreign currency forward contracts for trading or speculative purposes. The net gain or loss from the settlement of these foreign currency forward contracts is recorded in interest and other income (expense), net in the Consolidated Statement of Operations.\n63\nForeign Currency\nFor our international subsidiaries where the U.S. dollar is the functional currency, we analyze on an annual basis or more often if necessary, if a significant change in facts and circumstances indicate that the primary economic currency has changed. For certain European and Asia Pacific subsidiaries where the local currency is the functional currency, adjustments from translating financial statements from the local currency to the U.S. dollar reporting currency are recorded as a separate component of accumulated other comprehensive income (loss), net in the stockholders’ equity section of the Consolidated Balance Sheet. This foreign currency translation adjustment reflects the translation of the balance sheet at period end exchange rates, and the income statement at an average exchange rate in effect during the period. As of December 31, 2016 and 2015, there were no material amounts in accumulated other comprehensive income (loss), net related to the translation of our foreign subsidiaries’ financial statements. The foreign currency revaluation that are derived from monetary assets and liabilities stated in a currency other than functional currency are included in interest and other income (expense), net. For the year ended December 31, 2016 and 2015, we had foreign currency net losses of $8.0 million and $4.0 million, respectively.\nCertain Risks and Uncertainties\nOur operating results depend to a significant extent on our ability to market and develop our products. The life cycles of our products are difficult to estimate due, in part, to the effect of future product enhancements and competition. Our inability to successfully develop and market our products as a result of competition or other factors would have a material adverse effect on our business, financial condition and results of operations.\nOur cash and investments are held primarily by two financial institutions. Financial instruments which potentially expose us to concentrations of credit risk consist primarily of cash equivalents, marketable securities and accounts receivable. We invest excess cash primarily in money market funds, commercial paper, corporate bonds, U.S. government agency bonds, asset-backed securities, municipal securities, U.S. government treasury bonds and certificates of deposits. If the carrying value of our investments exceeds the fair value, and the decline in fair value is deemed to be other-than-temporary, we will be required to write down the value of our investments, which could adversely affect our results of operations and financial condition. Moreover, the performance of certain securities in our investment portfolio correlates with the credit condition of the U.S. economy. We provide credit to customers in the normal course of business. Collateral is not required for accounts receivable, but ongoing evaluations of customers’ credit worthiness are performed. We maintain reserves for potential credit losses and such losses have been within management’s expectations. No individual customer accounted for 10% or more of our accounts receivable at December 31, 2016 or 2015, or net revenues for the year ended December 31, 2016, 2015 or 2014.\nWe have certain credit risk under our Loan and Security Agreement (\"Loan Agreement\") with SmileDirectClub, LLC (\"SDC\"). We perform ongoing evaluation of credit worthiness of SDC. If the fair value of equity investment is deemed to be other-than temporary impaired, we will be required to write down the value of our investments, which could adversely affect our results of operations and financial condition (Refer to Note 8 \"Commitments and Contingencies\" of the Notes of Consolidated Financial Statements for more information on our Loan Agreement with SDC).\nIn the U.S., the Food and Drug Administration (“FDA”) regulates the design, manufacture, distribution, pre-clinical and clinical study, clearance and approval of medical devices. Products developed by us may require approvals or clearances from the FDA or other international regulatory agencies prior to commercialized sales. There can be no assurance that our products will receive any of the required approvals or clearances. If we were denied approval or clearance or such approval was delayed, it may have a material adverse impact on us.\nWe have manufacturing operations located outside the U.S. We currently rely on our treatment facility in Costa Rica to prepare digital treatment plans using a sophisticated, internally developed computer-modeling program. In addition, we manufacture our clear aligners and distribute our intraoral scanners at our facilities in Juarez, Mexico, and we produce our handheld scanner wand in Or Yehuda, Israel. Our reliance on international operations exposes us to related risks and uncertainties, including difficulties in staffing and managing international operations such as hiring and retaining qualified personnel; controlling production volume and quality of manufacture; political, social and economic instability, particularly as a result of increased levels of violence in Juarez, Mexico and Or Yehuda, Israel; interruptions and limitations in telecommunication services; product and material transportation delays or disruption; trade restrictions and changes in tariffs; import and export license requirements and restrictions; fluctuations in foreign currency exchange rates; and potential adverse tax consequences. If any of these risks materialize, our international manufacturing operations, as well as our operating results, may be harmed.\n64\nWe purchase certain inventory from sole suppliers. Additionally, we rely on a limited number of hardware manufacturers. The inability of any supplier or manufacturer to fulfill our supply requirements could materially and adversely impact our future operating results.\nInventories\nInventories are valued at the lower of cost or market, with cost computed using either standard cost, which approximates actual cost, or average cost on a first-in-first-out basis. Excess and obsolete inventories are determined primarily based on future demand forecasts, and write-downs of excess and obsolete inventories are recorded as a component of cost of revenues.\nProperty, Plant and Equipment\nProperty, plant and equipment are stated at historical cost less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets. Construction in progress (\"CIP\") is related to the construction or development of property (including land) and equipment that have not yet been placed in service for their intended use. Upon sale or retirement, the asset’s cost and related accumulated depreciation are removed from the general ledger and any related gains or losses are reflected in expenses. Maintenance and repairs are expensed as incurred. Refer to Note 3 \"Balance Sheet Components\" of the Notes of Consolidated Financial Statements for details on estimated useful lives.\nGoodwill and Finite-Lived Acquired Intangible Assets\nGoodwill represents the excess of the purchase price paid over the fair value of tangible and identifiable intangible net assets acquired in business combinations and is allocated to the respective reporting units based on relative synergies generated. For the year ended December 31, 2016 and 2015, all goodwill is attributed to our Clear Aligner reporting unit.\nOur intangible assets primarily consist of intangible assets acquired as part of the Cadent acquisition. These assets are amortized using the straight-line method over their estimated useful lives ranging from one to fifteen years, reflecting the period in which the economic benefits of the assets are expected to be realized.\nImpairment of Goodwill and Long-Lived Assets\nGoodwill\nWe evaluate goodwill for impairment at least annually on November 30th or more frequently if indicators are present, an event occurs or circumstances changes that suggest an impairment may exist and that it would more likely than not reduce the fair value of a reporting unit below its carrying amount. The allocation of goodwill to the respective reporting units is based on relative synergies generated as a result of an acquisition.\nWe perform an initial assessment of qualitative factors to determine whether the existence of events and circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. In performing the qualitative assessment, we identify and consider the significance of relevant key factors, events, and circumstances that affect the fair value of our reporting units. These factors include external factors such as macroeconomic, industry, and market conditions, as well as entity-specific factors, such as our actual and planned financial performance. We also give consideration to the difference between the reporting unit fair value and carrying value as of the most recent date a fair value measurement was performed. If, after assessing the totality of relevant events and circumstances, we determine that it is more likely than not that the fair value of the reporting unit exceeds its carrying value and there is no indication of impairment, no further testing is performed; however, if we conclude otherwise, the first step of the two-step impairment test is performed by estimating the fair value of the reporting unit and comparing it with its carrying value, including goodwill.\nStep one of the goodwill impairment test consists of a comparison of the fair value of a reporting unit against its carrying amount, including the goodwill allocated to each reporting unit. We determine the fair value of our reporting units based on the present value of estimated future cash flows under the income approach of the reporting units as well as various price or market multiples applied to the reporting unit's operating results along with the appropriate control premium under the marketing approach, both of which are classified as level 3 within the fair value hierarchy as described in Note 2. If the carrying amount of the reporting\n65\nunit is in excess of its fair value, step two requires the comparison of the implied fair value of the reporting unit’s goodwill against the carrying amount of the reporting unit’s goodwill. Any excess of the carrying value of the reporting unit’s goodwill over the implied fair value of the reporting unit’s goodwill is recorded as an impairment loss.\nFinite-Lived Intangible Assets and Long-Lived Assets\nWe evaluate long-lived assets (including finite-lived intangible assets) for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. An asset or asset group is considered impaired if its carrying amount exceeds the future undiscounted net cash flows the asset or asset group is expected to generate. Factors we consider important which could trigger an impairment review include significant negative industry or economic trends, significant loss of customers and changes in the competitive environment. If an asset or asset group is considered to be impaired, the impairment to be recognized is calculated as the amount by which the carrying amount of the asset or asset group exceeds its fair market value. Our estimates of future cash flows attributable to our long-lived assets require significant judgment based on our historical and anticipated results and are subject to many assumptions. The estimation of fair value utilizing a discounted cashflow approach includes numerous uncertainties which require our significant judgment when making assumptions of expected growth rates and the selection of discount rates, as well as assumptions regarding general economic and business conditions, and the structure that would yield the highest economic value, among other factors. Refer to Note 5 \"Goodwill and Intangible Assets\" of the Notes of Consolidated Financial Statements for details on intangible long-lived assets.\nThere were no triggering events in 2016 that would cause impairments of our goodwill or long-lived assets.\nDevelopment Costs for Internal Use Software\nInternally developed software includes enterprise-level business software that we customized to meet our specific operational needs. Such capitalized costs include external direct costs utilized in developing or obtaining the applications and payroll and payroll-related costs for employees, who are directly associated with the development of the applications. Internally developed software costs capitalized during the year ended December 31, 2016 and 2015 were $13.2 million and $25.4 million, respectively, related to our enterprise resource planning (\"ERP\") project which we placed into production during 2016 and amortize over 10 years.\nThe costs to develop software that is marketed externally have not been capitalized as we believe our current software development process is essentially completed concurrent with the establishment of technological feasibility. As such, all related software development costs are expensed as incurred and included in research and development expense in our Consolidated Statements of Operations.\nProduct Warranty\nClear Aligner\nWe warrant our Invisalign products against material defects until the aligner case is complete. We warrant SmileDirectClub, LLC (“SDC”) products against material defects for one year. We accrue for warranty costs in cost of net revenues upon shipment of products. The amount of accrued estimated warranty costs is primarily based on historical experience as to product failures as well as current information on replacement costs. Actual warranty costs could differ materially from the estimated amounts. We regularly review the accrued balances and update these balances based on historical warranty cost trends.\nScanners and Services\nWe warrant our intraoral scanners for a period of one year, which include materials and labor. We accrue for these warranty costs based on average historical repair costs. An extended warranty may be purchased for additional fees.\nAllowance for Doubtful Accounts and Returns\nWe maintain allowances for doubtful accounts for customers that are not able to make payments and allowances for sales returns. We periodically review these allowances, including an analysis of the customers’ payment history and information regarding the customers’ creditworthiness, as well as historical sales returns as a percentage of revenue. Actual write-offs have not materially differed from the estimated allowances.\n66\nRevenue Recognition\nWe measure and allocate revenue according to the accounting guidance for multiple-deliverable revenue arrangements in Accounting Standards Update (“ASU”) 2009-13, Multiple-Deliverable Revenue Arrangements-a consensus of the Financial Accounting Standard Board (“FASB”) Emerging Issues Task Force.\nMultiple-Element Arrangements (“MEAs”): Arrangements with customers may include multiple deliverables, including any combination of products/equipment and services. The deliverables included in the MEAs are separated into more than one unit of accounting when (i) the delivered product/equipment has value to the customer on a stand-alone basis, and (ii) delivery of the undelivered service element(s) is probable and substantially in our control. Arrangement consideration is then allocated to each unit, delivered or undelivered, based on the relative selling price of each unit of accounting based first on vendor-specific objective evidence (“VSOE”) if it exists, second on third-party evidence (“TPE”) if it exists, or on best estimated selling price (“BESP”) if neither VSOE or TPE exist.\n| • | VSOE - In most instances, this applies to products and services that are sold separately in stand-alone arrangements. We determine VSOE based on pricing and discounting practices for the specific product or service when sold separately, considering geographical, customer, and other economic or marketing variables, as well as renewal rates or stand-alone prices for the service element(s). |\n\n| • | TPE - If we cannot establish VSOE of selling price for a specific product or service included in a multiple-element arrangement, we use third-party evidence of selling price. We determine TPE based on sales of comparable amount of similar products or service offered by multiple third parties considering the degree of customization and similarity of product or service sold. |\n\n| • | BESP - The best estimated selling price represents the price at which we would sell a product or service if it were sold on a stand-alone basis. When VSOE or TPE does not exist for all elements, we determine BESP for the arrangement element based on sales, cost and margin analysis, as well as other inputs based on our pricing practices. Adjustments for other market and company specific factors are made as deemed necessary in determining BESP. We regularly review our estimates of selling price and maintain internal controls over the establishment and update of these estimates. |\n\nRevenue is recognized when persuasive evidence of the arrangement exists, the price is fixed or determinable, collectability is reasonably assured, title and risk of loss have passed to customers based on the shipping terms, and allowances for discounts, returns, and customer incentives can be reliably estimated. Provisions for discounts and rebates to customers are provided for in the same period that the related product sales are recorded.\nClear Aligner\nWe enter into arrangements (“treatment plans”) that involve multiple future product deliverables. Invisalign Full, Invisalign Teen, and Invisalign Assist products (\"Comprehensive Products\") include optional additional aligners at no charge for a period of up to five years after initial shipment. Invisalign Teen also includes up to six optional replacement aligners in the price of the product and may be ordered by the dental professional any time throughout treatment. Invisalign Lite (\"Non-Comprehensive Products\") includes one optional case refinement in the price of the product. Case refinement is a finishing tool used to adjust a patient's teeth to the desired final position and may be elected by the dental professional at any time during treatment; however, it is generally ordered in the last stages of orthodontic treatment.\nWe determined that our treatment plans, except Invisalign Assist with progress tracking, comprise the following deliverables which also represent separate units of accounting: initial aligners, additional aligners, case refinement, and replacement aligners. We allocate revenue for each treatment plan based on each unit's relative selling price based on BESP and recognize the revenue upon shipment of each unit in the treatment plan.\nFor Invisalign Assist with the progress tracking feature, aligners and services are provided to the dental professional every nine stages (“a batch”). We are able to reliably estimate the number of batches which are expected to be shipped for each case based upon our historical experience. The amounts allocated to this deliverable are recognized on a prorated basis as each batch is shipped.\n67\nScanners and Services\nWe recognize revenues from the sales of iTero intraoral scanners and CAD/CAM services. CAD/CAM services include scanning services, extended warranty for the intraoral scanners, a range of iTero restorative services, and OrthoCAD services such as OrthoCAD iRecord. We sell intraoral scanners and services through both our direct sales force and distribution partners. The intraoral scanner sales price includes one year of warranty, and for additional fees, the customer may select an unlimited scanning service agreement over a fixed period of time or extended warranty periods. When intraoral scanners are sold with either an unlimited scanning service agreement and/or extended warranty, we allocate revenue based on each element's relative selling price. We estimate the selling price of each element, as if it is sold on a stand-alone basis, taking into consideration historical prices as well as our discounting strategies.\nScanner revenue, net of related discounts and allowances, is recognized when products or equipment have been shipped and no significant obligations for installation or training remain. For certain distributors who provide installation and training to the customer, we recognize scanner revenue when the intraoral scanner is shipped to the distributor assuming all of the other revenue recognition criteria have been met. Discounts are deducted from revenue at the time of sale. Returns of products, excluding warranty related returns, are infrequent and insignificant.\nService revenue, including iTero restorative and all OrthoCAD services are recognized upon delivery or ratably over the contract term as the specified services are performed. If a customer selects a pay per use basis for scanning service fees, the revenue is recognized as the service is provided.\nWe offer customers an option to purchase extended warranties on certain products. We recognize revenue on these extended warranty contracts ratably over the life of the contract. The costs associated with these extended warranty contracts are recognized when incurred.\nShipping and Handling Costs\nShipping and handling charges to customers are included in net revenues, and the associated costs incurred are recorded in cost of revenues.\nLegal Proceedings and Litigations\nWe are involved in legal proceedings on an ongoing basis. If we believe that a loss arising from such matters is probable and can be reasonably estimated, we accrue the estimated liability in our financial statements. If only a range of estimated losses can be determined, we accrue an amount within the range that, in our judgment, reflect the most likely outcome; if none of the estimates within that range is a better estimate than any other amount, we accrue the low end of the range.\nResearch and Development\nResearch and development expense is expensed as incurred and includes the costs associated with the research and development of new products and enhancements to existing products. These costs primarily include personnel-related costs including stock-based compensation and outside consulting expenses associated with the research and development of new products and enhancements to existing products and allocations of corporate overhead expenses including facilities and IT.\nAdvertising Costs\nThe cost of advertising and media is expensed as incurred. For the year ended December 31, 2016, 2015 and 2014, advertising costs totaled $36.0 million, $23.4 million and $26.9 million, respectively.\nCommon Stock Repurchase\nWe repurchase our own common stock from time to time in the open market when our Board of Directors approve a stock repurchase program. We account for these repurchases under the accounting guidance for equity where we allocate the total\n68\nrepurchase value that are in excess over par between additional paid in capital and retained earnings. All shares repurchased are retired.\nOperating Leases\nWe currently lease office spaces, automobiles and equipment under operating leases with original lease periods of up to 9 years. Certain of these leases have free or escalating rent payment provisions and lease incentives provided by the landlord. We recognize rent expense under such leases on a straight-line basis over the term of the lease as certain leases have adjustments for market provisions.\nIncome Taxes\nWe make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of certain tax assets and liabilities, which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes.\nAs part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves us estimating our current tax exposure under the applicable tax laws and assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our Consolidated Balance Sheet.\nWe account for uncertainty in income taxes pursuant to authoritative guidance based on a two-step approach to recognize and measure uncertain tax positions taken or expected to be taken in a tax return. The first step is to determine if the weight of available evidence indicates that it is more likely than not that the tax position will be sustained on audit based on its technical merits, including resolution of any related appeals or litigation processes. The second step is to measure the tax benefit as the largest amount that is more than 50% likely to be realized upon ultimate settlement. We adjust reserves for our uncertain tax positions due to changing facts and circumstances, such as the closing of a tax audit, or refinement of estimates due to new information. To the extent that the final outcome of these matters is different than the amounts recorded, such differences will impact our tax provision in our Consolidated Statement of Operation in the period in which such determination is made.\nWe assess the likelihood that we will be able to realize our deferred tax assets. Should there be a change in our ability to realize our deferred tax assets, our tax provision would increase in the period in which we determine that it is more likely than not that we cannot realize our deferred tax assets. We consider all available evidence, both positive and negative, including historical levels of income, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance. If it is more likely than not that we will not realize our deferred tax assets, we will increase our provision for taxes by recording a valuation allowance against the deferred tax assets that we estimate will not ultimately be realizable. The available positive evidence at December 31, 2016 included historical operating profits and a projection of future income sufficient to realize most of our remaining deferred tax assets. As of December 31, 2016, it was considered more likely than not that our deferred tax assets would be realized with the exception of certain foreign loss carryovers as we are unable to forecast sufficient future profits to realize the deferred tax assets.\nAs of December 31, 2016, U.S. income taxes and foreign withholding taxes associated with the repatriation of undistributed earnings of foreign subsidiaries on a cumulative total of $438.0 million was not provided as we intend to reinvest these earnings indefinitely in our foreign subsidiaries. If these earnings were distributed in the form of dividends or otherwise, or if the shares of the relevant foreign subsidiaries were sold or otherwise transferred, we would be subject to additional U.S. income taxes subject to an adjustment for foreign tax credit, and foreign withholding taxes. Determination of the amount of unrecognized deferred income tax liability related to these earnings is not practicable.\nAccounting guidance for stock-based compensation prohibits recognition of a deferred income tax asset for excess tax benefits due to stock option exercises that have not yet been realized through a reduction in income taxes payable. We follow the tax law ordering method to determine when excess tax benefits have been realized and consider only the direct impacts of awards when calculating the amount of windfalls or shortfalls.\n69\nStock-Based Compensation\nWe recognize stock-based compensation cost for only those shares ultimately expected to vest on a straight-line basis over the requisite service period of the award. We use the Black-Scholes option pricing model to determine the fair value of employee stock purchase plan shares. We estimate the fair value of market-performance based restricted stock units using a Monte Carlo simulation model which requires the input of assumptions, including expected term, stock price volatility and the risk-free rate of return. In addition, judgment is also required in estimating the number of stock-based awards that are expected to be forfeited. Forfeitures are estimated based on historical experience at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management’s judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future.\nComprehensive Income\nComprehensive income includes all changes in equity during a period from non-owner sources. Comprehensive income, including unrealized gains and losses on investments and foreign currency translation adjustments, are reported net of their related tax effect.\nRecent Accounting Pronouncements\nIn May 2014, the Financial Accounting Standards Board (\"FASB\") released Accounting Standards Update (\"ASU\") 2014-9, \"Revenue from Contracts with Customers,\" (Topic 606) to supersede nearly all existing revenue recognition guidance under GAAP. The core principle of the standard is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration that is expected to be received for the goods or services. The new standard defines a five step process to achieve this core principle and, in doing so, it is possible more judgment and estimates may be required within the revenue recognition process than required under existing GAAP including identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. In addition, the new standard requires that reporting companies disclose the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. We are required to adopt this standard starting in the first quarter of fiscal year 2018 using either of two methods: (i) retrospective to each prior reporting period presented with the option to elect certain practical expedients as defined within the standard; or (ii) retrospective with the cumulative effect of initially applying the standard recognized at the date of initial application and providing certain additional disclosures as defined per the standard. We plan to adopt the standard in the first quarter of fiscal year 2018 by applying the full retrospective method. Our ability to adopt using the full retrospective method is dependent on the completion of our analysis of information necessary to restate prior period financial statements. We are continuing to assess the impact of the adoption of this update on our consolidated financial statements and related disclosures.\nIn April 2016, the FASB released ASU No. 2016-10, \"Revenue from Contracts with Customers,\" to clarify the following two aspects of Topic 606: identifying performance obligations and the licensing implementation guidance, while retaining the principles for those areas of the ASU 2014-9 issued in May 2014. The effective date and the transition requirement of the amendments in this update are the same as the effective date and transition requirements of Topic 606.\nIn May 2016, the FASB released ASU No. 2016-12, \"Revenue from Contracts with Customers,\" to address certain issues in the Topic 606 guidance on assessing the collectability, presentation of sales taxes, non-cash consideration, and completed contracts and contract modifications at transition. The ASU provides narrow-scope improvements and practical expedients to the ASU 2014-9 issued in May 2014. The effective date and the transition requirement of the amendments in this update are the same as the effective date and transition requirements of Topic 606.\nIn December 2016, the FASB released ASU No. 2016-20, \"Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers,\" to clarify certain aspects of guidance in the Topic 606 including its scope, disclosure requirements and contract cost accounting, while retaining the principles for those areas of the ASU 2014-9 issued in May 2014. The effective date and the transition requirement of the amendments in this update are the same as the effective date and transition requirements of Topic 606.\n70\nIn February 2016, the FASB issued ASU No. 2016-02, “Leases” (Topic 842). The FASB issued this update to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The updated guidance is effective for annual periods beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption of the standard is permitted. We plan to adopt the standard in the first quarter of fiscal year 2019 by electing practical expedients available in the standard. While we are currently evaluating the impact of the adoption of this guidance on our consolidated financial statements, we expect the adoption will have a material increase in the assets and liabilities of our consolidated balance sheet.\nIn March 2016, the FASB issued ASU No. 2016-09, \"Improvements to Employee Share-Based Payment Accounting\" (Topic 718). This ASU affects entities that issue share-based payment awards to their employees. The ASU is designed to simplify several aspects of accounting for share-based payment award transactions, which include the income tax consequences, classification of awards as either equity or liabilities, classification on the statements of cash flows and forfeiture rate calculations. This ASU is effective for fiscal years beginning after December 15, 2016 and interim periods within those years. We plan to adopt the standard in the first quarter of fiscal year 2017, and the adoption will have a material impact on our consolidated financial statements.\nIn June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments - Credit Losses” (Topic 326). The FASB issued this update to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. The amendments in this update replace the existing guidance of incurred loss impairment methodology with an approach that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. The updated guidance is effective for annual periods beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption of the update is permitted as of the fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. We are evaluating the impact of the adoption of this update on our consolidated financial statements and related disclosures.\nIn August 2016, the FASB issued ASU 2016-15, \"Classification of Certain Cash Receipts and Cash Payments\" (Topic 230). This FASB clarifies the presentation and classification of certain cash receipts and cash payments in the statements of cash flows. This ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2017. Early adoption is permitted. We are currently evaluating the impact of this guidance on our consolidated financial statements.\nIn October, 2016, the FASB issued ASU 2016-16, \"Intra-Entity Transfers of Assets Other Than Inventory,\" (Topic 740) which requires entities to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs. Prior to the issuance of this ASU, existing guidance prohibited the recognition of current and deferred income taxes for an intra-entity asset transfer until the asset had been sold to an outside party. This ASU is effective for fiscal years beginning after December 15, 2017 and interim periods within those years. Early adoption is permitted. We plan to early adopt the standard in the first quarter of 2017 by applying the modified retrospective approach with a cumulative catch-up adjustment to opening retained earnings at the beginning of the first quarter of 2017. The adoption will impact our consolidated balance sheet but we do not expect the impact to be material.\nIn November 2016, the FASB issued ASU 2016-18, \"Statement of Cash Flows - Restricted Cash,\" which provides guidance to address the classification and presentation of changes in restricted cash in the statements of cash flows. This standard is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period, but any adjustments must be reflected as of the beginning of the fiscal year that includes that interim period. The new standard must be adopted retrospectively. We are currently in the process of evaluating the impact of this new pronouncement on our consolidated statement of cash flows.\n71\nNote 2. Marketable Securities and Fair Value Measurements\nAs of December 31, 2016 and 2015, the estimated fair value of our short-term and long-term marketable securities, classified as available for sale, are as follows (in thousands):\nShort-term\n| December 31, 2016 | AmortizedCost | GrossUnrealizedGains | GrossUnrealizedLosses | Fair Value |\n| Commercial paper | $ | 42,397 | $ | — | $ | (6 | ) | $ | 42,391 |\n| Corporate bonds | 122,788 | 22 | (121 | ) | 122,689 |\n| Municipal securities | 5,852 | — | (5 | ) | 5,847 |\n| U.S. government agency bonds | 28,903 | 9 | (4 | ) | 28,908 |\n| U.S. government treasury bonds | 45,146 | 7 | (7 | ) | 45,146 |\n| Certificates of deposit | 6,000 | — | — | 6,000 |\n| Total Marketable Securities, Short-Term | $ | 251,086 | $ | 38 | $ | (143 | ) | $ | 250,981 |\n\nLong-term\n| December 31, 2016 | AmortizedCost | GrossUnrealizedGains | GrossUnrealizedLosses | Fair Value |\n| U.S. government agency bonds | $ | 6,805 | $ | — | $ | (16 | ) | $ | 6,789 |\n| Corporate bonds | 40,889 | 8 | (85 | ) | 40,812 |\n| U.S. government treasury bonds | 12,016 | 5 | (16 | ) | 12,005 |\n| Asset-backed securities | 177 | — | — | 177 |\n| Total Marketable Securities, Long-Term | $ | 59,887 | $ | 13 | $ | (117 | ) | $ | 59,783 |\n\nShort-term\n| December 31, 2015 | AmortizedCost | GrossUnrealizedGains | GrossUnrealizedLosses | Fair Value |\n| Commercial paper | $ | 38,537 | $ | — | $ | — | $ | 38,537 |\n| Corporate bonds | 179,765 | 6 | (251 | ) | 179,520 |\n| U.S. dollar dominated foreign corporate bonds | 510 | — | (2 | ) | 508 |\n| Municipal securities | 14,209 | 7 | (2 | ) | 14,214 |\n| U.S. government agency bonds | 75,172 | — | (53 | ) | 75,119 |\n| U.S. government treasury bonds | 51,763 | 1 | (81 | ) | 51,683 |\n| Total Marketable Securities, Short-Term | $ | 359,956 | $ | 14 | $ | (389 | ) | $ | 359,581 |\n\nLong-term\n| December 31, 2015 | AmortizedCost | GrossUnrealizedGains | GrossUnrealizedLosses | Fair Value |\n| U.S. government agency bonds | $ | 43,853 | $ | — | $ | (178 | ) | $ | 43,675 |\n| Corporate bonds | 64,012 | 9 | (218 | ) | 63,803 |\n| U.S. government treasury bonds | 37,673 | — | (107 | ) | 37,566 |\n| Municipal securities | 3,993 | — | (2 | ) | 3,991 |\n| Asset-backed securities | 2,338 | — | (3 | ) | 2,335 |\n| Total Marketable Securities, Long-Term | $ | 151,869 | $ | 9 | $ | (508 | ) | $ | 151,370 |\n\n72\nCash and cash equivalents are not included in the table above as the gross unrealized gains and losses are not material. We have no short-term or long-term investments that have been in a continuous material unrealized loss position for greater than twelve months as of December 31, 2016 and 2015. Amounts reclassified to earnings from accumulated other comprehensive income (loss), net related to unrealized gains or losses were not material in 2016 and 2015. For the year ended December 31, 2016 and 2015, realized gains or losses were not material.\nOur fixed-income securities investment portfolio consists of corporate bonds, U.S. dollar denominated foreign corporate bonds, commercial paper, municipal securities, U.S. government agency bonds, U.S. government treasury bonds, certificates of deposit and asset-backed securities that have a maximum effective maturity of 27 months. The securities that we invest in are generally deemed to be low risk based on their credit ratings from the major rating agencies. The longer the duration of these securities, the more susceptible they are to changes in market interest rates and bond yields. As interest rates increase, those securities purchased at a lower yield show a mark-to-market unrealized loss. The unrealized losses are due primarily to changes in credit spreads and interest rates. We expect to realize the full value of all these investments upon maturity or sale. The weighted average remaining duration of these securities was approximately 7 months and 9 months as of December 31, 2016 and 2015, respectively.\nAs the carrying value approximates the fair value for our short-term and long-term marketable securities shown in the tables above, the following table summarizes the fair value of our short-term and long-term marketable securities classified by maturity as of December 31, 2016 and 2015 (in thousands):\n| December 31, |\n| 2016 | 2015 |\n| One year or less | $ | 250,981 | $ | 359,581 |\n| Due in greater than one year | 59,783 | 151,370 |\n| Total available for short-term and long-term marketable securities | $ | 310,764 | $ | 510,951 |\n\nFair Value Measurements\nWe measure the fair value of our cash equivalents and marketable securities as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. We use the GAAP fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. This hierarchy requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The three levels of inputs that may be used to measure fair value:\nLevel 1 — Quoted (unadjusted) prices in active markets for identical assets or liabilities.\nOur Level 1 assets consist of money market funds and U.S. government treasury bonds. We did not hold any Level 1 liabilities as of December 31, 2016 and 2015.\nLevel 2 — Observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the asset or liability.\nOur Level 2 assets consist of commercial paper, corporate bonds, municipal securities, certificates of deposit, U.S. government agency bonds, asset-backed securities and our Israeli funds that are mainly invested in insurance policies. We obtain fair values for our Level 2 investments. Our custody bank and asset managers independently use professional pricing services to gather pricing data which may include quoted market prices for identical or comparable financial instruments, or inputs other than quoted prices that are observable either directly or indirectly, and we are ultimately responsible for these underlying estimates. We did not hold any Level 2 liabilities as of December 31, 2016 and 2015.\nLevel 3 — Unobservable inputs to the valuation methodology that are supported by little or no market activity and that are significant to the measurement of the fair value of the assets or liabilities. Level 3 assets and liabilities include those whose fair value measurements are determined using pricing models, discounted cash flow methodologies or similar valuation techniques, as well as significant management judgment or estimation. Our Level 3 assets consist of long-term notes receivable and are included in other assets on our consolidated balance sheet. In 2016, we entered into a long-term notes receivable for $2.0 million and we\n73\nrecognized $0.05 million in earnings during 2016 as a result of a change in its fair value. As of December 31, 2016, the fair value of long-term notes receivable was approximately $2.05 million. We did not hold any Level 3 liabilities as of December 31, 2016 and 2015.\nThe following tables summarize our financial assets measured at fair value on a recurring basis as of December 31, 2016 and 2015 (in thousands):\n| Description | Balance as ofDecember 31, 2016 | Quoted Prices inActive Markets forIdentical Assets(Level 1) | Significant OtherObservable Inputs(Level 2) | Significant OtherObservable Inputs(Level 3) |\n| Cash equivalents: |\n| Money market funds | $ | 87,179 | $ | 87,179 | $ | — | $ | — |\n| Commercial paper | 2,499 | — | 2,499 | — |\n| Corporate bonds | 750 | — | 750 | — |\n| Short-term investments: |\n| Commercial paper | 42,391 | — | 42,391 | — |\n| Corporate bonds | 122,689 | — | 122,689 | — |\n| Municipal securities | 5,847 | — | 5,847 | — |\n| U.S. government agency bonds | 28,908 | — | 28,908 | — |\n| U.S. government treasury bonds | 45,146 | 45,146 | — | — |\n| Certificates of deposit | 6,000 | — | 6,000 | — |\n| Long-term investments: |\n| U.S. government agency bonds | 6,789 | — | 6,789 | — |\n| Corporate bonds | 40,812 | — | 40,812 | — |\n| U.S. government treasury bonds | 12,005 | 12,005 | — | — |\n| Asset-backed securities | 177 | — | 177 | — |\n| Prepaid expenses and other current assets: |\n| Israeli funds | 2,956 | — | 2,956 | — |\n| Other assets: |\n| Long-term notes receivable | 2,047 | — | — | 2,047 |\n| $ | 406,195 | $ | 144,330 | $ | 259,818 | $ | 2,047 |\n\n74\n| Description | Balance as ofDecember 31, 2015 | Quoted Prices inActive Markets forIdentical Assets(Level 1) | Significant OtherObservable Inputs(Level 2) |\n| Cash equivalents: |\n| Money market funds | $ | 70,148 | $ | 70,148 | $ | — |\n| Commercial paper | 36,887 | — | 36,887 |\n| U.S. government agency bonds | 3,599 | — | 3,599 |\n| Corporate bonds | 625 | — | 625 |\n| Short-term investments: |\n| Commercial paper | 38,537 | — | 38,537 |\n| Corporate bonds | 179,520 | — | 179,520 |\n| U.S. dollar denominated foreign corporate bonds | 508 | — | 508 |\n| Municipal securities | 14,214 | — | 14,214 |\n| U.S. government agency bonds | 75,119 | — | 75,119 |\n| U.S. government treasury bonds | 51,683 | 51,683 | — |\n| Long-term investments: |\n| U.S. government agency bonds | 43,675 | — | 43,675 |\n| Corporate bonds | 63,803 | — | 63,803 |\n| U.S. government treasury bonds | 37,566 | 37,566 | — |\n| Municipal securities | 3,991 | — | 3,991 |\n| Asset-backed securities | 2,335 | — | 2,335 |\n| Prepaid expenses and other assets: |\n| Israeli funds | 2,436 | — | 2,436 |\n| $ | 624,646 | $ | 159,397 | $ | 465,249 |\n\nDerivative Financial Instruments\nWe have in the past and may in the future enter into foreign currency forward contracts to minimize the short-term impact of foreign currency exchange rate fluctuations associated with certain assets and liabilities. The net loss on these forward contracts was not material for the year ended December 31, 2016 and 2015. The net gain or loss from the settlement of these foreign currency forward contracts is recorded in interest and other income (expenses), net in the Consolidated Statements of Operations. We had no material foreign exchange forward contracts outstanding as of December 31, 2016 and 2015. Certain investments in private companies contain embedded derivatives, which do not require bifurcation as we have elected to measure these investments at fair value.\nNote 3. Balance Sheet Components\nInventories\nInventories consist of the following (in thousands):\n| December 31, |\n| 2016 | 2015 |\n| Raw materials | $ | 9,793 | $ | 9,950 |\n| Work in process | 10,773 | 7,067 |\n| Finished goods | 6,565 | 2,448 |\n| Total Inventories | $ | 27,131 | $ | 19,465 |\n\n75\nProperty, Plant and Equipment\nProperty, plant and equipment consist of the following (in thousands):\n| December 31, |\n| Generally Used Estimated Useful Life | 2016 | 2015 |\n| Clinical and manufacturing equipment | Up to 10 years | $ | 153,938 | $ | 128,044 |\n| Computer hardware | 3 years | 27,978 | 25,843 |\n| Computer software | 3 years | 59,997 | 21,451 |\n| Furniture and fixtures | 5 years | 10,306 | 8,855 |\n| Leasehold improvements | Lease term (1) | 22,370 | 20,172 |\n| Building | 20 years | 7,272 | 4,227 |\n| Land | — | 3,072 | 3,072 |\n| CIP | — | 25,948 | 42,846 |\n| Total | 310,881 | 254,510 |\n| Less: Accumulated depreciation and amortization and impairment charges | (135,714 | ) | (118,037 | ) |\n| Total Property, plant and equipment, net | $ | 175,167 | $ | 136,473 |\n\n(1) Shorter of remaining lease term or estimated useful lives of assets.\nDepreciation and amortization was $24.0 million, $18.0 million and $17.9 million, for the year ended December 31, 2016, 2015 and 2014, respectively.\nAccrued Liabilities\nAccrued liabilities consist of the following (in thousands):\n| December 31, |\n| 2016 | 2015 |\n| Accrued payroll and benefits | $ | 79,214 | $ | 55,430 |\n| Accrued sales and marketing expenses | 11,970 | 7,071 |\n| Accrued sales rebate | 10,342 | 8,486 |\n| Accrued sales tax and value added tax | 5,032 | 4,801 |\n| Accrued income taxes | 4,210 | 2,646 |\n| Accrued warranty | 3,841 | 2,638 |\n| Accrued professional fees | 3,604 | 2,775 |\n| Other accrued liabilities | 16,119 | 23,918 |\n| Total Accrued Liabilities | $ | 134,332 | $ | 107,765 |\n\nWarranty\nWe regularly review the accrued balances and update these balances based on historical warranty trends. Actual warranty costs incurred have not materially differed from those accrued; however, future actual warranty costs could differ from the estimated amounts.\nClear Aligner\nWe warrant our Invisalign products against material defects until the aligner case is complete. We warrant SDC products against material defects for one year. We accrue for warranty costs in cost of net revenues upon shipment of products. The amount of accrued estimated warranty costs is primarily based on historical experience as to product failures as well as current information on replacement costs.\n76\nScanners\nWe warrant our scanners for a period of one year from the date of training and installation. We accrue for these warranty costs which includes materials and labor based on estimated historical repair costs. Extended service packages may be purchased for additional fees.\nWarranty accrual as of December 31, 2016 and 2015 consists of the following activity (in thousands):\n| Warranty accrual, December 31, 2014 | $ | 3,148 |\n| Charged to cost of revenues | 1,796 |\n| Actual warranty expenditures | (2,306 | ) |\n| Warranty accrual, December 31, 2015 | 2,638 |\n| Charged to cost of revenues | 4,894 |\n| Actual warranty expenditures | (3,691 | ) |\n| Warranty accrual, December 31, 2016 | $ | 3,841 |\n\nNote 4. Equity Method Investments\nOn July 25, 2016, we acquired a 17% equity interest, on a fully diluted basis, in SmileDirectClub, LLC (“SDC”) for $46.7 million, and account for this as an equity method investment. The investment is reported on our consolidated balance sheet as a single amount under equity method investments, and we record our proportional share of SDC's earnings or losses within equity in losses of investee in our consolidated statement of operations. As of December 31, 2016, the balance of our equity method investments was $45.1 million.\nConcurrently with the investment on July 25, 2016, we also entered into a supply agreement with SDC to manufacture clear aligners for SDC's doctor-led, at-home program for simple teeth straightening. The term of the supply agreement expires on December 31, 2019. We commenced supplying aligners to SDC in October 2016. The sale of aligners to SDC and the income from under the supply agreement are reported in our Clear Aligner business segment after eliminating outstanding intercompany transactions.\nNote 5. Goodwill and Intangible Assets\nGoodwill\n| Total |\n| Balance as of December 31, 2014 | $ | 61,369 |\n| Adjustments (1) | (295 | ) |\n| Balance as of December 31, 2015 | 61,074 |\n| Adjustments (1) | (30 | ) |\n| Balance as of December 31, 2016 | $ | 61,044 |\n\n(1) The adjustments to goodwill were a result of foreign currency translation.\nImpairment of Goodwill\nWe evaluate goodwill for impairment at least annually on November 30th or more frequently if indicators are present, an event occurs or circumstances changes that suggest an impairment may exist and that it would more likely than not reduce the fair value of a reporting unit below its carrying amount. The allocation of goodwill to the respective reporting units is based on relative synergies generated as a result of an acquisition.\n77\nAnnual Impairment Test\nThe remaining goodwill is entirely attributable to our Clear Aligner reporting unit. During the fourth quarter of fiscal 2016, we performed the annual goodwill impairment testing and found no impairment as the fair value of our Clear Aligner reporting unit was significantly in excess of the carrying value.\nIntangible Long-Lived Assets\nWe amortize our intangible assets over their estimated useful lives. We evaluate long-lived assets, which includes property, plant and equipment and intangible assets, for impairment whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. The carrying value is not recoverable if it exceeds the undiscounted cash flows resulting from the use of the asset and its eventual disposition. Our estimates of future cash flows attributable to our long-lived assets require significant judgment based on our historical and anticipated results and are subject to many factors. Factors we consider important which could trigger an impairment review include significant negative industry or economic trends, significant loss of customers and changes in the competitive environment of our intraoral scanning business.\nThere were no triggering events in 2016 that would cause impairments of our long-lived assets.\nAcquired intangible long-lived assets are being amortized as follows (in thousands):\n| Weighted Average Amortization Period (in years) | Gross Carrying Amount as ofDecember 31, 2016 | AccumulatedAmortization | Accumulated Impairment Loss | Net CarryingValue as ofDecember 31, 2016 |\n| Trademarks | 15 | $ | 7,100 | $ | (1,631 | ) | $ | (4,179 | ) | $ | 1,290 |\n| Existing technology | 13 | 12,600 | (4,141 | ) | (4,328 | ) | 4,131 |\n| Customer relationships | 11 | 33,500 | (12,819 | ) | (10,751 | ) | 9,930 |\n| Patents | 8 | 6,316 | (713 | ) | — | 5,603 |\n| Total Intangible Assets | $ | 59,516 | $ | (19,304 | ) | $ | (19,258 | ) | $ | 20,954 |\n\n| Weighted Average Amortization Period (in years) | Gross CarryingAmount as ofDecember 31, 2015 | AccumulatedAmortization | Accumulated Impairment Loss | Net CarryingValue as ofDecember 31, 2015 |\n| Trademarks | 15 | $ | 7,100 | $ | (1,492 | ) | $ | (4,179 | ) | $ | 1,429 |\n| Existing technology | 13 | 12,600 | (3,577 | ) | (4,328 | ) | 4,695 |\n| Customer relationships | 11 | 33,500 | (10,957 | ) | (10,751 | ) | 11,792 |\n| Patents | 8 | 285 | (113 | ) | — | 172 |\n| Total Intangible Assets | $ | 53,485 | $ | (16,139 | ) | $ | (19,258 | ) | $ | 18,088 |\n\nThe total estimated annual future amortization expense for these acquired intangible assets as of December 31, 2016 is as follows (in thousands):\n| Fiscal Year |\n| 2017 | $ | 3,355 |\n| 2018 | 3,353 |\n| 2019 | 3,346 |\n| 2020 | 3,336 |\n| 2021 | 3,334 |\n| Thereafter | 4,230 |\n| Total | $ | 20,954 |\n\n78\nNote 6. Legal Proceedings\nSecurities Class Action Lawsuit\nOn November 28, 2012, plaintiff City of Dearborn Heights Act 345 Police & Fire Retirement System filed a lawsuit against Align, Thomas M. Prescott (“Mr. Prescott”), Align’s former President and Chief Executive Officer, and Kenneth B. Arola (“Mr. Arola”), Align’s former Vice President, Finance and Chief Financial Officer, in the United States District Court for the Northern District of California on behalf of a purported class of purchasers of our common stock (the “Securities Action”). On July 11, 2013, an amended complaint was filed, which named the same defendants, on behalf of a purported class of purchasers of our common stock between January 31, 2012 and October 17, 2012. The amended complaint alleged that Align, Mr. Prescott and Mr. Arola violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, and that Mr. Prescott and Mr. Arola violated Section 20(a) of the Securities Exchange Act of 1934. Specifically, the amended complaint alleged that during the purported class period defendants failed to take an appropriate goodwill impairment charge related to the April 29, 2011 acquisition of Cadent Holdings, Inc. in the fourth quarter of 2011, the first quarter of 2012 or the second quarter of 2012, which rendered our financial statements and projections of future earnings materially false and misleading and in violation of U.S. GAAP. The amended complaint sought monetary damages in an unspecified amount, costs and attorneys’ fees. On December 9, 2013, the court granted defendants’ motion to dismiss with leave for plaintiff to file a second amended complaint. Plaintiff filed a second amended complaint on January 8, 2014 on behalf of the same purported class. The second amended complaint states the same claims as the amended complaint. On August 22, 2014, the court granted our motion to dismiss without leave to amend. On September 22, 2014, Plaintiff filed a notice of appeal to the Ninth Circuit Court of Appeals. Briefing for the appeal was completed in May 2015 and the Ninth Circuit held oral arguments in October 2016. Align intends to vigorously defend itself against these allegations. Align is currently unable to predict the outcome of this amended complaint and therefore cannot determine the likelihood of loss nor estimate a range of possible loss, if any.\nShareholder Derivative Lawsuit\nOn February 1, 2013, plaintiff Gary Udis filed a shareholder derivative lawsuit against several of Align’s current and former officers and directors in the Superior Court of California, County of Santa Clara. The complaint alleges that our reported income and earnings were materially overstated because of a failure to timely write down goodwill related to the April 29, 2011 acquisition of Cadent Holdings, Inc., and that defendants made allegedly false statements concerning our forecasts. The complaint asserts various state law causes of action, including claims of breach of fiduciary duty, unjust enrichment, and insider trading, among others. The complaint seeks unspecified damages on behalf of Align, which is named solely as nominal defendant against whom no recovery is sought. The complaint also seeks an order directing Align to reform and improve its corporate governance and internal procedures, and seeks restitution in an unspecified amount, costs, and attorneys’ fees. On July 8, 2013, an Order was entered staying this derivative lawsuit until an initial ruling on our first motion to dismiss the Securities Action. On January 15, 2014, an Order was entered staying this derivative lawsuit until an initial ruling on our second motion to dismiss the Securities Action. On October 14, 2014, an Order was entered staying this derivative lawsuit until a ruling by the Ninth Circuit in the Securities Action discussed above. Align is currently unable to predict the outcome of this complaint and therefore cannot determine the likelihood of loss nor estimate a range of possible losses, if any.\nIn addition, in the course of Align's operations, Align is involved in a variety of claims, suits, investigations, and proceedings, including actions with respect to intellectual property claims, patent infringement claims, government investigations, labor and employment claims, breach of contract claims, tax, and other matters. Regardless of the outcome, these proceedings can have an adverse impact on us because of defense costs, diversion of management resources, and other factors. Although the results of complex legal proceedings are difficult to predict and Align's view of these matters may change in the future as litigation and events related thereto unfold; Align currently does not believe that these matters, individually or in the aggregate, will materially affect Align's financial position, results of operations or cash flows.\nNote 7. Credit Facility\nThe credit facility provides for a $50.0 million revolving line of credit, with a $10.0 million letter of credit sublimit. The credit facility requires us to comply with specific financial conditions and performance requirements. On December 13, 2016, we amended the credit facility to remove the requirement to maintain a minimum unrestricted cash balance of $50.0 million. On February 10, 2017, we amended the credit facility and extended the maturity date to March 22, 2018. The loans bear interest, at our option, at a fluctuating rate per annum equal to the daily one-month adjusted LIBOR rate plus a spread of 1.75% or an adjusted LIBOR rate (based on one, three, six or twelve-month interest periods) plus a spread of 1.75%. As of December 31, 2016, we had\n79\nno outstanding borrowings under this credit facility and were in compliance with the conditions and performance requirements.\nNote 8. Commitments and Contingencies\nOperating Leases\nWe lease our facilities and certain equipment and automobiles under non-cancelable operating lease arrangements that expire at various dates through 2024 and provide for pre-negotiated fixed rental rates during the terms of the lease. The terms of some of our leases provide for rental payments on a graduated scale. We recognize rent expense on a straight-line basis over the lease period and accrue for any rent expense incurred but not paid. Total rent expense was $9.9 million, $8.2 million and $7.6 million, for the year ended December 31, 2016, 2015 and 2014, respectively.\nMinimum future lease payments for non-cancelable leases as of December 31, 2016, are as follows (in thousands):\n\n| Fiscal Year | Operating Leases |\n| 2017 | $ | 12,880 |\n| 2018 | 10,338 |\n| 2019 | 8,466 |\n| 2020 | 6,849 |\n| 2021 | 6,247 |\n| Thereafter | 9,141 |\n| Total minimum lease payments | $ | 53,921 |\n\nOther Commitments\nOn July 25, 2016, we entered into a Loan and Security Agreement (the \"Loan Agreement\") with SmileDirectClub, LLC (\"SDC\") where we agreed to provide a loan of up to $15.0 million in one or more advances to SDC (the \"Loan Facility\"). Available advances under the Loan Facility are subject to a borrowing base of 80% of SDC's eligible accounts receivable, determined in accordance with the terms of the Loan Agreement, and the satisfaction of other customary conditions. The advances bear interest, paid quarterly, at the rate of 7% per annum. Advances that are repaid or prepaid may be reborrowed. All outstanding principal and accrued and unpaid interest on the advances are due and payable on July 25, 2021. SDC's obligations in respect of the Loan Agreement are collateralized by a security interest in substantially all of SDC's assets. As of December 31, 2016, no advances on the Loan Facility were issued or outstanding (Refer to Note 4 \"Equity Method Investments\" of the Notes of Consolidated Financial Statements for more information on our investments in SDC).\nWe have entered into certain investments with a privately held company where we have committed to purchase up to $5.0 million in convertible promissory notes. The first convertible promissory note for $2.0 million was issued in July 2016 and is outstanding as of December 31, 2016. The remaining $3.0 million is conditioned upon achievement of various business milestones. The notes all mature on December 30, 2018 and accrue interest annually at 2.5%.\nOn December 19, 2016, we entered into a Purchase and Sale Agreement (the \"Purchase Agreement\") with LBA RIV-COMPANY XXX, LLC (\"Seller\") to purchase the real property located in San Jose, California (the \"Property\") for purchase price of $44.1 million. The Property is comprised of land, building and other fixtures as set forth in the Purchase Agreement. As of December 31, 2016, $1.0 million was deposited into escrow and recorded in other current assets in our Consolidated Balance Sheet. We had a right to inspect the Property until January 6, 2017 and if we decided to terminate the Purchase Agreement during the period, the deposit would have been refunded to us. On January 26, 2017, we paid the purchase price of $44.1 million and closed the Purchase Agreement.\nOff-Balance Sheet Arrangements\nAs of December 31, 2016, we had no off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our consolidated financial condition, results of operations, liquidity, capital expenditures or capital resources.\n80\nIndemnification Provisions\nIn the normal course of business to facilitate transactions in our services and products, we indemnify certain parties: customers, vendors, lessors, and other parties with respect to certain matters, including, but not limited to, services to be provided by us and intellectual property infringement claims made by third parties. In addition, we have entered into indemnification agreements with our directors and our executive officers that will require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors or officers. Several of these agreements limit the time within which an indemnification claim can be made and the amount of the claim.\nIt is not possible to make a reasonable estimate of the maximum potential amount under these indemnification agreements due to the unique facts and circumstances involved in each particular agreement. Additionally, we have a limited history of prior indemnification claims and the payments we have made under such agreements have not had a material adverse effect on our results of operations, cash flows or financial position. However, to the extent that valid indemnification claims arise in the future, future payments by us could be significant and could have a material adverse effect on our results of operations or cash flows in a particular period. As of December 31, 2016, we did not have any material indemnification claims that were probable or reasonably possible.\nNote 9. Stockholders’ Equity\nCommon Stock\nThe holders of common stock are entitled to receive dividends whenever funds are legally available and when and if declared by the Board of Directors. We have never declared or paid dividends on our common stock.\nStock-Based Compensation Plans\nOur 2005 Incentive Plan, as amended, provides for the granting of incentive stock options, non-statutory stock options, restricted stock units, market stock units, stock appreciation rights, performance units and performance shares to employees, non-employee directors, and consultants. Shares granted on or after May 16, 2013 as an award of restricted stock, restricted stock unit, market stock units, performance share or performance unit (\"full value awards\") are counted against the authorized share reserve as one and nine-tenths (1 9/10) shares for every one (1) share subject to the award, and any shares canceled that were counted as one and nine-tenths against the plan reserve will be returned at the same ratio. Full value awards granted prior to May 16, 2013 were counted against the authorized share reserve as one and one half (1 1/2) share for every one (1) share subject to the award, and any shares canceled that were counted as one and one half against the plan reserve will be returned at this same ratio.\nAs of December 31, 2016, the 2005 Incentive Plan (as amended) has a total reserve of 27,783,379 shares for issuance of which 8,023,709 shares are available for issuance. In 2016, we added 4,500,000 shares to our pool and no shares were added to the plan in 2015. We issue new shares from our pool of authorized but unissued shares to satisfy the exercise and vesting obligations of our stock-based compensation plans.\nStock-Based Compensation\nStock-based compensation is based on the estimated fair value of awards, net of estimated forfeitures, and recognized over the requisite service period. Estimated forfeitures are based on historical experience at the time of grant and may be revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The stock-based compensation related to all of our stock-based awards and employee stock purchases for the year ended December 31, 2016, 2015 and 2014 is as follows (in thousands):\n| For the Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| Cost of net revenues | $ | 3,966 | $ | 3,938 | $ | 3,616 |\n| Selling, general and administrative | 42,612 | 40,813 | 29,625 |\n| Research and development | 7,570 | 8,192 | 6,582 |\n| Total stock-based compensation | $ | 54,148 | $ | 52,943 | $ | 39,823 |\n\n81\nStock Options\nWe have not granted options since 2011 and all outstanding options were fully vested in 2015. Activity for the year ended December 31, 2016, under the stock option plans are set forth below (in thousands, except years and per share amounts):\n| Stock Options |\n| Number ofSharesUnderlyingStock Options | WeightedAverageExercisePrice per Share | Weighted AverageRemainingContractual Term(in years ) | AggregateIntrinsicValue |\n| Outstanding as of December 31, 2015 | 496 | 15.14 |\n| Granted | — | — |\n| Exercised | (274 | ) | 15.33 |\n| Cancelled or expired | — | — |\n| Outstanding as of December 31, 2016 | 222 | $ | 14.90 | 1.12 | $ | 18,058 |\n| Vested and expected to vest at December 31, 2016 | 222 | $ | 14.90 | 1.12 | $ | 18,058 |\n| Exercisable at December 31, 2016 | 222 | $ | 14.90 | 1.12 | $ | 18,058 |\n\nThe aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between our closing stock price on the last trading day in 2016 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on the last trading day of 2016. This amount will fluctuate based on the fair market value of our stock. The total intrinsic value of stock options exercised for the year ended December 31, 2016, 2015 and 2014 was $18.2 million, $7.4 million and $24.5 million, respectively. The total fair value of the options vested during the year ended December 31, 2016, 2015 and 2014 was not material.\nRestricted Stock Units\nThe fair value of nonvested restricted stock units (“RSUs”) is based on our closing stock price on the date of grant. A summary for the year ended December 31, 2016, is as follows (in thousands, except years and per share amounts):\n\n| SharesUnderlying RSUs | Weighted Average Grant Date Fair Value | WeightedRemainingVesting Period(in years) | AggregateIntrinsicValue |\n| Nonvested as of December 31, 2015 | 2,079 | $ | 49.45 |\n| Granted | 714 | 67.82 |\n| Vested and released | (859 | ) | 45.45 |\n| Forfeited | (145 | ) | 53.36 |\n| Nonvested as of December 31, 2016 | 1,789 | $ | 58.39 | 1.12 | $ | 171,934 |\n\nThe aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (calculated by multiplying our closing stock price on the last trading day of 2016 by the number of nonvested RSUs) that would have been received by the unit holders had all RSUs been vested and released as of the last trading day of 2016. This amount will fluctuate based on the fair market value of our stock. During 2016, of the 859,410 shares vested and released, 300,031 vested shares were withheld for employee minimum statutory tax obligations, resulting in a net issuance of 559,379 shares.\nThe total intrinsic value of RSUs vested and released during 2016, 2015 and 2014 was $59.8 million, $45.9 million and $38.9 million, respectively. The total fair value RSUs vested during the year ended December 31, 2016, 2015 and 2014 was $39.1 million, $30.0 million and $22.0 million, respectively. The weighted average grant date fair value of RSUs granted during 2016, 2015 and 2014 was $67.82, $57.78 and $53.72, respectively. As of December 31, 2016, there was $63.3 million of total unamortized compensation costs, net of estimated forfeitures, related to RSUs and these costs are expected to be recognized over a weighted average period of 2.0 years.\nOn an annual basis, we grant market-performance based restricted stock units (“MSUs”) to our executive officers. Each MSU represents the right to one share of Align’s common stock and will be issued through our amended 2005 Incentive Plan. The actual\n82\nnumber of MSUs which will be eligible to vest will be based on the performance of Align’s stock price relative to the performance of the NASDAQ Composite Index over the vesting period, generally two to three years, up to 150% of the MSUs initially granted.\nThe following table summarizes the MSU performance as of December 31, 2016:\n| Number of SharesUnderlying MSUs(in thousands) | Weighted Average Grant Date Fair Value | Weighted AverageRemainingVesting Period(in years ) | AggregateIntrinsic Value(in thousands) |\n| Nonvested as of December 31, 2015 | 611 | 51.41 |\n| Granted | 218 | 55.77 |\n| Vested and released | (270 | ) | 36.73 |\n| Forfeited | (39 | ) | 56.41 |\n| Nonvested as of December 31, 2016 | 520 | 60.49 | 1.1 | $ | 50,021 |\n\nThe aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (calculated by multiplying our closing stock price on the last trading day of 2016 by the number of non-vested MSUs) that would have been received by the unit holders had all MSUs been vested and released as of the last trading day of 2016. This amount will fluctuate based on the fair market value of our stock. During 2016, of the 270,347 shares vested and released 136,758 shares were withheld for tax payments, resulting in a net issuance of 133,589 shares.\nThe total intrinsic value of MSUs vested and released during 2016, 2015 and 2014 was $17.4 million, $9.2 million and $2.9 million. The total fair value MSUs vested during the year ended December 31, 2016, 2015 and 2014 was $9.9 million, $4.9 million and $1.2 million, respectively. As of December 31, 2016, we expect to recognize $11.1 million of total unamortized compensation cost, net of estimated forfeitures, related to MSUs over a weighted average period of 1.1 years.\nThe fair value of the MSUs is estimated at the grant date using a Monte Carlo simulation that includes factors for market conditions. The following weighted-average assumptions used in the Monte Carlo simulation were as follows:\n| Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| Expected term (in years) | 3 | 3 | 3 |\n| Expected volatility | 34.0 | % | 36.9 | % | 46.0 | % |\n| Risk-free interest rate | 0.9 | % | 1.0 | % | 0.7 | % |\n| Expected dividends | — | — | — |\n| Weighted average fair value per share at grant date | $ | 68.88 | $ | 61.73 | $ | 50.46 |\n\nTotal payments to tax authorities for payroll taxes related to RSUs, including MSUs, that vested during the period were $29.9 million, $20.7 million and $7.6 million during the year ended December 31, 2016, 2015 and 2014, respectively, reflected as a financing activity in the Consolidated Statement of Cash Flows.\nEmployee Stock Purchase Plan\nIn May 2010, our shareholders approved the 2010 Employee Stock Purchase Plan (the “2010 Purchase Plan”), replacing our 2001 Employee Stock Purchase Plan, which consists of consecutive overlapping twenty-four month offering periods with four six-month purchase periods in each offering period. Employees purchase shares at 85% of the fair market value of the common stock at either the beginning of the offering period or the end of the purchase period, whichever is lower. The 2010 Purchase Plan will continue until terminated by either the Board of Directors or its administrator. The maximum number of shares available for issuance under the 2010 Purchase Plan is 2,400,000 shares. During the year ended December 31, 2016, 2015 and 2014, we issued 196,882, 230,078 and 247,343 shares, respectively, at average prices of $48.65, $36.66 and $29.24, respectively. As of December 31, 2016, 936,867 shares remain available for future issuance.\nThe fair value of the option component of the 2010 Purchase Plan shares was estimated at the grant date using the Black-Scholes option pricing model with the following weighted average assumptions:\n83\n| Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| Expected term (in years) | 1.2 | 1.2 | 1.2 |\n| Expected volatility | 30.5 | % | 31.1 | % | 38.8 | % |\n| Risk-free interest rate | 0.7 | % | 0.3 | % | 0.2 | % |\n| Expected dividends | — | — | — |\n| Weighted average fair value at grant date | $ | 22.23 | $ | 16.19 | $ | 17.15 |\n\nWe recognized stock-based compensation expense of $2.7 million, $4.1 million and $2.6 million related to our employee stock purchase plans for the year ended December 31, 2016, 2015 and 2014, respectively. As of December 31, 2016, there was $0.7 million of total unamortized compensation costs related to employee stock purchases which we expect to be recognized over a weighted average period of 0.3 years.\nNote 10. Common Stock Repurchase Program\nApril 2014 Repurchase Program\nOn April 23, 2014, we announced that our Board of Directors had authorized a stock repurchase program (\"April 2014 Repurchase Program\") pursuant to which we may purchase up to $300.0 million of our common stock over a three year period.\nIn 2014, we entered into an accelerated share repurchase agreement (\"2014 ASR\") to repurchase $70.0 million of our common stock. The 2014 ASR was completed in July 2014. We received a total of approximately 1.4 million shares for an average purchase price per share of $51.46. During 2014, we repurchased on the open market approximately 0.6 million shares of our common stock at an average price of $50.93 per share, including commissions, for an aggregate purchase price of approximately $28.2 million.\nIn 2015, we entered into an accelerated share purchase agreement (\"2015 ASR\") to repurchase $70.0 million of our common stock. The 2015 ASR was completed in July 2015. We received a total of approximately 1.2 million shares for an average share price of $60.52. During 2015, we repurchased on the open market approximately 0.5 million shares of our common stock at an average price of $58.89 per share, including commissions, for an aggregate purchase price of approximately $31.8 million.\nIn 2016, we entered into an accelerated share repurchase agreement (\"2016 ASR\") to repurchase $50.0 million of our common stock. The 2016 ASR was completed in September 2016. We received a total of approximately 0.6 million shares for an average share price of $81.89. During 2016, we repurchased on the open market approximately 0.5 million shares of our common stock at an average price of $92.58 per share, including commissions, for an aggregate purchase price of approximately $46.2 million.\nAll shares repurchased in 2016, 2015 and 2014 were retired.\nAs of December 31, 2016, we have $3.8 million remaining under the April 2014 Repurchase Program.\nApril 2016 Repurchase Program\nOn April 28, 2016, we announced that our Board of Directors had authorized an additional plan to repurchase up to $300.0 million of the Company's stock (\"April 2016 Repurchase Plan\"). Any purchases under this stock repurchase program may be made, from time-to-time, pursuant to open market purchases (including pursuant to Rule 10b5-1 plans), privately-negotiated transactions, accelerated stock repurchases, block trades or derivative contracts or otherwise in accordance with applicable federal securities laws, including Rule 10b-18 of the Securities Exchange Act of 1934. As of December 31, 2016, there have not been any repurchases under this plan.\n84\nNote 11. Employee Benefit Plans\n401(k) Plan\nIn January 1999, we adopted a defined contribution retirement plan under Section 401(k) of the Internal Revenue Code for our U.S. employees. This plan covers substantially all U.S. employees who meet minimum age and service requirements and allows participants to defer a portion of their annual compensation on a pre-tax basis. In 2009, our Board of Directors authorized us to match 50% of our employee’s salary deferral contributions up to a 6% of the employee’s eligible compensation effective 2010. We contributed approximately $3.4 million, $2.7 million and $2.2 million to the 401(k) plan during the year ended December 31, 2016, 2015 and 2014, respectively.\nIsraeli Funds\nUnder the Israeli severance fund law, we are required to make payments to dismissed employees and employees leaving employment in certain circumstances. The funding is calculated based on the salary of the employee multiplied by the number of years of employment as of the applicable balance sheet date. Our Israeli employees are entitled to one month’s salary for each year of employment, or a pro-rata portion thereof. We fund the liability through monthly deposits into funds, and the values of these contributions are recorded in other current assets.\nAs of December 31, 2016 and 2015, the accrued funds liability was approximately $3.1 million and $2.7 million, respectively.\nNote 12. Income Taxes\n| Year ended December 31, |\n| 2016 | 2015 | 2014 |\n| Domestic | $ | 118,871 | $ | 87,803 | $ | 94,784 |\n| Foreign | 123,695 | 98,298 | 95,585 |\n| Net income before provision for income taxes and equity in losses of investee | $ | 242,566 | $ | 186,101 | $ | 190,369 |\n\nThe provision for income taxes consists of the following (in thousands):\n| Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| Federal |\n| Current | $ | 40,235 | $ | 28,596 | $ | 1,569 |\n| Deferred | 24,794 | 6,679 | 37,570 |\n| 65,029 | 35,275 | 39,139 |\n| State |\n| Current | 2,603 | 3,271 | 2,162 |\n| Deferred | 2,636 | (703 | ) | 971 |\n| 5,239 | 2,568 | 3,133 |\n| Foreign |\n| Current | 8,964 | 4,305 | 1,596 |\n| Deferred | (28,032 | ) | (67 | ) | 669 |\n| (19,068 | ) | 4,238 | 2,265 |\n| Provision for income taxes | $ | 51,200 | $ | 42,081 | $ | 44,537 |\n\nThe differences between income taxes using the federal statutory income tax rate of 35% and our effective tax rate are as follows:\n85\n| Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| U.S. federal statutory income tax rate | 35.0 | % | 35.0 | % | 35.0 | % |\n| State income taxes, net of federal tax benefit | 2.1 | 1.5 | 1.6 |\n| Impact of differences in foreign tax rates | (6.3 | ) | (16.2 | ) | (16.4 | ) |\n| Valuation allowance release for Israel | (12.9 | ) | — | — |\n| Stock-based compensation | 1.2 | 1.6 | 1.0 |\n| Other items not individually material | 2.0 | 0.7 | 2.2 |\n| 21.1 | % | 22.6 | % | 23.4 | % |\n\nAs of December 31, 2016, approximately $438.0 million of undistributed earnings from non-U.S. operations held by our foreign subsidiaries are designated as indefinitely reinvested outside the U.S. We maintain sufficient cash reserves in the U.S. and do not intend to repatriate our foreign earnings. As a result, U.S. income taxes and foreign withholding taxes have not been provided on these foreign earnings. If these earnings were distributed in the form of dividends or otherwise, or if the shares of the relevant foreign subsidiaries were sold or otherwise transferred, we would be subject to additional U.S. income taxes subject to an adjustment for foreign tax credits and foreign withholding taxes. We intend to use the undistributed earnings for local operating expansions and to meet local operating working capital needs. In addition, a significant amount of the cash earned by foreign subsidiaries has been and will continue to be utilized to affect the new international corporate structure described above.\nOn July 1, 2016, we implemented a new international corporate structure. This changes the structure of our international procurement and sales operations, as well as realigns the ownership and use of intellectual property among our wholly-owned subsidiaries. We continue to anticipate that an increasing percentage of our consolidated pre-tax income will be derived from, and reinvested in our foreign operations. We believe that income taxed in certain foreign jurisdictions at a lower rate relative to the U.S. federal statutory rate will have a beneficial impact on our worldwide effective tax rate over time. Although the license of intellectual property rights between consolidated entities did not result in any gain in the consolidated financial statements, the Company generated taxable income in certain jurisdictions in 2016 resulting in a tax expense of $34.3 million. Additionally, as a result of the restructuring, we reassessed the need for a valuation allowance against our deferred tax assets considering all available evidence. Given the current earnings and anticipated future earnings of our subsidiary in Israel, we concluded that we have sufficient positive evidence to release the valuation allowance against our Israel operating loss carryforwards of $31.4 million, which resulted in an income tax benefit in this period of the same amount.\nIn June 2009, the Costa Rica Ministry of Foreign Trade, an agency of the Government of Costa Rica, granted a twelve year extension of certain tax incentives, which were previously granted in 2002. The incentive tax rates will expire in various years beginning in July 2017. We intend to seek a renewal of these income tax incentives before they expire. Under these incentives, all of the income in Costa Rica during these twelve year incentive periods is subject to a reduced tax rate. In order to receive the benefit of these incentives, we must hire specified numbers of employees and maintain certain minimum levels of fixed asset investment in Costa Rica. If we do not fulfill these conditions for any reason, our incentive could lapse, and our income in Costa Rica would be subject to taxation at higher rates, which could have a negative impact on our operating results. The Costa Rica corporate income tax rate that would apply, absent the incentives, is 30% for 2016, 2015 and 2014. As a result of these incentives, income taxes were reduced by $19.1 million, $32.7 million and $32.5 million in the year ended December 31, 2016, 2015 and 2014, respectively. The benefit of the tax holiday on diluted net income per share was $0.23 in the year ended December 31, 2016 and $0.40 for both the year ended December 31, 2015 and 2014.\n86\n| Year Ended December 31, |\n| 2016 | 2015 |\n| Deferred tax assets: |\n| Net operating loss and capital loss carryforwards | $ | 25,445 | $ | 31,247 |\n| Reserves and accruals | 22,954 | 17,455 |\n| Stock-based compensation | 16,399 | 16,523 |\n| Deferred revenue | 13,975 | 24,432 |\n| Net translation losses | 1,634 | 649 |\n| Credit carryforwards | 679 | 1,932 |\n| 81,086 | 92,238 |\n| Deferred tax liabilities: |\n| Depreciation and amortization | 12,034 | 8,555 |\n| Prepaid expenses | 969 | 601 |\n| 13,003 | 9,156 |\n| Net deferred tax assets before valuation allowance | 68,083 | 83,082 |\n| Valuation allowance | (256 | ) | (31,685 | ) |\n| Net deferred tax assets | $ | 67,827 | $ | 51,397 |\n\nAs of December 31, 2016, the valuation allowance decreased by $31.4 million in comparison to the balance at December 31, 2015. This decrease was due to the release of the valuation allowance against our Israel net deferred tax assets during the year. We determined that these deferred tax assets are more likely than not to be realized based upon our assessment of the available positive and negative evidence. Positive evidence, including expected profitability based upon the implementation of our international corporate restructuring outweighed available negative evidence, which included losses in recent years. The total valuation allowance as of December 31, 2016 was not material.\nAs of December 31, 2016, we have fully utilized California net operating loss carryforwards. As of December 31, 2016, we have California research credit carryforwards of approximately $3.7 million which can be carried forward indefinitely. In addition, we have foreign net operating loss carryforwards of approximately $104.3 million, which, if not utilized will expire beginning in 2025.\nIn the event of a change in ownership, as defined under federal and state tax laws, our tax credit carryforwards may be subject to annual limitations. The annual limitations may result in the expiration of the tax credit carryforwards before utilization.\nThe changes in the balance of gross unrecognized tax benefits, which exclude interest and penalties, for the year ended December 31, 2016, 2015 and 2014, are as follows (in thousands):\n| Unrecognized tax benefit as of December 31, 2013 | $ | 26,668 |\n| Tax positions related to current year: |\n| Additions for uncertain tax positions | 6,659 |\n| Tax positions related to prior year: |\n| Reductions for uncertain tax positions | (260 | ) |\n| Unrecognized tax benefit as of December 31, 2014 | 33,067 |\n| Tax positions related to current year: |\n| Additions for uncertain tax positions | 6,346 |\n| Unrecognized tax benefit as of December 31, 2015 | 39,413 |\n| Tax positions related to current year: |\n| Additions for uncertain tax positions | 6,971 |\n| Unrecognized tax benefit as of December 31, 2016 | $ | 46,384 |\n\n87\nWe account for uncertain tax positions pursuant to authoritative guidance based on a two-step approach to recognize and measure uncertain tax positions taken or expected to be taken in a tax return. We first determine whether it is more likely than not that a tax position will be sustained upon audit based on its technical merits. If a tax position meets the more-likely-than-not recognition threshold it is then measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured as the largest amount of benefit that is more than 50 percent likely to be realized upon ultimate settlement. We adjust our uncertain tax positions due to changing facts and circumstances, such as the closing of a tax audit, or refinement of estimates due to new information. To the extent the final outcome of these matters is different than the amounts recorded, such differences will impact our tax provision in our Consolidated Statements of Operations in the period in which such determination is made.\nDuring fiscal year 2016, the amount of gross unrecognized tax benefits increased by $7.0 million in comparison to fiscal year 2015. The total amount of unrecognized tax benefits, excluding interest and penalties, was $46.4 million and $39.4 million as of December 31, 2016 and 2015, respectively, all of which would impact our effective tax rate if recognized. We have elected to recognize interest and penalties related to unrecognized tax benefits as a component of income taxes. For the year ended December 31, 2016 and 2015, interest and penalties included in tax expense was $1.4 million and $0.7 million, respectively. Our total interest and penalties accrued as of December 31, 2016 and 2015 was $2.1 million and $0.7 million, respectively. We do not expect any significant changes to the amount of unrecognized tax benefit within the next twelve months.\nWe file U.S. federal, U.S. state, and non-U.S. income tax returns. Our major tax jurisdictions are U.S. federal and the State of California. For U.S. federal and state tax returns, we are no longer subject to tax examinations for years before 2000. With few exceptions, we are no longer subject to examination by foreign tax authorities for years before 2007. Our subsidiary in Israel is under audit by the local tax authorities for calendar years 2006 through 2013.\nNote 13. Net Income per Share\nBasic net income per share is computed using the weighted average number of shares of common stock outstanding during the period. Diluted net income per share is computed using the weighted average number of shares of common stock, adjusted for any dilutive effect of potential common stock. Potential common stock, computed using the treasury stock method, includes RSU, MSU, stock options and our ESPP.\nThe following table sets forth the computation of basic and diluted net income per share attributable to common stock (in thousands, except per share amounts):\n| Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| Numerator: |\n| Net income | $ | 189,682 | $ | 144,020 | $ | 145,832 |\n| Denominator: |\n| Weighted-average common shares outstanding, basic | 79,856 | 79,998 | 80,754 |\n| Dilutive effect of potential common stock | 1,628 | 1,523 | 1,529 |\n| Total shares, diluted | 81,484 | 81,521 | 82,283 |\n| Net income per share, basic | $ | 2.38 | $ | 1.80 | $ | 1.81 |\n| Net income per share, diluted | $ | 2.33 | $ | 1.77 | $ | 1.77 |\n\nFor the year ended December 31, 2016, 2015 and 2014, the anti-dilutive effect on net income per share from RSUs, MSUs and ESPP was not material.\n88\nNote 14. Supplemental Cash Flow Information\nThe supplemental cash flow information consists of the following (in thousands):\n| Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| Taxes paid | $ | 47,289 | $ | 40,621 | $ | 5,666 |\n| Non-cash investing activities: |\n| Fixed assets acquired with accounts payable or accrued liabilities | $ | 4,434 | $ | 14,636 | $ | 4,899 |\n\nNote 15. Segments and Geographical Information\nSegment Information\nOperating segments are defined as components of an enterprise for which separate financial information is available that is evaluated regularly by the Chief Operating Decision Maker (“CODM”), or decision-making group, in deciding how to allocate resources and in assessing performance. Our CODM is our Chief Executive Officer. We report segment information based on the management approach. The management approach designates the internal reporting used by CODM for decision making and performance assessment as the basis for determining our reportable segments. The performance measures of our reportable segments include net revenues and gross profit. In the fourth quarter of 2016, management decided to change the way it internally assesses the performance of our reportable segments by including income from operations measure in the performance metrics. Income from operations for each segment includes all geographic revenues, related cost of net revenues and operating expenses directly attributable to the segment. Certain operating expenses are attributable to operating segments and each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. Costs not specifically allocated to segment income from operations include various corporate expenses such as stock-based compensation and costs related to IT, facilities, human resources and accounting and finance, legal and regulatory, and other separately managed general and administrative costs outside the operating segments. We have included the new performance measure in the prior periods presentation to conform to the current year’s presentation.\nWe have grouped our operations into two reportable segments which are also our reporting units: Clear Aligner segment and Scanner segment.\n| • | Our Clear Aligner segment consists of our Invisalign System which includes Invisalign Full, Express/Lite, Teen, Assist, Vivera Retainers, along with our training and ancillary products for treating malocclusion. Clear Aligner segment also include the sale of aligners to SDC under our supply agreement which commenced in the fourth quarter of 2016. SDC revenue is recorded after eliminating outstanding intercompany transactions. |\n\n| • | Our Scanner and Services (\"Scanner\") segment consists of intraoral scanning systems and additional services available with the intraoral scanners that provide digital alternatives to the traditional cast models. This segment includes our iTero scanner and OrthoCAD services. |\n\nThese reportable operating segments are based on how our CODM views and evaluates our operations as well as allocation of resources. The following information relates to these segments (in thousands):\n89\n| For the Year Ended December 31, |\n| Net Revenues | 2016 | 2015 | 2014 |\n| Clear Aligner | $ | 958,327 | $ | 800,186 | $ | 712,549 |\n| Scanner | 121,547 | 45,300 | 49,104 |\n| Total net revenues | $ | 1,079,874 | $ | 845,486 | $ | 761,653 |\n| Gross Profit |\n| Clear Aligner | $ | 747,494 | $ | 628,187 | $ | 562,889 |\n| Scanner | 67,800 | 11,923 | 15,554 |\n| Total gross profit | $ | 815,294 | $ | 640,110 | $ | 578,443 |\n| Income from Operations |\n| Clear Aligner | $ | 411,817 | $ | 371,113 | $ | 341,055 |\n| Scanner | 37,498 | (12,337 | ) | (8,483 | ) |\n| Unallocated corporate expenses | (200,394 | ) | (170,142 | ) | (138,996 | ) |\n| Total income from operations | $ | 248,921 | $ | 188,634 | $ | 193,576 |\n| Depreciation and Amortization |\n| Clear Aligner | $ | 13,742 | $ | 9,842 | $ | 8,706 |\n| Scanner | 3,871 | 3,839 | 4,498 |\n| Unallocated corporate expenses | 6,389 | 4,323 | 4,652 |\n| Total depreciation and amortization | $ | 24,002 | $ | 18,004 | $ | 17,856 |\n\nThe following table reconciles total segment income from operations in the table above to net income before provision for income taxes and equity losses of investee:\n| For the Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| Total segment income from operations | $ | 449,315 | $ | 358,776 | $ | 332,572 |\n| Unallocated corporate expenses | (200,394 | ) | (170,142 | ) | (138,996 | ) |\n| Total income from operations | 248,921 | 188,634 | 193,576 |\n| Interest and other income (expense), net | (6,355 | ) | (2,533 | ) | (3,207 | ) |\n| Net income before provision for income taxes and equity losses of investee | $ | 242,566 | $ | 186,101 | $ | 190,369 |\n\nGeographical Information\nNet revenues are presented below by geographic area (in thousands):\n| For the Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| Net revenues (1): |\n| United States (2) | $ | 692,254 | $ | 585,874 | $ | 532,569 |\n| The Netherlands (2) | 291,053 | 167,128 | 156,817 |\n| Other International | 96,567 | 92,484 | 72,267 |\n| Total net revenues | $ | 1,079,874 | $ | 845,486 | $ | 761,653 |\n\n| (1) | Net revenues are attributed to countries based on location of where revenue is recognized. |\n\n(2) During 2016, we implemented a new international corporate structure. This changed the structure of our international procurement and sales operations.\n90\nTangible long-lived assets are presented below by geographic area (in thousands):\n| As of December 31, |\n| 2016 | 2015 |\n| Long-lived assets (1): |\n| The Netherlands (2) | $ | 111,515 | $ | 486 |\n| United States (2) | 43,278 | 112,632 |\n| Mexico | 17,918 | 15,422 |\n| Other International | 2,456 | 7,933 |\n| Total long-lived assets | $ | 175,167 | $ | 136,473 |\n\n(1) Long-lived assets are attributed to countries based on entity that owns the assets.\n(2) As a result of the new international corporate structure changes, approximately $92.0 million in long-lived assets were transferred from the U.S. to our Netherlands entity in 2016.\nITEM 9.\nCHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE\nNone\n\nITEM 9A.\nCONTROLS AND PROCEDURES\nEvaluation of disclosure controls and procedures.\nUnder the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective as of December 31, 2016 to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure, and that such information is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms.\nManagement's annual report on internal control over financial reporting.\nSee “Report of Management on Internal Control over Financial Reporting” of this Annual Report on Form 10-K.\nChanges in internal control over financial reporting.\nThere have been no changes in our internal control over financial reporting during the quarter ended December 31, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\nITEM 9B.\nOTHER INFORMATION\nNone.\n91\nPART III\nCertain information required by Part III is omitted from this Form 10-K because we intend to file a definitive Proxy Statement for our 2017 Annual Meeting of Stockholders (the “Proxy Statement”) not later than 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K, and certain information to be included therein is incorporated herein by reference.\n\nITEM 10.\nDIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE\nThe information required by Item 401 of Regulation S-K concerning our directors is incorporated by reference to the Proxy Statement under the section captioned “Election of Directors.” The information required by Item 401 of Regulation S-K concerning our executive officers is set forth in Item 1— “Business” of this Annual Report on Form 10-K. The information required by Item 405 of Regulation S-K is incorporated by reference to the section entitled “Section 16(a) Beneficial Ownership Reporting Compliance” contained in the Proxy Statement. The information required by Item 407(c)(3), 407(d)(4) and 407(d)(5) of Regulation S-K is incorporated by reference to the Proxy Statement under the section entitled “Corporate Governance”.\nCode of Ethics\nWe have a code of ethics that applies to all of our employees, including our principal executive officer, principal financial officer and principal accounting officer. This code of ethics is posted on our Internet website. The Internet address for our website is www.aligntech.com, and the code of ethics may be found on the “Corporate Governance” section of our “Investor Relations” webpage.\nWe intend to satisfy the disclosure requirement under Item 5.05 of Form 8-K regarding an amendment to, or waiver from, a provision of this code of ethics by posting such information on our website, at the address and location specified above, or as otherwise required by the NASDAQ Global Market.\n\nITEM 11.\nEXECUTIVE COMPENSATION\nThe information required by Item 402 of Regulation S-K is incorporated by reference to the Proxy Statement under the section captioned “Executive Compensation.” The information required by Items 407(e)(4) and (e)(5) is incorporated by reference to the Proxy Statement under the section captioned “Corporate Governance—Compensation Committee Interlocks” and “Compensation Committee Report,” respectively.\nITEM 12.\nSECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS\nThe information required by Item 403 of Regulation S-K is incorporated by reference to the Proxy Statement under the section captioned “Security Ownership of Certain Beneficial Owners and Management.”\nEquity Compensation Plan Information\nThe following table provides information as of December 31, 2016 about our common stock that may be issued upon the exercise of options and rights granted to employees, consultants or members of our Board of Directors under all existing equity compensation plans, including the 1997 Equity Incentive Plan, the Employee Stock Purchase Plan (\"ESPP\"), the 2001 Stock Incentive Plan and the 2005 Incentive Plan, each as amended, and certain individual arrangements. Please see Note 9 “Stockholders’ Equity” in the Notes to consolidated financial statements for a description of equity compensation plans.\n\n| Plan Category | Number of securitiesto be issued upon exerciseof outstanding optionsand restricted stockunits(a) | Weighted averageexercise price ofoutstandingoptions(b) | Number of securitiesremaining available forfuture issuance underequity compensation plans(excluding securitiesreflected in column(a)) |\n| Equity compensation plans approved by security holders | 2,531,027 | 1 | $ | 14.90 | 9,454,960 | 2, 3 |\n| Equity compensation plans not approved by security holders | — | — | — |\n| Total | 2,531,027 | $ | 14.90 | 9,454,960 |\n\n92\n\n| 1 | Includes 1,788,372 restricted stock units and 520,350 market-performance based restricted stock units at target, which have an exercise price of zero. |\n\n| 2 | Includes 936,867 shares available for issuance under our ESPP. We are unable to ascertain with specificity the number of securities to be issued upon exercise of outstanding rights or the weighted average exercise price of outstanding rights under the ESPP. |\n\n| 3 | Excludes 494,333 of potentially issuable MSUs if performance targets are achieved at maximum payout. |\n\nITEM 13.\nCERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE\nThe information required by Item 404 and Item 407 of Regulation S-K is incorporated by reference to the Proxy Statement under the sections captioned “Certain Relationships and Related Party Transactions” and “Corporate Governance—Director Independence,” respectively.\n\nITEM 14.\nPRINCIPAL ACCOUNTING FEES AND SERVICES\nThe information required by Item 9(e) of Schedule 14A of the Securities Act of 1934, as amended, is incorporated by reference to the Proxy Statement under the section captioned “Ratification of Appointment of Independent Registered Public Accountants.”\n93\nPART IV\n\nITEM 15.\nEXHIBITS, FINANCIAL STATEMENT SCHEDULES\n| (a) | Financial Statements |\n\n| 1. | Consolidated financial statements |\n\nThe following documents are filed as part of this Annual Report on Form 10-K:\n\n| Report of Independent Registered Public Accounting Firm | 56 |\n| Consolidated Statements of Operations for the year ended December 31, 2016, 2015 and 2014 | 57 |\n| Consolidated Statements of Comprehensive Income for the year ended December 31, 2016, 2015 and 2014 | 58 |\n| Consolidated Balance Sheets as of December 31, 2016 and 2015 | 59 |\n| Consolidated Statements of Stockholders’ Equity for the year ended December 31, 2016, 2015 and 2014 | 60 |\n| Consolidated Statements of Cash Flows for the year ended December 31, 2016, 2015 and 2014 | 61 |\n| Notes to Consolidated Financial Statements | 62 |\n\n\n| 2. | The following financial statement schedule is filed as part of this Annual Report on Form 10-K: |\n\nSchedule II—Valuation and Qualifying Accounts and Reserves\nAll other schedules have been omitted as they are not required, not applicable, or the required information is otherwise included.\nSCHEDULE II: VALUATION AND QUALIFYING ACCOUNTS AND RESERVES\n\n| Balance atBeginningof Period | Additions(Reductions)to CostsandExpenses | WriteOffs | Balance atEnd of Period |\n| (in thousands) |\n| Allowance for doubtful accounts and returns: |\n| Year ended December 31, 2014 | $ | 1,733 | $ | 6,563 | $ | (6,733 | ) | $ | 1,563 |\n| Year ended December 31, 2015 | $ | 1,563 | $ | 8,944 | $ | (8,035 | ) | $ | 2,472 |\n| Year ended December 31, 2016 | $ | 2,472 | $ | 8,585 | $ | (6,747 | ) | $ | 4,310 |\n| Valuation allowance for deferred tax assets: |\n| Year ended December 31, 2014 | $ | 35,108 | $ | (1,793 | ) | $ | (817 | ) | $ | 32,498 |\n| Year ended December 31, 2015 | $ | 32,498 | $ | (813 | ) | $ | — | $ | 31,685 |\n| Year ended December 31, 2016 | $ | 31,685 | $ | (31,429 | ) | $ | — | $ | 256 |\n\n94\n| (b) | The following Exhibits are included in this Annual Report on Form 10-K: |\n\n| ExhibitNumber | Description | Form | Date | ExhibitNumberIncorporatedby Referenceherein | Filedherewith |\n| 3.1 | Amended and Restated Certificate of Incorporation of registrant | Form S-1, as amended (File No. 333-49932) | 12/28/2000 | 3.1 |\n| 3.2 | Amended and Restated Bylaws of registrant | Form 8-K | 2/29/2012 | 3.2 |\n| 3.3 | Certificate of Designations of Rights, Preferences and Privileges of Series A Participating Preferred Stock registrant | Form 8-K | 10/27/2005 | 3.1 |\n| 4.1 | Form of Specimen Common Stock Certificate | Form S-1, as amended (File No. 333-49932) | 1/17/2001 | 4.1 |\n| 10.1† | Registrant's 2005 Incentive Plan (as amended May 2016) | * |\n| 10.2† | Form of RSU agreement under Registrant's 2005 Incentive Plan (Officer Form for officers appointed after September 2016) | * |\n| 10.2A† | Form of RSU agreement under Registrant's 2005 Incentive Plan (Officer Form for officers appointed prior to September 2016) | * |\n| 10.3 | Align’s 2010 Employee Stock Purchase Plan | Form 8-K | 5/25/2010 | 10.2 |\n| 10.4† | Form of Indemnification Agreement by and between registrant and its Board of Directors and its executive officers | Form S-1 as amended (File No. 333-49932) | 1/17/2001 | 10.15 |\n| 10.5† | Form of restricted stock unit award agreement under registrant’s 2005 Incentive Plan (General Form; Director Form) | Form 10-Q | 11/5/2007 | 10.1A,10.1C |\n| 10.6† | Form of option award agreement under registrant’s 2005 Incentive Plan | Form 10-Q | 8/4/2005 | 10.4 |\n| 10.7† | Form of Employment Agreement entered into by and between registrant and each executive officer (other than CEO for executives appointed prior to September 2016) | Form 10-Q | 5/8/2008 | 10.2 |\n| 10.8† | Form of Employment entered into by and between registrant and each executive officer (other than CEO for executives appointed after September 2016) | * |\n| 10.9 | Credit Agreement dated March 22, 2013 between registrant and Wells Fargo National Association | Form 8-K | 3/27/2013 | 10.1 |\n| 10.10† | Summary of 2016 Incentive Awards and Base Salaries | Form 8-K | 2/6/2017 |\n| 10.11† | Form of Market Stock Unit Agreement (officer) | Form 8-K | 2/23/2011 | 10.1 |\n| 10.12† | Form of Market Stock Unit Agreement (CEO) | Form 8-K | 2/23/2011 | 10.2 |\n| 10.13† | Description of Executive Officer Incentive Plan | Form 8-K | 2/23/2011 | Item 5.02 |\n| 10.14 | Fixed Dollar Accelerated Repurchase Transaction Agreement dated May 3, 2016 between Morgan Stanley & Co and registrant | Form 10-Q | 8/4/2016 | 10.1 |\n| 10.15† | Amended and Restated Chief Executive Officer Employment Agreement between Align Technology, Inc. and Joseph Hogan | Form 10-Q | 5/1/2015 | 10.30 |\n\n95\n| ExhibitNumber | Description | Form | Date | ExhibitNumberIncorporatedby Referenceherein | Filedherewith |\n| 10.16† | 2005 Incentive Plan Notice of Grant of Restricted Stock units (Chief Executive Officer) | Form 10-Q | 7/30/2015 | 10.31 |\n| 10.17† | Amended and Restated 2005 Incentive Plan Notice of Grant of Market Stock Units (Chief Executive Officer) | Form 10-Q | 7/30/2015 | 10.34 |\n| 10.18† | Employment Agreement between registrant and John Morici | Form 10-Q | 11/8/2016 | 10.2 |\n| 10.19 | Purchase and Sale Agreement between registrant and LBA RIV-Company XXX, LLC dated December 19, 2016 | Form 8-K | 12/23/2016 | 10.1 |\n| 10.20 | Class C Non-Incentive Unit Purchase Agreement dated July 25, 2016 | Form 8-K | 7/28/2016 | 10.1 |\n| 10.30 | Fifth Amendment to Credit Agreement | Form 8-K | 2/13/2017 | 10.1 |\n| 21.1 | Subsidiaries of Align Technology, Inc. | * |\n| 23.1 | Consent of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm | * |\n| 31.1 | Certifications of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2003 | * |\n| 31.2 | Certifications of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2003 | * |\n| 32 | Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2003 | * |\n| 101.INS | XBRL Instance Document | * |\n| 101.SCH | XBRL Taxonomy Extension Schema Document | * |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document | * |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document | * |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document | * |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document | * |\n\n__________________________________\n| † | Management contract or compensatory plan or arrangement filed as an Exhibit to this form pursuant to Items 14(a) and 14(c) of Form 10-K. |\n| †† | Portions of the exhibit have been omitted pursuant to a request for confidential treatment. The confidential portions have been filed with the SEC. |\n\n96\nSIGNATURES\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on February 28, 2017.\n\n| ALIGN TECHNOLOGY, INC. |\n| By: | /S/ JOSEPH M. HOGAN |\n| Joseph M. Hogan |\n| President and Chief Executive Officer |\n\nEach person whose signature appears below constitutes and appoints Joseph M. Hogan or John F. Morici, his or her attorney-in-fact, with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his or her substitute or substitutes, may do or cause to be done by virtue hereof.\nPursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.\n| Signature | Title | Date |\n| /S/ JOSEPH M. HOGAN | President and Chief Executive Officer (Principal Executive Officer) | February 28, 2017 |\n| Joseph M. Hogan |\n| /S/ JOHN F. MORICI | Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer) | February 28, 2017 |\n| John F. Morici |\n| /S/ JOSEPH LACOB | Director | February 28, 2017 |\n| Joseph Lacob |\n| /S/ C. RAYMOND LARKIN | Director | February 28, 2017 |\n| C. Raymond Larkin |\n| /S/ GEORGE J. MORROW | Director | February 28, 2017 |\n| George J. Morrow |\n| /S/ ANDREA L. SAIA | Director | February 28, 2017 |\n| Andrea L. Saia |\n| /S/ GREG J. SANTORA | Director | February 28, 2017 |\n| Greg J. Santora |\n| /S/ THOMAS M. PRESCOTT | Director | February 28, 2017 |\n| Thomas M. Prescott |\n| /S/ WARREN S. THALER | Director | February 28, 2017 |\n| Warren S. Thaler |\n\n97\nExhibit Index\n| ExhibitNumber | Description | Form | Date | ExhibitNumberIncorporatedby referenceherein | Filedherewith |\n| 3.1 | Amended and Restated Certificate of Incorporation of registrant | Form S-1, as amended (File No. 333-49932) | 12/28/2000 | 3.1 |\n| 3.2 | Amended and Restated Bylaws of registrant | Form 8-K | 2/29/2012 | 3.2 |\n| 3.3 | Certificate of Designations of Rights, Preferences and Privileges of Series A Participating Preferred Stock registrant | Form 8-K | 10/27/2005 | 3.1 |\n| 4.1 | Form of Specimen Common Stock Certificate | Form S-1, as amended (File No. 333-49932) | 1/17/2001 | 4.1 |\n| 10.1† | Registrant's 2005 Incentive Plan (as amended May 2016) | * |\n| 10.2† | Form of RSU agreement under Registrant's 2005 Incentive Plan (Officer Form for officers appointed after September 2016) | * |\n| 10.2A† | Form of RSU agreement under Registrant's 2005 Incentive Plan (Officer Form for officers appointed prior to September 2016) | * |\n| 10.3 | Align’s 2010 Employee Stock Purchase Plan | Form 8-K | 5/25/2010 | 10.2 |\n| 10.4† | Form of Indemnification Agreement by and between registrant and its Board of Directors and its executive officers | Form S-1 as amended (File No. 333-49932) | 1/17/2001 | 10.15 |\n| 10.5† | Form of restricted stock unit award agreement under registrant’s 2005 Incentive Plan (General Form; Director Form) | Form 10-Q | 11/5/2007 | 10.1A,10.1C |\n| 10.6† | Form of option award agreement under registrant’s 2005 Incentive Plan | Form 10-Q | 8/4/2005 | 10.40 |\n| 10.7† | Form of Employment Agreement entered into by and between registrant and each executive officer (other than CEO for executives appointed prior to September 2016) | Form 10-Q | 5/8/2008 | 10.2 |\n| 10.8† | Form of Employment entered into by and between registrant and each executive officer (other than CEO for executives appointed after September 2016) | * |\n| 10.9 | Credit Agreement dated March 22, 2013 between registrant and Wells Fargo National Association | Form 8-K | 3/27/2013 | 10.10 |\n| 10.10† | Summary of 2016 Incentive Awards and Base Salaries | Form 8-K | 2/6/2017 |\n| 10.11† | Form of Market Stock Unit Agreement (officer) | Form 8-K | 2/23/2011 | 10.1 |\n| 10.12† | Form of Market Stock Unit Agreement (CEO) | Form 8-K | 2/23/2011 | 10.2 |\n| 10.13† | Description of Executive Officer Incentive Plan | Form 8-K | 2/23/2011 | Item 5.02 |\n| 10.14 | Fixed Dollar Accelerated Repurchase Transaction Agreement dated May 3, 2016 between Morgan Stanley & Co and registrant | Form 10-Q | 8/4/2016 | 10.1 |\n| 10.15† | Amended and Restated Chief Executive Officer Employment Agreement between Align Technology, Inc. and Joseph Hogan | Form 10-Q | 5/1/2015 | 10.3 |\n| 10.16† | 2005 Incentive Plan Notice of Grant of Restricted Stock units (Chief Executive Officer) | Form 10-Q | 7/30/2015 | 10.3 |\n\n98\n| ExhibitNumber | Description | Form | Date | ExhibitNumberIncorporatedby referenceherein | Filedherewith |\n| 10.17† | Amended and Restated 2005 Incentive Plan Notice of Grant of Market Stock Units (Chief Executive Officer) | Form 10-Q | 7/30/2015 | 10.3 |\n| 10.18† | Employment Agreement between registrant and John Morici | Form 10-Q | 11/8/2016 | 10.2 |\n| 10.19 | Purchase and Sale Agreement between registrant and LBA RIV-Company XXX, LLC dated December 19, 2016 | Form 8-K | 12/23/2016 | 10.1 |\n| 10.20 | Class C Non-Incentive Unit Purchase Agreement dated July 25, 2016 | Form 8-K | 7/28/2016 | 10.1 |\n| 10.30 | Fifth Amendment to Credit Agreement | Form 8-K | 2/13/2017 | 10.1 |\n| 21.1 | Subsidiaries of Align Technology, Inc. | * |\n| 23.1 | Consent of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm | * |\n| 31.1 | Certifications of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2003 | * |\n| 31.2 | Certifications of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2003 | * |\n| 32 | Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2003 | * |\n| 101.INS | XBRL Instance Document | * |\n| 101.SCH | XBRL Taxonomy Extension Schema Document | * |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document | * |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document | * |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document | * |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document | * |\n\n__________________________________\n| † | Management contract or compensatory plan or arrangement filed as an Exhibit to this form pursuant to Items 14(a) and 14(c) of Form 10-K. |\n| †† | Portions of the exhibit have been omitted pursuant to a request for confidential treatment. The confidential portions have been filed with the SEC. |\n\n99\n \n\nWhat is the continuous compounded annual growth rate (CAGR) of net cash used by financing activities from 2014 to 2016? (in millions)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nITEM 1.\\nBUSINESS\\nOur Company\\nAlign Technology, Inc (“We”, “Our”, “Align”) designs, manufactures and markets a system of clear aligner therapy, intraoral scanners and CAD/CAM (computer-aided design and computer-aided manufacturing) digital services used in dentistry, orthodontics, and dental records storage. Align Technology was founded in March 1997 and incorporated in Delaware in April 1997. Our headquarters is located at 2560 Orchard Parkway, San Jose, California 95131, and our telephone number is 408-470-1000. Our internet address is www.aligntech.com. Our international headquarters is located in Amsterdam, the Netherlands.\\nWe have two operating segments: (1) Clear Aligner and (2) Scanners and Services (\\\"Scanner\\\"). For the year ended December 31, 2016, Clear Aligner revenues represent approximately 89% of worldwide revenue, while Scanner represent the remaining 11% of worldwide revenues. We distribute the vast majority of our products directly to our customers: orthodontists and general practitioner dentists (\\\"GPs\\\"), as well as to restorative dentists, including prosthodontists, periodontists, and oral surgeons. We also supply clear aligners to SmileDirectClub, LLC (\\\"SDC\\\") who sells them directly to consumers, with a doctor’s approved prescription.\\nWe received 510(k) clearance from the United States Food and Drug Administration (“FDA”) to market the Invisalign System in 1998. The Invisalign System is regulated by the FDA as a Class II medical device. In order to provide Invisalign treatment to their patients, orthodontists and GPs must initially complete an Invisalign training course. The Invisalign System is primarily sold through a direct sales force in the United States (\\\"U.S.\\\"), Canada, Europe, certain Asia Pacific countries, Latin America and Middle East and Africa including Australia, New Zealand, China and Japan. We use a distributor model for the sale of our products in non-core country markets in the Asia Pacific (\\\"APAC\\\"), Europe, Middle East and Africa (\\\"EMEA\\\"), and Latin America regions.\\nOur iTero scanner is used by dental professionals and/or labs and services for restorative and orthodontic digital procedures as well as Invisalign digital impression submission. We received 501(k) clearance from the FDA to market iTero software for expanded indications in 2013. Scanners and CAD/CAM Services are primarily sold through our direct sales force in North America, Europe and certain Asia Pacific countries including Taiwan, Singapore, Korea, Australia, New Zealand, and through distribution partners in Thailand, Scandinavia and Russia.\\n3\\nOur Products and Services\\nOur net revenues are generated from the sale of the following product offerings:\\n| Fiscal Year |\\n| Percentage of Net Revenues by Product | 2016 | 2015 | 2014 |\\n| Clear Aligner Segment |\\n| Comprehensive Products | 72 | % | 78 | % | 77 | % |\\n| Non-Comprehensive Products | 11 | 11 | 11 |\\n| Non-Case Products | 6 | 6 | 6 |\\n| Total Clear Aligner Segment | 89 | 95 | 94 |\\n| Scanners and Services Segment | 11 | 5 | 6 |\\n| Total Net Revenues | 100 | % | 100 | % | 100 | % |\\n\\nClear Aligner Segment\\nMalocclusion and Traditional Orthodontic Treatment\\nMalocclusion, or the misalignment of teeth, is one of the most prevalent clinical dental conditions, affecting billions of people, or approximately 60% to 75% of the population. Annually, approximately 10 million people in major developed countries elect treatment by orthodontists worldwide, of which approximately 50% or 5 million have mild to moderate malocclusion and are applicable to Invisalign treatment - our served market. In addition, approximately 100 million people with malocclusion want to straighten their teeth; however, they will not seek orthodontic treatment in a doctor's office and would instead elect to receive clear aligner treatment in the convenience of their own home - referred to as the doctor-directed at home market.\\nIn the U.S., orthodontists and GPs treat malocclusion primarily with metal arch wires and brackets, referred to as braces, and they may augment braces with elastics, metal expanders, headgear or functional appliances, and other ancillary devices as needed. Available options for improving treatment aesthetics include the use of ceramic, tooth-colored brackets or bonding brackets on the inside, or lingual surface, of the patient’s teeth. The average treatment takes approximately 12 to 24 months to complete and requires several hours of direct dental professional involvement, known in the industry as “chair time,” including the initial diagnosis, creation of an appropriate treatment plan and bonding of the brackets to the patient’s teeth, and attachment of arch wires to the brackets. Subsequent visits involve tightening or otherwise adjusting the braces approximately every six weeks until the final visit when the dental professional removes each bracket and residual bonding agent from the patient’s teeth. Upon completion of the treatment, the dental professional may, at his or her discretion, have the patient use a retainer. GPs, may also combine orthodontic treatment with restorative treatment. Many times the dental professional may need to move certain teeth or roots out of the way to create more space for implant placement, or move teeth to create space for restorations of missing teeth. In addition, GPs may need to move or adjust teeth or spaces to be able to place better restorations. The orthodontic portion of treatment generally comes before the restorative portion.\\nThe Invisalign System\\nThe Invisalign System is a proprietary method for treating malocclusion based on a series of doctor-prescribed, custom manufactured, clear plastic, removable orthodontic aligners. The Invisalign System offers a range of treatment options, specialized services, and proprietary software for treatment visualization and is comprised of the following phases:\\nOrthodontic diagnosis and transmission of treatment data to us. The Invisalign-trained dental professional prepares and sends us a patient’s treatment data package which consists of a prescription form, a polyvinyl-siloxane, (or \\\"PVS\\\") impression of the relevant dental arches, photographs of the patient and, at the dental professional’s election, x-rays of the patient’s dentition. The Invisalign-trained dental professional can also submit an intraoral digital scan instead of a physical PVS impression through either Align's iTero scanner or several third-party scanners. See \\\"Third Party Scanners.\\\"\\nPreparation of computer-simulated treatment plan. Upon receipt, we use the treatment data package to construct digital models of the patient’s dentition. In cases where a PVS impression has been submitted, we use computed tomography, known as CT scanning to develop a digital, three-dimensional computer model of the patient’s current dentition. In cases where the dental professional submits a digital scan, this step in the process is eliminated. We transform this initial digital model into a proposed custom, three-dimensional treatment plan, called a ClinCheck treatment plan. The ClinCheck treatment plan simulates\\n4\\nappropriate tooth movement broken down into a series of increments and details timing and placement of any attachments that will be used during treatment. Attachments are tooth-colored “buttons” that are sometimes used to increase the biomechanical force on a specific tooth or teeth in order to effect the desired movement.\\nReview and approval of the treatment plan by an Invisalign provider. The patient’s ClinCheck treatment plan is then made available to the prescribing dental professional via the Invisalign Doctor Site which enables the dental professional to project tooth movement with a level of accuracy not previously possible with metal arch wires and brackets. By reviewing, modifying as needed and approving the treatment plan, the dental professional retains control over the treatment plan.\\nManufacture of custom aligners. Upon the dental professional’s approval of the ClinCheck treatment plan, we use the data underlying the simulation, in conjunction with stereolithography technology (a form of 3D printing technology), to construct a series of molds depicting the future position of the patient’s teeth. Each mold is a replica of the patient’s teeth at each stage of the simulated course of treatment. From these molds, aligners are fabricated by pressure-forming polymeric sheets over each mold. Aligners are thin, clear plastic, removable dental appliances that are custom manufactured in a series to correspond to each stage of the ClinCheck treatment plan.\\nShipment to the dental professional and patient aligner wear. All the aligners for a patient are shipped directly to the dental professional, who then dispenses them to the patient at regular check-up intervals throughout the treatment. Aligners are generally worn for consecutive two-week periods or less which correspond to the approved ClinCheck treatment plan. The patient replaces the aligners with the next pair in the series when prescribed, advancing tooth movement with each aligner stage. Throughout treatment, the doctor may place attachments or use other auxiliaries to achieve desired tooth movements, per the doctor’s original prescription and resulting ClinCheck treatment plan. In October 2016, we introduced one-week aligner wear. At the treating doctor’s discretion, we recommend changing from two-week aligner wear to one-week aligner wear for Invisalign treatments with Invisalign Full, Invisalign Teen and Invisalign Assist products, thereby reducing treatment time by up to 50%. Align’s recommendation is based on clinical analysis of more than 200 in-progress Invisalign cases (data on file) and the experiences of numerous Invisalign providers.\\nTreatment progress and request for additional aligners. Should the dental professional determine that the treatment is not tracking for various reasons, such as patient compliance, certain teeth not tracking to plan, or they need to extend the treatment a few stages further to achieve their treatment goals, the dental professional can request additional aligners at no charge at any point during the treatment, subject to certain requirements.\\nClear Aligner Products\\nComprehensive Products:\\nInvisalign Full. Used for a wide range of malocclusion, the Invisalign Full treatment consists of the number of aligners necessary to achieve the doctor’s treatment goals. Invisalign Full treatment aligners are manufactured and then delivered to the dental professionals in a single shipment. Invisalign Full is sold in the U.S., Canada and our international regions.\\nInvisalign Teen. The Invisalign Teen treatment includes all the features of Invisalign Full treatment, plus additional features that address the orthodontic needs of teenage patients such as compliance indicators, compensation for tooth eruption and six free single arch replacement aligners. This product is predominantly marketed to orthodontists who treat the vast majority of malocclusion in teenage patients. Invisalign Teen treatment aligners (other than the replacement aligners) are manufactured and then delivered to the dental professionals in a single shipment. Invisalign Teen is sold in the U.S., Canada and our international regions.\\nInvisalign Assist. Used for anterior alignment and aesthetically-oriented cases, the Invisalign Assist treatment offers added support to our dental practitioners throughout the treatment process, including progress tracking that allows the dental professional to submit new impressions every nine stages. When the progress tracking feature is selected, aligners are shipped to the dental professional after every nine stages thereby helping to achieve successful treatment outcomes. Predominantly marketed to GPs, Invisalign Assist is intended to make it easier to select appropriate cases for their experience level or treatment approach, submit cases more efficiently and manage appointments with suggested tasks. Invisalign Assist is sold in the U.S. and Canada.\\n5\\nNon-Comprehensive Products:\\nInvisalign Express (10 and 5) and Invisalign Lite/i7. Invisalign Express treatments, Invisalign Lite treatment and Invisalign i7 treatment are lower-cost solutions for less complex orthodontic cases, non-comprehensive treatment relapse cases, or straightening prior to restorative or cosmetic treatments such as veneers. Invisalign Express 10 and Invisalign Express 5, which are sold in the U.S. and Canada, use up to 10 and 5 sets of aligners, respectively, and are also available as a single arch option. Invisalign Lite and Invisalign i7, sold in our international regions, use up to 14 and 7 sets of aligners, respectively. For Invisalign Express/Lite/i7, aligners are manufactured and then delivered to the dental professionals in a single shipment.\\nInvisalign Go. A simplified and streamlined solution designed for GP dentists to more easily identify and treat patients with mild malocclusion. Invisalign Go combines case assessment support, a simplified ClinCheck treatment plan and a progress assessment feature for case monitoring. Invisalign Go was launched in core European markets in the fourth quarter of 2016 and is expected to launch in North America in the first quarter of 2017.\\nSmileDirectClub Aligners. On July 25, 2016, we entered into a supply agreement with SmileDirectClub, LLC (\\\"SDC\\\") to manufacture non-Invisalign clear aligners for SDC's doctor-led, at-home program for simple teeth straightening. In October 2016, we became SDC's exclusive third-party supplier and began supplying aligners directly to SDC. SDC aligners include up to 20 stages without attachments or interproximal reduction (\\\"IPR\\\"). Align manufactures the aligners per SDC’s specifications for minor tooth movement using EX-30 aligner material.\\nNon-Case Products:\\nClear Aligner non-case products include retention products, Invisalign training fees and sales of ancillary products, such as cleaning material and adjusting tools used by dental professionals during the course of treatment.\\nRetention. We offer two products for post treatment retention. The first is a single set of custom clear aligner retainers. The second is offered as a set of four custom clear aligners called Vivera Retainers made with proprietary material strong enough to maintain tooth position and correct minor relapse if necessary. A shipment of four sets are available to both Invisalign and non-Invisalign patients.\\nFeature Enhancements\\nWe have consistently introduced enhanced features across the Invisalign System over the past several years, such as Invisalign G3 (launched in October 2010), Invisalign G4 (launched in November 2011), Invisalign G5 (launched in February 2014) and Invisalign G6 (launched in March 2015). In October 2016, we launched Invisalign G7, a set of features designed to deliver greater control of tooth movements and improved treatment outcomes.\\nInvisalign G5 innovations for deep bite is engineered to improve clinical outcomes in deep bite treatment with Invisalign treatment. Comprehensive features dedicated to deep bite treatment include new SmartForce® features that are designed to level the curve of spee by improving control of anterior intrusion and premolar extrusion for more predictable deep bite treatments, and precision bite ramps that are designed to disocclude the posterior teeth for improved efficiency in deep bite treatments.\\nInvisalign G6 clinical innovations for first premolar extraction is engineered to improve clinical outcomes for orthodontic treatment of severe crowding and bimaxillary protrusion. Feature enhancements include new SmartStage programmed tooth movements that optimize the progression of tooth movements and provide aligner activation, engineered to eliminate unwanted tipping and unwanted anterior extrusion during retraction and new SmartForce features that are designed to deliver the force systems necessary to achieve predictable tooth movements.\\nInvisalign G7 builds on earlier Invisalign G-series releases with new features to fine-tune certain tooth movements and deliver treatment outcome quality that Invisalign providers expect, particularly with teenage patients. Powered by Invisalign SmartStage technology that optimizes the staging and sequence of tooth movements and aligner activation for greater predictability, Invisalign G7 delivers better upper lateral control, improved root control, and features to address prevention of posterior open bites.\\nSmartTrack™ Aligner Material\\nSmartTrack is a proprietary, custom-engineered Invisalign clear aligner material that delivers gentle, more constant force considered ideal for orthodontic tooth movements. Conventional aligner materials relax and lose a substantial percent of energy in the initial days of aligner wear, but SmartTrack maintains more constant force over the period of time the patient wears the\\n6\\naligners. The flexible SmartTrack material also more precisely conforms to tooth morphology, attachments and interproximal spaces to improve control of tooth movement throughout treatment.\\nScanner Segment\\nIntraoral scanning is an emerging technology that we believe will have substantial impact on the future of dentistry. By enabling the dental practitioner to create a 3D image of the patient's teeth (digital scan) using a handheld intraoral scanner inside the mouth, digital scanning is more efficient and precise and more comfortable for patients, compared to the mess, discomfort and subjective nature of taking physical impressions. The digitally scanned model is more accurate than a physical impression and substantially reduces the rate of restoration \\\"remakes\\\" so patients are recalled less often and the appointment time for the restoration is shorter because of fewer adjustments which results in greater overall patient satisfaction. The digital model file can be used for various procedures and services including fabrication of physical dental models for use by labs to create restorative units such as veneers, inlays, onlays, crowns, bridges and implant abutments; digital records storage; orthodontic diagnosis; orthodontic retainers and appliances; and Invisalign digital impression submission.\\niTero Scanner. The iTero scanner is available as a single hardware platform with software options for restorative or orthodontic procedures. In March 2015, we announced our next generation iTero Element Intraoral Scanner which features a more compact footprint, enhanced wand and multi-touch display and is engineered to enable faster scan speeds for more efficient, real-time clinical evaluation. We began shipping the iTero Element Intraoral Scanner in September 2015. We market and sell the iTero Element in North America and in select international markets. The iTero scanner is interoperable with our Invisalign treatment such that a full arch digital scan can be submitted as part of the Invisalign case submission process. In addition, the Invisalign Outcome Simulator and features are exclusive to the iTero scanner.\\nRestorative software for iTero. Software designed for GPs, prosthodontists, periodontists, and oral surgeons which includes features for restorative procedures commonly performed in their practices such as veneers, inlays, onlays, crowns, bridges and implants. The iTero restorative software provides the ability to scan quadrants and full arches, and allows simple powder-free capture of digital impressions for single-unit cases as well as more complex restorative and implant treatment plans. The iTero software also contains Invisalign interoperability to support clear aligner orthodontic treatment.\\nOrthodontic software for iTero. Software designed for orthodontists for digital records storage, orthodontic diagnosis, Invisalign digital impression submission, and for the fabrication of printed models and retainers. The iTero orthodontic software digitally captures the contours of the dentition and the gingival structures, providing an accurate, powder-free digital orthodontic scan in just minutes. This digital impression procedure ensures a more comfortable patient experience and produces a precise scan that can be seamlessly integrated with Invisalign treatment, OrthoCAD iCast, and OrthoCAD iRecord which allows a doctor to utilize sophisticated measurement and treatment planning tools.\\nCAD/CAM Services\\niTero Models and Dies. An accurate physical model and dies are manufactured based on the digital scan and sent to the laboratory of the dentist’s choice for completion of the needed restoration. The laboratory also has the option to export the digital file for immediate production of coping and full-contour restorations on their laboratory CAD/CAM systems. The laboratory conducts then completes the ceramic buildup or staining and glazing and delivers the end result - a precisely fitting restoration. iTero prosthetics have a near-zero remake rate.\\nOrthoCAD iCast. iCast provides a digital alternative to traditional stone cast models which allows for simplified storage and digital record retrieval. The iCast digital model contains a full American Board of Orthodontics (\\\"ABO\\\") base and is available from an iTero scan or from a traditional alginate impression.\\nOrthoCAD iRecord. iRecord scans provide a digital alternative to traditional stone cast models which allows for simplified storage and digital record retrieval. iRecord scan data may also be exported to orthodontic laboratories for the fabrication of retainers, orthodontic appliances, and hard model fabrication.\\nThird Party Scanners and Digital scans for Invisalign treatment submission. We support an open systems approach to digital scans and other intraoral scanning companies interested in qualifying their scanners to submit a digital impression in place of a traditional PVS impression as part of the Invisalign case submission process. We have qualified several scanners for digital scan submission including 3M™ True Definition scanner (January 2014), the Sirona CEREC Omnicam scanner (March 2015) and certain TRIOS scanners (October 2016).\\n7\\nChair Side Applications\\nInvisalign Outcome Simulator. The Invisalign Outcome Simulator is an exclusive chair-side and cloud-based application for the iTero scanner that allows doctors to help patients visualize how their teeth may look at the end of Invisalign treatment through a dual view layout that shows a prospective patient an image of his/her own current dentition next to his/her simulated final position after Invisalign treatment. Using a full arch digital scan, the Invisalign Outcome Simulator takes a few minutes to run and may be viewed chair-side, on the scanner, or from a computer using MyAlignTech.com. Intuitive tools allow doctors to make real-time adjustments to individual teeth during consultations that increase patient education and the likelihood of patient acceptance. In October 2016, we introduced the following new features in the 4.0 upgrade:\\n| • | 3D Progress Tracking - Ability to compare a patient’s new scan with a specific stage of their ClinCheck treatment plan to visually assess and communicate Invisalign treatment progress with an easy to read, color-coded tooth movement report that allows the doctor to know how each tooth is tracking. |\\n\\n| • | Patient Simulation Sharing - Ability to easily share the patient’s 3D simulated Invisalign treatment outcome through a protected patient portal which can be viewed on smartphones, tablets and computers. |\\n\\nOur iTero scanner includes orthodontic software and/or restorative software and the Invisalign Outcome Simulator. The orthodontic or restorative software may also be purchased subsequently for an upgrade fee. The Invisalign Outcome Simulator is not available for sale separately.\\nOther proprietary software mentioned in this Annual Report on Form 10-K such as ClinCheck and ClinCheck Pro software, the Invisalign Doctor Site, and enhanced feature solutions such as Invisalign G7 are included as part of the Invisalign System and are not sold separately nor do they contribute as individual items of revenue.\\nBusiness Strategy\\nOur goal is to establish Invisalign clear aligners as the standard method for treating malocclusion and to establish the iTero intraoral scanner as the preferred scanning protocol for 3D digital scans, ultimately driving increased product adoption by dental professionals. We intend to achieve this by continued focus and execution of our strategic growth drivers: International, Orthodontists Utilization, GP Dentists Treat & Refer and Patient Demand & Conversion\\n| 1. | International Expansion. We expect to continue to grow and expand our business by investing in resources, infrastructure, and initiatives that will drive Invisalign treatment growth in our current and new international markets. As our core countries within the EMEA and APAC regions continue to grow in both number of new Invisalign providers and utilization, we strive to make sure we can support that growth through investments such as headcount, clinical support, education and advertising. Additionally, we are expanding our presence and entering new markets, such as India and Korea, by establishing a solid base of key opinion leaders and early adopters who can help build clinical confidence in the orthodontic community and create strong brand preference for Invisalign treatment among consumers. We have also transitioned most of our indirect smaller country markets to a direct sales model, and, while we do not expect a material impact from these countries for some time, in the near term, we will leverage our existing infrastructure in adjacent country markets as we build local sales organizations to drive long-term market penetration. |\\n\\n| 2. | Orthodontist Utilization. We want all of our orthodontist providers to have the confidence and motivation to lead with Invisalign for every patient that walks into their practice. We strive to achieve this by increasing the product applicability and predictability for a wide range of complex cases within adults, teenagers and younger aged patients. As an example, in 2015, we launched Invisalign G6 clinical innovations for first premolar extractions. The nature of malocclusion that requires first premolar tooth extraction is an orthodontic problem that affects more than 50% of people in Asia, 20% in Europe and 12% in North America. In October 2016, we launched Invisalign G7, which builds on earlier Invisalign G-series releases with new features to fine-tune certain tooth movements and deliver treatment outcome quality that Invisalign providers expect, particularly with teenage patients. We also continue to make improvements to our Invisalign treatment software, ClinCheck Pro, designed to deliver an exceptional user experience and increase treatment control to help our doctors achieve their treatment goals. |\\n\\n| 3. | GP Dentist Treat & Refer. We want to make it easier for GPs to identify the cases that they can treat and refer the cases that are too complex over to orthodontists. Although GPs have a larger pool of potential patients, which can expand the market for Invisalign treatment, overall, we need to provide them with tools to help them quickly identify cases they can treat, monitor patient progress or if needed, help refer them more easily to an orthodontist. The iTero scanner is an important component to that customer experience. In October 2016, we introduced a 3D progress tracking feature in the |\\n\\n8\\nInvisalign Outcome Simulator application that provides our customers with the ability to compare a patient’s new scan with a specific stage of their ClinCheck treatment plan to visually assess and communicate Invisalign treatment progress.\\n| 4. | Patient Demand & Conversion. Our goal is to make Invisalign a highly recognized name brand worldwide by creating awareness for Invisalign treatment among consumers and motiving potential patients to seek treatment from an Invisalign provider. In support of this objective, we invest in initiatives designed to strengthen our global brand name recognition, drive patient demand and covert that interest into Invisalign treatment case starts. We accomplish this objective through an integrated consumer marketing strategy that includes television, media, social networking and event marketing as well as educating patients on treatment options and directing them to high volume Invisalign providers. |\\n\\nSupply Agreement with SmileDirectClub, LLC\\nOn July 28, 2016, we announced a supply agreement with SmileDirectClub, LLC (\\\"SDC\\\") to manufacture non-Invisalign clear aligners for SDC’s doctor-led, at-home program for affordable, cosmetic teeth straightening. The agreement brings our manufacturing and production expertise to a new and growing segment of the adult treatment market, one that provides new treatment choices to consumers and new business opportunities to Invisalign providers.\\nBeginning October 2016, we became SDC’s exclusive third-party supplier for its minor tooth movement aligner program. Specifically, we provide a case setup through SDC’s SmileCheck viewer portal and upon review and approval by a participating licensed orthodontist or general dentist in SDC’s network, we manufacture clear aligners and ship them directly to SDC.\\nSDC aligners include up to 20 stages without attachments or interproximal reduction (IPR). We manufacture the aligners per SDC’s specifications for minor tooth movement using EX-30 aligner material. The Invisalign brand and system of clear aligners continue to be available exclusively for in office treatment with Invisalign-trained orthodontists and general dentists.\\nIn addition, under the agreement, Align and SDC created a new Invisalign doctor referral program similar to the Invisalign Doc Locator, that systematically refers the approximately 30% of SDC’s SmileCheck case assessments that are too complex for their minor tooth movement product, to Invisalign providers in the patient’s local area. The goal of the agreement is to help expand the market and opportunity for our Invisalign doctors, while supporting SDC’s efforts to provide consumers with access to more choices in treating simple cases from the convenience of their own home.\\nManufacturing and Suppliers\\nOur manufacturing facilities are located in Juarez, Mexico, where we conduct our aligner fabrication, distribute and repair our scanners and perform our CAD/CAM services, and in Or Yehuda, Israel where we produce our handheld intraoral scanner wand. The final assembly of our iTero scanner is performed by a third party manufacturer located in Israel. Our Invisalign digital treatment planning and interpretation for iTero restorative cases are conducted primarily at our facility located in San Jose, Costa Rica. Information regarding risks associated with our manufacturing process and foreign operations may be found in Item 1A of this Annual Report on Form 10-K under the heading “Risk Factors.”\\nOur quality system is required to be in compliance with the Quality System regulations enforced by the FDA, and similar regulations enforced by other worldwide regulatory authorities. We are certified to EN ISO 13485:2003, an internationally recognized standard for medical device manufacturing. We have a formal, documented quality system by which quality objectives are defined, understood and achieved. Systems, processes and procedures are implemented to ensure high levels of product and service quality. We monitor the effectiveness of the quality system based on internal data and direct customer feedback and strive to continually improve our systems and processes, taking corrective action, as needed.\\nSince the manufacturing process of our products requires substantial and varied technical expertise, we believe that our manufacturing capabilities are important to our success. In order to produce our highly customized, highly precise, medical quality products in volume, we have developed a number of proprietary processes and technologies. These technologies include complex software algorithms and solutions, CT scanning, stereolithography and automated aligner fabrication. To increase the efficiency of our manufacturing processes, we continue to focus our efforts on software development and the improvement of rate-limiting processes or bottlenecks. We continuously upgrade our proprietary, three-dimensional treatment planning software to enhance computer analysis of treatment data and to reduce time spent on manual and judgmental tasks for each case, thereby increasing the efficiency of our technicians in Costa Rica. In addition, to improve efficiency and increase the scale of our operations, we continue to invest in the development of automated systems for the fabrication and packaging of aligners.\\nWe are highly dependent on manufacturers of specialized scanning equipment, rapid prototyping machines, resin and other advanced materials for our aligners, as well as the optics, electronic and other mechanical components of our intraoral scanners. We\\n9\\nmaintain single supply relationships for many of these machines and materials technologies. In particular, our CT scanning and stereolithography equipment used in our aligner manufacturing and many of the critical components for the optics of our intraoral scanners are provided by single suppliers. We are also committed to purchasing all of our resin and polymer, the primary raw materials used in our manufacturing process for clear aligners, from a single source. The need to replace one of our single source suppliers could cause a disruption in our ability to timely deliver certain of our products or increase costs. See Item 1A Risk Factors — “We maintain single supply relationships for certain of our key machines and materials technologies, and our business and operating results could be harmed if supply is restricted or ends or the price of raw materials used in our manufacturing process increases.”\\nSales and Marketing\\nOur sales efforts are focused primarily on the Invisalign System and continuing to increase adoption and utilization by orthodontists and GPs worldwide. In North America, Europe and certain Asia Pacific country markets, and more recently in Brazil and certain regions in the Middle East and Africa, we have direct sales and support organizations, which includes quota carrying sales representatives, sales management and sales administration. We also have distribution partners that sell the Invisalign System in smaller non-core country markets outside of North America. We continued to expand in our existing markets through targeted investments in sales coverage, professional marketing and education programs, along with consumer marketing in selected country markets.\\nFor the iTero scanner, we have a small team of direct sales representatives in North America. Our intraoral scanner sales team leverages leads generated by our Invisalign sales and marketing resources, including customer events and industry trade-shows. We sell the iTero scanner in select country markets internationally and will expand to additional markets over time to grow the scanner business.\\nWe provide training, marketing and clinical support to orthodontists and GPs. In 2016, we had approximately 54,480 active Invisalign providers.\\nResearch and Development\\nWe are committed to investing in world-class technology development, which we believe is critical to achieving our goal of establishing the Invisalign System as the standard method for treating malocclusion and our intraoral scanning platform as the preferred scanning protocol for digital scans. Our research and development expenses were $75.7 million, $61.2 million and $52.8 million for the year ended December 31, 2016, 2015 and 2014, respectively.\\nOur research and development activities are directed toward developing the technology innovations that we believe will deliver our next generation of products and platforms. These activities range from accelerating product and clinical innovation to developing manufacturing process improvements to researching future technologies and products.\\nIn an effort to demonstrate Invisalign’s broad treatment capabilities, various clinical case studies and articles have been published that highlight the clinical applicability of Invisalign to malocclusion cases, including those of severe complexity. We undertake pre-commercialization trials and testing of our technological improvements to the product and manufacturing process.\\nIntellectual Property\\nWe believe our intellectual property position represents a substantial business advantage. As of December 31, 2016, we had issued 425 U.S. patents, 370 foreign issued patents, and 386 pending global patent applications.\\nWe continue to pursue further intellectual property protection through U.S. and foreign patent applications and non-disclosure agreements. Our issued U.S. patents expire between 2017 and 2035. In addition, corresponding foreign patents will start to expire in 2018. When patents expire, we lose the protection and competitive advantages they provided to us, which could negatively impact our operating results; however, we continue to pursue further intellectual property protection through U.S. and foreign patent applications and non-disclosure agreements. We also seek to protect our software, documentation and other written materials under trade secret and copyright laws. We cannot be certain that patents will be issued as a result of any patent application or that patents that have been issued to us or that may be issued in the future will be found to be valid and enforceable and sufficient to protect our technology or products. Our intellectual property rights may not be successfully asserted in the future or may be invalidated, circumvented or challenged. In addition, the laws of various foreign countries do not protect our intellectual property rights to the same extent as U.S. laws. Our inability to protect our proprietary information could harm our business. Information regarding risks associated with failing to protect our proprietary technology and our intellectual property rights may be found in Item 1A of this Annual Report on Form 10-K under the heading “Risk Factors.”\\n10\\nSeasonal Fluctuations\\nGeneral economic conditions impact our business and financial results, and we experience seasonal trends related to our two operating segments, customer channels and the geographic locations that we serve. For example, European sales of Invisalign treatment are often weaker in the summer months due to our customers and their patients being on holiday. In North America, summer is typically the busiest season for orthodontists with practices that have a high percentage of adolescent and teenage patients as many parents want to get their teenagers started in treatment before the start of the school year; however, many GPs are on vacation during this time and therefore tend to start fewer cases. For our Scanner segment, capital equipment sales are often stronger in the fourth calendar quarter. Consequently, these seasonal trends have caused and may continue to cause, fluctuations in our quarterly results, including fluctuations in sequential revenue growth rates.\\nBacklog\\nDue to the individualized nature of an Invisalign treatment which is prescribed by a doctor, no two cases are alike, thus we maintain relatively low levels of backlog. The period from which a treatment data package (or “a case”) is received until the acceptance of the digital ClinCheck treatment plan is dependent on the dental professional’s discretion to modify, accept or cancel the treatment plan. Therefore, we consider the case a firm order to manufacture aligners once the dental professional has approved the ClinCheck treatment plan. Our Invisalign backlog consists of ClinCheck treatment plans that have been accepted but not yet shipped. Because aligners are shipped shortly after the ClinCheck treatment plan has been accepted, we believe that backlog is not a good indicator of future Invisalign sales. Our quarterly Invisalign revenues can be impacted by the timing of the ClinCheck treatment plan acceptances and our ability to ship those cases in the same quarter. We define our intraoral scanner backlog as orders where payment is reasonably assured and credit and financing is approved but the scanner has not yet shipped. Our intraoral scanner backlog as of December 31, 2016 was not material.\\nCompetition\\nWe operate in a highly competitive market and we encounter a wide variety of competitors, including larger companies or divisions of larger companies with substantial sales, marketing, research and financial capabilities. We also face competition from early stage companies. Although the number of competitors varies by segment, currently our products compete directly against products manufactured and distributed by various companies, both within and outside the U.S., including Danaher Corporation, Sirona Dental Systems, Inc., Dentsply International, Inc., 3M Company and other private competitors. In addition, the expiration of certain of our key patents commencing in 2017, may result in additional competition. Information regarding risks associated with increased competition may be found in Item 1A of this Annual Report on Form 10-K under the heading “Risk Factors.”\\nKey competitive factors include:\\n| • | effectiveness of treatment; |\\n\\n| • | price; |\\n\\n| • | software features; |\\n\\n| • | aesthetic appeal of the treatment method; |\\n\\n| • | customer support; |\\n\\n| • | customer online interface; |\\n\\n| • | brand awareness; |\\n\\n| • | innovation; |\\n\\n| • | distribution network; |\\n\\n| • | comfort associated with the treatment method; |\\n\\n| • | oral hygiene; |\\n\\n| • | ease of use; and |\\n\\n| • | dental professionals’ chair time. |\\n\\nWe believe that our products compare favorably with our competitors’ products with respect to each of these factors.\\n11\\nGovernment Regulation\\nIn order for us to market our products, we must obtain regulatory authorization and comply with extensive product and quality system regulations both within and outside the U.S. These regulations, including the requirements for approvals or clearance and the time required for regulatory review, vary from country to country. Failure to obtain regulatory approval and to meet all local requirements including language and specific safety standards in any country in which we currently market or plan to market our products could prevent us from marketing products in such countries or subject us to sanctions and fines. The approval by government authorities is unpredictable and uncertain and may not be granted on a timely basis, if at all. Delays in receipt of, or a failure to receive, such approvals or clearances, or the loss of any previously received approvals or clearances, could have a material adverse effect on our business, financial condition, and results of operations.\\nCertain of our products are classified as medical devices under the United States Food, Drug, and Cosmetic Act (the “FD&CA”). The FD&CA requires these products, when sold in the U.S., to be safe and effective for their intended use and to comply with the regulations administered by the United States FDA. Our products may also be regulated by comparable agencies in non-U.S. countries in which they are produced or sold. In the European Union (\\\"EU\\\"), our products are subject to the medical devices laws of the various member states, which are based on a Directive of the European Commission. Such laws generally regulate the safety of the products in a similar way to the FDA regulations.\\nWe believe we are in compliance with all FDA, federal and state laws and International regulatory requirements that are applicable to our products and manufacturing operations.\\nWe are also subject to various laws inside and outside the U.S. concerning our relationships with healthcare professionals and government officials, price reporting and regulation, the promotion, sales and marketing of our products and services, the importation and exportation of our products, the operation of our facilities and distribution of our products. As a global company, we are subject to varying degrees of government regulation in the various countries in which we do business, and the general trend is toward increasingly stringent oversight and enforcement. Initiatives sponsored by government agencies, legislative bodies, and the private sector to limit the growth of healthcare expenses generally are ongoing in markets where we do business. It is not possible to predict at this time the long-term impact of such cost containment measures on our future business.\\nOur customers are healthcare providers that may be reimbursed by federally funded programs such as Medicaid or a foreign national healthcare program, each of which may offer some degree of oversight. Many government agencies, both domestic and foreign, have increased their enforcement activities with respect to healthcare providers and companies in recent years. Enforcement actions and associated defense can be expensive, and any resulting findings carry the risk of significant civil and criminal penalties. For example, the U.S. Federal Physician Payment Sunshine Act went into effect in 2014 which requires public transparency of transfers of value to physicians.\\nIn addition, we must comply with numerous data protection requirements that span from individual state and national laws in the U.S. to multinational requirements in the EU. In the U.S., final regulations implementing amendments to the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) became effective in the latter part of 2013 with the HIPAA Omnibus Rule. The EU is currently considering a proposal to enact legislation governing data protection which would transform the current mix of European countries’ laws to one overarching multinational law. Meanwhile, the Asia Pacific region has also seen rapid development of privacy laws, including in Singapore, Hong Kong, and Australia. We believe we have designed our product and service offerings to be compliant with the requirements of applicable data protection laws and regulations. Maintaining systems that are compliant with these laws and regulations is costly and could require complex changes in the way we do business or provide services to our customers and their patients. Additionally, our success may be dependent on the success of healthcare providers in managing data protection requirements.\\nEmployees\\nAs of December 31, 2016, we had approximately 6,060 employees, including 3,970 in manufacturing and operations, 1,270 in sales and marketing which includes customer care, 430 in research and development and 390 in general and administrative functions.\\n12\\nAvailable Information\\nOur website is www.aligntech.com, and our investor relations website is http://investor.aligntech.com. The information on or accessible through our websites is not part of this Annual Report on Form 10-K. Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, our proxy statement on Schedule 14A for our annual stockholders’ meeting and amendments to such reports are available, free of charge, on our investor relations website as soon as reasonably practicable after we electronically file or furnish such material with the SEC. Further, a copy of this Annual Report on Form 10-K is located at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Information on the operation of the Public Reference Room can be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains an internet site that contains reports, proxy and information statements and other information regarding our filings at www.sec.gov.\\nExecutive Officers of the Registrant\\nThe following table sets forth certain information regarding our executive officers as of February 28, 2017:\\n\\n| Name | Age | Position |\\n| Joseph M. Hogan | 59 | President and Chief Executive Officer |\\n| John F. Morici | 50 | Chief Financial Officer |\\n| Simon Beard | 50 | Vice President and Managing Director, EMEA |\\n| Roger E. George | 51 | Vice President, Corporate and Legal Affairs and General Counsel |\\n| Stuart Hockridge | 45 | Vice President, Global Human Resources |\\n| Sreelakshmi Kolli | 42 | Vice President, Information Technology |\\n| Jennifer Olson | 39 | Vice President and Managing Director, Doctor Directed Consumer Channel |\\n| Raphael Pascaud | 45 | Chief Marketing Portfolio and Business Development Officer, and Vice President iTero Scanner and Services |\\n| Lynn Pendergrass | 56 | Vice President and Managing Director, Americas |\\n| Christopher C. Puco | 56 | Vice President and Managing Director, North America |\\n| Zelko Relic | 52 | Vice President, Research & Development |\\n| Julie Tay | 50 | Vice President and Managing Director, Asia Pacific |\\n| Emory M. Wright | 47 | Vice President, Operations |\\n\\nJoseph M. Hogan has served as our President and Chief Executive Officer and as a member of our Board of Directors since June 2015. Prior to joining us, Mr. Hogan was Chief Executive Officer of ABB Ltd., a global power and automation technologies company based in Zurich, Switzerland from 2008 to 2013. Prior to working in ABB, Mr. Hogan worked at General Electric Company (GE) in a variety of executive and management roles from 1985 to 2008, including eight years as Chief Executive Officer of GE Healthcare from 2000 to 2008.\\nJohn F. Morici has served as our Chief Financial Officer since November 2016. Prior to joining us, Mr. Morici was at NBC Universal from 2007 to 2016 where he held several senior management positions in their Universal Pictures Home Entertainment U.S. and Canadian business, including Chief Financial Officer, Chief Operating Officer, and most recently, Executive Vice President and Managing Director from 2014 to 2016. Prior to NBC Universal, Mr. Morici was in various senior financial management positions at GE Healthcare from 1999 to 2007, including Chief Financial Officer for its Diagnostic Imaging and Global Products units from 2002 to 2003.\\nSimon Beard has served as our Vice President and Managing Director, EMEA since October 2015. Prior to joining us, from 2012 to 2014, Mr. Beard was Regional Director for the South East Asia business of Smith & Nephew, a multinational medical equipment manufacturing company. From 2006 to 2012, Mr. Beard was Director & General Manager for UK and Ireland for Smith & Nephew's Advanced Woundcare business. Prior to Smith & Nephew, Mr. Beard held multiple commercial, strategic, and general management positions in companies such as DePuy International (Johnson & Johnson), Sankyo Pharmaceutical and Sanofi Aventis.\\nRoger E. George has served as our Vice President, Corporate and Legal Affairs and General Counsel since July 2002. Prior to joining us, Mr. George was the Chief Financial Officer, Vice President of Finance and Legal Affairs and General Counsel of SkyStream Networks, a privately held broadband and broadcast network equipment company. Prior to SkyStream, Mr. George was a partner at Wilson Sonsini Goodrich & Rosati, P.C. in Palo Alto, California.\\n13\\nStuart Hockridge has served as our Vice President, Global Human Resources since May 2016. Prior to joining us, Mr. Hockridge was Senior Vice President of Talent at Visa Inc. from 2013 to 2016 where he led all aspects of talent delivery for the company including executive development, succession planning, employee engagement, learning and development, and talent acquisition. Prior to Visa, Mr. Hockridge held a number of human resource management positions at GE Healthcare from 2002 to 2012 leading HR processes both globally and for various divisions.\\nSreelakshmi Kolli has served as our Vice President, Information Technology since December 2012. Ms. Kolli joined us in June 2003 and has held positions leading business operations and engineering for customer-facing applications. Before joining us, she held technical lead positions with Sword CT Space and Accenture.\\nJennifer Olson has served as our Vice President and Managing Director, Doctor-Directed Consumer Channel since August 2016. Ms. Olson joined us in 2002 and has held multiple roles in sales, marketing, and business development. Most recently, she was Area Sales Director for the North America region where she led all sales activities in Western Canada and the Western region of the U.S. Prior to joining Align, Ms. Olson was with technology companies including Extreme Networks and PWI Technologies.\\nRaphael Pascaud has served as our Chief Marketing, Portfolio and Business Development Officer, and Vice President, iTero Scanner and Services since July 2015. He joined Align in 2010 as Vice President and Managing Director for the EMEA and was promoted in January 2014 to Vice President, International. Prior to Align, Mr. Pascaud spent 14 years in various management positions within DePuy, a Johnson & Johnson family of companies, including Vice President Orthopedics of EMEA and Vice President Marketing of International.\\nLynn Pendergrass has served as our Vice President and Managing Director, Americas since February 2017. Prior to joining us, Ms. Pendergrass was president of Sears Holdings Corporation's hardlines division from 2015 to 2016. Prior to Sears, Ms. Pendergrass served as Worldwide Chairman for Johnson & Johnson Consumer from 2013 to 2014, and as Americas Senior Vice President for Hewlett-Packard's Printing & Personal Systems and its Imaging & Printing Group from 2008 to 2012. Ms. Pendergrass also spent 22 years at General Electric in various operating and commercial roles and held several executive management positions in sales and marketing for its Consumer & Industrial division.\\nChristopher C. Puco has served as our Vice President and Managing Director, North America since February 2017. He joined us in 2006 as a sales director and in 2008 became senior director for the U.S. Eastern sales area. He served as Vice President of North America from December 2012 to February 2017. Mr. Puco has more than 20 years of experience in the medical device industry holding sales management positions in both starts-ups and established corporate environments. Prior to joining us, he was with United States Surgical Corporation, General Surgical Innovations, Baxter BioSurgery and Fusion Medical Technologies.\\nZelko Relic was appointed Vice President, Research & Development in December 2013. Prior to joining us, Mr. Relic was Vice President, Engineering for Datalogic Automation, a global leader in automatic data capture and industrial automation markets from 2012. Mr. Relic was previously Vice President, Engineering at Danaher Corporation, Accu-Sort Systems business from 2010 to 2012 before it was acquired by Datalogic Automation. From 2005 to 2010, he was at Siemens Medical Solutions USA, most recent as Vice President, and from 2002 to 2004, he held senior management positions in engineering at Kulicke & Soffa Industries, designers and manufactures of semiconductor products. He also held management positions at KLA-Tencor from 1994 to 2000.\\nJulie Tay was appointed Vice President and Managing Director, Asia Pacific in March 2013. Prior to joining us, Ms. Tay was regional head of Bayer Healthcare (Diabetes Care) overseeing operations across Asia from 2010 to 2013. From 2006 to 2010, Ms. Tay served as director of marketing and corporate accounts at Sealed Air Corporation (formerly Johnson Diversey), a global provider of food safety and security, facility hygiene and product protection. Prior to that, Ms. Tay spent 15 years with Johnson & Johnson Medical.\\nEmory M. Wright has served as our Vice President, Operations since December 2007. He has been with us since March 2000 predominantly in manufacturing and operations roles including Vice President, Manufacturing and was General Manager of New Product Development. Prior to joining Align, Mr. Wright was Senior Manufacturing Manager at Metrika, Inc. a medical device manufacturer from 1999 to 2000. From 1994 to 1999, Mr. Wright served as Manager of Manufacturing and Process Development for Metra Biosystems Inc.\\n14\\nITEM 1A.\\nRISK FACTORS\\nWe depend on the sale of the Invisalign system for the vast majority of our net revenues, and any decline in sales of Invisalign treatment for any reason, or a decline in average selling prices would adversely affect net revenues, gross margin and net income.\\nWe expect that net revenues from the sale of the Invisalign System, primarily Invisalign Full and Invisalign Teen, will continue to account for the vast majority of our total net revenues for the foreseeable future. Continued and widespread market acceptance of Invisalign by orthodontists, GPs and consumers is critical to our future success. If orthodontists and GPs experience a reduction in consumer demand for orthodontic services, if consumers prove unwilling to adopt Invisalign as rapidly as we anticipate or in the volume that we anticipate, if orthodontists or GPs choose to use a competitive product rather than Invisalign or if the average selling price of our product declines, our operating results would be harmed.\\nCompetition in the markets for our products is intense and we expect aggressive competition from existing competitors and other companies that may introduce new technologies in the future.\\nCurrently, our products compete directly against products manufactured and distributed by various companies, both within and outside the U.S. Many of these manufacturers, including Danaher Corporation, Sirona Dental Systems, Inc., Dentsply International, Inc. and 3M, have substantially greater financial resources and manufacturing and marketing experience than we do. In addition, as a result of the expiration of certain key patents owned by us, commencing in 2017, we expect that these existing competitors as well as new entrants into the clear aligner market will begin offering an orthodontic system more similar to ours in the near future. Several of these competitors will likely have greater resources as well as the ability to leverage their existing channels in the dental market to compete directly with us, and therefore our share of the clear aligner market could decline which would likely have a material adverse effect on our business, results of operation and financial condition. In addition, corresponding foreign patents will start to expire in 2018 which will likely result in increased competition in some of the markets outside the U.S. large consumer product companies may also enter the orthodontic supply market. Furthermore, we also face competition for companies that now offer clear aligner therapy directly to the consumer eliminating the need for the consumer to visit a dental office. In addition, we may also face competition in the future from new companies that may introduce new technologies. We may be unable to compete with these competitors and one or more of these competitors may render our technology obsolete or economically unattractive. If we are unable to compete effectively with existing products or respond effectively to any products developed by new or existing competitors, our business could be harmed. Increased competition has resulted in the past and may in the future result in volume discounting and price reductions, reduced gross margins, reduced profitability and loss of market share, and reduce dental professionals’ efforts and commitment to expand their use of our products, any of which could have a material adverse effect on our net revenues, volume growth, net income and stock price. We cannot assure that we will be able to compete successfully against our current or future competitors or that competitive pressures will not have a material adverse effect on our business, results of operations and financial condition.\\nWe are dependent on our international operations, which exposes us to foreign operational, political and other risks that may harm our business.\\nOur key production steps are performed in operations located outside of the U.S. At our facility in San Jose, Costa Rica, technicians use a sophisticated, internally developed computer-modeling program to prepare digital treatment plans, which are then transmitted electronically to Juarez, Mexico. These digital files form the basis of the ClinCheck treatment plan and are used to manufacture aligner molds. Our order acquisition, aligner fabrication and shipping operations are conducted in Juarez, Mexico and starting in July 2016, we transitioned order acquisition for EMEA region to our facility in Amsterdam, the Netherlands. In addition to the research and development efforts conducted in our North America facilities, we also carry out research and development in Moscow, Russia. We also have customer-care, accounts receivable, credit and collections, customer event registration and accounts payable organizations located at our facility in San Jose, Costa Rica. In addition, we have operations in Israel where the design and wand assembly and our intraoral scanner are manufactured. Our reliance on international operations exposes us to risks and uncertainties that may affect our business or results of operation, including:\\n| • | difficulties in hiring and retaining employees generally, as well as difficulties in hiring and retaining employees with the necessary skills to perform the more technical aspects of our operations; |\\n\\n| • | difficulties in managing international operations, including any travel restrictions to or from our facilities located in Russia, Israel and other countries; |\\n\\n| • | fluctuations in currency exchange rates; |\\n\\n| • | increased income taxes, and other restrictions and limitations, if we were to decide to repatriate any of our foreign cash balances back to the U.S.; |\\n\\n15\\n| • | import and export license requirements and restrictions; |\\n\\n| • | controlling production volume and quality of the manufacturing process; |\\n\\n| • | political, social and economic instability, including as a result of increased levels of violence in Juarez, Mexico or the Middle East. We cannot predict the effect on us of any future armed conflict, political instability or violence in these regions. In addition, some of our employees in Israel are obligated to perform annual reserve duty in the Israeli military and are subject to being called for additional active duty under emergency circumstances. We cannot predict the full impact of these conditions on us in the future, particularly if emergency circumstances or an escalation in the political situation occurs. If many of our employees are called for active duty, our operations in Israel and our business may not be able to function at full capacity; |\\n\\n| • | acts of terrorism and acts of war; |\\n\\n| • | general geopolitical instability and the responses to it, such as the possibility of additional sanctions against Russia which continue to bring uncertainty to this region; |\\n\\n| • | interruptions and limitations in telecommunication services; |\\n\\n| • | product or material transportation delays or disruption, including as a result of increased levels of violence, acts of terrorism, acts of war or health epidemics restricting travel to and from our international locations or as a result of natural disasters, such as earthquakes or volcanic eruptions; |\\n\\n| • | burdens of complying with a wide variety of local country and regional laws, including the risks associated with the Foreign Corrupt Practices Act and local anti-bribery compliance; |\\n\\n| • | trade restrictions and changes in tariffs; and |\\n\\n| • | potential adverse tax consequences. |\\n\\nIf any of these risks materialize in the future, we could experience production delays and lost or delayed revenue.\\nIn addition, President Donald Trump and his administration have made recent statements regarding the possibility of changing the way in which the international operations of U.S. companies are taxed, including through the implementation of a border tax, tariff or increase in custom duties on products manufactured in countries outside of the U.S., such as Mexico, and imported into the U.S. In the event such taxes, tariffs, increased custom duties or other measures are implemented, they could have a materially adverse effect on our business and or operating results, and we may have to consider relocating some of our international operations.\\nWe earn an increasingly larger portion of our total revenues from international sales and face risks attendant to those operations.\\nWe earn an increasingly larger portion of our total revenues from international sales generated through our foreign direct and indirect operations. Since our growth strategy depends in part on our ability to further penetrate markets outside the U.S. and increase the localization of our products and services, we expect to continue to increase our sales and presence outside the U.S., particularly in the high-growth markets. Our international operations are subject to risks that are customarily encountered in non-U.S. operations, including:\\n| • | local political and economic instability; |\\n\\n| • | the engagement of activities by our employees, contractors, partners and agents, especially in countries with developing economies, that are prohibited by international and local trade and labor laws and other laws prohibiting corrupt payments to government officials, including the Foreign Corrupt Practices Act, the UK Bribery Act of 2010 and export control laws, in spite of our policies and procedures designed to ensure compliance with these laws; |\\n\\n| • | although it is our intention to indefinitely reinvest earnings outside the U.S., restrictions on the transfer of funds held by our foreign subsidiaries, including with respect to restrictions on our ability to repatriate foreign cash to the U.S at favorable tax rates; |\\n\\n| • | fluctuations in currency exchange rates; and |\\n\\n| • | increased expense of developing, testing and making localized versions of our products. |\\n\\n16\\nAny of these factors, either individually or in combination, could materially impact our international operations and adversely affect our business as a whole.\\nWe face risks related to our international sales, including the need to obtain necessary foreign regulatory clearance or approvals.\\nOutside of North America, we currently sell our products in Europe, Asia Pacific, Latin America and the Middle East and may expand into other countries from time to time. For sales of our products outside the U.S., we are subject to foreign regulatory requirements that vary widely from country to country. The time required to obtain clearances or approvals required by other countries may be longer than that required for FDA clearance or approval, and requirements for such approvals may differ from FDA requirements. We may be unable to obtain regulatory approvals in one or more of the other countries in which we do business or in which we may do business in the future. We may also incur significant costs in attempting to obtain and maintain foreign regulatory approvals. If we experience delays in receipt of approvals to market our products outside of the U.S., or if we fail to receive these approvals, we may be unable to market our products or enhancements in international markets in a timely manner, if at all, which could materially impact our international operations and adversely affect our business as a whole.\\nDemand for our products may not increase as rapidly as we anticipate due to a variety of factors including a weakness in general economic conditions.\\nConsumer spending habits are affected by, among other things, prevailing economic conditions, levels of employment, salaries and wage rates, gas prices, consumer confidence and consumer perception of economic conditions. A general slowdown in the U.S. economy and certain international economies or an uncertain economic outlook would adversely affect consumer spending habits which may, among other things, result in a decrease in the number of overall orthodontic case starts, reduced patient traffic in dentists’ offices, reduction in consumer spending on higher value procedures or a reduction in the demand for dental services generally, each of which would have a material adverse effect on our sales and operating results. Weakness in the global economy results in a challenging environment for selling dental technologies and dentists may postpone investments in capital equipment, such as intraoral scanners. In addition, Invisalign treatment, which currently accounts for the vast majority of our net revenues, represents a significant change from traditional orthodontic treatment, and customers and consumers may be reluctant to accept it or may not find it preferable to traditional treatment. We have generally received positive feedback from orthodontists, GPs and consumers regarding Invisalign treatment as both an alternative to braces and as a clinical method for the treatment of malocclusion, but a number of dental professionals believe that the Invisalign treatment is appropriate for only a limited percentage of their patients. Increased market acceptance of all of our products will depend in part upon the recommendations of dental professionals, as well as other factors including effectiveness, safety, ease of use, reliability, aesthetics, and price compared to competing products.\\nThe frequency of use of the Invisalign system by orthodontists or GPs may not increase at the rate that we anticipate or at all.\\nOne of our key objectives is to continue to increase utilization, or the adoption and frequency of use, of the Invisalign System by new and existing customers. If utilization of the Invisalign System by our existing and newly trained orthodontists or GPs does not occur or does not occur as quickly as we anticipate, our operating results could be harmed.\\nWe may experience declines in average selling prices of our products which may decrease our net revenues.\\nWe provide volume based discount programs to our doctors. In addition, we sell a number of products at different list prices. If we introduce any price reductions or consumer rebate programs; if we expand our discount programs in the future or participation in these programs increases; or if our product mix shifts to lower priced products or products that have a higher percentage of deferred revenue, our average selling prices would be adversely affected and our net revenues, gross profit, gross margin and net income may be reduced. In July 2015, we launched a new product policy called \\\"Additional Aligners at No Charge\\\" that addresses one of our customer's top complaints. With this product policy change, we no longer distinguish between mid-course correction and case refinements and allow doctors to order additional aligners to address either treatment need at no charge, subject to certain requirements. Based on this product policy, beginning in the third quarter of 2015, we deferred more revenue as a result of providing free additional aligners for eligible treatments. Additionally, as we grandfathered over 1 million open cases, we will recognize lower revenues as additional aligners are shipped for at least the following two years until these cases complete.\\nWe are exposed to fluctuations in currency exchange rates, which could negatively affect our financial condition and results of operations.\\nAlthough the U.S. dollar is our reporting currency, a portion of our net revenues and net income are generated in foreign currencies. Net revenues and net income generated by subsidiaries operating outside of the U.S. are translated into U.S. dollars\\n17\\nusing exchange rates effective during the respective period and are affected by changes in exchange rates. As a result, negative movements in currency exchange rates against the U.S. dollar will adversely affect our net revenues and net income in our consolidated financial statements. The exchange rate between the U.S. dollar and foreign currencies has fluctuated substantially in recent years and may continue to fluctuate substantially in the future. We have in the past and may in the future enter into currency hedging transactions in an effort to cover some of our exposure to foreign currency exchange fluctuations. These transactions may not operate to fully or effectively hedge our exposure to currency fluctuations, and, under certain circumstances, these transactions could have an adverse effect on our financial condition.\\nAs we continue to grow, we are subject to growth related risks, including risks related to excess or constrained capacity at our existing facilities.\\nWe are subject to growth related risks, including excess or constrained capacity and pressure on our internal systems and personnel. In order to manage current operations and future growth effectively, we will need to continue to implement and improve our operational, financial and management information systems and to hire, train, motivate, manage and retain employees. We may be unable to manage such growth effectively. Any such failure could have a material adverse impact on our business, operations and prospects. In the near term, we intend to establish additional order acquisition and treatment planning facilities closer to our international customers in order to improve our operational efficiency and provide doctors with a better experience to further improve their confidence in using Invisalign to treat more patients, more often. Our ability to plan, construct and equip additional order acquisition, treatment planning and manufacturing facilities is subject to significant risk and uncertainty, including risks inherent in the establishment of a facility, such as hiring and retaining employees and delays and cost overruns as a result of a number of factors, any of which may be out of our control. If the transition into this additional facility is significantly delayed or demand for our product exceeds our current expectations, we may not be able to fulfill orders timely, which may negatively impact our financial results and overall business. In addition, because we cannot immediately adapt our production capacity and related cost structures to changing market conditions, our facility capacity may at times exceed or fall short of our production requirements. In addition, if product demand decreases or we fail to forecast demand accurately, we could be required to write off inventory or record excess capacity charges, which would lower our gross margin. Production of our intraoral scanners may also be limited by capacity constraints due to a variety of factors, including our dependency on third party vendors for key components in addition to limited production yields. Any or all of these problems could result in the loss of customers, provide an opportunity for competing products to gain market acceptance and otherwise harm our business and financial results.\\nIf we fail to sustain or increase profitability or revenue growth in future periods, the market price for our common stock may decline.\\nIf we are to sustain or increase profitability in future periods, we will need to continue to increase our net revenues, while controlling our expenses. Because our business is evolving, it is difficult to predict our future operating results or levels of growth, and we have not in the past and may not in the future be able to sustain our historical growth rates. If we do not increase profitability or revenue growth or otherwise meet the expectations of securities analysts or investors, the market price of our common stock will likely decline.\\nOur financial results have fluctuated in the past and may fluctuate in the future which may cause volatility in our stock price.\\nOur operating results have fluctuated in the past and we expect our future quarterly and annual operating results to fluctuate as we focus on increasing doctor and consumer demand for our products. These fluctuations could cause our stock price to decline or significantly fluctuate. Some of the factors that could cause our operating results to fluctuate include:\\n| • | limited visibility into and difficulty predicting the level of activity in our customers’ practices from quarter to quarter; |\\n\\n| • | weakness in consumer spending as a result of the slowdown in the U.S. economy and global economies; |\\n\\n| • | changes in relationships with our distributors; |\\n\\n| • | changes in the timing of receipt of Invisalign case product orders during a given quarter which, given our cycle time and the delay between case receipts and case shipments, could have an impact on which quarter revenue can be recognized; |\\n\\n| • | fluctuations in currency exchange rates against the U.S. dollar; |\\n\\n| • | changes in product mix; |\\n\\n| • | our inability to scale production of our iTero Element scanner to meet customer demand; |\\n\\n| • | if participation in our customer rebate or discount programs increases our average selling price will be adversely affected; |\\n\\n18\\n| • | seasonal fluctuations in the number of doctors in their offices and their availability to take appointments; |\\n\\n| • | success of or changes to our marketing programs from quarter to quarter; |\\n\\n| • | our reliance on our contract manufacturers for the production of sub-assemblies for our intraoral scanners; |\\n\\n| • | timing of industry tradeshows; |\\n\\n| • | changes in the timing of when revenue is recognized, including as a result of the introduction of new products or promotions, modifications to our terms and conditions or as a result of changes to critical accounting estimates or new accounting pronouncements; |\\n\\n| • | changes to our effective tax rate; |\\n\\n| • | unanticipated delays in production caused by insufficient capacity or availability of raw materials; |\\n\\n| • | any disruptions in the manufacturing process, including unexpected turnover in the labor force or the introduction of new production processes, power outages or natural or other disasters beyond our control; |\\n\\n| • | the development and marketing of directly competitive products by existing and new competitors; |\\n\\n| • | disruptions to our business as a result of our agreement to manufacture clear aligners for SmileDirectClub, LLC (\\\"SDC\\\"), including, market acceptance of the SDC business model and product, possible adverse customer reaction and negative publicity about us and our products; |\\n\\n| • | impairments in the value of our strategic investments in SDC and other privately held companies could be material; |\\n\\n| • | major changes in available technology or the preferences of customers may cause our current product offerings to become less competitive or obsolete; |\\n\\n| • | aggressive price competition from competitors; |\\n\\n| • | costs and expenditures in connection with litigation; |\\n\\n| • | the timing of new product introductions by us and our competitors, as well as customer order deferrals in anticipation of enhancements or new products; |\\n\\n| • | unanticipated delays in our receipt of patient records made through an intraoral scanner for any reason; |\\n\\n| • | disruptions to our business due to political, economic or other social instability, including the impact of an epidemic any of which results in changes in consumer spending habits, consumers unable or unwilling to visit the orthodontist or general practitioners office, as well as any impact on workforce absenteeism; |\\n\\n| • | inaccurate forecasting of net revenues, production and other operating costs, |\\n\\n| • | investments in research and development to develop new products and enhancements; |\\n\\n| • | changes in accounting rules; and |\\n\\n| • | our ability to successfully hedge against a portion of our foreign currency-denominated assets and liabilities. |\\n\\nTo respond to these and other factors, we may need to make business decisions that could adversely affect our operating results such as modifications to our pricing policy, business structure or operations. Most of our expenses, such as employee compensation and lease payment obligations, are relatively fixed in the short term. Moreover, our expense levels are based, in part, on our expectations regarding future revenue levels. As a result, if our net revenues for a particular period fall below our expectations, whether caused by changes in consumer spending, consumer preferences, weakness in the U.S. or global economies, changes in customer behavior related to advertising and prescribing our product or other factors, we may be unable to adjust spending quickly enough to offset any shortfall in net revenues. Due to these and other factors, we believe that quarter-to-quarter comparisons of our operating results may not be meaningful. You should not rely on our results for any one quarter as an indication of our future performance.\\n19\\nOur future success may depend on our ability to develop, successfully introduce and achieve market acceptance of new products.\\nOur future success may depend on our ability to develop, manufacture, market and obtain regulatory approval or clearance of new products. There can be no assurance that we will be able to successfully develop, sell and achieve market acceptance of these and other new products and applications and enhanced versions of our existing product or software. The extent of, and rate at which, market acceptance and penetration are achieved by future products is a function of many variables, which include, among other things, our ability to:\\n| • | correctly identify customer needs and preferences and predict future needs and preferences; |\\n\\n| • | include functionality and features that address customer requirements; |\\n\\n| • | ensure compatibility of our computer operating systems and hardware configurations with those of our customers; |\\n\\n| • | allocate our research and development funding to products with higher growth prospects; |\\n\\n| • | anticipate and respond to our competitors’ development of new products and technological innovations; |\\n\\n| • | differentiate our offerings from our competitors’ offerings; |\\n\\n| • | innovate and develop new technologies and applications; |\\n\\n| • | the availability of third-party reimbursement of procedures using our products; |\\n\\n| • | obtain adequate intellectual property rights; and |\\n\\n| • | encourage customers to adopt new technologies. |\\n\\nIf we fail to accurately predict customer needs and preferences or fail to produce viable technologies, we may invest heavily in research and development of products that do not lead to significant revenue. Even if we successfully innovate and develop new products and produce enhancements, we may incur substantial costs in doing so and our profitability may suffer. In addition, even if our new products are successfully introduced, it is unlikely that they will rapidly gain market share and acceptance primarily due to the relatively long period of time it takes to successfully treat a patient with Invisalign. Since it takes approximately 12 to 24 months to treat a patient, our customers may be unwilling to rapidly adopt our new products until they successfully complete at least one case or until more historical clinical results are available.\\nOur ability to market and sell new products may also be subject to government regulation, including approval or clearance by the FDA and foreign government agencies. Any failure in our ability to successfully develop and introduce or achieve market acceptance of our new products or enhanced versions of existing products could have a material adverse effect on our operating results and could cause our net revenues to decline.\\nA disruption in the operations of our primary freight carrier or higher shipping costs could cause a decline in our net revenues or a reduction in our earnings.\\nWe are dependent on commercial freight carriers, primarily UPS, to deliver our products to our customers. If the operations of these carriers are disrupted for any reason, we may be unable to deliver our products to our customers on a timely basis. If we cannot deliver our products in an efficient and timely manner, our customers may reduce their orders from us and our net revenues and operating profits could materially decline. In a rising fuel cost environment, our freight costs will increase. If freight costs materially increase and we are unable to pass that increase along to our customers for any reason or otherwise offset such increases in our cost of net revenues, our gross margin and financial results could be adversely affected.\\nIf we are unable to accurately predict our volume growth, and fail to hire a sufficient number of technicians in advance of such demand, the delivery time of our products could be delayed which could adversely affect our results of operations.\\nTreatment planning is a key step leading to our manufacturing process which relies on sophisticated computer technology requiring new technicians to undergo a relatively long training process. Training production technicians takes approximately 90 to 120 days. As a result, if we are unable to accurately predict our volume growth, we may not have a sufficient number of trained technicians to deliver our products within the timeframe our customers expect. Such a delay could cause us to lose existing customers or fail to attract new customers. This could cause a decline in our net revenues and net income and could adversely affect our results of operations.\\n20\\nOur headquarters, digital dental modeling processes, and other manufacturing processes are principally located in regions that are subject to earthquakes and other natural disasters.\\nOur digital dental modeling is processed in our facility located in San Jose, Costa Rica. The operations team in Costa Rica creates ClinCheck treatment plans using sophisticated computer software. In addition, our customer facing operations are located in Costa Rica. Our aligner molds and finished aligners are fabricated in Juarez, Mexico. Both locations in Costa Rica and Mexico are in earthquake zones and may be subject to other natural disasters. If there is a major earthquake or any other natural disaster in a region where one of these facilities is located, our ability to create ClinCheck treatment plans, respond to customer inquiries or manufacture and ship our aligners could be compromised which could result in our customers experiencing a significant delay in receiving their completed aligners and a decrease in service levels for a period of time. In addition, our corporate headquarters facility in California is located in the San Francisco Bay Area. An earthquake or other natural disaster in this region could result in a disruption in our operations. Any such business interruption could materially and adversely affect our business, financial condition and results of operations.\\nOur information technology systems are critical to our business. System integration and implementation issues and system security risks could disrupt our operations, which could have a material adverse impact on our business and operating results.\\nWe rely on the efficient and uninterrupted operation of complex information technology systems. All information technology systems are vulnerable to damage or interruption from a variety of sources. As our business has grown in size and complexity, the growth has placed, and will continue to place, significant demands on our information technology systems. To effectively manage this growth, our information systems and applications require an ongoing commitment of significant resources to maintain, protect and enhance existing systems and develop new systems to keep pace with continuing changes in information processing technology, evolving industry and regulatory standards and changing customer preferences. We are in a multi-year, company-wide program to transform certain business processes or extend established processes which includes the transition to a new enterprise resource planning (\\\"ERP\\\") software system. We implemented the first phase of our ERP on July 1, 2016 and, while we believe we are past any potential significant business disruption, we are still monitoring and troubleshooting potential issues. The implementation of additional functionality in the ERP system entails certain risks, including difficulties with changes in business processes that could disrupt our operations, such as our ability to track orders and timely ship products, manage our supply chain and aggregate financial and operational data. Additionally, this implementation may not achieve the anticipated benefits and may divert management's attention from other operational activities, negatively affect employee morale, or have other unintended consequences. Additionally, if we are not able to accurately forecast expenses related to the project, this may have an adverse impact on our financial condition and operating results.\\nIf the information we rely upon to run our businesses were to be found to be inaccurate or unreliable, if we fail to properly maintain our information systems and data integrity, or if we fail to develop new capabilities to meet our business needs in a timely manner, we could have operational disruptions, have customer disputes, lose our ability to produce timely and accurate reports, have regulatory or other legal problems, have increases in operating and administrative expenses, lose existing customers, have difficulty in attracting new customers or in implementing our growth strategies, or suffer other adverse consequences. In addition, experienced computer programmers and hackers may be able to penetrate our network security or our cloud-based software servers hosted by third party and misappropriate our confidential information or that of third parties, create system disruptions or cause shutdowns. Furthermore, sophisticated hardware and operating system software and applications that we either internally develop or procure from third parties which we depend upon may contain defects in design and manufacture, including “bugs” and other problems that can unexpectedly interfere with the operation of the system. The costs to eliminate or alleviate security problems, viruses and bugs could be significant, and the efforts to address these problems could result in interruptions that may have a material adverse impact on our operations, net revenues and operating results.\\nSystem upgrades and enhancements require significant expenditures and allocation of valuable employee resources. Delays in integration or disruptions to our business from implementation of these new or upgraded systems could have a material adverse impact on our financial condition and operating results.\\nAdditionally, we continuously upgrade our customer facing software applications, specifically the ClinCheck and MyAligntech software. Software applications frequently contain errors or defects, especially when they are first introduced or when new versions are released. The discovery of a defect or error or the incompatibility with the computer operating system and hardware configurations of customers in a new upgraded version or the failure of our primary information systems may result in the following consequences, among others: loss of revenue or delay in market acceptance, damage to our reputation or increased service costs, any of which could have a material adverse effect on our business, financial condition or results of operations.\\nFurthermore, our business requires the secure transmission of confidential information over public networks. Because of the confidential health information we store and transmit, security breaches could expose us to a risk of regulatory action, litigation,\\n21\\npossible liability and loss. Our security measures may be inadequate to prevent security breaches, and our business operations and profitability would be adversely affected by, among other things, loss of customers and potential criminal and civil sanctions if they are not prevented.\\nThere can be no assurance that our process of improving existing systems, developing new systems to support our expanding operations, integrating new systems, protecting confidential patient information, and improving service levels will not be delayed or that additional systems issues will not arise in the future. Failure to adequately protect and maintain the integrity of our information systems and data may result in a material adverse effect on our financial position, results of operations and cash flows.\\nIf the security of our customer and patient information is compromised, patient care could suffer, and we could be liable for related damages, and our reputation could be impaired.\\nWe retain confidential customer and patient information in our processing centers. Therefore, it is critical that our facilities and infrastructure remain secure and that our facilities and infrastructure are perceived by the marketplace and our customers to be secure. Despite the implementation of security measures, our infrastructure may be vulnerable to physical break-ins, computer viruses, programming errors, attacks by third parties or similar disruptive problems. If we fail to meet our clients’ expectations regarding the security of healthcare information, we could be liable for damages and our reputation could be impaired. In addition, patient care could suffer, and we could be liable if our systems fail to deliver correct information in a timely manner. Our insurance may not protect us from this risk.\\nOur success depends in part on our proprietary technology, and if we are unable to successfully enforce our intellectual property rights, our competitive position may be harmed. Litigating claims of this type is costly and could distract our management and cause a decline in our results of operations and stock price.\\nOur success will depend in part on our ability to maintain existing intellectual property and to obtain and maintain further intellectual property protection for our products, both in the U.S. and in other countries. Our inability to do so could harm our competitive position. As of December 31, 2016, we had issued 425 U.S. patents, 370 foreign issued patents, and 386 pending global patent applications.\\nWe intend to rely on our portfolio of issued and pending patent applications in the U.S. and in other countries to protect a large part of our intellectual property and our competitive position; however, our currently pending or future patent filings may not result in the issuance of patents. Additionally, any patents issued to us may be challenged, invalidated, held unenforceable, circumvented, or may not be sufficiently broad to prevent third parties from producing competing products similar in design to our products. In addition, any protection afforded by foreign patents may be more limited than that provided under U.S. patents and intellectual property laws. We also rely on protection of our copyrights, trade secrets, know-how and proprietary information. We generally enter into confidentiality agreements with our employees, consultants and our collaborative partners upon commencement of a relationship with us; however, these agreements may not provide meaningful protection against the unauthorized use or disclosure of our trade secrets or other confidential information, and adequate remedies may not exist if unauthorized use or disclosure were to occur. Our inability to maintain the proprietary nature of our technology through patents, copyrights or trade secrets would impair our competitive advantages and could have a material adverse effect on our operating results, financial condition and future growth prospects. In particular, a failure to protect our proprietary rights might allow competitors to copy our technology, which could adversely affect our pricing and market share. In addition, in an effort to protect our intellectual property we have in the past been and may in the future be involved in litigation. The potential effects on our business operations resulting from litigation that we may participate in the future, whether or not ultimately determined in our favor or settled by us, are costly and divert the efforts and attention of our management and technical personnel from normal business operations.\\nLitigation, interferences, oppositions, inter partes reviews or other proceedings are, have been and may in the future be necessary in some instances to determine the validity and scope of certain of our proprietary rights, and in other instances to determine the validity, scope or non-infringement of certain patent rights claimed by third parties to be pertinent to the manufacture, use or sale of our products. Litigation, interference, oppositions, inter partes reviews, administrative challenges or other similar types of proceedings are unpredictable and may be protracted, expensive and distracting to management. The outcome of such proceedings could adversely affect the validity and scope of our patent or other proprietary rights, hinder our ability to manufacture and market our products, require us to seek a license for the infringed product or technology or result in the assessment of significant monetary damages. An unfavorable ruling could include monetary damages or, in cases where injunctive relief is sought, an injunction prohibiting us from selling our products. Any of these results from our litigation could adversely affect our results of operations and stock price.\\n22\\nWhile we believe we currently have adequate internal control over financial reporting, we are required to assess our internal control over financial reporting on an annual basis and any future adverse results from such assessment could result in a loss of investor confidence in our financial reports and have an adverse effect on our stock price.\\nPursuant to the Sarbanes-Oxley Act of 2002 and the rules and regulations promulgated by the SEC, we are required to furnish in our Form 10-K a report by our management regarding the effectiveness of our internal control over financial reporting. The report includes, among other things, an assessment of the effectiveness of our internal control over financial reporting as of the end of our fiscal year, including a statement as to whether or not our internal control over financial reporting is effective. This assessment must include disclosure of any material weaknesses in our internal control over financial reporting identified by management. While we believe our internal control over financial reporting is currently effective, the effectiveness of our internal controls in future periods is subject to the risk that our controls may become inadequate because of changes in conditions including our transition to a new ERP software system, and, as a result, the degree of compliance of our internal control over financial reporting with the existing policies or procedures may become ineffective. Establishing, testing and maintaining an effective system of internal control over financial reporting requires significant resources and time commitments on the part of our management and our finance staff, may require additional staffing and infrastructure investments and would increase our costs of doing business. If we are unable to assert that our internal control over financial reporting is effective in any future period (or if our auditors are unable to express an opinion on the effectiveness of our internal controls or conclude that our internal controls are ineffective), we could lose investor confidence in the accuracy and completeness of our financial reports, which could have an adverse effect on our stock price.\\nIf we lose our key personnel or are unable to attract and retain key personnel, we may be unable to pursue business opportunities or develop our products.\\nWe are highly dependent on the key employees in our clinical engineering, technology development, sales, training and marketing personnel and management teams. The loss of the services provided by those individuals may significantly delay or prevent the achievement of our product development and other business objectives and could harm our business. Our future success will also depend on our ability to identify, recruit, train and retain additional qualified personnel, including orthodontists. Few orthodontists are accustomed to working in a manufacturing environment since they are generally trained to work in private practices, universities and other research institutions. Thus, we may be unable to attract and retain personnel with the advanced qualifications necessary for the further development of our business. Furthermore, we may not be successful in retaining our key personnel or their services. If we are unable to attract and retain key personnel, our business could be materially harmed.\\nIf we infringe the patents or proprietary rights of other parties or are subject to a patent infringement claim, our ability to grow our business may be severely limited.\\nExtensive litigation over patents and other intellectual property rights is common in the medical device industry. We have been sued for infringement of third party’s patents in the past and we may be the subject of patent or other litigation in the future. From time to time, we have received and may in the future receive letters from third parties drawing our attention to their patent rights. While we do not believe that we infringe upon any valid and enforceable rights that have been brought to our attention, there may be other more pertinent rights of which we are presently unaware. The defense and prosecution of intellectual property suits, interference proceedings and related legal and administrative proceedings could result in substantial expense to us and significant diversion of effort by our technical and management personnel. An adverse determination of any litigation or interference proceeding to which we may become a party could subject us to significant liabilities. An adverse determination of this nature could also put our patents at risk of being invalidated or interpreted narrowly or require us to seek licenses from third parties. Licenses may not be available on commercially reasonable terms or at all, in which event, our business would be materially adversely affected.\\n23\\nWe maintain single supply relationships for certain of our key machines and materials technologies, and our business and operating results could be harmed if supply is restricted or ends or the price of raw materials used in our manufacturing process increases.\\nWe are highly dependent on manufacturers of specialized scanning equipment, rapid prototyping machines, resin and other advanced materials, as well as the optics, electronic and other mechanical components of our intraoral scanners. We maintain single supply relationships for many of these machines and materials technologies. In particular, our CT scanning and stereolithography equipment used in our aligner manufacturing and many of the critical components for the optics of our scanners are provided by single suppliers. We are also committed to purchasing the vast majority of our resin and polymer, the primary raw materials used in our manufacturing process for clear aligners, from a single source. If these or other suppliers encounter financial, operating or other difficulties or if our relationship with them changes, we might not be able to quickly establish or qualify replacement sources of supply and could face production interruptions, delays and inefficiencies. In addition, technology changes by our vendors could disrupt access to required manufacturing capacity or require expensive, time consuming development efforts to adapt and integrate new equipment or processes. Our growth may exceed the capacity of one or more of these manufacturers to produce the needed equipment and materials in sufficient quantities to support our growth. Conversely, in order to secure supplies for production of products, we sometimes enter into non-cancelable purchase commitments with vendors, which could impact our ability to adjust our inventory to reflect declining market demands. If demand for our products is less than we expect, we may experience additional excess and obsolete inventories and be forced to incur additional charges and our profitability may suffer. In the event of technology changes, delivery delays, or shortages of or increases in price for these items, our business and growth prospects may be harmed.\\nWe depend on a single contract manufacturer and supplier of parts used in our iTero scanner and any disruption in this relationship may cause us to fail to meet the demands of our customers and damage our customer relationships.\\nWe rely on a third party manufacturer to supply key sub-assemblies for our iTero Element scanner. As a result, if this third party manufacturer fails to deliver its components, if we lose its services or if we fail to negotiate acceptable terms, we may be unable to deliver our products in a timely manner and our business may be harmed. Any difficulties encountered by the third party manufacturer with respect to hiring personnel and maintaining acceptable manufacturing standards, controls, procedures and policies could disrupt our ability to deliver our products in a timely manner. Finding a substitute manufacturer may be expensive, time-consuming or impossible and could result in a significant interruption in the supply of our intraoral scanning products. Any failure by our contract manufacturer that results in delays in our fulfillment of customer orders may cause us to lose revenues and suffer damage to our customer relationships.\\nWe primarily rely on our direct sales force to sell our products, and any failure to maintain our direct sales force could harm our business.\\nOur ability to sell our products and generate revenues primarily depends upon our direct sales force within our North American and international markets. We do not have any long-term employment contracts with the members of our direct sales force. The loss of the services provided by these key personnel may harm our business. If we are unable to retain our direct sales force personnel or replace them with individuals of equivalent technical expertise and qualifications, or if we are unable to successfully instill such technical expertise or if we fail to establish and maintain strong relationships with our customers within a relatively short period of time, our net revenues and our ability to maintain market share could be materially harmed. In addition, due to our large and fragmented customer base, we may not be able to provide all of our customers with product support immediately upon the launch of a new product. As a result, adoption of new products by our customers may be slower than anticipated and our ability to grow market share and increase our net revenues may be harmed.\\nIf our distributor relationships are not successful, our ability to market and sell our products would be harmed and our financial performance will be adversely affected.\\nWe depend on relationships with distributors for the marketing and sales of our products in various geographic regions, and we have a limited ability to influence their efforts. Relying on distributors for our sales and marketing could harm our business for various reasons, including:\\n24\\n| • | agreements with distributors may terminate prematurely due to disagreements or may result in litigation between the partners; |\\n\\n| • | we may not be able to renew existing distributor agreements on acceptable terms; |\\n\\n| • | our distributors may not devote sufficient resources to the sale of products; |\\n\\n| • | our distributors may be unsuccessful in marketing our products; |\\n\\n| • | our existing relationships with distributors may preclude us from entering into additional future arrangements with other distributors; and |\\n\\n| • | we may not be able to negotiate future distributor agreements on acceptable terms. |\\n\\nComplying with regulations enforced by the FDA and other regulatory authorities is an expensive and time-consuming process, and any failure to comply could result in substantial penalties.\\nOur products are considered medical devices and are subject to extensive regulation in the U.S. and internationally. FDA regulations are wide ranging and govern, among other things:\\n| • | product design, development, manufacturing and testing; |\\n\\n| • | product labeling; |\\n\\n| • | product storage; |\\n\\n| • | pre-market clearance or approval; |\\n\\n| • | complaint handling and corrective actions; |\\n\\n| • | advertising and promotion; and |\\n\\n| • | product sales and distribution. |\\n\\nOur failure to comply with applicable regulatory requirements could result in enforcement action by the FDA or state agencies, which may include any of the following sanctions:\\n| • | warning letters, fines, injunctions, consent decrees and civil penalties; |\\n\\n| • | repair, replacement, refunds, recall or seizure of our products; |\\n\\n| • | operating restrictions or partial suspension or total shutdown of production; |\\n\\n| • | refusing our requests for 510(k) clearance or pre-market approval of new products, new intended uses, or modifications to existing products; |\\n\\n| • | withdrawing clearance or pre-market approvals that have already been granted; and |\\n\\n| • | criminal prosecution. |\\n\\nIf any of these events were to occur, they could harm our business. We must comply with facility registration and product listing requirements of the FDA and adhere to applicable Quality System regulations. The FDA enforces its Quality System regulations through periodic unannounced inspections. Our failure to take satisfactory corrective action in response to an adverse inspection or the failure to comply with applicable manufacturing regulations could result in enforcement action, and we may be required to find alternative manufacturers, which could be a long and costly process. Any FDA enforcement action could have a material adverse effect on us.\\nBefore we can sell a new medical device in the U.S., or market a new use of or claim for an existing product, we must obtain FDA clearance or approval unless an exemption applies. Obtaining regulatory clearances or approvals can be a lengthy and time-consuming process. Even though the devices we market have obtained the necessary clearances from the FDA, we may be unable to maintain such clearances in the future. Furthermore, we may be unable to obtain the necessary clearances for new devices that\\n25\\nwe intend to market in the future. Our inability to maintain or obtain regulatory clearances or approvals could materially harm our business.\\nIn addition, as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC adopted disclosure requirements regarding the use of certain minerals, known as conflict minerals, which are mined from the Democratic Republic of Congo and adjoining countries, as well as procedures regarding a manufacturer's efforts to identify and discourage the sourcing of such minerals and metals produced from those minerals. Additional reporting obligations are being proposed by the European Union. The U.S. requirements and any additional requirements in Europe could affect the sourcing and availability of metals used in the manufacture of a limited number of parts (if any) contained in our products. For example, the implementation of these disclosure requirements may decrease the number of suppliers capable of supplying our needs for certain metals, thereby negatively affecting our ability to obtain products in sufficient quantities or at competitive prices. Our material sourcing is broad based and multi-tiered, and we may be unable to conclusively verify the origins for all metals used in our products. We may suffer financial and reputational harm if customers require, and we are unable to deliver, certification that our products are conflict free. Regardless, we will incur additional costs associated with compliance with these disclosure requirements, including time-consuming and costly efforts to determine the source of any conflict minerals used in our products.\\nIf compliance with healthcare regulations becomes costly and difficult for our customers or for us, we may not be able to grow our business.\\nParticipants in the healthcare industry are subject to extensive and frequently changing regulations under numerous laws administered by governmental entities at the federal, state and local levels, some of which are, and others of which may be, applicable to our business. In response to perceived increases in health care costs in recent years, Congress passed health care reform legislation that was signed into law in March 2010. This legislation contains many provisions designed to generate the revenues necessary to fund the coverage expansions. The most relevant of these provisions are those that impose fees or taxes on certain health-related industries, including medical device manufacturers.\\nFurthermore, our healthcare provider customers are also subject to a wide variety of laws and regulations that could affect the nature and scope of their relationships with us. The healthcare market itself is highly regulated and subject to changing political, economic and regulatory influences. Regulations implemented pursuant to the Health Insurance Portability and Accountability Act (\\\"HIPAA\\\"), including regulations affecting the security and privacy of patient healthcare information held by healthcare providers and their business associates may require us to make significant and unplanned enhancements of software applications or services, result in delays or cancellations of orders, or result in the revocation of endorsement of our products and services by healthcare participants. The effect of HIPAA and newly enforced regulations on our business is difficult to predict, and there can be no assurance that we will adequately address the business risks created by HIPAA and its implementation or that we will be able to take advantage of any resulting business opportunities.\\nExtensive and changing government regulation of the healthcare industry may be expensive to comply with and exposes us to the risk of substantial government penalties.\\nIn addition to medical device laws and regulations, numerous state and federal healthcare-related laws regulate our business, covering areas such as:\\n| • | storage, transmission and disclosure of medical information and healthcare records; |\\n\\n| • | prohibitions against the offer, payment or receipt of remuneration to induce referrals to entities providing healthcare services or goods or to induce the order, purchase or recommendation of our products; and |\\n\\n| • | the marketing and advertising of our products. |\\n\\nComplying with these laws and regulations could be expensive and time-consuming, and could increase our operating costs or reduce or eliminate certain of our sales and marketing activities or our revenues.\\nOur business exposes us to potential product liability claims, and we may incur substantial expenses if we are subject to product liability claims or litigation.\\nMedical devices involve an inherent risk of product liability claims and associated adverse publicity. We may be held liable if any product we develop or any product that uses or incorporates any of our technologies causes injury or is otherwise found unsuitable. Although we intend to continue to maintain product liability insurance, adequate insurance may not be available on acceptable terms, if at all, and may not provide adequate coverage against potential liabilities. A product liability claim, regardless\\n26\\nof its merit or eventual outcome, could result in significant legal defense costs. These costs would have the effect of increasing our expenses and diverting management’s attention away from the operation of our business, and could harm our business.\\nHistorically, the market price for our common stock has been volatile.\\nThe market price of our common stock could be subject to wide price fluctuations in response to various factors, many of which are beyond our control. The factors include:\\n| • | quarterly variations in our results of operations and liquidity; |\\n\\n| • | changes in recommendations by the investment community or in their estimates of our net revenues or operating results; |\\n\\n| • | speculation in the press or investment community concerning our business and results of operations; |\\n\\n| • | strategic actions by our competitors, such as product announcements or acquisitions; |\\n\\n| • | announcements of technological innovations or new products by us, our customers or competitors; and |\\n\\n| • | general economic market conditions. |\\n\\nIn addition, the stock market, in general and the market for technology and medical device companies, in particular, have experienced extreme price and volume fluctuations that have often been unrelated to or disproportionate to the operating performance of those companies. These broad market and industry factors may seriously harm the market price of our common stock, regardless of our operating performance. Historically, class action litigation is often brought against an issuing company following periods of volatility in the market price of a company’s securities.\\nFuture sales of significant amounts of our common stock may depress our stock price.\\nA large percentage of our outstanding common stock is currently owned by a small number of significant stockholders. These stockholders have sold in the past, and may sell in the future, large amounts of common stock over relatively short periods of time. Sales of substantial amounts of our common stock in the public market by our existing stockholders may adversely affect the market price of our common stock. Such sales could create public perception of difficulties or problems with our business and may depress our stock price.\\nWe are subject to risks associated with our strategic investments. Impairments in the value of our investments could negatively impact our financial results.\\nWe have invested in SmileDirectClub, LLC (\\\"SDC\\\") and other privately held companies for strategic reasons and to support key business initiatives, and we may not realize a return on our strategic investments. Many of such companies generate net losses and the market for their products, services or technologies may be slow to develop. Further, valuations of privately held companies are inherently complex due to the lack of readily available market data. If we determine that our investments in SDC or other privately held companies have experienced a decline in value, we may be required to record impairments, which could be material and could have an adverse impact on our financial results.\\nIf our goodwill or long-lived assets become impaired, we may be required to record a significant charge to earnings.\\nUnder Generally Accepted Accounting Principles in the United States (“U.S. GAAP”), we review our goodwill and long-lived asset group for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. Additionally, goodwill is required to be tested for impairment at least annually. The qualitative and quantitative analysis used to test goodwill are dependent upon various assumptions and reflect management’s best estimates. Changes in certain assumptions including revenue growth rates, discount rates, earnings multiples and future cash flows may cause a change in circumstances indicating that the carrying value of goodwill or the asset group may be impaired. We may be required to record a significant charge to earnings in the financial statements during the period in which any impairment of goodwill or asset group are determined.\\nChanges in, or interpretations of, accounting rules and regulations, could result in unfavorable accounting charges.\\nWe prepare our consolidated financial statements in conformity with U.S. GAAP. These principles are subject to interpretation by the SEC and various bodies formed to interpret and create appropriate accounting policies. A change in these policies can have a significant effect on our reported results and may even retroactively affect previously reported transactions. Our accounting\\n27\\npolicies that recently have been, or may be affected by changes in the accounting rules relate to stock-based compensation, revenue recognition and leases.\\nIf we fail to manage our exposure to global financial and securities market risk successfully, our operating results and financial statements could be materially impacted.\\nThe primary objective of our investment activities is to preserve principal. To achieve this objective, a majority of our marketable investments are investment grade, liquid, fixed-income securities and money market instruments denominated in U.S. dollars. If the carrying value of our investments exceeds the fair value, and the decline in fair value is deemed to be other-than-temporary, we will be required to write down the value of our investments, which could materially harm our results of operations and financial condition. Moreover, the performance of certain securities in our investment portfolio correlates with the credit condition of the U.S. financial sector. In a current unstable credit environment, we might incur significant realized, unrealized or impairment losses associated with these investments.\\nOn July 1, 2016, we changed our corporate structure; however, if we are unable to maintain this structure or if it is challenged by U.S. or foreign tax authorities, we may be unable to realize tax savings which could materially and adversely affect our operating results.\\nWe implemented a new international corporate structure on July 1, 2016. This corporate structure may reduce our overall effective tax rate over time through changes in the structure of our international procurement and sales operations, as well as realignment of the ownership and use of intellectual property among our wholly-owned subsidiaries.\\nThe structure includes legal entities located in jurisdictions with income tax rates lower than the U.S. federal statutory tax rate. Such intercompany arrangements would be designed to result in income earned by such entities in accordance with arm’s-length principles and commensurate with functions performed, risks assumed and ownership of valuable corporate assets. We believe that income taxed in certain foreign jurisdictions at a lower rate relative to the U.S. federal statutory rate will have a beneficial impact on our worldwide effective tax rate over the medium to long term.\\nIf the structure is challenged by U.S. or foreign tax authorities, if changes in domestic and international tax laws negatively impact the structure, including proposed legislation to reform U.S. taxation of international business activities, or if we do not operate our business in a manner consistent with the structure and applicable regulatory provisions, we may fail to achieve the financial and operational efficiencies that we anticipate as a result of the structure, and our business, financial condition and operating results may be materially and adversely affected.\\nOur effective tax rate may vary significantly from period to period.\\nVarious internal and external factors may have favorable or unfavorable effects on our future effective tax rate. These factors include, but are not limited to, changes in tax laws, regulations and/or rates, new or changes to accounting pronouncements, non-deductible goodwill impairments, changing interpretations of existing tax laws or regulations, changes in the relative proportions of revenues and income before taxes in the various jurisdictions in which we operate that have differing statutory tax rates, the future levels of tax benefits of stock-based compensation, settlement of income tax audits, and changes in overall levels of pretax earnings.\\nIn addition, our tax rate may be impacted by tax holidays or incentives. In June 2009, the Costa Rica Ministry of Foreign Trade, an agency of the Government of Costa Rica, granted a twelve year extension of certain income tax incentives, which were previously granted in 2002. The incentive tax rates will expire in various years beginning in 2017. We intend to seek a renewal of these income tax incentives before they expire. Under these incentives, all of the income in Costa Rica during these twelve year incentive periods is subject to a reduced tax rate. In order to receive the benefit of these incentives, we must hire specified numbers of employees and maintain certain minimum levels of fixed asset investment in Costa Rica. If we do not fulfill these conditions for any reason, our incentive could lapse, and our income in Costa Rica would be subject to taxation at higher rates, which could have a negative impact on our operating results. The Costa Rica corporate income tax rate that would apply, absent the incentives, is 30% for 2016, 2015 and 2014. As a result of these incentives, income taxes were reduced by $19.1 million, $32.7 million and $32.5 million in the year ended December 31, 2016, 2015 and 2014, respectively. The benefit of the tax holiday on diluted net income per share was $0.23 in the year ended December 31, 2016 and $0.40 in each of the year ended December 31, 2015 and 2014. Our subsidiary in Israel is under audit by the local tax authorities for calendar years 2006 through 2013.\\n28\\nChanges in tax laws or tax rulings could negatively impact our income tax provision and net income.\\nAs a U.S. multinational corporation, we are subject to changing tax laws both within and outside of the U.S. Changes in tax laws or tax rulings, or changes in interpretations of existing tax laws, could affect our income tax provision and net income or require us to change the manner in which we operate our business. Many countries in Europe, as well as a number of other countries and organizations, have recently proposed or recommended changes to existing tax laws or have enacted new laws. For example, the Organization for Economic Cooperation and Development (\\\"OECD\\\") has been working on a \\\"Base Erosion and Profit Shifting Project,\\\" which is focused on a number of issues, including the shifting of profits between affiliated entities in different tax jurisdictions. The OECD issued in 2015, and is expected to continue to issue, guidelines and proposals that may change various aspects of the existing framework under which our tax obligations are determined in many of the countries in which we do business. In addition, the current U.S. administration and key members of Congress have made public statements indicating that tax reform is a priority. Certain changes to U.S. tax laws, including limitations on the ability to defer U.S. taxation on earnings outside of the United States until those earnings are repatriated to the United States, could affect the tax treatment of our foreign earnings.\\nITEM 1B.\\nUNRESOLVED STAFF COMMENTS\\nNone.\\nITEM 2.\\nPROPERTIES\\nWe occupy several leased and owned facilities with total office and manufacturing area of over 987,000 square feet. At December 31, 2016, the significant facilities were occupied as follows:\\n\\n| Location | Lease/Own | Primary Use | Expiration of Lease |\\n| San Jose, California (1) | Lease | Office for corporate headquarters, research & development and administrative personnel | August 2017 |\\n| Juarez, Mexico | Own | Manufacturing and office facilities for manufacturing and administrative personnel | N/A |\\n| San Jose, Costa Rica | Lease | Office for administrative personnel, treatment personnel, and customer care | October 2018 |\\n| Or Yehuda, Israel | Lease | Manufacturing and office for manufacturing, administrative personnel, and research & development | February 2022 |\\n| Amsterdam, The Netherlands | Lease | Office for international headquarters, sales and marketing and administrative personnel | March 2020 |\\n| Moscow, Russia | Lease | Office for research & development | July 2023 |\\n| Raleigh, North Carolina | Lease | Office for research & development and administrative personnel | October 2024 |\\n\\n(1) Refer to Note 8 \\\"Commitments and Contingencies\\\" of the Notes of Consolidated Financial Statements for information on our corporate headquarters office Purchase Agreement in December 2016.\\n29\\nITEM 3.\\nLEGAL PROCEEDINGS\\nSecurities Class Action Lawsuit\\nOn November 28, 2012, plaintiff City of Dearborn Heights Act 345 Police & Fire Retirement System filed a lawsuit against Align, Thomas M. Prescott (“Mr. Prescott”), Align’s former President and Chief Executive Officer, and Kenneth B. Arola (“Mr. Arola”), Align’s former Vice President, Finance and Chief Financial Officer, in the United States District Court for the Northern District of California on behalf of a purported class of purchasers of our common stock (the “Securities Action”). On July 11, 2013, an amended complaint was filed, which named the same defendants, on behalf of a purported class of purchasers of our common stock between January 31, 2012 and October 17, 2012. The amended complaint alleged that Align, Mr. Prescott and Mr. Arola violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, and that Mr. Prescott and Mr. Arola violated Section 20(a) of the Securities Exchange Act of 1934. Specifically, the amended complaint alleged that during the purported class period defendants failed to take an appropriate goodwill impairment charge related to the April 29, 2011 acquisition of Cadent Holdings, Inc. in the fourth quarter of 2011, the first quarter of 2012 or the second quarter of 2012, which rendered our financial statements and projections of future earnings materially false and misleading and in violation of U.S. GAAP. The amended complaint sought monetary damages in an unspecified amount, costs and attorneys’ fees. On December 9, 2013, the court granted defendants’ motion to dismiss with leave for plaintiff to file a second amended complaint. Plaintiff filed a second amended complaint on January 8, 2014 on behalf of the same purported class. The second amended complaint states the same claims as the amended complaint. On August 22, 2014, the court granted our motion to dismiss without leave to amend. On September 22, 2014, Plaintiff filed a notice of appeal to the Ninth Circuit Court of Appeals. Briefing for the appeal was completed in May 2015 and the Ninth Circuit held oral arguments in October 2016. Align intends to vigorously defend itself against these allegations. Align is currently unable to predict the outcome of this amended complaint and therefore cannot determine the likelihood of loss nor estimate a range of possible loss, if any.\\nShareholder Derivative Lawsuit\\nOn February 1, 2013, plaintiff Gary Udis filed a shareholder derivative lawsuit against several of Align’s current and former officers and directors in the Superior Court of California, County of Santa Clara. The complaint alleges that our reported income and earnings were materially overstated because of a failure to timely write down goodwill related to the April 29, 2011 acquisition of Cadent Holdings, Inc., and that defendants made allegedly false statements concerning our forecasts. The complaint asserts various state law causes of action, including claims of breach of fiduciary duty, unjust enrichment, and insider trading, among others. The complaint seeks unspecified damages on behalf of Align, which is named solely as nominal defendant against whom no recovery is sought. The complaint also seeks an order directing Align to reform and improve its corporate governance and internal procedures, and seeks restitution in an unspecified amount, costs, and attorneys’ fees. On July 8, 2013, an Order was entered staying this derivative lawsuit until an initial ruling on our first motion to dismiss the Securities Action. On January 15, 2014, an Order was entered staying this derivative lawsuit until an initial ruling on our second motion to dismiss the Securities Action. On October 14, 2014, an Order was entered staying this derivative lawsuit until a ruling by the Ninth Circuit in the Securities Action discussed above. Align is currently unable to predict the outcome of this complaint and therefore cannot determine the likelihood of loss nor estimate a range of possible losses, if any.\\nIn addition, in the course of Align's operations, Align is involved in a variety of claims, suits, investigations, and proceedings, including actions with respect to intellectual property claims, patent infringement claims, government investigations, labor and employment claims, breach of contract claims, tax, and other matters. Regardless of the outcome, these proceedings can have an adverse impact on us because of defense costs, diversion of management resources, and other factors. Although the results of complex legal proceedings are difficult to predict and Align's view of these matters may change in the future as litigation and events related thereto unfold; Align currently does not believe that these matters, individually or in the aggregate, will materially affect Align's financial position, results of operations or cash flows.\\nITEM 4.\\nMINE SAFETY DISCLOSURES\\nNot applicable.\\n30\\nPART II\\n\\nITEM 5.\\nMARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES\\nPrice Range of Common Stock\\nOur common stock is quoted on the NASDAQ Global Select Market under the symbol “ALGN.” The following table sets forth the range of high and low per share sales prices as reported for each period indicated:\\n| High | Low |\\n| Year Ended December 31, 2016: |\\n| Fourth quarter | $ | 102.10 | $ | 83.27 |\\n| Third quarter | $ | 96.90 | $ | 80.30 |\\n| Second quarter | $ | 81.98 | $ | 70.03 |\\n| First quarter | $ | 73.55 | $ | 57.31 |\\n| Year Ended December 31, 2015: |\\n| Fourth quarter | $ | 68.48 | $ | 54.69 |\\n| Third quarter | $ | 66.53 | $ | 52.01 |\\n| Second quarter | $ | 64.99 | $ | 51.65 |\\n| First quarter | $ | 64.75 | $ | 51.77 |\\n\\nOn February 21, 2017, the closing price of our common stock on the NASDAQ Global Market was $101.86 per share. As of February 21, 2017, there were approximately 96 holders of record of our common stock. Because the majority of our shares of outstanding common stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders.\\nWe have never declared or paid any cash dividends on our common stock. We currently intend to retain any future earnings to fund the development and growth of our business and do not anticipate paying any cash dividends in the foreseeable future.\\nPerformance Graph\\nNotwithstanding any statement to the contrary in any of our previous or future filings with the SEC, the following information relating to the price performance of our common stock shall not be deemed “filed” with the SEC or “Soliciting Material” under the Securities Exchange Act of 1934, as amended, or subject to Regulation 14A or 14C, or to liabilities of Section 18 of the Exchange Act except to the extent we specifically request that such information be treated as soliciting material or to the extent we specifically incorporate this information by reference.\\nThe graph below matches our cumulative 5-year total shareholder return on common stock with the cumulative total returns of the NASDAQ Composite index, and the S&P 1500 Composite Health Care Equipment & Supplies index. The graph tracks the performance of a $100 investment in our common stock, in the peer group, and the index (with the reinvestment of all dividends) from December 31, 2011 to December 31, 2016.\\n31\\nUNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\\nFollowing is a summary of stock repurchases for the three months ended December 31, 2016:\\n| Period | Total Number of Shares Repurchased | Average Price Paid per Share | Total Number of Shares Repurchased as Part of Publicly Announced Program | Approximate Dollar Value of Shares that May Yet Be Repurchased Under the Program (1) |\\n| October 1, 2016 through October 31, 2016 | 179,500 | $ | 89.28 | 179,500 | $ | 325,777,042 |\\n| November 1, 2016 through November 30, 2016 | 126,000 | $ | 92.36 | 126,000 | $ | 314,139,921 |\\n| December 1, 2016 through December 31, 2016 | 106,000 | $ | 97.92 | 106,000 | $ | 303,760,487 |\\n\\n(1) Stock Repurchase Programs\\n| ◦ | April 2014 Repurchase Program. In 2016, we repurchased $50.0 million of our common stock through an accelerated stock repurchase agreement and $46.2 million of stock repurchase in the open market. |\\n\\n| ◦ | April 2016 Repurchase Program. On April 28, 2016, we announced that our Board of Directors had authorized a plan to repurchase up to $300.0 million of our stock. |\\n\\n| ◦ | Remaining Available Repurchases. As of December 31, 2016, we have approximately $3.8 million remaining available under the April 2014 Repurchase Program and $300.0 million under the April 2016 Repurchase Plan (Refer to Note 10 \\\"Common Stock Repurchase Program\\\" of the Notes to Consolidated Financial Statements for details on common stock repurchase). |\\n\\n32\\nITEM 6.\\nSELECTED CONSOLIDATED FINANCIAL DATA\\nThe following tables set forth the selected consolidated financial data for each of the years in the five-year period ended December 31, 2016. The selected consolidated financial data should be read in conjunction with the consolidated financial statements and accompanying notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations. We have derived the statements of operations data for the year ended December 31, 2016, 2015 and 2014 and the balance sheet data as of December 31, 2016 and 2015 from the consolidated audited financial statements included elsewhere in this Annual Report on Form 10-K. The statements of operations data for the year ended December 31, 2013 and 2012 and the balance sheet data as of December 31, 2014, 2013 and 2012 were derived from the consolidated audited financial statements that are not included in this Annual Report on Form 10-K.\\nSELECTED CONSOLIDATED FINANCIAL DATA\\n(in thousands, except per share data)\\n\\n| Year Ended December 31, |\\n| 2016 | 2015 | 2014 | 2013 | 2012 |\\n| Consolidated Statements of Operations Data: |\\n| Net revenues | $ | 1,079,874 | $ | 845,486 | $ | 761,653 | $ | 660,206 | $ | 560,041 |\\n| Gross profit (1) | $ | 815,294 | $ | 640,110 | $ | 578,443 | $ | 498,106 | $ | 416,388 |\\n| Income from operations (2) | 248,921 | 188,634 | 193,576 | 94,212 | 85,592 |\\n| Interest and other income (expense), net | (6,355 | ) | (2,533 | ) | (3,207 | ) | (1,073 | ) | (1,296 | ) |\\n| Net income before provision for income taxes and equity in losses of investee (2) | 242,566 | 186,101 | 190,369 | 93,139 | 84,296 |\\n| Provision for income taxes (3) | 51,200 | 42,081 | 44,537 | 28,844 | 25,605 |\\n| Equity in losses of investee, net of tax | 1,684 | — | — | — | — |\\n| Net income | $ | 189,682 | $ | 144,020 | $ | 145,832 | $ | 64,295 | $ | 58,691 |\\n| Net income per share: |\\n| Basic | $ | 2.38 | $ | 1.80 | $ | 1.81 | $ | 0.80 | $ | 0.73 |\\n| Diluted | $ | 2.33 | $ | 1.77 | $ | 1.77 | $ | 0.78 | $ | 0.71 |\\n| Shares used in computing net income per share: |\\n| Basic | 79,856 | 79,998 | 80,754 | 80,551 | 80,529 |\\n| Diluted | 81,484 | 81,521 | 82,283 | 82,589 | 83,040 |\\n| December 31, |\\n| 2016 | 2015 | 2014 | 2013 | 2012 |\\n| Consolidated Balance Sheet Data: |\\n| Working capital (4) | $ | 598,643 | $ | 460,338 | $ | 455,349 | $ | 369,338 | $ | 330,022 |\\n| Total assets | 1,396,151 | 1,158,633 | 987,997 | 832,147 | 756,312 |\\n| Total long-term liabilities | 46,427 | 39,035 | 33,415 | 22,839 | 19,224 |\\n| Stockholders’ equity | $ | 995,389 | $ | 847,926 | $ | 752,771 | $ | 633,970 | $ | 581,317 |\\n\\n| (1) | Gross profit includes: |\\n\\n| • | $1.7 million out of period adjustment in 2013 |\\n\\n| • | $0.2 million acquisition and integration related costs, $0.9 million amortization of intangible assets, and $0.5 million of exit costs in 2012 |\\n\\n33\\n(2) Income from operations and net income before provision for income taxes and equity in losses of investee include:\\n| • | $40.7 million and $26.3 million of goodwill and long-lived asset impairment, respectively, in 2013 |\\n\\n| • | $1.9 million, net of tax, out of period adjustment in 2013 |\\n\\n| • | $36.6 million of goodwill impairment, $1.3 million acquisition and integration related costs, $4.5 million of amortization of intangible assets, and $0.8 million of exit costs in 2012 |\\n\\n| (3) | Provision for income taxes includes: |\\n\\n| • | $1.8 million out of period income tax adjustment in 2014 (Refer to Note 1 \\\"Summary of Significant Accounting Policies\\\" of the Notes to Consolidated Financial Statements) |\\n\\n| (4) | Working capital is calculated as the difference between total current assets and total current liabilities. |\\n\\n34\\nITEM 7.\\nMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\\nThe following discussion and analysis of our financial condition and results of operations should be read together with “Selected Consolidated Financial Data” and our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K.\\nOverview\\nOur goal is to establish Invisalign clear aligners as the standard method for treating malocclusion and to establish the iTero intraoral scanner as the preferred scanning device for 3D digital scans, ultimately driving increased product adoption by dental professionals. We intend to achieve this by continued focus and execution of our strategic growth drivers set forth in the Business Strategy section in our Annual Report on Form 10-K.\\nThe successful execution of our business strategy in 2017 and beyond may be affected by a number of other factors including:\\n| • | New Products, Feature Enhancements and Technology Innovation. Product innovation drives greater treatment predictability and clinical applicability and ease of use for our customers which supports adoption of Invisalign in their practices. Increasing applicability and treating more complex cases requires that we move away from individual features to more comprehensive solutions so that Invisalign providers can more predictably treat the whole case, such as with our Invisalign \\\"G-Series\\\" of product innovations, including our most recent October 2016 release of Invisalign G7. Invisalign G7 delivers better upper lateral control, improved root control and features to address prevention of posterior open bites. Concurrently, we also announced ClinCheck Pro 5.0, which has new features designed to deliver an improved and user friendly experience and increased control to Invisalign providers. Since the iTero Element began shipping in September 2015, the use of iTero scanners for Invisalign case submissions in place of Polyvinyl-siloxane (\\\"PVS\\\") impressions has gradually increased to a record 51.3% of cases from North America and 24.9% of cases from international doctors as of the fourth quarter of 2016. We believe that over the long-term, clinical solutions and treatment tools will increase adoption of Invisalign and increase sales of our intraoral scanners; however, it is difficult to predict the rate of adoption which may vary by region and channel. |\\n\\n| • | Invisalign Adoption. Our goal is to establish Invisalign as the treatment of choice for treating malocclusion ultimately driving increased product adoption and frequency of use by dental professionals, also known as \\\"utilization rates.\\\" Our quarterly utilization rates for the last 9 quarters are as follows: |\\n\\n* Invisalign Utilization Rates = # of cases shipped divided by # of doctors cases were shipped to\\n35\\n| ◦ | Total utilization in the fourth quarter of 2016 increased to 5.2 cases per doctor compared to 4.9 in the fourth quarter of 2015. |\\n\\n| ▪ | North America: Utilization among our North American orthodontist customers reached an all time high of 11.3 cases per doctor in the fourth quarter of 2016 compared to 9.9 in the fourth quarter of 2015. The increase in North America orthodontist utilization reflects improvements in product and technology which continues to strengthen our doctors’ clinical confidence in the use of Invisalign such that they now utilize Invisalign more often and on more complex cases, including their teenage patients. |\\n\\n| ▪ | International: International doctor utilization of 5.0 cases per doctor in the fourth quarter of 2016 was flat compared with the fourth quarter of 2015. The International utilization reflects growth in both the Europe, Middle East and Africa (\\\"EMEA\\\") and Asia Pacific (\\\"APAC\\\") regions due to increasing adoption of the product and its ability to treat more complex cases; however, utilization remained flat primarily due to the expansion of our customer base, particularly in APAC. |\\n\\nWe expect that over the long-term our utilization rates will gradually improve as a result of advancements in product and technology, which continue to strengthen our doctors’ clinical confidence in the use of Invisalign; however, we expect that our utilization rates may fluctuate from period to period due to a variety of factors, including seasonal trends in our business along with adoption rates of new products and features.\\n| • | Number of New Invisalign Doctors Trained. We continue to expand our Invisalign customer base through the training of new doctors. In 2016, Invisalign growth was driven primarily by increased utilization across all regions as well as by the continued expansion of our customer base as we trained a total of 11,680 new Invisalign doctors, of which 60% were trained internationally. |\\n\\n| • | International Invisalign Growth. We will continue to focus our efforts towards increasing Invisalign adoption by dental professionals in our direct international markets. On a year over year basis, international Invisalign volume increased 32.4% driven primarily by strong performance in our APAC and in Europe regions. In 2017, we are continuing to expand in our existing markets through targeted investments in sales coverage and professional marketing and education programs, along with consumer marketing in selected country markets. We expect international Invisalign revenues to continue to grow at a faster rate than North America for the foreseeable future due to our continued investment in international market expansion, the size of the market opportunity, and our relatively low market penetration in this region (Refer to Item 1A Risk Factors - “We are exposed to fluctuations in currency exchange rates, which could negatively affect our financial condition and results of operations.” for information on related risk factors). |\\n\\n| • | Establish Regional Order Acquisition and Treatment Planning Facilities: We intend to establish additional order acquisition and treatment planning facilities closer to our international customers in order to improve our operational efficiency and provide doctors with a great experience to further improve their confidence in using Invisalign to treat more patients and more often (Refer to Item 1A Risk Factors - “As we continue to grow, we are subject to growth related risks, including risks related to excess or constrained capacity at our existing facilities.” for information on related risk factors). |\\n\\n| • | Operating Expenses. We expect operating expenses to increase in 2017 due in part to: |\\n\\n| ◦ | investments in international expansion in new country markets particularly in the APAC region; |\\n\\n| ◦ | investments in manufacturing to enhance our regional capabilities; |\\n\\n| ◦ | increases in legal expenses primarily related to the continued protection of our intellectual property rights, including our patents; |\\n\\n| ◦ | increases in sales and customer support resources; |\\n\\n| ◦ | increases in expenses related to the purchase of our new corporate headquarters in San Jose, California; and |\\n\\n| ◦ | product and technology innovation to address such things as treatment times, indications unique to teens and predictability. |\\n\\nWe believe that these investments will position us to increase our revenue and continue to grow our market share.\\n36\\n| • | Stock Repurchases: |\\n\\n| ◦ | April 2014 Repurchase Program. In 2016, we repurchased $50.0 million of our common stock through an accelerated stock repurchase agreement and $46.2 million of stock repurchase in the open market. |\\n\\n| ◦ | April 2016 Repurchase Program. On April 28, 2016, we announced that our Board of Directors had authorized a plan to repurchase up to $300.0 million of our stock. |\\n\\n| ◦ | Remaining Available Repurchases. As of December 31, 2016, we have $3.8 million remaining under the April 2014 Repurchase Program and $300.0 million under the April 2016 Repurchase Plan (Refer to Note 10 \\\"Common Stock Repurchase Program\\\" of the Notes to Consolidated Financial Statements for details on stock repurchase program). |\\n\\n| • | SmileDirectClub. On July 25, 2016, we entered into a supply agreement with SmileDirectClub, LLC (\\\"SDC\\\") to manufacture clear aligners for SDC's doctor-led, at-home program for simple teeth straightening. In October 2016, we became SDC's exclusive third-party supplier and commercial supplying aligners for its minor tooth movement aligner program. As part of the transaction, we acquired a 17% equity interest in SDC for $46.7 million. We also provided a revolving line of credit to SDC of up to $15.0 million to fund their working capital and general corporate needs (Refer to Note 4 \\\"Equity Method Investments\\\" of the Notes to Consolidated Financial Statements for details on accounting treatment). |\\n\\nWe expect the supply agreement to be incremental to revenue growth in 2017.\\n| • | New Corporate Headquarters Office Purchase Agreement. On December 19, 2016, we entered into a Purchase and Sale Agreement (the \\\"Purchase Agreement\\\") with LBA RIV-COMPANY XXX, LLC (\\\"Seller\\\") to purchase the real property located in San Jose, California (the \\\"Property\\\") for the purchase price of $44.1 million. We closed the Purchase Agreement on January 26, 2017 (Refer to Note 8 \\\"Commitments and Contingencies\\\" of the Notes of Consolidated Financial Statements for more information on the Purchase Agreement). |\\n\\nResults of Operations\\nNet Revenues by Reportable Segment Comparison for Year Ended December 31, 2016, 2015 and 2014:\\nWe group our operations into two reportable segments: Clear Aligner segment and Scanner segment\\n| • | Our Clear Aligner segment consists of our Invisalign system which includes Invisalign Full, Teen and Assist (\\\"Comprehensive Products\\\"), Express/Lite (\\\"Non-Comprehensive Products\\\"), Vivera retainers, along with our training and ancillary products for treating malocclusion (\\\"Non-Case\\\"). Clear Aligner segment also include the sale of aligners to SDC under our supply agreement which commenced in the fourth quarter of 2016. SDC revenue is recorded after eliminating outstanding intercompany transactions. |\\n\\n| • | Our Scanner segment consists of intraoral scanning systems and additional services available with the intraoral scanners that provide digital alternatives to the traditional cast models. This segment includes our iTero scanner and OrthoCAD services. |\\n\\nNet revenues for our Clear Aligner segment and Scanner segment by region for the year ended December 31, 2016, 2015 and 2014 are as follows (in millions):\\n37\\n| Year Ended | Year Ended |\\n| Net Revenues | December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\\n| Clear Aligner Revenues: |\\n| North America | $ | 568.7 | $ | 498.7 | $ | 70.0 | 14.0 | % | $ | 498.7 | $ | 446.6 | $ | 52.1 | 11.7 | % |\\n| International | 326.6 | 250.1 | 76.5 | 30.6 | % | 250.1 | 219.7 | 30.4 | 13.8 | % |\\n| Non-Case | 63.0 | 51.4 | 11.6 | 22.6 | % | 51.4 | 46.2 | 5.2 | 11.3 | % |\\n| Total Clear Aligner net revenues | $ | 958.3 | $ | 800.2 | $ | 158.1 | 19.8 | % | $ | 800.2 | $ | 712.5 | $ | 87.7 | 12.3 | % |\\n| Scanner net revenues | $ | 121.5 | $ | 45.3 | $ | 76.2 | 168.2 | % | $ | 45.3 | $ | 49.1 | $ | (3.8 | ) | (7.7 | )% |\\n| Total net revenues | $ | 1,079.8 | $ | 845.5 | $ | 234.3 | 27.7 | % | $ | 845.5 | $ | 761.6 | $ | 83.9 | 11.0 | % |\\n\\nChanges and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.\\nClear Aligner Case Volume by Region\\nCase volume data which represents Clear Aligner case shipments by region, for the year ended December 31, 2016, 2015 and 2014 is as follows (in millions):\\n| Year Ended | Year Ended |\\n| Region | December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\\n| North America | 464.5 | 398.4 | 66.1 | 16.6 | % | 398.4 | 338.5 | 59.9 | 17.7 | % |\\n| International | 244.7 | 184.8 | 59.9 | 32.4 | % | 184.8 | 139.5 | 45.3 | 32.5 | % |\\n| Total case volume | 709.2 | 583.2 | 126.0 | 21.6 | % | 583.2 | 478.0 | 105.2 | 22.0 | % |\\n\\nChanges and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.\\nFiscal Year 2016 compared to Fiscal Year 2015\\nTotal net revenues increased by $234.3 million in 2016 as compared to 2015 primarily as a result of case volume growth across all regions and products as well as increased non-case revenue.\\nClear Aligner - North America\\nNorth America net revenues increased by $70.0 million in 2016 compared to 2015 primarily due to case volume growth across all channels and products which increased net revenues by $82.7 million. This increase was offset in part by lower average selling price (\\\"ASP\\\") which decreased net revenues by $12.7 million. ASP declined in 2016 compared to 2015 as a result of higher promotional discounts of $21.9 million as well as an increase in net deferrals of $7.7 million primarily related to the full year effect of our new additional aligners product policy launched in July 2015. These declines were partially offset by price increases on our Comprehensive Products effective April 1, 2016 which contributed $17.7 million to net revenues.\\nClear Aligner - International\\nInternational net revenues increased by $76.5 million in 2016 compared to 2015 primarily driven by case volume growth across all channels and products which increased net revenues by $80.9 million. This increase was offset in part by lower ASP which decreased net revenues by $4.4 million. ASP declined in 2016 compared to 2015 as a result of higher promotional discounts of $6.9 million as well as the unfavorable impact of changes in foreign exchange rates of $6.8 million. These declines were partially offset by the price increases on our Comprehensive products effective April 1, 2016 which contributed $5.7 million to net revenues, as well as an increase in additional aligner revenue of $3.5 million.\\nClear Aligner - Non-Case\\nNon-case net revenues, consisting of training fees and ancillary product revenues, increased by $11.6 million in 2016 compared to 2015 primarily due to increased Vivera volume both in North America and International.\\n38\\nScanner\\nScanner net revenues increased by $76.2 million in 2016 compared to 2015 primarily as a result of an increase in the number of scanners recognized as we began shipping our next generation iTero Element scanner in September 2015, and, to a lesser extent, an increase in ASP.\\nFiscal Year 2015 compared to Fiscal Year 2014\\nTotal net revenues increased by $83.9 million in 2015 compared to 2014 primarily as a result of case volume growth across all regions and products as well as increased non-case revenue.\\nClear Aligner - North America\\nNorth America net revenues increased by $52.1 million in 2015 compared to 2014 primarily due to case volume growth across all channels and products which increased net revenues by approximately $79.0 million. These increases were offset in part by lower ASP, which decreased net revenues by $26.9 million. The decrease in ASP was primarily as a result of higher net revenue deferrals of $16.0 million, which includes the impact of our new additional aligner product policy launched in July 2015 of $8.9 million and the impact of higher promotional discounts in 2015 as compared to 2014 of $11.7 million. These decreases in ASP were offset in part by the price increase, effective April 1, 2015 on our Comprehensive Products.\\nClear Aligner - International\\nInternational net revenues increased by $30.4 million in 2015 compared to 2014 primarily driven by case volume growth across all products of $71.5 million. This was partially offset by lower ASP which decreased net revenues by approximately $41.1 million. The decrease in ASP was primarily as a result of the unfavorable impact from changes in foreign exchange rates primarily due to the weakening of the Euro compared to the U.S. dollar in 2015 compared to 2014 of $34.5 million, and, to a lesser extent, higher net revenue deferrals of $7.8 million which includes the impact of our new additional aligner product policy launched in July 2015 of $4.7 million, as well as higher promotional discounts of $6.3 million in 2015 compared to 2014. These decreases were partially offset by an increase in ASP as we transitioned to direct sales in certain APAC countries and EMEA regions, as well as the price increase on our Comprehensive Products effective July 1, 2015.\\nClear Aligner - Non-Case\\nNon-case net revenues, consisting of training fees and ancillary product revenues, increased by $5.2 million in 2015 as compared to 2014 primarily due to increased Vivera volume both in North America and International.\\nScanner\\nScanner net revenues decreased by $3.8 million in 2015 compared to 2014 primarily due to a decrease in scanner revenue, offset in part by a slight increase in services revenue. In March 2015, we announced our next generation scanner and began shipping the iTero Element scanner in September 2015. Scanner revenues declined in 2015 primarily due to fewer scanners recognized and permanent price reductions on our previous generation scanner. The increase in services revenue was primarily due to an increase in the volume of CAD/CAM services resulting from a larger installed base of scanners.\\n39\\nCost of net revenues and gross profit (in millions):\\n\\n| Year Ended | Year Ended |\\n| December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\\n| Clear Aligner |\\n| Cost of net revenues | $ | 210.8 | $ | 172.0 | $ | 38.8 | $ | 172.0 | $ | 149.7 | $ | 22.3 |\\n| % of net segment revenues | 22.0 | % | 21.5 | % | 21.5 | % | 21.0 | % |\\n| Gross profit | $ | 747.5 | $ | 628.2 | $ | 119.3 | $ | 628.2 | $ | 562.9 | $ | 65.3 |\\n| Gross margin % | 78.0 | % | 78.5 | % | 78.5 | % | 79.0 | % |\\n| Scanner |\\n| Cost of net revenues | $ | 53.7 | $ | 33.4 | $ | 20.3 | $ | 33.4 | $ | 33.6 | $ | (0.2 | ) |\\n| % of net segment revenues | 44.2 | % | 73.7 | % | 73.7 | % | 68.3 | % |\\n| Gross profit | $ | 67.8 | $ | 11.9 | $ | 55.9 | $ | 11.9 | $ | 15.6 | $ | (3.7 | ) |\\n| Gross margin % | 55.8 | % | 26.3 | % | 26.3 | % | 31.7 | % |\\n| Total cost of net revenues | $ | 264.6 | $ | 205.4 | $ | 59.2 | $ | 205.4 | $ | 183.2 | $ | 22.2 |\\n| % of net revenues | 24.5 | % | 24.3 | % | 24.3 | % | 24.1 | % |\\n| Gross profit | $ | 815.3 | $ | 640.1 | $ | 175.2 | $ | 640.1 | $ | 578.4 | $ | 61.7 |\\n| Gross margin % | 75.5 | % | 75.7 | % | 75.7 | % | 75.9 | % |\\n\\nChanges and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.\\nCost of net revenues for our Clear Aligner and Scanner segments includes salaries for staff involved in the production process, the cost of materials, packaging, shipping costs, depreciation on capital equipment and facilities used in the production process, amortization of acquired intangible assets from training costs and stock-based compensation.\\nFiscal Year 2016 compared to Fiscal Year 2015\\nClear Aligner\\nThe gross margin percentage declined in 2016 compared to 2015 primarily driven by a higher number of aligners per case and lower ASP which was partially offset by higher absorption as a result of increased production volumes.\\nScanner\\nThe gross margin percentage increased in 2016 compared to 2015 due to a product mix shift to our iTero Element scanner which has a higher ASP along with lower costs per unit.\\nFiscal Year 2015 compared to Fiscal Year 2014\\nClear Aligner\\nThe gross margin percentage declined in 2015 compared to 2014 due to lower ASP which was partially offset by higher absorption as a result of increased production volumes.\\nScanner\\nThe gross margin percentage decreased in 2015 compared to 2014 due to lower ASP from permanent price reductions on our previous generation scanner, higher manufacturing costs from lower production volumes and higher inventory reserves. This was partially offset by a product mix shift to the lower cost Element scanner which commenced shipping in September 2015.\\n40\\nSelling, general and administrative (in millions):\\n| Year Ended | Year Ended |\\n| December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\\n| Selling, general and administrative | $ | 490.7 | $ | 390.2 | $ | 100.5 | $ | 390.2 | $ | 332.1 | $ | 58.1 |\\n| % of net revenues | 45.4 | % | 46.2 | % | 46.2 | % | 43.6 | % |\\n\\nChanges and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.\\nSelling, general and administrative expense includes personnel-related costs including payroll, commissions and stock-based compensation for our sales force, marketing and administration in addition to media and advertising expenses, clinical education, trade shows and industry events, product marketing, outside consulting services, legal expenses, depreciation and amortization expense, the medical device excise tax (\\\"MDET\\\") and allocations of corporate overhead expenses including facilities and IT.\\nSelling, general and administrative expense increased in 2016 compared to 2015 primarily due to higher compensation related costs of $47.1 million as a result of increased headcount, resulting in higher salaries expense, incentive bonuses and fringe benefits. We also incurred higher expenses from advertising and marketing of $16.5 million, outside services costs of $12.2 million, equipment and material costs of $6.8 million, travel and related costs of $6.0 million and credit card processing fees of $4.2 million. In addition, during the first quarter of 2015, there was a refund of MDET taxes paid in 2014 of $6.8 million as our aligners are no longer subject to the excise tax.\\nSelling, general and administrative expense increased in 2015 compared to 2014 primarily due to higher compensation related costs of $50.1 million as a result of increased headcount, which led to higher salaries, stock based compensation and commissions. In addition, consulting costs increased by $9.7 million primarily due to our enterprise resource planning (\\\"ERP\\\") project. Partially offsetting these increases was the MDET refund of $6.8 million received in the first quarter of 2015.\\nResearch and development (in millions):\\n| Year Ended | Year Ended |\\n| December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\\n| Research and development | $ | 75.7 | $ | 61.2 | $ | 14.5 | $ | 61.2 | $ | 52.8 | $ | 8.4 |\\n| % of net revenues | 7.0 | % | 7.2 | % | 7.2 | % | 6.9 | % |\\n\\nChanges and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.\\nResearch and development expense includes the personnel-related costs including stock-based compensation and outside consulting expenses associated with the research and development of new products and enhancements to existing products and allocations of corporate overhead expenses including facilities and IT.\\nResearch and development expense increased in 2016 compared to 2015 due to higher compensation costs as a result of increased headcount along with annual salary increases.\\nResearch and development expense increased in 2015 compared to 2014 primarily as a result of our investment in obstructive sleep apnea which was terminated in the third quarter of 2015.\\n41\\nIncome from operations (in millions):\\n| Year Ended | Year Ended |\\n| December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\\n| Clear Aligner |\\n| Income from operations | $ | 411.8 | $ | 371.1 | $ | 40.7 | $ | 371.1 | $ | 341.1 | $ | 30.0 |\\n| Operating margin % | 43.0 | % | 46.4 | % | 46.4 | % | 47.9 | % |\\n| Scanner |\\n| Income (loss) from operations | $ | 37.5 | $ | (12.3 | ) | $ | 49.8 | $ | (12.3 | ) | $ | (8.5 | ) | $ | (3.8 | ) |\\n| Operating margin % | 30.9 | % | (27.2 | )% | (27.2 | )% | (17.3 | )% |\\n| Total income from operations(1) | $ | 248.9 | $ | 188.6 | $ | 60.3 | $ | 188.6 | $ | 193.6 | $ | (5.0 | ) |\\n| Operating margin % | 23.1 | % | 22.3 | % | 22.3 | % | 25.4 | % |\\n\\nChanges and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.\\n(1) Refer to Note 15 \\\"Segments and Geographical Information\\\" of the Notes to Consolidated Financial Statements for details on unallocated corporate expenses and the reconciliation to total income from operations.\\nFiscal Year 2016 compared to Fiscal Year 2015\\nClear Aligner\\nOperating margin percentage declined in 2016 compared to 2015 primarily due to higher compensation costs as a result of increased headcount, higher number of aligners manufactured per case and lower ASP.\\nScanner\\nOperating margin percentage increased in 2016 compared to 2015 due to a product mix shift to our iTero Element scanner resulting in a higher ASP and lower costs per unit. We also incurred lower operating expenses as a percentage of revenues as we leveraged our operating expenses on higher revenues.\\nFiscal Year 2015 compared to Fiscal Year 2014\\nClear Aligner\\nOperating margin percentage declined in 2015 compared to 2014 due to higher compensation costs as a result of increased headcount, higher research and development expenses due to our investment in obstructive sleep apnea and lower ASP.\\nScanner\\nOperating margin percentage decreased in 2015 compared to 2014 due to lower ASP, higher manufacturing costs, higher inventory reserves and increased compensation related costs.\\nInterest and other income (expense), net (in millions):\\n| Year Ended | Year Ended |\\n| December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\\n| Interest and other income (expense), net | $ | (6.4 | ) | $ | (2.5 | ) | $ | (3.9 | ) | $ | (2.5 | ) | $ | (3.2 | ) | $ | 0.7 |\\n\\nInterest and other income (expense), net, includes foreign currency revaluation gains and losses, interest income earned on cash, cash equivalents and investment balances, gains and losses on foreign currency forward contracts and other miscellaneous charges.\\n42\\nInterest and other income (expense), net, decreased in 2016 compared to 2015 mainly due to higher foreign exchange losses as a result of weakening of the Euro to the U.S. dollar.\\nInterest and other income (expense), net, increased in 2015 compared to 2014 mainly due to higher interest income on higher balances of cash, cash equivalents and investments offset in part by higher foreign exchange losses primarily due to the strengthening of the U.S. dollar to the Euro and Australian dollar.\\nEquity in losses of investee, net of tax (in millions):\\n| Year Ended | Year Ended |\\n| December 31, 2016 | December 31, 2015 | Change | December 31, 2015 | December 31, 2014 | Change |\\n| Equity in losses, net of tax | $ | 1.7 | — | $ | 1.7 | — | — | — |\\n\\nWe invested $46.7 million in SDC on July 25, 2016 and we account for this investment based on the equity method of accounting. In 2016, we recorded a $1.7 million charge representing our share of losses attributable to equity method investments (Refer to Note 4 \\\"Equity Method Investments\\\" of the Notes to Consolidated Financial Statements for details on equity method investments).\\nProvision for income taxes (in millions):\\n| Year Ended | Year Ended |\\n| December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\\n| Provision for income taxes | $ | 51.2 | $ | 42.1 | $ | 9.1 | $ | 42.1 | $ | 44.5 | $ | (2.4 | ) |\\n| Effective tax rates | 21.1 | % | 22.6 | % | 22.6 | % | 23.4 | % |\\n\\nChanges and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.\\nOur provision for income taxes was $51.2 million, $42.1 million and $44.5 million for the year ended December 31, 2016, 2015 and 2014, respectively, representing effective tax rates of 21.1%, 22.6% and 23.4%, respectively. Our effective tax rate differs from the statutory federal income tax rate of 35% due to certain foreign earnings, primarily in Costa Rica and the Netherlands, which are subject to lower tax rates and the impacts from our new international corporate structure in 2016, partially offset by the tax impact of certain stock-based compensation charges and unrecognized tax benefits. The decrease in the effective tax rate in 2016 compared to 2015 was primarily related to our international corporate restructuring as explained below. The decrease in the effective rate for the year ended December 31, 2015 compared to 2014 is mainly due to a $1.8 million tax adjustment recorded in 2014 which related to prior periods.\\nOur total gross unrecognized tax benefits, excluding interest and penalties, was $46.4 million and $39.4 million as of December 31, 2016 and 2015, respectively, all of which would impact our effective tax rate if recognized. We have elected to recognize interest and penalties related to unrecognized tax benefits as a component of income taxes. For the year ended December 31, 2016 and 2015, interest and penalties included in tax expense was $1.4 million and $0.7 million, respectively. Our total interest and penalties accrued as of December 31, 2016 was $2.1 million. We do not expect any significant changes to the amount of unrecognized tax benefit within the next twelve months.\\nWe file U.S. federal, U.S. state, and non-U.S. income tax returns. Our major tax jurisdictions are U.S. federal and the State of California. For U.S. federal and state tax returns, we are no longer subject to tax examinations for years before 2000. With few exceptions, we are no longer subject to examination by foreign tax authorities for years before 2007. Our subsidiary in Israel is under audit by the local tax authorities for calendar years 2006 through 2013.\\nOn July 1, 2016, we implemented a new international corporate structure. This changes the structure of our international procurement and sales operations, as well as realigns the ownership and use of intellectual property among our wholly-owned subsidiaries. We continue to anticipate that an increasing percentage of our consolidated pre-tax income will be derived from, and reinvested in our foreign operations. We believe that income taxed in certain foreign jurisdictions at a lower rate relative to the U.S. federal statutory rate will have a beneficial impact on our worldwide effective tax rate over time. Although the license of intellectual property rights between consolidated entities did not result in any gain in the consolidated financial statements, the Company generated taxable income in certain jurisdictions in 2016 resulting in a tax expense of $34.3 million. Additionally, as a result of the restructuring, we reassessed the need for a valuation allowance against our deferred tax assets considering all available evidence. Given the current earnings and anticipated future earnings of our subsidiary in Israel, we concluded that we have sufficient\\n43\\npositive evidence to release the valuation allowance against our Israel operating loss carryforwards of $31.4 million, which resulted in an income tax benefit in this period of the same amount.\\nAs of December 31, 2016, our remaining valuation allowance was not material.\\nIn June 2009, the Costa Rica Ministry of Foreign Trade, an agency of the Government of Costa Rica, granted a twelve year extension of certain income tax incentives, which were previously granted in 2002. The incentive tax rates will expire in various years beginning in 2017. We intend to seek a renewal of these income tax incentives before they expire. Under these incentives, all of the income in Costa Rica during these twelve year incentive periods is subject to a reduced tax rate. In order to receive the benefit of these incentives, we must hire specified numbers of employees and maintain certain minimum levels of fixed asset investment in Costa Rica. If we do not fulfill these conditions for any reason, our incentive could lapse, and our income in Costa Rica would be subject to taxation at higher rates, which could have a negative impact on our operating results. The Costa Rica corporate income tax rate that would apply, absent the incentives, is 30% for 2016, 2015 and 2014. As a result of these incentives, our income taxes were reduced by $19.1 million, $32.7 million and $32.5 million in the year ended December 31, 2016, 2015 and 2014, respectively, representing a benefit to diluted net income per share of $0.23 in the year ended December 31, 2016 and $0.40 for both the year ended December 31, 2015 and 2014.\\nAs of December 31, 2016, approximately $438.0 million of undistributed earnings from non-U.S. operations held by our foreign subsidiaries are designated as indefinitely reinvested outside the U.S. We maintain sufficient cash reserves in the U.S. and do not intend to repatriate our foreign earnings. As a result, U.S. income taxes and foreign withholding taxes have not been provided on these foreign earnings. If these earnings were distributed in the form of dividends or otherwise, or if the shares of the relevant foreign subsidiaries were sold or otherwise transferred, we would be subject to additional U.S. income taxes subject to an adjustment for foreign tax credits and foreign withholding taxes. We intend to use the undistributed earnings for local operating expansions and to meet local operating working capital needs. In addition, a significant amount of the cash earned by foreign subsidiaries has been and will continue to be utilized to affect the new international corporate structure described above.\\nLiquidity and Capital Resources\\nWe fund our operations from product sales. As of December 31, 2016 and 2015, we had the following cash and cash equivalents, and short-term and long-term marketable securities (in thousands):\\n| Year Ended December 31, |\\n| 2016 | 2015 |\\n| Cash and cash equivalents | $ | 389,275 | $ | 167,714 |\\n| Short-term marketable securities | 250,981 | 359,581 |\\n| Long-term marketable securities | 59,783 | 151,370 |\\n| Total | $ | 700,039 | $ | 678,665 |\\n\\nCash flows (in thousands):\\n| Year Ended December 31, |\\n| 2016 | 2015 | 2014 |\\n| Net cash flow provided by (used in): |\\n| Operating activities | $ | 247,654 | $ | 237,997 | $ | 226,899 |\\n| Investing activities | 72,848 | (166,361 | ) | (201,627 | ) |\\n| Financing activities | (95,524 | ) | (100,786 | ) | (66,420 | ) |\\n| Effects of exchange rate changes on cash and cash equivalents | (3,417 | ) | (3,007 | ) | (1,934 | ) |\\n| Net increase (decrease) in cash and cash equivalents | $ | 221,561 | $ | (32,157 | ) | $ | (43,082 | ) |\\n\\nAs of December 31, 2016, we had $700.0 million in cash, cash equivalents, and short-term and long-term marketable securities. Cash equivalents and marketable securities are comprised of money market funds and highly liquid debt instruments which primarily include commercial paper, corporate bonds, U.S. dollar denominated foreign corporate bonds, U.S. government agency bonds, U.S. government treasury bonds, municipal securities, asset-backed securities and certificates of deposit.\\nAs of December 31, 2016, approximately $459.0 million of cash, cash equivalents and short-term and long-term marketable securities was held by our foreign subsidiaries. Amounts held by foreign subsidiaries are generally subject to U.S. income taxation on repatriation to the U.S. The costs to repatriate our foreign earnings to the U.S. would likely be material; however, our intent is\\n44\\nto permanently reinvest our earnings from foreign operations, and our current plans do not require us to repatriate them to fund our U.S. operations as we generate sufficient domestic operating cash flow and have access to external funding under our current revolving line of credit.\\nOperating Activities\\nFor the year ended December 31, 2016, cash flows from operations of $247.7 million resulted primarily from our net income of approximately $189.7 million as well as the following:\\nSignificant non-cash activities\\n| • | Stock-based compensation was $54.1 million related to equity incentive compensation granted to employees and directors, |\\n\\n| • | Depreciation and amortization of $24.0 million related to our fixed assets and acquired and purchased intangible assets, |\\n\\n| • | Excess tax benefits from our share-based compensation arrangements of $16.8 million, |\\n\\n| • | Net change in deferred tax assets of $16.4 million, and |\\n\\n| • | Net tax benefits from stock based compensation of $15.9 million. |\\n\\nSignificant changes in working capital\\n| • | Increase of $94.4 million in accounts receivable which is a result of the increase in net revenues, |\\n\\n| • | Increase of $60.7 million in deferred revenues corresponding to the increases in case shipments and full year effect of our additional aligner product policy effective in July 2015, and |\\n\\n| • | Increase of $37.6 million in accrued and other long-term liabilities due to timing of payments and activities. |\\n\\nFor the year ended December 31, 2015, cash flows from operations of $238.0 million resulted primarily from our net income of approximately $144.0 million as well as the following:\\nSignificant non-cash activities\\n| • | Stock-based compensation was $52.9 million related to our equity incentive compensation granted to employees and directors, |\\n\\n| • | Depreciation and amortization of $18.0 million related to our fixed assets and acquired intangible assets, and |\\n\\n| • | Excess tax benefits from our share-based compensation arrangements of $10.4 million. |\\n\\nSignificant changes in working capital\\n| • | Increase of $41.9 million in deferred revenues corresponding to higher product sales along with the increased deferrals as a result of the change to our new additional aligner product policy in July 2015, |\\n\\n| • | Increase of $40.8 million in accounts receivable which is a result of the increase in net revenues, and |\\n\\n| • | Increase of $19.5 million in accrued and other long-term liabilities primarily due to an increase in income tax payable along with other accruals due to timing of payment. |\\n\\nFor the year ended December 31, 2014, cash flows from operations of $226.9 million resulted primarily from our net income of approximately $145.8 million as well as the following:\\n45\\nSignificant non-cash activities\\n| • | Stock-based compensation was $39.8 million related to our equity incentive compensation granted to employees and directors, |\\n\\n| • | Excess tax benefits from our share-based compensation arrangements of $21.4 million, and |\\n\\n| • | Depreciation and amortization of $17.9 million related to our fixed assets and acquired intangible assets. |\\n\\nSignificant changes in working capital\\n| • | Increase of $27.2 million in accounts receivable which is a result of the increase in net revenues, |\\n\\n| • | Increase of $22.7 million in accrued and other long-term liabilities primarily due to an increase in income tax payable along with other accruals due to timing of payment, and |\\n\\n| • | Increase of $15.8 million in deferred revenues corresponding to the increases in revenues. |\\n\\nInvesting Activities\\nNet cash provided by investing activities was $72.8 million for the year ended December 31, 2016, which primarily consisted of maturities and sales of our marketable securities of $604.0 million. These inflows were partially offset by purchases of marketable securities of $405.6 million, property, plant and equipment purchases of $70.6 million including the implementation of our new ERP system and $46.7 million related to our equity interest investment in SmileDirectClub, LLC (\\\"SDC\\\").\\nFor 2017, we expect to invest $220.0 million to $250.0 million on capital expenditures primarily for our purchase of a new corporate headquarters office, new order acquisition facility in Singapore and other additional manufacturing and capacity to support our international expansion. Although we believe our current investment portfolio has little risk of impairment, we cannot predict future market conditions or market liquidity and can provide no assurance that our investment portfolio will remain unimpaired.\\nNet cash used in investing activities was $166.4 million for the year ended December 31, 2015, which primarily consisted of purchases of marketable securities of $447.1 million and property, plant and equipment purchases of $53.5 million for additional manufacturing capacity and infrastructure including the project to implement a new ERP system which we started in late 2014. These uses were partially offset by $334.1 million of maturities and sales of our marketable securities.\\nNet cash used in investing activities was $201.6 million for the year ended December 31, 2014, which primarily consisted of purchases of marketable securities of $437.2 million and property, plant and equipment purchases of $24.1 million. These uses were partially offset by $259.8 million of maturities and sales of our marketable securities.\\nFinancing Activities\\nNet cash used by financing activities was $95.5 million for the year ended December 31, 2016 primarily resulting from a common stock repurchase of $96.2 million (Refer to Note 10 \\\"Common Stock Repurchase Program\\\" of the Notes to Consolidated Financial Statements for details on the stock repurchase program) and $29.9 million of payroll taxes paid for vesting of restricted stock units (\\\"RSUs\\\") through share withholdings, partially offset by excess tax benefit from our share-based compensation arrangements of $16.8 million and proceeds from issuance of common stock of $13.8 million.\\nNet cash used by financing activities was $100.8 million for the year ended December 31, 2015 resulting from repurchases of our common stock of $101.8 million and $20.7 million of payroll taxes paid for our employees' vesting of RSUs through share withholdings, partially off-set by proceeds from issuance of common stock of $11.3 million and $10.4 million from excess tax benefit from our share-based compensation arrangements.\\nNet cash used by financing activities was $66.4 million for the year ended December 31, 2014 resulting from repurchases of our common stock of $98.2 million and $7.6 million of payroll taxes paid for our employees' vesting of RSUs through share withholdings, partially off-set by proceeds from issuance of common stock of $18.0 million and $21.4 million from excess tax benefit from our share-based compensation arrangements.\\nAs restricted stock units are taxable to the individuals when they vest, the number of shares we issue to each of our employees will be net of applicable withholding taxes which will be paid by us on their behalf. During 2016, 2015 and 2014, we paid $29.9 million, $20.7 million and $7.6 million, respectively, for taxes related to RSUs that vested during the periods. The cash paid for\\n46\\ntaxes related to RSUs in 2016 and 2015 increased in comparison to 2014 due to the Company changing its policy in mid 2014 to pay for employees' payroll taxes related to their vesting RSUs instead of requiring employees to sell to cover for their payroll taxes.\\nStock Repurchases\\nRefer to Note 10 \\\"Common Stock Repurchase Program\\\" of the Notes to Consolidated Financial Statements for details on stock repurchase program.\\n| ◦ | April 2014 Repurchase Program. In 2016, we repurchased $50.0 million of our common stock through an accelerated stock repurchase agreement and $46.2 million of stock repurchase in the open market. |\\n\\n| ◦ | April 2016 Repurchase Program. On April 28, 2016, we announced that our Board of Directors had authorized a plan to repurchase up to $300.0 million of our stock. |\\n\\n| ◦ | Remaining Available Repurchases. As of December 31, 2016, we have $3.8 million remaining under the April 2014 Repurchase Program and $300.0 million under the April 2016 Repurchase Plan. |\\n\\nWe believe that our current cash and cash equivalents and marketable securities combined with our positive cash flows from operations will be sufficient to fund our operations and stock repurchases for at least the next 12 months. If we are unable to generate adequate operating cash flows, we may need to suspend our stock repurchase program or seek additional sources of capital through equity or debt financing, collaborative or other arrangements with other companies, bank financing and other sources in order to realize our objectives and to continue our operations. There can be no assurance that we will be able to obtain additional debt or equity financing on terms acceptable to us, or at all. If adequate funds are not available, we may need to make business decisions that could adversely affect our operating results such as modifications to our pricing policy, business structure or operations. Accordingly, the failure to obtain sufficient funds on acceptable terms when needed could have a material adverse effect on our business, results of operations and financial condition.\\nCredit Facility\\nOn March 22, 2013, we entered into a credit facility for a $50.0 million revolving line of credit, with a $10.0 million letter of credit sublimit, and has a maturity date on March 22, 2018 (Refer to Note 7 \\\"Credit Facility\\\" of the Notes to Consolidated Financial Statements for details of the credit facility).\\nContractual Obligations/Off Balance Sheet Arrangements\\nThe impact that our contractual obligations as of December 31, 2016 are expected to have on our liquidity and cash flows in future periods is as follows (in thousands):\\n| Payments Due by Period |\\n| Total | Less than1 Year | 1-3Years | 3-5Years | More than5 Years |\\n| Operating lease obligations | $ | 53,921 | $ | 12,880 | $ | 18,804 | $ | 13,096 | $ | 9,141 |\\n| Unconditional purchase obligations | 163,688 | — | — | — | — |\\n| Total contractual cash obligations | $ | 217,609 | $ | 12,880 | $ | 18,804 | $ | 13,096 | $ | 9,141 |\\n\\nOur contractual obligations table above excludes approximately $45.1 million of non-current uncertain tax benefits which are included in other long-term obligations and deferred tax assets on our balance sheet as of December 31, 2016. We have not included this amount because we cannot make a reasonably reliable estimate regarding the timing of settlements with taxing authorities, if any.\\nWe had no off-balance sheet arrangements as defined in Regulation S-K Item 303(a) (4) as of December 31, 2016.\\n47\\nIndemnification Provisions\\nIn the normal course of business to facilitate transactions in our services and products, we indemnify customers, vendors, lessors, and other parties with respect to certain matters, including, but not limited to, services to be provided by us and intellectual property infringement claims made by third parties. In addition, we have entered into indemnification agreements with our directors and certain of our officers that will require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors or officers. Several of these agreements limit the time within which an indemnification claim can be made and the amount of the claim.\\nIt is not possible to make a reasonable estimate of the maximum potential amount under these indemnification agreements due to the unique facts and circumstances involved in each particular agreement. Additionally, we have a limited history of prior indemnification claims and the payments we have made under such agreements have not had a material adverse effect on our results of operations, cash flows, or financial position. However, to the extent that valid indemnification claims arise in the future, future payments by us could be significant and could have a material adverse effect on our results of operations or cash flows in a particular period. As of December 31, 2016, we did not have any material indemnification claims that were probable or reasonably possible.\\nCritical Accounting Policies and Estimates\\nManagement’s discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses and disclosures at the date of the financial statements. We evaluate our estimates on an on-going basis, including those related to revenue recognition, stock-based compensation, goodwill and finite-lived assets and related impairment, and income taxes. We use authoritative pronouncements, historical experience and other assumptions as the basis for making estimates. Actual results could differ from those estimates.\\nWe believe the following critical accounting policies and estimates affect our more significant judgments used in the preparation of our consolidated financial statements. For further information on all of our significant accounting policies, see Note 1 \\\"Summary of Significant Accounting Policies\\\" of the Notes to Consolidated Financial Statements under Item 8.\\nRevenue Recognition\\nWe enter into sales arrangements that may consist of multiple deliverables of our products and services where certain elements of the sales arrangement are not delivered in one reporting period. We measure and allocate revenue according to the accounting guidance for multiple-deliverable revenue arrangements in Accounting Standards Update (“ASU”) 2009-13, Multiple-Deliverable Revenue Arrangements-a consensus of the Financial Accounting Standard Board (“FASB”) Emerging Issues Task Force.\\nEach element within a multiple-element arrangement is accounted for as a separate unit of accounting provided the following criteria are met: the delivered products or services have value to the customer on a standalone basis; and for an arrangement that includes a general right of return relative to the delivered products or services, delivery or performance of the undelivered product or service is considered probable and is substantially controlled by us. We consider a deliverable to have standalone value if the product or service is sold separately by us or another vendor or could be resold by the customer. Further, our revenue arrangements generally do not include a general right of return relative to the delivered products. The arrangement consideration is allocated to each element, delivered or undelivered, based on the relative selling price of each unit of accounting based first on vendor-specific objective evidence (“VSOE”) if it exists, second on third-party evidence (“TPE”) if it exists, or on best estimated selling price (“BESP”) if neither VSOE nor TPE exist (a description as to how we determine VSOE, TPE and BESP is provided below).\\n| • | VSOE - In most instances, this applies to products and services that are sold separately in stand-alone arrangements. We determine VSOE based on pricing and discounting practices for the specific product or service when sold separately, considering geographical, customer, and other economic or marketing variables, as well as renewal rates or stand-alone prices for the service element(s). |\\n\\n| • | TPE - If we cannot establish VSOE of selling price for a specific product or service included in a multiple-element arrangement, we use third-party evidence of selling price. We determine TPE based on sales of comparable amount of similar products or service offered by multiple third parties considering the degree of customization and similarity of product or service sold. |\\n\\n| • | BESP - The best estimated selling price represents the price at which we would sell a product or service if it were sold on a stand-alone basis. When VSOE or TPE does not exist for all elements, we determine BESP for the arrangement element based on sales, cost and margin analysis, as well as other inputs based on our pricing practices. Adjustments for |\\n\\n48\\nother market and company specific factors are made as deemed necessary in determining BESP. We regularly review our estimates of selling price and maintain internal controls over the establishment and update of these estimates.\\nJudgment is required to properly identify the accounting units of the multiple deliverable transactions, to determine the best estimated selling price for each accounting unit, and to determine the manner in which revenue should be allocated among the accounting units. Further, while changes in the allocation of the best estimated selling price between the accounting units will not affect the amount of total revenue recognized for a particular arrangement, any material changes in these allocations could impact the timing of revenue recognition, which could have a material effect on our financial position and results of operations.\\nClear Aligner\\nWe enter into arrangements (“treatment plans”) that involve multiple future product deliverables. Invisalign Full, Invisalign Teen, and Invisalign Assist products (\\\"Comprehensive Products\\\") include optional additional aligners at no charge for a period of up to five years after initial shipment. Invisalign Teen also includes up to six optional replacement aligners in the price of the product and may be ordered by the dental professional any time throughout treatment. Invisalign Lite (\\\"Non-Comprehensive Products\\\") includes one optional case refinement in the price of the product. Case refinement is a finishing tool used to adjust a patient's teeth to the desired final position and may be elected by the dental professional at any time during treatment; however, it is generally ordered in the last stages of orthodontic treatment.\\nWe determined that our treatment plans, except Invisalign Assist with progress tracking, comprise the following deliverables which also represent separate units of accounting: initial aligners, additional aligners, case refinement, and replacement aligners. We allocate revenue for each treatment plan based on each unit's relative selling price based on BESP and recognize the revenue upon shipment of each unit in the treatment plan.\\nFor Invisalign Assist with the progress tracking feature, aligners and services are provided to the dental professional every nine stages (“a batch”). We are able to reliably estimate the number of batches which are expected to be shipped for each case based upon our historical experience. The amounts allocated to this deliverable are recognized on a prorated basis as each batch is shipped.\\nScanners and Services\\nWe sell intraoral scanners and CAD/CAM services through both our direct sales force and distribution partners. The intraoral scanner sales price includes one year of warranty, and unlimited scanning services. The customer may, for additional fees, also select extended warranty and unlimited scanning services for periods beyond the initial year. When intraoral scanners are sold with an unlimited scanning service agreement and/or extended warranty, we allocate revenue based on each element's relative selling price. We estimate the selling price of each element, as if it is sold on a stand-alone basis, taking into consideration historical prices as well as our discounting strategies.\\nStock-Based Compensation Expense\\nWe recognize stock-based compensation cost for only those shares ultimately expected to vest on a straight-line basis over the requisite service period of the award. We use the Black-Scholes option pricing model to determine the fair value of stock options and employee stock purchase plan shares. We estimate the fair value of market-performance based restricted stock units using a Monte Carlo simulation model which requires the input of assumptions, including expected term, stock price volatility and the risk-free rate of return. In addition, judgment is required in estimating the number of stock-based awards that are expected to be forfeited. Forfeitures are estimated based on historical experience at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management’s judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future.\\nGoodwill and Finite-Lived Acquired Intangible Assets\\nGoodwill represents the excess of the purchase price paid over the fair value of tangible and identifiable intangible net assets acquired in business combinations and is allocated to the respective reporting units based on relative synergies generated. For the year ended December 31, 2016 and 2015, all goodwill is attributed to our Clear Aligner reporting unit.\\n49\\nOur intangible assets primarily consist of intangible assets acquired as part of acquisitions and are amortized using the straight-line method over their estimated useful lives, reflecting the period in which the economic benefits of the assets are expected to be realized.\\nImpairment of Goodwill, Finite-Lived Acquired Intangible Assets and Long-Lived assets\\nGoodwill\\nWe evaluate goodwill for impairment at least annually on November 30th or more frequently if indicators are present, an event occurs or circumstances changes that suggest an impairment may exist and that it would more likely than not reduce the fair value of a reporting unit below its carrying amount. The allocation of goodwill to the respective reporting unit is based on relative synergies generated as a result of an acquisition.\\nWe perform an initial assessment of qualitative factors to determine whether the existence of events and circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. In performing the qualitative assessment, we identify and consider the significance of relevant key factors, events, and circumstances that affect the fair value of our reporting units. These factors include external factors such as macroeconomic, industry, and market conditions, as well as entity-specific factors, such as our actual and planned financial performance. We also give consideration to the difference between the reporting unit fair value and carrying value as of the most recent date a fair value measurement was performed. If, after assessing the totality of relevant events and circumstances, we determine that it is more likely than not that the fair value of the reporting unit exceeds its carrying value and there is no indication of impairment, no further testing is performed; however, if we conclude otherwise, the first step of the two-step impairment test is performed by estimating the fair value of the reporting unit and comparing it with its carrying value, including goodwill. Refer to Note 5 \\\"Goodwill and Intangible Assets\\\" of Notes to Consolidated Financial Statements for details on intangible long-lived assets.\\nFinite-Lived Intangible Assets and Long-Lived Assets\\nWe evaluate long-lived assets (including finite-lived intangible assets) for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. An asset or asset group is considered impaired if its carrying amount exceeds the future undiscounted net cash flows the asset or asset group is expected to generate. If an asset or asset group is considered to be impaired, the impairment to be recognized is calculated as the amount by which the carrying amount of the asset or asset group exceeds its fair market value. Our estimates of future cash flows attributable to our long-lived assets require significant judgment based on our historical and anticipated results and are subject to many factors. Factors we consider important which could trigger an impairment review include significant negative industry or economic trends, significant loss of customers and changes in the competitive environment. The estimation of fair value utilizing a discounted cash flow approach includes numerous uncertainties which require our significant judgment when making assumptions of expected growth rates and the selection of discount rates, as well as assumptions regarding general economic and business conditions, and the structure that would yield the highest economic value, among other factors. Refer to Note 5 \\\"Goodwill and Intangible Assets\\\" of Notes to Consolidated Financial Statements for details of the impairment analysis.\\nAccounting for Income Taxes\\nWe make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of certain tax assets and liabilities, which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes.\\nAs part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves us estimating our current tax exposure under the applicable tax laws and assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our Consolidated Balance Sheets.\\nWe account for uncertainty in income taxes pursuant to authoritative guidance based on a two-step approach to recognize and measure uncertain tax positions taken or expected to be taken in a tax return. The first step is to determine if the weight of available evidence indicates that it is more likely than not that the tax position will be sustained on audit based on its technical merits, including resolution of any related appeals or litigation processes. The second step is to measure the tax benefit as the largest amount that is more than 50% likely to be realized upon ultimate settlement. We adjust reserves for our uncertain tax positions due to changing facts and circumstances, such as the closing of a tax audit, or refinement of estimates due to new\\n50\\ninformation. To the extent that the final outcome of these matters is different than the amounts recorded, such differences will impact our tax provision in our Consolidated Statements of Operations in the period in which such determination is made.\\nWe assess the likelihood that we will be able to realize our deferred tax assets. Should there be a change in our ability to realize our deferred tax assets, our tax provision would increase in the period in which we determine that it is more likely than not that we cannot realize our deferred tax assets. We consider all available evidence, both positive and negative, including historical levels of income, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance. If it is more likely than not that we will not realize our deferred tax assets, we will increase our provision for taxes by recording a valuation allowance against the deferred tax assets that we estimate will not ultimately be realized.\\nRecent Accounting Pronouncements\\nSee Note 1 “Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements in Item 8 for a full description of recent accounting pronouncements, including the expected dates of adoption and estimated effects on results of operations and financial condition, which is incorporated herein.\\n51\\nITEM 7A.\\nQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nIn the normal course of business, we are exposed to foreign currency exchange rate and interest rate risks that could impact our financial position and results of operations.\\nInterest Rate Risk\\nChanges in interest rates could impact our anticipated interest income on our cash equivalents and investments in marketable securities. Our cash equivalents and investments are fixed-rate short-term and long-term securities. Fixed-rate securities may have their fair market value adversely impacted due to a rise in interest rates, and as a result, our future investment income may fall short of expectations due to changes in interest rates or we may suffer losses in principal if forced to sell securities which have declined in market value due to changes in interest rates. As of December 31, 2016, we had approximately $310.8 million invested in available-for-sale marketable securities. An immediate 10% change in interest rates would not have a material adverse impact on our future operating results and cash flows.\\nWe do not have interest bearing liabilities as of December 31, 2016, and, therefore, we are not subject to risks from immediate interest rate increases.\\nCurrency Rate Risk\\nAs a result of our international business activities, including the impact of our new international corporate structure in 2016, our financial results could be affected by factors such as changes in foreign currency exchange rates or economic conditions in foreign markets, and there is no assurance that exchange rate fluctuations will not harm our business in the future. We generally sell our products in the local currency of the respective countries. This provides some natural hedging because most of the subsidiaries’ operating expenses are generally denominated in their local currencies as discussed further below. Regardless of this natural hedging, our results of operations may be adversely impacted by exchange rate fluctuations. For the year ended December 31, 2016 and 2015, we had foreign currency net losses of $8.0 million and $4.0 million, respectively.\\nIn September 2015, we started to enter into foreign currency forward contracts to minimize the short-term impact of foreign currency exchange rate fluctuations on cash and certain trade and intercompany receivables and payables. These forward contracts are not designated as hedging instruments and do not subject us to material balance sheet risk due to fluctuations in foreign currency exchange rates. The gains and losses on these forward contracts are intended to offset the gains and losses in the underlying foreign currency denominated monetary assets and liabilities being economically hedged. These instruments are marked to market through earnings every period and generally are one month in original maturity. We do not enter into foreign currency forward contracts for trading or speculative purposes. As our international operations grow, we will continue to reassess our approach to managing the risks relating to fluctuations in currency rates. It is difficult to predict the impact hedging activities could have on our results of operations. As of December 31, 2016, we did not have any outstanding foreign exchange forward contracts.\\nAlthough we will continue to monitor our exposure to currency fluctuations, and, where appropriate, may use financial hedging techniques in the future to minimize the effect of these fluctuations, the impact of an aggregate change of 10% in foreign currency exchange rates relative to the U.S. dollar on our results of operations and financial position could be material.\\n52\\nITEM 8.\\nCONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA\\nQuarterly Results of Operations\\n| Three Months Ended |\\n| 2016 | 2015 |\\n| December 31, 2016 | September 30, 2016 | June 30, 2016 | March 31, 2016 | December 31, 2015 | September 30, 2015 | June 30, 2015 | March 31, 2015 |\\n| (in thousands, except per share data)(unaudited ) |\\n| Net revenues | $ | 293,203 | $ | 278,589 | $ | 269,362 | $ | 238,720 | $ | 230,276 | $ | 207,636 | $ | 209,488 | $ | 198,086 |\\n| Gross profit | 220,249 | 209,202 | 205,216 | 180,627 | 172,810 | 157,576 | 158,634 | 151,090 |\\n| Income from operations | 68,372 | 62,079 | 65,136 | 53,334 | 59,339 | 38,046 | 42,325 | 48,924 |\\n| Net income | 47,621 | 51,367 | 50,148 | 40,546 | 48,877 | 27,616 | 31,350 | 36,177 |\\n| Net income per share: |\\n| Basic | $ | 0.60 | $ | 0.64 | $ | 0.63 | $ | 0.51 | $ | 0.61 | $ | 0.35 | $ | 0.39 | $ | 0.45 |\\n| Diluted | $ | 0.59 | $ | 0.63 | $ | 0.62 | $ | 0.50 | $ | 0.60 | $ | 0.34 | $ | 0.39 | $ | 0.44 |\\n| Shares used in computing net income per share: |\\n| Basic | 79,667 | 79,977 | 79,951 | 79,831 | 79,481 | 79,808 | 80,257 | 80,459 |\\n| Diluted | 81,248 | 81,466 | 81,281 | 81,320 | 81,051 | 81,092 | 81,394 | 81,824 |\\n\\n53\\nINDEX TO CONSOLIDATED FINANCIAL STATEMENTS\\n\\n| Page |\\n| Report of Management on Internal Control over Financial Reporting | 55 |\\n| Report of Independent Registered Public Accounting Firm | 56 |\\n| Consolidated Statements of Operations | 57 |\\n| Consolidated Statements of Comprehensive Income | 58 |\\n| Consolidated Balance Sheets | 59 |\\n| Consolidated Statements of Stockholders’ Equity | 60 |\\n| Consolidated Statements of Cash Flows | 61 |\\n| Notes to Consolidated Financial Statements | 62 |\\n\\n54\\nREPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING\\nManagement of Align is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Our internal control over financial reporting is designed by, or under supervision of, our CEO and CFO, and effected by the board of directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that:\\n| • | pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of Align; |\\n\\n| • | provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of Align are being made only in accordance with authorizations of management and directors of Align; and |\\n\\n| • | provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of Align's assets that could have a material effect on the financial statements. |\\n\\nBecause of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. In addition, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.\\nManagement assessed the effectiveness of our internal control over financial reporting as of December 31, 2016. In making this assessment, management used the criteria set forth in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).\\nBased on its assessment, management has concluded that, as of December 31, 2016, our internal control over financial reporting was effective based on criteria in Internal Control - Integrated Framework (2013) issued by the COSO.\\nThe effectiveness of our internal control over financial reporting as of December 31, 2016 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which is included herein.\\n| /S/ JOSEPH M. HOGAN |\\n| Joseph M. Hogan |\\n| President and Chief Executive Officer |\\n| February 28, 2017 |\\n| /S/ JOHN F. MORICI |\\n| John F. Morici |\\n| Chief Financial Officer |\\n| February 28, 2017 |\\n\\n55\\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\\nTo the Stockholders and Board of Directors of Align Technology, Inc.:\\nIn our opinion, the consolidated financial statements listed in the index appearing under Item 15(a) (1) present fairly, in all material respects, the financial position of Align Technology, Inc. and its subsidiaries at December 31, 2016 and December 31, 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control over Financial Reporting. Our responsibility is to express opinions on these financial statements, on the financial statement schedule, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.\\nA company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.\\nBecause of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.\\n/s/ PricewaterhouseCoopers LLP\\nSan Jose, California\\nFebruary 28, 2017\\n56\\nALIGN TECHNOLOGY, INC. AND SUBSIDIARIES\\nCONSOLIDATED STATEMENTS OF OPERATIONS\\n(in thousands, except per share data)\\n\\n| Year Ended December 31, |\\n| 2016 | 2015 | 2014 |\\n| Net revenues | $ | 1,079,874 | $ | 845,486 | $ | 761,653 |\\n| Cost of net revenues | 264,580 | 205,376 | 183,210 |\\n| Gross profit | 815,294 | 640,110 | 578,443 |\\n| Operating expenses: |\\n| Selling, general and administrative | 490,653 | 390,239 | 332,068 |\\n| Research and development | 75,720 | 61,237 | 52,799 |\\n| Total operating expenses | 566,373 | 451,476 | 384,867 |\\n| Income from operations | 248,921 | 188,634 | 193,576 |\\n| Interest and other income (expense), net | (6,355 | ) | (2,533 | ) | (3,207 | ) |\\n| Net income before provision for income taxes and equity in losses of investee | 242,566 | 186,101 | 190,369 |\\n| Provision for income taxes | 51,200 | 42,081 | 44,537 |\\n| Equity in losses of investee, net of tax | 1,684 | — | — |\\n| Net income | $ | 189,682 | $ | 144,020 | $ | 145,832 |\\n| Net income per share: |\\n| Basic | $ | 2.38 | $ | 1.80 | $ | 1.81 |\\n| Diluted | $ | 2.33 | $ | 1.77 | $ | 1.77 |\\n| Shares used in computing net income per share: |\\n| Basic | 79,856 | 79,998 | 80,754 |\\n| Diluted | 81,484 | 81,521 | 82,283 |\\n\\nThe accompanying notes are an integral part of these consolidated financial statements.\\n57\\nALIGN TECHNOLOGY, INC. AND SUBSIDIARIES\\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME\\n(in thousands)\\n| Year Ended December 31, |\\n| 2016 | 2015 | 2014 |\\n| Net income | $ | 189,682 | $ | 144,020 | $ | 145,832 |\\n| Net change in foreign currency translation adjustment | (670 | ) | (154 | ) | (196 | ) |\\n| Change in unrealized gains (losses) on investments, net of tax | 712 | (686 | ) | (238 | ) |\\n| Other comprehensive income (loss) | 42 | (840 | ) | (434 | ) |\\n| Comprehensive income | $ | 189,724 | $ | 143,180 | $ | 145,398 |\\n\\nThe accompanying notes are an integral part of these consolidated financial statements.\\n58\\nALIGN TECHNOLOGY, INC. AND SUBSIDIARIES\\nCONSOLIDATED BALANCE SHEETS\\n(in thousands, except per share data)\\n\\n| December 31, |\\n| 2016 | 2015 |\\n| ASSETS |\\n| Current assets: |\\n| Cash and cash equivalents | $ | 389,275 | $ | 167,714 |\\n| Marketable securities, short-term | 250,981 | 359,581 |\\n| Accounts receivable, net of allowance for doubtful accounts and returns of $4,310 and $2,472, respectively | 247,415 | 158,550 |\\n| Inventories | 27,131 | 19,465 |\\n| Prepaid expenses and other current assets | 38,176 | 26,700 |\\n| Total current assets | 952,978 | 732,010 |\\n| Marketable securities, long-term | 59,783 | 151,370 |\\n| Property, plant and equipment, net | 175,167 | 136,473 |\\n| Equity method investments | 45,061 | — |\\n| Goodwill and intangible assets, net | 81,998 | 79,162 |\\n| Deferred tax assets | 67,844 | 51,416 |\\n| Other assets | 13,320 | 8,202 |\\n| Total assets | $ | 1,396,151 | $ | 1,158,633 |\\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\\n| Current liabilities: |\\n| Accounts payable | $ | 28,596 | $ | 34,354 |\\n| Accrued liabilities | 134,332 | 107,765 |\\n| Deferred revenues | 191,407 | 129,553 |\\n| Total current liabilities | 354,335 | 271,672 |\\n| Income tax payable | 45,133 | 37,512 |\\n| Other long-term liabilities | 1,294 | 1,523 |\\n| Total liabilities | 400,762 | 310,707 |\\n| Commitments and contingencies (Notes 6 and 8) |\\n| Stockholders’ equity: |\\n| Preferred stock, $0.0001 par value (5,000 shares authorized; none issued) | — | — |\\n| Common stock, $0.0001 par value (200,000 shares authorized; 79,553 and 79,500 issued and outstanding, respectively) | 8 | 8 |\\n| Additional paid-in capital | 864,871 | 821,507 |\\n| Accumulated other comprehensive income (loss), net | (938 | ) | (980 | ) |\\n| Retained earnings | 131,448 | 27,391 |\\n| Total stockholders’ equity | 995,389 | 847,926 |\\n| Total liabilities and stockholders’ equity | $ | 1,396,151 | $ | 1,158,633 |\\n\\nThe accompanying notes are an integral part of these consolidated financial statements.\\n59\\nALIGN TECHNOLOGY, INC. AND SUBSIDIARIES\\nCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\\n(in thousands)\\n\\n| Common Stock | AdditionalPaid-InCapital | AccumulatedOtherComprehensiveIncome (Loss), Net | Retained Earnings (Deficit) | Total |\\n| Shares | Amount |\\n| Balances at December 31, 2013 | 80,583 | $ | 8 | $ | 729,578 | $ | 294 | $ | (95,910 | ) | $ | 633,970 |\\n| Net income | — | — | — | — | 145,832 | 145,832 |\\n| Net change in unrealized gains (losses) from investments | — | — | — | (238 | ) | — | (238 | ) |\\n| Net change in foreign currency translation adjustment | — | — | — | (196 | ) | — | (196 | ) |\\n| Issuance of common stock relating to employee equity compensation plans | 1,536 | — | 18,028 | — | — | 18,028 |\\n| Tax withholdings related to net share settlement of restricted stock units | — | — | (7,608 | ) | — | — | (7,608 | ) |\\n| Common stock repurchased and retired | (1,914 | ) | — | (17,804 | ) | — | (80,429 | ) | (98,233 | ) |\\n| Net tax benefits from stock-based awards | — | — | 21,393 | — | — | 21,393 |\\n| Stock-based compensation | — | — | 39,823 | — | — | 39,823 |\\n| Balances at December 31, 2014 | 80,205 | 8 | 783,410 | (140 | ) | (30,507 | ) | 752,771 |\\n| Net income | — | — | — | — | 144,020 | 144,020 |\\n| Net change in unrealized gains (losses) from investments | — | — | — | (686 | ) | — | (686 | ) |\\n| Net change in foreign currency translation adjustment | — | — | (10 | ) | (154 | ) | — | (164 | ) |\\n| Issuance of common stock relating to employee equity compensation plans | 991 | — | 11,325 | — | — | 11,325 |\\n| Tax withholdings related to net share settlements of restricted stock units | — | — | (20,716 | ) | — | — | (20,716 | ) |\\n| Common stock repurchased and retired | (1,696 | ) | — | (15,669 | ) | — | (86,122 | ) | (101,791 | ) |\\n| Net tax benefits from stock-based awards | — | — | 10,224 | — | — | 10,224 |\\n| Stock-based compensation | — | — | 52,943 | — | — | 52,943 |\\n| Balances at December 31, 2015 | 79,500 | 8 | 821,507 | (980 | ) | 27,391 | 847,926 |\\n| Net income | — | — | — | — | 189,682 | 189,682 |\\n| Net change in unrealized gains (losses) from investments | — | — | — | 712 | — | 712 |\\n| Net change in foreign currency translation adjustment | — | — | — | (670 | ) | — | (670 | ) |\\n| Issuance of common stock relating to employee equity compensation plans | 1,163 | — | 13,778 | — | — | 13,778 |\\n| Tax withholdings related to net share settlements of restricted stock units | — | — | (29,857 | ) | — | — | (29,857 | ) |\\n| Common stock repurchased and retired | (1,110 | ) | — | (10,593 | ) | — | (85,625 | ) | (96,218 | ) |\\n| Net tax benefits from stock-based awards | — | — | 15,888 | — | — | 15,888 |\\n| Stock-based compensation | — | — | 54,148 | — | — | 54,148 |\\n| Balances at December 31, 2016 | 79,553 | $ | 8 | $ | 864,871 | $ | (938 | ) | $ | 131,448 | $ | 995,389 |\\n\\nThe accompanying notes are an integral part of these consolidated financial statements.\\n60\\nALIGN TECHNOLOGY, INC. AND SUBSIDIARIES\\nCONSOLIDATED STATEMENTS OF CASH FLOWS\\n(in thousands)\\n\\n| Year Ended December 31, |\\n| 2016 | 2015 | 2014 |\\n| CASH FLOWS FROM OPERATING ACTIVITIES: |\\n| Net income | $ | 189,682 | $ | 144,020 | $ | 145,832 |\\n| Adjustments to reconcile net income to net cash provided by operating activities: |\\n| Deferred taxes | (16,401 | ) | (11,424 | ) | 4,088 |\\n| Depreciation and amortization | 24,002 | 18,004 | 17,856 |\\n| Stock-based compensation | 54,148 | 52,943 | 39,823 |\\n| Net tax benefits from stock-based awards | 15,888 | 10,224 | 21,393 |\\n| Excess tax benefit from share-based payment arrangements | (16,773 | ) | (10,396 | ) | (21,393 | ) |\\n| Equity in losses of investee | 1,684 | — | — |\\n| Other non-cash operating activities | 12,031 | 13,799 | 10,106 |\\n| Changes in assets and liabilities: |\\n| Accounts receivable | (94,444 | ) | (40,775 | ) | (27,229 | ) |\\n| Inventories | (7,663 | ) | (3,563 | ) | (1,999 | ) |\\n| Prepaid expenses and other assets | (9,390 | ) | (3,726 | ) | (2,924 | ) |\\n| Accounts payable | (3,395 | ) | 7,575 | 2,887 |\\n| Accrued and other long-term liabilities | 37,629 | 19,462 | 22,692 |\\n| Deferred revenues | 60,656 | 41,854 | 15,767 |\\n| Net cash provided by operating activities | 247,654 | 237,997 | 226,899 |\\n| CASH FLOWS FROM INVESTING ACTIVITIES: |\\n| Purchase of property, plant and equipment | (70,576 | ) | (53,451 | ) | (24,092 | ) |\\n| Purchase of marketable securities | (405,612 | ) | (447,092 | ) | (437,152 | ) |\\n| Proceeds from maturities of marketable securities | 387,873 | 304,125 | 176,810 |\\n| Purchase of equity method investments | (46,745 | ) | — | — |\\n| Proceeds from sales of marketable securities | 216,119 | 30,011 | 82,990 |\\n| Other investing activities | (8,211 | ) | 46 | (183 | ) |\\n| Net cash provided by (used in) investing activities | 72,848 | (166,361 | ) | (201,627 | ) |\\n| CASH FLOWS FROM FINANCING ACTIVITIES: |\\n| Proceeds from issuance of common stock | 13,778 | 11,325 | 18,028 |\\n| Common stock repurchases | (96,218 | ) | (101,791 | ) | (98,233 | ) |\\n| Excess tax benefit from share-based payment arrangements | 16,773 | 10,396 | 21,393 |\\n| Employees’ taxes paid upon the vesting of restricted stock units | (29,857 | ) | (20,716 | ) | (7,608 | ) |\\n| Net cash used in financing activities | (95,524 | ) | (100,786 | ) | (66,420 | ) |\\n| Effect of foreign exchange rate changes on cash and cash equivalents | (3,417 | ) | (3,007 | ) | (1,934 | ) |\\n| Net increase (decrease) in cash and cash equivalents | 221,561 | (32,157 | ) | (43,082 | ) |\\n| Cash and cash equivalents, beginning of year | 167,714 | 199,871 | 242,953 |\\n| Cash and cash equivalents, end of year | $ | 389,275 | $ | 167,714 | $ | 199,871 |\\n\\nThe accompanying notes are an integral part of these consolidated financial statements.\\n61\\nALIGN TECHNOLOGY, INC. AND SUBSIDIARIES\\nNOTES TO CONSOLIDATED FINANCIAL STATEMENTS\\nNote 1. Summary of Significant Accounting Policies\\nBusiness Description\\nAlign Technology, Inc. (“We”, “Our”, or “Align”) was incorporated in April 1997 in Delaware and focuses on designing, manufacturing and marketing innovative, technology-rich products to help dental professionals achieve the clinical results they expect and deliver effective, convenient cutting-edge dental treatment options to their patients. We are headquartered in San Jose, California with offices worldwide. Our international headquarters is located in Amsterdam, the Netherlands. We have two operating segments: (1) Clear Aligner, known as the Invisalign System, and (2) Scanners and Services (\\\"Scanner\\\"), known as the iTero intraoral scanner and OrthoCAD services.\\nBasis of Presentation and Preparation\\nThe consolidated financial statements include the accounts of Align and our wholly-owned subsidiaries after elimination of intercompany transactions and balances.\\nIn connection with the preparation of the consolidated financial statements, we evaluated events subsequent to the balance sheet date through the financial statement issuance date and determined that all material transactions have been recorded and disclosed properly.\\nOut of Period Adjustment\\nIn 2014, we recorded an out of period correction that resulted in an increase in the provision for income taxes of $1.8 million. We do not believe the decrease to net income related to the out of period adjustment is material to the consolidated financial statements for the fiscal year ended December 31, 2014 or to any prior years' consolidated financial statements.\\nUse of Estimates\\nThe preparation of financial statements in conformity with generally accepted accounting principles (\\\"GAAP\\\") in the United States of America (“U.S.”) requires our management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates. On an ongoing basis, we evaluate our estimates, including those related to the fair values of financial instruments, long-lived assets and goodwill, equity method investments, useful lives of intangible assets and property and equipment, revenue recognition, stock-based compensation, equity losses of investee, income taxes and contingent liabilities, among others. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities.\\nFair Value of Financial Instruments\\nWe measure our cash equivalents, marketable securities, Israeli fund and long-term notes receivable at fair value. Fair value is the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is estimated by applying the following hierarchy, which prioritizes the inputs used to measure fair value into three levels and bases the categorization within the hierarchy upon the lowest level of input that is available and significant to the fair value measurement:\\nLevel 1 – Quoted (unadjusted) prices in active markets for identical assets or liabilities.\\nLevel 2 – Observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the asset or liability.\\nLevel 3 – Inputs that are generally unobservable and typically reflect management’s estimate of assumptions that market participants would use in pricing the asset or liability.\\n62\\nCash and Cash Equivalents\\nWe consider currency on hand, demand deposits, time deposits, and all highly liquid investments with an original or remaining maturity of three months or less at the date of purchase to be cash and cash equivalents. Cash and cash equivalents are held in various financial institutions in the U.S. and internationally.\\nRestricted Cash\\nOur restricted cash balance as of December 31, 2016 was $3.7 million, of which $3.3 million was classified as a long-term asset and $0.4 million as a current asset. Our restricted cash balance as of December 31, 2015 was $3.5 million, of which $3.3 million was classified as a long-term asset and $0.2 million as a current asset. The restricted cash primarily consisted of funds reserved for legal requirements.\\nMarketable Securities\\nWe invest primarily in money market funds, commercial paper, corporate bonds, U.S. government agency bonds, asset-backed securities, municipal securities, U.S. government treasury bonds and certificates of deposits.\\nMarketable securities are classified as available-for-sale and are carried at fair value. Marketable securities classified as current assets have maturities of less than one year. Unrealized gains or losses on such securities are included in accumulated other comprehensive income (loss), net in stockholders’ equity. Realized gains and losses from maturities of all such securities are reported in earnings and computed using the specific identification cost method. Realized gains or losses and charges for other-than-temporary declines in value, if any, on available-for-sale securities are reported in interest and other income (expense), net as incurred. We periodically evaluate these investments for other-than-temporary impairment.\\nVariable Interest Entities\\nWe have interests in entities determined to be variable interest entity (“VIE”). If we determine we are the primary beneficiary of a VIE, we would consolidate the VIE into our financial statements. In determining if we are the primary beneficiary, we evaluate whether we have the power to direct the activities that most significantly impact the VIE's economic performance and the obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE. Our evaluation includes identification of significant activities and an assessment of our ability to direct those activities based on governance provisions and arrangements to provide or receive product and process technology, product supply, operations services, equity funding, financing, and other applicable agreements and circumstances. Our assessments of whether we are the primary beneficiary of a VIE require significant assumptions and judgments. We have concluded that we are not the primary beneficiary of our VIE investments; therefore, we do not consolidate their results into our consolidated financials.\\nInvestments in Privately Held Companies\\nInvestments in privately held companies in which we can exercise significant influence but do not own a majority equity interest or otherwise control, are accounted for under the equity method of accounting. Equity method investments are reported on our balance sheet as a single amount, and we record our share of their operating results within equity in losses of investee, net of tax in our Consolidated Statement of Operations.\\nDerivative Financial Instruments\\nWe may enter into foreign currency forward contracts to minimize the short-term impact of foreign currency exchange rate fluctuations associated with certain assets and liabilities. These forward contracts are not designated as hedging instruments and do not subject us to material balance sheet risk due to fluctuations in foreign currency exchange rates. The gains and losses on these forward contracts are intended to offset the gains and losses in the underlying foreign currency denominated monetary assets and liabilities being economically hedged. We do not enter into foreign currency forward contracts for trading or speculative purposes. The net gain or loss from the settlement of these foreign currency forward contracts is recorded in interest and other income (expense), net in the Consolidated Statement of Operations.\\n63\\nForeign Currency\\nFor our international subsidiaries where the U.S. dollar is the functional currency, we analyze on an annual basis or more often if necessary, if a significant change in facts and circumstances indicate that the primary economic currency has changed. For certain European and Asia Pacific subsidiaries where the local currency is the functional currency, adjustments from translating financial statements from the local currency to the U.S. dollar reporting currency are recorded as a separate component of accumulated other comprehensive income (loss), net in the stockholders’ equity section of the Consolidated Balance Sheet. This foreign currency translation adjustment reflects the translation of the balance sheet at period end exchange rates, and the income statement at an average exchange rate in effect during the period. As of December 31, 2016 and 2015, there were no material amounts in accumulated other comprehensive income (loss), net related to the translation of our foreign subsidiaries’ financial statements. The foreign currency revaluation that are derived from monetary assets and liabilities stated in a currency other than functional currency are included in interest and other income (expense), net. For the year ended December 31, 2016 and 2015, we had foreign currency net losses of $8.0 million and $4.0 million, respectively.\\nCertain Risks and Uncertainties\\nOur operating results depend to a significant extent on our ability to market and develop our products. The life cycles of our products are difficult to estimate due, in part, to the effect of future product enhancements and competition. Our inability to successfully develop and market our products as a result of competition or other factors would have a material adverse effect on our business, financial condition and results of operations.\\nOur cash and investments are held primarily by two financial institutions. Financial instruments which potentially expose us to concentrations of credit risk consist primarily of cash equivalents, marketable securities and accounts receivable. We invest excess cash primarily in money market funds, commercial paper, corporate bonds, U.S. government agency bonds, asset-backed securities, municipal securities, U.S. government treasury bonds and certificates of deposits. If the carrying value of our investments exceeds the fair value, and the decline in fair value is deemed to be other-than-temporary, we will be required to write down the value of our investments, which could adversely affect our results of operations and financial condition. Moreover, the performance of certain securities in our investment portfolio correlates with the credit condition of the U.S. economy. We provide credit to customers in the normal course of business. Collateral is not required for accounts receivable, but ongoing evaluations of customers’ credit worthiness are performed. We maintain reserves for potential credit losses and such losses have been within management’s expectations. No individual customer accounted for 10% or more of our accounts receivable at December 31, 2016 or 2015, or net revenues for the year ended December 31, 2016, 2015 or 2014.\\nWe have certain credit risk under our Loan and Security Agreement (\\\"Loan Agreement\\\") with SmileDirectClub, LLC (\\\"SDC\\\"). We perform ongoing evaluation of credit worthiness of SDC. If the fair value of equity investment is deemed to be other-than temporary impaired, we will be required to write down the value of our investments, which could adversely affect our results of operations and financial condition (Refer to Note 8 \\\"Commitments and Contingencies\\\" of the Notes of Consolidated Financial Statements for more information on our Loan Agreement with SDC).\\nIn the U.S., the Food and Drug Administration (“FDA”) regulates the design, manufacture, distribution, pre-clinical and clinical study, clearance and approval of medical devices. Products developed by us may require approvals or clearances from the FDA or other international regulatory agencies prior to commercialized sales. There can be no assurance that our products will receive any of the required approvals or clearances. If we were denied approval or clearance or such approval was delayed, it may have a material adverse impact on us.\\nWe have manufacturing operations located outside the U.S. We currently rely on our treatment facility in Costa Rica to prepare digital treatment plans using a sophisticated, internally developed computer-modeling program. In addition, we manufacture our clear aligners and distribute our intraoral scanners at our facilities in Juarez, Mexico, and we produce our handheld scanner wand in Or Yehuda, Israel. Our reliance on international operations exposes us to related risks and uncertainties, including difficulties in staffing and managing international operations such as hiring and retaining qualified personnel; controlling production volume and quality of manufacture; political, social and economic instability, particularly as a result of increased levels of violence in Juarez, Mexico and Or Yehuda, Israel; interruptions and limitations in telecommunication services; product and material transportation delays or disruption; trade restrictions and changes in tariffs; import and export license requirements and restrictions; fluctuations in foreign currency exchange rates; and potential adverse tax consequences. If any of these risks materialize, our international manufacturing operations, as well as our operating results, may be harmed.\\n64\\nWe purchase certain inventory from sole suppliers. Additionally, we rely on a limited number of hardware manufacturers. The inability of any supplier or manufacturer to fulfill our supply requirements could materially and adversely impact our future operating results.\\nInventories\\nInventories are valued at the lower of cost or market, with cost computed using either standard cost, which approximates actual cost, or average cost on a first-in-first-out basis. Excess and obsolete inventories are determined primarily based on future demand forecasts, and write-downs of excess and obsolete inventories are recorded as a component of cost of revenues.\\nProperty, Plant and Equipment\\nProperty, plant and equipment are stated at historical cost less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets. Construction in progress (\\\"CIP\\\") is related to the construction or development of property (including land) and equipment that have not yet been placed in service for their intended use. Upon sale or retirement, the asset’s cost and related accumulated depreciation are removed from the general ledger and any related gains or losses are reflected in expenses. Maintenance and repairs are expensed as incurred. Refer to Note 3 \\\"Balance Sheet Components\\\" of the Notes of Consolidated Financial Statements for details on estimated useful lives.\\nGoodwill and Finite-Lived Acquired Intangible Assets\\nGoodwill represents the excess of the purchase price paid over the fair value of tangible and identifiable intangible net assets acquired in business combinations and is allocated to the respective reporting units based on relative synergies generated. For the year ended December 31, 2016 and 2015, all goodwill is attributed to our Clear Aligner reporting unit.\\nOur intangible assets primarily consist of intangible assets acquired as part of the Cadent acquisition. These assets are amortized using the straight-line method over their estimated useful lives ranging from one to fifteen years, reflecting the period in which the economic benefits of the assets are expected to be realized.\\nImpairment of Goodwill and Long-Lived Assets\\nGoodwill\\nWe evaluate goodwill for impairment at least annually on November 30th or more frequently if indicators are present, an event occurs or circumstances changes that suggest an impairment may exist and that it would more likely than not reduce the fair value of a reporting unit below its carrying amount. The allocation of goodwill to the respective reporting units is based on relative synergies generated as a result of an acquisition.\\nWe perform an initial assessment of qualitative factors to determine whether the existence of events and circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. In performing the qualitative assessment, we identify and consider the significance of relevant key factors, events, and circumstances that affect the fair value of our reporting units. These factors include external factors such as macroeconomic, industry, and market conditions, as well as entity-specific factors, such as our actual and planned financial performance. We also give consideration to the difference between the reporting unit fair value and carrying value as of the most recent date a fair value measurement was performed. If, after assessing the totality of relevant events and circumstances, we determine that it is more likely than not that the fair value of the reporting unit exceeds its carrying value and there is no indication of impairment, no further testing is performed; however, if we conclude otherwise, the first step of the two-step impairment test is performed by estimating the fair value of the reporting unit and comparing it with its carrying value, including goodwill.\\nStep one of the goodwill impairment test consists of a comparison of the fair value of a reporting unit against its carrying amount, including the goodwill allocated to each reporting unit. We determine the fair value of our reporting units based on the present value of estimated future cash flows under the income approach of the reporting units as well as various price or market multiples applied to the reporting unit's operating results along with the appropriate control premium under the marketing approach, both of which are classified as level 3 within the fair value hierarchy as described in Note 2. If the carrying amount of the reporting\\n65\\nunit is in excess of its fair value, step two requires the comparison of the implied fair value of the reporting unit’s goodwill against the carrying amount of the reporting unit’s goodwill. Any excess of the carrying value of the reporting unit’s goodwill over the implied fair value of the reporting unit’s goodwill is recorded as an impairment loss.\\nFinite-Lived Intangible Assets and Long-Lived Assets\\nWe evaluate long-lived assets (including finite-lived intangible assets) for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. An asset or asset group is considered impaired if its carrying amount exceeds the future undiscounted net cash flows the asset or asset group is expected to generate. Factors we consider important which could trigger an impairment review include significant negative industry or economic trends, significant loss of customers and changes in the competitive environment. If an asset or asset group is considered to be impaired, the impairment to be recognized is calculated as the amount by which the carrying amount of the asset or asset group exceeds its fair market value. Our estimates of future cash flows attributable to our long-lived assets require significant judgment based on our historical and anticipated results and are subject to many assumptions. The estimation of fair value utilizing a discounted cashflow approach includes numerous uncertainties which require our significant judgment when making assumptions of expected growth rates and the selection of discount rates, as well as assumptions regarding general economic and business conditions, and the structure that would yield the highest economic value, among other factors. Refer to Note 5 \\\"Goodwill and Intangible Assets\\\" of the Notes of Consolidated Financial Statements for details on intangible long-lived assets.\\nThere were no triggering events in 2016 that would cause impairments of our goodwill or long-lived assets.\\nDevelopment Costs for Internal Use Software\\nInternally developed software includes enterprise-level business software that we customized to meet our specific operational needs. Such capitalized costs include external direct costs utilized in developing or obtaining the applications and payroll and payroll-related costs for employees, who are directly associated with the development of the applications. Internally developed software costs capitalized during the year ended December 31, 2016 and 2015 were $13.2 million and $25.4 million, respectively, related to our enterprise resource planning (\\\"ERP\\\") project which we placed into production during 2016 and amortize over 10 years.\\nThe costs to develop software that is marketed externally have not been capitalized as we believe our current software development process is essentially completed concurrent with the establishment of technological feasibility. As such, all related software development costs are expensed as incurred and included in research and development expense in our Consolidated Statements of Operations.\\nProduct Warranty\\nClear Aligner\\nWe warrant our Invisalign products against material defects until the aligner case is complete. We warrant SmileDirectClub, LLC (“SDC”) products against material defects for one year. We accrue for warranty costs in cost of net revenues upon shipment of products. The amount of accrued estimated warranty costs is primarily based on historical experience as to product failures as well as current information on replacement costs. Actual warranty costs could differ materially from the estimated amounts. We regularly review the accrued balances and update these balances based on historical warranty cost trends.\\nScanners and Services\\nWe warrant our intraoral scanners for a period of one year, which include materials and labor. We accrue for these warranty costs based on average historical repair costs. An extended warranty may be purchased for additional fees.\\nAllowance for Doubtful Accounts and Returns\\nWe maintain allowances for doubtful accounts for customers that are not able to make payments and allowances for sales returns. We periodically review these allowances, including an analysis of the customers’ payment history and information regarding the customers’ creditworthiness, as well as historical sales returns as a percentage of revenue. Actual write-offs have not materially differed from the estimated allowances.\\n66\\nRevenue Recognition\\nWe measure and allocate revenue according to the accounting guidance for multiple-deliverable revenue arrangements in Accounting Standards Update (“ASU”) 2009-13, Multiple-Deliverable Revenue Arrangements-a consensus of the Financial Accounting Standard Board (“FASB”) Emerging Issues Task Force.\\nMultiple-Element Arrangements (“MEAs”): Arrangements with customers may include multiple deliverables, including any combination of products/equipment and services. The deliverables included in the MEAs are separated into more than one unit of accounting when (i) the delivered product/equipment has value to the customer on a stand-alone basis, and (ii) delivery of the undelivered service element(s) is probable and substantially in our control. Arrangement consideration is then allocated to each unit, delivered or undelivered, based on the relative selling price of each unit of accounting based first on vendor-specific objective evidence (“VSOE”) if it exists, second on third-party evidence (“TPE”) if it exists, or on best estimated selling price (“BESP”) if neither VSOE or TPE exist.\\n| • | VSOE - In most instances, this applies to products and services that are sold separately in stand-alone arrangements. We determine VSOE based on pricing and discounting practices for the specific product or service when sold separately, considering geographical, customer, and other economic or marketing variables, as well as renewal rates or stand-alone prices for the service element(s). |\\n\\n| • | TPE - If we cannot establish VSOE of selling price for a specific product or service included in a multiple-element arrangement, we use third-party evidence of selling price. We determine TPE based on sales of comparable amount of similar products or service offered by multiple third parties considering the degree of customization and similarity of product or service sold. |\\n\\n| • | BESP - The best estimated selling price represents the price at which we would sell a product or service if it were sold on a stand-alone basis. When VSOE or TPE does not exist for all elements, we determine BESP for the arrangement element based on sales, cost and margin analysis, as well as other inputs based on our pricing practices. Adjustments for other market and company specific factors are made as deemed necessary in determining BESP. We regularly review our estimates of selling price and maintain internal controls over the establishment and update of these estimates. |\\n\\nRevenue is recognized when persuasive evidence of the arrangement exists, the price is fixed or determinable, collectability is reasonably assured, title and risk of loss have passed to customers based on the shipping terms, and allowances for discounts, returns, and customer incentives can be reliably estimated. Provisions for discounts and rebates to customers are provided for in the same period that the related product sales are recorded.\\nClear Aligner\\nWe enter into arrangements (“treatment plans”) that involve multiple future product deliverables. Invisalign Full, Invisalign Teen, and Invisalign Assist products (\\\"Comprehensive Products\\\") include optional additional aligners at no charge for a period of up to five years after initial shipment. Invisalign Teen also includes up to six optional replacement aligners in the price of the product and may be ordered by the dental professional any time throughout treatment. Invisalign Lite (\\\"Non-Comprehensive Products\\\") includes one optional case refinement in the price of the product. Case refinement is a finishing tool used to adjust a patient's teeth to the desired final position and may be elected by the dental professional at any time during treatment; however, it is generally ordered in the last stages of orthodontic treatment.\\nWe determined that our treatment plans, except Invisalign Assist with progress tracking, comprise the following deliverables which also represent separate units of accounting: initial aligners, additional aligners, case refinement, and replacement aligners. We allocate revenue for each treatment plan based on each unit's relative selling price based on BESP and recognize the revenue upon shipment of each unit in the treatment plan.\\nFor Invisalign Assist with the progress tracking feature, aligners and services are provided to the dental professional every nine stages (“a batch”). We are able to reliably estimate the number of batches which are expected to be shipped for each case based upon our historical experience. The amounts allocated to this deliverable are recognized on a prorated basis as each batch is shipped.\\n67\\nScanners and Services\\nWe recognize revenues from the sales of iTero intraoral scanners and CAD/CAM services. CAD/CAM services include scanning services, extended warranty for the intraoral scanners, a range of iTero restorative services, and OrthoCAD services such as OrthoCAD iRecord. We sell intraoral scanners and services through both our direct sales force and distribution partners. The intraoral scanner sales price includes one year of warranty, and for additional fees, the customer may select an unlimited scanning service agreement over a fixed period of time or extended warranty periods. When intraoral scanners are sold with either an unlimited scanning service agreement and/or extended warranty, we allocate revenue based on each element's relative selling price. We estimate the selling price of each element, as if it is sold on a stand-alone basis, taking into consideration historical prices as well as our discounting strategies.\\nScanner revenue, net of related discounts and allowances, is recognized when products or equipment have been shipped and no significant obligations for installation or training remain. For certain distributors who provide installation and training to the customer, we recognize scanner revenue when the intraoral scanner is shipped to the distributor assuming all of the other revenue recognition criteria have been met. Discounts are deducted from revenue at the time of sale. Returns of products, excluding warranty related returns, are infrequent and insignificant.\\nService revenue, including iTero restorative and all OrthoCAD services are recognized upon delivery or ratably over the contract term as the specified services are performed. If a customer selects a pay per use basis for scanning service fees, the revenue is recognized as the service is provided.\\nWe offer customers an option to purchase extended warranties on certain products. We recognize revenue on these extended warranty contracts ratably over the life of the contract. The costs associated with these extended warranty contracts are recognized when incurred.\\nShipping and Handling Costs\\nShipping and handling charges to customers are included in net revenues, and the associated costs incurred are recorded in cost of revenues.\\nLegal Proceedings and Litigations\\nWe are involved in legal proceedings on an ongoing basis. If we believe that a loss arising from such matters is probable and can be reasonably estimated, we accrue the estimated liability in our financial statements. If only a range of estimated losses can be determined, we accrue an amount within the range that, in our judgment, reflect the most likely outcome; if none of the estimates within that range is a better estimate than any other amount, we accrue the low end of the range.\\nResearch and Development\\nResearch and development expense is expensed as incurred and includes the costs associated with the research and development of new products and enhancements to existing products. These costs primarily include personnel-related costs including stock-based compensation and outside consulting expenses associated with the research and development of new products and enhancements to existing products and allocations of corporate overhead expenses including facilities and IT.\\nAdvertising Costs\\nThe cost of advertising and media is expensed as incurred. For the year ended December 31, 2016, 2015 and 2014, advertising costs totaled $36.0 million, $23.4 million and $26.9 million, respectively.\\nCommon Stock Repurchase\\nWe repurchase our own common stock from time to time in the open market when our Board of Directors approve a stock repurchase program. We account for these repurchases under the accounting guidance for equity where we allocate the total\\n68\\nrepurchase value that are in excess over par between additional paid in capital and retained earnings. All shares repurchased are retired.\\nOperating Leases\\nWe currently lease office spaces, automobiles and equipment under operating leases with original lease periods of up to 9 years. Certain of these leases have free or escalating rent payment provisions and lease incentives provided by the landlord. We recognize rent expense under such leases on a straight-line basis over the term of the lease as certain leases have adjustments for market provisions.\\nIncome Taxes\\nWe make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of certain tax assets and liabilities, which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes.\\nAs part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves us estimating our current tax exposure under the applicable tax laws and assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our Consolidated Balance Sheet.\\nWe account for uncertainty in income taxes pursuant to authoritative guidance based on a two-step approach to recognize and measure uncertain tax positions taken or expected to be taken in a tax return. The first step is to determine if the weight of available evidence indicates that it is more likely than not that the tax position will be sustained on audit based on its technical merits, including resolution of any related appeals or litigation processes. The second step is to measure the tax benefit as the largest amount that is more than 50% likely to be realized upon ultimate settlement. We adjust reserves for our uncertain tax positions due to changing facts and circumstances, such as the closing of a tax audit, or refinement of estimates due to new information. To the extent that the final outcome of these matters is different than the amounts recorded, such differences will impact our tax provision in our Consolidated Statement of Operation in the period in which such determination is made.\\nWe assess the likelihood that we will be able to realize our deferred tax assets. Should there be a change in our ability to realize our deferred tax assets, our tax provision would increase in the period in which we determine that it is more likely than not that we cannot realize our deferred tax assets. We consider all available evidence, both positive and negative, including historical levels of income, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance. If it is more likely than not that we will not realize our deferred tax assets, we will increase our provision for taxes by recording a valuation allowance against the deferred tax assets that we estimate will not ultimately be realizable. The available positive evidence at December 31, 2016 included historical operating profits and a projection of future income sufficient to realize most of our remaining deferred tax assets. As of December 31, 2016, it was considered more likely than not that our deferred tax assets would be realized with the exception of certain foreign loss carryovers as we are unable to forecast sufficient future profits to realize the deferred tax assets.\\nAs of December 31, 2016, U.S. income taxes and foreign withholding taxes associated with the repatriation of undistributed earnings of foreign subsidiaries on a cumulative total of $438.0 million was not provided as we intend to reinvest these earnings indefinitely in our foreign subsidiaries. If these earnings were distributed in the form of dividends or otherwise, or if the shares of the relevant foreign subsidiaries were sold or otherwise transferred, we would be subject to additional U.S. income taxes subject to an adjustment for foreign tax credit, and foreign withholding taxes. Determination of the amount of unrecognized deferred income tax liability related to these earnings is not practicable.\\nAccounting guidance for stock-based compensation prohibits recognition of a deferred income tax asset for excess tax benefits due to stock option exercises that have not yet been realized through a reduction in income taxes payable. We follow the tax law ordering method to determine when excess tax benefits have been realized and consider only the direct impacts of awards when calculating the amount of windfalls or shortfalls.\\n69\\nStock-Based Compensation\\nWe recognize stock-based compensation cost for only those shares ultimately expected to vest on a straight-line basis over the requisite service period of the award. We use the Black-Scholes option pricing model to determine the fair value of employee stock purchase plan shares. We estimate the fair value of market-performance based restricted stock units using a Monte Carlo simulation model which requires the input of assumptions, including expected term, stock price volatility and the risk-free rate of return. In addition, judgment is also required in estimating the number of stock-based awards that are expected to be forfeited. Forfeitures are estimated based on historical experience at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management’s judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future.\\nComprehensive Income\\nComprehensive income includes all changes in equity during a period from non-owner sources. Comprehensive income, including unrealized gains and losses on investments and foreign currency translation adjustments, are reported net of their related tax effect.\\nRecent Accounting Pronouncements\\nIn May 2014, the Financial Accounting Standards Board (\\\"FASB\\\") released Accounting Standards Update (\\\"ASU\\\") 2014-9, \\\"Revenue from Contracts with Customers,\\\" (Topic 606) to supersede nearly all existing revenue recognition guidance under GAAP. The core principle of the standard is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration that is expected to be received for the goods or services. The new standard defines a five step process to achieve this core principle and, in doing so, it is possible more judgment and estimates may be required within the revenue recognition process than required under existing GAAP including identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. In addition, the new standard requires that reporting companies disclose the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. We are required to adopt this standard starting in the first quarter of fiscal year 2018 using either of two methods: (i) retrospective to each prior reporting period presented with the option to elect certain practical expedients as defined within the standard; or (ii) retrospective with the cumulative effect of initially applying the standard recognized at the date of initial application and providing certain additional disclosures as defined per the standard. We plan to adopt the standard in the first quarter of fiscal year 2018 by applying the full retrospective method. Our ability to adopt using the full retrospective method is dependent on the completion of our analysis of information necessary to restate prior period financial statements. We are continuing to assess the impact of the adoption of this update on our consolidated financial statements and related disclosures.\\nIn April 2016, the FASB released ASU No. 2016-10, \\\"Revenue from Contracts with Customers,\\\" to clarify the following two aspects of Topic 606: identifying performance obligations and the licensing implementation guidance, while retaining the principles for those areas of the ASU 2014-9 issued in May 2014. The effective date and the transition requirement of the amendments in this update are the same as the effective date and transition requirements of Topic 606.\\nIn May 2016, the FASB released ASU No. 2016-12, \\\"Revenue from Contracts with Customers,\\\" to address certain issues in the Topic 606 guidance on assessing the collectability, presentation of sales taxes, non-cash consideration, and completed contracts and contract modifications at transition. The ASU provides narrow-scope improvements and practical expedients to the ASU 2014-9 issued in May 2014. The effective date and the transition requirement of the amendments in this update are the same as the effective date and transition requirements of Topic 606.\\nIn December 2016, the FASB released ASU No. 2016-20, \\\"Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers,\\\" to clarify certain aspects of guidance in the Topic 606 including its scope, disclosure requirements and contract cost accounting, while retaining the principles for those areas of the ASU 2014-9 issued in May 2014. The effective date and the transition requirement of the amendments in this update are the same as the effective date and transition requirements of Topic 606.\\n70\\nIn February 2016, the FASB issued ASU No. 2016-02, “Leases” (Topic 842). The FASB issued this update to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The updated guidance is effective for annual periods beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption of the standard is permitted. We plan to adopt the standard in the first quarter of fiscal year 2019 by electing practical expedients available in the standard. While we are currently evaluating the impact of the adoption of this guidance on our consolidated financial statements, we expect the adoption will have a material increase in the assets and liabilities of our consolidated balance sheet.\\nIn March 2016, the FASB issued ASU No. 2016-09, \\\"Improvements to Employee Share-Based Payment Accounting\\\" (Topic 718). This ASU affects entities that issue share-based payment awards to their employees. The ASU is designed to simplify several aspects of accounting for share-based payment award transactions, which include the income tax consequences, classification of awards as either equity or liabilities, classification on the statements of cash flows and forfeiture rate calculations. This ASU is effective for fiscal years beginning after December 15, 2016 and interim periods within those years. We plan to adopt the standard in the first quarter of fiscal year 2017, and the adoption will have a material impact on our consolidated financial statements.\\nIn June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments - Credit Losses” (Topic 326). The FASB issued this update to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. The amendments in this update replace the existing guidance of incurred loss impairment methodology with an approach that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. The updated guidance is effective for annual periods beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption of the update is permitted as of the fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. We are evaluating the impact of the adoption of this update on our consolidated financial statements and related disclosures.\\nIn August 2016, the FASB issued ASU 2016-15, \\\"Classification of Certain Cash Receipts and Cash Payments\\\" (Topic 230). This FASB clarifies the presentation and classification of certain cash receipts and cash payments in the statements of cash flows. This ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2017. Early adoption is permitted. We are currently evaluating the impact of this guidance on our consolidated financial statements.\\nIn October, 2016, the FASB issued ASU 2016-16, \\\"Intra-Entity Transfers of Assets Other Than Inventory,\\\" (Topic 740) which requires entities to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs. Prior to the issuance of this ASU, existing guidance prohibited the recognition of current and deferred income taxes for an intra-entity asset transfer until the asset had been sold to an outside party. This ASU is effective for fiscal years beginning after December 15, 2017 and interim periods within those years. Early adoption is permitted. We plan to early adopt the standard in the first quarter of 2017 by applying the modified retrospective approach with a cumulative catch-up adjustment to opening retained earnings at the beginning of the first quarter of 2017. The adoption will impact our consolidated balance sheet but we do not expect the impact to be material.\\nIn November 2016, the FASB issued ASU 2016-18, \\\"Statement of Cash Flows - Restricted Cash,\\\" which provides guidance to address the classification and presentation of changes in restricted cash in the statements of cash flows. This standard is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period, but any adjustments must be reflected as of the beginning of the fiscal year that includes that interim period. The new standard must be adopted retrospectively. We are currently in the process of evaluating the impact of this new pronouncement on our consolidated statement of cash flows.\\n71\\nNote 2. Marketable Securities and Fair Value Measurements\\nAs of December 31, 2016 and 2015, the estimated fair value of our short-term and long-term marketable securities, classified as available for sale, are as follows (in thousands):\\nShort-term\\n| December 31, 2016 | AmortizedCost | GrossUnrealizedGains | GrossUnrealizedLosses | Fair Value |\\n| Commercial paper | $ | 42,397 | $ | — | $ | (6 | ) | $ | 42,391 |\\n| Corporate bonds | 122,788 | 22 | (121 | ) | 122,689 |\\n| Municipal securities | 5,852 | — | (5 | ) | 5,847 |\\n| U.S. government agency bonds | 28,903 | 9 | (4 | ) | 28,908 |\\n| U.S. government treasury bonds | 45,146 | 7 | (7 | ) | 45,146 |\\n| Certificates of deposit | 6,000 | — | — | 6,000 |\\n| Total Marketable Securities, Short-Term | $ | 251,086 | $ | 38 | $ | (143 | ) | $ | 250,981 |\\n\\nLong-term\\n| December 31, 2016 | AmortizedCost | GrossUnrealizedGains | GrossUnrealizedLosses | Fair Value |\\n| U.S. government agency bonds | $ | 6,805 | $ | — | $ | (16 | ) | $ | 6,789 |\\n| Corporate bonds | 40,889 | 8 | (85 | ) | 40,812 |\\n| U.S. government treasury bonds | 12,016 | 5 | (16 | ) | 12,005 |\\n| Asset-backed securities | 177 | — | — | 177 |\\n| Total Marketable Securities, Long-Term | $ | 59,887 | $ | 13 | $ | (117 | ) | $ | 59,783 |\\n\\nShort-term\\n| December 31, 2015 | AmortizedCost | GrossUnrealizedGains | GrossUnrealizedLosses | Fair Value |\\n| Commercial paper | $ | 38,537 | $ | — | $ | — | $ | 38,537 |\\n| Corporate bonds | 179,765 | 6 | (251 | ) | 179,520 |\\n| U.S. dollar dominated foreign corporate bonds | 510 | — | (2 | ) | 508 |\\n| Municipal securities | 14,209 | 7 | (2 | ) | 14,214 |\\n| U.S. government agency bonds | 75,172 | — | (53 | ) | 75,119 |\\n| U.S. government treasury bonds | 51,763 | 1 | (81 | ) | 51,683 |\\n| Total Marketable Securities, Short-Term | $ | 359,956 | $ | 14 | $ | (389 | ) | $ | 359,581 |\\n\\nLong-term\\n| December 31, 2015 | AmortizedCost | GrossUnrealizedGains | GrossUnrealizedLosses | Fair Value |\\n| U.S. government agency bonds | $ | 43,853 | $ | — | $ | (178 | ) | $ | 43,675 |\\n| Corporate bonds | 64,012 | 9 | (218 | ) | 63,803 |\\n| U.S. government treasury bonds | 37,673 | — | (107 | ) | 37,566 |\\n| Municipal securities | 3,993 | — | (2 | ) | 3,991 |\\n| Asset-backed securities | 2,338 | — | (3 | ) | 2,335 |\\n| Total Marketable Securities, Long-Term | $ | 151,869 | $ | 9 | $ | (508 | ) | $ | 151,370 |\\n\\n72\\nCash and cash equivalents are not included in the table above as the gross unrealized gains and losses are not material. We have no short-term or long-term investments that have been in a continuous material unrealized loss position for greater than twelve months as of December 31, 2016 and 2015. Amounts reclassified to earnings from accumulated other comprehensive income (loss), net related to unrealized gains or losses were not material in 2016 and 2015. For the year ended December 31, 2016 and 2015, realized gains or losses were not material.\\nOur fixed-income securities investment portfolio consists of corporate bonds, U.S. dollar denominated foreign corporate bonds, commercial paper, municipal securities, U.S. government agency bonds, U.S. government treasury bonds, certificates of deposit and asset-backed securities that have a maximum effective maturity of 27 months. The securities that we invest in are generally deemed to be low risk based on their credit ratings from the major rating agencies. The longer the duration of these securities, the more susceptible they are to changes in market interest rates and bond yields. As interest rates increase, those securities purchased at a lower yield show a mark-to-market unrealized loss. The unrealized losses are due primarily to changes in credit spreads and interest rates. We expect to realize the full value of all these investments upon maturity or sale. The weighted average remaining duration of these securities was approximately 7 months and 9 months as of December 31, 2016 and 2015, respectively.\\nAs the carrying value approximates the fair value for our short-term and long-term marketable securities shown in the tables above, the following table summarizes the fair value of our short-term and long-term marketable securities classified by maturity as of December 31, 2016 and 2015 (in thousands):\\n| December 31, |\\n| 2016 | 2015 |\\n| One year or less | $ | 250,981 | $ | 359,581 |\\n| Due in greater than one year | 59,783 | 151,370 |\\n| Total available for short-term and long-term marketable securities | $ | 310,764 | $ | 510,951 |\\n\\nFair Value Measurements\\nWe measure the fair value of our cash equivalents and marketable securities as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. We use the GAAP fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. This hierarchy requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The three levels of inputs that may be used to measure fair value:\\nLevel 1 — Quoted (unadjusted) prices in active markets for identical assets or liabilities.\\nOur Level 1 assets consist of money market funds and U.S. government treasury bonds. We did not hold any Level 1 liabilities as of December 31, 2016 and 2015.\\nLevel 2 — Observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the asset or liability.\\nOur Level 2 assets consist of commercial paper, corporate bonds, municipal securities, certificates of deposit, U.S. government agency bonds, asset-backed securities and our Israeli funds that are mainly invested in insurance policies. We obtain fair values for our Level 2 investments. Our custody bank and asset managers independently use professional pricing services to gather pricing data which may include quoted market prices for identical or comparable financial instruments, or inputs other than quoted prices that are observable either directly or indirectly, and we are ultimately responsible for these underlying estimates. We did not hold any Level 2 liabilities as of December 31, 2016 and 2015.\\nLevel 3 — Unobservable inputs to the valuation methodology that are supported by little or no market activity and that are significant to the measurement of the fair value of the assets or liabilities. Level 3 assets and liabilities include those whose fair value measurements are determined using pricing models, discounted cash flow methodologies or similar valuation techniques, as well as significant management judgment or estimation. Our Level 3 assets consist of long-term notes receivable and are included in other assets on our consolidated balance sheet. In 2016, we entered into a long-term notes receivable for $2.0 million and we\\n73\\nrecognized $0.05 million in earnings during 2016 as a result of a change in its fair value. As of December 31, 2016, the fair value of long-term notes receivable was approximately $2.05 million. We did not hold any Level 3 liabilities as of December 31, 2016 and 2015.\\nThe following tables summarize our financial assets measured at fair value on a recurring basis as of December 31, 2016 and 2015 (in thousands):\\n| Description | Balance as ofDecember 31, 2016 | Quoted Prices inActive Markets forIdentical Assets(Level 1) | Significant OtherObservable Inputs(Level 2) | Significant OtherObservable Inputs(Level 3) |\\n| Cash equivalents: |\\n| Money market funds | $ | 87,179 | $ | 87,179 | $ | — | $ | — |\\n| Commercial paper | 2,499 | — | 2,499 | — |\\n| Corporate bonds | 750 | — | 750 | — |\\n| Short-term investments: |\\n| Commercial paper | 42,391 | — | 42,391 | — |\\n| Corporate bonds | 122,689 | — | 122,689 | — |\\n| Municipal securities | 5,847 | — | 5,847 | — |\\n| U.S. government agency bonds | 28,908 | — | 28,908 | — |\\n| U.S. government treasury bonds | 45,146 | 45,146 | — | — |\\n| Certificates of deposit | 6,000 | — | 6,000 | — |\\n| Long-term investments: |\\n| U.S. government agency bonds | 6,789 | — | 6,789 | — |\\n| Corporate bonds | 40,812 | — | 40,812 | — |\\n| U.S. government treasury bonds | 12,005 | 12,005 | — | — |\\n| Asset-backed securities | 177 | — | 177 | — |\\n| Prepaid expenses and other current assets: |\\n| Israeli funds | 2,956 | — | 2,956 | — |\\n| Other assets: |\\n| Long-term notes receivable | 2,047 | — | — | 2,047 |\\n| $ | 406,195 | $ | 144,330 | $ | 259,818 | $ | 2,047 |\\n\\n74\\n| Description | Balance as ofDecember 31, 2015 | Quoted Prices inActive Markets forIdentical Assets(Level 1) | Significant OtherObservable Inputs(Level 2) |\\n| Cash equivalents: |\\n| Money market funds | $ | 70,148 | $ | 70,148 | $ | — |\\n| Commercial paper | 36,887 | — | 36,887 |\\n| U.S. government agency bonds | 3,599 | — | 3,599 |\\n| Corporate bonds | 625 | — | 625 |\\n| Short-term investments: |\\n| Commercial paper | 38,537 | — | 38,537 |\\n| Corporate bonds | 179,520 | — | 179,520 |\\n| U.S. dollar denominated foreign corporate bonds | 508 | — | 508 |\\n| Municipal securities | 14,214 | — | 14,214 |\\n| U.S. government agency bonds | 75,119 | — | 75,119 |\\n| U.S. government treasury bonds | 51,683 | 51,683 | — |\\n| Long-term investments: |\\n| U.S. government agency bonds | 43,675 | — | 43,675 |\\n| Corporate bonds | 63,803 | — | 63,803 |\\n| U.S. government treasury bonds | 37,566 | 37,566 | — |\\n| Municipal securities | 3,991 | — | 3,991 |\\n| Asset-backed securities | 2,335 | — | 2,335 |\\n| Prepaid expenses and other assets: |\\n| Israeli funds | 2,436 | — | 2,436 |\\n| $ | 624,646 | $ | 159,397 | $ | 465,249 |\\n\\nDerivative Financial Instruments\\nWe have in the past and may in the future enter into foreign currency forward contracts to minimize the short-term impact of foreign currency exchange rate fluctuations associated with certain assets and liabilities. The net loss on these forward contracts was not material for the year ended December 31, 2016 and 2015. The net gain or loss from the settlement of these foreign currency forward contracts is recorded in interest and other income (expenses), net in the Consolidated Statements of Operations. We had no material foreign exchange forward contracts outstanding as of December 31, 2016 and 2015. Certain investments in private companies contain embedded derivatives, which do not require bifurcation as we have elected to measure these investments at fair value.\\nNote 3. Balance Sheet Components\\nInventories\\nInventories consist of the following (in thousands):\\n| December 31, |\\n| 2016 | 2015 |\\n| Raw materials | $ | 9,793 | $ | 9,950 |\\n| Work in process | 10,773 | 7,067 |\\n| Finished goods | 6,565 | 2,448 |\\n| Total Inventories | $ | 27,131 | $ | 19,465 |\\n\\n75\\nProperty, Plant and Equipment\\nProperty, plant and equipment consist of the following (in thousands):\\n| December 31, |\\n| Generally Used Estimated Useful Life | 2016 | 2015 |\\n| Clinical and manufacturing equipment | Up to 10 years | $ | 153,938 | $ | 128,044 |\\n| Computer hardware | 3 years | 27,978 | 25,843 |\\n| Computer software | 3 years | 59,997 | 21,451 |\\n| Furniture and fixtures | 5 years | 10,306 | 8,855 |\\n| Leasehold improvements | Lease term (1) | 22,370 | 20,172 |\\n| Building | 20 years | 7,272 | 4,227 |\\n| Land | — | 3,072 | 3,072 |\\n| CIP | — | 25,948 | 42,846 |\\n| Total | 310,881 | 254,510 |\\n| Less: Accumulated depreciation and amortization and impairment charges | (135,714 | ) | (118,037 | ) |\\n| Total Property, plant and equipment, net | $ | 175,167 | $ | 136,473 |\\n\\n(1) Shorter of remaining lease term or estimated useful lives of assets.\\nDepreciation and amortization was $24.0 million, $18.0 million and $17.9 million, for the year ended December 31, 2016, 2015 and 2014, respectively.\\nAccrued Liabilities\\nAccrued liabilities consist of the following (in thousands):\\n| December 31, |\\n| 2016 | 2015 |\\n| Accrued payroll and benefits | $ | 79,214 | $ | 55,430 |\\n| Accrued sales and marketing expenses | 11,970 | 7,071 |\\n| Accrued sales rebate | 10,342 | 8,486 |\\n| Accrued sales tax and value added tax | 5,032 | 4,801 |\\n| Accrued income taxes | 4,210 | 2,646 |\\n| Accrued warranty | 3,841 | 2,638 |\\n| Accrued professional fees | 3,604 | 2,775 |\\n| Other accrued liabilities | 16,119 | 23,918 |\\n| Total Accrued Liabilities | $ | 134,332 | $ | 107,765 |\\n\\nWarranty\\nWe regularly review the accrued balances and update these balances based on historical warranty trends. Actual warranty costs incurred have not materially differed from those accrued; however, future actual warranty costs could differ from the estimated amounts.\\nClear Aligner\\nWe warrant our Invisalign products against material defects until the aligner case is complete. We warrant SDC products against material defects for one year. We accrue for warranty costs in cost of net revenues upon shipment of products. The amount of accrued estimated warranty costs is primarily based on historical experience as to product failures as well as current information on replacement costs.\\n76\\nScanners\\nWe warrant our scanners for a period of one year from the date of training and installation. We accrue for these warranty costs which includes materials and labor based on estimated historical repair costs. Extended service packages may be purchased for additional fees.\\nWarranty accrual as of December 31, 2016 and 2015 consists of the following activity (in thousands):\\n| Warranty accrual, December 31, 2014 | $ | 3,148 |\\n| Charged to cost of revenues | 1,796 |\\n| Actual warranty expenditures | (2,306 | ) |\\n| Warranty accrual, December 31, 2015 | 2,638 |\\n| Charged to cost of revenues | 4,894 |\\n| Actual warranty expenditures | (3,691 | ) |\\n| Warranty accrual, December 31, 2016 | $ | 3,841 |\\n\\nNote 4. Equity Method Investments\\nOn July 25, 2016, we acquired a 17% equity interest, on a fully diluted basis, in SmileDirectClub, LLC (“SDC”) for $46.7 million, and account for this as an equity method investment. The investment is reported on our consolidated balance sheet as a single amount under equity method investments, and we record our proportional share of SDC's earnings or losses within equity in losses of investee in our consolidated statement of operations. As of December 31, 2016, the balance of our equity method investments was $45.1 million.\\nConcurrently with the investment on July 25, 2016, we also entered into a supply agreement with SDC to manufacture clear aligners for SDC's doctor-led, at-home program for simple teeth straightening. The term of the supply agreement expires on December 31, 2019. We commenced supplying aligners to SDC in October 2016. The sale of aligners to SDC and the income from under the supply agreement are reported in our Clear Aligner business segment after eliminating outstanding intercompany transactions.\\nNote 5. Goodwill and Intangible Assets\\nGoodwill\\n| Total |\\n| Balance as of December 31, 2014 | $ | 61,369 |\\n| Adjustments (1) | (295 | ) |\\n| Balance as of December 31, 2015 | 61,074 |\\n| Adjustments (1) | (30 | ) |\\n| Balance as of December 31, 2016 | $ | 61,044 |\\n\\n(1) The adjustments to goodwill were a result of foreign currency translation.\\nImpairment of Goodwill\\nWe evaluate goodwill for impairment at least annually on November 30th or more frequently if indicators are present, an event occurs or circumstances changes that suggest an impairment may exist and that it would more likely than not reduce the fair value of a reporting unit below its carrying amount. The allocation of goodwill to the respective reporting units is based on relative synergies generated as a result of an acquisition.\\n77\\nAnnual Impairment Test\\nThe remaining goodwill is entirely attributable to our Clear Aligner reporting unit. During the fourth quarter of fiscal 2016, we performed the annual goodwill impairment testing and found no impairment as the fair value of our Clear Aligner reporting unit was significantly in excess of the carrying value.\\nIntangible Long-Lived Assets\\nWe amortize our intangible assets over their estimated useful lives. We evaluate long-lived assets, which includes property, plant and equipment and intangible assets, for impairment whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. The carrying value is not recoverable if it exceeds the undiscounted cash flows resulting from the use of the asset and its eventual disposition. Our estimates of future cash flows attributable to our long-lived assets require significant judgment based on our historical and anticipated results and are subject to many factors. Factors we consider important which could trigger an impairment review include significant negative industry or economic trends, significant loss of customers and changes in the competitive environment of our intraoral scanning business.\\nThere were no triggering events in 2016 that would cause impairments of our long-lived assets.\\nAcquired intangible long-lived assets are being amortized as follows (in thousands):\\n| Weighted Average Amortization Period (in years) | Gross Carrying Amount as ofDecember 31, 2016 | AccumulatedAmortization | Accumulated Impairment Loss | Net CarryingValue as ofDecember 31, 2016 |\\n| Trademarks | 15 | $ | 7,100 | $ | (1,631 | ) | $ | (4,179 | ) | $ | 1,290 |\\n| Existing technology | 13 | 12,600 | (4,141 | ) | (4,328 | ) | 4,131 |\\n| Customer relationships | 11 | 33,500 | (12,819 | ) | (10,751 | ) | 9,930 |\\n| Patents | 8 | 6,316 | (713 | ) | — | 5,603 |\\n| Total Intangible Assets | $ | 59,516 | $ | (19,304 | ) | $ | (19,258 | ) | $ | 20,954 |\\n\\n| Weighted Average Amortization Period (in years) | Gross CarryingAmount as ofDecember 31, 2015 | AccumulatedAmortization | Accumulated Impairment Loss | Net CarryingValue as ofDecember 31, 2015 |\\n| Trademarks | 15 | $ | 7,100 | $ | (1,492 | ) | $ | (4,179 | ) | $ | 1,429 |\\n| Existing technology | 13 | 12,600 | (3,577 | ) | (4,328 | ) | 4,695 |\\n| Customer relationships | 11 | 33,500 | (10,957 | ) | (10,751 | ) | 11,792 |\\n| Patents | 8 | 285 | (113 | ) | — | 172 |\\n| Total Intangible Assets | $ | 53,485 | $ | (16,139 | ) | $ | (19,258 | ) | $ | 18,088 |\\n\\nThe total estimated annual future amortization expense for these acquired intangible assets as of December 31, 2016 is as follows (in thousands):\\n| Fiscal Year |\\n| 2017 | $ | 3,355 |\\n| 2018 | 3,353 |\\n| 2019 | 3,346 |\\n| 2020 | 3,336 |\\n| 2021 | 3,334 |\\n| Thereafter | 4,230 |\\n| Total | $ | 20,954 |\\n\\n78\\nNote 6. Legal Proceedings\\nSecurities Class Action Lawsuit\\nOn November 28, 2012, plaintiff City of Dearborn Heights Act 345 Police & Fire Retirement System filed a lawsuit against Align, Thomas M. Prescott (“Mr. Prescott”), Align’s former President and Chief Executive Officer, and Kenneth B. Arola (“Mr. Arola”), Align’s former Vice President, Finance and Chief Financial Officer, in the United States District Court for the Northern District of California on behalf of a purported class of purchasers of our common stock (the “Securities Action”). On July 11, 2013, an amended complaint was filed, which named the same defendants, on behalf of a purported class of purchasers of our common stock between January 31, 2012 and October 17, 2012. The amended complaint alleged that Align, Mr. Prescott and Mr. Arola violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, and that Mr. Prescott and Mr. Arola violated Section 20(a) of the Securities Exchange Act of 1934. Specifically, the amended complaint alleged that during the purported class period defendants failed to take an appropriate goodwill impairment charge related to the April 29, 2011 acquisition of Cadent Holdings, Inc. in the fourth quarter of 2011, the first quarter of 2012 or the second quarter of 2012, which rendered our financial statements and projections of future earnings materially false and misleading and in violation of U.S. GAAP. The amended complaint sought monetary damages in an unspecified amount, costs and attorneys’ fees. On December 9, 2013, the court granted defendants’ motion to dismiss with leave for plaintiff to file a second amended complaint. Plaintiff filed a second amended complaint on January 8, 2014 on behalf of the same purported class. The second amended complaint states the same claims as the amended complaint. On August 22, 2014, the court granted our motion to dismiss without leave to amend. On September 22, 2014, Plaintiff filed a notice of appeal to the Ninth Circuit Court of Appeals. Briefing for the appeal was completed in May 2015 and the Ninth Circuit held oral arguments in October 2016. Align intends to vigorously defend itself against these allegations. Align is currently unable to predict the outcome of this amended complaint and therefore cannot determine the likelihood of loss nor estimate a range of possible loss, if any.\\nShareholder Derivative Lawsuit\\nOn February 1, 2013, plaintiff Gary Udis filed a shareholder derivative lawsuit against several of Align’s current and former officers and directors in the Superior Court of California, County of Santa Clara. The complaint alleges that our reported income and earnings were materially overstated because of a failure to timely write down goodwill related to the April 29, 2011 acquisition of Cadent Holdings, Inc., and that defendants made allegedly false statements concerning our forecasts. The complaint asserts various state law causes of action, including claims of breach of fiduciary duty, unjust enrichment, and insider trading, among others. The complaint seeks unspecified damages on behalf of Align, which is named solely as nominal defendant against whom no recovery is sought. The complaint also seeks an order directing Align to reform and improve its corporate governance and internal procedures, and seeks restitution in an unspecified amount, costs, and attorneys’ fees. On July 8, 2013, an Order was entered staying this derivative lawsuit until an initial ruling on our first motion to dismiss the Securities Action. On January 15, 2014, an Order was entered staying this derivative lawsuit until an initial ruling on our second motion to dismiss the Securities Action. On October 14, 2014, an Order was entered staying this derivative lawsuit until a ruling by the Ninth Circuit in the Securities Action discussed above. Align is currently unable to predict the outcome of this complaint and therefore cannot determine the likelihood of loss nor estimate a range of possible losses, if any.\\nIn addition, in the course of Align's operations, Align is involved in a variety of claims, suits, investigations, and proceedings, including actions with respect to intellectual property claims, patent infringement claims, government investigations, labor and employment claims, breach of contract claims, tax, and other matters. Regardless of the outcome, these proceedings can have an adverse impact on us because of defense costs, diversion of management resources, and other factors. Although the results of complex legal proceedings are difficult to predict and Align's view of these matters may change in the future as litigation and events related thereto unfold; Align currently does not believe that these matters, individually or in the aggregate, will materially affect Align's financial position, results of operations or cash flows.\\nNote 7. Credit Facility\\nThe credit facility provides for a $50.0 million revolving line of credit, with a $10.0 million letter of credit sublimit. The credit facility requires us to comply with specific financial conditions and performance requirements. On December 13, 2016, we amended the credit facility to remove the requirement to maintain a minimum unrestricted cash balance of $50.0 million. On February 10, 2017, we amended the credit facility and extended the maturity date to March 22, 2018. The loans bear interest, at our option, at a fluctuating rate per annum equal to the daily one-month adjusted LIBOR rate plus a spread of 1.75% or an adjusted LIBOR rate (based on one, three, six or twelve-month interest periods) plus a spread of 1.75%. As of December 31, 2016, we had\\n79\\nno outstanding borrowings under this credit facility and were in compliance with the conditions and performance requirements.\\nNote 8. Commitments and Contingencies\\nOperating Leases\\nWe lease our facilities and certain equipment and automobiles under non-cancelable operating lease arrangements that expire at various dates through 2024 and provide for pre-negotiated fixed rental rates during the terms of the lease. The terms of some of our leases provide for rental payments on a graduated scale. We recognize rent expense on a straight-line basis over the lease period and accrue for any rent expense incurred but not paid. Total rent expense was $9.9 million, $8.2 million and $7.6 million, for the year ended December 31, 2016, 2015 and 2014, respectively.\\nMinimum future lease payments for non-cancelable leases as of December 31, 2016, are as follows (in thousands):\\n\\n| Fiscal Year | Operating Leases |\\n| 2017 | $ | 12,880 |\\n| 2018 | 10,338 |\\n| 2019 | 8,466 |\\n| 2020 | 6,849 |\\n| 2021 | 6,247 |\\n| Thereafter | 9,141 |\\n| Total minimum lease payments | $ | 53,921 |\\n\\nOther Commitments\\nOn July 25, 2016, we entered into a Loan and Security Agreement (the \\\"Loan Agreement\\\") with SmileDirectClub, LLC (\\\"SDC\\\") where we agreed to provide a loan of up to $15.0 million in one or more advances to SDC (the \\\"Loan Facility\\\"). Available advances under the Loan Facility are subject to a borrowing base of 80% of SDC's eligible accounts receivable, determined in accordance with the terms of the Loan Agreement, and the satisfaction of other customary conditions. The advances bear interest, paid quarterly, at the rate of 7% per annum. Advances that are repaid or prepaid may be reborrowed. All outstanding principal and accrued and unpaid interest on the advances are due and payable on July 25, 2021. SDC's obligations in respect of the Loan Agreement are collateralized by a security interest in substantially all of SDC's assets. As of December 31, 2016, no advances on the Loan Facility were issued or outstanding (Refer to Note 4 \\\"Equity Method Investments\\\" of the Notes of Consolidated Financial Statements for more information on our investments in SDC).\\nWe have entered into certain investments with a privately held company where we have committed to purchase up to $5.0 million in convertible promissory notes. The first convertible promissory note for $2.0 million was issued in July 2016 and is outstanding as of December 31, 2016. The remaining $3.0 million is conditioned upon achievement of various business milestones. The notes all mature on December 30, 2018 and accrue interest annually at 2.5%.\\nOn December 19, 2016, we entered into a Purchase and Sale Agreement (the \\\"Purchase Agreement\\\") with LBA RIV-COMPANY XXX, LLC (\\\"Seller\\\") to purchase the real property located in San Jose, California (the \\\"Property\\\") for purchase price of $44.1 million. The Property is comprised of land, building and other fixtures as set forth in the Purchase Agreement. As of December 31, 2016, $1.0 million was deposited into escrow and recorded in other current assets in our Consolidated Balance Sheet. We had a right to inspect the Property until January 6, 2017 and if we decided to terminate the Purchase Agreement during the period, the deposit would have been refunded to us. On January 26, 2017, we paid the purchase price of $44.1 million and closed the Purchase Agreement.\\nOff-Balance Sheet Arrangements\\nAs of December 31, 2016, we had no off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our consolidated financial condition, results of operations, liquidity, capital expenditures or capital resources.\\n80\\nIndemnification Provisions\\nIn the normal course of business to facilitate transactions in our services and products, we indemnify certain parties: customers, vendors, lessors, and other parties with respect to certain matters, including, but not limited to, services to be provided by us and intellectual property infringement claims made by third parties. In addition, we have entered into indemnification agreements with our directors and our executive officers that will require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors or officers. Several of these agreements limit the time within which an indemnification claim can be made and the amount of the claim.\\nIt is not possible to make a reasonable estimate of the maximum potential amount under these indemnification agreements due to the unique facts and circumstances involved in each particular agreement. Additionally, we have a limited history of prior indemnification claims and the payments we have made under such agreements have not had a material adverse effect on our results of operations, cash flows or financial position. However, to the extent that valid indemnification claims arise in the future, future payments by us could be significant and could have a material adverse effect on our results of operations or cash flows in a particular period. As of December 31, 2016, we did not have any material indemnification claims that were probable or reasonably possible.\\nNote 9. Stockholders’ Equity\\nCommon Stock\\nThe holders of common stock are entitled to receive dividends whenever funds are legally available and when and if declared by the Board of Directors. We have never declared or paid dividends on our common stock.\\nStock-Based Compensation Plans\\nOur 2005 Incentive Plan, as amended, provides for the granting of incentive stock options, non-statutory stock options, restricted stock units, market stock units, stock appreciation rights, performance units and performance shares to employees, non-employee directors, and consultants. Shares granted on or after May 16, 2013 as an award of restricted stock, restricted stock unit, market stock units, performance share or performance unit (\\\"full value awards\\\") are counted against the authorized share reserve as one and nine-tenths (1 9/10) shares for every one (1) share subject to the award, and any shares canceled that were counted as one and nine-tenths against the plan reserve will be returned at the same ratio. Full value awards granted prior to May 16, 2013 were counted against the authorized share reserve as one and one half (1 1/2) share for every one (1) share subject to the award, and any shares canceled that were counted as one and one half against the plan reserve will be returned at this same ratio.\\nAs of December 31, 2016, the 2005 Incentive Plan (as amended) has a total reserve of 27,783,379 shares for issuance of which 8,023,709 shares are available for issuance. In 2016, we added 4,500,000 shares to our pool and no shares were added to the plan in 2015. We issue new shares from our pool of authorized but unissued shares to satisfy the exercise and vesting obligations of our stock-based compensation plans.\\nStock-Based Compensation\\nStock-based compensation is based on the estimated fair value of awards, net of estimated forfeitures, and recognized over the requisite service period. Estimated forfeitures are based on historical experience at the time of grant and may be revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The stock-based compensation related to all of our stock-based awards and employee stock purchases for the year ended December 31, 2016, 2015 and 2014 is as follows (in thousands):\\n| For the Year Ended December 31, |\\n| 2016 | 2015 | 2014 |\\n| Cost of net revenues | $ | 3,966 | $ | 3,938 | $ | 3,616 |\\n| Selling, general and administrative | 42,612 | 40,813 | 29,625 |\\n| Research and development | 7,570 | 8,192 | 6,582 |\\n| Total stock-based compensation | $ | 54,148 | $ | 52,943 | $ | 39,823 |\\n\\n81\\nStock Options\\nWe have not granted options since 2011 and all outstanding options were fully vested in 2015. Activity for the year ended December 31, 2016, under the stock option plans are set forth below (in thousands, except years and per share amounts):\\n| Stock Options |\\n| Number ofSharesUnderlyingStock Options | WeightedAverageExercisePrice per Share | Weighted AverageRemainingContractual Term(in years ) | AggregateIntrinsicValue |\\n| Outstanding as of December 31, 2015 | 496 | 15.14 |\\n| Granted | — | — |\\n| Exercised | (274 | ) | 15.33 |\\n| Cancelled or expired | — | — |\\n| Outstanding as of December 31, 2016 | 222 | $ | 14.90 | 1.12 | $ | 18,058 |\\n| Vested and expected to vest at December 31, 2016 | 222 | $ | 14.90 | 1.12 | $ | 18,058 |\\n| Exercisable at December 31, 2016 | 222 | $ | 14.90 | 1.12 | $ | 18,058 |\\n\\nThe aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between our closing stock price on the last trading day in 2016 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on the last trading day of 2016. This amount will fluctuate based on the fair market value of our stock. The total intrinsic value of stock options exercised for the year ended December 31, 2016, 2015 and 2014 was $18.2 million, $7.4 million and $24.5 million, respectively. The total fair value of the options vested during the year ended December 31, 2016, 2015 and 2014 was not material.\\nRestricted Stock Units\\nThe fair value of nonvested restricted stock units (“RSUs”) is based on our closing stock price on the date of grant. A summary for the year ended December 31, 2016, is as follows (in thousands, except years and per share amounts):\\n\\n| SharesUnderlying RSUs | Weighted Average Grant Date Fair Value | WeightedRemainingVesting Period(in years) | AggregateIntrinsicValue |\\n| Nonvested as of December 31, 2015 | 2,079 | $ | 49.45 |\\n| Granted | 714 | 67.82 |\\n| Vested and released | (859 | ) | 45.45 |\\n| Forfeited | (145 | ) | 53.36 |\\n| Nonvested as of December 31, 2016 | 1,789 | $ | 58.39 | 1.12 | $ | 171,934 |\\n\\nThe aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (calculated by multiplying our closing stock price on the last trading day of 2016 by the number of nonvested RSUs) that would have been received by the unit holders had all RSUs been vested and released as of the last trading day of 2016. This amount will fluctuate based on the fair market value of our stock. During 2016, of the 859,410 shares vested and released, 300,031 vested shares were withheld for employee minimum statutory tax obligations, resulting in a net issuance of 559,379 shares.\\nThe total intrinsic value of RSUs vested and released during 2016, 2015 and 2014 was $59.8 million, $45.9 million and $38.9 million, respectively. The total fair value RSUs vested during the year ended December 31, 2016, 2015 and 2014 was $39.1 million, $30.0 million and $22.0 million, respectively. The weighted average grant date fair value of RSUs granted during 2016, 2015 and 2014 was $67.82, $57.78 and $53.72, respectively. As of December 31, 2016, there was $63.3 million of total unamortized compensation costs, net of estimated forfeitures, related to RSUs and these costs are expected to be recognized over a weighted average period of 2.0 years.\\nOn an annual basis, we grant market-performance based restricted stock units (“MSUs”) to our executive officers. Each MSU represents the right to one share of Align’s common stock and will be issued through our amended 2005 Incentive Plan. The actual\\n82\\nnumber of MSUs which will be eligible to vest will be based on the performance of Align’s stock price relative to the performance of the NASDAQ Composite Index over the vesting period, generally two to three years, up to 150% of the MSUs initially granted.\\nThe following table summarizes the MSU performance as of December 31, 2016:\\n| Number of SharesUnderlying MSUs(in thousands) | Weighted Average Grant Date Fair Value | Weighted AverageRemainingVesting Period(in years ) | AggregateIntrinsic Value(in thousands) |\\n| Nonvested as of December 31, 2015 | 611 | 51.41 |\\n| Granted | 218 | 55.77 |\\n| Vested and released | (270 | ) | 36.73 |\\n| Forfeited | (39 | ) | 56.41 |\\n| Nonvested as of December 31, 2016 | 520 | 60.49 | 1.1 | $ | 50,021 |\\n\\nThe aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (calculated by multiplying our closing stock price on the last trading day of 2016 by the number of non-vested MSUs) that would have been received by the unit holders had all MSUs been vested and released as of the last trading day of 2016. This amount will fluctuate based on the fair market value of our stock. During 2016, of the 270,347 shares vested and released 136,758 shares were withheld for tax payments, resulting in a net issuance of 133,589 shares.\\nThe total intrinsic value of MSUs vested and released during 2016, 2015 and 2014 was $17.4 million, $9.2 million and $2.9 million. The total fair value MSUs vested during the year ended December 31, 2016, 2015 and 2014 was $9.9 million, $4.9 million and $1.2 million, respectively. As of December 31, 2016, we expect to recognize $11.1 million of total unamortized compensation cost, net of estimated forfeitures, related to MSUs over a weighted average period of 1.1 years.\\nThe fair value of the MSUs is estimated at the grant date using a Monte Carlo simulation that includes factors for market conditions. The following weighted-average assumptions used in the Monte Carlo simulation were as follows:\\n| Year Ended December 31, |\\n| 2016 | 2015 | 2014 |\\n| Expected term (in years) | 3 | 3 | 3 |\\n| Expected volatility | 34.0 | % | 36.9 | % | 46.0 | % |\\n| Risk-free interest rate | 0.9 | % | 1.0 | % | 0.7 | % |\\n| Expected dividends | — | — | — |\\n| Weighted average fair value per share at grant date | $ | 68.88 | $ | 61.73 | $ | 50.46 |\\n\\nTotal payments to tax authorities for payroll taxes related to RSUs, including MSUs, that vested during the period were $29.9 million, $20.7 million and $7.6 million during the year ended December 31, 2016, 2015 and 2014, respectively, reflected as a financing activity in the Consolidated Statement of Cash Flows.\\nEmployee Stock Purchase Plan\\nIn May 2010, our shareholders approved the 2010 Employee Stock Purchase Plan (the “2010 Purchase Plan”), replacing our 2001 Employee Stock Purchase Plan, which consists of consecutive overlapping twenty-four month offering periods with four six-month purchase periods in each offering period. Employees purchase shares at 85% of the fair market value of the common stock at either the beginning of the offering period or the end of the purchase period, whichever is lower. The 2010 Purchase Plan will continue until terminated by either the Board of Directors or its administrator. The maximum number of shares available for issuance under the 2010 Purchase Plan is 2,400,000 shares. During the year ended December 31, 2016, 2015 and 2014, we issued 196,882, 230,078 and 247,343 shares, respectively, at average prices of $48.65, $36.66 and $29.24, respectively. As of December 31, 2016, 936,867 shares remain available for future issuance.\\nThe fair value of the option component of the 2010 Purchase Plan shares was estimated at the grant date using the Black-Scholes option pricing model with the following weighted average assumptions:\\n83\\n| Year Ended December 31, |\\n| 2016 | 2015 | 2014 |\\n| Expected term (in years) | 1.2 | 1.2 | 1.2 |\\n| Expected volatility | 30.5 | % | 31.1 | % | 38.8 | % |\\n| Risk-free interest rate | 0.7 | % | 0.3 | % | 0.2 | % |\\n| Expected dividends | — | — | — |\\n| Weighted average fair value at grant date | $ | 22.23 | $ | 16.19 | $ | 17.15 |\\n\\nWe recognized stock-based compensation expense of $2.7 million, $4.1 million and $2.6 million related to our employee stock purchase plans for the year ended December 31, 2016, 2015 and 2014, respectively. As of December 31, 2016, there was $0.7 million of total unamortized compensation costs related to employee stock purchases which we expect to be recognized over a weighted average period of 0.3 years.\\nNote 10. Common Stock Repurchase Program\\nApril 2014 Repurchase Program\\nOn April 23, 2014, we announced that our Board of Directors had authorized a stock repurchase program (\\\"April 2014 Repurchase Program\\\") pursuant to which we may purchase up to $300.0 million of our common stock over a three year period.\\nIn 2014, we entered into an accelerated share repurchase agreement (\\\"2014 ASR\\\") to repurchase $70.0 million of our common stock. The 2014 ASR was completed in July 2014. We received a total of approximately 1.4 million shares for an average purchase price per share of $51.46. During 2014, we repurchased on the open market approximately 0.6 million shares of our common stock at an average price of $50.93 per share, including commissions, for an aggregate purchase price of approximately $28.2 million.\\nIn 2015, we entered into an accelerated share purchase agreement (\\\"2015 ASR\\\") to repurchase $70.0 million of our common stock. The 2015 ASR was completed in July 2015. We received a total of approximately 1.2 million shares for an average share price of $60.52. During 2015, we repurchased on the open market approximately 0.5 million shares of our common stock at an average price of $58.89 per share, including commissions, for an aggregate purchase price of approximately $31.8 million.\\nIn 2016, we entered into an accelerated share repurchase agreement (\\\"2016 ASR\\\") to repurchase $50.0 million of our common stock. The 2016 ASR was completed in September 2016. We received a total of approximately 0.6 million shares for an average share price of $81.89. During 2016, we repurchased on the open market approximately 0.5 million shares of our common stock at an average price of $92.58 per share, including commissions, for an aggregate purchase price of approximately $46.2 million.\\nAll shares repurchased in 2016, 2015 and 2014 were retired.\\nAs of December 31, 2016, we have $3.8 million remaining under the April 2014 Repurchase Program.\\nApril 2016 Repurchase Program\\nOn April 28, 2016, we announced that our Board of Directors had authorized an additional plan to repurchase up to $300.0 million of the Company's stock (\\\"April 2016 Repurchase Plan\\\"). Any purchases under this stock repurchase program may be made, from time-to-time, pursuant to open market purchases (including pursuant to Rule 10b5-1 plans), privately-negotiated transactions, accelerated stock repurchases, block trades or derivative contracts or otherwise in accordance with applicable federal securities laws, including Rule 10b-18 of the Securities Exchange Act of 1934. As of December 31, 2016, there have not been any repurchases under this plan.\\n84\\nNote 11. Employee Benefit Plans\\n401(k) Plan\\nIn January 1999, we adopted a defined contribution retirement plan under Section 401(k) of the Internal Revenue Code for our U.S. employees. This plan covers substantially all U.S. employees who meet minimum age and service requirements and allows participants to defer a portion of their annual compensation on a pre-tax basis. In 2009, our Board of Directors authorized us to match 50% of our employee’s salary deferral contributions up to a 6% of the employee’s eligible compensation effective 2010. We contributed approximately $3.4 million, $2.7 million and $2.2 million to the 401(k) plan during the year ended December 31, 2016, 2015 and 2014, respectively.\\nIsraeli Funds\\nUnder the Israeli severance fund law, we are required to make payments to dismissed employees and employees leaving employment in certain circumstances. The funding is calculated based on the salary of the employee multiplied by the number of years of employment as of the applicable balance sheet date. Our Israeli employees are entitled to one month’s salary for each year of employment, or a pro-rata portion thereof. We fund the liability through monthly deposits into funds, and the values of these contributions are recorded in other current assets.\\nAs of December 31, 2016 and 2015, the accrued funds liability was approximately $3.1 million and $2.7 million, respectively.\\nNote 12. Income Taxes\\n| Year ended December 31, |\\n| 2016 | 2015 | 2014 |\\n| Domestic | $ | 118,871 | $ | 87,803 | $ | 94,784 |\\n| Foreign | 123,695 | 98,298 | 95,585 |\\n| Net income before provision for income taxes and equity in losses of investee | $ | 242,566 | $ | 186,101 | $ | 190,369 |\\n\\nThe provision for income taxes consists of the following (in thousands):\\n| Year Ended December 31, |\\n| 2016 | 2015 | 2014 |\\n| Federal |\\n| Current | $ | 40,235 | $ | 28,596 | $ | 1,569 |\\n| Deferred | 24,794 | 6,679 | 37,570 |\\n| 65,029 | 35,275 | 39,139 |\\n| State |\\n| Current | 2,603 | 3,271 | 2,162 |\\n| Deferred | 2,636 | (703 | ) | 971 |\\n| 5,239 | 2,568 | 3,133 |\\n| Foreign |\\n| Current | 8,964 | 4,305 | 1,596 |\\n| Deferred | (28,032 | ) | (67 | ) | 669 |\\n| (19,068 | ) | 4,238 | 2,265 |\\n| Provision for income taxes | $ | 51,200 | $ | 42,081 | $ | 44,537 |\\n\\nThe differences between income taxes using the federal statutory income tax rate of 35% and our effective tax rate are as follows:\\n85\\n| Year Ended December 31, |\\n| 2016 | 2015 | 2014 |\\n| U.S. federal statutory income tax rate | 35.0 | % | 35.0 | % | 35.0 | % |\\n| State income taxes, net of federal tax benefit | 2.1 | 1.5 | 1.6 |\\n| Impact of differences in foreign tax rates | (6.3 | ) | (16.2 | ) | (16.4 | ) |\\n| Valuation allowance release for Israel | (12.9 | ) | — | — |\\n| Stock-based compensation | 1.2 | 1.6 | 1.0 |\\n| Other items not individually material | 2.0 | 0.7 | 2.2 |\\n| 21.1 | % | 22.6 | % | 23.4 | % |\\n\\nAs of December 31, 2016, approximately $438.0 million of undistributed earnings from non-U.S. operations held by our foreign subsidiaries are designated as indefinitely reinvested outside the U.S. We maintain sufficient cash reserves in the U.S. and do not intend to repatriate our foreign earnings. As a result, U.S. income taxes and foreign withholding taxes have not been provided on these foreign earnings. If these earnings were distributed in the form of dividends or otherwise, or if the shares of the relevant foreign subsidiaries were sold or otherwise transferred, we would be subject to additional U.S. income taxes subject to an adjustment for foreign tax credits and foreign withholding taxes. We intend to use the undistributed earnings for local operating expansions and to meet local operating working capital needs. In addition, a significant amount of the cash earned by foreign subsidiaries has been and will continue to be utilized to affect the new international corporate structure described above.\\nOn July 1, 2016, we implemented a new international corporate structure. This changes the structure of our international procurement and sales operations, as well as realigns the ownership and use of intellectual property among our wholly-owned subsidiaries. We continue to anticipate that an increasing percentage of our consolidated pre-tax income will be derived from, and reinvested in our foreign operations. We believe that income taxed in certain foreign jurisdictions at a lower rate relative to the U.S. federal statutory rate will have a beneficial impact on our worldwide effective tax rate over time. Although the license of intellectual property rights between consolidated entities did not result in any gain in the consolidated financial statements, the Company generated taxable income in certain jurisdictions in 2016 resulting in a tax expense of $34.3 million. Additionally, as a result of the restructuring, we reassessed the need for a valuation allowance against our deferred tax assets considering all available evidence. Given the current earnings and anticipated future earnings of our subsidiary in Israel, we concluded that we have sufficient positive evidence to release the valuation allowance against our Israel operating loss carryforwards of $31.4 million, which resulted in an income tax benefit in this period of the same amount.\\nIn June 2009, the Costa Rica Ministry of Foreign Trade, an agency of the Government of Costa Rica, granted a twelve year extension of certain tax incentives, which were previously granted in 2002. The incentive tax rates will expire in various years beginning in July 2017. We intend to seek a renewal of these income tax incentives before they expire. Under these incentives, all of the income in Costa Rica during these twelve year incentive periods is subject to a reduced tax rate. In order to receive the benefit of these incentives, we must hire specified numbers of employees and maintain certain minimum levels of fixed asset investment in Costa Rica. If we do not fulfill these conditions for any reason, our incentive could lapse, and our income in Costa Rica would be subject to taxation at higher rates, which could have a negative impact on our operating results. The Costa Rica corporate income tax rate that would apply, absent the incentives, is 30% for 2016, 2015 and 2014. As a result of these incentives, income taxes were reduced by $19.1 million, $32.7 million and $32.5 million in the year ended December 31, 2016, 2015 and 2014, respectively. The benefit of the tax holiday on diluted net income per share was $0.23 in the year ended December 31, 2016 and $0.40 for both the year ended December 31, 2015 and 2014.\\n86\\n| Year Ended December 31, |\\n| 2016 | 2015 |\\n| Deferred tax assets: |\\n| Net operating loss and capital loss carryforwards | $ | 25,445 | $ | 31,247 |\\n| Reserves and accruals | 22,954 | 17,455 |\\n| Stock-based compensation | 16,399 | 16,523 |\\n| Deferred revenue | 13,975 | 24,432 |\\n| Net translation losses | 1,634 | 649 |\\n| Credit carryforwards | 679 | 1,932 |\\n| 81,086 | 92,238 |\\n| Deferred tax liabilities: |\\n| Depreciation and amortization | 12,034 | 8,555 |\\n| Prepaid expenses | 969 | 601 |\\n| 13,003 | 9,156 |\\n| Net deferred tax assets before valuation allowance | 68,083 | 83,082 |\\n| Valuation allowance | (256 | ) | (31,685 | ) |\\n| Net deferred tax assets | $ | 67,827 | $ | 51,397 |\\n\\nAs of December 31, 2016, the valuation allowance decreased by $31.4 million in comparison to the balance at December 31, 2015. This decrease was due to the release of the valuation allowance against our Israel net deferred tax assets during the year. We determined that these deferred tax assets are more likely than not to be realized based upon our assessment of the available positive and negative evidence. Positive evidence, including expected profitability based upon the implementation of our international corporate restructuring outweighed available negative evidence, which included losses in recent years. The total valuation allowance as of December 31, 2016 was not material.\\nAs of December 31, 2016, we have fully utilized California net operating loss carryforwards. As of December 31, 2016, we have California research credit carryforwards of approximately $3.7 million which can be carried forward indefinitely. In addition, we have foreign net operating loss carryforwards of approximately $104.3 million, which, if not utilized will expire beginning in 2025.\\nIn the event of a change in ownership, as defined under federal and state tax laws, our tax credit carryforwards may be subject to annual limitations. The annual limitations may result in the expiration of the tax credit carryforwards before utilization.\\nThe changes in the balance of gross unrecognized tax benefits, which exclude interest and penalties, for the year ended December 31, 2016, 2015 and 2014, are as follows (in thousands):\\n| Unrecognized tax benefit as of December 31, 2013 | $ | 26,668 |\\n| Tax positions related to current year: |\\n| Additions for uncertain tax positions | 6,659 |\\n| Tax positions related to prior year: |\\n| Reductions for uncertain tax positions | (260 | ) |\\n| Unrecognized tax benefit as of December 31, 2014 | 33,067 |\\n| Tax positions related to current year: |\\n| Additions for uncertain tax positions | 6,346 |\\n| Unrecognized tax benefit as of December 31, 2015 | 39,413 |\\n| Tax positions related to current year: |\\n| Additions for uncertain tax positions | 6,971 |\\n| Unrecognized tax benefit as of December 31, 2016 | $ | 46,384 |\\n\\n87\\nWe account for uncertain tax positions pursuant to authoritative guidance based on a two-step approach to recognize and measure uncertain tax positions taken or expected to be taken in a tax return. We first determine whether it is more likely than not that a tax position will be sustained upon audit based on its technical merits. If a tax position meets the more-likely-than-not recognition threshold it is then measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured as the largest amount of benefit that is more than 50 percent likely to be realized upon ultimate settlement. We adjust our uncertain tax positions due to changing facts and circumstances, such as the closing of a tax audit, or refinement of estimates due to new information. To the extent the final outcome of these matters is different than the amounts recorded, such differences will impact our tax provision in our Consolidated Statements of Operations in the period in which such determination is made.\\nDuring fiscal year 2016, the amount of gross unrecognized tax benefits increased by $7.0 million in comparison to fiscal year 2015. The total amount of unrecognized tax benefits, excluding interest and penalties, was $46.4 million and $39.4 million as of December 31, 2016 and 2015, respectively, all of which would impact our effective tax rate if recognized. We have elected to recognize interest and penalties related to unrecognized tax benefits as a component of income taxes. For the year ended December 31, 2016 and 2015, interest and penalties included in tax expense was $1.4 million and $0.7 million, respectively. Our total interest and penalties accrued as of December 31, 2016 and 2015 was $2.1 million and $0.7 million, respectively. We do not expect any significant changes to the amount of unrecognized tax benefit within the next twelve months.\\nWe file U.S. federal, U.S. state, and non-U.S. income tax returns. Our major tax jurisdictions are U.S. federal and the State of California. For U.S. federal and state tax returns, we are no longer subject to tax examinations for years before 2000. With few exceptions, we are no longer subject to examination by foreign tax authorities for years before 2007. Our subsidiary in Israel is under audit by the local tax authorities for calendar years 2006 through 2013.\\nNote 13. Net Income per Share\\nBasic net income per share is computed using the weighted average number of shares of common stock outstanding during the period. Diluted net income per share is computed using the weighted average number of shares of common stock, adjusted for any dilutive effect of potential common stock. Potential common stock, computed using the treasury stock method, includes RSU, MSU, stock options and our ESPP.\\nThe following table sets forth the computation of basic and diluted net income per share attributable to common stock (in thousands, except per share amounts):\\n| Year Ended December 31, |\\n| 2016 | 2015 | 2014 |\\n| Numerator: |\\n| Net income | $ | 189,682 | $ | 144,020 | $ | 145,832 |\\n| Denominator: |\\n| Weighted-average common shares outstanding, basic | 79,856 | 79,998 | 80,754 |\\n| Dilutive effect of potential common stock | 1,628 | 1,523 | 1,529 |\\n| Total shares, diluted | 81,484 | 81,521 | 82,283 |\\n| Net income per share, basic | $ | 2.38 | $ | 1.80 | $ | 1.81 |\\n| Net income per share, diluted | $ | 2.33 | $ | 1.77 | $ | 1.77 |\\n\\nFor the year ended December 31, 2016, 2015 and 2014, the anti-dilutive effect on net income per share from RSUs, MSUs and ESPP was not material.\\n88\\nNote 14. Supplemental Cash Flow Information\\nThe supplemental cash flow information consists of the following (in thousands):\\n| Year Ended December 31, |\\n| 2016 | 2015 | 2014 |\\n| Taxes paid | $ | 47,289 | $ | 40,621 | $ | 5,666 |\\n| Non-cash investing activities: |\\n| Fixed assets acquired with accounts payable or accrued liabilities | $ | 4,434 | $ | 14,636 | $ | 4,899 |\\n\\nNote 15. Segments and Geographical Information\\nSegment Information\\nOperating segments are defined as components of an enterprise for which separate financial information is available that is evaluated regularly by the Chief Operating Decision Maker (“CODM”), or decision-making group, in deciding how to allocate resources and in assessing performance. Our CODM is our Chief Executive Officer. We report segment information based on the management approach. The management approach designates the internal reporting used by CODM for decision making and performance assessment as the basis for determining our reportable segments. The performance measures of our reportable segments include net revenues and gross profit. In the fourth quarter of 2016, management decided to change the way it internally assesses the performance of our reportable segments by including income from operations measure in the performance metrics. Income from operations for each segment includes all geographic revenues, related cost of net revenues and operating expenses directly attributable to the segment. Certain operating expenses are attributable to operating segments and each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. Costs not specifically allocated to segment income from operations include various corporate expenses such as stock-based compensation and costs related to IT, facilities, human resources and accounting and finance, legal and regulatory, and other separately managed general and administrative costs outside the operating segments. We have included the new performance measure in the prior periods presentation to conform to the current year’s presentation.\\nWe have grouped our operations into two reportable segments which are also our reporting units: Clear Aligner segment and Scanner segment.\\n| • | Our Clear Aligner segment consists of our Invisalign System which includes Invisalign Full, Express/Lite, Teen, Assist, Vivera Retainers, along with our training and ancillary products for treating malocclusion. Clear Aligner segment also include the sale of aligners to SDC under our supply agreement which commenced in the fourth quarter of 2016. SDC revenue is recorded after eliminating outstanding intercompany transactions. |\\n\\n| • | Our Scanner and Services (\\\"Scanner\\\") segment consists of intraoral scanning systems and additional services available with the intraoral scanners that provide digital alternatives to the traditional cast models. This segment includes our iTero scanner and OrthoCAD services. |\\n\\nThese reportable operating segments are based on how our CODM views and evaluates our operations as well as allocation of resources. The following information relates to these segments (in thousands):\\n89\\n| For the Year Ended December 31, |\\n| Net Revenues | 2016 | 2015 | 2014 |\\n| Clear Aligner | $ | 958,327 | $ | 800,186 | $ | 712,549 |\\n| Scanner | 121,547 | 45,300 | 49,104 |\\n| Total net revenues | $ | 1,079,874 | $ | 845,486 | $ | 761,653 |\\n| Gross Profit |\\n| Clear Aligner | $ | 747,494 | $ | 628,187 | $ | 562,889 |\\n| Scanner | 67,800 | 11,923 | 15,554 |\\n| Total gross profit | $ | 815,294 | $ | 640,110 | $ | 578,443 |\\n| Income from Operations |\\n| Clear Aligner | $ | 411,817 | $ | 371,113 | $ | 341,055 |\\n| Scanner | 37,498 | (12,337 | ) | (8,483 | ) |\\n| Unallocated corporate expenses | (200,394 | ) | (170,142 | ) | (138,996 | ) |\\n| Total income from operations | $ | 248,921 | $ | 188,634 | $ | 193,576 |\\n| Depreciation and Amortization |\\n| Clear Aligner | $ | 13,742 | $ | 9,842 | $ | 8,706 |\\n| Scanner | 3,871 | 3,839 | 4,498 |\\n| Unallocated corporate expenses | 6,389 | 4,323 | 4,652 |\\n| Total depreciation and amortization | $ | 24,002 | $ | 18,004 | $ | 17,856 |\\n\\nThe following table reconciles total segment income from operations in the table above to net income before provision for income taxes and equity losses of investee:\\n| For the Year Ended December 31, |\\n| 2016 | 2015 | 2014 |\\n| Total segment income from operations | $ | 449,315 | $ | 358,776 | $ | 332,572 |\\n| Unallocated corporate expenses | (200,394 | ) | (170,142 | ) | (138,996 | ) |\\n| Total income from operations | 248,921 | 188,634 | 193,576 |\\n| Interest and other income (expense), net | (6,355 | ) | (2,533 | ) | (3,207 | ) |\\n| Net income before provision for income taxes and equity losses of investee | $ | 242,566 | $ | 186,101 | $ | 190,369 |\\n\\nGeographical Information\\nNet revenues are presented below by geographic area (in thousands):\\n| For the Year Ended December 31, |\\n| 2016 | 2015 | 2014 |\\n| Net revenues (1): |\\n| United States (2) | $ | 692,254 | $ | 585,874 | $ | 532,569 |\\n| The Netherlands (2) | 291,053 | 167,128 | 156,817 |\\n| Other International | 96,567 | 92,484 | 72,267 |\\n| Total net revenues | $ | 1,079,874 | $ | 845,486 | $ | 761,653 |\\n\\n| (1) | Net revenues are attributed to countries based on location of where revenue is recognized. |\\n\\n(2) During 2016, we implemented a new international corporate structure. This changed the structure of our international procurement and sales operations.\\n90\\nTangible long-lived assets are presented below by geographic area (in thousands):\\n| As of December 31, |\\n| 2016 | 2015 |\\n| Long-lived assets (1): |\\n| The Netherlands (2) | $ | 111,515 | $ | 486 |\\n| United States (2) | 43,278 | 112,632 |\\n| Mexico | 17,918 | 15,422 |\\n| Other International | 2,456 | 7,933 |\\n| Total long-lived assets | $ | 175,167 | $ | 136,473 |\\n\\n(1) Long-lived assets are attributed to countries based on entity that owns the assets.\\n(2) As a result of the new international corporate structure changes, approximately $92.0 million in long-lived assets were transferred from the U.S. to our Netherlands entity in 2016.\\nITEM 9.\\nCHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE\\nNone\\n\\nITEM 9A.\\nCONTROLS AND PROCEDURES\\nEvaluation of disclosure controls and procedures.\\nUnder the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective as of December 31, 2016 to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure, and that such information is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms.\\nManagement's annual report on internal control over financial reporting.\\nSee “Report of Management on Internal Control over Financial Reporting” of this Annual Report on Form 10-K.\\nChanges in internal control over financial reporting.\\nThere have been no changes in our internal control over financial reporting during the quarter ended December 31, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\nITEM 9B.\\nOTHER INFORMATION\\nNone.\\n91\\nPART III\\nCertain information required by Part III is omitted from this Form 10-K because we intend to file a definitive Proxy Statement for our 2017 Annual Meeting of Stockholders (the “Proxy Statement”) not later than 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K, and certain information to be included therein is incorporated herein by reference.\\n\\nITEM 10.\\nDIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE\\nThe information required by Item 401 of Regulation S-K concerning our directors is incorporated by reference to the Proxy Statement under the section captioned “Election of Directors.” The information required by Item 401 of Regulation S-K concerning our executive officers is set forth in Item 1— “Business” of this Annual Report on Form 10-K. The information required by Item 405 of Regulation S-K is incorporated by reference to the section entitled “Section 16(a) Beneficial Ownership Reporting Compliance” contained in the Proxy Statement. The information required by Item 407(c)(3), 407(d)(4) and 407(d)(5) of Regulation S-K is incorporated by reference to the Proxy Statement under the section entitled “Corporate Governance”.\\nCode of Ethics\\nWe have a code of ethics that applies to all of our employees, including our principal executive officer, principal financial officer and principal accounting officer. This code of ethics is posted on our Internet website. The Internet address for our website is www.aligntech.com, and the code of ethics may be found on the “Corporate Governance” section of our “Investor Relations” webpage.\\nWe intend to satisfy the disclosure requirement under Item 5.05 of Form 8-K regarding an amendment to, or waiver from, a provision of this code of ethics by posting such information on our website, at the address and location specified above, or as otherwise required by the NASDAQ Global Market.\\n\\nITEM 11.\\nEXECUTIVE COMPENSATION\\nThe information required by Item 402 of Regulation S-K is incorporated by reference to the Proxy Statement under the section captioned “Executive Compensation.” The information required by Items 407(e)(4) and (e)(5) is incorporated by reference to the Proxy Statement under the section captioned “Corporate Governance—Compensation Committee Interlocks” and “Compensation Committee Report,” respectively.\\nITEM 12.\\nSECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS\\nThe information required by Item 403 of Regulation S-K is incorporated by reference to the Proxy Statement under the section captioned “Security Ownership of Certain Beneficial Owners and Management.”\\nEquity Compensation Plan Information\\nThe following table provides information as of December 31, 2016 about our common stock that may be issued upon the exercise of options and rights granted to employees, consultants or members of our Board of Directors under all existing equity compensation plans, including the 1997 Equity Incentive Plan, the Employee Stock Purchase Plan (\\\"ESPP\\\"), the 2001 Stock Incentive Plan and the 2005 Incentive Plan, each as amended, and certain individual arrangements. Please see Note 9 “Stockholders’ Equity” in the Notes to consolidated financial statements for a description of equity compensation plans.\\n\\n| Plan Category | Number of securitiesto be issued upon exerciseof outstanding optionsand restricted stockunits(a) | Weighted averageexercise price ofoutstandingoptions(b) | Number of securitiesremaining available forfuture issuance underequity compensation plans(excluding securitiesreflected in column(a)) |\\n| Equity compensation plans approved by security holders | 2,531,027 | 1 | $ | 14.90 | 9,454,960 | 2, 3 |\\n| Equity compensation plans not approved by security holders | — | — | — |\\n| Total | 2,531,027 | $ | 14.90 | 9,454,960 |\\n\\n92\\n\\n| 1 | Includes 1,788,372 restricted stock units and 520,350 market-performance based restricted stock units at target, which have an exercise price of zero. |\\n\\n| 2 | Includes 936,867 shares available for issuance under our ESPP. We are unable to ascertain with specificity the number of securities to be issued upon exercise of outstanding rights or the weighted average exercise price of outstanding rights under the ESPP. |\\n\\n| 3 | Excludes 494,333 of potentially issuable MSUs if performance targets are achieved at maximum payout. |\\n\\nITEM 13.\\nCERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE\\nThe information required by Item 404 and Item 407 of Regulation S-K is incorporated by reference to the Proxy Statement under the sections captioned “Certain Relationships and Related Party Transactions” and “Corporate Governance—Director Independence,” respectively.\\n\\nITEM 14.\\nPRINCIPAL ACCOUNTING FEES AND SERVICES\\nThe information required by Item 9(e) of Schedule 14A of the Securities Act of 1934, as amended, is incorporated by reference to the Proxy Statement under the section captioned “Ratification of Appointment of Independent Registered Public Accountants.”\\n93\\nPART IV\\n\\nITEM 15.\\nEXHIBITS, FINANCIAL STATEMENT SCHEDULES\\n| (a) | Financial Statements |\\n\\n| 1. | Consolidated financial statements |\\n\\nThe following documents are filed as part of this Annual Report on Form 10-K:\\n\\n| Report of Independent Registered Public Accounting Firm | 56 |\\n| Consolidated Statements of Operations for the year ended December 31, 2016, 2015 and 2014 | 57 |\\n| Consolidated Statements of Comprehensive Income for the year ended December 31, 2016, 2015 and 2014 | 58 |\\n| Consolidated Balance Sheets as of December 31, 2016 and 2015 | 59 |\\n| Consolidated Statements of Stockholders’ Equity for the year ended December 31, 2016, 2015 and 2014 | 60 |\\n| Consolidated Statements of Cash Flows for the year ended December 31, 2016, 2015 and 2014 | 61 |\\n| Notes to Consolidated Financial Statements | 62 |\\n\\n\\n| 2. | The following financial statement schedule is filed as part of this Annual Report on Form 10-K: |\\n\\nSchedule II—Valuation and Qualifying Accounts and Reserves\\nAll other schedules have been omitted as they are not required, not applicable, or the required information is otherwise included.\\nSCHEDULE II: VALUATION AND QUALIFYING ACCOUNTS AND RESERVES\\n\\n| Balance atBeginningof Period | Additions(Reductions)to CostsandExpenses | WriteOffs | Balance atEnd of Period |\\n| (in thousands) |\\n| Allowance for doubtful accounts and returns: |\\n| Year ended December 31, 2014 | $ | 1,733 | $ | 6,563 | $ | (6,733 | ) | $ | 1,563 |\\n| Year ended December 31, 2015 | $ | 1,563 | $ | 8,944 | $ | (8,035 | ) | $ | 2,472 |\\n| Year ended December 31, 2016 | $ | 2,472 | $ | 8,585 | $ | (6,747 | ) | $ | 4,310 |\\n| Valuation allowance for deferred tax assets: |\\n| Year ended December 31, 2014 | $ | 35,108 | $ | (1,793 | ) | $ | (817 | ) | $ | 32,498 |\\n| Year ended December 31, 2015 | $ | 32,498 | $ | (813 | ) | $ | — | $ | 31,685 |\\n| Year ended December 31, 2016 | $ | 31,685 | $ | (31,429 | ) | $ | — | $ | 256 |\\n\\n94\\n| (b) | The following Exhibits are included in this Annual Report on Form 10-K: |\\n\\n| ExhibitNumber | Description | Form | Date | ExhibitNumberIncorporatedby Referenceherein | Filedherewith |\\n| 3.1 | Amended and Restated Certificate of Incorporation of registrant | Form S-1, as amended (File No. 333-49932) | 12/28/2000 | 3.1 |\\n| 3.2 | Amended and Restated Bylaws of registrant | Form 8-K | 2/29/2012 | 3.2 |\\n| 3.3 | Certificate of Designations of Rights, Preferences and Privileges of Series A Participating Preferred Stock registrant | Form 8-K | 10/27/2005 | 3.1 |\\n| 4.1 | Form of Specimen Common Stock Certificate | Form S-1, as amended (File No. 333-49932) | 1/17/2001 | 4.1 |\\n| 10.1† | Registrant's 2005 Incentive Plan (as amended May 2016) | * |\\n| 10.2† | Form of RSU agreement under Registrant's 2005 Incentive Plan (Officer Form for officers appointed after September 2016) | * |\\n| 10.2A† | Form of RSU agreement under Registrant's 2005 Incentive Plan (Officer Form for officers appointed prior to September 2016) | * |\\n| 10.3 | Align’s 2010 Employee Stock Purchase Plan | Form 8-K | 5/25/2010 | 10.2 |\\n| 10.4† | Form of Indemnification Agreement by and between registrant and its Board of Directors and its executive officers | Form S-1 as amended (File No. 333-49932) | 1/17/2001 | 10.15 |\\n| 10.5† | Form of restricted stock unit award agreement under registrant’s 2005 Incentive Plan (General Form; Director Form) | Form 10-Q | 11/5/2007 | 10.1A,10.1C |\\n| 10.6† | Form of option award agreement under registrant’s 2005 Incentive Plan | Form 10-Q | 8/4/2005 | 10.4 |\\n| 10.7† | Form of Employment Agreement entered into by and between registrant and each executive officer (other than CEO for executives appointed prior to September 2016) | Form 10-Q | 5/8/2008 | 10.2 |\\n| 10.8† | Form of Employment entered into by and between registrant and each executive officer (other than CEO for executives appointed after September 2016) | * |\\n| 10.9 | Credit Agreement dated March 22, 2013 between registrant and Wells Fargo National Association | Form 8-K | 3/27/2013 | 10.1 |\\n| 10.10† | Summary of 2016 Incentive Awards and Base Salaries | Form 8-K | 2/6/2017 |\\n| 10.11† | Form of Market Stock Unit Agreement (officer) | Form 8-K | 2/23/2011 | 10.1 |\\n| 10.12† | Form of Market Stock Unit Agreement (CEO) | Form 8-K | 2/23/2011 | 10.2 |\\n| 10.13† | Description of Executive Officer Incentive Plan | Form 8-K | 2/23/2011 | Item 5.02 |\\n| 10.14 | Fixed Dollar Accelerated Repurchase Transaction Agreement dated May 3, 2016 between Morgan Stanley & Co and registrant | Form 10-Q | 8/4/2016 | 10.1 |\\n| 10.15† | Amended and Restated Chief Executive Officer Employment Agreement between Align Technology, Inc. and Joseph Hogan | Form 10-Q | 5/1/2015 | 10.30 |\\n\\n95\\n| ExhibitNumber | Description | Form | Date | ExhibitNumberIncorporatedby Referenceherein | Filedherewith |\\n| 10.16† | 2005 Incentive Plan Notice of Grant of Restricted Stock units (Chief Executive Officer) | Form 10-Q | 7/30/2015 | 10.31 |\\n| 10.17† | Amended and Restated 2005 Incentive Plan Notice of Grant of Market Stock Units (Chief Executive Officer) | Form 10-Q | 7/30/2015 | 10.34 |\\n| 10.18† | Employment Agreement between registrant and John Morici | Form 10-Q | 11/8/2016 | 10.2 |\\n| 10.19 | Purchase and Sale Agreement between registrant and LBA RIV-Company XXX, LLC dated December 19, 2016 | Form 8-K | 12/23/2016 | 10.1 |\\n| 10.20 | Class C Non-Incentive Unit Purchase Agreement dated July 25, 2016 | Form 8-K | 7/28/2016 | 10.1 |\\n| 10.30 | Fifth Amendment to Credit Agreement | Form 8-K | 2/13/2017 | 10.1 |\\n| 21.1 | Subsidiaries of Align Technology, Inc. | * |\\n| 23.1 | Consent of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm | * |\\n| 31.1 | Certifications of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2003 | * |\\n| 31.2 | Certifications of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2003 | * |\\n| 32 | Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2003 | * |\\n| 101.INS | XBRL Instance Document | * |\\n| 101.SCH | XBRL Taxonomy Extension Schema Document | * |\\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document | * |\\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document | * |\\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document | * |\\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document | * |\\n\\n__________________________________\\n| † | Management contract or compensatory plan or arrangement filed as an Exhibit to this form pursuant to Items 14(a) and 14(c) of Form 10-K. |\\n| †† | Portions of the exhibit have been omitted pursuant to a request for confidential treatment. The confidential portions have been filed with the SEC. |\\n\\n96\\nSIGNATURES\\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on February 28, 2017.\\n\\n| ALIGN TECHNOLOGY, INC. |\\n| By: | /S/ JOSEPH M. HOGAN |\\n| Joseph M. Hogan |\\n| President and Chief Executive Officer |\\n\\nEach person whose signature appears below constitutes and appoints Joseph M. Hogan or John F. Morici, his or her attorney-in-fact, with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his or her substitute or substitutes, may do or cause to be done by virtue hereof.\\nPursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.\\n| Signature | Title | Date |\\n| /S/ JOSEPH M. HOGAN | President and Chief Executive Officer (Principal Executive Officer) | February 28, 2017 |\\n| Joseph M. Hogan |\\n| /S/ JOHN F. MORICI | Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer) | February 28, 2017 |\\n| John F. Morici |\\n| /S/ JOSEPH LACOB | Director | February 28, 2017 |\\n| Joseph Lacob |\\n| /S/ C. RAYMOND LARKIN | Director | February 28, 2017 |\\n| C. Raymond Larkin |\\n| /S/ GEORGE J. MORROW | Director | February 28, 2017 |\\n| George J. Morrow |\\n| /S/ ANDREA L. SAIA | Director | February 28, 2017 |\\n| Andrea L. Saia |\\n| /S/ GREG J. SANTORA | Director | February 28, 2017 |\\n| Greg J. Santora |\\n| /S/ THOMAS M. PRESCOTT | Director | February 28, 2017 |\\n| Thomas M. Prescott |\\n| /S/ WARREN S. THALER | Director | February 28, 2017 |\\n| Warren S. Thaler |\\n\\n97\\nExhibit Index\\n| ExhibitNumber | Description | Form | Date | ExhibitNumberIncorporatedby referenceherein | Filedherewith |\\n| 3.1 | Amended and Restated Certificate of Incorporation of registrant | Form S-1, as amended (File No. 333-49932) | 12/28/2000 | 3.1 |\\n| 3.2 | Amended and Restated Bylaws of registrant | Form 8-K | 2/29/2012 | 3.2 |\\n| 3.3 | Certificate of Designations of Rights, Preferences and Privileges of Series A Participating Preferred Stock registrant | Form 8-K | 10/27/2005 | 3.1 |\\n| 4.1 | Form of Specimen Common Stock Certificate | Form S-1, as amended (File No. 333-49932) | 1/17/2001 | 4.1 |\\n| 10.1† | Registrant's 2005 Incentive Plan (as amended May 2016) | * |\\n| 10.2† | Form of RSU agreement under Registrant's 2005 Incentive Plan (Officer Form for officers appointed after September 2016) | * |\\n| 10.2A† | Form of RSU agreement under Registrant's 2005 Incentive Plan (Officer Form for officers appointed prior to September 2016) | * |\\n| 10.3 | Align’s 2010 Employee Stock Purchase Plan | Form 8-K | 5/25/2010 | 10.2 |\\n| 10.4† | Form of Indemnification Agreement by and between registrant and its Board of Directors and its executive officers | Form S-1 as amended (File No. 333-49932) | 1/17/2001 | 10.15 |\\n| 10.5† | Form of restricted stock unit award agreement under registrant’s 2005 Incentive Plan (General Form; Director Form) | Form 10-Q | 11/5/2007 | 10.1A,10.1C |\\n| 10.6† | Form of option award agreement under registrant’s 2005 Incentive Plan | Form 10-Q | 8/4/2005 | 10.40 |\\n| 10.7† | Form of Employment Agreement entered into by and between registrant and each executive officer (other than CEO for executives appointed prior to September 2016) | Form 10-Q | 5/8/2008 | 10.2 |\\n| 10.8† | Form of Employment entered into by and between registrant and each executive officer (other than CEO for executives appointed after September 2016) | * |\\n| 10.9 | Credit Agreement dated March 22, 2013 between registrant and Wells Fargo National Association | Form 8-K | 3/27/2013 | 10.10 |\\n| 10.10† | Summary of 2016 Incentive Awards and Base Salaries | Form 8-K | 2/6/2017 |\\n| 10.11† | Form of Market Stock Unit Agreement (officer) | Form 8-K | 2/23/2011 | 10.1 |\\n| 10.12† | Form of Market Stock Unit Agreement (CEO) | Form 8-K | 2/23/2011 | 10.2 |\\n| 10.13† | Description of Executive Officer Incentive Plan | Form 8-K | 2/23/2011 | Item 5.02 |\\n| 10.14 | Fixed Dollar Accelerated Repurchase Transaction Agreement dated May 3, 2016 between Morgan Stanley & Co and registrant | Form 10-Q | 8/4/2016 | 10.1 |\\n| 10.15† | Amended and Restated Chief Executive Officer Employment Agreement between Align Technology, Inc. and Joseph Hogan | Form 10-Q | 5/1/2015 | 10.3 |\\n| 10.16† | 2005 Incentive Plan Notice of Grant of Restricted Stock units (Chief Executive Officer) | Form 10-Q | 7/30/2015 | 10.3 |\\n\\n98\\n| ExhibitNumber | Description | Form | Date | ExhibitNumberIncorporatedby referenceherein | Filedherewith |\\n| 10.17† | Amended and Restated 2005 Incentive Plan Notice of Grant of Market Stock Units (Chief Executive Officer) | Form 10-Q | 7/30/2015 | 10.3 |\\n| 10.18† | Employment Agreement between registrant and John Morici | Form 10-Q | 11/8/2016 | 10.2 |\\n| 10.19 | Purchase and Sale Agreement between registrant and LBA RIV-Company XXX, LLC dated December 19, 2016 | Form 8-K | 12/23/2016 | 10.1 |\\n| 10.20 | Class C Non-Incentive Unit Purchase Agreement dated July 25, 2016 | Form 8-K | 7/28/2016 | 10.1 |\\n| 10.30 | Fifth Amendment to Credit Agreement | Form 8-K | 2/13/2017 | 10.1 |\\n| 21.1 | Subsidiaries of Align Technology, Inc. | * |\\n| 23.1 | Consent of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm | * |\\n| 31.1 | Certifications of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2003 | * |\\n| 31.2 | Certifications of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2003 | * |\\n| 32 | Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2003 | * |\\n| 101.INS | XBRL Instance Document | * |\\n| 101.SCH | XBRL Taxonomy Extension Schema Document | * |\\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document | * |\\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document | * |\\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document | * |\\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document | * |\\n\\n__________________________________\\n| † | Management contract or compensatory plan or arrangement filed as an Exhibit to this form pursuant to Items 14(a) and 14(c) of Form 10-K. |\\n| †† | Portions of the exhibit have been omitted pursuant to a request for confidential treatment. The confidential portions have been filed with the SEC. |\\n\\n99\\n \\n\\nWhat is the continuous compounded annual growth rate (CAGR) of net cash used by financing activities from 2014 to 2016? (in millions)\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 12.878638913766904.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 72,\n \"input_length\": 82686\n}"}}},{"rowIdx":73,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nBLACK RIDGE OIL & GAS, INC.\nCONDENSED BALANCE SHEETS\n\n| September 30, | December 31, |\n| 2020 | 2019 |\n| ASSETS | (Unaudited) |\n| Current assets: |\n| Cash | $ | 417,109 | $ | 108,756 |\n| Investment in Allied Esports Entertainment, Inc. securities | 2,242,207 | 6,982,300 |\n| Receivable from Allied Esports Entertainment, Inc. | – | 505 |\n| Prepaid expenses | 25,684 | 47,151 |\n| Total current assets | 2,685,000 | 7,138,712 |\n| Property and equipment: |\n| Property and equipment | – | 134,202 |\n| Less accumulated depreciation | – | (127,803 | ) |\n| Total property and equipment, net | – | 6,399 |\n| Total assets | $ | 2,685,000 | $ | 7,145,111 |\n| LIABILITIES AND STOCKHOLDERS' EQUITY |\n| Current liabilities: |\n| Accounts payable | $ | 110,569 | $ | 35,727 |\n| Accrued expenses | 262,532 | 14,220 |\n| Deferred compensation | – | 1,396,460 |\n| Total current liabilities | 373,101 | 1,446,407 |\n| Notes payable | 262,925 | – |\n| Total liabilities | 636,026 | 1,446,407 |\n| Commitments and contingencies | – | – |\n| Stockholders' equity: |\n| Preferred stock, $0.001 par value, 20,000,000 shares authorized, no shares issued and outstanding | – | – |\n| Common stock, $0.001 par value, 500,000,000 shares authorized, 1,600,424 shares issued and outstanding | 1,600 | 1,600 |\n| Additional paid-in capital | 37,825,774 | 37,054,503 |\n| Accumulated deficit | (35,778,400 | ) | (31,357,399 | ) |\n| Total stockholders' equity | 2,048,974 | 5,698,704 |\n| Total liabilities and stockholders' equity | $ | 2,685,000 | $ | 7,145,111 |\n\nSee accompanying notes to unaudited condensed financial statements.\n\n| 1 |\n\nBLACK RIDGE OIL & GAS, INC.\nCONDENSED STATEMENTS OF OPERATIONS\n(Unaudited)\n\n| For the Three Months | For the Nine Months |\n| Ended September 30, | Ended September 30, |\n| 2020 | 2019 | 2020 | 2019 |\n| Management fee income | $ | – | $ | 153,279 | $ | – | $ | 153,279 |\n| Total revenues | – | 153,279 | – | 153,279 |\n| Operating expenses: |\n| General and administrative expenses: |\n| Salaries and benefits | 483,050 | 279,621 | 936,304 | 910,191 |\n| Stock-based compensation | 322,888 | 2,836,920 | 393,831 | 2,892,738 |\n| Professional services | 130,234 | 40,287 | 327,090 | 79,978 |\n| Other general and administrative expenses | 45,001 | 69,157 | 186,380 | 185,035 |\n| Total general and administrative expenses | 981,173 | 3,225,985 | 1,843,605 | 4,067,942 |\n| Depreciation and amortization | 380 | 131 | 1,030 | 754 |\n| Total operating expenses | 981,553 | 3,226,116 | 1,844,635 | 4,068,696 |\n| Net operating loss | (981,553 | ) | (3,072,837 | ) | (1,844,635 | ) | (3,915,417 | ) |\n| Other income (expense): |\n| Gain on deconsolidation of subsidiary | – | 26,322,687 | – | 26,322,687 |\n| Merger incentive expense | – | (5,874,000 | ) | – | (5,874,000 | ) |\n| Interest expense, including $-0- and $377,440 of warrants issued as a debt discount for the three and nine months ended September 30, 2020, respectively | (1,695 | ) | – | (384,456 | ) | – |\n| Other income | 14 | – | 16 | 51 |\n| Loss on disposal of property and equipment | (5,369 | ) | – | (5,369 | ) | – |\n| Gain (loss) on investment in Allied Esports Entertainment, Inc. securities | (1,503,601 | ) | 2,094,690 | (2,186,557 | ) | 2,094,690 |\n| Total other income (expense) | (1,510,651 | ) | 22,543,377 | (2,576,366 | ) | 22,543,428 |\n| Net income (loss) before provision for income taxes | (2,492,204 | ) | 19,470,540 | (4,421,001 | ) | 18,628,011 |\n| Provision for income taxes | – | – | – | – |\n| Net income (loss) from continuing operations, net of tax | (2,492,204 | ) | 19,470,540 | (4,421,001 | ) | 18,628,011 |\n| Net income from discontinued operations | – | (8,152,165 | ) | – | (7,421,050 | ) |\n| Net income (loss) before non-controlling interest | (2,492,204 | ) | 11,318,375 | (4,421,001 | ) | 11,206,961 |\n| Less net income attributable to redeemable non-controlling interest | – | (142,919 | ) | – | (1,332,529 | ) |\n| Net income (loss) attributable to Black Ridge Oil & Gas, Inc. | $ | (2,492,204 | ) | $ | 11,175,456 | $ | (4,421,001 | ) | $ | 9,874,432 |\n| Weighted average common shares outstanding - basic | 1,600,424 | 1,600,424 | 1,600,424 | 1,600,424 |\n| Weighted average common shares outstanding - fully diluted | 1,600,424 | 1,601,241 | 1,600,424 | 1,601,337 |\n| Net income per common share - basic | $ | (1.56 | ) | $ | 6.98 | $ | (2.76 | ) | $ | 6.17 |\n| Net income per common share - fully diluted | $ | (1.56 | ) | $ | 6.98 | $ | (2.76 | ) | $ | 6.17 |\n\nSee accompanying notes to unaudited condensed financial statements.\n\n| 2 |\n\nBLACK RIDGE OIL & GAS, INC.\nSTATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY\n(Unaudited)\n\n| For the Three Months Ended September 30, 2019 |\n| Additional | Total |\n| Common Stock | Paid-in | Accumulated | Stockholders' |\n| Shares | Amount | Capital | Deficit | Equity |\n| Balance, June 30, 2019 | 1,600,424 | $ | 1,600 | $ | 37,009,795 | $ | (36,788,926 | ) | $ | 222,469 |\n| Common stock options granted for services to employees and directors | – | – | 27,887 | – | 27,887 |\n| Net income attributable to Black Ridge Oil & Gas, Inc. | – | – | – | 11,175,456 | 11,175,456 |\n| Balance, September 30, 2019 | 1,600,424 | $ | 1,600 | $ | 37,037,682 | $ | (25,613,470 | ) | $ | 11,425,812 |\n\n\n| For the Three Months Ended September 30, 2020 |\n| Additional | Total |\n| Common Stock | Paid-in | Accumulated | Stockholders' |\n| Shares | Amount | Capital | Deficit | Equity |\n| Balance, June 30, 2020 | 1,600,424 | $ | 1,600 | $ | 37,502,886 | $ | (33,286,196 | ) | $ | 4,218,290 |\n| Common stock options granted for services to employees and directors | – | – | 322,888 | – | 322,888 |\n| Net loss attributable to Black Ridge Oil & Gas, Inc. | – | – | – | (2,492,204 | ) | (2,492,204 | ) |\n| Balance, September 30, 2020 | 1,600,424 | $ | 1,600 | $ | 37,825,774 | $ | (35,778,400 | ) | $ | 2,048,974 |\n\n\n| For the Nine Months Ended September 30, 2019 |\n| Additional | Total |\n| Common Stock | Paid-in | Accumulated | Stockholders' |\n| Shares | Amount | Capital | Deficit | Equity |\n| Balance, December 31, 2018 | 1,600,424 | $ | 1,600 | $ | 36,953,977 | $ | (35,487,902 | ) | $ | 1,467,675 |\n| Common stock options granted for services to employees and directors | – | – | 83,705 | – | 83,705 |\n| Net income attributable to Black Ridge Oil & Gas, Inc. | – | – | – | 9,874,432 | 9,874,432 |\n| Balance, September 30, 2019 | 1,600,424 | $ | 1,600 | $ | 37,037,682 | $ | (25,613,470 | ) | $ | 11,425,812 |\n\n\n| For the Nine Months Ended September 30, 2020 |\n| Additional | Total |\n| Common Stock | Paid-in | Accumulated | Stockholders' |\n| Shares | Amount | Capital | Deficit | Equity |\n| Balance, December 31, 2019 | 1,600,424 | $ | 1,600 | $ | 37,054,503 | $ | (31,357,399 | ) | $ | 5,698,704 |\n| Common stock options granted for services to employees and directors | – | – | 393,831 | – | 393,831 |\n| Common stock warrants granted to employees and directors for personal guaranty on debt | – | – | 377,440 | – | 377,440 |\n| Net loss attributable to Black Ridge Oil & Gas, Inc. | – | – | – | (4,421,001 | ) | (4,421,001 | ) |\n| Balance, September 30, 2020 | 1,600,424 | $ | 1,600 | $ | 37,825,774 | $ | (35,778,400 | ) | $ | 2,048,974 |\n\nSee accompanying notes to unaudited condensed financial statements.\n\n| 3 |\n\nBLACK RIDGE OIL & GAS, INC.\nCONDENSED STATEMENTS OF CASH FLOWS\n(Unaudited)\n\n| For the Nine Months |\n| Ended September 30, |\n| 2020 | 2019 |\n| CASH FLOWS FROM OPERATING ACTIVITIES |\n| Net income (loss) attributable to Black Ridge Oil & Gas, Inc. | $ | (4,421,001 | ) | $ | 9,874,432 |\n| Net income from discontinued operations | – | 7,421,050 |\n| Net loss attributable to redeemable non-controlling interest | – | 1,332,529 |\n| Adjustments to reconcile net loss attributable to Black Ridge Oil & Gas, Inc. |\n| to net cash used in operating activities: |\n| Gain on deconsolidation of subsidiary | – | (26,322,687 | ) |\n| Merger incentive expense | – | 5,874,000 |\n| Depreciation and amortization | 1,030 | 754 |\n| Loss on disposal of property and equipment | 5,369 | – |\n| (Gain) Loss on investment in Allied Esports Entertainment, Inc. securities, net | 2,186,557 | (2,094,690 | ) |\n| Amortization of stock options | 393,831 | 83,705 |\n| Amortization of stock warrants issued as a debt discount | 377,440 | – |\n| Deferred compensation | – | 2,809,033 |\n| Decrease (increase) in current assets: |\n| Accounts receivable | – | 13 |\n| Accounts receivable, related party | 505 | (181,211 | ) |\n| Prepaid expenses | 21,467 | 17,863 |\n| Increase (decrease) in current liabilities: |\n| Accounts payable | 74,842 | 16,481 |\n| Accrued expenses | 248,312 | 28,136 |\n| Net cash used in operating activities of continuing operations | (1,111,648 | ) | (1,140,592 | ) |\n| Net cash used in operating activities of discontinued operations | – | (8,618,568 | ) |\n| Net cash used in operating activities | (1,111,648 | ) | (9,759,160 | ) |\n| CASH FLOWS FROM INVESTING ACTIVITIES |\n| Cash disposed in deconsolidation | – | (9,991,684 | ) |\n| Purchase of property and equipment | – | (809 | ) |\n| Proceeds received from sale of investment in Allied Esports Entertainment, Inc. securities | 1,157,076 | – |\n| Net cash provided by (used in) investing activities of continuing operations | 1,157,076 | (9,992,493 | ) |\n| Net cash provided by investing activities of discontinued operations | – | 16,880,792 |\n| Net cash provided by investing activities | 1,157,076 | 6,888,299 |\n| CASH FLOWS FROM FINANCING ACTIVITIES |\n| Proceeds received from notes payable | 802,025 | – |\n| Repayments on notes payable | (539,100 | ) | – |\n| Net cash provided by financing activities from continuing operations | 262,925 | – |\n| Net cash provided by financing activities from discontinued operations | – | 1,431,974 |\n| Net cash provided by financing activities | 262,925 | 1,431,974 |\n| NET CHANGE IN CASH AND CASH EQUIVALENTS | 308,353 | (1,438,887 | ) |\n| CASH AT BEGINNING OF PERIOD | 108,756 | 1,503,500 |\n| CASH AT END OF PERIOD | $ | 417,109 | $ | 64,613 |\n| SUPPLEMENTAL INFORMATION: |\n| Interest paid | $ | 4,895 | $ | – |\n| Income taxes paid | $ | – | $ | 751,630 |\n| NON-CASH INVESTING AND FINANCING ACTIVITIES: |\n| Value of debt discounts attributable to warrants | $ | 377,440 | $ | – |\n| Value of investment in securities distributed to board members and employees | $ | 1,133,281 | $ | – |\n| Recognition of subsidiary equity upon deconsolidation | $ | – | $ | 8,498,212 |\n| BRAC Redemptions of redeemable preferred stock from trust account | $ | – | $ | 126,205,985 |\n| BRAC redeemable preferred stock transferred to equity | $ | – | $ | 15,865,798 |\n| BRAC stock issued in merger | $ | – | $ | 51,632,255 |\n| BRAC stock issued to settle intercompany debt | $ | – | $ | 19,300,000 |\n| BRAC loan and accrued interest assumed to settle intercompany debt | $ | – | $ | 10,992,877 |\n| BRAC stock issued to settle liabilities | $ | – | $ | 5,917,500 |\n\nSee accompanying notes to unaudited condensed financial statements.\n\n| 4 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nNote 1 – Organization and Nature of Business\nEffective April 2, 2012, Ante5, Inc. changed its corporate name to Black Ridge Oil & Gas, Inc., and continues to be quoted on the OTCQB under the trading symbol “ANFC”. Black Ridge Oil & Gas, Inc. (formerly Ante5, Inc.) (the “Company” and “BROG”) became an independent company in April 2010. We became a publicly traded company when our shares began trading on July 1, 2010. From October 2010 through August 2019, we had been engaged in the business of acquiring oil and gas leases and participating in the drilling of wells in the Bakken and Three Forks trends in North Dakota and Montana and /or managing similar assets for third parties.\nOn September 26, 2017, the Company finalized an equity raise utilizing a rights offering and backstop agreement, raising net proceeds of $5,051,675 and issuing 1,439,400 shares. The proceeds were used to sponsor a special purpose acquisition company, discussed below, with the remainder for general corporate purposes.\nOn October 10, 2017, the Company’s sponsored special purpose acquisition company, Black Ridge Acquisition Corp. (“BRAC”), completed an IPO raising $138,000,000 of gross proceeds (including proceeds from the exercise of an over-allotment option by the underwriters on October 18, 2017). In addition, the Company purchased 445,000 BRAC units at $10.00 per unit in a private placement transaction for a total contribution of $4,450,000 in order to fulfill its obligations in sponsoring BRAC, a blank check company formed for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities. BRAC’s efforts to identify a prospective target business were not limited to a particular industry or geographic region. Following the IPO and over-allotment, BROG owned 22% of the outstanding common stock of BRAC and managed BRAC’s operations via a management services agreement. On December 19, 2018, BRAC entered into a business combination agreement, which subsequently closed on August 9, 2019.\nOn October 1, 2020 the Company completed its acquisition of S-FDF, LLC pursuant to an Asset Purchase Agreement detailed in Footnote 15, Subsequent Events. In connection with the closing of the Asset Purchase Agreement, the Company acquired $2.5 million in cash and certain assets and agreements related to the Seller’s freeze-dried fruits and vegetables business for human consumption and entered into certain employment and registration rights agreements.\nThe Company currently owns 1,779,529 shares of Allied Esports Entertainment, Inc. (NASDAQ: AESE), the surviving entity after BRAC’s business combination (“Sponsor Shares”), after selling 368,871 shares for total proceeds of $1,282,067, selling warrants to purchase 505,000 shares of AESE (NASDAQ: AESEW) (“Sponsor Warrants”) for total proceeds of $73,668, and distributing 537,100 Sponsor Shares on August 9, 2020 to employees and directors under the 2018 Management Incentive Plan, dated March 6, 2018.\nNote 2 – Basis of Presentation and Significant Accounting Policies\nThe interim condensed financial statements included herein, presented in accordance with United States generally accepted accounting principles and stated in US dollars, have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations, although the Company believes that the disclosures are adequate to not make the information presented misleading.\nThese statements reflect all adjustments, which in the opinion of management, are necessary for fair presentation of the information contained therein. Except as otherwise disclosed, all such adjustments are of a normal recurring nature. It is suggested that these interim condensed financial statements be read in conjunction with the audited financial statements for the year ended December 31, 2019, which were included in our Annual Report on Form 10-K/A. The Company follows the same accounting policies in the preparation of interim reports.\n\n| 5 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nReclassifications\nIn the prior year, the income, expense and cash flows from Black Ridge Acquisition Corp., a wholly-owned subsidiary formed on October 10, 2017, which was consolidated as a variable interest entity through August 9, 2019, the date that BRAC completed a business combination with Allied Esports Entertainment, Inc. (“AESE”), were consolidated and have been retrospectively classified as discontinued operations. In addition, prior period investment in Allied Esports Entertainment, Inc. securities of $6,982,300 were reclassified from long term assets to current assets to conform to current period presentation.\nUse of Estimates\nThe preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates.\nEnvironmental Liabilities\nThe Company was formerly a direct owner of assets in the oil and gas industry. Oil and gas companies are subject, by their nature, to environmental hazard and clean-up costs. At this time, management knows of no substantial losses from environmental accidents or events which would have a material effect on the Company.\nCash in Excess of FDIC Limits\nThe Company maintains its cash in bank deposit accounts which, at times, may exceed federally insured limits. Accounts are guaranteed by the Federal Deposit Insurance Corporation (FDIC) and the Securities Investor Protection Corporation (SIPC) up to $250,000 and $500,000, respectively, under current regulations. The Company didn’t have any cash in excess of SIPC insured limits at September 30, 2020, and has not experienced any losses in such accounts.\nIncome Taxes\nThe Company recognizes deferred tax assets and liabilities based on differences between the financial reporting and tax basis of assets and liabilities using the enacted tax rates and laws that are expected to be in effect when the differences are expected to be recovered. The Company provides a valuation allowance for deferred tax assets for which it does not consider realization of such assets to be more likely than not.\nBasic and Diluted Earnings (Loss) Per Share\nBasic earnings (loss) per share (“EPS”) are computed by dividing net income (the numerator) by the weighted average number of common shares outstanding for the period (the denominator). Diluted EPS is computed by dividing net income by the weighted average number of common shares and potential common shares outstanding (if dilutive) during each period. Potential common shares include stock options, warrants and restricted stock. The number of potential common shares outstanding relating to stock options, warrants and restricted stock is computed using the treasury stock method.\n\n| 6 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nThe reconciliation of the denominators used to calculate basic EPS and diluted EPS for the three and nine months ended September 30, 2020 and 2019 are as follows:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| 2020 | 2019 | 2020 | 2019 |\n| Weighted average common shares outstanding – basic | 1,600,424 | 1,600,424 | 1,600,424 | 1,600,424 |\n| Plus: Potentially dilutive common shares: |\n| Common stock warrants | – | 817 | – | 913 |\n| Weighted average common shares outstanding – diluted | 1,600,424 | 1,601,241 | 1,600,424 | 1,601,337 |\n\nFor the three and nine months ended September 30, 2020, potential dilutive securities had an anti-dilutive effect and were not included in the calculation of diluted net loss per common share. Stock options and warrants excluded from the calculation of diluted EPS because their effect was anti-dilutive were 35,488 three and nine months ended September 30, 2019.\nFair Value of Financial Instruments\nUnder FASB ASC 820-10-05, the Financial Accounting Standards Board establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. This Statement reaffirms that fair value is the relevant measurement attribute. The adoption of this standard did not have a material effect on the Company’s financial statements as reflected herein. The carrying amounts of cash, accounts payable and accrued expenses reported on the balance sheets are estimated by management to approximate fair value primarily due to the short-term nature of the instruments. The Company had no items that required fair value measurement on a recurring basis.\nProperty and Equipment\nProperty and equipment are recorded at cost and depreciated using the straight-line method over their estimated useful lives of three to seven years. Expenditures for replacements, renewals, and betterments are capitalized. Maintenance and repairs are charged to operations as incurred. Long-lived assets are evaluated for impairment to determine if current circumstances and market conditions indicate the carrying amount may not be recoverable. Depreciation expense was $1,030 and $754 for the nine months ended September 30, 2020 and 2019, respectively.\nRevenue Recognition\nThe Company recognizes revenue in accordance with ASC 606 — Revenue from Contracts with Customers. Under ASC 606, the Company recognized revenue from management services through our previously consolidated Special Purpose Acquisition Company (“SPAC”), Black Ridge Acquisition Corp. until December 31, 2019.\nRevenue was primarily generated from BRAC in the form of management services performed within the state of Minnesota on a fixed fee basis. Revenue from the performance of those services was recognized upon completion of the services, at which time the services were delivered to the customer, and collectability of the fee was reasonably assured. We typically required payment within thirty days of the completion of services. Management estimates an allowance for doubtful accounts based on the aging of its receivables.\n\n| 7 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nStock-Based Compensation\nThe Company accounts for equity instruments issued to employees in accordance with the provisions of ASC 718 Stock Compensation (ASC 718) and Equity-Based Payments to Non-employees pursuant to ASC 2018-07 (ASC 2018-07). All transactions in which the consideration provided in exchange for the purchase of goods or services consists of the issuance of equity instruments are accounted for based on the fair value of the consideration received or the fair value of the equity instrument issued, whichever is more reliably measurable. The measurement date of the fair value of the equity instrument issued is the earlier of the date on which the counterparty’s performance is complete or the date at which a commitment for performance by the counterparty to earn the equity instruments is reached because of sufficiently large disincentives for nonperformance. Stock-based compensation was $393,831 and $83,705, consisting entirely of expenses related to common stock options issued for services for the nine months ended September 30, 2020 and 2019, respectively, using the Black-Scholes options pricing model and an effective term of 6 to 6.5 years based on the weighted average of the vesting periods and the stated term of the option grants and the discount rate on 5 to 7 year U.S. Treasury securities at the grant date. In addition, $377,440 of expenses related to the amortization of warrants issued in consideration of personal guarantees provided for debt financing for the nine months ended September 30, 2020, using the Black-Scholes options pricing model and an effective term of 5 years based on the weighted average of the vesting periods and the stated term of the warrant grants and the discount rate on 5 year U.S. Treasury securities at the grant date were recognized as interest expense for the nine months ended September 30, 2020.\nUncertain Tax Positions\nIn accordance with ASC 740, “Income Taxes” (“ASC 740”), the Company recognizes the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be capable of withstanding examination by the taxing authorities based on the technical merits of the position. These standards prescribe a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. These standards also provide guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.\nVarious taxing authorities may periodically audit the Company’s income tax returns. These audits include questions regarding the Company’s tax filing positions, including the timing and amount of deductions and the allocation of income to various tax jurisdictions. In evaluating the exposures connected with these various tax filing positions, including state and local taxes, the Company records allowances for probable exposures. A number of years may elapse before a particular matter, for which an allowance has been established, is audited and fully resolved. Black Ridge Oil & Gas, Inc. has not yet undergone an examination by any taxing authorities.\nThe assessment of the Company’s tax position relies on the judgment of management to estimate the exposures associated with the Company’s various filing positions.\nRecent Accounting Pronouncements\nFrom time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board (“FASB”) that are adopted by the Company as of the specified effective date. If not discussed below, management believes there have been no developments to recently issued accounting standards, including expected dates of adoption and estimated effects on our financial statements, from those disclosed in our Annual Report on Form 10-K/A for the year ended December 31, 2019.\nIn July 2018, the FASB issued ASU No. 2018-10, Codification Improvements to Topic 842, Leases. The amendments in ASU 2018-10 provide additional clarification and implementation guidance on certain aspects of the previously issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”) and have the same effective and transition requirements as ASU 2016-02. Upon the effective date, ASU 2018-10 will supersede the current lease guidance in ASC Topic 840, Leases. Under the new guidance, lessees will be required to recognize for all leases, with the exception of short-term leases, a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis. Concurrently, lessees will be required to recognize a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. ASU 2018-10 is effective for private companies and emerging growth public companies for interim and annual reporting periods beginning after December 15, 2019, with early adoption permitted. The guidance is required to be applied using a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative periods presented in the financial statements. The Company adopted this guidance effective January 1, 2019, and the standard did not have a material impact on the Company’s financial statements and related disclosures until the closing of the asset purchase with S-FDF, LLC on October 1, 2020.\n\n| 8 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nNote 3 – Going Concern\nAs shown in the accompanying financial statements, as of September 30, 2020, the Company has incurred recurring losses from operations resulting in an accumulated deficit of $35,778,400. As of September 30, 2020, the Company’s cash on hand may not be sufficient to sustain operations. These factors raise substantial doubt about the Company’s ability to continue as a going concern. The Company is currently seeking sources of capital to fund the requirements of the Asset Purchase Agreement. The Company intends to sell its AESE shares to continue as a going concern, however, there can be no assurance the share price will be sufficient to sustain operations, therefore the Company may be dependent upon its ability to secure equity and/or debt financing and there are also no assurances that the Company will be successful; therefore, without sufficient financing it would be unlikely for the Company to continue as a going concern.\nThe financial statements do not include any adjustments that might result from the outcome of any uncertainty as to the Company’s ability to continue as a going concern. The financial statements also do not include any adjustments relating to the recoverability and classification of recorded asset amounts, or amounts and classifications of liabilities that might be necessary should the Company be unable to continue as a going concern.\nNote 4 – Related Party\nManagement Incentive Plan\nOn March 1, 2018, the Board of Directors (the “Board”) of the Company approved and adopted the Black Ridge Gas, Inc. 2018 Management Incentive Plan (the “Plan”) and the form of 2018 Management Incentive Plan Award Agreement (the “Award Agreement”).\nIn connection with the approval of the Plan and Award Agreement, the Board approved the issuance of awards (the “Awards”) to certain individuals including officers and directors (the “Grantees”), representing a percentage of the shares of BRAC held by the Company as of the date of closing of a business combination for the acquisition of a target business as described in the BRAC prospectus dated October 4, 2017, as follows:\n\n| Percentage of BRAC Shares Owned by the |\n| Name | Company Granted to the Grantee |\n| Bradley Berman | 1.6% |\n| Lyle Berman | 1.6% |\n| Benjamin Oehler | 1.6% |\n| Joe Lahti | 1.6% |\n| Kenneth DeCubellis | 4.0% |\n| Michael Eisele | 2.8% |\n| James Moe | 2.1% |\n\nFollowing the AESE merger on August 9, 2019, the Company owned 2,685,500 shares of AESE common stock and 505,000 warrants to purchase AESE (NASDAQ: AESEW). During the nine months ending September 30, 2020, the Company sold some of these securities, resulting in gross proceeds of $1,157,076, consisting of 368,870 shares of common stock for total proceeds of $1,083,408, and the sale of warrants to purchase 505,000 shares for total proceeds of $73,668. The Company also distributed 537,101 Sponsor Shares on August 9, 2020 to employees and directors under the 2018 Management Incentive Plan. Employees and directors were required to remain in their positions for a one-year period from the AESE merger, with certain exceptions, to receive the granted shares. The AESE Plan Shares had a fair market value of $1,133,281 on August 10, 2020, when the shares were distributed. The Company recognized $1,396,460 of compensation expense related to the Plan during the year ended December 31, 2019. For the nine months ended September 30, 2020, the Company recognized a gain of $263,179 related to the reduction in the value of the shares to be paid to employees on August 10, 2020, which was offset against the Company’s loss on the investment in AESE shares due to changes in the AESE market price between December 31, 2019 and September 30, 2020.\nLease Agreement\nUpon closing of the Asset Purchase Agreement, the Company assumed the Seller’s obligations under a real property lease for its facility in Irving, Texas under which an entity owned entirely by Ira Goldfarb is the landlord.\n\n| 9 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nNote 5 – Fair Value of Financial Instruments\nUnder FASB ASC 820-10-5, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (an exit price). The standard outlines a valuation framework and creates a fair value hierarchy in order to increase the consistency and comparability of fair value measurements and the related disclosures. Under GAAP, certain assets and liabilities must be measured at fair value, and FASB ASC 820-10-50 details the disclosures that are required for items measured at fair value.\nThe Company has cash and cash equivalents and a revolving credit facility that must be measured under the fair value standard. The Company’s financial assets and liabilities are measured using inputs from the three levels of the fair value hierarchy. The three levels are as follows:\nLevel 1 - Inputs are unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date.\nLevel 2 - Inputs include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates, yield curves, etc.), and inputs that are derived principally from or corroborated by observable market data by correlation or other means (market corroborated inputs).\nLevel 3 - Unobservable inputs that reflect our assumptions about the assumptions that market participants would use in pricing the asset or liability.\nThe following schedule summarizes the valuation of financial instruments at fair value on a recurring basis in the balance sheets as of September 30, 2020 and December 31, 2019:\n\n| Fair Value Measurements at September 30, 2020 |\n| Level 1 | Level 2 | Level 3 |\n| Assets |\n| Cash | $ | 417,109 | $ | – | $ | – |\n| Investment in Allied Esports Entertainment, Inc. securities | 2,242,207 | – | – |\n| Total assets | 2,659,316 | – | – |\n| Liabilities |\n| Notes payable | – | (262,925 | ) | – |\n| Total liabilities | – | (262,925 | ) | – |\n| $ | 2,659,316 | $ | (262,925 | ) | $ | – |\n\n\n| 10 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\n\n| Fair Value Measurements at December 31, 2019 |\n| Level 1 | Level 2 | Level 3 |\n| Assets |\n| Cash | $ | 108,756 | $ | – | $ | – |\n| Investment in Allied Esports Entertainment, Inc. | 6,982,300 | – | – |\n| Total assets | 7,091,056 | – | – |\n| Liabilities |\n| None | – | – | – |\n| Total liabilities | – | – | – |\n| $ | 7,091,056 | $ | – | $ | – |\n\nThere were no transfers of financial assets or liabilities between Level 1 and Level 2 inputs for the nine months ended September 30, 2020.\nNote 6 – Prepaid Expenses\nPrepaid expenses consist of the following:\n\n| September 30, | December 31, |\n| 2020 | 2019 |\n| Prepaid insurance costs | $ | 3,185 | $ | 21,090 |\n| Prepaid employee benefits | 8,082 | 11,587 |\n| Prepaid office and other costs | 14,417 | 14,474 |\n| Total prepaid expenses | $ | 25,684 | $ | 47,151 |\n\nNote 7 – Property and Equipment\nProperty and equipment at September 30, 2020 and December 31, 2019, consisted of the following:\n\n| September 30, | December 31, |\n| 2020 | 2019 |\n| Property and equipment | $ | – | $ | 134,202 |\n| Less: Accumulated depreciation and amortization | – | (127,803 | ) |\n| Total property and equipment, net | $ | – | $ | 6,399 |\n\nOn September 30, 2020, the Company disposed of computer equipment no longer in service. No proceeds were received on the disposal of the equipment, resulting in a loss on disposal of fixed assets of $5,369, which represented the net book value at the time of disposal.\nThe Company recognized depreciation expense of $1,030 and $754 for the nine-month periods ended September 30, 2020 and 2019, respectively.\n\n| 11 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nNote 8 – Investment in Allied Esports Entertainment, Inc.\nFollowing the close of BRAC’s merger, the Company retained 2,685,500 shares of Allied Esports Entertainment Inc. (NASDAQ: AESE) common stock with a value, based on the closing stock of $4.45 on the merger, of $11,950,475, and tradeable warrants to purchase 505,000 shares of AESE (NASDAQ: AESEW) (“Sponsor Warrants”), of which the Company currently owns 1,779,529 shares, after selling 368,870 shares for total proceeds of $1,157,076, selling warrants to purchase 505,000 Sponsor Warrants for total proceeds of $73,668, and distributing 537,101 Sponsor Shares on August 10, 2020 to employees and directors under the 2018 Management Incentive Plan. As noted in Note 4 - Related Party Transactions, 20% or 537,101, of the shares were distributed to employees, officers and directors one year from the date of the merger, or on August 10, 2020. After the distribution and recent sales, the Company still holds 1,799,529 shares of AESE common stock.\nAs of September 30, 2020, the market value of the Company’s investment in AESE’s common stock was $2,242,207, based on the closing stock price of $1.26 per share, resulting in gains and losses on our investment in securities, as follows:\n\n| Net loss on investment in Allied Esports Entertainment, Inc. securities for the nine months ended September 30, 2020 | $ | (2,186,557 | ) |\n| Less: Net gains and losses recognized during 2020 on equity securities sold during the period | (198,012 | ) |\n| Unrealized losses recognized during 2020 on equity securities still held at September 30, 2020 | $ | (2,384,569 | ) |\n\nDuring the third quarter of 2020, the Company sold 51,902 of these shares for total proceeds of $120,596, resulting in a loss on investment of $14,352.\nDuring the second quarter of 2020, the Company sold 316,968 of these shares for total proceeds of $962,812, resulting in a gain on investment of $363,813.\nIn accordance with a brokerage account agreement with RBC Capital Markets, LLC, 500,000 of these shares were used as collateral for a $700,000 promissory note pursuant to a commercial pledge and security agreement, dated March 10, 2020, described below, which was subsequently repaid. Under this standard brokerage agreement, the Company will be able to borrow funds secured by the value of the AESE shares pursuant to a standard margin account arrangement.\n\n| 12 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nNote 9 – Notes Payable\nNotes payable consists of the following at September 30, 2020 and December 31, 2019, respectively:\n\n| September 30, | December 31, |\n| 2020 | 2019 |\n| On June 16, 2020, the Company entered into a loan authorization and loan agreement with the United States Small Business Administration (the “SBA”), as lender, pursuant to the SBA’s Economic Injury Disaster Loan (“EIDL”) assistance program in light of the impact of the COVID-19 pandemic on the Company’s business (the “EIDL Loan Agreement”) encompassing a $150,000 Promissory Note issued to the SBA (the “EIDL Note”)(together with the EIDL Loan Agreement, the “EIDL Loan”), bearing interest at 3.75% per annum. In connection with entering into the EIDL Loan, the Company also executed a security agreement, dated June 16, 2020, between the SBA and the Company (the “EIDL Security Agreement”) pursuant to which the EIDL Loan is secured by a security interest on all of the Company’s assets. Under the EIDL Note, the Company is required to pay principal and interest payments of $731 every month beginning June 16, 2021. All remaining principal and accrued interest is due and payable on June 16, 2050. The EIDL Note may be repaid at any time without penalty. | $ | 150,000 | $ | – |\n| On April 24, 2020, the Company entered into a loan agreement with Kensington Bank (“Kensington”), as lender (the “Loan Agreement”) encompassing a $112,925 Promissory Note issued to Kensington (the “PPP Note”) pursuant to Payroll Protection Program established as part of the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), which provides loans to qualifying businesses and is administered by the U.S. Small Business Administration (the “SBA”). The PPP Note bears interest at 1.00% per annum, with interest payable monthly beginning November 24, 2020, and principal due in full on April 24, 2022. The PPP Note may be repaid at any time without penalty. Under the Payroll Protection Program, the Company will be eligible for loan forgiveness up to the full amount of the PPP Note and any accrued interest. The forgiveness amount will be equal to the amount that the Company spends during the 24-week period beginning April 24, 2020 on payroll costs, payment of rent on any leases in force prior to February 15, 2020 and payment on any utility for which service began before February 15, 2020. The maximum amount of loan forgiveness for non-payroll expenses is 40% of the amount of the PPP Note. No assurance is provided that the Company will obtain forgiveness under the PPP Note in whole or in part. | 112,925 | – |\n| On November 25, 2019, the Company entered into a credit account agreement (“Margin Account”) with RBC Capital Markets, LLC (“RBC”). The Margin Account enables the Company to borrow against the Company’s AESE shares that are held in an account with RBC. The advances received on margin bear interest at rates of between 1.00% and 2.75% over the Base Lending Rate, depending on the average outstanding debit balance. The Base Lending Rate is internally determined by RBC using Broker Call, Prime Rate as determined by commercial banks utilized by RBC CM, Fed Funds, RBC CM’s cost of funds, and other commercially recognized rates of interest. The margin loans are collateralized by the underlying AESE shares. A total of $122,100 was borrowed on the Margin Account over various dates between January 29, 2020 and March 6, 2020. The outstanding balance was repaid in full on, or about, March 12, 2020 out of the proceeds of the loan from Cadence Bank, described below. | – | – |\n\n\n| 13 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\n\n| On March 12, 2020, the Company entered into a business loan agreement with Cadence Bank, N.A. (“Cadence”), as lender encompassing a $700,000 Promissory Note issued to Cadence (the “Note”), a Security Agreement by the Company in favor of Cadence and limited commercial guarantees by the Company’s Chief Executive Officer and Interim Chief Financial Officer, who is one in the same, and members of the Company’s Board of Directors (the “Guarantors”) (collectively, the “Cadence Loan”). The Note carried interest at a rate of 0.50 percentage points over the prime rate, as published in the Wall Street Journal, payable monthly, and was due on March 9, 2021. The Note could be repaid at any time without penalty. The Note was secured by all of the Company’s rights, title and interests in and to 500,000 shares of the common stock of Allied Esports Entertainment Inc. (NASDAQ: AESE) currently owned by the Company and held in the Company’s brokerage account with RBC Capital Markets, LLC. On March 26, 2020, the Company subsequently entered into a separate letter agreement with the Guarantors (the “Letter Agreement”), which provides that if the Company defaults or fails to make any payment due under the Cadence Loan and the Guarantors are required to make payment to Cadence pursuant to the Guarantees, then the Company agrees to issue additional equity interests or rights to Guarantors reflecting ninety-five percent (95%) of the outstanding equity of the Company at the time of such default to participating Guarantors who have made the payments to Cadence. All equity issuances will be subject to any third party or shareholder approvals required at the time of issuance. A total of $417,000 was advanced on the loan and subsequently repaid in full on June 30, 2020. | – | – |\n| Total notes payable | 262,925 | – |\n| Less unamortized derivative discounts: | – | – |\n| Notes payable | 262,925 | – |\n| Less: current maturities | – | – |\n| Notes payable, less current maturities | $ | 262,925 | $ | – |\n\nThe Company recorded total discounts of $377,440, consisting of debt discounts on warrants granted to four officers and directors for warrants issued in consideration of personal guarantees provided for debt financing incurred during the nine months ended September 30, 2020. The discounts were amortized to stock-based compensation expense over the term of the note, until repayment, using the straight-line method, which closely approximated the effective interest method. The Company recorded $377,440 of stock-based compensation expense pursuant to the amortization of note discounts during the nine months ended September 30, 2020.\nThe Company recognized $384,456 of interest expense, consisting of $7,016 of interest and $377,440 of stock-based warrant expense pursuant to the amortization of the debt discount on the business loans during the nine months ended September 30, 2020.\nNote 10 – Changes in Stockholders’ Equity\nReverse Stock Split\nOn February 21, 2020, the Company effected a 1-for-300 reverse stock split (the “Reverse Stock Split”). No fractional shares were issued. Instead, the Company issued the following to any stockholder who otherwise would have received a fractional share as a result of the Reverse Stock Split:\n| · | Stockholders owning 300 or more shares of Common Stock received (1) one share of Common Stock for every 300 shares owned and (2) cash in lieu of fractional shares upon the surrender of such stockholder’s shares; |\n| · | Stockholders owning between 25 and 300 shares of Common Stock had their ownership of shares of Common Stock rounded up to one share; and |\n| · | Stockholders owning fewer than 25 shares of Common Stock received cash in lieu of fractional shares upon the surrender of such stockholders’ shares and no longer own shares of Common Stock. |\n\n\n| 14 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nAny cash payment in lieu of fractional shares were based on the volume weighted average of the closing sales prices of the Company’s Common Stock on the OTCQB operated by OTC Markets Group Inc. (the “OTCQB”) during regular trading hours for the five consecutive trading days immediately preceding the Effective Date, which was $0.018 per share prior to the effects of the reverse stock split.\nThe Company was authorized to issue 500,000,000 shares of common stock prior to the Reverse Stock Split, which remains unaffected. The Reverse Stock Split did not have any effect on the stated par value of the common stock, or the Company’s authorized preferred stock. Unless otherwise stated, all share and per share information in this Interim Report has been retroactively adjusted to reflect the Reverse Stock Split.\nPreferred Stock\nThe Company has 20,000,000 authorized shares of $0.001 par value preferred stock. No shares have been issued to date.\nCommon Stock\nThe Company has 500,000,000 authorized shares of $0.001 par value common stock. As of September 30, 2020, and December 31, 2019, a total of 1,600,424 shares of common stock have been issued.\nNote 11 – Options\nThe 2020 Equity Plan was approved by written consent of a majority of shareholders of record as of November 12, 2019 and adopted by the Board on December 5, 2019, as provided in the definitive information statement filed with Securities and Exchange Commission on January 10, 2020 (the “DEF 14C”). The description of the 2020 Equity Plan is qualified in its entirety by the text of the 2020 Equity Plan, a copy of which was attached as Annex C to the DEF 14C.\nOutstanding Options\nOptions to purchase an aggregate total of 273,871 shares of common stock at a weighted average strike price of $16.32, exercisable over a weighted average life of 8.75 years were outstanding as of September 30, 2020.\nOptions Granted\nOn February 26, 2020, the Company’s Board of Directors granted an aggregate amount of 240,000 stock options pursuant to the 2020 Equity Plan to purchase shares of the Company’s common stock to several officers, directors, and employees at an exercise price of $5.41 per share, which represents the closing price of the Company’s shares on the OTCQB marketplace on February 20, 2020. The officers and directors receiving grants and the amounts of such grants were as follows:\n\n| Stock Option |\n| Name and Title | Shares Granted |\n| Ken DeCubellis, Chief Executive Officer and Interim Chief Financial Officer | 60,377 |\n| Michael Eisele, Chief Operating Officer | 42,264 |\n| Bradley Berman, Chairman of the Board and Director | 24,151 |\n| Joseph Lahti, Director | 24,151 |\n| Benjamin Oehler, Director | 24,151 |\n| Lyle Berman, Director | 24,151 |\n| Total: | 199,245 |\n\nAll of the stock options granted under the 2020 Equity Plan presented in the table above will vest in five equal installments, commencing one year from the date of grant on February 26, 2021, and continuing for the next four anniversaries thereof until fully vested, with the exception of 83,019 options that were awarded to four employees, whose vesting periods were accelerated to be fully vested as of September 30, 2019, pursuant to severance agreements.\nNo options were granted during the nine months ended September 30, 2019.\nThe Company recognized a total of $393,831, and $83,705 of compensation expense during the nine months ended September 30, 2020 and 2019, respectively, related to common stock options issued to Employees and Directors that are being amortized over the implied service term, or vesting period, of the options. The remaining unamortized balance of these options is $517,070 as of September 30, 2020.\n\n| 15 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nOptions Exercised\nNo options were exercised during the nine months ended September 30, 2020 and 2019.\nOptions Forfeited\nA total of 333 options with a weighted average exercise price of $90, and 457 options with a weighted average exercise price of $9.83 expired and were forfeited during the nine months ended September 30, 2020 and 2019, respectively.\nNote 12 – Warrants\nOutstanding Warrants\nWarrants to purchase an aggregate total of 106,300 shares of common stock at a $3.99 strike price, exercisable over a weighted average life of 9.36 years were outstanding as of September 30, 2020.\nWarrants Granted\nIn consideration for four officers and director’s willingness to serve as guarantors of the Cadence Loan, the Company issued warrants to each of the Guarantors (the “Guarantor Warrants”) for the purchase of the Company’s common stock on March 12, 2020. The Guarantor Warrants entitle each Guarantor to purchase 26,250 shares of the Company's common stock (the “Warrant Shares”) at an exercise price of $4.00 per share. The Guarantor Warrants expire on March 12, 2030. No warrants were granted during the comparative nine months ended September 30, 2019. The officers and directors receiving grants and the amounts of such grants were as follows:\n\n| Stock Warrant |\n| Name and Title | Shares Granted |\n| Ken DeCubellis, Chief Executive Officer and Interim Chief Financial Officer | 26,250 |\n| Bradley Berman, Chairman of the Board and Director | 26,250 |\n| Lyle Berman, Director | 26,250 |\n| Benjamin Oehler, Director | 26,250 |\n| Total: | 105,000 |\n\nWarrants Exercised\nNo warrants were exercised during the nine months ended September 30, 2020 and 2019.\n\n| 16 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nNote 13 – Income Taxes\nThe Company accounts for income taxes under ASC Topic 740, Income Taxes, which provides for an asset and liability approach of accounting for income taxes. Under this approach, deferred tax assets and liabilities are recognized based on anticipated future tax consequences, using currently enacted tax laws, attributed to temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts calculated for income tax purposes.\nLosses incurred during the period from April 9, 2011 (inception) to September 30, 2020 could be used to offset future tax liabilities. Accounting standards require the consideration of a valuation allowance for deferred tax assets if it is “more likely than not” that some component or all of the benefits of deferred tax assets will not be realized. As of September 30, 2020, net deferred tax assets were $7,013,057, with no deferred tax liability, primarily related to net operating loss carryforwards. A valuation allowance of approximately $7,013,057 was applied to the net deferred tax assets. Therefore, BROG has no tax expense for 2020 to date.\nIn accordance with FASB ASC 740, the Company has evaluated its tax positions and determined there are no significant uncertain tax positions as of any date on, or before September 30, 2020.\nNote 14 – Commitments\nThe Company from time to time may be involved in various inquiries, administrative proceedings and litigation relating to matters arising in the normal course of business. The Company is not aware of any inquiries or administrative proceedings and is not currently a defendant in any material litigation and is not aware of any threatened litigation that could have a material effect on the Company.\nThe Company periodically maintains cash balances at banks in excess of federally insured amounts. The extent of loss, if any, to be sustained as a result of any future failure of a bank or other financial institution is not subject to estimation at this time.\nNote 15 – Subsequent Events\nThe Company evaluates events that have occurred after the balance sheet date through the date these financial statements were issued.\nAsset Purchase\nOn October 1, 2020, the Company completed its acquisition of S-FDF, LLC, a Texas limited liability company, pursuant to an Asset Purchase Agreement, between the Company and the Seller, dated June 9, 2020, as subsequently amended effective October 1, 2020. In connection with the closing of the Asset Purchase Agreement, the Company acquired $2.5 million in cash and certain assets and agreements related to the Seller’s freeze-dried fruits and vegetables business for human consumption and entered into certain employment and registration rights agreements. The Company did not assume any liabilities of Seller or any liabilities, liens, or encumbrances pertaining to or encumbering the Purchased Assets except for those related to agreements or arrangements specified in the Asset Purchase Agreement. The Seller transferred the Purchased Assets to the Company in exchange for the issuance of 1,120,000 shares of the Company’s common stock to the Seller, representing 41.18% of the Company’s issued and outstanding common stock. The number of Seller Shares to be issued is subject to adjustment, as specified in the Asset Purchase Agreement, based on the extent to which the amount of cash proceeds held by the Company, as derived from the sale of the Company’s holdings of Sponsor Shares, are less than $5 million or greater than $6 million on the date specified in the Asset Purchase Agreement.\nThe Final Determination Date will be the first anniversary of the closing of the Asset Purchase Agreement and the Company has contributed $4 million to the business in the form of proceeds from either the sale of Sponsor Shares after October 1, 2020, proceeds from a financing secured by the AESE Shares after June 9, 2020, proceeds from an equity or convertible debt financing, legal fees paid in connection with the Asset Purchase Agreement, expenses incurred by the Company after August 1, 2020 (except for severance related to change in control payments made to the Company's employees), and the Company's cash as of October 1, 2020 (the “Company Contribution”). If the Company Contribution is less than $4 million on January 1, 2021, then the Final Determination Date will be January 1, 2021.\n\n| 17 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nPursuant to its obligations under the Asset Purchase Agreement, on the Closing Date the Company, (a) created three new seats on the Company’s Board of Directors and appointed the Seller’s principals, Ira Goldfarb and Claudia Goldfarb, and a third person designated by the Goldfarbs, Greg Creed, as directors, (b) entered into employment agreements with Ira Goldfarb and Claudia Goldfarb, (c) delivered a registration rights agreement with respect to the Seller Shares and any shares of common stock delivered as part of the employment compensation for Ira Goldfarb or Claudia Goldfarb, and (d) amended the Company’s 2020 Stock Incentive Plan to increase the number of shares of common stock reserved thereunder. At closing, the Company also assumed the Seller’s obligations under a real property lease for its facility in Irving, Texas under which an entity owned entirely by Ira Goldfarb is the landlord.\nAdoption of Non-Employee Director Compensation Plan\nOn October 1, 2020, the Company adopted a Non-Employee Director Compensation Plan. Pursuant to the Plan, each non-employee director will receive annual compensation of $25,000 to be paid in cash or common stock, at the Company’s election, each October 1, beginning with October 1, 2020. On October 1, 2020, the Company issued 4,167 shares to Mr. Bradley Berman, Mr. Lyle Berman, Mr. Joseph Lahti, Mr. Benjamin Oehler, and Mr. Creed under the Non-Employee Director Compensation Plan. In addition, the plan provides for annual compensation of $15,000 to be paid in cash or common stock, at the Company's election, each October 1, beginning with October 1, 2020, to Board committee chairs. On October 1, 2020, the Company issued 2,500 shares to Mr. Benjamin Oehler as its Audit Committee Chair.\nAmendment to 2020 Stock Incentive Plan\nAs a condition to closing on the Asset Purchase Agreement, the Board approved an increase in the number of shares of common stock reserved under the 2020 Stock Incentive Plan adopted in January 2020, from 320,000 shares to a total of 514,150 shares. The increase remains subject to shareholder approval, to be provided, if at all, by October 1, 2021.\nOption Grants\nOn October 1, 2020, Mr. Creed was granted options to purchase 24,151 shares of the Company’s common stock at an exercise price of $6.00 per share, which represented the closing price of the Company’s shares on the OTCQB marketplace on October 1, 2020. These options will vest 60% as of January 1, 2024 and 20% each anniversary thereafter until fully vested.\nOn October 2, 2020, the Company’s Board of Directors also granted an aggregate amount of 115,250 stock options pursuant to the 2020 Equity Plan to purchase shares of the Company’s common stock to several officers, directors, and employees at an exercise price of $5.25 per share, which represents the closing price of the Company’s shares on the OTCQB marketplace on October 2, 2020. The options are exercisable over a ten-year term, and vest 60% on the 3rd anniversary of the grant date and 20% each anniversary thereafter, until fully vested. The officers and directors receiving grants and the amounts of such grants were as follows:\n\n| Stock Option |\n| Name and Title | Shares Granted |\n| Ira Goldfarb, Chairman of the Board and Director | 50,000 |\n| Claudia Goldfarb, Chief Executive Officer | 50,000 |\n| Total: | 100,000 |\n\nManagement Changes\nKen DeCubellis stepped down from his roles as the Company’s Chief Executive Officer and interim Chief Financial Officer on September 30, 2020, and will serve as a transition resource employee and assist with the integration of the Seller’s freeze-dried fruit business into the Company's existing operations through December 15, 2020, or the earlier termination of his employment.\nEffective October 1, 2020, in connection with closing of the Asset Purchase Agreement, Ira Goldfarb was appointed as the Company’s Executive Chairman and Chairman of the Board, and Claudia Goldfarb was appointed as the Company’s Chief Executive Officer.\nEffective October 5, 2020, Brad Burke was appointed and agreed to serve on an interim basis as the Company’s Chief Financial Officer.\n\n| 18 |\n\n\nCautionary Statements\nWe are including the following discussion to inform our existing and potential security holders generally of some of the risks and uncertainties that can affect our company and to take advantage of the “safe harbor” protection for forward-looking statements that applicable federal securities law affords.\nFrom time to time, our management or persons acting on our behalf may make forward-looking statements to inform existing and potential security holders about our company. All statements other than statements of historical facts included in this report regarding our financial position, business strategy, plans and objectives of management for future operations and industry conditions are forward-looking statements. When used in this report, forward-looking statements are generally accompanied by terms or phrases such as “estimate,” “project,” “predict,” “believe,” “expect,” “anticipate,” “target,” “plan,” “intend,” “seek,” “goal,” “will,” “should,” “may” or other words and similar expressions that convey the uncertainty of future events or outcomes. Items making assumptions regarding actual or potential future sales, market size, collaborations, trends or operating results also constitute such forward-looking statements.\nForward-looking statements involve inherent risks and uncertainties, and important factors (many of which are beyond our control) that could cause actual results to differ materially from those set forth in the forward-looking statements include the following:\n\n| · | the effect of the coronavirus (“COVID-19”) pandemic on our ability to obtain funding through various financing transactions or arrangements; |\n\n| · | volatility or decline of our stock price; |\n\n| · | low trading volume and illiquidity of our common stock, and possible application of the SEC’s penny stock rules; |\n\n| · | potential fluctuation in quarterly results; |\n\n| · | low trading volume and price of our investment in AESE Shares; |\n\n| · | inability to maintain adequate liquidity to meet our financial obligations; |\n\n| · | failure to timely launch our freeze-dried fruit product offerings and obtain sufficient sales and distributions; |\n\n| · | litigation, disputes and legal claims involving outside parties; and |\n\n| · | risks related to our ability to be traded on the OTCQB and meeting trading requirements |\n\nWe have based these forward-looking statements on our current expectations and assumptions about future events. While our management considers these expectations and assumptions to be reasonable, they are inherently subject to significant business, economic, competitive, regulatory and other risks and uncertainties, most of which are difficult to predict and many of which are beyond our control. Accordingly, results actually achieved may differ materially from expected results in these statements. Forward-looking statements speak only as of the date they are made.\nReaders are urged not to place undue reliance on these forward-looking statements. We assume no obligation to update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this report, other than as may be required by applicable law or regulation. Readers are urged to carefully review and consider the various disclosures made by us in our reports filed with the United States Securities and Exchange Commission (the “SEC”) which attempt to advise interested parties of the risks and factors that may affect our business, financial condition, results of operation and cash flows. If one or more of these risks or uncertainties materialize, or if the underlying assumptions prove incorrect, our actual results may vary materially from those expected or projected.\n\n| 19 |\n\nOverview and Outlook\nEffective April 2, 2012, we changed our name to Black Ridge Oil & Gas, Inc. Our common stock is still quoted on the OTCQB under the trading symbol “ANFC.”\nAs the sponsor and manager of Black Ridge Acquisition Corp. beginning in May of 2017, the Company was focused on identifying and closing a business combination for BRAC, which closed on August 9, 2019. Upon BRAC (renamed Allied Esports Entertainment, Inc. following the merger or “AESE”, and hereafter named as such following the merger) completing its business combination, we continued to provide additional management services to BRAC until December 31, 2019.\nFollowing the close of the Merger, the Company commenced a strategic review to identify, review and explore alternatives for the Company, including a merger, acquisition, or a business combination. The result of that review is the transaction with S-FDF described below. The Company currently owns 1,779,529 shares of Allied Esports Entertainment, Inc. (NASDAQ: AESE), the surviving entity after BRAC’s business combination, after selling 368,870 shares for total proceeds of $1,083,408, selling warrants to purchase 505,000 shares of AESE (NASDAQ: AESEW) for total proceeds of $73,668, and distributing 537,101 Sponsor Shares on August 10, 2020 to employees and directors under the 2018 Management Incentive Plan.\nOn October 1, 2020, the Company completed its acquisition of S-FDF, LLC, as detailed in Footnote 15, Subsequent Events.\nGoing Concern Uncertainty\nAs of September 30, 2020, the Company has incurred recurring losses from operations resulting in an accumulated deficit of $35,778,400, and as of September 30, 2020, the Company’s cash on hand may not be sufficient to sustain operations. These factors raise substantial doubt about the Company’s ability to continue as a going concern. The Company is currently seeking sources of capital to fund the requirements of the Asset Purchase Agreement including selling its shares of AESE or other sources of capital. The Company intends to sell its AESE shares to continue as a going concern, however, there can be no assurance the share price will be sufficient to sustain operations, therefore the Company may be dependent upon its ability to secure equity and/or debt financing and there are also no assurances that the Company will be successful; therefore, without sufficient financing it would be unlikely for the Company to continue as a going concern.\nWe continue to pursue sources of additional capital through various financing transactions or arrangements, including joint venturing of projects, equity or debt financing or other means. We may not be successful in identifying suitable funding transactions in a sufficient time period or at all, and we may not obtain the capital we require by other means. If we do not succeed in raising additional capital, our resources may not be sufficient to fund our business.\nThe report of the Company’s independent registered public accounting firm that accompanies its audited consolidated financial statements in the Company’s Annual Report on Form 10-K/A contains an explanatory paragraph regarding the substantial doubt about the Company’s ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might result from the outcome of the going concern uncertainty.\n\n| 20 |\n\nResults of Operations for the Three Months Ended September 30, 2020 and 2019.\nThe following table summarizes selected items from the statement of operations for the three months ended September 30, 2020 and 2019, respectively.\n\n| Three Months Ended |\n| September 30, | Increase / |\n| 2020 | 2019 | (Decrease) |\n| Management fee income | $ | – | $ | 153,279 | $ | (153,279 | ) |\n| Total revenues: | – | 153,279 | (153,279 | ) |\n| Operating expenses: |\n| General and administrative expenses: |\n| Salaries and benefits | 483,050 | 279,621 | 203,429 |\n| Stock-based compensation | 322,888 | 2,836,920 | (2,514,032 | ) |\n| Professional services | 130,234 | 40,287 | 89,947 |\n| Other general and administrative expenses | 45,001 | 69,157 | (24,156 | ) |\n| Total general and administrative expenses | 981,173 | 3,225,985 | (2,244,812 | ) |\n| Depreciation and amortization | 380 | 131 | 249 |\n| Total operating expenses | 981,553 | 3,226,116 | (2,244,563 | ) |\n| Net operating loss | (981,553 | ) | (3,072,837 | ) | (2,091,284 | ) |\n| Other income (expense) |\n| Gain on deconsolidation of subsidiary | – | 26,322,687 | (26,322,687 | ) |\n| Merger incentive expense | – | (5,874,000 | ) | (5,874,000 | ) |\n| Interest expense | (1,695 | ) | – | 1,695 |\n| Other income | 14 | – | 14 |\n| Loss on disposal of property and equipment | (5,369 | ) | – | 5,369 |\n| Gain (loss) on investment in Allied Esports Entertainment, Inc. securities | (1,503,601 | ) | 2,094,690 | (3,598,291 | ) |\n| Total other income (expense) | (1,510,651 | ) | 22,543,377 | (24,054,028 | ) |\n| Net income (loss) from continuing operations, net of tax | (2,492,204 | ) | 19,470,540 | (21,962,744 | ) |\n| Provision for income taxes | – | – | – |\n| Net income (loss) from continuing operations, net of tax | (2,492,204 | ) | 19,470,540 | (21,962,744 | ) |\n| Net income from discontinued operations | – | (8,152,165 | ) | (8,142,165 | ) |\n| Net income (loss) before non-controlling interest | (2,492,204 | ) | 11,318,375 | (13,810,579 | ) |\n| Less: Net loss attributable to redeemable non-controlling interest | – | (142,919 | ) | (142,919 | ) |\n| Net income (loss) attributable to Black Ridge Oil & Gas, Inc. | $ | (2,492,204 | ) | $ | 11,175,456 | $ | (13,667,660 | ) |\n\nManagement fee income\nThe Company did not earn any management fees from its management agreement with BRAC during the three months ended September 30, 2020, compared to $153,279 during the three months ended September 30, 2019. The decrease is attributable to the termination of the agreement subsequent to the merger between BRAC and AESE on August 9, 2019.\n\n| 21 |\n\nGeneral and administrative expenses\nSalaries and benefits\nSalaries and benefits for the three months ended September 30, 2020 were $483,050, compared to $279,621 for the three months ended September 30, 2019, an increase of $203,429, or 73%. The increase in salaries and benefits was primarily due to payroll taxes on the distribution of AESE shares to employees in the current period pursuant to the Management Incentive Plan and accrued severance pay to former officers and employees.\nStock-based compensation\nStock-based compensation expense for the three months ended September 30, 2020 was $322,888, compared to $2,836,920 for the three months ended September 30, 2019, a decrease of $2,514,032, or 89%. Stock-based compensation consisted of stock options expense in both periods, and $2,809,033 of expense related to the 2018 Management Incentive Plan (the “2018 Plan”) in the prior period. Amortization of stock options increased as new options were granted toward the end of February 2020, with a five-year vesting period, and the vesting period was accelerated pursuant to separation agreements entered into on September 30, 2020.\nProfessional services\nGeneral and administrative expenses related to professional services were $130,234 for the 2020 period, compared to $40,287 for the 2019 period, an increase of $89,947, or 223%. The increase was primarily due to professional services related to our asset purchase agreement with S-FDF, LLC.\nOther general and administrative expenses\nOther general and administrative expenses for the three months ended September 30, 2020 was $45,001, compared to $69,157 for the three months ended September 30, 2019, a decrease of $24,156, or 35%. The decrease is primarily attributable to decreased administrative activity as we focused on completing the asset purchase with S-FDF, LLC.\nDepreciation\nDepreciation expense for the three months ended September 30, 2020 was $380, compared to $131 for the three months ended September 30, 2019, an increase of $249, or 190%. The increase is attributable to the addition of new computer equipment in 2020.\nOther income (expense)\nIn the three months ended September 30, 2020, other expense was $1,510,651, consisting of $1,695 of interest expense derived from the operating loans the Company received from the PPP and EIDL programs, a loss on the disposal of equipment of $5,369, and a net loss on investments in Allied Esports Entertainment, Inc. securities of $1,503,601, as offset by $14 of interest income. During the comparative three months ended September 30, 2019, other income was $22,543,377, consisting of the gain upon deconsolidation of BRAC of $26,322,687 and an offsetting merger incentive expense of $5,874,000 to recognize the cost related to transferring shares of AESE stock to the former owners of Allied Esports and WPT and other investors as an incentive to participate in the merger, and a gain of $2,094,690 on the investment in Allied Esports Entertainment, Inc. pursuant to the change in fair market value of the AESE shares.\nProvision for income taxes\nThe Company had no income tax expense in the 2020 or 2019 periods, as the Company continues to reserve against any deferred tax assets due to the uncertainty of realization of any benefit.\nNet income from discontinued operations\nNet income from discontinued operations relates to the income and expenses of BRAC during the periods prior to deconsolidation. Net income from discontinued operations for the three months ended September 30, 2019 was $8,152,165.\n\n| 22 |\n\nResults of Operations for the Nine Months Ended September 30, 2020 and 2019.\nThe following table summarizes selected items from the statement of operations for the nine months ended September 30, 2020 and 2019, respectively.\n\n| Nine Months Ended |\n| September 30, | Increase / |\n| 2020 | 2019 | (Decrease) |\n| Management fee income | $ | – | $ | 153,279 | $ | (153,279 | ) |\n| Total revenues: | – | 153,279 | (153,279 | ) |\n| Operating expenses: |\n| General and administrative expenses: |\n| Salaries and benefits | 936,304 | 910,191 | 26,113 |\n| Stock-based compensation | 393,831 | 2,892,738 | (2,498,907 | ) |\n| Professional services | 327,090 | 79,978 | 247,112 |\n| Other general and administrative expenses | 186,380 | 185,035 | 1,345 |\n| Total general and administrative expenses | 1,843,605 | 4,067,942 | (2,224,337 | ) |\n| Depreciation and amortization | 1,030 | 754 | 276 |\n| Total operating expenses | 1,844,635 | 4,068,696 | (2,224,061 | ) |\n| Net operating loss | (1,844,635 | ) | (3,915,417 | ) | (2,070,782 | ) |\n| Other income (expense) |\n| Gain on deconsolidation of subsidiary | – | 26,322,687 | (26,322,687 | ) |\n| Merger incentive expense | – | (5,874,000 | ) | (5,874,000 | ) |\n| Interest expense, including $377,440 of warrants issued as a debt discount | (384,456 | ) | – | 384,456 |\n| Other income | 16 | 51 | (35 | ) |\n| Loss on disposal of property and equipment | (5,369 | ) | – | 5,369 |\n| Gain (loss) on investment in Allied Esports Entertainment, Inc. securities | (2,186,557 | ) | 2,094,690 | (4,281,247 | ) |\n| Total other income (expense) | (2,576,366 | ) | 22,543,428 | (25,119,794 | ) |\n| Net income (loss) from continuing operations, net of tax | (4,421,001 | ) | 18,628,011 | (23,049,012 | ) |\n| Provision for income taxes | – | – | – |\n| Net loss from continuing operations, net of tax | (4,421,001 | ) | 18,628,011 | (23,049,012 | ) |\n| Net income from discontinued operations | – | (7,421,050 | ) | (7,421,050 | ) |\n| Net loss before non-controlling interest | (4,421,001 | ) | 11,206,961 | (15,627,962 | ) |\n| Less: Net loss attributable to redeemable non-controlling interest | – | (1,332,529 | ) | (1,332,529 | ) |\n| Net loss attributable to Black Ridge Oil & Gas, Inc. | (4,421,001 | ) | $ | 9,874,432 | $ | (14,295,433 | ) |\n\n\n| 23 |\n\nManagement fee income\nThe Company did not earn any management fees from its management agreement with BRAC during the nine months ended September 30, 2020, compared to $153,279 during the nine months ended September 30, 2019. The decrease is attributable to the termination of the agreement subsequent to the merger between BRAC and AESE on August 9, 2019.\nGeneral and administrative expenses\nSalaries and benefits\nSalaries and benefits for the nine months ended September 30, 2020 were $936,304, compared to $910,191 for the nine months ended September 30, 2019, an increase of $26,113, or 3%. The increase in salaries and benefits was primarily due to payroll taxes on the distribution of AESE shares to employees in the current period pursuant to the Management Incentive Plan and accrued severance pay to former officers and employees.\nStock-based compensation\nStock-based compensation expense for the nine months ended September 30, 2020 was $393,831, compared to $2,892,738 for the nine months ended September 30, 2019, a decrease of $2,498,907, or 86%. Stock-based compensation consisted of stock options expense in both periods, and $2,809,033 of expense related to the 2018 Management Incentive Plan in the prior period. Amortization of stock options increased as new options were granted toward the end of February 2020, with a five-year vesting period, and the vesting period was accelerated pursuant to separation agreements entered into on September 30, 2020.\nProfessional services\nGeneral and administrative expenses related to professional services were $327,090 for the 2020 period, compared to $79,978 for the 2019 period, an increase of $247,112, or 309%. The increase was primarily due to professional services related to our asset purchase agreement with S-FDF, LLC.\nOther general and administrative expenses\nOther general and administrative expenses for the nine months ended September 30, 2020 was $186,380, compared to $185,035 for the nine months ended September 30, 2019, an increase of $1,345, or 1%.\nDepreciation\nDepreciation expense for the nine months ended September 30, 2020 was $1,030, compared to $754 for the nine months ended September 30, 2019, an increase of $276, or 37%. The increase is attributable to the addition of new computer equipment in 2020.\n\n| 24 |\n\nOther income (expense)\nIn the nine months ended September 30, 2020, other expense was $2,576,366, consisting of $384,456 of interest expense derived from the business loans the Company received from Cadence Bank, N.A, RBC Capital Markets, LLC and additional operating loans from the PPP and EIDL programs, including $377,440 of expense related to the amortization of warrants issued in consideration of personal guarantees provided for debt financing, a loss on the disposal of equipment of $5,369, along with a net loss on investments in Allied Esports Entertainment, Inc. of $2,186,557, as offset by $16 of interest income, compared to other income of $22,543,428 during the nine months ended September 30, 2019, consisting of the $26,322,687 gain upon deconsolidation of BRAC and an offsetting merger incentive expense of $5,874,000 to recognize the cost related to transferring shares of AESE stock to the former owners of Allied Esports and WPT and other investors as incentive to participate in the merger, interest income of $51 and a gain of $2,094,690 on the investment in Allied Esports Entertainment, Inc. pursuant to the change in fair market value the AESE shares.\nProvision for income taxes\nThe Company had no income tax expense in the 2020 or 2019 periods, as the Company continues to reserve against any deferred tax assets due to the uncertainty of realization of any benefit.\nNet income from discontinued operations\nNet income from discontinued operations relates to the income and expenses of BRAC during the periods prior to deconsolidation. Net income from discontinued operations of $7,421,050 during the nine months ended September 30, 2019.\nLiquidity and Capital Resources\nThe following table summarizes our total current assets, liabilities and working capital at September 30, 2020 and December 31, 2019, respectively.\n\n| September 30, | December 31, |\n| 2020 | 2019 |\n| Current Assets | $ | 2,685,000 | $ | 7,138,712 |\n| Current Liabilities | $ | 373,101 | $ | 1,446,407 |\n| Working Capital | $ | 2,311,899 | $ | 5,692,305 |\n\nAs of September 30, 2020, we had working capital of $2,311,899.\n\n| 25 |\n\nThe following table summarizes our cash flows during the nine-month periods ended September 30, 2020 and 2019, respectively.\n\n| Nine Months Ended |\n| September 30, |\n| 2020 | 2019 |\n| Net cash used in operating activities | $ | (1,111,648 | ) | $ | (9,759,160 | ) |\n| Net cash provided by investing activities | 1,157,076 | 6,888,299 |\n| Net cash provided by financing activities | 262,925 | 1,431,974 |\n| Net change in cash and cash equivalents | $ | 308,353 | $ | (1,438,887 | ) |\n\nNet cash used in operating activities was $1,111,648 and $9,759,160 for the nine months ended September 30, 2020 and 2019, respectively, a period over period improvement of $8,647,512. The decrease was primarily due to a decrease of $8,618,568 in net losses in discontinued operations of BRAC. Changes in working capital from continuing operating activities resulted in a decrease in cash of $169,715 in the nine months ended September 30, 2020, as compared to a decrease in cash of $181,718 for the same period in the previous year.\nNet cash provided by investing activities were $1,157,076 and $6,888,299 for the nine months ended September 30, 2020 and 2019, respectively. Cash provided by investing activities were comprised of proceeds of $1,157,076 from the sale of Allied Esports Entertainment, Inc. securities during the nine months ended September 30, 2020. In the comparative period ended September 30, 2019, virtually all the cash was provided from discontinued operations and was the result of transfers and withdrawals from the Trust Account.\nNet cash provided by financing activities was $262,925 and $1,431,974 for the nine months ended September 30, 2020 and 2019, respectively. All of the 2020 activity was the result of $802,025 of net proceeds from notes payable, as offset by $539,100 of repayments, compared to $1,431,974 of cash provided by financing activities from discontinued operations in the comparative nine months ended September 30, 2019.\nSatisfaction of our cash obligations for the next 12 months\nAs of September 30, 2020, our balance of cash was $417,109 and we had total working capital of $2,311,899. We expect to incur significant costs related to the freeze-dried fruit Asset Purchase Agreement which closed on October 1, 2020, which will put a strain on our cash resources. Our plan for satisfying our cash requirements for the next twelve months is through cash on hand and the sale of its AESE shares, however, there can be no assurance the share price will be sufficient to cover our cash obligations for the next 12 months, therefore, additional financing in the form of equity or debt may be needed. The Company realized $1,157,076 of proceeds on the sale of 469,968 shares of AESE stock and 505,000 AESEW warrants, and received proceeds of $112,925 on a PPP loan and $150,000 of proceeds on an EIDL loan to be used as working capital to alleviate economic injury caused by COVID-19 during the second quarter of 2020. Pursuant to the Asset Purchase Agreement we entered into with S-FDF, LLC on June 9, 2020, we will need to contribute $4 million to the business in the form of proceeds from either the sale of Sponsor Shares after October 1, 2020, proceeds from a financing secured by the AESE Shares after June 9, 2020, proceeds from an equity or convertible debt financing, legal fees paid in connection with the Asset Purchase Agreement, expenses incurred by the Company after August 1, 2020 (except for severance related to change in control payments made to the Company's employees), and the Company's cash as of October 1, 2020 (the “Company Contribution”). If the Company Contribution is less than $4 million on January 1, 2021, then the Final Determination Date will be January 1, 2021. The net fair value of the Sponsor Shares is approximately $1.8 million currently, however, there can be no assurance we will be able to realize these proceeds upon the sale of the securities.\n\n| 26 |\n\nOff-Balance Sheet Arrangements\nWe have no off-balance sheet arrangements.\nCritical Accounting Policies and Estimates\nOur management’s discussion and analysis of financial conditions and results of operations is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, or GAAP. The preparation of these financial statements required us to make estimates and judgments that affect the reported amounts of assets, liabilities and expenses. On an ongoing basis, we evaluate these estimates and judgments. We base our estimates on our historical experience and on various other assumptions that we believe to be reasonable under the circumstances. These estimates and assumptions form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results and experiences may differ materially from these estimates.\nOur critical accounting policies are more fully described in Note 2 of the footnotes to our financial statements appearing elsewhere in this Form 10-Q, and Note 2 of the footnotes to the financial statements provided in our Annual Report on Form 10-K/A for the fiscal year ended December 31, 2019.\n\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide the information required by this Item\n\nWe maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed by the Company is recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission.\nOur management, under the direction of our Chief Executive Officer and Interim Chief Financial Officer has evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as such terms are defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of September 30, 2020. As part of such evaluation, management considered the matters discussed below relating to internal control over financial reporting. Based on this evaluation our management, including the Company’s Chief Executive Officer and Interim Chief Financial Officer, has concluded that the Company’s disclosure controls and procedures were effective as of September 30, 2020 to ensure that the information required to be disclosed in our Exchange Act reports was recorded, processed, summarized and reported on a timely basis.\nThere have been no changes in the Company’s internal control over financial reporting during the nine-month period ended September 30, 2020 that materially affected or are reasonably likely to materially affect the Company’s internal control over financial reporting.\n\n| 27 |\n\nPART II - OTHER INFORMATION\n\nITEM 1A.\nRISK FACTORS\n28\n\nNone.\n\nNone.\n\nNot applicable.\n\n| 31 |\n\n\nNone.\n\n\n| Exhibit | Description |\n| 3.1 | Certificate of Incorporation (incorporated by reference to Exhibit 3.1 of the Form 8-K filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on December 12, 2012) |\n| 3.2 | Bylaws (incorporated by reference to Exhibit 3.2 of the Form 8-K filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on December 12, 2012) |\n| 3.3 | Certificate of Amendment to Articles of Incorporation (incorporated by reference to Exhibit 3.1 of the Form 8-K filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on February 21, 2020) |\n| 10.1 | Business Loan Agreement dated March 10, 2020, between Cadence Bank, N.A. and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.1 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on May 15, 2020) |\n| 10.2 | Promissory Note dated March 10, 2020, between Cadence Bank, N.A. and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.2 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on May 15, 2020) |\n| 10.3 | Commercial Pledge and Security Agreement dated March 10, 2020, between Cadence Bank, N.A. and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.3 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on May 15, 2020) |\n| 10.4 | Form of Commercial Guaranty dated March 10, 2020, between Cadence Bank, N.A. and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.4 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on May 15, 2020) |\n| 10.5 | Asset Purchase Agreement dated June 9, 2020, between S-FDF, LLC and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.2 of the Form SC 13D/A filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on June 17, 2020) |\n| 10.6 | Amendment to Asset Purchase Agreement dated October 1, 2020, between S-FDF, LLC and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 2.1 of the Form 8-K filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on October 6, 2020) |\n| 10.7 | Promissory Note dated April 24, 2020, between Kensington Bank and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.6 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on August 11, 2020) |\n| 10.8 | Promissory Note dated June 16, 2020, between the U.S. Small Business Administration and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.7 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on August 11, 2020) |\n| 10.9 | Security Agreement dated June 16, 2020, between the U.S. Small Business Administration and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.8 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on August 11, 2020) |\n| 10.10 | Loan Authorization & Agreement dated June 16, 2020, between the U.S. Small Business Administration and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.9 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on August 11, 2020) |\n| 10.11* | Amended and Restated Employment Agreement dated September 30, 2020, between Kenneth DeCubellis and Black Ridge Oil & Gas, Inc |\n| 10.12* | Separation Agreement and Release dated September 30, 2020, between Michael Eisele and Black Ridge Oil & Gas, Inc. |\n| 31.1* | Section 302 Certification of Chief Executive Officer |\n| 31.2* | Section 302 Certification of Interim Chief Financial Officer |\n| 32.1* | Section 906 Certification of Chief Executive Officer |\n| 32.2* | Section 906 Certification of Interim Chief Financial Officer |\n| 101.INS* | XBRL Instance Document |\n| 101.SCH* | XBRL Schema Document |\n| 101.CAL* | XBRL Calculation Linkbase Document |\n| 101.DEF* | XBRL Definition Linkbase Document |\n| 101.LAB* | XBRL Labels Linkbase Document |\n| 101.PRE* | XBRL Presentation Linkbase Document |\n\n*Filed herewith\n\n| 32 |\n\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| BLACK RIDGE OIL & GAS, INC. |\n| Dated: November 12, 2020 | By: | /s/ Claudia Goldfarb |\n| Claudia Goldfarb, Chief Executive Officer (Principal Executive Officer) |\n| By: | /s/ Brad Burke |\n| Interim Chief Financial Officer (Principal Financial Officer) |\n\n\n| 33 |\n\n \n\nWhat will be the potential dilutive common shares increase (in units) if the company decides to issue common stock options to its CEO Michael Eisele representing 2.8% of shares?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nBLACK RIDGE OIL & GAS, INC.\\nCONDENSED BALANCE SHEETS\\n\\n| September 30, | December 31, |\\n| 2020 | 2019 |\\n| ASSETS | (Unaudited) |\\n| Current assets: |\\n| Cash | $ | 417,109 | $ | 108,756 |\\n| Investment in Allied Esports Entertainment, Inc. securities | 2,242,207 | 6,982,300 |\\n| Receivable from Allied Esports Entertainment, Inc. | – | 505 |\\n| Prepaid expenses | 25,684 | 47,151 |\\n| Total current assets | 2,685,000 | 7,138,712 |\\n| Property and equipment: |\\n| Property and equipment | – | 134,202 |\\n| Less accumulated depreciation | – | (127,803 | ) |\\n| Total property and equipment, net | – | 6,399 |\\n| Total assets | $ | 2,685,000 | $ | 7,145,111 |\\n| LIABILITIES AND STOCKHOLDERS' EQUITY |\\n| Current liabilities: |\\n| Accounts payable | $ | 110,569 | $ | 35,727 |\\n| Accrued expenses | 262,532 | 14,220 |\\n| Deferred compensation | – | 1,396,460 |\\n| Total current liabilities | 373,101 | 1,446,407 |\\n| Notes payable | 262,925 | – |\\n| Total liabilities | 636,026 | 1,446,407 |\\n| Commitments and contingencies | – | – |\\n| Stockholders' equity: |\\n| Preferred stock, $0.001 par value, 20,000,000 shares authorized, no shares issued and outstanding | – | – |\\n| Common stock, $0.001 par value, 500,000,000 shares authorized, 1,600,424 shares issued and outstanding | 1,600 | 1,600 |\\n| Additional paid-in capital | 37,825,774 | 37,054,503 |\\n| Accumulated deficit | (35,778,400 | ) | (31,357,399 | ) |\\n| Total stockholders' equity | 2,048,974 | 5,698,704 |\\n| Total liabilities and stockholders' equity | $ | 2,685,000 | $ | 7,145,111 |\\n\\nSee accompanying notes to unaudited condensed financial statements.\\n\\n| 1 |\\n\\nBLACK RIDGE OIL & GAS, INC.\\nCONDENSED STATEMENTS OF OPERATIONS\\n(Unaudited)\\n\\n| For the Three Months | For the Nine Months |\\n| Ended September 30, | Ended September 30, |\\n| 2020 | 2019 | 2020 | 2019 |\\n| Management fee income | $ | – | $ | 153,279 | $ | – | $ | 153,279 |\\n| Total revenues | – | 153,279 | – | 153,279 |\\n| Operating expenses: |\\n| General and administrative expenses: |\\n| Salaries and benefits | 483,050 | 279,621 | 936,304 | 910,191 |\\n| Stock-based compensation | 322,888 | 2,836,920 | 393,831 | 2,892,738 |\\n| Professional services | 130,234 | 40,287 | 327,090 | 79,978 |\\n| Other general and administrative expenses | 45,001 | 69,157 | 186,380 | 185,035 |\\n| Total general and administrative expenses | 981,173 | 3,225,985 | 1,843,605 | 4,067,942 |\\n| Depreciation and amortization | 380 | 131 | 1,030 | 754 |\\n| Total operating expenses | 981,553 | 3,226,116 | 1,844,635 | 4,068,696 |\\n| Net operating loss | (981,553 | ) | (3,072,837 | ) | (1,844,635 | ) | (3,915,417 | ) |\\n| Other income (expense): |\\n| Gain on deconsolidation of subsidiary | – | 26,322,687 | – | 26,322,687 |\\n| Merger incentive expense | – | (5,874,000 | ) | – | (5,874,000 | ) |\\n| Interest expense, including $-0- and $377,440 of warrants issued as a debt discount for the three and nine months ended September 30, 2020, respectively | (1,695 | ) | – | (384,456 | ) | – |\\n| Other income | 14 | – | 16 | 51 |\\n| Loss on disposal of property and equipment | (5,369 | ) | – | (5,369 | ) | – |\\n| Gain (loss) on investment in Allied Esports Entertainment, Inc. securities | (1,503,601 | ) | 2,094,690 | (2,186,557 | ) | 2,094,690 |\\n| Total other income (expense) | (1,510,651 | ) | 22,543,377 | (2,576,366 | ) | 22,543,428 |\\n| Net income (loss) before provision for income taxes | (2,492,204 | ) | 19,470,540 | (4,421,001 | ) | 18,628,011 |\\n| Provision for income taxes | – | – | – | – |\\n| Net income (loss) from continuing operations, net of tax | (2,492,204 | ) | 19,470,540 | (4,421,001 | ) | 18,628,011 |\\n| Net income from discontinued operations | – | (8,152,165 | ) | – | (7,421,050 | ) |\\n| Net income (loss) before non-controlling interest | (2,492,204 | ) | 11,318,375 | (4,421,001 | ) | 11,206,961 |\\n| Less net income attributable to redeemable non-controlling interest | – | (142,919 | ) | – | (1,332,529 | ) |\\n| Net income (loss) attributable to Black Ridge Oil & Gas, Inc. | $ | (2,492,204 | ) | $ | 11,175,456 | $ | (4,421,001 | ) | $ | 9,874,432 |\\n| Weighted average common shares outstanding - basic | 1,600,424 | 1,600,424 | 1,600,424 | 1,600,424 |\\n| Weighted average common shares outstanding - fully diluted | 1,600,424 | 1,601,241 | 1,600,424 | 1,601,337 |\\n| Net income per common share - basic | $ | (1.56 | ) | $ | 6.98 | $ | (2.76 | ) | $ | 6.17 |\\n| Net income per common share - fully diluted | $ | (1.56 | ) | $ | 6.98 | $ | (2.76 | ) | $ | 6.17 |\\n\\nSee accompanying notes to unaudited condensed financial statements.\\n\\n| 2 |\\n\\nBLACK RIDGE OIL & GAS, INC.\\nSTATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY\\n(Unaudited)\\n\\n| For the Three Months Ended September 30, 2019 |\\n| Additional | Total |\\n| Common Stock | Paid-in | Accumulated | Stockholders' |\\n| Shares | Amount | Capital | Deficit | Equity |\\n| Balance, June 30, 2019 | 1,600,424 | $ | 1,600 | $ | 37,009,795 | $ | (36,788,926 | ) | $ | 222,469 |\\n| Common stock options granted for services to employees and directors | – | – | 27,887 | – | 27,887 |\\n| Net income attributable to Black Ridge Oil & Gas, Inc. | – | – | – | 11,175,456 | 11,175,456 |\\n| Balance, September 30, 2019 | 1,600,424 | $ | 1,600 | $ | 37,037,682 | $ | (25,613,470 | ) | $ | 11,425,812 |\\n\\n\\n| For the Three Months Ended September 30, 2020 |\\n| Additional | Total |\\n| Common Stock | Paid-in | Accumulated | Stockholders' |\\n| Shares | Amount | Capital | Deficit | Equity |\\n| Balance, June 30, 2020 | 1,600,424 | $ | 1,600 | $ | 37,502,886 | $ | (33,286,196 | ) | $ | 4,218,290 |\\n| Common stock options granted for services to employees and directors | – | – | 322,888 | – | 322,888 |\\n| Net loss attributable to Black Ridge Oil & Gas, Inc. | – | – | – | (2,492,204 | ) | (2,492,204 | ) |\\n| Balance, September 30, 2020 | 1,600,424 | $ | 1,600 | $ | 37,825,774 | $ | (35,778,400 | ) | $ | 2,048,974 |\\n\\n\\n| For the Nine Months Ended September 30, 2019 |\\n| Additional | Total |\\n| Common Stock | Paid-in | Accumulated | Stockholders' |\\n| Shares | Amount | Capital | Deficit | Equity |\\n| Balance, December 31, 2018 | 1,600,424 | $ | 1,600 | $ | 36,953,977 | $ | (35,487,902 | ) | $ | 1,467,675 |\\n| Common stock options granted for services to employees and directors | – | – | 83,705 | – | 83,705 |\\n| Net income attributable to Black Ridge Oil & Gas, Inc. | – | – | – | 9,874,432 | 9,874,432 |\\n| Balance, September 30, 2019 | 1,600,424 | $ | 1,600 | $ | 37,037,682 | $ | (25,613,470 | ) | $ | 11,425,812 |\\n\\n\\n| For the Nine Months Ended September 30, 2020 |\\n| Additional | Total |\\n| Common Stock | Paid-in | Accumulated | Stockholders' |\\n| Shares | Amount | Capital | Deficit | Equity |\\n| Balance, December 31, 2019 | 1,600,424 | $ | 1,600 | $ | 37,054,503 | $ | (31,357,399 | ) | $ | 5,698,704 |\\n| Common stock options granted for services to employees and directors | – | – | 393,831 | – | 393,831 |\\n| Common stock warrants granted to employees and directors for personal guaranty on debt | – | – | 377,440 | – | 377,440 |\\n| Net loss attributable to Black Ridge Oil & Gas, Inc. | – | – | – | (4,421,001 | ) | (4,421,001 | ) |\\n| Balance, September 30, 2020 | 1,600,424 | $ | 1,600 | $ | 37,825,774 | $ | (35,778,400 | ) | $ | 2,048,974 |\\n\\nSee accompanying notes to unaudited condensed financial statements.\\n\\n| 3 |\\n\\nBLACK RIDGE OIL & GAS, INC.\\nCONDENSED STATEMENTS OF CASH FLOWS\\n(Unaudited)\\n\\n| For the Nine Months |\\n| Ended September 30, |\\n| 2020 | 2019 |\\n| CASH FLOWS FROM OPERATING ACTIVITIES |\\n| Net income (loss) attributable to Black Ridge Oil & Gas, Inc. | $ | (4,421,001 | ) | $ | 9,874,432 |\\n| Net income from discontinued operations | – | 7,421,050 |\\n| Net loss attributable to redeemable non-controlling interest | – | 1,332,529 |\\n| Adjustments to reconcile net loss attributable to Black Ridge Oil & Gas, Inc. |\\n| to net cash used in operating activities: |\\n| Gain on deconsolidation of subsidiary | – | (26,322,687 | ) |\\n| Merger incentive expense | – | 5,874,000 |\\n| Depreciation and amortization | 1,030 | 754 |\\n| Loss on disposal of property and equipment | 5,369 | – |\\n| (Gain) Loss on investment in Allied Esports Entertainment, Inc. securities, net | 2,186,557 | (2,094,690 | ) |\\n| Amortization of stock options | 393,831 | 83,705 |\\n| Amortization of stock warrants issued as a debt discount | 377,440 | – |\\n| Deferred compensation | – | 2,809,033 |\\n| Decrease (increase) in current assets: |\\n| Accounts receivable | – | 13 |\\n| Accounts receivable, related party | 505 | (181,211 | ) |\\n| Prepaid expenses | 21,467 | 17,863 |\\n| Increase (decrease) in current liabilities: |\\n| Accounts payable | 74,842 | 16,481 |\\n| Accrued expenses | 248,312 | 28,136 |\\n| Net cash used in operating activities of continuing operations | (1,111,648 | ) | (1,140,592 | ) |\\n| Net cash used in operating activities of discontinued operations | – | (8,618,568 | ) |\\n| Net cash used in operating activities | (1,111,648 | ) | (9,759,160 | ) |\\n| CASH FLOWS FROM INVESTING ACTIVITIES |\\n| Cash disposed in deconsolidation | – | (9,991,684 | ) |\\n| Purchase of property and equipment | – | (809 | ) |\\n| Proceeds received from sale of investment in Allied Esports Entertainment, Inc. securities | 1,157,076 | – |\\n| Net cash provided by (used in) investing activities of continuing operations | 1,157,076 | (9,992,493 | ) |\\n| Net cash provided by investing activities of discontinued operations | – | 16,880,792 |\\n| Net cash provided by investing activities | 1,157,076 | 6,888,299 |\\n| CASH FLOWS FROM FINANCING ACTIVITIES |\\n| Proceeds received from notes payable | 802,025 | – |\\n| Repayments on notes payable | (539,100 | ) | – |\\n| Net cash provided by financing activities from continuing operations | 262,925 | – |\\n| Net cash provided by financing activities from discontinued operations | – | 1,431,974 |\\n| Net cash provided by financing activities | 262,925 | 1,431,974 |\\n| NET CHANGE IN CASH AND CASH EQUIVALENTS | 308,353 | (1,438,887 | ) |\\n| CASH AT BEGINNING OF PERIOD | 108,756 | 1,503,500 |\\n| CASH AT END OF PERIOD | $ | 417,109 | $ | 64,613 |\\n| SUPPLEMENTAL INFORMATION: |\\n| Interest paid | $ | 4,895 | $ | – |\\n| Income taxes paid | $ | – | $ | 751,630 |\\n| NON-CASH INVESTING AND FINANCING ACTIVITIES: |\\n| Value of debt discounts attributable to warrants | $ | 377,440 | $ | – |\\n| Value of investment in securities distributed to board members and employees | $ | 1,133,281 | $ | – |\\n| Recognition of subsidiary equity upon deconsolidation | $ | – | $ | 8,498,212 |\\n| BRAC Redemptions of redeemable preferred stock from trust account | $ | – | $ | 126,205,985 |\\n| BRAC redeemable preferred stock transferred to equity | $ | – | $ | 15,865,798 |\\n| BRAC stock issued in merger | $ | – | $ | 51,632,255 |\\n| BRAC stock issued to settle intercompany debt | $ | – | $ | 19,300,000 |\\n| BRAC loan and accrued interest assumed to settle intercompany debt | $ | – | $ | 10,992,877 |\\n| BRAC stock issued to settle liabilities | $ | – | $ | 5,917,500 |\\n\\nSee accompanying notes to unaudited condensed financial statements.\\n\\n| 4 |\\n\\nBLACK RIDGE OIL & GAS, INC.\\nNotes to Condensed Financial Statements\\n(Unaudited)\\nNote 1 – Organization and Nature of Business\\nEffective April 2, 2012, Ante5, Inc. changed its corporate name to Black Ridge Oil & Gas, Inc., and continues to be quoted on the OTCQB under the trading symbol “ANFC”. Black Ridge Oil & Gas, Inc. (formerly Ante5, Inc.) (the “Company” and “BROG”) became an independent company in April 2010. We became a publicly traded company when our shares began trading on July 1, 2010. From October 2010 through August 2019, we had been engaged in the business of acquiring oil and gas leases and participating in the drilling of wells in the Bakken and Three Forks trends in North Dakota and Montana and /or managing similar assets for third parties.\\nOn September 26, 2017, the Company finalized an equity raise utilizing a rights offering and backstop agreement, raising net proceeds of $5,051,675 and issuing 1,439,400 shares. The proceeds were used to sponsor a special purpose acquisition company, discussed below, with the remainder for general corporate purposes.\\nOn October 10, 2017, the Company’s sponsored special purpose acquisition company, Black Ridge Acquisition Corp. (“BRAC”), completed an IPO raising $138,000,000 of gross proceeds (including proceeds from the exercise of an over-allotment option by the underwriters on October 18, 2017). In addition, the Company purchased 445,000 BRAC units at $10.00 per unit in a private placement transaction for a total contribution of $4,450,000 in order to fulfill its obligations in sponsoring BRAC, a blank check company formed for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities. BRAC’s efforts to identify a prospective target business were not limited to a particular industry or geographic region. Following the IPO and over-allotment, BROG owned 22% of the outstanding common stock of BRAC and managed BRAC’s operations via a management services agreement. On December 19, 2018, BRAC entered into a business combination agreement, which subsequently closed on August 9, 2019.\\nOn October 1, 2020 the Company completed its acquisition of S-FDF, LLC pursuant to an Asset Purchase Agreement detailed in Footnote 15, Subsequent Events. In connection with the closing of the Asset Purchase Agreement, the Company acquired $2.5 million in cash and certain assets and agreements related to the Seller’s freeze-dried fruits and vegetables business for human consumption and entered into certain employment and registration rights agreements.\\nThe Company currently owns 1,779,529 shares of Allied Esports Entertainment, Inc. (NASDAQ: AESE), the surviving entity after BRAC’s business combination (“Sponsor Shares”), after selling 368,871 shares for total proceeds of $1,282,067, selling warrants to purchase 505,000 shares of AESE (NASDAQ: AESEW) (“Sponsor Warrants”) for total proceeds of $73,668, and distributing 537,100 Sponsor Shares on August 9, 2020 to employees and directors under the 2018 Management Incentive Plan, dated March 6, 2018.\\nNote 2 – Basis of Presentation and Significant Accounting Policies\\nThe interim condensed financial statements included herein, presented in accordance with United States generally accepted accounting principles and stated in US dollars, have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations, although the Company believes that the disclosures are adequate to not make the information presented misleading.\\nThese statements reflect all adjustments, which in the opinion of management, are necessary for fair presentation of the information contained therein. Except as otherwise disclosed, all such adjustments are of a normal recurring nature. It is suggested that these interim condensed financial statements be read in conjunction with the audited financial statements for the year ended December 31, 2019, which were included in our Annual Report on Form 10-K/A. The Company follows the same accounting policies in the preparation of interim reports.\\n\\n| 5 |\\n\\nBLACK RIDGE OIL & GAS, INC.\\nNotes to Condensed Financial Statements\\n(Unaudited)\\nReclassifications\\nIn the prior year, the income, expense and cash flows from Black Ridge Acquisition Corp., a wholly-owned subsidiary formed on October 10, 2017, which was consolidated as a variable interest entity through August 9, 2019, the date that BRAC completed a business combination with Allied Esports Entertainment, Inc. (“AESE”), were consolidated and have been retrospectively classified as discontinued operations. In addition, prior period investment in Allied Esports Entertainment, Inc. securities of $6,982,300 were reclassified from long term assets to current assets to conform to current period presentation.\\nUse of Estimates\\nThe preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates.\\nEnvironmental Liabilities\\nThe Company was formerly a direct owner of assets in the oil and gas industry. Oil and gas companies are subject, by their nature, to environmental hazard and clean-up costs. At this time, management knows of no substantial losses from environmental accidents or events which would have a material effect on the Company.\\nCash in Excess of FDIC Limits\\nThe Company maintains its cash in bank deposit accounts which, at times, may exceed federally insured limits. Accounts are guaranteed by the Federal Deposit Insurance Corporation (FDIC) and the Securities Investor Protection Corporation (SIPC) up to $250,000 and $500,000, respectively, under current regulations. The Company didn’t have any cash in excess of SIPC insured limits at September 30, 2020, and has not experienced any losses in such accounts.\\nIncome Taxes\\nThe Company recognizes deferred tax assets and liabilities based on differences between the financial reporting and tax basis of assets and liabilities using the enacted tax rates and laws that are expected to be in effect when the differences are expected to be recovered. The Company provides a valuation allowance for deferred tax assets for which it does not consider realization of such assets to be more likely than not.\\nBasic and Diluted Earnings (Loss) Per Share\\nBasic earnings (loss) per share (“EPS”) are computed by dividing net income (the numerator) by the weighted average number of common shares outstanding for the period (the denominator). Diluted EPS is computed by dividing net income by the weighted average number of common shares and potential common shares outstanding (if dilutive) during each period. Potential common shares include stock options, warrants and restricted stock. The number of potential common shares outstanding relating to stock options, warrants and restricted stock is computed using the treasury stock method.\\n\\n| 6 |\\n\\nBLACK RIDGE OIL & GAS, INC.\\nNotes to Condensed Financial Statements\\n(Unaudited)\\nThe reconciliation of the denominators used to calculate basic EPS and diluted EPS for the three and nine months ended September 30, 2020 and 2019 are as follows:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| 2020 | 2019 | 2020 | 2019 |\\n| Weighted average common shares outstanding – basic | 1,600,424 | 1,600,424 | 1,600,424 | 1,600,424 |\\n| Plus: Potentially dilutive common shares: |\\n| Common stock warrants | – | 817 | – | 913 |\\n| Weighted average common shares outstanding – diluted | 1,600,424 | 1,601,241 | 1,600,424 | 1,601,337 |\\n\\nFor the three and nine months ended September 30, 2020, potential dilutive securities had an anti-dilutive effect and were not included in the calculation of diluted net loss per common share. Stock options and warrants excluded from the calculation of diluted EPS because their effect was anti-dilutive were 35,488 three and nine months ended September 30, 2019.\\nFair Value of Financial Instruments\\nUnder FASB ASC 820-10-05, the Financial Accounting Standards Board establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. This Statement reaffirms that fair value is the relevant measurement attribute. The adoption of this standard did not have a material effect on the Company’s financial statements as reflected herein. The carrying amounts of cash, accounts payable and accrued expenses reported on the balance sheets are estimated by management to approximate fair value primarily due to the short-term nature of the instruments. The Company had no items that required fair value measurement on a recurring basis.\\nProperty and Equipment\\nProperty and equipment are recorded at cost and depreciated using the straight-line method over their estimated useful lives of three to seven years. Expenditures for replacements, renewals, and betterments are capitalized. Maintenance and repairs are charged to operations as incurred. Long-lived assets are evaluated for impairment to determine if current circumstances and market conditions indicate the carrying amount may not be recoverable. Depreciation expense was $1,030 and $754 for the nine months ended September 30, 2020 and 2019, respectively.\\nRevenue Recognition\\nThe Company recognizes revenue in accordance with ASC 606 — Revenue from Contracts with Customers. Under ASC 606, the Company recognized revenue from management services through our previously consolidated Special Purpose Acquisition Company (“SPAC”), Black Ridge Acquisition Corp. until December 31, 2019.\\nRevenue was primarily generated from BRAC in the form of management services performed within the state of Minnesota on a fixed fee basis. Revenue from the performance of those services was recognized upon completion of the services, at which time the services were delivered to the customer, and collectability of the fee was reasonably assured. We typically required payment within thirty days of the completion of services. Management estimates an allowance for doubtful accounts based on the aging of its receivables.\\n\\n| 7 |\\n\\nBLACK RIDGE OIL & GAS, INC.\\nNotes to Condensed Financial Statements\\n(Unaudited)\\nStock-Based Compensation\\nThe Company accounts for equity instruments issued to employees in accordance with the provisions of ASC 718 Stock Compensation (ASC 718) and Equity-Based Payments to Non-employees pursuant to ASC 2018-07 (ASC 2018-07). All transactions in which the consideration provided in exchange for the purchase of goods or services consists of the issuance of equity instruments are accounted for based on the fair value of the consideration received or the fair value of the equity instrument issued, whichever is more reliably measurable. The measurement date of the fair value of the equity instrument issued is the earlier of the date on which the counterparty’s performance is complete or the date at which a commitment for performance by the counterparty to earn the equity instruments is reached because of sufficiently large disincentives for nonperformance. Stock-based compensation was $393,831 and $83,705, consisting entirely of expenses related to common stock options issued for services for the nine months ended September 30, 2020 and 2019, respectively, using the Black-Scholes options pricing model and an effective term of 6 to 6.5 years based on the weighted average of the vesting periods and the stated term of the option grants and the discount rate on 5 to 7 year U.S. Treasury securities at the grant date. In addition, $377,440 of expenses related to the amortization of warrants issued in consideration of personal guarantees provided for debt financing for the nine months ended September 30, 2020, using the Black-Scholes options pricing model and an effective term of 5 years based on the weighted average of the vesting periods and the stated term of the warrant grants and the discount rate on 5 year U.S. Treasury securities at the grant date were recognized as interest expense for the nine months ended September 30, 2020.\\nUncertain Tax Positions\\nIn accordance with ASC 740, “Income Taxes” (“ASC 740”), the Company recognizes the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be capable of withstanding examination by the taxing authorities based on the technical merits of the position. These standards prescribe a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. These standards also provide guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.\\nVarious taxing authorities may periodically audit the Company’s income tax returns. These audits include questions regarding the Company’s tax filing positions, including the timing and amount of deductions and the allocation of income to various tax jurisdictions. In evaluating the exposures connected with these various tax filing positions, including state and local taxes, the Company records allowances for probable exposures. A number of years may elapse before a particular matter, for which an allowance has been established, is audited and fully resolved. Black Ridge Oil & Gas, Inc. has not yet undergone an examination by any taxing authorities.\\nThe assessment of the Company’s tax position relies on the judgment of management to estimate the exposures associated with the Company’s various filing positions.\\nRecent Accounting Pronouncements\\nFrom time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board (“FASB”) that are adopted by the Company as of the specified effective date. If not discussed below, management believes there have been no developments to recently issued accounting standards, including expected dates of adoption and estimated effects on our financial statements, from those disclosed in our Annual Report on Form 10-K/A for the year ended December 31, 2019.\\nIn July 2018, the FASB issued ASU No. 2018-10, Codification Improvements to Topic 842, Leases. The amendments in ASU 2018-10 provide additional clarification and implementation guidance on certain aspects of the previously issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”) and have the same effective and transition requirements as ASU 2016-02. Upon the effective date, ASU 2018-10 will supersede the current lease guidance in ASC Topic 840, Leases. Under the new guidance, lessees will be required to recognize for all leases, with the exception of short-term leases, a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis. Concurrently, lessees will be required to recognize a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. ASU 2018-10 is effective for private companies and emerging growth public companies for interim and annual reporting periods beginning after December 15, 2019, with early adoption permitted. The guidance is required to be applied using a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative periods presented in the financial statements. The Company adopted this guidance effective January 1, 2019, and the standard did not have a material impact on the Company’s financial statements and related disclosures until the closing of the asset purchase with S-FDF, LLC on October 1, 2020.\\n\\n| 8 |\\n\\nBLACK RIDGE OIL & GAS, INC.\\nNotes to Condensed Financial Statements\\n(Unaudited)\\nNote 3 – Going Concern\\nAs shown in the accompanying financial statements, as of September 30, 2020, the Company has incurred recurring losses from operations resulting in an accumulated deficit of $35,778,400. As of September 30, 2020, the Company’s cash on hand may not be sufficient to sustain operations. These factors raise substantial doubt about the Company’s ability to continue as a going concern. The Company is currently seeking sources of capital to fund the requirements of the Asset Purchase Agreement. The Company intends to sell its AESE shares to continue as a going concern, however, there can be no assurance the share price will be sufficient to sustain operations, therefore the Company may be dependent upon its ability to secure equity and/or debt financing and there are also no assurances that the Company will be successful; therefore, without sufficient financing it would be unlikely for the Company to continue as a going concern.\\nThe financial statements do not include any adjustments that might result from the outcome of any uncertainty as to the Company’s ability to continue as a going concern. The financial statements also do not include any adjustments relating to the recoverability and classification of recorded asset amounts, or amounts and classifications of liabilities that might be necessary should the Company be unable to continue as a going concern.\\nNote 4 – Related Party\\nManagement Incentive Plan\\nOn March 1, 2018, the Board of Directors (the “Board”) of the Company approved and adopted the Black Ridge Gas, Inc. 2018 Management Incentive Plan (the “Plan”) and the form of 2018 Management Incentive Plan Award Agreement (the “Award Agreement”).\\nIn connection with the approval of the Plan and Award Agreement, the Board approved the issuance of awards (the “Awards”) to certain individuals including officers and directors (the “Grantees”), representing a percentage of the shares of BRAC held by the Company as of the date of closing of a business combination for the acquisition of a target business as described in the BRAC prospectus dated October 4, 2017, as follows:\\n\\n| Percentage of BRAC Shares Owned by the |\\n| Name | Company Granted to the Grantee |\\n| Bradley Berman | 1.6% |\\n| Lyle Berman | 1.6% |\\n| Benjamin Oehler | 1.6% |\\n| Joe Lahti | 1.6% |\\n| Kenneth DeCubellis | 4.0% |\\n| Michael Eisele | 2.8% |\\n| James Moe | 2.1% |\\n\\nFollowing the AESE merger on August 9, 2019, the Company owned 2,685,500 shares of AESE common stock and 505,000 warrants to purchase AESE (NASDAQ: AESEW). During the nine months ending September 30, 2020, the Company sold some of these securities, resulting in gross proceeds of $1,157,076, consisting of 368,870 shares of common stock for total proceeds of $1,083,408, and the sale of warrants to purchase 505,000 shares for total proceeds of $73,668. The Company also distributed 537,101 Sponsor Shares on August 9, 2020 to employees and directors under the 2018 Management Incentive Plan. Employees and directors were required to remain in their positions for a one-year period from the AESE merger, with certain exceptions, to receive the granted shares. The AESE Plan Shares had a fair market value of $1,133,281 on August 10, 2020, when the shares were distributed. The Company recognized $1,396,460 of compensation expense related to the Plan during the year ended December 31, 2019. For the nine months ended September 30, 2020, the Company recognized a gain of $263,179 related to the reduction in the value of the shares to be paid to employees on August 10, 2020, which was offset against the Company’s loss on the investment in AESE shares due to changes in the AESE market price between December 31, 2019 and September 30, 2020.\\nLease Agreement\\nUpon closing of the Asset Purchase Agreement, the Company assumed the Seller’s obligations under a real property lease for its facility in Irving, Texas under which an entity owned entirely by Ira Goldfarb is the landlord.\\n\\n| 9 |\\n\\nBLACK RIDGE OIL & GAS, INC.\\nNotes to Condensed Financial Statements\\n(Unaudited)\\nNote 5 – Fair Value of Financial Instruments\\nUnder FASB ASC 820-10-5, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (an exit price). The standard outlines a valuation framework and creates a fair value hierarchy in order to increase the consistency and comparability of fair value measurements and the related disclosures. Under GAAP, certain assets and liabilities must be measured at fair value, and FASB ASC 820-10-50 details the disclosures that are required for items measured at fair value.\\nThe Company has cash and cash equivalents and a revolving credit facility that must be measured under the fair value standard. The Company’s financial assets and liabilities are measured using inputs from the three levels of the fair value hierarchy. The three levels are as follows:\\nLevel 1 - Inputs are unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date.\\nLevel 2 - Inputs include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates, yield curves, etc.), and inputs that are derived principally from or corroborated by observable market data by correlation or other means (market corroborated inputs).\\nLevel 3 - Unobservable inputs that reflect our assumptions about the assumptions that market participants would use in pricing the asset or liability.\\nThe following schedule summarizes the valuation of financial instruments at fair value on a recurring basis in the balance sheets as of September 30, 2020 and December 31, 2019:\\n\\n| Fair Value Measurements at September 30, 2020 |\\n| Level 1 | Level 2 | Level 3 |\\n| Assets |\\n| Cash | $ | 417,109 | $ | – | $ | – |\\n| Investment in Allied Esports Entertainment, Inc. securities | 2,242,207 | – | – |\\n| Total assets | 2,659,316 | – | – |\\n| Liabilities |\\n| Notes payable | – | (262,925 | ) | – |\\n| Total liabilities | – | (262,925 | ) | – |\\n| $ | 2,659,316 | $ | (262,925 | ) | $ | – |\\n\\n\\n| 10 |\\n\\nBLACK RIDGE OIL & GAS, INC.\\nNotes to Condensed Financial Statements\\n(Unaudited)\\n\\n| Fair Value Measurements at December 31, 2019 |\\n| Level 1 | Level 2 | Level 3 |\\n| Assets |\\n| Cash | $ | 108,756 | $ | – | $ | – |\\n| Investment in Allied Esports Entertainment, Inc. | 6,982,300 | – | – |\\n| Total assets | 7,091,056 | – | – |\\n| Liabilities |\\n| None | – | – | – |\\n| Total liabilities | – | – | – |\\n| $ | 7,091,056 | $ | – | $ | – |\\n\\nThere were no transfers of financial assets or liabilities between Level 1 and Level 2 inputs for the nine months ended September 30, 2020.\\nNote 6 – Prepaid Expenses\\nPrepaid expenses consist of the following:\\n\\n| September 30, | December 31, |\\n| 2020 | 2019 |\\n| Prepaid insurance costs | $ | 3,185 | $ | 21,090 |\\n| Prepaid employee benefits | 8,082 | 11,587 |\\n| Prepaid office and other costs | 14,417 | 14,474 |\\n| Total prepaid expenses | $ | 25,684 | $ | 47,151 |\\n\\nNote 7 – Property and Equipment\\nProperty and equipment at September 30, 2020 and December 31, 2019, consisted of the following:\\n\\n| September 30, | December 31, |\\n| 2020 | 2019 |\\n| Property and equipment | $ | – | $ | 134,202 |\\n| Less: Accumulated depreciation and amortization | – | (127,803 | ) |\\n| Total property and equipment, net | $ | – | $ | 6,399 |\\n\\nOn September 30, 2020, the Company disposed of computer equipment no longer in service. No proceeds were received on the disposal of the equipment, resulting in a loss on disposal of fixed assets of $5,369, which represented the net book value at the time of disposal.\\nThe Company recognized depreciation expense of $1,030 and $754 for the nine-month periods ended September 30, 2020 and 2019, respectively.\\n\\n| 11 |\\n\\nBLACK RIDGE OIL & GAS, INC.\\nNotes to Condensed Financial Statements\\n(Unaudited)\\nNote 8 – Investment in Allied Esports Entertainment, Inc.\\nFollowing the close of BRAC’s merger, the Company retained 2,685,500 shares of Allied Esports Entertainment Inc. (NASDAQ: AESE) common stock with a value, based on the closing stock of $4.45 on the merger, of $11,950,475, and tradeable warrants to purchase 505,000 shares of AESE (NASDAQ: AESEW) (“Sponsor Warrants”), of which the Company currently owns 1,779,529 shares, after selling 368,870 shares for total proceeds of $1,157,076, selling warrants to purchase 505,000 Sponsor Warrants for total proceeds of $73,668, and distributing 537,101 Sponsor Shares on August 10, 2020 to employees and directors under the 2018 Management Incentive Plan. As noted in Note 4 - Related Party Transactions, 20% or 537,101, of the shares were distributed to employees, officers and directors one year from the date of the merger, or on August 10, 2020. After the distribution and recent sales, the Company still holds 1,799,529 shares of AESE common stock.\\nAs of September 30, 2020, the market value of the Company’s investment in AESE’s common stock was $2,242,207, based on the closing stock price of $1.26 per share, resulting in gains and losses on our investment in securities, as follows:\\n\\n| Net loss on investment in Allied Esports Entertainment, Inc. securities for the nine months ended September 30, 2020 | $ | (2,186,557 | ) |\\n| Less: Net gains and losses recognized during 2020 on equity securities sold during the period | (198,012 | ) |\\n| Unrealized losses recognized during 2020 on equity securities still held at September 30, 2020 | $ | (2,384,569 | ) |\\n\\nDuring the third quarter of 2020, the Company sold 51,902 of these shares for total proceeds of $120,596, resulting in a loss on investment of $14,352.\\nDuring the second quarter of 2020, the Company sold 316,968 of these shares for total proceeds of $962,812, resulting in a gain on investment of $363,813.\\nIn accordance with a brokerage account agreement with RBC Capital Markets, LLC, 500,000 of these shares were used as collateral for a $700,000 promissory note pursuant to a commercial pledge and security agreement, dated March 10, 2020, described below, which was subsequently repaid. Under this standard brokerage agreement, the Company will be able to borrow funds secured by the value of the AESE shares pursuant to a standard margin account arrangement.\\n\\n| 12 |\\n\\nBLACK RIDGE OIL & GAS, INC.\\nNotes to Condensed Financial Statements\\n(Unaudited)\\nNote 9 – Notes Payable\\nNotes payable consists of the following at September 30, 2020 and December 31, 2019, respectively:\\n\\n| September 30, | December 31, |\\n| 2020 | 2019 |\\n| On June 16, 2020, the Company entered into a loan authorization and loan agreement with the United States Small Business Administration (the “SBA”), as lender, pursuant to the SBA’s Economic Injury Disaster Loan (“EIDL”) assistance program in light of the impact of the COVID-19 pandemic on the Company’s business (the “EIDL Loan Agreement”) encompassing a $150,000 Promissory Note issued to the SBA (the “EIDL Note”)(together with the EIDL Loan Agreement, the “EIDL Loan”), bearing interest at 3.75% per annum. In connection with entering into the EIDL Loan, the Company also executed a security agreement, dated June 16, 2020, between the SBA and the Company (the “EIDL Security Agreement”) pursuant to which the EIDL Loan is secured by a security interest on all of the Company’s assets. Under the EIDL Note, the Company is required to pay principal and interest payments of $731 every month beginning June 16, 2021. All remaining principal and accrued interest is due and payable on June 16, 2050. The EIDL Note may be repaid at any time without penalty. | $ | 150,000 | $ | – |\\n| On April 24, 2020, the Company entered into a loan agreement with Kensington Bank (“Kensington”), as lender (the “Loan Agreement”) encompassing a $112,925 Promissory Note issued to Kensington (the “PPP Note”) pursuant to Payroll Protection Program established as part of the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), which provides loans to qualifying businesses and is administered by the U.S. Small Business Administration (the “SBA”). The PPP Note bears interest at 1.00% per annum, with interest payable monthly beginning November 24, 2020, and principal due in full on April 24, 2022. The PPP Note may be repaid at any time without penalty. Under the Payroll Protection Program, the Company will be eligible for loan forgiveness up to the full amount of the PPP Note and any accrued interest. The forgiveness amount will be equal to the amount that the Company spends during the 24-week period beginning April 24, 2020 on payroll costs, payment of rent on any leases in force prior to February 15, 2020 and payment on any utility for which service began before February 15, 2020. The maximum amount of loan forgiveness for non-payroll expenses is 40% of the amount of the PPP Note. No assurance is provided that the Company will obtain forgiveness under the PPP Note in whole or in part. | 112,925 | – |\\n| On November 25, 2019, the Company entered into a credit account agreement (“Margin Account”) with RBC Capital Markets, LLC (“RBC”). The Margin Account enables the Company to borrow against the Company’s AESE shares that are held in an account with RBC. The advances received on margin bear interest at rates of between 1.00% and 2.75% over the Base Lending Rate, depending on the average outstanding debit balance. The Base Lending Rate is internally determined by RBC using Broker Call, Prime Rate as determined by commercial banks utilized by RBC CM, Fed Funds, RBC CM’s cost of funds, and other commercially recognized rates of interest. The margin loans are collateralized by the underlying AESE shares. A total of $122,100 was borrowed on the Margin Account over various dates between January 29, 2020 and March 6, 2020. The outstanding balance was repaid in full on, or about, March 12, 2020 out of the proceeds of the loan from Cadence Bank, described below. | – | – |\\n\\n\\n| 13 |\\n\\nBLACK RIDGE OIL & GAS, INC.\\nNotes to Condensed Financial Statements\\n(Unaudited)\\n\\n| On March 12, 2020, the Company entered into a business loan agreement with Cadence Bank, N.A. (“Cadence”), as lender encompassing a $700,000 Promissory Note issued to Cadence (the “Note”), a Security Agreement by the Company in favor of Cadence and limited commercial guarantees by the Company’s Chief Executive Officer and Interim Chief Financial Officer, who is one in the same, and members of the Company’s Board of Directors (the “Guarantors”) (collectively, the “Cadence Loan”). The Note carried interest at a rate of 0.50 percentage points over the prime rate, as published in the Wall Street Journal, payable monthly, and was due on March 9, 2021. The Note could be repaid at any time without penalty. The Note was secured by all of the Company’s rights, title and interests in and to 500,000 shares of the common stock of Allied Esports Entertainment Inc. (NASDAQ: AESE) currently owned by the Company and held in the Company’s brokerage account with RBC Capital Markets, LLC. On March 26, 2020, the Company subsequently entered into a separate letter agreement with the Guarantors (the “Letter Agreement”), which provides that if the Company defaults or fails to make any payment due under the Cadence Loan and the Guarantors are required to make payment to Cadence pursuant to the Guarantees, then the Company agrees to issue additional equity interests or rights to Guarantors reflecting ninety-five percent (95%) of the outstanding equity of the Company at the time of such default to participating Guarantors who have made the payments to Cadence. All equity issuances will be subject to any third party or shareholder approvals required at the time of issuance. A total of $417,000 was advanced on the loan and subsequently repaid in full on June 30, 2020. | – | – |\\n| Total notes payable | 262,925 | – |\\n| Less unamortized derivative discounts: | – | – |\\n| Notes payable | 262,925 | – |\\n| Less: current maturities | – | – |\\n| Notes payable, less current maturities | $ | 262,925 | $ | – |\\n\\nThe Company recorded total discounts of $377,440, consisting of debt discounts on warrants granted to four officers and directors for warrants issued in consideration of personal guarantees provided for debt financing incurred during the nine months ended September 30, 2020. The discounts were amortized to stock-based compensation expense over the term of the note, until repayment, using the straight-line method, which closely approximated the effective interest method. The Company recorded $377,440 of stock-based compensation expense pursuant to the amortization of note discounts during the nine months ended September 30, 2020.\\nThe Company recognized $384,456 of interest expense, consisting of $7,016 of interest and $377,440 of stock-based warrant expense pursuant to the amortization of the debt discount on the business loans during the nine months ended September 30, 2020.\\nNote 10 – Changes in Stockholders’ Equity\\nReverse Stock Split\\nOn February 21, 2020, the Company effected a 1-for-300 reverse stock split (the “Reverse Stock Split”). No fractional shares were issued. Instead, the Company issued the following to any stockholder who otherwise would have received a fractional share as a result of the Reverse Stock Split:\\n| · | Stockholders owning 300 or more shares of Common Stock received (1) one share of Common Stock for every 300 shares owned and (2) cash in lieu of fractional shares upon the surrender of such stockholder’s shares; |\\n| · | Stockholders owning between 25 and 300 shares of Common Stock had their ownership of shares of Common Stock rounded up to one share; and |\\n| · | Stockholders owning fewer than 25 shares of Common Stock received cash in lieu of fractional shares upon the surrender of such stockholders’ shares and no longer own shares of Common Stock. |\\n\\n\\n| 14 |\\n\\nBLACK RIDGE OIL & GAS, INC.\\nNotes to Condensed Financial Statements\\n(Unaudited)\\nAny cash payment in lieu of fractional shares were based on the volume weighted average of the closing sales prices of the Company’s Common Stock on the OTCQB operated by OTC Markets Group Inc. (the “OTCQB”) during regular trading hours for the five consecutive trading days immediately preceding the Effective Date, which was $0.018 per share prior to the effects of the reverse stock split.\\nThe Company was authorized to issue 500,000,000 shares of common stock prior to the Reverse Stock Split, which remains unaffected. The Reverse Stock Split did not have any effect on the stated par value of the common stock, or the Company’s authorized preferred stock. Unless otherwise stated, all share and per share information in this Interim Report has been retroactively adjusted to reflect the Reverse Stock Split.\\nPreferred Stock\\nThe Company has 20,000,000 authorized shares of $0.001 par value preferred stock. No shares have been issued to date.\\nCommon Stock\\nThe Company has 500,000,000 authorized shares of $0.001 par value common stock. As of September 30, 2020, and December 31, 2019, a total of 1,600,424 shares of common stock have been issued.\\nNote 11 – Options\\nThe 2020 Equity Plan was approved by written consent of a majority of shareholders of record as of November 12, 2019 and adopted by the Board on December 5, 2019, as provided in the definitive information statement filed with Securities and Exchange Commission on January 10, 2020 (the “DEF 14C”). The description of the 2020 Equity Plan is qualified in its entirety by the text of the 2020 Equity Plan, a copy of which was attached as Annex C to the DEF 14C.\\nOutstanding Options\\nOptions to purchase an aggregate total of 273,871 shares of common stock at a weighted average strike price of $16.32, exercisable over a weighted average life of 8.75 years were outstanding as of September 30, 2020.\\nOptions Granted\\nOn February 26, 2020, the Company’s Board of Directors granted an aggregate amount of 240,000 stock options pursuant to the 2020 Equity Plan to purchase shares of the Company’s common stock to several officers, directors, and employees at an exercise price of $5.41 per share, which represents the closing price of the Company’s shares on the OTCQB marketplace on February 20, 2020. The officers and directors receiving grants and the amounts of such grants were as follows:\\n\\n| Stock Option |\\n| Name and Title | Shares Granted |\\n| Ken DeCubellis, Chief Executive Officer and Interim Chief Financial Officer | 60,377 |\\n| Michael Eisele, Chief Operating Officer | 42,264 |\\n| Bradley Berman, Chairman of the Board and Director | 24,151 |\\n| Joseph Lahti, Director | 24,151 |\\n| Benjamin Oehler, Director | 24,151 |\\n| Lyle Berman, Director | 24,151 |\\n| Total: | 199,245 |\\n\\nAll of the stock options granted under the 2020 Equity Plan presented in the table above will vest in five equal installments, commencing one year from the date of grant on February 26, 2021, and continuing for the next four anniversaries thereof until fully vested, with the exception of 83,019 options that were awarded to four employees, whose vesting periods were accelerated to be fully vested as of September 30, 2019, pursuant to severance agreements.\\nNo options were granted during the nine months ended September 30, 2019.\\nThe Company recognized a total of $393,831, and $83,705 of compensation expense during the nine months ended September 30, 2020 and 2019, respectively, related to common stock options issued to Employees and Directors that are being amortized over the implied service term, or vesting period, of the options. The remaining unamortized balance of these options is $517,070 as of September 30, 2020.\\n\\n| 15 |\\n\\nBLACK RIDGE OIL & GAS, INC.\\nNotes to Condensed Financial Statements\\n(Unaudited)\\nOptions Exercised\\nNo options were exercised during the nine months ended September 30, 2020 and 2019.\\nOptions Forfeited\\nA total of 333 options with a weighted average exercise price of $90, and 457 options with a weighted average exercise price of $9.83 expired and were forfeited during the nine months ended September 30, 2020 and 2019, respectively.\\nNote 12 – Warrants\\nOutstanding Warrants\\nWarrants to purchase an aggregate total of 106,300 shares of common stock at a $3.99 strike price, exercisable over a weighted average life of 9.36 years were outstanding as of September 30, 2020.\\nWarrants Granted\\nIn consideration for four officers and director’s willingness to serve as guarantors of the Cadence Loan, the Company issued warrants to each of the Guarantors (the “Guarantor Warrants”) for the purchase of the Company’s common stock on March 12, 2020. The Guarantor Warrants entitle each Guarantor to purchase 26,250 shares of the Company's common stock (the “Warrant Shares”) at an exercise price of $4.00 per share. The Guarantor Warrants expire on March 12, 2030. No warrants were granted during the comparative nine months ended September 30, 2019. The officers and directors receiving grants and the amounts of such grants were as follows:\\n\\n| Stock Warrant |\\n| Name and Title | Shares Granted |\\n| Ken DeCubellis, Chief Executive Officer and Interim Chief Financial Officer | 26,250 |\\n| Bradley Berman, Chairman of the Board and Director | 26,250 |\\n| Lyle Berman, Director | 26,250 |\\n| Benjamin Oehler, Director | 26,250 |\\n| Total: | 105,000 |\\n\\nWarrants Exercised\\nNo warrants were exercised during the nine months ended September 30, 2020 and 2019.\\n\\n| 16 |\\n\\nBLACK RIDGE OIL & GAS, INC.\\nNotes to Condensed Financial Statements\\n(Unaudited)\\nNote 13 – Income Taxes\\nThe Company accounts for income taxes under ASC Topic 740, Income Taxes, which provides for an asset and liability approach of accounting for income taxes. Under this approach, deferred tax assets and liabilities are recognized based on anticipated future tax consequences, using currently enacted tax laws, attributed to temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts calculated for income tax purposes.\\nLosses incurred during the period from April 9, 2011 (inception) to September 30, 2020 could be used to offset future tax liabilities. Accounting standards require the consideration of a valuation allowance for deferred tax assets if it is “more likely than not” that some component or all of the benefits of deferred tax assets will not be realized. As of September 30, 2020, net deferred tax assets were $7,013,057, with no deferred tax liability, primarily related to net operating loss carryforwards. A valuation allowance of approximately $7,013,057 was applied to the net deferred tax assets. Therefore, BROG has no tax expense for 2020 to date.\\nIn accordance with FASB ASC 740, the Company has evaluated its tax positions and determined there are no significant uncertain tax positions as of any date on, or before September 30, 2020.\\nNote 14 – Commitments\\nThe Company from time to time may be involved in various inquiries, administrative proceedings and litigation relating to matters arising in the normal course of business. The Company is not aware of any inquiries or administrative proceedings and is not currently a defendant in any material litigation and is not aware of any threatened litigation that could have a material effect on the Company.\\nThe Company periodically maintains cash balances at banks in excess of federally insured amounts. The extent of loss, if any, to be sustained as a result of any future failure of a bank or other financial institution is not subject to estimation at this time.\\nNote 15 – Subsequent Events\\nThe Company evaluates events that have occurred after the balance sheet date through the date these financial statements were issued.\\nAsset Purchase\\nOn October 1, 2020, the Company completed its acquisition of S-FDF, LLC, a Texas limited liability company, pursuant to an Asset Purchase Agreement, between the Company and the Seller, dated June 9, 2020, as subsequently amended effective October 1, 2020. In connection with the closing of the Asset Purchase Agreement, the Company acquired $2.5 million in cash and certain assets and agreements related to the Seller’s freeze-dried fruits and vegetables business for human consumption and entered into certain employment and registration rights agreements. The Company did not assume any liabilities of Seller or any liabilities, liens, or encumbrances pertaining to or encumbering the Purchased Assets except for those related to agreements or arrangements specified in the Asset Purchase Agreement. The Seller transferred the Purchased Assets to the Company in exchange for the issuance of 1,120,000 shares of the Company’s common stock to the Seller, representing 41.18% of the Company’s issued and outstanding common stock. The number of Seller Shares to be issued is subject to adjustment, as specified in the Asset Purchase Agreement, based on the extent to which the amount of cash proceeds held by the Company, as derived from the sale of the Company’s holdings of Sponsor Shares, are less than $5 million or greater than $6 million on the date specified in the Asset Purchase Agreement.\\nThe Final Determination Date will be the first anniversary of the closing of the Asset Purchase Agreement and the Company has contributed $4 million to the business in the form of proceeds from either the sale of Sponsor Shares after October 1, 2020, proceeds from a financing secured by the AESE Shares after June 9, 2020, proceeds from an equity or convertible debt financing, legal fees paid in connection with the Asset Purchase Agreement, expenses incurred by the Company after August 1, 2020 (except for severance related to change in control payments made to the Company's employees), and the Company's cash as of October 1, 2020 (the “Company Contribution”). If the Company Contribution is less than $4 million on January 1, 2021, then the Final Determination Date will be January 1, 2021.\\n\\n| 17 |\\n\\nBLACK RIDGE OIL & GAS, INC.\\nNotes to Condensed Financial Statements\\n(Unaudited)\\nPursuant to its obligations under the Asset Purchase Agreement, on the Closing Date the Company, (a) created three new seats on the Company’s Board of Directors and appointed the Seller’s principals, Ira Goldfarb and Claudia Goldfarb, and a third person designated by the Goldfarbs, Greg Creed, as directors, (b) entered into employment agreements with Ira Goldfarb and Claudia Goldfarb, (c) delivered a registration rights agreement with respect to the Seller Shares and any shares of common stock delivered as part of the employment compensation for Ira Goldfarb or Claudia Goldfarb, and (d) amended the Company’s 2020 Stock Incentive Plan to increase the number of shares of common stock reserved thereunder. At closing, the Company also assumed the Seller’s obligations under a real property lease for its facility in Irving, Texas under which an entity owned entirely by Ira Goldfarb is the landlord.\\nAdoption of Non-Employee Director Compensation Plan\\nOn October 1, 2020, the Company adopted a Non-Employee Director Compensation Plan. Pursuant to the Plan, each non-employee director will receive annual compensation of $25,000 to be paid in cash or common stock, at the Company’s election, each October 1, beginning with October 1, 2020. On October 1, 2020, the Company issued 4,167 shares to Mr. Bradley Berman, Mr. Lyle Berman, Mr. Joseph Lahti, Mr. Benjamin Oehler, and Mr. Creed under the Non-Employee Director Compensation Plan. In addition, the plan provides for annual compensation of $15,000 to be paid in cash or common stock, at the Company's election, each October 1, beginning with October 1, 2020, to Board committee chairs. On October 1, 2020, the Company issued 2,500 shares to Mr. Benjamin Oehler as its Audit Committee Chair.\\nAmendment to 2020 Stock Incentive Plan\\nAs a condition to closing on the Asset Purchase Agreement, the Board approved an increase in the number of shares of common stock reserved under the 2020 Stock Incentive Plan adopted in January 2020, from 320,000 shares to a total of 514,150 shares. The increase remains subject to shareholder approval, to be provided, if at all, by October 1, 2021.\\nOption Grants\\nOn October 1, 2020, Mr. Creed was granted options to purchase 24,151 shares of the Company’s common stock at an exercise price of $6.00 per share, which represented the closing price of the Company’s shares on the OTCQB marketplace on October 1, 2020. These options will vest 60% as of January 1, 2024 and 20% each anniversary thereafter until fully vested.\\nOn October 2, 2020, the Company’s Board of Directors also granted an aggregate amount of 115,250 stock options pursuant to the 2020 Equity Plan to purchase shares of the Company’s common stock to several officers, directors, and employees at an exercise price of $5.25 per share, which represents the closing price of the Company’s shares on the OTCQB marketplace on October 2, 2020. The options are exercisable over a ten-year term, and vest 60% on the 3rd anniversary of the grant date and 20% each anniversary thereafter, until fully vested. The officers and directors receiving grants and the amounts of such grants were as follows:\\n\\n| Stock Option |\\n| Name and Title | Shares Granted |\\n| Ira Goldfarb, Chairman of the Board and Director | 50,000 |\\n| Claudia Goldfarb, Chief Executive Officer | 50,000 |\\n| Total: | 100,000 |\\n\\nManagement Changes\\nKen DeCubellis stepped down from his roles as the Company’s Chief Executive Officer and interim Chief Financial Officer on September 30, 2020, and will serve as a transition resource employee and assist with the integration of the Seller’s freeze-dried fruit business into the Company's existing operations through December 15, 2020, or the earlier termination of his employment.\\nEffective October 1, 2020, in connection with closing of the Asset Purchase Agreement, Ira Goldfarb was appointed as the Company’s Executive Chairman and Chairman of the Board, and Claudia Goldfarb was appointed as the Company’s Chief Executive Officer.\\nEffective October 5, 2020, Brad Burke was appointed and agreed to serve on an interim basis as the Company’s Chief Financial Officer.\\n\\n| 18 |\\n\\n\\nCautionary Statements\\nWe are including the following discussion to inform our existing and potential security holders generally of some of the risks and uncertainties that can affect our company and to take advantage of the “safe harbor” protection for forward-looking statements that applicable federal securities law affords.\\nFrom time to time, our management or persons acting on our behalf may make forward-looking statements to inform existing and potential security holders about our company. All statements other than statements of historical facts included in this report regarding our financial position, business strategy, plans and objectives of management for future operations and industry conditions are forward-looking statements. When used in this report, forward-looking statements are generally accompanied by terms or phrases such as “estimate,” “project,” “predict,” “believe,” “expect,” “anticipate,” “target,” “plan,” “intend,” “seek,” “goal,” “will,” “should,” “may” or other words and similar expressions that convey the uncertainty of future events or outcomes. Items making assumptions regarding actual or potential future sales, market size, collaborations, trends or operating results also constitute such forward-looking statements.\\nForward-looking statements involve inherent risks and uncertainties, and important factors (many of which are beyond our control) that could cause actual results to differ materially from those set forth in the forward-looking statements include the following:\\n\\n| · | the effect of the coronavirus (“COVID-19”) pandemic on our ability to obtain funding through various financing transactions or arrangements; |\\n\\n| · | volatility or decline of our stock price; |\\n\\n| · | low trading volume and illiquidity of our common stock, and possible application of the SEC’s penny stock rules; |\\n\\n| · | potential fluctuation in quarterly results; |\\n\\n| · | low trading volume and price of our investment in AESE Shares; |\\n\\n| · | inability to maintain adequate liquidity to meet our financial obligations; |\\n\\n| · | failure to timely launch our freeze-dried fruit product offerings and obtain sufficient sales and distributions; |\\n\\n| · | litigation, disputes and legal claims involving outside parties; and |\\n\\n| · | risks related to our ability to be traded on the OTCQB and meeting trading requirements |\\n\\nWe have based these forward-looking statements on our current expectations and assumptions about future events. While our management considers these expectations and assumptions to be reasonable, they are inherently subject to significant business, economic, competitive, regulatory and other risks and uncertainties, most of which are difficult to predict and many of which are beyond our control. Accordingly, results actually achieved may differ materially from expected results in these statements. Forward-looking statements speak only as of the date they are made.\\nReaders are urged not to place undue reliance on these forward-looking statements. We assume no obligation to update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this report, other than as may be required by applicable law or regulation. Readers are urged to carefully review and consider the various disclosures made by us in our reports filed with the United States Securities and Exchange Commission (the “SEC”) which attempt to advise interested parties of the risks and factors that may affect our business, financial condition, results of operation and cash flows. If one or more of these risks or uncertainties materialize, or if the underlying assumptions prove incorrect, our actual results may vary materially from those expected or projected.\\n\\n| 19 |\\n\\nOverview and Outlook\\nEffective April 2, 2012, we changed our name to Black Ridge Oil & Gas, Inc. Our common stock is still quoted on the OTCQB under the trading symbol “ANFC.”\\nAs the sponsor and manager of Black Ridge Acquisition Corp. beginning in May of 2017, the Company was focused on identifying and closing a business combination for BRAC, which closed on August 9, 2019. Upon BRAC (renamed Allied Esports Entertainment, Inc. following the merger or “AESE”, and hereafter named as such following the merger) completing its business combination, we continued to provide additional management services to BRAC until December 31, 2019.\\nFollowing the close of the Merger, the Company commenced a strategic review to identify, review and explore alternatives for the Company, including a merger, acquisition, or a business combination. The result of that review is the transaction with S-FDF described below. The Company currently owns 1,779,529 shares of Allied Esports Entertainment, Inc. (NASDAQ: AESE), the surviving entity after BRAC’s business combination, after selling 368,870 shares for total proceeds of $1,083,408, selling warrants to purchase 505,000 shares of AESE (NASDAQ: AESEW) for total proceeds of $73,668, and distributing 537,101 Sponsor Shares on August 10, 2020 to employees and directors under the 2018 Management Incentive Plan.\\nOn October 1, 2020, the Company completed its acquisition of S-FDF, LLC, as detailed in Footnote 15, Subsequent Events.\\nGoing Concern Uncertainty\\nAs of September 30, 2020, the Company has incurred recurring losses from operations resulting in an accumulated deficit of $35,778,400, and as of September 30, 2020, the Company’s cash on hand may not be sufficient to sustain operations. These factors raise substantial doubt about the Company’s ability to continue as a going concern. The Company is currently seeking sources of capital to fund the requirements of the Asset Purchase Agreement including selling its shares of AESE or other sources of capital. The Company intends to sell its AESE shares to continue as a going concern, however, there can be no assurance the share price will be sufficient to sustain operations, therefore the Company may be dependent upon its ability to secure equity and/or debt financing and there are also no assurances that the Company will be successful; therefore, without sufficient financing it would be unlikely for the Company to continue as a going concern.\\nWe continue to pursue sources of additional capital through various financing transactions or arrangements, including joint venturing of projects, equity or debt financing or other means. We may not be successful in identifying suitable funding transactions in a sufficient time period or at all, and we may not obtain the capital we require by other means. If we do not succeed in raising additional capital, our resources may not be sufficient to fund our business.\\nThe report of the Company’s independent registered public accounting firm that accompanies its audited consolidated financial statements in the Company’s Annual Report on Form 10-K/A contains an explanatory paragraph regarding the substantial doubt about the Company’s ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might result from the outcome of the going concern uncertainty.\\n\\n| 20 |\\n\\nResults of Operations for the Three Months Ended September 30, 2020 and 2019.\\nThe following table summarizes selected items from the statement of operations for the three months ended September 30, 2020 and 2019, respectively.\\n\\n| Three Months Ended |\\n| September 30, | Increase / |\\n| 2020 | 2019 | (Decrease) |\\n| Management fee income | $ | – | $ | 153,279 | $ | (153,279 | ) |\\n| Total revenues: | – | 153,279 | (153,279 | ) |\\n| Operating expenses: |\\n| General and administrative expenses: |\\n| Salaries and benefits | 483,050 | 279,621 | 203,429 |\\n| Stock-based compensation | 322,888 | 2,836,920 | (2,514,032 | ) |\\n| Professional services | 130,234 | 40,287 | 89,947 |\\n| Other general and administrative expenses | 45,001 | 69,157 | (24,156 | ) |\\n| Total general and administrative expenses | 981,173 | 3,225,985 | (2,244,812 | ) |\\n| Depreciation and amortization | 380 | 131 | 249 |\\n| Total operating expenses | 981,553 | 3,226,116 | (2,244,563 | ) |\\n| Net operating loss | (981,553 | ) | (3,072,837 | ) | (2,091,284 | ) |\\n| Other income (expense) |\\n| Gain on deconsolidation of subsidiary | – | 26,322,687 | (26,322,687 | ) |\\n| Merger incentive expense | – | (5,874,000 | ) | (5,874,000 | ) |\\n| Interest expense | (1,695 | ) | – | 1,695 |\\n| Other income | 14 | – | 14 |\\n| Loss on disposal of property and equipment | (5,369 | ) | – | 5,369 |\\n| Gain (loss) on investment in Allied Esports Entertainment, Inc. securities | (1,503,601 | ) | 2,094,690 | (3,598,291 | ) |\\n| Total other income (expense) | (1,510,651 | ) | 22,543,377 | (24,054,028 | ) |\\n| Net income (loss) from continuing operations, net of tax | (2,492,204 | ) | 19,470,540 | (21,962,744 | ) |\\n| Provision for income taxes | – | – | – |\\n| Net income (loss) from continuing operations, net of tax | (2,492,204 | ) | 19,470,540 | (21,962,744 | ) |\\n| Net income from discontinued operations | – | (8,152,165 | ) | (8,142,165 | ) |\\n| Net income (loss) before non-controlling interest | (2,492,204 | ) | 11,318,375 | (13,810,579 | ) |\\n| Less: Net loss attributable to redeemable non-controlling interest | – | (142,919 | ) | (142,919 | ) |\\n| Net income (loss) attributable to Black Ridge Oil & Gas, Inc. | $ | (2,492,204 | ) | $ | 11,175,456 | $ | (13,667,660 | ) |\\n\\nManagement fee income\\nThe Company did not earn any management fees from its management agreement with BRAC during the three months ended September 30, 2020, compared to $153,279 during the three months ended September 30, 2019. The decrease is attributable to the termination of the agreement subsequent to the merger between BRAC and AESE on August 9, 2019.\\n\\n| 21 |\\n\\nGeneral and administrative expenses\\nSalaries and benefits\\nSalaries and benefits for the three months ended September 30, 2020 were $483,050, compared to $279,621 for the three months ended September 30, 2019, an increase of $203,429, or 73%. The increase in salaries and benefits was primarily due to payroll taxes on the distribution of AESE shares to employees in the current period pursuant to the Management Incentive Plan and accrued severance pay to former officers and employees.\\nStock-based compensation\\nStock-based compensation expense for the three months ended September 30, 2020 was $322,888, compared to $2,836,920 for the three months ended September 30, 2019, a decrease of $2,514,032, or 89%. Stock-based compensation consisted of stock options expense in both periods, and $2,809,033 of expense related to the 2018 Management Incentive Plan (the “2018 Plan”) in the prior period. Amortization of stock options increased as new options were granted toward the end of February 2020, with a five-year vesting period, and the vesting period was accelerated pursuant to separation agreements entered into on September 30, 2020.\\nProfessional services\\nGeneral and administrative expenses related to professional services were $130,234 for the 2020 period, compared to $40,287 for the 2019 period, an increase of $89,947, or 223%. The increase was primarily due to professional services related to our asset purchase agreement with S-FDF, LLC.\\nOther general and administrative expenses\\nOther general and administrative expenses for the three months ended September 30, 2020 was $45,001, compared to $69,157 for the three months ended September 30, 2019, a decrease of $24,156, or 35%. The decrease is primarily attributable to decreased administrative activity as we focused on completing the asset purchase with S-FDF, LLC.\\nDepreciation\\nDepreciation expense for the three months ended September 30, 2020 was $380, compared to $131 for the three months ended September 30, 2019, an increase of $249, or 190%. The increase is attributable to the addition of new computer equipment in 2020.\\nOther income (expense)\\nIn the three months ended September 30, 2020, other expense was $1,510,651, consisting of $1,695 of interest expense derived from the operating loans the Company received from the PPP and EIDL programs, a loss on the disposal of equipment of $5,369, and a net loss on investments in Allied Esports Entertainment, Inc. securities of $1,503,601, as offset by $14 of interest income. During the comparative three months ended September 30, 2019, other income was $22,543,377, consisting of the gain upon deconsolidation of BRAC of $26,322,687 and an offsetting merger incentive expense of $5,874,000 to recognize the cost related to transferring shares of AESE stock to the former owners of Allied Esports and WPT and other investors as an incentive to participate in the merger, and a gain of $2,094,690 on the investment in Allied Esports Entertainment, Inc. pursuant to the change in fair market value of the AESE shares.\\nProvision for income taxes\\nThe Company had no income tax expense in the 2020 or 2019 periods, as the Company continues to reserve against any deferred tax assets due to the uncertainty of realization of any benefit.\\nNet income from discontinued operations\\nNet income from discontinued operations relates to the income and expenses of BRAC during the periods prior to deconsolidation. Net income from discontinued operations for the three months ended September 30, 2019 was $8,152,165.\\n\\n| 22 |\\n\\nResults of Operations for the Nine Months Ended September 30, 2020 and 2019.\\nThe following table summarizes selected items from the statement of operations for the nine months ended September 30, 2020 and 2019, respectively.\\n\\n| Nine Months Ended |\\n| September 30, | Increase / |\\n| 2020 | 2019 | (Decrease) |\\n| Management fee income | $ | – | $ | 153,279 | $ | (153,279 | ) |\\n| Total revenues: | – | 153,279 | (153,279 | ) |\\n| Operating expenses: |\\n| General and administrative expenses: |\\n| Salaries and benefits | 936,304 | 910,191 | 26,113 |\\n| Stock-based compensation | 393,831 | 2,892,738 | (2,498,907 | ) |\\n| Professional services | 327,090 | 79,978 | 247,112 |\\n| Other general and administrative expenses | 186,380 | 185,035 | 1,345 |\\n| Total general and administrative expenses | 1,843,605 | 4,067,942 | (2,224,337 | ) |\\n| Depreciation and amortization | 1,030 | 754 | 276 |\\n| Total operating expenses | 1,844,635 | 4,068,696 | (2,224,061 | ) |\\n| Net operating loss | (1,844,635 | ) | (3,915,417 | ) | (2,070,782 | ) |\\n| Other income (expense) |\\n| Gain on deconsolidation of subsidiary | – | 26,322,687 | (26,322,687 | ) |\\n| Merger incentive expense | – | (5,874,000 | ) | (5,874,000 | ) |\\n| Interest expense, including $377,440 of warrants issued as a debt discount | (384,456 | ) | – | 384,456 |\\n| Other income | 16 | 51 | (35 | ) |\\n| Loss on disposal of property and equipment | (5,369 | ) | – | 5,369 |\\n| Gain (loss) on investment in Allied Esports Entertainment, Inc. securities | (2,186,557 | ) | 2,094,690 | (4,281,247 | ) |\\n| Total other income (expense) | (2,576,366 | ) | 22,543,428 | (25,119,794 | ) |\\n| Net income (loss) from continuing operations, net of tax | (4,421,001 | ) | 18,628,011 | (23,049,012 | ) |\\n| Provision for income taxes | – | – | – |\\n| Net loss from continuing operations, net of tax | (4,421,001 | ) | 18,628,011 | (23,049,012 | ) |\\n| Net income from discontinued operations | – | (7,421,050 | ) | (7,421,050 | ) |\\n| Net loss before non-controlling interest | (4,421,001 | ) | 11,206,961 | (15,627,962 | ) |\\n| Less: Net loss attributable to redeemable non-controlling interest | – | (1,332,529 | ) | (1,332,529 | ) |\\n| Net loss attributable to Black Ridge Oil & Gas, Inc. | (4,421,001 | ) | $ | 9,874,432 | $ | (14,295,433 | ) |\\n\\n\\n| 23 |\\n\\nManagement fee income\\nThe Company did not earn any management fees from its management agreement with BRAC during the nine months ended September 30, 2020, compared to $153,279 during the nine months ended September 30, 2019. The decrease is attributable to the termination of the agreement subsequent to the merger between BRAC and AESE on August 9, 2019.\\nGeneral and administrative expenses\\nSalaries and benefits\\nSalaries and benefits for the nine months ended September 30, 2020 were $936,304, compared to $910,191 for the nine months ended September 30, 2019, an increase of $26,113, or 3%. The increase in salaries and benefits was primarily due to payroll taxes on the distribution of AESE shares to employees in the current period pursuant to the Management Incentive Plan and accrued severance pay to former officers and employees.\\nStock-based compensation\\nStock-based compensation expense for the nine months ended September 30, 2020 was $393,831, compared to $2,892,738 for the nine months ended September 30, 2019, a decrease of $2,498,907, or 86%. Stock-based compensation consisted of stock options expense in both periods, and $2,809,033 of expense related to the 2018 Management Incentive Plan in the prior period. Amortization of stock options increased as new options were granted toward the end of February 2020, with a five-year vesting period, and the vesting period was accelerated pursuant to separation agreements entered into on September 30, 2020.\\nProfessional services\\nGeneral and administrative expenses related to professional services were $327,090 for the 2020 period, compared to $79,978 for the 2019 period, an increase of $247,112, or 309%. The increase was primarily due to professional services related to our asset purchase agreement with S-FDF, LLC.\\nOther general and administrative expenses\\nOther general and administrative expenses for the nine months ended September 30, 2020 was $186,380, compared to $185,035 for the nine months ended September 30, 2019, an increase of $1,345, or 1%.\\nDepreciation\\nDepreciation expense for the nine months ended September 30, 2020 was $1,030, compared to $754 for the nine months ended September 30, 2019, an increase of $276, or 37%. The increase is attributable to the addition of new computer equipment in 2020.\\n\\n| 24 |\\n\\nOther income (expense)\\nIn the nine months ended September 30, 2020, other expense was $2,576,366, consisting of $384,456 of interest expense derived from the business loans the Company received from Cadence Bank, N.A, RBC Capital Markets, LLC and additional operating loans from the PPP and EIDL programs, including $377,440 of expense related to the amortization of warrants issued in consideration of personal guarantees provided for debt financing, a loss on the disposal of equipment of $5,369, along with a net loss on investments in Allied Esports Entertainment, Inc. of $2,186,557, as offset by $16 of interest income, compared to other income of $22,543,428 during the nine months ended September 30, 2019, consisting of the $26,322,687 gain upon deconsolidation of BRAC and an offsetting merger incentive expense of $5,874,000 to recognize the cost related to transferring shares of AESE stock to the former owners of Allied Esports and WPT and other investors as incentive to participate in the merger, interest income of $51 and a gain of $2,094,690 on the investment in Allied Esports Entertainment, Inc. pursuant to the change in fair market value the AESE shares.\\nProvision for income taxes\\nThe Company had no income tax expense in the 2020 or 2019 periods, as the Company continues to reserve against any deferred tax assets due to the uncertainty of realization of any benefit.\\nNet income from discontinued operations\\nNet income from discontinued operations relates to the income and expenses of BRAC during the periods prior to deconsolidation. Net income from discontinued operations of $7,421,050 during the nine months ended September 30, 2019.\\nLiquidity and Capital Resources\\nThe following table summarizes our total current assets, liabilities and working capital at September 30, 2020 and December 31, 2019, respectively.\\n\\n| September 30, | December 31, |\\n| 2020 | 2019 |\\n| Current Assets | $ | 2,685,000 | $ | 7,138,712 |\\n| Current Liabilities | $ | 373,101 | $ | 1,446,407 |\\n| Working Capital | $ | 2,311,899 | $ | 5,692,305 |\\n\\nAs of September 30, 2020, we had working capital of $2,311,899.\\n\\n| 25 |\\n\\nThe following table summarizes our cash flows during the nine-month periods ended September 30, 2020 and 2019, respectively.\\n\\n| Nine Months Ended |\\n| September 30, |\\n| 2020 | 2019 |\\n| Net cash used in operating activities | $ | (1,111,648 | ) | $ | (9,759,160 | ) |\\n| Net cash provided by investing activities | 1,157,076 | 6,888,299 |\\n| Net cash provided by financing activities | 262,925 | 1,431,974 |\\n| Net change in cash and cash equivalents | $ | 308,353 | $ | (1,438,887 | ) |\\n\\nNet cash used in operating activities was $1,111,648 and $9,759,160 for the nine months ended September 30, 2020 and 2019, respectively, a period over period improvement of $8,647,512. The decrease was primarily due to a decrease of $8,618,568 in net losses in discontinued operations of BRAC. Changes in working capital from continuing operating activities resulted in a decrease in cash of $169,715 in the nine months ended September 30, 2020, as compared to a decrease in cash of $181,718 for the same period in the previous year.\\nNet cash provided by investing activities were $1,157,076 and $6,888,299 for the nine months ended September 30, 2020 and 2019, respectively. Cash provided by investing activities were comprised of proceeds of $1,157,076 from the sale of Allied Esports Entertainment, Inc. securities during the nine months ended September 30, 2020. In the comparative period ended September 30, 2019, virtually all the cash was provided from discontinued operations and was the result of transfers and withdrawals from the Trust Account.\\nNet cash provided by financing activities was $262,925 and $1,431,974 for the nine months ended September 30, 2020 and 2019, respectively. All of the 2020 activity was the result of $802,025 of net proceeds from notes payable, as offset by $539,100 of repayments, compared to $1,431,974 of cash provided by financing activities from discontinued operations in the comparative nine months ended September 30, 2019.\\nSatisfaction of our cash obligations for the next 12 months\\nAs of September 30, 2020, our balance of cash was $417,109 and we had total working capital of $2,311,899. We expect to incur significant costs related to the freeze-dried fruit Asset Purchase Agreement which closed on October 1, 2020, which will put a strain on our cash resources. Our plan for satisfying our cash requirements for the next twelve months is through cash on hand and the sale of its AESE shares, however, there can be no assurance the share price will be sufficient to cover our cash obligations for the next 12 months, therefore, additional financing in the form of equity or debt may be needed. The Company realized $1,157,076 of proceeds on the sale of 469,968 shares of AESE stock and 505,000 AESEW warrants, and received proceeds of $112,925 on a PPP loan and $150,000 of proceeds on an EIDL loan to be used as working capital to alleviate economic injury caused by COVID-19 during the second quarter of 2020. Pursuant to the Asset Purchase Agreement we entered into with S-FDF, LLC on June 9, 2020, we will need to contribute $4 million to the business in the form of proceeds from either the sale of Sponsor Shares after October 1, 2020, proceeds from a financing secured by the AESE Shares after June 9, 2020, proceeds from an equity or convertible debt financing, legal fees paid in connection with the Asset Purchase Agreement, expenses incurred by the Company after August 1, 2020 (except for severance related to change in control payments made to the Company's employees), and the Company's cash as of October 1, 2020 (the “Company Contribution”). If the Company Contribution is less than $4 million on January 1, 2021, then the Final Determination Date will be January 1, 2021. The net fair value of the Sponsor Shares is approximately $1.8 million currently, however, there can be no assurance we will be able to realize these proceeds upon the sale of the securities.\\n\\n| 26 |\\n\\nOff-Balance Sheet Arrangements\\nWe have no off-balance sheet arrangements.\\nCritical Accounting Policies and Estimates\\nOur management’s discussion and analysis of financial conditions and results of operations is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, or GAAP. The preparation of these financial statements required us to make estimates and judgments that affect the reported amounts of assets, liabilities and expenses. On an ongoing basis, we evaluate these estimates and judgments. We base our estimates on our historical experience and on various other assumptions that we believe to be reasonable under the circumstances. These estimates and assumptions form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results and experiences may differ materially from these estimates.\\nOur critical accounting policies are more fully described in Note 2 of the footnotes to our financial statements appearing elsewhere in this Form 10-Q, and Note 2 of the footnotes to the financial statements provided in our Annual Report on Form 10-K/A for the fiscal year ended December 31, 2019.\\n\\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide the information required by this Item\\n\\nWe maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed by the Company is recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission.\\nOur management, under the direction of our Chief Executive Officer and Interim Chief Financial Officer has evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as such terms are defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of September 30, 2020. As part of such evaluation, management considered the matters discussed below relating to internal control over financial reporting. Based on this evaluation our management, including the Company’s Chief Executive Officer and Interim Chief Financial Officer, has concluded that the Company’s disclosure controls and procedures were effective as of September 30, 2020 to ensure that the information required to be disclosed in our Exchange Act reports was recorded, processed, summarized and reported on a timely basis.\\nThere have been no changes in the Company’s internal control over financial reporting during the nine-month period ended September 30, 2020 that materially affected or are reasonably likely to materially affect the Company’s internal control over financial reporting.\\n\\n| 27 |\\n\\nPART II - OTHER INFORMATION\\n\\nITEM 1A.\\nRISK FACTORS\\n28\\n\\nNone.\\n\\nNone.\\n\\nNot applicable.\\n\\n| 31 |\\n\\n\\nNone.\\n\\n\\n| Exhibit | Description |\\n| 3.1 | Certificate of Incorporation (incorporated by reference to Exhibit 3.1 of the Form 8-K filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on December 12, 2012) |\\n| 3.2 | Bylaws (incorporated by reference to Exhibit 3.2 of the Form 8-K filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on December 12, 2012) |\\n| 3.3 | Certificate of Amendment to Articles of Incorporation (incorporated by reference to Exhibit 3.1 of the Form 8-K filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on February 21, 2020) |\\n| 10.1 | Business Loan Agreement dated March 10, 2020, between Cadence Bank, N.A. and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.1 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on May 15, 2020) |\\n| 10.2 | Promissory Note dated March 10, 2020, between Cadence Bank, N.A. and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.2 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on May 15, 2020) |\\n| 10.3 | Commercial Pledge and Security Agreement dated March 10, 2020, between Cadence Bank, N.A. and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.3 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on May 15, 2020) |\\n| 10.4 | Form of Commercial Guaranty dated March 10, 2020, between Cadence Bank, N.A. and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.4 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on May 15, 2020) |\\n| 10.5 | Asset Purchase Agreement dated June 9, 2020, between S-FDF, LLC and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.2 of the Form SC 13D/A filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on June 17, 2020) |\\n| 10.6 | Amendment to Asset Purchase Agreement dated October 1, 2020, between S-FDF, LLC and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 2.1 of the Form 8-K filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on October 6, 2020) |\\n| 10.7 | Promissory Note dated April 24, 2020, between Kensington Bank and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.6 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on August 11, 2020) |\\n| 10.8 | Promissory Note dated June 16, 2020, between the U.S. Small Business Administration and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.7 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on August 11, 2020) |\\n| 10.9 | Security Agreement dated June 16, 2020, between the U.S. Small Business Administration and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.8 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on August 11, 2020) |\\n| 10.10 | Loan Authorization & Agreement dated June 16, 2020, between the U.S. Small Business Administration and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.9 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on August 11, 2020) |\\n| 10.11* | Amended and Restated Employment Agreement dated September 30, 2020, between Kenneth DeCubellis and Black Ridge Oil & Gas, Inc |\\n| 10.12* | Separation Agreement and Release dated September 30, 2020, between Michael Eisele and Black Ridge Oil & Gas, Inc. |\\n| 31.1* | Section 302 Certification of Chief Executive Officer |\\n| 31.2* | Section 302 Certification of Interim Chief Financial Officer |\\n| 32.1* | Section 906 Certification of Chief Executive Officer |\\n| 32.2* | Section 906 Certification of Interim Chief Financial Officer |\\n| 101.INS* | XBRL Instance Document |\\n| 101.SCH* | XBRL Schema Document |\\n| 101.CAL* | XBRL Calculation Linkbase Document |\\n| 101.DEF* | XBRL Definition Linkbase Document |\\n| 101.LAB* | XBRL Labels Linkbase Document |\\n| 101.PRE* | XBRL Presentation Linkbase Document |\\n\\n*Filed herewith\\n\\n| 32 |\\n\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n\\n| BLACK RIDGE OIL & GAS, INC. |\\n| Dated: November 12, 2020 | By: | /s/ Claudia Goldfarb |\\n| Claudia Goldfarb, Chief Executive Officer (Principal Executive Officer) |\\n| By: | /s/ Brad Burke |\\n| Interim Chief Financial Officer (Principal Financial Officer) |\\n\\n\\n| 33 |\\n\\n \\n\\nWhat will be the potential dilutive common shares increase (in units) if the company decides to issue common stock options to its CEO Michael Eisele representing 2.8% of shares?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 44812.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 73,\n \"input_length\": 25467\n}"}}},{"rowIdx":74,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\nItem 1. Financial Statements (Unaudited).\nShoals Technologies Group, Inc.\nCondensed Consolidated Balance Sheets (Unaudited)\n(in thousands, except shares)\n| June 30,2021 | December 31, 2020 |\n| Assets |\n| Current Assets |\n| Cash and cash equivalents | $ | 13,171 | $ | 10,073 |\n| Accounts receivable, net | 42,977 | 27,004 |\n| Unbilled receivables | 6,797 | 3,794 |\n| Inventory, net | 21,272 | 15,121 |\n| Other current assets | 7,292 | 155 |\n| Total Current Assets | 91,509 | 56,147 |\n| Property, plant and equipment, net | 13,622 | 12,763 |\n| Goodwill | 50,176 | 50,176 |\n| Other intangible assets, net | 67,996 | 71,988 |\n| Deferred tax asset | 49,573 | — |\n| Other assets | 840 | 4,236 |\n| Total Assets | $ | 273,716 | $ | 195,310 |\n| Liabilities and Stockholders' Deficit / Members’ Deficit |\n| Current Liabilities |\n| Accounts payable | $ | 14,224 | $ | 14,634 |\n| Accrued expenses | 9,499 | 5,967 |\n| Long-term debt—current portion | 3,500 | 3,500 |\n| Total Current Liabilities | 27,223 | 24,101 |\n| Revolving line of credit | 49,000 | 20,000 |\n| Long-term debt, less current portion | 188,859 | 335,332 |\n| Payable Pursuant to the Tax Receivable Agreement | 43,356 | — |\n| Total Liabilities | 308,438 | 379,433 |\n| Commitments and Contingencies (Note 12) |\n| Stockholders’ Deficit / Members’ Deficit |\n| Members’ deficit | — | ( 184,123 ) |\n| Preferred stock, $ 0.00001 par value - 5,000,000 shares authorized; none issued and outstanding as of June 30, 2021 | — | — |\n| Class A common stock, $ 0.00001 par value - 1,000,000,000 shares authorized; 93,545,564 shares issued and outstanding as of June 30, 2021 | 1 | — |\n| Class B common stock, $ 0.00001 par value - 195,000,000 shares authorized; 73,066,607 shares issued and outstanding as of June 30, 2021 | 1 | — |\n| Additional paid-in capital | 78,883 | — |\n| Accumulated deficit | ( 93,782 ) | — |\n| Total stockholders’ deficit attributable to Shoals Technologies Group, Inc. / members' deficit | ( 14,897 ) | ( 184,123 ) |\n| Non-controlling interests | ( 19,825 ) | — |\n| Total stockholders’ deficit / members’ deficit | ( 34,722 ) | ( 184,123 ) |\n| Total Liabilities and Stockholders’ Deficit / Members’ Deficit | $ | 273,716 | $ | 195,310 |\n\nSee accompanying notes to condensed consolidated financial statements.\n1\nShoals Technologies Group, Inc.\nCondensed Consolidated Statements of Operations (Unaudited)\n(in thousands, except per share amounts)\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Revenue | $ | 59,722 | $ | 43,427 | $ | 105,326 | $ | 84,167 |\n| Cost of revenue | 33,543 | 26,598 | 60,373 | 53,152 |\n| Gross profit | 26,179 | 16,829 | 44,953 | 31,015 |\n| Operating Expenses |\n| General and administrative expenses | 10,018 | 9,317 | 16,834 | 11,875 |\n| Depreciation and amortization | 2,062 | 2,064 | 4,130 | 4,125 |\n| Total Operating Expenses | 12,080 | 11,381 | 20,964 | 16,000 |\n| Income from Operations | 14,099 | 5,448 | 23,989 | 15,015 |\n| Interest expense, net | ( 3,620 ) | ( 225 ) | ( 7,329 ) | ( 497 ) |\n| Tax receivable agreement liability adjustment | ( 1,664 ) | — | ( 1,664 ) | — |\n| Loss on debt repayment | — | — | ( 15,990 ) | — |\n| Income (loss) before income taxes | 8,815 | 5,223 | ( 994 ) | 14,518 |\n| Income tax benefit | 339 | — | 1,814 | — |\n| Net income | 9,154 | 5,223 | 820 | 14,518 |\n| Less: net income (loss) attributable to non-controlling interests | 4,596 | — | ( 879 ) | — |\n| Net income attributable to Shoals Technologies Group, Inc. | $ | 4,558 | $ | 5,223 | $ | 1,699 | $ | 14,518 |\n| Three Months EndedJune 30, 2021 | Period from January 27, 2021 to June 30, 2021 |\n| Earnings per share of Class A common stock: |\n| Basic | $ | 0.05 | $ | ( 0.01 ) |\n| Diluted | $ | 0.05 | $ | ( 0.01 ) |\n| Weighted average shares of Class A common stock outstanding: |\n| Basic | 93,544 | 93,542 |\n| Diluted | 166,827 | 93,542 |\n\nSee accompanying notes to condensed consolidated financial statements.\n2\nShoals Technologies Group, Inc.\nCondensed Consolidated Statements of Changes in Members’ / Stockholders’ Equity (Deficit) (Unaudited)\n(in thousands, except shares)\nFor the three and six months ended June 30, 2021\n| Members' Deficit | Class ACommon Stock | Class BCommon Stock | Additional Paid-In Capital | Accumulated Deficit | Non-Controlling Interest | Total Members'/Stockholders Deficit |\n| Shares | Amount | Shares | Amount |\n| Balance atDecember 31, 2020 | $ | ( 184,123 ) | — | $ | — | — | $ | — | $ | — | $ | — | $ | — | $ | ( 184,123 ) |\n| Net income prior to the Organizational Transactions | 2,675 | — | — | — | — | — | — | — | 2,675 |\n| Effect of Organizational Transactions | 181,448 | 81,977,751 | 1 | 78,300,817 | 1 | — | ( 92,806 ) | ( 88,644 ) | — |\n| Issuance of Class A common stock sold in IPO, net of underwriting discounts and commissions and offering costs | — | 11,550,000 | — | ( 5,234,210 ) | — | 70,188 | — | 70,976 | 141,164 |\n| Net loss subsequent to the Organizational Transactions | — | — | — | — | — | — | ( 5,534 ) | ( 5,475 ) | ( 11,009 ) |\n| Equity-based compensation recognized subsequent to the Organizational Transactions | — | — | — | — | — | 1,392 | — | — | 1,392 |\n| Activity under stock compensation plan | — | 11,941 | — | — | — | ( 687 ) | — | 550 | ( 137 ) |\n| Deferred tax adjustment related to Tax Receivable Agreement | — | — | — | — | — | 7,180 | — | — | 7,180 |\n| Balance atMarch 31, 2021 | — | 93,539,692 | 1 | 73,066,607 | 1 | 78,073 | ( 98,340 ) | ( 22,593 ) | ( 42,858 ) |\n| Net income | — | — | — | — | — | — | 4,558 | 4,596 | 9,154 |\n| Equity-based compensation | — | — | — | — | — | 1,955 | — | — | 1,955 |\n| Activity under stock compensation plan | — | 5,872 | — | — | — | ( 857 ) | — | 857 | — |\n| Distributions to Non-controlling interest | — | — | — | — | — | — | — | ( 2,973 ) | ( 2,973 ) |\n| Reallocation of non-controlling interest | — | — | — | — | — | ( 288 ) | — | 288 | — |\n| Balance atJune 30, 2021 | $ | — | 93,545,564 | $ | 1 | 73,066,607 | $ | 1 | $ | 78,883 | $ | ( 93,782 ) | $ | ( 19,825 ) | $ | ( 34,722 ) |\n\n3\nShoals Technologies Group, Inc.\nCondensed Consolidated Statements of Changes in Members’ / Stockholders’ Equity (Deficit) (Unaudited) (continued)\n(in thousands, except shares)\nFor the three and six months ended June 30, 2020\n| Members' Equity |\n| Balance at December 31, 2019 | $ | 149,906 |\n| Member distributions | ( 214 ) |\n| Equity-based compensation | — |\n| Net income | 9,295 |\n| Balance at March 31, 2020 | 158,987 |\n| Member distributions | — |\n| Equity-based compensation | 6,704 |\n| Net income | 5,223 |\n| Balance at June 30, 2020 | $ | 170,914 |\n\nSee accompanying notes to condensed consolidated financial statements.\n4\nShoals Technologies Group, Inc.\nCondensed Consolidated Statements of Cash Flows (Unaudited)\n(in thousands)\n| Six Months Ended June 30, |\n| 2021 | 2020 |\n| Cash Flows from Operating Activities |\n| Net income | $ | 820 | $ | 14,518 |\n| Adjustments to reconcile net income to net cash provided by (used in) operating activities: |\n| Depreciation and amortization | 4,808 | 4,656 |\n| Amortization/write off of deferred financing costs | 5,415 | 21 |\n| Equity-based compensation | 4,172 | 6,704 |\n| Deferred taxes | ( 524 ) | — |\n| Tax receivable agreement liability adjustment | 1,664 | — |\n| Gain on sale of assets | 61 | — |\n| Changes in assets and liabilities: |\n| Accounts receivable | ( 15,973 ) | 21 |\n| Unbilled receivables | ( 3,003 ) | ( 4,970 ) |\n| Inventory | ( 6,151 ) | ( 3,356 ) |\n| Other assets | ( 4,631 ) | 515 |\n| Accounts payable | ( 410 ) | ( 1,494 ) |\n| Accrued expenses | ( 362 ) | 2,313 |\n| Net Cash Provided by (Used in) Operating Activities | ( 14,114 ) | 18,928 |\n| Cash Flows Used In Investing Activities |\n| Purchases of property, plant and equipment | ( 1,736 ) | ( 1,345 ) |\n| Net Cash Used in Investing Activities | ( 1,736 ) | ( 1,345 ) |\n| Cash Flows from Financing Activities |\n| Member / non-controlling interest distributions | ( 2,973 ) | ( 214 ) |\n| Employee withholding taxes related to net settled equity awards | ( 137 ) | — |\n| Deferred financing costs | ( 94 ) | — |\n| Payments on term loan facility | ( 151,750 ) | — |\n| Proceeds from revolving credit facility | 34,000 | — |\n| Repayments of revolving credit facility | ( 5,000 ) | — |\n| Payments on senior debt - term loan | — | ( 1,747 ) |\n| Payments on senior debt - revolving line of credit | — | ( 8,400 ) |\n| Proceeds from issuance of Class A common stock sold in an IPO, net of underwriting discounts and commissions | 154,521 | — |\n| Deferred offering costs | ( 9,619 ) | — |\n| Net Cash Provided by (Used in) Financing Activities | 18,948 | ( 10,361 ) |\n| Net Increase in Cash and Cash Equivalents | 3,098 | 7,222 |\n| Cash and Cash Equivalents—Beginning of Period | 10,073 | 7,082 |\n| Cash and Cash Equivalents—End of Period | $ | 13,171 | $ | 14,304 |\n\n5\nShoals Technologies Group, Inc.\nCondensed Consolidated Statements of Cash Flows (Unaudited) (continued)\n(in thousands)\n| Six Months Ended June 30, |\n| 2021 | 2020 |\n| Supplemental Cash Flows Information: |\n| Cash paid for interest | $ | 5,634 | $ | 476 |\n| Cash paid for taxes | $ | 1,120 | $ | — |\n| Non-cash financing activities: |\n| Reclassification of deferred offering costs to additional paid-in capital | $ | 3,736 | $ | — |\n| Initial establishment of deferred tax assets | $ | 49,049 | $ | — |\n| Initial establishment of amounts payable under tax receivable agreement | $ | 41,692 | $ | — |\n| Capital contribution related to tax receivable agreement | $ | 7,178 | $ | — |\n| Income tax receivable from merger due to former owner | $ | 3,069 | $ | — |\n\nSee accompanying notes to condensed consolidated financial statements.\n6\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\n1. Organization and Business\nShoals Technologies Group, Inc. (the “Company”) was formed as a Delaware corporation on November 4, 2020 for the purpose of facilitating an initial public offering (\"IPO\") and other related organizational transactions to carry on the business of Shoals Parent LLC and its subsidiaries (“Shoals Parent”).\nShoals Parent is a Delaware limited liability company formed on May 9, 2017. The Company is headquartered in Portland, Tennessee and is a manufacturer of electrical balance of systems (“EBOS”) solutions and components related to solar fields selling to customers across the United States and internationally. Shoals Parent, through its wholly-owned subsidiaries, Shoals Intermediate Holdings LLC (“Intermediate”) and Shoals Holdings LLC (“Holdings”) owns four other subsidiaries through which it conducts substantially all operations: Shoals Technologies, LLC, Shoals Technologies Group, LLC, Solon, LLC, and Shoals Structures, LLC (collectively “Shoals”). Shoals Parent acquired Shoals on May 25, 2017.\nInitial Public Offering\nOn January 29, 2021, the Company closed an IPO of 11,550,000 shares of Class A common stock at a public offering price of $ 25.00 per share, including shares issued pursuant to the underwriters' over-allotment option. The Company received $ 278.8 million in proceeds, net of underwriting discounts and commissions of $ 9.9 million, which was used to purchase 6,315,790 newly-issued membership interests (the “LLC Interests”) from Shoals Parent and 5,234,210 LLC Interests from the founder and Class B unit holder in Shoals Parent at a price per interest equal to the IPO price of $ 25.00 per share. Subsequent to the IPO and related organizational transactions that occurred in connection with the IPO, the Company is the sole managing member of, and had a 56.14 % economic interest in, Shoals Parent.\nOrganizational Transactions\nIn connection with the IPO, the Company and Shoals Parent completed a series of transactions (the \"Organizational Transactions\") including the following:\n•the limited liability company agreement of Shoals Parent was amended and restated to, among other things, (i) provide for a new single class of common membership interests or the LLC Interests in Shoals Parent, (ii) exchange all of the then existing membership interests of the holders of Shoals Parent membership interests for LLC Interests and (iii) appoint the Company as the sole managing member of Shoals Parent;\n•the Company's certificate of incorporation was amended and restated to, among other things, (i) provide for Class A common stock with voting and economic rights (ii) provide for Class B common stock with voting rights but no economic rights and (iii) issue 78,300,817 shares of Class B common stock to the former Class B and Class C members of Shoals Parent (the “Continuing Equity Owners”) on a one -to-one basis with the number of LLC Interests they own;\n•the acquisition, by merger, of Shoals Investment CTB or the former Class A member of Shoals Parent (the \"Class A Shoals Equity Owners\"), for which the Company issued 81,977,751 shares Class A common stock as merger consideration (the \"Merger\").\nImmediately following the completion of the IPO and Organizational Transactions, the Company owned 56.14 % of Shoals Parent. The Continuing Equity Owners owned the remaining 43.86 % of Shoals Parent.\n2. Summary of Accounting Policies\n7\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\nBasis of Accounting and Presentation\nThe condensed consolidated financial statements have been prepared on the accrual basis of accounting in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”).\nPrinciples of Consolidation\nThe condensed consolidated financial statements include the accounts of the Company and its subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.\nNon-controlling Interest\nThe non-controlling interest on the condensed consolidated statement of operations represents the portion of earnings or loss attributable to the economic interest in the Company's subsidiary, Shoals Parent, held by the Continuing Equity Owners. Non-controlling interest on the condensed consolidated balance sheet represents the portion of net assets of the Company attributable to the Continuing Equity Owners, based on the portion of the LLC Interests owned by such unit holders. As of June 30, 2021, the non-controlling interest was 43.86 %.\nUnaudited Interim Financial Information\nThe accompanying condensed consolidated balance sheets as of June 30, 2021 and December 31, 2020, the statements of operations, stockholders’ deficit / members’ deficit and cash flows for the periods ended June 30, 2021 and 2020 are unaudited. The unaudited interim financial statements have been prepared on the same basis as the audited annual financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary for the fair statement of the Company’s financial position as of June 30, 2021 and the results of its operations and its cash flows for the periods ended June 30, 2021 and 2020. The financial data and other information disclosed in these notes related to the periods ended June 30, 2021 and 2020 are also unaudited. The results for the three and six months ended June 30, 2021 are not necessarily indicative of results to be expected for the year ending December 31, 2021, any other interim periods, or any future year or period. The balance sheet as of December 31, 2020 included herein was derived from the audited financial statements as of that date. Certain disclosures have been condensed or omitted from the interim financial statements. These financial statements should be read in conjunction with the Company’s consolidated financial statements and related notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2020.\nUse of Estimates\nThe preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates include revenue recognition, allowance for doubtful accounts, useful lives of property, plant and equipment and other intangible assets, impairment of long-lived assets, the reserve for excess and obsolete inventory, the tax receivable agreement, and valuation of deferred tax assets.\nImpact of COVID-19 Pandemic\n8\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\nThe global health crisis caused by the novel coronavirus COVID-19 pandemic and its resurgences has and may continue to negatively impact global economic activity, which, despite progress in vaccination efforts, remains uncertain and cannot be predicted with confidence. In addition, a new Delta variant of COVID-19, which appears to be the most transmissible variant to date, has begun to spread globally.\nTo date, the Company has maintained uninterrupted business operations with normal turnaround times for its delivery of solar EBOS solutions and components. The Company has implemented adjustments to its operations designed to keep employees safe and comply with federal, state and local guidelines, including those regarding social distancing. For the three and six months ended June 30, 2021, the Company incurred $ 0.1 million and $ 0.2 million, respectively, in COVID-19 related costs (disinfecting and reconfiguration of facilities, medical professionals to conduct daily screening of employees and direct legal costs associated with the pandemic) which is included in general and administrative expenses in the accompanying condensed consolidated financial statements.\nThe impact of the Delta variant cannot be predicted at this time, and could depend on numerous factors, including vaccination rates among the population, the effectiveness of the COVID-19 vaccines against the Delta variant and the response by governmental bodies and regulators. Given the ongoing and dynamic nature of the circumstances, it is difficult to predict the impact of the COVID-19 pandemic on our business.\nCustomer Concentrations\nThe Company had the following accounts receivable concentrations as of June 30, 2021 and December 31, 2020 and revenue concentrations for the six months ended June 30, 2021 and 2020:\n| 2021 | 2020 |\n| Revenue % | AccountsReceivable % | Revenue % | AccountsReceivable % |\n| Customer A | 25.5 | % | 41.3 | % | 21.4 | % | 16.7 | % |\n| Customer B | 13.2 | % | 4.2 | % | 23.9 | % | 14.2 | % |\n| Customer C | 3.9 | % | 2.2 | % | 12.1 | % | 12.0 | % |\n| Customer D | 6.5 | % | 8.7 | % | 12.3 | % | 12.5 | % |\n| Customer E | 0.1 | % | 0.3 | % | 10.4 | % | 0.0 | % |\n\nRecent Accounting Pronouncements\nAdopted\nIn December 2019, the FASB issued ASU No. 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes (“ASU No. 2019-12”), which is intended to simplify various aspects of the accounting for income taxes. ASU No. 2019-12 removes certain exceptions to the general principles in Topic 740 and also clarifies and amends existing guidance to improve consistent application. The Company adopted ASU No. 2019-12 as of January 1, 2021 and it did not have a material impact on its consolidated financial statements and related disclosures.\nNot Yet Adopted\nIn February 2016, the FASB issued ASU No. 2016-02 (Topic 842) “Leases” which supersedes the lease recognition requirements in ASC Topic 840, “Leases.” Under ASU No. 2016-02, lessees are required to recognize assets and liabilities on the balance sheet for most leases and provide enhanced disclosures.\n9\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\nLeases will continue to be classified as either finance or operating. For companies that are not emerging growth companies (“EGCs”), the ASU is effective for fiscal years beginning after December 15, 2018. For EGCs, the ASU is effective for fiscal years beginning after December 15, 2021. The Company plans to adopt the new standard using the modified retrospective method, under which the Company will apply Topic 842 to existing and new leases as of January 1, 2022, but prior periods will not be restated and will continue to be reported under Topic 840 guidance in effect during those periods. The Company anticipates that the adoption will not have a material impact on its statements of operations or its statements of cash flows but expects to recognize right-of-use assets and liabilities for lease obligations associated with its operating leases.\nIn June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses, which was subsequently amended by ASU No. 2018-19 and ASU No. 2019-10, and which requires the measurement of expected credit losses for financial instruments carried at amortized cost held at the reporting date based on historical experience, current conditions and reasonable forecasts. The updated guidance also amends the current other-than-temporary impairment model for available-for-sale debt securities by requiring the recognition of impairments relating to credit losses through an allowance account and limits the amount of credit loss to the difference between a security’s amortized cost basis and its fair value. In addition, the length of time a security has been in an unrealized loss position will no longer impact the determination of whether a credit loss exists. The main objective of this ASU is to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. For EGC’s, the standard is effective for fiscal years and interim periods within those fiscal years, beginning after December 15, 2022. The Company will continue to assess the possible impact of this standard, but currently does not expect the adoption of this standard will have a significant impact on its financial statements and its limited history of bad debt expense relating to trade accounts receivable.\n3. Accounts Receivable\nAccounts receivable consists of the following (in thousands):\n| June 30,2021 | December 31, 2020 |\n| Accounts receivable | $ | 43,179 | $ | 27,206 |\n| Less: allowance for doubtful accounts | ( 202 ) | ( 202 ) |\n| Accounts receivable, net | $ | 42,977 | $ | 27,004 |\n\n4. Inventory\n| June 30,2021 | December 31, 2020 |\n| Raw materials | $ | 23,274 | $ | 17,390 |\n| Allowance for slow-moving inventory | ( 2,002 ) | ( 2,269 ) |\n| Inventory, net | $ | 21,272 | $ | 15,121 |\n\n10\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\n5. Property, Plant and Equipment\nProperty, plant, and equipment, net consists of the following (in thousands):\n| Estimated Useful Lives (Years) |\n| June 30,2021 | December 31, 2020 |\n| Land | N/A | $ | 840 | $ | 840 |\n| Building and land improvements | 5 - 40 | 5,992 | 5,621 |\n| Machinery and equipment | 3 - 5 | 10,323 | 9,028 |\n| Furniture and fixtures | 3 - 7 | 1,090 | 1,025 |\n| Vehicles | 5 | 104 | 318 |\n| 18,349 | 16,832 |\n| Less: accumulated depreciation | ( 4,727 ) | ( 4,069 ) |\n| Property, plant and equipment, net | $ | 13,622 | $ | 12,763 |\n\nDepreciation expense for the three months ended June 30, 2021 and 2020 was $ 0.4 million and $ 0.3 million, respectively. During the three months ended June 30, 2021 and 2020, $ 0.3 million and $ 0.2 million, respectively, of depreciation expense was allocated to cost of revenue. During the three months ended June 30, 2021 and 2020, $ 0.1 million and $ 0.1 million, respectively, of depreciation expense was allocated to operating expenses.\nDepreciation expense for the six months ended June 30, 2021 and 2020 was $ 0.8 million and $ 0.7 million, respectively. During the six months ended June 30, 2021 and 2020, $ 0.7 million and $ 0.5 million, respectively, of depreciation expense was allocated to cost of revenue. During the six months ended June 30, 2021 and 2020, $ 0.1 million and $ 0.2 million, respectively, of depreciation expense was allocated to operating expenses.\n6. Goodwill and Other Intangible Assets\nGoodwill\nGoodwill relates to the acquisition of Shoals. As of June 30, 2021 and December 31, 2020, goodwill totaled $ 50.2 million.\nOther Intangible Assets\nOther intangible assets consisted of the following (in thousands):\n11\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\n| Estimated Useful Lives (Years) | June 30,2021 | December 31, 2020 |\n| Amortizable: |\n| Costs: |\n| Customer relationships | 13 | $ | 52,600 | $ | 52,600 |\n| Developed technology | 13 | 34,600 | 34,600 |\n| Trade names | 13 | 11,400 | 11,400 |\n| Noncompete agreements | 5 | 2,000 | 2,000 |\n| Total amortizable intangibles | 100,600 | 100,600 |\n| Accumulated amortization: |\n| Customer relationships | 16,522 | 14,499 |\n| Developed technology | 10,868 | 9,537 |\n| Trade names | 3,581 | 3,142 |\n| Noncompete agreements | 1,633 | 1,434 |\n| Total accumulated amortization | 32,604 | 28,612 |\n| Total amortizable intangibles, net | $ | 67,996 | $ | 71,988 |\n\nAmortization expense related to intangible assets amounted to $ 2.0 million and $ 2.0 million for the three months ended June 30, 2021 and 2020 and $ 4.0 million and $ 4.0 million for the six months ended June 30, 2021 and 2020, respectively.\n7. Long-Term Debt\nLong-term debt consists of the following (in thousands):\n| June 30,2021 | December 31, 2020 |\n| Term Loan Facility | $ | 198,250 | $ | 350,000 |\n| Revolving Credit Facility | 49,000 | 20,000 |\n| Senior Debt—term loan | — | — |\n| Less: deferred financing costs | ( 5,891 ) | ( 11,168 ) |\n| Total debt, net of deferred financing costs | 241,359 | 358,832 |\n| Less: current portion | ( 3,500 ) | ( 3,500 ) |\n| Long-term debt, net current portion | $ | 237,859 | $ | 355,332 |\n\nSenior Secured Credit Agreement\nOn November 25, 2020 Shoals Holdings, entered into that certain credit agreement with the lenders party thereto from time to time and Wilmington Trust, National Association, as administrative agent and collateral agent (the “Senior Secured Credit Agreement”), consisting of (i) a $ 350.0 million senior secured six-year term loan facility (the “Term Loan Facility”), (ii) a $ 30.0 million senior secured delayed draw term loan facility, which matures concurrently with the six-year Term Loan Facility (the “Delayed Draw Term Loan Facility”) and (iii) an uncommitted super senior first out revolving credit facility (the “Revolving Credit Facility”). The proceeds of the Term Loan Facility and a $ 10.0 million draw under the Delayed Draw Term Loan Facility were used to (i) make certain distributions from Shoals Holdings to Shoals Intermediate Holdings and from\n12\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\nthere to certain of the Company’s direct or indirect equity holders, (ii) pay transaction expenses, (iii) repay and terminate all outstanding commitments under the Senior Debt (as defined herein) and (iv) finance working capital and general corporate purposes.\nIn December 2020, Shoals Holdings entered into two amendments to the Senior Secured Credit Agreement in order to obtain a $ 100.0 million increase (the “Revolver Upsize”) to the Revolving Credit Facility and modify the terms of the interest rate and prepayment premium. As part of the first amendment the Company repaid and terminated all outstanding commitments under the Delayed Draw Term Loan Facility.\nOn January 29, 2021, the Company used proceeds from the IPO to repay $ 150.0 million of outstanding borrowings under the Term Loan Facility. The repayment of a portion of the borrowings under the Term Loan Facility resulted in a $ 16.0 million loss on debt repayment as the result of the $ 11.3 million prepayment premium and $ 4.7 million write-off of a portion of the deferred financing costs.\nAs of June 30, 2021, interest rates on the Term Loan facility and the Revolving credit facility were 4.25 % and 3.75 %, respectively and the Company had $ 51.0 million of availability under the Revolving Credit Facility.\nThe Senior Secured Credit Agreement contains affirmative and negative covenants, including covenants that restrict the Company’s incurrence of indebtedness, incurrence of liens, dispositions, investments, acquisitions, restricted payments, and transactions with affiliates. The Senior Secured Credit Agreement also includes customary events of default, including the occurrence of a change of control. As of June 30, 2021, the Company was in compliance with all the required covenants.\nSenior Debt\nIntermediate and subsidiaries were party to a credit agreement (the “Senior Debt Agreement” and obligations thereunder, the “Senior Debt”) under which Holdings and its subsidiaries were borrowers and Intermediate was a guarantor. The Senior Debt was collateralized by all of the assets of the guarantor and borrowers. The amended agreement provided a term loan of $ 35 million and a revolving line of credit of $ 25 million.\nOn October 8, 2020, the Company paid the outstanding amount due on the term loan and settled all obligations with respect to the Senior Debt.\nThe Senior Debt provided for an interest rate to equal the Base Rate plus margin. The Base Rate charged was the highest rate of three defined methods as follows: 1) Federal Funds Rate plus 0.5 %, 2) Fifth Third Bank N.A. Rate or 3) LIBOR Rate plus 1 %. The Base Rate ranged from 1 % to 2.5 % depending on the EBITDA Rate calculation as defined in the Senior Debt Agreement (the “EBITDA Rate calculation”) for the Federal Funds Rate. The Base Rate for the LIBOR Rate ranged from 2 % to 3.5 % depending on the EBITDA Rate calculation.\n8. Earnings (loss) per Share\nBasic earnings (loss) per share of Class A Common Stock is computed by dividing net loss attributable to the Company's losses by the weighted average number of shares of Class A Common Stock outstanding during the period. Diluted net loss per share of Class A Common Stock is computed similarly to basic net loss\n13\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\nper share except the weighted average shares outstanding are increased to include additional shares from the redemption of Class B Common Stock under the if-converted method and the assumed exercise of any common stock equivalents using the treasury stock method, if dilutive. The Company’s restricted stock units are considered common stock equivalents for this purpose.\nAll earnings prior to and up to January 26, 2021, the date of the IPO, were entirely allocable to non-controlling interest and, as a result, earnings (loss) per share information is not applicable for reporting periods prior to this date. Consequently, only the net loss allocable to Shoals Technologies Group, Inc. from the period subsequent to January 26, 2021 is included in the net loss attributable to the stockholders of Class A Common Stock for the periods ended June 30, 2021. Basic and diluted net loss per share of Class A Common Stock from January 27, 2021 to June 30, 2021 have been computed as follows (in thousands, except per share amounts):\n| Three Months Ended June 30, 2021 | Period from January 27, 2021 to June 30, 2021 |\n| Numerator: |\n| Net income (loss) attributable to Shoals Technologies Group, Inc. - basic | $ | 4,558 | $ | ( 976 ) |\n| Reallocation of net income (loss) attributable to non-controlling interests from the assumed conversion of class B common stock | 4,596 | — |\n| Net income (loss) attributable to Shoals Technologies Group, Inc. - diluted | $ | 9,154 | $ | ( 976 ) |\n| Denominator: |\n| Weighted average shares of Class A common stock outstanding - basic | 93,544 | 93,542 |\n| Effect of dilutive securities: |\n| Restricted Stock Units | 216 | — |\n| Class B Common Stock | 73,067 | — |\n| Weighted average shares of Class A common stock outstanding - diluted | 166,827 | 93,542 |\n| Earnings (loss) per share of Class A common stock - basic | $ | 0.05 | $ | ( 0.01 ) |\n| Earnings (loss) per share of Class A common stock - diluted | $ | 0.05 | $ | ( 0.01 ) |\n\nFor the period from January 27, 2021 to June 30, 2021, 1,169,601 restricted stock units and 73,066,607 Class B common stock shares were excluded from the computation of diluted loss per share of Class A common stock because the effect would have been anti-dilutive as we recorded a net loss for the period.\n9. Equity-Based Compensation\nOn January 26, 2021, the Shoals Technologies Group, Inc. 2021 Long-Term incentive Plan (the “2021 Incentive Plan”) became effective. The 2021 Incentive Plan authorized 8,768,124 new shares, subject to adjustment pursuant to the 2021 Incentive Plan.\n14\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\nSince January 26, 2021, the Company has granted 1,196,770 restricted stock units (“RSUs\") to certain employees, officers and directors of the Company. The RSUs were granted at varying prices ranging from $ 25.00 to $ 29.57 per unit and generally vest ratably over 4 years, except for some of the director grants which vest over 1 year.\nThe following table summarizes the restricted stock unit activity for the six months ended June 30, 2021 (in thousands, except per share amounts):\n| RestrictedStock Units | Weighted Average Price |\n| Outstanding at beginning of period | — | $ | — |\n| Granted | 1,196,770 | $ | 26.02 |\n| Forfeited | ( 5,297 ) | $ | 29.57 |\n| Vested | ( 21,872 ) | $ | 27.58 |\n| Outstanding at end of period | 1,169,601 | $ | 25.98 |\n\nFor the three and six months ended June 30, 2021, the Company recognized $ 2.8 million and $ 4.2 million, respectively, in equity-based compensation. As of June 30, 2021, the Company had $ 27.8 million of unrecognized compensation costs which is expected to be recognized over a period of 3.6 years.\n10. Stockholders' Deficit\nAmendment and Restatement of Certificate of Incorporation\nAs discussed in Note 1, on January 26, 2021, the Company's certificate of incorporation was amended and restated to, among other things, provide for the (i) authorization of 1,000,000,000 shares of Class A common stock with a par value of $ 0.00001 per share; (ii) authorization of 195,000,000 shares of Class B common stock with a par value of $ 0.00001 per share; (iii) authorization of 5,000,000 shares of preferred stock that may be issued from time to time by the Company's Board of Directors in one or more series; and (iv) establishment of a classified board of directors, divided into three classes, the members of which will serve for staggered terms.\nHolders of Class A common stock and Class B common stock are entitled to one vote per share and, except as otherwise required, will vote together as a single class on all matters on which stockholders generally are entitled to vote. Holders of Class B common stock are not entitled to receive dividends and will not be entitled to receive any distributions upon the liquidation, dissolution or winding up of the Company. Shares of Class B common stock may only be issued to the extent necessary to maintain the one -to-one ratio between the number of LLC Interests held by the Continuing Equity Owners and the number of shares of Class B common stock held by the Continuing Equity Owners. Shares of Class B common stock are transferable only together with an equal number of LLC Interests. Shares of Class B common stock will be canceled on a one -for-one basis if the Company, at the election of a Continuing Equity Owner, redeem or exchange LLC Interests.\nThe Company must, at all times, maintain a one -to-one ratio between the number of shares of Class A common stock issued by the Company and the number of LLC Interests owned by the Company (subject to certain exceptions for treasury shares and shares underlying certain convertible or exchangeable securities).\nInitial Public Offering\n15\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\nAs discussed in Note 1, on January 29, 2021, the Company closed an IPO of 11,550,000 shares of the Class A common stock at a public offering price of $ 25.00 per share. The Company received $ 278.8 million in proceeds, net of underwriting discounts and commissions, which was used to purchase 6,315,790 LLC Interests from Shoals Parent and 5,234,210 LLC Interests from the founder and Class B unit holder in Shoals Parent at a price per interest equal to the IPO price of the Class A common stock of $ 25.00 .\nShoals Parent Recapitalization\nAs noted above, in connection with the IPO, the limited liability company agreement of Shoals Parent was amended and restated to, among other things, (i) provide for a new single class of common membership interests in Shoals Parent, or the LLC Interests; (ii) exchange all of the then existing membership interests of the Continuing Equity Owners for LLC Interests (iii) exchange all the then existing membership interest of the Class A Shoals Equity Owners for LLC Interests and (iv) appoint the Company as the sole managing member of Shoals Parent. The Company has a majority economic interest in, is the sole managing member of, has the sole voting power in, and controls the management of Shoals Parent.\nThe amendment also requires that Shoals Parent, at all times, maintain (i) a one -to-one ratio between the number of shares of Class A common stock issued by the Company and the number of LLC Interests owned by the Company and (ii) a one -to-one ratio between the number of shares of Class B common stock owned by the Continuing Equity Owners and the number of LLC Interests owned by the Continuing Equity Owners.\nAcquisition of Former Shoals Equity Owners\nOn January 26, 2021, the Company acquired, by merger, an entity that was a member of Shoals Parent, or the Class A Shoals Equity Owners, for which the Company issued 81,977,751 shares of Class A common stock as merger consideration. The only assets held by the Class A Shoals Equity Owners were 81,977,751 LLC Interests. Upon consummation of the Merger, the Company recognized the LLC Interests at carrying value, as the Merger is considered to be a transaction between entities under common control.\n11. Non-Controlling Interests\nOn January 26, 2021, the Company used net proceeds from the IPO to purchase 6,315,790 LLC Interests from Shoals Parent and 5,234,210 LLC Interests from the founder and Class B unit holder in Shoals Parent. In addition, the Company issued 81,977,751 Class A common stock for the same number of LLC Interests as Merger consideration. Following the completion of the Organizational Transactions and as of June 30, 2021, the Company owned 56.14 % of Shoals Parent.\nThe following table summarizes the effects of the changes in ownership in Shoals Parent on equity:\n16\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\n| Three Months EndedJune 30, 2021 | Period from January 27, 2021 to June 30, 2021 |\n| Net income (loss) attributable to non-controlling interest | $ | 4,596 | $ | ( 879 ) |\n| Transfers to non-controlling interests |\n| Increase in accumulated deficit as a result of the Organizational Transactions | — | ( 88,644 ) |\n| Decrease in accumulated deficit as a result of newly issued LLC Interests in IPO | — | 70,976 |\n| Decrease in accumulated deficit as a result of activity under stock compensation plan | 857 | 1,407 |\n| Distributions to non-controlling interest | ( 2,973 ) | ( 2,973 ) |\n| Reallocation of non-controlling interest | 288 | 288 |\n| Change from net income (loss) attributable to non-controlling interest and transfers to non-controlling interest | $ | 2,768 | $ | ( 19,825 ) |\n\nIssuance of Additional LLC Interests\nUnder the first amended and restated limited liability company agreement of Shoals Parent, as amended (the \"LLC Agreement'), the Company is required to cause Shoals Parent to issue additional LLC Interests to the Company when the Company issues additional shares of Class A Common Stock. Other than as it relates to the issuance of Class A Common Stock in connection with an equity incentive program, the Company must contribute to Shoals Parent net proceeds and property, if any, received by the Company with respect to the issuance of such additional shares of Class A Common Stock. The Company must cause Shoals Parent to issue a number of LLC Interests equal to the number of shares of Class A Common Stock issued such that, at all times, the number of LLC Interests held by the Company equals the number of outstanding shares of Class A Common Stock. During the six months ended June 30, 2021, the Company caused Shoals Parent to issue to the Company a total of 6,315,790 LLC Interests in connection with the issuance of Class A common stock in the IPO and 17,813 LLC Interests for the vesting of awards granted under the Shoals Technologies Group, Inc. 2021 Long-Term Incentive Plan.\nDistributions for Taxes\nAs a limited liability company (treated as a partnership for income tax purposes), Shoals Parent does not incur significant federal, state or local income taxes, as these taxes are primarily the obligations of its members. As authorized by the LLC Agreement, Shoals Parent is required to distribute cash, to the extent that Shoals Parent has cash available, on a pro rata basis, to its members to the extent necessary to cover the members’ tax liabilities, if any, with respect to each member’s share of Shoals Parent taxable earnings. Shoals Parent makes such tax distributions to its members quarterly, based on an estimated tax rate and projected year-to-date taxable income, with a final accounting once actual taxable income or loss has been determined. During the six months ended June 30, 2021, tax distributions to non-controlling LLC Interests holders was $ 3.0 million.\n12. Commitments and Contingencies\nLitigation\n17\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\nThe Company is from time to time subject to legal proceedings and claims, which arise in the normal course of its business. In the opinion of management and legal counsel, the amount of losses that may be sustained, if any, would not have a material effect on the financial position, results of operations or cash flows of the Company.\nSurety Bonds\nThe Company provides surety bonds to various parties as required for certain transactions initiated during the ordinary course of business to guarantee the Company’s performance in accordance with contractual or legal obligations. As of June 30, 2021, the maximum potential payment obligation with regard to surety bonds was $ 11.8 million.\n13. Income Taxes\nThe Company is taxed as a subchapter C corporation and is subject to federal and state income taxes. The Company’s sole material asset is Shoals Parent, which is a limited liability company that is taxed as a partnership for US federal and certain state and local income tax purposes. Shoals Parent’s net taxable income and related tax credits, if any, are passed through to its members and included in the member’s tax returns. Shoals Parent is subject to and reports an entity level tax in Tennessee and Texas. The income tax burden on the earnings taxed to the noncontrolling interest holders is not reported by the Company in its consolidated financial statements under U.S. GAAP. As a result, the Company’s effective tax rate differs materially from the statutory rate. The Company’s income tax provision was a benefit of $ 0.3 million and $ 1.8 million for the three and six months ended June 30, 2021, respectively, and the effective tax rate is primarily impacted by the allocation of income taxes to the noncontrolling interest, benefit of the foreign derived intangible income and changes in our valuation allowance. The tax benefit for the three and six months ended June 30, 2021 includes $ 2.0 million of deferred income tax benefit resulting from an increase in the blended state income tax rate.\nAs of June 30, 2021, the Company had recorded a deferred tax asset related to the partnership basis differences in Shoals Parent of $ 49.6 million net of a $ 6.3 million valuation allowance. The Company also recorded an income tax receivable of $ 5.4 million of which the Company estimates $ 3.1 million is owed to the prior owner related to taxes paid prior to the IPO transaction.\nIn calculating the provision for interim income taxes, in accordance with ASC Topic 740, an estimated annual effective tax rate is applied to year-to-date ordinary income. At the end of each interim period, the Company estimates the effective tax rate expected to be applicable for the full fiscal year. This differs from the method utilized at the end of an annual period.\nFor annual periods, the Company accounts for income taxes using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. In assessing the realizability of deferred tax assets, management considers whether it is more-likely-than-not that the deferred tax assets will be realized. Deferred tax assets and liabilities are calculated by applying existing tax laws and the rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in the year of the enacted rate change.\n18\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\nThe Company accounts for uncertainty in income taxes using a recognition and measurement threshold for tax positions taken or expected to be taken in a tax return, which are subject to examination by federal and state taxing authorities. The tax benefit from an uncertain tax position is recognized when it is more likely than not that the position will be sustained upon examination by taxing authorities based on the technical merits of the position. The amount of the tax benefit recognized is the largest amount of the benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. The effective tax rate and the tax basis of assets and liabilities reflect management’s estimates of the ultimate outcome of various tax uncertainties. The Company recognizes penalties and interest related to uncertain tax positions within the provision (benefit) for income taxes line in the accompanying consolidated statements of operations. As of the quarter ended June 30, 2021, no uncertain tax positions have been recorded. The Company will continue to monitor this position each interim period.\nThe Company files U.S. federal and certain state income tax returns. The income tax returns of the Company are subject to examination by U.S. federal and state taxing authorities for various time periods, depending on those jurisdictions’ rules, generally after the income tax returns are filed.\n14. Tax Receivable Agreement\nIn connection with the Organization Transactions and the IPO, the Company entered into a tax receivable agreement (the “TRA”) with the founder and former equity owners of Shoals Investment CTB (the “TRA Owners”). The TRA provides for the payment from time to time by the Company to the TRA Owners of 85 % of the amount of the benefits, if any, that the Company has deemed to realize as a result of (i) increases in tax basis resulting from the purchase or exchange of LLC Interests and other qualifying transactions. These payment obligations are obligations of the Company and not of Shoals Parent. For purposes of the TRA, the benefit deemed realized by the Company will generally be computed by comparing the actual income tax liability of the Company (calculated with certain assumptions) to the amount of such taxes that the Company would have been required to pay had there been no increase to the tax basis of the assets of Shoals Parent as a result of the purchases or exchanges, and had the Company not entered into the TRA.\nThe TRA further provides that, upon certain mergers, asset sales or other forms of business combinations or other changes of control, the Company (or its successor) would owe to the TRA Owners a lump-sum payment equal to the present value of all forecasted future payments that would have otherwise been made under the TRA that would be based on certain assumptions, including a deemed exchange of Shoals Parent LLC Interests and that the Company would have sufficient taxable income to fully utilize the deductions arising from the increased tax basis and other tax benefits related to entering into the TRA. The Company also is entitled to terminate the TRA, which, if terminated, would obligate the Company to make early termination payments to the TRA Owners.\nOn January 26, 2021, the Company acquired 5,234,210 LLC Interests from the founder. This acquisition triggered a tax basis increase subject to the provisions of the TRA. In the first quarter of fiscal year 2021, the Company recognized (i) a deferred tax asset in the amount of $ 32.1 million, (ii) a corresponding liability of $ 27.2 million, representing 85 % of the tax benefits to the TRA Owners and (iii) $ 4.9 million of additional paid-in capital.\nOn January 26, 2021, in connection with the merger with Shoals Investment CTB, the Company distributed 85 % of the value in the tax basis from the original acquisition of Shoals Parent by Shoals investment CTB in 2017 to the holders of the TRA. In the first quarter of fiscal year 2021, the Company\n19\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\nrecognized (i) a deferred tax asset of $ 16.9 million, (ii) a corresponding liability of $ 14.4 million representing 85 % of the tax benefits to the TRA Owners and (iii) $ 2.5 million of additional paid-in capital.\nDuring the second quarter, the TRA liability was increased by $ 1.7 million resulting from an estimated increase in the Company’s blended state income tax rate. As a result of the adjustment to the Tax Receivable Agreement liability, the Company recorded approximately $ 1.7 million of other expense in the Condensed Consolidated Statement of Operations for the six months ended June 30, 2021. As of June 30, 2021, the amount of Tax Receivable Agreement payments due under the Tax Receivable Agreement was $ 43.4 million.\n15. Revenue by Product\nBased on Topic 606 provisions, the Company disaggregates its revenue from contracts with customers between system solutions and components. System solutions are contracts under which the Company provides multiple products typically in connection with the design and specification of an entire EBOS system. Components represents sales of individual solar components.\nThe following table presents the Company’s revenue disaggregated by system solutions and solar components which are recorded over time as follows (in thousands):\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| System solutions | $ | 51,242 | $ | 31,626 | $ | 84,611 | $ | 54,419 |\n| Solar components | 8,480 | 11,801 | 20,715 | 29,748 |\n| Total revenue | $ | 59,722 | $ | 43,427 | $ | 105,326 | $ | 84,167 |\n\n16. Subsequent Events\nFollow On Offering / Tax Receivable Agreement\nIn July 2021, the Company completed a follow-on offering consisting of 4,989,692 shares of Class A common stock offered by the selling shareholders and 10,402,086 shares of Class A common stock offered by the Company. The Company used the proceeds of the sale of Class A common stock to purchase an equal number of LLC Interests and Class B common stock corresponding to such number of LLC Interests from our founder and management. The Company obtains an increase in its share of the tax basis of the assets of Shoals Parent when LLC Interests and Class B common stock corresponding to such number of LLC Interests are redeemed or exchanged. This increase in tax basis may have the effect of reducing the amounts that the Company would otherwise pay in the future to various tax authorities. The increase in tax basis may also decrease gains (or increase losses) on future dispositions of certain capital assets to the extent tax basis is allocated to those capital assets. The exchange of 10,402,086 LLC Interests and shares of Class B common stock corresponding to such number of LLC Interests triggered a tax basis increase subject to the provisions of the Tax Receivable Agreement. In the third quarter of fiscal year 2021, the Company will recognize a deferred tax asset in the amount of approximately $ 71.8 million, a corresponding increase in the tax receivable agreement liability of $ 61.1 million, representing 85 % of the tax benefits and approximately $ 10.7 million of additional-paid-in capital.\n20\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nThis Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our financial statements and the related notes and other financial information included in our Annual Report on Form 10-K for the year ended December 31, 2020 (“2020 Form 10-K”) and this Quarterly Report on Form 10-Q. In addition to historical financial information, the following discussion and analysis contain forward-looking statements that involve risks, uncertainties and assumptions. For this purpose, any statements contained in this Form 10-Q that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, words such as “may,” “will,” “expect,” “believe,” “anticipate,” “estimate” or “continue” or comparable terminology are intended to identify forward-looking statements. Our actual results and timing of selected events may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those discussed under the sections of our 10-K and this Form 10-Q captioned “Special Note Regarding Forward-Looking Statements” and “Risk Factors”.\nThis Management’s Discussion and Analysis of Financial Condition and Results of Operations contain the presentation of Adjusted EBITDA and Adjusted Net Income, which are not presented in accordance with GAAP. Adjusted EBITDA and Adjusted Net Income are being presented because they provide the Company and readers of this Form 10-Q with additional insight into our operational performance relative to earlier periods and relative to our competitors. We do not intend Adjusted EBITDA and Adjusted Net Income to be substitutes for any GAAP financial information. Readers of this Form 10-Q should use Adjusted EBITDA and Adjusted Net Income only in conjunction with Net Income, the most comparable GAAP financial measure. Reconciliations of Adjusted EBITDA and Adjusted Net Income to Net Income, the most comparable GAAP measure to each, are provided in “—Non-GAAP Financial Measures.”\nOverview\nWe are a leading provider of electrical balance of system or “EBOS” solutions for solar energy projects in the United States. EBOS encompasses all of the components that are necessary to carry the electric current produced by solar panels to an inverter and ultimately to the power grid. EBOS components are mission-critical products that have a high consequence of failure, including lost revenue, equipment damage, fire damage, and even serious injury or death. As a result, we believe customers prioritize reliability and safety over price when selecting EBOS solutions.\nEBOS components that we produce include cable assemblies, inline fuses, combiners, disconnects, recombiners, wireless monitoring systems, junction boxes, transition enclosures and splice boxes. We derive the majority of our revenue from selling “system solutions” which are complete EBOS systems that include several of our products, many of which are customized for the customer’s project. We believe our system solutions are unique in our industry because they integrate design and engineering support, proprietary components and innovative installation methods into a single offering that would otherwise be challenging for a customer to obtain from a single provider or at all.\nWe sell our products principally to engineering, procurement and construction firms (\"EPCs”) that build solar energy projects. However, given the mission critical nature of EBOS, the decision to use our products typically involves input from both the EPC and the owner of the solar energy project. The custom nature of our system solutions and the long development cycle for solar energy projects typically gives us 12 months or more of lead time to quote, engineer, produce and ship each order we receive, and we do not stock large amounts of finished goods.\n21\nWe derived approximately 80% of our revenue from the sale of system solutions for the six months ended June 30, 2021. For the same period, we derived substantially all of our revenue from customers in the U.S. We had $200.5 million of backlog and awarded orders, backlog represents signed purchase orders or contractual minimum purchase commitments with take-or-pay provisions and awarded orders are orders we are in the process of documenting a contract but for which a contract has not yet been signed, as of June 30, 2021, representing a 63% and 11% increase relative to the same date last year and March 31, 2021, respectively.\nWe have maintained focus on our growth strategy throughout the quarter including developments in converting customers to our combine-as-you-go system and developing products for the rapidly growing electric vehicle charging infrastructure market. We believe that eight of the top 10 solar EPCs as reported by Solar Power World Magazine use our combine-as-you-go system on a majority of their projects and we are currently in the process of transitioning an additional 11 EPCs and developers to our system. Additionally, we are currently developing four new product families for the EV charging market: skid solutions that package the key components required for an EV charging station in the factory with the objective of reducing the amount of labor required in the field; raceways that allow wire to be run above ground rather than in underground conduit; EV-Big Lead Assembly (“BLA”) that eliminates homeruns from each dispenser and offers benefits similar to our solar BLA, including a 75% reduction in wire runs; and quad chargers that are prefabricated dispensers with four charge points. We expect to introduce our first offerings for this rapidly growing market in the fourth quarter of 2021.\nInitial Public Offering\nOn January 29, 2021, the Company closed an IPO of 11,550,000 shares of Class A common stock at a public offering price of $25.00 per share, including shares issued pursuant to the underwriters' over-allotment option. The Company received $278.8 million in proceeds, net of underwriting discounts and commissions, which was used to purchase 6,315,790 LLC Interests from Shoals Parent and 5,234,210 LLC Interests from the founder and Class B unit holder in Shoals Parent at a price per interest equal to the IPO price of $25.00 per share. Subsequent to the IPO and related organizational transactions that occurred in connection with the IPO, the Company is the sole managing member of, and had a 56.14% economic interest in, Shoals Parent.\nOrganizational Transactions\nSee Note 1 to the condensed consolidated financial statements of Shoals, included in this Quarterly Report on Form 10-Q for more information about the above-mentioned transactions as well as the other transactions completed in connection with the IPO.\nFollowing the completion of the Organizational Transactions, the Company owned 56.14% of Shoals Parent. The Continuing Equity Owners owned the remaining 43.86% of Shoals Parent.\nAs the Organization Transactions were considered transactions between entities under common control, the condensed consolidated financial statements for the periods prior to the IPO and Organizational Transactions have been adjusted to combine the previously separate entities for presentation purposes.\nImpact of COVID-19\nThe global health crisis caused by the novel coronavirus COVID-19 pandemic and its resurgences has and may continue to negatively impact global economic activity, which, despite progress in vaccination efforts, remains uncertain and cannot be predicted with confidence. In addition, a new Delta variant of COVID-19, which appears to be the most transmissible variant to date, has begun to spread globally. The impact of the Delta variant cannot be predicted at this time, and could depend on numerous factors, including vaccination\n22\nrates among the population, the effectiveness of the COVID-19 vaccines against the Delta variant and the response by governmental bodies and regulators. Given the ongoing and dynamic nature of the circumstances, it is difficult to predict the impact of the COVID-19 pandemic on our business.\nMany countries around the world have continued to impose quarantines and restrictions on travel and mass gatherings to slow the spread of the virus. Accordingly, our ability to continue to operate our business may also be limited. Such events may result in a period of business, supply and manufacturing disruptions, and in reduced operations, any of which could materially affect our business, financial condition and results of operations.\nA continuation or worsening of the levels of market disruption and volatility seen in the recent past could have an adverse effect on our ability to access capital, which could in the future negatively affect our liquidity. In addition, a recession or market correction resulting from the spread of COVID-19 could materially affect our business and the value of our common stock.\nWe continue to monitor the impacts of COVID-19 on the global economy and on our business operations. Although we expect the vaccinations for COVID-19 will continue to improve conditions, the ultimate impact from COVID-19 on our business operations and financial results during 2021 will depend on, among other things, the ultimate severity and scope of the pandemic, including the new variants of the virus, the pace at which governmental and private travel restrictions and public concerns about public gatherings will ease, the rate at which historically large increases in unemployment rates will decrease, if at all, and whether, and the speed with which, the economy recovers. We are not able to fully quantify the impact that these factors will have on our financial results during 2021 and beyond, but developments related to COVID-19 may materially affect us in 2021.\nKey Components of Our Results of Operations\nThe following discussion describes certain line items in our condensed consolidated statements of operations.\nRevenue\nWe generate revenue from the sale of EBOS systems and components for homerun and combine-as-you-go architectures. Our customers include EPCs, utilities, solar developers, independent power producers and solar module manufacturers. We derive the majority of our revenue from selling system solutions. When we sell a system solution, we enter into a contract with our customers covering the price, specifications, delivery dates and warranty for the products being purchased, among other things. Our contractual delivery period for system solutions can vary from one to three months whereas manufacturing typically requires a shorter time frame. Contracts for system solutions can range in value from several hundred thousand to several million dollars.\nOur revenue is affected by changes in the price, volume and mix of products purchased by our customers. The price and volume of our products is driven by the demand for our products, changes in product mix between homerun and combine-as-you-go EBOS, geographic mix of our customers, strength of competitors’ product offerings, and availability of government incentives to the end-users of our products.\nOur revenue growth is dependent on continued growth in the amount of solar energy projects constructed each year and our ability to increase our share of demand in the geographies where we currently compete and plan to compete in the future as well as our ability to continue to develop and commercialize new and innovative products that address the changing technology and performance requirements of our customers.\n23\nCost of Revenue and Gross Profit\nCost of revenue consists primarily of product costs, including purchased materials and components, as well as costs related to shipping, customer support, product warranty, personnel and depreciation of manufacturing and testing equipment. Personnel costs in cost of revenue include both direct labor costs as well as costs attributable to any individuals whose activities relate to the transformation of raw materials or component parts into finished goods or the transportation of materials to the customer. Our product costs are affected by the underlying cost of raw materials, including copper and aluminum; component costs, including fuses, resin, enclosures, and cable; technological innovation; economies of scale resulting in lower component costs; and improvements in production processes and automation. We do not currently hedge against changes in the price of raw materials. Some of these costs, primarily personnel and depreciation of manufacturing and testing equipment, are not directly affected by sales volume. Gross profit may vary from year to year and is primarily affected by our sales volume, product prices, product costs, product mix, customer mix, geographical mix, shipping method, warranty costs and seasonality.\nOperating Expenses\nOperating expenses consist of general and administrative costs as well as depreciation and amortization expense. Personnel-related costs are the most significant component of our operating expenses and include salaries, equity-based compensation, benefits, payroll taxes and commissions. The number of full-time employees in our general and administrative departments increased from 42 to 68 from June 30, 2020 to June 30, 2021, and we expect to hire new employees in the future to support our growth. The timing of these additional hires could materially affect our operating expenses in any particular period, both in absolute dollars and as a percentage of revenue. We expect to invest in additional resources to support our growth which will increase our operating expenses.\nGeneral and Administrative Expenses\nGeneral and administrative expenses consist primarily of salaries, equity-based compensation expense, employee benefits and payroll taxes related to our executives, and our sales, finance, human resources, information technology, engineering and legal organizations, travel expenses, facilities costs, marketing expenses, bad debt expense and fees for professional services. Professional services consist of audit, legal, tax, insurance, information technology and other costs. We expect to increase our sales and marketing personnel as we expand into new geographic markets. Substantially all of our sales in 2020 were in the U.S. We currently have a sales presence in the U.S., Australia and Spain. We intend to expand our sales presence and marketing efforts to additional countries in the future. We also expect that as a result of our recent IPO, we will incur additional audit, tax, accounting, legal and other costs related to compliance with applicable securities and other regulations, as well as additional insurance, investor relations and other costs associated with being a public company.\nDepreciation\nDepreciation in our operating expenses consists of costs associated with property, plant and equipment (“PP&E”) not used in manufacturing our products. We expect that as we increase both our revenue and the number of our general and administrative personnel, we will invest in additional PP&E to support our growth resulting in additional depreciation expense.\nAmortization\nAmortization of intangibles consists of customer relationships, developed technology, trade names and non-compete agreements over their expected period of use.\n24\nNon-operating Expenses\nInterest Expense\nInterest expense consists of interest and other charges paid in connection with our current Senior Secured Credit Agreement (as defined below) and our former Senior Debt which included a revolving line of credit and term loan, which was fully repaid on October 8, 2020.\nTax Receivable Agreement Liability Adjustment\nTax receivable agreement liability adjustment consists of changes to our effective interest rate since the initial recording of the liability related to our tax receivable agreement with our founder and former Class A Shoals Equity Owners of Shoals Parent.\nLoss on Debt Repayment\nLoss on debt repayment consists of prepayment premiums and the write-off off a portion of the deferred financing costs from the prepayment of outstanding borrowings under the Term Loan Facility.\nIncome Tax Expense\nShoals Technologies Group, Inc. is subject to U.S. federal and state income tax in multiple jurisdictions with respect to our allocable share of any net taxable income of Shoals Parent. Shoals Parent is a pass-through entity for federal income tax purposes but incurs income tax in certain state jurisdictions.\n25\nResults of Operations\nThe following table summarizes our results of operations (dollars in thousands):\n| Three Months Ended June 30, | Increase / (Decrease) | Six Months Ended June 30, | Increase / (Decrease) |\n| 2021 | 2020 | 2021 | 2020 |\n| Revenue | $ | 59,722 | $ | 43,427 | $ | 16,295 | 38 | % | $ | 105,326 | $ | 84,167 | $ | 21,159 | 25 | % |\n| Cost of revenue | 33,543 | 26,598 | 6,945 | 26 | % | 60,373 | 53,152 | 7,221 | 14 | % |\n| Gross profit | 26,179 | 16,829 | 9,350 | 56 | % | 44,953 | 31,015 | 13,938 | 45 | % |\n| Operating Expenses |\n| General and administrative expenses | 10,018 | 9,317 | 701 | 8 | % | 16,834 | 11,875 | 4,959 | 42 | % |\n| Depreciation and amortization | 2,062 | 2,064 | (2) | — | % | 4,130 | 4,125 | 5 | — | % |\n| Total Operating Expenses | 12,080 | 11,381 | 699 | 6 | % | 20,964 | 16,000 | 4,964 | 31 | % |\n| Income from Operations | 14,099 | 5,448 | 8,651 | 159 | % | 23,989 | 15,015 | 8,974 | 60 | % |\n| Interest expense, net | (3,620) | (225) | (3,395) | 1509 | % | (7,329) | (497) | (6,832) | 1375 | % |\n| Tax receivable agreement liability adjustment | (1,664) | — | (1,664) | 100 | % | (1,664) | — | (1,664) | 100 | % |\n| Loss on debt repayment | — | — | — | — | % | (15,990) | — | (15,990) | 100 | % |\n| Income (loss) before income taxes | 8,815 | 5,223 | 3,592 | 69 | % | (994) | 14,518 | (15,512) | (107) | % |\n| Income tax benefit | 339 | — | 339 | 100 | % | 1,814 | — | 1,814 | 100 | % |\n| Net income | 9,154 | 5,223 | 3,931 | 75 | % | 820 | 14,518 | (13,698) | (94) | % |\n| Less: net income (loss) attributable to non-controlling interests | 4,596 | — | 4,596 | 100 | % | (879) | — | (879) | 100 | % |\n| Net income attributable to Shoals Technologies Group, Inc. | $ | 4,558 | $ | 5,223 | $ | (665) | (13) | % | $ | 1,699 | $ | 14,518 | $ | (12,819) | (88) | % |\n\nComparison of the Three Months Ended June 30, 2021 and 2020\nRevenue\nRevenue increased by $16.3 million, or 38%, for the three months ended June 30, 2021 as compared to the three months ended June 30, 2020, driven by an increase in demand for solar EBOS generally and our combine-as-you-go system solutions specifically. Our total number of customers increased in 2021 as compared to 2020. We believe customer recognition of the benefits of our combine-as-you-go system is resulting in increased demand for our products.\nCost of Revenue and Gross Profit\nCost of revenue increased by $6.9 million, or 26%, for the three months ended June 30, 2021 as compared to the three months ended June 30, 2020, primarily driven by an increase in production volumes. Gross profit as a percentage of revenue increased from 38.8% in 2020 to 43.8% in 2021 in part due to purchasing efficiencies from increased volumes, improved material planning which reduced logistics costs,\n26\nenhancements to product design that lowered manufacturing costs and other manufacturing efficiencies resulting from higher production volumes. Changes in product mix also contributed to the increase in margin as sales of system solutions for combine-as-you-go EBOS, which have higher margin than our other products, increased as a percentage of our total revenue.\nOperating Expenses\nGeneral and Administrative\nGeneral and administrative expenses increased $0.7 million, or 8%, for the three months ended June 30, 2021 as compared to the three months ended June 30, 2020. The increase in general and administrative expenses was primarily the result of an increase in professional fees of $1.9 million related to preparation for our public offerings, wages and related taxes of $1.6 million related to increased head count and year-end bonuses, and an insurance expense of $0.8 million primarily related to increased costs for our directors and officers policy, offset by a decrease in equity-based compensation of $4.1 million.\nDepreciation and Amortization\nThere was no significant change in depreciation and amortization expense during the three months ended June 30, 2021 as compared to the three months ended June 30, 2020.\nInterest Expense\nInterest expense, net increased by $3.4 million or 1509%, for the three months ended June 30, 2021 as compared to the three months ended June 30, 2020, due to increased borrowings and related deferred financing costs under our Senior Secured Credit Facility entered into on November 25, 2020. We expect interest expense to increase in 2021 as a result of our higher average borrowings under the Senior Secured Credit Facility (see description under “Debt Obligations”).\nTax Receivable Agreement Liability Adjustment\nTax receivable agreement liability adjustment totaled $1.7 million for the three months ended June 30, 2021. The adjustment resulted from an estimated increase in the Company’s blended state income tax rate.\nIncome Tax Benefit\nIncome tax benefit totaled $0.3 million for the three months ended June 30, 2021. The Company did not incur income tax expense prior to the Organizational Transactions, or during the three months ended June 30, 2020.\nComparison of the Six Months Ended June 30, 2021 and 2020\nRevenue\nRevenue increased by $21.2 million, or 25%, for the six months ended June 30, 2021 as compared to the six months ended June 30, 2020, driven by an increase in demand for solar EBOS generally and our combine-as-you-go system solutions specifically. Our total number of customers increased in 2021 as compared to 2020. We believe customer recognition of the benefits of our combine-as-you-go system is resulting in increased demand for our products.\nCost of Revenue and Gross Profit\n27\nCost of revenue increased by $7.2 million, or 14%, for the six months ended June 30, 2021 as compared to the six months ended June 30, 2020, primarily driven by an increase in production volumes. Gross profit as a percentage of revenue increased from 36.8% for the six months ended June 30, 2020 to 42.7% for the six months ended June 30, 2021 in part due to purchasing efficiencies from increased volumes, improved material planning which reduced logistics costs, enhancements to product design that lowered manufacturing costs and other manufacturing efficiencies resulting from higher production volumes. Changes in product mix also contributed to the increase in margin as sales of system solutions for combine-as-you-go EBOS, which have higher margin than our other products, increased as a percentage of our total revenue.\nOperating Expenses\nGeneral and Administrative\nGeneral and administrative expenses increased by $5.0 million, or 42%, for the six months ended June 30, 2021 as compared to the six months ended June 30, 2020. The increase in general and administrative expenses was primarily the result of an increase in professional fees of $2.5 million related to preparation for our public offerings, wages and related taxes of $2.8 million related to increased head count and year-end bonuses, an insurance expense of $1.5 million primarily related to increased costs for our directors and officers policy and franchise and other related taxes of $0.3 million, offset by a decrease in equity-based compensation of $2.8 million and a decrease in travel and trade shows of $0.2 million as a result of COVID-19.\nDepreciation and Amortization\nThere was no significant change in depreciation and amortization expense during the six months ended June 30, 2021 as compared to the six months ended June 30, 2020.\nInterest Expense\nInterest expense, net increased by $6.8 million or 1375%, for the six months ended June 30, 2021 as compared to the six months ended June 30, 2020, due to increased borrowings and related deferred financing costs under our Senior Secured Credit Facility entered into on November 25, 2020. We expect interest expense to increase in 2021 as a result of our higher average borrowings under the Senior Secured Credit Facility (see description under “Debt Obligations”).\nTax Receivable Agreement Liability Adjustment\nTax receivable agreement liability adjustment totaled $1.7 million for the six months ended June 30, 2021. The adjustment resulted from an estimated increase in the Company’s blended state income tax rate.\nLoss on Debt Repayment\nLoss on debt repayment for the six months ended June 30, 2021 consists of $11.3 million of prepayment premium and $4.7 million in write-off off a portion of the deferred financing costs related to a prepayment of $150.0 million of outstanding borrowings under the Term Loan Facility.\nIncome Tax Benefit\nIncome tax benefit totaled $1.8 million for the six months ended June 30, 2021. The Company did not incur income tax expense prior to the Organizational Transactions, or during the six months ended June 30, 2020.\nNon-GAAP Financial Measures\nAdjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS\n28\nWe define Adjusted EBITDA as net income (loss) plus (i) interest expense, (ii) income taxes, (iii) depreciation expense, (iv) amortization of intangibles, (v) tax receivable agreement liability adjustment, (vi) loss on debt repayment, (vii) equity-based compensation, (viii) COVID-19 expenses and (ix) non-recurring and other expenses. We define Adjusted Net Income as net income (loss) plus (i) amortization of intangibles, (ii) tax receivable agreement liability adjustment, (iii) loss on debt repayment, (iv) amortization of deferred financing costs, (v) equity-based compensation, (vi) COVID-19 expenses and (vii) non-recurring and other expenses, all net of applicable income taxes. We define Adjusted Diluted EPS as Adjusted Net Income divided by the diluted weighted average shares of Class A common shares outstanding for the applicable period, which assumes the pro forma exchange of all outstanding Class B common shares for Class A common shares.\nAdjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS are intended as supplemental measures of performance that are neither required by, nor presented in accordance with, GAAP. We present Adjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS because we believe they assist investors and analysts in comparing our performance across reporting periods on a consistent basis by excluding items that we do not believe are indicative of our core operating performance. In addition, we use Adjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS: (i) as factors in evaluating management’s performance when determining incentive compensation; (ii) to evaluate the effectiveness of our business strategies; and (iii) because our credit agreement uses measures similar to Adjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS to measure our compliance with certain covenants.\nAmong other limitations, Adjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS do not reflect our cash expenditures, or future requirements for capital expenditures or contractual commitments; do not reflect the impact of certain cash charges resulting from matters we consider not to be indicative of our ongoing operations; in the case of Adjusted EBITDA, does not reflect income tax expense or benefit for periods prior to the reorganization; and may be calculated by other companies in our industry differently than we do or not at all, which may limit their usefulness as comparative measures.\nBecause of these limitations, Adjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS should not be considered in isolation or as substitutes for performance measures calculated in accordance with GAAP. You should review the reconciliation of net income to Adjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS below and not rely on any single financial measure to evaluate our business.\nReconciliation of Net Income to Adjusted EBITDA (in thousands):\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Net income | $ | 9,154 | $ | 5,223 | $ | 820 | $ | 14,518 |\n| Interest expense | 3,620 | 225 | 7,329 | 497 |\n| Income tax benefit | (339) | — | (1,814) | — |\n| Depreciation expense | 411 | 338 | 816 | 664 |\n| Amortization of intangibles | 1,996 | 1,996 | 3,992 | 3,992 |\n| Tax receivable agreement liability adjustment(a) | 1,664 | — | 1,664 | — |\n| Loss on debt repayment | — | — | 15,990 | — |\n| Equity-based compensation | 2,780 | 6,704 | 4,172 | 6,704 |\n| COVID-19 expenses(b) | 106 | 806 | 161 | 806 |\n| Non-recurring and other expenses(c) | 1,239 | 112 | 1,578 | 294 |\n| Adjusted EBITDA | $ | 20,631 | $ | 15,404 | $ | 34,708 | $ | 27,475 |\n\n29\n(a) Represents an adjustment to eliminate the remeasurement of the Tax Receivable Agreement.\n(b) Represents costs incurred as a direct impact from the COVID-19 pandemic, disinfecting and reconfiguration of facilities, medical professionals to conduct daily screenings of employees, premium pay during the pandemic to hourly workers in 2020 and direct legal costs associated with the pandemic.\n(c) Represents certain costs associated with non-recurring professional services, Oaktree’s expenses and other costs.\nReconciliation of Net Income Attributable to Shoals Technologies Group, Inc. to Adjusted Net Income (in thousands):\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Net income attributable to Shoals Technologies Group, Inc. | $ | 4,558 | $ | 5,223 | $ | 1,699 | $ | 14,518 |\n| Net income (loss) impact from pro forma conversion of Class B common stock to Class A common stock (a) | 4,596 | — | (879) | — |\n| Adjustment to the provision for income tax (b) | (942) | (1,133) | 192 | (3,150) |\n| Tax effected net income | 8,212 | 4,090 | 1,012 | 11,368 |\n| Amortization of intangibles | 1,996 | 1,996 | 3,992 | 3,992 |\n| Amortization of deferred financing costs | 305 | 12 | 675 | 21 |\n| Tax receivable agreement liability adjustment(c) | 1,664 | — | 1,664 | — |\n| Loss on debt repayment | — | — | 15,990 | — |\n| Equity-based compensation | 2,780 | 6,704 | 4,172 | 6,704 |\n| COVID-19 expenses (d) | 106 | 806 | 161 | 806 |\n| Non-recurring and other expenses (e) | 1,239 | 112 | 1,578 | 294 |\n| Tax impact of adjustments (f) | (1,635) | (635) | (5,806) | (1,110) |\n| Adjusted Net Income | $ | 14,667 | $ | 13,085 | $ | 23,438 | $ | 22,075 |\n\n(a) Reflects net income (loss) to Class A common shares from pro forma exchange of corresponding shares of our Class B common shares held by our founder and management.\n(b) Shoals Technologies Group, Inc. is subject to U.S. Federal income taxes, in addition to state and local taxes with respect to its allocable share of any net taxable income of Shoals Parent LLC. The adjustment to the provision for income tax reflects the effective tax rates below, assuming Shoals Technologies Group, Inc. owns 100% of the units in Shoals Parent LLC.\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Statutory U.S. Federal income tax rate | 21.0 | % | 21.0 | % | 21.0 | % | 21.0 | % |\n| State and local taxes (net of federal benefit) | 2.0 | % | 0.7 | % | 2.0 | % | 0.7 | % |\n| Permanent items, including valuation adjustment | (2.5) | % | — | % | (1.1) | % | — | % |\n| Effective income tax rate for Adjusted Net Income | 20.5 | % | 21.7 | % | 21.9 | % | 21.7 | % |\n\n30\n(c) Represents an adjustment to eliminate the remeasurement of the Tax Receivable Agreement.\n(d) Represents costs incurred as a direct impact from the COVID-19 pandemic, disinfecting and reconfiguration of facilities, medical professionals to conduct daily screenings of employees, premium pay during the pandemic to hourly workers in 2020 and direct legal costs associated with the pandemic.\n(e) Represents certain costs associated with non-recurring professional services, Oaktree’s expenses and other costs.\n(f) Represents the estimated tax impact of all Adjusted Net Income add-backs, excluding those which represent permanent differences between book versus tax.\nReconciliation of Diluted Weighted Average Shares Outstanding to Adjusted Diluted Weighted Average Shares Outstanding (in thousands, except per share):\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Diluted weighted average shares of Class A common shares outstanding, excluding Class B common shares | 93,760 | N/A (b) | 93,650 | N/A (b) |\n| Assumed pro forma conversion of Class B common shares to Class A common shares | 73,067 | N/A (b) | 73,067 | N/A (b) |\n| Adjusted diluted weighted average shares outstanding | 166,827 | N/A (b) | 166,717 | N/A (b) |\n| Adjusted Net Income (a) | $ | 14,667 | N/A (b) | $ | 23,438 | N/A (b) |\n| Adjusted Diluted EPS | $ | 0.09 | N/A (b) | $ | 0.14 | N/A (b) |\n\n(a) Represents Adjusted Net Income for the full period presented.\n(b) This Non-GAAP measure is not applicable for this period, as the reorganization transactions had not yet occurred.\nLiquidity and Capital Resources\n| Six Months Ended June 30, |\n| 2021 | 2020 |\n| Net cash provided by (used in) operating activities | $ | (14,114) | $ | 18,928 |\n| Net cash used in investing activities | (1,736) | (1,345) |\n| Net cash provided by (used in) financing activities | 18,948 | (10,361) |\n| Net increase in cash and cash equivalents | $ | 3,098 | $ | 7,222 |\n\nWe finance our operations primarily with operating cash flows and short and long-term borrowings. Our ability to generate positive cash flow from operations is dependent on the strength of our gross margins as well as our ability to quickly turn our working capital. Based on our past performance and current expectations, we believe that operating cash flows and availability under our Revolving Credit Facility will be sufficient to meet our near term future cash needs.\n31\nWe used cash from operating activities of $14.1 million in the six months ended June 30, 2021 as compared to cash generated from operating activities of $18.9 million for the six months ended June 30, 2020. As of June 30, 2021, our cash and cash equivalents were $13.2 million and we had outstanding borrowings of $247.3 million. We also had $51.0 million available for additional borrowings under our $100.0 million Revolving Credit Facility.\nOperating Activities\nFor the six months ended June 30, 2021, cash used in operating activities was $14.1 million, primarily due to operating results that included $0.8 million of net income which was reduced by $15.6 million, net of non-cash expenses, an increase of $6.2 million in inventory, $19.0 million in receivables, $4.6 million in other current assets and a decrease in accounts payable and accrued expenses of $0.8 million.\nFor the six months ended June 30, 2020, cash provided by operating activities was $18.9 million, primarily due to operating results that included $14.5 million of net income which was reduced by $11.4 million, net of non-cash expenses, an increase of $5.0 million in receivables, an increase of $3.4 million in inventory and an increase of $0.8 million in accounts payable and accrued expenses.\nInvesting Activities\nFor the six months ended June 30, 2021, net cash used in investing activities was $1.7 million, attributable to the purchase of property and equipment.\nFor the six months ended June 30, 2020, net cash used in investing activities was $1.3 million, attributable to the purchase of property and equipment.\nFinancing Activities\nFor the six months ended June 30, 2021, net cash provided by financing activities was $18.9 million, including $144.9 million in net proceeds from the IPO and $29.0 million in borrowings under the Revolving Credit Facility offset by $151.8 million of payments on term loan facility.\nFor the six months ended June 30, 2020, net cash used in financing activities was $10.4 million. We made $8.4 million in payments on our senior debt – revolving credit facility, tax distributions of $0.2 million and payments on our senior debt-term loan of $1.7 million.\nFrom time to time, we may seek to retire or purchase the Company’s outstanding debt or equity securities through cash purchases and/or exchanges for other debt or equity securities in open market purchases, privately negotiated transactions, or otherwise, that may be made pursuant to Rule 10b5-1 or otherwise. Such repurchases or exchanges, if any, will depend on prevailing market conditions, the Company’s liquidity requirements, contractual restrictions and other factors.\nDebt Obligations\nSenior Secured Credit Agreement\nOn November 25, 2020 Shoals Holdings, entered into that certain credit agreement with the lenders party thereto from time to time and Wilmington Trust, National Association, as administrative agent and collateral agent (the “Senior Secured Credit Agreement”), consisting of (i) a $350.0 million senior secured six-year term loan facility (the “Term Loan Facility”), (ii) a $30.0 million senior secured delayed draw term loan facility, which matures concurrently with the six-year Term Loan Facility (the “Delayed Draw Term Loan Facility”) and (iii) an uncommitted super senior first out revolving credit facility (the “Revolving Credit Facility”).\n32\nThe proceeds of the Term Loan Facility and a $10.0 million draw under the Delayed Draw Term Loan Facility were used to (i) make certain distributions from Shoals Holdings to Shoals Intermediate Holdings and from there to certain of our direct or indirect equity holders, (ii) pay transaction expenses, (iii) repay and terminate all outstanding commitments under the Senior Debt (as defined herein) and (iv) finance working capital and general corporate purposes. An additional $10.0 million draw under the Delayed Draw Term Loan Facility funded on December 14, 2020.\nIn December 2020, Shoals Holdings entered into two amendments to the Senior Secured Credit Agreement in order to obtain a $100.0 million increase (the “Revolver Upsize”) to the Revolving Credit Facility and modify the terms of the interest rate and prepayment premium. As part of the first amendment we repaid and terminated all outstanding commitments under the Delayed Draw Term Loan Facility.\nAs of June 30, 2021, interest rates on the Term Loan facility and the Revolving credit facility were 4.25% and 3.75%, respectively and we had $51.0 million of availability under the Revolving Credit Facility.\nThe Senior Secured Credit Agreement contains affirmative and negative covenants, including covenants that restrict our incurrence of indebtedness, incurrence of liens, dispositions, investments, acquisitions, restricted payments, and transactions with affiliates. The Senior Secured Credit Agreement also includes customary events of default, including the occurrence of a change of control. As of June 30, 2021, we were in compliance with all the required covenants.\nSenior Debt\nIntermediate and subsidiaries were party to the Senior Debt Agreement under which Holdings and its subsidiaries were borrowers and Intermediate was a guarantor. The Senior Debt was collateralized by all of the assets of the guarantor and borrowers. The amended agreement provided a term loan of $35 million and a revolving line of credit of $25 million.\nOn October 8, 2020, we paid the outstanding amount due on the term loan and settled all obligations with respect to the Senior Debt.\nThe Senior Debt provided for an interest rate to equal the Base Rate plus margin. The Base Rate charged was the highest rate of three defined methods as follows: 1) Federal Funds Rate plus 0.5%, 2) Fifth Third Bank N.A. Rate or 3) LIBOR Rate plus 1%. The Base Rate ranged from 1% to 2.5% depending on the EBITDA Rate calculation as defined in the Senior Debt (the “EBITDA Rate calculation”) for the Federal Funds Rate. The Base Rate for the LIBOR Rate ranged from 2% to 3.5% depending on the EBITDA Rate calculation.\nSurety Bonds\nWe provide surety bonds to various parties as required for certain transactions initiated during the ordinary course of business to guarantee our performance in accordance with contractual or legal obligations. As of June 30, 2021, the maximum potential payment obligation with regard to surety bonds was $11.8 million.\nCritical Accounting Policies and Significant Management Estimates\nIncome Taxes\nWe record valuation allowances against our deferred tax assets when it is more likely than not that all or a portion of a deferred tax asset will not be realized. In making such determination, we consider all available evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax planning strategies and results of operation. We routinely evaluate the realizability of our deferred tax assets by assessing the likelihood that our deferred tax assets will be recovered based on all available positive and\n33\nnegative evidence. Estimating future taxable income is inherently uncertain and requires judgment. In projecting future taxable income, we consider our historical results and incorporate certain assumptions, including revenue growth and operating margins, among others. As of June 30, 2021, we had $49.6 million of deferred tax assets, net of valuation allowances. We expect to realize future tax benefits related to the utilization of these assets. If we determine in the future that we will not be able to fully utilize all or part of these deferred tax assets, we would record a valuation allowance through earnings in the period the determination was made, which would have an adverse effect on our results of operations and earnings in future periods.\nLiabilities Under Tax Receivable Agreement\nAs described in Note 14 to the condensed consolidated financial statements, we are a party to the TRA under which we are contractually committed to pay the TRA Owners 85% of the amount of any tax benefits that we actually realize, or in some cases are deemed to realize, as a result of certain transactions. Amounts payable under the TRA are contingent upon, among other things, (i) generation of future taxable income over the term of the TRA and (ii) future changes in tax laws. If we do not generate sufficient taxable income in the aggregate over the term of the TRA to utilize the tax benefits, then we generally would not be required to make the related TRA payments. Therefore, we will only recognize a liability for TRA payments if we determine it is probable that we will generate sufficient future taxable income over the term of the TRA to utilize the related tax benefits. Estimating future taxable income is inherently uncertain and requires judgment. In projecting future taxable income, we consider our historical results and incorporate certain assumptions, including revenue growth, and operating margins, among others. As of June 30, 2021, we recognized $43.4 million of liabilities relating to our obligations under the TRA, after concluding that it was probable that we would have sufficient future taxable income to utilize the related tax benefits. There were no transactions subject to the TRA for which we did not recognize the related liability, as we concluded that we would have sufficient future taxable income to utilize all of the related tax benefits generated by all transactions that occurred in connection with the IPO. If we determine in the future that we will not be able to fully utilize all or part of the related tax benefits, we would de-recognize the portion of the liability related the benefits not expected to be utilized.\nAdditionally, we estimate the amount of TRA payments expected to be paid within the next 12 months and classify this amount as current on our condensed consolidated balance sheets. This determination is based on our estimate of taxable income for the next fiscal year. To the extent our estimate differs from actual results, we may be required to reclassify portions of our liabilities under the TRA between current and non-current.\nAs of June 30, 2021, there were no other significant changes in the application of our critical accounting policies or estimation procedures from those presented in our Annual Report on Form 10-K for the year ended December 31, 2020.\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\nThere have been no material changes with respect to our market risk disclosed in our Annual Report on Form 10-K for the year ended December 31, 2020.\nItem 4. Controls and Procedures\nEvaluation of Disclosure Controls and Procedures\nUnder the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on this evaluation, our Chief Executive Officer and Chief\n34\nFinancial Officer concluded that our disclosure controls and procedures were effective as of such date. Our disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.\nChanges in Internal Control Over Financial Reporting\nThere were no changes to our internal control over financial reporting that occurred during the quarter ended June 30, 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\nPART II – OTHER INFORMATION\nItem 1. Legal Proceedings\nFrom time to time, we may be involved in litigation relating to claims that arise out of our operations and businesses and that cover a wide range of matters, including, among others, intellectual property matters, contract and employment claims, personal injury claims, product liability claims and warranty claims. Currently, there are no claims or proceedings against us that we believe will have a material adverse effect on our business, financial condition, results of operations or cash flows. However, the results of any current or future litigation cannot be predicted with certainty, and regardless of the outcome, we may incur significant costs and experience a diversion of management resources as a result of litigation.\nItem 1A. Risk Factors\nThere have been no material changes with respect to our risk factors disclosed in our Annual Report on Form 10-K for the year ended December 31, 2020.\nItem 2. Unregistered Sale of Equity Securities and Use of Proceeds\nRecent Sales of Unregistered Equity Securities\nNone\nItem 3. Defaults Upon Senior Securities\nNone.\nItem 4. Mine Safety Disclosures\nNot applicable.\nItem 5. Other Information\nNone.\nItem 6. Exhibits\n35\n| Incorporated by Reference |\n| Number | Description of Document | Form | Filing Date | Exhibit No. |\n| 3.1 | Amended and Restated Certificate of Incorporation of Shoals Technologies Group, Inc., dated January 28, 2021 | 8-K | 1/29/2021 | 3.1 |\n| 3.2 | Amended and Restated Bylaws of Shoals Technologies Group, Inc., dated January 28, 2021 | 8-K | 1/29/2021 | 3.2 |\n| 31.1* | Certification of the Chief Executive Officer, as required by Section 302 of the Sarbanes- Oxley Act of 2002 (18 U.S.C. 1350) |\n| 31.2* | Certification of the Chief Financial Officer, as required by Section 302 of the Sarbanes- Oxley Act of 2002 (18 U.S.C. 1350) |\n| 32.1* | Certification of the Chief Executive Officer, as required by Section 906 of the Sarbanes-Oxley Act of 2002 ( and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350) |\n| 101.INS | XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document |\n| 101.SCH* | XBRL Taxonomy Extension Schema Document |\n| 101.CAL* | XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF* | XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB* | XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE* | XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104 | Cover Page Interactive Data File - the cover page interactive data file does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document |\n\n________\n* Filed herewith\n† Indicates a management contract or compensatory plan.\n36\nSIGNATURES\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n| Shoals Technologies Group, Inc. |\n| By: | /s/ Jason Whitaker | Date: | August 10, 2021 |\n| Name: | Jason Whitaker |\n| Title: | Chief Executive Officer |\n| By: | /s/ Philip Garton | Date: | August 10, 2021 |\n| Name: | Philip Garton |\n| Title: | Chief Financial Officer |\n\n37\n \n\nWhat would be the Adjusted EBITDA for the six months ended June 30, 2021, if the loss on debt repayment was 20% lower in thousands?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\nItem 1. Financial Statements (Unaudited).\\nShoals Technologies Group, Inc.\\nCondensed Consolidated Balance Sheets (Unaudited)\\n(in thousands, except shares)\\n| June 30,2021 | December 31, 2020 |\\n| Assets |\\n| Current Assets |\\n| Cash and cash equivalents | $ | 13,171 | $ | 10,073 |\\n| Accounts receivable, net | 42,977 | 27,004 |\\n| Unbilled receivables | 6,797 | 3,794 |\\n| Inventory, net | 21,272 | 15,121 |\\n| Other current assets | 7,292 | 155 |\\n| Total Current Assets | 91,509 | 56,147 |\\n| Property, plant and equipment, net | 13,622 | 12,763 |\\n| Goodwill | 50,176 | 50,176 |\\n| Other intangible assets, net | 67,996 | 71,988 |\\n| Deferred tax asset | 49,573 | — |\\n| Other assets | 840 | 4,236 |\\n| Total Assets | $ | 273,716 | $ | 195,310 |\\n| Liabilities and Stockholders' Deficit / Members’ Deficit |\\n| Current Liabilities |\\n| Accounts payable | $ | 14,224 | $ | 14,634 |\\n| Accrued expenses | 9,499 | 5,967 |\\n| Long-term debt—current portion | 3,500 | 3,500 |\\n| Total Current Liabilities | 27,223 | 24,101 |\\n| Revolving line of credit | 49,000 | 20,000 |\\n| Long-term debt, less current portion | 188,859 | 335,332 |\\n| Payable Pursuant to the Tax Receivable Agreement | 43,356 | — |\\n| Total Liabilities | 308,438 | 379,433 |\\n| Commitments and Contingencies (Note 12) |\\n| Stockholders’ Deficit / Members’ Deficit |\\n| Members’ deficit | — | ( 184,123 ) |\\n| Preferred stock, $ 0.00001 par value - 5,000,000 shares authorized; none issued and outstanding as of June 30, 2021 | — | — |\\n| Class A common stock, $ 0.00001 par value - 1,000,000,000 shares authorized; 93,545,564 shares issued and outstanding as of June 30, 2021 | 1 | — |\\n| Class B common stock, $ 0.00001 par value - 195,000,000 shares authorized; 73,066,607 shares issued and outstanding as of June 30, 2021 | 1 | — |\\n| Additional paid-in capital | 78,883 | — |\\n| Accumulated deficit | ( 93,782 ) | — |\\n| Total stockholders’ deficit attributable to Shoals Technologies Group, Inc. / members' deficit | ( 14,897 ) | ( 184,123 ) |\\n| Non-controlling interests | ( 19,825 ) | — |\\n| Total stockholders’ deficit / members’ deficit | ( 34,722 ) | ( 184,123 ) |\\n| Total Liabilities and Stockholders’ Deficit / Members’ Deficit | $ | 273,716 | $ | 195,310 |\\n\\nSee accompanying notes to condensed consolidated financial statements.\\n1\\nShoals Technologies Group, Inc.\\nCondensed Consolidated Statements of Operations (Unaudited)\\n(in thousands, except per share amounts)\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Revenue | $ | 59,722 | $ | 43,427 | $ | 105,326 | $ | 84,167 |\\n| Cost of revenue | 33,543 | 26,598 | 60,373 | 53,152 |\\n| Gross profit | 26,179 | 16,829 | 44,953 | 31,015 |\\n| Operating Expenses |\\n| General and administrative expenses | 10,018 | 9,317 | 16,834 | 11,875 |\\n| Depreciation and amortization | 2,062 | 2,064 | 4,130 | 4,125 |\\n| Total Operating Expenses | 12,080 | 11,381 | 20,964 | 16,000 |\\n| Income from Operations | 14,099 | 5,448 | 23,989 | 15,015 |\\n| Interest expense, net | ( 3,620 ) | ( 225 ) | ( 7,329 ) | ( 497 ) |\\n| Tax receivable agreement liability adjustment | ( 1,664 ) | — | ( 1,664 ) | — |\\n| Loss on debt repayment | — | — | ( 15,990 ) | — |\\n| Income (loss) before income taxes | 8,815 | 5,223 | ( 994 ) | 14,518 |\\n| Income tax benefit | 339 | — | 1,814 | — |\\n| Net income | 9,154 | 5,223 | 820 | 14,518 |\\n| Less: net income (loss) attributable to non-controlling interests | 4,596 | — | ( 879 ) | — |\\n| Net income attributable to Shoals Technologies Group, Inc. | $ | 4,558 | $ | 5,223 | $ | 1,699 | $ | 14,518 |\\n| Three Months EndedJune 30, 2021 | Period from January 27, 2021 to June 30, 2021 |\\n| Earnings per share of Class A common stock: |\\n| Basic | $ | 0.05 | $ | ( 0.01 ) |\\n| Diluted | $ | 0.05 | $ | ( 0.01 ) |\\n| Weighted average shares of Class A common stock outstanding: |\\n| Basic | 93,544 | 93,542 |\\n| Diluted | 166,827 | 93,542 |\\n\\nSee accompanying notes to condensed consolidated financial statements.\\n2\\nShoals Technologies Group, Inc.\\nCondensed Consolidated Statements of Changes in Members’ / Stockholders’ Equity (Deficit) (Unaudited)\\n(in thousands, except shares)\\nFor the three and six months ended June 30, 2021\\n| Members' Deficit | Class ACommon Stock | Class BCommon Stock | Additional Paid-In Capital | Accumulated Deficit | Non-Controlling Interest | Total Members'/Stockholders Deficit |\\n| Shares | Amount | Shares | Amount |\\n| Balance atDecember 31, 2020 | $ | ( 184,123 ) | — | $ | — | — | $ | — | $ | — | $ | — | $ | — | $ | ( 184,123 ) |\\n| Net income prior to the Organizational Transactions | 2,675 | — | — | — | — | — | — | — | 2,675 |\\n| Effect of Organizational Transactions | 181,448 | 81,977,751 | 1 | 78,300,817 | 1 | — | ( 92,806 ) | ( 88,644 ) | — |\\n| Issuance of Class A common stock sold in IPO, net of underwriting discounts and commissions and offering costs | — | 11,550,000 | — | ( 5,234,210 ) | — | 70,188 | — | 70,976 | 141,164 |\\n| Net loss subsequent to the Organizational Transactions | — | — | — | — | — | — | ( 5,534 ) | ( 5,475 ) | ( 11,009 ) |\\n| Equity-based compensation recognized subsequent to the Organizational Transactions | — | — | — | — | — | 1,392 | — | — | 1,392 |\\n| Activity under stock compensation plan | — | 11,941 | — | — | — | ( 687 ) | — | 550 | ( 137 ) |\\n| Deferred tax adjustment related to Tax Receivable Agreement | — | — | — | — | — | 7,180 | — | — | 7,180 |\\n| Balance atMarch 31, 2021 | — | 93,539,692 | 1 | 73,066,607 | 1 | 78,073 | ( 98,340 ) | ( 22,593 ) | ( 42,858 ) |\\n| Net income | — | — | — | — | — | — | 4,558 | 4,596 | 9,154 |\\n| Equity-based compensation | — | — | — | — | — | 1,955 | — | — | 1,955 |\\n| Activity under stock compensation plan | — | 5,872 | — | — | — | ( 857 ) | — | 857 | — |\\n| Distributions to Non-controlling interest | — | — | — | — | — | — | — | ( 2,973 ) | ( 2,973 ) |\\n| Reallocation of non-controlling interest | — | — | — | — | — | ( 288 ) | — | 288 | — |\\n| Balance atJune 30, 2021 | $ | — | 93,545,564 | $ | 1 | 73,066,607 | $ | 1 | $ | 78,883 | $ | ( 93,782 ) | $ | ( 19,825 ) | $ | ( 34,722 ) |\\n\\n3\\nShoals Technologies Group, Inc.\\nCondensed Consolidated Statements of Changes in Members’ / Stockholders’ Equity (Deficit) (Unaudited) (continued)\\n(in thousands, except shares)\\nFor the three and six months ended June 30, 2020\\n| Members' Equity |\\n| Balance at December 31, 2019 | $ | 149,906 |\\n| Member distributions | ( 214 ) |\\n| Equity-based compensation | — |\\n| Net income | 9,295 |\\n| Balance at March 31, 2020 | 158,987 |\\n| Member distributions | — |\\n| Equity-based compensation | 6,704 |\\n| Net income | 5,223 |\\n| Balance at June 30, 2020 | $ | 170,914 |\\n\\nSee accompanying notes to condensed consolidated financial statements.\\n4\\nShoals Technologies Group, Inc.\\nCondensed Consolidated Statements of Cash Flows (Unaudited)\\n(in thousands)\\n| Six Months Ended June 30, |\\n| 2021 | 2020 |\\n| Cash Flows from Operating Activities |\\n| Net income | $ | 820 | $ | 14,518 |\\n| Adjustments to reconcile net income to net cash provided by (used in) operating activities: |\\n| Depreciation and amortization | 4,808 | 4,656 |\\n| Amortization/write off of deferred financing costs | 5,415 | 21 |\\n| Equity-based compensation | 4,172 | 6,704 |\\n| Deferred taxes | ( 524 ) | — |\\n| Tax receivable agreement liability adjustment | 1,664 | — |\\n| Gain on sale of assets | 61 | — |\\n| Changes in assets and liabilities: |\\n| Accounts receivable | ( 15,973 ) | 21 |\\n| Unbilled receivables | ( 3,003 ) | ( 4,970 ) |\\n| Inventory | ( 6,151 ) | ( 3,356 ) |\\n| Other assets | ( 4,631 ) | 515 |\\n| Accounts payable | ( 410 ) | ( 1,494 ) |\\n| Accrued expenses | ( 362 ) | 2,313 |\\n| Net Cash Provided by (Used in) Operating Activities | ( 14,114 ) | 18,928 |\\n| Cash Flows Used In Investing Activities |\\n| Purchases of property, plant and equipment | ( 1,736 ) | ( 1,345 ) |\\n| Net Cash Used in Investing Activities | ( 1,736 ) | ( 1,345 ) |\\n| Cash Flows from Financing Activities |\\n| Member / non-controlling interest distributions | ( 2,973 ) | ( 214 ) |\\n| Employee withholding taxes related to net settled equity awards | ( 137 ) | — |\\n| Deferred financing costs | ( 94 ) | — |\\n| Payments on term loan facility | ( 151,750 ) | — |\\n| Proceeds from revolving credit facility | 34,000 | — |\\n| Repayments of revolving credit facility | ( 5,000 ) | — |\\n| Payments on senior debt - term loan | — | ( 1,747 ) |\\n| Payments on senior debt - revolving line of credit | — | ( 8,400 ) |\\n| Proceeds from issuance of Class A common stock sold in an IPO, net of underwriting discounts and commissions | 154,521 | — |\\n| Deferred offering costs | ( 9,619 ) | — |\\n| Net Cash Provided by (Used in) Financing Activities | 18,948 | ( 10,361 ) |\\n| Net Increase in Cash and Cash Equivalents | 3,098 | 7,222 |\\n| Cash and Cash Equivalents—Beginning of Period | 10,073 | 7,082 |\\n| Cash and Cash Equivalents—End of Period | $ | 13,171 | $ | 14,304 |\\n\\n5\\nShoals Technologies Group, Inc.\\nCondensed Consolidated Statements of Cash Flows (Unaudited) (continued)\\n(in thousands)\\n| Six Months Ended June 30, |\\n| 2021 | 2020 |\\n| Supplemental Cash Flows Information: |\\n| Cash paid for interest | $ | 5,634 | $ | 476 |\\n| Cash paid for taxes | $ | 1,120 | $ | — |\\n| Non-cash financing activities: |\\n| Reclassification of deferred offering costs to additional paid-in capital | $ | 3,736 | $ | — |\\n| Initial establishment of deferred tax assets | $ | 49,049 | $ | — |\\n| Initial establishment of amounts payable under tax receivable agreement | $ | 41,692 | $ | — |\\n| Capital contribution related to tax receivable agreement | $ | 7,178 | $ | — |\\n| Income tax receivable from merger due to former owner | $ | 3,069 | $ | — |\\n\\nSee accompanying notes to condensed consolidated financial statements.\\n6\\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\\n1. Organization and Business\\nShoals Technologies Group, Inc. (the “Company”) was formed as a Delaware corporation on November 4, 2020 for the purpose of facilitating an initial public offering (\\\"IPO\\\") and other related organizational transactions to carry on the business of Shoals Parent LLC and its subsidiaries (“Shoals Parent”).\\nShoals Parent is a Delaware limited liability company formed on May 9, 2017. The Company is headquartered in Portland, Tennessee and is a manufacturer of electrical balance of systems (“EBOS”) solutions and components related to solar fields selling to customers across the United States and internationally. Shoals Parent, through its wholly-owned subsidiaries, Shoals Intermediate Holdings LLC (“Intermediate”) and Shoals Holdings LLC (“Holdings”) owns four other subsidiaries through which it conducts substantially all operations: Shoals Technologies, LLC, Shoals Technologies Group, LLC, Solon, LLC, and Shoals Structures, LLC (collectively “Shoals”). Shoals Parent acquired Shoals on May 25, 2017.\\nInitial Public Offering\\nOn January 29, 2021, the Company closed an IPO of 11,550,000 shares of Class A common stock at a public offering price of $ 25.00 per share, including shares issued pursuant to the underwriters' over-allotment option. The Company received $ 278.8 million in proceeds, net of underwriting discounts and commissions of $ 9.9 million, which was used to purchase 6,315,790 newly-issued membership interests (the “LLC Interests”) from Shoals Parent and 5,234,210 LLC Interests from the founder and Class B unit holder in Shoals Parent at a price per interest equal to the IPO price of $ 25.00 per share. Subsequent to the IPO and related organizational transactions that occurred in connection with the IPO, the Company is the sole managing member of, and had a 56.14 % economic interest in, Shoals Parent.\\nOrganizational Transactions\\nIn connection with the IPO, the Company and Shoals Parent completed a series of transactions (the \\\"Organizational Transactions\\\") including the following:\\n•the limited liability company agreement of Shoals Parent was amended and restated to, among other things, (i) provide for a new single class of common membership interests or the LLC Interests in Shoals Parent, (ii) exchange all of the then existing membership interests of the holders of Shoals Parent membership interests for LLC Interests and (iii) appoint the Company as the sole managing member of Shoals Parent;\\n•the Company's certificate of incorporation was amended and restated to, among other things, (i) provide for Class A common stock with voting and economic rights (ii) provide for Class B common stock with voting rights but no economic rights and (iii) issue 78,300,817 shares of Class B common stock to the former Class B and Class C members of Shoals Parent (the “Continuing Equity Owners”) on a one -to-one basis with the number of LLC Interests they own;\\n•the acquisition, by merger, of Shoals Investment CTB or the former Class A member of Shoals Parent (the \\\"Class A Shoals Equity Owners\\\"), for which the Company issued 81,977,751 shares Class A common stock as merger consideration (the \\\"Merger\\\").\\nImmediately following the completion of the IPO and Organizational Transactions, the Company owned 56.14 % of Shoals Parent. The Continuing Equity Owners owned the remaining 43.86 % of Shoals Parent.\\n2. Summary of Accounting Policies\\n7\\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\\nBasis of Accounting and Presentation\\nThe condensed consolidated financial statements have been prepared on the accrual basis of accounting in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”).\\nPrinciples of Consolidation\\nThe condensed consolidated financial statements include the accounts of the Company and its subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.\\nNon-controlling Interest\\nThe non-controlling interest on the condensed consolidated statement of operations represents the portion of earnings or loss attributable to the economic interest in the Company's subsidiary, Shoals Parent, held by the Continuing Equity Owners. Non-controlling interest on the condensed consolidated balance sheet represents the portion of net assets of the Company attributable to the Continuing Equity Owners, based on the portion of the LLC Interests owned by such unit holders. As of June 30, 2021, the non-controlling interest was 43.86 %.\\nUnaudited Interim Financial Information\\nThe accompanying condensed consolidated balance sheets as of June 30, 2021 and December 31, 2020, the statements of operations, stockholders’ deficit / members’ deficit and cash flows for the periods ended June 30, 2021 and 2020 are unaudited. The unaudited interim financial statements have been prepared on the same basis as the audited annual financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary for the fair statement of the Company’s financial position as of June 30, 2021 and the results of its operations and its cash flows for the periods ended June 30, 2021 and 2020. The financial data and other information disclosed in these notes related to the periods ended June 30, 2021 and 2020 are also unaudited. The results for the three and six months ended June 30, 2021 are not necessarily indicative of results to be expected for the year ending December 31, 2021, any other interim periods, or any future year or period. The balance sheet as of December 31, 2020 included herein was derived from the audited financial statements as of that date. Certain disclosures have been condensed or omitted from the interim financial statements. These financial statements should be read in conjunction with the Company’s consolidated financial statements and related notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2020.\\nUse of Estimates\\nThe preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates include revenue recognition, allowance for doubtful accounts, useful lives of property, plant and equipment and other intangible assets, impairment of long-lived assets, the reserve for excess and obsolete inventory, the tax receivable agreement, and valuation of deferred tax assets.\\nImpact of COVID-19 Pandemic\\n8\\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\\nThe global health crisis caused by the novel coronavirus COVID-19 pandemic and its resurgences has and may continue to negatively impact global economic activity, which, despite progress in vaccination efforts, remains uncertain and cannot be predicted with confidence. In addition, a new Delta variant of COVID-19, which appears to be the most transmissible variant to date, has begun to spread globally.\\nTo date, the Company has maintained uninterrupted business operations with normal turnaround times for its delivery of solar EBOS solutions and components. The Company has implemented adjustments to its operations designed to keep employees safe and comply with federal, state and local guidelines, including those regarding social distancing. For the three and six months ended June 30, 2021, the Company incurred $ 0.1 million and $ 0.2 million, respectively, in COVID-19 related costs (disinfecting and reconfiguration of facilities, medical professionals to conduct daily screening of employees and direct legal costs associated with the pandemic) which is included in general and administrative expenses in the accompanying condensed consolidated financial statements.\\nThe impact of the Delta variant cannot be predicted at this time, and could depend on numerous factors, including vaccination rates among the population, the effectiveness of the COVID-19 vaccines against the Delta variant and the response by governmental bodies and regulators. Given the ongoing and dynamic nature of the circumstances, it is difficult to predict the impact of the COVID-19 pandemic on our business.\\nCustomer Concentrations\\nThe Company had the following accounts receivable concentrations as of June 30, 2021 and December 31, 2020 and revenue concentrations for the six months ended June 30, 2021 and 2020:\\n| 2021 | 2020 |\\n| Revenue % | AccountsReceivable % | Revenue % | AccountsReceivable % |\\n| Customer A | 25.5 | % | 41.3 | % | 21.4 | % | 16.7 | % |\\n| Customer B | 13.2 | % | 4.2 | % | 23.9 | % | 14.2 | % |\\n| Customer C | 3.9 | % | 2.2 | % | 12.1 | % | 12.0 | % |\\n| Customer D | 6.5 | % | 8.7 | % | 12.3 | % | 12.5 | % |\\n| Customer E | 0.1 | % | 0.3 | % | 10.4 | % | 0.0 | % |\\n\\nRecent Accounting Pronouncements\\nAdopted\\nIn December 2019, the FASB issued ASU No. 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes (“ASU No. 2019-12”), which is intended to simplify various aspects of the accounting for income taxes. ASU No. 2019-12 removes certain exceptions to the general principles in Topic 740 and also clarifies and amends existing guidance to improve consistent application. The Company adopted ASU No. 2019-12 as of January 1, 2021 and it did not have a material impact on its consolidated financial statements and related disclosures.\\nNot Yet Adopted\\nIn February 2016, the FASB issued ASU No. 2016-02 (Topic 842) “Leases” which supersedes the lease recognition requirements in ASC Topic 840, “Leases.” Under ASU No. 2016-02, lessees are required to recognize assets and liabilities on the balance sheet for most leases and provide enhanced disclosures.\\n9\\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\\nLeases will continue to be classified as either finance or operating. For companies that are not emerging growth companies (“EGCs”), the ASU is effective for fiscal years beginning after December 15, 2018. For EGCs, the ASU is effective for fiscal years beginning after December 15, 2021. The Company plans to adopt the new standard using the modified retrospective method, under which the Company will apply Topic 842 to existing and new leases as of January 1, 2022, but prior periods will not be restated and will continue to be reported under Topic 840 guidance in effect during those periods. The Company anticipates that the adoption will not have a material impact on its statements of operations or its statements of cash flows but expects to recognize right-of-use assets and liabilities for lease obligations associated with its operating leases.\\nIn June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses, which was subsequently amended by ASU No. 2018-19 and ASU No. 2019-10, and which requires the measurement of expected credit losses for financial instruments carried at amortized cost held at the reporting date based on historical experience, current conditions and reasonable forecasts. The updated guidance also amends the current other-than-temporary impairment model for available-for-sale debt securities by requiring the recognition of impairments relating to credit losses through an allowance account and limits the amount of credit loss to the difference between a security’s amortized cost basis and its fair value. In addition, the length of time a security has been in an unrealized loss position will no longer impact the determination of whether a credit loss exists. The main objective of this ASU is to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. For EGC’s, the standard is effective for fiscal years and interim periods within those fiscal years, beginning after December 15, 2022. The Company will continue to assess the possible impact of this standard, but currently does not expect the adoption of this standard will have a significant impact on its financial statements and its limited history of bad debt expense relating to trade accounts receivable.\\n3. Accounts Receivable\\nAccounts receivable consists of the following (in thousands):\\n| June 30,2021 | December 31, 2020 |\\n| Accounts receivable | $ | 43,179 | $ | 27,206 |\\n| Less: allowance for doubtful accounts | ( 202 ) | ( 202 ) |\\n| Accounts receivable, net | $ | 42,977 | $ | 27,004 |\\n\\n4. Inventory\\n| June 30,2021 | December 31, 2020 |\\n| Raw materials | $ | 23,274 | $ | 17,390 |\\n| Allowance for slow-moving inventory | ( 2,002 ) | ( 2,269 ) |\\n| Inventory, net | $ | 21,272 | $ | 15,121 |\\n\\n10\\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\\n5. Property, Plant and Equipment\\nProperty, plant, and equipment, net consists of the following (in thousands):\\n| Estimated Useful Lives (Years) |\\n| June 30,2021 | December 31, 2020 |\\n| Land | N/A | $ | 840 | $ | 840 |\\n| Building and land improvements | 5 - 40 | 5,992 | 5,621 |\\n| Machinery and equipment | 3 - 5 | 10,323 | 9,028 |\\n| Furniture and fixtures | 3 - 7 | 1,090 | 1,025 |\\n| Vehicles | 5 | 104 | 318 |\\n| 18,349 | 16,832 |\\n| Less: accumulated depreciation | ( 4,727 ) | ( 4,069 ) |\\n| Property, plant and equipment, net | $ | 13,622 | $ | 12,763 |\\n\\nDepreciation expense for the three months ended June 30, 2021 and 2020 was $ 0.4 million and $ 0.3 million, respectively. During the three months ended June 30, 2021 and 2020, $ 0.3 million and $ 0.2 million, respectively, of depreciation expense was allocated to cost of revenue. During the three months ended June 30, 2021 and 2020, $ 0.1 million and $ 0.1 million, respectively, of depreciation expense was allocated to operating expenses.\\nDepreciation expense for the six months ended June 30, 2021 and 2020 was $ 0.8 million and $ 0.7 million, respectively. During the six months ended June 30, 2021 and 2020, $ 0.7 million and $ 0.5 million, respectively, of depreciation expense was allocated to cost of revenue. During the six months ended June 30, 2021 and 2020, $ 0.1 million and $ 0.2 million, respectively, of depreciation expense was allocated to operating expenses.\\n6. Goodwill and Other Intangible Assets\\nGoodwill\\nGoodwill relates to the acquisition of Shoals. As of June 30, 2021 and December 31, 2020, goodwill totaled $ 50.2 million.\\nOther Intangible Assets\\nOther intangible assets consisted of the following (in thousands):\\n11\\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\\n| Estimated Useful Lives (Years) | June 30,2021 | December 31, 2020 |\\n| Amortizable: |\\n| Costs: |\\n| Customer relationships | 13 | $ | 52,600 | $ | 52,600 |\\n| Developed technology | 13 | 34,600 | 34,600 |\\n| Trade names | 13 | 11,400 | 11,400 |\\n| Noncompete agreements | 5 | 2,000 | 2,000 |\\n| Total amortizable intangibles | 100,600 | 100,600 |\\n| Accumulated amortization: |\\n| Customer relationships | 16,522 | 14,499 |\\n| Developed technology | 10,868 | 9,537 |\\n| Trade names | 3,581 | 3,142 |\\n| Noncompete agreements | 1,633 | 1,434 |\\n| Total accumulated amortization | 32,604 | 28,612 |\\n| Total amortizable intangibles, net | $ | 67,996 | $ | 71,988 |\\n\\nAmortization expense related to intangible assets amounted to $ 2.0 million and $ 2.0 million for the three months ended June 30, 2021 and 2020 and $ 4.0 million and $ 4.0 million for the six months ended June 30, 2021 and 2020, respectively.\\n7. Long-Term Debt\\nLong-term debt consists of the following (in thousands):\\n| June 30,2021 | December 31, 2020 |\\n| Term Loan Facility | $ | 198,250 | $ | 350,000 |\\n| Revolving Credit Facility | 49,000 | 20,000 |\\n| Senior Debt—term loan | — | — |\\n| Less: deferred financing costs | ( 5,891 ) | ( 11,168 ) |\\n| Total debt, net of deferred financing costs | 241,359 | 358,832 |\\n| Less: current portion | ( 3,500 ) | ( 3,500 ) |\\n| Long-term debt, net current portion | $ | 237,859 | $ | 355,332 |\\n\\nSenior Secured Credit Agreement\\nOn November 25, 2020 Shoals Holdings, entered into that certain credit agreement with the lenders party thereto from time to time and Wilmington Trust, National Association, as administrative agent and collateral agent (the “Senior Secured Credit Agreement”), consisting of (i) a $ 350.0 million senior secured six-year term loan facility (the “Term Loan Facility”), (ii) a $ 30.0 million senior secured delayed draw term loan facility, which matures concurrently with the six-year Term Loan Facility (the “Delayed Draw Term Loan Facility”) and (iii) an uncommitted super senior first out revolving credit facility (the “Revolving Credit Facility”). The proceeds of the Term Loan Facility and a $ 10.0 million draw under the Delayed Draw Term Loan Facility were used to (i) make certain distributions from Shoals Holdings to Shoals Intermediate Holdings and from\\n12\\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\\nthere to certain of the Company’s direct or indirect equity holders, (ii) pay transaction expenses, (iii) repay and terminate all outstanding commitments under the Senior Debt (as defined herein) and (iv) finance working capital and general corporate purposes.\\nIn December 2020, Shoals Holdings entered into two amendments to the Senior Secured Credit Agreement in order to obtain a $ 100.0 million increase (the “Revolver Upsize”) to the Revolving Credit Facility and modify the terms of the interest rate and prepayment premium. As part of the first amendment the Company repaid and terminated all outstanding commitments under the Delayed Draw Term Loan Facility.\\nOn January 29, 2021, the Company used proceeds from the IPO to repay $ 150.0 million of outstanding borrowings under the Term Loan Facility. The repayment of a portion of the borrowings under the Term Loan Facility resulted in a $ 16.0 million loss on debt repayment as the result of the $ 11.3 million prepayment premium and $ 4.7 million write-off of a portion of the deferred financing costs.\\nAs of June 30, 2021, interest rates on the Term Loan facility and the Revolving credit facility were 4.25 % and 3.75 %, respectively and the Company had $ 51.0 million of availability under the Revolving Credit Facility.\\nThe Senior Secured Credit Agreement contains affirmative and negative covenants, including covenants that restrict the Company’s incurrence of indebtedness, incurrence of liens, dispositions, investments, acquisitions, restricted payments, and transactions with affiliates. The Senior Secured Credit Agreement also includes customary events of default, including the occurrence of a change of control. As of June 30, 2021, the Company was in compliance with all the required covenants.\\nSenior Debt\\nIntermediate and subsidiaries were party to a credit agreement (the “Senior Debt Agreement” and obligations thereunder, the “Senior Debt”) under which Holdings and its subsidiaries were borrowers and Intermediate was a guarantor. The Senior Debt was collateralized by all of the assets of the guarantor and borrowers. The amended agreement provided a term loan of $ 35 million and a revolving line of credit of $ 25 million.\\nOn October 8, 2020, the Company paid the outstanding amount due on the term loan and settled all obligations with respect to the Senior Debt.\\nThe Senior Debt provided for an interest rate to equal the Base Rate plus margin. The Base Rate charged was the highest rate of three defined methods as follows: 1) Federal Funds Rate plus 0.5 %, 2) Fifth Third Bank N.A. Rate or 3) LIBOR Rate plus 1 %. The Base Rate ranged from 1 % to 2.5 % depending on the EBITDA Rate calculation as defined in the Senior Debt Agreement (the “EBITDA Rate calculation”) for the Federal Funds Rate. The Base Rate for the LIBOR Rate ranged from 2 % to 3.5 % depending on the EBITDA Rate calculation.\\n8. Earnings (loss) per Share\\nBasic earnings (loss) per share of Class A Common Stock is computed by dividing net loss attributable to the Company's losses by the weighted average number of shares of Class A Common Stock outstanding during the period. Diluted net loss per share of Class A Common Stock is computed similarly to basic net loss\\n13\\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\\nper share except the weighted average shares outstanding are increased to include additional shares from the redemption of Class B Common Stock under the if-converted method and the assumed exercise of any common stock equivalents using the treasury stock method, if dilutive. The Company’s restricted stock units are considered common stock equivalents for this purpose.\\nAll earnings prior to and up to January 26, 2021, the date of the IPO, were entirely allocable to non-controlling interest and, as a result, earnings (loss) per share information is not applicable for reporting periods prior to this date. Consequently, only the net loss allocable to Shoals Technologies Group, Inc. from the period subsequent to January 26, 2021 is included in the net loss attributable to the stockholders of Class A Common Stock for the periods ended June 30, 2021. Basic and diluted net loss per share of Class A Common Stock from January 27, 2021 to June 30, 2021 have been computed as follows (in thousands, except per share amounts):\\n| Three Months Ended June 30, 2021 | Period from January 27, 2021 to June 30, 2021 |\\n| Numerator: |\\n| Net income (loss) attributable to Shoals Technologies Group, Inc. - basic | $ | 4,558 | $ | ( 976 ) |\\n| Reallocation of net income (loss) attributable to non-controlling interests from the assumed conversion of class B common stock | 4,596 | — |\\n| Net income (loss) attributable to Shoals Technologies Group, Inc. - diluted | $ | 9,154 | $ | ( 976 ) |\\n| Denominator: |\\n| Weighted average shares of Class A common stock outstanding - basic | 93,544 | 93,542 |\\n| Effect of dilutive securities: |\\n| Restricted Stock Units | 216 | — |\\n| Class B Common Stock | 73,067 | — |\\n| Weighted average shares of Class A common stock outstanding - diluted | 166,827 | 93,542 |\\n| Earnings (loss) per share of Class A common stock - basic | $ | 0.05 | $ | ( 0.01 ) |\\n| Earnings (loss) per share of Class A common stock - diluted | $ | 0.05 | $ | ( 0.01 ) |\\n\\nFor the period from January 27, 2021 to June 30, 2021, 1,169,601 restricted stock units and 73,066,607 Class B common stock shares were excluded from the computation of diluted loss per share of Class A common stock because the effect would have been anti-dilutive as we recorded a net loss for the period.\\n9. Equity-Based Compensation\\nOn January 26, 2021, the Shoals Technologies Group, Inc. 2021 Long-Term incentive Plan (the “2021 Incentive Plan”) became effective. The 2021 Incentive Plan authorized 8,768,124 new shares, subject to adjustment pursuant to the 2021 Incentive Plan.\\n14\\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\\nSince January 26, 2021, the Company has granted 1,196,770 restricted stock units (“RSUs\\\") to certain employees, officers and directors of the Company. The RSUs were granted at varying prices ranging from $ 25.00 to $ 29.57 per unit and generally vest ratably over 4 years, except for some of the director grants which vest over 1 year.\\nThe following table summarizes the restricted stock unit activity for the six months ended June 30, 2021 (in thousands, except per share amounts):\\n| RestrictedStock Units | Weighted Average Price |\\n| Outstanding at beginning of period | — | $ | — |\\n| Granted | 1,196,770 | $ | 26.02 |\\n| Forfeited | ( 5,297 ) | $ | 29.57 |\\n| Vested | ( 21,872 ) | $ | 27.58 |\\n| Outstanding at end of period | 1,169,601 | $ | 25.98 |\\n\\nFor the three and six months ended June 30, 2021, the Company recognized $ 2.8 million and $ 4.2 million, respectively, in equity-based compensation. As of June 30, 2021, the Company had $ 27.8 million of unrecognized compensation costs which is expected to be recognized over a period of 3.6 years.\\n10. Stockholders' Deficit\\nAmendment and Restatement of Certificate of Incorporation\\nAs discussed in Note 1, on January 26, 2021, the Company's certificate of incorporation was amended and restated to, among other things, provide for the (i) authorization of 1,000,000,000 shares of Class A common stock with a par value of $ 0.00001 per share; (ii) authorization of 195,000,000 shares of Class B common stock with a par value of $ 0.00001 per share; (iii) authorization of 5,000,000 shares of preferred stock that may be issued from time to time by the Company's Board of Directors in one or more series; and (iv) establishment of a classified board of directors, divided into three classes, the members of which will serve for staggered terms.\\nHolders of Class A common stock and Class B common stock are entitled to one vote per share and, except as otherwise required, will vote together as a single class on all matters on which stockholders generally are entitled to vote. Holders of Class B common stock are not entitled to receive dividends and will not be entitled to receive any distributions upon the liquidation, dissolution or winding up of the Company. Shares of Class B common stock may only be issued to the extent necessary to maintain the one -to-one ratio between the number of LLC Interests held by the Continuing Equity Owners and the number of shares of Class B common stock held by the Continuing Equity Owners. Shares of Class B common stock are transferable only together with an equal number of LLC Interests. Shares of Class B common stock will be canceled on a one -for-one basis if the Company, at the election of a Continuing Equity Owner, redeem or exchange LLC Interests.\\nThe Company must, at all times, maintain a one -to-one ratio between the number of shares of Class A common stock issued by the Company and the number of LLC Interests owned by the Company (subject to certain exceptions for treasury shares and shares underlying certain convertible or exchangeable securities).\\nInitial Public Offering\\n15\\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\\nAs discussed in Note 1, on January 29, 2021, the Company closed an IPO of 11,550,000 shares of the Class A common stock at a public offering price of $ 25.00 per share. The Company received $ 278.8 million in proceeds, net of underwriting discounts and commissions, which was used to purchase 6,315,790 LLC Interests from Shoals Parent and 5,234,210 LLC Interests from the founder and Class B unit holder in Shoals Parent at a price per interest equal to the IPO price of the Class A common stock of $ 25.00 .\\nShoals Parent Recapitalization\\nAs noted above, in connection with the IPO, the limited liability company agreement of Shoals Parent was amended and restated to, among other things, (i) provide for a new single class of common membership interests in Shoals Parent, or the LLC Interests; (ii) exchange all of the then existing membership interests of the Continuing Equity Owners for LLC Interests (iii) exchange all the then existing membership interest of the Class A Shoals Equity Owners for LLC Interests and (iv) appoint the Company as the sole managing member of Shoals Parent. The Company has a majority economic interest in, is the sole managing member of, has the sole voting power in, and controls the management of Shoals Parent.\\nThe amendment also requires that Shoals Parent, at all times, maintain (i) a one -to-one ratio between the number of shares of Class A common stock issued by the Company and the number of LLC Interests owned by the Company and (ii) a one -to-one ratio between the number of shares of Class B common stock owned by the Continuing Equity Owners and the number of LLC Interests owned by the Continuing Equity Owners.\\nAcquisition of Former Shoals Equity Owners\\nOn January 26, 2021, the Company acquired, by merger, an entity that was a member of Shoals Parent, or the Class A Shoals Equity Owners, for which the Company issued 81,977,751 shares of Class A common stock as merger consideration. The only assets held by the Class A Shoals Equity Owners were 81,977,751 LLC Interests. Upon consummation of the Merger, the Company recognized the LLC Interests at carrying value, as the Merger is considered to be a transaction between entities under common control.\\n11. Non-Controlling Interests\\nOn January 26, 2021, the Company used net proceeds from the IPO to purchase 6,315,790 LLC Interests from Shoals Parent and 5,234,210 LLC Interests from the founder and Class B unit holder in Shoals Parent. In addition, the Company issued 81,977,751 Class A common stock for the same number of LLC Interests as Merger consideration. Following the completion of the Organizational Transactions and as of June 30, 2021, the Company owned 56.14 % of Shoals Parent.\\nThe following table summarizes the effects of the changes in ownership in Shoals Parent on equity:\\n16\\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\\n| Three Months EndedJune 30, 2021 | Period from January 27, 2021 to June 30, 2021 |\\n| Net income (loss) attributable to non-controlling interest | $ | 4,596 | $ | ( 879 ) |\\n| Transfers to non-controlling interests |\\n| Increase in accumulated deficit as a result of the Organizational Transactions | — | ( 88,644 ) |\\n| Decrease in accumulated deficit as a result of newly issued LLC Interests in IPO | — | 70,976 |\\n| Decrease in accumulated deficit as a result of activity under stock compensation plan | 857 | 1,407 |\\n| Distributions to non-controlling interest | ( 2,973 ) | ( 2,973 ) |\\n| Reallocation of non-controlling interest | 288 | 288 |\\n| Change from net income (loss) attributable to non-controlling interest and transfers to non-controlling interest | $ | 2,768 | $ | ( 19,825 ) |\\n\\nIssuance of Additional LLC Interests\\nUnder the first amended and restated limited liability company agreement of Shoals Parent, as amended (the \\\"LLC Agreement'), the Company is required to cause Shoals Parent to issue additional LLC Interests to the Company when the Company issues additional shares of Class A Common Stock. Other than as it relates to the issuance of Class A Common Stock in connection with an equity incentive program, the Company must contribute to Shoals Parent net proceeds and property, if any, received by the Company with respect to the issuance of such additional shares of Class A Common Stock. The Company must cause Shoals Parent to issue a number of LLC Interests equal to the number of shares of Class A Common Stock issued such that, at all times, the number of LLC Interests held by the Company equals the number of outstanding shares of Class A Common Stock. During the six months ended June 30, 2021, the Company caused Shoals Parent to issue to the Company a total of 6,315,790 LLC Interests in connection with the issuance of Class A common stock in the IPO and 17,813 LLC Interests for the vesting of awards granted under the Shoals Technologies Group, Inc. 2021 Long-Term Incentive Plan.\\nDistributions for Taxes\\nAs a limited liability company (treated as a partnership for income tax purposes), Shoals Parent does not incur significant federal, state or local income taxes, as these taxes are primarily the obligations of its members. As authorized by the LLC Agreement, Shoals Parent is required to distribute cash, to the extent that Shoals Parent has cash available, on a pro rata basis, to its members to the extent necessary to cover the members’ tax liabilities, if any, with respect to each member’s share of Shoals Parent taxable earnings. Shoals Parent makes such tax distributions to its members quarterly, based on an estimated tax rate and projected year-to-date taxable income, with a final accounting once actual taxable income or loss has been determined. During the six months ended June 30, 2021, tax distributions to non-controlling LLC Interests holders was $ 3.0 million.\\n12. Commitments and Contingencies\\nLitigation\\n17\\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\\nThe Company is from time to time subject to legal proceedings and claims, which arise in the normal course of its business. In the opinion of management and legal counsel, the amount of losses that may be sustained, if any, would not have a material effect on the financial position, results of operations or cash flows of the Company.\\nSurety Bonds\\nThe Company provides surety bonds to various parties as required for certain transactions initiated during the ordinary course of business to guarantee the Company’s performance in accordance with contractual or legal obligations. As of June 30, 2021, the maximum potential payment obligation with regard to surety bonds was $ 11.8 million.\\n13. Income Taxes\\nThe Company is taxed as a subchapter C corporation and is subject to federal and state income taxes. The Company’s sole material asset is Shoals Parent, which is a limited liability company that is taxed as a partnership for US federal and certain state and local income tax purposes. Shoals Parent’s net taxable income and related tax credits, if any, are passed through to its members and included in the member’s tax returns. Shoals Parent is subject to and reports an entity level tax in Tennessee and Texas. The income tax burden on the earnings taxed to the noncontrolling interest holders is not reported by the Company in its consolidated financial statements under U.S. GAAP. As a result, the Company’s effective tax rate differs materially from the statutory rate. The Company’s income tax provision was a benefit of $ 0.3 million and $ 1.8 million for the three and six months ended June 30, 2021, respectively, and the effective tax rate is primarily impacted by the allocation of income taxes to the noncontrolling interest, benefit of the foreign derived intangible income and changes in our valuation allowance. The tax benefit for the three and six months ended June 30, 2021 includes $ 2.0 million of deferred income tax benefit resulting from an increase in the blended state income tax rate.\\nAs of June 30, 2021, the Company had recorded a deferred tax asset related to the partnership basis differences in Shoals Parent of $ 49.6 million net of a $ 6.3 million valuation allowance. The Company also recorded an income tax receivable of $ 5.4 million of which the Company estimates $ 3.1 million is owed to the prior owner related to taxes paid prior to the IPO transaction.\\nIn calculating the provision for interim income taxes, in accordance with ASC Topic 740, an estimated annual effective tax rate is applied to year-to-date ordinary income. At the end of each interim period, the Company estimates the effective tax rate expected to be applicable for the full fiscal year. This differs from the method utilized at the end of an annual period.\\nFor annual periods, the Company accounts for income taxes using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. In assessing the realizability of deferred tax assets, management considers whether it is more-likely-than-not that the deferred tax assets will be realized. Deferred tax assets and liabilities are calculated by applying existing tax laws and the rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in the year of the enacted rate change.\\n18\\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\\nThe Company accounts for uncertainty in income taxes using a recognition and measurement threshold for tax positions taken or expected to be taken in a tax return, which are subject to examination by federal and state taxing authorities. The tax benefit from an uncertain tax position is recognized when it is more likely than not that the position will be sustained upon examination by taxing authorities based on the technical merits of the position. The amount of the tax benefit recognized is the largest amount of the benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. The effective tax rate and the tax basis of assets and liabilities reflect management’s estimates of the ultimate outcome of various tax uncertainties. The Company recognizes penalties and interest related to uncertain tax positions within the provision (benefit) for income taxes line in the accompanying consolidated statements of operations. As of the quarter ended June 30, 2021, no uncertain tax positions have been recorded. The Company will continue to monitor this position each interim period.\\nThe Company files U.S. federal and certain state income tax returns. The income tax returns of the Company are subject to examination by U.S. federal and state taxing authorities for various time periods, depending on those jurisdictions’ rules, generally after the income tax returns are filed.\\n14. Tax Receivable Agreement\\nIn connection with the Organization Transactions and the IPO, the Company entered into a tax receivable agreement (the “TRA”) with the founder and former equity owners of Shoals Investment CTB (the “TRA Owners”). The TRA provides for the payment from time to time by the Company to the TRA Owners of 85 % of the amount of the benefits, if any, that the Company has deemed to realize as a result of (i) increases in tax basis resulting from the purchase or exchange of LLC Interests and other qualifying transactions. These payment obligations are obligations of the Company and not of Shoals Parent. For purposes of the TRA, the benefit deemed realized by the Company will generally be computed by comparing the actual income tax liability of the Company (calculated with certain assumptions) to the amount of such taxes that the Company would have been required to pay had there been no increase to the tax basis of the assets of Shoals Parent as a result of the purchases or exchanges, and had the Company not entered into the TRA.\\nThe TRA further provides that, upon certain mergers, asset sales or other forms of business combinations or other changes of control, the Company (or its successor) would owe to the TRA Owners a lump-sum payment equal to the present value of all forecasted future payments that would have otherwise been made under the TRA that would be based on certain assumptions, including a deemed exchange of Shoals Parent LLC Interests and that the Company would have sufficient taxable income to fully utilize the deductions arising from the increased tax basis and other tax benefits related to entering into the TRA. The Company also is entitled to terminate the TRA, which, if terminated, would obligate the Company to make early termination payments to the TRA Owners.\\nOn January 26, 2021, the Company acquired 5,234,210 LLC Interests from the founder. This acquisition triggered a tax basis increase subject to the provisions of the TRA. In the first quarter of fiscal year 2021, the Company recognized (i) a deferred tax asset in the amount of $ 32.1 million, (ii) a corresponding liability of $ 27.2 million, representing 85 % of the tax benefits to the TRA Owners and (iii) $ 4.9 million of additional paid-in capital.\\nOn January 26, 2021, in connection with the merger with Shoals Investment CTB, the Company distributed 85 % of the value in the tax basis from the original acquisition of Shoals Parent by Shoals investment CTB in 2017 to the holders of the TRA. In the first quarter of fiscal year 2021, the Company\\n19\\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\\nrecognized (i) a deferred tax asset of $ 16.9 million, (ii) a corresponding liability of $ 14.4 million representing 85 % of the tax benefits to the TRA Owners and (iii) $ 2.5 million of additional paid-in capital.\\nDuring the second quarter, the TRA liability was increased by $ 1.7 million resulting from an estimated increase in the Company’s blended state income tax rate. As a result of the adjustment to the Tax Receivable Agreement liability, the Company recorded approximately $ 1.7 million of other expense in the Condensed Consolidated Statement of Operations for the six months ended June 30, 2021. As of June 30, 2021, the amount of Tax Receivable Agreement payments due under the Tax Receivable Agreement was $ 43.4 million.\\n15. Revenue by Product\\nBased on Topic 606 provisions, the Company disaggregates its revenue from contracts with customers between system solutions and components. System solutions are contracts under which the Company provides multiple products typically in connection with the design and specification of an entire EBOS system. Components represents sales of individual solar components.\\nThe following table presents the Company’s revenue disaggregated by system solutions and solar components which are recorded over time as follows (in thousands):\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| System solutions | $ | 51,242 | $ | 31,626 | $ | 84,611 | $ | 54,419 |\\n| Solar components | 8,480 | 11,801 | 20,715 | 29,748 |\\n| Total revenue | $ | 59,722 | $ | 43,427 | $ | 105,326 | $ | 84,167 |\\n\\n16. Subsequent Events\\nFollow On Offering / Tax Receivable Agreement\\nIn July 2021, the Company completed a follow-on offering consisting of 4,989,692 shares of Class A common stock offered by the selling shareholders and 10,402,086 shares of Class A common stock offered by the Company. The Company used the proceeds of the sale of Class A common stock to purchase an equal number of LLC Interests and Class B common stock corresponding to such number of LLC Interests from our founder and management. The Company obtains an increase in its share of the tax basis of the assets of Shoals Parent when LLC Interests and Class B common stock corresponding to such number of LLC Interests are redeemed or exchanged. This increase in tax basis may have the effect of reducing the amounts that the Company would otherwise pay in the future to various tax authorities. The increase in tax basis may also decrease gains (or increase losses) on future dispositions of certain capital assets to the extent tax basis is allocated to those capital assets. The exchange of 10,402,086 LLC Interests and shares of Class B common stock corresponding to such number of LLC Interests triggered a tax basis increase subject to the provisions of the Tax Receivable Agreement. In the third quarter of fiscal year 2021, the Company will recognize a deferred tax asset in the amount of approximately $ 71.8 million, a corresponding increase in the tax receivable agreement liability of $ 61.1 million, representing 85 % of the tax benefits and approximately $ 10.7 million of additional-paid-in capital.\\n20\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\\nThis Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our financial statements and the related notes and other financial information included in our Annual Report on Form 10-K for the year ended December 31, 2020 (“2020 Form 10-K”) and this Quarterly Report on Form 10-Q. In addition to historical financial information, the following discussion and analysis contain forward-looking statements that involve risks, uncertainties and assumptions. For this purpose, any statements contained in this Form 10-Q that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, words such as “may,” “will,” “expect,” “believe,” “anticipate,” “estimate” or “continue” or comparable terminology are intended to identify forward-looking statements. Our actual results and timing of selected events may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those discussed under the sections of our 10-K and this Form 10-Q captioned “Special Note Regarding Forward-Looking Statements” and “Risk Factors”.\\nThis Management’s Discussion and Analysis of Financial Condition and Results of Operations contain the presentation of Adjusted EBITDA and Adjusted Net Income, which are not presented in accordance with GAAP. Adjusted EBITDA and Adjusted Net Income are being presented because they provide the Company and readers of this Form 10-Q with additional insight into our operational performance relative to earlier periods and relative to our competitors. We do not intend Adjusted EBITDA and Adjusted Net Income to be substitutes for any GAAP financial information. Readers of this Form 10-Q should use Adjusted EBITDA and Adjusted Net Income only in conjunction with Net Income, the most comparable GAAP financial measure. Reconciliations of Adjusted EBITDA and Adjusted Net Income to Net Income, the most comparable GAAP measure to each, are provided in “—Non-GAAP Financial Measures.”\\nOverview\\nWe are a leading provider of electrical balance of system or “EBOS” solutions for solar energy projects in the United States. EBOS encompasses all of the components that are necessary to carry the electric current produced by solar panels to an inverter and ultimately to the power grid. EBOS components are mission-critical products that have a high consequence of failure, including lost revenue, equipment damage, fire damage, and even serious injury or death. As a result, we believe customers prioritize reliability and safety over price when selecting EBOS solutions.\\nEBOS components that we produce include cable assemblies, inline fuses, combiners, disconnects, recombiners, wireless monitoring systems, junction boxes, transition enclosures and splice boxes. We derive the majority of our revenue from selling “system solutions” which are complete EBOS systems that include several of our products, many of which are customized for the customer’s project. We believe our system solutions are unique in our industry because they integrate design and engineering support, proprietary components and innovative installation methods into a single offering that would otherwise be challenging for a customer to obtain from a single provider or at all.\\nWe sell our products principally to engineering, procurement and construction firms (\\\"EPCs”) that build solar energy projects. However, given the mission critical nature of EBOS, the decision to use our products typically involves input from both the EPC and the owner of the solar energy project. The custom nature of our system solutions and the long development cycle for solar energy projects typically gives us 12 months or more of lead time to quote, engineer, produce and ship each order we receive, and we do not stock large amounts of finished goods.\\n21\\nWe derived approximately 80% of our revenue from the sale of system solutions for the six months ended June 30, 2021. For the same period, we derived substantially all of our revenue from customers in the U.S. We had $200.5 million of backlog and awarded orders, backlog represents signed purchase orders or contractual minimum purchase commitments with take-or-pay provisions and awarded orders are orders we are in the process of documenting a contract but for which a contract has not yet been signed, as of June 30, 2021, representing a 63% and 11% increase relative to the same date last year and March 31, 2021, respectively.\\nWe have maintained focus on our growth strategy throughout the quarter including developments in converting customers to our combine-as-you-go system and developing products for the rapidly growing electric vehicle charging infrastructure market. We believe that eight of the top 10 solar EPCs as reported by Solar Power World Magazine use our combine-as-you-go system on a majority of their projects and we are currently in the process of transitioning an additional 11 EPCs and developers to our system. Additionally, we are currently developing four new product families for the EV charging market: skid solutions that package the key components required for an EV charging station in the factory with the objective of reducing the amount of labor required in the field; raceways that allow wire to be run above ground rather than in underground conduit; EV-Big Lead Assembly (“BLA”) that eliminates homeruns from each dispenser and offers benefits similar to our solar BLA, including a 75% reduction in wire runs; and quad chargers that are prefabricated dispensers with four charge points. We expect to introduce our first offerings for this rapidly growing market in the fourth quarter of 2021.\\nInitial Public Offering\\nOn January 29, 2021, the Company closed an IPO of 11,550,000 shares of Class A common stock at a public offering price of $25.00 per share, including shares issued pursuant to the underwriters' over-allotment option. The Company received $278.8 million in proceeds, net of underwriting discounts and commissions, which was used to purchase 6,315,790 LLC Interests from Shoals Parent and 5,234,210 LLC Interests from the founder and Class B unit holder in Shoals Parent at a price per interest equal to the IPO price of $25.00 per share. Subsequent to the IPO and related organizational transactions that occurred in connection with the IPO, the Company is the sole managing member of, and had a 56.14% economic interest in, Shoals Parent.\\nOrganizational Transactions\\nSee Note 1 to the condensed consolidated financial statements of Shoals, included in this Quarterly Report on Form 10-Q for more information about the above-mentioned transactions as well as the other transactions completed in connection with the IPO.\\nFollowing the completion of the Organizational Transactions, the Company owned 56.14% of Shoals Parent. The Continuing Equity Owners owned the remaining 43.86% of Shoals Parent.\\nAs the Organization Transactions were considered transactions between entities under common control, the condensed consolidated financial statements for the periods prior to the IPO and Organizational Transactions have been adjusted to combine the previously separate entities for presentation purposes.\\nImpact of COVID-19\\nThe global health crisis caused by the novel coronavirus COVID-19 pandemic and its resurgences has and may continue to negatively impact global economic activity, which, despite progress in vaccination efforts, remains uncertain and cannot be predicted with confidence. In addition, a new Delta variant of COVID-19, which appears to be the most transmissible variant to date, has begun to spread globally. The impact of the Delta variant cannot be predicted at this time, and could depend on numerous factors, including vaccination\\n22\\nrates among the population, the effectiveness of the COVID-19 vaccines against the Delta variant and the response by governmental bodies and regulators. Given the ongoing and dynamic nature of the circumstances, it is difficult to predict the impact of the COVID-19 pandemic on our business.\\nMany countries around the world have continued to impose quarantines and restrictions on travel and mass gatherings to slow the spread of the virus. Accordingly, our ability to continue to operate our business may also be limited. Such events may result in a period of business, supply and manufacturing disruptions, and in reduced operations, any of which could materially affect our business, financial condition and results of operations.\\nA continuation or worsening of the levels of market disruption and volatility seen in the recent past could have an adverse effect on our ability to access capital, which could in the future negatively affect our liquidity. In addition, a recession or market correction resulting from the spread of COVID-19 could materially affect our business and the value of our common stock.\\nWe continue to monitor the impacts of COVID-19 on the global economy and on our business operations. Although we expect the vaccinations for COVID-19 will continue to improve conditions, the ultimate impact from COVID-19 on our business operations and financial results during 2021 will depend on, among other things, the ultimate severity and scope of the pandemic, including the new variants of the virus, the pace at which governmental and private travel restrictions and public concerns about public gatherings will ease, the rate at which historically large increases in unemployment rates will decrease, if at all, and whether, and the speed with which, the economy recovers. We are not able to fully quantify the impact that these factors will have on our financial results during 2021 and beyond, but developments related to COVID-19 may materially affect us in 2021.\\nKey Components of Our Results of Operations\\nThe following discussion describes certain line items in our condensed consolidated statements of operations.\\nRevenue\\nWe generate revenue from the sale of EBOS systems and components for homerun and combine-as-you-go architectures. Our customers include EPCs, utilities, solar developers, independent power producers and solar module manufacturers. We derive the majority of our revenue from selling system solutions. When we sell a system solution, we enter into a contract with our customers covering the price, specifications, delivery dates and warranty for the products being purchased, among other things. Our contractual delivery period for system solutions can vary from one to three months whereas manufacturing typically requires a shorter time frame. Contracts for system solutions can range in value from several hundred thousand to several million dollars.\\nOur revenue is affected by changes in the price, volume and mix of products purchased by our customers. The price and volume of our products is driven by the demand for our products, changes in product mix between homerun and combine-as-you-go EBOS, geographic mix of our customers, strength of competitors’ product offerings, and availability of government incentives to the end-users of our products.\\nOur revenue growth is dependent on continued growth in the amount of solar energy projects constructed each year and our ability to increase our share of demand in the geographies where we currently compete and plan to compete in the future as well as our ability to continue to develop and commercialize new and innovative products that address the changing technology and performance requirements of our customers.\\n23\\nCost of Revenue and Gross Profit\\nCost of revenue consists primarily of product costs, including purchased materials and components, as well as costs related to shipping, customer support, product warranty, personnel and depreciation of manufacturing and testing equipment. Personnel costs in cost of revenue include both direct labor costs as well as costs attributable to any individuals whose activities relate to the transformation of raw materials or component parts into finished goods or the transportation of materials to the customer. Our product costs are affected by the underlying cost of raw materials, including copper and aluminum; component costs, including fuses, resin, enclosures, and cable; technological innovation; economies of scale resulting in lower component costs; and improvements in production processes and automation. We do not currently hedge against changes in the price of raw materials. Some of these costs, primarily personnel and depreciation of manufacturing and testing equipment, are not directly affected by sales volume. Gross profit may vary from year to year and is primarily affected by our sales volume, product prices, product costs, product mix, customer mix, geographical mix, shipping method, warranty costs and seasonality.\\nOperating Expenses\\nOperating expenses consist of general and administrative costs as well as depreciation and amortization expense. Personnel-related costs are the most significant component of our operating expenses and include salaries, equity-based compensation, benefits, payroll taxes and commissions. The number of full-time employees in our general and administrative departments increased from 42 to 68 from June 30, 2020 to June 30, 2021, and we expect to hire new employees in the future to support our growth. The timing of these additional hires could materially affect our operating expenses in any particular period, both in absolute dollars and as a percentage of revenue. We expect to invest in additional resources to support our growth which will increase our operating expenses.\\nGeneral and Administrative Expenses\\nGeneral and administrative expenses consist primarily of salaries, equity-based compensation expense, employee benefits and payroll taxes related to our executives, and our sales, finance, human resources, information technology, engineering and legal organizations, travel expenses, facilities costs, marketing expenses, bad debt expense and fees for professional services. Professional services consist of audit, legal, tax, insurance, information technology and other costs. We expect to increase our sales and marketing personnel as we expand into new geographic markets. Substantially all of our sales in 2020 were in the U.S. We currently have a sales presence in the U.S., Australia and Spain. We intend to expand our sales presence and marketing efforts to additional countries in the future. We also expect that as a result of our recent IPO, we will incur additional audit, tax, accounting, legal and other costs related to compliance with applicable securities and other regulations, as well as additional insurance, investor relations and other costs associated with being a public company.\\nDepreciation\\nDepreciation in our operating expenses consists of costs associated with property, plant and equipment (“PP&E”) not used in manufacturing our products. We expect that as we increase both our revenue and the number of our general and administrative personnel, we will invest in additional PP&E to support our growth resulting in additional depreciation expense.\\nAmortization\\nAmortization of intangibles consists of customer relationships, developed technology, trade names and non-compete agreements over their expected period of use.\\n24\\nNon-operating Expenses\\nInterest Expense\\nInterest expense consists of interest and other charges paid in connection with our current Senior Secured Credit Agreement (as defined below) and our former Senior Debt which included a revolving line of credit and term loan, which was fully repaid on October 8, 2020.\\nTax Receivable Agreement Liability Adjustment\\nTax receivable agreement liability adjustment consists of changes to our effective interest rate since the initial recording of the liability related to our tax receivable agreement with our founder and former Class A Shoals Equity Owners of Shoals Parent.\\nLoss on Debt Repayment\\nLoss on debt repayment consists of prepayment premiums and the write-off off a portion of the deferred financing costs from the prepayment of outstanding borrowings under the Term Loan Facility.\\nIncome Tax Expense\\nShoals Technologies Group, Inc. is subject to U.S. federal and state income tax in multiple jurisdictions with respect to our allocable share of any net taxable income of Shoals Parent. Shoals Parent is a pass-through entity for federal income tax purposes but incurs income tax in certain state jurisdictions.\\n25\\nResults of Operations\\nThe following table summarizes our results of operations (dollars in thousands):\\n| Three Months Ended June 30, | Increase / (Decrease) | Six Months Ended June 30, | Increase / (Decrease) |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Revenue | $ | 59,722 | $ | 43,427 | $ | 16,295 | 38 | % | $ | 105,326 | $ | 84,167 | $ | 21,159 | 25 | % |\\n| Cost of revenue | 33,543 | 26,598 | 6,945 | 26 | % | 60,373 | 53,152 | 7,221 | 14 | % |\\n| Gross profit | 26,179 | 16,829 | 9,350 | 56 | % | 44,953 | 31,015 | 13,938 | 45 | % |\\n| Operating Expenses |\\n| General and administrative expenses | 10,018 | 9,317 | 701 | 8 | % | 16,834 | 11,875 | 4,959 | 42 | % |\\n| Depreciation and amortization | 2,062 | 2,064 | (2) | — | % | 4,130 | 4,125 | 5 | — | % |\\n| Total Operating Expenses | 12,080 | 11,381 | 699 | 6 | % | 20,964 | 16,000 | 4,964 | 31 | % |\\n| Income from Operations | 14,099 | 5,448 | 8,651 | 159 | % | 23,989 | 15,015 | 8,974 | 60 | % |\\n| Interest expense, net | (3,620) | (225) | (3,395) | 1509 | % | (7,329) | (497) | (6,832) | 1375 | % |\\n| Tax receivable agreement liability adjustment | (1,664) | — | (1,664) | 100 | % | (1,664) | — | (1,664) | 100 | % |\\n| Loss on debt repayment | — | — | — | — | % | (15,990) | — | (15,990) | 100 | % |\\n| Income (loss) before income taxes | 8,815 | 5,223 | 3,592 | 69 | % | (994) | 14,518 | (15,512) | (107) | % |\\n| Income tax benefit | 339 | — | 339 | 100 | % | 1,814 | — | 1,814 | 100 | % |\\n| Net income | 9,154 | 5,223 | 3,931 | 75 | % | 820 | 14,518 | (13,698) | (94) | % |\\n| Less: net income (loss) attributable to non-controlling interests | 4,596 | — | 4,596 | 100 | % | (879) | — | (879) | 100 | % |\\n| Net income attributable to Shoals Technologies Group, Inc. | $ | 4,558 | $ | 5,223 | $ | (665) | (13) | % | $ | 1,699 | $ | 14,518 | $ | (12,819) | (88) | % |\\n\\nComparison of the Three Months Ended June 30, 2021 and 2020\\nRevenue\\nRevenue increased by $16.3 million, or 38%, for the three months ended June 30, 2021 as compared to the three months ended June 30, 2020, driven by an increase in demand for solar EBOS generally and our combine-as-you-go system solutions specifically. Our total number of customers increased in 2021 as compared to 2020. We believe customer recognition of the benefits of our combine-as-you-go system is resulting in increased demand for our products.\\nCost of Revenue and Gross Profit\\nCost of revenue increased by $6.9 million, or 26%, for the three months ended June 30, 2021 as compared to the three months ended June 30, 2020, primarily driven by an increase in production volumes. Gross profit as a percentage of revenue increased from 38.8% in 2020 to 43.8% in 2021 in part due to purchasing efficiencies from increased volumes, improved material planning which reduced logistics costs,\\n26\\nenhancements to product design that lowered manufacturing costs and other manufacturing efficiencies resulting from higher production volumes. Changes in product mix also contributed to the increase in margin as sales of system solutions for combine-as-you-go EBOS, which have higher margin than our other products, increased as a percentage of our total revenue.\\nOperating Expenses\\nGeneral and Administrative\\nGeneral and administrative expenses increased $0.7 million, or 8%, for the three months ended June 30, 2021 as compared to the three months ended June 30, 2020. The increase in general and administrative expenses was primarily the result of an increase in professional fees of $1.9 million related to preparation for our public offerings, wages and related taxes of $1.6 million related to increased head count and year-end bonuses, and an insurance expense of $0.8 million primarily related to increased costs for our directors and officers policy, offset by a decrease in equity-based compensation of $4.1 million.\\nDepreciation and Amortization\\nThere was no significant change in depreciation and amortization expense during the three months ended June 30, 2021 as compared to the three months ended June 30, 2020.\\nInterest Expense\\nInterest expense, net increased by $3.4 million or 1509%, for the three months ended June 30, 2021 as compared to the three months ended June 30, 2020, due to increased borrowings and related deferred financing costs under our Senior Secured Credit Facility entered into on November 25, 2020. We expect interest expense to increase in 2021 as a result of our higher average borrowings under the Senior Secured Credit Facility (see description under “Debt Obligations”).\\nTax Receivable Agreement Liability Adjustment\\nTax receivable agreement liability adjustment totaled $1.7 million for the three months ended June 30, 2021. The adjustment resulted from an estimated increase in the Company’s blended state income tax rate.\\nIncome Tax Benefit\\nIncome tax benefit totaled $0.3 million for the three months ended June 30, 2021. The Company did not incur income tax expense prior to the Organizational Transactions, or during the three months ended June 30, 2020.\\nComparison of the Six Months Ended June 30, 2021 and 2020\\nRevenue\\nRevenue increased by $21.2 million, or 25%, for the six months ended June 30, 2021 as compared to the six months ended June 30, 2020, driven by an increase in demand for solar EBOS generally and our combine-as-you-go system solutions specifically. Our total number of customers increased in 2021 as compared to 2020. We believe customer recognition of the benefits of our combine-as-you-go system is resulting in increased demand for our products.\\nCost of Revenue and Gross Profit\\n27\\nCost of revenue increased by $7.2 million, or 14%, for the six months ended June 30, 2021 as compared to the six months ended June 30, 2020, primarily driven by an increase in production volumes. Gross profit as a percentage of revenue increased from 36.8% for the six months ended June 30, 2020 to 42.7% for the six months ended June 30, 2021 in part due to purchasing efficiencies from increased volumes, improved material planning which reduced logistics costs, enhancements to product design that lowered manufacturing costs and other manufacturing efficiencies resulting from higher production volumes. Changes in product mix also contributed to the increase in margin as sales of system solutions for combine-as-you-go EBOS, which have higher margin than our other products, increased as a percentage of our total revenue.\\nOperating Expenses\\nGeneral and Administrative\\nGeneral and administrative expenses increased by $5.0 million, or 42%, for the six months ended June 30, 2021 as compared to the six months ended June 30, 2020. The increase in general and administrative expenses was primarily the result of an increase in professional fees of $2.5 million related to preparation for our public offerings, wages and related taxes of $2.8 million related to increased head count and year-end bonuses, an insurance expense of $1.5 million primarily related to increased costs for our directors and officers policy and franchise and other related taxes of $0.3 million, offset by a decrease in equity-based compensation of $2.8 million and a decrease in travel and trade shows of $0.2 million as a result of COVID-19.\\nDepreciation and Amortization\\nThere was no significant change in depreciation and amortization expense during the six months ended June 30, 2021 as compared to the six months ended June 30, 2020.\\nInterest Expense\\nInterest expense, net increased by $6.8 million or 1375%, for the six months ended June 30, 2021 as compared to the six months ended June 30, 2020, due to increased borrowings and related deferred financing costs under our Senior Secured Credit Facility entered into on November 25, 2020. We expect interest expense to increase in 2021 as a result of our higher average borrowings under the Senior Secured Credit Facility (see description under “Debt Obligations”).\\nTax Receivable Agreement Liability Adjustment\\nTax receivable agreement liability adjustment totaled $1.7 million for the six months ended June 30, 2021. The adjustment resulted from an estimated increase in the Company’s blended state income tax rate.\\nLoss on Debt Repayment\\nLoss on debt repayment for the six months ended June 30, 2021 consists of $11.3 million of prepayment premium and $4.7 million in write-off off a portion of the deferred financing costs related to a prepayment of $150.0 million of outstanding borrowings under the Term Loan Facility.\\nIncome Tax Benefit\\nIncome tax benefit totaled $1.8 million for the six months ended June 30, 2021. The Company did not incur income tax expense prior to the Organizational Transactions, or during the six months ended June 30, 2020.\\nNon-GAAP Financial Measures\\nAdjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS\\n28\\nWe define Adjusted EBITDA as net income (loss) plus (i) interest expense, (ii) income taxes, (iii) depreciation expense, (iv) amortization of intangibles, (v) tax receivable agreement liability adjustment, (vi) loss on debt repayment, (vii) equity-based compensation, (viii) COVID-19 expenses and (ix) non-recurring and other expenses. We define Adjusted Net Income as net income (loss) plus (i) amortization of intangibles, (ii) tax receivable agreement liability adjustment, (iii) loss on debt repayment, (iv) amortization of deferred financing costs, (v) equity-based compensation, (vi) COVID-19 expenses and (vii) non-recurring and other expenses, all net of applicable income taxes. We define Adjusted Diluted EPS as Adjusted Net Income divided by the diluted weighted average shares of Class A common shares outstanding for the applicable period, which assumes the pro forma exchange of all outstanding Class B common shares for Class A common shares.\\nAdjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS are intended as supplemental measures of performance that are neither required by, nor presented in accordance with, GAAP. We present Adjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS because we believe they assist investors and analysts in comparing our performance across reporting periods on a consistent basis by excluding items that we do not believe are indicative of our core operating performance. In addition, we use Adjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS: (i) as factors in evaluating management’s performance when determining incentive compensation; (ii) to evaluate the effectiveness of our business strategies; and (iii) because our credit agreement uses measures similar to Adjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS to measure our compliance with certain covenants.\\nAmong other limitations, Adjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS do not reflect our cash expenditures, or future requirements for capital expenditures or contractual commitments; do not reflect the impact of certain cash charges resulting from matters we consider not to be indicative of our ongoing operations; in the case of Adjusted EBITDA, does not reflect income tax expense or benefit for periods prior to the reorganization; and may be calculated by other companies in our industry differently than we do or not at all, which may limit their usefulness as comparative measures.\\nBecause of these limitations, Adjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS should not be considered in isolation or as substitutes for performance measures calculated in accordance with GAAP. You should review the reconciliation of net income to Adjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS below and not rely on any single financial measure to evaluate our business.\\nReconciliation of Net Income to Adjusted EBITDA (in thousands):\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Net income | $ | 9,154 | $ | 5,223 | $ | 820 | $ | 14,518 |\\n| Interest expense | 3,620 | 225 | 7,329 | 497 |\\n| Income tax benefit | (339) | — | (1,814) | — |\\n| Depreciation expense | 411 | 338 | 816 | 664 |\\n| Amortization of intangibles | 1,996 | 1,996 | 3,992 | 3,992 |\\n| Tax receivable agreement liability adjustment(a) | 1,664 | — | 1,664 | — |\\n| Loss on debt repayment | — | — | 15,990 | — |\\n| Equity-based compensation | 2,780 | 6,704 | 4,172 | 6,704 |\\n| COVID-19 expenses(b) | 106 | 806 | 161 | 806 |\\n| Non-recurring and other expenses(c) | 1,239 | 112 | 1,578 | 294 |\\n| Adjusted EBITDA | $ | 20,631 | $ | 15,404 | $ | 34,708 | $ | 27,475 |\\n\\n29\\n(a) Represents an adjustment to eliminate the remeasurement of the Tax Receivable Agreement.\\n(b) Represents costs incurred as a direct impact from the COVID-19 pandemic, disinfecting and reconfiguration of facilities, medical professionals to conduct daily screenings of employees, premium pay during the pandemic to hourly workers in 2020 and direct legal costs associated with the pandemic.\\n(c) Represents certain costs associated with non-recurring professional services, Oaktree’s expenses and other costs.\\nReconciliation of Net Income Attributable to Shoals Technologies Group, Inc. to Adjusted Net Income (in thousands):\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Net income attributable to Shoals Technologies Group, Inc. | $ | 4,558 | $ | 5,223 | $ | 1,699 | $ | 14,518 |\\n| Net income (loss) impact from pro forma conversion of Class B common stock to Class A common stock (a) | 4,596 | — | (879) | — |\\n| Adjustment to the provision for income tax (b) | (942) | (1,133) | 192 | (3,150) |\\n| Tax effected net income | 8,212 | 4,090 | 1,012 | 11,368 |\\n| Amortization of intangibles | 1,996 | 1,996 | 3,992 | 3,992 |\\n| Amortization of deferred financing costs | 305 | 12 | 675 | 21 |\\n| Tax receivable agreement liability adjustment(c) | 1,664 | — | 1,664 | — |\\n| Loss on debt repayment | — | — | 15,990 | — |\\n| Equity-based compensation | 2,780 | 6,704 | 4,172 | 6,704 |\\n| COVID-19 expenses (d) | 106 | 806 | 161 | 806 |\\n| Non-recurring and other expenses (e) | 1,239 | 112 | 1,578 | 294 |\\n| Tax impact of adjustments (f) | (1,635) | (635) | (5,806) | (1,110) |\\n| Adjusted Net Income | $ | 14,667 | $ | 13,085 | $ | 23,438 | $ | 22,075 |\\n\\n(a) Reflects net income (loss) to Class A common shares from pro forma exchange of corresponding shares of our Class B common shares held by our founder and management.\\n(b) Shoals Technologies Group, Inc. is subject to U.S. Federal income taxes, in addition to state and local taxes with respect to its allocable share of any net taxable income of Shoals Parent LLC. The adjustment to the provision for income tax reflects the effective tax rates below, assuming Shoals Technologies Group, Inc. owns 100% of the units in Shoals Parent LLC.\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Statutory U.S. Federal income tax rate | 21.0 | % | 21.0 | % | 21.0 | % | 21.0 | % |\\n| State and local taxes (net of federal benefit) | 2.0 | % | 0.7 | % | 2.0 | % | 0.7 | % |\\n| Permanent items, including valuation adjustment | (2.5) | % | — | % | (1.1) | % | — | % |\\n| Effective income tax rate for Adjusted Net Income | 20.5 | % | 21.7 | % | 21.9 | % | 21.7 | % |\\n\\n30\\n(c) Represents an adjustment to eliminate the remeasurement of the Tax Receivable Agreement.\\n(d) Represents costs incurred as a direct impact from the COVID-19 pandemic, disinfecting and reconfiguration of facilities, medical professionals to conduct daily screenings of employees, premium pay during the pandemic to hourly workers in 2020 and direct legal costs associated with the pandemic.\\n(e) Represents certain costs associated with non-recurring professional services, Oaktree’s expenses and other costs.\\n(f) Represents the estimated tax impact of all Adjusted Net Income add-backs, excluding those which represent permanent differences between book versus tax.\\nReconciliation of Diluted Weighted Average Shares Outstanding to Adjusted Diluted Weighted Average Shares Outstanding (in thousands, except per share):\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Diluted weighted average shares of Class A common shares outstanding, excluding Class B common shares | 93,760 | N/A (b) | 93,650 | N/A (b) |\\n| Assumed pro forma conversion of Class B common shares to Class A common shares | 73,067 | N/A (b) | 73,067 | N/A (b) |\\n| Adjusted diluted weighted average shares outstanding | 166,827 | N/A (b) | 166,717 | N/A (b) |\\n| Adjusted Net Income (a) | $ | 14,667 | N/A (b) | $ | 23,438 | N/A (b) |\\n| Adjusted Diluted EPS | $ | 0.09 | N/A (b) | $ | 0.14 | N/A (b) |\\n\\n(a) Represents Adjusted Net Income for the full period presented.\\n(b) This Non-GAAP measure is not applicable for this period, as the reorganization transactions had not yet occurred.\\nLiquidity and Capital Resources\\n| Six Months Ended June 30, |\\n| 2021 | 2020 |\\n| Net cash provided by (used in) operating activities | $ | (14,114) | $ | 18,928 |\\n| Net cash used in investing activities | (1,736) | (1,345) |\\n| Net cash provided by (used in) financing activities | 18,948 | (10,361) |\\n| Net increase in cash and cash equivalents | $ | 3,098 | $ | 7,222 |\\n\\nWe finance our operations primarily with operating cash flows and short and long-term borrowings. Our ability to generate positive cash flow from operations is dependent on the strength of our gross margins as well as our ability to quickly turn our working capital. Based on our past performance and current expectations, we believe that operating cash flows and availability under our Revolving Credit Facility will be sufficient to meet our near term future cash needs.\\n31\\nWe used cash from operating activities of $14.1 million in the six months ended June 30, 2021 as compared to cash generated from operating activities of $18.9 million for the six months ended June 30, 2020. As of June 30, 2021, our cash and cash equivalents were $13.2 million and we had outstanding borrowings of $247.3 million. We also had $51.0 million available for additional borrowings under our $100.0 million Revolving Credit Facility.\\nOperating Activities\\nFor the six months ended June 30, 2021, cash used in operating activities was $14.1 million, primarily due to operating results that included $0.8 million of net income which was reduced by $15.6 million, net of non-cash expenses, an increase of $6.2 million in inventory, $19.0 million in receivables, $4.6 million in other current assets and a decrease in accounts payable and accrued expenses of $0.8 million.\\nFor the six months ended June 30, 2020, cash provided by operating activities was $18.9 million, primarily due to operating results that included $14.5 million of net income which was reduced by $11.4 million, net of non-cash expenses, an increase of $5.0 million in receivables, an increase of $3.4 million in inventory and an increase of $0.8 million in accounts payable and accrued expenses.\\nInvesting Activities\\nFor the six months ended June 30, 2021, net cash used in investing activities was $1.7 million, attributable to the purchase of property and equipment.\\nFor the six months ended June 30, 2020, net cash used in investing activities was $1.3 million, attributable to the purchase of property and equipment.\\nFinancing Activities\\nFor the six months ended June 30, 2021, net cash provided by financing activities was $18.9 million, including $144.9 million in net proceeds from the IPO and $29.0 million in borrowings under the Revolving Credit Facility offset by $151.8 million of payments on term loan facility.\\nFor the six months ended June 30, 2020, net cash used in financing activities was $10.4 million. We made $8.4 million in payments on our senior debt – revolving credit facility, tax distributions of $0.2 million and payments on our senior debt-term loan of $1.7 million.\\nFrom time to time, we may seek to retire or purchase the Company’s outstanding debt or equity securities through cash purchases and/or exchanges for other debt or equity securities in open market purchases, privately negotiated transactions, or otherwise, that may be made pursuant to Rule 10b5-1 or otherwise. Such repurchases or exchanges, if any, will depend on prevailing market conditions, the Company’s liquidity requirements, contractual restrictions and other factors.\\nDebt Obligations\\nSenior Secured Credit Agreement\\nOn November 25, 2020 Shoals Holdings, entered into that certain credit agreement with the lenders party thereto from time to time and Wilmington Trust, National Association, as administrative agent and collateral agent (the “Senior Secured Credit Agreement”), consisting of (i) a $350.0 million senior secured six-year term loan facility (the “Term Loan Facility”), (ii) a $30.0 million senior secured delayed draw term loan facility, which matures concurrently with the six-year Term Loan Facility (the “Delayed Draw Term Loan Facility”) and (iii) an uncommitted super senior first out revolving credit facility (the “Revolving Credit Facility”).\\n32\\nThe proceeds of the Term Loan Facility and a $10.0 million draw under the Delayed Draw Term Loan Facility were used to (i) make certain distributions from Shoals Holdings to Shoals Intermediate Holdings and from there to certain of our direct or indirect equity holders, (ii) pay transaction expenses, (iii) repay and terminate all outstanding commitments under the Senior Debt (as defined herein) and (iv) finance working capital and general corporate purposes. An additional $10.0 million draw under the Delayed Draw Term Loan Facility funded on December 14, 2020.\\nIn December 2020, Shoals Holdings entered into two amendments to the Senior Secured Credit Agreement in order to obtain a $100.0 million increase (the “Revolver Upsize”) to the Revolving Credit Facility and modify the terms of the interest rate and prepayment premium. As part of the first amendment we repaid and terminated all outstanding commitments under the Delayed Draw Term Loan Facility.\\nAs of June 30, 2021, interest rates on the Term Loan facility and the Revolving credit facility were 4.25% and 3.75%, respectively and we had $51.0 million of availability under the Revolving Credit Facility.\\nThe Senior Secured Credit Agreement contains affirmative and negative covenants, including covenants that restrict our incurrence of indebtedness, incurrence of liens, dispositions, investments, acquisitions, restricted payments, and transactions with affiliates. The Senior Secured Credit Agreement also includes customary events of default, including the occurrence of a change of control. As of June 30, 2021, we were in compliance with all the required covenants.\\nSenior Debt\\nIntermediate and subsidiaries were party to the Senior Debt Agreement under which Holdings and its subsidiaries were borrowers and Intermediate was a guarantor. The Senior Debt was collateralized by all of the assets of the guarantor and borrowers. The amended agreement provided a term loan of $35 million and a revolving line of credit of $25 million.\\nOn October 8, 2020, we paid the outstanding amount due on the term loan and settled all obligations with respect to the Senior Debt.\\nThe Senior Debt provided for an interest rate to equal the Base Rate plus margin. The Base Rate charged was the highest rate of three defined methods as follows: 1) Federal Funds Rate plus 0.5%, 2) Fifth Third Bank N.A. Rate or 3) LIBOR Rate plus 1%. The Base Rate ranged from 1% to 2.5% depending on the EBITDA Rate calculation as defined in the Senior Debt (the “EBITDA Rate calculation”) for the Federal Funds Rate. The Base Rate for the LIBOR Rate ranged from 2% to 3.5% depending on the EBITDA Rate calculation.\\nSurety Bonds\\nWe provide surety bonds to various parties as required for certain transactions initiated during the ordinary course of business to guarantee our performance in accordance with contractual or legal obligations. As of June 30, 2021, the maximum potential payment obligation with regard to surety bonds was $11.8 million.\\nCritical Accounting Policies and Significant Management Estimates\\nIncome Taxes\\nWe record valuation allowances against our deferred tax assets when it is more likely than not that all or a portion of a deferred tax asset will not be realized. In making such determination, we consider all available evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax planning strategies and results of operation. We routinely evaluate the realizability of our deferred tax assets by assessing the likelihood that our deferred tax assets will be recovered based on all available positive and\\n33\\nnegative evidence. Estimating future taxable income is inherently uncertain and requires judgment. In projecting future taxable income, we consider our historical results and incorporate certain assumptions, including revenue growth and operating margins, among others. As of June 30, 2021, we had $49.6 million of deferred tax assets, net of valuation allowances. We expect to realize future tax benefits related to the utilization of these assets. If we determine in the future that we will not be able to fully utilize all or part of these deferred tax assets, we would record a valuation allowance through earnings in the period the determination was made, which would have an adverse effect on our results of operations and earnings in future periods.\\nLiabilities Under Tax Receivable Agreement\\nAs described in Note 14 to the condensed consolidated financial statements, we are a party to the TRA under which we are contractually committed to pay the TRA Owners 85% of the amount of any tax benefits that we actually realize, or in some cases are deemed to realize, as a result of certain transactions. Amounts payable under the TRA are contingent upon, among other things, (i) generation of future taxable income over the term of the TRA and (ii) future changes in tax laws. If we do not generate sufficient taxable income in the aggregate over the term of the TRA to utilize the tax benefits, then we generally would not be required to make the related TRA payments. Therefore, we will only recognize a liability for TRA payments if we determine it is probable that we will generate sufficient future taxable income over the term of the TRA to utilize the related tax benefits. Estimating future taxable income is inherently uncertain and requires judgment. In projecting future taxable income, we consider our historical results and incorporate certain assumptions, including revenue growth, and operating margins, among others. As of June 30, 2021, we recognized $43.4 million of liabilities relating to our obligations under the TRA, after concluding that it was probable that we would have sufficient future taxable income to utilize the related tax benefits. There were no transactions subject to the TRA for which we did not recognize the related liability, as we concluded that we would have sufficient future taxable income to utilize all of the related tax benefits generated by all transactions that occurred in connection with the IPO. If we determine in the future that we will not be able to fully utilize all or part of the related tax benefits, we would de-recognize the portion of the liability related the benefits not expected to be utilized.\\nAdditionally, we estimate the amount of TRA payments expected to be paid within the next 12 months and classify this amount as current on our condensed consolidated balance sheets. This determination is based on our estimate of taxable income for the next fiscal year. To the extent our estimate differs from actual results, we may be required to reclassify portions of our liabilities under the TRA between current and non-current.\\nAs of June 30, 2021, there were no other significant changes in the application of our critical accounting policies or estimation procedures from those presented in our Annual Report on Form 10-K for the year ended December 31, 2020.\\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\\nThere have been no material changes with respect to our market risk disclosed in our Annual Report on Form 10-K for the year ended December 31, 2020.\\nItem 4. Controls and Procedures\\nEvaluation of Disclosure Controls and Procedures\\nUnder the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on this evaluation, our Chief Executive Officer and Chief\\n34\\nFinancial Officer concluded that our disclosure controls and procedures were effective as of such date. Our disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.\\nChanges in Internal Control Over Financial Reporting\\nThere were no changes to our internal control over financial reporting that occurred during the quarter ended June 30, 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\nPART II – OTHER INFORMATION\\nItem 1. Legal Proceedings\\nFrom time to time, we may be involved in litigation relating to claims that arise out of our operations and businesses and that cover a wide range of matters, including, among others, intellectual property matters, contract and employment claims, personal injury claims, product liability claims and warranty claims. Currently, there are no claims or proceedings against us that we believe will have a material adverse effect on our business, financial condition, results of operations or cash flows. However, the results of any current or future litigation cannot be predicted with certainty, and regardless of the outcome, we may incur significant costs and experience a diversion of management resources as a result of litigation.\\nItem 1A. Risk Factors\\nThere have been no material changes with respect to our risk factors disclosed in our Annual Report on Form 10-K for the year ended December 31, 2020.\\nItem 2. Unregistered Sale of Equity Securities and Use of Proceeds\\nRecent Sales of Unregistered Equity Securities\\nNone\\nItem 3. Defaults Upon Senior Securities\\nNone.\\nItem 4. Mine Safety Disclosures\\nNot applicable.\\nItem 5. Other Information\\nNone.\\nItem 6. Exhibits\\n35\\n| Incorporated by Reference |\\n| Number | Description of Document | Form | Filing Date | Exhibit No. |\\n| 3.1 | Amended and Restated Certificate of Incorporation of Shoals Technologies Group, Inc., dated January 28, 2021 | 8-K | 1/29/2021 | 3.1 |\\n| 3.2 | Amended and Restated Bylaws of Shoals Technologies Group, Inc., dated January 28, 2021 | 8-K | 1/29/2021 | 3.2 |\\n| 31.1* | Certification of the Chief Executive Officer, as required by Section 302 of the Sarbanes- Oxley Act of 2002 (18 U.S.C. 1350) |\\n| 31.2* | Certification of the Chief Financial Officer, as required by Section 302 of the Sarbanes- Oxley Act of 2002 (18 U.S.C. 1350) |\\n| 32.1* | Certification of the Chief Executive Officer, as required by Section 906 of the Sarbanes-Oxley Act of 2002 ( and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350) |\\n| 101.INS | XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document |\\n| 101.SCH* | XBRL Taxonomy Extension Schema Document |\\n| 101.CAL* | XBRL Taxonomy Extension Calculation Linkbase Document |\\n| 101.DEF* | XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101.LAB* | XBRL Taxonomy Extension Label Linkbase Document |\\n| 101.PRE* | XBRL Taxonomy Extension Presentation Linkbase Document |\\n| 104 | Cover Page Interactive Data File - the cover page interactive data file does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document |\\n\\n________\\n* Filed herewith\\n† Indicates a management contract or compensatory plan.\\n36\\nSIGNATURES\\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\n| Shoals Technologies Group, Inc. |\\n| By: | /s/ Jason Whitaker | Date: | August 10, 2021 |\\n| Name: | Jason Whitaker |\\n| Title: | Chief Executive Officer |\\n| By: | /s/ Philip Garton | Date: | August 10, 2021 |\\n| Name: | Philip Garton |\\n| Title: | Chief Financial Officer |\\n\\n37\\n \\n\\nWhat would be the Adjusted EBITDA for the six months ended June 30, 2021, if the loss on debt repayment was 20% lower in thousands?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 31510.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 74,\n \"input_length\": 26520\n}"}}},{"rowIdx":75,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n||Years Ended December 31,||\n||2019|2018|\n|Network advertising|$22.7|$28.2|\n|Broadcast station|11.9|10.8|\n|Network distribution|4.9|4.8|\n|Other|2.3|1.6|\n|Total revenue from contracts with customers|41.8|45.4|\n|Other revenue|-|-|\n|Total Broadcasting segment revenue|$ 41.8|$ 45.4|\n Broadcasting Segment Network advertising revenue is generated primarily from the sale of television airtime for programs or advertisements. Network advertising revenue is recognized when the program or advertisement is broadcast. Revenues are reported net of agency commissions, which are calculated as a stated percentage applied to gross billings. The Network advertising contracts are generally short-term in nature. Network distribution revenue consists of payments received from cable, satellite and other multiple video program distribution systems for their retransmission of our network content. Network distribution revenue is recognized as earned over the life of the retransmission consent contract and varies from month to month. Variable fees are usage/sales based, calculated on the average number of subscribers, and recognized as revenue when the usage occurs. Transaction prices are based on the contract terms, with no material judgments or estimates. Broadcast station revenue is generated primarily from the sale of television airtime in return for a fixed fee or a portion of the related ad sales recognized by the third party. In a typical broadcast station revenue agreement, the licensee of a station makes available, for a fee, airtime on its station to a party which supplies content to be broadcast during that airtime and collects revenue from advertising aired during such content. Broadcast station revenue is recognized over the life of the contract, when the program is broadcast. The fees that we charge can be fixed or variable and the contracts that the Company enters into are generally short-term in nature. Variable fees are usage/salesbased and recognized as revenue when the subsequent usage occurs. Transaction prices are based on the contract terms, with no material judgments or estimates. Disaggregation of Revenues The following table disaggregates the Broadcasting segment's revenue by type (in millions):\n\n \n\nIf network advertising revenue in 2019 was 30.0 million, what would be the change from 2018 to 2019? (in million)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n||Years Ended December 31,||\\n||2019|2018|\\n|Network advertising|$22.7|$28.2|\\n|Broadcast station|11.9|10.8|\\n|Network distribution|4.9|4.8|\\n|Other|2.3|1.6|\\n|Total revenue from contracts with customers|41.8|45.4|\\n|Other revenue|-|-|\\n|Total Broadcasting segment revenue|$ 41.8|$ 45.4|\\n Broadcasting Segment Network advertising revenue is generated primarily from the sale of television airtime for programs or advertisements. Network advertising revenue is recognized when the program or advertisement is broadcast. Revenues are reported net of agency commissions, which are calculated as a stated percentage applied to gross billings. The Network advertising contracts are generally short-term in nature. Network distribution revenue consists of payments received from cable, satellite and other multiple video program distribution systems for their retransmission of our network content. Network distribution revenue is recognized as earned over the life of the retransmission consent contract and varies from month to month. Variable fees are usage/sales based, calculated on the average number of subscribers, and recognized as revenue when the usage occurs. Transaction prices are based on the contract terms, with no material judgments or estimates. Broadcast station revenue is generated primarily from the sale of television airtime in return for a fixed fee or a portion of the related ad sales recognized by the third party. In a typical broadcast station revenue agreement, the licensee of a station makes available, for a fee, airtime on its station to a party which supplies content to be broadcast during that airtime and collects revenue from advertising aired during such content. Broadcast station revenue is recognized over the life of the contract, when the program is broadcast. The fees that we charge can be fixed or variable and the contracts that the Company enters into are generally short-term in nature. Variable fees are usage/salesbased and recognized as revenue when the subsequent usage occurs. Transaction prices are based on the contract terms, with no material judgments or estimates. Disaggregation of Revenues The following table disaggregates the Broadcasting segment's revenue by type (in millions):\\n\\n \\n\\nIf network advertising revenue in 2019 was 30.0 million, what would be the change from 2018 to 2019? (in million)\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 1.8000000000000007.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 75,\n \"input_length\": 532\n}"}}},{"rowIdx":76,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n||Fiscal year-end||\n||2019|2018|\n|Current portion of Euro Term Loan(1)|$2,748|$3,092|\n|1.3% Term loan due 2024|1,367|1,448|\n|1.0% State of Connecticut term loan due 2023|378|374|\n|Capital lease obligations|370|158|\n|Line of credit borrowings|10,000|—|\n|Total current portion of long-term obligations|$14,863|$5,072|\n Short-term borrowings and current portion of long-term obligations consist of the following (in thousands): (1) Net of debt issuance costs of $4.6 million and $4.7 million at September 28, 2019 and September 29, 2018, respectively.\n\n \n\nWhat would the percentage change in Capital lease obligations from 2018 to 2019 be if the amount in 2019 was $358 thousand instead? (in percent)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n||Fiscal year-end||\\n||2019|2018|\\n|Current portion of Euro Term Loan(1)|$2,748|$3,092|\\n|1.3% Term loan due 2024|1,367|1,448|\\n|1.0% State of Connecticut term loan due 2023|378|374|\\n|Capital lease obligations|370|158|\\n|Line of credit borrowings|10,000|—|\\n|Total current portion of long-term obligations|$14,863|$5,072|\\n Short-term borrowings and current portion of long-term obligations consist of the following (in thousands): (1) Net of debt issuance costs of $4.6 million and $4.7 million at September 28, 2019 and September 29, 2018, respectively.\\n\\n \\n\\nWhat would the percentage change in Capital lease obligations from 2018 to 2019 be if the amount in 2019 was $358 thousand instead? (in percent)\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 126.58227848101266.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 76,\n \"input_length\": 289\n}"}}},{"rowIdx":77,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n||FY19|FY18¹|Growth %|Growth %|\n||$m (Reported)|$m (Reported)|(Reported)|(CC)|\n|Revenue by Region:|||||\n|– Americas|253.3|223.6|13.3|13.4|\n|– EMEA|363.6|324.5|12.0|12.7|\n|– APJ|93.7|90.9|3.1|6.2|\n||710.6|639.0|11.2|12.0|\n|Revenue by Product:|||||\n|– Network|328.5|316.5|3.8|4.7|\n|– Enduser|348.4|291.8|19.4|20.2|\n|– Other|33.7|30.7|9.8|10.0|\n||710.6|639.0|11.2|12.0|\n|Revenue by Type:|||||\n|– Subscription|593.9|512.4|15.9|16.7|\n|– Hardware|106.8|115.1|(7.2)|(6.3)|\n|– Other|9.9|11.5|(13.9)|(12.8)|\n||710.6|639.0|11.2|12.0|\n Revenue and deferred revenue The Group adopted IFRS 15 Revenue from Contracts with Customers in the current year and has therefore restated the results for the prior-year on a consistent basis, see note 2 of the Financial Statements for further details. The Group’s revenue increased by $71.6 million, or 11.2 per cent, to $710.6 million in the year-ended 31 March 2019. Subscription revenue was notably strong in the period, with reported growth of 15.9 per cent, or 16.7 per cent on a constant currency basis, because of strong prior-period billings and incremental growth of the MSP channel in the current period. 1 Restated for the adoption of IFRS 15 as explained in note 2 of the Financial Statements Revenue in the period of $710.6 million comprised $394.1 million from the recognition of prior-period deferred revenues and $316.5 million from in-period billings. The majority of the Group’s billings, which are recognised over the life of the contract, relate to subscription products (FY19: 84.8 per cent; FY18: 83.8 per cent), with the benefit from increased billings being spread over a number of years on the subsequent recognition of deferred revenue. The deferred revenue balance at the end of the period of $742.1 million increased $13.5 million year-on-year, an increase of 1.9 per cent. This was mainly due to a net deferral of billings amounting to $49.7 million partially offset by a net currency revaluation of $36.2 million, a consequence of the weakening of the euro and sterling against the US dollar during the year. Deferred revenue due within one year at the balance sheet date of $428.6M increased by 5.1 per cent at actual rates or by 10.7 per cent in constant currency. Revenue in the Americas increased by $29.7 million or 13.3 per cent to $253.3 million in the year-ended 31 March 2019, supported by the recognition of prior-period Enduser billings from the Sophos Central platform and the growth of the MSP channel in the current period. EMEA revenue increased by $39.1 million or 12.0 per cent to $363.6 million in the year-ended 31 March 2019, with growth in Enduser in particular, but also aided by Network sales. APJ revenue increased by $2.8 million, or 3.1 per cent to $93.7 million in the year-ended 31 March 2019, with good growth in Enduser products partially offset by a decline in Network sales following the legacy product transition.\n\n \n\nWhat would the average revenue earned across 2018 and 2019 be if the amount in 2019 was $700.0 million instead? (in million)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n||FY19|FY18¹|Growth %|Growth %|\\n||$m (Reported)|$m (Reported)|(Reported)|(CC)|\\n|Revenue by Region:|||||\\n|– Americas|253.3|223.6|13.3|13.4|\\n|– EMEA|363.6|324.5|12.0|12.7|\\n|– APJ|93.7|90.9|3.1|6.2|\\n||710.6|639.0|11.2|12.0|\\n|Revenue by Product:|||||\\n|– Network|328.5|316.5|3.8|4.7|\\n|– Enduser|348.4|291.8|19.4|20.2|\\n|– Other|33.7|30.7|9.8|10.0|\\n||710.6|639.0|11.2|12.0|\\n|Revenue by Type:|||||\\n|– Subscription|593.9|512.4|15.9|16.7|\\n|– Hardware|106.8|115.1|(7.2)|(6.3)|\\n|– Other|9.9|11.5|(13.9)|(12.8)|\\n||710.6|639.0|11.2|12.0|\\n Revenue and deferred revenue The Group adopted IFRS 15 Revenue from Contracts with Customers in the current year and has therefore restated the results for the prior-year on a consistent basis, see note 2 of the Financial Statements for further details. The Group’s revenue increased by $71.6 million, or 11.2 per cent, to $710.6 million in the year-ended 31 March 2019. Subscription revenue was notably strong in the period, with reported growth of 15.9 per cent, or 16.7 per cent on a constant currency basis, because of strong prior-period billings and incremental growth of the MSP channel in the current period. 1 Restated for the adoption of IFRS 15 as explained in note 2 of the Financial Statements Revenue in the period of $710.6 million comprised $394.1 million from the recognition of prior-period deferred revenues and $316.5 million from in-period billings. The majority of the Group’s billings, which are recognised over the life of the contract, relate to subscription products (FY19: 84.8 per cent; FY18: 83.8 per cent), with the benefit from increased billings being spread over a number of years on the subsequent recognition of deferred revenue. The deferred revenue balance at the end of the period of $742.1 million increased $13.5 million year-on-year, an increase of 1.9 per cent. This was mainly due to a net deferral of billings amounting to $49.7 million partially offset by a net currency revaluation of $36.2 million, a consequence of the weakening of the euro and sterling against the US dollar during the year. Deferred revenue due within one year at the balance sheet date of $428.6M increased by 5.1 per cent at actual rates or by 10.7 per cent in constant currency. Revenue in the Americas increased by $29.7 million or 13.3 per cent to $253.3 million in the year-ended 31 March 2019, supported by the recognition of prior-period Enduser billings from the Sophos Central platform and the growth of the MSP channel in the current period. EMEA revenue increased by $39.1 million or 12.0 per cent to $363.6 million in the year-ended 31 March 2019, with growth in Enduser in particular, but also aided by Network sales. APJ revenue increased by $2.8 million, or 3.1 per cent to $93.7 million in the year-ended 31 March 2019, with good growth in Enduser products partially offset by a decline in Network sales following the legacy product transition.\\n\\n \\n\\nWhat would the average revenue earned across 2018 and 2019 be if the amount in 2019 was $700.0 million instead? (in million)\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 669.5.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 77,\n \"input_length\": 1042\n}"}}},{"rowIdx":78,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n|FOR THE YEAR ENDED DECEMBER 31|NOTE|WEIGHTED AVERAGE INTEREST RATE AT DECEMBER 31, 2019|2019|2018|\n|Notes payable (1)|26|2.03%|1,994|3,201|\n|Loans secured by trade receivables|26|2.71%|1,050|919|\n|Long-term debt due within one year (2)|22|4.77%|837|525|\n|Total debt due within one year|||3,881|4,645|\n Note 21 Debt due within one year (1) Includes commercial paper of $1,502 million in U.S. dollars ($1,951 million in Canadian dollars) and $2,314 million in U.S. dollars ($3,156 million in Canadian dollars) as at December 31, 2019 and December 31, 2018, respectively, which were issued under our U.S. commercial paper program and have been hedged for foreign currency fluctuations through forward currency contracts. See Note 26, Financial and capital management, for additional details. (2) Included in long-term debt due within one year is the current portion of lease liabilities of $775 million as at December 31, 2019 and the current portion of finance leases of $466 million as at December 31, 2018.\n\n \n\nWhat would the total long-term debt due within one year in 2018 and 2019 be if the amount in 2019 is 875?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n|FOR THE YEAR ENDED DECEMBER 31|NOTE|WEIGHTED AVERAGE INTEREST RATE AT DECEMBER 31, 2019|2019|2018|\\n|Notes payable (1)|26|2.03%|1,994|3,201|\\n|Loans secured by trade receivables|26|2.71%|1,050|919|\\n|Long-term debt due within one year (2)|22|4.77%|837|525|\\n|Total debt due within one year|||3,881|4,645|\\n Note 21 Debt due within one year (1) Includes commercial paper of $1,502 million in U.S. dollars ($1,951 million in Canadian dollars) and $2,314 million in U.S. dollars ($3,156 million in Canadian dollars) as at December 31, 2019 and December 31, 2018, respectively, which were issued under our U.S. commercial paper program and have been hedged for foreign currency fluctuations through forward currency contracts. See Note 26, Financial and capital management, for additional details. (2) Included in long-term debt due within one year is the current portion of lease liabilities of $775 million as at December 31, 2019 and the current portion of finance leases of $466 million as at December 31, 2018.\\n\\n \\n\\nWhat would the total long-term debt due within one year in 2018 and 2019 be if the amount in 2019 is 875?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 1400.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 78,\n \"input_length\": 430\n}"}}},{"rowIdx":79,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n|All amounts in USD ‘000 |2019|2018|2017|\n|Spot charter revenues*|283,007|259,978|257,495|\n|Time charter revenues |34,213|29,038|39,646|\n|Total Voyage Revenues |317,220|289,016|297,141|\n 3. VOYAGE REVENUES Our voyage revenues consist of time charter revenues and spot charter revenues with the following split: *Spot charter revenues for 2019 and 2018 are presented in accordance we ASC 606 Revenue from Contracts with Customers. The comparative information for 2017 has not been restated.\n\n \n\nWhat would be the value of the 2019 total voyage revenue as a percentage of the 2018 total voyage revenues if the 2018 total voyage revenue is instead $300,000,000? (in percent)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n|All amounts in USD ‘000 |2019|2018|2017|\\n|Spot charter revenues*|283,007|259,978|257,495|\\n|Time charter revenues |34,213|29,038|39,646|\\n|Total Voyage Revenues |317,220|289,016|297,141|\\n 3. VOYAGE REVENUES Our voyage revenues consist of time charter revenues and spot charter revenues with the following split: *Spot charter revenues for 2019 and 2018 are presented in accordance we ASC 606 Revenue from Contracts with Customers. The comparative information for 2017 has not been restated.\\n\\n \\n\\nWhat would be the value of the 2019 total voyage revenue as a percentage of the 2018 total voyage revenues if the 2018 total voyage revenue is instead $300,000,000? (in percent)\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 105.74.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 79,\n \"input_length\": 283\n}"}}},{"rowIdx":80,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n||Number of Options|Weighted average exercise price|Weighted average remaining contractual life (years)|Aggregate intrinsic value $|\n|Outstanding, January 1, 2018|1,368,772|$3.12|||\n|Granted – 2018|401,099|$9.27|||\n|Exercised – 2018|(165,169)|$3.16|||\n|Expired – 2018|(50,002)|$5.48|||\n|Outstanding, December 31, 2018|1,554,700|$4.63|3.0||\n|Granted – 2019|410,134|$12.28|||\n|Exercised – 2019|(251,063)|$3.73|||\n|Expired – 2019|(89,550)|$12.55|||\n|Outstanding, December 31, 2019|1,624,221|$6.27|2.6|$7,925,643|\n|Exercisable, December 31, 2019|1,143,637|$4.39|1.9|$7,197,053|\n NOTE 11 – STOCK COMPENSATION The Company sponsors a stock-based incentive compensation plan known as the 2013 Equity Compensation Plan (the “Plan”), which was established by the Board of Directors of the Company in June 2013. A total of 500,000 shares were initially reserved for issuance under the Plan. The Plan was amended several times since then to eventually increase the authorized shares to 2,500,000 as of December 31, 2019. A total of 1,624,221 shares of common stock underlying options were outstanding at December 31, 2019. The Company had 236,614 remaining shares available to grant under the Plan at December 31, 2019. The Plan allows the Company to grant incentive stock options, non-qualified stock options, stock appreciation rights, or restricted stock. The incentive stock options are exercisable for up to ten years, at an option price per share not less than the fair market value on the date the option is granted. The incentive stock options are limited to persons who are regular full-time employees of the Company at the date of the grant of the option. Non-qualified options may be granted to any person, including, but not limited to, employees, independent agents, consultants and attorneys, who the Company’s Board or Compensation Committee believes have contributed, or will contribute, to the success of the Company. Non-qualified options may be issued at option prices of less than fair market value on the date of grant and may be exercisable for up to ten years from date of grant. The option vesting schedule for options granted is determined by the Compensation Committee of the Board of Directors at the time of the grant. The Plan provides for accelerated vesting of unvested options if there is a change in control, as defined in the Plan. The compensation cost that has been charged against income related to options for the years ended December 31, 2019 and 2018, was $1,687,745 and $1,317,904, respectively. No income tax benefit was recognized in the income statement and no compensation was capitalized in any of the years presented. The Company had the following option activity during the years ended December 31, 2019 and 2018: Of the options outstanding at December 31, 2019, 1,143,637 were exercisable with a weighted average contractual life of 1.9 years.\n\n \n\nWhat would be the total price of exercised or expired options during the fiscal year 2019 if the weighted-average exercise price of exercised options was $4.25?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n||Number of Options|Weighted average exercise price|Weighted average remaining contractual life (years)|Aggregate intrinsic value $|\\n|Outstanding, January 1, 2018|1,368,772|$3.12|||\\n|Granted – 2018|401,099|$9.27|||\\n|Exercised – 2018|(165,169)|$3.16|||\\n|Expired – 2018|(50,002)|$5.48|||\\n|Outstanding, December 31, 2018|1,554,700|$4.63|3.0||\\n|Granted – 2019|410,134|$12.28|||\\n|Exercised – 2019|(251,063)|$3.73|||\\n|Expired – 2019|(89,550)|$12.55|||\\n|Outstanding, December 31, 2019|1,624,221|$6.27|2.6|$7,925,643|\\n|Exercisable, December 31, 2019|1,143,637|$4.39|1.9|$7,197,053|\\n NOTE 11 – STOCK COMPENSATION The Company sponsors a stock-based incentive compensation plan known as the 2013 Equity Compensation Plan (the “Plan”), which was established by the Board of Directors of the Company in June 2013. A total of 500,000 shares were initially reserved for issuance under the Plan. The Plan was amended several times since then to eventually increase the authorized shares to 2,500,000 as of December 31, 2019. A total of 1,624,221 shares of common stock underlying options were outstanding at December 31, 2019. The Company had 236,614 remaining shares available to grant under the Plan at December 31, 2019. The Plan allows the Company to grant incentive stock options, non-qualified stock options, stock appreciation rights, or restricted stock. The incentive stock options are exercisable for up to ten years, at an option price per share not less than the fair market value on the date the option is granted. The incentive stock options are limited to persons who are regular full-time employees of the Company at the date of the grant of the option. Non-qualified options may be granted to any person, including, but not limited to, employees, independent agents, consultants and attorneys, who the Company’s Board or Compensation Committee believes have contributed, or will contribute, to the success of the Company. Non-qualified options may be issued at option prices of less than fair market value on the date of grant and may be exercisable for up to ten years from date of grant. The option vesting schedule for options granted is determined by the Compensation Committee of the Board of Directors at the time of the grant. The Plan provides for accelerated vesting of unvested options if there is a change in control, as defined in the Plan. The compensation cost that has been charged against income related to options for the years ended December 31, 2019 and 2018, was $1,687,745 and $1,317,904, respectively. No income tax benefit was recognized in the income statement and no compensation was capitalized in any of the years presented. The Company had the following option activity during the years ended December 31, 2019 and 2018: Of the options outstanding at December 31, 2019, 1,143,637 were exercisable with a weighted average contractual life of 1.9 years.\\n\\n \\n\\nWhat would be the total price of exercised or expired options during the fiscal year 2019 if the weighted-average exercise price of exercised options was $4.25?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 2190870.25.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 80,\n \"input_length\": 950\n}"}}},{"rowIdx":81,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n||2019|2018|\n|Prepaid expenses|$137,927|$90,981|\n|Prepaid income taxes .|47,811|59,319|\n|Indirect tax receivables .|29,908|26,327|\n|Restricted cash|13,697|19,671|\n|Notes receivable (1)|23,873|5,196|\n|Derivative instruments (2) .|1,199|2,364|\n|Other current assets|22,040|39,203|\n|Prepaid expenses and other current assets|$276,455|$243,061|\n Prepaid expenses and other current assets Prepaid expenses and other current assets consisted of the following at December 31, 2019 and 2018 (in thousands): (1) In November 2014 and February 2016, we entered into a term loan agreement and a convertible loan agreement, respectively, with Clean Energy Collective, LLC (“CEC”). Our term loan bears interest at 16% per annum, and our convertible loan bears interest at 10% per annum. In November 2018, we amended the terms of the loan agreements to (i) extend their maturity to June 2020, (ii) waive the conversion features on our convertible loan, and (iii) increase the frequency of interest payments, subject to certain conditions. In January 2019, CEC finalized certain restructuring arrangements, which resulted in a dilution of our ownership interest in CEC and the loss of our representation on the company’s board of managers. As a result of such restructuring, CEC no longer qualified to be accounted for under the equity method. As of December 31, 2019, the aggregate balance outstanding on the loans was $23.9 million and was presented within “Prepaid expenses and other current assets.” As of December 31, 2018, the aggregate balance outstanding on the loans was $22.8 million and was presented within “Notes receivable, affiliate.” (2) See Note 9. “Derivative Financial Instruments” to our consolidated financial statements for discussion of our derivative instruments.\n\n \n\nWhat will be the increase in prepaid expenses from 2018 to 2019 if the amount of prepaid expense in 2019 increased by 20%? (in thousand)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n||2019|2018|\\n|Prepaid expenses|$137,927|$90,981|\\n|Prepaid income taxes .|47,811|59,319|\\n|Indirect tax receivables .|29,908|26,327|\\n|Restricted cash|13,697|19,671|\\n|Notes receivable (1)|23,873|5,196|\\n|Derivative instruments (2) .|1,199|2,364|\\n|Other current assets|22,040|39,203|\\n|Prepaid expenses and other current assets|$276,455|$243,061|\\n Prepaid expenses and other current assets Prepaid expenses and other current assets consisted of the following at December 31, 2019 and 2018 (in thousands): (1) In November 2014 and February 2016, we entered into a term loan agreement and a convertible loan agreement, respectively, with Clean Energy Collective, LLC (“CEC”). Our term loan bears interest at 16% per annum, and our convertible loan bears interest at 10% per annum. In November 2018, we amended the terms of the loan agreements to (i) extend their maturity to June 2020, (ii) waive the conversion features on our convertible loan, and (iii) increase the frequency of interest payments, subject to certain conditions. In January 2019, CEC finalized certain restructuring arrangements, which resulted in a dilution of our ownership interest in CEC and the loss of our representation on the company’s board of managers. As a result of such restructuring, CEC no longer qualified to be accounted for under the equity method. As of December 31, 2019, the aggregate balance outstanding on the loans was $23.9 million and was presented within “Prepaid expenses and other current assets.” As of December 31, 2018, the aggregate balance outstanding on the loans was $22.8 million and was presented within “Notes receivable, affiliate.” (2) See Note 9. “Derivative Financial Instruments” to our consolidated financial statements for discussion of our derivative instruments.\\n\\n \\n\\nWhat will be the increase in prepaid expenses from 2018 to 2019 if the amount of prepaid expense in 2019 increased by 20%? (in thousand)\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 74531.4.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 81,\n \"input_length\": 596\n}"}}},{"rowIdx":82,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n||2019|2018|$ CHANGE|% CHANGE|\n|Operating costs|(6,942)|(6,946)|4|0.1%|\n|Adjusted EBITDA|5,414|5,321|93|1.7%|\n|Adjusted EBITDA margin|43.8%|43.4%||0.4 pts|\n OPERATING COSTS AND ADJUSTED EBITDA Bell Wireline operating costs were essentially stable year over year, decreasing by 0.1% in 2019, compared to 2018, resulting from: • The favourable impact from the adoption of IFRS 16 in 2019 • Continued effective cost containment • Lower pension expenses reflecting reduced DB costs These factors were partly offset by: • Higher cost of goods sold related to the growth in product sales • Increased costs from the acquisition of Axia • Greater payments to other carriers from increased sales of international wholesale long distance minutes Bell Wireline adjusted EBITDA grew by 1.7% in 2019, compared to last year, reflecting the growth in revenues as operating expenses were relatively stable year over year. Adjusted EBITDA margin increased to 43.8% in 2019, compared to the 43.4% achieved last year, resulting from the favourable impact of the adoption of IFRS 16 in 2019 and the flow-through of the service revenue growth, offset in part by higher low-margin product sales in our total revenue base.\n\n \n\nWhat would the sum of the adjusted EBITDA in 2018 and 2019 be if the amount for 2019 is 5,400?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n||2019|2018|$ CHANGE|% CHANGE|\\n|Operating costs|(6,942)|(6,946)|4|0.1%|\\n|Adjusted EBITDA|5,414|5,321|93|1.7%|\\n|Adjusted EBITDA margin|43.8%|43.4%||0.4 pts|\\n OPERATING COSTS AND ADJUSTED EBITDA Bell Wireline operating costs were essentially stable year over year, decreasing by 0.1% in 2019, compared to 2018, resulting from: • The favourable impact from the adoption of IFRS 16 in 2019 • Continued effective cost containment • Lower pension expenses reflecting reduced DB costs These factors were partly offset by: • Higher cost of goods sold related to the growth in product sales • Increased costs from the acquisition of Axia • Greater payments to other carriers from increased sales of international wholesale long distance minutes Bell Wireline adjusted EBITDA grew by 1.7% in 2019, compared to last year, reflecting the growth in revenues as operating expenses were relatively stable year over year. Adjusted EBITDA margin increased to 43.8% in 2019, compared to the 43.4% achieved last year, resulting from the favourable impact of the adoption of IFRS 16 in 2019 and the flow-through of the service revenue growth, offset in part by higher low-margin product sales in our total revenue base.\\n\\n \\n\\nWhat would the sum of the adjusted EBITDA in 2018 and 2019 be if the amount for 2019 is 5,400?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 10721.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 82,\n \"input_length\": 415\n}"}}},{"rowIdx":83,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n||Amortized Cost|Unrealized Gains|Unrealized Losses|Fair Value|\n|Current assets:|||||\n|Cash|$67,818|$—|$—|$67,818|\n|Cash equivalents:|||||\n|Money market funds|126,075|—|—|126,075|\n|Corporate bonds|1,000|—|—|1,000|\n|Agency bonds|6,485|1|—|6,486|\n|Commercial paper|9,609|—|(1)|9,608|\n|Certificates of deposit|171|—|—|171|\n|US treasury securities|4,749|—|—|4,749|\n|Total cash equivalents|148,089|1|(1)|148,089|\n|Total cash and cash equivalents|215,907|1|(1)|215,907|\n|Short-term investments:|||||\n|Corporate bonds|103,130|110|(7)|103,233|\n|Agency bonds|3,966|2|—|3,968|\n|US treasury securities|50,703|62|(1)|50,764|\n|Commercial paper|23,827|1|—|23,828|\n|Certificates of deposit|3,936|2|(1)|3,937|\n|Asset-backed securities|15,837|12|—|15,849|\n|Total short-term investments|201,399|189|(9)|201,579|\n|Long-term investments:|||||\n|Corporate bonds|19,407|12|(4)|19,415|\n|US treasury securities|19,300|25|—|19,325|\n|Asset-backed securities|11,693|10|(1)|11,702|\n|Strategic investments|9,750|—|—|9,750|\n|Total long-term investments|$60,150|$47|$(5)|$60,192|\n 5. INVESTMENTS Investments in Marketable Securities The Company’s investments in available-for-sale marketable securities are made pursuant to its investment policy, which has established guidelines relative to the diversification of the Company’s investments and their maturities, with the principal objective of capital preservation and maintaining liquidity sufficient to meet cash flow requirements. The following is a summary of investments, including those that meet the definition of a cash equivalent, as of December 31, 2019 (in thousands):\n\n \n\nWhat percentage of total unrealised gains for short-term investments would consist of US treasury securities if total unrealised gains for short-term investments were 200 thousands instead without change to unrealised gains in US treasury securities? (in percent)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n||Amortized Cost|Unrealized Gains|Unrealized Losses|Fair Value|\\n|Current assets:|||||\\n|Cash|$67,818|$—|$—|$67,818|\\n|Cash equivalents:|||||\\n|Money market funds|126,075|—|—|126,075|\\n|Corporate bonds|1,000|—|—|1,000|\\n|Agency bonds|6,485|1|—|6,486|\\n|Commercial paper|9,609|—|(1)|9,608|\\n|Certificates of deposit|171|—|—|171|\\n|US treasury securities|4,749|—|—|4,749|\\n|Total cash equivalents|148,089|1|(1)|148,089|\\n|Total cash and cash equivalents|215,907|1|(1)|215,907|\\n|Short-term investments:|||||\\n|Corporate bonds|103,130|110|(7)|103,233|\\n|Agency bonds|3,966|2|—|3,968|\\n|US treasury securities|50,703|62|(1)|50,764|\\n|Commercial paper|23,827|1|—|23,828|\\n|Certificates of deposit|3,936|2|(1)|3,937|\\n|Asset-backed securities|15,837|12|—|15,849|\\n|Total short-term investments|201,399|189|(9)|201,579|\\n|Long-term investments:|||||\\n|Corporate bonds|19,407|12|(4)|19,415|\\n|US treasury securities|19,300|25|—|19,325|\\n|Asset-backed securities|11,693|10|(1)|11,702|\\n|Strategic investments|9,750|—|—|9,750|\\n|Total long-term investments|$60,150|$47|$(5)|$60,192|\\n 5. INVESTMENTS Investments in Marketable Securities The Company’s investments in available-for-sale marketable securities are made pursuant to its investment policy, which has established guidelines relative to the diversification of the Company’s investments and their maturities, with the principal objective of capital preservation and maintaining liquidity sufficient to meet cash flow requirements. The following is a summary of investments, including those that meet the definition of a cash equivalent, as of December 31, 2019 (in thousands):\\n\\n \\n\\nWhat percentage of total unrealised gains for short-term investments would consist of US treasury securities if total unrealised gains for short-term investments were 200 thousands instead without change to unrealised gains in US treasury securities? (in percent)\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 31.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 83,\n \"input_length\": 716\n}"}}},{"rowIdx":84,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n|||Year-ended 31 March 2019|Year-ended 31 March 2018|Year-ended 31 March 2017|\n|||tCO2e|tCO2e|tCO2e|\n|Scope 1|Combustion of natural gas and operation of owned vehicles|220.9|320.0|251.8|\n|Scope 2|Electricity consumption in offices|4,487.2|4,457.3|4,681.9|\n|Scope 3|Business travel (air and car)|3,260.9|5,117.4|4,510.9|\n|Total||7,969.0|9,894.7|9,444.6|\n|Intensity ratio|||||\n|tCO2e per $M of billings||10.5|12.9|14.9|\n Greenhouse gas emissions In line with the Companies Act 2006, Sophos is required to measure and report on its Greenhouse Gas (“GHG”) emissions disclosures. These have been calculated for the year-ending 31 March 2019, in line with the Group’s financial year. The calculation of the disclosures has been performed in accordance with Greenhouse Gas Protocol Corporate Standard and using the UK government’s conversion factor guidance for the year reported. The Group’s operations that primarily release GHG includes usage of electricity and gas of owned and leased offices, business travel and usage of vehicles. The Group keeps its data capture process under review, seeking to extend the availability of direct information wherever possible. Where direct information for certain sites is not available, estimates have been developed that enable reporting for them. These estimates are revised if new or improved data is obtained. The Group will continue to build its GHG reporting capabilities. The Group’s chosen intensity ratio is ‘tonnes of CO2 equivalent per million US dollars of billings’ as it aligns with Sophos’ strategic growth ambitions. Creating an environmentally friendly HQ The Group commissioned a greening study of its global headquarters in Abingdon, Oxfordshire. The purpose of the study was to benchmark the current environmental, health and wellbeing performance of the building against current best practice and against direct and indirect competitors. The findings of the study showed that the building performance was consistent with intermediate good practice and the building management was consistent with standard good practice. The study highlighted areas of future improvement. The findings and recommendations of this report will be a key driver for developing best practice in environmental sustainability to match the growth aspirations and objectives of the Company. The Group is endeavouring to achieve the standards in environmental performance, health and wellbeing that is expected of a global technology organisation at the Group’s headquarters.\n\n \n\nWhat would the percentage change in the intensity ratio in 2019 from 2018 be if the ratio in 2019 was 10.0 instead? (in percent)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n|||Year-ended 31 March 2019|Year-ended 31 March 2018|Year-ended 31 March 2017|\\n|||tCO2e|tCO2e|tCO2e|\\n|Scope 1|Combustion of natural gas and operation of owned vehicles|220.9|320.0|251.8|\\n|Scope 2|Electricity consumption in offices|4,487.2|4,457.3|4,681.9|\\n|Scope 3|Business travel (air and car)|3,260.9|5,117.4|4,510.9|\\n|Total||7,969.0|9,894.7|9,444.6|\\n|Intensity ratio|||||\\n|tCO2e per $M of billings||10.5|12.9|14.9|\\n Greenhouse gas emissions In line with the Companies Act 2006, Sophos is required to measure and report on its Greenhouse Gas (“GHG”) emissions disclosures. These have been calculated for the year-ending 31 March 2019, in line with the Group’s financial year. The calculation of the disclosures has been performed in accordance with Greenhouse Gas Protocol Corporate Standard and using the UK government’s conversion factor guidance for the year reported. The Group’s operations that primarily release GHG includes usage of electricity and gas of owned and leased offices, business travel and usage of vehicles. The Group keeps its data capture process under review, seeking to extend the availability of direct information wherever possible. Where direct information for certain sites is not available, estimates have been developed that enable reporting for them. These estimates are revised if new or improved data is obtained. The Group will continue to build its GHG reporting capabilities. The Group’s chosen intensity ratio is ‘tonnes of CO2 equivalent per million US dollars of billings’ as it aligns with Sophos’ strategic growth ambitions. Creating an environmentally friendly HQ The Group commissioned a greening study of its global headquarters in Abingdon, Oxfordshire. The purpose of the study was to benchmark the current environmental, health and wellbeing performance of the building against current best practice and against direct and indirect competitors. The findings of the study showed that the building performance was consistent with intermediate good practice and the building management was consistent with standard good practice. The study highlighted areas of future improvement. The findings and recommendations of this report will be a key driver for developing best practice in environmental sustainability to match the growth aspirations and objectives of the Company. The Group is endeavouring to achieve the standards in environmental performance, health and wellbeing that is expected of a global technology organisation at the Group’s headquarters.\\n\\n \\n\\nWhat would the percentage change in the intensity ratio in 2019 from 2018 be if the ratio in 2019 was 10.0 instead? (in percent)\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is -22.48062015503876.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 84,\n \"input_length\": 673\n}"}}},{"rowIdx":85,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n|||Years Ended December 31,||\n||2019|2018|2017|\n|Net income|$67,062|$68,921|$5,135|\n|Other comprehensive income (loss):||||\n|Foreign currency translation adjustments|1,034|-15,261|16,744|\n|Total other comprehensive income (loss)|1,034|(15,261 )|16,744|\n|Comprehensive income|$68,096|$53,660|$21,879|\n ACI WORLDWIDE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (in thousands) The accompanying notes are an integral part of the consolidated financial statements.\n\n \n\nWhat would be the change in comprehensive income between 2018 and 2019 if comprehensive income in 2019 was $70,000 thousand instead? (in thousand)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n|||Years Ended December 31,||\\n||2019|2018|2017|\\n|Net income|$67,062|$68,921|$5,135|\\n|Other comprehensive income (loss):||||\\n|Foreign currency translation adjustments|1,034|-15,261|16,744|\\n|Total other comprehensive income (loss)|1,034|(15,261 )|16,744|\\n|Comprehensive income|$68,096|$53,660|$21,879|\\n ACI WORLDWIDE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (in thousands) The accompanying notes are an integral part of the consolidated financial statements.\\n\\n \\n\\nWhat would be the change in comprehensive income between 2018 and 2019 if comprehensive income in 2019 was $70,000 thousand instead? (in thousand)\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 16340.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 85,\n \"input_length\": 268\n}"}}},{"rowIdx":86,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n||2019|2018|2017|\n|||(in thousands)||\n|Income before income taxes||||\n|U.S|$192,442|$189,691|$76,699|\n|Non-U.S|333,330|278,110|447,713|\n||$525,772|$467,801|$524,412|\n|Provision (benefit) for income taxes||||\n|Current:||||\n|U.S. Federal|$19,297|$(59,122)|$162,679|\n|Non-U.S|52,810|45,083|64,313|\n|State|(4,347)|1,721|2,623|\n||67,760|(12,318)|229,615|\n|Deferred:||||\n|U.S. Federal|(4,522)|29,252|43,687|\n|Non-U.S|(8,007)|(1,243)|(6,476)|\n|State|3,073|331|(106)|\n||(9,456)|28,340|37,105|\n|Total provision for income taxes|$58,304|$16,022|$266,720|\n S. INCOME TAXES The components of income (loss) before income taxes and the provision (benefit) for income taxes as shown in the consolidated statements of operations were as follows: Income tax expense for 2019, 2018 and 2017 totaled $58.3 million, $16.0 million and $266.7 million, respectively. The effective tax rate for 2019, 2018 and 2017 was 11.1%, 3.4% and 50.9%, respectively. On December 22, 2017, the U.S. enacted the Tax Cuts and Jobs Act of 2017 (the “Tax Reform Act”), making significant changes to the Internal Revenue Code. The Tax Reform Act has significant direct and indirect implications for accounting for income taxes under ASC 740, “Accounting for Income Taxes” some of which could not be calculated with precision until further clarification and guidance was made available from tax authorities, regulatory bodies or the FASB. In light of this uncertainty, on December 22, 2017 the SEC issued Staff Accounting Bulletin (“SAB”) No. 118, “Income Tax Accounting Implications of the Tax Cuts and Jobs Act,” to address uncertainty in the application of U.S. GAAP when the registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Tax Reform Act. In accordance with SAB 118, Teradyne recorded $186.0 million of additional income tax expense in the fourth quarter of 2017 which represented Teradyne’s best estimate of the impact of the Tax Reform Act in accordance with Teradyne’s understanding of the Tax Reform Act and available guidance as of that date. The $186.0 million was primarily composed of expense of $161.0 million related to the one-time transition tax on the mandatory deemed repatriation of foreign earnings, $33.6 million of expense related to the remeasurement of certain deferred tax assets and liabilities based on the rates at which they are expected to reverse in the future, and a benefit of $10.3 million associated with the impact of correlative adjustments on uncertain tax positions. In accordance with the requirements of SAB 118, in the fourth quarter of 2018, Teradyne completed its analysis of the effect of the Tax Reform Act based on the application of the most recently available guidance as of December 31, 2018 and recorded $49.5 million of net income tax benefit. The net benefit consisted of $51.7 million of benefit resulting from a reduction in the estimate of the one-time transition tax on the mandatory deemed repatriation of foreign earnings and an expense of $2.2 million associated with the impact of correlative adjustments on uncertain tax positions.\n\n \n\nWhat would the change in U.S. Income before income taxes in 2019 from 2018 if the amount in 2019 was $193,000 thousand instead? (in thousand)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n||2019|2018|2017|\\n|||(in thousands)||\\n|Income before income taxes||||\\n|U.S|$192,442|$189,691|$76,699|\\n|Non-U.S|333,330|278,110|447,713|\\n||$525,772|$467,801|$524,412|\\n|Provision (benefit) for income taxes||||\\n|Current:||||\\n|U.S. Federal|$19,297|$(59,122)|$162,679|\\n|Non-U.S|52,810|45,083|64,313|\\n|State|(4,347)|1,721|2,623|\\n||67,760|(12,318)|229,615|\\n|Deferred:||||\\n|U.S. Federal|(4,522)|29,252|43,687|\\n|Non-U.S|(8,007)|(1,243)|(6,476)|\\n|State|3,073|331|(106)|\\n||(9,456)|28,340|37,105|\\n|Total provision for income taxes|$58,304|$16,022|$266,720|\\n S. INCOME TAXES The components of income (loss) before income taxes and the provision (benefit) for income taxes as shown in the consolidated statements of operations were as follows: Income tax expense for 2019, 2018 and 2017 totaled $58.3 million, $16.0 million and $266.7 million, respectively. The effective tax rate for 2019, 2018 and 2017 was 11.1%, 3.4% and 50.9%, respectively. On December 22, 2017, the U.S. enacted the Tax Cuts and Jobs Act of 2017 (the “Tax Reform Act”), making significant changes to the Internal Revenue Code. The Tax Reform Act has significant direct and indirect implications for accounting for income taxes under ASC 740, “Accounting for Income Taxes” some of which could not be calculated with precision until further clarification and guidance was made available from tax authorities, regulatory bodies or the FASB. In light of this uncertainty, on December 22, 2017 the SEC issued Staff Accounting Bulletin (“SAB”) No. 118, “Income Tax Accounting Implications of the Tax Cuts and Jobs Act,” to address uncertainty in the application of U.S. GAAP when the registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Tax Reform Act. In accordance with SAB 118, Teradyne recorded $186.0 million of additional income tax expense in the fourth quarter of 2017 which represented Teradyne’s best estimate of the impact of the Tax Reform Act in accordance with Teradyne’s understanding of the Tax Reform Act and available guidance as of that date. The $186.0 million was primarily composed of expense of $161.0 million related to the one-time transition tax on the mandatory deemed repatriation of foreign earnings, $33.6 million of expense related to the remeasurement of certain deferred tax assets and liabilities based on the rates at which they are expected to reverse in the future, and a benefit of $10.3 million associated with the impact of correlative adjustments on uncertain tax positions. In accordance with the requirements of SAB 118, in the fourth quarter of 2018, Teradyne completed its analysis of the effect of the Tax Reform Act based on the application of the most recently available guidance as of December 31, 2018 and recorded $49.5 million of net income tax benefit. The net benefit consisted of $51.7 million of benefit resulting from a reduction in the estimate of the one-time transition tax on the mandatory deemed repatriation of foreign earnings and an expense of $2.2 million associated with the impact of correlative adjustments on uncertain tax positions.\\n\\n \\n\\nWhat would the change in U.S. Income before income taxes in 2019 from 2018 if the amount in 2019 was $193,000 thousand instead? (in thousand)\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 3309.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 86,\n \"input_length\": 1073\n}"}}},{"rowIdx":87,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n|As at December 31,|2019|2018|\n|Equity securities|||\n|Canada|22.3%|20.8%|\n|United States|19.8%|12.7%|\n|International (other than United States)|14.1%|18.1%|\n|Fixed income instruments|||\n|Canada|41.2%|45.7%|\n|Cash and cash equivalents|||\n|Canada|2.6%|2.7%|\n 30. EMPLOYEE BENEFIT PLANS (cont.) The fair value of the plan assets were allocated as follows between the various types of investments: Plan assets are valued at the measurement date of December 31 each year. The investments are made in accordance with the Statement of Investment Policies and Procedures. The Statement of Investment Policies and Procedures is reviewed on an annual basis by the Management Level Pension Fund Investment Committee with approval of the policy being provided by the Audit Committee.\n\n \n\nWhat would be the percentage change in plan asset fair value allocated in Canada equity securities between 2018 and 2019 if the percentage accorded in 2019 is doubled and then increased by 5%? (in percent)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n|As at December 31,|2019|2018|\\n|Equity securities|||\\n|Canada|22.3%|20.8%|\\n|United States|19.8%|12.7%|\\n|International (other than United States)|14.1%|18.1%|\\n|Fixed income instruments|||\\n|Canada|41.2%|45.7%|\\n|Cash and cash equivalents|||\\n|Canada|2.6%|2.7%|\\n 30. EMPLOYEE BENEFIT PLANS (cont.) The fair value of the plan assets were allocated as follows between the various types of investments: Plan assets are valued at the measurement date of December 31 each year. The investments are made in accordance with the Statement of Investment Policies and Procedures. The Statement of Investment Policies and Procedures is reviewed on an annual basis by the Management Level Pension Fund Investment Committee with approval of the policy being provided by the Audit Committee.\\n\\n \\n\\nWhat would be the percentage change in plan asset fair value allocated in Canada equity securities between 2018 and 2019 if the percentage accorded in 2019 is doubled and then increased by 5%? (in percent)\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 28.8.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 87,\n \"input_length\": 306\n}"}}},{"rowIdx":88,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n||Capped Call|Embedded exchange feature of Notes|Non-marketable investments|\n|||(U.S. $ in thousands)||\n|Balance as of June 30, 2017|$—|$—|$—|\n|Purchases|87,700|(177,907)|—|\n|Gains (losses)||||\n|Recognized in other non-operating (expense) income, net|12,232|(24,646)||\n|Balance as of June 30, 2018|99,932|(202,553)|—|\n|Change in unrealized gains (losses) relating to assets and liabilities held as of June 30, 2018||||\n|Recognized in other non-operating income (expense), net|12,232|(24,646)|—|\n|Balance as of June 30, 2018|$99,932|$(202,553)|$—|\n|Purchases|—|—|23,000|\n|Transfer out|—|—|(20,942)|\n|Gains (losses)||||\n|Recognized in finance income|—|—|270|\n|Recognized in other non-operating (expense) income, net|114,665|(648,573)|—|\n|Recognized in other comprehensive income|—|—|672|\n|Balance as of June 30, 2019|$214,597|$(851,126)|$3,000|\n|Change in unrealized gains (losses) relating to assets and liabilities held as of June 30, 2019||||\n|Recognized in other non-operating income (expense), net|114,665|(648,573)|—|\n Non-marketable investments Non-marketable equity securities are measured at fair value using market data, such as publicly available financing round valuations. Financial information of private companies may not be available and consequently we will estimate the fair value based on the best available information at the measurement date. The following table presents the reconciliations of Level 3 financial instrument fair values: There were transfers out from Level 3 due to initial public offerings of the respective investees during fiscal year 2019. There were no transfers between levels during fiscal year 2018.\n\n \n\nWhat would be the percentage change in the balance of capped call between fiscal year ended June 30, 2018 and 2019 if the value in fiscal year 2018 was $150,000 thousand instead? (in percent)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n||Capped Call|Embedded exchange feature of Notes|Non-marketable investments|\\n|||(U.S. $ in thousands)||\\n|Balance as of June 30, 2017|$—|$—|$—|\\n|Purchases|87,700|(177,907)|—|\\n|Gains (losses)||||\\n|Recognized in other non-operating (expense) income, net|12,232|(24,646)||\\n|Balance as of June 30, 2018|99,932|(202,553)|—|\\n|Change in unrealized gains (losses) relating to assets and liabilities held as of June 30, 2018||||\\n|Recognized in other non-operating income (expense), net|12,232|(24,646)|—|\\n|Balance as of June 30, 2018|$99,932|$(202,553)|$—|\\n|Purchases|—|—|23,000|\\n|Transfer out|—|—|(20,942)|\\n|Gains (losses)||||\\n|Recognized in finance income|—|—|270|\\n|Recognized in other non-operating (expense) income, net|114,665|(648,573)|—|\\n|Recognized in other comprehensive income|—|—|672|\\n|Balance as of June 30, 2019|$214,597|$(851,126)|$3,000|\\n|Change in unrealized gains (losses) relating to assets and liabilities held as of June 30, 2019||||\\n|Recognized in other non-operating income (expense), net|114,665|(648,573)|—|\\n Non-marketable investments Non-marketable equity securities are measured at fair value using market data, such as publicly available financing round valuations. Financial information of private companies may not be available and consequently we will estimate the fair value based on the best available information at the measurement date. The following table presents the reconciliations of Level 3 financial instrument fair values: There were transfers out from Level 3 due to initial public offerings of the respective investees during fiscal year 2019. There were no transfers between levels during fiscal year 2018.\\n\\n \\n\\nWhat would be the percentage change in the balance of capped call between fiscal year ended June 30, 2018 and 2019 if the value in fiscal year 2018 was $150,000 thousand instead? (in percent)\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 43.06466666666667.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 88,\n \"input_length\": 649\n}"}}},{"rowIdx":89,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n||International|Pinnacle Foods|Corporate|Total|\n|Other cost of goods sold|$—|$3.7|$—|$3.7|\n|Total cost of goods sold .|—|3.7|—|3.7|\n|Severance and related costs|0.7|0.6|110.8|112.1|\n|Accelerated depreciation|—|—|4.7|4.7|\n|Contract/lease termination .|—|0.8|0.3|1.1|\n|Consulting/professional fees .|0.2|—|38.1|38.3|\n|Other selling, general and administrative expenses .|0.1|—|8.2|8.3|\n|Total selling, general and administrative expenses|1.0|1.4|162.1|164.5|\n|Consolidated total|$1.0|$5.1|$162.1|$168.2|\n Notes to Consolidated Financial Statements - (Continued) Fiscal Years Ended May 26, 2019, May 27, 2018, and May 28, 2017 (columnar dollars in millions except per share amounts) During fiscal 2019, we recognized the following pre-tax expenses for the Pinnacle Integration Restructuring Plan: Included in the above results are $163.5 million of charges that have resulted or will result in cash outflows and $4.7 million in non-cash charges.\n\n \n\nWhat would be the proportion of cash charges that have resulted or will result in cash outflows over total consolidated pre-tax expenses if the total consolidated pre-tax expenses were $200 million?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n||International|Pinnacle Foods|Corporate|Total|\\n|Other cost of goods sold|$—|$3.7|$—|$3.7|\\n|Total cost of goods sold .|—|3.7|—|3.7|\\n|Severance and related costs|0.7|0.6|110.8|112.1|\\n|Accelerated depreciation|—|—|4.7|4.7|\\n|Contract/lease termination .|—|0.8|0.3|1.1|\\n|Consulting/professional fees .|0.2|—|38.1|38.3|\\n|Other selling, general and administrative expenses .|0.1|—|8.2|8.3|\\n|Total selling, general and administrative expenses|1.0|1.4|162.1|164.5|\\n|Consolidated total|$1.0|$5.1|$162.1|$168.2|\\n Notes to Consolidated Financial Statements - (Continued) Fiscal Years Ended May 26, 2019, May 27, 2018, and May 28, 2017 (columnar dollars in millions except per share amounts) During fiscal 2019, we recognized the following pre-tax expenses for the Pinnacle Integration Restructuring Plan: Included in the above results are $163.5 million of charges that have resulted or will result in cash outflows and $4.7 million in non-cash charges.\\n\\n \\n\\nWhat would be the proportion of cash charges that have resulted or will result in cash outflows over total consolidated pre-tax expenses if the total consolidated pre-tax expenses were $200 million?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 0.8175.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 89,\n \"input_length\": 419\n}"}}},{"rowIdx":90,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n|Period|(a) Total Number of Shares (or Units) Purchased|(b) Average Price Paid per Share (or Unit)|(c) Total Number of Shares (or Units) Purchased as Part of Publicly Announced Plans or Programs|(d) Maximum Number (or Approximate Dollar Value) of Shares (or Unites) that May Yet Be Purchased Under the Plans or Programs*|\n|July 1-31, 2019|293|$ 99.35|293|74,706|\n|August 1 - 31, 2019|39,769|107.71|39,769|34,937|\n|September 1 - 30, 2019|91|75.51|91|34,846|\n|Total|40,153|$ 107.58|40,153|34,846|\n REPURCHASE OF COMPANY SHARES The Company repurchased a total of 75,113 and 74,880 shares of its common stock during fiscal 2019 and fiscal 2018, respectively, for cash totaling approximately $7.5 million and $7.7 million, respectively. All repurchased shares were recorded in treasury stock at cost. At September 2019, 34,846 shares of the Company’s common shares remained authorized for repurchase in either the open market or privately negotiated transactions, as previously approved by the Company’s Board of Directors. In October 2019, our Board of Directors renewed the repurchase authorization for up to 75,000 shares of the Company’s common stock. During the fourth quarter of fiscal 2019, the Company repurchased shares of its common stock for cash totaling approximately $4.3 million. The following table summarizes these repurchases made by or on behalf of our Company or certain affiliated purchasers of shares of our common stock for the quarterly period ended September 30, 2019: * In October 2019 and subsequent to the end of fiscal 2019, our Board of Directors authorized purchases of up to\n75,000 shares of our Company’s common stock in open market or negotiated transactions. Management was\ngiven discretion to determine the number and pricing of the shares to be purchased, as well as the timing of any\nsuch purchases.\n\n \n\nWhat would be the percentage change in the shares of common stock repurchased between fiscal 2018 and 2019 if the number of shares repurchased in 2019 is increased by 5,000? (in percent)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n|Period|(a) Total Number of Shares (or Units) Purchased|(b) Average Price Paid per Share (or Unit)|(c) Total Number of Shares (or Units) Purchased as Part of Publicly Announced Plans or Programs|(d) Maximum Number (or Approximate Dollar Value) of Shares (or Unites) that May Yet Be Purchased Under the Plans or Programs*|\\n|July 1-31, 2019|293|$ 99.35|293|74,706|\\n|August 1 - 31, 2019|39,769|107.71|39,769|34,937|\\n|September 1 - 30, 2019|91|75.51|91|34,846|\\n|Total|40,153|$ 107.58|40,153|34,846|\\n REPURCHASE OF COMPANY SHARES The Company repurchased a total of 75,113 and 74,880 shares of its common stock during fiscal 2019 and fiscal 2018, respectively, for cash totaling approximately $7.5 million and $7.7 million, respectively. All repurchased shares were recorded in treasury stock at cost. At September 2019, 34,846 shares of the Company’s common shares remained authorized for repurchase in either the open market or privately negotiated transactions, as previously approved by the Company’s Board of Directors. In October 2019, our Board of Directors renewed the repurchase authorization for up to 75,000 shares of the Company’s common stock. During the fourth quarter of fiscal 2019, the Company repurchased shares of its common stock for cash totaling approximately $4.3 million. The following table summarizes these repurchases made by or on behalf of our Company or certain affiliated purchasers of shares of our common stock for the quarterly period ended September 30, 2019: * In October 2019 and subsequent to the end of fiscal 2019, our Board of Directors authorized purchases of up to\\n75,000 shares of our Company’s common stock in open market or negotiated transactions. Management was\\ngiven discretion to determine the number and pricing of the shares to be purchased, as well as the timing of any\\nsuch purchases.\\n\\n \\n\\nWhat would be the percentage change in the shares of common stock repurchased between fiscal 2018 and 2019 if the number of shares repurchased in 2019 is increased by 5,000? (in percent)\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 6.988514957264957.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 90,\n \"input_length\": 635\n}"}}},{"rowIdx":91,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n|||YearEnded||\n||June 30, 2019|June 24, 2018|June 25, 2017|\n|||(in thousands)||\n|United States|$(59,876)|$128,190|$7,553|\n|Foreign|2,506,447|3,023,599|1,804,120|\n||$2,446,571|$3,151,789|$1,811,673|\n Note 7: Income Taxes On December 22, 2017, the “Tax Cuts & Jobs Act” was signed into law and was effective for the Company starting in the quarter ended December 24, 2017. U.S. tax reform reduced the U.S. federal statutory tax rate from 35% to 21%, assessed a one-time transition tax on earnings of certain foreign subsidiaries that were previously tax deferred, and created new taxes on certain foreign sourced earnings. The impact on income taxes due to a change in legislation is required under the authoritative guidance of Accounting Standards Codification (“ASC”) 740, Income Taxes, to be recognized in the period in which the law is enacted. In conjunction, the SEC issued Staff Accounting Bulletin (“SAB”) 118, which allowed for the recording of provisional amounts related to U.S. tax reform and subsequent adjustments related to U.S. tax reform during an up to one-year measurement period that is similar to the measurement period used when accounting for business combinations. The Company recorded what it believed to be reasonable estimates during the SAB 118 measurement period. During the December 2018 quarter, the Company finalized the accounting of the income tax effects of U.S. tax reform. Although the SAB 118 measurement period has ended, there may be some aspects of U.S. tax reform that remain subject to future regulations and/or notices which may further clarify certain provisions of U.S. tax reform. The Company may need to adjust its previously recorded amounts to reflect the recognition and measurement of its tax accounting positions in accordance with ASC 740; such adjustments could be material. The computation of the one-time transition tax on accumulated unrepatriated foreign earnings was recorded on a provisional basis in the amount of $883.0 million in the fiscal year ended June 24, 2018, as permitted under SAB 118. The Company recorded a subsequent provisional adjustment of $36.6 million, as a result of incorporating new information into the estimate, in the Condensed Consolidated Financial Statements in the three months ended September 23, 2018. The Company finalized the computation of the transition tax liability during the December 2018 quarter. The final adjustment resulted in a tax benefit of $51.2 million, which was recorded in the Company’s Condensed Consolidated Financial Statements in the three months ended December 23, 2018. The final balance of total transition tax is $868.4 million. The one-time transition tax is based on the Company’s total post-1986 earnings and profits (“E&P”) that was previously deferred from U.S. income taxes. The Company had previously accrued deferred taxes on a portion of this E&P. The Company has completed the calculation of total post-1986 E&P and related income tax pools for its foreign subsidiaries. The Company elected to pay the one-time transition tax over a period of eight years. Beginning in fiscal year 2019, the Company is subject to the impact of the GILTI provision of U.S. tax reform. The GILTI provision imposes taxes on foreign earnings in excess of a deemed return on tangible assets. The Company has calculated the impact of the GILTI provision on current year earnings and has included the impact in the effective tax rate. The Company made an accounting policy election in the September 2018 quarter to record deferred taxes in relation to the GILTI provision, and recorded a provisional tax benefit of $48.0 million in the Condensed Consolidated Financial Statements in the three months ended September 23, 2018, under SAB 118. The Company finalized the computation of the accounting policy election during the December 2018 quarter. The final adjustment resulted in a tax expense of $0.4 million, which was recorded in the Company’s Condensed Consolidated Financial Statements in the three months ended December 23, 2018. The final tax benefit of the election is $47.6 million. The components of income (loss) before income taxes were as follows:\n\n \n\nWhat would the percentage change in the income before income taxes from Foreign countries from 2018 to 2019 be if the amount in 2019 was 3,000,000 thousand instead? (in percent)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n|||YearEnded||\\n||June 30, 2019|June 24, 2018|June 25, 2017|\\n|||(in thousands)||\\n|United States|$(59,876)|$128,190|$7,553|\\n|Foreign|2,506,447|3,023,599|1,804,120|\\n||$2,446,571|$3,151,789|$1,811,673|\\n Note 7: Income Taxes On December 22, 2017, the “Tax Cuts & Jobs Act” was signed into law and was effective for the Company starting in the quarter ended December 24, 2017. U.S. tax reform reduced the U.S. federal statutory tax rate from 35% to 21%, assessed a one-time transition tax on earnings of certain foreign subsidiaries that were previously tax deferred, and created new taxes on certain foreign sourced earnings. The impact on income taxes due to a change in legislation is required under the authoritative guidance of Accounting Standards Codification (“ASC”) 740, Income Taxes, to be recognized in the period in which the law is enacted. In conjunction, the SEC issued Staff Accounting Bulletin (“SAB”) 118, which allowed for the recording of provisional amounts related to U.S. tax reform and subsequent adjustments related to U.S. tax reform during an up to one-year measurement period that is similar to the measurement period used when accounting for business combinations. The Company recorded what it believed to be reasonable estimates during the SAB 118 measurement period. During the December 2018 quarter, the Company finalized the accounting of the income tax effects of U.S. tax reform. Although the SAB 118 measurement period has ended, there may be some aspects of U.S. tax reform that remain subject to future regulations and/or notices which may further clarify certain provisions of U.S. tax reform. The Company may need to adjust its previously recorded amounts to reflect the recognition and measurement of its tax accounting positions in accordance with ASC 740; such adjustments could be material. The computation of the one-time transition tax on accumulated unrepatriated foreign earnings was recorded on a provisional basis in the amount of $883.0 million in the fiscal year ended June 24, 2018, as permitted under SAB 118. The Company recorded a subsequent provisional adjustment of $36.6 million, as a result of incorporating new information into the estimate, in the Condensed Consolidated Financial Statements in the three months ended September 23, 2018. The Company finalized the computation of the transition tax liability during the December 2018 quarter. The final adjustment resulted in a tax benefit of $51.2 million, which was recorded in the Company’s Condensed Consolidated Financial Statements in the three months ended December 23, 2018. The final balance of total transition tax is $868.4 million. The one-time transition tax is based on the Company’s total post-1986 earnings and profits (“E&P”) that was previously deferred from U.S. income taxes. The Company had previously accrued deferred taxes on a portion of this E&P. The Company has completed the calculation of total post-1986 E&P and related income tax pools for its foreign subsidiaries. The Company elected to pay the one-time transition tax over a period of eight years. Beginning in fiscal year 2019, the Company is subject to the impact of the GILTI provision of U.S. tax reform. The GILTI provision imposes taxes on foreign earnings in excess of a deemed return on tangible assets. The Company has calculated the impact of the GILTI provision on current year earnings and has included the impact in the effective tax rate. The Company made an accounting policy election in the September 2018 quarter to record deferred taxes in relation to the GILTI provision, and recorded a provisional tax benefit of $48.0 million in the Condensed Consolidated Financial Statements in the three months ended September 23, 2018, under SAB 118. The Company finalized the computation of the accounting policy election during the December 2018 quarter. The final adjustment resulted in a tax expense of $0.4 million, which was recorded in the Company’s Condensed Consolidated Financial Statements in the three months ended December 23, 2018. The final tax benefit of the election is $47.6 million. The components of income (loss) before income taxes were as follows:\\n\\n \\n\\nWhat would the percentage change in the income before income taxes from Foreign countries from 2018 to 2019 be if the amount in 2019 was 3,000,000 thousand instead? (in percent)\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is -0.780493709648667.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 91,\n \"input_length\": 1105\n}"}}},{"rowIdx":92,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n|||Fiscal Year Ended||\n||December 27, 2019 |December 28, 2018 |December 29, 2017|\n|Net income per share:||||\n|Basic|$0.82|$0.71|$0.55|\n|Diluted|$0.81|$0.70|$0.54|\n|Weighted average common shares:||||\n|Basic|29,532,342|28,703,265|26,118,482|\n|Diluted|30,073,338|29,678,919|27,424,526|\n Note 3 – Net Income per Share The following table sets forth the computation of basic and diluted earnings per share:\n\n \n\nWhat would be the change in net income per diluted share between 2018 and 2019 if the value in 2019 was $0.75 instead?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n|||Fiscal Year Ended||\\n||December 27, 2019 |December 28, 2018 |December 29, 2017|\\n|Net income per share:||||\\n|Basic|$0.82|$0.71|$0.55|\\n|Diluted|$0.81|$0.70|$0.54|\\n|Weighted average common shares:||||\\n|Basic|29,532,342|28,703,265|26,118,482|\\n|Diluted|30,073,338|29,678,919|27,424,526|\\n Note 3 – Net Income per Share The following table sets forth the computation of basic and diluted earnings per share:\\n\\n \\n\\nWhat would be the change in net income per diluted share between 2018 and 2019 if the value in 2019 was $0.75 instead?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 0.050000000000000044.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 92,\n \"input_length\": 273\n}"}}},{"rowIdx":93,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n||||Total Number of|Approximate Dollar|\n||||Shares Purchased as|Value of Shares that|\n||Total Number of|Average Price|Part of Publicly|May Yet Be|\n||Shares|Paid per|Announced|Purchased|\n|(in millions, except per share amounts)|Purchased|Share|Program|Under the Program|\n|March 1, 2019—March 31, 2019|58.0|$52.93|58.0|$8,780.5|\n|April 1, 2019—April 30, 2019|29.1|$54.41|29.1|$7,198.4|\n|May 1, 2019—May 31, 2019|24.9|$54.11|24.9|$5,848.4|\n|Total|112.0|$53.57|112.0||\n Stock Repurchase Program Our Board of Directors has approved a program for us to repurchase shares of our common stock. On September 17, 2018 and February 15, 2019, we announced that our Board of Directors approved expansions of our stock repurchase program totaling $24.0 billion. As of May 31, 2019, approximately $5.8 billion remained available for stock repurchases pursuant to our stock repurchase program. Our stock repurchase authorization does not have an expiration date and the pace of our repurchase activity will depend on factors such as our working capital needs, our cash requirements for acquisitions and dividend payments, our debt repayment obligations or repurchases of our debt, our stock price, and economic and market conditions. Our stock repurchases may be effected from time to time through open market purchases or pursuant to a rule 10b5-1 plan. Our stock repurchase program may be accelerated, suspended, delayed or discontinued at any time. The following table summarizes the stock repurchase activity for the three months ended May 31, 2019 and the approximate dollar value of shares that may yet be purchased pursuant to our stock repurchase program:\n\n \n\nHow much was the Average Price Paid per Share from February 2019 to April 2019 if the total number of shares purchased in February 2019 was the same as that for April 2019 and the Average Price Paid per Share was 88.91?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n||||Total Number of|Approximate Dollar|\\n||||Shares Purchased as|Value of Shares that|\\n||Total Number of|Average Price|Part of Publicly|May Yet Be|\\n||Shares|Paid per|Announced|Purchased|\\n|(in millions, except per share amounts)|Purchased|Share|Program|Under the Program|\\n|March 1, 2019—March 31, 2019|58.0|$52.93|58.0|$8,780.5|\\n|April 1, 2019—April 30, 2019|29.1|$54.41|29.1|$7,198.4|\\n|May 1, 2019—May 31, 2019|24.9|$54.11|24.9|$5,848.4|\\n|Total|112.0|$53.57|112.0||\\n Stock Repurchase Program Our Board of Directors has approved a program for us to repurchase shares of our common stock. On September 17, 2018 and February 15, 2019, we announced that our Board of Directors approved expansions of our stock repurchase program totaling $24.0 billion. As of May 31, 2019, approximately $5.8 billion remained available for stock repurchases pursuant to our stock repurchase program. Our stock repurchase authorization does not have an expiration date and the pace of our repurchase activity will depend on factors such as our working capital needs, our cash requirements for acquisitions and dividend payments, our debt repayment obligations or repurchases of our debt, our stock price, and economic and market conditions. Our stock repurchases may be effected from time to time through open market purchases or pursuant to a rule 10b5-1 plan. Our stock repurchase program may be accelerated, suspended, delayed or discontinued at any time. The following table summarizes the stock repurchase activity for the three months ended May 31, 2019 and the approximate dollar value of shares that may yet be purchased pursuant to our stock repurchase program:\\n\\n \\n\\nHow much was the Average Price Paid per Share from February 2019 to April 2019 if the total number of shares purchased in February 2019 was the same as that for April 2019 and the Average Price Paid per Share was 88.91?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 62.31111876075732.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 93,\n \"input_length\": 585\n}"}}},{"rowIdx":94,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n||2019|2018|\n|Advances|500|-|\n|Board compensation|413|413|\n|Other accrued expenses|168|150|\n||$1,081|$563|\n 7. ACCRUED LIABILITIES Other accrued expenses consisted of the following at December 31, 2019 and 2018 (in thousands): Advances are amounts received from litigation counsel as advanced reimbursement of out-of-pocket expenses expected to be incurred by us. Board compensation of $0.4 million at December 31, 2019 and 2018 represents accrued and unpaid board and committee fees from prior periods. In the first quarter of 2020, current and prior board members agreed to waive unpaid cash fees in exchange for share-based compensation awards with an aggregate grant-date fair value of approximately $0.1 million (see Note 18).\n\n \n\nWhat is the total amount of the top 2 categories of accrued liabilities in 2019, if Other accrued expenses made up $1,000 thousand? (in thousand)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n||2019|2018|\\n|Advances|500|-|\\n|Board compensation|413|413|\\n|Other accrued expenses|168|150|\\n||$1,081|$563|\\n 7. ACCRUED LIABILITIES Other accrued expenses consisted of the following at December 31, 2019 and 2018 (in thousands): Advances are amounts received from litigation counsel as advanced reimbursement of out-of-pocket expenses expected to be incurred by us. Board compensation of $0.4 million at December 31, 2019 and 2018 represents accrued and unpaid board and committee fees from prior periods. In the first quarter of 2020, current and prior board members agreed to waive unpaid cash fees in exchange for share-based compensation awards with an aggregate grant-date fair value of approximately $0.1 million (see Note 18).\\n\\n \\n\\nWhat is the total amount of the top 2 categories of accrued liabilities in 2019, if Other accrued expenses made up $1,000 thousand? (in thousand)\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 1500.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 94,\n \"input_length\": 282\n}"}}},{"rowIdx":95,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n|||Years Ended December 31,||\n||2019|2018|2017|\n|Average daily utilization|$87,800|$106,189|$268,775|\n|Interest expense (1)|$3,465|$3,817|$6,668|\n|Weighted average interest rate (1)|3.9%|3.6%|2.5%|\n The following table presents information related to our credit agreements (dollars in thousands): (1) Excludes the amortization of deferred loan fees and includes the commitment fee. In January 2018, the Company repaid $175.0 million of long-term debt outstanding under its 2015 Credit Agreement, primarily using funds repatriated from its foreign subsidiaries.\n\n \n\nWhat would the percentage change in Interest expense in 2019 from 2018 be if the amount in 2019 was $3,417 thousand instead? (in percent)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n|||Years Ended December 31,||\\n||2019|2018|2017|\\n|Average daily utilization|$87,800|$106,189|$268,775|\\n|Interest expense (1)|$3,465|$3,817|$6,668|\\n|Weighted average interest rate (1)|3.9%|3.6%|2.5%|\\n The following table presents information related to our credit agreements (dollars in thousands): (1) Excludes the amortization of deferred loan fees and includes the commitment fee. In January 2018, the Company repaid $175.0 million of long-term debt outstanding under its 2015 Credit Agreement, primarily using funds repatriated from its foreign subsidiaries.\\n\\n \\n\\nWhat would the percentage change in Interest expense in 2019 from 2018 be if the amount in 2019 was $3,417 thousand instead? (in percent)\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is -10.47943411055803.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 95,\n \"input_length\": 266\n}"}}},{"rowIdx":96,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n||||Year Ended December 31,|\n|(In thousands, unaudited)|2019|2018|2017|\n|Net income (loss)|$ (19,931)|$ (50,571)|$ 65,299|\n|Add (subtract):||||\n|Interest expense, net of interest income|136,660|134,578|129,786|\n|Income tax benefit|(3,714)|(24,127)|(124,927)|\n|Depreciation and amortization|381,237|432,668|291,873|\n|EBITDA|494,252|492,548|362,031|\n|Adjustments to EBITDA:||||\n|Other, net (1)|(8,847)|549|19,314|\n|Investment distributions (2)|35,809|39,078|29,993|\n|Gain on extinguishment of debt|(4,510)|—|—|\n|Non-cash, stock-based compensation|6,836|5,119|2,766|\n|Adjusted EBITDA|$ 523,540|$ 537,294|$ 414,104|\n Non-GAAP Measures In addition to the results reported in accordance with US GAAP, we also use certain non-GAAP measures such as EBITDA and adjusted EBITDA to evaluate operating performance and to facilitate the comparison of our historical results and trends. These financial measures are not a measure of financial performance under US GAAP and should not be considered in isolation or as a substitute for net income as a measure of performance and net cash provided by operating activities as a measure of liquidity. They are not, on their own, necessarily indicative of cash available to fund cash needs as determined in accordance with GAAP. The calculation of these non-GAAP measures may not be comparable to similarly titled measures used by other companies. Reconciliations of these non-GAAP measures to the most directly comparable financial measures presented in accordance with GAAP are provided below. EBITDA is defined as net earnings before interest expense, income taxes, and depreciation and amortization. Adjusted EBITDA is comprised of EBITDA, adjusted for certain items as permitted or required under our credit facility as described in the reconciliations below. These measures are a common measure of operating performance in the telecommunications industry and are useful, with other data, as a means to evaluate our ability to fund our estimated uses of cash. The following tables are a reconciliation of net income (loss) to adjusted EBITDA for the years ended December 31, 2019, 2018 and 2017: (1) Other, net includes the equity earnings from our investments, dividend income, income attributable to noncontrolling interests in subsidiaries, acquisition and transaction related costs including integration and severance, non-cash pension and post-retirement benefits and certain other miscellaneous items. (2) Includes all cash dividends and other cash distributions received from our investments.\n\n \n\nIf the Net income (loss) in 2019 reduced to (14,047 thousand) what would be the increase/ (decrease) in Net income (loss) from 2018 to 2019? (in thousand)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n||||Year Ended December 31,|\\n|(In thousands, unaudited)|2019|2018|2017|\\n|Net income (loss)|$ (19,931)|$ (50,571)|$ 65,299|\\n|Add (subtract):||||\\n|Interest expense, net of interest income|136,660|134,578|129,786|\\n|Income tax benefit|(3,714)|(24,127)|(124,927)|\\n|Depreciation and amortization|381,237|432,668|291,873|\\n|EBITDA|494,252|492,548|362,031|\\n|Adjustments to EBITDA:||||\\n|Other, net (1)|(8,847)|549|19,314|\\n|Investment distributions (2)|35,809|39,078|29,993|\\n|Gain on extinguishment of debt|(4,510)|—|—|\\n|Non-cash, stock-based compensation|6,836|5,119|2,766|\\n|Adjusted EBITDA|$ 523,540|$ 537,294|$ 414,104|\\n Non-GAAP Measures In addition to the results reported in accordance with US GAAP, we also use certain non-GAAP measures such as EBITDA and adjusted EBITDA to evaluate operating performance and to facilitate the comparison of our historical results and trends. These financial measures are not a measure of financial performance under US GAAP and should not be considered in isolation or as a substitute for net income as a measure of performance and net cash provided by operating activities as a measure of liquidity. They are not, on their own, necessarily indicative of cash available to fund cash needs as determined in accordance with GAAP. The calculation of these non-GAAP measures may not be comparable to similarly titled measures used by other companies. Reconciliations of these non-GAAP measures to the most directly comparable financial measures presented in accordance with GAAP are provided below. EBITDA is defined as net earnings before interest expense, income taxes, and depreciation and amortization. Adjusted EBITDA is comprised of EBITDA, adjusted for certain items as permitted or required under our credit facility as described in the reconciliations below. These measures are a common measure of operating performance in the telecommunications industry and are useful, with other data, as a means to evaluate our ability to fund our estimated uses of cash. The following tables are a reconciliation of net income (loss) to adjusted EBITDA for the years ended December 31, 2019, 2018 and 2017: (1) Other, net includes the equity earnings from our investments, dividend income, income attributable to noncontrolling interests in subsidiaries, acquisition and transaction related costs including integration and severance, non-cash pension and post-retirement benefits and certain other miscellaneous items. (2) Includes all cash dividends and other cash distributions received from our investments.\\n\\n \\n\\nIf the Net income (loss) in 2019 reduced to (14,047 thousand) what would be the increase/ (decrease) in Net income (loss) from 2018 to 2019? (in thousand)\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 36524.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 96,\n \"input_length\": 803\n}"}}},{"rowIdx":97,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n|||Years Ended September 30,||\n||2019|2018|2017|\n|||(in thousands)||\n|Tax expense at U.S. statutory rate|$ 10,992|$ 3,124|$ (3,877)|\n|State income taxes, net of federal tax effect|1,416|(237)|(923)|\n|Nondeductible expenses|1,720|1,186|(185)|\n|Change in reserve for tax contingencies|(1,468)|(1,047)|(4,435)|\n|Change in deferred tax asset valuation allowance|(10,007)|8,784|17,374|\n|Foreign rate differential (1)|2,149|5,684|9,912|\n|Tax credits|(4,767)|(2,656)|(3,459)|\n|Impact of U.S. Tax Reform|—|(7,053)|—|\n|Global Intangible Low-Tax Income|8,182|—|—|\n|Stock Based Compensation|(448)|59|16|\n|Non-controlling interest in equity arrangements|1,802|99|—|\n|Other|1,469|(850)|235|\n|Provision for income taxes|$ 11,040|$ 7,093|$ 14,658|\n The reconciliation of income tax computed at the U.S. federal statutory tax rate to income tax expense is as follows: (1) In 2018, we recorded $3.5 million of tax expense related to foreign earnings which were not permanently reinvested prior to the enactment of the U.S. Tax Act. After enactment, certain foreign earnings are taxed at higher statutory rates than the U.S. which results in $2.1 million of incremental tax expense in 2019. In 2017, we provided for deferred taxes on all cumulative unremitted foreign earnings, as the earnings were no longer considered permanently reinvested resulting in a charge of $9.5 million.\n\n \n\nWhat would the percentage change in nondeductible expenses in 2019 from 2018 be if the amount in 2019 was $1,700 thousand instead? (in percent)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n|||Years Ended September 30,||\\n||2019|2018|2017|\\n|||(in thousands)||\\n|Tax expense at U.S. statutory rate|$ 10,992|$ 3,124|$ (3,877)|\\n|State income taxes, net of federal tax effect|1,416|(237)|(923)|\\n|Nondeductible expenses|1,720|1,186|(185)|\\n|Change in reserve for tax contingencies|(1,468)|(1,047)|(4,435)|\\n|Change in deferred tax asset valuation allowance|(10,007)|8,784|17,374|\\n|Foreign rate differential (1)|2,149|5,684|9,912|\\n|Tax credits|(4,767)|(2,656)|(3,459)|\\n|Impact of U.S. Tax Reform|—|(7,053)|—|\\n|Global Intangible Low-Tax Income|8,182|—|—|\\n|Stock Based Compensation|(448)|59|16|\\n|Non-controlling interest in equity arrangements|1,802|99|—|\\n|Other|1,469|(850)|235|\\n|Provision for income taxes|$ 11,040|$ 7,093|$ 14,658|\\n The reconciliation of income tax computed at the U.S. federal statutory tax rate to income tax expense is as follows: (1) In 2018, we recorded $3.5 million of tax expense related to foreign earnings which were not permanently reinvested prior to the enactment of the U.S. Tax Act. After enactment, certain foreign earnings are taxed at higher statutory rates than the U.S. which results in $2.1 million of incremental tax expense in 2019. In 2017, we provided for deferred taxes on all cumulative unremitted foreign earnings, as the earnings were no longer considered permanently reinvested resulting in a charge of $9.5 million.\\n\\n \\n\\nWhat would the percentage change in nondeductible expenses in 2019 from 2018 be if the amount in 2019 was $1,700 thousand instead? (in percent)\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 43.3389544688027.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 97,\n \"input_length\": 576\n}"}}},{"rowIdx":98,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n||2019|2018|\n||$|$|\n|Short-term employee benefits|12,175,184|14,217,931|\n|Post employment benefits|322,733|297,319|\n|Other long-term benefits|161,569|139,776|\n|Share-based payments|9,177,425|6,594,300|\n||21,836,911|21,249,326|\n This section highlights the Group’s transactions with its related parties, such as its subsidiaries and Key Management Personnel. During the reporting period and previous reporting periods, Woolworths Group Limited advanced loans to, received and repaid loans from, and provided treasury, accounting, legal, taxation, and administrative services to other entities within the Group. Entities within the Group also exchanged goods and services in sale and purchase transactions. All transactions occurred on the basis of normal commercial terms and conditions. Balances and transactions between the Company and its subsidiaries, which are related parties of the Company, have been eliminated on consolidation and are not disclosed in this note. All transactions with directors and Key Management Personnel (including their related parties) were conducted on an arm’s length basis in the ordinary course of business and under normal terms and conditions for customers and employees. Related parties of Key Management Personnel who are employees received normal employee benefits on standard terms and conditions. The total remuneration for Key Management Personnel of the Group is as follows: Details of equity instruments provided as compensation to Key Management Personnel and shares issued on exercise of these instruments, together with the terms and conditions of the instruments, are disclosed in the Remuneration Report.\n\n \n\nWhat is the difference in the total remuneration for Key Management Personnel of the Group between 2018 and 2019 if the total remuneration in 2019 is 22,000,000?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n||2019|2018|\\n||$|$|\\n|Short-term employee benefits|12,175,184|14,217,931|\\n|Post employment benefits|322,733|297,319|\\n|Other long-term benefits|161,569|139,776|\\n|Share-based payments|9,177,425|6,594,300|\\n||21,836,911|21,249,326|\\n This section highlights the Group’s transactions with its related parties, such as its subsidiaries and Key Management Personnel. During the reporting period and previous reporting periods, Woolworths Group Limited advanced loans to, received and repaid loans from, and provided treasury, accounting, legal, taxation, and administrative services to other entities within the Group. Entities within the Group also exchanged goods and services in sale and purchase transactions. All transactions occurred on the basis of normal commercial terms and conditions. Balances and transactions between the Company and its subsidiaries, which are related parties of the Company, have been eliminated on consolidation and are not disclosed in this note. All transactions with directors and Key Management Personnel (including their related parties) were conducted on an arm’s length basis in the ordinary course of business and under normal terms and conditions for customers and employees. Related parties of Key Management Personnel who are employees received normal employee benefits on standard terms and conditions. The total remuneration for Key Management Personnel of the Group is as follows: Details of equity instruments provided as compensation to Key Management Personnel and shares issued on exercise of these instruments, together with the terms and conditions of the instruments, are disclosed in the Remuneration Report.\\n\\n \\n\\nWhat is the difference in the total remuneration for Key Management Personnel of the Group between 2018 and 2019 if the total remuneration in 2019 is 22,000,000?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]"},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 750674.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 98,\n \"input_length\": 467\n}"}}},{"rowIdx":99,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n\n\n|($ in millions)||||\n|For the year ended December 31:|2019|2018|Yr.-to-Yr. Percent Change|\n|Retirement-related plans—cost||||\n|Service cost|$385|$431|(10.7)%|\n|Multi-employer plans|32|38|(16.9)|\n|Cost of defined contribution plans|1,040|1,024|1.5|\n|Total operating costs/ (income)|$1,457|$1,494|(2.5)%|\n|Interest cost|$2,929|$2,726|7.4%|\n|Expected return on plan assets|(4,192)|(4,049)|3.5|\n|Recognized actuarial losses|1,819|2,941|(38.2)|\n|Amortization of prior service costs/(credits)|(9)|(73)|(87.6)|\n|Curtailments/settlements|41|11|262.2|\n|Other costs|28|16|76.2|\n|Total non-operating costs/(income)|$615|$1,572|(60.9)%|\n|Total retirement-related plans—cost|$2,072|$3,066|(32.4)%|\n Retirement-Related Plans The following table provides the total pre-tax cost for all retirement-related plans. Total operating costs/(income) are included in the Consolidated Income Statement within the caption (e.g., Cost, SG&A, RD&E) relating to the job function of the plan participants. Total pre-tax retirement-related plan cost decreased by $994 million compared to 2018, primarily driven by a decrease in recognized actuarial losses ($1,123 million), primarily due to the change in the amortization period in the U.S. Qualified Personal Pension Plan and higher expected return on plan assets ($143 million), partially offset by higher interest costs ($203 million). As discussed in the “Operating (non-GAAP) Earnings” section, we characterize certain retirement-related costs as operating and others as non-operating. Utilizing this characterization, operating retirement-related costs in 2019 were $1,457 million, a decrease of $37 million compared to 2018. Non-operating costs of $615 million in 2019 decreased $957 million year to year, driven primarily by the same factors as above.\n\n \n\nIf interest cost in 2019 increased to 3,000 million, what was the revised average? (in million)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n\\n\\n|($ in millions)||||\\n|For the year ended December 31:|2019|2018|Yr.-to-Yr. Percent Change|\\n|Retirement-related plans—cost||||\\n|Service cost|$385|$431|(10.7)%|\\n|Multi-employer plans|32|38|(16.9)|\\n|Cost of defined contribution plans|1,040|1,024|1.5|\\n|Total operating costs/ (income)|$1,457|$1,494|(2.5)%|\\n|Interest cost|$2,929|$2,726|7.4%|\\n|Expected return on plan assets|(4,192)|(4,049)|3.5|\\n|Recognized actuarial losses|1,819|2,941|(38.2)|\\n|Amortization of prior service costs/(credits)|(9)|(73)|(87.6)|\\n|Curtailments/settlements|41|11|262.2|\\n|Other costs|28|16|76.2|\\n|Total non-operating costs/(income)|$615|$1,572|(60.9)%|\\n|Total retirement-related plans—cost|$2,072|$3,066|(32.4)%|\\n Retirement-Related Plans The following table provides the total pre-tax cost for all retirement-related plans. Total operating costs/(income) are included in the Consolidated Income Statement within the caption (e.g., Cost, SG&A, RD&E) relating to the job function of the plan participants. Total pre-tax retirement-related plan cost decreased by $994 million compared to 2018, primarily driven by a decrease in recognized actuarial losses ($1,123 million), primarily due to the change in the amortization period in the U.S. Qualified Personal Pension Plan and higher expected return on plan assets ($143 million), partially offset by higher interest costs ($203 million). As discussed in the “Operating (non-GAAP) Earnings” section, we characterize certain retirement-related costs as operating and others as non-operating. Utilizing this characterization, operating retirement-related costs in 2019 were $1,457 million, a decrease of $37 million compared to 2018. Non-operating costs of $615 million in 2019 decreased $957 million year to year, driven primarily by the same factors as above.\\n\\n \\n\\nIf interest cost in 2019 increased to 3,000 million, what was the revised average? 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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1.\nBusiness\nGeneral\nColumbus McKinnon is a leading worldwide designer, manufacturer and marketer of intelligent motion solutions, including motion control products, technologies, automated systems and services, that efficiently and ergonomically move, lift, position and secure materials. Our key products include hoists, crane components, precision conveyors, actuators, rigging tools, light rail workstations, and digital power and motion control systems. These are highly relevant, professional-grade solutions that solve customers’ critical material handling requirements.\nThe Company is focused on commercial and industrial applications for our products, which require the safety, reliability and quality provided by our advanced design and engineering know-how. Our products are used for mission critical applications where we have established, trusted brands with significant customer retention. Our targeted market verticals include general industries, mobile industries, energy and utilities, process industries, industrial automation, construction and infrastructure, food processing, entertainment, life sciences, consumer packaged goods and e-commerce/supply chain/warehousing.\nIn March 2021, the Company announced that it had entered into a definitive agreement to acquire Dorner Mfg. Corp. (\"Dorner\"). The acquisition of Dorner closed on April 7, 2021. Dorner, headquartered in Hartland, Wisconsin, is a leading automation solutions company providing unique, patented technologies in the design, application, manufacturing and integration of high-precision conveying systems. The acquisition of Dorner accelerates the Company’s shift to intelligent motion and serves as a platform to expand capabilities in advanced, higher technology automation solutions. Dorner is a leading supplier to the stable life sciences, food processing, and consumer packaged goods markets as well as the high growth industrial automation and e-commerce sectors. The addition of Dorner provides attractive complementary adjacencies including sortation and asynchronous conveyance systems. Dorner offers a broad range of precision conveying systems to our product offerings, which include low profile, flexible chain, large scale, sanitary and vertical elevation conveyor systems, as well as pallet system conveyors. Dorner’s conveying solutions are offered in both modular standard and highly engineered custom formats, along with significant aftermarket offerings and support.\nIn the United States, we are the market leader for hoists, material handling digital power control systems and precision conveyors, our principal lines of products, and have strong market positions with certain chain, forged fittings, and actuator products. Additionally, in Europe, we believe we are the market leader for manual hoists and a market leader in the heavy load, rail and niche custom applications for actuation. We have achieved this leadership position through strategic acquisitions, our extensive, diverse, and well-established distribution channels and our commitment to product innovation and quality. We believe the substantial breadth of our product offering and broad distribution channels in the United States and Europe provide us a strategic advantage in our markets. The acquisition of STAHL CraneSystems (\"STAHL\") in fiscal 2017, which is well renowned for its custom engineering lifting solutions and hoisting technology, advanced our position as a global leader in the production of explosion-protected hoists. STAHL serves independent crane builders and Engineering Procurement and Construction (\"EPC\") firms, providing products to a variety of end markets including automotive, general manufacturing, oil and gas, steel and concrete, power generation, as well as process industries such as chemical and pharmaceuticals.\nWe initiated our Blueprint for Growth strategy in early fiscal 2018. It originally had three phases. In Phase 1, which was completed during fiscal 2018, we focused on attaining operational control and instilling a performance-based culture to drive results, which included reorganizing the business into three product groups. Phase II, which began in the latter half of fiscal 2018, included simplifying the business with our 80/20 process, improving our operational excellence, and ramping the growth engine by investing in new product development and a digital platform to grow profitably. Through the simplification process, we identified three businesses in our portfolio that were not a fit with our product offerings and strategy that represented approximately $38 million in revenue in fiscal 2018. By the end of fiscal 2019, we divested these three businesses and completed the closure of one manufacturing facility in Ohio, which provided $2 million in cost savings in fiscal 2020. During fiscal 2020, the Company began to further reduce its manufacturing footprint by initiating the closure and consolidation of the remaining facility in Ohio into our remaining U.S. facilities, which was completed in fiscal 2021. Similarly, one of our manufacturing facilities in China was closed during fiscal 2020 and its operations were consolidated into our other manufacturing facility in China. A small operation in France was closed during fiscal 2021. The annual savings from these factory consolidations is approximately $8.3 million. Simplification with the 80/20 process and other operational efficiencies implemented enabled the consolidations without reducing our ability to serve our customers and address demand. Phase III of the strategy was centered on evolving the business model including optimizing our current product portfolio as well as pursuing acquisitions to advance our transformation into a leading industrial technology company.\n4\nWe have since evolved our Blueprint for Growth strategy to version 2.0 in order to accelerate our pivot to growth with an emphasis on broadening our expertise in intelligent motion solutions for material handling. Our Blueprint for Growth 2.0 strategy is focused on delivering above market growth through organic and inorganic initiatives as well as improved financial performance, which we believe drives shareholder value creation. The strategy is underpinned with the Columbus McKinnon Business System, (\"CMBS\") that provides the discipline, processes and core competencies necessary to scale our business. At the core of CMBS are our people and our values.\nWith CMBS as the foundation, we are well positioned to execute the Core Growth Framework of our Blueprint for Growth 2.0 strategy. The Framework defines four parallel paths for Columbus McKinnon’s growth and provides clear organic and strategic initiatives. We have detailed action plans for each of the paths of our Core Growth framework.\n•Strengthening the core is a foundational path focused on initiatives that will strengthen competencies and improve our competitive position within our existing share of our Serviceable Addressable Market (”SAM”). Initiatives include further developing commercial and product management competencies and improving our digital tools for a better, more efficient customer experience.\n•Growing the core is a path that is focused on taking greater marker share, both organically and through acquisitions, within our SAM. We are making progress on this path with product localization, new product development and advancements in automation and aftermarket support for our distributors.\n•Expanding the core is a path that is focused on improved channel access and geographic expansion. Here we expand beyond our SAM into the broader Total Addressable Market (“TAM”). This will involve building out our presence both geographically and in new verticals with expanded offerings, which we expect we can accomplish organically as well as with acquisitions.\n•Reimagining the core is a more transformational path that rethinks our TAM and targets strategic expansion beyond that. As we think more broadly about material handling and increasing trends in intelligent motion, not just lifting, but solutions for how materials move throughout customer environments, there are some compelling ideas that emerge. The Dorner acquisition is an example of reimagining Columbus McKinnon’s core, which added an additional $5 billion to our TAM, which specialty conveying microsegment of material handling is growing at an estimated 6% to 8% rate annually.\nThe strategy is geared toward investing in new products that solve customers’ tough problems and expanding into new platforms that provide intelligent motion solutions for material handling, such as precision conveyance capabilities. We believe the acquisition of Dorner establishes a platform for expansion supported by new product development, a fragmented competitive landscape and complementary adjacencies. It also allows Dorner to expand geographically and provides us with an entry point into a pipeline of additional acquisition opportunities in the fragmented precision conveying industry.\nOur business is cyclical in nature and sensitive to changes in general economic conditions, including changes in industrial capacity utilization, industrial production, and general economic activity indicators, like GDP growth. Both U.S. and Eurozone capacity utilization and the ISM Production Index are leading market indicators for our Company. Like many global companies, we have been, and continue to be, affected by the Novel Coronavirus (\"COVID-19\"). During fiscal 2021, we took appropriate measures to generate positive operating income and protect the cash flow and liquidity of the Company. This included reducing our cost base, reducing working capital needs, and reducing capital expenditures. These measures helped contribute to positive operating income and strong cash flow throughout fiscal 2021 despite the impact of COVID-19.\nBusiness Description\nWe design, manufacture, and distribute a broad range of material handling products for various applications. Products include a wide variety of electric, air-powered, lever, and hand hoists, hoist trolleys, explosion-protected hoists, winches, and aluminum work stations; alloy and carbon steel chain; forged attachments, such as hooks, shackles, textile slings, clamps, and load binders; mechanical and electromechanical actuators and rotary unions; and below-the-hook special purpose lifters; power and motion control systems, such as AC and DC drive systems, radio remote controls, push button pendant stations, brakes, and collision avoidance and power delivery subsystems. The fiscal 2022 acquisition of Dorner expands our product offerings to include a broad range of highly engineered, precision conveying solutions. Our products are typically manufactured for stock or assembled to order from standard components, and are sold primarily through a variety of commercial distributors and, to a lesser extent, directly to end-users. Our STAHL subsidiary brings market leadership with independent crane builders and EPC firms. The diverse end-users of our products are in a variety of industries including manufacturing, power generation and distribution, utilities, wind power, warehouses, commercial construction, oil and gas exploration and refining, petrochemical, marine, ship building, transportation and heavy-duty trucking, agriculture, logging and mining. The fiscal 2022 Dorner\n5\nacquisition expands the Company's reach to include the stable life sciences, food processing and consumer packaged goods markets and high growth industrial automation and e-commerce sectors. We also serve a niche market for the entertainment industry, including permanent and traveling concerts, live theater, and sporting venues.\nProducts\nOf our fiscal 2021 sales, $341,887,000, or 53%, were U.S. and $307,755,000 or 47% were non-U.S. The following table sets forth certain sales data for our products, expressed as a percentage of net sales for fiscal 2021 and 2020:\n\n| Fiscal Years Ended March 31, |\n| 2021 | 2020 |\n| Hoists | 61 | % | 61 | % |\n| Digital power control and delivery systems | 12 | 12 |\n| Actuators and rotary unions | 11 | 10 |\n| Chain and rigging tools | 7 | 8 |\n| Industrial cranes | 6 | 6 |\n| Elevator application drive systems | 3 | 3 |\n| 100 | % | 100 | % |\n\nHoists - We manufacture a wide variety of electric chain hoists, electric wire rope hoists, hand-operated hoists, winches, lever tools, and air-powered hoists. Load capacities for our hoist product lines range from one-eighth of a ton to nearly 140 tons with the acquisition of STAHL. These products are sold under our Budgit, Chester, CM, Coffing, Little Mule, Pfaff, Shaw-Box, STAHL, Yale, and other recognized brands. Our hoists are sold for use in numerous general industrial applications, as well as for use in the construction, energy and utilities, steel and metals processing, mining, transportation, entertainment, and other markets. We also supply hoist trolleys, driven manually or by electric motors, that are used in conjunction with hoists.\nWe also offer several lines of standard and custom-designed, below-the-hook tooling, clamps, and textile strappings. Below-the-hook tooling, textile, and chain slings and associated forgings, and clamps are specialized lifting apparatus used in a variety of lifting activities performed in conjunction with hoisting or lifting applications.\nWe also manufacture explosion-protected hoists and custom engineered hoists, including wire rope and manual and electric chain hoists. Our STAHL branded products are sold to a variety of end markets including automotive, general manufacturing, oil and gas, steel and concrete, power generation as well as process industries such as chemical and pharmaceuticals.\nDigital Power Control and Delivery Systems - Through our Magnetek brand, we are a leading provider of innovative power control and delivery systems and solutions for overhead material handling applications used in a number of diverse industries, including aerospace, automotive, steel, aluminum, paper, logging, mining, ship loading, nuclear power plants, and heavy movable structures. We are a major supplier in North America of power and motion control systems, which include AC and DC drive systems, radio remote controls, push button pendant stations, brakes, and collision avoidance and power delivery subsystems. While we sell primarily to OEMs of overhead cranes and hoists, we spend a great deal of effort understanding the needs of end users to gain specification. We can combine our products with engineered services to provide complete customer-specific system solutions.\nWe are also a leading independent supplier of AC and DC digital motion control systems for underground coal mining equipment. Our systems are used in coal hauling vehicles, shuttle cars, scoops, and other heavy mining equipment.\nActuators and Rotary Unions - Through our Duff-Norton and Pfaff brands, we design and manufacture industrial components such as mechanical and electromechanical actuators and rotary unions. Actuators are linear motion devices used in a variety of industries, including the transportation, paper, steel, energy, aerospace, and many other commercial industries. Rotary unions are devices that transfer a liquid or gas from a fixed pipe or hose to a rotating drum, cylinder or other device. Rotary unions are used in a variety of industries including pulp and paper, printing, textile and fabric manufacturing, rubber, and plastic.\nChain and Rigging Tools - We manufacture alloy and carbon steel chain for various industrial and consumer applications. U.S. federal regulations require the use of alloy chain for overhead lifting applications because of its strength and wear characteristics. A line of our alloy chain is sold under the Herc-AlloyTM brand name for use in overhead lifting, pulling, and restraining applications. In addition, we also sell specialized load chain for use in hoists, as well as three grades and multiple sizes of carbon steel welded-link chain for various load securing and other non-overhead lifting applications.\n6\nWe produce a broad line of alloy and carbon steel closed-die forged chain attachments, including hooks, shackles, HammerloksTM, and master links. These forged attachments are used in chain, wire rope, and textile rigging applications in a variety of industries, including transportation, mining, construction, marine, logging, petrochemical, and agriculture.\nIn addition, we manufacture carbon steel forged and stamped products, such as load binders, logging tools, and other securing devices, for sale to the industrial and logging markets through industrial distributors, hardware distributors, mass merchandiser outlets, and original equipment manufacturers (\"OEMs\").\nIndustrial Cranes - We manufacture and market under our Unified Industries brand overhead aluminum light rail workstations primarily used in automotive and other industrial applications. We also manufacture crane components and crane kits through our STAHL branded products.\nElevator Application Drive Systems - Through our Magnetek brand we also design, build, sell, and support elevator application-specific drive products that efficiently deliver power used to control motion, primarily in high-rise, high-speed elevator applications. We are recognized as an industry leader for DC high-performance elevator drives, as well as for AC drives used with low- and high-performance traction elevators, due to our extensive application expertise and product reliability. Our elevator product offerings are comprised of highly integrated subsystems and drives, sold mainly to elevator OEMs. In addition, our product options include a number of regenerative controls for both new building installations and elevator modernization projects that help building owners save energy.\nHigh-precision conveying systems – Our fiscal 2022 acquisition of Dorner expands our product offerings to include high-precision, specialty conveyor system solutions. These conveyor systems range from build to order modular standard systems to highly engineered customer solutions. These products offer customers high quality and reliable solutions that enhance productivity and profitability. Our fiscal 2021 results did not include any sales of these products as the acquisition of Dorner was completed on April 7, 2021.\nDistribution and Markets\nWe sell our products and solutions through various distribution channels and direct to certain end users. The following describes our global distribution channels:\nGeneral Distribution Channels - Our global general distribution channels consist of:\n— Industrial distributors that serve local or regional industrial markets and sell a variety of products for maintenance repair, operating, and production, or MROP, applications through their own direct sales force.\n— Rigging shops that are distributors with expertise in rigging, lifting, positioning, and load securing. Most rigging shops assemble and distribute chain, wire rope and synthetic slings, and distribute manual hoists and attachments, chain slings, and other products.\n— Independent crane builders that design, build, install, and service overhead crane and light-rail systems for general industry and also distribute a wide variety of hoists and crane components. We sell electric wire rope hoists and chain hoists as well as crane components, such as end trucks, trolleys, drives, and electrification systems to crane builders.\nSpecialty Distribution Channels - Our global specialty distribution channels consist of:\n— National and regional distributors that market a variety of MROP supplies, including material handling products, either exclusively through large, nationally distributed catalogs, or through a combination of catalog, internet, and branch sales and a field sales force.\n— Material handling specialists and integrators that design and assemble systems incorporating hoists, overhead rail systems, trolleys, scissor lift tables, manipulators, air balancers, jib arms, and other material handling products to provide end-users with solutions to their material handling problems.\n— Entertainment equipment distributors that design, supply, and install a variety of material handling and rigging equipment for concerts, theaters, ice shows, sporting events, convention centers, and night clubs.\n7\nService-After-Sale Distribution Channel - Service-after-sale distributors include our authorized network of 23 chain repair service stations and over 227 certified hoist service and repair stations globally. This service network is designed for easy parts and service access for our large installed base of hoists and related equipment in that region.\nOEM/Government Distribution Channels - This channel consists of:\n— OEMs that supply various component parts directly to other industrial manufacturers as well as private branding and packaging of our traditional products for material handling, lifting, positioning, and special purpose applications.\n— Government agencies, including the U.S. and Canadian Navies and Coast Guards, that primarily purchase load securing chain and forged attachments. We also provide our products to the U.S. and other governments for a variety of military applications.\nIndependent Crane Builders and Engineering Procurement and Construction (\"EPC\") firms - In addition to the Distribution Channels mentioned above, we sell explosion-protected hoists and custom engineered non-standard hoists to independent crane builders and EPC firms. Independent crane builders are lifting solution developers and final crane assemblers that source hoists as components. EPC firms are responsible for project management or construction management of production facilities that purchase lifting solutions from crane and hoist builders.\nBacklog\nOur backlog of orders at March 31, 2021 was approximately $171,698,000 compared to approximately $131,030,000 at March 31, 2020. The increase is a result of higher order rates as markets recover from COVID-19 and to a lesser extent, changing foreign currency rates. Our orders for standard products are generally shipped within one week. Orders for products that are manufactured to customer specifications are generally shipped within four to twelve weeks. Given the short product lead times, we do not believe that the amount of our backlog of orders is a reliable indication of our future sales. Fluctuations in backlog can reflect the project-oriented nature of certain aspects of our business.\nCompetitive Conditions\nThe material handling industry remains fragmented. We face competition from a wide range of regional, national, and international manufacturers globally. In addition, we often compete with individual operating units of larger, highly diversified companies.\nThe principal competitive factors affecting our business include customer service and support as well as product availability, performance, functionality, brand reputation, reliability, and price. Other important factors include distributor relationships and territory coverage as well as the robustness of our digital tools which impacts the customer experience.\nWe believe we have leading U.S. market share in various products categories including hoists, trolleys and components, AC and DC material handling drives, screw jacks, and elevator DC drives. These product categories represented 64% of our U.S. net sales for fiscal 2021.\nMajor competitors for hoists are Konecranes, which acquired Terex's Material Handling and Port Solutions business segment, and Kito (and its U.S. subsidiary Harrington); for chain are Campbell Chain, Peerless Chain Company (acquired by Kito), and American Chain and Cable Company; for digital power control systems are Konecranes, Power Electronics International, Inc., Cattron Group International (a division of Harbor Group), Conductix-Wampfler (a division of Delachaux Group), Control Techniques (a division of Emerson Electric), OMRON Corporation, KEB GmbH, and Fujitec; for forged attachments are The Crosby Group and Brewer Tichner Company; and for actuators and rotary unions are Deublin, Joyce-Dayton, and Nook Industries.\nHuman Capital Management\nHeadquartered in Buffalo, New York, Columbus McKinnon’s global footprint includes offices and manufacturing facilities in more than 23 countries across North America, Latin America, Europe, Africa and Asia. At March 31, 2021, we had 2,651 employees globally. Approximately 8% of our employees are represented under two separate U.S. collective bargaining agreements that expire in June 2021 and September 2021. We also have various labor agreements with our non-U.S. employees that we negotiate from time to time. We have good relationships with our employees and positive, productive relationships with our unions. We believe the risk of employee or union led disruption in production is remote. The acquisition of Dorner in fiscal 2022 adds approximately 400 employees to our global workforce and four primary manufacturing facilities.\n8\nSuccessful execution of our way forward is dependent on attracting, developing, and retaining key employees and members of\nour management team, which we achieve through the following:\n•We always begin with people and values at the center of all that we do and at the heart of our corporate social responsibility efforts. The Company’s people and the behaviors they display define our success, including integrity, respect and teamwork. Many of our material social factors, including Employee Health and Safety, Training and Development, Talent Recruitment and Retention, Diversity, Equity and Inclusion, and Community Involvement, are directly connected to our commitment to people and values. Our people enable us to grow, and our values ensure we grow responsibly and sustainably.\n•The Company believes strongly in workplace safety. We feel it is critical to ensure our most valuable assets, our employees, have a safe environment to work in every day. We added safety as our first core value as we entered fiscal 2021, recognizing the significant impact of the pandemic on everyone’s lives. “Connect safety to everything you do” highlights the importance of safety to our culture. As a permanent agenda item at all management meetings, safety comes first. For fiscal 2021, the Company had an overall safety incident rate of 0.74 (number of injuries and illnesses multiplied by 200,000, divided by hours worked).\n•We are committed to embracing diversity, equity and inclusion and making it a part of everything we do. We know the positive impact diverse and inclusive teams have on our business, employees, customers, and communities around the world. We are dedicated to building a company that future generations can be proud of and a team that embraces diversity and appreciates differences across the enterprise. In fiscal 2021, we made diversity, equity and inclusion a strategic development area and hired a Director of Talent and Diversity, Equity and Inclusion to raise awareness and drive behaviors aligned to our values. We have embedded diversity, equity and inclusion into the People and Values framework of the Columbus McKinnon Business System. We are working to create an environment of inclusion. We launched a series of virtual training modules around diversity, inclusion and unconscious bias. We have updated our core value “Win as a team” to specifically address embracing diversity.\nIn response to the COVID-19 pandemic, we immediately mobilized an Enterprise Covid-19 Task Force and local task forces at each of our manufacturing sites and worked diligently to stay current with constantly evolving information. With guidance from the World Health Organization, U.S. Centers for Disease Control and Prevention, and other health organizations around the world, we implemented strict safety protocols at our sites, such as face covering requirements, daily temperature testing, social distancing, and frequent cleaning and sanitizing measures to keep our employees safe. We had, and continue to have, regular communication with employees to keep them abreast of the corporate-wide expectations and posted signage throughout our facilities to remind our associates of the new heightened safety protocols. All associates who were able to work remotely were asked to do so and all safety protocols and policies were kept up to date by the Enterprise COVID-19 Task Force and documented in a Company “playbook.”\nWe also recognize our corporate responsibility to advance our Environmental Social and Governance (“ESG”) efforts and to be held accountable for making progress. We are making significant investments in our people and systems to enable meaningful progress in areas including, but not limited to, environmental stewardship, safety for our employees, workplace diversity and inclusion, connecting with our communities, and strong governance and risk management. We are taking deliberate steps to fully integrate ESG into our enterprise strategy, our business system, and our daily actions.\nOur focus for fiscal 2021 was to develop and formalize our ESG strategy and build the framework that will enable us to prosper on this exciting journey. Our main objectives for fiscal 2021 included:\n•Lay the foundation for our ESG journey with solid processes and policies;\n•Make significant investments in forward advancement of ESG (People & Technology enablers);\n•Perform extensive data collection and analysis to identify areas for improvement;\n•Establish Fiscal Year 2021 as our baseline year for ESG metrics;\n•Perform Materiality and Risk Assessments to allow for discipline and focus regarding ESG efforts; and\n•Be more transparent with internal and external stakeholders through communications and public disclosures.\nAs we look forward to fiscal 2022 and beyond, we will continue evolving and improving. We have set aggressive targets and aspirational goals for ourselves and we are committed to holding ourselves accountable to our commitments by embedding them into our business goals.\nRaw Materials and Components\nOur principal raw material and component purchases aggregated to approximately $255 million in fiscal 2021 (or 59% of Cost of product sold in fiscal 2021) and included steel, consisting of rod, wire, bar, structural, and other forms of steel; electric motors; bearings; gear reducers; castings; steel and aluminum enclosures and wire harnesses; electro-mechanical components\n9\nand standard variable drives. These commodities are all available from multiple sources. We purchase most of these raw materials and components from a limited number of strategic and preferred suppliers under agreements that are negotiated on a Company-wide basis through our global purchasing group. Generally, as we experience fluctuations in our costs, we reflect these increases in costs as price increases to our customers with the goal of being margin neutral. Our ability to pass on these increases is dependent upon market conditions.\nEnvironmental and Other Governmental Regulation\nLike most manufacturing companies, we are subject to various federal, state, and local laws relating to the protection of the environment. To address the requirements of such laws, we have adopted a corporate environmental protection policy which provides that all of our owned or leased facilities must comply, and all of our employees have the duty to comply, with all applicable environmental regulatory standards, and we have initiated an environmental auditing program for our facilities to ensure compliance with such regulatory standards. We have also established managerial responsibilities and internal communication channels for dealing with environmental compliance issues that may arise in the course of our business. We have made, and could be required to continue to make, significant expenditures to comply with environmental requirements. Because of the complexity and changing nature of environmental regulatory standards, it is possible that situations will arise from time to time requiring us to incur additional expenditures to ensure environmental regulatory compliance. However, we are not aware of any environmental condition or any operation at any of our facilities, either individually or in the aggregate, which would cause expenditures having a material adverse effect on our results of operations, financial condition or cash flows.\nOur operations are also governed by many other laws and regulations, including those relating to workplace safety and worker health, principally OSHA in the U.S. and others outside the U.S. and regulations thereunder. We believe that we are in substantial compliance with these laws and regulations and do not believe that future compliance with such laws and regulations will have a material adverse effect on our operating results, financial condition, or liquidity.\nSee Note 16 to our March 31, 2021 consolidated financial statements for more information on our matters involving litigation.\nAvailable Information\nOur internet address is www.columbusmckinnon.com. We make available free of charge through our website our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after such documents are electronically filed with, or furnished to, the Securities and Exchange Commission.\n10\n\nItem 1A.\nRisk Factors\nColumbus McKinnon is subject to a number of risk factors that could negatively affect our results from business operations or cause actual results to differ materially from those projected or indicated in any forward-looking statement. Such factors include, but are not limited to, the following:\nBusiness Risks\nOur business is cyclical and is affected by industrial economic and macroeconomic conditions.\nMany of the end-users of our products are in highly cyclical industries, such as manufacturing, power generation and distribution, commercial construction, oil and gas exploration and refining, transportation, agriculture, logging, and mining that are sensitive to changes in general economic conditions. Their demand for our products, and thus our results of operations, is directly related to the level of production in their facilities, which changes as a result of changes in general macroeconomic conditions, including, among others, movements in interest rates, inflation, changes in currency exchange rates and higher fuel and other energy costs, and other factors beyond our control. In particular, higher interest rates could result in decreased demand for our products from end-users, which would have a material adverse effect on our business and results of operations, and higher interest expense related to borrowings under our credit facilities. In addition, inflation can also result in higher interest rates. With inflation, the costs of capital increases, and the purchasing power of our and our end users’ cash resources can decline. Current or future efforts by the government to stimulate the economy may increase the risk of significant inflation, which could have a direct and indirect adverse impact on our business and results of operations. If there is deterioration in the general economy or in the industries we serve, our business, results of operations, and financial condition could be materially adversely affected. In addition, the cyclical nature of our business could at times also adversely affect our liquidity and ability to borrow under our revolving credit facility.\nOur business is highly competitive and subject to consolidation of competitors. Increased competition could reduce our sales, earnings, and profitability.\nThe principal markets that we serve within the material handling industry are fragmented and highly competitive. Competition is based primarily on customer service and support as well as product availability, performance, functionality, brand reputation, reliability, and price. Our competition in the markets in which we participate comes from companies of various sizes, some of which have greater financial and other resources than we do. Increased competition could force us to lower our prices or to offer additional services at a higher cost to us, which could reduce our gross margins and net income.\nThe greater financial resources or the lower amount of debt of certain of our competitors may enable them to commit larger amounts of capital in response to changing market conditions. Certain competitors may also have the ability to develop product or service innovations that could put us at a disadvantage. In addition, through consolidation, some of our competitors have achieved substantially more market penetration in certain of the markets in which we operate. If we are unable to compete successfully against other manufacturers of material handling equipment, we could lose customers and our revenues may decline. There can also be no assurance that customers will continue to regard our products favorably, that we will be able to develop new products that appeal to customers, that we will be able to improve or maintain our profit margins on sales to our customers or that we will be able to continue to compete successfully in our core markets.\nOur strategy depends on successful integration of acquisitions.\nAcquisitions are a key part of our growth strategy. Our historical growth has depended, and our future growth is likely to depend on our ability to successfully implement our acquisition strategy, and the successful integration of acquired businesses, including Dorner, into our existing business. We intend to continue to seek additional acquisition opportunities in accordance with our acquisition strategy, both to expand into new markets and to enhance our position in existing markets throughout the world. If we are unable to successfully integrate acquired businesses, including Dorner, into our existing business or expand into new markets, our sales and earnings growth could be reduced.\nThe risk related to COVID-19 has, and may in the future continue to, adversely affect our business.\nWe have been, and may continue to be, materially and adversely impacted by the effects of COVID-19. In addition to global macroeconomic effects, the COVID-19 outbreak and any other related adverse public health developments have caused, and are expected to continue to cause, disruption to both our domestic and international operations and sales activities. The continued operation of our facilities is subject to local laws and regulations. While all of our facilities have been deemed essential under applicable law, there is no guarantee this will continue. Our third-party manufacturers, suppliers, distributors, sub-contractors and customers have been, and are expected to continue to be, disrupted by worker absenteeism, quarantines and restrictions on their employees’ ability to work, office and factory closures, disruptions to ports and other shipping infrastructure, border\n11\nclosures, and other travel or health-related restrictions. Depending on the magnitude of such effects on our manufacturing operations or the operations of our suppliers, third-party distributors, or sub-contractors, our supply chain, manufacturing and product shipments have been, and in the future may continue to be, delayed, which could adversely affect our business, operations, and customer relationships. In addition, COVID-19 or other disease outbreaks will in the short-run and may over the longer term adversely affect the economies and financial markets of many countries, which could result in an economic downturn that could affect demand for our products and impact our operating results. There can be no assurance that any decrease in sales resulting from the COVID-19 will be offset by increased sales in subsequent periods. Although the magnitude of the impact of the COVID-19 outbreak on our business and operations remains uncertain, the continued spread of the COVID-19 or the occurrence of other epidemics and the imposition of related public health measures and travel and business restrictions has, and may in the future continue to, adversely impact our business, financial condition, operating results and cash flows.\nOur future operating results may be affected by price fluctuations and trade tariffs on steel, aluminum, and other raw materials purchased to manufacture our products. We may not be able to pass on increases in raw material costs to our customers.\nThe primary raw materials used in our chain, forging and crane building operations are steel, aluminum, and other raw materials such as motors, electrical and electronic components, castings and machined parts and components. These industries are highly cyclical and at times pricing and availability can be volatile due to a number of factors beyond our control, including general economic conditions, labor costs, competition, import duties, tariffs, and currency exchange rates. This volatility can significantly affect our raw material costs. In an environment of increasing raw material prices and trade tariffs, competitive conditions will determine how much of the price increases we can pass on to our customers. In the future, to the extent we are unable to pass on any steel, aluminum, or other raw material price increases to our customers, our profitability could be adversely affected.\nWe rely in large part on independent distributors for sales of our products.\nFor the most part, we depend on independent distributors to sell our products and provide service and aftermarket support to our end-user customers. Distributors play a significant role in determining which of our products are stocked at their locations, and hence are most readily accessible to aftermarket buyers, and the price at which these products are sold. Almost all of the distributors with whom we transact business offer competitive products and services to our end-user customers. For the most part, we do not have written agreements with our distributors. The loss of a substantial number of these distributors or an increase in the distributors' sales of our competitors' products to our ultimate customers could materially reduce our sales and profits.\nThe Dorner acquired business may underperform relative to our expectations.\nFollowing completion of the acquisition of Dorner, we may not be able to maintain the levels of revenue, earnings or operating efficiency that Dorner and we have achieved or might achieve separately. The business and financial performance of Dorner are subject to certain risks and uncertainties, including the risk of the loss of, or changes to, its relationships with its customers. We may be unable to achieve the same growth, revenues and profitability that Dorner has achieved in the past.\nThe future results of our Company will suffer if we do not effectively manage our expanded operations following the acquisition of Dorner.\nSince the completion of the acquisition of Dorner, the size of our business has increased significantly beyond its pre-acquisition size. Our future success depends, in part, upon our ability to manage Dorner, which will pose substantial challenges for management, including challenges related to the management and monitoring of new operations and associated increased costs and complexity. There can be no assurances that the Dorner business will be successful or that we will realize the expected benefits currently anticipated from the acquisition of Dorner.\nWe will incur significant acquisition-related integration costs and have incurred significant transaction costs in connection with the acquisition of Dorner and the related financing transactions.\nWe are currently implementing a plan to integrate the operations of Dorner into the Company. In connection with that plan, we anticipate that we will incur certain non-recurring charges in connection with this integration including costs for:\n•employee retention, redeployment, relocation or severance;\n•integration, including of people, technology, operations, marketing, and systems and processes; and\n•maintenance and management of customers and other assets;\n12\nhowever, we cannot identify the timing, nature and amount of all such charges. Further, we have incurred significant transaction costs relating to negotiating and completing the acquisition of Dorner and the related financing transactions. These integration costs and transaction expenses will be charged as an expense in the period incurred. The significant transaction costs and acquisition-related integration costs could materially affect our results of operations in the period in which such charges are recorded. Although we believe that the elimination of duplicative costs, as well as the realization of other efficiencies related to the integration of the business, will offset incremental transaction and acquisition-related costs over time, this net benefit may not be achieved in the near term, or at all.\nFinancial Risks\nChanges in the method of determining the London Interbank Offered Rate (\"LIBOR\"), or the replacement of LIBOR with an alternative reference rate, may adversely affect interest rates.\nOn July 27, 2017, the United Kingdom’s Financial Conduct Authority, which regulates LIBOR, announced that it intends to phase out LIBOR by the end of 2021, although on November 30, 2020 it announced that it had extended the period in which it will continue to publish certain LIBOR tenors, including three-month LIBOR, to June 30, 2023. It is unclear if at that time LIBOR will cease to exist or if new methods of calculating LIBOR will be established such that it continues to exist after June 30, 2023, or whether different benchmark rates used to price indebtedness will develop. The Alternative Reference Rates Committee, a group of market participants convened by the U.S. Federal Reserve Board and the Federal Reserve Bank of New York, has recommended the Secured Overnight Financing Rate (“SOFR”), a rate calculated based on repurchase agreements backed by treasury securities, as its recommended alternative benchmark rate to replace LIBOR. At this time, it is not known whether or when SOFR or other alternative reference rates will attain market traction as replacements for LIBOR. Any new benchmark rate will likely not replicate LIBOR exactly. The interest rate on the Company’s First Lien Term Facility and revolving credit facility have a variable component that is based on LIBOR. The phase-out of LIBOR may negatively impact the terms of our outstanding indebtedness. In addition, the overall financial market may be disrupted as a result of the phase-out or replacement of LIBOR. Disruption in the financial market could have a material adverse effect on our financial position, results of operations, and liquidity.\nIn connection with the completion of the acquisition of Dorner, our indebtedness has increased significantly. Our indebtedness could limit our cash flow available for operations and our flexibility.\nIn connection with the completion of the acquisition of Dorner, our indebtedness has increased significantly. In connection with this acquisition, we incurred $650,000,000 of debt under our First Lien Term Facility and, as of March 31, 2021, we had approximately $82,700,000 available for borrowing under the revolving credit facility (after deducting approximately $17,302,000 of letters of credit outstanding as of March 31, 2021). On a pro forma basis, as of March 31, 2021, after giving effect to the acquisition of Dorner and the related financing transactions, including our $207,000,000 offering of common stock completed in May 2021 and associated use of proceeds to pay down outstanding indebtedness under our First Lien Term Facility, we would have had approximately $451,800,000 of debt outstanding under the credit facility and our indebtedness is substantially greater than prior to the acquisition of Dorner.\nThe degree to which we are leveraged could have important consequences to our shareholders, including the following:\n•we may have greater difficulty satisfying our obligations with respect to our indebtedness;\n•we must dedicate a substantial portion of our cash flow from operations to the payment of principal and interest on our indebtedness, reducing the funds available for our operations;\n•our ability to obtain additional financing in the future for working capital, capital expenditures, acquisitions or other purposes may be impaired;\n•we may be limited in our ability to make additional acquisitions or pay dividends on our common stock;\n•our flexibility in planning for, or reacting to, changes in the markets in which we compete may be limited;\n•we may be at a competitive disadvantage relative to our competitors with less indebtedness;\n•we may be rendered more vulnerable to general adverse economic and industry conditions;\n•our credit ratings may be downgraded; and\n•we are exposed to increased interest rate risk given that a portion of our indebtedness obligations are at variable interest rates.\nDorner was previously a private company and has not been required to comply with the Sarbanes-Oxley Act of 2002, as amended (“Sarbanes-Oxley”).\nSarbanes-Oxley requires public companies to have and maintain effective internal control over financial reporting to provide reasonable assurance regarding the reliability of financial reporting and preparation of financial statements and to have\n13\nmanagement report on the effectiveness of those controls on an annual basis (and have its independent public accountants attest annually to the effectiveness of such internal controls). As a private company, Dorner was not required to comply with the requirements of Sarbanes-Oxley.\nIn connection with the completion of the acquisition of Dorner, we are beginning to apply our Sarbanes-Oxley procedures regarding internal controls over financial reporting with respect to Dorner. This process will require a significant amount of time from our management and other personnel and will require us to expend a significant amount of financial resources, which is likely to increase our compliance costs, and we will be required to assess Dorner’s internal controls over financial reporting beginning one year after the date of the acquisition.\nOur operations outside the U.S. pose certain risks that may adversely impact sales and earnings.\nWe have operations and assets located outside of the United States, primarily in China, Mexico, Germany, the United Kingdom, Hungary and Malaysia. In addition, we import a portion of our hoist product line from Asia and sell our products to distributors located in approximately 50 countries. In our fiscal year ended March 31, 2021, approximately 47% of our net sales were derived from non-U.S. markets. These non-U.S. operations are subject to a number of special risks, in addition to the risks of our U.S. business, differing protections of intellectual property, trade barriers, labor unrest, exchange controls, regional economic uncertainty, differing (and possibly more stringent) labor regulation, risk of governmental expropriation, U.S. and foreign customs and tariffs, current and changing regulatory environments, difficulty in obtaining distribution support, difficulty in staffing and managing widespread operations, differences in the availability, and terms of financing, political instability and risks of increases in taxes. Also, in some foreign jurisdictions we may be subject to laws limiting the right and ability of entities organized or operating therein to pay dividends or remit earnings to affiliated companies unless specified conditions are met. These factors may adversely affect our future profits.\nPart of our strategy is to expand our worldwide market share and reduce costs by strengthening our international distribution capabilities and sourcing components in lower cost countries, such as China, Mexico, Hungary and Malaysia. Implementation of this strategy may increase the impact of the risks described above, and we cannot assure you that such risks will not have an adverse effect on our business, results of operations or financial condition.\nOther risks of doing business in international markets include the increased risks and burdens of complying with different legal and regulatory standards, difficulties in managing and staffing foreign operations, recruiting and retaining talented direct sales personnel, limitations on the repatriation of funds and fluctuations of foreign exchange rates, varying levels of internet technology adoption and infrastructure and our ability to enforce contracts and our intellectual property rights in foreign jurisdictions. Additionally, there are risks associated with fundamental changes to international markets, such as those that may occur as a result of the United Kingdom's withdrawal from the European Union (\"Brexit\"). Brexit may adversely affect global economic and market conditions and could contribute to volatility in the foreign exchange markets, which we may be unable to effectively manage.\nIn addition, our success in international expansion could be limited by barriers to international expansion such as adverse tax consequences and export controls. If we cannot manage these risks effectively, the costs of doing business in some international markets may be prohibitive or our costs may increase disproportionately to our revenue.\nWe are subject to currency fluctuations from our sales outside the U.S.\nOur products are sold in many countries around the world. Thus, a portion of our revenues (approximately $307,755,000 in our fiscal year ended March 31, 2021) are generated in foreign currencies, including principally the Euro, the British Pound, the Canadian Dollar, the South African Rand, the Brazilian Real, the Mexican Peso, and the Chinese Yuan, and while much of the costs incurred to generate those revenues are incurred in the same currency, a portion is incurred in other currencies. Since our financial statements are denominated in U.S. dollars, changes in currency exchange rates between the U.S. dollar and other currencies have had, and will continue to have, a currency translation impact on our earnings. Currency fluctuations may impact our financial performance in the future.\nWe are subject to debt covenant restrictions.\nOur First Lien Term Facility and revolving credit facility contain a financial leverage covenant, which will only be tested if any extensions of credit (other than letters of credit) are outstanding under the revolving credit facility at the end of any fiscal quarter, and other restrictive covenants. A significant decline in our operating income or cash generating ability could cause us to violate our leverage covenant in our bank credit facilities. Other material adverse changes in our business could also cause us to be in default of our debt covenants. This could result in our being unable to borrow under our bank credit facilities or being obliged to refinance and renegotiate the terms of our indebtedness.\n14\nLegal Risks\nOur products involve risks of personal injury and property damage, which exposes us to potential liability.\nOur business exposes us to possible claims for personal injury or death and property damage resulting from the products that we sell. We maintain insurance through a combination of self-insurance retentions and excess insurance coverage. We monitor claims and potential claims of which we become aware and establish accrued liability reserves for the self-insurance amounts based on our liability estimates for such claims. We cannot give any assurance that existing or future claims will not exceed our estimates for self-insurance or the amount of our excess insurance coverage. In addition, we cannot give any assurance that insurance will continue to be available to us on economically reasonable terms or that our insurers would not require us to increase our self-insurance amounts. Claims brought against us that are not covered by insurance or that are in excess of insurance coverage could have a material adverse effect on our results, financial condition, or liquidity.\nIn addition, like many industrial manufacturers, we are also involved in asbestos-related litigation. In continually evaluating costs relating to our estimated asbestos-related liability, we review, among other things, the incidence of past and recent claims, the historical case dismissal rate, the mix of the claimed illnesses and occupations of the plaintiffs, our recent and historical resolution of the cases, the number of cases pending against us, the status and results of broad-based settlement discussions, and the number of years such activity might continue. Based on this review, we estimate our share of liability to defend and resolve probable asbestos related personal injury claims. This estimate is highly uncertain due to the limitations of the available data and the difficulty of forecasting with any certainty the numerous variables that can affect the range of the liability. We continue to study the variables in light of additional information in order to identify trends that may become evident and to assess their impact on the range of liability that is probable and estimable. We believe that the potential additional costs for claims will not have a material effect on the financial condition of the Company or its liquidity, although the effect of any future liabilities recorded could be material to earnings in a future period. See Note 16 to our March 31, 2021 consolidated financial statements included in Item 8 of this Form 10-K.\nAs indicated above, our self-insurance coverage is provided through our captive insurance subsidiary. The reserves of our captive insurance subsidiary are subject to periodic adjustments based upon actuarial evaluations, which adjustments impact our overall results of operations. These periodic adjustments can be favorable or unfavorable.\nWe are subject to various environmental laws, which may require us to expend significant capital and incur substantial cost.\nOur operations and facilities are subject to various federal, state, local, and foreign requirements relating to the protection of the environment, including those governing the discharges of pollutants in the air and water, the generation, management and disposal of hazardous substances and wastes, and the cleanup of contaminated sites. We have made, and will continue to make, expenditures to comply with such requirements. Violations of, or liabilities under, environmental laws and regulations, or changes in such laws and regulations (such as the imposition of more stringent standards for discharges into the environment), could result in substantial costs to us, including operating costs and capital expenditures, fines and civil and criminal sanctions, third party claims for property damage or personal injury, clean-up costs, or costs relating to the temporary or permanent discontinuance of operations. Certain of our facilities have been in operation for many years, and we have remediated contamination at some of our facilities. Over time, we and other predecessor operators of such facilities have generated, used, handled, and disposed of hazardous and other regulated wastes. Additional environmental liabilities could exist, including clean-up obligations at these locations or other sites at which materials from our operations were disposed, which could result in substantial future expenditures that cannot be currently quantified and which could reduce our profits or have an adverse effect on our financial condition, operations, or liquidity.\nWe may face claims of infringement on the intellectual property of others, or others may infringe upon our intellectual property.\nOur future success depends in part on our ability to prevent others from infringing on our proprietary rights, as well as our ability to operate without infringing upon the proprietary rights of others. We may be required at times to take legal action to protect our proprietary rights and, despite our best efforts, we may be sued for infringing on the intellectual property rights of others. Intellectual property-related litigation is costly and, even if we prevail, the cost of such litigation could adversely affect our financial condition. In addition, we could be adversely affected financially should we be judged to have infringed upon the intellectual property of others.\nWe rely on subcontractors or suppliers to perform their contractual obligations.\n15\nSome of our contracts involve subcontracts with other companies upon which we rely to perform a portion of the services we must provide to our customers. There is a risk that we may have disputes with our subcontractors, including disputes regarding the quality and timeliness of work performed by our subcontractor or customer concerns about the subcontractor. Failure by our subcontractors to satisfactorily provide on a timely basis the agreed-upon supplies or perform the agreed upon services may materially and adversely impact our ability to perform our obligations as the prime contractor. A delay in our ability to obtain components and equipment parts from our suppliers may affect our ability to meet our customers' needs and may have an adverse effect upon our profitability.\nGeneral Risks\nAdverse changes in global economic conditions may negatively affect our industry, business, and results of operations.\nOur industry is affected by changes in economic conditions outside our control, which can result in a general decrease in product demand from our customers. Such economic developments, like Brexit or the China trade wars, may affect our business in a number of ways. Reduced demand may drive us and our competitors to offer products at promotional prices, which would have a negative impact on our profitability. In addition, the tightening of credit in financial markets may adversely affect the ability of our customers and suppliers to obtain financing for significant purchases and operations and could result in a decrease in, or cancellation of, orders for our products. If demand for our products slows down or decreases, we will not be able to maintain our revenue and we may run the risk of failing to satisfy the financial and other restrictive covenants to which we are subject under our existing indebtedness. Reduced revenue as a result of decreased demand may also reduce our planned growth and otherwise hinder our ability to improve our performance in connection with our long-term strategy.\nOur business operations may be adversely affected by information systems interruptions or intrusion.\nWe depend on various information technologies throughout our Company to administer, store, and support multiple business activities, including to process the data we collect, store and use in connection with our business. If these systems are damaged, cease to function properly, or are subject to cyber-security attacks, such as those involving unauthorized access, malicious software and/or other intrusions, we could experience production downtimes, operational delays, other detrimental impacts on our operations or ability to provide products and services to our customers, the compromising of confidential or otherwise protected information, destruction or corruption of data, security breaches, other manipulation or improper use of our systems or networks, financial losses from remedial actions, loss of business or potential liability, and/or damage to our reputation. While we attempt to mitigate these risks by employing a number of measures, including employee training, technical security controls, and maintenance of backup and protective systems, our systems, networks, products, and services remain potentially vulnerable to known or unknown threats, any of which could have a material adverse effect on our business, financial condition or results of operations. We are subject to a variety of laws and regulations in the United States, Europe and around the world, as well as contractual obligations, regarding data privacy, security and protection. Any failure or perceived failure by us, or any third parties with which we do business, to comply with our posted privacy policies, changing consumer expectations, evolving laws, rules and regulations, industry standards, or contractual obligations to which we or such third parties are or may become subject, may result in actions or other claims against us by governmental entities or private actors, the expenditure of substantial costs, time and other resources or the incurrence of significant fines, penalties or other liabilities. In addition, any such action, particularly to the extent we were found to be guilty of violations or otherwise liable for damages, could damage our reputation and adversely affect our business, financial condition and results of operations.\nWe depend on our management team and the loss of any member could adversely affect our operations.\nOur success is dependent on the management and leadership skills of our management team, including our senior team. The loss of any of these individuals or an inability to attract, retain, and maintain additional personnel, especially in a post-COVID job market, could prevent us from implementing our business strategy. We cannot assure you that we will be able to retain our existing management personnel or to attract additional qualified personnel when needed.\nOn May 14, 2020, the Company announced that David J. Wilson has been named President and CEO effective June 1, 2020. The Company has entered into an Employment Agreement and Change in Control agreement with Mr. Wilson which was filed on Form 8-K on May 14, 2020. Under Mr. Wilson’s leadership, the Company has evolved its Blueprint for Growth strategy to Blueprint for Growth 2.0 and continues to execute as demonstrated by the acquisition of Dorner.\nItem 1B.\nUnresolved Staff Comments\nNone.\n16\n\nItem 2.\nProperties\nWe maintain our corporate headquarters in Buffalo, New York (an owned property) and, as of March 31, 2021, conducted our principal manufacturing at the following facilities:\n| Location | Products/Operations | SquareFootage | Owned orLeased |\n| 1 | Kunzelsau, Germany | Hoists | 345,000 | Leased |\n| 2 | Wadesboro, NC | Hoists | 180,000 | Owned |\n| 3 | Lexington, TN | Chain | 164,000 | Owned |\n| 4 | Charlotte, NC | Actuators and Rotary Unions | 146,000 | Leased |\n| 5 | Menomonee Falls, WI | Power control systems | 144,000 | Leased |\n| Tennessee forging operation: |\n| 6 | Chattanooga, TN | Forged attachments | 81,000 | Owned |\n| 7 | Chattanooga, TN | Forged attachments | 59,000 | Owned |\n| 8 | Wuppertal, Germany | Hoists | 124,000 | Leased |\n| 9 | Kissing, Germany | Hoists, winches, and actuators | 107,000 | Leased |\n| 10 | Damascus, VA | Hoists | 97,000 | Owned |\n| 11 | Hangzhou, China | Hoists | 82,000 | Owned |\n| 12 | Brighton, MI | Overhead light rail workstations | 71,000 | Leased |\n| 13 | Chester, England | Plate clamps | 56,000 | Owned |\n| 14 | Santiago Tianguistenco, Mexico | Hoists | 54,000 | Owned |\n| 15 | Szekesfehervar, Hungary | Textiles and textile strappings | 24,000 | Leased |\n\nIn addition, we have a total of 48 sales offices, distribution centers, and warehouses. We believe that our properties have been adequately maintained, are in generally good condition and are suitable for our business as presently conducted. We also believe our existing facilities provide sufficient production capacity for our present needs and for our anticipated needs in the foreseeable future. Upon the expiration of our current leases, we believe that either we will be able to secure renewal terms or enter into leases for alternative locations at market terms.\nThe addition of Dorner properties expands our footprint in the U.S. (Hartland, WI), Canada, Mexico, France, and Malaysia with Dorner's primary manufacturing facility in the U.S.\n17\n\nItem 3.\nLegal Proceedings\nFrom time to time, we are named a defendant in legal actions arising out of the normal course of business. We are not a party to any pending legal proceeding other than ordinary, routine litigation incidental to our business. We do not believe that any of our pending litigation will have a material impact on our business. We maintain comprehensive general product liability insurance against risks arising out of the use of our products sold to customers through our wholly owned New York State captive insurance subsidiary of which we are the sole policy holder. The per occurrence limits on the self-insurance for general and product liability coverage were $2,000,000 from inception through fiscal 2003 and $3,000,000 for fiscal 2004 and thereafter. In addition to the per occurrence limits, our coverage is also subject to an annual aggregate limit, applicable to losses only. These limits range from $2,000,000 to $6,000,000 for each policy year from inception through fiscal 2021. We obtain additional insurance coverage from independent insurers to cover potential losses in excess of these limits.\nLike many industrial manufacturers, we are also involved in asbestos-related litigation. In continually evaluating costs relating to our estimated asbestos-related liability, we review, among other things, the incidence of past and recent claims, the historical case dismissal rate, the mix of the claimed illnesses and occupations of the plaintiffs, our recent and historical resolution of the cases, the number of cases pending against us, the status and results of broad-based settlement discussions, and the number of years such activity might continue. Because this liability is likely to extend over many years, management believes that the potential additional costs for claims will not have a material effect on the financial condition of the Company or its liquidity, although the effect of any future liabilities recorded could be material to earnings in a future period.\nSee Note 16 to our March 31, 2021 consolidated financial statements for more information on our matters involving litigation.\nItem 4.\nMine Safety Disclosures.\nNot Applicable.\n18\nPART II\nItem 5.\nMarket for the Company’s Common Stock and Related Security Holder Matters\nOur common stock is traded on the Nasdaq Global Select Market under the symbol ‘‘CMCO.” As of April 30, 2021, there were 334 holders of record of our common stock.\nDuring fiscal 2021, the Company declared quarterly cash dividends totaling $5,745,000. On March 22, 2021, the Company's Board of Directors declared a regular quarterly dividend of $0.06 per common share. The dividend was paid on May 13, 2021 to shareholders of record as of May 3, 2021 and totaled approximately $1,440,000.\nOur current credit agreement allows for the declaration and payment of dividends, subject to specified limitation as set forth in our credit agreement.\nPERFORMANCE GRAPH\nThe Performance Graph shown below compares the cumulative total shareholder return on our common stock based on its market price, with the total return of the S&P SmallCap 600 Index, and the Dow Jones U.S. Diversified Industrials. The comparison of total return assumes that a fixed investment of $100 was invested on March 31, 2016 in our common stock and in each of the foregoing indices and further assumes the reinvestment of dividends. The stock price performance shown on the graph is not necessarily indicative of future price performance.\nItem 6.\nSelected Financial Data.\nPart II, Item 6 is no longer required as the Company has adopted certain provisions within the amendments to Regulation S-K that eliminate Item 301.\n19\n\nItem 7.\nManagement’s Discussion and Analysis of Results of Operations and Financial Condition\nThis section should be read in conjunction with our consolidated financial statements included elsewhere in this Annual Report on Form 10-K.\nEXECUTIVE OVERVIEW\nThe Company is a leading worldwide designer, manufacturer and marketer of intelligent motion solutions, including motion control products, technologies, automated systems and services, that efficiently and ergonomically move, lift, position and secure materials. Our key products include hoists, crane components, precision conveyors, actuators, rigging tools, light rail workstations, and digital power and motion control systems. These are highly relevant, professional-grade solutions that solve customers’ critical material handling requirements.\nFounded in 1875, we have grown to our current size and leadership position through organic growth and acquisitions. We developed our leading market position over our 146-year history by emphasizing technological innovation, manufacturing excellence and superior customer service. In addition, acquisitions significantly broadened our product lines and services and expanded our geographic reach, end-user markets and customer base. In accordance with our Blueprint for Growth 2.0 Strategy, we are simplifying the business utilizing our 80/20 process, improving our operational excellence, and ramping the growth engine by investing in new product development and a digital platform to grow profitably. Shareholder value will be enhanced by expanding EBITDA margins and return on invested capital (\"ROIC\").\nOur revenue base is geographically diverse with approximately 47% derived from customers outside the U.S. for the year ended March 31, 2021. We believe this diversity balances the impact of changes that occur in local economies, as well as benefits the Company by providing access to growing emerging markets. We monitor both U.S. and Eurozone Industrial Capacity Utilization statistics as well as the ISM Production Index as indicators of anticipated demand for our products. In addition, we continue to monitor the potential impact of other global and U.S. trends including, industrial production, trade tariffs, raw material cost inflation, interest rates, foreign currency exchange rates, and activity of end-user markets around the globe.\nFrom a strategic perspective, we are investing in new products as we focus on our greatest opportunities for growth. We maintain a strong North American market share with significant leading market positions in hoists, lifting and sling chain, forged attachments, actuators, and digital power and motion control systems for the material handling industry. We seek to maintain and enhance our market share by focusing our sales and marketing activities toward select North American and global market sectors including general industrial, energy, automotive, heavy OEM, entertainment, and construction and infrastructure.\nIn March 2021, the Company announced that it had entered into a definitive agreement to acquire Dorner. The acquisition of Dorner closed on April 7, 2021. Dorner, headquartered in Hartland, Wisconsin, is a leading automation solutions company providing unique, patented technologies in the design, application, manufacturing and integration of high-precision conveying systems. The acquisition of Dorner accelerates the Company’s shift to intelligent motion and serves as a platform to expand capabilities in advanced, higher technology automation solutions. Dorner is a leading supplier to the stable life sciences, food processing, and consumer packaged goods markets as well as the high growth industrial automation and e-commerce sectors. The addition of Dorner provides attractive complementary adjacencies including sortation and asynchronous conveyance systems.\nRegardless of the economic climate and point in the economic cycle, we constantly explore ways to increase operating margins as well as further improve our productivity and competitiveness. We have specific initiatives to reduce quote lead-times, improve on-time deliveries, reduce warranty costs, and improve material and factory productivity. The initiatives are being driven by the implementation of our business operating system, CMBS. We are working to achieve these strategic initiatives through business simplification, operational excellence, and profitable growth initiatives. We believe these initiatives will enhance future operating margins.\nOur principal raw materials and components purchases were approximately $255 million in fiscal 2021 (or 59% of Cost of product sold) and include steel, consisting of rod, wire, bar, structural, and other forms of steel; electric motors; bearings; gear reducers; castings; steel and aluminum enclosures and wire harnesses; electro-mechanical components and standard variable drives. These commodities are all available from multiple sources. We purchase most of these raw materials and components from a limited number of strategic and preferred suppliers under agreements which are negotiated on a company-wide basis through our global purchasing group. Generally, as we experience fluctuations in our costs, we reflect them as price increases to our customers with the goal of being margin neutral.\nWe operate in a highly competitive and global business environment. We face a variety of opportunities in those markets and geographies, including trends toward increasing productivity of the global labor force and the expansion of market\n20\nopportunities in Asia and other emerging markets. While we execute our long-term growth strategy, we are supported by our strong free cash flow as well as our liquidity position and flexible debt structure. Like many global companies, we have been, and continue to be, affected by COVID-19. During fiscal 2021, we took appropriate measures to generate positive operating income and protect the cash flow and liquidity of the Company. This included reducing our cost base, reducing working capital needs, and reducing capital expenditures. These measures helped contribute to positive operating income and strong cash flow throughout fiscal 2021 despite the impact of COVID-19.\nRESULTS OF OPERATIONS\nFiscal 2021 Compared to 2020\nFiscal 2021 sales were $649,642,000, a decrease of 19.7%, or $159,520,000 compared with fiscal 2020 sales of $809,162,000. Sales for the fiscal year were negatively impacted by $177,233,000 in decreased sales volume as a result of the COVID-19 pandemic, offset by price increases which positively impacted sales by $8,566,000. Favorable foreign currency translation increased sales by $9,147,000.\nGross profit was $220,225,000 and $283,186,000 or 33.9% and 35.0% of net sales in fiscal 2021 and 2020, respectively. The fiscal 2021 decrease in gross profit of $62,961,000 or 22.2% is the result of $62,797,000 in lower sales volume, $15,980,000 in decreased productivity and unfavorable manufacturing costs, and $382,000 received in the prior year from an insurance settlement which did not reoccur. These decreases were offset by $8,311,000 of price increases net of material inflation, $2,189,000 from a gain recorded for a building sold in China classified as Cost of products sold, $1,705,000 in decreased tariffs, $223,000 in decreased product liability costs, $207,000 in decreased severance costs, and $128,000 in lower costs incurred in fiscal 2021 to consolidate the Company's Ohio operations. The translation of foreign currencies had a $3,435,000 favorable impact on gross profit for the year ended March 31, 2021.\nSelling expenses were $76,907,000 and $91,054,000, or 11.8% and 11.3% of net sales in fiscal years 2021 and 2020. Selling expense decreased primarily due to lower variable selling costs and cost measures put in place as a result of the COVID-19 pandemic in fiscal 2021. Foreign currency translation had a $1,204,000 unfavorable impact on selling expenses.\nGeneral and administrative expenses were $76,035,000 and $77,880,000 or 11.7% and 9.6% of net sales in fiscal 2021 and 2020, respectively. The decrease in general and administrative expenses was due to $1,674,000 in prior fiscal year factory closure and business realignment costs which did not reoccur in the current fiscal year, $1,452,000 in reduced bad debt expense, a $449,000 gain in general and administrative expenses as a result of the Company selling one of its owned manufacturing facilities in China, $409,000 in decreased medical expenses, and $356,000 in lower legal costs related to an insurance recovery legal action which was settled in fiscal 2021. A reduction in travel related business expenses and professional services in response to the COVID-19 pandemic further contributed to the reduction in general and administrative expenses. These decreases were offset by $4,161,000 of higher stock compensation expense, of which $1,981,000 was reversed in the prior fiscal year for shares that were forfeited upon the former Chief Executive Officer's resignation, offset by $418,000 in lower incentive compensation expense in the current fiscal year. $3,951,000 in Dorner acquisition costs also contributed to higher general and administrative expenses in fiscal 2021. Foreign currency translation had a $395,000 unfavorable impact on general and administrative expenses.\nResearch and development expenses were $12,405,000 and $11,310,000 in fiscal 2021 and 2020, respectively. As a percentage of consolidated net sales, research and development expenses were 1.9% and 1.4% in fiscal 2021 and 2020. The increase in research and development expenses is primarily due to $525,000 in current year severance costs associated with a research and development facility closure and $307,000 in higher incentive compensation expense in fiscal 2021. Foreign currency translation had a $70,000 unfavorable impact on research and development expenses.\nAmortization of intangibles remained relatively consistent at $12,623,000 and $12,942,000 in fiscal 2021 and 2020, respectively, with the decrease related to certain intangible assets that are now fully amortized.\nInterest and debt expense was $12,081,000 and $14,234,000 in fiscal 2021 and 2020, respectively, and primarily related to a decrease in interest and debt expense on the Company's Term Loan due to lower average borrowings outstanding during the fiscal 2021 period.\nInvestment income of $1,693,000 and $891,000, in fiscal 2021 and 2020, respectively, related to earnings on marketable securities held in the Company’s wholly owned captive insurance subsidiary and the Company's equity method investment in EMC, described in Note 7 to our March 31, 2021 consolidated financial statements.\n21\nForeign currency exchange resulted in a loss of $941,000 and gain of $1,514,000 in fiscal 2021 and 2020, respectively, as a result of foreign currency volatility related to foreign currency denominated sales and purchases and intercompany debt.\nOther expense was $20,850,000 in fiscal 2021 and $839,000 in fiscal 2020. The increase primarily related to a $19,038,000 settlement charge as a result of the termination of one of the Company's U.S. pension plans, as described in Note 13 to our March 31, 2021 consolidated financial statements.\nIncome tax expense as a percentage of income from continuing operations before income tax expense was 9.6% and 22.7% in fiscal 2021 and 2020, respectively. Typically these percentages vary from the U.S. statutory rate of 21% due to varying effective tax rates at the Company's foreign subsidiaries and the jurisdictional mix of income for these subsidiaries. In fiscal 2021 the tax rate was primarily reduced by 6.9 percentage points due to federal tax credits including research and development credits.\nFiscal 2020 Compared to 2019\nFiscal 2020 sales were $809,162,000, a decrease of 7.7%, or $67,120,000 compared with fiscal 2019 sales of $876,282,000. Sales for the year were negatively impacted by $34,195,000 in sales in the previous fiscal year from sold businesses and $32,951,000 in decreased sales volume, offset by $13,169,000 in price increases. Unfavorable foreign currency translation decreased sales by $13,143,000.\nGross profit was $283,186,000 and $304,997,000 or 35.0% and 34.8% of net sales in fiscal 2020 and 2019, respectively. The fiscal 2020 decrease in gross profit of $21,811,000 or 7.2% is the result of $14,069,000 in decreased volume, $7,053,000 in gross profit from sold businesses, $3,461,000 in decreased productivity and unfavorable manufacturing costs, $1,327,000 in costs incurred to consolidate the Salem and Lisbon Ohio facilities, $778,000 in increased tariffs, $751,000 in increased severance costs, and $622,000 in increased product liability costs. These decreases were offset by $10,338,000 of price increases net of material inflation and $382,000 received from insurance settlement. The translation of foreign currencies had a $4,470,000 unfavorable impact on gross profit for the year ended March 31, 2020.\nSelling expenses were $91,054,000 and $97,925,000 or 11.3% and 11.2% of net sales in fiscal years 2020 and 2019. Selling expenses from sold businesses decreased selling expenses by $1,468,000 in fiscal 2020. In addition, we had $804,000 in lower advertising expenses, $550,000 in reduced U.S. warehouse rent expense, $331,000 lower incentive compensation, and $453,000 in costs incurred to consolidate the Salem and Lisbon Ohio facilities classified as selling expense. These decreases were offset by $299,000 in fiscal 2020 severance costs. Additionally, foreign currency translation had a $1,765,000 favorable impact on selling expenses. The remainder of the decrease is due to lower sales volume.\nGeneral and administrative expenses were $77,880,000 and $83,567,000 or 9.6% and 9.5% of net sales in fiscal 2020 and 2019, respectively. The fiscal 2020 decrease in general and administrative expenses was primarily due to $7,540,000 of lower incentive compensation and stock compensation expense including $1,981,000 in stock compensation expense that was reversed in the third quarter of fiscal 2020 for shares that were forfeited upon our Chief Executive Officer's resignation, $1,564,000 from sold businesses, and a $697,000 net reduction in legal costs related to an insurance recovery legal action. The decrease in general and administrative expense was partially offset by $1,528,000 in increased bed debt expenses, $1,455,000 in costs incurred to close a plant in the Asia Pacific region and reorganize the business, $635,000 in tax professional services fees primarily related to a legal entity restructuring, $624,000 in increased medical and benefit expenses, $436,000 of occupancy costs for our center of excellence in North Carolina, and $352,000 in increased environmental costs. Foreign currency translation had a $1,036,000 favorable impact on general and administrative expenses.\nResearch and development expenses were $11,310,000 and $13,491,000 in fiscal 2020 and 2019, respectively. As a percentage of consolidated net sales, research and development expenses were 1.4% and 1.5% in fiscal 2020 and 2019. The reduction in research and development expenses is largely due to lower professional services and other expenses. $277,000 of the decrease in research and development expenses is from sold businesses.\nA net loss on sales of businesses in the amount of $176,000 was recorded as a result of a final working capital adjustment in the year ended March 31, 2020 from businesses that were sold in fiscal 2019.\nAmortization of intangibles remained relatively consistent at $12,942,000 and $14,900,000 in fiscal 2020 and 2019, respectively. The decrease is primarily related to foreign currency translation.\nInterest and debt expense was $14,234,000 and $17,144,000 in fiscal 2020 and 2019, respectively, and primarily related to a decrease in interest and debt expense on the Company's Term Loan due to lower average borrowings outstanding during the fiscal 2020 period.\n22\nInvestment income of $891,000 and $727,000, in fiscal 2020 and 2019, respectively, related to earnings on marketable securities held in the Company’s wholly owned captive insurance subsidiary and the Company's equity method investment in EMC, described in Note 7 to our March 31, 2021 consolidated financial statements.\nForeign currency exchange resulted in a gain of $1,514,000 and loss of $843,000 in fiscal 2020 and 2019, respectively, as a result of foreign currency volatility related to foreign currency denominated sales and purchases and intercompany debt.\nOther expense was $839,000 in fiscal 2020 and other income was $716,000 in fiscal 2019. This includes components of pension expense (all except service costs, described in Note 13 to our March 31, 2021 consolidated financial statements) and various non-operating income and expense related activities.\nIncome tax expense as a percentage of income from continuing operations before income tax expense was 22.7% and 19.5% in fiscal 2020 and 2019, respectively. These percentages vary from the U.S. statutory rate of 21% primarily due to varying effective tax rates at the Company's foreign subsidiaries, and the jurisdictional mix of taxable income for these subsidiaries.\nLIQUIDITY AND CAPITAL RESOURCES\nCash, cash equivalents, and restricted cash totaled $202,377,000, $114,700,000, and $71,343,000 at March 31, 2021, 2020, and 2019, respectively.\nCash flow from operating activities\nNet cash provided by operating activities was $98,890,000, $106,795,000, and $79,499,000 in fiscal 2021, 2020, and 2019, respectively. In fiscal 2021, net income of $9,106,000 and non-cash adjustments to net income of $52,370,000 were the largest contributors to cash provided by operating activities. In addition, cash increased as a result of better working capital performance including a decrease in inventory of $20,659,000, a decrease in trade accounts receivable of $21,472,000, and an increase in trade accounts payable of $10,343,000. The increase in cash was partially offset by a decrease in accrued expenses and non-current liabilities of $10,806,000. The decrease in accrued expenses and non-current liabilities primarily consists of the fiscal 2020 annual incentive plan payments offset by fiscal 2021 incentive plan accruals, $1,316,000 in pension plan contributions net of $3,790,000 of plan assets returned to the Company on the termination of one of its U.S. pension plans, and $8,909,000 in cash paid for amounts included in the measurement of operating lease liabilities.\nIn fiscal 2020, net income of $59,672,000 and non-cash adjustments to net income of $51,188,000 contributed the most to cash provided by operating activities as well as a decrease in inventory of $15,752,000 and an increase in trade accounts payable of $8,110,000. The increase in cash was partially offset by a decrease in accrued expenses and non-current liabilities of 27,693,000. The net decrease in non-current liabilities is largely due to pension plan contributions of $10,967,000.\nCash flow from investing activities\nNet cash (used) provided by investing activities was $(5,548,000), $(9,962,000), and $2,486,000 in fiscal 2021, 2020, and 2019, respectively. In fiscal 2021, the most significant use of cash in investing activities was $12,300,000 in capital expenditures.\nIn fiscal 2020, the most significant use of cash provided by investing activities was $9,432,000 in capital expenditures.\nCash flow from by financing activities\nNet cash used by financing activities was $10,189,000, $51,551,000, and $67,778,000 in fiscal 2021, 2020, and 2019, respectively. In fiscal 2021, the most significant uses of cash were $4,450,000 in repayments on our Term Loan and dividends paid in the amount $5,733,000, offset by $820,000 in net inflows from stock related transactions, which includes proceeds of $1,973,000 from stock options exercised. The Company drew $25,000,000 on the Revolver during the three months ended June 30, 2020 and subsequently repaid the amount in full during the three months ended December 31, 2020 which resulted in no net impact on cash used by financing activities in fiscal 2021.\nIn fiscal 2020, the most significant uses of cash were $51,113,000 in repayments on our Term Loan and dividends paid in the amount of $5,670,000, offset by $5,232,000 in net inflows from stock related transactions, which included proceeds of $6,000,000 from stock options exercised.\n23\nWe believe that our cash on hand, cash flows, and borrowing capacity under our New Revolving Credit Facility will be sufficient to fund our ongoing operations and budgeted capital expenditures for at least the next twelve months. This belief is dependent upon successful execution of our current business plan and effective working capital utilization. No material restriction exists in accessing cash held by our non-U.S. subsidiaries. As of March 31, 2021, $111,021,000 of cash and cash equivalents were held by foreign subsidiaries. Subsequent to March 31, 2021, the Company's cash balance decreased by approximately $120,000,000 to fund the Dorner acquisition, however, the Company still believes cash on hand is sufficient to fund ongoing operations and budgeted capital expenditures for the next 12 months.\nDebt - Key Terms as of March 31, 2021\nOn January 31, 2017 the Company entered into a Credit Agreement (\"Credit Agreement\") and $545,000,000 of debt facilities (\"Facilities\") in connection with the STAHL acquisition. The Facilities consist of a Revolving Facility (\"Revolver\") in the amount of $100,000,000 and a $445,000,000 1st Lien Term Loan (\"Term Loan\"). The Term Loan has a seven-year term maturing in 2024.\nOn February 26, 2018, the Company amended the Credit Agreement (known as the \"First Amended Credit Agreement\"). The First Amended Credit Agreement has the same terms mentioned above except for a reduction in interest rates. The applicable rate for the repriced term loan was reduced from 3.00% to 2.50%. The Company accounted for the First Amended Credit Agreement as a debt modification, therefore, debt repricing fees incurred in fiscal 2018 were expensed as General and Administrative expenses and the deferred financing fees incurred as part of the Credit Agreement (discussed below) remain unchanged.\nOn August 26, 2020, the Company entered into a Second Amendment (known as the \"Second Amended Credit Agreement\") to the Credit Agreement (as amended by the First Amended Credit Agreement). The First Amended Credit Agreement extends the $100,000,000 secured Revolver which was originally set to expire on January 31, 2022 to August 25, 2023. At March 31, 2021 the Company has not drawn from the Revolver.\nThe key terms of the agreement are as follows:\n•Term Loan: An aggregate $445,000,000 1st Lien Term Loan which requires quarterly principal amortization of 0.25% with the remaining principal due at maturity date. In addition, if the Company has Excess Cash Flow (\"ECF\") as defined in the Credit Agreement, the ECF Percentage of the Excess Cash Flow for such fiscal year minus optional prepayment of the Loans (except prepayments of Revolving Loans that are not accompanied by a corresponding permanent reduction of Revolving Commitments) pursuant to Section 2.10(a) of the Credit Agreement other than to the extent that any such prepayment is funded with the proceeds of Funded Debt, shall be applied toward the prepayment of the Term Loan. The ECF Percentage is defined as 50% stepping down to 25% or 0% based on the Secured Leverage Ratio as of the last day of the fiscal year.\n•Revolver: An aggregate $100,000,000 secured revolving facility which includes sublimits for the issuance of standby letters of credit, swingline loans and multi-currency borrowings in certain specified foreign currencies.\n•Fees and Interest Rates: Commitment fees and interest rates are determined on the basis of either a Eurocurrency rate or a Base rate plus an applicable margin based upon the Company's Total Leverage Ratio (as defined in the Credit Agreement).\n•Prepayments: Provisions permitting a Borrower to voluntarily prepay either the Term Loan or Revolver in whole or in part at any time, and provisions requiring certain mandatory prepayments of the Term Loan or Revolver on the occurrence of certain events which will permanently reduce the commitments under the Credit Agreement, each without premium or penalty, subject to reimbursement of certain costs of the Lenders. A prepayment premium of 1% of the principal amount of the First Lien Term Loans is required if the prepayment is associated with a Repricing Transaction and it were to occur within the first twelve months.\n•Covenants: Provisions containing covenants required of the Corporation and its subsidiaries including various affirmative and negative financial and operational covenants. The key financial covenant is triggered only on any date when any Extension of Credit under the Revolving Facility is outstanding (excluding any Letters of Credit) (the “Covenant Trigger”), and permits the Total Leverage Ratio for the Reference Period ended on such date to not exceed (i) 4.50:1.00 as of any date of determination prior to December 31, 2017, (ii) 4.00:1.00 as of any date of determination on December 31, 2017 and thereafter but prior to December 31, 2018, (iii) 3.50:1.00 as of any date of determination on December 31, 2018 and thereafter but prior to December 31, 2019 and (iv) 3.00:1.00 as of any date of determination on December 31, 2019 and thereafter. As there is no amount drawn on the Revolver as of March 31, 2021 the\n24\nrequirement to comply with the covenant is not triggered. Had we been required to determine the covenant ratio we would have been in compliance with the covenant provisions as of March 31, 2021 and 2020.\nThe Facility is secured by all U.S. inventory, receivables, equipment, real property, certain subsidiary stock (limited to 65% of non-U.S. subsidiaries) and intellectual property. The Credit Agreement allows the declaration of dividends, but limits our ability to pay dividends.\nAs discussed in Note 3, the Company completed its acquisition of Dorner on April 7, 2021 and entered into a $750,000,000 credit facility (\"First Lien Facilities\") with JPMorgan Chase Bank, N.A. (\"JPMorgan Chase Bank\"), PNC Capital Markets LLC, and Wells Fargo Securities LLC. The First Lien Facilities consist of a Revolving Facility (the “New Revolving Credit Facility”) in an aggregate amount of $100,000,000 and a $650,000,000 First Lien Term Facility. Proceeds from the First Lien Term Facility was used, among other things, to finance the purchase price for the Dorner acquisition, pay related fees, expenses and transaction costs, and refinance the Company's borrowings under its prior Term Loan and Revolver. Refer to Note 3 to our March 31, 2021 consolidated financial statements for key terms of the First Lien Facilities, which went into effect during fiscal 2022.\nThe outstanding balance of the Term Loan was $254,900,000 and $259,350,000 as of March 31, 2021 and 2020, respectively. The Company made $4,450,000 of principal payment on the Term Loan during fiscal 2021 and $51,113,000 of principal payment on the Term Loan during fiscal 2020. The Company is obligated to make $4,450,000 of principal payments over the next 12 months. As previously discussed, in response to COVID-19 the Company is seeking to take all appropriate measures to protect the cash flow and liquidity of the Company. As such, only the required principal amount has been recorded within the current portion of long-term debt on the Company's Consolidated Balance Sheet with the remaining balance recorded as long-term debt.\nThere was $0 outstanding on the Revolving Credit Facility and $17,302,000 outstanding letters of credit as of March 31, 2021. The outstanding letters of credit at March 31, 2021 consisted of $537,000 in commercial letters of credit and $16,765,000 of standby letters of credit.\nThe gross balance of deferred financing costs on the term loan was $14,690,000 as of March 31, 2021 and 2020. The accumulated amortization balances were $8,744,000 and $6,645,000 as of March 31, 2021 and 2020, respectively.\nThe gross balance of deferred financing costs associated with the Revolving Credit Facility is included in Other assets is $3,615,000 as of March 31, 2021 and $2,789,000 as of March 31, 2020. The accumulated amortization balance is $2,313,000 and $1,766,000 as of March 31, 2021 and March 31, 2020 respectively. These balances are classified in Other assets since no funds were drawn on the Revolving Credit Facility as of March 31, 2021 and March 31, 2020.\nNon-U.S. Lines of Credit and Loans\nUnsecured and uncommitted lines of credit are available to meet short-term working capital needs for certain of our subsidiaries operating outside of the U.S. The lines of credit are available on an offering basis, meaning that transactions under the line of credit will be on such terms and conditions, including interest rate, maturity, representations, covenants, and events of default, as mutually agreed between our subsidiaries and the local bank at the time of each specific transaction. As of March 31, 2021, unsecured credit lines totaled approximately $2,580,000, of which $0 was drawn. In addition, unsecured lines of $15,478,000 were available for bank guarantees issued in the normal course of business of which $12,598,000 was utilized.\nDebt - Key Terms subsequent to March 31, 2021\nAs discussed in Note 3 to our March 31, 2021 consolidated financial statements, on April 7, 2021, the Company completed its acquisition of Dorner for $485,000,000 on a cash-free, debt-free basis with a working capital adjustment.\nTo finance the Dorner acquisition, on April 7, 2021 the Company entered into a $750,000,000 credit facility (\"First Lien Facilities\") with JPMorgan Chase Bank, N.A. (\"JPMorgan Chase Bank\"), PNC Capital Markets LLC, and Wells Fargo Securities LLC. The First Lien Facilities consist of a Revolving Facility (the “New Revolving Credit Facility”) in an aggregate amount of $100,000,000 and a $650,000,000 First Lien Term Facility (\"Bridge Facility\"). Proceeds from the Bridge Facility were used, among other things, to finance the purchase price for the Dorner acquisition, pay related fees, expenses and transaction costs, and refinance the Company's borrowings under its prior Term Loan and Revolver.\nThe key terms of the First Lien Facility are as follows:\n25\n1) Bridge Facility: An aggregate $650,000,000 Bridge Facility which requires quarterly principal amortization of 0.25% with the remaining principal due at maturity date. In addition, if the Company has Excess Cash Flow (ECF) as defined in the Credit Agreement, the ECF Percentage of the Excess Cash Flow for each fiscal year minus optional prepayments of the Loans (except\nprepayments of Revolving Loans that are not accompanied by a corresponding permanent reduction of Revolving Commitments) pursuant to Section 2.10(a) of the Credit Agreement other than to the extent that any such prepayment is funded with the proceeds of Funded Debt, shall be applied toward the prepayment of the Bridge Facility. The ECF Percentage is defined as 50% stepping down to 25% or 0% based on the achievement of specified Secured Leverage Ratios as of the last day of such fiscal year.\n2) Revolver: An aggregate $100,000,000 secured revolving facility which includes sublimits for the issuance of standby letters of credit, swingline loans and multi-currency borrowings in certain specified foreign currencies.\n3) Fees and Interest Rates: Commitment fees and interest rates are determined on the basis of either a Eurocurrency rate or a Base rate plus an applicable margin, which is based upon the Company's Total Leverage Ratio (as defined in the Credit Agreement) in the case of Revolver loans.\n4) Prepayments: Provisions permitting a Borrower to voluntarily prepay either the Bridge Facility or Revolver in whole or in part at any time, and provisions requiring certain mandatory prepayments of the Bridge Facility or Revolver on the occurrence of certain events which will permanently reduce the commitments under the Credit Agreement, each without premium or penalty, subject to reimbursement of certain costs of the Lenders. A prepayment premium of 1% of the principal amount of the First Lien Term Facility is required if the prepayment is associated with a Repricing Transaction and it were to occur within the first six months following the closing date.\n5) Covenants: Provisions containing covenants required of the Corporation and its subsidiaries including various affirmative and negative financial and operational covenants. The key financial covenant is triggered only on any date when any Extension of Credit under the Revolving Facility is outstanding (excluding any Letters of Credit) (the “Covenant Trigger”), and prohibits the Total Leverage Ratio for the Reference Period ended on such date from exceeding (i) 6.75:1.00 as of any date of determination prior to June 30, 2021, (ii) 5.75:1.00 as of any date of determination on June 30, 2021 and thereafter but prior to June 30, 2022, (iii) 4.75:1.00 as of any date of determination on June 30, 2022 and thereafter but prior to June 30, 2023 and (iv)\n3.50:1.00 as of any date of determination on June 30, 2023 and thereafter.\n6) Collateral: Obligations under the First Lien Facilities are secured by liens on substantially all assets of the Company and its material domestic subsidiaries.\nDebt and equity issuance costs were not material in fiscal 2021.\nIn the first quarter of fiscal 2022, the Company expects to incur $6,272,000 in debt extinguishment costs, of which $5,946,000 relates to the Company's prior Term Loan and $326,000 relates to the Company's prior Revolver. These costs will be classified as Cost of debt refinancing in the Consolidated Statements of Operations.\nFurther, in fiscal 2022 the Company expects to record $5,432,000 in deferred financing costs on the First Lien Term Facility, which will be amortized over seven years. The Company expects to record $4,027,000 in deferred financings costs on the New Revolver, of which $3,050,000 is related to the new Revolver and $977,000 is carried over from the Company's prior Revolver as certain Revolver lenders increased their borrowing capacity. These balances will be amortized over five years and classified in Other assets since no funds are expected to be drawn on the New Revolver in the first quarter of fiscal 2022.\nIn addition to the debt borrowing described above, the Company commenced an underwritten public offering of 4,312,500 shares of its common stock at a price of $48.00 per share for total gross proceeds of $207,000,000. The Company used all of the net proceeds from the equity offering to repay in part outstanding borrowings under its Bridge Facility. The equity offering closed on May 4, 2021. Following the repayment, the Bridge Facility was refinanced with a Term Loan B facility. The terms of the Term Loan B facility are similar to the terms for the Bridge Facility with the exception of the limits related to the financial covenants which are triggered only on any date when any Extension of Credit under the Revolving Facility is outstanding. The Term Loan B prohibits the Total Leverage Ratio on such date from exceeding (i) 6.75:1.00 as of any date of determination prior to June 30, 2021, (ii) 5.50:1.00 as of any date of determination on June 30, 2021 and thereafter but prior to June 30, 2022, (iii) 4.50:1.00 as of any date of determination on June 30, 2022 and thereafter but prior to June 30, 2023 and (iv) 3.50:1.00 as of any date of determination on June 30, 2023 and thereafter.\nFees paid on the portion of the First Lien Facilities that were associated with the Bridge Facility are expected to be expensed as part of Cost of debt refinancing in the Consolidated Statements of Operations in the amount of $8,531,000 in the first quarter of fiscal 2022.\n26\nCONTRACTUAL OBLIGATIONS\nThe following table reflects a summary of our expected future cash outflows associated with contractual obligations in effect as of March 31, 2021:\n| Total | Fiscal2022 | Fiscal 2023-Fiscal 2024 | Fiscal 2025-Fiscal 2026 | More ThanFive Years |\n| Long-term debt obligations (a) | $ | 255.0 | $ | 4.5 | $ | 250.5 | $ | — | $ | — |\n| Interest obligations (b) | 22.7 | 9.1 | 13.6 | — | — |\n| Letter of credit obligations | 17.3 | 15.2 | 2.1 | — | — |\n| Bank guarantees | 12.6 | 12.6 | — | — | — |\n| Operating lease obligations (c) | 39.8 | 9.0 | 13.2 | 8.3 | 9.3 |\n| Pension funding (d) | 233.9 | 23.8 | 47.9 | 47.5 | 114.7 |\n| Total | $ | 581.3 | $ | 74.2 | $ | 327.3 | $ | 55.8 | $ | 124.0 |\n\n(a)As described above, subsequent to March 31, 2021, the Company refinanced its Term Loan and Revolver in connection with its purchase of Dorner. The new required annual principal payments (taking into account the completion of the Company’s underwritten public common stock offering and associated use of proceeds for the repayment of amounts outstanding under the First Lien Term Facilities) will be $4,500,000 plus a required excess cash sweep on the $450,000,000 Term Loan B facility.\n(b)Estimated for our Term Loan and Revolving Credit Facility and interest rate swaps as described in Note 10 and Note 12 to our consolidated financial statements. Calculated using a Eurocurrency rate of 1.00% plus an applicable margin of 2.50%.\n(c)As described in Note 18 to consolidated financial statements.\n(d)As described in Note 13 to consolidated financial statements.\nWe have no additional off-balance sheet obligations that are not reflected above.\nCAPITAL EXPENDITURES\nIn addition to keeping our current equipment and plants properly maintained, we are committed to replacing, enhancing, and upgrading our property, plant and equipment to support new product development, improve productivity and customer responsiveness, reduce production costs, increase flexibility to respond effectively to market fluctuations and changes, meet environmental requirements, and enhance safety. Our capital expenditures for fiscal 2021, 2020, and 2019 were $12,300,000, $9,432,000, and $12,288,000 respectively. Excluded from fiscal 2021 capital expenditures is $730,000, $365,000, and $227,000 in property, plant and equipment purchases included in accounts payable at March 31, 2021, 2020, and 2019, respectively. We expect capital expenditure spending in fiscal 2022 to range from $20,000,000 to $25,000,000, of which $3,000,000 to $4,000,000 is attributable to Dorner.\nINFLATION AND OTHER MARKET CONDITIONS\nOur costs are affected by inflation in the U.S. economy and, to a lesser extent, in non-U.S. economies including those of Europe, Canada, Mexico, South America, and Asia-Pacific. We do not believe that general inflation has had a material effect on our results of operations over the periods presented primarily due to overall low inflation levels over such periods and our ability to generally pass on rising costs through annual price increases. However, increases in U.S. employee benefits costs such as health insurance and workers compensation insurance have exceeded general inflation levels. In the future, we may be further affected by inflation that we may not be able to pass on as price increases. With changes in worldwide demand for steel and fluctuating scrap steel prices over the past several years, we experienced fluctuations in our costs that we have reflected as price increases to our customers. We believe we have been successful in instituting price increases to pass on these material cost increases. We will continue to monitor our costs and reevaluate our pricing policies.\nSEASONALITY AND QUARTERLY RESULTS\nOur quarterly results may be materially affected by the timing of large customer orders, periods of high vacation and holiday concentrations, restructuring charges, and other costs attributable to plan closures as well as divestitures and acquisitions. Therefore, our operating results for any particular fiscal quarter are not necessarily indicative of results for any subsequent fiscal quarter or for the full fiscal year.\n27\nCRITICAL ACCOUNTING POLICIES AND ESTIMATES\nThe preparation of financial statements in conformity with U.S. generally accepted accounting principles requires us to make estimates and assumptions that affect the amounts reported in our consolidated financial statements and accompanying notes. We continually evaluate the estimates and their underlying assumptions, which form the basis for making judgments about the carrying value of our assets and liabilities. Actual results inevitably will differ from those estimates. If interpreted differently under different conditions or circumstances, changes in our estimates could result in material changes to our reported results. We have identified below the accounting policies involving estimates that are critical to our financial statements. Other accounting policies are more fully described in Note 2 of our consolidated financial statements.\nInsurance Reserves. Our accrued general and product liability reserves as described in Note 16 to consolidated financial statements involve actuarial techniques including the methods selected to estimate ultimate claims, and assumptions including emergence patterns, payment patterns, initial expected losses, and increased limit factors. These actuarial estimates are subject to a high degree of uncertainty due to a variety of factors, including extended lag time in the reporting and resolution of claims, trends or changes in claim settlement patterns, insurance industry practices, and legal interpretations. Changes to these estimates could result in material changes to the amount of expense and liabilities recorded in our financial statements. Further, actual costs could differ significantly from the estimated amounts. Adjustments to estimated reserves are recorded in the period in which the change in estimate occurs. Other insurance reserves such as workers compensation and group health insurance are based on actual historical and current claim data provided by third party administrators or internally maintained.\nGoodwill and indefinite-lived intangible asset impairment testing. Our goodwill balance of $331,176,000 as of March 31, 2021 is subject to impairment testing. We test goodwill for impairment at least annually, as of the end of February, and more frequently whenever events occur or circumstances change that indicate there may be impairment. These events or circumstances could include a significant long-term adverse change in the business climate, poor indicators of operating performance, or a sale or disposition of a significant portion of a reporting unit.\nWe test goodwill at the reporting unit level, which is one level below our operating segment. We identify our reporting units by assessing whether the components of our operating segment constitute businesses for which discrete financial information is available and segment management regularly reviews the operating results of those components. We also aggregate components that have similar economic characteristics into single reporting units (for example, similar products and / or services, similar long-term financial results, product processes, classes of customers, or in circumstances where the components share assets or other resources and have other economic interdependencies). We have four reporting units, only two of which have goodwill. The Duff-Norton and Rest of Products reporting units have goodwill totaling $9,699,000, and $321,477,000, respectively, at March 31, 2021.\nAnnual Goodwill Impairment Test\nWhen we evaluate the potential for goodwill impairment, we assess a range of qualitative factors including, but not limited to, macroeconomic conditions, industry conditions, the competitive environment, changes in the market for our products and services, regulatory and political developments, entity specific factors such as strategy, and changes in key personnel and overall financial performance. If, after completing this assessment, it is determined that it is more likely than not that the fair value of a reporting unit is less than its carrying value, we proceed to a quantitative impairment test. We also proceed to the quantitative model when economic or other business factors indicate that the fair value of our reporting units may have declined since our last quantitative test. We performed the qualitative assessment as of February 28, 2021 and determined that it was not more likely than not that the fair value of each of our reporting units was less than that its applicable carrying value. Accordingly, we did not perform the quantitative goodwill impairment test for any of our reporting units during fiscal 2021.\nWe further test our indefinite-lived intangible asset balance of $47,857,000 consisting of trademarks on our acquisitions on an annual basis for impairment. Similar to goodwill, we first assess various qualitative factors in the analysis. If, after completing this assessment, it is determined that it is more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying value, we proceed to a quantitative impairment test. We performed the qualitative assessment as of February 28, 2021 and determined that it was not more likely than not that the fair value of each of our indefinite-lived intangible assets was less than that its applicable carrying value.\nEffects of New Accounting Pronouncements\nInformation regarding the effects of new accounting pronouncements is included in Note 21 to the accompanying consolidated financial statements included in this Annual Report on Form 10-K.\n28\n\nItem 7A.\nQuantitative and Qualitative Disclosures About Market Risk\nMarket risk is the potential loss arising from adverse changes in market rates and prices, such as interest rates. We are exposed to various market risks, including commodity prices for raw materials, foreign currency exchange rates, and changes in interest rates. We may enter into financial instrument transactions, which attempt to manage and reduce the impact of such changes. We do not enter into derivatives or other financial instruments for trading or speculative purposes.\nOur costs are affected by inflation in the U.S. economy and, to a lesser extent, in non-U.S. economies including those of Europe, Canada, Mexico, South America, and Asia-Pacific. We do not believe that general inflation has had a material effect on our results of operations over the periods presented primarily due to overall low inflation levels over such periods and our ability to generally pass on rising costs through annual price increases. However, increases in U.S. employee benefits costs such as health insurance and workers compensation insurance have exceeded general inflation levels. In the future, we may be further affected by inflation that we may not be able to pass on as price increases. With changes in worldwide demand for steel and fluctuating scrap steel prices over the past several years, we experienced fluctuations in our costs that we have reflected as price increases to our customers. We believe we have been successful in instituting price increases to pass on these material cost increases. The company is exposed to trade tariffs with China. The Company monitors the impact of tariffs and actively works to mitigate this impact through material productivity actions and pricing strategies. We will continue to monitor our costs and reevaluate our pricing policies.\nWe have been, and may continue to be, materially and adversely impacted by the effects of COVID-19. In addition to global macroeconomic effects, the COVID-19 outbreak and any other related adverse public health developments have caused, and are expected to continue to cause, disruption to both our domestic and international operations and sales activities. The continued operation of our facilities is subject to local laws and regulations. While all of our facilities have been deemed essential under applicable law, there is no guarantee this will continue. Our third-party manufacturers, suppliers, distributors, sub-contractors and customers have been, and are expected to continue to be, disrupted by worker absenteeism, quarantines and restrictions on their employees’ ability to work, office and factory closures, disruptions to ports and other shipping infrastructure, border closures, and other travel or health-related restrictions. Depending on the magnitude of such effects on our manufacturing operations or the operations of our suppliers, third-party distributors, or sub-contractors, our supply chain, manufacturing and product shipments have been, and in the future may continue to be, delayed, which could adversely affect our business, operations, and customer relationships. In addition, COVID-19 or other disease outbreaks will in the short-run and may over the longer term adversely affect the economies and financial markets of many countries, which could result in an economic downturn that could affect demand for our products and impact our operating results. There can be no assurance that any decrease in sales resulting from the COVID-19 will be offset by increased sales in subsequent periods. Although the magnitude of the impact of the COVID-19 outbreak on our business and operations remains uncertain, the continued spread of the COVID-19 or the occurrence of other epidemics and the imposition of related public health measures and travel and business restrictions has, and may in the future continue to, adversely impact our business, financial condition, operating results and cash flows.\nIn fiscal 2021, 47% of our net sales were from manufacturing plants and sales offices in foreign jurisdictions. We manufacture our products in the United States, China, Germany, United Kingdom, Hungary, Mexico, and France and sell our products in over 50 countries. Our results of operations could be affected by factors such as changes in foreign currency rates or weak economic conditions in foreign markets. With our fiscal year 2017 acquisition of STAHL, we have an increased presence in the United Arab Emirates, with total assets of approximately $6,000,000. Our operating results are exposed to fluctuations between the U.S. Dollar and the Canadian Dollar, European currencies, the South African Rand, the Mexican Peso, the Brazilian Real, and the Chinese Yuan. For example, when the U.S. dollar weakens against the Euro, the value of our net sales and net income denominated in Euros increases when translated into U.S. dollars for inclusion in our consolidated results. We are also exposed to foreign currency fluctuations in relation to purchases denominated in foreign currencies. Our foreign currency risk is mitigated since the majority of our foreign operations’ net sales and the related expense transactions are denominated in the same currency, which reduces the impact of a significant change in foreign exchange rates on net income. For example, a 10% change in the value of the U.S. dollar in relation to our most significant foreign currency exposures would have had an impact of approximately $3,200,000 on our income from operations. In addition, the majority of our export sale transactions are denominated in U.S. dollars.\nThe Company has a cross currency swap agreement that is designated as a cash flow hedge to hedge changes in the value of an intercompany loan to a foreign subsidiary due to changes in foreign exchange rates. This intercompany loan is related to the acquisition of STAHL. As of March 31, 2021, the notional amount of this derivative was $159,520,000, and the contract matures on January 31, 2022. From its March 31, 2021 balance of AOCL, the Company expects to reclassify approximately $653,000 out of AOCL, and into foreign currency exchange loss (gain), during the next 12 months based on the contractual payments due under this intercompany loan.\n29\nThe Company has foreign currency forward agreements that are designated as cash flow hedges to hedge a portion of forecasted inventory purchases denominated in foreign currencies. The notional amount of those derivatives is $6,457,000 and all contracts mature by March 31, 2022. From its March 31, 2021 balance of AOCL, the Company expects to reclassify approximately $57,000 out of AOCL during the next 12 months based on the underlying transactions of the sales of the goods purchased.\nThe Company's policy is to maintain a capital structure that is comprised of 50-70% of fixed rate long-term debt and 30-50% of variable rate long-term debt. The Company has two interest rate swap agreements in which the Company receives interest at a variable rate and pays interest at a fixed rate. These interest rate swap agreements are designated as cash flow hedges to hedge changes in interest expense due to changes in the variable interest rate of the senior secured term loan. The amortizing interest rate swaps mature by December 31, 2023 and had a total notional amount of $119,820,000 as of March 31, 2021. The effective portion of the changes in fair values of the interest rate swaps is reported in AOCL and will be reclassified to interest expense over the life of the swap agreements. From its March 31, 2021 balance of AOCL, the Company expects to reclassify approximately $901,000 out of AOCL, and into interest expense, during the next 12 months.\n30\n\nItem 8.\nFinancial Statements and Supplemental Data.\nINDEX TO CONSOLIDATED FINANCIAL STATEMENTS\nColumbus McKinnon Corporation\nAudited Consolidated Financial Statements as of March 31, 2021:\n| Report of Independent Registered Public Accounting Firm | 33 |\n| Consolidated Balance Sheets | 36 |\n| Consolidated Statements of Operations | 37 |\n| Consolidated Statements of Comprehensive Income | 38 |\n| Consolidated Statements of Shareholders’ Equity | 39 |\n| Consolidated Statements of Cash Flows | 40 |\n| Notes to Consolidated Financial Statements |\n| 1 | Description of Business | 41 |\n| 2 | Accounting Principles and Practices | 41 |\n| 3 | Acquisitions & Disposals | 45 |\n| 4 | Revenue & Receivables | 48 |\n| 5 | Fair Value Measurements | 51 |\n| 6 | Inventories | 54 |\n| 7 | Marketable Securities and Other Investments | 54 |\n| 8 | Property, Plant, and Equipment | 55 |\n| 9 | Goodwill and Intangible Assets | 55 |\n| 10 | Derivative Instruments | 57 |\n| 11 | Accrued Liabilities and Other Non-current Liabilities | 59 |\n| 12 | Debt | 60 |\n| 13 | Pensions and Other Benefit Plans | 62 |\n| 14 | Employee Stock Ownership Plan (\"ESOP\") | 68 |\n| 15 | Earnings per Share and Stock Plans | 68 |\n| 16 | Loss Contingencies | 73 |\n| 17 | Income Taxes | 78 |\n| 18 | Leases | 81 |\n| 19 | Business Segment Information | 83 |\n| 20 | Accumulated Other Comprehensive Loss | 85 |\n| 21 | Effects of New Accounting Pronouncements | 87 |\n| Schedule II – Valuation and Qualifying Accounts. | 89 |\n\n31\nReport of Independent Registered Public Accounting Firm\nTo the Shareholders and the Board of Directors of Columbus McKinnon Corporation\nOpinion on the Financial Statements\nWe have audited the accompanying consolidated balance sheets of Columbus McKinnon Corporation (the Company) as of March 31, 2021 and 2020, the related consolidated statements of operations, comprehensive income, shareholders' equity and cash flows for each of the three years in the period ended March 31, 2021, and the related notes and financial statement schedule listed in the Index at Item 15(2) (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at March 31, 2021 and 2020, and the results of its operations and its cash flows for each of the three years in the period ended March 31, 2021, in conformity with U.S. generally accepted accounting principles.\nWe also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of March 31, 2021, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework), and our report dated May 26, 2021, expressed an unqualified opinion thereon.\nBasis for Opinion\nThese financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.\nWe conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.\nCritical Audit Matters\nThe critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate.\n32\n\n| Valuation of Goodwill |\n| Description of the Matter | At March 31, 2021, the Company’s goodwill was $331.2 million. As discussed in Notes 2 and 9 of the consolidated financial statements, goodwill is qualitatively assessed and quantitatively tested, when necessary, for impairment at least annually at the reporting unit level. For its fiscal 2021 annual impairment test, the Company qualitatively tested goodwill impairment for the Rest of Products reporting unit which had goodwill of $321.5 million. Auditing management's qualitative assessment for goodwill impairment for the Rest of Products reporting unit was complex and highly judgmental due to the significant judgments required in evaluating whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. In particular, the qualitative assessment requires management to assess the totality of events and circumstances such as macroeconomic conditions, industry and market conditions, overall financial performance, as well as other drivers of fair value and make judgments, on the basis of the weight of evidence, about the significance of all identified events and circumstances in the context of determining whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. |\n| How We Addressed the Matter in Our Audit | We obtained an understanding, evaluated the design and tested the operating effectiveness of controls over the Company’s goodwill impairment review process. Our procedures included, among others, testing management’s review and assessment of the qualitative factors considered in its evaluation. To test the Company’s qualitative assessment for goodwill impairment, we performed audit procedures that included, among others, inspecting the analysis prepared by management and evaluating the evidence gathered by management in support of its assessment of the events and circumstances discussed above. We considered the results of management’s most recent quantitative test as well as events that have occurred since that test was performed. We compared forecasts utilized by management in its most recent quantitative test to actual results. We inspected and analyzed other third-party evidence about, among other things, macroeconomic conditions and their expected trends, long-term growth rates, as well as industry and market conditions and their expected trends. We evaluated the evidence of these conditions and trends that had been gathered by management by agreeing the financial data presented by management to underlying financial records, as well as comparing market conditions and expected trends to economic and industry data. We also inspected evidence about other relevant entity-specific events such as changes in management, key personnel, strategy, or customers, or litigation and qualitatively assessed the impact of those events on the fair value of the Company’s Rest of Products reporting unit.In addition, we analyzed trends in the Company’s stock price to identify changes in the indicated fair value of the Company and compared the Company’s stock quotes to quoted market price from other independent sources, and we analyzed the Company’s weighted average cost of capital and compared it to the weighted average cost of capital used by management in its most recent quantitative test. |\n| Product Liabilities and Related Legal Costs |\n| Description of the Matter | At March 31, 2021 the Company’s liability for asbestos-related product liability claims and related legal costs was $15.0 million. As discussed in Note 16 to the consolidated financial statements, the Company is involved in asbestos-related litigation the cost of which is paid through a wholly-owned captive insurance company. Auditing management's estimate of its reserves for asbestos-related product liabilities is complex and highly judgmental due to the significant estimation and judgment required in determining the ultimate outcomes of the cases asserted against the Company and in determining the ultimate costs for the Company to defend against such claims. In particular, the estimated product liability reserve is sensitive to significant assumptions such as case dismissal rates, the number of years case activity might continue, legal and other costs to defend claims. The cost to defend claims takes into consideration the extent to which insurance carriers, under pre-existing insurance policies and pursuant to a legal settlement, are covering future indemnity payments and sharing in payment of future legal defense costs. |\n\n33\n\n| How We Addressed the Matter in Our Audit | We obtained an understanding, evaluated the design and tested the operating effectiveness of controls over the Company’s product liability estimation process. Our procedures included, among others, testing management’s review of significant assumptions used for purposes of calculating the estimated liability. To test the estimated liability for asbestos-related product liability claims, we performed audit procedures that included, among others, testing the completeness and accuracy of the asbestos-related claims data underlying the estimated liability. We compared forecasts of legal defense costs and dismissal ratios utilized by management in prior year reserve estimates to actual defense costs incurred and the actual ratios of asbestos claims asserted to claims dismissed. We inspected analyses prepared by the Company to support the current forecasts of defense costs and dismissal ratios. We inspected correspondence from the Company’s internal counsel as to the number and status of outstanding claims asserted and correspondence from external counsel to evaluate the information provided by management. We involved a specialist to assist with our procedures and to develop an independent range of asbestos-related product liability reserves, which we compared to the Company’s recorded amount. |\n\n| /s/ Ernst & Young LLP |\n| We have served as the Company’s auditor since at least 1917, but we are unable to determine the specific year. |\n| Buffalo, New York |\n| May 26, 2021 |\n\n34\nCOLUMBUS McKINNON CORPORATION\nCONSOLIDATED BALANCE SHEETS\n\n| March 31, |\n| 2021 | 2020 |\n| (In thousands, except share data) |\n| ASSETS |\n| Current assets: |\n| Cash and cash equivalents | $ | 202,127 | $ | 114,450 |\n| Trade accounts receivable, less allowance for doubtful accounts ($ 5,686 and $ 5,056 , respectively) | 105,464 | 123,743 |\n| Inventories | 111,488 | 127,373 |\n| Prepaid expenses and other | 22,763 | 17,180 |\n| Total current assets | 441,842 | 382,746 |\n| Net property, plant, and equipment | 74,753 | 79,473 |\n| Goodwill | 331,176 | 319,679 |\n| Other intangibles, net | 213,362 | 217,962 |\n| Marketable securities | 7,968 | 7,322 |\n| Deferred taxes on income | 20,080 | 26,281 |\n| Other assets | 61,251 | 59,809 |\n| Total assets | $ | 1,150,432 | $ | 1,093,272 |\n| LIABILITIES AND SHAREHOLDERS’ EQUITY |\n| Current liabilities: |\n| Trade accounts payable | $ | 68,593 | $ | 57,289 |\n| Accrued liabilities | 110,816 | 93,585 |\n| Current portion of long-term debt | 4,450 | 4,450 |\n| Total current liabilities | 183,859 | 155,324 |\n| Term loan and revolving credit facility | 244,504 | 246,856 |\n| Other non-current liabilities | 191,920 | 227,507 |\n| Total liabilities | 620,283 | 629,687 |\n| Shareholders’ equity: |\n| Voting common stock: 50,000,000 shares authorized; 23,984,299 and 23,771,620 shares issued and outstanding | 240 | 238 |\n| Additional paid-in capital | 296,093 | 287,256 |\n| Retained earnings | 293,802 | 290,441 |\n| Accumulated other comprehensive loss | ( 59,986 ) | ( 114,350 ) |\n| Total shareholders’ equity | 530,149 | 463,585 |\n| Total liabilities and shareholders’ equity | $ | 1,150,432 | $ | 1,093,272 |\n\nSee accompanying notes.\n35\nCOLUMBUS McKINNON CORPORATION\nCONSOLIDATED STATEMENTS OF OPERATIONS\n\n| Year Ended March 31, |\n| 2021 | 2020 | 2019 |\n| (In thousands, except per share data) |\n| Net sales | $ | 649,642 | $ | 809,162 | $ | 876,282 |\n| Cost of products sold | 429,417 | 525,976 | 571,285 |\n| Gross profit | 220,225 | 283,186 | 304,997 |\n| Selling expenses | 76,907 | 91,054 | 97,925 |\n| General and administrative expenses | 76,035 | 77,880 | 83,567 |\n| Research and development expenses | 12,405 | 11,310 | 13,491 |\n| Net loss on sales of businesses, including impairment | — | 176 | 25,672 |\n| Amortization of intangibles | 12,623 | 12,942 | 14,900 |\n| Income from operations | 42,255 | 89,824 | 69,442 |\n| Interest and debt expense | 12,081 | 14,234 | 17,144 |\n| Investment (income) loss, net | ( 1,693 ) | ( 891 ) | ( 727 ) |\n| Foreign currency exchange loss (gain), net | 941 | ( 1,514 ) | 843 |\n| Other (income) expense, net | 20,850 | 839 | ( 716 ) |\n| Income from continuing operations before income tax expense | 10,076 | 77,156 | 52,898 |\n| Income tax expense | 970 | 17,484 | 10,321 |\n| Net income | $ | 9,106 | $ | 59,672 | $ | 42,577 |\n| Average basic shares outstanding | 23,897 | 23,619 | 23,276 |\n| Average diluted shares outstanding | 24,173 | 23,855 | 23,660 |\n| Basic income per share | $ | 0.38 | $ | 2.53 | $ | 1.83 |\n| Diluted income per share | $ | 0.38 | $ | 2.50 | $ | 1.80 |\n| Dividends declared per common share | $ | 0.24 | $ | 0.24 | $ | 0.21 |\n\nSee accompanying notes.\n36\nCOLUMBUS McKINNON CORPORATION\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME\n| March 31, |\n| 2021 | 2020 | 2019 |\n| (In thousands) |\n| Net income | $ | 9,106 | $ | 59,672 | $ | 42,577 |\n| Other comprehensive income (loss), net of tax: |\n| Foreign currency translation adjustments | 12,583 | ( 9,004 ) | ( 16,708 ) |\n| Pension liability adjustments, net of taxes of $( 13,261 ), $ 8,062 and $ 2,242 | 41,571 | ( 24,051 ) | ( 5,711 ) |\n| Other post retirement obligations adjustments, net of taxes of $( 12 ), $( 35 ), and $( 126 ) | 38 | 104 | 475 |\n| Split-dollar life insurance arrangement adjustments, net of taxes of $( 24 ), $( 17 ), and $( 18 ) | 76 | 51 | 69 |\n| Change in derivatives qualifying as hedges, net of taxes of $( 8 ), $( 565 ), and $ 469 | 96 | 1,602 | ( 1,037 ) |\n| Total other comprehensive income (loss) | 54,364 | ( 31,298 ) | ( 22,912 ) |\n| Comprehensive income | $ | 63,470 | $ | 28,374 | $ | 19,665 |\n\nSee accompanying notes.\n37\nCOLUMBUS McKINNON CORPORATION\nCONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY\n(In thousands, except share data)\n| CommonStock($0.01 par value) | Additional Paid-inCapital | RetainedEarnings | AccumulatedOther Comprehensive Loss | TotalShareholders’Equity |\n| Balance at April 1, 2018 | $ | 230 | $ | 269,360 | $ | 197,897 | $ | ( 59,258 ) | $ | 408,229 |\n| Net income 2019 | — | — | 42,577 | — | 42,577 |\n| Dividends declared | — | — | ( 4,903 ) | — | ( 4,903 ) |\n| Change in accounting principle | — | — | 888 | — | 888 |\n| Change in foreign currency translation adjustment | — | — | — | ( 16,708 ) | ( 16,708 ) |\n| Change in net unrealized gain on investments, net of tax of | — | — | — | ( 883 ) | ( 883 ) |\n| Change in derivatives qualifying as hedges, net of tax of $ 469 | — | — | — | ( 1,037 ) | ( 1,037 ) |\n| Change in pension liability and postretirement obligations, net of tax of $ 2,097 | — | — | — | ( 5,166 ) | ( 5,166 ) |\n| Stock compensation - directors | — | 430 | — | — | 430 |\n| Stock options exercised, 187,907 shares | 4 | 4,148 | — | — | 4,152 |\n| Stock compensation expense | — | 5,768 | — | — | 5,768 |\n| Restricted stock units released, 157,715 shares, net of shares withheld for minimum statutory tax obligation | — | ( 2,188 ) | — | — | ( 2,188 ) |\n| Balance at March 31, 2019 | $ | 234 | $ | 277,518 | $ | 236,459 | $ | ( 83,052 ) | $ | 431,159 |\n| Net income 2020 | — | — | 59,672 | — | 59,672 |\n| Dividends declared | — | — | ( 5,690 ) | — | ( 5,690 ) |\n| Change in foreign currency translation adjustment | — | — | — | ( 9,004 ) | ( 9,004 ) |\n| Change in derivatives qualifying as hedges, net of tax of $( 565 ) | — | — | — | 1,602 | 1,602 |\n| Change in pension liability and postretirement obligations, net of tax of $ 8,010 | — | — | — | ( 23,896 ) | ( 23,896 ) |\n| Stock compensation - directors | — | 460 | — | — | 460 |\n| Stock options exercised, 296,027 shares | 3 | 5,997 | — | — | 6,000 |\n| Stock compensation expense | — | 4,047 | — | — | 4,047 |\n| Restricted stock units released, 82,861 shares, net of shares withheld for minimum statutory tax obligation | 1 | ( 766 ) | — | — | ( 765 ) |\n| Balance at March 31, 2020 | $ | 238 | $ | 287,256 | $ | 290,441 | $ | ( 114,350 ) | $ | 463,585 |\n| Net income 2021 | — | — | 9,106 | — | 9,106 |\n| Dividends declared | — | — | ( 5,745 ) | — | ( 5,745 ) |\n| Change in foreign currency translation adjustment | — | — | — | 12,583 | 12,583 |\n| Change in derivatives qualifying as hedges, net of tax of $( 8 ) | — | — | — | 96 | 96 |\n| Change in pension liability and postretirement obligations, net of tax of $( 13,297 ) | — | — | — | 41,685 | 41,685 |\n| Stock compensation - directors | — | 540 | — | — | 540 |\n| Stock options exercised, 97,398 shares | 2 | 1,971 | — | — | 1,973 |\n| Stock compensation expense | — | 7,482 | — | — | 7,482 |\n| Restricted stock units released, 115,281 shares, net of shares withheld for minimum statutory tax obligation | ( 1,156 ) | — | — | ( 1,156 ) |\n| Balance at March 31, 2021 | $ | 240 | $ | 296,093 | $ | 293,802 | $ | ( 59,986 ) | $ | 530,149 |\n\nSee accompanying notes.\n38\nCOLUMBUS McKINNON CORPORATION\nCONSOLIDATED STATEMENTS OF CASH FLOWS\n| Year ended March 31, |\n| 2021 | 2020 | 2019 |\n| Operating activities: | (In thousands) |\n| Net income | $ | 9,106 | $ | 59,672 | $ | 42,577 |\n| Adjustments to reconcile net income to net cash provided by (used for) operating activities: |\n| Depreciation and amortization | 28,153 | 29,126 | 32,675 |\n| Deferred income taxes and related valuation allowance | ( 8,704 ) | 7,364 | ( 958 ) |\n| Net loss (gain) on sale of real estate, investments and other | ( 1,594 ) | ( 563 ) | 194 |\n| Stock-based compensation | 8,022 | 4,507 | 6,198 |\n| Amortization of deferred financing costs | 2,646 | 2,655 | 2,655 |\n| Loss on sales of businesses | — | 176 | 25,672 |\n| Non-cash pension settlement expense (See Note 13) | 19,038 | — | — |\n| Gain on sale of building (See Note 3) | ( 2,638 ) | — | — |\n| Non-cash lease expense | 7,447 | 7,923 | — |\n| Changes in operating assets and liabilities, net of effects of business acquisitions and divestitures: |\n| Trade accounts receivable | 21,472 | 2,899 | ( 11,328 ) |\n| Inventories | 20,659 | 15,752 | ( 15,411 ) |\n| Prepaid expenses and other | ( 5,128 ) | ( 3,857 ) | ( 128 ) |\n| Other assets | 874 | 724 | 231 |\n| Trade accounts payable | 10,343 | 8,110 | 3,881 |\n| Accrued liabilities | ( 3,174 ) | ( 14,304 ) | 6,397 |\n| Non-current liabilities | ( 7,632 ) | ( 13,389 ) | ( 13,156 ) |\n| Net cash provided by (used for) operating activities | 98,890 | 106,795 | 79,499 |\n| Investing activities: |\n| Proceeds from sales of marketable securities | 5,111 | 5,380 | 3,266 |\n| Purchases of marketable securities | ( 4,945 ) | ( 5,747 ) | ( 2,604 ) |\n| Capital expenditures | ( 12,300 ) | ( 9,432 ) | ( 12,288 ) |\n| Proceeds from sale of building, net of transaction costs | 5,453 | — | — |\n| Proceeds from insurance reimbursement | 100 | — | — |\n| Dividend received from equity method investment | 587 | — | — |\n| Proceeds from sale of fixed assets | 446 | 51 | 176 |\n| Net (payments) proceeds from the sales of businesses | — | ( 214 ) | 14,230 |\n| Payment of restricted cash to former owner | — | — | ( 294 ) |\n| Net cash provided by (used for) investing activities | ( 5,548 ) | ( 9,962 ) | 2,486 |\n| Financing activities: |\n| Proceeds from issuance of common stock | 1,973 | 6,000 | 4,152 |\n| Borrowings under line-of-credit agreements | 25,000 | — | — |\n| Payments under line-of-credit agreements | ( 25,000 ) | — | — |\n| Repayment of debt | ( 4,450 ) | ( 51,113 ) | ( 65,088 ) |\n| Fees paid for revolver extension | ( 826 ) | — | — |\n| Payment of dividends | ( 5,733 ) | ( 5,670 ) | ( 4,652 ) |\n| Other | ( 1,153 ) | ( 768 ) | ( 2,190 ) |\n| Net cash provided by (used for) financing activities | ( 10,189 ) | ( 51,551 ) | ( 67,778 ) |\n| Effect of exchange rate changes on cash | 4,524 | ( 1,925 ) | ( 6,429 ) |\n| Net change in cash and cash equivalents | 87,677 | 43,357 | 7,778 |\n| Cash, cash equivalents, and restricted cash at beginning of year | 114,700 | 71,343 | 63,565 |\n| Cash, cash equivalents, and restricted cash at end of year | $ | 202,377 | $ | 114,700 | $ | 71,343 |\n| Supplementary cash flows data: |\n| Interest paid | $ | 9,451 | $ | 11,555 | $ | 14,411 |\n| Income taxes paid, net of refunds | $ | 10,186 | $ | 11,601 | $ | 4,840 |\n| Property, plant and equipment purchases included in trade accounts payable | $ | 730 | $ | 365 | $ | 227 |\n| Restricted cash presented in Other assets | $ | 250 | $ | 250 | $ | 250 |\n\nSee accompanying notes.\n39\nCOLUMBUS McKINNON CORPORATION\nNOTES TO CONSOLIDATED FINANCIAL STATEMENTS\n(tabular amounts in thousands, except share data)\n1. Description of Business\nColumbus McKinnon Corporation (\"the Company\") is a leading worldwide designer, manufacturer, and marketer of hoists, actuators, rigging tools, digital power control systems, motion control products, and other technologies, systems, and services that efficiently and ergonomically move, lift, position, and secure materials. Key products include hoists, rigging tools, digital power control systems, actuators, elevator application drive systems, and explosion-protected hoists. The Company is focused on commercial and industrial applications that require safety and productivity in moving material. The Company’s targeted market verticals include general industrial, construction and infrastructure, mining, oil & gas, energy, aerospace, transportation, automotive, heavy equipment manufacturing, and entertainment.\nThe Company’s material handling products are sold globally, principally to third party distributors through diverse distribution channels and, to a lesser extent, directly to end-users. During fiscal 2021, approximately 53 % of sales were to customers in the United States .\n2. Accounting Principles and Practices\nAdvertising\nCosts associated with advertising are expensed as incurred and are included in Selling expense in the Consolidated Statements of Operations. Advertising expenses were $ 999,000 , $ 1,648,000 , and $ 2,452,000 in fiscal 2021, 2020, and 2019, respectively. The decrease in fiscal 2021 was due to reduced spending including fewer trade shows expenses as a result of COVID-19.\nCash and Cash Equivalents\nThe Company considers as cash equivalents all highly liquid investments with an original maturity of three months or less.\nConcentrations of Labor\nApproximately 8 % of the Company’s employees are represented by two separate U.S. collective bargaining agreements which expire in June 2021 and September 2021.\nConsolidation\nThese consolidated financial statements include the accounts of the Company and its global subsidiaries; all significant intercompany accounts and transactions have been eliminated.\nEquity Method Investment\nThe Company has an investment in Eastern Morris Cranes Company Limited (\"EMC\") whose principal activity is to manufacture various electrical overhead traveling cranes. This investment represents a minority ownership interest that is accounted for under the equity method of accounting since the Company has significant influence over the investee. As a result, the Company records its portion of the gains and losses incurred by this entity in Investment (income) loss in the Consolidated Statements of Operations.\nForeign Currency Translations\nThe Company translates foreign currency financial statements as described in Financial Accounting Standards Board (\"FASB\") Accounting Standards Codification (\"ASC\") Topic 830, “Foreign Currency Matters.” Under this method, all items of income and expense are translated to U.S. dollars at average exchange rates during the year. All assets and liabilities are translated to U.S. dollars at the year-end exchange rate. Gains or losses on translations are recorded in accumulated other comprehensive loss\n40\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nin the shareholders’ equity section of the balance sheet. The functional currency is the foreign currency in which the foreign subsidiaries conduct their business. Gains and losses from foreign currency transactions are reported in foreign currency exchange loss (gain).\nGoodwill\nGoodwill is not amortized but is tested for impairment at least annually, or more frequently if indicators of impairment exist, in accordance with the provisions of ASC Topic 350-20-35-1. Goodwill impairment is deemed to exist if the net book value of a reporting unit exceeds its estimated fair value. The fair value of a reporting unit is determined using a discounted cash flow methodology. The Company’s reporting units are determined based upon whether discrete financial information is available and reviewed regularly, whether those units constitute a business, and the extent of economic similarities and interdependencies between those reporting units for purposes of aggregation. The Company’s reporting units identified under ASC Topic 350-20-35-33 are at the component level, or one level below the reporting segment level as defined under ASC Topic 280-10-50-10 “Segment Reporting – Disclosure.” As of March 31, 2021, the Company’s one segment is subdivided into two reporting units. Further, the Company adopted ASU No. 2017-04, \"Simplifying the Test for Goodwill Impairment (Topic 350),\" in fiscal 2018, therefore, is no longer required to compare the implied fair value of goodwill with its carrying value amount as part of step two of the goodwill test. An impairment charge is the amount by which the carrying value is greater than the reporting unit's fair value.\nWhen the Company evaluates the potential for goodwill impairment, it assesses a range of qualitative factors including, but not limited to, macroeconomic conditions, industry conditions, the competitive environment, changes in the market for its products and services, regulatory and political developments, entity specific factors such as strategy and changes in key personnel, and overall financial performance. If, after completing this assessment, it is determined that it is more likely than not that the fair value of a reporting unit is less than its carrying value or if economic or other business factors indicate that the fair value of our reporting units may have declined since our last quantitative test, the Company performs a quantitative test.\nTo perform the quantitative impairment test, the Company uses the discounted cash flow method and a market-based valuation model to estimate the fair value of the reporting units. The discounted cash flow method incorporates various assumptions, the most significant being projected revenue growth rates, operating profit margins and cash flows, the terminal growth rate, and the discount rate. The Company projects revenue growth rates, operating margins and cash flows based on each reporting unit's current business, expected developments, and operational strategies over a five-year period. In estimating the terminal growth rates, the Company considers its historical and projected results, as well as the economic environment in which its reporting units operate. The discount rates utilized for each reporting unit reflect the Company's assumptions of marketplace participants' cost of capital and risk assumptions, both specific to the reporting unit and overall in the economy.\nThe Company performed its qualitative assessment as of February 28, 2021 and determined that the quantitative goodwill impairment test was not required for the Rest of Products and Duff-Norton reporting units. Based on various conditions in the current fiscal year, such as financial performance, macroeconomic conditions, and other company specific events, it was determined that the Rest of Products and Duff-Norton's reporting unit's fair value was not more likely than not less than its applicable carrying value. See Note 9 for further discussion of goodwill and intangible assets.\nImpairment of Long-Lived Assets\nThe Company assesses impairment of its long-lived assets in accordance with the provisions of ASC Topic 360 “Property, Plant, and Equipment.” This statement requires long-lived assets, such as property and equipment and purchased intangibles subject to amortization, to be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset group to estimated undiscounted future cash flows expected to be generated by the asset group over its remaining useful life. If the carrying amount of an asset group exceeds its estimated future cash flows, an impairment charge is recognized equal to the amount by which the carrying amount of the asset group exceeds the fair value of the asset group. The fair values are determined in accordance with ASC 820.\nIn assessing long-lived assets for an impairment loss, assets are grouped with other assets and liabilities at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. Asset grouping requires a significant amount of judgment. Accordingly, facts and circumstances will influence how asset groups are determined for\n41\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nimpairment testing. In assessing long-lived assets for impairment, management considered the Company’s product line portfolio, customers and related commercial agreements, labor agreements and other factors in grouping assets and liabilities at the lowest level for which identifiable cash flows are independent. The Company considers projected future undiscounted cash flows, trends and other factors in its assessment of whether impairment conditions exist. While the Company believes that its estimates of future cash flows are reasonable, different assumptions regarding such factors as future production volumes, customer pricing, economics, and productivity and cost initiatives, could significantly affect its estimates. In determining fair value of long-lived assets, management uses management estimates, discounted cash flow calculations, and appraisals where necessary. There were no impairments recorded related to long-lived assets in the current year.\nIntangible Assets\nAt acquisition, the Company estimates and records the fair value of purchased intangible assets which primarily consist of trade names, customer relationships, and technology. The fair values are estimated based on management’s assessment as well as independent third party appraisals. Such valuations may include a discounted cash flow of anticipated revenues resulting from the acquired intangible asset.\nAmortization of intangible assets with finite lives is recognized over their estimated useful lives using an amortization method that reflects the pattern in which the economic benefits of the intangible assets are consumed or otherwise realized. The straight line method is used for customer relationships. As a result of the negligible attrition rate in our customer base, the difference between the straight line method and attrition method is not considered significant. The estimated useful lives for our intangible assets range from 1 to 25 years.\nSimilar to goodwill, indefinite-lived intangible assets (including trademarks on our acquisitions) are tested for impairment on an annual basis. When the Company evaluates the potential for impairment of intangible assets, it assesses a range of qualitative factors including, but not limited to, macroeconomic conditions, industry conditions, the competitive environment, changes in the market for its products and services, regulatory and political developments, entity specific factors such as strategy and changes in key personnel, and overall financial performance. If, after completing this assessment, it is determined that it is more likely than not that the fair value of an indefinite-lived intangible asset is greater than its carrying value, we conclude that the indefinite-lived intangible asset is not impaired. If, after completing this assessment, it is determined that it is more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying value or if economic or other business factors indicate that the fair value of our indefinite-lived intangible assets may have declined since our last quantitative test, the Company performs a new quantitative test. The methodology used to value trademarks is the relief from royalty method. The recorded book value of these trademarks in excess of the calculated fair value triggers an impairment. The key estimate used in this calculation consists of an overall royalty rate applied to the sales covered by the trademark. After performing a qualitative assessment as of February 28, 2021, it was determined that the trademarks were not impaired.\nInventories\nInventories are valued at the lower of cost and net realizable value. Cost of approximately 39 % of inventories at March 31, 2021 and 36 % at March 31, 2020 have been determined using the LIFO (last-in, first-out) method. Costs of other inventories have been determined using the FIFO (first-in, first-out) or average cost method. FIFO cost approximates replacement cost. Costs in inventory include components for direct labor and overhead costs.\nMarketable Securities\nThe Company’s marketable securities, which consist of equity and fixed income securities, are recorded at fair value. Under ASU 2016-01 all equity investments (including certain fixed income securities) in unconsolidated entities are measured at fair value through earnings. Therefore, gains and losses on marketable securities are realized within Investment (income) loss on the Consolidated Statements of Operations. Estimated fair value is based on published trading values at the balance sheet dates. The cost of securities sold is based on the specific identification method. Interest and dividend income are also included in Investment (income) loss on the Consolidated Statements of Operations.\nThe marketable securities are carried as long-term assets since they are held for the settlement of the Company’s general and products liability insurance claims filed through CM Insurance Company, Inc., a wholly owned captive insurance subsidiary. The marketable securities are not available for general working capital purposes.\n42\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nProperty, Plant, and Equipment\nProperty, plant, and equipment are stated at cost and depreciated principally using the straight-line method over their respective estimated useful lives (buildings and building equipment— 15 to 40 years; machinery and equipment— 3 to 18 years). When depreciable assets are retired, or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is reflected in operating results.\nResearch and Development\nConsistent with prior periods, the Company continues to account for R&D expenses in accordance with the provisions of ASC 730 and are expensed as incurred.\nRevenue Recognition, Accounts Receivable, and Concentration of Credit Risk\nThe Company adopted ASC 606, \"Revenue from Contracts with Customers,\" in fiscal 2019. Revenue from contracts with customers for standard products is recognized when legal title and significant risk and rewards has transferred to the customer, which is generally at the time of shipment. This is the point in time when control is deemed to transfer to the customer. The Company also sells custom engineered products and services which are contracts that are typically completed within one quarter but can extend beyond one year in duration. The Company generally recognizes revenue for customer engineered products upon satisfaction of its performance obligation under the contract which typically coincides with project completion which is when the products and services are controlled by the customer. Control is typically achieved at the later of when legal title and significant risk and rewards have transferred to the customer or the customer has accepted the asset. For both standard products and custom engineered products, the transaction price is based upon the price stated in either the purchase order or contract. Refer to Note 4 for further details.\nAdditionally, the Company performs ongoing credit evaluations of its customers’ financial condition, but generally does not require collateral to support customer receivables. The credit risk is controlled through credit approvals, limits, and monitoring procedures. Accounts receivable are reported at net realizable value and do not accrue interest. The Company establishes an allowance for doubtful accounts based upon factors surrounding the credit risk of specific customers, historical trends, and other factors. Accounts receivable are charged against the allowance for doubtful accounts once all collection efforts have been exhausted. The Company does not routinely permit customers to return product. However, sales returns are permitted in specific situations and typically include a restocking charge or the purchase of additional product. As a result of ASU No. 2016-13, “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments,\" discussed in Note 21 and effective in fiscal 2021, the Company has updated its existing allowance for doubtful accounts policy to comply with the new standard.\nShipping and Handling Costs\nShipping and handling costs are a component of cost of products sold.\nStock-Based Compensation\nThe Company records stock-based compensation in accordance with ASC Topic 718, “Compensation – Stock Compensation.” This standard requires all equity-based payments to employees, including grants of employee stock options, to be recognized in the Consolidated Statements of Operations based on the grant date fair value of the award. Stock compensation expense is included in Cost of products sold, Selling, and General and administrative expense depending on the nature of the service of the employee receiving the award. The Company uses a straight-line method of attributing the value of stock compensation expense, subject to minimum levels of expense, based on vesting. See Note 15 for further discussion of stock-based compensation.\nLeases\nAll leases are reviewed for operating or finance classification at their inception. Rent expense for leases that contain scheduled rent increases is recognized on a straight-line basis over the lease term. As described in Note 18, the Company adopted ASC\n43\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\n842, \"Leases,\" effective April 1, 2019 whereas leases with terms greater than twelve months are recorded on the balance sheet as a right-of-use (\"ROU\") asset and corresponding lease liability. Refer to Note 18 for further details.\nUse of Estimates\nThe preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.\nWarranties\nThe Company offers warranties for certain products it sells. The specific terms and conditions of those warranties vary depending upon the product sold and the country in which the Company sold the product. As noted in the Revenue Recognition note (Note 4), the Company offers standard warranties which are typically 12 months in duration for standard products and 24 to 36 months for custom engineered products. These are assurance-type warranties that do not qualify as separate performance obligations under ASC 606. The Company estimates the costs that may be incurred under its standard warranties, based largely upon actual warranty repair costs history, and records a liability in the amount of such costs in the month that revenue is recognized. The resulting accrual balance is reviewed during the year. Factors that affect the Company’s warranty liability include the number of units sold, historical and anticipated rate of warranty claims, and cost per claim. Changes in the Company’s product warranty accrual are as follows:\n| March 31, |\n| 2021 | 2020 |\n| Balance at beginning of year | $ | 3,581 | $ | 3,634 |\n| Accrual for warranties issued | 2,319 | 2,723 |\n| Warranties settled | ( 2,778 ) | ( 2,548 ) |\n| Foreign currency translation | 206 | ( 228 ) |\n| Balance at end of year | $ | 3,328 | $ | 3,581 |\n\n3. Acquisitions & Disposals\nDisposals\nAs part of our business strategy, in the first quarter of fiscal 2019 the Company started the process to sell its Tire Shredder business, its crane builder business, Crane Equipment and Service Inc., and Stahlhammer Bommern GmbH, its European forging business acquired in 2014 (the \"Sold Businesses\") as they were no longer considered part of the core business or a strategic fit with the Company's long-term growth and operational objectives. On December 28, 2018, the Company sold its Tire Shredder business and recognized a gain. On February 28, 2019, the Company sold the remaining two businesses, Crane Equipment and Service Inc. and Stahlhammer Bommern GmbH, and recognized a loss. As such, there are no remaining businesses which meet the criteria as being held for sale in accordance with ASC 360-10-45-9, \"Property, Plant, and Equipment.\" The businesses were not deemed a strategic shift or significant to be considered discontinued operations.\nWhen businesses or asset groups meet the criteria as held for sale, they are recorded at the lesser of their carrying value or fair value less cost to sell. The Company recognized a gain on the sale of its Tire Shredder business in the amount of $ 1,059,000 during the twelve months ending March 31, 2019. The Company recognized a loss on Crane Equipment and Service Inc. and Stahlhammer Bommern GmbH in the amount of $ 26,731,000 during the twelve months ended March 31, 2019. The loss of $ 26,731,000 recognized during fiscal 2019 includes an impairment loss on the Sold Businesses in the amount of $ 27,753,000 . The impairment loss included a $ 6,174,000 reduction to goodwill, a $ 1,872,000 reduction to other intangible assets, a $ 12,830,000 reduction to property, plant, and equipment, and a $ 6,877,000 reduction to inventory. Both the gain and loss on sale of business were recorded in Net loss on sales of businesses, including impairment on the Consolidated Statements of Operations and was determined based on the selling price less carrying value, described further in Note 5. Additionally, net sales and pre-tax income (loss) before recognized gain or loss on sales for the three Sold Businesses was $ 34,195,000 and $ 3,623,000 for the twelve months ended March 31, 2019. In the twelve months ending March 31, 2020, the Company recognized an additional loss of $ 176,000 as a result of a final working capital adjustment.\n44\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nAs part of its Blueprint for Growth 2.0 strategy, the Company is consolidating its manufacturing footprint. The Company previously announced in fiscal 2019 the closure of its Salem, Ohio facility. In fiscal 2020 the Company announced its plans to consolidate its hoist manufacturing facility in Lisbon, Ohio with its Wadesboro, North Carolina and Damascus, Virginia facilities in fiscal 2021. The Salem, Ohio facility consolidation was completed during the first quarter of fiscal 2020 and the Lisbon, Ohio consolidation was completed during the nine months ended December 31, 2020. In total $ 1,797,000 , $ 2,958,000 , and $ 1,473,000 are included in Cost of products sold on the Consolidated Statements of Operations during the twelve months ended March 31, 2021, 2020, and 2019 respectively, related to the consolidation of the Salem and Lisbon facilities. Costs incurred include accelerated depreciation, accelerated lease costs, severance and other payroll related costs, costs to relocate inventory and machinery and equipment, and a payment of a previously recorded tax credit that will be refunded to the state.\nFurther, the Company closed one of its facilities located in France and consolidated these operations into one of its German facilities. During the twelve months ended March 31, 2021, $ 815,000 of costs are included in Cost of products sold, $ 327,000 in General and administrative expenses, and $ 94,000 included in Selling expenses on the Consolidated Statements of Operations related to this consolidation, which primarily are severance and legal costs.\nDuring fiscal 2021, the Company sold one of its owned manufacturing facilities in China as a result of its plan to consolidate two of its Hangzhou, China manufacturing facilities into one and reorganize its Asia Pacific operations. The Company received cash in the amount of 45 million RMB (approximately $ 6,363,000 ) from the buyer to purchase the facility which resulted in a gain of $ 2,638,000 , of which $ 2,189,000 is included in Cost of products sold and $ 449,000 is included in General and administrative expenses on the Consolidated Statements of Operations during the twelve months ended March 31, 2021. $ 1,455,000 of costs are included in General and administrative expenses and $ 296,000 are included in Selling expenses on the Consolidated Statements of Operations during the twelve months ended March 31, 2020 related to this consolidation.\nAcquisitions - subsequent to March 31, 2021\nOn April 7, 2021, the Company completed its acquisition of Dorner Mfg. Corp. (\"Dorner\") for $ 485,000,000 on a cash-free, debt-free basis with a working capital adjustment. Dorner, headquartered in Hartland, WI, is a leading automation solutions company providing unique, patented technologies in the design, application, manufacturing and integration of high-precision conveying systems. The acquisition of Dorner accelerates the Company’s shift to intelligent motion and serves as a platform to expand capabilities in advanced, higher technology automation solutions. Dorner is a leading supplier to the life sciences, food processing, and consumer packaged goods markets as well as the faster growing industrial automation and e-commerce sectors.\nAcquisition expenses incurred by the Company total $ 3,951,000 through March 31, 2021 and have been recorded in General and administrative expenses.\nTo finance the Dorner acquisition, on April 7, 2021 the Company entered into a $ 750,000,000 credit facility (\"First Lien Facilities\") with JPMorgan Chase Bank, N.A. (\"JPMorgan Chase Bank\"), PNC Capital Markets LLC, and Wells Fargo Securities LLC. The First Lien Facilities consist of a Revolving Facility (the “New Revolving Credit Facility”) in an aggregate amount of $ 100,000,000 and a $ 650,000,000 First Lien Term Facility (\"Bridge Facility\"). Proceeds from the Bridge Facility were used, among other things, to finance the purchase price for the Dorner acquisition, pay related fees, expenses and transaction costs, and refinance the Company's borrowings under its prior Term Loan and Revolver.\nThe key terms of the First Lien Facility are as follows:\n1) Bridge Facility: An aggregate $ 650,000,000 Bridge Facility which requires quarterly principal amortization of 0.25% with the remaining principal due at maturity date. In addition, if the Company has Excess Cash Flow (ECF) as defined in the Credit Agreement, the ECF Percentage of the Excess Cash Flow for each fiscal year minus optional prepayments of the Loans (except\nprepayments of Revolving Loans that are not accompanied by a corresponding permanent reduction of Revolving Commitments) pursuant to Section 2.10(a) of the Credit Agreement other than to the extent that any such prepayment is funded with the proceeds of Funded Debt, shall be applied toward the prepayment of the Bridge Facility. The ECF Percentage is defined as 50% stepping down to 25% or 0% based on the achievement of specified Secured Leverage Ratios as of the last day of such fiscal year.\n2) Revolver: An aggregate $ 100,000,000 secured revolving facility which includes sublimits for the issuance of standby letters of credit, swingline loans and multi-currency borrowings in certain specified foreign currencies.\n45\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\n3) Fees and Interest Rates: Commitment fees and interest rates are determined on the basis of either a Eurocurrency rate or a Base rate plus an applicable margin, which is based upon the Company's Total Leverage Ratio (as defined in the Credit Agreement) in the case of Revolver loans.\n4) Prepayments: Provisions permitting a Borrower to voluntarily prepay either the Bridge Facility or Revolver in whole or in part at any time, and provisions requiring certain mandatory prepayments of the Bridge Facility or Revolver on the occurrence of certain events which will permanently reduce the commitments under the Credit Agreement, each without premium or penalty, subject to reimbursement of certain costs of the Lenders. A prepayment premium of 1% of the principal amount of the First Lien Term Facility is required if the prepayment is associated with a Repricing Transaction and it were to occur within the first six months following the closing date.\n5) Covenants: Provisions containing covenants required of the Corporation and its subsidiaries including various affirmative and negative financial and operational covenants. The key financial covenant is triggered only on any date when any Extension of Credit under the Revolving Facility is outstanding (excluding any Letters of Credit) (the “Covenant Trigger”), and prohibits the Total Leverage Ratio for the Reference Period ended on such date from exceeding (i) 6.75:1.00 as of any date of determination prior to June 30, 2021, (ii) 5.75:1.00 as of any date of determination on June 30, 2021 and thereafter but prior to June 30, 2022, (iii) 4.75:1.00 as of any date of determination on June 30, 2022 and thereafter but prior to June 30, 2023 and (iv)\n3.50:1.00 as of any date of determination on June 30, 2023 and thereafter.\n6) Collateral: Obligations under the First Lien Facilities are secured by liens on substantially all assets of the Company and its material domestic subsidiaries.\nDebt and equity issuance costs were no t material in fiscal 2021.\nIn the first quarter of fiscal 2022, the Company expects to incur $ 6,272,000 in debt extinguishment costs, of which $ 5,946,000 relates to the Company's prior Term Loan and $ 326,000 relates to the Company's prior Revolver. These costs will be classified as Cost of debt refinancing in the Consolidated Statements of Operations.\nFurther, in fiscal 2022 the Company expects to record $ 5,432,000 in deferred financing costs on the First Lien Term Facility, which will be amortized over seven years. The Company expects to record $ 4,027,000 in deferred financings costs on the New Revolver, of which $ 3,050,000 is related to the new Revolver and $ 977,000 is carried over from the Company's prior Revolver as certain Revolver lenders increased their borrowing capacity. These balances will be amortized over five years and classified in Other assets since no funds are expected to be drawn on the New Revolver in the first quarter of fiscal 2022.\nIn addition to the debt borrowing described above, the Company commenced an underwritten public offering of 4,312,500 shares of its common stock at a price of $ 48.00 per share for total gross proceeds of $ 207,000,000 . The Company used all of the net proceeds from the equity offering to repay in part outstanding borrowings under its Bridge Facility. The equity offering closed on May 4, 2021. Following the repayment, the Bridge Facility was refinanced with a Term Loan B facility. The terms of the Term Loan B facility are similar to the terms for the Bridge Facility with the exception of the limits related to the financial covenants which are triggered only on any date when any Extension of Credit under the Revolving Facility is outstanding. The Term Loan B prohibits the Total Leverage Ratio on such date from exceeding (i) 6.75:1.00 as of any date of determination prior to June 30, 2021, (ii) 5.50:1.00 as of any date of determination on June 30, 2021 and thereafter but prior to June 30, 2022, (iii) 4.50:1.00 as of any date of determination on June 30, 2022 and thereafter but prior to June 30, 2023 and (iv) 3.50:1.00 as of any date of determination on June 30, 2023 and thereafter.\nFees paid on the portion of the First Lien Facilities that were associated with the Bridge Facility are expected to be expensed as part of Cost of debt refinancing in the Consolidated Statements of Operations in the amount of $ 8,531,000 in the first quarter of fiscal 2022.\nLastly, purchase accounting allocations are not complete at this time. The Company has identified intangible assets and expects to record balances related to trade names, technology, customer relationships, and goodwill. Further, pro forma financial information presenting the combined results of operations as if the acquisitions had occurred as of April 1, 2020 has not been disclosed because it is deemed impracticable to do so. This is due to the initial accounting for the business combination is incomplete at this time.\n46\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\n4. Revenue & Receivables\nRevenue Recognition:\nThe core principle under ASC 606 is for revenue to be recognized when a customer obtains control of promised goods or services in an amount that reflects the consideration we expect to receive in exchange for those goods or services. To achieve this core principle, the Company applies the following five steps:\n1) Identifying contracts with customers\nA contract with a customer exists when (i) the Company enters into an enforceable contract with a customer that defines each party’s rights regarding the goods or services to be transferred and identifies the related payment terms, (ii) the contract has commercial substance, and (iii) the Company determines that collection of substantially all consideration for goods and services that are transferred is probable based on the customer’s intent and ability to pay the promised consideration.\n2) Identify the performance obligations in the contract\nPerformance obligations promised in a contract are identified based on the products and services that will be transferred to the customer that are both capable of being distinct, whereby the customer can benefit from the good or service either on its own or together with other available resources, and are distinct in the context of the contract, whereby the transfer of the good or service is separately identifiable from other promises in the contract. To the extent a contract includes multiple promised goods and services, the Company must apply judgment to determine whether promised goods and services are capable of being distinct and distinct in the context of the contract. If these criteria are not met, the promised goods and services are accounted for as a combined performance obligation.\n3) Determine the transaction price\nThe transaction price is determined based on the consideration to which the Company will be entitled in exchange for transferring products and services to the customer. To the extent the transaction price includes variable consideration, the Company estimates the amount of variable consideration that should be included in the transaction price utilizing either the expected value method or the most likely amount method depending on the nature of the variable consideration. Variable consideration is included in the transaction price if, in the Company’s judgment, it is probable that a significant future reversal of cumulative revenue under the contract will not occur. Any estimates, including the effect of the constraint on variable consideration, are evaluated at each reporting period for any changes. In applying this guidance, the Company also considers whether any significant financing components exist.\n4) Allocate the transaction price to the performance obligations in the contract\nIf the contract contains a single performance obligation, the entire transaction price is allocated to the single performance obligation. Contracts that contain multiple performance obligations require an allocation of the transaction price to each performance obligation on a relative standalone selling price basis unless the transaction price is variable and meets the criteria to be allocated entirely to a performance obligation or to a distinct service that forms part of a single performance obligation.\n5) Recognize revenue when or as the Company satisfies a performance obligation\nThe Company determines whether it satisfies performance obligations either over time or at a point in time. Revenue is recognized over time if either 1) the customer simultaneously receives and consumes the benefits provided by the entity’s performance, 2) the entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced, or 3) the entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date. If the entity does not satisfy a performance obligation over time, the related performance obligation is satisfied at a point in time by transferring the control of a promised good or service to a customer. Examples of control are using the asset to produce goods or services, enhancing the value of other assets, settling liabilities, and holding or selling the asset. For over time recognition, ASC 606 requires the Company to select a single revenue recognition method for the performance obligation that faithfully depicts the Company’s performance in transferring control of\n47\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nthe goods and services. The guidance allows entities to choose between either an input method or an output method to measure progress toward complete satisfaction of a performance obligation.\nPerformance obligations\nThe Company has contracts with customers for standard products and custom engineered products and determines when and how to recognize revenue for each performance obligation based on the nature and type of contract following the five steps above.\nRevenue from contracts with customers for standard products is recognized when legal title and significant risk and rewards has transferred to the customer, which is generally at the time of shipment. This is the point in time when control is deemed to transfer to the customer. The Company sells standard products to customers utilizing purchase orders. Payment terms for these types of contracts generally require payment within 30-60 days. Each standard product is deemed to be a single performance obligation and the amount of revenue recognized is based on the negotiated price. The transaction price for standard products is based on the price reflected in each purchase order. Sales incentives are offered to customers who purchase standard products and include offers such as volume-based discounts, rebates for priority customers, and discounts for early cash payments. These sales incentives are accounted for as variable consideration included in the transaction price. Accordingly, the Company reduces revenue for these incentives in the period which the sale occurs and is based on the most likely amount method for estimating the amount of consideration the Company expects to receive. These sales incentive estimates are updated each reporting information as additional information becomes available.\nThe Company also sells custom engineered products and services which are contracts that are typically completed within one quarter but can extend beyond one year in duration. For custom engineered products, the transaction price is based upon the price stated in the contract. Variable consideration has not been identified as a significant component of transaction price for custom engineered products and services. The Company generally recognizes revenue for custom engineered products upon satisfaction of its performance obligation under the contract which typically coincides with project completion which is when the products and services are controlled by the customer. Control is typically achieved at the later of when legal title and significant risk and rewards have transferred to the customer or the customer has accepted the asset. These contracts often require either up front or installment payments. These types of contracts are generally accounted for as one performance obligation as the products and services are not separately identifiable. The promised services (such as inspection, commissioning, and installation) are essential in order for the delivered product to operate as intended on the customer’s site and the services are therefore highly interrelated with product functionality.\nFor most custom engineered products contracts, the Company determined that while there is no alternative use for the custom engineered products, the Company does not have an enforceable right to payment (which must include a reasonable profit margin) for performance completed to date in order to meet the over time revenue recognition criteria. Therefore, revenue is recognized at a point in time (when the contract is complete). For custom engineered products contracts that contain an enforceable right to payment (including reasonable profit margin) the Company satisfies the performance obligation over time and recognizes revenue based on the extent of progress towards completion of the performance obligation. The cost-to-cost measure of progress is an appropriate measure of progress toward satisfaction of performance obligations as this measure most accurately depicts the progress of work performed and transfer of control to the customers. Under the cost-to-cost measure of progress, the extent of progress toward completion is measured based on the ratio of costs incurred to date to the total estimated costs at completion of the performance obligation. Revenues are recognized proportionally as costs are incurred.\nSales and other taxes collected with revenue are excluded from revenue, consistent with the previous revenue standard. Shipping and handling costs incurred prior to shipment are considered activities required to fulfill the Company’s promise to transfer goods, and do not qualify as a separate performance obligation. Additionally, the Company offers standard warranties which are typically 12 months in duration for standard products and 24 to 36 months for custom engineered products. These types of warranties are included in the purchase price of the product and are deemed to be assurance-type warranties which are not accounted for as a separate performance obligation. Other performance obligations included in a contract (such as drawings, owner’s manuals, and training services) are immaterial in the context of the contract and are not recognized as a separate performance obligation.\nReconciliation of contract balances\n48\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nThe Company records a contract liability when cash is received prior to recording revenue. Some standard contracts require a down payment while most custom engineered contracts require installment payments. Installment payments for the custom engineered contracts typically require a portion due at inception while the remaining payments are due upon completion of certain performance milestones. For both types of contracts, these contract liabilities, referred to as customer advances, are recorded at the time payment is received and are included in Accrued liabilities on the Consolidated Balance Sheets. When the related performance obligation is satisfied, the contract liability is released into revenue.\nThe following table illustrates the balance and related activity for customer advances in fiscal 2021 and 2020 (in thousands):\n| Customer advances (contract liabilities) |\n| March 31, |\n| 2021 | 2020 |\n| Beginning balance | $ | 10,796 | $ | 11,501 |\n| Additional customer advances received | 35,815 | 36,058 |\n| Revenue recognized from customer advances included in the beginning balance | ( 10,796 ) | ( 11,501 ) |\n| Other revenue recognized from customer advances | ( 21,177 ) | ( 25,037 ) |\n| Other (1) | 735 | ( 225 ) |\n| Ending balance | $ | 15,373 | $ | 10,796 |\n\n(1) Other includes the impact of foreign currency translation\nDuring the twelve months ended March 31, 2021, revenue was recognized prior to the right to invoice the customer which resulted in a contract asset balance in the amount of $ 8,559,000 and $ 2,361,000 as of March 31, 2021 and March 31, 2020, respectively. Contract assets are included in Prepaid expenses and other assets on the Consolidated Balance Sheets.\nRemaining Performance Obligations\nAs of March 31, 2021, the aggregate amount of the transaction price allocated to the performance obligations that are unsatisfied (or partially unsatisfied) was approximately $ 4,643,000 . We expect to recognize approximately 84 % of these sales over the next twelve months.\nDisaggregated revenue\nIn accordance with ASC 606, the Company is required to disaggregate revenue into categories that depict how economic factors affect the nature, amount, timing and uncertainty of revenue and cash flows. The following table illustrates the disaggregation of revenue by product grouping for the year ending March 31, 2021 (in thousands):\n| Twelve Months Ended | Twelve Months Ended |\n| Net Sales by Product Grouping | March 31, 2021 | March 31, 2020 |\n| Industrial Products | $ | 271,414 | $ | 353,155 |\n| Crane Solutions | 298,135 | 371,974 |\n| Engineered Products | 79,989 | 83,977 |\n| All other | 104 | 56 |\n| Total | $ | 649,642 | $ | 809,162 |\n\nIndustrial products include: manual chain hoists, electrical chain hoists, rigging/ clamps, industrial winches, hooks, shackles, and other forged attachments. Crane solutions products include: wire rope hoists, drives and controls, crane kits and components, and workstations. Engineered products include: linear and mechanical actuators, lifting tables, rail projects, and actuations systems. The All other product grouping includes miscellaneous revenue.\nPractical expedients\n49\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nIncremental costs to obtain a contract incurred by the Company primarily relate to sales commissions for contracts with a duration of one year or less. Therefore, these costs are expensed as incurred and are recorded in Selling Expenses on the Consolidated Statements of Operations.\nUnsatisfied performance obligations for contracts with an expected length of one year or less are not disclosed. Further, revenue from contracts with customers do not include a significant financing component as payment is generally expected within one year from when the performance obligation is controlled by the customer.\nAccounts Receivable:\nIn June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments” (“ASU 2016-13”). The standard changes the methodology for measuring credit losses on financial instruments and the timing of when such losses are recorded. The Company adopted this standard effective April 1, 2020 under the modified retrospective method whereas comparative period information is not restated. The adoption of this standard did not have a significant impact on the Company’s consolidated financial statements, therefore no cumulative effect or catch up adjustment to the opening balance of retained earnings was recorded. Additionally, the Company identified and implemented appropriate changes to its allowance for doubtful accounts policy and internal controls to support reporting and disclosures.\nUnder ASU 2016-13, the Company is required to remeasure expected credit losses for financial instruments held at the reporting date based on historical experience, current conditions and reasonable forecasts. In addition to these factors, the Company establishes an allowance for doubtful accounts based upon the credit risk of specific customers, historical trends, and other factors. Accounts receivable are charged against the allowance for doubtful accounts once all collection efforts have been exhausted. Due to the short-term nature of such accounts receivable, the estimated amount of accounts receivable that may not be collected is based on aging of the accounts receivable balances. In response to COVID-19, the Company continues to monitor the impact that COVID-19 is having on our customers and their outstanding receivable balances and is taking preventative measures, such as reducing credit limits and increasing bad debt expense, as necessary.\nThe following table illustrates the balance and related activity for the allowance for doubtful accounts that is deducted from accounts receivable to present the net amount expected to be collected in the twelve months ending March 31, 2021 (in thousands):\n| Allowance for doubtful accounts | March 31, 2021 |\n| April 1, beginning balance | $ | 5,056 |\n| Bad debt expense | 2,411 |\n| Less uncollectible accounts written off, net of recoveries | ( 1,973 ) |\n| Other (1) | 192 |\n| March 31, ending balance | $ | 5,686 |\n\n(1) Other includes the impact of foreign currency translation\n5. Fair Value Measurements\nASC Topic 820 “Fair Value Measurements and Disclosures” establishes the standards for reporting financial assets and liabilities and nonfinancial assets and liabilities that are recognized or disclosed at fair value on a recurring basis (at least annually). Under these standards, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e. the \"exit price\") in an orderly transaction between market participants at the measurement date.\nASC Topic 820-10-35-37 establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company's assumptions about the valuation techniques that market participants would use in pricing the asset or liability developed based on the best\n50\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\ninformation available in the circumstances. The hierarchy is separated into three levels based on the reliability of inputs as follows:\nLevel 1 - Valuations based on quoted prices in active markets for identical assets or liabilities that the Company has the ability to access. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment.\nLevel 2 - Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly, involving some degree of judgment.\nLevel 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement. The degree of judgment exercised in determining fair value is greatest for instruments categorized in Level 3.\nThe availability of observable inputs can vary and is affected by a wide variety of factors, including the type of asset/liability, whether the asset/liability is established in the marketplace, and other characteristics particular to the transaction. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, for disclosure purposes the level in the fair value hierarchy within which the fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety.\nFair value is a market-based measure considered from the perspective of a market participant rather than an entity-specific measure. Therefore, even when market assumptions are not readily available, assumptions are required to reflect those that market participants would use in pricing the asset or liability at the measurement date.\nThe Company primarily uses readily observable market data in conjunction with internally developed discounted cash flow valuation models when valuing its derivative portfolio and, consequently, the fair value of the Company’s derivatives is based on Level 2 inputs. The carrying amount of the Company's annuity contract is recorded at net asset value of the contract and, consequently, its fair value is based on Level 2 inputs and is included in other assets on the Company's Consolidated Balance Sheet. The Company uses quoted prices in an inactive market when valuing its term loan and, consequently, the fair value is based on Level 2 inputs.\nThe following table provides information regarding financial assets and liabilities measured or disclosed at fair value on a recurring basis:\n| Fair value measurements at reporting date using |\n| Quoted prices inactive markets foridentical assets | Significantother observableinputs | Significant unobservableinputs |\n| Description | At March31, 2021 | (Level 1) | (Level 2) | (Level 3) |\n| Assets/(Liabilities)Measured at fair value: |\n| Marketable securities | $ | 7,968 | $ | 7,968 | $ | — | $ | — |\n| Annuity contract | 2,025 | — | 2,025 | — |\n| Derivative assets (liabilities): |\n| Foreign exchange contracts | ( 83 ) | — | ( 83 ) | — |\n| Interest rate swap liability | ( 2,057 ) | — | ( 2,057 ) | — |\n| Cross currency swap liability | ( 13,895 ) | — | ( 13,895 ) | — |\n| Disclosed at fair value: |\n| Term loan | $ | ( 254,581 ) | $ | — | $ | ( 254,581 ) | $ | — |\n\n51\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\n| Fair value measurements at reporting date using |\n| Quoted prices inactive markets foridentical assets | Significantother observableinputs | Significant unobservableinputs |\n| Description | At March31, 2020 | (Level 1) | (Level 2) | (Level 3) |\n| Assets/(Liabilities)Measured at fair value: |\n| Marketable securities | $ | 7,322 | $ | 7,322 | $ | — | $ | — |\n| Annuity contract | 2,059 | — | 2,059 | — |\n| Derivative assets (liabilities): |\n| Foreign exchange contracts | 285 | — | 285 | — |\n| Interest rate swap asset | ( 3,296 ) | — | ( 3,296 ) | — |\n| Cross currency swap liability | ( 5,254 ) | — | ( 5,254 ) | — |\n| Cross currency swap asset | 1,750 | — | 1,750 | — |\n| Disclosed at fair value: |\n| Term loan | $ | ( 239,899 ) | $ | — | $ | ( 239,899 ) | $ | — |\n\nThe Company did not have any non-financial assets and liabilities that are recognized at fair value on a recurring basis.\nAt March 31, 2021, the term loan and revolving credit facility have been recorded at carrying value which approximates fair value.\nMarket gains, interest, and dividend income on marketable securities are recorded in investment (income) loss. Changes in the fair value of derivatives are recorded in foreign currency exchange (gain) loss or other comprehensive income (loss), to the extent that the derivative qualifies as a hedge under the provisions of ASC Topic 815. Interest and dividend income on marketable securities are measured based upon amounts earned on their respective declaration dates.\nFiscal 2021 Non-Recurring Measurements\nThere were no assets and liabilities measured at fair value on a non-recurring basis in Fiscal 2021.\nFiscal 2020 Non-Recurring Measurements\nThe fair value of the net assets of the Company’s Rest of Products and Duff-Norton reporting units were calculated on a non-recurring basis in fiscal 2020. These measurements have been used to quantitatively test goodwill for impairment on an annual basis under the provisions of ASC Topic 350-20-35-1 “Intangibles, Goodwill and Other – Goodwill Subsequent Measurement.” In fiscal 2021, the qualitative approach was used to determine if goodwill and indefinite-lived trademarks were impaired, and therefore, no non-recurring fair value measures were required in the analysis.\nThe fiscal 2020 goodwill impairment test consisted of determining the fair values of the Rest of Products and Duff-Norton reporting units on a quantitative basis. The fair value for the Company’s reporting units cannot be determined using readily available quoted Level 1 inputs or Level 2 inputs that are observable in active markets. Therefore, the Company used a blended discounted cash flow and market-based valuation model to estimate the fair value using Level 3 inputs. To estimate the fair values of the Rest of Products and Duff-Norton reporting units, the Company used significant estimates and judgmental factors. The key estimates and factors used in the discounted cash flow valuation include revenue growth rates and profit margins based on internal forecasts, terminal value, and the weighted-average cost of capital used to discount future cash flows. The estimates used are disclosed below:\n52\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\n| Rest of Products Reporting Unit | Duff-Norton Reporting Unit |\n| Compound annual growth rate | 1.91 | % | 5.68 | % |\n| Terminal value growth rate | 3.0 | % | 3.5 | % |\n| Weighted-average cost of capital | 11.7 | % | 12.2 | % |\n\nWe further test our indefinite-lived intangible asset balance of $ 47,857,000 consisting of trademarks on our recent acquisitions on an annual basis for impairment. The methodology used to value trademarks is the relief from royalty method. The recorded book value of these trademarks in excess of the calculated fair value results in impairment. The key estimate used in this calculation consists of an overall royalty rate applied to the sales covered by the trademark. After performing this analysis, we determined that the fair value of these trademarks exceeded their book values, and as such, other impairment was recorded.\n6. Inventories\nInventories consisted of the following:\n| March 31, |\n| 2021 | 2020 |\n| At cost—FIFO basis: |\n| Raw materials | $ | 79,981 | $ | 85,452 |\n| Work-in-process | 23,067 | 25,876 |\n| Finished goods | 27,201 | 33,216 |\n| 130,249 | 144,544 |\n| LIFO cost less than FIFO cost | ( 18,761 ) | ( 17,171 ) |\n| Net inventories | $ | 111,488 | $ | 127,373 |\n\nThere were LIFO liquidations resulting in $ 1,640,000 and $ 2,805,000 of additional income in fiscal 2021 and 2020 income, respectively.\n7. Marketable Securities and Other Investments\nIn accordance with ASU 2016-01 \"Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities,\" adopted by the Company on April 1, 2018, all equity investments in unconsolidated entities (other than those accounted for using the equity method of account) are measured at fair value through earnings. The Company's marketable securities are recorded at their fair value, with unrealized changes in market value realized within Investment (income) loss on the Consolidated Statements of Operations. The impact on earnings for unrealized gains and losses was a gain of $ 727,000 , a loss of $ 143,000 , and a loss of $ 183,000 in fiscal years 2021, 2020, and 2019, respectively.\nConsistent with prior periods, the estimated fair value is based on quoted prices at the balance sheet dates. The cost of securities is based on the specific identification method. Interest and dividend income are included in Investment (income) loss in the Consolidated Statements of Operations.\nMarketable securities are carried as long-term assets since they are held for the settlement of the Company’s general and products liability insurance claims filed through CM Insurance Company, Inc. (\"CMIC\"), a wholly owned captive insurance subsidiary. The marketable securities are not available for general working capital purposes.\nNet realized gains related to sales of marketable securities were $ 85,000 , $ 50,000 , and $ 201,000 in fiscal years 2021, 2020, and 2019, respectively, and are included in Investment (income) loss in the Consolidated Statements of Operations.\nThe Company owns a 49 % ownership interest in Eastern Morris Cranes Company Limited (\"EMC\"), a limited liability company organized and existing under the laws and regulations of the Kingdom of Saudi Arabia. The Company's ownership\n53\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nrepresents an equity investment in a strategic customer of STAHL serving the Kingdom of Saudi Arabia. The investment's carrying value is presented in Other assets in the Consolidated Balance Sheets in the amount of $ 3,040,000 and $ 3,402,000 as of March 31, 2021 and March 31, 2020, respectively, and has been accounted for as an equity method investment. The investment value was increased for the Company's ownership percentage of income earned by EMC in the amount of $ 715,000 and $ 778,000 in the twelve months ended March 31, 2021 and March 31, 2020, respectively, and is recorded in Investment (income) loss on the Consolidated Statement of Operations. Additionally, the investment value increased in the amount of $ 213,000 due to the effect of currency translation. Further, in the twelve months ended March 31, 2021, EMC distributed a cash dividend which the Company received 49 % of pursuant to its ownership interest. The investment value was decreased for the Company's share of EMC's cash dividend in the amount of $ 1,290,000 in the twelve months ended March 31, 2021 as it was determined to be a return of the Company's investment. A portion of the dividend is included in investing activities on the Consolidated Statements of Cash Flows in the amount of $ 587,000 , to the extent the distribution received exceeded cumulative equity in earnings, under the cumulative earnings approach. The balance of the cash dividend is included in operating activities on the Consolidated Statement of Cash Flows under the cumulative earnings approach. The March 31, 2021 and 2020 trade accounts receivable balances due from EMC are $ 2,250,000 and $ 4,166,000 , respectively, and are comprised of amounts due for the sale of goods and services in the ordinary course of business.\n8. Property, Plant, and Equipment\nConsolidated property, plant, and equipment of the Company consisted of the following:\n| March 31, |\n| 2021 | 2020 |\n| Land and land improvements | $ | 4,787 | $ | 4,985 |\n| Buildings | 39,941 | 39,930 |\n| Machinery, equipment, and leasehold improvements | 229,161 | 228,140 |\n| Construction in progress | 14,188 | 12,950 |\n| 288,077 | 286,005 |\n| Less accumulated depreciation | 213,324 | 206,532 |\n| Net property, plant, and equipment | $ | 74,753 | $ | 79,473 |\n\nDepreciation expense was $ 15,530,000 , $ 16,184,000 , and $ 17,775,000 for the years ended March 31, 2021, 2020, and 2019, respectively.\nGross property, plant, and equipment includes capitalized software costs of $ 38,925,000 and $ 37,864,000 at March 31, 2021 and 2020, respectively. Accumulated depreciation includes accumulated amortization on capitalized software costs of $ 27,207,000 and $ 22,962,000 at March 31, 2021 and 2020, respectively. Amortization expense on capitalized software costs was $ 3,639,000 , $ 2,937,000 , and $ 3,045,000 during the years ended March 31, 2021, 2020, and 2019, respectively.\n9. Goodwill and Intangible Assets\nAs discussed in Note 2, goodwill is not amortized but is tested for impairment at least annually, in accordance with the provisions of ASC Topic 350-20-35-1. Goodwill impairment is deemed to exist if the net book value of a reporting unit exceeds its estimated fair value. The fair value of a reporting unit is determined using a discounted cash flow methodology. The Company’s reporting units are determined based upon whether discrete financial information is available and reviewed regularly, whether those units constitute a business, and the extent of economic similarities and interdependencies between those reporting units for purposes of aggregation. The Company’s reporting units identified under ASC Topic 350-20-35-33 are at the component level, or one level below the operating segment level as defined under ASC Topic 280-10-50-10 “Segment Reporting – Disclosure.” The Company has two reporting units as of March 31, 2021, both of which have goodwill. The Duff-Norton reporting unit (which designs, manufactures, and sources mechanical and electromechanical actuators and rotary unions) had goodwill of $ 9,699,000 and $ 9,593,000 at March 31, 2021 and 2020, respectively, and the Rest of Products reporting unit (representing the hoist, chain, and forgings, digital power control systems, and distribution businesses) had goodwill of $ 321,477,000 and $ 310,086,000 at March 31, 2021 and 2020, respectively.\n54\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nFiscal 2021 Annual Goodwill and Intangible Asset Impairment Test\nWhen we evaluate the potential for goodwill impairment, we assess a range of qualitative factors including, but not limited to, macroeconomic conditions, industry conditions, the competitive environment, changes in the market for our products and services, regulatory and political developments, entity specific factors such as strategy and changes in key personnel, and overall financial performance. If, after completing this assessment, it is determined that it is more likely than not that the fair value of a reporting unit is less than its carrying value or if economic or other business factors indicate that the fair value of our reporting units may have declined since our last quantitative test, we proceed to a quantitative impairment test. To perform the quantitative impairment test, the Company uses the discounted cash flow method to estimate the fair value of the reporting units. The discounted cash flow method incorporates various assumptions, the most significant being projected revenue growth rates, operating profit margins and cash flows, the terminal growth rate, and the discount rate. The Company projects revenue growth rates, operating margins and cash flows based on each reporting unit's current business, expected developments, and operational strategies over a five-year period. In estimating the terminal growth rates, the Company considers its historical and projected results, as well as the economic environment in which its reporting units operate. The discount rates utilized for each reporting unit reflect the Company's assumptions of marketplace participants' cost of capital and risk assumptions, both specific to the reporting unit and overall in the economy.\nWe performed the qualitative assessment as of February 28, 2021 and determined that it is not more likely than not that the fair value of the Rest of Products and Duff-Norton reporting units are less than their carrying value. Further, other economic and business factors do not indicate that the fair value of our reporting units have declined since the last quantitative test. As a result, the quantitative goodwill impairment test was not required for the Rest of Products and Duff-Norton reporting units.\nIn accordance with ASC Topic 350-30-35, indefinite-lived intangible assets that are not subject to amortization shall be tested for impairment annually or more frequently if events or circumstances indicate that it is more likely than not that an asset is impaired. Similar to goodwill, we first assess various qualitative factors in the analysis. If, after completing this assessment, it is determined that it is more likely than not that the fair value of an indefinite-lived intangible asset is greater than its carrying value, we conclude that the indefinite-lived intangible asset is not impaired. If, after completing this assessment, it is determined that it is more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying value or if economic or other business factors indicate that the fair value of our indefinite-lived intangible assets may have declined since our last quantitative test, the Company performs a new quantitative test. The methodology used to value trademarks is the relief from royalty method. The recorded book value of these trademarks in excess of the calculated fair value triggers an impairment. The key estimate used in this calculation consists of an overall royalty rate applied to the sales covered by the trademark. After performing a qualitative assessment as of February 28, 2021, it was determined that the trademarks were not impaired.\nA summary of changes in goodwill during the years ended March 31, 2021 and 2020 is as follows:\n| Balance at April 1, 2019 | $ | 322,816 |\n| Currency translation | ( 3,137 ) |\n| Balance at March 31, 2020 | $ | 319,679 |\n| Currency translation | 11,497 |\n| Balance at March 31, 2021 | $ | 331,176 |\n\nGoodwill is recognized net of accumulated impairment losses of $ 113,174,000 as of both March 31, 2021 and 2020. There were no goodwill impairment losses recorded in fiscal 2021 and fiscal 2020, and $ 6,174,000 recorded in 2019, respectively. The goodwill impairment in fiscal 2019 was the result of classifying a business as held for sale. The held for sale classification required the Company to assign a portion of goodwill from the Rest of Products reporting unit to the held for sale business based on its relative fair value and to record the assets and liabilities of the businesses held for sale at the lower of its carrying amount or fair value less cost to sell. Based on this analysis, the Company recorded a $6,174,000 goodwill impairment charge at the time the business was classified as held for sale.\nIdentifiable intangible assets at March 31, 2021 are summarized as follows (in thousands):\n55\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\n| GrossCarrying Amount | AccumulatedAmortization | Net |\n| Trademark | $ | 6,377 | $ | ( 4,760 ) | $ | 1,617 |\n| Indefinite-lived trademark | 47,857 | — | 47,857 |\n| Customer relationships | 188,447 | ( 55,785 ) | 132,662 |\n| Acquired technology | 46,843 | ( 16,021 ) | 30,822 |\n| Other | 3,259 | ( 2,855 ) | 404 |\n| Balance at March 31, 2021 | $ | 292,783 | $ | ( 79,421 ) | $ | 213,362 |\n\nIdentifiable intangible assets at March 31, 2020 were as follows (in thousands):\n| Gross Carrying Amount | Accumulated Amortization | Net |\n| Trademark | $ | 6,016 | $ | ( 4,238 ) | $ | 1,778 |\n| Indefinite-lived trademark | 46,670 | — | 46,670 |\n| Customer relationships | 179,882 | ( 44,216 ) | 135,666 |\n| Acquired technology | 46,669 | ( 13,306 ) | 33,363 |\n| Other | 3,143 | ( 2,658 ) | 485 |\n| Balance at March 31, 2020 | $ | 282,380 | $ | ( 64,418 ) | $ | 217,962 |\n\nThe Company’s intangible assets that are considered to have finite lives are amortized over the period in which the assets are expected to generate future cash flows. Identifiable intangible assets acquired in a business combination are amortized over their estimated useful lives. The weighted-average amortization periods are 15 years for trademarks, 18 years for customer relationships, 18 years for acquired technology, 5 years for other, and 18 years in total. Trademarks with a book value of $ 47,857,000 have an indefinite useful life and are therefore not being amortized.\nTotal amortization expense was $ 12,623,000 , $ 12,942,000 , and $ 14,900,000 for fiscal 2021, 2020, and 2019, respectively. Based on the current amount of intangible assets, the estimated amortization expense for each of the succeeding five years is expected to be approximately $ 12,600,000 .\nOn April 7, 2021, the Company completed the acquisition of Dorner. The Company expects the acquisition to result in a material amount of goodwill and other intangible assets. Please refer to Note 3 for additional details on this acquisition.\n10. Derivative Instruments\nThe Company uses derivative instruments to manage selected foreign currency and interest rate exposures. The Company does not use derivative instruments for speculative trading purposes. All derivative instruments must be recorded on the balance sheet at fair value. For derivatives designated as cash flow hedges, the effective portion of changes in the fair value of the derivative is recorded as accumulated other comprehensive gain (loss), or “AOCL,” and is reclassified to earnings when the underlying transaction has an impact on earnings. The ineffective portion of changes in the fair value of the foreign currency forward agreements is reported in foreign currency exchange loss (gain) in the Company’s consolidated statement of operations. The ineffective portion of changes in the fair value of the interest rate swap agreements is reported in interest expense. For derivatives not designated as cash flow hedges, all changes in market value are recorded as a foreign currency exchange (gain) loss in the Company’s consolidated statements of operations. The cash flow effects of derivatives are reported within net cash provided by operating activities.\nThe Company is exposed to credit losses in the event of non-performance by the counterparties on its financial instruments. The counterparties have investment grade credit ratings. The Company anticipates that these counterparties will be able to fully satisfy their obligations under the contracts. The Company has derivative contracts with three counterparties as of March 31, 2021.\n56\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nThe Company's agreements with its counterparties contain provisions pursuant to which the Company could be declared in default of its derivative obligations. As of March 31, 2021, the Company had not posted any collateral related to these agreements. If the Company had breached any of these provisions as of March 31, 2021, it could have been required to settle its obligations under these agreements at amounts which approximate the March 31, 2021 fair values reflected in the table below. During the year ended March 31, 2021, the Company was not in default of any of its derivative obligations.\nAs of March 31, 2021 and 2020, the Company had no derivatives designated as net investments or fair value hedges in accordance with ASC Topic 815, “Derivatives and Hedging.”\nThe Company has a cross currency swap agreement that is designated as a cash flow hedge to hedge changes in the value of an intercompany loan to a foreign subsidiary due to changes in foreign exchange rates. This intercompany loan is related to the acquisition of STAHL. As of March 31, 2021, the notional amount of this derivatives was $ 159,520,000 , and the contract matures on January 31, 2022. From its March 31, 2021 balance of AOCL, the Company expects to reclassify approximately $ 653,000 out of AOCL, and into foreign currency exchange loss (gain), during the next 12 months based on the contractual payments due under this intercompany loan.\nThe Company has foreign currency forward agreements that are designated as cash flow hedges to hedge a portion of forecasted inventory purchases denominated in foreign currencies. The notional amount of those derivatives is $ 6,457,000 and all contracts mature by March 31, 2022. From its March 31, 2021 balance of AOCL, the Company expects to reclassify approximately $ 57,000 out of AOCL during the next 12 months based on the underlying transactions of the sales of the goods purchased.\nThe Company's policy is to maintain a capital structure that is comprised of 50-70% of fixed rate long-term debt and 30-50% of variable rate long-term debt. The Company has two interest rate swap agreements in which the Company receives interest at a variable rate and pays interest at a fixed rate. These interest rate swap agreements are designated as cash flow hedges to hedge changes in interest expense due to changes in the variable interest rate of the senior secured term loan. The amortizing interest rate swaps mature by December 31, 2023 and had a total notional amount of $ 119,820,000 as of March 31, 2021. The effective portion of the changes in fair values of the interest rate swaps is reported in AOCL and will be reclassified to interest expense over the life of the swap agreements. From its March 31, 2021 balance of AOCL, the Company expects to reclassify approximately $ 901,000 out of AOCL, and into interest expense, during the next 12 months.\nThe following is the effect of derivative instruments on the consolidated statements of operations for the years ended March 31, 2021, 2020, and 2019 (in thousands):\n57\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\n| Derivatives Designated as Cash Flow Hedges | Type of Instrument | Amount of Gain or (Loss) Recognized in Other Comprehensive Income (Loss) on Derivatives (Effective Portion) | Location of Gain or(Loss) Recognizedin Income onDerivatives | Amount of Gain or (Loss) Reclassified from AOCL into Income (Effective Portion) |\n| March 31, |\n| 2021 | Foreign exchange contracts | $ | ( 238 ) | Cost of products sold | $ | 83 |\n| 2021 | Interest rate swap | $ | ( 521 ) | Interest expense | $ | ( 1,463 ) |\n| 2021 | Cross currency swap | $ | ( 7,793 ) | Foreign currency exchange loss (gain) | $ | ( 7,268 ) |\n| 2020 | Foreign exchange contracts | $ | 303 | Cost of products sold | $ | 40 |\n| 2020 | Interest rate swap | $ | ( 3,185 ) | Interest expense | $ | 242 |\n| 2020 | Cross currency swap | $ | 7,654 | Foreign currency exchange loss (gain) | $ | 2,888 |\n| 2019 | Foreign exchange contracts | $ | ( 24 ) | Cost of products sold | $ | ( 16 ) |\n| 2019 | Interest rate swap | $ | ( 1,275 ) | Interest expense | $ | 765 |\n| 2019 | Cross currency swap | $ | 18,242 | Foreign currency exchange loss (gain) | $ | 17,231 |\n\n\n| Derivatives Not Designated as Hedging Instruments (ForeignExchange Contracts) | Location of Gain or (Loss) Recognized inIncome on Derivatives | Amount ofGain or (Loss)Recognized in Income on Derivatives |\n| March 31, |\n| 2021 | Foreign currency exchange loss (gain) | $ | — |\n| 2020 | Foreign currency exchange loss (gain) | $ | 17 |\n| 2019 | Foreign currency exchange loss (gain) | $ | 13 |\n\nThe following is information relative to the Company’s derivative instruments in the consolidated balance sheets as of March 31, 2021 and 2020 (in thousands):\n| Fair Value of Asset (Liability)March 31, |\n| Derivatives Designated asHedging Instruments | Balance Sheet Location | 2021 | 2020 |\n| Foreign exchange contracts | Prepaid expenses and other | $ | — | $ | 318 |\n| Foreign exchange contracts | Accrued Liabilities | ( 83 ) | ( 33 ) |\n| Interest rate swap | Accrued Liabilities | ( 1,185 ) | ( 1,402 ) |\n| Interest rate swap | Other non current liabilities | ( 872 ) | ( 1,894 ) |\n| Cross currency swap | Prepaid expenses and other | — | 1,750 |\n| Cross currency swap | Accrued liabilities | ( 13,895 ) | — |\n| Cross currency swap | Other non current liabilities | — | ( 5,254 ) |\n\n58\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\n11. Accrued Liabilities and Other Non-current Liabilities\nConsolidated accrued liabilities of the Company consisted of the following:\n| March 31, |\n| 2021 | 2020 |\n| Accrued payroll | $ | 29,871 | $ | 29,966 |\n| Accrued income taxes payable | 9,938 | 11,889 |\n| Accrued health insurance | 1,677 | 2,018 |\n| Accrued general and product liability costs | 3,500 | 3,500 |\n| Customer advances, deposits, and rebates | 15,643 | 13,507 |\n| Current ROU lease liabilities | 7,673 | 6,924 |\n| Cross currency swap | 13,895 | — |\n| Other accrued liabilities | 28,619 | 25,781 |\n| $ | 110,816 | $ | 93,585 |\n\nConsolidated other non-current liabilities of the Company consisted of the following:\n| March 31, |\n| 2021 | 2020 |\n| Accumulated postretirement benefit obligation | $ | 1,195 | $ | 1,617 |\n| Accrued general and product liability costs | 17,727 | 8,444 |\n| Accrued pension cost | 114,911 | 149,524 |\n| Cross currency swap | — | 5,254 |\n| Deferred income tax | 17,600 | 18,213 |\n| Non-current ROU lease liabilities | 27,321 | 31,629 |\n| Other non-current liabilities | 13,166 | 12,826 |\n| $ | 191,920 | $ | 227,507 |\n\nFor the year ended March 31, 2021, the Accrued general and product liability costs are presented gross of estimated recoveries of $ 8,052,000 . Refer to Note 16 for additional information.\n12. Debt\nConsolidated long-term debt of the Company consisted of the following:\n| March 31, |\n| 2021 | 2020 |\n| Term loan | 254,900 | 259,350 |\n| Unamortized deferred financing costs, net | ( 5,946 ) | ( 8,044 ) |\n| Total debt | 248,954 | 251,306 |\n| Less: current portion | 4,450 | 4,450 |\n| Total debt, less current portion | $ | 244,504 | $ | 246,856 |\n\nOn January 31, 2017 the Company entered into a Credit Agreement (\"Credit Agreement\") and $ 545,000,000 of debt facilities (\"Facilities\") in connection with the STAHL acquisition. The Facilities consist of a Revolving Facility (\"Revolver\") in the\n59\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\namount of $ 100,000,000 and a $ 445,000,000 1st Lien Term Loan (\"Term Loan\"). The Term Loan has a seven-year term maturing in 2024.\nOn February 26, 2018, the Company amended the Credit Agreement (known as the \"First Amended Credit Agreement\"). The First Amended Credit Agreement has the same terms mentioned above except for a reduction in interest rates. The applicable rate for the repriced term loan was reduced from 3.00 % to 2.50 %. The Company accounted for the First Amended Credit Agreement as a debt modification, therefore, debt repricing fees incurred in fiscal 2018 were expensed as General and Administrative expenses and the deferred financing fees incurred as part of the Credit Agreement (discussed below) remain unchanged.\nOn August 26, 2020, the Company entered into a Second Amendment (known as the \"Second Amended Credit Agreement\") to the Credit Agreement (as amended by the First Amended Credit Agreement). The First Amended Credit Agreement extends the $ 100,000,000 secured Revolver which was originally set to expire on January 31, 2022 to August 25, 2023. At March 31, 2021 the Company has not drawn from the Revolver.\nThe key terms of the agreement are as follows:\n•Term Loan: An aggregate $ 445,000,000 1st Lien Term Loan which requires quarterly principal amortization of 0.25% with the remaining principal due at maturity date. In addition, if the Company has Excess Cash Flow (\"ECF\") as defined in the Credit Agreement, the ECF Percentage of the Excess Cash Flow for such fiscal year minus optional prepayment of the Loans (except prepayments of Revolving Loans that are not accompanied by a corresponding permanent reduction of Revolving Commitments) pursuant to Section 2.10(a) of the Credit Agreement other than to the extent that any such prepayment is funded with the proceeds of Funded Debt, shall be applied toward the prepayment of the Term Loan. The ECF Percentage is defined as 50% stepping down to 25% or 0% based on the Secured Leverage Ratio as of the last day of the fiscal year.\n•Revolver: An aggregate $ 100,000,000 secured revolving facility which includes sublimits for the issuance of standby letters of credit, swingline loans and multi-currency borrowings in certain specified foreign currencies.\n•Fees and Interest Rates: Commitment fees and interest rates are determined on the basis of either a Eurocurrency rate or a Base rate plus an applicable margin based upon the Company's Total Leverage Ratio (as defined in the Credit Agreement).\n•Prepayments: Provisions permitting a Borrower to voluntarily prepay either the Term Loan or Revolver in whole or in part at any time, and provisions requiring certain mandatory prepayments of the Term Loan or Revolver on the occurrence of certain events which will permanently reduce the commitments under the Credit Agreement, each without premium or penalty, subject to reimbursement of certain costs of the Lenders. A prepayment premium of 1% of the principal amount of the First Lien Term Loans is required if the prepayment is associated with a Repricing Transaction and it were to occur within the first twelve months.\n•Covenants: Provisions containing covenants required of the Corporation and its subsidiaries including various affirmative and negative financial and operational covenants. The key financial covenant is triggered only on any date when any Extension of Credit under the Revolving Facility is outstanding (excluding any Letters of Credit) (the “Covenant Trigger”), and permits the Total Leverage Ratio for the Reference Period ended on such date to not exceed (i) 4.50:1.00 as of any date of determination prior to December 31, 2017, (ii) 4.00:1.00 as of any date of determination on December 31, 2017 and thereafter but prior to December 31, 2018, (iii) 3.50:1.00 as of any date of determination on December 31, 2018 and thereafter but prior to December 31, 2019 and (iv) 3.00:1.00 as of any date of determination on December 31, 2019 and thereafter. As there is no amount drawn on the Revolver as of March 31, 2021 the requirement to comply with the covenant is not triggered. Had we been required to determine the covenant ratio we would have been in compliance with the covenant provisions as of March 31, 2021 and 2020.\nThe Facility is secured by all U.S. inventory, receivables, equipment, real property, certain subsidiary stock (limited to 65% of non-U.S. subsidiaries) and intellectual property. The Credit Agreement allows the declaration of dividends, but limits our ability to pay dividends.\n60\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nAs discussed in Note 3, the Company completed its acquisition of Dorner on April 7, 2021 and entered into a $ 750,000,000 First Lien Facility with JPMorgan Chase Bank, PNC Capital Markets LLC, and Wells Fargo Securities LLC. The First Lien Facilities consist of a Revolving Facility in an aggregate amount of $ 100,000,000 and a $ 650,000,000 First Lien Term Facility (Bridge Facility). Proceeds from the Bridge Facility were used, among other things, to finance the purchase price for the Dorner acquisition, pay related fees, expenses and transaction costs, and refinance the Company's borrowings under its prior Term Loan and Revolving Credit Facilities. The Company subsequently used proceeds from an equity offering to repay $ 198,720,000 of the Bridge Facility. The Bridge Facility was refinanced and replaced with a Term Loan B facility. Refer to Note 3 for key terms of the credit agreement which go into effect in fiscal 2022.\nThe outstanding balance of the Term Loan was $ 254,900,000 and $ 259,350,000 as of March 31, 2021 and 2020, respectively. The Company made $ 4,450,000 of principal payment on the Term Loan during fiscal 2021 and $ 51,113,000 of principal payment on the Term Loan during fiscal 2020. The Company is obligated to make $ 4,450,000 of principal payments over the next 12 months. As previously discussed, in response to COVID-19 the Company took all appropriate measures to protect the cash flow and liquidity of the Company. As such, only the required principal amount has been recorded within the current portion of long-term debt on the Company's Consolidated Balance Sheet with the remaining balance recorded as long-term debt.\nThere was $ 0 outstanding on the Revolving Credit Facility and $ 17,302,000 outstanding letters of credit as of March 31, 2021. The outstanding letters of credit at March 31, 2021 consisted of $ 537,000 in commercial letters of credit and $ 16,765,000 of standby letters of credit.\nThe gross balance of deferred financing costs on the term loan was $ 14,690,000 as of March 31, 2021 and 2020. The accumulated amortization balances were $ 8,744,000 and $ 6,645,000 as of March 31, 2021 and 2020, respectively.\nThe gross balance of deferred financing costs associated with the Revolving Credit Facility is included in Other assets is $ 3,615,000 as of March 31, 2021 and $ 2,789,000 as of March 31, 2020. The accumulated amortization balance is $ 2,313,000 and $ 1,766,000 as of March 31, 2021 and March 31, 2020 respectively. These balances are classified in Other assets since no funds were drawn on the Revolving Credit Facility as of March 31, 2021 and March 31, 2020.\nThe principal payments obligated to be made as of March 31, 2021 on the Term Loan are as follows:\n| 2022 | 4,450 |\n| 2023 | 4,450 |\n| 2024 | 4,450 |\n| 2025 | 241,550 |\n| Thereafter | — |\n| $ | 254,900 |\n\nThe principal payments obligated to be made under the Term Loan B facility entered into during fiscal 2022 in connection with the Dorner acquisition are $ 4,500,000 per year, plus a required excess cash flow sweep as defined in the agreement.\nNon-U.S. Lines of Credit and Loans\nUnsecured and uncommitted lines of credit are available to meet short-term working capital needs for certain of our subsidiaries operating outside of the U.S. The lines of credit are available on an offering basis, meaning that transactions under the line of credit will be on such terms and conditions, including interest rate, maturity, representations, covenants, and events of default, as mutually agreed between our subsidiaries and the local bank at the time of each specific transaction. As of March 31, 2021, unsecured credit lines totaled approximately $ 2,580,000 , of which $ 0 was drawn. In addition, unsecured lines of $ 15,478,000 were available for bank guarantees issued in the normal course of business of which $ 12,598,000 was utilized.\n13. Pensions and Other Benefit Plans\nThe Company provides retirement plans, including defined benefit and defined contribution plans, and other postretirement benefit plans to certain employees. The Company applies ASC Topic 715 “Compensation – Retirement Benefits,” which\n61\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nrequired the recognition in pension and other postretirement benefits obligations and accumulated other comprehensive income of actuarial gains or losses, prior service costs or credits and transition assets or obligations that had previously been deferred. This statement also requires an entity to measure a defined benefit postretirement plan’s assets and obligations that determine its funded status as of the end of the fiscal year.\nPension Plans\nThe Company provides defined benefit pension plans to certain employees. The Company uses March 31 as the measurement date. The following provides a reconciliation of benefit obligation, plan assets, and funded status of the plans:\n| March 31, |\n| 2021 | 2020 |\n| Change in benefit obligation: |\n| Benefit obligation at beginning of year | $ | 459,866 | $ | 446,397 |\n| Service cost | 1,092 | 1,139 |\n| Interest cost | 11,527 | 14,759 |\n| Actuarial (gain) loss | 3,729 | 26,193 |\n| Benefits paid | ( 24,492 ) | ( 26,852 ) |\n| Settlement | ( 53,499 ) | — |\n| Foreign exchange rate changes | 6,618 | ( 1,770 ) |\n| Benefit obligation at end of year | $ | 404,841 | $ | 459,866 |\n| Change in plan assets: |\n| Fair value of plan assets at beginning of year | $ | 313,366 | $ | 321,902 |\n| Actual gain (loss) on plan assets | 49,582 | 7,512 |\n| Employer contribution | 1,316 | 10,967 |\n| Benefits paid | ( 24,492 ) | ( 26,852 ) |\n| Settlement | ( 53,499 ) | — |\n| Foreign exchange rate changes | 405 | ( 163 ) |\n| Fair value of plan assets at end of year | $ | 286,678 | $ | 313,366 |\n| Funded status | $ | ( 118,163 ) | $ | ( 146,500 ) |\n| Unrecognized actuarial loss | 51,540 | 105,878 |\n| Net amount recognized | $ | ( 66,623 ) | $ | ( 40,622 ) |\n\nDuring fiscal 2021, the Company settled the liabilities for one of its U.S. pension plans through a combination of (i) lump sum payments to eligible participants who elected to receive them and (ii) the purchase of annuity contracts for participants who did not elect lump sums. The lump sum payments were paid during the quarter ended June 30, 2020 and resulted in a settlement charge of $ 2,722,000 which was recorded in Other (income) expense, net on the Consolidated Statements of Operations. During the quarter ended September 30, 2020, the Company purchased annuity contracts to settle the remaining liabilities of the terminated plan. The total settlement charge of $ 19,038,000 was recorded in Other (income) expense, net on the Statements of Operations during the twelve months ending March 31, 2021. The remaining surplus of the terminated plan was $ 3,910,000 as of March 31, 2021 and will be used, as prescribed in the applicable regulations, to fund obligations associated with the Company's U.S. defined contribution plans.\nAmounts recognized in the consolidated balance sheets are as follows:\n62\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\n| March 31, |\n| 2021 | 2020 |\n| Other assets | $ | 427 | $ | 6,587 |\n| Accrued liabilities | ( 3,679 ) | ( 3,563 ) |\n| Other non-current liabilities | ( 114,911 ) | ( 149,524 ) |\n| Accumulated other comprehensive loss, before tax | 51,540 | 105,878 |\n| Net amount recognized | $ | ( 66,623 ) | $ | ( 40,622 ) |\n\nOther assets are presented separately from pension liabilities for pension plans that are overfunded. Other assets decreased in the current year due to the pension settlement, described above.\nNet periodic pension cost included the following components:\n| 2021 | 2020 | 2019 |\n| Service costs—benefits earned during the period | $ | 1,092 | $ | 1,139 | $ | 1,078 |\n| Interest cost on projected benefit obligation | 11,527 | 14,759 | 15,526 |\n| Expected return on plan assets | ( 12,787 ) | ( 15,887 ) | ( 18,454 ) |\n| Net amortization | 3,234 | 2,279 | 2,339 |\n| Settlement | 19,038 | — | — |\n| Net periodic pension cost (benefit) | $ | 22,104 | $ | 2,290 | $ | 489 |\n\nInformation for pension plans with a projected benefit obligation in excess of plan assets is as follows:\n| March 31, |\n| 2021 | 2020 |\n| Projected benefit obligation | $ | 401,870 | $ | 410,181 |\n| Fair value of plan assets | 283,280 | 257,093 |\n\nInformation for pension plans with an accumulated benefit obligation in excess of plan assets is as follows:\n| March 31, |\n| 2021 | 2020 |\n| Accumulated benefit obligation | $ | 396,673 | $ | 401,918 |\n| Fair value of plan assets | 283,280 | 254,508 |\n\nUnrecognized gains and losses are amortized through March 31, 2021 on a straight-line basis over the average remaining service period of active participants. Starting in fiscal 2016, the Company changed the amortization period of its largest plan to the average remaining lifetime of inactive participants, as a significant portion of the plan population is now inactive. This change increases the amortization period of the unrecognized gains and losses.\nThe weighted-average assumptions in the following table represent the rates used to develop the actuarial present value of the projected benefit obligation for the year listed and also net periodic pension cost for the following year:\n| 2021 | 2020 | 2019 |\n| Discount rate | 2.62 | % | 2.79 | % | 3.42 | % |\n| Expected long-term rate of return on plan assets | 4.60 | % | 5.01 | % | 5.77 | % |\n| Rate of compensation increase on active plans | 2.76 | % | 2.76 | % | 2.76 | % |\n| Interest crediting rates used in cash balance pension plans | 1.10 | % | 2.25 | % | 2.25 | % |\n\nThe expected rates of return on plan asset assumptions are determined considering long-term historical averages and real returns on each asset class.\n63\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nThe Company’s retirement plan target and actual asset allocations are as follows:\n| Target | Actual |\n| 2022 | 2021 | 2020 |\n| Equity securities | 45 %- 35 % | 45 % | 33 % |\n| Fixed income securities | 55 %- 65 % | 55 % | 67 % |\n| Total plan assets | 100 % | 100 % | 100 % |\n\nInvestments allocated to fixed income decreased as of March 31, 2021 due to the pension settlement, described above, since the plan was fully funded and invested in fixed income securities.\nThe Company has an investment objective for domestic pension plans to adequately provide for both the growth and liquidity needed to support all current and future benefit payment obligations. The Company's policy is to de-risk the portfolio by increasing liability-hedging investments as the pension liability funded status increases, which is known as the glide path method. Within the table above, cash equivalents are categorized as fixed income as they earn lower returns than equity securities which includes alternative real estate funds (shown in the fair value tables below).\nThe Company’s funding policy with respect to the defined benefit pension plans is to contribute annually at least the minimum amount required by the Employee Retirement Income Security Act of 1974 (ERISA). Additional contributions may be made to minimize PBGC premiums. The Company plans to contribute the minimum amount required (approximately $ 5,215,000 ) to its pension plans in fiscal 2022 as a response to COVID-19 but will reassess later in the fiscal year and increase contributions if economic conditions improve.\nInformation about the expected benefit payments for the Company’s defined benefit plans is as follows:\n| 2022 | $ | 23,615 |\n| 2023 | 23,838 |\n| 2024 | 23,729 |\n| 2025 | 23,638 |\n| 2026 | 23,612 |\n| 2027-2031 | 114,262 |\n\nPostretirement Benefit Plans\nThe Company sponsors a defined benefit other postretirement health care plan that provide medical and life insurance coverage to certain U.S. retirees and their dependents of one of its subsidiaries. Prior to the acquisition of this subsidiary, the Company did not sponsor any postretirement benefit plans. The Company pays the majority of the medical costs for certain retirees and their spouses who are under age 65 . For retirees and dependents of retirees who retired prior to January 1, 1989, and are age 65 or over, the Company contributes 100 % toward the American Association of Retired Persons (“AARP”) premium frozen at the 1992 level. For retirees and dependents of retirees who retired after January 1, 1989, the Company contributes $ 35 per month toward the AARP premium. The life insurance plan is noncontributory.\n64\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nThe Company’s postretirement health benefit plans are not funded. The following sets forth a reconciliation of benefit obligation and the funded status of the plan:\n| March 31, |\n| 2021 | 2020 |\n| Change in benefit obligation: |\n| Benefit obligation at beginning of year | $ | 1,887 | $ | 2,348 |\n| Interest cost | 46 | 71 |\n| Actuarial gain | ( 313 ) | ( 340 ) |\n| Benefits paid | ( 232 ) | ( 192 ) |\n| Benefit obligation at end of year | $ | 1,388 | $ | 1,887 |\n| Funded status | $ | ( 1,388 ) | $ | ( 1,887 ) |\n| Unrecognized actuarial gain | ( 1,467 ) | ( 1,417 ) |\n| Net amount recognized | $ | ( 2,855 ) | $ | ( 3,304 ) |\n\nAmounts recognized in the consolidated balance sheets are as follows:\n| March 31, |\n| 2021 | 2020 |\n| Accrued liabilities | $ | ( 193 ) | $ | ( 270 ) |\n| Other non-current liabilities | ( 1,195 ) | ( 1,617 ) |\n| Accumulated other comprehensive gain, before tax | ( 1,467 ) | ( 1,417 ) |\n| Net amount recognized | $ | ( 2,855 ) | $ | ( 3,304 ) |\n\nIn fiscal 2021, net periodic postretirement benefit cost included the following:\n| Year Ended March 31, |\n| 2021 | 2020 | 2019 |\n| Interest cost | $ | 46 | $ | 71 | $ | 92 |\n| Net amortization | ( 263 ) | ( 205 ) | ( 156 ) |\n| Net periodic postretirement benefit cost | $ | ( 217 ) | $ | ( 134 ) | $ | ( 64 ) |\n\nFor measurement purposes, healthcare costs are assumed to increase 6.00 % in fiscal 2022, grading down over time to 4.5 % in 2029. The discount rate used in determining the accumulated postretirement benefit obligation was 2.52 % and 3.17 % as of March 31, 2021 and 2020, respectively.\nInformation about the expected benefit payments for the Company’s postretirement health benefit plans is as follows:\n| 2022 | $ | 195 |\n| 2023 | 179 |\n| 2024 | 166 |\n| 2025 | 152 |\n| 2026 | 135 |\n| 2027-2031 | 454 |\n\nThe Company has collateralized split-dollar life insurance arrangements with two of its former officers. Under these arrangements, the Company pays certain premium costs on life insurance policies for the former officers. Upon the later of the death of the former officer and their spouse, the Company will receive all of the premiums paid to-date. The net periodic pension cost for fiscal 2021 was $ 141,000 and the liability at March 31, 2021 is $ 4,682,000 with $ 4,544,000 included in Other non-current liabilities and $ 138,000 included in Accrued liabilities in the Consolidated Balance Sheet. The cash surrender\n65\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nvalue of the policies is $ 3,496,000 and $ 3,346,000 at March 31, 2021 and 2020, respectively. The balance is included in Other assets in the consolidated balance sheet.\nOther Benefit Plans\nThe Company also sponsors defined contribution plans covering substantially all domestic employees and certain international employees. Participants may elect to contribute basic contributions. These plans provide for employer contributions based on employee eligibility and participation. The Company recorded a charge for such contributions of approximately $ 4,063,000 , $ 5,239,000 , and $ 5,260,000 for the years ended March 31, 2021, 2020, and 2019, respectively which are included in Cost of Products Sold, Selling Expenses, and General and Administrative Expenses within the Consolidated Statements of Operations. The Company expects its contributions for the defined contribution plans in future years to be higher than contributions in fiscal 2021 as the Company temporarily paused contributions to a portion of U.S. employees' defined contributions plans in response to COVID-19. In the first quarter of fiscal 2022 contributions have resumed.\nFair Values of Plan Assets\nThe Company classified its investments within the categories of equity securities, fixed income securities, alternative real estate, and cash equivalents, as the Company’s management bases its investment objectives and decisions from these four categories. The Company’s investment policy is to use its glide-path method to de-risk the portfolio by increasing liability-hedging investments as the pension liability funded status increases.\nThe fair values of the Company’s defined benefit plans’ consolidated assets by asset category as of March 31 were as follows:\n| March 31, |\n| 2021 | 2020 |\n| Asset categories: |\n| Equity securities | $ | 116,468 | $ | 94,336 |\n| Fixed income securities | 155,553 | 199,613 |\n| Alternative real estate | 12,863 | 9,401 |\n| Cash equivalents | 1,794 | 10,016 |\n| Total | $ | 286,678 | $ | 313,366 |\n\nThe fair values of our defined benefit plans’ consolidated assets were determined using the fair value hierarchy of inputs described in Note 5. The fair values by category of inputs as of March 31, 2021 and March 31, 2020 were as follows:\n| Measured at NAV (1) | Quoted Pricesin ActiveMarkets forIdentical Assets | Significant otherobservableInputs | SignificantunobservableInputs |\n| As of March 31, 2021: | (Level 1) | (Level 2) | (Level 3) | Total |\n| Asset categories: |\n| Equity securities | $ | 52,710 | $ | 63,758 | $ | — | $ | — | $ | 116,468 |\n| Fixed income securities | 25,198 | 7,115 | $ | 122,071 | 1,169 | 155,553 |\n| Alternative real estate | 12,862 | 1 | — | — | 12,863 |\n| Cash equivalents | — | 1,794 | — | — | 1,794 |\n| Total | $ | 90,770 | $ | 72,668 | $ | 122,071 | $ | 1,169 | $ | 286,678 |\n\n(1) Reflects the net asset value (NAV) practical expedient used to approximate fair value.\n66\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\n| Measured at NAV (1) | Quoted Pricesin ActiveMarkets forIdentical Assets | Significant otherobservableInputs | SignificantunobservableInputs |\n| As of March 31, 2020: | (Level 1) | (Level 2) | (Level 3) | Total |\n| Asset categories: |\n| Equity securities | $ | 42,252 | $ | 52,084 | $ | — | $ | — | $ | 94,336 |\n| Fixed income securities | 30,598 | 24,014 | 139,498 | 5,503 | 199,613 |\n| Alternative real estate | 4,195 | 5,206 | — | — | 9,401 |\n| Cash equivalents | — | 10,016 | — | — | 10,016 |\n| Total | $ | 77,045 | $ | 91,320 | $ | 139,498 | $ | 5,503 | $ | 313,366 |\n\n(1) Reflects the net asset value (NAV) practical expedient used to approximate fair value.\nLevel 1 securities consist of mutual funds with quoted market prices.\nThe Level 2 fixed income securities are investments in a combination of funds whose underlying investments are in a variety of fixed income securities including foreign and domestic corporate bonds, securities issued by the U.S. government, U.S. and foreign government obligations, and other similar fixed income investments. The fair values of the underlying investments in these funds are generally based on independent broker dealer bids, or by comparison to other debt securities having similar durations, yields, and credit ratings. The fair values of these funds are determined based on their net asset values which are published daily. We are not aware of any significant restrictions on the issuances or redemption of shares of these funds\nFair value of Level 3 fixed income securities at the beginning of the year was $ 5,503,000 . During fiscal 2021 fixed income securities earned investment return of $ 6,000 and had disbursements of $ 4,340,000 , which includes liquidations and termination of one of the Company's pension plans, resulting in an ending balance of $ 1,169,000 . These fixed income securities consist primarily of insurance contracts which are carried at their liquidation value based on actuarial calculations and the terms of the contracts. Significant inputs in determining the fair value for these contracts include company contributions, contract disbursements, and stated interest rates. Gains and losses on these contracts are recognized as part of net periodic pension cost and recorded as part of cost of sales, selling, or general and administrative expense.\n14. Employee Stock Ownership Plan (ESOP)\nEffective January 1, 2012 the ESOP was closed to new hires. Prior to this date, substantially all of the Company’s U.S. non-union employees were participants in the ESOP. Additionally, during the year ended March 31, 2015 the final loan payment was made by the ESOP to the Company and there was no compensation expense recorded in fiscal years 2021, 2020, or 2019.\nAt March 31, 2021 and 2020, 216,000 and 234,000 of ESOP shares, respectively, were allocated or available to be allocated to participants’ accounts. There are no shares of collateralized common stock related to the ESOP loan outstanding at March 31, 2021 and no ESOP shares were pledged as collateral to guarantee the ESOP term loans.\n15. Earnings per Share and Stock Plans\nEarnings per Share\nThe Company calculates earnings per share in accordance with ASC Topic 260, “Earnings per Share.” Basic earnings per share exclude any dilutive effects of options, warrants, and convertible securities. Diluted earnings per share include any dilutive effects of stock options, unvested restricted stock units, unvested performance shares, and unvested restricted stock. Stock options and performance shares with respect to 244,000 and 196,000 common shares were not included in the computation of diluted earnings per share for fiscal 2021 and 2020, respectively, because they were antidilutive. For the years ended March 31, 2021 and 2020, an additional 105,000 and 40,000 , respectively, in contingently issuable shares were not included in the computation of diluted earnings per share because a performance condition had not yet been met.\n67\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nThe following table sets forth the computation of basic and diluted earnings per share (share data presented in thousands):\n\n| Year Ended March 31, |\n| Numerator for basic and diluted earnings per share: | 2021 | 2020 | 2019 |\n| Net income | $ | 9,106 | $ | 59,672 | $ | 42,577 |\n| Denominators: |\n| Weighted-average common stock outstanding— denominator for basic EPS | 23,897 | 23,619 | 23,276 |\n| Effect of dilutive employee stock options, RSU's and performance shares | 276 | 236 | 384 |\n| Adjusted weighted-average common stock outstanding and assumed conversions— denominator for diluted EPS | 24,173 | 23,855 | 23,660 |\n\nThe weighted-average common stock outstanding shown above is net of unallocated ESOP shares (see Note 14).\nIn fiscal 2022, the Company issued 4,312,500 shares of common stock raising $ 198,720,000 net of fees in connection with the Dorner acquisition which was completed in April. Refer to Note 3 for additional details of this transaction.\nStock Plans\nThe Company records stock-based compensation in accordance with ASC Topic 718, “Compensation – Stock Compensation,” applying the modified prospective method. This Statement requires all equity-based payments to employees, including grants of employee stock options, to be recognized in the statement of earnings based on the grant date fair value of the award. Under the modified prospective method, the Company is required to record equity-based compensation expense for all awards granted after the date of adoption and for the unvested portion of previously granted awards outstanding as of the date of adoption.\nThe Company grants share based compensation to eligible participants under the 2016 Long Term Incentive Plan, as Amended and Restated in June 2019 (\"2016 LTIP\"). The total number of shares of common stock with respect to which awards may be granted under the 2016 LTIP were increased by 2,500,000 as a result of the June 2019 amendment. Shares not previously authorized for issuance under any of the prior stock plans and any shares not issued or subject to outstanding awards under the prior stock plans are still available for issuance. Details of the shares granted under these plans are discussed below.\nPrior to the adoption of the 2016 LTIP, the Company granted stock awards under the 2010 Long Term Incentive Plan and the 2006 Long Term Incentive Plan, collectively referred to as the “Prior Stock Plans.”\nStock based compensation expense was $ 8,022,000 , $ 4,507,000 , and $ 6,198,000 for fiscal 2021, 2020, and 2019, respectively. The lower stock based compensation expense in fiscal 2020 is primarily related to shares that were forfeited when the Company's Chief Executive Officer (CEO) resigned on January 10, 2020. The forfeiture resulted in the reversal of $ 1,981,000 in stock compensation expense during fiscal 2020 recorded as a reduction to General and administrative expenses.\nStock compensation expense is included in cost of products sold, selling, general and administrative, and research and development expenses depending on the nature of the service of the employee receiving the award. The Company recognizes expense for all share–based awards over the service period, which is the shorter of the period until the employees’ retirement eligibility dates or the service period for the award, for awards expected to vest. Accordingly, expense is generally reduced for estimated forfeitures. ASC Topic 718 requires forfeitures to be estimated at the time of grant and revised if necessary, in subsequent periods if actual forfeitures differ from those estimates.\nThe Company recognized compensation expense for stock option awards and unvested restricted share awards that vest based on time or market parameters straight-line over the requisite service period for vesting of the award.\nLong Term Incentive Plan\n68\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nUnder the 2016 LTIP, the total number of shares of common stock with respect to which awards may be granted under the plan is 2,500,000 in addition to shares not previously authorized for issuance under any of the prior stock plans and any shares not issued or subject to outstanding awards under the prior stock plans. As of March 31, 2021, 2,252,000 shares remain for future grants. The 2016 LTIP was designed as an omnibus plan and awards may consist of non-qualified stock options, incentive stock options, stock appreciation rights, restricted stock, restricted stock units, or stock bonuses.\nUnder the 2016 LTIP, the granting of awards to employees may take the form of options, restricted shares, and performance shares. The Compensation Committee of our Board of Directors determines the number of shares, the term, the frequency and date, the type, the exercise periods, any performance criteria pursuant to which awards may be granted, and the restriction and other terms and conditions of each grant in accordance with terms of the Plan.\nIn connection with the acquisition of Magnetek, the Company agreed to continue the 2014 Stock Incentive Plan of Magnetek, Inc. (the \"Magnetek Stock Plan\"). In doing so, the Company has available under the Magnetek Stock Plan 164,461 of the Company's shares which can be granted to certain employees as stock-based compensation.\nStock Option Plans\nPrior to fiscal 2021, options outstanding under the 2016 LTIP generally become exercisable over a 4-year period at a rate of 25 % per year commencing one year from the date of grant and have an exercise price of not less than 100 % of the fair market value of the common stock on the date of grant. For fiscal 2021, options outstanding under the 2016 LTIP generally become exercisable over a 3-year period at a rate of 33% per year commencing one year from the date of grant and have an exercise price of not less than 100 % of the fair market value of the common stock on the date of grant.\nA summary of option transactions during each of the three fiscal years in the period ended March 31, 2021 is as follows:\n| Shares | Weighted-averageExercise Price per share | Weighted-averageRemainingContractualLife (in years) | AggregateIntrinsicValue |\n| Outstanding at April 1, 2018 | 922,450 | 21.04 | 7.56 | $ | 13,654 |\n| Granted | 133,743 | 38.70 |\n| Exercised | ( 187,907 ) | 22.09 |\n| Cancelled | ( 33,509 ) | 23.94 |\n| Outstanding at March 31, 2019 | 834,777 | 23.52 | 7.04 | $ | 9,602 |\n| Granted | 171,515 | 35.16 |\n| Exercised | ( 296,027 ) | 20.26 |\n| Cancelled | ( 183,471 ) | 31.01 |\n| Outstanding at March 31, 2020 | 526,794 | 26.53 | 6.93 | $ | 1,518 |\n| Granted | 242,178 | 26.74 |\n| Exercised | ( 97,398 ) | 20.24 |\n| Cancelled | ( 13,760 ) | 31.85 |\n| Outstanding at March 31, 2021 | 657,814 | 27.45 | 7.29 | $ | 16,652 |\n| Exercisable at March 31, 2021 | 268,815 | $ | 24.41 | 5.66 | $ | 7,622 |\n\nThe Company calculated intrinsic value for those options that had an exercise price lower than the market price of our common shares as of March 31, 2021. The aggregate intrinsic value of outstanding options as of March 31, 2021 is calculated as the difference between the exercise price of the underlying options and the market price of our common shares for the 657,814 options that were in-the-money at that date. The aggregate intrinsic value of exercisable options as of March 31, 2021 is calculated as the difference between the exercise price of the underlying options and the market price of our common shares for the 268,815 exercisable options that were in-the-money at that date. The Company's closing stock price was $ 52.76 as of March\n69\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\n31, 2021. The total intrinsic value of stock options exercised was $ 1,749,000 , $ 5,438,000 , and $ 3,577,000 during fiscal 2021, 2020, and 2019, respectively.\nThe grant date fair value of options that vested was $ 9.15 , $ 7.43 , and $ 7.36 during fiscal 2021, 2020, and 2019, respectively.\nAs of March 31, 2021, $ 2,463,000 of unrecognized compensation cost related to non-vested stock options is expected to be recognized over a weighted-average period of approximately 2.0 years.\nExercise prices for options outstanding as of March 31, 2021, ranged from $ 13.43 to $ 38.70 . The following table provides certain information with respect to stock options outstanding at March 31, 2021:\n| Stock OptionsOutstanding | Weighted-averageExercise Price | Weighted-averageRemainingContractual Life |\n| Range of Exercise Prices |\n| $10.01 to 20.00 | 90,811 | $ | 15.26 | 4.92 |\n| $20.01 to 30.00 | 322,668 | $ | 25.15 | 7.41 |\n| $30.01 to $40.00 | 244,335 | $ 35.01 | 8.02 |\n| 657,814 | $ | 27.45 | 7.29 |\n\nThe following table provides certain information with respect to stock options exercisable at March 31, 2021:\n| Range of Exercise Prices | Stock OptionsExercisable | Weighted- averageExercise Price per share |\n| $10.01 to $20.00 | 90,811 | $ | 15.26 |\n| $20.01 to $30.00 | 116,935 | 24.81 |\n| $30.01 to $40.00 | 61,069 | 37.25 |\n| 268,815 | $ | 24.41 |\n\nThe fair value of stock options granted was estimated on the date of grant using a Black-Scholes option pricing model. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of subjective assumptions including the expected stock price volatility. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. The weighted-average grant date fair value of the options was $ 8.46 , $ 12.39 , and $ 13.56 for options granted during fiscal 2021, 2020, and 2019, respectively. The following table provides the weighted-average assumptions used to value stock options granted during fiscal 2021, 2020, and 2019:\n| Year EndedMarch 31,2021 | Year EndedMarch 31,2020 | Year EndedMarch 31,2019 |\n| Assumptions: |\n| Risk-free interest rate | 0.23 | % | 2.23 | % | 2.64 | % |\n| Dividend yield | 0.90 | % | 0.68 | % | 0.52 | % |\n| Volatility factor | 0.380 | 0.372 | 0.352 |\n| Expected life | 5.5 years | 5.5 years | 5.5 years |\n\nTo determine expected volatility, the Company uses historical volatility based on daily closing prices of its Common Stock over periods that correlate with the expected terms of the options granted. The risk-free rate is based on the United States Treasury yield curve at the time of grant for the appropriate term of the options granted. Expected dividends are based on the Company's history and expectation of dividend payouts. The expected term of stock options is based on vesting schedules, expected exercise patterns and contractual terms.\n70\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nRestricted Stock Units\nThe Company granted restricted stock units under the 2016 LTIP during fiscal 2021, 2020, and 2019 to employees as well as to the Company’s non-executive directors as part of their annual compensation. Prior to fiscal 2021, restricted stock units for employees vest ratably based on service one-quarter after each of years one, two, three, and four. For fiscal 2021, restricted stock units for employees vest ratably based on service one-third after each of years one, two, and three.\nA summary of the restricted stock unit awards granted under the Company’s LTIP plan as of March 31, 2021 is as follows:\n| Shares | Weighted-averageGrant DateFair Value per share |\n| Unvested at April 1, 2018 | 336,789 | $ | 22.62 |\n| Granted | 116,942 | 37.90 |\n| Vested | ( 211,932 ) | 22.66 |\n| Forfeited | ( 11,602 ) | 25.18 |\n| Unvested at March 31, 2019 | 230,197 | $ | 30.22 |\n| Granted | 151,351 | 38.40 |\n| Vested | ( 106,792 ) | 31.90 |\n| Forfeited | ( 62,035 ) | 31.61 |\n| Unvested at March 31, 2020 | 212,721 | $ | 35.20 |\n| Granted | 195,181 | 29.16 |\n| Vested | ( 125,150 ) | 31.85 |\n| Forfeited | ( 12,963 ) | 34.74 |\n| Unvested at March 31, 2021 | 269,789 | $ | 32.41 |\n\nTotal unrecognized compensation cost related to unvested restricted stock units as of March 31, 2021 is $ 5,152,000 and is expected to be recognized over a weighted average period of 2.1 years. The fair value of restricted stock units that vested during the year ended March 31, 2021 and 2020 was $ 3,986,000 and $ 3,320,000 , respectively.\nPerformance Shares\nThe Company granted performance shares under the 2016 LTIP during fiscal 2021, 2020, and 2019. Performance based shares are recognized as compensation expense based upon their grant date fair value and to the extent it is probable that the performance conditions will be met. This expense is recognized ratably over the three year period that these shares are restricted.\nFiscal 2018 performance shares granted vest pursuant to a performance condition based upon the Company’s Consolidated Net Sales. During fiscal 2019, the Company determined that the fiscal year 2018 performance shares were earned based on the performance condition being met. Fiscal 2019 performance shares granted vest pursuant to a performance condition based upon the Company’s Consolidated EBITDA margin for the twelve months ended March 31, 2020. During fiscal 2020, the Company determined that the fiscal year 2019 performance shares were earned based on the performance condition being met. Fiscal 2020 performance shares granted vest pursuant to a performance condition based upon the Company’s Consolidated EBITDA margin for the twelve months ended March 31, 2021. During fiscal 2021, the Company determined that this performance condition would not be met. Fiscal 2021 performance shares granted vest pursuant to a performance condition based upon the Company’s Consolidated EBITDA margin for the twelve months ended March 31, 2023. At this time the Company believes the March 31, 2023 performance condition will be met.\n71\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nA summary of the performance shares transactions during each of the three fiscal years in the period ended March 31, 2021 is as follows:\n| Shares | Weighted-averageGrant DateFair Value per share |\n| Unvested at April 1, 2018 | 126,570 | $ | 19.42 |\n| Granted | 34,695 | 36.43 |\n| Forfeited | ( 7,879 ) | 22.40 |\n| Unvested at March 31, 2019 | 153,386 | $ | 23.11 |\n| Granted | 38,585 | 37.67 |\n| Forfeited | ( 125,251 ) | 22.67 |\n| Unvested at March 31, 2020 | 66,720 | $ | 32.36 |\n| Granted | 83,164 | 25.97 |\n| Vested | ( 23,201 ) | 25.28 |\n| Forfeited | ( 3,451 ) | 25.28 |\n| Unvested at March 31, 2021 | 123,232 | $ | 29.58 |\n\nThe Company had $ 2,349,000 in unrecognized compensation costs related to the unvested performance share awards as of March 31, 2021.\nDirectors Stock\nDuring fiscal 2021, 2020, and 2019, a total of 16,209 , 11,768 , and 10,031 shares of stock, respectively, were granted under the 2016 LTIP to the Company’s non-executive directors as part of their annual compensation. The weighted average fair value grant price of those shares was $ 33.32 , $ 39.09 , and $ 41.88 for fiscal 2021, 2020, and 2019, respectively. The expense related to the shares for fiscal 2021 was $ 540,000 and $ 460,000 and $ 430,000 for fiscal years 2020 and 2019.\nDividends\nOn March 22, 2021 the Company's Board of Directors approved payment of a quarterly dividend of $ 0.06 per common share, representing an annual dividend rate of $ 0.24 per share. The dividend was paid on May 13, 2021 to shareholders of record on May 3, 2021 and totaled approximately $ 1,440,000 .\nStock Repurchase Plan\nOn March 26, 2019, the Board of Directors approved a new stock repurchase program authorizing the repurchase of up to $ 20 million of the Company's common stock. No repurchases were made during the fiscal years ended March 31, 2021 or 2020.\n16. Loss Contingencies\nFrom time to time, the Company is named a defendant in legal actions arising out of the normal course of business. The Company is not a party to any pending legal proceeding other than ordinary, routine litigation incidental to our business. The Company does not believe that any of our pending litigation will have a material impact on its business.\nAccrued general and product liability costs are actuarially estimated reserves based on amounts determined from loss reports, individual cases filed with the Company, and an amount for losses incurred but not reported. The aggregate amounts of reserves were $ 21,227,000 (gross of estimated insurance recoveries of $ 8,052,000 ) and $ 11,944,000 of which $ 17,727,000 and $ 8,444,000 are included in Other non current liabilities and $ 3,500,000 in Accrued liabilities for both years as of March 31, 2021 and 2020, respectively. The liability for accrued general and product liability costs are funded by investments in marketable securities (see Notes 2 and 7).\nThe following table provides a reconciliation of the beginning and ending balances for accrued general and product liability:\n72\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\n| Year Ended March 31, |\n| 2021 | 2020 | 2019 |\n| Accrued general and product liability, beginning of year | $ | 11,944 | $ | 12,686 | $ | 13,582 |\n| Estimated insurance recoveries | 8,052 | — | — |\n| Add provision for claims | 4,634 | 3,233 | 2,887 |\n| Deduct payments for claims | ( 3,403 ) | ( 3,975 ) | ( 3,783 ) |\n| Accrued general and product liability, end of year | $ | 21,227 | $ | 11,944 | $ | 12,686 |\n| Estimated insurance recoveries | ( 8,052 ) | — | — |\n| Net accrued general and product liability, end of year | $ | 13,175 | $ | 11,944 | $ | 12,686 |\n\nThe per occurrence limits on the self-insurance for general and product liability coverage to Columbus McKinnon through its wholly-owned captive insurance company were $ 2,000,000 from inception through fiscal 2003 and $ 3,000,000 for fiscal 2004 and thereafter. In addition to the per occurrence limits, the Company’s coverage is also subject to an annual aggregate limit, applicable to losses only. These limits range from $ 2,000,000 to $ 6,000,000 for each policy year from inception through fiscal 2021.\nAlong with other manufacturing companies, the Company is subject to various federal, state, and local laws relating to the protection of the environment. To address the requirements of such laws, the Company has adopted a corporate environmental protection policy which provides that all of its owned or leased facilities shall, and all of its employees have the duty to, comply with all applicable environmental regulatory standards, and the Company utilizes an environmental auditing program for its facilities to ensure compliance with such regulatory standards. The Company has also established managerial responsibilities and internal communication channels for dealing with environmental compliance issues that may arise in the course of its business. Because of the complexity and changing nature of environmental regulatory standards, it is possible that situations will arise from time to time requiring the Company to incur expenditures in order to ensure environmental regulatory compliance. However, the Company is not aware of any environmental condition or any operation at any of its facilities, either individually or in the aggregate, which would cause expenditures having a material adverse effect on its results of operations, financial condition or cash flows and, accordingly, has not budgeted any material capital expenditures for environmental compliance for fiscal 2021.\nWe have entered a voluntary environmental cleanup program in certain states where we operate and believe that our current reserves are sufficient to remediate these locations. For all of the currently known environmental matters, we have accrued as of March 31, 2021, a total of $ 777,000 which, in our opinion, is sufficient to deal with such matters. The Company is not aware of any environmental condition or any operation at any of its facilities, either individually or in the aggregate, which would cause expenditures to have a material adverse effect on its results of operations, financial condition or cash flows and, accordingly, has not budgeted any material capital expenditures for environmental compliance for fiscal 2021.\nLike many industrial manufacturers, the Company is involved in asbestos-related litigation. In continually evaluating costs relating to its estimated asbestos-related liability, the Company reviews, among other things, the incidence of past and recent claims, the historical case dismissal rate, the mix of the claimed illnesses and occupations of the plaintiffs, its recent and historical resolution of the cases, the number of cases pending against it, the status and results of broad-based settlement discussions, and the number of years such activity might continue. Based on this review, the Company has estimated its share of liability to defend and resolve probable asbestos-related personal injury claims. This estimate is highly uncertain due to the limitations of the available data and the difficulty of forecasting with any certainty the numerous variables that can affect the range of the liability. The Company will continue to study the variables in light of additional information in order to identify trends that may become evident and to assess their impact on the range of liability that is probable and estimable.\nBased on actuarial information, the Company has estimated its asbestos-related aggregate liability including related legal costs to range between $ 5,400,000 and $ 9,700,000 , net of insurance recoveries, using actuarial parameters of continued claims for a period of 37 years from March 31, 2021. The Company has estimated its asbestos-related aggregate liability that is probable and estimable, net of insurance recoveries, in accordance with U.S. generally accepted accounting principles to be $ 6,956,000 . The Company has reflected this liability gross of insurance recoveries of $ 8,052,000 as a liability in the consolidated financial statements as of March 31, 2021. The recorded liability does not consider the impact of any potential favorable federal\n73\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nlegislation. This liability will fluctuate based on the uncertainty in the number of future claims that will be filed and the cost to resolve those claims, which may be influenced by a number of factors, including the outcome of the ongoing broad-based settlement negotiations, defensive strategies, and the cost to resolve claims outside the broad-based settlement program. Of this amount, management expects to incur asbestos liability payments of approximately $ 2,000,000 over the next 12 months. Because payment of the liability is likely to extend over many years, management believes that the potential additional costs for claims will not have a material effect on the financial condition of the Company or its liquidity, although the effect of any future liabilities recorded could be material to earnings in a future period.\nA share of the Company's previously incurred asbestos-related expenses and future asbestos-related expenses are covered by pre-existing insurance policies. The Company had been engaged in a legal action against the insurance carriers for those policies to recover past expenses and future costs incurred. The Company came to an agreement with the insurance carriers to settle its case against them for recovery of a portion of past and future asbestos-related legal defense costs. The agreement was finalized during the quarter ended September 30, 2020. The terms of the settlement require the carriers to pay gross defense costs prior to retro-premiums of 65% for future asbestos-related defense costs subject to an annual cap of $ 1,650,000 for claims covered by the settlement. The reimbursement net of retro-premiums is approximately 47% which resulted in a $ 1,830,000 increase to the Company's asbestos liability during the year ended March 31, 2021.\nIn addition, the insurance carriers are required to reimburse the Company for past defense costs through the date of the settlement amounting to $ 3,006,000 . Of this amount, $ 2,842,000 has been paid prior to March 31, 2021 with the remaining expected to be paid in the next quarter. The reimbursement for past cost is recorded net of a contingent legal fee of $ 1,500,000 which was paid in fiscal 2021. Further, the insurance carriers accept 100% coverage for indemnity costs related to all covered cases. Estimates of the future cost sharing have been included in the loss reserve calculation as of March 31, 2021 and 2020. The Company has recorded a receivable for the estimated future cost sharing in Other assets in the Balance Sheet at March 31, 2021 in the amount of $ 8,052,000 , which offsets its asbestos reserves.\nThe Company is also involved in other unresolved legal actions that arise in the normal course of business. The most prevalent of these unresolved actions involve disputes related to product design, manufacture and performance liability. The Company's estimation of its product-related aggregate liability that is probable and estimable, in accordance with U.S. generally accepted accounting principles approximates $ 5,635,000 , which has been reflected as a liability in the consolidated financial statements as of March 31, 2021. In some cases, we cannot reasonably estimate a range of loss because there is insufficient information regarding the matter. Management believes that the potential additional costs for claims will not have a material effect on the financial condition of the Company or its liquidity, although the effect of any future liabilities recorded could be material to earnings in a future period.\nThe following loss contingencies relate to the Company's Magnetek subsidiary:\nProduct Liability\nMagnetek has been named, along with multiple other defendants, in asbestos-related lawsuits associated with business operations previously acquired but which are no longer owned. During Magnetek's ownership, none of the businesses produced or sold asbestos-containing products. For such claims, Magnetek is uninsured and either contractually indemnified against liability, or contractually obligated to defend and indemnify the purchaser of these former business operations. The Company aggressively seeks dismissal from these proceedings. Based on actuarial information, the asbestos related liability including legal costs is estimated to be approximately $ 565,000 which has been reflected as a liability in the consolidated financial statements at March 31, 2021.\nLitigation-Other\nIn October 2010, Magnetek received a request for indemnification from Power-One, Inc. (\"Power-One\") for an Italian tax matter arising out of the sale of Magnetek's power electronics business to Power-One in October 2006. With a reservation of rights, Magnetek affirmed its obligation to indemnify Power-One for certain pre-closing taxes. The sale included an Italian company, Magnetek, S.p.A., and its wholly owned subsidiary, Magnetek Electronics (Shenzhen) Co. Ltd. (the “Power-One China Subsidiary”). The tax authority in Arezzo, Italy, issued a notice of audit report in September 2010 wherein it asserted that the Power-One China Subsidiary had its administrative headquarters in Italy with fiscal residence in Italy and, therefore, is subject to taxation in Italy. In November 2010, the tax authority issued a notice of tax assessment for the period of July 2003 to\n74\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nJune 2004, alleging that taxes of approximately $ 2,200,000 (Euro 1,900,000) were due in Italy on taxable income earned by the Power-One China Subsidiary during this period. In addition, the assessment alleges potential penalties together with interest in the amount of approximately $ 3,000,000 (Euro 2,600,000) for the alleged failure of the Power-One China Subsidiary to file its Italian tax return. The Power-One China Subsidiary filed its response with the provincial tax commission of Arezzo, Italy in January 2011. A hearing before the Tax Court was held in July 2012 on the tax assessment for the period of July 2003 to June 2004. In September 2012, the Tax Court ruled in favor of the Power-One China Subsidiary dismissing the tax assessment for the period of July 2003 to June 2004. In February 2013, the tax authority filed an appeal of the Tax Court's September 2012 ruling. The Regional Tax Commission of Florence heard the appeal of the tax assessment dismissal for the period of July 2003 to June 2004 and thereafter issued its ruling finding in favor of the tax authority. Magnetek believes the court’s decision was based upon erroneous interpretations of the applicable law and appealed the ruling to the Italian Supreme Court in April 2015.\nThe tax authority in Arezzo, Italy also issued a tax inspection report in January 2011 for the periods July 2002 to June 2003 and July 2004 to December 2006 claiming that the Power-One China Subsidiary failed to file Italian tax returns for the reported periods. In August 2012, the tax authority in Arezzo, Italy issued notices of tax assessment for the periods July 2002 to June 2003 and July 2004 to December 2006, alleging that taxes of approximately $ 7,900,000 (Euro 6,700,000) were due in Italy on taxable income earned by the Power-One China Subsidiary together with an allegation of potential penalties in the amount of approximately $ 3,300,000 (Euro 2,800,000) for the alleged failure of the Power-One China Subsidiary to file its Italian tax returns. On June 3, 2015, the Tax Court ruled in favor of the Power-One China Subsidiary dismissing the tax assessments for the periods of July 2002 to June 2003 and July 2004 to December 2006. On July 27, 2015, the tax authority filed an appeal of the Tax Court's ruling of June 3, 2015. In May 2016, the Regional Tax Court of Florence rejected the appeal of the tax authority and at the same time canceled the notices of assessment for the fiscal years of 2004/2005 and 2005/2006. The tax authority had up to six months to appeal the decision. In December 2016, Magnetek was served by the Italian Revenue Service with two appeals to the Italian Supreme Court regarding the two positive judgments on the tax assessments for the fiscal periods 2004/2005 and 2005/2006. In March 2017, the tax authority rejected the appeal of the assessment for 2005/2006 fiscal year. The tax authority had until October 2017 to appeal this decision. In October 2017, Magnetek was served by the Italian Revenue Service with an appeal to the Italian Supreme Court against the positive judgment on the tax assessment for fiscal year 2005/2006. In November 2017 Magnetek filed a memorandum with the Italian Revenue Service and the Italian Supreme Court in response to the appeal made by the tax authority. In February 2018 an appeal hearing was held at the Regional Tax Court of Florence regarding the Italian tax authority's claim for taxes due for fiscal 2002/2003. In October 2018 Magnetek was served by the Italian Revenue Service with an appeal to the Italian Supreme Court against the positive judgment on the tax assessment for fiscal year 2002/2003. In November 2018 Magnetek filed a memorandum with the Italian Supreme Court in response to the appeal made by the tax authority.\nThe Company believes it will be successful and does not expect to incur a liability related to these assessments.\nEnvironmental Matters\nFrom time to time, Magnetek has taken action to bring certain facilities associated with previously owned businesses into compliance with applicable environmental laws and regulations. Upon the subsequent sale of certain businesses, Magnetek agreed to indemnify the buyers against environmental claims associated with the divested operations, subject to certain conditions and limitations. Remediation activities, including those related to indemnification obligations, did not involve material expenditures during fiscal year 2021.\nMagnetek has also been identified by the United States Environmental Protection Agency and certain state agencies as a potentially responsible party for cleanup costs associated with alleged past waste disposal practices at several previously utilized, owned or leased facilities and offsite locations. Its remediation activities as a potentially responsible party were not material in fiscal year 2021. Although the materiality of future expenditures for environmental activities may be affected by the level and type of contamination, the extent and nature of cleanup activities required by governmental authorities, the nature of Magnetek's alleged connection to the contaminated sites, the number and financial resources of other potentially responsible parties, the availability of indemnification rights against third parties, and the identification of additional contaminated sites, Magnetek's estimated share of liability, if any, for environmental remediation, including its indemnification obligations, is not expected to be material.\nIn 1986, Magnetek acquired the stock of Universal Manufacturing Corporation (“Universal”) from a predecessor of Fruit of the Loom (“FOL”), and the predecessor agreed to indemnify Magnetek against certain environmental liabilities arising from pre-\n75\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nacquisition activities at a facility in Bridgeport, Connecticut. Environmental liabilities covered by the indemnification agreement included completion of additional cleanup activities, if any, at the Bridgeport facility and defense and indemnification against liability for potential response costs related to offsite disposal locations. Magnetek's leasehold interest in the Bridgeport facility was assigned to the buyer in connection with the sale of Magnetek's transformer business in June 2001. FOL, the successor to the indemnification obligation, filed a petition for Reorganization under Chapter 11 of the Bankruptcy Code in 1999 and Magnetek filed a proof of claim in the proceeding for obligations related to the environmental indemnification agreement. Magnetek believes that FOL had substantially completed the clean-up obligations required by the indemnification agreement prior to the bankruptcy filing. In November 2001, Magnetek and FOL entered into an agreement involving the allocation of certain potential tax benefits and Magnetek withdrew its claims in the bankruptcy proceeding. Magnetek further believes that FOL's obligation to the state of Connecticut was not discharged in the reorganization proceeding.\nIn January 2007, the Connecticut Department of Environmental Protection (“DEP”) requested parties, including Magnetek, to submit reports summarizing the investigations and remediation performed to date at the site and the proposed additional investigations and remediation necessary to complete those actions at the site. DEP requested additional information relating to site investigations and remediation. Magnetek and the DEP agreed to the scope of the work plan in November 2010. The Company has recorded a liability of $ 377,000 , included in the amount specified above, related to the Bridgeport facility, representing the best estimate of future site investigation costs and remediation costs which are expected to be incurred in the future.\nThe Company has recorded total liabilities of $ 523,000 for all environmental matters related to Magnetek in the consolidated financial statements as of March 31, 2021 on an undiscounted basis.\nIn September of 2017, Magnetek received a request for defense and indemnification from Monsanto Company, Pharmacia, LLC, and Solutia, Inc. (collectively, “Monsanto”) with respect to: (1) lawsuits brought by plaintiffs claiming that Monsanto manufactured polychlorinated biphenyls (\"PCBs\"), exposure to which allegedly caused injury to plaintiffs; and (2) lawsuits brought by municipalities and municipal entities claiming that Monsanto should be responsible for a variety of damages due to the presence of PCBs in bodies of water in those municipalities and/or in water treated by those municipal entities. Monsanto claims to be entitled to defense and indemnification from Magnetek under a so-called “Special Undertaking” apparently executed by Universal in January of 1972, which purportedly required Universal to defend and indemnify Monsanto from liabilities “arising out of or in connection with the receipt, purchase, possession, handling, use, sale or disposition of” PCBs by Universal.\nMagnetek has declined Monsanto’s tender, and believes that it has meritorious legal and factual defenses to the demands made by Monsanto. Magnetek is vigorously defending against those demands and has commenced litigation to, among other things, declare the Special Undertaking void and unenforceable. Monsanto has, in turn, commenced an action to enforce the Special Undertaking. Magnetek intends to continue to vigorously prosecute its declaratory judgment action and to defend against Monsanto’s action against it. We cannot reasonably estimate a potential range of loss with respect to Monsanto’s tender because there is insufficient information regarding the underlying matters. Management believes, however, that the potential additional legal costs related to such matters will not have a material effect on the financial condition of the Company or its liquidity, although the effect of any future liabilities recorded could be material to earnings in a future period.\nThe Company had previously filed suit against Travelers in District Court seeking coverage under insurance policies in the name of Magnetek’s predecessor Universal Manufacturing. In July 2019, the District Court ruled that Travelers is obligated to defend Magnetek under these policies in connection with Magnetek’s litigation against Monsanto. The Court held that Monsanto’s claims against Magnetek fall within the insuring agreement of the Travelers policies and that none of the policy exclusions precluded the possibility of coverage. The Court also held that Travelers prior settlements with other insureds under the policies did not cut off or release Magnetek’s rights under the policies. Travelers moved for reconsideration and had sought discovery from Magnetek and Monsanto in connection with that motion. On September 22, 2020, the Court issued an order denying the motion to reconsider and denying the motion to compel discovery from Magnetek. The result was that the Court’s prior order granting Magnetek partial summary judgment and requiring Travelers’ to reimburse Magnetek’s defense costs to date and fund its defense costs moving forward was now binding, subject to Travelers right to appeal. Travelers moved for a reconsideration of the order which was denied in September 2020 and in March 2021 Traveler’s window to appeal the court order closed. As a result, the Company recorded a receivable for approximately $ 900,000 as of March 31, 2021 in past defense\n76\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\ncosts which are to be reimbursed. The receivable has been reflected as a reduction to Cost of products sold in fiscal 2021. The receivable was subsequently paid in full in April 2021.\nThe Company is also engaged in similar coverage litigation against Transportation Insurance Company in the Circuit Court of Cook County, Illinois. The Company has sought a ruling that Transportation Insurance Company is also obligated to reimburse Magnetek’s defense costs to date and fund its defense costs moving forward. That motion is not yet fully briefed.\n17. Income Taxes\nOn December 22, 2017, the President of the United States signed into law the Tax Cuts and Jobs Act (“Tax Reform Act” or “the Act”). The legislation significantly changed U.S. tax law by, among other things, lowering corporate income tax rates, assessing a one-time transition tax on a deemed repatriation of non-previously taxed earnings of foreign subsidiaries, and implementing a territorial tax system.\nWhile the Tax Reform Act provides for a territorial tax system, beginning in 2018, it includes two new U.S. tax base erosion provisions, the global intangible low-taxed income (“GILTI”) provisions and the base-erosion and anti-abuse tax (“BEAT”) provisions. The Act also provides for the foreign-derived intangible income (“FDII”) deduction for corporations that derive gross income from export activities\nThe GILTI provisions require the Company to include in its U.S. income tax return any foreign subsidiary earnings in excess of an allowable return on the foreign subsidiary’s tangible assets. For the years ended March 31, 2021, 2020, and 2019, the Company has not recorded material tax expense related to GILTI provisions. The Company has elected to account for GILTI tax in the period in which it is incurred, and therefore has not provided any deferred tax impacts of GILTI in its consolidated financial statements for the years ended March 31, 2021, 2020, and 2019.\nThe BEAT provisions in the Tax Reform Act eliminate the deduction of certain base-erosion payments made to related foreign corporations, and impose a minimum tax if greater than regular tax. The BEAT tax had no impact on the Company's consolidated financial statements for the years ended March 31, 2021, 2020, and 2019.\nThe FDII provisions of the Act provide an incentive to domestic corporations in the form of a lower tax rate on income derived from tangible and intangible products and services in foreign markets. This lower tax rate is accomplished via an additional tax deduction based on a percentage of qualifying sales. The FDII deduction provided the Company an additional tax benefit of $ 0 , $ 1,029,000 , and $ 945,000 in the years ended March 31, 2021, 2020, and 2019, respectively.\nSAB 118 measurement period adjustments\nOn December 22, 2017, the SEC staff issued Staff Accounting Bulletin No. 118 (“SAB 118”) to address the application of U.S. GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Tax Reform Act.\nWe applied the guidance in SAB 118 when accounting for the enactment-date effects of the Act in 2017 and throughout 2018. At December 31, 2017, we had not completed our accounting for all of the enactment-date income tax effects of the Act under ASC 740, Income Taxes, for the following aspects: remeasurement of deferred tax assets and liabilities and one-time transition tax. As of December 31, 2018, we completed our accounting for all of the enactment-date income tax effects of the Act, the impacts of which are summarized below.\nThe provision for income taxes differs from the amount computed by applying the statutory federal income tax rate to income from continuing operations before income tax expense. The sources and tax effects of the differences were as follows:\n77\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\n| Year Ended March 31, |\n| 2021 | 2020 | 2019 |\n| Statutory federal income tax rate | 21.00 | % | 21.00 | % | 21.00 | % |\n| Expected tax at statutory rate | $ | 2,116 | $ | 16,203 | $ | 11,108 |\n| Effect of Tax Reform Act (1) | — | — | ( 1,500 ) |\n| State income taxes net of federal benefit | ( 450 ) | 1,397 | 1,728 |\n| Foreign taxes at rates other than statutory federal rate | 287 | 1,102 | ( 145 ) |\n| Net loss on sale of businesses (3) | — | — | 4,041 |\n| Permanent items (6), (7) | 178 | 266 | ( 1,694 ) |\n| Valuation allowance (2), (4) | 84 | ( 1,184 ) | 13,190 |\n| Foreign tax credits (2) | — | — | ( 15,371 ) |\n| Federal tax credits (5) | ( 700 ) | ( 1,903 ) | ( 1,376 ) |\n| Other (8) | ( 545 ) | 1,603 | 340 |\n| Actual tax provision expense | $ | 970 | $ | 17,484 | $ | 10,321 |\n\n(1) For fiscal 2019, represents the discrete benefit of the reduction of the one-time transition tax of $ 1,500,000 recorded in fiscal 2018 to zero.\n(2) For fiscal 2019, primarily represents foreign tax credits generated by the one-time transition tax calculation and valuation allowance as the Company believes their utilization is uncertain.\n(3) For fiscal 2019, represents losses on sales of businesses that are not deductible for income tax purposes.\n(4) For fiscal 2020, represents the reversal of a valuation allowance on certain foreign tax credits offset by increases in valuation allowances required in certain foreign jurisdiction.\n(5) For fiscal 2021, Federal tax credits include research and development credits of $ 700,000 . For fiscal 2020, Federal tax credits include research and development credits of $ 800,000 and minimum tax credits of $ 1,103,000 . For fiscal 2019, Federal tax credits relate to research and development credits.\n(6) For fiscal 2019, permanent items include a FDII deduction of $ 945,000 .\n(7) For fiscal 2020, permanent items include a net GILTI inclusion of $ 525,000 and a FDII deduction of $ 1,029,000 .\n(8) For fiscal 2021, Other primarily relates to adjustments for previously estimated tax expenses.\nThe provision for income tax expense (benefit) consisted of the following:\n| Year Ended March 31, |\n| 2021 | 2020 | 2019 |\n| Current income tax expense (benefit): |\n| United States Federal | $ | 810 | $ | ( 2,491 ) | $ | ( 1,663 ) |\n| State taxes | 618 | 626 | 394 |\n| Foreign | 8,246 | 11,984 | 12,548 |\n| Deferred income tax expense (benefit): |\n| United States | ( 5,996 ) | 7,827 | 5,873 |\n| Foreign | ( 2,708 ) | ( 462 ) | ( 6,831 ) |\n| $ | 970 | $ | 17,484 | $ | 10,321 |\n\nThe Company applies the liability method of accounting for income taxes as required by ASC Topic 740, “Income Taxes.” The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are as follows:\n78\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\n| March 31, |\n| 2021 | 2020 |\n| Deferred tax assets: |\n| Federal net operating loss carryforwards | $ | 16,038 | $ | 18,091 |\n| State and foreign net operating loss carryforwards | 7,404 | 7,142 |\n| Employee benefit plans | 24,692 | 31,471 |\n| Insurance reserves | 3,488 | 3,216 |\n| Accrued vacation and incentive costs | 3,061 | 3,218 |\n| Federal tax credit carryforwards | 13,238 | 11,922 |\n| ASC 842 Lease Liability | 8,623 | 9,048 |\n| Equity compensation | 2,782 | 1,974 |\n| Other | 7,308 | 7,319 |\n| Valuation allowance | ( 15,103 ) | ( 15,036 ) |\n| Deferred tax assets after valuation allowance | 71,531 | 78,365 |\n| Deferred tax liabilities: |\n| Property, plant, and equipment | ( 1,889 ) | ( 1,962 ) |\n| ASC 842 Right-of-Use Asset | ( 8,446 ) | ( 8,938 ) |\n| Intangible assets | ( 58,716 ) | ( 59,397 ) |\n| Total deferred tax liabilities | ( 69,051 ) | ( 70,297 ) |\n| Net deferred tax assets (liabilities) | $ | 2,480 | $ | 8,068 |\n\nThe net deferred tax asset decreased in fiscal 2021 primarily as a result of the termination of one of the Company's pension plans.\nThe gross amount of the Company’s deferred tax assets were $ 86,634,000 and $ 93,401,000 at March 31, 2021 and 2020, respectively.\nThe valuation allowance includes $ 2,896,000 and $ 2,696,000 related to foreign net operating losses at March 31, 2021 and 2020, respectively. The remaining valuation allowance primarily relates to foreign tax credits which the Company believes it will not utilize of $ 11,900,000 and $ 11,800,000 for the years ended March 31, 2021 and 2020, respectively. The Company’s foreign subsidiaries have net operating loss carryforwards of $ 10,552,000 that expire in periods ranging from five years to indefinite.\nFederal net operating losses of $ 76,371,000 arose from the acquisition of Magnetek and have expiration dates ranging from 2022 through 2035 and are subject to certain limitations under U.S. tax law. The state net operating losses of $ 77,889,000 have expiration dates ranging from 2021 through 2041. The federal tax credits have expiration dates ranging from 2028 to 2041.\nDeferred income taxes are classified within the consolidated balance sheets based on the following breakdown:\n| March 31, |\n| 2021 | 2020 |\n| Net non-current deferred tax assets | $ | 20,080 | $ | 26,281 |\n| Net non-current deferred tax liabilities | ( 17,600 ) | ( 18,213 ) |\n| Net deferred tax assets (liabilities) | $ | 2,480 | $ | 8,068 |\n\nNet non-current deferred tax liabilities are included in other non-current liabilities.\nIncome from continuing operations before income tax expense includes foreign subsidiary income of $ 30,894,000 , $ 37,577,000 , and $ 14,362,000 for the years ended March 31, 2021, 2020, and 2019, respectively. As of March 31, 2021, the Company had approximately $ 69,000,000 of undistributed earnings of foreign subsidiaries. These earnings are considered to be\n79\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\npermanently invested in operations outside the U.S. with the exception of the current earnings from one foreign subsidiary. Any repatriation of these amounts would not be expected to result in a material increase to income tax expense due to the one-time transition tax and the new U.S. territorial tax system. Determination of the amount of unrecognized deferred U.S. income tax liability with respect to such earnings is not practicable.\nDuring fiscal 2018, the Company adopted ASU No. 2016-09. There were shares of common stock issued through restricted stock units, the exercise of non-qualified stock options, or through the disqualifying disposition of incentive stock options in the years ended March 31, 2021 and 2020. The tax effect to the Company from these share transactions during fiscal 2021 and 2020 was a reduction to income tax expense of ($ 283,000 ) and ($ 169,000 ), respectively.\nChanges in the Company’s uncertain income tax positions, excluding the related accrual for interest and penalties, are as follows:\n| 2021 | 2020 | 2019 |\n| Beginning balance | $ | 132 | $ | 936 | $ | 592 |\n| Additions for tax positions of the current year | — | — | 550 |\n| Reductions for prior year tax positions | — | ( 802 ) | ( 141 ) |\n| Foreign currency translation | 9 | ( 2 ) | ( 65 ) |\n| Lapses in statutes of limitation | — | — | — |\n| Ending balance | $ | 141 | $ | 132 | $ | 936 |\n\nThe Company had $ 57,000 , $ 46,000 , and $ 38,000 accrued for the payment of interest and penalties at March 31, 2021, 2020, and 2019 respectively. The Company recognizes interest expense or penalties related to uncertain tax positions as a part of income tax expense in its consolidated statements of operations.\nAll of the unrecognized tax benefits as of March 31, 2021 would impact the effective tax rate if recognized.\nThe Company and its subsidiaries file income tax returns in the U.S., various state, local, and foreign jurisdictions.\nThe Company’s major tax jurisdictions are the United States and Germany. With few exceptions, the Company is no longer subject to tax examinations by tax authorities in the United States for tax years prior to March 31, 2017 and in Germany for tax years prior to March 31, 2012. The Company has a current tax examination in Germany for fiscal years 2012 to 2014.\nThe Company anticipates that total unrecognized tax benefits will change due to the settlement of audits in certain foreign jurisdictions prior to March 31, 2022.\n18. Leases\nTransition\nIn February 2016, the FASB issued ASU No. 2016-02, \"Leases (Topic 842)\" (\"ASC 842\"). ASC 842 requires the recognition of lease ROU assets and lease liabilities by lessees for those leases classified as operating leases and additional disclosures regarding the nature of the Company's leases, significant judgments made, and amounts recognized in the financial statements relating to those leases. The Company adopted this standard effective April 1, 2019 under the modified retrospective method whereas comparative period information is not restated. In addition, the Company elected the package of practical expedients which permits the Company to not reassess whether existing contracts are or contain leases, to not reassess the lease classification of any existing leases, and to not reassess initial direct costs for any existing leases. The Company also elected the practical expedient to not separate lease and non-lease components for all classes of underlying assets and made an accounting policy election to not record leases with an initial term of twelve months or less on the balance sheet for all classes of underlying assets.\n80\nAs a result of the adoption of ASC 842, the Company recognized an initial operating lease ROU assets of $ 35,553,000 on April 1, 2019 with a corresponding lease liability of the same amount. The standard did not materially impact the Company's Consolidated Statement of Operations or the Consolidated Statements of Cash Flows for the fiscal year ending March 31, 2020.\nNature of leases\nThe Company's leases are classified as operating leases and consist of manufacturing facilities, sales offices, distribution centers, warehouses, vehicles, and equipment. For leases with terms greater than twelve months, at lease commencement the Company recognizes a ROU asset and a lease liability. The initial lease liability is recognized at the present value of remaining lease payments over the lease term. Leases with an initial term of twelve months or less are not recorded on the Company's Consolidated Balance Sheet. The Company recognizes lease expense for operating leases on a straight-line basis over the lease term. Additionally, because the Company has elected to not separate lease and non-lease components, variable costs also include payments to the landlord for common area maintenance, real estate taxes, insurance, and other operating expenses.\nThe Company's leases have lease terms ranging from 1 to 15 years, some of which include options to extend or terminate the lease. The exercise of lease renewal options is at the Company’s sole discretion. When deemed reasonably certain of exercise, the renewal options are included in the determination of the lease term. The Company’s lease agreements do not contain material residual value guarantees or any material restrictive covenants.\nAs of March 31, 2021, the Company does not have any significant additional operating leases that have not yet commenced.\nSignificant assumptions or judgments\nThe discount rate implicit within each lease is generally not readily determinable, therefore, the Company uses its estimated incremental borrowing rate in determining the present value of lease payments. The incremental borrowing rate is determined based on the Company’s recent debt issuances, lease term, and the currency in which lease payments are made.\nThe following table presents the weighted average remaining lease term and discount rate as of March 31, 2021 and March 31, 2020, respectively:\n| March 31, 2021 | March 31, 2020 |\n| Weighted-average remaining lease term (in years) | 5.99 | 6.74 |\n| Weighted-average discount rate | 3.86 | % | 4.05 | % |\n\nAmounts recognized on the financial statements\nThe following table illustrates the balance sheet classification for ROU assets and lease liabilities as of March 31, 2021 and March 31, 2020, respectively (in thousands):\n| Balance sheet classification | March 31, 2021 | March 31, 2020 |\n| Assets | Other assets | $ | 34,181 | $ | 38,125 |\n| Current | Accrued liabilities | 7,673 | 6,924 |\n| Non-current | Other non current liabilities | 27,321 | 31,629 |\n| Total liabilities | $ | 34,994 | $ | 38,553 |\n\nOperating lease expense of $ 9,175,000 and $ 8,869,000 for the fiscal years ending March 31, 2021 and March 31, 2020, respectively, is included in income from operations on the Consolidated Statements of Operations. Short-term lease expense, sublease income, and variable lease expenses are no t material for the fiscal year ending March 31, 2021. Rental expense for the year ended March 31, 2019 was $ 12,248,000 under ASC 840 (prior to the adoption of ASC 842).\n81\nOther lease disclosures\nAt March 31, 2021, the maturities of operating lease liabilities were as follows (in thousands):\n| Year: | March 31, 2021 |\n| 2022 | $ | 9,002 |\n| 2023 | 8,019 |\n| 2024 | 5,212 |\n| 2025 | 4,695 |\n| 2026 | 3,599 |\n| Thereafter | 9,345 |\n| Total undiscounted lease payments | $ | 39,872 |\n| Less: imputed interest | $ | 4,878 |\n| Present value of lease liabilities | $ | 34,994 |\n\nSupplemental cash flow information related to operating leases is as follows (in thousands):\n| Year ended March 31, 2021 | Year ended March 31, 2020 |\n| Cash paid for amounts included in the measurement of operating lease liabilities | $ | 8,909 | $ | 8,593 |\n| ROU assets obtained in exchange for new operating lease liabilities | $ | 2,866 | $ | 10,589 |\n\n19. Business Segment Information\nASC Topic 280, “Segment Reporting,” establishes the standards for reporting information about operating segments in financial statements. The Company has one operating and reportable segment for both internal and external reporting purposes.\nFinancial information relating to the Company’s operations by geographic area is as follows:\n| Year Ended March 31, |\n| 2021 | 2020 | 2019 |\n| Net sales: |\n| United States | $ | 348,986 | $ | 450,242 | $ | 485,969 |\n| Germany | 164,380 | 175,492 | 196,055 |\n| Europe, Middle East, and Africa (Excluding Germany) | 90,415 | 121,600 | 127,453 |\n| Canada | 15,443 | 21,984 | 22,206 |\n| Asia Pacific | 13,829 | 14,193 | 17,749 |\n| Latin America | 16,589 | 25,651 | 26,850 |\n| Total | $ | 649,642 | $ | 809,162 | $ | 876,282 |\n\nNote: Net sales to external customers are attributed to geographic areas based upon the location from which the product was shipped from the Company to the customer.\n82\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\n| Year Ended March 31, |\n| 2021 | 2020 | 2019 |\n| Total assets: |\n| United States | $ | 540,184 | $ | 518,914 | $ | 496,580 |\n| Germany | 435,638 | 438,210 | 429,859 |\n| Europe, Middle East, and Africa (Excluding Germany) | 125,262 | 86,638 | 85,680 |\n| Canada | 8,647 | 9,979 | 8,688 |\n| Asia Pacific | 19,326 | 20,314 | 22,129 |\n| Latin America | 21,375 | 19,217 | 18,635 |\n| Total | $ | 1,150,432 | $ | 1,093,272 | $ | 1,061,571 |\n\n| Year Ended March 31, |\n| 2021 | 2020 | 2019 |\n| Long-lived assets: |\n| United States | $ | 269,061 | $ | 272,816 | $ | 282,456 |\n| Germany | 336,606 | 327,420 | 342,150 |\n| Europe, Middle East, and Africa | 8,359 | 9,561 | 10,163 |\n| Canada | 1,395 | 1,192 | 1,319 |\n| Asia Pacific | 2,235 | 4,928 | 5,781 |\n| Latin America | 1,635 | 1,197 | 1,190 |\n| Total | $ | 619,291 | $ | 617,114 | $ | 643,059 |\n\nNote: Long-lived assets include net property, plant, and equipment, goodwill, and other intangibles, net.\n| Sales by major product group are as follows: | Year Ended March 31, |\n| 2021 | 2020 | 2019 |\n| Hoists | $ | 394,682 | $ | 492,126 | $ | 518,806 |\n| Chain and rigging tools | 47,557 | 68,666 | 89,215 |\n| Industrial cranes | 37,025 | 44,149 | 59,085 |\n| Actuators and rotary unions | 75,458 | 77,957 | 77,719 |\n| Digital power control and delivery systems | 74,943 | 100,658 | 98,187 |\n| Elevator application drive systems | 19,977 | 25,606 | 25,548 |\n| Other | — | — | 7,722 |\n| Total | $ | 649,642 | $ | 809,162 | $ | 876,282 |\n\nThe prior year sales by major product group amounts have been reclassified to be consistent with the current period presentation.\nOn December 28, 2018, the Company sold its Tire Shredder business, and on February 28, 2019, the Company sold Crane Equipment and Service Inc. and Stahlhammer Bommern GmbH. In fiscal year 2019, these businesses accounted for chain and rigging tools sales of $ 12,289,000 , industrial cranes sales of $ 14,184,000 , and other sales of $ 7,722,000 .\n83\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\n20. Accumulated Other Comprehensive Loss\nThe components of accumulated other comprehensive loss is as follows:\n| March 31, |\n| 2021 | 2020 |\n| Foreign currency translation adjustment – net of tax | $ | ( 21,776 ) | $ | ( 34,359 ) |\n| Pension liability – net of tax | ( 38,081 ) | ( 79,651 ) |\n| Postretirement obligations – net of tax | 1,989 | 1,950 |\n| Split-dollar life insurance arrangements – net of tax | ( 1,264 ) | ( 1,340 ) |\n| Derivatives qualifying as hedges – net of tax | ( 854 ) | ( 950 ) |\n| Accumulated other comprehensive loss | $ | ( 59,986 ) | $ | ( 114,350 ) |\n\nThe deferred taxes related to the adjustments associated with the items included in accumulated other comprehensive loss, net of deferred tax asset valuation allowances, were $( 13,305,000 ), $ 7,445,000 , and $ 2,566,000 for fiscal 2021, 2020, and 2019 respectively. Refer to Note 17 for discussion of the deferred tax asset valuation allowance. In the period subsequent to our initial recording of the valuation allowance in fiscal 2011, increases and decreases to both the deferred tax assets associated with items in accumulated other comprehensive loss, and the valuation allowance, have been recorded as offsets to comprehensive income.\nAs a result of the Act as described in Note 17, the Company recorded as an offsetting entry a $( 7,251,000 ) stranded tax effect in the minimum pension liability component and a $( 194,000 ) stranded tax effect in the split dollar life insurance arrangement component of other comprehensive income in fiscal 2018. The stranded tax effect related to the other post retirement obligations component was not material.\nAs a result of the recording of a deferred tax asset valuation allowance in fiscal 2011, the Company recorded as an offsetting entry a $ 7,605,000 stranded tax effect in the minimum pension liability component, $ 935,000 stranded tax effect in the other post retirement obligations component and a $ 747,000 stranded tax effect in the split dollar life insurance arrangement component of other comprehensive income. With the reversal of that valuation allowance in fiscal 2013, the Company recorded the reversal of the valuation allowance as a reduction of income taxes in the consolidated statement of operations.\nAs a result of the recording of a deferred tax asset valuation allowance in fiscal 2005, the Company recorded as an offsetting entry a $ 406,000 stranded tax effect in the minimum pension liability component of other comprehensive income. With the reversal of that valuation allowance in fiscal 2006, the Company recorded the reversal of the valuation allowance as a reduction of income taxes in the consolidated statement of operations.\nThe stranded tax effects described above are in accordance with ASC Topic 740, “Income Taxes” even though the impact of the act and the deferred tax asset valuation allowance described above were initially established as an adjustment to comprehensive income. This amount will remain indefinitely as a component of accumulated other comprehensive loss.\nThe activity by year related to investments, including reclassification adjustments for activity included in earnings are as follows (all items shown net of tax):\n| Year Ended March 31, |\n| 2021 | 2020 | 2019 |\n| Net unrealized investment gain (loss) at beginning of year | $ | — | $ | — | $ | 888 |\n| Unrealized holdings gain (loss) arising during the period | — | — | — |\n| Reclassification adjustments for gain included in earnings | — | — | — |\n| Adoption of ASU 2016-01 | — | — | ( 888 ) |\n| Net change in unrealized gain (loss) on investments | — | — | ( 888 ) |\n| Net unrealized investment gain at end of year | $ | — | $ | — | $ | — |\n\n84\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nChanges in accumulated other comprehensive income by component are as follows (in thousands):\n| March 31, 2021 |\n| Retirement Obligations | Foreign Currency | Change in Derivatives Qualifying as Hedges | Total |\n| Beginning balance net of tax | $ | ( 79,041 ) | $ | ( 34,359 ) | $ | ( 950 ) | ( 114,350 ) |\n| Other comprehensive income (loss) before reclassification | 24,999 | 12,583 | ( 8,552 ) | 29,030 |\n| Amounts reclassified from other comprehensive loss to net income | 16,686 | — | 8,648 | 25,334 |\n| Net current period other comprehensive (loss) income | 41,685 | 12,583 | 96 | 54,364 |\n| Ending balance net of tax | $ | ( 37,356 ) | $ | ( 21,776 ) | $ | ( 854 ) | $ | ( 59,986 ) |\n\n| March 31, 2020 |\n| Retirement Obligations | Foreign Currency | Change in Derivatives Qualifying as Hedges | Total |\n| Beginning balance net of tax | $ | ( 55,145 ) | $ | ( 25,355 ) | $ | ( 2,552 ) | ( 83,052 ) |\n| Other comprehensive income (loss) before reclassification | ( 25,449 ) | ( 9,004 ) | 4,772 | ( 29,681 ) |\n| Amounts reclassified from other comprehensive loss to net income | 1,553 | — | ( 3,170 ) | ( 1,617 ) |\n| Net current period other comprehensive (loss) income | ( 23,896 ) | ( 9,004 ) | 1,602 | ( 31,298 ) |\n| Ending balance net of tax | $ | ( 79,041 ) | $ | ( 34,359 ) | $ | ( 950 ) | $ | ( 114,350 ) |\n\nDetails of amounts reclassified out of accumulated other comprehensive loss for the year ended March 31, 2021 are as follows (in thousands):\n| Details of AOCL Components | Amount reclassified from AOCL | Affected line item on consolidated statement of operations |\n| Net pension amount unrecognized |\n| $ | 22,009 | (1) |\n| 22,009 | Total before tax |\n| ( 5,323 ) | Tax benefit |\n| $ | 16,686 | Net of tax |\n| Change in derivatives qualifying as hedges |\n| $ | ( 90 ) | Cost of products sold |\n| 1,585 | Interest expense |\n| 7,874 | Foreign currency |\n| 9,369 | Total before tax |\n| ( 721 ) | Tax benefit |\n| $ | 8,648 | Net of tax |\n\n(1)These accumulated other comprehensive loss components are included in the computation of net periodic pension cost. (See Note 13 — Pensions and Other Benefit Plans for additional details.)\nDetails of amounts reclassified out of accumulated other comprehensive loss for the year ended March 31, 2020 are as follows (in thousands):\n85\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\n| Details of AOCL Components | Amount reclassified from AOCL | Affected line item on consolidated statement of operations |\n| Net pension amount unrecognized |\n| $ | 2,074 | (1) |\n| 2,074 | Total before tax |\n| ( 521 ) | Tax benefit |\n| $ | 1,553 | Net of tax |\n| Change in derivatives qualifying as hedges |\n| $ | ( 54 ) | Cost of products sold |\n| ( 327 ) | Interest expense |\n| ( 3,907 ) | Foreign currency |\n| ( 4,288 ) | Total before tax |\n| 1,118 | Tax benefit |\n| $ | ( 3,170 ) | Net of tax |\n\n(1)These accumulated other comprehensive loss components are included in the computation of net periodic pension cost. (See Note 13 — Pensions and Other Benefit Plans for additional details.)\n21. Effects of New Accounting Pronouncements\nASU 2016-13 (Topic 326) - Adopted in fiscal 2021\nIn November 2019, the FASB issued ASU No. 2019-11, \"Codification Improvements to Topic 326: Financial Instruments - Credit Losses.\" The ASU allows, among other aspects, companies to make accounting policy elections to simplify certain aspects of the presentation and measurement of accrued interest on receivables as well as certain practical expedients for disclosure of accrued interest and financial assets secured by collateral maintenance provisions. The ASU was adopted in connection with the adoption of ASU 2016-13 described below.\nIn May 2019, the FASB issued ASU No. 2019-05, \"Financial Instruments - Credit Losses (Topic 326): Targeted Transition Relief.\" The ASU allows companies to elect, upon adoption of ASU 2016-13, the fair value option on financial instruments that were previously recorded at amortized cost and are within the scope of ASC 326-20 if the instruments are eligible for the fair value option under ASC 825-10. The ASU was adopted in connection with the adoption of ASU 2016-13 described below.\nIn November 2018, the FASB issued ASU No. 2018-19, \"Codification Improvements to Topic 326: Financial Instruments - Credit Losses.\" The ASU changes the effective date of ASU 2016-13, Financial Instruments - Credit Losses, to fiscal years beginning after December 15, 2019, including interim periods within those fiscal years.\nIn June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments” (“ASU 2016-13”). The standard changes the methodology for measuring credit losses on financial instruments and the timing of when such losses are recorded. ASU 2016-13 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2019. The Company adopted this standard and all related standards effective April 1, 2020. Refer to Note 4 (Revenue & Receivables) for the transition impact and further details.\nOther Topics adopted in fiscal 2021\nIn August 2020, the U.S. Securities and Exchange Commission (\"SEC\") issued its rule Modernization of Regulation S-K Items, which modernizes the disclosure requirements in Regulation S-K, Item 101, “Description of Business”; Item 103, “Legal Proceedings”; and Item 105, “Risk Factors.” The SEC stated that the final rule is intended to improve the readability of disclosures, reduce repetition, and eliminate immaterial information, thereby simplifying compliance for registrants and making disclosures more meaningful for investors. The SEC rule was effective November 9, 2020 and the Company adopted the rule in\n86\nCOLUMBUS McKINNON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (tabular amounts in thousands, except share data)\nthis Form 10-K. The main updates as a result of adopting the standard include enhanced disclosure on human capital in the Business section and elimination of Selected Financial Data and the Selected Quarterly Financial Data Note.\nIn August 2018, the FASB issued ASU No. 2018-13, \"Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement (Topic 820).\" The ASU changes the fair value measurement disclosure requirements including new, eliminated, and modified disclosure requirements of ASC 820. For instance, the ASU requires the addition of disclosures for Level 3 fair value measurements with unrealized gains and losses included in other comprehensive income and disclosure of the range of the weighted average assumpitions used to develop significant unobservable inputs for Level 3 measurements. The ASU is effective for fiscal years beginning after December 15, 2019, and interim periods within those years, with early adoption permitted for any eliminated or modified disclosures. The Company adopted this standard effective April 1, 2020 and the standard did not have a material impact on the financial statements for the twelve months ended March 31, 2021.\nIn August 2018, the FASB issued ASU No. 2018-14, \"Disclosure Framework - Changes to the Disclosure Requirements for Defined Benefit Plan (Topic 715).\" The ASU amends ASC 715 to add, remove, and clarify disclosure requirements related to defined benefit pension and other postretirement plans such as a narrative description describing the reasons for significant gains and losses affecting the benefit obligation for the period and the removal of disclosing amounts in accumulated other comprehensive income expected to be recognized as part of net periodic benefit cost over the next year. The ASU is effective for fiscal years ending after December 15, 2020. The Company has adopted the standard and applicable changes are reflected in Note 13, Pensions and Other Benefit Plans.\nOther Topics not yet adopted\nIn March 2020, the FASB issued ASU No. 2020-04, \"Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting.\" The ASU is elective and is relief to all entities, subject to meeting certain criteria, that have contracts, hedging relationships, and other transactions that reference LIBOR or another reference rate expected to be discontinued because of reference rate reform. Optional expedients are provided for contract modification accounting under topics such as debt, leases, and derivatives. The optional amendments are effective for all entities as of any date from the beginning of an interim period that includes or is subsequent to March 12, 2020 through December 31, 2022. We are currently evaluating the impact the standard will have on our consolidated financial statements if we chose to elect.\nIn December 2019, the FASB issued ASU No. 2019-12, \"Simplifying the Accounting for Income Taxes\" (Topic 740). The standard clarifies, among other topics, that the effects of an enacted change in tax law on taxes currently payable or refundable for the current year be reflected in the computation of the annual effective tax rate in the first interim period that includes the enactment date of the new legislation. The standard is effective for fiscal years, and interim periods within those years, beginning after December 15, 2020. Early adoption is permitted for fiscal years, and interim periods within those years. We are currently evaluating the impact the standard will have on our consolidated financial statements.\n87\nCOLUMBUS McKINNON CORPORATION\nSCHEDULE II—Valuation and qualifying accounts\nMarch 31, 2021, 2020, and 2019\nDollars in thousands\n| Additions |\n| Description | Balance atBeginningof Period | Chargedto CostsandExpenses | Chargedto OtherAccounts | Acquisition/Divestiture | Deductions | Balanceat End ofPeriod |\n| Year ended March 31, 2021: |\n| Deducted from asset accounts: |\n| Allowance for doubtful accounts | $ | 5,056 | $ | 2,411 | $ | 192 | $ | — | $ | 1,973 | (1) | $ | 5,686 |\n| Deferred tax asset valuation allowance | 15,036 | 84 | ( 17 ) | — | — | 15,103 |\n| Total | $ | 20,092 | $ | 2,495 | $ | 175 | $ | — | $ | 1,973 | $ | 20,789 |\n| Reserves on balance sheet: |\n| Accrued general and product liability costs, net of insurance recoveries | $ | 11,944 | $ | 4,634 | $ | — | $ | — | $ | 3,403 | (2) | $ | 13,175 |\n| Year ended March 31, 2020: |\n| Deducted from asset accounts: |\n| Allowance for doubtful accounts | $ | 3,264 | $ | 3,115 | $ | ( 69 ) | $ | — | $ | 1,254 | (1) | $ | 5,056 |\n| Deferred tax asset valuation allowance | 16,881 | ( 1,184 ) | ( 661 ) | — | — | 15,036 |\n| Total | $ | 20,145 | $ | 1,931 | $ | ( 730 ) | $ | — | $ | 1,254 | $ | 20,092 |\n| Reserves on balance sheet: |\n| Accrued general and product liability costs, net of insurance recoveries | $ | 12,686 | $ | 3,033 | $ | — | $ | — | $ | 3,775 | (2) | $ | 11,944 |\n| Year ended March 31, 2019: |\n| Deducted from asset accounts: |\n| Allowance for doubtful accounts | $ | 3,520 | $ | 784 | $ | ( 112 ) | $ | ( 26 ) | $ | 902 | (1) | $ | 3,264 |\n| Deferred tax asset valuation allowance | 4,671 | 13,190 | ( 848 ) | ( 132 ) | — | 16,881 |\n| Total | $ | 8,191 | $ | 13,974 | $ | ( 960 ) | $ | ( 158 ) | $ | 902 | $ | 20,145 |\n| Reserves on balance sheet: |\n| Accrued general and product liability costs, net of insurance recoveries | $ | 13,582 | $ | 2,887 | $ | — | $ | — | $ | 3,783 | (2) | $ | 12,686 |\n\n_________________\n(1)Uncollectible accounts written off, net of recoveries\n(2)Insurance claims and expenses paid\n88\n\nItem 9.\nChanges in and Disagreements with Accountants on Accounting and Financial Disclosures\nNone.\nItem 9A.\nControls and Procedures\nManagement’s Evaluation of Disclosure Controls and Procedures\nAs of March 31, 2021, an evaluation was performed under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on that evaluation, our management, including the Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of March 31, 2021.\nManagement’s Report on Internal Control Over Financial Reporting\nOur management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (COSO). Based on that evaluation, our management concluded that our internal control over financial reporting was effective as of March 31, 2021.\nThe effectiveness of the Company’s internal control over financial reporting as of March 31, 2021 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report which is included herein.\nOur management, including the CEO and CFO, does not expect that our disclosure controls or our internal control over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.\nChanges in Internal Control over Financial Reporting\nThere have been no changes in internal control over financial reporting during the three months ended March 31, 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n89\nReport of Independent Registered Public Accounting Firm\nTo the Shareholders and the Board of Directors of Columbus McKinnon Corporation\nOpinion on Internal Control over Financial Reporting\nWe have audited Columbus McKinnon Corporation’s internal control over financial reporting as of March 31, 2021, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, Columbus McKinnon Corporation (the Company) maintained, in all material respects, effective internal control over financial reporting as of March 31, 2021, based on the COSO criteria.\nWe also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets as of March 31, 2021 and 2020, the related consolidated statements of operations, comprehensive income, shareholders' equity and cash flows for each of the three years in the period ended March 31, 2021, and the related notes and financial statement schedule listed in the Index at Item 15(2) and our report dated May 26, 2021 expressed an unqualified opinion thereon.\nBasis for Opinion\nThe Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.\nWe conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.\nOur audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.\nDefinition and Limitations of Internal Control Over Financial Reporting\nA company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.\nBecause of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.\n/s/ Ernst & Young LLP\nBuffalo, New York\nMay 26, 2021\n90\n\nItem 9B.\nOther Information\nNone.\nPART III\nItem 10.\nDirectors and Executive Officers of the Registrant\nThe information regarding Directors and Executive Officers of the Registrant will be included in a Proxy Statement to be filed with the Securities and Exchange Commission (the \"Commission\") prior to July 31, 2021 and upon the filing of such Proxy Statement, is incorporated by reference herein.\nThe charters of our Audit Committee, Compensation and Succession Committee, and Governance and Nomination Committee are available on our website at www.columbusmckinnon.com and are available to any shareholder upon request to the Corporate Secretary. The information on the Company's website is not incorporated by reference into this Annual Report on Form 10-K.\nWe have adopted a code of ethics that applies to all of our employees, including our principal executive officer, principal financial officer and principal accounting officer, as well as our directors. Our code of ethics, the Columbus McKinnon Corporation Legal Compliance & Business Ethics Manual, is available on our website at www.columbusmckinnon.com. We intend to disclose any amendment to, or waiver from, the code of ethics that applies to our principal executive officer, principal financial officer or principal accounting officer otherwise required to be disclosed under Item 5.05 of Form 8-K by posting such amendment or waiver, as applicable, on our website.\nItem 11.\nExecutive Compensation\nThe information regarding Executive Compensation will be included in a Proxy Statement to be filed with the Commission prior to July 31, 2021 and upon the filing of such Proxy Statement, is incorporated by reference herein.\nItem 12.\nSecurity Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters\nThe information regarding Security Ownership of Certain Beneficial Owners and Management and regarding equity compensation plan incorporation will be included in a Proxy Statement to be filed with the Commission prior to July 31, 2021 and upon the filing of such Proxy Statement, is incorporated by reference herein.\nItem 13.\nCertain Relationships and Related Transactions, and Director Independence\nThe information regarding Certain Relationships and Related Transactions will be included in a Proxy Statement to be filed with the Commission prior to July 31, 2021 and upon the filing of such Proxy Statement, is incorporated by reference herein.\nItem 14.\nPrincipal Accountant Fees and Services\nThe information regarding Principal Accountant Fees and Services will be included in a Proxy Statement to be filed with the Commission prior to July 31, 2021 and upon the filing of such Proxy Statement, is incorporated by reference herein.\n91\nPART IV\nItem 15.\nExhibits and Financial Statement Schedules\n(1)Financial Statements:\nThe following consolidated financial statements of Columbus McKinnon Corporation are included in Item 8:\n| Reference | Page No. |\n| Report of Independent Registered Public Accounting Firm | 33 |\n| Consolidated Balance Sheets - March 31, 2021 and 2020 | 36 |\n| Consolidated Statements of Operations – Years ended March 31, 2021, 2020, and 2019 | 37 |\n| Consolidated Statements of Comprehensive Income – Years ended March 31, 2021, 2020, and 2019 | 38 |\n| Consolidated Statements of Shareholders’ Equity – Years ended March 31, 2021, 2020, and 2019 | 39 |\n| Consolidated Statements of Cash Flows – Years ended March 31, 2021, 2020, and 2019 | 40 |\n| Notes to consolidated financial statements | 41 |\n\n| (2) | Financial Statement Schedule: | Page No. |\n| Schedule II - Valuation and qualifying accounts | 89 |\n| All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted. |\n\n(3)Exhibits:\n| ExhibitNumber | Exhibit |\n| 2.1 | Agreement and Plan of Merger among Columbus McKinnon Corporation, Dorner Merger Sub Inc., Precision Blocker, Inc., and Precision TopCo LP (as representative of the company equityholders) (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K dated March 1, 2021). |\n| 3.1 | Restated Certificate of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 to the Company’s Registration Statement No. 33-80687 on Form S-1 dated December 21, 1995). |\n| 3.2 | Certificate of Amendment to the Restated Certificate of Incorporation of Columbus McKinnon Corporation, dated as of May 18, 2009 (incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K dated May 18, 2009). |\n| 3.3 | Certificate of Amendment to the Restated Certificate of Incorporation of Columbus McKinnon, dated as of March 29, 2018 (incorporated by reference to Exhibit 3.4 to the Company’s Current Report on Form 8-K dated March 29, 2018). |\n| 3.4 | Sixth Amended and Restated By-Laws of the Registrant (incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K dated April 12, 2021). |\n| 4.1 | Specimen common share certificate (incorporated by reference to Exhibit 4.1 to the Company’s Registration Statement No. 33-80687 on Form S-1 dated December 21, 1995.) |\n| *4.2 | Description of Securities of Columbus McKinnon Corporation registered under Section 12 of the Securities Exchange Act of 1934, as amended. |\n| #10.1 | Columbus McKinnon Corporation Personal Retirement Account Plan Trust Agreement, dated April 1, 1987 (incorporated by reference to Exhibit 10.25 to the Company’s Registration Statement No. 33-80687 on Form S-1 dated December 21, 1995). |\n\n92\n\n| *#10.2 | Form of Change in Control Agreement as entered into between Columbus McKinnon Corporation and certain of its executive officers. |\n| #10.3 | Form of Omnibus Code Section 409A Compliance Policy as entered into between Columbus McKinnon Corporation and certain of its executive officers. (incorporated by reference to Appendix to the definitive Proxy Statement for the Annual Meeting of Stockholders of Columbus McKinnon Corporation held on July 31, 2006). |\n| *#10.4 | Columbus McKinnon Corporation Employee Stock Ownership Plan, restated effective as of April 1, 2015, as amended by Amendment No. 1 thereto effective as of April 15, 2015. |\n| *#10.5 | Columbus McKinnon Corporation Deferred Compensation Plan Adoption Agreement, effective as of January 1, 2013. |\n| *#10.6 | Amendment No. 1, dated as of January 9, 2018, to the Columbus McKinnon Corporation Deferred Compensation Plan Adoption Agreement. |\n| *#10.7 | Amendment No. 2, dated as of August 23, 2018, to the Columbus McKinnon Corporation Deferred Compensation Plan Adoption Agreement. |\n| #10.8 | Columbus McKinnon Corporation 2010 Long Term Incentive Plan, effective July 26, 2010 (incorporated by reference to Exhibit 4.1 to the Company’s Registration Statement on Form S-8 filed on August 12, 2010). |\n| #10.9 | The 2014 Stock Incentive Plan of Magnetek, Inc. (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K dated September 16, 2015). |\n| #10.10 | Columbus McKinnon Corporation 2016 Long Term Incentive Plan, as amended and restated effective June 5, 2019 (incorporated by reference to Appendix A to the Company’s definitive Proxy Statement for the Annual Meeting of Shareholders held on July 22, 2019). |\n| *#10.11 | Form of Time-Based Restricted Stock Unit Award Agreement for the Columbus McKinnon Corporation 2016 Long Term Incentive Plan. |\n| *#10.12 | Form of Nonqualified Stock Option Award Agreement for the Columbus McKinnon Corporation 2016 Long Term Incentive Plan. |\n| *#10.13 | Form of Performance Stock Unit Award Agreement for the Columbus McKinnon Corporation 2016 Long Term Incentive Plan. |\n| #10.14 | Employment agreement effective May 11, 2020 between Columbus McKinnon Corporation and David J. Wilson (incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K dated May 11, 2020). |\n| #10.15 | Change in Control Agreement effective May 11, 2020 between Columbus McKinnon Corporation and David J. Wilson (incorporated by reference to Exhibit 10.2 of the Company’s Current Report on Form 8-K dated May 11, 2020). |\n| #10.16 | Employment Agreement Amendment effective June 1, 2020 between Columbus McKinnon Corporation and David J. Wilson (incorporated by reference to Exhibit 10.2 of the Company’s Current Report on Form 8-K dated June 3, 2020). |\n| #10.17 | Debt Commitment Letter, dated March 1, 2021 in favor of Columbus McKinnon Corporation (incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K dated March 1, 2021). |\n| #10.18 | Amended and Restated Credit Agreement, dated May 14, 2021, by and among Columbus McKinnon Corporation and the other parties thereto (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K dated May 14, 2021). |\n| *21.1 | Subsidiaries of the Registrant. |\n| *23.1 | Consent of Independent Registered Public Accounting Firm. |\n| *31.1 | Certification of the principal executive officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended. |\n| *31.2 | Certification of the principal financial officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended. |\n| *32.1 | Certification of the principal executive officer and the principal financial officer pursuant to Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended and 18 U.S.C. Section 1350, as adopted by pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. The information contained in this exhibit shall not be deemed filed with the Securities and Exchange Commission nor incorporated by reference in any registration statement foiled by the Registrant under the Securities Act of 1933, as amended. |\n| *101 | The financial statements from the Company’s Annual Report on Form 10-K for the twelve months ended March 31, 2021 formatted in iXBRL |\n| *101.INS | XBRL Instance Document |\n| *101.SCH | XBRL Taxonomy Extension Schema Document |\n| *101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document |\n| *101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\n| *101.LAB | XBRL Taxonomy Extension Label Linkbase Document |\n| *101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document |\n\n93\n\n| *104 | Cover Page Interactive Data File (the cover page XBRL tags are embedded within the Inline XBRL document) |\n\n* Filed herewith\n# Indicates a Management contract or compensation plan or arrangement\n94\nSIGNATURES\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n| Date: | May 26, 2021 |\n| COLUMBUS McKINNON CORPORATION |\n| By: | /s/ David J. Wilson |\n| David J. Wilson |\n| Chief Executive Officer |\n| (Principal Executive Officer) |\n\n95\nPursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.\n\n| Signature | Title | Date |\n| /s/ David J. Wilson | President, Chief Executive Officer and Director (Principal Executive Officer) | May 26, 2021 |\n| David J. Wilson |\n| /s/ Gregory P. Rustowicz | Vice President and Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer) | May 26, 2021 |\n| Gregory P. Rustowicz |\n| /s/ Richard H. Fleming | Chairman of the Board of Directors | May 26, 2021 |\n| Richard H. Fleming |\n| /s/ Aziz S. Aghili | Director | May 26, 2021 |\n| Aziz S. Aghili |\n| /s/ Jeanne Beliveau-Dunn | Director | May 26, 2021 |\n| Jeanne Beliveau-Dunn |\n| /s/ Liam G. McCarthy | Director | May 26, 2021 |\n| Liam G. McCarthy |\n| /s/ Heath A. Mitts | Director | May 26, 2021 |\n| Heath A. Mitts |\n| /s/ Nicholas T. Pinchuk | Director | May 26, 2021 |\n| Nicholas T. Pinchuk |\n| /s/ Kathryn V. Roedel | Director | May 26, 2021 |\n| Kathryn V. Roedel |\n\n96\n</text>\n\nWhat is the annual nominal interest rate if the company's deferred financing costs on the First Lien Term Facility for fiscal 2022 is $5,432,000 to be amortized over seven years and the principal amount of the loan is equal to the company's total long-term debt, in percentage?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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docmath_40000_plus
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nPART I - FINANCIAL INFORMATION\nITEM 1. FINANCIAL STATEMENTS.\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES\nCONSOLIDATED BALANCE SHEET\n(Dollars in millions)\n(unaudited)\nASSETS\n| June 30, 2014 | December 31, 2013 |\n| Investments: |\n| Fixed maturities, available for sale, at fair value (amortized cost: June 30, 2014 - $18,383.8; December 31, 2013 - $21,860.6) | $ | 20,533.6 | $ | 23,178.3 |\n| Equity securities at fair value (cost: June 30, 2014 - $272.6; December 31, 2013 - $237.9) | 287.5 | 249.3 |\n| Mortgage loans | 1,595.9 | 1,729.5 |\n| Policy loans | 99.7 | 277.0 |\n| Trading securities | 227.4 | 247.6 |\n| Investments held by variable interest entities | 1,241.1 | 1,046.7 |\n| Other invested assets | 426.1 | 423.3 |\n| Total investments | 24,411.3 | 27,151.7 |\n| Cash and cash equivalents - unrestricted | 378.8 | 699.0 |\n| Cash and cash equivalents held by variable interest entities | 101.8 | 104.3 |\n| Accrued investment income | 238.2 | 286.9 |\n| Present value of future profits | 512.3 | 679.3 |\n| Deferred acquisition costs | 698.9 | 968.1 |\n| Reinsurance receivables | 2,892.9 | 3,392.1 |\n| Income tax assets, net | 730.5 | 1,147.2 |\n| Assets held in separate accounts | 9.4 | 10.3 |\n| Other assets | 421.3 | 341.7 |\n| Assets of subsidiary being sold | 4,518.9 | — |\n| Total assets | $ | 34,914.3 | $ | 34,780.6 |\n\n(continued on next page)\nThe accompanying notes are an integral part\nof the consolidated financial statements.\n3\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES\nCONSOLIDATED BALANCE SHEET, continued\n(Dollars in millions)\n(unaudited)\nLIABILITIES AND SHAREHOLDERS' EQUITY\n| June 30, 2014 | December 31, 2013 |\n| Liabilities: |\n| Liabilities for insurance products: |\n| Policyholder account balances | $ | 10,649.7 | $ | 12,776.4 |\n| Future policy benefits | 10,372.2 | 11,222.5 |\n| Liability for policy and contract claims | 463.3 | 566.0 |\n| Unearned and advanced premiums | 270.7 | 300.6 |\n| Liabilities related to separate accounts | 9.4 | 10.3 |\n| Other liabilities | 560.7 | 590.6 |\n| Payable to reinsurer | — | 590.3 |\n| Investment borrowings | 1,507.6 | 1,900.0 |\n| Borrowings related to variable interest entities | 1,110.8 | 1,012.3 |\n| Notes payable – direct corporate obligations | 827.3 | 856.4 |\n| Liabilities of subsidiary being sold | 4,298.3 | — |\n| Total liabilities | 30,070.0 | 29,825.4 |\n| Commitments and Contingencies |\n| Shareholders' equity: |\n| Common stock ($0.01 par value, 8,000,000,000 shares authorized, shares issued and outstanding: June 30, 2014 – 213,755,190; December 31, 2013 – 220,323,823) | 2.1 | 2.2 |\n| Additional paid-in capital | 3,963.9 | 4,092.8 |\n| Accumulated other comprehensive income | 926.1 | 731.8 |\n| Retained earnings (accumulated deficit) | (47.8 | ) | 128.4 |\n| Total shareholders' equity | 4,844.3 | 4,955.2 |\n| Total liabilities and shareholders' equity | $ | 34,914.3 | $ | 34,780.6 |\n\nThe accompanying notes are an integral part\nof the consolidated financial statements.\n4\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES\nCONSOLIDATED STATEMENT OF OPERATIONS\n(Dollars in millions, except per share data)\n(unaudited)\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Revenues: |\n| Insurance policy income | $ | 679.0 | $ | 691.3 | $ | 1,364.9 | $ | 1,382.5 |\n| Net investment income (loss): |\n| General account assets | 347.4 | 348.8 | 695.5 | 700.7 |\n| Policyholder and reinsurer accounts and other special-purpose portfolios | 47.2 | 31.8 | 68.1 | 109.5 |\n| Realized investment gains (losses): |\n| Net realized investment gains, excluding impairment losses | 12.4 | 3.8 | 47.7 | 19.1 |\n| Other-than-temporary impairment losses: |\n| Total other-than-temporary impairment losses | — | (.6 | ) | (11.9 | ) | (.6 | ) |\n| Portion of other-than-temporary impairment losses recognized in accumulated other comprehensive income | — | — | — | — |\n| Net impairment losses recognized | — | (.6 | ) | (11.9 | ) | (.6 | ) |\n| Total realized gains | 12.4 | 3.2 | 35.8 | 18.5 |\n| Fee revenue and other income | 7.0 | 6.4 | 13.4 | 12.9 |\n| Total revenues | 1,093.0 | 1,081.5 | 2,177.7 | 2,224.1 |\n| Benefits and expenses: |\n| Insurance policy benefits | 691.1 | 673.2 | 1,381.4 | 1,427.3 |\n| Loss on sale of subsidiary | — | — | 278.6 | — |\n| Gain related to reinsurance transaction | (3.8 | ) | — | (3.8 | ) | — |\n| Interest expense | 24.3 | 26.9 | 48.9 | 54.2 |\n| Amortization | 64.9 | 79.2 | 131.6 | 158.5 |\n| Loss on extinguishment or modification of debt | .6 | 7.7 | .6 | 65.4 |\n| Other operating costs and expenses | 201.5 | 179.8 | 395.6 | 369.4 |\n| Total benefits and expenses | 978.6 | 966.8 | 2,232.9 | 2,074.8 |\n| Income (loss) before income taxes | 114.4 | 114.7 | (55.2 | ) | 149.3 |\n| Income tax expense: |\n| Tax expense on period income | 40.3 | 42.6 | 79.3 | 75.8 |\n| Valuation allowance for deferred tax assets and other tax items | (4.0 | ) | (5.0 | ) | 15.4 | (15.5 | ) |\n| Net income (loss) | $ | 78.1 | $ | 77.1 | $ | (149.9 | ) | $ | 89.0 |\n| Earnings per common share: |\n| Basic: |\n| Weighted average shares outstanding | 216,538,000 | 220,498,000 | 218,422,000 | 221,290,000 |\n| Net income (loss) | $ | .36 | $ | .35 | $ | (.69 | ) | $ | .40 |\n| Diluted: |\n| Weighted average shares outstanding | 222,108,000 | 230,893,000 | 218,422,000 | 237,180,000 |\n| Net income (loss) | $ | .35 | $ | .34 | $ | (.69 | ) | $ | .38 |\n\nThe accompanying notes are an integral part\nof the consolidated financial statements.\n5\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES\nCONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME\n(Dollars in millions)\n(unaudited)\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Net income (loss) | $ | 78.1 | $ | 77.1 | $ | (149.9 | ) | $ | 89.0 |\n| Other comprehensive income, before tax: |\n| Unrealized gains (losses) for the period | 479.1 | (1,179.7 | ) | 872.9 | (1,363.0 | ) |\n| Amortization of present value of future profits and deferred acquisition costs | (42.0 | ) | 113.4 | (119.4 | ) | 134.1 |\n| Amount related to premium deficiencies assuming the net unrealized gains had been realized | (180.1 | ) | 342.7 | (417.6 | ) | 478.0 |\n| Reclassification adjustments: |\n| For net realized investment gains included in net income (loss) | (9.7 | ) | (8.9 | ) | (35.7 | ) | (23.7 | ) |\n| For amortization of the present value of future profits and deferred acquisition costs related to net realized investment gains included in net income (loss) | .1 | .4 | .5 | 1.2 |\n| Unrealized gains (losses) on investments | 247.4 | (732.1 | ) | 300.7 | (773.4 | ) |\n| Change related to deferred compensation plan | .4 | 1.4 | .7 | 2.4 |\n| Other comprehensive income (loss) before tax | 247.8 | (730.7 | ) | 301.4 | (771.0 | ) |\n| Income tax (expense) benefit related to items of accumulated other comprehensive income | (87.9 | ) | 258.1 | (107.1 | ) | 271.7 |\n| Other comprehensive income (loss), net of tax | 159.9 | (472.6 | ) | 194.3 | (499.3 | ) |\n| Comprehensive income (loss) | $ | 238.0 | $ | (395.5 | ) | $ | 44.4 | $ | (410.3 | ) |\n\nThe accompanying notes are an integral part\nof the consolidated financial statements.\n6\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES\nCONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY\n(Dollars in millions)\n(unaudited)\n| Common stock and additionalpaid-in capital | Accumulated other comprehensive income | Retained earnings (accumulated deficit) | Total |\n| Balance, December 31, 2012 | $ | 4,176.9 | $ | 1,197.4 | $ | (325.0 | ) | $ | 5,049.3 |\n| Net income | — | — | 89.0 | 89.0 |\n| Change in unrealized appreciation (depreciation) of investments (net of applicable income tax benefit of $270.9) | — | (497.9 | ) | — | (497.9 | ) |\n| Change in noncredit component of impairment losses on fixed maturities, available for sale (net of applicable income tax benefit of $.8) | — | (1.4 | ) | — | (1.4 | ) |\n| Extinguishment of beneficial conversion feature related to the repurchase of convertible debentures | (12.6 | ) | — | — | (12.6 | ) |\n| Cost of shares acquired | (50.0 | ) | — | — | (50.0 | ) |\n| Dividends on common stock | — | — | (11.1 | ) | (11.1 | ) |\n| Stock options, restricted stock and performance units | 16.1 | — | — | 16.1 |\n| Balance, June 30, 2013 | $ | 4,130.4 | $ | 698.1 | $ | (247.1 | ) | $ | 4,581.4 |\n| Balance, December 31, 2013 | $ | 4,095.0 | $ | 731.8 | $ | 128.4 | $ | 4,955.2 |\n| Net loss | — | — | (149.9 | ) | (149.9 | ) |\n| Change in unrealized appreciation (depreciation) of investments (net of applicable income tax expense of $106.8) | — | 193.7 | — | 193.7 |\n| Change in noncredit component of impairment losses on fixed maturities, available for sale (net of applicable income tax expense of $.3) | — | .6 | — | .6 |\n| Cost of shares acquired | (136.6 | ) | — | — | (136.6 | ) |\n| Dividends on common stock | — | — | (26.3 | ) | (26.3 | ) |\n| Stock options, restricted stock and performance units | 7.6 | — | — | 7.6 |\n| Balance, June 30, 2014 | $ | 3,966.0 | $ | 926.1 | $ | (47.8 | ) | $ | 4,844.3 |\n\nThe accompanying notes are an integral part\nof the consolidated financial statements.\n7\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES\nCONSOLIDATED STATEMENT OF CASH FLOWS\n(Dollars in millions)\n(unaudited)\n| Six months ended |\n| June 30, |\n| 2014 | 2013 |\n| Cash flows from operating activities: |\n| Insurance policy income | $ | 1,185.3 | $ | 1,230.1 |\n| Net investment income | 686.1 | 685.1 |\n| Fee revenue and other income | 13.4 | 12.9 |\n| Insurance policy benefits | (1,049.1 | ) | (1,070.1 | ) |\n| Payment to reinsurer pursuant to long-term care business reinsured | (590.3 | ) | — |\n| Interest expense | (45.2 | ) | (48.9 | ) |\n| Deferrable policy acquisition costs | (116.9 | ) | (107.2 | ) |\n| Other operating costs | (396.2 | ) | (409.1 | ) |\n| Taxes | (2.0 | ) | (2.9 | ) |\n| Net cash from operating activities | (314.9 | ) | (a) | 289.9 |\n| Cash flows from investing activities: |\n| Sales of investments | 1,377.2 | 943.5 |\n| Maturities and redemptions of investments | 1,007.1 | 1,335.3 |\n| Purchases of investments | (2,072.4 | ) | (2,992.8 | ) |\n| Net sales of trading securities | 12.1 | 25.3 |\n| Change in cash and cash equivalents held by variable interest entities | 2.5 | (156.5 | ) |\n| Cash and cash equivalents held by subsidiary being sold | (164.7 | ) | — |\n| Other | (15.0 | ) | (10.6 | ) |\n| Net cash provided (used) by investing activities | 146.8 | (855.8 | ) |\n| Cash flows from financing activities: |\n| Payments on notes payable | (29.5 | ) | (101.9 | ) |\n| Expenses related to extinguishment or modification of debt | (.5 | ) | (61.3 | ) |\n| Amount paid to extinguish the beneficial conversion feature associated with repurchase of convertible debentures | — | (12.6 | ) |\n| Issuance of common stock | 3.6 | 12.7 |\n| Payments to repurchase common stock | (133.6 | ) | (50.0 | ) |\n| Common stock dividends paid | (26.3 | ) | (11.1 | ) |\n| Amounts received for deposit products | 677.7 | 634.0 |\n| Withdrawals from deposit products | (732.5 | ) | (749.9 | ) |\n| Issuance of investment borrowings: |\n| Federal Home Loan Bank | 300.0 | 400.0 |\n| Related to variable interest entities | 141.6 | 376.3 |\n| Payments on investment borrowings: |\n| Federal Home Loan Bank | (317.4 | ) | (200.2 | ) |\n| Related to variable interest entities and other | (43.6 | ) | (.2 | ) |\n| Investment borrowings - repurchase agreements, net | 8.4 | 27.6 |\n| Net cash provided (used) by financing activities | (152.1 | ) | 263.4 |\n| Net decrease in cash and cash equivalents | (320.2 | ) | (302.5 | ) |\n| Cash and cash equivalents, beginning of period | 699.0 | 582.5 |\n| Cash and cash equivalents, end of period | $ | 378.8 | $ | 280.0 |\n\n______________________\n| (a) | Cash flows from operating activities reflect outflows in the 2014 period due to the payment to reinsurer to transfer certain long-term care business. |\n\nThe accompanying notes are an integral part\nof the consolidated financial statements.\n8\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nBUSINESS AND BASIS OF PRESENTATION\nThe following notes should be read together with the notes to the consolidated financial statements included in our 2013 Annual Report on Form 10-K.\nCNO Financial Group, Inc., a Delaware corporation (\"CNO\"), is a holding company for a group of insurance companies operating throughout the United States that develop, market and administer health insurance, annuity, individual life insurance and other insurance products. The terms \"CNO Financial Group, Inc.\", \"CNO\", the \"Company\", \"we\", \"us\", and \"our\" as used in these financial statements refer to CNO and its subsidiaries. Such terms, when used to describe insurance business and products, refer to the insurance business and products of CNO's insurance subsidiaries.\nWe focus on serving middle-income pre-retiree and retired Americans, which we believe are attractive, underserved, high growth markets. We sell our products through three distribution channels: career agents, independent producers (some of whom sell one or more of our product lines exclusively) and direct marketing.\nOur unaudited consolidated financial statements reflect normal recurring adjustments that, in the opinion of management, are necessary for a fair statement of our financial position, results of operations and cash flows for the periods presented. As permitted by rules and regulations of the Securities and Exchange Commission (the \"SEC\") applicable to quarterly reports on Form 10-Q, we have condensed or omitted certain information and disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (\"GAAP\"). We have reclassified certain amounts from the prior periods to conform to the 2014 presentation. These reclassifications have no effect on net income or shareholders' equity. Results for interim periods are not necessarily indicative of the results that may be expected for a full year.\nThe balance sheet at December 31, 2013, presented herein, has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by GAAP for complete financial statements.\nWhen we prepare financial statements in conformity with GAAP, we are required to make estimates and assumptions that significantly affect reported amounts of various assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting periods. For example, we use significant estimates and assumptions to calculate values for deferred acquisition costs, the present value of future profits, fair value measurements of certain investments (including derivatives), other-than-temporary impairments of investments, assets and liabilities related to income taxes, liabilities for insurance products, liabilities related to litigation and guaranty fund assessment accruals. If our future experience differs from these estimates and assumptions, our financial statements would be materially affected.\nThe accompanying financial statements include the accounts of the Company and its subsidiaries. Our consolidated financial statements exclude transactions between us and our consolidated affiliates, or among our consolidated affiliates.\nAGREEMENT TO SELL SUBSIDIARY\nOn March 2, 2014, CNO entered into a Stock Purchase Agreement (the \"Stock Purchase Agreement\") with Wilton Reassurance Company (\"Wilton Re\"), pursuant to which CNO agreed to sell to Wilton Re all of the issued and outstanding shares of Conseco Life Insurance Company (\"CLIC\"), an indirect wholly owned subsidiary of CNO. The transaction, which closed on July 1, 2014, was subject to receipt of insurance regulatory approvals and satisfaction of other customary closing conditions. The transaction resulted in net proceeds of approximately $216 million based upon an estimated balance sheet of CLIC as of June 30, 2014 and after anticipated transaction costs and intercompany transactions completed in connection with the closing.\nIn connection with the closing of the transaction, CNO Services, LLC (\"CNO Services\"), an indirect wholly owned subsidiary of CNO, entered into a transition services agreement and a special support services agreement with Wilton Re, pursuant to which CNO Services will make available to Wilton Re and its affiliates, for a limited period of time, certain services required for the operation of CLIC's business following the closing. The costs of the services provided to Wilton Re are expected to approximate the fees received under the agreements.\n9\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nWe have accounted for the sale of CLIC as held for sale. A business classified as held for sale is recorded at the lower of its carrying amount or estimated fair value less costs to sell. As the carrying amount of the CLIC business being sold exceeded its costs to sell, we have recognized a loss on the sale of CLIC in the six months ended June 30, 2014, as summarized below (dollars in millions):\n| Net cash proceeds | $ | 216.0 |\n| Net assets being sold: |\n| Investments | 3,863.8 |\n| Cash and cash equivalents | 164.7 |\n| Accrued investment income | 42.7 |\n| Present value of future profits | 15.5 |\n| Deferred acquisition costs | 37.6 |\n| Reinsurance receivables | 307.4 |\n| Income tax assets, net | 84.4 |\n| Other assets | 2.8 |\n| Liabilities for insurance products | (3,201.3 | ) |\n| Other liabilities | (199.1 | ) |\n| Investment borrowings | (383.4 | ) |\n| Accumulated other comprehensive income | (240.5 | ) |\n| Net assets being sold | 494.6 |\n| Loss before taxes | (278.6 | ) |\n| Tax expense related to tax gain on sale | 21.6 |\n| Previously unrecognized tax benefit now recognized as a result of the gain | (7.4 | ) |\n| Valuation allowance release related to the gain | (14.2 | ) |\n| Valuation allowance increase related to the decrease in projected future taxable income | 19.4 |\n| Net loss | $ | (298.0 | ) |\n\nBecause the tax basis of CLIC is lower than the estimated cash proceeds, the transaction will generate a taxable gain and estimated tax expense of $21.6 million (subject to further adjustment based on the determination of the final sales price and net proceeds from the sale). Fully offsetting the tax is $7.4 million of previously unrecognized tax benefits (pertaining to a corporate matter unrelated to the sale of CLIC) which may now be recognized and $14.2 million of a valuation allowance release pertaining to net operating loss carryforwards (\"NOLs\") which may now be utilized. However, the disposition of CLIC is expected to result in a net reduction to CNO's taxable income in future periods which also requires us to establish a valuation allowance of $19.4 million.\n10\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nThe assets and liabilities of the CLIC business being sold have been segregated in the consolidated balance sheet as of June 30, 2014. The following summarizes the assets and liabilities held for sale as of June 30, 2014 (dollars in millions):\n| June 30, 2014 |\n| Investments | $ | 3,863.8 |\n| Cash and cash equivalents - unrestricted | 164.7 |\n| Accrued investment income | 42.7 |\n| Present value of future profits | 15.5 |\n| Deferred acquisition costs | 37.6 |\n| Reinsurance receivables | 307.4 |\n| Income tax assets, net | 84.4 |\n| Other assets | 2.8 |\n| Assets of subsidiary being sold | $ | 4,518.9 |\n| Liabilities for insurance products | $ | 3,201.3 |\n| Other liabilities | 199.1 |\n| Investment borrowings | 383.4 |\n| Loss accrual | 514.5 |\n| Liabilities of subsidiary being sold | $ | 4,298.3 |\n\nThe Stock Purchase Agreement also provided that, at the closing, Bankers Life and Casualty Company (\"Bankers Life\"), an indirect wholly owned subsidiary of CNO, would recapture the life insurance business written by Bankers Life that was reinsured by Wilton Re. The recapture agreement was conditioned on the concurrent consummation of the closing. On July 1, 2014, Bankers Life paid $28.0 million to recapture the life insurance business from Wilton Re and will recognize a gain (net of income taxes) of approximately $4.5 million in the third quarter of 2014 as a result of the recapture.\n11\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nOUT-OF-PERIOD ADJUSTMENTS\nIn the six months ended June 30, 2014, we recorded the net effect of an out-of-period adjustment related to the calculation of incentive compensation accruals which increased other operating costs and expenses by $2.4 million, decreased tax expense by $.8 million and increased our net loss by $1.6 million (or 1 cent per diluted share). In the six months ended June 30, 2013, we recorded the net effect of an out-of-period adjustment which increased our insurance policy benefits by $6.7 million, increased amortization expense by $2.5 million, decreased tax expense by $3.2 million and decreased our net income by $6.0 million (or 3 cents per diluted share), none of which was recognized in the second quarter of 2013. We evaluated these adjustments taking into account both qualitative and quantitative factors and considered the impact of these adjustments in relation to each period, as well as the periods in which they originated. The impact of recognizing these adjustments in prior years was not significant to any individual period. Management believes these adjustments are immaterial to the consolidated financial statements and all previously issued financial statements.\nINVESTMENTS\nWe classify our fixed maturity securities into one of two categories: (i) \"available for sale\" (which we carry at estimated fair value with any unrealized gain or loss, net of tax and related adjustments, recorded as a component of shareholders' equity); or (ii) \"trading\" (which we carry at estimated fair value with changes in such value recognized as net investment income (classified as investment income from policyholder and reinsurer accounts and other special-purpose portfolios)).\nOur trading securities include: (i) investments purchased with the intent of selling in the near term to generate income; and (ii) investments supporting certain insurance liabilities (including investments backing the market strategies of our multibucket annuity products) and certain reinsurance agreements. The change in fair value of these securities is recognized in income from policyholder and reinsurer accounts and other special-purpose portfolios (a component of net investment income). Investment income from trading securities backing certain insurance liabilities and certain reinsurance agreements is substantially offset by the change in insurance policy benefits related to certain products and agreements. The trading account also includes certain fixed maturity securities containing embedded derivatives for which we have elected the fair value option. The change in value of these securities is recognized in realized investment gains (losses). Our trading securities totaled $227.4 million and $247.6 million at June 30, 2014 and December 31, 2013, respectively.\nAccumulated other comprehensive income is primarily comprised of the net effect of unrealized appreciation (depreciation) on our investments. These amounts, included in shareholders' equity as of June 30, 2014 and December 31, 2013, were as follows (dollars in millions):\n| June 30, 2014 | December 31, 2013 |\n| Net unrealized appreciation (depreciation) on fixed maturity securities, available for sale, on which an other-than-temporary impairment loss has been recognized | $ | 8.5 | $ | 6.5 |\n| Net unrealized gains on all other investments | 2,157.8 | 1,322.6 |\n| Adjustment to present value of future profits (a) | (157.6 | ) | (47.7 | ) |\n| Adjustment to deferred acquisition costs | (395.5 | ) | (137.0 | ) |\n| Adjustment to insurance liabilities | (168.1 | ) | — |\n| Unrecognized net loss related to deferred compensation plan | (6.4 | ) | (7.1 | ) |\n| Deferred income tax liabilities | (512.6 | ) | (405.5 | ) |\n| Accumulated other comprehensive income | $ | 926.1 | $ | 731.8 |\n\n________\n| (a) | The present value of future profits is the value assigned to the right to receive future cash flows from contracts existing at September 10, 2003 (the date Conseco, Inc., an Indiana corporation (our \"Predecessor\"), emerged from bankruptcy. |\n\nAt June 30, 2014, adjustments to the present value of future profits, deferred acquisition costs, insurance liabilities and deferred tax assets included $(134.0) million, $(143.3) million, $(168.1) million and $158.3 million, respectively, for premium deficiencies that would exist on certain long-term health products if unrealized gains on the assets backing such products had been realized and the proceeds from the sales of such assets were invested at then current yields.\n12\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nAt June 30, 2014, the amortized cost, gross unrealized gains and losses, estimated fair value, other-than-temporary impairments in accumulated other comprehensive income of fixed maturities, available for sale, were as follows (dollars in millions):\n| Amortized cost | Gross unrealized gains | Gross unrealized losses | Estimated fair value | Other-than-temporary impairments included in accumulated other comprehensive income |\n| Corporate securities | $ | 12,217.4 | $ | 1,688.0 | $ | (23.8 | ) | $ | 13,881.6 | $ | — |\n| United States Treasury securities and obligations of United States government corporations and agencies | 149.6 | 10.7 | (.2 | ) | 160.1 | — |\n| States and political subdivisions | 1,944.3 | 212.9 | (6.3 | ) | 2,150.9 | — |\n| Asset-backed securities | 1,244.5 | 84.2 | (2.6 | ) | 1,326.1 | — |\n| Collateralized debt obligations | 319.9 | 5.2 | (.9 | ) | 324.2 | — |\n| Commercial mortgage-backed securities | 1,173.9 | 92.5 | (.2 | ) | 1,266.2 | — |\n| Mortgage pass-through securities | 8.4 | .5 | — | 8.9 | — |\n| Collateralized mortgage obligations | 1,325.8 | 90.7 | (.9 | ) | 1,415.6 | (3.7 | ) |\n| Total fixed maturities, available for sale | $ | 18,383.8 | $ | 2,184.7 | $ | (34.9 | ) | $ | 20,533.6 | $ | (3.7 | ) |\n| Fixed maturities of CLIC being sold | $ | 3,470.7 | $ | — | $ | — | $ | 3,470.7 | $ | — |\n\nThe following table sets forth the amortized cost and estimated fair value of fixed maturities, available for sale, at June 30, 2014, by contractual maturity. Actual maturities will differ from contractual maturities because certain borrowers may have the right to call or prepay obligations with or without penalties. In addition, structured securities (such as asset-backed securities, collateralized debt obligations, commercial mortgage-backed securities, mortgage pass-through securities and collateralized mortgage obligations, collectively referred to as \"structured securities\") frequently include provisions for periodic principal payments and permit periodic unscheduled payments.\n| Amortizedcost | Estimatedfairvalue |\n| (Dollars in millions) |\n| Due in one year or less | $ | 164.7 | $ | 169.5 |\n| Due after one year through five years | 1,762.1 | 1,957.6 |\n| Due after five years through ten years | 2,906.4 | 3,192.2 |\n| Due after ten years | 9,478.1 | 10,873.3 |\n| Subtotal | 14,311.3 | 16,192.6 |\n| Structured securities | 4,072.5 | 4,341.0 |\n| Total fixed maturities, available for sale | $ | 18,383.8 | $ | 20,533.6 |\n\n13\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nNet Realized Investment Gains (Losses)\nThe following table sets forth the net realized investment gains (losses) for the periods indicated (dollars in millions):\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Fixed maturity securities, available for sale: |\n| Gross realized gains on sale | $ | 4.9 | $ | 10.8 | $ | 46.4 | $ | 27.4 |\n| Gross realized losses on sale | (3.0 | ) | (1.4 | ) | (8.5 | ) | (3.4 | ) |\n| Impairments: |\n| Total other-than-temporary impairment losses | — | — | — | — |\n| Other-than-temporary impairment losses recognized in accumulated other comprehensive income | — | — | — | — |\n| Net impairment losses recognized | — | — | — | — |\n| Net realized investment gains from fixed maturities | 1.9 | 9.4 | 37.9 | 24.0 |\n| Equity securities | 7.9 | — | 7.9 | — |\n| Commercial mortgage loans | 1.1 | — | 1.1 | .7 |\n| Impairments of mortgage loans and other investments | — | (.6 | ) | (11.9 | ) | (.6 | ) |\n| Other | 1.5 | (5.6 | ) | .8 | (5.6 | ) |\n| Net realized investment gains | $ | 12.4 | $ | 3.2 | $ | 35.8 | $ | 18.5 |\n\nDuring the first six months of 2014, we recognized net realized investment gains of $35.8 million, which were comprised of $41.8 million of net gains from the sales of investments (primarily fixed maturities) with proceeds of $1.4 billion, the increase in fair value of certain fixed maturity investments with embedded derivatives of $5.9 million and $11.9 million of writedowns of investments for other than temporary declines in fair value recognized through net income.\nDuring the first six months of 2013, we recognized net realized investment gains of $18.5 million, which were comprised of $29.6 million of net gains from the sales of investments (primarily fixed maturities) with proceeds of $.9 billion and the decrease in fair value of certain fixed maturity investments with embedded derivatives of $10.5 million and $.6 million of writedowns of investments for other than temporary declines in fair value recognized through net income.\nOur fixed maturity investments are generally purchased in the context of various long-term strategies, including funding insurance liabilities, so we do not generally seek to generate short-term realized gains through the purchase and sale of such securities. In certain circumstances, including those in which securities are selling at prices which exceed our view of their underlying economic value, or when it is possible to reinvest the proceeds to better meet our long-term asset-liability objectives, we may sell certain securities.\nDuring the first six months of 2014, the $8.5 million of realized losses on sales of $156.9 million of fixed maturity securities, available for sale, included: (i) $.5 million of losses related to the sales of securities issued by state and political subdivisions; and (ii) $8.0 million of additional losses related to various corporate securities. Securities are generally sold at a loss following unforeseen issue-specific events or conditions or shifts in perceived risks. These reasons include but are not limited to: (i) changes in the investment environment; (ii) expectation that the market value could deteriorate further; (iii) desire to reduce our exposure to an asset class, an issuer or an industry; (iv) prospective or actual changes in credit quality; or (v) changes in expected cash flows.\nDuring the first six months of 2014, we recognized $11.9 million of impairment losses recorded in earnings which included: (i) a $3.9 million writedown of a commercial mortgage loan related to a property with expected occupancy challenges; and (ii) an $8.0 million impairment related to two legacy private company investments where earnings and cash flows have not met the expectations assumed in our previous valuations.\n14\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nWe regularly evaluate all of our investments with unrealized losses for possible impairment. Our assessment of whether unrealized losses are \"other than temporary\" requires significant judgment. Factors considered include: (i) the extent to which fair value is less than the cost basis; (ii) the length of time that the fair value has been less than cost; (iii) whether the unrealized loss is event driven, credit-driven or a result of changes in market interest rates or risk premium; (iv) the near-term prospects for specific events, developments or circumstances likely to affect the value of the investment; (v) the investment's rating and whether the investment is investment-grade and/or has been downgraded since its purchase; (vi) whether the issuer is current on all payments in accordance with the contractual terms of the investment and is expected to meet all of its obligations under the terms of the investment; (vii) whether we intend to sell the investment or it is more likely than not that circumstances will require us to sell the investment before recovery occurs; (viii) the underlying current and prospective asset and enterprise values of the issuer and the extent to which the recoverability of the carrying value of our investment may be affected by changes in such values; (ix) projections of, and unfavorable changes in, cash flows on structured securities including mortgage-backed and asset-backed securities; (x) our best estimate of the value of any collateral; and (xi) other objective and subjective factors.\nFuture events may occur, or additional information may become available, which may necessitate future realized losses in our portfolio. Significant losses could have a material adverse effect on our consolidated financial statements in future periods.\nImpairment losses on equity securities are recognized in net income. The manner in which impairment losses on fixed maturity securities, available for sale, are recognized in the financial statements is dependent on the facts and circumstances related to the specific security. If we intend to sell a security or it is more likely than not that we would be required to sell a security before the recovery of its amortized cost, the security is other-than-temporarily impaired and the full amount of the impairment is recognized as a loss through earnings. If we do not expect to recover the amortized cost basis, we do not plan to sell the security, and if it is not more likely than not that we would be required to sell a security before the recovery of its amortized cost, less any current period credit loss, the recognition of the other-than-temporary impairment is bifurcated. We recognize the credit loss portion in net income and the noncredit loss portion in accumulated other comprehensive income.\nWe estimate the amount of the credit loss component of a fixed maturity security impairment as the difference between amortized cost and the present value of the expected cash flows of the security. The present value is determined using the best estimate of future cash flows discounted at the effective interest rate implicit to the security at the date of purchase or the current yield to accrete an asset-backed or floating rate security. The methodology and assumptions for establishing the best estimate of future cash flows vary depending on the type of security.\nFor most structured securities, cash flow estimates are based on bond specific facts and circumstances that may include collateral characteristics, expectations of delinquency and default rates, loss severity, prepayment speeds and structural support, including excess spread, subordination and guarantees. For corporate bonds, cash flow estimates are derived from scenario-based outcomes of expected corporate restructurings or the disposition of assets using bond specific facts and circumstances. The previous amortized cost basis less the impairment recognized in net income becomes the security's new cost basis. We accrete the new cost basis to the estimated future cash flows over the expected remaining life of the security, except when the security is in default or considered nonperforming.\nThe remaining noncredit impairment, which is recorded in accumulated other comprehensive income, is the difference between the security's estimated fair value and our best estimate of future cash flows discounted at the effective interest rate prior to impairment. The remaining noncredit impairment typically represents changes in the market interest rates, current market liquidity and risk premiums. As of June 30, 2014, other-than-temporary impairments included in accumulated other comprehensive income of $3.7 million (before taxes and related amortization) related to structured securities.\n15\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nThe following table summarizes the amount of credit losses recognized in earnings on fixed maturity securities, available for sale, held at the beginning of the period, for which a portion of the other-than-temporary impairment was also recognized in accumulated other comprehensive income for the three and six months ended June 30, 2014, and 2013 (dollars in millions):\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Credit losses on fixed maturity securities, available for sale, beginning of period | $ | (1.3 | ) | $ | (1.5 | ) | $ | (1.3 | ) | $ | (1.6 | ) |\n| Add: credit losses on other-than-temporary impairments not previously recognized | — | — | — | — |\n| Less: credit losses on securities sold | .1 | — | .1 | .1 |\n| Less: credit losses on securities impaired due to intent to sell (a) | — | — | — | — |\n| Add: credit losses on previously impaired securities | — | — | — | — |\n| Less: increases in cash flows expected on previously impaired securities | — | — | — | — |\n| Credit losses on fixed maturity securities, available for sale, end of period | $ | (1.2 | ) | $ | (1.5 | ) | $ | (1.2 | ) | $ | (1.5 | ) |\n\n__________\n| (a) | Represents securities for which the amount previously recognized in accumulated other comprehensive income was recognized in earnings because we intend to sell the security or we more likely than not will be required to sell the security before recovery of its amortized cost basis. |\n\nGross Unrealized Investment Losses\nOur investment strategy is to maximize, over a sustained period and within acceptable parameters of quality and risk, investment income and total investment return through active investment management. Accordingly, we may sell securities at a gain or a loss to enhance the projected total return of the portfolio as market opportunities change, to reflect changing perceptions of risk, or to better match certain characteristics of our investment portfolio with the corresponding characteristics of our insurance liabilities.\n16\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nThe following table summarizes the gross unrealized losses and fair values of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that such securities have been in a continuous unrealized loss position, at June 30, 2014 (dollars in millions):\n| Less than 12 months | 12 months or greater | Total |\n| Description of securities | Fairvalue | Unrealizedlosses | Fairvalue | Unrealizedlosses | Fairvalue | Unrealizedlosses |\n| United States Treasury securities and obligations of United States government corporations and agencies | $ | — | $ | — | $ | 18.4 | $ | (.2 | ) | $ | 18.4 | $ | (.2 | ) |\n| States and political subdivisions | 15.6 | (.6 | ) | 124.1 | (5.7 | ) | 139.7 | (6.3 | ) |\n| Corporate securities | 173.3 | (1.1 | ) | 423.2 | (22.7 | ) | 596.5 | (23.8 | ) |\n| Asset-backed securities | 76.9 | (.5 | ) | 91.5 | (2.1 | ) | 168.4 | (2.6 | ) |\n| Collateralized debt obligations | 64.2 | (.7 | ) | 11.7 | (.2 | ) | 75.9 | (.9 | ) |\n| Commercial mortgage-backed securities | 14.8 | — | 19.2 | (.2 | ) | 34.0 | (.2 | ) |\n| Mortgage pass-through securities | 1.2 | — | .8 | — | 2.0 | — |\n| Collateralized mortgage obligations | 82.4 | (.4 | ) | 20.6 | (.5 | ) | 103.0 | (.9 | ) |\n| Total fixed maturities, available for sale | $ | 428.4 | $ | (3.3 | ) | $ | 709.5 | $ | (31.6 | ) | $ | 1,137.9 | $ | (34.9 | ) |\n| Preferred stock | $ | 34.3 | $ | (.4 | ) | $ | 20.3 | $ | (.9 | ) | $ | 54.6 | $ | (1.3 | ) |\n\nThe following table summarizes the gross unrealized losses and fair values of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that such securities have been in a continuous unrealized loss position, at December 31, 2013 (dollars in millions):\n| Less than 12 months | 12 months or greater | Total |\n| Description of securities | Fairvalue | Unrealized losses | Fairvalue | Unrealizedlosses | Fairvalue | Unrealizedlosses |\n| United States Treasury securities and obligations of United States government corporations and agencies | $ | 23.8 | $ | (.6 | ) | $ | — | $ | — | $ | 23.8 | $ | (.6 | ) |\n| States and political subdivisions | 473.6 | (30.3 | ) | 79.2 | (8.7 | ) | 552.8 | (39.0 | ) |\n| Corporate securities | 2,406.1 | (132.8 | ) | 170.3 | (20.8 | ) | 2,576.4 | (153.6 | ) |\n| Asset-backed securities | 308.4 | (6.5 | ) | 32.5 | (.7 | ) | 340.9 | (7.2 | ) |\n| Collateralized debt obligations | 46.7 | (.5 | ) | — | — | 46.7 | (.5 | ) |\n| Commercial mortgage-backed securities | 161.8 | (5.8 | ) | — | — | 161.8 | (5.8 | ) |\n| Mortgage pass-through securities | 1.6 | — | 1.6 | — | 3.2 | — |\n| Collateralized mortgage obligations | 121.8 | (1.6 | ) | 2.2 | — | 124.0 | (1.6 | ) |\n| Total fixed maturities, available for sale | $ | 3,543.8 | $ | (178.1 | ) | $ | 285.8 | $ | (30.2 | ) | $ | 3,829.6 | $ | (208.3 | ) |\n| Preferred stock | $ | 26.8 | $ | (4.9 | ) | $ | — | $ | — | $ | 26.8 | $ | (4.9 | ) |\n\nBased on management's current assessment of investments with unrealized losses at June 30, 2014, the Company believes the issuers of the securities will continue to meet their obligations (or with respect to equity-type securities, the investment value will recover to its cost basis). While we do not have the intent to sell securities with unrealized losses and it is not more likely than not that we will be required to sell securities with unrealized losses prior to their anticipated recovery,\n17\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nour intent on an individual security may change, based upon market or other unforeseen developments. In such instances, if a loss is recognized from a sale subsequent to a balance sheet date due to these unexpected developments, the loss is recognized in the period in which we had the intent to sell the security before its anticipated recovery.\nEARNINGS PER SHARE\nA reconciliation of net income and shares used to calculate basic and diluted earnings per share is as follows (dollars in millions and shares in thousands):\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Net income (loss) for basic earnings per share | $ | 78.1 | $ | 77.1 | $ | (149.9 | ) | $ | 89.0 |\n| Add: interest expense on 7.0% Senior Debentures due 2016 (the \"7.0% Debentures\"), net of income taxes | — | .4 | — | 1.6 |\n| Net income (loss) for diluted earnings per share | $ | 78.1 | $ | 77.5 | $ | (149.9 | ) | $ | 90.6 |\n| Shares: |\n| Weighted average shares outstanding for basic earnings per share | 216,538 | 220,498 | 218,422 | 221,290 |\n| Effect of dilutive securities on weighted average shares: |\n| 7.0% Debentures | — | 5,692 | — | 11,141 |\n| Stock options, restricted stock and performance units | 2,390 | 2,412 | — | 2,620 |\n| Warrants | 3,180 | 2,291 | — | 2,129 |\n| Dilutive potential common shares | 5,570 | 10,395 | — | 15,890 |\n| Weighted average shares outstanding for diluted earnings per share | 222,108 | 230,893 | 218,422 | 237,180 |\n\nIn the six months ended June 30, 2014, 5,687,000 equivalent common shares (comprised of 2,464,000 shares related to stock options, restricted stock and performance units and 3,223,000 shares related to warrants) were not included in the diluted weighted average shares outstanding, because their inclusion would have been antidilutive in such period due to the net loss recognized by the Company resulting from the sale of CLIC.\nBasic earnings per common share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Restricted shares (including our performance units) are not included in basic earnings per share until vested. Diluted earnings per share reflect the potential dilution that could occur if outstanding stock options and warrants were exercised and restricted stock was vested. The dilution from options, warrants and restricted shares is calculated using the treasury stock method. Under this method, we assume the proceeds from the exercise of the options and warrants (or the unrecognized compensation expense with respect to restricted stock and performance units) will be used to purchase shares of our common stock at the average market price during the period, reducing the dilutive effect of the exercise of the options and warrants (or the vesting of the restricted stock and performance units). Initially, the 7.0% Debentures were convertible into 182.1494 shares of our common stock for each $1,000 principal amount of 7.0% Debentures, which was equivalent to an initial conversion price of approximately $5.49 per share. The conversion rate was subject to adjustment following the occurrence of certain events (including the payment of dividends on our common stock) in accordance with the terms of the an indenture dated as of October 16, 2009. On July 1, 2013, the Company issued a conversion right termination notice to holders of the 7.0% Debentures and the right to convert the 7.0% Debentures into shares of its common stock was terminated effective July 30, 2013.\n18\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nBUSINESS SEGMENTS\nPrior to 2014, the Company managed its business through the following operating segments: Bankers Life, Washington National and Colonial Penn, which are defined on the basis of product distribution; Other CNO Business, comprised primarily of products we no longer sell actively; and corporate operations, comprised of holding company activities and certain noninsurance company businesses. As a result of the sale of CLIC which was completed on July 1, 2014 and the coinsurance agreements to cede certain long-term care business effective December 31, 2013 (as further described in the note to the consolidated financial statements entitled \"Reinsurance\"), management has changed the manner in which it disaggregates the Company's operations for making operating decisions and assessing performance. In periods prior to 2014: (i) the results in the Washington National segment have been adjusted to include the results from the business in the Other CNO Business segment that are being retained; (ii) the Other CNO Business segment included only the long-term care business that was ceded effective December 31, 2013 and the overhead expense of CLIC that is expected to continue after the completion of the sale; and (iii) the CLIC business being sold is excluded from our analysis of business segment results. Beginning on January 1, 2014: (i) the overhead expense of CLIC that is expected to continue after the completion of the sale has been reallocated primarily to the Bankers Life and Washington National segments; (ii) there is no longer an Other CNO Business segment; and (iii) the CLIC business being sold continues to be excluded from our analysis of business segment results. After the completion of the sale of CLIC: (i) the Bankers Life segment will include the results of certain life insurance business that was recaptured from Wilton Re; and (ii) the revenues and expenses associated with a transition services agreement and a special support services agreement with Wilton Re will be included in our non-operating earnings. Our prior period segment disclosures have been revised to reflect management's current view of the Company's operating segments.\nWe measure segment performance by excluding the loss on the operations of CLIC being sold, the earnings of CLIC being sold, net realized investment gains (losses), fair value changes in embedded derivative liabilities (net of related amortization), equity in earnings of certain non-strategic investments and earnings attributable to variable interest entities (\"VIEs\"), loss on extinguishment or modification of debt and income taxes (\"pre-tax operating earnings\") because we believe that this performance measure is a better indicator of the ongoing business and trends in our business. Our primary investment focus is on investment income to support our liabilities for insurance products as opposed to the generation of net realized investment gains (losses), and a long-term focus is necessary to maintain profitability over the life of the business.\nThe loss on the operations of CLIC being sold, the earnings of CLIC being sold, net realized investment gains (losses), fair value changes in embedded derivative liabilities (net of related amortization), equity in earnings of certain non-strategic investments and earnings attributable to VIEs and loss on extinguishment or modification of debt depend on market conditions or represent unusual items that do not necessarily relate to the underlying business of our segments. Net realized investment gains (losses) and fair value changes in embedded derivative liabilities (net of related amortization) may affect future earnings levels since our underlying business is long-term in nature and changes in our investment portfolio may impact our ability to earn the assumed interest rates needed to maintain the profitability of our business.\n19\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nOperating information by segment was as follows (dollars in millions):\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Revenues: |\n| Bankers Life: |\n| Insurance policy income: |\n| Annuities | $ | 7.7 | $ | 8.6 | $ | 15.2 | $ | 16.5 |\n| Health | 320.5 | 334.1 | 651.0 | 666.7 |\n| Life | 79.9 | 76.4 | 158.2 | 153.9 |\n| Net investment income (a) | 247.6 | 226.6 | 472.0 | 488.3 |\n| Fee revenue and other income (a) | 5.8 | 4.0 | 11.1 | 7.7 |\n| Total Bankers Life revenues | 661.5 | 649.7 | 1,307.5 | 1,333.1 |\n| Washington National: |\n| Insurance policy income: |\n| Annuities | 1.4 | 1.7 | 2.4 | 3.2 |\n| Health | 148.8 | 145.8 | 297.7 | 291.2 |\n| Life | 6.5 | 5.6 | 12.2 | 11.6 |\n| Net investment income (a) | 71.8 | 69.8 | 140.8 | 147.7 |\n| Fee revenue and other income (a) | .2 | .2 | .4 | .4 |\n| Total Washington National revenues | 228.7 | 223.1 | 453.5 | 454.1 |\n| Colonial Penn: |\n| Insurance policy income: |\n| Health | .9 | 1.1 | 1.9 | 2.2 |\n| Life | 60.8 | 56.9 | 120.3 | 112.7 |\n| Net investment income (a) | 10.5 | 9.9 | 21.2 | 19.8 |\n| Fee revenue and other income (a) | .3 | .2 | .5 | .4 |\n| Total Colonial Penn revenues | 72.5 | 68.1 | 143.9 | 135.1 |\n| Other CNO Business: |\n| Insurance policy income - health | — | 6.1 | — | 12.3 |\n| Net investment income (a) | — | 8.4 | — | 16.8 |\n| Total Other CNO Business revenues | — | 14.5 | — | 29.1 |\n| Corporate operations: |\n| Net investment income | 5.7 | 4.5 | 12.7 | 14.6 |\n| Fee and other income | 1.3 | 1.5 | 2.7 | 3.2 |\n| Total corporate revenues | 7.0 | 6.0 | 15.4 | 17.8 |\n| Total revenues | 969.7 | 961.4 | 1,920.3 | 1,969.2 |\n\n(continued on next page)\n20\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\n(continued from previous page)\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Expenses: |\n| Bankers Life: |\n| Insurance policy benefits | $ | 427.9 | $ | 434.1 | $ | 842.9 | $ | 904.6 |\n| Amortization | 45.4 | 45.7 | 93.6 | 100.2 |\n| Interest expense on investment borrowings | 1.9 | 1.7 | 3.8 | 3.1 |\n| Other operating costs and expenses | 98.9 | 89.1 | 195.6 | 184.0 |\n| Total Bankers Life expenses | 574.1 | 570.6 | 1,135.9 | 1,191.9 |\n| Washington National: |\n| Insurance policy benefits | 132.8 | 130.3 | 264.6 | 268.0 |\n| Amortization | 16.0 | 16.2 | 32.3 | 33.3 |\n| Interest expense on investment borrowings | .5 | .5 | .9 | 1.0 |\n| Other operating costs and expenses | 47.1 | 40.3 | 92.3 | 82.0 |\n| Total Washington National expenses | 196.4 | 187.3 | 390.1 | 384.3 |\n| Colonial Penn: |\n| Insurance policy benefits | 43.2 | 41.2 | 87.9 | 84.2 |\n| Amortization | 3.8 | 3.7 | 7.8 | 7.4 |\n| Other operating costs and expenses | 21.7 | 22.0 | 50.6 | 47.7 |\n| Total Colonial Penn expenses | 68.7 | 66.9 | 146.3 | 139.3 |\n| Other CNO Business: |\n| Insurance policy benefits | — | 15.3 | — | 30.9 |\n| Other operating costs and expenses | — | 6.4 | — | 12.7 |\n| Total Other CNO Business expenses | — | 21.7 | — | 43.6 |\n| Corporate operations: |\n| Interest expense on corporate debt | 11.1 | 13.1 | 22.2 | 28.2 |\n| Interest expense on investment borrowings | — | — | — | .1 |\n| Other operating costs and expenses | 22.5 | 3.6 | 36.9 | 12.3 |\n| Total corporate expenses | 33.6 | 16.7 | 59.1 | 40.6 |\n| Total expenses | 872.8 | 863.2 | 1,731.4 | 1,799.7 |\n| Pre-tax operating earnings by segment: |\n| Bankers Life | 87.4 | 79.1 | 171.6 | 141.2 |\n| Washington National | 32.3 | 35.8 | 63.4 | 69.8 |\n| Colonial Penn | 3.8 | 1.2 | (2.4 | ) | (4.2 | ) |\n| Other CNO Business | — | (7.2 | ) | — | (14.5 | ) |\n| Corporate operations | (26.6 | ) | (10.7 | ) | (43.7 | ) | (22.8 | ) |\n| Pre-tax operating earnings | $ | 96.9 | $ | 98.2 | $ | 188.9 | $ | 169.5 |\n\n___________________\n| (a) | It is not practicable to provide additional components of revenue by product or services. |\n\n21\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nA reconciliation of segment revenues and expenses to consolidated revenues and expenses and net income (loss) is as follows (dollars in millions):\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Total segment revenues | $ | 969.7 | $ | 961.4 | $ | 1,920.3 | $ | 1,969.2 |\n| Net realized investment gains | 11.7 | 1.6 | 33.0 | 14.8 |\n| Revenues related to certain non-strategic investments and earnings attributable to VIEs | 7.3 | 8.2 | 13.6 | 15.1 |\n| Revenues of CLIC being sold | 104.3 | 110.3 | 210.8 | 225.0 |\n| Consolidated revenues | 1,093.0 | 1,081.5 | 2,177.7 | 2,224.1 |\n| Total segment expenses | 872.8 | 863.2 | 1,731.4 | 1,799.7 |\n| Gain related to reinsurance transaction | (3.8 | ) | — | (3.8 | ) | — |\n| Insurance policy benefits - fair value changes in embedded derivative liabilities | 10.1 | (29.0 | ) | 25.3 | (32.1 | ) |\n| Amortization related to fair value changes in embedded derivative liabilities | (2.7 | ) | 10.5 | (6.9 | ) | 11.5 |\n| Amortization related to net realized investment gains | .1 | .4 | .5 | 1.2 |\n| Expenses related to certain non-strategic investments and earnings attributable to VIEs | 10.2 | 11.1 | 19.8 | 19.9 |\n| Loss on extinguishment or modification of debt | .6 | 7.7 | .6 | 65.4 |\n| Loss on sale of subsidiary | — | — | 278.6 | — |\n| Expenses of CLIC being sold | 91.3 | 102.9 | 187.4 | 209.2 |\n| Consolidated expenses | 978.6 | 966.8 | 2,232.9 | 2,074.8 |\n| Income (loss) before tax | 114.4 | 114.7 | (55.2 | ) | 149.3 |\n| Income tax expense: |\n| Tax expense on period income | 40.3 | 42.6 | 79.3 | 75.8 |\n| Valuation allowance for deferred taxes and other tax items | (4.0 | ) | (5.0 | ) | 15.4 | (15.5 | ) |\n| Net income (loss) | $ | 78.1 | $ | 77.1 | $ | (149.9 | ) | $ | 89.0 |\n\n22\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nACCOUNTING FOR DERIVATIVES\nOur fixed index annuity products provide a guaranteed minimum rate of return and a higher potential return that is based on a percentage (the \"participation rate\") of the amount of increase in the value of a particular index, such as the Standard & Poor's 500 Index, over a specified period. Typically, on each policy anniversary date, a new index period begins. We are generally able to change the participation rate at the beginning of each index period during a policy year, subject to contractual minimums. We typically buy call options (including call spreads) referenced to the applicable indices in an effort to offset or hedge potential increases to policyholder benefits resulting from increases in the particular index to which the policy's return is linked. We reflect changes in the estimated fair value of these options in net investment income (classified as investment income from policyholder and reinsurer accounts and other special-purpose portfolios). Net investment gains (losses) related to fixed index products were $36.7 million and $75.9 million in the six months ended June 30, 2014 and 2013, respectively. These amounts were substantially offset by a corresponding change to insurance policy benefits. The estimated fair value of these options was $130.7 million (including $4.3 million classified as \"Assets of subsidiary being sold\") and $156.2 million at June 30, 2014 and December 31, 2013, respectively. We classify these instruments as other invested assets.\nThe Company accounts for the options attributed to the policyholder for the estimated life of the annuity contract as embedded derivatives. The Company purchases options to hedge liabilities for the next policy period approximately on each policy anniversary date and must estimate the fair value of the forward embedded options related to the policies. These accounting requirements often create volatility in the earnings from these products. We record the changes in the fair values of the embedded derivatives in earnings as a component of insurance policy benefits. The fair value of these derivatives, which are classified as \"policyholder account balances\", was $980.3 million and $903.7 million at June 30, 2014 and December 31, 2013, respectively. We recognized an increase to earnings of $7.4 million and $18.5 million in the second quarters of 2014 and 2013, respectively, and $18.4 million and $20.6 million in the first six months of 2014 and 2013, respectively, from the volatility caused by the accounting requirements to record embedded options at fair value.\nIf the counterparties for the call options we hold fail to meet their obligations, we may have to recognize a loss. We limit our exposure to such a loss by diversifying among several counterparties believed to be strong and creditworthy. At June 30, 2014, substantially all of our counterparties were rated \"BBB\" or higher by Standard & Poor's Corporation (\"S&P\").\nIn periods prior to the second quarter of 2014, we were required to establish an embedded derivative related to a modified coinsurance agreement which ceded the risks of a block of interest sensitive life business. We recaptured this block in the second quarter of 2014, resulting in a gain of $3.8 million, primarily consisting of the release of the embedded derivative. Prior to the recapture of this block, we maintained the investments related to the modified coinsurance agreement in our trading securities account, which we carried at estimated fair value with changes in such value recognized as investment income. Such trading securities were sold in the second quarter of 2014 in conjunction with the reinsurance recapture.\nWe purchase certain fixed maturity securities that contain embedded derivatives that are required to be bifurcated from the instrument and held at fair value on the consolidated balance sheet. For certain of these securities, we have elected the fair value option to carry the entire security at fair value with changes in fair value reported in net income for operational ease. Such securities totaled $221.1 million (including $24.3 million classified as \"Assets of subsidiary being sold\") and $180.6 million at June 30, 2014 and December 31, 2013, respectively.\nREINSURANCE\nThe cost of reinsurance ceded totaled $55.4 million and $55.1 million in the second quarters of 2014 and 2013, respectively, and $107.5 million and $107.1 million in the first six months of 2014 and 2013, respectively. We deduct this cost from insurance policy income. Reinsurance recoveries netted against insurance policy benefits totaled $61.2 million and $39.1 million in the second quarters of 2014 and 2013, respectively, and $120.8 million and $92.7 million in the first six months of 2014 and 2013, respectively.\nFrom time-to-time, we assume insurance from other companies. Any costs associated with the assumption of insurance are amortized consistent with the method used to amortize deferred acquisition costs described above. Reinsurance premiums assumed totaled $3.8 million and $15.4 million in the second quarters of 2014 and 2013, respectively, and $14.7 million and $29.1 million in the first six months of 2014 and 2013, respectively. Reinsurance premiums included amounts assumed pursuant to marketing and quota-share agreements with Coventry Health Care (\"Coventry\") of nil and $10.8 million in the second quarters of 2014 and 2013, respectively and $6.8 million and $19.7 million in the first six months of 2014 and 2013,\n23\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nrespectively. In August 2013, we received a notice of Coventry's intent to terminate the Medicare Part D prescription drug plan (\"PDP\") quota-share reinsurance agreement whereby we assumed a portion of the risk related to the PDP business sold through our Bankers Life segment. The PDP premiums received in 2014 (all of which were received in the first quarter of 2014)represent adjustments on such business related to periods prior to the termination of the agreement. We continue to receive distribution income from Coventry for PDP business sold through our Bankers Life segment.\nIn December 2013, two of our insurance subsidiaries with long-term care business in the Other CNO Business segment entered into 100% coinsurance agreements ceding $495 million of long-term care reserves to Beechwood Re Ltd. (\"BRe\"). Pursuant to the agreements, the insurance subsidiaries paid an additional premium of $96.9 million to BRe and an amount equal to the related net liabilities. The insurance subsidiaries' ceded reserve credits are secured by assets in market-value trusts subject to a 7% over-collateralization, investment guidelines and periodic true-up provisions. Future payments into the trusts to maintain collateral requirements are the responsibility of BRe.\nIn the second quarter of 2014, we recaptured a block of interest-sensitive life business that was previously ceded under a modified coinsurance agreement. The recapture of this block resulted in a gain related to reinsurance transaction of $3.8 million. The gain primarily consisted of the release of an embedded derivative that is no longer required.\n24\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nINCOME TAXES\nThe Company's interim tax expense is based upon the estimated annual effective tax rate for the respective period. Under authoritative guidance, certain items are required to be excluded from the estimated annual effective tax rate calculation. Such items include changes in judgment about the realizability of deferred tax assets resulting from changes in projections of income expected to be available in future years, and items deemed to be unusual, infrequent, or that can not be reliably estimated. In these cases, the actual tax expense or benefit applicable to that item is treated discretely and is reported in the same period as the related item. Discrete items include: (i) the loss on the sale of CLIC of $278.6 million in the six months ended June 30, 2014; and (ii) the loss on extinguishment or modification of debt of $7.7 million and $65.4 million in the three and six months ended June 30, 2013, respectively. The components of income tax expense are as follows (dollars in millions):\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Current tax expense | $ | 3.9 | $ | 2.7 | $ | 6.1 | $ | 5.4 |\n| Deferred tax expense | 36.4 | 40.8 | 73.2 | 71.8 |\n| Income tax expense calculated based on estimated annual effective tax rate | 40.3 | 43.5 | 79.3 | 77.2 |\n| Income tax expense (benefit) on discrete items: |\n| Related to the sale of CLIC: |\n| Tax expense related to tax gain on sale | 8.4 | — | 21.6 | — |\n| Previously unrecognized tax benefit recognized as a result of the gain | — | — | (7.4 | ) | — |\n| Valuation allowance release related to the gain | (8.4 | ) | — | (14.2 | ) | — |\n| Valuation allowance increase related to the decrease in projected future taxable income | — | — | 19.4 | — |\n| Valuation allowance reduction resulting from the realization of capital gains and utilization of loss carryforwards | (4.0 | ) | (5.0 | ) | (4.0 | ) | (15.5 | ) |\n| Deferred tax benefit related to loss on extinguishment or modification of debt | — | (.9 | ) | — | (1.4 | ) |\n| Total income tax expense | $ | 36.3 | $ | 37.6 | $ | 94.7 | $ | 60.3 |\n\nA reconciliation of the U.S. statutory corporate tax rate to the estimated annual effective rate, before discrete items, reflected in the consolidated statement of operations is as follows:\n\n| Six months ended |\n| June 30, |\n| 2014 | 2013 |\n| U.S. statutory corporate rate | 35.0 | % | 35.0 | % |\n| Non-taxable income and nondeductible benefits, net | (1.0 | ) | (.5 | ) |\n| State taxes | 1.5 | 1.4 |\n| Estimated annual effective tax rate | 35.5 | % | 35.9 | % |\n\n25\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nThe components of the Company's income tax assets and liabilities are summarized below (dollars in millions):\n| June 30, 2014 | December 31, 2013 |\n| Deferred tax assets: |\n| Net federal operating loss carryforwards | $ | 1,141.8 | $ | 1,240.2 |\n| Net state operating loss carryforwards | 18.4 | 20.0 |\n| Tax credits | 40.6 | 43.9 |\n| Capital loss carryforwards | .6 | 13.4 |\n| Deductible temporary differences: |\n| Investments | 68.2 | 74.3 |\n| Insurance liabilities | 622.2 | 723.8 |\n| Other | (1.7 | ) | 64.7 |\n| Gross deferred tax assets | 1,890.1 | 2,180.3 |\n| Deferred tax liabilities: |\n| Present value of future profits and deferred acquisition costs | (318.1 | ) | (306.8 | ) |\n| Accumulated other comprehensive income | (512.6 | ) | (405.5 | ) |\n| Gross deferred tax liabilities | (830.7 | ) | (712.3 | ) |\n| Net deferred tax assets before valuation allowance | 1,059.4 | 1,468.0 |\n| Valuation allowance | (296.0 | ) | (294.8 | ) |\n| Net deferred tax assets | 763.4 | 1,173.2 |\n| Current income taxes accrued | (32.9 | ) | (26.0 | ) |\n| Income tax assets, net | $ | 730.5 | $ | 1,147.2 |\n\nOur income tax expense includes deferred income taxes arising from temporary differences between the financial reporting and tax bases of assets and liabilities, capital loss carryforwards and NOLs. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply in the years in which temporary differences are expected to be recovered or paid. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in earnings in the period when the changes are enacted.\nA reduction of the net carrying amount of deferred tax assets by establishing a valuation allowance is required if, based on the available evidence, it is more likely than not that such assets will not be realized. In assessing the need for a valuation allowance, all available evidence, both positive and negative, shall be considered to determine whether, based on the weight of that evidence, a valuation allowance for deferred tax assets is needed. This assessment requires significant judgment and considers, among other matters, the nature, frequency and severity of current and cumulative losses, forecasts of future profitability, the duration of carryforward periods, our experience with operating loss and tax credit carryforwards expiring unused, and tax planning strategies. We evaluate the need to establish a valuation allowance for our deferred income tax assets on an ongoing basis. The realization of our deferred tax assets depends upon generating sufficient future taxable income of the appropriate type during the periods in which our temporary differences become deductible and before our capital loss carryforwards and life and non-life NOLs expire.\nBased on our assessment, it appears more likely than not that $763.4 million of our deferred tax assets will be realized through future taxable earnings. We will continue to assess the need for a valuation allowance in the future. If future results are less than projected, a valuation allowance may be required to reduce the deferred tax asset, which could have a material impact on our results of operations in the period in which it is recorded.\nOur deferred tax valuation model reflects projections of future taxable income based on a normalized average annual taxable income for the last three years, plus 3 percent growth for the next five years and level income thereafter. Such normalized projected taxable income has been adjusted to reflect the investment trading strategies and the coinsurance\n26\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nagreements to cede certain long-term care business, both completed in 2013. In addition, projected taxable income has been adjusted to reflect the sale of CLIC, which is expected to result in a net reduction to CNO's taxable income in future periods and required us to establish a valuation allowance of $19.4 million in the first six months of 2014. Our current deferred tax valuation model assumes estimated normalized taxable income of approximately $315.0 million in 2014. We have evaluated each component of the deferred tax asset and assessed the effect of limitations and/or interpretations on the value of each component and have concluded that it is more likely than not that the components recognized will be fully realized in the future.\nRecovery of our deferred tax asset is dependent on achieving the level of future taxable income projected in our deferred tax valuation model and failure to do so could result in an increase in the valuation allowance in a future period. Any future increase in the valuation allowance may result in additional income tax expense and reduce shareholders' equity, and such an increase could have a significant impact upon our earnings in the future. In addition, the use of the Company's NOLs is dependent, in part, on whether the Internal Revenue Service (the \"IRS\") ultimately agrees with the tax position we have taken in our tax returns with respect to the character of the loss recognized as a result of the transfer of the stock of our former subsidiary, Conseco Senior Health Insurance Company (\"CSHI\"), to Senior Health Care Oversight Trust, an independent trust (the \"Independent Trust\").\nThe Internal Revenue Code (the \"Code\") limits the extent to which losses realized by a non-life entity (or entities) may offset income from a life insurance company (or companies) to the lesser of: (i) 35 percent of the income of the life insurance company; or (ii) 35 percent of the total loss of the non-life entities (including NOLs of the non-life entities). There is no similar limitation on the extent to which losses realized by a life insurance entity (or entities) may offset income from a non-life entity (or entities). This limitation is the primary reason a valuation allowance for NOL carryforwards is required.\nSection 382 of the Code imposes limitations on a corporation's ability to use its NOLs when the company undergoes an ownership change. Future transactions and the timing of such transactions could cause an ownership change for Section 382 income tax purposes. Such transactions may include, but are not limited to, additional repurchases under our securities repurchase program, issuances of common stock and acquisitions or sales of shares of CNO stock by certain holders of our shares, including persons who have held, currently hold or may accumulate in the future five percent or more of our outstanding common stock for their own account. Many of these transactions are beyond our control. If an additional ownership change were to occur for purposes of Section 382, we would be required to calculate an annual restriction on the use of our NOLs to offset future taxable income. The annual restriction would be calculated based upon the value of CNO's equity at the time of such ownership change, multiplied by a federal long-term tax exempt rate (3.32 percent at June 30, 2014), and the annual restriction could effectively eliminate our ability to use a substantial portion of our NOLs to offset future taxable income. We regularly monitor ownership change (as calculated for purposes of Section 382) and, as of June 30, 2014, we were below the 50 percent ownership change level that would trigger further impairment of our ability to utilize our NOLs.\n27\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nAs of June 30, 2014, we had $3.3 billion of federal NOLs and $1.8 million of capital loss carryforwards. The following table summarizes the expiration dates of our loss carryforwards assuming the IRS ultimately agrees with the position we have taken with respect to the loss on our investment in CSHI (dollars in millions):\n| Year of expiration | Net operating loss carryforwards | Capital loss | Total loss |\n| Life | Non-life | carryforwards | carryforwards |\n| 2018 | $ | 120.6 | $ | — | $ | — | $ | 120.6 |\n| 2021 | 30.0 | — | — | 30.0 |\n| 2022 | 152.0 | — | — | 152.0 |\n| 2023 | 742.6 | 2,126.1 | — | 2,868.7 |\n| 2025 | — | 115.3 | — | 115.3 |\n| 2027 | — | 202.6 | — | 202.6 |\n| 2028 | — | .5 | — | .5 |\n| 2029 | — | 272.3 | — | 272.3 |\n| 2032 | — | 44.0 | — | 44.0 |\n| Subtotal | 1,045.2 | 2,760.8 | — | 3,806.0 |\n| Less: |\n| Unrecognized tax benefits | (344.7 | ) | (199.0 | ) | 1.8 | (541.9 | ) |\n| Total | $ | 700.5 | $ | 2,561.8 | $ | 1.8 | $ | 3,264.1 |\n\nWe had deferred tax assets related to NOLs for state income taxes of $18.4 million and $20.0 million at June 30, 2014 and December 31, 2013, respectively. The related state NOLs are available to offset future state taxable income in certain states through 2025.\nWe recognized an $878 million ordinary loss on our investment in CSHI which was worthless when it was transferred to the Independent Trust in 2008. Of this loss, $742 million has been reported as a life loss and $136 million as a non-life loss. The IRS has disagreed with our ordinary loss treatment and believes that it should be treated as a capital loss, subject to a five year carryover. If the IRS position is ultimately determined to be correct, $473 million would have expired unused in 2013. Due to this uncertainty, we have not recognized a tax benefit of $166.0 million. However, if this unrecognized tax benefit would have been recognized, we would also have established a valuation allowance of $41.0 million at June 30, 2014.\nTax years 2004 and 2008 through 2012 are open to examination by the IRS. The Company's various state income tax returns are generally open for tax years 2010 through 2012 based on the individual state statutes of limitation. Generally, for tax years which generate NOLs, capital losses or tax credit carryforwards, the statute of limitations does not close until the expiration of the statute of limitations for the tax year in which such carryforwards are utilized.\n28\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nNOTES PAYABLE - DIRECT CORPORATE OBLIGATIONS\nThe following notes payable were direct corporate obligations of the Company as of June 30, 2014 and December 31, 2013 (dollars in millions):\n| June 30, 2014 | December 31, 2013 |\n| Senior Secured Credit Agreement (as defined below) | $ | 555.5 | $ | 581.5 |\n| 6.375% Senior Secured Notes due October 2020 (the \"6.375% Notes\") | 275.0 | 275.0 |\n| 7.0% Debentures | — | 3.5 |\n| Unamortized discount on Senior Secured Credit Agreement | (3.2 | ) | (3.6 | ) |\n| Direct corporate obligations | $ | 827.3 | $ | 856.4 |\n\nSenior Secured Credit Agreement\nOn September 28, 2012, the Company entered into a new senior secured credit agreement, providing for: (i) a $425.0 million six-year term loan facility ($393.0 million remained outstanding at June 30, 2014); (ii) a $250.0 million four-year term loan facility ($162.5 million remained outstanding at June 30, 2014); and (iii) a $50.0 million three-year revolving credit facility, with JPMorgan Chase Bank, N.A., as administrative agent, and the lenders from time to time party thereto (the \"Senior Secured Credit Agreement\"). The Senior Secured Credit Agreement is guaranteed by the Subsidiary Guarantors (as defined below) and secured by a first-priority lien (which ranks pari passu with the liens securing the 6.375% Notes) on substantially all of the Company's and the Subsidiary Guarantors' assets. As of June 30, 2014, no amounts have been borrowed under the revolving credit facility.\nThe revolving credit facility includes an uncommitted subfacility for swingline loans of up to $5.0 million, and up to $5.0 million of the revolving credit facility is available for the issuance of letters of credit. The six-year term loan facility amortizes in quarterly installments in amounts resulting in an annual amortization of 1% and the four-year term loan facility amortizes in quarterly installments resulting in an annual amortization of 20% during the first and second years and 30% during the third and fourth years. Subject to certain conditions, the Company may incur additional incremental loans under the Senior Secured Credit Agreement in an amount of up to $250.0 million.\nThe interest rates with respect to loans under: (i) the six-year term loan facility are, at the Company's option, equal to a eurodollar rate, plus 2.75% per annum, or a base rate, plus 1.75% per annum, subject to a eurodollar rate \"floor\" of 1.00% and a base rate \"floor\" of 2.25% (such rate was 3.75% at June 30, 2014); (ii) the four-year term loan facility are, at the Company's option, equal to a eurodollar rate, plus 2.25% per annum, or a base rate, plus 1.25% per annum, subject to a eurodollar rate \"floor\" of .75% and a base rate \"floor\" of 2.00% (such rate was 3.00% at June 30, 2014); and (iii) the revolving credit facility will be, at the Company's option, equal to a eurodollar rate, plus 3.00% per annum, or a base rate, plus 2.00% per annum, in each case, with respect to revolving credit facility borrowings only, subject to certain step-downs based on the debt to total capitalization ratio of the Company.\nIn the first six months of 2014, we made $26.0 million of scheduled quarterly principal payments due under the Senior Secured Credit Agreement.\nOn May 30, 2014, the Company completed an amendment to the Senior Secured Credit Agreement to waive the requirement that the net proceeds in excess of $125 million to be received from the sale of CLIC be used to prepay amounts outstanding under the Senior Secured Credit Agreement. In the second quarter of 2014, we recognized expenses related to the amendment of the Senior Secured Credit Agreement totaling $.4 million which are included in the loss on extinguishment or modification of debt.\nThe amendment to the Senior Secured Credit Agreement did not impact the restrictions set forth in the 6.375% Indenture dated as of September 28, 2012 (the \"6.375% Indenture\") for the Company’s 6.375% Notes regarding the Company’s use of the proceeds from the sale of CLIC. Under the Indenture, the net proceeds received by the Company from the sale of CLIC\n29\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\n(defined as \"Net Available Cash\" under the Indenture) may be used to: (i) reinvest in or acquire assets to be used in the insurance business or a related business; or (ii) repay the Senior Secured Credit Agreement. Under the Indenture, any Net Available Cash not so reinvested or applied within 365 days after the closing of the sale of CLIC must be used to make an offer to purchase the outstanding notes at par and, in the interim, may only be invested as set forth in the Indenture. The Company currently plans to reinvest the cash received from the sale of CLIC in its business including the payment on July 1, 2014, of $28.0 million to recapture a block of life insurance business from Wilton Re.\nMandatory prepayments of the Senior Secured Credit Agreement will be required, subject to certain exceptions, in an amount equal to: (i) 100% of the net cash proceeds from certain asset sales or casualty events; (ii) 100% of the net cash proceeds received by the Company or any of its restricted subsidiaries from certain debt issuances; and (iii) 100% of the amount of certain restricted payments made (including any common stock dividends and share repurchases) as defined in the Senior Secured Credit Agreement provided that if, as of the end of the fiscal quarter immediately preceding such restricted payment, the debt to total capitalization ratio is: (x) equal to or less than 25.0%, but greater than 20.0%, the prepayment requirement shall be reduced to 33.33%; or (y) equal to or less than 20.0%, the prepayment requirement shall not apply.\nNotwithstanding the foregoing, no mandatory prepayments pursuant to item (i) in the preceding paragraph shall be required if: (x) the debt to total capitalization ratio is equal or less than 20% and (y) either (A) the financial strength rating of certain of the Company's insurance subsidiaries is equal or better than A- (stable) from A.M. Best Company (\"A.M. Best\") or (B) the Senior Secured Credit Agreement is rated equal or better than BBB- (stable) from S&P and Baa3 (stable) by Moody's Investor Services, Inc. (\"Moody's\").\nThe Senior Secured Credit Agreement requires the Company to maintain (each as calculated in accordance with the Senior Secured Credit Agreement): (i) a debt to total capitalization ratio of not more than 27.5 percent (such ratio was 17.6 percent at June 30, 2014); (ii) an interest coverage ratio of not less than 2.50 to 1.00 for each rolling four quarters (or, if less, the number of full fiscal quarters commencing after the effective date of the Senior Secured Credit Agreement) (such ratio was 9.81 to 1.00 for the four quarters ended June 30, 2014); (iii) an aggregate ratio of total adjusted capital to company action level risk-based capital for the Company's insurance subsidiaries of not less than 250 percent (such ratio was 437 percent at June 30, 2014); and (iv) a combined statutory capital and surplus for the Company's insurance subsidiaries of at least $1,300.0 million (combined statutory capital and surplus at June 30, 2014, was $2,057 million).\n6.375% Notes\nOn September 28, 2012, we issued $275.0 million in aggregate principal amount of 6.375% Notes pursuant to the 6.375% Indenture, among the Company, the subsidiary guarantors party thereto (the \"Subsidiary Guarantors\") and Wilmington Trust, National Association, as trustee and as collateral agent. The net proceeds from the issuance of the 6.375% Notes, together with the net proceeds from the Senior Secured Credit Agreement, were used to repay other outstanding indebtedness and for general corporate purposes. The 6.375% Notes mature on October 1, 2020. Interest on the 6.375% Notes accrues at a rate of 6.375% per annum and is payable semiannually in arrears on April 1 and October 1 of each year, commencing on April 1, 2013. The 6.375% Notes and the guarantees thereof (the \"Guarantees\") are senior secured obligations of the Company and the Subsidiary Guarantors and rank equally in right of payment with all of the Company's and the Subsidiary Guarantors' existing and future senior obligations, and senior to all of the Company's and the Subsidiary Guarantors' future subordinated indebtedness. The 6.375% Notes are secured by a first-priority lien on substantially all of the assets of the Company and the Subsidiary Guarantors, subject to certain exceptions. The 6.375% Notes and the Guarantees are pari passu with respect to security and in right of payment with all of the Company's and the Subsidiary Guarantors' existing and future secured indebtedness under the Senior Secured Credit Agreement. The 6.375% Notes are structurally subordinated to all of the liabilities and preferred stock of each of the Company's insurance subsidiaries, which are not guarantors of the 6.375% Notes.\nUnder the 6.375% Indenture, the Company can make Restricted Payments (as such term is defined in the 6.375% Indenture) up to a calculated limit, provided that the Company's pro forma risk-based capital ratio exceeds 225% after giving effect to the Restricted Payment and certain other conditions are met. Restricted Payments include, among other items, repurchases of common stock and cash dividends on common stock (to the extent such dividends exceed $30.0 million in the aggregate in any calendar year).\nThe limit of Restricted Payments permitted under the 6.375% Indenture is the sum of (x) 50% of the Company's \"Net Excess Cash Flow\" (as defined in the 6.375% Indenture) for the period (taken as one accounting period) from July 1, 2012 to\n30\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nthe end of the Company's most recently ended fiscal quarter for which financial statements are available at the time of such Restricted Payment, (y) $175.0 million and (z) certain other amounts specified in the 6.375% Indenture. Based on the provisions set forth in the 6.375% Indenture and the Company's Net Excess Cash Flow for the period from July 1, 2012 through June 30, 2014, the Company could have made additional Restricted Payments under this 6.375% Indenture covenant of approximately $178 million as of June 30, 2014. This limitation on Restricted Payments does not apply if the Debt to Total Capitalization Ratio (as defined in the 6.375% Indenture) as of the last day of the Company's most recently ended fiscal quarter for which financial statements are available that immediately precedes the date of any Restricted Payment, calculated immediately after giving effect to such Restricted Payment and any related transactions on a pro forma basis, is equal to or less than 17.5%.\n7.0% Debentures\nOn May 30, 2014, we repurchased the remaining $3.5 million principal amount of the 7.0% Debentures for a purchase price of $3.7 million and recognized a loss on the extinguishment of debt of $.2 million.\nScheduled Repayment of our Direct Corporate Obligations\nThe scheduled repayment of our direct corporate obligations was as follows at June 30, 2014 (dollars in millions):\n| Year ending June 30, |\n| 2015 | $ | 73.0 |\n| 2016 | 79.3 |\n| 2017 | 23.0 |\n| 2018 | 4.2 |\n| 2019 | 376.0 |\n| Thereafter | 275.0 |\n| $ | 830.5 |\n\nINVESTMENT BORROWINGS\nTwo of the Company's insurance subsidiaries (Washington National Insurance Company (\"Washington National\") and Bankers Life) are members of the Federal Home Loan Bank (\"FHLB\"). As members of the FHLB, Washington National and Bankers Life have the ability to borrow on a collateralized basis from the FHLB. Washington National and Bankers Life are required to hold certain minimum amounts of FHLB common stock as a condition of membership in the FHLB, and additional amounts based on the amount of the borrowings. At June 30, 2014, the carrying value of the FHLB common stock was $73.5 million. As of June 30, 2014, collateralized borrowings from the FHLB totaled $1.5 billion and the proceeds were used to purchase fixed maturity securities. The borrowings are classified as investment borrowings in the accompanying consolidated balance sheet. The borrowings are collateralized by investments with an estimated fair value of $1.8 billion at June 30, 2014, which are maintained in a custodial account for the benefit of the FHLB. Substantially all of such investments are classified as fixed maturities, available for sale, in our consolidated balance sheet.\nCLIC was also a member of the FHLB and \"Assets of subsidiary being sold\" included FHLB common stock of $22.5 million and \"Liabilities of subsidiary being sold\" included collateralized borrowings of $383.4 million, both as of June 30, 2014. These borrowings are collateralizd by investments with an estimated fair value of $503.9 million included in the \"Assets of subsidiary being sold\".\n31\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nThe following summarizes the terms of the borrowings from the FHLB by Washington National and Bankers Life (dollars in millions):\n| Amount | Maturity | Interest rate at |\n| borrowed | date | June 30, 2014 |\n| $ | 50.0 | September 2015 | Variable rate – 0.528% |\n| 50.0 | October 2015 | Variable rate – 0.502% |\n| 100.0 | June 2016 | Variable rate – 0.592% |\n| 75.0 | June 2016 | Variable rate – 0.394% |\n| 100.0 | October 2016 | Variable rate – 0.412% |\n| 50.0 | November 2016 | Variable rate – 0.497% |\n| 50.0 | November 2016 | Variable rate – 0.622% |\n| 57.7 | June 2017 | Variable rate – 0.581% |\n| 50.0 | August 2017 | Variable rate – 0.424% |\n| 75.0 | August 2017 | Variable rate – 0.377% |\n| 100.0 | October 2017 | Variable rate – 0.656% |\n| 50.0 | November 2017 | Variable rate – 0.737% |\n| 50.0 | January 2018 | Variable rate – 0.578% |\n| 50.0 | January 2018 | Variable rate – 0.566% |\n| 50.0 | February 2018 | Variable rate – 0.533% |\n| 50.0 | February 2018 | Variable rate – 0.315% |\n| 22.0 | February 2018 | Variable rate – 0.559% |\n| 100.0 | May 2018 | Variable rate – 0.600% |\n| 50.0 | July 2018 | Variable rate – 0.698% |\n| 50.0 | August 2018 | Variable rate – 0.344% |\n| 50.0 | January 2019 | Variable rate – 0.649% |\n| 50.0 | February 2019 | Variable rate – 0.315% |\n| 100.0 | March 2019 | Variable rate – 0.634% |\n| 21.8 | June 2020 | Fixed rate – 1.960% |\n| 27.2 | March 2023 | Fixed rate – 2.160% |\n| 20.5 | June 2025 | Fixed rate – 2.940% |\n| $ | 1,499.2 |\n\n32\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nThe following summarizes the terms of the borrowings classified as \"Liabilities of subsidiary being sold\" (dollars in millions):\n| Amount | Maturity | Interest rate at |\n| borrowed | date | June 30, 2014 |\n| $ | 146.4 | November 2015 | Fixed rate – 5.300% |\n| 100.0 | December 2015 | Fixed rate – 4.710% |\n| 100.0 | July 2017 | Fixed rate – 3.900% |\n| 37.0 | November 2017 | Fixed rate – 3.750% |\n| $ | 383.4 |\n\nThe variable rate borrowings are pre-payable on each interest reset date without penalty. The fixed rate borrowings are pre-payable subject to payment of a yield maintenance fee based on current market interest rates. At June 30, 2014, the aggregate yield maintenance fee to prepay all fixed rate borrowings was $29.5 million.\nInterest expense of $13.8 million and $13.6 million in the first six months of 2014 and 2013, respectively, was recognized related to total borrowings from the FHLB.\nAs part of our investment strategy, we may enter into repurchase agreements to increase our investment return. Pursuant to such agreements, the Company sells securities subject to an obligation to repurchase the same securities. Under these arrangements, the Company may transfer legal control over the assets but still retain effective control through an agreement that both entitles and obligates the Company to repurchase the assets. As a result, these repurchase agreements are accounted for as collateralized financing arrangements (i.e., secured borrowings) and not as a sale and subsequent repurchase of securities. Such borrowings totaled $8.4 million at June 30, 2014 and mature prior to June 30, 2015.\nThe primary risks associated with short-term collateralized borrowings are: (i) a substantial decline in the market value of the margined security; and (ii) that a counterparty may be unable to perform under the terms of the contract or be unwilling to extend such financing in future periods especially if the liquidity or value of the margined security has declined. Exposure is limited to any depreciation in value of the related securities.\nCHANGES IN COMMON STOCK\nChanges in the number of shares of common stock outstanding were as follows (shares in thousands):\n| Balance, December 31, 2013 | 220,324 |\n| Treasury stock purchased and retired | (7,834 | ) |\n| Stock options exercised | 732 |\n| Restricted and performance stock vested | 533 | (a) |\n| Balance, June 30, 2014 | 213,755 |\n\n____________________\n| (a) | Such amount was reduced by 227 thousand shares which were tendered to the Company for the payment of required federal and state tax withholdings owed on the vesting of restricted and performance stock. |\n\nIn May 2011, the Company announced a common share repurchase program of up to $100.0 million. In February 2012, June 2012, December 2012 and December 2013, the Company's Board of Directors approved, in aggregate, an additional $800.0 million to repurchase the Company's outstanding securities. In the first six months of 2014, we repurchased 7.8 million shares of common stock for $136.6 million under the securities repurchase program. The Company had remaining repurchase authority of $260.8 million as of June 30, 2014.\nIn the first six months of 2014, dividends declared and paid on common stock totaled $26.3 million ($0.12 per common share). In March 2014, the Company increased its quarterly common stock dividend to $0.06 per share from $0.03 per share.\n33\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nSALES INDUCEMENTS\nCertain of our annuity products offer sales inducements to contract holders in the form of enhanced crediting rates or bonus payments in the initial period of the contract. Certain of our life insurance products offer persistency bonuses credited to the contract holders balance after the policy has been outstanding for a specified period of time. These enhanced rates and persistency bonuses are considered sales inducements in accordance with GAAP. Such amounts are deferred and amortized in the same manner as deferred acquisition costs. Sales inducements deferred totaled $3.1 million and $2.5 million during the six months ended June 30, 2014 and 2013, respectively. Amounts amortized totaled $9.4 million and $13.3 million during the six months ended June 30, 2014 and 2013, respectively. The unamortized balance of deferred sales inducements was $102.3 million (including $33.9 million classified as \"Assets of subsidiary being sold\") and $108.6 million at June 30, 2014 and December 31, 2013, respectively. The balance of insurance liabilities for persistency bonus benefits was $27.6 million (including $25.7 million classified as \"Liabilities of subsidiary being sold\") and $28.9 million at June 30, 2014 and December 31, 2013, respectively.\nASSETS AND LIABILITIES SUBJECT TO OFFSETTING DISCLOSURE REQUIREMENTS\nCall options\nAs further described in the note entitled \"Accounting for Derivatives\", we buy call options (including call spreads) referenced to applicable indices in an effort to offset or hedge potential increases to policyholder benefits resulting from increases in the particular index to which the policy's return is linked. We limit our exposure to the counterparties failing to meet their obligation with respect to the call options by diversifying among several counterparties believed to be strong and credit worthy. The call options are free-standing derivatives and are recorded at fair value in the Company's consolidated balance sheet. The Company and its subsidiaries are parties to master netting arrangements with its counterparties related to entering into various derivative contracts. However, the offsetting of assets and liabilities is not applicable to the derivative contracts that were in place at June 30, 2014 or December 31, 2013. The counterparties do not provide collateral to the Company related to their obligations under the call options.\nThe following table summarizes information related to call options as of June 30, 2014 and December 31, 2013 (dollars in millions):\n| Gross amounts not offset in the balance sheet |\n| Gross amounts of recognized assets | Gross amounts offset in the balance sheet | Net amounts of assets presented in the balance sheet | Financial instruments | Cash collateral received | Net amount |\n| June 30, 2014: |\n| Call Options (a) | $ | 130.7 | $ | — | $ | 130.7 | $ | — | $ | — | $ | 130.7 |\n| December 31, 2013: |\n| Call Options | 156.2 | — | 156.2 | — | — | 156.2 |\n\n___________________________\n(a) Includes $4.3 million classified as \"Assets of subsidiary being sold\".\n34\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nRepurchase agreements\nWe may enter into agreements under which we sell securities subject to an obligation to repurchase the same securities. These repurchase agreements are accounted for as collateralized financing arrangements and not as a sale and subsequent repurchase of securities. The obligation to repurchase the securities is reflected as investment borrowings in the Company's consolidated balance sheet, while the securities underlying the repurchase agreements remain in the respective investment asset accounts. There is no offsetting or netting of the investment securities assets with the repurchase agreement liabilities. In addition, as the Company does not currently have any outstanding reverse repurchase agreements, there is no such offsetting to be done with the repurchase agreements.\nThe right of setoff for a repurchase agreement resembles a secured borrowing, whereby the collateral would be used to settle the fair value of the repurchase agreement should the Company be in default (e.g., fails to make an interest payment to the counterparty). If the counterparty were to default (e.g., declare bankruptcy), the Company could cancel the repurchase agreement (i.e., cease payment of principal and interest), and attempt collection on the amount of collateral value in excess of the repurchase agreement fair value. The collateral is held by a third party financial institution in the counterparty's custodial account. The counterparty has the right to sell or repledge the investment securities.\nThe following table summarizes information related to repurchase agreements as of June 30, 2014 (dollars in millions):\n| Gross amounts not offset in the balance sheet |\n| Gross amounts of recognized liabilities | Gross amounts offset in the balance sheet | Net amounts of liabilities presented in the balance sheet | Financial instruments | Cash collateral pledged | Net amount |\n| June 30, 2014: |\n| Repurchase agreements (a) | $ | 8.4 | $ | — | $ | 8.4 | $ | — | $ | — | $ | 8.4 |\n\n_________________\n| (a) | As of June 30, 2014, these agreements were collateralized by investment securities with a fair value of $10.5 million. There were no repurchase agreements outstanding at December 31, 2013. |\n\nRECENTLY ISSUED ACCOUNTING STANDARDS\nPending Accounting Standards\nIn April 2014, the Financial Accounting Standards Board (the \"FASB\") issued authoritative guidance changing the criteria for reporting discontinued operations. Under the revised guidance, only disposals of a component or a group of components, including those classified as held for sale, which represent a strategic shift that has or will have a major effect on a company's operations and financial results will be reported as discontinued operations. The guidance is effective prospectively for new disposals occurring after January 1, 2015.\nIn May 2014, the FASB issued authoritative guidance for recognizing revenue from contracts with customers. Certain contracts with customers are specifically excluded from this guidance, including insurance contracts. The core principle of the new guidance is that an entity should recognize revenue when it transfers promised goods or services in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance also requires additional disclosures about the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. The guidance will be effective for the Company on January 1, 2017 and permits two methods of transition upon adoption; full retrospective and modified retrospective. Under the full retrospective method, prior periods would be restated under the new revenue standard, providing for comparability in all periods presented. Under the modified retrospective method, prior periods would not be restated. Instead, revenues and other disclosures for pre-2017 periods would be provided in\n35\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nthe notes to the financial statements as previously reported under the current revenue standard. The Company is currently assessing the impact the guidance will have upon adoption.\nIn June 2014, the FASB issued authoritative guidance on the accounting and disclosure of repurchase-to-maturity transactions and repurchase financings. Under this new accounting guidance, repurchase-to-maturity transactions will be accounted for as secured borrowings rather than sales of an asset, and transfers of financial assets with a contemporaneous repurchase financing arrangement will no longer be evaluated to determine whether they should be accounted for on a combined basis as forward contracts. The new guidance also prescribes additional disclosures particularly on the nature of collateral pledged in the repurchase agreement accounted for as a secured borrowing. The new guidance is effective beginning on January 1, 2015. The Company is currently assessing the impact the guidance will have upon adoption.\nAdopted Accounting Standards\nIn July 2013, the FASB issued authoritative guidance regarding the financial statement presentation of an unrecognized tax benefit when a NOL carryforward, a similar tax loss or a tax credit carryforward exists. Such guidance will require an unrecognized tax benefit, or a portion of an unrecognized tax benefit, to be presented in the financial statements as a reduction to a deferred tax asset for a NOL carryforward, a similar tax loss, or a tax credit carryforward, except under certain circumstances as further described in the guidance. Such guidance does not require new recurring disclosures. This guidance was effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. The adoption of this guidance did not have a material impact on our consolidated financial statements.\nLITIGATION AND OTHER LEGAL PROCEEDINGS\nLegal Proceedings\nThe Company and its subsidiaries are involved in various legal actions in the normal course of business, in which claims for compensatory and punitive damages are asserted, some for substantial amounts. We recognize an estimated loss from these loss contingencies when we believe it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. Some of the pending matters have been filed as purported class actions and some actions have been filed in certain jurisdictions that permit punitive damage awards that are disproportionate to the actual damages incurred. The amounts sought in certain of these actions are often large or indeterminate and the ultimate outcome of certain actions is difficult to predict. In the event of an adverse outcome in one or more of these matters, there is a possibility that the ultimate liability may be in excess of the liabilities we have established and could have a material adverse effect on our business, financial condition, results of operations and cash flows. In addition, the resolution of pending or future litigation may involve modifications to the terms of outstanding insurance policies or could impact the timing and amount of rate increases, which could adversely affect the future profitability of the related insurance policies. Based upon information presently available, and in light of legal, factual and other defenses available to the Company and its subsidiaries, the Company does not believe that it is probable that the ultimate liability from either pending or threatened legal actions, after consideration of existing loss provisions, will have a material adverse effect on the Company's consolidated financial condition, operating results or cash flows. However, given the inherent difficulty in predicting the outcome of legal proceedings, there exists the possibility that such legal actions could have a material adverse effect on the Company's consolidated financial condition, operating results or cash flows.\nIn addition to the inherent difficulty of predicting litigation outcomes, particularly those that will be decided by a jury, the matters specifically identified below purport to seek substantial or an unspecified amount of damages for unsubstantiated conduct spanning several years based on complex legal theories and damages models. The alleged damages typically are indeterminate or not factually supported in the complaint, and, in any event, the Company's experience indicates that monetary demands for damages often bear little relation to the ultimate loss. In some cases, plaintiffs are seeking to certify classes in the litigation and class certification either has been denied or is pending and we have filed oppositions to class certification or sought to decertify a prior class certification. In addition, for many of these cases: (i) there is uncertainty as to the outcome of pending appeals or motions; (ii) there are significant factual issues to be resolved; and/or (iii) there are novel legal issues presented. Accordingly, the Company cannot reasonably estimate the possible loss or range of loss in excess of amounts accrued, if any, or predict the timing of the eventual resolution of these matters. The Company reviews these matters on an ongoing basis. When assessing reasonably possible and probable outcomes, the Company bases its assessment on the expected ultimate outcome following all appeals.\nLitigation\nOn October 25, 2012, a purported nationwide class action was filed in the United States District Court for the Central District of California, William Jeffrey Burnett and Joe H. Camp v. Conseco Life Insurance Company, CNO Financial Group, Inc., CDOC, Inc. and CNO Services, LLC, Case No. EDCV12-01715VAPSPX. The plaintiffs bring this action under Rule 23(B)(3) on behalf of various Lifetrend policyholders who since October 2008 have surrendered their policies or had them lapse. Additionally, plaintiffs seek certification of a subclass of various Lifetrend policyholders who accepted optional benefits and\n36\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nsigned a release pursuant to a regulatory settlement. The plaintiffs allege breach of contract and seek declaratory relief, compensatory damages, attorney fees and costs. On November 30, 2012, CLIC and the other defendants filed a motion to dismiss the complaint. On November 18, 2013, the court granted the dismissal, with leave to amend, of CNO Financial Group, Inc., CDOC, Inc. and CNO Services, LLC, and denied the motion to dismiss CLIC. With the completion of the sale of CLIC on July 1, 2014, our consolidated financial statements will no longer include CLIC's liability related to this litigation in future periods.\nRegulatory Examinations and Fines\nInsurance companies face significant risks related to regulatory investigations and actions. Regulatory investigations generally result from matters related to sales or underwriting practices, payment of contingent or other sales commissions, claim payments and procedures, product design, product disclosure, additional premium charges for premiums paid on a periodic basis, denial or delay of benefits, charging excessive or impermissible fees on products, procedures related to canceling policies, changing the way cost of insurance charges are calculated for certain life insurance products or recommending unsuitable products to customers. We are, in the ordinary course of our business, subject to various examinations, inquiries and information requests from state, federal and other authorities. The ultimate outcome of these regulatory actions (including the costs of complying with information requests and policy reviews) cannot be predicted with certainty. In the event of an unfavorable outcome in one or more of these matters, the ultimate liability may be in excess of liabilities we have established and we could suffer significant reputational harm as a result of these matters, which could also have a material adverse effect on our business, financial condition, results of operations or cash flows.\nIn August 2011, we were notified of an examination to be done on behalf of a number of states for the purpose of determining compliance with unclaimed property laws by the Company and its subsidiaries. Such examination has included inquiries related to the use of data available on the U.S. Social Security Administration's Death Master File to identify instances where benefits under life insurance policies, annuities and retained asset accounts are payable. We are continuing to provide information to the examiners in response to their requests. A total of 38 states and the District of Columbia are currently participating in this examination.\n37\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nCONSOLIDATED STATEMENT OF CASH FLOWS\nThe following disclosures supplement our consolidated statement of cash flows.\nThe following reconciles net income to net cash provided by operating activities (dollars in millions):\n| Six months ended |\n| June 30, |\n| 2014 | 2013 |\n| Cash flows from operating activities: |\n| Net income (loss) | $ | (149.9 | ) | $ | 89.0 |\n| Adjustments to reconcile net income to net cash from operating activities: |\n| Amortization and depreciation | 146.2 | 172.6 |\n| Income taxes | 92.7 | 57.4 |\n| Insurance liabilities | 155.2 | 205.3 |\n| Accrual and amortization of investment income | (77.5 | ) | (125.0 | ) |\n| Deferral of policy acquisition costs | (116.9 | ) | (107.2 | ) |\n| Net realized investment gains | (35.8 | ) | (18.5 | ) |\n| Payment to reinsurer pursuant to long-term care business reinsured | (590.3 | ) | — |\n| Loss on sale of subsidiary | 278.6 | — |\n| Gain related to reinsurance transaction | (3.8 | ) | — |\n| Loss on extinguishment or modification of debt | .6 | 65.4 |\n| Other | (14.0 | ) | (49.1 | ) |\n| Net cash from operating activities | $ | (314.9 | ) | (a) | $ | 289.9 |\n\n______________________\n| (a) | Cash flows from operating activities reflect outflows in the 2014 period due to the payment to reinsurer to transfer certain long-term care business. |\n\nNon-cash items not reflected in the investing and financing activities sections of the consolidated statement of cash flows (dollars in millions):\n| Six months ended |\n| June 30, |\n| 2014 | 2013 |\n| Stock options, restricted stock and performance units | $ | 8.1 | $ | 7.2 |\n\nINVESTMENTS IN VARIABLE INTEREST ENTITIES\nWe have concluded that we are the primary beneficiary with respect to certain VIEs, which are consolidated in our financial statements. The following is a description of our significant investments in VIEs.\nAll of the VIEs are collateralized loan trusts that were established to issue securities to finance the purchase of corporate loans and other permitted investments (including two new VIEs which were consolidated in 2014). The assets held by the trusts are legally isolated and not available to the Company. The liabilities of the VIEs are expected to be satisfied from the cash flows generated by the underlying loans held by the trusts, not from the assets of the Company. The Company has no financial obligation to the VIEs beyond its investment in each VIE.\n38\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nCertain of our insurance subsidiaries are noteholders of the VIEs. Another subsidiary of the Company is the investment manager for the VIEs. As such, it has the power to direct the most significant activities of the VIEs which materially impacts the economic performance of the VIEs.\nThe following table provides supplemental information about the assets and liabilities of the VIEs which have been consolidated in accordance with authoritative guidance (dollars in millions):\n| June 30, 2014 |\n| VIEs | Eliminations | Net effect onconsolidatedbalance sheet |\n| Assets: |\n| Investments held by variable interest entities | $ | 1,241.1 | $ | — | $ | 1,241.1 |\n| Notes receivable of VIEs held by insurance subsidiaries | — | (116.0 | ) | (116.0 | ) |\n| Cash and cash equivalents held by variable interest entities | 101.8 | — | 101.8 |\n| Accrued investment income | 2.5 | — | 2.5 |\n| Income tax assets, net | 6.8 | (2.2 | ) | 4.6 |\n| Other assets | 14.2 | (.9 | ) | 13.3 |\n| Total assets | $ | 1,366.4 | $ | (119.1 | ) | $ | 1,247.3 |\n| Liabilities: |\n| Other liabilities | $ | 148.2 | $ | (3.2 | ) | $ | 145.0 |\n| Borrowings related to variable interest entities | 1,110.8 | — | 1,110.8 |\n| Notes payable of VIEs held by insurance subsidiaries | 120.1 | (120.1 | ) | — |\n| Total liabilities | $ | 1,379.1 | $ | (123.3 | ) | $ | 1,255.8 |\n\n| December 31, 2013 |\n| VIEs | Eliminations | Net effect onconsolidatedbalance sheet |\n| Assets: |\n| Investments held by variable interest entities | $ | 1,046.7 | $ | — | $ | 1,046.7 |\n| Notes receivable of VIEs held by insurance subsidiaries | — | (108.5 | ) | (108.5 | ) |\n| Cash and cash equivalents held by variable interest entities | 104.3 | — | 104.3 |\n| Accrued investment income | 1.9 | — | 1.9 |\n| Income tax assets, net | 5.4 | (2.5 | ) | 2.9 |\n| Other assets | 22.6 | (.9 | ) | 21.7 |\n| Total assets | $ | 1,180.9 | $ | (111.9 | ) | $ | 1,069.0 |\n| Liabilities: |\n| Other liabilities | $ | 66.0 | $ | (4.0 | ) | $ | 62.0 |\n| Borrowings related to variable interest entities | 1,012.3 | — | 1,012.3 |\n| Notes payable of VIEs held by insurance subsidiaries | 112.5 | (112.5 | ) | — |\n| Total liabilities | $ | 1,190.8 | $ | (116.5 | ) | $ | 1,074.3 |\n\nThe investment portfolios held by the VIEs are primarily comprised of commercial bank loans to corporate obligors which are almost entirely rated below-investment grade. At June 30, 2014, such loans had an amortized cost of $1,241.5\n39\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nmillion; gross unrealized gains of $3.3 million; gross unrealized losses of $3.7 million; and an estimated fair value of $1,241.1 million.\nThe following table sets forth the amortized cost and estimated fair value of the investments held by the VIEs at June 30, 2014, by contractual maturity. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without penalties.\n| Amortizedcost | Estimatedfairvalue |\n| (Dollars in millions) |\n| Due in one year or less | $ | 2.8 | $ | 2.8 |\n| Due after one year through five years | 353.8 | 354.1 |\n| Due after five years through ten years | 884.9 | 884.2 |\n| Total | $ | 1,241.5 | $ | 1,241.1 |\n\nDuring the first six months of 2014, we recognized net realized investment losses on the VIE investments of $2.0 million. During the first six months of 2013, we recognized net realized investment losses on the VIE investments of $.3 million, which were comprised of $.3 million of net gains from the sales of fixed maturities, and $.6 million of writedowns of investments for other than temporary declines in fair value recognized through net income.\nAt June 30, 2014, there were no investments held by the VIEs that were in default.\nDuring the first six months of 2014, $21.3 million of investments held by the VIEs were sold which resulted in gross investment losses (before income taxes) of $2.1 million. During the first six months of 2013, no investments held by the VIEs were sold which resulted in gross investment losses.\nAt June 30, 2014, the VIEs held: (i) investments with a fair value of $470.8 million and gross unrealized losses of $2.2 million that had been in an unrealized loss position for less than twelve months; and (ii) investments with a fair value of $157.2 million and gross unrealized losses of $1.5 million that had been in an unrealized loss position for greater than twelve months.\nAt December 31, 2013, the VIEs held: (i) investments with a fair value of $355.5 million and gross unrealized losses of $3.1 million that had been in an unrealized loss position for less than twelve months; and (ii) investments with a fair value of $7.9 million and gross unrealized losses of less than $.1 million that had been in an unrealized loss position for greater than twelve months.\nThe investments held by the VIEs are evaluated for other-than-temporary declines in fair value in a manner that is consistent with the Company's fixed maturities, available for sale.\nIn addition, the Company, in the normal course of business, makes passive investments in structured securities issued by VIEs for which the Company is not the investment manager. These structured securities include asset-backed securities, collateralized debt obligations, commercial mortgage-backed securities, residential mortgage-backed securities and collateralized mortgage obligations. Our maximum exposure to loss on these securities is limited to our cost basis in the investment. We have determined that we are not the primary beneficiary of these structured securities due to the relative size of our investment in comparison to the total principal amount of the individual structured securities and the level of credit subordination which reduces our obligation to absorb gains or losses.\nAt June 30, 2014, we held investments in various limited partnerships, in which we are not the primary beneficiary, totaling $24.6 million (classified as other invested assets). At June 30, 2014, we had unfunded commitments to these partnerships of $99.5 million. Our maximum exposure to loss on these investments is limited to the amount of our investment.\n40\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nFAIR VALUE MEASUREMENTS\nFair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date and, therefore, represents an exit price, not an entry price. We carry certain assets and liabilities at fair value on a recurring basis, including fixed maturities, equity securities, trading securities, investments held by VIEs, derivatives, cash and cash equivalents, separate account assets and embedded derivatives. We carry our company-owned life insurance policy, which is backed by a series of mutual funds, at its cash surrender value and our hedge fund investments at their net asset values; in both cases, we believe these values approximate their fair values. In addition, we disclose fair value for certain financial instruments, including mortgage loans and policy loans, insurance liabilities for interest-sensitive products, investment borrowings, notes payable and borrowings related to VIEs.\nThe degree of judgment utilized in measuring the fair value of financial instruments is largely dependent on the level to which pricing is based on observable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our view of market assumptions in the absence of observable market information. Financial instruments with readily available active quoted prices would be considered to have fair values based on the highest level of observable inputs, and little judgment would be utilized in measuring fair value. Financial instruments that rarely trade would often have fair value based on a lower level of observable inputs, and more judgment would be utilized in measuring fair value.\nValuation Hierarchy\nThere is a three-level hierarchy for valuing assets or liabilities at fair value based on whether inputs are observable or unobservable.\n| • | Level 1 – includes assets and liabilities valued using inputs that are unadjusted quoted prices in active markets for identical assets or liabilities. Our Level 1 assets primarily include cash and exchange traded securities. |\n\n| • | Level 2 – includes assets and liabilities valued using inputs that are quoted prices for similar assets in an active market, quoted prices for identical or similar assets in a market that is not active, observable inputs, or observable inputs that can be corroborated by market data. Level 2 assets and liabilities include those financial instruments that are valued by independent pricing services using models or other valuation methodologies. These models consider various inputs such as interest rate, credit or issuer spreads, reported trades and other inputs that are observable or derived from observable information in the marketplace or are supported by observable levels at which transactions are executed in the marketplace. Financial assets in this category primarily include: certain public and privately placed corporate fixed maturity securities; certain government or agency securities; certain mortgage and asset-backed securities; certain equity securities; most investments held by our consolidated VIEs; certain mutual fund and hedge fund investments; and most short-term investments; and non-exchange-traded derivatives such as call options to hedge liabilities related to our fixed index annuity products. Financial liabilities in this category include investment borrowings, notes payable and borrowings related to VIEs. |\n\n| • | Level 3 – includes assets and liabilities valued using unobservable inputs that are used in model-based valuations that contain management assumptions. Level 3 assets and liabilities include those financial instruments whose fair value is estimated based on broker/dealer quotes, pricing services or internally developed models or methodologies utilizing significant inputs not based on, or corroborated by, readily available market information. Financial assets in this category include certain corporate securities (primarily certain below-investment grade privately placed securities), certain structured securities, mortgage loans, and other less liquid securities. Financial liabilities in this category include our insurance liabilities for interest-sensitive products, which includes embedded derivatives (including embedded derivatives related to our fixed index annuity products and to a modified coinsurance arrangement) since their values include significant unobservable inputs including actuarial assumptions. |\n\nAt each reporting date, we classify assets and liabilities into the three input levels based on the lowest level of input that is significant to the measurement of fair value for each asset and liability reported at fair value. This classification is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established, the characteristics specific to the transaction and overall market conditions. Our assessment of the significance of a particular input to the fair value measurement and the ultimate classification of each asset and liability requires judgment\n41\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nand is subject to change from period to period based on the observability of the valuation inputs. Any transfers between levels are reported as having occurred at the beginning of the period. There were no transfers between Level 1 and Level 2 in both the first six months of 2014 and 2013.\nThe vast majority of our fixed maturity and equity securities, including those held in trading portfolios and those held by consolidated VIEs, short-term and separate account assets use Level 2 inputs for the determination of fair value. These fair values are obtained primarily from independent pricing services, which use Level 2 inputs for the determination of fair value. Substantially all of our Level 2 fixed maturity securities and separate account assets were valued from independent pricing services. Third party pricing services normally derive the security prices through recently reported trades for identical or similar securities making adjustments through the reporting date based upon available market observable information. If there are no recently reported trades, the third party pricing services may use matrix or model processes to develop a security price where future cash flow expectations are discounted at an estimated risk-adjusted market rate. The number of prices obtained for a given security is dependent on the Company's analysis of such prices as further described below.\nFor securities that are not priced by pricing services and may not be reliably priced using pricing models, we obtain broker quotes. These broker quotes are non-binding and represent an exit price, but assumptions used to establish the fair value may not be observable and therefore represent Level 3 inputs. Approximately 43 percent of our Level 3 fixed maturity securities were valued using unadjusted broker quotes or broker-provided valuation inputs. The remaining Level 3 fixed maturity investments do not have readily determinable market prices and/or observable inputs. For these securities, we use internally developed valuations. Key assumptions used to determine fair value for these securities may include risk-free rates, risk premiums, performance of underlying collateral and other factors involving significant assumptions which may not be reflective of an active market. For certain investments, we use a matrix or model process to develop a security price where future cash flow expectations are discounted at an estimated market rate. The pricing matrix incorporates term interest rates as well as a spread level based on the issuer's credit rating and other factors relating to the issuer and the security's maturity. In some instances issuer-specific spread adjustments, which can be positive or negative, are made based upon internal analysis of security specifics such as liquidity, deal size, and time to maturity.\nAs the Company is responsible for the determination of fair value, we have control processes designed to ensure that the fair values received from third-party pricing sources are reasonable and the valuation techniques and assumptions used appear reasonable and consistent with prevailing market conditions. Additionally, when inputs are provided by third-party pricing sources, we have controls in place to review those inputs for reasonableness. As part of these controls, we perform monthly quantitative and qualitative analysis on the prices received from third parties to determine whether the prices are reasonable estimates of fair value. The Company's analysis includes: (i) a review of the methodology used by third party pricing services; (ii) where available, a comparison of multiple pricing services' valuations for the same security; (iii) a review of month to month price fluctuations; (iv) a review to ensure valuations are not unreasonably dated; and (v) back testing to compare actual purchase and sale transactions with valuations received from third parties. As a result of such procedures, the Company may conclude the prices received from third parties are not reflective of current market conditions. In those instances, we may request additional pricing quotes or apply internally developed valuations. However, the number of instances is insignificant and the aggregate change in value of such investments is not materially different from the original prices received.\nThe categorization of the fair value measurements of our investments priced by independent pricing services was based upon the Company's judgment of the inputs or methodologies used by the independent pricing services to value different asset classes. Such inputs include: benchmark yields, reported trades, broker dealer quotes, issuer spreads, benchmark securities, bids, offers and reference data. The Company categorizes such fair value measurements based upon asset classes and the underlying observable or unobservable inputs used to value such investments.\nThe fair value measurements for derivative instruments, including embedded derivatives requiring bifurcation, are determined based on the consideration of several inputs including closing exchange or over-the-counter market price quotations; time value and volatility factors underlying options; market interest rates; and non-performance risk. For certain embedded derivatives, we use actuarial assumptions in the determination of fair value.\n42\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nThe categorization of fair value measurements, by input level, for our financial instruments carried at fair value on a recurring basis at June 30, 2014 is as follows (dollars in millions):\n| Quoted prices in active markets for identical assets or liabilities(Level 1) | Significant other observable inputs (Level 2) | Significant unobservable inputs (Level 3) | Total |\n| Assets: |\n| Fixed maturities, available for sale: |\n| Corporate securities | $ | — | $ | 13,491.8 | $ | 389.8 | $ | 13,881.6 |\n| United States Treasury securities and obligations of United States government corporations and agencies | — | 160.1 | — | 160.1 |\n| States and political subdivisions | — | 2,122.2 | 28.7 | 2,150.9 |\n| Asset-backed securities | — | 1,273.4 | 52.7 | 1,326.1 |\n| Collateralized debt obligations | — | 310.0 | 14.2 | 324.2 |\n| Commercial mortgage-backed securities | — | 1,266.2 | — | 1,266.2 |\n| Mortgage pass-through securities | — | 7.6 | 1.3 | 8.9 |\n| Collateralized mortgage obligations | — | 1,415.5 | .1 | 1,415.6 |\n| Total fixed maturities, available for sale | — | 20,046.8 | 486.8 | 20,533.6 |\n| Equity securities - corporate securities | 52.9 | 208.4 | 26.2 | 287.5 |\n| Trading securities: |\n| Corporate securities | — | 23.8 | — | 23.8 |\n| United States Treasury securities and obligations of United States government corporations and agencies | — | 4.2 | — | 4.2 |\n| Asset-backed securities | — | 20.9 | — | 20.9 |\n| Commercial mortgage-backed securities | — | 146.6 | — | 146.6 |\n| Mortgage pass-through securities | — | .1 | — | .1 |\n| Collateralized mortgage obligations | — | 23.9 | 5.9 | 29.8 |\n| Equity securities | 2.0 | — | — | 2.0 |\n| Total trading securities | 2.0 | 219.5 | 5.9 | 227.4 |\n| Investments held by variable interest entities - corporate securities | — | 1,241.1 | — | 1,241.1 |\n| Other invested assets - derivatives | .9 | 126.4 | — | 127.3 |\n| Assets held in separate accounts | — | 9.4 | — | 9.4 |\n| Assets of subsidiary being sold | — | 3,458.6 | 63.1 | 3,521.7 |\n| Total assets carried at fair value by category | $ | 55.8 | $ | 25,310.2 | $ | 582.0 | $ | 25,948.0 |\n| Liabilities: |\n| Liabilities for insurance products: |\n| Interest-sensitive products - embedded derivatives associated with fixed index annuity products | $ | — | $ | — | $ | 980.3 | $ | 980.3 |\n| Total liabilities for insurance products | — | — | 980.3 | 980.3 |\n| Total liabilities carried at fair value by category | $ | — | $ | — | $ | 980.3 | $ | 980.3 |\n\n43\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nThe categorization of fair value measurements, by input level, for our financial instruments carried at fair value on a recurring basis at December 31, 2013 is as follows (dollars in millions):\n| Quoted prices in active markets for identical assets or liabilities(Level 1) | Significant other observable inputs (Level 2) | Significant unobservable inputs (Level 3) | Total |\n| Assets: |\n| Fixed maturities, available for sale: |\n| Corporate securities | $ | — | $ | 15,313.8 | $ | 359.6 | $ | 15,673.4 |\n| United States Treasury securities and obligations of United States government corporations and agencies | — | 73.1 | — | 73.1 |\n| States and political subdivisions | — | 2,204.4 | — | 2,204.4 |\n| Asset-backed securities | — | 1,419.9 | 42.2 | 1,462.1 |\n| Collateralized debt obligations | — | 47.3 | 246.7 | 294.0 |\n| Commercial mortgage-backed securities | — | 1,609.0 | — | 1,609.0 |\n| Mortgage pass-through securities | — | 11.8 | 1.6 | 13.4 |\n| Collateralized mortgage obligations | — | 1,848.9 | — | 1,848.9 |\n| Total fixed maturities, available for sale | — | 22,528.2 | 650.1 | 23,178.3 |\n| Equity securities - corporate securities | 79.6 | 145.2 | 24.5 | 249.3 |\n| Trading securities: |\n| Corporate securities | — | 45.2 | — | 45.2 |\n| United States Treasury securities and obligations of United States government corporations and agencies | — | 4.6 | — | 4.6 |\n| States and political subdivisions | — | 14.1 | — | 14.1 |\n| Asset-backed securities | — | 24.3 | — | 24.3 |\n| Commercial mortgage-backed securities | — | 125.8 | — | 125.8 |\n| Mortgage pass-through securities | — | .1 | — | .1 |\n| Collateralized mortgage obligations | — | 31.1 | — | 31.1 |\n| Equity securities | 2.4 | — | — | 2.4 |\n| Total trading securities | 2.4 | 245.2 | — | 247.6 |\n| Investments held by variable interest entities - corporate securities | — | 1,046.7 | — | 1,046.7 |\n| Other invested assets - derivatives | .6 | 156.2 | — | 156.8 |\n| Assets held in separate accounts | — | 10.3 | — | 10.3 |\n| Total assets carried at fair value by category | $ | 82.6 | $ | 24,131.8 | $ | 674.6 | $ | 24,889.0 |\n| Liabilities: |\n| Liabilities for insurance products: |\n| Interest-sensitive products - embedded derivatives associated with fixed index annuity products | $ | — | $ | — | $ | 903.7 | $ | 903.7 |\n| Interest-sensitive products - embedded derivatives associated with modified coinsurance agreement | — | — | 1.8 | 1.8 |\n| Total liabilities for insurance products | — | — | 905.5 | 905.5 |\n| Total liabilities carried at fair value by category | $ | — | $ | — | $ | 905.5 | $ | 905.5 |\n\n44\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nFor those financial instruments disclosed at fair value, we use the following methods and assumptions to determine the estimated fair values:\nMortgage loans and policy loans. We discount future expected cash flows for loans included in our investment portfolio based on interest rates currently being offered for similar loans to borrowers with similar credit ratings. We aggregate loans with similar characteristics in our calculations. The fair value of policy loans approximates their carrying value.\nCompany-owned life insurance is backed by a series of mutual funds and is carried at cash surrender value which approximates estimated fair value.\nAlternative investment funds are carried at their net asset values which approximates estimated fair value.\nCash and cash equivalents include commercial paper, invested cash and other investments purchased with original maturities of less than three months. We carry them at amortized cost, which approximates estimated fair value.\nLiabilities for policyholder account balances. We discount future expected cash flows based on interest rates currently being offered for similar contracts with similar maturities.\nInvestment borrowings, notes payable and borrowings related to variable interest entities. For publicly traded debt, we use current fair values. For other notes, we use discounted cash flow analyses based on our current incremental borrowing rates for similar types of borrowing arrangements.\nAssets of subsidiary being sold include mortgage loans, policy loans, and cash and cash equivalents. The estimated fair value of these financial instruments is determined in the same manner as described above.\nLiabilities of subsidiary being sold include liabilities for policyholder account balances and investment borrowings. The estimated fair value of these financial instruments is determined in the same manner as described above.\nThe fair value measurements for our financial instruments disclosed at fair value on a recurring basis are as follows (dollars in millions):\n| June 30, 2014 |\n| Quoted prices in active markets for identical assets or liabilities(Level 1) | Significant other observable inputs (Level 2) | Significant unobservable inputs (Level 3) | Total estimated fair value | Total carrying amount |\n| Assets: |\n| Mortgage loans | $ | — | $ | — | $ | 1,647.1 | $ | 1,647.1 | $ | 1,595.9 |\n| Policy loans | — | — | 99.7 | 99.7 | 99.7 |\n| Other invested assets: |\n| Company-owned life insurance | — | 149.4 | — | 149.4 | 149.4 |\n| Alternative investment funds | — | 86.6 | — | 86.6 | 86.6 |\n| Cash and cash equivalents: |\n| Unrestricted | 167.8 | 211.0 | — | 378.8 | 378.8 |\n| Held by variable interest entities | 101.8 | — | — | 101.8 | 101.8 |\n| Assets of subsidiary being sold | 164.7 | — | 351.0 | 515.7 | 503.8 |\n| Liabilities: |\n| Policyholder account balances (a) | — | — | 10,649.7 | 10,649.7 | 10,649.7 |\n| Investment borrowings | — | 1,507.0 | — | 1,507.0 | 1,507.6 |\n| Borrowings related to variable interest entities | — | 955.9 | — | 955.9 | 1,110.8 |\n| Notes payable – direct corporate obligations | — | 852.4 | — | 852.4 | 827.3 |\n| Liabilities of subsidiary being sold | — | 412.9 | 2,070.0 | 2,482.9 | 2,453.4 |\n\n45\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\n| December 31, 2013 |\n| Quoted prices in active markets for identical assets or liabilities(Level 1) | Significant other observable inputs (Level 2) | Significant unobservable inputs (Level 3) | Total estimated fair value | Total carrying amount |\n| Assets: |\n| Mortgage loans | $ | — | $ | — | $ | 1,749.5 | $ | 1,749.5 | $ | 1,729.5 |\n| Policy loans | — | — | 277.0 | 277.0 | 277.0 |\n| Other invested assets: |\n| Company-owned life insurance | — | 144.8 | — | 144.8 | 144.8 |\n| Alternative investment funds | — | 67.6 | — | 67.6 | 67.6 |\n| Cash and cash equivalents: |\n| Unrestricted | 457.8 | 241.2 | — | 699.0 | 699.0 |\n| Held by variable interest entities | 104.3 | — | — | 104.3 | 104.3 |\n| Liabilities: |\n| Policyholder account balances (a) | — | — | 12,776.4 | 12,776.4 | 12,776.4 |\n| Investment borrowings | — | 1,948.5 | — | 1,948.5 | 1,900.0 |\n| Borrowings related to variable interest entities | — | 993.7 | — | 993.7 | 1,012.3 |\n| Notes payable – direct corporate obligations | — | 872.5 | — | 872.5 | 856.4 |\n\n____________________\n| (a) | The estimated fair value of insurance liabilities for policyholder account balances was approximately equal to its carrying value at June 30, 2014 and December 31, 2013. This was because interest rates credited on the vast majority of account balances approximate current rates paid on similar products and because these rates are not generally guaranteed beyond one year. |\n\n46\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nThe following table presents additional information about assets and liabilities measured at fair value on a recurring basis and for which we have utilized significant unobservable (Level 3) inputs to determine fair value for the three months ended June 30, 2014 (dollars in millions):\n| June 30, 2014 |\n| Beginning balance as of March 31, 2014 | Purchases, sales, issuances and settlements, net (b) | Total realized and unrealized gains (losses) included in net income | Total realized and unrealized gains (losses) included in accumulated other comprehensive income (loss) | Transfers into Level 3 (a) | Transfers out of Level 3 (a) | Ending balance as of June 30, 2014 | Amount of total gains (losses) for the three months ended June 30, 2014 included in our net income relating to assets and liabilities still held as of the reporting date |\n| Assets: |\n| Fixed maturities, available for sale: |\n| Corporate securities | $ | 336.8 | $ | 47.7 | $ | — | $ | 4.0 | $ | 16.3 | $ | (15.0 | ) | $ | 389.8 | $ | — |\n| States and political subdivisions | — | — | — | .7 | 28.0 | — | 28.7 | — |\n| Asset-backed securities | 42.2 | (.5 | ) | — | 1.1 | 9.9 | — | 52.7 | — |\n| Collateralized debt obligations | 14.1 | (.1 | ) | — | .2 | — | — | 14.2 | — |\n| Mortgage pass-through securities | .4 | .9 | — | — | — | — | 1.3 | — |\n| Collateralized mortgage obligations | — | — | — | (.1 | ) | .2 | — | .1 | — |\n| Total fixed maturities, available for sale | 393.5 | 48.0 | — | 5.9 | 54.4 | (15.0 | ) | 486.8 | — |\n| Equity securities - corporate securities | 25.4 | .8 | — | — | — | — | 26.2 | — |\n| Trading securities - collateralized mortgage obligations | 5.9 | — | — | — | — | — | 5.9 | — |\n| Liabilities: |\n| Liabilities for insurance products: |\n| Interest-sensitive products - embedded derivatives associated with fixed index annuity products | (930.8 | ) | (38.7 | ) | (10.8 | ) | — | — | — | (980.3 | ) | (10.8 | ) |\n| Interest-sensitive products - embedded derivatives associated with modified coinsurance agreement | (3.4 | ) | 3.4 | — | — | — | — | — | — |\n| Total liabilities for insurance products | (934.2 | ) | (35.3 | ) | (10.8 | ) | — | — | — | (980.3 | ) | (10.8 | ) |\n\n47\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\n_________\n| (a) | Transfers into Level 3 are the result of unobservable inputs utilized within valuation methodologies for assets that were previously valued using observable inputs. Transfers out of Level 3 are due to the use of observable inputs in valuation methodologies as well as the utilization of pricing service information for certain assets that the Company is able to validate. |\n\n| (b) | Purchases, sales, issuances and settlements, net, represent the activity that occurred during the period that results in a change of the asset or liability but does not represent changes in fair value for the instruments held at the beginning of the period. Such activity primarily consists of purchases and sales of fixed maturity and equity securities and changes to embedded derivative instruments related to insurance products resulting from the issuance of new contracts, or changes to existing contracts. The following summarizes such activity for the three months ended June 30, 2014 (dollars in millions): |\n\n| Purchases | Sales | Issuances | Settlements | Purchases, sales, issuances and settlements, net |\n| Assets: |\n| Fixed maturities, available for sale: |\n| Corporate securities | $ | 51.0 | $ | (3.3 | ) | $ | — | $ | — | $ | 47.7 |\n| Asset-backed securities | — | (.5 | ) | — | — | (.5 | ) |\n| Collateralized debt obligations | — | (.1 | ) | — | — | (.1 | ) |\n| Mortgage pass-through securities | 1.1 | (.2 | ) | — | — | .9 |\n| Total fixed maturities, available for sale | 52.1 | (4.1 | ) | — | — | 48.0 |\n| Equity securities - corporate securities | .8 | — | — | — | .8 |\n| Liabilities: |\n| Liabilities for insurance products: |\n| Interest-sensitive products - embedded derivatives associated with fixed index annuity products | (31.1 | ) | .5 | (22.5 | ) | 14.4 | (38.7 | ) |\n| Interest-sensitive products - embedded derivatives associated with modified coinsurance agreement | — | 3.4 | — | — | 3.4 |\n| Total liabilities for insurance products | (31.1 | ) | 3.9 | (22.5 | ) | 14.4 | (35.3 | ) |\n\n48\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nThe following table presents additional information about assets and liabilities measured at fair value on a recurring basis and for which we have utilized significant unobservable (Level 3) inputs to determine fair value for the six months ended June 30, 2014 (dollars in millions):\n| June 30, 2014 |\n| Beginning balance as of December 31, 2013 | Purchases, sales, issuances and settlements, net (b) | Total realized and unrealized gains (losses) included in net income | Total realized and unrealized gains (losses) included in accumulated other comprehensive income (loss) | Transfers into Level 3 (a) | Transfers out of Level 3 (a) | Amounts classified as Assets of subsidiary being sold | Ending balance as of June 30, 2014 | Amount of total gains (losses) for the six months ended June 30, 2014 included in our net income relating to assets and liabilities still held as of the reporting date |\n| Assets: |\n| Fixed maturities, available for sale: |\n| Corporate securities | $ | 359.6 | $ | 41.2 | $ | — | $ | 13.4 | $ | 26.8 | $ | — | $ | (51.2 | ) | $ | 389.8 | $ | — |\n| States and political subdivisions | — | — | — | 2.0 | 28.9 | — | (2.2 | ) | 28.7 | — |\n| Asset-backed securities | 42.2 | 9.0 | — | 3.3 | 7.9 | — | (9.7 | ) | 52.7 | — |\n| Collateralized debt obligations | 246.7 | (4.4 | ) | — | — | 12.6 | (240.7 | ) | — | 14.2 | — |\n| Mortgage pass-through securities | 1.6 | (.3 | ) | — | — | — | — | — | 1.3 | — |\n| Collateralized mortgage obligations | — | — | — | — | .1 | — | — | .1 | — |\n| Total fixed maturities, available for sale | 650.1 | 45.5 | — | 18.7 | 76.3 | (240.7 | ) | (63.1 | ) | 486.8 | — |\n| Equity securities - corporate securities | 24.5 | 1.7 | — | — | — | — | — | 26.2 | — |\n| Trading securities - collateralized mortgage obligations | — | — | — | .1 | 5.8 | — | — | 5.9 | .1 |\n| Assets of subsidiary being sold | — | — | — | — | — | — | 63.1 | 63.1 | — |\n| Liabilities: |\n| Liabilities for insurance products: |\n| Interest-sensitive products - embedded derivatives associated with fixed index annuity products | (903.7 | ) | (49.8 | ) | (26.8 | ) | — | — | — | — | (980.3 | ) | (26.8 | ) |\n| Interest-sensitive products - embedded derivatives associated with modified coinsurance agreement | (1.8 | ) | 1.8 | — | — | — | — | — | — | — |\n| Total liabilities for insurance products | (905.5 | ) | (48.0 | ) | (26.8 | ) | — | — | — | — | (980.3 | ) | (26.8 | ) |\n\n49\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\n_________\n| (a) | Transfers into Level 3 are the result of unobservable inputs utilized within valuation methodologies for assets that were previously valued using observable inputs. Transfers out of Level 3 are due to the use of observable inputs in valuation methodologies as well as the utilization of pricing service information for certain assets that the Company is able to validate. |\n\n| (b) | Purchases, sales, issuances and settlements, net, represent the activity that occurred during the period that results in a change of the asset or liability but does not represent changes in fair value for the instruments held at the beginning of the period. Such activity primarily consists of purchases and sales of fixed maturity and equity securities and changes to embedded derivative instruments related to insurance products resulting from the issuance of new contracts, or changes to existing contracts. The following summarizes such activity for the six months ended June 30, 2014 (dollars in millions): |\n\n| Purchases | Sales | Issuances | Settlements | Purchases, sales, issuances and settlements, net |\n| Assets: |\n| Fixed maturities, available for sale: |\n| Corporate securities | $ | 51.0 | $ | (9.8 | ) | $ | — | $ | — | $ | 41.2 |\n| Asset-backed securities | 9.9 | (.9 | ) | — | — | 9.0 |\n| Collateralized debt obligations | .9 | (5.3 | ) | — | — | (4.4 | ) |\n| Mortgage pass-through securities | 1.1 | (1.4 | ) | — | — | (.3 | ) |\n| Total fixed maturities, available for sale | 62.9 | (17.4 | ) | — | — | 45.5 |\n| Equity securities - corporate securities | 1.7 | — | — | — | 1.7 |\n| Liabilities: |\n| Liabilities for insurance products: |\n| Interest-sensitive products - embedded derivatives associated with fixed index annuity products | (57.7 | ) | 3.6 | (24.6 | ) | 28.9 | (49.8 | ) |\n| Interest-sensitive products - embedded derivatives associated with modified coinsurance agreement | — | 3.4 | (1.6 | ) | — | 1.8 |\n| Total liabilities for insurance products | (57.7 | ) | 7.0 | (26.2 | ) | 28.9 | (48.0 | ) |\n\n50\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nThe following table presents additional information about assets and liabilities measured at fair value on a recurring basis and for which we have utilized significant unobservable (Level 3) inputs to determine fair value for the three months ended June 30, 2013 (dollars in millions):\n| June 30, 2013 |\n| Beginning balance as of March 31, 2013 | Purchases, sales, issuances and settlements, net (b) | Total realized and unrealized gains (losses) included in net income | Total realized and unrealized gains (losses) included in accumulated other comprehensive income (loss) | Transfers into Level 3 (a) | Transfers out of Level 3 (a) | Ending balance as of June 30, 2013 | Amount of total gains (losses) for the three months ended June 30, 2013 included in our net income relating to assets and liabilities still held as of the reporting date |\n| Assets: |\n| Fixed maturities, available for sale: |\n| Corporate securities | $ | 356.3 | $ | 2.2 | $ | (.3 | ) | $ | (9.6 | ) | $ | 44.5 | $ | — | $ | 393.1 | $ | — |\n| States and political subdivisions | 15.0 | — | — | — | — | (15.0 | ) | — | — |\n| Asset-backed securities | 46.6 | (.2 | ) | — | (2.5 | ) | 2.0 | (.5 | ) | 45.4 | — |\n| Collateralized debt obligations | 309.7 | (33.7 | ) | (.1 | ) | .9 | 10.8 | — | 287.6 | — |\n| Commercial mortgage-backed securities | 3.8 | (.5 | ) | — | — | — | — | 3.3 | — |\n| Mortgage pass-through securities | 1.8 | — | — | — | — | — | 1.8 | — |\n| Collateralized mortgage obligations | 36.6 | — | — | — | — | (36.5 | ) | .1 | — |\n| Total fixed maturities, available for sale | 769.8 | (32.2 | ) | (.4 | ) | (11.2 | ) | 57.3 | (52.0 | ) | 731.3 | — |\n| Equity securities: |\n| Corporate securities | .1 | — | — | — | — | — | .1 | — |\n| Venture capital investments | 3.1 | — | — | — | — | — | 3.1 | — |\n| Total equity securities | 3.2 | — | — | — | — | — | 3.2 | — |\n| Trading securities: |\n| States and political subdivisions | .6 | — | — | — | — | (.6 | ) | — | — |\n| Collateralized mortgage obligations | 5.7 | — | — | (.1 | ) | 4.8 | — | 10.4 | — |\n| Total trading securities | 6.3 | — | — | (.1 | ) | 4.8 | (.6 | ) | 10.4 | — |\n| Liabilities: |\n| Liabilities for insurance products: |\n| Interest-sensitive products - embedded derivatives associated with fixed index annuity products | (794.3 | ) | (32.7 | ) | 30.7 | — | — | — | (796.3 | ) | 30.7 |\n| Interest-sensitive products - embedded derivatives associated with modified coinsurance agreement | (5.1 | ) | 2.5 | — | — | — | — | (2.6 | ) | — |\n| Total liabilities for insurance products | (799.4 | ) | (30.2 | ) | 30.7 | — | — | — | (798.9 | ) | 30.7 |\n\n51\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\n____________\n| (a) | Transfers into Level 3 are the result of unobservable inputs utilized within valuation methodologies for assets that were previously valued using observable inputs. Transfers out of Level 3 are due to the use of observable inputs in valuation methodologies as well as the utilization of pricing service information for certain assets that the Company is able to validate. |\n\n| (b) | Purchases, sales, issuances and settlements, net, represent the activity that occurred during the period that results in a change of the asset or liability but does not represent changes in fair value for the instruments held at the beginning of the period. Such activity primarily consists of purchases and sales of fixed maturity and equity securities and changes to embedded derivative instruments related to insurance products resulting from the issuance of new contracts, or changes to existing contracts. The following summarizes such activity for the three months ended June 30, 2013 (dollars in millions): |\n\n| Purchases | Sales | Issuances | Settlements | Purchases, sales, issuances and settlements, net |\n| Assets: |\n| Fixed maturities, available for sale: |\n| Corporate securities | $ | 10.0 | $ | (7.8 | ) | $ | — | $ | — | $ | 2.2 |\n| Asset-backed securities | — | (.2 | ) | — | — | (.2 | ) |\n| Collateralized debt obligations | — | (33.7 | ) | — | — | (33.7 | ) |\n| Commercial mortgage-backed securities | — | (.5 | ) | — | — | (.5 | ) |\n| Total fixed maturities, available for sale | 10.0 | (42.2 | ) | — | — | (32.2 | ) |\n| Liabilities: |\n| Liabilities for insurance products: |\n| Interest-sensitive products - embedded derivatives associated with fixed index annuity products | (27.7 | ) | — | (14.0 | ) | 9.0 | (32.7 | ) |\n| Interest-sensitive products - embedded derivatives associated with modified coinsurance agreement | — | 2.5 | — | — | 2.5 |\n| Total liabilities for insurance products | (27.7 | ) | 2.5 | (14.0 | ) | 9.0 | (30.2 | ) |\n\n52\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nThe following table presents additional information about assets and liabilities measured at fair value on a recurring basis and for which we have utilized significant unobservable (Level 3) inputs to determine fair value for the six months ended June 30, 2013 (dollars in millions):\n| June 30, 2013 |\n| Beginning balance as of December 31, 2012 | Purchases, sales, issuances and settlements, net (b) | Total realized and unrealized gains (losses) included in net income | Total realized and unrealized gains (losses) included in accumulated other comprehensive income (loss) | Transfers into Level 3 (a) | Transfers out of Level 3 (a) | Ending balance as of June 30, 2013 | Amount of total gains (losses) for the six months ended June 30, 2013 included in our net income relating to assets and liabilities still held as of the reporting date |\n| Assets: |\n| Fixed maturities, available for sale: |\n| Corporate securities | $ | 355.5 | $ | 63.6 | $ | (.3 | ) | $ | (13.4 | ) | $ | — | $ | (12.3 | ) | $ | 393.1 | $ | — |\n| States and political subdivisions | 13.1 | — | — | — | — | (13.1 | ) | — | — |\n| Asset-backed securities | 44.0 | 7.2 | — | (3.3 | ) | 2.0 | (4.5 | ) | 45.4 | — |\n| Collateralized debt obligations | 324.0 | (42.0 | ) | .1 | 5.5 | — | — | 287.6 | — |\n| Commercial mortgage-backed securities | 6.2 | (.7 | ) | — | .1 | — | (2.3 | ) | 3.3 | — |\n| Mortgage pass-through securities | 1.9 | (.1 | ) | — | — | — | — | 1.8 | — |\n| Collateralized mortgage obligations | 16.9 | (.1 | ) | — | — | — | (16.7 | ) | .1 | — |\n| Total fixed maturities, available for sale | 761.6 | 27.9 | (.2 | ) | (11.1 | ) | 2.0 | (48.9 | ) | 731.3 | — |\n| Equity securities: |\n| Corporate securities | .1 | — | — | — | — | — | .1 | — |\n| Venture capital investments | 2.8 | — | — | .3 | — | — | 3.1 | — |\n| Total equity securities | 2.9 | — | — | .3 | — | — | 3.2 | — |\n| Trading securities: |\n| States and political subdivisions | .6 | — | — | — | — | (.6 | ) | — | — |\n| Collateralized debt obligations | 7.3 | (7.7 | ) | .6 | (.2 | ) | — | — | — | — |\n| Collateralized mortgage obligations | 5.8 | — | — | (.3 | ) | 4.9 | — | 10.4 | — |\n| Total trading securities | 13.7 | (7.7 | ) | .6 | (.5 | ) | 4.9 | (.6 | ) | 10.4 | — |\n| Liabilities: |\n| Liabilities for insurance products: |\n| Interest-sensitive products - embedded derivatives associated with fixed index annuity products | (734.0 | ) | (95.8 | ) | 33.5 | — | — | — | (796.3 | ) | 33.5 |\n| Interest-sensitive products - embedded derivatives associated with modified coinsurance agreement | (5.5 | ) | 2.9 | — | — | — | — | (2.6 | ) | — |\n| Total liabilities for insurance products | (739.5 | ) | (92.9 | ) | 33.5 | — | — | — | (798.9 | ) | 33.5 |\n\n53\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\n____________\n| (a) | Transfers into Level 3 are the result of unobservable inputs utilized within valuation methodologies for assets that were previously valued using observable inputs. Transfers out of Level 3 are due to the use of observable inputs in valuation methodologies as well as the utilization of pricing service information for certain assets that the Company is able to validate. |\n\n| (b) | Purchases, sales, issuances and settlements, net, represent the activity that occurred during the period that results in a change of the asset or liability but does not represent changes in fair value for the instruments held at the beginning of the period. Such activity primarily consists of purchases and sales of fixed maturity and equity securities and changes to embedded derivative instruments related to insurance products resulting from the issuance of new contracts, or changes to existing contracts. The following summarizes such activity for the six months ended June 30, 2013 (dollars in millions): |\n\n| Purchases | Sales | Issuances | Settlements | Purchases, sales, issuances and settlements, net |\n| Assets: |\n| Fixed maturities, available for sale: |\n| Corporate securities | $ | 71.5 | $ | (7.9 | ) | $ | — | $ | — | $ | 63.6 |\n| Asset-backed securities | 7.6 | (.4 | ) | — | — | 7.2 |\n| Collateralized debt obligations | 13.3 | (55.3 | ) | — | — | (42.0 | ) |\n| Commercial mortgage-backed securities | — | (.7 | ) | — | — | (.7 | ) |\n| Mortgage pass-through securities | — | (.1 | ) | — | — | (.1 | ) |\n| Collateralized mortgage obligations | — | (.1 | ) | — | — | (.1 | ) |\n| Total fixed maturities, available for sale | 92.4 | (64.5 | ) | — | — | 27.9 |\n| Trading securities - collateralized debt obligations | — | (7.7 | ) | — | — | (7.7 | ) |\n| Liabilities: |\n| Liabilities for insurance products: |\n| Interest-sensitive products - embedded derivatives associated with fixed index annuity products | (52.8 | ) | 1.4 | (64.2 | ) | 19.8 | (95.8 | ) |\n| Interest-sensitive products - embedded derivatives associated with modified coinsurance agreement | — | 2.9 | — | — | 2.9 |\n| Total liabilities for insurance products | (52.8 | ) | 4.3 | (64.2 | ) | 19.8 | (92.9 | ) |\n\nAt June 30, 2014, 81 percent of our Level 3 fixed maturities, available for sale, were investment grade and 3 percent and 80 percent of our Level 3 fixed maturities, available for sale, consisted of structured securities and corporate securities, respectively.\nRealized and unrealized investment gains and losses presented in the preceding tables represent gains and losses during the time the applicable financial instruments were classified as Level 3.\nRealized and unrealized gains (losses) on Level 3 assets are primarily reported in either net investment income for policyholder and reinsurer accounts and other special-purpose portfolios, net realized investment gains (losses) or insurance\n54\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\npolicy benefits within the consolidated statement of operations or accumulated other comprehensive income within shareholders' equity based on the appropriate accounting treatment for the instrument.\nThe amount presented for gains (losses) included in our net loss for assets and liabilities still held as of the reporting date primarily represents impairments for fixed maturities, available for sale, changes in fair value of trading securities and certain derivatives and changes in fair value of embedded derivative instruments included in liabilities for insurance products that exist as of the reporting date.\nThe following table provides additional information about the significant unobservable (Level 3) inputs developed internally by the Company to determine fair value for certain assets and liabilities carried at fair value at June 30, 2014 (dollars in millions):\n| Fair value at June 30, 2014 | Valuation technique(s) | Unobservable inputs | Range (weighted average) |\n| Assets: |\n| Corporate securities (a) | $ | 254.5 | Discounted cash flow analysis | Discount margins | 1.50% - 5.00% (2.44%) |\n| Asset-backed securities (b) | 29.1 | Discounted cash flow analysis | Discount margins | 1.72% - 4.30% (2.81%) |\n| Other assets categorized as Level 3 (c) | 235.3 | Unadjusted third-party price source | Not applicable | Not applicable |\n| Assets of subsidiary being sold: |\n| Corporate securities (a) | 19.1 | Discounted cash flow analysis | Discount margins | 1.50% - 2.45% (1.96%) |\n| Asset-backed securities (b) | 8.7 | Discounted cash flow analysis | Discount margins | 3.50% |\n| Other assets categorized as Level 3 (c) | 35.3 | Unadjusted third-party price source | Not applicable | Not applicable |\n| Total | 582.0 |\n| Liabilities: |\n| Interest-sensitive products (d) | 980.3 | Discounted projected embedded derivatives | Projected portfolio yields | 5.35% - 6.63% (5.60%) |\n| Discount rates | 0.00 - 3.78% (2.04%) |\n| Surrender rates | 2.80% - 54.60% (14.39%) |\n\n________________________________\n| (a) | Corporate securities - The significant unobservable input used in the fair value measurement of our corporate securities is discount margin added to a riskless market yield. Significant increases (decreases) in discount margin in isolation would result in a significantly lower (higher) fair value measurement. |\n\n| (b) | Asset-backed securities - The significant unobservable input used in the fair value measurement of our asset-backed securities is discount margin added to a riskless market yield. Significant increases (decreases) in discount margin in isolation would result in a significantly lower (higher) fair value measurement. |\n\n| (c) | Other assets categorized as Level 3 - For these assets, there were no adjustments to quoted market prices obtained from third-party pricing sources. |\n\n| (d) | Interest-sensitive products - The significant unobservable inputs used in the fair value measurement of our interest-sensitive products are projected portfolio yields, discount rates and surrender rates. Increases (decreases) in projected portfolio yields in isolation would lead to a higher (lower) fair value measurement. The discount rate is based on the Treasury rate adjusted by a margin. Increases (decreases) in the discount rates would lead to a lower (higher) fair value measurement. Assumed surrender rates are used to project how long the contracts remain in force. Generally, the longer the contracts are assumed to be in force the higher the fair value of the embedded derivative. |\n\n55\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\nThe following table provides additional information about the significant unobservable (Level 3) inputs developed internally by the Company to determine fair value for certain assets and liabilities carried at fair value at December 31, 2013 (dollars in millions):\n| Fair value at December 31, 2013 | Valuation technique(s) | Unobservable inputs | Range (weighted average) |\n| Assets: |\n| Corporate securities (a) | $ | 260.3 | Discounted cash flow analysis | Discount margins | 1.65% - 2.90% (2.36%) |\n| Asset-backed securities (b) | 35.1 | Discounted cash flow analysis | Discount margins | 2.03% - 4.20% (3.09%) |\n| Collateralized debt obligations (c) | 240.7 | Discounted cash flow analysis | Recoveries | 64% - 67% (65.8%) |\n| Constant prepayment rate | 20% |\n| Discount margins | .95% - 2.00% (1.32%) |\n| Annual default rate | 1.14% - 5.57% (3.05%) |\n| Portfolio CCC % | 1.52% - 21.79% (12.57%) |\n| Equity security (d) | 24.5 | Cost approach | Historical cost | Not applicable |\n| Other assets categorized as Level 3 (e) | 114.0 | Unadjusted third-party price source | Not applicable | Not applicable |\n| Total | 674.6 |\n| Liabilities: |\n| Interest-sensitive products (f) | 905.5 | Discounted projected embedded derivatives | Projected portfolio yields | 5.35% - 6.63% (5.60%) |\n| Discount rates | 0.00 - 4.64% (2.47%) |\n| Surrender rates | 2.80% - 54.60% (14.39%) |\n\n________________________________\n| (a) | Corporate securities - The significant unobservable input used in the fair value measurement of our corporate securities is discount margin added to a riskless market yield. Significant increases (decreases) in discount margin in isolation would result in a significantly lower (higher) fair value measurement. |\n\n| (b) | Asset-backed securities - The significant unobservable input used in the fair value measurement of our asset-backed securities is discount margin added to a riskless market yield. Significant increases (decreases) in discount margin in isolation would result in a significantly lower (higher) fair value measurement. |\n\n| (c) | Collateralized debt obligations - The significant unobservable inputs used in the fair value measurement of our collateralized debt obligations relate to collateral performance, including default rate, recoveries and constant prepayment rate, as well as discount margins of the underlying collateral. Significant increases (decreases) in default rate in isolation would result in a significantly lower (higher) fair value measurement. Generally, a significant increase (decrease) in the constant prepayment rate and recoveries in isolation would result in a significantly higher (lower) fair value measurement. Generally a significant increase (decrease) in discount margin in isolation would result in a significantly lower (higher) fair value measurement. Generally, a change in the assumption used for the annual default rate is accompanied by a directionally similar change in the assumption used for discount margins and portfolio CCC % and a directionally opposite change in the assumption used for constant prepayment rate and recoveries. A tranche's payment priority and investment cost basis could alter generalized fair value outcomes. |\n\n| (d) | Equity security - The significant unobservable input used in the fair value measurement of this equity security is historical cost as that is the amount that would be required to replace the security with a comparable security. The amount represents an investment in an entity that is currently in the construction phase of a manufacturing facility. The fair value measurement is sensitive to the construction phase and operational risk of the security. |\n\n56\nTable of Contents CNO FINANCIAL GROUP, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements(unaudited)___________________\n| (e) | Other assets categorized as Level 3 - For these assets, there were no adjustments to quoted market prices obtained from third-party pricing sources. |\n\n| (f) | Interest-sensitive products - The significant unobservable inputs used in the fair value measurement of our interest-sensitive products are projected portfolio yields, discount rates and surrender rates. Increases (decreases) in projected portfolio yields in isolation would lead to a higher (lower) fair value measurement. The discount rate is based on the Treasury rate adjusted by a margin. Increases (decreases) in the discount rates would lead to a lower (higher) fair value measurement. Assumed surrender rates are used to project how long the contracts remain in force. Generally, the longer the contracts are assumed to be in force the higher the fair value of the embedded derivative. |\n\n57\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nITEM 2.\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS.\nIn this section, we review the consolidated financial condition of CNO at June 30, 2014, and its consolidated results of operations for the six months ended June 30, 2014 and 2013, and, where appropriate, factors that may affect future financial performance. Please read this discussion in conjunction with the accompanying consolidated financial statements and notes.\nCAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS\nOur statements, trend analyses and other information contained in this report and elsewhere (such as in filings by CNO with the SEC, press releases, presentations by CNO or its management or oral statements) relative to markets for CNO's products and trends in CNO's operations or financial results, as well as other statements, contain forward-looking statements within the meaning of the federal securities laws and the Private Securities Litigation Reform Act of 1995. Forward-looking statements typically are identified by the use of terms such as \"anticipate,\" \"believe,\" \"plan,\" \"estimate,\" \"expect,\" \"project,\" \"intend,\" \"may,\" \"will,\" \"would,\" \"contemplate,\" \"possible,\" \"attempt,\" \"seek,\" \"should,\" \"could,\" \"goal,\" \"target,\" \"on track,\" \"comfortable with,\" \"optimistic,\" \"guidance,\" \"outlook\" and similar words, although some forward-looking statements are expressed differently. You should consider statements that contain these words carefully because they describe our expectations, plans, strategies and goals and our beliefs concerning future business conditions, our results of operations, financial position, and our business outlook or they state other \"forward-looking\" information based on currently available information. The \"Risk Factors\" section of our 2013 Annual Report on Form 10-K provides examples of risks, uncertainties and events that could cause our actual results to differ materially from the expectations expressed in our forward-looking statements. Assumptions and other important factors that could cause our actual results to differ materially from those anticipated in our forward-looking statements include, among other things:\n| • | changes in or sustained low interest rates causing reductions in investment income, the margins of our fixed annuity and life insurance businesses, and sales of, and demand for, our products; |\n\n| • | expectations of lower future investment earnings may cause us to accelerate amortization, write down the balance of insurance acquisition costs or establish additional liabilities for insurance products; |\n\n| • | general economic, market and political conditions, including the performance of the financial markets which may affect the value of our investments as well as our ability to raise capital or refinance existing indebtedness and the cost of doing so; |\n\n| • | the ultimate outcome of lawsuits filed against us and other legal and regulatory proceedings to which we are subject; |\n\n| • | our ability to make anticipated changes to certain non-guaranteed elements of our life insurance products; |\n\n| • | our ability to obtain adequate and timely rate increases on our health products, including our long-term care business; |\n\n| • | the receipt of any required regulatory approvals for dividend and surplus debenture interest payments from our insurance subsidiaries; |\n\n| • | mortality, morbidity, the increased cost and usage of health care services, persistency, the adequacy of our previous reserve estimates and other factors which may affect the profitability of our insurance products; |\n\n| • | changes in our assumptions related to deferred acquisition costs or the present value of future profits; |\n\n| • | the recoverability of our deferred tax assets and the effect of potential ownership changes and tax rate changes on their value; |\n\n| • | our assumption that the positions we take on our tax return filings will not be successfully challenged by the IRS; |\n\n| • | changes in accounting principles and the interpretation thereof; |\n\n58\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\n| • | our ability to continue to satisfy the financial ratio and balance requirements and other covenants of our debt agreements; |\n\n| • | our ability to achieve anticipated expense reductions and levels of operational efficiencies including improvements in claims adjudication and continued automation and rationalization of operating systems; |\n\n| • | performance and valuation of our investments, including the impact of realized losses (including other-than-temporary impairment charges); |\n\n| • | our ability to identify products and markets in which we can compete effectively against competitors with greater market share, higher ratings, greater financial resources and stronger brand recognition; |\n\n| • | our ability to generate sufficient liquidity to meet our debt service obligations and other cash needs; |\n\n| • | our ability to maintain effective controls over financial reporting; |\n\n| • | our ability to continue to recruit and retain productive agents and distribution partners and customer response to new products, distribution channels and marketing initiatives; |\n\n| • | our ability to achieve additional upgrades of the financial strength ratings of CNO and our insurance company subsidiaries as well as the impact of our ratings on our business, our ability to access capital, and the cost of capital; |\n\n| • | the risk factors or uncertainties listed from time to time in our filings with the SEC; |\n\n| • | regulatory changes or actions, including those relating to regulation of the financial affairs of our insurance companies, such as the payment of dividends and surplus debenture interest to us, regulation of the sale, underwriting and pricing of products, and health care regulation affecting health insurance products; |\n\n| • | determination of the final sales price and net proceeds for the sale of CLIC; and |\n\n| • | changes in the Federal income tax laws and regulations which may affect or eliminate the relative tax advantages of some of our products or affect the value of our deferred tax assets. |\n\nOther factors and assumptions not identified above are also relevant to the forward-looking statements, and if they prove incorrect, could also cause actual results to differ materially from those projected.\nAll written or oral forward-looking statements attributable to us are expressly qualified in their entirety by the foregoing cautionary statement. Our forward-looking statements speak only as of the date made. We assume no obligation to update or to publicly announce the results of any revisions to any of the forward-looking statements to reflect actual results, future events or developments, changes in assumptions or changes in other factors affecting the forward-looking statements.\nThe reporting of risk-based capital (\"RBC\") measures is not intended for the purpose of ranking any insurance company or for use in connection with any marketing, advertising or promotional activities.\nOVERVIEW\nWe are a holding company for a group of insurance companies operating throughout the United States that develop, market and administer health insurance, annuity, individual life insurance and other insurance products. We focus on serving the senior and middle-income markets, which we believe are attractive, underserved, high growth markets. We sell our products through three distribution channels: career agents, independent producers (some of whom sell one or more of our product lines exclusively) and direct marketing.\nPrior to 2014, the Company managed its business through the following operating segments: Bankers Life, Washington National and Colonial Penn, which are defined on the basis of product distribution; Other CNO Business, comprised primarily of products we no longer sell actively; and corporate operations, comprised of holding company activities and certain noninsurance company businesses. As a result of the sale of CLIC which was completed on July 1, 2014 and the coinsurance\n59\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nagreements to cede certain long-term care business effective December 31, 2013 (as further described in the note to the consolidated financial statements entitled \"Reinsurance\"), management has changed the manner in which it disaggregates the Company's operations for making operating decisions and assessing performance. In periods prior to 2014: (i) the results in the Washington National segment have been adjusted to include the results from the business in the Other CNO Business segment that are being retained; (ii) the Other CNO Business segment included only the long-term care business that was ceded effective December 31, 2013 and the overhead expense of CLIC that is expected to continue after the completion of the sale; and (iii) the CLIC business being sold is excluded from our analysis of business segment results. Beginning on January 1, 2014: (i) the overhead expense of CLIC that is expected to continue after the completion of the sale has been reallocated primarily to the Bankers Life and Washington National segments; (ii) there is no longer an Other CNO Business segment; and (iii) the CLIC business being sold continues to be excluded from our analysis of business segment results. After the completion of the sale of CLIC: (i) the Bankers Life segment will include the results of certain life insurance business that was recaptured from Wilton Re; and (ii) the revenues and expenses associated with a transition services agreement and a special support services agreement with Wilton Re will be included in our non-operating earnings. Under such agreements, we will receive $30 million in the year ended June 30, 2015 and $20 million in the year ended June 30, 2016. In addition, certain services will continue to be provided in the three years ended June 30, 2019 for an annual fee of $.2 million per year. The income we receive from these services agreements will offset certain of our overhead costs. If we are not successful in reducing our overhead costs to the same extent as the reduction in fees to be received from Wilton Re over the period of the agreements, our results of operations will be adversely affected. Our prior period segment disclosures have been revised to reflect management's current view of the Company's operating segments. The Company’s insurance segments are described below:\n| • | Bankers Life, which markets and distributes Medicare supplement insurance, interest-sensitive life insurance, traditional life insurance, fixed annuities and long-term care insurance products to the middle-income senior market through a dedicated field force of career agents and sales managers supported by a network of community-based sales offices. The Bankers Life segment includes primarily the business of Bankers Life and Casualty Company. Bankers Life also markets and distributes Medicare Advantage plans primarily through distribution arrangements with Humana, Inc. and United HealthCare and PDP primarily through a distribution arrangement with Coventry. |\n\n| • | Washington National, which markets and distributes supplemental health (including specified disease, accident and hospital indemnity insurance products) and life insurance to middle-income consumers at home and at the worksite. These products are marketed through Performance Matters Associates of Texas, Inc. (\"PMA\") and through independent marketing organizations and insurance agencies including worksite marketing. The products being marketed are underwritten by Washington National. |\n\n| • | Colonial Penn, which markets primarily graded benefit and simplified issue life insurance directly to customers in the senior middle-income market through television advertising, direct mail, the internet and telemarketing. The Colonial Penn segment includes primarily the business of Colonial Penn Life Insurance Company (\"Colonial Penn\"). |\n\n60\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nThe following summarizes our earnings for the three and six months ending June 30, 2014 and 2013 (dollars in millions, except per share data):\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Income before the loss on the operations of CLIC being sold, the earnings of CLIC being sold, net realized investment gains, fair value changes in embedded derivative liabilities, equity in earnings of certain non-strategic investments and earnings attributable to VIEs, corporate interest expense, loss on extinguishment or modification of debt and income taxes (\"EBIT\" a non-GAAP financial measure) (a): |\n| Bankers Life | $ | 87.4 | $ | 79.1 | $ | 171.6 | $ | 141.2 |\n| Washington National | 32.3 | 35.8 | 63.4 | 69.8 |\n| Colonial Penn | 3.8 | 1.2 | (2.4 | ) | (4.2 | ) |\n| Other CNO Business: |\n| Losses from the long-term care business reinsured effective December 31, 2013 | — | (2.2 | ) | — | (4.9 | ) |\n| Overhead expense of CLIC allocated to other segments effective January 1, 2014 | — | (5.0 | ) | — | (9.6 | ) |\n| EBIT from business segments continuing after the CLIC sale | 123.5 | 108.9 | 232.6 | 192.3 |\n| Corporate operations, excluding corporate interest expense | (15.5 | ) | 2.4 | (21.5 | ) | 5.4 |\n| EBIT from operations continuing after the CLIC sale | 108.0 | 111.3 | 211.1 | 197.7 |\n| Corporate interest expense | (11.1 | ) | (13.1 | ) | (22.2 | ) | (28.2 | ) |\n| Operating earnings before taxes | 96.9 | 98.2 | 188.9 | 169.5 |\n| Tax expense on operating income | 33.2 | 34.3 | 65.3 | 60.0 |\n| Net operating income | 63.7 | 63.9 | 123.6 | 109.5 |\n| Earnings of CLIC being sold (net of taxes) | 8.5 | 4.8 | 15.2 | 10.3 |\n| Loss on operations of CLIC being sold (including impact of taxes) | — | — | (298.0 | ) | — |\n| Gain related to reinsurance transaction (net of taxes) | 2.5 | — | 2.5 | — |\n| Net realized investment gains (net of related amortization and taxes) | 7.5 | .8 | 21.1 | 8.8 |\n| Fair value changes in embedded derivative liabilities (net of related amortization and taxes) | (4.8 | ) | 12.1 | (12.0 | ) | 13.4 |\n| Equity in earnings of certain non-strategic investments and earnings attributable to VIEs (net of taxes) | (2.9 | ) | (2.7 | ) | (5.9 | ) | (4.5 | ) |\n| Loss on extinguishment or modification of debt (net of taxes) | (.4 | ) | (6.8 | ) | (.4 | ) | (64.0 | ) |\n| Valuation allowance for deferred tax assets and other tax items (b) | 4.0 | 5.0 | 4.0 | 15.5 |\n| Net income (loss) | $ | 78.1 | $ | 77.1 | $ | (149.9 | ) | $ | 89.0 |\n| Per diluted share: |\n| Net operating income | $ | .29 | $ | .28 | $ | .56 | $ | .47 |\n| Earnings of CLIC being sold (net of taxes) | .04 | .02 | .07 | .04 |\n| Loss on operations of CLIC being sold (including impact of taxes) | — | — | (1.36 | ) | — |\n| Gain related to reinsurance transaction (net of taxes) | .01 | — | .01 | — |\n| Net realized investment gains (net of related amortization and taxes) | .03 | .01 | .10 | .04 |\n| Fair value changes in embedded derivative liabilities (net of related amortization and taxes) | (.02 | ) | .05 | (.06 | ) | .06 |\n| Equity in earnings of certain non-strategic investments and earnings attributable to VIEs (net of taxes) | (.02 | ) | (.01 | ) | (.03 | ) | (.02 | ) |\n| Loss on extinguishment or modification of debt (net of taxes) | — | (.03 | ) | — | (.27 | ) |\n| Valuation allowance for deferred tax assets and other tax items (b) | .02 | .02 | .02 | .06 |\n| Net income (loss) | $ | .35 | $ | .34 | $ | (.69 | ) | $ | .38 |\n\n61\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\n____________\n| (a) | Management believes that an analysis of EBIT provides a clearer comparison of the operating results of the Company from period to period because it excludes: (i) the loss on the operations of CLIC being sold; (ii) the earnings of CLIC being sold; (iii) net realized investment gains or losses, net of related amortization and taxes; (iv) fair value changes due to fluctuations in the interest rates used to discount embedded derivative liabilities related to our fixed index annuities, net of related amortization and taxes; (v) equity in earnings of certain non-strategic investments and earnings attributable to VIEs, net of taxes; (vi) loss on extinguishment or modification of debt, net of taxes; and (vii) changes in the valuation allowance for deferred tax assets. Net realized investment gains or losses include: (i) gains or losses on the sales of investments; (ii) other-than-temporary impairments recognized through net income; and (iii) changes in fair value of certain fixed maturity investments with embedded derivatives. The table above reconciles the non-GAAP measure to the corresponding GAAP measure. |\n\n| (b) | Increase in valuation allowance of $19.4 million in the six months ended June 30, 2014, related to the expected change in future taxable income following the sale of CLIC, is included in the \"loss on operations of CLIC being sold (including impact of taxes)\". |\n\nCRITICAL ACCOUNTING POLICIES\nRefer to \"Critical Accounting Policies\" in our 2013 Annual Report of Form 10-K for information on our other accounting policies that we consider critical in preparing our consolidated financial statements.\n62\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nRESULTS OF OPERATIONS\nThe following tables and narratives summarize the operating results of our segments (dollars in millions):\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Pre-tax operating earnings (a non-GAAP measure) (a): |\n| Bankers Life | $ | 87.4 | $ | 79.1 | $ | 171.6 | $ | 141.2 |\n| Washington National | 32.3 | 35.8 | 63.4 | 69.8 |\n| Colonial Penn | 3.8 | 1.2 | (2.4 | ) | (4.2 | ) |\n| Corporate operations | (26.6 | ) | (10.7 | ) | (43.7 | ) | (22.8 | ) |\n| Other CNO Business | — | (7.2 | ) | — | (14.5 | ) |\n| 96.9 | 98.2 | 188.9 | 169.5 |\n| Gain related to reinsurance transaction: |\n| Washington National | 3.8 | — | 3.8 | — |\n| Net realized investment gains (losses), net of related amortization: |\n| Bankers Life | 1.9 | 2.9 | 3.4 | 10.8 |\n| Washington National | 1.2 | (1.8 | ) | 30.3 | 2.5 |\n| Colonial Penn | .2 | .4 | .4 | .1 |\n| Corporate operations | 8.3 | (.3 | ) | (1.6 | ) | .2 |\n| 11.6 | 1.2 | 32.5 | 13.6 |\n| Fair value changes in embedded derivative liabilities, net of related amortization: |\n| Bankers Life | (7.3 | ) | 18.2 | (18.2 | ) | 20.3 |\n| Washington National | (.1 | ) | .3 | (.2 | ) | .3 |\n| (7.4 | ) | 18.5 | (18.4 | ) | 20.6 |\n| Equity in earnings of certain non-strategic investments and earnings attributable to VIEs: |\n| Corporate operations | (2.9 | ) | (2.9 | ) | (6.2 | ) | (4.8 | ) |\n| Loss on extinguishment or modification of debt: |\n| Corporate operations | (.6 | ) | (7.7 | ) | (.6 | ) | (65.4 | ) |\n| Amounts related to CLIC being sold: |\n| Earnings of CLIC being sold | 13.0 | 7.4 | 23.4 | 15.8 |\n| Loss on sale of CLIC | — | — | (278.6 | ) | — |\n| 13 | 7.4 | (255.2 | ) | 15.8 |\n| Income (loss) before income taxes: |\n| Bankers Life | 82.0 | 100.2 | 156.8 | 172.3 |\n| Washington National | 37.2 | 34.3 | 97.3 | 72.6 |\n| Colonial Penn | 4.0 | 1.6 | (2.0 | ) | (4.1 | ) |\n| Corporate operations | (21.8 | ) | (21.6 | ) | (52.1 | ) | (92.8 | ) |\n| Other CNO Business | — | (7.2 | ) | — | (14.5 | ) |\n| Amount related to CLIC being sold | 13.0 | 7.4 | (255.2 | ) | 15.8 |\n| Income (loss) before income taxes | $ | 114.4 | $ | 114.7 | $ | (55.2 | ) | $ | 149.3 |\n\n63\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\n____________________\n| (a) | These non-GAAP measures as presented in the above table and in the following segment financial data and discussions of segment results exclude the loss on the operations of CLIC being sold, the earnings of CLIC being sold, net realized investment gains (losses), fair value changes in embedded derivative liabilities, net of related amortization, equity in earnings of certain non-strategic investments and earnings attributable to VIEs, loss on extinguishment or modification of debt and before income taxes. These are considered non-GAAP financial measures. A non-GAAP measure is a numerical measure of a company's performance, financial position, or cash flows that excludes or includes amounts that are normally excluded or included in the most directly comparable measure calculated and presented in accordance with GAAP. |\n\nThese non-GAAP financial measures of \"pre-tax operating earnings\" differ from \"income (loss) before income taxes\" as presented in our consolidated statement of operations prepared in accordance with GAAP due to the exclusion of the loss on the operations of CLIC being sold, the earnings of CLIC being sold, realized investment gains (losses), fair value changes in embedded derivative liabilities, net of related amortization, equity in earnings of certain non-strategic investments and earnings attributable to VIEs and loss on extinguishment or modification of debt. We measure segment performance excluding these items because we believe that this performance measure is a better indicator of the ongoing businesses and trends in our business. Our primary investment focus is on investment income to support our liabilities for insurance products as opposed to the generation of realized investment gains (losses), and a long-term focus is necessary to maintain profitability over the life of the business. Realized investment gains (losses), fair value changes in embedded derivative liabilities and equity in earnings of certain non-strategic investments and earnings attributable to VIEs depend on market conditions and do not necessarily relate to decisions regarding the underlying business of our segments. However, \"pre-tax operating earnings\" does not replace \"income (loss) before income taxes\" as a measure of overall profitability.\nWe may experience realized investment gains (losses), which will affect future earnings levels since our underlying business is long-term in nature and we need to earn the assumed interest rates on the investments backing our liabilities for insurance products to maintain the profitability of our business. In addition, management uses this non-GAAP financial measure in its budgeting process, financial analysis of segment performance and in assessing the allocation of resources. We believe these non-GAAP financial measures enhance an investor's understanding of our financial performance and allows them to make more informed judgments about the Company as a whole. These measures also highlight operating trends that might not otherwise be transparent. The table above reconciles the non-GAAP measure to the corresponding GAAP measure.\nGeneral: CNO is the top tier holding company for a group of insurance companies operating throughout the United States that develop, market and administer health insurance, annuity, individual life insurance and other insurance products. We distribute these products through our Bankers Life segment, which utilizes a career agency force, through our Washington National segment, which utilizes independent producers and through our Colonial Penn segment, which utilizes direct response marketing.\n64\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nBankers Life (dollars in millions)\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Premium collections: |\n| Annuities | $ | 200.8 | $ | 183.7 | $ | 391.3 | $ | 349.3 |\n| Medicare supplement and other supplemental health | 310.1 | 324.6 | 625.6 | 659.7 |\n| Life | 101.5 | 91.1 | 195.5 | 180.6 |\n| Total collections | $ | 612.4 | $ | 599.4 | $ | 1,212.4 | $ | 1,189.6 |\n| Average liabilities for insurance products: |\n| Fixed index annuities | $ | 3,575.7 | $ | 3,132.2 | $ | 3,519.2 | $ | 3,085.5 |\n| Deferred annuities | 3,889.6 | 4,162.1 | 3,936.3 | 4,203.9 |\n| SPIAs and supplemental contracts: |\n| Mortality based | 206.5 | 227.2 | 204.8 | 228.2 |\n| Deposit based | 148.1 | 157.9 | 149.1 | 158.3 |\n| Health: |\n| Long-term care | 4,682.5 | 4,651.7 | 4,625.3 | 4,744.7 |\n| Medicare supplement | 330.6 | 333.3 | 334.4 | 335.4 |\n| Other health | 47.1 | 45.3 | 46.8 | 45.2 |\n| Life: |\n| Interest sensitive | 552.5 | 480.3 | 542.9 | 473.9 |\n| Non-interest sensitive | 693.6 | 598.1 | 683.0 | 584.3 |\n| Total average liabilities for insurance products, net of reinsurance ceded | $ | 14,126.2 | $ | 13,788.1 | $ | 14,041.8 | $ | 13,859.4 |\n| Revenues: |\n| Insurance policy income | $ | 408.1 | $ | 419.1 | $ | 824.4 | $ | 837.1 |\n| Net investment income: |\n| General account invested assets | 220.5 | 211.0 | 440.3 | 423.8 |\n| Fixed index products | 27.1 | 15.6 | 31.7 | 64.5 |\n| Fee revenue and other income | 5.8 | 4.0 | 11.1 | 7.7 |\n| Total revenues | 661.5 | 649.7 | 1,307.5 | 1,333.1 |\n| Expenses: |\n| Insurance policy benefits | 356.0 | 370.4 | 721.7 | 744.2 |\n| Amounts added to policyholder account balances: |\n| Cost of interest credited to policyholders | 32.2 | 36.0 | 65.1 | 71.9 |\n| Cost of options to fund index credits, net of forfeitures | 12.1 | 11.9 | 24.1 | 23.7 |\n| Market value changes credited to policyholders | 27.6 | 15.8 | 32.0 | 64.8 |\n| Amortization related to operations | 45.4 | 45.7 | 93.6 | 100.2 |\n| Interest expense on investment borrowings | 1.9 | 1.7 | 3.8 | 3.1 |\n| Other operating costs and expenses | 98.9 | 89.1 | 195.6 | 184.0 |\n| Total benefits and expenses | 574.1 | 570.6 | 1,135.9 | 1,191.9 |\n| Income before net realized investment gains, net of related amortization, and fair value changes in embedded derivative liabilities, net of related amortization, and income taxes | 87.4 | 79.1 | 171.6 | 141.2 |\n| Net realized investment gains | 2.0 | 3.3 | 3.5 | 11.9 |\n| Amortization related to net realized investment gains | (.1 | ) | (.4 | ) | (.1 | ) | (1.1 | ) |\n| Net realized investment gains, net of related amortization | 1.9 | 2.9 | 3.4 | 10.8 |\n| Insurance policy benefits - fair value changes in embedded derivative liabilities | (9.6 | ) | 27.3 | (24.3 | ) | 30.5 |\n| Amortization related to fair value changes in embedded derivative liabilities | 2.3 | (9.1 | ) | 6.1 | (10.2 | ) |\n| Fair value changes in embedded derivative liabilities, net of related amortization | (7.3 | ) | 18.2 | (18.2 | ) | 20.3 |\n| Income before income taxes | $ | 82.0 | $ | 100.2 | $ | 156.8 | $ | 172.3 |\n\n65\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Health benefit ratios: |\n| All health lines: |\n| Insurance policy benefits | $ | 301.5 | $ | 310.0 | $ | 608.7 | $ | 620.8 |\n| Benefit ratio (a) | 94.0 | % | 92.8 | % | 93.5 | % | 93.1 | % |\n| Medicare supplement: |\n| Insurance policy benefits | $ | 134.2 | $ | 127.2 | $ | 265.8 | $ | 256.2 |\n| Benefit ratio (a) | 69.5 | % | 67.2 | % | 68.6 | % | 67.9 | % |\n| PDP: |\n| Insurance policy benefits | $ | — | $ | 9.2 | $ | 5.3 | $ | 15.9 |\n| Benefit ratio (a) | N/A | 85.2 | % | 77.9 | % | 80.5 | % |\n| Long-term care: |\n| Insurance policy benefits | $ | 167.2 | $ | 173.6 | $ | 337.5 | $ | 348.7 |\n| Benefit ratio (a) | 131.2 | % | 129.5 | % | 131.6 | % | 129.4 | % |\n| Interest-adjusted benefit ratio (b) | 79.2 | % | 81.4 | % | 80.1 | % | 81.5 | % |\n\n______________\n| (a) | We calculate benefit ratios by dividing the related product's insurance policy benefits by insurance policy income. |\n\n| (b) | We calculate the interest-adjusted benefit ratio (a non-GAAP measure) for Bankers Life's long-term care products by dividing such product's insurance policy benefits less the imputed interest income on the accumulated assets backing the insurance liabilities by policy income. These are considered non-GAAP financial measures. A non-GAAP measure is a numerical measure of a company's performance, financial position, or cash flows that excludes or includes amounts that are normally excluded or included in the most directly comparable measure calculated and presented in accordance with GAAP. |\n\nThese non-GAAP financial measures of \"interest-adjusted benefit ratios\" differ from \"benefit ratios\" due to the deduction of imputed interest income on the accumulated assets backing the insurance liabilities from the product's insurance policy benefits used to determine the ratio. Interest income is an important factor in measuring the performance of health products that are expected to be inforce for a longer duration of time, are not subject to unilateral changes in provisions (such as non-cancelable or guaranteed renewable contracts) and require the performance of various functions and services (including insurance protection) for an extended period of time. The net cash flows from long-term care products generally cause an accumulation of amounts in the early years of a policy (accounted for as reserve increases) that will be paid out as benefits in later policy years (accounted for as reserve decreases). Accordingly, as the policies age, the benefit ratio will typically increase, but the increase in benefits will be partially offset by the imputed interest income earned on the accumulated assets. The interest-adjusted benefit ratio reflects the effects of such interest income offset. Since interest income is an important factor in measuring the performance of this product, management believes a benefit ratio that includes the effect of interest income is useful in analyzing product performance. We utilize the interest-adjusted benefit ratio in measuring segment performance because we believe that this performance measure is a better indicator of the ongoing businesses and trends in the business. However, the \"interest-adjusted benefit ratio\" does not replace the \"benefit ratio\" as a measure of current period benefits to current period insurance policy income. Accordingly, management reviews both \"benefit ratios\" and \"interest-adjusted benefit ratios\" when analyzing the financial results attributable to these products. The imputed investment income earned on the accumulated assets backing Bankers Life's long-term care reserves was $66.3 million and $64.5 million in the three months ended June 30, 2014 and 2013, respectively, and was $132.0 million and $129.1 million in the six months ended June 30, 2014 and 2013, respectively.\nTotal premium collections were $612.4 million in the second quarter of 2014, up 2.2 percent from 2013, and were $1,212.4 million in the first six months of 2014, up 1.9 percent from 2013. See \"Premium Collections\" for further analysis of Bankers Life's premium collections.\n66\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nAverage liabilities for insurance products, net of reinsurance ceded were $14.1 billion in the second quarter of 2014, up 2.5 percent from 2013, and were $14.0 billion in the first six months of 2014, up 1.3 percent from 2013. Such average insurance liabilities for certain long-term care products were increased by $84 million and $195 million in the second quarters of 2014 and 2013, respectively, and $42 million and $311 million in the six months ended June 30, 2014 and 2013, respectively, to reflect the premium deficiencies that would exist if unrealized gains on the assets backing such products had been realized and the proceeds from the sales of such assets were invested at then current yields. Such increase is reflected as a reduction of accumulated other comprehensive income. Excluding the impact of the aforementioned additional liabilities, the increase in average liabilities for insurance products was primarily due to new sales of these products.\nInsurance policy income is comprised of premiums earned on policies which provide mortality or morbidity coverage and fees and other charges assessed on other policies.\nNet investment income on general account invested assets (which excludes income on policyholder accounts) was $220.5 million in the second quarter of 2014, up 4.5 percent from 2013, and was $440.3 million in the first six months of 2014, up 3.9 percent from 2013. The increase in net investment income is due to the impact of favorable experience resulting in prospective changes in assumptions which increased the yield on certain structured securities and higher general account invested assets resulting from sales and increased persistency of our annuity and health products in recent periods. Prepayment income was $3.2 million and $1.3 million in the second quarters of 2014 and 2013, respectively, and was $4.4 million and $6.9 million in the first six months of 2014 and 2013, respectively.\nNet investment income related to fixed index products represents the change in the estimated fair value of options which are purchased in an effort to offset or hedge certain potential benefits accruing to the policyholders of our fixed index products. Our fixed index products are designed so that investment income spread is expected to be more than adequate to cover the cost of the options and other costs related to these policies. Net investment income related to fixed index products was $27.1 million and $15.6 million in the second quarters of 2014 and 2013, respectively, and was $31.7 million and $64.5 million in the first six months of 2014 and 2013, respectively. Such amounts were generally offset by the corresponding charge to amounts added to policyholder account balances - market value changes credited to policyholders. Such income and related charges fluctuate based on the value of options embedded in the segment's fixed index annuity policyholder account balances subject to this benefit and to the performance of the index to which the returns on such products are linked.\nFee revenue and other income was $5.8 million and $4.0 million, in the second quarters of 2014 and 2013, respectively, and was $11.1 million and $7.7 million, in the first six months of 2014 and 2013, respectively. We recognized fee income of $5.7 million and $3.9 million, in the second quarters of 2014 and 2013, respectively, and $10.9 million and $7.5 million, in the first six months of 2014 and 2013, respectively, pursuant to marketing agreements to sell PDP and Medicare Advantage products of other insurance companies.\nInsurance policy benefits fluctuated as a result of the factors summarized below for benefit ratios. Benefit ratios are calculated by dividing the related insurance product’s insurance policy benefits by insurance policy income.\nThe Medicare supplement business consists of both individual and group policies. Government regulations generally require us to attain and maintain a ratio of total benefits incurred to total premiums earned (excluding changes in policy benefit reserves), after three years from the original issuance of the policy and over the lifetime of the policy, of not less than 65 percent on individual products and not less than 75 percent on group products, as determined in accordance with statutory accounting principles. Since the insurance product liabilities we establish for Medicare supplement business are subject to significant estimates, the ultimate claim liability we incur for a particular period is likely to be different than our initial estimate. Our benefit ratios were 69.5 percent and 67.2 percent in the second quarters of 2014 and 2013, respectively, and 68.6 percent and 67.9 percent in the first six months of 2014 and 2013, respectively. The benefit ratio in the second quarter of 2013 was impacted by the favorable development of prior period claim reserves of approximately $6.5 million. In 2014, we currently expect the benefit ratio on this Medicare supplement business will be approximately 70 percent.\nThe insurance policy benefits on our PDP business resulted from our quota-share reinsurance agreement with Coventry. Insurance margins (insurance policy income less insurance policy benefits) on the PDP business were nil and $1.6 million in the second quarters of 2014 and 2013, respectively, and were $1.5 million and $3.8 million in the first six months of 2014 and 2013, respectively. In August 2013, we received a notice of Coventry's intent to terminate our PDP quota-share\n67\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nreinsurance agreement, as further described in the note to the consolidated financial statements entitled \"Summary of Significant Accounting Policies - Reinsurance\". The PDP results in the first quarter of 2014 represent adjustments to earnings on such business related to periods prior to the termination of the agreement.\nThe net cash flows from our long-term care products generally cause an accumulation of amounts in the early years of a policy (accounted for as reserve increases) which will be paid out as benefits in later policy years (accounted for as reserve decreases). Accordingly, as the policies age, the benefit ratio typically increases, but the increase in reserves is partially offset by investment income earned on the accumulated assets. The benefit ratio on our long-term care business in the Bankers Life segment was 131.2 percent and 129.5 percent in the second quarters of 2014 and 2013, respectively, and was 131.6 percent and 129.4 percent in the first six months of 2014 and 2013, respectively. The interest-adjusted benefit ratio on this business was 79.2 percent and 81.4 percent in the second quarters of 2014 and 2013, respectively, and was 80.1 percent and 81.5 percent in the first six months of 2014 and 2013, respectively. We recognized an out-of-period adjustment of $6.7 million in the first quarter of 2013 and made certain refinements to reserving methodologies of $3.5 million in the second quarter of 2013, both of which increased insurance policy benefits. In 2014, we currently expect the interest adjusted benefit ratio on this long-term care business will be approximately 79 percent. Since the insurance product liabilities we establish for long-term care business are subject to significant estimates, the ultimate claim liability we incur for a particular period is likely to be different than our initial estimate.\nAmounts added to policyholder account balances - cost of interest credited to policyholders were $32.2 million and $36.0 million in the second quarters of 2014 and 2013, respectively, and were $65.1 million and $71.9 million in the first six months of 2014 and 2013, respectively. The weighted average crediting rates for these products was 2.8 percent and 3.0 percent in the second quarters of 2014 and 2013, respectively, and was 2.8 percent and 3.0 percent in the first six months of 2014 and 2013, respectively. The average liabilities of the deferred annuity block were $3.9 billion and $4.2 billion in the first six months of 2014 and 2013, respectively.\nAmounts added to policyholder account balances for fixed index products represent a guaranteed minimum rate of return and a higher potential return that is based on a percentage (the \"participation rate\") of the amount of increase in the value of a particular index, such as the S&P 500 Index, over a specified period. Such amounts include our cost to fund the annual index credits, net of policies that are canceled prior to their anniversary date (classified as cost of options to fund index credits, net of forfeitures). Market value changes in the underlying indices during a specified period of time are classified as market value changes credited to policyholders. Such market value changes are generally offset by the net investment income related to fixed index products discussed above.\nAmortization related to operations includes amortization of deferred acquisition costs and the present value of future profits. Deferred acquisition costs and the present value of future profits are collectively referred to as \"insurance acquisition costs\". Insurance acquisition costs are generally amortized either: (i) in relation to the estimated gross profits for interest-sensitive life and annuity products; or (ii) in relation to actual and expected premium revenue for other products. In addition, for interest-sensitive life and annuity products, we are required to adjust the total amortization recorded to date through the statement of operations if actual experience or other evidence suggests that earlier estimates of future gross profits should be revised. Accordingly, amortization for interest-sensitive life and annuity products is dependent on the profits realized during the period and on our expectation of future profits. For other products, we amortize insurance acquisition costs in relation to actual and expected premium revenue, and amortization is only adjusted if expected premium revenue changes or if we determine the balance of these costs is not recoverable from future profits. Bankers Life’s amortization expense was $45.4 million and $45.7 million in the second quarters of 2014 and 2013, respectively, and was $93.6 million and $100.2 million in the first six months of 2014 and 2013, respectively.\nInterest expense on investment borrowings represents interest expense on collateralized borrowings as further described in the note to the consolidated financial statements entitled \"Investment Borrowings\".\n68\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nOther operating costs and expenses in our Bankers Life segment were $98.9 million in the second quarter of 2014, up 11 percent from 2013, and were $195.6 million in the first six months of 2014, up 6.3 percent from 2013. Expenses in the 2014 periods included approximately $2 million and $4 million in the three and six months ended June 30, 2014, respectively, of overhead expenses that were allocated to the Other CNO Business segment prior to 2014 and are expected to continue after the completion of the sale of CLIC. Other operating costs and expenses include the following (dollars in millions):\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Commission expense and agent manager benefits | $ | 14.3 | $ | 15.1 | $ | 28.1 | $ | 31.3 |\n| Other operating expenses | 84.6 | 74.0 | 167.5 | 152.7 |\n| Total | $ | 98.9 | $ | 89.1 | $ | 195.6 | $ | 184.0 |\n\nNet realized investment gains fluctuated each period. During the first six months of 2014, we recognized $5.5 million of net gains from the sales of investments (primarily fixed maturities) and $2.0 million of writedowns of investments for other than temporary declines in fair value recognized through net income. During the first six months of 2013, we recognized $11.9 million of net gains from the sales of investments (primarily fixed maturities).\nAmortization related to net realized investment gains is the increase or decrease in the amortization of insurance acquisition costs which results from realized investment gains or losses. When we sell securities which back our interest-sensitive life and annuity products at a gain (loss) and reinvest the proceeds at a different yield, we increase (reduce) the amortization of insurance acquisition costs in order to reflect the change in estimated gross profits due to the gains (losses) realized and the resulting effect on estimated future yields. Sales of fixed maturity investments resulted in an increase in the amortization of insurance acquisition costs of $.1 million and $.4 million in the second quarters of 2014 and 2013, respectively, and $.1 million and $1.1 million in the first six months of 2014 and 2013, respectively.\nInsurance policy benefits - fair value changes in embedded derivative liabilities represents fair value changes due to fluctuations in the interest rates used to discount embedded derivative liabilities related to our fixed index annuities.\nAmortization related to fair value changes in embedded derivative liabilities is the increase or decrease in the amortization of insurance acquisition costs which results from changes in interest rates used to discount embedded derivative liabilities related to our fixed index annuities.\n69\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Premium collections: |\n| Supplemental health and other health | $ | 129.7 | $ | 122.7 | $ | 256.2 | $ | 243.8 |\n| Medicare supplement | 21.7 | 25.0 | 42.8 | 51.6 |\n| Life | 6.4 | 6.3 | 12.9 | 12.6 |\n| Annuity | .6 | 1.4 | 1.2 | 2.3 |\n| Total collections | $ | 158.4 | $ | 155.4 | $ | 313.1 | $ | 310.3 |\n| Average liabilities for insurance products: |\n| Fixed index annuities | $ | 426.3 | $ | 462.1 | $ | 430.0 | $ | 468.1 |\n| Deferred annuities | 131.4 | 151.2 | 132.9 | 154.1 |\n| SPIAs and supplemental contracts: |\n| Mortality based | 242.9 | 248.2 | 244.2 | 249.6 |\n| Deposit based | 252.3 | 245.9 | 250.9 | 243.9 |\n| Separate Accounts | 9.7 | 15.3 | 10.0 | 15.3 |\n| Health: |\n| Supplemental health | 2,415.7 | 2,224.5 | 2,340.5 | 2,218.2 |\n| Medicare supplement | 36.0 | 39.0 | 36.4 | 39.7 |\n| Other health | 16.8 | 12.3 | 13.9 | 12.6 |\n| Life: |\n| Interest sensitive life | 160.3 | 166.7 | 163.1 | 166.9 |\n| Non-interest sensitive life | 192.6 | 202.6 | 193.4 | 199.9 |\n| Total average liabilities for insurance products, net of reinsurance ceded | $ | 3,884.0 | $ | 3,767.8 | $ | 3,815.3 | $ | 3,768.3 |\n| Revenues: |\n| Insurance policy income | $ | 156.7 | $ | 153.1 | $ | 312.3 | $ | 306.0 |\n| Net investment income: |\n| General account invested assets | 67.6 | 68.3 | 135.8 | 138.1 |\n| Fixed index products | 2.8 | 1.6 | 3.7 | 8.4 |\n| Trading account income related to reinsurer accounts | (.2 | ) | (2.5 | ) | 1.4 | (2.9 | ) |\n| Change in value of embedded derivatives related to modified coinsurance agreements | .2 | 2.5 | (1.4 | ) | 2.9 |\n| Trading account income related to policyholder accounts | 1.4 | (.1 | ) | 1.3 | 1.2 |\n| Fee revenue and other income | .2 | .2 | .4 | .4 |\n| Total revenues | 228.7 | 223.1 | 453.5 | 454.1 |\n| Expenses: |\n| Insurance policy benefits | 123.3 | 123.3 | 249.3 | 246.9 |\n| Amounts added to policyholder account balances: |\n| Cost of interest credited to policyholders | 4.0 | 3.9 | 7.4 | 7.7 |\n| Cost of options to fund index credits, net of forfeitures | 1.4 | 1.4 | 2.9 | 3.3 |\n| Market value changes credited to policyholders | 4.1 | 1.7 | 5.0 | 10.1 |\n| Amortization related to operations | 16.0 | 16.2 | 32.3 | 33.3 |\n| Interest expense on investment borrowings | .5 | .5 | .9 | 1.0 |\n| Other operating costs and expenses | 47.1 | 40.3 | 92.3 | 82.0 |\n| Total benefits and expenses | 196.4 | 187.3 | 390.1 | 384.3 |\n| Income before net realized investment gains (losses) and fair value changes in embedded derivative liabilities, net of related amortization, and income taxes | 32.3 | 35.8 | 63.4 | 69.8 |\n| Gain related to reinsurance transaction | 3.8 | — | 3.8 | — |\n| Net realized investment gains (losses) | 1.2 | (1.8 | ) | 30.7 | 2.6 |\n| Amortization related to net realized investment gains (losses) | — | — | (.4 | ) | (.1 | ) |\n| Net realized investment gains (losses), net of related amortization | 1.2 | (1.8 | ) | 30.3 | 2.5 |\n| Insurance policy benefits - fair value changes in embedded derivative liabilities | (.5 | ) | 1.7 | (1.0 | ) | 1.6 |\n| Amortization related to fair value changes in embedded derivative liabilities | .4 | (1.4 | ) | .8 | (1.3 | ) |\n| Fair value changes in embedded derivative liabilities, net of related amortization | (.1 | ) | .3 | (.2 | ) | .3 |\n| Income before income taxes | $ | 37.2 | $ | 34.3 | $ | 97.3 | $ | 72.6 |\n\n70\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Health benefit ratios: |\n| Medicare supplement: |\n| Insurance policy benefits | $ | 13.6 | $ | 17.0 | $ | 28.4 | $ | 34.4 |\n| Benefit ratio (a) | 61.7 | % | 65.5 | % | 62.8 | % | 65.3 | % |\n| Supplemental health and other: |\n| Insurance policy benefits | $ | 101.8 | $ | 95.4 | $ | 201.1 | $ | 190.1 |\n| Benefit ratio (a) | 80.3 | % | 79.6 | % | 79.6 | % | 79.7 | % |\n| Interest-adjusted benefit ratio (b) | 54.8 | % | 53.5 | % | 53.9 | % | 53.5 | % |\n\n_________________\n| (a) | We calculate benefit ratios by dividing the related product’s insurance policy benefits by insurance policy income. |\n\n| (b) | We calculate the interest-adjusted benefit ratio (a non-GAAP measure) for Washington National's supplemental health products by dividing such product’s insurance policy benefits less the imputed interest income on the accumulated assets backing the insurance liabilities by policy income. These are considered non-GAAP financial measures. A non-GAAP measure is a numerical measure of a company's performance, financial position, or cash flows that excludes or includes amounts that are normally excluded or included in the most directly comparable measure calculated and presented in accordance with GAAP. |\n\nThese non-GAAP financial measures of \"interest-adjusted benefit ratios\" differ from \"benefit ratios\" due to the deduction of imputed interest income on the accumulated assets backing the insurance liabilities from the product’s insurance policy benefits used to determine the ratio. Interest income is an important factor in measuring the performance of health products that are expected to be inforce for a longer duration of time, are not subject to unilateral changes in provisions (such as non-cancelable or guaranteed renewable contracts) and require the performance of various functions and services (including insurance protection) for an extended period of time. The net cash flows from supplemental health products generally cause an accumulation of amounts in the early years of a policy (accounted for as reserve increases) that will be paid out as benefits in later policy years (accounted for as reserve decreases). Accordingly, as the policies age, the benefit ratio will typically increase, but the increase in benefits will be partially offset by the imputed interest income earned on the accumulated assets. The interest-adjusted benefit ratio reflects the effects of such interest income offset. Since interest income is an important factor in measuring the performance of these products, management believes a benefit ratio that includes the effect of interest income is useful in analyzing product performance. We utilize the interest-adjusted benefit ratio in measuring segment performance because we believe that this performance measure is a better indicator of the ongoing businesses and trends in the business. However, the \"interest-adjusted benefit ratio\" does not replace the \"benefit ratio\" as a measure of current period benefits to current period insurance policy income. Accordingly, management reviews both \"benefit ratios\" and \"interest-adjusted benefit ratios\" when analyzing the financial results attributable to these products. The imputed investment income earned on the accumulated assets backing the supplemental health reserves was $32.4 million and $31.3 million in the three months ended June 30, 2014 and 2013, respectively, and was $65.0 million and $62.4 million in the six months ended June 30, 2014 and 2013, respectively.\nTotal premium collections were $158.4 million in the second quarter of 2014, up 1.9 percent from 2013, and were $313.1 million in the first six months of 2014, up .9 percent from 2013. See \"Premium Collections\" for further analysis of fluctuations in premiums collected by product.\nAverage liabilities for insurance products, net of reinsurance ceded were $3.9 billion in the second quarter of 2014, up 3.1 percent from 2013, and were $3.8 billion in the first six months of 2014, up 1.2 percent from 2013, reflecting an increase in the health blocks; partially offset by the run-off of the annuity blocks. The increase in average liabilities for the supplemental health and other health blocks primarily relates to a change in how certain business will be ceded from CLIC to Washington National in conjunction with the sale of CLIC. In previous periods, it was assumed these blocks would be ceded under a modified coinsurance arrangement, pursuant to which the related reserves were included in the operations of CLIC being sold.\n71\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nIn the second quarter of 2014, an agreement was reached pursuant to which the blocks will be ceded under a coinsurance arrangement (subject to regulatory approval). Accordingly, effective April 1, 2014, the reserves related to these blocks were included in the Washington National segment.\nInsurance policy income is comprised of premiums earned on traditional insurance policies which provide mortality or morbidity coverage and fees and other charges assessed on other policies. Such income increased in recent periods as supplemental health premiums have increased and Medicare supplement premiums have decreased consistent with sales.\nNet investment income on general account invested assets (which excludes income on policyholder and reinsurer accounts) was $67.6 million in the second quarter of 2014, down 1.0 percent from 2013, and was $135.8 million in the first six months of 2014, down 1.7 percent from 2013. Prepayment income was not significant in the 2014 and 2013 periods.\nNet investment income related to fixed index products represents the change in the estimated fair value of options which are purchased in an effort to offset or hedge certain potential benefits accruing to the policyholders of our fixed index products. Our fixed index products are designed so that investment income spread is expected to be more than adequate to cover the cost of the options and other costs related to these policies. Net investment income related to fixed index products was $2.8 million and $1.6 million in the second quarters of 2014 and 2013, respectively, and was $3.7 million and $8.4 million in the first six months of 2014 and 2013, respectively. Such amounts were generally offset by the corresponding charge to amounts added to policyholder account balances - market value changes credited to policyholders. Such income and related charges fluctuate based on the value of options embedded in the segment's fixed index annuity policyholder account balances subject to this benefit and to the performance of the index to which the returns on such products are linked.\nTrading account income related to reinsurer accounts primarily represents the income on trading securities which were held to act as hedges for embedded derivatives related to a modified coinsurance agreement. Such trading securities were sold in the second quarter of 2014 in conjunction with the recapture of the modified coinsurance agreement.\nChange in value of embedded derivatives related to a modified coinsurance agreement is described in the note to our consolidated financial statements entitled \"Accounting for Derivatives.\" In the second quarter of 2014, we recaptured this modified coinsurance agreement and the embedded derivative was eliminated. The release of the embedded derivative was classified as a portion of the gain related to the reinsurance transaction (as further described below under gain related to reinsurance transaction).\nTrading account income related to policyholder accounts represents the income on investments backing the market strategies of certain annuity products which provide for different rates of cash value growth based on the experience of a particular market strategy. The income on our trading account securities is designed to substantially offset certain amounts included in insurance policy benefits related to the aforementioned annuity products.\nInsurance policy benefits fluctuated as a result of the factors summarized below for benefit ratios. Benefit ratios are calculated by dividing the related insurance product's insurance policy benefits by insurance policy income.\nWashington National's Medicare supplement business primarily consists of individual policies. The insurance product liabilities we establish for our Medicare supplement business are subject to significant estimates and the ultimate claim liability we incur for a particular period is likely to be different than our initial estimate. Governmental regulations generally require us to attain and maintain a ratio of total benefits incurred to total premiums earned (excluding changes in policy benefit reserves), after three years from the original issuance of the policy and over the lifetime of the policy, of not less than 65 percent on these products, as determined in accordance with statutory accounting principles. Insurance margins (insurance policy income less insurance policy benefits) on these products were $8.5 million and $8.9 million in the second quarters of 2014 and 2013, respectively, and were $16.8 million and $18.3 million in the first six months of 2014 and 2013, respectively. Such decrease reflects the run-off of this business as we discontinued new sales of Medicare supplement business in this segment in the fourth quarter of 2012.\nWashington National's supplemental health products (including specified disease, accident and hospital indemnity products) generally provide fixed or limited benefits. For example, payments under cancer insurance policies are generally made directly to, or at the direction of, the policyholder following diagnosis of, or treatment for, a covered type of cancer. Approximately three-fourths of our supplemental health policies inforce (based on policy count) are sold with return of\n72\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\npremium or cash value riders. The return of premium rider generally provides that after a policy has been inforce for a specified number of years or upon the policyholder reaching a specified age, we will pay to the policyholder, or a beneficiary under the policy, the aggregate amount of all premiums paid under the policy, without interest, less the aggregate amount of all claims incurred under the policy. The cash value rider is similar to the return of premium rider, but also provides for payment of a graded portion of the return of premium benefit if the policy terminates before the return of premium benefit is earned. Accordingly, the net cash flows from these products generally result in the accumulation of amounts in the early years of a policy (reflected in our earnings as reserve increases) which will be paid out as benefits in later policy years (reflected in our earnings as reserve decreases which offset the recording of benefit payments). As the policies age, the benefit ratio will typically increase, but the increase in benefits will be partially offset by investment income earned on the accumulated assets. The benefit ratio will fluctuate depending on the claim experience during the year.\nInsurance margins (insurance policy income less insurance policy benefits) on these products were $24.9 million and $24.5 million in the second quarters of 2014 and 2013, respectively, and were $51.4 million and $48.4 million in the first six months of 2014 and 2013, respectively. The interest adjusted benefit ratio on this supplemental health business was 54.8 percent and 53.5 percent in the second quarters of 2014 and 2013, respectively, and was 53.9 percent and 53.5 percent in the first six months of 2014 and 2013, respectively. The benefit ratios on this business can be impacted by changes in the extent to which policyholders convert their current policies to policies with additional benefits, as well as persistency in certain blocks. Changes in policy conversions and persistency have resulted in higher benefit ratios in recent periods and we currently expect that this interest-adjusted benefit ratio will be approximately 54 percent during 2014.\nAmounts added to policyholder account balances - cost of interest credited to policyholders were $4.0 million and $3.9 million in the second quarters of 2014 and 2013, respectively, and were $7.4 million and $7.7 million in the first six months of 2014 and 2013, respectively.\nAmounts added to policyholder account balances for fixed index products represent a guaranteed minimum rate of return and a higher potential return that is based on a percentage (the \"participation rate\") of the amount of increase in the value of a particular index, such as the S&P 500 Index, over a specified period. Such amounts include our cost to fund the annual index credits, net of policies that are canceled prior to their anniversary date (classified as cost of options to fund index credits, net of forfeitures). Market value changes in the underlying indices during a specified period of time are classified as market value changes credited to policyholders. Such market value changes are generally offset by the net investment income related to fixed index products discussed above.\nAmortization related to operations includes amortization of insurance acquisition costs. Insurance acquisition costs are generally amortized in relation to actual and expected premium revenue, and amortization is only adjusted if expected premium revenue changes or if we determine the balance of these costs is not recoverable from future profits. Such amounts were generally consistent with the related premium revenue. A revision to our current assumptions could result in increases or decreases to amortization expense in future periods.\nOther operating costs and expenses were $47.1 million and $40.3 million in the second quarters of 2014 and 2013, respectively, and were $92.3 million and $82.0 million in the first six months of 2014 and 2013, respectively. Other operating costs and expenses include commission expense of $15.9 million and $16.1 million in the second quarters of 2014 and 2013, respectively, and $32.1 million and $32.0 million in the first six months of 2014 and 2013, respectively. Expenses in the three and six months ended June 30, 2014 included approximately $2 million and $4 million, respectively, of overhead expenses that were allocated to the Other CNO Business segment prior to 2014 and are expected to continue after the completion of the sale of CLIC.\nGain related to reinsurance transaction pertained to the recapture of a modified coinsurance agreement in the second quarter of 2014. The gain of $3.8 million primarily resulted from the release of an embedded derivative that is no longer required.\nNet realized investment gains fluctuate each period. During the first six months of 2014, we recognized $32.6 million of net gains from the sales of investments (primarily fixed maturities) and $1.9 million of writedowns of investments for other than temporary declines in fair value recognized through net income. During the first six months of 2013, we recognized $2.6 million of net gains from the sales of investments (primarily fixed maturities).\n73\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nAmortization related to net realized investment gains is the increase or decrease in the amortization of insurance acquisition costs which results from realized investment gains or losses. When we sell securities which back our interest-sensitive life and annuity products at a gain (loss) and reinvest the proceeds at a different yield (or when we have the intent to sell the impaired investments before an anticipated recovery in value occurs), we increase (reduce) the amortization of insurance acquisition costs in order to reflect the change in estimated gross profits due to the gains (losses) realized and the resulting effect on estimated future yields. Sales of fixed maturity investments resulted in an increase in the amortization of insurance acquisition costs of $.4 million and $.1 million in the first six months of 2014 and 2013, respectively.\nInsurance policy benefits - fair value changes in embedded derivative liabilities represents fair value changes due to fluctuations in the interest rates used to discount embedded derivative liabilities related to our fixed index annuities.\nAmortization related to fair value changes in embedded derivative liabilities is the increase or decrease in the amortization of insurance acquisition costs which results from changes in interest rates used to discount embedded derivative liabilities related to our fixed index annuities.\n74\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nColonial Penn (dollars in millions)\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Premium collections: |\n| Life | $ | 60.0 | $ | 56.4 | $ | 120.1 | $ | 112.5 |\n| Supplemental health | .9 | 1.0 | 1.8 | 2.1 |\n| Total collections | $ | 60.9 | $ | 57.4 | $ | 121.9 | $ | 114.6 |\n| Average liabilities for insurance products: |\n| SPIAs - mortality based | $ | 68.8 | $ | 74.4 | $ | 69.1 | $ | 74.6 |\n| Health: |\n| Medicare supplement | 8.3 | 9.3 | 8.5 | 9.5 |\n| Other health | 4.5 | 4.8 | 4.5 | 4.8 |\n| Life: |\n| Interest sensitive | 17.1 | 17.7 | 17.1 | 17.7 |\n| Non-interest sensitive | 648.2 | 629.9 | 646.3 | 624.0 |\n| Total average liabilities for insurance products, net of reinsurance ceded | $ | 746.9 | $ | 736.1 | $ | 745.5 | $ | 730.6 |\n| Revenues: |\n| Insurance policy income | $ | 61.7 | $ | 58.0 | $ | 122.2 | $ | 114.9 |\n| Net investment income on general account invested assets | 10.5 | 9.9 | 21.2 | 19.8 |\n| Fee revenue and other income | .3 | .2 | .5 | .4 |\n| Total revenues | 72.5 | 68.1 | 143.9 | 135.1 |\n| Expenses: |\n| Insurance policy benefits | 43.1 | 41.1 | 87.6 | 83.9 |\n| Amounts added to annuity and interest-sensitive life product account balances | .1 | .1 | .3 | .3 |\n| Amortization related to operations | 3.8 | 3.7 | 7.8 | 7.4 |\n| Other operating costs and expenses | 21.7 | 22.0 | 50.6 | 47.7 |\n| Total benefits and expenses | 68.7 | 66.9 | 146.3 | 139.3 |\n| Income (loss) before net realized investment gains and income taxes | 3.8 | 1.2 | (2.4 | ) | (4.2 | ) |\n| Net realized investment gains | .2 | .4 | .4 | .1 |\n| Income (loss) before income taxes | $ | 4.0 | $ | 1.6 | $ | (2.0 | ) | $ | (4.1 | ) |\n\nThis segment's results are significantly impacted by the accounting standard related to deferred acquisition costs. We are not able to defer most of Colonial Penn's direct response advertising costs although such costs generate predictable sales and future in-force profits. We plan to continue to invest in this segment's business, including the development of new products and markets. The amount of our investment in new business during a particular period will have a significant impact on this segment's results. In the three months ended June 30, 2014, the Colonial Penn segment benefited from: (i) earnings growth from the in-force block; (ii) improvements in the effectiveness of our sales and marketing expenditures; and (iii) an increase in the deferral of acquisition costs due to a slight shift to deferrable direct mail marketing activities. Based on our current forecast, we expect this segment to report approximately break-even results for 2014 (before net realized investment gains (losses) and income taxes).\n75\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nTotal premium collections were $60.9 million in the second quarter of 2014, up 6.1 percent from 2013, and were $121.9 million in the first six months of 2014, up 6.4 percent from 2013. See \"Premium Collections\" for further analysis of Colonial Penn's premium collections.\nAverage liabilities for insurance products, net of reinsurance ceded have increased as a result of growth in this segment.\nInsurance policy income is comprised of premiums earned on policies which provide mortality or morbidity coverage and fees and other charges assessed on other policies. The increase in such income reflects the growth in the block of business.\nNet investment income on general account invested assets was $10.5 million in the second quarter of 2014, up 6.1 percent from 2013, and was $21.2 million in the first six months of 2014, up 7.1 percent from 2013. The increase in net investment income is primarily due to the higher general account invested assets as a result of the growth in this segment.\nInsurance policy benefits fluctuated as a result of the growth in this segment.\nAmortization related to operations includes amortization of insurance acquisition costs. Insurance acquisition costs in the Colonial Penn segment are amortized in relation to actual and expected premium revenue, and amortization is only adjusted if expected premium revenue changes or if we determine the balance of these costs is not recoverable from future profits. Such amounts were generally consistent with the related premium revenue and gross profits for such periods and the assumptions we made when we established the present value of future profits. A revision to our current assumptions could result in increases or decreases to amortization expense in future periods.\nOther operating costs and expenses in our Colonial Penn segment fluctuate primarily due to changes in the marketing expenses incurred to generate new business. Such marketing expenses totaled $16.8 million and $18.9 million, in the second quarters of 2014 and 2013, respectively and $36.5 million and $34.8 million, in the first six months of 2014 and 2013, respectively. The decrease in marketing expense in the second quarter of 2014 reflects a modest increase in the deferral of acquisition costs due to a slight shift to deferrable direct mail marketing activities. Although the effectiveness of our sales and marketing expenditures improved in the second quarter of 2014, we continue to face increased competition from other insurance companies who also distribute products through direct marketing. In addition, the demand and cost of television advertising appropriate for Colonial Penn's campaigns has fluctuated widely in certain periods. In some periods increased advertising costs have resulted in decisions to lower our planned spending. These factors may reoccur in the future.\nNet realized investment gains fluctuated each period. During the first six months of 2014, we recognized $.4 million of net gains from the sales of investments (primarily fixed maturities). During the first six months of 2013, we recognized $.1 million of net gains from the sales of investments (primarily fixed maturities).\n76\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nCorporate Operations (dollars in millions)\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Corporate operations: |\n| Interest expense on corporate debt | $ | (11.1 | ) | $ | (13.1 | ) | $ | (22.2 | ) | $ | (28.2 | ) |\n| Net investment income (loss): |\n| General investment portfolio | 1.7 | 1.5 | 3.5 | 2.6 |\n| Other special-purpose portfolios: |\n| COLI | 3.1 | .1 | 4.1 | 4.7 |\n| Investments held in a rabbi trust | .3 | — | .4 | .4 |\n| Investments in certain hedge funds | (1.8 | ) | (.2 | ) | (.7 | ) | — |\n| Other trading account activities | 2.4 | 3.1 | 5.4 | 6.9 |\n| Fee revenue and other income | 1.3 | 1.5 | 2.7 | 3.2 |\n| Interest expense on investment borrowings | — | — | — | (.1 | ) |\n| Other operating costs and expenses | (22.5 | ) | (3.6 | ) | (36.9 | ) | (12.3 | ) |\n| Loss before net realized investment gains (losses), equity in earnings of certain non-strategic investments and earnings attributable to VIEs, loss on extinguishment or modification of debt and income taxes | (26.6 | ) | (10.7 | ) | (43.7 | ) | (22.8 | ) |\n| Net realized investment gains (losses) | 8.3 | (.3 | ) | (1.6 | ) | .2 |\n| Equity in earnings of certain non-strategic investments and earnings attributable to VIEs | (2.9 | ) | (2.9 | ) | (6.2 | ) | (4.8 | ) |\n| Loss on extinguishment or modification of debt | (.6 | ) | (7.7 | ) | (.6 | ) | (65.4 | ) |\n| Loss before income taxes | $ | (21.8 | ) | $ | (21.6 | ) | $ | (52.1 | ) | $ | (92.8 | ) |\n\nInterest expense on corporate debt has been primarily impacted by: (i) repayments of the Senior Secured Credit Agreement; (ii) the amendment to our Senior Secured Credit Agreement in May 2013 which reduced the interest rate payable; and (iii) the completion of the cash tender offer (the \"Offer\") in March 2013 for $59.3 million aggregate principal amount of our 7.0% Debentures. Our average corporate debt outstanding was $853.6 million and $973.2 million in the first six months of 2014 and 2013, respectively. The average interest rate on our debt was 4.5 percent and 5.2 percent in the first six months of 2014 and 2013, respectively.\nNet investment income on general investment portfolio fluctuates based on the amount and type of invested assets in the corporate operations segment.\nNet investment income on other special-purpose portfolios includes the income (loss) from: (i) investments related to deferred compensation plans held in a rabbi trust (which is offset by amounts included in other operating costs and expenses as the investment results are allocated to participants' account balances); (ii) trading account activities; (iii) income (loss) from Company-owned life insurance (\"COLI\") equal to the difference between the return on these investments (representing the change in value of the underlying investments) and our overall portfolio yield; and (iv) other investments including certain hedge funds and other alternative strategies. COLI is utilized as an investment vehicle to fund Bankers Life's agent deferred compensation plan. For segment reporting, the Bankers Life segment is allocated a return on these investments equivalent to the yield on the Company’s overall portfolio, with any difference in the actual COLI return allocated to the Corporate operations segment. We recognized death benefits, net of cash surrender value, of $1.7 million in the first three months of 2014 and $2.9 million in the second quarter of 2013 related to the COLI.\n77\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nOther operating costs and expenses include general corporate expenses, net of amounts charged to subsidiaries for services provided by the corporate operations. These amounts fluctuate as a result of expenses such as consulting and legal costs which often vary from period to period. Other operating costs and expenses increased (decreased) by $11.8 million and $(6.1) million in the three months ended June 30, 2014 and 2013, respectively, due to the impact of changes in interest rates on the values of liabilities for our agent deferred compensation plan and certain retirement benefits. In addition, such amounts in the first three months of 2014 included higher expenses of $3 million primarily related to accrual adjustments for incentive compensation.\nNet realized investment gains (losses) often fluctuate each period. During the first six months of 2014, net realized investment losses in this segment included $6.4 million of net gains from the sales of investments (of which $2.0 million were losses recognized by VIEs) and $8.0 million of writedowns of investments (none of which were recognized by VIEs) related to two legacy private company investments where earnings and cash flows have not met the expectations assumed in our previous valuations. During the first six months of 2013, we recognized $.8 million of net gains from the sales of investments (of which $.3 million were net gains recognized by VIEs) and $.6 million of writedowns of investments (all of which were recognized by VIEs) due to other-than-temporary declines in value recognized through net income.\nEquity in earnings of certain non-strategic investments and earnings attributable to VIEs include the earnings attributable to non-controlling interests in certain VIEs that we are required to consolidate and certain private companies that were acquired in the commutation of an investment made by our Predecessor, net of affiliated amounts. Such earnings are not indicative and are unrelated to the Company's underlying fundamentals.\nLoss on extinguishment or modification of debt in the first six months of 2014 of $.6 million resulted from: (i) expenses related to the amendment of the Senior Secured Credit Agreement in May 2014; and (ii) the repurchase of the remaining $3.5 million principal amount of the 7.0% Debentures for a purchase price of $3.7 million. The loss on the extinguishment of debt in the first six months of 2013 of $65.4 million resulted from: (i) the Offer and repurchase of 7.0% Debentures, the write-off of unamortized discount and issuance costs associated with the 7.0% Debentures that were repurchased and other transaction costs; and (ii) expenses related to the amendment of our Senior Secured Credit Agreement in May 2013 and the write-off of unamortized discount and issuance costs associated with prepayments on the Senior Secured Credit Agreement.\n78\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nOther CNO Business (dollars in millions)\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2013 | 2013 |\n| Premium collections: |\n| Long-term care (all renewal) | $ | 6.1 | $ | 12.4 |\n| Average liabilities for insurance products: |\n| Average liabilities for long-term care products, net of reinsurance ceded | $ | 468.0 | $ | 468.0 |\n| Revenues: |\n| Insurance policy income | $ | 6.1 | $ | 12.3 |\n| Net investment income on general account invested assets | 8.4 | 16.8 |\n| Total revenues | 14.5 | 29.1 |\n| Expenses: |\n| Insurance policy benefits | 15.3 | 30.9 |\n| Other operating costs and expenses: |\n| Related to long-term care block reinsured effective December 31, 2013 | 1.4 | 3.1 |\n| Overhead expense of CLIC expected to continue after the completion of the sale | 5.0 | 9.6 |\n| Total benefits and expenses | 21.7 | 43.6 |\n| Loss before income taxes | $ | (7.2 | ) | $ | (14.5 | ) |\n\nThe Other CNO Business segment no longer exists, effective January 1, 2014. The Other CNO Business segment reflects the long-term care business that was ceded to BRe effective December 31, 2013, as further described in the note to the consolidated financial statements entitled \"Reinsurance\". This segment also included the overhead expense of CLIC that is expected to continue after the completion of the CLIC sale. Beginning on January 1, 2014 the overhead of CLIC that is expected to continue after the completion of the sale has been reallocated primarily to the Bankers Life and Washington National segments.\n79\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nAmounts related to CLIC being sold (dollars in millions)\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Premium collections: |\n| Annuities | $ | .2 | $ | .1 | $ | .2 | $ | .2 |\n| Life | 34.8 | 36.6 | 71.0 | 75.0 |\n| Total collections | $ | 35.0 | $ | 36.7 | $ | 71.2 | $ | 75.2 |\n| Average liabilities for insurance products: |\n| Fixed index annuities | $ | .8 | $ | .8 | $ | .8 | $ | .4 |\n| Deferred annuities | 142.9 | 148.9 | 143.4 | 150.4 |\n| SPIAs and supplemental contracts: |\n| Mortality based | 36.9 | 39.4 | 37.3 | 39.9 |\n| Deposit based | 94.4 | 109.6 | 95.5 | 110.5 |\n| Health: |\n| Supplemental health | — | 149.0 | 68.2 | 151.3 |\n| Medicare supplement | — | 2.2 | 1.0 | 2.3 |\n| Other health | — | 6.7 | 3.4 | 6.8 |\n| Life: |\n| Interest sensitive | 2,233.3 | 2,333.9 | 2,243.5 | 2,343.9 |\n| Non-interest sensitive | 415.4 | 433.0 | 418.3 | 436.5 |\n| Total average liabilities for insurance products, net of reinsurance ceded | $ | 2,923.7 | $ | 3,223.5 | $ | 3,011.4 | $ | 3,242.0 |\n| Revenues: |\n| Insurance policy income | $ | 52.5 | $ | 55.0 | $ | 106.0 | $ | 112.2 |\n| Net investment income: |\n| General account invested assets | 49.7 | 52.9 | 100.7 | 106.1 |\n| Fixed index products | 1.4 | .8 | 1.3 | 3.0 |\n| Total revenues | 103.6 | 108.7 | 208.0 | 221.3 |\n| Expenses: |\n| Insurance policy benefits | 54.1 | 57.3 | 115.8 | 121.9 |\n| Amounts added to policyholder account balances: |\n| Cost of interest credited to policyholders | 21.6 | 22.7 | 43.2 | 46.0 |\n| Cost of options to fund index credits, net of forfeitures | .4 | .3 | .8 | .7 |\n| Market value changes credited to policyholders | 1.0 | 1.0 | .9 | 3.1 |\n| Amortization related to operations | 2.3 | 2.7 | 4.3 | 4.9 |\n| Interest expense on investment borrowings | 4.4 | 4.8 | 9.1 | 9.6 |\n| Other operating costs and expenses | 7.5 | 14.1 | 13.3 | 23.0 |\n| Total benefits and expenses | 91.3 | 102.9 | 187.4 | 209.2 |\n| Income (loss) before net realized investment gains, loss on sale of CLIC and income taxes | 12.3 | 5.8 | 20.6 | 12.1 |\n| Net realized investment gains | .7 | 1.6 | 2.8 | 3.7 |\n| Earnings of CLIC being sold | 13.0 | 7.4 | 23.4 | 15.8 |\n| Loss on sale of CLIC | — | — | (278.6 | ) | — |\n| Income (loss) before income taxes | $ | 13.0 | $ | 7.4 | $ | (255.2 | ) | $ | 15.8 |\n\nThe information summarized above represents the pre-tax earnings related to the operations of CLIC being sold as well as the loss on the sale of CLIC. Operating expenses exclude overhead expense that is expected to continue after the sale of CLIC. Refer to the note to the consolidated financial statements entitled \"Agreement to Sell Subsidiary\" for additional information.\n80\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nEBIT from Business Segments Continuing After the CLIC Sale Summarized by In-Force and New Business\nManagement believes that an analysis of EBIT from our business segments continuing after the CLIC sale, separated between in-force and new business provides increased clarity around the value drivers of our business, particularly since the new business results are significantly impacted by the rate of sales, mix of business and the distribution channel through which new sales are made. EBIT from new business includes pre-tax revenues and expenses associated with new sales of our insurance products during the first year after the sale is completed. EBIT from in-force business includes all pre-tax revenues and expenses associated with sales of insurance products that were completed more than one year before the end of the reporting period. The allocation of certain revenues and expenses between new and in-force business is based on estimates, which we believe are reasonable.\nThe following summarizes our earnings, separated between in-force and new business on a consolidated basis and for each of our operating segments for the three and six months ended June 30, 2014 and 2013:\nBusiness segments - total (dollars in millions)\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| EBIT from In-Force Business |\n| Revenues: |\n| Insurance policy income | $ | 534.9 | $ | 539.6 | $ | 1,076.5 | $ | 1,074.6 |\n| Net investment income and other | 325.4 | 311.9 | 627.8 | 662.7 |\n| Total revenues | 860.3 | 851.5 | 1,704.3 | 1,737.3 |\n| Benefits and expenses: |\n| Insurance policy benefits | 542.5 | 557.0 | 1,075.4 | 1,152.9 |\n| Amortization | 58.6 | 57.6 | 120.2 | 126.2 |\n| Other expenses | 87.0 | 84.2 | 169.9 | 170.6 |\n| Total benefits and expenses | 688.1 | 698.8 | 1,365.5 | 1,449.7 |\n| EBIT from In-Force Business | $ | 172.2 | $ | 152.7 | $ | 338.8 | $ | 287.6 |\n| EBIT from New Business |\n| Revenues: |\n| Insurance policy income | $ | 91.6 | $ | 96.7 | $ | 182.4 | $ | 195.7 |\n| Net investment income and other | 10.8 | 7.2 | 18.2 | 18.4 |\n| Total revenues | 102.4 | 103.9 | 200.6 | 214.1 |\n| Benefits and expenses: |\n| Insurance policy benefits | 61.4 | 63.9 | 120.0 | 134.8 |\n| Amortization | 6.6 | 8.0 | 13.5 | 14.7 |\n| Other expenses | 83.1 | 75.8 | 173.3 | 159.9 |\n| Total benefits and expenses | 151.1 | 147.7 | 306.8 | 309.4 |\n| EBIT from New Business | $ | (48.7 | ) | $ | (43.8 | ) | $ | (106.2 | ) | $ | (95.3 | ) |\n| EBIT from In-Force and New Business |\n| Revenues: |\n| Insurance policy income | $ | 626.5 | $ | 636.3 | $ | 1,258.9 | $ | 1,270.3 |\n| Net investment income and other | 336.2 | 319.1 | 646.0 | 681.1 |\n| Total revenues | 962.7 | 955.4 | 1,904.9 | 1,951.4 |\n| Benefits and expenses: |\n| Insurance policy benefits | 603.9 | 620.9 | 1,195.4 | 1,287.7 |\n| Amortization | 65.2 | 65.6 | 133.7 | 140.9 |\n| Other expenses | 170.1 | 160.0 | 343.2 | 330.5 |\n| Total benefits and expenses | 839.2 | 846.5 | 1,672.3 | 1,759.1 |\n| EBIT from In-Force and New Business | $ | 123.5 | $ | 108.9 | $ | 232.6 | $ | 192.3 |\n\n81\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nBankers Life (dollars in millions)\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| EBIT from In-Force Business |\n| Revenues: |\n| Insurance policy income | $ | 346.2 | $ | 349.4 | $ | 700.4 | $ | 695.2 |\n| Net investment income and other | 242.6 | 223.4 | 464.9 | 477.6 |\n| Total revenues | 588.8 | 572.8 | 1,165.3 | 1,172.8 |\n| Benefits and expenses: |\n| Insurance policy benefits | 380.7 | 383.4 | 750.8 | 796.2 |\n| Amortization | 40.0 | 38.7 | 82.5 | 87.4 |\n| Other expenses | 43.8 | 41.1 | 85.3 | 83.5 |\n| Total benefits and expenses | 464.5 | 463.2 | 918.6 | 967.1 |\n| EBIT from In-Force Business | $ | 124.3 | $ | 109.6 | $ | 246.7 | $ | 205.7 |\n| EBIT from New Business |\n| Revenues: |\n| Insurance policy income | $ | 61.9 | $ | 69.7 | $ | 124.0 | $ | 141.9 |\n| Net investment income and other | 10.8 | 7.2 | 18.2 | 18.4 |\n| Total revenues | 72.7 | 76.9 | 142.2 | 160.3 |\n| Benefits and expenses: |\n| Insurance policy benefits | 47.2 | 50.7 | 92.1 | 108.4 |\n| Amortization | 5.4 | 7.0 | 11.1 | 12.8 |\n| Other expenses | 57.0 | 49.7 | 114.1 | 103.6 |\n| Total benefits and expenses | 109.6 | 107.4 | 217.3 | 224.8 |\n| EBIT from New Business | $ | (36.9 | ) | $ | (30.5 | ) | $ | (75.1 | ) | $ | (64.5 | ) |\n| EBIT from In-Force and New Business |\n| Revenues: |\n| Insurance policy income | $ | 408.1 | $ | 419.1 | $ | 824.4 | $ | 837.1 |\n| Net investment income and other | 253.4 | 230.6 | 483.1 | 496.0 |\n| Total revenues | 661.5 | 649.7 | 1,307.5 | 1,333.1 |\n| Benefits and expenses: |\n| Insurance policy benefits | 427.9 | 434.1 | 842.9 | 904.6 |\n| Amortization | 45.4 | 45.7 | 93.6 | 100.2 |\n| Other expenses | 100.8 | 90.8 | 199.4 | 187.1 |\n| Total benefits and expenses | 574.1 | 570.6 | 1,135.9 | 1,191.9 |\n| EBIT from In-Force and New Business | $ | 87.4 | $ | 79.1 | $ | 171.6 | $ | 141.2 |\n\n82\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nWashington National (dollars in millions)\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| EBIT from In-Force Business |\n| Revenues: |\n| Insurance policy income | $ | 138.5 | $ | 137.6 | $ | 276.6 | $ | 275.0 |\n| Net investment income and other | 72.0 | 70.0 | 141.2 | 148.1 |\n| Total revenues | 210.5 | 207.6 | 417.8 | 423.1 |\n| Benefits and expenses: |\n| Insurance policy benefits | 125.2 | 123.7 | 249.7 | 254.7 |\n| Amortization | 14.9 | 15.3 | 30.1 | 31.6 |\n| Other expenses | 35.6 | 30.7 | 69.3 | 61.6 |\n| Total benefits and expenses | 175.7 | 169.7 | 349.1 | 347.9 |\n| EBIT from In-Force Business | $ | 34.8 | $ | 37.9 | $ | 68.7 | $ | 75.2 |\n| EBIT from New Business |\n| Revenues: |\n| Insurance policy income | $ | 18.2 | $ | 15.5 | $ | 35.7 | $ | 31.0 |\n| Net investment income and other | — | — | — | — |\n| Total revenues | 18.2 | 15.5 | 35.7 | 31.0 |\n| Benefits and expenses: |\n| Insurance policy benefits | 7.6 | 6.6 | 14.9 | 13.3 |\n| Amortization | 1.1 | .9 | 2.2 | 1.7 |\n| Other expenses | 12.0 | 10.1 | 23.9 | 21.4 |\n| Total benefits and expenses | 20.7 | 17.6 | 41.0 | 36.4 |\n| EBIT from New Business | $ | (2.5 | ) | $ | (2.1 | ) | $ | (5.3 | ) | $ | (5.4 | ) |\n| EBIT from In-Force and New Business |\n| Revenues: |\n| Insurance policy income | $ | 156.7 | $ | 153.1 | $ | 312.3 | $ | 306.0 |\n| Net investment income and other | 72.0 | 70.0 | 141.2 | 148.1 |\n| Total revenues | 228.7 | 223.1 | 453.5 | 454.1 |\n| Benefits and expenses: |\n| Insurance policy benefits | 132.8 | 130.3 | 264.6 | 268.0 |\n| Amortization | 16.0 | 16.2 | 32.3 | 33.3 |\n| Other expenses | 47.6 | 40.8 | 93.2 | 83.0 |\n| Total benefits and expenses | 196.4 | 187.3 | 390.1 | 384.3 |\n| EBIT from In-Force and New Business | $ | 32.3 | $ | 35.8 | $ | 63.4 | $ | 69.8 |\n\n83\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nColonial Penn (dollars in millions)\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| EBIT from In-Force Business |\n| Revenues: |\n| Insurance policy income | $ | 50.2 | $ | 46.5 | $ | 99.5 | $ | 92.1 |\n| Net investment income and other | 10.8 | 10.1 | 21.7 | 20.2 |\n| Total revenues | 61.0 | 56.6 | 121.2 | 112.3 |\n| Benefits and expenses: |\n| Insurance policy benefits | 36.6 | 34.6 | 74.9 | 71.1 |\n| Amortization | 3.7 | 3.6 | 7.6 | 7.2 |\n| Other expenses | 7.6 | 6.0 | 15.3 | 12.8 |\n| Total benefits and expenses | 47.9 | 44.2 | 97.8 | 91.1 |\n| EBIT from In-Force Business | $ | 13.1 | $ | 12.4 | $ | 23.4 | $ | 21.2 |\n| EBIT from New Business |\n| Revenues: |\n| Insurance policy income | $ | 11.5 | $ | 11.5 | $ | 22.7 | $ | 22.8 |\n| Net investment income and other | — | — | — | — |\n| Total revenues | 11.5 | 11.5 | 22.7 | 22.8 |\n| Benefits and expenses: |\n| Insurance policy benefits | 6.6 | 6.6 | 13.0 | 13.1 |\n| Amortization | .1 | .1 | .2 | .2 |\n| Other expenses | 14.1 | 16.0 | 35.3 | 34.9 |\n| Total benefits and expenses | 20.8 | 22.7 | 48.5 | 48.2 |\n| EBIT from New Business | $ | (9.3 | ) | $ | (11.2 | ) | $ | (25.8 | ) | $ | (25.4 | ) |\n| EBIT from In-Force and New Business |\n| Revenues: |\n| Insurance policy income | $ | 61.7 | $ | 58.0 | $ | 122.2 | $ | 114.9 |\n| Net investment income and other | 10.8 | 10.1 | 21.7 | 20.2 |\n| Total revenues | 72.5 | 68.1 | 143.9 | 135.1 |\n| Benefits and expenses: |\n| Insurance policy benefits | 43.2 | 41.2 | 87.9 | 84.2 |\n| Amortization | 3.8 | 3.7 | 7.8 | 7.4 |\n| Other expenses | 21.7 | 22.0 | 50.6 | 47.7 |\n| Total benefits and expenses | 68.7 | 66.9 | 146.3 | 139.3 |\n| EBIT from In-Force and New Business | $ | 3.8 | $ | 1.2 | $ | (2.4 | ) | $ | (4.2 | ) |\n\n84\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nOther CNO Business (dollars in millions)\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2013 | 2013 |\n| EBIT from In-Force Business (a) |\n| Revenues: |\n| Insurance policy income | $ | 6.1 | $ | 12.3 |\n| Net investment income and other | 8.4 | 16.8 |\n| Total revenues | 14.5 | 29.1 |\n| Benefits and expenses: |\n| Insurance policy benefits | 15.3 | 30.9 |\n| Other expenses | 6.4 | 12.7 |\n| Total benefits and expenses | 21.7 | 43.6 |\n| EBIT from In-Force Business | $ | (7.2 | ) | $ | (14.5 | ) |\n\n_________________________\n| (a) | All activity in the Other CNO Business segment relates to in-force business. |\n\nThe above analysis of EBIT, separated between in-force and new business, illustrates how our business segments are impacted by the rate of sales, mix of business and distribution channel through which new sales are made. In addition, when the impacts from new business are separated, the value drivers of our in-force business are more apparent.\nThe EBIT from in-force business in the Bankers Life segment grew in the 2014 periods primarily due to the growth in the size of the block. The EBIT from new business in the Bankers Life segment reflects increased sales.\nThe EBIT from in-force business in the Washington National segment was lower in the 2014 periods due to the run-off of the Medicare supplement business in this segment and additional overhead expenses that were previously allocated to the Other CNO Business segment.\nThe EBIT from in-force business in the Colonial Penn segment in the 2014 periods reflects growth in the size of the block. The EBIT from new business in the Colonial Penn segment in the second quarter of 2014 reflects a modest increase in the deferral of acquisition costs due to a slight shift to deferrable direct mail marketing activities. The vast majority of the costs to generate new business in this segment are not deferrable and EBIT will fluctuate based on management's decisions on how much marketing costs to incur in each period.\n85\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nPREMIUM COLLECTIONS\nIn accordance with GAAP, insurance policy income in our consolidated statement of operations consists of premiums earned for traditional insurance policies that have life contingencies or morbidity features. For annuity and interest-sensitive life contracts, premiums collected are not reported as revenues, but as deposits to insurance liabilities. We recognize revenues for these products over time in the form of investment income and surrender or other charges.\nOur insurance segments sell products through three primary distribution channels - career agents (our Bankers Life segment), direct marketing (our Colonial Penn segment) and independent producers (our Washington National segment). Our career agency force in the Bankers Life segment sells primarily Medicare supplement and long-term care insurance policies, life insurance and annuities. These agents visit the customer's home, which permits one-on-one contact with potential policyholders and promotes strong personal relationships with existing policyholders. Our direct marketing distribution channel in the Colonial Penn segment is engaged primarily in the sale of graded benefit life and simplified issue life insurance policies which are sold directly to the policyholder. Our Washington National segment sells primarily supplemental health and life insurance. These products are marketed through PMA, a subsidiary that specializes in marketing and distributing health products, and through independent marketing organizations and insurance agencies, including worksite marketing.\nAgents, insurance brokers and marketing companies who market our products and prospective purchasers of our products use the financial strength ratings of our insurance subsidiaries as an important factor in determining whether to market or purchase. Ratings have the most impact on our sales of supplemental health and life products to consumers at the worksite. The current financial strength ratings of our primary insurance subsidiaries (except CLIC which was sold on July 1, 2014) from S&P, Fitch Ratings (\"Fitch\"), Moody's and A.M. Best are \"BBB+\", \"BBB\", \"Baa2\" and \"B++\", respectively. For a description of these ratings and additional information on our ratings, see \"Financial Strength Ratings of our Insurance Subsidiaries.\"\nWe set premium rates on our health insurance policies based on facts and circumstances known at the time we issue the policies using assumptions about numerous variables, including the actuarial probability of a policyholder incurring a claim, the probable size of the claim, and the interest rate earned on our investment of premiums. We also consider historical claims information, industry statistics, the rates of our competitors and other factors. If our actual claims experience is less favorable than we anticipated and we are unable to raise our premium rates, our financial results may be adversely affected. We generally cannot raise our health insurance premiums in any state until we obtain the approval of the state insurance regulator. We review the adequacy of our premium rates regularly and file for rate increases on our products when we believe such rates are too low. It is likely that we will not be able to obtain approval for all requested premium rate increases. If such requests are denied in one or more states, our net income may decrease. If such requests are approved, increased premium rates may reduce the volume of our new sales and may cause existing policyholders to lapse their policies. If the healthier policyholders allow their policies to lapse, this would reduce our premium income and profitability in the future.\n86\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nTotal premium collections by segment were as follows:\nBankers Life (dollars in millions)\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Premiums collected by product: |\n| Annuities: |\n| Fixed index (first-year) | $ | 166.6 | $ | 143.4 | $ | 313.9 | $ | 270.0 |\n| Other fixed rate (first-year) | 32.2 | 38.5 | 73.6 | 75.7 |\n| Other fixed rate (renewal) | 2.0 | 1.8 | 3.8 | 3.6 |\n| Subtotal - other fixed rate annuities | 34.2 | 40.3 | 77.4 | 79.3 |\n| Total annuities | 200.8 | 183.7 | 391.3 | 349.3 |\n| Health: |\n| Medicare supplement (first-year) | 22.3 | 22.7 | 43.5 | 45.4 |\n| Medicare supplement (renewal) | 155.5 | 153.4 | 313.7 | 315.9 |\n| Subtotal - Medicare supplement | 177.8 | 176.1 | 357.2 | 361.3 |\n| Long-term care (first-year) | 4.2 | 5.4 | 8.6 | 11.1 |\n| Long-term care (renewal) | 122.0 | 127.8 | 241.3 | 257.5 |\n| Subtotal - long-term care | 126.2 | 133.2 | 249.9 | 268.6 |\n| PDP (first year) | — | — | — | .1 |\n| PDP (renewal) | — | 10.5 | 6.8 | 20.6 |\n| Subtotal – PDP | — | 10.5 | 6.8 | 20.7 |\n| Supplemental health (first-year) | 2.0 | 2.0 | 4.1 | 3.6 |\n| Supplemental health (renewal) | 2.0 | .2 | 3.5 | .2 |\n| Subtotal – supplemental health | 4.0 | 2.2 | 7.6 | 3.8 |\n| Other health (first-year) | .2 | .4 | .4 | .7 |\n| Other health (renewal) | 1.9 | 2.2 | 3.7 | 4.6 |\n| Subtotal - other health | 2.1 | 2.6 | 4.1 | 5.3 |\n| Total health | 310.1 | 324.6 | 625.6 | 659.7 |\n| Life insurance: |\n| First-year | 39.2 | 41.0 | 77.4 | 83.4 |\n| Renewal | 62.3 | 50.1 | 118.1 | 97.2 |\n| Total life insurance | 101.5 | 91.1 | 195.5 | 180.6 |\n| Collections on insurance products: |\n| Total first-year premium collections on insurance products | 266.7 | 253.4 | 521.5 | 490.0 |\n| Total renewal premium collections on insurance products | 345.7 | 346.0 | 690.9 | 699.6 |\n| Total collections on insurance products | $ | 612.4 | $ | 599.4 | $ | 1,212.4 | $ | 1,189.6 |\n\nAnnuities in this segment include fixed index and other fixed annuities sold to the senior market. Annuity collections in this segment increased 9.3 percent, to $200.8 million, in the second quarter of 2014, and 12 percent, to $391.3 million, in the first six months of 2014, as compared to the same periods in 2013. Premium collections from our fixed index products were favorably impacted in the 2014 periods by the general stock market performance which made these products attractive to certain customers.\n87\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nHealth products include Medicare supplement, PDP contracts, long-term care and other insurance products. Our profits on health policies depend on the overall level of sales, the length of time the business remains inforce, investment yields, claims experience and expense management.\nCollected premiums on Medicare supplement policies in the Bankers Life segment increased 1.0 percent, to $177.8 million, in the second quarter of 2014, and decreased 1.1 percent, to $357.2 million, in the first six months of 2014, as compared to the same periods in 2013. In recent periods, we have experienced a slight shift in the sale of Medicare supplement policies to the sale of Medicare Advantage policies. Medicare Advantage policies are sold through Bankers Life's agency force for other providers in exchange for marketing fees.\nPremiums collected on Bankers Life's long-term care policies decreased 5.3 percent, to $126.2 million, in the second quarter of 2014, and 7.0 percent, to $249.9 million, in the first six months of 2014, as compared to the same periods in 2013, reflecting lower sales of these policies in recent periods and lower renewal premiums.\nPremiums collected on PDP business related to our quota-share reinsurance agreement with Coventry. In August 2013, we received a notice of Coventry's intent to terminate our PDP quota-share reinsurance agreement as further described in the note to the consolidated financial statements entitled \"Reinsurance\". The premiums collected in the first six months of 2014 represent adjustments to premiums on such business related to periods prior to the termination of the agreement.\nPremiums collected on supplemental health products relate to a new critical illness product that was introduced in 2012.\nLife products in this segment include traditional and interest-sensitive life products. Life premiums collected in this segment increased 11 percent, to $101.5 million, in the second quarter of 2014, and 8.3 percent, to $195.5 million, in the first six months of 2014, as compared to the same periods in 2013 due to growth in the size of the block.\n88\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nWashington National (dollars in millions)\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Premiums collected by product: |\n| Annuities: |\n| Fixed index (first-year) | $ | — | $ | .1 | $ | .1 | $ | .3 |\n| Fixed index (renewal) | .4 | 1.3 | .8 | 1.9 |\n| Subtotal - fixed index annuities | .4 | 1.4 | .9 | 2.2 |\n| Other fixed rate (renewal) | .2 | — | .3 | .1 |\n| Total annuities | .6 | 1.4 | 1.2 | 2.3 |\n| Health: |\n| Medicare supplement (first-year) | — | — | — | .2 |\n| Medicare supplement (renewal) | 21.7 | 25.0 | 42.8 | 51.4 |\n| Subtotal - Medicare supplement | 21.7 | 25.0 | 42.8 | 51.6 |\n| Supplemental health (first-year) | 18.5 | 16.3 | 35.2 | 31.9 |\n| Supplemental health (renewal) | 110.6 | 105.6 | 219.8 | 210.3 |\n| Subtotal – supplemental health | 129.1 | 121.9 | 255.0 | 242.2 |\n| Other health (first-year) | .1 | — | .1 | — |\n| Other health (renewal) | .5 | .8 | 1.1 | 1.6 |\n| Subtotal - Other health | .6 | .8 | 1.2 | 1.6 |\n| Total health | 151.4 | 147.7 | 299.0 | 295.4 |\n| Life insurance: |\n| First-year | 1.5 | 1.1 | 2.6 | 2.3 |\n| Renewal | 4.9 | 5.2 | 10.3 | 10.3 |\n| Total life insurance | 6.4 | 6.3 | 12.9 | 12.6 |\n| Collections on insurance products: |\n| Total first-year premium collections on insurance products | 20.1 | 17.5 | 38.0 | 34.7 |\n| Total renewal premium collections on insurance products | 138.3 | 137.9 | 275.1 | 275.6 |\n| Total collections on insurance products | $ | 158.4 | $ | 155.4 | $ | 313.1 | $ | 310.3 |\n\nAnnuities in this segment include fixed index and other fixed annuities. We are no longer actively pursuing sales of annuity products in this segment.\nHealth products in the Washington National segment include Medicare supplement, supplemental health and other insurance products. Our profits on health policies depend on the overall level of sales, the length of time the business remains inforce, investment yields, claim experience and expense management.\nCollected premiums on Medicare supplement policies in the Washington National segment decreased 13 percent, to $21.7 million, in the second quarter of 2014, and 17 percent, to $42.8 million, in the first six months of 2014, as compared to the same periods in 2013. We discontinued new sales of Medicare supplement policies in this segment in the fourth quarter of 2012.\nPremiums collected on supplemental health products (including specified disease, accident and hospital indemnity insurance products) increased 5.9 percent, to $129.1 million, in the second quarter of 2014, and 5.3 percent, to $255.0 million, in the first six months of 2014, as compared to the same periods in 2013. Such increase is due to higher new sales in recent periods and an improvement in persistency.\n89\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nOverall, excluding premiums from the Washington National Medicare supplement and annuity blocks which are in run-off, collected premiums were up 5.5 percent in the second quarter of 2014, and 5.0 percent in the first six months of 2014, as compared to the same periods in 2013, driven by strong sales and persistency.\nLife products in the Washington National segment are primarily traditional life products. Life premiums collected in this segment in the three and six months ended June 30, 2014 were slightly higher than the same periods in 2013.\nColonial Penn (dollars in millions)\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Premiums collected by product: |\n| Life insurance: |\n| First-year | $ | 11.3 | $ | 11.4 | $ | 22.6 | $ | 22.8 |\n| Renewal | 48.7 | 45.0 | 97.5 | 89.7 |\n| Total life insurance | 60.0 | 56.4 | 120.1 | 112.5 |\n| Health (all renewal): |\n| Medicare supplement | .8 | .9 | 1.6 | 1.9 |\n| Other health | .1 | .1 | .2 | .2 |\n| Total health | .9 | 1.0 | 1.8 | 2.1 |\n| Collections on insurance products: |\n| Total first-year premium collections on insurance products | 11.3 | 11.4 | 22.6 | 22.8 |\n| Total renewal premium collections on insurance products | 49.6 | 46.0 | 99.3 | 91.8 |\n| Total collections on insurance products | $ | 60.9 | $ | 57.4 | $ | 121.9 | $ | 114.6 |\n\nLife products in this segment are sold primarily to the senior market. Life premiums collected in this segment increased 6.4 percent, to $60.0 million, in the second quarter of 2014, and 6.8 percent, to $120.1 million, in the first six months of 2014, as compared to the same periods in 2013. Graded benefit life products sold through our direct response marketing channel accounted for $59.5 million and $55.7 million of our total collected premiums in the second quarters of 2014 and 2013, respectively, and $119.0 million and $111.2 million in the first six months of 2014 and 2013, respectively.\nHealth products include Medicare supplement and other insurance products. Our profits on health policies depend on the overall level of sales, the length of time the business remains inforce, investment yields, claims experience and expense management. Premiums collected on these products have decreased as we do not currently market these products through this segment.\nOther CNO Business (dollars in millions)\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Premiums collected by product: |\n| Health: |\n| Long-term care (all renewal) | $ | — | $ | 6.1 | $ | — | $ | 12.4 |\n\n90\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nThe Other CNO Business segment reflects the long-term care premiums collected prior to the reinsurance agreement with BRe effective December 31, 2013. Refer to the note to the consolidated financial statements entitled \"Reinsurance\" for additional information.\nLIQUIDITY AND CAPITAL RESOURCES\nOur capital structure as of June 30, 2014 and December 31, 2013 was as follows (dollars in millions):\n| June 30, 2014 | December 31, 2013 |\n| Total capital: |\n| Corporate notes payable | $ | 827.3 | $ | 856.4 |\n| Shareholders’ equity: |\n| Common stock | 2.1 | 2.2 |\n| Additional paid-in capital | 3,963.9 | 4,092.8 |\n| Accumulated other comprehensive income | 926.1 | 731.8 |\n| Retained earnings (accumulated deficit) | (47.8 | ) | 128.4 |\n| Total shareholders’ equity | 4,844.3 | 4,955.2 |\n| Total capital | $ | 5,671.6 | $ | 5,811.6 |\n\nThe following table summarizes certain financial ratios as of and for the six months ended June 30, 2014 and as of and for the year ended December 31, 2013:\n| June 30, 2014 | December 31, 2013 |\n| Book value per common share | $ | 22.66 | $ | 22.49 |\n| Book value per common share, excluding accumulated other comprehensive income (a) | 18.33 | 19.17 |\n| Ratio of earnings to fixed charges | (b) | 1.87X |\n| Debt to total capital ratios: |\n| Corporate debt to total capital | 14.6 | % | 14.7 | % |\n| Corporate debt to total capital, excluding accumulated other comprehensive income (a) | 17.4 | % | 16.9 | % |\n\n_____________________\n| (a) | This non-GAAP measure differs from the corresponding GAAP measure presented immediately above, because accumulated other comprehensive income has been excluded from the value of capital used to determine this measure. Management believes this non-GAAP measure is useful because it removes the volatility that arises from changes in accumulated other comprehensive income. Such volatility is often caused by changes in the estimated fair value of our investment portfolio resulting from changes in general market interest rates rather than the business decisions made by management. However, this measure does not replace the corresponding GAAP measure. |\n\n| (b) | For such ratio, earnings were $55.2 million less than fixed charges primarily due to the pre-tax loss recognized on the sale of CLIC of $278.6 million. |\n\nLiquidity for Insurance Operations\nOur insurance companies generally receive adequate cash flows from premium collections and investment income to meet their obligations. Life insurance, long-term care insurance and annuity liabilities are generally long-term in nature. Life and annuity policyholders may, however, withdraw funds or surrender their policies, subject to any applicable penalty provisions; there are generally no withdrawal or surrender benefits for long-term care insurance. We actively manage the relationship between the duration of our invested assets and the estimated duration of benefit payments arising from contract liabilities.\n91\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nTwo of the Company's insurance subsidiaries (Washington National and Bankers Life) are members of the FHLB. As members of the FHLB, Washington National and Bankers Life have the ability to borrow on a collateralized basis from the FHLB. Washington National and Bankers Life are required to hold certain minimum amounts of FHLB common stock as a condition of membership in the FHLB, and additional amounts based on the amount of the borrowings. At June 30, 2014, the carrying value of the FHLB common stock was $73.5 million. As of June 30, 2014, collateralized borrowings from the FHLB totaled $1.5 billion and the proceeds were used to purchase fixed maturity securities. The borrowings are classified as investment borrowings in the accompanying consolidated balance sheet. The borrowings are collateralized by investments with an estimated fair value of $1.8 billion at June 30, 2014, which are maintained in custodial accounts for the benefit of the FHLB.\nCLIC was also a member of the FHLB and \"Assets of subsidiary being sold\" included FHLB common stock of $22.5 million and \"Liabilities of subsidiary being sold\" included collateralized borrowings of $383.4 million, both as of June 30, 2014. These borrowings are collateralizd by investments with an estimated fair value of $503.9 million included in the \"Assets of subsidiary being sold\".\nThe following summarizes the terms of the borrowings from the FHLB by Washington National and Bankers Life(dollars in millions):\n| Amount | Maturity | Interest rate at |\n| borrowed | date | June 30, 2014 |\n| $ | 50.0 | September 2015 | Variable rate – 0.528% |\n| 50.0 | October 2015 | Variable rate – 0.502% |\n| 100.0 | June 2016 | Variable rate – 0.592% |\n| 75.0 | June 2016 | Variable rate – 0.394% |\n| 100.0 | October 2016 | Variable rate – 0.412% |\n| 50.0 | November 2016 | Variable rate – 0.497% |\n| 50.0 | November 2016 | Variable rate – 0.622% |\n| 57.7 | June 2017 | Variable rate – 0.581% |\n| 50.0 | August 2017 | Variable rate – 0.424% |\n| 75.0 | August 2017 | Variable rate – 0.377% |\n| 100.0 | October 2017 | Variable rate – 0.656% |\n| 50.0 | November 2017 | Variable rate – 0.737% |\n| 50.0 | January 2018 | Variable rate – 0.578% |\n| 50.0 | January 2018 | Variable rate – 0.566% |\n| 50.0 | February 2018 | Variable rate – 0.533% |\n| 50.0 | February 2018 | Variable rate – 0.315% |\n| 22.0 | February 2018 | Variable rate – 0.559% |\n| 100.0 | May 2018 | Variable rate – 0.600% |\n| 50.0 | July 2018 | Variable rate – 0.698% |\n| 50.0 | August 2018 | Variable rate – 0.344% |\n| 50.0 | January 2019 | Variable rate – 0.649% |\n| 50.0 | February 2019 | Variable rate – 0.315% |\n| 100.0 | March 2019 | Variable rate – 0.634% |\n| 21.8 | June 2020 | Fixed rate – 1.960% |\n| 27.2 | March 2023 | Fixed rate – 2.160% |\n| 20.5 | June 2025 | Fixed rate – 2.940% |\n| $ | 1,499.2 |\n\n92\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nThe following summarizes the terms of the borrowings classified as \"Liabilities of subsidiary being sold\" (dollars in millions):\n| Amount | Maturity | Interest rate at |\n| borrowed | date | June 30, 2014 |\n| $ | 146.4 | November 2015 | Fixed rate – 5.300% |\n| 100.0 | December 2015 | Fixed rate – 4.710% |\n| 100.0 | July 2017 | Fixed rate – 3.900% |\n| 37.0 | November 2017 | Fixed rate – 3.750% |\n| $ | 383.4 |\n\nState laws generally give state insurance regulatory agencies broad authority to protect policyholders in their jurisdictions. Regulators have used this authority in the past to restrict the ability of our insurance subsidiaries to pay any dividends or other amounts without prior approval. We cannot be assured that the regulators will not seek to assert greater supervision and control over our insurance subsidiaries' businesses and financial affairs.\nOur consolidated statutory RBC ratio of 437 percent at June 30, 2014, reflects consolidated statutory operating earnings of $225 million and net dividends to the holding company of $115 million during the first six months of 2014. Statutory earnings will often fluctuate on a quarterly basis due to the application of statutory accounting principles.\nFinancial Strength Ratings of our Insurance Subsidiaries\nFinancial strength ratings provided by S&P, Fitch, Moody's and A.M. Best and are the rating agency's opinions of the ability of our insurance subsidiaries to pay policyholder claims and obligations when due.\nOn July 2, 2014, S&P upgraded the financial strength ratings of our primary insurance subsidiaries (except CLIC which was sold on July 1, 2014) to \"BBB+\" from \"BBB\" and the outlook for these ratings is stable. On July 24, 2013, S&P upgraded the financial strength ratings of our primary insurance subsidiaries (except CLIC) to \"BBB\" from \"BBB-\". S&P financial strength ratings range from \"AAA\" to \"R\" and some companies are not rated. An insurer rated \"BBB\" or higher is regarded as having financial security characteristics that outweigh any vulnerabilities, and is highly likely to have the ability to meet financial commitments. An insurer rated \"BBB\", in S&P's opinion, has good financial security characteristics, but is more likely to be affected by adverse business conditions than are higher rated insurers. Pluses and minuses show the relative standing within a category. S&P has twenty-one possible ratings. There are seven ratings above the \"BBB+\" rating of our primary insurance subsidiaries (other than CLIC) and thirteen ratings that are below that rating.\nOn May 5, 2014, Fitch affirmed the financial strength ratings of \"BBB\" of our primary insurance subsidiaries (except CLIC) and revised the outlook for these ratings to positive from stable. A \"BBB\" rating, in Fitch's opinion, indicates that there is currently a low expectation of ceased or interrupted payments. The capacity to meet policyholder and contract obligations on a timely basis is considered adequate, but adverse changes in circumstances and economic conditions are more likely to impact this capacity. Fitch ratings for the industry range from \"AAA Exceptionally Strong\" to \"C Distressed\" and some companies are not rated. Pluses and minuses show the relative standing within a category. Fitch has nineteen possible ratings. There are eight ratings above the \"BBB\" rating of our primary insurance subsidiaries (other than CLIC) and ten ratings that are below that rating.\nOn March 27, 2014, Moody's upgraded the financial strength ratings of our primary insurance subsidiaries (except CLIC) to \"Baa2\" from \"Baa3\" and the outlook for these ratings is positive. A \"positive\" designation indicates a higher likelihood of a rating change over the medium term. Moody’s financial strength ratings range from \"Aaa\" to \"C\". These ratings may be supplemented with numbers \"1\", \"2\", or \"3\" to show relative standing within a category. In Moody's view, an insurer rated \"Baa\" offers adequate financial security, however, certain protective elements may be lacking or may be characteristically unreliable over any great length of time. Moody's has twenty-one possible ratings. There are eight ratings above the \"Baa2\" rating of our primary insurance subsidiaries (other than CLIC) and twelve ratings that are below the rating.\n93\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nOn September 27, 2013, A.M. Best affirmed the financial strength rating of \"B++\" of our primary insurance subsidiaries (except CLIC) and the outlook for these ratings is stable. On September 4, 2012, A.M. Best upgraded the financial strength ratings of our primary insurance subsidiaries (except CLIC) to \"B++\" from \"B+\". A \"stable\" designation means that there is a low likelihood of a rating change due to stable financial market trends. The \"B++\" rating is assigned to companies that have a good ability, in A.M. Best's opinion, to meet their ongoing obligations to policyholders. A.M. Best ratings for the industry currently range from \"A++ (Superior)\" to \"F (In Liquidation)\" and some companies are not rated. An \"A++\" rating indicates a superior ability to meet ongoing obligations to policyholders. A.M. Best has sixteen possible ratings. There are four ratings above the \"B++\" rating of our primary insurance subsidiaries (other than CLIC) and eleven ratings that are below that rating.\nRating agencies have increased the frequency and scope of their credit reviews and requested additional information from the companies that they rate, including us. They may also adjust upward the capital and other requirements employed in the rating agency models for maintenance of certain ratings levels. We cannot predict what actions rating agencies may take, or what actions we may take in response. Accordingly, downgrades and outlook revisions related to us or the life insurance industry may occur in the future at any time and without notice by any rating agency. These could increase policy surrenders and withdrawals, adversely affect relationships with our distribution channels, reduce new sales, reduce our ability to borrow and increase our future borrowing costs.\nLiquidity of the Holding Companies\nAvailability and Sources and Uses of Holding Company Liquidity; Limitations on Ability of Insurance Subsidiaries to Make Dividend and Surplus Debenture Interest Payments to the Holding Companies; Limitations on Holding Company Activities\nAt June 30, 2014, CNO, CDOC, Inc. (\"CDOC\", our wholly owned subsidiary and the immediate parent of Washington National, CLIC and Conseco Life Insurance Company of Texas (\"CLTX\")) and our other non-insurance subsidiaries held: (i) unrestricted cash and cash equivalents of $116.0 million; (ii) fixed income investments of $66.6 million; and (iii) equity securities and other invested assets totaling $94.2 million. CNO and CDOC are holding companies with no business operations of their own; they depend on their operating subsidiaries for cash to make principal and interest payments on debt, and to pay administrative expenses and income taxes. CNO and CDOC receive cash from insurance subsidiaries, consisting of dividends and distributions, interest payments on surplus debentures and tax-sharing payments, as well as cash from non-insurance subsidiaries consisting of dividends, distributions, loans and advances. The principal non-insurance subsidiaries that provide cash to CNO and CDOC are 40|86 Advisors, Inc. (\"40|86 Advisors\"), which receives fees from the insurance subsidiaries for investment services, and CNO Services which receives fees from the insurance subsidiaries for providing administrative services. The agreements between our insurance subsidiaries and CNO Services and 40|86 Advisors, respectively, were previously approved by the domestic insurance regulator for each insurance company, and any payments thereunder do not require further regulatory approval.\n94\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nThe following summarizes the current ownership structure of CNO’s primary subsidiaries reflecting the sale of CLIC on July 1, 2014:\nThe ability of our insurance subsidiaries to pay dividends is subject to state insurance department regulations and is based on the financial statements of our insurance subsidiaries prepared in accordance with statutory accounting practices prescribed or permitted by regulatory authorities, which differ from GAAP. These regulations generally permit dividends to be paid from statutory earned surplus of the insurance company for any 12-month period in amounts equal to the greater of (or in a few states, the lesser of): (i) statutory net gain from operations or net income for the prior year; or (ii) 10 percent of statutory capital and surplus as of the end of the preceding year. This type of dividend is referred to as an \"ordinary dividend\". Any dividend in excess of these levels or from an insurance company that has negative earned surplus requires the approval of the director or commissioner of the applicable state insurance department and is referred to as an \"extraordinary dividend\". Each of the direct insurance subsidiaries of CDOC has significant negative earned surplus and any dividend payments from the subsidiaries of CDOC would be considered extraordinary dividends and, therefore, require the approval of the director or commissioner of the applicable state insurance department. In the first six months of 2014, our insurance subsidiaries paid extraordinary dividends to CDOC totaling $140.0 million. We expect to receive regulatory approval for future dividends from our subsidiaries, but there can be no assurance that such payments will be approved or that the financial condition of our insurance subsidiaries will not change, making future approvals less likely.\nWe generally maintain capital and surplus levels in our insurance subsidiaries in an amount that is sufficient to maintain a minimum consolidated RBC ratio of 350 percent and may seek to have our insurance subsidiaries pay ordinary dividends or request regulatory approval for extraordinary dividends when the consolidated RBC ratio exceeds such level and we have concluded the capital level in each of our insurance subsidiaries is adequate to support their business and projected growth. The consolidated RBC ratio of our insurance subsidiaries was 437 percent at June 30, 2014.\nCDOC holds surplus debentures from CLTX with an aggregate principal amount of $749.6 million. Interest payments on those surplus debentures do not require additional approval provided the RBC ratio of CLTX exceeds 100 percent (but do require prior written notice to the Texas state insurance department). The RBC ratio of CLTX was 355 percent at June 30, 2014. CDOC also holds a surplus debenture from Colonial Penn with an outstanding principal balance of $160.0 million. Interest payments on that surplus debenture require prior approval by the Pennsylvania state insurance department. Dividends and other payments from our non-insurance subsidiaries, including 40|86 Advisors and CNO Services, to CNO or CDOC do not require approval by any regulatory authority or other third party. However, insurance regulators may prohibit payments by our insurance subsidiaries to parent companies if they determine that such payments could be adverse to our policyholders or contractholders.\nThe insurance subsidiaries of CDOC receive funds to pay dividends primarily from: (i) the earnings of their direct businesses; (ii) tax sharing payments received from subsidiaries (if applicable); and (iii) with respect to CLTX, dividends received from subsidiaries. At June 30, 2014, the subsidiaries of CLTX had earned surplus (deficit) as summarized below (dollars in millions):\n95\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\n| Subsidiary of CDOC | Earned surplus (deficit) | Additional information |\n| Subsidiaries of CLTX: |\n| Bankers Life | $ | 359.2 | (a) |\n| Colonial Penn | (259.9 | ) | (b) |\n\n____________________\n| (a) | Bankers Life paid ordinary dividends of $95.0 million to CLTX in the first six months of 2014. |\n\n| (b) | The deficit is primarily due to transactions which occurred several years ago, including a tax planning transaction and the fee paid to recapture a block of business previously ceded to an unaffiliated insurer. |\n\nA significant deterioration in the financial condition, earnings or cash flow of the material subsidiaries of CNO or CDOC for any reason could hinder such subsidiaries' ability to pay cash dividends or other disbursements to CNO and/or CDOC, which, in turn, could limit CNO's ability to meet debt service requirements and satisfy other financial obligations. In addition, we may choose to retain capital in our insurance subsidiaries or to contribute additional capital to our insurance subsidiaries to strengthen their surplus, and these decisions could limit the amount available at our top tier insurance subsidiaries to pay dividends to the holding companies. CDOC made a $25.0 million capital contribution to its insurance subsidiaries in the first six months of 2014.\nIn the first six months of 2014, we repurchased 7.8 million shares of common stock for $136.6 million under our securities repurchase program. The Company had remaining repurchase authority of $260.8 million as of June 30, 2014. We currently anticipate repurchasing securities in the range of $350 million to $400 million during 2014, absent compelling alternatives. The amount and timing of the securities repurchases will be based on business and market conditions and other factors.\nIn the first six months of 2014, we paid dividends on common stock of $26.3 million ($0.12 per common share). In March 2014, we increased our quarterly common stock dividend to $0.06 per share from $0.03 per share.\nIn the first six months of 2014, we made $26.0 million of scheduled quarterly principal payments due under the Senior Secured Credit Agreement.\nOn May 30, 2014, the Company completed an amendment to the Senior Secured Credit Agreement to waive the requirement that the net proceeds in excess of $125 million to be received from the sale of CLIC be used to prepay amounts outstanding under the Senior Secured Credit Agreement. In the second quarter of 2014, we recognized expenses related to the amendment of the Senior Secured Credit Agreement totaling $.4 million which are included in the loss on extinguishment or modification of debt.\nThe amendment to the Senior Secured Credit Agreement did not impact the restrictions set forth in the 6.375% Indenture regarding the Company’s use of the proceeds from the sale of CLIC. Under the Indenture, the net proceeds received by the Company from the sale of CLIC (defined as \"Net Available Cash\" under the Indenture) may be used to: (i) reinvest in or acquire assets to be used in the insurance business or a related business; or (ii) repay the Senior Secured Credit Agreement. Under the Indenture, any Net Available Cash not so reinvested or applied within 365 days after the closing of the sale of CLIC must be used to make an offer to purchase the outstanding notes at par and, in the interim, may only be invested as set forth in the Indenture. The Company currently plans to reinvest the cash received from the sale of CLIC in its business including the payment on July 1, 2014, of $28.0 million to recapture a block of life insurance business from Wilton Re.\nMandatory prepayments of the Senior Secured Credit Agreement will be required, subject to certain exceptions, in an amount equal to: (i) 100% of the net cash proceeds from certain asset sales or casualty events; (ii) 100% of the net cash proceeds received by the Company or any of its restricted subsidiaries from certain debt issuances; and (iii) 100% of the amount of certain restricted payments made (including any common stock dividends and share repurchases) as defined in the Senior Secured Credit Agreement provided that if, as of the end of the fiscal quarter immediately preceding such restricted payment, the debt to total capitalization ratio is: (x) equal to or less than 25.0%, but greater than 20.0%, the prepayment requirement shall be reduced to 33.33%; or (y) equal to or less than 20.0%, the prepayment requirement shall not apply.\n96\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nNotwithstanding the foregoing, no mandatory prepayments pursuant to item (i) in the preceding paragraph shall be required if: (x) the debt to total capitalization ratio is equal or less than 20% and (y) either (A) the financial strength rating of certain of the Company's insurance subsidiaries is equal or better than A- (stable) from A.M. Best or (B) the Senior Secured Credit Agreement is rated equal or better than BBB- (stable) from S&P and Baa3 (stable) by Moody's.\nThe Senior Secured Credit Agreement requires the Company to maintain (each as calculated in accordance with the Senior Secured Credit Agreement): (i) a debt to total capitalization ratio of not more than 27.5 percent (such ratio was 17.6 percent at June 30, 2014); (ii) an interest coverage ratio of not less than 2.50 to 1.00 for each rolling four quarters (or, if less, the number of full fiscal quarters commencing after the effective date of the Senior Secured Credit Agreement) (such ratio was 9.81 to 1.00 for the four quarters ended June 30, 2014); (iii) an aggregate ratio of total adjusted capital to company action level risk-based capital for the Company's insurance subsidiaries of not less than 250 percent (such ratio was 437 percent at June 30, 2014); and (iv) a combined statutory capital and surplus for the Company's insurance subsidiaries of at least $1,300.0 million (combined statutory capital and surplus at June 30, 2014, was $2,057 million).\nUnder the 6.375% Indenture, the Company can make Restricted Payments (as such term is defined in the 6.375% Indenture) up to a calculated limit, provided that the Company's pro forma risk-based capital ratio exceeds 225% after giving effect to the Restricted Payment and certain other conditions are met. Restricted Payments include, among other items, repurchases of common stock and cash dividends on common stock (to the extent such dividends exceed $30 million in the aggregate in any calendar year).\nThe limit of Restricted Payments permitted under the 6.375% Indenture is the sum of (x) 50% of the Company's \"Net Excess Cash Flow\" (as defined in the 6.375% Indenture) for the period (taken as one accounting period) from July 1, 2012 to the end of the Company's most recently ended fiscal quarter for which financial statements are available at the time of such Restricted Payment, (y) $175.0 million and (z) certain other amounts specified in the 6.375% Indenture. Based on the provisions set forth in the 6.375% Indenture and the Company's Net Excess Cash Flow for the period from July 1, 2012 through June 30, 2014, the Company could have made additional Restricted Payments under this 6.375% Indenture covenant of approximately $178 million as of June 30, 2014. This limitation on Restricted Payments does not apply if the Debt to Total Capitalization Ratio (as defined in the 6.375% Indenture) as of the last day of the Company's most recently ended fiscal quarter for which financial statements are available that immediately precedes the date of any Restricted Payment, calculated immediately after giving effect to such Restricted Payment and any related transactions on a pro forma basis, is equal to or less than 17.5%.\nOn May 30, 2014, we repurchased the remaining $3.5 million principal amount of the 7.0% Debentures for a purchase price of $3.7 million and recognized a loss on the extinguishment of debt of $.2 million.\nThe scheduled principal payments on our direct corporate obligations are as follows at June 30, 2014 (dollars in millions):\n| Year ending June 30, | Principal |\n| 2015 | $ | 73.0 |\n| 2016 | 79.3 |\n| 2017 | 23.0 |\n| 2018 | 4.2 |\n| 2019 | 376.0 |\n| 2021 | 275.0 |\n| $ | 830.5 |\n\nOn July 2, 2014, S&P upgraded our issuer credit and senior secured debt ratings to \"BB+\" from \"BB\" and the outlook for these ratings is stable. On July 24, 2013, S&P upgraded such ratings to \"BB\" from \"BB-\". In S&P's view, an obligation rated \"BB\" is less vulnerable to nonpayment than other speculative issues. However, it faces major ongoing uncertainties or exposure to adverse business, financial or economic conditions which could lead to the obligor's inadequate capacity to meet its financial commitment on the obligation. Pluses and minuses show the relative standing within a category. S&P has a total of\n97\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\n22 possible ratings ranging from \"AAA (Extremely Strong)\" to \"D (Payment Default)\". There are ten ratings above CNO's \"BB+\" rating and eleven ratings that are below its rating.\nOn May 5, 2014, Fitch upgraded our issuer credit and senior secured debt ratings to \"BB+\" from \"BB\" and the outlook for these ratings is positive. The rating outlook indicates the direction a rating is likely to move over a one to two year period. In Fitch's view, an obligation rated \"BB\" indicates an elevated vulnerability to default risk, particularly in the event of adverse changes in business or economic conditions over time; however, business or financial flexibility exists which supports the servicing of financial commitments. Pluses and minuses show the relative standing within a category. Fitch has a total of 21 possible ratings ranging from \"AAA\" to \"D\". There are ten ratings above CNO's \"BB+\" rating and ten ratings that are below its rating.\nOn March 27, 2014, Moody's upgraded our issuer credit and senior secured debt ratings to \"Ba2\" from \"Ba3\" and the outlook for these ratings is positive. A positive designation indicates a higher likelihood of a ratings change over the medium term. In Moody's view, obligations rated \"Ba\" are judged to have speculative elements and are subject to substantial credit risk. A rating is supplemented with numerical modifiers \"1\", \"2\" or \"3\" to show the relative standing within a category. Moody's has a total of 21 possible ratings ranging from \"Aaa\" to \"C\". There are eleven ratings above CNO's \"Ba2\" rating and nine ratings that are below its rating.\nWe believe that the existing cash available to the holding company, the cash flows to be generated from operations and other transactions will be sufficient to allow us to meet our debt service obligations, pay corporate expenses and satisfy other financial obligations. Furthermore, our accumulated deficit at June 30, 2014, primarily resulting from the loss on the sale of CLIC recognized in the first quarter of 2014, is not expected to affect our future ability to pay quarterly dividends on our common stock given our expected future profitability and strong financial position. However, our cash flow is affected by a variety of factors, many of which are outside of our control, including insurance regulatory issues, competition, financial markets and other general business conditions. We cannot provide assurance that we will possess sufficient income and liquidity to meet all of our debt service requirements and other holding company obligations.\n98\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nINVESTMENTS\nAt June 30, 2014, the amortized cost, gross unrealized gains and losses and estimated fair value of fixed maturities, available for sale, and equity securities were as follows (dollars in millions):\n| Amortizedcost | Grossunrealizedgains | Grossunrealizedlosses | Estimatedfairvalue |\n| Investment grade (a): |\n| Corporate securities | $ | 11,048.9 | $ | 1,626.9 | $ | (11.3 | ) | $ | 12,664.5 |\n| United States Treasury securities and obligations of United States government corporations and agencies | 149.6 | 10.7 | (.2 | ) | 160.1 |\n| States and political subdivisions | 1,939.2 | 212.9 | (6.0 | ) | 2,146.1 |\n| Asset-backed securities | 715.3 | 46.5 | (.8 | ) | 761.0 |\n| Collateralized debt obligations | 306.5 | 4.9 | (.8 | ) | 310.6 |\n| Commercial mortgage-backed securities | 1,173.9 | 92.5 | (.2 | ) | 1,266.2 |\n| Mortgage pass-through securities | 8.4 | .5 | — | 8.9 |\n| Collateralized mortgage obligations | 593.5 | 24.8 | (.6 | ) | 617.7 |\n| Total investment grade fixed maturities, available for sale | 15,935.3 | 2,019.7 | (19.9 | ) | 17,935.1 |\n| Below-investment grade (a): |\n| Corporate securities | 1,168.5 | 61.1 | (12.5 | ) | 1,217.1 |\n| States and political subdivisions | 5.1 | — | (.3 | ) | 4.8 |\n| Asset-backed securities | 529.2 | 37.7 | (1.8 | ) | 565.1 |\n| Collateralized debt obligations | 13.4 | .3 | (.1 | ) | 13.6 |\n| Collateralized mortgage obligations | 732.3 | 65.9 | (.3 | ) | 797.9 |\n| Total below-investment grade fixed maturities, available for sale | 2,448.5 | 165.0 | (15.0 | ) | 2,598.5 |\n| Total fixed maturities, available for sale | $ | 18,383.8 | $ | 2,184.7 | $ | (34.9 | ) | $ | 20,533.6 |\n| Equity securities | $ | 272.6 | $ | 16.2 | $ | (1.3 | ) | $ | 287.5 |\n\n_______________\n| (a) | Investment ratings – Investment ratings are assigned the second lowest rating by Nationally Recognized Statistical Rating Organizations (\"NRSROs\") (Moody's, S&P or Fitch), or if not rated by such firms, the rating assigned by the National Association of Insurance Commissioners (the \"NAIC\"). NAIC designations of \"1\" or \"2\" include fixed maturities generally rated investment grade (rated \"Baa3\" or higher by Moody's or rated \"BBB-\" or higher by S&P and Fitch). NAIC designations of \"3\" through \"6\" are referred to as below-investment grade (which generally are rated \"Ba1\" or lower by Moody's or rated \"BB+\" or lower by S&P and Fitch). References to investment grade or below-investment grade throughout our consolidated financial statements are determined as described above. |\n\nThe NAIC evaluates the fixed maturity investments of insurers for regulatory and capital assessment purposes and assigns securities to one of six credit quality categories called NAIC designations, which are used by insurers when preparing their annual statements based on statutory accounting principles. The NAIC designations are generally similar to the credit quality designations of the NRSROs for marketable fixed maturity securities, except for certain structured securities. However, certain structured securities rated below investment grade by the NRSROs can be assigned NAIC 1 or NAIC 2 designations dependent on the cost basis of the holding relative to estimated recoverable amounts as determined by the NAIC. The following summarizes the NAIC designations and NRSRO equivalent ratings:\n99\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\n| NAIC Designation | NRSRO Equivalent Rating |\n| 1 | AAA/AA/A |\n| 2 | BBB |\n| 3 | BB |\n| 4 | B |\n| 5 | CCC and lower |\n| 6 | In or near default |\n\nA summary of our fixed maturity securities, available for sale, by NAIC designations (or for fixed maturity securities held by non-regulated entities, based on NRSRO ratings) as of June 30, 2014 is as follows (dollars in millions):\n| NAIC designation | Amortized cost | Estimated fair value | Percentage of total estimated fair value |\n| 1 | $ | 8,985.0 | $ | 10,036.9 | 48.9 | % |\n| 2 | 8,176.4 | 9,223.9 | 44.9 |\n| 3 | 868.2 | 907.2 | 4.4 |\n| 4 | 323.6 | 334.3 | 1.6 |\n| 5 | 30.6 | 31.0 | .2 |\n| 6 | — | .3 | — |\n| $ | 18,383.8 | $ | 20,533.6 | 100.0 | % |\n\n100\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nConcentration of Fixed Maturity Securities, Available for Sale\nThe following table summarizes the carrying values and gross unrealized losses of our fixed maturity securities, available for sale, by category as of June 30, 2014 (dollars in millions):\n| Carrying value | Percent of fixed maturities | Gross unrealized losses | Percent of gross unrealized losses |\n| States and political subdivisions | $ | 2,150.9 | 10.5 | % | $ | 6.3 | 17.8 | % |\n| Energy/pipelines | 2,127.6 | 10.4 | 3.0 | 8.6 |\n| Utilities | 1,698.6 | 8.3 | .2 | .5 |\n| Collateralized mortgage obligations | 1,415.6 | 6.9 | .9 | 2.5 |\n| Insurance | 1,390.9 | 6.8 | .2 | .6 |\n| Asset-backed securities | 1,326.1 | 6.5 | 2.6 | 7.5 |\n| Commercial mortgage-backed securities | 1,266.2 | 6.2 | .2 | .6 |\n| Healthcare/pharmaceuticals | 1,131.3 | 5.5 | 2.8 | 8.0 |\n| Food/beverage | 932.6 | 4.5 | 2.5 | 7.2 |\n| Cable/media | 826.2 | 4.0 | 2.8 | 8.1 |\n| Real estate/REITs | 728.5 | 3.5 | .1 | .2 |\n| Banks | 665.9 | 3.2 | .3 | .7 |\n| Capital goods | 574.5 | 2.8 | — | — |\n| Aerospace/defense | 401.6 | 1.9 | — | — |\n| Chemicals | 380.2 | 1.9 | 1.1 | 3.0 |\n| Transportation | 372.7 | 1.8 | — | — |\n| Telecom | 368.2 | 1.8 | .1 | .3 |\n| Collateralized debt obligations | 324.2 | 1.6 | .9 | 2.7 |\n| Building materials | 313.8 | 1.5 | 3.7 | 10.5 |\n| Metals and mining | 281.9 | 1.4 | .9 | 2.6 |\n| Paper | 270.5 | 1.3 | .1 | .3 |\n| Brokerage | 234.5 | 1.1 | — | .1 |\n| Technology | 231.2 | 1.1 | — | .1 |\n| Business services | 228.6 | 1.1 | 5.4 | 15.5 |\n| Other | 891.2 | 4.4 | .8 | 2.6 |\n| Total fixed maturities, available for sale | $ | 20,533.5 | 100.0 | % | $ | 34.9 | 100.0 | % |\n\nBelow-Investment Grade Securities\nAt June 30, 2014, the amortized cost of the Company's below-investment grade fixed maturity securities was $2,448.5 million, or 13 percent of the Company's fixed maturity portfolio. The estimated fair value of the below-investment grade portfolio was $2,598.5 million, or 106 percent of the amortized cost.\nBelow-investment grade corporate debt securities typically have different characteristics than investment grade corporate debt securities. Based on historical performance, probability of default by the borrower is significantly greater for below-investment grade corporate debt securities and in many cases severity of loss is relatively greater as such securities are generally unsecured and often subordinated to other indebtedness of the issuer. Also, issuers of below-investment grade corporate debt securities frequently have higher levels of debt relative to investment-grade issuers, hence, all other things being equal, are generally more sensitive to adverse economic conditions. The Company attempts to reduce the overall risk related to its investment in below-investment grade securities, as in all investments, through careful credit analysis, strict investment policy guidelines, and diversification by issuer and/or guarantor and by industry.\n101\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nNet Realized Investment Gains (Losses)\nThe following table sets forth the net realized investment gains (losses) for the periods indicated (dollars in millions):\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Fixed maturity securities, available for sale: |\n| Gross realized gains on sale | $ | 4.9 | $ | 10.8 | $ | 46.4 | $ | 27.4 |\n| Gross realized losses on sale | (3.0 | ) | (1.4 | ) | (8.5 | ) | (3.4 | ) |\n| Impairments: |\n| Total other-than-temporary impairment losses | — | — | — | — |\n| Other-than-temporary impairment losses recognized in accumulated other comprehensive income | — | — | — | — |\n| Net impairment losses recognized | — | — | — | — |\n| Net realized investment gains from fixed maturities | 1.9 | 9.4 | 37.9 | 24.0 |\n| Equity securities | 7.9 | — | 7.9 | — |\n| Commercial mortgage loans | 1.1 | — | 1.1 | .7 |\n| Impairments of mortgage loans and other investments | — | (.6 | ) | (11.9 | ) | (.6 | ) |\n| Other | 1.5 | (5.6 | ) | .8 | (5.6 | ) |\n| Net realized investment gains | $ | 12.4 | $ | 3.2 | $ | 35.8 | $ | 18.5 |\n\nDuring the first six months of 2014, we recognized net realized investment gains of $35.8 million, which were comprised of $41.8 million of net gains from the sales of investments (primarily fixed maturities) with proceeds of $1.4 billion, the increase in fair value of certain fixed maturity investments with embedded derivatives of $5.9 million and $11.9 million of writedowns of investments for other than temporary declines in fair value recognized through net income.\nDuring the first six months of 2013, we recognized net realized investment gains of $18.5 million, which were comprised of $29.6 million of net gains from the sales of investments (primarily fixed maturities) with proceeds of $.9 billion and the decrease in fair value of certain fixed maturity investments with embedded derivatives of $10.5 million and $.6 million of writedowns of investments for other than temporary declines in fair value recognized through net income.\nAt June 30, 2014, fixed maturity securities in default or considered nonperforming had an aggregate amortized cost and a carrying value of nil and $.5 million, respectively.\nDuring the first six months of 2014, the $8.5 million of realized losses on sales of $156.9 million of fixed maturity securities, available for sale, included: (i) $.5 million of losses related to the sales of securities issued by state and political subdivisions; and (ii) $8.0 million of additional losses related to various corporate securities. Securities are generally sold at a loss following unforeseen issue-specific events or conditions or shifts in perceived risks. These reasons include but are not limited to: (i) changes in the investment environment; (ii) expectation that the market value could deteriorate further; (iii) desire to reduce our exposure to an asset class, an issuer or an industry; (iv) prospective or actual changes in credit quality; or (v) changes in expected cash flows.\nDuring the first six months of 2013, the $3.4 million of realized losses on sales of $181.3 million of fixed maturity securities, available for sale, included: (i) $1.0 million of losses related to the sales of mortgage-backed securities and asset-backed securities; and (ii) $2.4 million of additional losses primarily related to various corporate securities.\nOur fixed maturity investments are generally purchased in the context of various long-term strategies, including funding insurance liabilities, so we do not generally seek to generate short-term realized gains through the purchase and sale of such securities. In certain circumstances, including those in which securities are selling at prices which exceed our view of their\n102\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nunderlying economic value, or when it is possible to reinvest the proceeds to better meet our long-term asset-liability objectives, we may sell certain securities.\nWe regularly evaluate all of our investments with unrealized losses for possible impairment. Our assessment of whether unrealized losses are \"other than temporary\" requires significant judgment. Factors considered include: (i) the extent to which fair value is less than the cost basis; (ii) the length of time that the fair value has been less than cost; (iii) whether the unrealized loss is event driven, credit-driven or a result of changes in market interest rates or risk premium; (iv) the near-term prospects for specific events, developments or circumstances likely to affect the value of the investment; (v) the investment's rating and whether the investment is investment-grade and/or has been downgraded since its purchase; (vi) whether the issuer is current on all payments in accordance with the contractual terms of the investment and is expected to meet all of its obligations under the terms of the investment; (vii) whether we intend to sell the investment or it is more likely than not that circumstances will require us to sell the investment before recovery occurs; (viii) the underlying current and prospective asset and enterprise values of the issuer and the extent to which the recoverability of the carrying value of our investment may be affected by changes in such values; (ix) projections of, and unfavorable changes in, cash flows on structured securities including mortgage-backed and asset-backed securities; (x) our best estimate of the value of any collateral; and (xi) other objective and subjective factors.\nFuture events may occur, or additional information may become available, which may necessitate future realized losses in our portfolio. Significant losses could have a material adverse effect on our consolidated financial statements in future periods.\nThe following table sets forth the amortized cost and estimated fair value of those fixed maturities, available for sale, with unrealized losses at June 30, 2014, by contractual maturity. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without penalties. Structured securities frequently include provisions for periodic principal payments and permit periodic unscheduled payments.\n| Amortizedcost | Estimatedfairvalue |\n| (Dollars in millions) |\n| Due in one year or less | $ | 1.7 | $ | 1.7 |\n| Due after one year through five years | 46.7 | 46.5 |\n| Due after five years through ten years | 167.2 | 163.2 |\n| Due after ten years | 569.2 | 543.1 |\n| Subtotal | 784.8 | 754.5 |\n| Structured securities | 388.0 | 383.4 |\n| Total | $ | 1,172.8 | $ | 1,137.9 |\n\nThe following summarizes the investments in our portfolio rated below-investment grade which have been continuously in an unrealized loss position exceeding 20 percent of the cost basis for the period indicated as of June 30, 2014 (dollars in millions):\n| Costbasis | Unrealizedloss | Estimatedfair value |\n| Greater than or equal to 6 months and less than 12 months | $ | 4.4 | $ | (.9 | ) | $ | 3.5 |\n| Greater than 12 months | 19.5 | (4.5 | ) | 15.0 |\n| $ | 23.9 | $ | (5.4 | ) | $ | 18.5 |\n\nThe investments summarized above were issued by one company.\n103\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nThe following table summarizes the gross unrealized losses of our fixed maturity securities, available for sale, by category and ratings category as of June 30, 2014 (dollars in millions):\n| Investment grade | Below-investment grade |\n| AAA/AA/A | BBB | BB | B+ andbelow | Total grossunrealizedlosses |\n| States and political subdivisions | $ | 2.5 | $ | 3.5 | $ | .3 | $ | — | $ | 6.3 |\n| Business services | — | — | 5.4 | — | 5.4 |\n| Building materials | — | — | 3.7 | — | 3.7 |\n| Energy/pipelines | — | 2.0 | .1 | .9 | 3.0 |\n| Cable/media | — | 2.6 | .2 | — | 2.8 |\n| Healthcare/pharmaceuticals | — | 2.8 | — | — | 2.8 |\n| Asset-backed securities | .2 | .6 | .4 | 1.4 | 2.6 |\n| Food/beverage | .6 | .3 | 1.6 | — | 2.5 |\n| Chemicals | — | 1.1 | — | — | 1.1 |\n| Collateralized debt obligations | .4 | .4 | .1 | — | .9 |\n| Metals and mining | — | .6 | .3 | — | .9 |\n| Collateralized mortgage obligations | .5 | .1 | .2 | .1 | .9 |\n| Retail | — | .5 | — | — | .5 |\n| Banks | .2 | .1 | — | — | .3 |\n| Commercial mortgage-backed securities | — | .2 | — | — | .2 |\n| Insurance | — | .2 | — | — | .2 |\n| United States Treasury securities and obligations of United States government corporations and agencies | .2 | — | — | — | .2 |\n| Utilities | — | .2 | — | — | .2 |\n| Consumer products | — | — | .1 | — | .1 |\n| Telecom | .1 | — | — | — | .1 |\n| Paper | — | — | — | .1 | .1 |\n| Real estate/REITs | — | — | .1 | — | .1 |\n| Total fixed maturities, available for sale | $ | 4.7 | $ | 15.2 | $ | 12.5 | $ | 2.5 | $ | 34.9 |\n\nOur investment strategy is to maximize, over a sustained period and within acceptable parameters of quality and risk, investment income and total investment return through active investment management. Accordingly, we may sell securities at a gain or a loss to enhance the projected total return of the portfolio as market opportunities change, to reflect changing perceptions of risk, or to better match certain characteristics of our investment portfolio with the corresponding characteristics of our insurance liabilities.\n104\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nThe following table summarizes the gross unrealized losses and fair values of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that such securities have been in a continuous unrealized loss position, at June 30, 2014 (dollars in millions):\n| Less than 12 months | 12 months or greater | Total |\n| Description of securities | Fairvalue | Unrealizedlosses | Fairvalue | Unrealizedlosses | Fairvalue | Unrealizedlosses |\n| United States Treasury securities and obligations of United States government corporations and agencies | $ | — | $ | — | $ | 18.4 | $ | (.2 | ) | $ | 18.4 | $ | (.2 | ) |\n| States and political subdivisions | 15.6 | (.6 | ) | 124.1 | (5.7 | ) | 139.7 | (6.3 | ) |\n| Corporate securities | 173.3 | (1.1 | ) | 423.2 | (22.7 | ) | 596.5 | (23.8 | ) |\n| Asset-backed securities | 76.9 | (.5 | ) | 91.5 | (2.1 | ) | 168.4 | (2.6 | ) |\n| Collateralized debt obligations | 64.2 | (.7 | ) | 11.7 | (.2 | ) | 75.9 | (.9 | ) |\n| Commercial mortgage-backed securities | 14.8 | — | 19.2 | (.2 | ) | 34.0 | (.2 | ) |\n| Mortgage pass-through securities | 1.2 | — | .8 | — | 2.0 | — |\n| Collateralized mortgage obligations | 82.4 | (.4 | ) | 20.6 | (.5 | ) | 103.0 | (.9 | ) |\n| Total fixed maturities, available for sale | $ | 428.4 | $ | (3.3 | ) | $ | 709.5 | $ | (31.6 | ) | $ | 1,137.9 | $ | (34.9 | ) |\n| Equity securities | $ | 34.3 | $ | (.4 | ) | $ | 20.3 | $ | (.9 | ) | $ | 54.6 | $ | (1.3 | ) |\n\nBased on management's current assessment of investments with unrealized losses at June 30, 2014, the Company believes the issuers of the securities will continue to meet their obligations (or with respect to equity-type securities, the investment value will recover to its cost basis). While we do not have the intent to sell securities with unrealized losses and it is not more likely than not that we will be required to sell securities with unrealized losses prior to their anticipated recovery, our intent on an individual security may change, based upon market or other unforeseen developments. In such instances, if a loss is recognized from a sale subsequent to a balance sheet date due to these unexpected developments, the loss is recognized in the period in which we had the intent to sell the security before its anticipated recovery.\nStructured Securities\nAt June 30, 2014 fixed maturity investments included structured securities with an estimated fair value of $4.3 billion (or 21.1 percent of all fixed maturity securities). The yield characteristics of structured securities generally differ in some respects from those of traditional corporate fixed-income securities or government securities. For example, interest and principal payments on structured securities may occur more frequently, often monthly. In many instances, we are subject to variability in the amount and timing of principal and interest payments. For example, in many cases, partial prepayments may occur at the option of the issuer and prepayment rates are influenced by a number of factors that cannot be predicted with certainty, including: the relative sensitivity of prepayments on the underlying assets backing the security to changes in interest rates and asset values; the availability of alternative financing; a variety of economic, geographic and other factors; the timing, pace and proceeds of liquidations of defaulted collateral; and various security-specific structural considerations (for example, the repayment priority of a given security in a securitization structure). In addition, the total amount of payments for non-agency structured securities may be affected by changes to cumulative default rates or loss severities of the related collateral.\n105\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nThe following table sets forth the par value, amortized cost and estimated fair value of structured securities, summarized by interest rates on the underlying collateral, at June 30, 2014 (dollars in millions):\n| Parvalue | Amortizedcost | Estimatedfair value |\n| Below 4 percent | $ | 1,154.4 | $ | 949.7 | $ | 975.2 |\n| 4 percent – 5 percent | 707.1 | 664.5 | 700.4 |\n| 5 percent – 6 percent | 1,914.3 | 1,785.4 | 1,924.2 |\n| 6 percent – 7 percent | 588.7 | 547.8 | 602.3 |\n| 7 percent – 8 percent | 94.7 | 96.3 | 109.4 |\n| 8 percent and above | 28.0 | 28.8 | 29.5 |\n| Total structured securities | $ | 4,487.2 | $ | 4,072.5 | $ | 4,341.0 |\n\nThe amortized cost and estimated fair value of structured securities at June 30, 2014, summarized by type of security, were as follows (dollars in millions):\n| Estimated fair value |\n| Type | Amortizedcost | Amount | Percentof fixedmaturities |\n| Pass-throughs, sequential and equivalent securities | $ | 1,058.0 | $ | 1,127.8 | 5.5 | % |\n| Planned amortization classes, target amortization classes and accretion-directed bonds | 243.1 | 263.7 | 1.3 |\n| Commercial mortgage-backed securities | 1,173.9 | 1,266.2 | 6.1 |\n| Asset-backed securities | 1,244.5 | 1,326.1 | 6.4 |\n| Collateralized debt obligations | 319.9 | 324.2 | 1.6 |\n| Other | 33.1 | 33.0 | .2 |\n| Total structured securities | $ | 4,072.5 | $ | 4,341.0 | 21.1 | % |\n\nPass-throughs, sequentials and equivalent securities have unique prepayment variability characteristics. Pass-through securities typically return principal to the holders based on cash payments from the underlying mortgage obligations. Sequential securities return principal to tranche holders in a detailed hierarchy. Planned amortization classes, targeted amortization classes and accretion-directed bonds adhere to fixed schedules of principal payments as long as the underlying mortgage loans experience prepayments within certain estimated ranges. In most circumstances, changes in prepayment rates are first absorbed by support or companion classes insulating the timing of receipt of cash flows from the consequences of both faster prepayments (average life shortening) and slower prepayments (average life extension).\nCommercial mortgage-backed securities are secured by commercial real estate mortgages, generally income producing properties that are managed for profit. Property types include multi-family dwellings including apartments, retail centers, hotels, restaurants, hospitals, nursing homes, warehouses, and office buildings. While most commercial mortgage-backed securities have call protection features whereby underlying borrowers may not prepay their mortgages for stated periods of time without incurring prepayment penalties, recoveries on defaulted collateral may result in involuntary prepayments.\n106\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nCommercial Mortgage Loans\nThe following table provides the carrying value and estimated fair value of our outstanding mortgage loans and the underlying collateral as of June 30, 2014 (dollars in millions):\n| Estimated fairvalue |\n| Loan-to-value ratio (a) | Carrying value | Mortgage loans | Collateral |\n| Less than 60% | $ | 597.6 | $ | 627.9 | $ | 1,403.9 |\n| 60% to 70% | 396.4 | 408.2 | 611.8 |\n| Greater than 70% to 80% | 439.4 | 445.4 | 593.7 |\n| Greater than 80% to 90% | 138.0 | 143.5 | 160.3 |\n| Greater than 90% | 24.5 | 22.1 | 27.0 |\n| Total | $ | 1,595.9 | $ | 1,647.1 | $ | 2,796.7 |\n\n________________\n| (a) | Loan-to-value ratios are calculated as the ratio of: (i) the carrying value of the commercial mortgage loans; to (ii) the estimated fair value of the underlying collateral. |\n\nINVESTMENTS IN VARIABLE INTEREST ENTITIES\nThe following table provides supplemental information about the revenues and expenses of the VIEs which have been consolidated in accordance with authoritative guidance, after giving effect to the elimination of our investment in the VIEs and investment management fees earned by a subsidiary of the Company (dollars in millions):\n| Three months ended | Six months ended |\n| June 30, | June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Revenues: |\n| Net investment income – policyholder and reinsurer accounts and other special-purpose portfolios | $ | 10.5 | $ | 10.9 | $ | 20.9 | $ | 20.4 |\n| Fee revenue and other income | .1 | .5 | .2 | 1.3 |\n| Total revenues | 10.6 | 11.4 | 21.1 | 21.7 |\n| Expenses: |\n| Interest expense | 6.4 | 6.8 | 12.9 | 12.2 |\n| Other operating expenses | .4 | .8 | .6 | .9 |\n| Total expenses | 6.8 | 7.6 | 13.5 | 13.1 |\n| Income before net realized investment losses and income taxes | 3.8 | 3.8 | 7.6 | 8.6 |\n| Net realized investment losses | — | (.4 | ) | (2.0 | ) | (.3 | ) |\n| Income before income taxes | $ | 3.8 | $ | 3.4 | $ | 5.6 | $ | 8.3 |\n\nDuring the first six months of 2014, we recognized net realized investment losses on the VIE investments of $2.0 million. During the first six months of 2013, we recognized net realized investment losses on the VIE investments of $.3 million, which were comprised of $.3 million of net gains from the sales of fixed maturities, and $.6 million of writedowns of investments for other than temporary declines in fair value recognized through net income.\n107\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nSupplemental Information on Investments Held by VIEs\nThe following table summarizes the carrying values of the investments held by the VIEs by category as of June 30, 2014 (dollars in millions):\n| Carrying value | Percentof fixedmaturities | Grossunrealizedlosses | Percent ofgrossunrealizedlosses |\n| Cable/media | $ | 135.4 | 10.9 | % | $ | .7 | 20.0 | % |\n| Healthcare/pharmaceuticals | 120.5 | 9.7 | .1 | 2.3 |\n| Technology | 118.0 | 9.5 | .3 | 6.7 |\n| Food/beverage | 107.3 | 8.6 | .2 | 6.3 |\n| Autos | 87.0 | 7.0 | .2 | 4.3 |\n| Energy/pipelines | 54.0 | 4.4 | .2 | 4.9 |\n| Entertainment/hotels | 50.8 | 4.1 | .2 | 4.7 |\n| Capital goods | 49.4 | 4.0 | — | .7 |\n| Utilities | 47.2 | 3.8 | .4 | 11.0 |\n| Brokerage | 45.8 | 3.7 | .4 | 10.7 |\n| Paper | 44.8 | 3.6 | .1 | 1.6 |\n| Aerospace/defense | 44.0 | 3.6 | .2 | 3.8 |\n| Consumer products | 40.2 | 3.2 | — | 1.0 |\n| Chemicals | 37.5 | 3.0 | — | 1.2 |\n| Building materials | 35.8 | 2.9 | — | .8 |\n| Transportation | 33.8 | 2.7 | .1 | 3.8 |\n| Gaming | 29.8 | 2.4 | .1 | 2.6 |\n| Insurance | 27.2 | 2.2 | .1 | 2.2 |\n| Retail | 25.8 | 2.1 | .1 | 3.5 |\n| Metals and mining | 23.8 | 1.9 | — | .4 |\n| Real estate/REITs | 16.8 | 1.4 | .1 | 2.2 |\n| Telecom | 10.9 | .9 | .1 | 3.4 |\n| Textiles | 5.3 | .4 | — | .4 |\n| Other | 50.0 | 4.0 | .1 | 1.5 |\n| Total | $ | 1,241.1 | 100.0 | % | $ | 3.7 | 100.0 | % |\n\n108\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nThe following table sets forth the amortized cost and estimated fair value of those investments held by the VIEs with unrealized losses at June 30, 2014, by contractual maturity. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without penalties.\n| Amortizedcost | Estimatedfairvalue |\n| (Dollars in millions) |\n| Due in one year or less | $ | 2.0 | $ | 2.0 |\n| Due after one year through five years | 143.1 | 142.3 |\n| Due after five years through ten years | 483.9 | 481.0 |\n| Total | $ | 629.0 | $ | 625.3 |\n\nThere were no investments held by the VIEs rated below-investment grade which had been continuously in an unrealized loss position exceeding 20 percent of the cost basis as of June 30, 2014.\nNEW ACCOUNTING STANDARDS\nSee \"Recently Issued Accounting Standards\" in the notes to consolidated financial statements for a discussion of recently issued accounting standards.\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.\nOur market risks, and the ways we manage them, are summarized in \"Management's Discussion and Analysis of Financial Condition and Results of Operations\", included in our Annual Report on Form 10-K for the year ended December 31, 2013. There have been no material changes in the first six months of 2014 to such risks or our management of such risks.\nITEM 4. CONTROLS AND PROCEDURES.\nEvaluation of Disclosure Controls and Procedures. CNO's management, under the supervision and with the participation of the Chief Executive Officer and the Chief Financial Officer, evaluated the effectiveness of CNO's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended). Based on its evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of June 30, 2014, CNO's disclosure controls and procedures were effective to ensure that information required to be disclosed by CNO in reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. Disclosure controls and procedures are also designed to reasonably assure that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.\nChanges to Internal Control Over Financial Reporting. There were no changes in the Company's internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934) during the three months ended June 30, 2014, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n109\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nPART II - OTHER INFORMATION\nITEM 1. LEGAL PROCEEDINGS.\nInformation required for Part II, Item 1 is incorporated by reference to the discussion under the heading \"Litigation and Other Legal Proceedings\" in the footnotes to our consolidated financial statements included in Part I, Item 1 of this Form 10-Q.\nITEM 1A. RISK FACTORS.\nCNO and its businesses are subject to a number of risks including general business and financial risk factors. Any or all of such factors could have a material adverse effect on the business, financial condition or results of operations of CNO. Refer to \"Risk Factors\" in our Annual Report on Form 10-K for the year ended December 31, 2013, for further discussion of such risk factors. There have been no material changes from such previously disclosed risk factors.\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.\nIssuer Purchases of Equity Securities\n| Period | Total number of shares (or units) | Average price paid per share (or unit) | Total number of shares (or units) purchased as part of publicly announced plans or programs | Maximum number (or approximate dollar value) of shares (or units) that may yet be purchased under the plans or programs (a) |\n| (dollars in millions) |\n| April 1 through April 30 | 1,773,127 | $ | 17.58 | 1,773,127 | $ | 325.2 |\n| May 1 through May 31 | 2,108,666 | 16.34 | 2,108,279 | 290.8 |\n| June 1 through June 30 | 1,754,658 | 17.12 | 1,751,858 | 260.8 |\n| Total | 5,636,451 | 16.97 | 5,633,264 | 260.8 |\n\n_________________\n| (a) | In May 2011, the Company announced a securities repurchase program of up to $100.0 million. In February 2012, June 2012, December 2012 and December 2013, the Company's Board of Directors approved, in aggregate, an additional $800.0 million to repurchase the Company's outstanding securities. |\n\n110\nCNO FINANCIAL GROUP, INC. AND SUBSIDIARIES___________________\nITEM 1. LEGAL PROCEEDINGS.\nInformation required for Part II, Item 1 is incorporated by reference to the discussion under the heading \"Litigation and Other Legal Proceedings\" in the footnotes to our consolidated financial statements included in Part I, Item 1 of this Form 10-Q.\nITEM 6. EXHIBITS.\n| 12.1 | Computation of Ratio of Earnings to Fixed Charges. |\n| 31.1 | Certification Pursuant to the Securities Exchange Act Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2 | Certification Pursuant to the Securities Exchange Act Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32.1 | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 32.2 | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 101.INS | XBRL Instance Document. |\n| 101.SCH | XBRL Taxonomy Extension Schema Document. |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document. |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document. |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document. |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document. |\n\n111\nSIGNATURE\nPursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\nCNO FINANCIAL GROUP, INC.\nDated: August 5, 2014\n| By: | /s/ Frederick J. Crawford |\n| Frederick J. Crawford |\n| Executive Vice President and Chief Financial Officer |\n| (authorized officer and principal financial officer) |\n\n112\n</text>\n\nWhat is the total percentage change in the collected premiums by product type (Medicare supplement, Life insurance, and health insurance) from the second quarter of 2013 to the second quarter of 2014?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"ground_truth": "Therefore, the answer is 3.9903125223748517."
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docmath_40000_plus
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1.\nFinancial Statements.\nHYATT HOTELS CORPORATION AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENTS OF INCOME (LOSS)\n(In millions of dollars, except per share amounts)\n(Unaudited)\n| Three Months Ended | Six Months Ended |\n| June 30, 2022 | June 30, 2021 | June 30, 2022 | June 30, 2021 |\n| REVENUES: |\n| Owned and leased hotels | $ | 331 | $ | 191 | $ | 602 | $ | 295 |\n| Management, franchise, and other fees | 204 | 93 | 358 | 156 |\n| Contra revenue | ( 9 ) | ( 9 ) | ( 18 ) | ( 17 ) |\n| Net management, franchise, and other fees | 195 | 84 | 340 | 139 |\n| Distribution and destination management | 256 | — | 502 | — |\n| Other revenues | 61 | 22 | 138 | 41 |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties | 640 | 366 | 1,180 | 626 |\n| Total revenues | 1,483 | 663 | 2,762 | 1,101 |\n| DIRECT AND SELLING, GENERAL, AND ADMINISTRATIVE EXPENSES: |\n| Owned and leased hotels | 229 | 174 | 439 | 298 |\n| Distribution and destination management | 206 | — | 400 | — |\n| Depreciation and amortization | 105 | 74 | 224 | 148 |\n| Other direct costs | 69 | 24 | 136 | 47 |\n| Selling, general, and administrative | 76 | 86 | 187 | 181 |\n| Costs incurred on behalf of managed and franchised properties | 628 | 375 | 1,184 | 652 |\n| Direct and selling, general, and administrative expenses | 1,313 | 733 | 2,570 | 1,326 |\n| Net gains (losses) and interest income from marketable securities held to fund rabbi trusts | ( 46 ) | 24 | ( 77 ) | 36 |\n| Equity earnings (losses) from unconsolidated hospitality ventures | 1 | ( 34 ) | ( 8 ) | 20 |\n| Interest expense | ( 38 ) | ( 42 ) | ( 78 ) | ( 83 ) |\n| Gains on sales of real estate | 251 | 105 | 251 | 105 |\n| Asset impairments | ( 7 ) | ( 2 ) | ( 10 ) | ( 2 ) |\n| Other income (loss), net | ( 19 ) | 25 | ( 29 ) | 37 |\n| INCOME (LOSS) BEFORE INCOME TAXES | 312 | 6 | 241 | ( 112 ) |\n| PROVISION FOR INCOME TAXES | ( 106 ) | ( 15 ) | ( 108 ) | ( 201 ) |\n| NET INCOME (LOSS) | 206 | ( 9 ) | 133 | ( 313 ) |\n| NET INCOME (LOSS) ATTRIBUTABLE TO NONCONTROLLING INTERESTS | — | — | — | — |\n| NET INCOME (LOSS) ATTRIBUTABLE TO HYATT HOTELS CORPORATION | $ | 206 | $ | ( 9 ) | $ | 133 | $ | ( 313 ) |\n| EARNINGS (LOSSES) PER SHARE—Basic |\n| Net income (loss) | $ | 1.88 | $ | ( 0.08 ) | $ | 1.21 | $ | ( 3.07 ) |\n| Net income (loss) attributable to Hyatt Hotels Corporation | $ | 1.88 | $ | ( 0.08 ) | $ | 1.21 | $ | ( 3.07 ) |\n| EARNINGS (LOSSES) PER SHARE—Diluted |\n| Net income (loss) | $ | 1.85 | $ | ( 0.08 ) | $ | 1.19 | $ | ( 3.07 ) |\n| Net income (loss) attributable to Hyatt Hotels Corporation | $ | 1.85 | $ | ( 0.08 ) | $ | 1.19 | $ | ( 3.07 ) |\n\nSee accompanying Notes to condensed consolidated financial statements.\n1\nHYATT HOTELS CORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)(In millions of dollars)(Unaudited)\n| Three Months Ended | Six Months Ended |\n| June 30, 2022 | June 30, 2021 | June 30, 2022 | June 30, 2021 |\n| Net income (loss) | $ | 206 | $ | ( 9 ) | $ | 133 | $ | ( 313 ) |\n| Other comprehensive income (loss), net of taxes: |\n| Foreign currency translation adjustments, net of tax of $ — for the three and six months ended June 30, 2022 and June 30, 2021 | ( 34 ) | 17 | ( 13 ) | ( 29 ) |\n| Unrealized gains on derivative activity, net of tax of $ — for the three and six months ended June 30, 2022 and June 30, 2021 | 1 | 2 | 3 | 4 |\n| Unrecognized pension benefit, net of tax of $ — for the three and six months ended June 30, 2022 and June 30, 2021 | 2 | — | — | — |\n| Unrealized losses on available-for-sale debt securities, net of tax of $ — for the three and six months ended June 30, 2022 and June 30, 2021 | ( 3 ) | — | ( 10 ) | ( 1 ) |\n| Other comprehensive income (loss) | ( 34 ) | 19 | ( 20 ) | ( 26 ) |\n| COMPREHENSIVE INCOME (LOSS) | 172 | 10 | 113 | ( 339 ) |\n| COMPREHENSIVE INCOME (LOSS) ATTRIBUTABLE TO NONCONTROLLING INTERESTS | — | — | — | — |\n| COMPREHENSIVE INCOME (LOSS) ATTRIBUTABLE TO HYATT HOTELS CORPORATION | $ | 172 | $ | 10 | $ | 113 | $ | ( 339 ) |\n\nSee accompanying Notes to condensed consolidated financial statements.\n2\nHYATT HOTELS CORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATED BALANCE SHEETS(In millions of dollars, except share and per share amounts)(Unaudited)\n| June 30, 2022 | December 31, 2021 |\n| ASSETS |\n| CURRENT ASSETS: |\n| Cash and cash equivalents | $ | 1,428 | $ | 960 |\n| Restricted cash | 53 | 57 |\n| Short-term investments | 527 | 227 |\n| Receivables, net of allowances of $ 59 and $ 53 at June 30, 2022 and December 31, 2021, respectively | 699 | 633 |\n| Inventories | 8 | 10 |\n| Prepaids and other assets | 159 | 149 |\n| Prepaid income taxes | 18 | 26 |\n| Total current assets | 2,892 | 2,062 |\n| Equity method investments | 185 | 216 |\n| Property and equipment, net | 2,286 | 2,848 |\n| Financing receivables, net of allowances of $ 60 and $ 69 at June 30, 2022 and December 31, 2021, respectively | 63 | 41 |\n| Operating lease right-of-use assets | 377 | 446 |\n| Goodwill | 3,080 | 2,965 |\n| Intangibles, net | 1,810 | 1,977 |\n| Deferred tax assets | 12 | 14 |\n| Other assets | 1,945 | 2,034 |\n| TOTAL ASSETS | $ | 12,650 | $ | 12,603 |\n| LIABILITIES AND EQUITY |\n| CURRENT LIABILITIES: |\n| Current maturities of long-term debt | $ | 6 | $ | 10 |\n| Accounts payable | 554 | 523 |\n| Accrued expenses and other current liabilities | 392 | 299 |\n| Current contract liabilities | 1,280 | 1,178 |\n| Accrued compensation and benefits | 144 | 187 |\n| Current operating lease liabilities | 35 | 35 |\n| Total current liabilities | 2,411 | 2,232 |\n| Long-term debt | 3,798 | 3,968 |\n| Long-term contract liabilities | 1,463 | 1,349 |\n| Long-term operating lease liabilities | 294 | 349 |\n| Other long-term liabilities | 1,072 | 1,139 |\n| Total liabilities | 9,038 | 9,037 |\n| Commitments and contingencies (see Note 12) |\n| EQUITY: |\n| Preferred stock, $ 0.01 par value per share, 10,000,000 shares authorized and none outstanding at June 30, 2022 and December 31, 2021 | — | — |\n| Class A common stock, $ 0.01 par value per share, 1,000,000,000 shares authorized, 50,096,332 issued and outstanding at June 30, 2022, and Class B common stock, $ 0.01 par value per share, 391,012,161 shares authorized, 59,017,749 shares issued and outstanding at June 30, 2022. Class A common stock, $ 0.01 par value per share, 1,000,000,000 shares authorized, 50,322,050 issued and outstanding at December 31, 2021, and Class B common stock, $ 0.01 par value per share, 391,647,683 shares authorized, 59,653,271 shares issued and outstanding at December 31, 2021 | 1 | 1 |\n| Additional paid-in capital | 573 | 640 |\n| Retained earnings | 3,300 | 3,167 |\n| Accumulated other comprehensive loss | ( 265 ) | ( 245 ) |\n| Total stockholders' equity | 3,609 | 3,563 |\n| Noncontrolling interests in consolidated subsidiaries | 3 | 3 |\n| Total equity | 3,612 | 3,566 |\n| TOTAL LIABILITIES AND EQUITY | $ | 12,650 | $ | 12,603 |\n\nSee accompanying Notes to condensed consolidated financial statements.\n3\nHYATT HOTELS CORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(In millions of dollars)(Unaudited)\n| Six Months Ended |\n| June 30, 2022 | June 30, 2021 |\n| CASH FLOWS FROM OPERATING ACTIVITIES: |\n| Net income (loss) | $ | 133 | $ | ( 313 ) |\n| Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |\n| Depreciation and amortization | 224 | 148 |\n| Gains on sales of real estate | ( 251 ) | ( 105 ) |\n| Amortization of share awards | 44 | 41 |\n| Amortization of operating lease right-of-use assets | 17 | 14 |\n| Deferred income taxes | ( 2 ) | 203 |\n| Asset impairments | 10 | 2 |\n| Equity (earnings) losses from unconsolidated hospitality ventures | 8 | ( 20 ) |\n| Loss on extinguishment of debt | 8 | — |\n| Contra revenue | 18 | 17 |\n| Unrealized (gains) losses, net | 44 | ( 13 ) |\n| Working capital changes and other | 130 | ( 32 ) |\n| Net cash provided by (used in) operating activities | 383 | ( 58 ) |\n| CASH FLOWS FROM INVESTING ACTIVITIES: |\n| Purchases of marketable securities and short-term investments | ( 662 ) | ( 603 ) |\n| Proceeds from marketable securities and short-term investments | 387 | 663 |\n| Contributions to equity method and other investments | ( 5 ) | ( 24 ) |\n| Return of equity method and other investments | 23 | 25 |\n| Acquisitions, net of cash acquired | ( 39 ) | ( 230 ) |\n| Capital expenditures | ( 104 ) | ( 37 ) |\n| Issuance of financing receivables | ( 10 ) | ( 8 ) |\n| Proceeds from sales of real estate, net of cash disposed | 591 | 268 |\n| Other investing activities | 20 | ( 7 ) |\n| Net cash provided by investing activities | 201 | 47 |\n| CASH FLOWS FROM FINANCING ACTIVITIES: |\n| Repayments and repurchases of debt | ( 16 ) | ( 2 ) |\n| Repurchases of common stock | ( 101 ) | — |\n| Utilization of restricted cash for legal defeasance of Series 2005 Bonds | ( 8 ) | — |\n| Other financing activities | ( 17 ) | ( 14 ) |\n| Net cash used in financing activities | ( 142 ) | ( 16 ) |\n| EFFECT OF EXCHANGE RATE CHANGES ON CASH | 11 | ( 7 ) |\n| NET INCREASE (DECREASE) IN CASH, CASH EQUIVALENTS, AND RESTRICTED CASH | 453 | ( 34 ) |\n| CASH, CASH EQUIVALENTS, AND RESTRICTED CASH—BEGINNING OF YEAR | 1,065 | 1,237 |\n| CASH, CASH EQUIVALENTS, AND RESTRICTED CASH—END OF PERIOD | $ | 1,518 | $ | 1,203 |\n\nSee accompanying Notes to condensed consolidated financial statements.\nSupplemental disclosure of cash flow information:\n| June 30, 2022 | June 30, 2021 |\n| Cash and cash equivalents | $ | 1,428 | $ | 1,144 |\n| Restricted cash (1) | 53 | 18 |\n| Restricted cash included in other assets (1) | 37 | 41 |\n| Total cash, cash equivalents, and restricted cash | $ | 1,518 | $ | 1,203 |\n| (1) Restricted cash generally represents debt service on bonds, escrow deposits, and other arrangements. |\n\n| Six Months Ended |\n| June 30, 2022 | June 30, 2021 |\n| Cash paid during the period for interest | $ | 68 | $ | 74 |\n| Cash paid during the period for income taxes, net | $ | 39 | $ | 2 |\n| Cash paid for amounts included in the measurement of operating lease liabilities | $ | 22 | $ | 18 |\n| Non-cash investing and financing activities are as follows: |\n| Non-cash contributions to equity method and other investments (Note 12) | $ | — | $ | 42 |\n| Change in accrued capital expenditures | $ | 8 | $ | 1 |\n| Non-cash right-of-use assets obtained in exchange for operating lease liabilities | $ | 3 | $ | 12 |\n| Non-cash legal defeasance of Series 2005 Bonds (see Note 6) | $ | 166 | $ | — |\n| Non-cash reduction in right-of-use assets and operating lease liabilities for lease reassessment | $ | 12 | $ | — |\n| Non-cash held-to-maturity debt security received (see Note 6) | $ | 19 | $ | — |\n\nSee accompanying Notes to condensed consolidated financial statements.\n4\nHYATT HOTELS CORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY(In millions of dollars, except share and per share amounts)(Unaudited)\n| Common Shares Outstanding | Common Stock Amount | Additional Paid-in Capital | Retained Earnings | Accumulated Other Comprehensive Income (Loss) | Noncontrolling Interests in Consolidated Subsidiaries | Total |\n| Class | Class | Class | Class |\n| A | B | A | B |\n| BALANCE—January 1, 2021 | 39,250,241 | 62,038,918 | $ | 1 | $ | — | $ | 13 | $ | 3,389 | $ | ( 192 ) | $ | 3 | $ | 3,214 |\n| Total comprehensive loss | — | — | — | — | — | ( 304 ) | ( 45 ) | — | ( 349 ) |\n| Employee stock plan issuance | 10,992 | — | — | — | 1 | — | — | — | 1 |\n| Class share conversions | 800,169 | ( 800,169 ) | — | — | — | — | — | — | — |\n| Share-based payment activity | 462,103 | — | — | — | 22 | — | — | — | 22 |\n| BALANCE—March 31, 2021 | 40,523,505 | 61,238,749 | 1 | — | 36 | 3,085 | ( 237 ) | 3 | 2,888 |\n| Total comprehensive income (loss) | — | — | — | — | — | ( 9 ) | 19 | — | 10 |\n| Employee stock plan issuance | 9,603 | — | — | — | 1 | — | — | — | 1 |\n| Class share conversions | 614,831 | ( 614,831 ) | — | — | — | — | — | — | — |\n| Share-based payment activity | 11,150 | — | — | — | 10 | — | — | — | 10 |\n| BALANCE—June 30, 2021 | 41,159,089 | 60,623,918 | $ | 1 | $ | — | $ | 47 | $ | 3,076 | $ | ( 218 ) | $ | 3 | $ | 2,909 |\n| BALANCE—January 1, 2022 | 50,322,050 | 59,653,271 | $ | 1 | $ | — | $ | 640 | $ | 3,167 | $ | ( 245 ) | $ | 3 | $ | 3,566 |\n| Total comprehensive income (loss) | — | — | — | — | — | ( 73 ) | 14 | — | ( 59 ) |\n| Employee stock plan issuance | 12,221 | — | — | — | 1 | — | — | — | 1 |\n| Class share conversions | 635,522 | ( 635,522 ) | — | — | — | — | — | — | — |\n| Share-based payment activity | 303,355 | — | — | — | 16 | — | — | — | 16 |\n| BALANCE—March 31, 2022 | 51,273,148 | 59,017,749 | 1 | — | 657 | 3,094 | ( 231 ) | 3 | 3,524 |\n| Total comprehensive income (loss) | — | — | — | — | — | 206 | ( 34 ) | — | 172 |\n| Repurchases of common stock | ( 1,210,402 ) | — | — | — | ( 101 ) | — | — | — | ( 101 ) |\n| Employee stock plan issuance | 13,963 | — | — | — | 1 | — | — | — | 1 |\n| Class share conversions | — | — | — | — | — | — | — | — | — |\n| Share-based payment activity | 19,623 | — | — | — | 16 | — | — | — | 16 |\n| BALANCE—June 30, 2022 | 50,096,332 | 59,017,749 | $ | 1 | $ | — | $ | 573 | $ | 3,300 | $ | ( 265 ) | $ | 3 | $ | 3,612 |\n\nSee accompanying Notes to condensed consolidated financial statements.\n5\nHYATT HOTELS CORPORATION AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(amounts in millions of dollars, unless otherwise indicated)\n(Unaudited)\n1. ORGANIZATION\nHyatt Hotels Corporation, a Delaware corporation, and its consolidated subsidiaries (collectively, \"Hyatt Hotels Corporation\") has offerings that consist of full services hotels, select service hotels, all-inclusive resorts, and other forms of residential, vacation ownership, and condominium units. We also offer travel distribution and destination management services through ALG Vacations and a paid membership program through the Unlimited Vacation Club. At June 30, 2022, our hotel portfolio included 525 full service hotels, comprising 172,729 rooms throughout the world; 548 select service hotels, comprising 79,604 rooms, of which 444 hotels are located in the United States; and 121 all-inclusive resorts, comprising 38,654 rooms. At June 30, 2022, our portfolio of properties operated in 72 countries around the world. Additionally, through strategic relationships, we provide certain reservation and/or loyalty program services to hotels that are unaffiliated with our hotel portfolio and operate under other tradenames or marks owned by such hotels or licensed by third parties.\nAs used in these Notes and throughout this Quarterly Report on Form 10-Q:\n•\"Hyatt,\" \"Company,\" \"we,\" \"us,\" or \"our\" mean Hyatt Hotels Corporation and its consolidated subsidiaries;\n•\"hotel portfolio\" refers to our full service hotels, including our wellness resorts, our select service hotels, and our all-inclusive resorts;\n•\"properties,\" \"portfolio of properties,\" or \"property portfolio\" refer to our hotel portfolio and residential, vacation ownership, and condominium units that we operate, manage, franchise, own, lease, develop, license, or to which we provide services or license our trademarks, including under the Park Hyatt, Grand Hyatt, Hyatt Regency, Hyatt, Hyatt Residence Club, Hyatt Place, Hyatt House, UrCove, Miraval, Alila, Andaz, Thompson Hotels, Hyatt Centric, Caption by Hyatt, The Unbound Collection by Hyatt, Destination by Hyatt, JdV by Hyatt, Hyatt Ziva, Hyatt Zilara, Zoëtry Wellness & Spa Resorts, Secrets Resorts & Spas, Breathless Resorts & Spas, Dreams Resorts & Spas, Vivid Hotels & Resorts, Alua Hotels & Resorts, and Sunscape Resorts & Spas brands; and\n•\"hospitality ventures\" refers to entities in which we own less than a 100% equity interest.\nThe accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (\"GAAP\") for interim financial information, the instructions to Form 10-Q, and Article 10 of Regulation S-X. Accordingly, they do not include all information or footnotes required by GAAP for complete annual financial statements. As a result, this Quarterly Report on Form 10-Q should be read in conjunction with the Consolidated Financial Statements and accompanying Notes in our Annual Report on Form 10-K for the fiscal year ended December 31, 2021 (the \"2021 Form 10-K\").\nWe have eliminated all intercompany accounts and transactions in our condensed consolidated financial statements. We consolidate entities under our control, including entities where we are deemed to be the primary beneficiary.\nManagement believes the accompanying condensed consolidated financial statements reflect all adjustments, which are all of a normal recurring nature, considered necessary for a fair presentation of the interim periods.\n2. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS\nAdopted Accounting Standards\nGovernment Assistance—In November 2021, the Financial Accounting Standards Board (\"FASB\") issued Accounting Standards Update No. 2021-10 (\"ASU 2021-10\"), Government Assistance (Topic 832): Disclosures by Business Entities about Government Assistance. ASU 2021-10 requires annual disclosures that are expected to increase the transparency of transactions involving government grants, including (1) the types of transactions, (2) the accounting for those transactions, and (3) the effect of those transactions on an entity's financial statements. The provisions of ASU 2021-10 are effective for fiscal years beginning after December 31, 2021, and we adopted\n6\nASU 2021-10 on January 1, 2022. We are currently evaluating the impact of ASU 2021-10 on our annual disclosures and do not expect a material impact to our consolidated financial statements.\nFuture Adoption of Accounting Standards\nReference Rate Reform—In March 2020, the FASB issued Accounting Standards Update No. 2020-04 (\"ASU 2020-04\"), Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting. ASU 2020-04 provides optional expedients and exceptions that we can elect to adopt, subject to meeting certain criteria, regarding contract modifications, hedging relationships, and other transactions that reference the London Interbank Offered Rate or another reference rate expected to be discontinued because of reference rate reform. The provisions of ASU 2020-04 are available through December 31, 2022, and we are currently assessing the impact of adopting ASU 2020-04.\n3. REVENUE FROM CONTRACTS WITH CUSTOMERS\nDisaggregated Revenues\nThe following tables present our revenues disaggregated by the nature of the product or service:\n| Three Months Ended June 30, 2022 |\n| Owned and leased hotels | Americas management and franchising | ASPAC management and franchising | EAME/SW Asia management and franchising | Apple Leisure Group | Corporate and other | Eliminations | Total |\n| Rooms revenues | $ | 209 | $ | — | $ | — | $ | — | $ | 4 | $ | — | $ | ( 8 ) | $ | 205 |\n| Food and beverage | 87 | — | — | — | — | — | — | 87 |\n| Other | 39 | — | — | — | — | — | — | 39 |\n| Owned and leased hotels | 335 | — | — | — | 4 | — | ( 8 ) | 331 |\n| Base management fees | — | 61 | 8 | 11 | 9 | — | ( 10 ) | 79 |\n| Incentive management fees | — | 18 | 6 | 8 | 17 | — | ( 4 ) | 45 |\n| Franchise fees | — | 50 | 1 | 1 | — | — | — | 52 |\n| Other fees | — | 3 | 3 | 1 | 10 | 11 | — | 28 |\n| Management, franchise, and other fees | — | 132 | 18 | 21 | 36 | 11 | ( 14 ) | 204 |\n| Contra revenue | — | ( 6 ) | ( 1 ) | ( 2 ) | — | — | — | ( 9 ) |\n| Net management, franchise, and other fees | — | 126 | 17 | 19 | 36 | 11 | ( 14 ) | 195 |\n| Distribution and destination management | — | — | — | — | 256 | — | — | 256 |\n| Other revenues | — | 25 | — | — | 33 | 2 | 1 | 61 |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties | — | 557 | 34 | 23 | 26 | — | — | 640 |\n| Total | $ | 335 | $ | 708 | $ | 51 | $ | 42 | $ | 355 | $ | 13 | $ | ( 21 ) | $ | 1,483 |\n\n7\n| Six Months Ended June 30, 2022 |\n| Owned and leased hotels | Americas management and franchising | ASPAC management and franchising | EAME/SW Asia management and franchising | Apple Leisure Group | Corporate and other | Eliminations | Total |\n| Rooms revenues | $ | 376 | $ | — | $ | — | $ | — | $ | 4 | $ | — | $ | ( 14 ) | $ | 366 |\n| Food and beverage | 156 | — | — | — | — | — | — | 156 |\n| Other | 80 | — | — | — | — | — | — | 80 |\n| Owned and leased hotels | 612 | — | — | — | 4 | — | ( 14 ) | 602 |\n| Base management fees | — | 107 | 16 | 17 | 17 | — | ( 18 ) | 139 |\n| Incentive management fees | — | 30 | 10 | 15 | 36 | — | ( 6 ) | 85 |\n| Franchise fees | — | 84 | 1 | 2 | — | — | — | 87 |\n| Other fees | — | 6 | 5 | 2 | 13 | 21 | — | 47 |\n| Management, franchise, and other fees | — | 227 | 32 | 36 | 66 | 21 | ( 24 ) | 358 |\n| Contra revenue | — | ( 12 ) | ( 2 ) | ( 4 ) | — | — | — | ( 18 ) |\n| Net management, franchise, and other fees | — | 215 | 30 | 32 | 66 | 21 | ( 24 ) | 340 |\n| Distribution and destination management | — | — | — | — | 502 | — | — | 502 |\n| Other revenues | — | 63 | — | — | 67 | 6 | 2 | 138 |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties | — | 1,018 | 63 | 44 | 55 | — | — | 1,180 |\n| Total | $ | 612 | $ | 1,296 | $ | 93 | $ | 76 | $ | 694 | $ | 27 | $ | ( 36 ) | $ | 2,762 |\n\n| Three Months Ended June 30, 2021 |\n| Owned and leased hotels | Americas management and franchising | ASPAC management and franchising | EAME/SW Asia management and franchising | Corporate and other | Eliminations | Total |\n| Rooms revenues | $ | 117 | $ | — | $ | — | $ | — | $ | — | $ | ( 3 ) | $ | 114 |\n| Food and beverage | 43 | — | — | — | — | — | 43 |\n| Other | 34 | — | — | — | — | — | 34 |\n| Owned and leased hotels | 194 | — | — | — | — | ( 3 ) | 191 |\n| Base management fees | — | 30 | 9 | 3 | — | ( 6 ) | 36 |\n| Incentive management fees | — | 4 | 6 | 3 | — | ( 1 ) | 12 |\n| Franchise fees | — | 28 | 1 | — | — | — | 29 |\n| Other fees | — | 4 | 4 | — | 8 | — | 16 |\n| Management, franchise, and other fees | — | 66 | 20 | 6 | 8 | ( 7 ) | 93 |\n| Contra revenue | — | ( 5 ) | ( 1 ) | ( 3 ) | — | — | ( 9 ) |\n| Net management, franchise, and other fees | — | 61 | 19 | 3 | 8 | ( 7 ) | 84 |\n| Other revenues | — | 19 | — | — | 3 | — | 22 |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties | — | 327 | 24 | 15 | — | — | 366 |\n| Total | $ | 194 | $ | 407 | $ | 43 | $ | 18 | $ | 11 | $ | ( 10 ) | $ | 663 |\n\n8\n| Six Months Ended June 30, 2021 |\n| Owned and leased hotels | Americas management and franchising | ASPAC management and franchising | EAME/SW Asia management and franchising | Corporate and other | Eliminations | Total |\n| Rooms revenues | $ | 179 | $ | — | $ | — | $ | — | $ | — | $ | ( 6 ) | $ | 173 |\n| Food and beverage | 63 | — | — | — | — | — | 63 |\n| Other | 59 | — | — | — | — | — | 59 |\n| Owned and leased hotels | 301 | — | — | — | — | ( 6 ) | 295 |\n| Base management fees | — | 46 | 17 | 6 | — | ( 9 ) | 60 |\n| Incentive management fees | — | 5 | 11 | 5 | — | ( 1 ) | 20 |\n| Franchise fees | — | 45 | 1 | — | — | — | 46 |\n| Other fees | — | 8 | 6 | 2 | 14 | — | 30 |\n| Management, franchise, and other fees | — | 104 | 35 | 13 | 14 | ( 10 ) | 156 |\n| Contra revenue | — | ( 9 ) | ( 2 ) | ( 6 ) | — | — | ( 17 ) |\n| Net management, franchise, and other fees | — | 95 | 33 | 7 | 14 | ( 10 ) | 139 |\n| Other revenues | — | 36 | — | — | 5 | — | 41 |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties | — | 554 | 44 | 28 | — | — | 626 |\n| Total | $ | 301 | $ | 685 | $ | 77 | $ | 35 | $ | 19 | $ | ( 16 ) | $ | 1,101 |\n\nContract Balances\nOur contract assets, included in receivables, net on our condensed consolidated balance sheets, were insignificant at both June 30, 2022 and December 31, 2021. As our profitability hurdles are generally calculated on a full-year basis, we expect our contract assets to be insignificant at year end.\nContract liabilities were comprised of the following:\n| June 30, 2022 | December 31, 2021 |\n| Deferred revenue related to the paid membership program | $ | 943 | $ | 833 |\n| Deferred revenue related to the loyalty program | 875 | 814 |\n| Deferred revenue related to travel distribution and destination management services | 721 | 629 |\n| Advanced deposits | 52 | 61 |\n| Initial fees received from franchise owners | 44 | 42 |\n| Deferred revenue related to insurance programs | 22 | 52 |\n| Other deferred revenue | 86 | 96 |\n| Total contract liabilities | $ | 2,743 | $ | 2,527 |\n\n9\nThe following table summarizes the activity in our contract liabilities:\n| 2022 | 2021 |\n| Beginning balance, January 1 | $ | 2,527 | $ | 941 |\n| Cash received and other | 1,410 | 105 |\n| Revenue recognized | ( 1,245 ) | ( 86 ) |\n| Ending balance, March 31 | $ | 2,692 | $ | 960 |\n| Cash received and other | 1,283 | 133 |\n| Revenue recognized | ( 1,232 ) | ( 115 ) |\n| Ending balance, June 30 | $ | 2,743 | $ | 978 |\n\nRevenue recognized during the three months ended June 30, 2022 and June 30, 2021 included in the contract liabilities balance at the beginning of each year was $ 168 million and $ 78 million, respectively. Revenue recognized during the six months ended June 30, 2022 and June 30, 2021 included in the contract liabilities balance at the beginning of the year was $ 669 million and $ 147 million, respectively. This revenue primarily relates to travel distribution and destination management services, the loyalty program, and the paid membership program.\nRevenue Allocated to Remaining Performance Obligations\nRevenue allocated to remaining performance obligations represents contracted revenue that has not yet been recognized, which includes deferred revenue and amounts that will be invoiced and recognized as revenue in future periods. Contracted revenue expected to be recognized in future periods was approximately $ 475 million at June 30, 2022, of which we expect to recognize approximately 20 % of the revenue over the next 12 months and the remainder thereafter.\n4. DEBT AND EQUITY SECURITIES\nEquity Method Investments\nEquity method investments were $ 185 million and $ 216 million at June 30, 2022 and December 31, 2021, respectively.\nDuring the three and six months ended June 30, 2022, we received $ 23 million of proceeds related to the sale of our ownership interest in an equity method investment and recognized a $ 4 million pre-tax gain in equity earnings (losses) from unconsolidated hospitality ventures on our condensed consolidated statements of income (loss), net of a $ 5 million reclassification from accumulated other comprehensive loss (see Note 13).\nDuring the three and six months ended June 30, 2021, we received $ 17 million of proceeds related to sales activity of certain equity method investments and recognized an insignificant net loss in equity earnings (losses) from unconsolidated hospitality ventures on our condensed consolidated statements of income (loss).\nDuring the six months ended June 30, 2021, we purchased our hospitality venture partner's interest in the entities that own Grand Hyatt São Paulo for $ 6 million of cash, and we repaid the $ 78 million third-party mortgage loan on the property. We recognized a $ 69 million pre-tax gain in equity earnings (losses) from unconsolidated hospitality ventures on our condensed consolidated statements of income (loss) (see Note 6).\nMarketable Securities\nWe hold marketable securities with readily determinable fair values to fund certain operating programs and for investment purposes. We periodically transfer available cash and cash equivalents to purchase marketable securities for investment purposes.\n10\nMarketable Securities Held to Fund Operating Programs—Marketable securities held to fund operating programs, which are recorded at fair value on our condensed consolidated balance sheets, were as follows:\n| June 30, 2022 | December 31, 2021 |\n| Loyalty program (Note 8) | $ | 654 | $ | 601 |\n| Deferred compensation plans held in rabbi trusts (Note 8 and Note 10) | 426 | 543 |\n| Captive insurance company (Note 8) | 114 | 148 |\n| Total marketable securities held to fund operating programs | $ | 1,194 | $ | 1,292 |\n| Less: current portion of marketable securities held to fund operating programs included in cash and cash equivalents and short-term investments | ( 254 ) | ( 173 ) |\n| Marketable securities held to fund operating programs included in other assets | $ | 940 | $ | 1,119 |\n\nAt June 30, 2022 and December 31, 2021, marketable securities held to fund operating programs included:\n•$ 164 million and $ 141 million, respectively, of available-for-sale (\"AFS\") debt securities with contractual maturity dates ranging from 2022 through 2069. The fair value of our AFS debt securities approximates amortized cost;\n•$ 139 million and $ 4 million, respectively, of time deposits classified as held-to-maturity (\"HTM\") debt securities with contractual maturity dates ranging from 2022 through 2026. The fair value of our time deposits approximates amortized cost;\n•$ 61 million and $ 89 million, respectively, of equity securities with a readily determinable fair value.\nNet unrealized and realized gains (losses) from marketable securities held to fund operating programs recognized on our condensed consolidated financial statements were as follows:\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Unrealized gains (losses), net |\n| Net gains (losses) and interest income from marketable securities held to fund rabbi trusts | $ | ( 46 ) | $ | 20 | $ | ( 78 ) | $ | 23 |\n| Other income (loss), net (Note 18) | ( 12 ) | 4 | ( 30 ) | ( 5 ) |\n| Other comprehensive loss (Note 13) | ( 3 ) | — | ( 10 ) | ( 1 ) |\n| Realized gains, net |\n| Net gains (losses) and interest income from marketable securities held to fund rabbi trusts | $ | — | $ | 4 | $ | 1 | $ | 13 |\n\nMarketable Securities Held for Investment Purposes— Marketable securities held for investment purposes, which are recorded at cost or fair value, depending on the nature of the investment, on our condensed consolidated balance sheets, were as follows:\n| June 30, 2022 | December 31, 2021 |\n| Interest-bearing money market funds | $ | 765 | $ | 231 |\n| Time deposits (1) | 379 | 255 |\n| Common shares in Playa N.V. (Note 8) | 83 | 97 |\n| Total marketable securities held for investment purposes | $ | 1,227 | $ | 583 |\n| Less: current portion of marketable securities held for investment purposes included in cash and cash equivalents and short-term investments | ( 1,144 ) | ( 486 ) |\n| Marketable securities held for investment purposes included in other assets | $ | 83 | $ | 97 |\n| (1) Time deposits have contractual maturity dates in 2022. |\n\n11\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Other income (loss), net (Note 18) | $ | ( 22 ) | $ | 1 | $ | ( 14 ) | $ | 18 |\n\nFair Value— We measure marketable securities held to fund operating programs and held for investment purposes at fair value on a recurring basis:\n| June 30, 2022 | Cash and cash equivalents | Short-term investments | Other assets |\n| Level One - Quoted Prices in Active Markets for Identical Assets |\n| Interest-bearing money market funds | $ | 871 | $ | 871 | $ | — | $ | — |\n| Mutual funds | 487 | — | — | 487 |\n| Common shares in Playa N.V. | 83 | — | — | 83 |\n| Level Two - Significant Other Observable Inputs |\n| Time deposits | 518 | — | 515 | 3 |\n| U.S. government obligations | 234 | — | 3 | 231 |\n| U.S. government agencies | 56 | — | 2 | 54 |\n| Corporate debt securities | 119 | — | 7 | 112 |\n| Mortgage-backed securities | 23 | — | — | 23 |\n| Asset-backed securities | 24 | — | — | 24 |\n| Municipal and provincial notes and bonds | 6 | — | — | 6 |\n| Total | $ | 2,421 | $ | 871 | $ | 527 | $ | 1,023 |\n\n| December 31, 2021 | Cash and cash equivalents | Short-term investments | Other assets |\n| Level One - Quoted Prices in Active Markets for Identical Assets |\n| Interest-bearing money market funds | $ | 397 | $ | 397 | $ | — | $ | — |\n| Mutual funds | 632 | — | — | 632 |\n| Common shares in Playa N.V. | 97 | — | — | 97 |\n| Level Two - Significant Other Observable Inputs |\n| Time deposits | 259 | 35 | 221 | 3 |\n| U.S. government obligations | 235 | — | — | 235 |\n| U.S. government agencies | 58 | — | — | 58 |\n| Corporate debt securities | 137 | — | 6 | 131 |\n| Mortgage-backed securities | 24 | — | — | 24 |\n| Asset-backed securities | 28 | — | — | 28 |\n| Municipal and provincial notes and bonds | 8 | — | — | 8 |\n| Total | $ | 1,875 | $ | 432 | $ | 227 | $ | 1,216 |\n\nDuring the six months ended June 30, 2022 and June 30, 2021, there were no transfers between levels of the fair value hierarchy. We do not have nonfinancial assets or nonfinancial liabilities required to be measured at fair value on a recurring basis.\n12\nOther Investments\nHTM Debt Securities— We also hold investments in third-party entities related to certain of our hotels, which are redeemable on various dates through 2062 and are recorded as HTM debt securities within other assets on our condensed consolidated balance sheets:\n| June 30, 2022 | December 31, 2021 |\n| HTM debt securities | $ | 113 | $ | 91 |\n| Less: allowance for credit losses | ( 40 ) | ( 38 ) |\n| Total HTM debt securities, net of allowances | $ | 73 | $ | 53 |\n\nThe following table summarizes the activity in our HTM debt securities allowance for credit losses:\n| 2022 | 2021 |\n| Allowance at January 1 | $ | 38 | $ | 21 |\n| Provisions (1) | 1 | 1 |\n| Allowance at March 31 | $ | 39 | $ | 22 |\n| Provisions (1) | 1 | 7 |\n| Allowance at June 30 | $ | 40 | $ | 29 |\n| (1) Provisions for credit losses were partially or fully offset by interest income recognized in the same periods (see Note 18). |\n\nWe estimated the fair value of these HTM debt securities to be approximately $ 100 million and $ 77 million at June 30, 2022 and December 31, 2021, respectively. The fair values, which are classified as Level Three in the fair value hierarchy, are estimated using internally developed discounted cash flow models based on current market inputs for similar types of arrangements. The primary sensitivity in these models is based on the selection of appropriate discount rates. Fluctuations in these assumptions could result in different estimates of fair value.\nEquity Securities Without a Readily Determinable Fair Value—At both June 30, 2022 and December 31, 2021, we held $ 12 million of investments in equity securities without a readily determinable fair value, which are recorded within other assets on our condensed consolidated balance sheets and represent investments in entities where we do not have the ability to significantly influence the operations of the entity.\n5. RECEIVABLES\nReceivables\nAt June 30, 2022 and December 31, 2021, we had $ 699 million and $ 633 million of net receivables, respectively, recorded on our condensed consolidated balance sheets.\nThe following table summarizes the activity in our receivables allowance for credit losses:\n| 2022 | 2021 |\n| Allowance at January 1 | $ | 53 | $ | 56 |\n| Provisions | 7 | 1 |\n| Other | ( 4 ) | — |\n| Allowance at March 31 | $ | 56 | $ | 57 |\n| Provisions | 6 | 4 |\n| Other | ( 3 ) | ( 3 ) |\n| Allowance at June 30 | $ | 59 | $ | 58 |\n\n13\nFinancing Receivables\n| June 30, 2022 | December 31, 2021 |\n| Unsecured financing to hotel owners | $ | 137 | $ | 133 |\n| Less: current portion of financing receivables, included in receivables, net | ( 14 ) | ( 23 ) |\n| Less: allowance for credit losses | ( 60 ) | ( 69 ) |\n| Total long-term financing receivables, net of allowances | $ | 63 | $ | 41 |\n\nAllowance for Credit Losses— The following table summarizes the activity in our unsecured financing receivables allowance for credit losses:\n| 2022 | 2021 |\n| Allowance at January 1 | $ | 69 | $ | 114 |\n| Provisions | — | 3 |\n| Foreign currency exchange, net | 3 | ( 2 ) |\n| Allowance at March 31 | $ | 72 | $ | 115 |\n| Provisions and reversals, net | ( 7 ) | 3 |\n| Write-offs | ( 1 ) | — |\n| Foreign currency exchange, net | ( 4 ) | 2 |\n| Allowance at June 30 | $ | 60 | $ | 120 |\n\nCredit Monitoring— Our unsecured financing receivables were as follows:\n| June 30, 2022 |\n| Gross loan balance (principal and interest) | Related allowance | Net financing receivables | Gross receivables on nonaccrual status |\n| Loans | $ | 135 | $ | ( 59 ) | $ | 76 | $ | 48 |\n| Other financing arrangements | 2 | ( 1 ) | 1 | — |\n| Total unsecured financing receivables | $ | 137 | $ | ( 60 ) | $ | 77 | $ | 48 |\n\n| December 31, 2021 |\n| Gross loan balance (principal and interest) | Related allowance | Net financing receivables | Gross receivables on nonaccrual status |\n| Loans | $ | 130 | $ | ( 67 ) | $ | 63 | $ | 47 |\n| Other financing arrangements | 3 | ( 2 ) | 1 | — |\n| Total unsecured financing receivables | $ | 133 | $ | ( 69 ) | $ | 64 | $ | 47 |\n\nFair Value—We estimated the fair value of financing receivables to be approximately $ 108 million and $ 88 million at June 30, 2022 and December 31, 2021, respectively. The fair values, which are classified as Level Three in the fair value hierarchy, are estimated using discounted future cash flow models. The principal inputs used are projected future cash flows and the discount rate, which is generally the effective interest rate of the loan.\n6. ACQUISITIONS AND DISPOSITIONS\nAcquisitions\nApple Leisure Group—During the year ended December 31, 2021, we acquired 100 % of the outstanding limited partnership interests in Casablanca Global Intermediate Holdings L.P., doing business as Apple Leisure Group (\"ALG\"), and 100 % of the outstanding ordinary shares of Casablanca Global GP Limited, its general partner, in a business combination for a purchase price of $ 2.7 billion (the \"ALG Acquisition\"). The transaction included $ 69 million of contingent consideration payable upon achieving certain targets related to ALG's outstanding travel\n14\ncredits; however, we did not record a contingent liability as the achievement was not considered probable as of the acquisition date.\nWe closed on the transaction on November 1, 2021 and paid $ 2,718 million of cash, inclusive of $ 39 million of purchase price adjustments for amounts due back to the seller that were recorded in accrued expenses and other current liabilities on our condensed consolidated balance sheet at December 31, 2021 and paid during the six months ended June 30, 2022.\nNet assets acquired were determined as follows:\n| Cash paid, net of cash acquired | $ | 2,718 |\n| Cash and cash equivalents acquired | 460 |\n| Restricted cash acquired | 16 |\n| Net assets acquired | $ | 3,194 |\n\nThe acquisition includes (i) management and marketing agreements for operating and pipeline hotels, primarily across Mexico, the Caribbean, Central America, and Europe, and brand names affiliated with ALG resorts; (ii) customer relationships and brand names related to ALG Vacations; and (iii) customer relationships and a brand name associated with the Unlimited Vacation Club paid membership program.\nOur condensed consolidated balance sheets at both June 30, 2022 and December 31, 2021 reflect preliminary estimates of the fair value of the assets acquired and liabilities assumed based on available information as of the acquisition date. The fair values of intangible assets acquired are estimated using either discounted future cash flow models or the relief from royalty method, both of which include revenue projections based on the expected contract terms and long-term growth rates, which are primarily Level Three assumptions. The fair values of performance guarantee liabilities assumed are estimated using scenario-based weighting, which utilizes a Monte Carlo simulation to model the probability of possible outcomes. The valuation methodology includes assumptions and judgments regarding probability weighting, discount rates, volatility, and hotel operating results as well as qualitative factors, which are primarily Level Three assumptions (see Note 12). The remaining assets and liabilities were recorded at their carrying values, which approximate their fair values.\nDuring 2022, the fair values of certain assets acquired and liabilities assumed were revised. The measurement period adjustments primarily resulted from the refinement of contract terms, renewal periods, useful lives, and other assumptions, which affected the underlying cash flows in the valuation and were based on facts and circumstances that existed at the acquisition date. Measurement period adjustments recorded on our condensed consolidated balance sheet at June 30, 2022 primarily include a $ 74 million increase in other long-term liabilities, net of $ 10 million of tax impacts (see Note 12); a $ 41 million decrease in intangibles, net; and a $ 16 million decrease in property and equipment, net, all of which resulted in a corresponding $ 131 million increase to goodwill. During the six months ended June 30, 2022, we recognized insignificant income and $ 11 million of expenses on our condensed consolidated statements of income (loss) that would have been recognized during the three months ended March 31, 2022 and the year ended December 31, 2021, respectively, if the measurement period adjustments would have been made as of the acquisition date.\nWe will continue to evaluate the contracts acquired and the underlying inputs and assumptions used in our valuation of assets acquired and liabilities assumed. Accordingly, these estimates, along with any related tax impacts, are subject to change during the measurement period, which is up to one year from the acquisition date.\n15\nThe following table summarizes the preliminary fair value of the identifiable net assets acquired recorded on the Apple Leisure Group segment at June 30, 2022:\n| Cash and cash equivalents | $ | 460 |\n| Restricted cash | 16 |\n| Receivables | 168 |\n| Prepaids and other assets | 74 |\n| Property and equipment | 6 |\n| Financing receivables, net | 19 |\n| Operating lease right-of-use assets | 78 |\n| Goodwill (1) | 2,808 |\n| Indefinite-lived intangibles (2) | 503 |\n| Management agreement intangibles (3) | 481 |\n| Customer relationships intangibles (4) | 608 |\n| Other intangibles | 15 |\n| Other assets | 42 |\n| Total assets acquired | $ | 5,278 |\n| Accounts payable | $ | 255 |\n| Accrued expenses and other current liabilities | 97 |\n| Current contract liabilities (5) | 646 |\n| Accrued compensation and benefits | 49 |\n| Current operating lease liabilities | 8 |\n| Long-term contract liabilities (5) | 747 |\n| Long-term operating lease liabilities | 70 |\n| Other long-term liabilities | 212 |\n| Total liabilities assumed | $ | 2,084 |\n| Total net assets acquired attributable to Hyatt Hotels Corporation | $ | 3,194 |\n\n(1) The goodwill is attributable to the growth opportunities we expect to realize by expanding our footprint in luxury and resort travel, expanding our platform for growth, increasing choices and experiences for guests, and enhancing end-to-end leisure travel offerings. Goodwill of $ 36 million is tax deductible.\n(2) Includes intangible assets related to various ALG brand names.\n(3) Amortized over useful lives of approximately 1 to 15 years, with a weighted-average useful life of approximately 11 years.\n(4) Amortized over useful lives of 4 to 11 years, with a weighted-average useful life of approximately 8 years.\n(5) Contract liabilities assumed were recorded at carrying value at the date of acquisition.\nAlila Ventana Big Sur—During the three months ended June 30, 2021, we completed an asset acquisition of Alila Ventana Big Sur for $ 146 million, net of closing costs and proration adjustments, which primarily consisted of $ 149 million of property and equipment. The seller is indirectly owned by a limited partnership affiliated with the brother of our Executive Chairman. The acquisition was identified as replacement property in a potential reverse like-kind exchange; however, we sold the property before a suitable replacement property was identified.\nGrand Hyatt São Paulo—We previously held a 50 % interest in the entities that own Grand Hyatt São Paulo, and we accounted for the investment as an unconsolidated hospitality venture under the equity method. During the six months ended June 30, 2021, we purchased the remaining 50 % interest for $ 6 million of cash. Additionally, we repaid the $ 78 million third-party mortgage loan on the property and were released from our debt repayment guarantee. The transaction was accounted for as an asset acquisition, and we recognized a $ 69 million pre-tax gain related to the transaction in equity earnings (losses) from unconsolidated hospitality ventures on our condensed consolidated statements of income (loss). The pre-tax gain is primarily attributable to a $ 42 million reversal of other long-term liabilities associated with our equity method investment and a $ 22 million reclassification from accumulated other comprehensive loss (see Note 13).\n16\nNet assets acquired were determined as follows:\n| Cash paid | $ | 6 |\n| Repayment of third-party mortgage loan | 78 |\n| Fair value of our previously-held equity method investment | 6 |\n| Net assets acquired | $ | 90 |\n\nUpon acquisition, we recorded $ 101 million of property and equipment and $ 11 million of deferred tax liabilities within our owned and leased hotels segment on our condensed consolidated balance sheet.\nDispositions\nThe Confidante Miami Beach—During the three months ended June 30, 2022, we sold The Confidante Miami Beach to an unrelated third party for approximately $ 227 million, net of closing costs and proration adjustments, and accounted for the transaction as an asset disposition. Upon sale, we entered into a long-term management agreement for the property. The sale resulted in a $ 24 million pre-tax gain, which was recognized in gains on sales of real estate on our condensed consolidated statements of income (loss) during the three months ended June 30, 2022. The operating results and financial position of this hotel prior to the sale remain within our owned and leased hotels segment.\nThe Driskill—During the three months ended June 30, 2022, we sold The Driskill to an unrelated third party for approximately $ 119 million, net of closing costs and proration adjustments, and accounted for the transaction as an asset disposition. Upon sale, we entered into a long-term management agreement for the property. The sale resulted in a $ 51 million pre-tax gain, which was recognized in gains on sales of real estate on our condensed consolidated statements of income (loss) during the three months ended June 30, 2022. The operating results and financial position of this hotel prior to the sale remain within our owned and leased hotels segment. At March 31, 2022, we classified the assets and liabilities as held for sale on our condensed consolidated balance sheet.\nGrand Hyatt San Antonio River Walk—During the three months ended June 30, 2022, we sold Grand Hyatt San Antonio River Walk to an unrelated third party and accounted for the transaction as an asset disposition. We received approximately $ 109 million of cash consideration, net of closing costs; a $ 19 million HTM debt security as additional consideration; and $ 18 million from the release of restricted cash held for debt service related to Tax-Exempt Contract Revenue Empowerment Zone Bonds, Series 2005A and Contract Revenue Bonds, Senior Taxable Series 2005B (collectively, the \"Series 2005 Bonds\"). At the time of sale, we had $ 166 million of outstanding debt related to the Series 2005 Bonds, inclusive of accrued interest and net of $ 4 million of unamortized discounts, which was legally defeased in conjunction with the sale (see Note 9). Upon sale, we entered into a long-term management agreement for the property.\nThe sale resulted in a $ 137 million pre-tax gain, which was recognized in gains on sales of real estate on our condensed consolidated statements of income (loss) during the three months ended June 30, 2022. In connection with the disposition, we recognized a $ 7 million goodwill impairment charge in asset impairments on our condensed consolidated statements of income (loss) during the three months ended June 30, 2022. The assets disposed represented the entirety of the related reporting unit and therefore, no business operations remained to support the related goodwill, which was therefore impaired. The operating results and financial position of this hotel prior to the sale remain within our owned and leased hotels segment. At March 31, 2022, we classified the assets and liabilities as held for sale on our condensed consolidated balance sheet.\nHyatt Regency Indian Wells Resort & Spa—During the three months ended June 30, 2022, we sold Hyatt Regency Indian Wells Resort & Spa to an unrelated third party for approximately $ 136 million, net of closing costs and proration adjustments, and accounted for the transaction as an asset disposition. Upon sale, we entered into a long-term management agreement for the property. The sale resulted in a $ 40 million pre-tax gain, which was recognized in gains on sales of real estate on our condensed consolidated statements of income (loss) during the three months ended June 30, 2022. The operating results and financial position of this hotel prior to the sale remain within our owned and leased hotels segment. At March 31, 2022, we classified the assets and liabilities as held for sale on our condensed consolidated balance sheet.\nHyatt Regency Lost Pines Resort and Spa—During the three months ended June 30, 2021, we sold Hyatt Regency Lost Pines Resort and Spa to an unrelated third party for approximately $ 268 million, net of closing costs and proration adjustments, and accounted for the transaction as an asset disposition. Upon sale, we entered into a long-term management agreement for the property. The sale resulted in a $ 104 million pre-tax gain, which was recognized in gains on sales of real estate on our condensed consolidated statements of income (loss) during the\n17\nthree months ended June 30, 2021. The operating results and financial position of this hotel prior to the sale remain within our owned and leased hotels segment.\n7. INTANGIBLES, NET\n| June 30, 2022 | Weighted-average usefullives in years | December 31, 2021 |\n| Management and franchise agreement intangibles | $ | 814 | 14 | $ | 835 |\n| Brand and other indefinite-lived intangibles | 626 | — | 646 |\n| Customer relationships intangibles | 608 | 9 | 586 |\n| Other intangibles | 21 | 5 | 58 |\n| Intangibles | 2,069 | 2,125 |\n| Less: accumulated amortization | ( 259 ) | ( 148 ) |\n| Intangibles, net | $ | 1,810 | $ | 1,977 |\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Amortization expense | $ | 51 | $ | 7 | $ | 111 | $ | 14 |\n\n8. OTHER ASSETS\n| June 30, 2022 | December 31, 2021 |\n| Management and franchise agreement assets constituting payments to customers (1) | $ | 619 | $ | 571 |\n| Marketable securities held to fund rabbi trusts (Note 4) | 426 | 543 |\n| Marketable securities held to fund the loyalty program (Note 4) | 414 | 439 |\n| Marketable securities held for captive insurance company (Note 4) | 100 | 137 |\n| Long-term investments (Note 4) | 85 | 65 |\n| Common shares in Playa N.V. (Note 4) | 83 | 97 |\n| Long-term restricted cash | 37 | 48 |\n| Other | 181 | 134 |\n| Total other assets | $ | 1,945 | $ | 2,034 |\n| (1) Includes cash consideration as well as other forms of consideration provided, such as debt repayment or performance guarantees. |\n\n9. DEBT\nLong-term debt was $ 3,798 million and $ 3,968 million at June 30, 2022 and December 31, 2021, respectively.\nRevolving Credit Facility—During the three months ended June 30, 2022, we entered into a new credit agreement with a syndicate of lenders that provides for a $ 1.5 billion senior unsecured revolving credit facility (the \"revolving credit facility\") that matures in May 2027. The credit agreement refinanced and replaced in its entirety our Second Amended and Restated Credit Agreement dated as of January 6, 2014, as amended (the \"prior revolving credit facility\"). The credit agreement provides for the issuance of revolving loans to us in U.S. dollars and, subject to a sublimit of $ 250 million, certain other currencies, and the issuance of up to $ 300 million of letters of credit. We have the option during the term of the revolving credit facility to increase the facility by an aggregate amount of up to an additional $ 500 million provided that, among other things, new and/or existing lenders agree to provide commitments for the increased amount. We may prepay any outstanding aggregate principal amount, in whole or in part, at any time, subject to certain restrictions and upon proper notice. The credit agreement contains customary affirmative, negative, and financial covenants; representations and warranties; and default provisions.\nDuring the six months ended June 30, 2022 and June 30, 2021, we had no borrowings or repayments on our revolving credit facility or our prior revolving credit facility. At both June 30, 2022 and December 31, 2021, we had no balance outstanding on our revolving credit facility or our prior revolving credit facility. At June 30, 2022, we had $ 1,496 million of borrowing capacity available under our revolving credit facility, net of letters of credit outstanding.\n18\nFair Value—We estimate the fair value of debt, excluding finance leases, which consists of the notes below (collectively, the \"Senior Notes\") and other long-term debt.\n•$ 300 million of floating rate senior notes due 2023\n•$ 350 million of 3.375 % senior notes due 2023\n•$ 700 million of 1.300 % senior notes due 2023\n•$ 750 million of 1.800 % senior notes due 2024\n•$ 450 million of 5.375 % senior notes due 2025\n•$ 400 million of 4.850 % senior notes due 2026\n•$ 400 million of 4.375 % senior notes due 2028\n•$ 450 million of 5.750 % senior notes due 2030\nOur Senior Notes are classified as Level Two due to the use and weighting of multiple market inputs in the final price of the security. We estimated the fair value of other debt instruments using a discounted cash flow analysis based on current market inputs for similar types of arrangements. Based on the lack of available market data, we have classified our revolving credit facility, as applicable, and other debt instruments as Level Three. The primary sensitivity in these models is based on the selection of appropriate discount rates. Fluctuations in our assumptions will result in different estimates of fair value.\n| June 30, 2022 |\n| Carrying value | Fair value | Quoted prices in active markets for identical assets (Level One) | Significant other observable inputs (Level Two) | Significant unobservable inputs (Level Three) |\n| Debt (1) | $ | 3,817 | $ | 3,748 | $ | — | $ | 3,707 | $ | 41 |\n\n(1) Excludes $ 7 million of finance lease obligations and $ 20 million of unamortized discounts and deferred financing fees.\n| December 31, 2021 |\n| Carrying value | Fair value | Quoted prices in active markets for identical assets (Level One) | Significant other observable inputs (Level Two) | Significant unobservable inputs (Level Three) |\n| Debt (2) | $ | 4,000 | $ | 4,230 | $ | — | $ | 4,193 | $ | 37 |\n\n(2) Excludes $ 7 million of finance lease obligations and $ 29 million of unamortized discounts and deferred financing fees.\nSenior Notes Repurchases—During the three months ended June 30, 2022, we repurchased $ 4 million of our senior notes due 2024, $ 1 million of our senior notes due 2028, and $ 10 million of our senior notes due 2030 in the open market.\nSeries 2005 Bonds—The Series 2005 Bonds had $ 166 million outstanding, inclusive of accrued interest and net of $ 4 million of unamortized discounts, and were legally defeased in conjunction with the sale of Grand Hyatt San Antonio River Walk during the three months ended June 30, 2022 (see Note 6). We recognized an $ 8 million loss on extinguishment of debt in other income (loss), net on our condensed consolidated statements of income (loss), which related to restricted cash utilized to defease the debt (see Note 18).\n19\n10. OTHER LONG-TERM LIABILITIES\n| June 30, 2022 | December 31, 2021 |\n| Deferred compensation plans funded by rabbi trusts (Note 4) | $ | 426 | $ | 543 |\n| Income taxes payable | 299 | 281 |\n| Guarantee liabilities (Note 12) | 147 | 92 |\n| Deferred income taxes (Note 11) | 79 | 93 |\n| Self-insurance liabilities (Note 12) | 66 | 66 |\n| Other | 55 | 64 |\n| Total other long-term liabilities | $ | 1,072 | $ | 1,139 |\n\n11. INCOME TAXES\nThe provision for income taxes for the three months ended June 30, 2022 and June 30, 2021 was $ 106 million and $ 15 million, respectively. The increase was driven by the sales of Hyatt Regency Indian Wells Resort & Spa, Grand Hyatt San Antonio River Walk, The Driskill, and The Confidante Miami Beach. The provision for income taxes for the six months ended June 30, 2022 and June 30, 2021 was $ 108 million and $ 201 million, respectively. The decrease was driven by the impact of a non-cash expense to record a valuation allowance on U.S. federal and state deferred tax assets in the first quarter of 2021 as a result of entering into a three-year cumulative U.S. pre-tax loss position during the period.\nWe are subject to audits by federal, state, and foreign tax authorities. U.S. tax years 2009 through 2011 are before the U.S. Tax Court concerning the tax treatment of the loyalty program. The U.S. Tax Court trial proceedings occurred during April 2022, and the trial outcome is pending, subject to the U.S. Tax Court Judge's ruling. During the six months ended June 30, 2021, we received a Notice of Proposed Adjustment for tax years 2015 through 2017 related to the loyalty program issue. As a result, U.S. tax years 2009 through 2017 are pending the outcome of the issue currently in U.S. Tax Court. If the IRS' position to include loyalty program contributions as taxable income to the Company is upheld, it would result in an estimated income tax payment of $ 227 million (including $ 69 million of interest, net of federal tax benefit) for all assessed years. We believe we have an adequate uncertain tax liability recorded in connection with this matter.\nAt June 30, 2022 and December 31, 2021, total unrecognized tax benefits recorded in other long-term liabilities on our condensed consolidated balance sheets were $ 216 million and $ 205 million, respectively, of which $ 196 million and $ 186 million, respectively, would impact the effective tax rate if recognized. While it is reasonably possible that the amount of uncertain tax benefits associated with the U.S. treatment of the loyalty program could significantly change within the next 12 months, at this time, we are not able to estimate the range by which the reasonably possible outcomes of the pending litigation could impact our uncertain tax benefits within the next 12 months.\n12. COMMITMENTS AND CONTINGENCIES\nIn the ordinary course of business, we enter into various commitments, guarantees, surety and other bonds, and letter of credit agreements.\nCommitments—At June 30, 2022, we are committed, under certain conditions, to lend, provide certain consideration to, or invest in, various business ventures up to $ 317 million, net of any related letters of credit.\nPerformance Guarantees—Certain of our contractual agreements with third-party hotel owners require us to guarantee payments to the owners if specified levels of operating profit are not achieved by their hotels. Except as described below, at June 30, 2022, our performance guarantees have $ 111 million of remaining maximum exposure and expire between 2022 and 2042.\nWe acquired certain management agreements in the ALG Acquisition with performance guarantees expiring between 2022 and 2045. Our condensed consolidated balance sheet at June 30, 2022 reflects preliminary estimates of the fair value of the performance guarantees liabilities assumed based on information that was available as of the date of acquisition. The performance guarantees are based on annual performance levels. Contract terms within the management agreements limit our exposure, and therefore, we are unable to reasonably estimate our maximum potential future payments. Based on current forecasts and long-term financial expectations of the hotels, the likelihood of funding under these performance guarantees is not probable at June 30, 2022. We\n20\ncontinue to review and evaluate the agreements acquired in the ALG Acquisition and the contractual obligations therein. Any additional contractual obligations identified could be material and may increase our liabilities assumed in the ALG Acquisition (see Note 6).\nAt June 30, 2022 and December 31, 2021, we had $ 115 million and $ 52 million, respectively, of total performance guarantee liabilities, which included $ 109 million and $ 41 million, respectively, recorded in other long-term liabilities and $ 6 million and $ 11 million, respectively, recorded in accrued expenses and other current liabilities on our condensed consolidated balance sheets.\nAdditionally, we enter into certain management contracts where we have the right, but not an obligation, to make payments to certain hotel owners if their hotels do not achieve specified levels of operating profit. If we choose not to fund the shortfall, the hotel owner has the option to terminate the management contract. At June 30, 2022 and December 31, 2021, we had $ 6 million and $ 7 million, respectively, recorded in accrued expenses and other current liabilities on our condensed consolidated balance sheets related to these performance cure payments.\nDebt Repayment Guarantees— We enter into various debt repayment guarantees in order to assist hotel owners and unconsolidated hospitality ventures in obtaining third-party financing or to obtain more favorable borrowing terms.\n| Geographical region | Maximum potential future payments | Maximum exposure net of recoverability from third parties | Other long-term liabilities recorded at June 30, 2022 | Other long-term liabilities recorded at December 31, 2021 | Year of guarantee expiration |\n| United States (1), (2) | $ | 134 | $ | 51 | $ | 6 | $ | 10 | various, through 2024 |\n| All foreign (1), (3) | 207 | 197 | 32 | 41 | various, through 2031 |\n| Total | $ | 341 | $ | 248 | $ | 38 | $ | 51 |\n\n(1) We have agreements with our unconsolidated hospitality venture partners or the respective hotel owners to recover certain amounts funded under the debt repayment guarantee; the recoverability mechanism may be in the form of cash or HTM debt security.\n(2) Certain agreements give us the ability to assume control of the property if defined funding thresholds are met or if certain events occur.\n(3) Certain debt repayment guarantees are denominated in Indian rupees and translated using exchange rates at June 30, 2022. We have the contractual right to recover amounts funded from an unconsolidated hospitality venture, which is a related party. We expect our maximum exposure to be approximately $ 93 million, taking into account our partner's 50 % ownership interest in the unconsolidated hospitality venture. Under certain events or conditions, we have the right to force the sale of the properties in order to recover amounts funded.\nAt June 30, 2022, we are not aware, nor have we received any notification, that our unconsolidated hospitality ventures or hotel owners are not current on their debt service obligations where we have provided a debt repayment guarantee.\nGuarantee Liabilities Fair Value—We estimated the fair value of our guarantees to be approximately $ 141 million and $ 87 million at June 30, 2022 and December 31, 2021, respectively. Based on the lack of available market data, we have classified our guarantees as Level Three in the fair value hierarchy.\nInsurance —We obtain commercial insurance for potential losses for general liability, workers' compensation, automobile liability, employment practices, crime, property, cyber risk, and other miscellaneous coverages. A portion of the risk is retained on a self-insurance basis primarily through a U.S.-based and licensed captive insurance company that is a wholly owned subsidiary of Hyatt and generally insures our deductibles and retentions. Reserve requirements are established based on actuarial projections of ultimate losses. Reserves for losses in our captive insurance company to be paid within 12 months are $ 33 million and $ 34 million at June 30, 2022 and December 31, 2021, respectively, and are recorded in accrued expenses and other current liabilities on our condensed consolidated balance sheets. Reserves for losses in our captive insurance company to be paid in future periods are $ 66 million at both June 30, 2022 and December 31, 2021 and are recorded in other long-term liabilities on our condensed consolidated balance sheets.\nCollective Bargaining Agreements—At June 30, 2022, approximately 21 % of our U.S.-based employees were covered by various collective bargaining agreements, generally providing for basic pay rates, working hours, other conditions of employment, and orderly settlement of labor disputes. Certain employees are covered by union-sponsored, multi-employer pension and health plans pursuant to agreements between various unions and us.\n21\nGenerally, labor relations have been maintained in a normal and satisfactory manner, and we believe our employee relations are good.\nSurety and Other Bonds—Surety and other bonds issued on our behalf were $ 46 million at June 30, 2022 and primarily relate to workers' compensation, taxes, licenses, construction liens, and utilities related to our lodging operations.\nLetters of Credit—Letters of credit outstanding on our behalf at June 30, 2022 were $ 274 million, which primarily relate to our ongoing operations, collateral for customer deposits associated with ALG Vacations, collateral for estimated insurance claims, and securitization of our performance under our debt repayment guarantees associated with the hotel properties in India, which are only called on if we default on our guarantees. Of the letters of credit outstanding, $ 4 million reduces the available capacity under our revolving credit facility (see Note 9).\nCapital Expenditures—As part of our ongoing business operations, expenditures are required to complete renovation projects that have been approved.\nOther—We act as general partner of various partnerships owning hotel properties that are subject to mortgage indebtedness. These mortgage agreements generally limit the lender's recourse to security interests in assets financed and/or other assets of the partnership(s) and/or the general partner(s) thereof.\nIn conjunction with financing obtained for our unconsolidated hospitality ventures and certain managed hotels, we may provide standard indemnifications to the lender for loss, liability, or damage occurring as a result of our actions or actions of the other unconsolidated hospitality venture partners or respective hotel owners.\nAs a result of certain dispositions, we have agreed to provide customary indemnifications to third-party purchasers for certain liabilities incurred prior to sale and for breach of certain representations and warranties made during the sales process, such as representations of valid title, authority, and environmental issues that may not be limited by a contractual monetary amount. These indemnification agreements survive until the applicable statutes of limitation expire or until the agreed upon contract terms expire.\nWe are subject, from time to time, to various claims and contingencies related to lawsuits, taxes, and environmental matters, as well as commitments under contractual obligations. Many of these claims are covered under our current insurance programs, subject to deductibles. Although the ultimate liability for these matters cannot be determined at this point, based on information currently available, we do not expect the ultimate resolution of such claims and litigation to have a material effect on our condensed consolidated financial statements.\nDuring the year ended December 31, 2018, we received a notice from the Indian tax authorities assessing additional service tax on our operations in India. We appealed this decision and do not believe a loss is probable, and therefore, we have not recorded a liability in connection with this matter. At June 30, 2022, our maximum exposure is not expected to exceed $ 18 million.\n22\n13. EQUITY\nAccumulated Other Comprehensive Loss\nThe components of accumulated other comprehensive loss, net of insignificant tax impacts, were as follows:\n| Balance atApril 1, 2022 | Current period other comprehensive income (loss) before reclassification | Amount reclassified from accumulated other comprehensive loss | Balance at June 30, 2022 |\n| Foreign currency translation adjustments (1) | $ | ( 185 ) | $ | ( 39 ) | $ | 5 | $ | ( 219 ) |\n| Unrealized losses on AFS debt securities | ( 8 ) | ( 3 ) | — | ( 11 ) |\n| Unrecognized pension benefit (cost) | ( 6 ) | 1 | 1 | ( 4 ) |\n| Unrealized gains (losses) on derivative instruments (2) | ( 32 ) | — | 1 | ( 31 ) |\n| Accumulated other comprehensive loss | $ | ( 231 ) | $ | ( 41 ) | $ | 7 | $ | ( 265 ) |\n| (1) The amount reclassified from accumulated other comprehensive loss includes realized losses recognized in equity earnings (losses) from unconsolidated hospitality ventures related to the disposition of our ownership interest in an unconsolidated hospitality venture (see Note 4). |\n| (2) The amount reclassified from accumulated other comprehensive loss included realized losses recognized in interest expense related to the settlement of interest rate locks. |\n| Balance atJanuary 1, 2022 | Current period other comprehensive income (loss) before reclassification | Amount reclassified from accumulated other comprehensive loss | Balance at June 30, 2022 |\n| Foreign currency translation adjustments (3) | $ | ( 206 ) | $ | ( 18 ) | $ | 5 | $ | ( 219 ) |\n| Unrealized losses on AFS debt securities | ( 1 ) | ( 10 ) | — | ( 11 ) |\n| Unrecognized pension cost | ( 4 ) | — | — | ( 4 ) |\n| Unrealized gains (losses) on derivative instruments (4) | ( 34 ) | — | 3 | ( 31 ) |\n| Accumulated other comprehensive loss | $ | ( 245 ) | $ | ( 28 ) | $ | 8 | $ | ( 265 ) |\n| (3) The amount reclassified from accumulated other comprehensive loss included realized losses recognized in equity earnings (losses) from unconsolidated hospitality ventures related to the disposition of our ownership interest in an unconsolidated hospitality venture (see Note 4). |\n| (4) The amount reclassified from accumulated other comprehensive loss included realized losses recognized in interest expense related to the settlement of interest rate locks. We expect to reclassify $ 6 million of losses over the next 12 months. |\n\n23\n| Balance atApril 1, 2021 | Current period other comprehensive income (loss) before reclassification | Amount reclassified from accumulated other comprehensive loss | Balance atJune 30, 2021 |\n| Foreign currency translation adjustments (5) | $ | ( 191 ) | $ | 15 | $ | 2 | $ | ( 174 ) |\n| Unrealized gains (losses) on AFS debt securities | — | — | — | — |\n| Unrecognized pension cost | ( 7 ) | — | — | ( 7 ) |\n| Unrealized gains (losses) on derivative instruments (6) | ( 39 ) | — | 2 | ( 37 ) |\n| Accumulated other comprehensive loss | $ | ( 237 ) | $ | 15 | $ | 4 | $ | ( 218 ) |\n| (5) The amount reclassified from accumulated other comprehensive loss included realized losses recognized in equity earnings (losses) from unconsolidated hospitality ventures related to the disposition of our ownership interest in certain unconsolidated hospitality ventures (see Note 4). |\n| (6) The amount reclassified from accumulated other comprehensive loss included realized losses recognized in interest expense related to the settlement of interest rate locks. |\n| Balance atJanuary 1, 2021 | Current period other comprehensive income (loss) before reclassification | Amount reclassified from accumulated other comprehensive loss | Balance at June 30, 2021 |\n| Foreign currency translation adjustments (7) | $ | ( 145 ) | $ | ( 9 ) | $ | ( 20 ) | $ | ( 174 ) |\n| Unrealized gains (losses) on AFS debt securities | 1 | ( 1 ) | — | — |\n| Unrecognized pension cost | ( 7 ) | — | — | ( 7 ) |\n| Unrealized gains (losses) on derivative instruments (8) | ( 41 ) | — | 4 | ( 37 ) |\n| Accumulated other comprehensive loss | $ | ( 192 ) | $ | ( 10 ) | $ | ( 16 ) | $ | ( 218 ) |\n| (7) The amount reclassified from accumulated other comprehensive loss included realized net gains recognized in equity earnings (losses) from unconsolidated hospitality ventures related to the acquisition of the remaining interest in the entities which own Grand Hyatt São Paulo (see Note 6) and the disposition of our ownership interest in certain unconsolidated hospitality ventures (see Note 4). |\n| (8) The amount reclassified from accumulated other comprehensive loss included realized losses recognized in interest expense related to the settlement of interest rate locks. |\n\nShare Repurchases—During 2019 and 2018, our board of directors authorized the repurchase of up to $ 750 million and $ 750 million, respectively, of our common stock. These repurchases may be made from time to time in the open market, in privately negotiated transactions, or otherwise, including pursuant to a Rule 10b5-1 plan or an accelerated share repurchase transaction, at prices we deem appropriate and subject to market conditions, applicable law, and other factors deemed relevant in our sole discretion. The common stock repurchase program applies to our Class A and Class B common stock. The common stock repurchase program does not obligate us to repurchase any dollar amount or number of shares of common stock and the program may be suspended or discontinued at any time.\nDuring the six months ended June 30, 2022, we repurchased 1,210,402 shares of Class A common stock. The shares of common stock were repurchased at a weighted-average price of $ 83.34 per share for an aggregate purchase price of $ 101 million, excluding insignificant related expenses. The shares repurchased during the six months ended June 30, 2022 represented approximately 1 % of our total shares of common stock outstanding at December 31, 2021.\nDuring the six months ended June 30, 2021, we did no t repurchase common stock.\nThe shares of Class A common stock repurchased in the open market were retired and returned to the status of authorized and unissued shares. At June 30, 2022, we had $ 827 million remaining under the share repurchase authorization.\n24\n14. STOCK-BASED COMPENSATION\nAs part of our Long-Term Incentive Plan, we award time-vested stock appreciation rights (\"SARs\"), time-vested restricted stock units (\"RSUs\"), and performance-vested restricted stock units (\"PSUs\") to certain employees and non-employee directors. In addition, non-employee directors may elect to receive their annual fees and/or annual equity retainers in the form of shares of our Class A common stock. Compensation expense and unearned compensation presented below exclude amounts related to employees of our managed hotels and other employees whose payroll is reimbursed, as these expenses have been and will continue to be reimbursed by our third-party hotel owners and are recognized in revenues for the reimbursement of costs incurred on behalf of managed and franchised properties and costs incurred on behalf of managed and franchised properties on our condensed consolidated statements of income (loss). Stock-based compensation expense recognized in selling, general, and administrative expenses on our condensed consolidated statements of income (loss) related to these awards was as follows:\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| SARs | $ | 1 | $ | 1 | $ | 11 | $ | 10 |\n| RSUs | 8 | 3 | 24 | 16 |\n| PSUs | 3 | 4 | 5 | 10 |\n| Total | $ | 12 | $ | 8 | $ | 40 | $ | 36 |\n\nSARs—During the six months ended June 30, 2022, we granted 359,113 SARs to employees with a weighted-average grant date fair value of $ 37.56 . During the six months ended June 30, 2021, we granted 396,889 SARs to employees with a weighted-average grant date fair value of $ 28.68 .\nRSUs—During the six months ended June 30, 2022, we granted 520,935 RSUs to employees and non-employee directors with a weighted-average grant date fair value of $ 91.75 . During the six months ended June 30, 2021, we granted 407,585 RSUs to employees and non-employee directors with a weighted-average grant date fair value of $ 80.31 .\nPSUs—During the six months ended June 30, 2022, we granted 176,756 PSUs to employees with a weighted-average grant date fair value of $ 81.14 . During the six months ended June 30, 2021, we granted 153,256 PSUs to employees with a weighted-average grant date fair value of $ 82.02 .\nOur total unearned compensation for our stock-based compensation programs at June 30, 2022 was $ 4 million for SARs, $ 47 million for RSUs, and $ 23 million for PSUs, which will primarily be recognized in stock-based compensation expense over a weighted-average period of three years .\n15. RELATED-PARTY TRANSACTIONS\nIn addition to those included elsewhere in the Notes to our condensed consolidated financial statements, related-party transactions entered into by us are summarized as follows:\nLegal Services—A partner in a law firm that provided services to us throughout 2022 and 2021 is the brother-in-law of our Executive Chairman. During the three and six months ended June 30, 2022, we incurred $ 4 million and $ 6 million of legal fees with this firm, respectively. During both the three and six months ended June 30, 2021, we incurred insignificant amounts of legal fees with this firm. At June 30, 2022 and December 31, 2021, we had $ 4 million and insignificant amounts due to the law firm, respectively.\nEquity Method Investments—We have equity method investments in entities that own, operate, manage, or franchise properties for which we receive management, franchise, or license fees. We recognized $ 6 million and $ 3 million of fees during the three months ended June 30, 2022 and June 30, 2021, respectively. During the six months ended June 30, 2022 and June 30, 2021, we recognized $ 10 million and $ 4 million of fees, respectively. In addition, in some cases we provide loans (see Note 5) or guarantees (see Note 12) to these entities. During both the three months ended June 30, 2022 and June 30, 2021, we recognized insignificant income related to these guarantees. During the six months ended June 30, 2022 and June 30, 2021, we recognized $ 3 million and $ 2 million of income related to these guarantees, respectively. At June 30, 2022 and December 31, 2021, we had $ 51 million and $ 29 million of net receivables due from these properties, respectively. Our ownership interest in these unconsolidated hospitality ventures varies from 24 % to 50 %.\n25\nClass B Share Conversion—During the six months ended June 30, 2022, 635,522 shares of Class B common stock were converted on a share-for-share basis into shares of Class A common stock, $ 0.01 par value per share. During the three and six months ended June 30, 2021, 614,831 and 1,415,000 shares of Class B common stock, respectively, were converted on a share-for-share basis into shares of Class A common stock, $ 0.01 par value per share. The shares of Class B common stock that were converted into shares of Class A common stock have been retired, thereby reducing the shares of Class B common stock authorized and outstanding.\n16. SEGMENT INFORMATION\nOur reportable segments are components of the business which are managed discretely and for which discrete financial information is reviewed regularly by the chief operating decision maker (\"CODM\") to assess performance and make decisions regarding the allocation of resources. Our CODM is our President and Chief Executive Officer. Following the ALG Acquisition during the year ended December 31, 2021, ALG is managed as a separate reportable segment, but in the future, we may realign our reportable segments after integrating aspects of ALG's business. We define our reportable segments as follows:\n•Owned and leased hotels—This segment derives its earnings from owned and leased hotel properties located predominantly in the United States but also in certain international locations, and for purposes of segment Adjusted EBITDA, includes our pro rata share of the Adjusted EBITDA of our unconsolidated hospitality ventures, based on our ownership percentage of each venture. Adjusted EBITDA includes intercompany expenses related to management fees paid to the Company's management and franchising segments, which are eliminated in consolidation. Intersegment revenues relate to promotional award redemptions earned by our owned and leased hotels related to our co-branded credit card program and are eliminated in consolidation.\n•Americas management and franchising—This segment derives its earnings primarily from a combination of hotel management services and licensing of our portfolio of brands to franchisees located in the United States, Canada, the Caribbean, Mexico, Central America, and South America, as well as revenues from residential management operations. This segment's revenues also include the reimbursement of costs incurred on behalf of managed and franchised properties. These reimbursed costs relate primarily to payroll at managed properties where the Company is the employer, as well as costs associated with sales, reservations, digital and technology, digital media, and marketing services (collectively, \"system-wide services\") and the loyalty program operated on behalf of owners of managed and franchised properties. The intersegment revenues relate to management fees earned from the Company's owned and leased hotels and are eliminated in consolidation.\n•ASPAC management and franchising—This segment derives its earnings primarily from a combination of hotel management services and licensing of our portfolio of brands to franchisees located in Southeast Asia, Greater China, Australia, New Zealand, South Korea, Japan, and Micronesia. This segment's revenues also include the reimbursement of costs incurred on behalf of managed and franchised properties. These reimbursed costs relate primarily to system-wide services and the loyalty program operated on behalf of owners of managed and franchised properties.\n•EAME/SW Asia management and franchising—This segment derives its earnings primarily from a combination of hotel management services and licensing of our portfolio of brands to franchisees located in Europe, Africa, the Middle East, India, Central Asia, and Nepal. This segment's revenues also include the reimbursement of costs incurred on behalf of managed and franchised properties. These reimbursed costs relate primarily to system-wide services and the loyalty program operated on behalf of owners of managed and franchised properties. The intersegment revenues relate to management fees earned from the Company's owned and leased hotels and are eliminated in consolidation.\n•Apple Leisure Group—This segment derives its earnings from distribution and destination management services offered through ALG Vacations; management and marketing services primarily for all-inclusive ALG resorts located in Mexico, the Caribbean, Central America, South America, and Europe; and through a paid membership program offering benefits exclusively at ALG resorts in Mexico, the Caribbean, and Central America. This segment's revenues also include the reimbursement of costs incurred on behalf of managed and franchised properties. These reimbursed costs relate to certain system-wide services provided on behalf of owners of ALG resorts.\n26\nAs previously announced, the Company plans a geographic realignment of its Europe, Africa & Middle East (EAME) region in which the Indian subcontinent will become part of the ASPAC management and franchising segment. This change is expected to be effective on January 1, 2023.\nOur CODM evaluates performance based on owned and leased hotels revenues; management, franchise, and other fees revenues; distribution and destination management revenues; other revenues; and Adjusted EBITDA. Adjusted EBITDA, as we define it, is a non-GAAP measure. We define Adjusted EBITDA as net income (loss) attributable to Hyatt Hotels Corporation plus our pro rata share of unconsolidated owned and leased hospitality ventures' Adjusted EBITDA based on our ownership percentage of each owned and leased venture, adjusted to exclude interest expense; benefit (provision) for income taxes; depreciation and amortization; amortization of management and franchise agreement assets and performance cure payments, which constitute payments to customers (\"Contra revenue\"); revenues for the reimbursement of costs incurred on behalf of managed and franchised properties; costs incurred on behalf of managed and franchised properties that we intend to recover over the long term; equity earnings (losses) from unconsolidated hospitality ventures; stock-based compensation expense; gains (losses) on sales of real estate and other; asset impairments; and other income (loss), net.\nThe table below shows summarized consolidated financial information by segment. Included within corporate and other are results related to our co-branded credit card program and unallocated corporate expenses.\n27\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Owned and leased hotels |\n| Owned and leased hotels revenues | $ | 335 | $ | 194 | $ | 612 | $ | 301 |\n| Intersegment revenues (1) | 8 | 3 | 14 | 6 |\n| Adjusted EBITDA | 99 | 12 | 153 | ( 17 ) |\n| Depreciation and amortization | 44 | 58 | 96 | 117 |\n| Americas management and franchising |\n| Management, franchise, and other fees revenues | 132 | 66 | 227 | 104 |\n| Contra revenue | ( 6 ) | ( 5 ) | ( 12 ) | ( 9 ) |\n| Other revenues | 25 | 19 | 63 | 36 |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties | 557 | 327 | 1,018 | 554 |\n| Intersegment revenues (1) | 12 | 7 | 21 | 10 |\n| Adjusted EBITDA | 117 | 54 | 202 | 82 |\n| Depreciation and amortization | 6 | 6 | 11 | 11 |\n| ASPAC management and franchising |\n| Management, franchise, and other fees revenues | 18 | 20 | 32 | 35 |\n| Contra revenue | ( 1 ) | ( 1 ) | ( 2 ) | ( 2 ) |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties | 34 | 24 | 63 | 44 |\n| Adjusted EBITDA | 6 | 10 | 11 | 15 |\n| Depreciation and amortization | 1 | 1 | 1 | 2 |\n| EAME/SW Asia management and franchising |\n| Management, franchise, and other fees revenues | 21 | 6 | 36 | 13 |\n| Contra revenue | ( 2 ) | ( 3 ) | ( 4 ) | ( 6 ) |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties | 23 | 15 | 44 | 28 |\n| Intersegment revenues (1) | 2 | — | 3 | — |\n| Adjusted EBITDA | 13 | ( 1 ) | 19 | ( 1 ) |\n| Apple Leisure Group |\n| Owned and leased hotels revenue | 4 | — | 4 | — |\n| Management, franchise, and other fees revenues | 36 | — | 66 | — |\n| Distribution and destination management revenues | 256 | — | 502 | — |\n| Other revenues | 33 | — | 67 | — |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties | 26 | — | 55 | — |\n| Adjusted EBITDA | 54 | — | 110 | — |\n| Depreciation and amortization | 47 | — | 102 | — |\n| Corporate and other |\n| Revenues | 13 | 11 | 27 | 19 |\n| Intersegment revenues (1) | ( 1 ) | — | ( 2 ) | — |\n| Adjusted EBITDA | ( 34 ) | ( 21 ) | ( 72 ) | ( 45 ) |\n| Depreciation and amortization | 7 | 9 | 14 | 18 |\n| Eliminations |\n| Revenues (1) | ( 21 ) | ( 10 ) | ( 36 ) | ( 16 ) |\n| Adjusted EBITDA | — | 1 | 1 | 1 |\n| TOTAL |\n| Revenues | $ | 1,483 | $ | 663 | $ | 2,762 | $ | 1,101 |\n| Adjusted EBITDA | 255 | 55 | 424 | 35 |\n| Depreciation and amortization | 105 | 74 | 224 | 148 |\n| (1) Intersegment revenues are included in management, franchise, and other fees revenues, owned and leased hotels revenues, and other revenues and eliminated in Eliminations. |\n\n28\nThe table below provides a reconciliation of our net income (loss) attributable to Hyatt Hotels Corporation to EBITDA and a reconciliation of EBITDA to our consolidated Adjusted EBITDA:\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Net income (loss) attributable to Hyatt Hotels Corporation | $ | 206 | $ | ( 9 ) | $ | 133 | $ | ( 313 ) |\n| Interest expense | 38 | 42 | 78 | 83 |\n| Provision for income taxes | 106 | 15 | 108 | 201 |\n| Depreciation and amortization | 105 | 74 | 224 | 148 |\n| EBITDA | 455 | 122 | 543 | 119 |\n| Contra revenue | 9 | 9 | 18 | 17 |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties | ( 640 ) | ( 366 ) | ( 1,180 ) | ( 626 ) |\n| Costs incurred on behalf of managed and franchised properties | 628 | 375 | 1,184 | 652 |\n| Equity (earnings) losses from unconsolidated hospitality ventures | ( 1 ) | 34 | 8 | ( 20 ) |\n| Stock-based compensation expense (Note 14) | 12 | 8 | 40 | 36 |\n| Gains on sales of real estate (Note 6) | ( 251 ) | ( 105 ) | ( 251 ) | ( 105 ) |\n| Asset impairments | 7 | 2 | 10 | 2 |\n| Other (income) loss, net (Note 18) | 19 | ( 25 ) | 29 | ( 37 ) |\n| Pro rata share of unconsolidated owned and leased hospitality ventures' Adjusted EBITDA | 17 | 1 | 23 | ( 3 ) |\n| Adjusted EBITDA | $ | 255 | $ | 55 | $ | 424 | $ | 35 |\n\n29\n17. EARNINGS (LOSSES) PER SHARE\nThe calculation of basic and diluted earnings (losses) per share, including a reconciliation of the numerator and denominator, is as follows:\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Numerator: |\n| Net income (loss) | $ | 206 | $ | ( 9 ) | $ | 133 | $ | ( 313 ) |\n| Net income (loss) attributable to noncontrolling interests | — | — | — | — |\n| Net income (loss) attributable to Hyatt Hotels Corporation | $ | 206 | $ | ( 9 ) | $ | 133 | $ | ( 313 ) |\n| Denominator: |\n| Basic weighted-average shares outstanding | 109,953,302 | 101,898,773 | 110,062,212 | 101,713,331 |\n| Share-based compensation | 1,973,560 | — | 2,120,840 | — |\n| Diluted weighted-average shares outstanding | 111,926,862 | 101,898,773 | 112,183,052 | 101,713,331 |\n| Basic Earnings (Losses) Per Share: |\n| Net income (loss) | $ | 1.88 | $ | ( 0.08 ) | $ | 1.21 | $ | ( 3.07 ) |\n| Net income (loss) attributable to noncontrolling interests | — | — | — | — |\n| Net income (loss) attributable to Hyatt Hotels Corporation | $ | 1.88 | $ | ( 0.08 ) | $ | 1.21 | $ | ( 3.07 ) |\n| Diluted Earnings (Losses) Per Share: |\n| Net income (loss) | $ | 1.85 | $ | ( 0.08 ) | $ | 1.19 | $ | ( 3.07 ) |\n| Net income (loss) attributable to noncontrolling interests | — | — | — | — |\n| Net income (loss) attributable to Hyatt Hotels Corporation | $ | 1.85 | $ | ( 0.08 ) | $ | 1.19 | $ | ( 3.07 ) |\n\nThe computations of diluted net earnings (losses) per share for the three and six months ended June 30, 2022 and June 30, 2021 do not include the following shares of Class A common stock assumed to be issued as stock-settled SARs and RSUs because they are anti-dilutive.\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| SARs | 11,500 | 1,321,700 | 9,200 | 1,317,600 |\n| RSUs | 10,500 | 587,900 | 1,700 | 584,100 |\n\n18. OTHER INCOME (LOSS), NET\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Unrealized gains (losses), net (Note 4) | $ | ( 34 ) | $ | 5 | $ | ( 44 ) | $ | 13 |\n| Loss on extinguishment of debt (Note 9) | ( 8 ) | — | ( 8 ) | — |\n| Foreign currency gains (losses), net | ( 3 ) | 13 | ( 2 ) | 7 |\n| Performance guarantee expense (Note 12) | ( 1 ) | ( 4 ) | ( 8 ) | ( 5 ) |\n| Depreciation recovery | 4 | 5 | 8 | 9 |\n| Performance guarantee liability amortization (Note 12) | 5 | — | 7 | 1 |\n| Credit loss provisions and reversals, net (Note 4 and Note 5) | 6 | ( 8 ) | 5 | ( 10 ) |\n| Interest income | 9 | 8 | 15 | 14 |\n| Other, net | 3 | 6 | ( 2 ) | 8 |\n| Other income (loss), net | $ | ( 19 ) | $ | 25 | $ | ( 29 ) | $ | 37 |\n\n30\n19. SUBSEQUENT EVENT\nOn August 3, 2022, we acquired Hotel Irvine, located in Irvine, California, from an unrelated third party for approximately $ 135 million.\n31\nItem 2.\nManagement's Discussion and Analysis of Financial Condition and Results of Operations.\nThis quarterly report contains \"forward-looking statements\" within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include statements about the Company's plans, strategies, and financial performance; the impact of the COVID-19 pandemic and pace of recovery; the amount by which the Company intends to reduce its real estate asset base and the anticipated timeframe for such asset dispositions; and prospective or future events. Forward-looking statements involve known and unknown risks that are difficult to predict. As a result, our actual results, performance or achievements may differ materially from those expressed or implied by these forward-looking statements. In some cases, you can identify forward-looking statements by the use of words such as \"may,\" \"could,\" \"expect,\" \"intend,\" \"plan,\" \"seek,\" \"anticipate,\" \"believe,\" \"estimate,\" \"predict,\" \"potential,\" \"continue,\" \"likely,\" \"will,\" \"would,\" and variations of these terms and similar expressions, or the negative of these terms or similar expressions. Such forward-looking statements are necessarily based upon estimates and assumptions that, while considered reasonable by us and our management, are inherently uncertain. Factors that may cause actual results to differ materially from current expectations include, but are not limited to: the factors discussed in our filings with the SEC, including our Annual Report on Form 10-K; risks associated with the acquisition of Apple Leisure Group; our ability to realize the anticipated benefits of the acquisition of Apple Leisure Group as rapidly or to the extent anticipated, including successful integration of the Apple Leisure Group business; the duration and severity of the COVID-19 pandemic and the pace of recovery following the pandemic, any additional resurgence, or COVID-19 variants; the short and long-term effects of the COVID-19 pandemic, including on the demand for travel, transient and group business, and levels of consumer confidence; the impact of the COVID-19 pandemic, any additional resurgence, or COVID-19 variants, and the impact of actions that governments, businesses, and individuals take in response, on global and regional economies, travel limitations or bans, and economic activity, including the duration and magnitude of its impact on unemployment rates and consumer discretionary spending; the broad distribution and efficacy of COVID-19 vaccines and treatments, wide acceptance by the general population of such vaccines, and the availability, use, and effectiveness of COVID-19 testing, including at-home testing kits; the ability of third-party owners, franchisees, or hospitality venture partners to successfully navigate the impacts of the COVID-19 pandemic, any additional resurgence, or COVID-19 variants; general economic uncertainty in key global markets and a worsening of global economic conditions or low levels of economic growth; the rate and the pace of economic recovery following economic downturns; global supply chain constraints and interruptions, rising costs of construction-related labor and materials, and increases in costs due to inflation or other factors that may not be fully offset by increases in revenues in our business; risks affecting the luxury, resort, and all-inclusive lodging segments; levels of spending in business, leisure, and group segments as well as consumer confidence; declines in occupancy and average daily rate (\"ADR\"); limited visibility with respect to future bookings; loss of key personnel; domestic and international political and geo-political conditions, including political or civil unrest or changes in trade policy; hostilities, or fear of hostilities, including future terrorist attacks, that affect travel; travel-related accidents; natural or man-made disasters such as earthquakes, tsunamis, tornadoes, hurricanes, floods, wildfires, oil spills, nuclear incidents, and global outbreaks of pandemics or contagious diseases, or fear of such outbreaks; our ability to successfully achieve certain levels of operating profits at hotels that have performance tests or guarantees in favor of our third-party owners; the impact of hotel renovations and redevelopments; risks associated with our capital allocation plans, share repurchase program, and dividend payments, including a reduction in, or elimination or suspension of, repurchase activity or dividend payments; the seasonal and cyclical nature of the real estate and hospitality businesses; changes in distribution arrangements, such as through internet travel intermediaries; changes in the tastes and preferences of our customers; relationships with colleagues and labor unions and changes in labor laws; the financial condition of, and our relationships with, third-party property owners, franchisees, and hospitality venture partners; the possible inability of third-party owners, franchisees, or development partners to access the capital necessary to fund current operations or implement our plans for growth; risks associated with potential acquisitions and dispositions and the introduction of new brand concepts; the timing of acquisitions and dispositions and our ability to successfully integrate completed acquisitions with existing operations; failure to successfully complete proposed transactions (including the failure to satisfy closing conditions or obtain required approvals); our ability to successfully execute on our strategy to expand our management and franchising business while at the same time reducing our real estate asset base within targeted timeframes and at expected values; declines in the value of our real estate assets; unforeseen terminations of our management or franchise agreements; changes in federal, state, local, or foreign tax law; increases in interest rates, wages, and other operating costs; foreign exchange rate fluctuations or currency restructurings; lack of acceptance of new brands or innovation; general volatility of the capital markets and our ability to access such markets; changes in the competitive environment in our industry, including as a result of the COVID-19 pandemic, industry consolidation, and the markets where we operate; our ability to successfully grow the World of Hyatt loyalty program and Unlimited Vacation Club paid membership program; cyber incidents and\n32\ninformation technology failures; outcomes of legal or administrative proceedings; and violations of regulations or laws related to our franchising business.\nThese factors are not necessarily all of the important factors that could cause our actual results, performance, or achievements to differ materially from those expressed in or implied by any of our forward-looking statements. Other unknown or unpredictable factors could also harm our business, financial condition, results of operations, or cash flows. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements set forth above. Forward-looking statements speak only as of the date they are made, and we do not undertake or assume any obligation to update publicly any of these forward-looking statements to reflect actual results, new information or future events, changes in assumptions, or changes in other factors affecting forward-looking statements, except to the extent required by applicable law. If we update one or more forward-looking statements, no inference should be drawn that we will make additional updates with respect to those or other forward-looking statements.\nThe following discussion should be read in conjunction with the Company's condensed consolidated financial statements and accompanying Notes, which appear elsewhere in this Quarterly Report on Form 10-Q.\nExecutive Overview\nOur portfolio of properties consists of full service hotels, select service hotels, all-inclusive resorts, and other properties, including timeshare, fractional, and other forms of residential, vacation ownership, and condominium units.\nAt June 30, 2022, our hotel portfolio consisted of 1,194 hotels (290,987 rooms), including:\n•453 managed properties (137,268 rooms), all of which we operate under management and hotel services agreements with third-party property owners;\n•554 franchised properties (92,682 rooms), all of which are owned by third parties that have franchise agreements with us and are operated by third parties;\n•23 owned properties (10,019 rooms), 1 finance leased property (171 rooms), and 5 operating leased properties (1,965 rooms), all of which we manage;\n•22 managed properties and 2 franchised properties owned or leased by unconsolidated hospitality ventures (7,918 rooms);\n•13 franchised properties (2,310 rooms) that are operated by an unconsolidated hospitality venture in connection with a master license agreement by Hyatt, 5 of these properties (1,114 rooms) are leased by the unconsolidated hospitality venture; and\n•121 all-inclusive resorts (38,654 rooms), including 106 owned by a third party (33,784 rooms), 9 owned by a third party in which we hold common shares (3,591 rooms), and 6 leased properties (1,279 rooms).\nOur property portfolio also included:\n•22 vacation ownership properties under the Hyatt Residence Club brand and operated by third parties;\n•37 residential properties, which consist of branded residences and serviced apartments. We manage all of the serviced apartments and those branded residential units that participate in a rental program with an adjacent Hyatt-branded hotel; and\n•39 condominium properties for which we provide services for the rental programs and/or homeowners associations (including 1 unconsolidated hospitality venture).\nAdditionally, through strategic relationships, we provide certain reservation and/or loyalty program services to hotels that are unaffiliated with our hotel portfolio and operate under other tradenames or marks owned by such hotels or licensed by third parties. We also offer travel distribution and destination management services through ALG Vacations and a paid membership program through Unlimited Vacation Club.\nWe report our consolidated operations in U.S. dollars. Amounts are reported in millions, unless otherwise noted. Percentages may not recompute due to rounding, and percentage changes that are not meaningful are presented as \"NM.\" Constant currency disclosures used throughout Management's Discussion and Analysis of\n33\nFinancial Condition and Results of Operations are non-GAAP measures. See \"—Non-GAAP Measures\" for further discussion of constant currency disclosures. We manage our business within five reportable segments as described below:\n•Owned and leased hotels, which consists of our owned and leased full service and select service hotels and, for purposes of segment Adjusted EBITDA, our pro rata share of the Adjusted EBITDA of our unconsolidated hospitality ventures, based on our ownership percentage of each venture;\n•Americas management and franchising (\"Americas\"), which consists of our management and franchising of properties, including all-inclusive resorts under the Hyatt Ziva and Hyatt Zilara brand names, located in the United States, Canada, the Caribbean, Mexico, Central America, and South America, as well as our residential management operations;\n•ASPAC management and franchising (\"ASPAC\"), which consists of our management and franchising of properties located in Southeast Asia, Greater China, Australia, New Zealand, South Korea, Japan, and Micronesia;\n•EAME/SW Asia management and franchising (\"EAME/SW Asia\"), which consists of our management and franchising of properties located in Europe, Africa, the Middle East, India, Central Asia, and Nepal; and\n•Apple Leisure Group, which consists of distribution and destination management services offered through ALG Vacations; management and marketing of primarily all-inclusive ALG resorts in Mexico, the Caribbean, Central America, South America, and Europe; and the Unlimited Vacation Club paid membership program, which offers benefits exclusively at ALG resorts within Mexico, the Caribbean, and Central America.\nWithin corporate and other, we include the results from our co-branded credit card program and unallocated corporate expenses.\nThe Company is planning a geographic realignment of its EAME/SW Asia and ASPAC segments, which is expected to be effective on January 1, 2023. See Part I, Item 1 \"Financial Statements—Note 16 to the Condensed Consolidated Financial Statements\" for further discussion of our segment structure and the planned geographic realignment.\nRecent Developments\nCOVID-19 Pandemic\nWe are experiencing continued recovery from the COVID-19 pandemic, which is being led by robust leisure demand and growing momentum in group and business transient travel. However, we acknowledge that demand may be varied and uneven as the recovery continues to progress. Factors such as the spread of new COVID-19 variants, travel bans, or restrictions in certain markets may continue to impact our financial results for a period of time that we are currently unable to predict. In addition, certain labor and supply chain challenges, and increases in costs due to inflation or other factors may also continue to impact our financial results in the future.\nRussian Invasion of Ukraine\nIn February 2022, Russia commenced a military invasion of Ukraine, and the ongoing invasion and subsequent financial and economic sanctions have increased global political and economic uncertainty. While this conflict has affected our operations in Ukraine and Russia, our financial results for the three months ended June 30, 2022 were not materially affected by this conflict, as hotels in these countries represented less than 1% of our total managed and franchised hotels and contributed less than 1% of total management and franchise fee revenues.\nOverview of Financial Results\nFor the quarter ended June 30, 2022, we reported net income attributable to Hyatt Hotels Corporation of $206 million, compared to a net loss attributable to Hyatt Hotels Corporation of $9 million for the quarter ended June 30, 2021, representing an increase of $215 million. The increase was primarily driven by improved operating performance and gains recognized on the sales of real estate.\nConsolidated revenues increased $820 million, or 123.6%, during the quarter ended June 30, 2022 compared to the quarter ended June 30, 2021, driven by continued recovery in operating performance, as compared to the prior year, as well as the acquisition of ALG, which contributed $355 million of total revenues.\n34\nOur consolidated Adjusted EBITDA for the quarter ended June 30, 2022 was $255 million, an increase of $200 million compared to the second quarter of 2021, driven by the aforementioned increases in revenues due to the ongoing recovery from the COVID-19 pandemic. The increase in Adjusted EBITDA was primarily driven by our owned and leased hotels segment and Americas management and franchising segment, which increased $87 million and $63 million, respectively, for the quarter ended June 30, 2022, compared to the same period in the prior year. During the quarter ended June 30, 2022, our consolidated Adjusted EBITDA also included $54 million from the Apple Leisure Group segment. See \"—Segment Results\" for further discussion. See \"—Non-GAAP Measures\" for an explanation of how we utilize Adjusted EBITDA, why we present it, and material limitations on its usefulness, as well as a reconciliation of our net income (loss) attributable to Hyatt Hotels Corporation to EBITDA and a reconciliation of EBITDA to consolidated Adjusted EBITDA.\nDuring the quarter ended June 30, 2022, we returned $101 million of capital to our shareholders through share repurchases. Additionally, we reduced our outstanding debt through the legal defeasance of $166 million of the Series 2005 Bonds and through the repurchase of $15 million of our Senior Notes in the open market.\nHotel Chain Revenue per Available Room (\"RevPAR\") Statistics.\n| RevPAR |\n| Three Months Ended June 30, |\n| (Comparable locations) | Number of comparable hotels (1) | 2022 | vs. 2021(in constant $) |\n| System-wide hotels | 922 | $ | 130 | 81.7 | % |\n| Owned and leased hotels | 26 | $ | 186 | 140.1 | % |\n| Americas full service hotels | 217 | $ | 175 | 112.0 | % |\n| Americas select service hotels | 435 | $ | 117 | 55.2 | % |\n| ASPAC full service hotels | 120 | $ | 71 | 0.8 | % |\n| ASPAC select service hotels | 31 | $ | 33 | (22.6) | % |\n| EAME/SW Asia full service hotels | 99 | $ | 135 | 239.9 | % |\n| EAME/SW Asia select service hotels | 20 | $ | 62 | 148.2 | % |\n| (1) The number of comparable hotels presented above includes owned and leased hotels. |\n\nSystem-wide RevPAR increased 81.7% during the three months ended June 30, 2022, compared to the three months ended June 30, 2021, driven primarily by the continued recovery from the COVID-19 pandemic in the Americas and EAME/SW Asia management and franchising segments. See \"—Segment Results\" for discussion of RevPAR by segment.\nOur comparable system-wide hotels RevPAR of $130 for the quarter ended June 30, 2022 represents significant improvement, compared to the quarter ended June 30, 2021, and is approaching the pre-COVID-19 pandemic levels for the quarter ended June 30, 2019. Strength in leisure transient travel continues to lead the recovery with sustained elevated levels significantly exceeding 2019.\nDuring the three months ended June 30, 2022, we also experienced strong momentum in group travel, which is at the highest level since the start of the COVID-19 pandemic. Compared to 2021, group bookings production increased at our Americas full service managed hotels, including owned and leased hotels, and business transient demand continued to improve, particularly in the Americas management and franchising segment.\n35\nResults of Operations\nThree and Six Months Ended June 30, 2022 Compared with Three and Six Months Ended June 30, 2021\nDiscussion on Consolidated Results\nFor additional information regarding our consolidated results, refer to our condensed consolidated statements of income (loss) included in this quarterly report. During the three and six months ended June 30, 2022, consolidated results improved significantly in most markets, compared to the three and six months ended June 30, 2021, which were negatively impacted by the COVID-19 pandemic. The three and six months ended June 30, 2022 also benefited from strong performance by ALG, which was acquired on November 1, 2021. See \"—Segment Results\" for further discussion.\nThe impact from our investments in marketable securities held to fund our deferred compensation plans through rabbi trusts was recognized on the following financial statement line items and had no impact on net income (loss): revenues for the reimbursement of costs incurred on behalf of managed and franchised properties; owned and leased hotels expenses; selling, general, and administrative expenses; costs incurred on behalf of managed and franchised properties; and net gains (losses) and interest income from marketable securities held to fund rabbi trusts.\nOwned and leased hotels revenues.\n| Three Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) | Currency Impact |\n| Comparable owned and leased hotels revenues | $ | 278 | $ | 118 | $ | 160 | 134.7 | % | $ | (1) |\n| Non-comparable owned and leased hotels revenues | 53 | 73 | (20) | (26.2) | % | — |\n| Total owned and leased hotels revenues | $ | 331 | $ | 191 | $ | 140 | 73.3 | % | $ | (1) |\n\n| Six Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) | Currency Impact |\n| Comparable owned and leased hotels revenues | $ | 481 | $ | 177 | $ | 304 | 170.8 | % | $ | (1) |\n| Non-comparable owned and leased hotels revenues | 121 | 118 | 3 | 3.5 | % | — |\n| Total owned and leased hotels revenues | $ | 602 | $ | 295 | $ | 307 | 104.1 | % | $ | (1) |\n\nComparable owned and leased hotels revenues increased during the three and six months ended June 30, 2022, compared to the same periods in the prior year, driven by increased demand and ADR in 2022 due to the ongoing recovery from the COVID-19 pandemic. The decrease in non-comparable owned and leased hotels revenues during the three months ended June 30, 2022, compared to the three months ended June 30, 2021, was primarily driven by disposition activity, partially offset by the re-opening of an owned hotel that was closed for an extended period in 2021.\n36\nManagement, franchise, and other fees revenues.\n| Three Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Base management fees | $ | 79 | $ | 36 | $ | 43 | 119.2 | % |\n| Incentive management fees | 45 | 12 | 33 | 264.6 | % |\n| Franchise fees | 52 | 29 | 23 | 83.4 | % |\n| Management and franchise fees | 176 | 77 | 99 | 129.4 | % |\n| Other fees revenues | 28 | 16 | 12 | 68.6 | % |\n| Management, franchise, and other fees | $ | 204 | $ | 93 | $ | 111 | 118.3 | % |\n\n| Three Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Management, franchise, and other fees | $ | 204 | $ | 93 | $ | 111 | 118.3 | % |\n| Contra revenue | (9) | (9) | — | (8.0) | % |\n| Net management, franchise, and other fees | $ | 195 | $ | 84 | $ | 111 | 129.8 | % |\n\n| Six Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Base management fees | $ | 139 | $ | 60 | $ | 79 | 131.5 | % |\n| Incentive management fees | 85 | 20 | 65 | 324.4 | % |\n| Franchise fees | 87 | 46 | 41 | 91.9 | % |\n| Management and franchise fees | 311 | 126 | 185 | 147.9 | % |\n| Other fees revenues | 47 | 30 | 17 | 53.7 | % |\n| Management, franchise, and other fees | $ | 358 | $ | 156 | $ | 202 | 129.3 | % |\n\n| Six Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Management, franchise, and other fees | $ | 358 | $ | 156 | $ | 202 | 129.3 | % |\n| Contra revenue | (18) | (17) | (1) | (7.6) | % |\n| Net management, franchise, and other fees | $ | 340 | $ | 139 | $ | 201 | 144.1 | % |\n\nThe increases in management and franchise fees during the three and six months ended June 30, 2022, compared to the same periods in the prior year, were due to increased demand and ADR in 2022 driven by the ongoing recovery from the COVID-19 pandemic as well as portfolio growth. During the three and six months ended June 30, 2022, ALG's base and incentive management fees were $26 million and $53 million, respectively.\nOther fees revenues increased for the three and six months ended June 30, 2022, compared to the three and six months ended June 30, 2021, primarily driven by fees from marketing services provided by ALG and increased license fees related to our co-branded credit card program.\nDistribution and destination management revenues. Distribution and destination management revenues related to ALG Vacations were $256 million and $502 million for the three and six months ended June 30, 2022, respectively, driven by strong leisure travel demand.\nOther revenues. During the three and six months ended June 30, 2022, compared to the three and six months ended June 30, 2021, other revenues increased $39 million and $97 million, respectively, primarily driven by the Unlimited Vacation Club paid membership program, which was acquired in the ALG Acquisition, and increases in revenues related to our residential management operations due to the ongoing recovery from the COVID-19 pandemic.\n37\nRevenues for the reimbursement of costs incurred on behalf of managed and franchised properties.\n| Three Months Ended June 30, |\n| 2022 | 2021 | Change |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties | $ | 640 | $ | 366 | $ | 274 | 75.1 | % |\n| Less: rabbi trust impact | 21 | (11) | 32 | 303.4 | % |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties excluding rabbi trust impact | $ | 661 | $ | 355 | $ | 306 | 86.6 | % |\n\n| Six Months Ended June 30, |\n| 2022 | 2021 | Change |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties | $ | 1,180 | $ | 626 | $ | 554 | 88.7 | % |\n| Less: rabbi trust impact | 36 | (16) | 52 | 330.2 | % |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties excluding rabbi trust impact | $ | 1,216 | $ | 610 | $ | 606 | 99.5 | % |\n\nRevenues for the reimbursement of costs incurred on behalf of managed and franchised properties increased during the three and six months ended June 30, 2022, compared to the same periods in the prior year, primarily driven by higher reimbursements for payroll and related expenses at managed properties where we are the employer and reimbursements for costs related to system-wide services provided to managed and franchised properties due to increased hotel operations and performance as a result of the ongoing recovery from the COVID-19 pandemic. During the three and six months ended June 30, 2022, ALG revenues for the reimbursement of costs incurred on behalf of managed and franchised properties were $26 million and $55 million, respectively.\nThe increases in revenues for the reimbursement of costs incurred on behalf of managed and franchised properties during the three and six months ended June 30, 2022, compared to the three and six months ended June 30, 2021, also reflect a $32 million and $52 million decrease, respectively, in marketable securities held to fund our deferred compensation plans through rabbi trusts due to a decline in market performance.\nOwned and leased hotels expenses.\n| Three Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Comparable owned and leased hotels expenses | $ | 188 | $ | 111 | $ | (77) | (70.6) | % |\n| Non-comparable owned and leased hotels expenses | 46 | 60 | 14 | 24.1 | % |\n| Rabbi trust impact | (5) | 3 | 8 | 250.4 | % |\n| Total owned and leased hotels expenses | $ | 229 | $ | 174 | $ | (55) | (32.1) | % |\n\n| Six Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Comparable owned and leased hotels expenses | $ | 345 | $ | 188 | $ | (157) | (83.4) | % |\n| Non-comparable owned and leased hotels expenses | 102 | 105 | 3 | 2.8 | % |\n| Rabbi trust impact | (8) | 5 | 13 | 270.0 | % |\n| Total owned and leased hotels expenses | $ | 439 | $ | 298 | $ | (141) | (47.3) | % |\n\nThe increases in comparable owned and leased hotels expenses during the three and six months ended June 30, 2022, compared to the same periods in the prior year, were primarily due to higher variable expenses driven by increased demand in 2022 due to the ongoing recovery from the COVID-19 pandemic. The decrease in non-comparable owned and leased hotels expenses during the three months ended June 30, 2022, compared to the three months ended June 30, 2021, was primarily driven by disposition activity, partially offset by the re-opening of an owned hotel that was closed for an extended period in 2021.\n38\nDistribution and destination management expenses. Distribution and destination management expenses related to ALG Vacations were $206 million and $400 million for the three and six months ended June 30, 2022, respectively, driven by strong leisure travel demand.\nDepreciation and amortization expenses. Depreciation and amortization expenses increased $31 million and $76 million during the three and six months ended June 30, 2022, compared to the three and six months ended June 30, 2021, respectively, primarily driven by amortization of intangible assets acquired in the ALG Acquisition, partially offset by dispositions of owned hotels.\nOther direct costs. During the three and six months ended June 30, 2022, compared to the same periods in the prior year, other direct costs increased $45 million and $89 million, respectively, primarily driven by the Unlimited Vacation Club paid membership program, which was acquired in the ALG Acquisition, and increases in expenses related to our residential management operations due to the ongoing recovery from the COVID-19 pandemic.\nSelling, general, and administrative expenses.\n| Three Months Ended June 30, |\n| 2022 | 2021 | Change |\n| Selling, general, and administrative expenses | $ | 76 | $ | 86 | $ | (10) | (11.4) | % |\n| Less: rabbi trust impact | 41 | (21) | 62 | 299.8 | % |\n| Less: stock-based compensation expense | (12) | (8) | (4) | (71.6) | % |\n| Adjusted selling, general, and administrative expenses | $ | 105 | $ | 57 | $ | 48 | 81.2 | % |\n\n| Six Months Ended June 30, |\n| 2022 | 2021 | Change |\n| Selling, general, and administrative expenses | $ | 187 | $ | 181 | $ | 6 | 3.4 | % |\n| Less: rabbi trust impact | 69 | (31) | 100 | 323.9 | % |\n| Less: stock-based compensation expense | (40) | (36) | (4) | (12.3) | % |\n| Adjusted selling, general, and administrative expenses | $ | 216 | $ | 114 | $ | 102 | 88.7 | % |\n\nSelling, general, and administrative expenses during the three and six months ended June 30, 2022 compared to the three and six months ended June 30, 2021, reflect the decline in market performance of the underlying investments in marketable securities held to fund our deferred compensation plans through rabbi trusts.\nAdjusted selling, general, and administrative expenses exclude the impact of deferred compensation plans funded through rabbi trusts and stock-based compensation expense. Adjusted selling, general, and administrative expenses increased during the three and six months ended June 30, 2022, compared to the same periods in the prior year, primarily driven by costs from the ALG businesses as well as $4 million and $11 million, respectively, of ALG integration-related costs. Adjusted selling, general, and administrative expenses, as we define it, is a non-GAAP measure. See \"—Non-GAAP Measures\" for further discussion of Adjusted selling, general, and administrative expenses.\n39\nCosts incurred on behalf of managed and franchised properties.\n| Three Months Ended June 30, |\n| 2022 | 2021 | Change |\n| Costs incurred on behalf of managed and franchised properties | $ | 628 | $ | 375 | $ | 253 | 67.6 | % |\n| Less: rabbi trust impact | 21 | (11) | 32 | 303.4 | % |\n| Costs incurred on behalf of managed and franchised properties excluding rabbi trust impact | $ | 649 | $ | 364 | $ | 285 | 78.5 | % |\n\n| Six Months Ended June 30, |\n| 2022 | 2021 | Change |\n| Costs incurred on behalf of managed and franchised properties | $ | 1,184 | $ | 652 | $ | 532 | 81.7 | % |\n| Less: rabbi trust impact | 36 | (16) | 52 | 330.2 | % |\n| Costs incurred on behalf of managed and franchised properties excluding rabbi trust impact | $ | 1,220 | $ | 636 | $ | 584 | 92.0 | % |\n\nCosts incurred on behalf of managed and franchised properties increased during the three and six months ended June 30, 2022, compared to the three and six months ended June 30, 2021, primarily driven by increased payroll and related expenses at managed properties where we are the employer and expenses related to system-wide services provided to managed and franchised properties due to improved hotel operating performance as a result of the ongoing recovery from the COVID-19 pandemic. During the three and six months ended June 30, 2022, ALG costs incurred on behalf of managed and franchised properties were $25 million and $54 million, respectively.\nThe increases during the three and six months ended June 30, 2022, compared to the three and six months ended June 30, 2021, also reflect a $32 million and $52 million decrease, respectively, in the value of the marketable securities held to fund our deferred compensation plans through rabbi trusts due to a decline in market performance.\nNet gains (losses) and interest income from marketable securities held to fund rabbi trusts.\n| Three Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Rabbi trust impact allocated to selling, general, and administrative expenses | $ | (41) | $ | 21 | $ | (62) | (299.8) | % |\n| Rabbi trust impact allocated to owned and leased hotels expenses | (5) | 3 | (8) | (250.4) | % |\n| Net gains (losses) and interest income from marketable securities held to fund rabbi trusts | $ | (46) | $ | 24 | $ | (70) | (293.1) | % |\n\n| Six Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Rabbi trust impact allocated to selling, general, and administrative expenses | $ | (69) | $ | 31 | $ | (100) | (323.9) | % |\n| Rabbi trust impact allocated to owned and leased hotels expense | (8) | 5 | (13) | (270.0) | % |\n| Net gains (losses) and interest income from marketable securities held to fund rabbi trusts | $ | (77) | $ | 36 | $ | (113) | (316.6) | % |\n\nNet gains (losses) and interest income from marketable securities held to fund rabbi trusts decreased during the three and six months ended June 30, 2022, compared to the same periods in the prior year, driven by the performance of the underlying invested assets.\n40\nEquity earnings (losses) from unconsolidated hospitality ventures.\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2022 | 2021 | Better /(Worse) | 2022 | 2021 | Better /(Worse) |\n| Hyatt's share of unconsolidated hospitality ventures net losses excluding foreign currency | $ | (10) | $ | (14) | $ | 4 | $ | (21) | $ | (34) | $ | 13 |\n| Net gains (losses) from sales activity related to unconsolidated hospitality ventures (Note 4) | 4 | (1) | 5 | 4 | 68 | (64) |\n| Hyatt's share of unconsolidated hospitality ventures foreign currency net gains | — | — | — | — | 4 | (4) |\n| Other (1) | 7 | (19) | 26 | 9 | (18) | 27 |\n| Equity earnings (losses) from unconsolidated hospitality ventures | $ | 1 | $ | (34) | $ | 35 | $ | (8) | $ | 20 | $ | (28) |\n| (1) During the three and six months ended June 30, 2021, losses primarily related to the debt repayment guarantees that we entered into for the hotel properties in India. See Part I, Item 1 \"Financial Statements—Note 12 to the Condensed Consolidated Financial Statements\" for additional information. |\n\nGains on sales of real estate. During the three months ended June 30, 2022 we recognized the following:\n•$137 million pre-tax gain related to the sale of Grand Hyatt San Antonio River Walk;\n•$51 million pre-tax gain related to the sale of The Driskill;\n•$40 million pre-tax gain related to the sale of Hyatt Regency Indian Wells Resort & Spa; and\n•$24 million pre-tax gain related to the sale of The Confidante Miami Beach.\nDuring the three months ended June 30, 2021 we recognized a $104 million pre-tax gain related to the sale of Hyatt Regency Lost Pines Resort and Spa.\nSee Part I, Item 1 \"Financial Statements—Note 6 to the Condensed Consolidated Financial Statements\" for additional information.\nAsset impairments. During the three months ended June 30, 2022, we recognized a $7 million goodwill impairment charge in connection with the sale of Grand Hyatt San Antonio River Walk. Additionally, during the six months ended June 30, 2022, we recognized $3 million of asset impairment charges related to intangible assets, primarily as a result of contract terminations.\nDuring the three and six months ended June 30, 2021, we recognized $2 million of asset impairment charges related to intangible assets, primarily as a result of contract terminations.\nOther income (loss), net. Other income (loss), net decreased $44 million and $66 million during the three and six months ended June 30, 2022, respectively, compared to the same periods in the prior year. See Part I, Item 1 \"Financial Statements—Note 18 to the Condensed Consolidated Financial Statements\" for additional information.\n41\nProvision for income taxes.\n| Three Months Ended June 30, |\n| 2022 | 2021 | Change |\n| Income before income taxes | $ | 312 | $ | 6 | $ | 306 | NM |\n| Provision for income taxes | (106) | (15) | (91) | (578.5) | % |\n| Effective tax rate | 33.7 | % | 227.6 | % | (193.9) | % |\n\n| Six Months Ended June 30, |\n| 2022 | 2021 | Change |\n| Income (loss) before income taxes | $ | 241 | $ | (112) | $ | 353 | 315.8 | % |\n| Provision for income taxes | (108) | (201) | 93 | 46.4 | % |\n| Effective tax rate | 44.7 | % | (180.0) | % | 224.7 | % |\n\nThe increase in the provision for income taxes during the three months ended June 30, 2022, compared to the three months ended June 30, 2021, was primarily attributable to the sales of Hyatt Regency Indian Wells Resort & Spa, Grand Hyatt San Antonio River Walk, The Driskill, and The Confidante Miami Beach.\nThe decrease in the provision for income taxes during the six months ended June 30, 2022, compared to the six months ended June 30, 2021, was primarily driven by a non-cash expense to recognize a full valuation allowance on U.S. federal and state deferred tax assets in 2021. See Part I, Item 1 \"Financial Statements—Note 11 to the Condensed Consolidated Financial Statements.\"\nSegment Results\nAs described in Part I, Item 1 \"Financial Statements—Note 16 to the Condensed Consolidated Financial Statements,\" we evaluate segment operating performance using owned and leased hotels revenues; management, franchise, and other fees revenues; distribution and destination management revenues; and Adjusted EBITDA.\nDuring the three and six months ended June 30, 2022, our segment revenues, comparable RevPAR, and Adjusted EBITDA improved significantly in most markets, compared to the three and six months ended June 30, 2021, which were negatively impacted by the COVID-19 pandemic.\nOwned and leased hotels segment revenues.\n| Three Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) | Currency Impact |\n| Comparable owned and leased hotels revenues | $ | 286 | $ | 121 | $ | 165 | 134.6 | % | $ | (1) |\n| Non-comparable owned and leased hotels revenues | 49 | 73 | (24) | (32.4) | % | — |\n| Total segment revenues | $ | 335 | $ | 194 | $ | 141 | 71.9 | % | $ | (1) |\n\n| Six Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) | Currency Impact |\n| Comparable owned and leased hotels revenues | $ | 495 | $ | 183 | $ | 312 | 169.3 | % | $ | (1) |\n| Non-comparable owned and leased hotels revenues | 117 | 118 | (1) | (0.4) | % | — |\n| Total segment revenues | $ | 612 | $ | 301 | $ | 311 | 103.0 | % | $ | (1) |\n\nComparable owned and leased hotels revenues increased during the three and six months ended June 30, 2022, compared to the same periods in the prior year, driven by increased demand and ADR in 2022 due to the ongoing recovery from the COVID-19 pandemic.\nNon-comparable owned and leased hotels revenues decreased during the three and six months ended June 30, 2022, compared to the three and six months ended June 30, 2021, primarily driven by disposition activity, partially offset by the re-opening of an owned hotel that was closed for an extended period in 2021.\n42\n| Three Months Ended June 30, |\n| RevPAR | Occupancy | ADR |\n| 2022 | vs. 2021(in constant $) | 2022 | vs. 2021 | 2022 | vs. 2021(in constant $) |\n| Comparable owned and leased hotels | $ | 186 | 140.1 | % | 70.4 | % | 30.8% pts | $ | 265 | 35.2 | % |\n\n| Six Months Ended June 30, |\n| RevPAR | Occupancy | ADR |\n| 2022 | vs. 2021(in constant $) | 2022 | vs. 2021 | 2022 | vs. 2021(in constant $) |\n| Comparable owned and leased hotels | $ | 161 | 180.4 | % | 61.7 | % | 30.9% pts | $ | 261 | 39.8 | % |\n\nThe increases in RevPAR at our comparable owned and leased hotels during the three and six months ended June 30, 2022, compared to the same periods in the prior year, were due to continued recovery from the COVID-19 pandemic, primarily driven by strong leisure transient demand and ADR across various markets in the United States and Europe as well as growing momentum in group and business transient travel.\nDuring the three months ended June 30, 2022, we removed four properties from the comparable owned and leased hotels results as they were sold and combined two properties, thereby reducing the number of properties within our comparable owned and leased hotel results by one. Additionally, during the six months ended June 30, 2022, we removed one property from the comparable owned and leased hotels results as the property is undergoing a significant renovation.\nOwned and leased hotels segment Adjusted EBITDA.\n| Three Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Owned and leased hotels Adjusted EBITDA | $ | 82 | $ | 11 | $ | 71 | 687.5 | % |\n| Pro rata share of unconsolidated hospitality ventures' Adjusted EBITDA | 17 | 1 | 16 | NM |\n| Segment Adjusted EBITDA | $ | 99 | $ | 12 | $ | 87 | 752.4 | % |\n\n| Six Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Owned and leased hotels Adjusted EBITDA | $ | 130 | $ | (14) | $ | 144 | 998.3 | % |\n| Pro rata share of unconsolidated hospitality ventures' Adjusted EBITDA | 23 | (3) | 26 | NM |\n| Segment Adjusted EBITDA | $ | 153 | $ | (17) | $ | 170 | NM |\n\nThe increases in Adjusted EBITDA at our owned and leased hotels for the three and six months ended June 30, 2022, compared to the same periods in the prior year, were primarily driven by increases in comparable owned and leased hotels revenues, partially offset by increases in comparable owned and leased hotels expenses due to higher variable expenses incurred as a result of higher demand in 2022 related to the ongoing recovery from the COVID-19 pandemic.\nOur pro rata share of Adjusted EBITDA from our unconsolidated hospitality ventures increased during the three and six months ended June 30, 2022, compared to the same periods in 2021, primarily driven by the increased demand during 2022 due to continued recovery from the COVID-19 pandemic.\n43\nAmericas management and franchising segment revenues.\n| Three Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Segment revenues |\n| Management, franchise, and other fees | $ | 132 | $ | 66 | $ | 66 | 101.5 | % |\n| Contra revenue | (6) | (5) | (1) | (32.0) | % |\n| Other revenues | 25 | 19 | 6 | 35.5 | % |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties (1) | 557 | 327 | 230 | 70.4 | % |\n| Total segment revenues | $ | 708 | $ | 407 | $ | 301 | 74.3 | % |\n\n| Six Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Segment revenues |\n| Management, franchise, and other fees | $ | 227 | $ | 104 | $ | 123 | 118.6 | % |\n| Contra revenue | (12) | (9) | (3) | (27.6) | % |\n| Other revenues | 63 | 36 | 27 | 73.8 | % |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties (1) | 1,018 | 554 | 464 | 83.7 | % |\n| Total segment revenues | $ | 1,296 | $ | 685 | $ | 611 | 89.3 | % |\n| (1) See \"—Results of Operations\" for further discussion regarding the increase in revenues for the reimbursement of costs incurred on behalf of managed and franchised properties. |\n\nThe increases in management, franchise, and other fees for the three and six months ended June 30, 2022, compared to the same periods in the prior year, were driven by the continued recovery from the COVID-19 pandemic, which was led by certain markets in the United States, particularly leisure destinations.\nThe increases in other revenues for the three and six months ended June 30, 2022, compared to the same periods in the prior year, were driven by our residential management business due to continued recovery from the COVID-19 pandemic.\n| Three Months Ended June 30, |\n| RevPAR | Occupancy | ADR |\n| (Comparable System-wide Hotels) | 2022 | vs. 2021(in constant $) | 2022 | vs. 2021 | 2022 | vs. 2021(in constant $) |\n| Americas full service | $ | 175 | 112.0 | % | 70.2 | % | 27.7% pts | $ | 250 | 28.5 | % |\n| Americas select service | $ | 117 | 55.2 | % | 74.6 | % | 11.6% pts | $ | 157 | 31.3 | % |\n\n| Six Months Ended June 30, |\n| RevPAR | Occupancy | ADR |\n| (Comparable System-wide Hotels) | 2022 | vs. 2021(in constant $) | 2022 | vs. 2021 | 2022 | vs. 2021(in constant $) |\n| Americas full service | $ | 150 | 136.1 | % | 61.0 | % | 26.5% pts | $ | 245 | 33.5 | % |\n| Americas select service | $ | 100 | 62.6 | % | 68.1 | % | 12.7% pts | $ | 147 | 32.5 | % |\n\nThe RevPAR increases at our comparable system-wide full service and select service hotels during the three and six months ended June 30, 2022, compared to the three and six months ended June 30, 2021, were due to the continued recovery from the COVID-19 pandemic, primarily driven by ADR as well as demand increases from leisure transient business with increased contributions from group and business transient travel.\nDuring the three months ended June 30, 2022, we removed three properties from the comparable Americas full service system-wide hotel results as they left the hotel portfolio and combined two properties, thereby reducing the number of properties within our comparable Americas full service system-wide hotel results by one. During the\n44\nsix months ended June 30, 2022, we removed two additional properties from the comparable Americas full service system-wide hotel results as one property left the hotel portfolio and one property is undergoing a significant renovation.\nDuring the three months ended June 30, 2022, we removed one property that left the hotel portfolio from the comparable Americas select service system-wide hotel results. During the six months ended June 30, 2022, we removed one additional property that left the hotel portfolio from the comparable Americas select service system-wide hotel results.\nAmericas management and franchising segment Adjusted EBITDA.\n| Three Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Segment Adjusted EBITDA | $ | 117 | $ | 54 | $ | 63 | 115.3 | % |\n\n| Six Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Segment Adjusted EBITDA | $ | 202 | $ | 82 | $ | 120 | 145.8 | % |\n\nThe increases in Adjusted EBITDA during the three and six months ended June 30, 2022, compared to the same periods in the prior year, were primarily driven by the increases in management and franchise fees.\nASPAC management and franchising segment revenues.\n| Three Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Segment revenues |\n| Management, franchise, and other fees | $ | 18 | $ | 20 | $ | (2) | (12.1) | % |\n| Contra revenue | (1) | (1) | — | (6.8) | % |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties (1) | 34 | 24 | 10 | 39.6 | % |\n| Total segment revenues | $ | 51 | $ | 43 | $ | 8 | 16.9 | % |\n\n| Six Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Segment revenues |\n| Management, franchise, and other fees | $ | 32 | $ | 35 | $ | (3) | (7.5) | % |\n| Contra revenue | (2) | (2) | — | (11.5) | % |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties (1) | 63 | 44 | 19 | 41.3 | % |\n| Total segment revenues | $ | 93 | $ | 77 | $ | 16 | 20.2 | % |\n| (1) See \"—Results of Operations\" for further discussion regarding the increase in revenues for the reimbursement of costs incurred on behalf of managed and franchised properties. |\n\nThe decreases in management, franchise, and other fees for the three and six months ended June 30, 2022, compared to the three and six months ended June 30, 2021, were driven by decreases in management fees in Greater China due to COVID-19-related restrictions in certain markets. The decreases for the three and six months ended June 30, 2022, compared to the same periods in the prior year, were partially offset by increased management fees driven by improved demand in markets outside of Greater China.\n45\n| Three Months Ended June 30, |\n| RevPAR | Occupancy | ADR |\n| (Comparable System-wide Hotels) | 2022 | vs. 2021(in constant $) | 2022 | vs. 2021 | 2022 | vs. 2021(in constant $) |\n| ASPAC full service | $ | 71 | 0.8 | % | 43.9 | % | (2.3)% pts | $ | 161 | 6.2 | % |\n| ASPAC select service | $ | 33 | (22.6) | % | 49.9 | % | (11.6)% pts | $ | 66 | (4.5) | % |\n\n| Six Months Ended June 30, |\n| RevPAR | Occupancy | ADR |\n| (Comparable System-wide Hotels) | 2022 | vs. 2021(in constant $) | 2022 | vs. 2021 | 2022 | vs. 2021(in constant $) |\n| ASPAC full service | $ | 67 | 7.4 | % | 40.6 | % | (0.4)% pts | $ | 165 | 8.6 | % |\n| ASPAC select service | $ | 32 | (16.1) | % | 47.5 | % | (9.1)% pts | $ | 68 | 0.0 | % |\n\nComparable full service RevPAR increased for the three and six months ended June 30, 2022, compared to the three and six months ended June 30, 2021, primarily due to increased demand and ADR in Northeast Asia, Southeast Asia, and Australia, largely offset by decreased demand and ADR within Greater China.\nComparable select service RevPAR decreased for the three and six months ended June 30, 2022, compared to the same period in the prior year, primarily driven by decreased demand in Greater China.\nDuring the three months ended June 30, 2022, one property was removed from the comparable ASPAC full service hotel results as it is undergoing a significant renovation, and two properties were removed from the comparable ASPAC select service system-wide hotel results as one property left the hotel portfolio and one property had suspended operations.\nASPAC management and franchising segment Adjusted EBITDA.\n| Three Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Segment Adjusted EBITDA | $ | 6 | $ | 10 | $ | (4) | (40.5) | % |\n\n| Six Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Segment Adjusted EBITDA | $ | 11 | $ | 15 | $ | (4) | (28.6) | % |\n\nThe decreases in Adjusted EBITDA during the three and six months ended June 30, 2022, compared to the same periods in the prior year, were primarily driven by the decreases in management and franchise fees.\n46\nEAME/SW Asia management and franchising segment revenues.\n| Three Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Segment revenues |\n| Management, franchise, and other fees | $ | 21 | $ | 6 | $ | 15 | 222.5 | % |\n| Contra revenue | (2) | (3) | 1 | 33.9 | % |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties (1) | 23 | 15 | 8 | 64.4 | % |\n| Total segment revenues | $ | 42 | $ | 18 | $ | 24 | 141.9 | % |\n\n| Six Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Segment revenues |\n| Management, franchise, and other fees | $ | 36 | $ | 13 | $ | 23 | 173.9 | % |\n| Contra revenue | (4) | (6) | 2 | 30.2 | % |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties (1) | 44 | 28 | 16 | 62.6 | % |\n| Total segment revenues | $ | 76 | $ | 35 | $ | 41 | 121.9 | % |\n| (1) See \"—Results of Operations\" for further discussion regarding the increase in revenues for the reimbursement of costs incurred on behalf of managed and franchised properties. |\n\nThe increases in management, franchise, and other fees during the three and six months ended June 30, 2022, compared to the three and six months ended June 30, 2021, were driven by increases in base and incentive management fees across certain markets in Western Europe and the Middle East primarily due to the continued recovery from the COVID-19 pandemic. The three months ended June 30, 2022 also benefited from increased management fees in India as certain travel restrictions were eased.\n| Three Months Ended June 30, |\n| RevPAR | Occupancy | ADR |\n| (Comparable System-wide Hotels) | 2022 | vs. 2021(in constant $) | 2022 | vs. 2021 | 2022 | vs. 2021(in constant $) |\n| EAME/SW Asia full service | $ | 135 | 239.9 | % | 65.2 | % | 36.6% pts | $ | 208 | 49.3 | % |\n| EAME/SW Asia select service | $ | 62 | 148.2 | % | 71.9 | % | 32.1% pts | $ | 87 | 37.4 | % |\n\n| Six Months Ended June 30, |\n| RevPAR | Occupancy | ADR |\n| (Comparable System-wide Hotels) | 2022 | vs. 2021(in constant $) | 2022 | vs. 2021 | 2022 | vs. 2021(in constant $) |\n| EAME/SW Asia full service | $ | 113 | 204.5 | % | 57.0 | % | 28.1% pts | $ | 198 | 54.5 | % |\n| EAME/SW Asia select service | $ | 57 | 119.2 | % | 64.0 | % | 22.4% pts | $ | 89 | 42.5 | % |\n\nComparable system-wide hotels RevPAR increased during the three and six months ended June 30, 2022, compared to the three and six months ended June 30, 2021, primarily driven by certain leisure destinations in Western Europe, the Middle East, and India due to the continued recovery from the COVID-19 pandemic.\nDuring the three months ended June 30, 2022, three properties were removed from the comparable EAME/SW Asia full service system-wide hotel results due to suspended operations. During the six months ended June 30, 2022, we removed two additional properties from the comparable EAME/SW Asia full service system-wide hotel results as one property left the hotel portfolio and one property had suspended operations.\nDuring the six months ended June 30, 2022, one property was removed from the comparable EAME/SW Asia select service system-wide hotel results as it converted from franchised to managed.\n47\nEAME/SW Asia management and franchising segment Adjusted EBITDA.\n| Three Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Segment Adjusted EBITDA | $ | 13 | $ | (1) | $ | 14 | NM |\n\n| Six Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Segment Adjusted EBITDA | $ | 19 | $ | (1) | $ | 20 | NM |\n\nDuring the three and six months ended June 30, 2022, compared to the three and six months ended June 30, 2021, Adjusted EBITDA increased primarily due to the increases in management, franchise, and other fees revenues.\n| Three Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Segment revenues |\n| Owned and leased hotels | $ | 4 | $ | — | $ | 4 | NM |\n| Management, franchise, and other fees | 36 | — | 36 | NM |\n| Distribution and destination management | 256 | — | 256 | NM |\n| Other revenues | 33 | — | 33 | NM |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties | 26 | — | 26 | NM |\n| Total segment revenues | $ | 355 | $ | — | $ | 355 | NM |\n\n| Six Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Segment revenues |\n| Owned and leased hotels | $ | 4 | $ | — | $ | 4 | NM |\n| Management, franchise, and other fees | 66 | — | 66 | NM |\n| Distribution and destination management | 502 | — | 502 | NM |\n| Other revenues | 67 | — | 67 | NM |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties | 55 | — | 55 | NM |\n| Total segment revenues | $ | 694 | $ | — | $ | 694 | NM |\n\nFor the three and six months ended June 30, 2022, management, franchise, and other fees revenues reflect Net Package RevPAR of $205 and $209, respectively, for ALG resorts in the Americas, including resorts in Mexico, the Caribbean, Central America, and South America. For the three and six months ended June 30, 2022, management, franchise, and other fees revenues reflect Net Package RevPAR of $80 and $78, respectively, for ALG resorts in Europe.\n48\nApple Leisure Group segment Adjusted EBITDA.\n| Three Months Ended June 30, |\n| 2022 | 2021 | Change |\n| Segment Adjusted EBITDA | $ | 54 | $ | — | $ | 54 | NM |\n| Net Deferral activity |\n| Increase in deferred revenue | $ | 52 | $ | — | $ | 52 | NM |\n| Increase in deferred costs | (27) | — | (27) | NM |\n| Net Deferrals | $ | 25 | $ | — | $ | 25 | NM |\n| Increase in Net Financed Contracts | $ | 15 | $ | — | $ | 15 | NM |\n\n| Six Months Ended June 30, |\n| 2022 | 2021 | Change |\n| Segment Adjusted EBITDA | $ | 110 | $ | — | $ | 110 | NM |\n| Net Deferral activity |\n| Increase in deferred revenue | $ | 101 | $ | — | $ | 101 | NM |\n| Increase in deferred costs | (52) | — | (52) | NM |\n| Net Deferrals | $ | 49 | $ | — | $ | 49 | NM |\n| Increase in Net Financed Contracts | $ | 22 | $ | — | $ | 22 | NM |\n\nDuring the three and six months ended June 30, 2022, ALG benefited from the sale of new Unlimited Vacation Club membership contracts, which increased Net Deferrals and Net Financed Contracts. Net Deferrals will increase revenues and expenses recognized over the estimated membership period, and Net Financed Contracts represents an estimate of future cash flows to the Company.\nCorporate and other.\n| Three Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Revenues | $ | 13 | $ | 11 | $ | 2 | 21.5 | % |\n| Adjusted EBITDA | $ | (34) | $ | (21) | $ | (13) | (62.2) | % |\n\n| Six Months Ended June 30, |\n| 2022 | 2021 | Better / (Worse) |\n| Revenues | $ | 27 | $ | 19 | $ | 8 | 40.9 | % |\n| Adjusted EBITDA | $ | (72) | $ | (45) | $ | (27) | (57.9) | % |\n\nRevenues increased during the three and six months ended June 30, 2022, compared to the three and six months ended June 30, 2021, driven by increased revenues related to our co-branded credit card program.\nAdjusted EBITDA decreased during the three and six months ended June 30, 2022, compared to the three and six months ended June 30, 2021, primarily driven by increases in certain selling, general, administrative expenses, including $4 million and $11 million, respectively, of ALG integration-related costs, as well as increases in payroll and related costs due to increased headcount.\n49\nNon-GAAP Measures\nAdjusted Earnings Before Interest Expense, Taxes, Depreciation, and Amortization (\"Adjusted EBITDA\") and EBITDA\nWe use the terms Adjusted EBITDA and EBITDA throughout this quarterly report. Adjusted EBITDA and EBITDA, as we define them, are non-GAAP measures. We define consolidated Adjusted EBITDA as net income (loss) attributable to Hyatt Hotels Corporation plus our pro rata share of unconsolidated owned and leased hospitality ventures' Adjusted EBITDA based on our ownership percentage of each owned and leased venture, adjusted to exclude the following items:\n•interest expense;\n•benefit (provision) for income taxes;\n•depreciation and amortization;\n•contra revenue;\n•revenues for the reimbursement of costs incurred on behalf of managed and franchised properties;\n•costs incurred on behalf of managed and franchised properties that we intend to recover over the long term;\n•equity earnings (losses) from unconsolidated hospitality ventures;\n•stock-based compensation expense;\n•gains (losses) on sales of real estate and other;\n•asset impairments; and\n•other income (loss), net.\nWe calculate consolidated Adjusted EBITDA by adding the Adjusted EBITDA of each of our reportable segments and eliminations to corporate and other Adjusted EBITDA.\nOur board of directors and executive management team focus on Adjusted EBITDA as one of the key performance and compensation measures both on a segment and on a consolidated basis. Adjusted EBITDA assists us in comparing our performance over various reporting periods on a consistent basis because it removes from our operating results the impact of items that do not reflect our core operations both on a segment and on a consolidated basis. Our President and Chief Executive Officer, who is our CODM, also evaluates the performance of each of our reportable segments and determines how to allocate resources to those segments, in part, by assessing the Adjusted EBITDA of each segment. In addition, the compensation committee of our board of directors determines the annual variable compensation for certain members of our management based in part on consolidated Adjusted EBITDA, segment Adjusted EBITDA, or some combination of both.\nWe believe Adjusted EBITDA is useful to investors because it provides investors with the same information that we use internally for purposes of assessing our operating performance and making compensation decisions and facilitates our comparison of results with results from other companies within our industry.\nAdjusted EBITDA excludes certain items that can vary widely across different industries and among companies within the same industry including interest expense and benefit (provision) for income taxes, which are dependent on company specifics including capital structure, credit ratings, tax policies, and jurisdictions in which they operate; depreciation and amortization which are dependent on company policies including how the assets are utilized as well as the lives assigned to the assets; Contra revenue which is dependent on company policies and strategic decisions regarding payments to hotel owners; and stock-based compensation expense which varies among companies as a result of different compensation plans companies have adopted. We exclude revenues for the reimbursement of costs and costs incurred on behalf of managed and franchised properties which relate to the reimbursement of payroll costs and for system-wide services and programs that we operate for the benefit of our hotel owners as contractually we do not provide services or operate the related programs to generate a profit over the terms of the respective contracts. Over the long term, these programs and services are not designed to impact our economics, either positively or negatively. Therefore, we exclude the net impact when evaluating period-over-period changes in our operating results. Adjusted EBITDA includes costs incurred on behalf of our managed and\n50\nfranchised properties related to system-wide services and programs that we do not intend to recover from hotel owners. Finally, we exclude other items that are not core to our operations, such as asset impairments and unrealized and realized gains and losses on marketable securities.\nAdjusted EBITDA and EBITDA are not substitutes for net income (loss) attributable to Hyatt Hotels Corporation, net income (loss), or any other measure prescribed by GAAP. There are limitations to using non-GAAP measures such as Adjusted EBITDA and EBITDA. Although we believe that Adjusted EBITDA can make an evaluation of our operating performance more consistent because it removes items that do not reflect our core operations, other companies in our industry may define Adjusted EBITDA differently than we do. As a result, it may be difficult to use Adjusted EBITDA or similarly named non-GAAP measures that other companies may use to compare the performance of those companies to our performance. Because of these limitations, Adjusted EBITDA should not be considered as a measure of the income (loss) generated by our business. Our management compensates for these limitations by referencing our GAAP results and using Adjusted EBITDA supplementally. See our condensed consolidated statements of income (loss) in our condensed consolidated financial statements included elsewhere in this quarterly report.\nSee below for a reconciliation of net income (loss) attributable to Hyatt Hotels Corporation to EBITDA and a reconciliation of EBITDA to consolidated Adjusted EBITDA.\nAdjusted selling, general, and administrative expenses\nAdjusted selling, general, and administrative expenses, as we define it, is a non-GAAP measure. Adjusted selling, general, and administrative expenses exclude the impact of deferred compensation plans funded through rabbi trusts and stock-based compensation expense. Adjusted selling, general, and administrative expenses assist us in comparing our performance over various reporting periods on a consistent basis because it removes from our operating results the impact of items that do not reflect our core operations, both on a segment and consolidated basis. See \"—Results of Operations\" for a reconciliation of selling, general, and administrative expenses to Adjusted selling, general, and administrative expenses.\nComparable hotels\n\"Comparable system-wide hotels\" represents all properties we manage or franchise, including owned and leased properties, that are operated for the entirety of the periods being compared and that have not sustained substantial damage, business interruption, or undergone large scale renovations during the periods being compared or for which comparable results are not available. Hotels that suspended operations due to the COVID-19 pandemic and have not yet re-opened are no longer included in our definition of comparable system-wide hotels. We may use variations of comparable system-wide hotels to specifically refer to comparable system-wide Americas full service hotels, including our wellness resorts, our select service hotels, or our all-inclusive resorts, for those properties that we manage or franchise within the Americas management and franchising segment, comparable system-wide ASPAC full service or select service hotels for those properties we manage or franchise within the ASPAC management and franchising segment, or comparable system-wide EAME/SW Asia full service or select service hotels for those properties that we manage or franchise within the EAME/SW Asia management and franchising segment. \"Comparable owned and leased hotels\" represents all properties we own or lease that are operated and consolidated for the entirety of the periods being compared and have not sustained substantial damage, business interruption, or undergone large scale renovations during the periods being compared or for which comparable results are not available. Comparable system-wide hotels and comparable owned and leased hotels are commonly used as a basis of measurement in our industry. \"Non-comparable system-wide hotels\" or \"non-comparable owned and leased hotels\" represent all hotels that do not meet the respective definition of \"comparable\" as defined above.\nConstant dollar currency\nWe report the results of our operations both on an as-reported basis, as well as on a constant dollar basis. Constant dollar currency, which is a non-GAAP measure, excludes the effects of movements in foreign currency exchange rates between comparative periods. We believe constant dollar analysis provides valuable information regarding our results as it removes currency fluctuations from our operating results. We calculate constant dollar currency by restating prior-period local currency financial results at the current period's exchange rates. These restated amounts are then compared to our current period reported amounts to provide operationally driven variances in our results.\n51\nNet Financed Contracts\nNet Financed Contracts represent Unlimited Vacation Club contracts signed during the period for which an initial cash down payment has been received and the remaining balance is contractually due in monthly installments over an average term of less than 4 years. The Net Financed Contract balance is calculated as the unpaid portion of membership contracts reduced by expenses related to fulfilling the membership program contracts and further reduced by an allowance for future estimated uncollectible installments. Net Financed Contract balances are not reported on our condensed consolidated balance sheets as our right to collect future installments is conditional on our ability to provide continuous access to member benefits at ALG resorts over the contract term, and the associated expenses to fulfill the membership contracts become liabilities of the Company only after the installments are collected. We believe Net Financed Contracts is useful to investors as it represents an estimate of future cash flows due in accordance with contracts signed in the current period. At June 30, 2022, the Net Financed Contract balance not recorded on our condensed consolidated balance sheet was $155 million.\nNet Deferrals\nNet Deferrals represent the change in contract liabilities associated with the Unlimited Vacation Club membership contracts less the change in deferred cost assets associated with the contracts. The contract liabilities and deferred cost assets are recognized as revenue and expense, respectively, on our condensed consolidated statements of income (loss) over the customer life, which ranges from 3 to 25 years.\nThe table below provides a reconciliation of our net income (loss) attributable to Hyatt Hotels Corporation to EBITDA and a reconciliation of EBITDA to consolidated Adjusted EBITDA:\n| Three Months Ended June 30, |\n| 2022 | 2021 | Change |\n| Net income (loss) attributable to Hyatt Hotels Corporation | $ | 206 | $ | (9) | $ | 215 | NM |\n| Interest expense | 38 | 42 | (4) | (7.7) | % |\n| Provision for income taxes | 106 | 15 | 91 | 578.5 | % |\n| Depreciation and amortization | 105 | 74 | 31 | 40.7 | % |\n| EBITDA | 455 | 122 | 333 | 270.8 | % |\n| Contra revenue | 9 | 9 | — | 8.0 | % |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties | (640) | (366) | (274) | (75.1) | % |\n| Costs incurred on behalf of managed and franchised properties | 628 | 375 | 253 | 67.6 | % |\n| Equity (earnings) losses from unconsolidated hospitality ventures | (1) | 34 | (35) | (104.1) | % |\n| Stock-based compensation expense | 12 | 8 | 4 | 71.6 | % |\n| Gains on sales of real estate | (251) | (105) | (146) | (138.2) | % |\n| Asset impairments | 7 | 2 | 5 | 177.5 | % |\n| Other (income) loss, net | 19 | (25) | 44 | 175.3 | % |\n| Pro rata share of unconsolidated owned and leased hospitality ventures' Adjusted EBITDA | 17 | 1 | 16 | NM |\n| Adjusted EBITDA | $ | 255 | $ | 55 | $ | 200 | 365.4 | % |\n\n52\n| Six Months Ended June 30, |\n| 2022 | 2021 | Change |\n| Net income (loss) attributable to Hyatt Hotels Corporation | $ | 133 | $ | (313) | $ | 446 | 142.6 | % |\n| Interest expense | 78 | 83 | (5) | (5.7) | % |\n| Provision for income taxes | 108 | 201 | (93) | (46.4) | % |\n| Depreciation and amortization | 224 | 148 | 76 | 51.3 | % |\n| EBITDA | 543 | 119 | 424 | 356.2 | % |\n| Contra revenue | 18 | 17 | 1 | 7.6 | % |\n| Revenues for the reimbursement of costs incurred on behalf of managed and franchised properties | (1,180) | (626) | (554) | (88.7) | % |\n| Costs incurred on behalf of managed and franchised properties | 1,184 | 652 | 532 | 81.7 | % |\n| Equity (earnings) losses from unconsolidated hospitality ventures | 8 | (20) | 28 | 141.2 | % |\n| Stock-based compensation expense | 40 | 36 | 4 | 12.3 | % |\n| Gains on sales of real estate | (251) | (105) | (146) | (138.2) | % |\n| Asset impairments | 10 | 2 | 8 | 317.1 | % |\n| Other (income) loss, net | 29 | (37) | 66 | 176.7 | % |\n| Pro rata share of unconsolidated owned and leased hospitality ventures' Adjusted EBITDA | 23 | (3) | 26 | NM |\n| Adjusted EBITDA | $ | 424 | $ | 35 | $ | 389 | NM |\n\nLiquidity and Capital Resources\nOverview\nWe finance our business primarily with existing cash, short-term investments, and cash generated from our operations. As part of our long-term business strategy, we use net proceeds from dispositions to pay down debt; support new investment opportunities, including acquisitions; and return capital to our shareholders when appropriate. If we deem it necessary, we borrow cash under our revolving credit facility or from other third-party sources and raise funds by issuing debt or equity securities. We maintain a cash investment policy that emphasizes the preservation of capital.\nWe expect to successfully execute our commitment announced in August of 2021 to realize $2.0 billion of proceeds from the disposition of owned assets, net of acquisitions, by the end of 2024. At August 9, 2022, we have realized $681 million of proceeds from the net disposition of owned assets as part of this commitment.\nWe may, from time to time, seek to retire or purchase our outstanding equity and/or debt securities through cash purchases and/or exchanges for other securities, in open market purchases, privately negotiated transactions, or otherwise, including pursuant to a Rule 10b5-1 plan or an accelerated share repurchase transaction. Such repurchases or exchanges, if any, will depend on prevailing market conditions, restrictions in our existing or future financing arrangements, our liquidity requirements, contractual restrictions, and other factors. The amounts involved may be material. During the quarter ended June 30, 2022, we returned $101 million of capital to our shareholders through share repurchases and repurchased $15 million of our Senior Notes. Additionally, we reduced our outstanding debt through the legal defeasance of $166 million of the Series 2005 Bonds. During the three and six months ended June 30, 2022, there were no dividend payments.\nWe believe that our cash position, short-term investments, and cash from operations, together with borrowing capacity under our revolving credit facility and our access to the capital markets, will be adequate to meet all of our funding requirements and capital deployment objectives in both the short term and long term.\nRecent Transactions Affecting our Liquidity and Capital Resources\nDuring the six months ended June 30, 2022 and June 30, 2021, various transactions impacted our liquidity. See \"—Sources and Uses of Cash.\"\n53\nSources and Uses of Cash\n| Six Months Ended June 30, |\n| 2022 | 2021 |\n| Cash provided by (used in): |\n| Operating activities | $ | 383 | $ | (58) |\n| Investing activities | 201 | 47 |\n| Financing activities | (142) | (16) |\n| Effect of exchange rate changes on cash | 11 | (7) |\n| Net increase (decrease) in cash, cash equivalents, and restricted cash | $ | 453 | $ | (34) |\n\nCash Flows from Operating Activities\nCash provided by (used in) operating activities increased $441 million for the six months ended June 30, 2022 compared to the six months ended June 30, 2021. The increase was primarily due to improved performance driven by continued recovery from the COVID-19 pandemic and the acquisition of ALG. Cash provided by operating activities in 2022 also includes increased working capital driven by ALG's cash deposits received related to significant booking demand within ALG Vacations.\nCash Flows from Investing Activities\nDuring the six months ended June 30, 2022:\n•We received $227 million of proceeds, net of closing costs and proration adjustments, from the sale of The Confidante Miami Beach.\n•We received $136 million of proceeds, net of closing costs and proration adjustments, from the sale of Hyatt Regency Indian Wells Resort & Spa.\n•We received $119 million of proceeds, net of closing costs and proration adjustments, from the sale of The Driskill.\n•We received $109 million of cash consideration, net of closing costs, from the sale of Grand Hyatt San Antonio River Walk.\n•We invested $275 million in net purchases of marketable securities and short-term investments.\n•We invested $104 million in capital expenditures (see \"—Capital Expenditures\").\n•We paid $39 million related to the ALG Acquisition for amounts due back to the seller for purchase price adjustments.\nDuring the six months ended June 30, 2021:\n•We received $268 million of proceeds, net of closing costs and proration adjustments, from the sale of Hyatt Regency Lost Pines Resort and Spa.\n•We received $60 million in net proceeds of marketable securities and short-term investments.\n•We received $25 million of proceeds from the sales activity related to certain equity method investments and the redemption of a HTM debt security.\n•We acquired Alila Ventana Big Sur for $146 million of cash, net of closing costs and proration adjustments.\n•We purchased our partner's interest in the entities that own Grand Hyatt São Paulo for $6 million of cash, and we repaid the $78 million third-party mortgage loan on the property.\n•We invested $37 million in capital expenditures (see \"—Capital Expenditures\").\n•We invested $24 million in unconsolidated hospitality ventures.\n54\nCash Flows from Financing Activities\nDuring the six months ended June 30, 2022:\n•We repurchased 1,210,402 shares of Class A common stock for an aggregate purchase price of $101 million.\n•We repurchased $15 million of our Senior Notes.\n•We utilized $8 million of restricted cash to defease the Series 2005 Bonds.\nDuring the six months ended June 30, 2021:\n•We did not have any significant financing activities.\nWe define net debt as total debt less the total of cash and cash equivalents and short-term investments. We consider net debt and its components to be an important indicator of liquidity and a guiding measure of capital structure strategy. Net debt is a non-GAAP measure and may not be computed the same as similarly titled measures used by other companies. The following table provides a summary of our debt to capital ratios:\n| June 30, 2022 | December 31, 2021 |\n| Consolidated debt (1) | $ | 3,804 | $ | 3,978 |\n| Stockholders' equity | 3,609 | 3,563 |\n| Total capital | 7,413 | 7,541 |\n| Total debt to total capital | 51.3 | % | 52.8 | % |\n| Consolidated debt (1) | 3,804 | 3,978 |\n| Less: cash and cash equivalents and short-term investments | (1,955) | (1,187) |\n| Net consolidated debt | $ | 1,849 | $ | 2,791 |\n| Net debt to total capital | 24.9 | % | 37.0 | % |\n\n(1) Excludes approximately $589 million and $581 million of our share of unconsolidated hospitality venture indebtedness at June 30, 2022 and December 31, 2021, respectively, substantially all of which is non-recourse to us and a portion of which we guarantee pursuant to separate agreements.\nCapital Expenditures\nWe routinely make capital expenditures to enhance our business. We classify our capital expenditures into maintenance and technology, enhancements to existing properties, and other. We have been, and will continue to be, disciplined with respect to our capital spending, taking into account our cash flow from operations.\n| Six Months Ended June 30, |\n| 2022 | 2021 |\n| Enhancements to existing properties | $ | 59 | $ | 23 |\n| Maintenance and technology | 40 | 14 |\n| Other | 5 | — |\n| Total capital expenditures | $ | 104 | $ | 37 |\n\nThe increase in enhancements to existing properties is primarily driven by increased renovation spend at an owned hotel in 2022. Total capital expenditures for the six months ended June 30, 2022 include $13 million related to ALG. Excluding ALG, our capital expenditures continue to be below pre-COVID-19 pandemic levels.\n55\nSenior Notes\nThe table below sets forth the outstanding principal balance of our Senior Notes at June 30, 2022, as described in Part I, Item 1 \"Financial Statements—Note 9 to the Condensed Consolidated Financial Statements.\" Interest on the Senior Notes is payable semi-annually or quarterly.\n| Outstanding principal amount |\n| $300 million senior unsecured notes maturing in 2023—floating rate notes | $ | 300 |\n| $350 million senior unsecured notes maturing in 2023—3.375% | 350 |\n| $700 million senior unsecured notes maturing in 2023—1.300% | 700 |\n| $750 million senior unsecured notes maturing in 2024—1.800% | 746 |\n| $450 million senior unsecured notes maturing in 2025—5.375% | 450 |\n| $400 million senior unsecured notes maturing in 2026—4.850% | 400 |\n| $400 million senior unsecured notes maturing in 2028—4.375% | 399 |\n| $450 million senior unsecured notes maturing in 2030—5.750% | 440 |\n| Total Senior Notes | $ | 3,785 |\n\nWe are in compliance with all applicable covenants under the indenture governing our Senior Notes at June 30, 2022.\nRevolving Credit Facility\nOn May 18, 2022, we entered into a new credit agreement that refinanced and replaced in its entirety our prior revolving credit facility. The revolving credit facility is intended to provide financing for working capital and general corporate purposes, including commercial paper backup and permitted investments and acquisitions. At both June 30, 2022 and December 31, 2021, we had no balance outstanding. See Part I, Item 1 \"Financial Statements—Note 9 to the Condensed Consolidated Financial Statements.\"\nWe are in compliance with all applicable covenants under the revolving credit facility at June 30, 2022.\nLetters of Credit\nWe issue letters of credit either under the revolving credit facility or directly with financial institutions. We had $270 million and $276 million in letters of credit issued directly with financial institutions outstanding at June 30, 2022 and December 31, 2021, respectively. At June 30, 2022, these letters of credit had weighted-average fees of approximately 154 basis points and typically have maturity dates of up to one year.\nCritical Accounting Policies and Estimates\nPreparing financial statements in conformity with GAAP requires management to make estimates and assumptions that affect reported amounts and related disclosures. We have disclosed those estimates that we believe are critical and require complex judgment in their application in our 2021 Form 10-K. Since the date of our 2021 Form 10-K, there have been no material changes to our critical accounting policies or the methodologies or assumptions we apply under them.\n56\nItem 3.\nQuantitative and Qualitative Disclosures About Market Risk.\nWe are exposed to market risk, primarily from changes in interest rates and foreign currency exchange rates. In certain situations, we seek to reduce earnings and cash flow volatility associated with changes in interest rates and foreign currency exchange rates by entering into financial arrangements to provide a hedge against a portion of the risks associated with such volatility. We continue to have exposure to such risks to the extent they are not hedged. We enter into derivative financial arrangements to the extent they meet the objectives described above, and we do not use derivatives for trading or speculative purposes. At June 30, 2022, we were a party to hedging transactions, including the use of derivative financial instruments, as discussed below.\nInterest Rate Risk\nIn the normal course of business, we are exposed to the impact of interest rate changes due to our borrowing activities. Our objective is to manage the risk of interest rate changes on the results of operations, cash flows, and the market value of our debt by creating an appropriate balance between our fixed and floating-rate debt. We enter into interest rate derivative transactions from time to time, including interest rate swaps and interest rate locks, in order to maintain a level of exposure to interest rate variability that we deem acceptable. At both June 30, 2022 and December 31, 2021, we did not hold any interest rate swap contracts or have outstanding interest rate locks.\nThe following table sets forth the contractual maturities and the total fair values at June 30, 2022 for our financial instruments materially affected by interest rate risk:\n| Maturities by Period |\n| 2022 | 2023 | 2024 | 2025 | 2026 | Thereafter | Total carrying amount (1) | Total fair value (1) |\n| Fixed-rate debt | $ | — | $ | 1,051 | $ | 746 | $ | 450 | $ | 400 | $ | 839 | $ | 3,486 | $ | 3,408 |\n| Average interest rate (2) | 3.46 | % |\n| Floating-rate debt (3) | $ | 1 | $ | 304 | $ | 4 | $ | 4 | $ | 4 | $ | 14 | $ | 331 | $ | 340 |\n| Average interest rate (2) | 2.32 | % |\n\n(1) Excludes $7 million of finance lease obligations and $20 million of unamortized discounts and deferred financing fees.\n(2) Average interest rate at June 30, 2022.\n(3) Includes Grand Hyatt Rio de Janeiro construction loan, which had an 8.01% interest rate at June 30, 2022.\nForeign Currency Exposures and Exchange Rate Instruments\nWe transact business in various foreign currencies and utilize foreign currency forward contracts to offset our exposure associated with the fluctuations of certain foreign currencies. The U.S. dollar equivalents of the notional amount of the outstanding forward contracts, the majority of which relate to intercompany transactions, with terms of less than one year, were $170 million and $184 million at June 30, 2022 and December 31, 2021, respectively.\nWe intend to offset the gains and losses related to our third-party debt and intercompany transactions with gains or losses on our foreign currency forward contracts such that there is a negligible effect on our annual net income (loss). Our exposure to market risk has not materially changed from what we previously disclosed in our 2021 Form 10-K.\nFor the three and six months ended June 30, 2022, the effects of these derivative instruments resulted in $12 million and $17 million of net gains, respectively, recognized in other income (loss), net on our condensed consolidated statements of income (loss). For the three and six months ended June 30, 2021, the effects of these derivative instruments resulted in insignificant gains (losses) recognized in other income (loss), net on our condensed consolidated statements of income (loss). We offset the gains and losses on our foreign currency forward contracts with gains and losses related to our intercompany loans and transactions, such that there is a negligible effect to our net income (loss). At both June 30, 2022 and December 31, 2021, we had insignificant assets recorded in prepaids and other assets on our condensed consolidated balance sheets related to derivative instruments.\n57\nItem 4.\nControls and Procedures.\nDisclosure Controls and Procedures. We maintain a set of disclosure controls and procedures designed to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934, as amended (the \"Exchange Act\"), is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms. In accordance with Rule 13a-15(b) of the Exchange Act, as of the end of the period covered by this quarterly report, an evaluation was carried out under the supervision and with the participation of our management, including our Principal Executive Officer and Principal Financial Officer, of the effectiveness of our disclosure controls and procedures. Based on that evaluation, our Principal Executive Officer and Principal Financial Officer concluded that our disclosure controls and procedures, as of the end of the period covered by this quarterly report, were effective to provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms and is accumulated and communicated to our management, including the Principal Executive Officer and Principal Financial Officer, as appropriate to allow timely decisions regarding required disclosure.\nChanges in Internal Control Over Financial Reporting.\nWe are in the process of integrating Apple Leisure Group into our internal control over financial reporting processes.\nExcept as described above, there has been no change in the Company's internal control over financial reporting during the Company's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting.\n58\nPART II. OTHER INFORMATION\nItem 1.\nLegal Proceedings.\nWe are involved in various claims and lawsuits arising in the normal course of business, including proceedings involving tort and other general liability claims, workers' compensation and other employee claims, intellectual property claims, and claims related to our management of certain hotel properties. Most occurrences involving liability, claims of negligence, and employees are covered by insurance, in each case, with solvent insurance carriers. We record a liability when we believe the loss is probable and reasonably estimable. We currently believe that the ultimate outcome of such lawsuits and proceedings will not, individually or in the aggregate, have a material effect on our consolidated financial position, results of operations, or liquidity.\nSee Part I, Item 1, \"Financial Statements—Note 11 and Note 12 to our Consolidated Financial Statements\" for more information related to tax and legal contingencies.\nItem 1A.\nRisk Factors.\nAt June 30, 2022, there have been no material changes from the risk factors previously disclosed in response to Item 1A to Part I of our Annual Report on Form 10-K for the fiscal year ended December 31, 2021 and Item 1A to Part II of our Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2022.\nItem 2.\nUnregistered Sales of Equity Securities and Use of Proceeds.\nIssuer Purchases of Equity Securities\nThe following table sets forth information regarding our purchases of shares of Class A common stock during the quarter ended June 30, 2022:\n| Total numberof sharespurchased (1) | Weighted-averageprice paidper share | Total number ofshares purchasedas part of publiclyannounced plans | Maximum number (or approximate dollar value) of shares that may yet be purchased under the program |\n| April 1 to April 30, 2022 | — | $ | — | — | $ | 927,760,966 |\n| May 1 to May 31, 2022 | 990,402 | 82.17 | 990,402 | $ | 846,380,843 |\n| June 1 to June 30, 2022 | 220,000 | 88.63 | 220,000 | $ | 826,882,975 |\n| Total | 1,210,402 | $ | 83.34 | 1,210,402 |\n\n(1)On each of October 30, 2018 and December 18, 2019, we announced the approvals of the expansions of our share repurchase program. Under each approval, we are authorized to purchase up to an additional $750 million of Class A and Class B common stock in the open market, in privately negotiated transactions, or otherwise, including pursuant to a Rule 10b5-1 plan or an accelerated share repurchase transaction. The repurchase program does not obligate the Company to repurchase any dollar amount or number of shares and the program may be suspended or discontinued at any time and does not have an expiration date. Following the suspension of our share repurchase program in March 2020, we resumed share repurchases in May 2022. At June 30, 2022, we had approximately $827 million remaining under the share repurchase authorization.\nItem 3.\nDefaults Upon Senior Securities.\nNone.\nItem 4.\nMine Safety Disclosures.\nNot Applicable.\nItem 5.\nOther Information.\nNone.\n59\nItem 6.\nExhibits.\n| Exhibit Number | Exhibit Description |\n| 3.1 | Amended and Restated Certificate of Incorporation of Hyatt Hotels Corporation |\n| 3.2 | Amended and Restated Bylaws of Hyatt Hotels Corporation (incorporated by reference to Exhibit 3.2 to the Company's Current Report on Form 8-K (File No. 001-34521) filed with the Securities and Exchange Commission on September 11, 2014) |\n| 10.1 | Credit Agreement, dated as of May 18, 2022, by and among Hyatt Hotels Corporation, as borrower, certain subsidiaries of the borrower from time to time party thereto, the lenders party thereto, Bank of America, National Association, as administrative agent, Wells Fargo Bank, National Association, as syndication agent, BofA Securities, Inc., Wells Fargo Securities, LLC, JPMorgan Chase Bank, N.A. and The Bank of Nova Scotia, as joint bookrunners and co-lead arrangers, JPMorgan Chase Bank, N.A., The Bank of Nova Scotia, Deutsche Bank AG New York Branch, Goldman Sachs Lending Partners LLC, PNC Bank, National Association, Truist Bank and U.S. Bank National Association, as co-documentation agents, and Credit Agricole Corporate and Investment Bank, Fifth Third Bank, National Association and Sumitomo Mitsui Banking Corporation, as co-senior managing agents (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K (File No. 001-34521) filed with the Securities and Exchange Commission on May 24, 2022) |\n| +10.2 | Form of HHC 2022-2024 Performance Share Unit Agreement under the Fourth Amended and Restated Hyatt Hotels Corporation Long-Term Incentive Plan (incorporated by reference to Exhibit 10.2 to the Company's Current Report on Form 8-K (File No. 001-34521) filed with the Securities and Exchange Commission on May 24, 2022) |\n| +10.3 | Form of ALG 2022-2024 Performance Share Unit Agreement under the Fourth Amended and Restated Hyatt Hotels Corporation Long-Term Incentive Plan (incorporated by reference to Exhibit 10.3 to the Company's Current Report on Form 8-K (File No. 001-34521) filed with the Securities and Exchange Commission on May 24, 2022) |\n| 31.1 | Certification of the Chief Executive Officer pursuant to Rules 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2 | Certification of the Chief Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1 | Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2 | Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS | XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. |\n| 101.SCH | XBRL Taxonomy Extension Schema Document |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\n| + Management contract or compensatory plan arrangement. |\n\n60\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n| Hyatt Hotels Corporation |\n| Date: | August 9, 2022 | By: | /s/ Mark S. Hoplamazian |\n| Mark S. Hoplamazian |\n| President and Chief Executive Officer |\n| (Principal Executive Officer) |\n\n| Hyatt Hotels Corporation |\n| Date: | August 9, 2022 | By: | /s/ Joan Bottarini |\n| Joan Bottarini |\n| Executive Vice President, Chief Financial Officer |\n| (Principal Financial Officer and Principal Accounting Officer) |\n\n61\n</text>\n\nWhat is the change in the Debt-to-equity ratio from December 31, 2021 to June 30, 2022 in percentage change?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"ground_truth": "Therefore, the answer is -1.2626079740346454."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nPART I —FINANCIAL INFORMATION\nItem 1. Condensed Consolidated Financial Statements (unaudited)\nELEVATION ONCOLOGY, INC.\nCondensed Consolidated Balance Sheets\n(in thousands, except share and per share data)\n\n| | | | | | | |\n| | | March 31, | | December 31, |\n| | 2023 | 2022 |\n| | | (unaudited) | | | (Note 2) |\n| Assets | | |\n| Current assets: | | |\n| Cash and cash equivalents | | $ | 55,902 | | $ | 45,917 |\n| Marketable securities, available for sale | | | 18,027 | | | 44,363 |\n| Prepaid expenses and other current assets | | 1,906 | | 2,697 |\n| Total current assets | | 75,835 | | 92,977 |\n| Property and equipment, net | | 88 | | 98 |\n| Other non-current assets | | 975 | | 1,086 |\n| Total assets | | $ | 76,898 | | $ | 94,161 |\n| Liabilities and Stockholders’ Equity | | |\n| Current liabilities: | | |\n| Accounts payable | | $ | 4,043 | | $ | 6,362 |\n| Accrued expenses | | 9,491 | | 9,330 |\n| Total current liabilities | | 13,534 | | 15,692 |\n| Non-current liabilities: | | |\n| Long-term debt, net of discount | | | 29,600 | | | 29,435 |\n| Restricted stock repurchase liability | | — | | 2 |\n| Total liabilities | | 43,134 | | 45,129 |\n| | | | | | | |\n| Commitments and contingencies (see Note 12) | | |\n| | | | | | | |\n| Stockholders’ equity: | | |\n| Preferred stock, $ 0.0001 par value; 10,000,000 shares authorized as of March 31, 2023 and December 31, 2022; no shares issued or outstanding as of March 31, 2023 and December 31, 2022, respectively | | | — | | | — |\n| Common stock, $ 0.0001 par value; 500,000,000 shares authorized as of March 31, 2023 and December 31, 2022, respectively; 23,819,751 and 23,345,115 shares issued as of March 31, 2023 and December 31, 2022, respectively; 23,786,337 and 23,312,529 shares outstanding as of March 31, 2023 and December 31, 2022, respectively | | 2 | | 2 |\n| Additional paid-in capital | | 201,185 | | 199,492 |\n| Accumulated other comprehensive loss | | | ( 51 ) | | | ( 161 ) |\n| Treasury stock, 33,414 and 28,641 shares as of March 31, 2023 and December 31, 2022, respectively; at cost | | | ( 47 ) | | | ( 35 ) |\n| Accumulated deficit | | ( 167,325 ) | | ( 150,266 ) |\n| Total stockholders’ equity | | 33,764 | | 49,032 |\n| Total liabilities and stockholders’ equity | | $ | 76,898 | | $ | 94,161 |\n\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n5\n| | | | | | | |\n| | | Three months ended March 31, |\n| | | 2023 | 2022 |\n| Operating expenses: | | | |\n| Research and development | | $ | 7,292 | | $ | 13,575 |\n| General and administrative | | 4,346 | | 3,793 |\n| Restructuring charges | | | 5,107 | | | — |\n| Total operating expenses | | 16,745 | | 17,368 |\n| Loss from operations | | ( 16,745 ) | | ( 17,368 ) |\n| Other income (expense), net | | ( 309 ) | | 93 |\n| Loss before income taxes | | | ( 17,054 ) | | | ( 17,275 ) |\n| Income tax expense | | | 5 | | | — |\n| Net loss | | $ | ( 17,059 ) | | $ | ( 17,275 ) |\n| Net loss per share, basic and diluted | | $ | ( 0.72 ) | | $ | ( 0.74 ) |\n| Weighted average common shares outstanding, basic and diluted | | 23,618,559 | | 23,216,206 |\n| | | | | | | |\n| Comprehensive loss: | | | | | | |\n| Net loss | | $ | ( 17,059 ) | | $ | ( 17,275 ) |\n| Other comprehensive gain (loss): | | | | | | |\n| Unrealized gain (loss) on marketable securities | | | 110 | | | ( 204 ) |\n| Total other comprehensive gain (loss) | | | 110 | | | ( 204 ) |\n| Total comprehensive loss | | $ | ( 16,949 ) | | $ | ( 17,479 ) |\n\n| | | | | | | | | | | | | | | | | | | | | |\n| | | | | | | | | | | | | | Accumulated | | | | | | |\n| | | | Additional | | | Other | | Total |\n| | | Common Stock | | Paid-in | | Treasury | | Comprehensive | | Accumulated | | Stockholders’ |\n| | Shares | Amount | Capital | Stock | (loss) | Deficit | Equity |\n| Balance at December 31, 2021 | 23,205,915 | | $ | 2 | | $ | 195,881 | | $ | — | | $ | — | | $ | ( 55,186 ) | | $ | 140,697 |\n| Vesting of restricted common stock | | 3,946 | | — | | | 2 | | | — | | | — | | | — | | | 2 |\n| Issuance of common stock upon stock option exercises | | 44,105 | | | — | | | 19 | | | — | | | — | | | — | | | 19 |\n| Stock-based compensation | — | | — | | 627 | | — | | — | | — | | 627 |\n| Unrealized loss on marketable securities | | — | | | — | | | — | | | — | | | ( 204 ) | | | — | | | ( 204 ) |\n| Net loss | — | | — | | — | | — | | — | | ( 17,275 ) | | ( 17,275 ) |\n| Balance at March 31, 2022 | 23,253,966 | | $ | 2 | | $ | 196,529 | | $ | — | | $ | ( 204 ) | | $ | ( 72,461 ) | | $ | 123,866 |\n| | | | | | | | | | | | | | | | | | | | | |\n| | | | | | | | | | | | | | Accumulated | | | | | | |\n| | | | Additional | | | Other | | Total |\n| | | Common Stock | | Paid-in | | Treasury | | Comprehensive | | Accumulated | | Stockholders’ |\n| | Shares | Amount | Capital | Stock | (loss) | Deficit | Equity |\n| Balance at December 31, 2022 | 23,312,529 | | $ | 2 | | $ | 199,492 | | $ | ( 35 ) | | $ | ( 161 ) | | $ | ( 150,266 ) | | $ | 49,032 |\n| Vesting of restricted common stock | 3,946 | | — | | 1 | | — | | — | | — | | 1 |\n| Issuance of common stock upon stock option exercises | | 462,073 | | | — | | | 228 | | | — | | | — | | | — | | | 228 |\n| Stock-based compensation | — | | — | | 1,464 | | — | | — | | — | | 1,464 |\n| Common stock repurchase | | 7,789 | | — | | — | | ( 12 ) | | — | | — | | ( 12 ) |\n| Unrealized gain on marketable securities | | — | | | — | | | — | | | — | | | 110 | | | — | | | 110 |\n| Net loss | — | | — | | — | | — | | — | | ( 17,059 ) | | ( 17,059 ) |\n| Balance at March 31, 2023 | 23,786,337 | | $ | 2 | | $ | 201,185 | | $ | ( 47 ) | | $ | ( 51 ) | | $ | ( 167,325 ) | | $ | 33,764 |\n\n| | | | | | | |\n| | | Three months ended March 31, |\n| | 2023 | 2022 |\n| Operating activities | | |\n| Net loss | | $ | ( 17,059 ) | | $ | ( 17,275 ) |\n| Reconciliation of net loss to net cash used in operating activities: | | |\n| Stock-based compensation | | 1,464 | | 627 |\n| Non-cash interest expense | | | 165 | | | — |\n| Accretion of premium and interest on marketable securities | | | ( 153 ) | | | 13 |\n| Depreciation expense | | 10 | | 4 |\n| Changes in operating assets and liabilities: | | | |\n| Prepaid expenses and other assets | | 901 | | 960 |\n| Accounts payable | | ( 2,320 ) | | ( 4,765 ) |\n| Accrued expenses | | 161 | | 6,412 |\n| Net cash used in operating activities | | ( 16,831 ) | | ( 14,024 ) |\n| Investing activities | | | | | | |\n| Purchase of marketable securities | | | — | | | ( 79,271 ) |\n| Proceeds from sales and maturities of marketable securities | | | 26,600 | | | — |\n| Net cash provided by (used in) investing activities | | | 26,600 | | | ( 79,271 ) |\n| Financing activities | | |\n| Proceeds from issuance of common stock upon stock option exercises | | | 228 | | | 19 |\n| Common stock repurchase | | | ( 12 ) | | | — |\n| Net cash provided by financing activities | | 216 | | 19 |\n| Increase (decrease) in cash and cash equivalents | | 9,985 | | ( 93,276 ) |\n| Cash and cash equivalents, beginning of period | | 45,917 | | 146,284 |\n| Cash and cash equivalents, end of period | | $ | 55,902 | | $ | 53,008 |\n| Supplemental disclosure of cash flow information | | | | | | |\n| Interest paid | | $ | 532 | | $ | — |\n\nELEVATION ONCOLOGY, INC.Notes to Condensed Consolidated Financial Statements(dollars in thousands, except share and per share data)(unaudited) 1. Nature of BusinessElevation Oncology, Inc. (the “Company” or “Elevation”), which was formerly known as 14ner, Inc., was incorporated under the laws of the State of Delaware on April 29, 2019 (“Inception”). The Company is an innovative oncology company focused on the discovery and development of selective cancer therapies to treat patients across a range of solid tumors with significant unmet medical needs. The Company is rethinking drug development by seeking innovative, selective cancer therapies that can be matched to a patient’s unique tumor characteristics. The Company obtained exclusive worldwide rights outside Greater China (the People’s Republic of China, Hong Kong, Macau and Taiwan) to develop and commercialize EO-3021, a clinical stage antibody drug conjugate targeting Claudin 18.2, pursuant to a license agreement executed with CSPC Megalith Biopharmaceutical Co., Ltd., a subsidiary of CSPC Pharmaceutical Group Limited, during the year ended December 31, 2022 (see Note 11). During the quarter ended March 31, 2023, the Company announced that it paused further investment in the clinical development of seribantumab, an anti-HER3 monoclonal antibody for solid tumors driven by neuregulin-1, or NRG1 fusions, a type of genomic alteration and oncogenic driver in solid tumors. As a result, further enrollment in the Phase 2 CRESTONE study of seribantumab was paused. Long-term follow-up of all patients who have been treated with seribantumab to date remains ongoing. The Company intends to pursue further clinical development of seribantumab only in collaboration with a partner. The Company is exploring opportunities through new or existing partnerships and business development opportunities to expand its novel oncology pipeline. Risks and uncertaintiesThe Company is subject to risks and uncertainties common to early-stage companies in the biotechnology industry, including, but not limited to, development by competitors of new technological innovations, dependence on key personnel, protection of proprietary technology, compliance with government regulations and the ability to secure additional capital to fund operations. Product candidates currently under development will require significant additional research and development efforts, including preclinical and clinical testing and regulatory approval, prior to commercialization. These efforts require significant amounts of additional capital, adequate personnel and infrastructure, and extensive compliance-reporting capabilities.There can be no assurance that the Company’s research and development of its product candidates will be successfully completed, that adequate protection for the Company’s intellectual property will be obtained, that any products developed will obtain necessary government regulatory approval or that any approved products will be commercially viable. Even if the Company’s product development efforts are successful, it is uncertain when, if ever, the Company will generate significant revenue from product sales. The Company operates in an environment of rapid change in technology and substantial competition from pharmaceutical and biotechnology companies.The Company continues to monitor the COVID-19 pandemic. The extent of the impact of COVID-19 on the Company’s operational and financial performance will continue to depend on certain developments, including the duration and spread of the outbreak, new variants, the vaccination and booster rate, impact on the Company’s clinical studies, employee or industry events, and effect on the Company’s suppliers and manufacturers, all of which are uncertain and cannot be predicted. COVID-19 has not had a significant impact on the operations or financial results of the Company to date. 9\nGoing ConcernThe Company has incurred recurring net losses since inception and has funded its operations to date through the proceeds from the sale of convertible preferred stock, proceeds from its IPO, and borrowings under loan agreements. The Company incurred net losses of approximately $ 17.1 million and $ 17.3 million for the three months ended March 31, 2023 and 2022, respectively. As of March 31, 2023, the Company had an accumulated deficit of $ 167.3 million and cash, cash equivalents, and marketable securities totaling $ 73.9 million. Based on current operating plans, the Company does not expect that this amount will meet its anticipated capital requirements over the next 12 months, when giving effect to financial covenant compliance under the Company’s debt facility. The Company is subject to risks, expenses, and uncertainties frequently encountered by companies in its industry. The Company intends to continue its research and development of its product candidates, which will require significant additional funding. If the Company is unable to obtain additional funding in the future and/or its research, development, and commercialization efforts require higher than anticipated capital, there may be a negative impact on the financial viability of the Company. The Company plans to fund its operations through public and private placements of equity and/or debt, payments from potential strategic research and development arrangements, licensing and/or collaboration arrangements with pharmaceutical companies or other institutions, or funding from other third parties. Such financing and funding may not be available at all, or on terms that are favorable to the Company. Failure to raise additional capital could have a material adverse effect on the Company’s ability to achieve its intended business objectives.As a result of these factors, together with the anticipated increase in spending that will be necessary to continue to research, develop, and commercialize the Company’s product candidates, there is substantial doubt about the Company’s ability to continue as a going concern within one year after the date that these condensed consolidated financial statements are issued. The condensed consolidated financial statements do not contain any adjustments that might result from the resolution of any of the above uncertainties. 2. Basis of Presentation and Significant Accounting Policies Principles of ConsolidationThe condensed consolidated interim financial statements include the accounts of the Company and its wholly-owned subsidiary, Elevation Oncology Securities Corporation. All significant intercompany balances and transactions have been eliminated in consolidation. Basis of presentation of unaudited interim consolidated financial statementsThe condensed consolidated interim financial statements have been prepared in conformity with U.S. generally accepted accounting principles (“U.S. GAAP”). The accompanying unaudited condensed consolidated financial statements were prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) and, in the opinion of management, include all normal and recurring adjustments necessary to present fairly the results of the interim periods shown. The December 31, 2022 condensed consolidated balance sheet was derived from the December 31, 2022 audited consolidated financial statements. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to such SEC rules and regulations. Management believes that the disclosures made are adequate to make the information presented not misleading. The results for the interim periods are not necessarily indicative of results to be expected for the fiscal year ending December 31, 2023. The accompanying condensed consolidated interim financial statements should be read in conjunction with the Company’s audited consolidated financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2022 (the “Annual Report”). 10\n| • | Level 1—Quoted prices in active markets for identical assets or liabilities. |\n| • | Level 2—Observable inputs (other than Level 1 quoted prices), such as quoted prices in active markets for similar assets or liabilities, quoted prices in markets that are not active for identical or similar assets or liabilities, or other inputs that are observable or can be corroborated by observable market data. |\n\n| • | Level 3—Non-observable inputs that are supported by little or no market activity and that are significant to determining the fair value of the assets or liabilities, including pricing models, discounted cash flow methodologies and similar techniques. |\n| | | | | | | | | | | | | |\n| | | As of March 31, 2023 |\n| | | Level 1 | | Level 2 | | Level 3 | | Total |\n| | | (in thousands) |\n| Cash and Cash Equivalents: | | | | | | | | | | | | |\n| Money market funds | | $ | 9,786 | | $ | — | | $ | — | | $ | 9,786 |\n| | | $ | 9,786 | | $ | — | | $ | — | | $ | 9,786 |\n| Marketable Securities | | | | | | | | | | | | |\n| Corporate debt securities | | $ | — | | $ | 9,555 | | $ | — | | $ | 9,555 |\n| Commercial paper | | | — | | | 6,486 | | | — | | | 6,486 |\n| U.S. Government debt securities | | | — | | | 1,986 | | | — | | | 1,986 |\n| Total | | $ | — | | $ | 18,027 | | $ | — | | $ | 18,027 |\n\n| | | | | | | | | | | | | |\n| | | As of December 31, 2022 |\n| | | Level 1 | | Level 2 | | Level 3 | | Total |\n| | | (in thousands) |\n| Cash and Cash Equivalents: | | | | | | | | | | | | |\n| Money market funds | | $ | 3,298 | | $ | — | | $ | — | | $ | 3,298 |\n| | | $ | 3,298 | | $ | — | | $ | — | | $ | 3,298 |\n| | | | | | | | | | | | | |\n| Marketable Securities | | | | | | | | | | | | |\n| Corporate debt securities | | $ | — | | $ | 15,460 | | $ | — | | $ | 15,460 |\n| Commercial paper | | | — | | | 14,999 | | | — | | | 14,999 |\n| U.S. Government debt securities | | | — | | | 13,904 | | | — | | | 13,904 |\n| Total | | $ | — | | $ | 44,363 | | $ | — | | $ | 44,363 |\n| | | | | | | | | | | | | |\n| | | As of March 31, 2023 |\n| | Amortized | Unrealized | Unrealized | Fair |\n| | | Cost | | gains | | losses | | value |\n| | | (in thousands) |\n| Marketable Securities: | | | | | | | | | | | | |\n| Corporate debt securities | | $ | 9,606 | | $ | — | | $ | ( 51 ) | | $ | 9,555 |\n| Commercial paper | | | 6,486 | | | — | | | — | | | 6,486 |\n| U.S. Government debt securities | | | 1,986 | | | — | | | — | | | 1,986 |\n| Total | | $ | 18,078 | | $ | — | | $ | ( 51 ) | | $ | 18,027 |\n| | | | | | | | | | | | | |\n| | | As of December 31, 2022 |\n| | Amortized | Unrealized | Unrealized | Fair |\n| | | Cost | | gains | | losses | | value |\n| | | (in thousands) |\n| Marketable Securities: | | | | | | | | | | | | |\n| Corporate debt securities | | $ | 15,627 | | $ | — | | $ | ( 167 ) | | $ | 15,460 |\n| Commercial paper | | | 14,999 | | | — | | | — | | | 14,999 |\n| U.S. Government debt securities | | | 13,898 | | | 6 | | | — | | | 13,904 |\n| Total | | $ | 44,524 | | $ | 6 | | $ | ( 167 ) | | $ | 44,363 |\n\n| | | | | | | |\n| | March 31, | December 31, |\n| | | 2023 | | 2022 |\n| | | (in thousands) |\n| Accrued preclinical and clinical trial costs | | $ | 4,724 | | $ | 6,174 |\n| Accrued restructuring charges | | | 3,401 | | | — |\n| Accrued compensation | | 701 | | 2,498 |\n| Accrued consulting | | 171 | | 75 |\n| Accrued professional services | | 108 | | 218 |\n| Accrued other | | 386 | | 365 |\n| Total accrued expenses | | $ | 9,491 | | $ | 9,330 |\n| | | | | | | | | | |\n| | | Expense incurred during the three months ended March 31, 2023 | | Amounts paid during the three months ended March 31, 2023 | | Amounts unpaid at March 31, 2023 |\n| | | (in thousands) |\n| Employee severance, benefits and related costs | | $ | 1,610 | | $ | ( 1,474 ) | | $ | 136 |\n| Obligations under manufacturing and development contracts | | | 3,497 | | | ( 136 ) | | | 3,361 |\n| | | $ | 5,107 | | $ | ( 1,610 ) | | $ | 3,497 |\n\n7. DebtK2 HealthVentures Loan and Security AgreementIn July 2022, the Company entered into a loan and security agreement (the “Loan Agreement”) with K2 HealthVentures LLC (together with its affiliates, “K2HV”, and together with any other lender from time to time party thereto, the “Lenders”), as administrative agent for the Lenders, and Ankura Trust Company, LLC, as collateral agent for the Lenders. The Loan Agreement provides up to $ 50.0 million principal in term loans (the “Term Loan”) consisting of a first tranche of $ 30.0 million funded at closing and a subsequent second tranche of up to $ 20.0 million upon the Company’s request before March 1, 2025, subject to review by the Lenders of certain information from the Company and discretionary approval by the Lenders.In connection with entering into the Loan Agreement, the Company also issued to K2HV a warrant to purchase shares of common stock (see Note 8), which was an incremental cost to the Loan Agreement; thus, the allocated fair value of the warrant was recorded as part of the issuance cost.The Term Loan will mature on August 1, 2026, with interest only payments for 30 months , and thereafter interest and principal payments for the remaining 18 months . It bears a variable interest rate equal to the greater of (i) 7.95 % and (ii) the sum of (A) the prime rate last quoted in The Wall Street Journal (or a comparable replacement rate, as determined by the Lenders, if The Wall Street Journal ceases to quote such rate) and (B) 3.20 %. Upon the final payment under the Loan Agreement, the Lenders are entitled to an end of term charge equal to 6.45 % of the aggregate original principal amount of the term loans made pursuant to the Loan Agreement. The final payment fee is being accreted and amortized into interest expense using the effective interest rate method over the term of the loan. The effective interest is 11.19 % for the first tranche. This could change given it is a variable interest rate facility.The Company may prepay, at its option, all, but not less than all, of the outstanding principal balance and all accrued and unpaid interest with respect to the principal balance being prepaid of the term loans, subject to a prepayment premium as follows: 3 % of the loan amounts prepaid if such prepayment occurs in the first year after funding; 2 % if such prepayment occurs in the second year after funding; 1 % if such prepayment occurs in the third year after funding; and 0 % thereafter. The Lenders may elect at any time following the closing and prior to the full repayment of the term loans to convert any portion of the principal amount of the term loans then outstanding, up to an aggregate of $ 3.25 million in principal amount, into shares of the Company’s common stock, $ 0.0001 par value per share, at a conversion price of $ 2.6493 , subject to customary 19.99 % Nasdaq beneficial ownership limitations. The Company also granted registration rights to the Lenders with respect to shares received upon such conversion.Further, the Lenders may elect to invest up to $ 5.0 million in future equity financings of the Company, provided such investment is limited to no more than 10 % of the total amount raised in such equity financing.The Loan Agreement contains customary representations and warranties, events of default and affirmative and negative covenants, including covenants that limit or restrict the Company’s ability to, among other things, dispose of assets, make changes to the Company’s business, management, ownership or business locations, merge or consolidate, incur additional indebtedness, pay dividends or other distributions or repurchase equity, make investments, and enter into certain transactions with affiliates, in each case subject to certain exceptions. The Loan Agreement also contains covenants requiring that the Company maintain cash, cash equivalents and marketable securities balance of at least $ 25.0 million so long as the Company’s total market capitalization is less than $ 250.0 million.As security for its obligations under the Loan Agreement, the Company granted the Lenders a first priority security interest on substantially all of the Company’s assets (other than intellectual property), subject to certain exceptions.The Company capitalized $ 0.9 million of debt issuance costs which consist of incremental costs incurred for the Lenders and third-party legal firms as well as the fair value of the warrant issued in conjunction with the origination of the term loan. The book value of debt approximates its fair value given the variable interest rate. Long-term debt and the unamortized discount balances are as follows: 15\n| | | | | | |\n| | March 31, 2023 | | December 31, 2022 |\n| | (in thousands) |\n| Outstanding principal amount | $ | 30,000 | | $ | 30,000 |\n| Add: accreted liability of final payment fee | | 313 | | | 198 |\n| Less: unamortized debt discount, long term | | ( 713 ) | | | ( 763 ) |\n| Long-term debt, net of discount | $ | 29,600 | | $ | 29,435 |\n| | | |\n| | For the Three Months EndedMarch 31, 2023 |\n| | (in thousands) |\n| Interest paid or accrued | $ | 816 |\n| Non-Cash amortization of Debt discount (Including Warrants) | | 50 |\n| Non-Cash accrued Back-end fee | | 115 |\n| | $ | 981 |\n| | | |\n| Year Ending December 31, | | |\n| (in thousands) | | |\n| 2023 (remainder of the year) | $ | — |\n| 2024 | | — |\n| 2025 | | 17,713 |\n| 2026 | | 12,287 |\n| | $ | 30,000 |\n\n| | | | | | | |\n| | Shares | Initial Recognition Date | | Exercise Price | Expiration Date |\n| Warrant | 339,725 | July 27, 2022 | | $ | 1.3246 | July 27, 2032 |\n| | |\n| |\n| | |\n| Stock price | $ 1.41 |\n| Strike price | $ 1.32 |\n| Volatility (annual) | 75.30 % |\n| Risk-free rate | 2.74 % |\n| Estimated time to expiration (years) | 10 |\n| Dividend yield | —% |\n| | | | | | | | |\n| | | Three months ended March 31, | |\n| | 2023 | 2022 | |\n| | | (in thousands) | |\n| Research and development | | $ | 449 | | $ | 83 | |\n| General and administrative | | 1,015 | | 544 | |\n| Stock-based compensation expense included in operating expenses | | $ | 1,464 | | $ | 627 | |\n\n| | | | | | | | | | | |\n| | | Weighted- | Weighted- average | Aggregate |\n| | | | | average | | remaining contractual | | intrinsic value |\n| | | Options | | exercise price | | term (in years) | | (in thousands) |\n| Outstanding at December 31, 2022 | 4,408,274 | | $ | 3.44 | 8.52 | | $ | 350 |\n| Granted | 2,101,316 | | 1.06 | | | |\n| Exercised | | ( 462,073 ) | | | 0.49 | | | | | |\n| Cancelled | | ( 893,071 ) | | | 2.64 | | | | | |\n| Outstanding at March 31, 2023 | 5,154,446 | | 2.87 | 7.63 | | $ | 2,819 |\n| Vested at March 31, 2023 | 2,569,967 | | 2.42 | 4.17 | | $ | 1,092 |\n| Vested and expected to vest at March 31, 2023 | 5,154,446 | | $ | 2.87 | 7.63 | | $ | 2,819 |\n\n| | | | | | | | | | | |\n| | | Weighted- | Weighted- average | Aggregate |\n| | | | | average | | remaining contractual | | intrinsic value |\n| | | Options | | exercise price | | term (in years) | | (in thousands) |\n| Outstanding at December 31, 2021 | 3,021,799 | | $ | 3.71 | 8.94 | | $ | 10,903 |\n| Granted | 1,314,200 | | 3.46 | | | |\n| Exercised | | ( 44,105 ) | | | 0.43 | | | | | |\n| Cancelled | | ( 145,787 ) | | | 4.10 | | | | | |\n| Outstanding at March 31, 2022 | 4,146,107 | | 2.55 | 9.31 | | $ | 2,529 |\n| Vested at March 31, 2022 | 760,028 | | 1.37 | 8.23 | | $ | 1,188 |\n| Vested and expected to vest at March 31, 2022 | 4,146,107 | | $ | 2.55 | 9.31 | | $ | 2,529 |\n| | | | | | |\n| | Three months ended March 31, |\n| | | 2023 | 2022 |\n| Risk-free interest rate | 3.67 - 4.24 | % | 1.62 - 2.41 | % |\n| Volatility | 73-74 | % | 75-76 | % |\n| Dividend yield | 0.00 | % | 0.00 | % |\n| Expected term (years) | 2 - 6 | 6 | |\n\n| | | | | | |\n| | | Weighted- average |\n| | | | | grant date |\n| | | Number of shares | | fair value |\n| Unvested at December 31, 2022 | 125,622 | | $ | 16.00 |\n| Granted | 96,025 | | 0.98 |\n| Vested | | ( 12,562 ) | | $ | 16.00 |\n| Unvested at March 31, 2023 | 209,085 | | $ | 9.10 |\n\n| ● | Dyax—The Company assumed all rights and obligations provided for under the amended and restated collaboration agreement executed between Dyax Corp. (“Dyax”) and the previous sponsor (the “Dyax Agreement”). Pursuant to the Dyax Agreement, Dyax utilized its proprietary phage technology to identify antibodies that would bind to targets of interest to the previous sponsor. Additionally, Dyax granted to the previous sponsor a world-wide, non-exclusive, royalty free right to use and make any and all of the antibodies identified by Dyax for certain research purposes. Seribantumab was identified as a result of the research activities performed under the Dyax Agreement. |\n| ● | Ligand Pharmaceuticals—The Company assumed all rights and obligations provided for under the amended commercial license agreement executed between Selexis SA (“Selexis”) and the previous sponsor (the “Selexis Agreement”). Pursuant to the Selexis Agreement, the Company received non-exclusive rights to technology for use in the manufacture of seribantumab and may be required to make milestone payments of up to approximately € 900 , per licensed product, if certain development and regulatory milestones are achieved. Additionally, Selexis may have the right to obtain a royalty of the greater of € 0.2 million annually and less than one percent on net sales of seribantumab. The obligation to pay royalties with respect to each product sold in a country continues until the expiration of the patent rights covering the product in such country. Either party may terminate the |\n\n| agreement in the event of an uncured material breach by the other party. The Company also has the right to terminate the agreement at any time upon 60 days ’ prior written notice. In November 2021, the Selexis agreement was assigned to Ligand Pharmaceuticals Incorporated. |\n| ● | National Institute of Health—The Company assumed all rights and obligations provided for under the amended commercial license agreement executed between the U.S. Public Health Service, a division of the U.S. Department of Health and Human Services (the “NIH”) and the previous sponsor (the “NIH Agreement”). Pursuant to the NIH Agreement, the Company received non-exclusive rights in the United States to patents related to certain antibodies associated with seribantumab. If certain development and regulatory milestones are achieved, the Company may be obligated to pay NIH additional milestone payments of up to approximately $ 0.4 million per licensed product. |\n\n| | | | | | | |\n| | | Three months ended |\n| | | March 31, |\n| | | 2023 | 2022 |\n| Net loss | | $ | ( 17,059 ) | | $ | ( 17,275 ) |\n| Weighted average common stock outstanding, basic and diluted | | | 23,618,559 | | | 23,216,206 |\n| Net loss per share, basic and diluted | | $ | ( 0.72 ) | | $ | ( 0.74 ) |\n| | | | | |\n| | | March 31, |\n| | 2023 | 2022 |\n| Outstanding stock options | 5,154,446 | 4,146,107 |\n| Unvested restricted stock | | — | | 15,776 |\n| Unvested RSUs | 209,085 | 200,996 |\n| Warrant | | 339,725 | | — |\n| | 5,703,255 | 4,362,879 |\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nYou should read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2022, filed with the Securities and Exchange Commission (the “SEC”). This discussion and other parts of this Quarterly Report on Form 10-Q contain forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Quarterly Report on Form 10-Q, our actual results could differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis.\nOverview\nWe are an innovative oncology company focused on the discovery and development of selective cancer therapies to treat patients across a range of solid tumors with significant unmet medical needs. We are rethinking drug development by seeking innovative, selective cancer therapies that can be matched to a patient’s unique tumor characteristics.\nOur lead product candidate, EO-3021 (also known as SYSA1801 or CPO102), is an antibody-drug conjugate (“ADC”) designed to target Claudin 18.2, a clinically validated molecular target, which can selectively deliver a cytotoxic payload directly to cancer cells expressing Claudin 18.2. We currently retain worldwide development and commercialization rights for EO-3021 outside Greater China (the People’s Republic of China, Hong Kong, Macau and Taiwan). Our licensor and partner, CSPC Pharmaceutical Group Limited (collectively with its affiliates, “CSPC”), is actively recruiting patients in its ongoing Phase 1 clinical trial of SYSA1801 (EO-3021) in China.\nWe are working to rapidly advance EO-3021 into the clinic in the United States and other territories outside Greater China across a range of solid tumor indications. We expect to initiate a Phase 1 clinical trial of EO-3021 in the United States in the second half of 2023. An Investigational New Drug application (“IND”) for EO-3021 has been cleared with the U.S. Food and Drug Administration (the “FDA”). EO-3021 was granted orphan drug designation by the FDA for the treatment of gastric cancer (including cancer of gastroesophageal junction) in November 2020 and for the treatment of pancreatic cancer in May 2021.\nClaudin 18.2 is expressed across several solid tumor types, including many gastrointestinal cancers such as gastric, gastroesophageal junction and pancreatic cancer. Claudin 18.2 is also expressed in ovarian cancer, non-small cell lung cancer (“NSCLC”) and other solid tumors. EO-3021 is an anti-Claudin 18.2 ADC that binds to Claudin 18.2 on the cell surface and is internalized, upon which the linker is cleaved in the lysosome to release the monomethyl auristatin E (“MMAE”) payload, a potent anti-mitotic agent. This results in microtubule disruption, inhibiting cell division and promoting cancer cell death via apoptosis. MMAE has been clinically validated as an effective anti-tumor payload and is the cytotoxic component of several FDA-approved ADCs.\nIn July 2022, we entered into a license agreement with CSPC (the “CSPC License Agreement”) to develop and commercialize EO-3021 outside Greater China. Pursuant to the terms of the CSPC License Agreement, we paid to CSPC a one-time, upfront payment of $27.0 million. CSPC will also be eligible to receive up to $148.0 million in potential development and regulatory milestone payments and up to $1.0 billion in potential commercial milestone payments plus royalties on net sales.\nIn April 2023, we presented preclinical proof-of-concept data and a clinical case study for EO-3021 at the American Association for Cancer Research Annual Meeting 2023 (“AACR 2023”). The clinical case study was from the ongoing Phase 1 clinical trial being conducted in China by CSPC and involved a patient with metastatic gastric cancer who achieved a confirmed partial response on treatment with EO-3021.\n24\n| ● | EO-3021 is an ADC comprised of a fully human immunoglobulin G1 (IgG1) mAb that targets Claudin 18.2 and is site-specifically conjugated to the MMAE payload via a cleavable linker with a drug-to-antibody ratio (DAR) of 2. |\n| ● | EO-3021 retains antibody-dependent cell-mediated cytotoxicity (ADCC) and complement dependent cytotoxicity (CDC). |\n| ● | EO-3021 reduction in cell viability requires Claudin 18.2 expression in vitro with no effects seen on Claudin 18.2-negative cells. |\n| ● | EO-3021 demonstrated anti-tumor activity in in vivo xenograft models of pancreatic and gastric cancers expressing varying levels of Claudin 18.2. |\n| o | A single dose of EO-3021 demonstrated tumor regression across low, medium, and high Claudin 18.2-expressing models, with a lower minimal efficacious dose in models with medium and high levels of Claudin 18.2 relative to models with low levels of Claudin 18.2. |\n| o | EO-3021 outperformed standard of care chemotherapy in gastric and pancreatic cancer in vivo models. |\n| ● | Patient was treated with dose level 2, or 1.0 mg/kg EO-3021, intravenously, every three weeks for 12 cycles. |\n| ● | The best overall response, as evaluated per RECIST v1.1, was a confirmed partial response (66.7% maximal tumor reduction). |\n| ● | Duration of response was approximately 11 months. |\n\n| ● | employee-related expenses, including salaries, related benefits, and stock-based compensation expense for employees engaged in research and development activities; |\n| ● | external research and development expenses incurred in connection with the preclinical and clinical development of seribantumab, as well as the preclinical development of EO-3021, including expenses incurred under agreements with contract research organizations and consultants; |\n\n| ● | costs incurred with contract manufacturing organizations that manufacture drug products for use in our preclinical studies and clinical trials of seribantumab; |\n| ● | fees paid to consultants for services directly related to our product development and regulatory efforts; and |\n| ● | costs related to compliance with regulatory requirements related to conducting our clinical activity. |\n| | | | | | | |\n| | | Three months ended |\n| | | March 31, |\n| | | 2023 | 2022 |\n| | | | | | | |\n| Seribantumab | | $ | 3,317 | | $ | 10,903 |\n| EO-3021 | | | 627 | | | — |\n| Unallocated and other research and development expenses | | | 720 | | 676 |\n| Unallocated personnel costs (including stock-based compensation) | | | 2,628 | | 1,996 |\n| Total research and development expenses | | $ | 7,292 | | $ | 13,575 |\n| ● | successful completion of preclinical studies and timely and successful enrollment of patients in, and completion of, clinical trials with favorable results; |\n| ● | demonstration of safety, efficacy and acceptable risk-benefit profiles of our product candidates to the satisfaction of the FDA and other regulatory agencies; |\n| ● | acceptance of an IND and a BLA by the FDA or other similar clinical trial applications by foreign regulatory authorities for clinical trials for our product candidates; |\n| ● | our ability, or that of our collaborators, to develop and obtain clearance or approval of companion or complementary diagnostics, on a timely basis, or at all; |\n| ● | receipt and related terms of marketing approvals from applicable regulatory authorities for our product candidates, including the completion of any required post-marketing studies or trials; |\n\n| ● | raising additional funds necessary to complete the clinical development of and commercialization of our product candidates; |\n| ● | successfully identifying and developing, acquiring or in-licensing additional product candidates to expand our pipeline; |\n| ● | obtaining and maintaining patent, trade secret and other intellectual property protection and regulatory exclusivity for our product candidates, and protecting and enforcing our rights in our intellectual property portfolio; |\n| ● | making arrangements with third-party manufacturers, or establishing manufacturing capabilities, for both clinical and commercial supplies of our product candidates; |\n| ● | establishing sales, marketing and distribution capabilities and launching commercial sales of our products, if approved, whether alone or in collaboration with third parties; |\n| ● | acceptance of our products, if approved, by patients, the medical community and third-party payors; |\n| ● | effectively competing with other therapies available on the market or in development; |\n| ● | obtaining and maintaining third-party payor coverage and adequate reimbursement; and |\n| ● | maintaining a continued acceptable safety profile of any products following regulatory approval. |\n\n| | | | | | | | | | |\n| | | Three months ended |\n| | | March 31, |\n| | 2023 | 2022 | Change |\n| | | (in thousands) |\n| Operating expenses: | | | |\n| Research and development | | $ | 7,292 | | $ | 13,575 | | $ | (6,283) |\n| General and administrative | | 4,346 | | 3,793 | | 553 |\n| Restructuring charges | | | 5,107 | | | — | | | 5,107 |\n| Total operating expenses | | 16,745 | | 17,368 | | (623) |\n| Loss from operations | | (16,745) | | (17,368) | | 623 |\n| Other income (expense), net | | (309) | | 93 | | (402) |\n| Loss before income taxes | | | (17,054) | | | (17,275) | | | 221 |\n| Income tax expense | | | 5 | | | — | | | 5 |\n| Net loss | | $ | (17,059) | | $ | (17,275) | | $ | 216 |\n\n| | | | | | | |\n| | | Three months ended |\n| | | March 31, |\n| | 2023 | 2022 |\n| | | (in thousands) |\n| Statement of cash flows data: | | | | |\n| Cash used in operating activities | | $ | (16,831) | | $ | (14,024) |\n| Cash provided by (used in) investing activities | | 26,600 | | (79,271) |\n| Cash provided by financing activities | | 216 | | 19 |\n| Net increase (decrease) in cash and cash equivalents | | $ | 9,985 | | $ | (93,276) |\n\n| ● | the timing and progress of preclinical and clinical development activities; |\n| ● | successful enrollment in and completion of clinical trials; |\n| ● | the timing and outcome of regulatory review of our product candidates; |\n| ● | the cost to develop companion or complementary diagnostics as needed for each of our product candidates; |\n| ● | our ability to establish agreements with third-party manufacturers for clinical supply for our clinical trials and, if any of our product candidates are approved, commercial manufacturing; |\n| ● | addition and retention of key research and development personnel; |\n| ● | our efforts to enhance operational, financial and information management systems, and hire additional personnel, including personnel to support development of our product candidates; |\n| ● | the costs and timing of future commercialization activities, including product manufacturing, marketing, sales and distribution, for any of our product candidates for which we obtain marketing approval; |\n| ● | the legal patent costs involved in prosecuting patent applications and enforcing patent claims and other intellectual property claims; and |\n| ● | the terms and timing of any collaboration, license or other arrangement, including the terms and timing of any milestone payments thereunder. |\n| ● | the progress, timing and results of preclinical studies and clinical trials for EO-3021 and our other product candidates; |\n| ● | disruptions or delays in enrollment of our clinical trials, including due to the COVID-19 pandemic; |\n| ● | the extent to which we develop, in-license or acquire other pipeline product candidates or technologies; |\n\n| ● | the number and development requirements of other future product candidates that we may pursue, and other indications for our current product candidates that we may pursue; |\n| ● | the costs, timing and outcome of obtaining regulatory approvals of EO-3021 and our other product candidates and any companion or complementary diagnostics we may pursue; |\n| ● | the scope and costs of making arrangements with third-party manufacturers, or establishing manufacturing capabilities, for both clinical and commercial supplies of our product candidates; |\n| ● | the costs involved in growing our organization to the size needed to allow for the research, development and potential commercialization of our current or future product candidates; |\n| ● | the costs associated with commercializing any approved product candidates, including establishing sales, marketing and distribution capabilities; |\n| ● | the costs associated with completing any post-marketing studies or trials required by the FDA or other regulatory authorities; |\n| ● | the revenue, if any, received from any product candidates that receive marketing approval; |\n| ● | the costs of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending intellectual property-related claims that we may become subject to, including any litigation costs and the outcome of such litigation; |\n| ● | the costs associated with potential product liability claims, including the costs associated with obtaining insurance against such claims and with defending against such claims; and |\n| ● | to the extent we pursue strategic collaborations, including collaborations to commercialize seribantumab or to develop any future product candidates, our ability to establish and maintain collaborations on favorable terms, if at all, as well as the timing and amount of any milestone or royalty payments we are required to make or are eligible to receive under such collaborations, if any. |\n\nBecause of the numerous risks and uncertainties associated with product development, we are unable to predict the timing or amount of increased expenses or when or if we will be able to achieve or maintain profitability. Even if we are able to generate revenue from product sales, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, then we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations.Contractual Obligations and CommitmentsWe enter into contracts in the normal course of business with various third parties for clinical trials, preclinical research studies and testing, manufacturing and other services and products for operating purposes. These contracts do not contain any minimum purchase commitments and provide for termination upon notice. In May 2019, we entered into the Asset Purchase Agreement with the previous sponsor, pursuant to which we acquired all rights and interest to patents, know-how, and inventory for assets related to seribantumab. If we are successful in finding a partner to develop and commercialize seribantumab, we may be obligated to pay the previous sponsor up to $54.5 million in development, regulatory and sales milestone payments pursuant to the terms of the asset purchase agreement. Additionally, in conjunction with the asset purchase agreement with the previous sponsor, we assumed the rights and obligations under certain collaboration and license agreements which may require the payment of milestones and/or royalties on future sales of seribantumab. We are currently unable to estimate the timing or likelihood of achieving these milestones or generating future product sales. See “Business — Asset purchase, licensing and collaboration agreements” for additional information about these license agreements, including with respect to potential payments thereunder.In July 2022, we entered into the Loan Agreement with K2HV, as administrative agent for the Lenders, and Ankura Trust Company, LLC, as collateral agent for the Lenders. The Loan Agreement provides up to $50.0 million principal in the Term Loan consisting of a first tranche of $30.0 million funded at closing and a subsequent second tranche of up to $20.0 million upon our request, subject to review by the Lenders of certain information from us and discretionary approval by the Lenders.The Term Loan will mature on August 1, 2026, with interest-only payments for 30 months, and bears a variable interest rate equal to the greater of (i) 7.95% and (ii) the sum of (A) the prime rate last quoted in The Wall Street Journal (or a comparable replacement rate, as determined by the Lenders, if The Wall Street Journal ceases to quote such rate) and (B) 3.20%. Upon the final payment under the Loan Agreement, the Lenders are entitled to an end of term charge equal to 6.45% of the aggregate original principal amount of the term loans made pursuant to the Loan Agreement. We may prepay, at our option, all, but not less than all, of the outstanding principal balance and all accrued and unpaid interest with respect to the principal balance being prepaid of the term loans, subject to a prepayment premium to which the Lenders are entitled and certain notice requirements. Critical Accounting Policies and Significant Judgments and EstimatesOur management’s discussion and analysis of financial condition and results of operations is based on our condensed consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States, or U.S. GAAP. The preparation of our condensed consolidated financial statements and related disclosures requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, costs and expenses and the disclosure of contingent assets and liabilities in our condensed consolidated financial statements. We base our estimates on known trends and events and various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates under different assumptions or conditions.For a discussion of our critical accounting estimates, see Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2022 (the “Annual Report”), filed with the SEC on March 9, 2023 in connection with the notes to our audited consolidated financial statements appearing in the Annual Report and the notes to the condensed consolidated financial statements appearing elsewhere in 33\nthis Quarterly Report on Form 10-Q. There have been no material changes to these critical accounting policies and estimates through March 31, 2023, from those discussed in our Annual Report.Recently Issued and Adopted Accounting PronouncementsThere were no recently adopted accounting pronouncements which would have a material effect on the Company's financial condition, results of operations and cash flows.Emerging Growth Company StatusThe Jumpstart Our Business Startups Act of 2012 permits an “emerging growth company” such as us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies until those standards would otherwise apply to private companies. We have elected not to “opt out” of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, we will adopt the new or revised standard at the time private companies adopt the new or revised standard and will do so until such time that we either (i) irrevocably elect to “opt out” of such extended transition period or (ii) no longer qualify as an emerging growth company.\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\nAs of March 31, 2023, we had cash, cash equivalents and marketable securities of $73.9 million. Interest income is sensitive to changes in the general level of interest rates; however, due to the nature these investments, an immediate 10% change in interest rates would not have a material effect on the fair market value of our investment portfolio.\nWe are not currently exposed to significant risk related to changes in foreign currency exchange rates; however, we have contracted with and may continue to contract with foreign vendors. Our operations may be subject to fluctuations in foreign currency exchange rates in the future.\nItem 4. Controls and Procedures\nEvaluation of Disclosure Controls and Procedures\nUnder the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15(e) and 15d-15(e) under the Exchange Act as of the end of the period covered by this report. Our disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including the Chief Executive Officer and the Chief Financial Officer, to allow timely decisions regarding required disclosures. Any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objective and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective at a reasonable assurance level as of March 31, 2023.\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the three months ended March 31, 2023, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n34\nPART II — OTHER INFORMATION\nItem 1. Legal Proceedings\nNone.\nItem 1A. Risk Factors\nRISK FACTORS\nInvesting in our common stock involves a high degree of risk. Before making your decision to invest in shares of our common stock, you should carefully consider and read carefully all of the risks described below, together with the other information contained in this Quarterly Report on Form 10-Q, including our financial statements and the related notes and the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations”. We cannot assure you that any of the events discussed below will not occur. These events could have a material and adverse impact on our business, financial condition, results of operations and prospects. Unless otherwise indicated, references to our business being harmed in these risk factors will include harm to our business, reputation, financial condition, results of operations, net revenue and future prospects. In such event, the trading price of our common stock could decline, and you could lose all or part of your investment. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations and the market price of our common stock. This Quarterly Report on Form 10-Q also contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements as a result of factors that are described below and elsewhere in this Quarterly Report on Form 10-Q.\nRisk Factor Summary\nThe following summarizes the most material risks that make an investment in our securities risky or speculative. If any of the following risks occur or persist, our business, financial condition and results of operations could be materially harmed and the price of our common stock could significantly decline.\n| ● | We have a limited operating history, which may make it difficult to evaluate the success of our business to date and to assess our future viability. We have incurred significant operating losses since our inception in 2019 and have not generated any revenue. We expect to incur continued losses for the foreseeable future and may never achieve or maintain profitability. |\n\n| ● | We are highly dependent on the success of our lead product candidate, EO-3021. We have not completed clinical development or obtained regulatory approval for any product candidate. We may never obtain approval for EO-3021 or any other product candidate. |\n\n| ● | If we experience delays or difficulties in enrolling patients in our ongoing or planned clinical trials, our receipt of necessary regulatory approval could be delayed or prevented. |\n\n| ● | Adverse side effects or other safety risks associated with our product candidates could delay or preclude approval, cause us to suspend or discontinue clinical trials or abandon further development, limit the commercial profile of an approved product or result in significant negative consequences following marketing approval, if any. |\n\n| ● | We have, and we may in the future, seek to engage in strategic transactions to acquire or in-license new products, product candidates or technologies. If we are unable to realize the benefits from such transactions, it may adversely affect our ability to develop and commercialize product candidates, negatively impact our cash position, increase our expenses and present significant distractions to our management. |\n\n| ● | The development and commercialization of biological products are subject to extensive regulation, and we may not obtain regulatory approvals for any of our product candidates, on a timely basis or at all. |\n\n35\n| ● | If we are unable to successfully develop, validate, obtain regulatory approval of and commercialize companion or complementary diagnostic tests for our product candidates or any future product candidates that require or would benefit from such tests, or experience significant delays in doing so, we may not realize the full commercial potential of these product candidates. |\n| ● | Manufacturing biological products is complex and subject to product loss for a variety of reasons. We rely on third parties to manufacture clinical supplies of our product candidates and we intend to rely on third parties to produce commercial supplies of any approved product. This reliance on third parties increases the risk that we will not have sufficient quantities of our product candidates or products or such quantities at an acceptable cost or quality, which could delay, prevent or impair our development or commercialization efforts. |\n| ● | The incidence and prevalence for target patient populations of our product candidates have not been established with precision. If the market opportunities for our product candidates are smaller than we estimate or if any approval that we obtain is based on a narrower definition of the patient population, then our revenue potential and ability to achieve profitability will be adversely affected. |\n| ● | We face substantial competition, which may result in others discovering, developing or commercializing products before or more successfully than we do. |\n| ● | We expect to significantly expand our development and regulatory capabilities as we grow our company, and as a result, we may encounter difficulties in managing our growth, which could disrupt our operations. |\n| ● | If we or our licensors are unable to obtain and maintain sufficient patent protection for our product candidates, or if the scope of the patent protection is not sufficiently broad, third parties, including our competitors, could develop and commercialize products similar or identical to ours, and our ability to commercialize our product candidates may be adversely affected. |\n| ● | The continued presence of COVID-19, or the outbreak of similar public health crises, could adversely impact our business, including our supply chain and the conduct of our clinical trials. |\n\n| ● | Initiate and successfully meet our clinical endpoints in our planned clinical trials for EO-3021; |\n| ● | initiate and successfully complete all safety, pharmacokinetic and other registrational-enabling studies required to obtain U.S. and foreign marketing approval for EO-3021; |\n| ● | initiate and complete successful later-stage clinical trials that meet their clinical endpoints; |\n| ● | submit a BLA for EO-3021 to the FDA that is filed by the FDA; |\n| ● | obtain marketing approval for EO-3021 and our other product candidates; |\n| ● | establish licenses, collaborations or strategic partnerships that may increase the value of our programs; |\n| ● | successfully manufacture or contract with others to manufacture our product candidates; |\n| ● | further develop seribantumab in collaboration with a partner; |\n| ● | commercialize product candidates, if approved, by building a sales force or entering into collaborations with third parties; |\n| ● | obtain, maintain, protect and defend our intellectual property portfolio; |\n| ● | achieve market acceptance of our product candidates with the medical community and with third-party payors; and |\n| ● | attract, hire and retain additional administrative, clinical, regulatory and scientific personnel. |\n\nterritory. If the number of our addressable patients is significantly lower than we estimate, the indication approved by regulatory authorities is narrower than we expect, or the treatment population is narrowed by competition, physician choice or treatment guidelines, we may not generate significant revenue from sales of such products, even if they are approved.Because of the numerous risks and uncertainties associated with drug development, we are unable to accurately predict the timing or amount of increased expenses we will incur and when, or if, we will be able to achieve profitability. If we decide to or are required by the FDA or regulatory authorities in other jurisdictions to perform studies or clinical trials in addition to those we currently anticipate, or if there are any delays in establishing appropriate manufacturing arrangements for, in initiating or completing our current and planned clinical trials for, or in the development of, our product candidates, our expenses could increase materially and our potential profitability could be further delayed.Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis. Accordingly, you should not rely upon the results of any quarterly or annual periods as predictions or indications of future operating performance. We expect our financial condition and operating results to fluctuate from quarter-to-quarter and year-to-year due to a variety of factors, many of which are beyond our control. Our failure to become and remain profitable would decrease the value of our company and could impair our ability to raise capital, expand our business, maintain our research and development efforts, diversify our product offerings or even continue our operations. A decline in the value of our company could also cause you to lose all or part of your investment.Based on current operating plans, there is substantial doubt regarding our ability to continue as a going concern. We will require substantial additional funding to finance our operations, and if we are unable to raise capital, we could be forced to delay, reduce or explore other strategic options for certain of our development programs, or even terminate our operations.We have evaluated whether there are conditions and events, considered in the aggregate, that raise substantial doubt about our ability to continue as a going concern within one year after the date the financial statements included in this Quarterly Report on Form 10-Q are issued. Based upon our current operating plans we believe that our existing cash, cash equivalents, and marketable securities will not meet our anticipated capital requirements over the next 12 months, when giving effect to financial covenant compliance under our debt facility. Accordingly, we determined that there is substantial doubt about our ability to continue as a going concern within twelve months of the issuance date of these financial statements.In view of these matters, our ability to continue as a going concern is dependent upon our ability to raise additional capital through outside sources. We plan to fund our operations through public and private placements of equity and/or debt, payments from potential strategic research and development arrangements, licensing and/or collaboration arrangements, or funding from other third parties. Such financing and funding may not be available at all, or on terms that are favorable to us. Failure to raise additional capital could have a material adverse effect on our ability to achieve our intended business objectives.We require substantial additional funding to pursue our business objectives. If we are unable to raise additional capital when needed or on terms acceptable to us, we could be forced to delay, reduce or terminate our research or drug development programs, any future commercialization efforts or other operations.Identifying and developing potential product candidates and conducting preclinical studies and clinical trials is a time-consuming, expensive and uncertain process that takes years to complete, and we may never generate the necessary data or results required to obtain regulatory approval and begin selling any approved product. We expect to incur substantial expenses as we advance the clinical development of our product candidates and seek to develop, acquire or in-license additional product candidates. We expect increased expenses as we continue our research and development activities, initiate additional clinical trials and seek marketing approval for our product candidates. In addition, if we obtain marketing approval for any product candidate, we expect to incur significant commercialization expenses related to product manufacturing, marketing, sales and distribution. Furthermore, we have incurred, and expect to continue to incur, additional costs associated with operating as a public company. Accordingly, we will need to obtain substantial additional funding in connection with our continuing operations. Adequate additional financing may not be available to us on favorable terms, or at all. 38\n| ● | the progress, timing and results of preclinical studies and clinical trials for EO-3021 and our other product candidates; |\n| ● | disruptions or delays in enrollment of our clinical trials, including due to the COVID-19 pandemic; |\n| ● | the extent to which we develop, in-license or acquire other product candidates or technologies; |\n| ● | the number and development requirements of other future product candidates that we may pursue, and other indications for product candidates that we may pursue; |\n| ● | the costs, timing and outcome of obtaining regulatory approvals of EO-3021 and our other product candidates and any companion or complementary diagnostics that we may pursue; |\n| ● | the scope and costs of making arrangements with third-party manufacturers, or establishing manufacturing capabilities, for both clinical and commercial supplies of our product candidates; |\n| ● | the costs involved in growing our organization to the size needed to allow for the research, development and potential commercialization of our current or future product candidates; |\n| ● | the costs associated with commercializing any approved product candidates, including establishing sales, marketing and distribution capabilities; |\n| ● | the costs associated with completing any post-marketing studies or trials required by the FDA or other regulatory authorities; |\n| ● | the revenue, if any, received from commercial sales of our product candidates, if approved; |\n| ● | the costs of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending intellectual property-related claims that we may become subject to, including any litigation costs and the outcome of such litigation; |\n| ● | the costs associated with potential product liability claims, including the costs associated with obtaining insurance against such claims and with defending against such claims; and |\n\n| ● | to the extent we pursue strategic collaborations, including collaborations to commercialize our product candidates or to develop any future product candidates, our ability to establish and maintain collaborations on favorable terms, if at all, as well as the timing and amount of any milestone or royalty payments that we are required to make or are eligible to receive under any such collaborations. |\n\n| ● | successful completion of preclinical studies and timely and successful enrollment of patients in, and completion of, clinical trials with favorable results; |\n| ● | demonstration of safety, efficacy and acceptable risk-benefit profiles of our product candidates to the satisfaction of the FDA and other regulatory agencies; |\n| ● | acceptance of an IND and a BLA by the FDA or other similar clinical trial applications by foreign regulatory authorities for clinical trials for our product candidates; |\n| ● | our ability, or that of our collaborators, to develop and obtain clearance or approval of companion or complementary diagnostics, on a timely basis, or at all; |\n| ● | receipt and related terms of marketing approvals from applicable regulatory authorities for our product candidates, including the completion of any required post-marketing studies or trials; |\n| ● | raising additional funds necessary to complete the clinical development of and commercialization of our product candidates; |\n| ● | successfully identifying and developing, acquiring or in-licensing additional product candidates to expand our pipeline; |\n| ● | obtaining and maintaining patent, trade secret and other intellectual property protection and regulatory exclusivity for our product candidates, and protecting and enforcing our rights in our intellectual property portfolio; |\n| ● | making arrangements with third-party manufacturers, or establishing manufacturing capabilities, for both clinical and commercial supplies of our product candidates; |\n| ● | establishing sales, marketing and distribution capabilities and launching commercial sales of our products, if approved, whether alone or in collaboration with third parties; |\n\n| ● | acceptance of our products, if approved, by patients, the medical community and third-party payors; |\n| ● | effectively competing with other therapies available on the market or in development; |\n| ● | obtaining and maintaining third-party payor coverage and adequate reimbursement; and |\n| ● | maintaining a continued acceptable safety profile of any products following regulatory approval. |\n\n| ● | regulators, institutional review boards (“IRBs”), or ethics committees (“ECs”), may not authorize us or our investigators to commence a clinical trial or conduct a clinical trial at a prospective trial site; |\n| ● | the FDA may disagree as to the design or implementation of our clinical trials or with our recommended doses with respect to any of our current or future product candidates; |\n| ● | we may experience delays in reaching, or fail to reach, agreement on acceptable clinical trial contracts or clinical trial protocols with prospective contract research organizations (“CROs”) and prospective trial sites; |\n| ● | clinical trials for our product candidates may produce negative or inconclusive results, and we may decide, or regulators may require us, to conduct additional clinical trials, delay or halt clinical trials or abandon product development programs; |\n| ● | lack of adequate funding to continue clinical trials; |\n| ● | the number of patients required for clinical trials may be larger than we anticipate, enrollment in these clinical trials may be slower than we anticipate or may be lower than we anticipate due to challenges in recruiting and enrolling suitable patients who meet the trial criteria, participants may drop out of these clinical trials at a higher rate than we anticipate or the duration of these clinical trials may be longer than we anticipate; |\n| ● | competition for clinical trial participants from investigational and approved therapies may make it more difficult to enroll patients in our clinical trials; |\n| ● | we may experience difficulties in maintaining contact with patients after treatment, resulting in incomplete data; |\n| ● | we or third-party collaborators may fail to obtain regulatory approval of companion or complementary diagnostic tests, if required, on a timely basis, or at all; |\n| ● | our third-party contractors may fail to meet their contractual obligations to us in a timely manner, or at all, or may fail to comply with regulatory requirements; |\n| ● | we may have to suspend or terminate clinical trials for various reasons, including a finding by us or by a Data Monitoring Committee for a trial that the participants are being exposed to unacceptable health risks; |\n| ● | our product candidates may have undesirable or unexpected side effects or other unexpected characteristics, causing us or our investigators, regulators or IRBs or ECs to suspend or terminate the trials; |\n| ● | the cost of clinical trials may be greater than we anticipate; |\n| ● | changes to clinical trial protocols; |\n| ● | the supply or quality of our product candidates or other materials necessary to conduct clinical trials may be insufficient or inadequate and result in delays or suspension of our clinical trials; and |\n\n| ● | the impact of the continued presence of COVID-19, which may slow potential enrollment, reduce the number of eligible patients for clinical trials, or reduce the number of patients who remain in trials. |\n| ● | the severity of the disease under investigation; |\n| ● | our ability to recruit clinical trial investigators of appropriate competencies and experience; |\n| ● | the incidence and prevalence of our target indications; |\n| ● | clinicians’ and patients’ awareness of testing mechanisms to screen patients and perceptions as to the potential advantages and risks of our product candidates in relation to other available therapies, including any new drugs that may be approved for the indications we are investigating; |\n| ● | competing studies or trials with similar eligibility criteria; |\n| ● | invasive procedures required to enroll patients and to obtain evidence of the product candidates’ performance during clinical trials; |\n| ● | availability and efficacy of approved medications for the disease under investigation; |\n| ● | eligibility criteria defined in the protocol for the trial in question; |\n| ● | the size and nature of the patient population required for analysis of the trial’s primary endpoints; |\n\n| ● | efforts to facilitate timely enrollment in clinical trials; |\n| ● | whether we are subject to a partial or full clinical hold on any of our clinical trials; |\n| ● | reluctance of physicians to encourage patient participation in clinical trials; |\n| ● | the ability to monitor patients adequately during and after treatment; |\n| ● | our ability to obtain and maintain patient consents; and |\n| ● | proximity and availability of clinical trial sites for prospective patients. |\n\n| ● | regulatory authorities may withdraw approval of the drug; |\n| ● | we may be required to recall a product or change the way the drug is administered to patients; |\n| ● | regulatory authorities may require additional warnings in the labeling, such as a contraindication or a boxed warning, or issue safety alerts, Dear Healthcare Provider letters, press releases or other communications containing warnings or other safety information about the product; |\n| ● | we may be required to implement a risk evaluation and mitigation strategy (“REMS”), or create a medication guide outlining the risks of such side effects for distribution to patients; |\n| ● | additional restrictions may be imposed on the marketing or promotion of the particular product or the manufacturing processes for the product or any component thereof; |\n| ● | we could be sued and held liable for harm caused to patients; |\n| ● | we may be subject to regulatory investigations and government enforcement actions; |\n| ● | the drug could become less competitive; and |\n| ● | our reputation may suffer. |\n\nparticular program, the approvability or commercialization of the particular product candidate or product and our company in general. In addition, the information we choose to publicly disclose regarding a particular study or clinical trial is typically selected from a more extensive amount of available information. Third parties may not agree with what we determine is the material or otherwise appropriate information to include in our disclosure, and any information we determine not to disclose may ultimately be deemed significant with respect to future decisions, conclusions, views, activities or otherwise regarding a particular product, product candidate or our business.Additionally, planned clinical trials we conduct may be open-label trials in which both the patient and investigator know whether the patient is receiving the investigational product candidate or either an existing approved product or placebo. Open-label clinical trials typically test only the investigational product candidate and sometimes may do so at different dose levels. Open-label clinical trials are subject to various limitations that may exaggerate any therapeutic effect as patients in open-label clinical trials are aware when they are receiving treatment. Open-label clinical trials may be subject to a “patient bias” where patients perceive their symptoms to have improved merely due to their awareness of receiving an experimental treatment. In addition, open-label clinical trials may be subject to an “investigator bias” where those assessing and reviewing the physiological outcomes of the clinical trials are aware of which patients have received treatment and may interpret the information of the treated group more favorably given this knowledge.If the preliminary or topline data or results of pre-specified interim analyses that we report differs from late, final or actual results, or if others, including regulatory authorities, disagree with the conclusions reached, our ability to obtain approval for, and commercialize, our product candidates may be harmed.We have, and we may in the future, seek to engage in strategic transactions to acquire or in-license new products, product candidates or technologies, or partner or out-license our product candidates. If we are unable to realize the benefits from such transactions, it may adversely affect our ability to develop and commercialize product candidates, negatively impact our cash position, increase our expenses and present significant distractions to our management.From time to time, we may consider strategic transactions, such as additional collaborations, acquisitions of companies, asset purchases, joint ventures, in-licensing of new products, product candidates or technologies, and partnering or out-licensing our product candidates, that we believe will complement or augment our existing business. For example, in July 2022, we entered into a license agreement pursuant to which CSPC granted us exclusive rights to develop and commercialize EO-3021 worldwide outside of Greater China. If we acquire additional assets with promising markets or technologies, we may not be able to realize the benefit of acquiring such assets if we are not able to successfully integrate them with our existing technologies. We may encounter numerous difficulties in developing, testing, manufacturing and marketing any new products resulting from a strategic acquisition that delay or prevent us from realizing their expected benefits or enhancing our business. Even if we partner or out-license seribantumab, we may not be able to realize any benefit of the transaction and collaboration, financial or otherwise.Following any such strategic transaction, we may not achieve any expected synergies to justify the transaction. For example, such transactions may require us to incur non-recurring or other charges, increase our near-term and long-term expenditures and pose significant integration or implementation challenges or disrupt our management or business. These transactions would entail numerous operational and financial risks, including, but not limited to, exposure to unknown liabilities, disruption of our business and diversion of our management’s time and attention in order to manage a collaboration or develop acquired products, product candidates or technologies, incurrence of substantial debt or dilutive issuances of equity securities to pay transaction consideration or costs, higher than expected acquisition or integration costs, write-downs of assets or goodwill or impairment charges, increased amortization expenses, difficulty and cost in facilitating the transaction or combining the operations and personnel of any acquired business, impairment of relationships with key suppliers, manufacturers or customers of any acquired business due to changes in management and ownership and the inability to retain key employees of any acquired business.Accordingly, although there can be no assurance that we will undertake or successfully complete any transactions of the nature described above, any transactions that we do complete may be subject to the foregoing or other risks and could have a material and adverse effect on our business, financial condition, results of operations and prospects. Conversely, any failure to enter any strategic transaction that would be beneficial to us could delay the development and potential 47\ncommercialization of our product candidates and could have a negative impact on the competitiveness of any product candidate that reaches market.We may not be successful in finding collaborators for continuing the development of seribantumab.We recently announced that we have paused further investment in the clinical development of seribantumab and intend to pursue further clinical development of seribantumab only in collaboration with a partner. We face significant competition in seeking appropriate collaborators. Any such collaboration may be on terms that are not optimal for us, and we may not be able to maintain any new collaboration. Collaborations are complex and time-consuming to negotiate and document. In addition, a significant number of recent business combinations among large pharmaceutical companies has resulted in a reduced number of potential future collaborators. Whether we reach a definitive agreement for a collaboration will depend, among other things, upon our assessment of the collaborator’s resources and expertise, the terms and conditions of the proposed collaboration and the proposed collaborator’s evaluation of a number of factors. Those factors may include the design or results of clinical trials, the likelihood of approval by the FDA or similar regulatory authorities outside the United States, the potential market for the subject product candidate, the costs and complexities of manufacturing and delivering such product candidate to patients, the potential of competing drugs, the existence of uncertainty with respect to our ownership of technology, which can exist if there is a challenge to such ownership without regard to the merits of the challenge and industry and market conditions generally. The collaborator may also consider alternative product candidates or technologies for similar indications that may be available to collaborate on and whether such a collaboration could be more attractive than the one with us for our product candidate. The terms of any additional collaborations or other arrangements that we may establish may not be favorable to us.We may expend our limited resources to pursue a particular product candidate or indication and fail to capitalize on product candidates or indications that may be more profitable or for which there is a greater likelihood of success.Because we have limited financial and managerial resources, we focus on research programs and product candidates that we identify for specific indications. As a result, we may forego or delay pursuit of opportunities with other future product candidates or for other indications that later prove to have greater commercial potential. For example, in January 2023, we announced a pipeline prioritization and realignment of resources to advance EO-3021.Our resource allocation decisions may cause us to fail to capitalize on viable commercial products or profitable market opportunities. Our spending on current and future research and development programs and product candidates for specific indications may not yield any commercially viable products. If we do not accurately evaluate the commercial potential or target market for a particular product candidate, we may relinquish valuable rights to that product candidate through collaboration, licensing or other royalty arrangements in cases in which it would have been more advantageous for us to retain sole development and commercialization rights to that product candidate.We may in the future conduct clinical trials for our product candidates outside the United States, and the FDA or comparable foreign regulatory authorities may not accept data from such trials.We may in the future choose to conduct one or more clinical trials outside the United States. The acceptance of trial data from clinical trials conducted outside the United States or another jurisdiction by the FDA or comparable regulatory authorities may be subject to certain conditions or may not be accepted at all. In cases where data from clinical trials conducted outside the United States is intended to serve as the basis for marketing approval in the United States, the FDA will generally not approve the application on the basis of these data alone unless the data is applicable to the U.S. population and U.S. medical practice, including availability of drugs as standard of care, and the trials were performed by clinical investigators of recognized competence and pursuant to GCP regulations. Additionally, the FDA’s clinical trial requirements, including sufficient size of patient populations and statistical powering, must be met. Many other regulatory authorities have similar approval requirements. In addition, such trials would be subject to the applicable local laws of the respective jurisdictions where the trials are conducted. There can be no assurance that the FDA, EMA or any comparable regulatory authority will accept data from trials conducted outside of the United States or the applicable jurisdiction. If the FDA, EMA or any comparable regulatory authority does not accept such data, it would result in the need for additional trials, which would be costly and time-consuming and delay aspects of our business plan, and which may result in product candidates that we may develop not receiving approval for commercialization in the applicable jurisdiction.48\n| ● | delays or difficulties in screening, enrolling and maintaining patients in our clinical trials; |\n| ● | delays or difficulties in clinical site initiation, including difficulties in recruiting clinical site investigators and clinical site staff; |\n| ● | diversion of healthcare resources away from the conduct of clinical trials, including the diversion of hospitals serving as our clinical trial sites and hospital staff supporting the conduct of our clinical trials; |\n| ● | inability or unwillingness of subjects to travel to the clinical trial sites; |\n| ● | delays, difficulties or incompleteness in data collection and analysis and other related activities; |\n| ● | decreased implementation of protocol required clinical trial activities and quality of source data verification at clinical trial sites; |\n| ● | interruption of key clinical trial activities, such as clinical trial site monitoring, due to limitations on travel imposed or recommended by federal or state governments, employers and others; |\n| ● | limitations in employee resources that would otherwise be focused on the conduct of our clinical trials and our other research and development activities, including because of sickness of employees or their families or mitigation measures such as lock-downs and social distancing; |\n| ● | delays due to production shortages resulting from any events affecting raw material supply or manufacturing capabilities domestically and abroad; |\n| ● | delays in receiving approval from local regulatory authorities to initiate our planned clinical trials; |\n| ● | delays in clinical sites receiving the supplies and materials needed to conduct our clinical trials; |\n| ● | interruption in global and domestic shipping that may affect the transport of clinical trial materials, such as investigational drug products used in our clinical trials; |\n| ● | changes in local regulations as part of a response to the continued presence of COVID-19 which may require us to change the ways in which our clinical trials are conducted, which may result in unexpected costs, delays or require us to discontinue the clinical trials altogether; |\n| ● | delays in necessary interactions with local regulators, ethics committees and other important agencies and contractors due to limitations in employee resources or forced furlough of government employees; |\n| ● | refusal of regulatory authorities such as FDA or European Medicines Agency, or EMA, to accept data from clinical trials in affected geographies; and |\n\n| ● | adverse impacts on global economic conditions which could have an adverse effect on our business and financial condition, including impairing our ability to raise capital when needed. |\n\n| ● | may not deem our product candidate to be safe and effective; |\n| ● | determines that the product candidate does not have an acceptable benefit-risk profile; |\n| ● | determines in the case of a BLA seeking accelerated approval that the BLA does not provide evidence that the product candidate represents a meaningful advantage over available therapies for each tumor type; |\n| ● | determines that the objective response rate (“ORR”), and duration of response are not clinically meaningful; |\n| ● | determines that a tissue agnostic indication is not appropriate, for example, because a consistent anti-tumor effect is not observed across multiple tumor types or the response is too heavily weighted on a specific tumor type; |\n| ● | may not agree that the data collected from preclinical studies and clinical trials are acceptable or sufficient to support the submission of a BLA or other submission or to obtain regulatory approval, and may impose requirements for additional preclinical studies or clinical trials; |\n| ● | may determine that adverse events experienced by participants in our clinical trials represent an unacceptable level of risk; |\n| ● | may determine that the population studied in the clinical trial may not be sufficiently broad or representative to assure safety in the full population for which we seek approval; |\n| ● | may not accept clinical data from trials, which are conducted at clinical facilities or in countries where the standard of care is potentially different from that of the United States; |\n| ● | may disagree regarding the formulation, labeling and/or specifications; |\n| ● | may not approve the manufacturing processes associated with our product candidate or may determine that a manufacturing facility does not have an acceptable compliance status; |\n| ● | may change approval policies or adopt new regulations; or |\n| ● | may not file a submission due to, among other reasons, the content or formatting of the submission. |\n\n| ● | the trial or trials required to verify the predicted clinical benefit of our product candidate fail to verify such benefit or do not demonstrate sufficient clinical benefit to justify the risks associated with the candidate; |\n| ● | other evidence demonstrates that our product candidate is not shown to be safe or effective under the conditions of use; |\n| ● | we fail to conduct any required post-approval trial of our product candidate with due diligence; or |\n| ● | we disseminate false or misleading promotional materials relating to the relevant product candidate. |\n\nOur failure to obtain marketing approval in jurisdictions outside the United States would prevent our product candidates from being marketed in those jurisdictions, and any approval we are granted for it in the United States would not assure approval in other jurisdictions.In order to market and sell our products in any jurisdiction outside the United States, we must obtain separate marketing approvals and comply with numerous and varying regulatory requirements. The approval procedure varies among countries and can involve additional testing. The time required to obtain approval may differ substantially from that required to obtain FDA approval. The regulatory approval process outside the United States generally includes all of the risks associated with obtaining FDA approval. In addition, in many countries outside the United States, it is required that the product be approved for reimbursement before the product can be approved for sale in that country. We may not obtain approvals from regulatory authorities outside the United States on a timely basis, if at all. Approval by the FDA does not ensure approval by regulatory authorities in other countries or jurisdictions, and approval by one regulatory authority outside the United States does not ensure approval by regulatory authorities in other countries or jurisdictions or by the FDA. We may not be able to submit for marketing approvals and may not receive necessary approvals to commercialize our products in any market, which would impair our financial prospects.We may not be able to obtain or maintain orphan drug designation or exclusivity for our product candidates.Regulatory authorities in some jurisdictions, including the United States, may designate drugs for relatively small patient populations as “orphan drugs.” Under the Orphan Drug Act, the FDA may designate a drug as an orphan drug if it is intended to treat a rare disease or condition, which is generally defined as a patient population of fewer than 200,000 individuals in the United States, or if the disease or condition affects more than 200,000 individuals in the United States and there is no reasonable expectation that the cost of developing the drug for the type of disease or condition will be recovered from sales of the product in the United States.Orphan drug designation entitles a party to financial incentives, such as tax advantages and user fee waivers. Additionally, if a product that has orphan designation subsequently receives the first FDA approval for the disease or condition for which it has such designation, the product is entitled to orphan drug exclusivity, which means that the FDA may not approve any other applications to market the same drug for the same indication for seven years, except in certain circumstances, such as a showing of clinical superiority (i.e., another product is safer, more effective or makes a major contribution to patient care) over the product with orphan exclusivity or where the manufacturer is unable to assure sufficient product quantity. Competitors, however, may receive approval of different products for the same indication for which the orphan product has exclusivity, or obtain approval for the same product but for a different indication than that for which the orphan product has exclusivity.The FDA has granted orphan drug designation in the United States to EO-3021 for the treatment of gastric cancer (including cancer of gastroesophageal junction) and for the treatment of pancreatic cancer. We may apply for an additional orphan drug designation in the United States or other geographies for EO-3021 or our other product candidates. However, obtaining an orphan drug designation can be difficult, and we may not be successful in doing so. For instance, in the case of a request for orphan drug designation for a tumor agnostic indication, preliminary findings of a product candidate’s treatment effect that is not observed across multiple tumor types or that is too heavily weighted on a specific tumor type may not be sufficient for the FDA to grant a tumor agnostic orphan drug designation. Even if we obtain orphan drug designation for a product candidate in specific indications, we may not be the first to obtain regulatory approval of the product candidate for the orphan-designated indication, due to the uncertainties associated with developing biological products. In addition, exclusive marketing rights in the United States may be limited if we seek approval for an indication broader than the orphan-designated indication or may be lost if the FDA later determines that the request for orphan designation was materially defective or if the manufacturer is unable to assure sufficient quantities of the product to meet the needs of patients with the rare disease or condition. Orphan drug designation does not ensure that we will receive marketing exclusivity in a particular market, and we cannot assure you that any future application for orphan drug designation in any other geography or with respect to any other future product candidate will be granted. Orphan drug designation neither shortens the development time or regulatory review time of a drug, nor gives the drug any advantage in the regulatory review or approval process.53\nA Breakthrough Therapy designation by the FDA for any of our product candidates may not lead to a faster development or regulatory review or approval process, and it would not increase the likelihood that the product candidate will receive marketing approval.We may seek a Breakthrough Therapy designation for EO-3021 or our other product candidates. A breakthrough therapy is defined as a drug or biologic that is intended, alone or in combination with one or more other drugs, to treat a serious or life-threatening disease or condition, and preliminary clinical evidence indicates that the drug may demonstrate substantial improvement over existing therapies on one or more clinically significant endpoints, such as substantial treatment effects observed early in clinical development. For drugs that have been designated as breakthrough therapies, interaction and communication between the FDA and the sponsor of the trial can help to identify the most efficient path for clinical development while minimizing the number of patients placed in ineffective control regimens. Drugs designated as breakthrough therapies by the FDA are also eligible for priority review if supported by clinical data at the time of the submission of the BLA.Designation as a breakthrough therapy is at the discretion of the FDA. Accordingly, even if we believe that a product candidate meets the criteria for designation as a breakthrough therapy, the FDA may disagree and instead determine not to make such designation. In any event, the receipt of a Breakthrough Therapy designation for a drug may not result in a faster development process, review, or approval compared to drugs considered for approval under conventional FDA procedures and it would not assure ultimate approval by the FDA. In addition, even if the product candidate qualifies as a breakthrough therapy, the FDA may later decide that the product candidate no longer meets the conditions for qualification or that the time period for FDA review or approval will not be shortened.A Fast Track designation by the FDA for any of our product candidates may not lead to a faster development or regulatory review or approval process.We may seek Fast Track designation for EO-3021 or our other product candidates. If a drug or biologic is intended for the treatment of a serious or life-threatening condition and the drug demonstrates the potential to address unmet medical needs for this condition, the product sponsor may apply for FDA Fast Track designation. The FDA has broad discretion whether to grant this designation, so even if we believe a particular product candidate is eligible for this designation, we cannot assure you that the FDA would decide to grant it. Even if we do receive Fast Track designation for a particular product candidate, we may not experience a faster development process, review or approval compared to conventional FDA procedures. The FDA may withdraw Fast Track designation if it believes that the designation is no longer supported by data from our clinical development program.If we are unable to successfully develop, validate, obtain regulatory approval of and commercialize companion or complementary diagnostic tests for product candidates that require or would benefit from such tests, or experience significant delays in doing so, we may not realize the full commercial potential of these product candidates.A companion diagnostic is a medical device, often an in vitro device, which provides information that is essential for the safe and effective use of a corresponding therapeutic drug or biologic product. A companion or complementary diagnostic can be used to identify patients who are most likely to benefit from the therapeutic product.A companion or complementary diagnostic is generally developed in conjunction with the clinical program for an associated therapeutic product. To date, the FDA has generally required premarket approval of companion and complementary diagnostics for cancer therapies. Generally, when a companion diagnostic is essential to the safe and effective use of a drug product, the FDA requires that the companion diagnostic be approved before or concurrent with approval of the therapeutic product and before a product can be commercialized. The approval of a companion diagnostic as part of the therapeutic product’s labeling limits the use of the therapeutic product to only those patients who express the specific genetic alteration that the companion diagnostic was developed to detect. However, it is possible that the FDA may permit approval of the companion diagnostic as a post-marketing commitment following a potential regulatory approval.Development of a companion or complementary diagnostic could include additional meetings with regulatory authorities, such as a pre- submission meeting and the requirement to submit an investigational device exemption application. In the 54\ncase of a companion diagnostic that is designated as “significant risk device,” approval of an investigational device exemption by the FDA and IRB is required before such diagnostic is used in conjunction with the clinical trials for a corresponding product candidate.To be successful in developing, validating, obtaining approval of and commercializing a companion or complementary diagnostic, we or our collaborators will need to address a number of scientific, technical, regulatory and logistical challenges. We have no prior experience with medical device or diagnostic test development. If we choose to develop and seek FDA approval for companion or complementary diagnostic tests on our own, we will require additional personnel. We may rely on third parties for the design, development, testing, validation and manufacture of companion or complementary diagnostic tests for our therapeutic product candidates that require such tests, the application for and receipt of any required regulatory approvals, and the commercial supply of these companion or complementary diagnostics. If these parties are unable to successfully develop companion or complementary diagnostics for these therapeutic product candidates, or experience delays in doing so, we may be unable to enroll enough patients for our current and planned clinical trials, the development of these therapeutic product candidates may be adversely affected, these therapeutic product candidates may not obtain marketing approval, and we may not realize the full commercial potential of any of these therapeutics that obtain marketing approval. For any product candidate for which a companion diagnostic is necessary to select patients who may benefit from use of the product candidate, any failure to successfully develop a companion diagnostic may cause or contribute to delayed enrollment of our clinical trials, and may prevent us from initiating a pivotal trial. In addition, the commercial success of any product candidate that requires a companion diagnostic will be tied to and dependent upon the receipt of required regulatory approvals and the continued ability of such third parties to make the companion diagnostic commercially available to us on reasonable terms in the relevant geographies. Any failure to do so could materially harm our business, results of operations and financial condition.Even if we obtain marketing approval for a product candidate, the terms of approvals, ongoing regulation of our products or other post-approval restrictions may limit how we manufacture and market our products and compliance with such requirements may involve substantial resources, which could materially impair our ability to generate revenue.Any product candidates for which we receive accelerated approval from the FDA are required to undergo one or more confirmatory clinical trials. If such a product candidate fails to meet its safety and efficacy endpoints in such confirmatory clinical trials, the regulatory authority may withdraw its conditional approval. There is no assurance that any such product will successfully advance through its confirmatory clinical trial(s). Therefore, even if a product candidate receives accelerated approval from the FDA, such approval may be withdrawn at a later date.Even if marketing approval of a product candidate is granted, an approved product and its manufacturer and marketer are subject to ongoing review and extensive regulation, which may include the requirement to implement a REMS or to conduct costly post-marketing studies or clinical trials and surveillance to monitor the safety or efficacy of the product.We must also comply with requirements concerning advertising and promotion for our product candidates for which we obtain marketing approval. Promotional communications with respect to prescription drugs or biologics are subject to a variety of legal and regulatory restrictions and must be consistent with the information in the product’s approved labeling. Thus, we will not be able to promote any products we develop for indications or uses for which they are not approved.In addition, manufacturers of approved products and those manufacturers’ facilities are required to ensure that quality control and manufacturing procedures conform to current good manufacturing practices (“cGMPs”), which include requirements relating to quality control and quality assurance as well as the corresponding maintenance of records and documentation and reporting requirements. We and our contract manufacturing organizations (“CMOs”) will be subject to periodic unannounced inspections by the FDA to monitor and ensure compliance with cGMPs.Accordingly, even if we obtain marketing approval for a product candidate, we and our CMOs will continue to expend time, money and effort in all areas of regulatory compliance, including manufacturing, production, product surveillance and quality control. If we are not able to comply with post-approval regulatory requirements, we could have the marketing approvals for our products withdrawn by regulatory authorities and our ability to market any future products could be 55\n| ● | litigation involving patients taking our products; |\n| ● | restrictions on such products, manufacturers or manufacturing processes; |\n| ● | restrictions on the labeling or marketing of a product; |\n| ● | restrictions on product distribution or use; |\n| ● | requirements to conduct post-marketing studies or clinical trials; |\n| ● | warning or untitled letters; |\n| ● | withdrawal of the products from the market; |\n| ● | refusal to approve pending applications or supplements to approved applications that we submit; |\n| ● | recall of products; |\n| ● | fines, restitution or disgorgement of profits or revenues; |\n| ● | suspension or withdrawal of marketing approvals; |\n| ● | damage to relationships with any potential collaborators; |\n| ● | unfavorable press coverage and damage to our reputation; |\n\n| ● | refusal to permit the import or export of our products; |\n| ● | product seizure; or |\n| ● | injunctions or the imposition of civil or criminal penalties. |\n| ● | the federal Anti-Kickback Statute prohibits, among other things, persons from knowingly and willfully soliciting, offering, receiving or providing remuneration, directly or indirectly, in cash or in kind, to induce or reward, or in return for, either the referral of an individual for, or the purchase, order or recommendation of, any good or service, for which payment may be made under a federal healthcare program such as Medicare and Medicaid; |\n| ● | the federal civil and criminal false claims laws, including the False Claims Act, which can be enforced by civil whistleblower or qui tam actions on behalf of the government, and criminal false claims laws and the civil monetary penalties law, prohibit individuals or entities from, among other things, knowingly presenting, or causing to be presented false or fraudulent claims for payment by a federal government program, or making a false statement or record material to payment of a false claim or avoiding, decreasing or concealing an obligation to pay money to the federal government; |\n| ● | HIPAA prohibits, among other things, knowingly and willfully executing, or attempting to execute, a scheme to defraud any healthcare benefit program, regardless of the payor (e.g. public or private), and knowingly and willfully falsifying, concealing or covering up by any trick or device a material fact or making any materially false, fictitious or fraudulent statements in connection with the delivery of, or payment for, healthcare benefits, items or services relating to healthcare matters; |\n| ● | HIPAA, as amended by HITECH, and their implementing regulations, impose requirements on certain covered healthcare providers, health plans, and healthcare clearinghouses as well as their respective business associates and their subcontractors that perform services for them that involve the use, or disclosure of, protected health information, relating to the privacy, security, and transmission of such protected health information; |\n| ● | the federal Physician Payments Sunshine Act’s transparency requirements under the ACA requires certain manufacturers of drugs, devices, biologics and medical supplies to annually report to CMS information related to payments and other transfers of value provided to physicians (defined to include doctors, dentists, optometrists, podiatrists and chiropractors), physician assistants, certain types of advance practice nurses and teaching hospitals, as well as ownership and investment interests held by physicians, and their immediate family members. The reported information is made available on a public website; and |\n\n| ● | analogous state laws and regulations such as state anti-kickback and false claims laws and analogous non-U.S. fraud and abuse laws and regulations, may apply to sales or marketing arrangements and claims involving healthcare items or services reimbursed by non-governmental third-party payors, including private insurers. Some state laws require biologics companies to comply with the pharmaceutical industry’s voluntary compliance guidelines and the relevant compliance regulations promulgated by the federal government and may require drug manufacturers to report information related to payments and other transfers of value to physicians and other healthcare providers, marketing expenditures, or drug pricing, including price increases. State and local laws require the registration of pharmaceutical sales representatives. State and non-U.S. laws that also govern the privacy and security of health information in some circumstances, many of which differ from each other in significant ways and often are not preempted by HIPAA, thus complicating compliance efforts. |\n\nis uncertain how any such challenges and healthcare measures of the Biden administration will impact the ACA and our business.In addition, other legislative changes have been proposed and adopted in the United States since the ACA was enacted to reduce healthcare expenditures. U.S. federal government agencies also currently face potentially significant spending reductions, which may further impact healthcare expenditures, including reductions of Medicare payments to providers of 2% per fiscal year, which went into effect on April 1, 2013 and, due to subsequent legislative amendments to the statute, including the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), will remain in effect through 2031. The Medicare reductions phase back in starting with a 1% reduction in effect from April 1, 2022 to June 30, 2022 before increasing to the full 2% reduction. Moreover, on January 2, 2013, the American Taxpayer Relief Act of 2012 was signed into law, which, among other things, further reduced Medicare payments to several types of providers, including hospitals, imaging centers and cancer treatment centers, and increased the statute of limitations period for the government to recover overpayments to providers from three to five years. If federal spending is further reduced, anticipated budgetary shortfalls may also impact the ability of relevant agencies, such as the FDA or the National Institutes of Health to continue to function at current levels. Amounts allocated to federal grants and contracts may be reduced or eliminated. These reductions may also impact the ability of relevant agencies to timely review and approve research and development, manufacturing, and marketing activities, which may delay our ability to develop, market and sell any products we may develop.Moreover, payment methodologies, including payment for companion or complementary diagnostics, may be subject to changes in healthcare legislation and regulatory initiatives. For example, the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (the “MMA”), changed the way Medicare covers and pays for pharmaceutical products. The legislation expanded Medicare coverage for drug purchases by the elderly and introduced a new reimbursement methodology based on average sales prices for physician-administered drugs. In addition, this legislation provided authority for limiting the number of drugs that will be covered in any therapeutic class. While the MMA only applies to drug benefits for Medicare beneficiaries, private payors often follow Medicare coverage policy and payment limitations in setting their own reimbursement rates. Therefore, any reduction in reimbursement that results from the MMA may result in a similar reduction in payments from private payors. In addition, CMS has begun bundling the Medicare payments for certain laboratory tests ordered while a patient received services in a hospital outpatient setting and, beginning in 2018, CMS will pay for clinical laboratory services based on a weighted average of reported prices that private payors, Medicare Advantage plans, and Medicaid Managed Care plans pay for laboratory services. Further, on March 16, 2018, CMS finalized its National Coverage Determination (the “NCD”), for certain diagnostic laboratory tests using next generation sequencing that are approved by the FDA as a companion in vitro diagnostic and used in a cancer with an FDA-approved companion diagnostic indication. Under the NCD, diagnostic tests that gain FDA approval or clearance as an in vitro companion diagnostic will automatically receive full coverage and be available for patients with recurrent, metastatic relapsed, refractory or stages III and IV cancer. Additionally, the NCD extended coverage to repeat testing when the patient has a new primary diagnosis of cancer.Recently there has been heightened governmental scrutiny over the manner in which manufacturers set prices for their marketed products, which has resulted in several Presidential executive orders, Congressional inquiries and proposed and enacted federal and state legislation designed to, among other things, bring more transparency to product pricing, review the relationship between pricing and manufacturer patient programs, and reform government program reimbursement methodologies for drug products.Further, in November 2020, the U.S. Department of Health and Human Services (\"HHS\") finalized a regulation removing safe harbor protection for price reductions from pharmaceutical manufacturers to plan sponsors under Part D, either directly or through pharmacy benefit managers, unless the price reduction is required by law. The rule also creates a new safe harbor for price reductions reflected at the point-of-sale, as well as a safe harbor for certain fixed fee arrangements between pharmacy benefit managers and manufacturers. The implementation of this final rule was delayed by the Biden administration until January 1, 2023 and subsequently delayed by the Inflation Reduction Act (the “IRA”) until January 1, 2032. In December 2020, CMS issued a final rule implementing significant manufacturer price reporting changes under the Medicaid Drug Rebate Program, including regulations that affect manufacturer-sponsored patient assistance programs subject to pharmacy benefit manager accumulator programs and Best Price reporting related to certain value-based purchasing arrangements. Under the American Rescue Plan Act of 2021, effective January 1, 2024, the statutory cap on 59\nMedicaid Drug Rebate Program rebates that manufacturers pay to state Medicaid programs will be eliminated. Elimination of this cap may require pharmaceutical manufacturers to pay more in rebates than they receive on the sale of products. It is unclear to what extent these new regulations requirements will be implemented and to what extent these regulations or any future legislation or regulations by the Biden administration will have on our business, including our ability to generate revenue and achieve profitability.Additionally, on September 9, 2021, the Biden administration published a wide-ranging list of policy proposals, most of which would need to be carried out by Congress, to reduce drug prices and drug payment. The HHS plan includes, among other reform measures, proposals to lower prescription drug prices, including by allowing Medicare to negotiate prices and disincentivizing price increases, and to support market changes that strengthen supply chains, promote biosimilars and generic drugs, and increase price transparency. These initiatives recently culminated in the enactment of the IRA in August 2022, which will, among other things, allow HHS to negotiate the selling price of certain drugs and biologics that CMS reimburses under Medicare Part B and Part D, although only high-expenditure single-source drugs that have been approved for at least 7 years (11 years for biologics) can be selected by CMS for negotiation. The negotiated prices, which will first become effective in 2026, will be capped at a statutory ceiling price. Beginning in January 2023 for Medicare Part B and October 2022 for Medicare Part D, the IRA will also penalize drug manufacturers that increase prices of Medicare Part B and Part D drugs at a rate greater than the rate of inflation. The IRA permits the Secretary of HHS to implement many of these provisions through guidance, as opposed to regulation, for the initial years. Manufacturers that fail to comply with the IRA may be subject to various penalties, including civil monetary penalties. The IRA also extends enhanced subsidies for individuals purchasing health insurance coverage in ACA marketplaces through plan year 2025. These provisions will take effect progressively starting in 2023, although they may be subject to legal challenges. The full economic impact of the IRA is unknown at this time, but the law’s passage may affect the pricing of our products and product candidates. The adoption of restrictive price controls in new jurisdictions, more restrictive controls in existing jurisdictions or the failure to obtain or maintain timely or adequate pricing could also adversely impact revenue. We expect pricing pressures will continue globally.Additionally, on May 30, 2018, the Trickett Wendler, Frank Mongiello, Jordan McLinn, and Matthew Bellina Right to Try Act of 2017 was signed into law. The law, among other things, provides a federal framework for certain patients to access certain investigational new drug products that have completed a Phase 1 clinical trial and that are undergoing investigation for FDA approval. Under certain circumstances, eligible patients can seek treatment without enrolling in clinical trials and without obtaining FDA authorization under an FDA expanded access program; however, manufacturers are not obligated to provide investigational new drug products under the current federal right to try law. We may choose to seek an expanded access program for our product candidates, or to utilize comparable rules in other countries that allow the use of a drug, on a named patient basis or under a compassionate use program.At the state level, legislatures are increasingly passing legislation and implementing regulations designed to control pharmaceutical and biological product pricing, including price or patient reimbursement constraints, discounts, restrictions on certain product access and marketing cost disclosure and transparency measures, and, in some cases, designed to encourage importation from other countries and bulk purchasing. We expect that additional state and federal healthcare reform measures will be adopted in the future, any of which could limit the amounts that federal and state governments will pay for healthcare products and services, which could result in reduced demand for our product candidates or companion or complementary diagnostics or additional pricing pressures.We expect that additional state and federal healthcare reform measures will be adopted in the future. Such reform measures may result in more rigorous coverage criteria and in additional downward pressure on the price that we receive for any approved product. The implementation of cost containment measures or other healthcare reforms may prevent us from being able to generate revenue, attain profitability, or commercialize our products.Governments outside of the United States tend to impose strict price controls, which may adversely affect our revenues, if any.In some countries, particularly the countries of the European Union (the “EU”), the pricing of prescription biological products is subject to governmental control. In these countries, pricing negotiations with governmental authorities can take considerable time after the receipt of marketing approval for a product. To obtain reimbursement or pricing approval in 60\nsome countries, we may be required to conduct a clinical trial that compares the cost-effectiveness of any of our product candidates to other available therapies. If reimbursement of our products is unavailable or limited in scope or amount, or if pricing is set at unsatisfactory levels, our business could be harmed. Political, economic and regulatory developments may further complicate pricing negotiations, and pricing negotiations may continue after reimbursement has been obtained. Reference pricing used by various EU member states, and parallel trade, such as arbitrage between low-priced and high-priced member states, can further reduce prices. There can be no assurance that any country that has price controls or reimbursement limitations for biological products will allow favorable reimbursement and pricing arrangements for any products, if approved in those countries. In addition, the recent withdrawal of the United Kingdom (the “UK”) from its membership in the EU, often referred to as “Brexit”, has caused uncertainty in the current regulatory framework in Europe and could lead to the UK and EU adopting divergent laws and regulations, including those related to the pricing of prescription biological products, as the UK determines which EU laws to replicate or replace. If the UK were to significantly alter its regulations affecting the pricing of prescription biological products, we could face significant new costs. As a result, Brexit could impair our ability to transact business in the EU and the UK.Laws and regulations governing any international operations we may have in the future may preclude us from developing, manufacturing and selling certain product candidates and products outside of the United States and require us to develop and implement costly compliance programs.If we expand our operations outside of the United States, we must dedicate additional resources to comply with numerous laws and regulations in each jurisdiction in which we plan to operate. The Foreign Corrupt Practices Act (the “FCPA”), prohibits any U.S. individual or business from paying, offering, authorizing payment or offering anything of value, directly or indirectly, to any foreign official, political party or candidate for the purpose of influencing any act or decision of such third party in order to assist the individual or business in obtaining or retaining business. The FCPA also obligates companies whose securities are listed in the United States to comply with certain accounting provisions requiring the company to maintain books and records that accurately and fairly reflect all transactions of the company, including international subsidiaries, and to devise and maintain an adequate system of internal accounting controls for international operations.Compliance with the FCPA is expensive and difficult, particularly in countries in which corruption is a recognized problem. In addition, the FCPA presents particular challenges in the biological products industry, because, in many countries, hospitals are operated by the government, and doctors and other hospital employees are considered foreign officials. Certain payments to hospitals in connection with clinical trials and other work have been deemed to be improper payments to government officials and have led to FCPA enforcement actions.Various laws, regulations and executive orders also restrict the use and dissemination outside of the United States, or the sharing with certain non-U.S. nationals, of information classified for national security purposes, as well as certain products and technical data relating to those products. If we expand our presence outside of the United States, it will require us to dedicate additional resources to comply with these laws, and these laws may preclude us from developing, manufacturing or selling certain product candidates and products outside of the United States, which could limit our growth potential and increase our development costs.The failure to comply with laws governing international business practices may result in substantial civil and criminal penalties and suspension or debarment from government contracting. The SEC also may suspend or bar issuers from trading securities on U.S. exchanges for violations of the FCPA’s accounting provisions.If we fail to comply with environmental, health and safety laws and regulations, we could become subject to fines or penalties or incur costs that could harm our business.We and our third-party contractors are subject to numerous foreign, federal, state and local environmental, health and safety laws and regulations, including those governing laboratory procedures and the handling, use, storage, treatment and disposal of hazardous materials and wastes. Our operations involve the use of hazardous and flammable materials, including chemicals and biological materials. Our operations also produce hazardous waste products. We generally contract with third parties for the disposal of these materials and wastes. We cannot eliminate the risk of contamination or 61\ninjury from these materials. In the event of contamination or injury resulting from our use of hazardous materials, we could be held liable for any resulting damages, and any liability could exceed our resources, including any available insurance.In addition, our leasing and operation of real property may subject us to liability pursuant to certain of these laws or regulations. Under existing U.S. environmental laws and regulations, current or previous owners or operators of real property and entities that disposed or arranged for the disposal of hazardous substances may be held strictly, jointly and severally liable for the cost of investigating or remediating contamination caused by hazardous substance releases, even if they did not know of and were not responsible for the releases.We could incur significant costs and liabilities which may adversely affect our financial condition and operating results for failure to comply with such laws and regulations, including, among other things, civil or criminal fines and penalties, property damage and personal injury claims, costs associated with upgrades to our facilities or changes to our operating procedures, or injunctions limiting or altering our operations.Although we maintain liability insurance to cover us for costs and expenses we may incur due to injuries to our employees, this insurance may not provide adequate coverage against potential liabilities. We do not maintain insurance for environmental liability or toxic tort claims that may be asserted against us in connection with our storage or disposal of biological, hazardous or radioactive materials.In addition, we may incur substantial costs in order to comply with current or future environmental, health and safety laws and regulations. These current or future laws and regulations, which are becoming increasingly more stringent, may impair our research, development or production efforts. Our failure to comply with these laws and regulations also may result in substantial fines, penalties or other sanctions.We are subject to certain U.S. and certain other anti-corruption, anti-money laundering, export control, sanctions and other trade laws and regulations. We can face serious consequences for violations.U.S. and other anti-corruption, anti-money laundering, export control, sanctions and other trade laws and regulations prohibit, among other things, companies and their employees, agents, CROs, CMOs, legal counsel, accountants, consultants, contractors and other partners from authorizing, promising, offering, providing, soliciting, or receiving directly or indirectly, corrupt or improper payments or anything else of value to or from recipients in the public or private sector. Violations of these laws can result in substantial criminal fines and civil penalties, imprisonment, the loss of trade privileges, debarment, tax reassessments, breach of contract and fraud litigation, reputational harm and other consequences. We have direct or indirect interactions with officials and employees of government agencies or government-affiliated hospitals, universities and other organizations. We also expect our non-U.S. activities to increase over time. We expect to rely on third parties for research, preclinical studies and clinical trials and/or to obtain necessary permits, licenses, patent registrations and other marketing approvals. We can be held liable for the corrupt or other illegal activities of our personnel, agents, or partners, even if we do not explicitly authorize or have prior knowledge of such activities.Any violations of the laws and regulations described above may result in substantial civil and criminal fines and penalties, imprisonment, the loss of export or import privileges, debarment, tax reassessments, breach of contract and fraud litigation, reputational harm and other consequences.Risks related to our reliance on third partiesWe rely, and intend to continue to rely, on third parties to conduct our clinical trials and perform all of our research and preclinical studies. If these third parties do not satisfactorily carry out their contractual duties, fail to comply with applicable regulatory requirements or do not meet expected deadlines, our development programs may be delayed or subject to increased costs or we may be unable to obtain regulatory approval, each of which may have an adverse effect on our business, financial condition, results of operations and prospects.We do not have the ability to independently conduct all aspects of our preclinical testing or clinical trials ourselves. As a result, we expect to be dependent on third parties to conduct our planned preclinical studies and clinical trials of EO-3021 and other product candidates. The timing of the initiation and completion of these trials will therefore be partially 62\ncontrolled by such third parties and may result in delays to our development programs. Specifically, we expect CROs, clinical investigators and consultants to play a significant role in the conduct of these trials and the subsequent collection and analysis of data. However, these CROs and other third parties are not our employees, and we will not be able to control all aspects of their activities. Nevertheless, we are responsible for ensuring that each clinical trial is conducted in accordance with the applicable protocol and legal, regulatory and scientific standards, and our reliance on the CROs and other third parties does not relieve us of our regulatory responsibilities. We and our CROs are required to comply with GCP requirements, which are regulations and guidelines enforced by the FDA for product candidates in clinical development. Regulatory authorities enforce these GCP requirements through periodic inspections of trial sponsors, clinical trial investigators and clinical trial sites. If we or any of our CROs or clinical trial sites fail to comply with applicable GCP requirements, the data generated in our clinical trials may be deemed unreliable, and the FDA may require us to perform additional clinical trials before approving our marketing applications. We cannot assure you that, upon inspection, the FDA will determine that our clinical trials comply with GCPs. In addition, our clinical trials must be conducted with product produced under cGMP regulations. Our failure, or the failure of third parties on whom we rely, to comply with these regulations may require us to stop and/or repeat clinical trials, which would delay the marketing approval process.There is no guarantee that any such CROs, clinical trial investigators or other third parties on which we rely will devote adequate time and resources to our development activities or perform as contractually required. If any of these third parties fail to meet expected deadlines, adhere to our clinical protocols or meet regulatory requirements, otherwise perform in a substandard manner, or terminate their engagements with us, the timelines for our development programs may be extended or delayed or our development activities may be suspended or terminated. If our clinical trial site terminates for any reason, we may experience the loss of follow-up information on subjects enrolled in such clinical trial unless we are able to transfer those subjects to another qualified clinical trial site, which may be difficult or impossible.Furthermore, these third parties may also have relationships with other entities, some of which may be our competitors, for whom they may also be conducting clinical trials or other biological product development activities that could harm our competitive position. If these third parties do not successfully carry out their contractual duties, meet expected deadlines or conduct our clinical trials in accordance with regulatory requirements or our stated protocols, we will not be able to obtain, or may be delayed in obtaining, marketing approvals for EO-3021 or any other product candidates and will not be able to, or may be delayed in our efforts to, successfully commercialize our products.Manufacturing biological products is complex and subject to product loss for a variety of reasons. We rely on third parties to manufacture clinical supplies of our product candidates and we intend to rely on third parties to produce commercial supplies of any approved product. This reliance on third parties increases the risk that we will not have sufficient quantities of our product candidates or products or such quantities at an acceptable cost or quality, which could delay, prevent or impair our development or commercialization efforts.We do not have any manufacturing facilities. We rely, and expect to continue to rely, on third parties for the manufacture of our product candidates and future product candidates for clinical testing, product development purposes, to support regulatory application submissions, as well as for commercial manufacture if a product candidate obtains marketing approval. In addition, we expect to contract with analytical laboratories for release and stability testing of our product candidates. Subject to certain exceptions, we are required to acquire our clinical and commercial supply of EO-3021 primarily from CSPC in China. This reliance on third parties increases the risk that we will not have sufficient quantities of our product candidates or products or such quantities at an acceptable cost or quality, which could delay, prevent or impair our development or commercialization efforts. In addition, the continued presence of COVID-19 may result in disruptions to the operations or an extended shutdown of certain businesses, which could include CSPC and other suppliers.With rising international trade tensions or sanctions, our business may be adversely affected following new or increased tariffs that result in increased costs as a result of international transportation of supplies, as well as the costs of materials and products imported into the United States, particularly if these measures occur in regions where we source our product candidates, components or raw materials, such as China. Tariffs, trade restrictions, sanctions, export controls or other restrictive actions imposed by the United States or other countries, including as a result geopolitical tension, such as a deterioration in the relationship between the United States and China or escalation in conflict between Russia and Ukraine, could increase the prices of our and our partners’ products and product candidates, affect our and our partners’ ability to 63\n| ● | reliance on the third party for regulatory, compliance and quality assurance; |\n| ● | reliance on the third party for product development, analytical testing, and data generation to support regulatory applications; |\n| ● | lack of qualified backup suppliers for those components or materials that are currently purchased from a sole or single source supplier; |\n| ● | operations of our third-party manufacturers or suppliers could be disrupted by conditions unrelated to our business or operations, including the bankruptcy of the manufacturer or supplier, the issuance of an FDA Form 483 notice or warning letter or other enforcement action by FDA or other regulatory authority; |\n| ● | the possible breach of the manufacturing agreement by the third party; |\n| ● | the possible misappropriation of our proprietary information, including our trade secrets and know-how; |\n| ● | the possible termination or nonrenewal of the agreement by the third party at a time that is costly or inconvenient for us; |\n| ● | carrier disruptions or increased costs that are beyond our control; and |\n| ● | failure to deliver our drugs under specified storage conditions and in a timely manner. |\n\nongoing compliance with extensive FDA requirements and the requirements of other similar agencies, including ensuring that quality control and manufacturing procedures conform to cGMP requirements. As such, our third-party manufacturers are subject to continual review and periodic inspections to assess compliance with cGMPs. Furthermore, although we do not have day-to-day control over the operations of our third-party manufacturers, we are responsible for ensuring compliance with applicable laws and regulations, including cGMPs.Further, if we make manufacturing or formulation changes to our product candidates or add or change CMOs in the future, the FDA or other regulatory authorities will require a demonstration of the comparability of the new product to the prior product, including potentially through a clinical bridging study.In addition, our third-party manufacturers and suppliers are subject to numerous environmental, health and safety laws and regulations, including those governing the handling, use, storage, treatment and disposal of waste products, and failure to comply with such laws and regulations could result in significant costs associated with civil or criminal fines and penalties for such third parties. Based on the severity of regulatory actions that may be brought against these third parties in the future, our clinical or commercial supply of drug and packaging and other services could be interrupted or limited, which could harm our business.Our product candidates and any products that we may develop may compete with other future product candidates and products for access to manufacturing facilities. As a result, we may not obtain access to these facilities on a priority basis or at all. There are a limited number of manufacturers that operate under cGMP regulations and that might be capable of manufacturing for us.Any performance failure on the part of our existing or future CMOs could delay clinical development or marketing approval. We do not currently have arrangements in place for redundant supply or a second source for bulk drug substances. If our current CMOs for preclinical and clinical testing cannot perform as agreed, we may be required to replace such CMOs, and we may incur added costs and delays in identifying and qualifying any such replacement manufacturer or we may not be able to reach agreement with any alternative manufacturer. Further, our third-party manufacturers may experience manufacturing or shipping difficulties due to resource constraints or as a result of natural disasters, labor disputes, unstable political environments or public health epidemics such as the COVID-19 pandemic. If our current third-party manufacturers cannot perform as agreed, we may be required to replace such manufacturers and we may be unable to replace them on a timely basis or at all.Our current and anticipated future dependence upon others for the manufacture of our product candidates or products may adversely affect our future profit margins and our ability to commercialize any products that obtain marketing approval on a timely and competitive basis.We may enter into collaborations with third parties for the development and commercialization of our product candidates. If those collaborations are not successful, we may not be able to capitalize on the market potential of our product candidates.We may seek third-party collaborators for the development and commercialization of our product candidates on a select basis. For example, we intend to pursue further development of seribantumab only in collaboration with a partner. We have not entered into any such collaborations to date, and we may not be successful in finding a partner for further development of seribantumab. Our likely collaborators for any future collaboration arrangements include large and mid-size biologics companies, regional and national biologics companies and biotechnology companies. We will face significant competition in seeking appropriate collaborators. Our ability to reach a definitive agreement for a future collaboration will depend, among other things, upon our assessment of the future collaborator’s resources and expertise, the terms and conditions of the proposed collaboration and the proposed collaborator’s evaluation of a number of factors.If we do enter into any such arrangements with any third parties, we will likely have limited control over the amount and timing of resources that our future collaborators dedicate to the development or commercialization of our product candidates. Our ability to generate revenues from these arrangements will depend on our future collaborators’ abilities and 65\n| ● | collaborators have significant discretion in determining the efforts and resources that they will apply to these collaborations and may not perform their obligations as expected; |\n| ● | collaborators may de-emphasize or not pursue development and commercialization of our product candidates or may elect not to continue or renew development or commercialization programs based on clinical trial results, changes in the collaborators’ strategic focus, including as a result of a sale or disposition of a business unit or development function, or available funding or external factors such as an acquisition that diverts resources or creates competing priorities; |\n| ● | collaborators may delay clinical trials, provide insufficient funding for a clinical trial program, stop a clinical trial or abandon a product candidate, repeat or conduct new clinical trials or require a new formulation of a product candidate for clinical testing; |\n| ● | collaborators could independently develop, or develop with third parties, products that compete directly or indirectly with our products or product candidates if the collaborators believe that competitive products are more likely to be successfully developed or can be commercialized under terms that are more economically attractive than ours; |\n| ● | a collaborator with marketing and distribution rights to multiple products may not commit sufficient resources to the marketing and distribution of our product relative to other products; |\n| ● | collaborators may not properly obtain, maintain, defend or enforce our intellectual property rights or may use our proprietary information and intellectual property in such a way as to invite litigation or other intellectual property related proceedings that could jeopardize or invalidate our proprietary information and intellectual property or expose us to potential litigation or other intellectual property related proceedings; |\n| ● | disputes may arise between the collaborators and us that result in the delay or termination of the research, development or commercialization of our products or product candidates or that result in costly litigation or arbitration that diverts management attention and resources; |\n| ● | collaborations may be terminated and, if terminated, may result in a need for additional capital to pursue further development or commercialization of the applicable product candidates; |\n| ● | collaboration agreements may not lead to development or commercialization of product candidates in the most efficient manner or at all; and |\n| ● | if a future collaborator of ours were to be involved in a business combination, the continued pursuit and emphasis on our product development or commercialization program could be delayed, diminished or terminated. |\n\n| ● | the efficacy and potential advantages compared to alternative treatments; |\n| ● | the acceptance of our product candidates as front-line treatments for various indications; |\n| ● | the prevalence and severity of any side effects, in particular compared to alternative treatments; |\n| ● | limitations or warnings contained in the labeling approved by the FDA or other regulatory authorities; |\n| ● | the size of the target patient population; |\n| ● | the willingness of the target patient population to try new therapies and of physicians to prescribe these therapies; |\n| ● | our ability to offer our products for sale at competitive prices; |\n| ● | the convenience and ease of administration compared to alternative treatments; |\n| ● | the strength of marketing and distribution support; |\n| ● | publicity for our product candidates and competing products and treatments; |\n| ● | the existence of distribution and/or use restrictions, such as through a REMS; |\n| ● | the availability of third-party payor coverage and adequate reimbursement; |\n| ● | the timing of any marketing approval in relation to other product approvals; |\n\n| ● | support from patient advocacy groups; and |\n| ● | any restrictions on the use of our products together with other medications. |\n| ● | our inability to recruit, train and retain adequate numbers of effective sales and marketing personnel; |\n| ● | our inability to raise financing necessary to build our commercialization infrastructure; |\n| ● | the inability of sales personnel to obtain access to physicians or educate an adequate number of physicians as to the benefits of our products; |\n| ● | unfavorable third-party payor coverage and reimbursement in any geography; |\n| ● | the lack of complementary products to be offered by sales personnel, which may put us at a competitive disadvantage relative to companies with more extensive product lines; and |\n| ● | unforeseen costs and expenses associated with creating an independent sales and marketing organization. |\n\nWe face substantial competition, which may result in others discovering, developing or commercializing products before or more successfully than we do.The development and commercialization of biological products is highly competitive. We face competition with respect to our current product candidates and will face competition with respect to any product candidates that we may seek to develop or commercialize in the future, from major biologics companies, specialty biologics companies and existing or emerging biotechnology companies, academic research institutions and governmental agencies and public and private research institutions worldwide.There are a number of biological and biotechnology companies that currently are pursuing the development of selective cancer therapies for patients with significant unmet medical needs. In particular, we expect that EO-3021 will compete against other ADCs targeting Claudin 18.2. Several such candidates are currently in clinical development, including those of Antengene Corporation (ATG-022), AstraZeneca (CMG901) (rights licensed from Keymed Biosciences), KLUS Pharma Inc. (SKB315), RemeGen (RC118), SOTIO Biotech (SOT102), TORL Biotherapeutics, LLC (TORL-2-307-ADC) and Turning Point Therapeutics, Inc. (now owned by Bristol Myers Squibb) (LM-302). We may face further competition from companies pursuing the development of product candidates that target Claudin 18.2 through other modalities, including Astellas Pharma Inc., Beijing Mabworks Biotech Co., Ltd., CARsgen Therapeutics Holdings Limited, Flame Biosciences, Jiangsu Aosaikang Pharmaceutical Co., Ltd., Legend Biotech Corporation, NovaRock Biotherapeutics Limited, Transcenta Holding Limited, Zai Lab Limited, and others. Development efforts with respect to, and clinical trial results of, these potentially competitive product candidates may be unsuccessful, which could result in a negative perception of product candidates targeting Claudin 18.2 in general, for instance, which could in turn negatively impact the regulatory approval process for EO-3021.Many of the companies against which we are competing or against which we may compete in the future, either alone or through collaborations, have significantly greater financial resources and expertise in research and development, manufacturing, preclinical testing, conducting clinical trials, obtaining regulatory approvals and marketing approved products than we do. Mergers and acquisitions in the pharmaceutical and biotechnology industries may result in even more resources being concentrated among a smaller number of our competitors. Smaller and other early-stage companies may also prove to be significant competitors, particularly through collaborative arrangements with large and established companies. These third parties compete with us in recruiting and retaining qualified scientific, management and sales and marketing personnel, establishing clinical trial sites and patient registration for clinical trials, as well as in acquiring technologies complementary to, or necessary for, our programs.Furthermore, we also face competition more broadly across the oncology market for cost-effective and reimbursable cancer treatments. There are a variety of available drug therapies marketed for cancer. In many cases, these drugs are administered in combination to enhance efficacy. While our product candidates, if approved, may compete with these existing drugs and other therapies, to the extent they are ultimately used in combination with or as an adjunct to these therapies, our product candidates may not be competitive with them. Some of these drugs are branded and subject to patent protection, and others are available on a generic basis. Insurers and other third-party payors may also encourage the use of generic products or specific branded products. As a result, obtaining market acceptance of, and gaining significant share of the market for, our product candidates may pose challenges. In addition, many companies are developing new oncology therapeutics, and we cannot predict what the standard of care will be as product candidates progress through clinical development.Our commercial opportunity could be reduced or eliminated if our competitors develop and commercialize products that are safer, more effective, have fewer or less severe side effects, are more convenient to administer, are less expensive or with a more favorable labeling than our product candidates. Our competitors also may obtain FDA, foreign regulatory authority, or other marketing or regulatory approval for their products more rapidly than any approval we may obtain for ours, which could result in our competitors establishing a strong market position before we are able to enter the market, thereby limiting our potential for commercial success.69\nEven if we are able to commercialize any product candidates, the products may become subject to unfavorable pricing regulations, third-party reimbursement practices or healthcare reform initiatives, which would harm our business.The regulations that govern marketing approvals, pricing, coverage and reimbursement for new drug products vary widely from country to country. Current and future legislation may significantly change the approval requirements in ways that could involve additional costs and cause delays in obtaining approvals. Some countries require approval of the sale price of a drug before it can be marketed. In many countries, the pricing review period begins after marketing or product licensing approval is granted. To obtain reimbursement or pricing approval in some countries, we may be required to conduct a clinical trial that compares the cost-effectiveness of our product candidate to other available therapies. In some foreign markets, prescription pharmaceutical pricing remains subject to continuing governmental control even after initial approval is granted. As a result, we might obtain marketing approval for a product candidate in a particular country, but then be subject to price regulations that delay our commercial launch of the product, possibly for lengthy time periods, and negatively impact the revenues, if any, we are able to generate from the sale of the product in that country. Adverse pricing limitations may hinder our ability to recoup our investment in one or more product candidates, even if such product candidates obtain marketing approval.Our ability to commercialize any product candidates successfully also will depend in part on the extent to which coverage and adequate reimbursement for these products and related treatments will be available from third-party payors, including government healthcare programs, private health insurers and other organizations. Third-party payors decide which medications they will pay for and establish reimbursement levels. In the United States, the principal decisions about reimbursement for new medicines are typically made by the CMS, which decides whether and to what extent a new medicine will be covered and reimbursed under Medicare. Private payors often, but not always, follow CMS’s decisions regarding coverage and reimbursement.A primary trend in the U.S. healthcare industry and elsewhere is cost containment. Third-party payors have attempted to control costs by limiting coverage and the amount of reimbursement for particular medications. Increasingly, third- party payors are requiring that drug companies provide them with predetermined discounts from list prices and are challenging the prices charged for medical products. Coverage and reimbursement may not be available for any product that we commercialize and, even if these are available, the level of reimbursement may not be satisfactory. Reimbursement may affect the demand for, or the price of, any product candidate for which we obtain marketing approval. Obtaining and maintaining coverage and adequate reimbursement for our products may be difficult. We may be required to conduct expensive pharmacoeconomic studies to justify coverage and reimbursement or the level of reimbursement relative to other therapies. If coverage and adequate reimbursement are not available or reimbursement is available only to limited levels, we may not be able to successfully commercialize any product candidate for which we obtain marketing approval.Additionally, we may develop, either by ourselves or with collaborators, companion or complementary diagnostic tests for our product candidates for certain indications. We, or our collaborators, if any, will be required to obtain coverage and reimbursement for these tests separate and apart from the coverage and reimbursement we seek for our product candidates, if approved. While we have not yet developed any companion or complementary diagnostic test for our product candidates, if we do, there is significant uncertainty regarding our ability to obtain coverage and adequate reimbursement for the same reasons that are applicable to our product candidates.There may also be significant delays in obtaining coverage and reimbursement for newly approved drugs, and coverage may be more limited than the purposes for which the drug is approved by the FDA or similar regulatory authorities outside of the United States. Moreover, eligibility for coverage and reimbursement does not imply that a drug will be paid for in all cases or at a rate that covers our costs, including research, development, intellectual property, manufacture, sale and distribution expenses. Interim reimbursement levels for new drugs, if applicable, may also not be sufficient to cover our costs and may not be made permanent. Reimbursement rates may vary according to the use of the drug and the clinical setting in which it is used, may be based on reimbursement levels already set for lower cost drugs and may be incorporated into existing payments for other services. Net prices for drugs may be reduced by mandatory discounts or rebates required by government healthcare programs or private payors and by any future relaxation of laws that presently restrict imports of drugs from countries where they may be sold at lower prices than in the United States. Third-party payors often rely upon Medicare coverage policy and payment limitations in setting their own reimbursement policies, but also have their own methods and approval process apart from Medicare determinations. Our inability to promptly obtain coverage and 70\n| ● | decreased demand for any product candidates or products that we may develop; |\n| ● | injury to our reputation and significant negative media attention; |\n| ● | initiation of investigations by regulators; |\n| ● | withdrawal of clinical trial participants; |\n| ● | significant time and costs to defend the related litigation; |\n| ● | diversion of management and scientific resources from our business operations; |\n| ● | substantial monetary awards to trial participants or patients; |\n| ● | loss of revenue; |\n| ● | reduced resources of our management to pursue our business strategy; and |\n| ● | the inability to commercialize any products that we may develop. |\n\nWe may experience significant growth in the number of our employees and the scope of our operations, particularly in the areas of clinical development, clinical operations, manufacturing, late-stage regulatory affairs, finance, accounting, business operations, public company compliance, communications and other corporate development functions, and, if any of our product candidates receives marketing approval, sales, marketing and distribution. If we acquire additional product candidates or enter into future collaborations, we may need to expand our employee base beyond our current projections, which may include further preclinical research and development or later-stage regulatory operations. To manage our potential growth, we must continue to implement and improve our managerial, operational and financial systems, expand our facilities and continue to recruit and train additional qualified personnel. Due to our limited financial resources and the limited experience of our management team in managing a company with such anticipated growth and with developing sales, marketing and distribution infrastructure, we may not be able to effectively manage the expansion of our operations or recruit and train additional qualified personnel. The expansion of our operations may lead to significant costs and may divert our management and business development resources. Further, rapid expansion of our workforce while remaining a virtual company may have a detrimental impact on employee morale and cohesion.Further, we currently rely, and for the foreseeable future will continue to rely, in substantial part on certain third-party contract organizations, advisors and consultants to provide certain services, including assuming substantial responsibilities for the conduct of our clinical trials and the manufacturing of our product candidates. We cannot assure you that the services of such third-party contract organizations, advisors and consultants will continue to be available to us on a timely basis when needed, or that we can find qualified replacements. In addition, if we are unable to effectively manage our outsourced activities or if the quality or accuracy of the services provided by our vendors or consultants is compromised for any reason, our clinical trials may be extended, delayed or terminated, and we may not be able to obtain marketing approval of our product candidates or otherwise advance our business. We cannot assure you that we will be able to properly manage our existing vendors or consultants or find other competent outside vendors and consultants on economically reasonable terms, or at all.If we are not able to effectively manage growth and expand our organization, we may not be able to successfully implement the tasks necessary to further develop and commercialize our product candidates and, accordingly, we may not achieve our research, development and commercialization goals.Our future success depends on our ability to retain key employees and to attract, retain and motivate qualified personnel and manage our human capital.Our ability to compete in the highly competitive biotechnology and pharmaceutical industries depends upon our ability to attract, motivate and retain highly qualified managerial, scientific and medical personnel. We are highly dependent on the development and management expertise of the principal members of our management, scientific and clinical teams. We currently do not maintain key person insurance on these individuals. Although we have entered into employment agreements with our executive officers, each of them may terminate their employment with us at any time. In addition, we rely on consultants and advisors, including scientific and clinical advisors, to assist us in formulating our research and development and manufacturing strategy. Our consultants and advisors may be employed by employers other than us and may have commitments under consulting or advisory contracts with other entities that may limit their availability to us. Recruiting and retaining qualified finance and accounting personnel will also be critical to our success. We may not be able to attract or retain qualified personnel in the future due to the intense competition for a limited number of qualified personnel among pharmaceutical companies. Our workforce reduction announced in January 2023 may make retention of our current personnel both more important and more challenging. Many of the other pharmaceutical companies against which we compete have greater financial and other resources, different risk profiles and a longer history in the industry than we do. Our competitors may provide higher compensation, more diverse opportunities and/or better opportunities for career advancement. Any or all of these competing factors may limit our ability to continue to attract and retain high quality personnel, which could negatively affect our ability to successfully develop and commercialize our product candidates and to grow our business and operations as currently contemplated.Further, we recently underwent a leadership transition, which may be viewed negatively by employees, investors and collaborators. Moreover, any attrition associated with this transition could significantly delay or prevent the achievement of our business objectives and adversely impact our stock price.72\nOur employees, clinical trial investigators, CROs, CMOs, consultants, vendors and any potential commercial partners may engage in misconduct or other improper activities, including non-compliance with regulatory standards and requirements and insider trading.We are exposed to the risk of fraud or other misconduct by our employees, clinical trial investigators, CROs, CMOs, consultants, vendors and any potential commercial partners. Misconduct by these parties could include intentional, reckless and/or negligent conduct or disclosure of unauthorized activities to us that violates: (i) FDA regulations or those of comparable foreign regulatory authorities, including those laws that require the reporting of true, complete and accurate information, (ii) manufacturing standards, (iii) federal and state health and data privacy, security, fraud and abuse, government price reporting, transparency reporting requirements, and other healthcare laws and regulations in the United States and abroad, (iv) sexual harassment and other workplace misconduct or (v) laws that require the true, complete and accurate reporting of financial information or data. Such misconduct could also involve the improper use of information obtained in the course of clinical trials, which could result in regulatory sanctions and cause serious harm to our reputation.We have adopted a code of conduct applicable to all of our employees, as well as a disclosure program and other applicable policies and procedures, but it is not always possible to identify and deter employee misconduct, and the precautions we take to detect and prevent this activity may not be effective in controlling unknown or unmanaged risks or losses or in protecting us from governmental investigations or other actions or lawsuits stemming from a failure to comply with these laws or regulations. If any such actions are instituted against us, and we are not successful in defending ourselves or asserting our rights, those actions could have a significant impact on our business, including the imposition of significant civil, criminal and administrative penalties, damages, fines, disgorgement, imprisonment, exclusion from government funded healthcare programs, such as Medicare, Medicaid and other federal healthcare programs, contractual damages, reputational harm, diminished profits and future earnings, additional integrity reporting and oversight obligations, and the curtailment or restructuring of our operations, any of which could adversely affect our ability to operate our business and our results of operations.We are a virtual company and our business depends on the efficient and uninterrupted operation of our information technology systems and those of our third-party CROs, CMOs, or other vendors, contractors or consultants, may fail or suffer security breaches, cyberattacks, loss or leakage of data and other disruptions, which could result in a material disruption of our development programs, compromise sensitive information related to our business or prevent us from accessing critical information, potentially exposing us to liability or otherwise adversely affecting our business.We are a virtual company, our business success depends on the security and efficient and uninterrupted operation of our information technology systems, and we may be unable to adequately protect our information technology systems from cyberattacks, which could result in the disclosure of confidential information, damage our reputation, and subject us to significant financial and legal exposure. We are increasingly dependent upon information technology systems, infrastructure and data to operate our business. In the ordinary course of business, we collect, store and transmit confidential information (including but not limited to intellectual property, proprietary business information, personal health information and sensitive personal information). It is critical that we do so in a secure manner to maintain the confidentiality and integrity of such confidential information. We also have outsourced elements of our operations to third parties, and as a result we manage a number of third-party CROs, CMOs, vendors, and other contractors and consultants who have access to our confidential information. System failures or outages, including any potential disruptions due to significantly increased global demand on certain cloud-based systems during the remote work environment resulting from the COVID-19 pandemic, could compromise our ability to perform these functions in a timely manner, which could harm our ability to conduct business or delay our financial reporting.Despite the implementation of security measures, given their size and complexity and the increasing amounts of confidential information that they maintain, our internal information technology systems and those of our third-party CROs, CMOs, vendors and other contractors and consultants are potentially vulnerable to breakdown or other damage or interruption from service interruptions, system malfunction, accidents by our employees or third-party service providers, natural disasters, terrorism, war, global pandemics, and telecommunication and electrical failures, as well as security breaches from inadvertent or intentional actions by our employees, third-party CROs, CMOs, vendors, contractors, consultants, business partners and/or other third parties, or from cyberattacks or supply chain attacks by malicious third parties (including the deployment of harmful malware, ransomware, denial-of-service attacks, social engineering and other 73\nmeans to affect service reliability and threaten the confidentiality, integrity and availability of information), which may compromise our system infrastructure, or that of our third-party CROs, CMOs, vendors and other contractors and consultants, or lead to data leakage. The risk of a security breach or disruption, particularly through cyberattacks or cyber intrusion, including by computer hackers, foreign governments, and cyber terrorists, has generally increased as the number, intensity, and sophistication of attempted attacks and intrusions from around the world have increased. The COVID-19 pandemic has generally increased the attack surface available for exploitation, as more companies and individuals work online and remotely, and as such, the risk of a cybersecurity incident occurring, and our investment in risk mitigations against such an incident, are increasing. For example, there has been an increase in phishing and spam email attacks as well as social engineering attempts from “hackers” hoping to use the COVID-19 pandemic to their advantage. We may not be able to anticipate all types of security threats, nor implement preventive measures effective against all such security threats. The techniques used by cyber criminals change frequently, may not be recognized until launched and can originate from a wide variety of sources, including outside groups such as external service providers, organized crime affiliates, terrorist organizations, or hostile foreign governments or agencies. Any breach, loss or compromise of clinical trial participant personal data may also subject us to civil fines and penalties, including under HIPAA, and other relevant state and federal privacy laws in the United States. If the information technology systems of our third-party CROs, CMOs, vendors and other contractors and consultants become subject to disruptions or security breaches, we may have insufficient recourse against such third parties and we may have to expend significant resources to mitigate the impact of such an event, and to develop and implement protections to prevent future events of this nature from occurring.While we have not experienced any such system failure, accident or security breach to date, we cannot assure you that our data protection efforts and our investment in information technology will prevent significant breakdowns, data leakages, breaches in our systems, or those of our third-party CROs, CMOs, vendors and other contractors and consultants, or other cyber incidents that could have a material adverse effect upon our reputation, business, operations, or financial condition. For example, if such an event were to occur and cause interruptions in our operations, or those of our third-party CROs, CMOs, vendors and other contractors and consultants, it could result in a material disruption of our programs and the development of our product candidates could be delayed. In addition, the loss of clinical trial data for our product candidates could result in delays in our marketing approval efforts and significantly increase our costs to recover or reproduce the data. Furthermore, significant disruptions of our internal information technology systems or those of our third-party CROs, CMOs, vendors and other contractors and consultants, or security breaches could result in the loss, misappropriation and/or unauthorized access, use, or disclosure of, or the prevention of access to, confidential information (including trade secrets or other intellectual property, proprietary business information, and sensitive personal information), which could result in financial, legal, business and reputational harm to us.A security breach may cause us to breach customer contracts. Our agreements with certain customers may require us to use industry-standard or reasonable measures to safeguard sensitive personal information or confidential information. A security breach could lead to claims by our customers, their end users, or other relevant stakeholders that we have failed to comply with such legal or contractual obligations. As a result, we could be subject to legal action or our customers could end their relationships with us. There can be no assurance that the limitations of liability in our contracts would be enforceable or adequate or would otherwise protect us from liabilities or damages.In addition, litigation resulting from security breaches may adversely affect our business. Unauthorized access to our platform, systems, networks, or physical facilities could result in litigation with our customers, our customers’ end users, or other relevant stakeholders. These proceedings could force us to spend money in defense or settlement, divert management’s time and attention, increase our costs of doing business, or adversely affect our reputation. We could be required to fundamentally change our business activities and practices or modify our solutions and/or platform capabilities in response to such litigation, which could have an adverse effect on our business. If a security breach were to occur and the confidentiality, integrity or availability of our data or the data of our partners, our customers or our customers’ end users was disrupted, we could incur significant liability, or our platform, systems or networks may be perceived as less desirable, which could negatively affect our business and damage our reputation.We may not have adequate insurance coverage with respect to security breaches or disruptions. The successful assertion of one or more large claims against us that exceeds our available insurance coverage, or results in changes to our insurance policies (including premium increases or the imposition of large deductible or co-insurance requirements), could have an adverse effect on our business. Even claims that ultimately are unsuccessful could result in our expenditure of funds in 74\nlitigation, divert management’s time and other resources, and harm our reputation. In addition, we cannot be sure that our existing insurance coverage and coverage for errors and omissions will continue to be available on acceptable terms or that our insurers will not deny coverage as to any future claim.Currently, we carry business interruption coverage to mitigate certain potential losses, but this insurance is limited in amount and may not be sufficient in type or amount to cover us against claims related to a cybersecurity breach and related business and system disruptions. We cannot be certain that such potential losses will not exceed our policy limits, insurance will continue to be available to us on economically reasonable terms, or at all, or any insurer will not deny coverage as to any future claim. In addition, we may be subject to changes in our insurance policies, including premium increases or the imposition of large deductible or co-insurance requirements.We are subject to stringent and changing laws, regulations, rules, policies, standards, and contractual obligations related to privacy and data security. Our actual or perceived failure to comply with such obligations could lead to government enforcement actions (which could include civil or criminal penalties), private litigation and/or adverse publicity and could negatively affect our operating results and business.We and any potential collaborators may be subject to federal, state and other data protection laws and regulations (i.e., laws and regulations that address privacy and data security). The regulatory framework for privacy, data security and data transfers worldwide is rapidly evolving and there has been an increasing focus on privacy and data protection issues with the potential to affect our business and as a result, interpretation and implementation standards and enforcement practices are likely to remain uncertain for the foreseeable future. Failure to comply with any of these laws and regulations could result in enforcement actions against us, including fines, public censure, claims for damages by affected individuals, damage to our reputation and loss of goodwill, any of which could have a material adverse effect on our business.In the United States, numerous federal and state laws and regulations, including federal and state health information privacy laws, data breach notification laws, and consumer protection laws (e.g., Section 5 of the Federal Trade Commission Act), that govern the collection, use, disclosure and protection of health-related and other personal information could apply to our operations or the operations of our collaborators. In addition, we may obtain health information from third parties (including research institutions from which we obtain clinical trial data) that are subject to privacy and security requirements under HIPAA, as amended by HITECH and other laws. Depending on the facts and circumstances, we could be subject to penalties if we obtain, use, or disclose personal health information maintained by a HIPAA-covered entity in a manner that is not authorized or permitted by HIPAA.In addition, the state of California enacted the California Consumer Privacy Act (the “CCPA”), which created new individual privacy rights for California consumers (as defined in the CCPA) and places increased privacy and security obligations on entities handling certain personal data of consumers or households. The CCPA requires covered companies to provide new disclosures to consumers about such companies’ data collection, use and sharing practices, provide such consumers new ways to opt-out of certain sales or transfers of personal information, and provide consumers with a private right of action for data breaches. The CCPA went into effect on January 1, 2020 and may impact our business activities and exemplifies the vulnerability of our business to the evolving regulatory environment related to personal data and protected health information. On January 1, 2023, the California Privacy Rights Act (the “CPRA”), which supersedes the CCPA, went into effect. The CCPA and the CPRA give California residents expanded privacy rights, including the right to request correction, access, and deletion of their personal information, the right to opt out of certain personal information sharing, and the right to receive detailed information about how their personal information is processed. The CCPA and CPRA provide for unlimited civil penalties for violations, as well as a private right of action for data breaches that is expected to increase data breach litigation. The CCPA and CPRA may increase our compliance costs and potential liability, particularly in the event of a data breach.Other states have followed California: Virginia enacted the Virginia Consumer Data Protection Act that became effective January 1, 2023; Colorado recently enacted its Colorado Privacy Act, which will be effective July 1, 2023; Connecticut recently passed the Connecticut Data Privacy Act which will become effective July 1, 2023, and Utah recently enacted the Utah Consumer Privacy Act which will become effective December 31, 2023 and as the year 2023 began, four states (Michigan, New Jersey, Ohio and Pennsylvania), have active, pending consumer privacy legislation under review, which if enacted would add additional costs and expense of resources to maintain compliance. It is difficult to confidently predict 75\nthe impact of such laws on our business and operations, but it also required and will likely continue to require us to modify our data processing practices and policies and to incur substantial costs and expenses in an effort to comply.Additionally, laws, regulations, rules and standards in many foreign jurisdictions apply broadly to the collection, use, retention, security, disclosure, transfer and other processing of personal information, which may impose significant compliance obligations on us. For example, in the EU, the processing of personal data, is governed by the provisions of the General Data Protection Regulation (the “GDPR”).In May 2018, the GDPR took effect in the European Economic Area (the “EEA”). The GDPR governs the collection, use, disclosure, transfer or other processing of personal data of natural persons. Among other things, the GDPR imposes strict obligations on the ability to process health-related and other personal data of data subjects in the EEA, including in relation to use, collection, analysis and transfer (including cross-border transfers) of such personal data. The GDPR includes requirements relating to the consent of the individuals to whom the personal data relates, including detailed notices for clinical trial subjects and investigators. The GDPR also includes certain requirements regarding the security of personal data and notification of data processing obligations or security incidents to appropriate data protection authorities or data subjects, as well as requirements for establishing a lawful basis on which personal data can be processed. In addition, the GDPR increases the scrutiny of cross-border transfers of personal data from clinical trial sites located in the EEA to the United States and other jurisdictions that the European Commission does not recognize as having “adequate” data protection laws, and imposes substantial fines for breaches and violations (up to the greater of €20 million or 4% of our consolidated annual worldwide gross revenue). Additionally, following the withdrawal by the UK from the EU and the EEA, companies must comply with both the GDPR and the UK GDPR as incorporated into UK national law, the latter regime having the ability to separately fine up to the greater of £17.5 million or 4 percent of global turnover. Further, recent legal developments in Europe and the UK have created complexity and compliance uncertainty regarding certain transfers of information from the UK and EEA to the United States. For example, on June 16, 2020, the Court of Justice of the EU (the “CJEU”), declared the EU-U.S. Privacy Shield framework (the “Privacy Shield”), to be invalid. As a result, Privacy Shield is no longer a valid mechanism for transferring personal data from the EEA to the United States. Moreover, it is uncertain whether the standard contractual clauses will also be invalidated by the European courts or legislature, which seems possible given the rationale behind the CJEU’s concerns about U.S. law and practice on government surveillance. The UK GDPR and EU GDPR also confer a private right of action on data subjects and consumer associations to lodge complaints with supervisory authorities, seek judicial remedies and obtain compensation for damages resulting from violations of the GDPR.We also may make public statements about our use and disclosure of personal information through our privacy policy and press statements. Although we endeavor to comply with our public statements and documentation, we may at times fail to do so or be alleged to have failed to do so. Despite our efforts, we may not be successful in achieving compliance if our employees or vendors fail to comply with our policies, certifications, and documentation. The publication of our privacy policy and other statements that provide promises and assurances about data privacy and security can subject us to potential government or legal action if they are found to be deceptive, unfair or misrepresentative of our actual practices. Any failure, real or perceived, by us to comply with our posted privacy policies or with any legal or regulatory requirements, standards, certifications or orders or other privacy or consumer protection-related laws and regulations applicable to us could cause our customers to reduce their use of our solutions and services and could materially and adversely affect our business, results of operations, financial condition, cash flows and prospects.Compliance with U.S. and foreign data protection laws and regulations could require us to take on more onerous obligations in our contracts, restrict our ability to collect, transfer, use and disclose data, or in some cases, impact our ability to operate in certain jurisdictions. Failure to comply with U.S. and foreign data protection laws and regulations could result in government enforcement actions (which could include civil, criminal, and administrative penalties), private litigation and/or adverse publicity and could negatively affect our operating results and business. Moreover, clinical trial subjects about whom we or our potential collaborators obtain information, as well as the providers who share this information with us, may contractually limit our ability to use and disclose the information. Claims that we have violated individuals’ privacy rights, failed to comply with data protection laws, or breached our contractual obligations, even if we are not found liable, could be expensive and time consuming to defend and could result in adverse publicity that could harm our business.76\nWe or the third parties upon whom we depend may be adversely affected by natural disasters and our business continuity and disaster recovery plans may not adequately protect us from a serious disaster.Any unplanned event, such as flood, fire, explosion, earthquake, extreme weather condition, public health epidemic, power shortage, telecommunication failure or other natural or manmade accidents or incidents that result in us being unable to fully utilize our facilities, or the manufacturing facilities of our third-party manufacturers, may have a material and adverse effect on our ability to operate our business, particularly on a daily basis, and have significant negative consequences on our financial and operating conditions. Extreme weather conditions or other natural disasters could further disrupt our operations and have a material and adverse effect on our business, financial condition, results of operations and prospects. If a natural disaster, power outage or other event occurred that prevented us from using all or a significant portion of our facilities, that damaged critical infrastructure, such as our research facilities or the manufacturing facilities of our third-party manufacturers, or that otherwise disrupted operations, it may be difficult or, in certain cases, impossible, for us to continue our business for a substantial period of time.Operating as a virtual company, our employees conduct business outside of any leased or owned facilities. These locations may be subject to additional security and other risk factors due to the limited control of our employees. The disaster recovery and business continuity plans we have in place may prove inadequate in the event of a serious disaster or similar event. We may incur substantial expenses as a result of the limited nature of our disaster recovery and business continuity plans, which could have a material adverse effect on our business. As part of our risk management policy, we maintain insurance coverage at levels that we believe are appropriate for our business. However, in the event of an accident or incident at these facilities, we cannot assure you that the amounts of insurance will be sufficient to satisfy any damages and losses. If our facilities, or the manufacturing facilities of our third-party manufacturers, are unable to operate because of an accident or incident or for any other reason, even for a short period of time, any or all of our research and development programs may be harmed. Any business interruption could have a material and adverse effect on our business, financial condition, results of operations and prospects.Changes in tax laws or regulations that are applied adversely to us may have a material adverse effect on our business, cash flow, financial condition or results of operations.New income, sales, use or other tax laws, statutes, rules, regulations or ordinances could be enacted at any time, which could adversely affect our business operations and financial performance. Further, existing tax laws, statutes, rules, regulations or ordinances could be interpreted, changed, modified or applied adversely to us. For example, the TCJA, enacted many significant changes to the U.S. tax laws. Future guidance from the Internal Revenue Service and other tax authorities with respect to the TCJA may affect us, and certain aspects of the TCJA could be repealed or modified in future legislation. For example, the CARES Act modified certain provisions of the TCJA. In addition, it is uncertain if and to what extent various states will conform to the TCJA, the CARES Act, or any other newly enacted federal tax legislation. Changes in corporate tax rates, the realization of net deferred tax assets relating to our operations, the taxation of foreign earnings, and the deductibility of expenses under the TCJA, the CARES Act or future reform legislation could have a material impact on the value of our deferred tax assets, could result in significant one-time charges, and could increase our future U.S. tax expense.Our ability to use our net operating loss carryforwards and certain other tax attributes may be limited.We have incurred substantial losses during our history and do not expect to become profitable in the near future, and we may never achieve profitability. Under the TCJA, as modified by the CARES Act, unused U.S. federal net operating losses generated in tax years beginning after December 31, 2017, will not expire and may be carried forward indefinitely but the deductibility of such federal net operating losses may be limited to 80% of current year taxable income. It is uncertain if and to what extent various states will conform to the TCJA or the CARES Act. In addition, both our current and our future unused losses and other tax attributes may be subject to limitation under Sections 382 and 383 of the U.S. Internal Revenue Code of 1986, as amended (the “Code”), if we undergo, or have undergone, an “ownership change,” generally defined as a greater than 50 percentage point change (by value) in our equity ownership by certain stockholders over a three-year period. We have not completed a Section 382 study to assess whether an ownership change has occurred or whether there have been multiple ownership changes since our formation due to the complexity and cost associated with such a study and the fact that there may be additional ownership changes in the future. As a result, if we undergo an ownership change 77\n(or if we previously underwent such an ownership change), our ability to use all of our pre-change net operating loss carryforwards and other pre-change tax attributes (such as research tax credits) to offset our post-change income or taxes may be limited. Similar provisions of state tax law may also apply to limit our use of accumulated state tax attributes. In addition, at the state level, there may be periods during which the use of net operating losses is suspended or otherwise limited, which could accelerate or permanently increase state taxes owed. As a result, even if we attain profitability, we may be unable to use all or a material portion of our net operating losses and other tax attributes, which could adversely affect our future cash flows.Risks related to intellectual propertyIf we or our licensors are unable to obtain and maintain sufficient patent protection for our product candidates, or if the scope of the patent protection is not sufficiently broad, third parties, including our competitors, could develop and commercialize products similar or identical to ours, and our ability to commercialize our product candidates may be adversely affected.Our success depends in large part on our ability and our licensors’ ability to protect our proprietary technologies that we believe are important to our business, including pursuing, obtaining and maintaining patent protection in the United States and other countries intended to cover the compositions of matter of our product candidates, their methods of use, related technologies and other inventions that are important to our business. In addition to patent protection, we also rely on trade secrets to protect aspects of our business that are not amenable to, or that we do not consider appropriate for, patent protection. If we do not adequately pursue, obtain, maintain, protect or enforce our intellectual property, third parties, including our competitors, may be able to erode or negate any competitive advantage we may have, which could harm our business and ability to achieve profitability.The patent application and approval process is expensive, time-consuming and complex. We may not be able to file, prosecute and maintain all necessary or desirable patent applications at a reasonable cost or in a timely manner or in all jurisdictions. We also cannot predict whether the patent applications we are currently pursuing will issue as patents in any particular jurisdictions. It is also possible that we will fail to identify patentable aspects of our product candidates before it is too late to obtain patent protection. Moreover, depending on the terms of any license agreements to which we may become a party, we may not have the right to control the preparation, filing, and prosecution of patent applications, or to maintain the patents, covering technology licensed from third parties. Therefore, these patents and patent applications may not be prosecuted and enforced in a manner consistent with the best interests of our business. For example, CSPC has the sole right to control the preparation, filing, prosecution and maintenance of all patents and patent applications within the licensed patents and any jointly owned foreground intellectual property under the CSPC License Agreement.Furthermore, the patent position of biotechnology and pharmaceutical companies generally is highly uncertain. No consistent policy regarding the breadth of claims allowed in biotechnology and pharmaceutical patents has emerged to date in the United States or in many foreign jurisdictions. The standards applied by the United States Patent and Trademark Office (the “USPTO”), and foreign patent offices in granting patents are not always applied uniformly or predictably. In addition, the determination of patent rights with respect to biological and pharmaceutical products commonly involves complex legal and factual questions, which have in recent years been the subject of much litigation. As a result, the issuance, scope, validity, enforceability and commercial value of our patent rights are highly uncertain. Thus, we cannot offer any assurances about which, if any, patents will be issued, the breadth of any such patents, whether any issued patents will be found invalid and unenforceable or will be threatened by third parties or whether any issued patents will effectively prevent others from commercializing competing technologies and product candidates. While we have filed patent applications covering aspects of seribantumab, we currently have only one U.S. application, as well as a corresponding Patent Cooperation Treaty (“PCT”) application, specifically covering the use of seribantumab to treat patients with tumors harboring an NRG1 fusion according to our CRESTONE clinical dosing regimen. Any patents issuing from these published applications would expire in 2042, subject to any disclaimers or extensions.Our pending patent applications cannot be enforced against third parties practicing the technology claimed in such applications unless and until at least one patent issues from such applications. Assuming the other requirements for patentability are met, currently, the first to file a patent application is generally entitled to the patent. However, prior to March 16, 2013, in the United States, the first to invent was entitled to the patent. Publications of discoveries in the 78\nscientific literature often lag behind the actual discoveries, and patent applications in the United States and other jurisdictions are typically not published until 18 months after filing, or in some cases not at all. Since patent applications in the United States and most other countries are confidential for a period of time after filing, and some remain so until issued, we cannot be certain that we were the first to file or invent (prior to March 16, 2013) any patent application related to our product candidates. In addition, we enter into non-disclosure and confidentiality agreements with parties who have access to confidential or patentable aspects of our research and development output, such as our employees, collaborators, CROs, CMOs, hospitals, independent treatment centers, consultants, independent contractors, suppliers, advisors and other third parties; however, any of these parties may breach the agreements and disclose such output before a patent application is filed, thereby jeopardizing our ability to seek patent protection. Furthermore, if third parties have filed patent applications related to our product candidates or technology, we may not be able to obtain our own patent rights to those product candidates or technology.Moreover, because the issuance of a patent is not conclusive as to its inventorship, scope, validity or enforceability, our patents or pending patent applications may be challenged in the courts or patent offices in the United States and abroad. For example, we may be subject to a third-party pre-issuance submission of prior art to the USPTO or become involved in post-grant review procedures, oppositions, derivations, revocation, reexaminations, inter partes review or interference proceedings, in the United States or elsewhere, challenging our patent rights or the patent rights of others. An adverse determination in any such submission, proceeding or litigation could reduce the scope of, or invalidate, our patent rights, allow third parties to commercialize our technology or products and compete directly with us, without payment to us, or result in our inability to manufacture or commercialize products without infringing third-party rights. Moreover, we may have to participate in interference proceedings declared by the USPTO to determine priority of invention or in post-grant challenge proceedings, such as oppositions in a foreign patent office, that challenge priority of invention or other features of patentability. Such challenges may result in loss of exclusivity or in our patent claims being narrowed, invalidated or held unenforceable, in whole or in part, which could limit our ability to stop others from using or commercializing similar or identical technology and products or limit the duration of the patent protection of our technology and products. Such challenges also may result in substantial cost and require significant time from our scientists and management, even if the eventual outcome is favorable to us. Any of the foregoing could have a material adverse effect on our business, financial condition, results of operations, and prospects.In addition, given the amount of time required for the development, testing and regulatory review of new product candidates, our patents protecting such product candidates might expire before or shortly after such product candidates are commercialized. As a result, our intellectual property may not provide us with sufficient rights to exclude others from commercializing products similar or identical to ours. Moreover, some of our patents and patent applications may in the future be co-owned with third parties. If we are unable to obtain an exclusive license to any such third-party co-owners’ interest in such patents or patent applications, such co-owners may be able to license their rights to other third parties, including our competitors, and our competitors could market competing products and technology. In addition, we may need the cooperation of any such co-owners of our patents in order to enforce such patents against third parties, and such cooperation may not be provided to us. Any of the foregoing could have a material adverse effect on our competitive position, business, financial conditions, results of operations, and prospects.Our pending and future patent applications may not result in patents being issued that protect our product candidates, in whole or in part, or which effectively prevent others from commercializing competitive products. Changes in either the patent laws or interpretation of the patent laws in the United States and other countries may diminish the value of our patents or narrow the scope of our patent protection. In addition, the laws of other countries may not protect our rights to the same extent or in the same manner as the laws of the United States. For example, European patent law restricts the patentability of methods of treatment of the human body more than United States law does.Even if our patent applications issue as patents, they may not issue in a form that will provide us with any meaningful protection, prevent competitors or other third parties from competing with us or otherwise provide us with any competitive advantage. Moreover, the coverage claimed in a patent application can be significantly reduced before the patent is issued and its scope can be reinterpreted after issuance. Consequently, we do not know whether our product candidates will be protectable or remain protected by valid and enforceable patents. Our competitors and other third parties may be able to circumvent our patents by developing similar or alternative technologies or products in a non-infringing manner. Our competitors and other third parties may also seek approval to market their own products similar to or otherwise competitive 79\nwith our products. Alternatively, our competitors or other third parties may seek to market generic versions or “follow-on” versions of any approved products by submitting NDAs or abbreviated NDAs under Section 505(b)(2) of the FDC Act, respectively, to the FDA during which they may claim that patents owned by us are invalid, unenforceable or not infringed. In these circumstances, we may need to defend or assert our patents, or both, including by filing lawsuits alleging patent infringement. In any of these types of proceedings, a court or other agency with jurisdiction may find our patents invalid or unenforceable, or that our competitors are competing in a non-infringing manner. Thus, even if we have valid and enforceable patents, these patents still may not provide protection against competing products or processes sufficient to achieve our business objectives. Any of the foregoing could have a material adverse effect on our competitive position, business, financial conditions, results of operations, and prospects.Furthermore, future patents may be subject to a reservation of rights by one or more third parties. For example, to the extent the research resulting in future patent rights or technologies is funded in the future in part by the U.S. government, the government could have certain rights in any resulting patents and technology, including a non-exclusive license authorizing the government to use the invention or to have others use the invention on its behalf for non-commercial purposes. If the U.S. government then decides to exercise these rights, it is not required to engage us as its contractor in connection with doing so. These rights may also permit the government to disclose our confidential information to third parties and to exercise march-in rights to use or allow third parties to use our licensed technology. The government may also exercise its march-in rights if it determines that action is necessary because we failed to achieve practical application of the government-funded technology, because action is necessary to alleviate health or safety needs, to meet requirements of federal regulations, or to give preference to U.S. industry. In addition, our rights in such government-funded inventions may be subject to certain requirements to manufacture products embodying such inventions in the United States. Any exercise by the government of aforementioned proprietary rights could harm our competitive position, business, financial condition, results of operations, and prospects.Changes to patent laws in the United States and other jurisdictions could diminish the value of patents in general, thereby impairing our ability to protect our products.As is the case with other biopharmaceutical companies, our success is heavily dependent on intellectual property, particularly patents. Obtaining and enforcing patents in the biotechnology and pharmaceutical industries involves both technological and legal complexity and is therefore costly, time consuming and inherently uncertain. Changes in either the patent laws or interpretation of the patent laws in the United States could increase the uncertainties and costs surrounding the prosecution of patent applications and the enforcement or defense of issued patents. Patent reform legislation in the United States and other countries, including the Leahy-Smith America Invents Act (the “Leahy-Smith Act”), signed into law in September 2011, could increase those uncertainties and costs. The Leahy-Smith Act includes a number of significant changes to U.S. patent law. These include provisions that affect the way patent applications are prosecuted, redefine prior art and provide more efficient and cost-effective avenues for competitors to challenge the validity of patents. For example, the Leahy-Smith Act allows third-party submission of prior art to the USPTO during patent prosecution and additional procedures to attack the validity of a patent by USPTO administered post-grant proceedings, including post-grant review, inter partes review, and derivation proceedings. In addition, the Leahy-Smith Act has transformed the U.S. patent system from a “first-to-invent” system to a “first-to-file” system in which, assuming that other requirements for patentability are met, the first inventor to file a patent application will be entitled to the patent on an invention regardless of whether a third party was the first to invent the claimed invention. The first-to-file provisions became effective on March 16, 2013. It is not yet clear what, if any, impact the Leahy-Smith Act will have on the operation of our business. However, the Leahy-Smith Act and its implementation could make it more difficult to obtain patent protection for our inventions and increase the uncertainties and costs surrounding the prosecution of our or our potential collaboration partners’ patent applications and the enforcement or defense of our or our future collaboration partners’ issued patents, all of which could harm our business, results of operations, financial condition and prospects.In addition, the patent positions of companies in the development and commercialization of biologics are particularly uncertain. The U.S. Supreme Court has ruled on several patent cases in recent years, either narrowing the scope of patent protection available in certain circumstances or weakening the rights of patent owners in certain situations. This combination of events has created uncertainty with respect to the validity and enforceability of patents, once obtained. Additionally, there have been recent proposals for additional changes to the patent laws of the United States and other countries that, if adopted, could impact our ability to enforce our proprietary technology. Depending on future actions by 80\nthe U.S. Congress, the U.S. courts, the USPTO and the relevant law-making bodies in other countries, the laws and regulations governing patents could change in unpredictable ways that could have a material adverse effect on our existing patent portfolio and weaken our ability to obtain new patents or to enforce our existing patents and patents that we might obtain in the future.We may become involved in lawsuits or administrative disputes to protect or enforce our patents or other intellectual property, which could be expensive, time consuming and unsuccessful.Competitors and other third parties may infringe, misappropriate or otherwise violate our patents, trademarks, copyrights, trade secrets or other intellectual property. To counter infringement, misappropriation or other violations, we may be required to file infringement, misappropriation or other violation claims, which can be expensive and time consuming and divert the time and attention of our management and business and scientific personnel. In addition, many of our adversaries in these proceedings may have the ability to dedicate substantially greater resources to prosecuting these legal actions than we can.Any claims we assert against perceived infringers could provoke these parties to assert counterclaims against us alleging that we infringe, misappropriate or otherwise violate their patents or their other intellectual property, in addition to counterclaims asserting that our patents are invalid or unenforceable, or both. In patent litigation in the United States, counterclaims challenging the validity, enforceability or scope of asserted patents are commonplace. Similarly, third parties may initiate legal proceedings against us seeking a declaration that certain of our intellectual property is non-infringed, invalid or unenforceable. The outcome of any such proceeding is generally unpredictable.In any patent infringement proceeding, there is a risk that a court will decide that a patent of ours is invalid or unenforceable, in whole or in part, and that we do not have the right to stop the other party from using the invention at issue. There is also a risk that, even if the validity of such patents is upheld, the court will construe the patent’s claims narrowly or decide that we do not have the right to stop the other party from using the invention at issue on the grounds that our patent claims do not cover the invention. An adverse outcome in a litigation or proceeding involving our patents could limit our ability to assert our patents against those parties or other competitors, and may curtail or preclude our ability to exclude third parties from making and selling similar or competitive products. If a defendant were to prevail on a legal assertion of invalidity or unenforceability of our patents covering one of our product candidates, we could lose at least a part, and perhaps all, of the patent protection covering such a product candidate. Competing drugs may also be sold in other countries in which our patent coverage might not exist or be as strong. If we lose a foreign patent lawsuit, alleging our infringement of a competitor’s patents, we could be prevented from marketing our product candidates in one or more foreign countries. Any of these occurrences could adversely affect our competitive business position, business prospects and financial condition. Similarly, if we assert trademark infringement claims, a court may determine that the marks we have asserted are invalid or unenforceable, or that the party against whom we have asserted trademark infringement has superior rights to the marks in question. In this case, we could ultimately be forced to cease use of such trademarks.Even if we establish infringement, the court may decide not to grant an injunction against further infringing activity and instead award only monetary damages, which may or may not be an adequate remedy. Furthermore, because of the substantial amount of discovery required in connection with intellectual property litigation, there is a risk that some of our confidential information could be compromised by disclosure during litigation. There could also be public announcements of the results of hearings, motions or other interim proceedings or developments. If securities analysts or investors perceive these results to be negative, it could have a material adverse effect on the price of shares of our common stock. Moreover, there can be no assurance that we will have sufficient financial or other resources to file and pursue such infringement claims, which typically last for years before they are concluded. Even if we ultimately prevail in such claims, the monetary cost of such litigation and the diversion of the attention of our management and scientific personnel could outweigh any benefit we receive as a result of the proceedings.Furthermore, third parties may also raise invalidity or unenforceability claims before administrative bodies in the United States or foreign authorities, even outside the context of litigation. Such mechanisms include re-examination, inter partes review, post-grant review, interference proceedings, derivation proceedings and equivalent proceedings in foreign jurisdictions (e.g., opposition proceedings). Such proceedings could result in revocation, cancellation or amendment to our patents in such a way that they no longer cover and protect our product candidates. The outcome following legal assertions 81\nof invalidity and unenforceability is unpredictable. Grounds for a validity challenge could be an alleged failure to meet any of several statutory requirements, including lack of novelty, obviousness, non-enablement or written description. Grounds for an unenforceability assertion could be an allegation that someone connected with the prosecution of the patent withheld relevant information from the USPTO, or made a misleading statement, during prosecution of the patent. With respect to the validity of our patents, for example, we cannot be certain that there is no invalidating prior art of which we, our licensors, our patent counsel and the patent examiner were unaware during prosecution. Moreover, it is possible that prior art may exist that we are aware of but do not believe is relevant to our current or future patents, but that could nevertheless be determined to render our patents invalid. If a third party were to prevail on a legal assertion of invalidity or unenforceability, we could lose at least part, and perhaps all, of the patent protection on our product candidates. Any such loss of patent protection could have a material adverse impact on our business, financial condition, results of operations and prospects.We and our licensors may not be able to effectively protect or enforce our intellectual property and proprietary rights throughout the world.Filing, prosecuting and defending patents with respect to our product candidates in all countries throughout the world would be prohibitively expensive, and the laws of other countries may not protect our rights to the same extent as the laws of the United States. The requirements for patentability may differ in certain countries, particularly in developing countries. In addition, any future intellectual property license agreements may not always include worldwide rights. Consequently, competitors and other third parties may use our technologies in jurisdictions where we have not obtained patent protection to develop their own products and, further, may export otherwise infringing products to territories where we may obtain patent protection, but where patent enforcement is not as strong as that in the United States and where our ability to enforce our patents to stop infringing activities may be inadequate. These products may compete with our products in such territories and in jurisdictions where we do not have any patent rights or where any future patent claims or other intellectual property or proprietary rights may not be effective or sufficient to prevent them from competing with us, which could have a material adverse effect on our business, financial condition, results of operations and prospects.Moreover, our ability to protect and enforce our intellectual property and proprietary rights may be adversely affected by unforeseen changes in foreign intellectual property laws. Additionally, the laws of some countries outside of the United States and Europe do not afford intellectual property protection to the same extent as the laws of the United States and Europe. Many companies have encountered significant problems in protecting and defending intellectual property and proprietary rights in certain jurisdictions. The legal systems of some countries, including, for example, India, China and other developing countries, do not view favorably the enforcement of patents and other intellectual property or proprietary rights, particularly those relating to biotechnology products, which could make it difficult for us to stop the infringement, misappropriation or other violation of our patents or other intellectual property or proprietary rights. For example, many countries have compulsory licensing laws under which a patent owner must grant licenses to third parties. Consequently, we may not be able to prevent third parties from practicing our inventions in certain countries outside the United States and Europe. In addition, many countries limit the enforceability of patents against government agencies or government contractors. In these countries, the patent owner may have limited remedies, which could materially diminish the value of such patent. If we are forced to grant a license to third parties with respect to any patents relevant to our business, our competitive position may be impaired, and our business, financial condition, results of operations, and prospects may be adversely affected. Proceedings to enforce our intellectual property and proprietary rights in foreign jurisdictions, whether or not successful, could result in substantial costs and divert our efforts and resources from other aspects of our business, could put our patents, trademarks or other intellectual property and proprietary rights at risk of being invalidated or interpreted narrowly, could put our patent applications at risk of not issuing, and could provoke third parties to assert claims against us. We may not prevail in any lawsuits that we initiate, and the damages or other remedies awarded, if any, may not be commercially meaningful. Furthermore, while we intend to protect our intellectual property and proprietary rights in major markets for our products, we cannot ensure that we will be able to initiate or maintain similar efforts in all jurisdictions in which we may wish to market our products. Accordingly, our efforts to protect our intellectual property and proprietary rights in such countries may be inadequate.82\nIf we are sued for infringing, misappropriating or otherwise violating intellectual property or proprietary rights of third parties, such litigation or disputes could be costly and time consuming and could prevent or delay us from developing or commercializing our product candidates.Our commercial success depends, in part, on our ability to develop, manufacture, market and sell our product candidates and use our proprietary technologies without infringing, misappropriating or otherwise violating the intellectual property and other proprietary rights of third parties. If any third-party patents, patent applications or other proprietary rights are found to cover our product candidates or any related companion or complementary diagnostics or their compositions, methods of use or manufacturing, we may be required to pay damages, which could be substantial, and we would not be free to manufacture or market our product candidates or to do so without obtaining a license, which may not be available on commercially reasonable terms, or at all.We may in the future become party to, or threatened with, adversarial proceedings or litigation regarding intellectual property or proprietary rights with respect to our product candidates and technologies we use in our business. Our competitors or other third parties may assert infringement claims against us, alleging that our product candidates are covered by their patents. We cannot be certain that we do not infringe existing patents or that we will not infringe patents that may be granted in the future. Furthermore, because patent applications can take many years to issue and may be confidential for 18 months or more after filing, and because patent claims can be revised before issuance, there may be applications now pending which may later result in issued patents that may be infringed by the manufacture, use or sale of our product candidates. If a patent holder believes our product candidate infringes its patent rights, the patent holder may sue us even if we have received patent protection for our technology. Moreover, we may face patent infringement claims from non-practicing entities that have no relevant drug revenue and against whom our own patent portfolio may thus have no deterrent effect.There is a substantial amount of intellectual property litigation in the biotechnology and biological product industries, and we may become party to, or threatened with, litigation or other adversarial proceedings regarding intellectual property or proprietary rights with respect to our product candidates, including interference proceedings before the USPTO. Third parties may assert infringement, misappropriation or other claims against us based on existing or future intellectual property or proprietary rights. The outcome of intellectual property litigation and other disputes is subject to uncertainties that cannot be adequately quantified in advance. The biological product and biotechnology industries have produced a significant number of patents, and it may not always be clear to industry participants, including us, which patents cover various types of products or methods of using or manufacturing products. The coverage of patents is subject to interpretation by the courts, and the interpretation is not always uniform. If we were sued for patent infringement, we would need to demonstrate that our product candidates, products or methods of use, manufacturing or other applicable activities either do not infringe the patent claims of the relevant patent or that the patent claims are invalid or unenforceable, and we may not be successful in doing so. However, proving invalidity or unenforceability is difficult. For example, in the United States, proving invalidity requires a showing of clear and convincing evidence to overcome the presumption of validity enjoyed by issued patents. Even if we believe third-party intellectual property claims are without merit, there is no assurance that a court would find in our favor on questions of infringement, validity, or enforceability. Even if we are successful in these proceedings, we may incur substantial costs and the time and attention of our management and business and scientific personnel could be diverted in pursuing these proceedings, which could significantly harm our business and operating results. In addition, we may not have sufficient resources to bring these actions to a successful conclusion.If we are found to infringe, misappropriate or otherwise violate a third party’s intellectual property or proprietary rights and we are unsuccessful in demonstrating that such intellectual property or proprietary rights are invalid or unenforceable, we could be forced, including by court order, to cease developing, manufacturing or commercializing the infringing product candidate or product. Alternatively, we may be required to obtain a license from such third party in order to use the infringing technology and continue developing, manufacturing or marketing the infringing product candidate. However, we may not be able to obtain any required license on commercially reasonable terms or at all. Even if we were able to obtain such a license, it could be granted on non- exclusive terms, thereby giving our competitors and other third parties access to the same technologies licensed to us. In addition, we could be found liable for significant monetary damages, including treble damages and attorneys’ fees if we are found to have willfully infringed such third-party patent rights. A finding of infringement could prevent us from commercializing our product candidates or force us to cease some of our business operations, which could materially harm our business. Claims that we have misappropriated the 83\nconfidential information or trade secrets of third parties could have a similar negative impact on our business, financial condition, results of operations and prospects.We may be subject to claims by third parties asserting that our employees or consultants or we have misappropriated their intellectual property, or claiming ownership of what we regard as our own intellectual property.Some of our employees and consultants are currently or have been previously employed at universities or at other biotechnology or biologics companies, including our competitors or potential competitors. These employees and consultants may have executed proprietary rights, non-disclosure and non-competition agreements, or similar agreements, in connection with such other current or previous employment. Although we try to ensure that our employees and consultants do not use the proprietary information or know-how of others in their work for us, we may be subject to claims that we or these individuals have used or disclosed intellectual property, including trade secrets or other proprietary information, of third parties. Litigation may be necessary to defend against such claims. If we fail in defending any such claims, in addition to paying monetary damages, we may lose valuable intellectual property or personnel or sustain damages. Such intellectual property could be awarded to a third party, and we could be required to obtain a license from such third party to commercialize our technology or products. Such a license may not be available on commercially reasonable terms or at all. Even if we are successful in defending against such claims, litigation could result in substantial costs and be a distraction to our management. Any of the foregoing would have a material adverse effect on our business, financial condition, results of operations and prospects.In addition, while it is our policy to require our employees, consultants and contractors who may be involved in the conception or development of intellectual property to execute agreements assigning such intellectual property to us, we may be unsuccessful in executing such an agreement with each party who, in fact, conceives or develops intellectual property that we regard as our own, which may result in claims by or against us related to the ownership of such intellectual property. In addition, such agreements may not be self-executing such that the intellectual property subject to such agreements may not be assigned to us without additional assignments being executed, and we may fail to obtain such assignments. In addition, such agreements may be breached. In addition, we have entered into in the past, and may enter into in the future, sponsored research agreements relating to our product candidates with various academic institutions. Some of these academic institutions may not have intellectual property assignments or similar agreements with their employees and consultants, which may result in claims by or against us related to ownership of any intellectual property. Accordingly, we may be forced to bring claims against third parties, or defend claims that they may bring against us to determine the ownership of what we regard as our intellectual property. If we fail in prosecuting or defending any such claims, in addition to paying monetary damages, we may lose valuable intellectual property. Even if we are successful in prosecuting or defending against such claims, litigation could result in substantial costs and be a distraction to our senior management and scientific personnel, which would have a material adverse effect on our business, financial condition, results of operations and prospects.Rights to improvements to our product candidates may be held by third parties, which could require us to obtain a license to such rights. Such a license may not be available on commercially reasonable terms, if at all.We have entered into agreements with third parties to conduct clinical testing of our product candidates, which provide that improvements to our product candidates may be owned solely by a party or jointly between the parties. If we determine that rights to such improvements owned solely by a third party are necessary to commercialize our product candidates or maintain our competitive advantage, we may need to obtain a license from such third party in order to use the improvements and continue developing, manufacturing or marketing the product candidates. However, we may not be able to obtain any required license on commercially reasonable terms or at all. Even if we were able to obtain such a license, it could be granted on non-exclusive terms, thereby giving our competitors and other third parties access to the same technologies licensed to us. Failure to obtain a license on commercially reasonable terms or at all, or to obtain an exclusive license, could prevent us from commercializing our product candidates or force us to cease some of our business operations, which could materially harm our business. If we determine that rights to improvements jointly owned between us and a third party are necessary to commercialize our product candidates or maintain our competitive advantage, we may need to obtain an exclusive license from such third party. If we are unable to obtain an exclusive license to any such third-party co-owners’ interest in such improvements, such co-owners may be able to license their rights to other third parties, including our competitors, and our competitors could market competing products and technology. In addition, we may 84\nneed the cooperation of any such co-owners of our intellectual property in order to enforce such intellectual property against third parties, and such cooperation may not be provided to us. Any of the foregoing could have a material adverse effect on our competitive position, business, financial conditions, results of operations, and prospects.We may be subject to claims challenging the inventorship of our patents and other intellectual property.We or any of our licensors may be subject to claims that former employees, collaborators or other third parties have an interest in our owned or in-licensed patents, trade secrets, or other intellectual property as an inventor or co-inventor. For example, we or any of our licensors may have inventorship disputes arise from conflicting obligations of employees, consultants or others who are involved in developing our product candidates. Litigation may be necessary to defend against these and other claims challenging inventorship or our or any of our licensors’ ownership of our owned or in-licensed patents, trade secrets or other intellectual property. If we or any of our licensors fail in defending any such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights, such as exclusive ownership of, or right to use, intellectual property that is important to our product candidates. Even if we are successful in defending against such claims, litigation could result in substantial costs and be a distraction to management and other employees. Any of the foregoing could have a material adverse effect on our business, financial condition, results of operations and prospects.The term of our patents may be inadequate to protect our competitive position on our products.Given the amount of time required for the development, testing and regulatory review of new product candidates, patents protecting such candidates might expire before or shortly after such candidates are commercialized. For example, our wholly owned patent portfolio includes a patent family with claims directed to antibodies and related compositions covering seribantumab, as well as methods of treating cancer using such antibodies and compositions. The family contains three U.S. patents directed to seribantumab which expire in February 2028 and a fourth U.S. patent which expires in October 2029 (including 614 days of Patent Term Adjustment), subject to any disclaimers or extensions. The family also contains a pending U.S. application, which if issued, would expire in February 2028, subject to any disclaimers or extensions. In addition, the above-discussed patent family includes granted patents in China, Europe, Hong Kong, Israel, and Japan with claims directed to compositions of matter covering seribantumab and related methods of therapy. These patents expire in February 2028, subject to any disclaimers or extensions. Depending upon the timing, duration and other factors relating to any FDA marketing approval we receive for seribantumab, one or more of our U.S. patents may be eligible for limited patent term extension under the Drug Price Competition and Patent Term Restoration Action of 1984 (the “Hatch-Waxman Amendments”). We expect to seek extensions of patent terms in the United States and, if available, in other countries where we are prosecuting patents. In the United States, the Hatch-Waxman Amendments permit a patent term extension of up to five years beyond the normal expiration of the patent, limited to the approved indication (or any additional indications approved during the period of extension), as compensation for patent term lost to the regulatory review process during which the sponsor was unable to commercially market its new product. A patent term extension cannot extend the remaining term of a patent beyond a total of 14 years from the date of product approval, only one patent applicable to an approved drug is eligible for the extension and only those claims covering the approved drug, a method for using it, or a method for manufacturing it may be extended, and the application for the extension must be submitted prior to the expiration of the patent. However, the applicable authorities, including the FDA and the USPTO in the United States, and any equivalent regulatory authority in other countries, may not agree with our assessment of whether such extensions are available for our patents, may refuse to grant extensions to our patents, or may grant more limited extensions than we request. We may not be granted an extension because of, for example, failing to exercise due diligence during the testing phase or regulatory review process, failing to apply within applicable deadlines, failing to apply prior to expiration of relevant patents, or otherwise failing to satisfy applicable requirements. If we are unable to obtain patent term extension or the term of any such extension is less than we request, our competitors and other third parties may be able to obtain approval of competing products following our patent expiration and take advantage of our investment in development and clinical trials by referencing our clinical and preclinical data and launch their product earlier than might otherwise be the case. Any of the foregoing would have a material adverse effect on our business, financial condition, results of operations and prospects.85\n| ● | others may be able to make products similar to any product candidates we may develop or utilize similarly related technologies that are not covered by the claims of the patents that we may license or may own in the future; |\n| ● | we, or any licensors or collaborators, might not have been the first to make the inventions covered by the issued patent or pending patent application that we license or may own in the future; |\n| ● | we, or any licensors or collaborators, might not have been the first to file patent applications covering certain of our or their inventions; |\n\n| ● | others may independently develop similar or alternative technologies or duplicate any of our technologies without infringing, misappropriating or otherwise violating any of our owned or licensed intellectual property rights; |\n| ● | it is possible that our pending patent applications or those that we may own in the future will not lead to issued patents; |\n| ● | issued patents that we hold rights to may be held invalid or unenforceable, including as a result of legal challenges by our competitors or other third parties; |\n| ● | our competitors or other third parties might conduct research and development activities in countries where we do not have patent rights and then use the information learned from such activities to develop competitive products for sale in our major commercial markets; |\n| ● | we may not develop additional proprietary technologies that are patentable; |\n| ● | the patents of others may harm our business; and |\n| ● | we may choose not to file a patent in order to maintain certain trade secrets or know how, and a third party may subsequently file a patent covering such intellectual property. |\n| ● | enrollment or results of clinical trials of EO-3021 or our other product candidates, or those of our competitors or our future collaborators, or changes in the development status of our product candidates; |\n| ● | regulatory or legal developments in the United States and other countries, especially changes in laws or regulations applicable to EO-3021 or our other product candidates; |\n| ● | the success of competitive products or technologies; |\n| ● | introductions and announcements of new products by us, our future commercialization partners, or our competitors, and the timing of these introductions or announcements; |\n| ● | actions taken by regulatory agencies with respect to our products, clinical studies, manufacturing process or sales and marketing terms; |\n| ● | actual or anticipated variations in our financial results or those of companies that are perceived to be similar to us; |\n| ● | the success of our efforts to acquire or in-license additional technologies, products or product candidates; |\n\n| ● | developments concerning any future collaborations, including but not limited to those with development and commercialization partners; |\n| ● | market conditions in the biologics and biotechnology sectors; |\n| ● | announcements by us or our competitors of significant acquisitions, strategic collaborations, joint ventures or capital commitments; |\n| ● | developments or disputes concerning patents or other proprietary rights, including patents, litigation matters and our ability to obtain patent protection for our product candidates; |\n| ● | our ability or inability to raise additional capital and the terms on which we raise it; |\n| ● | the recruitment or departure of key personnel; |\n| ● | changes in the structure of healthcare payment systems; |\n| ● | actual or anticipated changes in earnings estimates or changes in stock market analyst recommendations regarding our common stock, other comparable companies or our industry generally; |\n| ● | our failure or the failure of our competitors to meet analysts’ projections or guidance that we or our competitors may give to the market; |\n| ● | fluctuations in the valuation of companies perceived by investors to be comparable to us; |\n| ● | announcement and expectation of additional financing efforts; |\n| ● | speculation in the press or investment community; |\n| ● | share price and fluctuations of trading volume of our common stock; |\n| ● | sales of our common stock by us, insiders or our stockholders; |\n| ● | the concentrated ownership of our common stock; |\n| ● | changes in accounting principles; |\n| ● | terrorist acts, acts of war or periods of widespread civil unrest; |\n| ● | natural disasters and other calamities; and |\n| ● | general economic, market and geopolitical conditions, including rising interest rates, market volatility and inflation, and the impact of geopolitical tensions with China and the war in Ukraine. |\n\nIn the past, securities class action litigation has often been brought against public companies following declines in the market price of their securities. This risk is especially relevant for biopharmaceutical companies, which have experienced significant stock price volatility in recent years. If we face such litigation, it could result in substantial costs and a diversion of management’s attention and our resources, which could harm our business.A sale of a substantial number of shares of our common stock may cause the price of our common stock to decline.Sales of a substantial number of shares of our common stock in the public market could occur at any time. If our stockholders sell, or the market perceives that our stockholders intend to sell, substantial amounts of our common stock in the public market, the market price of our common stock could decline significantly. The holders of a significant portion of our outstanding common stock have rights, subject to some conditions, to require us to file registration statements covering their shares or to include their shares in registration statements that we may file for ourselves or our stockholders.We cannot predict what effect, if any, sales of our shares in the public market or the availability of shares for sale will have on the market price of our common stock. However, future sales of substantial amounts of our common stock in the public market, including shares issued upon exercise of our outstanding options, or the perception that such sales may occur, could adversely affect the market price of our common stock, even if our business is doing well.We also expect that significant additional capital may be needed in the future to continue our planned operations. To raise capital, we may sell common stock, convertible securities or other equity securities in one or more transactions at prices and in a manner we determine from time to time. To the extent that additional capital is raised through the sale and issuance of shares or other securities convertible into shares, our stockholders will be diluted. These sales, or the perception in the market that the holders of a large number of shares intend to sell shares, could reduce the market price of our common stock.Our principal stockholders and management own a significant percentage of our stock and will be able to exert significant control over matters subject to stockholder approval.Based on the beneficial ownership of our common stock as of December 31, 2022, our executive officers, directors, holders of 5% or more of our capital stock and their respective affiliates beneficially hold the majority of our outstanding voting stock. As a result, these stockholders, if acting together, have significant control over the outcome of corporate actions requiring stockholder approval, including the election of directors, amendment of our organizational documents, any merger, consolidation or sale of all or substantially all of our assets and any other significant corporate transaction. The interests of these stockholders may not be the same as or may even conflict with your interests. For example, these stockholders could delay or prevent a change of control of our company, even if such a change of control would benefit our other stockholders, which could deprive our stockholders of an opportunity to receive a premium for their common stock as part of a sale of our company or our assets and might affect the prevailing market price of our common stock.We are an “emerging growth company” and a “smaller reporting company” and we cannot be certain if the reduced reporting requirements applicable to “emerging growth companies” or “smaller reporting companies” will make our common stock less attractive to investors.We are an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. For as long as we continue to be an “emerging growth company,” we may take advantage of exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies, including (i) not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002, as amended, or the Sarbanes-Oxley Act, (ii) reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements and (iii) exemptions from the requirements of holding nonbinding advisory stockholder votes on executive compensation and stockholder approval of any golden parachute payments not approved previously. In addition, as an “emerging growth company,” we are only required to provide two years of audited financial statements.We could be an “emerging growth company” until December 31, 2026, although circumstances could cause us to lose that status earlier, including if we are deemed to be a “large accelerated filer,” which occurs when the market value of our 89\n| ● | establish a classified board of directors so that not all members of our board are elected at one time; |\n| ● | permit only the board of directors to establish the number of directors and fill vacancies on the board; |\n| ● | provide that directors may only be removed “for cause” and only with the approval of two-thirds of our stockholders; |\n| ● | require super-majority voting to amend some provisions in our restated certificate of incorporation and amended and restated bylaws; |\n| ● | authorize the issuance of “blank check” preferred stock that our board could use to implement a stockholder rights plan; |\n| ● | eliminate the ability of our stockholders to call special meetings of stockholders; |\n| ● | prohibit stockholder action by written consent, which requires all stockholder actions to be taken at a meeting of our stockholders; |\n| ● | prohibit cumulative voting; and |\n| ● | establish advance notice requirements for nominations for election to our board or for proposing matters that can be acted upon by stockholders at annual stockholder meetings. |\n\nIn addition, Section 203 of the Delaware General Corporation Law (the “DGCL”), may discourage, delay or prevent a change in control of our company. Section 203 imposes certain restrictions on mergers, business combinations and other transactions between us and holders of 15% or more of our common stock.Any provision of our restated certificate of incorporation, amended and restated bylaws or Delaware law that has the effect of delaying or preventing a change in control could limit the opportunity for our stockholders to receive a premium for their shares of our capital stock and could also affect the price that some investors are willing to pay for our common stock.The exclusive forum provision in our organizational documents may limit a stockholder’s ability to bring a claim in a judicial forum that it finds favorable for disputes with us or any of our directors, officers, or other employees, which may discourage lawsuits with respect to such claims.Our restated certificate of incorporation, to the fullest extent permitted by law, provides that the Court of Chancery of the State of Delaware is the exclusive forum for: any derivative action or proceeding brought on our behalf; any action asserting a breach of fiduciary duty; any action asserting a claim against us arising pursuant to the DGCL, our restated certificate of incorporation, or our amended and restated bylaws; or any action asserting a claim against us that is governed by the internal affairs doctrine. This exclusive forum provision does not apply to suits brought to enforce a duty or liability created by the Exchange Act. It could apply, however, to a suit that falls within one or more of the categories enumerated in the exclusive forum provision.This choice of forum provision may result in increased costs for investors to bring a claim. Further, this choice of forum provision may limit a stockholder’s ability to bring a claim in a judicial forum that it finds favorable for disputes with us or any of our directors, officers, or other employees, which may discourage lawsuits with respect to such claims. Alternatively, if a court were to find the choice of forum provisions contained in our restated certificate of incorporation to be inapplicable or unenforceable in an action, we may incur additional costs associated with resolving such action in other jurisdictions, which could harm our business, results of operations and financial condition.Section 22 of the Securities Act creates concurrent jurisdiction for federal and state courts over all claims brought to enforce any duty or liability created by the Securities Act or the rules and regulations thereunder. Our amended and restated bylaws provide that the federal district courts of the United States of America, to the fullest extent permitted by law, shall be the exclusive forum for resolving any complaint asserting a cause of action arising under the Securities Act(“Federal Forum Provision”). Our decision to adopt a Federal Forum Provision followed a decision by the Supreme Court of the State of Delaware holding that such provisions are facially valid under Delaware law. While there can be no assurance that federal or state courts will follow the holding of the Delaware Supreme Court or determine that the Federal Forum Provision should be enforced in a particular case, application of the Federal Forum Provision means that suits brought by our stockholders to enforce any duty or liability created by the Securities Act must be brought in federal court and cannot be brought in state court.Section 27 of the Exchange Act creates exclusive federal jurisdiction over all claims brought to enforce any duty or liability created by the Exchange Act or the rules and regulations thereunder. In addition, neither the exclusive forum provision nor the Federal Forum Provision applies to suits brought to enforce any duty or liability created by the Exchange Act. Accordingly, actions by our stockholders to enforce any duty or liability created by the Exchange Act or the rules and regulations thereunder must be brought in federal court.Our stockholders will not be deemed to have waived our compliance with the federal securities laws and the regulations promulgated thereunder.Any person or entity purchasing or otherwise acquiring or holding any interest in any of our securities shall be deemed to have notice of and consented to our exclusive forum provisions, including the Federal Forum Provision. These provisions may limit a stockholder’s ability to bring a claim in a judicial forum of their choosing for disputes with us or our directors, officers, or other employees, which may discourage lawsuits against us and our directors, officers, and other employees. If a court were to find either exclusive-forum provision in our restated certificate of incorporation to be inapplicable or unenforceable in an action, we may incur further significant additional costs associated with resolving the dispute in other jurisdictions, all of which could harm our business.91\nWe will incur increased costs as a result of operating as a public company, and our management will be required to devote substantial time to new compliance initiatives and corporate governance practices.As a public company, we incur significant legal, accounting, compliance and other expenses that we did not incur as a private company. The Sarbanes-Oxley Act, the Dodd-Frank Wall Street Reform and Consumer Protection Act, the listing requirements of the Nasdaq Global Select Market and other applicable securities rules and regulations impose various requirements on public companies, including establishment and maintenance of effective disclosure and financial controls and corporate governance practices. Our management and other personnel need to devote a substantial amount of time to these compliance initiatives. Moreover, we expect these rules and regulations to substantially increase our legal and financial compliance costs and to make some activities more time consuming and costly. For example, these rules and regulations have made it more expensive for us to obtain director and officer liability insurance and we may be required to incur substantial costs to maintain sufficient coverage. We cannot predict or estimate the amount or timing of additional costs we may incur to respond to these requirements. The impact of these requirements could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, our board committees or as executive officers. The increased costs may require us to reduce costs in other areas of our business or increase the prices of our products once commercialized. Moreover, these rules and regulations are often subject to varying interpretations, in many cases due to their lack of specificity, and, as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies.This could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices.Pursuant to Section 404 of the Sarbanes-Oxley Act, we are required to furnish a report by our management on our internal control over financial reporting beginning with this annual report on Form 10-K. However, while we remain an “emerging growth company,” we will not be required to include an attestation report on internal control over financial reporting issued by our independent registered public accounting firm. In addition, for as long as we are a smaller reporting company with less than $100 million in annual revenue, we would be exempt from the requirement to obtain an external audit on the effectiveness of internal control over financial reporting provided in Section 404(b) of the Sarbanes-Oxley Act. To achieve compliance with Section 404 within the prescribed period, we will be engaged in a process to document and evaluate our internal control over financial reporting, which is both costly and challenging. In this regard, we will need to continue to dedicate internal resources, potentially engage outside consultants and adopt a detailed work plan to assess and document the adequacy of internal control over financial reporting, continue steps to improve control processes as appropriate, validate through testing that controls are functioning as documented and implement a continuous reporting and improvement process for internal control over financial reporting. This process will be time- consuming, costly and complicated. Despite our efforts, there is a risk that we will not be able to conclude, within the prescribed timeframe or at all, that our internal control over financial reporting is effective as required by Section 404. If we identify one or more material weaknesses, it could result in an adverse reaction in the financial markets due to a loss of confidence in the reliability of our financial statements. In addition, if we are not able to continue to meet these requirements, we may not be able to remain listed on the Nasdaq Global Select Market.Because we do not anticipate paying any cash dividends on our capital stock in the foreseeable future, capital appreciation, if any, will be your sole source of gain.We have never declared or paid cash dividends on our capital stock. We currently intend to retain all of our future earnings, if any, to finance the growth and development, operation and expansion of our business and do not anticipate declaring or paying any cash dividends for the foreseeable future. As a result, capital appreciation, if any, of our common stock will be your sole source of gain for the foreseeable future.92\nGeneral risk factorsIf securities or industry analysts do not publish research or reports about our business, or if they issue an adverse or misleading opinion regarding our stock, our stock price and trading volume could decline.The trading market for our common stock will be influenced by the research and reports that industry or securities analysts publish about us or our business. If no or few securities or industry analysts commence or maintain coverage of us, the trading price for our common stock could be impacted negatively. In the event we obtain securities or industry analyst coverage, if any of the analysts who cover us issue an adverse or misleading opinion regarding us, our business model, our intellectual property or our stock performance, or if our preclinical studies and clinical trials and operating results fail to meet the expectations of analysts, our stock price would likely decline. If one or more of such analysts cease coverage of us or fail to publish reports on us regularly, we could lose visibility in the financial markets, which in turn could cause a decline in our stock price or trading volume.Our disclosure controls and procedures may not prevent or detect all errors or acts of fraud.We are subject to the periodic reporting requirements of the Exchange Act. We have designed our disclosure controls and procedures to reasonably assure that information we must disclose in reports we file or submit under the Exchange Act is accumulated and communicated to management, and recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC. However, any disclosure controls and procedures or internal controls and procedures, no matter how well-conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system will be met.These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. For example, our directors or executive officers could inadvertently fail to disclose a new relationship or arrangement causing us to fail to make required related party transaction disclosures. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by an unauthorized override of the controls. Accordingly, because of the inherent limitations in a control system, misstatements due to error or fraud may occur and not be detected. In addition, we do not have a risk management program or processes or procedures for identifying and addressing risks to our business in other areas.Failure to establish and maintain an effective system of internal controls could result in material misstatements of our financial statements or cause us to fail to meet our reporting obligations or fail to prevent fraud in which case, our stockholders could lose confidence in our financial reporting and the market price of our common stock could decline.We are subject to the reporting requirements of the Exchange Act, the Sarbanes-Oxley Act and the rules and regulations of the Nasdaq Global Select Market. Under Section 404 of the Sarbanes-Oxley Act, we are required to furnish a report by our management on our internal control over financial reporting. This assessment must include disclosure of any material weaknesses identified by our management in our internal control over financial reporting. However, our independent registered public accounting firm will not be required to attest to the effectiveness of our internal control over financial reporting until our first annual report required to be filed with the SEC following the date we are no longer an EGC. At such time as we are required to obtain auditor attestation, if we then have a material weakness, we would receive an adverse opinion regarding our internal control over financial reporting from our independent registered accounting firm. To achieve compliance with Section 404 within the prescribed period, we will be engaged in a process to document and evaluate our internal control over financial reporting, which is both costly and challenging. In this regard, we will need to continue to dedicate internal resources, including through hiring additional financial and accounting personnel, potentially engage outside consultants and adopt a detailed work plan to assess and document the adequacy of internal control over financial reporting, continue steps to improve control processes as appropriate, validate through testing that controls are functioning as documented, and implement a continuous reporting and improvement process for internal control over financial reporting. During our evaluation of our internal control, if we identify one or more material weaknesses in our internal control over financial reporting, we will be unable to assert that our internal control over financial reporting is effective.In addition, our internal control over financial reporting will not prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s 93\nobjectives will be met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud will be detected.Furthermore, in connection with the future attestation process by our independent registered public accounting firm, we may encounter problems or delays in completing the implementation of any requested improvements and receiving a favorable attestation. If we cannot favorably assess the effectiveness of our internal control over financial reporting, or if our independent registered public accounting firm is unable to provide an unqualified attestation report on our internal controls, our stockholders could lose confidence in our reporting and the market price of our common stock could decline. In addition, we could be subject to sanctions or investigations by the Nasdaq Global Select Market, the SEC or other regulatory authorities.We may be subject to securities litigation, which is expensive and could divert management attention.The market price of our common stock may be volatile. The stock market in general, and pharmaceutical and biologics companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of these companies. In the past, companies that have experienced volatility in the market price of their stock have been subject to securities class action litigation. We may be the target of this type of litigation in the future. Securities litigation against us could result in substantial costs and divert our management’s attention from other business concerns, which could seriously harm our business.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\n| (a) | Unregistered Sales of Equity Securities |\n\nNone.(b) Use of Proceeds from Public Offering of Common Stock\nOn June 29, 2021, the Company closed its initial public offering, and issued 6,250,000 shares of its common stock at a price of $16.00 per share for net proceeds of $91.1 million, after deducting underwriting discounts, commissions, and other expenses of $8.9 million. On July 19, 2021, in connection with the Company’s IPO, the underwriters exercised the right to purchase 403,407 shares of the Company’s common stock at a price of $16.00 per share for net proceeds of $6.0 million, after deduction underwriting discounts of $0.5 million.\nThere has been no material change in the planned use of proceeds from our IPO as described in the registration statement on Form S-1.\nItem 3. Defaults Upon Senior Securities\nNone.\nItem 4. Mine Safety Disclosures\nNone.\nItem 5. Other Information\nNone.\nItem 6. Exhibits\nSee Exhibit Index.\n\n94\n| | | | | | | | |\n| | | | Incorporated by Reference | |\n| ExhibitNo. | Description | Form | File No. | Exhibit | Filing Date | Filedherewith |\n| | | | | | | | |\n| | | | | | | | |\n| 10.1†# | | Separation Agreement, dated January 5, 2023, between the Company and Shawn M. Leland. | | | | | X |\n| | | | | | | | |\n| 31 | | Certification of Principal Executive Officer and Principal Financial Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | | | | | X |\n| | | | | | |\n| 32* | | Certification of Principal Executive Officer and Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | | | | | X |\n| | | | | | |\n| 101.INS | | XBRL Instance Document – the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document | | | | | X |\n| | | | | | |\n| 101.SCH | | XBRL Taxonomy Extension Schema Document | | | | | X |\n| | | | | | |\n| 101.CAL | | XBRL Taxonomy Extension Calculation Linkbase Document | | | | | X |\n| | | | | | |\n| 101.DEF | | XBRL Taxonomy Extension Definition Linkbase Document | | | | | X |\n| | | | | | |\n| 101.LAB | | XBRL Taxonomy Extension Label Linkbase Document | | | | | X |\n| | | | | | |\n| 101.PRE | | XBRL Taxonomy Extension Presentation Linkbase Document | | | | | X |\n| | | | | | | | |\n| 104 | | Cover Page Interactive Data File (formatted in Inline XBRL and contained in Exhibit 101) | | | | | X |\n| * | This certification is deemed not filed for purposes of section 18 of the Exchange Act or otherwise subject to the liability of that section, nor shall it be deemed incorporated by reference into any filing under the Securities Act or the Exchange Act. |\n| † | The Registrant has omitted schedules and exhibits pursuant to Item 601(b)(2) of Regulation S-K and/or has omitted certain portions of this exhibit as permitted under Item 601(b)(10) of Regulation S-K. The Registrant agrees to furnish supplementally a copy of the omitted information to the SEC upon request. |\n| # | Indicates management contract or compensatory plan. |\n\n| | ELEVATION ONCOLOGY, INC. |\n| | | | |\n| | | By: | /s/ Joseph J. Ferra, Jr. |\n| | | Name: | Joseph J. Ferra, Jr. |\n| | | Title: | Interim Chief Executive Officer and President, and Chief Financial Officer |\n| | | | (Principal Executive Officer and Principal Financial and Accounting Officer) |\n| | | | |\n\n</text>\n\nIf Elevation Oncology, Inc. plans to liquidate all of its Level 1 and Level 2 assets to cover its total accrued expenses, how much excess or deficit liquid capital will the company have after the asset liquidation as of March 31, 2023?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"ground_truth": "Therefore, the answer is 18322.0."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial Statements.\nZomedica Corp.\nCondensed unaudited interim consolidated financial statements\nFor the three and nine months ended September 30, 2020 and 2019\n(Expressed in United States Dollars, except as otherwise noted)\nZomedica Corp.\nCondensed unaudited interim consolidated balance sheets\nAs at September 30, 2020 and December 31, 2019\n(Stated in United States dollars)\n\n| September 30, | December 31, |\n| Note | 2020 | 2019 |\n| Assets |\n| Current assets: |\n| Cash and cash equivalents | $ | 52,032,640 | $ | 510,586 |\n| Prepaid expenses and deposits | 5 | 932,408 | 1,228,585 |\n| Tax credits | 129,269 | 67,618 |\n| 53,094,317 | 1,806,789 |\n| Prepaid expenses and deposits | 5 | 1,000,000 | - |\n| Property and equipment | 6 | 720,701 | 729,142 |\n| Right-of-use asset | 8 | 1,380,744 | 1,103,658 |\n| Intangible assets | 7 | 408,583 | 543,395 |\n| $ | 56,604,345 | $ | 4,182,984 |\n| Liabilitites and shareholders' equity |\n| Current liabilities: |\n| Accounts payable and accrued liabilities | $ | 1,827,761 | 2,087,525 |\n| Current portion of lease obligations | 8 | 242,491 | - |\n| 2,070,252 | 2,087,525 |\n| Lease obligations | 8 | 1,154,304 | - |\n| 3,224,556 | 2,087,525 |\n| Shareholders' equity |\n| Capital stock |\n| Series 1 preferred shares, without par value; 20 shares authorized (2019 - 20) Issued and outstanding 12 series 1 preferred shares (2019 - 12) | 10 | 11,961,397 | 11,961,397 |\n| Unlimited common shares without par value; Issued and outstanding 564,051,438 common shares (2019 - 108,308,398) | 11 | 87,958,137 | 38,566,820 |\n| Additional paid-in capital | 13 | 18,256,678 | 3,625,083 |\n| Accumulated deficit | (64,796,423 | ) | (52,057,841 | ) |\n| 53,379,789 | 2,095,459 |\n| $ | 56,604,345 | $ | 4,182,984 |\n\nCommitments and contingencies (Note 14)\nThe accompanying notes are an integral part of these condensed unaudited interim consolidated financial statements.\n\n| 2 |\n\nZomedica Corp.\nCondensed unaudited interim consolidated statements of operations and comprehensive loss\nFor the three and nine months ended September 30, 2020 and 2019\n(Stated in United States dollars)\n\n| Three months ended September 30, | Nine months ended September 30, |\n| Note | 2020 | 2019 | 2020 | 2019 |\n| Expenses: |\n| Research and development | 17 | $ | 2,702,103 | $ | 962,463 | $ | 7,205,674 | $ | 9,555,345 |\n| General and administrative | 17 | 1,335,085 | 1,377,252 | 3,607,346 | 5,490,928 |\n| Professional fees | 17 | 839,646 | 306,937 | 1,413,118 | 1,296,884 |\n| Amortization - right-of-use asset | 8 | - | 127,345 | 42,448 | 382,035 |\n| Amortization - intangible assets | 7 | 45,399 | 273 | 135,425 | 810 |\n| Depreciation | 6 | 78,200 | 70,096 | 232,475 | 201,075 |\n| Loss from operations | 5,000,433 | 2,844,366 | 12,636,486 | 16,927,077 |\n| Interest income | (21,238 | ) | - | (21,566 | ) | - |\n| Interest expense | - | - | 732 | 18,338 |\n| Loss on disposal of property and equipment | 6 | - | - | 69,834 | 1,308 |\n| Loss on right-of-use-asset | 8 | - | - | 59,097 | - |\n| Gain on settlement of liabilities | - | - | - | (19,737 | ) |\n| Other income | (1,963 | ) | - | (7,463 | ) | - |\n| Foreign exchange loss (gain) | 2,743 | 1,313 | 1,462 | 30 |\n| Loss before income taxes | 4,979,975 | 2,845,679 | 12,738,582 | 16,927,016 |\n| Income tax expense | - | - | - | - |\n| Net loss and comprehensive loss | $ | 4,979,975 | $ | 2,845,679 | $ | 12,738,582 | $ | 16,927,016 |\n| Weighted average number of common shares - basic and diluted | 550,541,878 | 108,038,398 | 291,314,002 | 105,711,459 |\n| Loss per share - basic and diluted | $ | (0.01 | ) | $ | (0.03 | ) | $ | (0.04 | ) | $ | (0.16 | ) |\n\nThe accompanying notes are an integral part of these condensed unaudited interim consolidated financial statements.\n\n| 3 |\n\nZomedica Corp.\nCondensed unaudited interim consolidated statements of shareholders’ equity\nFor the three and nine months ended September 30, 2020 and 2019\n(Stated in United States dollars)\n\n| Series 1 preferred stock | Common stock |\n| Note | Shares | Amount | Shares | Amount | Common stock subscribed | Additional paid-in capital | Accumulated deficit | Total |\n| Balance at December 31, 2018 | - | $ | - | 97,598,898 | $ | 30,410,648 | $ | 4,280,000 | $ | 1,240,139 | $ | (32,273,787 | ) | $ | 3,657,000 |\n| Stock issuance for services | 11 | - | - | 707,236 | 792,104 | - | - | - | 792,104 |\n| Stock-based compensation | 12 | - | - | - | - | - | 2,539,092 | - | 2,539,092 |\n| Stock issuance for financing, net of cost | 10,11 | 12 | 11,961,397 | 9,337,529 | 6,690,922 | (4,280,000 | ) | - | - | 14,372,319 |\n| Stock issued due to exercise of options | 11,12 | - | - | 394,735 | 754,148 | - | (154,148 | ) | - | 600,000 |\n| Net loss | - | - | - | - | - | - | (16,927,016 | ) | (16,927,016 | ) |\n| Balance at September 30, 2019 | 12 | $ | 11,961,397 | 108,038,398 | $ | 38,647,822 | $ | - | $ | 3,625,083 | $ | (49,200,803 | ) | $ | 5,033,499 |\n| Balance at December 31, 2019 | 12 | $ | 11,961,397 | 108,038,398 | $ | 38,566,820 | $ | - | $ | 3,625,083 | $ | (52,057,841 | ) | $ | 2,095,459 |\n| Stock, warrants and prefunded warrant issued for financing | 11 | - | - | 337,830,001 | 32,275,266 | - | 24,221,017 | - | 56,496,283 |\n| Stock issuance costs | 11 | - | - | - | (2,979,594 | ) | - | (2,128,021 | ) | - | (5,107,615 | ) |\n| Placement agent warrants | 11 | - | - | - | (154,767 | ) | - | 154,767 | - | - |\n| Stock-based compensation | 12 | - | - | - | - | - | 478,835 | - | 478,835 |\n| Stock issued due to exercise of warrants and prefunded warrants | 11 | - | - | 118,183,039 | 20,250,412 | (8,095,003 | ) | - | 12,155,409 |\n| Net loss | - | - | - | - | - | - | (12,738,582 | ) | (12,738,582 | ) |\n| Balance at September 30, 2020 | 12 | $ | 11,961,397 | 564,051,438 | $ | 87,958,137 | $ | - | $ | 18,256,678 | $ | (64,796,423 | ) | $ | 53,379,789 |\n\nThe accompanying notes are an integral part of these condensed unaudited interim consolidated financial statements.\n\n| 4 |\n\nZomedica Corp.\nCondensed unaudited interim consolidated statements of cash flows\nFor the three and nine months ended September 30, 2020 and 2019\n(Stated in United States dollars)\n\n| Three months ended September 30, | Nine months ended September 30, |\n| Note | 2020 | 2019 | 2020 | 2019 |\n| Cash flows used in operating activities: |\n| Net loss for the period | $ | (4,979,975 | ) | $ | (2,845,679 | ) | $ | (12,738,582 | ) | $ | (16,927,016 | ) |\n| Adjustments for |\n| Depreciation | 6 | 78,200 | 70,096 | 232,475 | 201,075 |\n| Amortization - intangible assets | 7 | 45,399 | 273 | 135,425 | 810 |\n| Amortization - right-of-use-asset | 8 | - | 127,345 | 42,448 | 382,035 |\n| Loss on disposal of property and equipment | 6 | - | - | 69,834 | 1,308 |\n| Loss on right-of-use asset | 8 | - | - | 59,097 | - |\n| Non-cash portion of rent expense | 8 | 6,019 | - | 16,051 | - |\n| Stock issued for services | 11 | - | - | - | 792,104 |\n| Stock-based compensation | 12 | 187,969 | 197,988 | 478,835 | 2,539,092 |\n| Change in non-cash operating working capital |\n| Tax credits and other receivables | 53,228 | 19,558 | (61,651 | ) | (22,333 | ) |\n| Prepaid expenses | (243,461 | ) | (122,315 | ) | (175,553 | ) | 140,695 |\n| Deposits | (906,300 | ) | 21,366 | (827,538 | ) | (76,709 | ) |\n| Accounts payable and accrued liabilities | 96,292 | (1,378,710 | ) | (787,124 | ) | (798,994 | ) |\n| (5,662,629 | ) | (3,910,078 | ) | (13,556,283 | ) | (13,767,933 | ) |\n| Cash flows from financing activities: |\n| Proceeds from financing of preferred shares | 10 | - | - | - | 12,000,000 |\n| Proceeds from issuance of common shares, warrants and pre-funded warrants | 11,13 | 29,997,500 | - | 56,496,283 | 3,000,000 |\n| Cash received from warrant exercises | 13 | 863,550 | - | 12,155,409 | 600,000 |\n| Cash paid on stock issuance costs | 11,13 | (2,268,217 | ) | (1,414 | ) | (5,107,615 | ) | (627,681 | ) |\n| Cash received for government loan | 9 | - | - | 527,360 | - |\n| 28,592,833 | (1,414 | ) | 64,071,437 | 14,972,319 |\n| Cash flows (used in) from investing activities: |\n| Cash from sale of property and equipment | 6 | - | - | 5,400 | - |\n| Investment in intangibles | - | (501,487 | ) | - | (501,487 | ) |\n| Investment in property and equipment | 6 | (613 | ) | (80,950 | ) | (613 | ) | (155,513 | ) |\n| Cash from lease repurchase | 8 | - | - | 1,002,113 | - |\n| (613 | ) | (582,437 | ) | 1,006,900 | (657,000 | ) |\n| Increase in cash and cash equivalents | 22,929,591 | (4,493,929 | ) | 51,522,054 | 547,386 |\n| Cash and cash equivalents, beginning of period | 29,103,049 | 6,981,580 | 510,586 | 1,940,265 |\n| Cash and cash equivalents, end of period | $ | 52,032,640 | $ | 2,487,651 | $ | 52,032,640 | $ | 2,487,651 |\n| Supplemental cash flow information: |\n| Interest paid | $ | - | $ | 12,164 | $ | 651 | $ | 18,338 |\n| Interest received | $ | 14,347 | $ | - | $ | 14,347 | $ | - |\n\nThe accompanying notes are an integral part of these condensed unaudited interim consolidated financial statements.\n\n| 5 |\n\n| Zomedica Corp. |\n| Notes to the condensed unaudited interim consolidated financial statements |\n| For the three and nine months ended September 30, 2020 and 2019 |\n| (Stated in United States dollars) |\n\n\n| 1. | Nature of operations and going concern |\n\n\n| 2. | Basis of preparation |\n\n| 6 |\n\n| Zomedica Corp. |\n| Notes to the condensed unaudited interim consolidated financial statements |\n| For the three and nine months ended September 30, 2020 and 2019 |\n| (Stated in United States dollars) |\n\n\n\n| 3. | Significant accounting policies |\n| 7 |\n| Zomedica Corp. |\n| Notes to the condensed unaudited interim consolidated financial statements |\n| For the three and nine months ended September 30, 2020 and 2019 |\n| (Stated in United States dollars) |\n| 3. | Significant accounting policies (continued) |\n\n\n| 4. | Critical accounting judgments and key sources of estimation uncertainty |\n| 8 |\n| Zomedica Corp. |\n| Notes to the condensed unaudited interim consolidated financial statements |\n| For the three and nine months ended September 30, 2020 and 2019 |\n| (Stated in United States dollars) |\n| 4. | Critical accounting judgments and key sources of estimation uncertainty (continued) |\n\n| 9 |\n\n| Zomedica Corp. |\n| Notes to the condensed unaudited interim consolidated financial statements |\n| For the three and nine months ended September 30, 2020 and 2019 |\n| (Stated in United States dollars) |\n\n\n| 5. | Prepaid expenses and deposits |\n| September 30, | December 31, |\n| 2020 | 2019 |\n| Deposits (i) | $ | 1,561,503 | $ | 1,033,231 |\n| Prepaid marketing (ii) | 32,190 | 19,829 |\n| Prepaid insurance (ii) | 258,306 | 110,636 |\n| Other (iii) | 80,409 | 64,889 |\n| Total | $ | 1,932,408 | $ | 1,228,585 |\n| (i) | Deposits include payments made to vendors in advance and are primarily associated with, research activity, leasing deposits and costs for additional office space. As of September 30, 2020, and December 31, 2019, the Company classified $1,000,000 and nil as a non-current asset, with the remainder classified as a current asset in the consolidated balance sheet; |\n| (ii) | As of September 30, 2020, and December 31, 2019, all amounts were classified as a current asset in the consolidated balance sheet; |\n| (iii) | Other is comprised of deferred financing costs, subscription payments, utilities, travel costs and software licensing. As of September 30, 2020, and December 31, 2019, the Company classified all amounts as a current asset in the consolidated balance sheet. |\n\n\n| 10 |\n\n| Zomedica Corp. |\n| Notes to the condensed unaudited interim consolidated financial statements |\n| For the three and nine months ended September 30, 2020 and 2019 |\n| (Stated in United States dollars) |\n\n\n\n| 6. | Property and equipment |\n| Computer equipment | Furniture and equipment | Laboratory equipment | Leasehold improvements | Total |\n| Cost |\n| Balance at December 31, 2018 | $ | 170,002 | $ | 181,879 | $ | 352,637 | $ | 282,975 | $ | 987,493 |\n| Additions | 218,076 | 3,415 | 3,350 | 65,672 | 290,513 |\n| Disposals | (2,210 | ) | - | - | - | (2,210 | ) |\n| Balance at December 31, 2019 | 385,868 | 185,294 | 355,987 | 348,647 | 1,275,796 |\n| Additions | - | - | - | 299,268 | 299,268 |\n| Disposals | (9,933 | ) | (64,018 | ) | (13,712 | ) | (76,455 | ) | (164,117 | ) |\n| Balance at September 30, 2020 | 375,935 | 121,276 | 342,275 | 571,460 | 1,410,947 |\n| Accumulated depreciation |\n| Balance at December 31, 2018 | 104,918 | 29,585 | 99,696 | 36,206 | 270,405 |\n| Depreciation | 88,417 | 26,617 | 68,519 | 93,597 | 277,150 |\n| Disposals | (901 | ) | - | - | - | (901 | ) |\n| Balance at December 31, 2019 | 192,434 | 56,202 | 168,215 | 129,803 | 546,654 |\n| Depreciation | 65,330 | 13,333 | 52,267 | 101,545 | 232,475 |\n| Disposals | (2,849 | ) | (28,505 | ) | (30,843 | ) | (26,686 | ) | (88,883 | ) |\n| Balance at September 30, 2020 | 254,915 | 41,030 | 189,639 | 204,662 | 690,246 |\n| Net book value as at: |\n| December 31, 2019 | $ | 193,434 | $ | 129,092 | $ | 187,772 | $ | 218,844 | $ | 729,142 |\n| September 30, 2020 | $ | 121,020 | $ | 80,246 | $ | 152,636 | $ | 366,798 | $ | 720,701 |\n\n\n| 11 |\n\n| Zomedica Corp. |\n| Notes to the condensed unaudited interim consolidated financial statements |\n| For the three and nine months ended September 30, 2020 and 2019 |\n| (Stated in United States dollars) |\n\n\n\n| 7. | Intangible assets |\n| Computer software | Trademarks | Website | Total intangible assets |\n| Cost |\n| Balance at December 31, 2018 | $ | 5,143 | $ | 16,236 | $ | - | $ | 21,379 |\n| Additions | - | - | 531,419 | 531,419 |\n| Balance at December 31, 2019 | 5,143 | 16,236 | 531,419 | 552,798 |\n| Additions | - | - | 613 | 613 |\n| Balance at September 30, 2020 | 5,143 | 16,236 | 532,032 | 553,411 |\n| Accumulated amortization |\n| Balance at December 31, 2018 | 5,143 | 3,178 | - | 8,321 |\n| Amortization | - | 1,082 | - | 1,082 |\n| Balance at December 31, 2019 | 5,143 | 4,260 | - | 9,403 |\n| Amortization | - | 820 | 134,605 | 135,425 |\n| Balance at September 30, 2020 | 5,143 | 5,080 | 134,605 | 144,828 |\n| Net book value as at: |\n| December 31, 2019 | $ | - | $ | 11,976 | $ | 531,419 | $ | 543,395 |\n| September 30, 2020 | $ | - | $ | 11,156 | $ | 397,427 | $ | 408,583 |\n| 2020 | $ | 46,009 |\n| 2021 | 180,144 |\n| 2022 | 180,144 |\n| 2023 | 1,089 |\n| 2024 | 1,089 |\n| 2025 | 108 |\n| Total | $ | 408,583 |\n\n\n| 12 |\n\n| Zomedica Corp. |\n| Notes to the condensed unaudited interim consolidated financial statements |\n| For the three and nine months ended September 30, 2020 and 2019 |\n| (Stated in United States dollars) |\n\n\n| 8. | Leases |\n| 13 |\n| Zomedica Corp. |\n| Notes to the condensed unaudited interim consolidated financial statements |\n| For the three and nine months ended September 30, 2020 and 2019 |\n| (Stated in United States dollars) |\n| 8. | Leases (continued) |\n| Right-of-use asset | Premise lease |\n| Cost |\n| Aggregate lease commitments | $ | 2,067,505 |\n| Less: impact of present value | (513,894 | ) |\n| Balance at September 30, 2020 | 1,553,611 |\n| Reduction in right-of-use asset |\n| Straight line amortization | 275,667 |\n| Interest | (102,800 | ) |\n| Balance at September 30, 2020 | 172,867 |\n| Net book value as of: |\n| September 30, 2020 | $ | 1,380,744 |\n| Lease liabilities | Premise lease |\n| Additions | $ | 1,553,611 |\n| Payments | (259,616 | ) |\n| Interest | 102,800 |\n| Total lease liabilities at September 30, 2020 | 1,396,795 |\n| Current portion of lease liabilities | 242,491 |\n| Long term portion of lease liabilities | 1,154,304 |\n| Total lease liabilities at September 30, 2020 | $ | 1,396,795 |\n| 2020 | $ | 97,357 |\n| 2021 | 400,133 |\n| 2022 | 412,137 |\n| 2023 | 424,501 |\n| 2024 | 437,236 |\n| 2025 | 36,525 |\n| Total | $ | 1,807,889 |\n\n\n| 14 |\n\n| Zomedica Corp. |\n| Notes to the condensed unaudited interim consolidated financial statements |\n| For the three and nine months ended September 30, 2020 and 2019 |\n| (Stated in United States dollars) |\n\n\n| 9. | Loan arrangements |\n\n\n| 10. | Preferred stock |\n| Number of |\n| preferred | Preferred |\n| stock | stock amount |\n| Balance at December 31, 2018 | - | $ | - |\n| Stock issued from financing (i) | 12 | 11,961,397 |\n| Balance at December 31, 2019 | 12 | $ | 11,961,397 |\n| Balance at September 30, 2020 | 12 | $ | 11,961,397 |\n\n\n| 15 |\n\n| Zomedica Corp. |\n| Notes to the condensed unaudited interim consolidated financial statements |\n| For the three and nine months ended September 30, 2020 and 2019 |\n| (Stated in United States dollars) |\n\n\n\n| 11. | Common stock |\n| Common | Common |\n| stock amount | stock value |\n| Balance at December 31, 2018 | 97,598,898 | $ | 30,410,648 |\n| Stock issuance for services (i and ii) | 707,236 | 792,104 |\n| Stock issued from financing (iii and iv) | 9,337,529 | 6,690,922 |\n| Stock issued due to exercise of options | 394,735 | 754,148 |\n| Balance at September 30, 2019 | 108,038,398 | $ | 38,647,822 |\n| Balance at December 31, 2019 | 108,038,398 | $ | 38,566,820 |\n| Stock issued from financing (v,vi,vii,viii) | 337,830,001 | 29,140,905 |\n| Stock issued from the financing and exercise of prefunded warrants (viii) | 37,146,984 | 3,410,276 |\n| Stock issued from the exercise of warrants (ix and xi) | 81,036,055 | 16,840,136 |\n| Balance at September 30, 2020 | 564,051,438 | $ | 87,958,137 |\n| (i) | On January 14, 2019, the Company settled $75,000 of amounts due to a vendor by issuing 49,342 common shares valued at $55,263 at the date of issuance. The Company recorded a $19,737 gain on the settlement of liabilities. |\n| (ii) | On January 14, 2019, the Company issued 657,894 common shares in satisfaction of $1,000,000 of all remaining milestones under a License and Supply Agreement with a third party. The Company recognized $736,841 as research and development expense, based on the value of the common stock on the date of issuance. |\n| (iii) | On January 14, 2019, the Company completed a non-brokered private placement, and issued 2,815,789 common shares. Gross proceeds of $4,280,000 were received prior to December 31, 2018. The Company recorded $465 of share issuance costs as an offset to common stock. |\n| (iv) | On March 28, 2019, the Company completed an underwritten public offering of its common stock pursuant to which the Company sold an aggregate 6,521,740 common shares for gross proceeds of $3,000,000. The Company recorded $592,707 of share issuance costs as an offset to common stock. |\n| (v) | On February 14, 2020, the Company completed a registered direct offering (“RDO”) of its common shares and a simultaneous private placement of its warrants (“Series A Warrants”) in a fixed combination of one common share and a Series A Warrant to purchase one common share, resulting in the sale of 20,833,334 common shares and Series A Warrants to purchase 20,833,334 common shares at a combined offering price of $0.12 per share and related Series A Warrant. Each Series A Warrant has an exercise price of $0.20 per share, is exercisable six months after issuance and has a term of 5- and one-half years. The Company also issued warrants to the placement agents to purchase 1,041,667 common shares at an exercise price of $0.15 per share (“Series A Placement Agent Warrants”), which were exercisable immediately upon issuance and have a term of 5 years. In aggregate, the Company issued 20,833,334 common shares, 20,833,334 Series A Warrants, in and an additional 1,041,667 Series A Placement Agent Warrants. |\n| 16 |\n| Zomedica Corp. |\n| Notes to the condensed unaudited interim consolidated financial statements |\n| For the three and nine months ended September 30, 2020 and 2019 |\n| (Stated in United States dollars) |\n| 11. | Common stock (continued) |\n| (vi) | On April 9, 2020 the Company completed a confidentially marketed public offering (“CMPO”) of its common shares and warrants (“Series B Warrants”) of 33,333,334 common shares and warrants to purchase up to 16,666,667 common shares. The securities were sold in a fixed combination of one common share and 0.5 of a Series B Warrant at a combined offering price of $0.12 per share and accompanying warrant. Each whole warrant is exercisable immediately for one common share after issuance, at an exercise price of $0.15 per share and has a term of 5 years. The Company also issued warrants to the placement agents to purchase 1,666,667 common shares at an exercise price of $0.15 per share (“Series B Placement Agent Warrants”), which were exercisable immediately upon issuance and have a term of 5 years. In aggregate, the Company issued 33,333,334 common shares,16,666,667 Series B Warrants, and an additional 1,666,667 Series B Placement Agent Warrants. |\n| (vii) | On May 29, 2020 the Company completed a public offering of its common shares or common share equivalents (“Series C Pre-Funded Warrants”), and warrants (“Series C Warrants”) in a fixed combination of one common share or Series C Pre-Funded Warrant, and a Series C Warrant to purchase one common share, resulting in the sale of 121,163,333 common shares, 12,170,000 Series C Pre-Funded Warrants, and Series C Warrants to purchase 133,333,333 common shares at a combined offering price of $0.15 per share for the common shares and related Series C Warrant, or a combined offering price of $0.1499 per Pre-Funded Warrant and related Series C Warrant. Each Series C Pre-Funded Warrant has an exercise price of $0.0001 per share, is exercisable immediately after issuance, is exercisable only on a cashless exercise basis, and will not expire prior to exercise. Each Series C Warrant has an exercise price of $0.15 per share, is exercisable immediately after issuance and has a term of 2 years. |\n| 17 |\n| Zomedica Corp. |\n| Notes to the condensed unaudited interim consolidated financial statements |\n| For the three and nine months ended September 30, 2020 and 2019 |\n| (Stated in United States dollars) |\n| 11. | Common stock (continued) |\n| (viii) | On July 7, 2020 the Company completed a public offering of its common shares or common share equivalents (“Series D Pre-Funded Warrants”), and warrants (“Series D Warrants”) in a fixed combination of one common share or Series D Pre-Funded warrant, and a Series D Warrant to purchase one common share, resulting in the sale of 162,500,000 common shares, 25,000,000 Series D Pre-Funded Warrants, and Series D Warrants to purchase 187,500,000 common shares at a combined offering price of $0.16 per share for the common shares and related Series D Warrant, or a combined offering price of $0.1599 per Series D Pre-Funded warrant and related Series D Warrant. Each Series D Pre-Funded warrant has an exercise price of $0.0001 per share, is exercisable immediately after issuance, is exercisable only on a cashless exercise basis, and will not expire prior to exercise. Each Series D Warrant has an exercise price of $0.16 per share, is exercisable immediately after issuance, and has a term of 2 years. |\n| (ix) | All Series C Pre-Funded Warrants were exercised in June 2020. The cashless exercise option resulted in the issuance of 12,162,492 shares. |\n| (x) | All Series D Pre-Funded Warrants were exercised in July 2020. The cashless exercise, option resulted in the issuance of 24,984,492 shares. |\n| (xi) | As of September 30, 2020, 11,602,084 Series B Warrants have been exercised, resulting in additional cash proceeds of $1,740,313, and 69,433,971 Series C Warrants have been exercised, resulting in additional cash proceeds of $10,415,096. |\n\n\n| 18 |\n\n| Zomedica Corp. |\n| Notes to the condensed unaudited interim consolidated financial statements |\n| For the three and nine months ended September 30, 2020 and 2019 |\n| (Stated in United States dollars) |\n\n\n\n| 12. | Stock-based compensation |\n| Number of options | Weighted avg exercise price |\n| Balance at December 31, 2019 | 7,040,265 | $ | 1.28 |\n| Stock options forfeited January 23, 2020 | (50,000 | ) | 1.52 |\n| Stock options forfeited February 25, 2020 | (5,000 | ) | 1.12 |\n| Stock options forfeited March 1, 2020 | (50,000 | ) | 1.52 |\n| Stock options granted March 14, 2020 | 5,056,000 | 0.19 |\n| Stock options forfeited April 21, 2020 | (150,000 | ) | 0.19 |\n| Stock options forfeited May 4, 2019 | (15,000 | ) | 0.19 |\n| Stock options forfeited May 5, 2020 | (30,000 | ) | 1.52 |\n| Stock options forfeited May 7, 2020 | (15,000 | ) | 1.52 |\n| Stock options forfeited June 11, 2020 | (15,000 | ) | 1.52 |\n| Stock options granted June 16, 2020 | 2,000,000 | 0.19 |\n| Stock options granted July 9, 2020 | 175,000 | 0.18 |\n| Stock options forfeited July 20, 2020 | (400,000 | ) | 1.52 |\n| Stock options forfeited July 20, 2020 | (50,000 | ) | 0.19 |\n| Stock options forfeited July 31, 2020 | (3,750 | ) | 0.19 |\n| Stock options forfeited August 2, 2020 | (10,000 | ) | 1.52 |\n| Stock options forfeited August 2, 2020 | (5,000 | ) | 0.19 |\n| Stock options forfeited August 14, 2020 | (675,000 | ) | 0.19 |\n| Stock options forfeited August 19, 2020 | (75,375 | ) | 0.19 |\n| Stock options granted August 25, 2020 | 40,000 | 0.13 |\n| Stock options forfeited September 25, 2020 | (37,500 | ) | 0.19 |\n| Stock options granted September 29, 2020 | 300,000 | 0.11 |\n| Balance at September 30, 2020 | 13,024,640 | $ | 0.72 |\n| Vested at September 30, 2020 | 9,136,348 | $ | 0.95 |\n| 19 |\n| Zomedica Corp. |\n| Notes to the condensed unaudited interim consolidated financial statements |\n| For the three and nine months ended September 30, 2020 and 2019 |\n| (Stated in United States dollars) |\n| 12. | Stock-based compensation (continued) |\n| Grant date | Exercise price | Number of options issued and outstanding | Number of vested options outstanding | Number of unvested options outstanding | Weighted Avg Remaining Life outstanding (years) |\n| January 10, 2019 | $ | 1.52 | 4,965,265 | 4,965,265 | - | 0.28 |\n| August 19, 2019 | 0.26 | 500,000 | 500,000 | - | 0.88 |\n| August 19, 2019 | 0.35 | 100,000 | 100,000 | - | 0.88 |\n| August 19, 2019 | 0.45 | 100,000 | 100,000 | - | 0.88 |\n| August 19, 2019 | 0.55 | 100,000 | 100,000 | - | 0.88 |\n| August 19, 2019 | 0.65 | 100,000 | 100,000 | - | 0.88 |\n| August 19, 2019 | 0.75 | 100,000 | 100,000 | - | 0.88 |\n| September 16, 2019 | 0.43 | 500,000 | 500,000 | - | 0.96 |\n| March 14, 2020 | 0.19 | 4,044,375 | 1,209,000 | 2,835,375 | 4.45 |\n| June 16, 2020 | 0.19 | 2,000,000 | 1,333,334 | 666,666 | 4.71 |\n| July 9, 2020 | 0.18 | 175,000 | 43,750 | 131,250 | 4.78 |\n| August 25, 2020 | 0.13 | 40,000 | 10,000 | 30,000 | 4.90 |\n| September 29, 2020 | 0.11 | 300,000 | 75,000 | 225,000 | 5.00 |\n| Balance at September 30, 2020 | 13,024,640 | 9,136,349 | 3,888,291 |\n| July 9, 2020 | June 16, 2020 | March 14, 2020 |\n| Volatility | 100% | 100% | 87% |\n| Risk-free interest rate | 0.28% | 0.21% | 0.49% |\n| Expected life (years) | 5 | 5 | 5 |\n| Divedend yield | 0% | 0% | 0% |\n| Common share price | $0.17 | $0.19 | $0.18 |\n| Strike price | $0.18 | $0.19 | $0.19 |\n| Forfeiture rate | nil | nil | nil |\n| September 29, 2020 | August 25, 2020 |\n| Volatility | 100% | 99% |\n| Risk-free interest rate | 0.24% | 0.30% |\n| Expected life (years) | 5 | 5 |\n| Divedend yield | 0% | 0% |\n| Common share price | $0.10 | $0.13 |\n| Strike price | $0.11 | $0.13 |\n| Forfeiture rate | nil | nil |\n| 20 |\n| Zomedica Corp. |\n| Notes to the condensed unaudited interim consolidated financial statements |\n| For the three and nine months ended September 30, 2020 and 2019 |\n| (Stated in United States dollars) |\n| 12. | Stock-based compensation (continued) |\n\n\n| 13. | Warrants |\n| Original Issue date | Exercise Price | Warrants Outstanding | Weighted Average Remaining Life |\n| February 14, 2020 | 0.20 | 20,833,334 | 4.87 |\n| February 14, 2020 | 0.15 | 1,041,667 | 4.37 |\n| April 9, 2020 | 0.15 | 6,731,250 | 4.53 |\n| May 29, 2020 | 0.15 | 63,899,362 | 1.66 |\n| July 7, 2020 | 0.16 | 187,500,000 | 1.77 |\n| Balance at September 30, 2020 | 280,005,613 |\n| 21 |\n| Zomedica Corp. |\n| Notes to the condensed unaudited interim consolidated financial statements |\n| For the three and nine months ended September 30, 2020 and 2019 |\n| (Stated in United States dollars) |\n| 13. | Warrants (continued) |\n| Series A Warrants February 14, 2020 | Series A Placement Agent Warrants February 14, 2020 |\n| Volatility | 87% | 87% |\n| Risk-free interest rate | 1.42% | 1.42% |\n| Expected life (years) | 5.5 | 5 |\n| Dividend yield | 0% | 0% |\n| Common share price | $0.12 | $0.12 |\n| Strike price | $0.20 | $0.15 |\n| Forfeiture rate | nil | nil |\n| Series B Warrants April 9, 2020 | Series B Placement Agent Warrants April 9, 2020 |\n| Volatility | 99% | 99% |\n| Risk-free interest rate | 0.41% | 0.41% |\n| Expected life (years) | 5 | 5 |\n| Dividend yield | 0% | 0% |\n| Common share price | $0.14 | $0.14 |\n| Strike price | $0.15 | $0.15 |\n| Forfeiture rate | nil | nil |\n| Series C Warrants May 29, 2020 |\n| Volatility | 118% |\n| Risk-free interest rate | 0.16% |\n| Expected life (years) | 2 |\n| Dividend yield | 0% |\n| Common share price | $0.16 |\n| Strike price | $0.15 |\n| Forfeiture rate | nil |\n| Series D Warrants July 7, 2020 |\n| Volatility | 118% |\n| Risk-free interest rate | 0.16% |\n| Expected life (years) | 2 |\n| Dividend yield | 0% |\n| Common share price | $0.17 |\n| Strike price | $0.16 |\n| Forfeiture rate | nil |\n\n\n| 22 |\n\n| Zomedica Corp. |\n| Notes to the condensed unaudited interim consolidated financial statements |\n| For the three and nine months ended September 30, 2020 and 2019 |\n| (Stated in United States dollars) |\n\n\n\n| 14. | Commitments and contingencies |\n| • | 1st payment: At the later of the achievement of a future milestone event or September 12, 2019, can decide to receive payment as follows: |\n| ○ | $3,000,000 in cash or |\n| ○ | $1,500,000 in cash and $1.95 million in equity |\n| • | 2nd payment: At the later of the achievement of a future milestone or February 19, 2020 - $2,000,000 in cash. |\n| • | 3rd payment: At the later of the achievement of a future milestone event or September 12, 2019, can decide to receive payment as follows: |\n| ○ | $3,000,000 in cash or |\n| ○ | $1,500,000 in cash and $1.95 million in equity |\n| • | 4th payment: At the later of the achievement of a future milestone or February 19, 2020 - $2,000,000 in cash. |\n| • | 1st payment: $3,500,000 in cash payment upon the achievement of future development milestones. |\n| • | 2nd payment: $3,500,000 in equity based on the number of the Company’s common stock determined by dividing the amount due by the VWAP of the Company’s common stock on the NYSE American exchange over the 10 trading days prior to the achievement of the milestone event. |\n| 23 |\n| Zomedica Corp. |\n| Notes to the condensed unaudited interim consolidated financial statements |\n| For the three and nine months ended September 30, 2020 and 2019 |\n| (Stated in United States dollars) |\n| 14. | Commitments and contingencies (continued) |\n\n\n| 15. | Financial instruments |\n| (a) | Fair values |\n| (b) | Interest rate and credit risk |\n| 24 |\n| Zomedica Corp. |\n| Notes to the condensed unaudited interim consolidated financial statements |\n| For the three and nine months ended September 30, 2020 and 2019 |\n| (Stated in United States dollars) |\n| 15. | Financial instruments (continued) |\n| (c) | Foreign exchange risk |\n| (d) | Liquidity risk |\n| September 30, 2020 |\n| Less than | 3 to 6 | 6 to 9 | 9 months | Greater than |\n| 3 months | months | months | 1 year | 1 year | Total |\n| $ | $ | $ | $ | $ | $ |\n| Third parties |\n| Accounts payable and accrued liabilities | 1,827,761 | - | - | - | - | 1,827,761 |\n| 1,827,761 | - | - | - | - | 1,827,761 |\n| December 31, 2019 |\n| Less than | 3 to 6 | 6 to 9 | 9 months | Greater than |\n| 3 months | months | months | 1 year | 1 year | Total |\n| $ | $ | $ | $ | $ | $ |\n| Third parties |\n| Accounts payable and accrued liabilities | 2,087,525 | - | - | - | - | 2,087,525 |\n| 2,087,525 | - | - | - | - | 2,087,525 |\n\n\n| 25 |\n\n| Zomedica Corp. |\n| Notes to the condensed unaudited interim consolidated financial statements |\n| For the three and nine months ended September 30, 2020 and 2019 |\n| (Stated in United States dollars) |\n\n\n\n| 16. | Segmented information |\n| September 30, | December 31, |\n| 2020 | 2019 |\n| $ | $ |\n| Total assets |\n| Canada | 52,077,832 | 249,929 |\n| US | 4,526,513 | 3,933,055 |\n| Total US property and equipment | 720,701 | 729,142 |\n| Total US right-of-use asset | 1,380,744 | 1,103,658 |\n| 2,101,445 | 1,832,800 |\n\n\n| 17. | Schedule of expenses |\n| For the three months ended September 30, | For the three months ended September 30, |\n| 2020 | 2019 |\n| Research and | Professional | General and | Research and | Professional | General and |\n| Development | Fees | Administrative | Development | Fees | Administrative |\n| Salaries, bonus and benefits | $ | 118,015 | $ | - | $ | 910,668 | $ | 147,515 | $ | - | $ | 879,422 |\n| Contracted expenditures | 544,952 | - | - | 661,917 | - | - |\n| Marketing and investor relations | - | - | 59,559 | - | - | 165,837 |\n| Travel and accommodation | - | - | 91 | 8,327 | - | 198,993 |\n| Insurance | 181 | - | 62,649 | 1,301 | - | 36,065 |\n| License fees | 2,000,000 | - | - | - | - | - |\n| Office | 9,750 | - | 63,771 | 11,565 | - | 52,332 |\n| Consultants | 6,500 | 839,646 | - | 29,343 | 306,937 | - |\n| Regulatory | - | - | 152,201 | 31,773 | - | 26,163 |\n| Rent | 17,229 | - | 86,146 | - | - | 7,603 |\n| Supplies | 5,476 | - | - | 70,722 | - | 10,837 |\n| Total | $ | 2,702,103 | $ | 839,646 | $ | 1,335,085 | $ | 962,463 | $ | 306,937 | $ | 1,377,252 |\n| For the nine months ended September 30, | For the nine months ended September 30, |\n| 2020 | 2019 |\n| Research and | Professional | General and | Research and | Professional | General and |\n| Development | Fees | Administrative | Development | Fees | Administrative |\n| Salaries, bonus and benefits | $ | 433,659 | $ | - | $ | 2,414,103 | $ | 651,315 | $ | - | $ | 4,524,682 |\n| Contracted expenditures | 1,423,764 | - | - | 2,474,483 | - | - |\n| Marketing and investor relations | - | - | 176,938 | - | - | 297,252 |\n| Travel and accommodation | 407 | - | 13,006 | 21,103 | - | 318,730 |\n| Insurance | 622 | - | 154,999 | 4,197 | - | 77,165 |\n| License fees | 5,000,000 | - | - | 5,936,841 | - | - |\n| Office | 31,827 | - | 361,967 | 31,162 | - | 149,788 |\n| Consultants | 84,626 | 1,413,118 | - | 178,223 | 1,296,884 | - |\n| Regulatory | 151,073 | - | 262,557 | 95,418 | - | 76,333 |\n| Rent | 56,221 | - | 223,776 | - | - | 19,483 |\n| Supplies | 23,475 | - | - | 162,603 | - | 27,495 |\n| Total | $ | 7,205,674 | $ | 1,413,118 | $ | 3,607,346 | $ | 9,555,345 | $ | 1,296,884 | $ | 5,490,928 |\n\n\n| 26 |\n\n| Zomedica Corp. |\n| Notes to the condensed unaudited interim consolidated financial statements |\n| For the three and nine months ended September 30, 2020 and 2019 |\n| (Stated in United States dollars) |\n\n\n\n| 18. | Capital risk management |\n\n\n| 19. | Loss per share |\n| For the three months ended September 30, | For the nine months ended September 30, |\n| 2020 | 2019 | 2020 | 2019 |\n| Numerator |\n| Net loss for the period | $ | 4,979,975 | $ | 2,845,679 | $ | 12,738,582 | $ | 16,927,016 |\n| Denominator |\n| Weighted average shares - basic | 550,541,878 | 108,038,398 | 291,314,002 | 105,711,459 |\n| Warrants | - | - | - | - |\n| Stock options | - | - | - | - |\n| Denominator for diluted loss per share | 550,541,878 | 108,038,398 | 291,314,002 | 105,711,459 |\n| Loss per share - basic and diluted | $ | (0.01 | ) | $ | (0.03 | ) | $ | (0.04 | ) | $ | (0.16 | ) |\n\n\n| 20. | Related party transactions and key management compensation |\n| For the three months ended September 30, | For the nine months ended September 30, |\n| 2020 | 2019 | 2020 | 2019 |\n| Salaries and benefits, including bonuses | $ | 281,868 | $ | 251,737 | $ | 624,604 | $ | 887,635 |\n| Stock-based compensation | 15,445 | 100,002 | 393,470 | 1,744,327 |\n| Total | $ | 297,313 | $ | 351,739 | $ | 1,018,074 | $ | 2,631,962 |\n\n| 21. | Comparative figures |\n\n\n| 27 |\n\n\nItem 2.\nMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.\nMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION\nAND RESULTS OF OPERATION\nThe following discussion and analysis of our financial condition and results of operations should be read together with our financial statements and the related notes and the other financial information included elsewhere in this Quarterly Report. This discussion contains forward-looking statements and forward-looking information under applicable Canadian securities legislation (collectively, “forward-looking statements”) that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Quarterly Report, and those set forth in our most recent Annual Report on Form 10-K particularly those under “Risk Factors” discussed below and in our most recent Annual Report on Form 10-K.\nCAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS\nThis report on Form 10-Q contains forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 under Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and pursuant to applicable Canadian securities legislation that are based on management’s beliefs and assumptions and on information currently available to management. Some of the statements under “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this Form 10-Q contain forward-looking statements. In some cases, you can identify forward-looking statements through our use of words such as “may,” “might,” “will,” “could,” “would,” “should,” “expect,” “intend,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “project,” “potential,” “continue,” “ongoing” or the negative of these terms or other comparable terminology, although not all forward-looking statements contain these words.\nThere are a number of important factors that could cause the actual results to differ materially from those expressed in any forward-looking statement made by us. These factors include, but are not limited to:\n\n| · | the success, cost and timing of our research and development activities, validation studies and beta testing, including with respect to our lead product, TRUFORMA™; |\n\n\n| · | our ability to obtain and maintain any required approvals from the USDA Center for Veterinary Biologics for our proposed and future diagnostic products, to the extent applicable; |\n\n\n| · | our ability to obtain funding for our operations; |\n\n\n| · | the ability of our contract research organizations to appropriately conduct our safety studies and certain development activities; |\n\n\n| · | the ability of our contract manufacturing organizations to manufacture and supply our products; |\n\n\n| · | our plans to develop and commercialize our planned and future products; |\n\n\n| · | the expected impact of the novel coronavirus pandemic on our operations, including the development and commercialization of our TRUFORMA™ platform and the five initial assays; |\n\n\n| · | our ability to develop and commercialize products that can compete effectively; |\n\n\n| · | the size and growth of the veterinary diagnostics and medical device markets; |\n\n\n| · | our ability to obtain and maintain intellectual property protection for our planned and future products candidates; |\n\n\n| · | regulatory developments in the United States; |\n\n\n| · | the loss of key scientific or management personnel; |\n\n\n| 28 |\n\n\n| · | our expectations regarding the period during which we will be an “emerging growth company” under the JOBS Act; |\n\n\n| · | the accuracy of our estimates regarding expenses, future revenues, capital requirements and needs for additional financing; |\n\n\n| · | risks related to our Series 1 preferred shares; |\n\n\n| · | our ability to maintain the listing of our common shares on the NYSE American exchange; |\n\n\n| · | our status as a “passive foreign investment company” for U.S. federal income tax purposes; and |\n\n\n| · | the anticipated U.S. and Canadian federal income tax consequences of our proposed domestication into a Delaware corporation. |\n\nThe foregoing does not represent an exhaustive list of matters that may be covered by the forward-looking statements contained herein or risk factors that we are faced with that may cause our actual results to differ from those anticipate in our forward-looking statements. Please see “Risk Factors” below and in our most recent Annual Report on Form 10-K for additional risks which could adversely impact our business and financial performance.\nAll forward-looking statements are expressly qualified in their entirety by this cautionary notice. You are cautioned not to place undue reliance on any forward-looking statements, which speak only as of the date of this report. We have no obligation, and expressly disclaim any obligation, to update, revise or correct any of the forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. We have expressed our expectations, beliefs and projections in good faith, and we believe they have a reasonable basis. However, we cannot assure you that our expectations, beliefs or projections will result or be achieved or accomplished.\nOverview\nWe are a veterinary health company creating products for companion animals by focusing on the unmet needs of clinical veterinarians. We expect that our product portfolio will include innovative diagnostics and medical devices that emphasize patient health and practice health. With a team that includes clinical veterinary professionals, our goal is to provide veterinarians the opportunity to increase productivity and grow revenue while better serving the animals in their care.\nOur strategic focus is on the final development and commercialization of our TRUFORMA™ diagnostic biosensor platform and the first five assays for the detection of adrenal and thyroid disorders in cats and dogs. The TRUFORMA™ platform uses Bulk Acoustic Wave (BAW) technology to provide a non-optical and fluorescence free detection system for use at the point-of-care. We believe that BAW technology will enable precise and repeatable test results at the point-of-care during a typical veterinary appointment. We believe that the TRUFORMA™ diagnostic platform does not require pre-market regulatory approval for use with companion animals in the United States.\nFollowing the commercial launch of TRUFORMA™, we expect to continue the development of another point-of-care diagnostic platform, which is based on miniaturized laser-based Raman spectroscopy technology and is designed to detect pathogens in companion animals. We believe this platform will enable the identification of biological and biochemical signatures in complex biological samples and has the potential to achieve reference lab sensitivity/specificity to screen for a wide range of pathogens in companion animal feces, urine, respiratory, and dermatological samples in minutes without the need for extensive sample prep or the use of reagents. The diagnostic platform requires a small fecal sample preparation. Additionally, the platform has automated analysis and does not require specialized staff training. Assuming development work is successfully completed, we expect the commercial launch of our fecal test to occur by 2022 and urine tests by 2023. We believe that this diagnostic platform does not require pre-market regulatory approval for use with companion animals in the United States.\nWe have performed initial development work on a circulating tumor cell (CTC) “liquid biopsy” platform for use in a reference lab setting as a canine cancer diagnostic. This platform is intended for use to detect canine cancers faster, more affordably and less invasively compared to existing methods, which can be expensive and cost-prohibitive for pet owners. We have worked on the development of an assay for use with this platform that targets hard-to-diagnose canine cancers, such as hemangiosarcoma and osteosarcoma.\n\n| 29 |\n\nConsistent with our focus on the development of point-of-care diagnostic platforms, we intend to seek one or more partners for the further development and commercialization of the liquid biopsy platform.\nWe are a development-stage company with no products approved for marketing and sale, and we have not generated any revenue. We have incurred significant net losses since our inception. We incurred net losses of approximately $5.0 million and $12.7 million for the three and nine months ended September 30, 2020 and approximately $2.8 million and $16.9 million for the three and nine months ended September 30, 2019. These losses have resulted principally from costs incurred in connection with investigating and developing our product candidates, research and development activities, and general and administrative costs associated with our operations. As of September 30, 2020, we had an accumulated deficit of approximately $64.8 million and cash and cash equivalents of approximately $52.0 million.\nFor the foreseeable future, we expect to continue to incur losses, which will increase from historical levels as we expand our product development activities, commercialize products, seek regulatory approvals for our planned and future products to the extent required, and expand our sales and marketing activities.\nFor further information on the regulatory, business and product pipeline, please see the “Business” section of our Annual Report on Form 10-K. For further information on the risk factors we face, please see the “Risk Factors” section of our Annual Report on Form 10-K and this Quarterly Report on Form 10-Q.\nRevenue\nWe do not have any products approved for sale, have not generated any revenue from product sales since our inception and do not expect to generate any revenue from the sale of products in the near future. If our development efforts result in clinical success or collaboration agreements with third parties for any of our product candidates, we may generate revenue from those product candidates.\nOperating Expenses\nThe majority of our operating expenses to date have been for the general and administrative activities related to general business activities, capital market activities and stock-based compensation, and research and development activities related to the development of our product candidates.\nResearch and Development Expense\nAll costs of research and development are expensed in the period in which they are incurred. Research and development costs primarily consist of salaries and related expenses for personnel, fees paid to consultants, outside service providers, professional services, travel costs and materials used in clinical trials and research and development.\nGeneral and Administrative Expense\nGeneral and administrative expense consists primarily of personnel costs, including salaries, related benefits and stock-based compensation for employees, consultants and directors. General and administrative expenses also include rent and other facilities costs and professional and consulting fees for legal, accounting, tax services and other general business services.\nProfessional Fees\nProfessional fees include attorney’s fees, accounting fees and consulting fees incurred in connection with product investigation and analysis, regulatory analysis, government relations, audit, securities offerings, investor relations, and general corporate and intellectual property advice.\n\n| 30 |\n\nIncome Taxes\nAs of December 31, 2019, we had net operating loss carryforwards for federal and state income tax purposes of approximately $16.1 million and non-capital loss carryforwards for Canadian income tax purposes of approximately $20.4 million, which will begin to expire in fiscal year 2035. We have evaluated the factors bearing upon the realizability of our deferred tax assets, which are comprised principally of net operating loss carryforwards and non-capital loss carryforwards. We concluded that, due to the uncertainty of realizing any tax benefits as of December 31, 2019, a valuation allowance was necessary to fully offset our deferred tax assets.\nCritical Accounting Policies and Significant Judgments and Estimates\nOur management’s discussion and analysis of financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, or U.S. GAAP. The preparation of our consolidated financial statements and related disclosures requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, and revenue, costs and expenses and related disclosures during the reporting periods. On an ongoing basis, we evaluate our estimates and judgments, including those described below. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.\nWhile our significant accounting policies are more fully described in Note 3 of the notes to our consolidated financial statements appearing elsewhere in this report, we believe that the estimates and assumptions involved in the following accounting policies may have the greatest potential impact on our financial statements.\nJOBS Act\nThe Jumpstart Our Business Startups Act, or the JOBS Act, contains provisions that, among other things, reduce certain reporting requirements for an “emerging growth company.” We have irrevocably elected not to avail ourselves of the JOBS Act provision that an emerging growth company may delay adopting new or revised accounting standards until such times as those standards apply to private companies.\nIn addition, as an “emerging growth company” we are not required to, among other things, (i) provide an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404, and (ii) comply with any requirement that may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis). These exemptions will apply until December 31, 2022 or until we no longer meet the requirements of being an “emerging growth company,” whichever is earlier.\nUse of Estimates\nThe preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of expenses during the year. Actual results could differ from those estimates.\nAreas where significant judgment is involved in making estimates are, the determination of fair value of stock-based compensation, the useful lives of property and equipment, allocation of proceeds from financings to shares and warrants, fair value of placement agent warrants and forecasting future cash flows for assessing the going concern assumption.\nResearch and Development Costs\nResearch and development expenses include costs incurred in performing research and development activities, including salaries and benefits, safety and efficacy studies, contract manufacturing costs, contract research costs, patent procurement costs, materials and supplies, and occupancy costs. Research and development activities include internal and external activities associated with research and development studies of current product candidates and advancing product candidates towards a goal of obtaining regulatory approval to manufacture and market the product candidate.\n\n| 31 |\n\nResearch and development costs related to continued research and development programs are expensed as incurred in accordance with ASC topic 730.\nTranslation of Foreign Currencies\nThe functional currency, as determined by management, is U.S. dollars, which is also our reporting currency. Transactions denominated in currencies other than U.S. dollars and the monetary value of assets and liabilities are remeasured at the period-end exchange rates. Revenue and expenses are measured at rates of exchange prevailing on the transaction dates. All of the exchange gains or losses resulting from these other transactions are recognized in the consolidated statements of operations and comprehensive loss.\nStock-Based Compensation\nWe measure the cost of equity-settled transactions by reference to the fair value of the equity instruments at the date at which they are granted if the fair value of the goods or services received by us cannot be reliably estimated.\nWe calculate stock-based compensation using the fair value method, under which the fair value of the options at the grant date is calculated using the Black-Scholes Option Pricing Model, and subsequently expensed over the vesting period of the option using the graded vesting method. The provisions of our stock-based compensation plans do not require us to settle any options by transferring cash or other assets, and therefore we classify the awards as equity. Stock-based compensation expense recognized during the period is based on the value of stock-based payment awards that ultimately are expected to vest. We estimate forfeitures at the time of grant and revise these estimates, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The expected term, which represents the period of time that options granted are expected to be outstanding, is estimated based on an average of the term of the options. The risk-free rate assumed in valuing the options is based on the US treasury yield curve in effect at the time of grant for the expected term of the option. The expected dividend yield percentage at the date of grant is nil as we are not expected to pay dividends in the foreseeable future.\nLoss Per Share\nBasic loss per share, or EPS, is computed by dividing the loss attributable to common shareholders by the weighted average number of common shares outstanding. Diluted EPS reflects the potential dilution that could occur from common shares issuable through the exercise or conversion of stock options, restricted stock awards, warrants, and convertible securities. In certain circumstances, the conversion of options, warrants, and convertible securities are excluded from diluted EPS if the effect of such inclusion would be anti-dilutive.\nThe dilutive effect of stock options is determined using the treasury stock method. Stock options and warrants to purchase our common shares issued during the period were not included in the computation of diluted EPS, as the effect would be anti-dilutive.\nComprehensive Loss\nWe follow ASC topic 220. This statement establishes standards for reporting and display of comprehensive (loss) income and its components. Comprehensive loss is net loss plus certain items that are recorded directly to shareholders' equity. We currently have no other comprehensive loss items.\n\n| 32 |\n\nResults of Operations\nThree and nine months ended September 30, 2020 compared to three and nine months ended September 30, 2019\nOur results of operations for the three and nine months ended September 30, 2020 and September 30, 2019 are as follows:\n\n| Three months ended September 30, | Nine months ended September 30, |\n| 2020 | 2019 | Change | 2020 | 2019 | Change |\n| $ | $ | $ | % | $ | $ | $ | % |\n| Expenses |\n| Research and development | 2,702,103 | 962,463 | 1,739,640 | 181 | % | 7,205,674 | 9,555,345 | (2,349,671 | ) | -25 | % |\n| General and administrative | 1,335,085 | 1,377,252 | (42,167 | ) | -3 | % | 3,607,346 | 5,490,928 | (1,883,582 | ) | -34 | % |\n| Professional fees | 839,646 | 306,937 | 532,709 | 174 | % | 1,413,118 | 1,296,884 | 116,234 | 9 | % |\n| Amortization - right-of-use asset | - | 127,345 | (127,345 | ) | -100 | % | 42,448 | 382,035 | (339,587 | ) | -89 | % |\n| Amortization - intangible | 45,399 | 273 | 45,126 | 16530 | % | 135,425 | 810 | 134,615 | 16619 | % |\n| Depreciation | 78,200 | 70,096 | 8,104 | 12 | % | 232,475 | 201,075 | 31,400 | 16 | % |\n| Loss from operations | 5,000,433 | 2,844,366 | 2,156,067 | 76 | % | 12,636,486 | 16,927,077 | (4,290,591 | ) | -25 | % |\n| Interest income | (21,238 | ) | - | (21,238 | ) | N/A | (21,566 | ) | - | (21,566 | ) | N/A |\n| Interest expense | - | - | - | N/A | 732 | 18,338 | (17,606 | ) | -96 | % |\n| Loss on property and equipment | - | - | - | N/A | 69,834 | 1,308 | 68,526 | 5239 | % |\n| Loss on right-of-use asset | - | - | - | N/A | 59,097 | - | 59,097 | N/A |\n| Gain on settlement of liabilities | - | - | - | N/A | - | (19,737 | ) | 19,737 | -100 | % |\n| Other income | (1,963 | ) | - | (1,963 | ) | N/A | (7,463 | ) | - | (7,463 | ) | N/A |\n| Foreign exchange gain | 2,743 | 1,313 | 1,430 | 109 | % | 1,462 | 30 | 1,432 | 4773 | % |\n| Loss before income taxes | 4,979,975 | 2,845,679 | 2,134,296 | 75 | % | 12,738,582 | 16,927,016 | (4,188,434 | ) | -25 | % |\n| Income tax expense | - | - | - | N/A | - | - | - | N/A |\n| Net loss and comprehensive loss | 4,979,975 | 2,845,679 | 2,134,296 | 75 | % | 12,738,582 | 16,927,016 | (4,188,434 | ) | -25 | % |\n\nRevenue\nWe did not generate any revenue during the three and nine months ended September 30, 2020 and September 30, 2019.\nResearch and Development\nResearch and development expense for the three months ended September 30, 2020 was approximately $2.7 million, compared to approximately $1.0 million for the three months ended September 30, 2019, an increase of approximately $1.7 million, or 181%. The increase primarily resulted from a milestone expense of $2.0 million pursuant to our development and supply agreement with Qorvo Biotechnologies, LLC. (“Qorvo”), offset in part by decreases in contracted expenditures, supplies, regulatory fees and consulting fees of approximately $237,000.\nResearch and development expense for the nine months ended September 30, 2020 was approximately $7.2 million, compared to approximately $9.6 million for the nine months ended September 30, 2019, a decrease of approximately $2.3 million, or 25%. The decrease primarily was due to a reduction in general research and development activity as we continue to focus on TRUFORMATM activities, and is more specifically related to contracted expenditures, milestone expenses, salaries, bonus and benefits, supplies, and consulting fees as compared to the commensurate period in 2019.\nGeneral and Administrative\nGeneral and administrative expense for the three months ended September 30, 2020 was approximately $1.3 million, compared to approximately $1.4 million for the three months ended September 30, 2019, a decrease of approximately $42,000, or 3%. The decrease resulted primarily from a decrease in travel and accommodation, marketing and investor relations, and other expenses of approximately $316,000, offset in part by increases in regulatory fees, rent expense, which is related to the reclassification of right-of-use asset expense from amortization to rent, salaries, bonus and benefits, insurance and office expense of approximately $274,000.\n\n| 33 |\n\nGeneral and administrative expense for the nine months ended September 30, 2020 was approximately $3.6 million, compared to approximately $5.5 million for the nine months ended September 30, 2019, a decrease of approximately $1.9 million, or 34%. The decrease primarily was due to a reduction in stock compensation expense of approximately $2.1 million compared to the prior period and a reduction in travel and accommodation, marketing and investor relations expenses, salary expense, and supplies of approximately $504,000. These decreases were offset in part by an increase in office expense associated with the expensing of furniture in the office space completed in the first quarter, rent expense which is related to the reclassification of right-of-use asset expense from amortization to rent, regulatory fees, and insurance expense of approximately $681,000.\nProfessional Fees\nProfessional fees for the three months ended September 30, 2020 were approximately $840,000, compared to approximately $307,000 for the three months ended September 30, 2019, an increase of $0.5 million, or 174%. The increase primarily was due to an increase in legal fees incurred in connection with our 2020 annual and special meeting and our proposed domestication into a Delaware corporation.\nProfessional fees for the nine months ended September 30, 2020 were approximately $1.4 million, compared to approximately $1.3 million for the nine months ended September 30, 2019, an increase of approximately $116,000, or 9%. The increase primarily was due to the reasons described in the prior paragraph.\nNet Loss\nOur net loss for the three months ended September 30, 2020 was approximately $5.0 million, or $0.01 per share, compared with a net loss of approximately $2.8 million, or $0.03 per share, for the three months ended September 30, 2019, an increase of approximately $2.1 million, or 75%. The net loss in each period was attributed to the matters described above.\nOur net loss for the nine months ended September 30, 2020 was approximately $12.7 million, or $0.04 per share, compared with a net loss of approximately $16.9 million, or $0.16 per share, for the nine months ended September 30, 2019, a decrease of approximately $4.2 million, or 25%. The net loss in each period was attributed to the matters described above. We expect to continue to record net losses in future periods until such time, if ever, as we have sufficient revenue from our products to offset our operating expenses.\nCash Flows\nThree and nine months ended September 30, 2020 compared to three and nine months ended September 30, 2019\nThe following table shows a summary of our cash flows for the periods set forth below:\n\n| Three months ended September 30, | Nine months ended September 30, |\n| 2020 | 2019 | Change | 2020 | 2019 | Change |\n| $ | $ | $ | % | $ | $ | $ | % |\n| Cash flows used in operating activities | (5,662,629 | ) | (3,910,078 | ) | (1,752,551 | ) | 45 | % | (13,556,283 | ) | (13,767,933 | ) | 211,650 | -2 | % |\n| Cash flows from financing activities | 28,592,833 | (1,414 | ) | 28,594,247 | -2022224 | % | 64,071,437 | 14,972,319 | 49,099,118 | 328 | % |\n| Cash flows from (used) in investing activities | (613 | ) | (582,437 | ) | 581,824 | -100 | % | 1,006,900 | (657,000 | ) | 1,663,900 | -253 | % |\n| Increase in cash | 22,929,591 | (4,493,929 | ) | 27,423,520 | -610 | % | 51,522,054 | 547,386 | 50,974,668 | 9312 | % |\n| Cash and cash equivalents, beginning of period | 29,103,049 | 6,981,580 | 22,121,469 | 317 | % | 510,586 | 1,940,265 | (1,429,679 | ) | -74 | % |\n| Cash and cash equivalents, end of period | 52,032,640 | 2,487,651 | 49,544,989 | 1992 | % | 52,032,640 | 2,487,651 | 49,544,989 | 1992 | % |\n\n\n| 34 |\n\nOperating Activities\nNet cash used in operating activities for the three months ended September 30, 2020 was approximately $5.7 million, compared to approximately $3.9 million for the three months ended September 30, 2019, an increase of approximately $1.8 million, or 45%. The increase resulted primarily from a higher net loss in the third quarter of 2020 compared to the third quarter of 2019. In addition, other operating uses of cash included approximately $1.1 million of deposits and prepaid expenses for inventory, insurance, and property tax paid, offset in part by an increase in of accounts payable of approximately $100,000.\nNet cash used in operating activities for the nine months ended September 30, 2020 was approximately $13.6 million, compared to approximately $13.8 million for the nine months ended September 30, 2019, a decrease of approximately $212,000, or 2%. The decrease resulted primarily from a lower net loss for the nine months ended September 30, 2020 compared to the comparable period of 2019. In addition, other operating uses of cash include a reduction in accounts payable of approximately $799,000, more than offset by non-cash items including stock compensation expense of approximately $2.5 million, and expense recorded for the issuance of stock for services, amortization of right-of-use asset, and depreciation of approximately $1.4 million.\nFinancing Activities\nNet cash from financing activities for the three months ended September 30, 2020 was approximately $28.6 million, compared to a use of cash of approximately $1,400 for the three months ended September 30, 2019, an increase of approximately $28.6 million. The increase resulted primarily from the sale of our equity securities during the third quarter of 2020 for total gross proceeds of approximately $30.0 million and proceeds from warrant exercises of approximately $864,000, offset in part by stock issuance costs of approximately $2.2 million.\nNet cash from financing activities for the nine months ended September 30, 2020 was approximately $64.0 million, compared to approximately $15.0 million for the nine months ended September 30, 2019, an increase of approximately $49.1 million, or 328%. The increase resulted primarily from the sale of our equity securities during the nine months ended September 30, 2020 for total gross proceeds of approximately $56.5 million, proceeds from warrant exercises of approximately $12.1 million, and approximately $527,000 in loan proceeds from the SBA’s Paycheck Protection Program, offset in part by stock issuance costs of approximately $5.1 million.\nInvesting Activities\nNet cash used in investing activities for the three months ended September 30, 2020 was approximately $1,000, compared to approximately $582,000 for the three months ended September 30, 2019, a decrease of approximately $582,000, or 100%. Cash used in the 2020 period related to enhancements to our finance and accounting software used in the buying and selling of inventory, whereas cash used in the 2019 period included the addition of the website.\nNet cash from investing activities for the nine months ended September 30, 2020 was approximately $1.0 million, compared to net cash used of approximately $657,000 for the nine months ended September 30, 2019, an increase of approximately $1.7 million, or 253%. The increase in net cash from investing activities during the nine months ended September 30, 2020 related primarily to approximately $1.0 million of cash received in connection with the cancellation and buyout of our office lease compared to the prior period in which approximately $700,000 was used in association with the digital data platform, the construction of marketing assets, and the capitalization of integration costs associated with the implementation of an ERP system.\nLiquidity and Capital Resources\nWe have incurred losses and negative cash flows from operations and have not generated any revenue since our inception in May 2015. As of September 30, 2020, we had an accumulated deficit of approximately $64.7 million. We have funded our working capital requirements primarily through the sale of our securities and the exercise of stock options and warrants.\n\n| 35 |\n\nAs of September 30, 2020, the Company had cash of approximately $52.0 million, prepaid expenses and deposits of approximately $932,000, and accounts receivable of approximately $129,000. Current assets amounted to approximately $53.1 million, with current liabilities of approximately $2.1 million, resulting in working capital (defined as current assets minus current liabilities) of approximately $51.0 million.\nAs of September 30, 2020, we had shareholders’ equity of approximately $53.4 million.\nAs of November 11, 2020, we had cash of approximately $50.0 million.\nOn October 17, 2017 we entered into a five-year $5.0 million unsecured working capital facility with Equidebt LLC, one of our shareholders (the “Equidebt Facility”). Amounts borrowed under the Equidebt Facility bear interest at a rate of 14% per annum payable at maturity. All amounts borrowed under the Equidebt Facility become due and payable on October 17, 2022. We can make two borrowings per month under the Equidebt Facility, each of which must be for a minimum of $250,000. The Equidebt Facility is unsecured. As of September 30, 2020, no amounts have been borrowed against this facility.\nWe believe that our existing cash resources will be sufficient to fund our expected working capital needs through December 2022. If we raise additional funds by issuing equity securities, our existing security holders will likely experience dilution, and the incurring of indebtedness would result in increased debt service obligations and could require us to agree to operating and financial covenants that could restrict operations. In the event that we are unable to obtain sufficient capital to meet our working capital requirements, we may be required to change or curtail current or planned operations in order to conserve cash until such time, if ever, that sufficient proceeds from operations are generated. In such an event, we may not be able to take advantage of business opportunities and may have to terminate or delay safety and efficacy studies, curtail our product development programs, or sell or assign rights to our product candidates, products and technologies.\nOur future capital requirements depend on many factors, including, but not limited to:\n\n| · | the scope, progress, results and costs of researching and developing our current and future diagnostics and medical device products; |\n\n\n| · | the extent to which any of our future diagnostic assays or medical devices may be subject to USDA-CVB pre-market regulation; |\n\n\n| · | the timing of, and the costs involved in, obtaining regulatory approvals for any of our existing or future diagnostics or medical device products; |\n\n\n| · | the number and characteristics of the diagnostics and/or medical device products we pursue; |\n\n\n| · | the cost of manufacturing our existing and future diagnostic and medical device products and any additional products we seek to commercialize; |\n\n\n| · | the cost of commercialization activities, including marketing, sales and distribution costs; |\n\n\n| · | the expenses needed to attract and retain skilled personnel; |\n\n\n| · | the costs associated with being a public company; |\n\n\n| · | our ability to establish and maintain strategic partnerships, licensing or other arrangements and the financial terms of such agreements; and |\n\n\n| · | the costs involved in preparing and filing patent applications, maintaining any successfully obtained patents and protecting and enforcing any such patents. |\n\n\n| 36 |\n\nOff Balance Sheet Arrangements\nSince inception, we have not engaged in the use of any off-balance sheet arrangements, such as structured finance entities, special purpose entities, or variable interest entities.\nOutstanding Share Data\nThe only class of outstanding voting or equity securities of the Company are the common shares. As of November 11, 2020:\n\n| · | there are 564,051,438 common shares issued and outstanding; |\n\n\n| · | there are stock options outstanding under our Stock Option Plan to acquire an aggregate of 13,024,640 common shares; and |\n\n\n| · | there are common share purchase warrants (collectively, the “February Warrants”) outstanding to acquire an aggregate of 21,875,001 common shares, which February Warrants were issued in connection with an offering completed by the Company on February 14, 2020 (which has been described in a Form 8-K dated February 12, 2020). Of these February Warrants, 20,833,334 are Series A Warrants exercisable for a cash price of $0.20 per share, and 1,041,667 are Series A Placement Agent Warrants exercisable for a cash price of $0.15 per share. |\n\n\n| · | there were common share purchase warrants (collectively, the “April Warrants”) outstanding to acquire an aggregate of 18,333,334 common shares, which April Warrants were issued in connection with an offering completed by the Company on April 9, 2020 (which has been described in a Form 8-K dated April 7, 2020). Of these April Warrants, 16,666,667 are Series B Warrants, 1,666,667 are Series B Placement Agent Warrants, and all are exercisable for a cash price of $0.15 per share. There are currently 6,731,250 April Warrants outstanding to acquire an aggregate of 6,731,250 common shares. |\n\n\n| · | there were common share purchase warrants (collectively, the “May Warrants”) outstanding to acquire an aggregate of 145,503,333 common shares, which May Warrants were issued in connection with an offering completed by the Company on May 29, 2020 (which has been described in a registration statement on Form S-1 (File No. 333-238322) filed on May 26, 2020). Of these May Warrants, 133,333,333 are Series C Warrants, all exercisable for a cash price of $0.15 per share, and 12,170,000 are Pre-funded Warrants, all of which have now been exercised. There are currently 63,899,362 Series C Warrants outstanding to acquire an aggregate of 63,899,362 common shares. |\n\n\n| · | the there were common share purchase warrants (collectively, the “July Warrants”) outstanding to acquire an aggregate of 212,500,000 common shares, which July Warrants were issued in connection with an offering completed by the Company on July 7, 2020 (which has been described in a Form 8-K dated July 6, 2020). Of these July Warrants, 187,500,000 are Series D Warrants, all exercisable for a cash price of $0.16 per share, and 25,000,000 are Pre-funded Warrants, all of which have now been exercised. There are currently 187,500,000 Series D Warrants outstanding to acquire an aggregate of 187,500,000 common shares. |\n\n\n| · | All of the currently outstanding warrants also have a “cashless exercise” feature which is applicable in certain circumstances. The cashless exercise feature could result in the potential issuance of common shares based upon the “in-the-money” value of the applicable warrants at the time of exercise of the applicable warrants. The number of the common shares that may be issued is not determinable. However, the number of common shares that are issuable is based upon a formula contained in the applicable warrants, which determines the number of common shares issuable by dividing the “in-the-money” value (based upon the then current market price, as provided in the applicable warrants) by the then current market price, and multiplying this result by the number of common shares that are issuable under the applicable warrants pursuant to cash exercise. |\n\n\n| 37 |\n\n\nItem 3. Quantitative and Qualitative Disclosures About Market Risk.\nNot applicable.\n\nItem 4. Controls and Procedures.\nDisclosure Controls and Procedures\nEvaluation of Our Disclosure Controls\nWe maintain disclosure controls and procedures that are designed to provide reasonable assurance that material information required to be disclosed in our periodic reports filed under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms and to provide reasonable assurance that such information is accumulated and communicated to our management, our chief executive officer and our chief financial officer, to allow timely decisions regarding required disclosure. We carried out an evaluation, under the supervision and with the participation of our management, including our principal executive and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rule 13(a)-15(e) under the Exchange Act. Based on this evaluation, our principal executive officer and principal financial officer concluded that, as of September 30, 2020, our disclosure controls and procedures were effective.\nManagement’s Report on Internal Control Over Financial Reporting\nOur management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on criteria established in the framework in “Internal Control — Integrated Framework (2013)” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, our management concluded that our internal control over financial reporting was effective as of September 30, 2020.\nPART II — OTHER INFORMATION\n\nItem 1. Legal Proceedings.\nOn November 1, 2019, Heska Corporation (“Heska”) filed a complaint for damages and injunctive relief (the “Complaint”) in the United States District Court for the Middle District of North Carolina, Case 1:19-cv-01108-LCB-JLW, against Qorvo US, Inc. (“Qorvo US”), Qorvo Biotechnologies, LLC (“Qorvo Biotech” and, together with Qorvo US, “Qorvo”) and us (collectively with Qorvo, the “Defendants”) which was amended on November 22, 2019. The amended Complaint alleges, among other things, that the Defendants improperly obtained Heska’s trade secrets and confidential information and/or conspired to use improper means to misappropriate Heska’s trade secrets related to an instrument and related consumable products for performing immunoassay analysis of biomarkers and other substances. The amended Complaint seeks compensatory and exemplary damages, as well as preliminary and permanent injunctive relief to prevent the Defendants from commercializing our TRUFORMATM diagnostic instrument. On January 21, 2020, the Defendants filed a motion seeking dismissal of the Complaint. On February 11, 2020, Heska filed its response to the Defendants’ motion to dismiss to which the Defendants responded on February 25, 2020. Heska subsequently moved to strike a portion of the Defendants’ response. On September 30, 2020, the court denied the Defendants’ motion to dismiss and granted Heska’s motion to strike. On October 14, 2020 the Defendants filed their answer to the amended Complaint. We believe that the allegations in the amended Complaint have no merit and will not have a material adverse effect on our business, results of operations or financial condition.\nUnder the terms of the Development and Supply Agreement, dated November 26, 2018, by and between Qorvo Biotech and the Company (as amended, the “Qorvo Agreement”), Qorvo Biotech agreed to indemnify us and certain related parties against claims alleging infringement or misappropriation of third-party intellectual property rights, subject to certain limitations and exceptions. Qorvo Biotech has notified us that Qorvo Biotech has assumed the defense of the amended Complaint and will indemnify us for losses arising from the amended Complaint in accordance with the terms of the Qorvo Agreement. Qorvo Biotech has further advised us that it intends to mount a vigorous defense to the claims in the amended Complaint, and that it believes the allegations contained in the amended Complaint are without merit.\n\n| 38 |\n\n\nItem 1A.\nRisk Factors.\nRISK FACTORS\nAs used below, “Corporation” refers to Zomedica Corp., an Alberta corporation.\nRisks Relating to Our Proposed Domestication\nWhile we believe the domestication will be tax-free to U.S. Holders(as defined below) for U.S. federal income tax purposes, if the Internal Revenue Service (“IRS”) does not agree with our calculation of the “all earnings and profits amount” attributable to a holder’s shares in the Corporation, Zomedica Corp.’s U.S. Holders may owe U.S. federal income taxes as a result of the domestication under Section 367(b) of the United States Internal Revenue Code of 1986, as amended (the “Code”).\nCode Section 367(b) has the effect of potentially imposing income tax on U.S. Holders (as defined below) in connection with the domestication. Pursuant to the Treasury Regulations under Code Section 367(b), any 10% Shareholder (as defined below) will have to recognize a deemed dividend on the domestication equal to the “all earnings and profits amount,” within the meaning of Treasury Regulations Section 1.367(b)-2, attributable to such U.S. Holder’s shares in the Corporation. Any U.S. Holder that is not a 10% Shareholder and whose shares have a fair market value of less than $50,000 on the date of the domestication will recognize no gain or loss pursuant to Code Section 367(b) as a result of the domestication. A U.S. Holder that is not a 10% Shareholder but whose shares have a fair market value of at least $50,000 on the date of the domestication must generally recognize gain (but not loss) on the domestication equal to the difference between the fair market value of the Zomedica Corp. stock received at the time of the domestication over the U.S. Holder’s tax basis in the Corporation’s shares. Such a holder, however, instead of recognizing gain, may elect to include in income as a deemed U.S. dividend the “all earnings and profits amount” attributable to such holder’s shares in the Corporation, which we refer to as a “Deemed Dividend Election.”\nAs used herein, the term ‘‘U.S. Holder’’ means a beneficial owner of shares or warrants of the Corporation or stock or warrants of Zomedica Corp. that is for U.S. federal income tax purposes:\n\n| · | a citizen or resident of the United States; |\n\n\n| · | a corporation (including any entity treated as a corporation for U.S. federal income tax purposes) created or organized under the laws of the United States, any state thereof, or the District of Columbia; |\n\n\n| · | an estate the income of which is taxable in the United States regardless of its source; or |\n\n\n| · | a trust, the administration of which is subject to the primary supervision of a U.S. Court and one or more United States persons (within the meaning of Section 7701(a)(30)) have the authority to control all substantial decisions of the trust, or that has a valid election in effect under applicable Treasury Regulations to be treated as a United States person. |\n\nAs used herein, the term “10% Shareholders” means U.S. Holders who own, directly or by attribution, ten percent (10%) or more of the total voting power of the Corporation’s all classes of shares or ten percent (10%) or more of the total value of shares of all classes of stock of the Corporation.\nBased on the Corporation’s limited activity at the holding company level and the size of the Corporation’s existing earnings and profits deficit, we believe that no U.S. Holder should have a positive ‘‘all earnings and profits amount’’ attributable to such holder’s shares in the Corporation, and accordingly no 10% Shareholder or U.S. Holder who makes a Deemed Dividend Election should be required to include any such amount in income on the domestication. Our belief with respect to the “all earnings and profits amount” results from calculations performed by our accounting firm based on information provided to them by us. However, no assurance can be given that the IRS will agree with us. If it does not agree, then a U.S. Holder may be subject to adverse U.S. federal income tax consequences.\n\n| 39 |\n\nWhile we believe the domestication will be tax-free to U.S. Holders for U.S. federal income tax purposes, if proposed Treasury Regulations under Code Section 1291(f) are finalized in their current form, Zomedica Corp.’s U.S. Holders may owe U.S. federal income taxes as a result of the domestication under the rules applicable to a passive foreign investment company (“PFIC”).\nThe Corporation believes that it is likely a PFIC for U.S. federal income tax purposes. In the event that the Corporation is considered a PFIC, then proposed Treasury Regulations under Code Section 1291(f) (which were promulgated in 1992 with a retroactive effective date), if finalized in their current form, generally would require a U.S. Holder to recognize gain on the exchange of equity securities of the Corporation for equity securities of Zomedica Corp. pursuant to the domestication. The tax on any such gain so recognized would be imposed at the rate applicable to ordinary income and an interest charge would apply based on a complex set of computational rules designed to offset the tax deferral to such U.S. Holders on the Corporation’s undistributed earnings. Any “all earnings and profits amount” included in income by a U.S. Holder as a result of the domestication generally would be treated as gain subject to these rules. However, it is difficult to predict whether, in what form and with what effective date final Treasury Regulations under Code Section 1291(f) will be adopted. U.S. Holders that make or have made certain elections with respect to their common shares of the Corporation are generally not subject to the same gain recognition rules under the current proposed Treasury Regulations.\nThe rights of our shareholders under Canadian law will differ from their rights under Delaware law, which will, in some cases, provide less protection to shareholders following the domestication.\nUpon consummation of the domestication, our shareholders will become stockholders of a Delaware corporation. There are material differences between the Alberta Business Corporations Act (the “ABCA”) and the Delaware General Corporations Law (the “DGCL”) and our current and proposed charter and bylaws. For example, under Canadian law, many significant corporate actions such as amending a corporation’s articles of incorporation, effecting a share consolidation or consummating a merger require the approval of two-thirds of the votes cast by shareholders, whereas under Delaware law, a majority of the total voting power of all of those entitled to vote may approve the matter. Furthermore, shareholders under Canadian law are entitled to dissent and appraisal rights under a number of extraordinary corporate actions, including an amalgamation with another unrelated corporation, certain amendments to a corporation’s articles of incorporation or the sale of all or substantially all of a corporation’s assets; under Delaware law, stockholders are entitled to dissent and appraisal rights for certain specified corporate transactions such as mergers or consolidations. If the domestication is approved, shareholders may be afforded less protection under the DGCL than they had under the ABCA in certain circumstances.\nThe proposed domestication will result in additional direct and indirect costs whether or not it is completed.\nThe domestication will result in additional direct costs. We will incur attorneys’ fees, accountants’ fees, filing fees, mailing expenses and financial printing expenses in connection with the domestication. The domestication will also temporarily divert the attention of our management and employees from the day-to-day management of the business to a limited extent.\nThe amount of corporate tax payable by us will be affected by the value of our property on the date of the domestication.\nFor Canadian tax purposes, on the date of the domestication we will be deemed to have a year end and to have disposed of all of our property for proceeds equal to the fair market value of those properties. We will also be subject to an additional corporate emigration tax imposed on the amount, if any, by which the fair market value of our property, net of certain liabilities, exceeds the paid-up capital of our issued and outstanding shares. We have completed certain calculations of our tax accounts with the assistance of tax advisors, and we have estimated that the domestication will not result in any Canadian tax liability.\n\n| 40 |\n\nProvisions in Zomedica Corp.’s certificate of incorporation and bylaws and Delaware law might discourage, delay or prevent a change of control of our company or changes in our management and, therefore, depress the trading price of our common stock.\nZomedica Corp.’s certificate of incorporation and bylaws will contain provisions that could depress the trading price of our common stock by acting to discourage, delay or prevent a change in control of our company or changes in our management that the stockholders of our company may deem advantageous. These provisions:\n\n| · | establish a classified board of directors so that not all members of our board are elected at one time; |\n\n\n| · | provide that directors may only be removed ‘‘for cause;’’ |\n\n\n| · | authorize the issuance of ‘‘blank check’’ preferred stock that our board of directors could issue from time to time to increase the number of outstanding shares and discourage a takeover attempt; |\n\n\n| · | eliminate the ability of our stockholders to call special meetings of stockholders; |\n\n\n| · | prohibit stockholder action by written consent, which has the effect of requiring all stockholder actions to be taken at a meeting of stockholders; |\n\n\n| · | provide that the board of directors is expressly authorized to make, alter or repeal our bylaws; |\n\n\n| · | establish advance notice requirements for nominations for election to our board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings; and |\n\n\n| · | require supermajority approvals to remove the protective provisions in our certificate of incorporation and bylaws listed above or to amend our bylaws. |\n\nSuch provisions could impede any merger, consolidation, takeover or other business combination involving the company or discourage a potential acquirer from making a tender offer or otherwise attempting to obtain control of the company.\nThe certificate of incorporation of Zomedica Corp. will designate the Court of Chancery of the State of Delaware as the sole and exclusive forum for certain types of actions and proceedings that may be initiated by Zomedica Corp.’s stockholders, which could limit the ability of Zomedica Corp.’s stockholders to obtain a favorable judicial forum for disputes with us or our directors, officers or other employees.\nThe certificate of incorporation of Zomedica Corp. will require that, unless we consent in writing to the selection of an alternative forum:\n\n| · | any derivative action or proceeding brought on our behalf; |\n\n\n| · | any action asserting a claim of breach of any fiduciary duty owed by any current or former director, officer, other employee or stockholder of ours to our company or our stockholders; |\n\n\n| · | any action asserting a claim arising pursuant to any provision of the DGCL, our certificate of incorporation or bylaws or as to which the DGCL confers jurisdiction on the Court of Chancery of the State of Delaware; or |\n\n\n| · | any action asserting a claim governed by the internal affairs doctrine; |\n\n\n| 41 |\n\nthe Court of Chancery of the State of Delaware will, to the fullest extent permitted by law, be the exclusive forum or if the Court of Chancery of the State of Delaware does not have subject matter jurisdiction thereof, the federal district court of the State of Delaware.\nFurthermore, Section 22 of the Securities Act of 1933, as amended (the “Securities Act”) creates concurrent jurisdiction for federal and state courts over all such Securities Act actions. Accordingly, both state and federal courts have jurisdiction to entertain such claims. To prevent having to litigate claims in multiple jurisdictions and the threat of inconsistent or contrary rulings by different courts, among other considerations, Zomedica Corp.’s certificate of incorporation will provide that the federal district courts of the United States of America will be the exclusive forum for resolving any complaint asserting a cause of action arising under the Securities Act.\nThe exclusive forum provisions described above will not apply to claims arising under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). While the Delaware courts have determined that such choice of forum provisions are facially valid, a stockholder may nevertheless seek to bring such a claim arising under the Securities Act against Zomedica Corp., its directors, officers, or other employees in a venue other than in the federal district courts of the United States of America. In such instance, we would expect to vigorously assert the validity and enforceability of the exclusive forum provisions of Zomedica Corp.’s certificate of incorporation.\nAlthough we believe this provision benefits Zomedica Corp. by providing increased consistency in the application of Delaware law in the types of lawsuits to which it applies, this provision may limit or discourage a stockholder’s ability to bring a claim in a judicial forum that it finds favorable for disputes with Zomedica Corp. or its directors, officers or other employees, which may discourage such lawsuits against Zomedica Corp. and its directors, officers and other employees. Alternatively, if a court were to find the choice of forum provision contained in the certificate of incorporation to be inapplicable or unenforceable in an action, Zomedica Corp. may incur additional costs associated with resolving such action in other jurisdictions, which could adversely affect its business and financial condition.\nWe note that there is uncertainty as to whether a court would enforce the provision and that investors cannot waive compliance with the federal securities laws and the rules and regulations thereunder. Although we believe this provision will benefit Zomedica Corp. by providing increased consistency in the application of Delaware law in the types of lawsuits to which it applies, the provision may have the effect of discouraging lawsuits against Zomedica Corp.’s directors and officers.\nThe anticipated benefits of the domestication may not be realized.\nWe may not realize the benefits we expect from the domestication. If we do not, we will have expended considerable resources and management efforts in completing the domestication without benefiting the company or our shareholders. Such expenditure of time and resources would adversely affect our business, operating results, and financial condition if the anticipated benefits are not achieved.\nRisks Related to our Business\nWe have a limited operating history, are not profitable and may never become profitable.\nWe have not generated any revenue to date, and we expect to continue to incur significant research and development costs and other expenses. Our net loss and comprehensive loss for (i) the three months ended September 30, 2020 and September 30, 2019 was approximately $5.0 million and $2.8 million, respectively, (ii) for the nine months ended September 30, 2020 and September 30, 2019 was approximately $12.7 million and $16.9 million, respectively, and (iii) for the years ended December 31, 2019 and December 31, 2018 was approximately $19.8 million and $16.6 million, respectively. Our accumulated deficit as of September 30, 2020 was approximately $64.7 million. As of September 30, 2020, we had total shareholders' equity of approximately $53.4 million. We expect to continue to incur losses for the foreseeable future, as we continue our product development and commercialization activities. Even if we succeed in developing and broadly commercializing one or more of our product candidates, we expect to continue to incur losses for the foreseeable future, and we may never become profitable. If we fail to achieve or maintain profitability, then we may be unable to continue our operations at planned levels and be forced to reduce or cease operations.\n\n| 42 |\n\nWe may need to raise additional capital to achieve our goals.\nWe do not have any products available for sale at this time. Although we believe that we do not require pre-market approval from the U.S. Food and Drug Administration’s Center for Veterinary Medicine, or the FDA-CVM, or the United States Department of Agriculture Animal and Health Inspection Service’s Center for Veterinary Biologics, or USDA-CVB, to market and sell TRUMFORMATM , our Raman spectroscopy-based point-of-care diagnostic platform, nor our circulating tumor cell, or CTC, diagnostic assay that we are developing, the COVID-19 pandemic has impacted our expected timing for the development and commercialization of our TRUFORMA™ platform and the five initial assays.\nWe are also seeking to identify potential complementary opportunities in the animal health sectors. We will continue to expend substantial resources for the foreseeable future to develop our existing products and any other product that we may develop or acquire. These expenditures will include: costs of developing and validating our diagnostic products and related assays and consumables; costs associated with conducting any required clinical trials; costs associated with completing other research and development activities; costs of identifying additional potential products; costs associated with payments to technology licensors and maintaining other intellectual property; costs of obtaining regulatory approvals; costs associated with securing contract manufacturers to meet our commercial manufacturing and supply capabilities; and costs associated with marketing and selling our products. In addition, our existing and future development agreements may require us to make significant cash milestone payments to our development partners and to pay certain development costs. We will not control the timing of these payments. We also may incur unanticipated costs. Because the outcome of our development activities and commercialization efforts is inherently uncertain, the actual amounts necessary to successfully complete the development and commercialization of our existing or future products may be greater or less than we anticipate.\nAs a result, we may need to obtain additional capital to fund the development of our business. Except for our unsecured working capital line we have no existing agreements or arrangements with respect to any financings, and any such financings may result in dilution to our shareholders, the imposition of debt covenants and repayment obligations or other restrictions that may adversely affect our business or the value of our common shares.\nOur future capital requirements depend on many factors, including, but not limited to:\n\n| · | the scope, progress, results and costs of researching and developing our existing or future diagnostics and medical device products; |\n\n\n| · | the extent to which any of our future diagnostic assays or medical devices may be subject to USDA-CVB pre-market regulation; |\n\n\n| · | the timing of, and the costs involved in, obtaining regulatory approvals for any of our existing or future diagnostics or medical device products; |\n\n\n| · | the number and characteristics of the diagnostics and/or medical device products we pursue; |\n\n\n| · | the cost of contract manufacturers to manufacture our existing and future diagnostic and medical device products and any additional products we seek to commercialize; |\n\n\n| · | the cost of commercialization activities, including marketing, sales and distribution costs; |\n\n\n| · | the expenses needed to attract and retain skilled personnel; |\n\n\n| · | the costs associated with being a public company; |\n\n\n| 43 |\n\n\n| · | our ability to establish and maintain strategic partnerships, licensing or other arrangements and the financial terms of such agreements; and |\n\n\n| · | the costs involved in preparing and filing patent applications, maintaining any successfully obtained patents and protecting and enforcing any such patents. |\n\nAdditional funds may not be available when we need them on terms that are acceptable to us, or at all. If adequate funds are not available to us on a timely basis, we may be required to delay, limit, reduce or terminate one or more of our product development programs or any future commercialization efforts.\nThe “Novel Coronavirus Disease 2019” (“COVID-19”) pandemic has materially and adversely affected the development and commercialization of our TRUFORMA™ platform.\nThe COVID-19 pandemic materially and adversely affected the development and commercialization of our TRUFORMA™ platform and the initial five assays. In response to the pandemic, our development partner had reduced the number of employees working in its facilities for a period of time which has delayed the completion of the verification of the five initial TRUFORMA™ assays and the manufacturing of commercial quantities of the TRUFORMA™ platform and the related assays. Veterinary hospitals and clinics that had agreed to participate in the validation of our initial TRUFORMA™ assays either shut down for a period of time or limited their operations to those involving only life-threatening conditions, which we have mitigated to a certain extent with our recent ability to successfully complete remote installations. Potential customers have at times restricted access to their facilities which has affected and may continue to affect our ability to perform on-site demonstrations and other marketing activities. The extent to which the COVID-19 pandemic may impact our business will depend on future developments, which are highly uncertain and cannot be predicted with confidence, such as the duration of the outbreak, the spread and severity of COVID-19, and the effectiveness of governmental actions in response to the pandemic.\nThe COVID-19 outbreak has disrupted our development partners and the COVID-19 pandemic, and any future outbreak of a health epidemic or other adverse public health developments could materially and adversely affect our business and operating results.\nThe COVID-19 outbreak disrupted our development partners and the COVID-19 pandemic, and any future outbreak of a health epidemic or other adverse public health developments could materially and adversely affect our business and operating results. For example, our development partner for our TRUFORMA™ platform and the related assays had reduced the number of employees working in its facility which significantly impacted our expected timing for the completion of the development and the commencement of the commercialization of our TRUFORMA™ platform and the related assays. If our suppliers are unable or fail to fulfill their obligations to us for any reason, we may not be able to manufacture our products and satisfy customer demand or our obligations under sales agreements in a timely manner, and our business could be harmed as a result. As noted above, there is continuing uncertainty relating to the potential effect of COVID-19 on our business. Infections may become more widespread and should that cause supply disruptions it would have a negative impact on our business, financial condition and operating results. In addition, a significant health epidemic could adversely affect the economies and financial markets of many countries, resulting in an economic downturn that could affect the market for our products, which could have a material adverse effect on our business, operating results and financial condition.\nThe COVID-19 pandemic and any future outbreak of a health epidemic or other adverse public health developments could materially and adversely affect the sales of our products.\nThe COVID-19 pandemic resulted in a significant spike in unemployment and a concomitant decline in economic activity in the U.S. and many other countries. A worsening of the COVID-19 pandemic, any future outbreak of a health epidemic or other adverse public health developments may have similar effects. Pet owners may be unwilling or unable to seek treatment for their pets in such circumstances, thereby decreasing demand for our products. In addition, as noted above, potential customers for our products have either shut down or limited their operations which has affected and may continue to affect our ability to perform on-site demonstrations and other marketing activities. Potential customers also may be unwilling or unable to invest in new equipment or to introduce new treatments for their patients. As a result, the COVID-19 pandemic and any future outbreak of a health epidemic or other adverse public health developments could materially and adversely affect the sales of our products.\n\n| 44 |\n\nThe audit opinion on our financial statements contains a going concern modification.\nAs a result of our recurring losses from operations and our accumulated deficit, the opinion of our independent registered public accountants on our financial statements as of and for the year ended December 31, 2019 contains a going concern modification. If we are unable to continue as a going concern, we might have to liquidate our assets and the values we receive for our assets in liquidation or dissolution could be significantly lower than the values reflected in our financial statements. In addition, the inclusion of a going concern modification by our independent registered public accountants, our recurring losses, our accumulated deficit and our potential inability to continue as a going concern may materially adversely affect our share price and our ability to raise new capital or to enter into contractual relationships with third parties.\nWe have generated net operating loss carryforwards for U.S. income tax purposes, but our ability to use these net operating losses may be limited by our inability to generate future taxable income.\nOur U.S. businesses have generated consolidated net operating loss carryforwards (“U.S. NOLs”) for U.S. federal and state income tax purposes of approximately $16.1 million as of December 31, 2019. These U.S. NOLs can be available to reduce income taxes that might otherwise be incurred on future U.S. taxable income. The utilization of these U.S. NOLs would have a positive effect on our cash flow. However, there can be no assurance that we will generate the taxable income in the future necessary to utilize these U.S. NOLs and realize the positive cash flow benefit. A portion of our U.S. NOLs have expiration dates. There can be no assurance that, if and when we generate taxable income in the future from operations or the sale of assets or businesses, we will generate such taxable income before such portion of our U.S. NOLs expire. Under the Tax Cuts and Jobs Act (the “TCJA”), federal NOLs generated in tax years ending after December 31, 2017 may be carried forward indefinitely. Under the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), federal NOL carryforwards arising in tax years beginning after December 31, 2017 and before January 1, 2021 may be carried back to each of the five tax years preceding the tax year of such loss. Due to our cumulative losses through September 30, 2020 we do not anticipate that such provision of the CARES Act will be relevant to us. The deductibility of federal NOLs, particularly for tax years beginning after December 31, 2020, may be limited. It is uncertain if and to what extent various states will conform to TCJA or the CARES Act.\nWe have generated U.S. NOLs, but our ability to reserve and use these U.S. NOLs may be limited or impaired by future ownership changes.\nOur ability to utilize the U.S. NOLs after an “ownership change” is subject to the rules of Code Section 382. An ownership change occurs if, among other things, the shareholders (or specified groups of shareholders) who own or have owned, directly or indirectly, five (5%) percent or more of the value of our shares or are otherwise treated as five (5%) percent shareholders under Code Section 382 and the Treasury Regulations promulgated thereunder increase their aggregate percentage ownership of the value of our shares by more than 50 percentage points over the lowest percentage of the value of the shares owned by these shareholders over a three-year rolling period. An ownership change could also be triggered by other activities, including the sale of our shares that are owned by our five (5%) shareholders. In the event of an ownership change, Section 382 would impose an annual limitation on the amount of taxable income we may offset with U.S. NOLs. This annual limitation is generally equal to the product of the value of our shares on the date of the ownership change multiplied by the long-term tax-exempt rate in effect on the date of the ownership change. The long-term tax-exempt rate is published monthly by the IRS. Any unused Section 382 annual limitation may be carried over to later years until the applicable expiration date for the respective U.S. NOLs (if any). In the event an ownership change as defined under Section 382 were to occur, our ability to utilize our U.S. NOLs would become substantially limited. The consequence of this limitation would be the potential loss of a significant future cash flow benefit because we would no longer be able to substantially offset future taxable income with U.S. NOLs. There can be no assurance that such ownership change will not occur in the future.\n\n| 45 |\n\nWe are substantially dependent on the success of our TRUMFORMATM platform and cannot be certain that it will be successfully commercialized.\nWe are focused primarily on the development of our TRUMFORMATM diagnostic platform and the related assays. Accordingly, our near-term prospects, including our ability to generate material product revenue, or enter into potential strategic transactions, will depend heavily on the successful development and commercialization of this product and the related assays, which in turn will depend on a number of factors, including the following:\n\n| · | the successful completion of clinical validation and verification of our TRUMFORMATM diagnostic platform and the related assays, which may take significantly longer than we anticipate and will depend, in part, upon the satisfactory performance of our strategic partner and third-party contractors; |\n\n\n| · | the ability of our strategic partner to manufacture supplies of our TRUMFORMATM diagnostic instrument and the related assays and to develop, validate and maintain viable commercial manufacturing processes that are compliant with Good Manufacturing Practices, or GMP, to the extent applicable; |\n\n\n| · | our ability to successfully market our TRUMFORMATM diagnostic platform and the related assays, whether alone or in partnership with others; |\n\n\n| · | the availability, perceived advantages, relative cost, relative safety and relative efficacy of TRUMFORMATM diagnostic platform and the related assays compared to alternative and competing products; |\n\n\n| · | the acceptance of our TRUMFORMATM diagnostic platform and the related assays by veterinarians, pet owners and the animal health community; |\n\n\n| · | our ability to achieve and maintain compliance with all regulatory requirements applicable to our business; and |\n\n\n| · | our ability to obtain and enforce intellectual property rights, and avoid or prevail in any third-party patent interference, patent infringement claims or administrative patent proceedings initiated by third parties or the United States Patent and Trademark Office (“USPTO”). |\n\nMany of these factors are beyond our control. Accordingly, we cannot assure you that we will be successful in developing or commercializing our TRUMFORMATM diagnostic platform and the related assays or any of our future products. If we are unsuccessful or are significantly delayed in developing and commercializing our products, our business and prospects will be materially adversely affected, and you may lose all or a portion of your investment.\nWe face unproven markets for our products.\nThe companion animal diagnostic and medical device markets are less developed than the related human markets and as a result no assurance can be given that our products will be successful. Veterinarians, pet owners or other veterinary health providers in general may not accept or utilize any products that we may develop. The companion animal care industry is characterized by rapid technological changes, frequent new product introductions and enhancements, and evolving industry standards, all of which could make our products obsolete. Our future success will depend on our ability to keep pace with the evolving needs of our customers on a timely and cost-effective basis and to pursue new market opportunities that develop as a result of technological and scientific advances. We must continuously enhance our product offerings to keep pace with evolving standards of care. If we do not update our product offerings to reflect new scientific knowledge or new standards of care, our products could become obsolete, which would have a material adverse effect on our business, financial condition, and results of operations.\n\n| 46 |\n\nOur ability to successfully develop and commercialize our existing and any future products will depend on several factors, including:\n\n| · | our ability to convince the veterinary community of the clinical utility of our products and their potential advantages over existing tests and devices; |\n\n\n| · | the willingness or ability by pet owners to pay for our products and the willingness of veterinarians to recommend our products; |\n\n\n| · | the willingness of veterinarians to utilize our diagnostic tests and devices; and |\n\n\n| · | where applicable, the willingness of testing labs to buy our assay equipment. |\n\nOur dependence on suppliers could limit our ability to develop and commercialize certain products\nWe rely on third-party suppliers to provide components in our products, manufacture products that we do not manufacture ourselves and perform services that we do not provide ourselves. Because these suppliers are independent third parties with their own financial objectives, actions taken by them could have a materially negative effect on our results of operations. The risks of relying on suppliers include our inability to enter into contracts with third-party suppliers on reasonable terms, inconsistent or inadequate quality control, relocation of supplier facilities, supplier work stoppages and suppliers’ failure to comply with applicable regulations or their contractual obligations. Problems with suppliers could materially negatively impact our ability to complete development, supply the market, lead to higher costs or damage our reputation with our customers.\nIn addition, we currently purchase many products and materials from sole or single sources. Some of the products that we purchase from these sources are proprietary and, therefore, cannot be readily or easily replaced by alternative sources. To mitigate risks associated with sole and single source suppliers, we will seek when possible to enter into long-term contracts that provide for an uninterrupted supply of products at predictable prices. However, some suppliers may decline to enter into long-term contracts, and we are required to purchase products with short term contracts or on a purchase order basis. There can be no assurance that suppliers with which we do not have contracts will continue to supply our requirements for products, that suppliers with which we do have contracts will always fulfill their obligations under these contracts, or that any of our suppliers will not experience disruptions in their ability to supply our requirements for products. In cases where we purchase sole and single source products or components under purchase orders, we are more susceptible to unanticipated cost increases or changes in other terms of supply. In addition, under some contracts with suppliers we have minimum purchase obligations, and our failure to satisfy those obligations may result in loss of some or all of our rights under these contracts or require us to compensate the supplier. If we are unable to obtain adequate quantities of products in the future from sole and single source suppliers, we may be unable to supply the market, which could have a material adverse effect on our results of operations.\nThe commercial potential of our products is difficult to predict. The market for any product, or for companion animal diagnostics and medical devices overall, is uncertain and may be smaller than we anticipate, which could significantly and negatively impact our revenue, results of operations and financial condition.\nWe believe that the emerging nature of our industry and our unproven business plan make it difficult to estimate the commercial potential of any of our proposed or future products. The market for any product that we seek to commercialize will depend on important factors such as the cost, utility and ease of use of our products, changing standards of care, preferences of veterinarians, the willingness of pet owners to pay for such products, and the availability of competitive alternatives that may emerge either during the product development process or after commercial introduction. If the market potential for our proposed and future products is less than we anticipate due to one or more of these factors, it could negatively impact our business, financial condition and results of operations. Further, the willingness of pet owners to pay for the use of our products may be less than we anticipate and may be negatively affected by overall economic conditions. Because relatively few pet owners purchase insurance for their companion animals, pet owners are more likely to have to pay for the use of our products directly and may be unwilling or unable to pay for any such use.\n\n| 47 |\n\nOur proposed and future products will face significant competition and may be unable to compete effectively.\nThe development and commercialization of veterinary diagnostics and medical devices is highly competitive, and our success depends on our ability to compete effectively with other products in the market and identify potential partners for continued development and commercialization.\nThere are a number of competitors in the diagnostic market that have substantially greater financial and operational resources and established marketing, sales and service organizations. We expect to compete primarily with commercial clinical laboratories, hospitals’ clinical laboratories and other veterinary diagnostic equipment manufacturers. Our principal competitors in the veterinary diagnostic market are IDEXX Laboratories, Inc., Antech Diagnostics, a unit of VCA Inc., Abaxis, Inc., a wholly-owned subsidiary of Zoetis Inc., Heska Corporation and Zoetis Inc. We must develop our distribution channels and build our direct sales force in order to compete effectively in these markets. If we are unable to effectively manage our distribution channels in our highly competitive industry, we may fail to retain customers or obtain new customers and our business will suffer.\nMany of our competitors and potential competitors have substantially more financial, technical and human resources than we do. Many also have far more experience than we have in the development, manufacture, regulation and worldwide commercialization of animal health diagnostics and medical devices. We also expect to compete with academic institutions, governmental agencies and private organizations that are conducting research in the fields of animal diagnostics and medical devices. If such competing products are commercialized prior to our products, or if our intellectual property protection fail to provide us with exclusive marketing rights for our products, we may be unable to compete effectively in the markets in which we participate. Contractual agreements between clinics and from competitors may limit practices’ ability to use other tests and technologies due to predetermined minimums in those agreements.\nThe research, testing, manufacturing, labeling, approval, sale, marketing and distribution of our proposed and future products may be subject to extensive regulation. We may be unable to obtain regulatory approval for our proposed or future diagnostic or medical device products under applicable regulatory requirements or maintain any regulatory approval obtained. The denial, delay or loss of any regulatory approval would prevent or delay our commercialization efforts and adversely affect our financial condition and results of operations.\nThe research, testing, manufacturing, labeling, approval, sale, marketing and distribution of our product candidates may be subject to extensive regulation. We may not be able to market and sell any point-of-care diagnostic products or medical devices without pre-marketing approval from the USDA-CVB and/or FDA-CVM. To gain approval to market a pet point-of-care diagnostic product kit or a medical device, we must provide the results of specific tests required to be conducted in accordance with USDA-CVB and/or FDA-CVM’s guidance demonstrating data from Assay Validation Studies that demonstrate the diagnostic accuracy, analytical sensitivity, analytical specificity and ruggedness, and stability. In addition, we must provide manufacturing data meeting Good Manufacturing Procedures (“GMP”). The USDA-CVB and/or FDA-CVM may also require us to conduct costly postapproval testing and/or collect post-approval safety data to maintain our approval for any diagnostic or medical device. The results of our development activities, and the results of any previous studies conducted by us or third parties, may not be predictive of future results of future studies, and failure can occur at any time during or after the completion of development activities by us or our contract research organizations or CROs.\nThe USDA-CVB and/or FDA-CVM can delay, limit, deny or revoke approval of any of our product candidates for many reasons, including:\n\n| · | if they disagree with our interpretation of data from our studies or other development efforts; |\n\n\n| · | if they require additional studies or changes its approval policies or regulations; |\n\n\n| 48 |\n\n\n| · | if they do not approve of the specifications of our proposed and future products; |\n\n\n| · | if they fail to approve the manufacturing processes of our third-party contract manufacturers; and |\n\n\n| · | if any approved product subsequently fails post-approval testing required by them. |\n\nFurther, even if we receive approval of our products, such approval may be for a more limited claim than we originally requested, the USDA-CVB may not approve the labeling that we believe is necessary or desirable for the successful commercialization of our products and we may be required to conduct costly post-approval testing. Any delay or failure in obtaining applicable regulatory approval for the intended claims of our product candidates would delay or prevent commercialization of such products and would materially adversely impact our business and prospects.\nOur strategic partnerships are important to our business. If we are unable to maintain any of these partnerships, or if these partnerships are not successful, our business could be adversely affected.\nWe have entered into a number of strategic partnerships that are important to our business and we expect to enter into similar partnerships as part of our growth strategy. These partnerships may pose a number of risks, including:\n\n| · | partners may have significant discretion in determining the efforts and resources that they will apply to these partnerships; |\n\n\n| · | partners may not perform their obligations as expected; |\n\n\n| · | partners may not pursue development of our product candidates or may elect not to continue or renew development based on development results, changes in the partners’ strategic focus or available funding, or external factors, such as an acquisition, that divert resources or create competing priorities; |\n\n\n| · | partners could independently develop, or develop with third parties, products that compete directly or indirectly with our products or product candidates if the partners believe that competitive products are more likely to be successfully developed or can be commercialized under terms that are more economically attractive than ours, which may cause partners to cease to devote resources to the development of our product candidates; |\n\n\n| · | disagreements with partners, including disagreements over proprietary rights, contract interpretation or the preferred course of development, might cause delays or termination of the research and development of product candidates, might lead to additional responsibilities for us with respect to product candidates, or might result in litigation or arbitration, any of which would be time-consuming and expensive; |\n\n\n| · | partners may not properly maintain or defend their intellectual property rights or may use proprietary information in such a way as to invite litigation that could jeopardize or invalidate the intellectual property or proprietary information or expose us to potential litigation; |\n\n\n| · | partners may infringe the intellectual property rights of third parties, which may expose us to litigation and potential liability; |\n\n\n| · | partners may learn about our technology and use this knowledge to compete with us in the future; |\n\n\n| · | there may be conflicts between different partners that could negatively affect those partnerships and potentially others; and |\n\n\n| · | the number and type of our partnerships could adversely affect our attractiveness to future partners or acquirers. |\n\n\n| 49 |\n\nIf any partnerships we enter into do not result in the successful development of our product candidates or if one of our partners terminates its agreement with us, we may not be able to successfully develop our product candidates, our continued development of our product candidates could be delayed and we may need additional resources to develop additional product candidates. All of the risks relating to our product development, regulatory approval and commercialization also apply to the activities of our partners and there can be no assurance that our partnerships will produce positive results or successful products on a timely basis or at all.\nAdditionally, subject to its contractual obligations to us, if a partner of ours is involved in a business combination or otherwise changes its business priorities, the partner might deemphasize or terminate the development of any technology licensed to it by us. If one of our partners terminates its agreement with us, we may find it more difficult to attract new partners and our perception in the business and financial communities and our stock price could be adversely affected.\nWe may in the future determine to partner with additional life science and technology companies for development of additional products. We face significant competition in seeking appropriate partners. Our ability to reach a definitive agreement for partnership will depend, among other things, upon our assessment of the partner’s resources and expertise, the terms and conditions of the proposed partnership and the proposed partner’s evaluation of a number of factors. If we are unable to reach agreements with suitable partners on a timely basis, on acceptable terms, or at all, we may not be able to access technologies that are important for the future development of our business. If we elect to fund and undertake development activities on our own, we may need to obtain additional expertise and additional capital, which may not be available to us on acceptable terms or at all. If we fail to enter into partnerships and do not have sufficient funds or expertise to undertake the necessary development activities, we may not be able to further develop our product candidates and our business may be materially and adversely affected.\nUnder the terms of our partnership arrangements, we are required to make significant milestone and other payments to our strategic partners. The timing of any such payments is uncertain and could adversely affect our cash flows and results of operations. If we are not able to make such payments when due, our business could be materially and adversely affected.\nIn November 2018, we entered into a development and supply agreement with Qorvo Biotechnologies, LLC, or Qorvo, a wholly-owned subsidiary of Qorvo, Inc. Under this agreement, Qorvo is responsible for the development of certain assay cartridges and the related instrument. We agreed to pay the associated non-recurring engineering costs of up to $500,000 per assay cartridge and the instrument and are responsible for the validation of the assay cartridges and the instrument. Under the terms of this agreement, we were required to pay Qorvo additional milestone payments in cash or, if elected by Qorvo, additional unregistered common shares having a value calculated as specified in the agreement. All of the milestones under this agreement have been met and we paid Qorvo a total of $10.0 million in cash in connection therewith. Under the terms of the agreement, we will be responsible for the cost of additional development work undertaken by Qorvo on our behalf.\nIn May 2018, we entered into a development, commercialization and exclusive distribution agreement with Seraph Biosciences, Inc., or Seraph. Under this agreement, we are responsible for development and validation, and their associated costs. Seraph is entitled to additional payments for development costs. Seraph will be entitled to receive up to an additional $7,000,000, payable 50 percent in cash and 50 percent in additional unregistered common shares, upon the achievement of a series of staged, specified milestones, including completion of laboratory studies and field studies, production and commercial shipment of products. In addition, we have agreed to pay Seraph license fees based on a percentage of gross profit from commercial sales of ZM-020. At September 30, 2020, all milestone payments under our agreement with Seraph remain unpaid.\n\n| 50 |\n\nWe will rely on third parties to conduct certain portions of our development activities. If these third parties do not successfully carry out their contractual duties or meet expected deadlines, we may be unable to obtain regulatory approval for or commercialize our product candidates.\nWe have used contract manufacturing organizations (“CMOs”) and contract research organizations (“CROs”) to conduct our manufacturing and research and development activities. We expect to continue to do so, including with respect to our manufacturing, clinical validation, verification and beta testing of our proposed and future diagnostic and medical device products. These CMOs and CROs are not our employees, and except for contractual duties and obligations, we have limited ability to control the amount or timing of resources that they devote to our programs or manage the risks associated with their activities on our behalf. We are responsible to regulatory authorities for ensuring that products subject to regulatory authority are manufactured using good manufacturing practices and studies are conducted in accordance with the development plans and trial protocols, and any failure by our CMOs and CROs to do so may adversely affect our ability to obtain regulatory approvals, subject us to penalties, or harm our credibility with regulators.\nOur agreements with our CMOs and CROs may allow termination by the CMOs and CROs in certain circumstances with little or no advance notice to us. These agreements generally will require our CMOs and CROs to reasonably cooperate with us at our expense for an orderly winding down of the CMOs’ and CROs’ services under the agreements. If the CMOs and CROs conducting our manufacturing and studies do not comply with their contractual duties or obligations to us, or if they experience work stoppages, do not meet expected deadlines, terminate their agreements with us or need to be replaced, or if the quality or accuracy of the data they obtain is compromised due to the failure to adhere to our development protocols or quality expectations or for any other reason, we may need to secure new arrangements with alternative CMOs and CROs, which could be difficult and costly. In such event, our studies also may need to be extended, delayed or terminated as a result, or may need to be repeated. If any of the foregoing were to occur, regulatory approval and commercialization of our product candidates may be delayed, and we may be required to expend substantial additional resources.\nThe failure of any CMO and CRO to perform adequately or the termination of any arrangements with any of them may adversely affect our business.\nWe will rely on third-party manufacturers to produce our products. If we experience problems with any of these suppliers, the manufacturing of our product candidates or products could be delayed.\nWe do not have the capability to manufacture our proposed and future products and do not intend to develop that capability. As a result, we will rely on CMOs to produce our proposed and future products. We expect to enter into contracts with CMOs for the commercial scale production of the products we intend to commercialize. Reliance on CMOs involves risks, including:\n\n| · | the inability to meet our product specifications and quality requirements consistently; |\n\n\n| · | inability to access production facilities on a timely basis; |\n\n\n| · | inability or delay in increasing manufacturing capacity; |\n\n\n| · | manufacturing and product quality issues related to the scale-up of manufacturing; |\n\n\n| · | costs and validation of new equipment and facilities required for commercial level activity; |\n\n\n| · | a failure to satisfy any applicable regulatory requirements on a consistent basis; |\n\n\n| · | the inability to negotiate manufacturing agreements with third parties under commercially reasonable terms; |\n\n\n| · | termination or nonrenewal of manufacturing agreements with third parties in a manner or at a time that is costly or damaging to us; |\n\n\n| · | the reliance on a single source of supply which, if unavailable, would delay our ability to complete the development and testing and commercialization of our products; |\n\n\n| 51 |\n\n\n| · | the lack of qualified backup suppliers for supplies that are currently purchased from a single source supplier; |\n\n\n| · | operations of our CMOs or suppliers could be disrupted by conditions unrelated to our business or operations, including the bankruptcy of the CMO or supplier; |\n\n\n| · | carrier disruptions or increased costs that are beyond our control; and |\n\n\n| · | the failure to deliver products under specified storage conditions and in a timely manner. |\n\nAny of these risks could cause the delay of validation studies, clinical trials, regulatory submissions, the receipt of any required approvals or the commercialization of our products, cause us to incur higher costs and prevent us from commercializing our product candidates successfully. Furthermore, if our CMOs fail to deliver the required commercial quantities of finished product on a timely basis and at commercially reasonable prices and we are unable to find one or more replacement manufacturers capable of production at a substantially equivalent cost, in substantially equivalent volumes and quality and on a timely basis, we would likely be unable to meet demand for our products and could lose potential revenue.\nEven if a product receives regulatory approval, it may never achieve market acceptance or commercial success.\nEven if we obtain USDA-CVB or other regulatory approvals for a specific product, that product may not achieve market acceptance among veterinarians and pet owners and may not be commercially successful. Market acceptance of our products depends on a number of factors, including:\n\n| · | the claims for which our products are approved or intended; |\n\n\n| · | the acceptance by veterinarians and pet owners of the product as safe and effective; |\n\n\n| · | the proper training and use of our products by veterinarians; |\n\n\n| · | the potential and perceived advantages of our products over alternative diagnostics or medical devices; |\n\n\n| · | the cost of our products in relation to alternative diagnostics and willingness to pay for our products, if approved, on the part of veterinarians and pet owners; |\n\n\n| · | the willingness of pet owners to pay for the use of our products, relative to other discretionary items, especially during economically challenging times; |\n\n\n| · | the relative convenience and ease of use; and |\n\n\n| · | the effectiveness of our sales and marketing efforts. |\n\nIf our products fail to achieve market acceptance or commercial success, our business could fail and you could lose your entire investment.\nIf we are unable to establish sales capabilities on our own or through third parties, we may not be able to market and sell our existing or future products or generate product revenue.\nWe do not currently have a fully staffed sales organization. We intend to commercialize our products with a direct sales force and through third-party distributors. To achieve this, we will be required to build a direct sales organization and to establish relationships with distributors of veterinary products. We also will have to build our marketing, sales, managerial and other non-technical capabilities and make arrangements with third parties for distribution and to perform certain of these other services, and we may not be successful in doing so. Building an internal sales organization is time consuming and expensive and will significantly increase our compensation expense. We may be unable to secure third-party distribution contracts with distributors on favorable terms or at all. We have no prior experience in the marketing, sale and distribution of diagnostic products or medical devices for companion animals and there are significant risks involved in building and managing a sales organization, including our ability to hire, retain and motivate qualified individuals, generate sufficient sales leads, provide adequate training to sales and marketing personnel, and effectively oversee a geographically dispersed sales and marketing team. If we are unable to build an effective sales organization and/or if we are unable to secure relationships with third-party distributors for our products, we will not be able to successfully commercialize our products, our future product revenue will suffer and we would incur significant additional losses.\n\n| 52 |\n\nIn jurisdictions outside of the United States we intend to utilize companies with an established commercial presence to market our products in those jurisdictions, but we may be unable to enter into such arrangements on acceptable terms, it at all.\nIf we fail to attract and keep senior management and key scientific personnel, we may be unable to successfully develop any of our existing or future product candidates, conduct our in-licensing and development efforts and commercialize any of our existing or future products.\nOur success depends in part on our continued ability to attract, retain and motivate highly qualified management and scientific personnel. We are highly dependent upon our senior management, particularly Robert Cohen, our interim Chief Executive Officer, Ann Marie Cotter, our Chief Financial Officer, Stephanie Morley, DVM, our President and Chief Medical Officer, and Bruk Herbst, our Chief Commercial Officer. The loss of services of any of these individuals could delay or prevent the successful development of our existing or future product pipeline, completion of our planned development efforts or the commercialization of our product candidates. Although we have entered employment agreements with Dr. Morley and Mr. Herbst for one-year terms (automatically extending for one-year terms thereafter) there can be no assurance that either of Dr. Morley or Mr. Herbst will extend their terms of service. We have also entered into an employment agreement with Mr. Cohen without a fixed term of service.\nConsolidation of our customers could negatively affect the pricing of our products.\nVeterinarians will be our primary customers for our proposed and future products. In recent years, there has been a trend towards the consolidation of veterinary clinics and animal hospitals. If this trend continues, these large clinics and hospitals could attempt to leverage their buying power to obtain favorable pricing from us and other similar companies. Any resulting downward pressure on the prices of any of our products could have a material adverse effect on our results of operations and financial condition.\nWe will need to increase the size of our organization and may not successfully manage our growth.\nWe will need to significantly expand our organization and systems to support our future expected growth. If we fail to manage our growth effectively, we will not be successful, and our business could fail.\nWe may seek to raise additional funds in the future through debt financing which may impose operational restrictions on our business and may result in dilution to existing or future holders of our common shares.\nWe expect that we will need to raise additional capital in the future to help fund our business operations. Debt financing, if available, may require restrictive covenants, which may limit our operating flexibility and may restrict or prohibit us from:\n\n| · | paying dividends and/or making certain distributions, investments and other restricted payments; |\n\n\n| · | incurring additional indebtedness or issuing certain preferred shares; |\n\n\n| 53 |\n\n\n| · | selling some or all of our assets; |\n\n\n| · | entering into transactions with affiliates; |\n\n\n| · | creating certain liens or encumbrances; |\n\n\n| · | merging, consolidating, selling or otherwise disposing of all or substantially all of our assets; and |\n\n\n| · | designating our subsidiaries as unrestricted subsidiaries. |\n\nDebt financing may also involve debt instruments that are convertible into or exercisable for our common shares. The conversion of the debt to equity financing may dilute the equity position of our existing shareholders.\nWe may not be able to obtain or maintain sufficient insurance on commercially reasonable terms or with adequate coverage against potential liabilities in order to protect ourselves against product liability claims.\nOur business exposes us to potential product liability risks that are inherent in the testing, manufacturing and marketing of diagnostic products and medical devices. We may become subject to product liability claims resulting from the use of our product candidates. We do not currently have product liability insurance and we may not be able to obtain or maintain this type of insurance for any future trials or product candidates. In addition, product liability insurance is becoming increasingly expensive. Being unable to obtain or maintain product liability insurance in the future on acceptable terms or with adequate coverage against potential liabilities could have a material adverse effect on our business.\nWe may acquire other businesses or form joint ventures that may be unsuccessful and could adversely dilute your ownership of our company.\nAs part of our business strategy, we may pursue in-licenses or acquisitions of other complementary assets and businesses and may also pursue strategic alliances. We have no experience in acquiring other assets or businesses and have limited experience in forming such alliances. We may not be able to successfully integrate any acquisitions into our existing business, and we could assume unknown or contingent liabilities or become subject to possible stockholder claims in connection with any related-party or third-party acquisitions or other transactions. We also could experience adverse effects on our reported results of operations from acquisition-related charges, amortization of acquired technology and other intangibles and impairment charges relating to write-offs of goodwill and other intangible assets from time to time following an acquisition. Integration of an acquired company requires management resources that otherwise would be available for ongoing development of our existing business. We may not realize the anticipated benefits of any acquisition, technology license or strategic alliance.\nTo finance future acquisitions, we may choose to issue shares of our common stock as consideration, which would dilute your ownership interest in us. Alternatively, it may be necessary for us to raise additional funds through public or private financings. Additional funds may not be available on terms that are favorable to us and, in the case of equity financings, may result in dilution to our stockholders.\nRisks Related to Government Regulation\nVarious government regulations could limit or delay our ability to develop and commercialize our products or otherwise negatively impact our business.\nIn the U.S., the manufacture and sale of certain diagnostic products are regulated by agencies such as the USDA, the FDA or the EPA. While our point-of-care Bulk Acoustic Wave sensor-based diagnostic platform and Raman spectroscopy-based diagnostic platform and our reference lab-based diagnostic test for canine cancer do not require approval by the USDA-CVB prior to sale in the U.S., these diagnostic solutions will be subject to postmarketing oversight by the FDA-CVM. In addition, delays in obtaining regulatory approvals for new products or product upgrades could have a negative impact on our growth and profitability.\n\n| 54 |\n\nThe manufacture and sale of our products, as well as our research and development processes, are subject to similar and potentially more stringent laws in foreign countries.\nWe are also subject to a variety of federal, state, local and international laws and regulations that govern, among other things, the importation and exportation of products; our business practices in the U.S. and abroad, such as anti-corruption and anti-competition laws; and immigration and travel restrictions. These legal and regulatory requirements differ among jurisdictions around the world and are rapidly changing and increasingly complex. The costs associated with compliance with these legal and regulatory requirements are significant and likely to increase in the future.\nAny failure to comply with applicable legal and regulatory requirements could result in fines, penalties and sanctions; product recalls; suspensions or discontinuations of, or limitations or restrictions on, our ability to design, manufacture, market, import, export or sell our products; and damage to our reputation.\nEven if we receive regulatory approval for a product candidate, we will be subject to ongoing FDA-CVM or USDA-CVB obligations and continued regulatory oversight, which may result in significant additional expense. Additionally, any product candidates, if approved, will be subject to labeling and manufacturing requirements and could be subject to other restrictions. Failure to comply with these regulatory requirements or the occurrence of unanticipated problems with our products could result in significant penalties.\nIf the FDA-CVM or USDA-CVB approves any of our existing or future diagnostic product candidates, the manufacturing processes, labeling, packaging, distribution, adverse event reporting, storage, advertising, promotion and recordkeeping for the product will be subject to extensive and ongoing regulatory requirements. These requirements include post-marketing information and reports, establishment registration, and product listing, as well as continued compliance with GMP, GLP and GCP for any studies that we conduct post-approval. Later discovery of previously unknown problems with a product, including adverse events of unanticipated severity or frequency, or with our third-party manufacturers or manufacturing processes, or failure to comply with regulatory requirements, may result in, among other things:\n\n| · | restrictions on the marketing or manufacturing of the product, withdrawal of the product from the market, or voluntary product recalls; |\n\n\n| · | fines, warning letters or holds on promotional materials and claims; |\n\n\n| · | refusal by the FDA-CVM or USDA-CVB to approve pending applications or supplements to approved applications filed by us or our strategic collaborators, or suspension or revocation of product license approvals; |\n\n\n| · | product seizure or detention, or refusal to permit the import or export of products; and |\n\n\n| · | injunctions or the imposition of civil or criminal penalties. |\n\nThe FDA-CVM’s or USDA-CVB’s policies may change and additional government regulations may be enacted that could prevent, limit or delay regulatory approval of our product candidates. We cannot predict the likelihood, nature or extent of government regulation that may arise from future legislation or administrative action in the United States or abroad. If we are slow or unable to adapt to changes in existing requirements or the adoption of new requirements or policies, or if we are not able to maintain regulatory compliance, we may lose any marketing approval that we may have obtained and we may not achieve or sustain profitability, which would adversely affect our business.\n\n| 55 |\n\nLegislative or regulatory reforms with respect to veterinary diagnostics, medical devices and test kits may make it more difficult and costly for us to obtain regulatory clearance or approval of any of our existing or future product candidates and to produce, market, and distribute our products after clearance or approval is obtained.\nFrom time to time, legislation is drafted and introduced in the U.S. Congress that could significantly change the statutory provisions governing the testing, regulatory clearance or approval, manufacture, and marketing of regulated and/or licensed products. In addition, FDA-CVM and USDA-CVB regulations and guidance are often revised or reinterpreted by the FDA-CVM and USDA-CVB in ways that may significantly affect our business and our products. Similar changes in laws or regulations can occur in other countries. Any new regulations or revisions or reinterpretations of existing regulations in the United States may impose additional costs or lengthen review times of any of our existing or future product candidates. We cannot determine what effect changes in regulations, statutes, legal interpretation or policies, when and if promulgated, enacted or adopted may have on our business in the future. Such changes could, among other things, require:\n\n| · | changes to manufacturing methods; |\n\n\n| · | recall, replacement or discontinuance of certain products; and |\n\n\n| · | additional record-keeping. |\n\nEach of these would likely entail substantial time and cost and could materially harm our financial results. In addition, delays in receipt of or failure to receive regulatory clearances or approvals for any future products would harm our business, financial condition, and results of operations.\nRisks Related to Intellectual Property\nOur ability to obtain intellectual property protection for our products is limited.\nOur diagnostic technologies are dependent on intellectual property developed by our strategic partners and licensed to us. We do not own the intellectual property rights that underlie these technology licenses. Our rights to use the technology we license are subject to the negotiation of, continuation of and compliance with the terms of our licenses. However, we have filed four U.S. patent applications and two Patent Cooperation Treaty (PCT) applications for U.S. and international protection of our diagnostic tests. These applications cover tests developed for our ZM-017, ZM-022 and ZM- 020 technology platforms. Even if such patents are issued, we do not expect that all of the patents will provide significant protection for our intellectual property.\nSome of our products may or may not be covered by a patent. Further if an application is filed, it is not certain that a patent will be granted or if granted whether it will be held to be valid. All of which may impact our market share and ability to prevent others (competitor third parties) from making, selling, or using our products.\nWe intend to rely upon a combination of patents, trade secret protection, confidentiality agreements, and license agreements to protect the intellectual property related to our proposed and future products. We may not be successful in protecting our intellectual property rights, including our unpatented proprietary know-how and trade secrets, or in avoiding claims that we infringed on the intellectual property rights of others. In addition to relying on patent and trademark rights, we rely on unpatented proprietary know-how and trade secrets, and employ various methods, including confidentiality agreements with employees and consultants, customers and suppliers to protect our know-how and trade secrets. However, these methods and our patents and trademarks may not afford complete protection and there can be no assurance that others will not independently develop the know-how and trade secrets or develop better production methods than us. Further, we may not be able to deter current and former employees, contractors and other parties from breaching confidentiality agreements and misappropriating proprietary information and it is possible that third parties may copy or otherwise obtain and use our information and proprietary technology without authorization or otherwise infringe on our intellectual property rights. In the future, we may also rely on litigation to enforce our intellectual property rights and contractual rights, and, if not successful, we may not be able to protect the value of our intellectual property. Any litigation could be protracted and costly and could have a material adverse effect on our business and results of operations regardless of its outcome.\n\n| 56 |\n\nIf we are unable to obtain trademark registrations for our products our business could be adversely affected.\nWe have pending trademark applications for our company name and composite marks comprised of our company name, logo and/or slogan in the U.S., Canada, European Union, the United Kingdom, and Mexico. In addition, we have approved pending trademark applications for our “Voice of the Vet” mark in the U.S. and Canada. We have secured two registrations in the European Union for our company name, company name and logo, and for the mark “Voice of the Vet powered by Zomedica” (and Design). We also have secured registrations in Brazil for our company name and logo. While we cannot make assurances that any pending trademark applications will mature to registration, most of these applications are now poised to mature to registration.\nWe have also filed for protection of several product names in the U.S., Canada and European Union. Currently, no significant hurdles have been encountered in the registration process. Moreover, any name we propose to use with our product candidates in the United States must be approved by the FDA-CVM or the USDA-CVB if it is a regulated product. The FDA-CVM typically conducts a review of proposed product names, including an evaluation of potential for confusion with other product names. If the FDA-CVM or the USDA-CVB object to any of our proposed proprietary product names, we may be required to expend significant additional resources in an effort to identify a suitable substitute name that would qualify under applicable trademark laws, not infringe the existing rights of third parties and be acceptable to the FDA-CVM and the USDA-CVB.\nThird parties may have intellectual property rights, which may require us to obtain a license or other applicable rights to make, sell or use our products. If such rights are not granted or obtained, it could have a material adverse effect on our business, financial condition and results of operations.\nOur success depends in part on our ability to obtain, or license from third parties, patents, trademarks, trade secrets and similar proprietary rights without infringing on the proprietary rights of third parties. Although we believe our intellectual property rights are sufficient to allow us to conduct our business without incurring liability to third parties, our products may infringe on the intellectual property rights of such persons. Furthermore, no assurance can be given that we will not be subject to claims asserting the infringement of the intellectual property rights of third parties seeking damages, the payment of royalties or licensing fees and/or injunctions against the sale of our products. Any such litigation could be protracted and costly and could have a material adverse effect on our business, financial condition and results of operations.\nOur diagnostic technologies depend on certain technologies that are licensed to us. We do not control these technologies and any loss of our rights to them could prevent us from marketing our diagnostic product candidates.\nOur diagnostic technologies are dependent on intellectual property developed by our strategic partners and licensed to us. We do not own the intellectual property rights that underlie these licenses. Our rights to use the technology we license are subject to the negotiation of, continuation of and compliance with the terms of our licenses. We do not control the prosecution, maintenance or filing of the patents and other intellectual property licensed to us, or the enforcement of these intellectual property rights against third parties. The patents and patent applications underlying our licenses were not written by us or our attorneys, and we do not have control over the drafting and prosecution of such rights. Our partners might not have given the same attention to the drafting and prosecution of patents and patent applications as we would have if we had been the owners of the intellectual property rights and had control over such drafting and prosecution. We cannot be certain that drafting and/or prosecution of the licensed patents and patent applications has been or will be conducted in compliance with applicable laws and regulations or will result in valid and enforceable patents and other intellectual property rights.\n\n| 57 |\n\nOur intellectual property agreements with third parties may be subject to disagreements over contract interpretation, which could narrow the scope of our rights to the relevant intellectual property or technology or increase our financial or other obligations to our licensors.\nCertain provisions in our intellectual property agreements may be susceptible to multiple interpretations. The resolution of any contract interpretation disagreement that may arise could affect the scope of our rights to the relevant intellectual property or technology, or affect financial or other obligations under the relevant agreement, either of which could have a material adverse effect on our business, financial condition, results of operations and prospects.\nIn addition, while it is our policy to require our employees and contractors who may be involved in the conception or development of intellectual property to execute agreements assigning such intellectual property to us, we may be unsuccessful in executing such an agreement with each party who in fact conceives or develops intellectual property that we regard as our own. Our assignment agreements may not be self-executing or may be breached, and we may be forced to bring claims against third parties, or defend claims they may bring against us, to determine the ownership of what we regard as our intellectual property.\nWe may be subject to claims that our employees, consultants or independent contractors have wrongfully used or disclosed confidential information of third parties.\nWe have received confidential and proprietary information from third parties. In addition, we employ individuals who were previously employed at other pharmaceutical or animal health companies. We may be subject to claims that we or our employees, consultants or independent contractors have inadvertently or otherwise improperly used or disclosed confidential information of these third parties or our employees’ former employers. Litigation may be necessary to defend against any such claims. Even if we are successful in defending against any such claims, such litigation could result in substantial cost and be a distraction to our management and employees.\nRisks Related to Our Preferred Shares\nWe will be obligated to pay a significant portion of our net sales to the holders of our Series 1 Preferred Shares. This payment obligation will materially and adversely affect our liquidity and capital resources, may adversely impact our ability to raise additional capital, and could adversely affect the trading price of our common shares.\nWe are obligated to make annual payments to the holders of our Series 1 Preferred Shares in an amount equal to nine percent of the net sales (as defined in the Series 1 Preferred Shares), if any, of our company and our affiliates (the “Net Sales Payments”) until such time as the holders have received total Net Sales Payments equal to nine times the aggregate stated value of the outstanding Series 1 Preferred Shares. Such payments will materially and adversely affect our liquidity and capital resources which could result in a shortage of capital necessary to fund our operations or to take advantage of business opportunities as they arise. Our obligation to make these payments may make it more difficult for us to raise additional capital on terms acceptable to us, or at all. This payment obligation also may adversely affect investor perceptions of our company which could adversely affect the trading price of our common shares.\nIn the event of a sale of our company, holders of our Series 1 Preferred Shares will be entitled to a substantial premium on the purchase price they paid for their Series 1 Preferred Shares, which will reduce the sale proceeds to be received by holders of our common shares.\nIn the event that our company is the subject of a “fundamental transaction” (defined in the Series 1 Preferred Shares to include an amalgamation, merger or other business combination transaction involving our company in which our shareholders do not have the right to cast more than 50% of the votes that may be cast for the election of directors, or a sale, lease or other disposition of the properties and/or assets of our company as an entirety or substantially as an entirety to a third party) the holders of the Series 1 Preferred Shares will have the right, in preference to the holders of our common shares, to receive a portion of the aggregate consideration paid in the fundamental transaction that will represent a substantial premium on the purchase price they paid for their Series 1 Preferred Shares. Such premium will reduce the proceeds of any such fundamental transaction that would be received by holders of our common shares.\n\n| 58 |\n\nIn the event of the liquidation, dissolution or winding up of our company, holders of the Series 1 Preferred Shares will have a liquidation preference over holders of our common shares and if the net assets of our company available for distribution to holders of our equity securities is not sufficient to pay this liquidation preference in full, holders of our common shares would receive no liquidating distribution in respect of their common shares.\nIn the event of the liquidation, dissolution or winding up of our company, holders of the Series 1 Preferred Shares will have a liquidation preference equal to the stated value of the Series 1 Preferred Shares less the Net Sales Returns (as defined in the Series 1 Preferred Shares) paid on the Series 1 Preferred Shares before holders of our common shares would be entitled to any proceeds of such liquidation, dissolution or winding up. If the net assets of our company available for distribution to holders of our equity securities is not sufficient to pay this liquidation preference in full, holders of our common shares would receive no liquidating distribution in respect of their common shares.\nOur Series 1 Preferred Shares will be reclassified as a liability on our consolidated balance sheet once we begin to recognize revenues which may cause us to fail to meet the NYSE American’s continued listing requirements.\nBecause we are obligated to make annual payments to the holders of our Series 1 Preferred Shares in an amount equal to nine percent of the Net Sales (as defined in the Series 1 Preferred Shares), if any, of our company and our affiliates, once we begin to recognize revenues from our commercial activities, we will be required under United States general accounting principles to reclassify the Series 1 Preferred Shares as a liability on our consolidated balance sheet. The reclassification will significantly increase our total liabilities and significantly reduce our shareholders’ equity. Under the NYSE American’s continued listing requirements, we are required to maintain shareholders’ equity of at least $4.0 million, which will increase to $6.0 million after December 31, 2020. As a result of the reclassification, we may fail to meet this continued listing requirement. If we are unable to satisfy the NYSE American’s continued listing requirements, our common shares could be delisted from the NYSE American which could adversely affect the liquidity and market price of our common shares.\nRisks Related to Our Common Shares\nIf securities or industry analysts do not publish research or reports about our company, or if they issue adverse or misleading opinions regarding us or our stock, our stock price and trading volume could decline.\nAlthough we have research coverage by securities and industry analysts, if coverage is not maintained, the market price for our stock may be adversely affected. Our stock price also may decline if any analyst who covers us issues an adverse or erroneous opinion regarding us, our business model, our intellectual property or our stock performance, or if our product validations and operating results fail to meet analysts’ expectations. If one or more analysts cease coverage of us or fail to regularly publish reports on us, we could lose visibility in the financial markets, which could cause our stock price or trading volume to decline and possibly adversely affect our ability to engage in future financings.\nWe expect that the price of our common shares will fluctuate substantially.\nYou should consider an investment in our common shares risky and invest only if you can withstand a significant loss and wide fluctuations in the market value of your investment. The price of our common shares that will prevail in the market after the sale of our common shares by a selling shareholder may be higher or lower than the price you have paid. Numerous factors, including many over which we have no control, may have a significant impact on the market price of our common shares. These risks include those described or referred to in this “Risk Factors” section and elsewhere in this report as well as, among other things:\n\n| · | any delays in, or suspension or failure of, our existing and future studies; |\n\n\n| · | announcements of regulatory approval or disapproval of any of our existing or future product candidates or of regulatory actions affecting us or our industry; |\n\n\n| 59 |\n\n\n| · | delays in the commercialization of our existing or future product candidates; |\n\n\n| · | manufacturing and supply issues related to our development programs and commercialization of our existing or future product candidates; |\n\n\n| · | quarterly variations in our results of operations or those of our competitors; |\n\n\n| · | changes in our earnings estimates or recommendations by securities analysts or adverse publicity about us or our product candidates; |\n\n\n| · | announcements by us or our competitors of new product candidates, significant contracts, commercial relationships, acquisitions or capital commitments; |\n\n\n| · | announcements relating to future development or license agreements including termination of such agreements; |\n\n\n| · | adverse developments with respect to our intellectual property rights or those of our principal collaborators; |\n\n\n| · | commencement of litigation involving us or our competitors; |\n\n\n| · | any major changes in our board of directors or management; |\n\n\n| · | new legislation in the United States relating to the prescription, sale, distribution or pricing of pet pharmaceuticals or diagnostic products; |\n\n\n| · | product liability claims, other litigation or public concern about the safety of our product candidates or future products; |\n\n\n| · | market conditions in the animal health industry, in general, or in the pet therapeutics sector, in particular, including performance of our competitors; and |\n\n\n| · | general economic conditions in the United States and abroad. |\n\nIn addition, the stock market, in general, or the market for stocks in our industry, in particular, may experience broad market fluctuations, which may adversely affect the market price or liquidity of our common shares. Any sudden decline in the market price of our common shares could trigger securities class-action lawsuits against us. If any of our shareholders were to bring such a lawsuit against us, we could incur substantial costs defending the lawsuit and the time and attention of our management would be diverted from our business and operations. We also could be subject to damages claims if we are found to be at fault in connection with a decline in our stock price.\nWe are an “emerging growth company,” as defined under the JOBS Act and if we take advantage of reduced disclosure requirements applicable to “emerging growth companies,” our common shares could be less attractive to investors.\nWe are an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012, as amended, or the JOBS Act, and, for as long as we continue to be an “emerging growth company,” we may choose to take advantage of certain exemptions from various reporting requirements applicable to other public companies but not to “emerging growth companies,” including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act of 2002, as amended, or SOX, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved. We could be an “emerging growth company” for up to five years, or until the earliest of (i) the last day of the first fiscal year in which our annual gross revenues exceed $1.07 billion, (ii) the date that we become a “large accelerated filer” as defined in Rule 12b-2 under the Exchange Act, which would occur if the market value of our common shares that is held by non-affiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter, or (iii) the date on which we have issued more than $1 billion in non-convertible debt during the preceding three year period. We cannot predict if investors will find our common shares less attractive if we choose to continue to rely on these exemptions. If some investors find our common shares less attractive as a result of any choices to reduce future disclosure, there may be a less active trading market for our common shares and our stock price may be more volatile.\n\n| 60 |\n\nIn addition, Section 107 of the JOBS Act provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. An “emerging growth company” can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have chosen to “opt out” of such extended transition period, however, and, as a result, we are required to comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to opt out of the extended transition period for complying with new or revised accounting standards is irrevocable.\nOur Articles of Amalgamation (as amended) authorize us to issue an unlimited number of common shares and preferred shares without shareholder approval and we may issue additional equity securities, or engage in other transactions that could dilute your ownership interest, which may adversely affect the market price of our common shares\nOur Articles of Amalgamation (as amended) authorize our Board of Directors, subject to the provisions of the ABCA, to issue an unlimited number of common shares and preferred shares without shareholder approval. Our Board of Directors may determine from time to time to raise additional capital by issuing common shares, preferred shares or other equity securities. We are not restricted from issuing additional securities, including securities that are convertible into or exchangeable for, or that represent the right to receive, common shares or preferred shares. Because our decision to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing, or nature of any future offerings, or the prices at which such offerings may be affected. Additional equity offerings may dilute the holdings of our existing shareholders or reduce the market price of our common shares, or both. Holders of our common shares are not entitled to pre-emptive rights or other protections against dilution. New investors also may have rights, preferences and privileges that are senior to, and that adversely affect, the then-current holders of our common shares. Additionally, if we raise additional capital by making offerings of debt or preference shares, upon our liquidation, holders of our debt securities and preferred shares, and lenders with respect to other borrowings, may receive distributions of our available assets before the holders of our common shares.\nWe have incurred significant costs as a result of operating as a U.S. public company, and our management will continue to devote substantial time to new compliance initiatives.\nAs a U.S. publicly traded company, we have incurred significant legal, accounting and other expenses and will incur additional expenses after we are no longer an “emerging growth company” as defined under the JOBS Act. In addition, new and changing laws, regulations and standards relating to corporate governance and public disclosure, including the Dodd-Frank Wall Street Reform and Consumer Protection Act and the rules and regulations promulgated thereunder, as well as under the Sarbanes-Oxley Act, the JOBS Act, and the rules and regulations of the U.S. Securities and Exchange Commission, or SEC, have created uncertainty for U.S. public companies and increased our costs and time that our board of directors and management must devote to complying with these rules and regulations. We expect these rules and regulations to increase our legal and financial compliance costs and lead to a diversion of management time and attention from revenue generating activities.\nFor as long as we remain an “emerging growth company” as defined in the JOBS Act, we may choose to take advantage of certain exemptions from various reporting requirements that are applicable to other U.S. public companies that are not “emerging growth companies.” These exceptions provide for, but are not limited to, relief from the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, less extensive disclosure obligations regarding executive compensation in our periodic reports and proxy statements, exemptions from the requirements to hold a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved and an extended transition period for complying with new or revised accounting standards. We may take advantage of these reporting exemptions until we are no longer an “emerging growth company.” We may remain an “emerging growth company” for up to five years. To the extent we are no longer eligible to use exemptions from various reporting requirements under the JOBS Act, we may be unable to realize our anticipated cost savings from those exemptions.\n\n| 61 |\n\nFailure to maintain effective internal control over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act could have a material adverse effect on our business and share price.\nAs a Canadian public company, we were not required to evaluate our internal control over financial reporting in a manner that meets the standards of U.S. public companies required by Section 404 of the Sarbanes-Oxley Act, or Section 404. We were required to meet these standards in the course of preparing our financial statements as of and for the year ended December 31, 2019, and our management has reported on the effectiveness of our internal control over financial reporting for such year. Additionally, under the JOBS Act, our independent registered public accounting firm is not required to attest to the effectiveness of our internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act until we are no longer an “emerging growth company.” The rules governing the standards that must be met for our management to assess our internal control over financial reporting are complex and require significant documentation, testing and possible remediation.\nIn connection with the implementation of the necessary procedures and practices related to internal control over financial reporting, we may identify deficiencies that we may not be able to remediate in time to meet the deadline imposed by the Sarbanes-Oxley Act for compliance with the requirements of Section 404. In addition, we may encounter problems or delays in completing the implementation of any requested improvements and receiving a favorable attestation in connection with the attestation provided by our independent registered public accounting firm. We will be unable to issue securities in the public markets through the use of a shelf registration statement if we are not in compliance with Section 404. Furthermore, failure to achieve and maintain an effective internal control environment could have a material adverse effect on our business and share price and could limit our ability to report our financial results accurately and timely.\nIf we sell common shares in future financings, shareholders may experience immediate dilution and, as a result, our share price may decline.\nWe may from time to time issue additional common shares at a discount from the existing trading price of our common shares. As a result, our shareholders would experience immediate dilution upon the sale of any shares of our common shares at such discount. In addition, as opportunities present themselves, we may enter into financing or similar arrangements in the future, including the issuance of debt securities, preferred shares or common shares. If we issue common shares or securities convertible into common shares, our common shareholders would experience additional dilution and, as a result, our share price may decline.\nFuture sales of our common shares by our shareholders or the perception that these sales may occur could cause our stock price to decline.\nAs of November 11, 2020, we had 564,051,438 common shares outstanding. Substantially all of our outstanding common shares have been registered for resale or other disposition by the holders thereof or are otherwise freely tradable by the holders thereof.\nSales of a substantial number of our common shares by our shareholders or the perception that these sales may occur, could depress the market price of our common shares and could impair our ability to raise capital through the sale of additional equity securities, even if there is no relationship between such sales and the performance of our business.\n\n| 62 |\n\nWe have never and do not, in the future, intend to pay dividends on our common shares, and your ability to achieve a return on your investment will depend on appreciation in the market price of our common shares.\nWe have never paid and do not expect to pay dividends on our common shares in the future. We intend to invest our future earnings, if any, to fund our growth and not to pay any cash dividends on our common shares. Since we do not intend to pay dividends, your ability to receive a return on your investment will depend on any future appreciation in the market price of our common shares. There is no assurance that our common shares will appreciate in price.\nAn active, liquid and orderly market for our common shares may not develop or be sustained, and you may not be able to sell your common shares.\nOur common shares trade on the NYSE American exchange. We cannot assure you that an active trading market for our common shares will develop or be sustained. The lack of an active market may impair your ability to sell the common shares at the time you wish to sell them or at a price that you consider reasonable. An inactive market may also impair our ability to raise capital by selling common shares and may impair our ability to acquire other businesses, applications or technologies using our common shares as consideration, which, in turn, could materially adversely affect our business.\nWe are subject to the continued listing requirements of the NYSE American. If we are unable to comply with such requirements, our common shares would be delisted from the NYSE American, which would limit investors’ ability to effect transactions in our common shares and subject us to additional trading restrictions.\nOur common shares are currently listed on the NYSE American. In order to maintain our listing, we must maintain certain share prices, financial and share distribution targets, including maintaining a minimum amount of shareholders’ equity and a minimum number of public shareholders. In addition to these objective standards, the NYSE American may delist the securities of any issuer if, in its opinion, the issuer’s financial condition and/or operating results appear unsatisfactory; if it appears that the extent of public distribution or the aggregate market value of the security has become so reduced as to make continued listing on the NYSE American inadvisable; if the issuer sells or disposes of principal operating assets or ceases to be an operating company; if an issuer fails to comply with the NYSE American’s listing requirements; if an issuer’s common stock sells at what the NYSE American considers a “low selling price” (generally trading below $0.20 per share for an extended period of time); or if any other event occurs or any condition exists which makes continued listing on the NYSE American, in its opinion, inadvisable. On April 10, 2020, we received a deficiency letter from the NYSE American indicating that the we are not compliance with Section 1003(f)(v) of the NYSE American Company Guide, because our common shares have been selling for a low price per share for a substantial period time. In addition, the NYSE American has advised us that if the trading price of our common shares falls below $0.06 per share, our common shares may be immediately suspended from further trading on the exchange.\nOur shareholders failed to approve a proposal to effect a reverse split of our common shares at our annual and special meeting of shareholders held on September 25, 2020. If shareholders approve the domestication and the domestication is effected, we intend to seek stockholder approval for a reverse split of our common stock promptly thereafter to regain compliance with the NYSE American’s continued listing standards, although no assurance can be given that stockholders will approve a reverse stock split.\nIf the NYSE American delists our common shares from trading on its exchange and we are not able to list our securities on another national securities exchange, we expect our common shares would qualify to be quoted on an over-the-counter market. If this were to occur, we could face significant material adverse consequences, including:\n\n| · | a limited availability of market quotations for our securities; |\n\n\n| · | reduced liquidity for our securities; |\n\n\n| · | a determination that our common shares are a “penny stock” which will require brokers trading in our common shares to adhere to more stringent rules and possibly result in a reduced level of trading activity in the secondary trading market for our securities; |\n\n\n| · | a limited amount of news and analyst coverage; and |\n\n\n| · | a decreased ability to issue additional securities or obtain additional financing in the future. |\n\n\nItem 6. Exhibits.\nThe exhibits listed on the accompanying index to exhibits immediately preceding the exhibits are filed as part of, or hereby incorporated by reference into, this Quarterly Report.\n\n| 63 |\n\nSIGNATURES\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| Zomedica Corp. |\n| By: | /s/ Robert Cohen |\n| Name: | Robert Cohen |\n| Title: | Interim Chief Executive Officer |\n| By: | /s/ Ann Marie Cotter |\n| Name: | Ann Marie Cotter |\n| Title: | Chief Financial Officer |\n\n\n| 64 |\n\nEXHIBIT INDEX\n\n| Exhibit No. | Description |\n| 3.1 | Articles of Amalgamation of Zomedica Pharmaceuticals Corp. (incorporated by reference to Exhibit 3.1 to the Company's Registration Statement on Form S-1 filed with the Commission on April 21, 2017 (File No. 333-217409)) |\n| 3.2 | Certificate of Amendment and Registration of Restated Articles of Zomedica Pharmaceuticals Corp. (incorporated by reference to Exhibit 3.3 to the Company's Registration Statement on Form S-1 filed with the Commission on April 21, 2017 (File No. 333-217409)) |\n| 3.3 | Certificate of Amalgamation of Zomedica Pharmaceuticals Corp. (incorporated by reference to Exhibit 3.4 to the Company's Registration Statement on Form S-1 filed with the Commission on April 21, 2017 (File No. 333-217409)) |\n| 3.4 | Articles of Amendment to the Articles of Incorporation of Zomedica Pharmaceuticals Corp. (incorporated by reference to Exhibit 3.5 to the Company’s Quarterly Report on Form 10-Q filed with the Commission on May 10, 2019 (File No. 001-38298)) |\n| 3.5 | Amended and Restated By-Law No. 1 (2nd Version) of Zomedica Pharmaceuticals Corp. (incorporated by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K filed with the Commission on August 7, 2020 (File No. 001-38298)) |\n| 10.9^ | Amendment, dated August 14, 2020, to Development and Supply Agreement with Qorvo Biotechnologies, LLC (incorporated by referent to Exhibit 10.9 to the company’s Registration Statement on Form S-4 filed with the Commission on October 9, 2020 (File No. 333-249401)) |\n| 10.10 | Letter Agreement, dated September 3, 2020, with Qorvo Biotechnologies, LLC (incorporated by referent to Exhibit 10.10 to the company’s Registration Statement on Form S-4 filed with the Commission on October 9, 2020 (File No. 333-249401)) |\n| 31.1 | Certification of Interim Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2 | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32.1* | Certification of Interim Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350. |\n| 101.INS | XBRL Instance Document.* |\n| 101.SCH | XBRL Taxonomy Extension Schema Document.* |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document.* |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document.* |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document.* |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document.* |\n\n* This certification is not deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, or otherwise subject to the liability of that section. Such certification will not be deemed to be incorporated by reference into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent that the registrant specifically incorporates it by reference.\n^ Certain identified information has been excluded from this exhibit because it is both (i) not material and (ii) would be competitively harmful if publicly disclosed.\n65\n\n</text>\n\nWhat is the change in the company's intrinsic value per share from December 31, 2019, to September 30, 2020?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nITEM 1. BUSINESS.\nKibush Capital Corporation (\"we\", \"us\", \"our\", the \"Company\" or the \"Registrant\") is a mineral and natural resources exploration company. We are currently undertaking mineral exploration activities in Australia and Papua New Guinea. Our business is comprised two subsidiaries Aqua Mining and Angel Jade. Our Aqua Mining subsidiary is active in mineral exploration in Papua New Guinea where we are exploring for gold. Our Angel Jade subsidiary is active in mineral exploration in New South Wales, Australia where we are exploring for jade. In addition, on June 12, 2015, the Company has taken over management of Paradise Gardens (PNG) Ltd., a timber logging and processing company in Papua New Guinea.\nWe are an exploration stage company as defined by the Security and Exchange Commission's (\"SEC\") Industry Guide 7 as the Company has no established reserves as required under the Industry Guide 7.\nHistory\nWe were incorporated in the State of Nevada on January 5, 2005 under the name Premier Platform Holding Company, Inc. The Company changed its name to Paolo Nevada Enterprises, Inc. on February 4, 2005. On August 18, 2006, the Company completed a merger with Premier Platform Holding Company, Inc., a Colorado corporation, where Paolo Nevada Enterprises, Inc. was the surviving entity. On November 1, 2006, the Company changed its name to the David Loren Corporation. On July 5, 2013, More Superannuation Fund, an Australian entity (\"More\"), obtained control of the Company from Beachwood Capital, LLC, a Nevada limited liability company. On August 23, 2013, the Company changed its name to Kibush Capital Corporation.\nOn October 15, 2013, the Company completed the acquisition of 80% of the common stock of Instacash Pty Ltd., a micro-lender licensed in Australia (\"Instacash\"). For the fiscal year ended September 30, 2014, Instacash had no revenues, $396,493 in assets and $429,270 in liabilities. In order to focus solely on its mining investments, the Company disposed of Instacash during the quarter ended March 31, 2015.\nOn March 23, 2015, the Company increased its ownership in Aqua Mining Limited, a Papua New Guinea limited company (\"Aqua Mining\") from 49% to 90% in exchange for assignment of the Company's entire interest in the Koranga Joint Venture to Aqua Mining. Due to the increase in ownership and due to the fact that the additional interest in Aqua Mining was acquired from a related party we changed the ament accounting treatment for this asset and are now consolidating its financials with our own. For the fiscal year ended September 30, 2014, Aqua Mining had no revenues, $18,565 in assets and $91,872 in liabilities. For the interim period ended March 31, 2015, Aqua Mining had no revenues, $46,755 in assets and $215,003 in liabilities.\nThe Company acquired control of Angel Jade Pty Ltd., an Australian limited company (\"Angel Jade\") through a series of transactions as follows: In October 2014, the Company negotiated the acquisition of a 50% interest in Angel Jade (which was 90,000,000 shares of common stock) from Five Arrows Limited in exchange for 14,000,000 shares of our common stock. However, this agreement was not formalized until December 10, 2014. On October 9, 2014, the Company acquired 3,673,470 shares of newly issued common stock of Angel Jade in exchange for $17,170 ($19,584 AUD). These two transactions combined were intended to provided Kibush Capital with exactly 51% of the common stock of Angel Jade and control of the that company. On November 6, 2014, the Company further increased its ownership of Angel Jade by purchasing an additional 45,918,300 shares of common stock directly from Angel Jade for $215,994 ($250,000 AUD) and by purchasing 18,367,350 share of common stock from Laima Trust for $86,398 ($100,000 AUD). Several minority shareholders have disputed the issuance of additional shares to the Company. See Item 3 for more detail. We now own approximately 69% share of the issued and outstanding shares of Angel Jade's common stock which totals 229,591,770 shares. For the fiscal year ended September 30, 2014, Angel Jade had no revenues, $13,906 in assets and no liabilities. For the interim period ended March 31, 2015, Angel Jade had no revenues, $179,075 in assets and $397 in liabilities. Angel Jade's financials are consolidated with our own financials in this report.\nThe Company is an \"emerging growth company\" as defined in the Jumpstart Our Business Startups Act (\"JOBS Act\").\nOur auditors have issued a going concern opinion. This means that our auditors believe there is substantial doubt that we can continue as an on-going business for the next twelve months unless we obtain additional capital to pay our bills. This is because we have not generated any significant revenues from our current business. In addition, we have sustained losses for the past two years and have a negative working capital at September 30, 2015. We must raise cash from sources other than operations. Our only other source for cash at this time is investments by others in our company. We must raise cash to continue our mining exploration activities and business development.\n\n| 4 |\n\nOur Business\nOur business is comprised of mining exploration activities through our subsidiaries Aqua Mining and Angel Jade. Our primary office is located at 7 Sarah Crescent, Templestowe, Victoria 3106, Australia. The company is an exploration stage company and there is no assurance that a commercially viable mineral deposit exists on any of our properties. Further exploration will be required before a final evaluation as to the economic and legal feasibility is determined.\nOn February 14, 2014, we entered into an Assignment and Bill of Sale with Five Arrows Limited (\"Five Arrows\") pursuant to which Five Arrows agreed to assign to the Company all of its right, title and interest in two 50 ton per hour trammels, one 35 ton excavator, a warehouse/office, a concrete processing apron and four 35 ton per hour particle concentrators which may be utilized for alluvial mining, the assignment also conveyed Five Arrow's interest in a joint venture with the holders of mining leases (\"Leaseholders\") for gold exploration in Papua New Guinea, specifically Mining Leases ML296-301 and ML278 covering approximately 26 hectares located at Koranga in Wau, Morobe Province, Papua, New Guinea (the \"Koranga Property\"). In consideration therefor, the Company issued 40,000,000 shares of its common stock to Five Arrows. On February 28, 2014, we entered into a joint venture agreement with the Leaseholders (the \"Joint Venture Agreement\") for the exploration of minerals on the Koranga Property. The Joint Venture Agreement entitles the leaseholders to 30% and the Company to 70% of net profits from the joint venture. On May 23rd 2015 this Joint Venture was sold to our subsidiary Aqua Mining (PNG) Ltd. Aqua Mining will manage and carry out the exploration at the site, including entering into contracts with third parties and subcontractors (giving priority to the Leaseholders and their relatives and the local community for employment opportunities and spin-off business) at its cost, and all assets, including equipment and structures built on the site, will be the property of the Company. The Leaseholders and Aqua Mining will each contribute 1% from their share of net profits to a trust account for landowner and government requirements. For the period ending September 30,2014 we have incurred expenditure of $208,512 primarily spent on exploration. From October through to December there has been an expenditure of $56,526 on capital equipment and further exploration costs.\nThe joint venture involves a lease that, between 2008 and 2011, has produced a total of 55,300 cubic meters of mined material which was processed to extract 51,000 grams of gold - raw weight (approximately 31kg pure gold) over the three years of mining activities. Gold production in 2010 averaged 1.97kg per month and in 2011 averaged 2.26kg per month. The overall raw gold grade is 0.92g per cubic meter. Pure gold grade is 0.55g per cubic meter. The Company is currently in the exploration stage for this lease. If and when successful, the Company may endeavor to undertake additional joint ventures on neighboring leaseholds (8 leaseholds border the area) to capitalize on the infrastructure and equipment we may install at Koranga.\nWe entered into a memorandum of understanding, dated May 1, 2014 with New Guinea Gold Corporation, for the purchase of New Guinea Gold Ltd., which was terminated by us on May 24, 2014 prior to commencing any transactions contemplated in connection therewith. The Company has no continuing obligations as a result of such termination.\nAqua Mining\nAqua Mining is currently in the exploration stage. Aqua Mining was created to undertake certain opportunities that exist within the mining sector of the economy of Papua New Guinea. The Director Mr. Vincent Appo, has extensive experience and knowledge in this sector and has over the years assembled a vast network of contacts and contractors that will assist the company in their managerial and operational endeavors. From the outset the company is negotiating over 2 mine sites for further exploration.\nAqua Mining in the past six months has negotiated and finalized with landowners in the WAU area of PNG, Joint Ventures to conduct mineral exploration activities. These Joint Venture Agreements will form the basis of applications to the Mining Resource Authority in PNG for Mining Licenses. In addition, Aqua Mining has been accepted as a developer of AML 694-695.\nOn or about April 8, 2015, the Company commenced exploration of the Alluvial Mining Lease 694/695 via its Subsidiary Aqua Mining PNG Limited. Mr. Vincent Appo, PNG Operations Manager, is overseeing the construction of the required infrastructure which is required for the Company's exploration activities.\nOn or about April 16, 2015, the Company announced commencement of a Jorc/43-101 report on the Mining Lease 694/695 and pending Mining Lease 296/301 held by its subsidiary, Aqua Mining PNG Limited.\nKen Unamba, a member of the Advisory Committee has been nominated to oversee this report. Vincent Appo, PNG Operations Manager, has undertaken substantial testing over the past 12 months on both areas and has enough data as a basis for assessment and review. Mr. Unamba will undertake additional surveys and sampling where necessary to provide further data to finalize the report to Kibush Capital.\nAngel Jade\nThe Company owns 70% of the ordinary shares of Angel Jade Pty Ltd, an Australian company. The assets of Angel Jade are comprised of Exploration License 8104, the area covered is 35 km SE of Tamworth, 300 sq. km in size, 250 km from the port of Newcastle, NSW and accessible by sealed road. Nephrite jade occurs in the New England Fold Belt, which extends from northeast New South Wales into southeast Queensland. The target mineral in this tenement is jade, but we will also explore for rhodonite.\n\n| 5 |\n\nAngel Jade has identified a 3 tiered exploitation of jade. The First Tier, finely ground lower quality jade to nano particle sized powder, enabling the jade to release infra-red radiation. These particles can be added to paint, ceramic tiles and to cotton for use in fabrics. The Second Tier, exclusive works of art created by the renowned artist Xie Shen. These carved pieces are typically between 0.5 and 2 tons each, and would be showcased at major Asian Art Galleries. The Third Tier is to establish a premium high end Jade Brand for jewelry and art, to be sold and marketed through respected gallery and jewelry outlets. The current price of jade per kilogram has a spread of $5 to $50 depending on the grade.\nParadise Gardens Development\nKibush Capital Corporation had entered into a management agreement with Paradise Gardens Development (PNG) Ltd, a Timber Logging and Processing Company with operations in Papua New Guinea (\"Paradise Gardens\"). The Company has the right to Paradise Gardens operates a Timber Authority registered with the PNG Forest Authority which permits an annual timber harvest of 5000 cubic meters, the total area under the Timber Authority is 3300 hectares. Predominant species include Terminalia, Aglaia, White Cheesewood, Pink Satinwood, Erima, Taun, Rosewood, Kwila and other hardwoods. Paradise Gardens primarily sells its timber locally to retailers and wholesalers in Papua New Guinea. The Company is in negotiations with the owner of Paradise Gardens to acquire control of Paradise Gardens. During the negotiation period, the Company's management fee includes the profit earned by Paradise Gardens during such period.\nThe Market\nAngel Jade\nNephrite jade is not a common mineral and occurs in nature very rarely and usually in remote locations, hence its prized status and value. It is currently mined in New Zealand, Pakistan, Canada, Russia and Australia. Climatic concerns limit the amount of mining that can be done in Canada and Russia and political extremism is a threat in Pakistan. New Zealand nephrite whilst generally high grade only occurs under the southern alps and glaciers and is usually only of the green variety and found in isolated small pods in small quantities.\nIn Australia, nephrite occurs in South Australia near Cowell, in Western Australia near Ninghan in the Murchison region outside of Perth and in New South Wales at the Angel Jade tenements near Tamworth. The Cowell and Ninghan nephrite deposits consist of 'black' nephrite mainly and are generally lower grade with small quantities of high-grade commercial saleable material.\nThe Angel Jade Tamworth occurrences are extensive, ranging along the great NS serpentinite belt of NSW that runs for over 200kms. The nephrite found there ranges in quality and varietal characteristics from classic imperial green, through to blue, black and the much prized 'mutton fat' coloration. Angel Jade is better placed than its competitors to be able to successfully continually supply quality and quantity of material to its selected markets.\nAqua Mining\nThe primary product is Gold and our market price based on the London Metals Exchange Daily Rate. This rate determines a market price for all material sold within the Refinery Market. Outside of that market competition dictates the price available, and that competition has effectively no difference in the quality of the material as it based on a gold percentage. A higher price can be obtained by selling to the spot traders who can distribute the material at lower volumes to industry consumers.\nMarketing and Distribution:\nAngel Jade\nA four pronged distribution approach for our nephrite (jade) has been developed that target: wholesale building suppliers through industry groups and trade shows, wholesale jewelry suppliers in China and SE Asia, direct marketing to the high end art market in China and the Middle East via brokers and producing material suitable for high tech industrial usage such as substrates and insulators through an industry based online campaign targeting research universities, R&D facilities and allied scientific suppliers.\nAqua Mining\nAs the principal material is gold, the options are to sell either to a refinery and be paid the daily spot rate, or to sell to the jewelry wholesale market. Both of these options exist internally within PNG however the wholesale market is quite small. There are several options when the material is exported from PNG, again it could be to any refinery within the region and that rate again would be the daily spot rate. The wholesale market outside the country would be significant and there are many opportunities within Australia to sell at a higher than spot rate to that market. There may also be parties that would take up the material on a contractual basis.\n\n| 6 |\n\nCompetition\nThe mining industry is acutely competitive in all of its phases. We face strong competition from other mining companies in connection with the acquisition of exploration stage properties or properties containing gold, jade and other mineral reserves. Many of these companies have greater financial resources, operational experience and technical capabilities than us. It is our goal to find under valued properties and team up with local joint venture partners to streamline our time to market and costs. In PNG in particular we are finding a number of such properties, as the enforcement of the Mining Act has forced traditional landowners to comply with the relevant requirements of the act. Their ability to do so is limited as they do not have the financial, or management resources to comply.\nRaw Materials, Principal Suppliers and Customers\nAngel Jade\nWe are not dependent on any principal suppliers and our raw materials are produced principally through our own mining activities. Our principal customers for our mining activities are wholesale markers in China, SE Asia and the Middle East. A customer base is yet to be established but that will occur over the next 12 months.\nAqua Mining\nWe are not dependent on any principal suppliers and our raw materials are produced principally through our own mining activities. Our principal customers for our mining activities are Refineries based in PNG. A wholesale customer base is yet to be established but that will occur over the next 12 months, after the company received the appropriate export licenses from the PNG government.\nIntellectual Property\nIntellectual property is not a large part of our current business model as we are selling non-unique materials through primarily conventional channels. One or more brands may yet be developed if we determine branding will benefit the Company.\nGovernment Regulations\nOur products and services are subject to foreign, federal, state, provincial and local laws and regulations concerning business activities in general, including the laws of Papua New Guinea and Australia.\nOur operations will be affected from time to time in varying degrees by domestic and foreign political developments, foreign, federal and state laws.\nAngel Jade\nThe mining industry in Australia is governed by Federal Government law but administered by the States. Angel Jade tenements are administered and regulated by the NSW Department of Trade and Industry (DTI). Its principal field office for the mining sector is located in Maitland, approximately 250 kilometers from Tamworth. To maintain the company's tenements in good order and standing with the DTI, an Annual Report must be lodged every year detailing all works to date and monies expended toward same. An environmental bond is also held by the DTI to ensure compliance and remediation on vacation of the tenement.\nAngel Jade currently holds an Exploration License, EL8104, which requires renewal every two years. Current date of renewal is June 30, 2015. Renewal is usually only withheld where there have been serious compliance issues. During the course of the exploration program, the company may elect to apply for one or more mining leases within the boundaries of its EL. This would be subject to satisfactory interpretation of geological data suggesting a commercial mining would be viable and could be established with some certainty.\nAqua Mining\nAs the 90% owner of Aqua Mining [PNG] Limited, a Papua, New Guinea company, we are required to obtain approval from the Investment Promotion Authority of Papua New Guinea to be recognized as a foreign investor for our mineral exploration joint venture with the Leaseholders of approximately 26 hectares located at Koranga in Wau, Morobe Province, Papua, New Guinea.\n\n| 7 |\n\nOn July 24, 2015, we received final approval from the Papua New Guinea Department of Environment and Conservation, the Papua New Guinea Mining Resources Authority and the Mining Advisory Committee. This approval allows for mechanized processing on on land controlled by the Koranga Joint Venture for a period of 20 years and Aqua Mining is the licensed contract miner for a period of 5 years. This AML license is limited to 50,000 tones of processing per year and to a maximum of 5-hectares of mining at any one time. We must report our exploration activities and sales monthly to the Mining Resource Authority and comply with the terms of the agreements with the landowners. The tribute agreement for this land requires contribution of 2% of gross sales over 3 grams of ton and 2% of gross sales when under 5 grams per ton.\nEnvironmental Regulations:\nAngel Jade\nEnvironmental issues and compliance are administered by the NSW EPA. The proposed mining activity and processing by Angel Jade will not involve the use of any chemicals, hence the key areas of concern to the EPA will be in the areas of soil erosion, flora and fauna, water monitoring and effective remediation. The EPA can issue non compliance notices that in the case of serious breaches may jeopardize the tenement's standing. However, this is considered a low risk for this style of mining where no chemicals are utilized and the mining activity is near surface.\nAqua Mining\nUnder our Alluvial Mining Lease, we must comply with the provisions of the Mining Act pertaining to Environmental requirements. We are subject to applicable environmental legislation including specific site conditions attached to the mining tenements imposed by the PNG Government Department of Environment and Conservation (\"DEC\"), the terms and conditions of operating licenses issued by the PNG Mineral Resources Authority (\"MRA\") and DEC, and the environment permits for water extraction and waste discharge issued by DEC. In the fourth quarter of fiscal 2014, the PNG Parliament approved a name change for the Department of Environment and Conservation to the Conservation Environment Protection Authority and that change has become effective.\nEmployees\nAs of January 10, 2015, the Company has 42 full time employees.\n\nITEM 1A. RISK FACTORS.\nWe are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and are not required to provide the information under this item.\n\nITEM 1B. UNRESOLVED STAFF COMMENTS.\nNot applicable to smaller reporting companies.\n\nITEM 2. PROPERTIES.\nThe Company does not lease any properties or facilities. We own a building consisting of 1,200 square feet of office and warehouse space on property owned by James Koitamara, a member of the Kornaga Joint Venture, located on mining lease ML297 in New Guinea. The building and other personal property was assigned to us by Five Arrows pursuant to the Assignment Agreement attached as Exhibit 10.5. The Company utilizes office space from its corporate counsel for a nominal quarterly fee, this space is physically located at 5635 N. Scottsdale Road, Suite 170, Scottsdale, AZ 85250. Management has determined that this arrangement is adequate for its current and immediate foreseeable operating needs. 8 1. The Koranga Joint Venture properties located in Papua, New Guinea: Description and Location of the Leases The Company does not own or lease any of the mining properties directly and we have no right to acquire a lease or license for the Koranga properties. Rather titles are held by the landowners who were given the properties covered by the mining leases by the Papua, New Guinea government from 1966 to 1968. The Company has the right to manage and finance the exploration of each mining license pursuant to a Joint Venture Agreement with each of the landowners. As part of that agreement, the Company is entitled to 70% of the net profits from mineral exploration and any production. The mining licenses included in the Koranga Joint Venture are: ML296, ML297, ML298, ML299, ML300 and ML301. Our conversion application for Mining Lease Nos. ML 296 through ML 301 was approved on July 24, 2015. The permit requires payment of K6440.96 (approximately $2,329 U.S. Dollars) within 30 days. This fee is comprised of a Security Deposit, a Tribute Agreement Fee, and rent through July 23, 2015. Furthermore, the permit holder must carry out works associated with the mining activity in accordance with the plans and specifications in the environment permit. Such requirements include nominal monetary payments, development of an environmental management plan, a waste management plan, water extraction plan, monitoring and reporting. Exploration History The historic alluvial mining activities for the Koranga leases was previously undertaken by New Guinea Gold Ltd. from 1935 to 1942, by Koranga Aluvial Mining Ltd. from 1943 to 1944, and by Koranga Westland Ltd. from 2008 to 2011. Koranga Westland Ltd.'s results were follows: 9 The results were produced by utilizing day and night shifts each day. Available production data collected over two years shows the following: 1. An average of 75 cubic meters of materials was processed per shift. However, records from Koranga Westland Ltd. show that without breakdowns, 130-50 cubic meters could be processed in a shift period. 2. The gold grade of the material ranges between 0.1g and 5 grams per cubic meter and averages around 0.6grams per cubic meter. Raw weight is around 0.92grams per cubic meter. 3. Fineness of the alluvial gold from the lease area is between 58% and 65%, and at times higher. 4. A total of 55,300 cubic meters of mined material was processed to extract 51,000 grams of gold - raw weight (approximately 31kg pure gold) over the two years of mining activities, during the period from 2008 to 2011. 5. The mined material is comprised both of conglomerates and interbedded conglomerate, siltstone, sandstone and mudstones. 6. The mined material was rare to weakly lithified, free digging, poorly consolidated with rock clasts dislodging easily. 7. Only sluice boxes were used to capture the concentrates. The recovery was 80% during the period from 2008 to 2011. All production data was recorded in a computer on site. A summary of the production data is given in Table 001 below Total Loads Production Grade (Ave) Trommels in Date From To M3 Gold (g) (g/m3) Operation 11/27/2009 12/21/2009 311.04 245.6 0.8 Trommel 1 1/01/2010 08/16/2010 10295.2 9136.2 0.9 Trommel 1 8/17/2010 08/31/2010 924.8 2097.1 2.3 Trommel 1 09/01/2010 09/30/2010 1730 3447.2 1.3 Trommel 1 10/01/2010 10/31/2010 2513 2584.8 1.03 Trommel 1 11/01/2010 11/30/2010 4332 2605.3 0.6 Trommel 1 01/01/2011 01/31/2011 1555 2018.6 1.3 Trommel 1 02/01/2011 02/28/2011 2061 915.9 0.45 Trommel 1&2 03/01/2011 03/31/2011 3666 2967.3 0.81 Trommel 1&2 04/01/2011 04/30/2011 4195 4051.4 0.97 Trommel 1&2 Koranga Westland Ltd. ceased production in 2011 due to capital constraints. The Company does not plan to undertake any exploration and/or development of the property. The property is split by the Koranga creek with sedimentary deposits running through the creek and side walls with visible gold strata's. The exploration activities will be alluvial mining and to that nature will be open pit. The present condition of the property is an open area with a river running through the center of the mining leases. The equipment used is new, the modernization is basic as the type of mining at this stage is sluice boxes and pressure hoses. The current mining lease only allows for non-mechanized processing. The current cost of equipment is approximately $150,000 and if and when we move to mechanized processing, we estimate the cost of equipment to be in excess of $1,000,000. There has been no annual production of minerals to report for the Koranga Joint Venture properties for fiscal years 2015 and 2014. Geology The tectonic feature that hosts the project site and may have been influential in creating an environment conducive for the alluvial gold deposit is the Bulolo graben. It is bounded on the East and West by sub parallel Northwest trending transfer structures while bounded by Northeast trending transfer structures on the North and South. The Northwest trending structures and the subsidiary fractures have accommodated much of the mineralization and have controlled a series of intrusions. The basement rock of the area is metamorphics, intruded by Miocene granodiorite, and believed to be the source of high fineness gold mineralization in the area. A serious of other intrusions occurred, giving rise to further mineralization which is believed to have contributed to much of the prospects in the project area. These intrusions where associated with volcanism that resulted in blocking off of the Bulolo River and consequently the formation of the gold bearing sequence. 10 Otibanda Formation The Otibanda Formation is the target alluvial gold bearing sedimentary sequence. It is a lacustrine sequence that was deposited in a fresh water lake. Mapping shows the apparent thickness of the sequence to be 700m and is alluvial gold bearing. The sequence is comprised of interbedded agglomerates, sandstones, siltstones and intercalated thin mudstone. The deposit is the result of an eruptive volcanism that blocked off the Bulolo River resulting in blockage and setting up of a fresh water lake. All sediments including gold shedding off from the surrounding hills and mountains were deposited into the lake. The enriched sequence is the source of gold for the miners down creek and our target in this project. Proven or probable reserves have not been established. The Koranga property has been physically inspected by Ken Unamba, a professional geologist, but a formal feasibility study for the property has not been prepared. Furthermore, there are no current detailed plans to conduct exploration on the property, nor are any phased programs planned. Exploration work will be performed and/or supervised by Mr. Ken Unamba, a geologist and member of our advisory committee. Mr. Unamba has a Science Degree majoring in Geology. His 22 years' work experience covers Exploration Geologist for Tolukuma Gold Mine Ltd., Consulting Geologist for Harmony Gold SE Asia and Filmena Resources Corp Philippines. He was appointed to the then Mining Advisory Board in 2000 for five years as Technical Advisor. Our exploration budget for Aqua Mining is $200,000, including geophysics, sampling and exploration labor. At this time, we are uncertain how our exploration work will be funded. 2. Angel Jade's EL8104 located near Tamworth, Australia: EL 8104 is situated approximately 35 kilometres south-east of the major regional centre of Tamworth, in north-eastern New South Wales. The EL covers about 100 square kilometres and was granted for Group 2 and Group 3 mineral exploration for a two-year renewable term. This EL (8104) supersedes Angel Jade's previous EL (7883) which covered the same area but without extensions to the north and east. EL8104 is believed to contain nephrite jade and other minerals. Proven or probable reserves have not been established. The license for EL8104 is issued by the New South Wales State Government. This license permits us to take up to 70 tons of material for evaluation and testing annually. In order to maintain our license, the Company must undertake exploration activities of at least AUS $150,000 per year. We are currently in the renewal period as our renewal application was submitted June 10, 2015. If approved, the renewal term would run through June 15, 2017. While we have no reason to believe the renewal application will be denied, if our renewal is not approved, our license would immediately terminate. Access to the license area is obtained along a sealed road connecting Tamworth with Port Macquarie. The road runs south-east from Dungowan to Ogunbil and passes through the south-west corner of the licence area, following Dungowan Creek. The main access to EL8104 is via a dirt road which turns off this road about 10.5 kilometres south-east of Dungowan and follows Spring Creek and Teatree Gully, to Mulla Creek, through the centre of the EL. There are a number of habitations and other buildings along Dungowan Creek, but most of the licence area is fairly hilly and forested, with no buildings. Cattle are pastured in the Dungowan Creek area and to a lesser extent in the west and north of the licence. This EL was applied for to cover a serpentinite belt which is known to host several nephrite jade occurrences. This serpentinite trends slightly east of north and is probably a splay from the major north-north-west trending Peel Fault serpentinite belt to the west. Jade was apparently first found here in about 1962 (MacNevin & Holmes, 1980) but was not officially documented or petrologically identified until 1964 (Smith, 1964). Angel Jade applied for and was granted 59 units in addition to the original EL in June 2013. In October of 2013, access was arranged with three of the landholders whose properties contain the area of old workings and most potential for further discoveries. 11 The company has been unable to explore significant portions of the EL because access agreements have not yet been established with all of the landowners. The Company has spent money and resources negotiating access agreements with many of the landholders and is making progress with many of the owners. However, there are some landowners who are holding out and may force the Company to take legal action to secure its right to access the property for mineral exploration. There has been no annual production of minerals to report for Angel Jade for fiscal years 2015 and 2014. 12 Geology: The nephrite jade occurs in the New England Fold Belt, which extends from northeast New South Wales into southeast Queensland. The jade occurrence is within the central block of the fold belt, a few kilometres east of the Peel Fault, a major structure which runs slightly west of north in the project area location. The \"country rock\" in the jade region is predominantly metamorphosed (sub-green schist facies) fine grained sediments, plus chemical sediments (chert, jasper) and some meta-volcanics (mostly basaltic and/or andesitic). These are part of the Woolomin Group and the stratigraphy is steeply dipping and trends roughly north-south. EL 8104 covers a smaller serpentinite belt which is known to host several nephrite jade occurrences. The jade-bearing serpentinite belt was evidently not properly recognised when the jade was first found and mined and is not shown on the 1:250,000 Tamworth geological map sheet, first published by the Geological Survey of New South Wales in 1971, about nine years after the first jade discovery in the project area. It is, however, shown in the 1:250,000 digital dataset now available and the fault-bounded serpentinite bodies from this dataset are shown within that dataset. There are three smaller bodies to the south and one larger elongate body to the north. Copper is probably the main economic mineral in the area, with a number of small to medium sized deposits occurring, usually in association with the serpentinites and/or (possibly) meta-volcanics within the country rock. No copper has been recorded in the serpentinites hosting the jade occurrences. There are also numerous rhodonite occurrences of varying sizes within a north-south zone extending about 20 kilometres east of the Peel Fault. These are typically lenses in the country rock, associated with stratiform manganese oxide bodies. There is a small historic gold-field about 5 kilometres east of EL 8104, at Weabonga. The gold is in small quartz veins and recorded production was about 7,000 ounces (Mumbil Mines NL, 1989). This area is currently covered by EL 6620, Icon Resources Ltd. The Tamworth nephrite jade has been documented as occurring in lens-shaped bodies (locally referred to as \"seams\") on the faulted contact of the serpentinite and country rock. The country rock is mostly comprised of low-grade metamorphosed shale, siltstone, and silty sandstone. The compact, fine-grained nephrite is inferred to have formed under pressure in this contact zone. 13 Hockley et al, 1978, identifies a zonation from massive serpentinite, to schistose serpentinite, to talc, to nephrite, to \"country rock\" (quartz phyllite). This is probably based on one of the two sites apparently visited by Hockley, however and may be a gross simplification, which may not generally apply. The serpentinite is probably commonly schistose close to the faulted margin/contact with the country rock, as might be expected in such a deformational zone but the nephrite and talc will not always be present (one or both may be missing) and the \"talc\" may actually (often) be more a massive fine grained serpentine mineral. Serpentine is a secondary mineral produced by the hydrothermal alteration of magnesium silicate minerals. The distinction needs to be made between serpentine, the mineral and serpentinite, the rock. Serpentine mineral is typically massive, fine grained, moderately soft (hardness 2 to 5), may have a slightly greasy feel and is commonly greenish in colour. Differentiation between serpentine and nephrite in hand specimen may be difficult, except by identifying the greater hardness of the nephrite. At the Tamworth jade project, much of the material dismissed as \"talc\" may actually be a serpentine, as may some of the rock initially identified as \"jade\". There are a number of varieties of serpentine minerals recognised and some may be of value in their own right (though less so than nephrite) for carving or ornamental purposes. \"Bowenite\", which apparently occurs within EL 8104, is a variety of antigorite serpentine. The Angel Jade property has been physically inspected by Matthew Stephens, a professional geologist, but a formal feasibility study for the property has not been prepared. Furthermore, there are no current detailed plans to conduct exploration on the property, nor are any phased programs planned. Exploration work will be performed and/or supervised by Matthew Stephens. Mr. Stephens has had over 25 years of continuous experience in the Mining Industry, having worked in Metalliferous Mining, Development, Resource Evaluation and Exploration. Matthew has been involved in the active (i.e. \"hands on\") exploration of a variety of commodities including Gold, Base Metals, Iron and Uranium as well as having detailed exposure with the development and mining of nine underground mines and nine open pit operations throughout Queensland, Western Australia, New South Wales and the Northern Territory. Matthew holds a BAppSc (Geology) and is a member if the AusIMM (MAusIMM). Our exploration budget for the Angel Jade project is $2,000,000 as follows: · Detailed mapping of EL and new extensions - $250,000 · Costeaning and trenching on 'Pitt' property - $550,000 · Drill program to explore nephrite intrusion at depth - $1,200,000 At this time, we are uncertain how our exploration work will be funded.\nITEM 3. LEGAL PROCEEDINGS.\nWe are not presently a party to any litigation. However, the minority shareholders in Angel Jade are challenging the basis of funding by Kibush Capital that resulted in the share issuances that gave Kibush Capital a controlling interest in Angel Jade. Our Australian legal representatives have expressed the opinion that the Angel Jade Board did unanimously resolve and pass the share issuances in question. Kibush Capital will vigorously contest any challenge to the share issuance.\n\nITEM 4. MINE SAFETY DISCLOSURES.\nNot Applicable.\n\n| 14 |\n\nPART II\n\nITEM 5. MARKET PRICE FOR THE REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.\nMarket Information\nFiscal Year - 2015 High Bid Low Bid Fourth Quarter: 7/1/15 to 9/30/15 0.045 0.0075 Third Quarter: 4/1/15 to 6/30/15 0.12 0.027 Second Quarter: 1/1/15 to 3/31/15 0.32 0.1004 First Quarter: 10/1/14 to 12/31/14 0.50 0.1101 Fiscal Year - 2014 High Bid Low Bid Fourth Quarter: 7/1/14 to 9/30/14 0.52 0.30 Third Quarter: 4/1/14 to 6/30/14 0.4151 0.2001 Second Quarter: 1/1/14 to 3/31/14 0.38 0.2001 First Quarter: 10/1/13 to 12/31/13 1.00 0.23 Our shares of common stock are traded on the OTC Pink operated by the Financial Industry Regulatory Authority (FINRA) under the symbol \"DLCR\". The shares trading of our common stock began on August 1, 2013. Holders As of January 10, 2016, we had 202 stockholders of record. Dividends We have never declared or paid cash dividends. There are currently no restrictions which limit our ability to pay dividends in the future. On January 8, 2016 the closing bid price of our common stock on the OTC pink sheets quotation system was $0.0175 per share. As of January 10, 2016 there were 202 holders of record of our common stock. Dividends We have not declared or paid any cash dividends on our common stock and we do not anticipate paying any dividends in the foreseeable future. We expect to retain any future earnings to finance our business activities and any potential expansion. The payment of cash dividends in the future will depend upon our future revenues, earnings and capital requirements and other factors the Board considers relevant. Warrants or Options The Company does not have any warrants outstanding and the Company has not yet adopted a stock option plan. Securities Authorized for Issuance under Equity Compensation Plans We do not have any equity compensation plans. Repurchase of Securities None. 15 Recent Sales of Unregistered Securities On April 29, 2015, the Company issued 3,001,702 shares of its common stock to Warren Sheppard (previously authorized by for issuance by the company on December 10, 2014) pursuant to his employment agreement. Between April 1, 2015 and June 24, 2015, the Company issued a total of 4,000,000 shares of common stock upon the requests from convertible note holders to convert principal totaling $4,000 into the Company's common stock based on the terms set forth in the loans. The conversion rate was $0.001. On February 4, 2015, the Company issued 2,000,000 shares of common stock to Cavanagh pursuant to conversion of a portion of the Convertible Promissory Note dated May 1, 2012. On April 5, 2015, the Company issued 2,000,000 shares of common stock to Cavanagh pursuant to conversion of a portion of the Convertible Promissory Note dated May 1, 2012. On or about April 24, 2015, the Company issued 14,000,000 shares of common stock to Five Arrows for the Angel Jade acquisition pursuant to that Agreement dated December 10, 2014. Each of the foregoing issuances was exempt from the registration requirements of the Securities Act of 1933, as amended pursuant to Section 4(2). As of January 10, 2016, there are 80,399,187 shares of the Company's common stock issued and outstanding. Securities authorized for issuance under equity compensation plans We have no equity compensation plans at the present time. Section 15(g) of the Securities Exchange Act of 1934 Our company's shares are covered by Section 15(g) of the Securities Exchange Act of 1934, as amended that imposes additional sales practice requirements on broker/dealers who sell such securities to persons other than established customers and accredited investors (generally institutions with assets in excess of $5,000,000 or individuals with net worth in excess of $1,000,000 or annual income exceeding $200,000 or $300,000 jointly with their spouses). For transactions covered by the Rule, the broker/dealer must make a special suitability determination for the purchase and have received the purchaser's written agreement to the transaction prior to the sale. Consequently, the Rule may affect the ability of broker/dealers to sell our securities and also may affect your ability to sell your shares in the secondary market. Section 15(g) also imposes additional sales practice requirements on broker/dealers who sell penny securities. These rules require a one page summary of certain essential items. The items include the risk of investing in penny stocks in both public offerings and secondary marketing; terms important to in understanding of the function of the penny stock market, such as \"bid\" and \"offer\" quotes, a dealers \"spread\" and broker/dealer compensation; the broker/dealer compensation, the broker/dealers duties to its customers, including the disclosures required by any other penny stock disclosure rules; the customers rights and remedies in causes of fraud in penny stock transactions; and, the FINRA's toll free telephone number and the central number of the North American Administrators Association, for information on the disciplinary history of broker/dealers and their associated persons. The application of the penny stock rules may affect your ability to resell your shares.\nITEM 6. SELECTED FINANCIAL DATA.\nWe are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and are not required to provide the information under this item.\n\nITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.\nUntil 2013 we were engaged in the design, production and wholesale merchandising of quality women's and men's apparel, and home furnishings. Since then our business activities are conducted through our wholly-owned subsidiaries. Our business consists of a jade exploration venture in Australia and an gold exploration venture in Papua, New Guinea.\nWe qualify as an \"emerging growth company\" under the JOBS Act. As a result, we are permitted to, and intend to, rely on exemptions from certain disclosure requirements. For so long as we are an emerging growth company, we will not be required to:\n\n| 16 |\n\n\n| · | have an auditor report on our internal controls over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act; |\n| · | comply with any requirement that may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor's report providing additional information about the audit and the financial statements (i.e., an auditor discussion and analysis); |\n| · | submit certain executive compensation matters to shareholder advisory votes, such as \"say-on-pay\" and \"say-on-frequency;\" and |\n| · | disclose certain executive compensation related items such as the correlation between executive compensation and performance and comparisons of the CEO's compensation to median employee compensation. |\n\nIn addition, Section 107 of the JOBS Act also provides that an emerging growth company can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. In other words, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have elected to take advantage of the benefits of this extended transition period. Our financial statements may therefore not be comparable to those of companies that comply with such new or revised accounting standards. We will remain an \"emerging growth company\" for up to five years, or until the earliest of (i) the last day of the first fiscal year in which our total annual gross revenues exceed $1 billion, (ii) the date that we become a \"large accelerated filer\" as defined in Rule 12b-2 under the Securities Exchange Act of 1934, which would occur if the market value of our ordinary shares that is held by non-affiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter or (iii) the date on which we have issued more than $1 billion in non-convertible debt during the preceding three year period. The following discussion of the financial condition and results of our operations should be read in conjunction with the financial statements and the related notes thereto included elsewhere in this Annual Report on Form 10-K for the year ended September 30, 2015 (this \"Report\"). This report contains certain forward-looking statements and our future operating results could differ materially from those discussed herein. Certain statements including, without limitation, statements containing the words \"believes\", \"anticipates,\" \"expects\" and the like, constitute \"forward-looking statements\". Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Given these uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. We disclaim any obligation to update any such factors or to announce publicly the results of any revisions of the forward-looking statements contained or incorporated by reference herein to reflect future events or developments. Plan of Operations The Company's current strategy is to engage in mining activities. We are currently focused on building its management team. The Company hopes to undertake a number of additional mining projects so the cost of the team could be amortized over a number of cost centers. We believe that this team would enable the Company to consider exploration in various geographical locations in addition to Papua New Guinea. For example, there are a number of projects that we have identified that would flow from our involvement in our mining joint venture in Papua New Guinea. Under the terms of our joint venture we are able to supply food, clothing, housing and medical supplies which we would hope to be able to service not only our requirements in the region but to expand and supply other markets within that region. We believe that there may be other opportunities that would evolve from our presence in Papua, New Guinea if we have an infrastructure to capitalize on those opportunities. We currently believe that we will need $2,000,000 over the next 12 months to develop plans for our business. In addition to the dispute described in Item 3, we have recently experienced a few setbacks with our Angel Jade subsidiary. In addition, the government has imposed new requirements which would require us to hire a registered Mine Manager and limits the extraction volumes allowed under an exploration lease to 1 ton per year. Moreover, the Mining Department has been slow to renew our exploration license for the current period. As a result of the foregoing difficulties, we are reviewing our current opportunities and analyzing whether whether Angel Jade is in alignment with the financial model required by the Company. 17 We are exited about the opportunity to takeover of the management of Paradise Gardens and its timber operation. In fact, all of our revenue from the year ended September 30, 2015 was generated from the management agreement with Paradise Gardens. The management agreement provides us, through our subsidiary Aqua Mining, with the opportunity to develop the current logging areas under permit, to develop new areas for logging outside the existing area permit area, and to spread the customer base from the existing to now incorporate retail, contract felling and long term commercial orders. In December 2015, we established a small lumber outlet in Port Moresby to serve the local construction industry. We are now seeking to acquire ownership of Paradise Gardens and/or other timber assets in Papua New Guinea. Results of Operations For the year ended September 30, 2015 and September 30, 2014 Revenues The Company had $32,000 in revenue for the year ended September 30, 2015 and no revenue for the year ended September 30, 2014. The increase in revenue of $32,000 is attributable to the sale of timber under the management agreement with Paradise Gardens. Operating expenses The Company had operating expenses of $1,243,666 for the year ended September 30, 2015 consisting of general and administrative expenses, as compared with operating expenses of $818,588 for the year ended September 30, 2014 consisting of general and administrative expenses. The increase of $425,078 was attributable in part to the costs associated with getting the timber logging operations up to date, starting works on the infrastructure at Koranga and additional administrative expense Net Loss The Company had a net operating loss of $1,211,666 for the year ended September 30, 201 compared with a net operating loss of $818,588 for the year ended September 30, 2014. The increase of $393,078 was primarily attributable to the costs associated with getting the timber logging operations up to date, starting works on the infrastructure at Koranga and additional administrative expense. Operating Activities Net cash used in operating activities was $925,853 for the year ended September 30, 2015 compared to net cash used in operating activities of $193,239 for the year ended September 30, 2014. The increase of $732,614 was a result mainly from in part to the costs associated with getting the timber logging operations up to date, starting works on the infrastructure at Koranga and additional administrative expense. Investing Activities Net cash used in investing activities was $17,050 for the year ended September 30, 2015 compared to $92,586 for the year ended September 30, 2014. This increase resulted from the acquisition of Instacash which is no longer operated by the Company. Financing Activities Net cash provided by financing activities was $1,353,993 for the year ended September 30, 2015 compared to $1,651,454 for the year ended September 30, 2014.The decrease of $297,455 was mainly due to a decrease in cost of financing. Liquidity and Capital Resources As of September 30, 2015, the Company had total current assets of $105,496 and total current liabilities of $1,923,196 resulting in a working capital deficit of $1,817,699. As of September 30, 2014, the Company had total current assets of $236,280 and total current liabilities of $1,745,730 resulting in a working capital deficit of $1,509,450. The increase in working capital deficit arose mainly due to increase in loans owing to related parties, who provided advances to the Company for working capital purposes. The Company had cash as of September 30, 2015 of $10,763. The Company intends to fund its exploration through the sale of its equity securities. However, there can be no assurance that the Company will be successful doing so. We currently have no agreements, arrangements or understandings with any person to obtain funds through bank loans, lines of credit or any other sources. We currently believe that the Company will need approximately $2,000,000 over the next 12 months to implement our desired expansion of mining activities. 18 Going Concern The Company is in the development stage and has insufficient revenues to cover its operating costs. As of September 30, 2015, the Company had an accumulated deficit of $10,986,677 and a working capital deficiency and insufficient cash resources to meet its planned business objectives. These and other factors raise substantial doubt about the Company's ability to continue as a going concern. Management's plan for our continued existence includes selling additional stock through private placements and borrowing additional funds to pay overhead expenses while maintaining marketing efforts to raise our sales volume. Our future success is dependent upon our ability to achieve profitable operations, generate cash from operating activities and obtain additional financing. There is no assurance that we will be able to generate sufficient cash from operations, sell additional shares of common stock or borrow additional funds. Our inability to obtain additional cash could have a material adverse effect on our financial position, results of operations and our ability to continue as a going concern. We have only had operating losses which raise substantial doubts about our viability to continue our business and our auditors have issued an opinion expressing the uncertainty of our Company to continue as a going concern. If we are not able to continue operations, investors could lose their entire investment in our Company. Contractual Obligations The Company is not party to any contractual obligations other than indicated in Notes 5 and 6. Off Balance Sheet Arrangements We have no off balance sheet arrangements other than as described above. We have not entered into any other financial guarantees or other commitments to guarantee the payment obligations of any third parties. We have not entered into any derivative contracts that are indexed to our shares and classified as shareholder's equity or that are not reflected in our consolidated financial statements. Furthermore, we do not have any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity. We do not have any variable interest in any unconsolidated entity that provides financing, liquidity, market risk or credit support to us or engages in leasing, hedging or research and development services with us.\nITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.\nWe are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and are not required to provide the information under this item.\n\n| 19 |\n\n\nITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.\nINDEX TO FINANCIAL STATEMENTS\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM 21 Balance Sheet 22 Statement of Stockholders' Equity (Deficiency) 23 Statements of Operations 24 Statements of Cash Flows 25 Notes to Financial Statements 26 20 Scrudato & Co., PACERTIFIED PUBLIC ACCOUNTING FIRM REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders ofKibush Capital Corporation We have audited the accompanying balance sheet of Kibush Capital Corporation as of September 30, 2015 and 2014 and the related consolidated statements of operations, changes in stockholders' deficit and cash flows for the years then ended. These financial statements are the responsibility of the Company management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Kibush Capital Corporation at September 30, 2015 and 2014, and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. The accompanying financial statements have been prepared assuming that Kibush Capital Corporation will continue as a going concern. As more fully described in Note 4, the Company had an accumulated deficit at September 30, 2015 and 2014, a net loss and net cash used in operating activities for the fiscal year then ended. These conditions raise substantial doubt about the ability of the Company to continue as a going concern. Management's plans in regards to these matters are also described in Note 4. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty. /s/ Scrudato & Co., PA Scrudato & Co., PACalifon, New JerseyJanuary 6, 2016 7 Valley View Drive Califon, New Jersey 07830 (908)534-0008 Registered Public Company Accounting Oversight Board Firm 21 KIBUSH CAPITAL CORPORATION CONSOLIDATED BALANCE SHEETSeptember 30, 2015 2014 ASSETS: CURRENT ASSETS Cash $ 10,763 $ 110,152 Prepaid expenses 0 6,035 TOTAL CURRENT ASSETS $ 10,763 $ 116,187 Property and equipment, net 48,544 79,594 Investment in unconsolidated Joint Venture/Mining Rights 0 40,000 OTHER ASSETS 22,627 499 Deposits Paid 9,562 499 Goodwill 14,000 TOTAL CURRENT ASSETS AND TOTAL ASSETS 105,496 236,280 LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIENCY): CURRENT LIABILITIES: Accounts Payable 11,147 2,957 Accrued Expenses 326,187 354,685 Promissory Notes Payable 34,374 Convertible notes payable, net of discounts of $80,434 and $3,099, respectively 182,166 108,292 Loans from Related Parties 679,227 446,799 Derivative Liabilities 498,417 752,997 Deposits 155,300 80,000 Shares to be Issued - Five Arrows 36,378 TOTAL CURRENT LIABILITIES $ 1,923,196 1,745,730 TOTAL CURRENT LIABILITIES $ 1,923,196 1,745,730 STOCKHOLDERS' EQUITY (DEFICIENCY) Preferred stock, $0.001 par value; 50,000,000 shares authorized; Series A 3,000,000 shares issued and outstanding at September 30, 2015 and 2014, respectively $ 3,000 $ 3,000 Common stock, $0.001 par value; 500,000,000 shares authorized at September 30, 2015 and 2014, respectively; 53,837,485 and 563,485 shares issued and outstanding at September 30, 2015 and 2014, respectively 77,399 53,837 Additional paid-in capital 9,151,960 8,494,962 Accumulated deficit (10,986,677 ) (10,225,051 ) Accumulated other comprehensive income 0 55,022 Total stockholders' deficit, including non-controlling interest $ (1,754,318 ) $ (1,618,230 ) Non-Controlling interest $ (63,381 ) $ 108,780 Total stockholders' deficit (1,817,699 ) (1,509,450 ) Total liabilities and stockholders' deficit 105,496 236,280 \"See notes to financial statements\" 22 KIBUSH CAPITAL CORPORATIONCONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (DEFICIENCY)For the years ended September 30, 2015 and 2014 Additional Non Accumulated Other Total Common Stock Preferred Stock Paid-in Controlling Accumulated Comprehensive Stockholders' Shares Amount Shares Amount Capital Interest Deficit Income Deficit Balance at September 30, 2013 563,485 563 3,000,000 3,000 8,494,962 (8,589,817 ) - (91,292 ) Purchase of MOU for acquisition of Instacash Group @ 0.0117 per share of common stock 10,000,000 10,000 10,000 Repayment of convertible loans @ .001 per share of common stock 3,274,000 3,274 3,274 Purchased of MOU for the acquisition of Joint Venture Group @ 0.00369 Per Share of common stock 40,000,000 40,000 40,000 Purchase of controlling interest in subsidiary 125,000 125,000 Foreign currency translation adjustment 55,022 55,022 Prior Period adjustment - - Net Income (Loss) (16,220 ) (1,635,234 ) (1,651,454 ) Balance at September 30, 2014 53,837,485 53,837 3,000,000 3,000 8,494,962 108,780 (10,225,051 ) 55,022 (1,509,450 ) . Repayment of convertible loans @ .001 per share of common stock 2,560,000 2,560 2,560 Repayment of convertible loans @ .001 per share of common stock 2,000,000 2,000 2,000 Repayment of convertible loans @ .001 per share of common stock 2,000,000 2,000 2,000 Common stock issued - Warren Sheppard 3,001,702 3,002 696,998 700,000 Common stock issued - Five Arrows 14,000,000 14,000 14,000 Prior period adjustment - Investment in Aqua Mining (40,000 ) (40,000 ) Prior period adjustment 3 529,486 (55,022 ) 474,467 Sold subsidiary consolidated reversals (108,780 ) (108,780 ) Adjustment of sold subsidiary (501 ) (501 ) Exchange rate variation (928 ) 2 (926 ) Net Income (Loss) (62,456 ) (1,290,613 ) (1,353,069 ) Balance at September 30, 2015 77,399,187 77,399 3,000,000 3,000 9,151,960 (63,381 ) (10,986,677 ) - (1,817,699 ) \"See notes to financial statements\" 23 KIBUSH CAPITAL CORPORATIONCONSOLIDATED STATEMENTS OF OPERATIONSFor the years ended September 30, 2015 2014 Net revenues $ 32,000 - Cost of sales - - Gross profit 32,000 - Operating expenses: Research and development - - General and administrative 1,243,666 818,588 Total operating expenses 1,243,666 818,588 Loss from operations (1,211,666 ) (818,588 ) Other income (expense): Interest income - - Interest expense (389,425 ) (925,248 ) Other income - - Change in fair value of derivative liabilities 247,098 92,382 Total other expense, net (142,327 ) (832,866 ) Loss before provision for income taxes (1,353,993 ) (1,651,454 ) Provision for income taxes - - Net loss from Operations $ (1,353,993 ) $ (1,651,454 ) Less: Loss attributable to non-controlling interest 63,381 16,220 Net loss attributable to Holding Company (1,290,613 ) (1,635,234 ) Basic and diluted loss per common share $ (0.04 ) $ (0.05 ) Weighted average common shares outstanding basic and diluted 36,026,011 36,026,011 \"See notes to financial statements\" 24 KIBUSH CAPITAL CORPORATIONCONSOLIDATED STATEMENTS OF CASH FLOWSFor the years ended September 30, Year Ended September 30, Year Ended September 30, 2015 2014 Operating Activities: Net loss $ (1,290,613 ) $ (1,651,454 ) Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Depreciation and amortization 5,604 12,992 Amortization of debt discount 334,731 721,360 Interest expense related to fair value of derivative instruments granted 378,563 Change in fair value of derivative instruments (247,098 ) (92,382 ) Stock based payments 10,000 Changes in operating assets and liabilities: Prepaid expenses and other assets 6,035 (6,035 ) Others asset (22,128 ) (499 ) Accounts payable 8,190 2,957 Accrued expenses 137,500 251,329 Accrued interest 76,187 99,930 Deposits 65,738 80,000 Net cash used in operating activities (925,854 ) (193,239 ) Investing Activities: Goodwill on Consolidation (14,000 ) - Purchase of property and equipment 31,050 (92,586 ) Net cash used in investing activities 17,050 (92,586 ) Financing Activities: Proceeds from issuance of convertible debt, net of debt discounts - - Repayment of loan from related party - - Proceeds from related party loans, net of debt discounts 745,204 339,920 Effective of exchange rates on cash 64,211 55,022 Net cash provided by financing activities 809,414 394,942 Net change in cash (99,390 ) 109,117 Cash, beginning of year 110,152 1,035 Cash, end of year $ 10,762 $ 110,152 \"See notes to financial statements\" 25 KIBUSH CAPITAL CORPORATIONNOTES TO FINANCIAL STATEMENTS NOTE 1 - CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Business Kibush Capital Corporation (formerly David Loren Corporation) (the \"Company\") includes 90% owned subsidiary Aqua Mining (PNG), and its 70% owned subsidiary Angel Jade Pty, Ltd. See Basis of Presentation below. The Company has two primary businesses: (i) mining exploration within Aqua Mining and Angel Jade, and (ii) management services currently operated by Aqua Mining. Basis of Presentation The Company maintains its accounting records on an accrual basis in accordance with generally accepted accounting principles in the United States of America (\"U.S. GAAP\"). The consolidated financial statements of the Company include the accounts of the Company, and all entities in which a direct or indirect controlling interest exists through voting rights or qualifying variable interests. All intercompany balances and transactions have been eliminated in the consolidated financial statements. Change in Fiscal Year End The Board of Directors of the Company approved on September 14, 2014, a change in the Company's fiscal year end from December 31 to September 30 of each year. Going Concern The accompanying financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and the liquidation of liabilities in the normal course of business. As at September 30, 2014, the Company has an accumulated deficit of $10,332,404 and $9,172,862 as of September 30, 2015 and has not earned sufficient revenues to cover operating costs since inception and has a working capital deficit. The Company intends to fund its mining exploration through equity financing arrangements, which may be insufficient to fund its capital expenditures, working capital and other cash requirements for the year. The ability of the Company to emerge from the development stage is dependent upon, among other things, obtaining additional financing to continue mining exploration and execution of its business plan. In response to these problems, management intends to raise additional funds through public or private placement offerings. These factors, among others, raise substantial doubt about the Company's ability to continue as a going concern. The accompanying financial statements do not include any adjustments that might result from the outcome of this uncertainty. Functional and Reporting Currency The consolidated financial statements are presented in U.S. Dollars. The Company's functional currency is the U,S, Dollar. The functional currency of Angel Jade is the Australian dollar. Assets and liabilities are translated using the exchange rate on the respective balance sheet dates. Items in the income statement and cash flow statement are translated into U.S. Dollars using the average rates of exchange for the periods involved. The resulting translation adjustments are recorded as a separate component of other comprehensive income/(loss) within stockholders' equity. The functional currency of foreign entities is generally the local currency unless the primary economic environment requires the use of another currency. Gains or losses arising from the translation or settlement of foreign-currency-denominated monetary assets and liabilities into the functional currency are recognized in the income in the period in which they arise. However, currency differences on intercompany loans that have the nature of a permanent investment are accounted for as translation differences as a separate component of other comprehensive income/(loss) within stockholders' equity. 26 NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES A summary of the principal accounting policies are set out below: Cash The Company maintains its cash balances in interest and non-interest bearing accounts which do not exceed Federal Deposit Insurance Corporation limits. Principles of Consolidation The accompanying consolidated financial statements include the accounts of Kibush Capital and Instacash. All intercompany accounts and transactions have been eliminated. Other Comprehensive Income and Foreign Currency Translation FASB ASC 220-10-05, Comprehensive Income, establishes standards for the reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. Comprehensive income is defined to include all changes in equity except those resulting from investments by owners and distribution to owners. The accompanying consolidated financial statements are presented in United States dollars. Reclassifications Reclassifications have been made to prior year consolidated financial statements in order to conform the presentation to the statements as of and for the period ended September 30, 2014. On June 10, 2014, the FASB issued Accounting Standards Update (ASU) No. 2014-10, Development Stage Entities (Topic 915) - Elimination of Certain Financial Reporting Requirements, Including an Amendment to Variable Interest Entities Guidance in Topic 810, Consolidation, which eliminates the concept of a development stage entity (DSE) in its entirety from current accounting guidance. The Company has elected early adoption of this new standard. Use of Estimates The preparation of financial statements in conformity with Generally Accepted Accounting Principles in the United States of America (\"GAAP\") requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates made by management are, recoverability of long-lived assets, valuation and useful lives of intangible assets, valuation of derivative liabilities, and valuation of common stock, options, warrants and deferred tax assets. Actual results could differ from those estimates. Non-Controlling Interests Investments in associated companies over which the Company has the ability to exercise significant influence are accounted for under the consolidation method, after appropriate adjustments for intercompany profits and dividends. In December 2007, the FASB issued SFAS No. 141(R), \"Business Combinations.\" It requires an acquirer to recognize, at the acquisition date, the assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree at their full fair values as of that date. In a business combination achieved in stages (step acquisitions), the acquirer will be required to re-measure its previously held equity interest in the acquiree at its acquisition-date fair value and recognize the resulting gain or loss in earnings. The acquisition-related transaction and restructuring costs will no longer be included as part of the capitalized cost of the acquired entity but will be required to be accounted for separately in accordance with applicable generally accepted accounting principles. U.S. SFAS No. 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. 27 A non-controlling interest in a subsidiary is an ownership interest in a consolidated entity that is reported as equity in the consolidated financial statements and separate from the Company's equity. In addition, net income/(loss) attributable to non-controlling interests is reported separately from net income attributable to the Company in the consolidated financial statements. The Company's consolidated statements present the full amount of assets, liabilities, income and expenses of all of our consolidated subsidiaries, with a partially offsetting amount shown in non-controlling interests for the portion of these assets and liabilities that are not controlled by us. For our investments in affiliated entities that are included in the consolidation, the excess cost over underlying fair value of net assets is referred to as goodwill and reported separately as \"Goodwill\" in our accompanying consolidated balance sheets. Goodwill may only arise where consideration has been paid. Property and Equipment Property and equipment is stated at cost. Depreciation is computed using the straight-line method over estimated useful lives as follows: Plant and Equipment 2 to 15 years Computer and Software 1 to 2 years Office Equipment 3 to 10 years Building improvements 20 years Maintenance and repairs are charged to expense as incurred. Renewals and improvements of a major nature are capitalized. At the time of retirement or other disposition of property and equipment, the cost and accumulated depreciation are removed from the accounts and any resulting gains or losses are reflected in the consolidated statement of operations. Impairment of Long-Lived Assets In accordance with FASB ASC 360-10-5, Accounting for the Impairment or Disposal ofLong-Lived Assets, the Company evaluates the carrying value of its long-lived assets for impairment whenever events or changes in circumstances indicate that such carrying values may not be recoverable. The Company uses its best judgment based on the current facts and circumstances relating to its business when determining whether any significant impairment factors exist. The Company considers the following factors or conditions, among others, that could indicate the need for an impairment review: · Significant under performance relative to expected historical or projected future operating results; · Significant changes in its strategic business objectives and utilization of the assets; · Significant negative industry or economic trends, including legal factors; If the Company determines that the carrying values of long-lived assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, the Company's management performs an undiscounted cash flow analysis to determine if impairment exists. If impairment exists, the Company measures the impairment based on the difference between the asset's carrying amount and its fair value, and the impairment is charged to operations in the period in which the long-lived asset impairment is determined by management. The carrying value of the Company's investment in Joint Venture contract with leaseholders of certain Mining Leases in Papua New Guinea represents its ownership, accounted for under the equity method. The ownership interest is not adjusted to fair value on a recurring basis. Each reporting period the Company assesses the fair value of the Company's ownership interest in Joint Venture in accordance with FASB ASC 325-20-35. Each year the Company conducts an impairment analysis in accordance with the provisions within FASB ASC 320-10-35 paragraphs 25 through 32. Fair Value of Financial Instruments The carrying amounts of the Company's cash, accounts payable and accrued expenses approximate their estimated fair values due to the short-term maturities of those financial instruments. The Company believes the carrying amount of its notes payable approximates its fair value based on rates and other terms currently available to the Company for similar debt instruments Beneficial Conversion Features of Debentures In accordance with FASB ASC 470-20, Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios, we recognize the advantageous value of conversion rights attached to convertible debt. Such rights give the debt holder the ability to convert debt into common stock at a price per share that is less than the trading price to the public on the day the loan is made to us. The beneficial value is calculated as the intrinsic value (the market price of the stock at the commitment date in excess of the conversion rate) of the beneficial conversion feature of debentures and related accruing interest is recorded as a discount to the related debt and an addition to additional paid in capital. The discount is amortized over the remaining outstanding period of related debt using the interest method. 28 Derivative Financial Instruments We apply the provisions of FASB ASC 815-10, Derivatives and Hedging (\"ASC 815-10\"). Derivatives within the scope of ASC 815-10 must be recorded on the balance sheet at fair value. During the year ended September 30, 2014, the Company issued convertible debt and recorded derivative liabilities related to a reset provision associated with the embedded conversion feature of the convertible debt. The Company computed the fair value of these derivative liabilities on the grant date and various measurement dates using the Black-Scholes pricing model. Due to the reset provisions within the embedded conversion feature, the Company determined that the Black-Scholes pricing model was the most appropriate for valuing these instruments. In applying the Black-Scholes valuation model, the Company used the following assumptions during the year ended September 30, 2014: For the year ended September 30, 2014 Annual dividend yield - Expected life (years) 0.50 - 1.00 Risk-free interest rate 0.03% - 0.13% Expected volatility 210.12.% - 400.48% The inputs used to measure fair value fall in different levels of the fair value hierarchy, a financial security's hierarchy level is based upon the lowest level of input that is significant to the fair value measurement. The Company determines the fair value of its derivative instruments using a three-level hierarchy for fair value measurements which these assets and liabilities must be grouped, based on significant levels of observable or unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company's market assumptions. This hierarchy requires the use of observable market data when available. These two types of inputs have created the following fair-value hierarchy: Level 1 - Valuation based on unadjusted quoted market prices in active markets for identical securities. Currently, the Company does not have any items as Level 1. Level 2 - Valuations based on observable inputs (other than Level 1 prices), such as quoted prices for similar assets at the measurement date; quoted prices in markets that are not active; or other inputs that are observable, either directly or indirectly. Currently, the Company does not have any items classified as Level 2. Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement, and involve management judgment. The Company used the Black-Scholes option pricing models to determine the fair value of the instruments. The following table presents the Company's embedded conversion features of its convertible debt measured at fair value on a recurring basis as of September 30, 2015 and as of September 30, 2014: Carry Value at Carry Value at September 30, September 30, 2015 2014 Derivative liabilities: Embedded conversion features - notes $ 498,417 $ 752,997 Total derivative liability $ 498,417 $ 752,997 For the year ended For the year ended September 30, September 30, 2015 2014 Change in fair value included in other income (expense), net 131,044 -$92,382 29 The following table provides a reconciliation of the beginning and ending balances for the Company's derivative liabilities measured at fair value using Level 3 inputs: For the year ended For the year ended September 30, September 30, 2015 2014 Embedded Conversion Features - Notes: Balance at beginning of year $ 752,997 $ - Change in derivative liabilities $ (385,624 ) $ 845,379 Net change in fair value included in net loss $ 131,044 $ (92,382 ) Ending balance $ 498,417 $ 752,997 The Company re-measures the fair values of all of its derivative liabilities as of each period end and records the net aggregate gain/loss due to the change in the fair value of the derivative liabilities as a component of other expense, net in the accompanying consolidated statement of operations. During the years ended September 30, 2015 and 2014, the Company recorded a net increase (decrease) to the fair value of derivative liabilities balance of $131,044 and $(92,382), respectively. Loss per Share The Company applies FASB ASC 260, \"Earnings per Share.\" Basic earnings (loss) per share is computed by dividing earnings (loss) available to common stockholders by the weighted-average number of common shares outstanding. Diluted earnings (loss) per share is computed similar to basic earnings (loss) per share except that the denominator is increased to include additional common shares available upon exercise of stock options and warrants using the treasury stock method, except for periods for which no common share equivalents are included because their effect would be anti-dilutive. Income Taxes Income taxes are accounted for in accordance with ASC Topic 740, \"Income Taxes.\" Under the asset and liability method, deferred tax assets and liabilities are recognized for the future consequences of differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases (temporary differences). Deferred tax assets and liabilities are measured using tax rates expected to apply to taxable income in the years in which those temporary differences are recovered or settled. Valuation allowances for deferred tax assets are established when it is more likely than not that some portion or all of the deferred tax assets will not be realized. Mineral Property, Mineral Rights (Claims) Payments and Exploration Costs Pursuant to EITF 04-02, \"Whether Mineral Rights are Tangible or Intangible Assets and Related Issues\", the Company has an accounting policy to capitalize the direct costs to acquire or lease mineral properties and mineral rights as tangible assets. The direct costs include the costs of signature (lease) bonuses, options to purchase or lease properties, and brokers' and legal fees. If the acquired mineral rights relate to unproven properties, the Company does not amortize the capitalized mineral costs, but evaluates the capitalized mineral costs periodically for impairment. The Company expenses all costs related to the exploration of mineral claims in which it had secured exploration rights prior to establishment of proven and probable reserves. 30 Accounting Treatment of Mining Interests At this time, the Company does not directly own or directly lease mining properties. However, the Company does have contractual rights and governmental permits which allow the Company to conduct mining exploration on the properties referenced in this report. These contractual relationships, coupled with the government permits issued to the Company (or a subsidiary), are substantially similar in nature to a mining lease. Therefore, we have treated these contracts as lease agreements from an accounting prospective. Research and Development Research and development costs are recognized as an expense in the period in which they are incurred. The Company incurred no research and development costs for the years ended September 30, 2015 and 2014, respectively. Recent Accounting Pronouncements New accounting standards Development State Entities. In June 2014, the Financial Accounting Standards Board (\"FASB\") issued Accounting Standards Update 2014-10 - Development Stage Entities (Topic 915): Elimination of Certain Financial Reporting Requirements, Including an Amendment to Variable Interest Entities Guidance in Topic 810, Consolidation (\"ASU 2014-10\"). The amendments in this update remove the definition of a development stage entity from the Master Glossary of the Accounting Standards Codification. In addition, the amendments eliminate the requirements for development stage entities to (1) present inception-to-date information in the statements of income, cash flows, and shareholder equity, (2) label the financial statements as those of a development stage entity, (3) disclose a description of the development stage activities in which the entity is engaged, and (4) disclose in the first year in which the entity is no longer a development stage entity that in prior years it had been in the development stage. For public business entities, those amendments are effective for annual reporting periods beginning after December 15, 2014, and interim periods therein. For other entities, the amendments are effective for annual reporting periods beginning after December 15, 2014, and interim reporting periods beginning after December 15, 2015. Early application of each of the amendments is permitted for any annual reporting period or interim period for which the entity's financial statements have not yet been issued (public business entities) or made available for issuance (other entities). Upon adoption, entities will no longer present or disclose any information required by Topic 915. The Company has early adopted ASU 2014-10 commencing with its financial statements for the year ended September 30, 2014 and subsequent periods. Accounting standards to be adopted in future periods In May 2014, the Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU) which provides guidance for accounting for revenue from contracts with customers. The core principle of this ASU is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration the entity expects to be entitled in exchange for those goods or services. To achieve that core principle, an entity would be required to apply the following five steps: 1) identify the contract(s) with a customer; 2) identify the performance obligations in the contract; 3) determine the transaction price; 4) allocate the transaction price to the performance obligations in the contract; and 5) recognize revenue when (or as) the entity satisfies a performance obligation. The ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2016. Early adoption is not permitted. Entities will have the option to apply the final standard retrospectively or use a modified retrospective method, recognizing the cumulative effect of the ASU in retained earnings at the date of initial application. An entity will not restate prior periods if it uses the modified retrospective method, but will be required to disclose the amount by which each financial statement line item is affected in the current reporting period by the application of the ASU as compared to the guidance in effect prior to the change, as well as reasons for significant changes. The Company will adopt the updated standard in the first quarter of 2017. The Company is currently evaluating the impact that implementing this ASU will have on its financial statements and disclosures, as well as whether it will use the retrospective or modified retrospective method of adoption. Company management do not believe that the adoption of recently issued accounting pronouncements will have a significant impact on the Company's financial position, results of operations, or cash flows. 31 NOTE 3 - INVESTMENTS IN SUBSIDIARIES The Company owns interests in the following entities which was recorded at their book value since they were related party common control acquisitions. As the Subsidiaries Angel Jade Pty Ltd and Aqua Mining (PNG) Ltd were acquired from a related entity, Five Arrows Limited (see Note 9 - Business Combinations), the shares were recorded in the accounts at their true cost value. Investment Ownership % Aqua Mining (PNG) 34 90 % Angel Jade Pty Ltd 104,000 70 % NOTE 4 - PROPERTY AND EQUIPMENT September 30, September 30, 2015 2014 Building and Improvements $ - $ 70,665 Plant Equipment 3,724 19,133 Computer Equipment - 6,274 Office Equipment - 504 Motor Vehicle 50,424 - 54,148 96,576 Less accumulated depreciation (5,604 ) (16,982 ) $ 48,544 $ 79,594 Depreciation expense was approximately $5,604 for the year ended September 30, 2015 and $16,982 for the year ended September 30, 2014. NOTE 5 - CONVERTIBLE NOTES PAYABLE September 30, 2015 Note Face Amount Debt Discount Net Amount of Note 2011 Note $ 22,166 $ - $ 22,166 2012 Note 48,000 - 48,000 2013 Note 12,000 - 12,000 2014 Note 100,000 - 100,000 Total $ 182,166 $ - $ 182,166 September 30, 2014 Note Face Amount Debt Discount Net Amount of Note 2011 Note $ 28,726 $ - $ 28,726 2012 Note 48,000 - 48,000 2013 Note 12,000 - 12,000 2014 Note 100,000 (80,434 ) 19,566 Total $ 188,726 $ (80,434 ) $ 108,292 32 2011 Note On May 1, 2011, the Company issued a 2.00% Convertible Note due April 30, 2012 with a principal amount of $32,000 (the \"2011 Note\") for cash. Interest on the 2011 Note is accrued annually effective from May 1, 2011 forward. The 2011 Note is unsecured and repayable on demand. The 2011 Note is senior in right to all existing and future indebtedness which is subordinated by its terms and at the option of the Lender, the principal along with any accrued interest may be converted in whole or part into Common Stock at a price of $0.001. As this note carries a conversion rate that is less than market rate, the rules of beneficial conversion apply. The difference between the conversion rate and the market rate is classified as a discount on the note and accreted over the term of the note, which with respect to this note is 12 months. The face amount of the outstanding note as of September 30, 2015 and September 30, 2014 is $22,166 and $28,726 respectively. As of September 30, 2015 and September 30, 2014, the note has been discounted by $0. 2012 Note On January 2, 2012, the Company issued a 2.00% Convertible Note due January 1, 2013 with a principal amount of $48,000 (the \"2012 Note\") for cash. Interest on the 2012 Note is accrued annually effective from January 2, 2012 forward. The 2012 Note is unsecured and repayable on demand. The 2012 Note is senior in right to all existing and future indebtedness which is subordinated by its terms and at the option of the Lender, the principal along with any accrued interest may be converted in whole or part into Common Stock at a price of $0.001. As this note carries a conversion rate that is less than market rate, the rules of beneficial conversion apply. The difference between the conversion rate and the market rate is classified as a discount on the note and accreted over the term of the note, which with respect to this note is 12 months. The face amount of the outstanding note as of September 30, 2015 is $48,000 respectively. As of September 30, 2015, the note has been discounted by $0. 2013 Note On January 3, 2013, the Company issued a 2.00% Convertible Note due January 2, 2014 with a principal amount of $12,000 (the \"2013 Note\") for cash. Interest on the 2013 Note is accrued annually effective from January 3, 2013 forward. The 2013 Note is unsecured and repayable on demand. The 2013 Note is senior in right to all existing and future indebtedness which is subordinated by its terms and at the option of the Lender, the principal along with any accrued interest may be converted in whole or part into Common Stock at a price of $0.001. As this note carries a conversion rate that is less than market rate, the rules of beneficial conversion apply. The difference between the conversion rate and the market rate is classified as a discount on the note and accreted over the term of the note, which with respect to this note is 12 months. The face amount of the outstanding note as of September 30, 2015 is $12,000. As of September 30, 2015 the note has been discounted by $0. 2014 Note On August 25, 2014, the Company issued two 12.00% Convertible Promissory Note due February 25, 2015 with a principal amount of $50,000 each (the \"2014 Note\") for cash. Interest on the 2014 Note is accrued annually effective from August 25, 2014 forward. The 2014 Note is unsecured. The notes are convertible at a conversion price the lesser of (a) $0.25 per share, or (b) the price per share as reported on the Over-the-Counter Bulletin Board on the conversion date. The Note Holders also received Warrants to purchase an aggregate of 800,000 shares of our common stock at an initial exercise price of $0.25 per share. Each of the Warrants has a term of five (5) years. The embedded conversion feature of the 2014 Notes and Warrants were recorded as derivative liabilities in accordance with relevant accounting guidance due to the variable conversion price of the 2014 Notes. The fair value on the grant date of the embedded conversion feature of the convertible debt was $145,362 as computed using the Black-Scholes option pricing model. The Company established a debt discount of $100,000, representing the value of the embedded conversion feature inherent in the convertible debt and warrant, as limited to the face amount of the debt. The debt discount is being amortized over the life of the debt using the straight-line method over the terms of the debt, which approximates the effective-interest method. For the year ended September 30, 2014, the Company recorded amortization of the debt discount of $19,566. The balance of the debt discount was $80,434 at September 30, 2014. For the year ended September 30, 2015, the Company recorded amortization of the debt discount of $0. The balance of the debt discount was $0 at September 30, 2015. 33 NOTE 6 - LOAN FROM RELATED PARTY Convertible Notes Issued to the President and Director of Kibush Capital Corporation: September 30, 2015 Note Face Amount Debt Discount Net Amount of Note Loan from related party $ 682,862 $ - $ 682,862 Total $ 682,862 $ - $ 682,862 On March 31, 2014, the Company issued a 12.50% Convertible Promissory Note due March 31, 2015 with a principal amount of $157,500 (the \"March 2014 Note\") for cash. Interest on the March 2014 Note is accrued annually effective from March 31, 2014 forward. The March 2014 Note is unsecured. The note is convertible into common stock at a price of 50 percent of the average closing bid price, determined on the then current trading market for the ten business days prior to the conversion date. The embedded conversion feature of the March 2014 Notes was recorded as derivative liabilities in accordance with relevant accounting guidance due to the variable conversion price of the March 2014 Notes. The fair value on the grant date of the embedded conversion feature of the convertible debt was $305,039 as computed using the Black-Scholes option pricing model. The Company established a debt discount of $157,500, representing the value of the embedded conversion feature inherent in the convertible debt, as limited to the face amount of the debt. The debt discount is being amortized over the life of the debt using the straight-line method over the terms of the debt, which approximates the effective-interest method. For the year ended September 30, 2014, the Company recorded amortization of the debt discount of $78,966. The balance of the debt discount was $78,534 at September 30, 2014. As of September 30, 2015, the balance of the debt discount was $0. On June 30, 2014, the Company issued a 12.50% Convertible Promissory Note due June 30, 2015 with a principal amount of $110,741 (the \"June 2014 Note\") for cash. Interest on the June 2014 Note is accrued annually effective from June 30, 2014 forward. The June 2014 Note is unsecured. The note is convertible into common stock at a price of 50 percent of the average closing bid price, determined on the then current trading market for the ten business days prior to the conversion date. The embedded conversion feature of the June 2014 Note was recorded as derivative liabilities in accordance with relevant accounting guidance due to the variable conversion price of the June 2014 Note. The fair value on the grant date of the embedded conversion feature of the convertible debt was $213,207 as computed using the Black-Scholes option pricing model. The Company established a debt discount of $110,741 representing the value of the embedded conversion feature inherent in the convertible debt, as limited to the face amount of the debt. The debt discount is being amortized over the life of the debt using the straight-line method over the terms of the debt, which approximates the effective-interest method. For the year ended September 30, 2014, the Company recorded amortization of the debt discount of $27,913. The balance of the debt discount was $82,828 at September 30, 2014. As of September 30, 2015, the balance of the debt discount was $0. On September 30, 2014, the Company issued a 12.50% Convertible Promissory Note due September 30, 2015 with a principal amount of $98,575 (the \"September 2014 Note\") for cash. Interest on the September 2014 Note is accrued annually effective from September 30, 2014 forward. The September 2014 Note is unsecured. The note is convertible into common stock at a price of 50 percent of the average closing bid price, determined on the then current trading market for the ten business days prior to the conversion date. The embedded conversion feature of the September 2014 Notes was recorded as derivative liabilities in accordance with relevant accounting guidance due to the variable conversion price of the September 2014 Note. The fair value on the grant date of the embedded conversion feature of the convertible debt was $181,771 as computed using the Black-Scholes option pricing model. The Company established a debt discount of $98,575 representing the value of the embedded conversion feature inherent in the convertible debt, as limited to the face amount of the debt. The debt discount is being amortized over the life of the debt using the straight-line method over the terms of the debt, which approximates the effective-interest method. For the year ended September 30, 2014, the Company recorded amortization of the debt discount of $0. The balance of the debt discount was $98,575 at September 30, 2014. As of September 30, 2015, the balance of the debt discount was $0. 34 As of September 30, 2014 and 2013, cumulative interest of $96,579 and $0 respectively, has been accrued on these notes. The Company established a debt discount of $61,273 representing the value of the embedded conversion feature inherent in the convertible debt, as limited to the face amount of the debt. The debt discount is being amortized over the life of the debt using the straight-line method over the terms of the debt, which approximates the effective-interest method. For the year ended September 30, 2015, the Company recorded amortization of the debt discount of $0. The balance of the debt discount was $0 at September 30, 2015. NOTE 7 - STOCKHOLDER'S DEFICIT Common Stock On August 22, 2013, the Company's Board authorized a 225:1 reverse stock split. All share and per share data in the accompanying financial statements and footnotes has been adjusted retrospectively for the effects of the stock split. On October 12, 2013, the Company issued by directors resolution, 10,000,000 shares of newly issued common stock for the purchase of a Memorandum of Understanding (dated September 2, 2013) from a related company (Five Arrows Limited); which gave Kibush Capital Corporation the right to acquire 80% ownership in Instacash Pty Ltd, an Australian Currency Services provider, and corporate trustee of the Instacash Trust. As this transaction was with a related party, the value was recorded at the par value of the stock i.e. $0.001 per share of common stock. Between October 23, 2013 and September 30, 2014, the Company issued a total of 3,274,000 shares of common stock upon the requests from convertible note holders to convert principal totaling $3,274 into the Company's common stock based on the terms set forth in the loans. The conversion rate was $0.001. On February 28, 2014, the Company issued by director's resolution, 40,000,000 shares of newly issued common stock to conclude a Assignment and Bill of Sale (dated February 14, 2014) from a related company (Five Arrows Limited); which gave Kibush Capital Corporation the right to enter into a Joint Venture contract with the leaseholders of certain Mining Leases in Papua New Guinea. As this transaction was with a related party, the value was recorded at par value of the stock i.e. $0.001 per share of common stock. Between November 1, 2014 and March 31, 2015, the Company issued a total of 4,560,000 shares of common stock upon the requests from convertible note holders to convert principal totaling $3,274 into the Company's common stock based on the terms set forth in the loans. The conversion rate was $0.001. Preferred Stock Preferred stock includes 50,000,000 shares authorized at $0.001 par value, of which 10,000,000 have been designated Series A. 3,000,000 Series A are issued and outstanding as of September 30, 2014 and September 30, 2015. NOTE 8 - INCOME TAXES The provision/(benefit) for income taxes for the year ended September 30, 2015 and 2014 was as follows (assuming a 15% effective tax rate) September 30, September 30, 2015 2014 Current Tax Provision Federal - Taxable income $ - $ - Total current tax provisions $ - $ - $ - $ - Deferred Tax Provision Federal - Loss carry forwards $ 193,592 $ 263,821 Change in valuation allowance $ 193,592 $ 263,821 Total deferred tax provisions $ - $ - 35 The Company had deferred income tax assets as of September 30, 2015 and September 30, 2014 as follows: September 30, 2015 2014 Loss carry forward $ 1,290,613 $ 1,560,122 Less - Valuation allowance $ 1,290,613 $ 1,560,122 $ - $ - The Company provided a valuation allowance equal to the deferred income tax assets for period ended September 30, 2014 because it is not presently known whether future taxable income will be sufficient to utilize the loss carryforwards. As of September 30, 2015, the Company had approximately $10,986,677 in tax loss carryforwards that can be utilized future periods to reduce taxable income, and the carryforward incurred for the year ended September 30, 2015 will expire by the year 2035. The Company did not identify any material uncertain tax positions. The Company did not recognize any interest or penalties for unrecognized tax benefits. The federal income tax returns of the Corporation are subject to examination by the IRS, generally for three years after they are filed. NOTE 9 - RELATED PARTY TRANSACTIONS Details of transactions between the Corporation and related parties are disclosed below. The following transactions were carried out with related parties: September 30, September 30, 2015 2014 Loan from related party - unsecured loan (a) $ 679,227 $ 339,920 Convertible loans (b) $ 182,166 $ 366,816 Loan from related party $ 861,393 $ 706,736 (a) From time to time, the president and stockholder of the Company provides advances to the Company for its working capital purposes. These advances bear no interest and are due on demand. (b) See Note 6 for details of Convertible notes. (c) On April 29, 2015, the Company issued 3,001,702 shares of its common stock to Warren Sheppard (previously authorized by for issuance by the company on December 10, 2014) pursuant to his employment agreement. (d) Between April 1, 2015 and June 24, 2015, the Company issued a total of 4,000,000 shares of common stock upon the requests from convertible note holders to convert principal totaling $4,000 into the Company's common stock based on the terms set forth in the loans. The conversion rate was $0.001. (e) The Company has entered into related party acquisitions. Details of these transactions are provided therewith Five Arrows, as described in more detail in Note 10 below. 36 NOTE 10 - BUSINESS COMBINATIONS Set out below are the controlled and non-controlled members of the group as of September 30, 2015, which, in the opinion of the directors, are material to the group. The subsidiaries as listed below have share capital consisting solely of ordinary shares, which are held directly by the Company; the country of incorporation is also their principal place of business. Name of Entity Country of Incorporation Acquisition Date Voting Equity Interests Nature of Relationship Aqua Mining (PNG) Ltd Papua New Guinea 28-Feb-2014 90 % Note 1 Angel Jade Pty Ltd Australia 10-Dec-2014 70 % Note 2 Note 1: On February 14, 2014, the Company entered into an Assignment and Bill of Sale with Five Arrows Limited (\"Five Arrows\"), a related party, pursuant to which Five Arrows agreed to assign to the Company all of its right, title and interest in two 50 ton per hour trammels, one 35 ton excavator, a warehouse/office, a concrete processing apron and four 35 ton per hour particle concentrators for use in our mining exploration. In consideration, the Company issued 40,000,000 shares of its common stock to Five Arrows. On February 28, 2014, the Company entered into a joint venture agreement with the holders of alluvial gold mining leases (\"Leaseholders\") of Mining Leases covering approximately 26 hectares located at Koranga in Wau, Morobe Province, Papua, New Guinea for gold mining exploration (\"Joint Venture Agreement\"). The Joint Venture Agreement entitles the leaseholders to 30% and the Company to 70% of net profits from the joint venture. The Company will manage and carry out mining exploration at the site, including entering into contracts with third parties and subcontractors (giving priority to the Leaseholders and their relatives and the local community for employment opportunities and spin-off business) at its cost, and all assets, including equipment and structures built on the site, will be the property of the Company. The Leaseholders and the Company will each contribute 1% from their share of net profits to a trust account for landowner and government requirements. On July 27, 2015, we recently received a 5-year extension for our Mining Lease of ML 296-301 from the Mining Resource Authority in Papua New Guinea. ML 296-301 is part of the Koranga Joint Venture and is controlled by our subsidiary Aqua Mining. Note 2: On December 10, 2014, the Company entered into an Assignment and Bill of Sale with Five Arrows Limited, a related party, pursuant to which Five Arrows agreed to assign to the Company all of its right, title and interest in 90,000,000 shares in Angel Jade Pty Ltd. In consideration, the Company issued 14,000,000 shares of its common stock to Five Arrows. The Company owns 70% of the ordinary shares of Angel Jade Pty Ltd, an Australian company. The assets of Angel Jade are comprised of Exploration License 8104, the area covered is 35 km SE of Tamworth, 300 sq. km in size, 250 km from the port of Newcastle, NSW and accessible by sealed road. Nephrite jade occurs in the New England Fold Belt, which extends from northeast New South Wales into southeast Queensland. The target mineral in this tenement is jade, but we will also explore for rhodonite. NOTE 11 - SUBSEQUENT EVENTS Management evaluated all activity of the Company through the date of the Financial Statements were available to be issued and noted there were no material subsequent events which require recognition or disclosure as of that date. 37\nITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.\nOur financial statements for the fiscal years ended September 30, 2014 and September 30, 2015, included in this report, have been audited by Scrudato & Co., PA. There have been no disagreements on accounting and financial disclosures with Scrudato & Co., PA through the date of this Form 10-K.\n\nITEM 9A. CONTROLS AND PROCEDURES.\nLimitations on the Effectiveness of Controls\nOur management, does not expect that our Disclosure Controls and internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management or board override of the control.\nThe design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.\nManagement's Report on Internal Control over Financial Reporting\nOur management is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) or 15d-15(f) promulgated under the Securities Exchange Act of 1934 as a process designed by, or under the supervision of, the company's principal executive and principal financial officers and effected by the company's board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.\nAll internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Because of the inherent limitations of internal control, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk.\nAs of September 30, 2015, management assessed the effectiveness of our internal control over financial reporting based on the criteria for effective internal control over financial reporting established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (\"COSO\") and SEC guidance on conducting such assessments. Based upon that evaluation, the Company's management concluded that the Company's disclosure controls and procedures are not effective at the reasonable assurance level due to the material weaknesses described below:\n1. We do not have written documentation of our internal control policies and procedures. Written documentation of key internal controls over financial reporting is a requirement of Section 404 of the Sarbanes-Oxley Act which is applicable to us. Management evaluated the impact of our failure to have written documentation of our internal controls and procedures on our assessment of our disclosure controls and procedures and has concluded that the control deficiency that resulted represented a material weakness. 2. The Company's board of directors has no audit committee, independent director or member with financial expertise which causes ineffective oversight of the Company's external financial reporting and internal control over financial reporting. 3. We do not have sufficient segregation of duties within accounting functions, which is a basic internal control. Due to our size and nature, segregation of all conflicting duties may not always be possible and may not be economically feasible. However, to the extent possible, the initiation of transactions, the custody of assets and the recording of transactions should be performed by separate individuals. Management evaluated the impact of our failure to have segregation of duties on our assessment of our disclosure controls and procedures and has concluded that the control deficiency that resulted represented a material weakness. 38 Due to these factors, during the period covered by this report, our internal controls and procedures were not effective to detect the inappropriate application of US GAAP rules as more fully described below. Most notably, we failed to convert reporting to an interested party standard for certain balance sheet items once we exceeded the applicable threshold which affected our balance sheet for the quarter ended June 30, 2015. Management believes that the material weakness set forth above caused a material misstatement in our Form 10-Q for the period ended June 30, 2015. Therefore, we are promptly amending that report. Management believes they have corrected some of the conditions which allowed for the misstatement. However, the lack of a functioning audit committee, the lack of segregation of duties within accounting functions, and the lack of multiple directors on our board of directors may result in ineffective oversight in the establishment and monitoring of required internal controls and procedures, which could result in a material misstatement in our financial statements in future periods. The Company plans to add additional directors, add accounting personnel and establish an audit committee over time, once it has sufficient income and cash flow to make those changes. This annual report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management's report was not subject to attestation by our registered public accounting firm because we are a smaller reporting company. CEO and CFO Certifications Appearing immediately following the Signatures section of this report there is Certification of our CEO/CFO. The Certification is required in accordance with Section 302 of the Sarbanes-Oxley Act of 2002 (the Section 302 Certifications). This Item of this report, which you are currently reading is the information concerning the Evaluation referred to in the Section 302 Certifications and this information should be read in conjunction with the Section 302 Certifications for a more complete understanding of the topics presented. Changes in Internal Controls There were no changes in our internal control over financial reporting during the year ended September 30, 2015 that have affected, or are reasonably likely to affect, our internal control over financial reporting.\nITEM 9B. OTHER INFORMATION.\nNone.\n\n| 39 |\n\nPART III\n\nITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.\nThe following table presents information with respect to our officers, directors and significant employees as of the date of this Report:\nName Age Position Warren Sheppard 58 President, Chief Executive Officer and director Vincent Appo 48 PNG Operations Manager; Director of Aqua Mining Our directors hold office until the next annual general meeting of the stockholders or until their successors are elected and qualified. Our officers are appointed by our board of directors and hold office until their earlier death, retirement, resignation or removal. Biographical Information Regarding Officers and Directors Warren Sheppard has served as our President, Chief Executive Officer and director since July 5, 2013. Mr. Sheppard has had an Accountancy Practice, primarily tax based in Australia for approximately the last 30 years. In addition Mr. Sheppard also has served in an oversight capacity as Chief Executive Officer of Q6 Pty Ltd., a software development company, from 2005 to date, and in an oversight capacity as Chief Financial Officer of Uniware Pty Ltd., an accounting software company, from 2001 to date; Westvantage Pty Ltd., a software company, from 2011 to date; Xceed Pty Ltd., an internet development company, from 2001 to date; Ozisp Pty Ltd., an internet service provider company, from 2001 to date; and Altius Mining Ltd., a gold exploration mining company from 2008 to 2011, devoting a few hours per month to these entities, none of which compete with the Company. Mr. Sheppard has served as director of several Australian private companies as well as serving as Trustee of the Australian Aiding Australia Trust, More Superannuation Fund and McMahon Superannuation Fund. Mr. Sheppard's accounting background as well as his experience serving as chief executive officer and chief financial officer and director of various Australian private companies led to his appointment to the board of directors. 40 Vincent Appo has been mining manager of the Company since October 2013. Prior thereto, from June 2012 to November 2013, Mr. Appo was the Mine Operations Manager/Acting General Manager for Tolukuma Gold Mines Limited in Papua, New Guinea. Mr. Appo served as Consulting Survey Project Manager for Dempsey Australia Ltd, Papua, New Guinea from May 2011 to December 2011, and Mine Technical Services Manager/Acting Mine General Manager for Tolukuma Gold Mines Limited from January 2011 to July 2011 and for other gold mines in Papua, New Guinea in various positions since 2002. From 1997 to 2002, Mr. Appo was Chief Surveyor for two companies in New Guinea. Mr. Appo also serves as director of Aqua Mining, a subsidiary of the Company. Neither Mr. Sheppard nor Mr. Appo are directors in any other U.S. reporting companies nor have they been affiliated with any company that has filed for bankruptcy within the last ten years. The Company is not aware of any proceedings to which he or any of his associates is a party adverse to the Company or any of the Company's subsidiaries or has a material interest adverse to it or any of its subsidiaries. Significant Employees Vincent Appo has been mining manager of the Company since October 2013. Prior thereto, from June 2012 to November 2013, Mr. Appo was the Mine Operations Manager/Acting General Manager for Tolukuma Gold Mines Limited in Papua, New Guinea. Mr. Appo served as Consulting Survey Project Manager for Dempsey Australia Ltd, Papua, New Guinea from May 2011 to December 2011, and Mine Technical Services Manager/Acting Mine General Manager for Tolukuma Gold Mines Limited from January 2011 to July 2011 and for other gold mines in Papua, New Guinea in various positions since 2002. From 1997 to 2002, Mr. Appo was Chief Surveyor for two companies in New Guinea. Compliance With Section 16(a) of the Securities Exchange Act of 1934 Section 16(a) of the Securities Exchange Act of 1934 requires our executive officers and directors, and persons who beneficially own more than 10% of our equity securities, to file reports of ownership and changes in ownership with the Securities and Exchange Commission. Officers, directors and greater than 10% shareholders are required by SEC regulation to furnish the Company with copies of all Section 16(a) forms they file. However, the Company is aware that certain Section 16 reports have not yet been filed. While our registration statement went effective on August 10, 2015, it appears Form 3s were not filed by Warren Sheppard, Vincent Appo and Five Arrows Limited. The Company has communicated with these parties and it understands that such filings are imminent. Conflicts of Interest At this time, we are not subject to the listing requirements of any national securities exchange or national securities association and, as a result, we are not required to have our board comprised of a majority of \"independent directors.\" Furthermore, we do not believe that our director currently meets the definition of \"independent\" as promulgated by the rules and regulations of the NYSE Alternext US (formerly known as the American Stock Exchange). We currently have one director who is also our chief executive. We do not have an audit or compensation committee comprised of independent directors, and the functions that would have been performed by such committees are performed by our Board of Directors. Thus, there is a potential conflict of interest in that our directors have the authority to determine issues concerning management compensation, in essence their own, and audit issues that may affect management decisions. Audit Committee We have no separately-designated audit committee. Audit committee functions are performed by our board of directors. None of our directors are deemed independent. All directors also hold positions as our officers. Our board of directors is responsible for: (1) selection and oversight of our independent accountant; (2) establishing procedures for the receipt, retention and treatment of complaints regarding accounting, internal controls and auditing matters; (3) establishing procedures for the confidential, anonymous submission by our employees of concerns regarding accounting and auditing matters; and (4) engaging outside advisors. Moreover, our Board of Directors has not established compensation or disclosure committees. Audit Committee Financial Expert We do not have an audit committee financial expert. We do not have an audit committee financial expert because we believe the cost related to retaining a financial expert at this time is prohibitive. Further, because we are only beginning our commercial operations, at the present time, we believe the services of a financial expert are not warranted. 41 Code of Ethics We have adopted a corporate code of ethics. We believe our code of ethics is reasonably designed to deter wrongdoing and promote honest and ethical conduct; provide full, fair, accurate, timely and understandable disclosure in public reports; comply with applicable laws; ensure prompt internal reporting of code violations; and provide accountability for adherence to the code. A copy of the code of ethics is filed as Exhibit 14.1 to this annual report on Form 10-K. Involvement in Certain Legal Proceedings During the past ten years, Mr. Warren Sheppard has not been the subject of the following events: 1. A petition under the Federal bankruptcy laws or any state insolvency law was filed by or against, or a receiver, fiscal agent or similar officer was appointed by a court for the business or property of such person, or any partnership in which he was a general partner at or within two years before the time of such filing, or any corporation or business association of which he was an executive officer at or within two years before the time of such filing; 2. Convicted in a criminal proceeding or is a named subject of a pending criminal proceeding (excluding traffic violations and other minor offenses); 3. The subject of any order, judgment, or decree, not subsequently reversed, suspended or vacated, of any court of competent jurisdiction, permanently or temporarily enjoining him from, or otherwise limiting, the following activities; i) Acting as a futures commission merchant, introducing broker, commodity trading advisor, commodity pool operator, floor broker, leverage transaction merchant, any other person regulated by the Commodity Futures Trading Commission, or an associated person of any of the foregoing, or as an investment adviser, underwriter, broker or dealer in securities, or as an affiliated person, director or employee of any investment company, bank, savings and loan association or insurance company, or engaging in or continuing any conduct or practice in connection with such activity; ii) Engaging in any type of business practice; or iii) Engaging in any activity in connection with the purchase or sale of any security or commodity or in connection with any violation of Federal or State securities laws or Federal commodities laws; 4. The subject of any order, judgment or decree, not subsequently reversed, suspended or vacated, of any Federal or State authority barring, suspending or otherwise limiting for more than 60 days the right of such person to engage in any activity described in paragraph 3.i in the preceding paragraph or to be associated with persons engaged in any such activity; 5. Was found by a court of competent jurisdiction in a civil action or by the Commission to have violated any Federal or State securities law, and the judgment in such civil action or finding by the Commission has not been subsequently reversed, suspended, or vacated; 6. Was found by a court of competent jurisdiction in a civil action or by the Commodity Futures Trading Commission to have violated any Federal commodities law, and the judgment in such civil action or finding by the Commodity Futures Trading Commission has not been subsequently reversed, suspended or vacated; 7. Was the subject of, or a party to, any Federal or State judicial or administrative order, judgment, decree, or finding, not subsequently reversed, suspended or vacated, relating to an alleged violation of: i) Any Federal or State securities or commodities law or regulation; or ii) Any law or regulation respecting financial institutions or insurance companies including, but not limited to, a temporary or permanent injunction, order of disgorgement or restitution, civil money penalty or temporary or permanent cease-and-desist order, or removal or prohibition order, or iii) Any law or regulation prohibiting mail or wire fraud or fraud in connection with any business entity; or 8. Was the subject of, or a party to, any sanction or order, not subsequently reversed, suspended or vacated, of any self-regulatory organization (as defined in Section 3(a)(26) of the Exchange Act (15 U.S.C. 78c(a)(26))), any registered entity (as defined in Section 1(a)(29) of the Commodity Exchange Act (7 U.S.C. 1(a)(29))), or any equivalent exchange, association, entity or organization that has disciplinary authority over its members or persons associated with a member. 42\nITEM 11. EXECUTIVE COMPENSATION.\nCompensation of Officers\nOption award compensation is the fair value for stock options vested during the period, a notional amount estimated at the date of the grant using the Black-Scholes option-pricing model. The actual value received by the executives may differ materially and adversely from that estimated. A summary of cash and other compensation paid in accordance with management consulting contracts for our Principal Executive Officer and other executives for the most recent two years is as follows:\nExecutive Compensation\nName and Principal Position (a) Year (b) Salary (US$) (c) Bonus (US$) (d) Stock Awards (US$) (e) Option Awards (US$) (f) Non-Equity Incentive Plan Compensation (US$) (g) Nonqualified Deferred Compensation Earnings (US$) (h) All Other Compensation (US$) (i) Total (US$) (j) Warren Sheppard 2015 250,000 0 0 0 0 0 0 250,000 President & CEO 2014 250,000 450,000 0 0 0 0 0 700,000 Vincent Appo 2015 55,821 0 0 0 0 0 0 55,821 Operations Manager & 2014 71,703 0 0 0 0 0 0 71,703 Director of Aqua Mining ______________ (1) Mr. Sheppard was appointed president and CEO on May 20 , 2013. Mr. Sheppard earned a salary of $250,000 during the fiscal years ended September 30, 2015 and September 30, 2014. Mr. Sheppard earned earned no bonuses during the fiscal year ended September 30, 2015 and earned bonuses of $450,000 for the year ended September 30, 2014. Since the Company did not have the ability to pay Mr. Sheppard's earnings in cash, he was compensated through the issuance of a convertible promissory note pursuant to the terms of his employment agreement. Mr. Sheppard's compensation for the fiscal year ended September 30, 2014 was converted into 3,001,702 shares of the Company's common stock on or about April 29, 2015. Mr. Sheppard's compensation for the fiscal year ended September 30, 2015 has not yet issued, but is convert in to approximately 49,668,874 shares of the Company's common stock based on the year end closing price of $0.0151 per share. Mr. Sheppard has not waived his rights to these shares. (2) Mr. Appo was appointed as operations manager on January 1, 2014 and became director of Aqua Mining on May 26, 2014. Mr. Appo earned a salary of $ 55,821 (156 ,000 PGK) during fiscal year 2015 and $71,703 (156,000 PGK) during fiscal year 2014. Employment Contracts Warren Sheppard: At the beginning of the fiscal year ended September 30, 2014, we entered into an employment agreement, dated October 1, 2013, with Warren Sheppard to serve as our President and as a director. The initial term of the agreement is five years, which term shall automatically be renewed for additional two-year periods, unless the Company shall notify Mr. Sheppard at least 90 days prior to the expiration of the then current term or its desire not to renew the agreement. As the President, Mr. Sheppard receives an annual base salary of $250,000 which shall not be decreased except in connection with the reduction of the salaries of all executives of the Company. If the Company does not have sufficient funds to pay Mr. Sheppard's salary, he shall be paid in common stock of the Company in an amount equal to three times the amount of unpaid base salary based on the closing price of the Company's stock as of the final day of the fiscal year in which such salary was earned. In addition, Mr. Sheppard shall be entitled to a bonus in the amount of $150,000 to be payable in common stock of the Company, upon the acquisition of a subsidiary or business valued at greater than $1,000,000. Such acquisition bonuses will be issued based upon the closing price of the Company's stock as of the date of the closing of such an acquisition. Mr. Sheppard receives no separate compensation to serve as a director of the Company. In the event Mr. Sheppard employment is terminated for whatever reason, he will be entitled to salary and benefits that have accrued prior to the date of termination. There are no provisions for severance payments upon termination in the agreement. Mr. Sheppard is subject to a non-solicitation prohibition for two years after his termination of employment with the Company. 43 Other Executive Officers During 2015, no employment contracts were entered into with any officers. Retirement, Resignation or Termination Plans We sponsor no plan, whether written or verbal, that would provide compensation or benefits of any type to an executive upon retirement, or any plan that would provide payment for retirement, resignation, or termination as a result of a change in control of our company or as a result of a change in the responsibilities of an executive following a change in control of our company. Outstanding Equity Awards Our officers and directors do not have unexercised options, stock that has not vested, or equity awards. There were no outstanding equity awards to our named executive officers at September 30, 2015. Compensation of Directors Directors' Compensation Name (a) Fees Earned or Paid in Cash (US$) (b) Stock Awards (US$) (c) Option Awards (US$) (d) Non-Equity Incentive Plan Compensation (US$) (e) Deferred Compensation Earnings (US$) (f) All Other Compensation (US$) (g) Total (US$) (h) Warren Sheppard 0 0 0 0 0 0 0 The persons who served as members of our board of directors, including executive officers did not receive any compensation for services as a director for 2015. We do not currently have Board committees, including an audit committee. Indemnification Our Amended and Restated Articles of Incorporation (\"Articles\") provide that our directors and officers be indemnified by us to the fullest extent authorized by the Nevada Revised Statutes, against all expenses and liabilities reasonably incurred in connection with services for us or on our behalf except for (i) acts or omissions that involve intentional misconduct, fraud or a knowing violation of law or (ii the payment of dividends in violation of Nevada law. Our Articles also permit us to secure insurance on behalf of any officer, director, employee or other agent for any liability arising out of his or her actions in this capacity. Our Articles provide that we will advance all expenses incurred to any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding, whether civil or criminal, upon receipt of an undertaking by or on behalf of such person to repay said amounts should it be ultimately determined that the person was not entitled to be indemnified under our Articles or otherwise. Our Bylaws provide that our directors and officers be indemnified by us to the fullest extent authorized by the Nevada Revised Statutes, against all expenses and liabilities reasonably incurred in connection with services for us or on our behalf except that there shall be no indemnification if a person is adjudged liable to the Company unless and to the extent that despite such adjudication, the court determines that such person is entitled to indemnity or determined by the majority of directors, independent legal counsel or the stockholders. Insofar as indemnification for liabilities arising under the Securities Act may be permitted by directors, executive officers or persons controlling us, we have been informed that in the opinion of the SEC, such indemnification is against public policy as expressed in the Securities Act and is therefore unenforceable. 44\nITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.\nThe following table lists, as of January 10, 2016: (i) each person or entity known to us to be the beneficial owner of more than 5% of our outstanding common stock or preferred stock; (ii) each of our named executive officers and directors; and (iii) all executive officers and directors as a group. Information relating to beneficial ownership of the Company's stock by our principal stockholders and management is based upon information furnished by each person using \"beneficial ownership\" concepts under the rules of the Securities and Exchange Commission. Under these rules, a person is deemed to be a beneficial owner of a security if that person has or shares voting power, which includes the power to vote or direct the voting of the security, or investment power, which includes the power to vote or direct the voting of the security. The person is also deemed to be a beneficial owner of any security of which that person has a right to acquire beneficial ownership within 60 days. Under the Securities and Exchange Commission rules, more than one person may be deemed to be a beneficial owner of the same securities, and a person may be deemed to be a beneficial owner of securities as to which he or she may not have any pecuniary beneficial interest. Except as noted below, each person has sole voting and investment power.\nThe percentages below are calculated based on 80,399,187 shares of common stock issued and outstanding as of January 10, 2016 and 3,000,000 shares of our Series A preferred stock issued and outstanding as of the same date.\nTable of Beneficial Ownership of Stock\nTitle of Class Name of Beneficial Owner Amount and Nature of Beneficial Ownership (1) Percent of Class Common Stock Five Arrows Limited (1) 64,000,000 79.60 % Common Stock Cavenagh Capital Corporation (2) 3,333,334 4.15 % Common Stock More Superannuation Fund (5) 3,298,503 4.10 % Common Stock Warren Sheppard (3) 3,001,702 3.73 % President, Chief Executive Officer and director Common Stock Vincent Appo 0 0.00 % PNG Operations Manager; Director of Aqua Mining Common Stock Directors and officers as a group (2 persons) 3,001,702 3.73 % Series A Preferred Stock More Superannuation Fund 3,000,000 (4)(5) 100 % (4)(5) ____________ (1) Richard N. Wilson, Chief Executive Officer of Five Arrows Limited (\"Five Arrows\") has sole voting and investment power over the shares held by Five Arrows. (2) Richard N. Wilson, director of Cavenagh Capital Corporation (\"Cavenagh\"), has sole voting and investment power over the shares held by Cavenagh. (3) Excludes (i) 3,298,503 shares held by More Superannuation Fund of which Mr. Sheppard is co-trustee and co-member and shares voting and investment power of the shares held by More; (ii) 64,000,000 shares held by Five Arrows of which Mr. Sheppard is the sole owner; and (iii) 3,000,000 shares of Series A Preferred Stock held by More which have voting rights equal to 20 shares of common stock for each share of preferred. When these shares are included by attribution, Mr. Sheppard's voting power exceeds 87.44%. Also excludes any shares of common stock to which Mr. Sheppard may earn pursuant to his employment agreement with the Company; should the Company have insufficient funds to pay Mr. Sheppard's salary, in an amount equal to three times the amount of unpaid base salary and shares in the amount of $150,000 upon the acquisition of a subsidiary or business valued at greater than $1,000,000 as a bonus. (4) Represents 100% of the total issued and outstanding shares of Series A Preferred Stock which has voting rights equal to 20 shares of common stock. Series A preferred stockholders votes together with common share holders, not as a separate class. (5) More Superannuation Fund controls 63,298,503 votes, 3,298,503 from common stock and 60,000,000 from its preferred stock which votes with common stock at 20:1. This provides More with 45.08% of the combined voting power of the Company. The Company does not have any change-in-control agreements with its executive officer nor know of any arrangements which may result in a change of control of the Company. 45\nITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE.\nRelated Party Transactions\nExcept as described below, there were no transactions with any executive officers, directors, 5% stockholders and their families and affiliates during the fiscal year ended September 30, 2015.\nVincent Appo, the Company's mining manager is a director and a 10% shareholder of our Papua New Guinea subsidiary, Aqua Mining (PNG) Limited.\nOn December 10, 2014, the Company authorized the issuance of 3,001,702 shares of common stock to Warren Sheppard pursuant to the employment contract between the Company and Mr. Sheppard.\nFrom time to time, the Warren Sheppard provided advances to the Company for its working capital purposes. These advances bear no interest and are due on demand. For the fiscal year ended September 30, 2015, these advances totaled $339,920. Moreover, from time to time, the Company issued Convertible Notes to Warren Sheppard as detailed in Note 6 to the Financial Statements. For the fiscal year ended September 30, 2015, the Company had issued a total of $366,318 in such Convertible Notes to Warren Sheppard.\nThe related party loans consist of (1) a five-year loan agreement dated July 15, 2011 for $150,000 AUD loan from Hancore Pty Ltd. (Hancore Pty Ltd. is a related party via it's more than 10% ownership by Warren Sheppard), and (2) a $230,000 AUD loan dated September 30, 2014 from Warren Sheppard. The Hancore loan is unsecured and has a 20 percent per annum interest rate. The Sheppard note is unsecured and is interest free.\nOn February 28, 2015 the Company sold to Hancore Pty Ltd., a related party, its interest in Instacash in exchange for cancellation of the $500,000 promissory note and accrued interest owed to Hancore Pty Ltd. from the acquisition of Instacash in October of 2013.\nDirector Independence\nWe are not subject to the listing requirements of any national securities exchange or national securities association and, as a result, we are not at this time required to have our board comprised of a majority of \"independent directors.\" We do not believe that our director currently meets the definition of \"independent\" as promulgated by the rules and regulations of the NYSE Alternext US (formerly known as the American Stock Exchange).\nThe Board of Directors has not established an audit committee and does not have an audit committee financial expert.\n\n| 46 |\n\n\nITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES.\n(1) Audit Fees\nThe aggregate fees billed for each of the last two fiscal years for professional services rendered by the principal accountant for our audit of annual financial statements and reviews of our interim financial statements included in our Form 10-Q and Form 10-K or services that are normally provided by the accountant in connection with statutory and regulatory filings or engagements for those fiscal years was:\n2015 Scrudato & Co., PA $ 13,000 2014 Scrudato & Co., PA $ 17,000 (2) Audit-Related Fees The aggregate fees billed in each of the last two fiscal years for assurance and related services by the principal accountants that are reasonably related to the performance of the audit or review of our financial statements and are not reported in the preceding paragraph: 2015 Scrudato & Co., PA $ 0 2014 Scrudato & Co., PA $ 0 (3) Tax Fees The aggregate fees billed in each of the last two fiscal years for professional services rendered by the principal accountant for tax compliance, tax advice, and tax planning was: 2014 Scrudato & Co., PA $ 0 (4) All Other Fees The aggregate fees billed in each of the last two fiscal years for the products and services provided by the principal accountant, other than the services reported in paragraphs (1), (2), and (3) was: 2015 Scrudato & Co., PA $ 0 2014 Scrudato & Co., PA $ 0 (5) As a smaller reporting company, we do not have an audit committee. Warren Sheppard, our sole director, approves all accounting related activities prior to the performance of any services by any accountant or auditor. (6) The percentage of hours expended on the principal accountants engagement to audit our consolidated financial statements for the most recent fiscal year that were attributed to work performed by persons other than the principal accountants full time, permanent employees, to the best of our knowledge, was 0%. 47 PART IV.\nITEM 15. EXHIBITS AND CONSOLIDATED FINANCIAL STATEMENT SCHEDULES.\nThe following is a complete list of exhibits filed as part of this annual report:\nIncorporated by reference Exhibit Number Document Description Form Date Number Filed herewith 3.1 Articles of Incorporation, as amended Form 10/A 8/05/15 3.1 - 3.6 3.2 Bylaws Form 10/A 8/05/15 3.7 4.1 Certificate of Designation, dated April 19, 2011 Form 10/A 8/05/15 4.1 10.1 Management Agreement for Paradise Gardens (PNG) 10-Q 8/20/15 10.1 14.1 Code of Ethics X 31.1 Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 32.1 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 for the Chief Executive Officer X 101.INS XBRL Instance Document 101.SCH XBRL Taxonomy Extension - Schema 101.CAL XBRL Taxonomy Extension - Calculations 101.DEF XBRL Taxonomy Extension - Definitions 101.LAB XBRL Taxonomy Extension - Labels 101.PRE XBRL Taxonomy Extension - Presentation\n\n| Incorporated by reference |\n| Exhibit Number | Document Description | Form | Date | Number | Filed herewith |\n| 3.1 | Articles of Incorporation, as amended | Form 10/A | 8/05/15 | 3.1 - 3.6 |\n| 3.2 | Bylaws | Form 10/A | 8/05/15 | 3.7 |\n| 4.1 | Certificate of Designation, dated April 19, 2011 | Form 10/A | 8/05/15 | 4.1 |\n| 10.1 | Management Agreement for Paradise Gardens (PNG) | 10-Q | 8/20/15 | 10.1 |\n| 14.1 | Code of Ethics | X |\n| 31.1 | Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | X |\n| 32.1 | Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 for the Chief Executive Officer | X |\n| 101.INS | XBRL Instance Document |\n| 101.SCH | XBRL Taxonomy Extension - Schema |\n| 101.CAL | XBRL Taxonomy Extension - Calculations |\n| 101.DEF | XBRL Taxonomy Extension - Definitions |\n| 101.LAB | XBRL Taxonomy Extension - Labels |\n| 101.PRE | XBRL Taxonomy Extension - Presentation |\n\nSIGNATURES\nIn accordance with Section 13 or 15(d) of the Securities and Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on this 13th day of January 2016.\nKIBUSH CAPITAL CORPORATION By: /s/ WARREN SHEPPARD Warren Sheppard President and Principal Executive Officer, Principal Accounting Officer, Principal Financial Officer, Secretary and Treasurer In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dated indicated. Signature Title Date /s/ WARREN SHEPPARD President, Chief Executive Officer, Chief January 13, 2016 Warren Sheppard Financial Officer and Director 49 Exhibit Index Incorporated by reference Exhibit Number Document Description Form Date Number Filed herewith 3.1 Articles of Incorporation, as amended Form 10/A 8/05/15 3.1 - 3.6 3.2 Bylaws Form 10/A 8/05/15 3.7 4.1 Certificate of Designation, dated April 19, 2011 Form 10/A 8/05/15 4.1 10.1 Management Agreement for Paradise Gardens (PNG) 10-Q 8/20/15 10.1 14.1 Code of Ethics X 31.1 Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 32.1 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 for the Chief Executive Officer X 101.INS XBRL Instance Document 101.SCH XBRL Taxonomy Extension - Schema 101.CAL XBRL Taxonomy Extension - Calculations 101.DEF XBRL Taxonomy Extension - Definitions 101.LAB XBRL Taxonomy Extension - Labels 101.PRE XBRL Taxonomy Extension - Presentation 50\n</text>\n\nWhat is the net change in total assets for the Company from the fiscal year ended September 30, 2014 to the interim period ended March 31, 2015 in dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"ground_truth": "Therefore, the answer is 193359.0."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nPART I – FINANCIAL INFORMATION\nItem 1. Financial Statements (unaudited)\nZILLOW GROUP, INC.\nCONDENSED CONSOLIDATED BALANCE SHEETS\n(in thousands, except share data, unaudited)\n| September 30, 2019 | December 31, 2018 |\n| Assets |\n| Current assets: |\n| Cash and cash equivalents | $ | 1,791,918 | $ | 651,058 |\n| Short-term investments | 531,679 | 903,867 |\n| Accounts receivable, net of allowance for doubtful accounts of $4,464 and $4,838 at September 30, 2019 and December 31, 2018, respectively | 77,674 | 66,083 |\n| Mortgage loans held for sale | 36,762 | 35,409 |\n| Inventory | 879,353 | 162,829 |\n| Prepaid expenses and other current assets | 66,413 | 61,067 |\n| Restricted cash | 75,004 | 12,385 |\n| Total current assets | 3,458,803 | 1,892,698 |\n| Contract cost assets | 46,047 | 45,819 |\n| Property and equipment, net | 154,251 | 135,172 |\n| Right of use assets | 218,564 | — |\n| Goodwill | 1,984,907 | 1,984,907 |\n| Intangible assets, net | 197,527 | 215,904 |\n| Other assets | 15,889 | 16,616 |\n| Total assets | $ | 6,075,988 | $ | 4,291,116 |\n| Liabilities and shareholders’ equity |\n| Current liabilities: |\n| Accounts payable | $ | 9,717 | $ | 7,471 |\n| Accrued expenses and other current liabilities | 76,061 | 63,101 |\n| Accrued compensation and benefits | 33,540 | 31,388 |\n| Revolving credit facilities | 698,280 | 116,700 |\n| Warehouse lines of credit | 30,116 | 33,018 |\n| Deferred revenue | 41,955 | 34,080 |\n| Deferred rent, current portion | — | 1,740 |\n| Lease liabilities, current portion | 17,937 | — |\n| Total current liabilities | 907,606 | 287,498 |\n| Deferred rent, net of current portion | — | 19,945 |\n| Lease liabilities, net of current portion | 223,989 | — |\n| Long-term debt | 1,478,719 | 699,020 |\n| Deferred tax liabilities and other long-term liabilities | 13,796 | 17,474 |\n| Total liabilities | 2,624,110 | 1,023,937 |\n| Commitments and contingencies (Note 17) |\n| Shareholders’ equity: |\n| Preferred stock, $0.0001 par value; 30,000,000 shares authorized; no shares issued and outstanding | — | — |\n| Class A common stock, $0.0001 par value; 1,245,000,000 shares authorized; 58,522,404 and 58,051,448 shares issued and outstanding as of September 30, 2019 and December 31, 2018, respectively | 6 | 6 |\n| Class B common stock, $0.0001 par value; 15,000,000 shares authorized; 6,217,447 shares issued and outstanding as of September 30, 2019 and December 31, 2018 | 1 | 1 |\n| Class C capital stock, $0.0001 par value; 600,000,000 shares authorized; 142,689,395 and 139,635,370 shares issued and outstanding as of September 30, 2019 and December 31, 2018, respectively | 14 | 14 |\n| Additional paid-in capital | 4,327,003 | 3,939,842 |\n| Accumulated other comprehensive income (loss) | 784 | ( 905 | ) |\n| Accumulated deficit | ( 875,930 | ) | ( 671,779 | ) |\n| Total shareholders’ equity | 3,451,878 | 3,267,179 |\n| Total liabilities and shareholders’ equity | $ | 6,075,988 | $ | 4,291,116 |\n\nSee accompanying notes to condensed consolidated financial statements.\n3\nZILLOW GROUP, INC.\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\n(in thousands, except per share data, unaudited)\n| Three Months EndedSeptember 30, | Nine Months EndedSeptember 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Revenue: |\n| Homes | $ | 384,626 | $ | 11,018 | $ | 762,022 | $ | 11,018 |\n| IMT | 335,290 | 313,638 | 957,231 | 900,435 |\n| Mortgages | 25,292 | 18,438 | 79,637 | 56,766 |\n| Total revenue | 745,208 | 343,094 | 1,798,890 | 968,219 |\n| Cost of revenue (exclusive of amortization) (1): |\n| Homes | 370,796 | 10,226 | 733,947 | 10,312 |\n| IMT | 24,318 | 25,186 | 74,628 | 72,070 |\n| Mortgages | 4,721 | 1,260 | 13,829 | 3,736 |\n| Total cost of revenue | 399,835 | 36,672 | 822,404 | 86,118 |\n| Sales and marketing | 181,347 | 128,734 | 530,367 | 413,752 |\n| Technology and development | 123,974 | 105,314 | 352,074 | 299,623 |\n| General and administrative | 88,493 | 70,743 | 267,106 | 187,395 |\n| Impairment costs | — | 10,000 | — | 10,000 |\n| Acquisition-related costs | — | 1,405 | — | 2,064 |\n| Integration costs | 5 | 523 | 650 | 523 |\n| Total costs and expenses | 793,654 | 353,391 | 1,972,601 | 999,475 |\n| Loss from operations | ( 48,446 | ) | ( 10,297 | ) | ( 173,711 | ) | ( 31,256 | ) |\n| Other income | 8,999 | 7,773 | 27,625 | 13,308 |\n| Interest expense | ( 26,502 | ) | ( 12,668 | ) | ( 61,865 | ) | ( 26,928 | ) |\n| Loss before income taxes | ( 65,949 | ) | ( 15,192 | ) | ( 207,951 | ) | ( 44,876 | ) |\n| Income tax benefit | 1,300 | 14,700 | 3,800 | 22,700 |\n| Net loss | $ | ( 64,649 | ) | $ | ( 492 | ) | $ | ( 204,151 | ) | $ | ( 22,176 | ) |\n| Net loss per share — basic and diluted | $ | ( 0.31 | ) | $ | — | $ | ( 0.99 | ) | $ | ( 0.11 | ) |\n| Weighted-average shares outstanding — basic and diluted | 207,002 | 202,416 | 205,766 | 195,208 |\n| ____________________(1) Amortization of website development costs and intangible assets included in technology and development | $ | 15,835 | $ | 18,165 | $ | 44,891 | $ | 61,735 |\n\nSee accompanying notes to condensed consolidated financial statements.\n4\nZILLOW GROUP, INC.\nCONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS\n(in thousands, unaudited)\n| Three Months EndedSeptember 30, | Nine Months EndedSeptember 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Net loss | $ | ( 64,649 | ) | $ | ( 492 | ) | $ | ( 204,151 | ) | $ | ( 22,176 | ) |\n| Other comprehensive income (loss): |\n| Unrealized gains (losses) on investments | ( 143 | ) | ( 428 | ) | 1,752 | ( 537 | ) |\n| Currency translation adjustments | 31 | 42 | ( 63 | ) | ( 24 | ) |\n| Total other comprehensive income (loss) | ( 112 | ) | ( 386 | ) | 1,689 | ( 561 | ) |\n| Comprehensive loss | $ | ( 64,761 | ) | $ | ( 878 | ) | $ | ( 202,462 | ) | $ | ( 22,737 | ) |\n\nSee accompanying notes to condensed consolidated financial statements.\n5\nZILLOW GROUP, INC.\nCONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY\n(in thousands, except share data, unaudited)\n| Class A CommonStock, Class BCommon Stock andClass C Capital Stock | AdditionalPaid-InCapital | AccumulatedDeficit | AccumulatedOtherComprehensiveIncome | TotalShareholders’Equity |\n| Shares | Amount |\n| Balance at July 1, 2019 | 206,513,636 | $ | 21 | $ | 4,088,470 | $ | ( 811,281 | ) | $ | 896 | $ | 3,278,106 |\n| Issuance of common and capital stock upon exercise of stock options | 347,261 | — | 8,017 | — | — | 8,017 |\n| Vesting of restricted stock units | 568,355 | — | — | — | — | — |\n| Shares and value of restricted stock units withheld for tax liability | ( 6 | ) | — | — | — | — | — |\n| Share-based compensation expense | — | — | 45,192 | — | — | 45,192 |\n| Premiums paid for Capped Call Confirmations | — | — | ( 150,530 | ) | — | — | ( 150,530 | ) |\n| Equity component of issuance of 2024 Notes and 2026 Notes, net of issuance costs of $4,430 | — | — | 335,854 | — | — | 335,854 |\n| Net loss | — | — | — | ( 64,649 | ) | — | ( 64,649 | ) |\n| Other comprehensive loss | — | — | — | — | ( 112 | ) | ( 112 | ) |\n| Balance at September 30, 2019 | 207,429,246 | $ | 21 | $ | 4,327,003 | $ | ( 875,930 | ) | $ | 784 | $ | 3,451,878 |\n\n| Class A CommonStock, Class BCommon Stock andClass C Capital Stock | AdditionalPaid-InCapital | AccumulatedDeficit | AccumulatedOtherComprehensiveLoss | TotalShareholders’Equity |\n| Shares | Amount |\n| Balance at July 1, 2018 | 195,449,104 | $ | 20 | $ | 3,428,541 | $ | ( 573,605 | ) | $ | ( 1,275 | ) | $ | 2,853,681 |\n| Issuance of common and capital stock upon exercise of stock options | 697,301 | — | 14,970 | — | — | 14,970 |\n| Vesting of restricted stock units | 453,958 | — | — | — | — | — |\n| Shares and value of restricted stock units withheld for tax liability | ( 27 | ) | — | ( 2 | ) | — | — | ( 2 | ) |\n| Share-based compensation expense | — | — | 43,730 | — | — | 43,730 |\n| Issuance of Class C capital stock in connection with equity offering, net of issuance costs of $13,425 | 6,557,017 | — | 360,345 | — | — | 360,345 |\n| Premiums paid for capped call confirmations | — | — | ( 29,414 | ) | — | — | ( 29,414 | ) |\n| Equity component of issuance of convertible notes maturing in 2023, net of issuance costs of $2,047 | — | — | 76,587 | — | — | 76,587 |\n| Net loss | — | — | — | ( 492 | ) | — | ( 492 | ) |\n| Other comprehensive loss | — | — | — | — | ( 386 | ) | ( 386 | ) |\n| Balance at September 30, 2018 | 203,157,353 | $ | 20 | $ | 3,894,757 | $ | ( 574,097 | ) | $ | ( 1,661 | ) | $ | 3,319,019 |\n\n6\n| Class A CommonStock, Class BCommon Stock andClass C Capital Stock | AdditionalPaid-InCapital | AccumulatedDeficit | AccumulatedOtherComprehensiveIncome (Loss) | TotalShareholders’Equity |\n| Shares | Amount |\n| Balance at January 1, 2019 | 203,904,265 | $ | 21 | $ | 3,939,842 | $ | ( 671,779 | ) | $ | ( 905 | ) | $ | 3,267,179 |\n| Issuance of common and capital stock upon exercise of stock options | 1,891,111 | — | 41,014 | — | — | 41,014 |\n| Vesting of restricted stock units | 1,633,962 | — | — | — | — | — |\n| Shares and value of restricted stock units withheld for tax liability | ( 92 | ) | — | ( 3 | ) | — | — | ( 3 | ) |\n| Share-based compensation expense | — | — | 160,826 | — | — | 160,826 |\n| Premiums paid for Capped Call Confirmations | — | — | ( 150,530 | ) | — | — | ( 150,530 | ) |\n| Equity component of issuance of 2024 Notes and 2026 Notes, net of issuance costs of $4,430 | — | — | 335,854 | — | — | 335,854 |\n| Net loss | — | — | — | ( 204,151 | ) | — | ( 204,151 | ) |\n| Other comprehensive income | — | — | — | — | 1,689 | 1,689 |\n| Balance at September 30, 2019 | 207,429,246 | $ | 21 | $ | 4,327,003 | $ | ( 875,930 | ) | $ | 784 | $ | 3,451,878 |\n\n| Class A CommonStock, Class BCommon Stock andClass C Capital Stock | AdditionalPaid-InCapital | AccumulatedDeficit | AccumulatedOtherComprehensiveLoss | TotalShareholders’Equity |\n| Shares | Amount |\n| Balance at January 1, 2018 | 190,115,148 | $ | 20 | $ | 3,254,146 | $ | ( 592,243 | ) | $ | ( 1,100 | ) | $ | 2,660,823 |\n| Cumulative-effect adjustment from adoption of guidance on revenue from contracts with customers | — | — | — | 40,322 | — | 40,322 |\n| Issuance of common and capital stock upon exercise of stock options | 5,177,060 | — | 114,623 | — | — | 114,623 |\n| Vesting of restricted stock units | 1,288,746 | — | — | — | — | — |\n| Shares and value of restricted stock units withheld for tax liability | ( 1,345 | ) | — | ( 67 | ) | — | — | ( 67 | ) |\n| Share-based compensation expense | — | — | 118,037 | — | — | 118,037 |\n| Portion of conversion recorded in additional paid-in-capital in connection with partial conversion of convertible notes maturing in 2020 | 20,727 | — | 500 | — | — | 500 |\n| Issuance of Class C capital stock in connection with equity offering, net of issuance costs of $13,425 | 6,557,017 | — | 360,345 | — | 360,345 |\n| Premiums paid for capped call confirmations | — | — | ( 29,414 | ) | — | — | ( 29,414 | ) |\n| Equity component of issuance of convertible notes maturing in 2023, net of issuance costs of $2,047 | — | — | 76,587 | — | — | 76,587 |\n| Net loss | — | — | — | ( 22,176 | ) | — | ( 22,176 | ) |\n| Other comprehensive loss | — | — | — | — | ( 561 | ) | ( 561 | ) |\n| Balance at September 30, 2018 | 203,157,353 | $ | 20 | $ | 3,894,757 | $ | ( 574,097 | ) | $ | ( 1,661 | ) | $ | 3,319,019 |\n\nSee accompanying notes to condensed consolidated financial statements.\n7\nZILLOW GROUP, INC.\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(in thousands, unaudited)\n| Nine Months EndedSeptember 30, |\n| 2019 | 2018 |\n| Operating activities |\n| Net loss | $ | ( 204,151 | ) | $ | ( 22,176 | ) |\n| Adjustments to reconcile net loss to net cash provided by (used in) operating activities: |\n| Depreciation and amortization | 63,888 | 76,301 |\n| Share-based compensation expense | 151,884 | 111,366 |\n| Amortization of right of use assets | 16,710 | — |\n| Amortization of contract cost assets | 26,722 | 27,227 |\n| Amortization of discount and issuance costs on convertible senior notes maturing in 2021, 2023, 2024 and 2026 | 29,868 | 17,990 |\n| Impairment costs | — | 10,000 |\n| Deferred income taxes | ( 3,800 | ) | ( 22,700 | ) |\n| Loss on disposal of property and equipment | 5,744 | 3,129 |\n| Bad debt expense | 1,894 | 1,053 |\n| Deferred rent | — | ( 3,116 | ) |\n| Accretion of bond discount | ( 5,241 | ) | ( 2,172 | ) |\n| Changes in operating assets and liabilities: |\n| Accounts receivable | ( 13,485 | ) | ( 12,994 | ) |\n| Mortgage loans held for sale | ( 1,353 | ) | — |\n| Inventory | ( 716,524 | ) | ( 43,257 | ) |\n| Prepaid expenses and other assets | ( 5,848 | ) | ( 15,012 | ) |\n| Lease liabilities | ( 15,029 | ) | — |\n| Contract cost assets | ( 26,950 | ) | ( 32,143 | ) |\n| Accounts payable | 2,999 | 2,254 |\n| Accrued expenses and other current liabilities | 12,241 | ( 3,751 | ) |\n| Accrued compensation and benefits | 2,152 | 6,503 |\n| Deferred revenue | 7,875 | 4,041 |\n| Other long-term liabilities | 122 | — |\n| Net cash provided by (used in) operating activities | ( 670,282 | ) | 102,543 |\n| Investing activities |\n| Proceeds from maturities of investments | 859,142 | 261,675 |\n| Purchases of investments | ( 479,963 | ) | ( 848,838 | ) |\n| Purchases of property and equipment | ( 45,140 | ) | ( 44,482 | ) |\n| Purchases of intangible assets | ( 15,123 | ) | ( 8,179 | ) |\n| Cash paid for acquisition, net | — | ( 2,000 | ) |\n| Net cash provided by (used in) investing activities | 318,916 | ( 641,824 | ) |\n| Financing activities |\n| Proceeds from issuance of convertible notes, net of issuance costs | 1,085,686 | 364,020 |\n| Premiums paid for capped call confirmations | ( 150,530 | ) | ( 29,414 | ) |\n| Proceeds from issuance of Class C capital stock, net of issuance costs | — | 360,345 |\n| Proceeds from borrowing on revolving credit facilities | 581,580 | 24,674 |\n| Net repayments on warehouse lines of credit | ( 2,902 | ) | — |\n| Proceeds from exercise of stock options | 41,014 | 114,623 |\n| Value of equity awards withheld for tax liability | ( 3 | ) | ( 67 | ) |\n| Net cash provided by financing activities | 1,554,845 | 834,181 |\n| Net increase in cash, cash equivalents and restricted cash during period | 1,203,479 | 294,900 |\n| Cash, cash equivalents and restricted cash at beginning of period | 663,443 | 352,095 |\n| Cash, cash equivalents and restricted cash at end of period | $ | 1,866,922 | $ | 646,995 |\n| Supplemental disclosures of cash flow information |\n| Cash paid for interest | $ | 25,837 | $ | 4,800 |\n| Noncash transactions: |\n| Capitalized share-based compensation | $ | 8,942 | $ | 6,674 |\n| Write-off of fully depreciated property and equipment | $ | 28,951 | $ | 18,687 |\n| Write-off of fully amortized intangible assets | $ | 9,959 | $ | 10,797 |\n\n8\nZILLOW GROUP, INC.\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nNote 1. Organization and Description of Business\nZillow Group, Inc. houses one of the largest portfolios of real estate brands on mobile and the web. Zillow Group is committed to leveraging its proprietary data, technology and innovations to make home buying, selling, financing and renting a seamless, on-demand experience for consumers. As its flagship brand, Zillow now offers a fully integrated home shopping experience that includes access to for sale and rental listings, Zillow Offers, which provides a new, hassle-free way to buy and sell homes directly through Zillow, and Zillow Home Loans, Zillow’s affiliated lender that provides an easy way to receive mortgage pre-approvals and financing. Other consumer brands include Trulia, StreetEasy, HotPads, Naked Apartments and Out East. In addition, Zillow Group provides a comprehensive suite of marketing software and technology solutions to help real estate professionals maximize business opportunities and connect with millions of consumers. Zillow Group also operates a number of business brands for real estate, rental and mortgage professionals, including Mortech, dotloop, Bridge Interactive and New Home Feed. Zillow, Inc. was incorporated as a Washington corporation in December 2004, and we launched the initial version of our website, Zillow.com, in February 2006. Zillow Group, Inc. was incorporated as a Washington corporation in July 2014 in connection with our acquisition of Trulia, Inc. (“Trulia”). Upon the closing of the Trulia acquisition in February 2015, each of Zillow, Inc. and Trulia became wholly owned subsidiaries of Zillow Group.\nCertain Significant Risks and Uncertainties\nWe operate in a dynamic industry and, accordingly, can be affected by a variety of factors. For example, we believe that changes in any of the following areas could have a significant negative effect on us in terms of our future financial position, results of operations or cash flows: rates of revenue growth; our ability to manage advertising inventory or pricing; engagement and usage of our products; our investment of resources to pursue strategies that may not prove effective; competition in our market; the stability of the residential real estate market and the impact of interest rate changes; changes in technology, products, markets or services by us or our competitors; addition or loss of significant customers; our ability to maintain or establish relationships with listings and data providers; our ability to obtain or maintain licenses and permits to support our current and future businesses; changes in government regulation affecting our business; outcomes of legal proceedings; natural disasters and catastrophic events; scaling and adaptation of existing technology and network infrastructure; management of our growth; our ability to attract and retain qualified employees and key personnel; our ability to successfully integrate and realize the benefits of our past or future strategic acquisitions or investments; protection of customers’ information and other privacy concerns; protection of our brand and intellectual property; and intellectual property infringement and other claims, among other things.\nNote 2. Summary of Significant Accounting Policies\nBasis of Presentation\nThe accompanying condensed consolidated financial statements include Zillow Group, Inc. and its wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. These condensed consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles (“GAAP”) and applicable rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Certain information and note disclosures normally included in the financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Accordingly, these interim condensed consolidated financial statements should be read in conjunction with the audited financial statements and accompanying notes included in Zillow Group, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2018, which was filed with the SEC on February 21, 2019. The condensed consolidated balance sheet as of December 31, 2018, included herein, was derived from the audited financial statements of Zillow Group, Inc. as of that date.\nThe unaudited condensed consolidated interim financial statements, in the opinion of management, reflect all adjustments, consisting only of normal recurring adjustments, necessary to present fairly our financial position as of September 30, 2019, our results of operations, comprehensive loss and shareholders’ equity for the three and nine month periods ended September 30, 2019 and 2018, and our cash flows for the nine month periods ended September 30, 2019 and 2018. The results of the three and nine month periods ended September 30, 2019 are not necessarily indicative of the results to be expected for the year ending December 31, 2019 or for any interim period or for any other future year.\n9\nUse of Estimates\nThe preparation of financial statements in conformity with GAAP requires management to make certain estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and the related disclosures at the date of the financial statements, as well as the reported amounts of revenue and expenses during the periods presented. On an ongoing basis, we evaluate our estimates, including those related to the net realizable value of inventory, amortization period and recoverability of contract cost assets, website and software development costs, recoverability of long-lived assets and intangible assets with definite lives, share-based compensation, income taxes, business combinations and the recoverability of goodwill and indefinite-lived intangible assets, among others. To the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected.\nRecently Issued Accounting Standards Not Yet Adopted\nIn August 2018, the Financial Accounting Standards Board (“FASB”) issued guidance related to a customer’s accounting for implementation costs incurred in hosting arrangements. The guidance conforms the requirements for capitalizing implementation costs incurred in cloud computing arrangements that are service contracts with the accounting guidance that provides for the capitalization of costs incurred to develop or obtain internal-use software. Under the guidance, implementation costs that are capitalized should be characterized in financial statements in the same manner as other service costs and assets related to service costs and amortized over the term of the hosting arrangement. This guidance is effective for interim and annual reporting periods beginning after December 15, 2019, and early adoption is permitted. Entities are permitted to apply either a retrospective or prospective transition approach to adopt this guidance. We expect to adopt this guidance on January 1, 2020 using the prospective transition approach, under which we will apply the guidance to all eligible costs incurred subsequent to adoption. We have not historically incurred material amounts of implementation costs for cloud computing arrangements, however, we are continuing to assess the impact the adoption of this guidance will have on our financial position, results of operations and cash flows.\nIn August 2018, the FASB issued guidance related to disclosure requirements for fair value measurements. This guidance removes, modifies and adds disclosures related to certain assets and liabilities measured at fair value. The amendments on changes in unrealized gains and losses, the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements and the narrative description of measurement uncertainty should be applied prospectively for only the most recent interim and annual period presented in the initial fiscal year of adoption. All other amendments should be applied retrospectively to all periods presented upon their effective date. This guidance is effective for interim and annual periods beginning after December 15, 2019, and early adoption is permitted. We expect to adopt this guidance on January 1, 2020. We have not historically recorded material amounts of Level 3 assets and liabilities or material transfers of assets or liabilities between levels within the fair value hierarchy. However, we are continuing to assess the impact the adoption of this guidance will have on our financial statement disclosures.\nIn June 2016, and subsequently amended in April 2019 and May 2019, the FASB issued guidance on the measurement of credit losses on financial assets. This guidance will require an entity to measure and recognize expected credit losses for certain financial instruments and financial assets, including trade receivables. This guidance requires an entity to recognize an allowance that reflects the entity’s current estimate of credit losses expected to be incurred over the life of the financial instrument on initial recognition and at each reporting period, whereas current guidance employs an incurred loss methodology. This guidance is effective for interim and annual periods beginning after December 15, 2019, and early adoption is permitted for interim and annual reporting periods beginning after December 15, 2018. The adoption of this guidance requires a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. We expect to adopt this guidance on January 1, 2020. We are currently evaluating necessary changes to our accounting policies, processes and systems as a result of the adoption of the guidance, primarily related to our trade accounts receivable and certain available-for-sale investments. We continue to assess the impact the adoption of this guidance will have on our financial position, results of operations and cash flows.\nNote 3. Fair Value Measurements\nAccounting standards define fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market in an orderly transaction between market participants on the measurement date. The standards also establish a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. There are three levels of inputs that may be used to measure fair value:\n\n| • | Level 1—Quoted prices in active markets for identical assets or liabilities. |\n\n10\n| • | Level 2—Assets and liabilities valued based on observable market data for similar instruments, such as quoted prices for similar assets or liabilities. |\n\n| • | Level 3—Unobservable inputs that are supported by little or no market activity; instruments valued based on the best available data, some of which is internally developed, and considers risk premiums that a market participant would require. |\n\nWe applied the following methods and assumptions in estimating our fair value measurements:\nCash equivalents — The fair value measurement of money market funds is based on quoted market prices in active markets. The fair value measurement of certificates of deposit and commercial paper is based on observable market-based inputs or inputs that are derived principally from or corroborated by observable market data by correlation or other means.\nShort-term investments — The fair value measurement of our short-term investments is based on observable market-based inputs or inputs that are derived principally from or corroborated by observable market data by correlation or other means.\nRestricted cash — Restricted cash consists of cash received from the resale of homes through Zillow Offers which may be used to repay amounts borrowed on our revolving credit facilities (see Note 13) and amounts held in escrow related to funding home purchases in our mortgage origination business. The carrying value of restricted cash approximates fair value due to the short period of time amounts borrowed on the revolving credit facilities are outstanding.\nMortgage loans held for sale — The fair value of mortgage loans held for sale is generally calculated by reference to quoted prices in secondary markets for commitments to sell mortgage loans with similar characteristics.\nInterest rate lock commitments — The fair value of interest rate lock commitments (“IRLCs”) is calculated by reference to quoted prices in secondary markets for commitments to sell mortgage loans with similar characteristics. Expired commitments are excluded from the fair value measurement. We generally only issue IRLCs for products that meet specific purchaser guidelines. Since not all IRLCs will become closed loans, we adjust our fair value measurements for the estimated amount of IRLCs that will not close.\nForward contracts — The fair value of mandatory loan sales commitments and derivative instruments such as forward sales of mortgage-backed securities that are utilized as hedging instruments are calculated by reference to quoted prices for similar assets.\nThe following tables present the balances of assets and liabilities measured at fair value on a recurring basis, by level within the fair value hierarchy, as of the dates presented (in thousands):\n| September 30, 2019 |\n| Total | Level 1 | Level 2 |\n| Cash equivalents: |\n| Money market funds | $ | 1,353,600 | $ | 1,353,600 | $ | — |\n| Certificates of deposit | 742 | — | 742 |\n| Short-term investments: |\n| U.S. government agency securities | 350,665 | — | 350,665 |\n| Commercial paper | 68,915 | — | 68,915 |\n| Corporate notes and bonds | 63,585 | — | 63,585 |\n| Treasury bills | 29,911 | — | 29,911 |\n| Municipal securities | 18,603 | — | 18,603 |\n| Mortgage origination-related: |\n| Mortgage loans held for sale | 36,762 | — | 36,762 |\n| IRLCs | 1,503 | — | 1,503 |\n| Forward contracts - other current assets | 84 | — | 84 |\n| Forward contracts - other current liabilities | ( 184 | ) | — | ( 184 | ) |\n| Total | $ | 1,924,186 | $ | 1,353,600 | $ | 570,586 |\n\n11\n| December 31, 2018 |\n| Total | Level 1 | Level 2 |\n| Cash equivalents: |\n| Money market funds | $ | 541,575 | $ | 541,575 | $ | — |\n| Commercial paper | 3,999 | — | 3,999 |\n| Short-term investments: |\n| U.S. government agency securities | 646,496 | — | 646,496 |\n| Corporate notes and bonds | 112,933 | — | 112,933 |\n| Commercial paper | 85,506 | — | 85,506 |\n| Municipal securities | 39,306 | — | 39,306 |\n| Foreign government securities | 14,915 | — | 14,915 |\n| Certificates of deposit | 4,711 | — | 4,711 |\n| Mortgage origination-related: |\n| Mortgage loans held for sale | 35,409 | — | 35,409 |\n| IRLCs | 847 | — | 847 |\n| Forward contracts - other current liabilities | ( 125 | ) | — | ( 125 | ) |\n| Total | $ | 1,485,572 | $ | 541,575 | $ | 943,997 |\n\nAt September 30, 2019, the notional amounts of the hedging instruments related to our mortgage loans held for sale were $ 57.9 million and $ 99.8 million for our IRLCs and forward contracts, respectively. At December 31, 2018, the notional amounts of the hedging instruments related to our mortgage loans held for sale were $ 26.7 million and $ 28.8 million for our IRLCs and forward contracts, respectively. We do not have the right to offset our forward contract derivative positions.\nSee Note 13 for the carrying amount and estimated fair value of the Company’s convertible senior notes.\nWe did no t have material Level 3 assets or liabilities as of September 30, 2019 or December 31, 2018 .\nNote 4. Cash and Cash Equivalents, Short-term Investments and Restricted Cash\nThe following tables present the amortized cost, gross unrealized gains and losses and estimated fair market value of our cash and cash equivalents, available-for-sale investments and restricted cash as of the dates presented (in thousands):\n| September 30, 2019 |\n| AmortizedCost | GrossUnrealizedGains | GrossUnrealizedLosses | EstimatedFair MarketValue |\n| Cash | $ | 437,576 | $ | — | $ | — | $ | 437,576 |\n| Cash equivalents: |\n| Money market funds | 1,353,600 | — | — | 1,353,600 |\n| Certificates of deposit | 742 | — | — | 742 |\n| Short-term investments: |\n| U.S. government agency securities | 350,153 | 514 | ( 2 | ) | 350,665 |\n| Commercial paper | 68,915 | — | — | 68,915 |\n| Corporate notes and bonds | 63,419 | 166 | — | 63,585 |\n| Treasury bills | 29,900 | 11 | — | 29,911 |\n| Municipal securities | 18,511 | 92 | — | 18,603 |\n| Restricted cash | 75,004 | — | — | 75,004 |\n| Total | $ | 2,397,820 | $ | 783 | $ | ( 2 | ) | $ | 2,398,601 |\n\n12\n| December 31, 2018 |\n| AmortizedCost | GrossUnrealizedGains | GrossUnrealizedLosses | EstimatedFair MarketValue |\n| Cash | $ | 105,484 | $ | — | $ | — | $ | 105,484 |\n| Cash equivalents: |\n| Money market funds | 541,575 | — | — | 541,575 |\n| Commercial paper | 3,999 | — | — | 3,999 |\n| Short-term investments: |\n| U.S. government agency securities | 647,266 | 51 | ( 821 | ) | 646,496 |\n| Corporate notes and bonds | 113,109 | 1 | ( 177 | ) | 112,933 |\n| Commercial paper | 85,506 | — | — | 85,506 |\n| Municipal securities | 39,316 | 23 | ( 33 | ) | 39,306 |\n| Foreign government securities | 14,929 | — | ( 14 | ) | 14,915 |\n| Certificates of deposit | 4,711 | 1 | ( 1 | ) | 4,711 |\n| Restricted cash | 12,385 | — | — | 12,385 |\n| Total | $ | 1,568,280 | $ | 76 | $ | ( 1,046 | ) | $ | 1,567,310 |\n\nAll available-for-sale investments as of September 30, 2019 have a contractual maturity date of one year or less.\nNote 5. Accounts Receivable, net\nThe opening balance of accounts receivable, net was $ 66.1 million as of January 1, 2019.\nThe following table presents the changes in the allowance for doubtful accounts (in thousands):\n| Balance as of January 1, 2019 | $ | 4,838 |\n| Bad debt expense | 1,894 |\n| Less: write-offs, net of recoveries and other adjustments | ( 2,268 | ) |\n| Balance as of September 30, 2019 | $ | 4,464 |\n\nNote 6. Inventory\nThe following table presents the components of inventory, net of applicable lower of cost or net realizable value adjustments, as of the dates presented (in thousands):\n| September 30, 2019 | December 31, 2018 |\n| Work-in-process | $ | 196,295 | $ | 45,943 |\n| Finished goods | 683,058 | 116,886 |\n| Inventory | $ | 879,353 | $ | 162,829 |\n\nNote 7. Contract Cost Assets\nAs of September 30, 2019 and December 31, 2018, we had $ 46.0 million and $ 45.8 million, respectively, of contract cost assets. During the three and nine month periods ended September 30, 2019 and 2018, we recorded no impairment losses. We recorded amortization expense related to contract cost assets of $ 8.8 million and $ 8.9 million during the three months ended September 30, 2019 and 2018, respectively, and $ 26.7 million and $ 27.2 million during the nine months ended September 30, 2019 and 2018, respectively.\nNote 8. Property and Equipment, net\nThe following table presents the detail of property and equipment as of the dates presented (in thousands):\n| September 30, 2019 | December 31, 2018 |\n| Website development costs | $ | 151,314 | $ | 149,891 |\n| Leasehold improvements | 79,216 | 65,012 |\n| Office equipment, furniture and fixtures | 34,801 | 39,510 |\n| Computer equipment | 33,349 | 22,477 |\n| Construction-in-progress | 26,519 | 29,037 |\n| Property and equipment | 325,199 | 305,927 |\n| Less: accumulated amortization and depreciation | ( 170,948 | ) | ( 170,755 | ) |\n| Property and equipment, net | $ | 154,251 | $ | 135,172 |\n\nWe recorded depreciation expense related to property and equipment (other than website development costs) of $ 6.1 million and $ 5.1 million during the three months ended September 30, 2019 and 2018, respectively, and $ 18.5 million and $ 14.2 million during the nine months ended September 30, 2019 and 2018, respectively.\nWe capitalized $ 10.8 million and $ 8.0 million in website development costs during the three months ended September 30, 2019 and 2018, respectively, and $ 31.1 million and $ 26.6 million during the nine months ended September 30, 2019 and 2018, respectively. Amortization expense for website development costs included in technology and development expenses was $ 4.8 million and $ 6.2 million during the three months ended September 30, 2019 and 2018, respectively, and $ 11.8 million and $ 24.2 million during the nine months ended September 30, 2019 and 2018, respectively.\nNote 9. Equity Investment\nIn October 2016, we purchased a 10 % equity interest in a privately held variable interest entity within the real estate industry for $ 10.0 million. The entity is financed through its business operations. We are not the primary beneficiary of the entity, as we do not direct the activities that most significantly impact the entity’s economic performance. Therefore, we do not consolidate the entity. Our maximum exposure to loss is $ 10.0 million, the carrying amount of the investment as of September 30, 2019. This investment is an equity security without a readily determinable fair value which we account for at cost minus any impairment, plus or minus changes resulting from observable price changes in orderly transactions for identical or similar investments of the same issuer. There has been no impairment or upward or downward adjustments to our equity investment as of September 30, 2019 that would impact the carrying amount of the investment. The equity investment is classified within other assets in the condensed consolidated balance sheet.\nNote 10. Intangible Assets, net\nThe following tables present the detail of intangible assets subject to amortization as of the dates presented (in thousands):\n| September 30, 2019 |\n| Cost | AccumulatedAmortization | Net |\n| Purchased content | $ | 45,542 | $ | ( 38,095 | ) | $ | 7,447 |\n| Software | 32,959 | ( 18,577 | ) | 14,382 |\n| Customer relationships | 103,300 | ( 70,354 | ) | 32,946 |\n| Developed technology | 107,200 | ( 78,284 | ) | 28,916 |\n| Lender licenses | 400 | ( 167 | ) | 233 |\n| Intangibles-in-progress | 5,603 | — | 5,603 |\n| Total | $ | 295,004 | $ | ( 205,477 | ) | $ | 89,527 |\n\n13\n| December 31, 2018 |\n| Cost | AccumulatedAmortization | Net |\n| Purchased content | $ | 42,110 | $ | ( 30,477 | ) | $ | 11,633 |\n| Software | 24,296 | ( 13,925 | ) | 10,371 |\n| Customer relationships | 103,900 | ( 60,733 | ) | 43,167 |\n| Developed technology | 111,980 | ( 72,788 | ) | 39,192 |\n| Trade names and trademarks | 4,900 | ( 4,683 | ) | 217 |\n| Lender licenses | 400 | ( 17 | ) | 383 |\n| Intangibles-in-progress | 2,941 | — | 2,941 |\n| Total | $ | 290,527 | $ | ( 182,623 | ) | $ | 107,904 |\n\nAmortization expense recorded for intangible assets for the three months ended September 30, 2019 and 2018 was $ 11.1 million and $ 12.0 million, respectively. Amortization expense recorded for intangible assets for the nine months ended September 30, 2019 and 2018 was $ 33.1 million and $ 37.6 million, respectively. These amounts are included in technology and development expenses.\nWe have an indefinite-lived intangible asset that we recorded in connection with our February 2015 acquisition of Trulia for Trulia’s trade names and trademarks that is not subject to amortization. The carrying value of the Trulia trade names and trademarks intangible asset was $ 108.0 million as of September 30, 2019 and December 31, 2018.\nIntangibles-in-progress consists of software that is capitalizable but has not been placed in service.\n14\nNote 11. Deferred Revenue\nThe following tables present the changes in deferred revenue for the periods presented (in thousands):\n| Three Months EndedSeptember 30, 2019 |\n| Balance as of July 1, 2019 | $ | 37,080 |\n| Deferral of revenue | 300,715 |\n| Less: Revenue recognized | ( 295,840 | ) |\n| Balance as of September 30, 2019 | $ | 41,955 |\n\n| Nine Months EndedSeptember 30, 2019 |\n| Balance as of January 1, 2019 | $ | 34,080 |\n| Deferral of revenue | 802,699 |\n| Less: Revenue recognized | ( 794,824 | ) |\n| Balance as of September 30, 2019 | $ | 41,955 |\n\nDuring the three months ended September 30, 2019 we recognized as revenue a total of $ 34.2 million pertaining to amounts that were recorded in deferred revenue as of July 1, 2019. During the nine months ended September 30, 2019, we recognized as revenue a total of $ 31.5 million pertaining to amounts that were recorded in deferred revenue as of January 1, 2019.\nNote 12. Leases\nOur lease portfolio is primarily composed of operating leases for our office space. We have lease agreements that include lease components (e.g., fixed rent) and non-lease components (e.g., common area maintenance), which are accounted for as a single component, as we have elected the practical expedient to group lease and non-lease components. We also elected the practical expedient to keep leases with an initial term of 12 months or less off the balance sheet and recognize the associated lease payments in the condensed consolidated statements of operations on a straight-line basis over the lease term.\nOur leases have remaining lease terms ranging from less than one year to twelve years , some of which include options to extend the lease term for up to an additional ten years . For example, our largest leases, which include our corporate headquarters in Seattle, Washington and office space in New York, New York and San Francisco, California, include options to renew the existing leases for either one or two periods of five years . When determining if a renewal option is reasonably certain of being exercised at lease commencement, we consider several factors, including but not limited to, contract-based, asset-based and entity-based factors. We reassess the term of existing leases if there is a significant event or change in circumstances within our control that affects whether we are reasonably certain to exercise an option to extend a lease. Examples of such events or changes include construction of significant leasehold improvements or other modifications or customizations to the underlying asset, relevant business decisions or subleases. In most cases, we have concluded that renewal options are not reasonably certain of being exercised, therefore, such renewals are not included in the right of use asset and lease liability.\nDuring the nine months ended September 30, 2019, it became reasonably certain that in a future period we would exercise the first of two five years renewal options related to the office space lease for our corporate headquarters in Seattle, Washington, due to the construction of significant leasehold improvements. Therefore, the payments associated with the renewal are included in the measurement of the lease liability and right of use asset.\nAs our leases do not provide an implicit rate, we use our incremental borrowing rate based on the information available at the lease commencement date in determining the present value of the lease payments. For those leases that existed as of January 1, 2019, we used our incremental borrowing rate based on information available at that date. We apply a portfolio approach for determining the incremental borrowing rate based on the applicable lease terms and the current economic environment, and we utilize the assistance of third-party specialists to assist us in determining our yield curve.\n15\nThe components of our operating lease expense were as follows for the periods presented (in thousands):\n| Three Months EndedSeptember 30, 2019 | Nine Months EndedSeptember 30, 2019 |\n| Operating lease cost | $ | 10,025 | $ | 25,552 |\n| Variable lease cost | 4,631 | 14,377 |\n| Total lease cost | $ | 14,656 | $ | 39,929 |\n\nCash paid for amounts included in the measurement of lease liabilities for the three and nine month periods ended September 30, 2019 was $ 7.3 million and $ 23.6 million, respectively. Right of use assets obtained in exchange for new operating lease obligations for the three and nine month periods ended September 30, 2019 were $ 14.6 million and $ 128.3 million, respectively. The weighted average remaining term for our leases as of September 30, 2019 was 8.75 years. The weighted average discount rate for our leases as of September 30, 2019 was 6.5 %.\nThe following table presents the scheduled maturities of our operating lease liabilities by fiscal year as of September 30, 2019 (in thousands):\n| Remainder of 2019 | $ | 7,776 |\n| 2020 | 38,891 |\n| 2021 | 43,073 |\n| 2022 | 39,686 |\n| 2023 | 39,065 |\n| All future years | 179,179 |\n| Total lease payments | 347,670 |\n| Less: Imputed interest | ( 105,744 | ) |\n| Present value of lease liabilities | $ | 241,926 |\n\nOperating lease expense for the three and nine month periods ended September 30, 2018, was $ 5.8 million and $ 17.2 million, respectively. The following table presents our future minimum payments for all operating leases as of December 31, 2018, including future minimum payments for operating leases that had not yet commenced as of December 31, 2018 totaling $ 112.9 million (in thousands):\n| 2019 | $ | 29,085 |\n| 2020 | 38,060 |\n| 2021 | 40,099 |\n| 2022 | 37,721 |\n| 2023 | 36,458 |\n| All future years | 85,462 |\n| Total future minimum lease payments | $ | 266,885 |\n\n16\nNote 13. Debt\nRevolving Credit Facilities\nTo provide capital for Zillow Offers, we utilize revolving credit facilities that are classified as current liabilities in our condensed consolidated balance sheets. The following table summarizes our revolving credit facilities as of the periods presented (in thousands, except interest rates):\n| Effective Date | Maximum Borrowing Capacity | Outstanding Borrowings at September 30, 2019 | Outstanding Borrowings at December 31, 2018 | Weighted Average Interest Rate |\n| July 31, 2018 | $ | 500,000 | $ | 432,484 | $ | 116,700 | 5.81 | % |\n| January 31, 2019 | 500,000 | 265,796 | — | 5.77 | % |\n| Total | $ | 1,000,000 | $ | 698,280 | $ | 116,700 |\n\nEach credit facility described in the table above provides for a maximum borrowing capacity of $ 500.0 million. The January 31, 2019 revolving credit facility has a current borrowing capacity of $ 266.0 million as of September 30, 2019, and has an initial term of two years and may be extended for up to two additional periods of six months each, subject to agreement by the lender. The July 31, 2018 revolving credit facility has an initial term of one year and automatically renews on a monthly basis as of July 31, 2019 for up to 24 additional months, subject to agreement by the lender, and has a current borrowing capacity of $ 442.5 million as of September 30, 2019.\nRecourse under each facility is limited to the assets and equity of certain Zillow Group subsidiaries that purchase and sell select residential properties through Zillow Offers. The applicable lender is not committed to, but may in their sole discretion, advance loan funds in excess of the current borrowing capacity. Zillow Group formed certain special purpose entities to effectuate the transactions contemplated by each revolving credit facility (each, an “SPE”). Each SPE is a wholly owned subsidiary of Zillow Group and a separate legal entity, and neither the assets nor credit of any such SPE are available to satisfy the debts and other obligations of any affiliate or other entity.\nOutstanding amounts drawn under each credit facility are required to be repaid on the facility termination date or earlier if accelerated due to an event of default. Further, each SPE is required to repay any resulting shortfall if the value of the eligible properties owned by such SPE falls below a certain percentage of the principal amount outstanding under the applicable credit facility. Inclusion of properties in each facility is subject to various eligibility criteria. For example, a property is no longer eligible under a credit facility if such property exceeds agreed aging criteria. Each of the credit facilities permits only a portion of the financed properties to be owned longer than 180 days, and no financed properties may be owned for longer than one year . Any financed property excluded by such aging criteria will be removed from the eligible property borrowing base, and any resulting shortfall is required to be repaid.\nThe stated interest rate on our revolving credit facilities is one-month LIBOR plus an applicable margin as defined in the respective credit agreements. Our revolving credit facilities include customary representations and warranties, covenants (including financial covenants applicable to Zillow Group) and provisions regarding events of default. As of September 30, 2019, Zillow Group was in compliance with all financial covenants and no event of default had occurred. In certain circumstances Zillow Group may be obligated to fund some or all of the payment obligations under the credit agreements. Our revolving credit facilities also require that we establish, maintain and in certain circumstances that Zillow Group fund, certain specified reserve accounts. These reserve accounts include, but are not limited to, interest reserves, insurance, tax reserves, renovation cost reserves and reserves for specially permitted liens. Amounts funded to these reserve accounts and the collection accounts have been classified within our condensed consolidated balance sheets as restricted cash.\nFor additional details related to our revolving credit facilities, see Note 22 herein and Note 14 in the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2018.\nWarehouse Lines of Credit\nTo provide capital for Zillow Home Loans, we utilize warehouse lines of credit that are classified as current liabilities in our condensed consolidated balance sheets. The following table summarizes our warehouse lines of credit as of the periods presented (in thousands, except interest rates):\n17\n| Maturity Date | Maximum Borrowing Capacity | Outstanding Borrowings at September 30, 2019 | Outstanding Borrowings at December 31, 2018 | Weighted Average Interest Rate |\n| October 15, 2019 | $ | 50,000 | $ | — | $ | 14,125 | 4.89 | % |\n| June 27, 2020 | 50,000 | 30,116 | 18,892 | 4.51 | % |\n| Total | $ | 100,000 | $ | 30,116 | $ | 33,017 |\n\nOn July 11, 2019, Zillow Home Loans extended the term of its $ 50.0 million warehouse line of credit previously maturing on July 15, 2019 such that it now matures on October 15, 2019.\nOn June 28, 2019, Zillow Home Loans amended and restated its warehouse line of credit previously maturing on June 29, 2019. The amended and restated credit agreement extends the term of the original agreement for one year , through June 27, 2020, and continues to provide for a maximum borrowing capacity of $ 50.0 million with availability under the warehouse line of credit limited depending on the types of loans originated.\nBorrowings on the warehouse lines of credit bear interest at the one-month LIBOR plus an applicable margin, as defined in the credit agreements governing each of the warehouse lines of credit. The warehouse lines of credit include customary representations and warranties, covenants and provisions regarding events of default. As of September 30, 2019, Zillow Home Loans was in compliance with all financial covenants and no event of default had occurred.\nFor additional details related to our warehouse lines of credit, see Note 22.\nConvertible Senior Notes\nThe following table summarizes our outstanding convertible senior notes as of the periods presented (in thousands, except interest rates):\n| Maturity Date | Aggregate Principal Amount | Fair Value at September 30, 2019 | Fair Value at December 31, 2018 | Stated Interest Rate | Effective Interest Rate |\n| September 1, 2026 | $ | 500,000 | $ | 469,375 | $ | — | 1.375 | % | 8.10 | % |\n| September 1, 2024 | 600,000 | 573,900 | — | 0.75 | % | 7.67 | % |\n| July 1, 2023 | 373,750 | 328,818 | 321,855 | 1.50 | % | 6.99 | % |\n| December 1, 2021 | 460,000 | 455,492 | 446,200 | 2.00 | % | 7.44 | % |\n| December 15, 2020 | 9,637 | 16,842 | 16,744 | 2.75 | % | N/A |\n| Total | $ | 1,943,387 | $ | 1,844,427 | $ | 784,799 |\n\nThe convertible notes are senior unsecured obligations and are classified as long-term debt in our condensed consolidated balance sheets. Interest on the convertible notes is paid semi-annually. As of September 30, 2019 and December 31, 2018, respectively, the total unamortized debt discount and debt issuance costs for our outstanding senior convertible notes were $ 464.7 million and $ 144.4 million. The estimated fair value of the convertible senior notes was determined through consideration of quoted market prices. The fair value is classified as Level 3 due to the limited trading activity for each of the convertible senior notes. The convertible senior notes maturing in 2021, 2023, 2024 and 2026 are not redeemable or convertible as of September 30, 2019. The convertible senior notes maturing in 2020 are convertible, at the option of the holder, and redeemable, at our option, as of September 30, 2019.\nOn September 9, 2019, Zillow Group issued $ 600.0 million aggregate principal amount of Convertible Senior Notes due 2024 (the “2024 Notes”) and $ 500.0 million aggregate principal amount of Convertible Senior Notes due 2026 (the “2026 Notes”) in a private offering to qualified institutional buyers. The 2024 Notes bear interest at a fixed rate of 0.75 % per year, and the 2026 Notes bear interest at a fixed rate of 1.375 % per year, each payable semi-annually in arrears on March 1 and September 1 of each year, beginning on March 1, 2020. The 2024 Notes and 2026 Notes are convertible into cash, shares of Class C capital stock or a combination thereof, at our election, and may be settled as described below. The 2024 Notes and the 2026 Notes are senior, unsecured obligations of the Company, and will mature on September 1, 2024 and September 1, 2026, respectively, unless earlier repurchased, redeemed or converted in accordance with their terms.\nThe net proceeds from the issuance of the 2024 Notes were approximately $ 592.2 million and the net proceeds from the issuance of the 2026 Notes were approximately $ 493.5 million, in each case after deducting fees and expenses payable by the Company. We used approximately $ 75.2 million of the net proceeds from the issuance of the 2024 Notes and approximately $ 75.4 million of the net proceeds from the issuance of the 2026 Notes to pay the cost of the capped call transactions entered into in connection with the issuances (“Capped Call Confirmations”) described below. The Company intends to use the\n18\nremainder of the net proceeds for general corporate purposes, which may include working capital, sales and marketing activities, general and administrative matters and capital expenditures.\nPrior to the close of business on the business day immediately preceding March 1, 2024 (for the 2024 Notes) or March 1, 2026 (for the 2026 Notes), the 2024 Notes and the 2026 Notes will be convertible at the option of the holders only under certain conditions. On or after March 1, 2024 (for the 2024 Notes) or March 1, 2026 (for the 2026 Notes), until the close of business on the second scheduled trading day immediately preceding the applicable maturity date, holders may convert their 2024 Notes or 2026 Notes at their option at the conversion rate then in effect, irrespective of these conditions. The Company will settle conversions of the 2024 Notes and the 2026 Notes by paying or delivering, as the case may be, cash, shares of its Class C capital stock, or a combination of cash and shares of its Class C capital stock, at its election. The conversion rate for the 2024 Notes and 2026 Notes will initially be 22.9830 shares of Class C capital stock per $1,000 principal amount of 2024 Notes or 2026 Notes (equivalent to an initial conversion price of approximately $ 43.51 per share of Class C capital stock). The conversion rate and the corresponding conversion price will be subject to adjustment in some events but will not be adjusted for any accrued and unpaid interest. The Company may redeem for cash all or part of the 2024 Notes or 2026 Notes, at its option, on or after September 5, 2022 (for the 2024 Notes) or September 5, 2023 (for the 2026 Notes), under certain circumstances, at a redemption price equal to 100 % of the principal amount of the 2024 Notes or 2026 Notes, to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date (as defined in the indentures governing the 2024 Notes and 2026 Notes). The conversion option does not meet the criteria for separate accounting as a derivative as it is indexed to our own stock.\nIf the Company undergoes a fundamental change (as defined in the indentures governing the 2024 Notes and the 2026 Notes), holders may require the Company to repurchase for cash all or part of their 2024 Notes or 2026 Notes, as applicable, at a repurchase price equal to 100 % of the principal amount of the notes to be purchased, plus accrued and unpaid interest to, but excluding, the fundamental change repurchase date (as defined in the indentures governing the 2024 Notes and the 2026 Notes). In addition, if certain fundamental changes occur, the Company may be required, in certain circumstances, to increase the conversion rate for any 2024 Notes or 2026 Notes converted in connection with such fundamental changes by a specified number of shares of its Class C capital stock. Certain events are also considered “Events of Default,” which may result in the acceleration of the maturity of the 2024 Notes or 2026 Notes, as described in the indentures governing the 2024 Notes and 2026 Notes. There are no financial covenants associated with the 2024 Notes or 2026 Notes.\nThe Capped Call Confirmations are expected generally to reduce the potential dilution of our Class C capital stock upon any conversion of the 2024 Notes or 2026 Notes and/or offset the cash payments the Company is required to make in excess of the principal amount of such notes in the event that the market price of the Class C capital stock is greater than the strike price of the Capped Call Confirmations (which initially corresponds to the initial conversion price of such notes and is subject to certain adjustments under the terms of the Capped Call Confirmations), with such reduction and/or offset subject to a cap based on the cap price of the Capped Call Confirmations. The Capped Call Confirmations with respect to the 2024 Notes have an initial cap price of $ 72.5175 per share, which represents a premium of approximately 125 % over the closing price of the Company’s Class C capital stock on the Nasdaq Global Select Market on September 4, 2019, and is subject to certain adjustments under the terms of the Capped Call Confirmations. The Capped Call Confirmations with respect to the 2026 Notes have an initial cap price of $ 80.5750 per share, which represents a premium of approximately 150 % over the closing price of the Company’s Class C capital stock on The Nasdaq Global Select Market on September 4, 2019, and is subject to certain adjustments under the terms of the Capped Call Confirmations. The Capped Call Confirmations will cover, subject to anti-dilution adjustments substantially similar to those applicable to the 2024 Notes or 2026 Notes, the number of shares of Class C capital stock that will underlie such notes. The Capped Call Confirmations do not meet the criteria for separate accounting as a derivative as they are indexed to our own stock. The premiums paid for the Capped Call Confirmations have been included as a net reduction to additional paid-in capital within shareholders’ equity.\nWe may not redeem the 2024 Notes prior to September 5, 2022 or the 2026 Notes prior to September 5, 2023. We may redeem for cash all or any portion of the 2024 Notes or 2026 Notes, at our option, in whole or in part on or after September 5, 2022 for the 2024 Notes or on or after September 5, 2023 for the 2026 Notes if the last reported sale price per share of our Class C capital stock has been at least 130 % of the conversion price then in effect for at least 20 trading days (whether or not consecutive) during any 30 consecutive trading day period.\nIn accounting for the issuance of the 2024 Notes and the 2026 Notes, the Company separated the 2024 Notes and the 2026 Notes into liability and equity components. The carrying amount of the liability component for each of the 2024 Notes and 2026 Notes was calculated by measuring the fair value of a similar liability that does not have an associated convertible feature. The carrying amount of the equity component, representing the conversion option, was determined by deducting the fair value of the liability component from the par value of the 2024 Notes and the 2026 Notes, respectively. The difference between the principal amounts of the 2024 Notes and the 2026 Notes and their liability components represents their respective debt discounts, which are recorded as a direct deduction from the related debt liability in the condensed consolidated balance sheet and amortized to interest expense using the effective interest method over the term of the 2024 Notes and the 2026 Notes. The equity components of the 2024 Notes and 2026 Notes of $ 163.6 million and $ 172.3 million, respectively, net of issuance\n19\ncosts of $ 2.1 million and $ 2.3 million, respectively, are included in additional paid-in capital in the condensed consolidated balance sheet and are not remeasured as long as they continue to meet the conditions for equity classification.\nFor additional details related to our 2024 Notes, please see Note 22. For additional details related to our convertible senior notes maturing in 2020, 2021, and 2023, see Note 14 in the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2018.\nNote 14. Income Taxes\nWe are subject to federal and state income taxes in the United States and in Canada. As of September 30, 2019 and December 31, 2018, we have provided a valuation allowance against our net deferred tax assets that we believe, based on the weight of available evidence, are not more likely than not to be realized. Therefore, no material current tax liability or expense has been recorded in the condensed consolidated financial statements. We have accumulated federal tax losses of approximately $ 1,081.7 million as of December 31, 2018, which are available to reduce future taxable income. We have accumulated state tax losses of approximately $ 32.5 million (tax effected) as of December 31, 2018.\nWe recorded an income tax benefit of $ 1.3 million for the three months ended September 30, 2019 and an income tax benefit of $ 3.8 million for the nine months ended September 30, 2019.\nWe recorded an income tax benefit of $ 14.7 million for the three months ended September 30, 2018, which was calculated as the difference between the income tax benefit of $ 22.7 million recorded for the nine months ended September 30, 2018 and the income tax benefit of $ 8.0 million recorded for the six months ended June 30, 2018. The $ 22.7 million tax benefit recorded for the nine months ended September 30, 2018 was comprised of a $ 1.9 million income tax benefit, which was calculated using an estimate of our annual effective tax rate of 4.3 % applied to our loss before income taxes of $ 44.9 million for the nine months ended September 30, 2018 and a $ 20.8 million discrete income tax benefit as a result of the treatment of stock compensation windfall deductions and the impact from the Tax Cuts and Jobs Act (the “Tax Act”) related to IRC Section 162(m). Our estimated annual effective tax rate for the nine months ended September 30, 2018 was primarily impacted by the release in valuation allowance resulting from indefinite-lived deferred tax assets and their ability to offset indefinite-lived intangible deferred tax liabilities.\nAs of September 30, 2018, we had completed our accounting for the income tax effects related to the deduction limitations on compensation under the Tax Act and recorded a discrete tax benefit adjustment of $ 3.3 million during the three months ended September 30, 2018. The Internal Revenue Service provided further guidance in applying the written binding contracts requirement under the Tax Act and certain of our executive compensation previously eligible to be deducted for tax purposes under Section 162(m) of the Internal Revenue Code will be considered grandfathered and, therefore, will continue to be deductible. Based on the clarification of these rules, the accounting related to the Section 162(m) limitation of the Internal Revenue Code was considered complete and we recorded a $ 5.9 million discrete tax benefit adjustment related to this item for the nine months ended September 30, 2018.\n20\nNote 15. Share-Based Awards\nOption Awards\nThe following table summarizes option award activity for the nine months ended September 30, 2019:\n| Numberof SharesSubject toExistingOptions | Weighted-AverageExercisePrice PerShare | Weighted-AverageRemainingContractualLife (Years) | AggregateIntrinsicValue(in thousands) |\n| Outstanding at January 1, 2019 | 27,310,110 | $ | 34.04 | 6.23 | $ | 97,941 |\n| Granted | 7,401,975 | 39.52 |\n| Exercised | ( 1,891,111 | ) | 21.69 |\n| Forfeited or cancelled | ( 1,840,756 | ) | 41.36 |\n| Outstanding at September 30, 2019 | 30,980,218 | 35.67 | 6.37 | 59,722 |\n| Vested and exercisable at September 30, 2019 | 18,305,093 | 32.26 | 4.78 | 55,130 |\n\nThe fair value of options granted is estimated at the date of grant using the Black-Scholes-Merton option-pricing model, assuming no dividends and with the following assumptions for the periods presented:\n| Three Months EndedSeptember 30, | Nine Months EndedSeptember 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Expected volatility | 45 % | 42 % | 45%-47% | 42%-45% |\n| Expected dividend yield | — | — | — | — |\n| Risk-free interest rate | 1.61 % | 2.84 % | 1.61%-2.53% | 2.52%-2.84% |\n| Weighted-average expected life | 5.00 years | 4.50 years | 4.75-5.25 years | 4.50-5.00 years |\n| Weighted-average fair value of options granted | $ 14.15 | $ 19.21 | $ 16.55 | $ 20.89 |\n\nAs of September 30, 2019, there was a total of $ 193.0 million in unrecognized compensation cost related to unvested stock options.\nRestricted Stock Units\nThe following table summarizes activity for restricted stock units for the nine months ended September 30, 2019:\n| RestrictedStock Units | Weighted-Average Grant-Date FairValue |\n| Unvested outstanding at January 1, 2019 | 5,266,324 | $ | 42.19 |\n| Granted | 4,492,544 | 37.79 |\n| Vested | ( 1,633,962 | ) | 40.41 |\n| Forfeited or cancelled | ( 933,917 | ) | 41.38 |\n| Unvested outstanding at September 30, 2019 | 7,190,989 | 39.95 |\n\nAs of September 30, 2019, there was a total of $ 265.6 million in unrecognized compensation cost related to unvested restricted stock units.\n21\nShare-Based Compensation Expense\nThe following table presents the effects of share-based compensation expense in our condensed consolidated statements of operations during the periods presented (in thousands):\n| Three Months EndedSeptember 30, | Nine Months EndedSeptember 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Cost of revenue | $ | 1,062 | $ | 969 | $ | 2,878 | $ | 3,180 |\n| Sales and marketing | 6,588 | 5,911 | 19,039 | 17,413 |\n| Technology and development | 18,034 | 15,031 | 51,942 | 40,920 |\n| General and administrative | 16,444 | 19,771 | 78,025 | 49,853 |\n| Total | $ | 42,128 | $ | 41,682 | $ | 151,884 | $ | 111,366 |\n\nOn February 21, 2019, Zillow Group announced the appointment of Richard N. Barton as Zillow Group’s Chief Executive Officer, effective February 21, 2019. Mr. Barton succeeds Spencer Rascoff, who served as Zillow Group’s Chief Executive Officer since 2010 and who remains a member of Zillow Group’s board of directors. In connection with Mr. Rascoff’s resignation as Chief Executive Officer, Zillow Group entered into an Executive Departure Agreement and Release (the “Agreement”) with Mr. Rascoff. Pursuant to the Agreement, Mr. Rascoff remained a full-time employee of Zillow Group until March 22, 2019 (the “Departure Date”) in order to provide transition services until such date. Pursuant to the Agreement, Mr. Rascoff received, among other things, accelerated vesting of outstanding stock options held by Mr. Rascoff as of the Departure Date by an additional eighteen months from the Departure Date. Options not vested as of the Departure Date, taking into account the foregoing vesting acceleration, were terminated. Each of Mr. Rascoff’s vested stock options outstanding as of the Departure Date will remain exercisable until, except for any later date contemplated by the following proviso, the earlier of (x) the third anniversary of the Departure Date and (y) the latest day upon which the option would have expired by its original terms under any circumstances (the “Option Expiration Outside Date”); provided, however, that the options will remain exercisable for so long as Mr. Rascoff serves on Zillow Group’s board of directors (but not later than any applicable Option Expiration Outside Date), and if Mr. Rascoff ceases to serve on Zillow Group’s board of directors on or after the third anniversary of the Departure Date, each option will remain exercisable until the earlier of (i) ninety days from the final date of Mr. Rascoff’s service on Zillow Group’s board of directors and (ii) the applicable Option Expiration Outside Date. The change in the exercise period of the options as well as the vesting acceleration pursuant to the Agreement have been accounted for as equity modifications, and we recorded $ 26.4 million of share-based compensation expense associated with the modifications in the nine months ended September 30, 2019. We measured the modification charge by calculating the incremental fair value of the modified award compared to the fair value of the original award immediately prior to the modification. The value of the modified awards as of the modification date was estimated using the Black-Scholes-Merton option-pricing model, assuming no dividends, expected volatility of 46 %- 47 %, a risk-free interest rate of 2.47 %- 2.49 % and a weighted-average expected life of 3.84-5.25 years.\nNote 16. Net Loss Per Share\nFor the periods presented, the following Class A common stock and Class C capital stock equivalents were excluded from the calculations of diluted net loss per share because their effect would have been antidilutive (in thousands):\n| Three Months EndedSeptember 30, | Nine Months EndedSeptember 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Weighted-average Class A common stock and Class C capital stock option awards outstanding | 18,900 | 21,766 | 19,394 | 23,508 |\n| Weighted-average Class A common stock and Class C capital stock restricted stock units outstanding | 6,964 | 5,072 | 6,690 | 4,891 |\n| Class A common stock issuable upon conversion of the convertible notes maturing in 2020 | 424 | 410 | 424 | 410 |\n| Total Class A common stock and Class C capital stock equivalents | 26,288 | 27,248 | 26,508 | 28,809 |\n\n22\nSince the Company expects to settle the principal amount of the outstanding convertible notes maturing in 2021, 2023, 2024 and 2026 in cash, the Company uses the treasury stock method for calculating any potential dilutive effect of the conversion spread on diluted net income per share, if applicable. The conversion spread for each of the notes has a dilutive impact on diluted net income per share when the market price of the Company’s Class C capital stock at the end of the period exceeds the conversion price per share. The following table presents the conversion spread and conversion price per share of Class C capital stock for each of the convertible senior notes (in thousands, except per share amounts):\n| Maturity Date | Conversion Spread | Conversion Price per Share |\n| September 1, 2026 | 11,492 | $ | 43.51 |\n| September 1, 2024 | 13,790 | 43.51 |\n| July 1, 2023 | 4,769 | 78.37 |\n| December 1, 2021 | 8,785 | 52.36 |\n\nNote 17. Commitments and Contingencies\nLease Commitments\nWe have entered into various non-cancelable operating lease agreements for certain of our office space and equipment with original lease periods expiring between 2019 and 2030. For additional information regarding our lease agreements, see Note 12.\nPurchase Commitments\nPurchase commitments primarily include various non-cancelable agreements to purchase content related to our mobile applications and websites as well as homes we are under contract to purchase through Zillow Offers but that have not closed as of the respective date. As of September 30, 2019, the value of homes under contract that have not closed was $ 221.1 million.\nLetters of Credit\nAs of September 30, 2019, we have outstanding letters of credit of approximately $ 16.9 million, which secure our lease obligations in connection with certain of our office space operating leases.\nSurety Bonds\nIn the course of business, we are required to provide financial commitments in the form of surety bonds to third parties as a guarantee of our performance on and our compliance with certain obligations. If we were to fail to perform or comply with these obligations, any draws upon surety bonds issued on our behalf would then trigger our payment obligation to the surety bond issuer. We have outstanding surety bonds issued for our benefit of approximately $ 10.1 million and $ 8.9 million, respectively, as of September 30, 2019 and December 31, 2018.\nLegal Proceedings\nWe are involved in a number of legal proceedings concerning matters arising in connection with the conduct of our business activities, some of which are at preliminary stages and some of which seek an indeterminate amount of damages. We regularly evaluate the status of legal proceedings in which we are involved to assess whether a loss is probable or there is a reasonable possibility that a loss or additional loss may have been incurred to determine if accruals are appropriate. We further evaluate each legal proceeding to assess whether an estimate of possible loss or range of loss can be made if accruals are not appropriate. For certain cases described below, management is unable to provide a meaningful estimate of the possible loss or range of possible loss because, among other reasons, (i) the proceedings are in preliminary stages; (ii) specific damages have not been sought; (iii) damages sought are, in our view, unsupported and/or exaggerated; (iv) there is uncertainty as to the outcome of pending appeals or motions; (v) there are significant factual issues to be resolved; and/or (vi) there are novel legal issues or unsettled legal theories presented. For these cases, however, management does not believe, based on currently available information, that the outcomes of these proceedings will have a material effect on our financial position, results of operations or cash flow. For the matters discussed below, we have not recorded any material accruals as of September 30, 2019 or December 31, 2018.\nIn July 2015, VHT, Inc. (“VHT”) filed a complaint against us in the U.S. District Court for the Western District of Washington alleging copyright infringement of VHT’s images on the Zillow Digs site. In January 2016, VHT filed an amended complaint alleging copyright infringement of VHT’s images on the Zillow Digs site as well as the Zillow listing site. In\n23\nDecember 2016, the court granted a motion for partial summary judgment that dismissed VHT’s claims with respect to the Zillow listing site. A federal jury trial began on January 23, 2017, and on February 9, 2017, the jury returned a verdict finding that the Company had infringed VHT’s copyrights in images displayed or saved to the Digs site. The jury awarded VHT $ 79,875 in actual damages and approximately $ 8.2 million in statutory damages. In March 2017, the Company filed motions in the district court seeking judgment for the Company on certain claims that are the subject of the verdict, and for a new trial on others. On June 20, 2017, the judge ruled and granted in part our motions, finding that VHT failed to present sufficient evidence to prove direct copyright infringement for a portion of the images, reducing the total damages to approximately $ 4.1 million. On March 15, 2019, after the Company had filed an appeal with the Ninth Circuit Court of Appeals seeking review of the final judgment and certain prior rulings entered by the district court, the Ninth Circuit Court of Appeals issued an opinion that, among other things, (i) affirmed the district court’s grant of summary judgment in favor of Zillow on direct infringement of images on Zillow’s listing site, (ii) affirmed the district court’s grant in favor of Zillow of judgment notwithstanding the verdict on certain images that were displayed on the Zillow Digs site, (iii) remanded consideration of the issue whether VHT’s images on the Zillow Digs site were part of a compilation or individual photos, and (iv) vacated the jury’s finding of willful infringement. On October 7, 2019, the United States Supreme Court denied VHT’s petition for writ of certiorari seeking review of certain rulings by the Ninth Circuit Court of Appeals. We do not believe there is a reasonable possibility that a material loss may be incurred related to this complaint.\nIn August and September 2017, two purported class action lawsuits were filed against us and certain of our executive officers, alleging, among other things, violations of federal securities laws on behalf of a class of those who purchased our common stock between February 12, 2016 and August 8, 2017. One of those purported class actions, captioned Vargosko v. Zillow Group, Inc. et al, was brought in the U.S. District Court for the Central District of California. The other purported class action lawsuit, captioned Shotwell v. Zillow Group, Inc. et al, was brought in the U.S. District Court for the Western District of Washington. The complaints allege, among other things, that during the period between February 12, 2016 and August 8, 2017, we issued materially false and misleading statements regarding our business practices. The complaints seek to recover, among other things, alleged damages sustained by the purported class members as a result of the alleged misconduct. In November 2017, an amended complaint was filed against us and certain of our executive officers in the Shotwell v. Zillow Group class action lawsuit, extending the beginning of the class period to November 17, 2014. In January 2018, the Vargosko v. Zillow Group purported class action lawsuit was transferred to the U.S. District Court for the Western District of Washington and consolidated with the Shotwell v. Zillow Group purported class action lawsuit. In February 2018, the plaintiffs filed a consolidated amended complaint, and in April 2018, we filed our motion to dismiss the consolidated amended complaint. In October 2018, our motion to dismiss was granted without prejudice, and in November 2018, the plaintiffs filed a second consolidated amended complaint, which we moved to dismiss in December 2018. On April 19, 2019, our motion to dismiss the second consolidated amended complaint was denied, and we filed our answer to the second amended complaint on May 3, 2019. On October 11, 2019, plaintiffs filed a motion for class certification. We have denied the allegations of wrongdoing and intend to vigorously defend the claims in this lawsuit. We do not believe a loss related to this complaint is probable.\nIn October and November 2017 and January and February 2018, four shareholder derivative lawsuits were filed in the U.S. District Court for the Western District of Washington and the Superior Court of the State of Washington, King County, against certain of our executive officers and directors seeking unspecified damages on behalf of the Company and certain other relief, such as reform to corporate governance practices. The plaintiffs in the derivative suits (in which the Company is a nominal defendant) allege, among other things, that the defendants breached their fiduciary duties in connection with oversight of the Company’s public statements and legal compliance, and as a result of the breach of such fiduciary duties, the Company was damaged, and defendants were unjustly enriched. Certain of the plaintiffs also allege, among other things, violations of Section 14(a) of the Securities Exchange Act of 1934 and waste of corporate assets. On February 5, 2018, the U.S. District Court for the Western District of Washington consolidated the two shareholder derivative lawsuits pending in that court. On February 16, 2018, the Superior Court of the State of Washington, King County, consolidated the two shareholder derivative lawsuits pending in that court. All four of the shareholder derivative lawsuits were stayed until our motion to dismiss the second consolidated amended complaint in the securities class action lawsuit discussed above was denied in April 2019. On July 8, 2019, the plaintiffs in the consolidated federal derivative lawsuit filed a consolidated shareholder derivative complaint, which we moved to dismiss on August 22, 2019. Plaintiffs opposed our motion to dismiss on October 7, 2019 and we filed our reply to plaintiffs’ opposition to our motion to dismiss on November 6, 2019. We do not believe a loss is probable related to these lawsuits.\nOn September 17, 2019, International Business Machines Corporation (“IBM”) filed a complaint against us in the United States District Court for the Central District of California, alleging, among other things, that the Company has infringed and continues to willfully infringe seven patents held by IBM and seeks unspecified damages, including a request that the amount of compensatory damages be trebled, injunctive relief and costs and reasonable attorneys’ fees. We deny the allegations of any wrongdoing and intend to vigorously defend the claims in the lawsuit. There is a reasonable possibility that a loss may be incurred related to this complaint; however, the possible loss or range of loss is not estimable.\n24\nIn addition to the matters discussed above, from time to time, we are involved in litigation and claims that arise in the ordinary course of business. Although we cannot be certain of the outcome of any such litigation or claims, nor the amount of damages and exposure that we could incur, we currently believe that the final disposition of such matters will not have a material effect on our business, financial position, results of operations or cash flow. Regardless of the outcome, litigation can have an adverse impact on us because of defense and settlement costs, diversion of management resources and other factors.\nIndemnifications\nIn the ordinary course of business, we enter into contractual arrangements under which we agree to provide indemnification of varying scope and terms to business partners and other parties with respect to certain matters, including, but not limited to, losses arising out of the breach of such agreements and out of intellectual property infringement claims made by third parties. In addition, we have agreements that indemnify certain issuers of surety bonds against losses that they may incur as a result of executing surety bonds on our behalf. For our indemnification arrangements, payment may be conditional on the other party making a claim pursuant to the procedures specified in the particular contract. Further, our obligations under these agreements may be limited in terms of time and/or amount, and in some instances, we may have recourse against third parties for certain payments. In addition, we have indemnification agreements with certain of our directors and executive officers that require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors or officers. The terms of such obligations may vary.\nNote 18. Related Party Transactions\nOn April 3, 2019, we entered into a Charter Service Agreement with Executive Jet Management, Inc. for the occasional use by us of an aircraft owned by an entity that is owned by Mr. Lloyd Frink, our Executive Chairman and President, for business travel. We recognized approximately $ 0.1 million and $ 0.3 million in expenses pursuant to the Charter Service Agreement for the three- and nine-month periods ended September 30, 2019, respectively.\nNote 19. Self-Insurance\nWe are self-insured for medical benefits and dental benefits for all qualifying Zillow Group employees. The medical plan carries a stop-loss policy which provides protection when cumulative medical claims exceed 125 % of expected claims for the plan year with a limit of $ 1.0 million and from individual claims during the plan year exceeding $ 500,000 . We record estimates of the total costs of claims incurred based on an analysis of historical data and independent estimates. Our liability for self-insured claims is included within accrued compensation and benefits in our condensed consolidated balance sheets and was $ 3.6 million and $ 3.9 million, respectively, as of September 30, 2019 and December 31, 2018.\nNote 20. Employee Benefit Plan\nWe have a defined contribution 401(k) retirement plan covering Zillow Group employees who have met certain eligibility requirements (the “Zillow Group 401(k) Plan”). Eligible employees may contribute pretax compensation up to a maximum amount allowable under the Internal Revenue Service limitations. Employee contributions and earnings thereon vest immediately. We currently match up to 4 % of employee contributions under the Zillow Group 401(k) Plan. The total expense related to the Zillow Group 401(k) Plan was $ 5.6 million and $ 4.1 million, respectively, for the three months ended September 30, 2019 and 2018, and $ 15.7 million and $ 11.9 million, respectively, for the nine months ended September 30, 2019 and 2018.\nNote 21. Segment Information and Revenue\nBeginning January 1, 2019, we have three operating and reportable segments, which have been identified based on the way in which our chief operating decision-maker manages our business, makes operating decisions and evaluates operating performance. The chief executive officer acts as the chief operating decision-maker and reviews financial and operational information for the Internet, Media & Technology (“IMT”), Homes and Mortgages segments.\nThe IMT segment includes the financial results for the Premier Agent, Rentals and new construction marketplaces, dotloop, and display, as well as revenue from the sale of various other marketing and business products and services to real estate professionals. The Homes segment includes the financial results from Zillow Group’s purchase and sale of homes directly. The Mortgages segment includes financial results for advertising sold to mortgage lenders and other mortgage\n25\nprofessionals, mortgage originations through Zillow Home Loans and the sale of mortgages on the secondary market, as well as Mortech mortgage software solutions.\nRevenue and costs are directly attributed to our segments when possible. However, due to the integrated structure of our business, certain costs incurred by one segment may benefit the other segments. These costs primarily include headcount-related expenses, general and administrative expenses including executive, finance, accounting, legal, human resources, recruiting, and facilities costs, product development and data acquisition costs and marketing and advertising costs. These costs are allocated to each segment based on the estimated benefit each segment receives from such expenditures.\nThe chief executive officer reviews information about our revenue categories as well as statement of operations data inclusive of loss before income taxes by segment. This information is included in the following tables for the periods presented (in thousands):\n| Three Months EndedSeptember 30, 2019 | Three Months EndedSeptember 30, 2018 |\n| Homes | IMT | Mortgages | Homes | IMT | Mortgages |\n| Revenue: |\n| Homes | $ | 384,626 | $ | — | $ | — | $ | 11,018 | $ | — | $ | — |\n| Premier Agent | — | 240,698 | — | — | 232,703 | — |\n| Rentals | — | 44,430 | — | — | 37,319 | — |\n| Other | — | 50,162 | — | — | 43,616 | — |\n| Mortgages | — | — | 25,292 | — | — | 18,438 |\n| Total revenue | 384,626 | 335,290 | 25,292 | 11,018 | 313,638 | 18,438 |\n| Costs and expenses: |\n| Cost of revenue | 370,796 | 24,318 | 4,721 | 10,226 | 25,186 | 1,260 |\n| Sales and marketing | 49,186 | 118,514 | 13,647 | 4,650 | 117,522 | 6,562 |\n| Technology and development | 20,651 | 94,656 | 8,667 | 6,128 | 93,930 | 5,256 |\n| General and administrative | 22,174 | 55,749 | 10,570 | 6,010 | 60,678 | 4,055 |\n| Impairment costs | — | — | — | — | 10,000 | — |\n| Acquisition-related costs | — | — | — | — | — | 1,405 |\n| Integration costs | — | — | 5 | — | — | 523 |\n| Total costs and expenses | 462,807 | 293,237 | 37,610 | 27,014 | 307,316 | 19,061 |\n| Income (loss) from operations | ( 78,181 | ) | 42,053 | ( 12,318 | ) | ( 15,996 | ) | 6,322 | ( 623 | ) |\n| Segment other income | — | — | 344 | — | — | — |\n| Segment interest expense | ( 9,689 | ) | — | ( 280 | ) | ( 432 | ) | — | — |\n| Income (loss) before income taxes (1) | $ | ( 87,870 | ) | $ | 42,053 | $ | ( 12,254 | ) | $ | ( 16,428 | ) | $ | 6,322 | $ | ( 623 | ) |\n\n26\n| Nine Months EndedSeptember 30, 2019 | Nine Months EndedSeptember 30, 2018 |\n| Homes | IMT | Mortgages | Homes | IMT | Mortgages |\n| Revenue: |\n| Homes | $ | 762,022 | $ | — | $ | — | $ | 11,018 | $ | — | $ | — |\n| Premier Agent | — | 690,394 | — | — | 677,320 | — |\n| Rentals | — | 124,938 | — | — | 99,670 | — |\n| Other | — | 141,899 | — | — | 123,445 | — |\n| Mortgages | — | — | 79,637 | — | — | 56,766 |\n| Total revenue | 762,022 | 957,231 | 79,637 | 11,018 | 900,435 | 56,766 |\n| Costs and expenses: |\n| Cost of revenue | 733,947 | 74,628 | 13,829 | 10,312 | 72,070 | 3,736 |\n| Sales and marketing | 107,457 | 380,608 | 42,302 | 7,035 | 384,241 | 22,476 |\n| Technology and development | 51,130 | 276,886 | 24,058 | 12,154 | 270,978 | 16,491 |\n| General and administrative | 54,339 | 181,270 | 31,497 | 11,964 | 163,303 | 12,128 |\n| Impairment costs | — | — | — | — | 10,000 | — |\n| Acquisition-related costs | — | — | — | — | 27 | 2,037 |\n| Integration costs | — | — | 650 | — | — | 523 |\n| Total costs and expenses | 946,873 | 913,392 | 112,336 | 41,465 | 900,619 | 57,391 |\n| Income (loss) from operations | ( 184,851 | ) | 43,839 | ( 32,699 | ) | ( 30,447 | ) | ( 184 | ) | ( 625 | ) |\n| Segment other income | — | — | 1,059 | — | — | — |\n| Segment interest expense | ( 19,346 | ) | — | ( 668 | ) | ( 432 | ) | — | — |\n| Income (loss) before income taxes (1) | $ | ( 204,197 | ) | $ | 43,839 | $ | ( 32,308 | ) | $ | ( 30,879 | ) | $ | ( 184 | ) | $ | ( 625 | ) |\n\n(1) The following table presents the reconciliation of total segment loss before income taxes to consolidated loss before income taxes for the periods presented (in thousands, unaudited):\n| Three Months EndedSeptember 30, | Nine Months EndedSeptember 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Total segment loss before income taxes | $ | ( 58,071 | ) | $ | ( 10,729 | ) | $ | ( 192,666 | ) | $ | ( 31,688 | ) |\n| Corporate interest expense | ( 16,533 | ) | ( 12,236 | ) | ( 41,851 | ) | ( 26,496 | ) |\n| Corporate other income | 8,655 | 7,773 | 26,566 | 13,308 |\n| Consolidated loss before income taxes | $ | ( 65,949 | ) | $ | ( 15,192 | ) | $ | ( 207,951 | ) | $ | ( 44,876 | ) |\n\nCertain corporate items are not directly attributable to any of our segments, including interest income earned on our short-term investments included in Other income and interest costs on our convertible senior notes included in Interest expense.\n27\nNote 22. Subsequent Events\nIssuance of Additional 0.75 % Convertible Senior Notes due in 2024\nOn October 9, 2019, the Company issued $ 73.0 million aggregate principal amount of 0.75 % Convertible Senior Notes due 2024 (the “Additional Notes”). The Additional Notes were sold pursuant to the initial purchasers’ partial exercise of their option to purchase such notes, granted in connection with the offering of the 2024 Notes. For additional details related to the 2024 Notes, please see Note 13. The Additional Notes have the same terms, and were issued under the same indenture, as the 2024 Notes. The net proceeds from the offering of the Additional Notes were approximately $ 72.0 million, after deducting fees and expenses payable by the Company. The Company used approximately $ 9.1 million of the net proceeds to pay the cost of the capped call transactions entered into in connection with the issuance of the Additional Notes. The Additional Notes will be separated into liability and equity components, with the liability component classified as long-term debt and the equity component, reflecting the conversion option, included in additional paid-in capital in our consolidated balance sheet. The premiums paid for the capped call confirmations will be included as a net reduction to additional paid-in capital within shareholders’ equity.\nExtension of Warehouse Line of Credit\nOn October 11, 2019, Zillow Home Loans extended the term of its $ 50.0 million warehouse line of credit previously maturing on October 15, 2019 such that it now matures on October 31, 2019.\nEntry into Revolving Credit Agreement\nOn October 21, 2019, certain of Zillow Group’s wholly owned subsidiaries entered into a credit agreement with Goldman Sachs Bank USA, as the lender, and certain other parties thereto (the “GS Credit Agreement”). The GS Credit Agreement provides for a maximum borrowing capacity of $ 500.0 million (the “Maximum Amount”) subject to the satisfaction of certain conditions, through a credit facility secured by a pledge of the assets and equity of certain subsidiaries that purchase and sell select residential properties through Zillow Offers. The lender has the discretion to determine the borrowing capacity available under the credit facility, up to the Maximum Amount. The GS Credit Agreement has an initial term of two years which may be extended for one additional period of six months , subject to the satisfaction of certain conditions. The stated interest rate is one-month LIBOR plus an applicable margin. The GS Credit Agreement includes customary representations and warranties, covenants (including financial covenants applicable to Zillow Group), and provisions regarding events of default. The GS Credit Agreement includes repayment terms similar to the repayment terms under our other two credit facilities that finance the purchase of residential properties through Zillow Offers. The GS Credit Agreement will be classified within current liabilities in our consolidated balance sheet.\nRecourse under the credit facility is limited to the assets and equity of certain Zillow Group subsidiaries that purchase and sell select residential properties through Zillow Offers. Zillow Group formed certain special purpose entities to effectuate the transactions contemplated by the GS Credit Agreement (each, an “SPE”). Each SPE is a wholly owned subsidiary of Zillow Group and a separate legal entity, and neither the assets nor credit of any such SPE are available to satisfy the debts and other obligations of any affiliate or other entity. In certain circumstances Zillow Group may be obligated to fund some or all of the payment obligations under the credit facility.\nEntry into Master Repurchase Agreement\nOn October 29, 2019, Zillow Home Loans, LLC (“Zillow Homes Loans”) entered into a master repurchase agreement (the “Repurchase Agreement”) with Citibank, N.A. (“Citibank”) to provide funding for mortgage loans. In accordance with the Repurchase Agreement, Citibank agrees to pay Zillow Home Loans a negotiated purchase price for eligible loans and Zillow Home Loans simultaneously agrees to repurchase such loans from Citibank under a specified timeframe at an agreed upon price that includes interest. The Repurchase Agreement provides for a maximum borrowing capacity of $ 75.0 million, including a committed amount of $ 25.0 million . The Repurchase Agreement matures on October 27, 2020 and includes customary representations and warranties, covenants and provisions regarding events of default. Transactions under the Repurchase Agreement bear interest at the one-month LIBOR plus an applicable margin, as defined in the Repurchase Agreement. We have not yet determined the impact this Repurchase Agreement will have on our financial statements.\n28\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nThe following discussion of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and the related notes included elsewhere in this Quarterly Report on Form 10-Q. In addition to historical financial information, the following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results may differ materially from those described in or implied by any forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Quarterly Report on Form 10-Q, including in the section titled “Note Regarding Forward-Looking Statements,” and also those factors discussed in Part I, Item 1A (Risk Factors) of our Annual Report on Form 10-K for the year ended December 31, 2018.\nOverview of our Business\nZillow Group, Inc. houses one of the largest portfolios of real estate brands on mobile and the web. Zillow Group is committed to leveraging its proprietary data, technology and innovations to make home buying, selling, financing and renting a seamless, on-demand experience for consumers. As its flagship brand, Zillow now offers a fully integrated home shopping experience that includes access to for sale and rental listings, Zillow Offers, which provides a hassle-free way to buy and sell homes directly through Zillow, and Zillow Home Loans, Zillow’s affiliated lender that provides an easy way to receive mortgage pre-approvals and financing. Other consumer brands include Trulia, StreetEasy, HotPads, Naked Apartments and Out East. In addition, Zillow Group provides a comprehensive suite of marketing software and technology solutions to help real estate professionals maximize business opportunities and connect with millions of consumers. Zillow Group also operates a number of business brands for real estate, rental and mortgage professionals, including Mortech, dotloop, Bridge Interactive and New Home Feed.\nReportable Segments and Revenue Overview\nAs of January 1, 2019, Zillow Group has three reportable segments: the Homes segment, the Internet, Media & Technology (“IMT”) segment and the Mortgages segment. The Homes segment includes the financial results from Zillow Group’s purchase and sale of homes directly through the Zillow Offers service. The IMT segment includes the financial results for the Premier Agent, Rentals and new construction marketplaces, as well as dotloop, display and other advertising and business software solutions. The Mortgages segment includes the financial results for advertising sold to mortgage lenders and other mortgage professionals, mortgage originations through Zillow Home Loans and our Mortech mortgage software solutions.\nIn our Homes segment, we generate revenue from the resale of homes on the open market through our Zillow Offers service. We began buying homes through the Zillow Offers service in April 2018, and we began selling homes in July 2018.\nPremier Agent revenue is generated by the sale of advertising services, as well as marketing and technology products and services, to help real estate agents and brokers grow and manage their businesses. We offer these products and services through our Premier Agent and Premier Broker programs. Premier Agent and Premier Broker advertising products, which include the delivery of impressions and validated consumer connections, or leads, are sold on a share of voice basis. Impressions and leads are distributed to Premier Agents and Premier Brokers in proportion to their share of voice, or an agent advertiser’s share of total advertising purchased in a particular zip code. Impressions are delivered when an advertisement of a Premier Agent or Premier Broker appears on pages viewed by users of our mobile applications and websites and connections are delivered when consumer contact information is provided to Premier Agents and Premier Brokers. Connections and impressions are each provided as part of our advertising services for Premier Agent and Premier Brokers; we do not charge a separate fee for these consumer leads.\nIn October 2018, we began testing a new Flex pricing model for Premier Agent and Premier Broker advertising services in limited markets. With the Flex model, Premier Agent and Premier Brokers are provided with impressions and connections at no upfront cost, and they pay a performance advertising fee only when a real estate transaction is closed with one of those leads.\nRentals revenue primarily includes advertising sold to property managers, landlords and other rental professionals on a cost per lead, cost per click, cost per lease or cost per listing basis. Rentals revenue also includes revenue generated through our rental applications product, whereby potential renters can submit applications to multiple properties over a 30-day period for a flat service fee.\nOther revenue primarily includes revenue generated by new construction and display advertising, as well as revenue from the sale of various other advertising and business technology solutions for real estate professionals, including dotloop. New construction revenue primarily includes advertising services sold to home builders on a cost per residential community basis.\n29\nDisplay revenue primarily consists of graphical mobile and web advertising sold to advertisers promoting their brands on our mobile applications and websites.\nIn our Mortgages segment, we generate revenue from advertising sold to mortgage lenders and other mortgage professionals on a cost per lead or subscription basis, including our Connect and Custom Quote services, through mortgage originations and the related sale of mortgages on the secondary market through Zillow Home Loans and from Mortech, which provides subscription-based mortgage software solutions, including a product and pricing engine and lead management platform.\nDuring the three months ended September 30, 2019, we generated total revenue of $745.2 million, as compared to $343.1 million in the three months ended September 30, 2018, an increase of $402.1 million, or 117%. This increase was primarily the result of the addition of $373.6 million in Homes revenue, an $8.0 million, or 3% increase in Premier Agent revenue, a $7.1 million, or 19% increase in Rentals revenue, a $6.9 million, or 37% increase in Mortgages revenue and a $6.5 million, or 15% increase in Other revenue. There were approximately 195.6 million average monthly unique users of our mobile applications and websites for the three months ended September 30, 2019, representing year-over-year growth of 5%. Visits increased 11% to 2,104.9 million for the three months ended September 30, 2019 from 1,888.9 million for the three months ended September 30, 2018.\nOn September 9, 2019, we issued $600.0 million aggregate principal amount of 0.75% Convertible Senior Notes due 2024 (the “2024 Notes”) and $500.0 million aggregate principal amount of 1.375% Convertible Senior Notes due 2026 (the “2026 Notes”). The net proceeds from the issuances of the 2024 Notes and 2026 Notes were approximately $592.2 million and $493.5 million, respectively, in each case after deducting fees and expenses payable by Zillow Group. We used approximately $75.2 million of the net proceeds from the 2024 Notes and approximately $75.4 million of the net proceeds from the 2026 Notes to pay the cost of the capped call transactions entered into in connection with the issuances. We intend to use the remainder of the net proceeds for general corporate purposes, which may include working capital, sales and marketing activities, general and administrative matters and capital expenditures.\nAs of September 30, 2019, we had 5,168 full-time employees compared to 4,336 full-time employees as of December 31, 2018.\nKey Metrics\nManagement has identified unique users and visits as relevant to investors’ and others’ assessment of our financial condition and results of operations.\nUnique Users\nMeasuring unique users is important to us because much of our revenue depends in part on our ability to enable real estate, rental and mortgage professionals to connect with our consumer users - home buyers and sellers, renters, and individuals with or looking for a mortgage. Growth in consumer traffic to our mobile applications and websites increases the number of impressions, clicks, connections, leads and other events we can monetize to generate revenue. For example, our Homes segment revenue depends in part on users accessing our mobile applications and websites to engage in the sale and purchase of homes with Zillow Group, and Premier Agent revenue and display revenue depend on advertisements being served to users of our mobile applications and websites.\n30\nWe count a unique user the first time an individual accesses one of our mobile applications using a mobile device during a calendar month and the first time an individual accesses one of our websites using a web browser during a calendar month. If an individual accesses our mobile applications using different mobile devices within a given month, the first instance of access by each such mobile device is counted as a separate unique user. If an individual accesses more than one of our mobile applications within a given month, the first access to each mobile application is counted as a separate unique user. If an individual accesses our websites using different web browsers within a given month, the first access by each such web browser is counted as a separate unique user. If an individual accesses more than one of our websites in a single month, the first access to each website is counted as a separate unique user since unique users are tracked separately for each domain. Zillow, StreetEasy, HotPads and Naked Apartments measure unique users with Google Analytics, and Trulia measures unique users with Adobe Analytics.\nThe following table presents our average monthly unique users for the periods presented (in millions):\n| Three Months EndedSeptember 30, | 2018 to 2019% Change |\n| 2019 | 2018 |\n| Average Monthly Unique Users | 195.6 | 186.6 | 5 | % |\n\nVisits\nThe number of visits is an important metric because it is an indicator of consumers’ level of engagement with our mobile applications, websites and other services. We believe highly engaged consumers are more likely to participate in our Zillow Offers program or use Zillow Homes Loans or more likely to be transaction-ready real estate market participants and therefore more sought-after by our real estate advertisers.\nWe define a visit as a group of interactions by users with the Zillow, Trulia and StreetEasy mobile applications and websites, as we monetize our Premier Agent and Premier Broker products on these mobile applications and websites. A single visit can contain multiple page views and actions, and a single user can open multiple visits across domains, web browsers, desktop or mobile devices. Visits can occur on the same day, or over several days, weeks or months.\nZillow and StreetEasy measure visits with Google Analytics, and Trulia measures visits with Adobe Analytics. Visits to Trulia end after thirty minutes of user inactivity. Visits to Zillow and StreetEasy end either: (i) after thirty minutes of user inactivity or at midnight; or (ii) through a campaign change. A visit ends through a campaign change if a visitor arrives via one campaign or source (for example, via a search engine or referring link on a third-party website), leaves the mobile application or website, and then returns via another campaign or source.\nThe following table presents the number of visits to our mobile applications and websites for the periods presented (in millions):\n| Three Months EndedSeptember 30, | 2018 to 2019% Change |\n| 2019 | 2018 |\n| Visits | 2,104.9 | 1,888.9 | 11 | % |\n\nBasis of Presentation\nRevenue\nWe recognize revenue when (or as) we satisfy our performance obligations by transferring control of promised products or services to our customers in an amount that reflects the consideration to which we expect to be entitled in exchange for those products or services.\nIn our Homes segment, we generate revenue from the resale of homes on the open market through our Zillow Offers program.\nIn our IMT segment, we generate revenue from the sale of advertising services and our suite of marketing software and technology solutions to residential real estate businesses and professionals. These professionals include real estate, rental and new construction professionals and brand advertisers. Our three primary revenue categories within our IMT segment are Premier Agent, Rentals and Other.\n31\nIn our Mortgages segment, we generate revenue from the sale of advertising services to mortgage lenders and other mortgage professionals, mortgage originations and the related sale of mortgages on the secondary market through Zillow Home Loans, as well as Mortech mortgage software solutions.\nHomes Revenue. Homes revenue is derived from the resale of homes on the open market through our Zillow Offers program. Homes revenue is recognized at the time of the closing of the home sale when title to and possession of the property are transferred to the buyer. The amount of revenue recognized for each home sale is equal to the full sale price of the home net of resale concessions and credits to the buyer and does not reflect real estate agent commissions, closing or other costs associated with the transaction.\nPremier Agent Revenue. Premier Agent revenue is derived from our Premier Agent and Premier Broker programs. Our Premier Agent and Premier Broker programs offer a suite of marketing and business technology products and services to help real estate agents and brokers achieve their advertising goals, while growing and managing their businesses and brands. All Premier Agents and Premier Brokers receive access to a dashboard portal on our mobile application or website that provides individualized program performance analytics, our customer relationship management, or CRM, tool that captures detailed information about each contact made with a Premier Agent or Premier Broker through our mobile and web platforms and our account management tools. The marketing and business technology products and services promised to Premier Agents and Premier Brokers are delivered over time, as the customer simultaneously receives and consumes the benefit of the performance obligations.\nPremier Agent and Premier Broker advertising products, which include the delivery of impressions and validated consumer connections, or leads, are primarily offered on a share of voice basis. Payment is received prior to the delivery of impressions and connections. Impressions are delivered when an advertisement appears on pages viewed by users of our mobile applications and websites and connections are delivered when consumer contact information is provided to Premier Agents and Premier Brokers. We do not promise any minimum or maximum number of impressions to customers, but instead control when and how many impressions to deliver based on a customer’s share of voice. We determine the number of impressions and connections to deliver to Premier Agents and Premier Brokers in each zip code using a market-based pricing method in consideration of the total amount spent by Premier Agents and Premier Brokers to purchase impressions and connections in the zip code during the month. This results in the delivery of impressions and connections over time in proportion to each Premier Agent’s and Premier Broker’s share of voice. A Premier Agent’s or Premier Broker’s share of voice in a zip code is determined by their proportional monthly prepaid spend in that zip code as a percentage of the total monthly prepaid spend of all Premier Agents and Premier Brokers in that zip code, and includes both the share of impressions delivered as advertisements appearing on pages viewed by users of our mobile applications and websites, as well as the proportion of consumer connections a Premier Agent or Premier Broker receives. The number of impressions and connections delivered for a given spend level is dynamic - as demand for advertising in a zip code increases or decreases, the number of impressions and connections delivered to a Premier Agent or Premier Broker in that zip code decreases or increases accordingly.\nWe primarily recognize revenue related to the Premier Agent and Premier Broker products and services based on the monthly prepaid spend recognized on a straight-line basis during the monthly billing period over which the products and services are provided. This methodology best depicts how we satisfy our performance obligations to customers, as we continuously transfer control of the performance obligations to the customer over time. Given a Premier Agent or Premier Broker typically prepays their monthly spend and the monthly spend is refunded on a pro-rata basis upon cancellation of the contract by a customer at any point in time, we have determined that Premier Agent and Premier Broker contracts are effectively daily contracts, and each performance obligation is satisfied over time as each day lapses. We have not allocated the transaction price to each performance obligation within our Premier Agent and Premier Broker arrangements, as the amounts recognized would be the same irrespective of any allocation.\nIn October 2018, we began testing a new pricing model, Flex, for Premier Agent and Premier Broker advertising services in limited markets. With the Flex model, Premier Agents and Premier Brokers are provided with validated leads at no upfront cost, and they pay a performance advertising fee only when a real estate transaction is closed with one of the leads. With this pricing model, the transaction price represents variable consideration, as the amount to which we expect to be entitled varies based on the number of validated leads that convert into real estate transactions and the value of those transactions. During this testing phase, we recognize revenue when we receive payment for a real estate transaction closed with a Flex lead. We will continuously reevaluate this determination and the point at which we may begin to estimate variable consideration and record revenue as performance obligations are transferred.\nRentals Revenue. Rentals revenue includes the sale of advertising and a suite of tools to rental professionals, landlords and other market participants. Rentals revenue primarily includes revenue generated by advertising sold to property managers, landlords and other rental professionals on a cost per lead, cost per click, cost per lease, cost per listing or cost per impression basi\n32\ns. We recognize revenue as leads, clicks and impressions are provided to rental professionals, or as rental listings are published on our mobile applications and websites, which is the amount for which we have the right to invoice. The number of leases generated through our rentals pay per lease product during the period is accounted for as variable consideration, and we estimate the amount of variable consideration based on the expected number of qualified leases secured during the period. We do not believe that a significant reversal in the amount of cumulative revenue recognized will occur once the uncertainty related to the number of leases secured is subsequently resolved.\nRentals revenue also includes revenue generated from our rental applications product through which potential renters can submit applications to multiple rental properties over a 30-day period for a flat service fee. We recognize revenue for the rental applications product on a straight-line basis during the contractual period over which the customer has the right to access and submit the rental application.\nOther Revenue. Other revenue primarily includes revenue generated by new construction and display, as well as revenue from the sale of various other marketing and business products and services to real estate professionals. Our new construction marketing solutions allow home builders to showcase their available inventory to home shoppers. New construction revenue primarily includes revenue generated by advertising sold to builders on a cost per residential community basis, and revenue is recognized on a straight-line basis during the contractual period over which the communities are advertised on our mobile applications and websites. New construction revenue also includes revenue generated on a cost per impression basis whereby revenue is recognized on a straight-line basis during the contractual period over which the advertising impressions are delivered. Consideration for new construction products is billed in arrears. Display revenue primarily consists of graphical mobile and web advertising sold on a cost per thousand impressions or cost per click basis to advertisers promoting their brands on our mobile applications and websites. We recognize display revenue as clicks occur or as impressions are delivered to users interacting with our mobile applications or websites, which is the amount for which we have the right to invoice.\nMortgages Revenue. Mortgages revenue includes marketing products sold to mortgage professionals on a cost per lead basis, including our Custom Quote and a portion of our Connect services, and on a subscription basis, including a portion of our Connect service. Zillow Group operates Custom Quote and Connect through its wholly owned subsidiary, Zillow Group Marketplace, Inc., a licensed mortgage broker. For our Connect and Custom Quote cost per lead marketing products, participating qualified mortgage professionals typically make a prepayment to gain access to consumers interested in connecting with mortgage professionals. Mortgage professionals who exhaust their initial prepayment prepay additional funds to continue to participate in the marketplace. For our Connect subscription mortgage marketing product, participating qualified mortgage professionals generally prepay a monthly subscription fee, which they then allocate to desired geographic counties. In Zillow Group’s Connect platform, consumers answer a series of questions to find a local lender, and mortgage professionals receive consumer contact information, or leads, when the consumer chooses to share their information with a lender. Consumers who request rates for mortgage loans in Custom Quotes are presented with customized quotes from participating mortgage professionals.\nFor our cost per lead mortgages products, we recognize revenue when a user contacts a mortgage professional through our mortgages platform, which is the amount for which we have the right to invoice. For our subscription product, the opportunity to receive a consumer contact is based on the mortgage professional’s relative share of voice in a geographic county. When a consumer submits a contact, we contact a group of subscription mortgage professionals via text message, and the first mortgage professional to respond receives the consumer contact information. We recognize revenue based on the contractual spend recognized on a straight-line basis during the contractual period over which the service is provided. This methodology best depicts how we satisfy our performance obligation to subscription customers, as we continuously transfer control of the performance obligation to the customer throughout the contractual period.\nBeginning in the fourth quarter of 2018, mortgages revenue also includes revenue generated by Zillow Home Loans, Zillow’s affiliated mortgage lender. We elect the fair value option for our mortgage loans held for sale, which are initially recorded at fair value based on either sale commitments or current market quotes and are adjusted for subsequent changes in fair value until the loans are closed. Net origination costs and fees associated with mortgage loans are recognized as incurred. We sell substantially all of the mortgages we originate and the related servicing rights to third-party purchasers in the secondary mortgage market within a short period of time after origination.\nMortgages revenue also includes revenue generated by Mortech, which provides subscription-based mortgage software solutions, including a product and pricing engine and lead management platform, for which we recognize revenue on a straight-line basis during the contractual period over which the services are provided.\n33\nCosts and Expenses\nCost of Revenue. Our cost of revenue consists of expenses related to operating our mobile applications and websites, including associated headcount expenses, such as salaries, benefits, bonuses and share-based compensation expense, as well as revenue-sharing costs related to our commercial business relationships, depreciation expense and costs associated with hosting our mobile applications and websites. For our Homes segment, our cost of revenue also consists of the consideration paid to acquire and make certain repairs and updates to each home, including associated overhead costs, as well as inventory valuation adjustments. For our IMT and Mortgages segment, cost of revenue also includes credit card fees and ad serving costs paid to third parties. For our Mortgages segment, our cost of revenue consists of lead acquisition costs and direct costs to originate loans, including underwriting and processing costs.\nSales and Marketing. Sales and marketing expenses consist of advertising costs and other sales expenses related to promotional and marketing activities, headcount expenses, including salaries, commissions, benefits, bonuses and share-based compensation expense for sales, sales support, customer support, marketing and public relations employees and depreciation expense. For our Homes segment, sales and marketing expenses also consist of selling costs, such as real estate agent commissions, escrow and title fees, and staging costs, as well as holding costs incurred during the period that homes are listed for sale, including utilities, taxes and maintenance. For our Mortgages segment, sales and marketing expenses also include headcount expenses for loan officers and specialists supporting Zillow Home Loans.\nTechnology and Development. Technology and development expenses consist of headcount expenses, including salaries, benefits, bonuses and share-based compensation expense for individuals engaged in the design, development and testing of our mobile applications and websites and the tools and applications that support our products. Technology and development expenses also include equipment and maintenance costs. Technology and development expenses also include amortization costs related to capitalized website and development activities, amortization of software, amortization of certain intangibles and other data agreement costs related to the purchase of data used to populate our mobile applications and websites, and amortization of intangible assets recorded in connection with acquisitions, including developed technology and customer relationships, amongst others. Technology and development expenses also include depreciation expense.\nGeneral and Administrative. General and administrative expenses consist of headcount expenses, including salaries, benefits, bonuses and share-based compensation expense for executive, finance, accounting, legal, human resources, recruiting, corporate information technology costs and other administrative support. General and administrative expenses also include legal settlement costs and estimated legal liabilities, legal, accounting and other third-party professional service fees, rent expense, depreciation expense and bad debt expense.\nAcquisition-related Costs. Acquisition-related costs consist of investment banking, legal, accounting, tax and regulatory filing fees associated with effecting acquisitions.\nIntegration Costs. Integration costs consist of expenses incurred to incorporate operations, systems, technology and rights and responsibilities of acquired companies, during both pre-closing and post-closing periods, into Zillow Group’s business. For the three and nine month periods ended September 30, 2019, integration costs primarily include consulting-related expenses incurred in connection with the integration of Zillow Home Loans.\nOther Income\nOther income consists primarily of interest income earned on our cash, cash equivalents and short-term investments. For our Mortgages segment, other income includes interest income earned on mortgage loans held for sale.\n34\nInterest Expense\nOur corporate interest expense consists of interest on Trulia’s Convertible Senior Notes due in 2020 (the “2020 Notes”) we guaranteed in connection with our February 2015 acquisition of Trulia, interest on the Convertible Senior Notes due in 2021 (the “2021 Notes”) we issued in December 2016, interest on the Convertible Senior Notes due in 2023 (the “2023 Notes”) we issued in July 2018, and interest on the 2024 Notes and the 2026 Notes we issued in September 2019. Interest is payable on the 2020 Notes at the rate of 2.75% semi-annually on June 15 and December 15 of each year. Interest is payable on the 2021 Notes at the rate of 2.00% semi-annually on June 1 and December 1 of each year. Interest is payable on the 2023 Notes at the rate of 1.50% semi-annually on January 1 and July 1 of each year. Interest is payable on the 2024 Notes at the rate of 0.75% semi-annually on March 1 and September 1 of each year. Interest is payable on the 2026 Notes at the rate of 1.375% semi-annually on March 1 and September 1 of each year.\nFor our Homes segment, interest expense includes interest on borrowings, funding fees and other fees, including the amortization of deferred issuance costs, on our revolving credit facilities related to our Zillow Offers business. Borrowings on our revolving credit facilities bear interest at a floating rate based on the one-month LIBOR plus an applicable margin, as defined in the credit agreements.\nFor our Mortgages segment, interest expense includes interest on the warehouse lines of credit related to our Zillow Home Loans business. Each warehouse line of credit provides for a current and maximum borrowing capacity of $50.0 million, or $100.0 million in total. Borrowings on the warehouse lines of credit bear interest at the one-month LIBOR rate plus an applicable margin, as defined in the credit agreements.\nIncome Taxes\nWe are subject to federal and state income taxes in the United States and in Canada. As of September 30, 2019 and December 31, 2018, we have provided a valuation allowance against our net deferred tax assets that we believe, based on the weight of available evidence, are not more likely than not to be realized. Therefore, no material current tax liability or expense has been recorded in the condensed consolidated financial statements. We have accumulated federal tax losses of approximately $1,081.7 million as of December 31, 2018, which are available to reduce future taxable income. We have accumulated state tax losses of approximately $32.5 million (tax effected) as of December 31, 2018.\nWe recorded an income tax benefit of $1.3 million for the three months ended September 30, 2019 and an income tax benefit of $3.8 million for the nine months ended September 30, 2019.\nWe recorded an income tax benefit of $14.7 million for the three months ended September 30, 2018, which was calculated as the difference between the income tax benefit of $22.7 million recorded for the nine months ended September 30, 2018 and the income tax benefit of $8.0 million recorded for the six months ended June 30, 2018. The $22.7 million tax benefit recorded for the nine months ended September 30, 2018 was comprised of a $1.9 million income tax benefit, which was calculated using an estimate of our annual effective tax rate of 4.3% applied to our loss before income taxes of $44.9 million for the nine months ended September 30, 2018 and a $20.8 million discrete income tax benefit as a result of the treatment of stock compensation windfall deductions and the impact from the Tax Cuts and Jobs Act (the “Tax Act”) related to IRC Section 162(m). Our estimated annual effective tax rate for the nine months ended September 30, 2018 was primarily impacted by the release in valuation allowance resulting from indefinite-lived deferred tax assets and their ability to offset indefinite-lived intangible deferred tax liabilities.\nAs of September 30, 2018, we had completed our accounting for the income tax effects related to the deduction limitations on compensation under the Tax Act and recorded a discrete tax benefit adjustment of $3.3 million during the three months ended September 30, 2018. The Internal Revenue Service provided further guidance in applying the written binding contracts requirement under the Tax Act and certain of our executive compensation previously eligible to be deducted for tax purposes under Section 162(m) of the Internal Revenue Code will be considered grandfathered and, therefore, will continue to be deductible. Based on the clarification of these rules, the accounting related to the Section 162(m) limitation of the Internal Revenue Code was considered complete and we recorded a $5.9 million discrete tax benefit adjustment related to this item for the nine months ended September 30, 2018.\n35\nResults of Operations\nIn 2018, our business model evolved significantly with the launch of Zillow Offers in April and the acquisition of Zillow Home Loans in October. Zillow Offers, for example, is a cash- and inventory-intensive business with a high cost of revenue as compared with other parts of our operations; the cost of revenue includes the amount we pay to purchase homes. Revenue for the Homes segment includes the full sale prices of homes less resale concessions and credits to the buyer, and does not reflect real estate agent commissions, closing or other associated costs. As a result of this evolution of our business model, financial performance for prior year periods may not be indicative of future performance.\nThe following tables present our results of operations for the periods indicated and as a percentage of total revenue (in thousands, except per share and percentage data, unaudited):\n| Three Months EndedSeptember 30, | Nine Months EndedSeptember 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Statements of Operations Data: |\n| Revenue: |\n| Homes | $ | 384,626 | $ | 11,018 | $ | 762,022 | $ | 11,018 |\n| IMT | 335,290 | 313,638 | 957,231 | 900,435 |\n| Mortgages | 25,292 | 18,438 | 79,637 | 56,766 |\n| Total revenue | 745,208 | 343,094 | 1,798,890 | 968,219 |\n| Cost of revenue (exclusive of amortization) (1)(2): |\n| Homes | 370,796 | 10,226 | 733,947 | 10,312 |\n| IMT | 24,318 | 25,186 | 74,628 | 72,070 |\n| Mortgages | 4,721 | 1,260 | 13,829 | 3,736 |\n| Total cost of revenue | 399,835 | 36,672 | 822,404 | 86,118 |\n| Sales and marketing (1) | 181,347 | 128,734 | 530,367 | 413,752 |\n| Technology and development (1) | 123,974 | 105,314 | 352,074 | 299,623 |\n| General and administrative (1) | 88,493 | 70,743 | 267,106 | 187,395 |\n| Impairment costs | — | 10,000 | — | 10,000 |\n| Acquisition-related costs | — | 1,405 | — | 2,064 |\n| Integration costs | 5 | 523 | 650 | 523 |\n| Total costs and expenses | 793,654 | 353,391 | 1,972,601 | 999,475 |\n| Loss from operations | (48,446 | ) | (10,297 | ) | (173,711 | ) | (31,256 | ) |\n| Other income | 8,999 | 7,773 | 27,625 | 13,308 |\n| Interest expense | (26,502 | ) | (12,668 | ) | (61,865 | ) | (26,928 | ) |\n| Loss before income taxes | (65,949 | ) | (15,192 | ) | (207,951 | ) | (44,876 | ) |\n| Income tax benefit | 1,300 | 14,700 | 3,800 | 22,700 |\n| Net loss | $ | (64,649 | ) | $ | (492 | ) | $ | (204,151 | ) | $ | (22,176 | ) |\n| Net loss per share — basic and diluted | $ | (0.31 | ) | $ | — | $ | (0.99 | ) | $ | (0.11 | ) |\n| Weighted-average shares outstanding — basic and diluted | 207,002 | 202,416 | 205,766 | 195,208 |\n| Other Financial Data: |\n| Segment income (loss) before income taxes |\n| Homes segment | $ | (87,870 | ) | $ | (16,428 | ) | $ | (204,197 | ) | $ | (30,879 | ) |\n| IMT segment | $ | 42,053 | $ | 6,322 | $ | 43,839 | $ | (184 | ) |\n| Mortgages segment | $ | (12,254 | ) | $ | (623 | ) | $ | (32,308 | ) | $ | (625 | ) |\n| Adjusted EBITDA (3) |\n| Homes segment | $ | (67,825 | ) | $ | (13,409 | ) | $ | (158,801 | ) | $ | (25,274 | ) |\n| IMT segment | 91,102 | 75,363 | 216,204 | 181,764 |\n| Mortgages segment | (7,435 | ) | 4,211 | (15,342 | ) | 11,985 |\n| Total Adjusted EBITDA | $ | 15,842 | $ | 66,165 | $ | 42,061 | $ | 168,475 |\n\n36\n| Three Months EndedSeptember 30, | Nine Months EndedSeptember 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| (1) Includes share-based compensation as follows: |\n| Cost of revenue | $ | 1,062 | $ | 969 | $ | 2,878 | $ | 3,180 |\n| Sales and marketing | 6,588 | 5,911 | 19,039 | 17,413 |\n| Technology and development | 18,034 | 15,031 | 51,942 | 40,920 |\n| General and administrative | 16,444 | 19,771 | 78,025 | 49,853 |\n| Total | $ | 42,128 | $ | 41,682 | $ | 151,884 | $ | 111,366 |\n| (2) Amortization of website development costs and intangible assets included in technology and development | $ | 15,835 | $ | 18,165 | $ | 44,891 | $ | 61,735 |\n| (3) See “Adjusted EBITDA” below for more information and for a reconciliation of Adjusted EBITDA to the most directly comparable financial measure calculated and presented in accordance with U.S. generally accepted accounting principles, or GAAP, which is net loss on a consolidated basis and income (loss) before income taxes for each segment. |\n\n| Three Months EndedSeptember 30, | Nine Months EndedSeptember 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Percentage of Revenue: |\n| Revenue: |\n| Homes | 52 | % | 3 | % | 42 | % | 1 | % |\n| IMT | 45 | 91 | 53 | 93 |\n| Mortgages | 3 | 5 | 4 | 6 |\n| Total revenue | 100 | 100 | 100 | 100 |\n| Cost of revenue (exclusive of amortization): |\n| Homes | 50 | 3 | 41 | 1 |\n| IMT | 3 | 7 | 4 | 7 |\n| Mortgages | 1 | — | 1 | — |\n| Total cost of revenue | 54 | 11 | 46 | 9 |\n| Sales and marketing | 24 | 38 | 29 | 43 |\n| Technology and development | 17 | 31 | 20 | 31 |\n| General and administrative | 12 | 21 | 15 | 19 |\n| Impairment costs | 0 | 3 | 0 | 1 |\n| Acquisition-related costs | 0 | — | 0 | — |\n| Integration costs | — | — | — | — |\n| Total costs and expenses | 107 | 103 | 110 | 103 |\n| Loss from operations | (7 | ) | (3 | ) | (10 | ) | (3 | ) |\n| Other income | 1 | 2 | 2 | 1 |\n| Interest expense | (4 | ) | (4 | ) | (3 | ) | (3 | ) |\n| Loss before income taxes | (9 | ) | (4 | ) | (12 | ) | (5 | ) |\n| Income tax benefit | — | 4 | — | 2 |\n| Net loss | (9 | )% | — | % | (11 | )% | (2 | )% |\n\nAdjusted EBITDA\nTo provide investors with additional information regarding our financial results, we have disclosed Adjusted EBITDA in total and for each segment, each a non-GAAP financial measure, within this Quarterly Report on Form 10-Q. We have provided a reconciliation below of Adjusted EBITDA in total to net loss and Adjusted EBITDA by segment to income (loss) before income taxes for each segment, the most directly comparable GAAP financial measures.\n37\nWe have included Adjusted EBITDA in total and for each segment in this Quarterly Report on Form 10-Q as they are key metrics used by our management and board of directors to measure operating performance and trends and to prepare and approve our annual budget. In particular, the exclusion of certain expenses in calculating Adjusted EBITDA facilitates operating performance comparisons on a period-to-period basis.\nOur use of Adjusted EBITDA in total and for each segment has limitations as an analytical tool, and you should not consider these measures in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are:\n| • | Adjusted EBITDA does not reflect our cash expenditures or future requirements for capital expenditures or contractual commitments; |\n\n| • | Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs; |\n\n| • | Adjusted EBITDA does not consider the potentially dilutive impact of share-based compensation; |\n\n| • | Although depreciation and amortization are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future, and Adjusted EBITDA does not reflect cash capital expenditure requirements for such replacements or for new capital expenditure requirements; |\n\n| • | Adjusted EBITDA does not reflect impairment costs; |\n\n| • | Adjusted EBITDA does not reflect acquisition-related costs; |\n\n| • | Adjusted EBITDA does not reflect interest expense or other income; |\n\n| • | Adjusted EBITDA does not reflect income taxes; and |\n\n| • | Other companies, including companies in our own industry, may calculate Adjusted EBITDA differently than we do, limiting its usefulness as a comparative measure. |\n\nBecause of these limitations, you should consider Adjusted EBITDA in total and for each segment alongside other financial performance measures, including various cash flow metrics, net loss, income (loss) before income taxes for each segment and our other GAAP results.\nThe following tables present a reconciliation of Adjusted EBITDA to the most directly comparable GAAP financial measure, which is net loss on a consolidated basis and income (loss) before income taxes for each segment, for each of the periods presented (in thousands, unaudited):\n| Three Months Ended September 30, 2019 |\n| Homes | IMT | Mortgages | Corporate Items (2) | Consolidated |\n| Reconciliation of Adjusted EBITDA to Net Loss and Income (Loss) Before Income Taxes: |\n| Net loss (1) | N/A | N/A | N/A | N/A | $ | (64,649 | ) |\n| Income tax benefit | N/A | N/A | N/A | N/A | (1,300 | ) |\n| Income (loss) before income taxes | $ | (87,870 | ) | $ | 42,053 | $ | (12,254 | ) | $ | (7,878 | ) | $ | (65,949 | ) |\n| Other income | — | — | (344 | ) | (8,655 | ) | (8,999 | ) |\n| Depreciation and amortization expense | 2,331 | 18,362 | 1,467 | — | 22,160 |\n| Share-based compensation expense | 8,025 | 30,687 | 3,416 | — | 42,128 |\n| Interest expense | 9,689 | — | 280 | 16,533 | 26,502 |\n| Adjusted EBITDA | $ | (67,825 | ) | $ | 91,102 | $ | (7,435 | ) | $ | — | $ | 15,842 |\n\n38\n| Three Months Ended September 30, 2018 |\n| Homes | IMT | Mortgages | Corporate Items (2) | Consolidated |\n| Reconciliation of Adjusted EBITDA to Net Loss and Income (Loss) Before Income Taxes: |\n| Net loss (1) | N/A | N/A | N/A | N/A | $ | (492 | ) |\n| Income tax benefit | N/A | N/A | N/A | N/A | (14,700 | ) |\n| Income (loss) before income taxes | $ | (16,428 | ) | $ | 6,322 | $ | (623 | ) | $ | (4,463 | ) | $ | (15,192 | ) |\n| Other income | — | — | — | (7,773 | ) | (7,773 | ) |\n| Depreciation and amortization expense | 368 | 22,053 | 954 | — | 23,375 |\n| Share-based compensation expense | 2,219 | 36,988 | 2,475 | — | 41,682 |\n| Impairment costs | — | 10,000 | — | — | 10,000 |\n| Acquisition-related costs | — | — | 1,405 | — | 1,405 |\n| Interest expense | 432 | — | — | 12,236 | 12,668 |\n| Adjusted EBITDA | $ | (13,409 | ) | $ | 75,363 | $ | 4,211 | $ | — | $ | 66,165 |\n\n| Nine Months Ended September 30, 2019 |\n| Homes | IMT | Mortgages | Corporate Items (2) | Consolidated |\n| Reconciliation of Adjusted EBITDA to Net Loss and Income (Loss) Before Income Taxes: |\n| Net loss (1) | N/A | N/A | N/A | N/A | $ | (204,151 | ) |\n| Income tax benefit | N/A | N/A | N/A | N/A | (3,800 | ) |\n| Income (loss) before income taxes | $ | (204,197 | ) | $ | 43,839 | $ | (32,308 | ) | $ | (15,285 | ) | $ | (207,951 | ) |\n| Other income | — | — | (1,059 | ) | (26,566 | ) | (27,625 | ) |\n| Depreciation and amortization expense | 5,384 | 54,264 | 4,240 | — | 63,888 |\n| Share-based compensation expense | 20,666 | 118,101 | 13,117 | — | 151,884 |\n| Interest expense | 19,346 | — | 668 | 41,851 | 61,865 |\n| Adjusted EBITDA | $ | (158,801 | ) | $ | 216,204 | $ | (15,342 | ) | $ | — | $ | 42,061 |\n\n| Nine Months Ended September 30, 2018 |\n| Homes | IMT | Mortgages | Corporate Items (2) | Consolidated |\n| Reconciliation of Adjusted EBITDA to Net Loss and Loss Before Income Taxes: |\n| Net loss (1) | N/A | N/A | N/A | N/A | $ | (22,176 | ) |\n| Income tax benefit | N/A | N/A | N/A | N/A | (22,700 | ) |\n| Loss before income taxes | $ | (30,879 | ) | $ | (184 | ) | $ | (625 | ) | $ | (13,188 | ) | $ | (44,876 | ) |\n| Other income | — | — | — | (13,308 | ) | (13,308 | ) |\n| Depreciation and amortization expense | 608 | 72,168 | 3,525 | — | 76,301 |\n| Share-based compensation expense | 4,565 | 99,753 | 7,048 | — | 111,366 |\n| Impairment costs | — | 10,000 | — | — | 10,000 |\n| Acquisition-related costs | — | 27 | 2,037 | — | 2,064 |\n| Interest expense | 432 | — | — | 26,496 | 26,928 |\n| Adjusted EBITDA | $ | (25,274 | ) | $ | 181,764 | $ | 11,985 | $ | — | $ | 168,475 |\n\n39\n(1) We use income (loss) before income taxes as our profitability measure in making operating decisions and assessing the performance of our segments, therefore, net loss and income tax benefit are calculated and presented only on a consolidated basis within our financial statements.\n(2) Certain corporate items are not directly attributable to any of our segments, including interest income earned on our short-term investments included in Other income and interest costs on our convertible senior notes included in Interest expense.\nThree Months Ended September 30, 2019 Compared to Three Months Ended September 30, 2018\nRevenue\nThe following table presents Zillow Group’s revenue by category and by segment for the periods presented (in thousands, unaudited):\n| Three Months EndedSeptember 30, | 2018 to 2019% Change |\n| 2019 | 2018 |\n| Homes | $ | 384,626 | $ | 11,018 | 3,391 | % |\n| IMT Revenue: |\n| Premier Agent | 240,698 | 232,703 | 3 | % |\n| Rentals | 44,430 | 37,319 | 19 | % |\n| Other | 50,162 | 43,616 | 15 | % |\n| Total IMT revenue | 335,290 | 313,638 | 7 | % |\n| Mortgages | 25,292 | 18,438 | 37 | % |\n| Total revenue | $ | 745,208 | $ | 343,094 | 117 | % |\n\nThe following table presents Zillow Group’s revenue by category and by segment as percentages of total revenue for the periods presented (unaudited):\n| Three Months EndedSeptember 30, |\n| 2019 | 2018 |\n| Percentage of Total Revenue: |\n| Homes | 52 | % | 3 | % |\n| IMT Revenue: |\n| Premier Agent | 32 | 68 |\n| Rentals | 6 | 11 |\n| Other | 7 | 13 |\n| Total IMT revenue | 45 | 91 |\n| Mortgages | 3 | 5 |\n| Total revenue | 100 | % | 100 | % |\n\n40\nTotal revenue increased by $402.1 million, or 117%, for the three months ended September 30, 2019 compared to the three months ended September 30, 2018. The increase in total revenue was primarily attributable to our Zillow Offers business, which began selling homes in July of 2018. Homes revenue grew to $384.6 million for the three months ended September 30, 2019 from $11.0 million for the three months ended September 30, 2018, an increase of $373.6 million. There were approximately 195.6 million average monthly unique users of our mobile applications and websites for the three months ended September 30, 2019 compared to 186.6 million average monthly unique users for the three months ended September 30, 2018, representing year-over-year growth of 5%. Visits increased 11% to 2,104.9 million for the three months ended September 30, 2019 from 1,888.9 million for the three months ended September 30, 2018. The increases in unique users and visits increased the number of impressions, leads, clicks and other events we monetized across our revenue categories.\nHomes Segment\nHomes revenue was $384.6 million for the three months ended September 30, 2019 due to the sale of 1,211 homes at an average selling price of $317.6 thousand per home. For the three months ended September 30, 2018, Homes revenue was $11.0 million as a result of the sale of 36 homes at an average selling price of $306.1 thousand per home. The increase in Homes revenue was due to an increase in the number of homes sold in the period as consumer adoption of Zillow Offers increases in geographic areas in which it is currently operating and as Zillow Offers expands into new geographic markets. As of September 30, 2019, Zillow Offers was operating in 19 metropolitan areas.\nIMT Segment\nPremier Agent Revenue. Premier Agent revenue grew to $240.7 million for the three months ended September 30, 2019 from $232.7 million for the three months ended September 30, 2018, an increase of $8.0 million, or 3%. Premier Agent revenue was positively impacted by an increase in visits. As discussed above, visits increased 11% to 2,104.9 million for the three months ended September 30, 2019 from 1,888.9 million for the three months ended September 30, 2018. The increase in visits increased the number of impressions and leads we could monetize in our Premier Agent marketplace. Advertiser churn, or exit from our advertising platform, normalized throughout 2019, which contributed to the increase in Premier Agent revenue during the three months ended September 30, 2019.\nPremier Agent revenue per visit decreased by 7% to $0.114 for the three months ended September 30, 2019 from $0.123 for the three months ended September 30, 2018. We calculate Premier Agent revenue per visit by dividing the revenue generated by our Premier Agent and Premier Broker programs in the period by the number of visits in the period. We believe the decrease in Premier Agent revenue per visit was primarily a result of changes we made to our Premier Agent and Premier Broker programs in 2018. For example, in April 2018, we began testing a new method of consumer lead validation and distribution to our Premier Agent and Premier Broker advertisers. A validated consumer connection is made when a consumer who is interested in connecting with a real estate professional does not select a specific Premier Agent or Premier Broker with whom they want to connect through one of our mobile applications or websites; applying the new model, these validated consumer leads are distributed to Premier Agents and Premier Brokers in proportion to their share of voice, or an agent advertiser’s share of total advertising purchased in a particular zip code. This transition to the new lead validation and distribution process resulted in a decrease in the total number of leads received by some advertisers and increased advertiser churn in the third and fourth quarters of 2018 as current and prospective Premier Agents and Premier Brokers evaluated the value of these higher-quality leads and market-based pricing continued to take effect. We believe we made appropriate adjustments to the Premier Agent and Premier Broker programs to help address this advertiser churn, by, for example, decreasing the number of screening questions posed to consumers during the consumer lead validation process, in an effort to return to prior lead volumes, and setting price caps on the cost per impression and cost per lead paid by Premier Agents and Premier Brokers to help stabilize auction-based pricing dynamics in certain markets, as advertiser churn normalized throughout 2019.\nPremier Agent revenue for the three months ended September 30, 2019 also included an immaterial amount of revenue generated from our initial testing of a new pricing model for Premier Agent and Premier Broker advertisers, Flex, in limited markets. With the Flex model, Premier Agents and Premiers Brokers are provided with validated leads at no upfront cost, and they pay a performance advertising fee only when a real estate transaction is closed with one of the leads. We expect to extend the testing of this pricing model to two additional regions during the fourth quarter of 2019, and we may extend the testing of this pricing model to additional regions in the future.\nRentals Revenue. Rentals revenue was $44.4 million for the three months ended September 30, 2019 compared to $37.3 million for the three months ended September 30, 2018, an increase of $7.1 million, or 19%. The increase in Rentals revenue was positively impacted by an increase in quarterly revenue per average monthly rental listing, which increased 22% to approximately $1,113 for the three months ended September 30, 2019 from approximately $911 for the three months ended September 30, 2018. We calculate quarterly revenue per average monthly rental listing by dividing total Rentals revenue for the period by the average monthly deduplicated rental listings for the period and then dividing by the number of quarters in the period. The increase in quarterly revenue per average monthly rental listing was primarily driven by an increase in revenue from our Rentals application product and revenue from our Rentals cost per impression product. The increase in Rentals revenue was also attributable to an increase in the number of average monthly rental listings on our mobile applications and websites, which increased to 41,245 average monthly rental listings for the three months ended September 30, 2019 from 40,962 average monthly rental listings for the three months ended September 30, 2018. Average monthly rental listings include the average monthly monetized, deduplicated rental listings for the period, which are displayed across all of our mobile applications and websites. An increase in rental listings on our mobile applications and websites increases the likelihood that a consumer will contact a rental professional, which in turn increases the likelihood of a lead, click, lease or listing that we monetize. Finally, the increase in Rentals revenue was also driven in part by the 11% increase in visits to 2,104.9 million for the three months ended September 30, 2019, which increases the likelihood a consumer will contact a rental professional and, in turn, increases the likelihood of a lead, click, impression or lease that we monetize.\n41\nOther Revenue. Other revenue was $50.2 million for the three months ended September 30, 2019 compared to $43.6 million for the three months ended September 30, 2018, an increase of $6.5 million, or 15%. The increase in Other revenue was primarily a result of a 20% increase in revenue generated by our new construction marketing solutions. Growth in new construction revenue was primarily attributable to higher spend in our cost per impression product and increases in adoption by and advertising sales to new home builders through our new construction platform.\nMortgages Segment\nMortgages revenue was $25.3 million for the three months ended September 30, 2019 compared to $18.4 million for the three months ended September 30, 2018, an increase of $6.9 million, or 37%. The increase in mortgages revenue was primarily a result of the addition of revenue generated by Zillow Home Loans, Zillow’s affiliated mortgage lender, which we acquired in the fourth quarter of 2018.\nNine Months Ended September 30, 2019 Compared to Nine Months Ended September 30, 2018\nRevenue\nThe following table presents Zillow Group’s revenue by category and by segment for the periods presented (in thousands, unaudited):\n| Nine Months EndedSeptember 30, | 2018 to 2019% Change |\n| 2019 | 2018 |\n| Homes | $ | 762,022 | $ | 11,018 | 6,816 | % |\n| IMT Revenue: |\n| Premier Agent | 690,394 | 677,320 | 2 | % |\n| Rentals | 124,938 | 99,670 | 25 | % |\n| Other | 141,899 | 123,445 | 15 | % |\n| Total IMT revenue | 957,231 | 900,435 | 6 | % |\n| Mortgages | 79,637 | 56,766 | 40 | % |\n| Total revenue | $ | 1,798,890 | $ | 968,219 | 86 | % |\n\nThe following table presents Zillow Group’s revenue by category and by segment as percentages of total revenue for the periods presented (unaudited):\n42\n| Nine Months EndedSeptember 30, |\n| 2019 | 2018 |\n| Percentage of Total Revenue: |\n| Homes | 42 | % | 1 | % |\n| IMT Revenue: |\n| Premier Agent | 38 | 70 |\n| Rentals | 7 | 10 |\n| Other | 8 | 13 |\n| Total IMT revenue | 53 | 93 |\n| Mortgages | 4 | 6 |\n| Total revenue | 100 | % | 100 | % |\n\nTotal revenue increased by $830.7 million, or 86%, for the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018. The increase in total revenue was primarily attributable to our Zillow Offers business, which began selling homes in July of 2018. Homes revenue was $762.0 million for the nine months ended September 30, 2019 compared to $11.0 million for the nine months ended September 30, 2018. There were approximately 195.6 million average monthly unique users of our mobile applications and websites for the three months ended September 30, 2019 compared to 186.6 million average monthly unique users for the three months ended September 30, 2018, representing year-over-year growth of 5%. The increase in unique users increased the number of impressions, leads, clicks and other events we monetized across our revenue categories.\nHomes Segment\nHomes revenue was $762.0 million for the nine months ended September 30, 2019 due to the sale of 2,411 homes at an average selling price of $316.0 thousand per home. Homes revenue was $11.0 million for the nine months ended September 30, 2018 due to the sale of 36 homes at an average selling price of $306.1 thousand per home.\nIMT Segment\nPremier Agent Revenue. Premier Agent revenue grew to $690.4 million for the nine months ended September 30, 2019 from $677.3 million for the nine months ended September 30, 2018, an increase of $13.1 million, or 2%. Premier Agent revenue was positively impacted by an increase in visits. Visits increased 13% to 6,306.0 million for the nine months ended September 30, 2019 from 5,574.3 million for the nine months ended September 30, 2018. The increase in visits increased the number of impressions we could monetize in our Premier Agent marketplace. Year-over-year Premier Agent revenue growth slowed, which we believe was primarily due to changes made to our Premier Agent and Premier Broker advertising programs in 2018 to improve lead quality and consumer connections, which led to an increase in advertiser churn, or exit from our advertising platform. Advertiser churn has normalized throughout 2019.\nDuring the nine months ended September 30, 2019, Premier Agent revenue also included an immaterial amount of revenue generated from our initial testing of a new pricing model for Premier Agent and Premier Broker advertisers, Flex, in limited markets.\nRentals Revenue. Rentals revenue was $124.9 million for the nine months ended September 30, 2019 compared to $99.7 million for the nine months ended September 30, 2018, an increase of $25.3 million, or 25%. Rentals revenue was positively impacted by an increase in the number of average monthly rental listings on our mobile applications and websites, which increased 6% to 40,237 average monthly rental listings for the nine months ended September 30, 2019 from 38,125 average monthly rental listings for the nine months ended September 30, 2018. The quarterly revenue per average monthly rental listing increased 20% to approximately $1,047 for the nine months ended September 30, 2019 from approximately $871 for the nine months ended September 30, 2018. The increase in quarterly revenue per average monthly rental listing is primarily due to an increase in the adoption of our rental applications product as well as an increase in the number of impressions delivered for our Rentals cost per impression product. The increase in Rentals revenue was also driven in part by the 13% increase in visits to 6,306.0 million for the nine months ended September 30, 2019.\n43\nOther Revenue. Other revenue was $141.9 million for the nine months ended September 30, 2019 compared to $123.4 million for the nine months ended September 30, 2018, an increase of $18.5 million, or 15%. The increase in Other revenue was primarily a result of a 28% increase in revenue generated by our new construction marketing solutions. Growth in new construction revenue was primarily attributable to increases in adoption by and advertising sales to new home builders through our new construction platform.\nMortgages Segment\nMortgages revenue was $79.6 million for the nine months ended September 30, 2019 compared to $56.8 million for the nine months ended September 30, 2018, an increase of $22.9 million, or 40%. The increase in mortgages revenue was primarily a result of the addition of revenue generated by Zillow Home Loans, Zillow’s affiliated mortgage lender, which we acquired in the fourth quarter of 2018.\nThree Months Ended September 30, 2019 Compared to Three Months Ended September 30, 2018\nSegment Results of Operations\nThe following table presents Zillow Group’s segment results for the periods presented (in thousands, unaudited):\n| Three Months EndedSeptember 30, 2019 | Three Months EndedSeptember 30, 2018 |\n| Homes | IMT | Mortgages | Homes | IMT | Mortgages |\n| Revenue | $ | 384,626 | $ | 335,290 | $ | 25,292 | $ | 11,018 | $ | 313,638 | $ | 18,438 |\n| Costs and expenses: |\n| Cost of revenue | 370,796 | 24,318 | 4,721 | 10,226 | 25,186 | 1,260 |\n| Sales and marketing | 49,186 | 118,514 | 13,647 | 4,650 | 117,522 | 6,562 |\n| Technology and development | 20,651 | 94,656 | 8,667 | 6,128 | 93,930 | 5,256 |\n| General and administrative | 22,174 | 55,749 | 10,570 | 6,010 | 60,678 | 4,055 |\n| Impairment costs | — | — | — | — | 10,000 | — |\n| Acquisition-related costs | — | — | — | — | — | 1,405 |\n| Integration costs | — | — | 5 | — | — | 523 |\n| Total costs and expenses | 462,807 | 293,237 | 37,610 | 27,014 | 307,316 | 19,061 |\n| Income (loss) from operations | (78,181 | ) | 42,053 | (12,318 | ) | (15,996 | ) | 6,322 | (623 | ) |\n| Other income | — | — | 344 | — | — | — |\n| Interest expense | (9,689 | ) | — | (280 | ) | (432 | ) | — | — |\n| Income (loss) before income taxes (1) | $ | (87,870 | ) | $ | 42,053 | $ | (12,254 | ) | $ | (16,428 | ) | $ | 6,322 | $ | (623 | ) |\n\n(1) The following table presents the reconciliation of total segment loss before income taxes to consolidated loss before income taxes for the periods presented (in thousands, unaudited):\n| Three Months EndedSeptember 30, |\n| 2019 | 2018 |\n| Total segment loss before income taxes | $ | (58,071 | ) | $ | (10,729 | ) |\n| Corporate interest expense | (16,533 | ) | (12,236 | ) |\n| Corporate other income | 8,655 | 7,773 |\n| Consolidated loss before income taxes | $ | (65,949 | ) | $ | (15,192 | ) |\n\nHomes Segment\nCost of Revenue. Cost of revenue was $370.8 million for the three months ended September 30, 2019 compared to $10.2 million for the three months ended September 30, 2018, an increase of $360.6 million. The increase in cost of revenue was primarily attributable to home acquisition and renovation costs related to the 1,211 homes that we sold during the period compared to the sale of 36 homes during the three months ended September 30, 2018. We expect cost of revenue to increase in\n44\nabsolute dollars in future years as we continue to incur more expenses that are associated with growth in revenue and expansion of Zillow Offers into new markets.\nSales and Marketing. Sales and marketing expenses were $49.2 million for the three months ended September 30, 2019 compared to $4.7 million for the three months ended September 30, 2018, an increase of $44.5 million. The increase in sales and marketing expenses was primarily attributable to a $16.4 million increase in selling expenses directly attributable to the resale of homes, an $11.9 million increase in headcount-related expenses, including share-based compensation expense, a $7.4 million increase in holding costs, a $5.2 million increase in marketing and advertising expenses and a $3.6 million increase in miscellaneous expenses.\nSales and marketing expenses include $7.7 million in holding costs for the three months ended September 30, 2019 and $0.3 million in holding costs for the three months ended September 30, 2018.\nWe expect our sales and marketing expenses to increase in absolute dollars in future periods as we continue to expand the Homes segment.\nTechnology and Development. Technology and development expenses, which include research and development costs, were $20.7 million for the three months ended September 30, 2019 compared to $6.1 million for the three months ended September 30, 2018, an increase of $14.5 million. The increase in technology and development expenses was primarily due to an $11.2 million increase in headcount-related expenses, including share-based compensation expense, as we continue to grow our teams to support the Homes segment, a $1.2 million increase in data acquisition costs, a $1.0 million increase in depreciation and amortization expense and a $1.1 million increase in miscellaneous expenses. We expect our technology and development expenses to increase in absolute dollars in future periods as we continue to build new website functionality and other technologies that will facilitate the purchasing and sales processes related to our Homes segment.\nGeneral and Administrative. General and administrative expenses were $22.2 million for the three months ended September 30, 2019 compared to $6.0 million for the three months ended September 30, 2018, an increase of $16.2 million. The increase in general and administrative expenses was primarily due to a $9.6 million increase in headcount-related expenses, including share-based compensation expense, as we continue to grow our teams to support the Homes segment. In addition, there was a $2.6 million increase in building lease-related expenses including rent, utilities and insurance, a $1.2 million increase in professional services fees, a $1.0 million increase software and hardware costs and a $1.8 million increase in miscellaneous expenses. We expect general and administrative expenses to increase in absolute dollars in future periods as we continue to expand our Homes business.\nInterest Expense. Interest expense was $9.7 million for the three months ended September 30, 2019 compared to $0.4 million for the three months ended September 30, 2018, an increase of $9.3 million. The increase in interest expense was attributable to borrowings, funding fees and other fees, including the amortization of deferred issuance costs, on our revolving credit facilities. We expect interest expense to increase in absolute dollars in future periods as we continue to expand our Homes business.\nIMT Segment\nCost of Revenue. Cost of revenue was $24.3 million for the three months ended September 30, 2019 compared to $25.2 million for the three months ended September 30, 2018, a decrease of $0.9 million, or 3%. The decrease in cost of revenue was primarily due to a $1.0 million decrease in headcount-related expenses, including share-based compensation expense, and a $0.8 million decrease in miscellaneous expenses, partially offset by a $1.1 million increase in other direct product costs.\nSales and Marketing. Sales and marketing expenses were $118.5 million for the three months ended September 30, 2019 compared to $117.5 million for the three months ended September 30, 2018, an increase of $1.0 million, or 1%. The increase in sales and marketing expenses was primarily attributable to a $3.2 million increase in professional services fees and a $0.8 million increase in headcount-related expenses, including share-based compensation expense, partially offset by a $2.7 million decrease in marketing and advertising expenses.\nTechnology and Development. Technology and development expenses, which include research and development costs, were $94.7 million for the three months ended September 30, 2019 compared to $93.9 million for the three months ended September 30, 2018, an increase of $0.7 million, or 1%. Approximately $1.5 million of the increase related to growth in headcount-related expenses, including share-based compensation expense, as we continue to grow our engineering teams to support current and future product initiatives. In addition, there was a $1.2 million increase in software and hardware costs. These increases were partially offset by a $3.2 million decrease in depreciation and amortization expense.\n45\nGeneral and Administrative. General and administrative expenses were $55.7 million for the three months ended September 30, 2019 compared to $60.7 million for the three months ended September 30, 2018, a decrease of $4.9 million, or 8%. The decrease in general and administrative expenses was primarily due to a $6.2 million decrease in headcount-related expenses, including share-based compensation expense, and a $1.3 million decrease in miscellaneous expenses, partially offset by a $2.6 million increase in building lease-related expenses including rent, utilities and insurance.\nImpairment Costs. There were no impairment costs for the three months ended September 30, 2019. Impairment costs for the three months ended September 30, 2018 consisted of the $10.0 million non-cash impairment related to our June 2017 equity investment.\nMortgages Segment\nCost of Revenue. Cost of revenue was $4.7 million for the three months ended September 30, 2019 compared to $1.3 million for the three months ended September 30, 2018, an increase of $3.5 million. The increase in cost of revenue was primarily attributable to our October 2018 acquisition of Zillow Home Loans and includes a $2.5 million increase in headcount-related expenses, including share-based compensation expense and a $0.5 million increase in mortgage loan processing costs. We expect cost of revenue to increase in absolute dollars in future years as we continue to incur more expenses that are associated with growth in revenue and expansion of Zillow Home Loans.\nSales and Marketing. Sales and marketing expenses were $13.6 million for the three months ended September 30, 2019 compared to $6.6 million for the three months ended September 30, 2018, an increase of $7.1 million, or 108%. The increase in sales and marketing expenses was primarily attributable to a $5.5 million increase in headcount-related expenses, including share-based compensation expense, primarily related to our October 2018 acquisition of Zillow Home Loans, and a $1.0 million increase in marketing and advertising expenses. We expect our sales and marketing expenses to increase in absolute dollars in future periods as we continue to expand the Mortgages segment.\nTechnology and Development. Technology and development expenses, which include research and development costs, were $8.7 million for the three months ended September 30, 2019 compared to $5.3 million for the three months ended September 30, 2018, an increase of $3.4 million, or 65%. The increase in technology and development expenses was primarily a result of a $2.6 million increase in headcount-related expenses, including share-based compensation expense, primarily related to our October 2018 acquisition of Zillow Home Loans. We expect our technology and development expenses to increase in absolute dollars in future periods as we continue to build new website functionality and other technologies that will facilitate the origination of mortgages in Zillow Home Loans.\nGeneral and Administrative. General and administrative expenses were $10.6 million for the three months ended September 30, 2019 compared to $4.1 million for the three months ended September 30, 2018, an increase of $6.5 million. The increase in general and administrative expenses was primarily due to a $4.2 million increase in headcount-related expenses, including share-based compensation expense, primarily related to our October 2018 acquisition of Zillow Home Loans. In addition, there was a $0.7 million increase in building lease-related expenses including rent, utilities and insurance and a $1.6 million increase in miscellaneous expenses. We expect general and administrative expenses to increase over time in absolute dollars as we continue to expand our mortgage business.\nAcquisition-Related Costs. There were no acquisition-related costs for the three months ended September 30, 2019. Acquisition-related costs were $1.4 million for the three months ended September 30, 2018 and related to our acquisition of Zillow Home Loans.\nCorporate Items\nCertain corporate items are not directly attributable to any of our segments, including interest income earned on our short-term investments included in Other income and interest costs on our convertible senior notes included in Interest expense.\nInterest Expense. Interest expense was $16.5 million for the three months ended September 30, 2019 compared to $12.2 million for the three months ended September 30, 2018, an increase of $4.3 million, or 35%. This increase was primarily a result of the issuance of the 2024 Notes and 2026 Notes on September 9, 2019. We expect that our corporate interest expense will increase in future periods related to the contractual coupon interest and amortization of debt discount and debt issuance costs that will be recognized in interest expense for the 2024 Notes and 2026 Notes. For additional information regarding the convertible senior notes, see Note 13 to our condensed consolidated financial statements.\nOther Income. Other income not directly attributable to any of our segments was $8.7 million for the three months ended September 30, 2019 compared to $7.8 million for the three months ended September 30, 2018, an increase of $0.9 million. This\n46\nincrease was due to the higher average balance of our short-term investment portfolio coupled with higher interest rates earned on our portfolio generating an increase in interest income.\nNine Months Ended September 30, 2019 Compared to Nine Months Ended September 30, 2018\nSegment Results of Operations\nThe following table presents Zillow Group’s segment results for the periods presented (in thousands, unaudited):\n| Nine Months EndedSeptember 30, 2019 | Nine Months EndedSeptember 30, 2018 |\n| Homes | IMT | Mortgages | Homes | IMT | Mortgages |\n| Revenue | $ | 762,022 | $ | 957,231 | $ | 79,637 | $ | 11,018 | $ | 900,435 | $ | 56,766 |\n| Costs and expenses: |\n| Cost of revenue | 733,947 | 74,628 | 13,829 | 10,312 | 72,070 | 3,736 |\n| Sales and marketing | 107,457 | 380,608 | 42,302 | 7,035 | 384,241 | 22,476 |\n| Technology and development | 51,130 | 276,886 | 24,058 | 12,154 | 270,978 | 16,491 |\n| General and administrative | 54,339 | 181,270 | 31,497 | 11,964 | 163,303 | 12,128 |\n| Impairment costs | — | — | — | — | 10,000 | — |\n| Acquisition-related costs | — | — | — | — | 27 | 2,037 |\n| Integration costs | — | — | 650 | — | — | 523 |\n| Total costs and expenses | 946,873 | 913,392 | 112,336 | 41,465 | 900,619 | 57,391 |\n| Income (loss) from operations | (184,851 | ) | 43,839 | (32,699 | ) | (30,447 | ) | (184 | ) | (625 | ) |\n| Other income | — | — | 1,059 | — | — | — |\n| Interest expense | (19,346 | ) | — | (668 | ) | (432 | ) | — | — |\n| Income (loss) before income taxes (1) | $ | (204,197 | ) | $ | 43,839 | $ | (32,308 | ) | $ | (30,879 | ) | $ | (184 | ) | $ | (625 | ) |\n\n(1) The following table presents the reconciliation of total segment loss before income taxes to consolidated loss before income taxes for the periods presented (in thousands):\n| Nine Months EndedSeptember 30, |\n| 2019 | 2018 |\n| Total segment loss before income taxes | $ | (192,666 | ) | $ | (31,688 | ) |\n| Corporate interest expense | (41,851 | ) | (26,496 | ) |\n| Corporate other income | 26,566 | 13,308 |\n| Consolidated loss before income taxes | $ | (207,951 | ) | $ | (44,876 | ) |\n\nHomes Segment\nCost of Revenue. Cost of revenue was $733.9 million for the nine months ended September 30, 2019 compared to $10.3 million for the nine months ended September 30, 2018. The increase in cost of revenue for the nine months ended September 30, 2019 was primarily attributable to the increase in acquisition and renovation costs as a result of the increase in the number of homes sold from 36 homes during the nine months ended September 30, 2018 to 2,411 homes during the nine months ended September 2019.\nSales and Marketing. Sales and marketing expenses were $107.5 million for the nine months ended September 30, 2019 compared to $7.0 million for the nine months ended September 30, 2018, an increase of $100.4 million. The increase in sales and marketing expenses was primarily attributable to a $32.6 million increase in selling expenses directly attributable to the resale of homes, a $31.7 million increase in headcount-related expenses, including share-based compensation expense, a $14.0 million increase in holding costs, a $12.7 million increase in marketing and advertising expenses, a $2.8 million increase in travel expenses, a $2.0 million increase in professional services fees and a $4.6 million increase in miscellaneous expenses.\n47\nSales and marketing expenses include $14.3 million in holding costs for the nine months ended September 30, 2019 and $0.3 million in holding costs for the nine months ended September 30, 2018.\nTechnology and Development. Technology and development expenses, which include research and development costs, were $51.1 million for the nine months ended September 30, 2019 compared to $12.2 million for the nine months ended September 30, 2018, an increase of $39.0 million. The increase in technology and development expenses was primarily due to a $30.9 million increase in headcount-related expenses, including share-based compensation expense, as we continue to grow our teams to support the Homes segment, a $2.7 million increase in data acquisition costs, a $2.3 million increase in depreciation and amortization expense, a $1.2 million increase in professional services fees and a $1.9 million increase in miscellaneous expenses.\nGeneral and Administrative. General and administrative expenses were $54.3 million for the nine months ended September 30, 2019 compared to $12.0 million for the nine months ended September 30, 2018, an increase of $42.4 million. The increase in general and administrative expenses was primarily due to a $25.5 million increase in headcount-related expenses, including share-based compensation expense, as we continue to grow our teams to support the Homes segment. In addition, there was a $6.2 million increase in building lease-related expenses including rent, utilities and insurance, a $2.9 million increase in professional services fees, a $2.5 million increase in software and hardware costs, a $1.7 million increase in travel expense and a $3.6 million increase in miscellaneous expenses.\nInterest Expense. Interest expense was $19.3 million for the nine months ended September 30, 2019 compared to $0.4 million for the nine months ended September 30, 2018, an increase of $18.9 million. The increase in interest expense was attributable to borrowings, funding fees and other fees, including the amortization of deferred issuance costs, on our revolving credit facilities.\nIMT Segment\nCost of Revenue. Cost of revenue was $74.6 million for the nine months ended September 30, 2019 compared to $72.1 million for the nine months ended September 30, 2018, an increase of $2.6 million, or 4%. The increase in cost of revenue was primarily attributable to a $4.4 million increase in data center and connectivity costs and a $1.0 million increase in miscellaneous expenses, partially offset by a $2.8 million decrease in headcount-related expenses, including share-based compensation expense.\nSales and Marketing. Sales and marketing expenses were $380.6 million for the nine months ended September 30, 2019 compared to $384.2 million for the nine months ended September 30, 2018, a decrease of $3.6 million, or 1%. The decrease in sales and marketing expenses was primarily attributable to a $19.9 million decrease in marketing and advertising expenses, partially offset by a $10.2 million increase in professional services fees and a $5.8 million increase in headcount-related expenses, including share-based compensation expense.\nTechnology and Development. Technology and development expenses, which include research and development costs, were $276.9 million for the nine months ended September 30, 2019 compared to $271.0 million for the nine months ended September 30, 2018, an increase of $5.9 million, or 2%. Approximately $14.3 million of the increase related to growth in headcount-related expenses, including share-based compensation expense, as we continue to grow our engineering teams to support current and future product initiatives. In addition, there was a $3.4 million increase in software and hardware costs, a $2.8 million increase in other non-capitalizable data content expenses, a $1.7 million increase in the gain on disposal of assets and a $1.3 million increase in miscellaneous expenses. These increases were partially offset by a $17.6 million decrease in depreciation and amortization expense.\nGeneral and Administrative. General and administrative expenses were $181.3 million for the nine months ended September 30, 2019 compared to $163.3 million for the nine months ended September 30, 2018, an increase of $18.0 million, or 11%. The increase in general and administrative expenses was primarily due to a $17.3 million increase in headcount-related expenses driven primarily by the recognition of a total of $23.3 million of share-based compensation expense in the IMT segment during the nine months ended September 30, 2019 in connection with the modification of certain outstanding equity awards related to the departure of Spencer Rascoff, who served as Zillow Group’s Chief Executive Officer since 2010 and who remains a member of Zillow Group’s board of directors. For additional information regarding the equity modification, see Note 15 to our condensed consolidated financial statements.\n48\nImpairment Costs. There were no impairment costs for the nine months ended September 30, 2019. Impairment costs for the nine months ended September 30, 2018 consisted of the $10.0 million non-cash impairment related to our June 2017 equity investment.\nMortgages Segment\nCost of Revenue. Cost of revenue was $13.8 million for the nine months ended September 30, 2019 compared to $3.7 million for the nine months ended September 30, 2018, an increase of $10.1 million. The increase in cost of revenue was primarily attributable to our October 2018 acquisition of Zillow Home Loans, and includes a $6.0 million increase in headcount-related expenses, including share-based compensation expense, a $1.6 million increase in mortgage loan processing costs, a $0.9 million increase in lead acquisition costs and a $1.6 million increase in miscellaneous expenses.\nSales and Marketing. Sales and marketing expenses were $42.3 million for the nine months ended September 30, 2019 compared to $22.5 million for the nine months ended September 30, 2018, an increase of $19.8 million, or 88%. The increase in sales and marketing expenses was primarily attributable to a $15.6 million increase in headcount-related expenses, including share-based compensation expense, primarily related to our October 2018 acquisition of Zillow Home Loans, a $2.4 million increase in marketing and advertising expenses and a $1.8 million increase in miscellaneous expenses.\nTechnology and Development. Technology and development expenses, which include research and development costs, were $24.1 million for the nine months ended September 30, 2019 compared to $16.5 million for the nine months ended September 30, 2018, an increase of $7.6 million, or 46%. The increase in technology and development expenses was primarily a result of a $6.0 million increase in headcount-related expenses, including share-based compensation expense, related to our October 2018 acquisition of Zillow Home Loans and a $1.6 million increase in miscellaneous expenses.\nGeneral and Administrative. General and administrative expenses were $31.5 million for the nine months ended September 30, 2019 compared to $12.1 million for the nine months ended September 30, 2018, an increase of $19.4 million. The increase in general and administrative expenses was primarily due to a $13.6 million increase in headcount-related expenses, including share-based compensation expense, primarily related to our October 2018 acquisition of Zillow Home Loans. In addition, there was a $1.8 million increase in building lease-related expenses including rent, utilities and insurance, a $1.1 million increase in professional services fees, a $1.1 million increase in software and hardware costs and a $1.8 million increase in miscellaneous expenses.\nAcquisition-Related Costs. There were no acquisition-related costs for the nine months ended September 30, 2019. Acquisition-related costs were $2.0 million for the nine months ended September 30, 2018 and related to our acquisition of Zillow Home Loans.\nCorporate Items\nCertain corporate items are not directly attributable to any of our segments, including interest income earned on our short-term investments included in Other income and interest costs on our convertible senior notes included in Interest expense.\nInterest Expense. Interest expense was $41.9 million for the nine months ended September 30, 2019 compared to $26.5 million for the nine months ended September 30, 2018, an increase of $15.4 million, or 58%. This increase was primarily due to the July 2018 issuance of our convertible senior notes maturing in 2023. Beginning in September 2019, interest expense also related to the 2024 Notes and 2026 Notes that were issued on September 9, 2019. For additional information regarding the convertible senior notes, see Note 13 to our condensed consolidated financial statements.\nOther Income. Other income not directly attributable to any of our segments was $26.6 million for the nine months ended September 30, 2019 compared to $13.3 million for the nine months ended September 30, 2018, an increase of $13.3 million. This increase is primarily due to an increase in the balance of our short-term investment portfolio generating an increase in interest income.\nLiquidity and Capital Resources\nAs of September 30, 2019 and December 31, 2018, we had cash and cash equivalents, investments and restricted cash of $2,398.6 million and $1,567.3 million, respectively. Cash and cash equivalents balances consist of operating cash on deposit with financial institutions, money market funds, commercial paper and certificates of deposit. Investments consist of fixed income securities, which include U.S. government agency securities, corporate notes and bonds, commercial paper, municipal securities, foreign government securities, certificates of deposit and treasury bills. Restricted cash consists of amounts funded to the reserve and collection accounts related to our revolving credit facilities and amounts held in escrow related to funding\n49\nhome purchases in our mortgage origination business. Amounts on deposit with third-party financial institutions exceed the Federal Deposit Insurance Corporation and the Securities Investor Protection Corporation insurance limits, as applicable. We believe that cash from operations and cash and cash equivalents and investment balances will be sufficient to meet our ongoing operating activities, working capital, capital expenditures and other capital requirements for at least the next 12 months.\nThe expansion of Zillow Group’s purchase of homes in the Zillow Offers program and sale of homes on the open market continues to have a significant impact on our liquidity and capital resources as a cash and inventory intensive initiative. We primarily use debt financing to fund a portion of the purchase price of homes and certain related costs. As of September 30, 2019, we have $698.3 million of total outstanding borrowings on revolving credit facilities to provide capital for Zillow Offers with a total maximum borrowing capacity of $1,000.0 million. For additional information regarding the revolving credit facilities, see Note 13 and Note 22 to our condensed consolidated financial statements.\nThe October 31, 2018 acquisition of Zillow Home Loans also continues to impact our liquidity and capital resources as a cash intensive business that funds mortgage loans originated for resale in the secondary market. We primarily use debt financing to fund the mortgage loan originations. On June 28, 2019, Zillow Home Loans amended and restated the warehouse line of credit previously maturing on June 29, 2019. The amended and restated credit agreement extends the term of the original agreement for one year through June 27, 2020, and continues to provide for a maximum borrowing capacity of $50.0 million with availability under the warehouse line of credit limited depending on the types of loans originated. On July 11, 2019, Zillow Home Loans extended the terms of its $50.0 million warehouse line of credit previously maturing on July 15, 2019 such that it now matures on October 15, 2019. As of September 30, 2019, we have $30.1 million of total outstanding borrowings on warehouse lines of credit to provide capital for Zillow Home Loans with a total maximum borrowing capacity of $100.0 million. For additional information regarding financing for Zillow Home Loans, see Note 13 and Note 22 to our condensed consolidated financial statements.\nAs of September 30, 2019, we have outstanding a total of $1,943.4 million aggregate principal of senior convertible notes. The convertible notes are senior unsecured obligations, and interest on the convertible notes is paid semi-annually. For additional information regarding the senior convertible notes, see Note 13 to our condensed consolidated financial statements.\nOn September 9, 2019, Zillow Group issued the 2024 Notes and the 2026 Notes (together, the “Notes”) in a private offering to qualified institutional buyers. The net proceeds from the offering of the 2024 Notes were approximately $592.2 million and the net proceeds from the offering of the 2026 Notes were approximately $493.5 million, in each case after deducting fees and expenses payable by the Company. We used approximately $75.2 million of the net proceeds from the 2024 Notes and approximately $75.4 of the net proceeds from the 2026 Notes to pay the cost of the capped call transactions entered into in connection with the offerings. The Company intends to use the remainder of the net proceeds for general corporate purposes, which may include working capital, sales and marketing activities, general and administrative matters and capital expenditures.\nInterest on the Notes is payable semiannually in arrears on March 1 and September 1 of each year, beginning on March 1, 2020. The Notes are convertible into cash, shares of Class C capital stock or a combination thereof, at the Company’s election. The 2024 Notes and 2026 Notes will mature on September 1, 2024 and September 1, 2026, respectively, unless earlier repurchased, redeemed, or converted in accordance with their terms. Prior to the close of business on the business day immediately preceding March 1, 2024 (for the 2024 Notes) or March 1, 2026 (for the 2026 Notes), the Notes will be convertible at the option of the holders only under certain conditions. On or after March 1, 2024 (for the 2024 Notes) or March 1, 2026 (for the 2026 Notes), until the close of business on the second scheduled trading day immediately preceding the maturity date, holders may convert their Notes at their option at the conversion rate then in effect, irrespective of these conditions. The Company will settle conversions of the Notes by paying or delivering, as the case may be, cash, shares of the Company’s Class C capital stock, or a combination of cash and shares of Class C capital stock, at its election. The conversion rate for the Notes will initially be 22.9830 shares of Class C capital stock per $1,000 principal amount of Notes (equivalent to an initial conversion price of approximately $43.51 per share of Class C capital stock). The conversion rate is subject to customary adjustments upon the occurrence of certain events. The Company may redeem for cash all or part of the Notes, at its option, on or after September 5, 2022 for the 2024 Notes or on or after September 5, 2023 for the 2026 Notes, under certain circumstances at a redemption price equal to 100% of the principal amount of the Notes to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date (as defined in the indentures governing the Notes). For additional information regarding the Notes, see Note 13 to our condensed consolidated financial statements.\n50\nThe following table presents selected cash flow data for the periods presented (in thousands, unaudited):\n| Nine Months EndedSeptember 30, |\n| 2019 | 2018 |\n| Cash Flow Data: |\n| Net cash provided by (used in) operating activities | $ | (670,282 | ) | $ | 102,543 |\n| Net cash provided by (used in) investing activities | 318,916 | (641,824 | ) |\n| Net cash provided by financing activities | 1,554,845 | 834,181 |\n\nCash Flows Provided By (Used In) Operating Activities\nOur operating cash flows result primarily from cash received from real estate professionals, rental professionals, mortgage professionals and brand advertisers, as well as cash received from consumers for sales of homes through Zillow Offers and sales of mortgages originated by Zillow Home Loans to third parties. Our primary uses of cash from operating activities include payments for homes purchased through Zillow Offers, marketing and advertising activities, mortgages funded through Zillow Home Loans and employee compensation and benefits. Additionally, uses of cash from operating activities include costs associated with operating our mobile applications and websites and other general corporate expenditures.\nFor the nine months ended September 30, 2019, net cash used in operating activities was $670.3 million. This was primarily driven by a net loss of $204.2 million, adjusted by share-based compensation expense of $151.9 million, depreciation and amortization expense of $63.9 million, amortization of the discount and issuance costs on the convertible notes maturing in 2021, 2023, 2024 and 2026 of $29.9 million, amortization of contract cost assets of $26.7 million, amortization of right of use assets of $16.7 million, a loss on disposal of property and equipment of $5.7 million, accretion of bond discount of $5.2 million and a $3.8 million change in deferred income taxes. Changes in operating assets and liabilities increased cash used in operating activities by $753.8 million. The changes in operating assets and liabilities are primarily due to a $716.5 million increase in inventory due to the purchase of homes through Zillow Offers, a $27.0 million increase in contract cost assets due primarily to the capitalization of sales commissions, a $15.0 million decrease in lease liabilities, a $13.5 million increase in accounts receivable due primarily to an increase in revenue, a $5.8 million increase in prepaid expenses and other assets driven primarily by the timing of payments and a $1.4 million increase in mortgage loans held for sale, partially offset by a $12.2 million increase in accrued expenses and other current liabilities driven primarily by the timing of payments and a $7.9 million increase in deferred revenue.\nFor the nine months ended September 30, 2018, net cash provided by operating activities was $102.5 million. This was primarily driven by a net loss of $22.2 million, adjusted by share-based compensation expense of $111.4 million, depreciation and amortization expense of $76.3 million, amortization of contract cost assets of $27.2 million, a non-cash change in our deferred income taxes of $22.7 million, amortization of the discount and issuance costs on the convertible notes maturing in 2021 and 2023 of $18.0 million, a non-cash impairment charge of $10.0 million, a change in deferred rent of $3.1 million, and a loss on disposal of property and equipment of $3.1 million. Changes in operating assets and liabilities decreased cash provided by operating activities by $94.4 million. The changes in operating assets and liabilities are primarily due to a $43.3 million increase in inventory due to the purchase of homes through Zillow Offers, a $32.1 million increase in contract cost assets due primarily to the capitalization of sales commissions, a $15.0 million increase in prepaid expenses and other assets driven primarily by the timing of payments, a $13.0 million increase in accounts receivable due primarily to an increase in revenue, and a $6.5 million increase in accrued compensation and benefits driven primarily by the timing of payments.\nCash Flows Provided By (Used In) Investing Activities\nOur primary investing activities include the purchase and sale or maturity of investments, the purchase of property and equipment and intangible assets and cash paid in connection with acquisitions.\nFor the nine months ended September 30, 2019, net cash provided by investing activities was $318.9 million. This was primarily the result of $379.2 million of net purchases of investments in connection with investment of a portion of the net proceeds from our September 2019 issuance of the 2024 Notes and 2026 Notes and $60.3 million of purchases for property and equipment and intangible assets.\nFor the nine months ended September 30, 2018, net cash used in investing activities was $641.8 million. This was primarily the result of $587.2 million of net purchases of investments in connection with investment of a portion of the net proceeds from our July 2018 public offerings of Class C capital stock and convertible notes maturing in 2023 and $52.7 million of purchases for property and equipment and intangible assets.\n51\nCash Flows Provided By Financing Activities\nNet cash provided by financing activities has primarily resulted from the exercise of employee option awards and equity awards withheld for tax liabilities, net proceeds from the issuance of convertible notes, net proceeds from equity offerings, proceeds from borrowings on our revolving credit facilities related to Zillow Offers and proceeds from borrowings on warehouse lines of credit related to Zillow Home Loans.\nFor the nine months ended September 30, 2019, cash provided by financing activities was $1,554.8 million, which primarily resulted from the net proceeds from the September 2019 issuance of the 2024 Notes and 2026 Notes of $1,085.7 million, partially offset by $150.5 million paid in premiums for the related capped call confirmations. Cash provided by financing activities also included $581.6 million of proceeds from borrowings on our revolving credit facilities related to Zillow Offers and $41.0 million of proceeds from the exercise of option awards, partially offset by $2.9 million of net repayments on our warehouse lines of credit related to Zillow Home Loans.\nFor the nine months ended September 30, 2018, net cash provided by financing activities was approximately $834.2 million, which was primarily related to net proceeds from the issuance of the convertible notes maturing in 2023 of $364.0 million, net proceeds from the public offering of our Class C capital stock of $360.3 million, proceeds from the exercise of option awards of $114.6 million, partially offset by approximately $29.4 million paid in premiums for the related capped call confirmations in July 2018, and proceeds from borrowing on our revolving credit facility related to Zillow Offers of $24.7 million.\nOff-Balance Sheet Arrangements\nWe did not have any off-balance sheet arrangements other than outstanding surety bonds issued for our benefit of approximately $10.1 million as of September 30, 2019. We do not believe that the surety bonds will have a material effect on our liquidity, capital resources, market risk support or credit risk support. For additional information regarding the surety bonds, see Note 17 to our condensed consolidated financial statements under the subsection titled “Surety Bonds”.\nContractual Obligations and Other Commitments\nThere have been no material changes outside the ordinary course of business in our commitments under contractual obligations as previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2018, except for the categories of contractual obligations included in the table below, which have been updated to reflect our contractual obligations as of September 30, 2019 (in thousands, unaudited):\n| Payments Due By Period |\n| Total | Less Than 1 Year | 1-3 Years | 3-5 Years | More Than 5 Years |\n| 2024 Notes (1) | $ | 600,000 | $ | — | $ | — | $ | 600,000 | $ | — |\n| Interest on 2024 Notes (2) | 22,125 | 4,500 | 9,000 | 8,625 | — |\n| 2026 Notes (3) | 500,000 | — | — | — | 500,000 |\n| Interest on 2026 Notes (4) | 47,552 | 6,875 | 13,750 | 13,750 | 13,177 |\n| Homes under contract (5) | 221,114 | 221,114 | — | — | — |\n| Revolving credit facilities (6) | 698,280 | 698,280 | — | — | — |\n| Warehouse lines of credit (7) | 30,116 | 30,116 | — | — | — |\n| Operating lease obligations (8) | 145,953 | 9,275 | 33,224 | 33,777 | 69,677 |\n| ____________________(1) The aggregate principal amount of the 2024 Notes is due on September 1, 2024 if not earlier converted or redeemed.(2) The stated interest rate on the 2024 Notes is 0.75%.(3) The aggregate principal amount of the 2026 Notes is due on September 1, 2026 if not earlier converted or redeemed.(4) The stated interest rate on the 2026 Notes is 1.375%.(5) We have obligations to purchase homes under contract through our Zillow Offers business.(6) Includes principal amounts due for amounts borrowed under the revolving credit facilities used to provide capital for our Zillow Offers business. Amounts exclude an immaterial amount of estimated interest payments.(7) Includes principal amounts due for amounts borrowed under the warehouse lines of credit used to finance Zillow Home Loans. Amounts exclude an immaterial amount of estimated interest payments.(8) Our operating lease obligations consist of office space in New York, New York, Seattle, Washington, Scottsdale, Arizona, Irvine, California, Atlanta, Georgia, Dallas, Texas, Lincoln, Nebraska and Vancouver, British Columbia. For additional information regarding our operating leases, see Note 12 to our condensed consolidated financial statements. |\n\n52\nAs of September 30, 2019, we have outstanding letters of credit of approximately $16.9 million, which secure our lease obligations in connection with certain of the operating leases of our office spaces.\nIn the course of business, we are required to provide financial commitments in the form of surety bonds to third parties as a guarantee of our performance on and our compliance with certain obligations. If we were to fail to perform or comply with these obligations, any draws upon surety bonds issued on our behalf would then trigger our payment obligation to the surety bond issuer. We have outstanding surety bonds issued for our benefit of approximately $10.1 million as of September 30, 2019.\nCritical Accounting Policies and Estimates\nOur condensed consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles, or GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses and related disclosures. We evaluate our estimates and assumptions on an ongoing basis. Our estimates are based on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Our actual results could differ from these estimates. For information on our critical accounting policies and estimates, see Part II, Item 7 (Management’s Discussion and Analysis of Financial Condition and Results of Operations) of our Annual Report on Form 10-K for the year ended December 31, 2018. There have been no material changes to our critical accounting policies and estimates as previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2018.\n53\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\nWe are exposed to market risks in the ordinary course of our business. These risks primarily consist of fluctuations in interest rates.\nInterest Rate Risk\nUnder our current investment policy, we invest our excess cash in money market funds, certificates of deposit, U.S. government agency securities, commercial paper, foreign government securities, municipal securities and corporate notes and bonds. Our current investment policy seeks first to preserve principal, second to provide liquidity for our operating and capital needs and third to maximize yield without putting our principal at risk.\nOur investments are exposed to market risk due to the fluctuation of prevailing interest rates that may reduce the yield on our investments or their fair value. As our investment portfolio is short-term in nature, we do not believe an immediate 10% increase in interest rates would have a material effect on the fair market value of our portfolio.\nThe following table summarizes our outstanding convertible senior notes as of September 30, 2019 (in thousands, except interest rates):\n| Issuance Date | Maturity Date | Aggregate Principal Amount | Stated Interest Rate |\n| September 9, 2019 | September 1, 2026 | $ | 500,000 | 1.375 | % |\n| September 9, 2019 | September 1, 2024 | 600,000 | 0.75 | % |\n| July 3, 2018 | July 1, 2023 | 373,750 | 1.50 | % |\n| December 12, 2016 | December 1, 2021 | 460,000 | 2.00 | % |\n| December 17, 2013 | December 15, 2020 | 9,637 | 2.75 | % |\n| Total | $ | 1,943,387 |\n\nSince the convertible senior notes bear interest at fixed rates, we have no direct financial statement risk associated with changes in interest rates as of September 30, 2019. However, the fair values of the convertible senior notes change primarily when the market price of our stock fluctuates or interest rates change.\nWe are subject to market risk by way of changes in interest rates on borrowings under our revolving credit facilities that provide capital for Zillow Offers. As of September 30, 2019, we have outstanding $698.3 million of borrowings on our revolving credit facilities which bear interest at a floating rate based on the one-month London Interbank Offered Rate (“LIBOR”) plus an applicable margin. Accordingly, fluctuations in market interest rates may increase or decrease our interest expense. Assuming no change in the outstanding borrowings on our revolving credit facilities, we estimate that a 1% increase in LIBOR would increase our annual interest expense by approximately $7.0 million.\nWe are also subject to market risk by way of changes in interest rates on borrowings under our warehouse lines of credit that provide capital for Zillow Home Loans. As of September 30, 2019, we have outstanding $30.1 million of borrowings on our warehouse lines of credit which bear interest at a floating rate based on LIBOR plus an applicable margin. We manage the interest rate risk associated with our mortgage loan origination services through the use of forward sales of mortgage-backed securities. Assuming no change in the outstanding borrowings on the warehouse lines of credit, we estimate that a 1.0% increase in LIBOR would increase our annual interest expense associated with the warehouse lines of credit by approximately $0.3 million.\nInflation Risk\nWe do not believe that inflation has had a material effect on our business, results of operations or financial condition. If our costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could harm our business, results of operations and financial condition.\nForeign Currency Exchange Risk\nWe do not believe that foreign currency exchange risk has had a material effect on our business, results of operations or financial condition. As we do not maintain a significant balance of foreign currency, we do not believe an immediate 10% increase or decrease in foreign currency exchange rates relative to the U.S. dollar would have a material effect on our business, results of operations or financial condition.\n54\nItem 4. Controls and Procedures\nEvaluation of Disclosure Controls and Procedures\nThe Company maintains disclosure controls and procedures (as defined under Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended). Management, under the supervision and with the participation of our Chief Executive Officer and our Chief Financial Officer, evaluated the effectiveness of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b) as of September 30, 2019. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that these disclosure controls and procedures were effective as of September 30, 2019.\nChanges in Internal Control Over Financial Reporting\nThere were no changes in our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15(d) and 15d-15(d) of the Exchange Act that occurred during the three months ended September 30, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n55\nPART II – OTHER INFORMATION\nItem 1. Legal Proceedings\nFor information regarding legal proceedings in which we are involved, see Note 17 under the subsection titled “Legal Proceedings” in our Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Quarterly Report on Form 10-Q.\n56\nItem 1A. Risk Factors\nThere have not been any material changes to the risk factors affecting our business, financial condition or future results from those set forth in Part I, Item 1A (Risk Factors) in our Annual Report on Form 10-K for the year ended December 31, 2018. However, you should carefully consider the factors discussed in our Annual Report on Form 10-K, which could materially affect our business, financial condition or future results. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.\n57\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nUnregistered Sales of Equity Securities\nExcept as previously reported on a current report on Form 8-K, we had no unregistered sales of equity securities during the three months ended September 30, 2019.\n58\nItem 1. Legal Proceedings\nFor information regarding legal proceedings in which we are involved, see Note 17 under the subsection titled “Legal Proceedings” in our Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Quarterly Report on Form 10-Q.\n56\nItem 6. Exhibits\nThe exhibits listed below are filed as part of this Quarterly Report on Form 10-Q.\n| ExhibitNumber | Description |\n| 4.1 | Indenture dated as of September 9, 2019 by and between Zillow Group, Inc. and The Bank of New York Mellon Trust Company, N.A., as trustee (Filed as Exhibit 4.1 to Zillow Group, Inc.’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 10, 2019, and incorporated herein by reference). |\n| 4.2 | Indenture dated as of September 9, 2019 by and between Zillow Group, Inc. and The Bank of New York Mellon Trust Company, N.A., as trustee (Filed as Exhibit 4.2 to Zillow Group, Inc.’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 10, 2019, and incorporated herein by reference). |\n| 4.3 | Form of 0.75% Convertible Senior Note due 2024 (incorporated by reference from Exhibit A to Exhibit 4.1 hereto). |\n| 4.4 | Form of 1.375% Convertible Senior Note due 2026 (incorporated by reference to Exhibit A to Exhibit 4.2 hereto). |\n| 10.1* | Zillow Group, Inc. 2019 Equity Inducement Plan (Filed as Exhibit 99.2 to Zillow Group, Inc’s. Form S-8, filed with the Securities and Exchange Commission (SEC File No. 333-233105) on August 8, 2019, and incorporated herein by reference). |\n| 10.2* | Form of Stock Option Grant Notice and Stock Option Agreement under the Zillow Group, Inc. 2019 Equity Inducement Plan. |\n| 10.3* | Form of Restricted Stock Unit Award Notice and Restricted Stock Unit Award Agreement under the Zillow Group, Inc. 2019 Equity Inducement Plan. |\n| 10.4 | Capped Call Confirmation (2024 Notes), dated September 4, 2019, between Zillow Group, Inc. and Morgan Stanley & Co., LLC (Filed as Exhibit 10.1 to Zillow Group, Inc.’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 10, 2019, and incorporated herein by reference). |\n| 10.5 | Capped Call Confirmation (2026 Notes), dated September 4, 2019, between Zillow Group, Inc. and Morgan Stanley & Co., LLC. (Filed as Exhibit 10.2 to Zillow Group, Inc.’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 10, 2019, and incorporated herein by reference). |\n| 10.6 | Capped Call Confirmation (2024 Notes), dated September 4, 2019, between Zillow Group, Inc. and Citibank, N.A. (Filed as Exhibit 10.3 to Zillow Group, Inc.’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 10, 2019, and incorporated herein by reference). |\n| 10.7 | Capped Call Confirmation (2026 Notes), dated September 4, 2019, between Zillow Group, Inc. and Citibank, N.A. (Filed as Exhibit 10.4 to Zillow Group, Inc.’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 10, 2019, and incorporated herein by reference). |\n| 10.8 | Capped Call Confirmation (2024 Notes), dated September 4, 2019, between Zillow Group, Inc. and Goldman Sachs & Co. LLC (Filed as Exhibit 10.5 to Zillow Group, Inc.’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 10, 2019, and incorporated herein by reference). |\n| 10.9 | Capped Call Confirmation (2024 Notes), dated September 4, 2019, between Zillow Group, Inc. and Barclays Bank PLC (Filed as Exhibit 10.6 to Zillow Group, Inc.’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 10, 2019, and incorporated herein by reference). |\n| 10.10 | Capped Call Confirmation (2026 Notes), dated September 4, 2019, between Zillow Group, Inc. and Barclays Bank PLC (Filed as Exhibit 10.7 to Zillow Group, Inc.’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 10, 2019, and incorporated herein by reference). |\n| 10.11 | Capped Call Confirmation (2026 Notes), dated September 4, 2019, between Zillow Group, Inc. and JPMorgan Chase Bank, National Association (Filed as Exhibit 10.8 to Zillow Group, Inc.’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 10, 2019, and incorporated herein by reference). |\n| 31.1 | Certification of Chief Executive Officer pursuant to Rule 13-14(a) of the Securities Exchange Act of 1934 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2 | Certification of Chief Financial Officer pursuant to Rule 13-14(a) of the Securities Exchange Act of 1934 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n\n59\n| 32.1 | Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 32.2 | Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 101.INS | Inline XBRL Instance Document (the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the inline XBRL document). |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document. |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document. |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document. |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document. |\n| 101.PRE | InlineXBRL Taxonomy Extension Presentation Linkbase Document. |\n| 104 | Coverage Page Interactive Data File (embedded within the Inline XBRL document). |\n| * | Indicates a management contract or compensatory plan or arrangement. |\n\n60\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| Dated: November 7, 2019 | ZILLOW GROUP, INC. |\n| By: | /s/ JENNIFER ROCK |\n| Name: | Jennifer Rock |\n| Title: | Chief Accounting Officer |\n\n61\n</text>\n\nIf Zillow group inc. incurred 'Net loss' every three months at the same rate as in the three months ended September 30, 2019, what will be the total comprehensive loss after a year in USD?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nPART I—FINANCIAL INFORMATION\nItem 1. Condensed Consolidated Financial Statements (Unaudited)\n908 DEVICES INC.\nCONDENSED CONSOLIDATED BALANCE SHEETS\n(Unaudited)\n(In thousands, except share and per share amounts)\n| | | | | | | |\n| | | June 30, | | December 31, |\n| | 2023 | 2022 |\n| Assets | | | |\n| Current assets: | | | |\n| Cash and cash equivalents | | $ | 132,996 | | $ | 188,422 |\n| Marketable securities | | | 19,691 | | | — |\n| Accounts receivable, net of allowance for credit losses of $ 133 and $ 25 at June 30, 2023 and December 31, 2022 | | 10,308 | | 10,033 |\n| Inventory | | 14,135 | | 12,513 |\n| Prepaid expenses and other current assets | | 3,947 | | 4,658 |\n| Total current assets | | 181,077 | | 215,626 |\n| Operating lease, right-of-use assets | | 7,136 | | 3,956 |\n| Property and equipment, net | | 2,940 | | 3,083 |\n| Goodwill | | | 10,185 | | | 10,050 |\n| Intangible assets, net | | | 8,162 | | | 8,488 |\n| Other long-term assets | | 1,330 | | 1,384 |\n| Total assets | | $ | 210,830 | | $ | 242,587 |\n| Liabilities and Stockholders' Equity | | | | |\n| Current liabilities: | | | | |\n| Accounts payable | | $ | 1,486 | | $ | 1,397 |\n| Accrued expenses | | 6,034 | | 8,847 |\n| Deferred revenue | | 10,814 | | 7,514 |\n| Operating lease liabilities | | 1,860 | | 1,468 |\n| Total current liabilities | | 20,194 | | 19,226 |\n| Long-term debt | | — | | 15,000 |\n| Operating lease liabilities, net of current portion | | 4,962 | | 3,040 |\n| Deferred revenue, net of current portion | | 8,474 | | 11,496 |\n| Deferred income taxes | | 2,585 | | 2,671 |\n| Other long-term liabilities | | 156 | | 555 |\n| Total liabilities | | 36,371 | | 51,988 |\n| Commitments and contingencies | | | | |\n| Stockholders' equity: | | | | |\n| Preferred stock, $ 0.001 par value; 5,000,000 shares authorized, no shares issued or outstanding at June 30, 2023 and December 31, 2022, respectively | | | — | | | — |\n| Common stock, $ 0.001 par value; 100,000,000 shares authorized; 32,326,861 shares and 31,859,847 shares issued and outstanding at June 30, 2023 and December 31, 2022, respectively | | 32 | | 32 |\n| Additional paid-in capital | | 329,361 | | 323,969 |\n| Accumulated other comprehensive income | | | 1,144 | | | 798 |\n| Accumulated deficit | | ( 156,078 ) | | ( 134,200 ) |\n| Total stockholders' equity | | 174,459 | | 190,599 |\n| Total liabilities and stockholders' equity | | $ | 210,830 | | $ | 242,587 |\n\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n\n4\n| | | | | | | | | | | | | | |\n| | | Three Months Ended June 30, | | Six Months Ended June 30, | |\n| | 2023 | 2022 | 2023 | 2022 | |\n| Revenue: | | | | | | | | | | | | | |\n| Product revenue | | $ | 9,595 | | $ | 9,082 | | $ | 16,617 | | $ | 15,589 | |\n| Service revenue | | 2,354 | | 1,526 | | 4,594 | | 3,048 | |\n| Contract revenue | | 145 | | 498 | | 370 | | 775 | |\n| Total revenue | | 12,094 | | 11,106 | | 21,581 | | 19,412 | |\n| Cost of revenue: | | | | | | | | | |\n| Product cost of revenue | | 4,800 | | 3,304 | | 8,586 | | 6,276 | |\n| Service cost of revenue | | 1,448 | | 1,057 | | 2,718 | | 2,126 | |\n| Contract cost of revenue | | 52 | | 111 | | 99 | | 247 | |\n| Total cost of revenue | | 6,300 | | 4,472 | | 11,403 | | 8,649 | |\n| Gross profit | | 5,794 | | 6,634 | | 10,178 | | 10,763 | |\n| Operating expenses: | | | | | | | | | |\n| Research and development | | 5,525 | | 4,293 | | 10,923 | | 8,198 | |\n| Selling, general and administrative | | 11,208 | | 10,710 | | 23,211 | | 20,455 | |\n| Total operating expenses | | 16,733 | | 15,003 | | 34,134 | | 28,653 | |\n| Loss from operations | | ( 10,939 ) | | ( 8,369 ) | | ( 23,956 ) | | ( 17,890 ) | |\n| Other income: | | | | | | | | | |\n| Interest income | | | 1,689 | | | 293 | | | 2,706 | | | 464 | |\n| Interest expense | | — | | ( 15 ) | | ( 551 ) | | ( 35 ) | |\n| Other expense, net | | ( 167 ) | | ( 8 ) | | ( 200 ) | | ( 53 ) | |\n| Total other income, net | | 1,522 | | 270 | | 1,955 | | 376 | |\n| Loss from operations before income taxes | | | ( 9,417 ) | | | ( 8,099 ) | | | ( 22,001 ) | | | ( 17,514 ) | |\n| Benefit for income taxes | | | 71 | | | — | | | 122 | | | — | |\n| Net loss | | $ | ( 9,346 ) | | $ | ( 8,099 ) | | $ | ( 21,879 ) | | $ | ( 17,514 ) | |\n| Net loss per share | | | | | | | | | | | | | |\n| Basic and diluted | | $ | ( 0.29 ) | | $ | ( 0.26 ) | | $ | ( 0.68 ) | | $ | ( 0.56 ) | |\n| Weighted average common shares outstanding | | | | | | | | | |\n| Basic and diluted | | | 32,199,156 | | | 31,413,431 | | | 32,083,122 | | | 31,312,559 | |\n\n| | | | | | | | | | | | | | | |\n| | | Three Months Ended June 30, | | Six Months Ended June 30, | |\n| | 2023 | | 2022 | | 2023 | | 2022 | |\n| Net loss | | $ | ( 9,346 ) | | $ | ( 8,099 ) | | $ | ( 21,879 ) | | $ | ( 17,514 ) | | |\n| Other comprehensive income | | | | | | | | | | | | | | |\n| Foreign currency translation adjustment | | ( 57 ) | | — | | 234 | | — | | |\n| Unrealized gains on marketable securities, net of tax of $ 0 | | | 112 | | | — | | | 112 | | | — | | |\n| Total other comprehensive income | | $ | 55 | | $ | — | | $ | 346 | | $ | — | | |\n| Comprehensive loss | | $ | ( 9,291 ) | | $ | ( 8,099 ) | | $ | ( 21,533 ) | | $ | ( 17,514 ) | | |\n\n| | | | | | | | | | | | | | | | | | |\n| | | | | | | | | | | Accumulated | | | | | | |\n| | | | | Additional | | Other | | | | Total |\n| | | Common Stock | | Paid-in | | Comprehensive | | Accumulated | | Stockholders' |\n| | Shares | Amount | Capital | | Income | Deficit | Equity |\n| Balances at December 31, 2022 | | 31,859,847 | | $ | 32 | | $ | 323,969 | | $ | 798 | | $ | ( 134,200 ) | | $ | 190,599 |\n| Issuance of common stock upon exercise of stock options | 56,547 | | — | | 88 | | — | | — | | 88 |\n| Stock-based compensation expense | — | | — | | 2,166 | | — | | — | | 2,166 |\n| Vesting of restricted stock units | | 145,123 | | | — | | | — | | | — | | | — | | | — |\n| Net loss | — | | — | | — | | — | | ( 12,532 ) | | ( 12,532 ) |\n| Foreign currency translation adjustments | | — | | | — | | | — | | | 291 | | | — | | | 291 |\n| Balances at March 31, 2023 | | 32,061,517 | | $ | 32 | | $ | 326,223 | | $ | 1,089 | | $ | ( 146,732 ) | | $ | 180,612 |\n| Issuance of common stock upon exercise of stock options | | 166,226 | | | — | | | 301 | | | — | | | — | | | 301 |\n| Stock-based compensation expense | | — | | | — | | | 2,578 | | | — | | | — | | | 2,578 |\n| Issuance of common stock upon ESPP purchase | | 45,082 | | | — | | | 259 | | | — | | | — | | | 259 |\n| Vesting of restricted stock units | | 54,036 | | | — | | | — | | | — | | | — | | | — |\n| Net loss | | — | | | — | | | — | | | — | | | ( 9,346 ) | | | ( 9,346 ) |\n| Foreign currency translation adjustments | | — | | | — | | | — | | | ( 57 ) | | | — | | | ( 57 ) |\n| Unrealized gains on marketable securities | | — | | | — | | | — | | | 112 | | | — | | | 112 |\n| Balances at June 30, 2023 | | 32,326,861 | | $ | 32 | | $ | 329,361 | | $ | 1,144 | | $ | ( 156,078 ) | | $ | 174,459 |\n| | | | | | | | | | | | | | | |\n| | | | | Additional | | | | Total |\n| | | Common Stock | | Paid-in | | Accumulated | | Stockholders' |\n| | Shares | Amount | Capital | Deficit | Equity |\n| Balances at December 31, 2021 | | 31,077,004 | | $ | 31 | | $ | 315,210 | | $ | ( 100,637 ) | | $ | 214,604 |\n| Issuance of common stock upon exercise of stock options | 243,842 | | — | | 324 | | — | | 324 |\n| Stock-based compensation expense | — | | — | | 1,289 | | — | | 1,289 |\n| Vesting of restricted stock units | | 12,936 | | | — | | | — | | | — | | | — |\n| Net loss | — | | — | | — | | ( 9,415 ) | | ( 9,415 ) |\n| Balances at March 31, 2022 | | 31,333,782 | | $ | 31 | | $ | 316,823 | | $ | ( 110,052 ) | | $ | 206,802 |\n| Issuance of common stock upon exercise of stock options | | 164,638 | | | 1 | | | 275 | | | — | | | 276 |\n| Stock-based compensation expense | | — | | | — | | | 1,894 | | | — | | | 1,894 |\n| Issuance of common stock upon ESPP purchase | | 16,052 | | | — | | | 242 | | | — | | | 242 |\n| Vesting of restricted stock units | | 16,643 | | | — | | | — | | | — | | | — |\n| Net loss | | — | | | — | | | — | | | ( 8,099 ) | | | ( 8,099 ) |\n| Balances at June 30, 2022 | | 31,531,115 | | $ | 32 | | $ | 319,234 | | $ | ( 118,151 ) | | $ | 201,115 |\n\n| | | | | | | |\n| | | Six Months Ended June 30, |\n| | 2023 | 2022 |\n| Cash flows from operating activities: | | | | |\n| Net loss | | $ | ( 21,879 ) | | $ | ( 17,514 ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: | | | | |\n| Depreciation and amortization expense | | 1,239 | | 578 |\n| Stock-based compensation expense | | 4,744 | | 3,183 |\n| Noncash interest expense and loss on extinguishment of debt | | 523 | | 6 |\n| Provision for inventory obsolescence | | 38 | | 39 |\n| Provision for credit losses | | | 108 | | | — |\n| Change in fair value of contingent consideration | | | 231 | | | — |\n| Deferred income tax | | | ( 122 ) | | | — |\n| Changes in operating assets and liabilities: | | | | |\n| Accounts receivable, net | | ( 376 ) | | 5,277 |\n| Inventory | | ( 1,680 ) | | ( 3,857 ) |\n| Prepaid expenses and other current assets | | ( 274 ) | | 1,119 |\n| Other long-term assets | | ( 58 ) | | 18 |\n| Accounts payable and accrued expenses | | ( 918 ) | | ( 1,043 ) |\n| Deferred revenue | | 278 | | 1,372 |\n| Right-of-use operating lease assets | | 741 | | 599 |\n| Operating lease liabilities | | ( 682 ) | | ( 653 ) |\n| Other long-term liabilities | | ( 442 ) | | | — |\n| Net cash used in operating activities | | ( 18,529 ) | | ( 10,876 ) |\n| Cash flows from investing activities: | | | | |\n| Purchases of property and equipment | | ( 1,505 ) | | ( 689 ) |\n| Purchases of marketable securities | | | ( 19,616 ) | | | — |\n| Net cash used in investing activities | | ( 21,121 ) | | ( 689 ) |\n| Cash flows from financing activities: | | | | |\n| Payments for withholding taxes on vested awards | | | ( 530 ) | | | ( 133 ) |\n| Proceeds from issuance of common stock | | | 648 | | | 842 |\n| Payments of public offering costs | | | — | | | ( 112 ) |\n| Proceeds from borrowings on revolving line of credit | | — | | 30,000 |\n| Payments for contingent consideration | | | ( 900 ) | | | — |\n| Repayment of notes payable | | | ( 15,000 ) | | | ( 30,000 ) |\n| Net cash (used in) provided by financing activities | | ( 15,782 ) | | 597 |\n| Effect of foreign exchange rate changes on cash and cash equivalents | | | 6 | | | — |\n| Net decrease in cash, cash equivalents and restricted cash | | ( 55,426 ) | | ( 10,968 ) |\n| Cash, cash equivalents and restricted cash at beginning of period | | 188,593 | | 224,133 |\n| Cash, cash equivalents and restricted cash at end of period | | $ | 133,167 | | $ | 213,165 |\n| Supplemental disclosure of noncash investing and financing information: | | | | |\n| Property and equipment included in account payable | | | 48 | | | 147 |\n| Transfers of inventory to property and equipment | | | 195 | | | 558 |\n| Reconciliation of cash, cash equivalents and restricted cash: | | | | | | |\n| Cash and cash equivalents | | $ | 132,996 | | $ | 212,994 |\n| Restricted cash included in prepaid expenses and other current assets | | | — | | 60 |\n| Restricted cash included in other long-term assets | | | 171 | | | 111 |\n| Total cash, cash equivalents and restricted cash shown in the statement of cash flows | | $ | 133,167 | | $ | 213,165 |\n\n908 DEVICES INC.NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited) 1. Nature of the Business and Basis of Presentation908 Devices Inc. (the “Company”) was incorporated in the State of Delaware on February 10, 2012 . The Company is a commercial-stage technology company providing a suite of purpose-built handheld and desktop devices used at the point-of-need for chemical and biochemical analysis in a broad array of markets including life sciences research, bioprocessing, pharma/biopharma, forensics and adjacent markets.The Company is subject to risks and uncertainties common to technology companies in the device industry and of similar size, including, but not limited to, development by competitors of new technological innovations, dependence on key personnel, protection of proprietary technology, compliance with government regulations, uncertainty of market acceptance of products, and the need to obtain additional financing to fund operations. Potential risks and uncertainties also include, without limitation, uncertainties regarding rising inflation and higher interest rates. Products currently under development will require additional research and development efforts prior to commercialization and will require additional capital and adequate personnel and infrastructure. The Company’s research and development may not be successfully completed, adequate protection for the Company’s technology may not be obtained, the Company may not obtain necessary government regulatory approval, and approved products may not prove commercially viable. The Company operates in an environment of rapid change in technology and competition.AcquisitionThe Company acquired TRACE Analytics GmbH, located in Braunschweig, Germany (“Trace”) in August 2022. Trace changed its corporate name to 908 Devices GmbH in February 2023. Trace is a leading provider of online analysis systems for biotech applications in research, development and production. Trace’s products are used for monitoring and control of complex processes in industrial pharmaceutical productions under continuous measurement conditions. With the acquisition of Trace, the Company has acquired enabling sampling technology that it expects to integrate within future product offerings. See Note 13, Acquisition, for further information.Basis of PresentationThe Company’s condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”). Any reference in these notes to applicable guidance is meant to refer to the authoritative GAAP as found in the Accounting Standards Codification (“ASC”) and Accounting Standards Update (“ASU”) of the Financial Accounting Standards Board (“FASB”).The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, 908 Devices Securities Corporation, 908 Devices (Shanghai) Technology Co., Ltd. and 908 Devices GmbH. All intercompany balances and transactions have been eliminated.The accompanying condensed consolidated financial statements have been prepared based on continuity of operations, realization of assets and the satisfaction of liabilities and commitments in the ordinary course of business. The Company has incurred recurring losses since inception, including net losses of $ 21.9 million for the six months ended June 30, 2023 and $ 33.6 million for the year ended December 31, 2022. As of June 30, 2023, the Company had an accumulated deficit of $ 156.1 million. The Company expects to continue to generate operating losses in the foreseeable future. The Company expects that its cash and cash equivalents and revenue from product and service will be sufficient to fund its operating expenses and capital expenditure requirements for at least 12 months from the issuance date of the condensed consolidated financial statements. The Company may seek additional funding through private or public equity financings, debt financings, collaborations, strategic alliances and marketing, distribution or licensing arrangements. The Company may not be able to obtain financing on acceptable terms, or at all, and the Company may not be able to enter into collaborations or other arrangements. The terms of any financing may adversely affect the holdings or the rights of the Company’s stockholders. If the Company is unable to obtain funding, the Company could be forced to delay, reduce or eliminate some or all of its research and development programs, product expansion or commercialization efforts, or the Company may be unable to continue operations. 9\n 2. Summary of Significant Accounting Policies Unaudited Condensed Interim Financial InformationThe condensed consolidated balance sheet at December 31, 2022 was derived from audited consolidated financial statements but does not include all disclosures required by GAAP. The accompanying unaudited condensed consolidated financial statements as of June 30, 2023 and for the three and six months ended June 30, 2023 and 2022 have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) for interim financial statements. Certain information and footnote disclosures normally included in the consolidated financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Therefore, these condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements and the notes thereto for the year ended December 31, 2022 included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2022 on file with the SEC. In the opinion of management, all adjustments, consisting only of normal recurring adjustments necessary for a fair statement of the Company’s financial position as of June 30, 2023 and results of operations for the three and six months ended June 30, 2023 and 2022 and statements of stockholders’ equity for the three and six months ended June 30, 2023 and 2022 and cash flows for the six months ended June 30, 2023 and 2022 have been made. The Company’s results of operations for the three and six months ended June 30, 2023 are not necessarily indicative of the results of operations that may be expected for the year ending December 31, 2023 or any other period. Use of EstimatesThe preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting periods. Significant estimates and assumptions reflected in these condensed consolidated financial statements include, but are not limited to, revenue recognition and accounts receivable, the valuation of inventory, fair value of assets acquired and liabilities assumed in acquisitions and the valuation of stock-based awards. The Company bases its estimates on historical experience, known trends and other market-specific or other relevant factors that it believes to be reasonable under the circumstances. Due to rising inflation and higher interest rates, there has been uncertainty and disruption in the global economy and financial markets. The Company is not aware of any specific event or circumstance that would require further updates to its estimates or judgments or a revision of the carrying value of its assets or liabilities as of the date of issuance of these condensed consolidated financial statements. These estimates may change, as new events occur and additional information is obtained. On an ongoing basis, management evaluates its estimates as there are changes in circumstances, facts and experience. Changes in estimates are recorded in the period in which they become known. Actual results may differ from those estimates or assumptions. Risk of Concentrations of Credit, Significant Customers and Significant SuppliersFinancial instruments that potentially expose the Company to concentrations of credit risk consist primarily of cash and cash equivalents and accounts receivable. The Company maintains the majority of its cash and cash equivalents with three financial institutions that management believes to be of high credit quality. The Company has not experienced any other-than-temporary losses with respect to its cash and cash equivalents and does not believe that it is subject to unusual credit risk beyond the normal credit risk associated with commercial banking relationships.Significant customers are those that accounted for 10 % or more of the Company’s total revenue or accounts receivable. For the three months ended June 30, 2023, three customers represented 13 %, 12 % and 10 % of total revenue, respectively. For the comparable three months ended June 30, 2022, one customer represented 17 % of total revenue, respectively. For the six months ended June 30, 2023 and 2022, one customer represented 14 % and 19 % of total revenue, respectively. As of June 30, 2023, two customers accounted for 26 % and 14 % of gross accounts receivable, respectively. As of December 31, 2022, two customers accounted for 20 % and 12 % of gross accounts receivable, respectively. Certain of the components included in the Company’s products are obtained from a sole source, a single source or a limited group of suppliers. Although the Company seeks to reduce dependence on those limited sources of suppliers and manufacturers, the partial or complete loss of certain of these sources, or the requirement to establish a new supplier for the 10\n| | | | | | | | | | | | | |\n| | | Three Months Ended June 30, | | Six Months Ended June 30, |\n| | 2023 | 2022 | 2023 | 2022 |\n| Balances at beginning of period | | $ | 25 | | $ | 1,750 | | $ | 25 | | $ | 1,750 |\n| Provision for credit losses, net of recoveries | | | 108 | | | — | | | 108 | | | — |\n| Balances at end of period | | $ | 133 | | $ | 1,750 | | $ | 133 | | $ | 1,750 |\n| ● | Level 1 — Quoted prices in active markets for identical assets or liabilities. |\n| ● | Level 2 — Observable inputs (other than Level 1 quoted prices), such as quoted prices in active markets for similar assets or liabilities, quoted prices in markets that are not active for identical or similar assets or liabilities, or other inputs that are observable or can be corroborated by observable market data. |\n| ● | Level 3 — Unobservable inputs that are supported by little or no market activity and that are significant to determining the fair value of the assets or liabilities, including pricing models, discounted cash flow methodologies and similar techniques. |\n\n| | | |\n| | | |\n| Customer Relationships | | 8 years |\n| Developed Technology | | 15 years |\n| Software | | 3 years |\n| Trade Name | | 2 years |\n\n| | | | | | | |\n| | | Six Months Ended June 30, |\n| | 2023 | 2022 |\n| Balances at beginning of period | | $ | 16,510 | | $ | 14,521 |\n| Recognition of revenue included in balance at beginning of the period | | ( 3,811 ) | | ( 2,494 ) |\n| Revenue deferred during the period, net of revenue recognized | | 6,589 | | 3,863 |\n| Balances at end of period | | $ | 19,288 | | $ | 15,890 |\n\n| | | | | | | |\n| | | June 30, | | December 31, |\n| | 2023 | 2022 |\n| Deferred revenue expected to be recognized in: | | |\n| One year or less | | $ | 10,814 | | $ | 7,514 |\n| One to two years | | 5,425 | | 4,750 |\n| Three years and beyond | | 3,049 | | 4,246 |\n| | | $ | 19,288 | | $ | 16,510 |\n\n| | | | | | | | | | | | | |\n| | | Three Months Ended June 30, | | Six Months Ended June 30, |\n| | 2023 | 2022 | 2023 | 2022 |\n| Product and service revenue: | | | | |\n| Device sales revenue | | $ | 7,959 | | $ | 7,755 | | $ | 13,042 | | $ | 13,287 |\n| Recurring revenue | | 3,990 | | 2,853 | | 8,169 | | 5,350 |\n| Total product and service revenue | | 11,949 | | 10,608 | | 21,211 | | 18,637 |\n| Contract revenue | | 145 | | 498 | | 370 | | 775 |\n| Total revenue | | $ | 12,094 | | $ | 11,106 | | $ | 21,581 | | $ | 19,412 |\n| | | | | | | | | | | | | | |\n| | | Three Months Ended June 30, | | Six Months Ended June 30, | |\n| | 2023 | 2022 | 2023 | 2022 | |\n| Handheld revenue: | | | | | | | | | | | | | |\n| Device sales revenue | | $ | 6,503 | | $ | 5,431 | | $ | 10,249 | | $ | 8,731 | |\n| Recurring revenue | | | 2,319 | | | 1,506 | | | 4,745 | | | 2,676 | |\n| Total handheld revenue | | | 8,822 | | | 6,937 | | | 14,994 | | | 11,407 | |\n| Desktop revenue: | | | | | | | | | | | | | |\n| Device sales revenue | | | 1,456 | | | 2,323 | | | 2,793 | | | 4,556 | |\n| Recurring revenue | | | 1,671 | | | 1,348 | | | 3,424 | | | 2,674 | |\n| Total desktop revenue | | | 3,127 | | | 3,671 | | | 6,217 | | | 7,230 | |\n| Total product and service revenue | | $ | 11,949 | | $ | 10,608 | | $ | 21,211 | | $ | 18,637 | |\n\n| | | | | | | | | | | | | |\n| | Three Months Ended June 30, | | Six Months Ended June 30, | |\n| | 2023 | 2022 | 2023 | 2022 | |\n| Government | $ | 8,812 | | $ | 7,002 | | $ | 14,992 | | $ | 11,719 | |\n| Pharmaceutical/Biotechnology | | 3,106 | | 3,577 | | | 6,158 | | 6,705 | |\n| Academia and other | | 31 | | 29 | | | 61 | | 213 | |\n| Total product and service revenue | $ | 11,949 | | $ | 10,608 | | $ | 21,211 | | $ | 18,637 | |\n| | | | | | | | | | | | | |\n| | Three Months Ended June 30, | | Six Months Ended June 30, | |\n| | 2023 | 2022 | 2023 | 2022 | |\n| United States | $ | 7,857 | | $ | 9,460 | | $ | 14,350 | | $ | 15,512 | |\n| Europe, Middle East and Africa | | 3,954 | | 1,245 | | | 5,942 | | 2,601 | |\n| Asia Pacific | | 221 | | | 391 | | | 797 | | | 1,273 | |\n| Americas other | | 62 | | 10 | | | 492 | | 26 | |\n| | $ | 12,094 | | $ | 11,106 | | $ | 21,581 | | $ | 19,412 | |\n\nthe aggregate value of tangible and intangible assets, net of liabilities assumed, is recorded as goodwill. These valuations require significant estimates and assumptions, especially with respect to intangible assets.The Company estimates the fair value of the contingent consideration earnouts using the Monte Carlo Simulation or probability weighted scenario depending on the nature of the contingent consideration and updates the fair value of the contingent consideration at each reporting period based on the estimated probability of achieving the earnout targets and applying a discount rate that captures the risk associated with the expected contingent payments. To the extent that these estimates change in the future regarding the likelihood of achieving these targets, the Company may need to record material adjustments to its accrued contingent consideration. Such changes in the fair value of contingent consideration are recorded as contingent consideration expense or income in the consolidated statements of operations.The Company uses the income approach to determine the fair value of certain identifiable intangible assets including customer relationships and developed technology. This approach determines fair value by estimating after-tax cash flows attributable to these assets over their respective useful lives and then discounting these after-tax cash flows back to a present value. The Company bases its assumptions on estimates of future cash flows, expected growth rates, expected trends in technology, probabilities of customer renewals, etc. The Company bases the discount rates used to arrive at a present value as of the date of acquisition on the time value of money and certain industry-specific risk factors. The Company believes the estimated purchased customer relationships, developed technology, software and trade name amounts determined represent the fair value at the date of acquisition and do not exceed the amount a third-party would pay for the assets. Recently Adopted Accounting PronouncementsThe Company qualifies as an “emerging growth company” as defined in the Jumpstart Our Business Startups Act of 2012 and has elected not to “opt out” of the extended transition related to complying with new or revised accounting standards, which means that when a standard is issued or revised and it has different application dates for public and nonpublic companies, the Company will adopt the new or revised standard at the time nonpublic companies adopt the new or revised standard and will do so until such time that the Company either (i) irrevocably elects to “opt out” of such extended transition period or (ii) no longer qualifies as an emerging growth company.In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments—Credit Losses (Topic 326). The new standard adjusts the accounting for assets held at amortized costs basis, including marketable securities accounted for as available for sale, and trade receivables. The standard eliminates the probable initial recognition threshold and requires an entity to reflect its current estimate of all expected credit losses. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial assets to present the net amount expected to be collected. For public entities except smaller reporting companies, the guidance is effective for annual reporting periods beginning after December 15, 2019 and for interim periods within those fiscal years. For non-public entities and smaller reporting companies, the guidance was effective for annual reporting periods beginning after December 15, 2021. In November 2019, the FASB issued ASU No. 2019-10, which deferred the effective date for non-public entities to annual reporting periods beginning after December 15, 2022, including interim periods within those fiscal years. Early application is allowed. The Company adopted this standard effective January 1, 2023 and deemed no material impact on our condensed consolidated financial statements. 17\n| | | | | | | | | | | | | |\n| | | Fair Value Measurements at June 30, 2023 Using: |\n| | Level 1 | Level 2 | Level 3 | Total |\n| Assets: | | | | |\n| Cash equivalents - Money market funds | | $ | 90,527 | | $ | — | | $ | — | | $ | 90,527 |\n| Cash equivalents - U.S. Treasury securities | | | — | | | 9,969 | | | — | | | 9,969 |\n| Marketable securities - U.S. Treasury securities | | | — | | | 19,691 | | | — | | | 19,691 |\n| Total assets measured at fair value | $ | 90,527 | $ | 29,660 | $ | — | $ | 120,187 |\n| Other current liabilities: | | | | | | | | | | | | |\n| Acquisition-related contingent consideration | | $ | — | | $ | — | | $ | 973 | | $ | 973 |\n| Other long-term liabilities: | | | | | | | | | | | | |\n| Acquisition-related contingent consideration | | | — | | | — | | | 156 | | | 156 |\n| Total liabilities measured at fair value | | $ | — | | $ | — | | $ | 1,129 | | $ | 1,129 |\n| | | | | | | | | | | | | |\n| | | Fair Value Measurements at December 31, 2022 Using: |\n| | Level 1 | Level 2 | Level 3 | Total |\n| Assets: | | | | |\n| Cash equivalents - Money market funds | | $ | 27,866 | | $ | — | | $ | — | | $ | 27,866 |\n| | $ | 27,866 | $ | — | $ | — | $ | 27,866 |\n| Other current liabilities: | | | | | | | | | | | | |\n| Acquisition-related contingent consideration | | $ | — | | $ | — | | $ | 343 | | $ | 343 |\n| Acquisition-related contingent consideration - pension liability | | | — | | | — | | | 900 | | | 900 |\n| | | | — | | | — | | | 1,243 | | | 1,243 |\n| Other long-term liabilities: | | | | | | | | | | | | |\n| Acquisition-related contingent consideration | | | — | | | — | | | 555 | | | 555 |\n| Total liabilities measured at fair value | | $ | — | | $ | — | | $ | 1,798 | | $ | 1,798 |\n\n| | | | |\n| Balance as of December 31, 2022 | | $ | 1,798 |\n| Accretion - earnout | | | 231 |\n| Release of pension liability | | | ( 900 ) |\n| Balance as of June 30, 2023 | | $ | 1,129 |\n| | | | | | | | | | | | | | | | | |\n| | | June 30, 2023 | |\n| | | Amortized Cost | | GrossUnrealizedGain | | GrossUnrealizedLoss | | Credit Losses | | Fair Value | |\n| | | | | | | | | | | | | | | | | |\n| Cash equivalents - U.S. Treasury securities | | | 9,932 | | | 37 | | | — | | | — | | | 9,969 | |\n| Marketable securities - U.S. Treasury securities | | | 19,616 | | | 75 | | | — | | | — | | | 19,691 | |\n| | | $ | 29,548 | | $ | 112 | | $ | — | | $ | — | | $ | 29,660 | |\n| | | | | | | | |\n| | | June 30, | | December 31, | |\n| | 2023 | 2022 | |\n| Raw materials | | $ | 9,579 | | $ | 8,343 | |\n| Work-in-progress | | | 2,916 | | 2,722 | |\n| Finished goods | | | 1,640 | | 1,448 | |\n| | | $ | 14,135 | | $ | 12,513 | |\n\n| | | | |\n| | | Six Months Ended |\n| | June 30, 2023 |\n| Balances at beginning of period | | $ | 10,050 |\n| Foreign currency impact | | | 135 |\n| Balances at end of period | | $ | 10,185 |\n| | | | | | | | | | | | | |\n| | | June 30, 2023 |\n| | | Cost | | Accumulated Amortization | | Translation adjustments | | Net Book Value |\n| Customer Relationships | | $ | 3,142 | | $ | ( 371 ) | | $ | 191 | | $ | 2,962 |\n| Developed Technology | | | 4,967 | | | ( 312 ) | | | 309 | | | 4,964 |\n| Software | | | 254 | | | ( 68 ) | | | 14 | | | 200 |\n| Trade Name | | | 61 | | | ( 29 ) | | | 4 | | | 36 |\n| | | $ | 8,424 | | $ | ( 780 ) | | $ | 518 | | $ | 8,162 |\n| | | | | | | | | | | | | |\n| | | December 31, 2022 |\n| | | Cost | | Accumulated Amortization | | Translation adjustments | | Net Book Value |\n| Customer Relationships | | $ | 3,142 | | $ | ( 163 ) | | $ | 150 | | $ | 3,129 |\n| Developed Technology | | | 4,967 | | | ( 137 ) | | | 243 | | | 5,073 |\n| Software | | | 254 | | | ( 30 ) | | | 11 | | | 235 |\n| Trade Name | | | 61 | | | ( 13 ) | | | 3 | | | 51 |\n| | | $ | 8,424 | | $ | ( 343 ) | | $ | 407 | | $ | 8,488 |\n| | | | | | | | | | | | | | |\n| | | Three Months Ended June 30, | | Six Months Ended June 30, | |\n| | 2023 | 2022 | 2023 | 2022 | |\n| Product cost of revenue | | $ | 107 | | $ | — | | $ | 213 | | $ | — | |\n| Selling, general and administrative expenses | | | 112 | | | — | | | 224 | | | — | |\n| | | $ | 219 | | $ | — | | $ | 437 | | $ | — | |\n| | | | |\n| 2023 (six months) | | $ | 442 |\n| 2024 | | | 870 |\n| 2025 | | | 851 |\n| 2026 | | | 779 |\n| 2027 | | | 774 |\n| Thereafter | | | 4,446 |\n| | | $ | 8,162 |\n\n| | | | | | | |\n| | | June 30, | | December 31, |\n| | 2023 | 2022 |\n| Accrued employee compensation and benefits | | $ | 2,506 | | $ | 4,909 |\n| Accrued warranty | | | 854 | | 1,119 |\n| Accrued professional fees | | | 729 | | 677 |\n| Contingent consideration | | | 973 | | | 1,243 |\n| Accrued other | | | 972 | | 899 |\n| | | $ | 6,034 | | $ | 8,847 |\n| | | | | | | |\n| | | Six Months Ended June 30, |\n| | 2023 | 2022 |\n| Accrual balance at beginning of period | | $ | 1,119 | | $ | 1,593 |\n| Provision for new warranties | | 341 | | 1,166 |\n| Settlements and adjustments made during the period | | ( 606 ) | | ( 1,476 ) |\n| Accrual balance at end of period | | $ | 854 | | $ | 1,283 |\n\n2022 Loan RevolverOn November 2, 2022, the Company entered into a Loan and Security Agreement (the “2022 Revolver”), by and between, the Company, as borrower, and Silicon Valley Bank (“SVB”), as lender. The 2022 Revolver provided for a revolving line of credit of up to $ 35.0 million. The Company was permitted to make interest-only payments on the revolving line of credit through November 2, 2025, at which time all outstanding indebtedness would be immediately due and payable. The outstanding principal amount of any advance accrued interest at a floating rate per annum equal to the greater of (i) three and one-half percent ( 3.50 %) and (ii) the “prime rate” as published in The Wall Street Journal for the relevant period minus one-half percent ( 0.50 %). The Company’s obligations under the 2022 Revolver were secured by substantially all of the Company’s assets, excluding its intellectual property, which was subject to a negative pledge. The revolving line of credit under the 2022 Revolver was scheduled to terminate on November 2, 2025. As of June 30, 2023, there were no balances outstanding under the 2022 Revolver. As of December 31, 2022, the outstanding principal balance under the 2022 Revolver was $ 15.0 million, which was repaid in full on January 4, 2023. The interest rate applicable to borrowing under the 2022 Revolver was 7.0 % as of December 31, 2022.The 2022 Revolver also contained certain financial covenants, including a requirement that the amount of unrestricted and unencumbered cash minus advances under the 2022 Revolver, was not less than the amount equal to the greater of (i) $ 10.0 million or (ii) nine (9) months of cash burn. The 2022 Revolver contained customary representations and warranties, as well as certain non-financial covenants, including limitations on, among other things, the Company’s ability to change the principal nature of its business, dispose of the Company’s business or property, engage in any change of control transaction, merge or consolidate with any other entity or to acquire all or substantially all the capital stock or property of another entity, incur additional indebtedness or liens, pay dividends or make other distributions on capital stock, redeem the Company’s capital stock, engage in transactions with affiliates or otherwise encumber the Company’s intellectual property, in each case, subject to customary exceptions.On March 10, 2023, SVB, one of our financial institutions, was closed by the California Department of Financial Protection and Innovation, which appointed the Federal Deposit Insurance Corporation (“FDIC”) as receiver. On March 12, 2023, the U.S. Department of the Treasury, Federal Reserve Board, and FDIC released a joint statement announcing that the FDIC would complete its resolution of SVB in a manner that fully protected all depositors and that depositors would have access to all of their money starting March 13, 2023.As of March 31, 2023, the Company had transferred substantially all its cash and cash equivalents away from SVB and deposited the funds with new financial institutions. As a result of the transfer of the Company’s cash, cash equivalents and marketable securities, the Company was in default, and continued to be in default as of June 30, 2023, of its financial covenants under the 2022 Revolver. The Company recorded a loss on extinguishment of debt of $ 0.5 million in the three months ended March 31, 2023, which was included in interest expense in the condensed consolidated statements of operations and comprehensive loss. On August 4, 2023, the Company entered into a Default Waiver and First Amendment to Loan and Security Agreement (the “Amended 2022 Revolver”), by and between, the Company, as borrower, and SVB, as lender. The Amended 2022 Revolver provides for a revolving line of credit of up to $ 10.0 million. The Company is permitted to make interest-only payments on the revolving line of credit through November 2, 2025, at which time all outstanding indebtedness shall be immediately due and payable. The outstanding principal amount of any advance shall accrue interest at a floating rate per annum equal to the greater of (i) four and one-half percent ( 4.50 %) and (ii) the “prime rate” as published in The Wall Street Journal for the relevant period minus one-half percent ( 0.50 %). The Company’s obligations under the Amended 2022 Revolver are secured by substantially all of the Company’s assets, excluding its intellectual property, which is subject to a negative pledge. The revolving line of credit under the Amended 2022 Revolver terminates on November 2, 2025.Pursuant to the Amended 2022 Revolver, SVB waived filing any legal action or instituting or enforcing any rights and remedies it may have had against the Company in connection with the Company’s failing to maintain all of its operating accounts, depository accounts and excess cash with SVB, as previously required prior to the effectiveness of the Amended 2022 Revolver. 22\n| | | | | |\n| | | June 30, |\n| | 2023 | 2022 |\n| Warrants to purchase common stock | | 92,703 | | 92,703 |\n| Options to purchase common stock | | 2,499,439 | 2,764,916 |\n| Performance stock units | | 53,794 | | — |\n| Restricted stock units | | 1,867,917 | | 254,482 |\n| | 4,513,853 | 3,112,101 |\n\n| | | | | | | | | | | | | | |\n| | | Three Months Ended June 30, | | Six Months Ended June 30, | |\n| | 2023 | 2022 | 2023 | 2022 | |\n| Cost of revenue | | $ | 140 | | $ | 86 | | $ | 255 | | $ | 149 | |\n| Research and development expenses | | | 732 | | 421 | | | 1,327 | | 681 | |\n| Selling, general and administrative expenses | | | 1,706 | | 1,387 | | | 3,162 | | 2,353 | |\n| | | $ | 2,578 | | $ | 1,894 | | $ | 4,744 | | $ | 3,183 | |\n\n| | | | | | | | | | | | | |\n| | Three Months Ended June 30, | | Six Months Ended June 30, |\n| | 2023 | 2022 | | 2023 | 2022 |\n| Operating lease cost | | $ | 485 | | $ | 583 | | $ | 969 | | $ | 1,165 |\n| Short-term lease cost | | 16 | | 11 | | | 32 | | 20 |\n| Variable lease cost | | 27 | | 2 | | | 54 | | 4 |\n| | | $ | 528 | | $ | 596 | | $ | 1,055 | | $ | 1,189 |\n| | | | | | | | |\n| | Six Months Ended June 30, |\n| | 2023 | 2022 |\n| Cash paid for amounts included in the measurement of operating lease liabilities | | $ | 961 | | $ | 894 |\n| Operating lease liabilities arising from obtaining right-of-use assets | | $ | 3,014 | | $ | — | |\n| | | | | | |\n| | June 30, | | December 31, |\n| | 2023 | | 2022 |\n| Weighted-average remaining lease term - operating leases (in years) | | 4.25 | | 2.75 |\n| Weighted-average discount rate - operating leases | 8.5 | % | 9.5 | % |\n| | | | |\n| 2023 (six months) | | $ | 1,156 |\n| 2024 | | 2,431 |\n| 2025 | | 2,001 |\n| 2026 | | 580 |\n| 2027 | | | 594 |\n| Thereafter | | 1,347 |\n| Total future minimum lease payments | | 8,109 |\n| Less: imputed interest | | ( 1,287 ) |\n| Total operating lease liabilities | | $ | 6,822 |\n\n401(k) Savings PlanThe Company has a defined-contribution savings plan under Section 401(k) of the Internal Revenue Code. This plan covers substantially all employees who meet minimum age and service requirements and allows participants to defer a portion of their annual compensation on a pre-tax basis. Company contributions to the plan may be made at the discretion of the board of directors. On October 1, 2021, the Company commenced an employer match program whereby the Company matches 100 % of the first 3 % that each employee contributes to the plan, capped at a maximum of $ 3,500 per year per employee. During the six months ended June 30, 2023 and 2022, the Company made $ 0.3 million, respectively, in contributions to the plan. Contingent Consideration – Earnout and Pension LiabilityThe Company agreed to pay three milestone based earnouts under the Trace purchase agreement for the total potential payout of $ 2.0 million. Milestones are based on target revenues and technical integration of Trace systems and knowledge and range to June 30, 2024. During the six months ended June 30, 2023, the Company received notice that the pension obligation had been transferred and no longer in Trace’s name and therefore the Company released the $ 0.9 million assignment of the pension liability. The Trace acquisition consideration withheld in respect of the pension plan was paid out to the sellers in April 2023. See Note 13, Acquisition. Indemnification AgreementsIn the ordinary course of business, the Company may provide indemnification of varying scope and terms to vendors, lessors, business partners and other parties with respect to certain matters including, but not limited to, losses arising out of breach of such agreements or from intellectual property infringement claims made by third parties. In addition, the Company has entered into indemnification agreements with its executive officers and members of its board of directors that will require the Company, among other things, to indemnify them against certain liabilities that may arise by reason of their status or services as directors or officers. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is, in many cases, unlimited. To date, the Company has not incurred any material costs as a result of such indemnifications. The Company is not currently aware of any indemnification claims and had not accrued any liabilities related to such obligations in its condensed consolidated financial statements as of June 30, 2023.Legal ProceedingsThe Company is not currently party to any material legal proceedings. At each reporting date, the Company evaluates whether or not a potential loss amount or a potential range of loss is probable and reasonably estimable under the provisions of the authoritative guidance that addresses accounting for contingencies. The Company expenses as incurred the costs related to such legal proceedings. 13. AcquisitionOn August 3, 2022, the Company entered into a share purchase and transfer agreement and completed its acquisition of 100 % of the registered share capital of Trace, for total purchase price consideration of $ 17.3 million, comprised of (i) a $ 14.4 million initial cash payment, (ii) up to $ 2.0 million contingent cash consideration upon achievement of certain milestones over a twenty four month period and (iii) $ 0.9 million contingent pension liability holdback to be released upon discharging or transferring of such liability from Trace. Trace is a leading provider of online analysis systems for biotech applications in research, development and production. Trace’s products are used for monitoring and controlling of complex processes in industrial pharmaceutical productions under continuous measurement conditions. The Company expects to integrate acquired sampling technology within future product offerings. 26\n| | | | |\n| Consideration Transferred: | | | |\n| Cash paid | | $ | 14,400 |\n| Net cash and working capital adjustment | | | 113 |\n| Contingent consideration - pension liability | | | 900 |\n| Contingent consideration - earnout | | | 737 |\n| Total consideration transferred | | $ | 16,150 |\n| | | | |\n| Assets acquired and liabilities assumed: | | | |\n| Cash and cash equivalents | | $ | 638 |\n| Accounts receivable | | | 168 |\n| Inventory | | | 364 |\n| Prepaid expenses and other current assets | | | 11 |\n| Property and equipment, net | | | 32 |\n| Intangible assets | | | |\n| Customer Relationships | | | 3,142 |\n| Developed Technology | | | 4,967 |\n| Software | | | 254 |\n| Trade Name | | | 61 |\n| Goodwill | | | 9,566 |\n| Indemnification assets | | | 917 |\n| Pension liability | | | ( 917 ) |\n| Accounts payable, accrued expenses and other current liabilities | | | ( 306 ) |\n| Deferred tax liability, net | | | ( 2,672 ) |\n| Other liabilities | | | ( 75 ) |\n| Total | | $ | 16,150 |\n\n| | | | | | | |\n| | | June 30, | | December 31, |\n| | 2023 | 2022 |\n| Long-lived assets(1) by country: | | | | | | |\n| United States | | $ | 9,555 | | $ | 7,852 |\n| All other countries | | | 521 | | 63 |\n| Total long-lived assets | | $ | 10,076 | | $ | 7,915 |\n| (1) | Long-lived assets exclude goodwill, other intangible assets and other assets. |\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.\nThe following discussion and analysis of our financial condition and results of operations should be read in conjunction with our unaudited condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2022, as filed with the SEC on March 15, 2023 (“2022 Form 10-K”). Some of the information contained in this discussion and analysis or set forth elsewhere in this Quarterly Report on Form 10-Q, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors set forth in “Item 1.A. Risk Factors” section of our 2022 Form 10-K, our actual results could differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis.\nOverview\nWe have developed an innovative suite of purpose-built handheld and desktop devices for point-of-need chemical and biochemical analysis. Leveraging our proprietary mass spectrometry, or Mass Spec, microfluidics, and analytics and machine learning technologies, we make devices that are significantly smaller and more accessible than conventional laboratory instruments. Our devices are used at the point-of-need to interrogate unknown and invisible materials and provide quick, actionable answers to directly address some of the most critical problems in life sciences research, bioprocessing, pharma/biopharma, forensics and adjacent markets.\nWe create simplified measurement devices that our customers can use as accurate tools where and when their work needs to be done, rather than overly complex and centralized analytical instrumentation. We believe the insights and answers our devices provide will accelerate workflows, reduce costs, and offer transformational opportunities for our end users.\nFront-line workers rely upon our handheld devices to combat the opioid crisis and detect counterfeit pharmaceuticals and illicit materials in the air or on surfaces at levels 1,000 times below their lethal dose. Our desktop devices are accelerating development and production of biotherapeutics by identifying and quantifying extracellular species in bioprocessing critical to cell health and productivity. They sit alongside bioreactors and fermenters producing drug candidates, functional proteins, cell and gene therapies, and synthetic biology derived products. We believe the insights and answers our devices provide accelerate workflows, reduce costs, and offer transformational opportunities for our end users. The term “products” as used in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” refers to the MX908, Rebel, ZipChip Interface, Maven and related sampling devices.\nOn August 3, 2022, we entered into a share purchase and transfer agreement and completed our acquisition of 100% of the registered share capital of Trace, for a total purchase price consideration of $17.3 million, comprised of (i) a $14.4 million initial cash payment, (ii) up to $2.0 million contingent cash consideration upon achievement of certain milestones over a twenty-four-month period and (iii) $0.9 million contingent pension liability holdback to be released upon discharging or transferring of such liability from Trace. Trace is a leading provider of online analysis systems for biotech applications in research, development and production. Trace’s products are used for monitoring and control of complex processes in industrial pharmaceutical productions under continuous measurement conditions. We expect to integrate acquired sampling technology within future product offerings.\n28\nSince our inception, we have incurred significant operating losses. Our ability to generate revenue sufficient to achieve profitability will depend on the successful further development and commercialization of our products. We generated revenue of $21.6 million and $19.4 million for the six months ended June 30, 2023 and 2022, respectively, and incurred net losses of $21.9 million and $17.5 million for those same periods. As of June 30, 2023, we had an accumulated deficit of $156.1 million. We expect to continue to incur net losses as we focus on growing commercial sales of our products in both the United States and international markets, including growing our sales teams, scaling our manufacturing operations, continuing research and development efforts to develop new products and further enhance our existing products. Further, we expect to incur additional costs associated with operating as a public company. As a result, we may need additional funding for expenses related to our operating activities, including selling, general and administrative expenses and research and development expenses.Because of the numerous risks and uncertainties associated with product development and commercialization, we are unable to accurately predict the timing or amount of increased expenses or when, or if, we will be able to achieve or maintain profitability. Until such time, if ever, as we can generate substantial revenue sufficient to achieve profitability, we expect to finance our operations through a combination of equity offerings, debt financings and strategic alliances. We may be unable to raise additional funds or enter into such other agreements or arrangements when needed on favorable terms, or at all. If we are unable to raise capital or enter into such agreements as, and when, needed, we may have to significantly delay, scale back or discontinue the further development and commercialization efforts of one or more of our products, or may be forced to reduce or terminate our operations.We believe that our existing cash and cash equivalents and revenue from product and service will enable us to fund our operating expenses, capital expenditure requirements and debt service payments for at least the next 12 months. We have based this estimate on assumptions that may prove to be wrong, and we could exhaust our available capital resources sooner than we expect. See “Liquidity and Capital Resources.”Global Economic ConditionsWe are continuing to closely monitor macroeconomic impacts, including, but not limited to, continued inflationary and interest rate pressures, challenging capital markets and financing alternatives and developments affecting financial institutions on our business, results of operations and financial results.We are closely monitoring continued economic uncertainty in the United States and abroad, including volatility in the global markets and the rise and fluctuations in inflation and interest rates. These developments and the potential worsening of other macro-economic conditions present risks for us, and our suppliers and customers. For example, general inflation in the United States, EMEA and other geographies has risen to levels not experienced in recent decades, which has led to rising prices for our raw materials and other inputs, as well as rising salaries and travel expenses, which could continue to negatively impact our business by increasing our cost of sales and operating expenses. General inflation could also negatively impact our business if it leads to spending pressure and decreased available capital for our customers to deploy to purchase our products and services. In addition, the United States Federal Reserve has raised, and may again raise, interest rates in response to concerns about inflation. Inflation, together with increased interest rates, may cause our customers to reduce or delay orders for our goods and services thereby causing a decrease in or change in timing of sales of our products and services. The impact of future inflation and interest rate fluctuations on the results of our operations cannot be accurately predicted.There also continues to be a challenging environment for the public capital markets and other financing alternatives to raise cash, which, together with inflationary and interest rates pressures, may be contributing to more cautious spending by our customers. Certain of our pharmaceutical and biotechnology customers, including bioprocessing customers, may evaluate their inventory levels, cash on hand and path to profitability, and institute cost controls and take other actions to reduce or delay purchases of our products and services. We cannot accurately predict the extent of the full impact on the budgets and capital expenditures of our customers, or the timing of the normalization of customer purchasing patterns. We are also monitoring ongoing events involving limited liquidity, defaults, non-performance or other adverse developments that affect financial institutions or other companies in the financial services industry or the financial services industry generally, including SVB, being closed by the California Department of Financial Protection and Innovation, which appointed the FDIC as receiver on March 10, 2023, Signature Bank being closed by its New York State Department of 29\nFinancial Services on March 12, 2023, and other financial institutions. We are also monitoring the impacts that these events may have on our customers and vendors. Despite the steps taken to date by U.S. agencies to protect depositors, and the subsequent acquisition of SVB by First-Citizens Bank & Trust Company, the follow-on effects of the events surrounding the SVB and Signature Bank failures and pressure on other banks are unknown, and could include failures of other financial institutions to which we may encounter direct or indirect exposure. The extent of such impacts is uncertain, and there may be additional risks that we have not yet identified. We continue to monitor the situation on U.S. financial institutions and potential impact on our business.While conditions related to the COVID-19 pandemic generally have improved further in the first half of 2023 compared to fiscal 2022, and our business operations are no longer significantly impacted, we will continue to monitor supply chain risks and other potential lingering impacts. On April 10, 2023, the U.S. announced that the public health emergency related to COVID-19 ended. The Company does not anticipate significant impact from the expiration of the public health emergency.While it is difficult to predict all of the impacts these global economic events and developments affecting financial institutions, and rising inflation and interest rates will have on our business and to predict the effects of these factors on our customers’ spending in the near term, we believe the long-term opportunity that we see for our products and services remain unchanged.For further discussion of the possible impacts of these global factors and other risks on our business, see Part I, Item 1A, “Risk Factors,” of our 2022 Form 10-K.Factors Affecting Our PerformanceWe believe that our financial performance has been and in the foreseeable future will continue to be primarily driven by the following factors. While each of these factors presents significant opportunities for our business, they also pose important challenges that we must successfully address to sustain our growth and improve our results of operations. Our ability to successfully address the factors below is subject to various risks and uncertainties.Device salesOur financial performance has largely been driven by, and in the future will continue to be impacted by, the rate of sales of our handheld and desktop devices. Management focuses on device sales as an indicator of current business success and a leading indicator of likely future recurring revenue from consumables and services. We expect our device sales to continue to grow as we increase penetration in our existing markets and expand into, or offer new features and solutions that appeal to, new markets.We plan to grow our device sales in the coming years through multiple strategies including expanding our sales efforts domestically and globally and continuing to enhance the underlying technology and applications for life sciences research related to our Rebel, ZipChip Interface, Maven and related sampling devices. We regularly solicit feedback from our customers and focus our research and development efforts on enhancing our devices and enabling our customers to use additional applications that address their needs, which we believe in turn helps to drive additional sales of our devices and consumables.Our sales process varies considerably depending upon the type of customer to whom we are selling. Historically, our handheld devices have been used by state, federal and foreign governments and governmental agencies. Our sales process with government customers is often long and involves multiple levels of approvals, testing and, in some cases, trials. Device orders from a government customer are typically large orders and can be impacted by the timing of their capital budgets. As a result, the revenue for our handheld devices can vary significantly from period-to-period and has been and may continue to be concentrated in a small number of customers in any given period.Our desktop devices are typically used by the pharmaceutical, biotechnology and academia markets. Our sales cycles within these markets tend to vary based on the size of the customer and the number of devices they purchase. Our shortest sales cycles are typically for small laboratories and individual researchers where, in some cases, we receive purchase orders from these customers within three months. Our sales process with other institutions can be longer with most customers submitting purchase orders within six to twelve months. Given the variability of our sales cycle, we have in the past experienced, and likely will in the future experience, fluctuations in our desktop device sales on a period-to-period basis. 30\n| ● | Testing—a customer is actively engaged with internal or external testing of our products. This may include an onsite or virtual demonstration with a salesperson, a customer submitting samples for testing in one of our facilities or testing by a third party. |\n| ● | Trials—a customer has committed to a trial of one of our products, which may include a defined period to assess functionality of the device in their operational environment (in the field or onsite within the customer’s facility). |\n| ● | Pilot—a customer commits to the purchase of an initial quantity of devices to deploy in their operational environment to assess a broader opportunity that may grow to tens or hundreds of devices. |\n\n| ● | Deployment—a customer has completed testing, a trial, and/or a pilot and intends to roll out the technology across their enterprise (either at a site or throughout the entire organization). |\n| | | | | | | | | | |\n| | | Three Months Ended June 30, | | Six Months Ended June 30, | |\n| | 2023 | 2022 | 2023 | 2022 | |\n| Product Placements: | | | | | | | |\n| Handheld | 107 | 102 | 169 | 165 |\n| Desktop | 15 | 22 | 31 | 42 |\n| | | | | | |\n| | | June 30, | |\n| | 2023 | 2022 | |\n| Cumulative Product Placements: | | | | |\n| Handheld | 2,189 | 1,815 |\n| Desktop | 401 | 327 |\n| ● | Handheld devices—MX908; and |\n| ● | Desktop devices—Rebel and ZipChip Interface, Maven and related sampling devices. |\n| ● | MX908—accessories and swabs; |\n| ● | Rebel—consumables kit with a microfluidic chip and standards; |\n\n| ● | ZipChip Interface—microfluidic chip, reagent and assay kits; and |\n| ● | Maven and related sampling devices—probes, tubing sets and accessories. |\n| | | | | | | | | | | | | |\n| | | Three Months Ended June 30, | | Six Months Ended June 30, |\n| | 2023 | 2022 | 2023 | 2022 |\n| Product and service revenue: | | | | |\n| Device sales revenue | | $ | 7,959 | | $ | 7,755 | | $ | 13,042 | | $ | 13,287 |\n| Recurring revenue | | 3,990 | | 2,853 | | 8,169 | | 5,350 |\n| Total product and service revenue | | 11,949 | | 10,608 | | 21,211 | | 18,637 |\n| Contract revenue | | 145 | | 498 | | 370 | | 775 |\n| Total revenue | | $ | 12,094 | | $ | 11,106 | | $ | 21,581 | | $ | 19,412 |\n| | | | | | | | | | | | | |\n| | Three Months Ended June 30, | | Six Months Ended June 30, | |\n| | 2023 | 2022 | 2023 | 2022 | |\n| Government | $ | 8,812 | | $ | 7,002 | | $ | 14,992 | | $ | 11,719 | |\n| Pharmaceutical/Biotechnology | | 3,106 | | 3,577 | | | 6,158 | | 6,705 | |\n| Academia and other | | 31 | | 29 | | | 61 | | 213 | |\n| Total product and service revenue | $ | 11,949 | | $ | 10,608 | | $ | 21,211 | | $ | 18,637 | |\n\n| ● | employee-related expenses, including salaries, related benefits and stock-based compensation expense for employees engaged in research and hardware and software development functions; |\n| ● | the cost of maintaining and improving our product designs, including third party development costs for new products and materials for prototypes; |\n| ● | research materials and supplies; and |\n| ● | facilities, depreciation and other expenses, which include direct and allocated expenses for rent and maintenance of facilities and insurance. |\n\ndemonstration equipment, broaden our customer base and grow our business. We also anticipate that we will incur increased accounting, audit, legal, regulatory, compliance and director and officer insurance costs as well as investor and public relations expenses associated with operating as a public company.Other Income (Expense)Interest incomeInterest income consists of interest earned on our invested cash balances.Interest expenseInterest expense consists of interest expense associated with outstanding borrowings under our loan and security agreements and the amortization of deferred financing costs and debt discounts associated with such arrangements. In the three and six months ended June 30, 2023, our interest expense also includes our loss on debt extinguishment resulting from the write off of the initial fees incurred and potential termination fees related to our 2022 Revolver.Other income (expense), netOther income (expense), net consists of miscellaneous other income and expense unrelated to our core operations.Provision for Income TaxesWe have not recorded any U.S. federal or state income tax benefits for the net operating losses we have incurred in each year or for the research and development tax credits we generated in the United States and have recorded a full valuation allowance against our net deferred assets, as we believe, based upon the weight of available evidence, that it is more likely than not that all of our net operating loss carryforwards and tax credits will not be realized. As of December 31, 2022, we had gross federal and state operating loss carryforwards of $92.3 million and $64.0 million, respectively, which may be available to offset future taxable income and begin to expire in 2032 and 2025, respectively, of which $57.9 million of federal gross operating losses do not expire. As of December 31, 2022, we also had U.S. federal and state research and development tax credit carryforwards of $5.9 million and $2.8 million, respectively, which may be available to offset future tax liabilities and begin to expire in 2032 and 2029, respectively.35\n| | | | | | | | | | |\n| | | Three Months Ended June 30, | | | |\n| | 2023 | 2022 | Change |\n| | | (in thousands) |\n| Revenue: | | | |\n| Product revenue | | $ | 9,595 | | $ | 9,082 | | $ | 513 |\n| Service revenue | | | 2,354 | | | 1,526 | | | 828 |\n| Contract revenue | | 145 | | 498 | | (353) |\n| Total revenue | | 12,094 | | 11,106 | | 988 |\n| Cost of revenue: | | | |\n| Product cost of revenue | | 4,800 | | 3,304 | | 1,496 |\n| Service cost of revenue | | | 1,448 | | | 1,057 | | | 391 |\n| Contract cost of revenue | | 52 | | 111 | | (59) |\n| Total cost of revenue | | 6,300 | | 4,472 | | 1,828 |\n| Gross profit | | 5,794 | | 6,634 | | (840) |\n| Operating expenses: | | | |\n| Research and development | | 5,525 | | 4,293 | | 1,232 |\n| Selling, general and administrative | | 11,208 | | 10,710 | | 498 |\n| Total operating expenses | | 16,733 | | 15,003 | | 1,730 |\n| Loss from operations | | (10,939) | | (8,369) | | (2,570) |\n| Other income (expense): | | | |\n| Interest income | | | 1,689 | | | 293 | | | 1,396 |\n| Interest expense | | — | | (15) | | 15 |\n| Other expense, net | | (167) | | (8) | | (159) |\n| Total other income, net | | 1,522 | | 270 | | 1,252 |\n| Loss from operations before income taxes | | | (9,417) | | | (8,099) | | | (1,318) |\n| Benefit for income taxes | | | 71 | | | — | | | 71 |\n| Net loss | | $ | (9,346) | | $ | (8,099) | | $ | (1,247) |\n| | | | | | | | | | | | | |\n| | | Three Months Ended June 30, | | Change | |\n| | 2023 | 2022 | Amount | % | |\n| | | (dollars in thousands) | |\n| Product revenue | | $ | 9,595 | | $ | 9,082 | | $ | 513 | 6 | % |\n| Product cost of revenue | | 4,800 | | 3,304 | | 1,496 | 45 | % |\n| Gross profit | | $ | 4,795 | | $ | 5,778 | | $ | (983) | (17) | % |\n| Gross profit margin | | 50 | % | 64 | % | (14) | % | | |\n\n| | | | | | | | | | | | | |\n| | | Three Months Ended June 30, | | Change | |\n| | 2023 | 2022 | Amount | % | |\n| | | (dollars in thousands) | |\n| Service revenue | | $ | 2,354 | | $ | 1,526 | | $ | 828 | 54 | % |\n| Service cost of revenue | | 1,448 | | 1,057 | | 391 | 37 | % |\n| Gross profit | | $ | 906 | | $ | 469 | | $ | 437 | 93 | % |\n| Gross profit margin | | 38 | % | 31 | % | 7 | % | | |\n\n| | | | | | | | | | | | | |\n| | | Three Months Ended June 30, | | Change | |\n| | 2023 | 2022 | Amount | % | |\n| | | (dollars in thousands) | |\n| Contract revenue | | $ | 145 | | $ | 498 | | $ | (353) | (71) | % |\n| Contract cost of revenue | | 52 | | 111 | | (59) | (53) | % |\n| Gross profit | | $ | 93 | | $ | 387 | | $ | (294) | (76) | % |\n| Gross profit margin | | | 64 | % | | 78 | % | | (14) | % | | |\n| | | | | | | | | | | | | |\n| | | Three Months Ended June 30, | | Change | |\n| | 2023 | 2022 | Amount | % | |\n| | | (dollars in thousands) | |\n| Research and development expenses | | $ | 5,525 | | $ | 4,293 | $ | 1,232 | 29 | % |\n| Percentage of total revenue | | 46 | % | 39 | % | | | | |\n| | | | | | | | | | | | | |\n| | | Three Months Ended June 30, | | Change | |\n| | 2023 | 2022 | Amount | % | |\n| | | (dollars in thousands) | |\n| Selling, general and administrative expenses | | $ | 11,208 | | $ | 10,710 | | $ | 498 | 5 | % |\n| Percentage of total revenue | | 93 | % | 96 | % | | | | | |\n\n| | | | | | | | | | |\n| | | Six Months Ended June 30, | | | |\n| | 2023 | 2022 | Change |\n| | | (in thousands) |\n| Revenue: | | | | | | |\n| Product revenue | | $ | 16,617 | | $ | 15,589 | | $ | 1,028 |\n| Service revenue | | | 4,594 | | | 3,048 | | | 1,546 |\n| Contract revenue | | 370 | | 775 | | (405) |\n| Total revenue | | 21,581 | | 19,412 | | 2,169 |\n| Cost of revenue: | | | |\n| Product cost of revenue | | 8,586 | | 6,276 | | 2,310 |\n| Service cost of revenue | | | 2,718 | | | 2,126 | | | 592 |\n| Contract cost of revenue | | 99 | | 247 | | (148) |\n| Total cost of revenue | | 11,403 | | 8,649 | | 2,754 |\n| Gross profit | | 10,178 | | 10,763 | | (585) |\n| Operating expenses: | | | |\n| Research and development | | 10,923 | | 8,198 | | 2,725 |\n| Selling, general and administrative | | 23,211 | | 20,455 | | 2,756 |\n| Total operating expenses | | 34,134 | | 28,653 | | 5,481 |\n| Loss from operations | | (23,956) | | (17,890) | | (6,066) |\n| Other income: | | | |\n| Interest income | | | 2,706 | | | 464 | | | 2,242 |\n| Interest expense | | (551) | | (35) | | (516) |\n| Other expense, net | | | (200) | | (53) | | (147) |\n| Total other income, net | | 1,955 | | 376 | | 1,579 |\n| Loss from operations before income taxes | | | (22,001) | | | (17,514) | | | (4,487) |\n| Benefit for income taxes | | | 122 | | | — | | | 122 |\n| Net loss | | $ | (21,879) | | $ | (17,514) | | $ | (4,365) |\n\n| | | | | | | | | | | | | |\n| | | Six Months Ended June 30, | | Change |\n| | 2023 | 2022 | Amount | % |\n| | | (dollars in thousands) |\n| Product revenue | | $ | 16,617 | | $ | 15,589 | | $ | 1,028 | 7 | % |\n| Product cost of revenue | | 8,586 | | 6,276 | | 2,310 | 37 | % |\n| Gross profit | | $ | 8,031 | | $ | 9,313 | | $ | (1,282) | (14) | % |\n| Gross profit margin | | 48 | % | 60 | % | (12) | % | |\n| | | | | | | | | | | | | |\n| | | Six Months Ended June 30, | | Change |\n| | 2023 | 2022 | Amount | % |\n| | | (dollars in thousands) |\n| Service revenue | | $ | 4,594 | | $ | 3,048 | | $ | 1,546 | 51 | % |\n| Service cost of revenue | | 2,718 | | 2,126 | | 592 | 28 | % |\n| Gross profit | | $ | 1,876 | | $ | 922 | | $ | 954 | 103 | % |\n| Gross profit margin | | 41 | % | 30 | % | 11 | % | |\n\n| | | | | | | | | | | | | |\n| | | Six Months Ended June 30, | | Change |\n| | 2023 | 2022 | Amount | % |\n| | | (dollars in thousands) |\n| Contract revenue | | $ | 370 | | $ | 775 | | $ | (405) | (52) | % |\n| Contract cost of revenue | | 99 | | 247 | | (148) | (60) | % |\n| Gross profit | | $ | 271 | | $ | 528 | | $ | (257) | (49) | % |\n| Gross profit margin | | 73 | % | | 68 | % | | 5 | % | |\n| | | | | | | | | | | | | |\n| | | Six Months Ended June 30, | | Change |\n| | 2023 | 2022 | Amount | % |\n| | | (dollars in thousands) |\n| Research and development expenses | | $ | 10,923 | | $ | 8,198 | | $ | 2,725 | 33 | % |\n| Percentage of total revenue | | 51 | % | 42 | % | |\n\n| | | | | | | | | | | | | |\n| | | Six Months Ended June 30, | | Change |\n| | 2023 | 2022 | Amount | % |\n| | | (dollars in thousands) |\n| Selling, general and administrative expenses | | $ | 23,211 | | $ | 20,455 | | $ | 2,756 | 13 | % |\n| Percentage of total revenue | | 108 | % | 105 | % | |\n| ● | market uptake of our products and growth into new and existing markets; |\n| ● | the cost of our research and development efforts to expand the applications of our current devices and to create enhanced products with our platform of technologies; |\n\n| ● | the cost of expanding our commercial operations, including distribution capabilities, and accelerating planned investments, such as hiring additional support, service, and sales management in Europe, Asia Pacific and Latin America, bolstering our infrastructure in these regions; |\n| ● | the cost of acquiring complementary businesses, products, services or technologies, when and if required; |\n| ● | the success of our existing collaborations and our ability to enter additional collaborations in the future; |\n| ● | the effect of competing technological and market developments; and |\n| ● | the level of our selling, general and administrative expenses. |\n\nmillion or (ii) nine (9) months of cash burn. The 2022 Revolver contained customary representations and warranties, as well as certain non-financial covenants, including limitations on, among other things, our ability to change the principal nature of our business, dispose of our business or property, engage in any change of control transaction, merge or consolidate with any other entity or to acquire all or substantially all the capital stock or property of another entity, incur additional indebtedness or liens, pay dividends or make other distributions on capital stock, redeem our capital stock, engage in transactions with affiliates or otherwise encumber our intellectual property, in each case, subject to customary exceptions.On March 10, 2023, SVB, one of our financial institutions, was closed by the California Department of Financial Protection and Innovation, which appointed the FDIC as receiver. As of March 31, 2023, the Company had transferred substantially all its cash and cash equivalents away from SVB and deposited the funds with new financial institutions. As a result of the transfer of the Company’s cash, cash equivalents and marketable securities, the Company was in default, and continued to be in default as of June 30, 2023, of its financial covenants under the 2022 Revolver. The Company recorded a loss on extinguishment of $0.5 million in the three months ended March 31, 2023, which was included in interest expense in the condensed consolidated statements of operations and comprehensive loss. On August 4, 2023, the Company entered into the Amended 2022 Revolver, by and between, the Company, as borrower, and SVB, as lender. The Amended 2022 Revolver provides for a revolving line of credit of up to $10.0 million. The Company is permitted to make interest-only payments on the revolving line of credit through November 2, 2025, at which time all outstanding indebtedness shall be immediately due and payable. The outstanding principal amount of any advance shall accrue interest at a floating rate per annum equal to the greater of (i) four and one-half percent (4.50%) and (ii) the “prime rate” as published in The Wall Street Journal for the relevant period minus one-half percent (0.50%). The Company’s obligations under the Amended 2022 Revolver are secured by substantially all of the Company’s assets, excluding its intellectual property, which is subject to a negative pledge. The revolving line of credit under the Amended 2022 Revolver terminates on November 2, 2025.Pursuant to the Amended 2022 Revolver, SVB waived filing any legal action or instituting or enforcing any rights and remedies it may have had against the Company in connection with the Company’s failing to maintain all of its operating accounts, depository accounts and excess cash with SVB, as previously required prior to the effectiveness of the Amended 2022 Revolver. The Amended 2022 Revolver also contains certain financial covenants, including a requirement that the Company maintain $20.0 million on account at or through SVB and the amount of unrestricted and unencumbered cash minus advances under the Amended 2022 Revolver, is not less than the amount equal to the greater of (i) $10.0 million or (ii) nine (9) months of cash burn. The Amended 2022 Revolver contains customary representations and warranties, as well as certain non-financial covenants, including limitations on, among other things, the Company’s ability to change the principal nature of its business, dispose of the Company’s business or property, engage in any change of control transaction, merge or consolidate with any other entity or to acquire all or substantially all the capital stock or property of another entity, incur additional indebtedness or liens, pay dividends or make other distributions on capital stock, redeem the Company’s capital stock, engage in transactions with affiliates or otherwise encumber the Company’s intellectual property, in each case, subject to customary exceptions.We may seek additional funding through private or public equity financings, debt financings, collaborations, strategic alliances and marketing, distribution or licensing arrangements. We cannot assure you that we will be able to obtain additional funds on acceptable terms, or at all. If we raise additional funds by issuing equity or equity-linked securities, our stockholders may experience dilution. Future debt financing, if available, may involve covenants, in addition to our existing covenants, restricting our operations or our ability to incur additional debt or potentially limiting our ability to obtain new debt financing or the refinance of our existing debt. Any debt or equity financing that we raise may contain terms that are not favorable to us or our stockholders. If we raise additional funds through collaboration and licensing arrangements with third parties, it may be necessary to relinquish some rights to our technologies or our products, or grant licenses on terms that are not favorable to us. If we do not have or are not able to obtain sufficient funds, we may have to delay development or commercialization of our products. We also may have to reduce marketing, customer support or other resources devoted to our products or cease operations. 44\n| | | | | | | |\n| | | Six Months Ended June 30, |\n| | 2023 | 2022 |\n| | | (in thousands) |\n| Cash used in operating activities | | $ | (18,529) | | $ | (10,876) |\n| Cash used in investing activities | | (21,121) | | (689) |\n| Cash (used in) provided by financing activities | | (15,782) | | 597 |\n| Effect of foreign exchange rate changes on cash and cash equivalents | | | 6 | | | — |\n| Net decrease in cash, cash equivalents and restricted cash | | $ | (55,426) | | $ | (10,968) |\n\nFor a further discussion of our critical accounting policies, please refer to Note 2 to our unaudited condensed consolidated financial statements included in this Quarterly Report on Form 10-Q and our 2022 Report on Form 10-K. There were no significant changes to our critical accounting policies for the six months ended June 30, 2023.Recently Issued Accounting PronouncementsA description of recently issued accounting pronouncements that may potentially impact our financial position and results of operations is disclosed in Note 2 to our unaudited condensed consolidated financial statements included in this Quarterly Report on Form 10-Q and is incorporated herein by reference.\nItem 3. Quantitative and Qualitative Disclosures About Market Risk.\nWe are a smaller reporting company, as defined in Rule 12b-2 under the Exchange Act for this reporting period and are not required to provide the information required under this item.\n\nItem 4. Controls and Procedures.\nOur management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a- 15(e) and 15d- 15(e) under the Exchange Act), as of the end of the period covered by this Quarterly Report on Form 10-Q. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and our management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q, our principal executive officer and principal financial officer have concluded that as of such date, our disclosure controls and procedures were effective at a reasonable assurance level.\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting during our most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n\n\n46\nPART II—OTHER INFORMATION\nItem 1. Legal Proceedings.\nWe are not currently party to any material legal proceedings.\n\n\nItem 1A. Risk Factors.\nOur operations and financial results are subject to various risks and uncertainties. A detailed discussion of the risks that affect our business is included in the section titled “Item 1A. Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2022, as filed with the SEC on March 15, 2023, or 2022 Form 10-K. There have been no material changes to our risk factors during the three months ended June 30, 2023 from those discussed in our 2022 Form 10-K.\n\n\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\nNone.\nItem 3. Defaults Upon Senior Securities.\nNone.\nItem 4. Mine Safety Disclosures.\nNone.\nItem 5. Other Information.\nNone.\n47\nItem 6. Exhibits.\n\n| |\n| ExhibitNumber | Description |\n| | | |\n| 31.1 | | Certification of Chief Executive Officer of the Registrant Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| | | |\n| 31.2 | | Certification of Chief Financial Officer of the Registrant Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| | | |\n| 32.1† | | Certification of Chief Executive Officer of the Registrant Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| | | |\n| 32.2† | | Certification of Chief Financial Officer of the Registrant Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 10.18 | | Default Waiver and First Amendment to Loan and Security Agreement, dated as of August 4, 2023, by and between 908 Devices Inc. and Silicon Valley Bank, a division of First-Citizens Bank & Trust Company (successor by purchase to the Federal Deposit Insurance Corporation as Receiver for Silicon Valley Bridge Bank, N.A. (as successor to Silicon Valley Bank)) (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K (File No. 001-39815) filed with the SEC on August 8, 2023) |\n| 101.INS | | Inline XBRL Instance Document |\n| | | |\n| 101.SCH | | Inline XBRL Taxonomy Extension Schema Document |\n| | | |\n| 101.CAL | | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| | | |\n| 101.LAB | | Inline XBRL Taxonomy Extension Labels Linkbase Document |\n| | | |\n| 101.PRE | | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| | | |\n| 101.DEF | | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| | | |\n| 104 | | Cover Page Data File (the cover page XBRL tags are embedded within the iXBRL document). |\n\n| † | The certifications attached as Exhibits 32.1 and 32.2 that accompany this Quarterly Report on Form 10-Q, are not deemed filed with the Securities and Exchange Commission and are not to be incorporated by reference into any filing of 908 Devices Inc. under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this Quarterly Report on Form 10-Q, irrespective of any general incorporation language contained in such filing. |\n\n\n48\n| | | | |\n| | | 908 DEVICES INC. |\n| | | | |\n| Date: August 8, 2023 | | By: | /s/ Kevin J. Knopp, Ph.D. |\n| | | Kevin J. Knopp, Ph.D.Chief Executive Officer(Principal Executive Officer) |\n| | | | |\n| Date: August 8, 2023 | | By: | /s/ Joseph H. Griffith IV |\n| | | Joseph H. Griffith IVChief Financial Officer(Principal Financial Officer) |\n\n</text>\n\nWhat is the total potential amount, in millions, of tax that the company could save if it manages to apply all of its federal and state operating loss carryforwards and research and development tax credit carryforwards, with the federal and state income tax rates of 21% and 6% respectively?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"ground_truth": "Therefore, the answer is 24.63."
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docmath_0_20000
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nMALO HOLDINGS CORPORATION\nCONDENSED BALANCE SHEETS\n\n| September 30, 2020 | December 31, 2019 |\n| (Unaudited) |\n| ASSETS |\n| Current assets |\n| Cash | $ | 3,956 | $ | 224 |\n| Total current assets | 3,956 | 224 |\n| Total assets | $ | 3,956 | $ | 224 |\n| LIABILITIES AND STOCKHOLDERS’ DEFICIT |\n| Current liabilities |\n| Accounts payable and accrued expenses | $ | 13,010 | $ | 3,173 |\n| Note payable - stockholder | 98,010 | 65,510 |\n| Total current liabilities | 111,020 | 68,683 |\n| Total liabilities | 111,020 | 68,683 |\n| Commitments and contingencies |\n| Stockholders’ deficit |\n| Preferred stock, $.0001 par value, 5,000,000 shares authorized, 0 shares issued and outstanding | - | - |\n| Common stock, $.0001 par value, 50,000,000 shares authorized, 5,000,000 shares issued and outstanding | 500 | 500 |\n| Accumulated deficit | (107,564 | ) | (68,959 | ) |\n| Total stockholders’ deficit | (107,064 | ) | (68,459 | ) |\n| Total liabilities and stockholders’ deficit | $ | 3,956 | $ | 224 |\n\nSee accompanying notes to condensed financial statements\n1\nMALO HOLDINGS CORPORATION\nCONDENSED STATEMENTS OF OPERATIONS\n\n| For the three months ended | For the three months ended | For the nine months ended | For the nine months ended |\n| September 30, 2020 | September 30, 2019 | September 30, 2020 | September 30, 2019 |\n| (Unaudited) | (Unaudited) | (Unaudited) | (Unaudited) |\n| Revenue | $ | - | $ | - | $ | - | $ | - |\n| General and administrative expenses | 16,964 | 7,862 | 34,767 | 23,356 |\n| Loss from operations | (16,964 | ) | (7,862 | ) | (34,767 | ) | (23,356 | ) |\n| Other expense |\n| Interest expense | 1,458 | 854 | 3,838 | 2,197 |\n| Net loss | $ | (18,422 | ) | $ | (8,716 | ) | $ | (38,605 | ) | $ | (25,553 | ) |\n| Loss per common share - basic and dilutive | $ | (0.00 | ) | $ | (0.00 | ) | $ | (0.01 | ) | $ | (0.01 | ) |\n| Weighted average common shares outstanding - basic and dilutive | 5,000,000 | 5,000,000 | 5,000,000 | 5,000,000 |\n\nSee accompanying notes to condensed financial statements\n2\nMALO HOLDINGS CORPORATION\nCONDENSED STATEMENT OF CHANGES IN STOCKHOLDERS’ (DEFICIT)\n(Unaudited)\nFor the Nine months Ended September 30, 2020\n\n| Preferred Stock | Common Stock | Accumulated | Stockholders’ |\n| Shares | Amount | Shares | Amount | Deficit | (Deficit) |\n| Balance, December 31, 2019 | - | $ | - | 5,000,000 | $ | 500 | $ | (68,959 | ) | $ | (68,459 | ) |\n| Net loss | - | $ | - | - | $ | - | $ | (38,605 | ) | $ | (38,605 | ) |\n| Balance, September 30, 2020 | - | $ | - | 5,000,000 | $ | 500 | $ | (107,564 | ) | $ | (107,064 | ) |\n\nSee accompanying notes to condensed financial statements\n3\nMALO HOLDINGS CORPORATION\nCONDENSED STATEMENTS OF CASH FLOWS\n\n| For the nine months ended | For the nine months ended |\n| September 30, 2020 | September 30, 2019 |\n| (Unaudited) | (Unaudited) |\n| Cash flows from operating activities: |\n| Net loss | $ | (38,605 | ) | $ | (25,553 | ) |\n| Adjustments to reconcile net loss to net cash (used in) operating activities: |\n| Increase in accounts payable and accrued expenses | 9,837 | 2,197 |\n| Net cash (used in) operating activities | (28,768 | ) | (23,356 | ) |\n| Cash flow from financing activities: |\n| Proceeds from the sale of common stock | - | 25 |\n| Proceeds from note payable - stockholder | 32,500 | 23,485 |\n| Net cash provided by financing activities | 32,500 | 23,510 |\n| Net change in cash | 3,732 | 154 |\n| Cash, beginning of period | 224 | - |\n| Cash, end of period | $ | 3,956 | $ | 154 |\n\nSee accompanying notes to condensed financial statements\n4\nMALO HOLDINGS CORPORATION\nNOTES TO CONDENSED FINANCIAL STATEMENTS\n(UNAUDITED)\nSeptember 30, 2020\nNote 1 – Nature of Operations\nMalo Holdings Corporation (the “Company”) was incorporated in the State of Delaware on December 27, 2018 with the objective to acquire, or merge with, an operating business.\nThe Company was organized as a vehicle to investigate and, if such investigation warrants, acquire a target company or business seeking the perceived advantages of being a publicly traded corporation. The Company’s principal business objective is to achieve long-term growth potential through a combination with a business, rather than immediate short-term earnings. The Company will not restrict its potential target companies to any specific business, industry, or geographical location. The analysis of business opportunities will be undertaken by, or under the supervision of, the officer and directors of the Company.\nNote 2 – Summary of Significant Accounting Policies\nBasis of Presentation\nThe accompanying unaudited condensed interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and applicable rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Certain information and note disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. As such, the information included in this quarterly report on Form 10-Q should be read in conjunction with the financial statements and accompanying notes included in the Form 10-K filed with the SEC on March 30, 2020. The balance sheet as of December 31, 2019 included herein was derived from the audited financial statements as of that date but does not include all disclosures including notes required by GAAP. In the opinion of management, all adjustments for a fair presentation of the results of operations and financial position for the interim period presented have been included. All such adjustments are of a normal recurring nature. Interim results are not necessarily indicative of the results for a full year.\nEmerging Growth Company\nThe Company is an “emerging growth company” and has elected to use the extended transition period for complying with new or revised accounting standards under Section 102(b)(1) of the JOBS Act. This election allows the Company to delay the adoption of new or revised accounting standards that have different effective dates for public and private companies until those standards apply to private companies.\nRecent Accounting Pronouncements\nManagement does not believe that any recently issued yet effective accounting pronouncements, if adopted, would have a material effect on the accompanying condensed financial statements.\nNote 3 – Income Taxes\nAs of September 30, 2020, the Company has net operating loss carryforwards of approximately $108,000, to reduce future federal and state taxable income through 2040, which results in a deferred tax asset of approximately $22,600 against which a full valuation allowance has been recorded.\n5\nThe provision for income taxes is as follows:\n\n| For the Nine Months Ended September 30, 2020 | For the Nine Months Ended September 30, 2019 |\n| Current expense: |\n| Federal | $ | - | $ | - |\n| Deferred tax benefit: | - | - |\n| Federal | 8,100 | 5,400 |\n| Valuation allowance | (8,100 | ) | (5,400 | ) |\n| Total | $ | - | $ | - |\n\nAs of September 30, 2020, there is no provision for federal income taxes because we have historically incurred operating losses and we maintain a full valuation allowance against our net deferred tax asset.\nThe differences between our effective income tax rate and the U.S. federal income tax rate is as follows:\n\n| For the Nine Months Ended September 30, 2020 | For the Nine Months Ended September 30, 2019 |\n| Statutory federal income tax rates | 21 | % | 21 | % |\n| Valuation allowance | -21 | % | -21 | % |\n| Effective tax rate | - | - |\n\nPursuant to Section 382 of the Internal Revenue Code of 1986, the annual utilization of a company’s net operating loss carryforwards could be limited if the Company experiences a change in ownership of more than 50 percentage points within a three-year period. An ownership change occurs with respect to a corporation if it is a loss corporation on a testing date and, immediately after the close of the testing date, the percentage of stock of the corporation owned by one or more five-percent stockholders has increased by more than 50 percentage points over the lowest percentage of stock of such corporation owned by such stockholders at any time during the testing period.\nAs of September 30, 2020, the Company has not had any ownership changes that may limit the use of the Company’s net operating loss carryforwards.\nThe Company currently has no federal or state tax examinations in progress nor has it had any federal or state examinations since its inception. All of the Company’s tax years are subject to federal and state tax examination.\nNote 4 – Common Stock\nAs of September 30, 2020, the Company had 50,000,000 shares of common stock, par value of $0.0001, authorized and has issued 5,000,000 shares of common stock for $500 to the founders of the Company.\nNote 5 – Preferred Stock\nAs of September 30, 2020, the Company had 5,000,000 shares of preferred stock, par value of $.0001, authorized, none issued or outstanding.\nNote 6 – Commitments and Related Party Transactions\nOffice Space\nAs of September 30, 2020, the Company’s office facilities are located in Boca Raton, Florida. Such facilities are leased by the sole officer and a stockholder of the Company and used by the Company at no charge.\n6\nNote Payable - Stockholder\nOn December 27, 2018, the Company issued a promissory note (the “Note”) to a stockholder of the Company pursuant to which the Company agreed to repay the sum of any and all amounts advanced to the Company, on or before the date that the Company consummates a business combination with a private company or reverse takeover transaction or other transaction after which the Company would cease to be a shell company. Interest shall accrue on the outstanding principal amount of the Note on the basis of a 360-day year from the date of borrowing until paid in full at the rate of six percent (6%) per annum.\nAs of September 30, 2020, the total amount due under the Note was $105,021, including accrued interest of $7,011, which is reported as a component of accounts payable and accrued expenses in the accompanying condensed balance sheets.\nNote 7 – Going Concern\nThe accompanying condensed interim financial statements have been prepared assuming the Company will continue as a going concern, which contemplates the recoverability of assets and the satisfaction of liabilities in the normal course of business.\nAs of September 30, 2020, the Company has incurred losses from inception of approximately $108,000 and has negative working capital of approximately $107,000. Management believes these conditions raise substantial doubt about the Company’s ability to continue as a going concern for the twelve months following the date these condensed financial statements are issued. Management intends to finance operations over the next twelve months through additional borrowings from the existing Note.\nNote 8 – COVID-19\nOn March 11, 2020, the World Health Organization officially declared the outbreak of the novel coronavirus COVID-19 a “pandemic.” A significant outbreak of COVID-19 and other infectious diseases has resulted in a widespread health crisis that has significantly adversely affected businesses of all types, economies and financial markets worldwide. The business of any potential target business with which the Company consummates a business combination could be materially and adversely affected. Furthermore, the Company may be unable to complete a business combination if continued concerns relating to COVID-19 restrict travel, limit the ability to have meetings with potential investors or the target company’s personnel, vendors and services providers are unavailable to negotiate and consummate a transaction in a timely manner. The extent to which COVID-19 impacts our search for a business combination will depend on future developments, which are highly uncertain and cannot be predicted, including new information which may emerge concerning the severity of COVID-19 and the actions to contain COVID-19 or treat its impact, among others. If the disruptions posed by COVID-19 or other matters of global concern continue for an extended period of time, the Company’s ability to consummate a business combination, or the operations of a target business with which the Company ultimately consummates a business combination, may be materially adversely affected.\nNote 9 – Proposed Merger Agreement\nOn September 21, 2020, the Company filed with the SEC a Schedule 14F-1 Information Statement relating to an anticipated change in the composition of its board of directors that is expected to occur in connection with a proposed merger to be completed by and among the Company, a recently formed wholly-owned subsidiary of the Company (“Merger Sub”), and Augmedix, Inc., a Delaware corporation (“Augmedix”), pursuant to which Merger Sub would merge with and into Augmedix, with Augmedix continuing as the surviving entity (the “Merger”) and as the Company’s wholly-owned subsidiary, after which the Company would continue the business of Augmedix. The Merger would occur pursuant to an Agreement and Plan of Merger and Reorganization expected to be entered into by and among the Company, Augmedix and Merger Sub (the “Merger Agreement”).\nAugmedix is a provider of remote medical documentation and live clinical support services with a mission to rehumanize the clinician-patient relationship so that doctors can focus on what they do best — patient care. The company is headquartered in San Francisco, California.\n7\nPursuant to the terms of the proposed Merger Agreement, it is expected that all outstanding equity interests of Augmedix will be converted into shares of our Common Stock, such that the holders of Augmedix equity before the proposed Merger will own approximately 88% of the outstanding shares of our Common Stock after the Merger (before giving effect to a potential private placement offering of Common Stock by the Company that we expect will be consummated simultaneously with or immediately after the proposed Merger), resulting in a change of control of the Company. Completion of a private placement financing is expected to be a condition to completion of the Merger.\nCertain other information regarding the proposed Merger and proposed changes to the management and share ownership of the Company is set forth in the Schedule 14F-1.\nThe foregoing description of the proposed Merger Agreement and potential Common Stock private placement and related matters does not purport to be complete and is qualified in its entirety by the terms of the actual Merger Agreement and of terms and documentation for a private placement, none of which has yet been completed and executed. The proposed Merger is expected to be subject to satisfaction of a number of other conditions precedent, and there can be no assurance that the Merger Agreement will be signed or that the Merger or Common Stock private placement will be consummated or other such conditions satisfied. If and when the Merger Agreement is signed, it will be further described in and filed by the Company with the SEC as an exhibit to a Current Report on Form 8-K. If and when a Common Stock private placement is consummated, it will be further described in, and material agreements relating thereto will be filed by the Company with the SEC as exhibits to a Current Report on Form 8-K.\n8\n\nOverview of our Business\nMalo Holdings Corporation was incorporated in the State of Delaware on December 27, 2018. Since inception, the Company has been engaged in organizational efforts and obtaining initial financing. The Company was formed as a vehicle to pursue a business combination through the acquisition of, or merger with, an operating business. The Company filed a registration statement on Form 10 with the U.S. Securities and Exchange Commission (the “SEC”) on March 14, 2019, and since its effectiveness, the Company has focused its efforts to identify a possible business combination.\nThe Company is currently considered to be a “blank check” company. The SEC defines those companies as “any development stage company that is issuing a penny stock, within the meaning of Section 3(a)(51) of the Exchange Act, and that has no specific business plan or purpose, or has indicated that its business plan is to merge with an unidentified company or companies.” Many states have enacted statutes, rules and regulations limiting the sale of securities of “blank check” companies in their respective jurisdictions. The Company is also a “shell company,” defined in Rule 12b-2 under the Exchange Act as a company with no or nominal assets (other than cash) and no or nominal operations. Management does not intend to undertake any efforts to cause a market to develop in our securities, either debt or equity, until we have successfully concluded a business combination. The Company intends to comply with the periodic reporting requirements of the Exchange Act for so long as we are subject to those requirements.\nIn addition, the Company is an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012 (“JOBS Act”), and may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not “emerging growth companies” including, but not limited to, not being required to comply with the auditor attestation requirements of section 404(b) of the Sarbanes-Oxley Act, and exemptions from the requirements of Sections 14A(a) and (b) of the Exchange Act to hold a nonbinding advisory vote of shareholders on executive compensation and any golden parachute payments not previously approved.\nThe Company has also elected to use the extended transition period for complying with new or revised accounting standards under Section 102(b)(1) of the JOBS Act. This election allows us to delay the adoption of new or revised accounting standards that have different effective dates for public and private companies until those standards apply to private companies. As a result of this election, our financial statements may not be comparable to companies that comply with public company effective dates.\nWe will remain an “emerging growth company” until the earliest of (1) the last day of the fiscal year during which our revenues exceed $1.07 billion, (2) the date on which we issue more than $1 billion in non-convertible debt in a three year period, (3) the last day of the fiscal year following the fifth anniversary of the date of the first sale of our common equity securities pursuant to an effective registration statement filed pursuant to the Securities Act, or (4) when the market value of our common stock that is held by non-affiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter. To the extent that we continue to qualify as a “smaller reporting company,” as such term is defined in Rule 12b-2 under the Exchange Act, after we cease to qualify as an emerging growth company, certain of the exemptions available to us as an emerging growth company may continue to be available to us as a smaller reporting company, including: (1) not being required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes Oxley Act; (2) scaled executive compensation disclosures; and (3) the requirement to provide only two years of audited financial statements, instead of three years.\nThe Company was organized as a vehicle to investigate and, if such investigation warrants, acquire a target company or business seeking the perceived advantages of being a publicly held corporation. The Company’s principal business objective for the next 12 months and beyond such time will be to achieve long-term growth potential through a combination with an operating business. The Company will not restrict its potential candidate target companies to any specific business, industry or geographical location and, thus, may acquire any type of business.\n9\nThe Company currently does not engage in any business activities that provide cash flow. During the next twelve months we anticipate incurring costs related to:\n(i) filing Exchange Act reports, and\n(ii) investigating, analyzing and consummating an acquisition.\nWe believe we will be able to meet these costs through use of funds to be loaned by or invested in us by our stockholders, management or other investors. As of September 30, 2020, the Company had $8,344 in cash. There are no assurances that the Company will be able to secure any additional funding as needed. Currently, however, our ability to continue as a going concern is dependent upon our ability to generate future profitable operations and/or to obtain the necessary financing to meet our obligations and repay our liabilities arising from normal business operations when they come due. Our ability to continue as a going concern is also dependent on our ability to find a suitable target company and enter into a possible reverse merger with such company. Management’s plan includes obtaining additional funds by equity financing through a reverse merger transaction and/or related party advances, however, there is no assurance of additional funding being available.\nThe Company may consider acquiring a business that has recently commenced operations, is a developing company in need of additional funds for expansion into new products or markets, is seeking to develop a new product or service, or is an established business which may be experiencing financial or operating difficulties and is in need of additional capital. In the alternative, a business combination may involve the acquisition of, or merger with, a company which does not need substantial additional capital but which desires to establish a public trading market for its shares while avoiding, among other things, the time delays, significant expense, and loss of voting control which may occur in a public offering.\nAny target business that is selected may be a financially unstable company or an entity in its early stages of development or growth, including entities without established records of sales or earnings. In that event, we will be subject to numerous risks inherent in the business and operations of financially unstable and early stage or potential emerging growth companies. In addition, we may effect a business combination with an entity in an industry characterized by a high level of risk, and, although our management will endeavor to evaluate the risks inherent in a particular target business, there can be no assurance that we will properly ascertain or assess all significant risks. Our management anticipates that it will likely be able to effect only one business combination, due primarily to our limited financing and the dilution of interest for present and prospective stockholders, which is likely to occur as a result of our management’s plan to offer a controlling interest to a target business in order to achieve a tax-free reorganization. This lack of diversification should be considered a substantial risk in investing in us because it will not permit us to offset potential losses from one venture against gains from another.\nThe Company anticipates that the selection of a business combination will be complex and extremely risky. Our management believes that there are numerous firms seeking the perceived benefits of becoming a publicly traded corporation. Such perceived benefits of becoming a publicly traded corporation include, among other things, facilitating or improving the terms on which additional equity financing may be obtained, providing liquidity for the principals of and investors in a business, creating a means for providing incentive stock options or similar benefits to key employees, and offering greater flexibility in structuring acquisitions, joint ventures and the like through the issuance of stock. Potentially available business combinations may occur in many different industries and at various stages of development, all of which will make the task of comparative investigation and analysis of such business opportunities extremely difficult and complex.\nOn March 11, 2020, the World Health Organization officially declared the outbreak of the novel coronavirus COVID-19 a “pandemic.” A significant outbreak of COVID-19 and other infectious diseases has resulted in a widespread health crisis that has significantly adversely affected businesses of all types, economies and financial markets worldwide. The business of any potential target business with which we consummate a business combination could be materially and adversely affected. Furthermore, we may be unable to complete a business combination if continued concerns relating to COVID-19 restrict travel, limit the ability to have meetings with potential investors or the target company’s personnel, vendors and services providers are unavailable to negotiate and consummate a transaction in a timely manner. The extent to which COVID-19 impacts our search for a business combination will depend on future developments, which are highly uncertain and cannot be predicted, including new information which may emerge concerning the severity of COVID-19 and the actions to contain COVID-19 or treat its impact, among others. If the disruptions posed by COVID-19 or other matters of global concern continue for an extended period of time, our ability to consummate a business combination, or the operations of a target business with which we ultimately consummate a business combination, may be materially adversely affected.\n10\nAs of the date of this Form 10-Q, the Company has not entered into any definitive agreement with any party, nor have there been any specific discussions with any potential business combination candidate regarding business opportunities for the Company, except as described below.\nRecent Development—Proposed Merger\nOn September 21, 2020, the Company filed with the SEC, a Schedule 14F-1 Information Statement relating to an anticipated change in the composition of its board of directors that is expected to occur in connection with a proposed merger to be completed by and among the Company, a recently formed wholly-owned subsidiary of the Company (“Merger Sub”), and Augmedix, Inc., a Delaware corporation (“Augmedix”), pursuant to which Merger Sub would merge with and into Augmedix, with Augmedix continuing as the surviving entity (the “Merger”) and as the Company’s wholly-owned subsidiary, after which the Company would continue the business of Augmedix. The Merger would occur pursuant to an Agreement and Plan of Merger and Reorganization expected to be entered into by and among the Company, Augmedix and Merger Sub (the “Merger Agreement”).\nAugmedix is a provider of remote medical documentation and live clinical support services with a mission to rehumanize the clinician-patient relationship so that doctors can focus on what they do best — patient care. The company is headquartered in San Francisco, California.\nPursuant to the terms of the proposed Merger Agreement, it is expected that all outstanding equity interests of Augmedix will be converted into shares of our Common Stock, such that the holders of Augmedix equity before the proposed Merger will own approximately 88% of the outstanding shares of our Common Stock after the Merger (before giving effect to a potential private placement offering of Common Stock by the Company that we expect will be consummated simultaneously with or immediately after the proposed Merger), resulting in a change of control of the Company. Completion of a private placement financing is expected to be a condition to completion of the Merger.\nCertain other information regarding the proposed Merger and proposed changes to the management and share ownership of the Company is set forth in the Schedule 14F-1.\nThe foregoing description of the proposed Merger Agreement and potential Common Stock private placement and related matters does not purport to be complete and is qualified in its entirety by the terms of the actual Merger Agreement and of terms and documentation for a private placement, none of which has yet been completed and executed. The proposed Merger is expected to be subject to satisfaction of a number of other conditions precedent, and there can be no assurance that the Merger Agreement will be signed or that the Merger or Common Stock private placement will be consummated or other such conditions satisfied. If and when the Merger Agreement is signed, it will be further described in and filed by the Company with the SEC as an exhibit to a Current Report on Form 8-K. If and when a Common Stock private placement is consummated, it will be further described in, and material agreements relating thereto will be filed by the Company with the SEC as exhibits to a Current Report on Form 8-K.\nLiquidity and Capital Resources\nAs of September 30, 2020, the Company had total assets of $3,956 comprised exclusively of cash. This compares with total assets of $224, comprised exclusively of cash, as of December 31, 2019. The Company’s current liabilities as of September 30, 2020 totaled $111,020 comprised of accounts payable for accounting and review services for the September 30, 2020 SEC filings, accrued interest and the amount due under a note payable to a shareholder. This compares to the Company’s total current liabilities of $68,683, comprised of accrued interest and the amount due under a note payable to a shareholder, as of December 31, 2019. The Company can provide no assurance that it can continue to satisfy its cash requirements for at least the next twelve months.\n11\nThe following is a summary of the Company’s cash flows provided by (used in) operating and financing activities for the nine months ended September 30, 2020:\n\n| Nine months ended September 30, 2020 |\n| Net Cash (Used In) Operating Activities | $ | (28,768 | ) |\n| Net Cash Provided by Financing Activities | $ | 32,500 |\n| Net Change in Cash | $ | 3,732 |\n\nThe Company has only cash assets and has generated no revenues since inception. The Company is also dependent upon the receipt of capital investment or other financing to fund its ongoing operations and to execute its business plan of seeking a combination with a private operating company. In addition, the Company is dependent upon certain related parties to provide continued funding and capital resources. If continued funding and capital resources are unavailable at reasonable terms, the Company may not be able to implement its plan of operations.\nIssuance of Promissory Note to a Stockholder and Director\nOn December 27, 2018, in connection with advances made in connection with costs incurred by the Company, the Company issued a promissory note to Mark Tompkins, a stockholder and director of the Company, pursuant to which the Company agreed to repay Mr. Tompkins the sum of any and all amounts that Mr. Tompkins may advance to the Company on or before the date that the Company consummates a business combination with a private company or reverse takeover transaction or other transaction after which the Company would cease to be a shell company (as defined in Rule 12b-2 under the Exchange Act). Although Mr. Tompkins has no obligation to advance funds to the Company under the terms of the note, it is anticipated that he may advance funds to the Company as fees and expenses are incurred in the future. As a result, the Company issued the note in anticipation of such advances. Interest shall accrue on the outstanding principal amount of the note on the basis of a 360-day year from the date of borrowing until paid in full at the rate of six percent (6%) per annum. In the event that an Event of Default (as defined in the note) has occurred, the entire note shall automatically become due and payable (the “Default Date”), and starting from five (5) days after the Default Date, the interest rate on the note shall accrue at the rate of eighteen percent (18%) per annum.\nAs of September 30, 2020, the amount due under the note was $105,020 including accrued interest of $7,010.\nResults of Operations\nThe Company has not conducted any active operations since inception, except for its efforts to locate suitable acquisition candidates. No revenue has been generated by the Company from December 27, 2018 (Inception), through September 30, 2020. It is unlikely the Company will have any revenues unless it is able to effect an acquisition or merger with an operating company, of which there can be no assurance. It is management’s assertion that these circumstances may hinder the Company’s ability to continue as a going concern. The Company’s plan of operation for the next twelve months shall be to continue its efforts to locate suitable acquisition candidates.\nFor the nine months ended September 30, 2020, the Company had a net loss of $38,605, comprised of legal, accounting, audit and other professional services fees incurred in relation to the preparation and filing of the Company’s SEC filings, general and administrative expenses, and interest expense.\nOff-Balance Sheet Arrangements\nThe Company does not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.\nContractual Obligations\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide this information.\nEmerging Growth Company\nAs an “emerging growth company” under the JOBS Act, the Company has elected to use the extended transition period for complying with new or revised accounting standards under Section 102(b)(1) of the JOBS Act. This election allows us to delay the adoption of new or revised accounting standards that have different effective dates for public and private companies until those standards apply to private companies. As a result of this election, our financial statements may not be comparable to companies that comply with public company effective dates.\n12\n\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide the information required by this Item.\n\nDisclosure Controls and Procedures\nDisclosure controls are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Exchange Act, such as this Form 10-Q, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the Principal Executive Officer and Principal Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Internal controls are procedures which are designed with the objective of providing reasonable assurance that (1) our transactions are properly authorized, recorded and reported; and (2) our assets are safeguarded against unauthorized or improper use, to permit the preparation of our condensed financial statements in conformity with GAAP.\nIn connection with the preparation of this Form 10-Q, management, with the participation of our Principal Executive Officer and Principal Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e) and 15d-15(e)). Based upon that evaluation, our Principal Executive and Financial Officer concluded that, as of the end of the period covered by this Form 10-Q, our disclosure controls and procedures were effective.\nChanges in Internal Controls\nThere have been no changes in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rule 13a-15 or 15d-15 under the Exchange Act that occurred during the quarter ended September 30, 2020 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\nLimitations of the Effectiveness of Control\nA control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations of any control system, no evaluation of controls can provide absolute assurance that all control issues, if any, within a company have been detected.\n13\nPART II—OTHER INFORMATION\n\nThere are no material pending legal proceedings as defined by Item 103 of Regulation S-K, to which we are a party or of which any of our property is the subject, other than ordinary routine litigation incidental to the Company’s business.\nThere are no proceedings in which any of the directors, officers or affiliates of the Company, or any registered or beneficial holder of more than 5% of the Company’s voting securities, is an adverse party or has a material interest adverse to that of the Company.\n\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide the information required by this Item.\n\nNone.\n\nNone.\n\nNone.\n\nNone.\n\nSee the Exhibit Index following the signature page to this Form 10-Q for a list of exhibits filed or furnished with this report, which Exhibit Index is incorporated herein by reference.\n14\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| Date: October 1, 2020 | MALO HOLDINGS CORPORATION |\n| By: | /s/ Ian Jacobs |\n| Ian Jacobs Chief Executive Officer, President, Chief Financial Officer, Secretary and Director (principal executive officer and principal financial officer) |\n\n15\nEXHIBIT INDEX\n\n| Exhibit No. | Description |\n| 31.1* | Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002 |\n| 32.1** | Certification of the Company’s Principal Executive Officer and Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS* | XBRL Instance Document. |\n| 101.SCH* | XBRL Taxonomy Extension Schema Document. |\n| 101.CAL* | XBRL Taxonomy Extension Calculation Linkbase Document. |\n| 101.DEF* | XBRL Taxonomy Extension Definition Linkbase Document. |\n| 101.LAB* | XBRL Taxonomy Extension Labels Linkbase Document. |\n| 101.PRE* | XBRL Taxonomy Extension Presentation Linkbase Document. |\n\n\n| * | Filed herewith. |\n\n\n| ** | Furnished herewith. |\n\n16\n\n</text>\n\nWhat is the percentage change in the company's Quick Ratio from December 31, 2019 to September 30, 2020 in percentage?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nGLOBALINK INVESTMENT INC.\nCONDENSED BALANCE SHEETS\n\n| June 30, 2022 | December 31, 2021 |\n| (Unaudited) |\n| ASSETS |\n| CURRENT ASSETS |\n| Cash in escrow account | $ | 516,280 | $ | 812,232 |\n| Prepaid expenses-current | 237,555 | 217,461 |\n| Total current assets | 753,835 | 1,029,693 |\n| Prepaid expenses-non current | 174,730 | 202,567 |\n| Investments held in Trust Account | 116,813,337 | 116,725,099 |\n| TOTAL ASSETS | $ | 117,741,902 | $ | 117,957,359 |\n| LIABILITIES, REDEEMABLE COMMON STOCK AND STOCKHOLDERS’ DEFICIT |\n| CURRENT LIABILITIES |\n| Accounts payable | $ | 19,335 | $ | 139,550 |\n| Franchise tax payable | 184,254 | 84,254 |\n| Due to affiliate | 67,000 | 7,000 |\n| Total current liabilities | 270,589 | 230,804 |\n| Deferred underwriting fee payable | 4,025,000 | 4,025,000 |\n| Total liabilities | 4,295,589 | 4,255,804 |\n| COMMITMENTS AND CONTINGENCIES | - |\n| REDEEMABLE COMMON STOCK |\n| Common stock subject to possible redemption, $ 0.001 par value, 11,500,000 shares at redemption value of $ 10.15 per share, respectively | 116,725,000 | 116,725,000 |\n| STOCKHOLDERS’ DEFICIT AT JUNE 30, 2022 AND DECEMBER 31, 2021 |\n| Common Stock; $ 0.001 par value; 500,000,000 shares authorized; 3,445,000 shares issued and outstanding (excluding 11,500,000 shares subject to possible redemption) | 3,445 | 3,445 |\n| Additional paid-in capital | - | - |\n| Accumulated deficit | ( 3,282,132 | ) | ( 3,026,890 | ) |\n| Total stockholders’ deficit | ( 3,278,687 | ) | ( 3,023,445 | ) |\n| LIABILITIES, REDEEMABLE COMMON STOCK AND STOCKHOLDERS’ DEFICIT | $ | 117,741,902 | $ | 117,957,359 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements\n\n| 1 |\n\nGLOBALINK INVESTMENT INC.\nSTATEMENTS OF OPERATIONS (UNAUDITED)\n\n| For the three months ended June 30, | For the six months ended June 30, |\n| 2022 |\n| OPERATING EXPENSES |\n| General and administrative | $ | 89,962 | $ | 243,480 |\n| Franchise tax expense | 50,000 | 100,000 |\n| Total operating expenses | 139,962 | 343,480 |\n| OTHER INCOME |\n| Income on investments held in Trust Account | 86,981 | 88,238 |\n| Total other income | 86,981 | 88,238 |\n| NET LOSS | $ | ( 52,981 | ) | $ | ( 255,242 | ) |\n| Weighted average shares outstanding Common stock-redeemable | 11,500,000 | 11,500,000 |\n| Basic and diluted net loss per share, Common stock-redeemable | $ | ( 0.00 | ) | $ | ( 0.02 | ) |\n| Weighted average shares outstanding Common stock-non redeemable | 3,445,000 | 3,445,000 |\n| Basic and diluted net loss per share, Common stock-non-redeemable | $ | ( 0.00 | ) | $ | ( 0.02 | ) |\n\nThe Company was incorporated on March 24, 2021 and had no operation since, hence comparative amounts for the period March 24, 2021 (inception) to June 30, 2021 are not included.\nThe accompanying notes are an integral part of these unaudited condensed financial statements\n\n| 2 |\n\nGLOBALINK INVESTMENT INC.\nSTATEMENT OF CHANGES IN STOCKHOLDERS’ DEFICIT\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2022 (UNAUDITED)\n\n| N | - | - | - | - | ) | - | ) |\n| Common stock | Additional | Accumulated | Total stockholders’ |\n| Shares | Amount | paid-in capital | deficit | deficit |\n| Balance, December 31, 2021 | 3,445,000 | $ | 3,445 | $ | - | $ | ( 3,026,890 | ) | $ | ( 3,023,445 | ) |\n| Net loss | - | - | - | ( 202,261 | ) | ( 202,261 | ) |\n| Balance, March 31, 2022 | 3,445,000 | 3,445 | - | ( 3,229,151 | ) | ( 3,225,706 | ) |\n| Balance | 3,445,000 | 3,445 | - | ( 3,229,151 | ) | ( 3,225,706 | ) |\n| Net loss | - | - | - | ( 52,981 | ) | ( 52,981 | ) |\n| Balance, June 30, 2022 | 3,445,000 | $ | 3,445 | $ | - | $ | ( 3,282,132 | ) | $ | ( 3,278,687 | ) |\n| Balance | 3,445,000 | $ | 3,445 | $ | - | $ | ( 3,282,132 | ) | $ | ( 3,278,687 | ) |\n\nThe Company was incorporated on March 24, 2021 and had no operation since, hence comparative amounts for the period March 24, 2021 (inception) to June 30, 2021 are not included.\nThe accompanying notes are an integral part of these unaudited condensed financial statements\n\n| 3 |\n\nGLOBALINK INVESTMENT INC.\nSTATEMENT OF CASH FLOWS\nFOR THE SIX MONTHS ENDED JUNE 30, 2022 (UNAUDITED)\n\n| CASH FLOWS FROM OPERATING ACTIVITIES |\n| Net loss | $ | ( 255,242 | ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: |\n| Income on investments held in Trust Account | ( 88,238 | ) |\n| Changes in operating assets and liabilities: |\n| Prepaid expenses - current | 7,743 |\n| Accounts payable | ( 120,215 | ) |\n| Franchise tax payable | 100,000 |\n| Net cash used in operating activities | ( 355,952 | ) |\n| CASH FLOWS FROM FINANCING ACTIVITIES |\n| Due to affiliate | 60,000 |\n| Net cash provided by financing activities | 60,000 |\n| NET CHANGE IN CASH | ( 295,952 | ) |\n| CASH, BEGINNING OF PERIOD | 812,232 |\n| CASH, END OF PERIOD | $ | 516,280 |\n\nThe Company was incorporated on March 24, 2021 and had no operation since, hence comparative amounts for the period March 24, 2021 (inception) to June 30, 2021 are not included.\nThe accompanying notes are an integral part of these unaudited condensed financial statements\n\n| 4 |\n\nGLOBALINK INVESTMENT INC\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nJUNE 30, 2022\nNote 1 – Description of Organization and Business Operations and Liquidity\nGlobalink Investment Inc. (the “Company”) was incorporated in Delaware on March 24, 2021. The Company is a blank check company formed for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities (the “Business Combination”).\nThe Company is not limited to a particular industry or geographic region for purposes of consummating a Business Combination. The Company is an early stage and emerging growth company and, as such, the Company is subject to all of the risks associated with early stage and emerging growth companies.\nAs of June 30, 2022, the Company had not commenced any operations. All activity through June 30, 2022, relates to the Company’s formation and Initial Public Offering (“IPO”), which is described below and, since the offering, the search for a prospective initial Business Combination. The Company will not generate any operating revenues until after the completion of its initial Business Combination, at the earliest. The Company will generate non-operating income in the form of interest income earned on investments from the proceeds derived from the IPO. The registration statement for the Company’s IPO was declared effective on December 6, 2021. On December 9, 2021, the Company consummated the IPO of 10,000,000 units (“Units”) at $ 10.00 per Unit generating gross proceeds of $ 100,000,000 , which is discussed in Note 3. The Company has selected December 31 as its fiscal year end.\nSimultaneously with the closing of the IPO, the Company consummated the sale of 517,500 units (“Private Placement Units”) at a price of $ 10.00 per Private Placement Unit in a private placement to Public Gold Marketing Sdn. Bhd, a Malaysian private limited company, an entity not affiliated with the Company, the sponsor or the underwriters, generating gross proceeds of $ 5,175,000 , which is described in Note 4.\nAdditionally with the closing of the IPO, the Company granted the underwriters a 45-day option to purchase up to 1,500,000 Units to cover over-allotment. On December 13, 2021, the underwriters fully exercised the option and purchased 1,500,000 additional Units (the “Over-allotment Units”), generating additional gross proceeds of $ 15,000,000 .\nSimultaneously with the exercise of the over-allotment, the Company consummated a private sale of an additional 52,500 Private Placement Units at a price of $ 10.00 per Private Placement Unit, generating additional gross proceeds of $ 525,000 . Since the underwriters’ over-allotment was exercised in full, the sponsor did not forfeit any Founder Shares (as defined in Note 5).\nOffering costs for the IPO and the exercise of the underwriters’ over-allotment option amounted to $ 6,887,896 , consisting of $ 2,300,000 of underwriting fees, $ 4,025,000 of deferred underwriting fees payable (which are held in the Trust Account (defined below)) and $ 562,896 of other costs. As described in Note 6, the $ 4,025,000 of deferred underwriting fee payable is contingent upon the consummation of a Business Combination by March 9, 2023, subject to the terms of the underwriting agreement.\nFollowing the closing of the IPO, $ 116,725,000 ($ 10.15 per Unit) from the net proceeds of the sale of the Units in the IPO and the Private Placement Units was placed in a trust account (“Trust Account”) and will be invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), with a maturity of 180 days or less or in any open-ended investment company that holds itself out as a money market fund selected by the Company meeting the conditions of paragraphs (d)(2), (d)(3) and (d)(4) of Rule 2a-7 of the Investment Company Act, as determined by the Company, until the earlier of: (i) the completion of a Business Combination and (ii) the distribution of the Trust Account, as described below.\n\n| 5 |\n\nThe Company’s management has broad discretion with respect to the specific application of the net proceeds of the Initial Public Offering and the sale of the Private Placement Units, although substantially all of the net proceeds are intended to be applied generally toward consummating a Business Combination. There is no assurance that the Company will be able to complete a Business Combination successfully. The Company must complete one or more initial Business Combinations having an aggregate fair market value of at least 80 % of the assets held in the Trust Account excluding the deferred underwriting discounts and taxes payable on income earned on the Trust Account at the time of the agreement to enter into the initial Business Combination. However, the Company will only complete a Business Combination if the post-transaction company owns or acquires 50 % or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act. There is no assurance the Company will be able to successfully effect a Business Combination.\nThe Company will provide the holders (the “Public Stockholders”) of the outstanding shares of common stock included in the Units, or the Public Shares with the opportunity to redeem all or a portion of their Public Shares upon the completion of a Business Combination either (i) in connection with a stockholder meeting called to approve the Business Combination or (ii) by means of a tender offer. The decision as to whether the Company will seek stockholder approval of a Business Combination or conduct a tender offer will be made by the Company. The Public Stockholders will be entitled to redeem their Public Shares for a pro rata portion of the amount then in the Trust Account (initially anticipated to be $ 10.15 per Public Share, plus any pro rata interest then in the Trust Account, net of taxes payable). There will be no redemption rights with respect to the Company’s warrants.\nAll of the Public Shares contain a redemption feature which allows for the redemption of such Public Shares in connection with the Company’s liquidation, if there is a stockholder vote or tender offer in connection with the Company’s Business Combination and in connection with certain amendments to the Company’s amended and restated certificate of incorporation. In accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 480-10-S99, redemption provisions not solely within the control of a company require the Public Shares subject to redemption to be classified outside of permanent equity. Given that the Public Shares will be issued with other freestanding instruments (i.e., public warrants and rights), the initial carrying value of common stock classified as temporary equity will be the allocated proceeds determined in accordance with ASC 470-20. The Public Shares are subject to ASC 480-10-S99. If it is probable that the equity instrument will become redeemable, the Company has the option to either (i) accrete changes in the redemption value over the period from the date of issuance (or from the date that it becomes probable that the instrument will become redeemable, if later) to the earliest redemption date of the instrument or (ii) recognize changes in the redemption value immediately as they occur and adjust the carrying amount of the instrument to equal the redemption value at the end of each reporting period. The Company has elected to recognize the changes immediately. While redemptions cannot cause the Company’s net tangible assets to fall below $ 5,000,001 , the Public Shares are redeemable and are classified as such on the balance sheet until such date that a redemption event takes place.\nRedemptions of the Company’s Public Shares may be subject to the satisfaction of conditions, including minimum cash conditions, pursuant to an agreement relating to the Company’s Business Combination. If the Company seeks stockholder approval of the Business Combination, the Company will proceed with a Business Combination if a majority of the shares voted are voted in favor of the Business Combination, or such other vote as required by law or stock exchange rule. If a stockholder vote is not required by applicable law or stock exchange listing requirements and the Company does not decide to hold a stockholder vote for business or other reasons, the Company will, pursuant to its Certificate of Incorporation, conduct the redemptions pursuant to the tender offer rules of the U.S. Securities and Exchange Commission (“SEC”) and file tender offer documents with the SEC prior to completing a Business Combination. If, however, stockholder approval of the transaction is required by applicable law or stock exchange listing requirements, or the Company decides to obtain stockholder approval for business or other reasons, the Company will offer to redeem shares in conjunction with a proxy solicitation pursuant to the proxy rules and not pursuant to the tender offer rules. If the Company seeks stockholder approval in connection with a Business Combination, the sponsor has agreed to vote its Founder Shares (as defined in Note 5) and any Public Shares purchased during or after the IPO in favor of approving a Business Combination. Additionally, each Public Stockholder may elect to redeem their Public Shares without voting, and if they do vote, irrespective of whether they vote for or against the proposed transaction.\n\n| 6 |\n\nNotwithstanding the foregoing, the amended and restated certificate of incorporation of the Company (the “Certificate of Incorporation”) provides that a Public Stockholder, together with any affiliate of such stockholder or any other person with whom such stockholder is acting in concert or as a “group” (as defined under Section 13 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), will be restricted from redeeming its shares with respect to more than an aggregate of 15 % or more of the common stock sold in the Initial Public Offering, without the prior consent of the Company.\nThe Company’s sponsor, officers and directors (the “Initial Stockholders”) have agreed not to propose an amendment to the Certificate of Incorporation that would affect the substance or timing of the Company’s obligation to redeem 100 % of its Public Shares if the Company does not complete a Business Combination, unless the Company provides the Public Stockholders with the opportunity to redeem their shares of common stock in conjunction with any such amendment.\nIf the Company is unable to complete a Business Combination by March 9, 2023, 15 months from the closing of the IPO (“Combination Period”), the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account including interest earned on the funds held in the Trust Account and not previously released to us to pay the Company’s franchise and income taxes (less up to $ 100,000 of interest to pay dissolution expenses), divided by the number of then outstanding Public Shares, which redemption will completely extinguish the Public Stockholders’ rights as stockholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the Company’s remaining stockholders and the Company’s board of directors, dissolve and liquidate, subject in each case to the Company’s obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law.\nThe Initial Stockholders have agreed to waive their liquidation rights with respect to the Founder Shares if the Company fails to complete a Business Combination within the Combination Period. However, if the Initial Stockholders should acquire Public Shares in or after the Initial Public Offering, they will be entitled to liquidating distributions from the Trust Account with respect to such Public Shares if the Company fails to complete a Business Combination within the Combination Period. The underwriters have agreed to waive their rights to deferred underwriting discounts (see Note 6) held in the Trust Account in the event the Company does not complete a Business Combination within the Combination Period, and, in such event, such amounts will be included with the other funds held in the Trust Account that will be available to fund the redemption of the Public Shares. In the event of such distribution, it is possible that the per share value of the residual assets remaining available for distribution (including Trust Account assets) will be only $ 10.15 per share held in the Trust Account. In order to protect the amounts held in the Trust Account, the sponsor has agreed to be liable to the Company if and to the extent any claims by a vendor for services rendered or products sold to the Company, or a prospective target business with which the Company has discussed entering into a transaction agreement, reduce the amount of funds in the Trust Account. This liability will not apply with respect to any claims by a third party who executed a waiver of any right, title, interest or claim of any kind in or to any monies held in the Trust Account or to any claims under the Company’s indemnity of the underwriters of the Initial Public Offering against certain liabilities, including liabilities under the Securities Act of 1933, as amended (the “Securities Act”). Moreover, in the event that an executed waiver is deemed to be unenforceable against a third party, the sponsor will not be responsible to the extent of any liability for such third-party claims. The Company will seek to reduce the possibility that the sponsor will have to indemnify the Trust Account due to claims of creditors by endeavoring to have all vendors, service providers (except the Company’s independent registered public accounting firm), prospective target businesses or other entities with which the Company does business, execute agreements waiving any right, title, interest or claim of any kind in or to monies held in the Trust Account.\nRisks and Uncertainties\nIn March 2020, the World Health Organization declared the outbreak of a novel coronavirus (“COVID-19”) as a pandemic which continues to spread throughout the United States and the world. As of the date the financial statements were issued, there was still considerable uncertainty around the expected duration of this pandemic. The Company has concluded that while it is reasonably possible that COVID-19 could have a negative effect on identifying a target company for a Business Combination, the specific impact is not readily determinable as of the date of this financial statement. The financial statement does not include any adjustments that might result from the outcome of this uncertainty.\n\n| 7 |\n\nIn February 2022, the Russian Federation and Belarus commenced a military action with the country of Ukraine. As a result of this action, various nations, including the United States, have instituted economic sanctions against the Russian Federation and Belarus. Further, the impact of this action and related sanctions on the world economy are not determinable as of the date of these financial statements and the specific impact on the Company’s financial condition, results of operations, and cash flows is also not determinable as of the date of these financial statements.\nLiquidity and Capital Resources\nAs of June 30, 2022, the Company had $ 516,280 of cash held in escrow which is available to meet working capital needs, $ 116,813,337 in securities held in the Trust Account to be used for a Business Combination or to repurchase or redeem its common stock in connection therewith and working capital of $ 483,246 .\nUntil the consummation of a Business Combination, the Company will be using the funds not held in the Trust Account for identifying and evaluating prospective acquisition candidates, performing due diligence on prospective target businesses, paying for travel expenditures, selecting the target business to acquire, and structuring, negotiating and consummating the Business Combination. The Company will need to raise additional capital through loans or additional investments from its sponsor, shareholders, officers, directors, or third parties. The Company’s officers, directors and sponsor may, but are not obligated to, loan the Company funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet the Company’s working capital needs. Accordingly, the Company may not be able to obtain additional financing.\nNote 2 — Summary of Significant Accounting Policies\nBasis of Presentation\nThe accompanying financial statements of the Company are presented in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and pursuant to the rules and regulations of the SEC. Certain information or footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted, pursuant to the rules and regulations of the SEC for interim financial reporting. Accordingly, they do not include all the information and footnotes necessary for a complete presentation of financial position, results of operations, or cash flows. In the opinion of management, the accompanying unaudited condensed financial statements include all adjustments, consisting of a normal recurring nature, which are necessary for a fair presentation of the financial position, operating results and cash flows for the periods presented. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K, as filed with the SEC on April 1, 2022. The interim results for six months ended June 30, 2022 presented are not necessarily indicative of the results to be expected for the year ending December 31, 2022 or for any future interim periods.\nEmerging Growth Company\nThe Company is an emerging growth company as defined in Section 102(b)(1) of the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), which exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that an emerging growth company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such an election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period, which means that when a standard is issued or revised, and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company that is neither an emerging growth company nor an emerging growth company that has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\n\n| 8 |\n\nUse of Estimates\nThe preparation of financial statements in conformity with U.S. GAAP requires the Company’s management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. Making estimates requires management to exercise significant judgment. Such estimates may be subject to change as more current information becomes available and accordingly the actual results could differ significantly from those estimates. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. Actual results could differ from those estimates.\nCash held in escrow\nThe Company had $ 516,280 and $ 812,232 held in escrow on June 30, 2022 and December 31, 2021 respectively. This balance will be transferred in whole as soon as practicable to the Company’s operating account.\nCash and cash equivalents\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company had no cash and did not have any cash equivalents as of June 30, 2022 and December 31, 2021.\nInvestments Held in Trust Account\nAt June 30, 2022 and December 31, 2021, substantially all of the assets held in the Trust Account were held in U.S. Treasury securities. The Company’s investments held in the Trust Account are classified as trading securities. Trading securities are presented on the balance sheet at fair value at the end of each reporting period. Gains and losses resulting from the change in fair value of investments held in Trust Account are included in interest earned on marketable securities held in Trust Account in the accompanying statements of operations. The estimated fair values of investments held in Trust Account are determined using available market information.\nOffering Costs associated with the Initial Public Offering\nOffering costs consist principally of legal, accounting, underwriting fees and other costs directly related to the IPO and the over- allotment. Offering costs amounted to $ 6,887,896 which was charged against additional paid-in capital upon the completion of the IPO in December 2021.\nConcentration of Credit Risk\nFinancial instruments that potentially subject the Company to concentrations of credit risk consist of cash accounts in a financial institution, which, at times, may exceed the Federal Depository Insurance Corporation coverage limit. At June 30, 2022 and December 31, 2021, the Company has not experienced losses on these accounts.\nFair Value of Financial Instruments\nThe fair value of the Company’s assets and liabilities which qualify as financial instruments under the FASB ASC 820, “Fair Value Measurements and Disclosures,” approximate the carrying amounts represented in the accompanying balance sheet, primarily due to their short-term nature.\nIncome Taxes\nThe Company complies with the accounting and reporting requirements of ASC 740, “Income Taxes,” which requires an asset and liability approach to financial accounting and reporting for income taxes. Deferred income tax assets and liabilities are computed for differences between the financial statement and tax bases of assets and liabilities that will result in future taxable or deductible amounts, based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.\n\n| 9 |\n\nFASB ASC 740 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more likely than not to be sustained upon examination by taxing authorities. There were no unrecognized tax benefits as of June 30, 2022 or December 31, 2021. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. No amounts were accrued for the payment of interest and penalties for the period March 24, 2021 (inception) to December 31, 2021 or for the six months ended June 30, 2022. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position. The Company is subject to income tax examinations by major taxing authorities since inception.\nCommon Stock Subject to Possible Redemption\nThe Company accounts for its common stock subject to possible redemption in accordance with the guidance in ASC Topic 480 “Distinguishing Liabilities from Equity.” Shares of common stock subject to mandatory redemption (if any) is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that features redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. The Company’s common stock sold in the IPO and as a result of the exercise by the underwriters of their over-allotment option features certain redemption rights that are considered to be outside of the Company’s control and subject to occurrence of uncertain future events. Accordingly, on June 30, 2022 and December 31, 2021, 11,500,000 shares of common stock subject to possible redemption were presented as temporary equity, outside of the stockholders’ deficit section of the Company’s balance sheet.\nImmediately upon the closing of the IPO and the over-allotment, the Company recognized the accretion from the initial book value to redemption amount value. The change in the carrying value of redeemable shares of common stick resulted in charges against additional paid-in capital and accumulated deficit.\nAt June 30, 2022, and December 31, 2021, the common stock subject to possible redemption reflected in the balance sheet is reconciled in the following table:\nSchedule of Subject to Possible Redemption\n| Gross proceeds | $ | 115,000,000 |\n| Less: |\n| Proceeds allocated to Public Warrants | ( 11,695,950 | ) |\n| Common stock issuance costs | ( 6,190,074 | ) |\n| Plus: Accretion of carrying value to redemption value | 19,611,024 |\n| Common stock subject to possible redemption | $ | 116,725,000 |\n\nNet loss per common stock\nThe Company has one class of shares. Public Warrants (see Note 3) and Private Placement Warrants (see Note 4) to purchase 7,242,000 Common Stock at $10 per share were issued on December 9, 2021. At June 30, 2022, no Public Warrants or Private Placement Warrants have been exercised. The 7,242,000 potential shares of common stock for outstanding Public Warrants and Private Placement Warrants to purchase the Company’s stock were excluded from diluted earnings per share for the period ended June 30, 2022 because they are contingently exercisable, and the contingencies have not yet been met. As a result, diluted net loss per common stock is the same as basic net loss per common stock for the period. The table below presents a reconciliation of the numerator and denominator used to compute basic and diluted net loss per share for each class of stock.\nSchedule of Net Loss Basic and Diluted Per Share\n| Redeemable | Non-redeemable |\n| For the three months ended June 30, 2022 | Common Stock |\n| Basic and diluted net loss per share: | Redeemable | Non-redeemable |\n| NUMERATOR |\n| Allocation of net loss | $ | ( 40,768 | ) | $ | ( 12,213 | ) |\n| DENOMINATOR |\n| Weighted Average Shares Outstanding including common stock subject to redemption | 11,500,000 | 3,445,000 |\n| EPS |\n| Basic and diluted net loss per share | $ | ( 0.00 | ) | $ | ( 0.00 | ) |\n\n\n| 10 |\n\n\n| Basic and diluted net loss per share: | Redeemable | Non-redeemable |\n| For the six months ended June 30, 2022 | Common Stock |\n| Basic and diluted net loss per share: | Redeemable | Non-redeemable |\n| NUMERATOR |\n| Allocation of net loss | $ | ( 196,406 | ) | $ | ( 58,836 | ) |\n| DENOMINATOR |\n| Weighted Average Shares Outstanding including common stock subject to redemption | 11,500,000 | 3,445,000 |\n| EPS |\n| Basic and diluted net loss per share | $ | ( 0.02 | ) | $ ( 0.02 | ) |\n\nAccounting for Warrants\nThe Company accounts for the Public Warrants and Private Placement Warrants (as defined in Note 3 and Note 4) as either equity-classified or liability-classified instruments based on an assessment of the instruments’ specific terms and applicable authoritative guidance in ASC 480 and ASC 815, “Derivatives and Hedging” (“ASC 815”). The assessment considers whether the instruments are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and whether the instruments meet all of the requirements for equity classification under ASC 815, including whether the instruments are indexed to the Company’s own common shares and whether the instrument holders could potentially require “net cash settlement” in a circumstance outside of the Company’s control, among other conditions for equity classification. This assessment, which requires the use of professional judgment, is conducted at the time of warrant issuance and as of each subsequent quarterly period end date while the instruments are outstanding. As discussed in Note 7, the Company determined that upon further review of the warrant agreement the Public Warrants and Private Placement Warrants issued pursuant to the warrant agreement qualify for equity accounting treatment.\nRecent Accounting Pronouncements\nThe Company’s management does not believe that any recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on the Company’s financial statement.\nNote 3 — Initial Public Offering and Over-allotment\nPursuant to the IPO and the over-allotment in December 2021, the Company sold 11,500,000 units at a price of $ 10.00 per Unit. Each Unit consists of one share of common stock, one redeemable warrant (each, a “Public Warrant”) and one right (“Public Right”). Each Public Warrant entitles the holder to purchase one-half (1/2) of one share of common stock at a price of $ 11.50 per share, subject to adjustment. Each Public right entitles the holder to receive one-tenth (1/10) of one share of common stock at the closing of a Business Combination (see Note 7).\n\n| 11 |\n\nNote 4 — Private Placement\nOn December 9, 2021 and December 13 2021, simultaneously with the consummation of the IPO and the underwriters’ exercise of their over-allotment option, the Company consummated the issuance and sale (“Private Placement”) of 570,000 Private Placement Units in a private placement transaction at a price of $10.00 per Private Placement Unit, generating gross proceeds of $ 5,700,000 . Each whole Private Placement Unit consists of one share, one redeemable warrant (“Private Placement Warrant”) and one right to receive one-tenth (1/10) of one share of common stock at the closing of a Business Combination. Each whole Private Placement Warrant will be exercisable to purchase one-half of one share of common stock at a price of $ 11.50 per share. A portion of the proceeds from the Private Placement Units were added to the proceeds from the IPO to be held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the proceeds from the sale of the Private Placement Units will be used to fund the redemption of the Public Shares (subject to the requirements of applicable law), and the Private Placement Units and all underlying securities will be worthless .\nNote 5 — Related Party Transactions\nFounder Shares\nOn August 19, 2021, our sponsor purchased 2,875,000 shares (the “Founder Shares”) of the Company’s common stock, par value $ 0.001 , for an aggregate price of $ 25,000 . The Founder Shares are subject to certain transfer restrictions, as described in Note 7.\nThe Initial Stockholders have agreed, subject to limited exceptions, that 50% of these shares will not be transferred, assigned, sold or released from escrow until the earlier of six months after the date of the consummation of the Company’s initial Business Combination and the date on which the closing price of our common stock equals or exceeds $12.50 per share (as adjusted for stock splits, stock dividends, reorganizations and recapitalizations) for any 20 trading days within any 30-trading day period commencing after our initial business combination and the remaining 50% of the Founder Shares will not be transferred, assigned, sold or released from escrow until six months after the date of the consummation of our initial Business Combination, or earlier, in either case, if, subsequent to our initial Business Combination, we complete a liquidation, merger, stock exchange or other similar transaction which results in all of our stockholders having the right to exchange their shares of common stock for cash, securities or other property .\nRelated Party Loans\nOn October 7, 2021, Lin Ding Jie, a member of the sponsor agreed to loan the Company an aggregate of up to $ 300,000 to cover expenses related to the IPO pursuant to a promissory note (the “Note”). As of June 30, 2022 and December 31, 2021, the Company had no borrowings under the Note.\nIn addition, in order to finance transaction costs in connection with a Business Combination, the sponsor or an affiliate of the sponsor, or certain of the Company’s officers and directors may, but are not obligated to, loan the Company funds as may be required (“Working Capital Loans”). If the Company completes a Business Combination, the Company will repay the Working Capital Loans out of the proceeds of the Trust Account released to the Company. Otherwise, the Working Capital Loans would be repaid only out of funds held outside the Trust Account. In the event that a Business Combination does not close, the Company may use a portion of proceeds held outside the Trust Account to repay the Working Capital Loans, but no proceeds held in the Trust Account would be used to repay the Working Capital Loans. Except for the foregoing, the terms of such Working Capital Loans, if any, have not been determined and no written agreements exist with respect to such loans. The Working Capital Loans would either be repaid upon consummation of a Business Combination, without interest, or, at the lender’s discretion, up to $ 1.5 million of such Working Capital Loans may be convertible into units of the post Business Combination entity at a price of $ 10.00 per unit. The units would be identical to the Private Placement Units. As of June 30, 2022 and December 31, 2021, there were no Working Capital Loans outstanding.\nSupport Services\nThe Company has entered into an administrative services agreement pursuant to which the Company will pay our sponsor a total of $ 10,000 per month for office space, administrative and support services. Upon completion of our initial Business Combination or our liquidation, the Company will cease paying these monthly fees. As of June 30, 2022 and December 31, 2021, $ 67,000 and $ 7,000 respectively, have been accrued under this arrangement and shown under “Due to affiliate” in the accompanying balance sheet.\n\n| 12 |\n\nNote 6 — Commitments and Contingencies\nRegistration Rights\nThe holders of Founder Shares, Private Placement Units and warrants that may be issued upon conversion of Working Capital Loans, if any, will be entitled to registration rights (in the case of the Founder Shares, only after conversion of such shares to shares of common stock) pursuant to a registration rights signed on the date of the prospectus for the IPO. These holders are entitled to certain demand and “piggyback” registration rights. However, the registration rights agreement provides that the Company will not permit any registration statement filed under the Securities Act to become effective until the termination of the applicable lock-up period for the securities to be registered. The Company will bear the expenses incurred in connection with the filing of any such registration statements.\nUnderwriting Agreement\nThe Company granted the underwriters a 45-day option from the final prospectus relating to the IPO to purchase up to 1,500,000 additional Units to cover over-allotments, if any, at the IPO price less the underwriting discounts.\nThe underwriters were paid a cash underwriting discount of $ 0.20 per unit on the offering including the Units issued with the underwriter’s exercise of their over-allotment option, or $ 2,300,000 in the aggregate at the closing of the IPO. In addition, the underwriters are entitled to deferred underwriting discounts of $ 0.35 per unit, or $ 4,025,000 from the closing of the IPO and the exercise of the over-allotment option. The deferred discounts will become payable to the underwriters from the amounts held in the Trust Account solely if the Company completes a Business Combination, subject to the terms of the underwriting agreement.\nNote 7 — Stockholders’ Deficit\nCommon stock\nThe Company is authorized to issue 500,000,000 shares of common stock with a par value of $ 0.001 per share. As of June 30, 2022, and December 31, 2021, there were 3,445,000 (excluding 11,500,000 shares of common stock subject to possible redemption) shares of common stock issued and outstanding.\nWarrants:\nAs of June 30, 2022 and December 31, 2021, the Company had 11,500,000 Public Warrants and 570,000 Private Placement Warrants outstanding.\nThe Public Warrants are accounted for as an equity instrument in the Company’s financial statements. Public Warrants may only be exercised for a whole number of shares. No fractional shares will be issued upon exercise of the Public Warrants. The Public Warrants will become exercisable on the later of the completion of an initial Business Combination and will expire five years after the completion of an initial Business Combination, or earlier upon redemption. No Public Warrants will be exercisable for cash unless the Company has an effective and current registration statement covering the common stock issuable upon exercise of the Public Warrants and a current prospectus relating to such common stock. Notwithstanding the foregoing, if a registration statement covering the common stock issuable upon exercise of the Public Warrants is not effective within a specified period following the consummation of a Business Combination, Warrant holders may, until such time as there is an effective registration statement and during any period when the Company shall have failed to maintain an effective registration statement, exercise Warrants on a cashless basis pursuant to the exemption provided by Section 3(a)(9) of the Securities Act, provided that such exemption is available. If that exemption, or another exemption, is not available, holders will not be able to exercise their Warrants on a cashless basis. The Public Warrants will expire five years after the completion of a Business Combination or earlier upon redemption or liquidation.\nRedemption of warrants when the price per common stock equals or exceeds $ 16.50\n\n| 13 |\n\nOnce the warrants become exercisable, the Company may redeem the outstanding warrants (except as described herein with respect to the private placement warrants):\n\n| ● | in whole and not in part; |\n| ● | at a price of $ 0.01 per warrant; |\n| ● | upon a minimum of 30 days’ prior written notice of redemption, which the Company refers to as the “30-day redemption period”; and |\n| ● | if, and only if, the last reported sale price (the “closing price”) of our common stock equals or exceeds $ 16.50 per share (as adjusted for adjustments to the number of shares issuable upon exercise or the exercise price of a warrant as described under the heading “Description of Securities—Warrants”) for any 20 trading days within a 30-trading day period ending on the third trading day prior to the date on which the Company sends the notice of redemption to the warrant holders. |\n\nThe Company will not redeem the warrants as described above unless an effective registration statement under the Securities Act covering the common stock issuable upon exercise of the warrants is effective and a current prospectus relating to those common stock is available throughout the 30-day redemption period. If and when the warrants become redeemable by us, the Company may exercise our redemption right even if the Company is unable to register or qualify the underlying securities for sale under all applicable state securities laws.\nIf the Company calls the Public Warrants for redemption, management will have the option to require all holders that wish to exercise the Public Warrants to do so on a “cashless basis,” as described in the warrant agreement.\nThe Private Warrants will be identical to the Public Warrants underlying the Units being sold in the IPO, except that the Private Warrants and the common stock issuable upon the exercise of the Private Warrants will not be transferable, assignable or saleable until after the completion of a Business Combination, subject to certain limited exceptions.\nThe exercise price and number of common stock issuable on exercise of the warrants may be adjusted in certain circumstances including in the event of a share dividend, extraordinary dividend or our recapitalization, reorganization, merger or consolidation. However, the warrants will not be adjusted for issuances of common stock at a price below their respective exercise prices. Additionally, in no event will the Company be required to net cash settle the warrants. If the Company is unable to complete a Business Combination within the Combination Period and the Company liquidates the funds held in the Trust Account, holders of warrants will not receive any of such funds with respect to their warrants, nor will they receive any distribution from the Company’s assets held outside of the Trust Account with the respect to such warrants. Accordingly, the warrants may expire worthless.\nIn addition, if the Company issues additional common stock or equity-linked securities for capital raising purposes in connection with the closing of a Business Combination at an issue price or effective issue price of less than $ 9.50 per share of common stock (with such issue price or effective issue price to be determined in good faith by the Company’s board of directors, and in the case of any such issuance to the initial stockholders or their affiliates, without taking into account any Founder Shares held by them prior to such issuance), (y) the aggregate gross proceeds from such issuances represent more than 60 % of the total equity proceeds, and interest thereon, available for the funding of a Business Combination on the date of the consummation of a Business Combination (net of redemptions), and (z) the volume weighted average trading price of the Company’s common stock during the 20 trading day period starting on the trading day prior to the day on which the Company consummates Business Combination (such price, the “Market Value”) is below $ 9.50 per share, the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 165 % of the greater of (i) the Market Value or (ii) the price at which the Company issues the additional common stock or equity-linked securities.\n\n| 14 |\n\nRights\nExcept in cases where the Company is not the surviving company in a Business Combination, each holder of a Public Right will automatically receive one-tenth of one share of common stock upon consummation of a Business Combination, even if the holder of a Public Right converted all shares held by him, her or it in connection with a Business Combination or an amendment to the Company’s Amended and Restated Certificate of Incorporation with respect to its pre-business combination activities. In the event that the Company will not be the surviving company upon completion of a Business Combination, each holder of a Public Right will be required to affirmatively convert his, her or its rights in order to receive the one-tenth of a share underlying each Public Right upon consummation of the Business Combination.\nThe Company will not issue fractional shares in connection with an exchange of Public Rights. Fractional shares will either be rounded down to the nearest whole share or otherwise addressed in accordance with the applicable provisions of the Delaware General Corporation Law. As a result, the holders of the Public Rights must hold rights in multiples of 10 in order to receive shares for all of the holders’ rights upon closing of a Business Combination.\nNote 8 — Fair Value Measurements\nThe fair value of the Company’s financial assets and liabilities reflects management’s estimate of amounts that the Company would have received in connection with the sale of the assets or paid in connection with the transfer of the liabilities in an orderly transaction between market participants at the measurement date. In connection with measuring the fair value of its assets and liabilities, the Company seeks to maximize the use of observable inputs (market data obtained from independent sources) and to minimize the use of unobservable inputs (internal assumptions about how market participants would price assets and liabilities). The following fair value hierarchy is used to classify assets and liabilities based on the observable inputs and unobservable inputs used in order to value the assets and liabilities:\nLevel 1: Quoted prices in active markets for identical assets or liabilities. An active market for an asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis.\nLevel 2: Observable inputs other than Level 1 inputs. Examples of Level 2 inputs include quoted prices in active markets for similar assets or liabilities and quoted prices for identical assets or liabilities in markets that are not active.\nLevel 3: Unobservable inputs based on our assessment of the assumptions that market participants would use in pricing the asset or liability.\nAt June 30, 2022 and December 31, 2021, the assets held in the Trust Account were held in U.S. Treasury Securities. All of the Company’s investments held in the Trust Account are classified as trading securities.\nThe following table presents information about the Company’s liabilities that are measured at fair value on a recurring basis at June 30, 2022 and December 31, 2021 and indicates the fair value hierarchy of the valuation inputs the Company utilized to determine such fair value.\nSchedule of Financial Assets and Liabilities Measured at Fair Value on Recurring Basis\nJune 30, 2022\n\n| Quoted Prices in Active Markets | Significant Other Observable Inputs | Significant Other Unobservable Inputs |\n| Level | (Level 1) | (Level 2) | (Level 3) |\n| Assets: |\n| U.S. Treasury Securities | 1 | $ | 116,813,337 | — | — |\n\nDecember 31, 2021\n\n| Quoted Prices in Active Markets | Significant Other Observable Inputs | Significant Other Unobservable Inputs |\n| Level | (Level 1) | (Level 2) | (Level 3) |\n| Assets: |\n| U.S. Treasury Securities | 1 | $ | 116,725,099 | — | — |\n\nNote 9 — Subsequent Events\nThe Company evaluated subsequent events and transactions that occurred after the balance sheet date up to August 15, 2022, the date that the financial statements were available to be issued has determined that there have been no events that have occurred that would require adjustments to the disclosures of the financial statements.\nOn August 3, 2022, Tomorrow Crypto Group Inc., a Nevada corporation (“Tomorrow Crypto”) and Globalink Investment Inc. (NASDAQ: “GLLI”, “GLLIU” units, “GLLIW” warrants, and “GLLIR” rights) (“Globalink”), a publicly traded special purpose acquisition company, announced that they have entered into a definitive merger agreement. Transaction values Tomorrow Crypto at an enterprise value of approximately $ 310 million and provides up to $ 131,725,000 in gross proceeds, including up to $ 116,725,000 of cash held in the trust account of Globalink Investment Inc. (depending on the amount of redemptions by Globalink’s public stockholders) and $ 15,000,000 from a concurrent PIPE investment. The transaction is expected to close in Q4 of 2022. The combined company will be named Tomorrow Crypto Group Holding Inc. and is expected to be listed on Nasdaq.\n\n| 15 |\n\n\nReferences in this report (this “Quarterly Report”) to “we,” “us” or the “Company” refer to Globalink Investment Inc. References to our “management” or our “management team” refer to our officers and directors, and references to the “Sponsor” refer to GL Sponsor LLC. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Quarterly Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\nSpecial Note Regarding Forward-Looking Statements\nThis Quarterly Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act that are not historical facts and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. All statements, other than statements of historical fact included in this Form 10-Q including, without limitation, statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. Words such as “expect,” “believe,” “anticipate,” “intend,” “estimate,” “seek” and variations and similar words and expressions are intended to identify such forward-looking statements. Such forward-looking statements relate to future events or future performance, but reflect management’s current beliefs, based on information currently available. A number of factors could cause actual events, performance or results to differ materially from the events, performance and results discussed in the forward-looking statements. For information identifying important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements, please refer to the Risk Factors section of the Company’s final prospectus filed with the U.S. Securities and Exchange Commission (the “SEC”). The Company’s securities filings can be accessed on the EDGAR section of the SEC’s website at www.sec.gov. Except as expressly required by applicable securities law, the Company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.\nOverview\nWe are a blank check company incorporated on March 24, 2021 in Delaware and formed for the purpose of effectuating a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses, which we refer to throughout this Quarterly Report as our “Business Combination.” We intend to effectuate our initial Business Combination using cash from the proceeds of our IPO and the private placement of the Private Units (as defined below), the proceeds of the sale of our shares in connection with our initial business combination, our shares, debt or a combination of the foregoing.\nThe issuance of additional shares in connection with an initial Business Combination:\n\n| ● | may significantly dilute the equity interest of our investors who would not have pre-emption rights in respect of any such issuance; |\n| ● | may subordinate the rights of holders of shares of common stock if we issue shares of preferred stock with rights senior to those afforded to our shares of common stock; |\n| ● | could cause a change in control if a substantial number of shares of our common stock is issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and could result in the resignation or removal of our present officers and directors; |\n| ● | may have the effect of delaying or preventing a change of control of us by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and |\n| ● | may adversely affect prevailing market prices for our common stock, rights and/or warrants. |\n\n\n| 16 |\n\n\n| Similarly, if we issue debt securities or otherwise incur significant debt, it could result in: |\n| ● | default and foreclosure on our assets if our operating revenues after an initial Business Combination are insufficient to repay our debt obligations; |\n| ● | acceleration of our obligations to repay the indebtedness even if we make all principal and interest payments when due if we breach certain covenants that require the maintenance of certain financial ratios or reserves without a waiver or renegotiation of that covenant; |\n| ● | our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; |\n| ● | our inability to obtain necessary additional financing if the debt security contains covenants restricting our ability to obtain such financing while the debt security is outstanding; |\n| ● | using a substantial portion of our cash flow to pay principal and interest on our debt, which will reduce the funds available for dividends on our common stock if declared, our ability to pay expenses, make capital expenditures and acquisitions, and fund other general corporate purposes; |\n| ● | limitations on our flexibility in planning for and reacting to changes in our business and in the industry in which we operate; |\n| ● | increased vulnerability to adverse changes in general economic, industry and competitive conditions and adverse changes in government regulation; |\n| ● | limitations on our ability to borrow additional amounts for expenses, capital expenditures, acquisitions, debt service requirements, and execution of our strategy; and |\n| ● | other purposes and other disadvantages compared to our competitors who have less debt. |\n\nWe expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete a Business Combination will be successful.\nResults of Operations\nAs of June 30, 2022, the Company had not commenced any operations. All activity through June 30, 2022 relates to the Company’s formation and the IPO and search for a prospective initial business combination target. The Company will not generate any operating revenues until after the completion of an initial Business Combination, at the earliest. The Company will generate non-operating income in the form of interest income from the proceeds derived from the IPO placed in the Trust Account (defined below).\nFor the three months ended June 30, 2022, we had a net loss of $52,981 all of which consisted of operating expenses incurred driven by general and administrative expenses of $89,962 and accrual of Delaware franchise taxes of $50,000 and interest income on investments held in the Trust Account of $86,981.\nFor the six months ended June 30, 2022, we had a net loss of $255,242 all of which consisted of operating expenses incurred driven by general and administrative expenses of $ 243,480 and accrual of Delaware franchise taxes of $100,000 and interest income on investments held in the Trust Account of $88,238.\nLiquidity and Capital Resources\nThe registration statement on Form S-1 for the Company’s IPO was declared effective on December 6, 2021. On December 9, 2021, we consummated our IPO of 10,000,000 units. Each Unit consists of one share of common stock, $0.001 par value, one right to receive one-tenth (1/10) of a share of common stock upon the consummation of an initial business combination and one redeemable warrant entitling the holder thereof to purchase one-half (1/2) of a share of common stock at a price of $11.50 per whole share. The units were sold at an offering price of $10.00 per Unit, generating gross proceeds of $100,000,000. Simultaneously with the closing of the IPO, we consummated the private placement of 517,500 private units at a price of $10.00 per unit, generating total proceeds of $5,175,000.\n\n| 17 |\n\nOn December 9, 2021, the underwriters exercised the over-allotment option in full, and the closing of the Over-Allotment Units occurred on December 13, 2021. The total aggregate issuance by the Company of 1,500,000 units at a price of $10.00 per unit resulted in total gross proceeds of $15,000,000. On December 13, 2021, simultaneously with the sale of the Over-Allotment Units, we consummated the private sale of an additional 52,500 private units, generating gross proceeds of $525,000. Since the underwriter’s over-allotment was exercised in full, the Sponsor did not forfeit any insider shares.\nOffering costs for the IPO and the exercise of the underwriters’ Over-allotment Option amounted to $6,887,896, consisting of $2,300,000 of underwriting fees, $4,025,000 of deferred underwriting fees payable (which are held in the trust account) and $562,896 of other costs. The $4,025,000 of deferred underwriting fee payable is contingent upon the consummation of an initial Business Combination by March 9, 2023, subject to the terms of the underwriting agreement.\nFollowing the closing of the IPO (including the Over-Allotment Units), $116,725,000 ($10.15 per Unit) from the net proceeds of the sale of the units in the IPO, Over-Allotment Units, and the private units was placed in a trust account established for the benefit of the Company’s public stockholders at JPMorgan Chase Bank, N.A. maintained by Continental Stock Transfer & Trust Company, acting as trustee and is invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), with a maturity of 180 days or less or in any open-ended investment company that holds itself out as a money market fund selected by the Company meeting the conditions of paragraphs (d)(2), (d)(3) and (d)(4) of Rule 2a-7 of the Investment Company Act, as determined by the Company, until the earlier of: (i) the completion of an initial Business Combination and (ii) the distribution of the trust account.\nFor the three and six months ended June 30, 2022, net loss was $52,981 and $255,242 mainly consisting of general and administration expenses of $89,962 and $243,480 and offset partially by interest earned on marketable securities held in the trust account of $86,981 and $88,238. Net cash used in operating activities was $355,952, which was due to prepaid expenses and other assets of $7,743, accounts payable and accrued expenses of $120,215 and franchise tax payable of $100,000. Net cash used in financing activities was $60,000 which was due to affiliate.\nWe had investment held in the trust account of $116,813,337 and $116,725,099 as of June 30, 2022, and December 31, 2021 respectively. Interest income on the balance in the trust account of $88,238 for the six months ended June 30, 2022 may be used by us to pay taxes. Through June 30, 2022, no amount was withdrawn from the trust account to pay for taxes.\nWe intend to use substantially all of the funds held in the trust account, including any amounts representing interest earned on the trust account (less income taxes payable), to complete our initial business combination. To the extent that our capital stock or debt is used, in whole or in part, as consideration to complete our initial business combination, the remaining proceeds held in the trust account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies.\nWe had $516,280 and 812,232 of cash held outside of the trust account as of June 30, 2022, and December 31, 2021 respectively. We intend to use the funds held outside the trust account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, and structure, negotiate and complete initial business combination.\nDing Jie Lin, a member of the Sponsor agreed to loan the Company an aggregate of up to $300,000 to cover expenses related to the IPO pursuant to a promissory note (the “Note”). As of June 30, 2022, the Company had no borrowings under the Note which was repaid on December 13, 2021.\n\n| 18 |\n\nIn order to finance transaction costs in connection with an initial Business Combination, the Sponsor or an affiliate of the Sponsor, or certain of the Company’s officers and directors may, but are not obligated to, loan the Company funds as may be required. If the Company completes an initial Business Combination, the Company will repay the working capital loans out of the proceeds of the trust account released to the Company. Otherwise, the working capital loans would be repaid only out of funds held outside the trust account. In the event that our initial business combination does not close, the Company may use a portion of proceeds held outside the trust account to repay the working capital loans, but no proceeds held in the trust account would be used to repay the working capital loans. Except for the foregoing, the terms of such working capital loans, if any, have not been determined and no written agreements exist with respect to such loans. The working capital loans would either be repaid upon consummation of an initial business combination, without interest, or, at the lender’s discretion, up to $1,500,000 of such working capital loans may be convertible into units of the post initial business combination entity at a price of $10.00 per unit. The units would be identical to the private units. As of June 30, 2022, there were no working capital loans outstanding.\nWe do not believe we will need to raise additional funds in order to meet the expenditures required for operating our business. However, if our estimate of the costs of identifying a target business, undertaking in-depth due diligence and negotiating a Business Combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our Business Combination. Moreover, we may need to obtain additional financing either to complete our Business Combination or because we become obligated to redeem a significant number of our Public Shares upon consummation of our Business Combination, in which case we may issue additional securities or incur debt in connection with such Business Combination.\nOff-Balance Sheet Arrangements\nWe have no obligations, assets or liabilities, which would be considered off-balance sheet arrangements as of June 30, 2022. We do not participate in transactions that create relationships with entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets.\nContractual obligations\nWe do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities.\nUnderwriting Agreement\nThe Company granted the underwriters a 45-day option to purchase up to 1,500,000 Units to cover Over-allotment. On December 13, 2021, the Underwriters fully exercised the option and purchased 1,500,000 additional Units (the “Over-allotment Units”), generating gross proceeds of $11,500,000. The underwriters are entitled to a deferred underwriting discounts of $0.35 per unit, or $4,025,000 from the closing of the IPO and the Over-Allotment Units. The deferred discounts will become payable to the underwriters from the amounts held in the Trust Account solely if the Company completes an initial Business Combination, subject to the terms of the underwriting agreement.\nRight of First Refusal\nSubject to certain conditions, we granted Chardan, the representative of the underwriters in the IPO, for a period of 18 months after the date of the consummation of our Business Combination, a right of first refusal to act as book-running manager, with at least 30% of the economics, for any and all future public and private equity and debt offerings. In accordance with FINRA Rule 5110(f)(2)(E)(i), such right of first refusal shall not have a duration of more than three years from the effective date of the registration statement for the IPO.\nJOBS Act\nOn April 5, 2012, the JOBS Act was signed into law. The JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We will qualify as an “emerging growth company” and under the JOBS Act will be allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) companies. We are electing to delay the adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As such, our financial statements may not be comparable to companies that comply with public company effective dates.\n\n| 19 |\n\nAdditionally, we are in the process of evaluating the benefits of relying on the other reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, if, as an “emerging growth company,” we choose to rely on such exemptions we may not be required to, among other things, (i) provide an auditor’s attestation report on our system of internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act, (ii) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (iii) comply with any requirement that may be adopted by the PCAOB regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis) and (iv) disclose certain executive compensation related items such as the correlation between executive compensation and performance and comparisons of executive compensation to median employee compensation. These exemptions will apply for a period of five years following the completion of our IPO or until we are no longer an “emerging growth company,” whichever is earlier.\nCritical Accounting Policies\nThe preparation of unaudited condensed financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have identified the following critical accounting policies:\nNet Loss Per Share\nThe Company complies with accounting and disclosure requirements of FASB ASC 260, “Earnings Per Share.” Net loss per share is computed by dividing net loss by the weighted average number of common stock outstanding during the period. Weighted average shares were reduced for the effect of an aggregate of 375,000 common stock that are subject to forfeiture if the underwriters’ over-allotment option is not exercised by the underwriters (Please see Note 5 for more information). As of June 30, 2022, the Company did not have any dilutive securities and other contracts that could, potentially, be exercised or converted into common stock and then share in the earnings of the Company. As a result, diluted loss per share is the same as basic loss per share for the period presented.\nAccounting for Warrants\nThe Company accounts for warrants as either equity-classified or liability-classified instruments based on an assessment of the instruments’ specific terms and applicable authoritative guidance in ASC 480, “Distinguishing Liabilities from Equity” (“ASC 480”) and ASC 815, “Derivatives and Hedging” (“ASC 815”). The assessment considers whether the instruments are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and whether the instruments meet all of the requirements for equity classification under ASC 815, including whether the instruments are indexed to the Company’s own common shares and whether the instrument holders could potentially require “net cash settlement” in a circumstance outside of the Company’s control, among other conditions for equity classification. This assessment, which requires the use of professional judgment, is conducted at the time of warrant issuance and as of each subsequent quarterly period end date while the instruments are outstanding. As discussed in Note 7, the Company determined that upon further review of the warrant agreement, management concluded that the Public Warrants and Private Placement Warrants issued pursuant to the warrant agreement qualify for equity accounting treatment.\nManagement does not believe that any other recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on our condensed financial statements as of June 30, 2022.\n\n| 20 |\n\n\nAs of June 30, 2022, we were not subject to any market or interest rate risk. The net proceeds held in the Trust Account have been invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, with a maturity of 180 days or less or in any open-ended investment company that holds itself out as a money market fund selected by the Company meeting the conditions of paragraphs (d)(2), (d)(3) and (d)(4) of Rule 2a-7 of the Investment Company Act, as determined by the Company. Due to the short-term nature of these investments, we believe there will be no associated material exposure to interest rate risk.\n\nDisclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.\nEvaluation of Disclosure Controls and Procedures\nAs required by Rules 13a-15 and 15d-15 under the Exchange Act, our Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2022. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15 (e) and 15d-15 (e) under the Exchange Act) were effective at a reasonable assurance level and, accordingly, provided reasonable assurance that the information required to be disclosed by us in reports filed under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.\nChanges in Internal Control Over Financial Reporting\nDuring the most recently completed period, there has been no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\nPART II - OTHER INFORMATION\n\nNone.\n\nAs a smaller reporting company, we are not required to make disclosures under this Item. We have provided a comprehensive list of risk factors in the final prospectus for our IPO as filed with the SEC on December 8, 2021.\n\nNone.\n\nNone.\n\nNot applicable.\n\nNone.\n\n| 21 |\n\n\nThe following exhibits are filed as part of, or incorporated by reference into, this Quarterly Report on Form 10-Q.\n\n| Exhibit No. | Description |\n| 3.1 | Certificate of Incorporation (incorporated by reference to our Form S-1, exhibit 3.1 filed with the Securities and Exchange Commission on November 19, 2021) |\n| 3.2 | Amended and Restated Certificate of Incorporation (incorporated by reference to our Form 8-k, exhibit 3.1, filed with the Securities and Exchange Commission on December 10, 2021) |\n| 3.3 | Bylaws (incorporated by reference to our Form S-1, exhibit 3.3 filed with the Securities and Exchange Commission on November 19, 2021) |\n| 3.4 | Form of Amended and Restated Bylaws. (incorporated by reference to our Form S-1, exhibit 3.4 filed with the Securities and Exchange Commission on November 19, 2021) |\n| 4.1 | Specimen Unit Certificate (incorporated by reference to our Form S-1, exhibit 4.1 filed with the Securities and Exchange Commission on November 19, 2021) |\n| 4.2 | Specimen Common Stock Certificate (incorporated by reference to our Form S-1, exhibit 4.2 filed with the Securities and Exchange Commission on November 19, 2021) |\n| 4.3 | Specimen of Right Certificate (incorporated by reference to our Form S-1, exhibit 4.3 filed with the Securities and Exchange Commission on November 19, 2021) |\n| 4.4 | Form of Rights Agreement between Continental Stock Transfer & Trust Company and the Registrant (incorporated by reference to our Form S-1, exhibit 4.4 filed with the Securities and Exchange Commission on November 19, 2021) |\n| 4.5 | Specimen Warrant Certificate (incorporated by reference to our Form S-1, exhibit 4.5 filed with the Securities and Exchange Commission on November 19, 2021) |\n| 4.6 | Form of Warrant Agreement between Continental Stock Transfer & Trust Company and the Registrant (incorporated by reference to our Form S-1, exhibit 4.6 filed with the Securities and Exchange Commission on November 19, 2021) |\n| 31.1* | Certification of Principal Executive Officer Pursuant to Securities Exchange Act Rules 13a-14(a) and 15(d)-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2* | Certification of Principal Financial Officer Pursuant to Securities Exchange Act Rules 13a-14(a) and 15(d)-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1** | Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2** | Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS* | Inline XBRL Instance Document |\n| 101.CAL* | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.SCH* | Inline XBRL Taxonomy Extension Schema Document |\n| 101.DEF* | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB* | Inline XBRL Taxonomy Extension Labels Linkbase Document |\n| 101.PRE* | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104 | Cover Page Interactive Data File (embedded within the Inline XBRL document) |\n\n\n| * | Filed herewith. |\n| ** | Furnished. |\n\n\n| 22 |\n\nSIGNATURES\nIn accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| GLOBALINK INVESTMENT INC. |\n| Date: August 15, 2022 | By: | /s/ Say Leong Lim |\n| Name: | Say Leong Lim |\n| Title: | Chief Executive Officer and Director |\n| (Principal Executive Officer) |\n| Date: August 15, 2022 | By: | /s/ Cliff (Ming Hang) Chong |\n| Name: | Cliff (Ming Hang) Chong |\n| Title: | Chief Financial Officer and Director |\n| (Principal Financial and Accounting Officer) |\n\n\n| 23 |\n\n</text>\n\nWhat is the percentage change in the company's cash held in escrow from December 31, 2021 to June 30, 2022?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n| ITEM 1. | FINANCIAL STATEMENTS |\n\nChico’s FAS, Inc. and Subsidiaries\nConsolidated Statements of Net Income and Comprehensive Income\n(Unaudited)\n(In thousands, except per share amounts)\n\n| Twenty-Six Weeks Ended | Thirteen Weeks Ended |\n| July 28, 2012 | July 30, 2011 | July 28, 2012 | July 30, 2011 |\n| Net sales: |\n| Chicos/Soma Intimates | $ | 839,960 | $ | 749,258 | $ | 414,618 | $ | 374,324 |\n| White House | Black Market | 386,225 | 339,349 | 194,498 | 177,125 |\n| Boston Proper | 66,354 | | 32,606 | |\n| Total net sales | 1,292,539 | 1,088,607 | 641,722 | 551,449 |\n| Cost of goods sold | 551,763 | 461,617 | 279,542 | 242,122 |\n| Gross margin | 740,776 | 626,990 | 362,180 | 309,327 |\n| Selling, general and administrative expenses | 567,797 | 485,201 | 276,121 | 240,356 |\n| Acquisition and integration costs | 841 | | 283 | |\n| Income from operations | 172,138 | 141,789 | 85,776 | 68,971 |\n| Interest income, net | 402 | 820 | 219 | 420 |\n| Income before income taxes | 172,540 | 142,609 | 85,995 | 69,391 |\n| Income tax provision | 65,500 | 53,300 | 32,600 | 26,000 |\n| Net income | $ | 107,040 | $ | 89,309 | $ | 53,395 | $ | 43,391 |\n| Per share data: |\n| Net income per common sharebasic | $ | 0.64 | $ | 0.51 | $ | 0.32 | $ | 0.25 |\n| Net income per common and common equivalent sharediluted | $ | 0.64 | $ | 0.51 | $ | 0.32 | $ | 0.25 |\n| Weighted average common shares outstandingbasic | 163,898 | 173,082 | 163,822 | 171,282 |\n| Weighted average common and common equivalent shares outstandingdiluted | 164,834 | 174,298 | 164,732 | 172,495 |\n| Comprehensive income | $ | 107,019 | $ | 89,651 | $ | 53,496 | $ | 43,588 |\n| Dividends declared per share | $ | 0.1575 | $ | 0.15 | $ | 0.0525 | $ | 0.05 |\n\nSee Accompanying Notes to the Consolidated Financial Statements.\n3\nChico’s FAS, Inc. and Subsidiaries Consolidated Balance Sheets (In thousands) July 28, 2012 January 28, 2012 July 30, 2011 (Unaudited) (Unaudited) ASSETS Current Assets: Cash and cash equivalents $ 109,466 $ 58,919 $ 56,109 Marketable securities, at fair value 248,480 188,934 448,211 Inventories 191,694 194,469 190,745 Prepaid expenses and other current assets 52,642 55,104 57,190 Total Current Assets 602,282 497,426 752,255 Property and Equipment, net 576,788 550,230 524,782 Other Assets: Goodwill 238,693 238,693 96,774 Other intangible assets, net 129,933 132,112 38,930 Other assets, net 6,628 6,691 5,532 Total Other Assets 375,254 377,496 141,236 $ 1,554,324 $ 1,425,152 $ 1,418,273 LIABILITIES AND STOCKHOLDERS’ EQUITY Current Liabilities: Accounts payable $ 139,800 $ 100,395 $ 132,703 Other current liabilities 151,936 137,714 113,035 Total Current Liabilities 291,736 238,109 245,738 Noncurrent Liabilities: Deferred liabilities 129,782 125,690 127,227 Deferred taxes 50,840 52,125 2,969 Total Noncurrent Liabilities 180,622 177,815 130,196 Stockholders’ Equity: Preferred stock — — — Common stock 1,660 1,657 1,722 Additional paid-in capital 320,161 302,612 293,881 Retained earnings 759,838 704,631 746,006 Accumulated other comprehensive income 307 328 730 Total Stockholders’ Equity 1,081,966 1,009,228 1,042,339 $ 1,554,324 $ 1,425,152 $ 1,418,273 See Accompanying Notes to the Consolidated Financial Statements. 4 Chico’s FAS, Inc. and Subsidiaries Consolidated Statements of Cash Flows (Unaudited) (In thousands) Twenty-Six Weeks Ended July 28, 2012 July 30, 2011 Cash Flows From Operating Activities: Net income $ 107,040 $ 89,309 Adjustments to reconcile net income to net cash provided by operating activities — Depreciation and amortization 52,655 48,353 Deferred tax (benefit) expense (4,490 ) 4,845 Stock-based compensation expense 11,005 8,365 Excess tax benefit from stock-based compensation (3,367 ) (1,642 ) Deferred rent and lease credits (8,082 ) (9,167 ) Loss on disposal and impairment of property and equipment 1,759 1,756 Decrease (increase) in assets — Inventories 2,775 (30,931 ) Prepaid expenses and other assets 5,519 (12,416 ) Increase in liabilities — Accounts payable 30,689 17,417 Accrued and other deferred liabilities 30,032 6,637 Total adjustments 118,495 33,217 Net cash provided by operating activities 225,535 122,526 Cash Flows From Investing Activities: (Increase) decrease in marketable securities (59,568 ) 86,150 Purchases of property and equipment (78,755 ) (56,265 ) Net cash (used in) provided by investing activities (138,323 ) 29,885 Cash Flows From Financing Activities: Proceeds from issuance of common stock 6,524 2,762 Excess tax benefit from stock-based compensation 3,367 1,642 Dividends paid (17,530 ) (17,521 ) Repurchase of common stock (29,026 ) (97,880 ) Net cash used in financing activities (36,665 ) (110,997 ) Net increase in cash and cash equivalents 50,547 41,414 Cash and Cash Equivalents, Beginning of period 58,919 14,695 Cash and Cash Equivalents, End of period $ 109,466 $ 56,109 Supplemental Disclosures of Cash Flow Information: Cash paid for interest $ 175 $ 195 Cash paid for income taxes, net $ 46,457 $ 51,587 See Accompanying Notes to the Consolidated Financial Statements. 5 Chico’s FAS, Inc. and Subsidiaries Notes to Consolidated Financial Statements July 28, 2012 (Unaudited) (in thousands, except share data) Note 1. Basis of Presentation The accompanying unaudited consolidated financial statements of Chico’s FAS, Inc. and its wholly-owned subsidiaries (collectively, the “Company”) have been prepared in accordance with the instructions to Form 10-Q and do not include all of the information and notes required by accounting principles generally accepted in the U.S. (“U.S. GAAP”) for complete financial statements. In the opinion of management, such interim financial statements reflect all normal, recurring adjustments considered necessary to present fairly the financial position, the results of operations and cash flows for the interim periods presented. All significant intercompany balances and transactions have been eliminated in consolidation. For further information, refer to the consolidated financial statements and notes thereto for the fiscal year ended January 28, 2012, included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”) on March 21, 2012. The January 28, 2012 consolidated balance sheet amounts were derived from audited financial statements included in the Company’s Annual Report. As used in this report, all references to “we,” “us,” “our,” and “the Company,” refer to Chico’s FAS, Inc. and all of its wholly-owned subsidiaries. Our fiscal years end on the Saturday closest to January 31 and are designated by the calendar year in which the fiscal year commences. Operating results for the thirteen and twenty-six weeks ended July 28, 2012 are not necessarily indicative of the results that may be expected for the entire year. Certain prior year amounts have been reclassified in order to conform to the current year presentation. Note 2. New Accounting Pronouncements In July 2012, the Financial Accounting Standards Board (“FASB”) issued updated guidance on the periodic testing of indefinite-lived intangible assets for impairment. This guidance provides companies the option to first assess qualitative factors to determine if it is more likely than not that an indefinite-lived intangible asset is impaired and whether it is necessary to perform an annual quantitative impairment test. This guidance is effective for fiscal years beginning after September 15, 2012, with early adoption permitted. We plan to early adopt this guidance and do not expect its adoption to have an impact on our consolidated results of operations, financial position or cash flows. In June 2011, the FASB issued new disclosure guidance related to the presentation of the statement of comprehensive income. This guidance provides an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The option to report other comprehensive income and its components in the statement of changes in stockholders’ equity was eliminated. This guidance is effective for periods beginning after December 15, 2011 and must be retroactively applied to all reporting periods presented. We adopted this guidance effective January 29, 2012 and the interim presentation has been adjusted to show total comprehensive income in one continuous statement with net income in accordance with the new guidance. Other than the change in presentation, this guidance did not have an impact on our consolidated results of operations, financial position or cash flows. 6 Chico’s FAS, Inc. and Subsidiaries Notes to Consolidated Financial Statements July 28, 2012 (Unaudited) (in thousands, except share data) Note 3. Acquisition of Boston Proper On September 19, 2011, we acquired all of the outstanding equity of Boston Proper, Inc. (“Boston Proper”), a privately held online and catalog retailer of distinctive women’s apparel and accessories. Total cash consideration was approximately $214 million. We allocated the purchase price to the tangible and intangible assets acquired and liabilities assumed based on their estimated fair values on the acquisition date, with the remaining unallocated purchase price recorded as goodwill. The allocation of the purchase price to assets acquired and liabilities assumed is subject to further adjustment pending finalization of management’s analysis. Note 4. Stock-Based Compensation For the twenty-six weeks ended July 28, 2012 and July 30, 2011, stock-based compensation expense was $11.0 million and $8.4 million, respectively, and for the thirteen weeks ended July 28, 2012 and July 30, 2011, stock-based compensation expense was $5.7 million and $4.7 million, respectively. We recognize stock-based compensation expense, net of a forfeiture rate, on a straight-line basis over the requisite service period of the award. As of July 28, 2012, approximately 10.5 million shares remain available for future grants of equity awards under our 2012 Omnibus Stock and Incentive Plan. For the twenty-six weeks ended July 28, 2012, we did not grant any stock options. In the years that we granted options, we used the Black-Scholes option-pricing model to value our stock options. The weighted average assumptions relating to the valuation of our stock options for the twenty-six and thirteen weeks ended July 30, 2011 were as follows: Twenty-Six Weeks Ended July 30, 2011 Thirteen Weeks Ended July 30, 2011 Weighted average fair value of grants $ 6.70 $ 6.66 Expected volatility 66 % 64 % Expected term (years) 4.5 4.5 Risk-free interest rate 1.9 % 1.6 % Expected dividend yield 1.5 % 1.4 % Stock-Based Awards Activity The following table presents a summary of our stock option activity for the twenty-six weeks ended July 28, 2012: Number of Shares Weighted Average Exercise Price Outstanding, beginning of period 6,303,378 $ 13.09 Granted — — Exercised (853,757 ) 6.59 Canceled or expired (218,544 ) 18.43 Outstanding, end of period 5,231,077 13.92 Exercisable at July 28, 2012 3,807,890 14.23 7 Chico’s FAS, Inc. and Subsidiaries Notes to Consolidated Financial Statements July 28, 2012 (Unaudited) (in thousands, except share data) Note 4. Stock-Based Compensation (continued) The following table presents a summary of our restricted stock activity for the twenty-six weeks ended July 28, 2012: Number of Shares Weighted Average Grant Date Fair Value Unvested, beginning of period 2,107,951 $ 11.36 Granted 1,553,537 14.97 Vested (355,112 ) 13.56 Canceled (116,111 ) 13.02 Unvested, end of period 3,190,265 12.79 Performance-based Awards For the twenty-six weeks ended July 28, 2012, we granted performance-based restricted stock units (“PSUs”), contingent upon the achievement of a Company-specific performance goal during fiscal 2012. Any units earned as a result of the achievement of this goal will vest over 3 years from the date of grant and will be settled in shares of our common stock. We are recording compensation expense based on the number of units ultimately expected to vest, recognized on a straight-line basis over the 3-year service period. The following table presents a summary of our PSU activity for the twenty-six weeks ended July 28, 2012: Number of Units Weighted Average Grant Date Fair Value Unvested, beginning of period — $ — Granted 696,596 15.01 Vested — — Canceled (13,710 ) 15.01 Unvested, end of period 682,886 15.01 Note 5. Earnings Per Share In accordance with accounting guidance, unvested share-based payment awards that include non-forfeitable rights to dividends, whether paid or unpaid, are considered participating securities. As a result, such awards are required to be included in the calculation of basic earnings per common share pursuant to the “two-class” method. For us, participating securities are comprised of unvested restricted stock awards. Earnings per share (“EPS”) is determined using the two-class method, as it is more dilutive than the treasury stock method. Basic EPS is computed by dividing net income available to common stockholders by the weighted-average number of common shares outstanding during the period. Diluted EPS reflects the dilutive effect of potential common shares from securities such as stock options and PSUs. 8 Chico’s FAS, Inc. and Subsidiaries Notes to Consolidated Financial Statements July 28, 2012 (Unaudited) (in thousands, except share data) Note 5. Earnings Per Share (continued) The following table sets forth the computation of basic and diluted EPS shown on the face of the accompanying consolidated statements of net income and comprehensive income: Twenty-Six Weeks Ended Thirteen Weeks Ended July 28, 2012 July 30, 2011 July 28, 2012 July 30, 2011 Numerator Net income $ 107,040 $ 89,309 $ 53,395 $ 43,391 Net income and dividends declared allocated to unvested restricted stock (1,941 ) (1,110 ) (1,006 ) (573 ) Net income available to common stockholders $ 105,099 $ 88,199 $ 52,389 $ 42,818 Denominator Weighted average common shares outstanding – basic 163,897,542 173,081,952 163,822,041 171,282,434 Dilutive effect of outstanding awards 935,972 1,216,112 910,234 1,212,573 Weighted average common and common equivalent shares outstanding – diluted 164,833,514 174,298,064 164,732,275 172,495,007 Net income per common share Basic $ 0.64 $ 0.51 $ 0.32 $ 0.25 Diluted $ 0.64 $ 0.51 $ 0.32 $ 0.25 For the twenty-six weeks ended July 28, 2012 and July 30, 2011, stock options representing 2,829,889 and 3,964,669 shares of common stock, respectively, were excluded from the computation of diluted EPS because they were anti-dilutive. For the thirteen weeks ended July 28, 2012 and July 30, 2011, stock options representing 2,698,666 and 3,980,832 shares of common stock, respectively, were excluded from the computation of diluted EPS because they were anti-dilutive. Note 6. Fair Value Measurements Our financial instruments consist of cash and cash equivalents, marketable securities, trade receivables and payables. The carrying values of these assets and liabilities approximate their fair value due to the short-term nature of the instruments. Marketable securities are classified as available-for-sale and generally consist of corporate bonds, municipal securities, and U.S. government and agency securities. As of July 28, 2012, our holdings consisted of $129.4 million of securities with maturity dates within one year or less and $119.1 million with maturity dates over one year and less than or equal to two years. 9 Chico’s FAS, Inc. and Subsidiaries Notes to Consolidated Financial Statements July 28, 2012 (Unaudited) (in thousands, except share data) Note 6. Fair Value Measurements (continued) We consider all securities available-for-sale, including those with maturity dates beyond 12 months, and therefore classify these securities within current assets on the consolidated balance sheets as they are available to support current operational liquidity needs. Marketable securities are carried at fair value, with the unrealized holding gains and losses, net of income taxes, reflected as a separate component of stockholders’ equity until realized. For the purposes of computing realized and unrealized gains and losses, cost is determined on a specific identification basis. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market in an orderly transaction between market participants on the measurement date. Entities are required to use a three-level hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability on the measurement date. The three levels are defined as follows: Level 1 – Unadjusted quoted prices in active markets for identical assets or liabilities Level 2 – Unadjusted quoted prices in active markets for similar assets or liabilities, or; Unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or; Inputs other than quoted prices that are observable for the asset or liability Level 3 – Unobservable inputs for the asset or liability. We measure certain financial assets at fair value on a recurring basis, including our marketable securities, which are classified as available-for-sale securities, certain cash equivalents, specifically our money market accounts, and assets held in our non-qualified deferred compensation plan. The money market accounts are valued based on quoted market prices in active markets. Our marketable securities are generally valued based on other observable inputs for those securities (including market-corroborated pricing or other models that utilize observable inputs such as interest rates and yield curves) based on information provided by independent third party entities, except for U.S. government securities which are valued based on quoted market prices in active markets. The investments in our non-qualified deferred compensation plan are valued using quoted market prices in active markets and are included in other assets on our consolidated balance sheets. From time to time, we measure certain assets at fair value on a non-recurring basis, specifically long-lived assets evaluated for impairment. We estimate the fair value of our long-lived assets using company-specific assumptions which would fall within Level 3 of the fair value hierarchy. During the quarter ended July 28, 2012, we did not make any transfers between Level 1 and Level 2 financial assets. Furthermore, as of July 28, 2012, January 28, 2012 and July 30, 2011, we did not have any Level 3 financial assets. We conduct reviews on a quarterly basis to verify pricing, assess liquidity, and determine if significant inputs have changed that would impact the fair value hierarchy disclosure. 10 Chico’s FAS, Inc. and Subsidiaries Notes to Consolidated Financial Statements July 28, 2012 (Unaudited) (in thousands, except share data) Note 6. Fair Value Measurements (continued) In accordance with the provisions of the guidance, we categorized our financial assets based on the priority of the inputs to the valuation technique for the instruments, as follows: Fair Value Measurements at Reporting Date Using Balance as of July 28, 2012 Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Current Assets Cash equivalents: Money market account $ 18,808 $ 18,808 $ — $ — Marketable securities: Municipal securities 87,741 — 87,741 — U.S. government securities 28,569 28,569 — — U.S. government agencies 26,596 — 26,596 — Corporate bonds 101,580 — 101,580 — Commercial paper 3,994 — 3,994 — Non Current Assets Deferred compensation plan 4,175 4,175 — — Total $ 271,463 $ 51,552 $ 219,911 $ — Balance as of January 28, 2012 Current Assets Cash equivalents: Money market account $ 3,793 $ 3,793 $ — $ — Marketable securities: Municipal securities 61,260 — 61,260 — U.S. government securities 25,355 25,355 — — U.S. government agencies 23,648 — 23,648 — Corporate bonds 73,107 — 73,107 — Commercial paper 1,988 — 1,988 — Certificates of deposit 3,576 — 3,576 — Non Current Assets Deferred compensation plan 4,146 4,146 — — Total $ 196,873 $ 33,294 $ 163,579 $ — Balance as of July 30, 2011 Current Assets Cash equivalents: Money market account $ 9,895 $ 9,895 $ — $ — Marketable securities: Municipal securities 136,826 — 136,826 — U.S. government securities 52,890 52,890 — — U.S. government agencies 47,829 — 47,829 — Corporate bonds 162,914 — 162,914 — Commercial paper 45,064 — 45,064 — Certificates of deposit 2,072 — 2,072 — Asset-backed securities 616 — 616 — Non Current Assets Deferred compensation plan 4,256 4,256 — — Total $ 462,362 $ 67,041 $ 395,321 $ — 11\nMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the accompanying unaudited consolidated financial statements and notes thereto and our 2011 Annual Report to Stockholders.\nExecutive Overview\nWe are a national specialty retailer of private branded, sophisticated, casual-to-dressy clothing, intimates, complementary accessories, and other non-clothing items operating under the Chico’s, White House | Black Market (“WH|BM”), Soma Intimates (“Soma”) and Boston Proper brand names. We earn revenues and generate cash through the sale of merchandise in our retail stores, on our various websites and through our call centers, which take orders for all of our brands.\nNet sales for the second quarter of fiscal 2012 were $641.7 million, an increase of 16.4%, compared to $551.4 million last year. The increase reflects comparable sales growth of 5.6%, square footage increase of 7.4%, and sales for Boston Proper of $32.6 million. The 5.6% increase in comparable sales for the second quarter followed a 12.8% increase in last year’s second quarter and reflected increases in both average dollar sale and transaction count. The Chico’s/Soma Intimates brands’ comparable sales increased 7.2% following an 11.9% increase in last year’s second quarter and the WH|BM brand’s comparable sales increased 2.3% following a 14.9% increase in last year’s second quarter.\nNet income for the second quarter of fiscal 2012 was $53.4 million, an increase of 23% compared to net income of $43.4 million in last year’s second quarter and earnings per diluted share for the second quarter of fiscal 2012 were $0.32, an increase of 28% compared to $0.25 per diluted share in last year’s second quarter. The percentage increase in earnings per diluted share was higher than the percentage increase in net income, primarily reflecting the repurchase of 9.0 million shares since the end of the second quarter last year. We believe these results reflected the effectiveness of our innovative marketing plans, a positive customer response to our merchandise offering and new product launches.\nFuture Outlook\nAs a result of our first half results, we are updating our planning assumptions for fiscal 2012. The new planning assumptions are:\n\n| | Net sales of approximately $2.55 billion to $2.6 billion, which includes comparable store growth at a mid-single digit percent; |\n\n\n| | Gross margin rate of approximately flat to 2011; |\n\n\n| | Selling, general and administrative expenses (SG&A), as a percentage of net sales, down approximately 50 basis points to 2011; |\n\n\n| | One-time acquisition and integration costs for Boston Proper of approximately $4 million pre-tax; |\n\n\n| | Effective tax rate of approximately 38%; |\n\n\n| | Weighted average diluted shares of approximately 165 million, excluding any potential future impact of share repurchases; |\n\n\n| | Inventory increase in-line with sales growth; and |\n\n\n| | Capital expenditures of approximately $155 million, reflecting an additional $5 million for Boston Proper initiatives, including new stores in early fiscal 2013 and system integration costs. |\n\nThese are our internal planning assumptions and are not intended to be guidance.\n12\nResults of Operations The following table sets forth the percentage relationship of certain items in our consolidated statements of net income and comprehensive income to net sales for the periods shown below: Twenty-Six Weeks Ended Thirteen Weeks Ended July 28, 2012 July 30, 2011 July 28, 2012 July 30, 2011 Net sales 100.0 % 100.0 % 100.0 % 100.0 % Cost of goods sold 42.7 42.4 43.6 43.9 Gross margin 57.3 57.6 56.4 56.1 Selling, general and administrative expenses 43.9 44.6 43.0 43.6 Acquisition and integration costs 0.1 — 0.0 — Income from operations 13.3 13.0 13.4 12.5 Interest income, net 0.0 0.1 0.0 0.1 Income before income taxes 13.3 13.1 13.4 12.6 Income tax provision 5.0 4.9 5.1 4.7 Net income 8.3 % 8.2 % 8.3 % 7.9 % Thirteen Weeks Ended July 28, 2012 Compared to the Thirteen Weeks Ended July 30, 2011 Net Sales The following table depicts net sales by Chico’s/Soma Intimates, WH|BM and Boston Proper in dollars and as a percentage of total net sales for the thirteen weeks ended July 28, 2012 and July 30, 2011 (dollar amounts in thousands): Thirteen Weeks Ended July 28, 2012 July 30, 2011 Net sales: Chico’s/Soma Intimates $ 414,618 64.6 % $ 374,324 67.9 % WH|BM 194,498 30.3 177,125 32.1 Boston Proper 32,606 5.1 — — Total net sales $ 641,722 100.0 % $ 551,449 100.0 % Net sales for the quarter increased 16.4% to $641.7 million from $551.4 million in last year’s second quarter, primarily reflecting comparable sales growth of 5.6%, square footage increase of 7.4%, and sales for Boston Proper of $32.6 million. Comparable sales increased 5.6% for the second quarter, following a 12.8% increase in last year’s second quarter and reflected increases in both average dollar sale and transaction count. The Chico’s/Soma Intimates brands’ comparable sales increased by 7.2% following an 11.9% increase in last year’s second quarter and the WH|BM brand’s comparable sales increased by 2.3% following a 14.9% increase in last year’s second quarter. 13 Cost of Goods Sold/Gross Margin The following table depicts cost of goods sold and gross margin in dollars and gross margin as a percentage of total net sales for the thirteen weeks ended July 28, 2012 and July 30, 2011 (dollar amounts in thousands): Thirteen Weeks Ended July 28, 2012 July 30, 2011 Cost of goods sold $ 279,542 $ 242,122 Gross margin $ 362,180 $ 309,327 Gross margin percentage 56.4 % 56.1 % Gross margin for the quarter was $362.2 million, an increase of 17.1%, compared to $309.3 million in last year’s second quarter. As a percentage of net sales, gross margin was 56.4%, a 30 basis point improvement from last year’s second quarter, primarily reflecting increased full-price selling and effective promotional activities, partially offset by the inclusion of Boston Proper’s results. Selling, General, and Administrative Expenses The following table depicts SG&A in dollars and as a percentage of total net sales for the thirteen weeks ended July 28, 2012 and July 30, 2011 (dollar amounts in thousands): Thirteen Weeks Ended July 28, 2012 July 30, 2011 Selling, general and administrative expenses $ 276,121 $ 240,356 Percentage of total net sales 43.0 % 43.6 % SG&A consists of store and direct operating expenses, marketing expenses and National Store Support Center expenses. SG&A for the quarter was $276.1 million compared to $240.4 million in last year’s second quarter. As a percentage of net sales, SG&A was 43.0%, a 60 basis point improvement from last year’s second quarter, primarily reflecting the sales leverage impact on store expenses and the inclusion of Boston Proper’s results. Provision for Income Taxes Our effective tax rate for the quarter was 37.9% compared to an effective tax rate of 37.5% in last year’s second quarter. The effective tax rate for last year reflected favorable state tax settlements. Net Income and Earnings Per Diluted Share Net income for the second quarter was $53.4 million, an increase of 23.0%, compared to $43.4 million in last year’s second quarter. Earnings per diluted share for the second quarter were $0.32, an increase of 28.0%, compared to $0.25 per diluted share in last year’s second quarter. The percentage increase in earnings per diluted share was higher than the percentage increase in net income, primarily reflecting the repurchase of 9.0 million shares since the end of the second quarter last year. 14 Twenty-Six Weeks Ended July 28, 2012 Compared to the Twenty-Six Weeks Ended July 30, 2011 Net Sales The following table depicts net sales by Chico’s/Soma Intimates, WH|BM and Boston Proper in dollars and as a percentage of total net sales for the year-to-date period ended July 28, 2012 and July 30, 2011 (dollar amounts in thousands): Twenty-Six Weeks Ended July 28, 2012 July 30, 2011 Net sales: Chico’s/Soma Intimates $ 839,960 65.0 % $ 749,258 68.8 % WH|BM 386,225 29.9 339,349 31.2 Boston Proper 66,354 5.1 — — Total net sales $ 1,292,539 100.0 % $ 1,088,607 100.0 % Net sales for the year-to-date period increased 18.7% to $1.293 billion from $1.089 billion in last year’s year-to-date period, primarily reflecting comparable sales growth of 7.6%, square footage increase of 7.4%, and sales for Boston Proper of $66.4 million. Comparable sales increased 7.6% for the year-to-date period, following a 10.2% increase for the same period last year, and reflected increases in both average dollar sale and transaction count. The Chico’s/Soma Intimates brands’ comparable sales increased by 8.1% following a 9.7% increase for the same period last year and the WH|BM brand’s comparable sales increased by 6.7% following an 11.1% increase for the same period last year. Cost of Goods Sold/Gross Margin The following table depicts cost of goods sold and gross margin in dollars and gross margin as a percentage of total net sales for the year-to-date period ended July 28, 2012 and July 30, 2011 (dollar amounts in thousands): Twenty-Six Weeks Ended July 28, 2012 July 30, 2011 Cost of goods sold $ 551,763 $ 461,617 Gross margin $ 740,776 $ 626,990 Gross margin percentage 57.3 % 57.6 % Gross margin for the year-to-date period was $740.8 million, an increase of 18.1%, compared to $627.0 million for the same period last year. As a percentage of net sales, gross margin was 57.3%, a 30 basis point decrease from the same period last year, primarily reflecting the inclusion of Boston Proper’s results. 15 Selling, General, and Administrative Expenses The following table depicts SG&A in dollars and as a percentage of total net sales for the year-to-date period ended July 28, 2012 and July 30, 2011 (dollar amounts in thousands): Twenty-Six Weeks Ended July 28, 2012 July 30, 2011 Selling, general and administrative expenses $ 567,797 $ 485,201 Percentage of total net sales 43.9 % 44.6 % SG&A for the year-to-date period was $567.8 million compared to $485.2 million for the same period last year. As a percentage of net sales, SG&A was 43.9%, a 70 basis point improvement from the same period last year, primarily reflecting the sales leverage impact on store expenses and the inclusion of Boston Proper’s results. Provision for Income Taxes Our effective tax rate for the year-to-date period was 38.0% compared to an effective tax rate of 37.4% for the same period last year. The effective tax rate for last year reflected favorable state tax settlements. Net Income and Earnings Per Diluted Share Net income for the year-to-date period was $107.0 million, an increase of 19.9%, compared to $89.3 million for the same period last year. Earnings per diluted share for the year-to-date period were $0.64, an increase of 25.5%, compared to $0.51 for the same period last year. The percentage increase in earnings per diluted share was higher than the percentage increase in net income, primarily reflecting the repurchase of 9.0 million shares since the end of the second quarter last year. Liquidity and Capital Resources We believe that our existing cash and marketable securities balances and cash to be generated from operations will be sufficient to fund capital expenditures, working capital needs, dividend payments, potential share repurchases, commitments and other liquidity requirements associated with our operations through at least the next 12 months. Furthermore, while it is our intention to repurchase our stock and pay a quarterly cash dividend in the future, any determination to repurchase our stock or pay future dividends will be made by the Board of Directors and will depend on our stock price, future earnings, financial condition and other factors established by the Board. Our ongoing capital requirements will continue to be primarily for: new, expanded, relocated and remodeled stores; our distribution center and other central support facilities; the planned expansion of our NSSC campus; and information technology. 16 Operating Activities Net cash provided by operating activities for the year-to-date period was $225.5 million, an increase of approximately $103.0 million from the same period last year. This increase reflects improvements in working capital, primarily related to planned inventory reductions, as well as higher net income compared to the same period last year. Investing Activities Net cash used in investing activities for the year-to-date period was $138.3 million compared to $29.9 million provided by investing activities for the same period last year. The net change of $168.2 million primarily reflects increased capital expenditures compared to the same period last year and proceeds from the sale of marketable securities last year as we rebalanced our investment portfolio. Financing Activities Net cash used in financing activities for the year-to-date period in fiscal 2012 and 2011 was $36.7 million and $111.0 million, respectively. The decrease is primarily attributable to a reduction in share repurchase activity compared to the same period last year. During the second quarter of fiscal 2012, we repurchased 1.8 million shares for $25.6 million under our $200 million share repurchase program announced in November 2011, with $149.4 million remaining under the program as of the end of the second quarter. For the four quarter period ended July 28, 2012, we repurchased 9.0 million shares for $110.6 million. Credit Facility In fiscal 2011, we entered into a $70 million senior five-year unsecured revolving credit facility (the “Credit Facility”) with a syndicate led by JPMorgan Chase Bank, N.A., as administrative agent and HSBC Bank USA, National Association, as syndication agent. The Credit Facility provides a $70 million revolving credit facility that matures on July 27, 2016. The Credit Facility provides for swing advances of up to $5 million and issuance of letters of credit up to $40 million. The Credit Facility also contains a feature that provides us the ability, subject to satisfaction of certain conditions, to expand the commitments available under the Credit Facility from $70 million up to $125 million. As of July 28, 2012, no borrowings are outstanding under the Credit Facility. New Store Openings During fiscal 2012, we had 59 net store openings consisting of 11 Chico’s net openings, 29 WH|BM net openings and 19 Soma net openings. Currently, we expect our new stores in fiscal 2012 to increase approximately 8%, reflecting approximately 20-24 net openings of Chico’s stores, 53-57 net openings of WH|BM stores, and 27-31 net openings of Soma stores. We continuously evaluate the appropriate new store growth rate in light of economic conditions and may adjust the growth rate as conditions require or as opportunities arise. 17 Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations are based upon the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Management has discussed the development and selection of these critical accounting policies and estimates with the Audit Committee of our Board of Directors and believes the assumptions and estimates, as set forth in our Annual Report on Form 10-K for the fiscal year ended January 28, 2012, are significant to reporting our results of operations and financial position. There have been no material changes to our critical accounting policies as disclosed in our Annual Report on Form 10-K for the fiscal year ended January 28, 2012. Forward-Looking Statements This Form 10-Q may contain certain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which reflect our current views with respect to certain events that could have an effect on our future financial performance, including but without limitation, statements regarding our plans, objectives, and future growth rates of our store concepts. These statements may address items such as future sales, gross margin expectations, SG&A expectations, operating margin expectations, earnings per share expectations, planned store openings, closings and expansions, future comparable sales, future product sourcing plans, inventory levels, planned marketing expenditures, planned capital expenditures and future cash needs. In addition, from time to time, we may issue press releases and other written communications, and our representatives may make oral statements, which contain forward-looking information. These statements, including those in this Form 10-Q and those in press releases or made orally, relate to expectations concerning matters that are not historical fact and may include the words or phrases such as “expects,” “believes,” “anticipates,” “plans,” “estimates,” “approximately,” “our planning assumptions,” “future outlook,” and similar expressions. Except for historical information, matters discussed in such oral and written statements, including this Form 10-Q, are forward-looking statements. These forward-looking statements are based largely on information currently available to our management and on our current expectations, assumptions, plans, estimates, judgments and projections about our business and our industry, and are subject to various risks and uncertainties that could cause actual results to differ materially from historical results or those currently anticipated. Although we believe our expectations are based on reasonable estimates and assumptions, they are not guarantees of performance and there are a number of known and unknown risks, uncertainties, contingencies, and other factors (many of which are outside our control) that could cause actual results to differ materially from those expressed or implied by such forward-looking statements. Accordingly, there is no assurance that our expectations will, in fact, occur or that our estimates or assumptions will be correct, and we caution investors and all others not to place undue reliance on such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those described in Item 1A, “Risk Factors” in our Annual Report on Form 10-K filed with the SEC on March 21, 2012 and the following: These potential risks and uncertainties include the financial strength of retailing in particular and the economy in general, the extent of financial difficulties that may be experienced by customers, our ability to secure and maintain customer acceptance of styles and store concepts, the ability to maintain an appropriate 18 level of inventory, the quality of merchandise received from suppliers, the extent and nature of competition in the markets in which we operate, the extent of the market demand and overall level of spending for women’s private branded clothing and related accessories, the effectiveness of our brand awareness and marketing programs, the adequacy and perception of customer service, the ability to coordinate product development with buying and planning, the ability to efficiently, timely and successfully execute significant shifts in the countries from which merchandise is supplied, the ability of our suppliers to timely produce and deliver clothing and accessories, the changes in the costs of manufacturing, labor and advertising, the rate of new store openings, our ability to grow through new store openings and the buying public’s acceptance of any of our new store concepts, the performance, implementation and integration of management information systems, the ability to hire, train, energize and retain qualified sales associates and other employees, the availability of quality store sites, the ability to expand our distribution center and other support facilities in an efficient and effective manner, the ability to hire and train qualified managerial employees, the ability to effectively and efficiently establish our websites, the ability to secure and protect trademarks and other intellectual property rights and to protect our reputation and brand images, the ability to effectively and efficiently operate our brands, risks associated with terrorist activities, risks associated with natural disasters such as hurricanes and other risks. In addition, there are potential risks and uncertainties that are related to our reliance on sourcing from foreign suppliers, including the impact of work stoppages, transportation delays and other interruptions, political or civil instability, imposition of and changes in tariffs and import and export controls such as import quotas, changes in governmental policies in or towards foreign countries, currency exchange rates and other similar factors. All written or oral forward-looking statements that are made or attributable to us are expressly qualified in their entirety by this cautionary notice. The forward-looking statements included herein are only made as of the date of this Quarterly Report on Form 10-Q. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Litigation In the normal course of business, we are subject to proceedings, lawsuits and other claims including proceedings under laws and government regulations relating to labor, product, intellectual property and other matters including the matters described in Item 1 of Part II of this quarterly report on Form 10-Q. Such matters are subject to many uncertainties, and outcomes are not predictable with assurance. Consequently, the ultimate aggregate amount of monetary liability or financial impact with respect to these matters at July 28, 2012, cannot be ascertained. Although these matters could affect the consolidated operating results of any one quarter when resolved in future periods, and although there can be no assurance with respect thereto, management believes that, after final disposition, any monetary liability or financial impact to us would not be material to the annual consolidated financial statements.\nQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nThe market risk of our financial instruments as of July 28, 2012 has not significantly changed since January 28, 2012. We are exposed to market risk from changes in interest rates on any future indebtedness and our marketable securities.\nOur exposure to interest rate risk relates in part to our revolving line of credit with our bank. However, as of July 28, 2012, we did not have any outstanding borrowings on our line of credit and, given our current liquidity position, do not expect to utilize our line of credit in the foreseeable future.\nOur investment portfolio is maintained in accordance with our investment policy which identifies allowable investments, specifies credit quality standards and limits the credit exposure of any single issuer.\n19\nOur investment portfolio consists of cash equivalents and marketable securities, including corporate bonds, municipal securities, and U.S. government and agency securities. The portfolio as of July 28, 2012, consisted of $129.4 million of securities with maturity dates within one year or less and $119.1 million with maturity dates over one year and less than or equal to two years. We consider all securities available-for-sale, including those with maturity dates beyond 12 months, and therefore classify these securities within current assets on the consolidated balance sheets as they are available to support current operational liquidity needs. As of July 28, 2012, an increase of 100 basis points in interest rates would reduce the fair value of our marketable securities portfolio by approximately $2.4 million. Conversely, a reduction of 100 basis points in interest rates would increase the fair value of our marketable securities portfolio by approximately $0.8 million.\nCONTROLS AND PROCEDURES\nEvaluation of Disclosure Controls and Procedures\nOur disclosure controls and procedures are designed to provide reasonable assurance that information required to be disclosed in our reports under the Securities and Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.\nAs of the end of the period covered by this report, an evaluation was carried out under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities and Exchange Act of 1934, as amended). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of such period, our disclosure controls and procedures were effective in providing reasonable assurance in timely alerting them to material information relating to us (including our consolidated subsidiaries) and that information required to be disclosed in our reports is recorded, processed, summarized, and reported as required to be included in our periodic SEC filings.\nChanges in Internal Controls\nThere were no significant changes in our internal controls or in other factors that could significantly affect our disclosure controls and procedures subsequent to the date of the above referenced evaluation. Furthermore, there was no change in our internal control over financial reporting or in other factors during the quarterly period covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\n20\nPART II – OTHER INFORMATION\nLEGAL PROCEEDINGS\nThe Company was named as a defendant in a putative class action filed in March 2011 in the Superior Court of the State of California for the County of Los Angeles, Eileen Schlim v. Chico’s FAS, Inc. The Complaint attempts to allege numerous violations of California law related to wages, meal periods, rest periods, and failure to issue timely final pay, among other things. The Company denies the material allegations of the Complaint. The Company believes that its policies and procedures for paying its associates comply with all applicable California laws. As a result, the Company does not believe that the case should have a material adverse effect on the Company’s consolidated financial condition or results of operations.\nOther than as noted above, we are not currently a party to any legal proceedings, other than various claims and lawsuits arising in the normal course of business, none of which we believe should have a material adverse effect on our consolidated financial condition or results of operations.\n\n\nRISK FACTORS\nIn addition to the other information discussed in this report, the factors described in Part I, Item 1A. “Risk Factors” in our 2011 Annual Report on Form 10-K filed with the SEC on March 21, 2012 should be considered as they could materially affect our business, financial condition or future results. There have not been any significant changes with respect to the risks described in our 2011 Form 10-K, but these are not the only risks facing our company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may adversely affect our business, financial condition or operating results.\n\n\nUNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nThe following table sets forth information concerning our purchases of common stock for the periods indicated (dollar amounts in thousands, except per share amounts):\n\n| Period | TotalNumber ofSharesPurchased(a) | AveragePrice Paidper Share | TotalNumber ofSharesPurchased asPart ofPubliclyAnnouncedPlans (b) | ApproximateDollar Valueof Shares thatMay Yet BePurchasedUnder thePubliclyAnnouncedPlans |\n| April 29, 2012 to May 26, 2012 | 6,756 | $ | 14.88 | | $ | 175,006 |\n| May 27, 2012 to June 30, 2012 | 1,826,848 | $ | 14.02 | 1,826,137 | $ | 149,402 |\n| July 1, 2012 to July 28, 2012 | | $ | | | $ | 149,402 |\n| Total | 1,833,604 | $ | 14.02 | 1,826,137 | $ | 149,402 |\n\n\n| (a) | Includes 7,467 shares of restricted stock repurchased in connection with employee tax withholding obligations under employee compensation plans, which are not purchases under any publicly announced plan. |\n\n| (b) | In November 2011, we announced a $200 million share repurchase program. There is $149.4 million remaining under the program as of the end of the second quarter. The repurchase program has no specific termination date and will expire when we have repurchased all securities authorized for repurchase thereunder, unless terminated earlier by our Board of Directors. |\n\n21\n\nEXHIBITS\n\n| (a) | The following documents are filed as exhibits to this Quarterly Report on Form 10-Q (exhibits marked with an asterisk have been previously filed with the Commission as indicated and are incorporated herein by this reference): |\n\n\n| Exhibit 10.1* | Chicos FAS, Inc. 2012 Omnibus Stock and Incentive Plan (Filed as Exhibit 4.4 to the Companys Form S-8, as filed with the Commission on August 1, 2012) |\n| Exhibit 31.1 | Chicos FAS, Inc. and Subsidiaries Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 - Chief Executive Officer |\n| Exhibit 31.2 | Chicos FAS, Inc. and Subsidiaries Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 - Chief Financial Officer |\n| Exhibit 32.1 | Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| Exhibit 32.2 | Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| Exhibit 101.INS | XBRL Instance Document |\n| Exhibit 101.SCH | XBRL Taxonomy Extension Schema Document |\n| Exhibit 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document |\n| Exhibit 101.DEF | XBRL Taxonomy Definition Linkbase Document |\n| Exhibit 101.LAB | XBRL Taxonomy Extension Label Linkbase Document |\n| Exhibit 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document |\n\n22\nSIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. CHICO’S FAS, INC. Date: August 23, 2012 By: /s/ David F. Dyer David F. Dyer President and Chief Executive Officer (Principal Executive Officer) Date: August 23, 2012 By: /s/ Pamela K Knous Pamela K Knous Executive Vice President - Chief Financial Officer (Principal Financial and Accounting Officer) 23\n</text>\n\nWhat's the percentage change in earnings per share (EPS) for the Twenty-Six Weeks Ended July 28, 2012 compared to July 30, 2011 in %?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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doc-math
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"ground_truth": "Therefore, the answer is 26.569517568255023."
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docmath_20000_40000
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial Statements\nACCRETION ACQUISITION CORP.\nCONDENSED BALANCE SHEETS\n\n| | | | | | | |\n| | | September 30, 2022 | | December 31, 2021 |\n| | (Unaudited) | |\n| Assets | | | | | | |\n| Cash | | $ | 255,951 | | $ | 661,776 |\n| Prepaid expenses - current | | 299,590 | | 315,012 |\n| Total Current Assets | | | 555,541 | | | 976,788 |\n| Cash held in Trust Account | | | 210,308,794 | | | 209,072,882 |\n| Prepaid expenses - non current | | | 17,238 | | | 241,314 |\n| Total Assets | | $ | 210,881,573 | | $ | 210,290,984 |\n| | | | | | | |\n| Liabilities, Common Stock Subject to Possible Redemption and Stockholders’ Deficit | | |\n| Current Liabilities | | | | | | |\n| Accrued expenses | | $ | 596,924 | | $ | 98,495 |\n| Related party payable | | | 112,318 | | | 22,258 |\n| Income tax payable | | | 208,777 | | | — |\n| Franchise tax payable | | | 79,175 | | | 118,177 |\n| Total Current Liabilities | | | 997,194 | | | 238,930 |\n| Deferred underwriting commission | | 7,245,000 | | 7,245,000 |\n| Total Liabilities | | 8,242,194 | | 7,483,930 |\n| | | | | |\n| Commitments and Contingencies (Note 6) | | | | | | |\n| | | | | | | |\n| Common stock subject to possible redemption, $ 0.001 par value; 20,700,000 shares at $ 10.16 per share redemption value as of September 30, 2022 and at $ 10.10 per share redemption value as of December 31, 2021 | | 210,308,794 | | 209,070,000 |\n| | | |\n| Stockholders’ Deficit | | | | | | |\n| Preferred stock, $ 0.001 par value; 1,000,000 shares authorized; none issued or outstanding | | | — | | | — |\n| Common stock, $ 0.001 par value; 50,000,000 shares authorized; 5,295,000 shares issued and outstanding | | 5,295 | | 5,295 |\n| Additional paid-in capital | | — | | — |\n| Accumulated deficit | | ( 7,674,710 ) | | ( 6,268,241 ) |\n| Total Stockholders’ Deficit | | ( 7,669,415 ) | | ( 6,262,946 ) |\n| Total Liabilities, Common Stock Subject to Possible Redemption and Stockholders’ Deficit | | $ | 210,881,573 | | $ | 210,290,984 |\n\n\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\n\n\n3\n| | | | | | | | | | | | | |\n| | | | | | | | | | | | For the period from |\n| | | For the Three | | For the Three | | For the Nine | | February 26, 2021 |\n| | | Months Ended | | Months Ended | | Months Ended | | (inception) through |\n| | September 30, 2022 | September 30, 2021 | September 30, 2022 | September 30, 2021 |\n| Formation and operating costs | | $ | 232,400 | | $ | — | | $ | 1,068,370 | | $ | 1,359 |\n| Stock-based compensation | | | — | | | 1,700,000 | | | — | | | 1,700,000 |\n| Franchise tax expense | | | 50,000 | | | — | | | 150,000 | | | — |\n| Loss on operations | | | ( 282,400 ) | | | ( 1,700,000 ) | | | ( 1,218,370 ) | | | ( 1,701,359 ) |\n| Other income: | | | | | | | | | | | | |\n| Dividends earned from Trust Account | | | 945,302 | | | — | | | 1,259,472 | | | — |\n| Profit (loss) before provision for income taxes | | | 662,902 | | | ( 1,700,000 ) | | | 41,102 | | | ( 1,701,359 ) |\n| Income tax expense | | | ( 188,013 ) | | | — | | | ( 208,777 ) | | | — |\n| Net profit (loss) | | $ | 474,889 | | $ | ( 1,700,000 ) | | $ | ( 167,675 ) | | $ | ( 1,701,359 ) |\n| | | | | | | | | | | |\n| Basic and diluted weighted average shares outstanding of redeemable common stock | | 20,700,000 | | | — | | | 20,700,000 | | — |\n| Basic and diluted net profit (loss) per share, redeemable common stock | | $ | 0.02 | | $ | — | | $ | ( 0.01 ) | | $ | — |\n| | | | | | | | | | | | | |\n| Basic and diluted weighted average shares outstanding of non-redeemable common stock | | 5,295,000 | | | 4,620,000 | | | 5,295,000 | | 4,594,884 |\n| Basic and diluted net profit (loss) per share, non-redeemable common stock | | $ | 0.02 | | $ | ( 0.37 ) | | $ | ( 0.01 ) | | $ | ( 0.37 ) |\n\n| | | | | | | | | | | | | | | |\n| | | | | | | | Additional | | | | | Total |\n| | | Common Stock | | Paid-in | | Accumulated | | Stockholders’ |\n| | Shares | Amount | Capital | Deficit | Deficit |\n| Balance – December 31, 2021 (audited) | | 5,295,000 | | $ | 5,295 | | $ | — | | $ | ( 6,268,241 ) | | $ | ( 6,262,946 ) |\n| Net loss | | — | | | — | | | — | | | ( 540,145 ) | | | ( 540,145 ) |\n| Balance - March 31, 2022 (unaudited) | | 5,295,000 | | | 5,295 | | | — | | | ( 6,808,386 ) | | | ( 6,803,091 ) |\n| Remeasurement of common stock to redemption amount | | — | | | — | | | — | | | ( 317,051 ) | | | ( 317,051 ) |\n| Net loss | — | | — | | — | | ( 102,419 ) | | ( 102,419 ) |\n| Balance - June 30, 2022 (unaudited) | 5,295,000 | | | 5,295 | | | — | | | ( 7,227,856 ) | | | ( 7,222,561 ) |\n| Remeasurement of common stock to redemption amount | | — | | | — | | | — | | | ( 921,743 ) | | | ( 921,743 ) |\n| Net profit | | — | | | — | | | — | | | 474,889 | | | 474,889 |\n| Balance - September 30, 2022 (unaudited) | | 5,295,000 | | $ | 5,295 | | $ | — | | $ | ( 7,674,710 ) | | $ | ( 7,669,415 ) |\n| | | | | | | | | | | | | | | |\n| | | | | | | | Additional | | | | | Total |\n| | | Common Stock | | Paid-in | | Accumulated | | Stockholders’ |\n| | Shares | Amount | Capital | Deficit | Equity |\n| Balance - February 26, 2021 (inception) | | — | | $ | — | | $ | — | | $ | — | | $ | — |\n| Issuance of common stock to Sponsor | | 5,175,000 | | | 5,175 | | | — | | | — | | | 5,175 |\n| Net loss | — | | — | | — | | ( 780 ) | | ( 780 ) |\n| Balance - March 31, 2021 (unaudited) | 5,175,000 | | | 5,175 | | | — | | | ( 780 ) | | | 4,395 |\n| Issuance of common stock to Sponsor | | — | | | — | | | 19,825 | | | — | | | 19,825 |\n| Issuance of EBC Founder Shares | | 120,000 | | | 120 | | | 460 | | | — | | | 580 |\n| Net loss | | — | | — | | — | | ( 579 ) | | ( 579 ) |\n| Balance - June 30, 2021 (unaudited) | | 5,295,000 | | | 5,295 | | | 20,285 | | | ( 1,359 ) | | | 24,221 |\n| Transfer of Founder Shares to Independent Directors | | — | | | — | | | 1,700,000 | | | — | | | 1,700,000 |\n| Net loss | | — | | | — | | | — | | | ( 1,700,000 ) | | | ( 1,700,000 ) |\n| Balance - September 30, 2021 (unaudited) | | 5,295,000 | | $ | 5,295 | | $ | 1,720,285 | | $ | ( 1,701,359 ) | | $ | 24,221 |\n\n| | | | | | | |\n| | | | | | For the period from |\n| | | For the Nine | | February 26, 2021 |\n| | | Months Ended | | (inception) through |\n| | September 30, 2022 | September 30, 2021 |\n| Cash Flows from Operating Activities: | | | | | |\n| Net loss | | $ | ( 167,675 ) | | $ | ( 1,701,359 ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: | | | | | |\n| Dividends earned from Trust Account | | | ( 1,259,472 ) | | | — |\n| Stock-based compensation | | | — | | | 1,700,000 |\n| Changes in operating assets and liabilities: | | |\n| Prepaid expenses - current | | | 15,423 | | | — |\n| Prepaid expenses - non-current | | 224,076 | | — |\n| Accrued expenses | | | 498,429 | | | 1,359 |\n| Related party payable | | | 90,060 | | | — |\n| Income tax payable | | | 208,777 | | | — |\n| Franchise tax payable | | | ( 39,002 ) | | | — |\n| Net cash used in operating activities | | ( 429,384 ) | | — |\n| Cash Flows from Investing Activities: | | | | | | |\n| Transfer from Trust Account | | | 23,559 | | | — |\n| Net cash provided by investing activities | | | 23,559 | | | — |\n| Cash Flows from Financing Activities: | | |\n| Proceeds from issuance of common stock to Sponsor | | — | | 25,000 |\n| Proceeds from promissory note - related party | | — | | 150,000 |\n| Payment of offering costs | | | — | | | ( 103,711 ) |\n| Net cash provided by financing activities | | — | | 71,289 |\n| | | |\n| Net change in cash: | | ( 405,825 ) | | 71,289 |\n| Cash - Beginning | | 661,776 | | — |\n| Cash - Ending | | $ | 255,951 | | $ | 71,289 |\n| | | | | |\n| Supplemental disclosure of non-cash financing activities: | | | | |\n| Deferred offering costs included in accrued expenses | | $ | — | | $ | 276,672 |\n| Deferred offering costs paid through promissory note - related party | | $ | — | | $ | 91,211 |\n| Issuance of EBC Founder Shares | | $ | — | | $ | 580 |\n| Remeasurement of common stock subject to redemption to redemption value | | $ | 1,238,794 | | $ | — |\n\nACCRETION ACQUISITION CORP.NOTES TO CONDENSED FINANCIAL STATEMENTS(UNAUDITED) NOTE 1 ─ ORGANIZATION AND DESCRIPTION OF BUSINESS OPERATIONSAccretion Acquisition Corp. (the “Company”) was incorporated in Delaware on February 26, 2021. The Company was formed for the purpose of entering into a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses (the “Business Combination”).The Company is not limited to a particular industry or geographic region for purposes of consummating a Business Combination, however, the Company intends to concentrate its efforts to focus identifying businesses in the upstream energy industry or in related businesses in the midstream, services, software or commodity risk management sectors. The Company is an early stage and emerging growth company and, as such, the Company is subject to all of the risks associated with early stage and emerging growth companies.As of September 30, 2022, the Company had not commenced any operations. All activity for the period from February 26, 2021 (inception) through September 30, 2022, relates to the Company’s formation and the initial public offering (“Initial Public Offering”), which is described below. The Company will not generate any operating revenues until after the completion of a Business Combination, at the earliest. The Company will generate non-operating income in the form of interest income or dividend income from the proceeds derived from the Initial Public Offering. The Company has selected December 31 as its fiscal year end.On October 25, 2021, the Company closed its Initial Public Offering of 18,000,000 units at $ 10.00 per unit (the “Units” and, with respect to the shares of common stock included in the Units, the “Public Shares”) which is discussed in Note 3 and the sale of 7,300,000 warrants (each, a “Private Warrant” and collectively, the “Private Warrants”) at a price of $ 1.00 per Private Warrant in a private placement to its sponsor, Accretion Acquisition Sponsor, LLC (the “Sponsor”) and its underwriters that closed simultaneously with the closing of the Initial Public Offering (as described in Note 4). The Company has listed the Units on the Nasdaq Capital Market (“Nasdaq”).Transaction costs amounted to $ 11.94 million consisting of $ 4.14 million in cash of underwriting commissions, $ 7.25 million of deferred underwriting commissions and $ 0.55 million of other offering costs.The Company’s management has broad discretion with respect to the specific application of the net proceeds of the Initial Public Offering and the sale of the Private Warrants, although substantially all of the net proceeds are intended to be applied generally toward consummating a Business Combination. There is no assurance that the Company will be able to complete a Business Combination successfully. The Company must complete a Business Combination with one or more operating businesses or assets that together have an aggregate fair market value equal to at least 80 % of the net assets held in the Trust Account (as defined below, net of amounts disbursed to management for working capital purposes, if permitted, and excluding the amount of any deferred underwriting commissions) at the time of the Company’s signing a definitive agreement in connection with its initial Business Combination. The Company will only complete a Business Combination if the post-transaction company owns or acquires 50 % or more of the outstanding voting securities of the target or otherwise acquires an interest in the target business or assets sufficient for it not to be required to register as an investment company under the Investment Company Act of 1940, as amended (the “Investment Company Act”).Upon the closing of the Initial Public Offering on October 25, 2021, the Company deposited $ 181.80 million ($ 10.10 per Unit) from the proceeds of the Initial Public Offering in the trust account (“Trust Account”), located in the United States and invested only in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, with a maturity of 185 days or less or in any open-ended investment company that holds itself out as a money market fund selected by the Company meeting certain conditions of Rule 2a-7 of the Investment Company Act, as determined by the Company, until the earlier of: (i) the completion of a Business Combination and (ii) the distribution of the funds held in the Trust Account, as described below. 7\nACCRETION ACQUISITION CORP.NOTES TO CONDENSED FINANCIAL STATEMENTS(UNAUDITED) NOTE 1 ─ ORGANIZATION AND DESCRIPTION OF BUSINESS OPERATIONS (Continued)On October 27, 2021, the underwriters exercised their over-allotment option in full (see Note 6), according to which, on October 28, 2021, the Company consummated the sale of an additional 2,700,000 Units, at $ 10.00 per Unit, and the sale of an additional 810,000 Private Warrants, at $ 1.00 per Private Warrant, generating total gross proceeds of $ 27.81 million, and incurring additional cash underwriting commissions of approximately $ 0.54 million and deferred underwriting discount of approximately $ 0.95 million. The proceeds from the sale of the additional Units were deposited into the Trust Account, bringing the aggregate proceeds held in the Trust Account to $ 209.07 million.The Company will provide its holders of the outstanding Public Shares (the “public stockholders”) with the opportunity to redeem all or a portion of their Public Shares upon the completion of a Business Combination either (i) in connection with a stockholder meeting called to approve the Business Combination or (ii) by means of a tender offer. The decision as to whether the Company will seek stockholder approval of a Business Combination or conduct a tender offer will be made by the Company, solely in its discretion. The public stockholders will be entitled to redeem their Public Shares for a pro rata portion of the amount then in the Trust Account (initially anticipated to be $ 10.10 per Public Share, plus any pro rata income earned on the funds held in the Trust Account and not previously released to the Company to pay its tax obligations). There will be no redemption rights upon the completion of a Business Combination with respect to the Company’s warrants. The Public Shares subject to redemption will be recorded at redemption value and classified as temporary equity upon the completion of the Initial Public Offering in accordance with the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”) Topic 480, “Distinguishing Liabilities from Equity.”The Company will only proceed with a Business Combination if the Company has net tangible assets of at least $ 5,000,001 either prior to or upon such consummation of a Business Combination and, if the Company seeks stockholder approval, a majority of the shares voted are voted in favor of the Business Combination. If a stockholder vote is not required by applicable law or stock exchange rules and the Company does not decide to hold a stockholder vote for business or other reasons, the Company will, pursuant to its Amended and Restated Certificate of Incorporation (the “Amended and Restated Certificate of Incorporation”), conduct the redemptions pursuant to the tender offer rules of the U.S. Securities and Exchange Commission (“SEC”) and file tender offer documents with the SEC prior to completing a Business Combination. If, however, stockholder approval of the transaction is required by applicable law or stock exchange rules, or the Company decides to obtain stockholder approval for business or other reasons, the Company will offer to redeem shares in conjunction with a proxy solicitation pursuant to the proxy rules and not pursuant to the tender offer rules. If the Company seeks stockholder approval in connection with a Business Combination, the Sponsor has agreed to vote its Founder Shares (as defined in Note 5), and any Public Shares purchased during or after the Initial Public Offering in favor of approving a Business Combination. Additionally, each public stockholder may elect to redeem their Public Shares irrespective of whether they vote for or against the proposed transaction or do not vote at all.Notwithstanding the above, if the Company seeks shareholder approval of a Business Combination and it does not conduct redemptions pursuant to the tender offer rules, the Certificate of Incorporation provides that a public shareholder, together with any affiliate of such shareholder or any other person with whom such shareholder is acting in concert or as a “group” (as defined under Section 13 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), will be restricted from redeeming its shares with respect to more than an aggregate of 20% or more of the Public Shares, without the prior consent of the Company.The Sponsor has agreed (a) to waive its redemption rights with respect to its Founder Shares (as defined in Note 5) and Public Shares held by it in connection with the completion of a Business Combination and (b) not to propose an amendment to the Amended and Restated Certificate of Incorporation (i) to modify the substance or timing of the Company’s obligation to allow redemption in connection with the Company’s initial Business Combination or to redeem 100 % of its Public Shares if the Company does not complete a Business Combination or (ii) with respect to any other provision relating to stockholders’ rights or pre-initial Business Combination activity, unless the Company provides the public stockholders with the opportunity to redeem their Public Shares in conjunction with any such amendment. 8\nACCRETION ACQUISITION CORP.NOTES TO CONDENSED FINANCIAL STATEMENTS(UNAUDITED) NOTE 1 ─ ORGANIZATION AND DESCRIPTION OF BUSINESS OPERATIONS (Continued)The Company will have until 18 months from the closing of the Initial Public Offering to complete a Business Combination (the “Combination Period”). If the Company is unable to complete a Business Combination within the Combination Period, the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account including income earned on the funds held in the Trust Account and not previously released to the Company to pay its tax obligations (less up to $ 100,000 of interest to pay dissolution expenses), divided by the number of then outstanding Public Shares, which redemption will completely extinguish public stockholders’ rights as stockholders (including the right to receive further liquidating distributions, if any), and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the Company’s remaining stockholders and the Company’s board of directors, dissolve and liquidate, subject in each case to the Company’s obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law. There will be no redemption rights or liquidating distributions with respect to the Company’s warrants, which will expire worthless if the Company fails to complete a Business Combination within the Combination Period.The Sponsor has agreed to waive its liquidation rights with respect to the Founder Shares (as defined in Note 5) if the Company fails to complete a Business Combination within the Combination Period. However, if the Sponsor acquires Public Shares in or after the Initial Public Offering, such Public Shares will be entitled to liquidating distributions from the Trust Account if the Company fails to complete a Business Combination within the Combination Period. The underwriters have agreed to waive their rights to their deferred underwriting commission (see Note 6) held in the Trust Account in the event the Company does not complete a Business Combination within the Combination Period and, in such event, such amounts will be included with the other funds held in the Trust Account that will be available to fund the redemption of the Public Shares. In the event of such distribution, it is possible that the per share value of the assets remaining available for distribution will be less than the Initial Public Offering price per Unit of $ 10.10 .In order to protect the amounts held in the Trust Account, the Sponsor has agreed to be liable to the Company if and to the extent any claims by a third party for services rendered or products sold to the Company, or a prospective target business with which the Company has discussed entering into a transaction agreement, reduce the amount of funds in the Trust Account to below the lesser of (1) $ 10.10 per Public Share and (2) the actual amount per Public Share held in the Trust Account as of the date of the liquidation of the Trust Account due to reductions in the value of the trust assets, less taxes payable, provided that such liability will not apply to claims by a third party or prospective target business who executed a waiver of any and all rights to the monies held in the Trust Account nor will it apply to any claims under the Company’s indemnity of the underwriters of the Initial Public Offering against certain liabilities, including liabilities under the Securities Act of 1933, as amended (the “Securities Act”). Moreover, in the event that an executed waiver is deemed to be unenforceable against a third party, the Sponsor will not be responsible to the extent of any liability for such third-party claims. The Company will seek to reduce the possibility that the Sponsor will have to indemnify the Trust Account due to claims of creditors by endeavoring to have all vendors, service providers (except the Company’s independent registered public accounting firm), prospective target businesses and other entities with which the Company does business, execute agreements with the Company waiving any right, title, interest or claim of any kind in or to monies held in the Trust Account.Liquidity and Going ConcernAs of September 30, 2022, the Company had $ 0.26 million in its operating bank account, and $ 210.31 million of cash held in the Trust Account to be used for a Business Combination or to repurchase or redeem its common stock in connection therewith and a working capital deficiency of $ 0.44 million.Until the consummation of a Business Combination, the Company will be using the funds not held in the Trust Account for identifying and evaluating prospective acquisition candidates, performing due diligence on prospective target businesses, paying for travel expenditures, selecting the target business to acquire, and structuring, negotiating and consummating the Business Combination. 9\nACCRETION ACQUISITION CORP.NOTES TO CONDENSED FINANCIAL STATEMENTS(UNAUDITED) NOTE 1 ─ ORGANIZATION AND DESCRIPTION OF BUSINESS OPERATIONS (Continued)Liquidity and Going Concern (Continued)The Company will need to raise additional capital through loans or additional investments through April 25, 2023 from its Sponsor, stockholders, officers, directors, or third parties. The Company’s officers, directors and Sponsor may, but are not obligated to, loan the Company funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet the Company’s working capital needs. Accordingly, the Company may not be able to obtain additional financing. If the Company is unable to raise additional capital, it may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, and reducing overhead expenses. The Company cannot provide any assurance that new financing will be available to it on commercially acceptable terms, if at all. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. These financial statements do not include any adjustments relating to the recovery of the recorded assets or the classification of the liabilities that might be necessary should the Company be unable to continue as a going concern.Risks and UncertaintiesManagement continues to evaluate the impact of the COVID-19 pandemic on the industry and has concluded that while it is reasonably possible that the virus could have a negative effect on the Company’s financial position, results of its operations, and/or search for a target company, the specific impact is not readily determinable as of the date of these financial statements. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.Additionally, as a result of the military action commenced in February 2022 by the Russian Federation and Belarus in the country of Ukraine and related economic sanctions, the Company’s ability to consummate a Business Combination, or the operations of a target business with which the Company ultimately consummates a Business Combination, may be materially and adversely affected. In addition, the Company’s ability to consummate a transaction may be dependent on the ability to raise equity and debt financing which may be impacted by these evets, including as a result of increased market volatility, or decreased market liquidity in third-party financing being unavailable on terms acceptable to the Company or at all. The impact of this action and related sanctions on the world economy and the specific impact on the Company’s financial position, results of operations and/or ability to consummate a Business Combination are not yet determinable. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. NOTE 2 ─ SIGNIFICANT ACCOUNTING POLICIES Basis of PresentationThe accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 8 of Regulation S-X of the SEC. Certain information or footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted, pursuant to the rules and regulations of the SEC for interim financial reporting. Accordingly, they do not include all the information and footnotes necessary for a complete presentation of financial position, results of operations, or cash flows. In the opinion of management, the accompanying unaudited condensed financial statements include all adjustments, consisting of a normal recurring nature, which are necessary for a fair presentation of the financial position, operating results and cash flows for the periods presented. The Company has reclassified certain prior-year amounts to conform to the current-year’s presentation. See Note 5 for further information.The accompanying unaudited condensed financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the period ended December 31, 2021, as filed with the SEC on March 31, 2022. The interim results for the three months ended September 30, 2022 are not necessarily indicative of the results to be expected for the year ending December 31, 2022 or for any future periods. 10\nACCRETION ACQUISITION CORP.NOTES TO CONDENSED FINANCIAL STATEMENTS(UNAUDITED) NOTE 2 ─ SIGNIFICANT ACCOUNTING POLICIES (Continued) Emerging Growth CompanyThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as amended by the Jumpstart Our Business Startups Act of 2012, (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved.Further, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that an emerging growth company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard.This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used. Use of EstimatesThe preparation of financial statements in conformity with GAAP requires the Company’s management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of expenses during the reporting period. Making estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. Actual results could differ from those estimates. Cash and Cash EquivalentsThe Company had $ 0.26 million in cash as of September 30, 2022 and $ 0.66 million at December 31, 2021. The Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did no t have any cash equivalents as of September 30, 2022. Cash Held in Trust AccountOn September 30, 2022, the Company had $ 210.31 million cash held in the Trust Account, and $ 209.07 million at December 31, 2021, that were held in U.S. government treasury obligations with maturities of 185 days or less, which were invested in U.S. Treasury Securities. 11\n| | | | | | | |\n| | As of | | As of |\n| | | September 30, 2022 | December 31, 2021 |\n| Gross proceeds | | $ | 207,000,000 | | $ | 207,000,000 |\n| Less: | | |\n| Proceeds allocated to public warrants | | ( 3,321,653 ) | | ( 3,321,653 ) |\n| Proceeds allocated to rights issue | | ( 16,892,298 ) | | ( 16,892,298 ) |\n| Issuance cost of redeemable common stock | | ( 10,763,962 ) | | ( 10,763,962 ) |\n| Plus: | | |\n| Remeasurement of carrying value to redemption value | | 34,286,707 | | 33,047,913 |\n| Contingently redeemable common stock | | $ | 210,308,794 | | $ | 209,070,000 |\n\n| | | | | | | | | | | | | |\n| | | | For the Three | For the Six | For the period from |\n| | | For the Three | | Months Ended | | Months Ended | | February 26, 2021 |\n| | | Months Ended | | September 30, | | September 30, | | (inception) through |\n| | | September 30, 2022 | | 2021 | | 2022 | | September 30, 2021 |\n| Redeemable common stock | | | | | | | | |\n| Numerator: | | | | | | | | | | | | |\n| Net profit (loss) allocable to common stock subject to possible redemption | | $ | 378,157 | | $ | — | | $ | ( 133,521 ) | | $ | — |\n| Denominator: | | | | | | | | |\n| Weighted average shares outstanding, redeemable common stock | | 20,700,000 | | — | | 20,700,000 | | — |\n| Basic and diluted net profit (loss) per share, redeemable common stock | | $ | 0.02 | | $ | — | | $ | ( 0.01 ) | | $ | — |\n| | | | | | | | | | | | | |\n| Non-redeemable common stock | | | | | | | | |\n| Numerator: | | | | | | | | |\n| Net profit (loss) allocable to non-redeemable common stock | | $ | 96,732 | | $ | ( 1,700,000 ) | | $ | ( 34,154 ) | | $ | ( 1,701,359 ) |\n| Denominator: | | | | | | | | |\n| Weighted average shares outstanding, non-redeemable common stock | | 5,295,000 | | 4,620,000 | | 5,295,000 | | 4,594,884 |\n| Basic and diluted net profit (loss) per share, non-redeemable common stock | | $ | 0.02 | | $ | ( 0.37 ) | | $ | ( 0.01 ) | | $ | ( 0.37 ) |\n\nACCRETION ACQUISITION CORP.NOTES TO CONDENSED FINANCIAL STATEMENTS(UNAUDITED) NOTE 2 ─ SIGNIFICANT ACCOUNTING POLICIES (Continued) Income TaxesThe Company accounts for income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Under this method, deferred tax assets and liabilities are determined on the basis of the differences between the financial statements and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.The Company recorded income tax expense of $ 0.21 million based on activities through September 30, 2022, primarily as a result of significant expenses not currently deductible for U.S. income tax purposes.The Company’s effective tax rate (“ETR”) from continuing operations was 28.4 % and 508.0 % for the three months and nine months ended September 30, 2022, respectively. The variation in the Company’s ETR’s is largely due to the full valuation allowance provided for against start-up costs, which are not currently deductible for tax purposes, as well as how those start-up costs were incurred throughout the year relative to dividend income that was earned from Trust Account.On August 16, 2022, the Inflation Reduction Act (the “IRA”) was signed into law in the U.S. Among other changes, the IRA introduced a corporate minimum tax on certain corporations with average adjusted financial statement income over a three-tax year period in excess of $ 1.0 billion, an excise tax on certain stock repurchases by certain covered corporations for taxable years beginning after December 31, 2022, and several tax incentives to promote clean energy. Based on our current analysis and pending future guidance to be issued by Treasury, we believe the excise tax could apply to the Company after the effective date whether or not a Business Combination is completed; however, we do not believe any other provisions of the IRA will apply to the Company absent a Business Combination.The Company recognizes deferred tax assets to the extent that it believes these assets are more likely than not to be realized. In making such a determination, the Company considers all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax-planning strategies, and results of recent operations. If the Company determines that it would be able to realize its deferred tax assets in the future in excess of their net recorded amount, the Company would make an adjustment to the deferred tax asset valuation allowance, which would reduce the provision for income taxes.The Company records uncertain tax positions in accordance with ASC 740 on the basis of a two-step process whereby (1) it determines whether it is more likely than not that the tax positions will be sustained on the basis of the technical merits of the position and (2) for those tax positions that meet the more-likely-than-not recognition threshold, the Company recognizes the largest amount of tax benefit that is more than 50% likely to be realized upon ultimate settlement with the related tax authority.The Company recognizes interest and penalties related to unrecognized tax benefits within the income tax expense line in the accompanying condensed statements of operations. WarrantsASC 480 requires a reporting entity to classify certain freestanding financial instruments as liabilities (or in some cases as assets). ASC 480-10-S99 addresses concerns raised by the SEC regarding the financial statements classification and measurement of securities subject to mandatory redemption requirements or whose redemption is outside the control of the issuer. If the stock subject to mandatory redemption provisions represents the only shares in the reporting entity, it must report instruments in the liabilities section of its statement of financial position. The stock subject must then describe them as shares subject to mandatory redemption, so as to distinguish the instruments from other financial statements liabilities. The Company concludes that the Public Warrants (defined in Note 3) do not exhibit any of the above characteristics and, therefore, are outside the scope of ASC 480.In addition to the 16,300,000 warrants (representing 9,000,000 Public Warrants (as defined at Note 3) included in the units and 7,300,000 Private Warrants) issued by the Company at the close of the Initial Public Offering, a further 2,160,000 warrants (representing 1,350,000 Public Warrants (as defined at Note 3) included in the units and 810,000 Private Warrants) were issued as a result of the underwriters’ full exercise of the over-allotment option. All warrants were issued in accordance with the guidance contained in ASC 14\nACCRETION ACQUISITION CORP.NOTES TO CONDENSED FINANCIAL STATEMENTS(UNAUDITED) 815-40, Derivatives and Hedging — Contracts in Entity’s Own Equity. Such guidance provides that because the warrants meet the criteria for equity treatment. 15\nACCRETION ACQUISITION CORP.NOTES TO CONDENSED FINANCIAL STATEMENTS(UNAUDITED) NOTE 2 ─ SIGNIFICANT ACCOUNTING POLICIES (Continued) Recent Accounting PronouncementsIn August 2020, FASB issued Accounting Standards Update (“ASU”) 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40) (“ASU 2020-06”) to simplify accounting for certain financial instruments. ASU 2020-06 eliminates the current models that require separation of beneficial conversion and cash conversion features from convertible instruments and simplifies the derivative scope exception guidance pertaining to equity classification of contracts in an entity’s own equity. The new standard also introduces additional disclosures for convertible debt and freestanding instruments that are indexed to and settled in an entity’s own equity. ASU 2020-06 amends the diluted earnings per share guidance, including the requirement to use the if-converted method for all convertible instruments.ASU 2020-06 is effective December 15, 2021 and should be applied on a full or modified retrospective basis. On February 26, 2021, the date of the Company’s inception, the Company adopted the new standard.Management does not believe that any recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on the Company’s financial statements. NOTE 3 ─ INITIAL PUBLIC OFFERINGPursuant to the Initial Public Offering, the Company sold 18,000,000 Units at a purchase price of $ 10.00 per Unit. Each Unit consists of one share of common stock, one right (“Right”) and one-half of one warrant (“Public Warrant”). Each Right will convert to one-tenth (1/10) share of common stock upon consummation of Business Combination (see Note 7). Each whole Public Warrant will entitle the holder to purchase one share of common stock at an exercise price of $ 11.50 per share, subject to adjustment (see Note 7).On October 27, 2021, the underwriters fully exercised their over-allotment option and, on October 28, 2021, purchased an additional 2,700,000 Units, generating additional gross proceeds of approximately $ 27.00 million, and incurring additional cash underwriting commissions of approximately $ 0.54 million and deferred underwriting discount of approximately $ 0.95 million. In connection with the sale of Units pursuant to the over-allotment option, the Company sold an additional 810,000 Private Warrants to the Sponsor and the underwriters generating additional gross proceeds of approximately $ 0.81 million. A total of approximately $ 27.27 million of the net proceeds was deposited into the Trust Account, bringing the aggregate proceeds held in the Trust Account to approximately $ 209.07 million.In connection with the Initial Public Offering, the Company granted the underwriters an option to purchase 2,700,000 shares of the Company’s common stock at the Initial Public Offering price, or $ 10.00 per share, for 45 days commencing on October 25, 2021 (grant date). Since this option extended beyond the closing of the Initial Public Offering, this option feature represented a call option that was accounted for under ASC 480, Distinguishing Liabilities from Equity. Accordingly, the call option has been separately accounted for at a fair value with the change in fair value between the grant date and October 27, 2021 recorded as other income. The Company used the Black-Scholes valuation model to determine the fair value of the call option at the grant date and again at October 27, 2021 (refer to Note 8 for fair value information). NOTE 4 ─ PRIVATE WARRANTS Concurrently with the closing of the Initial Public Offering, the Sponsor and the underwriters purchased an aggregate of 7,300,000 Private Warrants, generating gross proceeds of $ 7.30 million in aggregate in a private placement. Each Private Warrant is exercisable for one share of common stock at a price of $ 11.50 per share, subject to adjustment (see Note 7).As a result of the underwriters’ election to fully exercise their over-allotment option on October 27, 2021, the Sponsor and the underwriters and its designees purchased an additional 810,000 Private Warrants, at a purchase price of $ 1.00 per Private Warrant.If the Company does not complete a Business Combination within the Combination Period, the proceeds from the sale of the Private Warrants held in the Trust Account will be used to fund the redemption of the Public Shares (subject to the requirements of applicable law) and the Private Warrants will expire worthless. 16\nACCRETION ACQUISITION CORP.NOTES TO CONDENSED FINANCIAL STATEMENTS(UNAUDITED) NOTE 5 ─ RELATED PARTY TRANSACTIONSFounder SharesOn April 7, 2021, the Sponsor purchased 4,312,500 shares of the Company’s common stock (the “Founder Shares”) for an aggregate purchase price of $ 25,000 .In September 2021, the Sponsor subsequently transferred an aggregate of 250,000 Founder Shares to the Company’s independent director nominees at the same price originally paid for such shares.The sale of the Founder Shares to the Company’s independent director nominees is in the scope of FASB ASC Topic 718, “Compensation-Stock Compensation” (“ASC 718”). Under ASC 718, stock-based compensation associated with equity-classified awards is measured at fair value upon the grant date. The Company has assessed the fair value associated with the Founder Shares granted. The fair value of the 250,000 Founder Shares granted to the Company’s independent director nominees was $ 1.70 million or $ 6.80 per share. The Founder Shares granted to the Company’s independent director nominees will be offered back to the Sponsor at the same purchase price, in the event a person(s) no longer remained in such designated position upon the consummation of a Business Combination. The Sponsor will have 30 days from the offer date to acquire back these Founder Shares at the same purchase price.In October 2021, the Company effected a dividend of 862,500 of the Company’s Founder Shares, which resulted in an aggregate of 5,175,000 Founder Shares outstanding. All share and associated amounts have been retroactively restated to reflect the share dividend.The Founder Shares include an aggregate of up to 675,000 shares of common stock subject to forfeiture by the Sponsors to the extent that the underwriters’ over-allotment is not exercised in full or in part, so that the number of Founder Shares will collectively represent 20 % of the Company’s issued and outstanding shares upon the completion of the Initial Public Offering. On October 27, 2021, the underwriters fully exercised the over-allotment option. Thus, no share of common stock remains subject to forfeiture.Founder Shares are subject to lock-up until the earlier of (A) 180 days after the completion of its initial Business Combination or (B) the date on which the Company completes a liquidation, merger, stock exchange or other similar transaction after its initial Business Combination that results in all of its public stockholders having the right to exchange their shares of common stock for cash, securities or other property.Promissory Note — Related PartyOn April 7, 2021, the Sponsor issued an unsecured promissory note to the Company (the “Promissory Note”), pursuant to which the Company may borrow up to an aggregate principal amount of $ 0.15 million. The Promissory Note is non-interest bearing and payable on the earlier of December 31, 2021, or the consummation of the Initial Public Offering. The Promissory Note was repaid in full on October 25, 2021.Related Party LoansIn addition, in order to finance transaction costs in connection with a Business Combination, the Sponsor, an affiliate of the Sponsor, or certain of the Company’s officers and directors or their affiliates may, but are not obligated to, loan the Company funds as may be required (“Working Capital Loans”). If the Company completes a Business Combination, the Company would repay the Working Capital Loans out of the proceeds of the Trust Account released to the Company. Otherwise, the Working Capital Loans would be repaid only out of funds held outside the Trust Account. In the event that a Business Combination does not close, the Company may use a portion of proceeds held outside the Trust Account to repay the Working Capital Loans but no proceeds held in the Trust Account would be used to repay the Working Capital Loans. The Working Capital Loans would either be repaid upon consummation of a Business Combination, without interest, or, at the lender’s discretion, up to $ 1.5 million of such Working Capital Loans may be convertible into warrants of the post Business Combination entity. The warrants would be identical to the Private Warrants. Except for the foregoing, the terms of such Working Capital Loans, if any, have not been determined and no written agreements exist with respect to such loans. As of September 30, 2022 and December 31, 2021, respectively, no Working Capital Loans were outstanding. 17\nACCRETION ACQUISITION CORP.NOTES TO CONDENSED FINANCIAL STATEMENTS(UNAUDITED) NOTE 5 ─ RELATED PARTY TRANSACTIONS (Continued)Related Party PayableAs of September 30, 2022, an amount of $ 0.11 million was payable to the Sponsor, in connection with a filing fee of $ 60 paid on behalf of the Company and unpaid administrative support fees of $ 0.11 million.As of December 31, 2021, an amount of $ 0.02 million was payable to the Sponsor, in connection with unpaid administrative support fees. This amount has been reclassified from accrued expenses to related party payable in order to conform to the presentation of this period.Administrative Support AgreementCommencing on the effective date of the Initial Public Offering, the Company agreed to pay the Sponsor a total of up to $ 10,000 per month in the aggregate for up to 18 months for office space, utilities and secretarial and administrative support. Upon completion of the initial Business Combination or the Company’s liquidation, the Company will cease paying these monthly fees. For the three months ended September 30, 2022, the Company accrued $ 0.03 million for these services, and for the nine months ended September 30, 2022, the Company has accrued $ 0.09 million. These amounts are included in the operating costs on accompanying condensed statements of operations. No such amounts were recorded during the three months and nine months ended September 30, 2021. NOTE 6 ─ COMMITMENTS AND CONTINGENCIESRegistration RightsThe holders of the Founder Shares, EBC Founder Shares (as defined in Note 7), and any warrants that may be issued in payment of Working Capital Loans made to Company (and underlying securities) are entitled to registration rights pursuant to an agreement entered into on October 20, 2021. The holders of a majority of these securities are entitled to make up to two demands that the Company register such securities. The holders of the majority of the Founder Shares can elect to exercise these registration rights at any time commencing three months prior to the date on which these shares of common stock are to be released from escrow. The holders of a majority of the EBC Founder Shares (as defined in Note 7) and units issued to the Sponsor, officers, directors or their affiliates in payment of Working Capital Loans made to the Company (or underlying securities) can elect to exercise these registration rights at any time after the consummation of a Business Combination. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the consummation of a Business Combination. The registration rights agreement does not contain liquidated damages or other cash settlement provisions resulting from delays in registering its securities. The Company will bear the expenses incurred in connection with the filing of any such registration statements.Underwriting AgreementThe Company had granted the underwriters a 45 -day option from the date of Initial Public Offering to purchase up to 2,700,000 additional Units to cover over-allotments, if any, at the Initial Public Offering price less the underwriting discounts and commissions.The underwriters were entitled to an underwriting discount of $ 0.20 per unit, or $ 3.60 million in the aggregate payable upon the closing of the Initial Public Offering. $ 0.35 per unit, or $ 6.30 million in the aggregate will be payable to the underwriters for deferred underwriting commissions. The deferred fee will become payable to the underwriters from the amounts held in the Trust Account solely in the event that the Company completes a Business Combination, subject to the terms of the underwriting agreement.On October 27, 2021, the underwriters fully exercised the over-allotment option. As a result, they were entitled to an additional underwriting discount of $ 0.54 million in cash, and a further deferred underwriting discount of $ 0.95 million. 18\nACCRETION ACQUISITION CORP.NOTES TO CONDENSED FINANCIAL STATEMENTS(UNAUDITED) NOTE 6 ─ COMMITMENTS AND CONTINGENCIES (Continued)Advisory AgreementThrough September 30, 2022, the Company entered into an agreement with the M&A advisors (who also served as the Company’s underwriters during the Initial Public Offering) in connection with the evaluation, pursuit and conduct of one or more proposed transactions for a potential Business Combination (the “Advisory Agreement”). At balance sheet date, fees for the services performed were contingent upon the closing of a Business Combination and therefore not included as liabilities on the accompanying condensed balance sheets.Engagement for Legal ServicesThe Company has a contingent fee arrangement with their legal counsel pursuant to which a flat fee of $ 3.00 million is payable to the Company’s legal counsel in the event that the Company completes a Business Combination. In the event the Company does not complete a Business Combination, the Company’s legal counsel will bill the Company the lesser of the actual time incurred or $ 0.10 million.As of September 30, 2022, the Company has accrued an amount of $ 0.47 million. NOTE 7 ─ STOCKHOLDERS’ DEFICITCommon StockThe Company is authorized to issue 50,000,000 shares of common stock with a par value of $ 0.001 per share.At September 30, 2021, there were 5,295,000 shares of common stock issued and outstanding, which such amount having been restated to reflect the share dividend in October 2021 (excluding 18,000,000 shares of common stock subject to possible redemption).Of the 5,295,000 shares of common stock outstanding, an aggregate of up to 675,000 shares were subject to forfeiture, to the extent that the underwriters’ over-allotment option is not exercised in full or in part, so that the Sponsor will collectively own 20 % of the Company’s issued and outstanding common stock after the Initial Public Offering (assuming Sponsor does not purchase any Public Shares in the Initial Public Offering).As of October 27, 2021, as a result of the underwriters’ full exercise of the over-allotment option, no share of common stock was available for forfeiture.Preferred StockThe Company is authorized to issue 1,000,000 shares of preferred stock, par value $ 0.001 per share, with such designations, voting and other rights and preferences as may be determined from time to time by the Company’s board of directors. As of September 30, 2022 and December 31, 2021, no share of preferred stock was issued or outstanding.RightsEach holder of a Right will receive one-tenth (1/10) share of common stock upon consummation of a Business Combination, even if the holder of such Right redeemed all shares held by it in connection with a Business Combination. No fractional shares will be issued upon exchange of the rights. No additional consideration will be required to be paid by a holder of rights in order to receive its additional shares upon consummation of a Business Combination as the consideration related thereto has been included in the Unit purchase price paid for by investors in the Initial Public Offering. If the Company enters into a definitive agreement for a Business Combination in which the Company will not be the surviving entity, the definitive agreement will provide for the holders of rights to receive the same per share consideration the holders of the common stock will receive in the transaction on an as-converted into common stock basis and each holder of a right will be required to affirmatively covert its rights in order to receive one-tenth (1/10) share underlying each right (without paying additional consideration). The shares issuable upon exchange of the rights will be freely tradable (except to the extent held by affiliates of the Company). 19\n| ● | in whole and not in part; |\n| ● | at a price of $ 0.01 per warrant; |\n| ● | at any time after the warrants become exercisable; |\n| ● | upon not less than 30 days ’ prior written notice of redemption to each warrant holder; |\n| ● | if, and only if, the reported last sale price of the shares of common stock equals or exceeds $ 18.00 per share (as adjusted for stock splits, stock dividends, reorganizations and recapitalizations), for any 20 trading days within a 30 -trading day period commencing at any time after the warrants become exercisable and ending on the third business day prior to the notice of redemption to warrant holders; and |\n| ● | if, and only if, there is a current registration statement in effect with respect to the shares of common stock underlying the warrants. |\n\nACCRETION ACQUISITION CORP.NOTES TO CONDENSED FINANCIAL STATEMENTS(UNAUDITED) NOTE 7 ─ STOCKHOLDERS’ DEFICIT (Continued)Warrants (Continued)In addition, if (x) the Company issues additional common stock or equity-linked securities for capital raising purposes in connection with the closing of a Business Combination at an issue price or effective issue price of less than $ 9.20 per common stock (with such issue price or effective issue price to be determined in good faith by the Company’s board of directors and, in the case of any such issuance to the Sponsor or its affiliates, without taking into account any Founder Shares held by the Sponsor or such affiliates, as applicable, prior to such issuance), (y) the aggregate gross proceeds from such issuances represent more than 60 % of the total equity proceeds, and interest thereon, available for the funding of a Business Combination on the date of the consummation of a Business Combination (net of redemptions), and (z) the volume weighted average trading price of its common stock during the 20 trading day period starting on the trading day prior to the day on which the Company consummates its Business Combination (such price, the “Market Value”) is below $ 9.20 per share, the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115 % of the greater of (i) Market Value or (ii) the price at which the Company issue the additional shares of common stock or equity-linked securities.The Private Warrants will be identical to the Public Warrants underlying the Units being sold in the Initial Public Offering.EBC Founder SharesIn April 2021, the Company issued to EarlyBirdCapital and its designees 100,000 shares of common stock (the “EBC Founder Shares”) at $ 0.001 per share. The Company accounted for the EBC Founder Shares as an offering cost of the Initial Public Offering, with a corresponding credit to stockholders’ equity. The Company estimated the fair value of EBC Founder Shares to be $ 580 based upon the price of the Founder Shares issued to the Sponsor. In October 2021, the Company effected a dividend of 20,000 of the Company’s EBC Founder Shares, which resulted in an aggregate of 120,000 EBC Founder Shares outstanding. All share and associated amounts have been retroactively restated to reflect the share dividend. The holders of the EBC Founder Shares have agreed not to transfer, assign, or sell any such shares until the completion of a Business Combination. In addition, the holders have agreed (i) to waive their redemption rights with respect to such shares in connection with the completion of a Business Combination and (ii) to waive their rights to liquidating distributions from the Trust Account with respect to such shares if the Company fails to complete a Business Combination within the Combination Period.The EBC Founder Shares have been deemed compensation by FINRA and are therefore subject to a lock-up for a period of 180 days immediately following the effective date of the registration statement related to the Initial Public Offering pursuant to Rule 5110(g)(1) of FINRA’s NASD Conduct Rules. Pursuant to FINRA Rule 5110(g)(1), these securities will not be sold during the Initial Public Offering, or sold, transferred, assigned, pledged, or hypothecated, or be the subject of any hedging, short sale, derivative, put or call transaction that would result in the economic disposition of the securities by any person for a period of 180 days immediately following the effective date of the Initial Public Offering, except to any underwriter and selected dealer participating in the Initial Public Offering and their bona fide officers or partners, provided that all securities so transferred remain subject to the lockup restriction above for the remainder of the time period. 21\n| ● | Level 1 - Quoted prices in active markets for identical assets or liabilities. An active market for an asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. |\n| ● | Level 2 - Observable inputs other than Level 1 inputs. Examples of Level 2 inputs include quoted prices in active markets for similar assets or liabilities and quoted prices for identical assets or liabilities in markets that are not active. |\n| ● | Level 3 - Unobservable inputs based on the Company’s assessment of the assumptions that market participants would use in pricing the asset or liability. |\n| | | | | | | | | | |\n| | | | Significant | Significant |\n| | Quoted Prices | Other | Other |\n| | in Active | Observable | Unobservable |\n| | Markets | Inputs | Inputs |\n| Description | | (Level 1) | (Level 2) | (Level 3) |\n| Assets: | | | | | | | | | |\n| U.S Treasury securities | | $ | 210,308,794 | | $ | — | | $ | — |\n| | | $ | 210,308,794 | | $ | — | | $ | — |\n\n| | | | | | | | | | |\n| | | | Significant | Significant |\n| | Quoted Prices | Other | Other |\n| | in Active | Observable | Unobservable |\n| | Markets | Inputs | Inputs |\n| Description | | (Level 1) | (Level 2) | (Level 3) |\n| Assets: | | | | | | | | | |\n| U.S Treasury securities | | $ | 209,072,882 | | $ | — | | $ | — |\n| | | $ | 209,072,882 | | $ | — | | $ | — |\n| | | | |\n| Over allotment option at October 25, 2021 | $ | 597,091 |\n| Change in fair value of over allotment option transfer to statement of operations | | ( 81,168 ) |\n| Transfer to additional paid-in capital upon exercise of over allotment option | | ( 515,923 ) |\n| Over allotment option at December 31, 2021 | | $ | — |\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nReferences in this report (the “Quarterly Report”) to “we,” “us” or the “Company” refer to Accretion Acquisition Corp. References to our “management” or our “management team” refer to our officers and directors, and references to the “Sponsor” refer to Accretion Acquisition Sponsor, LLC. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the unaudited condensed financial statements and the notes thereto contained elsewhere in this Quarterly Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\nSpecial Note Regarding Forward-Looking Statements\nThis Quarterly Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Exchange Act that are not historical facts, and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. All statements, other than statements of historical fact included in this Quarterly Report including, without limitation, statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. Words such as “expect,” “believe,” “anticipate,” “intend,” “estimate,” “seek” and variations and similar words and expressions are intended to identify such forward-looking statements. Such forward-looking statements relate to future events or future performance, but reflect management’s current beliefs, based on information currently available. A number of factors could cause actual events, performance or results to differ materially from the events, performance and results discussed in the forward-looking statements. For information identifying important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements, please refer to the Risk Factors section of the Company’s final prospectus for its initial public offering filed with the U.S. Securities and Exchange Commission (the “SEC”). The Company’s securities filings can be accessed on the EDGAR section of the SEC’s website at www.sec.gov. Except as expressly required by applicable securities law, the Company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.\nOverview\nWe are a blank check company formed under the laws of the State of Delaware on February 26, 2021 for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or other similar business combination with one or more businesses. We intend to effectuate our business combination using cash from the proceeds of the IPO and the sale of the private warrants, our capital stock, debt or a combination of cash, stock and debt.\nAll activity through September 30, 2022 relates to our formation, the IPO, and search for a prospective business combination target.\nResults of Operations\nWe have neither engaged in any operations nor generated any revenues to date. Our only activities from inception through September 30, 2022, were organizational activities and those necessary to prepare for the IPO, described below. We do not expect to generate any operating revenues until after the completion of our business combination. We expect to generate non-operating income in the form of interest income or dividend income on cash held in the trust account after the IPO. We incur expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses.\nFor the three months ended September 30, 2022, we had a net profit of $0.48 million, which consisted of dividend income of $0.95 million, offset by franchise tax expense of $0.05 million, income tax expense of $0.19 million and operating costs of $0.23 million.\nFor the three months ended September 30, 2021, we had a net loss of $1.70 million, which consisted of stock-based compensation.\nFor the nine months ended September 30, 2022, we had a net loss of $0.17 million, which consisted of dividend income of $1.26 million, offset by franchise tax expense of $0.15 million, income tax expense of $0.21 million and operating costs of $1.07 million.\n24\nFor the period from February 26, 2021 (inception) through September 30, 2021, we had a net loss of $1.70 million which consisted of formation costs and stock-based compensation.Liquidity and Capital ResourcesAs of September 30, 2022, we had $0.26 million in cash and no cash equivalents.Until the consummation of the IPO, our only source of liquidity was an initial purchase of common stock by the Sponsor and loans from the Sponsor.On October 25, 2021, the Company consummated the IPO of 18,000,000 units, at a price of $10.00 per unit, generating gross proceeds of $180.00 million. Simultaneously with the closing of the IPO, we consummated the sale of 7,300,000 private warrants at a price of $1.00 per warrant in a private placement to Sponsor, generating gross proceeds of $7.30 million. On October 27, 2021, the underwriters exercised the over-allotment option in full and on October 28, 2021, purchased an additional 2,700,000 units, generating gross proceeds of approximately $27.00 million. In connection with the underwriters’ full exercise of the over-allotment option, the Company issued an additional 810,000 private warrants at a price of $1.00 per warrant in a private placement to Sponsor generating gross proceeds of $0.81 million.Following the IPO and the private placement, a total of $209.07 million was placed in the trust account (at $10.10 per Unit). We incurred $11.94 million in transaction costs, including $4.14 million of underwriting fees, $7.25 million of deferred underwriting fees and $0.55 million of other offering costs.As of September 30, 2022, we had cash held in the trust account of $210.31 million. We intend to use substantially all of the funds held in the trust account, including any amounts representing income earned on the trust account, to complete our business combination. To the extent that our capital stock or debt is used, in whole or in part, as consideration to complete our business combination, the remaining proceeds held in the trust account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies.As of September 30, 2022, we had cash of $0.26 million outside of the trust account. We intend to use the funds held outside the trust account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, and structure, negotiate and complete a business combination.In order to fund working capital deficiencies or finance transaction costs in connection with a business combination, our Sponsor or an affiliate of our Sponsor or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If we complete a business combination, we may repay such loaned amounts out of the proceeds of the trust account released to us. In the event that a business combination does not close, we may use a portion of the working capital held outside the trust account to repay such loaned amounts, but no proceeds from our trust account would be used for such repayment. Up to $1.50 million of such loans may be convertible into warrants at the option of the lender. The warrants would be identical to the private warrants.We do not believe we will need to raise additional funds in order to meet the expenditures required for operating our business. However, if our estimate of the costs of identifying a target business, undertaking in-depth due diligence and negotiating a business combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our business combination. Moreover, we may need to obtain additional financing either to complete our business combination or because we become obligated to redeem a significant number of our public shares upon consummation of our business combination, in which case we may issue additional securities or incur debt in connection with such business combination. Subject to compliance with applicable securities laws, we would only complete such financing simultaneously with the completion of our business combination. If we are unable to complete our business combination because we do not have sufficient funds available to us, we will be forced to cease operations and liquidate the trust account. In addition, following our business combination, if cash on hand is insufficient, we may need to obtain additional financing in order to meet our obligations.25\nGoing ConcernIn connection with our assessment of going concern considerations in accordance with the authoritative guidance in Financial Accounting Standard Board (“FASB”) Accounting Standards Update (“ASU”) 2014-15, “Disclosures of Uncertainties about an Entity’s Ability to Continue as a Going Concern,” management has determined that the mandatory liquidation and subsequent dissolution, should the we be unable to complete a business combination, raises substantial doubt about the our ability to continue as a going concern.Off-Balance Sheet ArrangementsWe have no obligations, assets or liabilities, which would be considered off-balance sheet arrangements as of September 30, 2022. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets.Contractual ObligationsWe do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities, other than as described below.Registration RightsThe holders of the founders’ shares, EBC founder shares, the private warrants, and any warrants that may be issued upon conversion of working capital loans will be entitled to registration rights pursuant to a registration rights agreement. These holders will be entitled to certain demand and “piggyback” registration rights. We will bear the expenses incurred in connection with the filing of any such registration statements.Underwriting AgreementThe underwriters were entitled to an underwriting discount of $0.20 per unit, or $3.60 million in the aggregate payable upon the closing of the IPO and the over-allotment option. $0.35 per unit, or $6.30 million in the aggregate will be payable to the underwriters for deferred underwriting commissions. The deferred fee will become payable to the underwriters from the amounts held in the trust account solely in the event that the Company completes a business combination, subject to the terms of the underwriting agreement.On October 27, 2021, the underwriters fully exercised the over-allotment option. As a result, they were entitled to an additional underwriting discount of $0.54 million in cash, and a further deferred underwriting discount of $0.95 million.Administrative Support AgreementCommencing on the effective date of the IPO, we have agreed to pay the Sponsor a total of up to $10,000 per month in the aggregate for up to 18 months for office space, utilities and secretarial and administrative support. Upon completion of the initial business combination or the Company’s liquidation, we will cease paying these monthly fees. For the three months ended September 30, 2022, the Company accrued $0.03 million for these services, and for the nine months ended September 30, 2022, the Company accrued $0.09 million. These amounts are included in the operating costs on accompanying condensed statements of operations.Advisory AgreementThrough September 30, 2022, the Company entered into an agreement with the M&A advisors (who also served as the Company’s underwriters during the Initial Public Offering) in connection with the evaluation, pursuit and conduct of one or more proposed transactions for a potential Business Combination (the “Advisory Agreement”). At balance sheet date, fees for the services performed were contingent upon the closing of a Business Combination and therefore not included as liabilities on the accompanying condensed balance sheets.26\nEngagement for Legal ServicesThe Company has a contingent fee arrangement with their legal counsel pursuant to which a flat fee of $3.00 million is payable to the Company’s legal counsel in the event that the Company completes a Business Combination. In the event the Company does not complete a Business Combination, the Company’s legal counsel will bill the Company the lesser of the actual time incurred or $100,000.As of September 30, 2022, the Company has accrued an amount of $0.47 million.Critical Accounting PoliciesManagement does not believe that any recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on our condensed financial statements.The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. The Company has identified the following as its critical accounting policies:WarrantsWe do not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks. We evaluate all of our financial instruments, including issued stock purchase warrants, to determine if such instruments are derivatives or contain features that qualify as embedded derivatives, pursuant to ASC 480 and ASC 815-15.We account for the public warrants and private warrants collectively (“Warrants”), as either equity or liability-classified instruments based on an assessment of the specific terms of the Warrants and the applicable authoritative guidance in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 815, Derivatives and Hedging (“ASC 815”). The assessment considers whether the Warrants meet all of the requirements for equity classification under ASC 815, including whether the Warrants are indexed to our own common stocks and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of our control, among other conditions for equity classification. This assessment, which requires the use of professional judgment, is conducted at the time of issuance of the Warrants and as of each subsequent quarterly period end date while the Warrants are outstanding.For issued or modified warrants that meet all of the criteria for equity classification, such warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all the criteria for equity classification, such warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of liability-classified warrants are recognized as a non-cash gain or loss on the statements of operations.We evaluated the public warrants and private warrants in accordance with ASC 815-40, “Derivatives and Hedging — Contracts in Entity’s Own Equity,” and concluded that they met the criteria for equity classification and are required to be recorded as part a component of additional paid-in capital at the time of issuance.Common Stock Subject to Possible RedemptionWe account for the common stock subject to possible redemption in accordance with the guidance in ASC 480, Distinguishing Liabilities from Equity. Common stock subject to mandatory redemption are classified as a liability instrument and are measured at fair value. Conditionally redeemable common stock (including common stock that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, common stock are classified as stockholders’ equity. The Company’s common stock features certain redemption rights that are considered to be outside of our control and subject to occurrence of uncertain future events.27\nNet Profit (Loss) Per Share of Common StockWe comply with accounting and disclosure requirements of Financial Accounting Standards Board Accounting Standard Codification, or FASB ASC, Topic 260, “Earnings Per Share.” Net Profit (loss) per share of common stock is computed by dividing net loss attributable to common stockholders by the weighted average number of shares of common stock outstanding during the period, excluding common stock subject to forfeiture. The Company applies the two-class method in calculating earnings per share. The calculation of diluted profit (loss) per share of common stock does not consider the effect of the warrants issued in connection with the IPO since the exercise of the warrants are contingent upon the occurrence of future events and the inclusion of such warrants would be anti-dilutive.Recent Accounting PronouncementsIn August 2020, FASB issued Accounting Standards Update (“ASU”) 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40) (“ASU 2020-06”) to simplify accounting for certain financial instruments. ASU 2020-06 eliminates the current models that require separation of beneficial conversion and cash conversion features from convertible instruments and simplifies the derivative scope exception guidance pertaining to equity classification of contracts in an entity’s own equity. The new standard also introduces additional disclosures for convertible debt and freestanding instruments that are indexed to and settled in an entity’s own equity. ASU 2020-06 amends the diluted earnings per share guidance, including the requirement to use the if-converted method for all convertible instruments. ASU 2020-06 is effective December 15, 2021 and should be applied on a full or modified retrospective basis. On February 26, 2021, the date of the Company’s inception, the Company adopted the new standard.Management does not believe that any recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on the Company’s condensed financial statements.\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\nNot required for smaller reporting companies.\nItem 4. Controls and Procedures\nDisclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.\nEvaluation of Disclosure Controls and Procedures\nDisclosure controls and procedures are designed to ensure that information required to be disclosed by us in our Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial and accounting officer or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.\nWe do not expect that our disclosure controls and procedures will prevent all errors and all instances of fraud. Disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Further, the design of disclosure controls and procedures must reflect the fact that there are resource constraints, and the benefits must be considered relative to their costs. Because of the inherent limitations in all disclosure controls and procedures, no evaluation of disclosure controls and procedures can provide absolute assurance that we have detected all our control deficiencies and instances of fraud, if any. The design of disclosure controls and procedures also is based partly on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.\nAs required by Rules 13a-15 and 15d-15 under the Exchange Act, our Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2022. Based upon their evaluation, and due to a material weakness in our internal control over financial reporting over the accounting for complex financial instruments, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were not effective as of September 30, 2022.\n28\nChanges in Internal Control Over Financial ReportingDuring our most recently completed fiscal quarter, there has been no change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.PART II. OTHER INFORMATION\nItem 1. Legal Proceedings\nNone.\nItem 1A. Risk Factors\nAs of the date of this Quarterly Report on Form 10-Q, there have been no material changes to the risk factors disclosed in our Annual Report on Form 10-K filed with the SEC on March 31, 2022. We may disclose changes to such factors or disclose additional factors from time to time in our future filings with the SEC.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nWe had no sales of unregistered equity securities during the period covered by this Quarterly Report on Form 10-Q.\nItem 3. Defaults Upon Senior Securities\nNone.\nItem 4. Mine Safety Disclosures\nNot applicable.\nItem 5. Other Information\nNone.\nItem 6. Exhibits\n\n| Exhibit Number | Description of Document |\n| 31.1 | | Certification of Principal Executive Officer, pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2 | | Certification of Principal Financial Officer, pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32.1* | | Certification of Principal Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 32.2* | | Certification of Principal Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 101.SCH | | Inline XBRL Taxonomy Extension Schema Document. |\n| 101.CAL | | Inline XBRL Taxonomy Extension Calculation Linkbase Document. |\n| 101.DEF | | Inline XBRL Taxonomy Extension Definition Linkbase Document. |\n| 101.LAB | | Inline XBRL Taxonomy Extension Label Linkbase Document. |\n| 101.PRE | | Inline XBRL Taxonomy Extension Presentation Linkbase Document. |\n| 104 | | Inline XBRL for the cover page of this Quarterly Report on Form 10-Q, included in the Exhibit 101 Inline XBRL Document Set. |\n\n| * | Furnished herewith. |\n\n\n29\n| | | |\n| | ACCRETION ACQUISITION CORP. |\n| | (Registrant) |\n| | | |\n| Date: November 14, 2022 | By: | /s/ M. Grant Farn |\n| | | M. Grant Farn |\n| | | Chief Financial Officer |\n| | | (Principal Financial Officer) |\n\n</text>\n\nHow many years could the company sustain the dividend payments at the current rate if the dividends were to be paid solely from the company's Cash on Hand?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1 Financial Statements\nBADGER METER, INC.\nConsolidated Condensed Balance Sheets\n| March 31, | December 31, |\n| (Unaudited) |\n| (In thousands) |\n| Assets | 2018 | 2017 |\n| Current assets: |\n| Cash | $ | 13,532 | $ | 11,164 |\n| Receivables | 63,372 | 58,210 |\n| Inventories: |\n| Finished goods | 22,668 | 23,125 |\n| Work in process | 19,012 | 22,035 |\n| Raw materials | 43,448 | 40,012 |\n| Total inventories | 85,128 | 85,172 |\n| Prepaid expenses and other current assets | 4,728 | 4,077 |\n| Total current assets | 166,760 | 158,623 |\n| Property, plant and equipment, at cost | 215,512 | 212,485 |\n| Less accumulated depreciation | (121,979 | ) | (118,884 | ) |\n| Net property, plant and equipment | 93,533 | 93,601 |\n| Intangible assets, at cost less accumulated amortization | 57,468 | 59,326 |\n| Other assets | 9,226 | 9,897 |\n| Deferred income taxes | 855 | 2,856 |\n| Goodwill | 67,424 | 67,424 |\n| Total assets | $ | 395,266 | $ | 391,727 |\n| Liabilities and shareholders’ equity |\n| Current liabilities: |\n| Short-term debt | $ | 48,170 | $ | 44,550 |\n| Payables and other current liabilities | 24,300 | 28,601 |\n| Accrued compensation and employee benefits | 9,375 | 15,509 |\n| Warranty and after-sale costs | 3,702 | 3,367 |\n| Income and other taxes | 3,003 | 1,082 |\n| Total current liabilities | 88,550 | 93,109 |\n| Other long-term liabilities | 11,324 | 4,073 |\n| Deferred income taxes | 1,546 | 3,434 |\n| Accrued non-pension postretirement benefits | 5,834 | 5,703 |\n| Other accrued employee benefits | 7,290 | 7,956 |\n| Commitments and contingencies (Note 6) |\n| Shareholders’ equity: |\n| Common stock | 37,177 | 37,165 |\n| Capital in excess of par value | 32,870 | 32,182 |\n| Reinvested earnings | 247,866 | 244,224 |\n| Accumulated other comprehensive loss | (10,411 | ) | (10,893 | ) |\n| Less: Employee benefit stock | (461 | ) | (460 | ) |\n| Treasury stock, at cost | (26,319 | ) | (24,766 | ) |\n| Total shareholders’ equity | 280,722 | 277,452 |\n| Total liabilities and shareholders’ equity | $ | 395,266 | $ | 391,727 |\n\nSee accompanying notes to unaudited consolidated condensed financial statements.\n4\nTable of Contents\nBADGER METER, INC.\nConsolidated Statements of Operations\n\n| Three Months Ended |\n| March 31, |\n| (Unaudited) |\n| (In thousands except share and per share amounts) |\n| 2018 | 2017 |\n| Net sales | $ | 105,041 | $ | 101,606 |\n| Cost of sales | 68,293 | 62,956 |\n| Gross margin | 36,748 | 38,650 |\n| Selling, engineering and administration | 26,774 | 25,085 |\n| Operating earnings | 9,974 | 13,565 |\n| Interest expense, net | 290 | 178 |\n| Other pension and postretirement (benefits) costs | (19 | ) | 96 |\n| Earnings before income taxes | 9,703 | 13,291 |\n| Provision for income taxes | 2,157 | 4,542 |\n| Net earnings | $ | 7,546 | $ | 8,749 |\n| Earnings per share: |\n| Basic | $ | 0.26 | $ | 0.30 |\n| Diluted | $ | 0.26 | $ | 0.30 |\n| Dividends declared per common share | $ | 0.130 | $ | 0.115 |\n| Shares used in computation of earnings per share: |\n| Basic | 28,932,787 | 28,900,702 |\n| Impact of dilutive securities | 217,259 | 182,279 |\n| Diluted | 29,150,046 | 29,082,981 |\n\nSee accompanying notes to unaudited consolidated condensed financial statements.\n5\nTable of Contents\nBADGER METER, INC.\nConsolidated Statements of Comprehensive Income\n\n| Three Months Ended |\n| March 31, |\n| (Unaudited) |\n| (In thousands) |\n| 2018 | 2017 |\n| Net earnings | $ | 7,546 | $ | 8,749 |\n| Other comprehensive income: |\n| Foreign currency translation adjustment | 421 | 291 |\n| Pension and postretirement benefits, net of tax | 61 | 83 |\n| Comprehensive income | $ | 8,028 | $ | 9,123 |\n\nSee accompanying notes to unaudited consolidated condensed financial statements.\n6\nTable of Contents\nBADGER METER, INC.\nConsolidated Condensed Statements of Cash Flows\n\n| Three Months Ended |\n| March 31 |\n| (Unaudited)(In thousands) |\n| 2018 | 2017 |\n| Operating activities: |\n| Net earnings | $ | 7,546 | $ | 8,749 |\n| Adjustments to reconcile net earnings to net cash provided by operations: |\n| Depreciation | 3,175 | 2,918 |\n| Amortization | 3,537 | 2,945 |\n| Deferred income taxes | 1 | (12 | ) |\n| Noncurrent employee benefits | 94 | 115 |\n| Stock-based compensation expense | 471 | 366 |\n| Changes in: |\n| Receivables | (4,919 | ) | (5,958 | ) |\n| Inventories | 265 | 7,423 |\n| Prepaid expenses and other assets | (1,586 | ) | (2,819 | ) |\n| Liabilities other than debt | (1,809 | ) | (1,319 | ) |\n| Total adjustments | (771 | ) | 3,659 |\n| Net cash provided by operations | 6,775 | 12,408 |\n| Investing activities: |\n| Property, plant and equipment expenditures | (3,043 | ) | (3,806 | ) |\n| Acquisitions, net of cash acquired and future payments | — | (200 | ) |\n| Net cash used for investing activities | (3,043 | ) | (4,006 | ) |\n| Financing activities: |\n| Net increase in short-term debt | 3,500 | 126 |\n| Dividends paid | (3,770 | ) | (3,336 | ) |\n| Proceeds from exercise of stock options | 231 | 654 |\n| Repurchase of treasury stock | (1,619 | ) | (2,242 | ) |\n| Issuance of treasury stock | 65 | 89 |\n| Net cash used for financing activities | (1,593 | ) | (4,709 | ) |\n| Effect of foreign exchange rates on cash | 229 | 280 |\n| Increase in cash | 2,368 | 3,973 |\n| Cash – beginning of period | 11,164 | 7,338 |\n| Cash – end of period | $ | 13,532 | $ | 11,311 |\n\nSee accompanying notes to unaudited consolidated condensed financial statements.\n7\nTable of Contents\nBADGER METER, INC.\nNotes to Unaudited Consolidated Condensed Financial Statements\nNote 1 Basis of Presentation\nIn the opinion of management, the accompanying unaudited consolidated condensed financial statements of Badger Meter, Inc. (the “Company” or “Badger Meter”) contain all adjustments (consisting only of normal recurring accruals except as otherwise discussed) necessary to present fairly the Company’s consolidated condensed financial position at March 31, 2018, results of operations for the three-month periods ended March 31, 2018 and 2017, comprehensive income for the three-month periods ended March 31, 2018 and 2017, and cash flows for the three-month periods ended March 31, 2018 and 2017. The results of operations for any interim period are not necessarily indicative of the results to be expected for the full year.\nThe preparation of financial statements in conformity with United States generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.\nNote 2 Additional Financial Information Disclosures\nThe consolidated condensed balance sheet at December 31, 2017 was derived from amounts included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017. Refer to the footnotes to the financial statements included in that report for a description of the Company’s accounting policies and for additional details of the Company’s financial condition. The details in those notes have not changed except as discussed below and as a result of normal adjustments in the interim.\nWarranty and After-Sale Costs\nThe Company estimates and records provisions for warranties and other after-sale costs in the period in which the sale is recorded, based on a lag factor and historical warranty claim experience. After-sale costs represent a variety of activities outside of the written warranty policy, such as investigation of unanticipated problems after the customer has installed the product, or analysis of water quality issues. Changes in the Company’s warranty and after-sale costs reserve are as follows:\n| Three months ended |\n| March 31, |\n| (In thousands) | 2018 | 2017 |\n| Balance at beginning of period | $ | 3,367 | $ | 2,779 |\n| Net additions charged to earnings | 1,041 | 752 |\n| Adjustments to pre-existing warranties | (53 | ) | (394 | ) |\n| Costs incurred | (653 | ) | (589 | ) |\n| Balance at end of period | $ | 3,702 | $ | 2,548 |\n\nNote 3 Employee Benefit Plans\nThe Company maintains a non-contributory defined benefit pension plan that covers substantially all U.S. employees who were employed at December 31, 2011. After that date, no further benefits are being accrued in this plan. For the frozen pension plan, benefits are based primarily on years of service and, for certain plans, levels of compensation. The Company plans to terminate the pension plan in 2018, but there will be no accounting recognition until the final disposition of assets occurs.\nThe Company also maintains supplemental non-qualified plans for certain officers and other key employees, and an Employee Savings and Stock Option Plan (“ESSOP”) for the majority of the U.S. employees.\nThe Company additionally has a postretirement healthcare benefit plan that provides medical benefits for certain U.S. retirees and eligible dependents hired prior to November 1, 2004. Employees are eligible to receive postretirement healthcare benefits upon meeting certain age and service requirements. No employees hired after October 31, 2004 are eligible to receive these benefits. This plan requires employee contributions to offset benefit costs.\n8\nTable of Contents\nThe following table sets forth the components of net periodic benefit (income) cost for the three months ended March 31, 2018 and 2017 based on December 31, 2017 and 2016 actuarial measurement dates, respectively:\n| Definedpension planbenefits | Otherpostretirementbenefits |\n| (In thousands) | 2018 | 2017 | 2018 | 2017 |\n| Service cost – benefits earned during the year | $ | 29 | $ | 24 | $ | 34 | $ | 35 |\n| Interest cost on projected benefit obligations | 95 | 318 | 48 | 51 |\n| Expected return on plan assets | (244 | ) | (402 | ) | — | — |\n| Amortization of prior service cost | — | — | (6 | ) | (6 | ) |\n| Amortization of net loss | 88 | 135 | — | — |\n| Net periodic benefit (income) cost | $ | (32 | ) | $ | 75 | $ | 76 | $ | 80 |\n\nThe Company disclosed in its financial statements for the year ended December 31, 2017 that it was not required to make a minimum contribution to the defined benefit pension plan for the 2018 calendar year. The Company believes that no additional contributions will be required during 2018.\nThe Company also disclosed in its financial statements for the year ended December 31, 2017 that it estimated it would pay $0.4 million in other postretirement benefits in 2018 based on actuarial estimates. As of March 31, 2018, $71,500 of such benefits have been paid. The Company continues to believe that its estimated payments for the full year are reasonable. However, such estimates contain inherent uncertainties because cash payments can vary significantly depending on the timing of postretirement medical claims and the collection of the retirees’ portion of certain costs. Note that the amount of benefits paid in calendar year 2018 will not impact the expense for postretirement benefits for 2018.\nNote 4 Accumulated Other Comprehensive Loss\nComponents of and changes in accumulated other comprehensive loss at March 31, 2018 are as follows:\n| (In thousands) | Unrecognized pension and postretirement benefits | Foreign currency | Total |\n| Balance at beginning of period | $ | (11,597 | ) | $ | 704 | $ | (10,893 | ) |\n| Other comprehensive income before reclassifications | — | 421 | 421 |\n| Amounts reclassified from accumulated other comprehensive loss, net of tax of $(21) | 61 | — | 61 |\n| Net current period other comprehensive income, net of tax | 61 | 421 | 482 |\n| Accumulated other comprehensive (loss) income | $ | (11,536 | ) | $ | 1,125 | $ | (10,411 | ) |\n\n9\nTable of Contents\nDetails of reclassifications out of accumulated other comprehensive loss during the three months ended March 31, 2018 are as follows:\n| (In thousands) | Amount reclassified from accumulated other comprehensive loss |\n| Amortization of pension and postretirement benefits items: |\n| Prior service benefit (1) | $ | (6 | ) |\n| Amortization of actuarial loss (1) | 88 |\n| Total before tax | 82 |\n| Income tax benefit | (21 | ) |\n| Amount reclassified out of accumulated other comprehensive loss | $ | 61 |\n\n(1) These accumulated other comprehensive loss components are included in the computation of net periodic benefit (income) cost in Note 3 “Employee Benefit Plans.”\nComponents of and changes in accumulated other comprehensive loss at March 31, 2017 are as follows:\n| (In thousands) | Unrecognized pension and postretirement benefits | Foreign currency | Total |\n| Balance at beginning of period | $ | (10,495 | ) | $ | (1,140 | ) | $ | (11,635 | ) |\n| Other comprehensive income before reclassifications | — | 291 | 291 |\n| Amounts reclassified from accumulated other comprehensive loss, net of tax of $(46) | 83 | — | 83 |\n| Net current period other comprehensive income, net of tax | 83 | 291 | 374 |\n| Accumulated other comprehensive loss | $ | (10,412 | ) | $ | (849 | ) | $ | (11,261 | ) |\n\nDetails of reclassifications out of accumulated other comprehensive loss during the three months ended March 31, 2017 are as follows:\n| (In thousands) | Amount reclassified from accumulated other comprehensive loss |\n| Amortization of pension and postretirement benefits items: |\n| Prior service benefit (1) | $ | (6 | ) |\n| Amortization of actuarial loss (1) | 135 |\n| Total before tax | 129 |\n| Income tax benefit | (46 | ) |\n| Amount reclassified out of accumulated other comprehensive loss | $ | 83 |\n\n| (1) | These accumulated other comprehensive loss components are included in the computation of net periodic benefit (income) cost in Note 3 “Employee Benefit Plans.” |\n\nNote 5 Acquisitions\nOn November 1, 2017, the Company acquired certain assets of Utility Metering Services, Inc.'s business Carolina Meter & Supply (\"Carolina Meter\") of Wilmington, North Carolina, which was one of the Company's distributors serving North Carolina, South Carolina and Virginia.\n10\nTable of Contents\nThe total purchase consideration for the Carolina Meter assets was $6.2 million, which included $2.0 million in cash and settlement of $4.2 million of pre-existing Company receivables. The Company's preliminary allocation of the purchase price at December 31, 2017 included $0.6 million of receivables, $0.3 million of inventory, $3.3 million of intangibles and $2.0 million of goodwill. The intangible assets acquired are primarily customer relationships with an estimated average useful life of 12 years. The preliminary allocation of the purchase price to the assets acquired was based upon the estimated fair values at the date of acquisition. As of March 31, 2018, the Company had not completed its analysis for estimating the fair value of the assets acquired.\nThe Carolina Meter acquisition was accounted for under the purchase method, and accordingly, the results of operations were included in the Company's financial statements from the date of acquisition. The acquisition did not have a material impact on the Company's consolidated financial statements or the notes thereto.\nOn May 1, 2017, the Company acquired 100% of the outstanding common stock of D-Flow Technology AB (\"D-Flow\") of Luleå, Sweden. The D-Flow acquisition facilitates the continued advancement of the existing E-Series® ultrasonic product line while also adding a technology center for the Company.\nThe purchase price was approximately $23.2 million in cash, plus a small working capital adjustment. The purchase price included $5.4 million in payments that are anticipated to be made in 2018 which are recorded in payables and other current liabilities on the Consolidated Balance Sheets at March 31, 2018. The Company's preliminary allocation of the purchase price included approximately $0.3 million in receivables, $0.6 million in inventory, $0.2 million in property, plant and equipment, $10.9 million of intangibles and $16.1 million of goodwill. The majority of the intangible assets acquired related to ultrasonic technology. The Company also assumed $4.9 million of liabilities as part of the acquisition. As of March 31, 2018, the Company has completed its analysis for estimating the fair value of the assets acquired with no additional adjustments.\nThe D-Flow acquisition was accounted for under the purchase method, and accordingly, the results of operations were included in the Company's financial statements from the date of acquisition. The acquisition did not have a material impact on the Company's consolidated condensed financial statements or the notes thereto.\nNote 6 Contingencies, Litigation and Commitments\nIn the normal course of business, the Company is named in legal proceedings. There are currently no material legal proceedings pending with respect to the Company.\nThe Company is subject to contingencies related to environmental laws and regulations. A future change in circumstances with respect to specific matters or with respect to sites formerly or currently owned or operated by the Company, off-site disposal locations used by the Company, and property owned by third parties that is near such sites, could result in future costs to the Company and such amounts could be material. Expenditures for compliance with environmental control provisions and regulations during 2017 and the first quarter of 2018 were not material.\nThe Company relies on single suppliers for most brass castings and certain resin and electronic subassemblies in several of its product lines. The Company believes these items would be available from other sources, but that the loss of certain suppliers would result in a higher cost of materials, delivery delays, short-term increases in inventory and higher quality control costs in the short term. The Company attempts to mitigate these risks by working closely with key suppliers, purchasing minimal amounts from alternative suppliers and by purchasing business interruption insurance where appropriate.\nThe Company reevaluates its exposures on a periodic basis and makes adjustments to reserves as appropriate.\nNote 7 Income Taxes\nThe provision for income taxes as a percentage of earnings before income taxes for the first quarter of 2018 was 22.2% compared to 34.2% in the first quarter of 2017. Interim provisions are tied to an estimate of the overall annual rate which can vary due to state taxes and the relationship of foreign and domestic earnings. These items cause variations between periods. The decrease between years was due almost entirely to the lower Federal tax rate, which declined from 35% in 2017 to 21% in 2018 as a result of U.S. tax reform that was enacted in December 2017. For the three months ended March 31, 2018 and 2017, the Company recognized a discrete tax benefit related to the excess tax benefits from stock-based compensation of $0.3 million and $0.2 million, respectively.\nIn December 2017, the Tax Cuts and Jobs Act of 2017 (the “Act”) was signed into law making significant changes to the Internal Revenue Code. Changes include, but are not limited to, a corporate tax rate decrease from 35% to 21% effective for tax\n11\nTable of Contents\nyears beginning after December 31, 2017, the transition of U.S. international taxation from a worldwide tax system to a territorial system, and a one-time transition tax on the mandatory deemed repatriation of cumulative foreign earnings as of December 31, 2017.\nOn December 22, 2017, Staff Accounting Bulletin No. 118 (“SAB 118”) was issued to address the application of U.S. GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Act. For the three months ended March 31, 2018, the Company did not update the provisional amount of transition tax recorded as of December 31, 2017, as there was no new information that would materially impact the Company’s consolidated financial statements. The Company will continue to monitor any new guidance and update its transition tax calculation in a later quarter if necessary. Additional work is still needed for a more detailed analysis of the Company's deferred tax assets and liabilities and its historical foreign earnings, as well as potential correlative adjustments. Any subsequent adjustment to these amounts will be recorded to current tax expense in the quarter that the analysis is completed.\nThe Company is subject to numerous other provisions of the Act that were effective for tax years starting after December 31, 2017. These provisions include the Global Intangible Low-Taxed Income Tax inclusion, the deduction for Foreign-Derived Intangible Income, the business interest expense deduction limitation under Section 163(j), the executive compensation provision under Section 162(m), and the reduced deduction for certain meals and entertainment related expenses. The Company will continue to refine its computation related to these provisions as additional guidance becomes available. The net impact of these provisions is not expected to have a material impact on the Company’s consolidated financial statements.\nNote 8 Fair Value Measurements of Financial Instruments\nThe Company applies the accounting standards for fair value measurements and disclosures for its financial assets and financial liabilities. The carrying amounts of cash, receivables and payables in the financial statements approximate their fair values due to the short-term nature of these financial instruments. Short-term debt is comprised of notes payable drawn against the Company's lines of credit and commercial paper. Because of its short-term nature, the carrying amount of the short-term debt also approximates fair value. Included in other assets are insurance policies on various individuals who were associated with the Company. The carrying amounts of these insurance policies approximate their fair value.\nNote 9 Subsequent Events\nThe Company evaluates subsequent events at the date of the balance sheet as well as conditions that arise after the balance sheet date but before the financial statements are issued. The effects of conditions that existed at the balance sheet date are recognized in the financial statements. Events and conditions arising after the balance sheet date but before the financial statements are issued are evaluated to determine if disclosure is required to keep the financial statements from being misleading. To the extent such events and conditions exist, if any, disclosures are made regarding the nature of events and the estimated financial effects for those events and conditions. For purposes of preparing the accompanying consolidated condensed financial statements and the notes to these financial statements, the Company evaluated subsequent events through the date the accompanying financial statements were issued.\nOn April 2, 2018, the Company acquired 100% of the outstanding stock of Innovative Metering Solutions, Inc. (\"IMS\") of Odessa, Florida, which was one of the Company's distributors serving Florida. The purchase consideration was approximately $8.5 million. The IMS acquisition will be accounted for under the purchase method, and accordingly, the results of operations will be included in the Company's financial statements from the date of acquisition. The acquisition will not have a material impact on the Company's consolidated financial statements or the notes thereto.\n12\nTable of Contents\nNote 10 New Pronouncements\nIn February 2018, the Financial Accounting Standards Board (\"FASB\") issued Accounting Standards Update (\"ASU\") 2018-02 \"Income Statement - Reporting Comprehensive Income (Topic 220).\" Under existing U.S. generally accepted accounting principles, the effects of changes in tax rates and laws on deferred tax balances are recorded as a component of income tax expense in the period in which the law was enacted. When deferred tax balances related to items originally recorded in accumulated other comprehensive income are adjusted, certain tax effects become stranded in accumulated other comprehensive income. The amendments in ASU 2018-02 allow a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act of 2017. The amendments in this ASU also require certain disclosures about stranded tax effects. The guidance is effective for fiscal years beginning after December 15, 2018 and interim periods within those fiscal years. Early adoption in any period is permitted. The Company’s provisional adjustments recorded in 2017 to account for the impact of the Tax Cuts and Jobs Act resulted in stranded tax effects. The Company is currently evaluating the timing and impact of adopting ASU 2018-02.\nIn May 2017, the FASB issued ASU 2017-09 “Compensation - Stock Compensation (Topic 718),” which clarifies when a change to terms or conditions of a share-based payment award must be accounted for as a modification. The new guidance requires modification accounting if the vesting condition, fair value or the award classification is not the same both before and after a change to the terms and conditions of the award. The new guidance was adopted on a prospective basis on January 1, 2018. The adoption of this standard did not have an impact on the Company's consolidated financial statements.\nIn March 2017, the FASB issued ASU 2017-07 “Compensation - Retirement Benefits (Topic 715),” which changes the presentation of defined benefit and post-retirement benefit plan expense on the income statement by requiring separation between operating and non-operating expense. Under the ASU, the service cost of net periodic benefit expense is an operating expense that will be reported with similar compensation costs. The non-operating components, which include all other components of net periodic benefit expense, are reported outside of operating income. The ASU also stipulates that only the service cost component of pension and postretirement (benefits) costs is eligible for capitalization. The ASU was adopted by the Company on January 1, 2018. Application was done retrospectively for the presentation of the components of these (benefits) costs. In the Consolidated Statements of Operations, the Company previously recorded service and other (benefits) costs in operating cost and expense accounts along with compensation costs. The adoption of the standard resulted in reclassification of those (benefits) costs to the other pension and postretirement (benefits) costs line in the Consolidated Statements of Operations. Adoption of the standard reduced operating earnings for the first quarter of 2018 by $19,000 and established that amount in other pension and postretirement (benefits) costs. In the first quarter of 2017, operating earnings were increased by $0.1 million and a corresponding amount was reclassified to other pension and postretirement (benefits) costs. The specific net periodic benefit components are disclosed in Note 3 \"Employee Benefit Plans.\"\nIn January 2017, the FASB issued ASU 2017-04 \"Intangibles - Goodwill and Other (Topic 350).\" The update requires\na single-step quantitative test to measure potential impairment based on the excess of a reporting unit's carrying amount over its fair value. A qualitative assessment can still be completed first for an entity to determine if a quantitative impairment test is necessary. The ASU is effective for fiscal year 2021 and is to be adopted on a prospective basis. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017.\nIn February 2016, the FASB issued ASU 2016-02 \"Leases (Topic 842),\" which requires lessees to record most leases on their balance sheets. Lessees initially recognize a lease liability (measured at the present value of the lease payments over the lease term) and a right-of-use (\"ROU\") asset (measured at the lease liability amount, adjusted for lease prepayments, lease incentives received and the lessee's initial direct costs). Lessees can make an accounting policy election not to recognize ROU assets and lease liabilities for leases with a lease term of 12 months or less as long as the leases do not include options to purchase the underlying assets that the lessee is reasonably certain to exercise. For lessors, the guidance modifies the classification criteria and the accounting for sales-type and direct financing leases. The ASU is effective for the Company beginning on January 1, 2019 and early adoption is permitted. The standard requires the use of a modified retrospective approach for leases that exist or are entered into after the beginning of the earliest comparative period in the financial statements. Full retrospective application is prohibited. The Company is continuing to evaluate the impact that the adoption of this guidance will have on its financial condition, results of operations and the presentation of its consolidated financial statements. The Company expects that upon adoption the most significant impact will be the recognition of right of use assets and lease liabilities for operating leases on the Company's consolidated balance sheet.\nIn May 2014, the FASB issued ASU 2014-09 \"Revenue from Contracts with Customers (Topic 606).\" ASU 2014-09 provides a single principles-based, five-step model to be applied to all contracts with customers. The five steps are to identify the contract(s) with the customer, to identify the performance obligations in the contract, to determine the transaction price, to allocate the transaction price to the performance obligations in the contract and to recognize revenue when each performance obligation\n13\nTable of Contents\nis satisfied. Revenue will be recognized when promised goods or services are transferred to the customer in an amount that reflects the consideration expected in exchange for those goods or services. In addition, the standard requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. During 2016, the FASB issued additional ASU’s which enhanced the originally issued guidance. These ASU’s encompassed narrow scope improvements and practical expedients along with providing further clarifications. Effective January 1, 2018, the Company adopted ASU 2014-09 using the modified retrospective method, which resulted in an immaterial impact. For a complete discussion of the adoption of ASU 2014-09, see Note 11 \"Revenue Recognition.\"\nNote 11 Revenue Recognition\nAdoption of ASU 2014-09 \"Revenue from Contracts with Customers (Topic 606)\"\nOn January 1, 2018, the Company adopted ASU 2014-09 using the modified retrospective method applied to those contracts that were not completed or substantially complete as of January 1, 2018. Results for the reporting period beginning after January 1, 2018 are presented under Topic 606, while prior period amounts have not been adjusted and continue to be reported in accordance with the Company's historic accounting under Topic 605. The Company recorded a net reduction to opening retained earnings of $0.1 million as of January 1, 2018 as a result of the cumulative impact of adopting Topic 606. The impact to revenues as a result of applying Topic 606 for the quarter ended March 31, 2018 was a decrease of $41,000.\nContracts with Customers\nRevenue for sales of products and services is derived from contracts with customers. The products and services promised in contracts include the sale of municipal and flow instrumentation products, such as flow meters and radios, software access and other ancillary services. Contracts with each customer generally state the terms of the sale, including the description, quantity and price of each product or service. Payment terms are stated in the contract. Since the customer typically agrees to a stated rate and price in the contract that does not vary over the life of the contract, the majority of the Company's contracts do not contain variable consideration. The Company establishes a provision for estimated warranty and returns as well as certain after sale costs as discussed in Note 2 \"Additional Financial Information Disclosures.\"\nDisaggregation of Revenue\nIn accordance with Topic 606, the Company disaggregates revenue from contracts with customers into geographical regions and by the timing of when goods and services are transferred. The Company determined that disaggregating revenue into these categories meets the disclosure objective in Topic 606 which is to depict how the nature, amount, timing and uncertainty of revenue and cash flows are affected by regional economic factors.\nInformation regarding revenues disaggregated by geographic area is as follows (in millions):\n| Three Months Ended |\n| March 31, 2018 |\n| Revenues: |\n| United States | $ | 91,153 |\n| Foreign: |\n| Asia | 1,700 |\n| Canada | 3,260 |\n| Europe | 5,047 |\n| Mexico | 623 |\n| Middle East | 2,152 |\n| Other | 1,106 |\n| Total | $ | 105,041 |\n\n14\nTable of Contents\nInformation regarding revenues disaggregated by the timing of when goods and services are transferred is as follows (in millions):\n| Three Months Ended |\n| March 31, 2018 |\n| Revenue recognized over time | $ | 2,687 |\n| Revenue recognized at a point in time | 102,354 |\n| Total | $ | 105,041 |\n\nContract Balances\nThe Company performs its obligations under a contract with a customer by transferring products and/or services in exchange for consideration from the customer. The Company typically invoices its customers as soon as control of an asset is transferred and a receivable for the Company is established. The Company, however, recognizes a contract liability when a customer prepays for goods and/or services and the Company has not transferred control of the goods and/or services.\nThe opening and closing balances of the Company's contract liabilites and receivables are as follows:\n| March 31, 2018 | December 31, 2017 |\n| Receivables | $ | 63,372 | $ | 58,210 |\n| Contract liabilities | $ | 10,620 | $ | 9,670 |\n\nThe balance of contract assets was immaterial as the Company did not have a significant amount of uninvoiced receivables in the period ended March 31, 2018 and December 31, 2017.\nThe amount of revenue recognized in the period that was included in the opening contract liability balance was $0.3 million. The difference between the opening and closing balances of the Company's contract liabilities was the result of a timing difference between the Company's performance and the customers' prepayments. The increased receivables balance was due to higher sales in the first quarter of 2018 compared to the fourth quarter of 2017. Generally, receivables balances are lower at year-end than at other times of the year.\nPerformance Obligations\nA performance obligation is a promise in a contract to transfer a distinct good or service to the customer, and is the unit of measurement in Topic 606. At contract inception, the Company assesses the products and services promised in its contracts with customers. The Company then identifies performance obligations to transfer distinct products or services to the customer. In order to identify performance obligations, the Company considers all of the products or services promised in the contract regardless of whether they are explicitly stated or are implied by customary business practices.\nThe Company's performance obligations are satisfied at a point in time or over time as work progresses. Revenue from products and services transferred to customers at a single point in time accounted for 97.4% of net sales for the three-month period ended March 31, 2018. The majority of the Company's revenue recognized at a point in time is for the sale of municipal and flow instrumentation products. Revenue from these contracts is recognized when the customer is able to direct the use of and obtain substantially all of the benefits from the product which generally coincides with title transfer during the shipping process.\nRevenue from services transferred to customers over time accounted for 2.6% of net sales for the three-month period ended March 31, 2018. The majority of the Company's revenue that is recognized over time relates to the BEACON AMA software as a service.\nAs of March 31, 2018, the Company had entered into contracts where there were unsatisfied performance obligations. For contracts recorded as long-term liabilities, $8.6 million was the aggregate amount of the transaction price allocated to performance obligations that were unsatisfied or partially unsatisfied as of the end of the reporting period. The Company estimates that revenue recognized from satisfying those performance obligations will be approximately $1.4 million for the remainder of 2018 and $1.8 million in each year from 2019 through 2022.\n15\nTable of Contents\nSignificant Judgments\nThe Company records revenue for BEACON AMA services over time as the customer benefits from the data that is provided through the Company's software. Control of an asset is therefore transferred to the customer over time, and the Company will recognize revenue for Beacon AMA services as service units are used by the customer.\nRevenue is recorded for various ancillary services, such as project management and training, over time as the customer benefits from the services provided. The majority of this revenue will be recognized equally throughout the contract period as the customer receives benefits from the Company's promise to provide such services. If the service is not provided evenly over the contract period, revenue will be recognized by the associated input/output method that best measures the progress towards contract completion.\nThe Company also has contracts that include both the sale and installation of flow meters as performance obligations. In those cases, the Company records revenue for installed flow meters at the point in time when the flow meters have been accepted by the customer. The customer cannot control the use of and obtain substantially all of the benefits from the equipment until the customer has accepted the installed product. Therefore, for both the flow meter and the related installation, the Company has concluded that control is transferred to the customer upon customer acceptance of the installed flow meters. In addition, the Company has a variety of ancillary revenue streams which are minor. The types and composition of the Company's revenue streams did not materially change during the three-month period ended March 31, 2018 from year end 2017.\nCertain customers may receive cash-based incentives or credits, which are accounted for as variable consideration. Variable consideration in contracts for the three months ended March 31, 2018 was insignificant.\nTransaction Price Allocation\nThe transaction price for a contract is allocated to each distinct performance obligation and recognized as revenue when, or as, each performance obligation is satisfied. For contracts with multiple performance obligations, the Company allocates the contract's transaction price to each performance obligation using the best estimate of the standalone selling price of each distinct good or service in a contract. The primary method used to estimate standalone selling price is the observable price when the good or service is sold separately in similar circumstances and to similar customers. If standalone selling price is not directly observable, it is estimated using either a market adjustment or cost plus margin approach.\nContract Costs\nThe recording of assets recognized from the costs to obtain and fulfill customer contracts primarily relate to the deferral of sales commissions on the Company's BEACON AMA software arrangements. The Company's costs incurred to obtain or fulfill a contract with a customer are amortized over the period of benefit of the related revenue. The Company expenses any costs incurred immediately when the amortization period would be one year or less. These costs are recorded within selling, engineering and administration expenses.\nPractical Expedients\nFor the period ended March 31, 2018, the Company elected the following practical expedients:\nIn accordance with Subtopic 340-40 \"Other Assets and Deferred Costs - Contracts with Customers,\" the Company elected to expense the incremental costs of obtaining a contract when the amortization period for such contracts would have been one year or less. The Company does not disclose the value of unsatisfied performance obligations for contracts with an original expected length of one year or less and contracts for which we recognize revenue at the amount to which we have the right to invoice for services performed.\nThe Company has made an accounting policy election to exclude all taxes by governmental authorities from the measurement of the transaction price.\n16\nTable of Contents\nItem 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations\nBusiness Description and Overview\nBadger Meter is an innovator in flow measurement, control and communication solutions, serving water utilities, municipalities, and commercial and industrial customers worldwide. The Company’s products measure water, oil, chemicals and other fluids, and are known for accuracy, long-lasting durability and for providing and communicating valuable and timely measurement data. The Company’s product lines fall into two categories: sales of water meters and related technologies to municipal water utilities (municipal water) and sales of meters to various industries for water and other fluids (flow instrumentation). The Company estimates that over 85% of its products are used in water applications when both categories are grouped together.\nMunicipal water, the largest category by sales volume, includes mechanical and ultrasonic (electronic) water meters and related technologies and services used by municipal water utilities as the basis for generating water and wastewater revenues. The key market for the Company’s municipal water meter products is North America, primarily the United States, because most of the Company's meters are designed and manufactured to conform to standards promulgated by the American Water Works Association. The majority of water meters sold by the Company continue to be mechanical in nature. In recent years, the Company has made inroads in selling ultrasonic water meters. The development of smaller diameter ultrasonic water meters combined with advanced radio technology now provides the Company with the opportunity to sell into other geographical markets, for example Europe, the Middle East and South America. In the municipal water category, sales of water meters and related technologies and services are also commonly referred to as residential or commercial water meter sales, the latter referring to larger sizes of water meters.\nFlow instrumentation includes meters and valves sold worldwide to measure and control materials flowing through a pipe or pipeline including water, air, steam, oil, and other liquids and gases. These products are used in a variety of applications, primarily into the following industries: water/wastewater; heating, ventilating and air conditioning (HVAC); oil and gas; chemical and petrochemical; test and measurement; automotive aftermarket; and the concrete construction process. Furthermore, the Company’s flow instrumentation technologies are sold to original equipment manufacturers as the primary flow measurement device within a product or system.\nResidential and commercial water meters are generally classified as either manually read meters or remotely read meters via radio technology. A manually read meter consists of a water meter and a register that provides a visual totalized meter reading. Meters equipped with radio technology (endpoints) receive flow measurement data from encoder registers attached to the water meter, which is encrypted and transmitted via radio frequency to a receiver that collects and formats the data appropriately for water utility billing systems. These remotely read, or mobile, systems are either automatic meter reading (AMR) systems, where a vehicle equipped for meter reading purposes, including a radio receiver, computer and reading software, collects the data from utilities’ meters; or fixed network advanced metering infrastructure (AMI) systems, where data is gathered utilizing a network of permanent data collectors or gateway receivers that are always active or listening for the radio transmission from the utilities’ meters. AMI systems eliminate the need for utility personnel to drive through service territories to collect data from the meters. These systems provide the utilities with more frequent and diverse data from their meters at specified intervals.\nThe ORION® family of radio endpoints provides water utilities with a range of industry-leading options for meter reading. These include ORION Migratable (ME) for mobile meter reading, ORION (SE) for traditional fixed network applications, and ORION Cellular for infrastructure-free fixed network meter reading. ORION Migratable makes the migration to fixed network easier for utilities that prefer to start with mobile reading and later adopt fixed network communications, allowing utilities to choose a solution for their current needs and be positioned for their future operational changes. ORION Cellular eliminates the need for utility-owned fixed network infrastructure, allows for rapid deployment and decreases ongoing maintenance.\nCritical to the water metering ecosystem is information and analytics. The Company’s BEACON AMA Managed Solution is the latest in metering technology. BEACON AMA combines the BEACON analytical software suite with proven ORION technologies using two-way fixed and cellular networks in a managed solution, improving utilities’ visibility of their water consumption and eliminating the need for costly utility-managed infrastructure.\nThe BEACON AMA secure, cloud-hosted software suite includes a customizable dashboard, the ability to establish alerts for specific conditions, and consumer engagement tools that allow end water customers to view and manage their water usage activity. Benefits to the utility include improved customer service, increased visibility through faster leak detection, the ability to promote and quantify the effects of its water conservation efforts, and easier compliance reporting.\nThe Company’s net sales and corresponding net earnings depend on unit volume and product mix, with the Company generally earning higher margins on meters equipped with radio technology. The Company’s proprietary radio products generally\n17\nTable of Contents\nresult in higher margins than the remarketed, non-proprietary technology products. The Company also sells registers and endpoints separately to customers who wish to upgrade their existing meters in the field.\nWater meter replacement and the adoption and deployment of new technology comprise the majority of water meter product sales, including radio products. To a much lesser extent, housing starts also contribute to the new product sales base. Over the last decade, there has been a growing trend in the conversion from manually read water meters to radio technology. This conversion rate is accelerating and contributes to an increased water meter and radio solutions base of business. The Company estimates that approximately 55% to 60% of water meters installed in the United States have been converted to a radio solutions technology. The Company’s strategy is to fulfill customers’ metering expectations and requirements with its proprietary meter reading systems or other systems available through its alliance partners in the marketplace.\nFlow instrumentation products serve flow measurement and control applications across a broad industrial spectrum, occasionally leveraging the same technologies used in the municipal water category. Specialized communication protocols that control the entire flow measurement process and mandatory certifications drive these markets. The Company’s specific flow measurement and control applications and technologies serve the flow measurement market through both customized and standard flow instrumentation solutions.\nIndustries today face accelerating demands to contain costs, reduce product variability, and meet ever-changing safety, regulatory and sustainability requirements. To address these challenges, customers must reap more value from every component in their systems. This system-wide scrutiny has heightened the focus on flow instrumentation in industrial process, manufacturing, commercial fluid, building automation, and precision engineering applications where flow measurement and control are critical.\nAn industry leader in both mechanical and electrical flow metering technologies, the Company offers one of the broadest flow measurement, control and communication portfolios in the market. The portfolio carries respected brand names including Recordall®, E-Series, ORION, Hedland®, Dynasonics®, Blancett®, and Research Control®, and includes eight of the ten major flow meter technologies. Customers rely on the Company for application-specific solutions that deliver accurate, timely and dependable flow data and control essential for product quality, cost control, safer operations, regulatory compliance, and more sustainable operations.\nBusiness Trends\nIncreasingly, the electric utility industry relies on AMI technology for two-way communication to monitor and control electrical devices at the customer's site. Although the Company does not sell products for electric market applications, the trend toward AMI affects the markets in which the Company does participate, particularly for those customers in the water utility market that are interested in more frequent and diverse data collection. Specifically, AMI and AMA technologies enable water utilities to capture readings from each meter at more frequent and variable intervals. Similar to the electric utility industry’s conversion to solid-state meters in recent years, the water utility industry is beginning the conversion from mechanical to ultrasonic meters. Ultrasonic water metering has lower barriers to entry, which could affect the competitive landscape for the water meter market in North America.\nThe Company sells its technology solutions to meet customer requirements. Since the technology products have comparable margins, any change in the mix between AMR, AMI or AMA is not expected to have a significant impact on the Company's net sales related to meter reading technology.\nThere are approximately 52,000 water utilities in the United States and the Company estimates that approximately 55% to 60% of them have converted to a radio solutions technology. With the BEACON AMA managed solution and its wide breadth of water meters, the Company believes it is well positioned to meet customers' future needs.\nIn the global market, companies need to comply with increasing regulations requiring companies to better manage critical resources, monitor their use of hazardous materials, and reduce exhaust gases. Some customers measure fluids to identify leaks and/or misappropriation for cost control or add measurement points to help automate manufacturing. Other customers employ measurement to comply with government mandates and laws. The Company provides technology to measure water, hydrocarbon-based fluids, chemicals, gases and steams.\nFlow measurements are critical to provide a baseline and quantify reductions as customers attempt to reduce consumption. Once water usage is better understood, a strategy for water-use reduction can be developed with specific water-reduction initiatives targeted to those areas where water reduction is most viable. With the Company’s technology, customers have found costly leaks, pinpointed equipment in need of repair, and identified areas for process improvements.\n18\nTable of Contents\nAcquisitions\nOn November 1, 2017, the Company acquired certain assets of Utility Metering Services, Inc.'s business Carolina Meter & Supply (\"Carolina Meter\") of Wilmington, North Carolina, which was one of the Company's distributors serving North Carolina, South Carolina and Virginia.\nThe total purchase consideration for the Carolina Meter assets was $6.2 million, which included $2.0 million in cash and settlement of $4.2 million of pre-existing Company receivables. The Company's preliminary allocation of the purchase price at December 31, 2017 included $0.6 million of receivables, $0.3 million of inventory, $3.3 million of intangibles and $2.0 million of goodwill. The intangible assets acquired are primarily customer relationships with an estimated average useful life of 12 years. The preliminary allocation of the purchase price to the assets acquired was based upon the estimated fair values at the date of acquisition. As of March 31, 2018, the Company has not completed its analysis for estimating the fair value of the assets acquired. This acquisition is further described in Note 5 “Acquisitions” in the Notes to Consolidated Condensed Financial Statements.\nOn May 1, 2017, the Company acquired 100% of the outstanding common stock of D-Flow Technology AB (\"D-Flow\") of Luleå, Sweden. The D-Flow acquisition facilitates the continued advancement of the existing E-Series® ultrasonic product line while also adding a technology center for the Company.\nThe purchase price was approximately $23.2 million in cash, plus a small working capital adjustment. The purchase price included $5.4 million in payments that are anticipated to be made in 2018 which are recorded in payables and other current liabilities on the Consolidated Balance Sheets at March 31, 2018. The Company's preliminary allocation of the purchase price included approximately $0.3 million in receivables, $0.6 million in inventory, $0.2 million in machinery and equipment, $10.9 million of intangibles and $16.1 million of goodwill. The Company also assumed $4.9 million of liabilities as part of the acquisition. As of March 31, 2018, the Company has completed its analysis for estimating the fair value of the assets acquired with no additional adjustments. This acquisition is further described in Note 5 “Acquisitions” in the Notes to Consolidated Condensed Financial Statements.\nRevenue and Product Mix\nAs the industry continues to evolve, the Company has been vigilant in anticipating and exceeding customer expectations. In 2011, the Company introduced AMA as a hardware and software solution for water and gas utilities, and then in early 2014 launched its new BEACON AMA system, as a managed solution, which it believes will help maintain the Company's position as a market leader. Since its inception, sales of BEACON AMA have continued to grow with large cities and private water utilities selecting BEACON AMA and the Company’s industry-leading water meters.\nThe Company continues to seek opportunities for additional revenue enhancement. For instance, the Company is periodically asked to oversee and perform field installation of its products for certain customers. The Company assumes the role of general contractor, hiring installation subcontractors and supervising their work. The Company also supports its product and technology sales with the sale of extended service programs that provide additional services beyond the standard warranty. In recent years, the Company has sold ORION radio technology to natural gas utilities for installation on their gas meters. Most recently, the introduction of the BEACON AMA system opens the door to “software as a service” revenues. Revenues from such products and services are not yet significant and the Company is uncertain of the potential growth achievable for such products and services in future periods.\nResults of Operations - Three Months Ended March 31, 2018\nThe Company’s net sales for the three months ended March 31, 2018 increased $3.4 million, or 3.3%, to $105.0 million compared to $101.6 million during the same period in 2017.\nMunicipal water sales represented 76.7% of sales in the first quarter of 2018 compared to 77.3% in the first quarter of 2017. These sales increased $2.0 million, or 2.5%, to $80.5 million in the first quarter of 2018 from $78.5 million in the first quarter of 2017. The increase between years was the net impact of higher pricing, higher sales to the Middle East, higher service revenue due to increases in BEACON radio sales and higher sales from recently acquired companies, offset somewhat by lower volumes of domestic meters and radios sold. The company attributes the decrease in domestic volumes to timing of orders and a slower start at the beginning of the year. Weather may have played a role in the timing of orders, particularly in a number of key markets.\nFlow instrumentation products represented 23.3% of sales for the three months ended March 31, 2018 compared to 22.7% during the same period in 2017. These sales increased $1.4 million, or 6.1%, to $24.5 million from $23.1 million in the same\n19\nTable of Contents\nperiod last year. The increase was due to the continuing rebound in the oil and gas market and broadening distribution channels in industrial markets served.\nGross margin as a percentage of sales was 35.0% in the first quarter of 2018 compared to 38.0% in the first quarter of 2017. The decline was caused by the lower volumes impact on capacity utilization, higher brass costs and expenses associated with the move of the Company’s Scottsdale, Arizona operations, which closed on March 31, 2018, to the Company's Racine, Wisconsin facility. These factors were offset somewhat by higher prices on products sold.\nSelling, engineering and administration expenses for the three months ended March 31, 2018 increased $1.7 million, or 6.8%, to $26.8 from $25.1 million in the first quarter of 2017. The main reasons for the increase were additional staff associated with the 2017 acquisitions, which occurred after the first quarter of that year, and normal inflationary increases.\nOperating earnings for the first quarter of 2018 decreased $3.6 million, or 26.5%, to $10.0 million compared to $13.6 million in the same period in 2017. The decrease was the net impact of the lower gross margins and higher selling, engineering and administration expenses.\nThe provision for income taxes as a percentage of earnings before income taxes for the first quarter of 2018 was 22.2% compared to 34.2% in the first quarter of 2017. Interim provisions are tied to an estimate of the overall annual rate that can vary due to state taxes, the relationship of foreign and domestic earnings and other credits available. The decrease between years was due almost entirely to the lower Federal tax rate, which declined from 35% in 2017 to 21% in 2018.\nAs a result of the above-mentioned items, net earnings for the three months ended March 31, 2018 were $7.5 million, or $0.26 per diluted share, compared to $8.7 million, or $0.30 per diluted share, for the same period in 2017.\nLiquidity and Capital Resources\nThe main sources of liquidity for the Company are cash from operations and borrowing capacity. Cash provided by operations was $6.8 million for the first three months of 2018 compared to $12.4 million through the first three months of 2017. Last year’s amount was favorably impacted by a decrease in inventory balances which did not recur this year. These, along with lower net income, were the primary reasons for the decrease in cash provided from operations.\nReceivables increased from $58.2 million at December 31, 2017 to $63.4 million at March 31, 2018. Generally, receivable balances are lower at year-end than at other times of the year due to seasonality in the Company’s business. The Company believes its net receivables balance is fully collectible.\nInventories at March 31, 2018 were $85.1 million, only a slight change from $85.2 million at December 31, 2017. These balances fluctuate from time to time due to the level of sales and the timing of inventory purchases.\nNet property, plant and equipment at March 31, 2018 decreased slightly from $93.6 million at December 31, 2017 to $93.5 million at March 31, 2018. This was the net effect of depreciation expense, offset somewhat by $3.0 million of capital expenditures in the first three months of 2018.\nIntangible assets decreased to $57.5 million at March 31, 2018 from $59.3 million at December 31, 2017 due to normal amortization expense.\nShort-term debt at March 31, 2018 increased to $48.2 million from $44.6 million at December 31, 2017 due to the timing of cash needs.\nPayables and other current liabilities of $24.3 million at March 31, 2018 decreased from $28.6 million at December 31, 2017. These balances were impacted by the timing of purchases and payments.\nAccrued compensation and employee benefits decreased to $9.4 million at March 31, 2018 from $15.5 million at December 31, 2017 due to payments made in the first quarter of 2018 related to 2017 earned incentives, offset somewhat by provisions made for 2018 incentives earned to date.\nIncome and other taxes payable increased to $3.0 million at March 31, 2018 from $1.1 million at December 31, 2017. The change was the net impact of the lower Federal tax rate for 2018 and the timing of actual tax payments.\n20\nTable of Contents\nThe overall increase in total shareholders’ equity from $277.5 million at December 31, 2017 to $280.7 million at March 31, 2018 was the net effect of net earnings and stock options exercised, offset by dividends paid and repurchased stock.\nThe Company’s financial condition remains strong. In September 2016, the Company amended its May 2012 credit agreement with its primary lender to a three-year $125.0 million line of credit that supports commercial paper (up to $70.0 million) and includes $5.0 million of a Euro line of credit. While the facility is unsecured, there are a number of financial covenants with which the Company must comply, and the Company was in compliance as of March 31, 2018. The Company believes that its operating cash flows, available borrowing capacity, and its ability to raise capital provide adequate resources to fund ongoing operating requirements, future capital expenditures and the development of new products. The Company continues to take advantage of its local commercial paper market and carefully monitors the current borrowing market. The Company had $85.4 million of unused credit lines available at March 31, 2018.\nOther Matters\nThe Company is subject to contingencies related to environmental laws and regulations. A future change in circumstances with respect to these specific matters or with respect to sites formerly or currently owned or operated by the Company, off-site disposal locations used by the Company, and property owned by third parties that is near such sites, could result in future costs to the Company and such amounts could be material. Expenditures for compliance with environmental control provisions and regulations during 2017 and the first quarter of 2018 were not material.\nSee the “Special Note Regarding Forward Looking Statements” at the front of this Quarterly Report on Form 10-Q and Part I, Item 1A “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 for a discussion of risks and uncertainties that could impact the Company’s financial performance and results of operations.\nOff-Balance Sheet Arrangements and Contractual Obligations\nThe Company’s off-balance sheet arrangements and contractual obligations are discussed in Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the headings “Off-Balance Sheet Arrangements” and “Contractual Obligations” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 and have not materially changed since that report was filed unless otherwise indicated in this Form 10-Q.\nItem 3\nQuantitative and Qualitative Disclosures about Market Risk\nThe Company’s quantitative and qualitative disclosures about market risk are included in Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the heading “Market Risks” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 and have not materially changed since that report was filed.\nItem 4\nControls and Procedures\nEvaluation of Disclosure Controls and Procedures\nIn accordance with Rule 13a-15(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), the Company’s management evaluated, with the participation of the Company’s Chairman, President and Chief Executive Officer and the Company’s Senior Vice President - Finance, Chief Financial Officer and Treasurer, the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of the end of the quarter ended March 31, 2018. Based upon their evaluation of these disclosure controls and procedures, the Company’s Chairman, President and Chief Executive Officer and the Company’s Senior Vice President - Finance, Chief Financial Officer and Treasurer concluded that, as of the date of such evaluation, the Company’s disclosure controls and procedures were effective.\nChanges in Internal Control over Financial Reporting\nThere was no change in the Company’s internal control over financial reporting that occurred during the quarter ended March 31, 2018 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.\n21\nTable of Contents\nPart II – Other Information\nItem 6 Exhibits\nEXHIBIT INDEX\n| Exhibit No. | Description |\n| 31.1 | Certification by the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2 | Certification by the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32 | Certification of Periodic Financial Report by the Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 101 | The following materials from the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2018 formatted in Extensible Business Reporting Language (XBRL): (i) the Consolidated Condensed Balance Sheets, (ii) the Consolidated Statements of Operations, (iii) the Consolidated Statements of Comprehensive Income, (iv) the Consolidated Condensed Statements of Cash Flows, (v) Notes to Unaudited Consolidated Condensed Financial Statements, tagged as blocks of text and (vi) document and entity information. |\n\n22\nTable of Contents\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| BADGER METER, INC. |\n| Dated: April 24, 2018 | By | /s/ Richard A. Meeusen |\n| Richard A. Meeusen |\n| Chairman, President and Chief Executive Officer |\n| By | /s/ Richard E. Johnson |\n| Richard E. Johnson |\n| Senior Vice President – Finance, Chief Financial Officer and Treasurer |\n| By | /s/ Beverly L. P. Smiley |\n| Beverly L. P. Smiley |\n| Vice President – Controller |\n\n23\n</text>\n\nWhat is the estimated yearly amortization expense for the company related to the intangible assets it acquired during the purchase of Utility Metering Services, Inc.'s business Carolina Meter & Supply and 100% of the outstanding common stock of D-Flow Technology AB in million dollars, if we assume the average useful life of intangible assets to be approximated as 12 years?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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doc-math
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"ground_truth": "Therefore, the answer is 1.18."
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docmath_20000_40000
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial Statements\n| SCHOLASTIC CORPORATIONCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS - UNAUDITED(Dollar amounts in millions, except per share data) |\n\n\n| Three months ended |\n| August 31, |\n| 2022 | 2021 |\n| Revenues | $ | 262.9 | $ | 259.8 |\n| Operating costs and expenses: |\n| Cost of goods sold | 144.5 | 133.3 |\n| Selling, general and administrative expenses | 162.8 | 143.6 |\n| Depreciation and amortization | 13.7 | 14.9 |\n| Total operating costs and expenses | 321.0 | 291.8 |\n| Operating income (loss) | ( 58.1 ) | ( 32.0 ) |\n| Interest income (expense), net | 0.2 | ( 1.3 ) |\n| Other components of net periodic benefit (cost) | 0.0 | 0.0 |\n| Earnings (loss) before income taxes | ( 57.9 ) | ( 33.3 ) |\n| Provision (benefit) for income taxes | ( 12.5 ) | ( 8.9 ) |\n| Net income (loss) | ( 45.4 ) | ( 24.4 ) |\n| Less: Net income (loss) attributable to noncontrolling interest | 0.1 | ( 0.2 ) |\n| Net income (loss) attributable to Scholastic Corporation | $ | ( 45.5 ) | $ | ( 24.2 ) |\n| Basic and diluted earnings (loss) per share of Class A and Common Stock |\n| Basic | $ | ( 1.33 ) | $ | ( 0.70 ) |\n| Diluted | $ | ( 1.33 ) | $ | ( 0.70 ) |\n\nSee accompanying notes\n3\n| SCHOLASTIC CORPORATIONCONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) - UNAUDITED(Dollar amounts in millions) |\n\n\n| Three months ended |\n| August 31, |\n| 2022 | 2021 |\n| Net income (loss) | $ | ( 45.4 ) | $ | ( 24.4 ) |\n| Other comprehensive income (loss), net: |\n| Foreign currency translation adjustments | ( 9.6 ) | ( 5.8 ) |\n| Pension and postretirement adjustments (net of tax) | 0.0 | 0.1 |\n| Total other comprehensive income (loss), net | $ | ( 9.6 ) | $ | ( 5.7 ) |\n| Comprehensive income (loss) | $ | ( 55.0 ) | $ | ( 30.1 ) |\n| Less: Net income (loss) attributable to noncontrolling interest | 0.1 | ( 0.2 ) |\n| Comprehensive income (loss) attributable to Scholastic Corporation | $ | ( 55.1 ) | $ | ( 29.9 ) |\n\nSee accompanying notes\n4\n| SCHOLASTIC CORPORATIONCONDENSED CONSOLIDATED BALANCE SHEETS - UNAUDITED(Dollar amounts in millions, except per share data) |\n\n| August 31, 2022 | May 31, 2022 | August 31, 2021 |\n| (unaudited) | (audited) | (unaudited) |\n| ASSETS |\n| Current Assets: |\n| Cash and cash equivalents | $ | 239.7 | $ | 316.6 | $ | 308.6 |\n| Accounts receivable, net | 242.9 | 299.4 | 244.3 |\n| Inventories, net | 379.1 | 281.4 | 298.1 |\n| Income tax receivable | 40.4 | 26.8 | 35.4 |\n| Prepaid expenses and other current assets | 89.4 | 68.1 | 71.7 |\n| Assets held for sale | — | 3.7 | — |\n| Total current assets | 991.5 | 996.0 | 958.1 |\n| Noncurrent Assets: |\n| Property, plant and equipment, net | 512.6 | 517.0 | 550.6 |\n| Prepublication costs, net | 53.6 | 55.5 | 63.0 |\n| Operating lease right-of-use assets, net | 77.9 | 81.9 | 71.7 |\n| Royalty advances, net | 57.6 | 49.2 | 47.8 |\n| Goodwill | 124.7 | 125.3 | 125.9 |\n| Noncurrent deferred income taxes | 21.1 | 21.5 | 25.1 |\n| Other assets and deferred charges | 92.7 | 94.4 | 83.1 |\n| Total noncurrent assets | 940.2 | 944.8 | 967.2 |\n| Total assets | $ | 1,931.7 | $ | 1,940.8 | $ | 1,925.3 |\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\n| Current Liabilities: |\n| Lines of credit and current portion of long-term debt | $ | 6.3 | $ | 6.5 | $ | 89.5 |\n| Accounts payable | 208.9 | 162.3 | 185.6 |\n| Accrued royalties | 85.0 | 61.3 | 65.8 |\n| Deferred revenue | 182.6 | 172.8 | 125.5 |\n| Other accrued expenses | 162.6 | 193.3 | 168.2 |\n| Accrued income taxes | 1.7 | 2.7 | 3.2 |\n| Operating lease liabilities | 21.2 | 20.8 | 23.8 |\n| Total current liabilities | 668.3 | 619.7 | 661.6 |\n| Noncurrent Liabilities: |\n| Long-term debt | — | — | — |\n| Operating lease liabilities | 65.8 | 69.8 | 60.0 |\n| Other noncurrent liabilities | 31.3 | 32.9 | 54.1 |\n| Total noncurrent liabilities | 97.1 | 102.7 | 114.1 |\n| Commitments and Contingencies (see Note 6) | — | — | — |\n| Stockholders’ Equity: |\n| Preferred Stock, $ 1.00 par value: Authorized, 2.0 shares; Issued and Outstanding, none | $ | — | $ | — | $ | — |\n| Class A Stock, $ 0.01 par value: Authorized, 4.0 shares; Issued and Outstanding, 1.7 shares | 0.0 | 0.0 | 0.0 |\n| Common Stock, $ 0.01 par value: Authorized, 70.0 shares; Issued, 42.9 shares; Outstanding, 32.7 , 32.5 , and 32.8 shares, respectively | 0.4 | 0.4 | 0.4 |\n| Additional paid-in capital | 629.5 | 627.0 | 627.6 |\n| Accumulated other comprehensive income (loss) | ( 55.0 ) | ( 45.4 ) | ( 40.4 ) |\n| Retained earnings | 924.1 | 976.5 | 887.0 |\n| Treasury stock, at cost: 10.2 , 10.4 and 10.2 shares, respectively | ( 334.2 ) | ( 341.5 ) | ( 326.3 ) |\n| Total stockholders’ equity of Scholastic Corporation | 1,164.8 | 1,217.0 | 1,148.3 |\n| Noncontrolling interest | 1.5 | 1.4 | 1.3 |\n| Total stockholders’ equity | 1,166.3 | 1,218.4 | 1,149.6 |\n| Total liabilities and stockholders’ equity | $ | 1,931.7 | $ | 1,940.8 | $ | 1,925.3 |\n\nSee accompanying notes\n5\n| SCHOLASTIC CORPORATIONCONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY - UNAUDITED(Dollar amounts in millions, except per share data) |\n\n| Class A Stock | Common Stock | Additional Paid-in Capital | AccumulatedOther ComprehensiveIncome (Loss) | RetainedEarnings | Treasury StockAt Cost | TotalStockholders'Equity of Scholastic Corporation | Noncontrolling Interest | TotalStockholders'Equity |\n| Shares | Amount | Shares | Amount |\n| Balance at June 1, 2021 | 1.7 | $ | 0.0 | 32.7 | $ | 0.4 | $ | 626.5 | $ | ( 34.7 ) | $ | 916.4 | $ | ( 327.8 ) | $ | 1,180.8 | $ | 1.5 | $ | 1,182.3 |\n| Net Income (loss) | — | — | — | — | — | — | ( 24.2 ) | — | ( 24.2 ) | ( 0.2 ) | ( 24.4 ) |\n| Foreign currency translation adjustment | — | — | — | — | — | ( 5.8 ) | — | — | ( 5.8 ) | — | ( 5.8 ) |\n| Pension and post-retirement adjustments (net of tax of $ 0.1 ) | — | — | — | — | — | 0.1 | — | — | 0.1 | — | 0.1 |\n| Stock-based compensation | — | — | — | — | 1.5 | — | — | — | 1.5 | — | 1.5 |\n| Proceeds pursuant to stock-based compensation plans | — | — | — | — | 0.5 | — | — | — | 0.5 | — | 0.5 |\n| Treasury stock issued pursuant to equity-based plans | — | — | 0.1 | — | ( 0.9 ) | — | — | 1.5 | 0.6 | — | 0.6 |\n| Dividends ($ 0.15 per share) | — | — | — | — | — | — | ( 5.2 ) | — | ( 5.2 ) | — | ( 5.2 ) |\n| Balance at August 31, 2021 | 1.7 | $ | 0.0 | 32.8 | $ | 0.4 | $ | 627.6 | $ | ( 40.4 ) | $ | 887.0 | $ | ( 326.3 ) | $ | 1,148.3 | $ | 1.3 | $ | 1,149.6 |\n\n| Class A Stock | Common Stock | Additional Paid-in Capital | AccumulatedOther ComprehensiveIncome (Loss) | RetainedEarnings | Treasury StockAt Cost | TotalStockholders'Equity of Scholastic Corporation | Noncontrolling Interest | TotalStockholders'Equity |\n| Shares | Amount | Shares | Amount |\n| Balance at June 1, 2022 | 1.7 | $ | 0.0 | 32.5 | $ | 0.4 | $ | 627.0 | $ | ( 45.4 ) | $ | 976.5 | $ | ( 341.5 ) | $ | 1,217.0 | $ | 1.4 | $ | 1,218.4 |\n| Net Income (loss) | — | — | — | — | — | — | ( 45.5 ) | — | ( 45.5 ) | 0.1 | ( 45.4 ) |\n| Foreign currency translation adjustment | — | — | — | — | — | ( 9.6 ) | — | — | ( 9.6 ) | — | ( 9.6 ) |\n| Pension and post-retirement adjustments (net of tax of $ 0.1 ) | — | — | — | — | — | 0.0 | — | — | 0.0 | — | 0.0 |\n| Stock-based compensation | — | — | — | — | 1.7 | — | — | — | 1.7 | — | 1.7 |\n| Proceeds pursuant to stock-based compensation plans | — | — | — | — | 11.6 | — | — | — | 11.6 | — | 11.6 |\n| Purchases of treasury stock at cost | — | — | ( 0.1 ) | — | — | — | — | ( 5.1 ) | ( 5.1 ) | — | ( 5.1 ) |\n| Treasury stock issued pursuant to equity-based plans | — | — | 0.3 | — | ( 10.8 ) | — | — | 12.4 | 1.6 | — | 1.6 |\n| Dividends ($ 0.20 per share) | — | — | — | — | — | — | ( 6.9 ) | — | ( 6.9 ) | — | ( 6.9 ) |\n| Balance at August 31, 2022 | 1.7 | $ | 0.0 | 32.7 | $ | 0.4 | $ | 629.5 | $ | ( 55.0 ) | $ | 924.1 | $ | ( 334.2 ) | $ | 1,164.8 | $ | 1.5 | $ | 1,166.3 |\n\nSee accompanying notes\n6\n| SCHOLASTIC CORPORATIONCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS – UNAUDITED(Dollar amounts in millions) |\n\n\n| Three months ended |\n| August 31, | August 31, |\n| 2022 | 2021 |\n| Cash flows - operating activities: |\n| Net income (loss) attributable to Scholastic Corporation | $ | ( 45.5 ) | $ | ( 24.2 ) |\n| Adjustments to reconcile Net income (loss) to net cash provided by (used in) operating activities: |\n| Provision for losses on accounts receivable | ( 1.5 ) | 1.6 |\n| Provision for losses on inventory | 4.2 | 4.5 |\n| Provision for losses on royalty advances | 0.9 | 0.9 |\n| Amortization of prepublication costs | 6.3 | 6.8 |\n| Depreciation and amortization | 16.2 | 16.4 |\n| Amortization of pension and postretirement plans | ( 0.1 ) | ( 0.0 ) |\n| Deferred income taxes | 0.1 | 0.0 |\n| Stock-based compensation | 1.7 | 1.5 |\n| Income from equity-method investments | ( 0.1 ) | ( 1.1 ) |\n| Changes in assets and liabilities, net of amounts acquired: |\n| Accounts receivable | 54.6 | 8.1 |\n| Inventories | ( 105.9 ) | ( 35.6 ) |\n| Prepaid expenses and other current assets | ( 20.8 ) | ( 25.1 ) |\n| Income tax receivable | ( 13.7 ) | 53.4 |\n| Royalty advances | ( 9.7 ) | ( 5.2 ) |\n| Accounts payable | 48.9 | 48.9 |\n| Accrued income taxes | ( 0.9 ) | 0.3 |\n| Accrued royalties | 24.5 | 20.8 |\n| Deferred revenue | 10.4 | 26.9 |\n| Other accrued expenses | ( 28.7 ) | ( 32.5 ) |\n| Other, net | ( 1.2 ) | ( 2.8 ) |\n| Net cash provided by (used in) operating activities | ( 60.3 ) | 63.6 |\n| Cash flows - investing activities: |\n| Prepublication expenditures | ( 4.8 ) | ( 4.3 ) |\n| Additions to property, plant and equipment | ( 11.4 ) | ( 10.2 ) |\n| Net cash provided by (used in) investing activities | ( 16.2 ) | ( 14.5 ) |\n| Cash flows - financing activities: |\n| Borrowings under lines of credit, credit agreement and revolving loan | 1.2 | 0.9 |\n| Repayments of lines of credit, credit agreement and revolving loan | ( 1.3 ) | ( 101.3 ) |\n| Repayment of capital lease obligations | ( 0.6 ) | ( 0.6 ) |\n| Reacquisition of common stock | ( 4.7 ) | — |\n| Proceeds pursuant to stock-based compensation plans | 12.1 | 0.5 |\n| Payment of dividends | ( 5.1 ) | ( 5.2 ) |\n| Other | — | 0.1 |\n| Net cash provided by (used in) financing activities | 1.6 | ( 105.6 ) |\n| Effect of exchange rate changes on cash and cash equivalents | ( 2.0 ) | ( 1.4 ) |\n| Net increase (decrease) in cash and cash equivalents | ( 76.9 ) | ( 57.9 ) |\n| Cash and cash equivalents at beginning of period | 316.6 | 366.5 |\n| Cash and cash equivalents at end of period | $ | 239.7 | $ | 308.6 |\n\nSee accompanying notes\n7\n| SCHOLASTIC CORPORATIONNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – UNAUDITED(Dollar amounts in millions, except per share data) |\n\n1. BASIS OF PRESENTATION\nPrinciples of consolidation\nThe accompanying condensed consolidated interim financial statements (referred to as the “Financial Statements” herein) include the accounts of Scholastic Corporation (the “Corporation”) and all wholly-owned and majority-owned subsidiaries (collectively, “Scholastic” or the “Company”). Intercompany transactions are eliminated in consolidation.\nThe Company’s fiscal year is not a calendar year. Accordingly, references in this document to fiscal 2023 relate to the twelve-month period ending May 31, 2023.\nNoncontrolling Interest\nThe Company owns a 95.0 % majority ownership interest in Make Believe Ideas Limited (\"MBI\"), a UK-based children's book publishing company. The founder and chief executive officer of MBI retains a 5.0 % noncontrolling ownership interest in MBI. The Company fully consolidated MBI as of the acquisition date, and the 5.0 % noncontrolling interest is classified within stockholder's equity.\nInterim Financial Statements\nThe accompanying Financial Statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) and Article 10 of Regulation S-X of the U.S. Securities and Exchange Commission (“SEC”) for interim financial information, and should be read in conjunction with the Company’s Annual Report on Form 10-K for the fiscal year ended May 31, 2022. The Financial Statements presented in this Quarterly Report on Form 10-Q are unaudited; however, in the opinion of management, the Financial Statements reflect all adjustments, consisting solely of normal, recurring adjustments, necessary for the fair presentation of the Financial Statements for the periods presented.\nSeasonality\nThe Company’s Children’s Book Publishing and Distribution school-based book club and book fair channels and most of its Education Solutions businesses operate on a school-year basis; therefore, the Company’s business is highly seasonal. As a result, the Company’s revenues in the first and third quarters of the fiscal year generally are lower than its revenues in the other two fiscal quarters. Typically, school-based channels and magazine revenues are minimal in the first quarter of the fiscal year as schools are not in session. Education channel revenues are generally higher in the fourth quarter. Trade sales can vary throughout the year due to varying release dates of published titles.\nUse of estimates\nThe preparation of these Financial Statements involves the use of estimates and assumptions by management, which affects the amounts reported in the Financial Statements and accompanying notes. The Company bases its estimates on historical experience, current business factors, and various other assumptions believed to be reasonable under the circumstances, all of which are necessary, in order to form a basis for determining the carrying values of certain assets and liabilities. Actual results may differ from those estimates and assumptions. On an on-going basis, the Company evaluates the adequacy of its reserves and the estimates used in these calculations, including, but not limited to:\n•Accounts receivable allowance for credit losses\n•Pension and postretirement benefit plans\n•Uncertain tax positions\n•The timing and amount of future income taxes and related deductions\n•Inventory reserves\n•Cost of goods sold from book fair operations during interim periods based on estimated gross profit rates\n•Sales tax contingencies\n•Royalty advance reserves and royalty expense accruals\n•Impairment testing for goodwill, intangible and other long-lived assets and investments\n8\n| SCHOLASTIC CORPORATIONNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – UNAUDITED(Dollar amounts in millions, except per share data) |\n\n•Assets and liabilities acquired in business combinations\n•Variable consideration related to anticipated returns\n•Allocation of transaction price to contractual performance obligations\nNew Accounting Pronouncements\nThere were no new accounting pronouncements issued in the first quarter of fiscal 2023 which would impact the Company. Refer to the Company’s Annual Report on Form 10-K for the fiscal year ended May 31, 2022 for more information on current applicable authoritative guidance and its impact on the Company's financial statements.\n2. REVENUES\nDisaggregated Revenue Data\nThe following table presents the Company’s segment revenues disaggregated by region and domestic channel:\n| Three months ended |\n| August 31, |\n| 2022 | 2021 |\n| Book Clubs - U.S. | $ | 6.3 | $ | 6.8 |\n| Book Fairs - U.S. | 28.3 | 16.0 |\n| Trade - U.S. | 76.2 | 80.1 |\n| Trade - International(1) | 13.9 | 12.9 |\n| Total Children's Book Publishing and Distribution | $ | 124.7 | $ | 115.8 |\n| Education Solutions - U.S. | $ | 73.2 | $ | 80.1 |\n| Total Education Solutions | $ | 73.2 | $ | 80.1 |\n| International - Major Markets(2) | $ | 53.4 | $ | 47.5 |\n| International - Other Markets(3) | 11.6 | 16.4 |\n| Total International | $ | 65.0 | $ | 63.9 |\n| Total Revenues | $ | 262.9 | $ | 259.8 |\n\n(1) Primarily includes foreign rights and certain product sales in the UK.\n(2) Includes Canada, UK, Australia and New Zealand.\n(3) Primarily includes markets in Asia.\nEstimated Returns\nA liability for expected returns of $ 41.5 , $ 42.2 , and $ 44.9 is recorded within Other accrued expenses as of August 31, 2022, May 31, 2022, and August 31, 2021, respectively. In addition, a return asset of $ 7.8 , $ 5.3 , and $ 4.2 is recorded within Prepaid expenses and other current assets as of August 31, 2022, May 31, 2022, and August 31, 2021, respectively, for the recoverable cost of product estimated to be returned by customers.\n9\n| SCHOLASTIC CORPORATIONNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – UNAUDITED(Dollar amounts in millions, except per share data) |\n\nDeferred Revenue\nThe following table presents further detail regarding the Company's deferred revenue balance as of the dates indicated:\n| August 31, 2022 | May 31, 2022 | August 31, 2021 |\n| Book fairs incentive credits | $ | 84.4 | $ | 100.1 | $ | 52.4 |\n| Magazines+ subscriptions | 24.7 | 4.5 | 21.7 |\n| U.S. digital subscriptions | 23.8 | 19.5 | 21.8 |\n| U.S. education-related(1) | 16.5 | 13.6 | 10.6 |\n| Media-related | 15.6 | 15.8 | 5.6 |\n| Stored value cards | 9.3 | 9.4 | 3.9 |\n| Other(2) | 8.3 | 9.9 | 9.5 |\n| Total deferred revenue | $ | 182.6 | $ | 172.8 | $ | 125.5 |\n\n(1) Primarily includes deferred revenue related to contracts with school districts and professional services.\n(2) Primarily includes deferred revenue related to various international products and services.\nThe Company's deferred revenue consists of contract liabilities for advance billings and payments received from customers in excess of revenue recognized and revenue allocated to outstanding book fairs incentive credits. These liabilities are recorded within Deferred revenue on the Company's Condensed Consolidated Balance Sheets and are classified as short term, as substantially all of the associated performance obligations are expected to be satisfied, and related revenue recognized, within one year. The Company recognized revenue which was included in the opening Deferred revenue balance in the amount of $ 30.8 and $ 15.3 for the three months ended August 31, 2022 and August 31, 2021, respectively.\nAllowance for Credit Losses\nThe Company recognizes an allowance for credit losses on customer receivables that are expected to be incurred over the lifetime of the receivable. Reserves for estimated credit losses are established at the time of sale and are based on relevant information about past events, current conditions, and supportable forecasts impacting its ultimate collectability, including specific reserves on a customer-by-customer basis, creditworthiness of the Company’s customers and prior collection experience. The Company reviews new information as it becomes available and makes adjustments to the reserves accordingly. At the time the Company determines that a receivable balance, or any portion thereof, is deemed to be permanently uncollectible, the balance is then written off.\nThe following table presents the change in the allowance for credit losses, which is included in Accounts Receivable, net on the Condensed Consolidated Balance Sheets:\n| Allowance for Credit Losses |\n| Balance as of June 1, 2022 | $ | 25.9 |\n| Current period provision (benefit) | ( 1.5 ) |\n| Write-offs and other | ( 7.0 ) |\n| Balance as of August 31, 2022 | $ | 17.4 |\n\n3. SEGMENT INFORMATION\nThe Company categorizes its businesses into three reportable segments: Children’s Book Publishing and Distribution, Education Solutions and International.\n•Children’s Book Publishing and Distribution operates as an integrated business which includes the publication and distribution of children’s books, ebooks, media and interactive products primarily in the United States through its book clubs and book fairs in its school channels and through the trade channel. This segment is comprised of three operating segments.\n10\n| SCHOLASTIC CORPORATIONNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – UNAUDITED(Dollar amounts in millions, except per share data) |\n\n•Education Solutions includes the publication and distribution to schools and libraries of children’s books, classroom magazines, print and digital supplemental and core classroom materials and related support services, and print and online reference and non-fiction products for grades prekindergarten to 12 in the United States. This segment is comprised of one operating segment.\n•International includes the publication and distribution of products and services outside the United States by the Company’s international operations and its export businesses. This segment is comprised of three operating segments.\nThe following table sets forth the Company's revenue and operating income (loss) by segment for the fiscal quarter ended August 31, 2022:\n| Three months ended |\n| August 31, |\n| 2022 | 2021 |\n| Revenues |\n| Children's Book Publishing and Distribution | $ | 124.7 | $ | 115.8 |\n| Education Solutions | 73.2 | 80.1 |\n| International | 65.0 | 63.9 |\n| Total | $ | 262.9 | $ | 259.8 |\n| Operating income (loss) |\n| Children's Book Publishing and Distribution | $ | ( 30.1 ) | $ | ( 21.7 ) |\n| Education Solutions | ( 4.3 ) | 7.3 |\n| International | ( 3.5 ) | ( 1.7 ) |\n| Overhead (1) | ( 20.2 ) | ( 15.9 ) |\n| Total | $ | ( 58.1 ) | $ | ( 32.0 ) |\n| (1) Overhead includes all domestic corporate amounts not allocated to segments, including expenses and costs related to the management of corporate assets. |\n\n4. ASSET WRITE DOWN AND SALE\nDuring the first quarter of fiscal 2023, the Company completed the disposition of the direct sales business in Asia. The Company committed to a plan to cease operations and exit the direct sales business in Asia, including the disposition of the Malaysia legal entity, during the fourth quarter of fiscal 2022. Accordingly, the Company wrote down the related assets during fiscal 2022, which were included in the International segment and consisted of accounts receivable, inventory, other current assets and long-lived assets, to their recoverable value of $ 3.7 . The remaining assets, consisting of accounts receivable and inventory, were classified as held for sale and recorded as a current asset on the Company's Condensed Consolidated Balance Sheet as of May 31, 2022. The Company recognized a loss of $ 15.1 in fiscal 2022 which was included in Gain (Loss) on assets held for sale within the Company's Condensed Consolidated Statement of Operations. The impact of the impairment was a loss per basic and diluted share of Class A and Common Stock of $ 0.33 and $ 0.32 , respectively, in the twelve months ended May 31, 2022.\n5. DEBT\nThe following table summarizes the carrying value of the Company's debt as of the dates indicated:\n| August 31, 2022 | May 31, 2022 | August 31, 2021 |\n| US Revolving Credit Agreement | $ | — | $ | — | $ | 75.0 |\n| Unsecured lines of credit | 6.3 | 6.5 | 7.4 |\n| UK Loans | — | — | 7.1 |\n| Total debt | $ | 6.3 | $ | 6.5 | $ | 89.5 |\n| Less lines of credit, short-term debt and current portion of long-term debt | ( 6.3 ) | ( 6.5 ) | ( 89.5 ) |\n| Total long-term debt | $ | — | $ | — | $ | — |\n\nThe Company's debt obligations as of August 31, 2022 have maturities of one year or less.\nUS Credit Agreement\nOn October 27, 2021, Scholastic Corporation (the “Corporation”) and its principal operating subsidiary, Scholastic Inc., entered into an amended and restated 5-year credit agreement with a syndicate of banks and Bank of America, N.A., as administrative agent (the “Credit Agreement”). The arrangement was accounted for as a debt modification. The revised terms of the amended Credit Agreement include the following:\n•an increase in borrowing limits to $ 300.0 from $ 250.0 , as amended on December 16, 2020;\n•the elimination of the required securitization of the Company’s inventory and accounts receivable;\n•an unlimited basket for permitted payments of dividends and other distributions in respect of capital stock so long as the Corporation’s pro forma Consolidated Net Leverage Ratio, as defined, is not in excess of 2.75 :1;\n•the elimination of a minimum liquidity covenant;\n•the removal of an interest rate floor; and\n•the extension of the maturity date to October 27, 2026.\nThe Credit Agreement provides for an unsecured revolving credit facility and allows the Company to borrow, repay or prepay and reborrow at any time prior to the October 27, 2026 maturity date. Under the Credit Agreement, interest on amounts borrowed thereunder is due and payable in arrears on the last day of the interest period (defined as the period commencing on the date of the advance and ending on the last day of the period selected by the Borrower at the time each advance is made). The interest pricing under the Credit Agreement is dependent upon the Borrower’s election of a rate that is either:\n•a Base Rate equal to the higher of (i) the prime rate, (ii) the prevailing Federal Funds rate plus 0.50 % or (iii) the Eurodollar Rate plus 1.00 % plus, in each case, an applicable margin ranging from 0.35 % to 0.75 %, as determined by the Company’s prevailing Consolidated Leverage Ratio (as defined in the Credit Agreement);\n- or -\n•a Eurodollar Rate equal to the London interbank offered rate (LIBOR), plus an applicable margin ranging from 1.35 % to 1.75 %, as determined by the Company’s prevailing Consolidated Leverage Ratio.\nAs of August 31, 2022, the applicable margin on Base Rate Advances was 0.35 % and the applicable margin on Eurodollar Advances was 1.35 %, both based on the Company’s prevailing Consolidated Leverage Ratio.\nThe Credit Agreement provides for payment of a commitment fee in respect of the aggregate unused amount of revolving credit commitments ranging from 0.20 % per annum to 0.30 % per annum based upon the Corporation’s then prevailing Consolidated Leverage Ratio. As of August 31, 2022, the commitment fee rate was 0.20 %.\nA portion of the revolving credit facility, up to a maximum of $ 50.0 , is available for the issuance of letters of credit. In addition, a portion of the revolving credit facility, up to a maximum of $ 15.0 , is available for swingline loans. The Credit Agreement has an accordion feature which permits the Company, provided certain conditions are satisfied, to increase the facility by up to an additional $ 150.0 .\nAs of August 31, 2022, the Company had no outstanding borrowings under the Credit Agreement.\nThe Credit Agreement contains certain financial covenants related to leverage and interest coverage ratios (as defined in the Credit Agreement), limitations on the amount of dividends and other distributions, and other limitations on fundamental changes to the Corporation or its business. The Company was in compliance with required covenants for all periods presented.\nAt August 31, 2022, the Company had open standby letters of credit totaling $ 4.1 issued under certain credit lines, including $ 0.4 under the Credit Agreement and $ 3.7 under the domestic credit lines discussed below.\nUK Loan Agreements\nOn January 24, 2020, Scholastic Limited UK entered into a term loan facility to fund the construction of the new UK facility in Warwickshire. The term loan facility was repaid and closed on March 31, 2022. As of August 31, 2021, the Company had $ 4.3 outstanding on the loan.\nOn September 23, 2019, Scholastic Limited UK entered into a term loan agreement to borrow £ 2.0 to fund a land purchase in connection with the construction of the new UK facility in Warwickshire. The loan agreement was repaid and closed on May 12, 2022. As of August 31, 2021, the Company had $ 2.8 outstanding on the loan.\nLines of Credit\nAs of August 31, 2022, the Company’s domestic credit lines available under unsecured money market bid rate credit lines totaled $ 10.0 . There were no outstanding borrowings under these credit lines as of August 31, 2022, May 31, 2022 and August 31, 2021. As of August 31, 2022, availability under these unsecured money market bid rate credit lines totaled $ 6.3 . All loans made under these credit lines are at the sole discretion of the lender and at an interest rate and term agreed to at the time each loan is made, but not to exceed 365 days. These credit lines may be renewed, if requested by the Company, at the option of the lender.\nAs of August 31, 2022, the Company had various local currency international credit lines totaling $ 26.4 underwritten by banks primarily in the United States, Canada and the United Kingdom. Outstanding borrowings under these facilities were $ 6.3 at August 31, 2022 at a weighted average interest rate of 5.8 %, $ 6.5 at May 31, 2022 at a weighted average interest rate of 5.4 %, and $ 7.4 at August 31, 2021 at a weighted average interest rate of 4.8 %. As of August 31, 2022, the amounts available under these facilities totaled $ 20.1 . These credit lines are typically available for overdraft borrowings or loans up to 364 days and may be renewed, if requested by the Company, at the sole option of the lender.\n6. COMMITMENTS AND CONTINGENCIES\nLegal Matters\nVarious claims and lawsuits arising in the normal course of business are pending against the Company. The Company accrues a liability for such matters when it is probable that a liability has occurred and the amount of such liability can be reasonably estimated. When only a range can be estimated, the most probable amount in the range is accrued unless no amount within the range is a better estimate than any other amount, in which case the minimum amount in the range is accrued. Legal costs associated with litigation are expensed in the period in which they are incurred. The Company does not expect, in the case of those various claims and lawsuits arising in the normal course of business where a loss is considered probable or reasonably possible, that the reasonably possible losses from such claims and lawsuits (either individually or in the aggregate) would have a material adverse effect on the Company’s consolidated financial position or results of operations.\nDuring the first quarter of fiscal 2022, the Company received $ 6.6 in recoveries from its insurance programs related to an intellectual property legal settlement, which was accrued in fiscal 2021. The recoveries were recognized as an offset to the legal settlement and reflected in Selling, general and administrative expenses in the Company's Condensed Consolidated Statement of Operations for the quarter ended August 31, 2021. While the Company expects to receive additional recoveries from its insurance programs, it is premature to determine with any level of probability or accuracy the amount of those recoveries at this time.\n11\n| SCHOLASTIC CORPORATIONNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – UNAUDITED(Dollar amounts in millions, except per share data) |\n\n7. EARNINGS (LOSS) PER SHARE\nThe following table summarizes the reconciliation of the numerators and denominators for the basic and diluted earnings (loss) per share computation for the periods indicated:\n| Three months ended |\n| August 31, |\n| 2022 | 2021 |\n| Net income (loss) attributable to Class A and Common Stockholders | $ | ( 45.5 ) | $ | ( 24.2 ) |\n| Weighted average Shares of Class A Stock and Common Stock outstanding for basic earnings (loss) per share (in millions) | 34.3 | 34.4 |\n| Dilutive effect of Class A Stock and Common Stock potentially issuable pursuant to stock-based compensation plans (in millions) * | — | — |\n| Adjusted weighted average Shares of Class A Stock and Common Stock outstanding for diluted earnings (loss) per share (in millions) | 34.3 | 34.4 |\n| Earnings (loss) per share of Class A Stock and Common Stock: |\n| Basic | $ | ( 1.33 ) | $ | ( 0.70 ) |\n| Diluted | $ | ( 1.33 ) | $ | ( 0.70 ) |\n\n* The Company experienced a net loss for all periods presented and therefore did not report any dilutive share impact.\nThe Company experienced a loss for the three month periods ended August 31, 2022 and August 31, 2021 and therefore did not allocate any loss to certain participating restricted stock units.\nThe following table sets forth options outstanding pursuant to stock-based compensation plans as of the dates indicated:\n| August 31, 2022 | August 31, 2021 |\n| Options outstanding pursuant to stock-based compensation plans (in millions) | 3.3 | 4.9 |\n\nThere are no potentially anti-dilutive shares pursuant to stock-based compensation plans as of August 31, 2022.\nA portion of the Company’s Restricted Stock Units (\"RSUs\"), which are granted to employees, participate in earnings through cumulative dividends. These dividends are payable and non-forfeitable to the employees upon vesting of the RSUs. Accordingly, the Company measures earnings per share based upon the lower of the Two-class method or the Treasury Stock method.\nAs of August 31, 2022, $ 28.8 remained available for future purchases of common shares under the repurchase authorization of the Board of Directors (the \"Board\") in effect on that date. See Note 12, Treasury Stock, for a more complete description of the Company’s share buy-back program.\n8. GOODWILL AND OTHER INTANGIBLES\nThe Company assesses goodwill and other intangible assets with indefinite lives for impairment annually or more frequently if indicators arise. The Company monitors impairment indicators in light of changes in market conditions, near and long-term demand for the Company’s products and other relevant factors.\n12\n| SCHOLASTIC CORPORATIONNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – UNAUDITED(Dollar amounts in millions, except per share data) |\n\nThe following table summarizes the activity in Goodwill for the periods indicated:\n| August 31, 2022 | May 31, 2022 | August 31, 2021 |\n| Gross beginning balance | $ | 164.9 | $ | 165.9 | $ | 165.9 |\n| Accumulated impairment | ( 39.6 ) | ( 39.6 ) | ( 39.6 ) |\n| Beginning balance | $ | 125.3 | $ | 126.3 | $ | 126.3 |\n| Foreign currency translation | ( 0.6 ) | ( 1.0 ) | ( 0.4 ) |\n| Ending balance | $ | 124.7 | $ | 125.3 | $ | 125.9 |\n\nThere were no impairment charges related to Goodwill in any of the periods presented.\nThe following table summarizes the activity in other intangibles included in Other assets and deferred charges on the Company’s Financial Statements for the periods indicated:\n| August 31, 2022 | May 31, 2022 | August 31, 2021 |\n| Beginning balance - Other intangibles subject to amortization | $ | 6.0 | $ | 8.4 | $ | 8.4 |\n| Amortization expense | ( 0.5 ) | ( 2.0 ) | ( 0.5 ) |\n| Foreign currency translation | ( 0.2 ) | ( 0.4 ) | ( 0.1 ) |\n| Total other intangibles subject to amortization, net of accumulated amortization of $ 34.8 , $ 34.3 and $ 32.8 , respectively | $ | 5.3 | $ | 6.0 | $ | 7.8 |\n| Total other intangibles not subject to amortization | $ | 2.1 | $ | 2.1 | $ | 2.1 |\n| Total other intangibles | $ | 7.4 | $ | 8.1 | $ | 9.9 |\n\nThere were no additions to intangible assets within the three months ended August 31, 2022 and August 31, 2021.\nIntangible assets with indefinite lives consist principally of trademark and tradename rights. Intangible assets with definite lives consist principally of customer lists, intellectual property, tradenames and other agreements. Intangible assets with definite lives are amortized over their estimated useful lives. The weighted-average remaining useful lives of all amortizable intangible assets is approximately 4.2 years.\nThere were no impairment charges related to Intangible assets in any of the periods presented.\n9. INVESTMENTS\nInvestments are included in Other assets and deferred charges on the Condensed Consolidated Balance Sheets. The following table summarizes the Company’s investments as of the dates indicated:\n| August 31, 2022 | May 31, 2022 | August 31, 2021 | Segment |\n| Equity method investments | $ | 28.7 | $ | 31.0 | $ | 34.4 | International |\n| Other equity investments | 6.0 | 6.0 | 6.0 | Children's Book Publishing & Distribution |\n| Total Investments | $ | 34.7 | $ | 37.0 | $ | 40.4 |\n\nThe Company’s 26.2 % equity interest in a children’s book publishing business located in the UK is accounted for using the equity method of accounting. Equity method income from this investment is reported in the International segment.\nThe Company has a 4.6 % ownership interest in a financing and production company that makes film, television, and digital programming designed for the youth market. This equity investment does not have a readily determinable fair value and the Company has elected to apply the measurement alternative and report this investment at cost, less impairment on the Company's Condensed Consolidated Balance Sheets. There have been no impairments or adjustments to the carrying value of this investment.\n13\n| SCHOLASTIC CORPORATIONNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – UNAUDITED(Dollar amounts in millions, except per share data) |\n\nIncome from equity investments is reported in Selling, general and administrative expenses in the Condensed Consolidated Statements of Operations and totaled $ 0.1 and $ 1.1 for the three months ended August 31, 2022 and August 31, 2021, respectively .\n10. EMPLOYEE BENEFIT PLANS\nThe following table sets forth the components of net periodic benefit cost for the periods indicated under the Company’s defined benefit pension plan of Scholastic Ltd., an indirect subsidiary of Scholastic Corporation located in the United Kingdom (the “UK Pension Plan”), and the postretirement benefits plan, consisting of certain healthcare and life insurance benefits provided by the Company to its eligible retired United States-based employees (the “US Postretirement Benefits”), for the periods indicated:\n| UK Pension Plan | US Postretirement Benefits |\n| Three months ended | Three months ended |\n| August 31, | August 31, |\n| 2022 | 2021 | 2022 | 2021 |\n| Components of net periodic benefit cost: |\n| Interest cost | $ | 0.3 | $ | 0.2 | $ | 0.1 | $ | 0.1 |\n| Expected return on assets | ( 0.3 ) | ( 0.3 ) | — | — |\n| Amortization of prior service (credit) loss | 0.0 | 0.0 | ( 0.2 ) | ( 0.2 ) |\n| Amortization of net actuarial (gain) loss | 0.1 | 0.2 | — | 0.0 |\n| Total | $ | 0.1 | $ | 0.1 | $ | ( 0.1 ) | $ | ( 0.1 ) |\n\nActuarial gains and losses are amortized using a corridor approach. The gain or loss corridor is equal to 10% of the greater of the projected benefit obligation and the market-related value of assets. Gains and losses in excess of the corridor are amortized over the future working lifetime.\nThe Company’s funding practice with respect to the UK Pension Plan is to contribute on an annual basis at least the minimum amounts required by applicable law. For the three months ended August 31, 2022, the Company contributed $ 0.3 to the UK Pension Plan. The Company expects, based on actuarial calculations, to contribute cash of approximately $ 1.1 to the UK Pension Plan for the fiscal year ending May 31, 2023.\n11. STOCK-BASED COMPENSATION\nThe following table summarizes stock-based compensation expense included in Selling, general and administrative expenses for the periods indicated:\n| Three months ended |\n| August 31, |\n| 2022 | 2021 |\n| Stock option expense | $ | 0.6 | $ | 0.7 |\n| Restricted stock unit expense | 1.0 | 0.7 |\n| Management stock purchase plan | 0.0 | 0.0 |\n| Employee stock purchase plan | 0.1 | 0.1 |\n| Total stock-based compensation expense | $ | 1.7 | $ | 1.5 |\n\nThe following table sets forth Common Stock issued pursuant to stock-based compensation plans for the periods indicated:\n| Three months ended |\n| August 31, |\n| 2022 | 2021 |\n| Common Stock issued pursuant to stock-based compensation plans (in millions) | 0.3 | 0.1 |\n\n14\n| SCHOLASTIC CORPORATIONNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – UNAUDITED(Dollar amounts in millions, except per share data) |\n\n12. TREASURY STOCK\nThe Board has authorized the Company to repurchase Common Stock, from time to time as conditions allow, on the open market or through privately negotiated transactions.\nThe table below represents the Board authorization at the dates indicated:\n| Authorization | Amount |\n| March 2020 | 50.0 |\n| Total current Board authorization at June 1, 2022 | $ | 50.0 |\n| Less repurchases made under this authorization | $ | ( 21.2 ) |\n| Remaining Board authorization at August 31, 2022 | $ | 28.8 |\n\nRemaining Board authorization at August 31, 2022 represents the amount remaining under the current $ 50.0 Board authorization for Common share repurchases announced on March 18, 2020, which is available for further repurchases, from time to time as conditions allow, on the open market or through privately negotiated transactions.\nRepurchases of the Company's Common Stock were $ 5.1 during the three months ended August 31, 2022. The Company's repurchase program may be suspended at any time without prior notice.\n13. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)\n| Three months ended August 31, 2022 |\n| Foreign currency translation adjustments | Retirement benefit plans | Total |\n| Beginning balance at June 1, 2022 | $ | ( 44.6 ) | $ | ( 0.8 ) | $ | ( 45.4 ) |\n| Other comprehensive income (loss) before reclassifications | ( 9.6 ) | — | ( 9.6 ) |\n| Less amount reclassified from Accumulated other comprehensive income (loss): |\n| Amortization of net actuarial loss (net of tax of $ 0.0 ) | — | 0.1 | 0.1 |\n| Amortization of prior service (credit) cost (net of tax of $ 0.1 ) | — | ( 0.1 ) | ( 0.1 ) |\n| Other comprehensive income (loss) | ( 9.6 ) | 0.0 | ( 9.6 ) |\n| Ending balance at August 31, 2022 | $ | ( 54.2 ) | $ | ( 0.8 ) | $ | ( 55.0 ) |\n| Three months ended August 31, 2021 |\n| Foreign currency translation adjustments | Retirement benefit plans | Total |\n| Beginning balance at June 1, 2021 | $ | ( 30.1 ) | $ | ( 4.6 ) | $ | ( 34.7 ) |\n| Other comprehensive income (loss) before reclassifications | ( 5.8 ) | — | ( 5.8 ) |\n| Less amount reclassified from Accumulated other comprehensive income (loss): |\n| Amortization of net actuarial loss (net of tax of $ 0.0 ) | — | 0.2 | 0.2 |\n| Amortization of prior service (credit) cost (net of tax of $ 0.1 ) | — | ( 0.1 ) | ( 0.1 ) |\n| Other comprehensive income (loss) | ( 5.8 ) | 0.1 | ( 5.7 ) |\n| Ending balance at August 31, 2021 | $ | ( 35.9 ) | $ | ( 4.5 ) | $ | ( 40.4 ) |\n\n15\n| SCHOLASTIC CORPORATIONNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – UNAUDITED(Dollar amounts in millions, except per share data) |\n\nThe following table presents the impact on earnings of reclassifications out of Accumulated other comprehensive income (loss) for the periods indicated:\n| Three months ended | Condensed Consolidated Statements of Operations line item |\n| August 31, | August 31, |\n| 2022 | 2021 |\n| Employee benefit plans: |\n| Amortization of net actuarial loss | $ | 0.1 | $ | 0.2 | Other components of net periodic benefit (cost) |\n| Amortization of prior service (credit) loss | ( 0.2 ) | ( 0.2 ) | Other components of net periodic benefit (cost) |\n| Less: Tax effect | 0.1 | 0.1 | Provision (benefit) for income taxes |\n| Total cost, net of tax | $ | 0.0 | $ | 0.1 |\n\n14. FAIR VALUE MEASUREMENTS\nThe Company determines the appropriate level in the fair value hierarchy for each fair value measurement of assets and liabilities carried at fair value on a recurring basis in the Company’s financial statements. The fair value hierarchy prioritizes the inputs, which refer to assumptions that market participants would use in pricing an asset or liability, based upon the highest and best use, into three levels as follows:\n•Level 1 Unadjusted quoted prices in active markets for identical assets or liabilities at the measurement date.\n•Level 2 Observable inputs other than quoted prices included in Level 1, including quoted prices for similar assets or liabilities in active markets, quoted prices for identical assets or liabilities in inactive markets, inputs other than quoted prices that are observable for the asset or liability and inputs derived principally from or corroborated by observable market data.\n•Level 3 Unobservable inputs in which there is little or no market data available, which are significant to the fair value measurement and require the Company to develop its own assumptions.\nThe Company’s financial assets and liabilities measured at fair value consisted of cash and cash equivalents, debt and foreign currency forward contracts. Cash and cash equivalents are comprised of bank deposits and short-term investments, such as money market funds, the fair value of which is based on quoted market prices, a Level 1 fair value measure. The Company employs Level 2 fair value measurements for the disclosure of the fair value of its various lines of credit and long term debt. The fair value of the Company's debt approximates the carrying value for all periods presented. The fair values of foreign currency forward contracts, used by the Company to manage the impact of foreign exchange rate changes, are based on quotations from financial institutions, a Level 2 fair value measure.\nNon-financial assets for which the Company employs fair value measures on a non-recurring basis include:\n•Long-lived assets, including held for sale\n•Operating lease right-of-use (ROU) assets\n•Investments\n•Assets acquired in a business combination\n•Impairment assessment of goodwill and intangible assets\nLevel 2 and Level 3 inputs are employed by the Company in the fair value measurement of these assets. For the fair value measurements employed by the Company for certain property, plant and equipment, investments and prepublication assets, the Company assessed future expected cash flows attributable to these assets. See Note 9, Investments, for a more complete description of the fair value measurements employed.\n16\n| SCHOLASTIC CORPORATIONNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – UNAUDITED(Dollar amounts in millions, except per share data) |\n\n15. INCOME TAXES AND OTHER TAXES\nTax Legislation Updates\nIn response to the COVID-19 pandemic, the U.S. government enacted the Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”). The Company applied the provisions in the CARES Act related to the carry back of net operating losses and the Employee Retention Credit. In fiscal 2021, the Company applied for employee retention credits in the U.S. and the related receivable was $ 12.1 as of August 31, 2022. During the first quarter of fiscal 2022, the Company received a federal tax refund of $ 63.1 primarily related to the carry back of net operating losses generated in the U.S.\nIncome Taxes\nIn calculating the provision for income taxes on an interim basis, the Company uses an estimate of the annual effective tax rate based upon currently known facts and circumstances and applies that rate to its year-to-date earnings or losses. The Company’s effective tax rate is based on expected income and statutory tax rates and takes into consideration permanent differences between financial statement and tax return income applicable to the Company in the various jurisdictions in which the Company operates. The effect of discrete items, such as changes in estimates, changes in rates or tax status, and unusual or infrequently occurring events, is recognized in the interim period in which the discrete item occurs. The accounting estimates used to compute the provision for income taxes may change as new events occur, additional information is obtained or as the result of new judicial interpretations or regulatory or tax law changes.\nThe Company's interim effective tax rate, inclusive of discrete items, for the three months ended August 31, 2022 was 21.6 % compared to 26.7 % for the prior fiscal year period. The decrease in the interim effective tax rate for the three months ended August 31, 2022 was primarily due to tax shortfalls related to vested option cancellations in the current fiscal year quarter.\nThe Company, including its domestic subsidiaries, files a consolidated U.S. income tax return, and also files tax returns in various states and other local jurisdictions. Also, certain subsidiaries of the Company file income tax returns in foreign jurisdictions. The Company is routinely audited by various tax authorities. The IRS is substantially complete with the examination of the U.S. income tax returns for the fiscal 2015 through fiscal 2020 tax years. The examination is expected to be finalized in the third quarter of fiscal 2023 and the Company does not expect any additional impact to the financial results. As of August 31, 2022, there was approximately $ 20.0 in receivables from the IRS related to the years under audit included in Income tax receivable in the Company’s Condensed Consolidated Balance Sheet for that period.\nNon-income Taxes\nThe Company is subject to tax examinations for sales-based taxes. A number of these examinations are ongoing and, in certain cases, have resulted in assessments from taxing authorities. The Company assesses sales tax contingencies for each jurisdiction in which it operates, considering all relevant facts including statutes, regulations, case law and experience. Where a sales tax liability with respect to a jurisdiction is probable and can be reliably estimated for such jurisdiction, the Company has made accruals for these matters which are reflected in the Company’s Condensed Consolidated Financial Statements. These amounts are included in the Financial Statements in Selling, general and administrative expenses. Future developments relating to the foregoing could result in adjustments being made to these accruals.\n16. DERIVATIVES AND HEDGING\nThe Company enters into foreign currency derivative contracts to economically hedge the exposure to foreign currency fluctuations associated with the forecasted purchase of inventory, the foreign exchange risk associated with certain receivables denominated in foreign currencies and certain future commitments for foreign expenditures. These derivative contracts are economic hedges and are not designated as cash flow hedges.\nThe Company marks-to-market these instruments and records the changes in the fair value of these items in Selling, general and administrative expenses and recognizes the unrealized gain or loss in Other current assets or Other current liabilities. The notional values of the contracts as of August 31, 2022 and August 31, 2021 were\n17\n| SCHOLASTIC CORPORATIONNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – UNAUDITED(Dollar amounts in millions, except per share data) |\n\n$ 21.3 and $ 26.8 , respectively. A net unrealized gain of $ 0.6 and a net unrealized loss of less than $ 0.1 were recognized for the three months ended August 31, 2022 and August 31, 2021, respectively.\n17. OTHER ACCRUED EXPENSES\nOther accrued expenses consisted of the following as of the dates indicated:\n| August 31, 2022 | May 31, 2022 | August 31, 2021 |\n| Accrued payroll, payroll taxes and benefits | $ | 36.8 | $ | 32.2 | $ | 35.1 |\n| Accrued bonus and commissions | 12.2 | 44.2 | 12.1 |\n| Returns liability | 41.5 | 42.2 | 44.9 |\n| Accrued other taxes | 21.1 | 26.8 | 25.3 |\n| Accrued advertising and promotions | 9.9 | 10.3 | 13.5 |\n| Other accrued expenses | 41.1 | 37.6 | 37.3 |\n| Total accrued expenses | $ | 162.6 | $ | 193.3 | $ | 168.2 |\n\n18. SUBSEQUENT EVENTS\nOn September 1, 2022, the Company acquired 100 % of the share capital of Learning Ovations Inc., a U.S.-based education technology business and developer of a literacy assessment and instructional system, for a base purchase price of $ 11.0 , subject to purchase price adjustments. The results of operations of this business subsequent to the acquisition will be included in the Education Solutions segment.\nThe Board declared a quarterly cash dividend of $ 0.20 per share on the Company’s Class A and Common Stock for the second quarter of fiscal 2023. The dividend is payable on December 15, 2022 to shareholders of record as of the close of business on October 31, 2022.\n18\n| SCHOLASTIC CORPORATION |\n\nOverview and Outlook\nRevenues for the first quarter ended August 31, 2022 were $262.9 million, compared to $259.8 million in the prior fiscal year quarter, an increase of $3.1 million. The Company reported net loss per diluted share of Class A and Common Stock of $1.33 in the first quarter of fiscal 2023, compared to a net loss of $0.70 in the prior fiscal year quarter.\nThe Children's Book Publishing and Distribution segment drove a majority of the revenue increase in the first quarter with increased book fairs redemptions of incentive program credits. Although the trade channel experienced lower frontlist sales, backlist titles from the Company's popular series continued to drive sales and the trade channel benefited from revenue associated with the production of the animated series \"Eva the Owlet,\"TM based on the Owl DiariesTM books, which will be released on AppleTV+® later this fiscal year. Within the Education Solutions segment, the New Worlds Reading Initiative shipped over 800,000 books to students in the program during June and July as the first year of the program concluded. As expected, segment revenues decreased due to the timing of sales of instructional products and programs in the first quarter. In the International segment, Australia and Canada drove increased revenues from their respective book fairs and trade channels, while the Asia markets had lower sales, primarily due to the disposition of the direct sales business.\nOperating loss was $58.1 million for the quarter ended August 31, 2022, which was consistent with the Company's expectations and seasonality of the business. The increase over the prior year period was due to increased product costs, which were impacted by higher freight and printing costs due to the continued inflationary pressures, coupled with the timing of revenues in the Education Solutions segment.\nThe Company is expecting increased sales from the Children’s Book Publishing and Distribution segment, with book fairs anticipated to reach its goal of 85% of pre-pandemic fair count levels and the trade channel expected to benefit from multiple new releases from bestselling authors, including the fourth Cat Kid Comic Club® in Dav Pilkey’s latest series. The Education Solutions segment will focus on the integration of the Learning OvationsTM acquisition and continue to assess capital allocations to enhance literacy offerings. Due to the seasonality of the education selling cycle, any benefits from state and federal funding for literacy initiatives would occur toward the end of the fiscal year, primarily in the fourth fiscal quarter. Internationally, the Company expects to benefit from the recovery in Canada, Australia and New Zealand, while the UK continues to be negatively impacted by inflationary pressures. Operating income is expected to improve from higher revenues in Australia and the disposition of the low margin direct sales business in Asia which generated losses in the prior fiscal year. Margin improvement is expected to be partially offset by the lack of government subsidies in certain markets, the slow recovery in Asia and the impact of foreign currency translation due to the strong U.S. dollar. The Company continues to monitor and control discretionary spending which is expected to favorably impact unallocated overhead costs except to the extent offset by headwinds from inflationary pressures, primarily higher freight costs that are still expected to impact the cost of product.\nResults of Operations\nConsolidated\nRevenues for the quarter ended August 31, 2022 increased by $3.1 million to $262.9 million, compared to $259.8 million in the prior fiscal year quarter. The Children's Book Publishing and Distribution segment revenues increased by $8.9 million, primarily driven by higher book fairs channel revenues resulting from increased redemptions of book fair incentive program credits, partially offset by lower trade channel revenues. In the Education Solutions segment, revenues decreased by $6.9 million, primarily driven by lower sales of instructional products and programs due to the timing of shipments as compared to the prior fiscal year quarter, as well as lower professional learning services and sales of teaching resources products, partially offset by revenues from the New Worlds Reading Initiative. In local currency, the International segment revenues increased by $5.8 million, primarily driven by increased sales in the book fairs and trade channels within the Australia and Canada markets, partially offset by decreased revenues as a result of the disposition of the direct sales business in Asia. International segment revenues were impacted by unfavorable foreign exchange of $4.7 million in the quarter ended August 31, 2022.\n19\n| SCHOLASTIC CORPORATION Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) |\n\nComponents of Cost of goods sold for the three months ended August 31, 2022 and August 31, 2021 are as follows:\n| Three months ended |\n| August 31, | August 31, |\n| 2022 | 2021 |\n| ($ amounts in millions) | $ | % of Revenue | $ | % of Revenue |\n| Product, service and production costs and inventory reserves | $ | 82.4 | 31.4 | % | $ | 76.3 | 29.4 | % |\n| Royalty costs | 27.4 | 10.4 | % | 27.8 | 10.7 | % |\n| Prepublication amortization | 6.4 | 2.4 | % | 6.9 | 2.7 | % |\n| Postage, freight, shipping, fulfillment and other | 28.3 | 10.8 | % | 22.3 | 8.5 | % |\n| Total | $ | 144.5 | 55.0 | % | $ | 133.3 | 51.3 | % |\n\nCost of goods sold for the quarter ended August 31, 2022 was $144.5 million, or 55.0% of revenues, compared to $133.3 million, or 51.3% of revenues, in the prior fiscal year quarter. Cost of goods sold was impacted by higher inbound freight and printing costs resulting in an increase in product costs, as well as higher postage, freight and shipping costs. These cost increases were due to continued inflationary pressures, which are expected to continue to negatively impact costs during the remainder of fiscal 2023.\nSelling, general and administrative expenses for the quarter ended August 31, 2022 increased to $162.8 million, compared to $143.6 million in the prior fiscal year quarter. The $19.2 million increase was primarily attributable to increased strategic spending and higher labor costs, primarily in the book fairs channel as the Company prepares for the anticipated increase in fair count, in addition to the discontinuation of government subsidies related to the COVID-related governmental retention program in Canada. The increase was also driven by the $6.6 million of insurance recoveries received in the quarter ended August 31, 2021 related to the intellectual property legal settlement accrued in fiscal 2021 that did not reoccur in the current quarter, higher marketing costs associated with the New Worlds Reading Initiative and lower equity investment income. Partially offsetting this increase, the Company incurred lower severance expense from its restructuring programs of $2.4 million.\nDepreciation and amortization expenses in the three months ended August 31, 2022 were $13.7 million compared to $14.9 million in the prior fiscal year quarter. The $1.2 million decrease was primarily attributable to a shift towards spending on cloud computing arrangements in which the amortization expense is included in Selling, general and administrative expenses rather than Depreciation and amortization. Amortization related to cloud computing arrangements increased $1.0 million when compared to the prior fiscal year quarter which substantially offset the decrease in Depreciation and amortization as there were no significant assets placed into service during the first quarter of fiscal 2023. Management expects this trend to continue as more cloud-based software tools are utilized by the Company.\nNet interest income in the quarter ended August 31, 2022 was $0.2 million compared to net interest expense of $1.3 million in the prior fiscal year quarter. The Company had lower average debt borrowings as compared to the prior fiscal year quarter as the outstanding borrowings on the U.S credit agreement were paid down during fiscal 2022, resulting in no outstanding borrowings as of August 31, 2022.\nThe Company’s effective tax rate for the quarter ended August 31, 2022 was 21.6%, compared to 26.7% in the prior fiscal year quarter. The decrease in the interim effective tax rate was primarily due to tax shortfalls related to vested option cancellations in the fiscal year quarter ended August 31, 2022.\nNet loss attributable to Scholastic Corporation for the quarter ended August 31, 2022 increased by $21.3 million to $45.5 million, compared to $24.2 million in the prior fiscal year quarter. Loss per basic and diluted share of Class A and Common Stock was $1.33 and $1.33, respectively, for the fiscal quarter ended August 31, 2022, compared to loss per basic and diluted share of Class A and Common Stock of $0.70 and $0.70, respectively, in the prior fiscal year quarter.\nNet income attributable to noncontrolling interest for the quarter ended August 31, 2022 was $0.1 million compared to Net loss attributable to noncontrolling interest of $0.2 million in the prior fiscal year quarter.\n20\n| SCHOLASTIC CORPORATIONItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) |\n\nChildren’s Book Publishing and Distribution\n| Three months ended |\n| August 31, | August 31, | $ | % |\n| ($ amounts in millions) | 2022 | 2021 | Change | Change |\n| Revenues | $ | 124.7 | $ | 115.8 | $ | 8.9 | 7.7 | % |\n| Cost of goods sold | 77.1 | 66.1 | 11.0 | 16.6 | % |\n| Other operating expenses (1) | 77.7 | 71.4 | 6.3 | 8.8 | % |\n| Operating income (loss) | $ | (30.1) | $ | (21.7) | $ | (8.4) | (38.7) | % |\n| Operating margin | — | % | — | % |\n\n(1) Other operating expenses include selling, general and administrative expenses, bad debt expenses and depreciation and amortization.\nRevenues for the quarter ended August 31, 2022 increased by $8.9 million to $124.7 million, compared to $115.8 million in the prior fiscal year quarter. The increase in segment revenues was primarily driven by higher book fairs channel revenues of $12.3 million resulting from increased redemptions of book fair incentive program credits, which are common in the summer months, but were not significant in the prior fiscal year quarter as the book fair business had not yet begun to recover from the pandemic-related shutdowns. Decreased trade channel sales of $2.9 million partially offset book fairs revenues on lower sales of frontlist titles, due in part to the prior fiscal year quarter release of the limited edition foil covers for Dog Man®, which did not repeat in the current quarter. The trade channel benefited from increased sales of backlist titles, with continued strong sales from the Company's popular series, including Five Nights at Freddy'sTM, The Baby-sitters Club® GraphixTM, HeartstopperTM, Wings of FireTM, The Bad GuysTM, Cat Kid Comic Club® and I Survived. The trade channel also benefited from an increase in media revenue as the Company delivered certain episodes associated with the production of the animated series \"Eva the Owlet,\"TM based on the Owl DiariesTM books, which will be released on AppleTV+® later this fiscal year. Book clubs channel revenues remained relatively consistent with the prior fiscal year quarter, decreasing $0.5 million, as this channel is seasonally quiet during the summer months.\nCost of goods sold for the quarter ended August 31, 2022 was $77.1 million, or 61.8% of revenues, compared to $66.1 million, or 57.1% of revenues, in the prior fiscal year quarter. The increase in Cost of goods sold as a percentage of revenue was primarily driven by increased product and freight costs due to continued inflationary pressures, predominantly in the trade channel.\nOther operating expenses for the quarter ended August 31, 2022 increased to $77.7 million, compared to $71.4 million in the prior fiscal year quarter. The $6.3 million increase was primarily attributable to higher labor costs, largely in the book fairs channel as the Company prepares for the anticipated increase in fair count during fiscal 2023. Labor costs were also impacted by inflationary pressures.\nSegment operating loss for the quarter ended August 31, 2022 was $30.1 million, compared to $21.7 million in the prior fiscal year quarter. The $8.4 million increase in the operating loss was primarily driven by increased cost of goods sold and selling, general, and administrative costs, both due to inflationary pressures on freight and labor costs.\nEducation Solutions\n| Three months ended |\n| August 31, | August 31, | $ | % |\n| ($ amounts in millions) | 2022 | 2021 | Change | Change |\n| Revenues | $ | 73.2 | $ | 80.1 | $ | (6.9) | (8.6) | % |\n| Cost of goods sold | 30.4 | 32.8 | (2.4) | (7.3) | % |\n| Other operating expenses (1) | 47.1 | 40.0 | 7.1 | 17.8 | % |\n| Operating income (loss) | $ | (4.3) | $ | 7.3 | $ | (11.6) | NM |\n| Operating margin | — | % | 9.1 | % |\n\n(1) Other operating expenses include selling, general and administrative expenses, bad debt expenses and depreciation and amortization.\nNM Not meaningful\nRevenues for the quarter ended August 31, 2022 decreased by $6.9 million to $73.2 million, compared to $80.1 million in the prior fiscal year quarter. The decrease in segment revenues was largely driven by lower sales of instructional products and programs, primarily early childhood programs and summer learning product\n21\n| SCHOLASTIC CORPORATIONItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) |\n\nofferings, as the prior fiscal year quarter benefited from shipments, which primarily consisted of summer learning products, that shifted in from the fourth quarter of fiscal 2021 due to supply chain constraints at that time. During the fourth quarter of fiscal 2022, orders were shipped more timely with fewer sales shifted into the first quarter of fiscal 2023. In addition, the segment had lower revenues in the first quarter from professional learning services and teaching resource products. The overall decrease was partially offset by revenues of $9.2 million from the New Worlds Reading Initiative, which did not commence shipping until the third quarter of the prior fiscal year.\nCost of goods sold for the quarter ended August 31, 2022 was $30.4 million, or 41.5% of revenues, compared to $32.8 million, or 40.9% of revenues, in the prior fiscal year quarter. The increase in Cost of goods sold as a percentage of revenues was primarily attributable to increased postage and freight costs driven by inflationary pressures, in addition to moderately higher royalty costs driven by the mix of products sold in the first quarter of fiscal 2023.\nOther operating expenses for the quarter ended August 31, 2022 were $47.1 million, compared to $40.0 million in the prior fiscal year quarter. The $7.1 million increase in Other operating expenses was primarily related to increased marketing costs associated with the New Worlds Reading Initiative as well as higher employee-related costs.\nSegment operating loss for the quarter ended August 31, 2022 was $4.3 million, compared to income of $7.3 million in the prior fiscal year quarter. The $11.6 million change was driven by the lower revenues in the first quarter of fiscal 2023, coupled with increased cost of goods sold due to higher freight and royalty costs, marketing costs associated with the New Worlds Reading Initiative and employee-related costs.\nInternational\n| Three months ended |\n| August 31, | August 31, | $ | % |\n| ($ amounts in millions) | 2022 | 2021 | Change | Change |\n| Revenues | $ | 65.0 | $ | 63.9 | $ | 1.1 | 1.7 | % |\n| Cost of goods sold | 39.5 | 36.1 | 3.4 | 9.4 | % |\n| Other operating expenses (1) | 29.0 | 29.5 | (0.5) | (1.7) | % |\n| Operating income (loss) | $ | (3.5) | $ | (1.7) | $ | (1.8) | NM |\n| Operating margin | — | % | — | % |\n\n(1) Other operating expenses include selling, general and administrative expenses, bad debt expenses, severance and depreciation and amortization.\nNM Not meaningful\nRevenues for the quarter ended August 31, 2022 increased to $65.0 million, compared to $63.9 million in the prior fiscal year quarter. Local currency revenues across the Company's foreign operations increased by $5.8 million, offset by an unfavorable foreign exchange impact of $4.7 million. The increase in segment revenues was primarily driven by higher revenues in Australia, New Zealand and Canada. Australia and New Zealand local currency revenues increased by $6.1 million as a result of increased sales in the book fairs and trade channels as the additional lockdowns imposed by the COVID variant, which had occurred later than in other markets, have continued to be lifted. In Canada, local currency revenues increased $4.0 million driven by higher trade channel sales of best-selling titles including HeartstoppersTM, coupled with increased sales in the book fairs and education channels. The increase in segment revenues was partially offset by lower local currency revenues in Asia of $3.8 million primarily attributable to the disposition of the direct sales business, coupled with lower sales within the Asia export channel. In addition, local currency revenues in the UK decreased by $0.1 million primarily due to lower sales in the trade and education channels, partially offset by increased sales in the book fairs channel, driven by higher fair count. Export channel revenues also decreased by $0.4 million as compared to the prior fiscal year quarter.\nCost of goods sold for the quarter ended August 31, 2022 was $39.5 million, or 60.8% of revenues, compared to $36.1 million, or 56.5% of revenues, in the prior fiscal year quarter. The increase in Cost of goods sold as a percentage of revenue was driven by an overall increase in freight costs across all channels due to inflationary pressures as well as increased paper and printing costs in the UK and increased variable fulfillment costs in Australia due to increased labor costs.\n22\n| SCHOLASTIC CORPORATIONItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) |\n\nOther operating expenses for the quarter ended August 31, 2022 were $29.0 million, compared to $29.5 million in the prior fiscal year quarter. Other operating expenses decreased $0.5 million impacted by a favorable foreign exchange impact of $1.8 million, resulting in a local currency increase of $1.3 million. This increase was primarily driven by lower equity investment income and increased employee-related expenses as a result of the discontinuation of government subsidies related to COVID-related governmental retention programs, partially offset by lower severance expense related to restructuring programs.\nSegment operating loss for the quarter ended August 31, 2022 was $3.5 million, compared to a loss of $1.7 million in the prior fiscal year quarter. The increased loss was primarily driven by increased product costs related to freight, paper and printing.\nOverhead\nUnallocated overhead expense for the quarter ended August 31, 2022 increased by $4.3 million to $20.2 million, from $15.9 million in the prior fiscal year quarter. The increase was primarily attributable to $6.6 million of insurance recoveries received and recognized in the quarter ended August 31, 2021 related to the intellectual property legal settlement accrued in fiscal 2021, partially offset by lower severance expense from the Company's restructuring programs of $2.0 million.\nSeasonality\nThe Company’s Children’s Book Publishing and Distribution school-based book club and book fair channels and most of its Education Solutions businesses operate on a school-year basis; therefore, the Company’s business is highly seasonal. As a result, the Company’s revenues in the first and third quarters of the fiscal year generally are lower than its revenues in the other two fiscal quarters. Typically, school-based channels and magazine revenues are minimal in the first quarter of the fiscal year as schools are not in session. Education channel revenues are generally higher in the fourth quarter. Trade sales can vary throughout the year due to varying release dates of published titles.\nLiquidity and Capital Resources\nCash used by operating activities was $60.3 million for the three months ended August 31, 2022, compared to cash provided by operating activities of $63.6 million for the prior fiscal year period, representing an increase in cash used by operating activities of $123.9 million. The increase in cash used was primarily driven by increased inventory purchases of $77.3 million to offset long lead times and meet expected demand, primarily related to the book fairs and trade channels. The increase in cash used was also impacted by the $63.1 million federal income tax refund and $6.6 million of insurance recoveries received in the prior period which was partially offset by $39.6 million in higher customer remittances in the current period.\nCash used in investing activities was $16.2 million for the three months ended August 31, 2022, compared to $14.5 million in the prior fiscal year period, representing an increase in cash used in investing activities of $1.7 million. The increase in cash used was driven by higher capital expenditures of $1.2 million, primarily for new equipment to meet the expected demand in the book fairs channel, coupled with increased prepublication spending of $0.5 million related to digital products.\nCash provided by financing activities was $1.6 million for the three months ended August 31, 2022, compared to cash used in financing activities of $105.6 million for the prior fiscal year period, representing a decrease in cash used in financing activities of $107.2 million. The decrease in cash used was primarily related to repayments of borrowings under the U.S. credit agreement of $100.0 million during the prior period, coupled with an increase in net proceeds from stock option exercises of $11.6 million in the first quarter of fiscal 2023. Partially offsetting this decrease, the Company reacquired $4.7 million of common stock with no such repurchases in the prior fiscal year period during which the repurchase program was suspended.\nCash Position\nThe Company’s cash and cash equivalents totaled $239.7 million at August 31, 2022, $316.6 million at May 31, 2022 and $308.6 million at August 31, 2021. Cash and cash equivalents held by the Company’s U.S. operations totaled $202.2 million at August 31, 2022, $275.5 million at May 31, 2022 and $271.9 million at August 31, 2021.\n23\n| SCHOLASTIC CORPORATIONItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) |\n\nDue to the seasonal nature of its business as discussed under “Seasonality”, the Company usually experiences negative cash flows in the June through September time period.\nThe Company’s operating philosophy is to use cash provided by operating activities to create value by paying down debt, reinvesting in existing businesses and, from time to time, making acquisitions that will complement its portfolio of businesses or acquiring other strategic assets, as well as engaging in shareholder enhancement initiatives, such as share repurchases or dividend declarations. The Company has lifted the temporary suspension of its open-market buy-back program under which $28.8 million remained available for future purchases of common shares as of August 31, 2022. During the three months ended August 31, 2022, the Company repurchased $4.7 million of its common stock.\nThe Company has maintained, and expects to maintain for the foreseeable future, sufficient liquidity to fund ongoing operations, including working capital requirements, pension contributions, postretirement benefits, debt service, planned capital expenditures and other investments, as well as dividends and share repurchases. As of August 31, 2022, the Company’s primary sources of liquidity consisted of cash and cash equivalents of $239.7 million, cash from operations and the Company's U.S. credit agreement. The Company expects the U.S. credit agreement to provide it with an appropriate level of flexibility to strategically manage its business operations. The Company's U.S. credit agreement, less commitments of $0.4 million, has $299.6 million of availability. Additionally, the Company has short-term credit facilities of $36.4 million, less current borrowings of $6.3 million and commitments of $3.7 million, resulting in $26.4 million of current availability under these facilities at August 31, 2022. Accordingly, the Company believes these sources of liquidity are sufficient to finance its currently anticipated ongoing operating needs, as well as its financing and investing activities.\nFinancing\nThe Company is party to the U.S. credit agreement and certain credit lines with various banks as described in Note 5 of Notes to Condensed Consolidated Financial Statements - unaudited in Item 1, “Financial Statements.\" The Company had no outstanding borrowings under the U.S. credit agreement as of August 31, 2022.\nThe Company is party to loan agreements, notes or other documents or instruments which reference the London Interbank Offered Rate, or LIBOR, as the benchmark interest rate index used to set the borrowing rate on certain short-term and variable-rate loans or advances. The ICE Benchmark Administration (IBA) ceased the publication of 1-week and 2-month USD LIBORs effective December 31, 2021 and will cease overnight, 1-month, 3-month, 6-month and 12-month LIBORs effective June 30, 2023. The Company is working with its financial institutions to replace USD LIBOR with alternative reference rates in financial contracts as they mature, or as the Company requires.\nThe markets have provided several replacements for USD LIBOR, including the Bloomberg Short-Term Bank Yield Index (BSBY) and the ARRC’s Secured Overnight Financing Rate (SOFR), either of which will be made available to the Company by its agent banks as a substitute for USD LIBOR. The Company does not believe that the change in reference rates will have any material effect on its ability to access the credit markets under its existing financing agreements, or its ability to modify or amend financial contracts, if required.\n24\n| SCHOLASTIC CORPORATIONItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) |\n\nNew Accounting Pronouncements\nReference is made to Note 1 of Notes to Financial Statements - unaudited in Item 1, “Financial Statements,” for information concerning recent accounting pronouncements since the filing of the Company’s Annual Report on Form 10-K for the fiscal year ended May 31, 2022.\n25\n| SCHOLASTIC CORPORATIONItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) |\n\nForward Looking Statements\nThis Quarterly Report on Form 10-Q contains forward-looking statements. Additional written and oral forward-looking statements may be made by the Company from time to time in Securities and Exchange Commission (\"SEC\") filings and otherwise. The Company cautions readers that results or expectations expressed by forward-looking statements, including, without limitation, those relating to the Company’s future business prospects and strategic plans, ecommerce and digital initiatives, new product introductions, strategies, new education standards, goals, revenues, improved efficiencies, general operating costs, including transportation and labor costs and the extent such costs are impacted by inflationary pressures, manufacturing costs, medical costs, potential cost savings, merit pay, operating margins, working capital, liquidity, capital needs, the cost and timing of capital projects, interest costs, cash flows and income, are subject to risks and uncertainties, which may have an impact on the Company's operations and could cause actual results to differ materially from those indicated in the forward-looking statements, due to factors including those noted in the Annual Report and this Quarterly Report and other risks and factors identified from time to time in the Company’s filings with the SEC. The Company disclaims any intention or obligation to update or revise forward-looking statements, whether as a result of new information, future events or otherwise.\n26\n| SCHOLASTIC CORPORATION |\n\nThe Company conducts its business in various foreign countries, and as such, its cash flows and earnings are subject to fluctuations from changes in foreign currency exchange rates. The Company sells products from its domestic operations to its foreign subsidiaries, creating additional currency risk. The Company manages its exposures to this market risk through internally established procedures and, when deemed appropriate, through the use of short-term forward exchange contracts, which were not significant as of August 31, 2022. The Company does not enter into derivative transactions or use other financial instruments for trading or speculative purposes.\nMarket risks relating to the Company’s operations result primarily from changes in interest rates in its variable-rate borrowings. The Company is subject to the risk that market interest rates and its cost of borrowing will increase and thereby increase the interest charged under its variable-rate debt.\nAdditional information relating to the Company’s outstanding financial instruments is included in Note 5 of Notes to Condensed Consolidated Financial Statements - unaudited in Item 1, “Financial Statements.”\nThe following table sets forth information about the Company’s debt instruments as of August 31, 2022:\n| ($ amounts in millions) | Fiscal Year Maturity |\n| 2023(1) | 2024 | 2025 | 2026 | 2027 | Thereafter | Total | FairValue at8/31/2022 |\n| Debt Obligations |\n| Lines of credit and current portion of long-term debt | $ | 6.3 | $ | — | $ | — | $ | — | $ | — | $ | — | $ | 6.3 | $ | 6.3 |\n| Average interest rate | 5.8 | % | — | — | — | — | — |\n\n(1) Fiscal 2023 includes the remaining nine months of the current fiscal year ending May 31, 2023.\n27\n| SCHOLASTIC CORPORATION |\n\nThe Chief Executive Officer and the Chief Financial Officer of the Corporation, after conducting an evaluation, together with other members of the Company’s management, of the effectiveness of the design and operation of the Corporation’s disclosure controls and procedures as of August 31, 2022, have concluded that the Corporation’s disclosure controls and procedures were effective to ensure that information required to be disclosed by the Corporation in its reports filed or submitted under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the SEC and accumulated and communicated to members of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. There was no change in the Corporation’s internal control over financial reporting that occurred during the quarter ended August 31, 2022 that has materially affected, or is reasonably likely to materially affect, the Corporation’s internal control over financial reporting.\n28\nPART II – OTHER INFORMATION\nSCHOLASTIC CORPORATION\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nThe following table provides information with respect to repurchases of shares of Common Stock by the Corporation during the three months ended August 31, 2022:\nIssuer Purchases of Equity Securities\n| Period | Total number ofshares purchased | Averageprice paidper share | Total number of sharespurchased as part of publiclyannounced plans orprograms | Maximum number of shares (orapproximate dollar value) that may yet be purchased under the plans or programs (i) |\n| June 1 through June 30, 2022 | — | — | — | $33.9 |\n| July 1 through July 31, 2022 | 19,234 | 45.86 | 19,234 | 33.0 |\n| August 1 through August 31, 2022 | 90,798 | 46.35 | 90,798 | 28.8 |\n| Total | 110,032 | 110,032 | $28.8 |\n\n(i) Represents the amount remaining at August 31, 2022 under the current $50.0 Board authorization for Common share repurchases announced on March 18, 2020, which is available for further repurchases, from time to time as conditions allow, on the open market or through privately negotiated transactions. See Note 12 of Notes to Condensed Consolidated Financial Statements - unaudited in Item 1, “Financial Statements,” for a description of the Company’s share buy-back program and share repurchase authorizations.\n29\n\nItem 6. Exhibits\nExhibits:\n| 10.1* | The Scholastic Corporation 2021 Stock Incentive Plan (supersedes and replaces the Scholastic Corporation 2021 Stock Incentive Plan filed as Exhibit 10.2 to the Corporation’s Quarterly Report on Form 10-Q as filed with the SEC on December 17, 2021). |\n| 10.2* | Amended and Restated Employment Agreement between Scholastic Corporation and Peter Warwick, effective August 1, 2021 (supersedes and replaces the Amended and Restated Employment Agreement between Scholastic Corporation and Peter Warwick filed as Exhibit 10.5 to the Corporation’s Quarterly Report on Form 10-Q as filed with the SEC on December 17, 2021). |\n| 10.3* | Performance Stock Unit Agreement between Scholastic Corporation and Peter Warwick, dated July 19, 2022. |\n| 31.1 | Certification of the Chief Executive Officer of Scholastic Corporation filed pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2 | Certification of the Chief Financial Officer of Scholastic Corporation filed pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32 | Certifications of the Chief Executive Officer and Chief Financial Officer of Scholastic Corporation furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 101 | Financial Statements from the Quarterly Report on Form 10-Q of the Company for the quarter ended August 31, 2022 formatted in Inline Extensible Business Reporting Language: (i) Condensed Consolidated Statements of Operations; (ii) Condensed Consolidated Statements of Comprehensive Income (Loss), (iii) Condensed Consolidated Balance Sheets; (iv) Condensed Consolidated Statements of Changes in Stockholders' Equity; (v) Condensed Consolidated Statements of Cash Flows; and (vi) Notes to Condensed Consolidated Financial Statements. |\n| 104 | Cover Page, formatted in Inline Extensible Business Reporting Language and contained in Exhibit 101. |\n| * The referenced exhibit is a management contract or compensation plan or arrangement described in Item 601(b) (10) (iii) of Regulation S-K. |\n\n30\nSCHOLASTIC CORPORATION\nQUARTERLY REPORT ON FORM 10-Q, DATED August 31, 2022\nExhibits Index\n| Exhibit Number | Description of Document |\n| 10.1* | The Scholastic Corporation 2021 Stock Incentive Plan (supersedes and replaces the Scholastic Corporation 2021 Stock Incentive Plan filed as Exhibit 10.2 to the Corporation’s Quarterly Report on Form 10-Q as filed with the SEC on December 17, 2021). |\n| 10.2* | Amended and Restated Employment Agreement between Scholastic Corporation and Peter Warwick, effective August 1, 2021 (supersedes and replaces the Amended and Restated Employment Agreement between Scholastic Corporation and Peter Warwick filed as Exhibit 10.5 to the Corporation’s Quarterly Report on Form 10-Q as filed with the SEC on December 17, 2021). |\n| 10.3* | Performance Stock Unit Agreement between Scholastic Corporation and Peter Warwick, dated July 19, 2022. |\n| 31.1 | Certification of the Chief Executive Officer of Scholastic Corporation filed pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2 | Certification of the Chief Financial Officer of Scholastic Corporation filed pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32 | Certifications of the Chief Executive Officer and Chief Financial Officer of Scholastic Corporation furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 101 | Financial Statements from the Quarterly Report on Form 10-Q of the Company for the quarter ended August 31, 2022 formatted in Inline Extensible Business Reporting Language: (i) Condensed Consolidated Statements of Operations; (ii) Condensed Consolidated Statements of Comprehensive Income (Loss), (iii) Condensed Consolidated Balance Sheets; (iv) Condensed Consolidated Statements of Changes in Stockholders' Equity; (v) Condensed Consolidated Statements of Cash Flows; and (vi) Notes to Condensed Consolidated Financial Statements. |\n| 104 | Cover Page, formatted in Inline Extensible Business Reporting Language and contained in Exhibit 101. |\n| * The referenced exhibit is a management contract or compensation plan or arrangement described in Item 601(b) (10) (iii) of Regulation S-K. |\n\n31\nSCHOLASTIC CORPORATION\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n| SCHOLASTIC CORPORATION |\n| (Registrant) |\n| Date: September 23, 2022 | By: | /s/ Peter Warwick |\n| Peter Warwick |\n| President and ChiefExecutive Officer(Principal Executive Officer) |\n| Date: September 23, 2022 | By: | /s/ Kenneth J. Cleary |\n| Kenneth J. Cleary |\n| Chief Financial Officer(Principal Financial Officer) |\n\n32\n</text>\n\nWhat is the change in profit margin for the company's \"Children's Book Publishing and Distribution\" segment from fiscal year 2021 to 2022 (in percentage)?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nITEM 1.\nFinancial Statements:\nCondensed Consolidated Balance Sheets 1\nCondensed Consolidated Statements of Operations 2\nCondensed Consolidated Statements of Comprehensive Income (Loss) 3\nCondensed Consolidated Statements of Cash Flows 4\nNotes to Condensed Consolidated Financial Statements 5\nITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 23\nITEM 3. Quantitative and Qualitative Disclosures about Market Risk 37\nITEM 4. Controls and Procedures 38\nPART II – OTHER INFORMATION\nITEM 1. Legal Proceedings 39\nITEM 1A. Risk Factors 39\nITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds 39\nITEM 4. Mine Safety Disclosures 39\nITEM 6. Exhibits 40\nSIGNATURE 41\nIn this Form 10-Q, references to “we,” “our,” “us,” \"Tapestry\" and the “Company” refer to Tapestry, Inc., including consolidated subsidiaries. References to \"Coach,\" \"Kate Spade,\" \"kate spade new york\" or \"Stuart Weitzman\" refer only to the referenced brand.\nSPECIAL NOTE ON FORWARD-LOOKING INFORMATION\nThis document, and the documents incorporated by reference in this document, our press releases and oral statements made from time to time by us or on our behalf, may contain certain \"forward-looking statements\" within the meaning of the federal securities laws, including Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are based on management's current expectations, that involve risks and uncertainties that could cause our actual results to differ materially from our current expectations. In this context, forward-looking statements often address expected future business and financial performance and financial condition, and often contain words such as \"may,\" \"can,\" \"continue,\" \"project,\" \"should,\" \"expect,\" \"confidence,\" \"trends,\" \"anticipate,\" \"intend,\" \"estimate,\" \"on track,\" \"well positioned to,\" \"plan,\" \"potential,\" \"position,\" \"believe,\" \"seek,\" \"see,\" \"will,\" \"would,\" \"target,\" similar expressions, and variations or negatives of these words. Forward-looking statements by their nature address matters that are, to different degrees, uncertain. Such statements involve risks, uncertainties and assumptions. If such risks or uncertainties materialize or such assumptions prove incorrect, the results of Tapestry, Inc. and its consolidated subsidiaries could differ materially from those expressed or implied by such forward-looking statements and assumptions. All statements other than statements of historical fact are statements that could be deemed forward-looking statements. Tapestry, Inc. assumes no obligation to revise or update any such forward-looking statements for any reason, except as required by law.\nTapestry, Inc.’s actual results could differ materially from the results contemplated by these forward-looking statements and are subject to a number of risks, uncertainties, estimates and assumptions that may cause actual results to differ materially from current expectations due to a number of factors, including, but not limited to: (i) the impact of the novel coronavirus (\"Covid-19\") global pandemic on our business and financial results, including impacts on our supply chain due to temporary closures of our manufacturing partners and shipping and fulfillment constraints; (ii) our ability to successfully execute our multi-year growth agenda under our Acceleration Program; (iii) the impact of economic conditions; (iv) our ability to control costs; (v) our exposure to international risks, including currency fluctuations and changes in economic or political conditions in the markets where we sell or source our products; (vi) the risk of cyber security threats and privacy or data security breaches; (vii) the effect of existing and new competition in the marketplace; (viii) our ability to retain the value of our brands and to respond to changing fashion and retail trends in a timely manner, including our ability to execute on our e-commerce and digital strategies; (ix) the effect of seasonal and quarterly fluctuations on our sales or operating results; (x) our ability to protect against infringement of our trademarks and other proprietary rights; (xi) the impact of tax and other legislation; (xii) our ability to achieve intended benefits, cost savings and synergies from acquisitions; (xiii) the risks associated with potential changes to international trade agreements and the imposition of additional duties on importing our products; (xiv) the impact of pending and potential future legal proceedings; and (xv) the risks associated with climate change and other corporate responsibility issues and (xvi) such other risk factors as set forth in Part II, Item 1A. \"Risk Factors\" and elsewhere in this report and in the Company’s Annual Report on Form 10-K for the fiscal year ended July 3, 2021. These factors are not necessarily all of the factors that could cause actual results to differ materially from those expressed in any of our forward-looking statements.\nWHERE YOU CAN FIND MORE INFORMATION\nTapestry's quarterly financial results and other important information are available by calling the Investor Relations Department at (212) 629-2618.\nTapestry maintains its website at www.tapestry.com where investors and other interested parties may obtain, free of charge, press releases and other information as well as gain access to our periodic filings with the SEC.\nTAPESTRY, INC.\nCONDENSED CONSOLIDATED BALANCE SHEETS\n| October 2,2021 | July 3,2021 |\n| (millions) |\n| (unaudited) |\n| ASSETS |\n| Current Assets: |\n| Cash and cash equivalents | $ | 1,252.6 | $ | 2,007.7 |\n| Short-term investments | 402.6 | 8.1 |\n| Trade accounts receivable, less allowances for credit losses of $ 4.5 and $ 4.2 , respectively | 236.8 | 200.2 |\n| Inventories | 818.3 | 734.8 |\n| Income tax receivable | 193.7 | 254.6 |\n| Prepaid expenses | 103.3 | 93.8 |\n| Other current assets | 78.9 | 76.1 |\n| Total current assets | 3,086.2 | 3,375.3 |\n| Property and equipment, net | 657.1 | 678.1 |\n| Operating lease right-of-use assets | 1,446.0 | 1,496.6 |\n| Goodwill | 1,294.9 | 1,297.3 |\n| Intangible assets | 1,371.7 | 1,373.4 |\n| Other assets | 158.2 | 161.7 |\n| Total assets | $ | 8,014.1 | $ | 8,382.4 |\n| LIABILITIES AND STOCKHOLDERS' EQUITY |\n| Current Liabilities: |\n| Accounts payable | $ | 414.0 | $ | 445.2 |\n| Accrued liabilities | 482.3 | 609.2 |\n| Current portion of operating lease liabilities | 312.8 | 319.4 |\n| Accrued income taxes | 37.5 | 52.0 |\n| Current debt | 400.0 | — |\n| Total current liabilities | 1,646.6 | 1,425.8 |\n| Long-term debt | 1,191.4 | 1,590.7 |\n| Long-term operating lease liabilities | 1,471.1 | 1,525.9 |\n| Deferred income taxes | 191.0 | 203.9 |\n| Other liabilities | 364.0 | 376.8 |\n| Total liabilities | 4,864.1 | 5,123.1 |\n| See Note 15 on commitments and contingencies |\n| Stockholders' Equity: |\n| Preferred stock: (authorized 25.0 million shares; $ 0.01 par value per share) none issued | — | — |\n| Common stock: (authorized 1.0 billion shares; $ 0.01 par value per share) issued and outstanding - 275.0 million and 279.5 million shares, respectively | 2.8 | 2.8 |\n| Additional paid-in-capital | 3,480.5 | 3,487.0 |\n| Retained earnings (accumulated deficit) | ( 251.2 ) | ( 158.5 ) |\n| Accumulated other comprehensive income (loss) | ( 82.1 ) | ( 72.0 ) |\n| Total stockholders' equity | 3,150.0 | 3,259.3 |\n| Total liabilities and stockholders' equity | $ | 8,014.1 | $ | 8,382.4 |\n\nSee accompanying Notes.\n1\nTAPESTRY, INC.\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\n\n| Three Months Ended |\n| October 2,2021 | September 26,2020 |\n| (millions, except per share data) |\n| (unaudited) |\n| Net sales | $ | 1,480.9 | $ | 1,172.2 |\n| Cost of sales | 412.2 | 342.0 |\n| Gross profit | 1,068.7 | 830.2 |\n| Selling, general and administrative expenses | 773.7 | 628.0 |\n| Operating income (loss) | 295.0 | 202.2 |\n| Interest expense, net | 16.1 | 19.4 |\n| Other expense (income) | 2.2 | ( 2.6 ) |\n| Income (loss) before provision for income taxes | 276.7 | 185.4 |\n| Provision (benefit) for income taxes | 49.8 | ( 46.3 ) |\n| Net income (loss) | $ | 226.9 | $ | 231.7 |\n| Net income (loss) per share: |\n| Basic | $ | 0.82 | $ | 0.84 |\n| Diluted | $ | 0.80 | $ | 0.83 |\n| Shares used in computing net income (loss) per share: |\n| Basic | 278.2 | 276.8 |\n| Diluted | 285.2 | 277.9 |\n\nSee accompanying Notes.\n2\nTAPESTRY, INC.\nCONDENSED CONSOLIDATED STATEMENTS OF\nCOMPREHENSIVE INCOME (LOSS)\n\n| Three Months Ended |\n| October 2,2021 | September 26,2020 |\n| (millions) |\n| (unaudited) |\n| Net income (loss) | $ | 226.9 | $ | 231.7 |\n| Other comprehensive income (loss), net of tax: |\n| Unrealized gains (losses) on cash flow hedging derivatives, net | ( 0.4 ) | ( 3.5 ) |\n| Unrealized gains (losses) on available-for-sale investments, net | ( 0.2 ) | — |\n| Foreign currency translation adjustments | ( 9.5 ) | 19.2 |\n| Other comprehensive income (loss), net of tax | ( 10.1 ) | 15.7 |\n| Comprehensive income (loss) | $ | 216.8 | $ | 247.4 |\n\nSee accompanying Notes.\n3\nTAPESTRY, INC.\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n| Three Months Ended |\n| October 2,2021 | September 26,2020 |\n| (millions) |\n| (unaudited) |\n| CASH FLOWS PROVIDED BY OPERATING ACTIVITIES |\n| Net income (loss) | $ | 226.9 | $ | 231.7 |\n| Adjustments to reconcile net income to net cash provided by (used in) operating activities: |\n| Depreciation and amortization | 50.8 | 51.2 |\n| Provision for bad debt | 5.0 | ( 3.2 ) |\n| Share-based compensation | 14.9 | 14.0 |\n| Acceleration Program charges | 5.0 | ( 5.4 ) |\n| Changes to lease related balances, net | ( 10.0 ) | ( 38.8 ) |\n| Deferred income taxes | ( 12.4 ) | ( 67.8 ) |\n| Gain on sale of building | — | ( 13.2 ) |\n| Other non-cash charges, net | 1.2 | 2.7 |\n| Changes in operating assets and liabilities: |\n| Trade accounts receivable | ( 40.3 ) | ( 29.4 ) |\n| Inventories | ( 84.8 ) | ( 57.5 ) |\n| Accounts payable | ( 32.7 ) | 135.1 |\n| Accrued liabilities | ( 140.3 ) | ( 61.2 ) |\n| Other liabilities | ( 10.0 ) | ( 1.8 ) |\n| Other assets | 48.5 | ( 66.4 ) |\n| Net cash provided by operating activities | 21.8 | 90.0 |\n| CASH FLOWS USED IN INVESTING ACTIVITIES |\n| Proceeds from sale of building | — | 23.9 |\n| Purchases of investments | ( 402.9 ) | ( 0.1 ) |\n| Proceeds from maturities and sales of investments | 7.9 | 0.2 |\n| Purchases of property and equipment | ( 33.4 ) | ( 26.0 ) |\n| Net cash used in investing activities | ( 428.4 ) | ( 2.0 ) |\n| CASH FLOWS USED IN FINANCING ACTIVITIES |\n| Dividend payments | ( 69.6 ) | — |\n| Repurchase of common stock | ( 250.0 ) | — |\n| Proceeds from share-based awards | 3.7 | — |\n| Taxes paid to net settle share-based awards | ( 30.1 ) | ( 8.2 ) |\n| Payments of finance lease liabilities | ( 0.2 ) | ( 0.2 ) |\n| Net cash used in financing activities | ( 346.2 ) | ( 8.4 ) |\n| Effect of exchange rate changes on cash and cash equivalents | ( 2.3 ) | 8.0 |\n| Net increase (decrease) in cash and cash equivalents | ( 755.1 ) | 87.6 |\n| Cash and cash equivalents at beginning of period | 2,007.7 | 1,426.3 |\n| Cash and cash equivalents at end of period | $ | 1,252.6 | $ | 1,513.9 |\n| Supplemental information: |\n| Cash paid for income taxes, net | $ | 21.5 | $ | 154.4 |\n| Cash paid for interest | $ | 31.4 | $ | 21.8 |\n| Noncash investing activity - property and equipment obligations | $ | 9.0 | $ | 22.2 |\n\nSee accompanying Notes.\n4\nTAPESTRY, INC. Notes to Condensed Consolidated Financial Statements(Unaudited)\n1. NATURE OF OPERATIONS\nTapestry, Inc. (the \"Company\") is a leading New York-based house of modern luxury accessories and lifestyle brands. Our global house of brands unites the magic of Coach, kate spade new york and Stuart Weitzman. Each of our brands are unique and independent, while sharing a commitment to innovation and authenticity defined by distinctive products and differentiated customer experiences across channels and geographies. We use our collective strengths to move our customers and empower our communities, to make the fashion industry more sustainable, and to build a company that’s equitable, inclusive, and diverse. Individually, our brands are iconic. Together, we can stretch what’s possible.\nThe Coach segment includes global sales of Coach products to customers through Coach operated stores, including e-commerce sites and concession shop-in-shops, and sales to wholesale customers and through independent third party distributors.\nThe Kate Spade segment includes global sales primarily of kate spade new york brand products to customers through Kate Spade operated stores, including e-commerce sites, sales to wholesale customers, through concession shop-in-shops and through independent third party distributors.\nThe Stuart Weitzman segment includes global sales of Stuart Weitzman brand products primarily through Stuart Weitzman operated stores, including e-commerce sites, sales to wholesale customers and through numerous independent third party distributors.\n2. BASIS OF PRESENTATION AND ORGANIZATION\nInterim Financial Statements\nThese unaudited interim condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (\"SEC\") and are unaudited. In the opinion of management, such condensed consolidated financial statements contain all normal and recurring adjustments necessary to present fairly the condensed consolidated financial position, results of operations, comprehensive income (loss) and cash flows of the Company for the interim periods presented. In addition, certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the U.S. (\"U.S. GAAP\") have been condensed or omitted from this report as is permitted by the SEC's rules and regulations. However, the Company believes that the disclosures provided herein are adequate to prevent the information presented from being misleading. This report should be read in conjunction with the audited consolidated financial statements and notes thereto, included in the Company’s Annual Report on Form 10-K for the year ended July 3, 2021 (\"fiscal 2021\") and other filings filed with the SEC.\nThe results of operations, cash flows and comprehensive income for the three months ended October 2, 2021 are not necessarily indicative of results to be expected for the entire fiscal year, which will end on July 2, 2022 (\"fiscal 2022\").\nFiscal Periods\nThe Company utilizes a 52-53 week fiscal year ending on the Saturday closest to June 30. Fiscal 2022 will be a 52-week period. Fiscal 2021, ended on July 3, 2021, was a 53-week period. The first quarter of fiscal 2022 ended on October 2, 2021 and the first quarter of fiscal 2021 ended on September 26, 2020, both of which were 13-week periods.\nCovid-19 Pandemic\nThe outbreak of a novel strain of coronavirus (\"Covid-19\") continues to impact a significant majority of the regions in which we operate, resulting in significant global business disruptions. The widespread impact of Covid-19 resulted in temporary closures of directly operated stores globally, as well as at our wholesale and licensing partners starting in fiscal 2020. Since then, certain directly operated stores and the stores of our wholesale and licensing partners have experienced temporary re-closures or are operating under tighter restrictions in compliance with local government regulation. Covid-19 has also resulted in ongoing supply chain challenges, such as logistic constraints, the closure of certain third-party manufacturers and increased freight costs.\nThe global Covid-19 pandemic is continuously evolving and the extent to which this impacts the Company - including unforeseen increased costs to the Company's business - will depend on future developments, which cannot be predicted, including the ultimate duration, severity and geographic resurgence of the virus and the success of actions to contain the virus, including variants of the novel strain, or treat its impact, among others. As the full magnitude of the effects on the Company's business is difficult to predict, the Covid-19 pandemic has and may continue to have a material adverse impact on the Company's business, financial condition, results of operations and cash flows for the foreseeable future. The Company believes\n5\nTAPESTRY, INC. Notes to Condensed Consolidated Financial Statements (continued)\nthat cash flows from operations, access to the credit and capital markets and our credit lines, on-hand cash and cash equivalents and our investments provide adequate funds to support our operating, capital, and debt service requirements. There can be no assurance, however, that any such capital will be available to the Company on acceptable terms or at all. The Company could experience other potential adverse impacts as a result of the Covid-19 pandemic, including, but not limited to, further charges from adjustments to the carrying amount of goodwill and other intangible assets, long-lived asset impairment charges, reserves for uncollectible accounts receivable and reserves for the realizability of inventory.\nIn response to the Covid-19 pandemic, the Company took actions to reinforce its liquidity and financial flexibility. If stores are required to close again for an extended period of time due to a resurgence of increased infections, the Company's liquidity may be negatively impacted.\nUse of Estimates\nThe preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and footnotes thereto. Actual results could differ from estimates in amounts that may be material to the financial statements.\nSignificant estimates inherent in the preparation of the condensed consolidated financial statements include reserves for the realizability of inventory; customer returns, end-of-season markdowns and operational chargebacks; useful lives and impairments of long-lived tangible and intangible assets; accounting for income taxes and related uncertain tax positions; accounting for business combinations; the valuation of stock-based compensation awards and related expected forfeiture rates; reserves for restructuring; and reserves for litigation and other contingencies, amongst others.\nPrinciples of Consolidation\nThese unaudited interim condensed consolidated financial statements include the accounts of the Company and all 100% owned and controlled subsidiaries. All intercompany transactions and balances are eliminated in consolidation.\nShare Repurchases\nThe Company accounts for stock repurchases by allocating the repurchase price to common stock and retained earnings. Under Maryland law, the Company's state of incorporation, there are no treasury shares. The Company accrues for the shares purchased under the share repurchase plan based on the trade date. Purchases of the Company's common stock are executed through open market purchases, including through a purchase agreement under Rule 10b5-1. The Company may terminate or limit the share repurchase program at any time. As a result, all repurchased shares are authorized but unissued shares. The Company may terminate or limit the stock repurchase program at any time.\n3. RECENT ACCOUNTING PRONOUNCEMENTS\nRecently Adopted Accounting Pronouncements\nIn December 2019, the Financial Accounting Standards Board (\"FASB\") issued Accounting Standards Update (\"ASU\") No. 2019-12, \"Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes\". The ASU simplifies the accounting for income taxes by, among other things, eliminating certain existing exceptions related to the general approach in Topic 740 relating to franchise taxes, reducing complexity in the interim-period accounting for year-to-date loss limitations and changes in tax laws, and clarifying the accounting for the step-up in the tax basis of goodwill. The Company adopted ASU 2019-12 as of the beginning of fiscal 2022. The adoption of ASU 2019-12 did not have a material impact on the Company's condensed consolidated financial statements and notes thereto.\nRecently Issued Accounting Pronouncements\nThe Company has considered all new accounting pronouncements and have concluded that there are no new pronouncements that may have a material impact on our results of operations, financial condition or cash flows based on current information.\n6\nTAPESTRY, INC. Notes to Condensed Consolidated Financial Statements (continued)\n4. REVENUE\nThe Company recognizes revenue primarily from sales of the products of its brands through retail and wholesale channels, including e-commerce sites. The Company also generates revenue from royalties related to licensing its trademarks, as well as sales in ancillary channels. In all cases, revenue is recognized upon the transfer of control of the promised products or services to the customer, which may be at a point in time or over time. Control is transferred when the customer obtains the ability to direct the use of and obtain substantially all of the remaining benefits from the products or services. The amount of revenue recognized is the amount of consideration to which the Company expects to be entitled, including estimation of sale terms that may create variability in the consideration. Revenue subject to variability is constrained to an amount which will not result in a significant reversal in future periods when the contingency that creates variability is resolved.\nThe Company recognizes revenue in its retail stores, including concession shop-in-shops, at the point-of-sale when the customer obtains physical possession of the products. Digital revenue from sales of products ordered through the Company's e-commerce sites is recognized upon delivery and receipt of the shipment by its customers and includes shipping and handling charges paid by customers. Retail and digital revenues are recorded net of estimated returns, which are estimated by developing an expected value based on historical experience. Payment is due at the point of sale.\nGift cards issued by the Company are recorded as a liability until redeemed by the customer, at which point revenue is recognized. The Company also uses historical information to estimate the amount of gift card balances that will never be redeemed and recognizes that amount as revenue over time in proportion to actual customer redemptions if the Company does not have a legal obligation to remit unredeemed gift cards to any jurisdiction as unclaimed property.\nCertain of the Company's retail operations use sales incentive programs, such as customer loyalty programs and the issuance of coupons. Loyalty programs provide the customer a material right to acquire additional products and give rise to the Company having a separate performance obligation. Additionally, certain products sold by the Company include an assurance warranty that is not considered a separate performance obligation. These programs are immaterial individually and in the aggregate.\nThe Company recognizes revenue within the wholesale channel at the time title passes and risk of loss is transferred to customers, which is generally at the point of shipment of products but may occur upon receipt of the shipment by the customer in certain cases. Payment is generally due 30 to 90 days after shipment. Wholesale revenue is recorded net of estimates for returns, discounts, end-of-season markdowns, cooperative advertising allowances and other consideration provided to the customer. Discounts are based on contract terms with the customer, while cooperative advertising allowances and other consideration may be based on contract terms or negotiated on a case-by-case basis. Returns and markdowns generally require approval from the Company and are estimated based on historical trends, current season results and inventory positions at the wholesale locations, current market and economic conditions as well as, in select cases, contractual terms. The Company's historical estimates of these variable amounts have not differed materially from actual results.\nThe Company recognizes licensing revenue over time during the contract period in which licensees are granted access to the Company's trademarks. These arrangements require licensees to pay a sales-based royalty and may include a contractually guaranteed minimum royalty amount. Revenue for contractually guaranteed minimum royalty amounts is recognized ratably over the license year and any excess sales-based royalties are recognized as earned once the minimum royalty threshold is achieved. Payments from the customer are generally due quarterly in an amount based on the licensee's sales of goods bearing the licensed trademarks during the period, which may differ from the amount of revenue recorded during the period thereby generating a contract asset or liability. Contract assets and liabilities and contract costs related to the licensing arrangements are immaterial as the licensing business represents approximately 1 % of total net sales in the three months ended October 2, 2021.\nThe Company has elected a practical expedient not to disclose the remaining performance obligations that are unsatisfied as of the end of the period related to contracts with an original duration of one year or less or variable consideration related to sales-based royalty arrangements. There are no other contracts with transaction price allocated to remaining performance obligations other than future minimum royalties as discussed above, which are not material.\nOther practical expedients elected by the Company include (i) assuming no significant financing component exists for any contract with a duration of one year or less, (ii) accounting for shipping and handling as a fulfillment activity within SG&A expense regardless of the timing of the shipment in relation to the transfer of control and (iii) excluding sales and value added tax from the transaction price.\n7\nTAPESTRY, INC. Notes to Condensed Consolidated Financial Statements (continued)\nDisaggregated Net Sales\nThe following table disaggregates the Company's net sales into geographies that depict how economic factors may impact the revenues and cash flows for the periods presented. Each geography presented includes net sales related to the Company's directly operated channels, global travel retail business and to wholesale customers, including distributors, in locations within the specified geographic area.\n| North America | Greater China(1) | Other Asia(2) | Other(3) | Total |\n| (millions) |\n| Three Months Ended October 2, 2021 |\n| Coach | $ | 681.7 | $ | 242.0 | $ | 136.9 | $ | 54.3 | $ | 1,114.9 |\n| Kate Spade | 232.2 | 11.7 | 26.8 | 28.8 | 299.5 |\n| Stuart Weitzman | 35.7 | 22.7 | 0.3 | 7.8 | 66.5 |\n| Total | $ | 949.6 | $ | 276.4 | $ | 164.0 | $ | 90.9 | $ | 1,480.9 |\n| Three Months Ended September 26, 2020 |\n| Coach | $ | 466.7 | $ | 196.2 | $ | 162.3 | $ | 50.2 | $ | 875.4 |\n| Kate Spade | 172.3 | 13.8 | 34.4 | 19.9 | 240.4 |\n| Stuart Weitzman | 26.3 | 17.7 | 2.5 | 9.9 | 56.4 |\n| Total | $ | 665.3 | $ | 227.7 | $ | 199.2 | $ | 80.0 | $ | 1,172.2 |\n\n(1) Greater China includes mainland China, Hong Kong SAR, Taiwan and Macao SAR.\n(2) Other Asia includes Japan, Australia, New Zealand, South Korea, Thailand and other countries within Asia.\n(3) Other sales primarily represents sales in Europe, the Middle East and royalties related to licensing.\nDeferred Revenue\nDeferred revenue results from cash payments received or receivable from customers prior to the transfer of the promised goods or services, and is generally comprised of unredeemed gift cards, net of breakage which has been recognized. Additional deferred revenue may result from sales-based royalty payments received or receivable which exceed the revenue recognized during the contractual period. The balance of such amounts as of October 2, 2021 and July 3, 2021 was $ 37.2 million and $ 32.4 million, respectively, which were primarily recorded within Accrued liabilities on the Company's Condensed Consolidated Balance Sheets and are generally expected to be recognized as revenue within a year. For the three months ended October 2, 2021, net sales of $ 3.6 million were recognized from amounts recorded as deferred revenue as of July 3, 2021. For the three months ended September 26, 2020, net sales of $ 4.7 million were recognized from amounts recorded as deferred revenue as of June 27, 2020.\n5. RESTRUCTURING ACTIVITIES\nAcceleration Program\nThe Company has implemented a strategic growth plan after undergoing a review of its business under its multi-year growth agenda. This multi-faceted, multi-year strategic growth plan (the \"Acceleration Program\") reflects: (i) actions to streamline the Company's organization; (ii) select store closures as the Company optimizes its fleet (including store closure costs incurred as the Company exits certain regions in which it currently operates); and (iii) professional fees and compensation costs incurred as a result of the development and execution of the Company's comprehensive strategic initiatives aimed at increasing profitability. Under the Acceleration Program, the Company expects to incur total pre-tax charges of approximately $ 205 - $ 220 million. The Acceleration Program is expected to be substantially complete by the end of fiscal 2022.\nUnder the Acceleration Program, the Company incurred charges of $ 12.1 million during the three months ended October 2, 2021, all of which was recorded within SG&A expenses. Of the total charges, $ 8.9 million was recorded within Corporate, $ 1.4 million was recorded within the Coach segment, $ 1.4 million was recorded within the Kate Spade segment and $ 0.4 million was recorded within the Stuart Weitzman segment.\n8\nTAPESTRY, INC. Notes to Condensed Consolidated Financial Statements (continued)\nFor the three months ended September 26, 2020, the Company incurred charges of $ 26.6 million, all of which was recorded within SG&A expenses. Of the total charges, $ 17.3 million was recorded within Corporate, $ 10.7 million was recorded within the Coach segment, $ 1.0 million was recorded within the Kate Spade segment and a reduction of expense of $ 2.4 million was recorded within the Stuart Weitzman segment.\nA summary of charges and related liabilities under the Acceleration Program is as follows:\n| Organization-Related(1) | Store Closure(2) | Other(3) | Total |\n| (millions) |\n| Fiscal 2020 charges | $ | 44.7 | $ | 32.3 | $ | 10.0 | $ | 87.0 |\n| Cash payments | ( 15.8 ) | ( 11.0 ) | ( 7.1 ) | ( 33.9 ) |\n| Non-cash charges | ( 4.0 ) | ( 20.8 ) | — | ( 24.8 ) |\n| Liability balance as of June 27, 2020 | $ | 24.9 | $ | 0.5 | $ | 2.9 | $ | 28.3 |\n| Fiscal 2021 charges | 16.6 | 5.9 | 67.1 | 89.6 |\n| Cash payments | ( 38.2 ) | ( 11.9 ) | ( 36.6 ) | ( 86.7 ) |\n| Non-cash charges | — | 5.8 | ( 10.9 ) | ( 5.1 ) |\n| Liability balance as of July 3, 2021 | $ | 3.3 | $ | 0.3 | $ | 22.5 | $ | 26.1 |\n| Fiscal 2022 charges | $ | — | $ | 1.1 | $ | 11.0 | $ | 12.1 |\n| Cash payments | ( 0.8 ) | ( 1.4 ) | ( 6.7 ) | ( 8.9 ) |\n| Non-cash charges | — | — | ( 5.0 ) | ( 5.0 ) |\n| Liability balance as of October 2, 2021 | $ | 2.5 | $ | — | $ | 21.8 | $ | 24.3 |\n\n(1) Organization-related charges, recorded within SG&A expenses, primarily relates to severance and other related costs.\n(2) Store closure charges represent lease termination penalties, removal or modification of lease assets and liabilities, establishing inventory reserves, accelerated depreciation and severance.\n(3) Other charges, recorded within SG&A, primarily relates to share-based compensation and professional fees.\nThe Company expects to incur approximately $ 15 - $ 30 million in additional charges under the Acceleration Program in fiscal 2022.\n9\nTAPESTRY, INC. Notes to Condensed Consolidated Financial Statements (continued)\n6. GOODWILL AND OTHER INTANGIBLE ASSETS\nGoodwill\nThe change in the carrying amount of the Company’s goodwill by segment is as follows:\n| Coach | Kate Spade | Stuart Weitzman(1) | Total |\n| (millions) |\n| Balance at July 3, 2021 | $ | 656.3 | $ | 641.0 | $ | — | $ | 1,297.3 |\n| Foreign exchange impact | ( 1.7 ) | ( 0.7 ) | — | ( 2.4 ) |\n| Balance at October 2, 2021 | $ | 654.6 | $ | 640.3 | $ | — | $ | 1,294.9 |\n\n(1) Amount is net of accumulated goodwill impairment charges of $ 210.7 million as of October 2, 2021 and July 3, 2021.\nIntangible Assets\nIntangible assets consist of the following:\n| October 2, 2021 | July 3, 2021 |\n| Gross Carrying Amount | Accum.Amort. | Net | Gross Carrying Amount | Accum.Amort. | Net |\n| (millions) |\n| Intangible assets subject to amortization: |\n| Customer relationships | $ | 100.5 | $ | ( 38.6 ) | $ | 61.9 | $ | 100.5 | $ | ( 36.9 ) | $ | 63.6 |\n| Intangible assets not subject to amortization: |\n| Trademarks and trade names | 1,309.8 | — | 1,309.8 | 1,309.8 | — | 1,309.8 |\n| Total intangible assets | $ | 1,410.3 | $ | ( 38.6 ) | $ | 1,371.7 | $ | 1,410.3 | $ | ( 36.9 ) | $ | 1,373.4 |\n\nAs of October 2, 2021, the expected amortization expense for intangible assets is as follows:\n| Amortization Expense |\n| (millions) |\n| Remainder of fiscal 2022 | $ | 4.9 |\n| Fiscal 2023 | 6.5 |\n| Fiscal 2024 | 6.5 |\n| Fiscal 2025 | 6.5 |\n| Fiscal 2026 | 6.5 |\n| Fiscal 2027 | 6.5 |\n| Thereafter | 24.5 |\n| Total | $ | 61.9 |\n\nThe expected amortization expense above reflects remaining useful lives ranging from approximately 8.6 to 10.8 years for customer relationships.\n10\nTAPESTRY, INC. Notes to Condensed Consolidated Financial Statements (continued)\n7. STOCKHOLDERS' EQUITY\nA reconciliation of stockholders' equity is presented below:\n| Shares ofCommonStock | Common Stock | AdditionalPaid-in-Capital | Retained Earnings / (Accumulated Deficit) | AccumulatedOtherComprehensiveIncome (Loss) | TotalStockholders'Equity |\n| (millions, except per share data) |\n| Balance at June 27, 2020 | 276.2 | $ | 2.8 | $ | 3,358.5 | $ | ( 992.7 ) | $ | ( 92.2 ) | $ | 2,276.4 |\n| Net income (loss) | — | — | — | 231.7 | — | 231.7 |\n| Other comprehensive income (loss) | — | — | — | — | 15.7 | 15.7 |\n| Shares issued, pursuant to stock-based compensation arrangements, net of shares withheld for taxes | 1.2 | — | ( 8.3 ) | — | — | ( 8.3 ) |\n| Share-based compensation | — | — | 14.6 | — | — | 14.6 |\n| Balance at September 26, 2020 | 277.4 | $ | 2.8 | $ | 3,364.8 | $ | ( 761.0 ) | $ | ( 76.5 ) | $ | 2,530.1 |\n| Shares ofCommonStock | Common Stock | AdditionalPaid-in-Capital | Retained Earnings / (Accumulated Deficit) | AccumulatedOtherComprehensiveIncome (Loss) | TotalStockholders'Equity |\n| (millions, except per share data) |\n| Balance at July 3, 2021 | 279.5 | $ | 2.8 | $ | 3,487.0 | $ | ( 158.5 ) | $ | ( 72.0 ) | $ | 3,259.3 |\n| Net income (loss) | — | — | — | 226.9 | — | 226.9 |\n| Other comprehensive income (loss) | — | — | — | — | ( 10.1 ) | ( 10.1 ) |\n| Shares issued, pursuant to stock-based compensation arrangements, net of shares withheld for taxes | 1.6 | — | ( 26.4 ) | — | — | ( 26.4 ) |\n| Share-based compensation | — | — | 19.9 | — | — | 19.9 |\n| Repurchase of common stock | ( 6.1 ) | — | — | ( 250.0 ) | — | ( 250.0 ) |\n| Dividends declared ($ 0.25 per share) | — | — | — | ( 69.6 ) | — | ( 69.6 ) |\n| Balance at October 2, 2021 | 275.0 | $ | 2.8 | $ | 3,480.5 | $ | ( 251.2 ) | $ | ( 82.1 ) | $ | 3,150.0 |\n\n11\nTAPESTRY, INC. Notes to Condensed Consolidated Financial Statements (continued)\nThe components of accumulated other comprehensive income (loss) (\"AOCI\"), as of the dates indicated, are as follows:\n| Unrealized Gains (Losses) on CashFlowHedging Derivatives(1) | Unrealized Gains(Losses) on Available-for-Sale Investments | CumulativeTranslationAdjustment | Total |\n| (millions) |\n| Balances at June 27, 2020 | $ | 1.1 | $ | — | $ | ( 93.3 ) | $ | ( 92.2 ) |\n| Other comprehensive income (loss) before reclassifications | ( 3.5 ) | — | 19.2 | 15.7 |\n| Less: amounts reclassified from accumulated other comprehensive income to earnings | — | — | — | — |\n| Net current-period other comprehensive income (loss) | ( 3.5 ) | — | 19.2 | 15.7 |\n| Balances at September 26, 2020 | $ | ( 2.4 ) | $ | — | $ | ( 74.1 ) | $ | ( 76.5 ) |\n| Balances at July 3, 2021 | $ | ( 0.7 ) | $ | — | $ | ( 71.3 ) | $ | ( 72.0 ) |\n| Other comprehensive income (loss) before reclassifications | ( 0.9 ) | ( 0.2 ) | ( 9.5 ) | ( 10.6 ) |\n| Less: amounts reclassified from accumulated other comprehensive income to earnings | ( 0.5 ) | — | — | ( 0.5 ) |\n| Net current-period other comprehensive income (loss) | ( 0.4 ) | ( 0.2 ) | ( 9.5 ) | ( 10.1 ) |\n| Balances at October 2, 2021 | $ | ( 1.1 ) | $ | ( 0.2 ) | $ | ( 80.8 ) | $ | ( 82.1 ) |\n\n(1) The ending balances of AOCI related to cash flow hedges are net of tax of $ 0.5 million and less than $ 0.1 million as of October 2, 2021 and September 26, 2020, respectively. The amounts reclassified from AOCI are net of tax of $ 0.1 million and less than $ 0.1 million as of October 2, 2021 and September 26, 2020, respectively.\n8. LEASES\nThe Company leases retail space, office space, warehouse facilities, fulfillment centers, storage space, machinery, equipment and certain other items under operating leases. The Company's leases have initial terms ranging from 1 to 20 years and may have renewal or early termination options ranging from 1 to 10 years. These leases may also include rent escalation clauses or lease incentives. In determining the lease term used in the lease right-of-use (\"ROU\") asset and lease liability calculations, the Company considers various factors such as market conditions and the terms of any renewal or termination options that may exist. When deemed reasonably certain, the renewal and termination options are included in the determination of the lease term and calculation of the lease ROU asset and lease liability. The Company is typically required to make fixed minimum rent payments, variable rent payments primarily based on performance (i.e., percentage-of-sales-based payments), or a combination thereof, directly related to its ROU asset. The Company is also often required, by the lease, to pay for certain other costs including real estate taxes, insurance, common area maintenance fees, and/or certain other costs, which may be fixed or variable, depending upon the terms of the respective lease agreement. To the extent these payments are fixed, the Company has included them in calculating the lease ROU assets and lease liabilities.\nThe Company calculates lease ROU assets and lease liabilities as the present value of fixed lease payments over the reasonably certain lease term beginning at the commencement date. The Company is required to use the implicit rate to determine the present value of lease payments. As the rate implicit in the Company's leases is not readily determinable, the Company uses its incremental borrowing rate based on the information available at the lease commencement date, including the Company's credit rating, credit spread and adjustments for the impact of collateral, lease tenors, economic environment and currency.\nFor operating leases, fixed lease payments are recognized as operating lease cost on a straight-line basis over the lease term. For finance leases and impaired operating leases, the ROU asset is depreciated on a straight-line basis over the remaining lease term, along with recognition of interest expense associated with accretion of the lease liability. For leases with a lease term of 12 months or less (\"short-term lease\"), any fixed lease payments are recognized on a straight-line basis over such term,\n12\nTAPESTRY, INC. Notes to Condensed Consolidated Financial Statements (continued)\nand are not recognized on the Condensed Consolidated Balance Sheets. Variable lease cost for both operating and finance leases, if any, is recognized as incurred.\nThe Company acts as sublessor in certain leasing arrangements, primarily related to a sublease of a portion the Company's leased headquarters space as well as certain retail locations. Fixed sublease payments received are recognized on a straight-line basis over the sublease term.\nROU assets, along with any other related long-lived assets, are periodically evaluated for impairment.\nThe following table summarizes the ROU assets and lease liabilities recorded on the Company's Condensed Consolidated Balance Sheets as of October 2, 2021 and July 3, 2021:\n| October 2,2021 | July 3,2021 | Location Recorded on Balance Sheet |\n| (millions) |\n| Assets: |\n| Operating leases | $ | 1,446.0 | $ | 1,496.6 | Operating lease right-of-use assets |\n| Finance leases | 2.4 | 2.6 | Property and equipment, net |\n| Total lease assets | $ | 1,448.4 | $ | 1,499.2 |\n| Liabilities: |\n| Operating leases: |\n| Current lease liabilities | $ | 312.8 | $ | 319.4 | Current lease liabilities |\n| Long-term lease liabilities | 1,471.1 | 1,525.9 | Long-term lease liabilities |\n| Total operating lease liabilities | $ | 1,783.9 | $ | 1,845.3 |\n| Finance leases: |\n| Current lease liabilities | $ | 1.0 | $ | 1.0 | Accrued liabilities |\n| Long-term lease liabilities | 3.2 | 3.4 | Other liabilities |\n| Total finance lease liabilities | $ | 4.2 | $ | 4.4 |\n| Total lease liabilities | $ | 1,788.1 | $ | 1,849.7 |\n\nThe following table summarizes the composition of net lease costs, primarily recorded within SG&A expenses on the Company's Condensed Consolidated Statements of Operations for the three months ended October 2, 2021 and September 26, 2020:\n| Three Months Ended |\n| October 2, 2021 | September 26, 2020 |\n| (millions) |\n| Finance lease cost: |\n| Amortization of right-of-use assets | $ | 0.2 | $ | 0.2 |\n| Interest on lease liabilities(1) | 0.1 | 0.1 |\n| Total finance lease cost | 0.3 | 0.3 |\n| Operating lease cost | 84.9 | 86.8 |\n| Short-term lease cost | 4.5 | 6.1 |\n| Variable lease cost(2) | 43.6 | 40.9 |\n| Less: sublease income | ( 4.9 ) | ( 4.2 ) |\n| Total net lease cost | $ | 128.4 | $ | 129.9 |\n\n(1) Interest on lease liabilities is recorded within Interest expense, net on the Company's Condensed Consolidated Statement of Operations.\n13\nTAPESTRY, INC. Notes to Condensed Consolidated Financial Statements (continued)\n(2) Rent concessions negotiated related to Covid-19 are recorded in variable lease expense.\nThe following table summarizes certain cash flow information related to the Company's leases for the three months ended October 2, 2021 and September 26, 2020:\n| Three Months Ended |\n| October 2, 2021 | September 26,2020 |\n| (millions) |\n| Cash paid for amounts included in the measurement of lease liabilities: |\n| Operating cash flows from operating leases | $ | 104.5 | $ | 132.5 |\n| Operating cash flows from finance leases | 0.1 | 0.1 |\n| Financing cash flows from finance leases | 0.2 | 0.2 |\n| Non-cash transactions: |\n| Right-of-use assets obtained in exchange for operating lease liabilities | 32.2 | 8.5 |\n\nAdditionally, the Company had approximately $ 145.5 million of future payment obligations related to executed lease agreements for which the related lease had not yet commenced as of October 2, 2021. This obligation primarily relates to a lease agreement for a fulfillment center to be located in Las Vegas, Nevada.\n9. EARNINGS PER SHARE\nBasic net income per share is calculated by dividing net income by the weighted-average number of shares outstanding during the period. Diluted net income per share is calculated similarly but includes potential dilution from the exercise of stock options and restricted stock units and any other potentially dilutive instruments, only in the periods in which such effects are dilutive under the treasury stock method.\nThe following is a reconciliation of the weighted-average shares outstanding and calculation of basic and diluted earnings per share:\n| Three Months Ended |\n| October 2,2021 | September 26,2020 |\n| (millions, except per share data) |\n| Net income (loss) | $ | 226.9 | $ | 231.7 |\n| Weighted-average basic shares | 278.2 | 276.8 |\n| Dilutive securities: |\n| Effect of dilutive securities | 7.0 | 1.1 |\n| Weighted-average diluted shares | 285.2 | 277.9 |\n| Net income (loss) per share: |\n| Basic | $ | 0.82 | $ | 0.84 |\n| Diluted | $ | 0.80 | $ | 0.83 |\n\nEarnings per share amounts have been calculated based on unrounded numbers. Options to purchase shares of the Company's common stock at an exercise price greater than the average market price of the common stock during the reporting period are anti-dilutive and therefore not included in the computation of diluted net income (loss) per common share. In addition, the Company has outstanding restricted stock unit awards that are issuable only upon the achievement of certain performance goals. Performance-based restricted stock unit awards are included in the computation of diluted shares only to the extent that the underlying performance conditions and any applicable market condition modifiers (i) are satisfied as of the end of the reporting period or (ii) would be considered satisfied if the end of the reporting period were the end of the related contingency period and the result would be dilutive under the treasury stock method. As of October 2, 2021 and September 26,\n14\nTAPESTRY, INC. Notes to Condensed Consolidated Financial Statements (continued)\n2020, there were 5.2 million and 16.6 million, respectively, of additional shares issuable upon exercise of anti-dilutive options and contingent vesting of performance-based restricted stock unit awards, which were excluded from the diluted share calculations.\n10. SHARE-BASED COMPENSATION\nThe following table shows the share-based compensation expense and the related tax benefits recognized in the Company's Condensed Consolidated Statements of Operations for the periods indicated:\n| Three Months Ended |\n| October 2,2021 | September 26,2020 |\n| (millions) |\n| Share-based compensation expense(1) | $ | 19.9 | $ | 14.6 |\n| Income tax benefit related to share-based compensation expense | 3.8 | 2.6 |\n\n(1) During the three months ended October 2, 2021 and September 26, 2020, the Company incurred $ 5.0 million and $ 0.6 million of share-based compensation expense related to its Acceleration Program, respectively.\nStock Options\nA summary of stock option activity during the three months ended October 2, 2021 is as follows:\n| Number of OptionsOutstanding |\n| (millions) |\n| Outstanding at July 3, 2021 | 13.3 |\n| Granted | 0.7 |\n| Exercised | ( 0.2 ) |\n| Forfeited or expired | ( 0.7 ) |\n| Outstanding at October 2, 2021 | 13.1 |\n\nThe weighted-average grant-date fair value of options granted during the three months ended October 2, 2021 and September 26, 2020 was $ 13.96 and $ 6.60 , respectively. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model and the following weighted-average assumptions:\n| October 2,2021 | September 26,2020 |\n| Expected term (years) | 4.9 | 5.1 |\n| Expected volatility | 47.1 | % | 48.8 | % |\n| Risk-free interest rate | 0.7 | % | 0.3 | % |\n| Dividend yield | 2.4 | % | — | % |\n\n15\nTAPESTRY, INC. Notes to Condensed Consolidated Financial Statements (continued)\nService-based Restricted Stock Unit Awards (\"RSUs\")\nA summary of service-based RSU activity during the three months ended October 2, 2021 is as follows:\n| Number ofNon-vested RSUs |\n| (millions) |\n| Non-vested at July 3, 2021 | 7.3 |\n| Granted | 1.7 |\n| Vested | ( 2.1 ) |\n| Forfeited | ( 0.1 ) |\n| Non-vested at October 2, 2021 | 6.8 |\n\nThe weighted-average grant-date fair value of share awards granted during the three months ended October 2, 2021 and September 26, 2020 was $ 42.22 and $ 15.81 , respectively.\nPerformance-based Restricted Stock Unit Awards (\"PRSUs\")\nA summary of PRSU activity during the three months ended October 2, 2021 is as follows:\n| Number of Non-vested PRSUs |\n| (millions) |\n| Non-vested at July 3, 2021 | 1.0 |\n| Granted | 0.3 |\n| Change due to performance condition achievement | ( 0.1 ) |\n| Vested | — |\n| Forfeited | — |\n| Non-vested at October 2, 2021 | 1.2 |\n\nThe PRSU awards included in the non-vested amount are based on certain Company-specific financial metrics. The effect of the change due to performance condition on the non-vested amount is recognized at the conclusion of the performance period, which may differ from the date on which the award vests.\nThe weighted-average grant-date fair value per share of PRSU awards granted during the three months ended October 2, 2021 and September 26, 2020 was $ 42.25 and $ 15.83 , respectively.\n16\nTAPESTRY, INC. Notes to Condensed Consolidated Financial Statements (continued)\n11. DEBT\nThe following table summarizes the components of the Company’s outstanding debt:\n| October 2,2021 | July 3, 2021 |\n| (millions) |\n| Current debt: |\n| 3.000 % Senior Notes due 2022 | 400.0 | — |\n| Total current debt | $ | 400.0 | $ | — |\n| Long-term debt: |\n| 4.250 % Senior Notes due 2025 | $ | 600.0 | $ | 600.0 |\n| 3.000 % Senior Notes due 2022 | — | 400.0 |\n| 4.125 % Senior Notes due 2027 | 600.0 | 600.0 |\n| Total long-term debt | 1,200.0 | 1,600.0 |\n| Less: Unamortized discount and debt issuance costs on Senior Notes | ( 8.6 ) | ( 9.3 ) |\n| Total long-term debt, net | $ | 1,191.4 | $ | 1,590.7 |\n\nDuring three months ended October 2, 2021 and September 26, 2020, the Company recognized interest expense related to its debt of $ 16.8 million and $ 20.1 million, respectively.\nRevolving Credit Facility\nOn October 24, 2019, the Company entered into a definitive credit agreement whereby Bank of America, N.A., as administrative agent, the other agents party thereto, and a syndicate of banks and financial institutions have made available to the Company a $ 900.0 million revolving credit facility (\"Revolving Credit Facility\"), including sub-facilities for letters of credit, with a maturity date of October 24, 2024. The Revolving Credit Facility may be used to finance the working capital needs, capital expenditures, permitted investments, share purchases, dividends and other general corporate purposes of the Company and its subsidiaries (which may include commercial paper back-up). Letters of credit and swing line loans may be issued under the Revolving Credit Facility as described below.\nBorrowings under the Revolving Credit Facility bear interest at a rate per annum equal to, at the Borrowers’ option, either (a) an alternate base rate (which is a rate equal to the greatest of (i) the Prime Rate in effect on such day, (ii) the Federal Funds Effective Rate in effect on such day plus ½ of 1% or (iii) the Adjusted LIBO Rate for a one month Interest Period on such day plus 1 % or (b) a rate based on the rates applicable for deposits in the interbank market for U.S. Dollars or the applicable currency in which the loans are made plus, in each case, an applicable margin. The applicable margin will be determined by reference to a grid, as defined in the Credit Agreement, based on the ratio of (a) consolidated debt plus operating lease liability less excess cash above $ 300 million to (b) consolidated EBITDAR. Additionally, the Company pays a commitment fee at a rate determined by the reference to the aforementioned pricing grid.\nOn May 19, 2020 (the \"Effective Date\"), the Company entered into Amendment No. 1 (the “Amendment”) to the Revolving Credit Facility. Under the terms of the Amendment, during the period from the Effective Date until October 2, 2021, the Company must maintain available liquidity of $ 700 million (with available liquidity defined as the sum of unrestricted cash and cash equivalents and available commitments under credit facilities, including the Revolving Credit Facility). This requirement, among others that the Company is subject to during the period from the Effective Date until the compliance certificate is delivered for the fiscal quarter ending October 2, 2021 (the “Covenant Relief Period”), have been fulfilled. Going forward, the Company must comply on a quarterly basis with a maximum net leverage ratio of 4.0 to 1.0. The $ 900 million aggregate commitment amount under the Revolving Credit Facility remained unchanged under the amendment. There were no outstanding borrowings on the Revolving Credit Facility as of October 2, 2021.\n4.250 % Senior Notes due 2025\nOn March 2, 2015, the Company issued $ 600.0 million aggregate principal amount of 4.250 % senior unsecured notes due April 1, 2025 at 99.445 % of par (the “2025 Senior Notes”). Interest is payable semi-annually on April 1 and October 1 beginning October 1, 2015. Prior to January 1, 2025 ( 90 days prior to the scheduled maturity date), the Company may redeem the 2025 Senior Notes in whole or in part, at its option at any time or from time to time, at a redemption price equal to the greater of (1) 100 % of the principal amount of the 2025 Senior Notes to be redeemed or (2) the sum of the present values of the\n17\nTAPESTRY, INC. Notes to Condensed Consolidated Financial Statements (continued)\nremaining scheduled payments of principal and interest thereon that would have been payable in respect of the 2025 Senior Notes calculated as if the maturity date of the 2025 Senior Notes was January 1, 2025 (not including any portion of payments of interest accrued to the date of redemption), discounted to the redemption date on a semi-annual basis at the Adjusted Treasury Rate (as defined in the indenture for the 2025 Senior Notes) plus 35 basis points, plus, in the case of each of (1) and (2), accrued and unpaid interest to the redemption date. On and after January 1, 2025 ( 90 days prior to the scheduled maturity date), the Company may redeem the 2025 Senior Notes in whole or in part, at its option at any time or from time to time, at a redemption price equal to 100 % of the principal amount of the 2025 Senior Notes to be redeemed, plus accrued and unpaid interest to the redemption date.\n3.000 % Senior Notes due 2022\nOn June 20, 2017, the Company issued $ 400.0 million aggregate principal amount of 3.000 % senior unsecured notes due July 15, 2022 at 99.505 % of par (the \"2022 Senior Notes\"). Interest is payable semi-annually on January 15 and July 15 beginning January 15, 2018. Prior to June 15, 2022 (one month prior to the scheduled maturity date), the Company may redeem the 2022 Senior Notes in whole or in part, at its option at any time or from time to time, at a redemption price equal to the greater of (1) 100 % of the principal amount of the 2022 Senior Notes to be redeemed or (2) as determined by a Quotation Agent, the sum of the present values of the remaining scheduled payments of principal and interest thereon that would have been payable in respect of the 2022 Senior Notes calculated as if the maturity date of the 2022 Senior Notes was June 15, 2022 (not including any portion of payments of interest accrued to the date of redemption), discounted to the redemption date on a semi-annual basis (assuming a 360-day year consisting of twelve 30-day months) at the Adjusted Treasury Rate (as defined in the Prospectus Supplement) plus 25 basis points, plus, in the case of each of (1) and (2), accrued and unpaid interest to the redemption date.\n4.125 % Senior Notes due 2027\nOn June 20, 2017, the Company issued $ 600.0 million aggregate principal amount of 4.125 % senior unsecured notes due July 15, 2027 at 99.858 % of par (the \"2027 Senior Notes\"). Interest is payable semi-annually on January 15 and July 15 beginning January 15, 2018. Prior to April 15, 2027 (the date that is three months prior to the scheduled maturity date), the Company may redeem the 2027 Senior Notes in whole or in part, at its option at any time or from time to time, at a redemption price equal to the greater of (1) 100 % of the principal amount of the 2027 Senior Notes to be redeemed or (2) as determined by a Quotation Agent, the sum of the present values of the remaining scheduled payments of principal and interest thereon that would have been payable in respect of the 2027 Senior Notes calculated as if the maturity date of the 2027 Senior Notes was April 15, 2027 (not including any portion of payments of interest accrued to the date of redemption), discounted to the redemption date on a semi-annual basis (assuming a 360-day year consisting of twelve 30-day months) at the Adjusted Treasury Rate (as defined in the Prospectus Supplement) plus 30 basis points, plus, in the case of each of (1) and (2), accrued and unpaid interest to the redemption date.\nAt October 2, 2021, the fair value of the 2025, 2022 and 2027 Senior Notes was approximately $ 651.0 million, $ 406.9 million, and $ 657.0 million, respectively, based on external pricing data, including available quoted market prices of these instruments, and consideration of comparable debt instruments with similar interest rates and trading frequency, among other factors, and is classified as a Level 2 measurement within the fair value hierarchy. At July 3, 2021, the fair value of the 2025, 2022 and 2027 Senior Notes was approximately $ 651.9 million, $ 407.4 million and $ 659.3 million, respectively.\n12. FAIR VALUE MEASUREMENTS\nThe Company categorizes its assets and liabilities, based on the priority of the inputs to the valuation technique, into a three-level fair value hierarchy as set forth below. The three levels of the hierarchy are defined as follows:\nLevel 1 — Unadjusted quoted prices in active markets for identical assets or liabilities.\nLevel 2 — Observable inputs other than quoted prices included in Level 1. Level 2 inputs include quoted prices for identical assets or liabilities in non-active markets, quoted prices for similar assets or liabilities in active markets, and inputs other than quoted prices that are observable for substantially the full term of the asset or liability.\nLevel 3 — Unobservable inputs reflecting management’s own assumptions about the input used in pricing the asset or liability. The Company does not have any Level 3 investments.\n18\nTAPESTRY, INC. Notes to Condensed Consolidated Financial Statements (continued)\nThe following table shows the fair value measurements of the Company’s financial assets and liabilities at October 2, 2021 and July 3, 2021:\n| Level 1 | Level 2 |\n| October 2,2021 | July 3,2021 | October 2,2021 | July 3,2021 |\n| (millions) |\n| Assets: |\n| Cash equivalents(1) | $ | 79.4 | $ | 662.0 | $ | 12.8 | $ | 0.4 |\n| Short-term investments: |\n| Time deposits(2) | — | — | 0.7 | 0.7 |\n| Commercial paper(2) | — | — | 112.0 | — |\n| Government securities - U.S.(2) | 93.6 | — | 7.0 | — |\n| Corporate debt securities - U.S.(2) | — | — | 180.3 | — |\n| Other | — | — | 9.0 | 7.4 |\n| Long-term investments: |\n| Other | — | — | 0.1 | 0.1 |\n| Derivative assets: |\n| Intercompany loan and payable hedges(3) | — | — | 0.2 | 0.3 |\n| Liabilities: |\n| Derivative liabilities: |\n| Inventory-related instruments(3) | — | — | 1.8 | 1.2 |\n| Intercompany loan and payable hedges(3) | — | — | 1.6 | — |\n\n(1)Cash equivalents consist of money market funds and time deposits with maturities of three months or less at the date of purchase. Due to their short-term maturity, management believes that their carrying value approximates fair value.\n(2)Short-term investments are recorded at fair value, which approximates their carrying value, and are primarily based upon quoted vendor or broker priced securities in active markets.\n(3)The fair value of these hedges is primarily based on the forward curves of the specific indices upon which settlement is based and includes an adjustment for the counterparty’s or Company’s credit risk.\nRefer to Note 11, \"Debt,\" for the fair value of the Company's outstanding debt instruments.\nNon-Financial Assets and Liabilities\nThe Company’s non-financial instruments, which primarily consist of goodwill, intangible assets, right-of-use assets and property and equipment, are not required to be measured at fair value on a recurring basis and are reported at carrying value. However, on a periodic basis whenever events or changes in circumstances indicate that their carrying value may not be fully recoverable (and at least annually for goodwill and indefinite-lived intangible assets), non-financial instruments are assessed for impairment and, if applicable, written-down to and recorded at fair value, considering market participant assumptions. There were no impairment charges recorded during the three months ended October 2, 2021 or the three months ended September 26, 2020.\n19\nTAPESTRY, INC. Notes to Condensed Consolidated Financial Statements (continued)\n13. INVESTMENTS\nThe following table summarizes the Company’s U.S. dollar-denominated investments, recorded within the Company's Condensed Consolidated Balance Sheets as of October 2, 2021 and July 3, 2021:\n| October 2, 2021 | July 3, 2021 |\n| Short-term | Long-term | Total | Short-term | Long-term | Total |\n| (millions) |\n| Available-for-sale investments: |\n| Commercial paper(1) | $ | 112.0 | $ | — | $ | 112.0 | $ | — | $ | — | $ | — |\n| Government securities - U.S.(2) | 100.6 | — | 100.6 | — | — | — |\n| Corporate debt securities - U.S.(2) | 180.3 | — | 180.3 | — | — | — |\n| Available-for-sale investments, total | $ | 392.9 | $ | — | $ | 392.9 | $ | — | $ | — | $ | — |\n| Other: |\n| Time deposits(1) | $ | 0.7 | $ | — | $ | 0.7 | $ | 0.7 | $ | — | $ | 0.7 |\n| Other | 9.0 | 0.1 | 9.1 | 7.4 | 0.1 | 7.5 |\n| Total Investments | $ | 402.6 | $ | 0.1 | $ | 402.7 | $ | 8.1 | $ | 0.1 | $ | 8.2 |\n\n(1)These securities have original maturities greater than three months and are recorded at fair value.\n(2)These securities as of October 2, 2021 have maturity dates between calendar years 2021 and 2022 and are recorded at fair value.\nThere were no material gross unrealized gains or losses on available-for-sale investments as of the period ended October 2, 2021.\n14. INCOME TAXES\nThe Company's effective tax rate for the three months ended October 2, 2021 was 18.0 %, as compared to ( 25.0 )% for the three months ended September 26, 2020. The increase in effective tax rate is primarily due to geographic mix of earnings and the benefit from the net operating loss (\"NOL\") carryback claim recognized under the Coronavirus Aid, Relief and Economic Security (\"CARES\") Act during the three months ended September 26, 2020.\n15. COMMITMENTS AND CONTINGENCIES\nLetters of Credit\nThe Company had standby letters of credit, surety bonds and bank guarantees totaling $ 39.2 million and $ 40.5 million outstanding at October 2, 2021 and July 3, 2021, respectively. The agreements, which expire at various dates through calendar 2027, primarily collateralize the Company's obligation to third parties for duty, leases, insurance claims and materials used in product manufacturing. The Company pays certain fees with respect to these instruments that are issued.\nOther\nThe Company had other contractual cash obligations as of October 2, 2021 related to debt repayments. Refer to Note 11, \"Debt,\" for further information. Additionally, the Company had future payment obligations related to executed lease agreements for which the related lease had not yet commenced. Refer to Note 8, \"Leases,\" for further information.\nThe Company is involved in various routine legal proceedings as both plaintiff and defendant incident to the ordinary course of its business, including proceedings to protect Tapestry's intellectual property rights, litigation instituted by persons alleged to have been injured by advertising claims or upon premises within the Company’s control, contractual disputes, insurance claims and litigation with present or former employees.\nAs part of Tapestry’s policing program for its intellectual property rights, from time to time, the Company files lawsuits in the U.S. and abroad alleging acts of trademark counterfeiting, trademark infringement, patent infringement, trade dress infringement, copyright infringement, unfair competition, trademark dilution and/or state or foreign law claims. At any given point in time, Tapestry may have a number of such actions pending. These actions often result in seizure of counterfeit\n20\nTAPESTRY, INC. Notes to Condensed Consolidated Financial Statements (continued)\nmerchandise and/or out of court settlements with defendants. From time to time, defendants will raise, either as affirmative defenses or as counterclaims, the invalidity or unenforceability of certain of Tapestry’s intellectual properties.\nAlthough the Company's litigation as described above is routine and incidental to the conduct of Tapestry’s business, such litigation can result in large monetary awards, such as when a civil jury is allowed to determine compensatory and/or punitive damages.\nThe Company believes that the outcome of all pending legal proceedings in the aggregate will not have a material effect on the Company's business or condensed consolidated financial statements.\n16. SEGMENT INFORMATION\nThe Company has three reportable segments:\n•Coach - Includes global sales of Coach products to customers through Coach operated stores, including e-commerce sites and concession shop-in-shops, and sales to wholesale customers and through independent third party distributors.\n•Kate Spade - Includes global sales primarily of kate spade new york brand products to customers through Kate Spade operated stores, including e-commerce sites, sales to wholesale customers, through concession shop-in-shops and through independent third party distributors.\n•Stuart Weitzman - Includes global sales of Stuart Weitzman brand products primarily through Stuart Weitzman operated stores, including e-commerce sites, sales to wholesale customers and through numerous independent third party distributors.\nIn deciding how to allocate resources and assess performance, the Company's chief operating decision maker regularly evaluates the sales and operating income of these segments. Operating income is the gross margin of the segment less direct expenses of the segment.\nThe following table summarizes segment performance for the three months ended October 2, 2021 and September 26, 2020:\n| Coach | Kate Spade | Stuart Weitzman | Corporate(1) | Total |\n| (millions) |\n| Three Months Ended October 2, 2021 |\n| Net sales | $ | 1,114.9 | $ | 299.5 | $ | 66.5 | $ | — | $ | 1,480.9 |\n| Gross profit | 831.0 | 199.2 | 38.5 | — | 1,068.7 |\n| Operating income (loss) | 365.7 | 37.2 | ( 1.5 ) | ( 106.4 ) | 295.0 |\n| Income (loss) before provision for income taxes | 365.7 | 37.2 | ( 1.5 ) | ( 124.7 ) | 276.7 |\n| Depreciation and amortization expense(2) | 20.7 | 10.8 | 2.2 | 17.1 | 50.8 |\n| Additions to long-lived assets(3) | 12.8 | 1.0 | 0.2 | 19.4 | 33.4 |\n| Three Months Ended September 26, 2020 |\n| Net sales | $ | 875.4 | $ | 240.4 | $ | 56.4 | $ | — | $ | 1,172.2 |\n| Gross profit | 644.9 | 154.1 | 31.2 | — | 830.2 |\n| Operating income (loss) | 270.0 | 23.2 | — | ( 91.0 ) | 202.2 |\n| Income (loss) before provision for income taxes | 270.0 | 23.2 | — | ( 107.8 ) | 185.4 |\n| Depreciation and amortization expense(2) | 24.8 | 10.4 | 2.4 | 13.6 | 51.2 |\n| Additions to long-lived assets(3) | 10.9 | 4.6 | 0.5 | 10.0 | 26.0 |\n\n(1) Corporate, which is not a reportable segment, represents certain costs that are not directly attributable to a brand. These costs primarily include administration and certain information systems expense.\n(2) Depreciation and amortization expense for the segments includes an allocation of expense related to assets which support multiple segments.\n21\nTAPESTRY, INC. Notes to Condensed Consolidated Financial Statements (continued)\n(3) Additions to long-lived assets for the reportable segments primarily includes store assets as well as assets that support a specific brand. Corporate additions include all other assets which include a combination of Corporate assets, as well as assets that may support all segments. As such, depreciation expense for these assets may be subsequently allocated to a reportable segment.\n17. SUBSEQUENT EVENTS\nSubsequent to October 2, 2021, the Company announced that its Board of Directors had authorized the additional repurchase of up to $ 1.00 billion of its outstanding common stock. This authorization is incremental to the Company's existing authorization, under which $ 350.0 million remains. Pursuant to this program, purchases of the Company's common stock will be made subject to market conditions and at prevailing market prices, through open market purchases. Repurchased shares of common stock will become authorized but unissued shares. These shares may be issued in the future for general corporate and other purposes. In addition, the Company may terminate or limit the stock repurchase program at any time.\n22\nITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nThe following discussion of the Company's financial condition and results of operations should be read together with the Company's condensed consolidated financial statements and notes to those financial statements included elsewhere in this document. When used herein, the terms \"the Company,\" \"Tapestry,\" \"we,\" \"us\" and \"our\" refer to Tapestry, Inc., including consolidated subsidiaries. References to \"Coach,\" \"Stuart Weitzman,\" \"Kate Spade\" or \"kate spade new york\" refer only to the referenced brand.\nEXECUTIVE OVERVIEW\nTapestry, Inc. (the \"Company\") is a leading New York-based house of modern luxury accessories and lifestyle brands. Our global house of brands unites the magic of Coach, kate spade new york and Stuart Weitzman. Each of our brands are unique and independent, while sharing a commitment to innovation and authenticity defined by distinctive products and differentiated customer experiences across channels and geographies. We use our collective strengths to move our customers and empower our communities, to make the fashion industry more sustainable, and to build a company that’s equitable, inclusive, and diverse. Individually, our brands are iconic. Together, we can stretch what’s possible.\nThe Company has three reportable segments:\n•Coach - Includes global sales of Coach products to customers through Coach operated stores, including e-commerce sites and concession shop-in-shops, and sales to wholesale customers and through independent third party distributors.\n•Kate Spade - Includes global sales primarily of kate spade new york brand products to customers through Kate Spade operated stores, including e-commerce sites, sales to wholesale customers, through concession shop-in-shops and through independent third party distributors.\n•Stuart Weitzman - Includes global sales of Stuart Weitzman brand products primarily through Stuart Weitzman operated stores, including e-commerce sites, sales to wholesale customers and through numerous independent third party distributors.\nEach of our brands is unique and independent, while sharing a commitment to innovation and authenticity defined by distinctive products and differentiated customer experiences across channels and geographies. Our success does not depend solely on the performance of a single channel, geographic area or brand.\nAcceleration Program\nThe guiding principle of the Company’s multi-year growth agenda under the Acceleration Program is to better meet the needs of each of its brands' unique customers by:\n•Sharpening our Focus on the Consumer: Operating with a clearly defined purpose and strategy for each brand and an unwavering focus on the consumer at the core of everything we do\n•Leveraging Data and Leading with a Digital-First Mindset: Building significant data and analytics capabilities to drive decision-making and increase efficiency; Offering immersive customer experiences across our e-commerce and social channels to meet the needs of consumers who are increasingly utilizing digital platforms to engage with brands; Rethinking the role of stores with an intent to optimize our fleet\n•Transforming into a Leaner and More Responsive Organization: Moving with greater agility, simplifying internal processes and empowering teams to act quickly to meet the rapidly changing needs of the consumer\nIn the first quarter of fiscal 2022, the Company continues to make meaningful progress against its Acceleration Program to sharpen its focus on the consumer, leverage data to lead with a digital-first mindset and transform into a leaner and more responsive organization:\n•Recruited over 1.6 million new customers across channels in North America, representing an increase of over 20% versus prior year, with growth in stores and online;\n•Drove higher repeat transactions and continued to reactivate lapsed customers across brands through a sharpened focus on the consumer;\n•Realized low double-digit revenue gains with Chinese consumers globally compared to pre-pandemic levels, representing a sequential improvement from the prior quarter;\n•Increased global average unit retail (\"AUR\") across Coach, Kate Spade and Stuart Weitzman, reflecting strong brand momentum and successful structural changes to lessen promotional activity and improve assortment productivity;\n23\n•Advanced Digital capabilities through significant investments in the channel, including in talent, to improve the customer experience and drive conversion, resulting in a sequential acceleration in revenue trends on a two-year basis; and\n•Remain on track to realize gross run-rate savings of $300 million in FY22.\nRecent Developments\nCovid-19 Pandemic\nThe disruptions related to Covid-19 have materially adversely impacted our operations, cash flow, and liquidity. The virus has impacted all regions around the world, resulting in restrictions and shutdowns implemented by national, state, and local authorities. These requirements have resulted in closures of our directly operated stores and locations of our wholesale partners globally, causing a significant reduction in sales starting in the third quarter of fiscal 2020. While the vast majority of the Company's stores reopened for either in-store or curb-side service and have continued to operate since then, some store locations have experienced temporary re-closures or are operating under tighter restrictions in compliance with local government regulation, and other stores may be required to close again for an extended period of time due to the possibility of a resurgence of increased infections. The Company has noted that certain geographies have experienced increased infection rates due to new variants of Covid-19, resulting in a decline in store traffic in these regions. The Company currently expects that this trend will not have a material adverse impact on its financial results for Fiscal 2022. However, if such infections rates continue to rise resulting in further declines in store traffic, the Company's financial results may be negatively impacted from that which is currently expected.\nFurthermore, Covid-19 has and may continue to cause disruptions in the Company’s supply chain within our third-party manufacturers and logistics providers. The Company manufactures a significant amount of its products from Southeast Asia, which has and continues to experience increased rates of Covid-19. During the first quarter of fiscal 2022, certain of the Company’s third-party manufacturers, primarily located in Vietnam, have experienced ongoing and longer-than-expected government mandated restrictions, which resulted in a significant decrease in production capacity for these third-party manufacturers. In response, the Company took deliberate actions to mitigate the impact of these closures, such as shifting production to other countries, adjusting its merchandising strategies, where possible, and increasing the use of air freight to expedite delivery. In October 2021, some of these third-party manufacturers have begun to increase production capacity. The Company currently expects that these third-party manufacturers will return to full capacity in fiscal 2022, however the exact timing remains uncertain. If capacity restrictions in our third-party manufacturer facilities persist beyond our current expectations, our outlook might be negatively impacted from that which is currently expected.\nThe Company has been experiencing other global logistics challenges, such as delays as a result of port congestion, vessel availability, container shortages for imported products and rising freight costs. These challenges are expected to persist throughout fiscal 2022. The Company expects both ocean and air freight costs will continue to be higher as a result of elevated demand globally. The Company is working to mitigate delays through the strategic use of air freight with greater frequency than in the past.\nHowever, there is still uncertainty associated with the duration of these disruptions and the possibility of other effects on the business. We will continue to monitor the rapidly evolving situation pertaining to the Covid-19 outbreak, including guidance from international and domestic authorities. In these circumstances, the Company will need to adjust our operating plan. Refer to Part II, Item 1A. \"Risk Factors\" herein and as disclosed in our Annual Report on Form 10-K for the year ended July 3, 2021.\nThe Company continues to take strategic actions in response to the current environment. The Company remains committed to driving SG&A savings, including actions taken under the Acceleration Program. The Company will continue to consider near-term exigencies and the long-term financial health of the business as clear steps are taken to mitigate the consequences of the Covid-19 pandemic.\nAcceleration Program\nThe Company has implemented a strategic growth plan after undergoing a review of its business under the Acceleration Program, resulting in certain costs to date reflecting: (i) actions to streamline the Company's organization; (ii) select store closures as the Company optimizes its fleet (including store closure costs incurred as the Company exits certain regions in which it currently operates); and (iii) professional fees and compensation costs incurred as a result of the development and execution of the Company's comprehensive strategic initiatives aimed at increasing profitability. Including charges taken in fiscal 2020 and fiscal 2021, the Company expects to incur total pre-tax charges of approximately $205 - $220 million related to the Acceleration Program. The Acceleration Program is expected to be substantially complete by the end of fiscal 2022. The Company achieved approximately $200 million of gross run rate expense savings in fiscal 2021 and remains on track to realize gross run-rate savings of $300 million. Refer to Note 5, \"Restructuring Activities,\" and the \"GAAP to Non-GAAP Reconciliation,\" herein, for further information.\n24\nCurrent Trends and Outlook\nThe environment in which we operate is subject to a number of different factors driving global consumer spending. Consumer preferences, macroeconomic conditions, foreign currency fluctuations and geopolitical events continue to impact overall levels of consumer travel and spending on discretionary items, with inconsistent patterns across channels and geographies.\nThe outbreak of a novel strain of Covid-19 continues to impact a significant majority of the regions in which we operate, resulting in significant global business disruptions. The widespread impact of Covid-19 resulted in temporary closures of directly operated stores globally, as well as at our wholesale and licensing partners starting in fiscal 2020. Since then, certain directly operated stores and the stores of our wholesale and licensing partners have experienced temporary re-closures or are operating under tighter restrictions in compliance with local government regulation. Covid-19 has also resulted in ongoing supply chain challenges, such as logistic constraints, the closure of certain third-party manufacturers and increased freight costs. Refer to \"Recent Developments,\" herein, for further information.\nThe global Covid-19 pandemic is continuously evolving and the extent to which this impacts the Company - including unforeseen increased costs to the Company's business - will depend on future developments, which cannot be predicted, including the ultimate duration, severity and geographic resurgence of the virus and the success of actions to contain the virus, including variants of the novel strain, or treat its impact, among others.\nWhile pressures from supply chain disruptions and public health concerns due to mutations of Covid-19 virus linger, the International Monetary Fund continues to forecast growth in the global economy, which is contingent on multilateral vaccination efforts by members of the organization. Additionally, economists expect inflationary pressures to become more pronounced over the next year, which may be exacerbated if supply chain disruptions continue to impact businesses, among other factors, such as increasing real-estate and rental rates as well as higher prices on imported goods. However, these inflationary pressures may normalize to pre-pandemic levels during calendar year 2022, in the absence of unpredicted factors, based on current recovery and supported by ample labor supply through wage increases in advanced economies.\nCertain markets around the world have been faced with labor shortages, which have not impacted the Company's operations to date. If these trends continue or worsen, it could potentially affect the Company's ability to attract and retain employees for its retail and fulfillment locations in the future.\nFurthermore, currency volatility, political instability and potential changes to trade agreements or duty rates may contribute to a worsening of the macroeconomic environment or adversely impact our business. Since fiscal 2019, the U.S. and China have both imposed tariffs on the importation of certain product categories into the respective country, with limited progress in negotiations to reduce or remove the tariffs. However, while the U.S. has participated in multi-national negotiations on trade agreements and duty rates, there continues to be a possibility of increases in tariffs on goods imported into the U.S. from other countries.\nFurthermore, certain tax legislation contemplated by the Biden Administration, including increasing the U.S. corporate tax rate, and by the Organization for Economic Co-operation and Development, would have an adverse impact on our tax rate and financial results if passed as currently communicated.\nWe will continue to monitor these trends and evaluate and adjust our operating strategies and cost management opportunities to mitigate the related impact on our results of operations, while remaining focused on the long-term growth of our business and protecting the value of our brands.\nFor a detailed discussion of significant risk factors that have the potential to cause our actual results to differ materially from our expectations, see Part II, Item 1A. \"Risk Factors\" herein and as disclosed in our Annual Report on Form 10-K for the year ended July 3, 2021.\n25\nFIRST QUARTER FISCAL 2022 COMPARED TO FIRST QUARTER FISCAL 2021\nThe following table summarizes results of operations for the first quarter of fiscal 2022 compared to the first quarter of fiscal 2021. All percentages shown in the table below and the discussion that follows have been calculated using unrounded numbers.\n| Three Months Ended |\n| October 2, 2021 | September 26, 2020 | Variance |\n| (millions, except per share data) |\n| Amount | % ofnet sales | Amount | % ofnet sales | Amount | % |\n| Net sales | $ | 1,480.9 | 100.0 | % | $ | 1,172.2 | 100.0 | % | $ | 308.7 | 26.3 | % |\n| Gross profit | 1,068.7 | 72.2 | 830.2 | 70.8 | 238.5 | 28.7 |\n| SG&A expenses | 773.7 | 52.2 | 628.0 | 53.6 | 145.7 | 23.2 |\n| Operating income (loss) | 295.0 | 19.9 | 202.2 | 17.3 | 92.8 | 45.9 |\n| Interest expense, net | 16.1 | 1.1 | 19.4 | 1.7 | (3.3) | (16.9) |\n| Other expense (income) | 2.2 | 0.2 | (2.6) | (0.2) | 4.8 | NM |\n| Provision (benefit) for income taxes | 49.8 | 3.4 | (46.3) | (4.0) | 96.1 | NM |\n| Net income (loss) | 226.9 | 15.3 | 231.7 | 19.8 | (4.8) | (2.1) |\n| Net income (loss) per share: |\n| Basic | $ | 0.82 | $ | 0.84 | $ | (0.02) | (2.5) |\n| Diluted | $ | 0.80 | $ | 0.83 | $ | (0.03) | (4.6) |\n\nNM - Not meaningful\nGAAP to Non-GAAP Reconciliation\nThe Company’s reported results are presented in accordance with accounting principles generally accepted in the United States of America (\"GAAP\"). The reported results during the first quarter of fiscal 2022 and fiscal 2021 reflect certain items which affect the comparability of our results, as noted in the following tables. Refer to \"Non-GAAP Measures\" herein for further discussion on the Non-GAAP measures.\n26\nFirst Quarter Fiscal 2022 Items\n| Three Months Ended October 2, 2021 |\n| Item Affecting Comparability |\n| GAAP Basis(As Reported) | Acceleration Program | Non-GAAP Basis(Excluding Items) |\n| (millions, except per share data) |\n| Coach | 831.0 | — | 831.0 |\n| Kate Spade | 199.2 | — | 199.2 |\n| Stuart Weitzman | 38.5 | — | 38.5 |\n| Gross profit(1) | $ | 1,068.7 | $ | — | $ | 1,068.7 |\n| Coach | 465.3 | 1.4 | 463.9 |\n| Kate Spade | 162.0 | 1.4 | 160.6 |\n| Stuart Weitzman | 40.0 | 0.4 | 39.6 |\n| Corporate | 106.4 | 8.9 | 97.5 |\n| SG&A expenses | $ | 773.7 | $ | 12.1 | $ | 761.6 |\n| Coach | 365.7 | (1.4) | 367.1 |\n| Kate Spade | 37.2 | (1.4) | 38.6 |\n| Stuart Weitzman | (1.5) | (0.4) | (1.1) |\n| Corporate | (106.4) | (8.9) | (97.5) |\n| Operating income (loss) | $ | 295.0 | $ | (12.1) | $ | 307.1 |\n| Provision for income taxes | 49.8 | (3.9) | 53.7 |\n| Net income (loss) | $ | 226.9 | $ | (8.2) | $ | 235.1 |\n| Net income (loss) per diluted common share | $ | 0.80 | $ | (0.02) | $ | 0.82 |\n\n(1)Adjustments within Gross profit are recorded within Cost of sales.\nIn the first quarter of fiscal 2022 the Company incurred charges as follows:\n•Acceleration Program - Total charges incurred under the Acceleration Program are primarily share-based compensation and professional fees incurred as a result of the development and execution of the Company's comprehensive strategic initiatives. Refer to the \"Executive Overview\" herein and Note 5, \"Restructuring Activities,\" for further information.\nThese actions taken together increased the Company's SG&A expenses by $12.1 million and reduced Provision for income taxes by $3.9 million, negatively impacting Net income by $8.2 million or $0.02 per diluted share.\n27\nFirst Quarter Fiscal 2021 Items\n| Three Months Ended September 26, 2020 |\n| Items Affecting Comparability |\n| GAAP Basis(As Reported) | CARES Act Tax Impact | Acceleration Program | Non-GAAP Basis(Excluding Items) |\n| (millions, except per share data) |\n| Coach | 644.9 | — | — | 644.9 |\n| Kate Spade | 154.1 | — | — | 154.1 |\n| Stuart Weitzman | 31.2 | — | — | 31.2 |\n| Gross profit(1) | $ | 830.2 | $ | — | $ | — | $ | 830.2 |\n| Coach | 374.9 | — | 10.7 | 364.2 |\n| Kate Spade | 130.9 | — | 1.0 | 129.9 |\n| Stuart Weitzman | 31.2 | — | (2.4) | 33.6 |\n| Corporate | 91.0 | — | 17.3 | 73.7 |\n| SG&A expenses | $ | 628.0 | $ | — | $ | 26.6 | $ | 601.4 |\n| Coach | 270.0 | — | (10.7) | 280.7 |\n| Kate Spade | 23.2 | — | (1.0) | 24.2 |\n| Stuart Weitzman | — | — | 2.4 | (2.4) |\n| Corporate | (91.0) | — | (17.3) | (73.7) |\n| Operating income (loss) | $ | 202.2 | $ | — | $ | (26.6) | $ | 228.8 |\n| Provision for income taxes | (46.3) | (91.7) | (5.8) | 51.2 |\n| Net income (loss) | $ | 231.7 | $ | 91.7 | $ | (20.8) | $ | 160.8 |\n| Net income (loss) per diluted common share | $ | 0.83 | $ | 0.33 | $ | (0.08) | $ | 0.58 |\n\n(1)Adjustments within Gross profit are recorded within Cost of sales.\nIn the first quarter of fiscal 2021, the Company incurred charges as follows:\n•CARES Act Tax Impact - Total amount primarily relates to the income tax benefits, most notably as a result of the Net Operating Loss (\"NOL\") carryback claim. Refer to Note 14, \"Income Taxes\" for further information.\n•Acceleration Program - Total charges incurred under the Acceleration Program are primarily professional fees incurred as a result of the development and execution of the Company's strategic initiatives, as well as actions to streamline the Company's organization, which include severance. Refer to the \"Executive Overview\" herein and Note 5, \"Restructuring Activities,\" for further information.\nThese actions taken together increased the Company's SG&A expenses by $26.6 million and reduced Provision for income taxes by $97.5 million, positively impacting Net income by $70.9 million or $0.25 per diluted share.\nTapestry, Inc. Summary – First Quarter of Fiscal 2022\nCurrency Fluctuation Effects\nThe change in net sales and gross margin for the first quarter of fiscal 2022 compared to the first quarter of fiscal 2021 has been presented both including and excluding currency fluctuation effects. All percentages shown in the tables below and the discussion that follows have been calculated using unrounded numbers.\n28\nNet Sales\nIn addition to comparisons to fiscal year 2021 results, the Company has provided comparisons to certain fiscal year 2020 results, which the Company believes is useful to investors and others in evaluating the Company’s results, due to the significant impact of the Covid-19 pandemic on the Company’s operations and financial results, which started in the second half of fiscal year 2020.\n| Three Months Ended | Variance |\n| October 2,2021 | September 26,2020 | Amount | % | Constant Currency Change | % Change versus FY20 |\n| (millions) |\n| Coach | $ | 1,114.9 | $ | 875.4 | $ | 239.5 | 27.4 | % | 25.6 | % | 15.4 | % |\n| Kate Spade | 299.5 | 240.4 | 59.1 | 24.5 | 23.8 | (2.0) |\n| Stuart Weitzman | 66.5 | 56.4 | 10.1 | 17.9 | 14.8 | (23.1) |\n| Total Tapestry | $ | 1,480.9 | $ | 1,172.2 | $ | 308.7 | 26.3 | 24.7 | 9.1 |\n\nNet sales in the first quarter of fiscal 2022 increased 26.3% or $308.7 million to $1.48 billion. Excluding the effects of foreign currency, net sales increased by 24.7% or $289.6 million.\n•Coach Net Sales increased 27.4% or $239.5 million to $1.11 billion in the first quarter of fiscal 2022. Excluding the impact of foreign currency, net sales increased 25.6% or $223.9 million. This increase in net sales is primarily attributed to an increase of $183.9 million in net global retail sales driven by higher global e-commerce sales and store sales in North America, partially offset by lower store sales in Other Asia, including Japan, due to the impact of Covid-19. This increase in net sales is also partially attributed to a $37.9 million increase in wholesale sales.\n•Kate Spade Net Sales increased 24.5% or $59.1 million to $299.5 million in the first quarter of fiscal 2022. Excluding the impact of foreign currency, net sales increased 23.8% or $57.3 million. This increase is primarily due to an increase of $43.2 million in net global retail sales driven by higher store sales and global e-commerce sales in North America, partially offset by lower store sales in Other Asia, notably Japan, as well as Greater China. This increase in net sales is also partially attributed to a $15.3 million increase in wholesale sales.\n•Stuart Weitzman Net Sales increased 17.9% or $10.1 million to $66.5 million in the first quarter of fiscal 2022. Excluding the impact of foreign currency, net sales increased 14.8% or $8.4 million. This increase was primarily due to a net increase of $5.0 million in the retail business, which is attributed to an increase in global e-commerce sales and an increase in store sales in North America and mainland China, partially offset by store closures. This increase in net sales is also partially attributed to a $3.4 million increase in wholesale sales.\nGross Profit\n| Three Months Ended |\n| October 2, 2021 | September 26, 2020 | Variance |\n| (millions) |\n| Amount | % of Net Sales | Amount | % of Net Sales | Amount | % |\n| Coach | $ | 831.0 | 74.5 | % | $ | 644.9 | 73.7 | % | $ | 186.1 | 28.8 | % |\n| Kate Spade | 199.2 | 66.5 | 154.1 | 64.1 | 45.1 | 29.3 |\n| Stuart Weitzman | 38.5 | 57.9 | 31.2 | 55.3 | 7.3 | 23.4 |\n| Tapestry | $ | 1,068.7 | 72.2 | $ | 830.2 | 70.8 | $ | 238.5 | 28.7 |\n\nGross profit increased 28.7% or $238.5 million to $1.07 billion in the first quarter of fiscal 2022 from $830.2 million in the first quarter of fiscal 2021. Gross margin for the first quarter of fiscal 2022 was 72.2% as compared to 70.8% in the first quarter of fiscal 2021. Gross margin increased 140 basis points and on a constant currency basis, gross margin increased 130 basis points from the first quarter of fiscal 2021.\nThe Company includes inbound product-related transportation costs from our service providers within Cost of sales. The Company, similar to some companies, includes certain transportation-related costs due to our distribution network in SG&A expenses rather than in Cost of sales; for this reason, our gross margins may not be comparable to that of entities that include all costs related to their distribution network in Cost of sales.\n29\n•Coach Gross Profit increased 28.8% or $186.1 million to $831.0 million in the first quarter of fiscal 2022 from $644.9 million in the first quarter of fiscal 2021. Gross margin increased to 74.5% in the first quarter of fiscal 2022 from 73.7% in the first quarter of fiscal 2021. Gross margin increased 80 basis points and gross margin was not materially impacted by foreign currency. This increase in gross margin was primarily due to reduced promotional activity and higher AUR, partially offset by unfavorable geography mix and higher inbound freight expense.\n•Kate Spade Gross Profit increased 29.3% or $45.1 million to $199.2 million in the first quarter of fiscal 2022 from $154.1 million in the first quarter of fiscal 2021. Gross margin increased to 66.5% in the first quarter of fiscal 2022 from 64.1% in the first quarter of fiscal 2021. Gross margin increased 240 basis points and gross margin was not materially impacted by foreign currency. This increase in gross margin was primarily due to reduced promotional activity and higher AUR, partially offset by unfavorable geography mix and higher inbound freight expense.\n•Stuart Weitzman Gross Profit increased 23.4% or $7.3 million to $38.5 million during the first quarter of fiscal 2022 from $31.2 million in the first quarter of fiscal 2021. Gross margin increased to 57.9% in the first quarter of fiscal 2022 from 55.3% in the first quarter of fiscal 2021. Gross margin increased 260 basis points and on a constant currency basis, gross margin increased 210 basis points from the first quarter of fiscal 2021. This increase in gross margin was primarily due to reduced promotional activity and favorable geography mix, partially offset by higher inbound freight expense.\nSelling, General and Administrative Expenses (\"SG&A\")\n| Three Months Ended |\n| October 2, 2021 | September 26, 2020 | Variance |\n| (millions) |\n| Amount | % of Net Sales | Amount | % of Net Sales | Amount | % |\n| Coach | $ | 465.3 | 41.7 | % | $ | 374.9 | 42.8 | % | $ | 90.4 | 24.1 | % |\n| Kate Spade | 162.0 | 54.1 | 130.9 | 54.5 | 31.1 | 23.7 |\n| Stuart Weitzman | 40.0 | 60.2 | 31.2 | 55.2 | 8.8 | 28.4 |\n| Corporate | 106.4 | NA | 91.0 | NA | 15.4 | 17.0 |\n| Tapestry | $ | 773.7 | 52.2 | $ | 628.0 | 53.6 | $ | 145.7 | 23.2 |\n\nSG&A expenses increased 23.2% or $145.7 million to $773.7 million in the first quarter of fiscal 2022 as compared to $628.0 million in the first quarter of fiscal 2021. As a percentage of net sales, SG&A expenses decreased to 52.2% during the first quarter of fiscal 2022 from 53.6% in the first quarter of fiscal 2021. Excluding items affecting comparability of $12.1 million and $26.6 million in the first quarter of fiscal 2022 and fiscal 2021, respectively, SG&A expenses increased 26.6% or $160.2 million to $761.6 million from $601.4 million in the first quarter of fiscal 2021. SG&A as a percentage of sales increased to 51.4% as compared to 51.3% during the first quarter of fiscal 2021.\n•Coach SG&A Expenses increased 24.1% or $90.4 million to $465.3 million in the first quarter of fiscal 2022 as compared to $374.9 million in the first quarter of fiscal 2021. SG&A expenses as a percentage of net sales decreased to 41.7% during the first quarter of fiscal 2022 from 42.8% during the first quarter of fiscal 2021. Excluding items affecting comparability of $1.4 million and $10.7 million in the first quarter of fiscal 2022 and fiscal 2021, respectively, SG&A expenses increased 27.3% or $99.7 million to $463.9 million during the first quarter of fiscal 2022; and SG&A expenses as a percentage of net sales remained flat at 41.6% in the first quarter of fiscal 2022. This increase in SG&A expenses is primarily due to increased marketing spend, most notably in digital, increased selling and operational costs in support of higher e-commerce sales and increased compensation costs due to stores trending back to normal operations in the first quarter of fiscal 2022 as compared to the first quarter of fiscal 2021, where stores were more notably impacted by Covid-19.\n•Kate Spade SG&A Expenses increased 23.7% or $31.1 million to $162.0 million in the first quarter of fiscal 2022 as compared to $130.9 million in the first quarter of fiscal 2021. As a percentage of net sales, SG&A expenses decreased to 54.1% during the first quarter of fiscal 2022 as compared to 54.5% during the first quarter of fiscal 2021. Excluding items affecting comparability of $1.4 million and $1.0 million in the first quarter of fiscal 2022 and fiscal 2021, respectively, SG&A expenses increased 23.7% or $30.7 million to $160.6 million during the first quarter of fiscal 2022; and SG&A expenses as a percentage of net sales decreased to 53.7% in the first quarter of fiscal 2022 from 54.0% in the first quarter of fiscal 2021. This increase in SG&A expenses is primarily due to higher marketing spend most notably in digital, and increased compensation costs due to stores trending back to normal operations in the first quarter of fiscal 2022 as compared to the first quarter of fiscal 2021, where stores were more notably impacted by Covid-19 and increased selling and operational costs in support of higher e-commerce sales.\n30\n•Stuart Weitzman SG&A Expenses increased 28.4% or $8.8 million to $40.0 million in the first quarter of fiscal 2022 as compared to $31.2 million in the first quarter of fiscal 2021. As a percentage of net sales, SG&A expenses increased to 60.2% during the first quarter of fiscal 2022 as compared to 55.2% during the first quarter of fiscal 2021. Excluding items affecting comparability of $0.4 million and $(2.4) million in the first quarter of fiscal 2022 and fiscal 2021, respectively, SG&A expenses increased 17.9% or $6.0 million to $39.6 million during the first quarter of fiscal 2022 from $33.6 million during the first quarter of fiscal 2021; and SG&A expenses as a percentage of net sales decreased to 59.4% in the first quarter of fiscal 2022 from 59.5% in the first quarter of fiscal 2021. This increase is primarily due to a true up of reserves in the first quarter of fiscal 2021 and higher marketing spend most notably in digital in the first quarter of fiscal 2022.\n•Corporate expenses, which are included within SG&A expenses discussed above but are not directly attributable to a reportable segment, increased 17.0% or $15.4 million to $106.4 million in the first quarter of fiscal 2022 as compared to $91.0 million in the first quarter of fiscal 2021. Excluding items affecting comparability of $8.9 million and $17.3 million in the first quarter of fiscal 2022 and fiscal 2021, respectively, SG&A expenses increased 32.3% or $23.8 million to $97.5 million in the first quarter of fiscal 2022 as compared to $73.7 million in the first quarter of fiscal 2021. This increase in SG&A expenses was primarily driven by the gain on the sale of our corporate office in Hong Kong SAR, China in the first quarter of fiscal 2021 and higher compensation costs.\nOperating Income (Loss)\n| Three Months Ended |\n| October 2, 2021 | September 26, 2020 | Variance |\n| (millions) |\n| Amount | % of Net Sales | Amount | % of Net Sales | Amount | % |\n| Coach | $ | 365.7 | 32.8 | % | $ | 270.0 | 30.8 | % | $ | 95.7 | 35.4 | % |\n| Kate Spade | 37.2 | 12.4 | 23.2 | 9.6 | 14.0 | 60.8 |\n| Stuart Weitzman | (1.5) | (2.3) | — | — | (1.5) | NM |\n| Corporate | (106.4) | NA | (91.0) | NA | (15.4) | 17.0 |\n| Tapestry | $ | 295.0 | 19.9 | $ | 202.2 | 17.3 | $ | 92.8 | 45.9 |\n\nOperating income increased 45.9% or $92.8 million to $295.0 million in the first quarter of fiscal 2022 as compared to an operating income of $202.2 million in the first quarter of fiscal 2021. Operating margin was 19.9% in the first quarter of fiscal 2022 as compared to 17.3% in the first quarter of fiscal 2021. Excluding items affecting comparability of $12.1 million and $26.6 million in the first quarter of fiscal 2022 and fiscal 2021, respectively, operating income increased 34.2% or $78.3 million to $307.1 million in the first quarter of fiscal 2022 from $228.8 million in the first quarter of fiscal 2021; and operating margin increased to 20.7% in the first quarter of fiscal 2022 as compared to 19.5% in the first quarter of fiscal 2021.\n•Coach Operating Income increased 35.4% or $95.7 million to $365.7 million in the first quarter of fiscal 2022, resulting in an operating margin of 32.8%, as compared to $270.0 million and 30.8%, respectively, in the first quarter of fiscal 2021. Excluding items affecting comparability, Coach operating income increased 30.8% or $86.4 million to $367.1 million from $280.7 million in the first quarter of fiscal 2021; and operating margin was 32.9% in the first quarter of fiscal 2022 as compared to 32.1% in the first quarter of fiscal 2021.\n•Kate Spade Operating Income increased 60.8% or $14.0 million to $37.2 million in the first quarter of fiscal 2022, resulting in an operating margin of 12.4%, as compared to an operating income of $23.2 million and operating margin of 9.6% in the first quarter of fiscal 2021. Excluding items affecting comparability, Kate Spade operating income increased 59.2% or $14.4 million to $38.6 million from $24.2 million in the first quarter of fiscal 2021; and operating margin was 12.9% in the first quarter of fiscal 2022 as compared to 10.1% in the first quarter of fiscal 2021.\n•Stuart Weitzman Operating Loss increased $1.5 million to $1.5 million in the first quarter of fiscal 2022, resulting in an operating margin of (2.3)%, as compared to an operating loss of $0.0 million in the first quarter of fiscal 2021. Excluding items affecting comparability, Stuart Weitzman operating loss decreased $1.3 million to $1.1 million, resulting in an operating margin of (1.6)%, as compared to operating loss of $2.4 million and operating margin of (4.2)% in the first quarter of fiscal 2021.\nInterest Expense, net\nInterest expense, net decreased 16.9% or $3.3 million to $16.1 million in the first quarter of fiscal 2022 as compared to $19.4 million in the first quarter of fiscal 2021. This decrease in interest expense, net is mainly due to lower interest expense due to the repayment of the Revolving Credit Facility during fiscal 2021.\n31\nOther Expense (Income)\nOther expense increased $4.8 million to $2.2 million in the first quarter of fiscal 2022 as compared to income of $2.6 million in the first quarter of fiscal 2021. This increase in other expense is related to an increase in foreign exchange losses.\nProvision (Benefit) for Income Taxes\nThe effective tax rate was 18.0% in the first quarter of fiscal 2022 as compared to (25.0)% in the first quarter of fiscal 2021. Excluding items affecting comparability, the effective tax rate was 18.6% in the first quarter of 2022 as compared to 24.1% in the first quarter of fiscal 2021. This decrease in our effective tax rate was primarily attributable to the impact of vesting of equity compensation awards during the period and geographic mix of earnings.\nNet Income (Loss)\nNet income decreased 2.1% or $4.8 million to $226.9 million in the first quarter of fiscal 2022 as compared to $231.7 million in the first quarter of fiscal 2021. Excluding items affecting comparability, net income increased 46.2% or $74.3 million to a net income of $235.1 million in the first quarter of fiscal 2022 as compared to $160.8 million in the first quarter of fiscal 2021. This increase was primarily due to higher operating income.\nNet Income (Loss) per Share\nNet income per diluted share decreased 4.6% or $0.03 to $0.80 in the first quarter of fiscal 2022 as compared to $0.83 in the first quarter of fiscal 2021. Excluding items affecting comparability, net income per diluted share increased 42.4% or $0.24 to $0.82 in the first quarter of fiscal 2022 as compared to $0.58 in the first quarter of fiscal 2021. This change was primarily due to higher net income.\n32\nNON-GAAP MEASURES\nThe Company’s reported results are presented in accordance with GAAP. The reported SG&A expenses, operating income, provision for income taxes, net income and earnings per diluted share in the first quarter of fiscal 2022 and fiscal 2021 reflect certain items, including Acceleration Program costs in fiscal 2022 and fiscal 2021 and the CARES Act Tax Impact in fiscal 2021. As a supplement to the Company's reported results, these metrics are also reported on a non-GAAP basis to exclude the impact of these items, along with a reconciliation to the most directly comparable GAAP measures.\nThe Company has historically reported comparable store sales, which reflects sales performance at stores that have been open for at least 12 months, and includes sales from e-commerce sites. The Company excludes new stores, including newly acquired locations, from the comparable store base for the first twelve months of operation. The Company excludes closed stores from the calculation. Comparable store sales are not adjusted for store expansions. Due to extensive full and partial store closures resulting from the impact of the Covid-19 pandemic, comparable store sales are not reported for the three months ended October 2, 2021 as the Company does not believe this metric is currently meaningful to the readers of its financial statements for this period.\nThese non-GAAP performance measures were used by management to conduct and evaluate its business during its regular review of operating results for the periods affected. Management and the Company’s Board utilized these non-GAAP measures to make decisions about the uses of Company resources, analyze performance between periods, develop internal projections and measure management performance. The Company’s internal management reporting excluded these items. In addition, the human resources committee of the Company’s Board uses these non-GAAP measures when setting and assessing achievement of incentive compensation goals.\nThe Company operates on a global basis and reports financial results in U.S. dollars in accordance with GAAP. Fluctuations in foreign currency exchange rates can affect the amounts reported by the Company in U.S. dollars with respect to its foreign revenues and profit. Accordingly, certain material increases and decreases in operating results for the Company and its segments have been presented both including and excluding currency fluctuation effects. These effects occur from translating foreign-denominated amounts into U.S. dollars and comparing to the same period in the prior fiscal year. Constant currency information compares results between periods as if exchange rates had remained constant period-over-period. The Company calculates constant currency revenue results by translating current period revenue in local currency using the prior year period's currency conversion rate.\nWe believe these non-GAAP measures are useful to investors and others in evaluating the Company’s ongoing operating and financial results in a manner that is consistent with management's evaluation of business performance and understanding how such results compare with the Company’s historical performance. Additionally, we believe presenting certain increases and decreases in constant currency provides a framework for assessing the performance of the Company's business outside the United States and helps investors and analysts understand the effect of significant year-over-year currency fluctuations. We believe excluding these items assists investors and others in developing expectations of future performance.\nBy providing the non-GAAP measures, as a supplement to GAAP information, we believe we are enhancing investors’ understanding of our business and our results of operations. The non-GAAP financial measures are limited in their usefulness and should be considered in addition to, and not in lieu of, GAAP financial measures. Further, these non-GAAP measures may be unique to the Company, as they may be different from non-GAAP measures used by other companies.\nFor a detailed discussion on these non-GAAP measures, see Item 2. \"Management’s Discussion and Analysis of Financial Condition and Results of Operations.\"\n33\nLIQUIDITY AND CAPITAL RESOURCES\nCash Flows\n| Three Months Ended |\n| October 2,2021 | September 26,2020 | Change |\n| (millions) |\n| Net cash provided by (used in) operating activities | $ | 21.8 | $ | 90.0 | $ | (68.2) |\n| Net cash used in investing activities | (428.4) | (2.0) | (426.4) |\n| Net cash used in financing activities | (346.2) | (8.4) | (337.8) |\n| Effect of exchange rate changes on cash and cash equivalents | (2.3) | 8.0 | (10.3) |\n| Net increase/ (decrease) in cash and cash equivalents | $ | (755.1) | $ | 87.6 | $ | (842.7) |\n\nThe Company’s cash and cash equivalents decreased by $755.1 million in the first quarter of fiscal 2022 as compared to an increase of $87.6 million in the first three months ended of fiscal 2021, as discussed below.\nNet cash provided by (used in) operating activities\nNet cash provided by operating activities decreased $68.2 million due to changes in operating assets and liabilities of $178.4 million and lower net income of $4.8 million, partially off by the impact of non-cash adjustments of $115.0 million.\nThe $178.4 million decrease in changes in operating asset and liability balances were primarily driven by the following:\n•Accounts payable were a use of cash of $32.7 million in the first three months ended of fiscal 2022 compared to a source of cash of $135.1 million in the first three months ended of fiscal 2021, primarily due to the extension of payment terms to certain vendors in the first quarter of fiscal 2021.\n•Accrued liabilities were a use of cash of $140.3 million in the first three months ended of fiscal 2022 compared to a use of cash of $61.2 million in the first three months ended of fiscal 2021, primarily attributed to the Annual Incentive Plan payment as the Company did not pay out under its Annual Incentive Plan during fiscal 2021, partially offset by the timing of tax payments and employee-related costs.\n•Inventories were a use of cash of $84.8 million in the first three months ended of fiscal 2022 compared to a use of cash of $57.5 million in the first three months ended of fiscal 2021, primarily driven by increased inbound freight costs.\n•Other assets were a source of cash of $48.5 million in the first three months ended of fiscal 2022 compared to a use of cash of $66.4 million in the first three months ended of fiscal 2021, primarily related to the income tax receivable filed in the first quarter of fiscal 2021 primarily due to the NOL carryback claim under the CARES Act.\nNet cash used in investing activities\nNet cash used in investing activities in the first three months ended of fiscal 2022 was $428.4 million as compared to a use of cash of $2.0 million in the first three months ended of fiscal 2021, resulting in a $426.4 million increase in net cash used in investing activities.\nThe $428.4 million use of cash in the first three months ended of fiscal 2022 is primarily due to purchases of investments of $402.9 million and purchases of property and equipment of $33.4 million, partially offset by proceeds from maturities and sales of investments $7.9 million.\nThe $2.0 million use of cash in the first three months ended of fiscal 2021 is primarily due to capital expenditures of $26.0 million, offset by the sale of building of $23.9 million.\nNet cash used in financing activities\nNet cash used in financing activities was $346.2 million in the first three months ended of fiscal 2022 as compared to a use of cash of $8.4 million in the first three months ended of fiscal 2021, resulting in a net increase in use of cash for financing activities of $337.8 million.\nThe $346.2 million of cash used in the first three months ended of fiscal 2022 was primarily due to repurchase of common stock of $250.0 million and dividend payments of $69.6 million.\nThe $8.4 million use of cash in the first three months ended of fiscal 2021 was primarily due to taxes paid to net settle share-based awards of $8.2 million.\n34\nWorking Capital and Capital Expenditures\nAs of October 2, 2021, in addition to our cash flows from operations, our sources of liquidity and capital resources were comprised of the following:\n| Sources of Liquidity | Outstanding Indebtedness | Total Available Liquidity(1) |\n| (millions) |\n| Cash and cash equivalents(1) | $ | 1,252.6 | $ | — | $ | 1,252.6 |\n| Short-term investments(1) | 402.6 | — | 402.6 |\n| Revolving Credit Facility(2) | 900.0 | — | 900.0 |\n| 3.000% Senior Notes due 2022(3) | 400.0 | 400.0 | — |\n| 4.250% Senior Notes due 2025(3) | 600.0 | 600.0 | — |\n| 4.125% Senior Notes due 2027(3) | 600.0 | 600.0 | — |\n| Total | $ | 4,155.2 | $ | 1,600.0 | $ | 2,555.2 |\n\n(1) As of October 2, 2021, approximately 21% of our cash and short-term investments were held outside the United States. The Company will likely repatriate some portion of available foreign cash in the foreseeable future, and has recorded deferred taxes on certain earnings of non-US subsidiaries that are deemed likely to be repatriated.\n(2) In October 2019, the Company entered into a definitive credit agreement whereby Bank of America, N.A., as administrative agent, the other agents party thereto, and a syndicate of banks and financial institutions have made available to the Company a $900.0 million revolving credit facility, including sub-facilities for letters of credit, with a maturity date of October 24, 2024 (the \"Revolving Credit Facility\"). Borrowings under the Revolving Credit Facility bear interest at a rate per annum equal to, at the Borrowers’ option, either (a) an alternate base rate (which is a rate equal to the greatest of (i) the Prime Rate in effect on such day, (ii) the Federal Funds Effective Rate in effect on such day plus ½ of 1% or (iii) the Adjusted LIBO Rate for a one month Interest Period on such day plus 1%) or (b) a rate based on the rates applicable for deposits in the interbank market for U.S. Dollars or the applicable currency in which the loans are made plus, in each case, an applicable margin. The applicable margin will be determined by reference to a grid, defined in the Credit Agreement, based on the ratio of (a) consolidated debt plus operating lease liability less excess cash above $300 million to (b) consolidated EBITDAR. Additionally, the Company pays a commitment fee at a rate determined by the reference to the aforementioned pricing grid. On May 19, 2020 (the \"Effective Date\"), the Company entered into Amendment No. 1 (the “Amendment”) to the Revolving Credit Facility. Under the terms of the Amendment, during the period from the Effective Date until October 2, 2021, the Company must maintain available liquidity of $700 million (with available liquidity defined as the sum of unrestricted cash and cash equivalents and available commitments under credit facilities, including the Revolving Credit Facility). This requirement, among others that the Company is subject to during the period from the Effective Date until the compliance certificate is delivered for the fiscal quarter ending July 3, 2021 (the “Covenant Relief Period”) have been fulfilled. Going forward, the Company must comply on a quarterly basis with a maximum net leverage ratio of 4.0 to 1.0. The $900 million aggregate commitment amount under the Revolving Credit Facility remained unchanged under the amendment. As of October 2, 2021, there were no borrowings outstanding under the Revolving Credit Facility. Refer to Note 11, \"Debt,\" for further information on our existing debt instruments.\n(3) In March 2015, the Company issued $600.0 million aggregate principal amount of 4.250% senior unsecured notes due April 1, 2025 at 99.445% of par (the “2025 Senior Notes”). Furthermore, in June 2017, the Company issued $400.0 million aggregate principal amount of 3.000% senior unsecured notes due July 15, 2022 at 99.505% of par (the \"2022 Senior Notes\"), and $600.0 million aggregate principal amount of 4.125% senior unsecured notes due July 15, 2027 at 99.858% of par (the \"2027 Senior Notes\"). Furthermore, the indentures for the 2025 Senior Notes, 2022 Senior Notes and 2027 Senior Notes contain certain covenants limiting the Company’s ability to: (i) create certain liens, (ii) enter into certain sale and leaseback transactions and (iii) merge, or consolidate or transfer, sell or lease all or substantially all of the Company’s assets. As of October 2, 2021, no known events of default have occurred. Refer to Note 11, \"Debt,\" for further information on our existing debt instruments.\nWe believe that our Revolving Credit Facility is adequately diversified with no undue concentrations in any one financial institution. As of October 2, 2021, there were 12 financial institutions participating in the Revolving Credit Facility, with no one participant maintaining a combined maximum commitment percentage in excess of 14%.\nWe have the ability to draw on our credit facilities or access other sources of financing options available to us in the credit and capital markets for, among other things, acquisition or integration-related costs, our restructuring initiatives, settlement of a\n35\nmaterial contingency, or a material adverse business or macroeconomic development, as well as for other general corporate business purposes.\nManagement believes that cash flows from operations, access to the credit and capital markets and our credit lines, on-hand cash and cash equivalents and our investments will provide adequate funds to support our operating, capital, and debt service requirements for the remainder of fiscal 2022 and beyond. There can be no assurance that any such capital will be available to the Company on acceptable terms or at all. Our ability to fund working capital needs, planned capital expenditures, and scheduled debt payments, as well as to comply with all of the financial covenants under our debt agreements, depends on future operating performance and cash flow. This future operating performance and cash flow are subject to prevailing economic conditions, which is uncertain as a result of Covid-19, and to financial, business and other factors, some of which are beyond the Company's control.\nAs part of our efforts to improve our working capital efficiency, we have worked with certain suppliers to revisit terms and conditions, including the extension of payment terms. As an alternative to our payment terms, available to certain suppliers is a voluntary supply chain finance (“SCF”) program that enables our suppliers to sell their receivables from the Company to a global financial institution on a non-recourse basis at a rate that leverages our credit rating. We do not have the ability to refinance or modify payment terms to the global financial institution through the SCF program. No guarantees are provided by the Company or any of our subsidiaries under the SCF program.\nReference should be made to our most recent Annual Report on Form 10-K and other filings with the SEC for additional information regarding liquidity and capital resources. The Company expects total fiscal 2022 capital expenditures to be approximately $220 million.\nSeasonality\nThe Company's results are typically affected by seasonal trends. During the first fiscal quarter, we build inventory for the holiday selling season. In the second fiscal quarter, working capital requirements are reduced substantially as we generate higher net sales and operating income, especially during the holiday months of November and December. Accordingly, the Company’s net sales, operating income and operating cash flows for the three months ended October 2, 2021 are not necessarily indicative of that expected for the full fiscal 2022. However, fluctuations in net sales, operating income and operating cash flows of the Company in any fiscal quarter may be affected by the timing of wholesale shipments and other events affecting retail sales, including adverse weather conditions or other macroeconomic events, including pandemics such as Covid-19.\nCRITICAL ACCOUNTING POLICIES AND ESTIMATES\nThe Company's significant accounting policies are described in Note 3 to the audited consolidated financial statements in our Annual Report on Form 10-K for fiscal 2021. Our discussion of results of operations and financial condition relies on our condensed consolidated financial statements that are prepared based on certain critical accounting policies that require management to make judgments and estimates which are subject to varying degrees of uncertainty. While we believe that these accounting policies are based on sound measurement criteria, actual future events can and often do result in outcomes that can be materially different from these estimates or forecasts.\nFor a complete discussion of our critical accounting policies and estimates, see the \"Critical Accounting Policies and Estimates\" section of the Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for fiscal 2021. As of October 2, 2021, there have been no material changes to any of the critical accounting policies.\nThe Company performs its annual impairment assessment of goodwill as well as brand intangibles at the beginning of the fourth quarter of each fiscal year. In all fiscal years, the fair values of our Coach brand reporting units significantly exceeded their respective carrying values. The fair values of the Kate Spade brand reporting unit and indefinite-lived brand as of the fiscal 2021 testing date exceeded their respective carrying values by approximately 41% and 77%, respectively. Several factors could impact the Kate Spade brand's ability to achieve expected future cash flows, including continued economic volatility and potential operational challenges related to the Covid-19 pandemic, the reception of new collections in all channels, the success of international expansion strategies, the optimization of the store fleet productivity, the impact of promotional activity in department stores, and other initiatives aimed at increasing profitability of the business. Given the relatively small excess of fair value over carrying value as noted above, if profitability trends decline during fiscal 2022 from those that are expected, it is possible that an interim test, or our annual impairment test, could result in an impairment of those assets.\n36\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nThe market risk inherent in our financial instruments represents the potential loss in fair value, earnings or cash flows, arising from adverse changes in foreign currency exchange rates or interest rates. The Company manages these exposures through operating and financing activities and, when appropriate, through the use of derivative financial instruments. The use of derivative financial instruments is in accordance with the Company's risk management policies, and we do not enter into derivative transactions for speculative or trading purposes.\nThe quantitative disclosures in the following discussion are based on quoted market prices obtained through independent pricing sources for the same or similar types of financial instruments, taking into consideration the underlying terms and maturities and theoretical pricing models. These quantitative disclosures do not represent the maximum possible loss or any expected loss that may occur, since actual results may differ from those estimates.\nForeign Currency Exchange Rate Risk\nForeign currency exposures arise from transactions, including firm commitments and anticipated contracts, denominated in a currency other than the entity’s functional currency, and from foreign-denominated revenues and expenses translated into U.S. dollars. The majority of the Company's purchases and sales involving international parties, excluding international consumer sales, are denominated in U.S. dollars and, therefore, our foreign currency exchange risk is limited. The Company is exposed to risk from foreign currency exchange rate fluctuations resulting from its operating subsidiaries’ transactions denominated in foreign currencies. To mitigate such risk, certain subsidiaries enter into forward currency contracts. As of October 2, 2021 and July 3, 2021, forward currency contracts designated as cash flow hedges with a notional amount of $52.2 million and $61.4 million, respectively, were outstanding. As a result of the use of derivative instruments, we are exposed to the risk that counterparties to the derivative instruments will fail to meet their contractual obligations. To mitigate the counterparty credit risk, we only enter into derivative contracts with carefully selected financial institutions. The Company also reviews the creditworthiness of our counterparties on a regular basis. As a result of the above considerations, we do not believe that we are exposed to any undue concentration of counterparty credit risk associated with our derivative contracts as of October 2, 2021.\nThe Company is also exposed to transaction risk from foreign currency exchange rate fluctuations with respect to various cross-currency intercompany loans, payables and receivables. This primarily includes exposure to exchange rate fluctuations in the Chinese Renminbi, Japanese Yen, British Pound Sterling and the Euro. To manage the exchange rate risk related to these balances, the Company enters into forward currency contracts. As of October 2, 2021 and July 3, 2021 the total notional values of outstanding forward foreign currency contracts related to these loans, payables and receivables were $304.1 million and $248.2 million, respectively.\nThe fair value of outstanding forward currency contracts included in current assets at October 2, 2021 and July 3, 2021 was $0.2 million and $0.3 million, respectively. The fair value of outstanding foreign currency contracts included in current liabilities at October 2, 2021 and July 3, 2021 was $3.4 million and $1.2 million, respectively. The fair value of these contracts is sensitive to changes in foreign currency exchange rates. A sensitivity analysis of the effects of foreign exchange rate fluctuations on the fair values of our derivative contracts was performed to assess the risk of loss.\nInterest Rate Risk\nThe Company is exposed to interest rate risk in relation to its Revolving Credit Facility entered into under the credit agreement dated October 24, 2019 as amended on May 19, 2020, the 2025 Senior Notes, 2022 Senior Notes, 2027 Senior Notes (collectively the \"Senior Notes\") and investments.\nOur exposure to changes in interest rates is primarily attributable to debt outstanding under the Revolving Credit Facility. Borrowings under the Revolving Credit Facility bear interest at a rate per annum equal to, at the Company’s option, either (a) an alternate base rate (which is a rate equal to the greatest of (i) the Prime Rate in effect on such day, (ii) the Federal Funds Effective Rate in effect on such day plus ½ of 1% or (iii) the Adjusted LIBO Rate for a one month Interest Period on such day plus 1%) or (b) a rate based on the rates applicable for deposits in the interbank market for U.S. dollars or the applicable currency in which the loans are made plus, in each case, an applicable margin. The applicable margin will be determined by reference to a grid, as set forth in the Credit Agreement, based on the ratio of (a) consolidated debt plus operating lease liability to (b) consolidated EBITDAR. Furthermore, a prolonged disruption on our business resulting from the Covid-19 pandemic may impact our ability to satisfy the terms of our Revolving Credit Facility, including our liquidity covenant.\nThe Company is exposed to changes in interest rates related to the fair value of the Senior Notes. At October 2, 2021, the fair value of the 2025 Senior Notes, 2022 Senior Notes and 2027 Senior Notes was approximately $651 million, $407 million and $657 million, respectively. At July 3, 2021, the fair value of the 2025 Senior Notes, 2022 Senior Notes and 2027 Senior Notes was approximately $652 million, $407 million and $659 million, respectively. These fair values are based on external pricing data, including available quoted market prices of these instruments, and consideration of comparable debt instruments with similar interest rates and trading frequency, among other factors, and are classified as Level 2 measurements within the fair value hierarchy. The interest rate payable on the 2022 and 2027 Senior Notes will be subject to adjustments from time to time if either Moody’s or S&P or a substitute rating agency (as defined in the Prospectus Supplement furnished with the SEC on June 7, 2017) downgrades (or downgrades and subsequently upgrades) the credit rating assigned to the respective Senior Notes of such series.\nThe Company’s investment portfolio is maintained in accordance with the Company’s investment policy, which defines our investment principles including credit quality standards and limits the credit exposure of any single issuer. The primary objective of our investment activities is the preservation of principal while maximizing interest income and minimizing risk. We do not hold any investments for trading purposes.\n37\nITEM 4. CONTROLS AND PROCEDURES\nBased on the evaluation of the Company's disclosure controls and procedures, as that term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended, the Chief Executive Officer of the Company and the Chief Financial Officer of the Company have concluded that the Company's disclosure controls and procedures are effective as of October 2, 2021.\nReference should be made to our most recent Annual Report on Form 10-K for additional information regarding discussion of the effectiveness of the Company’s controls and procedures. There were no changes in our internal control over financial reporting during the quarter ended October 2, 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n38\nPART II – OTHER INFORMATION\nITEM 1. LEGAL PROCEEDINGS\nThe Company is involved in various routine legal proceedings as both plaintiff and defendant incident to the ordinary course of its business, including proceedings to protect Tapestry, Inc.'s intellectual property rights, litigation instituted by persons alleged to have been injured by advertising claims or upon premises within the Company's control, contract disputes, insurance claims and litigation with present or former employees.\nAs part of Tapestry’s policing program for its intellectual property rights, from time to time, the Company files lawsuits in the U.S. and abroad alleging acts of trademark counterfeiting, trademark infringement, patent infringement, trade dress infringement, copyright infringement, unfair competition, trademark dilution and/or state or foreign law claims. At any given point in time, Tapestry may have a number of such actions pending. These actions often result in seizure of counterfeit merchandise and/or out of court settlements with defendants. From time to time, defendants will raise, either as affirmative defenses or as counterclaims, the invalidity or unenforceability of certain of Tapestry’s intellectual properties.\nAlthough the Company's litigation as described above is routine and incidental to the conduct of Tapestry’s business, such litigation can result in large monetary awards, such as when a civil jury is allowed to determine compensatory and/or punitive damages.\nThe Company believes that the outcome of all pending legal proceedings in the aggregate will not have a material effect on the Company's business or condensed consolidated financial statements.\nITEM 1A. RISK FACTORS\nThere are no material changes from the risk factors previously disclosed in Part I, Item 1A, Risk Factors of our Annual Report on Form 10-K for the fiscal year ended July 3, 2021.\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nThe following table provides information regarding the Company's purchases of shares of common stock during the first quarter of fiscal 2022 related to the Company's share repurchase program:\n| Fiscal Period | Total Number of Shares Repurchased | Average Price per Share | Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs(1) | Approximate Dollar Value of Shares that May Yet be Purchased Under the Plans or Programs(1) |\n| (in millions, except share data and per share data) |\n| July 4, 2021 - August 7, 2021 | — | $ | — | — | $ | — |\n| August 8, 2021 - September 4, 2021 | 2,998,586 | 41.69 | 2,998,586 | 475,002,168 |\n| September 5, 2021 - October 2, 2021 | 3,095,638 | 40.38 | 3,095,638 | 350,002,198 |\n| Total | 6,094,224 | 6,094,224 |\n\n(1) The Company repurchases its common shares under the repurchase program of $1.00 billion that was approved by the Board on May 9, 2019. Subsequent to October 2, 2021, the Company announced that its Board of Directors authorized the additional repurchase of up to $1.00 billion of its outstanding common stock. This authorization is incremental to the Company's existing authorization, under which $350.0 million remains. Refer to Note 17, \"Subsequent Events\" for further information. Purchases of the Company's common stock were executed through open market purchases, including through a purchase agreement under Rule 10b5-1.\nITEM 4. MINE SAFETY DISCLOSURES\nNot applicable.\n39\nITEM 6. EXHIBITS\n| 10.1 | Waiver, dated August 11, 2021, to the Credit Agreement, dated as of October 24, 2019 by and among Tapestry, Inc., Bank of America, N.A. as Administrative Agent, JPMorgan Chase Bank, N.A. and HSBC Bank USA, N.A., as Co-Syndication Agents, and the other lenders party thereto, incorporated by reference from Exhibit 10.44 to the Company’s Annual Report on Form 10-K |\n| 31.1* | Rule 13(a) – 14(a)/15(d) – 14(a) Certifications |\n| 32.1* | Section 1350 Certifications |\n| 101.INS* | XBRL Instance Document |\n| Note: the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. |\n| 101.SCH* | XBRL Taxonomy Extension Schema Document |\n| 101.CAL* | XBRL Taxonomy Extension Calculation Linkbase |\n| 101.LAB* | XBRL Taxonomy Extension Label Linkbase |\n| 101.PRE* | XBRL Taxonomy Extension Presentation Linkbase |\n| 101.DEF* | XBRL Taxonomy Extension Definition Linkbase |\n\n* Filed Herewith\n40\nSIGNATURE\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n| TAPESTRY, INC. |\n| (Registrant) |\n| By: | /s/ Manesh B. Dadlani |\n| Name: | Manesh B. Dadlani |\n| Title: | Corporate Controller |\n| (Principal Accounting Officer) |\n\nDated: November 12, 2021\n41\n</text>\n\nWhat is the percentage change in the company's total investments from July 3, 2021 to October 2, 2021?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"ground_truth": "Therefore, the answer is 4810.9756097560985."
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docmath_40000_plus
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1.\nFinancial Statements\n3\nItem 1A. Forward-Looking Statements 66\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\n\nINTRODUCTION\n\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to provide a reader of our financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A is presented in five main sections:\n\n| ● | Overview |\n\n| ● | Results of Operations |\n\n| ● | Liquidity and Capital Resources |\n\n| ● | Off-Balance Sheet Arrangements and Contractual Obligations |\n\n| ● | Critical Accounting Policies and Estimates |\n\n\nThe following discussion should be read in conjunction with our unaudited interim consolidated financial statements and accompanying Notes included in Item 1, \"Financial Statements,\" of this quarterly report on Form 10-Q and with Items 6, 7, 8, and 9A of our annual report on Form 10-K. See \"Forward-Looking Statements\" in this quarterly report on Form 10-Q and in our annual report on Form 10-K and \"Critical Accounting Policies and Use of Estimates\" in our annual report on Form 10-K for certain other factors that could cause actual results or future events to differ, perhaps materially, from historical performance and from those anticipated in the forward-looking statements included in this quarterly report on Form 10-Q.\n\nOVERVIEW\n\nOur Business\n\nWe are a multi-strategy real estate finance company that originates, acquires, finances, and services SBC loans, SBA loans, residential mortgage loans, and to a lesser extent, MBS collateralized primarily by SBC loans, or other real estate-related investments. Our loans generally range in original principal amounts up to $35 million and are used by businesses to purchase real estate used in their operations or by investors seeking to acquire small multi-family, office, retail, mixed use or warehouse properties. Our originations and acquisition platforms consist of the following four operating segments:\n\n| ● | Acquisitions. We acquire performing and non-performing SBC loans as part of our business strategy. We hold performing SBC loans to term, and we seek to maximize the value of the non-performing SBC loans acquired by us through borrower-based resolution strategies. We typically acquire non-performing loans at a discount to their unpaid principal balance (“UPB”) when we believe that resolution of the loans will provide attractive risk-adjusted returns. We also acquire purchased future receivables through our Knight Capital platform. |\n\n\n| ● | SBC Originations. We originate SBC loans secured by stabilized or transitional investor properties using multiple loan origination channels through our wholly-owned subsidiary, ReadyCap Commercial, LLC (“ReadyCap Commercial”). These originated loans are generally held-for-investment or placed into securitization structures. Additionally, as part of this segment, we originate and service multi-family loans |\n\n68\n| under the Federal Home Loan Mortgage Corporation’s Small Balance Loan Program (“Freddie Mac” and the “Freddie Mac program”). These originated loans are held for sale, then sold to Freddie Mac. |\n| ● | SBA Originations, Acquisitions and Servicing. We acquire, originate and service owner-occupied loans guaranteed by the SBA under its Section 7(a) loan program (the “SBA Section 7(a) Program”) through our wholly-owned subsidiary, ReadyCap Lending, LLC (“ReadyCap Lending”). We hold an SBA license as one of only 14 non-bank Small Business Lending Companies (“SBLCs”) and have been granted preferred lender status by the SBA. These originated loans are either held-for-investment, placed into securitization structures, or sold. |\n| ● | Residential Mortgage Banking. We operate our residential mortgage loan origination segment through our wholly-owned subsidiary, GMFS, LLC (\"GMFS\"). GMFS originates residential mortgage loans eligible to be purchased, guaranteed or insured by the Federal National Mortgage Association (“Fannie Mae”), Freddie Mac, Federal Housing Administration (“FHA”), U.S. Department of Agriculture (“USDA”) and U.S. Department of Veterans Affairs (“VA”) through retail, correspondent and broker channels. These originated loans are then sold to third parties, primarily agency lending programs. |\n\n| ● | the interest expense associated with our variable-rate borrowings to increase; |\n| ● | the value of fixed-rate loans, MBS and other real estate-related assets to decline; |\n| ● | coupons on variable-rate loans and MBS to reset to higher interest rates; and |\n| ● | prepayments on loans and MBS to slow. |\n| ● | the interest expense associated with variable-rate borrowings to decrease; |\n| ● | the value of fixed-rate loans, MBS and other real estate-related assets to increase; |\n| ● | coupons on variable-rate loans and MBS to reset to lower interest rates; and |\n| ● | prepayments on loans and MBS to increase. |\n\nThe spread between the yield on our assets and our funding costs is an important factor in the performance of this aspect of our business. Wider spreads imply greater income on new asset purchases but may have a negative impact on our stated book value. Wider spreads generally negatively impact asset prices. In an environment where spreads are widening, counterparties may require additional collateral to secure borrowings which may require us to reduce leverage by selling assets. Conversely, tighter spreads imply lower income on new asset purchases but may have a positive impact on our stated book value. Tighter spreads generally have a positive impact on asset prices. In this case, we may be able to reduce the amount of collateral required to secure borrowings.Loan and ABS Extension RiskWaterfall estimates the projected weighted-average life of our investments based on assumptions regarding the rate at which the borrowers will prepay the underlying mortgages and/or the speed at which we are able to liquidate an asset. If the timeline to resolve non-performing assets extends, this could have a negative impact on our results of operations, as carrying costs may therefore be higher than initially anticipated. This situation may also cause the fair market value of our investment to decline if real estate values decline over the extended period. In extreme situations, we may be forced to sell assets to maintain adequate liquidity, which could cause us to incur losses.Credit RiskWe are subject to credit risk in connection with our investments in loans and ABS and other target assets we may acquire in the future. Increases in defaults and delinquencies will adversely impact our operating results, while declines in rates of default and delinquencies will improve our operating results from this aspect of our business. Default rates are influenced by a wide variety of factors, including, property performance, property management, supply and demand factors, construction trends, consumer behavior, regional economics, interest rates, the strength of the United States economy and other factors beyond our control. All loans are subject to the possibility of default. We seek to mitigate this risk by seeking to acquire assets at appropriate prices given anticipated and unanticipated losses and by deploying a value-driven approach to underwriting and diligence, consistent with our historical investment strategy, with a focus on projected cash flows and potential risks to cash flow. We further mitigate our risk of potential losses while managing and servicing our loans by performing various workout and loss mitigation strategies with delinquent borrowers. Nevertheless, unanticipated credit losses could occur which could adversely impact operating results.Size of Investment PortfolioThe size of our investment portfolio, as measured by the aggregate principal balance of our loans and ABS and the other assets we own, is also a key revenue driver. Generally, as the size of our investment portfolio grows, the amount of interest income and realized gains we receive increases. A larger investment portfolio, however, drives increased expenses, as we may incur additional interest expense to finance the purchase of our assets.Current market conditions The outbreak of the COVID-19 pandemic around the globe continues to adversely impact global commercial activity and has contributed to significant volatility in financial markets. The impact of the outbreak has been rapidly evolving, with several countries taking drastic measures to limit the spread of the virus by instituting quarantines or lockdowns and imposing travel restrictions. While some of these restrictions have been relaxed or phased out, many of these or similar restrictions remain in place, continue to be implemented or additional restrictions are being considered. Such actions are creating significant disruptions to global supply chains and adversely impacting several industries, including but not limited to airlines, hospitality, retail, and the broader real estate industry. The major disruption caused by COVID-19 significantly reduced economic activity in most of the United States resulting in a significant increase in unemployment claims. COVID-19 has had a continued and prolonged adverse impact on economic and market conditions and has had a period of global economic slowdown which could have a material adverse effect on the Company’s results and financial condition. The full impact of COVID-19 on the real estate industry, the commercial real estate market, the small business lending market and the credit markets generally, and consequently on the Company’s financial condition and results of operations is uncertain and cannot be predicted at the current time as it depends on several factors beyond the control of the Company including, but not limited to, (i) the uncertainty around the severity and duration of the outbreak, (ii) the effectiveness of 71\n| | | | | | | | | | | | | | | | | |\n| | | Three Months Ended September 30, | | Three Months Ended September 30, | | Nine Months Ended September 30, | | Nine Months Ended September 30, |\n| (in thousands, except share data) | | 2020 | | 2019 | | 2020 | | 2019 |\n| Net Income | | $ | 35,363 | | | $ | 12,427 | | | $ | 18,510 | | | $ | 54,120 | |\n| Earnings per common share - basic | | $ | 0.63 | | | $ | 0.27 | | | $ | 0.32 | | | $ | 1.29 | |\n| Earnings per common share - diluted | | $ | 0.63 | | | $ | 0.27 | | | $ | 0.31 | | | $ | 1.29 | |\n| Core Earnings | | $ | 32,126 | | | $ | 18,249 | | | $ | 72,574 | | | $ | 46,297 | |\n| Core Earnings per common share - basic and diluted | | $ | 0.57 | | | $ | 0.40 | | | $ | 1.30 | | | $ | 1.10 | |\n| Dividends declared per common share | | $ | 0.30 | | | $ | 0.40 | | | $ | 0.95 | | | $ | 1.20 | |\n| Dividend yield(1) | | | 10.7 | % | | | 10.1 | % | | | 10.7 | % | | | 10.1 | % |\n| Book value per common share | | $ | 14.86 | | | $ | 16.20 | | | $ | 14.86 | | | $ | 16.20 | |\n| Adjusted net book value per common share(2) | | $ | 14.84 | | | $ | 16.16 | | | $ | 14.84 | | | $ | 16.16 | |\n| (1) Based on the closing share price on September 30, 2020 and 2019, respectively. | | | | | | | | | | | | | | | | |\n| (2) Excludes the equity component of our 2017 convertible note issuance. | | | | | | | | | | | | | | | | |\n\n| | | | | | | | | | | | | |\n| | | Three Months Ended | | Three Months Ended | | Nine Months Ended | | Nine Months Ended |\n| (in thousands) | | September 30, 2020 | | September 30, 2019 | | September 30, 2020 | | September 30, 2019 |\n| Loan originations | | | | | | | | | | | | |\n| SBC loan originations | | $ | 122,487 | | $ | 465,374 | | $ | 750,164 | | $ | 1,176,942 |\n| SBA loan originations | | | 82,912 | | | 48,244 | | | 149,283 | | | 146,021 |\n| Residential agency mortgage loan originations | | | 1,184,237 | | | 656,791 | | | 3,066,711 | | | 1,519,377 |\n| Total loan originations | | $ | 1,389,636 | | $ | 1,170,409 | | $ | 3,966,158 | | $ | 2,842,340 |\n| Total loan acquisitions | | $ | 20,989 | | $ | 77,900 | | $ | 72,483 | | $ | 568,784 |\n| Total loan investment activity | | $ | 1,410,625 | | $ | 1,248,309 | | $ | 4,038,641 | | $ | 3,411,124 |\n\nThe following table provides a detailed breakdown of our calculation of return on equity and core return on equity for the three months ended September 30, 2020. Core return on equity is not a measure calculated in accordance with GAAP and is defined further within Item 7 – Non-GAAP Financial Measures in our 2019 Annual report on Form 10-K.74\nPortfolio MetricsSBC OriginationsThe following table includes certain portfolio metrics related to our SBC originations segment:75\nSBA Originations, Acquisitions, and ServicingThe following table includes certain portfolio metrics related to our SBA originations, acquisitions and servicing segment: 76\nAcquired PortfolioThe following table includes certain portfolio metrics related to our acquisitions segment:77\nResidential Mortgage BankingThe following table includes certain portfolio metrics related to our residential mortgage banking segment:78\n| | | | | | | | | | | | | |\n| | | September 30, | | June 30, | | $ Change | | % Change |\n| (In Thousands) | 2020 | 2020 | | Q3'20 vs. Q2'20 | | Q3'20 vs. Q2'20 |\n| Assets | | | | | | | | | | | | |\n| Cash and cash equivalents | | $ | 149,847 | | $ | 257,017 | | $ | (107,170) | (41.7) | % |\n| Restricted cash | | 46,204 | | 91,539 | | | (45,335) | | (49.5) | |\n| Loans, net (including $119,965 and $124,298 held at fair value) | | 1,393,139 | | 1,432,807 | | | (39,668) | | (2.8) | |\n| Loans, held for sale, at fair value | | 348,719 | | 297,669 | | | 51,050 | | 17.1 | |\n| Mortgage backed securities, at fair value | | 90,427 | | 75,411 | | | 15,016 | | 19.9 | |\n| Loans eligible for repurchase from Ginnie Mae | | | 237,542 | | | 186,197 | | | 51,345 | | 27.6 | |\n| Investment in unconsolidated joint ventures | | | 69,204 | | | 53,939 | | | 15,265 | | 28.3 | |\n| Purchased future receivables, net | | | 16,659 | | | 27,190 | | | (10,531) | | (38.7) | |\n| Derivative instruments | | 20,849 | | 19,037 | | | 1,812 | | 9.5 | |\n| Servicing rights (including $74,384 and $73,645 held at fair value) | | 110,045 | | 107,761 | | | 2,284 | | 2.1 | |\n| Real estate, held for sale | | | 45,063 | | | 47,009 | | | (1,946) | | (4.1) | |\n| Other assets | | 98,614 | | 103,701 | | | (5,087) | | (4.9) | |\n| Assets of consolidated VIEs | | | 2,691,198 | | | 2,761,655 | | | (70,457) | | (2.6) | |\n| Total Assets | | $ | 5,317,510 | | $ | 5,460,932 | | $ | (143,422) | | (2.6) | % |\n| Liabilities | | | | | | | | | | | | |\n| Secured borrowings | | $ | 1,176,621 | | $ | 1,253,895 | | $ | (77,274) | | (6.2) | % |\n| Securitized debt obligations of consolidated VIEs, net | | 2,059,114 | | 2,140,009 | | | (80,895) | | (3.8) | |\n| Convertible notes, net | | | 111,855 | | | 111,581 | | | 274 | | 0.2 | |\n| Senior secured notes, net | | 179,572 | | 179,481 | | | 91 | | 0.1 | |\n| Corporate debt, net | | | 150,658 | | | 150,387 | | | 271 | | 0.2 | |\n| Guaranteed loan financing | | 421,183 | | 436,532 | | | (15,349) | | (3.5) | |\n| Liabilities for loans eligible for repurchase from Ginnie Mae | | | 237,542 | | | 186,197 | | | 51,345 | | 27.6 | |\n| Derivative instruments | | 7,774 | | 9,106 | | | (1,332) | | (14.6) | |\n| Dividends payable | | 16,934 | | 14,524 | | | 2,410 | | 16.6 | |\n| Accounts payable and other accrued liabilities | | 132,087 | | 166,174 | | | (34,087) | | (20.5) | |\n| Total Liabilities | | $ | 4,493,340 | | $ | 4,647,886 | | $ | (154,546) | | (3.3) | % |\n| Stockholders’ Equity | | | | | | | | | | | | |\n| Common stock | | $ | 5 | | $ | 5 | | $ | — | | 0.0 | % |\n| Additional paid-in capital | | 846,960 | | 854,222 | | | (7,262) | | (0.9) | |\n| Retained earnings (deficit) | | | (31,779) | | | (49,755) | | | 17,976 | | (36.1) | |\n| Accumulated other comprehensive (loss) | | (9,916) | | (9,876) | | | (40) | | 0.4 | |\n| Total Ready Capital Corporation equity | | 805,270 | | 794,596 | | | 10,674 | | 1.3 | % |\n| Non-controlling interests | | 18,900 | | 18,450 | | | 450 | | 2.4 | |\n| Total Stockholders’ Equity | | $ | 824,170 | | $ | 813,046 | | $ | 11,124 | | 1.4 | % |\n| Total Liabilities and Stockholders’ Equity | | $ | 5,317,510 | | $ | 5,460,932 | | $ | (143,422) | | (2.6) | % |\n| |\n\n| | | | | | | | | | | | | | | | |\n| (in thousands) | | Acquisitions | | SBC Originations | | SBA Originations, Acquisitions and Servicing | | Residential Mortgage Banking | | Total |\n| Assets | | | | | | | | | | | | | | | |\n| Loans, net (1)(2) | | $ | 949,728 | $ | 2,366,167 | $ | 743,114 | $ | 5,235 | $ | 4,064,244 |\n| Loans, held for sale, at fair value | | | 510 | | | 20,486 | | | 39,764 | | | 287,959 | | | 348,719 |\n| Mortgage backed securities, at fair value | | | 22,842 | | | 67,585 | | | — | | | — | | | 90,427 |\n| Servicing rights | | | — | | | 18,121 | | | 17,540 | | | 74,384 | | | 110,045 |\n| Investment in unconsolidated joint ventures | | | 69,204 | | | — | | | — | | | — | | | 69,204 |\n| Purchased future receivables, net | | | 16,659 | | | — | | | — | | | — | | | 16,659 |\n| Real estate, held for sale (1) | | | 45,063 | | | 8,422 | | | — | | | — | | | 53,485 |\n| | | | | | | | | | | | | | | | |\n| Liabilities | | | | | | | | | | | | | | | |\n| Secured borrowings | | $ | 226,545 | | $ | 482,665 | | $ | 159,467 | | $ | 307,944 | | $ | 1,176,621 |\n| Securitized debt obligations of consolidated VIEs | | | 552,998 | | | 1,399,224 | | | 106,892 | | | — | | | 2,059,114 |\n| Guaranteed loan financing | | | — | | | — | | | 421,183 | | | — | | | 421,183 |\n| Senior secured notes, net | | | 42,609 | | | 129,919 | | | 7,045 | | | — | | | 179,572 |\n| Corporate debt, net | | | 75,189 | | | 75,469 | | | — | | | — | | | 150,658 |\n| Convertible notes, net | | | 55,125 | | | 51,132 | | | 5,598 | | | — | | | 111,855 |\n| (1) Includes assets of consolidated VIEs(2) Excludes allowance for loan losses. |\n\n| | | | | | | | | | | | | | | | | | | |\n| | | | | | | | | | | | | | | | | |\n| | | Three Months Ended September 30, | | $ Change | | Nine Months Ended September 30, | | $ Change |\n| | | 2020 | | 2019 | | 2020 vs. 2019 | | 2020 | | 2019 | | 2020 vs. 2019 |\n| Interest income | | | | | | | | | | | | | | | | | | |\n| Loan acquisitions | | $ | 14,532 | $ | 18,880 | $ | (4,348) | | $ | 45,993 | $ | 47,761 | $ | (1,768) |\n| SBC originations | | | 35,287 | | | 32,354 | | | 2,933 | | | 112,052 | | | 91,182 | | | 20,870 |\n| SBA originations, acquisitions and servicing | | | 9,037 | | | 7,235 | | | 1,802 | | | 30,316 | | | 23,468 | | | 6,848 |\n| Residential mortgage banking | | | 2,218 | | | 1,254 | | | 964 | | | 5,465 | | | 3,099 | | | 2,366 |\n| Total interest income | | $ | 61,074 | | $ | 59,723 | | $ | 1,351 | | $ | 193,826 | | $ | 165,510 | | $ | 28,316 |\n| Interest expense | | | | | | | | | | | | | | | | | | |\n| Loan acquisitions | | $ | (11,011) | | $ | (11,076) | | $ | 65 | | $ | (32,871) | | $ | (29,383) | | $ | (3,488) |\n| SBC originations | | | (23,342) | | | (23,835) | | | 493 | | | (72,476) | | | (65,903) | | | (6,573) |\n| SBA originations, acquisitions and servicing | | | (6,414) | | | (2,739) | | | (3,675) | | | (21,766) | | | (11,529) | | | (10,237) |\n| Residential mortgage banking | | | (2,157) | | | (1,740) | | | (417) | | | (5,778) | | | (4,104) | | | (1,674) |\n| Corporate - other | | | (899) | | | - | | | (899) | | | (1,271) | | | - | | | (1,271) |\n| Total interest expense | | $ | (43,823) | | $ | (39,390) | | $ | (4,433) | | $ | (134,162) | | $ | (110,919) | | $ | (23,243) |\n| Net interest income before provision for loan losses | | $ | 17,251 | | $ | 20,333 | | $ | (3,082) | | $ | 59,664 | | $ | 54,591 | | $ | 5,073 |\n| Loan acquisitions | | $ | 4,824 | | $ | (94) | | $ | 4,918 | | $ | (2,865) | | $ | (771) | | $ | (2,094) |\n| SBC originations | | | 117 | | | (33) | | | 150 | | | (23,890) | | | (342) | | | (23,548) |\n| SBA originations, acquisitions and servicing | | | (710) | | | (566) | | | (144) | | | (7,729) | | | (1,446) | | | (6,283) |\n| Residential mortgage banking | | | - | | | — | | | - | | | (500) | | | — | | | (500) |\n| Provision for loan losses | | $ | 4,231 | | $ | (693) | | | 4,924 | | | (34,984) | | | (2,559) | | | (32,425) |\n| Net interest income after provision for loan losses | | $ | 21,482 | | $ | 19,640 | | $ | 1,842 | | $ | 24,680 | | $ | 52,032 | | $ | (27,352) |\n| Non-interest income | | | | | | | | | | | | | | | | | | |\n| Loan acquisitions | | $ | 8,643 | | $ | 1,329 | | $ | 7,314 | | $ | 7,385 | | $ | 7,090 | | $ | 295 |\n| SBC originations | | | 10,066 | | | 5,806 | | | 4,260 | | | 16,393 | | | 15,052 | | | 1,341 |\n| SBA originations, acquisitions and servicing | | | 12,020 | | | 5,513 | | | 6,507 | | | 49,269 | | | 15,861 | | | 33,408 |\n| Residential mortgage banking | | | 77,178 | | | 27,292 | | | 49,886 | | | 178,190 | | | 60,366 | | | 117,824 |\n| Corporate - other | | | (1) | | | 44 | | | (45) | | | 114 | | | 30,837 | | | (30,723) |\n| Total non-interest income | | $ | 107,906 | | $ | 39,984 | | $ | 67,922 | | $ | 251,351 | | $ | 129,206 | | $ | 122,145 |\n| Non-interest expense | | | | | | | | | | | | | | | | | | |\n| Loan acquisitions | | $ | (8,554) | | $ | (2,602) | | $ | (5,952) | | $ | (27,926) | | $ | (6,277) | | $ | (21,649) |\n| SBC originations | | | (9,339) | | | (6,855) | | | (2,484) | | | (28,357) | | | (19,022) | | | (9,335) |\n| SBA originations, acquisitions and servicing | | | (6,344) | | | (6,062) | | | (282) | | | (22,837) | | | (17,854) | | | (4,983) |\n| Residential mortgage banking | | | (53,820) | | | (28,116) | | | (25,704) | | | (148,415) | | | (68,842) | | | (79,573) |\n| Corporate - other | | | (9,414) | | | (6,207) | | | (3,207) | | | (25,870) | | | (23,727) | | | (2,143) |\n| Total non-interest expense | | $ | (87,471) | | $ | (49,842) | | $ | (37,629) | | $ | (253,405) | | $ | (135,722) | | $ | (117,683) |\n| Net income (loss) before provision for income taxes | | | | | | | | | | | | | | | | | | |\n| Loan acquisitions | | $ | 8,434 | | $ | 6,437 | | $ | 1,997 | | $ | (10,284) | | $ | 18,420 | | $ | (28,704) |\n| SBC originations | | | 12,789 | | | 7,437 | | | 5,352 | | | 3,722 | | | 20,967 | | | (17,245) |\n| SBA originations, acquisitions and servicing | | | 7,589 | | | 3,381 | | | 4,208 | | | 27,253 | | | 8,500 | | | 18,753 |\n| Residential mortgage banking | | | 23,419 | | | (1,310) | | | 24,729 | | | 28,962 | | | (9,481) | | | 38,443 |\n| Corporate - other | | | (10,314) | | | (6,163) | | | (4,151) | | | (27,027) | | | 7,110 | | | (34,137) |\n| Total net income (loss) before provision for income taxes | | $ | 41,917 | | $ | 9,782 | | $ | 32,135 | | $ | 22,626 | | $ | 45,516 | | $ | (22,890) |\n\n| | | | | | | | | | | | | |\n| | | Three Months Ended September 30, | | Nine Months Ended September 30, |\n| (In Thousands) | 2020 | 2019 | 2020 | 2019 |\n| Realized gains (losses) on financial instruments | | | | | | | | | | | | |\n| Realized gains on loans - Freddie Mac | | $ | 1,518 | | $ | 1,954 | | $ | 5,517 | | $ | 3,817 |\n| Creation of mortgage servicing rights - Freddie Mac | | | 2,107 | | | 1,798 | | | 7,094 | | | 3,745 |\n| Realized gains on loans - SBA | | | 3,448 | | | 2,098 | | | 7,937 | | | 8,148 |\n| Creation of mortgage servicing rights - SBA | | | 993 | | | 600 | | | 2,328 | | | 2,481 |\n| Realized gain (loss) on derivatives, at fair value | | | (1,996) | | | 132 | | | (2,700) | | | 1,048 |\n| Realized gain (loss) on mortgage backed securities, at fair value | | | 471 | | | 1,112 | | | 2,060 | | | 2,349 |\n| Net realized gains (losses) - all other | | | 966 | | | (317) | | | (118) | | | (674) |\n| Net realized gain on financial instruments | | $ | 7,507 | | $ | 7,377 | | $ | 22,118 | | $ | 20,914 |\n| Unrealized gains (losses) on financial instruments | | | | | | | | | | | | |\n| Unrealized gain (loss) on loans - Freddie Mac | | $ | (40) | | $ | (64) | | $ | (18) | | $ | 234 |\n| Unrealized gain (loss) on loans - SBA | | | 2,353 | | | 772 | | | 1,302 | | | 267 |\n| Unrealized gain (loss) on residential mortgage servicing rights, at fair value | | (4,688) | | (7,582) | | (33,168) | | (21,050) |\n| Unrealized gain (loss) on derivatives, at fair value | | | 648 | | | (701) | | | (4,415) | | | (2,827) |\n| Unrealized gain (loss) on mortgage backed securities, at fair value | | | 3,708 | | | (245) | | | (8,314) | | | 1,466 |\n| Net unrealized gains (losses) - all other | | | 1,439 | | | (61) | | | 851 | | | 111 |\n| Net unrealized gain (loss) on financial instruments | | $ | 3,420 | | $ | (7,881) | | $ | (43,762) | | $ | (21,799) |\n| | | | | | | | | | | | | |\n| | | | | | | | | | | | | | | | | | | |\n| | | | | |\n| | | Three Months Ended September 30, | | Nine Months Ended September 30, |\n| (In Thousands) | | 2020 | | 2019 | | $ Change | | 2020 | | 2019 | | $ Change |\n| Interest income | | $ | 14,532 | | $ | 18,880 | | $ | (4,348) | | $ | 45,993 | | $ | 47,761 | | $ | (1,768) |\n| Interest expense | | | (11,011) | | (11,076) | | 65 | | | (32,871) | | (29,383) | | (3,488) |\n| Net interest income before provision for loan losses | | $ | 3,521 | | $ | 7,804 | | $ | (4,283) | | $ | 13,122 | | $ | 18,378 | | $ | (5,256) |\n| Provision for loan losses | | | 4,824 | | | (94) | | | 4,918 | | | (2,865) | | | (771) | | | (2,094) |\n| Net interest income after provision for loan losses | | $ | 8,345 | | $ | 7,710 | | $ | 635 | | $ | 10,257 | | $ | 17,607 | | $ | (7,350) |\n| Non-interest income | | | 8,643 | | | 1,329 | | | 7,314 | | | 7,385 | | | 7,090 | | | 295 |\n| Non-interest expense | | | (8,554) | | | (2,602) | | | (5,952) | | | (27,926) | | | (6,277) | | | (21,649) |\n| Total non-interest income (expense) | | $ | 89 | | $ | (1,273) | | $ | 1,362 | | $ | (20,541) | | $ | 813 | | $ | (21,354) |\n| Net income (loss) before provision for income taxes | | $ | 8,434 | | $ | 6,437 | | $ | 1,997 | | $ | (10,284) | | $ | 18,420 | | $ | (28,704) |\n| | | | | | | | | | | | | | | | | | | |\n\n| | | | | | | | | | | | | | | | | | | |\n| | | | | |\n| | | Three Months Ended September 30, | | Nine Months Ended September 30, |\n| (In Thousands) | | 2020 | | 2019 | | $ Change | | 2020 | | 2019 | | $ Change |\n| Interest income | | $ | 35,287 | | $ | 32,354 | | $ | 2,933 | | $ | 112,052 | | $ | 91,182 | | $ | 20,870 |\n| Interest expense | | | (23,342) | | (23,835) | | 493 | | | (72,476) | | (65,903) | | (6,573) |\n| Net interest income before provision for loan losses | | $ | 11,945 | | $ | 8,519 | | $ | 3,426 | | $ | 39,576 | | $ | 25,279 | | $ | 14,297 |\n| Recoveries of (provision for) loan losses | | | 117 | | | (33) | | | 150 | | | (23,890) | | | (342) | | | (23,548) |\n| Net interest income after provision for loan losses | | $ | 12,062 | | $ | 8,486 | | $ | 3,576 | | $ | 15,686 | | $ | 24,937 | | $ | (9,251) |\n| Non-interest income (loss) | | | 10,066 | | | 5,806 | | | 4,260 | | | 16,393 | | | 15,052 | | | 1,341 |\n| Non-interest expense | | | (9,339) | | | (6,855) | | | (2,484) | | | (28,357) | | | (19,022) | | | (9,335) |\n| Total non-interest income (expense) | | $ | 727 | | $ | (1,049) | | $ | 1,776 | | $ | (11,964) | | $ | (3,970) | | $ | (7,994) |\n| Net income (loss) before provision for income taxes | | $ | 12,789 | | $ | 7,437 | | $ | 5,352 | | $ | 3,722 | | $ | 20,967 | | $ | (17,245) |\n\nInterest income of $112.1 million for the nine months ended September 30, 2020 in our SBC originations segment represented an increase of $20.9 million from the prior year period primarily reflecting an increase in SBC loan originations, resulting in higher average loan balances. Originated SBC loans contributed $44.2 million in interest income during the nine months ended September 30, 2020, representing an $8.4 million increase from the nine months ended September 30, 2019. Originated transitional loans contributed $66.0 million in interest income during the nine months ended September 30, 2020, representing a $14.6 million increase from the nine months ended September 30, 2019. Interest expenseInterest expense of $23.3 million in our SBC originations segment was relatively unchanged from the prior year quarter ended September 30, 2019.Interest expense of $72.5 million in our SBC originations segment represented an increase of $6.6 million from the prior year period ended September 30, 2019, primarily reflecting an increase in borrowing activities under our shorter-term secured borrowings and securitized debt obligations.Provision for (Recoveries of) loan losses Recoveries of loan losses of $0.1 million in our SBC originations segment was relatively unchanged from the prior year quarter ended September 30, 2019. Provision for loan losses of $23.9 million for the nine months ended September 30, 2020 in our SBC originations segment represented an increase of $23.5 million from the prior year period. The increase in the provision for loan losses during the nine months ended September 30, 2020 was primarily the result of the implementation of the CECL impairment standard and the adverse change in the economic outlook due to the COVID-19 pandemic.Non-interest income Non-interest income of $10.1 million for the quarter ended September 30, 2020 in our SBC originations segment represented an increase of $4.3 million from the prior quarter ended September 30, 2019 primarily reflecting an increase in the fair value of owned Freddie Mac bonds in the quarter.Non-interest income of $16.4 million for the nine months ended September 30, 2020 in our SBC originations segment represented an increase of $1.3 million from the prior year period ended September 30, 2019 reflecting an increase in realized gains on sales of Freddie Mac loans (including creation of servicing rights) of $5.0 million. Non-interest expenseNon-interest expense of $9.3 million for the quarter ended September 30, 2020 in our SBC originations segment represented an increase of $2.5 million from the prior year quarter ended September 30, 2019, primarily reflecting an increase in employee compensation expense of $2.6 million, and an increase in servicing expense of $0.8 million.Non-interest expense of $28.4 million for the nine months ended September 30, 2020 in our SBC originations segment represented an increase of $9.3 million from the prior year period ended September 30, 2019, primarily reflecting an increase in general operating expenses of $2.1 million, an increase in employee compensation expense of $6.0 million, and an increase in servicing expense of $1.5 million.84\n| | | | | | | | | | | | | | | | | | | |\n| | | | | |\n| | | Three Months Ended September 30, | | Nine Months Ended September 30, |\n| (In Thousands) | | 2020 | | 2019 | | $ Change | | 2020 | | 2019 | | $ Change |\n| Interest income | | $ | 9,037 | | $ | 7,235 | | $ | 1,802 | | $ | 30,316 | | $ | 23,468 | | $ | 6,848 |\n| Interest expense | | | (6,414) | | (2,739) | | (3,675) | | | (21,766) | | (11,529) | | (10,237) |\n| Net interest income before provision for loan losses | | $ | 2,623 | | $ | 4,496 | | $ | (1,873) | | $ | 8,550 | | $ | 11,939 | | $ | (3,389) |\n| Provision for loan losses | | | (710) | | | (566) | | | (144) | | | (7,729) | | | (1,446) | | | (6,283) |\n| Net interest income after provision for loan losses | | $ | 1,913 | | $ | 3,930 | | $ | (2,017) | | $ | 821 | | $ | 10,493 | | $ | (9,672) |\n| Non-interest income | | | 12,020 | | | 5,513 | | | 6,507 | | | 49,269 | | | 15,861 | | | 33,408 |\n| Non-interest expense | | | (6,344) | | | (6,062) | | | (282) | | | (22,837) | | | (17,854) | | | (4,983) |\n| Total non-interest income (expense) | | $ | 5,676 | | $ | (549) | | $ | 6,225 | | $ | 26,432 | | $ | (1,993) | | $ | 28,425 |\n| Net income (loss) before provision for income taxes | | $ | 7,589 | | $ | 3,381 | | $ | 4,208 | | $ | 27,253 | | $ | 8,500 | | $ | 18,753 |\n\n| | | | | | | | | | | | | | | | | | | |\n| | | | | |\n| | | Three Months Ended September 30, | | Nine Months Ended September 30, |\n| (In Thousands) | | 2020 | | 2019 | | $ Change | | 2020 | | 2019 | | $ Change |\n| Interest income | | $ | 2,218 | | $ | 1,254 | | $ | 964 | | $ | 5,465 | | $ | 3,099 | | $ | 2,366 |\n| Interest expense | | | (2,157) | | (1,740) | | (417) | | | (5,778) | | (4,104) | | (1,674) |\n| Net interest income before provision for loan losses | | $ | 61 | | $ | (486) | | $ | 547 | | $ | (313) | | $ | (1,005) | | $ | 692 |\n| Provision for loan losses | | | — | | | — | | | - | | | (500) | | | — | | | (500) |\n| Net interest income after provision for loan losses | | $ | 61 | | $ | (486) | | $ | 547 | | $ | (813) | | $ | (1,005) | | $ | 192 |\n| Non-interest income | | | 77,178 | | | 27,292 | | | 49,886 | | | 178,190 | | | 60,366 | | | 117,824 |\n| Non-interest expense | | | (53,820) | | | (28,116) | | | (25,704) | | | (148,415) | | | (68,842) | | | (79,573) |\n| Total non-interest income (expense) | | $ | 23,358 | | $ | (824) | | $ | 24,182 | | $ | 29,775 | | $ | (8,476) | | $ | 38,251 |\n| Net income (loss) before provision for income taxes | | $ | 23,419 | | $ | (1,310) | | $ | 24,729 | | $ | 28,962 | | $ | (9,481) | | $ | 38,443 |\n| | | | | | | | | | | | | | | | | | | |\n\nNon-interest income Non-interest income of $77.2 million in our residential mortgage banking segment for the quarter ended September 30, 2020 represented an increase of $49.9 million from the prior year quarter ended September 30, 2019, primarily reflecting an increase in revenue on residential mortgage banking activities of $46.5 million as a result of an increase in loan originations in the current year and by a decrease in unrealized losses on residential MSRs of $4.7 million during the quarter ended September 30, 2020 compared to $7.6 million of unrealized losses during the quarter ended September 30, 2019. Non-interest income of $178.2 million in our residential mortgage banking segment for the nine months ended September 30, 2020 represented an increase of $117.8 million from the prior year period ended September 30, 2019, primarily reflecting an increase in revenue on residential mortgage banking activities of $128.1 million as a result of an increase in loan originations in the current year. This was offset by unrealized losses on residential MSRs of $33.3 million during the nine months ended September 30, 2020 compared to $21.1 million of unrealized losses during the nine months ended September 30, 2019.Non-interest expense Non-interest expense of $53.8 million in our residential mortgage banking segment for the quarter ended September 30, 2020 represented an increase of $25.7 million from the prior year quarter ended September 30, 2019, primarily reflecting an increase in variable expenses on residential mortgage banking activities of $13.6 million, an increase in employee compensation of $8.2 million, and an increase in loan servicing expense of $2.5 million.Non-interest expense of $148.4 million in our residential mortgage banking segment for the nine months ended September 30, 2020 represented an increase of $79.6 million from the prior year period ended September 30, 2019, primarily reflecting increases in variable expenses on residential mortgage banking activities of $47.5 million, employee compensation of $22.6 million and loan servicing expense of $8.2 million.Corporate- OtherNon-interest incomeNon-interest income of $30.8 million in our Corporate – Other segment for the nine months ended September 30, 2019 represented a bargain purchase gain associated with the ORM merger. There were no significant changes for the three months ended September 30, 2020 compared to the prior year quarter.Non-interest expenseNon-interest expense of $9.4 million for the quarter ended September 30, 2020 increased $3.2 million from the prior year quarter ended September 30, 2019, primarily due to an increase in professional fees of $1.3 million and incentive fees due to our Manager of $1.1 million.Non-interest expense of $25.9 million for the nine months ended September 30, 2020 increased $2.1 million from the prior year period ended September 30, 2019, primarily due to an increase in incentive fees and management fees due to our Manager of $5.6 million and an increase in professional fees of $2.1 million, partially offset by due to an increase in merger related expense of $6.0 million. Non-GAAP financial measuresWe believe that providing investors with core earnings, a non-U.S. GAAP financial measure, in addition to the related U.S. GAAP measures, gives investors greater transparency into the information used by management in our financial and operational decision-making. However, because core earnings is an incomplete measure of our financial performance and involves differences from net income computed in accordance with U.S. GAAP, it should be considered along with, but not as an alternative to, our net income as a measure of our financial performance. In addition, because not all companies use identical calculations, our presentation of core earnings may not be comparable to other similarly-titled measures of other companies.87\n| i) | any unrealized gains or losses on certain MBS |\n| ii) | any realized gains or losses on sales of certain MBS |\n| iii) | any unrealized gains or losses on Residential MSRs |\n| iv) | one-time non-recurring gains or losses, such as gains or losses on discontinued operations, bargain purchase gains, or merger related expenses |\n| | | | | | | | | | | | | | | | | | |\n| | Three Months Ended September 30, | | | | | Nine Months Ended September 30, | | | |\n| (in thousands) | 2020 | | 2019 | | Change | | 2020 | | 2019 | | Change |\n| Net Income | $ | 35,363 | | $ | 12,427 | | $ | 22,936 | | $ | 18,510 | | $ | 54,120 | | $ | (35,610) |\n| Reconciling items: | | | | | | | | | | | | | | | | | |\n| Unrealized (gain) loss on mortgage servicing rights | | 4,688 | | | 7,582 | | | (2,894) | | | 33,169 | | | 21,049 | | | 12,120 |\n| Impact of the adoption of ASU 2016-13 on accrual loans | | (7,248) | | | — | | | (7,248) | | | 23,114 | | | — | | | 23,114 |\n| Non-recurring REO impairment | | (114) | | | — | | | (114) | | | 2,961 | | | — | | | 2,961 |\n| Merger transaction costs and other non-recurring expenses | | 998 | | | 51 | | | 947 | | | 3,220 | | | 6,914 | | | (3,694) |\n| Bargain purchase gain | | — | | | — | | | — | | | — | | | (30,728) | | | 30,728 |\n| Unrealized (gain) loss on mortgage-backed securities | | — | | | 85 | | | (85) | | | 185 | | | 205 | | | (20) |\n| Unrealized loss on de-designated cash flow hedges | | — | | | — | | | — | | | 2,118 | | | — | | | 2,118 |\n| Total reconciling items | $ | (1,676) | | $ | 7,718 | | $ | (9,394) | | $ | 64,767 | | $ | (2,560) | | $ | 67,327 |\n| Income tax adjustments | | (1,561) | | | (1,896) | | | 335 | | | (10,703) | | | (5,263) | | | (5,440) |\n| Core earnings | $ | 32,126 | | $ | 18,249 | | $ | 13,877 | | $ | 72,574 | | $ | 46,297 | | $ | 26,277 |\n| Less: Core earnings attributable to non-controlling interests | | (731) | | | (474) | | | (257) | | | (2,160) | | | (1,352) | | | (808) |\n| Less: Income attributable to participating shares | | (339) | | | (79) | | | (260) | | | (1,087) | | | (240) | | | (847) |\n| Core earnings attributable to common stockholders | $ | 31,056 | | $ | 17,696 | | $ | 13,360 | | $ | 69,814 | | $ | 44,705 | | $ | 25,109 |\n| Core Earnings per common share - basic and diluted | $ | 0.57 | | $ | 0.40 | | $ | 0.17 | | $ | 1.30 | | $ | 1.10 | | $ | 0.20 |\n| | | | | | | | | | |\n\nThree Months Ended September 30, 2020 Compared to the Three Months Ended September 30, 2019Consolidated net income increased by $22.9 million, from $12.4 million during the three months ended September 30, 2019 to $35.4 million during the three months ended September 30, 2020. Core earnings increased by $13.9 million, from $18.2 million during the three months ended September 30, 2019 to $32.1 million during the three months ended September 30, 2020.The increase in consolidated net income and core earnings was primarily the result of an increase in residential mortgage banking activities net of variable costs of $32.9 million. Nine Months Ended September 30, 2020 Compared to the Nine Months Ended September 30, 2019Consolidated net income decreased by $35.6 million, from $54.1 million during the nine months ended September 30, 2019 to $18.5 million during the nine months ended September 30, 2020. Core earnings increased by $26.3 million, from $46.3 million during the nine months ended September 30, 2019 to $72.6 million during the nine months ended September 30, 2020.The decrease in consolidated net income was the result of a number of factors, including a $35.4 million reduction due to the adoption of CECL during the three months ended March 31, 2020. In addition, unrealized losses on MSRs of $16.4 million and $3.0 million of non-recurring REO impairment experienced in the first quarter of 2020. In addition, we experienced a bargain purchase gain of $30.7 million, offset by merger related expenses of $5.5 million, as a result of the ORM merger transaction in the first quarter of 2019. This was partially offset by the $25.8 million of revenue recognized on loans originated under the SBA’s PPP program. Core earnings increased by $26.3 million primarily due to $25.8 million of revenue recognized on loans originated under the SBA’s PPP program and revenue growth in our residential mortgage banking segment.COVID-19 Impact on Operating ResultsThe significant and wide-ranging response of international, federal, state and local public health and governmental authorities to the COVID-19 pandemic in regions across the United States and the world, including the imposition of quarantines, “stay-at-home” orders and similar mandates for many individuals to substantially restrict daily activities and for many businesses to curtail or cease normal operations, and the volatile economic, business and financial market conditions resulting therefrom, are expected to negatively impact our business, financial performance and operating results in later periods of 2020. Although we are uncertain of the potential full magnitude or duration of the business and economic impacts from the unprecedented public health efforts to contain and combat the spread of COVID-19, we will likely experience material deterioration in our financial performance and operating results, revenues, cash flow and/or profitability in one or more of the remaining periods in 2020 compared to the corresponding prior-year periods and compared to our expectations at the beginning of our 2020 fiscal year. Further discussion of the potential impacts on our business from the COVID-19 pandemic is provided in the section entitled “Risk Factors” in Part II, Item 1A of this Quarterly Report on Form 10-Q.Incentive distribution payable to our ManagerUnder the partnership agreement of our operating partnership, our Manager, the holder of the Class A special unit in our operating partnership, is entitled to receive an incentive distribution, distributed quarterly in arrears in an amount not less than zero equal to the difference between (i) the product of (A) 15% and (B) the difference between (x) core earnings (as described below) of our operating partnership, on a rolling four-quarter basis and before the incentive distribution for the current quarter, and (y) the product of (1) the weighted average of the issue price per share of common stock or operating partnership unit (“OP unit”) (without double counting) in all of our offerings multiplied by the weighted average number of shares of common stock outstanding (including any restricted shares of common stock and any other shares of common stock underlying awards granted under our 2012 equity incentive plan) and OP units (without double counting) in such quarter and (2) 8%, and (ii) the sum of any incentive distribution paid to our Manager with respect to the first three quarters of such previous four quarters; provided, however, that no incentive distribution is payable with respect to any calendar quarter unless cumulative core earnings is greater than zero for the most recently completed 12 calendar quarters, or the number of completed calendar quarters since the closing date of the merger with ZAIS Financial Corp. (“ZAIS Financial merger”), whichever is less.89\nFor purposes of calculating the incentive distribution, the shares of common stock and OP units issued as of the closing of the ZAIS Financial merger in connection with the merger agreement were deemed to be issued at the per share price equal to (i) the sum of (A) the weighted average of the issue price per share of common stock or OP units (without double counting) issued prior to the closing of the ZAIS Financial merger multiplied by the number of shares of Sutherland common stock outstanding and Sutherland OP units (without double counting) issued prior to the closing of the merger plus (B) the amount by which the net book value of our Company as of the closing of the merger (after giving effect to the closing of the merger agreement) exceeded the amount of the net book value of Sutherland immediately preceding the closing of the merger, divided by (ii) all of the shares of our common stock and OP units issued and outstanding as of the closing of the merger (including the date of the closing of the mergers).The incentive distribution shall be calculated within 30 days after the end of each quarter and such calculation shall promptly be delivered to our Company. We are obligated to pay the incentive distribution 50% in cash and 50% in either common stock or OP units, as determined in our discretion, within five business days after delivery to our Company of the written statement from the holder of the Class A special unit setting forth the computation of the incentive distribution for such quarter. Subject to certain exceptions, our Manager may not sell or otherwise dispose of any portion of the incentive distribution issued to it in common stock or OP units until after the three year anniversary of the date that such shares of common stock or OP units were issued to our Manager. The price of shares of our common stock for purposes of determining the number of shares payable as part of the incentive distribution is the closing price of such shares on the last trading day prior to the approval by our board of the incentive distribution.For purposes of determining the incentive distribution payable to our Manager, core earnings is defined under the partnership agreement of our operating partnership in a manner that is similar to the definition of core earnings described above under \"Non-GAAP Financial Measures\" but with the following additional adjustments which (i) further exclude: (a) the incentive distribution, (b) non-cash equity compensation expense, if any, (c) unrealized gains or losses on SBC loans (not just MBS and MSRs), (d) depreciation and amortization (to the extent we foreclose on any property), and (e) one-time events pursuant to changes in U.S. GAAP and certain other non-cash charges after discussions between our Manager and our independent directors and after approval by a majority of the independent directors and (ii) add back any realized gains or losses on the sales of MBS and on discontinued operations which were excluded from the definition of core earnings described above under \"Non-GAAP Financial Measures\". Liquidity and Capital Resources Liquidity is a measure of our ability to turn non-cash assets into cash and to meet potential cash requirements. We use significant cash to purchase SBC loans and other target assets, originate new SBC loans, pay dividends, repay principal and interest on our borrowings, fund our operations and meet other general business needs. Our primary sources of liquidity will include our existing cash balances, borrowings, including securitizations, re-securitizations, repurchase agreements, warehouse facilities, bank credit facilities (including term loans and revolving facilities), the net proceeds of this and future offerings of equity and debt securities, including our Senior Secured Notes, Corporate debt, and Convertible Notes, and net cash provided by operating activities. We are continuing to monitor the COVID-19 pandemic and its impact on us, the borrowers underlying our real estate-related assets, the tenants in the properties we own, our financing sources, and the economy as a whole. Because the severity, magnitude and duration of the COVID-19 pandemic and its economic consequences are uncertain, rapidly changing and difficult to predict, the pandemic’s impact on our operations and liquidity remains uncertain and difficult to predict. Further discussion of the potential impacts on us from the COVID-19 pandemic is provided in the section entitled “Risk Factors” in Part II, Item 1A of this Quarterly Report on Form 10-Q.90\n| | | | | | | | | | | | | |\n| | | Three Months Ended September 30, | | Nine Months Ended September 30, |\n| (in thousands) | | 2020 | | 2019 | | 2020 | | 2019 |\n| Cash flows provided by (used in) operating activities | | $ | (48,289) | | $ | (7,063) | | $ | (261) | | $ | (64,870) |\n| Cash flows provided by (used in) investing activities | | $ | 129,694 | | $ | (245,446) | | $ | (7,688) | | $ | (920,245) |\n| Cash flows provided by (used in) financing activities | | $ | (207,044) | | $ | 255,607 | | $ | 103,715 | | $ | 995,283 |\n| | | | | | | | | | | | | |\n| Net increase (decrease) in cash and cash equivalents and restricted cash | | $ | (125,639) | | $ | 3,098 | | $ | 95,766 | | $ | 10,168 |\n| ● | Net cash used in operating activities of $48.3 million for the current quarter related primarily to: |\n| - | Cash outflows on originations of new loans held for sale of $1,392.9 million and gains on sales of residential mortgages held for sale of $61.1 million. These reductions in cash were partially offset by inflows relating to repayments and sales of loans, held for sale at fair value of $1,415.2 million. |\n| ● | Net cash provided by investing activities of $129.7 million for the current quarter related primarily to: |\n| - | Cash inflows of $302.2 million relating to outflows repayments sales of loans, net, partially offset by purchases and originations of loans, net of $149.0 million and investment in unconsolidated joint ventures of $14.6 million. |\n| ● | Net cash used in financing activities of $207.0 million for the current quarter related primarily to: |\n| - | Net repayment of secured borrowings of $77.2 million, payment of securitized debt obligations of $84.2 million, dividend payments of $14.5 million, and repurchase of the Company’s stock of $9.2 million. |\n| ● | Net cash used in operating activities of $7.1 million for the current quarter related primarily to: |\n| - | Cash inflows from proceeds on sales and pay-downs on loans, held-for-sale, at fair value of $802.4 million, offset by cash outflows on originations and purchases of new loans of $805.1 million. |\n| ● | Net cash used in investing activities of $245.4 million for the current quarter related primarily to: |\n| - | Cash outflows of $418.7 million relating to originations and purchases of loans, held at fair value and held-for-investment loans, offset by cash inflows relating to repayments of loans, held at fair value and held-for-investment of $170.6 million and sales and repayments of MBS of $4.3 million. |\n| ● | Net cash provided by financing activities of $255.6 million for the current quarter related primarily to: |\n| - | Net proceeds from secured borrowings of $327.0 million, proceeds from the issuance of corporate debt of $57.5 million, offset by net repayments of securitized debt of $103.7 million. |\n| ● | Net cash used in operating activities of $0.3 million for the current quarter related primarily to: |\n\n| - | Cash outflows on originations of new loans held for sale of $3,675.8 million and gains on sales of residential mortgages held for sale of $143.7 million. These reductions in cash were partially offset by inflows relating to repayments and sales of loans, held for sale at fair value of $3,680.5 million. |\n| ● | Net cash used in investing activities of $7.7 million for the current quarter related primarily to: |\n| - | Cash outflows of $677.0 million relating to originations and purchases of loans, held at fair value and held-for-investment loans, offset by cash inflows relating to repayments of loans, held at fair value and held-for-investment of $673.9 million, sales and repayments of MBS of $10.5 million, and investment in unconsolidated joint ventures of $16.3 million. |\n| ● | Net cash provided by financing activities of $103.7 million for the current quarter related primarily to: |\n| - | Net proceeds from securitized debt of $242.9 million, partially offset by net repayments of secured borrowings of $11.4 million and repayments of guaranteed loan financing of $78.8 million. |\n| ● | Net cash used in operating activities of $64.9 million related primarily to: |\n| - | Cash outflows on originations and purchases of new loans, held-for-sale, at fair value of $1,889.8 million and other general changes to operating assets and liabilities of $7.8 million, partially offset by cash inflows on sales and pay-downs of loans of $1,859.5 million. |\n| ● | Net cash used in investing activities of $920.2 million related primarily to: |\n| - | Cash outflows of $1,488.1 million relating to originations and purchases of loans, held-for-investment, purchases of MBS of $9.6 million, partially offset by cash inflows relating to repayments of loans, held at fair value and held-for-investment of $550.2 million and sales and repayments of MBS of $9.7 million. |\n| ● | Net cash provided by financing activities of $995.3 million related primarily to: |\n| - | Net proceeds from securitized debt obligations of $564.1 million and secured borrowings of $469.4 million. |\n| | | | | | | | | | |\n| Quarter End | | Quarter End Balance | | Average Balance in Quarter | | Highest Month End Balance in Quarter |\n| Q3 2017 | | $ | 320,371 | | $ | 420,270 | | $ | 433,183 |\n| Q4 2017 | | | 382,612 | | | 351,492 | | | 382,612 |\n| Q1 2018 | | | 446,663 | | | 414,638 | | | 446,663 |\n| Q2 2018 | | | 443,263 | | | 444,963 | | | 447,751 |\n| Q3 2018 | | | 610,251 | | | 526,757 | | | 610,251 |\n| Q4 2018 | | | 635,233 | | | 622,742 | | | 635,233 |\n| Q1 2019 | | | 597,963 | | | 604,107 | | | 635,233 |\n| Q2 2019 | | | 612,383 | | | 605,173 | | | 612,383 |\n| Q3 2019 | | | 876,163 | | | 744,273 | | | 876,163 |\n| Q4 2019 | | | 809,189 | | | 842,676 | | | 876,163 |\n| Q1 2020 | | | 1,159,357 | | | 984,273 | | | 1,159,357 |\n| Q2 2020 | | | 714,162 | | | 936,760 | | | 1,057,522 |\n| Q3 2020 | | | 624,549 | | | 669,356 | | | 831,200 |\n\n| | | | | | | | | | | | | | | | | |\n| | | | | | | | | | | | | Carrying Value at |\n| Lender | Asset Class | Current Maturity | Pricing | Facility Size | Pledged Assets Carrying Value | September 30, 2020 | December 31, 2019 |\n| JPMorgan | Acquired loans, SBA loans | June 2021 | | 1M L + 1.75 to 2.75% | | $ | 250,000 | | $ | 44,840 | | $ | 30,742 | | $ | 88,972 |\n| Keybank | Freddie Mac loans | February 2021 | | 1M L + 1.30% | | | 100,000 | | | 20,486 | | | 20,242 | | | 21,513 |\n| East West Bank | SBA loans | October 2022 | | Prime - 0.821 to + 0.29% | | | 50,000 | | | 40,550 | | | 33,184 | | | 13,294 |\n| Credit Suisse | Acquired loans (non USD) | December 2021 | | Euribor + 2.50% | | | 234,420 | (a) | | 53,021 | | | 32,267 | | | 37,646 |\n| FCB | Acquired loans | June 2021 | | 2.75% | | | — | | | — | | | — | | | 1,354 |\n| Comerica Bank | Residential loans | March 2021 | | 1M L + 1.75% | | | 125,000 | | | 90,515 | | | 83,704 | | | 56,822 |\n| TBK Bank | Residential loans | October 2021 | | Variable Pricing | | | 150,000 | | | 123,980 | | | 118,581 | | | 52,151 |\n| Origin Bank | Residential loans | June 2021 | | Variable Pricing | | | 60,000 | | | 25,093 | | | 23,471 | | | 15,343 |\n| Associated Bank | Residential loans | November 2020 | | 1M L + 1.50% | | | 60,000 | | | 47,918 | | | 44,489 | | | 5,823 |\n| East West Bank | Residential MSRs | September 2023 | | 1M L + 2.50% | | | 50,000 | | | 49,140 | | | 37,700 | | | 39,900 |\n| Credit Suisse | Purchased future receivables, PPP loans | June 2021 | | 1M L + 4.50% | | | 150,000 | | | — | | | — | | | 34,900 |\n| Rabobank | Real estate | January 2021 | | 4.22% | | | 14,500 | | | — | | | — | | | 12,485 |\n| Federal Reserve Bank of Minneapolis | PPP loans | April 2022 | | 0.35% | | | 105,222 | | | 105,089 | | | 105,005 | | | — |\n| Bank of the Sierra | Real estate | August 2050 | | 3.25% | | | 22,750 | | | 37,562 | | | 22,687 | | | — |\n| Total borrowings under credit facilities (b) | | | | $ | 1,371,892 | | $ | 638,194 | | $ | 552,072 | | $ | 380,203 |\n| Citibank | Fixed rate, Transitional, Acquired loans | October 2021 | | 1M L + 1.875 to 2.125% | | $ | 500,000 | | $ | 114,196 | | $ | 103,307 | | $ | 124,718 |\n| Deutsche Bank | Fixed rate, Transitional loans | November 2021 | | 3M L + 2.00 to 2.40% | | | 350,000 | | | 232,524 | | | 161,100 | | | 141,356 |\n| JPMorgan | Transitional loans | December 2020 | | 1M L + 2.25 to 4.00% | | | 400,000 | | | 265,599 | | | 175,764 | | | 250,466 |\n| JPMorgan | MBS | March 2021 | | 1.54 to 4.75% | | | 70,875 | | | 115,128 | | | 70,875 | | | 93,715 |\n| Deutsche Bank | MBS | January 2021 | | 3.54% | | | 16,354 | | | 20,189 | | | 16,354 | | | 44,730 |\n| Citibank | MBS | November 2020 | | 3.25 to 3.76% | | | 58,422 | | | 114,749 | | | 58,422 | | | 56,189 |\n| Bank of America | MBS | Matured | | 1.31 to 1.61% | | | — | | | — | | | — | | | 38,954 |\n| RBC | MBS | February 2021 | | 3.05 to 4.43% | | | 38,727 | | | 61,595 | | | 38,727 | | | 59,061 |\n| Total borrowings under repurchase agreements (c) | | $ | 1,434,378 | | $ | 923,980 | | $ | 624,549 | | $ | 809,189 |\n| Total secured borrowings | | $ | 2,806,270 | | $ | 1,562,174 | | $ | 1,176,621 | | $ | 1,189,392 |\n\nAs of September 30, 2020, we had $161.1 million outstanding under the DB Loan Repurchase Facility. The DB Loan Repurchase Facility is used to finance SBC loans, and the interest rate is LIBOR plus a spread, which varies depending on the type and age of the loan. The DB Loan Repurchase Facility has been extended through November 2021 and our subsidiaries have an option to extend the DB Loan Repurchase Facility for an additional year, subject to certain conditions. Up to 100% of the then-current unpaid obligations of ReadyCap Commercial, Sutherland Asset I, and Sutherland Warehouse Trust II are fully guaranteed by us.The eligible assets for the DB Loan Repurchase Facility are loans secured by a first mortgage lien on commercial properties subject to certain eligibility criteria, such as property type, geographical location, LTV ratios, debt yield and debt service coverage ratios. The principal amount paid by the bank for each mortgage loan is based on a percentage of the lesser of the mortgaged property value or the principal balance of such mortgage loan. ReadyCap Commercial, Sutherland Asset I, and Sutherland Warehouse Trust II paid the bank an up-front fee and are also required to pay the bank availability fees, and a minimum utilization fee for the DB Loan Repurchase Facility, as well as certain other administrative costs and expenses. The DB Loan Repurchase Facility also includes financial maintenance covenants, which include (i) an adjusted tangible net worth that does not decline by more than 25% in a quarter, 35% in a year or 50% from the highest adjusted tangible net worth, (ii) a minimum liquidity amount of the greater of (a) $5 million and (b) 3% of the sum of any outstanding recourse indebtedness plus the aggregate repurchase price of the mortgage loans on the Repurchase Agreement, (iii) a debt-to-assets ratio no greater than 80% and (iv) a tangible net worth at least equal to the sum of (a) the product of 1/15 and the amount of all non-recourse indebtedness (excluding the aggregate repurchase price) and other securitization indebtedness and (b) the product of 1/3 and the sum of the aggregate repurchase price and all recourse indebtedness.JPMorgan loan repurchase facilityOur subsidiaries, ReadyCap Warehouse Financing, LLC (“ReadyCap Warehouse Financing”), Sutherland Warehouse Trust, LLC (“Sutherland Warehouse Trust”) entered into a master repurchase agreement in December 2015, pursuant to which ReadyCap Warehouse Financing, Sutherland Warehouse Trust and Ready Capital Mortgage Depositor II, LLC (which joined as a seller in October 2019), may sell, and later repurchase, mortgage loans in an aggregate principal amount of up to $400 million. Our subsidiaries renewed their master repurchase agreement with JPMorgan in February 2020 (the “JPM Loan Repurchase Facility”). As of September 30, 2020, we had $175.8 million outstanding under the JPM Loan Repurchase Facility. The JPM Loan Repurchase Facility is used to finance commercial transitional loans, conventional commercial loans and commercial mezzanine loans and securities and the interest rate is LIBOR plus a spread, which is determined by the lender on an asset-by-asset basis. The JPM Loan Repurchase Facility is committed through December 10, 2020, and up to 25% of the then-current unpaid obligations of ReadyCap Warehouse Financing, Sutherland Warehouse Trust and Ready Capital Mortgage Depositor II, LLC are fully guaranteed by us.The eligible assets for the JPM Loan Repurchase Facility are loans secured by first and junior mortgage liens on commercial properties and subject to approval by JPM as the Buyer. The principal amount paid by the bank for each mortgage loan is based on the principal balance of such mortgage loan. ReadyCap Warehouse Financing and Sutherland Warehouse Trust paid the bank a structuring fee and are also required to pay the bank unused fees for the JPM Loan Repurchase Facility, as well as certain other administrative costs and expenses. The JPM Loan Repurchase Facility also includes financial maintenance covenants, which include (i) total stockholders’ equity must not be permitted to be less than the sum of (a) 60% of total stockholders’ equity as of the closing date of the facility plus (b) 50% of the net proceeds of any equity issuance after the closing date (ii) maximum leverage of 3:1 and (iii) liquidity equal to at least the lesser of (a) 4% of the sum of (without duplication) (1) any outstanding indebtedness plus (2) amounts due under the repurchase agreement and (b) $15.0 million.Citibank loan repurchase agreementOur subsidiaries, Waterfall Commercial Depositor, LLC, Sutherland Asset I, LLC, Ready Capital Subsidiary REIT I, LLC, and ReadyCap Commercial, LLC renewed a master repurchase agreement in August 2020 with Citibank, N.A. (the \"Citi Loan Repurchase Facility\" and, together with the DB Loan Repurchase Facility and the JPM Loan Repurchase Facility, the \"Loan Repurchase Facilities\"), pursuant to which Waterfall Commercial Depositor and Sutherland Asset I may sell, and later repurchase, a trust certificate (the “Trust Certificate”), representing interests in mortgage loans in an aggregate principal amount of up to $500 million. 94\nAs of September 30, 2020, we had $103.3 million outstanding under the Citi Loan Repurchase Facility. The Citi Loan Repurchase Facility is used to finance SBC loans, and the interest rate is one month LIBOR plus a spread, depending on asset characteristics. The Citi Loan Repurchase Facility is committed for a period of 364 days, and up to 25% of the then-current unpaid obligations of Waterfall Commercial Depositor, Sutherland Asset I, and ReadyCap Commercial, LLC are fully guaranteed by us.The eligible assets for the Citi Loan Repurchase Facility are loans secured by a first mortgage lien on commercial properties, which, amongst other things, generally have a UPB of less than $10 million. The principal amount paid by the bank for the Trust Certificate is based on a percentage of the lesser of the market value or the UPB of such mortgage loans backing the Trust Certificate. Waterfall Commercial Depositor, Sutherland Asset I, and ReadyCap Commercial, LLC are required to pay the bank a commitment fee for the Citi Loan Repurchase Facility, as well as certain other administrative costs and expenses. The Citi Loan Repurchase Facility includes financial maintenance covenants, which include (i) our operating partnership’s net asset value not (A) declining more than 15% in any calendar month, (B) declining more than 25% in any calendar quarter, (C) declining more than 35% in any calendar year, or (D) declining more than 50% from our operating partnership’s highest net asset value set forth in any audited financial statement provided to the bank; (ii) our operating partnership maintaining liquidity in an amount equal to at least 1% of our outstanding indebtedness; and (iii) the ratio of our operating partnership’s total indebtedness (excluding non-recourse liabilities in connection with any securitization transaction) to our net asset value not exceeding 4:1 at any time.Securities repurchase agreements As of September 30, 2020, we had $184.4 million of secured borrowings related to SBC ABS and pledged Trust Certificates with four counterparties (lenders).General statements regarding loan and securities repurchase facilities At September 30, 2020, we had $850.1 million in fair value of Trust Certificates and loans pledged against our borrowings under the Loan Repurchase Facilities and $73.9 million in fair value of SBC ABS and short term investments pledged against our securities repurchase agreement borrowings.Under the Loan Repurchase Facilities and securities repurchase agreements, we may be required to pledge additional assets to our counterparties in the event that the estimated fair value of the existing pledged collateral under such agreements declines and such lenders demand additional collateral, which may take the form of additional assets or cash. Generally, the Loan Repurchase Facilities and securities repurchase agreements contain a LIBOR-based financing rate, term and haircuts depending on the types of collateral and the counterparties involved. If the estimated fair values of the assets increase due to changes in market interest rates or other market factors, lenders may release collateral back to us. Margin calls may result from a decline in the value of the investments securing the Loan Repurchase Facilities and securities repurchase agreements, prepayments on the loans securing such investments and from changes in the estimated fair value of such investments generally due to principal reduction of such investments from scheduled amortization and resulting from changes in market interest rates and other market factors. Counterparties also may choose to increase haircuts based on credit evaluations of our Company and/or the performance of the assets in question. Historically, disruptions in the financial and credit markets have resulted in increased volatility in these levels, and this volatility could persist as market conditions continue to change. Should prepayment speeds on the mortgages underlying our investments or market interest rates suddenly increase, margin calls on the Loan Repurchase Facilities and securities repurchase agreements could result, causing an adverse change in our liquidity position. To date, we have satisfied all of our margin calls and have never sold assets in response to any margin call under these borrowings.Our borrowings under repurchase agreements are renewable at the discretion of our lenders and, as such, our ability to roll-over such borrowings is not guaranteed. The terms of the repurchase transaction borrowings under our repurchase agreements generally conform to the terms in the standard master repurchase agreement as published by the Securities Industry and Financial Markets Association, as to repayment, margin requirements and the segregation of all assets we have initially sold under the repurchase transaction. In addition, each lender typically requires that we include supplemental terms and conditions to the standard master repurchase agreement. Typical supplemental terms and conditions, which differ by lender, may include changes to the margin maintenance requirements, required haircuts and purchase price 95\nmaintenance requirements, requirements that all controversies related to the repurchase agreement be litigated in a particular jurisdiction, and cross default and setoff provisions.JPMorgan credit facility We renewed our master loan and security agreement with JPMorgan in June 2020 providing for a credit facility of up to $250 million. As of September 30, 2020, we had $30.7 million outstanding under this credit facility. The credit facility is structured as a secured loan facility in which ReadyCap Commercial, ReadyCap Lending and Sutherland 2016-1 JPM Grantor Trust act as borrowers. Under this facility, ReadyCap and Sutherland 2016-1 JPM Grantor Trust pledge loans guaranteed by the SBA under the SBA Section 7(a) Loan Program, SBA 504 loans and other loans which were part of the CIT loan acquisition. We act as a guarantor under this facility. The agreement contains financial maintenance covenants, which include (i) total stockholders’ equity must not be permitted to be less than the sum of (a) 60% of total stockholders’ equity as of the effective date of the facility plus (b) 50% of the net proceeds of any equity issuance after the effective date (ii) maximum leverage of 3:1 and (iii) liquidity equal to at least the lesser of (a) 4% of the sum of (without duplication) (1) any outstanding recourse indebtedness plus (2) amounts due under the repurchase agreement and (b) $15.0 million. The amended terms have an interest rate based on utilization ranging from one month LIBOR (reset daily), plus a spread. The term of the facility is one year, with an option to extend for an additional year.At September 30, 2020, we had a leverage ratio of 2.0x on a recourse debt-to-equity basis.We maintain certain assets, which, from time to time, may include cash, unpledged SBC loans, SBC ABS and short term investments (which may be subject to various haircuts if pledged as collateral to meet margin requirements) and collateral in excess of margin requirements held by our counterparties, or collectively, the “Cushion”, to meet routine margin calls and protect against unforeseen reductions in our borrowing capabilities. Our ability to meet future margin calls will be impacted by the Cushion, which varies based on the fair value of our investments, our cash position and margin requirements. Our cash position fluctuates based on the timing of our operating, investing and financing activities and is managed based on our anticipated cash needs. At September 30, 2020, we were in compliance with all debt covenants.East West Bank credit facilityOur subsidiary, ReadyCap Lending, LLC entered into a senior secured revolving credit facility with East West Bank on July 13, 2018, which provides financing of up to $50.0 million. The agreement extends for two years, with an additional one year extension at the Company’s request and pays interest equal to the Prime Rate minus 0.821% on SBA 7(a) guaranteed loans and the Prime Rate plus 0.029% on unguaranteed loans.Other credit facilitiesGMFS funds its origination platform through warehouse lines of credit with five counterparties with total borrowings outstanding of $307.9 million at September 30, 2020. GMFS utilizes committed warehouse lines of credit agreements ranging from $50.0 million to $150.0 million, with expiration dates between November 2020 and September 2023. The lines of credit are collateralized by the underlying mortgages, related documents, and instruments, and contain a LIBOR-based financing rate and term, haircut and collateral posting provisions which depend on the types of collateral and the counterparties involved. These agreements contain covenants that include certain financial requirements, including maintenance of minimum liquidity, minimum tangible net worth, maximum debt to net worth ratio and current ratio and limitations on capital expenditures, indebtedness, distributions, transactions with affiliates and maintenance of positive net income, as defined in the agreements. We were in compliance with all significant debt covenants as of September 30, 2020.96\nPublic offeringsDebt offeringsConvertible notesOn August 9, 2017, we closed an underwritten public sale of $115.0 million aggregate principal amount of its 7.00% convertible senior notes due 2023 (the “Convertible Notes”). The Convertible Notes will mature on August 15, 2023, unless earlier repurchased, redeemed or converted. During certain periods and subject to certain conditions, the Convertible Notes will be convertible by holders into shares of our common stock at an initial conversion rate of 1.4997 shares of common stock per $25 principal amount of the Convertible Notes, which is equivalent to an initial conversion price of approximately $16.67 per share of common stock. Upon conversion, holders will receive, at our discretion, cash, shares of our common stock or a combination thereof.We may, upon the satisfaction of certain conditions, redeem all or any portion of the Convertible Notes, at its option, on or after August 15, 2021, at a redemption price payable in cash equal to 100% of the principal amount of the Convertible Notes to be redeemed, plus accrued and unpaid interest. Additionally, upon the occurrence of certain corporate transactions, holders may require us to purchase the Convertible Notes for cash at a purchase price equal to 100% of the principal amount of the Convertible Notes to be purchased, plus accrued and unpaid interest. As of September 30, 2020, we were in compliance with all covenants with respect to the Convertible Notes.Corporate debtOn April 27, 2018, we completed the public offer and sale of $50.0 million aggregate principal amount of its 6.50% Senior Notes due 2021(the “2021 Notes”). We issued the 2021 Notes under a base indenture, dated August 9, 2017, as supplemented by the second supplemental indenture, dated as of April 27, 2018, between us and U.S. Bank National Association, as trustee. The 2021 Notes bear interest at a rate of 6.50% per annum, payable quarterly in arrears on January 30, April 30, July 30, and October 30 of each year, beginning on July 30, 2018. The 2021 Notes will mature on April 30, 2021, unless earlier redeemed or repurchased.Prior to April 30, 2019, the 2021 Notes are not redeemable by us. We may redeem for cash all or any portion of the 2021 Notes, at its option, on or after April 30, 2019 and before April 30, 2020 at a redemption price equal to 101% of the principal amount of the 2021 Notes to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date. On or after April 30, 2020, we may redeem for cash all or any portion of the 2021 Notes, at its option, at a redemption price equal to 100% of the principal amount of the 2021 Notes to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date. If we undergo a change of control repurchase event, holders may require it to purchase the 2021 Notes, in whole or in part, for cash at a repurchase price equal to 101% of the aggregate principal amount of the 2021 Notes to be purchased, plus accrued and unpaid interest, if any, to, but excluding, the date of repurchase, as described in greater detail in the Indenture.The 2021 Notes are our senior direct unsecured obligations and will not be guaranteed by any of its subsidiaries, except to the extent described in the Indenture upon the occurrence of certain events. The 2021 Notes rank equal in right of payment to any of our existing and future unsecured and unsubordinated indebtedness; effectively junior in right of payment to any of its existing and future secured indebtedness to the extent of the value of the assets securing such indebtedness; and structurally junior to all existing and future indebtedness, other liabilities (including trade payables) and (to the extent not held by us) preferred stock, if any, of its subsidiaries.On July 22, 2019, we completed the public offer and sale of $57.5 million aggregate principal amount of its 6.20% Senior Notes due 2026 (the “2026 Notes” and together with the 2021 Notes, the “Corporate Debt”), which includes $7.5 million aggregate principal amount of the 2026 Notes relating to the full exercise of the underwriters’ over-allotment option. The net proceeds from the sale of the 2026 Notes are approximately $55.3 million, after deducting underwriters’ discount and estimated offering expenses. We will contribute the net proceeds to Sutherland Partners, L.P. (the “Operating Partnership”), its operating partnership subsidiary, in exchange for the issuance by the Operating Partnership of a senior unsecured note with terms that are substantially equivalent to the terms of the 2026 Notes. The Operating Partnership intends to use the net proceeds to originate or acquire our target assets and for general business purposes.97\nThe 2026 Notes bear interest at a rate of 6.20% per annum, payable quarterly in arrears on January 30, April 30, July 30, and October 30 of each year, beginning on October 30, 2019. The 2026 Notes will mature on July 30, 2026, unless earlier repurchased or redeemed. We may redeem for cash all or any portion of the 2026 Notes, at its option, on or after July 30, 2022 and before July 30, 2025 at a redemption price equal to 101% of the principal amount of the 2026 Notes to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date. On or after July 30, 2025, we may redeem for cash all or any portion of the 2026 Notes, at its option, at a redemption price equal to 100% of the principal amount of the 2026 Notes to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date. If we undergo a change of control repurchase event, holders may require it to purchase the 2026 Notes, in whole or in part, for cash at a repurchase price equal to 101% of the aggregate principal amount of the 2026 Notes to be purchased, plus accrued and unpaid interest, if any, to, but excluding, the date of repurchase, as described in greater detail in the Indenture.The 2026 Notes are our senior unsecured obligations and will not be guaranteed by any of its subsidiaries, except to the extent described in the Indenture upon the occurrence of certain events. The 2026 Notes rank equal in right of payment to any of our existing and future unsecured and unsubordinated indebtedness; effectively junior in right of payment to any of its existing and future secured indebtedness to the extent of the value of the assets securing such indebtedness; and structurally junior to all existing and future indebtedness, other liabilities (including trade payables) and (to the extent not held by us) preferred stock, if any, of its subsidiaries.In December 2019, we completed the public offer and sale of $45.0 million aggregate principal amount of the 2026 Notes. The new notes have the same terms (expect with respect to issue date, issue price and the date from which interest will accrue) as, are fully fungible with and are treated as a single series of debt securities as, the 6.20% Senior Notes due 2026 we issued on July 22, 2019. As of September 30, 2020, we were in compliance with all covenants with respect to the corporate debt.Equity offeringIn December 2019, we completed a public offering of 6,000,000 shares of our common stock at a public offering price of $15.30 per share and an additional 900,000 shares of common stock at a public offering price of $15.30 per share pursuant to the underwriter’s full exercise of the over-allotment option in January 2020. Proceeds, net of offering costs and expenses were $ 91.8 million and $13.8 million for December 2019 and January 2020, respectively. There were no equity offerings during 2018.U.S. federal income tax proposed regulations The discussion under the heading “Additional U.S. Federal Income Tax Considerations” in our Prospectus dated August 31, 2018, describes certain tax legislative changes applicable to us. As described in the discussion under the heading \"Additional U.S. Federal Income Tax Considerations – U.S. Federal Income Tax Legislation – Income Accrual,\" we and our subsidiaries are required to recognize certain items of income for U.S. federal income tax purposes no later than we would report such items on our financial statements. Recently proposed Treasury regulations, which are not yet in effect but upon which taxpayers may rely, generally would exclude, among other items, original issue discount and market discount income from the applicability of this rule Other long term financingReadyCap Holdings’ 7.50% senior secured notes due 2022During 2017, ReadyCap Holdings LLC, a subsidiary of the Company, issued $140.0 million in 7.50% Senior Secured Notes due 2022. On January 30, 2018 ReadyCap Holdings LLC, issued an additional $40.0 million in aggregate principal amount of 7.50% Senior Secured Notes due 2022, which have identical terms (other than issue date and issue price) to the notes issued during 2017 (collectively “the Senior Secured Notes”). The additional $40.0 million in Senior Secured Notes were priced with a yield to par call date of 6.5%. Payments of the amounts due on the Senior Secured Notes are fully and unconditionally guaranteed by the Company and its subsidiaries: Sutherland Partners LP, Sutherland Asset I, LLC, and ReadyCap Commercial. The funds were used to fund new SBC and SBA loan originations and new SBC loan acquisitions. 98\nThe Senior Secured Notes bear interest at 7.50% per annum payable semiannually on each February 15 and August 15, beginning on August 15, 2017. The Senior Secured Notes will mature on February 15, 2022, unless redeemed or repurchased prior to such date. ReadyCap Holdings may redeem the Senior Secured Notes prior to November 15, 2021, at its option, in whole or in part at any time and from time to time, at a price equal to 100% of the outstanding principal amount thereof, plus the applicable “make-whole” premium as of, and unpaid interest, if any, accrued to, the redemption date. On and after November 15, 2021, ReadyCap Holdings may redeem the Senior Secured Notes, at its option, in whole or in part at any time and from time to time, at a price equal to 100% of the outstanding principal amount thereof plus unpaid interest, if any, accrued to the redemption date.ReadyCap Holdings’ and the Guarantors’ respective obligations under the Senior Secured Notes and the Guarantees are secured by a perfected first-priority lien on the capital stock of ReadyCap Holdings and ReadyCap Commercial and certain other assets owned by certain of our Company’s subsidiaries as described in greater detail in our Current Report on Form 8-K filed on June 15, 2017. The Senior Secured Notes were issued pursuant to an indenture (the \"Indenture\") and a first supplemental indenture (the \"First Supplemental Indenture\"), which contains covenants that, among other things: (i) limit the ability of our Company and its subsidiaries (including ReadyCap Holdings and the other Guarantors) to incur additional indebtedness; (ii) require that our Company maintain, on a consolidated basis, quarterly compliance with the applicable consolidated recourse indebtedness to equity ratio of our Company and consolidated indebtedness to equity ratio of our Company and specified ratios of our Company’s stockholders’ equity to aggregate principal amount of the outstanding Senior Secured Notes and our Company's consolidated unencumbered assets to aggregate principal amount of the outstanding Senior Secured Notes; (iii) limit the ability of ReadyCap Holdings and ReadyCap Commercial to pay dividends or distributions on, or redeem or repurchase, the capital stock of ReadyCap Holdings or ReadyCap Commercial; (iv) limit (1) ReadyCap's Holdings ability to create or incur any lien on the collateral and (2) unless the Senior Secured Notes are equally and ratably secured, (a) ReadyCap's Holdings ability to create or incur any lien on the capital stock of its wholly-owned subsidiary, ReadyCap Lending and (b) ReadyCap's Holdings ability to permit ReadyCap Lending to create or incur any lien on its assets to secure indebtedness of its affiliates other than its subsidiaries or any securitization entity; and (v) limit ReadyCap Holding's and the Guarantors' ability to consolidate, merge or transfer all or substantially all of ReadyCap' Holdings and the Guarantors’ respective properties and assets. The First Supplemental Indenture also requires that our Company ensure that the Replaceable Collateral Value (as defined therein) is not less than the aggregate principal amount of the Senior Secured Notes outstanding as of the last day of each of our Company's fiscal quarters.As of September 30, 2020, we were in compliance with all covenants with respect to the Senior Secured Notes.Securitization transactionsOur Manager’s extensive experience in loan acquisition, origination, servicing and securitization strategies has enabled us to complete several securitizations of SBC and SBA loan assets since January 2011. These securitizations allow us to match fund the SBC and SBA loans on a long-term, non-recourse basis. The assets pledged as collateral for these securitizations were contributed from our portfolio of assets. By contributing these SBC and SBA assets to the various securitizations, these transactions created capacity for us to fund other investments. 99\n| | | | | | |\n| Deal Name | Collateral Asset Class | Issuance | Active / Collapsed | Bonds Issued(in $ millions) |\n| Trusts (Firm sponsored) | | | | | |\n| Waterfall Victoria Mortgage Trust 2011-1 (SBC1) | SBC Acquired loans | February 2011 | Collapsed | $ | 40.5 |\n| Waterfall Victoria Mortgage Trust 2011-3 (SBC3) | SBC Acquired loans | October 2011 | Collapsed | | 143.4 |\n| Sutherland Commercial Mortgage Trust 2015-4 (SBC4) | SBC Acquired loans | August 2015 | Collapsed | | 125.4 |\n| Sutherland Commercial Mortgage Trust 2018 (SBC7) | SBC Acquired loans | November 2018 | Active | | 217.0 |\n| ReadyCap Lending Small Business Trust 2015-1 (RCLT 2015-1) | Acquired SBA 7(a) loans | June 2015 | Collapsed | | 189.5 |\n| ReadyCap Lending Small Business Loan Trust 2019-2 (RCLT 2019-2) | Originated SBA 7(a) loans, Acquired SBA 7(a) loans | December 2019 | Active | | 131.0 |\n| | | | | | |\n| Real Estate Mortgage Investment Conduits (REMICs) | | | | | |\n| ReadyCap Commercial Mortgage Trust 2014-1 (RCMT 2014-1) | SBC Originated conventional | September 2014 | Active | $ | 181.7 |\n| ReadyCap Commercial Mortgage Trust 2015-2 (RCMT 2015-2) | SBC Originated conventional | November 2015 | Active | | 218.8 |\n| ReadyCap Commercial Mortgage Trust 2016-3 (RCMT 2016-3) | SBC Originated conventional | November 2016 | Active | | 162.1 |\n| ReadyCap Commercial Mortgage Trust 2018-4 (RCMT 2018-4) | SBC Originated conventional | March 2018 | Active | | 165.0 |\n| Ready Capital Mortgage Trust 2019-5 (RCMT 2019-5) | SBC Originated conventional | January 2019 | Active | | 355.8 |\n| Ready Capital Mortgage Trust 2019-6 (RCMT 2019-6) | SBC Originated conventional | November 2019 | Active | | 430.7 |\n| Waterfall Victoria Mortgage Trust 2011-2 (SBC2) | SBC Acquired loans | March 2011 | Active | | 97.6 |\n| Sutherland Commercial Mortgage Trust 2018 (SBC6) | SBC Acquired loans | August 2017 | Active | | 139.4 |\n| Sutherland Commercial Mortgage Trust 2019 (SBC8) | SBC Acquired loans | June 2019 | Active | | 306.5 |\n| Sutherland Commercial Mortgage Trust 2020 (SBC9) | SBC Acquired loans | June 2020 | Active | | 172.4 |\n| | | | | | |\n| Collateralized Loan Obligations (CLOs) | | | | | |\n| Ready Capital Mortgage Financing 2017– FL1 | SBC Originated transitional | August 2017 | Collapsed | $ | 198.8 |\n| Ready Capital Mortgage Financing 2018 – FL2 | SBC Originated transitional | June 2018 | Active | | 217.1 |\n| Ready Capital Mortgage Financing 2019 – FL3 | SBC Originated transitional | April 2019 | Active | | 320.2 |\n| Ready Capital Mortgage Financing 2020 – FL4 | SBC Originated transitional | June 2020 | Active | | 393.8 |\n| | | | | | |\n| Trusts (Non-firm sponsored) | | | | | |\n| Freddie Mac Small Balance Mortgage Trust 2016-SB11 | Originated agency multi-family | January 2016 | Active | $ | 110.0 |\n| Freddie Mac Small Balance Mortgage Trust 2016-SB18 | Originated agency multi-family | July 2016 | Active | | 118.0 |\n| Freddie Mac Small Balance Mortgage Trust 2017-SB33 | Originated agency multi-family | June 2017 | Active | | 197.9 |\n| Freddie Mac Small Balance Mortgage Trust 2018-SB45 | Originated agency multi-family | January 2018 | Active | | 362.0 |\n| Freddie Mac Small Balance Mortgage Trust 2018-SB52 | Originated agency multi-family | September 2018 | Active | | 505.0 |\n| Freddie Mac Small Balance Mortgage Trust 2018-SB56 | Originated agency multi-family | December 2018 | Active | | 507.3 |\n| Key Commercial Mortgage Trust 2020-S3(1) | SBC Originated conventional | September 2020 | Active | | 250.0 |\n| (1) Contributed portion of assets into trust | | | | | |\n\nAccounting Policies” included in Item 8, “Financial Statements and Supplementary Data,” in our 2019 annual report on Form 10-K. Loan impairment and allowance for loan lossesThe allowance for loan losses is intended to provide for credit losses inherent in the loans, held-for-investment portfolio and is reviewed quarterly for adequacy considering credit quality indicators, including probable and historical losses, collateral values, loan-to-value (“LTV”) ratio and economic conditions. The allowance for loan losses is increased through provisions for loan losses charged to earnings and reduced by charge-offs, net of recoveries. On January 1, 2020, the Company adopted ASU No. 2016-13, Financial Instruments-Credit Losses, and subsequent amendments (“ASU 2016-13”), which replaces the incurred loss methodology with an expected loss model known as the Current Expected Credit Loss (\"CECL\") model. CECL amends the previous credit loss model to reflect a reporting entity's current estimate of all expected credit losses, not only based on historical experience and current conditions, but also by including reasonable and supportable forecasts incorporating forward-looking information. The measurement of expected credit losses under CECL is applicable to financial assets measured at amortized cost. The allowance for loan losses required under ASU 2016-13 is deducted from the respective loans’ amortized cost basis on our unaudited consolidated balance sheets. The guidance also requires a cumulative-effect adjustment to retained earnings as of the beginning of the reporting period of adoption.In connection with the Company’s adoption of ASU 2016-13 on January 1, 2020, the Company implemented new processes including the utilization of loan loss forecasting models, updates to the Company’s reserve policy documentation, changes to internal reporting processes and related internal controls. The Company has implemented loan loss forecasting models for estimating expected life-time credit losses, at the individual loan level, for its loan portfolio. The CECL forecasting methods used by the Company include (i) a probability of default and loss given default method using underlying third-party CMBS/CRE loan database with historical loan losses from 1998 to 2019 and (ii) probability weighted expected cash flow method, depending on the type of loan and the availability of relevant historical market loan loss data. The Company might use other acceptable alternative approaches in the future depending on, among other factors, the type of loan, underlying collateral, and availability of relevant historical market loan loss data.The Company estimates the CECL expected credit losses for its loan portfolio at the individual loan level. Significant inputs to the Company’s forecasting methods include (i) key loan-specific inputs such as LTV, vintage year, loan-term, underlying property type, occupancy, geographic location, and others, and (ii) a macro-economic forecast. These estimates may change in future periods based on available future macro-economic data and might result in a material change in the Company’s future estimates of expected credit losses for its loan portfolio.In certain instances, the Company considers relevant loan-specific qualitative factors to certain loans to estimate its CECL expected credit losses. The Company considers loan investments that are both (i) expected to be substantially repaid through the operation or sale of the underlying collateral, and (ii) for which the borrower is experiencing financial difficulty, to be “collateral-dependent” loans. For such loans that the Company determines that foreclosure of the collateral is probable, the Company measures the expected losses based on the difference between the fair value of the collateral and the amortized cost basis of the loan as of the measurement date. For collateral-dependent loans that the Company determines foreclosure is not probable, the Company applies a practical expedient to estimate expected losses using the difference between the collateral’s fair value (less costs to sell the asset if repayment is expected through the sale of the collateral) and the amortized cost basis of the loan.While we have a formal methodology to determine the adequate and appropriate level of the allowance for loan losses, estimates of inherent loan losses involve judgment and assumptions as to various factors, including current economic conditions. Our determination of adequacy of the allowance for loan losses is based on quarterly evaluations of the above factors. Accordingly, the provision for loan losses will vary from period to period based on management's ongoing assessment of the adequacy of the allowance for loan losses.Significant judgment is required when evaluating loans for impairment; therefore, actual results over time could be materially different. Refer to “Notes to Consolidated Financial Statements, Note 6 – Loans and Allowance for Loan Losses” included in Item 8, “Financial Statements and Supplementary Data,” in this quarterly report on Form 10-Q for results of our loan impairment evaluation.101\nValuation of financial assets and liabilities carried at fair valueWe measure our MBS, derivative assets and liabilities, residential mortgage servicing rights, and any assets or liabilities where we have elected the fair value option at fair value, including certain loans we have originated that are expected to be sold to third parties or securitized in the near term. We have established valuation processes and procedures designed so that fair value measurements are appropriate and reliable, that they are based on observable inputs where possible, and that valuation approaches are consistently applied, and the assumptions and inputs are reasonable. We also have established processes to provide that the valuation methodologies, techniques and approaches for investments that are categorized within Level 3 of the ASC 820 Fair Value Measurement fair value hierarchy (the “fair value hierarchy”) are fair, consistent and verifiable. Our processes provide a framework that ensures the oversight of our fair value methodologies, techniques, validation procedures, and results.When actively quoted observable prices are not available, we either use implied pricing from similar assets and liabilities or valuation models based on net present values of estimated future cash flows, adjusted as appropriate for liquidity, credit, market and/or other risk factors. Refer to “Notes to Consolidated Financial Statements, Note 7 – Fair Value Measurements” included in Item 8, “Financial Statements and Supplementary Data,” in this annual report on Form 10-K for a more complete discussion of our critical accounting estimates as they pertain to fair value measurements. Servicing rights impairment Servicing rights, at amortized cost, are initially recorded at fair value and subsequently carried at amortized cost. We have elected the fair value option on our residential mortgage servicing rights, which are not subject to impairment. For purposes of testing our servicing rights, carried at amortized cost, for impairment, we first determine whether facts and circumstances exist that would suggest the carrying value of the servicing asset is not recoverable. If so, we then compare the net present value of servicing cash flow with its carrying value. The estimated net present value of servicing cash flows of the intangibles is determined using discounted cash flow modeling techniques which require management to make estimates regarding future net servicing cash flows, taking into consideration historical and forecasted loan prepayment rates, delinquency rates and anticipated maturity defaults. If the carrying value of the servicing rights exceeds the net present value of servicing cash flows, the servicing rights are considered impaired and an impairment loss is recognized in earnings for the amount by which carrying value exceeds the net present value of servicing cash flows. We monitor the actual performance of our servicing rights by regularly comparing actual cash flow, credit, and prepayment experience to modeled estimates.Significant judgment is required when evaluating servicing rights for impairment; therefore, actual results over time could be materially different. Refer to “Notes to Consolidated Financial Statements, Note 9 – Servicing Rights” included in Item 8, “Financial Statements and Supplementary Data,” in this annual report on Form 10-K for a more complete discussion of our critical accounting estimates as they pertain to servicing rights impairment.Refer to “Notes to Consolidated Financial Statements, Note 4– Recently Issued Accounting Pronouncements” included in Item 8, “Financial Statements and Supplementary Data,” in this annual report on Form 10-K for a discussion of recent accounting developments and the expected impact to the Company.INFLATIONVirtually all of our assets and liabilities are and will be interest rate sensitive in nature. As a result, interest rates and other factors influence our performance far more than does inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates. Our consolidated financial statements are prepared in accordance with U.S. GAAP and our activities and balance sheet shall be measured with reference to historical cost and/or fair market value without considering inflation.\nItem 3.\nQuantitative and Qualitative Disclosures about Market Risk\n102\nItem 4.\nControls and Procedures\n106\nPART II. OTHER INFORMATION 107\nItem 1.\nLegal Proceedings\n107\nItem 1A.\nRisk Factors\n107\nItem 2.\nUnregistered Sales of Equity Securities and Use of Proceeds\n110\nItem 3.\nDefaults Upon Senior Securities\n110\nItem 4.\nMine Safety Disclosures\n110\nItem 5.\nOther Information\n110\nItem 6.\nExhibits\n110\nSIGNATURES 113\nEXHIBIT 31.1 CERTIFICATIONS \nEXHIBIT 31.2 CERTIFICATIONS \nEXHIBIT 32.1 CERTIFICATION PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002, 10 U.S.C. SECTION 1350 \nEXHIBIT 32.2 CERTIFICATION PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002, 10 U.S.C. SECTION 1350 \n\n\n\n\n2\n| | | | | | | |\n| (In Thousands) | September 30, 2020 | December 31, 2019 |\n| Assets | | | | | | |\n| Cash and cash equivalents | | $ | 149,847 | | $ | 67,928 |\n| Restricted cash | | 46,204 | | 51,728 |\n| Loans, net (including $ 119,965 and $ 20,212 held at fair value) | | 1,393,139 | | 1,727,984 |\n| Loans, held for sale, at fair value | | 348,719 | | 188,077 |\n| Mortgage backed securities, at fair value | | 90,427 | | 92,466 |\n| Loans eligible for repurchase from Ginnie Mae | | | 237,542 | | | 77,953 |\n| Investment in unconsolidated joint ventures | | | 69,204 | | | 58,850 |\n| Purchased future receivables, net | | | 16,659 | | | 43,265 |\n| Derivative instruments | | 20,849 | | 2,814 |\n| Servicing rights (including $ 74,384 and $ 91,174 held at fair value) | | 110,045 | | 121,969 |\n| Real estate, held for sale | | | 45,063 | | | 58,573 |\n| Other assets | | 98,614 | | 106,925 |\n| Assets of consolidated VIEs | | | 2,691,198 | | | 2,378,486 |\n| Total Assets | | $ | 5,317,510 | | $ | 4,977,018 |\n| Liabilities | | | | | | |\n| Secured borrowings | | 1,176,621 | | 1,189,392 |\n| Securitized debt obligations of consolidated VIEs, net | | 2,059,114 | | 1,815,154 |\n| Convertible notes, net | | | 111,855 | | | 111,040 |\n| Senior secured notes, net | | 179,572 | | 179,289 |\n| Corporate debt, net | | | 150,658 | | | 149,986 |\n| Guaranteed loan financing | | 421,183 | | 485,461 |\n| Liabilities for loans eligible for repurchase from Ginnie Mae | | | 237,542 | | | 77,953 |\n| Derivative instruments | | 7,774 | | 5,250 |\n| Dividends payable | | 16,934 | | 21,302 |\n| Accounts payable and other accrued liabilities | | 132,087 | | 97,407 |\n| Total Liabilities | | $ | 4,493,340 | | $ | 4,132,234 |\n| Stockholders’ Equity | | | | | | |\n| Common stock, $ 0.0001 par value, 500,000,000 shares authorized, 54,175,648 and 51,127,326 shares issued and outstanding, respectively | | 5 | | 5 |\n| Additional paid-in capital | | 846,960 | | 822,837 |\n| Retained earnings | | | ( 31,779 ) | | | 8,746 |\n| Accumulated other comprehensive loss | | ( 9,916 ) | | ( 6,176 ) |\n| Total Ready Capital Corporation equity | | 805,270 | | 825,412 |\n| Non-controlling interests | | 18,900 | | 19,372 |\n| Total Stockholders’ Equity | | $ | 824,170 | | $ | 844,784 |\n| Total Liabilities and Stockholders’ Equity | | $ | 5,317,510 | | $ | 4,977,018 |\n\n| | | | | | | | | | | | | |\n| | | Three Months Ended September 30, | | Nine Months Ended September 30, |\n| (In Thousands, except share data) | 2020 | 2019 | 2020 | 2019 |\n| Interest income | | $ | 61,074 | | $ | 59,723 | | $ | 193,826 | | $ | 165,510 |\n| Interest expense | | ( 43,823 ) | | ( 39,390 ) | | ( 134,162 ) | | ( 110,919 ) |\n| Net interest income before provision for loan losses | | $ | 17,251 | | $ | 20,333 | | $ | 59,664 | | $ | 54,591 |\n| Provision for (Recovery of) loan losses | | 4,231 | | ( 693 ) | | ( 34,984 ) | | | ( 2,559 ) |\n| Net interest income after provision for (recovery of) loan losses | | $ | 21,482 | | $ | 19,640 | | $ | 24,680 | | $ | 52,032 |\n| Non-interest income | | | | | | | | | | | | |\n| Residential mortgage banking activities | | | 75,524 | | | 29,013 | | | 192,757 | | | 64,621 |\n| Net realized gains on financial instruments and real estate owned | | | 7,507 | | | 7,377 | | | 22,118 | | | 20,914 |\n| Net unrealized gain (losses) on financial instruments | | | 3,420 | | | ( 7,881 ) | | | ( 43,762 ) | | | ( 21,799 ) |\n| Servicing income, net of amortization and impairment of $ 1,555 and $ 4,556 for the three and nine months ended September 30, 2020, and $ 1,609 and $ 1,425 for the three and nine months ended September 30, 2019, respectively | | 10,115 | | 7,449 | | 27,193 | | | 22,012 |\n| Income on purchased future receivables, net of allowance for doubtful accounts of $ 2,888 and $ 9,805 for the three and nine months ended September 30, 2020, and $ 0 and $ 0 for the three and nine months ended September 30, 2019, respectively | | | 4,848 | | | — | | | 13,917 | | | — |\n| Income (loss) on unconsolidated joint ventures | | | 1,996 | | | 1,047 | | | ( 1,035 ) | | | 6,059 |\n| Other income | | 4,496 | | 2,979 | | 40,163 | | | 6,671 |\n| Gain on bargain purchase | | — | | — | | — | | | 30,728 |\n| Total non-interest income | | $ | 107,906 | | $ | 39,984 | | $ | 251,351 | | $ | 129,206 |\n| Non-interest expense | | | | | | | | | | | | |\n| Employee compensation and benefits | | ( 27,612 ) | | ( 13,438 ) | | ( 73,836 ) | | | ( 37,395 ) |\n| Allocated employee compensation and benefits from related party | | ( 2,250 ) | | ( 1,500 ) | | ( 4,750 ) | | | ( 3,603 ) |\n| Variable expenses on residential mortgage banking activities | | ( 30,918 ) | | ( 17,318 ) | | ( 87,494 ) | | | ( 39,995 ) |\n| Professional fees | | ( 4,158 ) | | ( 2,030 ) | | ( 8,632 ) | | | ( 5,445 ) |\n| Management fees – related party | | ( 2,714 ) | | ( 2,495 ) | | ( 7,941 ) | | | ( 6,987 ) |\n| Incentive fees – related party | | ( 1,134 ) | | — | | ( 4,640 ) | | | — |\n| Loan servicing expense | | ( 8,231 ) | | ( 4,866 ) | | ( 24,122 ) | | | ( 13,085 ) |\n| Merger related expenses | | | ( 6 ) | | | ( 51 ) | | | ( 63 ) | | | ( 6,121 ) |\n| Other operating expenses | | ( 10,448 ) | | ( 8,144 ) | | ( 41,927 ) | | | ( 23,091 ) |\n| Total non-interest expense | | $ | ( 87,471 ) | | $ | ( 49,842 ) | | $ | ( 253,405 ) | | $ | ( 135,722 ) |\n| Income (loss) before provision for income taxes | | $ | 41,917 | | $ | 9,782 | | $ | 22,626 | | $ | 45,516 |\n| Income tax (provision) benefit | | ( 6,554 ) | | | 2,645 | | ( 4,116 ) | | | 8,604 |\n| Net income (loss) | | $ | 35,363 | | $ | 12,427 | | $ | 18,510 | | $ | 54,120 |\n| Less: Net income (loss) attributable to non-controlling interest | | 805 | | | 323 | | 551 | | | 1,580 |\n| Net income (loss) attributable to Ready Capital Corporation | | $ | 34,558 | | $ | 12,104 | | $ | 17,959 | | $ | 52,540 |\n| | | | | | | | | | | | | |\n| Earnings (loss) per common share - basic | | $ | 0.63 | | $ | 0.27 | | $ | 0.32 | | $ | 1.29 |\n| Earnings (loss) per common share - diluted | | $ | 0.63 | | $ | 0.27 | | $ | 0.31 | | $ | 1.29 |\n| | | | | | | | | | | | | |\n| Weighted-average shares outstanding | | | | | | | | |\n| Basic | | | 54,626,995 | | | 44,438,652 | | | 53,534,497 | | | 40,517,231 |\n| Diluted | | | 54,704,611 | | | 44,467,801 | | | 53,612,113 | | | 40,546,380 |\n| | | | | | | | | | | | | |\n| Dividends declared per share of common stock | | $ | 0.30 | | $ | 0.40 | | $ | 0.95 | | $ | 1.20 |\n\n| | | | | | | | | | | | |\n| | Three Months Ended September 30, | | Nine Months Ended September 30, |\n| (In Thousands) | | 2020 | | | 2019 | | | 2020 | | | 2019 |\n| Net Income (loss) | $ | 35,363 | | $ | 12,427 | | $ | 18,510 | | $ | 54,120 |\n| Other comprehensive income (loss) - net change by component | | | | | | | | | | | |\n| Net change in hedging derivatives (cash flow hedges) | $ | 671 | | $ | ( 2,614 ) | | $ | ( 2,478 ) | | $ | ( 9,611 ) |\n| Foreign currency translation adjustment | | ( 712 ) | | | — | | | ( 1,342 ) | | | — |\n| Other comprehensive loss | $ | ( 41 ) | | $ | ( 2,614 ) | | $ | ( 3,820 ) | | $ | ( 9,611 ) |\n| Comprehensive income (loss) | $ | 35,322 | | $ | 9,813 | | $ | 14,690 | | $ | 44,509 |\n| Comprehensive income (loss) attributable to non-controlling interests | | 804 | | | 259 | | | 471 | | | 1,300 |\n| Comprehensive income (loss) attributable to Ready Capital Corporation | $ | 34,518 | | $ | 9,554 | | $ | 14,219 | | $ | 43,209 |\n| | | | | | | | | | | | |\n\n| | | | | | | | | | | | | | | | | | | | | | | | |\n| | | Nine Months Ended September 30, 2019 |\n| | | | | | | | | | | Retained | | | Accumulated Other | | Total | | | | | | |\n| | | Common Stock | | Additional Paid- | | Earnings | | | Comprehensive | | Ready Capital | | Non-controlling | | Total Stockholders' |\n| (in thousands, except share data) | Shares | Par Value | In Capital | (Deficit) | | | Loss | Corporation Equity | Interests | Equity |\n| Balance at January 1, 2019 | | 32,105,112 | | $ | 3 | | $ | 540,478 | | $ | 5,272 | | $ | ( 922 ) | | $ | 544,831 | | $ | 19,244 | | $ | 564,075 |\n| Dividend declared on common stock ($ 1.20 per share) | | — | | | — | | | — | | | ( 48,639 ) | | | — | | | ( 48,639 ) | | | — | | | ( 48,639 ) |\n| Dividend declared on OP units | | — | | | — | | | — | | | — | | | — | | | — | | | ( 1,341 ) | | | ( 1,341 ) |\n| Shares issued pursuant to merger transactions | | 12,223,552 | | | 1 | | | 179,320 | | | — | | | — | | | 179,321 | | | — | | | 179,321 |\n| Offering costs | | — | | | — | | | ( 73 ) | | | — | | | — | | | ( 73 ) | | | ( 2 ) | | | ( 75 ) |\n| Equity component of 2017 convertible note issuance | | — | | | — | | | ( 261 ) | | | — | | | — | | | ( 261 ) | | | ( 7 ) | | | ( 268 ) |\n| Distributions, net | | — | | | — | | | — | | | — | | | — | | | — | | | 70 | | | 70 |\n| Stock-based compensation | | 78,212 | | | — | | | 1,126 | | | — | | | — | | | 1,126 | | | — | | | 1,126 |\n| Manager incentive fee paid in stock | | 14,939 | | | — | | | 233 | | | — | | | — | | | 233 | | | — | | | 233 |\n| Net income | | — | | | — | | | — | | | 52,540 | | | — | | | 52,540 | | | 1,580 | | | 54,120 |\n| Other comprehensive loss | | — | | | — | | | — | | | — | | | ( 9,331 ) | | | ( 9,331 ) | | | ( 280 ) | | | ( 9,611 ) |\n| Balance at September 30, 2019 | | 44,421,815 | | $ | 4 | | $ | 720,823 | | $ | 9,173 | | $ | ( 10,253 ) | | $ | 719,747 | | $ | 19,264 | | $ | 739,011 |\n| | | | | | | | | | | | | | | | | | | | | | | | |\n| | | Nine Months Ended September 30, 2020 |\n| | | | | | | | | | | Retained | | | Accumulated Other | | Total | | | | | | |\n| | | Common Stock | | Additional Paid- | | Earnings | | | Comprehensive | | Ready Capital | | Non-controlling | | Total Stockholders' |\n| (in thousands, except share data) | Shares | Par Value | In Capital | (Deficit) | | | Loss | Corporation Equity | Interests | Equity |\n| Balance at January 1, 2020 | | 51,127,326 | | $ | 5 | | $ | 822,837 | | $ | 8,746 | | $ | ( 6,176 ) | | $ | 825,412 | | $ | 19,372 | | $ | 844,784 |\n| Cumulative-effect adjustment upon adoption of ASU 2016-13, net of taxes (Note 4) | | — | | | — | | | | | | ( 6,599 ) | | | — | | | ( 6,599 ) | | | ( 155 ) | | | ( 6,754 ) |\n| Dividend declared on common stock ($ 0.95 per share) | | — | | | — | | | — | | | ( 51,885 ) | | | — | | | ( 51,885 ) | | | — | | | ( 51,885 ) |\n| Dividend declared on OP units | | — | | | — | | | — | | | — | | | — | | | — | | | ( 1,093 ) | | | ( 1,093 ) |\n| Stock issued in connection with stock dividend | | 2,764,487 | | | — | | | 17,033 | | | — | | | — | | | 17,033 | | | 362 | | | 17,395 |\n| Equity issuances | | 900,000 | | | — | | | 13,410 | | | — | | | — | | | 13,410 | | | — | | | 13,410 |\n| Offering costs | | — | | | — | | | ( 49 ) | | | — | | | — | | | ( 49 ) | | | ( 1 ) | | | ( 50 ) |\n| Distributions, net | | — | | | — | | | — | | | — | | | — | | | — | | | ( 50 ) | | | ( 50 ) |\n| Equity component of 2017 convertible note issuance | | — | | | — | | | ( 283 ) | | | — | | | — | | | ( 283 ) | | | ( 6 ) | | | ( 289 ) |\n| Stock-based compensation | | 103,424 | | | — | | | 1,441 | | | — | | | — | | | 1,441 | | | — | | | 1,441 |\n| Manager incentive fee paid in stock | | 212,844 | | | — | | | 1,806 | | | — | | | — | | | 1,806 | | | — | | | 1,806 |\n| Share repurchases | | ( 932,433 ) | | | — | | | ( 9,235 ) | | | | | | — | | | ( 9,235 ) | | | — | | | ( 9,235 ) |\n| Net income | | — | | | — | | | — | | | 17,959 | | | — | | | 17,959 | | | 551 | | | 18,510 |\n| Other comprehensive loss | | — | | | — | | | — | | | — | | | ( 3,740 ) | | | ( 3,740 ) | | | ( 80 ) | | | ( 3,820 ) |\n| Balance at September 30, 2020 | | 54,175,648 | | $ | 5 | | $ | 846,960 | | $ | ( 31,779 ) | | $ | ( 9,916 ) | | $ | 805,270 | | $ | 18,900 | | $ | 824,170 |\n| | | | | | | | | | | | | | | | | | | | | | | | |\n| | | Three Months Ended September 30, 2019 |\n| | | | | | | | | | | Retained | | | Accumulated Other | | Total | | | | | | |\n| | | Common Stock | | Additional Paid- | | Earnings | | | Comprehensive | | Ready Capital | | Non-controlling | | Total Stockholders' |\n| (in thousands, except share data) | Shares | Par Value | In Capital | (Deficit) | | | Loss | Corporation Equity | Interests | Equity |\n| Balance at July 1, 2019 | | 44,415,479 | | $ | 4 | | $ | 720,812 | | $ | 14,914 | | $ | ( 7,703 ) | | $ | 728,027 | | $ | 19,379 | | $ | 747,406 |\n| Dividend declared on common stock ($ 0.40 per share) | | — | | | — | | | — | | | ( 17,845 ) | | | — | | | ( 17,845 ) | | | — | | | ( 17,845 ) |\n| Dividend declared on OP units | | — | | | — | | | — | | | — | | | — | | | — | | | ( 447 ) | | | ( 447 ) |\n| Equity component of 2017 convertible note issuance | | — | | | — | | | ( 89 ) | | | — | | | — | | | ( 89 ) | | | ( 2 ) | | | ( 91 ) |\n| Contributions, net | | — | | | — | | | — | | | — | | | — | | | — | | | 75 | | | 75 |\n| Stock-based compensation | | 6,336 | | | — | | | 100 | | | — | | | — | | | 100 | | | — | | | 100 |\n| Net income | | — | | | — | | | — | | | 12,104 | | | — | | | 12,104 | | | 323 | | | 12,427 |\n| Other comprehensive loss | | — | | | — | | | — | | | — | | | ( 2,550 ) | | | ( 2,550 ) | | | ( 64 ) | | | ( 2,614 ) |\n| Balance at September 30, 2019 | | 44,421,815 | | $ | 4 | | $ | 720,823 | | $ | 9,173 | | $ | ( 10,253 ) | | $ | 719,747 | | $ | 19,264 | | $ | 739,011 |\n| | | | | | | | | | | | | | | | | | | | | | | | |\n| | | Three Months Ended September 30, 2020 |\n| | | | | | | | | | | Retained | | | Accumulated Other | | Total | | | | | | |\n| | | Common Stock | | Additional Paid- | | Earnings | | | Comprehensive | | Ready Capital | | Non-controlling | | Total Stockholders' |\n| (in thousands, except share data) | Shares | Par Value | In Capital | (Deficit) | | | Loss | Corporation Equity | Interests | Equity |\n| Balance at July 1, 2020 | | 54,872,789 | | $ | 5 | | $ | 854,222 | | $ | ( 49,755 ) | | $ | ( 9,876 ) | | $ | 794,596 | | $ | 18,450 | | $ | 813,046 |\n| Dividend declared on common stock ($ 0.30 per share) | | — | | | — | | | — | | | ( 16,582 ) | | | — | | | ( 16,582 ) | | | — | | | ( 16,582 ) |\n| Dividend declared on OP units | | — | | | — | | | — | | | — | | | — | | | — | | | ( 352 ) | | | ( 352 ) |\n| Stock issued in connection with stock dividend | | — | | | | | | — | | | — | | | — | | | — | | | — | | | — |\n| Contributions, net | | — | | | — | | | — | | | — | | | — | | | — | | | — | | | — |\n| Offering costs | | — | | | — | | | ( 4 ) | | | — | | | — | | | ( 4 ) | | | — | | | ( 4 ) |\n| Equity component of 2017 convertible note issuance | | — | | | — | | | ( 96 ) | | | — | | | — | | | ( 96 ) | | | ( 2 ) | | | ( 98 ) |\n| Stock-based compensation | | 26,602 | | | — | | | 320 | | | — | | | — | | | 320 | | | — | | | 320 |\n| Manager incentive fee paid in stock | | 208,690 | | | — | | | 1,753 | | | — | | | — | | | 1,753 | | | — | | | 1,753 |\n| Share repurchases | | ( 932,433 ) | | | — | | | ( 9,235 ) | | | — | | | — | | | ( 9,235 ) | | | — | | | ( 9,235 ) |\n| Net income | | — | | | — | | | — | | | 34,558 | | | — | | | 34,558 | | | 805 | | | 35,363 |\n| Other comprehensive loss | | — | | | — | | | — | | | — | | | ( 40 ) | | | ( 40 ) | | | ( 1 ) | | | ( 41 ) |\n| Balance at September 30, 2020 | | 54,175,648 | | $ | 5 | | $ | 846,960 | | $ | ( 31,779 ) | | $ | ( 9,916 ) | | $ | 805,270 | | $ | 18,900 | | $ | 824,170 |\n\n| | | | | | | | |\n| | | Nine Months Ended September 30, | |\n| (In Thousands, except share information) | 2020 | 2019 | |\n| Cash Flows From Operating Activities: | | | | | | | |\n| Net income (loss) | | $ | 18,510 | | $ | 54,120 | |\n| Adjustments to reconcile net income (loss) to net cash (used in) provided by operating activities: | | | | | | | |\n| Amortization of premiums, discounts, and debt issuance costs, net | | | 25,971 | | | 11,582 | |\n| Provision for loan losses | | | 34,984 | | | 2,559 | |\n| Impairment loss on real estate, held for sale | | | 3,075 | | | 824 | |\n| Change in repair and denial reserve | | | 2,452 | | | 221 | |\n| Net settlement of derivative instruments | | | ( 10,226 ) | | | ( 4,068 ) | |\n| Purchase of loans, held for sale, at fair value | | | — | | | ( 4,458 ) | |\n| Origination of loans, held for sale, at fair value | | | ( 3,675,821 ) | | | ( 1,889,835 ) | |\n| Proceeds from disposition and principal payments of loans, held for sale, at fair value | | | 3,680,537 | | | 1,859,478 | |\n| Realized gains, net | | | ( 199,559 ) | | | ( 77,847 ) | |\n| Unrealized losses, net | | | 45,786 | | | 21,799 | |\n| Gain on bargain purchase | | | — | | | ( 30,728 ) | |\n| Net loss (income) of unconsolidated joint ventures, net of distributions | | | 1,202 | | | ( 5,687 ) | |\n| Foreign currency (gain) loss, net | | | ( 2,452 ) | | | — | |\n| Payoff of purchased future receivables, net of originations | | | 16,801 | | | — | |\n| Allowance for doubtful accounts on purchased future receivables | | | 9,805 | | | — | |\n| Net changes in operating assets and liabilities | | | | | | | |\n| Assets of consolidated VIEs (excluding loans, net), accrued interest and due from servicers | | | 2,897 | | | ( 3,188 ) | |\n| Receivable from third parties | | | 114 | | | 8,183 | |\n| Other assets | | | 6,929 | | | ( 17,185 ) | |\n| Accounts payable and other accrued liabilities | | | 38,734 | | | 9,360 | |\n| Net cash (used in) provided by operating activities | | | ( 261 ) | | | ( 64,870 ) | |\n| Cash Flows From Investing Activities: | | | | | | | |\n| Origination of loans | | | ( 555,028 ) | | | ( 918,805 ) | |\n| Purchase of loans | | | ( 121,990 ) | | | ( 569,254 ) | |\n| Purchase of mortgage backed securities, at fair value | | | ( 14,216 ) | | | ( 9,593 ) | |\n| Purchase of real estate | | | ( 329 ) | | | ( 117 ) | |\n| Funding of unconsolidated joint ventures | | | ( 16,294 ) | | | ( 14,726 ) | |\n| Purchase of servicing rights | | | — | | | ( 894 ) | |\n| Proceeds on unconsolidated joint venture in excess of earnings recognized | | | 4,738 | | | 6,807 | |\n| Proceeds from disposition and principal payment of loans | | | 673,868 | | | 550,152 | |\n| Proceeds from sale and principal payment of mortgage backed securities, at fair value | | | 10,518 | | | 9,737 | |\n| Proceeds from sale of real estate | | | 11,045 | | | 15,626 | |\n| Cash acquired in connection with the ORM Merger | | | — | | | 10,822 | |\n| Net cash (used in) provided by investing activities | | | ( 7,688 ) | | | ( 920,245 ) | |\n| Cash Flows From Financing Activities: | | | | | | | |\n| Proceeds from secured borrowings | | | 5,321,953 | | | 3,956,325 | |\n| Payment of secured borrowings | | | ( 5,336,010 ) | | | ( 3,486,916 ) | |\n| Proceeds from issuance of securitized debt obligations of consolidated VIEs | | | 495,220 | | | 879,585 | |\n| Proceeds from corporate debt | | | — | | | 57,500 | |\n| Payment of securitized debt obligations of consolidated VIEs | | | ( 252,276 ) | | | ( 315,474 ) | |\n| Payment of offering costs | | | — | | | ( 75 ) | |\n| Payment of guaranteed loan financing | | | ( 78,784 ) | | | ( 30,165 ) | |\n| Payment of deferred financing costs | | | ( 10,512 ) | | | ( 18,127 ) | |\n| Equity issuance, net of offering costs | | | 13,360 | | | — | |\n| Payment of contingent consideration | | | — | | | ( 1,207 ) | |\n| Payment of promissory note | | | — | | | ( 1,199 ) | |\n| Distributions from non-controlling interests, net | | | ( 50 ) | | | 70 | |\n| Dividend payments | | | ( 39,951 ) | | | ( 45,034 ) | |\n| Share repurchase program | | | ( 9,235 ) | | | — | |\n| Net cash (used in) provided by financing activities | | | 103,715 | | | 995,283 | |\n| Net increase (decrease) in cash, cash equivalents, and restricted cash | | | 95,766 | | | 10,168 | |\n| Cash, cash equivalents, and restricted cash at beginning of period | | | 127,980 | | | 94,970 | |\n| Cash, cash equivalents, and restricted cash at end of period | | $ | 223,746 | | $ | 105,138 | |\n| | | | | | | | |\n| Supplemental disclosure of operating cash flow | | | | | | | |\n| Cash paid for interest | | $ | 123,499 | | $ | 94,841 | |\n| Cash (received) paid for income taxes | | $ | ( 5,878 ) | | $ | ( 2,609 ) | |\n| Stock-based compensation | | $ | 1,121 | | $ | 1,126 | |\n| Supplemental disclosure of non-cash investing activities | | | | | | | |\n| Loans transferred from loans, held for sale, at fair value to loans, net | | $ | 509 | | $ | 750 | |\n| Loans transferred to real estate owned | | $ | 8,832 | | $ | — | |\n| Deconsolidation of assets in securitization trusts | | $ | — | | $ | 177,815 | |\n| Supplemental disclosure of non-cash financing activities | | | | | | | |\n| Dividend paid in stock | | $ | 17,395 | | $ | — | |\n| Common stock issued in connection with merger transactions | | | — | | | 12,223,552 | |\n| Deconsolidation of borrowings in securitization trusts | | $ | — | | $ | 177,815 | |\n| Share-based component of incentive fees | | $ | 1,806 | | $ | 233 | |\n| | | | | | | | |\n| Cash and restricted cash reconciliation | | | | | | | |\n| Cash and cash equivalents | | $ | 149,847 | | $ | 52,727 | |\n| Restricted cash | | | 46,204 | | | 45,303 | |\n| Cash, cash equivalents, and restricted cash in assets of consolidated VIEs | | | 27,695 | | | 7,108 | |\n| Cash, cash equivalents, and restricted cash at end of period | | $ | 223,746 | | $ | 105,138 | |\n| | | | | | | | |\n\n| ● | Acquisitions. We acquire performing and non-performing SBC loans as part of our business strategy. We hold performing SBC loans to term, and we seek to maximize the value of the non-performing SBC loans acquired by us through borrower-based resolution strategies. We typically acquire non-performing loans at a discount to their unpaid principal balance (“UPB”) when we believe that resolution of the loans will provide attractive risk-adjusted returns. We also acquire purchased future receivables through our Knight Capital, LLC (“Knight Capital”) funding platform. |\n| ● | SBC Originations. We originate SBC loans secured by stabilized or transitional investor properties using multiple loan origination channels through our wholly-owned subsidiary, ReadyCap Commercial, LLC (“ReadyCap Commercial”). These originated loans are generally held-for-investment or placed into securitization structures. Additionally, as part of this segment, we originate and service multi-family loans under the Federal Home Loan Mortgage Corporation’s Small Balance Loan Program (“Freddie Mac” and the “Freddie Mac program”). These originated loans are held for sale, then sold to Freddie Mac. |\n| ● | SBA Originations, Acquisitions, and Servicing. We acquire, originate and service owner-occupied loans guaranteed by the SBA under its Section 7(a) loan program (the “SBA Section 7(a) Program”) through our wholly-owned subsidiary, ReadyCap Lending, LLC (“ReadyCap Lending”). We hold an SBA license as one of only 14 non-bank Small Business Lending Companies (“SBLCs”) and have been granted preferred lender status by the SBA. These originated loans are either held-for-investment, placed into securitization structures, or sold. |\n| ● | Residential Mortgage Banking. We operate our residential mortgage loan origination segment through our wholly-owned subsidiary, GMFS, LLC (\"GMFS\"). GMFS originates residential mortgage loans eligible to be purchased, guaranteed or insured by the Federal National Mortgage Association (“Fannie Mae”), Freddie Mac, Federal Housing Administration (“FHA”), U.S. Department of Agriculture (“USDA”) and U.S. Department of |\n\n| Veterans Affairs (“VA”) through retail, correspondent and broker channels. These originated loans are then sold to third parties, primarily agency lending programs. |\n\nor phased out, many of these or similar restrictions remain in place, continue to be implemented or additional restrictions are being considered. Such actions are creating significant disruptions to global supply chains, and adversely impacting several industries, including but not limited to, airlines, hospitality, retail and the broader real estate industry. The major disruption caused by COVID-19 significantly reduced economic activity in most of the United States resulting in a significant increase in unemployment claims. COVID-19 has had a continued and prolonged adverse impact on economic and market conditions and has triggered a period of global economic slowdown which could have a material adverse effect on the Company’s results and financial condition. The full impact of COVID-19 on the real estate industry, the credit markets and consequently on the Company’s financial condition and results of operations is uncertain and cannot be predicted at the current time as it depends on several factors beyond the control of the Company including, but not limited to (i) the uncertainty around the severity and duration of the outbreak, (ii) the effectiveness of the United States public health response, (iii) the pandemic’s impact on U.S. and global economies, (iv) the timing, scope and effectiveness of additional governmental responses to the pandemic, (v) the timing and speed of economic recovery, (vi) the availability of a treatment or vaccination for COVID-19, and (vii) the negative impact on our borrowers, real estate values and cost of capital. Use of estimatesThe preparation of the Company’s unaudited interim consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the unaudited interim consolidated financial statements and the reported amounts of income and expenses during the reporting period. Management makes subjective estimates to project cash flows the Company expects to receive on its loans and securities as well as the related market discount rates, which significantly impacts the interest income, impairments, allowance for loan loss, and fair values recorded or disclosed. The effects of COVID-19 may negatively and materially impact significant estimates and assumptions used by the Company including, but not limited to estimates of expected credit losses, valuation of our equity method investments and the fair value estimates of the Company’s assets and liabilities. The uncertainty over the ultimate impact COVID-19 will have on the U.S. economy and global economy generally, and on our business in particular, makes any estimates and assumptions as of September 30, 2020 inherently less certain than they would be absent the current and potential impacts of COVID-19. Actual results could materially differ from those estimates. Basis of consolidationThe accompanying unaudited interim consolidated financial statements of the Company include the accounts and results of operations of the Operating Partnership and other consolidated subsidiaries and VIEs in which we are the primary beneficiary. The unaudited interim consolidated financial statements are prepared in accordance with ASC 810, Consolidations. Intercompany accounts and transactions have been eliminated. ReclassificationsCertain amounts reported for the prior periods in the accompanying unaudited interim consolidated financial statements have been reclassified in order to conform to the current period’s presentation. Cash and cash equivalentsThe Company accounts for cash and cash equivalents in accordance with ASC 305, Cash and Cash Equivalents. The Company defines cash and cash equivalents as cash, demand deposits, and short-term, highly liquid investments with original maturities of 90 days or less when purchased. Cash and cash equivalents are exposed to concentrations of credit risk. We deposit our cash with institutions that we believe to have highly valuable and defensible business franchises, strong financial fundamentals, and predictable and stable operating environments. Restricted cashRestricted cash represents cash held by the Company as collateral against its derivatives, borrowings under repurchase agreements, borrowings under credit facilities with counterparties, construction and mortgage escrows, as well as cash held for remittance on loans serviced for third parties. Restricted cash is not available for general corporate purposes but 10\nmay be applied against amounts due to counterparties under existing swaps and repurchase agreement borrowings or returned to the Company when the restriction requirements no longer exist or at the maturity of the swap or repurchase agreement. Loans, netLoans, net consists of loans, held-for-investment, net of allowance for loan losses and loans, held at fair value.Loans, held-for-investmentLoans, held-for-investment are loans acquired from third parties (“acquired loans”), loans originated by the Company that we do not intend to sell, or securitized loans that were previously originated by us. Securitized loans remain on the Company’s balance sheet because the securitization vehicles are consolidated under ASC 810. Acquired loans are recorded at cost at the time they are acquired. The Company uses the interest method to recognize, as a constant effective yield adjustment, the difference between the initial recorded investment in the loan and the principal amount of the loan. The calculation of the constant effective yield necessary to apply the interest method uses the payment terms required by the loan contract, and prepayments of principal are not anticipated to shorten the loan term.Recognition of interest income is suspended when any loans are placed on non-accrual status. Generally, all classes of loans are placed on non-accrual status when principal or interest has been delinquent for 90 days or when full collection is determined to be not probable. Interest income accrued, but not collected, at the date loans are placed on non-accrual status is reversed and subsequently recognized only to the extent it is received in cash or until the loan qualifies for return to accrual status. However, where there is doubt regarding the ultimate collectability of loan principal, all cash received is applied to reduce the carrying value of such loans. Loans are restored to accrual status only when contractually current and the collection of future payments is reasonably assured.Loans, held at fair valueLoans, held at fair value represent certain loans originated by the Company for which we have elected the fair value option. Interest is recognized as interest income in the unaudited interim consolidated statements of income when earned and deemed collectible. Changes in fair value are recurring and are reported as net unrealized gain (loss) on the unaudited interim consolidated statements of income. Allowance for loan lossesThe allowance for loan losses is intended to provide for credit losses inherent in the loans, held-for-investment portfolio and is reviewed quarterly for adequacy considering credit quality indicators, including probable and historical losses, collateral values, loan-to-value (“LTV”) ratio and economic conditions. The allowance for loan losses is increased through provisions for loan losses charged to earnings and reduced by charge-offs, net of recoveries. On January 1, 2020, the Company adopted ASU No. 2016-13, Financial Instruments-Credit Losses, and subsequent amendments (“ASU 2016-13”), which replaces the incurred loss methodology with an expected loss model known as the Current Expected Credit Loss (\"CECL\") model. CECL amends the previous credit loss model to reflect a reporting entity's current estimate of all expected credit losses, not only based on historical experience and current conditions, but also by including reasonable and supportable forecasts incorporating forward-looking information. The measurement of expected credit losses under CECL is applicable to financial assets measured at amortized cost. The allowance for loan losses required under ASU 2016-13 is deducted from the respective loans’ amortized cost basis on our unaudited consolidated balance sheets. The guidance also requires a cumulative-effect adjustment to retained earnings as of the beginning of the reporting period of adoption.In connection with the Company’s adoption of ASU 2016-13 on January 1, 2020, the Company implemented new processes including the utilization of loan loss forecasting models, updates to the Company’s reserve policy documentation, changes to internal reporting processes and related internal controls. The Company has implemented loan loss forecasting models for estimating expected life-time credit losses, at the individual loan level, for its loan portfolio. The CECL forecasting methods used by the Company include (i) a probability of default and loss given default method 11\nusing underlying third-party CMBS/CRE loan database with historical loan losses from 1998 to 2020 and (ii) probability weighted expected cash flow method, depending on the type of loan and the availability of relevant historical market loan loss data. The Company might use other acceptable alternative approaches in the future depending on, among other factors, the type of loan, underlying collateral, and availability of relevant historical market loan loss data.The Company estimates the CECL expected credit losses for its loan portfolio at the individual loan level. Significant inputs to the Company’s forecasting methods include (i) key loan-specific inputs such as LTV, vintage year, loan-term, underlying property type, occupancy, geographic location, and others, and (ii) a macro-economic forecast, including unemployment rates, interest rates, commercial real estate prices, and others. These estimates may change in future periods based on available future macro-economic data and might result in a material change in the Company’s future estimates of expected credit losses for its loan portfolio.In certain instances, the Company considers relevant loan-specific qualitative factors to certain loans to estimate its CECL expected credit losses. The Company considers loan investments that are both (i) expected to be substantially repaid through the operation or sale of the underlying collateral, and (ii) for which the borrower is experiencing financial difficulty, to be “collateral-dependent” loans. For such loans that the Company determines that foreclosure of the collateral is probable, the Company measures the expected losses based on the difference between the fair value of the collateral and the amortized cost basis of the loan as of the measurement date. For collateral-dependent loans that the Company determines foreclosure is not probable, the Company applies a practical expedient to estimate expected losses using the difference between the collateral’s fair value (less costs to sell the asset if repayment is expected through the sale of the collateral) and the amortized cost basis of the loan.While we have a formal methodology to determine the adequate and appropriate level of the allowance for loan losses, estimates of inherent loan losses involve judgment and assumptions as to various factors, including current economic conditions. Our determination of adequacy of the allowance for loan losses is based on quarterly evaluations of the above factors. Accordingly, the provision for loan losses will vary from period to period based on management's ongoing assessment of the adequacy of the allowance for loan losses. Non-accrual loansNon-accrual loans are the loans for which we are not accruing interest income. Non-accrual loans include PCD (“purchased credit-deteriorated”) loans when principal or interest has been delinquent for 90 days or more. Troubled debt restructuringsIn situations where, for economic or legal reasons related to the borrower’s financial difficulties, we grant concessions for a period of time to the borrower that we would not otherwise consider, the related loans are classified as troubled debt restructurings (“TDR”). These modified terms may include interest rate reductions, principal forgiveness, term extensions, payment forbearance and other actions intended to minimize our economic loss and to avoid foreclosure or repossession of collateral. For modifications where we forgive principal, the entire amount of such principal forgiveness is immediately charged off. Other than resolutions such as foreclosures and sales, we may remove loans held-for-investment from TDR classification, but only if they have been refinanced or restructured at market terms and qualify as a new loan. Generally, all loans modified in a TDR are placed or remain on non-accrual status at the time of the restructuring. However, certain accruing loans modified in a TDR that are current at the time of restructuring may remain on accrual status if payment in full under the restructured terms is expected.Additionally, based on recently issued regulatory guidance provided by federal and state regulatory agencies, loan modifications made in response to the COVID-19 pandemic are not considered TDRs if loans were considered current at the date the modification program was implemented. Loans, held for sale, at fair value Loans, held for sale, at fair value are loans that are expected to be sold to third parties in the near term. Interest is recognized as interest income in the unaudited interim consolidated statements of income when earned and deemed collectible. For loans originated by our SBC originations and SBA originations segments, changes in fair value are 12\nrecurring and are reported as net unrealized gain (loss) in the unaudited interim consolidated statements of income. For originated SBA loans, the guaranteed portion is held for sale, at fair value. For loans originated by GMFS, changes in fair value are reported as residential mortgage banking activities in the unaudited interim consolidated statements of income. Mortgage backed securities, at fair valueThe Company accounts for MBS as trading securities and carries them at fair value under ASC 320, Investments-Debt and Equity Securities. Our MBS portfolio is comprised of asset-backed securities collateralized by interest in or obligations backed by pools of SBC loans. Purchases and sales of MBS are recorded as of the trade date. Our MBS securities pledged as collateral against borrowings under repurchase agreements are included in mortgage backed securities, at fair value on our unaudited interim consolidated balance sheets.MBS are recorded at fair value as determined by market prices provided by independent broker dealers or other independent valuation service providers. The fair values assigned to these investments are based upon available information and may not reflect amounts that may be realized. We generally intend to hold our investment in MBS to generate interest income; however, we have and may continue to sell certain of our investment securities as part of the overall management of our assets and liabilities and operating our business. Loans eligible for repurchase from Ginnie Mae When the Company has the unilateral right to repurchase Ginnie Mae pool loans it has previously sold (generally loans that are more than 90 days past due), the Company then records the right to repurchase the loan as an asset and liability in its unaudited interim consolidated balance sheets. Such amounts reflect the unpaid principal balance of the loans. Derivative instruments, at fair valueSubject to maintaining our qualification as a REIT for U.S. federal income tax purposes, we utilize derivative financial instruments, currently comprised of credit default swaps (“CDSs”), interest rate swaps, and interest rate lock commitments (“IRLCs”) as part of our risk management. The Company accounts for derivative instruments under ASC 815, Derivatives and Hedges.All derivatives are reported as either assets or liabilities in the unaudited interim consolidated balance sheets at the estimated fair value with the changes in the fair value recorded in earnings, unless hedge accounting is elected. As of September 30, 2020, the Company has offset $ 7.7 million of cash collateral receivable against our gross derivative liability positions. As of September 30, 2020 and December 31, 2019, the cash collateral receivable for derivatives that has not been offset against our derivative liability positions is $ 11.2 million and $ 9.5 million, respectively, and is included in restricted cash in the unaudited interim consolidated balance sheets.Interest rate swap agreementsAn interest rate swap is an agreement between two counterparties to exchange periodic interest payments where one party to the contract makes a fixed-rate payment in exchange for a floating-rate payment from the other party. The dollar amount each party pays is an agreed-upon periodic interest rate multiplied by some pre-determined dollar principal (notional amount). No principal (notional amount) is exchanged between the two parties at trade initiation date. Only interest payments are exchanged. Interest rate swaps are classified as Level 2 in the fair value hierarchy. The fair value adjustments are reported within net unrealized gain (loss) on financial instruments, while the related interest income or interest expense, are reported within net realized gain (loss) on financial instruments in the unaudited interim consolidated statements of income.IRLCsIRLCs are agreements under which GMFS agrees to extend credit to a borrower under certain specified terms and conditions in which the interest rate and the maximum amount of the loan are set prior to funding. Unrealized gains and 13\nlosses on the IRLCs, reflected as derivative assets and derivative liabilities, respectively, are measured based on the value of the underlying mortgage loan, quoted government-sponsored enterprise Fannie Mae, Freddie Mac, and the Government National Mortgage Association ((“Ginnie Mae”), collectively, “GSEs”) or MBS prices, estimates of the fair value of the mortgage servicing rights (“MSRs”) and the probability that the mortgage loan will fund within the terms of the IRLC, net of commission expense and broker fees. The realized and unrealized gains or losses are reported in the unaudited interim consolidated statements of income as residential mortgage banking activities. IRLCs are classified as Level 3 in the fair value hierarchy.FX forwards FX forwards are agreements between two counterparties to exchange a pair of currencies at a set rate on a future date. FX forward contracts are used to convert the foreign currency risk to U.S. dollars to mitigate exposure to fluctuations in FX rates. The fair value adjustments are reported within net unrealized gain (loss) on financial instruments in the consolidated statements of income. FX forwards are classified as Level 2 in the fair value hierarchy. CDSsCDSs are contracts between two parties, a protection buyer, who makes fixed periodic payments, and a protection seller, who collects the premium in exchange for making the protection buyer whole in the case of default. The fair value adjustments are reported within net unrealized gain (loss) on financial instruments, while the related interest income or interest expense, are reported within net realized gain (loss) on financial instruments in the unaudited interim consolidated statements of income. CDS are classified as Level 2 in the fair value hierarchy.Hedge accountingAs a general rule, hedge accounting is permitted where the Company is exposed to a particular risk, such as interest rate risk, that causes changes in the fair value of an asset or liability or variability in the expected future cash flows of an existing asset, liability, or forecasted transaction that may affect earnings.To qualify as an accounting hedge under the hedge accounting rules (versus an economic hedge where hedge accounting is not applied), a hedging relationship must be highly effective in offsetting the risk designated as being hedged. We use cash flow hedges to hedge the exposure to variability in cash flows from forecasted transactions, including the anticipated issuance of securitized debt obligations. ASC 815 requires that a forecasted transaction be identified as either: 1) a single transaction, or 2) a group of individual transactions that share the same risk exposures for which they are designated as being hedged. Hedges of forecasted transactions are considered cash flow hedges since the price is not fixed, hence involve variability of cash flows.For qualifying cash flow hedges, the change in the fair value of the derivative (the hedging instrument) is recorded in other comprehensive income (loss) (\"OCI\"), and is reclassified out of OCI and into the consolidated statements of income when the hedged cash flows affect earnings. These amounts are recognized consistent with the classification of the hedged item, primarily interest expense (for hedges of interest rate risk). If the hedge relationship is terminated, then the value of the derivative recorded in accumulated other comprehensive income (loss) (\"AOCI\") is recognized in earnings when the cash flows that were hedged affect earnings, so long as the forecasted transaction remains probable of occurring. For hedge relationships that are discontinued because a forecasted transaction is probable of not occurring according to the original hedge forecast (including an additional two-month window), any related derivative values recorded in AOCI are immediately recognized in earnings. Hedge accounting is generally terminated at the debt issuance date because we are no longer exposed to cash flow variability subsequent to issuance. Accumulated amounts recorded in AOCI at that date are then released to earnings in future periods to reflect the difference in 1) the fixed rates economically locked in at the inception of the hedge and 2) the actual fixed rates established in the debt instrument at issuance. Because of the effects of the time value of money, the actual interest expense reported in earnings will not equal the effective yield locked in at hedge inception multiplied by the par value. Similarly, this hedging strategy does not actually fix the interest payments associated with the forecasted debt issuance. Servicing rights Servicing rights initially represent the fair value of expected future cash flows for performing servicing activities for others. The fair value considers estimated future servicing fees and ancillary revenue, offset by estimated costs to service 14\nthe loans, and generally declines over time as net servicing cash flows are received, effectively amortizing the servicing right asset against contractual servicing and ancillary fee income.Servicing rights are recognized upon sale of loans, including a securitization of loans accounted for as a sale in accordance with GAAP, if servicing is retained. For servicing rights, gains related to servicing rights retained is included in net realized gain (loss) in the unaudited interim consolidated statements of income. For residential mortgage servicing rights, gains on servicing rights retained upon sale of a loan are included in residential mortgage banking activities in the unaudited interim consolidated statements of income.The Company treats its servicing rights and residential mortgage servicing rights as two separate classes of servicing assets based on the class of the underlying mortgages and it treats these assets as two separate pools for risk management purposes. Servicing rights relating to the Company’s servicing of loans guaranteed by the SBA under its Section 7(a) loan program and servicing rights related to the Freddie Mac program are accounted for under ASC 860, Transfers and Servicing, while the Company’s residential mortgage servicing rights are accounted for under the fair value option under ASC 825, Financial Instruments.Servicing rights – SBA and Freddie MacSBA and Freddie Mac servicing rights are initially recorded at fair value and subsequently carried at amortized cost. We capitalize the value expected to be realized from performing specified servicing activities for others. Servicing rights are amortized in proportion to and over the period of estimated servicing income and are evaluated for potential impairment quarterly.For purposes of testing our servicing rights for impairment, we first determine whether facts and circumstances exist that would suggest the carrying value of the servicing asset is not recoverable. If so, we then compare the net present value of servicing cash flow with its carrying value. The estimated net present value of servicing cash flows is determined using discounted cash flow modeling techniques, which require management to make estimates regarding future net servicing cash flows, taking into consideration historical and forecasted loan prepayment rates, delinquency rates and anticipated maturity defaults. If the carrying value of the servicing rights exceeds the net present value of servicing cash flows, the servicing rights are considered impaired and an impairment loss is recognized in earnings for the amount by which carrying value exceeds the net present value of servicing cash flows.We estimate the fair value of servicing rights by determining the present value of future expected servicing cash flows using modeling techniques that incorporate management's best estimates of key variables including estimates regarding future net servicing cash flows, forecasted loan prepayment rates, delinquency rates, and return requirements commensurate with the risks involved. Cash flow assumptions are modeled using our internally forecasted revenue and expenses, and where possible, the reasonableness of assumptions is periodically validated through comparisons to market data. Prepayment speed estimates are determined from historical prepayment rates or obtained from third-party industry data. Return requirement assumptions are determined using data obtained from market participants, where available, or based on current relevant interest rates plus a risk-adjusted spread. We also consider other factors that can impact the value of the servicing rights, such as surety provider termination clauses and servicer terminations that could result if we failed to materially comply with the covenants or conditions of our servicing agreements and did not remedy the failure. Since many factors can affect the estimate of the fair value of servicing rights, we regularly evaluate the major assumptions and modeling techniques used in our estimate and review these assumptions against market comparables, if available. We monitor the actual performance of our servicing rights by regularly comparing actual cash flow, credit, and prepayment experience to modeled estimates.Servicing rights - Residential (carried at fair value)The Company’s residential mortgage servicing rights consist of conforming conventional residential loans sold to Fannie Mae and Freddie Mac or loans securitized in Ginnie Mae securities. Government insured loans serviced by the Company are securitized through Ginnie Mae, whereby the Company is insured against loss by the Federal Housing Administration or partially guaranteed against loss by the Department of Veterans Affairs.The Company has elected to account for its portfolio of residential mortgage servicing rights (“MSRs”) at fair value. For these assets, the Company uses a third-party vendor to assist management in estimating the fair value. The third-party vendor uses a discounted cash flow approach which consists of projecting servicing cash flows discounted at a rate that 15\nmanagement believes market participants would use in their determinations of fair value. The key assumptions used in the estimation of the fair value of MSRs include prepayment rates, discount rates, default rates, and cost of servicing rates. Residential MSRs are classified as Level 3 in the fair value hierarchy. Real estate, held for saleReal estate, held for sale, includes purchased real estate and real estate acquired in full or partial settlement of loan obligations, generally through foreclosure, that is being marketed for sale. Real estate, held for sale is recorded at acquisition at the property’s estimated fair value less estimated costs to sell.After acquisition, costs incurred relating to the development and improvement of property are capitalized to the extent they do not cause the recorded value to exceed the net realizable value, whereas costs relating to holding and disposition of the property are expensed as incurred. After acquisition, real estate held for sale is analyzed periodically for changes in fair values and any subsequent write down is charged through impairment.The Company records a gain or loss from the sale of real estate when control of the property transfers to the buyer, which generally occurs at the time of an executed deed. When the Company finances the sale of real estate to the buyer, the Company assesses whether the buyer is committed to perform their obligations under the contract and whether the collectability of the transaction price is probable. Once these criteria are met, the real estate is derecognized and the gain or loss on sale is recorded upon transfer of control of the property to the buyer. In determining the gain or loss on the sale, the Company adjusts the transaction price and related gain (loss) on sale if a significant financing component is present. This adjustment is based on management’s estimate of the fair value of the loan extended to the buyer to finance the sale. Investment in unconsolidated joint ventures According to ASC 323, Equity Method and Joint Ventures, investors in unincorporated entities such as partnerships and unincorporated joint ventures generally shall account for their investments using the equity method of accounting if the investor has the ability to exercise significant influence over the investee. Under the equity method, we recognize our allocable share of the earnings or losses of the investment monthly in earnings and adjust the carrying amount for our share of the distributions that exceed our earnings. Purchased future receivablesThrough Knight Capital, the Company provides working capital advances to small businesses through the purchase of their future revenues. The Company enters into a contract with the business whereby the Company pays the business an upfront amount in return for a specific amount of the business’s future revenue receivables, known as payback amounts. The payback amounts are primarily received through daily payments initiated by automated clearing house (“ACH”) transactions. Revenues from purchased future receivables are realized when funds are received under each contract. The allocation of the amount received is determined by apportioning the amount received based upon the factor (discount) rate of the business's contract. Management believes that this methodology best reflects the effective interest method. The Company has established an allowance for doubtful purchased future receivables. An increase in the allowance for doubtful purchased future receivables results in a charge to income and is reduced when purchased future receivables are charged-off. Purchased future receivables are charged-off after 90 days past due. Management believes that the allowance reflects the risk elements and is adequate to absorb losses inherent in the portfolio. Although management has performed this evaluation, future adjustments may be necessary based on changes in economic conditions or other factors. Intangible assets The Company accounts for intangible assets under ASC 350, Intangibles- Goodwill and Other. The Company’s intangible assets include an SBA license, capitalized software, a broker network, trade names, and an acquired favorable lease. The Company capitalizes software costs expected to result in long-term operational benefits, such as replacement systems or new applications that result in significantly increased operational efficiencies or functionality. All other costs incurred in connection with internal use software are expensed as incurred. The Company initially records its intangible assets at cost or fair value and will test for impairment if a triggering event occurs. Intangible assets are included within 16\nother assets in the consolidated balance sheets. The Company amortizes intangible assets with identified estimated useful lives on a straight-line basis over their estimated useful lives. GoodwillThe Company recorded goodwill in connection with the Company’s acquisition of Knight Capital. Goodwill is not amortized, but rather, is tested for impairment annually or more frequently if events or changes in circumstances indicate potential impairment. Goodwill represents the excess of the consideration paid over the fair value of net assets acquired in connection with the acquisition of Knight. In testing goodwill for impairment, the Company follows ASC 350, Intangibles- Goodwill and Other, which permits a qualitative assessment of whether it is more likely than not that the fair value of the reporting unit is less than its carrying value including goodwill. If the qualitative assessment determines that it is not more likely than not that the fair value of a reporting unit is less than its carrying value including goodwill, then no impairment is determined to exist for the reporting unit. However, if the qualitative assessment determines that it is more likely than not that the fair value of the reporting unit is less than its carrying value including goodwill, we compare the fair value of that reporting unit with its carrying value, including goodwill. If the carrying value of a reporting unit exceeds its fair value, goodwill is considered impaired with the impairment loss equal to the amount by which the carrying value of the goodwill exceeds the implied fair value of that goodwill. Deferred financing costsCosts incurred in connection with our secured borrowings are accounted for under ASC 340, Other Assets and Deferred Costs. Deferred costs are capitalized and amortized using the effective interest method over the respective financing term with such amortization reflected on our unaudited interim consolidated statements of income as a component of interest expense. Deferred financing costs may include legal, accounting and other related fees. Unamortized deferred financing costs are expensed when the associated debt is refinanced or repaid before maturity. Pursuant to the adoption of ASU 2015-03, unamortized deferred financing costs related to securitizations and note issuances are presented in the unaudited interim consolidated balance sheets as a direct deduction from the associated liability. Due from servicersThe loan servicing activities of the Company’s acquisitions and SBC originations reportable segments are performed primarily by third-party servicers. SBA loans originated by and held at RCL are internally serviced. Residential mortgage loans originated by and held at GMFS are both serviced by third-party servicers and internally serviced. The Company’s servicers hold substantially all of the cash owned by the Company related to loan servicing activities. These amounts include principal and interest payments made by borrowers, net of advances and servicing fees. Cash is generally received within thirty days of recording the receivable. The Company is subject to credit risk to the extent any servicer with whom the Company conducts business is unable to deliver cash balances or process loan-related transactions on the Company’s behalf. The Company monitors the financial condition of the servicers with whom the Company conducts business and believes the likelihood of loss under the aforementioned circumstances is remote. Secured borrowingsSecured borrowings include borrowings under credit facilities, borrowings under repurchase agreements, and promissory notes.Borrowings under credit facilitiesThe Company accounts for borrowings under credit facilities under ASC 470, Debt. The Company partially finances its loans, net through credit agreements with various counterparties. These borrowings are collateralized by loans, held-for-investment, and loans, held for sale, at fair value and have maturity dates within two years from the unaudited interim consolidated balance sheet date. If the fair value (as determined by the applicable counterparty) of the collateral securing these borrowings decreases, we may be subject to margin calls during the period the borrowings are outstanding. In instances where we do not satisfy the margin calls within the required time frame, the counterparty may retain the collateral 17\nand pursue collection of any outstanding debt amount from us. Interest paid and accrued in connection with credit facilities is recorded as interest expense in the unaudited interim consolidated statements of income.Borrowings under repurchase agreementsBorrowings under repurchase agreements are accounted for under ASC 860, Transfers and Servicing. Investment securities financed under repurchase agreements are treated as collateralized borrowings, unless they meet sale treatment or are deemed to be linked transactions. Through September 30, 2020, none of our repurchase agreements have been accounted for as components of linked transactions. All securities financed through a repurchase agreement have remained on our unaudited interim consolidated balance sheets as an asset and cash received from the lender was recorded on our unaudited interim consolidated balance sheets as a liability. Interest paid and accrued in connection with our repurchase agreements is recorded as interest expense in the unaudited interim consolidated statements of income. Securitized debt obligations of consolidated VIEs, netSince 2011, we have engaged in several securitization transactions, which the Company accounts for under ASC 810. Securitization involves transferring assets to an SPE, or securitization trust, and this SPE issues debt instruments. The entity that has a controlling financial interest in a VIE is referred to as the primary beneficiary and is required to consolidate the VIE. The consolidation of the SPE includes the issuance of senior securities to third parties, which are shown as securitized debt obligations of consolidated VIEs in the consolidated balance sheets.Debt issuance costs related to securitizations are presented as a direct deduction from the carrying value of the related debt liability. Debt issuance costs are amortized using the effective interest method and are included in interest expense in the unaudited interim consolidated statements of income. Convertible note, netASC 470 requires the liability and equity components of convertible debt instruments that may be settled in cash upon conversion to be separately accounted for in a manner that reflects the issuer’s nonconvertible debt borrowing rate. ASC 470-20 requires that the initial proceeds from the sale of these notes be allocated between a liability component and an equity component in a manner that reflects interest expense at the interest rate of similar nonconvertible debt that could have been issued by the Company at such time. We measured the estimated fair value of the debt component of our convertible notes as of the issuance date based on our nonconvertible debt borrowing rate. The equity components of the convertible senior notes have been reflected within additional paid-in capital in our unaudited interim consolidated balance sheet, and the resulting debt discount is amortized over the period during which the convertible notes are expected to be outstanding (through the maturity date) as additional non-cash interest expense. Upon repurchase of convertible debt instruments, ASC 470-20 requires the issuer to allocate total settlement consideration, inclusive of transaction costs, amongst the liability and equity components of the instrument based on the fair value of the liability component immediately prior to repurchase. The difference between the settlement consideration allocated to the liability component and the net carrying value of the liability component, including unamortized debt issuance costs, would be recognized as gain (loss) on extinguishment of debt in our unaudited interim consolidated statements of operations. The remaining settlement consideration allocated to the equity component would be recognized as a reduction of additional paid-in capital in our unaudited interim consolidated balance sheets. Senior secured notes, netThe Company accounts for secured debt offerings under ASC 470. Pursuant to the adoption of ASU 2015-03, the Company’s senior secured notes are presented net of debt issuance costs. These senior secured notes are collateralized by loans, MBS, and retained interests of consolidated VIE’s. Interest paid and accrued in connection with senior secured notes is recorded as interest expense in the unaudited interim consolidated statements of income. Corporate debt, netThe Company accounts for corporate debt offerings under ASC 470. The Company’s corporate debt is presented net of debt issuance costs. Interest paid and accrued in connection with corporate debt is recorded as interest expense in the unaudited interim consolidated statements of income. 18\n Guaranteed loan financingCertain partial loan sales do not qualify for sale accounting under ASC 860 because these sales do not meet the definition of a “participating interest,” as defined in the guidance, in order for sale treatment to be allowed. Participations or other partial loan sales which do not meet the definition of a participating interest remain as an investment in the unaudited interim consolidated balance sheets and the proceeds from the portion sold is recorded as guaranteed loan financing in the liabilities section of the unaudited interim consolidated balance sheets. For these partial loan sales, the interest earned on the entire loan balance is recorded as interest income and the interest earned by the buyer in the partial loan sale is recorded within interest expense in the accompanying unaudited interim consolidated statements of income. Repair and denial reserveThe repair and denial reserve represents the potential liability to the SBA in the event that we are required to make the SBA whole for reimbursement of the guaranteed portion of SBA loans. We may be responsible for the guaranteed portion of SBA loans if there are lien and collateral issues, unauthorized use of proceeds, liquidation deficiencies, undocumented servicing actions or denial of SBA eligibility. This reserve is calculated using an estimated frequency of a repair and denial event upon default, as well as an estimate of the severity of the repair and denial as a percentage of the guaranteed balance. Variable interest entitiesVIEs are entities that, by design, either (i) lack sufficient equity to permit the entity to finance its activities without additional subordinated financial support from other parties; or (ii) have equity investors that do not have the ability to make significant decisions relating to the entity’s operations through voting rights, or do not have the obligation to absorb the expected losses, or do not have the right to receive the residual returns of the entity. The entity that has a financial interest in a VIE is referred to as the primary beneficiary and is required to consolidate the VIE. An entity is deemed to be the primary beneficiary of a VIE if the entity has both (i) the power to direct the activities that most significantly impact the VIE’s economic performance and (ii) the right to receive benefits from the VIE or the obligation to absorb losses of the VIE that could be significant to the VIE. In determining whether we are the primary beneficiary of a VIE, we consider both qualitative and quantitative factors regarding the nature, size and form of our involvement with the VIE, such as our role establishing the VIE and our ongoing rights and responsibilities, the design of the VIE, our economic interests, servicing fees and servicing responsibilities, and other factors. We perform ongoing reassessments to evaluate whether changes in the entity’s capital structure or changes in the nature of our involvement with the entity result in a change to the VIE designation or a change to our consolidation conclusion. Non-controlling interestsNon-controlling interests, which are presented in the unaudited interim consolidated balance sheets and the unaudited interim consolidated statements of income, represent direct investment in the Operating Partnership by Sutherland OP Holdings II, Ltd., which is managed by our Manager, and third parties. Fair value optionASC 825, Financial Instruments, provides a fair value option election that allows entities to make an election of fair value as the initial and subsequent measurement attribute for certain eligible financial assets and liabilities. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. The decision to elect the fair value option is determined on an instrument by instrument basis and must be applied to an entire instrument and is irrevocable once elected. Assets and liabilities measured at fair value pursuant to this guidance are required to be reported separately in our unaudited interim consolidated balance sheets from those instruments using another accounting method. 19\nWe have elected the fair value option for certain loans held-for-sale originated by the Company that we intend to sell in the near term. The fair value elections for loans, held for sale at fair value originated by the Company were made due to the short-term nature of these instruments. We have elected the fair value option for loans held-for-sale originated by GMFS that the Company intends to sell in the near term. We have elected the fair value option for certain residential mortgage servicing rights acquired as part of the merger transaction. Share repurchase programThe Company accounts for repurchases of its common stock as a reduction in additional paid in capital. The amounts recognized represent the amount paid to repurchase these shares and are categorized on the balance sheet and changes in equity as a reduction in additional paid in capital. Earnings per shareWe present both basic and diluted earnings per share (“EPS”) amounts in our unaudited interim consolidated financial statements. Basic EPS excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of shares of common stock outstanding for the period. Diluted EPS reflects the maximum potential dilution that could occur from our share-based compensation, consisting of unvested restricted stock units (“RSUs”), unvested restricted stock awards (“RSAs”), as well as “in-the-money” conversion options associated with our outstanding convertible senior notes. Potential dilutive shares are excluded from the calculation if they have an anti-dilutive effect in the period.All of the Company’s unvested RSUs and unvested RSAs contain rights to receive non-forfeitable dividends and, thus, are participating securities. Due to the existence of these participating securities, the two-class method of computing EPS is required, unless another method is determined to be more dilutive. Under the two-class method, undistributed earnings are reallocated between shares of common stock and participating securities. Income taxesGAAP establishes financial accounting and reporting standards for the effect of income taxes. The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current period and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s unaudited interim consolidated financial statements or tax returns. We assess the recoverability of deferred tax assets through evaluation of carryback availability, projected taxable income and other factors as applicable. Significant judgment is required in assessing the future tax consequences of events that have been recognized in our unaudited interim consolidated financial statements or tax returns as well as the recoverability of amounts we record, including deferred tax assets.We provide for exposure in connection with uncertain tax positions, which requires significant judgment by management including determination, based on the weight of the tax law and available evidence, that it is more-likely-than-not that a tax result will be realized. Our policy is to recognize interest and/or penalties related to income tax matters in income tax expense on our unaudited interim consolidated statements of income. As of September 30, 2020 and December 31, 2019, we accrued no taxes, interest or penalties related to uncertain tax positions. In addition, we do not anticipate a change in this position in the next 12 months. Revenue recognitionRevenue is recognized upon the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Revenue is recognized through the following five-step process:Step 1: Identify the contract(s) with a customer.Step 2: Identify the performance obligations in the contract.Step 3: Determine the transaction price.Step 4: Allocate the transaction price to the performance obligations in the contract.Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation. 20\nSince the updated guidance does not apply to revenue associated with financial instruments, including interest income, realized or unrealized gains on financial instruments, loan servicing fees, loan origination fees, among other revenue streams, the adoption of this standard did not have a material impact on our unaudited interim consolidated financial statements. The revenue recognition guidance also included revisions to existing accounting rules regarding the determination of whether a company is acting as a principal or agent in an arrangement and accounting for sales of nonfinancial assets where the seller has continuing involvement. These additional revisions also did not materially impact the Company.Interest incomeInterest income on loans, held-for-investment, loans, held at fair value, loans, held for sale, at fair value, and MBS, at fair value is accrued based on the outstanding principal amount and contractual terms of the instrument. Discounts or premiums associated with the loans and investment securities are amortized or accreted into interest income as a yield adjustment on the effective interest method, based on contractual cash flows through the maturity date of the investment. On at least a quarterly basis, we review and, if appropriate, make adjustments to the accrual status of the asset. If the asset has been delinquent for the previous 90 days, the asset status will turn to non-accrual, and recognition of interest income will be suspended until the asset resumes contractual payments for three consecutive months. Realized gains (losses)Upon the sale or disposition (not including the prepayment of outstanding principal balance) of loans or securities, the excess (or deficiency) of net proceeds over the net carrying value or cost basis of such loans or securities is recognized as a realized gain (loss). Origination income and expenseOrigination income represents fees received for origination of either loans, held at fair value, loans, held for sale, at fair value, or loans, held-for-investment. For loans held, at fair value, and loans, held for sale, at fair value, pursuant to ASC 825, the Company reports origination fee income as revenue and fees charged and costs incurred as expenses. These fees and costs are excluded from the fair value. For originated loans, held-for-investment, under ASC 310-10, the Company defers these origination fees and costs at origination and amortizes them under the effective interest method over the life of the loan. Origination fees and expenses for loans, held at fair value and loans, held for sale, at fair value, are presented in the unaudited interim consolidated statements of income as components of other income and operating expenses. Origination fees for residential mortgage loans originated by GMFS are presented in the unaudited interim consolidated statements of income in residential mortgage banking activities, while origination expenses are presented within variable expenses on residential mortgage banking activities. The amortization of net origination fees and expenses for loans, held-for-investment are presented in the unaudited interim consolidated statements of income as a component of interest income. Residential mortgage banking activitiesResidential mortgage banking activities reflect revenue within our residential mortgage banking business directly related to loan origination and sale activity. This primarily consists of the realized gains on sales of residential loans held for sale and loan origination fee income, Residential mortgage banking activities also consists of unrealized gains and losses associated with the changes in fair value of the loans held for sale, the fair value of retained MSR additions, and the realized and unrealized gains and losses from derivative instruments. Gains and losses from the sale of mortgage loans held for sale are recognized based upon the difference between the sales proceeds and carrying value of the related loans upon sale and is included in residential mortgage banking activities, in the unaudited interim consolidated statements of income. Sales proceeds reflect the cash received from investors from the sale of a loan plus the servicing release premium if the related MSR is sold. Gains and losses also include the unrealized gains and losses associated with the mortgage loans held for sale and the realized and unrealized gains and losses from IRLCs. Loan origination fee income represents revenue earned from originating mortgage loans held for sale and are reflected in residential mortgage banking activities, when loans are sold. 21\n| | | | | |\n| Standard | Summary of guidance | Effects on financial statements |\n| ASU 2016-13, Financial Instruments—Credit Losses (Topic 326) – Measurement of Credit Losses on Financial Instruments | u | Replaces existing incurred loss impairment guidance and establishes a single allowance framework for financial assets carried at amortized cost, which will reflect management's estimate of credit losses over the full remaining expected life of the financial assets and will consider expected future changes in macroeconomic conditions. | u | Adopted January 1, 2020. |\n| Issued June 2016 | u | Eliminates existing guidance for PCI loans, and requires recognition of the accretable difference as an increase to the allowance for expected credit losses on financial assets purchased with more than insignificant credit deterioration since origination, with a corresponding increase in the recorded investment of related loans. | u | The Company adopted ASU 2016-13 using the modified retrospective method for all loans carried at amortized cost. We recorded a $ 6.8 million cumulative-effect adjustment to the opening retained earnings (net of taxes) in our consolidated statement of equity as of January 1, 2020. The Company's total increase in the allowance for loan losses was $ 11.1 million, which included a $ 3.6 million allowance for loan loss balance sheet gross up, relating to purchased credit deteriorated loans. |\n| | u | Requires inclusion of expected recoveries, limited to the cumulative amount of prior write-offs, when estimating the allowance for credit losses for in scope financial assets (including collateral dependent assets). | | |\n| | u | Requires a cumulative-effect adjustment to retained earnings as of the beginning of the reporting period of adoption. | | |\n| ASU 2017-4, Intangibles — Goodwill and Other (Topic 350) – Simplifying the Test for Goodwill Impairment | u | Requires an impairment loss to be recognized when the estimated fair value of a reporting unit falls below its carrying value. | u | Adopted January 1, 2020. |\n| Issued January 2017 | u | Eliminates the second condition in the current guidance that requires an impairment loss to be recognized only if the estimated implied fair value of the goodwill is below its carrying value. | u | Based on current impairment test results, the adoption did not have a material effect on the consolidated financial statements. |\n| | | | u | The guidance may result in more frequent goodwill impairment losses in future periods due to the removal of the second condition. |\n| ASU 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework—Changes to the Disclosure Requirements for Fair Value Measurement | u | Provides guidance on increasing the transparency and comparability of the disclosure requirements for fair value measurement. | u | Adopted in the first quarter of 2020. |\n| Issued August 2018 | | | u | The adoption did not have a material impact on our consolidated financial statements. |\n\n| | | | |\n| (In Thousands) | March 29, 2019 |\n| Assets | | | |\n| Cash and cash equivalents | | $ | 10,822 |\n| Loans | | 130,449 |\n| Real estate, held for sale | | 67,973 |\n| Investment in unconsolidated joint ventures | | 8,619 |\n| Other assets | | | |\n| Deferred tax assets | | | 4,660 |\n| Accrued interest | | 1,209 |\n| Other | | 379 |\n| Total assets acquired | | $ | 224,111 |\n| Liabilities | | | |\n| Secured borrowings | | 12,713 |\n| Accounts payable and other accrued liabilities | | | 1,000 |\n| Due to Manager | | | 228 |\n| Deferred tax liabilities | | | 123 |\n| Total liabilities assumed | | $ | 14,064 |\n| Net assets acquired | | $ | 210,047 |\n| | | | |\n| | | |\n| Total consideration transferred (in thousands, except share and per share data) |\n| FV of net assets acquired | $ | 210,047 |\n| | | |\n| ORM shares outstanding at March 29, 2019 | | 8,482,880 |\n| Exchange ratio | x | 1.441 |\n| Shares issued | | 12,223,830 |\n| Market price as of March 29, 2019 | $ | 14.67 |\n| Total consideration transferred based on value of shares issued | $ | 179,324 |\n| | | |\n| Bargain purchase gain | $ | 30,728 |\n| | | |\n\n| | | | |\n| | | | For the three months ended |\n| (In Thousands) | | | March 31, 2019 |\n| Selected Financial Data | | | |\n| Interest income | | $ | 51,543 |\n| Interest expense | | | ( 36,323 ) |\n| Provision for loan losses | | | ( 518 ) |\n| Non-interest income | | | 27,031 |\n| Non-interest expense | | | ( 37,721 ) |\n| Income before provision for income taxes | | | 4,012 |\n| Income tax benefit (provision) | | | 2,996 |\n| Net income | | $ | 7,008 |\n| | | | |\n| (In Thousands) | October 25, 2019 |\n| Assets | | | |\n| Cash and cash equivalents | | $ | 1,673 |\n| Purchased future receivables, | | 39,540 |\n| Prepaid expenses and other | | | 1,265 |\n| Intangible assets | | | 5,880 |\n| Total assets acquired | | $ | 48,358 |\n| Liabilities | | | |\n| Secured borrowings | | 30,600 |\n| Accounts payable and other accrued liabilities | | | 1,173 |\n| Total liabilities assumed | | $ | 31,773 |\n| Net assets acquired | | $ | 16,585 |\n| | | |\n| Total Consideration Transferred (in thousands) | | |\n| Cash consideration | $ | 17,500 |\n| Common stock consideration | | 10,290 |\n| Total consideration transferred | $ | 27,790 |\n| | | |\n| Net Tangible Assets | $ | 10,705 |\n| Identified Intangible Assets | | 5,880 |\n| FV of net assets acquired | $ | 16,585 |\n| | | |\n| Goodwill | $ | 11,205 |\n| | | | | |\n| (In Thousands) | Fair Value | | Weighted Average Amortization Life |\n| Internally developed software | $ | 3,800 | | 6 years |\n| Broker network | | 1,200 | | 4.5 years |\n| Trade name | | 880 | | 6 years |\n| Total Intangible Assets | $ | 5,880 | | 6 years |\n\n| | | | | |\n| | | | | | | |\n| | | | For the three months ended | | | For the nine months ended |\n| (In Thousands) | | | September 30, 2019 | | | September 30, 2019 |\n| Selected Financial Data | | | | | | |\n| Interest income | | $ | 59,723 | | $ | 165,510 |\n| Interest expense | | | ( 39,390 ) | | | ( 110,918 ) |\n| Provision for loan losses | | | ( 693 ) | | | ( 2,559 ) |\n| Non-interest income | | | 54,145 | | | 174,693 |\n| Non-interest expense | | | ( 62,747 ) | | | ( 176,111 ) |\n| Income before provision for income taxes | | | 11,038 | | | 50,615 |\n| Income tax benefit | | | 2,645 | | | 8,604 |\n| Net income | | $ | 13,683 | | $ | 59,219 |\n| | | | | | | |\n| ● | Originated or purchased loans held-for-investment– originated transitional loans, originated conventional SBC and SBA loans, or acquired loans with no signs of credit deterioration at time of purchase. |\n| ● | Loans at fair value – certain originated conventional SBC loans and PPP loans for which the Company has elected the fair value option |\n| ● | Loans, held-for-sale, at fair value – originated or acquired that we intend to sell in the near term |\n\n| | | | | | | | | | | | | | |\n| | | September 30, 2020 | | | December 31, 2019 |\n| Loans (In Thousands) | | Carrying Value | | UPB | | | Carrying Value | | UPB |\n| Loans | | | | | | | | | | | | | |\n| Originated Transitional loans | | $ | 393,069 | | $ | 396,639 | | | $ | 593,657 | | $ | 600,226 |\n| Originated SBA 7(a) loans | | | 307,450 | | | 310,454 | | | | 297,934 | | | 299,580 |\n| Acquired SBA 7(a) loans | | | 213,097 | | | 222,870 | | | | 255,240 | | | 269,396 |\n| Originated SBC loans | | | 177,870 | | | 174,286 | | | | 133,118 | | | 132,227 |\n| Acquired loans | | | 213,400 | | | 215,519 | | | | 430,307 | | | 433,079 |\n| Originated PPP loans, at fair value | | | 106,204 | | | 106,204 | | | | — | | | — |\n| Originated SBC loans, at fair value | | | 13,761 | | | 14,095 | | | | 20,212 | | | 19,565 |\n| Originated Residential Agency loans | | | 5,235 | | | 5,235 | | | | 3,396 | | | 3,395 |\n| Total Loans, before allowance for loan losses | | $ | 1,430,086 | | $ | 1,445,302 | | | $ | 1,733,864 | | $ | 1,757,468 |\n| Allowance for loan losses | | $ | ( 36,947 ) | | $ | — | | | $ | ( 5,880 ) | | $ | — |\n| Total Loans, net | | $ | 1,393,139 | | $ | 1,445,302 | | | $ | 1,727,984 | | $ | 1,757,468 |\n| Loans in consolidated VIEs | | | | | | | | | | | | | |\n| Loans | | | | | | | | | | | | | |\n| Originated SBC loans | | $ | 945,188 | | $ | 938,036 | | | $ | 1,037,844 | | $ | 1,026,921 |\n| Originated Transitional loans | | | 790,608 | | | 795,147 | | | | 490,913 | | | 493,217 |\n| Acquired loans | | | 781,997 | | | 787,399 | | | | 666,226 | | | 671,698 |\n| Originated SBA 7(a) loans | | | 71,871 | | | 75,718 | | | | 79,457 | | | 83,559 |\n| Acquired SBA 7(a) loans | | | 44,494 | | | 55,407 | | | | 53,320 | | | 66,997 |\n| Total Loans, in consolidated VIEs, before allowance for loan losses | | $ | 2,634,158 | | $ | 2,651,707 | | | $ | 2,327,760 | | $ | 2,342,392 |\n| Allowance for loan losses on loans in consolidated VIEs | | $ | ( 15,709 ) | | $ | — | | | $ | ( 1,561 ) | | $ | — |\n| Total Loans, net, in consolidated VIEs | | $ | 2,618,449 | | $ | 2,651,707 | | | $ | 2,326,199 | | $ | 2,342,392 |\n| Total Loans, net, and Loans, net in consolidated VIEs | | $ | 4,011,588 | | $ | 4,097,009 | | | $ | 4,054,183 | | $ | 4,099,860 |\n| Loans, held for sale, at fair value | | | | | | | | | |\n| Originated Residential Agency loans | | $ | 287,959 | | $ | 274,393 | | | $ | 136,506 | | $ | 132,016 |\n| Originated Freddie Mac loans | | | 20,486 | | | 20,242 | | | | 21,775 | | | 21,513 |\n| Originated SBA 7(a) loans | | | 39,764 | | | 36,581 | | | | 28,551 | | | 26,669 |\n| Acquired loans | | | 510 | | | 505 | | | | 1,245 | | | 1,208 |\n| Total Loans, held for sale, at fair value | | $ | 348,719 | | $ | 331,721 | | | $ | 188,077 | | $ | 181,406 |\n| Loans, held for sale, at fair value in consolidated VIEs | | | | | | | | | | | | | |\n| Loans, held for sale, at fair value | | | | | | | | | | | | | |\n| Acquired loans | | $ | — | | $ | — | | | $ | 4,434 | | $ | 4,400 |\n| Total Loans, held for sale, at fair value in consolidated VIEs | | $ | — | | $ | — | | | $ | 4,434 | | $ | 4,400 |\n| Total Loans, held for sale, at fair value, and Loans, held for sale, at fair value in consolidated VIEs | | $ | 348,719 | | $ | 331,721 | | | $ | 192,511 | | $ | 185,806 |\n| Total Loan portfolio | | $ | 4,360,307 | | $ | 4,428,730 | | | $ | 4,246,694 | | $ | 4,285,666 |\n| | | | | | | | | | | | | | |\n| | | | | | | | | | | | | | | | | | | | | | | | | |\n| | | | | Carrying Value by Year of Origination | |\n| (In Thousands) | UPB | | 2020 | 2019 | 2018 | 2017 | | 2016 | Pre 2016 | Total |\n| September 30, 2020 | | | | | | | | | | | | | | | | | | | | | | | | |\n| Loans(1) (2) | | | | | | | | | | | | | | | | | | | | | | | | |\n| Originated Transitional loans | | $ | 1,191,786 | | $ | 213,519 | | $ | 602,045 | | $ | 314,862 | | $ | 25,295 | | $ | 26,981 | | $ | 1,077 | | $ | 1,183,779 |\n| Originated SBC loans | | | 1,112,322 | | | 62,052 | | | 515,957 | | | 262,147 | | | 111,020 | | | 45,303 | | | 121,842 | | | 1,118,321 |\n| Acquired loans | | | 1,002,918 | | | 3,690 | | | 29,935 | | | 23,680 | | | 29,017 | | | 15,972 | | | 889,906 | | | 992,200 |\n| Originated SBA 7(a) loans | | | 386,172 | | | 34,566 | | | 99,871 | | | 140,433 | | | 74,017 | | | 21,924 | | | 4,277 | | | 375,088 |\n| Acquired SBA 7(a) loans | | | 278,277 | | | 226 | | | 21,837 | | | 14,856 | | | 285 | | | 21 | | | 215,868 | | | 253,093 |\n| Originated PPP loans, at fair value | | | 106,204 | | | 106,204 | | | — | | | — | | | — | | | — | | | — | | | 106,204 |\n| Originated SBC loans, at fair value | | | 14,095 | | | — | | | — | | | — | | | 1,590 | | | 12,171 | | | — | | | 13,761 |\n| Originated Residential Agency loans | | | 5,235 | | 2,767 | | 1,252 | | 707 | | | 218 | | | 89 | | 202 | | 5,235 |\n| Total Loans, before general allowance for loans losses | | $ | 4,097,009 | | $ | 423,024 | | $ | 1,270,897 | | $ | 756,685 | | $ | 241,442 | | $ | 122,461 | | $ | 1,233,172 | | $ | 4,047,681 |\n| General allowance for loan losses | | | | | | | | | | | | | | | | | | | | | | | $ | ( 36,093 ) |\n| Total Loans, net | | | | | | | | | | | | | | | | | | | | | | | $ | 4,011,588 |\n| (1) Loan balances include specific allowance for loan losses of $ 16.6 million. | | | | | | | | | | |\n| (2) Includes Loans, net in consolidated VIEs | | | | | | | | | | |\n| | | | | | | | | | | | | | | | | | | | | | | | | |\n\n| | | | | | | | | | | | | | | | | | | | | | | | | |\n| | | | | Carrying Value by Year of Origination | |\n| (In Thousands) | UPB | | 2020 | 2019 | 2018 | 2017 | | 2016 | Pre 2016 | Total |\n| September 30, 2020 | | | | | | | | | | | | | | | | | | | | | | | | |\n| Loans(1) (2) | | | | | | | | | | | | | | | | | | | | | | | | |\n| Current and less than 30 days past due | | $ | 3,909,657 | | $ | 421,458 | | $ | 1,262,993 | | $ | 700,411 | | $ | 211,174 | | $ | 112,066 | | $ | 1,167,986 | | $ | 3,876,088 |\n| 30 - 59 Days Past Due | | | 34,672 | | | — | | | — | | | 29,777 | | | — | | | 13 | | | 4,358 | | | 34,148 |\n| 60+ Days | | | 152,680 | | | 1,566 | | | 7,904 | | | 26,497 | | | 30,268 | | | 10,382 | | | 60,828 | | | 137,445 |\n| Total Loans, before general allowance for loans losses | | $ | 4,097,009 | | $ | 423,024 | | $ | 1,270,897 | | $ | 756,685 | | $ | 241,442 | | $ | 122,461 | | $ | 1,233,172 | | $ | 4,047,681 |\n| General allowance for loan losses | | | | | | | | | | | | | | | | | | | | | | | $ | ( 36,093 ) |\n| Total Loans, net | | | | | | | | | | | | | | | | | | | | | | | $ | 4,011,588 |\n| | | | | | | | | | | | | | | |\n| | September 30, 2020 |\n| Loans (In Thousands) | Current and less than 30 dayspast due | 30-59 Days Past Due | 60+ Days Past Due | Total Loans Carrying Value | | Non-Accrual Loans | | 90+ Days Past Due but Accruing |\n| Loans(1)(2) | | | | | | | | | | | | | | |\n| Originated Transitional loans | $ | 1,131,075 | $ | 29,777 | $ | 22,927 | $ | 1,183,779 | | $ | 13,926 | | $ | — |\n| Originated SBC loans | | 1,065,202 | | — | | 53,119 | | 1,118,321 | | | 35,393 | | | — |\n| Acquired loans | | 933,993 | | 3,939 | | 54,268 | | 992,200 | | | 43,350 | | | — |\n| Originated SBA 7(a) loans | | 374,331 | | — | | 757 | | 375,088 | | | 5,406 | | | — |\n| Acquired SBA 7(a) loans | | 250,046 | | 432 | | 2,615 | | 253,093 | | | 8,304 | | | — |\n| Originated PPP loans, at fair value | | 106,204 | | — | | — | | 106,204 | | | — | | | — |\n| Originated SBC loans, at fair value | | 13,761 | | — | | — | | 13,761 | | | — | | | — |\n| Originated Residential Agency loans | | 1,476 | | — | | 3,759 | | 5,235 | | | 4,153 | | | — |\n| Total Loans, before general allowance for loans losses | $ | 3,876,088 | $ | 34,148 | $ | 137,445 | $ | 4,047,681 | | $ | 110,532 | | $ | — |\n| General allowance for loan losses | | | | | | | $ | ( 36,093 ) | | | | | | |\n| Total Loans, net | | | | | | | $ | 4,011,588 | | | | | | |\n| Percentage of outstanding | | 95.8 % | | 0.8 % | | 3.4 % | | 100 % | | | 2.7 % | | | 0.0 % |\n| (1) Loan balances include specific allowance for loan losses of $ 16.6 million. |\n| (2) Includes Loans, net in consolidated VIEs |\n| | | | | | | | | | | | | | | |\n| | December 31, 2019 |\n| Loans (In Thousands) | Current and less than 30 dayspast due | 30-59 Days Past Due | 60+ Days Past Due | Total Loans Carrying Value | | Non-Accrual Loans | | 90+ Days Past Due but Accruing |\n| Loans(1)(2) | | | | | | | | | | | | | | |\n| Originated Transitional loans | $ | 1,074,955 | $ | 5,728 | $ | 5,645 | $ | 1,086,328 | | $ | 24,587 | | $ | — |\n| Originated SBC loans | | 1,137,140 | | 11,769 | | 19,990 | | 1,168,899 | | | 16,089 | | | — |\n| Acquired loans | | 1,032,259 | | 41,830 | | 20,194 | | 1,094,283 | | | 23,500 | | | 3,382 |\n| Acquired SBA 7(a) loans | | 297,172 | | 4,048 | | 5,640 | | 306,860 | | | 9,177 | | | 1,326 |\n| Originated SBC loans, at fair value | | 20,212 | | — | | — | | 20,212 | | | — | | | — |\n| Originated SBA 7(a) loans | | 370,101 | | 2,085 | | 4,443 | | 376,629 | | | 8,882 | | | — |\n| Originated Residential Agency loans | | 582 | | 209 | | 2,605 | | 3,396 | | | 2,105 | | | 74 |\n| Total Loans, before allowance for loans losses | $ | 3,932,421 | $ | 65,669 | $ | 58,517 | $ | 4,056,607 | | $ | 84,340 | | $ | 4,782 |\n| General allowance for loan losses | | | | | | | $ | ( 2,424 ) | | | | | | |\n| Total Loans, net | | | | | | | $ | 4,054,183 | | | | | | |\n| Percentage of outstanding | | 97.0 % | | 1.6 % | | 1.4 % | | 100 % | | | 2.1 % | | | 0.1 % |\n| (1) Loan balances include specific allowance for loan losses of $ 4.0 million. |\n| (2) Includes Loans, net in consolidated VIEs |\n\n| | | | | | | | | | | | | | | | |\n| | Loan-to-Value (a) | |\n| (In Thousands) | 0.0 – 20.0% | 20.1 – 40.0% | 40.1 – 60.0% | 60.1 – 80.0% | 80.1 – 100.0% | Greater than 100.0% | Total |\n| September 30, 2020 | | | | | | | | | | | | | | | |\n| Loans(1) (2) | | | | | | | | | | | | | | | |\n| Originated Transitional loans | | $ | 6,104 | $ | 29,020 | $ | 206,642 | $ | 797,901 | $ | 140,557 | $ | 3,555 | $ | 1,183,779 |\n| Originated SBC loans | | | — | | 63,989 | | 486,118 | | 545,201 | | 12,882 | | 10,131 | | 1,118,321 |\n| Acquired loans | | | 221,417 | | 383,481 | | 220,660 | | 121,732 | | 27,083 | | 17,827 | | 992,200 |\n| Originated SBA 7(a) loans | | | 892 | | 16,590 | | 50,106 | | 138,688 | | 67,419 | | 101,393 | | 375,088 |\n| Acquired SBA 7(a) loans | | | 8,308 | | 37,983 | | 94,666 | | 59,547 | | 28,124 | | 24,465 | | 253,093 |\n| Originated PPP loans, at fair value | | | — | | — | | — | | — | | — | | 106,204 | | 106,204 |\n| Originated SBC loans, at fair value | | | — | | 7,345 | | — | | 6,416 | | — | | — | | 13,761 |\n| Originated Residential Agency loans | | — | — | 89 | | 924 | | 3,455 | 767 | 5,235 |\n| Total Loans, before general allowance for loans losses | | $ | 236,721 | $ | 538,408 | $ | 1,058,281 | $ | 1,670,409 | $ | 279,520 | $ | 264,342 | $ | 4,047,681 |\n| General allowance for loan losses | | | | | | | | | | | | | | $ | ( 36,093 ) |\n| Total Loans, net | | | | | | | | | | | | | | $ | 4,011,588 |\n| Percentage of outstanding | | | 5.8 | % | 13.4 | % | 26.1 | % | 41.3 | % | 6.9 | % | 6.5 | % | |\n| December 31, 2019 | | | | | | | | | | | | | | | |\n| Loans(1) (2) | | | | | | | | | | | | | | | |\n| Originated Transitional loans | | $ | 1,736 | $ | 28,108 | $ | 277,388 | $ | 750,298 | $ | 28,059 | $ | 739 | $ | 1,086,328 |\n| Originated SBC loans | | — | | 60,601 | | 431,312 | | 660,733 | | 8,045 | | 8,208 | 1,168,899 |\n| Acquired loans | | 218,679 | | 371,471 | | 293,216 | | 161,431 | | 35,731 | | 13,755 | 1,094,283 |\n| Acquired SBA 7(a) loans | | | 7,712 | | 39,566 | | 103,590 | | 83,954 | | 39,726 | | 32,312 | | 306,860 |\n| Originated SBC loans, at fair value | | — | | 8,192 | | — | | 6,422 | | 5,598 | | — | 20,212 |\n| Originated SBA 7(a) loans | | | 865 | | 13,843 | | 41,166 | | 130,177 | | 78,544 | | 112,034 | | 376,629 |\n| Originated Residential Agency loans | | — | 51 | — | | 830 | | 2,393 | 122 | 3,396 |\n| Total Loans, before allowance for loans losses | | $ | 228,992 | $ | 521,832 | $ | 1,146,672 | $ | 1,793,845 | $ | 198,096 | $ | 167,170 | $ | 4,056,607 |\n| General allowance for loan losses | | | | | | | | | | | | | | $ | ( 2,424 ) |\n| Total Loans, net | | | | | | | | | | | | | | $ | 4,054,183 |\n| Percentage of outstanding | | | 5.6 | % | 12.9 | % | 28.3 | % | 44.2 | % | 4.9 | % | 4.1 | % | |\n| (a) Loan-to-value is calculated as carrying amount as a percentage of current collateral value |\n| (1) Loan balances include specific allowance for loan loss reserves. |\n| (2) Includes Loans, net in consolidated VIEs |\n| | | | | | | |\n| Geographic Concentration (% of Unpaid Principal Balance) | September 30, 2020 | | December 31, 2019 |\n| California | 18.7 | % | | 16.9 | % |\n| Texas | 14.5 | | | 15.2 | |\n| New York | 8.6 | | | 8.3 | |\n| Florida | 8.0 | | | 8.3 | |\n| Illinois | 5.2 | | | 5.2 | |\n| Georgia | 4.8 | | | 4.8 | |\n| North Carolina | 3.4 | | | 3.2 | |\n| Arizona | 3.2 | | | 3.4 | |\n| Washington | 3.1 | | | 2.8 | |\n| Colorado | | 2.5 | | | 2.8 | |\n| Other | 28.0 | | | 29.1 | |\n| Total | 100.0 | % | | 100.0 | % |\n| | | | | | | |\n| Collateral Concentration (% of Unpaid Principal Balance) | September 30, 2020 | | December 31, 2019 |\n| Multi-family | 24.1 | % | | 26.6 | % |\n| SBA(1) | 18.8 | | | 17.6 | |\n| Retail | 17.8 | | | 17.5 | |\n| Office | 12.1 | | | 12.9 | |\n| Mixed Use | 12.1 | | | 10.4 | |\n| Industrial | 6.6 | | | 6.4 | |\n| Lodging/Residential | 3.2 | | | 3.3 | |\n| Other | 5.3 | | | 5.3 | |\n| Total | 100.0 | % | | 100.0 | % |\n| (1) Further detail provided on SBA collateral concentration is included in table below. | | | | | | |\n\n| | | | | | | |\n| Collateral Concentration (% of Unpaid Principal Balance) | September 30, 2020 | | December 31, 2019 |\n| Lodging | | 16.1 | % | | 17.3 | % |\n| Offices of Physicians | | 12.2 | | | 14.1 | |\n| Child Day Care Services | 6.9 | | | 8.1 | |\n| Eating Places | 5.1 | | | 6.1 | |\n| Veterinarians | 3.3 | | | 4.1 | |\n| Gasoline Service Stations | | 3.3 | | | 3.7 | |\n| Funeral Service & Crematories | 1.8 | | | 2.0 | |\n| Grocery Stores | 1.7 | | | 2.0 | |\n| Auto | 0.9 | | | 1.3 | |\n| Other | 48.7 | | | 41.3 | |\n| Total | 100.0 | % | | 100.0 | % |\n| | | | | | | | | | | | | | | |\n| | Three Months Ended September 30, 2020 |\n| (In Thousands) | OriginatedSBC loans | Originated Transitional loans | Acquiredloans | AcquiredSBA 7(a) loans | OriginatedSBA 7(a) loans | Originated Residential Agency Loans | Total Allowance for loan losses |\n| Beginning balance | $ | 8,974 | $ | 19,831 | $ | 12,564 | $ | 5,744 | $ | 9,450 | $ | 500 | $ | 57,063 |\n| Provision for (Recoveries of) loan losses | | ( 181 ) | | ( 1,848 ) | | ( 2,906 ) | | ( 200 ) | | 904 | | — | | ( 4,231 ) |\n| Charge-offs and sales | | — | | — | | — | | ( 203 ) | | ( 42 ) | | — | | ( 245 ) |\n| Recoveries | | — | | — | | — | | 22 | | 47 | | — | | 69 |\n| Ending balance | $ | 8,793 | $ | 17,983 | $ | 9,658 | $ | 5,363 | $ | 10,359 | $ | 500 | $ | 52,656 |\n| | | | | | | | | | | | | | | |\n| | | | | | | | | | | | | | | |\n| | Three Months Ended September 30, 2019 |\n| (In Thousands) | OriginatedSBC loans | Originated Transitional loans | Acquiredloans | AcquiredSBA 7(a) loans | OriginatedSBA 7(a) loans | Originated Residential Agency Loans | Total Allowance for loan losses |\n| Beginning balance | $ | 421 | $ | 367 | $ | 5,138 | $ | 2,194 | $ | 694 | $ | — | $ | 8,814 |\n| Provision for (Recoveries of) loan losses | | 33 | | ( 79 ) | | 176 | | ( 183 ) | | 746 | | — | | 693 |\n| Charge-offs and sales | | ( 127 ) | | 2 | | ( 783 ) | | ( 93 ) | | ( 126 ) | | — | | ( 1,127 ) |\n| Recoveries | | — | | — | | ( 537 ) | | 122 | | — | | — | | ( 415 ) |\n| Ending balance | $ | 327 | $ | 290 | $ | 3,994 | $ | 2,040 | $ | 1,314 | $ | — | $ | 7,965 |\n| | | | | | | | | | | | | | | |\n| | | | | | | | | | | | | | | |\n| | Nine Months Ended September 30, 2020 |\n| (In Thousands) | OriginatedSBC loans | Originated Transitional loans | Acquiredloans | AcquiredSBA 7(a) loans | OriginatedSBA 7(a) loans | Originated Residential Agency Loans | Total Allowance for loan losses |\n| Beginning balance | $ | 304 | $ | 188 | $ | 3,054 | $ | 2,114 | $ | 1,781 | $ | — | $ | 7,441 |\n| Cumulative-effect adjustment upon adoption of ASU 2016-13 | | 2,400 | | 1,906 | | 1,878 | | 3,562 | | 1,379 | | — | | 11,125 |\n| Provision for (recoveries of) loan losses | | 6,089 | | 15,889 | | 4,776 | | 2 | | 7,728 | | 500 | | 34,984 |\n| Charge-offs and sales | | — | | — | | ( 50 ) | | ( 431 ) | | ( 577 ) | | — | | ( 1,058 ) |\n| Recoveries | | — | | — | | — | | 116 | | 48 | | — | | 164 |\n| Ending balance | $ | 8,793 | $ | 17,983 | $ | 9,658 | $ | 5,363 | $ | 10,359 | $ | 500 | $ | 52,656 |\n| | | | | | | | | | | | | | | |\n| | | | | | | | | | | | | | | |\n| | Nine Months Ended September 30, 2019 |\n| (In Thousands) | OriginatedSBC loans | Originated Transitional loans | Acquiredloans | AcquiredSBA 7(a) loans | OriginatedSBA 7(a) loans | Originated Residential Agency Loans | Total Allowance for loan losses |\n| Beginning balance | $ | 11 | $ | 353 | $ | 5,052 | $ | 2,318 | $ | 586 | $ | — | $ | 8,320 |\n| Provision for (recoveries of) loan losses | | 443 | | ( 65 ) | | 737 | | 590 | | 854 | | — | | 2,559 |\n| Charge-offs and sales | | ( 127 ) | | 2 | | ( 784 ) | | ( 1,055 ) | | ( 126 ) | | — | | ( 2,090 ) |\n| Recoveries | | — | | — | | ( 1,011 ) | | 187 | | — | | — | | ( 824 ) |\n| Ending balance | $ | 327 | $ | 290 | $ | 3,994 | $ | 2,040 | $ | 1,314 | $ | — | $ | 7,965 |\n\n| | | | | | |\n| (In Thousands) | September 30, 2020 | | December 31, 2019 |\n| Non-accrual loans | | | | | |\n| With an allowance | $ | 55,070 | | $ | 18,063 |\n| Without an allowance | | 55,462 | | | 60,036 |\n| Total recorded carrying value of non-accrual loans | $ | 110,532 | | $ | 78,099 |\n| Allowance for loan losses related to non-accrual loans | $ | ( 15,725 ) | | $ | ( 2,093 ) |\n| Unpaid principal balance of non-accrual loans | $ | 132,204 | | $ | 83,991 |\n| | | | | | |\n| | September 30, 2020 | | September 30, 2019 |\n| Interest income on non-accrual loans for the three months ended | $ | 198 | | $ | 328 |\n| Interest income on non-accrual loans for the nine months ended | $ | 2,660 | | $ | 934 |\n| | | | | | |\n| | | | | | |\n| | | | | | | | | | | | | | | | | | |\n| | September 30, 2020 | | December 31, 2019 |\n| (In Thousands) | SBC | | SBA | | Total | | SBC | | SBA | | Total |\n| Recorded carrying value modified loans classified as TDRs | $ | 10,453 | | $ | 13,287 | | $ | 23,740 | | $ | 6,258 | | $ | 14,204 | | $ | 20,462 |\n| Allowance for loan losses on loans classified as TDRs | $ | 215 | | $ | 3,417 | | $ | 3,632 | | $ | 274 | | $ | 454 | | $ | 728 |\n| | | | | | | | | | | | | | | | | | |\n| Carrying value of modified loans classified as TDRs | | | | | | | | | | | | | | | | | |\n| Carrying value of modified loans classified as TDRs on accrual status | $ | 296 | | $ | 7,009 | | $ | 7,305 | | $ | 333 | | $ | 7,437 | | $ | 7,770 |\n| Carrying value of modified loans classified as TDRs on non-accrual status | | 10,157 | | | 6,278 | | | 16,435 | | | 5,925 | | | 6,767 | | | 12,692 |\n| Total carrying value of modified loans classified as TDRs | $ | 10,453 | | $ | 13,287 | | $ | 23,740 | | $ | 6,258 | | $ | 14,204 | | $ | 20,462 |\n\n| | | | | | | | | | | | | | | | | | |\n| | Three Months Ended September 30, 2020 | | Three Months Ended September 30, 2019 |\n| (In Thousands, except number of loans) | SBC | | SBA | | Total | | SBC | | SBA | | Total |\n| Number of loans permanently modified | | — | | | 6 | | | 6 | | | 1 | | | 15 | | | 16 |\n| Pre-modification recorded balance (a) | $ | — | | $ | 713 | | $ | 713 | | $ | 596 | | $ | 1,843 | | $ | 2,439 |\n| Post-modification recorded balance (a) | $ | — | | | 730 | | $ | 730 | | $ | 596 | | $ | 1,658 | | $ | 2,254 |\n| | | | | | | | | | | | | | | | | | |\n| Number of loans that remain in default as of September 30, 2020 (b) | | — | | | 4 | | | 4 | | | 1 | | | 3 | | | 4 |\n| Balance of loans that remain in default as of September 30, 2020 (b) | $ | — | | $ | 733 | | $ | 733 | | $ | 596 | | $ | 61 | | $ | 657 |\n| | | | | | | | | | | | | | | | | | |\n| Concession granted (a): | | | | | | | | | | | | | | | | | |\n| Term extension | $ | — | | $ | 547 | | $ | 547 | | $ | — | | $ | 1,466 | | $ | 1,466 |\n| Interest rate reduction | | — | | | — | | | — | | | — | | | — | | | — |\n| Principal reduction | | — | | | — | | | — | | | — | | | — | | | — |\n| Foreclosure | | — | | | 187 | | | 187 | | | 596 | | | 61 | | | 657 |\n| Total | $ | — | | $ | 734 | | $ | 734 | | $ | 596 | | $ | 1,527 | | $ | 2,123 |\n| (a) Represents carrying value. |\n| (b) Represents the September 30, 2020 carrying values of the TDRs that occurred during the three months ended September 30, 2020 and 2019 that remained in default as of September 30, 2020. Generally, all loans modified in a TDR are placed or remain on non-accrual status at the time of the restructuring. However, certain accruing loans modified in a TDR that are current at the time of restructuring may remain on accrual status if payment in full under the restructured terms is expected. For purposes of this schedule, a loan is considered in default if it is 30 or more days past due. |\n| | | | | | | | | | | | | | | | | | |\n| | Nine Months Ended September 30, 2020 | | Nine Months Ended September 30, 2019 |\n| (In Thousands, except number of loans) | SBC | | SBA | | Total | | SBC | | SBA | | Total |\n| Number of loans permanently modified | | 3 | | | 16 | | | 19 | | | 2 | | | 27 | | | 29 |\n| Pre-modification recorded balance (a) | $ | 8,456 | | $ | 3,691 | | $ | 12,147 | | $ | 699 | | $ | 3,544 | | $ | 4,243 |\n| Post-modification recorded balance (a) | $ | 8,456 | | | 3,748 | | $ | 12,204 | | $ | 699 | | $ | 3,324 | | $ | 4,023 |\n| | | | | | | | | | | | | | | | | | |\n| Number of loans that remain in default as of September 30, 2020 (b) | | 2 | | | 5 | | | 7 | | | 2 | | | 7 | | | 9 |\n| Balance of loans that remain in default as of September 30, 2020 (b) | $ | 8,422 | | $ | 874 | | $ | 9,296 | | $ | 704 | | $ | 323 | | $ | 1,027 |\n| | | | | | | | | | | | | | | | | | |\n| Concession granted (a): | | | | | | | | | | | | | | | | | |\n| Term extension | $ | — | | $ | 2,371 | | $ | 2,371 | | $ | — | | $ | 2,843 | | $ | 2,843 |\n| Interest rate reduction | | — | | | — | | | — | | | — | | | — | | | — |\n| Principal reduction | | — | | | — | | | — | | | — | | | — | | | — |\n| Foreclosure | | 8,422 | | | 327 | | | 8,749 | | | 704 | | | 116 | | | 820 |\n| Total | $ | 8,422 | | $ | 2,698 | | $ | 11,120 | | $ | 704 | | $ | 2,959 | | $ | 3,663 |\n| (a) Represents carrying value. |\n| (b) Represents the September 30, 2020 carrying values of the TDRs that occurred during the nine months ended September 30, 2020 and 2019 that remained in default as of September 30, 2020. Generally, all loans modified in a TDR are placed or remain on non-accrual status at the time of the restructuring. However, certain accruing loans modified in a TDR that are current at the time of restructuring may remain on accrual status if payment in full under the restructured terms is expected. For purposes of this schedule, a loan is considered in default if it is 30 or more days past due. |\n\n| | | | | | | | | | | | | |\n| (In Thousands) | | Level 1 | | Level 2 | | Level 3 | | Total |\n| Assets: | | | | | | | | | | | | |\n| Loans, held for sale, at fair value | | $ | — | | $ | 348,719 | | $ | — | | $ | 348,719 |\n| Loans, net, at fair value | | — | | — | | 119,965 | | 119,965 |\n| Mortgage backed securities, at fair value | | — | | 77,777 | | 12,650 | | 90,427 |\n| Derivative instruments, at fair value | | | — | | — | | 20,849 | | 20,849 |\n| Residential mortgage servicing rights, at fair value | | — | | — | | 74,384 | | 74,384 |\n| Total assets | | $ | — | | $ | 426,496 | | $ | 227,848 | | $ | 654,344 |\n| | | | | | | | | | | | | |\n| Liabilities: | | | | | | | | | | | | |\n| Derivative instruments, at fair value | | $ | — | | $ | 7,774 | | $ | — | | $ | 7,774 |\n| Total liabilities | | $ | — | | $ | 7,774 | | $ | — | | $ | 7,774 |\n| | | | | | | | | | | | | |\n| (In Thousands) | | Level 1 | | Level 2 | | Level 3 | | Total |\n| Assets: | | | | | | | | | | | | |\n| Loans, held for sale, at fair value | | $ | — | | $ | 192,510 | | $ | — | | $ | 192,510 |\n| Loans, net, at fair value | | — | | — | | 20,212 | | 20,212 |\n| Mortgage backed securities, at fair value | | — | | 92,006 | | 460 | | 92,466 |\n| Derivative instruments, at fair value | | — | | — | | 2,814 | | 2,814 |\n| Residential mortgage servicing rights, at fair value | | — | | — | | 91,174 | | 91,174 |\n| Total assets | | $ | — | | $ | 284,516 | | $ | 114,660 | | $ | 399,176 |\n| | | | | | | | | | | | | |\n| Liabilities: | | | | | | | | | | | | |\n| Derivative instruments, at fair value | | $ | — | | $ | 5,250 | | $ | — | | $ | 5,250 |\n| Total liabilities | | $ | — | | $ | 5,250 | | $ | — | | $ | 5,250 |\n\n| | | | | | | | | | | | | |\n| | | Three Months Ended September 30, 2020 |\n| (In Thousands) | MBS | Derivatives | Loans, held at fair value | Residential MSRs, at fair value |\n| Beginning Balance | | $ | 411 | | $ | 19,037 | | $ | 124,298 | | $ | 73,645 |\n| Purchases or Originations | | 12,640 | | — | | 1,198 | | 11,343 |\n| Sales / Principal payments | | | ( 11 ) | | | — | | | ( 5,911 ) | | | ( 5,916 ) |\n| Realized gains, net | | | — | | | — | | | 375 | | | — |\n| Unrealized gains (losses), net | | | ( 114 ) | | | 1,812 | | | 5 | | | ( 4,688 ) |\n| Transfer to (from) Level 3 | | | ( 276 ) | | | — | | | — | | | — |\n| Ending Balance | | $ | 12,650 | | $ | 20,849 | | $ | 119,965 | | $ | 74,384 |\n| | | | | | | | | | | | | |\n| Unrealized gains (losses), net on assets or liabilities held at the end of the period | | $ | ( 82 ) | | $ | 20,849 | | $ | ( 333 ) | | $ | ( 43,123 ) |\n| | | | | | | | | | | | | |\n| | | | | | | | | | | | | | | | |\n| | | Three Months Ended September 30, 2019 |\n| (In Thousands) | MBS | Derivatives | Loans, held at fair value | Residential MSRs, at fair value | Contingent consideration |\n| Beginning Balance | | $ | 36,655 | | $ | 3,670 | | $ | 20,409 | | $ | 85,658 | | $ | — |\n| Purchases or Originations | | — | | — | | — | | 9,028 | | — |\n| Additions due to loans sold, servicing retained | | | — | | | — | | | — | | | — | | | — |\n| Sales / Principal payments | | | ( 673 ) | | | — | | | ( 45 ) | | | ( 2,466 ) | | | — |\n| Realized gains, net | | | 169 | | | — | | | 38 | | | — | | | — |\n| Unrealized gains (losses), net | | | 87 | | | 511 | | | 32 | | | ( 7,582 ) | | | — |\n| Accreted discount, net | | | 49 | | | — | | | — | | | — | | | — |\n| Transfer to (from) Level 3 | | | ( 5,994 ) | | | — | | | — | | | — | | | — |\n| Ending Balance | | $ | 30,293 | | $ | 4,181 | | $ | 20,434 | | $ | 84,638 | | $ | — |\n| | | | | | | | | | | | | | | | |\n| Unrealized gains (losses), net on assets or liabilities held at the end of the period | | $ | 2,946 | | $ | 4,181 | | $ | 363 | | $ | ( 10,287 ) | | $ | — |\n| | | | | | | | | | | | | | | | |\n| | | | | | | | | | | | | |\n| | | Nine Months Ended September 30, 2020 |\n| (In Thousands) | MBS | Derivatives | Loans, held at fair value | Residential MSRs, at fair value |\n| Beginning Balance | | $ | 460 | | $ | 2,814 | | $ | 20,212 | | $ | 91,174 |\n| Purchases or Originations | | 12,640 | | — | | 106,728 | | — |\n| Additions due to loans sold, servicing retained | | | — | | | — | | | — | | | 31,821 |\n| Sales / Principal payments | | | ( 13 ) | | | — | | | ( 6,207 ) | | | ( 15,443 ) |\n| Realized gains, net | | | — | | | — | | | 375 | | | |\n| Unrealized gains (losses), net | | | ( 154 ) | | | 18,035 | | | ( 1,143 ) | | | ( 33,168 ) |\n| Transfer to (from) Level 3 | | | ( 283 ) | | | — | | | — | | | — |\n| Ending Balance | | $ | 12,650 | | $ | 20,849 | | $ | 119,965 | | $ | 74,384 |\n| | | | | | | | | | | | | |\n| Unrealized gains (losses), net on assets or liabilities held at the end of the period | | $ | ( 82 ) | | $ | 20,849 | | $ | ( 333 ) | | $ | ( 43,123 ) |\n| | | | | | | | | | | | | |\n| | | | | | | | | | | | | | | | |\n| | | Nine Months Ended September 30, 2019 |\n| (In Thousands) | MBS | Derivatives | Loans, held at fair value | Residential MSRs, at fair value | Contingent consideration |\n| Beginning Balance | | $ | 12,148 | | $ | 1,776 | | $ | 22,664 | | $ | 93,065 | | $ | — |\n| Purchases or Originations | | 9,593 | | — | | — | | 18,482 | | — |\n| Additions due to loans sold, servicing retained | | | — | | | — | | | — | | | — | | | — |\n| Sales / Principal payments | | | ( 1,342 ) | | | — | | | ( 2,239 ) | | | ( 5,861 ) | | | — |\n| Realized gains (losses), net | | | 276 | | | — | | | ( 128 ) | | | — | | | — |\n| Unrealized gains (losses), net | | | 376 | | | 2,405 | | | 137 | | | ( 21,048 ) | | | — |\n| Accreted discount, net | | | 95 | | | — | | | — | | | — | | | — |\n| Amortization and adjustment for earn-out payments | | | — | | | — | | | — | | | — | | | — |\n| Transfer to (from) Level 3 | | | 9,147 | | | — | | | — | | | — | | | — |\n| Ending Balance | | $ | 30,293 | | $ | 4,181 | | $ | 20,434 | | $ | 84,638 | | $ | — |\n| | | | | | | | | | | | | | | | |\n| Unrealized gains (losses), net on assets or liabilities held at the end of the period | | $ | 2,946 | | $ | 4,181 | | $ | 363 | | $ | ( 10,287 ) | | $ | — |\n| | | | | | | | | | | | | | | | |\n\n| | | | | | | | | | | | | | |\n| | | | | | Predominant | | | | | | | Weighted |\n| | | | | | Valuation | | | | | | | Average Price |\n| (In Thousands, except price) | Fair Value | Technique | Type | Price Range | (a) |\n| Loans, held at fair value | | $ | 119,965 | | Single External Source | | Third Party Mark | | $ | 92.01 – 106.11 | | $ | 99.72 |\n| Mortgage backed securities, at fair value | | | 12,650 | | Transaction Price | Transaction Price | | | 14.34 – 99.00 | | | 48.02 |\n| Residential mortgage servicing rights, at fair value | | 74,384 | Single external source | Discounted cash flow | | N/A | | N/A |\n| (a) | Prices are weighted based on the unpaid principal balance of the loans and securities included in the range for each class |\n\n| | | | | | | | | | | | | | |\n| | | | Predominant | | | | Weighted |\n| | | | | | Valuation | | | | | | | Average Price |\n| (In Thousands, except price) | | Fair Value | | Technique | | Type | | Price Range | | (a) |\n| Loans, held at fair value | | $ | 20,212 | Single External Source | | Third Party Mark | | $ | 100.47 – 110.83 | | $ | 103.31 |\n| Mortgage backed securities, at fair value (b) | | 357 | Broker Quotes | | Third Party Mark | | | 1.00 – 1.00 | | | 1.00 |\n| Mortgage backed securities, at fair value | | | 103 | | Transaction Price | Transaction Price | | | 99.00 – 99.00 | | | 99.00 |\n| Residential mortgage servicing rights, at fair value | | | 91,174 | | Single external source | Discounted cash flow | | N/A | | N/A |\n| (a) | Prices are weighted based on the unpaid principal balance of the loans and securities included in the range for each class |\n| (b) | Price ranges and weighted averages represent interest-only strips with a fair value of $ 0.4 million as of December 31, 2019 |\n| | | | | | | | | | | | | |\n| | | September 30, 2020 | | December 31, 2019 |\n| (In Thousands) | Carrying Value | Estimated Fair Value | Carrying Value | EstimatedFair Value |\n| Assets: | | | | | | | | | | | | |\n| Loans, net | | $ | 3,891,623 | | $ | 3,980,896 | | $ | 4,033,972 | | $ | 4,147,831 |\n| Purchased future receivables, net | | | 16,659 | | | 16,659 | | | 43,265 | | | 43,265 |\n| Servicing rights | | | 35,661 | | 40,189 | | 30,795 | | 34,723 |\n| Total assets | | $ | 3,943,943 | | $ | 4,037,744 | | $ | 4,108,032 | | $ | 4,225,819 |\n| Liabilities: | | | | | | | | | | | | |\n| Secured borrowings | | $ | 1,176,621 | | $ | 1,176,621 | | $ | 1,189,392 | | $ | 1,189,392 |\n| Securitized debt obligations of consolidated VIEs, net | | 2,059,114 | | 2,092,985 | | 1,815,154 | | 1,859,047 |\n| Senior secured note, net | | | 179,572 | | | 186,419 | | | 179,289 | | | 190,923 |\n| Guaranteed loan financing | | 421,183 | | 449,010 | | 485,461 | | 515,182 |\n| Convertible notes, net | | | 111,855 | | | 79,975 | | | 111,040 | | | 116,654 |\n| Corporate debt, net | | | 150,658 | | | 144,345 | | | 149,986 | | | 161,098 |\n| Total liabilities | | $ | 4,099,003 | | $ | 4,129,355 | | $ | 3,930,322 | | $ | 4,032,296 |\n\n| | | | | | | | | | | | | | | | | | | | |\n| | | Weighted | | | | | | | | | |\n| | | Weighted | | Average | | | | | | | | | | | Gross | | Gross |\n| | | Average | | Interest | | Principal | | Amortized | | | | | Unrealized | | Unrealized |\n| (In Thousands) | | Maturity (a) | | Rate (a) | | Balance | | Cost | | Fair Value | | Gains | | Losses |\n| September 30, 2020 | | | | | | | | | | | | | | | | | | | |\n| Mortgage backed securities, at fair value | | | | | | | | | | | | | | | | | | | |\n| Freddie Mac Loans | 01/2037 | | 2.0 | % | $ | 142,552 | | $ | 53,569 | | $ | 55,025 | | $ | 2,023 | | $ | ( 567 ) |\n| Commercial Loans | | 11/2050 | | 4.5 | | | 73,160 | | | 39,284 | | | 35,311 | | | 26 | | | ( 3,999 ) |\n| Tax Liens | 09/2026 | 6.0 | | 92 | | 92 | | 91 | | — | | ( 1 ) |\n| Total Mortgage backed securities, at fair value | | 09/2041 | | 2.8 | % | $ | 215,804 | | $ | 92,945 | | $ | 90,427 | | $ | 2,049 | | $ | ( 4,567 ) |\n| December 31, 2019 | | | | | | | | | | | | | | | | | | | |\n| Mortgage backed securities, at fair value | | | | | | | | | | | | | | | | | | | |\n| Freddie Mac Loans | 06/2037 | | 4.3 | % | $ | 83,149 | | $ | 61,207 | | $ | 66,108 | | $ | 4,915 | | $ | ( 14 ) |\n| Commercial Loans | | 02/2051 | | 5.4 | | | 35,984 | | | 25,358 | | | 26,255 | | | 924 | | | ( 27 ) |\n| Tax Liens | 09/2026 | 6.0 | | 104 | | 104 | | 103 | | — | | ( 1 ) |\n| Total Mortgage backed securities, at fair value | | 07/2041 | | 4.6 | % | $ | 119,237 | | $ | 86,669 | | $ | 92,466 | | $ | 5,839 | | $ | ( 42 ) |\n| | | | | | | | | | | | | | | | | | | | |\n| (a) | Weighted based on current principal balance |\n| | | | | | | | | | | | |\n| | Weighted | | | | | | |\n| | | Average | | | | | | | | | |\n| | | Interest | | Principal | | Amortized | | |\n| (In Thousands) | | Rate (a) | | Balance | | Cost | | Fair Value |\n| September 30, 2020 | | | | | | | | | | | |\n| Mortgage backed securities, at fair value | | | | | | | | | | | |\n| After five years through ten years | 6.0 | % | $ | 92 | | $ | 92 | | $ | 91 |\n| After ten years | 2.8 | | 215,712 | | 92,853 | | 90,336 |\n| Total Mortgage backed securities, at fair value | | 2.8 | % | $ | 215,804 | | $ | 92,945 | | $ | 90,427 |\n| December 31, 2019 | | | | | | | | | | | |\n| Mortgage backed securities, at fair value | | | | | | | | | | | |\n| After five years through ten years | 3.8 | % | $ | 2,869 | | $ | 2,641 | | $ | 2,825 |\n| After ten years | 4.7 | | 116,368 | | 84,028 | | 89,641 |\n| Total | | 4.6 | % | $ | 119,237 | | $ | 86,669 | | $ | 92,466 |\n| (a) | Weighted based on current principal balance. |\n| (b) |\n| (c) |\n\n| | | | | | | | | | | | | |\n| | | Three Months Ended September 30, | | Nine Months Ended September 30, |\n| (In Thousands) | 2020 | 2019 | 2020 | 2019 |\n| SBA servicing rights, at amortized cost |\n| Beginning net carrying amount | | $ | 17,318 | | $ | 18,000 | | $ | 17,660 | | $ | 16,749 |\n| Additions due to loans sold, servicing retained | | 993 | | 550 | | 2,328 | | 2,431 |\n| Acquisitions | | | — | | | — | | | — | | | 894 |\n| Amortization | | ( 909 ) | | ( 869 ) | | ( 2,642 ) | | ( 2,529 ) |\n| Impairment | | 138 | | ( 149 ) | | 194 | | ( 13 ) |\n| Ending net carrying value of SBA servicing rights | | $ | 17,540 | | $ | 17,532 | | $ | 17,540 | | $ | 17,532 |\n| Freddie Mac multi-family servicing rights, at amortized cost |\n| Beginning net carrying amount | | $ | 16,798 | | $ | 11,103 | | $ | 13,135 | | $ | 10,248 |\n| Additions due to loans sold, servicing retained | | 2,107 | | 1,798 | | 7,094 | | 3,745 |\n| Amortization | | ( 784 ) | | ( 591 ) | | ( 2,108 ) | | ( 1,683 ) |\n| Ending net carrying value of Freddie Mac multi-family servicing rights | | $ | 18,121 | | $ | 12,310 | | $ | 18,121 | | $ | 12,310 |\n| Ending net carrying value of SBA and Freddie Mac multi-family servicing rights, at amortized cost | | $ | 35,661 | | $ | 29,842 | | $ | 35,661 | | $ | 29,842 |\n| Residential mortgage servicing rights, at fair value |\n| Beginning Balance | | $ | 73,645 | | $ | 85,658 | | $ | 91,174 | | $ | 93,065 |\n| Additions due to loans sold, servicing retained | | 11,343 | | 9,028 | | 31,821 | | 18,482 |\n| Loan pay-offs | | | ( 5,916 ) | | | ( 2,466 ) | | | ( 15,443 ) | | | ( 5,861 ) |\n| Unrealized losses | | ( 4,688 ) | | ( 7,582 ) | | ( 33,168 ) | | ( 21,048 ) |\n| Ending fair value of residential mortgage servicing rights | | $ | 74,384 | | $ | 84,638 | | $ | 74,384 | | $ | 84,638 |\n| Total servicing rights | | $ | 110,045 | | $ | 114,480 | | $ | 110,045 | | $ | 114,480 |\n| | | | | | | | | | | | | |\n| | | As of September 30, 2020 | | As of December 31, 2019 |\n| | | Unpaid Principal | | | | Unpaid Principal | | |\n| (In Thousands) | | Amount | | Carrying Value | | Amount | | Carrying Value |\n| SBA | | $ | 598,400 | | $ | 17,540 | | $ | 568,017 | | $ | 17,660 |\n| Freddie Mac multi-family | | | 1,458,517 | | | 18,121 | | | 1,167,476 | | | 13,135 |\n| Total | | $ | 2,056,917 | | $ | 35,661 | | $ | 1,735,493 | | $ | 30,795 |\n| | | | | | | | | | | | | |\n| | | | | | | | | | | | | | | | | | |\n| | | | September 30, 2020 | | December 31, 2019 |\n| | | Range of inputvalues | | Weighted Average | Range of inputvalues | | Weighted Average |\n| SBA servicing rights (at amortized cost) | | | | | | | | | | | | | | | | |\n| | • Forward prepayment rate | | 6.4 | - | 21.0 | % | | 8.7 | % | | 6.3 | - | 21.2 | % | | 9.3 | % |\n| | • Forward default rate | | 0.0 | - | 10.1 | % | | 7.6 | % | | 0.0 | - | 10.8 | % | | 7.3 | % |\n| | • Discount rate | | 7.1 | - | 7.1 | % | | 7.1 | % | | 8.8 | - | 8.8 | % | | 8.8 | % |\n| | • Servicing expense | | 0.4 | - | 0.4 | % | | 0.4 | % | | 0.4 | - | 0.4 | % | | 0.4 | % |\n| | | | | | | | | | | | | | | | | | |\n| Freddie Mac multi-family servicing rights (at amortized cost) | | | | | | | | | | | | | | | | |\n| | • Forward prepayment rate | | 0.5 | - | 15.9 | % | | 6.9 | % | | 0.5 | - | 15.9 | % | | 6.6 | % |\n| | • Forward default rate | | 0.0 | - | 0.5 | % | | 0.3 | % | | 0.0 | - | 0.5 | % | | 0.4 | % |\n| | • Discount rate | | 6.0 | - | 6.0 | % | | 6.0 | % | | 6.0 | - | 6.0 | % | | 6.0 | % |\n| | • Servicing expense | | 0.2 | - | 0.3 | % | | 0.2 | % | | 0.2 | - | 0.3 | % | | 0.2 | % |\n| | | | | | | | | | | | | | | | | | |\n\n| | | | | | | |\n| (In Thousands) | September 30, 2020 | December 31, 2019 |\n| SBA servicing rights (at amortized cost) | | | | | | |\n| • Forward prepayment rate | | | | | | |\n| 10% adverse change | | $ | ( 585 ) | | $ | ( 563 ) |\n| 20% adverse change | | ( 1,141 ) | | ( 1,097 ) |\n| | | | | | | |\n| • Default rate | | | | | |\n| 10% adverse change | | $ | ( 111 ) | | $ | ( 94 ) |\n| 20% adverse change | | | ( 220 ) | | | ( 186 ) |\n| | | | | | |\n| • Discount rate | | | | | | |\n| 10% adverse change | | $ | ( 475 ) | | $ | ( 520 ) |\n| 20% adverse change | | | ( 927 ) | | ( 1,011 ) |\n| | | | | | | |\n| Freddie Mac multi-family servicing rights (at amortized cost) | | | |\n| • Forward prepayment rate | | | | | | |\n| 10% adverse change | | $ | ( 398 ) | | $ | ( 285 ) |\n| 20% adverse change | | ( 778 ) | | ( 558 ) |\n| | | | | | | |\n| • Default rate | | | | | |\n| 10% adverse change | | $ | ( 6 ) | | $ | ( 5 ) |\n| 20% adverse change | | | ( 13 ) | | | ( 10 ) |\n| | | | | | |\n| • Discount rate | | | | | | |\n| 10% adverse change | | $ | ( 494 ) | | $ | ( 381 ) |\n| 20% adverse change | | ( 968 ) | | | ( 746 ) |\n| | | | |\n| (In Thousands) | September 30, 2020 |\n| 2020 | | $ | 1,718 |\n| 2021 | | 6,320 |\n| 2022 | | 5,511 |\n| 2023 | | 4,787 |\n| 2024 | | 4,131 |\n| Thereafter | | 13,194 |\n| Total | | $ | 35,661 |\n| | | | | | | | | | | | | |\n| | | As of September 30, 2020 | | As of December 31, 2019 |\n| | | Unpaid Principal | | | | Unpaid Principal | | |\n| (In Thousands) | | Amount | | Fair Value | | Amount | | Fair Value |\n| Fannie Mae | | $ | 3,625,230 | | $ | 28,011 | | $ | 3,388,630 | | $ | 37,309 |\n| Ginnie Mae | | | 2,687,994 | | | 25,244 | | | 2,504,993 | | | 29,869 |\n| Freddie Mac | | | 2,760,615 | | | 21,129 | | | 2,270,981 | | | 23,996 |\n| Total | | $ | 9,073,839 | | $ | 74,384 | | $ | 8,164,604 | | $ | 91,174 |\n\n| | | | | | | | | | | | | | | | | | |\n| | | | September 30, 2020 | | December 31, 2019 |\n| | | Range of inputvalues | | Weighted Average | Range of inputvalues | | Weighted Average |\n| Residential mortgage servicing rights (at fair value) | | | | | | | | | | | | | | | | |\n| | • Forward prepayment rate | | 12.5 | - | 23.5 | % | | 13.9 | % | | 7.1 | - | 18.7 | % | | 10.1 | % |\n| | • Discount rate | | 9.1 | - | 12.0 | % | | 10.0 | % | | 9.0 | - | 11.0 | % | | 9.6 | % |\n| | • Servicing expense | | $ 70 | - | $ 85 | | | $ 74 | | | $ 70 | - | $ 85 | | | $ 75 | |\n| | | | | | | | | | | | | | | | | | |\n| | | | | | | |\n| (In Thousands) | September 30, 2020 | | December 31, 2019 |\n| Prepayment rate | | | | | | |\n| 10% adverse change | | $ | ( 4,728 ) | | $ | ( 4,195 ) |\n| 20% adverse change | | ( 9,077 ) | | ( 8,091 ) |\n| Discount rate | | | | | | |\n| 10% adverse change | | $ | ( 2,523 ) | | $ | ( 3,450 ) |\n| 20% adverse change | | ( 4,876 ) | | ( 6,654 ) |\n| Cost of servicing | | | | | | |\n| 10% adverse change | | $ | ( 1,436 ) | | $ | ( 1,648 ) |\n| 20% adverse change | | ( 2,873 ) | | ( 3,297 ) |\n| | | | | | | | | | | | | | |\n| | | Three Months Ended September 30, | | Nine Months Ended September 30, | |\n| (In Thousands) | 2020 | 2019 | 2020 | 2019 | |\n| Realized and unrealized gain (loss) of residential mortgage loans held for sale, at fair value | | $ | 61,131 | | $ | 17,229 | | $ | 143,747 | | $ | 41,314 | |\n| Creation of new mortgage servicing rights, net of payoffs | | | 5,427 | | | 6,562 | | | 16,378 | | | 12,621 | |\n| Loan origination fee income on residential mortgage loans | | | 6,021 | | | 3,320 | | | 15,529 | | | 7,688 | |\n| Unrealized gain (loss) on IRLCs and other derivatives | | 2,945 | | | 1,902 | | 17,103 | | | 2,998 | |\n| Residential mortgage banking activities | | $ | 75,524 | | $ | 29,013 | | $ | 192,757 | | $ | 64,621 | |\n| | | | | | | | | | | | | | |\n| Variable expenses on residential mortgage banking activities | | $ | ( 30,918 ) | | $ | ( 17,318 ) | | $ | ( 87,494 ) | | $ | ( 39,995 ) | |\n| | |\n\n| | | | | | | | | | | | | | | | | |\n| | | | | | | | | | | | | Carrying Value at |\n| Lender | Asset Class | Current Maturity | Pricing | Facility Size | Pledged Assets Carrying Value | September 30, 2020 | December 31, 2019 |\n| JPMorgan | Acquired loans, SBA loans | June 2021 | | 1M L + 1.75 to 2.75 % | | $ | 250,000 | | $ | 44,840 | | $ | 30,742 | | $ | 88,972 |\n| Keybank | Freddie Mac loans | February 2021 | | 1M L + 1.30 % | | | 100,000 | | | 20,486 | | | 20,242 | | | 21,513 |\n| East West Bank | SBA loans | October 2022 | | Prime - 0.821 to + 0.29 % | | | 50,000 | | | 40,550 | | | 33,184 | | | 13,294 |\n| Credit Suisse | Acquired loans (non USD) | December 2021 | | Euribor + 2.50 % | | | 234,420 | (a) | | 53,021 | | | 32,267 | | | 37,646 |\n| FCB | Acquired loans | June 2021 | | 2.75 % | | | — | | | — | | | — | | | 1,354 |\n| Comerica Bank | Residential loans | March 2021 | | 1M L + 1.75 % | | | 125,000 | | | 90,515 | | | 83,704 | | | 56,822 |\n| TBK Bank | Residential loans | October 2021 | | Variable Pricing | | | 150,000 | | | 123,980 | | | 118,581 | | | 52,151 |\n| Origin Bank | Residential loans | June 2021 | | Variable Pricing | | | 60,000 | | | 25,093 | | | 23,471 | | | 15,343 |\n| Associated Bank | Residential loans | November 2020 | | 1M L + 1.50 % | | | 60,000 | | | 47,918 | | | 44,489 | | | 5,823 |\n| East West Bank | Residential MSRs | September 2023 | | 1M L + 2.50 % | | | 50,000 | | | 49,140 | | | 37,700 | | | 39,900 |\n| Credit Suisse | Purchased future receivables, PPP loans | June 2021 | | 1M L + 4.50 % | | | 150,000 | | | — | | | — | | | 34,900 |\n| Rabobank | Real estate | January 2021 | | 4.22 % | | | 14,500 | | | — | | | — | | | 12,485 |\n| Federal Reserve Bank of Minneapolis | PPP loans | April 2022 | | 0.35 % | | | 105,222 | | | 105,089 | | | 105,005 | | | — |\n| Bank of the Sierra | Real estate | August 2050 | | 3.25 % | | | 22,750 | | | 37,562 | | | 22,687 | | | — |\n| Total borrowings under credit facilities (b) | | | | $ | 1,371,892 | | $ | 638,194 | | $ | 552,072 | | $ | 380,203 |\n| Citibank | Fixed rate, Transitional, Acquired loans | October 2021 | | 1M L + 1.875 to 2.125 % | | $ | 500,000 | | $ | 114,196 | | $ | 103,307 | | $ | 124,718 |\n| Deutsche Bank | Fixed rate, Transitional loans | November 2021 | | 3M L + 2.00 to 2.40 % | | | 350,000 | | | 232,524 | | | 161,100 | | | 141,356 |\n| JPMorgan | Transitional loans | December 2020 | | 1M L + 2.25 to 4.00 % | | | 400,000 | | | 265,599 | | | 175,764 | | | 250,466 |\n| JPMorgan | MBS | March 2021 | | 1.54 to 4.75 % | | | 70,875 | | | 115,128 | | | 70,875 | | | 93,715 |\n| Deutsche Bank | MBS | January 2021 | | 3.54 % | | | 16,354 | | | 20,189 | | | 16,354 | | | 44,730 |\n| Citibank | MBS | November 2020 | | 3.25 to 3.76 % | | | 58,422 | | | 114,749 | | | 58,422 | | | 56,189 |\n| Bank of America | MBS | Matured | | 1.31 to 1.61 % | | | — | | | — | | | — | | | 38,954 |\n| RBC | MBS | February 2021 | | 3.05 to 4.43 % | | | 38,727 | | | 61,595 | | | 38,727 | | | 59,061 |\n| Total borrowings under repurchase agreements (c) | | $ | 1,434,378 | | $ | 923,980 | | $ | 624,549 | | $ | 809,189 |\n| Total secured borrowings | | $ | 2,806,270 | | $ | 1,562,174 | | $ | 1,176,621 | | $ | 1,189,392 |\n| | | | | | |\n| | | Pledged Assets Carrying Value at |\n| (In Thousands) | | September 30, 2020 | December 31, 2019 |\n| Collateral pledged - borrowings under credit facilities | | | | | |\n| Loans, held for sale, at fair value | | $ | 309,488 | $ | 159,928 |\n| Loans, net | | | 136,722 | | 276,810 |\n| Loans, held at fair value | | | 105,089 | | — |\n| Mortgage servicing rights | | | 49,140 | | 61,304 |\n| Purchased future receivables | | | — | | 43,265 |\n| Real estate, held for sale | | | 37,755 | | 19,950 |\n| Total collateral pledged on borrowings under credit facilities | | $ | 638,194 | $ | 561,257 |\n| Collateral pledged - borrowings under repurchase agreements | | | | | |\n| Loans, net | | $ | 612,319 | $ | 721,887 |\n| Mortgage backed securities | | 73,888 | | 113,436 |\n| Retained interest in assets of consolidated VIEs | | | 237,773 | | 271,880 |\n| Total collateral pledged on borrowings under repurchase agreements | | $ | 923,980 | $ | 1,107,203 |\n| Total collateral pledged on secured borrowings | | $ | 1,562,174 | $ | 1,668,460 |\n\nNote 12 – Senior secured notes, convertible notes, and corporate debt, netSenior secured notes, netDuring 2017, ReadyCap Holdings LLC, a subsidiary of the Company, issued $ 140.0 million in 7.50 % Senior Secured Notes due 2022. On January 30, 2018 ReadyCap Holdings LLC, issued an additional $ 40.0 million in aggregate principal amount of 7.50 % Senior Secured Notes due 2022, which have identical terms (other than issue date and issue price) to the notes issued during 2017 (collectively “the Senior Secured Notes”). The additional $ 40.0 million in Senior Secured Notes were priced with a yield to par call date of 6.5 %. Payments of the amounts due on the Senior Secured Notes are fully and unconditionally guaranteed by the Company and its subsidiaries: Sutherland Partners LP, Sutherland Asset I, LLC, and ReadyCap Commercial, LLC. The funds were used to fund new SBC and SBA loan originations and new SBC loan acquisitions. As of September 30, 2020, we were in compliance with all covenants with respect to the Senior Secured Notes.Convertible notes, netOn August 9, 2017, the Company closed an underwritten public sale of $ 115.0 million aggregate principal amount of its 7.00 % convertible senior notes due 2023 (“Convertible Notes”). The Convertible Notes will mature on August 15, 2023, unless earlier repurchased, redeemed or converted. During certain periods and subject to certain conditions, the Convertible Notes will be convertible by holders into shares of the Company's common stock at an initial conversion rate of 1.4997 shares of common stock per $ 25 principal amount of the Convertible Notes, which is equivalent to an initial conversion price of approximately $ 16.67 per share of common stock. Upon conversion, holders will receive, at the Company's discretion, cash, shares of the Company's common stock or a combination thereof.The Company may redeem all or any portion of the Convertible Notes, at its option, on or after August 15, 2021, at a redemption price payable in cash equal to 100 % of the principal amount of the Convertible Notes to be redeemed, plus accrued and unpaid interest. Additionally, upon the occurrence of certain corporate transactions, holders may require the Company to purchase the Convertible Notes for cash at a purchase price equal to 100% of the principal amount of the Convertible Notes to be purchased, plus accrued and unpaid interest. The Convertible Notes will be convertible only upon satisfaction of one or more of the following conditions: (1) the closing market price of the Company’s common stock is greater than or equal to 120 % of the conversion price of the respective Convertible Notes for at least 20 out of 30 days prior to the end of the preceding fiscal quarter, (2) the trading price of the Convertible Notes is less than 98 % of the product of (i) the conversion rate and (ii) the closing price of the Company’s common stock during any five consecutive trading day period, (3) the Company issues certain equity instruments at less than the 10-day average closing market price of its common stock or the per-share value of certain distributions exceeds the market price of the Company’s common stock by more than 10 %, or (4) certain other specified corporate events (significant consolidation, sale, merger share exchange, etc.) occur. At issuance, we allocated $ 112.7 million and $ 2.3 million of the carrying value of the Convertible Notes to its debt and equity components, respectively, before the allocation of deferred financing costs. As of September 30, 2020, we were in compliance with all covenants with respect to the Convertible Notes.Corporate debt, netOn April 27, 2018, the Company completed the public offer and sale of $ 50,000,000 aggregate principal amount of its 6.50 % Senior Notes due 2021 (the “2021 Notes”). The Company issued the 2021 Notes under a base indenture, dated August 9, 2017, as supplemented by the second supplemental indenture, dated as of April 27, 2018, between the Company and U.S. Bank National Association, as trustee. The 2021 Notes bear interest at a rate of 6.50% per annum, payable quarterly in arrears on January 30, April 30, July 30, and October 30 of each year, beginning on July 30, 2018. The 2021 Notes will mature on April 30, 2021, unless earlier redeemed or repurchased.The Company may redeem for cash all or any portion of the 2021 Notes, at its option, on or after April 30, 2019 and before April 30, 2020 at a redemption price equal to 101 % of the principal amount of the 2021 Notes to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date. On or after April 30, 2020, the Company may redeem for cash all or any portion of the 2021 Notes, at its option, at a redemption price equal to 100 % of the principal amount of 41\nthe 2021 Notes to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date. If the Company undergoes a change of control repurchase event, holders may require it to purchase the 2021 Notes, in whole or in part, for cash at a repurchase price equal to 101 % of the aggregate principal amount of the 2021 Notes to be purchased, plus accrued and unpaid interest, if any, to, but excluding, the date of repurchase, as described in greater detail in the Indenture.The 2021 Notes are the Company’s senior direct unsecured obligations and will not be guaranteed by any of its subsidiaries, except to the extent described in the Indenture upon the occurrence of certain events. The 2021 Notes rank equal in right of payment to any of the Company’s existing and future unsecured and unsubordinated indebtedness; effectively junior in right of payment to any of its existing and future secured indebtedness to the extent of the value of the assets securing such indebtedness; and structurally junior to all existing and future indebtedness, other liabilities (including trade payables) and (to the extent not held by the Company) preferred stock, if any, of its subsidiaries.On July 22, 2019, the Company completed the public offer and sale of $ 57.5 million aggregate principal amount of its 6.20 % Senior Notes due 2026 (the “2026 Notes” and together with the 2021 Notes, the “Corporate Debt”), which includes $ 7.5 million aggregate principal amount of the 2026 Notes relating to the full exercise of the underwriters’ over-allotment option. The net proceeds from the sale of the 2026 Notes are approximately $ 55.3 million, after deducting underwriters’ discount and estimated offering expenses. The Company will contribute the net proceeds to Sutherland Partners, L.P. (the “Operating Partnership”), its operating partnership subsidiary, in exchange for the issuance by the Operating Partnership of a senior unsecured note with terms that are substantially equivalent to the terms of the 2026 Notes. The Operating Partnership intends to use the net proceeds to originate or acquire the Company’s target assets and for general business purposes.The 2026 Notes bear interest at a rate of 6.20% per annum, payable quarterly in arrears on January 30, April 30, July 30, and October 30 of each year, beginning on October 30, 2019. The 2026 Notes will mature on July 30, 2026, unless earlier repurchased or redeemed. The Company may redeem for cash all or any portion of the 2026 Notes, at its option, on or after July 30, 2022 and before July 30, 2025 at a redemption price equal to 101 % of the principal amount of the 2026 Notes to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date. On or after July 30, 2025, the Company may redeem for cash all or any portion of the 2026 Notes, at its option, at a redemption price equal to 100 % of the principal amount of the 2026 Notes to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date. If the Company undergoes a change of control repurchase event, holders may require it to purchase the 2026 Notes, in whole or in part, for cash at a repurchase price equal to 101 % of the aggregate principal amount of the 2026 Notes to be purchased, plus accrued and unpaid interest, if any, to, but excluding, the date of repurchase, as described in greater detail in the Indenture.The 2026 Notes are the Company’s senior unsecured obligations and will not be guaranteed by any of its subsidiaries, except to the extent described in the Indenture upon the occurrence of certain events. The 2026 Notes rank equal in right of payment to any of the Company’s existing and future unsecured and unsubordinated indebtedness; effectively junior in right of payment to any of its existing and future secured indebtedness to the extent of the value of the assets securing such indebtedness; and structurally junior to all existing and future indebtedness, other liabilities (including trade payables) and (to the extent not held by the Company) preferred stock, if any, of its subsidiaries.In December 2019, the Company completed the public offer and sale of $ 45.0 million aggregate principal amount of the 2026 Notes. The new notes have the same terms (expect with respect to issue date, issue price and the date from which interest will accrue) as, are fully fungible with and are treated as a single series of debt securities as, the 6.20% Senior Notes due 2026 the Company issued on July 22, 2019. As of September 30, 2020, we were in compliance with all covenants with respect to the corporate debt. 42\n| | | | | | | | | |\n| (in thousands, except rates) | Coupon Rate | | Maturity Date | September 30, 2020 |\n| Senior secured notes - principal amount(1) | | 7.50 | % | | 2/15/2022 | | $ | 180,000 |\n| Unamortized premium - Senior secured notes | | | | | | | | 1,093 |\n| Unamortized deferred financing costs - Senior secured notes | | | | | | | | ( 1,521 ) |\n| Total Senior secured notes, net | | | | | | | $ | 179,572 |\n| Convertible notes - principal amount (2) | | 7.00 | % | 8/15/2023 | | $ | 115,000 |\n| Unamortized discount - Convertible notes (3) | | | | | | | | ( 1,157 ) |\n| Unamortized deferred financing costs - Convertible notes | | | | | | | | ( 1,988 ) |\n| Total Convertible notes, net | | | | | | | $ | 111,855 |\n| Corporate debt - principal amount(4) | | 6.50 | % | | 4/30/2021 | | $ | 50,000 |\n| Corporate debt - principal amount(5) | | 6.20 | % | | 7/30/2026 | | | 104,250 |\n| Unamortized premium - Corporate debt | | | | | | | | 392 |\n| Unamortized deferred financing costs - Corporate debt | | | | | | | | ( 3,984 ) |\n| Total Corporate debt, net | | | | | | | $ | 150,658 |\n| Total carrying amount of debt components | | | | | | | $ | 442,085 |\n| Total carrying amount of conversion option of equity components recorded in equity | | | | | | | $ | 1,157 |\n| (1) | Interest on the Senior Secured Notes is payable semiannually on each February 15 and August 15, beginning on August 15, 2017. |\n| (2) | Interest on the Convertible Notes is payable quarterly on February 15, May 15, August 15, and November 15 of each year, beginning on November 15, 2017. |\n| (3) | Represents the discount created by separating the conversion option from the debt host instrument. |\n| (4) | Interest on the corporate debt is payable January 30, April 30, July 30, and October 30 of each year, beginning on July 30, 2018. |\n| (5) | Interest on the corporate debt is payable January 30, April 30, July 30, and October 30 of each year, beginning on October 30, 2019. |\n| | | | |\n| (In Thousands) | September 30, 2020 |\n| 2020 | $ | — |\n| 2021 | | 50,000 |\n| 2022 | | 180,000 |\n| 2023 | | 115,000 |\n| 2024 | | | — |\n| Thereafter | | 104,250 |\n| Total contractual amounts | | | 449,250 |\n| Unamortized deferred financing costs, discounts, and premiums, net | | | ( 7,165 ) |\n| Total carrying amount of debt components | | $ | 442,085 |\n| | | | | | | | | | |\n| | Weighted | Range of | | | |\n| | | Average | | Interest | | Range of | | |\n| (In Thousands) | | Interest Rate | | Rates | | Maturities (Years) | | Ending Balance |\n| September 30, 2020 | | 3.77 | % | 0.99 - 6.50 % | 2020 - 2044 | | $ | 421,183 |\n| December 31, 2019 | | 5.45 | % | 1.70 - 7.50 % | 2020 - 2044 | | $ | 485,461 |\n\n| | | | |\n| (In Thousands) | September 30, 2020 |\n| 2020 | | $ | 54 |\n| 2021 | | 642 |\n| 2022 | | 1,678 |\n| 2023 | | 2,718 |\n| 2024 | | 3,856 |\n| Thereafter | | 412,235 |\n| Total | | $ | 421,183 |\n\n| | | | | | | | | | | | | | | | | | | |\n| | | September 30, 2020 | | | December 31, 2019 | |\n| | Current | | | Weighted | | Current | | | Weighted | |\n| | | Principal | | Carrying | | Average | | | Principal | | Carrying | | Average | |\n| (In Thousands) | | Balance | | value | | Interest Rate | | | Balance | | value | | Interest Rate | |\n| Waterfall Victoria Mortgage Trust 2011-SBC2 | | $ | 4,802 | | $ | 4,802 | | 5.5 | % | | $ | 6,399 | | $ | 6,399 | | 5.5 | % |\n| ReadyCap Lending Small Business Trust 2019-2 | | | 108,558 | | | 106,892 | | 3.2 | | | | 131,032 | | | 129,007 | | 4.3 | |\n| Sutherland Commercial Mortgage Trust 2017-SBC6 | | | 31,449 | | | 30,901 | | 3.6 | | | | 42,309 | | | 41,486 | | 3.4 | |\n| Sutherland Commercial Mortgage Trust 2018-SBC7 | | | 93,516 | | | 92,228 | | 4.7 | | | | 138,235 | | | 136,212 | | 4.7 | |\n| Sutherland Commercial Mortgage Trust 2019-SBC8 | | | 186,854 | | | 184,179 | | 2.9 | | | | 219,617 | | | 216,981 | | 2.9 | |\n| Sutherland Commercial Mortgage Trust 2020-SBC9 | | | 154,919 | | | 151,994 | | 3.8 | | | | — | | | — | | — | |\n| ReadyCap Commercial Mortgage Trust 2014-1 | | 17,974 | | | 17,979 | | 5.8 | | | 18,626 | | | 18,632 | | 5.6 | |\n| ReadyCap Commercial Mortgage Trust 2015-2 | | 38,669 | | | 36,417 | | 4.8 | | | 64,239 | | | 61,443 | | 4.5 | |\n| ReadyCap Commercial Mortgage Trust 2016-3 | | 26,646 | | | 25,497 | | 4.7 | | | 32,269 | | | 30,777 | | 4.7 | |\n| ReadyCap Commercial Mortgage Trust 2018-4 | | | 94,853 | | | 91,546 | | 4.0 | | | | 121,179 | | | 117,428 | | 3.9 | |\n| ReadyCap Commercial Mortgage Trust 2019-5 | | | 259,647 | | | 250,726 | | 4.1 | | | | 309,296 | | | 299,273 | | 4.1 | |\n| ReadyCap Commercial Mortgage Trust 2019-6 | | | 374,368 | | | 367,598 | | 3.2 | | | | 379,400 | | | 371,939 | | 3.2 | |\n| Ready Capital Mortgage Financing 2018-FL2 | | | 50,491 | | | 50,322 | | 2.5 | | | | 115,381 | | | 114,057 | | 3.8 | |\n| Ready Capital Mortgage Financing 2019-FL3 | | | 243,849 | | | 241,823 | | 2.1 | | | | 267,904 | | | 264,249 | | 3.5 | |\n| Ready Capital Mortgage Financing 2020-FL4 | | | 324,221 | | | 318,400 | | 3.1 | | | | — | | | — | | — | |\n| Total (1) | | $ | 2,010,816 | $ | 1,971,304 | | 3.3 | % | $ | 1,845,886 | $ | 1,807,883 | | 3.7 | % |\n| | | | | | | |\n| (In Thousands) | September 30, 2020 | December 31, 2019 |\n| Assets: | | | | | | |\n| Cash and cash equivalents | $ | 14,268 | $ | 23 |\n| Restricted cash | | 13,427 | | | 8,301 |\n| Loans, net | | | 2,618,449 | | | 2,326,199 |\n| Loans, held for sale, at fair value | | | — | | | 4,434 |\n| Real estate, held for sale | | | 8,422 | | | — |\n| Due from servicers | | | 20,065 | | | 27,964 |\n| Accrued interest | | | 16,567 | | | 11,565 |\n| Total assets | | $ | 2,691,198 | | $ | 2,378,486 |\n| Liabilities: | | | | | | |\n| Securitized debt obligations of consolidated VIEs, net | | | 2,059,114 | | | 1,815,154 |\n| Total liabilities | | $ | 2,059,114 | | $ | 1,815,154 |\n\n| | | | | | | | | | | | | |\n| | Carrying Amount | Maximum Exposure to Loss (1) |\n| (In Thousands) | | September 30, 2020 | | December 31, 2019 | | September 30, 2020 | | December 31, 2019 |\n| Assets: | | | | | | | | | | | | |\n| Mortgage backed securities, at fair value (2) | $ | 67,584 | | $ | 66,108 | $ | 67,584 | | $ | 66,108 |\n| Investment in unconsolidated joint ventures | | 69,204 | | | 58,850 | | | 69,204 | | | 58,850 |\n| Total assets in unconsolidated VIEs | | $ | 136,788 | | $ | 124,958 | | $ | 136,788 | | $ | 124,958 |\n| (1)Maximum exposure to loss is limited to the greater of the fair value or carrying value of the assets as of the consolidated balance sheet date.(2)Retained interest in Freddie Mac and third party sponsored securitizations. |\n| | | | | | | | | | | | | |\n| | | Three Months Ended September 30, | | Nine Months Ended September 30, |\n| (In Thousands) | 2020 | 2019 | 2020 | 2019 |\n| Interest income | | | | | | | | | | | | |\n| Loans | | | | | | | | | | | | |\n| Originated Transitional loans | | $ | 21,366 | | $ | 20,157 | | $ | 65,953 | | $ | 51,398 |\n| Originated SBC loans | | | 12,784 | | | 10,499 | | | 42,712 | | | 34,679 |\n| Acquired loans | | | 13,611 | | | 18,306 | | | 42,938 | | | 46,348 |\n| Acquired SBA 7(a) loans | | | 4,014 | | | 4,609 | | | 14,165 | | | 16,078 |\n| Originated SBA 7(a) loans | | | 4,715 | | | 2,626 | | | 15,649 | | | 7,390 |\n| Originated SBC loans, at fair value | | | 639 | | | 331 | | | 1,470 | | | 1,052 |\n| Originated Residential Agency loans | | | 40 | | | 30 | | | 89 | | | 52 |\n| Total loans (1) | | $ | 57,169 | | $ | 56,558 | | $ | 182,976 | | $ | 156,997 |\n| Held for sale, at fair value, loans | | | | | | | | | | | | |\n| Originated Residential Agency loans | | $ | 2,178 | | $ | 1,224 | | $ | 5,376 | | $ | 3,047 |\n| Originated Freddie loans | | | 221 | | | 351 | | | 911 | | | 806 |\n| Acquired loans | | | 39 | | | 50 | | | 166 | | | 123 |\n| Total loans, held for sale, at fair value (1) | | $ | 2,438 | | $ | 1,625 | | $ | 6,453 | | $ | 3,976 |\n| Mortgage backed securities, at fair value | | 1,467 | | 1,540 | | | 4,397 | | 4,537 |\n| Total interest income | | $ | 61,074 | | $ | 59,723 | | $ | 193,826 | | $ | 165,510 |\n| Interest expense | | | | | | | | | | | | |\n| Secured borrowings | | $ | ( 9,949 ) | | $ | ( 13,360 ) | | $ | ( 36,247 ) | | $ | ( 34,809 ) |\n| Securitized debt obligations of consolidated VIEs | | ( 21,351 ) | | ( 17,978 ) | | ( 58,196 ) | | ( 51,516 ) |\n| Guaranteed loan financing | | | ( 4,110 ) | | | ( 645 ) | | | ( 14,506 ) | | | ( 3,873 ) |\n| Senior secured note | | ( 3,466 ) | | ( 3,478 ) | | ( 10,407 ) | | ( 10,444 ) |\n| Convertible note | | | ( 2,188 ) | | | ( 2,188 ) | | | ( 6,564 ) | | | ( 6,564 ) |\n| Corporate debt | | | ( 2,759 ) | | | ( 1,741 ) | | | ( 8,242 ) | | | ( 3,713 ) |\n| Total interest expense | | $ | ( 43,823 ) | | $ | ( 39,390 ) | | $ | ( 134,162 ) | | $ | ( 110,919 ) |\n| Net interest income before provision for loan losses | | $ | 17,251 | | $ | 20,333 | | $ | 59,664 | | $ | 54,591 |\n| (1) Includes interest income on loans in consolidated VIEs. |\n\n| | | | | | | | | | | | | | | | | | | | | |\n| | | | | As of September 30, 2020 | | As of December 31, 2019 |\n| | | | | Asset | Liability | | | Asset | Liability |\n| | | | | Notional | | Derivatives | | Derivatives | | Notional | | Derivatives | | Derivatives |\n| (In Thousands) | | Primary Underlying Risk | | Amount | | Fair Value | | Fair Value | | Amount | | Fair Value | | Fair Value |\n| Interest rate lock commitments | | Interest rate risk | | $ | 735,936 | | | 20,849 | | $ | — | | $ | 238,283 | | $ | 2,814 | | $ | — |\n| Interest Rate Swaps - not designated as hedges | Interest rate risk | | | 760,391 | | | — | | | ( 1,713 ) | | | 291,001 | | | — | | | ( 3,181 ) |\n| Interest Rate Swaps - designated as hedges | | Interest rate risk | | | 121,325 | | | — | | | ( 5,564 ) | | | 158,325 | | | — | | | ( 1,709 ) |\n| Credit Default Swaps | Credit risk | | | 15,000 | | | — | | | ( 51 ) | | | 15,000 | | | — | | | ( 110 ) |\n| FX forwards | | Foreign exchange rate risk | | | 22,856 | | | — | | | ( 446 ) | | | 15,000 | | | — | | | ( 250 ) |\n| Total | | | | $ | 1,655,508 | | $ | 20,849 | | $ | ( 7,774 ) | | $ | 717,609 | | $ | 2,814 | | $ | ( 5,250 ) |\n| | | | | | | | | | | | | |\n| | | Three Months Ended September 30, 2020 | | Nine Months Ended September 30, 2020 |\n| | | Net Realized | | Unrealized | | Net Realized | | Unrealized |\n| (In Thousands) | | Gain (Loss) | | Gain (Loss) | | Gain (Loss) | | Gain (Loss) |\n| Credit default swaps (1) | | $ | — | | $ | ( 2 ) | | $ | — | | $ | 59 |\n| Interest rate swaps (1)(2) | | ( 1,189 ) | | 1,310 | | ( 2,185 ) | | ( 9,194 ) |\n| Residential mortgage banking activities interest rate swaps (3) | | — | | 957 | | — | | ( 1,148 ) |\n| Interest rate lock commitments (3) | | | — | | | 1,988 | | | — | | | 18,251 |\n| FX forwards (1) | | | ( 593 ) | | | ( 98 ) | | | ( 302 ) | | | ( 196 ) |\n| Total | | $ | ( 1,782 ) | | $ | 4,155 | | $ | ( 2,487 ) | | $ | 7,772 |\n| (1) Gains (losses) are recorded in net unrealized gain (loss) on financial instruments or net realized gain (loss) on financial instruments in the consolidated statements of income.(2) For qualifying hedges of interest rate risk, the effective portion relating to the unrealized gain (loss) on derivatives are recorded in accumulated other comprehensive income (loss).(3) Gains (losses) are recorded in residential mortgage banking activities in the consolidated statements of income. |\n| | | | | | | | | | | | | |\n| | | Three Months Ended September 30, 2019 | | Nine Months Ended September 30, 2019 |\n| | | | Net Change in | | | |\n| | | Net Realized | | Unrealized | | Net Realized | | Unrealized |\n| (In Thousands) | | Gain (Loss) | | Gain (Loss) | | Gain (Loss) | | Gain (Loss) |\n| Credit default swaps (1) | | $ | — | | $ | 2 | | $ | — | | $ | ( 352 ) |\n| Interest rate swaps (1)(2) | | 132 | | ( 4,268 ) | | ( 4,068 ) | | ( 8,817 ) |\n| Residential mortgage banking activities interest rate swaps (3) | | — | | 1,392 | | — | | 593 |\n| Interest rate lock commitments (3) | | | — | | | 510 | | | — | | | 2,405 |\n| Total | | $ | 132 | | $ | ( 2,364 ) | | $ | ( 4,068 ) | | $ | ( 6,171 ) |\n| (1) Gains (losses) are recorded in net unrealized gain (loss) on financial instruments or net realized gain (loss) on financial instruments in the consolidated statements of income.(2) For qualifying hedges of interest rate risk, the effective portion relating to the unrealized gain (loss) on derivatives are recorded in accumulated other comprehensive income (loss).(3) Gains (losses) are recorded in residential mortgage banking activities in the consolidated statements of income. |\n\n| | | | | | | | | | | | | | | |\n| (In Thousands) | Derivatives - effective portion reclassified from AOCI to income | | Hedge ineffectiveness recorded directly in income (2) | Total income statement impact | | Derivatives- effective portion recorded in OCI (3) | | Total change in OCI for period (3) |\n| Hedge type | | | | | | | | | | | | | | |\n| Interest rate - forecasted transactions (1) | $ | ( 371 ) | | $ | — | | $ | ( 371 ) | | $ | 300 | | $ | 671 |\n| Total - Three Months Ended September 30, 2020 | $ | ( 371 ) | | $ | — | $ | ( 371 ) | | $ | 300 | | $ | 671 |\n| Hedge type | | | | | | | | | | | | | | |\n| Interest rate - forecasted transactions (1) | $ | ( 169 ) | | $ | — | $ | ( 169 ) | | $ | ( 2,783 ) | | $ | ( 2,614 ) |\n| Total - Three Months Ended September 30, 2019 | $ | ( 169 ) | | $ | — | $ | ( 169 ) | | $ | ( 2,783 ) | | $ | ( 2,614 ) |\n| Hedge type | | | | | | | | | | | | | | |\n| Interest rate - forecasted transactions (1) | $ | ( 1,104 ) | | $ | ( 1,694 ) | | $ | ( 2,798 ) | | $ | ( 5,276 ) | | $ | ( 2,478 ) |\n| Total - Nine Months Ended September 30, 2020 | $ | ( 1,104 ) | | $ | ( 1,694 ) | $ | ( 2,798 ) | | $ | ( 5,276 ) | | $ | ( 2,478 ) |\n| Hedge type | | | | | | | | | | | | | | |\n| Interest rate - forecasted transactions (1) | $ | ( 269 ) | | $ | — | $ | ( 269 ) | | $ | ( 9,880 ) | | $ | ( 9,611 ) |\n| Total - Nine Months Ended September 30, 2019 | $ | ( 269 ) | | $ | — | $ | ( 269 ) | | $ | ( 9,880 ) | | $ | ( 9,611 ) |\n| (1) Consists of benchmark interest rate hedges of LIBOR-indexed floating-rate liabilities. |\n| (2) Hedge ineffectiveness is the amount by which the cumulative gain or loss on the designated derivative instrument exceeds the present value of the cumulative expected change in cash flows on the hedged item attributable to the hedged risk. |\n| (3) Represents after tax amounts recorded in OCI. |\n| | | | | | | |\n| (In Thousands) | September 30, 2020 | December 31, 2019 |\n| Acquired ORM Portfolio: | | | | | | |\n| Retail | | $ | 18,953 | | $ | 19,950 |\n| Mixed Use | | 14,440 | | 17,478 |\n| Land | | | 7,257 | | | 7,919 |\n| Lodging/Residential | | | 3,229 | | | 6,280 |\n| Office | | | — | | | 1,256 |\n| Total Acquired ORM REO | | $ | 43,879 | | $ | 52,883 |\n| Other REO held for sale: | | | | | | |\n| Retail | | $ | 660 | | 660 |\n| SBA | | 524 | | 286 |\n| Office | | | — | | | 4,465 |\n| Multi-family | | | — | | | — |\n| Mixed Use | | | — | | | 279 |\n| Total Other REO(1) | | $ | 1,184 | | $ | 5,690 |\n| | | | | | | |\n| Total Real estate, held for sale | | $ | 45,063 | | $ | 58,573 |\n| (1) Excludes $ 8.4 million of real estate, held for sale within consolidated VIEs. | | | | | | |\n\n| | | | | | | | | | | | | |\n| | | For the Three Months Ended September 30, | | For the Nine Months Ended September 30, |\n| | | 2020 | | 2019 | | 2020 | | 2019 |\n| Management fee - total | | $ | 2.7 million | | $ | 2.5 million | | $ | 7.9 million | | $ | 7.0 million |\n| Management fee - amount unpaid | | $ | 2.7 million | | $ | 2.5 million | | $ | 2.7 million | | $ | 2.5 million |\n| | | | | | | | | | | | | |\n| | | For the Three Months Ended September 30, | | For the Nine Months Ended September 30, |\n| | | 2020 | | 2019 | | 2020 | | 2019 |\n| Incentive fee distribution - total | | $ | 1.1 million | | $ | — | | $ | 4.6 million | | $ | — |\n| Incentive fee distribution - amount unpaid | | $ | 1.1 million | | $ | — | | $ | 1.1 million | | $ | — |\n\n| | | | | | | | | | | | | |\n| | | For the Three Months Ended September 30, | | For the Nine Months Ended September 30, |\n| | | 2020 | | 2019 | | 2020 | | 2019 |\n| Reimbursable expenses payable to our Manager - total | | $ | 0.8 million | | $ | 0.9 million | | $ | 2.8 million | | $ | 2.8 million |\n| Reimbursable expenses payable to our Manager - amount unpaid | | $ | 1.0 million | | $ | 1.0 million | | $ | 1.0 million | | $ | 1.0 million |\n| | | | | | | |\n| (In Thousands) | September 30, 2020 | December 31, 2019 |\n| Other assets: | | | | | | |\n| Deferred tax asset | $ | 31,803 | $ | 31,803 |\n| Tax receivable | | | — | | | 4,019 |\n| Deferred loan exit fees | | | 12,933 | | | 13,039 |\n| Accrued interest | | | 10,266 | | | 10,583 |\n| Goodwill | | | 11,206 | | | 11,206 |\n| Due from servicers | | | 10,451 | | | 10,127 |\n| Right-of-use lease asset | | | 3,608 | | | 4,531 |\n| Intangible assets | | 7,317 | | 8,309 |\n| Deferred financing costs | | | 1,770 | | | 2,046 |\n| Other assets | | | 9,260 | | | 11,262 |\n| Other assets | $ | 98,614 | | $ | 106,925 |\n| Accounts payable and other accrued liabilities: | | | | | | |\n| Deferred tax liability | | $ | 18,757 | | $ | 18,757 |\n| Accrued salaries, wages and commissions | | | 34,734 | | | 21,146 |\n| Accrued interest payable | | 14,369 | | 17,305 |\n| Servicing principal and interest payable | | | 10,543 | | | 14,145 |\n| Repair and denial reserve | | 7,631 | | 5,179 |\n| Payable to related parties | | 3,680 | | 2,697 |\n| Accrued professional fees | | | 2,483 | | | 1,809 |\n| Lease payable | | | 4,140 | | | 4,618 |\n| Deferred PPP loan revenue | | 12,976 | | — |\n| Other liabilities | | 22,774 | | 11,751 |\n| Total accounts payable and other accrued liabilities | | $ | 132,087 | | $ | 97,407 |\n| | | | | | | |\n| (In Thousands) | September 30, 2020 | | December 31, 2019 | Estimated Useful Life |\n| Internally developed software - Knight Capital | $ | 3,219 | | $ | 3,694 | 6 years |\n| Broker network - Knight Capital | | 956 | | | 1,156 | 4.5 years |\n| SBA license | | 1,000 | | | 1,000 | Indefinite life |\n| Favorable lease | | 802 | | | 905 | 12 years |\n| Trade name - Knight Capital | | 746 | | | 855 | 6 years |\n| Trade name - GMFS | | 594 | | | 699 | 15 years |\n| Total Intangible Assets | $ | 7,317 | | $ | 8,309 | |\n\n| | | |\n| (In Thousands) | September 30, 2020 |\n| Favorable lease | $ | 678 |\n| Trade name - GMFS | | 629 |\n| Internally developed software - Knight Capital | | 581 |\n| Broker network - Knight Capital | | 244 |\n| Trade name - Knight Capital | | 134 |\n| Total Accumulated Amortization | $ | 2,266 |\n| | | |\n| (In Thousands) | September 30, 2020 |\n| 2020 | $ | 331 |\n| 2021 | | 1,295 |\n| 2022 | | 1,268 |\n| 2023 | | 1,242 |\n| 2024 | | 1,210 |\n| Thereafter | | 971 |\n| Total | $ | 6,317 |\n\n| a. | assistance and services to the third-party in the underwriting, marketing, processing and funding of loans |\n| b. | processing forgiveness of the loans with the SBA |\n| c. | servicing and management of subsequently resulting PPP loan portfolios |\n| | | | | | | |\n| (In Thousands) | Three Months Ended September 30, 2020 | Nine Months Ended September 30, 2020 | | Financial statement account |\n| Income | | | | | | |\n| LSP origination fees | $ | 1,652 | $ | 27,768 | | Other income - origination fees |\n| PPP processing fees | | 7 | | 5,162 | | Other income - origination fees |\n| LSP fee income | | 1,700 | | 2,553 | | Servicing income |\n| Interest income | | 302 | | 496 | | Interest income |\n| Total PPP related income | $ | 3,661 | $ | 35,979 | | |\n| Expense | | | | | | |\n| Direct operating expenses | $ | 125 | $ | 5,650 | | Other operating expenses - origination costs |\n| R&D reserve | | 111 | | 2,430 | | Other income - change in repair and denial reserve |\n| Interest expense | | 687 | | 2,089 | | Interest expense |\n| Total PPP related expenses (direct) | $ | 923 | $ | 10,169 | | |\n| Net PPP related income | $ | 2,738 | $ | 25,810 | | |\n| | | | | | | |\n\n| | | | | | | | | | | | | | |\n| | | Three Months Ended September 30, | | Nine Months Ended September 30, | |\n| (In Thousands) | 2020 | 2019 | 2020 | 2019 | |\n| Other income | | | | | | | | | | | | | |\n| Origination income | $ | 3,144 | | $ | 1,213 | $ | 39,256 | | $ | 3,729 | |\n| Change in repair and denial reserve | | 316 | | | 573 | | ( 2,199 ) | | | 221 | |\n| Other | | 1,036 | | | 1,193 | | 3,106 | | | 2,721 | |\n| Total other income | | $ | 4,496 | | $ | 2,979 | | $ | 40,163 | | $ | 6,671 | |\n| Other operating expenses | | | | | | | | | | | | | |\n| Origination costs | | 2,717 | | | 3,042 | | 15,172 | | | 6,964 | |\n| Technology expense | | 1,650 | | | 1,155 | | 4,973 | | | 3,313 | |\n| Impairment on real estate | | — | | | 144 | | 3,075 | | | 824 | |\n| Rent and property tax expense | | 1,545 | | | 968 | | 3,929 | | | 2,762 | |\n| Recruiting, training and travel expense | | 254 | | | 366 | | 1,113 | | | 1,252 | |\n| Marketing expense | | | 400 | | | 391 | | | 1,331 | | | 1,519 | |\n| Loan acquisition costs | | | 353 | | | 359 | | | 806 | | | 464 | |\n| Financing costs on purchased future receivables | | | 63 | | | — | | | 1,476 | | | — | |\n| Other | | 3,466 | | | 1,719 | | 10,052 | | | 5,993 | |\n| Total other operating expenses | | $ | 10,448 | | $ | 8,144 | | $ | 41,927 | | $ | 23,091 | |\n| | | | | | | | | |\n| | | | Dividend per |\n| Declaration Date | | Record Date | | Payment Date | | Share |\n| December 12, 2018 | | December 31, 2018 | | January 31, 2019 | | $ | 0.40 | |\n| March 12, 2019 | | March 28, 2019 | | April 30, 2019 | | $ | 0.40 | |\n| June 11, 2019 | | June 28, 2019 | | July 31, 2019 | | $ | 0.40 | |\n| September 10, 2019 | | September 30, 2019 | | October 31, 2019 | | $ | 0.40 | |\n| December 11, 2019 | | December 31, 2019 | | January 31, 2020 | | $ | 0.40 | |\n| March 11, 2020 | | March 31, 2020 | | April 30, 2020 | | $ | 0.40 | (1) |\n| June 15, 2020 | | June 30, 2020 | | July 31, 2020 | | $ | 0.25 | |\n| September 16, 2020 | | September 30, 2020 | | October 30, 2020 | | $ | 0.30 | |\n\n| | | | | | | |\n| | Restricted Stock Awards |\n| (In Thousands, except share data) | Number of Shares | Grant date fair value | Weighted-average grant date fair value (per share) |\n| Outstanding, January 1, 2020 | 1,009,617 | | $ | 15,722 | $ | 15.57 |\n| Granted | 208,514 | | 3,298 | | 15.82 |\n| Vested | ( 60,370 ) | | | ( 894 ) | | 14.81 |\n| Forfeited | — | | | — | | — |\n| Outstanding, March 31, 2020 | 1,157,761 | $ | 18,126 | $ | 15.66 |\n| Granted | — | | | — | | — |\n| Vested | ( 16,452 ) | | | ( 227 ) | | 13.78 |\n| Forfeited | — | | | — | | — |\n| Canceled | — | | | — | | — |\n| Outstanding, June 30, 2020 | 1,141,309 | $ | 17,900 | $ | 15.68 |\n| Granted | 17,200 | | | 200 | | 11.63 |\n| Vested | ( 26,602 ) | | | ( 320 ) | | 12.03 |\n| Forfeited | ( 2,258 ) | | | ( 37 ) | | 16.26 |\n| Canceled | — | | | — | | — |\n| Outstanding, September 30, 2020 | 1,129,649 | $ | 17,743 | $ | 15.71 |\n\n| | | | | | | | | | | | | | |\n| | | Three Months Ended September 30, | | Nine Months Ended September 30, |\n| (In Thousands, except for share and per share amounts) | 2020 | 2019 | 2020 | 2019 |\n| Basic Earnings | | | | | | | | | | | | | |\n| Net income (loss) | | $ | 35,363 | | $ | 12,427 | | | $ | 18,510 | | $ | 54,120 |\n| Less: Income (loss) attributable to non-controlling interest | | | 805 | | | 323 | | | | 551 | | | 1,580 |\n| Less: Income attributable to participating shares | | | 339 | | | 79 | | | | 1,087 | | | 240 |\n| Basic earnings | | $ | 34,219 | | $ | 12,025 | | | $ | 16,872 | | $ | 52,300 |\n| | | | | | | | | | | | | | |\n| Diluted Earnings | | | | | | | | | | | | | |\n| Net income (loss) | | $ | 35,363 | | $ | 12,427 | | | $ | 18,510 | | $ | 54,120 |\n| Less: Income (loss) attributable to non-controlling interest | | | 805 | | | 323 | | | | 551 | | | 1,580 |\n| Less: Income attributable to participating shares | | | 339 | | | 79 | | | | 1,087 | | | 240 |\n| Diluted earnings | | $ | 34,219 | | $ | 12,025 | | | $ | 16,872 | | $ | 52,300 |\n| | | | | | | | | | | | | | |\n| | | | | | | | | | | | | | |\n| Number of Shares | | | | | | | | | | | | | |\n| Basic — Average shares outstanding | | | 54,626,995 | | | 44,438,652 | | | | 53,534,497 | | | 40,517,231 |\n| Effect of dilutive securities — Unvested participating shares | | | 77,616 | | | 29,149 | | | | 77,616 | | | 29,149 |\n| Diluted — Average shares outstanding | | | 54,704,611 | | | 44,467,801 | | | | 53,612,113 | | | 40,546,380 |\n| | | | | | | | | | | | | | |\n| Earnings Per Share Attributable to RC Common Stockholders: | | | | | | | | | | | | | |\n| Basic | | $ | 0.63 | | $ | 0.27 | | | $ | 0.32 | | $ | 1.29 |\n| Diluted | | $ | 0.63 | | $ | 0.27 | | | $ | 0.31 | | $ | 1.29 |\n| |\n\nsingle net payment. The provisions of the ISDA Master Agreement typically permit a single net payment in the event of default including the bankruptcy or insolvency of the counterparty. However, bankruptcy or insolvency laws of a particular jurisdiction may impose restrictions on or prohibitions against the right of offset in bankruptcy, insolvency or other events. In addition, certain ISDA Master Agreements allow counterparties to terminate derivative contracts prior to maturity in the event the Company’s stockholders’ equity declines by a stated percentage or the Company fails to meet the terms of its ISDA Master Agreements, which would cause the Company to accelerate payment of any net liability owed to the counterparty. As of September 30, 2020 and December 31, 2019 and for the periods then ended, the Company was in good standing on all of its ISDA Master Agreements or similar arrangements with its counterparties.For derivatives traded under an ISDA Master Agreement, the collateral requirements are listed under the Credit Support Annex, which is the sum of the mark to market for each derivative contract, the independent amount due to the derivative counterparty and any thresholds, if any. Collateral may be in the form of cash or any eligible securities, as defined in the respective ISDA agreements. Cash collateral pledged to and by the Company with the counterparty, if any, is reported separately in the unaudited interim consolidated balance sheets as restricted cash. All margin call amounts must be made before the notification time and must exceed a minimum transfer amount threshold before a transfer is required. All margin calls must be responded to and completed by the close of business on the same day of the margin call, unless otherwise specified. Any margin calls after the notification time must be completed by the next business day. Typically, the Company and its counterparties are not permitted to sell, rehypothecate or use the collateral posted. To the extent amounts due to the Company from its counterparties are not fully collateralized, the Company bears exposure and the risk of loss from a defaulting counterparty. The Company attempts to mitigate counterparty risk by establishing ISDA agreements with only high-grade counterparties that have the financial health to honor their obligations and diversification, entering into agreements with multiple counterparties.In accordance with ASU 2013-01, Balance Sheet (Topic 210): Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities, the Company is required to disclose the impact of offsetting of assets and liabilities represented in the unaudited interim consolidated balance sheets to enable users of the unaudited interim consolidated financial statements to evaluate the effect or potential effect of netting arrangements on its financial position for recognized assets and liabilities. These recognized assets and liabilities are financial instruments and derivative instruments that are either subject to enforceable master netting arrangements or ISDA Master Agreements or meet the following right of setoff criteria: (a) the amounts owed by the Company to another party are determinable, (b) the Company has the right to set off the amounts owed with the amounts owed by the counterparty, (c) the Company intends to offset, and (d) the Company’s right of offset is enforceable at law. As of September 30, 2020 and December 31, 2019, the Company has elected to offset assets and liabilities associated with its OTC derivative contracts in the unaudited interim consolidated balances sheets. 56\n| | | | | | | | | | | | | | | |\n| | | | | | | | | | | Gross amounts not offset in the Consolidated Balance Sheets(1) |\n| (in thousands) | Gross amounts of recognized Assets / Liabilities | | Gross amounts offset in the Consolidated Balance Sheets | | Amounts presented in the Consolidated Balance Sheets | | Financial Instruments | | Cash Collateral Received / Paid |\n| September 30, 2020 | | | | | | | | | | | | | | |\n| Assets | | | | | | | | | | | | | | |\n| Derivative instruments - Credit default swaps | $ | — | | $ | — | | $ | — | | $ | — | | $ | — |\n| Derivative instruments - FX forwards | | — | | | — | | | — | | | — | | | — |\n| Total | $ | — | | $ | — | | $ | — | | $ | — | | $ | — |\n| Liabilities | | | | | | | | | | | | | | |\n| Derivative instruments - Interest rate swaps | $ | 15,015 | | $ | 7,738 | | $ | 7,277 | | $ | — | | $ | 7,277 |\n| Derivative instruments - Credit default swaps | | 51 | | | — | | | 51 | | | — | | | 51 |\n| Derivative instruments - FX forwards | | 446 | | | — | | | 446 | | | — | | | — |\n| Secured borrowings | | 1,176,621 | | | — | | | 1,176,621 | | | 1,176,621 | | | — |\n| Total | $ | 1,192,133 | | $ | 7,738 | | $ | 1,184,395 | | $ | 1,176,621 | | $ | 7,328 |\n| December 31, 2019 | | | | | | | | | | | | | | |\n| Assets | | | | | | | | | | | | | | |\n| Derivative instruments - Interest rate swaps | $ | 2,814 | | $ | — | | $ | 2,814 | | $ | — | | $ | 2,814 |\n| Total | $ | 2,814 | | $ | — | | $ | 2,814 | | $ | — | | $ | 2,814 |\n| Liabilities | | | | | | | | | | | | | | |\n| Derivative instruments - Interest rate swaps | $ | 4,890 | | $ | — | | $ | 4,890 | | $ | — | | $ | 4,890 |\n| Derivative instruments - Credit default swaps | | 110 | | | — | | | 110 | | | — | | | 110 |\n| Derivative instruments - FX forwards | | 250 | | | — | | | 250 | | | — | | | 250 |\n| Secured borrowings | | 1,189,392 | | | — | | | 1,189,392 | | | 1,189,392 | | | — |\n| Total | $ | 1,194,642 | | $ | — | | $ | 1,194,642 | | $ | 1,189,392 | | $ | 5,250 |\n| (1) | Amounts presented in these columns are limited in total to the net amount of assets or liabilities presented in the prior column by instrument. In certain cases, there is excess cash collateral or financial assets we have pledged to a counterparty that exceed the financial liabilities subject to a master netting repurchase arrangement or similar agreement. Additionally, in certain cases, counterparties may have pledged excess cash collateral to us that exceeds our corresponding financial assets. In each case, any of these excess amounts are excluded from the table although they are separately reported in our unaudited interim consolidated balance sheets as assets or liabilities, respectively. |\n| (1) |\n\nThe Company is also subject to credit risk with respect to the counterparties to derivative contracts. If a counterparty becomes bankrupt or otherwise fails to perform its obligation under a derivative contract due to financial difficulties, we may experience significant delays in obtaining any recovery under the derivative contract in a dissolution, assignment for the benefit of creditors, liquidation, winding-up, bankruptcy, or other analogous proceeding. In the event of the insolvency of a counterparty to a derivative transaction, the derivative transaction would typically be terminated at its fair market value. If we are owed this fair market value in the termination of the derivative transaction and its claim is unsecured, we will be treated as a general creditor of such counterparty and will not have any claim with respect to the underlying security. We may obtain only a limited recovery or may obtain no recovery in such circumstances. In addition, the business failure of a counterparty with whom we enter a hedging transaction will most likely result in its default, which may result in the loss of potential future value and the loss of our hedge and force us to cover our commitments, if any, at the then current market price.Counterparty credit risk is the risk that counterparties may fail to fulfill their obligations, including their inability to post additional collateral in circumstances where their pledged collateral value becomes inadequate. The Company attempts to manage its exposure to counterparty risk through diversification, use of financial instruments and monitoring the creditworthiness of counterparties.The Company finances the acquisition of a significant portion of its loans and investments with repurchase agreements and borrowings under credit facilities. In connection with these financing arrangements, the Company pledges its loans, securities and cash as collateral to secure the borrowings. The amount of collateral pledged will typically exceed the amount of the borrowings (i.e., the haircut) such that the borrowings will be over-collateralized. As a result, the Company is exposed to the counterparty if, during the term of the repurchase agreement financing, a lender should default on its obligation and the Company is not able to recover its pledged assets. The amount of this exposure is the difference between the amount loaned to the Company plus interest due to the counterparty and the fair value of the collateral pledged by the Company to the lender including accrued interest receivable on such collateral.GMFS sells loans to investors without recourse. As such, the investors have assumed the risk of loss or default by the borrower. However, GMFS is usually required by these investors to make certain standard representations and warranties relating to credit information, loan documentation and collateral. To the extent that GMFS does not comply with such representations, or there are early payment defaults, GMFS may be required to repurchase the loans or indemnify these investors for any losses from borrower defaults. In addition, if loans pay-off within a specified time frame, GMFS may be required to refund a portion of the sales proceeds to the investors.Liquidity Risk — Liquidity risk arises in our investments and the general financing of our investing activities. It includes the risk of not being able to fund acquisition and origination activities at settlement dates and/or liquidate positions in a timely manner at reasonable prices, in addition to potential increases in collateral requirements during times of heightened market volatility. If we were forced to dispose of an illiquid investment at an inopportune time, we might be forced to do so at a substantial discount to the market value, resulting in a realized loss. We attempt to mitigate our liquidity risk by regularly monitoring the liquidity of our investments in SBC loans, MBS and other financial instruments. Factors such as our expected exit strategy for, the bid to offer spread of, and the number of broker dealers making an active market in a particular strategy and the availability of long-term funding, are considered in analyzing liquidity risk. To reduce any perceived disparity between the liquidity and the terms of the debt instruments in which we invest, we attempt to minimize our reliance on short-term financing arrangements. While we may finance certain investment in security positions using traditional margin arrangements and borrowings under repurchase agreements, other financial instruments such as collateralized debt obligations, and other longer term financing vehicles may be utilized to attempt to provide us with sources of long-term financing.Off-Balance Sheet Risk —The Company has undrawn commitments on outstanding loans which are disclosed in Note 25.Interest Rate — Interest rate risk is highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control.Our operating results will depend, in part, on differences between the income from our investments and our financing costs. Generally, our debt financing is based on a floating rate of interest calculated on a fixed spread over the relevant index, subject to a floor, as determined by the particular financing arrangement. In the event of a significant rising interest 58\n| | | | | | | |\n| | | September 30, | | December 31, |\n| (In Thousands) | | 2020 | | 2019 |\n| Loans, net | | $ | 287,978 | | $ | 128,719 |\n| Loans, held for sale at fair value | | $ | 5,401 | | $ | 6,982 |\n| | | | | | | |\n\n| | | | | | | |\n| | | September 30, | | December 31, |\n| (In Thousands) | | 2020 | | 2019 |\n| Commitments to originate residential agency loans | | $ | 691,962 | | $ | 190,806 |\n| | | | | | | |\n\nNote 27 – Segment reportingThe Company reports its results of operations through the following four business segments: i) Loan Acquisitions, ii) SBC Originations, iii) SBA Originations, Acquisitions and Servicing, and iv) Residential Mortgage Banking. The Company’s organizational structure is based on a number of factors that the Chief Operating Decision Maker (“CODM”), the Chief Executive Officer, uses to evaluate, view, and run its business operations, which includes customer base and nature of loan program types. The segments are based on this organizational structure and the information reviewed by the CODM and management to evaluate segment results. AcquisitionsThrough the acquisitions segment, the Company acquires performing and non-performing SBC loans and intends to continue to acquire these loans as part of the Company’s business strategy. The Company also acquires purchased future receivables through our Knight Capital platform.SBC originationsThrough the SBC originations segment, the Company originates SBC loans secured by stabilized or transitional investor properties using multiple loan origination channels. Additionally, as part of this segment, we originate and service multi-family loans under the Freddie Mac program. This segment also reflects the impact of our SBC securitization activities. SBA originations, acquisitions, and servicingThrough the SBA originations, acquisitions, and servicing segment, the Company acquires, originates and services loans guaranteed by the SBA under the SBA Section 7(a) Program. This segment also reflects the impact of our SBA securitization activities.Residential mortgage bankingThrough the residential mortgage banking segment, the Company originates residential mortgage loans eligible to be purchased, guaranteed or insured by Fannie Mae, Freddie Mac, FHA, USDA and VA through retail, correspondent and broker channels.Corporate - Other Corporate - Other consists primarily of unallocated corporate financing, including interest expense relating to our senior secured and convertible notes on funds yet to be deployed, allocated employee compensation from our Manager, management and incentive fees paid to our Manager and other general corporate overhead expenses. 61\n| | | | | | | | | | | | | | | | | | | |\n| | | | SBA Originations, | Residential | | |\n| | | Loan | | SBC | | Acquisitions, | | Mortgage | | Corporate- | | |\n| (In Thousands) | | Acquisitions | | Originations | | and Servicing | | Banking | | Other | | Consolidated |\n| Interest income | | $ | 14,532 | | $ | 35,287 | | $ | 9,037 | | $ | 2,218 | | $ | — | | $ | 61,074 |\n| Interest expense | | | ( 11,011 ) | | | ( 23,342 ) | | | ( 6,414 ) | | | ( 2,157 ) | | | ( 899 ) | | | ( 43,823 ) |\n| Net interest income before provision for loan losses | | $ | 3,521 | | $ | 11,945 | | $ | 2,623 | | $ | 61 | | $ | ( 899 ) | | $ | 17,251 |\n| Provision for loan losses | | 4,824 | | | 117 | | | ( 710 ) | | | — | | | — | | 4,231 |\n| Net interest income after provision for loan losses | | $ | 8,345 | | $ | 12,062 | | $ | 1,913 | | $ | 61 | | $ | ( 899 ) | | $ | 21,482 |\n| Non-interest income | | | | | | | | | | | | | | | | | | |\n| Residential mortgage banking activities | | $ | — | | $ | — | | $ | — | | $ | 75,524 | | $ | — | | $ | 75,524 |\n| Net realized gain on financial instruments | | | ( 2,244 ) | | | 5,309 | | | 4,442 | | | — | | | — | | | 7,507 |\n| Net unrealized gain on financial instruments | | | 2,295 | | | 3,459 | | | 2,353 | | | ( 4,687 ) | | | — | | | 3,420 |\n| Other income | | | 1,609 | | | 688 | | | 2,170 | | | 30 | | | ( 1 ) | | | 4,496 |\n| Servicing income | | | 139 | | | 610 | | | 3,055 | | | 6,311 | | | — | | | 10,115 |\n| Income on purchased future receivables, net of allowance for doubtful accounts | | | 4,848 | | | — | | | — | | | — | | | — | | | 4,848 |\n| Income from unconsolidated joint ventures | | | 1,996 | | | — | | | — | | | — | | | — | | | 1,996 |\n| Total non-interest income | | $ | 8,643 | | $ | 10,066 | | $ | 12,020 | | $ | 77,178 | | $ | ( 1 ) | | $ | 107,906 |\n| Non-interest expense | | | | | | | | | | | | | | | | | | |\n| Employee compensation and benefits | | ( 3,192 ) | | | ( 4,046 ) | | | ( 4,378 ) | | | ( 15,118 ) | | | ( 878 ) | | ( 27,612 ) |\n| Allocated employee compensation and benefits from related party | | ( 225 ) | | | — | | | — | | | — | | | ( 2,025 ) | | ( 2,250 ) |\n| Variable expenses on residential mortgage banking activities | | | — | | | — | | | — | | | ( 30,918 ) | | | — | | | ( 30,918 ) |\n| Professional fees | | ( 514 ) | | | ( 449 ) | | | ( 270 ) | | | ( 960 ) | | | ( 1,965 ) | | ( 4,158 ) |\n| Management fees – related party | | — | | | — | | | — | | | — | | | ( 2,714 ) | | ( 2,714 ) |\n| Incentive fees – related party | | — | | | — | | | — | | | — | | | ( 1,134 ) | | ( 1,134 ) |\n| Loan servicing expense | | ( 1,528 ) | | | ( 2,394 ) | | | ( 106 ) | | | ( 4,206 ) | | | 3 | | ( 8,231 ) |\n| Merger related expenses | | | — | | | — | | | — | | | — | | | ( 6 ) | | | ( 6 ) |\n| Other operating expenses | | ( 3,095 ) | | | ( 2,450 ) | | | ( 1,590 ) | | | ( 2,618 ) | | | ( 695 ) | | ( 10,448 ) |\n| Total non-interest expense | | $ | ( 8,554 ) | | $ | ( 9,339 ) | | $ | ( 6,344 ) | | $ | ( 53,820 ) | | $ | ( 9,414 ) | | $ | ( 87,471 ) |\n| Net income (loss) before provision for income taxes | | $ | 8,434 | | $ | 12,789 | | $ | 7,589 | | $ | 23,419 | | $ | ( 10,314 ) | | $ | 41,917 |\n| Total assets | | $ | 1,131,321 | | $ | 2,515,234 | | $ | 806,856 | | $ | 640,112 | | $ | 223,987 | | $ | 5,317,510 |\n\n| | | | | | | | | | | | | | | | | | | |\n| | | | SBA Originations, | Residential | | |\n| | | | | SBC | | Acquisitions, | | Mortgage | | Corporate- | | |\n| (In Thousands) | | Acquisitions | | Originations | | and Servicing | | Banking | | Other | | Consolidated |\n| Interest income | | $ | 45,993 | | $ | 112,052 | | $ | 30,316 | | $ | 5,465 | | $ | — | | $ | 193,826 |\n| Interest expense | | | ( 32,871 ) | | | ( 72,476 ) | | | ( 21,766 ) | | | ( 5,778 ) | | | ( 1,271 ) | | | ( 134,162 ) |\n| Net interest income before provision for loan losses | | $ | 13,122 | | $ | 39,576 | | $ | 8,550 | | $ | ( 313 ) | | $ | ( 1,271 ) | | $ | 59,664 |\n| Provision for loan losses | | ( 2,865 ) | | | ( 23,890 ) | | | ( 7,729 ) | | | ( 500 ) | | | — | | ( 34,984 ) |\n| Net interest income after provision for loan losses | | $ | 10,257 | | $ | 15,686 | | $ | 821 | | $ | ( 813 ) | | $ | ( 1,271 ) | | $ | 24,680 |\n| Non-interest income | | | | | | | | | | | | | | | | | | |\n| Residential mortgage banking activities | | $ | — | | $ | — | | $ | — | | $ | 192,757 | | $ | — | | $ | 192,757 |\n| Net realized gain (loss) on financial instruments | | | ( 3,378 ) | | | 15,190 | | | 10,306 | | | — | | | — | | | 22,118 |\n| Net unrealized gain (loss) on financial instruments | | | ( 8,148 ) | | | ( 3,748 ) | | | 1,302 | | | ( 33,168 ) | | | — | | | ( 43,762 ) |\n| Servicing income | | 665 | | | 1,541 | | | 6,522 | | | 18,465 | | | — | | 27,193 |\n| Income on purchased future receivables, net of allowance for doubtful accounts | | | 13,917 | | | — | | | — | | | — | | | — | | | 13,917 |\n| Loss from unconsolidated joint ventures | | | ( 1,035 ) | | | — | | | — | | | — | | | — | | | ( 1,035 ) |\n| Other income | | | 5,364 | | | 3,410 | | | 31,139 | | | 136 | | | 114 | | | 40,163 |\n| Total non-interest income (loss) | | $ | 7,385 | | $ | 16,393 | | $ | 49,269 | | $ | 178,190 | | $ | 114 | | $ | 251,351 |\n| Non-interest expense | | | | | | | | | | | | | | | | | | |\n| Employee compensation and benefits | | $ | ( 8,663 ) | | $ | ( 11,445 ) | | $ | ( 11,773 ) | | $ | ( 39,702 ) | | $ | ( 2,253 ) | | $ | ( 73,836 ) |\n| Allocated employee compensation and benefits from related party | | ( 475 ) | | | — | | | — | | | — | | | ( 4,275 ) | | ( 4,750 ) |\n| Variable expenses on residential mortgage banking activities | | — | | | — | | | — | | | ( 87,494 ) | | | — | | ( 87,494 ) |\n| Professional fees | | ( 999 ) | | | ( 891 ) | | | ( 697 ) | | | ( 1,518 ) | | | ( 4,527 ) | | ( 8,632 ) |\n| Management fees – related party | | — | | | — | | | — | | | — | | | ( 7,941 ) | | ( 7,941 ) |\n| Incentive fees – related party | | — | | | — | | | — | | | — | | | ( 4,640 ) | | ( 4,640 ) |\n| Loan servicing expense | | ( 4,387 ) | | | ( 5,685 ) | | | ( 688 ) | | | ( 13,325 ) | | | ( 37 ) | | ( 24,122 ) |\n| Merger related expenses | | | — | | | — | | | — | | | — | | | ( 63 ) | | | ( 63 ) |\n| Other operating expenses | | ( 13,402 ) | | | ( 10,336 ) | | | ( 9,679 ) | | | ( 6,376 ) | | | ( 2,134 ) | | ( 41,927 ) |\n| Total non-interest expense | | $ | ( 27,926 ) | | $ | ( 28,357 ) | | $ | ( 22,837 ) | | $ | ( 148,415 ) | | $ | ( 25,870 ) | | $ | ( 253,405 ) |\n| Net income (loss) before provision for income taxes | | $ | ( 10,284 ) | | $ | 3,722 | | $ | 27,253 | | $ | 28,962 | | $ | ( 27,027 ) | | $ | 22,626 |\n| Total assets | | $ | 1,131,321 | | $ | 2,515,234 | | $ | 806,856 | | $ | 640,112 | | $ | 223,987 | | $ | 5,317,510 |\n\n| | | | | | | | | | | | | | | | | | | |\n| | | | SBA Originations, | Residential | | |\n| | | Loan | | SBC | | Acquisitions, | | Mortgage | | Corporate- | | |\n| (In Thousands) | | Acquisitions | | Originations | | and Servicing | | Banking | | Other | | Consolidated |\n| Interest income | | $ | 18,880 | | $ | 32,354 | | $ | 7,235 | | $ | 1,254 | | $ | — | | $ | 59,723 |\n| Interest expense | | | ( 11,076 ) | | | ( 23,835 ) | | | ( 2,739 ) | | | ( 1,740 ) | | | — | | | ( 39,390 ) |\n| Net interest income before provision for loan losses | | $ | 7,804 | | $ | 8,519 | | $ | 4,496 | | $ | ( 486 ) | | $ | — | | $ | 20,333 |\n| Provision for loan losses | | ( 94 ) | | | ( 33 ) | | | ( 566 ) | | | — | | | — | | ( 693 ) |\n| Net interest income after provision for loan losses | | $ | 7,710 | | $ | 8,486 | | $ | 3,930 | | $ | ( 486 ) | | $ | — | | $ | 19,640 |\n| Non-interest income | | | | | | | | | | | | | | | | | | |\n| Residential mortgage banking activities | | $ | — | | $ | — | | $ | — | | $ | 29,013 | | $ | — | | $ | 29,013 |\n| Net realized gain on financial instruments | | | ( 437 ) | | | 5,065 | | | 2,749 | | | — | | | — | | | 7,377 |\n| Net unrealized gain (loss) on financial instruments | | | ( 206 ) | | | ( 865 ) | | | 772 | | | ( 7,582 ) | | | — | | | ( 7,881 ) |\n| Other income | | | 925 | | | 1,118 | | | 812 | | | 80 | | | 44 | | | 2,979 |\n| Servicing income | | — | | | 488 | | | 1,180 | | | 5,781 | | | — | | 7,449 |\n| Income from unconsolidated joint ventures | | | 1,047 | | | — | | | — | | | — | | | — | | | 1,047 |\n| Total non-interest income | | $ | 1,329 | | $ | 5,806 | | $ | 5,513 | | $ | 27,292 | | $ | 44 | | $ | 39,984 |\n| Non-interest expense | | | | | | | | | | | | | | | | | | |\n| Employee compensation and benefits | | $ | ( 26 ) | | $ | ( 1,420 ) | | $ | ( 4,070 ) | | $ | ( 7,091 ) | | $ | ( 831 ) | | $ | ( 13,438 ) |\n| Allocated employee compensation and benefits from related party | | ( 150 ) | | | — | | | — | | | — | | | ( 1,350 ) | | ( 1,500 ) |\n| Variable expenses on residential mortgage banking activities | | | — | | | — | | | — | | | ( 17,318 ) | | | — | | | ( 17,318 ) |\n| Professional fees | | ( 195 ) | | | ( 571 ) | | | ( 279 ) | | | ( 344 ) | | | ( 641 ) | | ( 2,030 ) |\n| Management fees – related party | | — | | | — | | | — | | | — | | | ( 2,495 ) | | ( 2,495 ) |\n| Incentive fees – related party | | | — | | | — | | | — | | | — | | | — | | | — |\n| Loan servicing (expense) income | | ( 1,461 ) | | | ( 1,495 ) | | | ( 205 ) | | | ( 1,672 ) | | | ( 33 ) | | ( 4,866 ) |\n| Merger related expenses | | | — | | | — | | | — | | | — | | | ( 51 ) | | | ( 51 ) |\n| Other operating expenses | | ( 770 ) | | | ( 3,369 ) | | | ( 1,508 ) | | | ( 1,691 ) | | | ( 806 ) | | ( 8,144 ) |\n| Total non-interest expense | | $ | ( 2,602 ) | | $ | ( 6,855 ) | | $ | ( 6,062 ) | | $ | ( 28,116 ) | | $ | ( 6,207 ) | | $ | ( 49,842 ) |\n| Net income (loss) before provision for income taxes | | $ | 6,437 | | $ | 7,437 | | $ | 3,381 | | $ | ( 1,310 ) | | $ | ( 6,163 ) | | $ | 9,782 |\n| Total assets | | $ | 1,165,470 | | $ | 2,266,076 | | $ | 273,217 | | $ | 327,162 | | $ | 91,094 | | $ | 4,123,019 |\n| | | | | | | | | | | | | | | | | | | |\n| | | | SBA Originations, | Residential | | |\n| | | Loan | | SBC | | Acquisitions, | | Mortgage | | Corporate- | | |\n| (In Thousands) | | Acquisitions | | Originations | | and Servicing | | Banking | | Other | | Consolidated |\n| Interest income | | $ | 47,761 | | $ | 91,182 | | $ | 23,468 | | $ | 3,099 | | $ | — | | $ | 165,510 |\n| Interest expense | | | ( 29,383 ) | | | ( 65,903 ) | | | ( 11,529 ) | | | ( 4,104 ) | | | — | | | ( 110,919 ) |\n| Net interest income before provision for loan losses | | $ | 18,378 | | $ | 25,279 | | $ | 11,939 | | $ | ( 1,005 ) | | $ | — | | $ | 54,591 |\n| Provision for loan losses | | ( 771 ) | | ( 342 ) | | ( 1,446 ) | | | — | | | — | | ( 2,559 ) |\n| Net interest income after provision for loan losses | | $ | 17,607 | | $ | 24,937 | | $ | 10,493 | | $ | ( 1,005 ) | | $ | — | | $ | 52,032 |\n| Non-interest income | | | | | | | | | | | | | | | | | | |\n| Residential mortgage banking activities | | $ | — | | $ | — | | $ | — | | $ | 64,621 | | $ | — | | $ | 64,621 |\n| Net realized gain (loss) on financial instruments | | | ( 33 ) | | | 10,232 | | | 10,715 | | | — | | | — | | | 20,914 |\n| Net unrealized gain (loss) on financial instruments | | | ( 886 ) | | | ( 131 ) | | | 268 | | | ( 21,050 ) | | | — | | | ( 21,799 ) |\n| Servicing income | | | — | | | 1,386 | | | 4,013 | | | 16,613 | | | — | | | 22,012 |\n| Income on unconsolidated joint ventures | | | 6,059 | | | — | | | — | | | — | | | — | | | 6,059 |\n| Other income | | | 1,950 | | | 3,565 | | | 865 | | | 182 | | | 109 | | | 6,671 |\n| Gain on bargain purchase | | | — | | | — | | | — | | | — | | | 30,728 | | | 30,728 |\n| Total non-interest income | | $ | 7,090 | | $ | 15,052 | | $ | 15,861 | | $ | 60,366 | | $ | 30,837 | | $ | 129,206 |\n| Non-interest expense | | | | | | | | | | | | | | | | | | |\n| Employee compensation and benefits | | $ | ( 53 ) | | $ | ( 5,454 ) | | $ | ( 12,262 ) | | $ | ( 17,131 ) | | $ | ( 2,495 ) | | $ | ( 37,395 ) |\n| Allocated employee compensation and benefits from related party | | ( 360 ) | | | — | | | — | | | — | | | ( 3,243 ) | | ( 3,603 ) |\n| Variable expenses on residential mortgage banking activities | | — | | | — | | | — | | | ( 39,995 ) | | | — | | ( 39,995 ) |\n| Professional fees | | ( 412 ) | | | ( 1,185 ) | | | ( 635 ) | | | ( 809 ) | | | ( 2,404 ) | | ( 5,445 ) |\n| Management fees – related party | | — | | | — | | | — | | | — | | | ( 6,987 ) | | ( 6,987 ) |\n| Loan servicing expense | | ( 3,379 ) | | | ( 4,185 ) | | | ( 322 ) | | | ( 5,089 ) | | | ( 110 ) | | ( 13,085 ) |\n| Merger related expenses | | | — | | | — | | | — | | | — | | | ( 6,121 ) | | | ( 6,121 ) |\n| Other operating expenses | | ( 2,073 ) | | | ( 8,198 ) | | | ( 4,635 ) | | | ( 5,818 ) | | | ( 2,367 ) | | ( 23,091 ) |\n| Total non-interest expense | | $ | ( 6,277 ) | | $ | ( 19,022 ) | | $ | ( 17,854 ) | | $ | ( 68,842 ) | | $ | ( 23,727 ) | | $ | ( 135,722 ) |\n| Net income (loss) before provision for income taxes | | $ | 18,420 | | $ | 20,967 | | $ | 8,500 | | $ | ( 9,481 ) | | $ | 7,110 | | $ | 45,516 |\n| Total assets | | $ | 1,165,470 | | $ | 2,266,076 | | $ | 273,217 | | $ | 327,162 | | $ | 91,094 | | $ | 4,123,019 |\n\n| | | | | | | | | | | | |\n| Statements of Income | | Three Months Ended September 30, 2020 | Three Months Ended September 30, 2019 |\n| (In Thousands) | | | Girod HoldCo, LLC | | | WFLLA, LLC | | Girod HoldCo, LLC | | | WFLLA, LLC |\n| Interest income | | $ | 661 | | $ | 330 | $ | 1,108 | | $ | 553 |\n| Realized gains | | | ( 178 ) | | | ( 89 ) | | 364 | | | 182 |\n| Unrealized gains (losses) | | | 1,117 | | | 557 | | 2,074 | | | 1,035 |\n| Servicing expense and other | | | ( 711 ) | | | ( 355 ) | | ( 1,224 ) | | | ( 615 ) |\n| Income (loss) before provision for income taxes | | $ | 889 | | $ | 443 | $ | 2,322 | | $ | 1,155 |\n| | | | | | | | | | | | |\n| Statements of Income | | Nine Months Ended September 30, 2020 | Nine Months Ended September 30, 2019 |\n| (In Thousands) | | | Girod HoldCo, LLC | | | WFLLA, LLC | | Girod HoldCo, LLC | | | WFLLA, LLC |\n| Interest income | | $ | 1,310 | | $ | 654 | $ | 5,943 | | $ | 2,966 |\n| Realized gains | | | ( 28 ) | | | ( 14 ) | | 995 | | | 497 |\n| Unrealized gains (losses) | | | ( 3,104 ) | | | ( 1,549 ) | | 18,442 | | | 9,203 |\n| Servicing expense and other | | | ( 3,141 ) | | | ( 1,567 ) | | ( 3,581 ) | | | ( 1,792 ) |\n| Income (loss) before provision for income taxes | | $ | ( 4,963 ) | | $ | ( 2,476 ) | $ | 21,799 | | $ | 10,874 |\n| | | | | | | | | | | | | |\n| | | | | | | | | | | | | |\n| | | Three Months Ended September 30, | | Nine Months Ended September 30, |\n| (In Thousands) | 2020 | 2019 | 2020 | 2019 |\n| Income (loss) on unconsolidated joint ventures | | | | | | | | | | | | |\n| WFLLA, LLC | | $ | 222 | | $ | 578 | | $ | ( 1,238 ) | | $ | 5,437 |\n| Other unconsolidated joint ventures | | | 1,774 | | | 469 | | | 203 | | | 622 |\n| Income (loss) on unconsolidated joint ventures | | $ | 1,996 | | $ | 1,047 | | $ | ( 1,035 ) | | $ | 6,059 |\n| | | | | | | | | | | | | |\n\n| ● | our investment objectives and business strategy; |\n| ● | our ability to obtain future financing arrangements; |\n| ● | our expected leverage; |\n| ● | our expected investments; |\n| ● | estimates or statements relating to, and our ability to make, future distributions; |\n| ● | our ability to compete in the marketplace; |\n| ● | the availability of attractive risk-adjusted investment opportunities in small to medium balance commercial loans (“SBC loans”), loans guaranteed by the U.S. Small Business Administration (the “SBA”) under its Section 7(a) loan program (the “SBA Section 7(a) Program”), mortgage backed securities (“MBS”), residential mortgage loans and other real estate-related investments that satisfy our investment objectives and strategies; |\n| ● | our ability to borrow funds at favorable rates; |\n| ● | market, industry and economic trends; |\n| ● | recent market developments and actions taken and to be taken by the U.S. Government, the U.S. Department of the Treasury (“Treasury”) and the Board of Governors of the Federal Reserve System, the Federal Depositary Insurance Corporation, the Federal National Mortgage Association (“Fannie Mae”), the Federal Home Loan Mortgage Corporation (“Freddie Mac” and together with Fannie Mae, the “GSEs”), the Government National Mortgage Association (“Ginnie Mae”), Federal Housing Administration (“FHA”) Mortgagee, U.S. Department of Agriculture (“USDA”), U.S. Department of Veterans Affairs (“VA”) and the U.S. Securities and Exchange Commission (“SEC”); |\n| ● | mortgage loan modification programs and future legislative actions; |\n| ● | our ability to maintain our qualification as a real estate investment trust (“REIT”); |\n| ● | our ability to maintain our exemption from qualification under the Investment Company Act of 1940, as amended (the “1940 Act” or “Investment Company Act”); |\n| ● | projected capital and operating expenditures; |\n| ● | availability of qualified personnel; |\n| ● | prepayment rates; and |\n\n| ● | projected default rates. |\n| ● | factors described in our 2019 annual report on Form 10-K, including those set forth under the captions “Risk Factors” and “Business”; |\n| ● | the severity and duration of the COVID-19 pandemic; |\n| ● | the impact of COVID-19 on our business and operations, financial condition, results of operations, liquidity and capital resources; |\n| ● | the impact of the COVID-19 pandemic on our borrowers, the real estate industry, and the United States and global economies; |\n| ● | actions that may be taken by governmental authorities to contain the COVID-19 outbreak or treat its impact; |\n| ● | applicable regulatory changes; |\n| ● | risks associated with acquisitions, including the acquisition of Owens Realty Mortgage, Inc. (“ORM”) and Knight Capital LLC (“Knight Capital”); |\n| ● | risks associated with achieving expected revenue synergies, cost savings and other benefits from acquisitions, including the acquisition of ORM and Knight Capital, and the increased scale of our Company; |\n| ● | general volatility of the capital markets; |\n| ● | changes in our investment objectives and business strategy; |\n| ● | the availability, terms and deployment of capital; |\n| ● | the availability of suitable investment opportunities; |\n| ● | our dependence on our external advisor, Waterfall Asset Management, LLC (“Waterfall” or our “Manager”), and our ability to find a suitable replacement if we or our Manager were to terminate the management agreement we have entered into with our Manager; |\n| ● | changes in our assets, interest rates or the general economy; |\n| ● | increased rates of default and/or decreased recovery rates on our investments; |\n| ● | changes in interest rates, interest rate spreads, the yield curve or prepayment rates; changes in prepayments of our assets; |\n| ● | limitations on our business as a result of our qualification as a REIT; and |\n| ● | the degree and nature of our competition, including competition for SBC loans, MBS, residential mortgage loans and other real estate-related investments that satisfy our investment objectives and strategies. |\n\n| ● | Overview |\n| ● | Results of Operations |\n| ● | Liquidity and Capital Resources |\n| ● | Off-Balance Sheet Arrangements and Contractual Obligations |\n| ● | Critical Accounting Policies and Estimates |\n| ● | Acquisitions. We acquire performing and non-performing SBC loans as part of our business strategy. We hold performing SBC loans to term, and we seek to maximize the value of the non-performing SBC loans acquired by us through borrower-based resolution strategies. We typically acquire non-performing loans at a discount to their unpaid principal balance (“UPB”) when we believe that resolution of the loans will provide attractive risk-adjusted returns. We also acquire purchased future receivables through our Knight Capital platform. |\n| ● | SBC Originations. We originate SBC loans secured by stabilized or transitional investor properties using multiple loan origination channels through our wholly-owned subsidiary, ReadyCap Commercial, LLC (“ReadyCap Commercial”). These originated loans are generally held-for-investment or placed into securitization structures. Additionally, as part of this segment, we originate and service multi-family loans |\n\n| under the Federal Home Loan Mortgage Corporation’s Small Balance Loan Program (“Freddie Mac” and the “Freddie Mac program”). These originated loans are held for sale, then sold to Freddie Mac. |\n| ● | SBA Originations, Acquisitions and Servicing. We acquire, originate and service owner-occupied loans guaranteed by the SBA under its Section 7(a) loan program (the “SBA Section 7(a) Program”) through our wholly-owned subsidiary, ReadyCap Lending, LLC (“ReadyCap Lending”). We hold an SBA license as one of only 14 non-bank Small Business Lending Companies (“SBLCs”) and have been granted preferred lender status by the SBA. These originated loans are either held-for-investment, placed into securitization structures, or sold. |\n| ● | Residential Mortgage Banking. We operate our residential mortgage loan origination segment through our wholly-owned subsidiary, GMFS, LLC (\"GMFS\"). GMFS originates residential mortgage loans eligible to be purchased, guaranteed or insured by the Federal National Mortgage Association (“Fannie Mae”), Freddie Mac, Federal Housing Administration (“FHA”), U.S. Department of Agriculture (“USDA”) and U.S. Department of Veterans Affairs (“VA”) through retail, correspondent and broker channels. These originated loans are then sold to third parties, primarily agency lending programs. |\n\n| ● | the interest expense associated with our variable-rate borrowings to increase; |\n| ● | the value of fixed-rate loans, MBS and other real estate-related assets to decline; |\n| ● | coupons on variable-rate loans and MBS to reset to higher interest rates; and |\n| ● | prepayments on loans and MBS to slow. |\n| ● | the interest expense associated with variable-rate borrowings to decrease; |\n| ● | the value of fixed-rate loans, MBS and other real estate-related assets to increase; |\n| ● | coupons on variable-rate loans and MBS to reset to lower interest rates; and |\n| ● | prepayments on loans and MBS to increase. |\n\nThe spread between the yield on our assets and our funding costs is an important factor in the performance of this aspect of our business. Wider spreads imply greater income on new asset purchases but may have a negative impact on our stated book value. Wider spreads generally negatively impact asset prices. In an environment where spreads are widening, counterparties may require additional collateral to secure borrowings which may require us to reduce leverage by selling assets. Conversely, tighter spreads imply lower income on new asset purchases but may have a positive impact on our stated book value. Tighter spreads generally have a positive impact on asset prices. In this case, we may be able to reduce the amount of collateral required to secure borrowings.Loan and ABS Extension RiskWaterfall estimates the projected weighted-average life of our investments based on assumptions regarding the rate at which the borrowers will prepay the underlying mortgages and/or the speed at which we are able to liquidate an asset. If the timeline to resolve non-performing assets extends, this could have a negative impact on our results of operations, as carrying costs may therefore be higher than initially anticipated. This situation may also cause the fair market value of our investment to decline if real estate values decline over the extended period. In extreme situations, we may be forced to sell assets to maintain adequate liquidity, which could cause us to incur losses.Credit RiskWe are subject to credit risk in connection with our investments in loans and ABS and other target assets we may acquire in the future. Increases in defaults and delinquencies will adversely impact our operating results, while declines in rates of default and delinquencies will improve our operating results from this aspect of our business. Default rates are influenced by a wide variety of factors, including, property performance, property management, supply and demand factors, construction trends, consumer behavior, regional economics, interest rates, the strength of the United States economy and other factors beyond our control. All loans are subject to the possibility of default. We seek to mitigate this risk by seeking to acquire assets at appropriate prices given anticipated and unanticipated losses and by deploying a value-driven approach to underwriting and diligence, consistent with our historical investment strategy, with a focus on projected cash flows and potential risks to cash flow. We further mitigate our risk of potential losses while managing and servicing our loans by performing various workout and loss mitigation strategies with delinquent borrowers. Nevertheless, unanticipated credit losses could occur which could adversely impact operating results.Size of Investment PortfolioThe size of our investment portfolio, as measured by the aggregate principal balance of our loans and ABS and the other assets we own, is also a key revenue driver. Generally, as the size of our investment portfolio grows, the amount of interest income and realized gains we receive increases. A larger investment portfolio, however, drives increased expenses, as we may incur additional interest expense to finance the purchase of our assets.Current market conditions The outbreak of the COVID-19 pandemic around the globe continues to adversely impact global commercial activity and has contributed to significant volatility in financial markets. The impact of the outbreak has been rapidly evolving, with several countries taking drastic measures to limit the spread of the virus by instituting quarantines or lockdowns and imposing travel restrictions. While some of these restrictions have been relaxed or phased out, many of these or similar restrictions remain in place, continue to be implemented or additional restrictions are being considered. Such actions are creating significant disruptions to global supply chains and adversely impacting several industries, including but not limited to airlines, hospitality, retail, and the broader real estate industry. The major disruption caused by COVID-19 significantly reduced economic activity in most of the United States resulting in a significant increase in unemployment claims. COVID-19 has had a continued and prolonged adverse impact on economic and market conditions and has had a period of global economic slowdown which could have a material adverse effect on the Company’s results and financial condition. The full impact of COVID-19 on the real estate industry, the commercial real estate market, the small business lending market and the credit markets generally, and consequently on the Company’s financial condition and results of operations is uncertain and cannot be predicted at the current time as it depends on several factors beyond the control of the Company including, but not limited to, (i) the uncertainty around the severity and duration of the outbreak, (ii) the effectiveness of 71\n| | | | | | | | | | | | | | | | | |\n| | | Three Months Ended September 30, | | Three Months Ended September 30, | | Nine Months Ended September 30, | | Nine Months Ended September 30, |\n| (in thousands, except share data) | | 2020 | | 2019 | | 2020 | | 2019 |\n| Net Income | | $ | 35,363 | | | $ | 12,427 | | | $ | 18,510 | | | $ | 54,120 | |\n| Earnings per common share - basic | | $ | 0.63 | | | $ | 0.27 | | | $ | 0.32 | | | $ | 1.29 | |\n| Earnings per common share - diluted | | $ | 0.63 | | | $ | 0.27 | | | $ | 0.31 | | | $ | 1.29 | |\n| Core Earnings | | $ | 32,126 | | | $ | 18,249 | | | $ | 72,574 | | | $ | 46,297 | |\n| Core Earnings per common share - basic and diluted | | $ | 0.57 | | | $ | 0.40 | | | $ | 1.30 | | | $ | 1.10 | |\n| Dividends declared per common share | | $ | 0.30 | | | $ | 0.40 | | | $ | 0.95 | | | $ | 1.20 | |\n| Dividend yield(1) | | | 10.7 | % | | | 10.1 | % | | | 10.7 | % | | | 10.1 | % |\n| Book value per common share | | $ | 14.86 | | | $ | 16.20 | | | $ | 14.86 | | | $ | 16.20 | |\n| Adjusted net book value per common share(2) | | $ | 14.84 | | | $ | 16.16 | | | $ | 14.84 | | | $ | 16.16 | |\n| (1) Based on the closing share price on September 30, 2020 and 2019, respectively. | | | | | | | | | | | | | | | | |\n| (2) Excludes the equity component of our 2017 convertible note issuance. | | | | | | | | | | | | | | | | |\n\n| | | | | | | | | | | | | |\n| | | Three Months Ended | | Three Months Ended | | Nine Months Ended | | Nine Months Ended |\n| (in thousands) | | September 30, 2020 | | September 30, 2019 | | September 30, 2020 | | September 30, 2019 |\n| Loan originations | | | | | | | | | | | | |\n| SBC loan originations | | $ | 122,487 | | $ | 465,374 | | $ | 750,164 | | $ | 1,176,942 |\n| SBA loan originations | | | 82,912 | | | 48,244 | | | 149,283 | | | 146,021 |\n| Residential agency mortgage loan originations | | | 1,184,237 | | | 656,791 | | | 3,066,711 | | | 1,519,377 |\n| Total loan originations | | $ | 1,389,636 | | $ | 1,170,409 | | $ | 3,966,158 | | $ | 2,842,340 |\n| Total loan acquisitions | | $ | 20,989 | | $ | 77,900 | | $ | 72,483 | | $ | 568,784 |\n| Total loan investment activity | | $ | 1,410,625 | | $ | 1,248,309 | | $ | 4,038,641 | | $ | 3,411,124 |\n\nThe following table provides a detailed breakdown of our calculation of return on equity and core return on equity for the three months ended September 30, 2020. Core return on equity is not a measure calculated in accordance with GAAP and is defined further within Item 7 – Non-GAAP Financial Measures in our 2019 Annual report on Form 10-K.74\nPortfolio MetricsSBC OriginationsThe following table includes certain portfolio metrics related to our SBC originations segment:75\nSBA Originations, Acquisitions, and ServicingThe following table includes certain portfolio metrics related to our SBA originations, acquisitions and servicing segment: 76\nAcquired PortfolioThe following table includes certain portfolio metrics related to our acquisitions segment:77\nResidential Mortgage BankingThe following table includes certain portfolio metrics related to our residential mortgage banking segment:78\n| | | | | | | | | | | | | |\n| | | September 30, | | June 30, | | $ Change | | % Change |\n| (In Thousands) | 2020 | 2020 | | Q3'20 vs. Q2'20 | | Q3'20 vs. Q2'20 |\n| Assets | | | | | | | | | | | | |\n| Cash and cash equivalents | | $ | 149,847 | | $ | 257,017 | | $ | (107,170) | (41.7) | % |\n| Restricted cash | | 46,204 | | 91,539 | | | (45,335) | | (49.5) | |\n| Loans, net (including $119,965 and $124,298 held at fair value) | | 1,393,139 | | 1,432,807 | | | (39,668) | | (2.8) | |\n| Loans, held for sale, at fair value | | 348,719 | | 297,669 | | | 51,050 | | 17.1 | |\n| Mortgage backed securities, at fair value | | 90,427 | | 75,411 | | | 15,016 | | 19.9 | |\n| Loans eligible for repurchase from Ginnie Mae | | | 237,542 | | | 186,197 | | | 51,345 | | 27.6 | |\n| Investment in unconsolidated joint ventures | | | 69,204 | | | 53,939 | | | 15,265 | | 28.3 | |\n| Purchased future receivables, net | | | 16,659 | | | 27,190 | | | (10,531) | | (38.7) | |\n| Derivative instruments | | 20,849 | | 19,037 | | | 1,812 | | 9.5 | |\n| Servicing rights (including $74,384 and $73,645 held at fair value) | | 110,045 | | 107,761 | | | 2,284 | | 2.1 | |\n| Real estate, held for sale | | | 45,063 | | | 47,009 | | | (1,946) | | (4.1) | |\n| Other assets | | 98,614 | | 103,701 | | | (5,087) | | (4.9) | |\n| Assets of consolidated VIEs | | | 2,691,198 | | | 2,761,655 | | | (70,457) | | (2.6) | |\n| Total Assets | | $ | 5,317,510 | | $ | 5,460,932 | | $ | (143,422) | | (2.6) | % |\n| Liabilities | | | | | | | | | | | | |\n| Secured borrowings | | $ | 1,176,621 | | $ | 1,253,895 | | $ | (77,274) | | (6.2) | % |\n| Securitized debt obligations of consolidated VIEs, net | | 2,059,114 | | 2,140,009 | | | (80,895) | | (3.8) | |\n| Convertible notes, net | | | 111,855 | | | 111,581 | | | 274 | | 0.2 | |\n| Senior secured notes, net | | 179,572 | | 179,481 | | | 91 | | 0.1 | |\n| Corporate debt, net | | | 150,658 | | | 150,387 | | | 271 | | 0.2 | |\n| Guaranteed loan financing | | 421,183 | | 436,532 | | | (15,349) | | (3.5) | |\n| Liabilities for loans eligible for repurchase from Ginnie Mae | | | 237,542 | | | 186,197 | | | 51,345 | | 27.6 | |\n| Derivative instruments | | 7,774 | | 9,106 | | | (1,332) | | (14.6) | |\n| Dividends payable | | 16,934 | | 14,524 | | | 2,410 | | 16.6 | |\n| Accounts payable and other accrued liabilities | | 132,087 | | 166,174 | | | (34,087) | | (20.5) | |\n| Total Liabilities | | $ | 4,493,340 | | $ | 4,647,886 | | $ | (154,546) | | (3.3) | % |\n| Stockholders’ Equity | | | | | | | | | | | | |\n| Common stock | | $ | 5 | | $ | 5 | | $ | — | | 0.0 | % |\n| Additional paid-in capital | | 846,960 | | 854,222 | | | (7,262) | | (0.9) | |\n| Retained earnings (deficit) | | | (31,779) | | | (49,755) | | | 17,976 | | (36.1) | |\n| Accumulated other comprehensive (loss) | | (9,916) | | (9,876) | | | (40) | | 0.4 | |\n| Total Ready Capital Corporation equity | | 805,270 | | 794,596 | | | 10,674 | | 1.3 | % |\n| Non-controlling interests | | 18,900 | | 18,450 | | | 450 | | 2.4 | |\n| Total Stockholders’ Equity | | $ | 824,170 | | $ | 813,046 | | $ | 11,124 | | 1.4 | % |\n| Total Liabilities and Stockholders’ Equity | | $ | 5,317,510 | | $ | 5,460,932 | | $ | (143,422) | | (2.6) | % |\n| |\n\n| | | | | | | | | | | | | | | | |\n| (in thousands) | | Acquisitions | | SBC Originations | | SBA Originations, Acquisitions and Servicing | | Residential Mortgage Banking | | Total |\n| Assets | | | | | | | | | | | | | | | |\n| Loans, net (1)(2) | | $ | 949,728 | $ | 2,366,167 | $ | 743,114 | $ | 5,235 | $ | 4,064,244 |\n| Loans, held for sale, at fair value | | | 510 | | | 20,486 | | | 39,764 | | | 287,959 | | | 348,719 |\n| Mortgage backed securities, at fair value | | | 22,842 | | | 67,585 | | | — | | | — | | | 90,427 |\n| Servicing rights | | | — | | | 18,121 | | | 17,540 | | | 74,384 | | | 110,045 |\n| Investment in unconsolidated joint ventures | | | 69,204 | | | — | | | — | | | — | | | 69,204 |\n| Purchased future receivables, net | | | 16,659 | | | — | | | — | | | — | | | 16,659 |\n| Real estate, held for sale (1) | | | 45,063 | | | 8,422 | | | — | | | — | | | 53,485 |\n| | | | | | | | | | | | | | | | |\n| Liabilities | | | | | | | | | | | | | | | |\n| Secured borrowings | | $ | 226,545 | | $ | 482,665 | | $ | 159,467 | | $ | 307,944 | | $ | 1,176,621 |\n| Securitized debt obligations of consolidated VIEs | | | 552,998 | | | 1,399,224 | | | 106,892 | | | — | | | 2,059,114 |\n| Guaranteed loan financing | | | — | | | — | | | 421,183 | | | — | | | 421,183 |\n| Senior secured notes, net | | | 42,609 | | | 129,919 | | | 7,045 | | | — | | | 179,572 |\n| Corporate debt, net | | | 75,189 | | | 75,469 | | | — | | | — | | | 150,658 |\n| Convertible notes, net | | | 55,125 | | | 51,132 | | | 5,598 | | | — | | | 111,855 |\n| (1) Includes assets of consolidated VIEs(2) Excludes allowance for loan losses. |\n\n| | | | | | | | | | | | | | | | | | | |\n| | | | | | | | | | | | | | | | | |\n| | | Three Months Ended September 30, | | $ Change | | Nine Months Ended September 30, | | $ Change |\n| | | 2020 | | 2019 | | 2020 vs. 2019 | | 2020 | | 2019 | | 2020 vs. 2019 |\n| Interest income | | | | | | | | | | | | | | | | | | |\n| Loan acquisitions | | $ | 14,532 | $ | 18,880 | $ | (4,348) | | $ | 45,993 | $ | 47,761 | $ | (1,768) |\n| SBC originations | | | 35,287 | | | 32,354 | | | 2,933 | | | 112,052 | | | 91,182 | | | 20,870 |\n| SBA originations, acquisitions and servicing | | | 9,037 | | | 7,235 | | | 1,802 | | | 30,316 | | | 23,468 | | | 6,848 |\n| Residential mortgage banking | | | 2,218 | | | 1,254 | | | 964 | | | 5,465 | | | 3,099 | | | 2,366 |\n| Total interest income | | $ | 61,074 | | $ | 59,723 | | $ | 1,351 | | $ | 193,826 | | $ | 165,510 | | $ | 28,316 |\n| Interest expense | | | | | | | | | | | | | | | | | | |\n| Loan acquisitions | | $ | (11,011) | | $ | (11,076) | | $ | 65 | | $ | (32,871) | | $ | (29,383) | | $ | (3,488) |\n| SBC originations | | | (23,342) | | | (23,835) | | | 493 | | | (72,476) | | | (65,903) | | | (6,573) |\n| SBA originations, acquisitions and servicing | | | (6,414) | | | (2,739) | | | (3,675) | | | (21,766) | | | (11,529) | | | (10,237) |\n| Residential mortgage banking | | | (2,157) | | | (1,740) | | | (417) | | | (5,778) | | | (4,104) | | | (1,674) |\n| Corporate - other | | | (899) | | | - | | | (899) | | | (1,271) | | | - | | | (1,271) |\n| Total interest expense | | $ | (43,823) | | $ | (39,390) | | $ | (4,433) | | $ | (134,162) | | $ | (110,919) | | $ | (23,243) |\n| Net interest income before provision for loan losses | | $ | 17,251 | | $ | 20,333 | | $ | (3,082) | | $ | 59,664 | | $ | 54,591 | | $ | 5,073 |\n| Loan acquisitions | | $ | 4,824 | | $ | (94) | | $ | 4,918 | | $ | (2,865) | | $ | (771) | | $ | (2,094) |\n| SBC originations | | | 117 | | | (33) | | | 150 | | | (23,890) | | | (342) | | | (23,548) |\n| SBA originations, acquisitions and servicing | | | (710) | | | (566) | | | (144) | | | (7,729) | | | (1,446) | | | (6,283) |\n| Residential mortgage banking | | | - | | | — | | | - | | | (500) | | | — | | | (500) |\n| Provision for loan losses | | $ | 4,231 | | $ | (693) | | | 4,924 | | | (34,984) | | | (2,559) | | | (32,425) |\n| Net interest income after provision for loan losses | | $ | 21,482 | | $ | 19,640 | | $ | 1,842 | | $ | 24,680 | | $ | 52,032 | | $ | (27,352) |\n| Non-interest income | | | | | | | | | | | | | | | | | | |\n| Loan acquisitions | | $ | 8,643 | | $ | 1,329 | | $ | 7,314 | | $ | 7,385 | | $ | 7,090 | | $ | 295 |\n| SBC originations | | | 10,066 | | | 5,806 | | | 4,260 | | | 16,393 | | | 15,052 | | | 1,341 |\n| SBA originations, acquisitions and servicing | | | 12,020 | | | 5,513 | | | 6,507 | | | 49,269 | | | 15,861 | | | 33,408 |\n| Residential mortgage banking | | | 77,178 | | | 27,292 | | | 49,886 | | | 178,190 | | | 60,366 | | | 117,824 |\n| Corporate - other | | | (1) | | | 44 | | | (45) | | | 114 | | | 30,837 | | | (30,723) |\n| Total non-interest income | | $ | 107,906 | | $ | 39,984 | | $ | 67,922 | | $ | 251,351 | | $ | 129,206 | | $ | 122,145 |\n| Non-interest expense | | | | | | | | | | | | | | | | | | |\n| Loan acquisitions | | $ | (8,554) | | $ | (2,602) | | $ | (5,952) | | $ | (27,926) | | $ | (6,277) | | $ | (21,649) |\n| SBC originations | | | (9,339) | | | (6,855) | | | (2,484) | | | (28,357) | | | (19,022) | | | (9,335) |\n| SBA originations, acquisitions and servicing | | | (6,344) | | | (6,062) | | | (282) | | | (22,837) | | | (17,854) | | | (4,983) |\n| Residential mortgage banking | | | (53,820) | | | (28,116) | | | (25,704) | | | (148,415) | | | (68,842) | | | (79,573) |\n| Corporate - other | | | (9,414) | | | (6,207) | | | (3,207) | | | (25,870) | | | (23,727) | | | (2,143) |\n| Total non-interest expense | | $ | (87,471) | | $ | (49,842) | | $ | (37,629) | | $ | (253,405) | | $ | (135,722) | | $ | (117,683) |\n| Net income (loss) before provision for income taxes | | | | | | | | | | | | | | | | | | |\n| Loan acquisitions | | $ | 8,434 | | $ | 6,437 | | $ | 1,997 | | $ | (10,284) | | $ | 18,420 | | $ | (28,704) |\n| SBC originations | | | 12,789 | | | 7,437 | | | 5,352 | | | 3,722 | | | 20,967 | | | (17,245) |\n| SBA originations, acquisitions and servicing | | | 7,589 | | | 3,381 | | | 4,208 | | | 27,253 | | | 8,500 | | | 18,753 |\n| Residential mortgage banking | | | 23,419 | | | (1,310) | | | 24,729 | | | 28,962 | | | (9,481) | | | 38,443 |\n| Corporate - other | | | (10,314) | | | (6,163) | | | (4,151) | | | (27,027) | | | 7,110 | | | (34,137) |\n| Total net income (loss) before provision for income taxes | | $ | 41,917 | | $ | 9,782 | | $ | 32,135 | | $ | 22,626 | | $ | 45,516 | | $ | (22,890) |\n\n| | | | | | | | | | | | | |\n| | | Three Months Ended September 30, | | Nine Months Ended September 30, |\n| (In Thousands) | 2020 | 2019 | 2020 | 2019 |\n| Realized gains (losses) on financial instruments | | | | | | | | | | | | |\n| Realized gains on loans - Freddie Mac | | $ | 1,518 | | $ | 1,954 | | $ | 5,517 | | $ | 3,817 |\n| Creation of mortgage servicing rights - Freddie Mac | | | 2,107 | | | 1,798 | | | 7,094 | | | 3,745 |\n| Realized gains on loans - SBA | | | 3,448 | | | 2,098 | | | 7,937 | | | 8,148 |\n| Creation of mortgage servicing rights - SBA | | | 993 | | | 600 | | | 2,328 | | | 2,481 |\n| Realized gain (loss) on derivatives, at fair value | | | (1,996) | | | 132 | | | (2,700) | | | 1,048 |\n| Realized gain (loss) on mortgage backed securities, at fair value | | | 471 | | | 1,112 | | | 2,060 | | | 2,349 |\n| Net realized gains (losses) - all other | | | 966 | | | (317) | | | (118) | | | (674) |\n| Net realized gain on financial instruments | | $ | 7,507 | | $ | 7,377 | | $ | 22,118 | | $ | 20,914 |\n| Unrealized gains (losses) on financial instruments | | | | | | | | | | | | |\n| Unrealized gain (loss) on loans - Freddie Mac | | $ | (40) | | $ | (64) | | $ | (18) | | $ | 234 |\n| Unrealized gain (loss) on loans - SBA | | | 2,353 | | | 772 | | | 1,302 | | | 267 |\n| Unrealized gain (loss) on residential mortgage servicing rights, at fair value | | (4,688) | | (7,582) | | (33,168) | | (21,050) |\n| Unrealized gain (loss) on derivatives, at fair value | | | 648 | | | (701) | | | (4,415) | | | (2,827) |\n| Unrealized gain (loss) on mortgage backed securities, at fair value | | | 3,708 | | | (245) | | | (8,314) | | | 1,466 |\n| Net unrealized gains (losses) - all other | | | 1,439 | | | (61) | | | 851 | | | 111 |\n| Net unrealized gain (loss) on financial instruments | | $ | 3,420 | | $ | (7,881) | | $ | (43,762) | | $ | (21,799) |\n| | | | | | | | | | | | | |\n| | | | | | | | | | | | | | | | | | | |\n| | | | | |\n| | | Three Months Ended September 30, | | Nine Months Ended September 30, |\n| (In Thousands) | | 2020 | | 2019 | | $ Change | | 2020 | | 2019 | | $ Change |\n| Interest income | | $ | 14,532 | | $ | 18,880 | | $ | (4,348) | | $ | 45,993 | | $ | 47,761 | | $ | (1,768) |\n| Interest expense | | | (11,011) | | (11,076) | | 65 | | | (32,871) | | (29,383) | | (3,488) |\n| Net interest income before provision for loan losses | | $ | 3,521 | | $ | 7,804 | | $ | (4,283) | | $ | 13,122 | | $ | 18,378 | | $ | (5,256) |\n| Provision for loan losses | | | 4,824 | | | (94) | | | 4,918 | | | (2,865) | | | (771) | | | (2,094) |\n| Net interest income after provision for loan losses | | $ | 8,345 | | $ | 7,710 | | $ | 635 | | $ | 10,257 | | $ | 17,607 | | $ | (7,350) |\n| Non-interest income | | | 8,643 | | | 1,329 | | | 7,314 | | | 7,385 | | | 7,090 | | | 295 |\n| Non-interest expense | | | (8,554) | | | (2,602) | | | (5,952) | | | (27,926) | | | (6,277) | | | (21,649) |\n| Total non-interest income (expense) | | $ | 89 | | $ | (1,273) | | $ | 1,362 | | $ | (20,541) | | $ | 813 | | $ | (21,354) |\n| Net income (loss) before provision for income taxes | | $ | 8,434 | | $ | 6,437 | | $ | 1,997 | | $ | (10,284) | | $ | 18,420 | | $ | (28,704) |\n| | | | | | | | | | | | | | | | | | | |\n\n| | | | | | | | | | | | | | | | | | | |\n| | | | | |\n| | | Three Months Ended September 30, | | Nine Months Ended September 30, |\n| (In Thousands) | | 2020 | | 2019 | | $ Change | | 2020 | | 2019 | | $ Change |\n| Interest income | | $ | 35,287 | | $ | 32,354 | | $ | 2,933 | | $ | 112,052 | | $ | 91,182 | | $ | 20,870 |\n| Interest expense | | | (23,342) | | (23,835) | | 493 | | | (72,476) | | (65,903) | | (6,573) |\n| Net interest income before provision for loan losses | | $ | 11,945 | | $ | 8,519 | | $ | 3,426 | | $ | 39,576 | | $ | 25,279 | | $ | 14,297 |\n| Recoveries of (provision for) loan losses | | | 117 | | | (33) | | | 150 | | | (23,890) | | | (342) | | | (23,548) |\n| Net interest income after provision for loan losses | | $ | 12,062 | | $ | 8,486 | | $ | 3,576 | | $ | 15,686 | | $ | 24,937 | | $ | (9,251) |\n| Non-interest income (loss) | | | 10,066 | | | 5,806 | | | 4,260 | | | 16,393 | | | 15,052 | | | 1,341 |\n| Non-interest expense | | | (9,339) | | | (6,855) | | | (2,484) | | | (28,357) | | | (19,022) | | | (9,335) |\n| Total non-interest income (expense) | | $ | 727 | | $ | (1,049) | | $ | 1,776 | | $ | (11,964) | | $ | (3,970) | | $ | (7,994) |\n| Net income (loss) before provision for income taxes | | $ | 12,789 | | $ | 7,437 | | $ | 5,352 | | $ | 3,722 | | $ | 20,967 | | $ | (17,245) |\n\nInterest income of $112.1 million for the nine months ended September 30, 2020 in our SBC originations segment represented an increase of $20.9 million from the prior year period primarily reflecting an increase in SBC loan originations, resulting in higher average loan balances. Originated SBC loans contributed $44.2 million in interest income during the nine months ended September 30, 2020, representing an $8.4 million increase from the nine months ended September 30, 2019. Originated transitional loans contributed $66.0 million in interest income during the nine months ended September 30, 2020, representing a $14.6 million increase from the nine months ended September 30, 2019. Interest expenseInterest expense of $23.3 million in our SBC originations segment was relatively unchanged from the prior year quarter ended September 30, 2019.Interest expense of $72.5 million in our SBC originations segment represented an increase of $6.6 million from the prior year period ended September 30, 2019, primarily reflecting an increase in borrowing activities under our shorter-term secured borrowings and securitized debt obligations.Provision for (Recoveries of) loan losses Recoveries of loan losses of $0.1 million in our SBC originations segment was relatively unchanged from the prior year quarter ended September 30, 2019. Provision for loan losses of $23.9 million for the nine months ended September 30, 2020 in our SBC originations segment represented an increase of $23.5 million from the prior year period. The increase in the provision for loan losses during the nine months ended September 30, 2020 was primarily the result of the implementation of the CECL impairment standard and the adverse change in the economic outlook due to the COVID-19 pandemic.Non-interest income Non-interest income of $10.1 million for the quarter ended September 30, 2020 in our SBC originations segment represented an increase of $4.3 million from the prior quarter ended September 30, 2019 primarily reflecting an increase in the fair value of owned Freddie Mac bonds in the quarter.Non-interest income of $16.4 million for the nine months ended September 30, 2020 in our SBC originations segment represented an increase of $1.3 million from the prior year period ended September 30, 2019 reflecting an increase in realized gains on sales of Freddie Mac loans (including creation of servicing rights) of $5.0 million. Non-interest expenseNon-interest expense of $9.3 million for the quarter ended September 30, 2020 in our SBC originations segment represented an increase of $2.5 million from the prior year quarter ended September 30, 2019, primarily reflecting an increase in employee compensation expense of $2.6 million, and an increase in servicing expense of $0.8 million.Non-interest expense of $28.4 million for the nine months ended September 30, 2020 in our SBC originations segment represented an increase of $9.3 million from the prior year period ended September 30, 2019, primarily reflecting an increase in general operating expenses of $2.1 million, an increase in employee compensation expense of $6.0 million, and an increase in servicing expense of $1.5 million.84\n| | | | | | | | | | | | | | | | | | | |\n| | | | | |\n| | | Three Months Ended September 30, | | Nine Months Ended September 30, |\n| (In Thousands) | | 2020 | | 2019 | | $ Change | | 2020 | | 2019 | | $ Change |\n| Interest income | | $ | 9,037 | | $ | 7,235 | | $ | 1,802 | | $ | 30,316 | | $ | 23,468 | | $ | 6,848 |\n| Interest expense | | | (6,414) | | (2,739) | | (3,675) | | | (21,766) | | (11,529) | | (10,237) |\n| Net interest income before provision for loan losses | | $ | 2,623 | | $ | 4,496 | | $ | (1,873) | | $ | 8,550 | | $ | 11,939 | | $ | (3,389) |\n| Provision for loan losses | | | (710) | | | (566) | | | (144) | | | (7,729) | | | (1,446) | | | (6,283) |\n| Net interest income after provision for loan losses | | $ | 1,913 | | $ | 3,930 | | $ | (2,017) | | $ | 821 | | $ | 10,493 | | $ | (9,672) |\n| Non-interest income | | | 12,020 | | | 5,513 | | | 6,507 | | | 49,269 | | | 15,861 | | | 33,408 |\n| Non-interest expense | | | (6,344) | | | (6,062) | | | (282) | | | (22,837) | | | (17,854) | | | (4,983) |\n| Total non-interest income (expense) | | $ | 5,676 | | $ | (549) | | $ | 6,225 | | $ | 26,432 | | $ | (1,993) | | $ | 28,425 |\n| Net income (loss) before provision for income taxes | | $ | 7,589 | | $ | 3,381 | | $ | 4,208 | | $ | 27,253 | | $ | 8,500 | | $ | 18,753 |\n\n| | | | | | | | | | | | | | | | | | | |\n| | | | | |\n| | | Three Months Ended September 30, | | Nine Months Ended September 30, |\n| (In Thousands) | | 2020 | | 2019 | | $ Change | | 2020 | | 2019 | | $ Change |\n| Interest income | | $ | 2,218 | | $ | 1,254 | | $ | 964 | | $ | 5,465 | | $ | 3,099 | | $ | 2,366 |\n| Interest expense | | | (2,157) | | (1,740) | | (417) | | | (5,778) | | (4,104) | | (1,674) |\n| Net interest income before provision for loan losses | | $ | 61 | | $ | (486) | | $ | 547 | | $ | (313) | | $ | (1,005) | | $ | 692 |\n| Provision for loan losses | | | — | | | — | | | - | | | (500) | | | — | | | (500) |\n| Net interest income after provision for loan losses | | $ | 61 | | $ | (486) | | $ | 547 | | $ | (813) | | $ | (1,005) | | $ | 192 |\n| Non-interest income | | | 77,178 | | | 27,292 | | | 49,886 | | | 178,190 | | | 60,366 | | | 117,824 |\n| Non-interest expense | | | (53,820) | | | (28,116) | | | (25,704) | | | (148,415) | | | (68,842) | | | (79,573) |\n| Total non-interest income (expense) | | $ | 23,358 | | $ | (824) | | $ | 24,182 | | $ | 29,775 | | $ | (8,476) | | $ | 38,251 |\n| Net income (loss) before provision for income taxes | | $ | 23,419 | | $ | (1,310) | | $ | 24,729 | | $ | 28,962 | | $ | (9,481) | | $ | 38,443 |\n| | | | | | | | | | | | | | | | | | | |\n\nNon-interest income Non-interest income of $77.2 million in our residential mortgage banking segment for the quarter ended September 30, 2020 represented an increase of $49.9 million from the prior year quarter ended September 30, 2019, primarily reflecting an increase in revenue on residential mortgage banking activities of $46.5 million as a result of an increase in loan originations in the current year and by a decrease in unrealized losses on residential MSRs of $4.7 million during the quarter ended September 30, 2020 compared to $7.6 million of unrealized losses during the quarter ended September 30, 2019. Non-interest income of $178.2 million in our residential mortgage banking segment for the nine months ended September 30, 2020 represented an increase of $117.8 million from the prior year period ended September 30, 2019, primarily reflecting an increase in revenue on residential mortgage banking activities of $128.1 million as a result of an increase in loan originations in the current year. This was offset by unrealized losses on residential MSRs of $33.3 million during the nine months ended September 30, 2020 compared to $21.1 million of unrealized losses during the nine months ended September 30, 2019.Non-interest expense Non-interest expense of $53.8 million in our residential mortgage banking segment for the quarter ended September 30, 2020 represented an increase of $25.7 million from the prior year quarter ended September 30, 2019, primarily reflecting an increase in variable expenses on residential mortgage banking activities of $13.6 million, an increase in employee compensation of $8.2 million, and an increase in loan servicing expense of $2.5 million.Non-interest expense of $148.4 million in our residential mortgage banking segment for the nine months ended September 30, 2020 represented an increase of $79.6 million from the prior year period ended September 30, 2019, primarily reflecting increases in variable expenses on residential mortgage banking activities of $47.5 million, employee compensation of $22.6 million and loan servicing expense of $8.2 million.Corporate- OtherNon-interest incomeNon-interest income of $30.8 million in our Corporate – Other segment for the nine months ended September 30, 2019 represented a bargain purchase gain associated with the ORM merger. There were no significant changes for the three months ended September 30, 2020 compared to the prior year quarter.Non-interest expenseNon-interest expense of $9.4 million for the quarter ended September 30, 2020 increased $3.2 million from the prior year quarter ended September 30, 2019, primarily due to an increase in professional fees of $1.3 million and incentive fees due to our Manager of $1.1 million.Non-interest expense of $25.9 million for the nine months ended September 30, 2020 increased $2.1 million from the prior year period ended September 30, 2019, primarily due to an increase in incentive fees and management fees due to our Manager of $5.6 million and an increase in professional fees of $2.1 million, partially offset by due to an increase in merger related expense of $6.0 million. Non-GAAP financial measuresWe believe that providing investors with core earnings, a non-U.S. GAAP financial measure, in addition to the related U.S. GAAP measures, gives investors greater transparency into the information used by management in our financial and operational decision-making. However, because core earnings is an incomplete measure of our financial performance and involves differences from net income computed in accordance with U.S. GAAP, it should be considered along with, but not as an alternative to, our net income as a measure of our financial performance. In addition, because not all companies use identical calculations, our presentation of core earnings may not be comparable to other similarly-titled measures of other companies.87\n| i) | any unrealized gains or losses on certain MBS |\n| ii) | any realized gains or losses on sales of certain MBS |\n| iii) | any unrealized gains or losses on Residential MSRs |\n| iv) | one-time non-recurring gains or losses, such as gains or losses on discontinued operations, bargain purchase gains, or merger related expenses |\n| | | | | | | | | | | | | | | | | | |\n| | Three Months Ended September 30, | | | | | Nine Months Ended September 30, | | | |\n| (in thousands) | 2020 | | 2019 | | Change | | 2020 | | 2019 | | Change |\n| Net Income | $ | 35,363 | | $ | 12,427 | | $ | 22,936 | | $ | 18,510 | | $ | 54,120 | | $ | (35,610) |\n| Reconciling items: | | | | | | | | | | | | | | | | | |\n| Unrealized (gain) loss on mortgage servicing rights | | 4,688 | | | 7,582 | | | (2,894) | | | 33,169 | | | 21,049 | | | 12,120 |\n| Impact of the adoption of ASU 2016-13 on accrual loans | | (7,248) | | | — | | | (7,248) | | | 23,114 | | | — | | | 23,114 |\n| Non-recurring REO impairment | | (114) | | | — | | | (114) | | | 2,961 | | | — | | | 2,961 |\n| Merger transaction costs and other non-recurring expenses | | 998 | | | 51 | | | 947 | | | 3,220 | | | 6,914 | | | (3,694) |\n| Bargain purchase gain | | — | | | — | | | — | | | — | | | (30,728) | | | 30,728 |\n| Unrealized (gain) loss on mortgage-backed securities | | — | | | 85 | | | (85) | | | 185 | | | 205 | | | (20) |\n| Unrealized loss on de-designated cash flow hedges | | — | | | — | | | — | | | 2,118 | | | — | | | 2,118 |\n| Total reconciling items | $ | (1,676) | | $ | 7,718 | | $ | (9,394) | | $ | 64,767 | | $ | (2,560) | | $ | 67,327 |\n| Income tax adjustments | | (1,561) | | | (1,896) | | | 335 | | | (10,703) | | | (5,263) | | | (5,440) |\n| Core earnings | $ | 32,126 | | $ | 18,249 | | $ | 13,877 | | $ | 72,574 | | $ | 46,297 | | $ | 26,277 |\n| Less: Core earnings attributable to non-controlling interests | | (731) | | | (474) | | | (257) | | | (2,160) | | | (1,352) | | | (808) |\n| Less: Income attributable to participating shares | | (339) | | | (79) | | | (260) | | | (1,087) | | | (240) | | | (847) |\n| Core earnings attributable to common stockholders | $ | 31,056 | | $ | 17,696 | | $ | 13,360 | | $ | 69,814 | | $ | 44,705 | | $ | 25,109 |\n| Core Earnings per common share - basic and diluted | $ | 0.57 | | $ | 0.40 | | $ | 0.17 | | $ | 1.30 | | $ | 1.10 | | $ | 0.20 |\n| | | | | | | | | | |\n\nThree Months Ended September 30, 2020 Compared to the Three Months Ended September 30, 2019Consolidated net income increased by $22.9 million, from $12.4 million during the three months ended September 30, 2019 to $35.4 million during the three months ended September 30, 2020. Core earnings increased by $13.9 million, from $18.2 million during the three months ended September 30, 2019 to $32.1 million during the three months ended September 30, 2020.The increase in consolidated net income and core earnings was primarily the result of an increase in residential mortgage banking activities net of variable costs of $32.9 million. Nine Months Ended September 30, 2020 Compared to the Nine Months Ended September 30, 2019Consolidated net income decreased by $35.6 million, from $54.1 million during the nine months ended September 30, 2019 to $18.5 million during the nine months ended September 30, 2020. Core earnings increased by $26.3 million, from $46.3 million during the nine months ended September 30, 2019 to $72.6 million during the nine months ended September 30, 2020.The decrease in consolidated net income was the result of a number of factors, including a $35.4 million reduction due to the adoption of CECL during the three months ended March 31, 2020. In addition, unrealized losses on MSRs of $16.4 million and $3.0 million of non-recurring REO impairment experienced in the first quarter of 2020. In addition, we experienced a bargain purchase gain of $30.7 million, offset by merger related expenses of $5.5 million, as a result of the ORM merger transaction in the first quarter of 2019. This was partially offset by the $25.8 million of revenue recognized on loans originated under the SBA’s PPP program. Core earnings increased by $26.3 million primarily due to $25.8 million of revenue recognized on loans originated under the SBA’s PPP program and revenue growth in our residential mortgage banking segment.COVID-19 Impact on Operating ResultsThe significant and wide-ranging response of international, federal, state and local public health and governmental authorities to the COVID-19 pandemic in regions across the United States and the world, including the imposition of quarantines, “stay-at-home” orders and similar mandates for many individuals to substantially restrict daily activities and for many businesses to curtail or cease normal operations, and the volatile economic, business and financial market conditions resulting therefrom, are expected to negatively impact our business, financial performance and operating results in later periods of 2020. Although we are uncertain of the potential full magnitude or duration of the business and economic impacts from the unprecedented public health efforts to contain and combat the spread of COVID-19, we will likely experience material deterioration in our financial performance and operating results, revenues, cash flow and/or profitability in one or more of the remaining periods in 2020 compared to the corresponding prior-year periods and compared to our expectations at the beginning of our 2020 fiscal year. Further discussion of the potential impacts on our business from the COVID-19 pandemic is provided in the section entitled “Risk Factors” in Part II, Item 1A of this Quarterly Report on Form 10-Q.Incentive distribution payable to our ManagerUnder the partnership agreement of our operating partnership, our Manager, the holder of the Class A special unit in our operating partnership, is entitled to receive an incentive distribution, distributed quarterly in arrears in an amount not less than zero equal to the difference between (i) the product of (A) 15% and (B) the difference between (x) core earnings (as described below) of our operating partnership, on a rolling four-quarter basis and before the incentive distribution for the current quarter, and (y) the product of (1) the weighted average of the issue price per share of common stock or operating partnership unit (“OP unit”) (without double counting) in all of our offerings multiplied by the weighted average number of shares of common stock outstanding (including any restricted shares of common stock and any other shares of common stock underlying awards granted under our 2012 equity incentive plan) and OP units (without double counting) in such quarter and (2) 8%, and (ii) the sum of any incentive distribution paid to our Manager with respect to the first three quarters of such previous four quarters; provided, however, that no incentive distribution is payable with respect to any calendar quarter unless cumulative core earnings is greater than zero for the most recently completed 12 calendar quarters, or the number of completed calendar quarters since the closing date of the merger with ZAIS Financial Corp. (“ZAIS Financial merger”), whichever is less.89\nFor purposes of calculating the incentive distribution, the shares of common stock and OP units issued as of the closing of the ZAIS Financial merger in connection with the merger agreement were deemed to be issued at the per share price equal to (i) the sum of (A) the weighted average of the issue price per share of common stock or OP units (without double counting) issued prior to the closing of the ZAIS Financial merger multiplied by the number of shares of Sutherland common stock outstanding and Sutherland OP units (without double counting) issued prior to the closing of the merger plus (B) the amount by which the net book value of our Company as of the closing of the merger (after giving effect to the closing of the merger agreement) exceeded the amount of the net book value of Sutherland immediately preceding the closing of the merger, divided by (ii) all of the shares of our common stock and OP units issued and outstanding as of the closing of the merger (including the date of the closing of the mergers).The incentive distribution shall be calculated within 30 days after the end of each quarter and such calculation shall promptly be delivered to our Company. We are obligated to pay the incentive distribution 50% in cash and 50% in either common stock or OP units, as determined in our discretion, within five business days after delivery to our Company of the written statement from the holder of the Class A special unit setting forth the computation of the incentive distribution for such quarter. Subject to certain exceptions, our Manager may not sell or otherwise dispose of any portion of the incentive distribution issued to it in common stock or OP units until after the three year anniversary of the date that such shares of common stock or OP units were issued to our Manager. The price of shares of our common stock for purposes of determining the number of shares payable as part of the incentive distribution is the closing price of such shares on the last trading day prior to the approval by our board of the incentive distribution.For purposes of determining the incentive distribution payable to our Manager, core earnings is defined under the partnership agreement of our operating partnership in a manner that is similar to the definition of core earnings described above under \"Non-GAAP Financial Measures\" but with the following additional adjustments which (i) further exclude: (a) the incentive distribution, (b) non-cash equity compensation expense, if any, (c) unrealized gains or losses on SBC loans (not just MBS and MSRs), (d) depreciation and amortization (to the extent we foreclose on any property), and (e) one-time events pursuant to changes in U.S. GAAP and certain other non-cash charges after discussions between our Manager and our independent directors and after approval by a majority of the independent directors and (ii) add back any realized gains or losses on the sales of MBS and on discontinued operations which were excluded from the definition of core earnings described above under \"Non-GAAP Financial Measures\". Liquidity and Capital Resources Liquidity is a measure of our ability to turn non-cash assets into cash and to meet potential cash requirements. We use significant cash to purchase SBC loans and other target assets, originate new SBC loans, pay dividends, repay principal and interest on our borrowings, fund our operations and meet other general business needs. Our primary sources of liquidity will include our existing cash balances, borrowings, including securitizations, re-securitizations, repurchase agreements, warehouse facilities, bank credit facilities (including term loans and revolving facilities), the net proceeds of this and future offerings of equity and debt securities, including our Senior Secured Notes, Corporate debt, and Convertible Notes, and net cash provided by operating activities. We are continuing to monitor the COVID-19 pandemic and its impact on us, the borrowers underlying our real estate-related assets, the tenants in the properties we own, our financing sources, and the economy as a whole. Because the severity, magnitude and duration of the COVID-19 pandemic and its economic consequences are uncertain, rapidly changing and difficult to predict, the pandemic’s impact on our operations and liquidity remains uncertain and difficult to predict. Further discussion of the potential impacts on us from the COVID-19 pandemic is provided in the section entitled “Risk Factors” in Part II, Item 1A of this Quarterly Report on Form 10-Q.90\n| | | | | | | | | | | | | |\n| | | Three Months Ended September 30, | | Nine Months Ended September 30, |\n| (in thousands) | | 2020 | | 2019 | | 2020 | | 2019 |\n| Cash flows provided by (used in) operating activities | | $ | (48,289) | | $ | (7,063) | | $ | (261) | | $ | (64,870) |\n| Cash flows provided by (used in) investing activities | | $ | 129,694 | | $ | (245,446) | | $ | (7,688) | | $ | (920,245) |\n| Cash flows provided by (used in) financing activities | | $ | (207,044) | | $ | 255,607 | | $ | 103,715 | | $ | 995,283 |\n| | | | | | | | | | | | | |\n| Net increase (decrease) in cash and cash equivalents and restricted cash | | $ | (125,639) | | $ | 3,098 | | $ | 95,766 | | $ | 10,168 |\n| ● | Net cash used in operating activities of $48.3 million for the current quarter related primarily to: |\n| - | Cash outflows on originations of new loans held for sale of $1,392.9 million and gains on sales of residential mortgages held for sale of $61.1 million. These reductions in cash were partially offset by inflows relating to repayments and sales of loans, held for sale at fair value of $1,415.2 million. |\n| ● | Net cash provided by investing activities of $129.7 million for the current quarter related primarily to: |\n| - | Cash inflows of $302.2 million relating to outflows repayments sales of loans, net, partially offset by purchases and originations of loans, net of $149.0 million and investment in unconsolidated joint ventures of $14.6 million. |\n| ● | Net cash used in financing activities of $207.0 million for the current quarter related primarily to: |\n| - | Net repayment of secured borrowings of $77.2 million, payment of securitized debt obligations of $84.2 million, dividend payments of $14.5 million, and repurchase of the Company’s stock of $9.2 million. |\n| ● | Net cash used in operating activities of $7.1 million for the current quarter related primarily to: |\n| - | Cash inflows from proceeds on sales and pay-downs on loans, held-for-sale, at fair value of $802.4 million, offset by cash outflows on originations and purchases of new loans of $805.1 million. |\n| ● | Net cash used in investing activities of $245.4 million for the current quarter related primarily to: |\n| - | Cash outflows of $418.7 million relating to originations and purchases of loans, held at fair value and held-for-investment loans, offset by cash inflows relating to repayments of loans, held at fair value and held-for-investment of $170.6 million and sales and repayments of MBS of $4.3 million. |\n| ● | Net cash provided by financing activities of $255.6 million for the current quarter related primarily to: |\n| - | Net proceeds from secured borrowings of $327.0 million, proceeds from the issuance of corporate debt of $57.5 million, offset by net repayments of securitized debt of $103.7 million. |\n| ● | Net cash used in operating activities of $0.3 million for the current quarter related primarily to: |\n\n| - | Cash outflows on originations of new loans held for sale of $3,675.8 million and gains on sales of residential mortgages held for sale of $143.7 million. These reductions in cash were partially offset by inflows relating to repayments and sales of loans, held for sale at fair value of $3,680.5 million. |\n| ● | Net cash used in investing activities of $7.7 million for the current quarter related primarily to: |\n| - | Cash outflows of $677.0 million relating to originations and purchases of loans, held at fair value and held-for-investment loans, offset by cash inflows relating to repayments of loans, held at fair value and held-for-investment of $673.9 million, sales and repayments of MBS of $10.5 million, and investment in unconsolidated joint ventures of $16.3 million. |\n| ● | Net cash provided by financing activities of $103.7 million for the current quarter related primarily to: |\n| - | Net proceeds from securitized debt of $242.9 million, partially offset by net repayments of secured borrowings of $11.4 million and repayments of guaranteed loan financing of $78.8 million. |\n| ● | Net cash used in operating activities of $64.9 million related primarily to: |\n| - | Cash outflows on originations and purchases of new loans, held-for-sale, at fair value of $1,889.8 million and other general changes to operating assets and liabilities of $7.8 million, partially offset by cash inflows on sales and pay-downs of loans of $1,859.5 million. |\n| ● | Net cash used in investing activities of $920.2 million related primarily to: |\n| - | Cash outflows of $1,488.1 million relating to originations and purchases of loans, held-for-investment, purchases of MBS of $9.6 million, partially offset by cash inflows relating to repayments of loans, held at fair value and held-for-investment of $550.2 million and sales and repayments of MBS of $9.7 million. |\n| ● | Net cash provided by financing activities of $995.3 million related primarily to: |\n| - | Net proceeds from securitized debt obligations of $564.1 million and secured borrowings of $469.4 million. |\n| | | | | | | | | | |\n| Quarter End | | Quarter End Balance | | Average Balance in Quarter | | Highest Month End Balance in Quarter |\n| Q3 2017 | | $ | 320,371 | | $ | 420,270 | | $ | 433,183 |\n| Q4 2017 | | | 382,612 | | | 351,492 | | | 382,612 |\n| Q1 2018 | | | 446,663 | | | 414,638 | | | 446,663 |\n| Q2 2018 | | | 443,263 | | | 444,963 | | | 447,751 |\n| Q3 2018 | | | 610,251 | | | 526,757 | | | 610,251 |\n| Q4 2018 | | | 635,233 | | | 622,742 | | | 635,233 |\n| Q1 2019 | | | 597,963 | | | 604,107 | | | 635,233 |\n| Q2 2019 | | | 612,383 | | | 605,173 | | | 612,383 |\n| Q3 2019 | | | 876,163 | | | 744,273 | | | 876,163 |\n| Q4 2019 | | | 809,189 | | | 842,676 | | | 876,163 |\n| Q1 2020 | | | 1,159,357 | | | 984,273 | | | 1,159,357 |\n| Q2 2020 | | | 714,162 | | | 936,760 | | | 1,057,522 |\n| Q3 2020 | | | 624,549 | | | 669,356 | | | 831,200 |\n\n| | | | | | | | | | | | | | | | | |\n| | | | | | | | | | | | | Carrying Value at |\n| Lender | Asset Class | Current Maturity | Pricing | Facility Size | Pledged Assets Carrying Value | September 30, 2020 | December 31, 2019 |\n| JPMorgan | Acquired loans, SBA loans | June 2021 | | 1M L + 1.75 to 2.75% | | $ | 250,000 | | $ | 44,840 | | $ | 30,742 | | $ | 88,972 |\n| Keybank | Freddie Mac loans | February 2021 | | 1M L + 1.30% | | | 100,000 | | | 20,486 | | | 20,242 | | | 21,513 |\n| East West Bank | SBA loans | October 2022 | | Prime - 0.821 to + 0.29% | | | 50,000 | | | 40,550 | | | 33,184 | | | 13,294 |\n| Credit Suisse | Acquired loans (non USD) | December 2021 | | Euribor + 2.50% | | | 234,420 | (a) | | 53,021 | | | 32,267 | | | 37,646 |\n| FCB | Acquired loans | June 2021 | | 2.75% | | | — | | | — | | | — | | | 1,354 |\n| Comerica Bank | Residential loans | March 2021 | | 1M L + 1.75% | | | 125,000 | | | 90,515 | | | 83,704 | | | 56,822 |\n| TBK Bank | Residential loans | October 2021 | | Variable Pricing | | | 150,000 | | | 123,980 | | | 118,581 | | | 52,151 |\n| Origin Bank | Residential loans | June 2021 | | Variable Pricing | | | 60,000 | | | 25,093 | | | 23,471 | | | 15,343 |\n| Associated Bank | Residential loans | November 2020 | | 1M L + 1.50% | | | 60,000 | | | 47,918 | | | 44,489 | | | 5,823 |\n| East West Bank | Residential MSRs | September 2023 | | 1M L + 2.50% | | | 50,000 | | | 49,140 | | | 37,700 | | | 39,900 |\n| Credit Suisse | Purchased future receivables, PPP loans | June 2021 | | 1M L + 4.50% | | | 150,000 | | | — | | | — | | | 34,900 |\n| Rabobank | Real estate | January 2021 | | 4.22% | | | 14,500 | | | — | | | — | | | 12,485 |\n| Federal Reserve Bank of Minneapolis | PPP loans | April 2022 | | 0.35% | | | 105,222 | | | 105,089 | | | 105,005 | | | — |\n| Bank of the Sierra | Real estate | August 2050 | | 3.25% | | | 22,750 | | | 37,562 | | | 22,687 | | | — |\n| Total borrowings under credit facilities (b) | | | | $ | 1,371,892 | | $ | 638,194 | | $ | 552,072 | | $ | 380,203 |\n| Citibank | Fixed rate, Transitional, Acquired loans | October 2021 | | 1M L + 1.875 to 2.125% | | $ | 500,000 | | $ | 114,196 | | $ | 103,307 | | $ | 124,718 |\n| Deutsche Bank | Fixed rate, Transitional loans | November 2021 | | 3M L + 2.00 to 2.40% | | | 350,000 | | | 232,524 | | | 161,100 | | | 141,356 |\n| JPMorgan | Transitional loans | December 2020 | | 1M L + 2.25 to 4.00% | | | 400,000 | | | 265,599 | | | 175,764 | | | 250,466 |\n| JPMorgan | MBS | March 2021 | | 1.54 to 4.75% | | | 70,875 | | | 115,128 | | | 70,875 | | | 93,715 |\n| Deutsche Bank | MBS | January 2021 | | 3.54% | | | 16,354 | | | 20,189 | | | 16,354 | | | 44,730 |\n| Citibank | MBS | November 2020 | | 3.25 to 3.76% | | | 58,422 | | | 114,749 | | | 58,422 | | | 56,189 |\n| Bank of America | MBS | Matured | | 1.31 to 1.61% | | | — | | | — | | | — | | | 38,954 |\n| RBC | MBS | February 2021 | | 3.05 to 4.43% | | | 38,727 | | | 61,595 | | | 38,727 | | | 59,061 |\n| Total borrowings under repurchase agreements (c) | | $ | 1,434,378 | | $ | 923,980 | | $ | 624,549 | | $ | 809,189 |\n| Total secured borrowings | | $ | 2,806,270 | | $ | 1,562,174 | | $ | 1,176,621 | | $ | 1,189,392 |\n\nAs of September 30, 2020, we had $161.1 million outstanding under the DB Loan Repurchase Facility. The DB Loan Repurchase Facility is used to finance SBC loans, and the interest rate is LIBOR plus a spread, which varies depending on the type and age of the loan. The DB Loan Repurchase Facility has been extended through November 2021 and our subsidiaries have an option to extend the DB Loan Repurchase Facility for an additional year, subject to certain conditions. Up to 100% of the then-current unpaid obligations of ReadyCap Commercial, Sutherland Asset I, and Sutherland Warehouse Trust II are fully guaranteed by us.The eligible assets for the DB Loan Repurchase Facility are loans secured by a first mortgage lien on commercial properties subject to certain eligibility criteria, such as property type, geographical location, LTV ratios, debt yield and debt service coverage ratios. The principal amount paid by the bank for each mortgage loan is based on a percentage of the lesser of the mortgaged property value or the principal balance of such mortgage loan. ReadyCap Commercial, Sutherland Asset I, and Sutherland Warehouse Trust II paid the bank an up-front fee and are also required to pay the bank availability fees, and a minimum utilization fee for the DB Loan Repurchase Facility, as well as certain other administrative costs and expenses. The DB Loan Repurchase Facility also includes financial maintenance covenants, which include (i) an adjusted tangible net worth that does not decline by more than 25% in a quarter, 35% in a year or 50% from the highest adjusted tangible net worth, (ii) a minimum liquidity amount of the greater of (a) $5 million and (b) 3% of the sum of any outstanding recourse indebtedness plus the aggregate repurchase price of the mortgage loans on the Repurchase Agreement, (iii) a debt-to-assets ratio no greater than 80% and (iv) a tangible net worth at least equal to the sum of (a) the product of 1/15 and the amount of all non-recourse indebtedness (excluding the aggregate repurchase price) and other securitization indebtedness and (b) the product of 1/3 and the sum of the aggregate repurchase price and all recourse indebtedness.JPMorgan loan repurchase facilityOur subsidiaries, ReadyCap Warehouse Financing, LLC (“ReadyCap Warehouse Financing”), Sutherland Warehouse Trust, LLC (“Sutherland Warehouse Trust”) entered into a master repurchase agreement in December 2015, pursuant to which ReadyCap Warehouse Financing, Sutherland Warehouse Trust and Ready Capital Mortgage Depositor II, LLC (which joined as a seller in October 2019), may sell, and later repurchase, mortgage loans in an aggregate principal amount of up to $400 million. Our subsidiaries renewed their master repurchase agreement with JPMorgan in February 2020 (the “JPM Loan Repurchase Facility”). As of September 30, 2020, we had $175.8 million outstanding under the JPM Loan Repurchase Facility. The JPM Loan Repurchase Facility is used to finance commercial transitional loans, conventional commercial loans and commercial mezzanine loans and securities and the interest rate is LIBOR plus a spread, which is determined by the lender on an asset-by-asset basis. The JPM Loan Repurchase Facility is committed through December 10, 2020, and up to 25% of the then-current unpaid obligations of ReadyCap Warehouse Financing, Sutherland Warehouse Trust and Ready Capital Mortgage Depositor II, LLC are fully guaranteed by us.The eligible assets for the JPM Loan Repurchase Facility are loans secured by first and junior mortgage liens on commercial properties and subject to approval by JPM as the Buyer. The principal amount paid by the bank for each mortgage loan is based on the principal balance of such mortgage loan. ReadyCap Warehouse Financing and Sutherland Warehouse Trust paid the bank a structuring fee and are also required to pay the bank unused fees for the JPM Loan Repurchase Facility, as well as certain other administrative costs and expenses. The JPM Loan Repurchase Facility also includes financial maintenance covenants, which include (i) total stockholders’ equity must not be permitted to be less than the sum of (a) 60% of total stockholders’ equity as of the closing date of the facility plus (b) 50% of the net proceeds of any equity issuance after the closing date (ii) maximum leverage of 3:1 and (iii) liquidity equal to at least the lesser of (a) 4% of the sum of (without duplication) (1) any outstanding indebtedness plus (2) amounts due under the repurchase agreement and (b) $15.0 million.Citibank loan repurchase agreementOur subsidiaries, Waterfall Commercial Depositor, LLC, Sutherland Asset I, LLC, Ready Capital Subsidiary REIT I, LLC, and ReadyCap Commercial, LLC renewed a master repurchase agreement in August 2020 with Citibank, N.A. (the \"Citi Loan Repurchase Facility\" and, together with the DB Loan Repurchase Facility and the JPM Loan Repurchase Facility, the \"Loan Repurchase Facilities\"), pursuant to which Waterfall Commercial Depositor and Sutherland Asset I may sell, and later repurchase, a trust certificate (the “Trust Certificate”), representing interests in mortgage loans in an aggregate principal amount of up to $500 million. 94\nAs of September 30, 2020, we had $103.3 million outstanding under the Citi Loan Repurchase Facility. The Citi Loan Repurchase Facility is used to finance SBC loans, and the interest rate is one month LIBOR plus a spread, depending on asset characteristics. The Citi Loan Repurchase Facility is committed for a period of 364 days, and up to 25% of the then-current unpaid obligations of Waterfall Commercial Depositor, Sutherland Asset I, and ReadyCap Commercial, LLC are fully guaranteed by us.The eligible assets for the Citi Loan Repurchase Facility are loans secured by a first mortgage lien on commercial properties, which, amongst other things, generally have a UPB of less than $10 million. The principal amount paid by the bank for the Trust Certificate is based on a percentage of the lesser of the market value or the UPB of such mortgage loans backing the Trust Certificate. Waterfall Commercial Depositor, Sutherland Asset I, and ReadyCap Commercial, LLC are required to pay the bank a commitment fee for the Citi Loan Repurchase Facility, as well as certain other administrative costs and expenses. The Citi Loan Repurchase Facility includes financial maintenance covenants, which include (i) our operating partnership’s net asset value not (A) declining more than 15% in any calendar month, (B) declining more than 25% in any calendar quarter, (C) declining more than 35% in any calendar year, or (D) declining more than 50% from our operating partnership’s highest net asset value set forth in any audited financial statement provided to the bank; (ii) our operating partnership maintaining liquidity in an amount equal to at least 1% of our outstanding indebtedness; and (iii) the ratio of our operating partnership’s total indebtedness (excluding non-recourse liabilities in connection with any securitization transaction) to our net asset value not exceeding 4:1 at any time.Securities repurchase agreements As of September 30, 2020, we had $184.4 million of secured borrowings related to SBC ABS and pledged Trust Certificates with four counterparties (lenders).General statements regarding loan and securities repurchase facilities At September 30, 2020, we had $850.1 million in fair value of Trust Certificates and loans pledged against our borrowings under the Loan Repurchase Facilities and $73.9 million in fair value of SBC ABS and short term investments pledged against our securities repurchase agreement borrowings.Under the Loan Repurchase Facilities and securities repurchase agreements, we may be required to pledge additional assets to our counterparties in the event that the estimated fair value of the existing pledged collateral under such agreements declines and such lenders demand additional collateral, which may take the form of additional assets or cash. Generally, the Loan Repurchase Facilities and securities repurchase agreements contain a LIBOR-based financing rate, term and haircuts depending on the types of collateral and the counterparties involved. If the estimated fair values of the assets increase due to changes in market interest rates or other market factors, lenders may release collateral back to us. Margin calls may result from a decline in the value of the investments securing the Loan Repurchase Facilities and securities repurchase agreements, prepayments on the loans securing such investments and from changes in the estimated fair value of such investments generally due to principal reduction of such investments from scheduled amortization and resulting from changes in market interest rates and other market factors. Counterparties also may choose to increase haircuts based on credit evaluations of our Company and/or the performance of the assets in question. Historically, disruptions in the financial and credit markets have resulted in increased volatility in these levels, and this volatility could persist as market conditions continue to change. Should prepayment speeds on the mortgages underlying our investments or market interest rates suddenly increase, margin calls on the Loan Repurchase Facilities and securities repurchase agreements could result, causing an adverse change in our liquidity position. To date, we have satisfied all of our margin calls and have never sold assets in response to any margin call under these borrowings.Our borrowings under repurchase agreements are renewable at the discretion of our lenders and, as such, our ability to roll-over such borrowings is not guaranteed. The terms of the repurchase transaction borrowings under our repurchase agreements generally conform to the terms in the standard master repurchase agreement as published by the Securities Industry and Financial Markets Association, as to repayment, margin requirements and the segregation of all assets we have initially sold under the repurchase transaction. In addition, each lender typically requires that we include supplemental terms and conditions to the standard master repurchase agreement. Typical supplemental terms and conditions, which differ by lender, may include changes to the margin maintenance requirements, required haircuts and purchase price 95\nmaintenance requirements, requirements that all controversies related to the repurchase agreement be litigated in a particular jurisdiction, and cross default and setoff provisions.JPMorgan credit facility We renewed our master loan and security agreement with JPMorgan in June 2020 providing for a credit facility of up to $250 million. As of September 30, 2020, we had $30.7 million outstanding under this credit facility. The credit facility is structured as a secured loan facility in which ReadyCap Commercial, ReadyCap Lending and Sutherland 2016-1 JPM Grantor Trust act as borrowers. Under this facility, ReadyCap and Sutherland 2016-1 JPM Grantor Trust pledge loans guaranteed by the SBA under the SBA Section 7(a) Loan Program, SBA 504 loans and other loans which were part of the CIT loan acquisition. We act as a guarantor under this facility. The agreement contains financial maintenance covenants, which include (i) total stockholders’ equity must not be permitted to be less than the sum of (a) 60% of total stockholders’ equity as of the effective date of the facility plus (b) 50% of the net proceeds of any equity issuance after the effective date (ii) maximum leverage of 3:1 and (iii) liquidity equal to at least the lesser of (a) 4% of the sum of (without duplication) (1) any outstanding recourse indebtedness plus (2) amounts due under the repurchase agreement and (b) $15.0 million. The amended terms have an interest rate based on utilization ranging from one month LIBOR (reset daily), plus a spread. The term of the facility is one year, with an option to extend for an additional year.At September 30, 2020, we had a leverage ratio of 2.0x on a recourse debt-to-equity basis.We maintain certain assets, which, from time to time, may include cash, unpledged SBC loans, SBC ABS and short term investments (which may be subject to various haircuts if pledged as collateral to meet margin requirements) and collateral in excess of margin requirements held by our counterparties, or collectively, the “Cushion”, to meet routine margin calls and protect against unforeseen reductions in our borrowing capabilities. Our ability to meet future margin calls will be impacted by the Cushion, which varies based on the fair value of our investments, our cash position and margin requirements. Our cash position fluctuates based on the timing of our operating, investing and financing activities and is managed based on our anticipated cash needs. At September 30, 2020, we were in compliance with all debt covenants.East West Bank credit facilityOur subsidiary, ReadyCap Lending, LLC entered into a senior secured revolving credit facility with East West Bank on July 13, 2018, which provides financing of up to $50.0 million. The agreement extends for two years, with an additional one year extension at the Company’s request and pays interest equal to the Prime Rate minus 0.821% on SBA 7(a) guaranteed loans and the Prime Rate plus 0.029% on unguaranteed loans.Other credit facilitiesGMFS funds its origination platform through warehouse lines of credit with five counterparties with total borrowings outstanding of $307.9 million at September 30, 2020. GMFS utilizes committed warehouse lines of credit agreements ranging from $50.0 million to $150.0 million, with expiration dates between November 2020 and September 2023. The lines of credit are collateralized by the underlying mortgages, related documents, and instruments, and contain a LIBOR-based financing rate and term, haircut and collateral posting provisions which depend on the types of collateral and the counterparties involved. These agreements contain covenants that include certain financial requirements, including maintenance of minimum liquidity, minimum tangible net worth, maximum debt to net worth ratio and current ratio and limitations on capital expenditures, indebtedness, distributions, transactions with affiliates and maintenance of positive net income, as defined in the agreements. We were in compliance with all significant debt covenants as of September 30, 2020.96\nPublic offeringsDebt offeringsConvertible notesOn August 9, 2017, we closed an underwritten public sale of $115.0 million aggregate principal amount of its 7.00% convertible senior notes due 2023 (the “Convertible Notes”). The Convertible Notes will mature on August 15, 2023, unless earlier repurchased, redeemed or converted. During certain periods and subject to certain conditions, the Convertible Notes will be convertible by holders into shares of our common stock at an initial conversion rate of 1.4997 shares of common stock per $25 principal amount of the Convertible Notes, which is equivalent to an initial conversion price of approximately $16.67 per share of common stock. Upon conversion, holders will receive, at our discretion, cash, shares of our common stock or a combination thereof.We may, upon the satisfaction of certain conditions, redeem all or any portion of the Convertible Notes, at its option, on or after August 15, 2021, at a redemption price payable in cash equal to 100% of the principal amount of the Convertible Notes to be redeemed, plus accrued and unpaid interest. Additionally, upon the occurrence of certain corporate transactions, holders may require us to purchase the Convertible Notes for cash at a purchase price equal to 100% of the principal amount of the Convertible Notes to be purchased, plus accrued and unpaid interest. As of September 30, 2020, we were in compliance with all covenants with respect to the Convertible Notes.Corporate debtOn April 27, 2018, we completed the public offer and sale of $50.0 million aggregate principal amount of its 6.50% Senior Notes due 2021(the “2021 Notes”). We issued the 2021 Notes under a base indenture, dated August 9, 2017, as supplemented by the second supplemental indenture, dated as of April 27, 2018, between us and U.S. Bank National Association, as trustee. The 2021 Notes bear interest at a rate of 6.50% per annum, payable quarterly in arrears on January 30, April 30, July 30, and October 30 of each year, beginning on July 30, 2018. The 2021 Notes will mature on April 30, 2021, unless earlier redeemed or repurchased.Prior to April 30, 2019, the 2021 Notes are not redeemable by us. We may redeem for cash all or any portion of the 2021 Notes, at its option, on or after April 30, 2019 and before April 30, 2020 at a redemption price equal to 101% of the principal amount of the 2021 Notes to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date. On or after April 30, 2020, we may redeem for cash all or any portion of the 2021 Notes, at its option, at a redemption price equal to 100% of the principal amount of the 2021 Notes to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date. If we undergo a change of control repurchase event, holders may require it to purchase the 2021 Notes, in whole or in part, for cash at a repurchase price equal to 101% of the aggregate principal amount of the 2021 Notes to be purchased, plus accrued and unpaid interest, if any, to, but excluding, the date of repurchase, as described in greater detail in the Indenture.The 2021 Notes are our senior direct unsecured obligations and will not be guaranteed by any of its subsidiaries, except to the extent described in the Indenture upon the occurrence of certain events. The 2021 Notes rank equal in right of payment to any of our existing and future unsecured and unsubordinated indebtedness; effectively junior in right of payment to any of its existing and future secured indebtedness to the extent of the value of the assets securing such indebtedness; and structurally junior to all existing and future indebtedness, other liabilities (including trade payables) and (to the extent not held by us) preferred stock, if any, of its subsidiaries.On July 22, 2019, we completed the public offer and sale of $57.5 million aggregate principal amount of its 6.20% Senior Notes due 2026 (the “2026 Notes” and together with the 2021 Notes, the “Corporate Debt”), which includes $7.5 million aggregate principal amount of the 2026 Notes relating to the full exercise of the underwriters’ over-allotment option. The net proceeds from the sale of the 2026 Notes are approximately $55.3 million, after deducting underwriters’ discount and estimated offering expenses. We will contribute the net proceeds to Sutherland Partners, L.P. (the “Operating Partnership”), its operating partnership subsidiary, in exchange for the issuance by the Operating Partnership of a senior unsecured note with terms that are substantially equivalent to the terms of the 2026 Notes. The Operating Partnership intends to use the net proceeds to originate or acquire our target assets and for general business purposes.97\nThe 2026 Notes bear interest at a rate of 6.20% per annum, payable quarterly in arrears on January 30, April 30, July 30, and October 30 of each year, beginning on October 30, 2019. The 2026 Notes will mature on July 30, 2026, unless earlier repurchased or redeemed. We may redeem for cash all or any portion of the 2026 Notes, at its option, on or after July 30, 2022 and before July 30, 2025 at a redemption price equal to 101% of the principal amount of the 2026 Notes to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date. On or after July 30, 2025, we may redeem for cash all or any portion of the 2026 Notes, at its option, at a redemption price equal to 100% of the principal amount of the 2026 Notes to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date. If we undergo a change of control repurchase event, holders may require it to purchase the 2026 Notes, in whole or in part, for cash at a repurchase price equal to 101% of the aggregate principal amount of the 2026 Notes to be purchased, plus accrued and unpaid interest, if any, to, but excluding, the date of repurchase, as described in greater detail in the Indenture.The 2026 Notes are our senior unsecured obligations and will not be guaranteed by any of its subsidiaries, except to the extent described in the Indenture upon the occurrence of certain events. The 2026 Notes rank equal in right of payment to any of our existing and future unsecured and unsubordinated indebtedness; effectively junior in right of payment to any of its existing and future secured indebtedness to the extent of the value of the assets securing such indebtedness; and structurally junior to all existing and future indebtedness, other liabilities (including trade payables) and (to the extent not held by us) preferred stock, if any, of its subsidiaries.In December 2019, we completed the public offer and sale of $45.0 million aggregate principal amount of the 2026 Notes. The new notes have the same terms (expect with respect to issue date, issue price and the date from which interest will accrue) as, are fully fungible with and are treated as a single series of debt securities as, the 6.20% Senior Notes due 2026 we issued on July 22, 2019. As of September 30, 2020, we were in compliance with all covenants with respect to the corporate debt.Equity offeringIn December 2019, we completed a public offering of 6,000,000 shares of our common stock at a public offering price of $15.30 per share and an additional 900,000 shares of common stock at a public offering price of $15.30 per share pursuant to the underwriter’s full exercise of the over-allotment option in January 2020. Proceeds, net of offering costs and expenses were $ 91.8 million and $13.8 million for December 2019 and January 2020, respectively. There were no equity offerings during 2018.U.S. federal income tax proposed regulations The discussion under the heading “Additional U.S. Federal Income Tax Considerations” in our Prospectus dated August 31, 2018, describes certain tax legislative changes applicable to us. As described in the discussion under the heading \"Additional U.S. Federal Income Tax Considerations – U.S. Federal Income Tax Legislation – Income Accrual,\" we and our subsidiaries are required to recognize certain items of income for U.S. federal income tax purposes no later than we would report such items on our financial statements. Recently proposed Treasury regulations, which are not yet in effect but upon which taxpayers may rely, generally would exclude, among other items, original issue discount and market discount income from the applicability of this rule Other long term financingReadyCap Holdings’ 7.50% senior secured notes due 2022During 2017, ReadyCap Holdings LLC, a subsidiary of the Company, issued $140.0 million in 7.50% Senior Secured Notes due 2022. On January 30, 2018 ReadyCap Holdings LLC, issued an additional $40.0 million in aggregate principal amount of 7.50% Senior Secured Notes due 2022, which have identical terms (other than issue date and issue price) to the notes issued during 2017 (collectively “the Senior Secured Notes”). The additional $40.0 million in Senior Secured Notes were priced with a yield to par call date of 6.5%. Payments of the amounts due on the Senior Secured Notes are fully and unconditionally guaranteed by the Company and its subsidiaries: Sutherland Partners LP, Sutherland Asset I, LLC, and ReadyCap Commercial. The funds were used to fund new SBC and SBA loan originations and new SBC loan acquisitions. 98\nThe Senior Secured Notes bear interest at 7.50% per annum payable semiannually on each February 15 and August 15, beginning on August 15, 2017. The Senior Secured Notes will mature on February 15, 2022, unless redeemed or repurchased prior to such date. ReadyCap Holdings may redeem the Senior Secured Notes prior to November 15, 2021, at its option, in whole or in part at any time and from time to time, at a price equal to 100% of the outstanding principal amount thereof, plus the applicable “make-whole” premium as of, and unpaid interest, if any, accrued to, the redemption date. On and after November 15, 2021, ReadyCap Holdings may redeem the Senior Secured Notes, at its option, in whole or in part at any time and from time to time, at a price equal to 100% of the outstanding principal amount thereof plus unpaid interest, if any, accrued to the redemption date.ReadyCap Holdings’ and the Guarantors’ respective obligations under the Senior Secured Notes and the Guarantees are secured by a perfected first-priority lien on the capital stock of ReadyCap Holdings and ReadyCap Commercial and certain other assets owned by certain of our Company’s subsidiaries as described in greater detail in our Current Report on Form 8-K filed on June 15, 2017. The Senior Secured Notes were issued pursuant to an indenture (the \"Indenture\") and a first supplemental indenture (the \"First Supplemental Indenture\"), which contains covenants that, among other things: (i) limit the ability of our Company and its subsidiaries (including ReadyCap Holdings and the other Guarantors) to incur additional indebtedness; (ii) require that our Company maintain, on a consolidated basis, quarterly compliance with the applicable consolidated recourse indebtedness to equity ratio of our Company and consolidated indebtedness to equity ratio of our Company and specified ratios of our Company’s stockholders’ equity to aggregate principal amount of the outstanding Senior Secured Notes and our Company's consolidated unencumbered assets to aggregate principal amount of the outstanding Senior Secured Notes; (iii) limit the ability of ReadyCap Holdings and ReadyCap Commercial to pay dividends or distributions on, or redeem or repurchase, the capital stock of ReadyCap Holdings or ReadyCap Commercial; (iv) limit (1) ReadyCap's Holdings ability to create or incur any lien on the collateral and (2) unless the Senior Secured Notes are equally and ratably secured, (a) ReadyCap's Holdings ability to create or incur any lien on the capital stock of its wholly-owned subsidiary, ReadyCap Lending and (b) ReadyCap's Holdings ability to permit ReadyCap Lending to create or incur any lien on its assets to secure indebtedness of its affiliates other than its subsidiaries or any securitization entity; and (v) limit ReadyCap Holding's and the Guarantors' ability to consolidate, merge or transfer all or substantially all of ReadyCap' Holdings and the Guarantors’ respective properties and assets. The First Supplemental Indenture also requires that our Company ensure that the Replaceable Collateral Value (as defined therein) is not less than the aggregate principal amount of the Senior Secured Notes outstanding as of the last day of each of our Company's fiscal quarters.As of September 30, 2020, we were in compliance with all covenants with respect to the Senior Secured Notes.Securitization transactionsOur Manager’s extensive experience in loan acquisition, origination, servicing and securitization strategies has enabled us to complete several securitizations of SBC and SBA loan assets since January 2011. These securitizations allow us to match fund the SBC and SBA loans on a long-term, non-recourse basis. The assets pledged as collateral for these securitizations were contributed from our portfolio of assets. By contributing these SBC and SBA assets to the various securitizations, these transactions created capacity for us to fund other investments. 99\n| | | | | | |\n| Deal Name | Collateral Asset Class | Issuance | Active / Collapsed | Bonds Issued(in $ millions) |\n| Trusts (Firm sponsored) | | | | | |\n| Waterfall Victoria Mortgage Trust 2011-1 (SBC1) | SBC Acquired loans | February 2011 | Collapsed | $ | 40.5 |\n| Waterfall Victoria Mortgage Trust 2011-3 (SBC3) | SBC Acquired loans | October 2011 | Collapsed | | 143.4 |\n| Sutherland Commercial Mortgage Trust 2015-4 (SBC4) | SBC Acquired loans | August 2015 | Collapsed | | 125.4 |\n| Sutherland Commercial Mortgage Trust 2018 (SBC7) | SBC Acquired loans | November 2018 | Active | | 217.0 |\n| ReadyCap Lending Small Business Trust 2015-1 (RCLT 2015-1) | Acquired SBA 7(a) loans | June 2015 | Collapsed | | 189.5 |\n| ReadyCap Lending Small Business Loan Trust 2019-2 (RCLT 2019-2) | Originated SBA 7(a) loans, Acquired SBA 7(a) loans | December 2019 | Active | | 131.0 |\n| | | | | | |\n| Real Estate Mortgage Investment Conduits (REMICs) | | | | | |\n| ReadyCap Commercial Mortgage Trust 2014-1 (RCMT 2014-1) | SBC Originated conventional | September 2014 | Active | $ | 181.7 |\n| ReadyCap Commercial Mortgage Trust 2015-2 (RCMT 2015-2) | SBC Originated conventional | November 2015 | Active | | 218.8 |\n| ReadyCap Commercial Mortgage Trust 2016-3 (RCMT 2016-3) | SBC Originated conventional | November 2016 | Active | | 162.1 |\n| ReadyCap Commercial Mortgage Trust 2018-4 (RCMT 2018-4) | SBC Originated conventional | March 2018 | Active | | 165.0 |\n| Ready Capital Mortgage Trust 2019-5 (RCMT 2019-5) | SBC Originated conventional | January 2019 | Active | | 355.8 |\n| Ready Capital Mortgage Trust 2019-6 (RCMT 2019-6) | SBC Originated conventional | November 2019 | Active | | 430.7 |\n| Waterfall Victoria Mortgage Trust 2011-2 (SBC2) | SBC Acquired loans | March 2011 | Active | | 97.6 |\n| Sutherland Commercial Mortgage Trust 2018 (SBC6) | SBC Acquired loans | August 2017 | Active | | 139.4 |\n| Sutherland Commercial Mortgage Trust 2019 (SBC8) | SBC Acquired loans | June 2019 | Active | | 306.5 |\n| Sutherland Commercial Mortgage Trust 2020 (SBC9) | SBC Acquired loans | June 2020 | Active | | 172.4 |\n| | | | | | |\n| Collateralized Loan Obligations (CLOs) | | | | | |\n| Ready Capital Mortgage Financing 2017– FL1 | SBC Originated transitional | August 2017 | Collapsed | $ | 198.8 |\n| Ready Capital Mortgage Financing 2018 – FL2 | SBC Originated transitional | June 2018 | Active | | 217.1 |\n| Ready Capital Mortgage Financing 2019 – FL3 | SBC Originated transitional | April 2019 | Active | | 320.2 |\n| Ready Capital Mortgage Financing 2020 – FL4 | SBC Originated transitional | June 2020 | Active | | 393.8 |\n| | | | | | |\n| Trusts (Non-firm sponsored) | | | | | |\n| Freddie Mac Small Balance Mortgage Trust 2016-SB11 | Originated agency multi-family | January 2016 | Active | $ | 110.0 |\n| Freddie Mac Small Balance Mortgage Trust 2016-SB18 | Originated agency multi-family | July 2016 | Active | | 118.0 |\n| Freddie Mac Small Balance Mortgage Trust 2017-SB33 | Originated agency multi-family | June 2017 | Active | | 197.9 |\n| Freddie Mac Small Balance Mortgage Trust 2018-SB45 | Originated agency multi-family | January 2018 | Active | | 362.0 |\n| Freddie Mac Small Balance Mortgage Trust 2018-SB52 | Originated agency multi-family | September 2018 | Active | | 505.0 |\n| Freddie Mac Small Balance Mortgage Trust 2018-SB56 | Originated agency multi-family | December 2018 | Active | | 507.3 |\n| Key Commercial Mortgage Trust 2020-S3(1) | SBC Originated conventional | September 2020 | Active | | 250.0 |\n| (1) Contributed portion of assets into trust | | | | | |\n\nAccounting Policies” included in Item 8, “Financial Statements and Supplementary Data,” in our 2019 annual report on Form 10-K. Loan impairment and allowance for loan lossesThe allowance for loan losses is intended to provide for credit losses inherent in the loans, held-for-investment portfolio and is reviewed quarterly for adequacy considering credit quality indicators, including probable and historical losses, collateral values, loan-to-value (“LTV”) ratio and economic conditions. The allowance for loan losses is increased through provisions for loan losses charged to earnings and reduced by charge-offs, net of recoveries. On January 1, 2020, the Company adopted ASU No. 2016-13, Financial Instruments-Credit Losses, and subsequent amendments (“ASU 2016-13”), which replaces the incurred loss methodology with an expected loss model known as the Current Expected Credit Loss (\"CECL\") model. CECL amends the previous credit loss model to reflect a reporting entity's current estimate of all expected credit losses, not only based on historical experience and current conditions, but also by including reasonable and supportable forecasts incorporating forward-looking information. The measurement of expected credit losses under CECL is applicable to financial assets measured at amortized cost. The allowance for loan losses required under ASU 2016-13 is deducted from the respective loans’ amortized cost basis on our unaudited consolidated balance sheets. The guidance also requires a cumulative-effect adjustment to retained earnings as of the beginning of the reporting period of adoption.In connection with the Company’s adoption of ASU 2016-13 on January 1, 2020, the Company implemented new processes including the utilization of loan loss forecasting models, updates to the Company’s reserve policy documentation, changes to internal reporting processes and related internal controls. The Company has implemented loan loss forecasting models for estimating expected life-time credit losses, at the individual loan level, for its loan portfolio. The CECL forecasting methods used by the Company include (i) a probability of default and loss given default method using underlying third-party CMBS/CRE loan database with historical loan losses from 1998 to 2019 and (ii) probability weighted expected cash flow method, depending on the type of loan and the availability of relevant historical market loan loss data. The Company might use other acceptable alternative approaches in the future depending on, among other factors, the type of loan, underlying collateral, and availability of relevant historical market loan loss data.The Company estimates the CECL expected credit losses for its loan portfolio at the individual loan level. Significant inputs to the Company’s forecasting methods include (i) key loan-specific inputs such as LTV, vintage year, loan-term, underlying property type, occupancy, geographic location, and others, and (ii) a macro-economic forecast. These estimates may change in future periods based on available future macro-economic data and might result in a material change in the Company’s future estimates of expected credit losses for its loan portfolio.In certain instances, the Company considers relevant loan-specific qualitative factors to certain loans to estimate its CECL expected credit losses. The Company considers loan investments that are both (i) expected to be substantially repaid through the operation or sale of the underlying collateral, and (ii) for which the borrower is experiencing financial difficulty, to be “collateral-dependent” loans. For such loans that the Company determines that foreclosure of the collateral is probable, the Company measures the expected losses based on the difference between the fair value of the collateral and the amortized cost basis of the loan as of the measurement date. For collateral-dependent loans that the Company determines foreclosure is not probable, the Company applies a practical expedient to estimate expected losses using the difference between the collateral’s fair value (less costs to sell the asset if repayment is expected through the sale of the collateral) and the amortized cost basis of the loan.While we have a formal methodology to determine the adequate and appropriate level of the allowance for loan losses, estimates of inherent loan losses involve judgment and assumptions as to various factors, including current economic conditions. Our determination of adequacy of the allowance for loan losses is based on quarterly evaluations of the above factors. Accordingly, the provision for loan losses will vary from period to period based on management's ongoing assessment of the adequacy of the allowance for loan losses.Significant judgment is required when evaluating loans for impairment; therefore, actual results over time could be materially different. Refer to “Notes to Consolidated Financial Statements, Note 6 – Loans and Allowance for Loan Losses” included in Item 8, “Financial Statements and Supplementary Data,” in this quarterly report on Form 10-Q for results of our loan impairment evaluation.101\nValuation of financial assets and liabilities carried at fair valueWe measure our MBS, derivative assets and liabilities, residential mortgage servicing rights, and any assets or liabilities where we have elected the fair value option at fair value, including certain loans we have originated that are expected to be sold to third parties or securitized in the near term. We have established valuation processes and procedures designed so that fair value measurements are appropriate and reliable, that they are based on observable inputs where possible, and that valuation approaches are consistently applied, and the assumptions and inputs are reasonable. We also have established processes to provide that the valuation methodologies, techniques and approaches for investments that are categorized within Level 3 of the ASC 820 Fair Value Measurement fair value hierarchy (the “fair value hierarchy”) are fair, consistent and verifiable. Our processes provide a framework that ensures the oversight of our fair value methodologies, techniques, validation procedures, and results.When actively quoted observable prices are not available, we either use implied pricing from similar assets and liabilities or valuation models based on net present values of estimated future cash flows, adjusted as appropriate for liquidity, credit, market and/or other risk factors. Refer to “Notes to Consolidated Financial Statements, Note 7 – Fair Value Measurements” included in Item 8, “Financial Statements and Supplementary Data,” in this annual report on Form 10-K for a more complete discussion of our critical accounting estimates as they pertain to fair value measurements. Servicing rights impairment Servicing rights, at amortized cost, are initially recorded at fair value and subsequently carried at amortized cost. We have elected the fair value option on our residential mortgage servicing rights, which are not subject to impairment. For purposes of testing our servicing rights, carried at amortized cost, for impairment, we first determine whether facts and circumstances exist that would suggest the carrying value of the servicing asset is not recoverable. If so, we then compare the net present value of servicing cash flow with its carrying value. The estimated net present value of servicing cash flows of the intangibles is determined using discounted cash flow modeling techniques which require management to make estimates regarding future net servicing cash flows, taking into consideration historical and forecasted loan prepayment rates, delinquency rates and anticipated maturity defaults. If the carrying value of the servicing rights exceeds the net present value of servicing cash flows, the servicing rights are considered impaired and an impairment loss is recognized in earnings for the amount by which carrying value exceeds the net present value of servicing cash flows. We monitor the actual performance of our servicing rights by regularly comparing actual cash flow, credit, and prepayment experience to modeled estimates.Significant judgment is required when evaluating servicing rights for impairment; therefore, actual results over time could be materially different. Refer to “Notes to Consolidated Financial Statements, Note 9 – Servicing Rights” included in Item 8, “Financial Statements and Supplementary Data,” in this annual report on Form 10-K for a more complete discussion of our critical accounting estimates as they pertain to servicing rights impairment.Refer to “Notes to Consolidated Financial Statements, Note 4– Recently Issued Accounting Pronouncements” included in Item 8, “Financial Statements and Supplementary Data,” in this annual report on Form 10-K for a discussion of recent accounting developments and the expected impact to the Company.INFLATIONVirtually all of our assets and liabilities are and will be interest rate sensitive in nature. As a result, interest rates and other factors influence our performance far more than does inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates. Our consolidated financial statements are prepared in accordance with U.S. GAAP and our activities and balance sheet shall be measured with reference to historical cost and/or fair market value without considering inflation.Item 3. Quantitative and Qualitative Disclosures About Market RiskIn the normal course of business, we enter into transactions in various financial instruments that expose us to various types of risk, both on and off balance sheet, which are associated with such financial instruments and markets for which we invest. These financial instruments expose us to varying degrees of market risk, credit risk, interest rate risk, liquidity 102\nrisk, off-balance sheet risk and prepayment risk. Many of these risks have been magnified due to the continuing economic disruptions caused by the COVID-19 pandemic; however, while we continue to monitor the pandemic its impact on such risks remains uncertain and difficult to predict.Market risk Market risk is the potential adverse changes in the values of the financial instrument due to unfavorable changes in the level or volatility of interest rates, foreign currency exchange rates, or market values of the underlying financial instruments. We attempt to mitigate our exposure to market risk by entering into offsetting transactions, which may include purchase or sale of interest bearing securities and equity securities. Credit riskWe are subject to credit risk in connection with our investments in SBC loans and SBC ABS and other target assets we may acquire in the future. The credit risk related to these investments pertains to the ability and willingness of the borrowers to pay, which is assessed before credit is granted or renewed and periodically reviewed throughout the loan or security term. We believe that loan credit quality is primarily determined by the borrowers’ credit profiles and loan characteristics. We seek to mitigate this risk by seeking to acquire assets at appropriate prices given anticipated and unanticipated losses and by deploying a value-driven approach to underwriting and diligence, consistent with our historical investment strategy, with a focus on projected cash flows and potential risks to cash flow. We further mitigate our risk of potential losses while managing and servicing our loans by performing various workout and loss mitigation strategies with delinquent borrowers. Nevertheless, unanticipated credit losses could occur which could adversely impact operating results.The COVID-19 pandemic has adversely impacted the commercial real estate markets, causing reduced occupancy, requests from tenants for rent deferral or abatement, and delays in property renovations currently planned or underway. These negative conditions may persist into the future and impair borrower’s ability to pay principal and interest due under our loan agreements. We maintain robust asset management relationships with our borrowers and have leveraged these relationships to address the potential impact of the COVID-19 pandemic on our loans secured by properties experiencing cash flow pressure, most significantly hospitality and retail assets. Some of our borrowers have indicated that due to the impact of the COVID-19 pandemic, they will be unable to timely execute their business plans, have had to temporarily close their businesses, or have experienced other negative business consequences and have requested temporary interest deferral or forbearance, or other modifications of their loans. Accordingly, we have discussed with our borrowers potential near-term defensive loan modifications, which could include repurposing of reserves, temporary deferrals of interest, or performance test or covenant waivers on loans collateralized by assets directly impacted by the COVID-19 pandemic, and which would typically be coupled with an additional equity commitment and/or guaranty from sponsors. As of September 30, 2020, approximately 1.8% of the loans in our commercial real estate portfolio are in forbearance plans. While we believe the principal amounts of our loans are generally adequately protected by underlying collateral value, there is a risk that we will not realize the entire principal value of certain investments.Interest rate risk Interest rate risk is highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. Our operating results will depend, in part, on differences between the income from our investments and our financing costs. Our debt financing is based on a floating rate of interest calculated on a fixed spread over the relevant index, subject to a floor, as determined by the particular financing arrangement. The general impact of changing interest rates are discussed above under “— Factors Impacting Operating Results — Changes in Market Interest Rates.” In the event of a significant rising interest rate environment and/or economic downturn, defaults could increase and result in credit losses to us, which could materially and adversely affect our business, financial condition, liquidity, results of operations and prospects. Furthermore, such defaults could have an adverse effect on the spread between our interest-earning assets and interest-bearing liabilities. Additionally, non-performing SBC loans are not as interest rate sensitive as performing loans, as earnings on non-performing loans are often generated from restructuring the assets through loss mitigation strategies and opportunistically disposing of them. Because non-performing SBC loans are short-term assets, the discount rates used for valuation are based on short-term market interest rates, which may not move in tandem with long-term market interest rates. A rising 103\n| | | | | | | | | | | | | | | | | |\n| | | 12-month pretax net interest income sensitivity profiles |\n| | | Instantaneous change in rates |\n| (in thousands) | | 25 basis point increase | | 50 basis point increase | | 75 basis point increase | | 100 basis point increase | | 25 basis point decrease | | 50 basis point decrease | | 75 basis point decrease | | 100 basis point decrease |\n| Assets: | | | | | | | | | | | | | | | | |\n| Loans held for investment | $ | 4,249 | $ | 8,498 | $ | 12,748 | $ | 16,997 | $ | (951) | $ | (1,815) | $ | (2,644) | $ | (3,453) |\n| Interest rate swap hedges | | 689 | | 1,379 | | 2,068 | | 2,757 | | (689) | | (1,379) | | (2,068) | | (2,757) |\n| Total | $ | 4,938 | $ | 9,877 | $ | 14,816 | $ | 19,754 | $ | (1,640) | $ | (3,194) | $ | (4,712) | $ | (6,210) |\n| Liabilities | | | | | | | | | | | | | | | | |\n| Recourse debt | $ | (2,067) | $ | (4,134) | $ | (6,201) | $ | (8,269) | $ | 1,350 | $ | 1,433 | $ | 1,516 | $ | 1,599 |\n| Non-recourse debt | | (2,057) | | (4,113) | | (6,170) | | (8,227) | | 1,376 | | 1,759 | | 2,143 | | 2,526 |\n| Total | $ | (4,124) | $ | (8,247) | $ | (12,371) | $ | (16,496) | $ | 2,726 | $ | 3,192 | $ | 3,659 | $ | 4,125 |\n| Total Net Impact to Net Interest Income (Expense) | $ | 814 | $ | 1,630 | $ | 2,445 | $ | 3,258 | $ | 1,086 | $ | (2) | $ | (1,053) | $ | (2,085) |\n\nagreements. This could have a negative impact on our results of operations. In some situations, we may be forced to sell assets to maintain adequate liquidity, which could cause us to incur losses. Real estate risk The market values of commercial mortgage assets are subject to volatility and may be affected adversely by a number of factors, including, but not limited to, national, regional and local economic conditions (which may be adversely affected by industry slowdowns and other factors); local real estate conditions; changes or continued weakness in specific industry segments; construction quality, age and design; demographic factors; and retroactive changes to building or similar codes. In addition, decreases in property values reduce the value of the collateral and the potential proceeds available to a borrower to repay the underlying loans, which could also cause us to suffer losses. Fair value risk The estimated fair value of our investments fluctuates primarily due to changes in interest rates and other factors. Generally, in a rising interest rate environment, the estimated fair value of the fixed-rate investments would be expected to decrease; conversely, in a decreasing interest rate environment, the estimated fair value of the fixed-rate investments would be expected to increase. As market volatility increases or liquidity decreases, the fair value of our assets recorded and/or disclosed may be adversely impacted. Our economic exposure is generally limited to our net investment position as we seek to fund fixed rate investments with fixed rate financing or variable rate financing hedged with interest rate swaps. Counterparty riskWe finance the acquisition of a significant portion of our commercial and residential mortgage loans, MBS and other assets with our repurchase agreements and credit facilities. In connection with these financing arrangements, we pledge our mortgage loans and securities as collateral to secure the borrowings. The amount of collateral pledged will typically exceed the amount of the borrowings (i.e. the haircut) such that the borrowings will be over-collateralized. As a result, we are exposed to the counterparty if, during the term of the financing, a lender should default on its obligation and we are not able to recover our pledged assets. The amount of this exposure is the difference between the amount loaned to us plus interest due to the counterparty and the fair value of the collateral pledged by us to the lender including accrued interest receivable on such collateral.We are exposed to changing interest rates and market conditions, which affects cash flows associated with borrowings. We enter into derivative instruments, such as interest rate swaps and credit default swaps (“CDS”), to mitigate these risks. Interest rate swaps are used to mitigate the exposure to changes in interest rates and involve the receipt of variable-rate interest amounts from a counterparty in exchange for us making payments based on a fixed interest rate over the life of the swap contract. CDSs are executed in order to mitigate the risk of deterioration in the current credit health of the commercial mortgage market.Certain of our subsidiaries have entered into over-the-counter interest rate swap agreements to hedge risks associated with movements in interest rates. Because certain interest rate swaps were not cleared through a central counterparty, we remain exposed to the counterparty's ability to perform its obligations under each such swap and cannot look to the creditworthiness of a central counterparty for performance. As a result, if an over-the-counter swap counterparty cannot perform under the terms of an interest rate swap, our subsidiary would not receive payments due under that agreement, we may lose any unrealized gain associated with the interest rate swap and the hedged liability would cease to be hedged by the interest rate swap. While we would seek to terminate the relevant over-the-counter swap transaction and may have a claim against the defaulting counterparty for any losses, including unrealized gains, there is no assurance that we would be able to recover such amounts or to replace the relevant swap on economically viable terms or at all. In such case, we could be forced to cover our unhedged liabilities at the then current market price. We may also be at risk for any collateral we have pledged to secure our obligations under the over-the-counter interest rate swap if the counterparty becomes insolvent or files for bankruptcy. Therefore, upon a default by an interest rate swap agreement counterparty, the interest rate swap would no longer mitigate the impact of changes in interest rates as intended.105\n| | | | | | | | | | |\n| (in thousands) | | Borrowings under repurchase agreements and credit facilities (1) | | Assets pledged on borrowings under repurchase agreements and credit facilities | | Net Exposure | | Exposure as aPercentage ofTotal Assets |\n| Total Counterparty Exposure | | $ 1,176,621 | | $ 1,562,174 | | $ 385,553 | | 7.3 | % |\n| (1) The exposure reflects the difference between (a) the amount loaned to the Company through repurchase agreements and credit facilities, including interest payable, and (b) the cash and the fair value of the assets pledged by the Company as collateral, including accrued interest receivable on such assets | |\n| | | | | | | | | |\n| (in thousands) | | Counterparty Rating (1) | Amount of Risk (2) | | WeightedAverageMonths toMaturity forAgreement | | Percentage ofStockholders’Equity |\n| JPMorgan Chase Bank, N.A. | | A+ / Aa2 | $ 134,088 | | 6 | | 16.3 | % |\n| Citibank, N.A. | | A+ / Aa3 | $ 67,216 | | 2 | | 8.2 | % |\n| Deutsche Bank AG | | BBB+ / A3 | $ 75,259 | | 17 | | 9.1 | % |\n| (1) The counterparty rating presented is the long-term issuer credit rating as rated at September 30, 2020 by S&P and Moody’s, respectively. | |\n| (2) The amount at risk reflects the difference between (a) the amount loaned to the Company through repurchase agreements, including interest payable, and (b) the cash and the fair value of the assets pledged by the Company as collateral, including accrued interest receivable on such securities | |\n\nappropriate, to allow timely decisions regarding required disclosure based on the definition of \"disclosure controls and procedures\" as promulgated under the Exchange Act and the rules and regulations thereunder. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.The Company, including its Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of its disclosure controls and procedures as of September 30, 2020. Based on the foregoing, the Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures were effective.Changes in Internal Controls over Financial ReportingThere have been no changes in the Company’s “internal control over financial reporting” (as defined in Rule 13a-15(f) of the Exchange Act) that occurred during the three and nine months ended September 30, 2020 that have materially affected, or were reasonably likely to materially affect, the Company’s internal control over financial reporting.PART II. OTHER INFORMATIONItem 1. Legal ProceedingsCurrently, no material legal proceedings are pending or, to our knowledge, threatened against us.Item 1A. Risk FactorsSee the Company's Annual Report on Form 10-K for the year ended December 31, 2019. The following risk factors are added to the Company’s risk factors previously disclosed. You should be aware that these risk factors and other information may not describe every risk facing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.The current outbreak of COVID-19 has caused severe disruptions in the U.S. and global economy and to our business, and may continue to have an adverse impact on our performance, financial condition and results of operations.The outbreak of COVID-19 in many countries continues to adversely impact global economic activity and has contributed to significant volatility in financial markets. On March 11, 2020, the World Health Organization publicly characterized COVID-19 as a pandemic. On March 13, 2020, the President of the United States declared the COVID-19 outbreak a national emergency. The global impact of the outbreak has been rapidly evolving, and as cases of the virus increased around the world, governments and organizations have implemented a variety of actions to mobilize efforts to mitigate the ongoing and expected impact. Many governments have reacted by instituting quarantines, restrictions on travel, school closures, bans on public events and on public gatherings, “shelter in place” or “stay at home” rules, restrictions on types of business that may continue to operate, and/or restrictions on types of construction projects that may continue. Although, in certain cases, exceptions may be available for certain essential operations and businesses, and in other cases certain of these restrictions have been relaxed or phased out, many of these or similar restrictions remain in place, continue to be implemented or additional restrictions are being considered. There is no assurance that any exceptions or easing of restrictions will enable us to avoid adverse effects to our results of operations and business. Further, such actions have created, and expect to continue to create, disruption in real estate financing transactions and the commercial real estate market and adversely impact a number of industries, including many small businesses throughout the United States. The outbreak has triggered a period of economic slowdown and experts are uncertain as to how long these conditions may last.In the United States, there have been a number of federal, state and local government initiatives applicable to a significant number of mortgage loans, to manage the spread of the virus and its impact on the economy, financial markets and continuity of businesses of all sizes and industries. On March 27, 2020, the U.S. Congress approved, and President Trump signed into law, the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”). The CARES Act provides approximately $2 trillion in financial assistance to individuals and businesses resulting from the outbreak of COVID-19. The CARES Act, among other things, provides certain measures to support individuals and businesses in 107\n| ● | to the extent the value of commercial real estate declines, which would also likely negatively impact the value of the loans we own, we could become subject to additional margin calls under our repurchase agreements; |\n| ● | our ability to continue to satisfy any additional margin calls from our lenders and to the extent we are unable to satisfy any such margin calls, any acceleration of our indebtedness, increase in the interest rate on advanced funds, termination of our ability to borrow funds from them, or foreclosure by our lenders on our assets; |\n| ● | difficulty accessing debt and equity capital on attractive terms, or at all; |\n| ● | a severe disruption and instability in the financial markets or deteriorations in credit and financing conditions may jeopardize the solvency and financial wherewithal of counterparties with whom we do business, including our borrowers and could affect our or our counterparties’ ability to make regular payments of principal and interest (whether due to an inability to make such payments, an unwillingness to make such payments, or a waiver of the requirement to make such payments on a timely basis or at all) and our ability to recover the full value of our loan, thus reducing our earnings and liquidity; |\n| ● | unavailability of information, resulting in restricted access to key inputs used to derive certain estimates and assumptions made in connection with evaluating our loans for impairments and establishing allowances for loan losses; |\n| ● | our ability to remain in compliance with the financial covenants under our borrowings, including in the event of impairments in the value of the loans we own; |\n| ● | disruptions to the efficient function of our operations because of, among other factors, any inability to access short-term or long-term financing for the loans we make; |\n| ● | our need to sell assets, including at a loss; |\n| ● | to the extent we elect or are forced to reduce our loan origination activities, such as the curtailment in the origination of purchased future receivables during the second quarter of 2020; |\n| ● | inability of other third-party vendors we rely on to conduct our business to operate effectively and continue to support our business and operations, including vendors that provide IT services, legal and accounting services, or other operational support services; |\n| ● | effects of legal and regulatory responses to concerns about the COVID-19 pandemic and related public health issues, which could result in additional regulation or restrictions affecting the conduct of our business; and |\n| ● | our ability to ensure operational continuity in the event our business continuity plan is not effective or ineffectually implemented or deployed during a disruption. |\n\nHolders of our common stock may not receive distributions or may receive them on a delayed basis and distributions may not be declared or paid or distributions may decrease over time. Distributions may be paid in shares of common stock, cash or a combination of shares of common stock and cash. Changes in the amount and timing of distributions we pay or in the tax characterization of distributions we pay may adversely affect the market price of our common stock or may result in holders of our common stock being taxed on distributions at a higher rate than initially expected.Our distributions are driven by a variety of factors, including our minimum distribution requirements under the REIT tax laws and our REIT taxable income (including certain items of non-cash income) as calculated pursuant to the Code. We are generally required to distribute to our stockholders at least 90% of our REIT taxable income, although our reported financial results for GAAP purposes may differ materially from our REIT taxable income.In the year ended December 31, 2019, we paid $63.3 million of cash distributions on our common stock, representing cumulative distributions of $1.60 per share. On March 11, 2020, the Company's Board of Directors declared a quarterly cash dividend of $0.40 per share of common stock. On March 20, 2020, the Company announced that the dividend would be paid in a combination of cash and common stock on April 30, 2020 to common stockholders of record as of the close of business of March 31, 2020, which resulted in the issuance of approximately 2.8 million shares of common stock on April 30, 2020. On June 15, 2020, the Company's Board of Directors declared a quarterly cash dividend of $0.25 per share of common stock to common stockholders of record as of the close of business on June 30, 2020. On September 15, 2020, the Company's Board of Directors declared a quarterly cash dividend of $0.30 per share of common stock to common stockholders of record as of the close of business on September 30, 2020.We continue to prudently evaluate our liquidity and review the ability and advisability of paying distributions in the future in light of our financial condition and the applicable minimum distribution requirements under applicable REIT tax laws and regulations. Our ability to continue to pay quarterly distributions in 2020 may be adversely affected by a number of factors, including the risk factors described in this Quarterly Report and in our Annual Report on Form 10-K for the year ended December 31, 2019. Further, we continue to monitor our cash balances and cash flows and may consider paying future distributions in shares of common stock, cash, or a combination of shares of common stock and cash. Any decision regarding the composition of such distributions will be made following an analysis and review of our liquidity, including our cash balances and cash flows, at the time of payment of the distribution. For example, we may determine to distribute shares of common stock in lieu of cash, or in combination with cash, in respect of our distribution obligations, which, among other things, could result in dilution to existing stockholders. To the extent we determine that future distributions would represent a return of capital to investors or would not be required under applicable REIT tax laws and regulations, rather than the distribution of income, we may determine to discontinue distribution payments until such time that distributions would again represent a distribution of income or be required under applicable REIT tax laws and regulations. Any reduction or elimination of our payment of distributions would not only reduce the amount of distributions you would receive as a holder of our common stock, but could also have the effect of reducing the market price of our common stock and our ability to raise capital in future securities offerings.In addition, the rate at which holders of our common stock are taxed on distributions we pay and the characterization of our distribution — be it ordinary income, capital gains, or a return of capital — could have an impact on the market price of our common stock. After we announce the expected characterization of distributions we have paid, the actual characterization (and, therefore, the rate at which holders of our common stock are taxed on the distributions they have received) could vary from our expectations, including due to errors, changes made in the course of preparing our corporate tax returns, or changes made in response to an audit by the Internal Revenue Service, or the IRS, with the result that holders of our common stock could incur greater income tax liabilities than expected.We may pay taxable distributions in our common stock and cash, in which case stockholders may sell shares of our common stock to pay tax on such distributions, placing downward pressure on the market price of our common stock.We may satisfy the REIT 90% distribution test with taxable distributions of our common stock. The IRS has issued Revenue Procedure 2017-45 authorizing elective cash/stock distributions to be made by \"publicly offered REITs.\" Pursuant to Revenue Procedure 2017-45, the IRS will treat the distribution of stock pursuant to an elective cash/stock distribution as a distribution of property under Section 301 of the Code (i.e., a distribution), as long as at least 20% of the total distribution is available in cash and certain other parameters detailed in the Revenue Procedure are satisfied. In 109\n| | | | | | | | | | | |\n| Period | | Total Number of Shares | | | Average Price Paid per Share | | Total Number of Shares Purchased as Part of Publicly Announced Program(1) | | | Maximum Number (or Approximate Dollar Value) of Shares that May Yet Be Purchased Under the Program(1) |\n| July 1 – July 31, 2020 | | - | | $ | - | | - | | $ | 25,000,000 |\n| August 1 – August 31, 2020 | | 712,421 | | | 9.73 | | 712,421 | | | 18,068,144 |\n| September 1 – September 30, 2020 | | 220,012 | | | 10.36 | | 220,012 | | | 15,788,819 |\n| Totals / Averages | | 932,433 | | $ | 9.96 | | 932,433 | | $ | 15,788,819 |\n| |\n| Exhibitnumber | Exhibit description |\n| 2.1 | * | Agreement and Plan of Merger, dated as of April 6, 2016, by and among ZAIS Financial Corp., ZAIS Financial Partners, L.P., ZAIS Merger Sub, LLC, Sutherland Asset Management Corporation and Sutherland Partners, L.P. (incorporated by reference to Exhibit 2.1 of the Registrant’s Current Report on Form 8-K filed April 7, 2016) |\n| | | |\n\n| 2.2 | * | Amendment No. 1 to the Agreement and Plan of Merger, dated as of May 9, 2016, by and among ZAIS Financial Corp., ZAIS Financial Partners, L.P., ZAIS Merger Sub, LLC, Sutherland Asset Management Corporation and Sutherland Partners, L.P. (incorporated by reference to Exhibit 2.1 of the Registrant's Current Report on Form 8-K filed May 9, 2016) |\n| | | |\n| 2.3 | * | Amendment No. 2 to the Agreement and Plan of Merger, dated as of August 4, 2016, by and among ZAIS Financial Corp., ZAIS Financial Partners, L.P., ZAIS Merger Sub, LLC, Sutherland Asset Management Corporation and Sutherland Partners, L.P. (incorporated by reference to Exhibit 2.3 of the Registrant's Current Report on Form 8-K filed November 4, 2016) |\n| | | |\n| 2.4 | * | Agreement and Plan of Merger, by and among Ready Capital Corporation, ReadyCap Merger Sub LLC and Owens Realty Mortgage, Inc., dated as of November 7, 2018 (incorporated by reference to Exhibit 2.1 of the Registrant's Current Report on Form 8-K filed November 9, 2018) |\n| |\n| 3.1 | * | Articles of Amendment and Restatement of ZAIS Financial Corp. (incorporated by reference to Exhibit 3.1 of the Registrant’s Form S-11, as amended (Registration No. 333-185938) |\n| | | |\n| 3.2 | * | Articles Supplementary of ZAIS Financial Corp. (incorporated by reference to Exhibit 3.2 of the Registrant’s Form S-11, as amended (Registration No. 333-185938) |\n| | | |\n| 3.3 | * | Articles of Amendment and Restatement of Sutherland Asset Management Corporation (incorporated by reference to Exhibit 3.1 of the Registrant’s Current Report on Form 8-K filed November 4, 2016) |\n| |\n| 3.4 | * | Articles of Amendment of Ready Capital Corporation (incorporated by reference to Exhibit 3.1 of the Registrant's Current Report on Form 8-K filed on September 26, 2018) |\n| | | |\n| 3.5 | * | Amended and Restated Bylaws of Ready Capital Corporation (incorporated by reference to Exhibit 3.2 to the Registrant’s Form 8-K filed on September 26, 2018) |\n| | | |\n| 4.1 | * | Specimen Common Stock Certificate of Ready Capital Corporation (incorporated by reference to Exhibit 4.1 to the Registrant’s Form S-4 filed on December 13, 2018) |\n| | | |\n| 4.2 | * | Indenture, dated February 13, 2017, by and among ReadyCap Holdings, LLC, as issuer, Sutherland Asset Management Corporation, Sutherland Partners, L.P., Sutherland Asset I, LLC and ReadyCap Commercial, LLC, each as guarantors, and U.S. Bank National Association, as trustee (incorporated by reference to Exhibit 4.1 of the Registrant's Current Report on Form 8-K filed February 13, 2017) |\n| | | |\n| 4.3 | * | First Supplemental Indenture, dated February 13, 2017, by and among ReadyCap Holdings, LLC, as issuer, Sutherland Asset Management Corporation, Sutherland Partners, L.P., Sutherland Asset I, LLC, ReadyCap Commercial, LLC, each as guarantors and U.S. Bank National Association, as trustee and as collateral agent, including the form of 7.5% Senior Secured Notes due 2022 and the related guarantees (incorporated by reference to Exhibit 4.2 of the Registrant's Current Report on Form 8-K filed February 13, 2017) |\n| | | |\n| 4.4 | * | Indenture, dated as of August 9, 2017, by and between Sutherland Asset Management Corporation and U.S. Bank National Association, as trustee (incorporated by reference to Exhibit 4.2 of the Registrant's Current Report on Form 8-K filed August 9, 2017) |\n| | | |\n| 4.5 | * | First Supplemental Indenture, dated as of August 9, 2017, by and between Sutherland Asset Management Corporation and U.S. Bank National Association, as trustee (incorporated by reference to Exhibit 4.3 of the Registrant's Current Report on Form 8-K filed August 9, 2017) |\n| | | |\n| 4.6 | * | Second Supplemental Indenture, dated as of April 27, 2018, by and between Sutherland Asset Management Corporation and U.S. Bank National Association, as trustee (incorporated by reference to Exhibit 4.2 of the Registrant's Current Report on Form 8-K filed April 27, 2018) |\n| | | |\n| 4.7 | * | Third Supplemental Indenture, dated as of February 26, 2019, by and between Ready Capital Corporation and U.S. Bank National Association, as trustee (incorporated by reference to Exhibit 4.7 of the Registrant's Current Report on Form 10-K filed March 13, 2019) |\n\n| | | |\n| 4.8 | * | Amendment No. 1, dated as of February 26, 2019, to the First Supplemental Indenture, dated as of August 9, 2017, by and between Ready Capital Corporation and U.S. Bank National Association, as trustee (incorporated by reference to Exhibit 4.8 of the Registrant's Current Report on Form 10-K filed March 13, 2019) |\n| | | |\n| 4.9 | * | Amendment No. 1, dated as of February 26, 2019, to the Second Supplemental Indenture, dated as of April 27, 2018, by and between Ready Capital Corporation and U.S. Bank National Association, as trustee (incorporated by reference to Exhibit 4.9 of the Registrant's Current Report on Form 10-K filed March 13, 2019) |\n| | | |\n| 4.10 | * | Fourth Supplemental Indenture, dated as of July 22, 2019, by and between Ready Capital Corporation and U.S. Bank National Association, as trustee (incorporated by reference to Exhibit 4.3 of the Registrant's Current Report on Form 8-K filed July 22, 2019) |\n| 10.1 | * | Third Amended and Restated Agreement of Limited Partnership of Sutherland Partners, L.P., dated as of March 5, 2019, by and among Ready Capital Corporation, as General Partner, and the limited partners listed on Exhibit A thereto (incorporated by reference to Exhibit 10.8 to the Registrant’s Form 10-K filed on March 13, 2019) |\n| | | |\n| 31.1 | | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| | | |\n| 31.2 | | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| | | |\n| 32.1 | ** | Certification of the Chief Executive Officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| | | |\n| 32.2 | ** | Certification of the Chief Financial Officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| | | |\n| 101.INS | | Inline XBRL Instance Document – the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. |\n| | | |\n| 101.SCH | | Inline XBRL Taxonomy Extension Schema Document |\n| | | |\n| 101.CAL | | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| | | |\n| 101.DEF | | Inline XBRL Taxonmy Extension Definition Linkbase Document |\n| | | |\n| 101.LAB | | Inline XBRL Taxonomy Extension Label Linkbase Document |\n| | | |\n| 101.PRE | | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| | | |\n| 104 | | The cover page from this quarterly Report on Form 10-Q for the quarter ended September 30, 2020, formatted in Inline XBRL (and contained in Exhibit 101). |\n\n| Date: November 6, 2020 | By: | /s/ Thomas E. Capasse |\n| | Thomas E. Capasse |\n| | Chairman of the Board and Chief Executive |\n| | (Principal Executive Officer) |\n| | |\n| | |\n| | |\n| | |\n| Date: November 6, 2020 | By: | /s/ Andrew Ahlborn |\n| | Andrew Ahlborn |\n| | Chief Financial Officer |\n| | (Principal Accounting and Financial Officer) |\n| | |\n| | |\n| | |\n| | |\n\n</text>\n\nCalculate the return on assets (ROA) for the \"Residential Mortgage Banking\" segment for the year 2020 (in percentage).\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"ground_truth": "Therefore, the answer is 3.6585784987627163."
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docmath_20000_40000
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1: Financial Statements\nPITNEY BOWES INC.\nCONDENSED CONSOLIDATED STATEMENTS OF INCOME\n(Unaudited; in thousands, except per share amounts)\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Revenue: |\n| Equipment sales | $ | 173,143 | $ | 163,857 | $ | 485,145 | $ | 495,328 |\n| Supplies | 61,306 | 71,174 | 198,631 | 215,178 |\n| Software | 89,087 | 97,700 | 257,760 | 283,241 |\n| Rentals | 102,747 | 108,420 | 309,706 | 333,729 |\n| Financing | 87,883 | 99,925 | 276,915 | 306,992 |\n| Support services | 123,954 | 136,820 | 383,632 | 415,615 |\n| Business services | 200,911 | 191,645 | 607,717 | 591,030 |\n| Total revenue | 839,031 | 869,541 | 2,519,506 | 2,641,113 |\n| Costs and expenses: |\n| Cost of equipment sales | 86,147 | 78,650 | 235,741 | 232,706 |\n| Cost of supplies | 20,348 | 21,629 | 60,662 | 65,912 |\n| Cost of software | 25,698 | 27,219 | 79,496 | 85,584 |\n| Cost of rentals | 16,041 | 21,423 | 54,951 | 63,127 |\n| Financing interest expense | 12,965 | 17,533 | 41,375 | 54,171 |\n| Cost of support services | 74,799 | 79,747 | 224,790 | 244,853 |\n| Cost of business services | 140,989 | 130,004 | 417,357 | 405,559 |\n| Selling, general and administrative | 300,983 | 309,211 | 916,445 | 939,318 |\n| Research and development | 28,680 | 29,153 | 89,761 | 83,693 |\n| Restructuring charges and asset impairments, net | 16,494 | 36 | 49,503 | 14,305 |\n| Interest expense, net | 22,294 | 20,165 | 62,394 | 65,200 |\n| Other (income) expense, net | — | (1,781 | ) | 536 | (94,916 | ) |\n| Total costs and expenses | 745,438 | 732,989 | 2,233,011 | 2,159,512 |\n| Income from continuing operations before income taxes | 93,593 | 136,552 | 286,495 | 481,601 |\n| Provision for income taxes | 23,197 | 42,676 | 93,615 | 145,574 |\n| Income from continuing operations | 70,396 | 93,876 | 192,880 | 336,027 |\n| Loss from discontinued operations, net of tax | (291 | ) | — | (1,951 | ) | (582 | ) |\n| Net income | 70,105 | 93,876 | 190,929 | 335,445 |\n| Less: Preferred stock dividends attributable to noncontrolling interests | 4,593 | 4,594 | 13,781 | 13,781 |\n| Net income attributable to Pitney Bowes Inc. | $ | 65,512 | $ | 89,282 | $ | 177,148 | $ | 321,664 |\n| Amounts attributable to common stockholders: |\n| Net income from continuing operations | $ | 65,803 | $ | 89,282 | $ | 179,099 | $ | 322,246 |\n| Loss from discontinued operations, net of tax | (291 | ) | — | (1,951 | ) | (582 | ) |\n| Net income attributable to Pitney Bowes Inc. | $ | 65,512 | $ | 89,282 | $ | 177,148 | $ | 321,664 |\n| Basic earnings per share attributable to common stockholders: |\n| Continuing operations | $ | 0.35 | $ | 0.45 | $ | 0.95 | $ | 1.60 |\n| Discontinued operations | — | — | (0.01 | ) | — |\n| Net income attributable to Pitney Bowes Inc. | $ | 0.35 | $ | 0.45 | $ | 0.94 | $ | 1.60 |\n| Diluted earnings per share attributable to common stockholders:(1) |\n| Continuing operations | $ | 0.35 | $ | 0.44 | $ | 0.94 | $ | 1.60 |\n| Discontinued operations | — | — | (0.01 | ) | — |\n| Net income attributable to Pitney Bowes Inc. | $ | 0.35 | $ | 0.44 | $ | 0.93 | $ | 1.59 |\n| Dividends declared per share of common stock | $ | 0.1875 | $ | 0.1875 | $ | 0.5625 | $ | 0.5625 |\n\n(1) The sum of earnings per share amounts may not equal the totals due to rounding.\nSee Notes to Condensed Consolidated Financial Statements\n3\nPITNEY BOWES INC.CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME(Unaudited; in thousands)\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Net income | $ | 70,105 | $ | 93,876 | $ | 190,929 | $ | 335,445 |\n| Less: Preferred stock dividends attributable to noncontrolling interests | 4,593 | 4,594 | 13,781 | 13,781 |\n| Net income attributable to Pitney Bowes Inc. | 65,512 | 89,282 | 177,148 | 321,664 |\n| Other comprehensive income (loss), net of tax: |\n| Foreign currency translations | 6,938 | (17,131 | ) | 37,263 | (76,153 | ) |\n| Net unrealized (loss) gain on cash flow hedges, net of tax of $(40), $79, $224 and $219, respectively | (64 | ) | 119 | 358 | 335 |\n| Net unrealized gain (loss) on investment securities, net of tax of $956, $721, $4,399 and $(142), respectively | 1,628 | 1,231 | 7,491 | (242 | ) |\n| Adjustments to pension and postretirement plans, net of tax of $(777) for the nine months ended September 30, 2016 | — | — | (1,230 | ) | — |\n| Amortization of pension and postretirement costs, net of tax of $3,243, $4,219, $10,362 and $12,001, respectively | 5,963 | 7,435 | 18,791 | 21,364 |\n| Other comprehensive income (loss), net of tax | 14,465 | (8,346 | ) | 62,673 | (54,696 | ) |\n| Comprehensive income attributable to Pitney Bowes Inc. | $ | 79,977 | $ | 80,936 | $ | 239,821 | $ | 266,968 |\n\nSee Notes to Condensed Consolidated Financial Statements\n4\nPITNEY BOWES INC.CONDENSED CONSOLIDATED BALANCE SHEETS(Unaudited; in thousands, except share and per share amounts)\n| September 30, 2016 | December 31, 2015 |\n| ASSETS |\n| Current assets: |\n| Cash and cash equivalents | $ | 992,089 | $ | 650,557 |\n| Short-term investments | 24,259 | 117,021 |\n| Accounts receivable (net of allowance of $10,722 and $9,997, respectively) | 427,556 | 476,583 |\n| Short-term finance receivables (net of allowance of $13,033 and $15,480, respectively) | 870,256 | 918,383 |\n| Inventories | 108,766 | 88,824 |\n| Current income taxes | 13,060 | 6,584 |\n| Other current assets and prepayments | 65,622 | 67,400 |\n| Total current assets | 2,501,608 | 2,325,352 |\n| Property, plant and equipment, net | 312,597 | 330,088 |\n| Rental property and equipment, net | 179,554 | 177,515 |\n| Long-term finance receivables (net of allowance of $5,092 and $6,210, respectively) | 704,294 | 760,657 |\n| Goodwill | 1,766,418 | 1,745,957 |\n| Intangible assets, net | 174,221 | 187,378 |\n| Non-current income taxes | 66,547 | 70,294 |\n| Other assets | 553,635 | 525,891 |\n| Total assets | $ | 6,258,874 | $ | 6,123,132 |\n| LIABILITIES, NONCONTROLLING INTERESTS AND STOCKHOLDERS’ EQUITY |\n| Current liabilities: |\n| Accounts payable and accrued liabilities | $ | 1,307,808 | $ | 1,448,321 |\n| Current income taxes | 19,170 | 16,620 |\n| Current portion of long-term debt and notes payable | 535,289 | 461,085 |\n| Advance billings | 303,153 | 353,025 |\n| Total current liabilities | 2,165,420 | 2,279,051 |\n| Deferred taxes on income | 229,998 | 205,668 |\n| Tax uncertainties and other income tax liabilities | 57,423 | 68,429 |\n| Long-term debt | 2,831,767 | 2,489,583 |\n| Other non-current liabilities | 547,444 | 605,310 |\n| Total liabilities | 5,832,052 | 5,648,041 |\n| Commitments and contingencies (See Note 13) |\n| Noncontrolling interests (Preferred stockholders’ equity in subsidiaries) | 296,370 | 296,370 |\n| Stockholders’ equity: |\n| Cumulative preferred stock, $50 par value, 4% convertible | 1 | 1 |\n| Cumulative preference stock, no par value, $2.12 convertible | 489 | 505 |\n| Common stock, $1 par value (480,000,000 shares authorized; 323,337,912 shares issued) | 323,338 | 323,338 |\n| Additional paid-in capital | 149,997 | 161,280 |\n| Retained earnings | 5,226,894 | 5,155,537 |\n| Accumulated other comprehensive loss | (825,962 | ) | (888,635 | ) |\n| Treasury stock, at cost (137,701,038 and 127,816,704 shares, respectively) | (4,744,305 | ) | (4,573,305 | ) |\n| Total Pitney Bowes Inc. stockholders’ equity | 130,452 | 178,721 |\n| Total liabilities, noncontrolling interests and stockholders’ equity | $ | 6,258,874 | $ | 6,123,132 |\n\nSee Notes to Condensed Consolidated Financial Statements\n5\nPITNEY BOWES INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited; in thousands)\n| Nine Months Ended September 30, |\n| 2016 | 2015 |\n| Cash flows from operating activities: |\n| Net income | $ | 190,929 | $ | 335,445 |\n| Restructuring payments | (51,161 | ) | (46,056 | ) |\n| Special pension plan contributions | (36,731 | ) | — |\n| Tax payments related to other investments | — | (20,602 | ) |\n| Adjustments to reconcile net income to net cash provided by operating activities: |\n| Loss (gain) on disposal of businesses | 3,938 | (109,069 | ) |\n| Depreciation and amortization | 140,225 | 127,486 |\n| Gain on debt forgiveness | (10,000 | ) | — |\n| Stock-based compensation | 16,014 | 14,921 |\n| Restructuring charges and asset impairments, net | 49,503 | 14,305 |\n| Changes in operating assets and liabilities, net of acquisitions/divestitures: |\n| Decrease in accounts receivable | 51,853 | 29,128 |\n| Decrease in finance receivables | 113,180 | 91,184 |\n| Increase in inventories | (20,489 | ) | (20,850 | ) |\n| Decrease (increase) in other current assets and prepayments | 3,312 | (16,697 | ) |\n| Decrease in accounts payable and accrued liabilities | (125,248 | ) | (138,481 | ) |\n| Increase in current and non-current income taxes | 1,543 | 68,894 |\n| Decrease in advance billings | (47,183 | ) | (535 | ) |\n| Other, net | 11,244 | 22,327 |\n| Net cash provided by operating activities | 290,929 | 351,400 |\n| Cash flows from investing activities: |\n| Purchases of available-for-sale securities | (163,134 | ) | (153,471 | ) |\n| Proceeds from sales/maturities of available-for-sale securities | 167,424 | 159,436 |\n| Net change in short-term and other investments | 62,256 | (119 | ) |\n| Capital expenditures | (115,532 | ) | (130,328 | ) |\n| Proceeds from sale of buildings | 17,671 | 38,640 |\n| Acquisition of businesses, net of cash acquired | (37,942 | ) | (387,391 | ) |\n| Divestiture of businesses, net of cash transferred | — | 290,543 |\n| Change in reserve account deposits | 1,813 | (25,630 | ) |\n| Other investing activities | (7,420 | ) | 3,011 |\n| Net cash used in investing activities | (74,864 | ) | (205,309 | ) |\n| Cash flows from financing activities: |\n| Proceeds from the issuance of long-term debt | 894,744 | 950 |\n| Principal payments of long-term debt | (371,007 | ) | (404,952 | ) |\n| Net change in short-term borrowings | (90,000 | ) | 150,000 |\n| Dividends paid to stockholders | (105,791 | ) | (113,158 | ) |\n| Common stock repurchases | (197,267 | ) | (100,000 | ) |\n| Dividends paid to noncontrolling interests | (9,188 | ) | (9,188 | ) |\n| Other financing activities | — | 4,531 |\n| Net cash provided by (used in) financing activities | 121,491 | (471,817 | ) |\n| Effect of exchange rate changes on cash and cash equivalents | 3,976 | (38,370 | ) |\n| Increase (decrease) in cash and cash equivalents | 341,532 | (364,096 | ) |\n| Cash and cash equivalents at beginning of period | 650,557 | 1,054,118 |\n| Cash and cash equivalents at end of period | $ | 992,089 | $ | 690,022 |\n| Cash interest paid | $ | 132,359 | $ | 146,838 |\n| Cash income tax payments, net of refunds | $ | 95,487 | $ | 95,770 |\n\nSee Notes to Condensed Consolidated Financial Statements\n6\nPITNEY BOWES INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited; table amounts in thousands unless otherwise noted, except per share amounts)\n1. Description of Business and Basis of Presentation\nPitney Bowes Inc. (we, us, our, or the company), was incorporated in the state of Delaware in 1920. We are a global technology company offering innovative products and solutions that help our clients navigate the complex world of commerce. We offer products and solutions for customer information management, location intelligence and customer engagement to help our clients market to their customers, and products and solutions for shipping, mailing, and cross border ecommerce that enable the sending of packages across the globe. Clients around the world rely on our products, solutions and services. For more information about us, our products, services and solutions, visit www.pb.com.\nThe accompanying unaudited Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information and the instructions to Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In addition, the December 31, 2015 Condensed Consolidated Balance Sheet data was derived from audited financial statements, but does not include all disclosures required by GAAP. In management's opinion, all adjustments, consisting only of normal recurring adjustments, considered necessary to fairly state our financial position, results of operations and cash flows for the periods presented have been included. Operating results for the periods presented are not necessarily indicative of the results that may be expected for any other interim period or for the year ending December 31, 2016. These statements should be read in conjunction with the financial statements and notes thereto included in our Annual Report to Stockholders on Form 10-K for the year ended December 31, 2015 (2015 Annual Report).\nDuring the second quarter of 2016, we determined that certain amounts included in finance receivables and rental property and equipment should be classified as accounts receivable and other current assets and prepayments. Accordingly, the Condensed Consolidated Balance Sheet as of December 31, 2015 was revised to increase accounts receivable by $19 million and prepaid and other current assets by $3 million and reduce rental property and equipment by $3 million, short-term finance receivables by $17 million and long-term finance receivables by $2 million. The Condensed Consolidated Statement of Cash Flows for the period ended September 30, 2015 has also been adjusted accordingly.\nIn 2015, we determined that certain investments were classified as cash and cash equivalents. Accordingly, the Condensed Consolidated Statement of Cash Flows for the period ended September 30, 2015 has been revised to reduce beginning cash and cash equivalents by $25 million and ending cash and cash equivalents by $26 million and investments and with corresponding changes to investment activity.\nNew Accounting Pronouncements - Standards Adopted in 2016\nIn September 2015, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) 2015-16, Business Combinations - Simplifying the Accounting for Measurement-Period Adjustments, which eliminates the requirement to restate prior period financial statements for measurement period adjustments. The new guidance requires that the cumulative impact of a measurement period adjustment (including the impact on prior periods) be recognized in the reporting period in which the adjustment is identified. Consistent with existing guidance, the new guidance requires an acquirer to disclose the nature and amount of measurement period adjustments. We adopted this standard as of January 1, 2016, and there was no impact to the consolidated financial statements.\nIn April 2015, the FASB issued ASU 2015-05, Intangibles - Goodwill and Other - Internal-Use Software, Customer's Accounting for Fees Paid in a Cloud Computing Arrangement, which provides guidance on fees paid by an entity in a cloud computing arrangement and whether an arrangement includes a license to the underlying software. We adopted this standard as of January 1, 2016, and there was no impact to the consolidated financial statements.\nIn April 2015, the FASB issued ASU 2015-03, Simplifying the Presentation of Debt Issuance Costs, which requires debt issuance costs to be presented in the balance sheet as a direct deduction from the associated debt liability. We adopted this standard effective January 1, 2016 and recast the Condensed Consolidated Balance Sheet at December 31, 2015 to reduce other assets and long-term debt by $18 million.\nIn January 2015, the FASB issued ASU 2015-01, Income Statement - Extraordinary and Unusual Items, which removes the concept of extraordinary items, thereby eliminating the need for companies to assess transactions for extraordinary treatment. The standard retained the presentation and disclosure requirements for items that are unusual in nature and/or infrequent in occurrence. We adopted this standard as of January 1, 2016, and there was no impact to the financial statements.\n7\nPITNEY BOWES INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited; table amounts in thousands unless otherwise noted, except per share amounts)\nNew Accounting Pronouncements - Standards Not Yet Adopted\nIn August, 2016, the FASB issued ASU No. 2016-15, Classification of Certain Cash Receipts and Cash Payments (a consensus of the Emerging Issues Task Force). The ASU is intended to reduce diversity in practice in presentation and classification of certain cash receipts and cash payments by providing guidance on eight specific cash flow issues. The ASU is effective for interim and annual periods beginning after December 15, 2017 and early adoption is permitted, including adoption during an interim period. We are currently assessing the impact this standard will have on our consolidated statement of cash flows.\nIn June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses. The ASU sets forth a “current expected credit loss” (CECL) model which requires companies to measure all expected credit losses for financial instruments held at the reporting date based on historical experience, current conditions and reasonable supportable forecasts. This replaces the existing incurred loss model and is applicable to the measurement of credit losses on financial assets measured at amortized cost and applies to some off-balance sheet credit exposures. This standard is effective for interim and annual periods beginning after December 15, 2019. We are currently assessing the impact this standard will have on our financial statements and disclosures.\nIn March 2016, the FASB issued ASU 2016-09, Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. The standard includes multiple provisions intended to simplify various aspects of the accounting for share-based payments. The standard is effective for interim and annual periods beginning after December 15, 2016 and early adoption is permitted. We are currently assessing the impact this standard will have on our financial statements and disclosures.\nIn February 2016, the FASB issued ASU 2016-02, Leases. This standard, among other things, will require lessees to recognize almost all leases on their balance sheet as a right-of-use asset and a lease liability and result in enhanced disclosures. The standard is effective for interim and annual periods beginning after December 15, 2018. The standard requires modified retrospective transition and early adoption is permitted. We are currently assessing the impact this standard will have on our financial statements and disclosures.\nIn January 2016, the FASB issued ASU 2016-01, Financial Instruments–Overall: Recognition and Measurement of Financial Assets and Financial Liabilities. This standard primarily affects the accounting for equity investments, financial liabilities under the fair value option, and the presentation and disclosure requirements for financial instruments. The standard is effective for interim and annual periods beginning after December 15, 2017, and early adoption is permitted. We are currently assessing the impact this standard will have on our financial statements and disclosures.\nIn July 2015, the FASB issued ASU 2015-11, Inventory - Simplifying the Measurement of Inventory, which requires inventory to be measured at the lower of cost and net realizable value (estimated selling price less reasonably predictable costs of completion, disposal and transportation). Inventory measured using the last-in, first-out (LIFO) basis is not impacted by the new guidance. The standard is effective for interim and annual periods beginning after December 15, 2016 and early adoption is permitted. We do not believe this standard will have a significant impact on our financial statements or disclosures.\nIn May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers. The standard requires companies to recognize revenue for the transfer of goods and services to customers in amounts that reflect the consideration the company expects to receive in exchange for those goods and services. The standard will also result in enhanced disclosures about revenue. In July 2015, the FASB approved a one-year deferral of the effective date. This standard is now effective for fiscal periods beginning after December 15, 2017. The standard can be adopted either retrospectively or as a cumulative-effect adjustment. Companies are permitted to adopt the standard as early as the original public entity effective date (fiscal periods beginning after December 15, 2016). Early adoption prior to that date is prohibited. We are in the process of evaluating a sample of contracts under the new standard. At this point, we cannot estimate the financial statement impact of this standard upon adoption, nor have we decided on the transition method we will use to adopt this standard.\n8\nPITNEY BOWES INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited; table amounts in thousands unless otherwise noted, except per share amounts)\n2. Segment Information\nThe principal products and services of each of our reportable segments are as follows:\nSmall & Medium Business Solutions:\nNorth America Mailing: Includes the revenue and related expenses from the sale, rental, financing and servicing of mailing equipment, software and supplies for small and medium businesses to efficiently create physical and digital mail and evidence postage for the sending of mail, flats and parcels in the U.S. and Canada.\nInternational Mailing: Includes the revenue and related expenses from the sale, rental, financing and servicing of mailing equipment, software and supplies for small and medium businesses to efficiently create physical and digital mail and evidence postage for the sending of mail, flats and parcels in areas outside the U.S. and Canada.\nEnterprise Business Solutions:\nProduction Mail: Includes the worldwide revenue and related expenses from the sale of production mail inserting and sortation equipment, high-speed production print systems, supplies and related support services to large enterprise clients to process inbound and outbound mail.\nPresort Services: Includes revenue and related expenses from presort mail services for our large enterprise clients to qualify large mail volumes for postal worksharing discounts.\nDigital Commerce Solutions:\nSoftware Solutions: Includes the worldwide revenue and related expenses from the licensing of non-equipment-based mailing, customer information management, location intelligence and customer engagement solutions and related support services.\nGlobal Ecommerce: Includes the worldwide revenue and related expenses from shipping solutions and cross-border ecommerce.\nWe determine segment earnings before interest and taxes (EBIT) by deducting from segment revenue the related costs and expenses attributable to the segment. Segment EBIT excludes interest, taxes, general corporate expenses, restructuring charges, and other items that are not allocated to a particular business segment. Management uses segment EBIT to measure profitability and performance at the segment level and believes that it provides a useful measure of operating performance and underlying trends of the businesses. Segment EBIT may not be indicative of our overall consolidated performance and therefore, should be read in conjunction with our consolidated results of operations.\n9\nPITNEY BOWES INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited; table amounts in thousands unless otherwise noted, except per share amounts)\nRevenue and EBIT by business segment is presented below:\n| Revenue |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| North America Mailing | $ | 329,995 | $ | 353,159 | $ | 1,001,789 | $ | 1,071,824 |\n| International Mailing | 95,628 | 104,615 | 305,725 | 331,398 |\n| Small & Medium Business Solutions | 425,623 | 457,774 | 1,307,514 | 1,403,222 |\n| Production Mail | 106,350 | 101,646 | 289,649 | 298,880 |\n| Presort Services | 114,053 | 115,912 | 357,214 | 351,365 |\n| Enterprise Business Solutions | 220,403 | 217,558 | 646,863 | 650,245 |\n| Software Solutions | 89,031 | 97,638 | 257,417 | 282,916 |\n| Global Ecommerce | 103,974 | 96,571 | 307,712 | 249,923 |\n| Digital Commerce Solutions | 193,005 | 194,209 | 565,129 | 532,839 |\n| Other | — | — | — | 54,807 |\n| Total revenue | $ | 839,031 | $ | 869,541 | $ | 2,519,506 | $ | 2,641,113 |\n\n| EBIT |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| North America Mailing | $ | 138,588 | $ | 159,319 | $ | 436,730 | $ | 482,376 |\n| International Mailing | 9,733 | 10,739 | 34,365 | 36,585 |\n| Small & Medium Business Solutions | 148,321 | 170,058 | 471,095 | 518,961 |\n| Production Mail | 15,696 | 12,401 | 35,434 | 31,461 |\n| Presort Services | 19,181 | 25,908 | 69,305 | 76,946 |\n| Enterprise Business Solutions | 34,877 | 38,309 | 104,739 | 108,407 |\n| Software Solutions | 10,329 | 14,613 | 17,908 | 34,904 |\n| Global Ecommerce | 4,389 | (1,240 | ) | 8,835 | 9,962 |\n| Digital Commerce Solutions | 14,718 | 13,373 | 26,743 | 44,866 |\n| Other | — | — | — | 10,569 |\n| Total EBIT | 197,916 | 221,740 | 602,577 | 682,803 |\n| Reconciling items: |\n| Interest, net | (35,259 | ) | (37,698 | ) | (103,769 | ) | (119,371 | ) |\n| Unallocated corporate expenses | (51,992 | ) | (49,235 | ) | (158,536 | ) | (151,959 | ) |\n| Restructuring charges and asset impairments, net | (16,494 | ) | (36 | ) | (49,503 | ) | (14,305 | ) |\n| Acquisition and disposition-related expenses | (578 | ) | — | (3,738 | ) | (10,483 | ) |\n| Other income (expense), net | — | 1,781 | (536 | ) | 94,916 |\n| Income from continuing operations before income taxes | 93,593 | 136,552 | 286,495 | 481,601 |\n| Provision for income taxes | 23,197 | 42,676 | 93,615 | 145,574 |\n| Loss from discontinued operations, net of tax | (291 | ) | — | (1,951 | ) | (582 | ) |\n| Net income | $ | 70,105 | $ | 93,876 | $ | 190,929 | $ | 335,445 |\n\n10\nPITNEY BOWES INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited; table amounts in thousands unless otherwise noted, except per share amounts)\n3. Earnings per Share\nThe calculations of basic and diluted earnings per share are presented below. The sum of earnings per share amounts may not equal the totals due to rounding.\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Numerator: |\n| Amounts attributable to common stockholders: |\n| Net income from continuing operations | $ | 65,803 | $ | 89,282 | $ | 179,099 | $ | 322,246 |\n| Loss from discontinued operations, net of tax | (291 | ) | — | (1,951 | ) | (582 | ) |\n| Net income attributable to Pitney Bowes Inc. (numerator for diluted EPS) | 65,512 | 89,282 | 177,148 | 321,664 |\n| Less: Preference stock dividend | 10 | 10 | 29 | 31 |\n| Income attributable to common stockholders (numerator for basic EPS) | $ | 65,502 | $ | 89,272 | $ | 177,119 | $ | 321,633 |\n| Denominator: |\n| Weighted-average shares used in basic EPS | 185,603 | 199,874 | 188,634 | 200,825 |\n| Effect of dilutive shares: |\n| Conversion of Preferred stock and Preference stock | 299 | 318 | 301 | 326 |\n| Employee stock plans | 781 | 825 | 657 | 734 |\n| Weighted-average shares used in diluted EPS | 186,683 | 201,017 | 189,592 | 201,885 |\n| Basic earnings per share: |\n| Continuing operations | $ | 0.35 | $ | 0.45 | $ | 0.95 | $ | 1.60 |\n| Discontinued operations | — | — | (0.01 | ) | — |\n| Net income | $ | 0.35 | $ | 0.45 | $ | 0.94 | $ | 1.60 |\n| Diluted earnings per share: |\n| Continuing operations | $ | 0.35 | $ | 0.44 | $ | 0.94 | $ | 1.60 |\n| Discontinued operations | — | — | (0.01 | ) | — |\n| Net income | $ | 0.35 | $ | 0.44 | $ | 0.93 | $ | 1.59 |\n| Anti-dilutive shares not used in calculating diluted weighted-average shares: | 8,036 | 7,934 | 8,148 | 8,609 |\n\n4. Inventories\nInventories are stated at the lower of cost or market. Cost is determined on the LIFO basis for most U.S. inventories and on the first-in, first-out (FIFO) basis for most non-U.S. inventories. Inventories at September 30, 2016 and December 31, 2015 consisted of the following:\n| September 30, 2016 | December 31, 2015 |\n| Raw materials | $ | 35,228 | $ | 25,803 |\n| Work in process | 8,512 | 6,408 |\n| Supplies and service parts | 45,653 | 44,323 |\n| Finished products | 31,701 | 24,618 |\n| Inventory at FIFO cost | 121,094 | 101,152 |\n| Excess of FIFO cost over LIFO cost | (12,328 | ) | (12,328 | ) |\n| Total inventory, net | $ | 108,766 | $ | 88,824 |\n\n11\nPITNEY BOWES INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited; table amounts in thousands unless otherwise noted, except per share amounts)\n5. Finance Assets\nFinance Receivables\nFinance receivables are comprised of sales-type lease receivables and unsecured revolving loan receivables. Sales-type lease receivables are generally due in monthly, quarterly or semi-annual installments over periods ranging from three to five years. Loan receivables arise primarily from financing services offered to our customers for postage and supplies. Loan receivables are generally due each month; however, customers may rollover outstanding balances. Interest is recognized on loan receivables using the effective interest method and related annual fees are initially deferred and recognized ratably over the annual period covered. Customer acquisition costs are expensed as incurred. During the second quarter of 2016, we determined that certain finance receivables with a net investment of $35 million at December 31, 2015 classified as a sales type lease receivable should have been classified as loan receivables. Accordingly, prior period amounts have been revised to reflect this change.\nFinance receivables at September 30, 2016 and December 31, 2015 consisted of the following:\n| September 30, 2016 | December 31, 2015 |\n| North America | International | Total | North America | International | Total |\n| Sales-type lease receivables |\n| Gross finance receivables | $ | 1,083,873 | $ | 287,519 | $ | 1,371,392 | $ | 1,157,189 | $ | 303,854 | $ | 1,461,043 |\n| Unguaranteed residual values | 95,618 | 14,701 | 110,319 | 100,000 | 15,709 | 115,709 |\n| Unearned income | (228,709 | ) | (63,599 | ) | (292,308 | ) | (247,854 | ) | (68,965 | ) | (316,819 | ) |\n| Allowance for credit losses | (6,054 | ) | (2,587 | ) | (8,641 | ) | (6,606 | ) | (3,542 | ) | (10,148 | ) |\n| Net investment in sales-type lease receivables | 944,728 | 236,034 | 1,180,762 | 1,002,729 | 247,056 | 1,249,785 |\n| Loan receivables |\n| Loan receivables | 365,725 | 37,547 | 403,272 | 399,193 | 41,604 | 440,797 |\n| Allowance for credit losses | (8,288 | ) | (1,196 | ) | (9,484 | ) | (10,024 | ) | (1,518 | ) | (11,542 | ) |\n| Net investment in loan receivables | 357,437 | 36,351 | 393,788 | 389,169 | 40,086 | 429,255 |\n| Net investment in finance receivables | $ | 1,302,165 | $ | 272,385 | $ | 1,574,550 | $ | 1,391,898 | $ | 287,142 | $ | 1,679,040 |\n\nAllowance for Credit Losses\nWe provide an allowance for probable credit losses based on historical loss experience, the nature and volume of our portfolios, adverse situations that may affect a client's ability to pay, prevailing economic conditions and our ability to manage the collateral. We continually evaluate the adequacy of the allowance for credit losses and make adjustments as necessary. The assumptions used in determining an estimate of credit losses are inherently subjective and actual results may differ significantly from estimated reserves.\nWe establish credit approval limits based on the credit quality of the client and the type of equipment financed. Our policy is to discontinue revenue recognition for lease receivables that are more than 120 days past due and for loan receivables that are more than 90 days past due. We resume revenue recognition when the client's payments reduce the account aging to less than 60 days past due. Finance receivables deemed uncollectible are written off against the allowance after all collection efforts have been exhausted and management deems the account to be uncollectible. We believe that our finance receivable credit risk is low because of the geographic and industry diversification of our clients and small account balances for most of our clients.\n12\nPITNEY BOWES INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited; table amounts in thousands unless otherwise noted, except per share amounts)\nActivity in the allowance for credit losses for the nine months ended September 30, 2016 and 2015 was as follows:\n| Sales-type Lease Receivables | Loan Receivables |\n| NorthAmerica | International | NorthAmerica | International | Total |\n| Balance at January 1, 2016 | $ | 6,606 | $ | 3,542 | $ | 10,024 | $ | 1,518 | $ | 21,690 |\n| Amounts charged to expense | 2,881 | 464 | 4,217 | 688 | 8,250 |\n| Write-offs and other | (3,433 | ) | (1,419 | ) | (5,953 | ) | (1,010 | ) | (11,815 | ) |\n| Balance at September 30, 2016 | $ | 6,054 | $ | 2,587 | $ | 8,288 | $ | 1,196 | $ | 18,125 |\n| Sales-type Lease Receivables | Loan Receivables |\n| NorthAmerica | International | NorthAmerica | International | Total |\n| Balance at January 1, 2015 | $ | 10,125 | $ | 5,024 | $ | 11,068 | $ | 1,788 | $ | 28,005 |\n| Amounts charged to expense | 793 | 183 | 6,180 | 867 | 8,023 |\n| Write-offs and other | (3,523 | ) | (1,711 | ) | (7,260 | ) | (1,005 | ) | (13,499 | ) |\n| Balance at September 30, 2015 | $ | 7,395 | $ | 3,496 | $ | 9,988 | $ | 1,650 | $ | 22,529 |\n\nAging of Receivables\nThe aging of gross finance receivables at September 30, 2016 and December 31, 2015 was as follows:\n| September 30, 2016 |\n| Sales-type Lease Receivables | Loan Receivables |\n| NorthAmerica | International | NorthAmerica | International | Total |\n| 1 - 90 days | $ | 1,017,772 | $ | 282,269 | $ | 361,883 | $ | 37,251 | $ | 1,699,175 |\n| > 90 days | 66,101 | 5,250 | 3,842 | 296 | 75,489 |\n| Total | $ | 1,083,873 | $ | 287,519 | $ | 365,725 | $ | 37,547 | $ | 1,774,664 |\n| Past due amounts > 90 days |\n| Still accruing interest | $ | 10,447 | $ | 1,748 | $ | — | $ | — | $ | 12,195 |\n| Not accruing interest | 55,654 | 3,502 | 3,842 | 296 | 63,294 |\n| Total | $ | 66,101 | $ | 5,250 | $ | 3,842 | $ | 296 | $ | 75,489 |\n\nAs of September 30, 2016, we had North America sales-type lease receivables aged greater than 90 days with a contract value of $66 million. As of October 30, 2016, we have received payments with a contract value of approximately $30 million related to these receivables.\n| December 31, 2015 |\n| Sales-type Lease Receivables | Loan Receivables |\n| NorthAmerica | International | NorthAmerica | International | Total |\n| 1 - 90 days | $ | 1,138,031 | $ | 298,772 | $ | 395,573 | $ | 41,117 | $ | 1,873,493 |\n| > 90 days | 19,158 | 5,082 | 3,620 | 487 | 28,347 |\n| Total | $ | 1,157,189 | $ | 303,854 | $ | 399,193 | $ | 41,604 | $ | 1,901,840 |\n| Past due amounts > 90 days |\n| Still accruing interest | $ | 5,041 | $ | 1,617 | $ | — | $ | — | $ | 6,658 |\n| Not accruing interest | 14,117 | 3,465 | 3,620 | 487 | 21,689 |\n| Total | $ | 19,158 | $ | 5,082 | $ | 3,620 | $ | 487 | $ | 28,347 |\n\n13\nPITNEY BOWES INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited; table amounts in thousands unless otherwise noted, except per share amounts)\nCredit Quality\nThe extension of credit and management of credit lines to new and existing clients uses a combination of an automated credit score, where available, and a detailed manual review of the client's financial condition and, when applicable, payment history. Once credit is granted, the payment performance of the client is managed through automated collections processes and is supplemented with direct follow up should an account become delinquent. We have robust automated collections and extensive portfolio management processes. The portfolio management processes ensure that our global strategy is executed, collection resources are allocated appropriately and enhanced tools and processes are implemented as needed.\nWe use a third party to score the majority of the North America portfolio on a quarterly basis using a commercial credit score. We do not use a third party to score our International portfolio because the cost to do so is prohibitive, given that it is a localized process and there is no single credit score model that covers all countries.\nThe table below shows the North America portfolio at September 30, 2016 and December 31, 2015 by relative risk class based on the relative scores of the accounts within each class. The relative scores are determined based on a number of factors, including the company type, ownership structure, payment history and financial information. A fourth class is shown for accounts that are not scored. Absence of a score is not indicative of the credit quality of the account. The degree of risk (low, medium, high), as defined by the third party, refers to the relative risk that an account in the next 12 month period may become delinquent.\n| • | Low risk accounts are companies with very good credit scores and are considered to approximate the top 30% of all commercial borrowers. |\n\n| • | Medium risk accounts are companies with average to good credit scores and are considered to approximate the middle 40% of all commercial borrowers. |\n\n| • | High risk accounts are companies with poor credit scores, are delinquent or are at risk of becoming delinquent and are considered to approximate the bottom 30% of all commercial borrowers. |\n\n| September 30, 2016 | December 31, 2015 |\n| Sales-type lease receivables |\n| Low | $ | 824,756 | $ | 886,198 |\n| Medium | 172,278 | 192,645 |\n| High | 19,339 | 37,573 |\n| Not Scored | 67,500 | 40,773 |\n| Total | $ | 1,083,873 | $ | 1,157,189 |\n| Loan receivables |\n| Low | $ | 278,210 | $ | 295,725 |\n| Medium | 70,052 | 85,671 |\n| High | 6,648 | 10,810 |\n| Not Scored | 10,815 | 6,987 |\n| Total | $ | 365,725 | $ | 399,193 |\n\n14\nPITNEY BOWES INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited; table amounts in thousands unless otherwise noted, except per share amounts)\n6. Acquisitions, Intangible Assets and Goodwill\nAcquisitions\nOn July 1, 2016, we acquired Maponics for $24 million, net of cash acquired. Maponics provides comprehensive boundary information and geospatial data that support location-based services and analytics and will be reported within our Software Solutions segment.\nOn January 12, 2016, we acquired Enroute for $14 million in cash. Additional cash payments may also be required during 2017-2019 based on the achievement of certain annual revenue targets for 2016-2018. Enroute is a software-as-a-service enterprise retail and fulfillment solutions company and is reported within our Global Ecommerce segment.\nIn June 2015, we acquired Borderfree, Inc. (\"Borderfree\"). During the second quarter of 2016, we obtained new information about facts and circumstances that existed as of the acquisition date and increased accounts payable and accrued expenses and goodwill acquired in the Borderfree acquisition by $2 million. On a supplemental pro forma basis, had we acquired Borderfree on January 1, 2015, our revenues would have been $47 million higher for the nine months ended September 30, 2015. The impact on our earnings would not have been material.\nIntangible Assets\nIntangible assets at September 30, 2016 and December 31, 2015 consisted of the following:\n| September 30, 2016 | December 31, 2015 |\n| GrossCarryingAmount | AccumulatedAmortization | NetCarryingAmount | GrossCarryingAmount | AccumulatedAmortization | NetCarryingAmount |\n| Customer relationships | $ | 450,890 | $ | (299,224 | ) | $ | 151,666 | $ | 437,459 | $ | (272,353 | ) | $ | 165,106 |\n| Software & technology | 152,201 | (137,680 | ) | 14,521 | 149,591 | (135,198 | ) | 14,393 |\n| Trademarks & other | 36,851 | (28,817 | ) | 8,034 | 35,314 | (27,435 | ) | 7,879 |\n| Total intangible assets | $ | 639,942 | $ | (465,721 | ) | $ | 174,221 | $ | 622,364 | $ | (434,986 | ) | $ | 187,378 |\n\nAmortization expense was $10 million and $11 million for the three months ended September 30, 2016 and 2015, respectively and $32 million and $27 million, for the nine months ended September 30, 2016 and 2015, respectively.\nFuture amortization expense as of September 30, 2016 was as follows:\n| Remaining for year ending December 31, 2016 | $ | 8,189 |\n| Year ending December 31, 2017 | 29,721 |\n| Year ending December 31, 2018 | 27,418 |\n| Year ending December 31, 2019 | 23,992 |\n| Year ending December 31, 2020 | 18,836 |\n| Thereafter | 66,065 |\n| Total | $ | 174,221 |\n\nActual amortization expense may differ from the amounts above due to, among other things, fluctuations in foreign currency exchange rates, impairments, acquisitions and accelerated amortization.\n15\nPITNEY BOWES INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited; table amounts in thousands unless otherwise noted, except per share amounts)\nGoodwill\nChanges in the carrying value of goodwill for the nine months ended September 30, 2016 were as follows:\n| December 31, 2015 | Acquisitions | Foreign currency translation | September 30, 2016 |\n| North America Mailing | $ | 296,053 | $ | — | $ | 3,993 | $ | 300,046 |\n| International Mailing | 148,351 | — | 5,552 | 153,903 |\n| Small & Medium Business Solutions | 444,404 | — | 9,545 | 453,949 |\n| Production Mail | 105,757 | — | (1,382 | ) | 104,375 |\n| Presort Services | 196,890 | — | — | 196,890 |\n| Enterprise Business Solutions | 302,647 | — | (1,382 | ) | 301,265 |\n| Software Solutions | 674,976 | 12,137 | (9,260 | ) | 677,853 |\n| Global Ecommerce | 323,930 | 9,421 | — | 333,351 |\n| Digital Commerce Solutions | 998,906 | 21,558 | (9,260 | ) | 1,011,204 |\n| Total goodwill | $ | 1,745,957 | $ | 21,558 | $ | (1,097 | ) | $ | 1,766,418 |\n\n7. Fair Value Measurements and Derivative Instruments\nWe measure certain financial assets and liabilities at fair value on a recurring basis. Fair value is a market-based measure considered from the perspective of a market participant rather than an entity-specific measure. An entity is required to classify certain assets and liabilities measured at fair value based on the following fair value hierarchy that prioritizes the inputs used to measure fair value:\n| Level 1 – | Unadjusted quoted prices in active markets for identical assets and liabilities. |\n\n| Level 2 – | Quoted prices for identical assets and liabilities in markets that are not active, quoted prices for similar assets and liabilities in active markets or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. |\n\n| Level 3 – | Unobservable inputs that are supported by little or no market activity, may be derived from internally developed methodologies based on management’s best estimate of fair value and that are significant to the fair value of the asset or liability. |\n\nFinancial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. Our assessment of the significance of a particular input to the fair value measurement requires judgment and may affect its placement within the fair value hierarchy. The following tables show, by level within the fair value hierarchy, our financial assets and liabilities that are accounted for at fair value on a recurring basis at September 30, 2016 and December 31, 2015.\n16\nPITNEY BOWES INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited; table amounts in thousands unless otherwise noted, except per share amounts)\n| September 30, 2016 |\n| Level 1 | Level 2 | Level 3 | Total |\n| Assets: |\n| Investment securities |\n| Money market funds / commercial paper | $ | 143,960 | $ | 104,169 | $ | — | $ | 248,129 |\n| Equity securities | — | 23,782 | — | 23,782 |\n| Commingled fixed income securities | 1,575 | 22,769 | — | 24,344 |\n| Debt securities - U.S. and foreign governments, agencies and municipalities | 93,515 | 19,396 | — | 112,911 |\n| Debt securities - corporate | — | 82,149 | — | 82,149 |\n| Mortgage-backed / asset-backed securities | — | 163,806 | — | 163,806 |\n| Derivatives |\n| Foreign exchange contracts | — | 3,508 | — | 3,508 |\n| Total assets | $ | 239,050 | $ | 419,579 | $ | — | $ | 658,629 |\n| Liabilities: |\n| Derivatives |\n| Interest rate swap | $ | — | $ | (591 | ) | $ | — | $ | (591 | ) |\n| Foreign exchange contracts | — | (1,515 | ) | — | (1,515 | ) |\n| Total liabilities | $ | — | $ | (2,106 | ) | $ | — | $ | (2,106 | ) |\n\n| December 31, 2015 |\n| Level 1 | Level 2 | Level 3 | Total |\n| Assets: |\n| Investment securities |\n| Money market funds / commercial paper | $ | 41,215 | $ | 292,412 | $ | — | $ | 333,627 |\n| Equity securities | — | 24,538 | — | 24,538 |\n| Commingled fixed income securities | — | 22,571 | — | 22,571 |\n| Debt securities - U.S. and foreign governments, agencies and municipalities | 102,235 | 12,566 | — | 114,801 |\n| Debt securities - corporate | — | 62,884 | — | 62,884 |\n| Mortgage-backed / asset-backed securities | — | 178,234 | — | 178,234 |\n| Derivatives |\n| Foreign exchange contracts | — | 1,716 | — | 1,716 |\n| Total assets | $ | 143,450 | $ | 594,921 | $ | — | $ | 738,371 |\n| Liabilities: |\n| Derivatives |\n| Foreign exchange contracts | $ | — | $ | (5,387 | ) | $ | — | $ | (5,387 | ) |\n| Total liabilities | $ | — | $ | (5,387 | ) | $ | — | $ | (5,387 | ) |\n\nInvestment Securities\nThe valuation of investment securities is based on the market approach using inputs that are observable, or can be corroborated by observable data, in an active marketplace. The following information relates to our classification into the fair value hierarchy:\n| • | Money Market Funds / Commercial Paper: Money market funds typically invest in government securities, certificates of deposit, commercial paper and other highly liquid, low risk securities. Money market funds are principally used for overnight deposits and are classified as Level 1 when unadjusted quoted prices in active markets are available and as Level 2 when they are not actively traded on an exchange. Direct investments in commercial paper are not listed on an exchange in an active market and are classified as Level 2. |\n\n17\nPITNEY BOWES INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited; table amounts in thousands unless otherwise noted, except per share amounts)\n| • | Equity Securities: Equity securities are comprised of mutual funds investing in U.S. and foreign common stock. These mutual funds are classified as Level 2 as they are not separately listed on an exchange. |\n\n| • | Commingled Fixed Income Securities: Mutual funds that invest in a variety of fixed-income securities including securities of the U.S. government and its agencies, corporate debt, mortgage-backed securities and asset-backed securities. The value of the funds is based on the market value of the underlying investments owned by each fund, minus its liabilities, divided by the number of shares outstanding, as reported by the fund manager. These commingled funds are not listed on an exchange in an active market and are classified as Level 2. |\n\n| • | Debt Securities – U.S. and Foreign Governments, Agencies and Municipalities: Debt securities are classified as Level 1 where active, high volume trades for identical securities exist. Valuation adjustments are not applied to these securities. Debt securities valued using quoted market prices for similar securities or benchmarking model derived prices to quoted market prices and trade data for identical or comparable securities are classified as Level 2. |\n\n| • | Debt Securities – Corporate: Corporate debt securities are valued using recently executed transactions, market price quotations where observable, or bond spreads. The spread data used are for the same maturity as the security. These securities are classified as Level 2. |\n\n| • | Mortgage-Backed Securities / Asset-Backed Securities: These securities are valued based on external pricing indices. When external index pricing is not observable, these securities are valued based on external price/spread data. These securities are classified as Level 2. |\n\nInvestment securities include investments held by The Pitney Bowes Bank (the Bank), whose primary business is to provide financing solutions to clients that rent postage meters and purchase supplies. The Bank's assets and liabilities consist primarily of cash, finance receivables, short and long-term investments and deposit accounts.\nAvailable-For-Sale Securities\nCertain investment securities are classified as available-for-sale and recorded at fair value in the Condensed Consolidated Balance Sheets as cash and cash equivalents, short-term investments and other assets depending on the type of investment and maturity. Unrealized holding gains and losses are recorded, net of tax, in accumulated other comprehensive loss (AOCL).\nAvailable-for-sale securities at September 30, 2016 and December 31, 2015 consisted of the following:\n| September 30, 2016 |\n| Amortized cost | Gross unrealized gains | Gross unrealized losses | Estimated fair value |\n| U.S. and foreign governments, agencies and municipalities | $ | 109,027 | $ | 4,145 | $ | (261 | ) | $ | 112,911 |\n| Corporate notes and bonds | 79,264 | 2,982 | (97 | ) | 82,149 |\n| Commingled fixed income securities | 1,559 | 16 | — | 1,575 |\n| Mortgage-backed / asset-backed securities | 161,131 | 3,378 | (703 | ) | 163,806 |\n| Total | $ | 350,981 | $ | 10,521 | $ | (1,061 | ) | $ | 360,441 |\n\n| December 31, 2015 |\n| Amortized cost | Gross unrealized gains | Gross unrealized losses | Estimated fair value |\n| U.S. and foreign governments, agencies and municipalities | $ | 114,265 | $ | 1,804 | $ | (1,268 | ) | $ | 114,801 |\n| Corporate notes and bonds | 63,140 | 823 | (1,079 | ) | 62,884 |\n| Mortgage-backed / asset-backed securities | 177,821 | 1,901 | (1,488 | ) | 178,234 |\n| Total | $ | 355,226 | $ | 4,528 | $ | (3,835 | ) | $ | 355,919 |\n\nAt September 30, 2016, investment securities that were in a loss position for 12 or more continuous months had aggregate unrealized holding losses of less than $1 million and an estimated fair value of $14 million, and investment securities that were in a loss position for less than 12 continuous months had aggregate unrealized holding losses of less than $1 million and an estimated fair value of $81 million.\n18\nPITNEY BOWES INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited; table amounts in thousands unless otherwise noted, except per share amounts)\nAt December 31, 2015, investment securities that were in a loss position for 12 or more continuous months had aggregate unrealized holding losses of $2 million and an estimated fair value of $36 million, and investment securities that were in a loss position for less than 12 continuous months had aggregate unrealized holding losses of $2 million and an estimated fair value of $146 million.\nWe have not recognized an other-than-temporary impairment on any of the investment securities in an unrealized loss position because we have the ability and intent to hold these securities until recovery of the unrealized losses and we expect to receive the contractual principal and interest on these investment securities at maturity.\nScheduled maturities of available-for-sale securities at September 30, 2016 were as follows:\n| Amortized cost | Estimated fair value |\n| Within 1 year | $ | 28,111 | $ | 28,208 |\n| After 1 year through 5 years | 120,611 | 122,284 |\n| After 5 years through 10 years | 56,375 | 58,585 |\n| After 10 years | 145,884 | 151,364 |\n| Total | $ | 350,981 | $ | 360,441 |\n\nThe expected payments on mortgage-backed and asset-backed securities may not coincide with their contractual maturities as borrowers have the right to prepay obligations with or without prepayment penalties.\nWe have not experienced any significant write-offs in our investment portfolio. The majority of our mortgage-backed securities are either guaranteed or supported by the U.S. Government. We have no investments in inactive markets that would warrant a possible change in our pricing methods or classification within the fair value hierarchy.\nDerivative Instruments\nIn the normal course of business, we are exposed to the impact of changes in foreign currency exchange rates and interest rates. We limit these risks by following established risk management policies and procedures, including the use of derivatives. We use derivative instruments to limit the effects of exchange rate fluctuations on financial results and manage the related cost of debt. We do not use derivatives for trading or speculative purposes. We record derivative instruments at fair value and the accounting for changes in the fair value depends on the intended use of the derivative, the resulting designation and the effectiveness of the instrument in offsetting the risk exposure it is designed to hedge.\nForeign Exchange Contracts\nWe enter into foreign exchange contracts to mitigate the currency risk associated with the anticipated purchase of inventory between affiliates and from third parties. These contracts are designated as cash flow hedges. The effective portion of the gain or loss on cash flow hedges is included in AOCL in the period that the change in fair value occurs and is reclassified to earnings in the period that the hedged item is recorded in earnings. At September 30, 2016 and December 31, 2015, we had outstanding contracts associated with these anticipated transactions with notional amounts of $14 million and $13 million, respectively.\nThe valuation of foreign exchange derivatives is based on the market approach using observable market inputs, such as foreign currency spot and forward rates and yield curves. We also incorporate counterparty credit risk and our credit risk into the fair value measurement of our derivative assets and liabilities, respectively. We derive credit risk from observable data in the credit default swap market. We have not seen a material change in the creditworthiness of those banks acting as derivative counterparties.\nInterest Rate Swaps\nIn September 2016, we entered into an interest rate swap with a notional amount of $300 million to mitigate the interest rate risk associated with our $300 million variable-rate term loans. The swap is designated as a cash flow hedge. The effective portion of the gain or loss on the cash flow hedge is included in AOCL in the period that the change in fair value occurs and is reclassified to earnings in the period that the hedged item is recorded in earnings. Under the terms of the swap agreement, we pay fixed-rate interest of 0.8826% and receive variable-rate interest based on 1-month LIBOR. The variable interest rate resets monthly.\nThe valuation of our interest rate swap is based on the income approach using a model with inputs that are observable or that can be derived from or corroborated by observable market data.\n19\nPITNEY BOWES INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited; table amounts in thousands unless otherwise noted, except per share amounts)\nThe majority of the amounts included in AOCL at September 30, 2016 will be recognized in earnings within the next 12 months. No amount of ineffectiveness was recorded in earnings for these designated cash flow hedges.\nThe fair value of derivative instruments at September 30, 2016 and December 31, 2015 was as follows:\n| Designation of Derivatives | Balance Sheet Location | September 30, 2016 | December 31, 2015 |\n| Derivatives designated ashedging instruments |\n| Foreign exchange contracts | Other current assets and prepayments | $ | 247 | $ | 217 |\n| Accounts payable and accrued liabilities | (573 | ) | (208 | ) |\n| Interest rate swap | Other non-current liabilities | (591 | ) | — |\n| Derivatives not designated ashedging instruments |\n| Foreign exchange contracts | Other current assets and prepayments | 3,261 | 1,499 |\n| Accounts payable and accrued liabilities | (942 | ) | (5,179 | ) |\n| Total derivative assets | $ | 3,508 | $ | 1,716 |\n| Total derivative liabilities | (2,106 | ) | (5,387 | ) |\n| Total net derivative asset (liabilities) | $ | 1,402 | $ | (3,671 | ) |\n\nThe following represents the results of cash flow hedging relationships for the three and nine months ended September 30, 2016 and 2015:\n| Three Months Ended September 30, |\n| Derivative Gain (Loss)Recognized in AOCL(Effective Portion) | Location of Gain (Loss)(Effective Portion) | Gain (Loss) Reclassifiedfrom AOCL to Earnings(Effective Portion) |\n| Derivative Instrument | 2016 | 2015 | 2016 | 2015 |\n| Foreign exchange contracts | $ | (158 | ) | $ | (140 | ) | Revenue | $ | (443 | ) | 211 |\n| Cost of sales | 301 | (41 | ) |\n| Interest rate swap | (591 | ) | — | Interest Expense | — | — |\n| $ | (749 | ) | $ | (140 | ) | $ | (142 | ) | $ | 170 |\n| Nine Months Ended September 30, |\n| Derivative Gain (Loss)Recognized in AOCL(Effective Portion) | Location of Gain (Loss)(Effective Portion) | Gain (Loss) Reclassifiedfrom AOCL to Earnings(Effective Portion) |\n| Derivative Instrument | 2016 | 2015 | 2016 | 2015 |\n| Foreign exchange contracts | $ | (114 | ) | $ | 614 | Revenue | $ | 290 | $ | 1,039 |\n| Cost of sales | (69 | ) | 544 |\n| Interest rate swap | (591 | ) | — | Interest Expense | — | — |\n| $ | (705 | ) | $ | 614 | $ | 221 | $ | 1,583 |\n\nWe also enter into foreign exchange contracts to minimize the impact of exchange rate fluctuations on short-term intercompany loans and related interest that are denominated in a foreign currency. The revaluation of the intercompany loans and interest and the mark-to-market adjustment on the derivatives are both recorded in earnings. All outstanding contracts at September 30, 2016 mature within 12 months.\n20\nPITNEY BOWES INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited; table amounts in thousands unless otherwise noted, except per share amounts)\nThe following represents the results of our non-designated derivative instruments for the three and nine months ended September 30, 2016 and 2015:\n| Three Months Ended September 30, |\n| Derivative Gain (Loss) Recognized in Earnings |\n| Derivatives Instrument | Location of Derivative Gain (Loss) | 2016 | 2015 |\n| Foreign exchange contracts | Selling, general and administrative expense | $ | 1,719 | $ | 2,138 |\n| Nine Months Ended September 30, |\n| Derivative Gain (Loss) Recognized in Earnings |\n| Derivatives Instrument | Location of Derivative Gain (Loss) | 2016 | 2015 |\n| Foreign exchange contracts | Selling, general and administrative expense | $ | 322 | $ | (1,437 | ) |\n\nCredit-Risk-Related Contingent Features\nCertain derivative instruments contain credit-risk-related contingent features that would require us to post collateral based on a combination of our long-term senior unsecured debt ratings and the net fair value of our derivatives. At September 30, 2016, we did not post any collateral and the maximum amount of collateral that we would have been required to post had the credit-risk-related contingent features been triggered was not significant.\nFair Value of Financial Instruments\nOur financial instruments include cash and cash equivalents, investment securities, accounts receivable, loan receivables, derivative instruments, accounts payable and debt. The carrying value for cash and cash equivalents, accounts receivable, loans receivable, and accounts payable approximate fair value because of the short maturity of these instruments.\nThe fair value of our debt is estimated based on recently executed transactions and market price quotations. The inputs used to determine the fair value of our debt were classified as Level 2 in the fair value hierarchy. The carrying value and estimated fair value of our debt at September 30, 2016 and December 31, 2015 were as follows:\n| September 30, 2016 | December 31, 2015 |\n| Carrying value | $ | 3,367,056 | $ | 2,950,668 |\n| Fair value | $ | 3,489,163 | $ | 3,084,561 |\n\n8. Restructuring Charges and Asset Impairments\nRestructuring charges\nActivity in our restructuring reserves for the nine months ended September 30, 2016 and 2015 was as follows:\n| Severance and benefits costs | Other exitcosts | Total |\n| Balance at January 1, 2016 | $ | 43,700 | $ | 3,722 | $ | 47,422 |\n| Expenses, net | 36,791 | 1,660 | 38,451 |\n| Cash payments | (47,241 | ) | (3,920 | ) | (51,161 | ) |\n| Balance at September 30, 2016 | $ | 33,250 | $ | 1,462 | $ | 34,712 |\n| Balance at January 1, 2015 | $ | 81,836 | $ | 8,343 | $ | 90,179 |\n| Expenses, net | 9,196 | (1,183 | ) | 8,013 |\n| Cash payments | (42,708 | ) | (3,348 | ) | (46,056 | ) |\n| Balance at September 30, 2015 | $ | 48,324 | $ | 3,812 | $ | 52,136 |\n\n21\nPITNEY BOWES INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited; table amounts in thousands unless otherwise noted, except per share amounts)\nRestructuring charges also include pension settlement charges of $2 million and $1 million for the nine months ended September 30, 2016 and 2015, respectively.\nThe majority of the remaining restructuring reserves are expected to be paid over the next 12 to 24 months; however, due to certain international labor laws and long-term lease agreements, some payments will extend beyond 24 months. We expect to fund these payments from cash flows from operations.\nAsset impairments\nFor the nine months ended September 30, 2016, asset impairment charges totaled $9 million and consisted primarily of a loss of $5 million on the sale of a facility and an impairment charge of $3 million related to a building. For the nine months ended September 30, 2015, asset impairment charges totaled $5 million and consisted primarily of a loss on the sale of our world headquarters building.\n9. Debt\nTotal debt at September 30, 2016 and December 31, 2015 consisted of the following:\n| Interest rate | September 30, 2016 | December 31, 2015 |\n| Commercial paper | variable | $ | — | $ | 90,000 |\n| Notes due January 2016 | 4.75% | — | 370,914 |\n| Notes due September 2017 | 5.75% | 385,109 | 385,109 |\n| Notes due March 2018 | 5.6% | 250,000 | 250,000 |\n| Notes due May 2018 | 4.75% | 350,000 | 350,000 |\n| Notes due March 2019 | 6.25% | 300,000 | 300,000 |\n| Notes due October 2021 | 3.375% | 600,000 | — |\n| Notes due March 2024 | 4.625% | 500,000 | 500,000 |\n| Notes due January 2037 | 5.25% | 115,041 | 115,041 |\n| Notes due March 2043 | 6.7% | 425,000 | 425,000 |\n| Term loans | Variable | 450,000 | 150,000 |\n| Other debt | 5,666 | 15,758 |\n| Principal amount | 3,380,816 | 2,951,822 |\n| Less: unamortized debt discount and issuance costs | 29,078 | 23,617 |\n| Plus: unamortized interest rate swap proceeds | 15,318 | 22,463 |\n| Total debt | 3,367,056 | 2,950,668 |\n| Less: current portion long-term debt and notes payable | 535,289 | 461,085 |\n| Long-term debt | $ | 2,831,767 | $ | 2,489,583 |\n\nIn September 2016, we issued $600 million of 3.375% fixed-rate notes due in October 2021. Interest is payable semi-annually. The notes mature in October 2021, but may be redeemed, at our option, in whole or in part, at any time or from time to time at par plus accrued and unpaid interest. We used a portion of these proceeds to repay commercial paper and used the remaining proceeds to redeem the PBIH Preferred Stock on November 1, 2016 (see Note 12).\nIn January 2016, we borrowed $300 million under a term loan agreement and applied the proceeds to the repayment of the $371 million, 4.75% notes due January 2016. The new term loans bear interest at the applicable Eurodollar Rate plus 1.25% and mature in December 2020. The effective interest rate of these loans for the third quarter were 1.95%. In September 2016, we entered into an interest rate swap with a notional amount of $300 million to mitigate the interest rate risk associated with these variable-rate term loans. Under the terms of the swap agreement, we pay fixed-rate interest of 0.8826% and receive variable-rate interest based on 1-month LIBOR. The variable rate resets monthly.\nIn March 2016, we satisfied certain employment obligations stipulated in the State of Connecticut Department of Economic and Community Development loan (issued in 2014), and under the terms of the loan, $10 million was forgiven. We recorded loan forgiveness income in selling, general and administrative expenses.\n22\nPITNEY BOWES INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited; table amounts in thousands unless otherwise noted, except per share amounts)\n10. Pensions and Other Benefit Programs\nThe components of net periodic benefit cost (income) were as follows:\n| Defined Benefit Pension Plans | Nonpension Postretirement Benefit Plans |\n| United States | Foreign |\n| Three Months Ended | Three Months Ended | Three Months Ended |\n| September 30, | September 30, | September 30, |\n| 2016 | 2015 | 2016 | 2015 | 2016 | 2015 |\n| Service cost | $ | 26 | $ | 38 | $ | 549 | $ | 557 | $ | 512 | $ | 530 |\n| Interest cost | 18,452 | 18,581 | 5,366 | 6,099 | 1,994 | 2,086 |\n| Expected return on plan assets | (25,480 | ) | (26,002 | ) | (7,976 | ) | (8,912 | ) | — | — |\n| Amortization of transition credit | — | — | (2 | ) | (2 | ) | — | — |\n| Amortization of prior service (credit) cost | (15 | ) | 2 | (19 | ) | (16 | ) | 74 | 74 |\n| Amortization of net actuarial loss | 6,779 | 7,327 | 1,302 | 1,482 | 904 | 1,704 |\n| Settlement (1) | 183 | 1,083 | — | — | — | — |\n| Net periodic benefit cost (income) | $ | (55 | ) | $ | 1,029 | $ | (780 | ) | $ | (792 | ) | $ | 3,484 | $ | 4,394 |\n\n| Defined Benefit Pension Plans | Nonpension Postretirement Benefit Plans |\n| United States | Foreign |\n| Nine Months Ended | Nine Months Ended | Nine Months Ended |\n| September 30, | September 30, | September 30, |\n| 2016 | 2015 | 2016 | 2015 | 2016 | 2015 |\n| Service cost | $ | 80 | $ | 114 | $ | 1,622 | $ | 1,677 | $ | 1,534 | $ | 1,849 |\n| Interest cost | 55,354 | 55,745 | 16,773 | 18,284 | 5,977 | 6,612 |\n| Expected return on plan assets | (76,439 | ) | (78,004 | ) | (25,029 | ) | (26,686 | ) | — | — |\n| Amortization of transition credit | — | — | (6 | ) | (7 | ) | — | — |\n| Amortization of prior service (credit) cost | (45 | ) | 6 | (54 | ) | (49 | ) | 222 | 222 |\n| Amortization of net actuarial loss | 20,336 | 21,982 | 4,018 | 4,471 | 2,711 | 5,657 |\n| Settlement (1) | 1,971 | 1,083 | — | — | — | — |\n| Net periodic benefit cost (income) | $ | 1,257 | $ | 926 | $ | (2,676 | ) | $ | (2,310 | ) | $ | 10,444 | $ | 14,340 |\n\n(1) Included in restructuring charges and asset impairments, net in the Condensed Consolidated Statements of Income.\nThrough September 30, 2016 and September 30, 2015, contributions to our U.S. pension plans were $8 million and $6 million, respectively, and contributions to our foreign plans were $41 million and $12 million, respectively. Nonpension postretirement benefit plan contributions were $14 million and $16 million through September 30, 2016 and September 30, 2015, respectively.\n23\nPITNEY BOWES INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited; table amounts in thousands unless otherwise noted, except per share amounts)\n11. Income Taxes\nThe effective tax rate for the three months ended September 30, 2016 and 2015 was 24.8% and 31.3%, respectively, and the effective tax rate for the nine months ended September 30, 2016 and 2015 was 32.7% and 30.2%, respectively. The effective tax rate for both the three and nine months ended September 30, 2016 includes $15 million of benefits from the resolution of tax examinations and a $5 million charge from the establishment of a valuation allowance on tax attribute carryovers. The effective tax rate for the nine months ended September 30, 2015 also includes a $20 million benefit resulting from the disposition of Imagitas.\nAs is the case with other large corporations, our tax returns are examined each year by tax authorities in the U.S. and other global taxing jurisdictions in which we have operations. As a result, it is reasonably possible that the amount of our unrecognized tax benefits will decrease in the next 12 months, and we expect this change could be up to 25% of our unrecognized tax benefits.\nThe IRS examinations of our consolidated U.S. income tax returns for tax years prior to 2012 are closed to audit. Additionally, various post-2006 U.S. state and local tax returns are subject to examination. In Canada, the examination of our tax filings prior to 2011 are closed to audit, except for the pending application of legal principles to specific issues arising in earlier years. Other significant jurisdictions in which we have, or have recently completed, tax examinations include France, closed through the end of 2012, Germany closed through the end of 2011 and except for an item under appeal, the U.K. is closed through the end of 2011. We have other less significant tax fillings currently subject to examination.\n12. Noncontrolling Interests (Preferred Stockholders’ Equity in Subsidiaries)\nPitney Bowes International Holdings, Inc. (PBIH), a subsidiary of the Company, has 300,000 shares of outstanding perpetual voting preferred stock valued at $300 million held by certain institutional investors (PBIH Preferred Stock). The holders of PBIH Preferred Stock are entitled as a group to 25% of the combined voting power of all classes of capital stock of PBIH. All outstanding common stock of PBIH, representing the remaining 75% of the combined voting power of all classes of capital stock, is owned directly or indirectly by the Company. The PBIH Preferred Stock is entitled to cumulative dividends at a rate of 6.125%. We redeemed all of the PBIH Preferred Stock on November 1, 2016 for $300 million plus accrued dividends.\n13. Commitments and Contingencies\nIn the ordinary course of business, we are routinely defendants in, or party to a number of pending and threatened legal actions. These may involve litigation by or against us relating to, among other things, contractual rights under vendor, insurance or other contracts; intellectual property or patent rights; equipment, service, payment or other disputes with clients; or disputes with employees. Some of these actions may be brought as a purported class action on behalf of a purported class of employees, customers or others. In management's opinion, the potential liability, if any, that may result from these actions, either individually or collectively, is not reasonably expected to have a material effect on our financial position, results of operations or cash flows. However, as litigation is inherently unpredictable, there can be no assurances in this regard.\n14. Stockholders’ Equity\nChanges in stockholders’ equity for the nine months ended September 30, 2016 and 2015 were as follows:\n| Preferredstock | Preferencestock | Common stock | Additional paid-in capital | Retained earnings | Accumulated other comprehensive loss | Treasury stock | Total equity |\n| Balance at January 1, 2016 | $ | 1 | $ | 505 | $ | 323,338 | $ | 161,280 | $ | 5,155,537 | $ | (888,635 | ) | $ | (4,573,305 | ) | $ | 178,721 |\n| Net income | — | — | — | — | 177,148 | — | — | 177,148 |\n| Other comprehensive income | — | — | — | — | — | 62,673 | — | 62,673 |\n| Dividends paid | — | — | — | — | (105,791 | ) | — | — | (105,791 | ) |\n| Issuance of common stock | — | — | — | (27,251 | ) | — | — | 25,930 | (1,321 | ) |\n| Conversion to common stock | — | (16 | ) | — | (321 | ) | — | — | 337 | — |\n| Stock-based compensation expense | — | — | — | 16,289 | — | — | — | 16,289 |\n| Repurchase of common stock | — | — | — | — | — | — | (197,267 | ) | (197,267 | ) |\n| Balance at September 30, 2016 | $ | 1 | $ | 489 | $ | 323,338 | $ | 149,997 | $ | 5,226,894 | $ | (825,962 | ) | $ | (4,744,305 | ) | $ | 130,452 |\n\n24\nPITNEY BOWES INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited; table amounts in thousands unless otherwise noted, except per share amounts)\n| Preferredstock | Preferencestock | Common stock | Additional paid-in capital | Retained earnings | Accumulated other comprehensive loss | Treasury stock | Total equity |\n| Balance at January 1, 2015 | $ | 1 | $ | 548 | $ | 323,338 | $ | 178,852 | $ | 4,897,708 | $ | (846,156 | ) | $ | (4,477,032 | ) | $ | 77,259 |\n| Net income | — | — | — | — | 321,664 | — | — | 321,664 |\n| Other comprehensive loss | — | — | — | — | — | (54,696 | ) | — | (54,696 | ) |\n| Dividends paid | — | — | — | — | (113,158 | ) | — | — | (113,158 | ) |\n| Issuance of common stock | — | — | — | (36,946 | ) | — | — | 32,983 | (3,963 | ) |\n| Conversion to common stock | — | (29 | ) | — | (632 | ) | — | — | 661 | — |\n| Stock-based compensation expense | — | — | — | 14,921 | — | — | — | 14,921 |\n| Repurchase of common stock | — | — | — | — | — | — | (100,000 | ) | (100,000 | ) |\n| Balance at September 30, 2015 | $ | 1 | $ | 519 | $ | 323,338 | $ | 156,195 | $ | 5,106,214 | $ | (900,852 | ) | $ | (4,543,388 | ) | $ | 142,027 |\n\n15. Accumulated Other Comprehensive Loss\nReclassifications out of AOCL for the three and nine months ended September 30, 2016 and 2015 were as follows:\n| Amount Reclassified from AOCL (a) |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Gains (losses) on cash flow hedges |\n| Revenue | $ | 443 | $ | 211 | $ | (290 | ) | $ | 1,039 |\n| Cost of sales | (301 | ) | (41 | ) | 69 | 544 |\n| Interest expense, net | (507 | ) | (507 | ) | (1,521 | ) | (1,521 | ) |\n| Total before tax | (365 | ) | (337 | ) | (1,742 | ) | 62 |\n| (Benefit) provision for income tax | (144 | ) | (132 | ) | (679 | ) | 15 |\n| Net of tax | $ | (221 | ) | $ | (205 | ) | $ | (1,063 | ) | $ | 47 |\n| Gains (losses) on available for sale securities |\n| Interest expense, net | $ | (1,125 | ) | $ | 1,085 | $ | (1,126 | ) | $ | 1,043 |\n| (Benefit) provision for income tax | (433 | ) | 401 | (433 | ) | 385 |\n| Net of tax | $ | (692 | ) | $ | 684 | $ | (693 | ) | $ | 658 |\n| Pension and Postretirement Benefit Plans (b) |\n| Transition credit | $ | 2 | $ | 2 | $ | 6 | $ | 7 |\n| Prior service costs | (40 | ) | (60 | ) | (123 | ) | (179 | ) |\n| Actuarial losses | (9,168 | ) | (11,596 | ) | (29,036 | ) | (33,193 | ) |\n| Total before tax | (9,206 | ) | (11,654 | ) | (29,153 | ) | (33,365 | ) |\n| Benefit from income tax | (3,243 | ) | (4,219 | ) | (10,362 | ) | (12,001 | ) |\n| Net of tax | $ | (5,963 | ) | $ | (7,435 | ) | $ | (18,791 | ) | $ | (21,364 | ) |\n\n(a) Amounts in parentheses indicate reductions to income and increases to other comprehensive income (loss).\n| (b) | Reclassified from accumulated other comprehensive loss into selling, general and administrative expenses. These amounts are included in the computation of net periodic costs (see Note 10 for additional details). |\n\n25\nPITNEY BOWES INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited; table amounts in thousands unless otherwise noted, except per share amounts)\nChanges in AOCL for the nine months ended September 30, 2016 and 2015 were as follows:\n| Cash flow hedges | Available for sale securities | Pension and postretirement benefit plans | Foreign currency adjustments | Total |\n| Balance at January 1, 2016 | $ | (3,912 | ) | $ | 536 | $ | (738,768 | ) | $ | (146,491 | ) | $ | (888,635 | ) |\n| Other comprehensive (loss) income before reclassifications (a) | (705 | ) | 6,798 | (1,230 | ) | 37,263 | 42,126 |\n| Reclassifications into earnings (a), (b) | 1,063 | 693 | 18,791 | — | 20,547 |\n| Net other comprehensive income | 358 | 7,491 | 17,561 | 37,263 | 62,673 |\n| Balance at September 30, 2016 | $ | (3,554 | ) | $ | 8,027 | $ | (721,207 | ) | $ | (109,228 | ) | $ | (825,962 | ) |\n\n| Cash flow hedges | Available for sale securities | Pension and postretirement benefit plans | Foreign currency adjustments | Total |\n| Balance at January 1, 2015 | $ | (4,689 | ) | $ | 2,966 | $ | (786,079 | ) | $ | (58,354 | ) | $ | (846,156 | ) |\n| Other comprehensive loss before reclassifications (a) | 382 | 416 | — | (76,153 | ) | (75,355 | ) |\n| Reclassifications into earnings (a), (b) | (47 | ) | (658 | ) | 21,364 | — | 20,659 |\n| Net other comprehensive income (loss) | 335 | (242 | ) | 21,364 | (76,153 | ) | (54,696 | ) |\n| Balance at September 30, 2015 | $ | (4,354 | ) | $ | 2,724 | $ | (764,715 | ) | $ | (134,507 | ) | $ | (900,852 | ) |\n\n(a) Amounts are net of tax. Amounts in parentheses indicate debits to AOCL.\n(b) See table above for additional details of these reclassifications.\n26\nItem 2: Management’s Discussion and Analysis of\nFinancial Condition and Results of Operations\nForward-Looking Statements\nThis Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) contains statements that are forward-looking. We want to caution readers that any forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 may change based on various factors. These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties and actual results could differ materially. Words such as \"estimate,\" \"target,\" \"project,\" \"plan,\" \"believe,\" \"expect,\" \"anticipate,\" \"intend\" and similar expressions may identify such forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Factors which could cause future financial performance to differ materially from the expectations as expressed in any forward-looking statement made by or on our behalf include, without limitation:\n| • | declining physical mail volumes |\n\n| • | competitive factors, including pricing pressures, technological developments and introduction of new products and services by competitors |\n\n| • | our success in developing new products and services, including digital-based products and services, obtaining regulatory approval if required, and the market’s acceptance of these new products and services |\n\n| • | our ability to efficiently and effectively transition into our new Enterprise Resource Planning (ERP) system in the U.S. without significant disruption to existing operations |\n\n| • | the success of our advertising and investment to rebrand the company and to build market awareness to create new demand for our businesses |\n\n| • | changes in postal or banking regulations |\n\n| • | macroeconomic factors, including global and regional business conditions that adversely impact customer demand, access to capital markets at reasonable costs, changes in interest rates, foreign currency exchange rates and fuel prices |\n\n| • | the continued availability and security of key information systems and the cost to comply with information security requirements and privacy laws |\n\n| • | third-party suppliers' ability to provide product components, assemblies or inventories |\n\n| • | our success at managing the relationships with our outsource providers, including the costs of outsourcing functions and operations not central to our business |\n\n| • | the loss of some of our larger clients in the Global Ecommerce segment |\n\n| • | integrating newly acquired businesses including operations and product and service offerings |\n\n| • | intellectual property infringement claims |\n\n| • | our success at managing customer credit risk |\n\n| • | significant changes in pension, health care and retiree medical costs |\n\n| • | income tax adjustments or other regulatory levies for prior audit years and changes in tax laws, rulings or regulations |\n\n| • | a disruption of our businesses due to changes in international or national political conditions, including the use of the mail for transmitting harmful biological agents or other terrorist attacks |\n\n| • | acts of nature |\n\n27\nOverview\nThrough the first three quarters of 2016, we continued to execute on our strategic priorities to stabilize and reinvent our mail business, drive operational excellence and grow our business through digital commerce. We acquired a software-as-a-service enterprise retail and fulfillment solutions company and a company that provides comprehensive boundary and geospatial data to support location-based services and analytics. We also exited certain geographic markets as part of our initiative to simplify our geographic footprint, launched a new advertising campaign and launched our Pitney Bowes Commerce Cloud that helps our clients identify customers, locate new sales opportunities, communicate with their existing and prospective customers, power shipping globally and manage payments for mailing and shipping.\nDuring the second quarter, we deployed our new enterprise business platform in the U.S. In the second quarter, due to the conversion process and training, our business was temporarily impacted from lost sales activity and reduced productivity that adversely impacted equipment sales and stream revenues. During the third quarter, the issues impacting equipment sales have subsided and equipment sales rebounded in the quarter. However, we continued to experience lower financing related fees as a result of proactive waivers to allow clients to adjust to new billing formats as well as due to the timing of invoices being sent.\nDuring the third quarter, we issued $600 million of 3.375% fixed rate five year notes. We used a portion of the proceeds to repay commercial paper and we used the remaining proceeds to redeem the $300 million PBIH Preferred Stock on November 1, 2016.\nFinancial Highlights\nRevenue - Third Quarter 2016 compared to Third Quarter 2015\nRevenue for the third quarter of 2016 decreased 4% to $839 million compared to $870 million in the third quarter of 2015. Of this decrease, 1% is attributable to foreign currency translation and 1% to the exit of direct operations in Mexico, South Africa and five markets in Asia (Market Exits), that occurred in the first quarter of 2016 and fourth quarter of 2015.\n| • | Equipment sales increased 6% and business services revenue grew 5%. However, support services revenue declined 9%, financing income declined 12%, supplies revenue declined 14%, software revenue declined 9% and rentals revenue declined 5%. |\n\n| • | Small & Medium Business Solutions (SMB) revenue decreased 7% driven by a 7% decline in North America Mailing revenue and a 9% decline in International Mailing revenue. Excluding the impacts of foreign currency translation and Market Exits, SMB revenue declined 6%. |\n\n| • | Enterprise Business Solutions revenue increased 1% as Production Mail revenue increased 5%, but was partially offset by a decrease of 2% in Presort Services. Excluding the impacts of foreign currency translation and Market Exits, Enterprise Business Solutions revenue increased 4%. |\n\n| • | Digital Commerce Solutions (DCS) revenue decreased 1%. Software Solutions revenue decreased 9%, but was mostly offset by an 8% increase in Global Ecommerce revenue. Excluding the impacts of foreign currency translation, DCS revenue increased 2%. |\n\nRevenue - First Nine Months of 2016 compared to First Nine Months of 2015\nRevenue for the first nine months of 2016 decreased 5% to $2,520 million compared to $2,641 million in the first nine months of 2015. Of this decrease, 1% is attributable to foreign currency translation and 1% to Market Exits.\n| • | Equipment sales declined 2%, supplies revenues declined 8%, software revenue declined 9%, rentals revenue declined 7%, financing income declined 10% and support services revenue declined 8%. Business services revenue increased 3%, partially offsetting these declines. |\n\n| • | SMB revenue decreased 7%. North America Mailing revenue was down 7% and International Mailing revenue was down 8%. Excluding the impacts of foreign currency translation and Market Exists, SMB revenue decreased 6%. |\n\n| • | Enterprise Business Solutions revenue decreased 1% as Production Mail revenue decreased 3%, but was mostly offset by a 2% increase in Presort Services revenue. Excluding the impacts of foreign currency translation and Market Exists, Enterprise Business Solutions revenue increased 1%. |\n\n| • | DCS revenue increased 6%. Global Ecommerce revenue increased 23%, but was partially offset by a 9% decrease in Software Solutions revenue. Excluding the impacts of foreign currency translation, DCS revenue increased 8%. |\n\n28\nNet Income\nNet income and diluted earnings per share from continuing operations for the third quarter of 2016 were $66 million and $0.35, respectively, compared to $89 million and $0.44, respectively, in the third quarter of 2015. Net income and diluted earnings per share from continuing operations for the first nine months of 2016 were $179 million and $0.94, respectively, compared to $322 million and $1.60, respectively, for the first nine months of 2015. The decreases in the quarter and first nine months of 2016 were primarily due to lower revenue and gross margin and higher restructuring charges and asset impairments. The decline in the first nine of months of 2016 compared to 2015 was also impacted by the gain on the sale of Imagitas in 2015.\nCash Flows\nCash and cash equivalents increased $342 million during the first nine months of 2016 since December 31, 2015. Sources and uses of cash include:\n| • | Generated cash from operations of $291 million; |\n\n| • | Increased net borrowings by $434 million; |\n\n| • | Decreased investments by $66 million; |\n\n| • | Received $18 million for the sale of assets; |\n\n| • | Acquired Enroute and Maponics for an aggregate $38 million; |\n\n| • | Paid dividends of $106 million to our common stockholders; |\n\n| • | Spent $197 million to repurchase our common stock; and |\n\n| • | Spent $116 million on capital expenditures. |\n\nOutlook\nWe anticipate that our restructuring actions, synergies and revenue from acquisitions, the introduction of new products and solutions, our implementation of our go-to-market strategy in all our major markets and the implementation of the new enterprise business platform will continue to provide long-term benefits.\nWithin SMB Solutions, we anticipate that the introduction of new solutions and services, particularly those included in the Pitney Bowes Commerce Cloud, will help further stabilize revenue over the long-term. We continue to work through the issues impacting stream revenues as a result of our new enterprise business platform and expect to see improvements in the near future. Internationally, the implementation of our go-to-market strategy is now complete in our major markets and, as a result, we anticipate further stabilizing financial results in those markets.\nWithin Enterprise Business Solutions, we anticipate revenue and profitability growth in Presort Services due to client expansion and higher processed mail volumes. We expect that Production Mail revenue growth will continue to be challenged by changes in the overall market and declining services revenue.\nWithin DCS, we continue to build our partner channel in Software Solutions by adding new regional systems integrators and location intelligence partners. Additionally, we anticipate improved sales efficiencies and new industry-specific solutions from the transition and training of a new sales group within the organization. We anticipate continued growth in our ecommerce business with our existing marketplace sites (sites where multiple sellers sell) and individual retail clients, as well as through continued new client acquisition and expanded service offerings. A strong U.S. dollar could continue to affect demand for U.S. goods sold to customers in other countries, but such an impact could continue to be mitigated by the effects of a weakened British Pound on sales of U.K. goods to customers in other countries. We continue to expand and globalize our cross-border ecommerce offerings which diversifies the business and helps to mitigate foreign currency risk.\n29\nRESULTS OF OPERATIONS\nRevenue by source and the related cost of revenue are shown in the following tables:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2016 | 2015 | % change | 2016 | 2015 | % change |\n| Equipment sales | $ | 173,143 | $ | 163,857 | 6 | % | $ | 485,145 | $ | 495,328 | (2 | )% |\n| Supplies | 61,306 | 71,174 | (14 | )% | 198,631 | 215,178 | (8 | )% |\n| Software | 89,087 | 97,700 | (9 | )% | 257,760 | 283,241 | (9 | )% |\n| Rentals | 102,747 | 108,420 | (5 | )% | 309,706 | 333,729 | (7 | )% |\n| Financing | 87,883 | 99,925 | (12 | )% | 276,915 | 306,992 | (10 | )% |\n| Support services | 123,954 | 136,820 | (9 | )% | 383,632 | 415,615 | (8 | )% |\n| Business services | 200,911 | 191,645 | 5 | % | 607,717 | 591,030 | 3 | % |\n| Total revenue | $ | 839,031 | $ | 869,541 | (4 | )% | $ | 2,519,506 | $ | 2,641,113 | (5 | )% |\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| Percentage of Revenue | Percentage of Revenue |\n| 2016 | 2015 | 2016 | 2015 | 2016 | 2015 | 2016 | 2015 |\n| Cost of equipment sales | $ | 86,147 | $ | 78,650 | 49.8 | % | 48.0 | % | $ | 235,741 | $ | 232,706 | 48.6 | % | 47.0 | % |\n| Cost of supplies | 20,348 | 21,629 | 33.2 | % | 30.4 | % | 60,662 | 65,912 | 30.5 | % | 30.6 | % |\n| Cost of software | 25,698 | 27,219 | 28.8 | % | 27.9 | % | 79,496 | 85,584 | 30.8 | % | 30.2 | % |\n| Cost of rentals | 16,041 | 21,423 | 15.6 | % | 19.8 | % | 54,951 | 63,127 | 17.7 | % | 18.9 | % |\n| Financing interest expense | 12,965 | 17,533 | 14.8 | % | 17.5 | % | 41,375 | 54,171 | 14.9 | % | 17.6 | % |\n| Cost of support services | 74,799 | 79,747 | 60.3 | % | 58.3 | % | 224,790 | 244,853 | 58.6 | % | 58.9 | % |\n| Cost of business services | 140,989 | 130,004 | 70.2 | % | 67.8 | % | 417,357 | 405,559 | 68.7 | % | 68.6 | % |\n| Total cost of revenue | $ | 376,987 | $ | 376,205 | 44.9 | % | 43.3 | % | $ | 1,114,372 | $ | 1,151,912 | 44.2 | % | 43.6 | % |\n\nRevenue and Cost of Revenues - 2016 compared to 2015\nEquipment sales\nEquipment sales revenue increased 6% in the quarter. Excluding the unfavorable impact from Market Exits of 2%, revenue increased 9% primarily due to higher sales in our production mail business due to a number of larger client installations of sorter, inserter and print equipment.\nEquipment sales revenue decreased 2% in the first nine months of 2016. Excluding the unfavorable impacts from foreign currency translation of 1% and Market Exits of 2%, revenue increased 1%. This increase is primarily due to 3% from higher sales in our production mail business, partially offset by 2% from lower mailing equipment sales in North America, due in part to sales disruption during the second quarter from the platform cut-over.\nCost of equipment sales as a percentage of equipment sales increased to 49.8% in the quarter and 48.6% in the first nine months of 2016 primarily due product mix.\nSupplies\nSupplies revenue decreased 14% in the quarter. Excluding the unfavorable impacts from foreign currency translation of 1% and Market Exits of 1%, revenue decreased 12% primarily due to:\n| • | 9% from North America mailing due to lower sales productivity and lower demand; and |\n\n| • | 2% from lower international mailing supplies sales, primarily in the U.K., due to lower demand. |\n\nSupplies revenue decreased 8% in the first nine months of 2016. Excluding the unfavorable impacts from foreign currency translation of 1% and Market Exits of 1%, revenue decreased 5% primarily due to:\n| • | 4% from North America mailing reflecting sales disruption from the platform cut-over in the second quarter of 2016, and lower demand in the third quarter; and |\n\n| • | 1% from lower international mailing supplies sales, primarily in the U.K. |\n\n30\nCost of supplies as a percentage of supplies revenue increased to 33.2% in the quarter due to lower sales and a greater mix of lower margin supply sales. Cost of supplies as a percentage of supplies revenue of 30.5% in the first nine months of 2016 was consistent with the prior year period.\nSoftware\nSoftware revenue decreased 9% in both the quarter and first nine months of 2016. Excluding the unfavorable impact from foreign currency translation of 3% in the quarter and 2% in the first nine months of 2016, revenue decreased 6% in the quarter and 7% in the first nine months of 2016. These decreases were primarily due to a worldwide decline in licensing revenue.\nCost of software as a percentage of software revenue increased to 28.8% for the quarter and 30.8% for the first nine months of 2016 due to the decline in high margin license revenue.\nRentals\nRentals revenue decreased 5% for the quarter and 7% for the first nine months of 2016. These declines are primarily due to a reduction in the number of installed meters worldwide as well as a shift by certain customers to less-featured, lower cost machines.\nCost of rentals as a percentage of rentals revenue improved to 15.6% for the quarter and 17.7% for the first nine months of 2016 primarily due to cost savings initiatives.\nFinancing\nFinancing revenue decreased 12% in the quarter and 10% in the first nine months of 2016. Excluding the unfavorable impact from foreign currency translation of 1% in both the quarter and the first nine months of 2016, revenue decreased 11% for the quarter and 9% for the first nine months of 2016. These decreases were primarily due to lower mailing equipment sales in prior periods, a declining lease portfolio and lower financing fees as a result of proactive waivers to allow clients to adjust to new billing formats and timing of invoices being sent as a result of the platform cutover.\nWe allocate a portion of our total cost of borrowing to financing interest expense. In computing financing interest expense, we assume an 8:1 debt to equity leverage ratio (10:1 in 2015) and apply our overall effective interest rate to the average outstanding finance receivables.\nFinancing interest expense as a percentage of financing revenue decreased to 14.8% for the quarter and 14.9% for the first nine months of 2016 primarily due to a decrease in our effective interest rate.\nSupport Services\nSupport services revenue decreased 9% in the quarter and 8% in the first nine months of 2016. Excluding the unfavorable impacts of foreign currency translation of 1% and Market Exits of 1% in both periods, revenue decreased 7% in the quarter and 6% in the first nine months of 2016, primarily due to:\n| • | 3% in both the quarter and year-to-date period from lower maintenance revenue on production mail equipment as some in-house mailers moved their mail processing to third-party service bureaus who service some of their own equipment; |\n\n| • | 2% in both the quarter and year-to-date period from the worldwide decline in the number of mailing machines in service and a shift to less-featured, lower cost machines; and |\n\n| • | 2% in the quarter and 1% in the year-to-date period from lower shipping solutions services revenues in our Global Ecommerce business. |\n\nCost of support services as a percentage of support services revenue increased to 60.3% for the quarter due to a mix of lower margin service revenues and improved to 58.6% for the first nine months of 2016 due to expense reductions and productivity initiatives.\nBusiness Services\nBusiness services revenue increased 5% in the quarter and 3% in the first nine months of 2016. Excluding the unfavorable impact from foreign currency translation of 1% in the quarter and the first nine months of 2016, revenue increased 6% in the quarter and 4% in the first nine months of 2016. These increases were primarily due to the growth in our Global Ecommerce business.\nCost of business services as a percentage of business services revenue increased to 70.2% for the quarter and to 68.7% for the first nine months of 2016 primarily due to higher mail processing costs in the presort business.\nSelling, general and administrative (SG&A)\nSG&A expense decreased 3% in the quarter to $301 million primarily due to $3 million lower spending on our enterprise business platform and other cost-saving initiatives.\n31\nSG&A expense decreased 2% in the first nine months of 2016 to $916 million primarily due to lower employee-related costs of $10 million, loan forgiveness income of $10 million (see Note 9 to the Condensed Consolidated Financial Statements), a $5 million favorable state sales tax adjustment and other cost-saving initiatives. Partially offsetting these decreases were higher marketing and advertising expense of $10 million, higher expense related to our new enterprise business platform of $9 million and higher amortization expense of $5 million, primarily related to the acquisition of Borderfree in 2015. SG&A expense in the first nine months of 2015 also included a one-time compensation charge of $10 million related to the acquisition of Borderfree.\nIncome taxes\nSee Note 11 to the Condensed Consolidated Financial Statements.\nPreferred stock dividends attributable to noncontrolling interests\nSee Note 12 to the Condensed Consolidated Financial Statements.\nBusiness segment results - 2016 compared to 2015\nThe principal products and services of each of our reportable segments are as follows:\nSmall & Medium Business Solutions:\nNorth America Mailing: Includes the revenue and related expenses from the sale, rental, financing and servicing of mailing equipment, software and supplies for small and medium businesses to efficiently create physical and digital mail and evidence postage for the sending of mail, flats and parcels in the U.S. and Canada.\nInternational Mailing: Includes the revenue and related expenses from the sale, rental, financing and servicing of mailing equipment, software and supplies for small and medium businesses to efficiently create physical and digital mail and evidence postage for the sending of mail, flats and parcels in areas outside the U.S. and Canada.\nEnterprise Business Solutions:\nProduction Mail: Includes the worldwide revenue and related expenses from the sale of production mail inserting and sortation equipment, high-speed production print systems, supplies and related support services to large enterprise clients to process inbound and outbound mail.\nPresort Services: Includes revenue and related expenses from presort mail services for our large enterprise clients to qualify large mail volumes for postal worksharing discounts.\nDigital Commerce Solutions:\nSoftware Solutions: Includes the worldwide revenue and related expenses from the licensing of non-equipment-based mailing, customer information management, location intelligence and customer engagement solutions and related support services.\nGlobal Ecommerce: Includes the worldwide revenue and related expenses from shipping solutions and cross-border ecommerce.\nWe determine EBIT by deducting from segment revenue the related costs and expenses attributable to the segment. Segment EBIT excludes interest, taxes, general corporate expenses and restructuring charges that are not allocated to a particular business segment. Management uses segment EBIT to measure profitability and performance at the segment level. Management believes segment EBIT provides a useful measure of our operating performance and underlying trends of the businesses. Segment EBIT may not be indicative of our overall consolidated performance and therefore, should be read in conjunction with our consolidated results of operations. See Note 2 to the Condensed Consolidated Financial Statements for a reconciliation of segment EBIT to net income.\n32\nRevenue and EBIT for the three and nine months ended September 30, 2016 and 2015 by reportable segment are presented below:\n| Revenue |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2016 | 2015 | % change | 2016 | 2015 | % change |\n| North America Mailing | $ | 329,995 | $ | 353,159 | (7 | )% | $ | 1,001,789 | $ | 1,071,824 | (7 | )% |\n| International Mailing | 95,628 | 104,615 | (9 | )% | 305,725 | 331,398 | (8 | )% |\n| Small & Medium Business Solutions | 425,623 | 457,774 | (7 | )% | 1,307,514 | 1,403,222 | (7 | )% |\n| Production Mail | 106,350 | 101,646 | 5 | % | 289,649 | 298,880 | (3 | )% |\n| Presort Services | 114,053 | 115,912 | (2 | )% | 357,214 | 351,365 | 2 | % |\n| Enterprise Business Solutions | 220,403 | 217,558 | 1 | % | 646,863 | 650,245 | (1 | )% |\n| Software Solutions | 89,031 | 97,638 | (9 | )% | 257,417 | 282,916 | (9 | )% |\n| Global Ecommerce | 103,974 | 96,571 | 8 | % | 307,712 | 249,923 | 23 | % |\n| Digital Commerce Solutions | 193,005 | 194,209 | (1 | )% | 565,129 | 532,839 | 6 | % |\n| Other | — | — | — | % | — | 54,807 | (100 | )% |\n| Total | $ | 839,031 | $ | 869,541 | (4 | )% | $ | 2,519,506 | $ | 2,641,113 | (5 | )% |\n\n| EBIT |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2016 | 2015 | % change | 2016 | 2015 | % change |\n| North America Mailing | $ | 138,588 | $ | 159,319 | (13 | )% | $ | 436,730 | $ | 482,376 | (9 | )% |\n| International Mailing | 9,733 | 10,739 | (9 | )% | 34,365 | 36,585 | (6 | )% |\n| Small & Medium Business Solutions | 148,321 | 170,058 | (13 | )% | 471,095 | 518,961 | (9 | )% |\n| Production Mail | 15,696 | 12,401 | 27 | % | 35,434 | 31,461 | 13 | % |\n| Presort Services | 19,181 | 25,908 | (26 | )% | 69,305 | 76,946 | (10 | )% |\n| Enterprise Business Solutions | 34,877 | 38,309 | (9 | )% | 104,739 | 108,407 | (3 | )% |\n| Software Solutions | 10,329 | 14,613 | (29 | )% | 17,908 | 34,904 | (49 | )% |\n| Global Ecommerce | 4,389 | (1,240 | ) | >100% | 8,835 | 9,962 | (11 | )% |\n| Digital Commerce Solutions | 14,718 | 13,373 | 10 | % | 26,743 | 44,866 | (40 | )% |\n| Other | — | — | — | % | — | 10,569 | (100 | )% |\n| Total | $ | 197,916 | $ | 221,740 | (11 | )% | $ | 602,577 | $ | 682,803 | (12 | )% |\n\nSmall & Medium Business Solutions\nNorth America Mailing\nNorth America Mailing revenue decreased 7% in both the quarter and the first nine months of 2016 primarily due to:\n| • | 3% in the quarter and 2% in the first nine months of 2016 from lower financing revenue primarily from declining equipment sales in prior periods and lower fees resulting from proactive waivers to allow clients to adjust to new billing formats as well as timing of invoices being sent as result of the platform cutover; |\n\n| • | 2% the quarter and 1% in the first nine months of 2016 from lower sales of supplies due to lower demand and sales productivity; |\n\n| • | 1% in the quarter and 2% for the first nine months of 2016 from lower rentals revenue and 1% in both the quarter and the first nine months of 2016 from lower support services revenue, primarily reflecting continuing decline in installed meters and shift to less featured lower cost machines; and |\n\n| • | 1% in the first nine months of 2016 from lower equipment sales which were impacted by the platform cut-over disruption in the second quarter. |\n\nEBIT decreased 13% in the quarter and 9% in the first nine months of 2016 compared to the prior year, primarily due to the decline in higher margin recurring revenue streams.\n33\nInternational Mailing\nInternational Mailing revenue decreased 9% in the quarter and 8% in the first nine months of 2016. Excluding the unfavorable impacts from foreign currency translation of 4% in the quarter and 3% in the year-to-date period and Market Exits of 2% in both the quarter and year-to-date period, revenue decreased 3% in the quarter and year-to-date periods primarily due to a 1% decline in each of rental, supplies and support services revenue resulting from the continuing decline in installed meters.\nEBIT decreased 9% in the quarter and 6% in the first nine months of 2016, primarily due to the decline in higher margin recurring revenue streams, partially offset by lower costs from cost savings and productivity initiatives.\nEnterprise Business Solutions\nProduction Mail\nProduction Mail revenue increased 5% in the quarter. Excluding the impact from Market Exits of 5%, revenue increased 11%, primarily due to 15% from higher equipment sales due to a number of larger client installations of sorter, inserter and print equipment in the quarter. This increase was partially offset by 4% due to lower support services revenue as a result of some in-house mailers shifting their mail processing to third-party outsourcers.\nProduction Mail revenue decreased 3% in the first nine months of 2016. Excluding the unfavorable impacts from foreign currency translation of 1% and Market Exits of 3%, revenue increased 1%, primarily due to 5% from an increase in equipment sales, offset by 3% from lower support services and supplies revenue.\nEBIT increased 27% in the quarter, primarily due to higher revenue, service delivery cost management initiatives and lower selling and marketing costs. Despite a decline in revenue, EBIT increased 13% in the first nine months of 2016, primarily due to service delivery cost management initiatives and lower sales and marketing costs. These benefits were partially offset by lower sales in 2016 of higher margin inserting equipment.\nPresort Services\nPresort Services revenue decreased 2% in the quarter primarily due to lower revenue per unit processed as a result of a United States Postal Service (USPS) rate change earlier in the year. Despite this USPS rate change, revenue for the first nine months of 2016 increased 2% primarily due to higher volumes of first class mail processed and expansion into new markets.\nEBIT decreased 26% in the quarter and 10% in the first nine months of 2016, primarily due to lower margins and increased mail processing costs related to higher labor costs.\nDigital Commerce Solutions\nSoftware Solutions\nSoftware Solutions revenue decreased 9% in both the quarter and first nine months of 2016. Excluding the unfavorable impact from foreign currency translation of 3% in the quarter and 2% in the first nine months of 2016, revenue decreased 6% in the quarter and 7% in the first nine months of 2016. These decreases were primarily due to a worldwide decline in licensing revenue.\nEBIT decreased 29% for the quarter and 49% for the first nine months of 2016 primarily due to lower high-margin licensing revenue.\nGlobal Ecommerce\nGlobal Ecommerce revenue increased 8% in the quarter. Excluding the unfavorable impact of foreign currency translation of 2%, revenue increased 10% primarily due to 11% from expansion of our U.S. and U.K. cross-border business and retail network. Outbound U.S. marketplace package shipments grew in the quarter despite the stronger U.S dollar versus prior year, as well as some temporary disruption on demand for parcel shipments from the U.S. to Canada prior to the resolution of the Canada Post labor dispute. Partially offsetting this increase was a 2% decrease from a decline in domestic shipping solutions revenue.\nGlobal Ecommerce revenue increased 23% in the first nine months of 2016. Excluding the unfavorable impact of foreign currency translation of 1%, revenue increased 24% primarily due to 29% from expansion of our U.S. and U.K. cross-border business and retail network, including the acquisition of Borderfree. This increase was partially offset by a decrease of 2% related to the one-time recognition of deferred cross-border delivery fees in the first quarter of 2015 and a 2% decrease from a decline in domestic shipping solutions revenue.\nEBIT increased to $4 million in the quarter compared to a loss of $1 million in the third quarter of 2015, primarily due to higher revenue and synergy savings partially offset by decline in higher margin domestic shipping solutions revenue. EBIT decreased 11% for the first nine months of the year primarily due to $7 million of additional amortization expense from acquisitions, $6 million of deferred cross-border delivery fees recognized in 2015, additional investments in the business and lower higher margin domestic shipping solutions revenue, partially offset by higher revenue in cross-border.\n34\nOther\nOther includes Imagitas, our Marketing Services business, which was sold in May 2015.\nLIQUIDITY AND CAPITAL RESOURCES\nWe believe that existing cash and investments, cash generated from operations and borrowing capacity under our commercial paper program will be sufficient to support our current cash needs, including discretionary uses such as capital investments, dividends, strategic acquisitions and share repurchases. Cash and cash equivalents and short-term investments were $1,016 million at September 30, 2016 and $768 million at December 31, 2015. We continuously review our credit profile through published credit ratings and the credit default swap market. We also monitor the creditworthiness of those banks acting as derivative counterparties, depository banks or credit providers.\nCash and cash equivalents held by our foreign subsidiaries were $500 million at September 30, 2016 and $470 million at December 31, 2015. Cash and cash equivalents held by our foreign subsidiaries are generally used to support the liquidity needs of these subsidiaries. Most of these amounts could be repatriated to the U.S. but would be subject to additional taxes. Repatriation of some foreign balances is restricted by local laws.\nCash Flow Summary\n| 2016 | 2015 | Change |\n| Net cash provided by operating activities | $ | 291 | $ | 351 | $ | (60 | ) |\n| Net cash used in investing activities | (75 | ) | (205 | ) | 130 |\n| Net cash provided by (used in) financing activities | 121 | (472 | ) | 593 |\n| Effect of exchange rate changes on cash and cash equivalents | 4 | (38 | ) | 42 |\n| Change in cash and cash equivalents | $ | 341 | $ | (364 | ) | $ | 705 |\n\nCash flows from operations decreased $60 million, primarily due to:\n| • | Lower income; |\n\n| • | A special pension plan contribution of $37 million to the U.K. pension plan; and |\n\n| • | Payments associated with the launch of the enterprise business platform and new advertising campaign; partially offset by: |\n\n| • | Lower employee-related costs and interest payments. |\n\nCash flows from investing activities improved by $130 million, primarily due to:\n| • | A decrease of $349 million in acquisitions; |\n\n| • | An increase of $60 million in net maturities of investments; |\n\n| • | An increase in reserve deposits of $27 million; |\n\n| • | Lower capital expenditures of $15 million, partially offset by: |\n\n| • | Proceeds of $292 million from the sale of Imagitas in 2015; and |\n\n| • | Lower proceeds from asset sales of $21 million. |\n\nCash flows from financing activities improved by $593 million, primarily due to:\n| • | Higher net borrowings of $688 million (we increased total debt by $434 million in 2016 compared to a net debt reduction of $254 million in 2015); partially offset by: |\n\n| • | Higher share repurchases of $97 million. |\n\nFinancings and Capitalization\nWe are a \"Well-Known Seasoned Issuer\" within the meaning of Rule 405 under the Securities Act, which allows us to issue debt securities, preferred stock, preference stock, common stock, purchase contracts, depositary shares, warrants and units in an expedited fashion. We have a commercial paper program that is an important source of liquidity for us and a committed credit facility of $1 billion to support our commercial paper issuances. The credit facility expires in January 2020. We have not drawn upon the credit facility.\nAt September 30, 2016, there were no outstanding commercial paper borrowings. During the third quarter of 2016, the average daily amount of outstanding commercial paper borrowings was $305 million at a weighted-average interest rate of 1.01% and the maximum amount outstanding at any time during the quarter was $409 million.\nIn September 2016, we issued $600 million of 3.375% fixed-rate notes due in October 2021. Interest is payable semi-annually. The notes mature in October 2021, but may be redeemed, at our option, in whole or in part, at any time or from time to time at a par plus accrued\n35\nand unpaid interest. We used a portion of these proceeds to repay commercial paper and used the remaining proceeds to redeem the PBIH Preferred Stock on November 1, 2016 (see Note 12 to the Condensed Consolidated Financial Statements).\nIn January 2016, we borrowed $300 million under a term loan agreement and applied the proceeds to the repayment of the $371 million, 4.75% notes due January 2016. The new term loans bear interest at the applicable Eurodollar Rate plus 1.25% and mature in December 2020. The effective interest rate of these loans for the third quarter was 1.95%. In September 2016, we entered into an interest rate swap with a notional amount of $300 million to mitigate the interest rate risk associated with these variable-rate term loans. Under the terms of the swap agreement, we pay fixed-rate interest of 0.8826% and receive variable-rate interest based on 1-month LIBOR. The variable rate resets monthly.\nIn March 2016, we satisfied certain employment obligations stipulated in the State of Connecticut Department of Economic and Community Development loan (issued in 2014), and under the terms of the loan, $10 million was forgiven.\nDividends and Share Repurchases\nThrough the nine months ended September 30, 2016, we paid dividends to our stockholders of $106 million. Each quarter, our Board of Directors considers our recent and projected earnings and other capital needs and priorities in deciding whether to approve the payment, as well as the amount, of a dividend. There are no material restrictions on our ability to declare dividends.\nDuring 2016, we spent $197 million to repurchase our common shares.\nOff-Balance Sheet Arrangements\nAt September 30, 2016, we had no off-balance sheet arrangements that have, or are reasonably likely to have, a material current or future effect on our financial condition, results of operations or liquidity.\nCritical Accounting Estimates\nFinance Receivables and Allowance for Credit Losses\nFinance receivables are composed of sales-type lease receivables and unsecured revolving loan receivables. We provide an allowance for probable credit losses based on historical loss experience, the nature and volume of our portfolios, adverse situations that may affect a client's ability to pay, prevailing economic conditions and our ability to manage the collateral. At September 30, 2016 gross finance receivables aged greater than 90 days have grown since the implementation of our enterprise business platform in the second quarter of 2016. We believe the majority of the increased delinquency is administrative in nature and the result of a change in our billing format and new process under our new enterprise business platform. The billing format under our new platform is different and clients are in the process of transitioning and understanding the new format and thus have not made payments timely. These accounts are considered delinquent in our analysis, but we continue to expect that payment in full will be received. The aging as disclosed in Note 5 of the condensed consolidated financial statements represents full contract value while only a small portion (approximately 25%) has been billed and recognized in income as of September 30, 2016.\nThe quality of the portfolio has not changed. Our loan portfolio delinquency has remained fairly constant when compared to loan delinquency in our legacy platform and there has been no significant changes in customers within the portfolio. Also, we use a third party to credit score our lease and loan portfolios. The credit quality of our portfolio as determined by this third party has shown no signs of deterioration suggesting that the increase in delinquency is not a result of our customer's ability to pay, but instead is a result of changes to invoice format and presentation. Accordingly, we do not believe that an increase in the allowance for credit losses as a result of the increase in delinquencies is necessary.\nGoodwill\nBased on the year-to-date operating results of our Software Solutions reporting unit, we performed a goodwill impairment test to access the adequacy of the carrying value of goodwill. As a result of our test, we determined that the estimated fair value of the reporting unit exceeded its carrying value by 15%. The assumptions used to estimate fair value were based on projections incorporated in our current operating plans as well as other available information. By their nature, projections are uncertain. Potential events and circumstances, such as declining revenue, loss of client contracts and inability to acquire new clients could have an adverse effect on our assumptions.\nThe goodwill balance related to the software reporting unit at September 30, 2016 was $678 million. We will continue to monitor and evaluate the carrying value of goodwill for this reporting unit, and should facts and circumstances change, a non-cash impairment charge could be recorded in the future. We will also perform our annual goodwill impairment testing for all reporting units during the fourth quarter.\n36\nRegulatory Matters\nThere have been no significant changes to the regulatory matters disclosed in our 2015 Annual Report.\n37\nItem 3: Quantitative and Qualitative Disclosures about Market Risk\nThere were no material changes to the disclosures made in the 2015 Annual Report.\nItem 4: Controls and Procedures\nDisclosure controls and procedures are designed to reasonably assure that information required to be disclosed in reports filed or submitted under the Securities Exchange Act of 1934, as amended (Exchange Act) is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures are also designed to reasonably assure that such information is accumulated and communicated to management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO), as appropriate to allow timely decisions regarding required disclosure.\nUnder the direction of our CEO and CFO, we evaluated our disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) under the Exchange Act) and internal control over financial reporting. Our CEO and CFO concluded that, as of the end of the period covered by this report, such disclosure controls and procedures were effective to ensure that information we are required to disclose in reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Exchange Act. In addition, no changes in internal control over financial reporting occurred during the fiscal quarter covered by this report that have materially affected, or are reasonably likely to materially affect, such internal control over financial reporting. It should be noted that any system of controls is based in part upon certain assumptions designed to obtain reasonable (and not absolute) assurance as to its effectiveness, and there can be no assurance that any design will succeed in achieving its stated goals. Notwithstanding this caution, the CEO and CFO have reasonable assurance that the disclosure controls and procedures were effective as of September 30, 2016.\nWe are implementing an Enterprise Resource Planning (\"ERP\") system on a worldwide basis, which is expected to improve the efficiency of our supply chain and financial transaction processes. The implementation is expected to occur in phases extending through 2017. The implementation of a worldwide ERP system will likely affect the processes and related controls that constitute our internal control over financial reporting and will require testing for effectiveness. During the second quarter of 2016, we implemented the ERP system in the U.S. after having implemented in Canada during the fourth quarter 2015.\n38\nPART II. OTHER INFORMATION\nItem 1: Legal Proceedings\nSee Note 13 to the Condensed Consolidated Financial Statements.\nItem 1A: Risk Factors\nThere were no material changes to the risk factors identified in our 2015 Annual Report.\nItem 2: Unregistered Sales of Equity Securities and Use of Proceeds\nRepurchases of Equity Securities\nWe periodically repurchase shares of our common stock to manage the dilution created by shares issued under employee stock plans and for other purposes in the open market. In February 2016, we received authorization from the Board of Directors to repurchase an additional $150 million of our common stock. The following table provides information about our purchases of our common stock during the three months ended September 30, 2016:\n| Total Number ofshares purchased | Average pricepaid per share | Total Number ofshares purchasedas part ofpubliclyannounced plans or programs | Approximatedollar value ofshares that maybe purchasedunder the plans or programs (inthousands) |\n| Beginning balance | $23,513 |\n| July 1, 2016 - July 31, 2016 | 144,734 | $17.21 | 144,734 | $21,022 |\n| August 1, 2016 - August 31, 2016 | — | — | — | $21,022 |\n| September 1, 2016 - September 30, 2016 | — | — | — | $21,022 |\n| 144,734 | $17.21 | 144,734 |\n\nItem 6: Exhibits\n| ExhibitNumber | Description | Exhibit Number in this Form 10-Q |\n| 12 | Computation of ratio of earnings to fixed charges | 12 |\n| 31.1 | Certification of Chief Executive Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as amended | 31.1 |\n| 31.2 | Certification of Chief Financial Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as amended | 31.2 |\n| 32.1 | Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 | 32.1 |\n| 32.2 | Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 | 32.2 |\n| 101.INS | XBRL Report Instance Document |\n| 101.SCH | XBRL Taxonomy Extension Schema Document |\n| 101.CAL | XBRL Taxonomy Calculation Linkbase Document |\n| 101.DEF | XBRL Taxonomy Definition Linkbase Document |\n| 101.LAB | XBRL Taxonomy Label Linkbase Document |\n| 101.PRE | XBRL Taxonomy Presentation Linkbase Document |\n\n39\nSignatures\nPursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n| PITNEY BOWES INC. |\n| Date: | November 7, 2016 |\n| /s/ Michael Monahan |\n| Michael Monahan |\n| Executive Vice President, Chief Operating Officer and Chief Financial Officer (Principal Financial Officer) |\n| /s/ Steven J. Green |\n| Steven J. Green |\n| Vice President – Finance and Chief Accounting Officer |\n| (Principal Accounting Officer) |\n\n40\nExhibit Index\n| ExhibitNumber | Description | Exhibit Number in this Form 10-Q |\n| 12 | Computation of ratio of earnings to fixed charges | 12 |\n| 31.1 | Certification of Chief Executive Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as amended | 31.1 |\n| 31.2 | Certification of Chief Financial Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as amended | 31.2 |\n| 32.1 | Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 | 32.1 |\n| 32.2 | Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 | 32.2 |\n| 101.INS | XBRL Report Instance Document |\n| 101.SCH | XBRL Taxonomy Extension Schema Document |\n| 101.CAL | XBRL Taxonomy Calculation Linkbase Document |\n| 101.DEF | XBRL Taxonomy Definition Linkbase Document |\n| 101.LAB | XBRL Taxonomy Label Linkbase Document |\n| 101.PRE | XBRL Taxonomy Presentation Linkbase Document |\n\n41\n</text>\n\nWhat is the total costs and expenses for the three months ending September 30, 2016 as a percentage of total revenue for the same period including the adjustment of investment activity in percentage?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"ground_truth": "Therefore, the answer is 88.84246105146735."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nPART I – FINANCIAL INFORMATION\nItem 1.Interim Financial Statements\nPAPAYA GROWTH OPPORTUNITY CORP. I\nCONDENSED BALANCE SHEETS\n| | | | | | | |\n| | June 30, 2023 | December 31, 2022 |\n| | (Unaudited) | (Audited) |\n| ASSETS | | |\n| | | | | | | |\n| CURRENT ASSETS | | |\n| Cash | | $ | 13,905 | | $ | 320,067 |\n| Prepaid expenses and other assets | | 59,237 | | 216,608 |\n| Advance taxes paid | | | 41,000 | | | 41,000 |\n| Interest income receivable | | | 424,024 | | | — |\n| Total current assets | | 538,166 | | 577,675 |\n| OTHER ASSETS | | | | | | |\n| Deferred tax asset | | 298,836 | | — |\n| Investments held in Trust Account | | | 103,814,984 | | | 297,568,272 |\n| TOTAL ASSETS | | $ | 104,651,986 | | $ | 298,145,947 |\n| | | | | | | |\n| LIABILITIES, REDEEMABLE COMMON STOCK, AND STOCKHOLDERS’ DEFICIT | | |\n| | | | | | | |\n| CURRENT LIABILITIES | | |\n| Accounts payable and accrued expenses | | $ | 236,694 | | $ | 223,640 |\n| Due to affiliate | | 87,000 | | 14,500 |\n| Note payable-related party | | | 1,283,102 | | | — |\n| State franchise tax payable | | 20,800 | | 200,800 |\n| Excise tax liability | | 1,962,245 | | — |\n| State income tax payable | | | — | | | 27,000 |\n| Deferred underwriting fee payable | | | 15,125,000 | | | 15,125,000 |\n| Total current liabilities | | 18,714,841 | | 15,590,940 |\n| Deferred tax liability | | — | | 555,020 |\n| Total liabilities | | 18,714,841 | | 16,145,960 |\n| COMMITMENTS AND CONTINGENCIES | | | |\n| Class A common stock subject to possible redemption, $ 0.0001 par value; 9,864,099 and 28,750,000 shares at redemption value of $ 10.52 and $ 10.20 per share on June 30, 2023 and December 31, 2022 | | 103,814,984 | | 293,250,000 |\n| STOCKHOLDERS’ DEFICIT | | | |\n| Preferred stock, $ 0.0001 par value; 1,000,000 shares authorized; none issued and outstanding | | — | | — |\n| Class A common stock; $ 0.0001 par value; 110,000,000 shares authorized; 1,365,500 shares issued and outstanding excluding, 9,864,099 and 28,750,000 shares subject to possible redemption at June 30, 2023 and December 31, 2022 | | 137 | | 137 |\n| Class B common stock; $ 0.0001 par value; 20,000,000 shares authorized; 7,528,875 shares issued and outstanding | | 753 | | 753 |\n| Additional paid-in capital | | — | | — |\n| Accumulated deficit | | ( 17,878,729 ) | | ( 11,250,903 ) |\n| Total stockholders’ deficit | | ( 17,877,839 ) | | ( 11,250,013 ) |\n| TOTAL LIABILITIES, REDEEMABLE COMMON STOCK AND STOCKHOLDERS’ DEFICIT | | $ | 104,651,986 | | $ | 298,145,947 |\n\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n\n2\n| | | | | | | | | | | | | |\n| | | For the three | | For the six |\n| | | months ended | | months ended |\n| | June 30, | | June 30, |\n| | 2023 | 2022 | 2023 | 2022 |\n| OPERATING EXPENSES | | | | | | | | | | |\n| General and administrative | | $ | 350,728 | | $ | 382,361 | | $ | 968,490 | | $ | 807,307 |\n| Franchise tax | | | 50,000 | | | 50,000 | | 100,000 | | | 95,857 |\n| Total expenses | | | 400,728 | | | 432,361 | | 1,068,490 | | | 903,164 |\n| | | | | | | | | | | | | |\n| OTHER INCOME | | | | | | | | | | |\n| Interest earned on Investments held in Trust Account | | | 1,741,734 | | | — | | | 4,283,238 | | | — |\n| Realized gain on investments held in Trust Account | | | — | | | — | | 479,857 | | | — |\n| Unrealized gain on investments held in Trust Account | | | — | | | 440,621 | | | — | | | 335,521 |\n| Total other income | | | 1,741,734 | | | 440,621 | | | 4,763,095 | | | 335,521 |\n| | | | | | | | | | | | | |\n| INCOME (LOSS) BEFORE PROVISION FOR INCOME TAXES | | | 1,341,006 | | | 8,260 | | | 3,694,605 | | | ( 567,643 ) |\n| Income tax expense | | | ( 252,343 ) | | | — | | | ( 1,405,144 ) | | | — |\n| NET INCOME (LOSS) | | $ | 1,088,663 | | $ | 8,260 | | $ | 2,289,461 | | $ | ( 567,643 ) |\n| | | | | | | | | | | | | |\n| Weighted-average shares outstanding of Class A common stock | | | 13,512,510 | | | 28,750,000 | | 21,768,140 | | | 25,875,000 |\n| Basic and diluted net income per share, Class A | | $ | 0.13 | | $ | 0.00 | | $ | 0.40 | | $ | 1.25 |\n| Weighted-average shares outstanding of Class B common stock | | | 7,528,875 | | | 7,528,875 | | 7,528,875 | | | 7,528,875 |\n| Basic and diluted net income (loss) per share, Class B | | $ | 0.05 | | $ | 0.00 | | $ | 0.08 | | $ | ( 0.02 ) |\n\n| | | | | | | | | | | | | | | | | | | | |\n| | | Common stock | | | | | | | | Total |\n| | | Class A | | Class B | | Additional paid | | Accumulated | | stockholders’ |\n| | Shares | Amount | Shares | Amount | in capital | Deficit | deficit |\n| Balance, December 31, 2022 (audited) | | 1,365,500 | | $ | 137 | | 7,528,875 | | $ | 753 | | $ | — | | $ | ( 11,250,903 ) | | $ | ( 11,250,013 ) |\n| Accretion of Class A common stock to redemption value | — | | — | — | | — | | — | | ( 5,910,917 ) | | ( 5,910,917 ) |\n| Net income | | — | | | — | | — | | | — | | | — | | | 1,200,798 | | | 1,200,798 |\n| Balance, March 31, 2023 | | 1,365,500 | | $ | 137 | | 7,528,875 | | $ | 753 | | $ | — | | $ | ( 15,961,022 ) | | $ | ( 15,960,132 ) |\n| Accretion of Class A common stock to redemption value | | — | | | — | | — | | | — | | | — | | | ( 1,044,125 ) | | | ( 1,044,125 ) |\n| Excise taxes on stock redemption | | — | | | — | | — | | | — | | | — | | | ( 1,962,245 ) | | | ( 1,962,245 ) |\n| Net income | — | | — | — | | — | | — | | 1,088,663 | | 1,088,663 |\n| Balance, June 30, 2023 | 1,365,500 | | $ | 137 | 7,528,875 | | $ | 753 | | $ | — | | $ | ( 17,878,729 ) | | $ | ( 17,877,839 ) |\n| | | | | | | | | | | | | | | | | | | | | |\n| | | Common stock | | | | | | | | Total |\n| | | Class A | | Class B | | Additional paid- | | Accumulated | | stockholders’ |\n| | Shares | Amount | Shares | Amount | in capital | Deficit | deficit |\n| Balance, December 31, 2021 (audited) | | — | | $ | — | 7,528,875 | | $ | 753 | $ | 24,247 | $ | ( 32,972 ) | $ | ( 7,972 ) |\n| Sale of Private Placement units including overallotment | | 1,365,500 | | 137 | — | | — | | 13,654,863 | | — | | 13,655,000 |\n| Proceeds from Initial Public Offering Costs allocated to Public Warrants (net of offering costs) | | — | | — | — | | — | | 6,272,244 | | — | | 6,272,244 |\n| Accretion of Class A common stock to redemption value | | — | | — | — | | — | | ( 19,951,354 ) | | ( 12,768,388 ) | | ( 32,719,742 ) |\n| Net loss | | — | | — | — | | — | | — | | ( 575,903 ) | | ( 575,903 ) |\n| Balance, March 31, 2022 | | $ | 1,365,500 | | $ | 137 | | 7,528,875 | | $ | 753 | | $ | — | | $ | ( 13,377,263 ) | | $ | ( 13,376,373 ) |\n| Net income | | | — | | | — | | — | | | — | | | — | | | 8,260 | | | 8,260 |\n| Balance, June 30, 2022 | | $ | 1,365,500 | | $ | 137 | 7,528,875 | | $ | 753 | | $ | — | | $ | ( 13,369,003 ) | | $ | ( 13,368,113 ) |\n\n| | | | | | | |\n| | | For the six | | For the six |\n| | | months ended | | months ended |\n| | June 30, 2023 | June 30, 2022 |\n| CASH FLOWS FROM OPERATING ACTIVITIES | | | | | |\n| Net income (loss) | | $ | 2,289,461 | | $ | ( 567,643 ) |\n| Adjustments to reconcile net income (loss) to net cash used in operating activities: | | | | | |\n| Interest earned on investments held in Trust Account | | | ( 4,283,238 ) | | | — |\n| Realized gain (net) on investment held in Trust Account | | ( 479,857 ) | | | ( 335,521 ) |\n| Deferred taxes | | | ( 853,856 ) | | | — |\n| Changes in operating assets and liabilities: | | | | | |\n| Prepaid expenses and other assets | | 157,371 | | | ( 448,529 ) |\n| Due to affiliate | | 72,500 | | | 14,500 |\n| Accounts payable and accrued expenses | | 13,054 | | | 55,758 |\n| Advance taxes paid | | | — | | | — |\n| State income tax payable | | | ( 27,000 ) | | | — |\n| State franchise tax payable | | ( 180,000 ) | | | 95,857 |\n| Net cash used in operating activities | | ( 3,291,565 ) | | | ( 1,185,578 ) |\n| | | | | | | |\n| CASH FLOWS FROM INVESTING ACTIVITIES | | | | |\n| Withdrawal from Trust Account for tax payments | | | 2,664,050 | | | — |\n| Cash deposited in Trust Account | | ( 961,750 ) | | | ( 29,325,000 ) |\n| Cash withdrawn from Trust Account in connection with Redemption | | | 196,390,058 | | | — |\n| Net cash provided by (used in) investing activities | | 198,092,359 | | | ( 29,325,000 ) |\n| | | | | | | |\n| CASH FLOWS FROM FINANCING ACTIVITIES | | | | |\n| Redemption of common stock | | ( 196,390,058 ) | | | — |\n| Payment of notes payable - related party | | — | | | ( 145,000 ) |\n| Proceeds from notes payable - related party | | 1,283,102 | | | — |\n| Proceeds from initial public offering, net of underwriters’ discount | | | — | | | 282,500,000 |\n| Proceeds from private placement units | | | — | | | 13,655,000 |\n| Payment of offering costs | | — | | | ( 404,600 ) |\n| Net cash provided by (used in) financing activities | | ( 195,106,956 ) | | | 295,605,400 |\n| | | | | | | |\n| NET CHANGE IN CASH | | ( 306,162 ) | | | 1,169,822 |\n| CASH, BEGINNING OF PERIOD | | 320,067 | | | 21,991 |\n| CASH, END OF PERIOD | | $ | 13,905 | | $ | 1,191,813 |\n| | | | | | | |\n| Supplemental disclosure of cash flow activities: | | | | | | |\n| Income taxes paid | | $ | 1,405,144 | | $ | — |\n| Supplemental disclosure of noncash financing activities: | | | | |\n| Deferred underwriting commissions payable | | $ | — | | $ | 15,125,000 |\n| Initial value of Class A common stock subject to possible redemption | | $ | — | | $ | 293,250,000 |\n| Excise taxes on stock redemption | | $ | 1,962,245 | | $ | — |\n| Accretion for Class A common stock to redemption value | | $ | 6,955,042 | | $ | 32,719,742 |\n| Income taxes paid | | $ | 1,405,144 | | $ | — |\n\nPAPAYA GROWTH OPPORTUNITY CORP. INOTES TO CONDENSED FINANCIAL STATEMENTSJUNE 30, 2023 (UNAUDITED) Note 1 — Description of Organization, Business Operations and LiquidityPapaya Growth Opportunity Corp. I (the “Company”) was incorporated in Delaware on October 8, 2021. The Company is a blank check company formed for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities (the “Business Combination”).The Company is not limited to a particular industry or geographic region for purposes of consummating a Business Combination. The Company is an early stage and emerging growth company and, as such, the Company is subject to all of the risks associated with early stage and emerging growth companies.As of June 30, 2023, the Company had not commenced any operations. All activity from October 8, 2021 (inception) through June 30, 2023, relates to the Company’s formation and Initial Public Offering (“IPO”), which is described below and, since the IPO, the search for a prospective Business Combination. The Company will not generate any operating revenues until after the completion of its initial Business Combination, at the earliest. The Company will generate non-operating income in the form of interest income earned on investments from the proceeds derived from the IPO held in the Trust Account (defined below). The registration statement for the Company’s IPO was declared effective on January 13, 2022. On January 19, 2022, the Company consummated the IPO of 25,000,000 units (“Units”), including shares of Class A common stock in the Units offered (the “Public Shares”), at $ 10.00 per Unit, generating gross proceeds of $ 250,000,000 , which is discussed in Note 3. The Company has selected December 31 as its fiscal year end.Simultaneously with the closing of the IPO, the Company consummated the sale of 1,290,500 private placement units (“Private Placement Units”) at a price of $ 10.00 per Private Placement Unit in a private placement to the Company’s sponsor, Papaya Growth Opportunity I Sponsor, LLC (the “Sponsor”), Cantor Fitzgerald & Co. (“Cantor”), and J.V.B. Financial Group, LLC on behalf of its Cohen & Company Capital Markets division (“CCM”), generating gross proceeds of $ 12,905,000 which is described in Note 4.Simultaneously with the closing of the IPO and the sale of the Private Placement Units, the Company consummated the closing of the sale of 3,750,000 additional Units upon receiving notice of the underwriter’s election to fully exercise its overallotment option (“Overallotment Units”), generating additional gross proceeds of $ 37,500,000 . Simultaneously with the exercise of the overallotment, the Company consummated the private placement of an additional 75,000 Private Placement Units to the Sponsor, generating gross proceeds of $ 750,000 .Offering costs for the IPO and sale of the Private Placement Units and Overallotment Units amounted to $ 20,697,498 , consisting of $ 5,000,000 of upfront underwriting fees, $ 15,125,000 of deferred underwriting fees payable (which are held in the Trust Account (defined below)), and $ 572,498 of other offering costs. As described in Note 6, the $ 15,125,000 of deferred underwriting fees payable is contingent upon the consummation of a Business Combination by August 19, 2023 or up to October 19, 2023, 21 months from the closing of the IPO, subject to the terms of the underwriting agreement.Following the closing of the IPO and the sale of the Private Placement Units and Overallotment Units, $ 293,250,000 ($ 10.20 per Unit) from the net proceeds of the sale of the Units in the IPO, Overallotment Units, and the Private Placement Units was placed in a trust account (“Trust Account”). The amounts placed in the Trust Account are invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), with a maturity of 185 days or less or in money market funds selected by the Company meeting the conditions of paragraphs (d)(2), (d)(3), (d)(4) and (d)(5) of Rule 2a-7 of the Investment Company Act, as determined by the Company, until the earlier of: (i) the completion of a Business Combination and (ii) the distribution of the Trust Account, as described below. 6\nThe Company’s management has broad discretion with respect to the specific application of the net proceeds of the IPO and the sale of the Private Placement Units and Overallotment Units, although substantially all of the net proceeds are intended to be applied generally toward consummating a Business Combination. The Company must complete one or more initial Business Combinations having an aggregate fair market value of at least 80 % of the assets held in the Trust Account (excluding the deferred underwriting commissions and taxes payable on the interest earned on the Trust Account) at the time of the agreement to enter into the initial Business Combination. However, the Company will only complete a Business Combination if the post-transaction company owns or acquires 50 % or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act. There is no assurance the Company will be able to successfully effect a Business Combination.The Company will provide the holders of the outstanding Public Shares (the “Public Stockholders”) with the opportunity to redeem all or a portion of their Public Shares upon the completion of a Business Combination either (i) in connection with a stockholder meeting called to approve the Business Combination or (ii) by means of a tender offer. The decision as to whether the Company will seek stockholder approval of a Business Combination or conduct a tender offer will be made by the Company. The Public Stockholders will be entitled to redeem their Public Shares for a pro rata portion of the amount then in the Trust Account (initially $ 10.20 per Public Share, plus any pro rata interest then in the Trust Account, net of taxes payable).All of the Public Shares contain a redemption feature which allows for the redemption of such Public Shares in connection with the Company’s liquidation, if there is a stockholder vote or tender offer in connection with the Company’s Business Combination and in connection with certain amendments to the Company’s amended and restated certificate of incorporation (the “Certificate of Incorporation”). In accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity” (“ASC 480”) Subtopic 10-S99, redemption provisions not solely within the control of a company require Class A common stock subject to redemption to be classified outside of permanent equity. Given that the Public Shares were issued with other freestanding instruments (i.e., Public Warrants as defined in Note 3), the initial carrying value of the Public Shares classified as temporary equity was the allocated proceeds determined in accordance with ASC 470-20 “Debt with Conversion and other Options”. The Public Shares are subject to ASC 480-10-S99. If it is probable that the equity instrument will become redeemable, the Company has the option to either (i) accrete changes in the redemption value over the period from the date of issuance (or from the date that it becomes probable that the instrument will become redeemable, if later) to the earliest redemption date of the instrument or (ii) recognize changes in the redemption value immediately as they occur and adjust the carrying amount of the instrument to equal the redemption value at the end of each reporting period. The Company has elected to recognize the changes immediately. While redemptions cannot cause the Company’s net tangible assets to fall below $ 5,000,001 , the Public Shares are redeemable and are classified as such on the balance sheet until such date that a redemption event takes place.Redemptions of the Company’s Public Shares may be subject to the satisfaction of conditions, including minimum cash conditions, pursuant to an agreement relating to the Company’s Business Combination. If the Company seeks stockholder approval of the Business Combination, the Company will proceed with a Business Combination if a majority of the shares voted are voted in favor of the Business Combination, or such other vote as required by law or stock exchange rule. If a stockholder vote is not required by applicable law or stock exchange listing requirements and the Company does not decide to hold a stockholder vote for business or other reasons, the Company will, pursuant to its Certificate of Incorporation, conduct the redemptions pursuant to the tender offer rules of the Securities and Exchange Commission (“SEC”) and file tender offer documents with the SEC prior to completing a Business Combination. If, however, stockholder approval of the transaction is required by applicable law or stock exchange listing requirements, or the Company decides to obtain stockholder approval for business or other reasons, the Company will offer to redeem shares in conjunction with a proxy solicitation pursuant to the proxy rules and not pursuant to the tender offer rules. If the Company seeks stockholder approval in connection with a Business Combination, the Sponsor has agreed to vote its Placement Shares (as defined in Note 4), Founder Shares (as defined in Note 5) and any Public Shares purchased during or after the IPO in favor of approving a Business Combination. Additionally, each Public Stockholder may elect to redeem their Public Shares without voting, and if they do vote, irrespective of whether they vote for or against the proposed transaction.Notwithstanding the foregoing, the Certificate of Incorporation provides that a Public Stockholder, together with any affiliate of such stockholder or any other person with whom such stockholder is acting in concert or as a “group” (as defined under Section 13 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), will be restricted from redeeming its shares with respect to more than an aggregate of 15 % or more of the Public Shares sold in the IPO, without the prior consent of the Company. 7\nThe Company’s Sponsor, officers and directors (the “Initial Stockholders”) have agreed not to propose an amendment to the Certificate of Incorporation that would affect the substance or timing of the Company’s obligation to redeem 100 % of its Public Shares if the Company does not complete a Business Combination, unless the Company provides the Public Stockholders with the opportunity to redeem their shares of Class A common stock in conjunction with any such amendment.On April 12, 2023, the Company’s stockholders approved an amendment (the “Extension Amendment”) to the Certificate of Incorporation to extend the date by which the Company must consummate an initial business combination up to six (6) times for an additional one (1) month each time, from April 19, 2023 to October 19, 2023 (which is 21 months from the closing of the IPO). If the Company is unable to complete a Business Combination by October 19, 2023, which is 21 months from the closing of the IPO, in compliance with the requirements set forth in the Certificate of Incorporation for such an extension (the “Combination Period”), the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account including interest earned on the funds held in the Trust Account and not previously released to the Company to pay (a) its income and franchise taxes and (b) up to $ 100,000 of dissolution expenses, if any, divided by the number of then outstanding Public Shares, which redemption will completely extinguish the Public Stockholders’ rights as stockholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the Company’s remaining stockholders and the Company’s board of directors, dissolve and liquidate, subject in each case to the Company’s obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law.The Initial Stockholders have agreed to waive their liquidation rights with respect to the Founder Shares (as defined in Note 5) and the Placement Shares if the Company fails to complete a Business Combination within the Combination Period. However, if the Initial Stockholders should acquire Public Shares in or after the IPO, they will be entitled to liquidating distributions from the Trust Account with respect to such Public Shares if the Company fails to complete a Business Combination within the Combination Period. The underwriters have agreed to waive their rights to the deferred underwriting commission (see Note 6) held in the Trust Account in the event the Company does not complete a Business Combination within the Combination Period, and, in such event, such amounts will be included with the other funds held in the Trust Account that will be available to fund the redemption of the Public Shares. In the event of such distribution, it is possible that the per share value of the residual assets remaining available for distribution (including Trust Account assets) will be only the $ 10.20 per share initially held in the Trust Account. In order to protect the amounts held in the Trust Account, the Sponsor has agreed to be liable to the Company if and to the extent any claims by a vendor for services rendered or products sold to the Company, or a prospective target business with which the Company has discussed entering into a transaction agreement, reduce the amount of funds in the Trust Account. This liability will not apply with respect to any claims by a third party who executed a waiver of any right, title, interest or claim of any kind in or to any monies held in the Trust Account or to any claims under the Company’s indemnity of the underwriters of the IPO against certain liabilities, including liabilities under the Securities Act of 1933, as amended (the “Securities Act”). Moreover, in the event that an executed waiver is deemed to be unenforceable against a third party, the Sponsor will not be responsible to the extent of any liability for such third-party claims. The Company will seek to reduce the possibility that the Sponsor will have to indemnify the Trust Account due to claims of creditors by endeavoring to have all vendors, service providers, prospective target businesses or other entities with which the Company does business, execute agreements with the Company waiving any right, title, interest or claim of any kind in or to monies held in the Trust Account.Liquidity, Going Concern, and Management’s PlanPrior to the completion of the IPO, the Company lacked the liquidity it needed to sustain operations for a reasonable period of time, which is considered to be one year from the issuance date of the financial statements. The Company has since completed its IPO at which time capital in excess of the funds deposited in the Trust Account and/or used to fund offering expenses was released to the Company for general working capital purposes. Accordingly, management has since re-evaluated the Company’s liquidity and financial condition and determined that the Company will need to raise additional capital through loans or additional investments from its Sponsor, stockholders, officers, directors or third parties. The Company’s officers, directors and Sponsor may, but are not obligated to, loan the Company funds, in whatever amount they deem reasonable in their sole discretion, to meet the Company’s working capital needs and there is no guarantee that the Company will receive such funds. As of June 30, 2023, the Company does not have sufficient working capital and will need to borrow additional funds from its Sponsor in order to fund its operations through one year from the date of this filing.In connection with the Company’s assessment of going concern considerations in accordance with the authoritative guidance in FASB Accounting Standards Update (“ASU”) 2014-15, “Disclosures of Uncertainties about an Entity’s Ability to Continue as a Going 8\nConcern,” management has determined that the mandatory liquidation and subsequent dissolution described in Note 1, should the Company be unable to complete a Business Combination, raises substantial doubt about the Company’s ability to continue as a going concern. The Company has until October 19, 2023, 21 months from the closing of the IPO, to consummate a Business Combination. It is uncertain that the Company will be able to consummate a Business Combination during the specified period. If a Business Combination is not consummated by October 19, 2023, there will be a mandatory liquidation and subsequent dissolution. These financial statements do not include any adjustments relating to the recovery of the recorded assets or the classification of the liabilities that might be necessary should the Company be unable to continue as a going concern. Note 2 — Summary of Significant Accounting Policies Basis of PresentationThe accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 8 of Regulation S-X of the SEC. Certain information or footnote disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted, pursuant to the rules and regulations of the SEC for interim financial reporting. Accordingly, they do not include all the information and footnotes necessary for a complete presentation of financial position, results of operations, or cash flows. In the opinion of management, the accompanying unaudited condensed financial statements include all adjustments, consisting of a normal recurring nature, which are necessary for a fair presentation of the financial position, operating results and cash flows for the periods presented.The accompanying unaudited condensed financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K filed with the SEC on March 31, 2023. The interim results for the period ended June 30, 2023 are not necessarily indicative of the results to be expected for any future periods. Inflation Reduction Act of 2022On August 16, 2022, the Inflation Reduction Act of 2022 (the “IR Act”) was signed into law. The IR Act provides for, among other things, a new 1% U.S. federal excise tax on certain repurchases (including redemptions) of stock by publicly traded U.S. corporations after December 31, 2022. The excise tax is imposed on the repurchasing corporation itself, not its stockholders from whom the shares are repurchased (although it may reduce the amount of cash distributable in a current or subsequent redemption). The amount of the excise tax is 1% of the fair market value of any shares repurchased by the repurchasing corporation during a taxable year, which may be potentially netted by the fair market value of certain new stock issuances by the repurchasing corporation during the same taxable year. In addition, a number of exceptions apply to this excise tax. The U.S. Department of the Treasury (the “Treasury”) has been given authority to provide regulations and other guidance to carry out, and prevent the abuse or avoidance of, this excise tax.On December 27, 2022, the Treasury published Notice 2023-2, which provided clarification on some aspects of the application of the excise tax. The notice generally provides that if a publicly traded U.S. corporation completely liquidates and dissolves, distributions in such complete liquidation and other distributions by such corporation in the same taxable year in which the final distribution in complete liquidation and dissolution is made are not subject to the excise tax.Any such excise tax would be payable by us and not by the redeeming holder, it could cause a reduction in the value of our Class A common stock, cash available with which to effectuate a business combination or cash available for distribution in a subsequent liquidation. Whether and to what extent we would be subject to the excise tax in connection with a business combination will depend on a number of factors, including (i) the structure of the business combination, (ii) the fair market value of the redemptions and repurchases in connection with the business combination, (iii) the nature and amount of any “PIPE” or other equity issuances in connection with the business combination (or any other equity issuances within the same taxable year of the business combination) and (iv) the content of any subsequent regulations, clarifications, and other guidance issued by the Treasury. 9\nEmerging Growth CompanyThe Company is an emerging growth company as defined in Section 102(b)(1) of the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”) which exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that an emerging growth company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period, which means that when a standard is issued or revised, and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard.This may make comparison of the Company’s financial statements with another public company that is neither an emerging growth company nor an emerging growth company that has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used. Use of EstimatesThe preparation of financial statements in conformity with U.S. GAAP requires the Company’s management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. Actual results could differ from those estimates. Cash and Cash EquivalentsThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did no t have any cash equivalents as of June 30, 2023 and December 31, 2022. Investments Held in Trust AccountThe Company’s portfolio of investments held in the Trust Account is comprised of investments in money market funds that invest in U.S. government securities. The Company’s investments held in the Trust Account are classified as trading securities. Trading securities are presented on balance sheets at fair value at the end of each reporting period. Gains and losses resulting from the change in fair value of these securities are included in unrealized gain on investments held in Trust Account in the accompanying statements of operations. The estimated fair values of investments held in the Trust Account are determined using available market information. As of June 30, 2023 and December 31, 2022, the Company had $ 103,814,984 and $ 297,568,272 , respectively, held in the Trust Account. At June 30, 2023, substantially all of the assets held in the Trust Account were held in U.S. Treasury securities. Class A Common Stock Subject to Possible RedemptionThe Company accounts for its Class A common stock subject to possible redemption in accordance with the guidance in ASC 480. Shares of Class A common stock subject to mandatory redemption (if any) are classified as a liability instrument and are measured at fair value. Conditionally redeemable Class A common stock (including Class A common stock that features redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, Class A common stock is classified as stockholders’ deficit. The Company’s Public Shares sold in the IPO feature certain redemption rights that are considered to be outside of the Company’s control and subject to occurrence of uncertain future events. Accordingly, as of June 30, 2023 and December 31, 2022, 9,864,099 and 28,750,000 shares of Class A common stock subject to possible redemption are presented at redemption value as temporary equity, outside of the stockholders’ deficit section of the Company’s condensed balance sheets, respectively.On April 12, 2023, the Company held a special meeting of its stockholders (the “Special Meeting”) at which the stockholders of 18,885,901 Public Shares exercised their right to redeem their shares for cash at a redemption price of approximately $ 10.3988 per share, for an aggregate redemption amount of approximately $ 196,390,058 . Following such redemptions, 9,864,099 Public Shares remain outstanding. 10\n| | | | |\n| Gross proceeds | $ | 287,500,000 |\n| Less: Proceeds allocated to Public Warrants | | | ( 6,756,250 ) |\n| Class A common stock issuance costs | | | ( 20,213,492 ) |\n| Plus: Remeasurement of carrying value to redemption value | | | 32,719,742 |\n| Class A common stock subject to possible redemption value as of December 31, 2022 | | | 293,250,000 |\n| Plus: Accretion of common stock to redemption value | | | 5,910,917 |\n| Class A common stock subject to possible redemption value as of March 31, 2023 | | | 299,160,917 |\n| Plus: Accretion of common stock to redemption value | | | 1,044,125 |\n| Less: Redemption of common stock | | | ( 196,390,058 ) |\n| Class A common stock subject to possible redemption value as of June 30, 2023 | | $ | 103,814,984 |\n\nLevel 1:Quoted prices in active markets for identical assets or liabilities. An active market for an asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis.Level 2:Observable inputs other than Level 1 inputs. Examples of Level 2 inputs include quoted prices in active markets for similar assets or liabilities and quoted prices for identical assets or liabilities in markets that are not active.Level 3:Unobservable inputs based on the Company’s assessment of the assumptions that market participants would use in pricing the asset or liability. Warrant InstrumentsThe Company accounts for warrants as either equity-classified or liability-classified instruments based on an assessment of the instruments’ specific terms and applicable authoritative guidance in ASC 480 and ASC 815, “Derivatives and Hedging” (“ASC 815”). The assessment considers whether the instruments are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and whether the instruments meet all of the requirements for equity classification under ASC 815, including whether the instruments are indexed to the Company’s own common shares and whether the instrument holders could potentially require “net cash settlement” in a circumstance outside of the Company’s control, among other conditions for equity classification. This assessment, which requires the use of professional judgment, is conducted at the time of warrant issuance and as of each subsequent quarterly period end date while the instruments are outstanding. The Company concluded that the Public Warrants and Private Placement Warrants issued pursuant to the warrant agreement qualify for equity accounting treatment. Income and State Franchise TaxesThe Company accounts for income taxes under ASC 740, “Income Taxes”, (“ASC 740”). requires the recognition of deferred tax assets and liabilities for both the expected impact of differences between the unaudited condensed financial statements carrying amounts and tax basis of assets and liabilities and for the expected future tax benefit to be derived from tax loss and tax credit carry forwards. ASC 740 additionally requires a valuation allowance to be established when it is more likely than not that all or a portion of deferred tax assets will not be realized. As of December 31, 2022, the Company’s deferred tax asset had a full valuation allowance recorded against it. The effective tax rate is 29.84 % for the six months ended June 30, 2023, and for the year ended December 31, 2022.While ASC 740 identifies usage of the effective annual tax rate for purposes of an interim provision, it does allow for estimating individual elements in the current period if they are significant, unusual, or infrequent. Computing the effective tax rate for the Company is complicated due to the potential impact of the Company’s change in value of warrants (or any other change in fair value of a complex financial instrument), the timing of any potential business combination expenses and the actual interest income that will be recognized during the year. The Company has taken a position as to the calculation of income tax expense in the current period based on 740-270-25-3 which states, “If an entity is unable to estimate a part of its ordinary income (or loss) or the related tax (or benefit) but is otherwise able to make a reliable estimate, the tax (or benefit) applicable to the item that cannot be estimated shall be reported in the interim period in which the item is reported.” The Company believes its calculation to be a reliable estimate and allows it to properly take into account the unusual elements that can impact its annualized book income and its impact on the effective tax rate. As such, the Company is computing its taxable income (loss) and associated income tax provision based on actual results through June 30, 2023.ASC 740 also clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. ASC 740 also provides guidance on derecognition, classification, interest and penalties, accounting in interim period, disclosure and transition. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of June 30, 2023 and December 31, 2022. The Company is currently not aware of any issues under review that could result in significant payments, accruals, or material deviation from its position. The Company is subject to income taxation by major taxing authorities since inception. These examinations may include questioning the timing and amount of deductions, the nexus of income among various tax jurisdictions and compliance with federal and state tax laws. The Company’s management does not expect that the total amount of unrecognized tax benefits will materially change over the next twelve months.The Company is incorporated in the State of Delaware and is required to pay franchise taxes to the State of Delaware and California on an annual basis. 12\n| | | | | | | | | | | | | |\n| | For the three months ended June 30, | For the three months ended June 30, |\n| | | 2023 | 2022 |\n| | Class A Stock | Class B Stock | Class A Stock | Class B Stock |\n| Basic and diluted net income per share: | | | | | | | | | | | | |\n| Numerator: | | | | | | | | |\n| Allocation of net income, including accretion of temporary equity | | $ | 1,743,251 | | $ | 389,538 | | $ | 6,546 | | $ | 1,714 |\n| | | | | | | | | | | | | |\n| Denominator: | | | | | | | | | | |\n| Weighted-average shares outstanding | | 13,512,510 | | 7,528,875 | | | 28,750,000 | | | 7,528,875 |\n| | | | | | | | | | | | | |\n| Basic and diluted net income per share | | $ | 0.13 | | $ | 0.05 | | $ | 0.00 | | $ | 0.00 |\n| | | | | | | | | | | | | |\n| | For the six months ended June 30, | For the six months ended June 30, |\n| | | 2023 | | 2022 |\n| | | Class A Stock | Class B Stock | Class A Stock | Class B Stock |\n| Basic and diluted net income (loss) per share: | | | | | | | | | | | | |\n| Numerator: | | | | | | | | |\n| Allocation of net income (loss), including accretion of temporary equity | | $ | 8,656,147 | | $ | 588,356 | | $ | 32,280,040 | | $ | ( 127,941 ) |\n| | | | | | | | | | | | | |\n| Denominator: | | | | | | | | |\n| Weighted-average shares outstanding | | 21,768,140 | | 7,528,875 | | 25,875,000 | | 7,528,875 |\n| | | | | | | | | | | | | |\n| Basic and diluted net income (loss) per share | | $ | 0.40 | | $ | 0.08 | | $ | 1.25 | | $ | ( 0.02 ) |\n\nThe fair value of the 25,000 Founder Shares granted to an independent director by the Sponsor on January 12, 2023, was $ 43,000 or $ 1.72 per share. The fair value of the 180,000 Founder Shares granted to certain independent directors by the Sponsor on December 8, 2022 was $ 414,000 or $ 2.30 per share, and the fair value of the 410,000 Founder Shares granted to certain independent directors on December 21, 2021 was $ 3,079,100 or $ 7.51 per share. The Company used a Monte Carlo Model simulation to arrive at the fair value of the stock compensation. The key assumptions in the option pricing model utilized are assumptions related to expected separation date of Units, anticipated business combination date, purchase price, share-price volatility, expected term, exercise date, risk-free interest rate and present value. The expected volatility as of the IPO closing date was derived based upon similar SPAC warrants and technology exchange funds within the Company’s stated industry target and with terms until the exercise date. The Company’s Founder Shares sold to independent directors (see Note 5) were deemed within the scope of ASC 718 and are subject to a performance condition, namely the occurrence of a Business Combination. Compensation expense related to the Founder Shares transferred is recognized only when the performance condition is probable of occurrence, or more specifically when a Business Combination is consummated. Therefore, no stock-based compensation expense has been recognized for the six months ended June 30, 2023 and June 30, 2022. Recent Accounting PronouncementsThe Company’s management does not believe that any recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on the Company’s financial statements. Note 3 — Initial Public OfferingIn the IPO, the Company sold 28,750,000 Units (including 3,750,000 Overallotment Units) at a price of $ 10.00 per Unit. Each Unit consists of one share of Class A common stock and one-half of a redeemable warrant (the “Public Warrants”). Each whole Public Warrant entitles the holder to purchase one share of Class A common stock at a price of $ 11.50 per share, subject to adjustment (see Note 7). Note 4 — Private Placement UnitsOn January 19, 2022, simultaneously with the consummation of the IPO and sale of the Overallotment Units, the Company consummated the issuance and sale of 1,365,500 Private Placement Units (including 75,000 Private Placement Units purchased simultaneously with the Overallotment Units) in a private placement transaction at a price of $ 10.00 per Private Placement Unit, generating gross proceeds of $ 13,655,000 , to the Sponsor ( 1,115,500 Private Placement Units), Cantor ( 212,500 Private Placement Units), and CCM ( 37,500 Private Placement Units). Each Private Placement Unit consists of one share of Class A common stock (the “Placement Shares”) and one-half of a warrant (the “Private Placement Warrants”). Each whole Private Placement Warrant entitles the holder to purchase one share of common stock at a price of $ 11.50 per share, subject to adjustment (see Note 7).A portion of the proceeds from the sale of the Private Placement Units was added to the proceeds from the IPO (including the Overallotment Units) to be held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the proceeds from the sale of the Private Placement Units will be used to fund the redemption of the Public Shares (subject to the requirements of applicable law), and the Private Placement Units and any underlying securities will be worthless. Note 5 — Related-Party TransactionsFounder SharesOn October 19, 2021, the Sponsor purchased 7,452,500 shares (the “Founder Shares”) of the Company’s Class B common stock, par value $ 0.0001 (“Class B common stock”) for an aggregate price of $ 25,000 (see Note 7). On November 19, 2021, the Company effected a 1.0102482 -for-1 split of the Company’s Class B common stock, such that the Sponsor owns 7,528,875 Founder Shares. The Founder Shares will automatically convert into shares of Class A common stock at the time of the Company’s initial Business Combination and are subject to certain transfer restrictions, as described below. Holders of Founder Shares may also elect to convert their shares of Class B common stock into an equal number of shares of Class A common stock, subject to adjustment, at any time. The Initial Stockholders agreed to forfeit up to 956,250 Founder Shares to the extent that the overallotment option is not exercised in full by the underwriters. Since the overallotment option was exercised in full, the 956,250 Founder Shares are no longer subject to forfeiture. 14\nThe Initial Stockholders have agreed, subject to limited exceptions, not to transfer, assign or sell any of their Founder Shares until the earlier to occur of (A) one year after the completion of the Company’s initial Business Combination and (B) the date on which the Company completes a liquidation, merger, capital stock exchange or other similar transaction after the Company’s initial Business Combination that results in all of the Company’s stockholders having the right to exchange their Class A common stock for cash, securities or other property, except to certain permitted transferees. Any permitted transferees will be subject to the same restrictions and other agreements of the Company’s Initial Stockholders with respect to any Founder Shares. Notwithstanding the foregoing, if (1) the closing price of the Company’s Class A common stock equals or exceeds $ 12.00 per share (as adjusted for stock splits, stock capitalizations, reorganizations, recapitalizations and the like) for any 20 trading days within any 30 -trading day period commencing at least 150 days after the Company’s initial Business Combination or (2) if the Company consummates a transaction after the Company’s initial Business Combination which results in the Company’s stockholders having the right to exchange their shares for cash, securities or other property, the Founder Shares will be released from the lock-up.Related-Party LoansOn October 19, 2021, the Sponsor agreed to loan the Company an aggregate of up to $ 300,000 to cover expenses related to the IPO pursuant to a promissory note (the “Note”). This Note became due upon the closing of the IPO. The Note was non-interest bearing. As of December 31, 2021, the Note had an outstanding balance of $ 145,000 . On January 19, 2022, the day the IPO was consummated, there was $ 145,000 outstanding on the loan, which was repaid fully on January 24, 2022.In addition, in order to finance transaction costs in connection with a Business Combination, the Sponsor or an affiliate of the Sponsor or certain of the Company’s officers and directors may, but are not obligated to, loan the Company funds as may be required (“Working Capital Loans”). If the Company completes a Business Combination, the Company would repay the Working Capital Loans out of the proceeds of the Trust Account released to the Company. Otherwise, the Working Capital Loans would be repaid only out of funds held outside the Trust Account. In the event that a Business Combination does not close, the Company may use a portion of proceeds held outside the Trust Account to repay the Working Capital Loans but no proceeds held in the Trust Account would be used to repay the Working Capital Loans. The Working Capital Loans would either be repaid upon consummation of a Business Combination, without interest, or, at the lender’s discretion, up to $ 1.5 million of such Working Capital Loans may be convertible into warrants of the post Business Combination entity at a price of $ 1.00 per warrant. These warrants would be identical to the Private Placement Warrants. As of June 30, 2023 and December 31, 2022, there were no Working Capital Loans outstanding.Issuance of unsecured Promissory noteOn April 17, 2023, the Company issued a promissory note (the “Promissory Note”) to the Sponsor. Pursuant to the Promissory Note, the Sponsor agreed to loan the Company up to an aggregate principal amount of $ 2.8 million. The Promissory Note is non-interest bearing and all outstanding amounts under the Promissory Note will be due on the date on which the Company consummates a business combination (the “Maturity Date”). If the Company does not consummate a business combination, it may use a portion of any funds held outside the Trust Account to repay the Promissory Note; however, no proceeds from the Trust Account may be used for such repayment. If such funds are insufficient to repay the Promissory Note, the unpaid amounts would be forgiven. At the Maturity Date, the Sponsor may receive, at its option and in lieu of repayment in cash of all or any portion of the amount outstanding under the Promissory Note, the same consideration to be received by holders of the Company’s Class A common stock at the closing of the Company’s initial business combination, on the basis of two ( 2 ) shares of Class A common stock for each $ 10.00 loaned thereunder. As of June 30, 2023, the Company has borrowed $ 1,283,102 under the Promissory Note.Note Payable – Related PartyThe Sponsor (or one or more of its affiliates or third-party designees) made monthly payments of $ 320,583 for the three months towards extension payment.Support ServicesThe Company pays the Sponsor a fee of up to $ 33,333 per month for the use of office and administrative support services following the consummation of the IPO until the earlier of the consummation of the Business Combination or liquidation. As of June 30, 2023, $ 248,875 had been expensed under the arrangement and included under Due to affiliate. As of December 31, 2022, $ 14,500 has been accrued as outstanding under this agreement under Due to affiliate and $ 161,875 has been expensed under the arrangement. 15\nThe Company pays FintechForce, Inc., an entity affiliated with the Chief Financial Officer, a fee of $ 15,000 per month for consulting services, financial planning and analysis and general professional services. As of June 30, 2023, $ 250,667 had been expensed under the arrangement. As of December 31, 2022, $ 15,000 had been accrued under this agreement and is included in accounts payable and accrued expenses in the accompanying balance sheet and $ 152,176 had been expensed under the arrangement.The Company paid Kuleana Capital Management, an affiliated entity with Mr. Tim Schenk, Chairman of the Board of Directors, approximately $ 14,900 a month for certain consulting services to the Company. Kuleana Capital Management has received a total of $ 160,425 for its services. The consulting arrangement with Kuleana Capital Management was terminated on December 7, 2022, upon Mr. Schenk’s appointment to the Board of Directors. Note 6 — Commitments and ContingenciesRegistration RightsThe holders of Founder Shares, Private Placement Units and warrants that may be issued upon conversion of Working Capital Loans, if any, will be entitled to registration rights pursuant to a registration rights agreement dated January 13, 2022. These holders will be entitled to certain demands and “piggyback” registration rights. However, the registration rights agreement provides that the Company will not permit any registration statement filed under the Securities Act to become effective until the termination of the applicable lock-up period for the securities to be registered. The Company will bear the expenses incurred in connection with the filing of any such registration statements.Underwriting AgreementThe Company granted the underwriters a 45 -day option from the date of the final prospectus relating to the IPO to purchase up to 3,750,000 additional Units to cover overallotments, if any, at the IPO price less the underwriting discounts and commissions. On January 19, 2022, the underwriters fully exercised their overallotment option and purchased 3,750,000 Units at $ 10.00 per Unit.The underwriters were paid an underwriting discount of $ 0.20 per unit, or $ 5,000,000 in the aggregate, upon the closing of the IPO (plus an additional $ 750,000 upon the underwriters’ exercise of the overallotment option in full). An additional $ 0.50 per unit, or $ 12,500,000 , plus an additional $ 0.70 per Overallotment Unit or $ 2,625,000 (or $ 15,125,000 in the aggregate) is payable to the underwriters for deferred underwriting commissions. The deferred fee will become payable to the underwriters from the amounts held in the Trust Account solely in the event that the Company completes a Business Combination, subject to the terms of the underwriting agreement. Note 7 — Stockholders’ DeficitClass A Common Stock — The Company is authorized to issue 110,000,000 shares of Class A common stock with a par value of $ 0.0001 per share. As of June 30, 2023 and December 31, 2022, there were 1,365,500 shares of Class A common stock outstanding, excluding 9,864,099 and 28,750,000 shares of Class A common stock subject to redemption.Class B Common Stock — The Company is authorized to issue 20,000,000 shares of Class B common stock with a par value of $ 0.0001 per share. Holders of Class B common stock are entitled to one vote for each share. As of June 30, 2023 and December 31, 2022, there were 7,528,875 shares of Class B common stock outstanding.Holders of Class A common stock and Class B common stock vote together as a single class on all matters submitted to a vote of stockholders except as required by law. 16\n| ● | in whole and not in part; |\n| ● | at a price of $ 0.01 per Public Warrant; |\n| ● | upon not less than 30 days ’ prior written notice of redemption; |\n| ● | if, and only if, the reported last sale price of the shares of Class A common stock equals or exceeds $ 18.00 per share (as adjusted for stock splits, stock dividends, reorganizations and recapitalizations), for any 20 trading days within a 30 -trading day period commencing at any time after the Public Warrants become exercisable and ending on the third business day prior to the notice of redemption to warrant holders; and |\n| ● | if, and only if, there is a current registration statement in effect with respect to the shares of Class A common stock underlying the Public Warrants. If the Company calls the Public Warrants for redemption, management will have the option to require all holders that wish to exercise the Public Warrants to do so on a “cashless basis,” as described in the warrant agreement. |\n\n| | | | | | | | |\n| | Quoted Prices in | | Significant Other | | Significant Other |\n| | | Active Markets | | Observable Inputs | | Unobservable Inputs |\n| June 30, 2023 | (Level 1) | (Level 2) | (Level 3) |\n| Assets: | |\n| Investments held in Trust Account | $ | 103,814,984 | — | — |\n| Total | $ | 103,814,984 | — | — |\n| | | | | | | | |\n| | | Quoted Prices in | | Significant Other | | Significant Other |\n| | | Active Markets | | Observable Inputs | | Unobservable Inputs |\n| December 31, 2022 | (Level 1) | (Level 2) | (Level 3) |\n| Assets: | |\n| Investments held in Trust Account - U.S. Treasury Securities | | $ | 297,568,272 | — | — |\n| Total | | $ | 297,568,272 | — | — |\n\nItem 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nReferences in this report (this “Quarterly Report”) to “we,” “us” or the “Company” refer to Papaya Growth Opportunity Corp. I. References to our “management” or our “management team” refer to our officers and directors, and references to the “Sponsor” refer to Papaya Growth Opportunity I Sponsor, LLC. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Quarterly Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\nSpecial Note Regarding Forward-Looking Statements\nThis Quarterly Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act that are not historical facts and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. All statements, other than statements of historical fact included in this Form 10-Q including, without limitation, statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. Words such as “expect,” “believe,” “anticipate,” “intend,” “estimate,” “seek” and variations and similar words and expressions are intended to identify such forward-looking statements. Such forward-looking statements relate to future events or future performance, but reflect management’s current beliefs, based on information currently available. A number of factors could cause actual events, performance or results to differ materially from the events, performance and results discussed in the forward-looking statements. For information identifying important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements, please refer to the Risk Factors section of the Company’s Annual Report on Form 10-K and Part II, Item 1A of this Quarterly Report filed with the U.S. Securities and Exchange Commission (the “SEC”). The Company’s securities filings can be accessed on the EDGAR section of the SEC’s website at www.sec.gov. Except as expressly required by applicable securities law, the Company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.\nOverview\nWe are a blank check company incorporated on October 8, 2021, as a Delaware corporation and formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar Business Combination with one or more businesses or entities that have not yet been selected. While we may pursue an acquisition opportunity in any business, industry, sector, or geographical location, we intend to focus on industries that complement our management’s background and to capitalize on the ability of our management team to identify and acquire a business. We may pursue a transaction in which our stockholders immediately prior to completion of our initial Business Combination, would collectively own a minority interest in the post-Business Combination company. We intend to effectuate our initial Business Combination using cash from the proceeds of the IPO and the sale of the Private Placement Units held in the Trust Account (defined below), our shares, debt or a combination of cash, equity and debt.\nWe expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete a Business Combination will be successful.\nResults of Operations\nWe have neither engaged in any operations nor generated any revenues to date. Our only activities through June 30, 2023, were organizational activities, those necessary to prepare for the IPO (defined below), and, after our IPO, identifying a target company for a Business Combination. We do not expect to generate any operating revenues until after the completion of our Business Combination, at the earliest. We generate non-operating income in the form of interest income on marketable securities held in a trust account (the “Trust Account”). We incur expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses.\nFor the three months ended June 30, 2023, we had net income of $1,088,663, operating expenses of $400,728 driven by general and administrative expenses of $350,728, accrual of Delaware franchise taxes of $50,000, interest on investments held in Trust Account of $1,741,734, and income tax expense of $252,343.\n19\nFor the six months ended June 30, 2023, we had net income of $2,289,461 primarily due to operating expenses of $1,068,490 driven by general and administrative expense of $968,490 in addition to the accrual of Delaware franchise taxes of $100,000, interest on investments held in Trust Account of $4,283,238 and realized gain on investments held in the Trust Account of $479,857.For the three months ended June 30, 2022, we had net income of $8,260, operating expenses of $432,361 driven by general and administrative expenses of $382,361, and accrual of Delaware franchise taxes of $50,000 and unrealized gain on investments held in the Trust Account of $440,621. For the six months ended June 30, 2022, we had a net loss of $567,643, operating expenses of $903,164 driven by general and administrative expense of $807,307, and accrual of Delaware franchise taxes of $95,857, and unrealized gain on investments held in the Trust Account of $335,521.Liquidity and Capital ResourcesFor the six months ended June 30, 2023, net cash used in operating activities was $(3,291,565), mainly on account of the payment of operating expenses incurred to operate the business. Cash used in investing activities was $198,092,359 and net cash provided by financing activities was $(195,106,956).For the six months ended June 30, 2022, net cash used in operating activities was $1,185,578, mainly on account of the payment of the director and officer insurance policy, and operating expenses incurred to operate the business. Cash used in investing activities was $293,250,000 and net cash provided by financing activities was $295,605,400, mainly reflecting the proceeds of our IPO and private placement and the deposit thereof in the Trust Account.We intend to use substantially all of the funds held in the Trust Account, including any amounts representing interest earned on the Trust Account (less taxes payable and deferred underwriting commissions), to complete our initial Business Combination. We may withdraw interest income to pay taxes, if any. Our annual tax obligations will depend on the amount of interest and other income earned on the amounts held in the Trust Account. To the extent that our equity or debt is used, in whole or in part, as consideration to complete our initial Business Combination, the remaining proceeds held in the Trust Account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies.At June 30, 2023, we had cash of $13,905 held outside of the Trust Account. We intend to use the funds held outside the Trust Account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, properties or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, and structure, negotiate and complete a Business Combination.In order to finance transaction costs in connection with a Business Combination, the Sponsor or an affiliate of the Sponsor, or certain of the Company’s officers and directors may, but are not obligated to, loan the Company funds as may be required (“Working Capital Loans”). If the Company completes a Business Combination, the Company would repay the Working Capital Loans out of the proceeds of the Trust Account released to the Company. Otherwise, the Working Capital Loans would be repaid only out of funds held outside the Trust Account. In the event that a Business Combination does not close, the Company may use a portion of proceeds held outside the Trust Account to repay the Working Capital Loans but no proceeds held in the Trust Account would be used to repay the Working Capital Loans. The Working Capital Loans would either be repaid upon consummation of a Business Combination, without interest, or, at the lender’s discretion, up to $1,500,000 of such Working Capital Loans may be convertible into warrants of the post Business Combination entity at a price of $1.00 per warrant. The warrants would be identical to the Private Placement Warrants.We will need to raise additional capital through loans or additional investments from our Sponsor, or an affiliate of our Sponsor, stockholders, officers or directors, or third parties. Our officers, directors and Sponsor may, but are not obligated to, loan us funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet our working capital needs. Accordingly, we may not be able to obtain additional financing. If we are unable to raise additional capital, we may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, and reducing overhead expenses. We cannot provide any assurance that new financing will be available to us on commercially acceptable terms, if at all. These conditions raise substantial doubt about our ability to continue as a going concern for a reasonable period of time, which is considered to be one year from the issuance date of the financial statements.On April 17, 2023, the Company issued a promissory note (the “Promissory Note”) to the Sponsor. Pursuant to the Promissory Note, the Sponsor agreed to loan the Company up to an aggregate principal amount of $2.8 million. The Promissory Note is non-interest bearing and all outstanding amounts under the Promissory Note will be due on the date on which the Company consummates a business 20\ncombination (the “Maturity Date”). If the Company does not consummate a business combination, it may use a portion of any funds held outside the Trust Accountto repay the Promissory Note; however, no proceeds from the Trust Account may be used for such repayment. If such funds are insufficient to repay the Promissory Note, the unpaid amounts would be forgiven. At the Maturity Date, the Sponsor may receive, at its option and in lieu of repayment in cash of all or any portion of the amount outstanding under the Promissory Note, the same consideration to be received by holders of the Company’s Class A common stock at the closing of the Company’s initial business combination, on the basis of two (2) shares of Class A common stock for each $10.00 loaned thereunder. As of June 30, 2023, the Company has borrowed $1,283,102 under the Promissory NoteRelated Party TransactionsFounder SharesThe information set forth in Note 5 of the Notes to the Financial Statements in Part I, Item 1 is hereby incorporated by reference herein.Related Party LoansThe information set forth in Note 5 of the Notes to the Financial Statements in Part I, Item 1 is hereby incorporated by reference herein.Support ServicesThe information set forth in Note 5 of the Notes to the Financial Statements in Part I, Item 1 is hereby incorporated by reference herein.Registration RightsThe information set forth in Note 6 of the Notes to the Financial Statements in Part I, Item 1 is hereby incorporated by reference herein.Underwriting AgreementThe information set forth in Note 6 of the Notes to the Financial Statements in Part I, Item 1 is hereby incorporated by reference herein.Off-Balance Sheet ArrangementsWe have no obligations, assets or liabilities, which would be considered off-balance sheet arrangements as of June 30, 2023. We do not participate in transactions that create relationships with entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets.Contractual ObligationsWe do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities. The underwriter is entitled to deferred underwriting commissions of $15,125,000 in the aggregate, as described above. The deferred fee will become payable to the underwriter from the amounts held in the Trust Account solely in the event that the Company completes a Business Combination, subject to the terms of the underwriting agreement.JOBS ActOn April 5, 2012, the JOBS Act was signed into law. The JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We qualify as an “emerging growth company” and under the JOBS Act are allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) 21\ncompanies. We are electing to delay the adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As such, our financial statements may not be comparable to companies that comply with public company effective dates.Additionally, we are in the process of evaluating the benefits of relying on the other reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, if, as an “emerging growth company,” we choose to rely on such exemptions we may not be required to, among other things, (i) provide an auditor’s attestation report on our system of internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act, (ii) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (iii) comply with any requirement that may be adopted by the Public Company Accounting Oversight Board (the “PCAOB”) regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis) and (iv) disclose certain executive compensation related items such as the correlation between executive compensation and performance and comparisons of executive compensation to median employee compensation. These exemptions will apply for a period of five years following the completion of our IPO or until we are no longer an “emerging growth company,” whichever is earlier.Critical Accounting PoliciesThe preparation of unaudited condensed financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have identified the following critical accounting policies:Warrant LiabilitiesWe account for warrants as either equity-classified or liability-classified instruments based on an assessment of the warrant’s specific terms and applicable authoritative guidance in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 480, Distinguishing Liabilities from Equity (“ASC 480”) and ASC 815, Derivatives and Hedging (“ASC 815”). The assessment considers whether the warrants are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and whether the warrants meet all of the requirements for equity classification under ASC 815, including whether the warrants are indexed to our own Class A common stock, among other conditions for equity classification. This assessment, which requires the use of professional judgment, is conducted at the time of warrant issuance and as of each subsequent quarterly period end date while the warrants are outstanding.For issued or modified warrants that meet all of the criteria for equity classification, the warrants are required to be recorded as a component of additional paid-in-capital at the time of issuance. For issued or modified warrants that do not meet all the criteria for equity classification, the warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of the warrants are recognized as a non-cash gain or loss on the statements of operations. The Company concluded that the Public Warrants and Private Placement Warrants issued pursuant to the warrant agreement qualify for equity accounting treatment.Common Stock Subject to Possible RedemptionWe account for our common stock subject to possible redemption in accordance with the guidance in ASC 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that features redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. Our common stock features certain redemption rights that are considered to be outside of our control and subject to occurrence of uncertain future events. Accordingly, common stock subject to possible redemption is presented as temporary equity, outside of the stockholders’ equity section of our condensed balance sheets. The Company recognizes changes in redemption value immediately as they occur and adjusts the carrying value of redeemable common stock to equal the redemption value at the end of each reporting period. Increases or decreases in the carrying amount of redeemable common stock are affected by charges against additional paid in capital and accumulated deficit.22\nNet Income (Loss) Per Share of Common StockWe apply the two-class method in calculating earnings per share. Net income (loss) per share of the redeemable shares, basic and diluted is calculated by dividing the interest income earned on the Trust Account by the weighted average number of shares of redeemable common shares outstanding since original issuance. Net income (loss) per share of common shares, basic and diluted, for non-redeemable common shares is calculated by dividing the net loss, less income attributable to shares of redeemable common shares, by the weighted average number of shares of non-redeemable common shares outstanding for the periods presented.Recently Adopted Accounting StandardsManagement does not believe that any recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on our unaudited condensed financial statements.\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\nNot required for smaller reporting companies.\nItem 4. Controls and Procedures\nDisclosure Controls and Procedures\nAs of our quarter ended June 30, 2023, an evaluation of the effectiveness of our “disclosure controls and procedures” (as such term is defined in Rules 13a-15I and 15d-15(e) under the Exchange Act) was carried out by our management, with the participation of our Chief Executive Officer (CEO) and Chief Financial Officer (CFO). Based upon that evaluation, the CEO and CFO have concluded that as of the end of that fiscal period, our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in SEC rules and forms and (ii) accumulated and communicated to the management of the registrant, including the CEO and CFO, to allow timely decisions regarding required disclosure.\nIt should also be noted that, although the CEO and CFO believe that our disclosure controls and procedures provide a reasonable assurance that they are effective, they do not expect that our disclosure controls and procedures or internal control over financial reporting will prevent all errors and fraud. A control system, no matter how well conceived or operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met.\nChanges in Internal Control over Financial Reporting\nThere were no changes in the Company’s internal controls over financial reporting that occurred during the period covered by this Quarterly Report that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\n\n23\nPART II-OTHER INFORMATION\nItem 1. Legal Proceedings\nTo the knowledge of our management team, there is no litigation currently pending or contemplated against us, any of our officers or directors in their capacity as such or against any of our property.\n\nItem 1A. Risk Factors.\nFactors that could cause our actual results to differ materially from those in this Quarterly Report include the risk factors described in our Annual Report on Form 10-K filed with the SEC on March 31, 2023, and the risk factors set forth below. You should review the risk factors below for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in this Quarterly Report. If any of the following risks actually occur, our business, financial condition and results of operations could be adversely affected.\nThe current economic downturn may lead to increased difficulty in completing our initial business combination.\nOur ability to consummate our initial business combination may depend, in part, on worldwide economic conditions. In recent months, we have observed increased economic uncertainty in the United States and abroad. Impacts of such economic weakness include:\n| ● | falling overall demand for goods and services, leading to reduced profitability; |\n\n| ● | reduced credit availability; |\n\n| ● | higher borrowing costs; |\n\n| ● | reduced liquidity; |\n\n| ● | volatility in credit, equity and foreign exchange markets; and |\n\n| ● | bankruptcies. |\n\nThese developments could lead to inflation, higher interest rates, and uncertainty about business continuity, which may adversely affect the business of our potential target businesses and create difficulties in obtaining debt or equity financing for our initial business combination, as well as leading to an increase in the number of public stockholders exercising redemption rights in connection therewith.\n\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds from Registered Securities\nOn January 19, 2022, we consummated our IPO of 28,750,000 units, including 3,750,000 units issued pursuant to the full exercise of the underwriter’s over-allotment option. Each unit consists of one share of Class A common stock of the Company, par value $0.0001 per share (“Class A common stock”), and one-half of one redeemable warrant of the Company, with each whole warrant entitling the holder thereof to purchase one share of Class A Common Stock for $11.50 per share, subject to adjustment. The units were sold at a price of $10.00 per unit, generating gross proceeds to the Company of $287,500,000.\nCantor Fitzgerald acted as the sole bookrunner for the IPO. The units sold in the IPO were registered under the Securities Act on a registration statement on Form S-1 (No. 333-261317), which was declared effective by the SEC on January 13, 2022.\nSimultaneously with the closing of the IPO, we completed the private sale of an aggregate of 1,365,500 Private Placement Units (1,115,500 Private Placement Units to our Sponsor, 212,500 Private Placement Units to Cantor and 37,500 Private Placement Units to CCM) at a purchase price of $10.00 per Private Placement Unit, generating gross proceeds to the Company of $13,655,000, pursuant to an exemption from registration contained in Section 4(a)(2) of the Securities Act.\nOffering costs for the initial public offering amounted to $20,697,498, consisting of $5,000,000 of upfront underwriting fees, $15,125,000 of deferred underwriting fees payable (which are held in the Trust Account), and $572,498 of other offering costs. The\n24\n$15,125,000 of deferred underwriting fees payable is contingent upon the consummation of a business combination by October 19, 2023, subject to the terms of the underwriting agreement.A total of $293,250,000, comprised of the proceeds from the IPO after offering expenses and a portion of the proceeds of the sale of the Private Placement Units, was placed in the Trust Account. The proceeds held in the Trust Account may be invested by the trustee only in U.S. government securities with a maturity of 185 days or less or in money market funds investing solely in U.S. government treasury obligations and meeting certain conditions under Rule 2a-7 under the Investment Company Act.For a description of the use of the proceeds generated in our IPO, see Part I, Item 2 of this Form 10-Q.\nItem 3. Defaults Upon Senior Securities\nNone.\n\nItem 4. Mine Safety Disclosures\nNot applicable.\n\nItem 5. Other Information\nNone.\n\nItem 6. Exhibits.\n| Exhibit No. | Description |\n| 31.1* | | Certification of Chief Executive Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934. |\n| 31.2* | | Certification of Chief Financial Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934. |\n| 32.1** | | Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350. |\n| 32.2** | | Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350. |\n| 101.INS* | | Inline XBRL Instance Document |\n| 101.SCH* | | Inline XBRL Taxonomy Extension Schema Document |\n| 101.CAL* | | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF* | | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB* | | Inline XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE* | | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104 | | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\n\n| * | Filed herewith. |\n\n| ** | Furnished herewith. |\n\n\n25\n| |\n| | PAPAYA GROWTH OPPORTUNITY CORP. I |\n| | |\n| | By: | /s/ Clay Whitehead |\n| | Name: | Clay Whitehead |\n| | Title: | Chief Executive Officer |\n| | PAPAYA GROWTH OPPORTUNITY CORP. I |\n| | |\n| | By: | /s/ Daniel Rogers |\n| | Name: | Daniel Rogers |\n| | Title: | Chief Financial Officer |\n\n</text>\n\nWhat would be the new total assets of Papaya Growth Opportunity Corp. I at June 30, 2023, if they had not incurred the general and administrative expense and the losses from unrealized and realized gains on investments held in Trust Account for the first six months of 2023, assuming all other factors remain the same in dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1.\nFinancial Statements (unaudited)\nOCCIDENTAL PETROLEUM CORPORATION AND SUBSIDIARIES\nCONSOLIDATED CONDENSED BALANCE SHEETS\nMARCH 31, 2018, AND DECEMBER 31, 2017\n(Amounts in millions)\n| 2018 | 2017 |\n| ASSETS |\n| CURRENT ASSETS |\n| Cash and cash equivalents | $ | 1,606 | $ | 1,672 |\n| Trade receivables, net | 5,184 | 4,145 |\n| Inventories | 1,057 | 1,246 |\n| Assets held for sale | 335 | 474 |\n| Other current assets | 712 | 733 |\n| Total current assets | 8,894 | 8,270 |\n| INVESTMENTS IN UNCONSOLIDATED ENTITIES | 1,509 | 1,515 |\n| PROPERTY, PLANT AND EQUIPMENT, net of accumulated depreciation, depletion and amortization of $39,918 at March 31, 2018, and $39,072 at December 31, 2017 | 31,344 | 31,174 |\n| LONG-TERM RECEIVABLES AND OTHER ASSETS, NET | 1,061 | 1,067 |\n| TOTAL ASSETS | $ | 42,808 | $ | 42,026 |\n| The accompanying notes are an integral part of these consolidated condensed financial statements. |\n\n2\n| 2018 | 2017 |\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\n| CURRENT LIABILITIES |\n| Current maturities of long-term debt | $ | — | $ | 500 |\n| Accounts payable | 5,059 | 4,408 |\n| Accrued liabilities | 2,011 | 2,492 |\n| Total current liabilities | 7,070 | 7,400 |\n| LONG-TERM DEBT, NET | 10,309 | 9,328 |\n| DEFERRED CREDITS AND OTHER LIABILITIES |\n| Deferred domestic and foreign income taxes | 659 | 581 |\n| Asset retirement obligations | 1,248 | 1,241 |\n| Pension and postretirement obligations | 1,008 | 1,005 |\n| Environmental remediation reserves | 729 | 728 |\n| Other | 1,063 | 1,171 |\n| 4,707 | 4,726 |\n| STOCKHOLDERS' EQUITY |\n| Common stock, at par value (894,134,418 shares at March 31, 2018 and 893,468,707 shares at December 31, 2017) | 179 | 179 |\n| Treasury stock (128,364,195 shares at March 31, 2018, and December 31, 2017) | (9,168 | ) | (9,168 | ) |\n| Additional paid-in capital | 7,916 | 7,884 |\n| Retained earnings | 22,107 | 21,935 |\n| Accumulated other comprehensive loss | (312 | ) | (258 | ) |\n| Total stockholders’ equity | 20,722 | 20,572 |\n| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY | $ | 42,808 | $ | 42,026 |\n| The accompanying notes are an integral part of these consolidated condensed financial statements. |\n\n3\n| 2018 | 2017 |\n| REVENUES AND OTHER INCOME |\n| Net sales | $ | 3,763 | $ | 2,957 |\n| Interest, dividends and other income | 29 | 21 |\n| Gain on sale of assets, net | 33 | — |\n| 3,825 | 2,978 |\n| COSTS AND OTHER DEDUCTIONS |\n| Cost of sales | 1,363 | 1,426 |\n| Selling, general and administrative and other operating expenses | 307 | 272 |\n| Taxes other than on income | 108 | 68 |\n| Depreciation, depletion and amortization | 921 | 942 |\n| Asset impairments and related items | 30 | 13 |\n| Exploration expense | 15 | 11 |\n| Interest and debt expense, net | 97 | 81 |\n| 2,841 | 2,813 |\n| Income before income taxes and other items | 984 | 165 |\n| Provision for domestic and foreign income taxes | (339 | ) | (78 | ) |\n| Income from equity investments | 63 | 30 |\n| NET INCOME | $ | 708 | $ | 117 |\n| BASIC EARNINGS PER COMMON SHARE | $ | 0.92 | $ | 0.15 |\n| DILUTED EARNINGS PER COMMON SHARE | $ | 0.92 | $ | 0.15 |\n| DIVIDENDS PER COMMON SHARE | $ | 0.77 | $ | 0.76 |\n| The accompanying notes are an integral part of these consolidated condensed financial statements. |\n\n4\n| 2018 | 2017 |\n| Net income | $ | 708 | $ | 117 |\n| Other comprehensive income (loss) items: |\n| Foreign currency translation gains | 1 | 1 |\n| Unrealized gains (losses) on derivatives (a) | (3 | ) | 5 |\n| Pension and postretirement gains (b) | 4 | 9 |\n| Reclassification of realized (gains) losses on derivatives (c) | 2 | (2 | ) |\n| Other comprehensive income, net of tax | 4 | 13 |\n| Comprehensive income | $ | 712 | $ | 130 |\n| (a) | Net of tax of $1 and $(3) for the three months ended March 31, 2018, and 2017, respectively. |\n| (b) | Net of tax of $(1) and $(5) for the three months ended March 31, 2018, and 2017, respectively. |\n| (c) | Net of tax of $(1) and $1 for the three months ended March 31, 2018, and 2017, respectively. |\n\n5\n| 2018 | 2017 |\n| CASH FLOW FROM OPERATING ACTIVITIES |\n| Net income | $ | 708 | $ | 117 |\n| Adjustments to reconcile net income to net cash provided byoperating activities: |\n| Depreciation, depletion and amortization of assets | 921 | 942 |\n| Deferred income tax (benefit) provision | 94 | (108 | ) |\n| Other noncash (gains) charges to income | (23 | ) | 84 |\n| Asset impairments and related items | 30 | 13 |\n| Gain on sale of assets, net | (33 | ) | — |\n| Changes in operating assets and liabilities, net | (688 | ) | (535 | ) |\n| Other operating, net | — | (8 | ) |\n| Net cash provided by operating activities | 1,009 | 505 |\n| CASH FLOW FROM INVESTING ACTIVITIES |\n| Capital expenditures | (1,032 | ) | (722 | ) |\n| Change in capital accrual | (45 | ) | (41 | ) |\n| Payments for purchases of assets and businesses | (177 | ) | (19 | ) |\n| Sales of assets, net | 275 | — |\n| Other investing, net | 8 | 110 |\n| Net cash used by investing activities | (971 | ) | (672 | ) |\n| CASH FLOW FROM FINANCING ACTIVITIES |\n| Proceeds from long-term debt, net | 978 | — |\n| Payments of long-term debt | (500 | ) | — |\n| Proceeds from issuance of common stock | 10 | 12 |\n| Cash dividends paid | (592 | ) | (584 | ) |\n| Net cash used by financing activities | (104 | ) | (572 | ) |\n| Decrease in cash and cash equivalents | (66 | ) | (739 | ) |\n| Cash and cash equivalents — beginning of period | 1,672 | 2,233 |\n| Cash and cash equivalents — end of period | $ | 1,606 | $ | 1,494 |\n| The accompanying notes are an integral part of these consolidated condensed financial statements. |\n\n6\nOCCIDENTAL PETROLEUM CORPORATION AND SUBSIDIARIESNOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTSMARCH 31, 2018 1. GeneralIn these unaudited consolidated condensed financial statements, \"Occidental\" means Occidental Petroleum Corporation, a Delaware corporation (OPC), or OPC and one or more entities in which it owns a controlling interest (subsidiaries). Occidental has made its disclosures in accordance with United States generally accepted accounting principles (GAAP) as they apply to interim reporting, and condensed or omitted, as permitted by the Securities and Exchange Commission’s rules and regulations, certain information and disclosures normally included in consolidated financial statements and the notes. These unaudited consolidated condensed financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto in Occidental’s Annual Report on Form 10-K for the year ended December 31, 2017.In the opinion of Occidental’s management, the accompanying unaudited consolidated condensed financial statements contain all adjustments (consisting of normal recurring adjustments) necessary to fairly present Occidental’s consolidated financial position as of March 31, 2018, and the consolidated statements of operations, comprehensive income and cash flows for the three months ended March 31, 2018, and 2017, as applicable. The income and cash flows for the periods ended March 31, 2018, and 2017, are not necessarily indicative of the income or cash flows to be expected for the full year.2. Asset Acquisitions, Dispositions and Other In March 2018, Occidental divested non-core midstream assets for approximately $150 million, resulting in a pre-tax gain of approximately $40 million. In addition, Occidental classified approximately $100 million of non-core proved Permian acreage as assets held for sale at March 31, 2018. In March 2018, Occidental issued $1.0 billion of 4.2-percent senior notes due 2048. Occidental received net proceeds of approximately $985 million. Interest on the notes will be payable semi-annually in arrears in March and September of each year, beginning on September 15, 2018. The proceeds were used to refinance the repayment of the $500 million aggregate principal amount of Occidental's 1.50-percent senior notes due in February 2018, with the remainder to be used for general corporate purposes.In January 2018, Occidental entered into a new five-year, $3.0 billion revolving credit facility (2018 Credit Facility), which replaced the previous credit facility, that was scheduled to expire in August 2019. The 2018 Credit Facility has similar terms to the previous credit facility and does not contain material adverse change clauses or debt ratings triggers that could restrict Occidental's ability to borrow under the facility.3. Accounting and Disclosure ChangesIn February 2018, the Financial Accounting Standards Board (FASB) released standards that allow the reclassification from accumulated other comprehensive income to retained earnings of stranded tax effects resulting from changes to U.S. federal tax law from the 2017 Tax Cuts and Jobs Act enacted in December 2017. Occidental early adopted this standard in the first quarter of 2018, resulting in the reclassification of $58 million in stranded tax effects from accumulated other comprehensive income to retained earnings. In the first quarter of 2018, Occidental adopted the new revenue recognition standard Topic 606 - Revenue from Contracts with Customers and related updates (ASC 606). The new standard requires more detailed disclosures related to the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. Occidental adopted the standard using the modified retrospective method. The cumulative-effect adjustment to retained earnings upon adoption was not material. See Note 4 Revenue Recognition.In March 2017, FASB issued guidance related to presentation of net periodic pension cost and net periodic postretirement benefit cost. The rules became effective in the first quarter of 2018. These rules did not have a material impact to Occidental's financial statements upon adoption.\n7\nIn January 2017, the FASB issued new guidance clarifying the definition of a business under the topic Business Combinations. The rules became effective in the first quarter of 2018, and did not have a material change to Occidental's financial statements upon adoption.In November 2016, FASB issued new guidance related to the cash flow classification and presentation of the changes in restricted cash on the statement of cash flows. The rules became effective in the first quarter of 2018 and must be applied retrospectively. Occidental did not have restricted cash as of March 31, 2018, or December 31, 2017.In August 2016, the FASB issued new guidance related to the classification of certain cash receipts and payments on the statement of cash flows. The rules were adopted for the first quarter of 2018 and resulted in the retrospective reclassification of $147 million of cash receipts from operating cash flows to investing cash flows for the three months ended March 31, 2017, within the Statement of Cash Flows.In February 2016, the FASB issued rules which require Occidental to recognize most leases, including operating leases, on the balance sheet. The new rules require lessees to recognize a right-of-use asset and lease liability for all leases with lease terms of more than 12 months. The lease liability represents the discounted obligation to make future minimum lease payments. The corresponding right-of-use asset includes the discounted obligation in addition to any upfront payment or cost incurred during contract execution of the lease. The guidance retains the current accounting for lessors and does not make significant changes to the recognition, measurement and presentation of expenses and cash flows by a lessee. Recognition, measurement and presentation of expenses and cash flows arising from a lease will depend on classification as a finance or operating lease. Occidental is the lessee under various agreements for real estate, equipment, plants and facilities, aircraft, information technology hardware and vehicles that are currently accounted for as operating leases. As a result, these new rules will increase reported assets and liabilities. Occidental will not be an early adopter of this standard. Occidental will apply the revised lease rules for its interim and annual reporting periods starting January 1, 2019, using a modified retrospective approach, including several optional practical expedients related to leases commenced before the effective date. Occidental is currently evaluating the effect of these rules on its financial statements, training accounting staff, working with third-party consultants and developing an internal interim software solution for the identification, documentation and tracking of leases in order to create an adoption plan based on Occidental's population of leases under the revised definition of leases. The quantitative impacts of the new standard are dependent on the leases in force at the time of adoption. As a result, the evaluation of the effect of the new standard will extend over future periods.4. Revenue RecognitionOn January 1, 2018, Occidental adopted ASC 606 using the modified retrospective method. Results for reporting periods beginning after January 1, 2018, are presented under ASC 606, while prior period amounts have not been adjusted. There was no impact of adopting ASC 606 to the opening balance of retained earnings. There was no impact to the timing or amount of revenue recognized in the first quarter of 2018 as a result of the adoption of ASC 606. Revenue from customers is recognized when obligations under the terms of a contract with our customer are satisfied; which generally occurs with the delivery of oil, gas, natural gas liquids (\"NGL\"), chemicals or services such as transportation. Revenue from customers is measured as the amount of consideration Occidental expects to receive in exchange for the delivery of goods or services. Contracts may last from one month to one year or more, and may have renewal terms that may extend indefinitely at the option of either party. Price is typically based on market indexes. Volumes fluctuate due to production and, in certain cases, customer demand and transportation availability. Occidental records revenue net of any taxes, such as sales taxes, that are assessed by governmental authorities on Occidental's customers. Occidental has elected a practical expedient under ASC 606 and will not disclose revenue recognizable in future periods for unsatisfied performance obligations because the consideration related to those performance obligations is based on volume or market prices which are variable. Occidental does not incur significant costs to obtain contracts. Incidental items that are immaterial in the context of the contract are recognized as expense. Sales of hydrocarbons and chemicals to customers are invoiced and settled on a monthly basis. Occidental is not usually subject to obligations for warranties, returns or refunds except in the case of customer incentive payments as discussed for the chemical segment below. Occidental does not typically receive payment in advance of satisfying its obligations under the terms of its sales contracts with customers; therefore liabilities related to such payment are immaterial to Occidental. As of March 31, 2018, accounts receivable, net, of\n8\n| For the three months ended March 31, | 2018 |\n| Revenue from customers | $ | 3,694 |\n| All other revenues (a) | 69 |\n| Total net sales | $ | 3,763 |\n\n9\n| For the three months ended March 31, 2018 |\n| Revenue by Product | United States | Middle East | Latin America | Other International | Total |\n| Oil and Gas Segment |\n| Oil | $ | 1,247 | $ | 773 | $ | 170 | $ | — | $ | 2,190 |\n| NGL | 89 | 51 | — | — | 140 |\n| Gas | 52 | 65 | 4 | — | 121 |\n| Other | 3 | — | — | — | 3 |\n| Segment Total | $ | 1,391 | $ | 889 | $ | 174 | $ | — | $ | 2,454 |\n| Chemical Segment | $ | 1,049 | $ | — | $ | 52 | $ | 21 | $ | 1,122 |\n| Midstream Segment |\n| Gas Processing | $ | 137 | $ | 96 | $ | — | $ | — | $ | 233 |\n| Pipelines | 94 | — | — | — | 94 |\n| Power and Other | 25 | — | — | — | 25 |\n| Segment Total | $ | 256 | $ | 96 | $ | — | $ | — | $ | 352 |\n| Intersegment Eliminations | $ | (234 | ) | $ | — | $ | — | $ | — | $ | (234 | ) |\n| Consolidated | $ | 2,462 | $ | 985 | $ | 226 | $ | 21 | $ | 3,694 |\n| 2018 | 2017 |\n| Raw materials | $ | 68 | $ | 66 |\n| Materials and supplies | 470 | 447 |\n| Finished goods | 562 | 776 |\n| 1,100 | 1,289 |\n| Revaluation to LIFO | (43 | ) | (43 | ) |\n| Total | $ | 1,057 | $ | 1,246 |\n\n10\n| Number of Sites | Reserve Balance(in millions) |\n| NPL sites | 34 | $ | 460 |\n| Third-party sites | 71 | 159 |\n| Occidental-operated sites | 15 | 107 |\n| Closed or non-operated Occidental sites | 29 | 139 |\n| Total | 149 | $ | 865 |\n\n11\ntrust became effective. Among other responsibilities, the trust will pursue claims against YPF, Repsol and others and distribute assets to Maxus' creditors in accordance with the trust agreement and Plan.8. Lawsuits, Claims, Commitments and Contingencies Legal MattersOccidental or certain of its subsidiaries are involved, in the normal course of business, in lawsuits, claims and other legal proceedings that seek, among other things, compensation for alleged personal injury, breach of contract, property damage or other losses, punitive damages, civil penalties, or injunctive or declaratory relief. Occidental or certain of its subsidiaries also are involved in proceedings under CERCLA and similar federal, state, local and foreign environmental laws. These environmental proceedings seek funding or performance of remediation and, in some cases, compensation for alleged property damage, punitive damages, civil penalties and injunctive relief. Usually Occidental or such subsidiaries are among many companies in these environmental proceedings and have to date been successful in sharing response costs with other financially sound companies. Further, some lawsuits, claims and legal proceedings involve acquired or disposed assets with respect to which a third party or Occidental retains liability or indemnifies the other party for conditions that existed prior to the transaction. In accordance with applicable accounting guidance, Occidental accrues reserves for outstanding lawsuits, claims and proceedings when it is probable that a liability has been incurred and the liability can be reasonably estimated. In Note 7, Environmental Liabilities and Expenditures, Occidental has disclosed its reserve balances for environmental remediation matters that satisfy this criteria. Reserve balances for matters, other than environmental remediation, that satisfy this criteria as of March 31, 2018, and December 31, 2017, were not material to Occidental’s consolidated balance sheets. In 2017, Andes Petroleum Ecuador Ltd. filed a demand for arbitration, claiming it is entitled to a 40 percent share of the settlement payments made by the Republic of Ecuador to Occidental for the 2006 expropriation of Occidental’s Participation Contract for Ecuador’s Block 15. Occidental intends to vigorously defend against this claim in arbitration.The ultimate outcome and impact of outstanding lawsuits, claims and proceedings on Occidental cannot be predicted. Management believes that the resolution of these matters will not, individually or in the aggregate, have a material adverse effect on Occidental's consolidated balance sheet, statements of operations or cash flows after consideration of recorded accruals. Occidental’s estimates are based on information known about the legal matters and its experience in contesting, litigating and settling similar matters. Occidental reassesses the probability and estimability of contingent losses as new information becomes available. Tax MattersDuring the course of its operations, Occidental is subject to audit by tax authorities for varying periods in various federal, state, local and foreign tax jurisdictions. Although taxable years through 2012 for United States federal income tax purposes have been audited by the United States Internal Revenue Service (IRS) pursuant to its Compliance Assurance Program, subsequent taxable years are currently under review. Taxable years from 2002 through the current year remain subject to examination by foreign and state government tax authorities in certain jurisdictions. In certain of these jurisdictions, tax authorities are in various stages of auditing Occidental’s income taxes. During the course of tax audits, disputes have arisen and other disputes may arise as to facts and matters of law. Occidental believes that the resolution of outstanding tax matters would not have a material adverse effect on its consolidated financial position or results of operations.Indemnities to Third Parties Occidental, its subsidiaries, or both, have indemnified various parties against specified liabilities those parties might incur in the future in connection with purchases and other transactions that they have entered into with Occidental. These indemnities usually are contingent upon the other party incurring liabilities that reach specified thresholds. As of March 31, 2018, Occidental is not aware of circumstances that it believes would reasonably be expected to lead to indemnity claims that would result in payments materially in excess of reserves.\n12\n| Three months ended March 31 | 2018 | 2017 |\n| Net Periodic Benefit Costs | Pension Benefit | Post-retirement Benefit | Pension Benefit | Post-retirement Benefit |\n| Service cost | $ | 2 | $ | 6 | $ | 2 | $ | 5 |\n| Interest cost | 4 | 9 | 4 | 10 |\n| Expected return on plan assets | (6 | ) | — | (6 | ) | — |\n| Recognized actuarial loss | 1 | 4 | 2 | 4 |\n| Total | $ | 1 | $ | 19 | $ | 2 | $ | 19 |\n| Fair Value Measurements at March 31, 2018: |\n| Embedded derivatives | Level 1 | Level 2 | Level 3 | Netting andCollateral | Total FairValue |\n| Liabilities: |\n| Accrued liabilities | $ | — | $ | 31 | $ | — | $ | — | $ | 31 |\n| Deferred credits and liabilities | $ | — | $ | 125 | $ | — | $ | — | $ | 125 |\n| Fair Value Measurements at December 31, 2017: |\n| Embedded derivatives | Level 1 | Level 2 | Level 3 | Netting andCollateral | Total FairValue |\n| Liabilities: |\n| Accrued liabilities | $ | — | $ | 39 | $ | — | $ | — | $ | 39 |\n| Deferred credits and liabilities | $ | — | $ | 147 | $ | — | $ | — | $ | 147 |\n\n13\nsuch instruments’ maturities. The estimated fair value of Occidental’s debt as of March 31, 2018, and December 31, 2017, was $10.6 billion and $10.4 billion, respectively. The remaining principal payments less the discount on long-term debt aggregated approximately $10.4 billion and $9.9 billion as of March 31, 2018, and December 31, 2017, respectively. 11. DerivativesOccidental uses a variety of derivative financial instruments and physical contracts, including those designated as cash flow hedges, to manage its exposure to commodity price fluctuations, transportation commitments and to fix margins on the future sale of stored volumes of oil and natural gas. Where Occidental buys product for its own consumption or sells its production to a defined customer, Occidental elects normal purchases and normal sales exclusions. Occidental usually applies cash flow hedge accounting treatment to derivative financial instruments to lock in margins on the forecast sales of its natural gas storage volumes, and at times for other strategies to lock in margins. Occidental also enters into derivative financial instruments for speculative or trading purposes; however, the results of any transactions are immaterial to the marketing portfolio. The financial instruments not designated as hedges will impact Occidental's earnings through mark-to-market until the offsetting future physical commodity is delivered. For GAAP purposes, any physical inventory is carried at lower of cost or market on the balance sheet. A substantial majority of Occidental's physical derivative contracts are index-based and carry no mark-to-market value in earnings. Net gains and losses associated with derivative instruments not designated as hedging instruments are recognized currently in net sales. Net gains and losses attributable to derivative instruments subject to hedge accounting reside in accumulated other comprehensive income (loss) and are reclassified to earnings as the transactions to which the derivatives relate are recognized in earnings.Credit RiskThe majority of Occidental's counterparty credit risk is related to the physical delivery of energy commodities to its customers and their inability to meet their settlement commitments. Occidental manages credit risk by selecting counterparties that it believes to be financially strong, by entering into netting arrangements with counterparties and by requiring collateral or other credit risk mitigants, as appropriate. Occidental actively evaluates the creditworthiness of its counterparties, assigns appropriate credit limits and monitors credit exposures against those assigned limits. Occidental also enters into future contracts through regulated exchanges with select clearinghouses and brokers, which are subject to minimal credit risk as a significant portion of these transactions settle on a daily margin basis.Certain of Occidental's over-the-counter derivative instruments contain credit-risk-contingent features, primarily tied to credit ratings for Occidental or its counterparties, which may affect the amount of collateral that each would need to post. Occidental believes that if it had received a one-notch reduction in its credit ratings, it would not have resulted in a material change in its collateral-posting requirements as of March 31, 2018, and December 31, 2017.Cash-Flow Hedges Occidental’s marketing operations store natural gas purchased from third parties at Occidental’s leased storage facilities. Derivative instruments are used to fix margins on the future sales of the stored volumes. As of March 31, 2018, Occidental did not have any cash-flow hedges. As of December 31, 2017, Occidental had approximately 7 billion cubic feet (Bcf) of natural gas held in storage, and had cash-flow hedges for the forecast sales, to be settled by physical delivery, of approximately 7 Bcf of stored natural gas. The amount of cash-flow hedges, including the ineffective portion, was immaterial for the three months ended March 31, 2018, and the year ended December 31, 2017.\n14\n| (in millions, except Long/(Short) volumes) | 2018 | 2017 |\n| Unrealized gain (loss) on derivatives not designated as hedges |\n| Oil Commodity Contracts | $ | (18 | ) | $ | (47 | ) |\n| Natural Gas Commodity Contracts | $ | (1 | ) | $ | 1 |\n| Outstanding net volumes on derivatives not designated as hedges |\n| Oil Commodity Contracts |\n| Volume (MMBL) | 57 | 61 |\n| Price Per Bbl | $ | 58.64 | $ | 57.38 |\n| Natural Gas Commodity Contracts |\n| Volume (Bcf) | (63 | ) | (47 | ) |\n| Price Per MMBTU | $ | 2.35 | $ | 2.73 |\n| As of March 31, 2018 | Fair Value Measurements Using | Netting (b) | Total Fair Value |\n| (in millions) | Balance Sheet Location | Level 1 | Level 2 | Level 3 |\n| Assets: |\n| Derivatives not designated as hedging instruments (a) |\n| Commodity contracts | Other current assets | 581 | 181 | — | (613 | ) | 149 |\n| Long-term receivables and other assets, net | 7 | 2 | — | (7 | ) | 2 |\n| Liabilities: |\n| Derivatives not designated as hedging instruments (a) |\n| Commodity contracts | Accrued liabilities | 613 | 168 | — | (613 | ) | 168 |\n| Deferred credits and liabilities | 6 | 3 | — | (7 | ) | 2 |\n| As of December 31, 2017 | Fair Value Measurements Using | Netting (b) | Total Fair Value |\n| (in millions) | Balance Sheet Location | Level 1 | Level 2 | Level 3 |\n| Assets: |\n| Cash-flow hedges (a) |\n| Commodity contracts | Other current assets | — | 3 | — | — | 3 |\n| Derivatives not designated as hedging instruments (a) |\n| Commodity contracts | Other current assets | 485 | 227 | — | (517 | ) | 195 |\n| Long-term receivables and other assets, net | 1 | 2 | — | (1 | ) | 2 |\n| Liabilities: |\n| Derivatives not designated as hedging instruments (a) |\n| Commodity contracts | Accrued liabilities | 535 | 222 | — | (517 | ) | 240 |\n| Deferred credits and liabilities | 1 | 3 | — | (1 | ) | 3 |\n| (a) | Fair values are presented at gross amounts, including when the derivatives are subject to master netting arrangements and presented on a net basis in the consolidated condensed balance sheets. |\n| (b) | These amounts do not include collateral. As of March 31, 2018, no collateral received has been netted against derivative assets and collateral paid of $32 million has been netted against derivative liabilities. As of December 31, 2017, no collateral received has been netted against derivative assets and collateral paid of $54 million has been netted against derivative liabilities. Select clearinghouse and brokers require Occidental to post an initial margin deposit. Collateral deposited by Occidental, mainly for initial margin, of $71 million and $53 million as of March 31, 2018 and December 31, 2017, respectively, has not been reflected in these derivative fair value tables. This collateral is included in other current assets in the consolidated condensed balance sheets. |\n\n15\n| Oil | Midstream | Corporate |\n| and | and | and |\n| Gas | Chemical | Marketing | Eliminations | Total |\n| Three months ended March 31, 2018 |\n| Net sales | $ | 2,454 | $ | 1,154 | $ | 389 | $ | (234 | ) | $ | 3,763 |\n| Pre-tax operating profit (loss) | $ | 750 | $ | 298 | $ | 179 | $ | (180 | ) | (a) | $ | 1,047 |\n| Income taxes | — | — | — | (339 | ) | (b) | (339 | ) |\n| Net income (loss) | $ | 750 | $ | 298 | $ | 179 | $ | (519 | ) | $ | 708 |\n| Three months ended March 31, 2017 |\n| Net sales | $ | 1,894 | $ | 1,068 | $ | 211 | $ | (216 | ) | $ | 2,957 |\n| Pre-tax operating profit (loss) | $ | 220 | $ | 170 | $ | (47 | ) | $ | (148 | ) | (a) | $ | 195 |\n| Income taxes | — | — | — | (78 | ) | (b) | (78 | ) |\n| Net income (loss) | $ | 220 | $ | 170 | $ | (47 | ) | $ | (226 | ) | $ | 117 |\n\n16\n| Three months ended March 31 |\n| 2018 | 2017 |\n| Basic EPS |\n| Net Income | $ | 708 | $ | 117 |\n| Less: Net income allocated to participating securities | (3 | ) | — |\n| Net Income, net of participating securities | 705 | 117 |\n| Weighted average number of basic shares | 765.6 | 764.4 |\n| Basic EPS | $ | 0.92 | $ | 0.15 |\n| Diluted EPS |\n| Net income, net of participating securities | $ | 705 | $ | 117 |\n| Weighted average number of basic shares | 765.6 | 764.4 |\n| Dilutive effect of potentially dilutive securities | 1.4 | 0.8 |\n| Total diluted weighted average common shares | 767.0 | 765.2 |\n| Diluted EPS | $ | 0.92 | $ | 0.15 |\n\n17\nItem 2.\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations\nIn this report, “Occidental” means Occidental Petroleum Corporation (OPC), or OPC and one or more entities in which it owns a controlling interest (subsidiaries). Portions of this report contain forward-looking statements and involve risks and uncertainties that could materially affect expected results of operations, liquidity, cash flows and business prospects. Actual results may differ from anticipated results, sometimes materially, and reported results should not be considered an indication of future performance. Factors that could cause results to differ include, but are not limited to: global commodity pricing fluctuations; supply and demand considerations for Occidental’s products; higher-than-expected costs; the regulatory approval environment; not successfully completing, or any material delay of, field developments, expansion projects, capital expenditures, efficiency projects, acquisitions or dispositions; uncertainties about the estimated quantities of oil and natural gas reserves; lower-than-expected production from development projects or acquisitions; exploration risks; general economic slowdowns domestically or internationally; political conditions and events; liability under environmental regulations including remedial actions; litigation; disruption or interruption of production or manufacturing or facility damage due to accidents, chemical releases, labor unrest, weather, natural disasters, cyber attacks or insurgent activity; failure of risk management; changes in law or regulations; reorganization or restructuring of Occidental’s operations; or changes in tax rates. Words such as “estimate,” “project,” “predict,” “will,” “would,” “should,” “could,” “may,” “might,” “anticipate,” “plan,” “intend,” “believe,” “expect,” “aim,” “goal,” “target,” “objective,” “likely” or similar expressions that convey the prospective nature of events or outcomes generally indicate forward-looking statements. You should not place undue reliance on these forward-looking statements, which speak only as of the date of this report. Unless legally required, Occidental does not undertake any obligation to update any forward-looking statements, as a result of new information, future events or otherwise. Material risks that may affect Occidental’s results of operations and financial position appear in Part I, Item 1A “Risk Factors” of Occidental's Annual Report on Form 10-K for the year ended December 31, 2017 (the 2017 Form 10-K).\nConsolidated Results of Operations\nOccidental reported net income of $708 million for the first quarter of 2018 on net sales of $3.8 billion, compared to net income of $117 million on net sales of $3.0 billion for the first quarter of 2017. The increase in net income mainly reflected higher crude oil prices and volumes in the oil and gas segment, significant improvements in realized caustic soda prices in the chemical segment, and higher marketing margins from improved crude oil price spreads and additional incremental margin earned from exporting crude oil from the Ingleside Crude Terminal and higher realized NGL prices from gas processing in the midstream and marketing segment. Diluted earnings per share was $0.92 for the first quarter of 2018 compared to $0.15 for the first quarter of 2017.\nSelected Statements of Operations Items\nNet sales increased for the three months ended March 31, 2018, compared to the same period in 2017, as a result of higher oil prices and volumes, higher realized caustic soda prices and higher marketing margins from improved crude oil spreads.\nCost of sales decreased for the three months ended March 31, 2018, compared to the same period in 2017, mainly due to changes in the fair value of a long-term contract to purchase CO2. The increase in selling, general and administrative and other operating expenses for the three months ended March 31, 2018, compared to the same period in 2017, reflected higher compensation costs, partially due to the change in timing of stock-based incentive compensation awards and improved stock price. Taxes other than on income increased for the three months ended March 31, 2018, compared to the same period of 2017, mainly due to higher production taxes as a result of higher domestic oil prices. The decrease in DD&A expense for the three months ended March 31, 2018, compared to the same period in 2017, was mainly due to lower DD&A rates in the Permian Resources oil and gas operations.\nThe increase in the domestic and foreign income tax provision for the three months ended March 31, 2018, compared to the same period in 2017, reflected higher pre-tax operating income in the first quarter of 2018.\nSelected Analysis of Financial Position\nSee “Liquidity and Capital Resources” for a discussion about the changes in cash and cash equivalents.\nThe increase in trade receivables, net, at March 31, 2018, compared to December 31, 2017, was primarily due to higher prices and volumes exported from the Ingleside crude terminal. The decrease in inventories at March 31,\n18\n| Three months ended March 31 |\n| 2018 | 2017 |\n| Net Sales (a) |\n| Oil and Gas | $ | 2,454 | $ | 1,894 |\n| Chemical | 1,154 | 1,068 |\n| Midstream and Marketing | 389 | 211 |\n| Eliminations | (234 | ) | (216 | ) |\n| $ | 3,763 | $ | 2,957 |\n| Segment Results |\n| Oil and Gas | $ | 750 | $ | 220 |\n| Chemical | 298 | 170 |\n| Midstream and Marketing | 179 | (47 | ) |\n| 1,227 | 343 |\n| Unallocated Corporate Items |\n| Interest expense, net | (92 | ) | (78 | ) |\n| Income tax expense | (339 | ) | (78 | ) |\n| Other expense, net | (88 | ) | (70 | ) |\n| Net income | $ | 708 | $ | 117 |\n\n19\n| Three months ended March 31 |\n| 2018 | 2017 |\n| Oil and Gas | $ | 750 | $ | 220 |\n| Chemical | 298 | 170 |\n| Midstream and Marketing | 179 | (47 | ) |\n| Unallocated Corporate Items | (180 | ) | (148 | ) |\n| Pre-tax Income | 1,047 | 195 |\n| Income tax expense (benefit) |\n| Federal and state | 95 | (113 | ) |\n| Foreign | 244 | 191 |\n| Total | 339 | 78 |\n| Income from continuing operations | $ | 708 | $ | 117 |\n| Worldwide effective tax rate | 32 | % | 40 | % |\n\n20\n| Three months ended March 31 |\n| Production Volumes per Day | 2018 | 2017 |\n| Oil (MBBL) |\n| United States (a) | 228 | 190 |\n| Middle East | 139 | 152 |\n| Latin America | 32 | 28 |\n| NGL (MBBL) |\n| United States (a) | 59 | 47 |\n| Middle East | 26 | 26 |\n| Natural Gas (MMCF) |\n| United States (a) | 294 | 244 |\n| Middle East | 449 | 444 |\n| Latin America | 6 | 8 |\n| Total Production Ongoing Operations (MBOE) | 609 | 559 |\n| Operations Exited | — | 25 |\n| Total Production Volumes (MBOE) (b) | 609 | 584 |\n| Three months ended March 31 |\n| Sales Volumes per Day | 2018 | 2017 |\n| Oil (MBBL) |\n| United States (a) | 228 | 190 |\n| Middle East | 140 | 152 |\n| Latin America | 32 | 27 |\n| NGL (MBBL) |\n| United States (a) | 59 | 47 |\n| Middle East | 26 | 26 |\n| Natural Gas (MMCF) |\n| United States (a) | 294 | 244 |\n| Middle East | 450 | 444 |\n| Latin America | 6 | 8 |\n| Total Sales Ongoing Operations (MBOE) | 610 | 558 |\n| Operations Exited | — | 25 |\n| Total Sales Volumes (MBOE) (b) | 610 | 583 |\n\n21\n| Three months ended March 31 |\n| Average Realized Prices | 2018 | 2017 |\n| Oil ($/BBL) |\n| United States | $ | 61.03 | $ | 48.67 |\n| Middle East | $ | 61.45 | $ | 49.63 |\n| Latin America | $ | 59.24 | $ | 48.26 |\n| Total Worldwide | $ | 61.04 | $ | 49.04 |\n| NGL ($/BBL) |\n| United States | $ | 26.89 | $ | 23.07 |\n| Middle East | $ | 21.89 | $ | 18.64 |\n| Total Worldwide | $ | 25.35 | $ | 21.59 |\n| Natural Gas ($/MCF) |\n| United States | $ | 2.06 | $ | 2.68 |\n| Latin America | $ | 5.68 | $ | 4.77 |\n| Total Worldwide | $ | 1.82 | $ | 2.07 |\n| Three months ended March 31 |\n| Average Index Prices | 2018 | 2017 |\n| WTI oil ($/BBL) | $ | 62.87 | $ | 51.91 |\n| Brent oil ($/BBL) | $ | 67.18 | $ | 54.66 |\n| NYMEX gas ($/MCF) | $ | 2.87 | $ | 3.26 |\n| Average Realized Prices as Percentage of Average Index Prices | Three months ended March 31 |\n| 2018 | 2017 |\n| Worldwide oil as a percentage of average WTI | 97 | % | 94 | % |\n| Worldwide oil as a percentage of average Brent | 91 | % | 90 | % |\n| Worldwide NGL as a percentage of average WTI | 40 | % | 42 | % |\n| Domestic natural gas as a percentage of average NYMEX | 72 | % | 82 | % |\n\n22\nMidstream and Marketing SegmentMidstream and marketing earnings were $179 million for the three months ended March 31, 2018, compared with a loss of $47 million for the same period 2017. The year over year improvement in midstream and marketing results reflected $43 million pre-tax gain on sale of interests in a gas plant and higher marketing margins due to the improved crude oil spreads, additional incremental margin earned from exporting crude oil from the Ingleside crude terminal and improved returns in the gas processing business as a result of higher NGL and sulfur prices.Liquidity and Capital Resources At March 31, 2018, Occidental had $1.6 billion in cash. Income and cash flows are largely dependent on the oil and gas segment's realized prices, sales volumes and operating costs. With a continued focus on capital efficiency and operational efficiency, Occidental expects to fund its liquidity needs, including future dividend payments, through cash on hand, cash generated from operations, monetization of non-core assets or investments, future borrowings, and, if necessary, proceeds from other forms of capital issuance. Net cash provided by operating activities was $1.0 billion for the three months ended March 31, 2018, compared to $0.5 billion for the same period of 2017. Cash flows were positively impacted by higher oil prices in the first three months of 2018 as compared to the same period in 2017. The impact of the chemical and the midstream and marketing segments on overall cash flows is typically less significant than the impact of the oil and gas segment because these segments are smaller. Occidental’s net cash used by investing activities was $1.0 billion for the first three months of 2018, compared to $0.7 billion for the same period of 2017. Capital expenditures for the first three months of 2018 were $1.0 billion of which $0.9 billion was for the oil and gas segment, compared to $0.7 billion for the first three months of 2017 of which $0.6 billion was for the oil and gas segment. The first quarter of 2018 also reflected $0.3 billion of cash received from the sale of assets and $0.2 billion of cash paid for the purchase of assets. Occidental’s net cash used by financing activities was $104 million for the three months of 2018, compared to net cash used by financing activities of $0.6 billion for the same period of 2017. Cash used by financing activities for the first quarter of 2018 included the first quarter dividend payment of $0.6 billion, payment of $0.5 billion of 1.5-percent senior notes that were due February of 2018 and proceeds from the issuance of $1.0 billion of 4.2-percent senior notes due 2048.As of March 31, 2018, Occidental was in compliance with all covenants of its financing agreements and had substantial capacity for additional unsecured borrowings, the payment of cash dividends and other distributions on, or acquisitions of, Occidental stock. Environmental Liabilities and ExpendituresOccidental’s operations are subject to stringent federal, state, local and foreign laws and regulations related to improving or maintaining environmental quality. Occidental’s environmental compliance costs have generally increased over time and are expected to rise in the future. Occidental factors environmental expenditures for its operations into its business planning process as an integral part of producing quality products responsive to market demand.The laws that require or address environmental remediation, including CERCLA and similar federal, state, local and foreign laws, may apply retroactively and regardless of fault, the legality of the original activities or the current ownership or control of sites. OPC or certain of its subsidiaries participate in or actively monitor a range of remedial activities and government or private proceedings under these laws with respect to alleged past practices at operating, closed and third-party sites. Remedial activities may include one or more of the following: investigation involving sampling, modeling, risk assessment or monitoring; cleanup measures including removal, treatment or disposal of hazardous substances; or operation and maintenance of remedial systems. These environmental proceedings seek funding or performance of remediation and, in some cases, compensation for alleged property damage, punitive damages, civil penalties, injunctive relief and government oversight costs.Refer to Note 7, Environmental Liabilities and Expenditures, in the Notes to the Consolidated Condensed Financial Statements in Part I Item 1 of this Form 10-Q and to the Environmental Liabilities and Expenditures section of Management’s Discussion and Analysis of Financial Condition and Results of Operations in the 2017 Form 10-K for\n23\nadditional information regarding Occidental’s environmental expenditures.Lawsuits, Claims, Commitments and ContingenciesOccidental accrues reserves for outstanding lawsuits, claims and proceedings when it is probable that a liability has been incurred and the liability can be reasonably estimated. Occidental has disclosed its reserve balances for environmental remediation matters. Reserve balances for other matters as of March 31, 2018, and December 31, 2017, were not material to Occidental's consolidated balance sheets. Occidental also evaluates the amount of reasonably possible losses that it could incur as a result of the matters mentioned above. Occidental has disclosed its range of reasonably possible additional losses for sites where it is a participant in environmental remediation. Occidental believes that other reasonably possible losses which it could incur in excess of reserves accrued on the balance sheet would not be material to its consolidated financial position or results of operations. For further information, see Note 8, Lawsuits, Claims, Commitments and Contingencies, in the Notes to Consolidated Condensed Financial Statements in Part I Item 1 of this Form 10-Q. Recently Adopted Accounting and Disclosure ChangesSee Note 3, Accounting and Disclosure Changes, in the Notes to Consolidated Condensed Financial Statements in Part I Item 1 of this Form 10-Q.\nItem 3.\nQuantitative and Qualitative Disclosures About Market Risk\nFor the three months ended March 31, 2018, there were no material changes in the information required to be provided under Item 305 of Regulation S-K included under Item 7A, \"Quantitative and Qualitative Disclosures About Market Risk\" in the 2017 Form 10-K.\nItem 4.\nControls and Procedures\nOccidental's President and Chief Executive Officer and its Senior Vice President and Chief Financial Officer supervised and participated in Occidental's evaluation of its disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based upon that evaluation, Occidental's President and Chief Executive Officer and Senior Vice President and Chief Financial Officer concluded that Occidental's disclosure controls and procedures were effective as of March 31, 2018.\nThere has been no change in Occidental's internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934) during the first three months of 2018 that has materially affected, or is reasonably likely to materially affect, Occidental's internal control over financial reporting.\nPART II OTHER INFORMATION\n\nItem 1.\nLegal Proceedings\nFor information regarding other legal proceedings, see Note 8, Lawsuits, Claims, Commitments and Contingencies in the Notes to Consolidated Condensed Financial Statements, in Part I Item 1 of this Form 10-Q, and Part I Item 3, “Legal Proceedings” in the 2017 Form 10-K.\n24\nItem 6.\nExhibits\n| 4.1* | Indenture, dated as of August 18, 2011, between Occidental and The Bank of New York Mellon Trust Company, N.A. (filed as Exhibit 4.1 to the Current Report on Form 8-K of Occidental filed August 19, 2011, File No. 1-9210). |\n| 4.2* | Officers’ Certificate of Occidental Petroleum Corporation dated March 2, 2018 establishing the 4.20% Senior Notes due 2048 (filed as Exhibit 4.2 to the Current Report on Form 8-K of Occidental dated February 28, 2018 (date of earliest event reported), filed March 2, 2018, File No. 1-9210). |\n| 4.3* | Form of 4.20% Senior Notes due 2048 (included as Exhibit A to Exhibit 4.2) (filed as Exhibit 4.3 to the Current Report on Form 8-K of Occidental dated February 28, 2018 (date of earliest event reported), filed March 2, 2018, File No. 1-9210). |\n| 4.4* | Second amendment to the Occidental Petroleum Corporation 2015 Long-Term Incentive Plan (filed as Exhibit 4.5 to the Registration Statement on Form S-8 of Occidental filed May 4, 2018, File No. 333-224691) |\n| 10.1 | Form of 2018 Occidental Petroleum Corporation 2015 Long-Term Incentive Plan Total Shareholder Return Incentive Award. |\n| 10.2 | Form of 2018 Occidental Petroleum Corporation 2015 Long-Term Incentive Plan Restricted Stock Unit Incentive Award. |\n| 10.3 | Form of 2018 Occidental Petroleum Corporation 2015 Long-Term Incentive Plan Cash Return on Capital Employed Incentive Award. |\n| 12 | Statement regarding the computation of total enterprise ratios of earnings to fixed charges for the three months ended March 31, 2018, and 2017, and for each of the five years in the period ended December 31, 2017. |\n| 31.1 | Certification of CEO Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2 | Certification of CFO Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32.1 | Certifications of CEO and CFO Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 101.INS | XBRL Instance Document. |\n| 101.SCH | XBRL Taxonomy Extension Schema Document. |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document. |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document. |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document. |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document. |\n\n____________________________\n* Incorporated herein by reference\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n| OCCIDENTAL PETROLEUM CORPORATION |\n\n| DATE | May 8, 2018 | /s/ Jennifer M. Kirk |\n| Jennifer M. Kirk |\n| Vice President, Controller and |\n| Principal Accounting Officer |\n\n25\n</text>\n\nWhat is the interest coverage ratio for the year 2018?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nITEM 1.\nFINANCIAL STATEMENTS\nMEXUS GOLD US AND SUBSIDIARIES\nCONDENSED CONSOLIDATED BALANCE SHEETS\n\n| September 30, 2019 | March 31, 2019 |\n| ASSETS | (Unaudited) |\n| CURRENT ASSETS |\n| Cash | $ | 49,650 | $ | 12,029 |\n| Prepaid and other assets | - | 5,500 |\n| TOTAL CURRENT ASSETS | 49,650 | 17,529 |\n| FIXED ASSETS |\n| Property and equipment, net of accumulated depreciation | 337,348 | 383,524 |\n| TOTAL FIXED ASSETS | 337,348 | 383,524 |\n| OTHER ASSETS |\n| Equipment under construction | - | 17,018 |\n| Property costs | 829,947 | 829,947 |\n| TOTAL OTHER ASSETS | 829,947 | 846,965 |\n| TOTAL ASSETS | $ | 1,216,945 | $ | 1,248,018 |\n| LIABILITIES AND STOCKHOLDERS' DEFICIT(EQUITY) |\n| CURRENT LIABILITIES |\n| Accounts payable and accrued liabilities | $ | 271,351 | $ | 254,578 |\n| Accounts payable - related party | 412,016 | 434,704 |\n| Notes payable (net unamortized debt discount of $125,206 and $94,127, respectively) | 759,866 | 626,190 |\n| Notes payable - related party | 75,110 | 67,410 |\n| Promissory notes | 65,000 | 65,000 |\n| Convertible promissory note (net of debt discount of $187,858 and $136,355, respectively) | 237,061 | 104,034 |\n| Convertible promissory note derivative liability | 254,467 | 113,091 |\n| TOTAL CURRENT LIABILITIES | 2,074,871 | 1,665,007 |\n| TOTAL LIABILITIES | 2,074,871 | 1,665,007 |\n| CONTINGENT LIABILITIES (Note 13) |\n| STOCKHOLDERS' (DEFICIT) EQUITY |\n| Capital stock |\n| Authorized |\n| 9,000,000 shares of Preferred Stock, $0.001 par value per share, nil issued and outstanding | - | - |\n| 1,000,000 shares of Series A Convertible Preferred Stock, $0.001 par value per share | - | - |\n| 2,000,000,000 shares of Common Stock, $0.001 par value per share | - | - |\n| Issued and outstanding |\n| 1,000,000 shares of Series A Convertible Preferred Stock (1,000,000 - March 31, 2019) | 1,000 | 1,000 |\n| 1,397,287,172 shares of Common Stock (1,011,848,975 - March 31, 2019) | 1,397,283 | 1,011,845 |\n| Additional paid-in capital | 28,014,189 | 27,064,698 |\n| Share subscription payable | 410,237 | 632,840 |\n| Accumulated deficit | (30,680,635) | (29,127,372) |\n| TOTAL STOCKHOLDERS' (DEFICIT) EQUITY | (857,926) | (416,989) |\n| TOTAL LIABILITIES AND STOCKHOLDERS' (DEFICIT) EQUITY | $ | 1,216,945 | $ | 1,248,018 |\n| The accompanying notes are an integral part of these unaudited condensed consolidated financial statements. |\n\n2\nMEXUS GOLD US AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\n(Unaudited)\n\n| Three Months Ended September 30, | Six Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| REVENUES |\n| Revenues | $ | - | $ | - | $ | - | $ | - |\n| Total revenues | - | - | - | - |\n| Expenses |\n| Exploration | 180,118 | 107,368 | 374,263 | 329,655 |\n| General and administrative | 270,417 | 141,423 | 487,057 | 334,149 |\n| Stock-based expense - consulting services | 137,250 | 164,531 | 375,415 | 233,956 |\n| Loss on settlement of accounts payable | - | - | 16,400 | - |\n| Total operating expenses | 587,785 | 413,322 | 1,253,135 | 897,760 |\n| OTHER INCOME (EXPENSE) |\n| Foreign exchange | 188 | (1,272) | (1,786) | 3,875 |\n| Interest | (248,747) | (169,435) | (463,594) | (336,118) |\n| Gain on sale of equipment | - | 10,000 | - | 10,000 |\n| Gain (loss) Loss on settlement of debt | (85,448) | (31,297) | (69,977) | 160,866 |\n| Loss (gain) on convertible promissory note derivative liability | 207,727 | 29,437 | 235,229 | 98,371 |\n| (126,280) | (162,567) | (300,128) | (63,006) |\n| NET LOSS BEFORE PROVISION FOR TAX | (714,065) | (575,889) | (1,553,263) | (960,766) |\n| Income tax | - | - | - | - |\n| NET LOSS | $ | (714,065) | $ | (575,889) | $ | (1,553,263) | $ | (960,766) |\n| BASIC AND DILUTED LOSS PER COMMON SHARE | $ | (0.00) | $ | (0.00) | $ | (0.00) | $ | (0.00) |\n| WEIGHTED AVERAGE NUMBER OF COMMON SHARES |\n| OUTSTANDING - BASIC AND DILUTED | 1,305,765,516 | 840,220,949 | 1,203,708,594 | 821,310,687 |\n| The accompanying notes are an integral part of these unaudited condensed consolidated financial statements. |\n\n3\nMEXUS GOLD US AND SUBSIDARIES\nCONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' (DEFICIT) EQUITY\n(Unaudited)\n\n| Three Months Ended September 30, 2018 |\n| Preferred Stock | Series A Preferred Stock | Common Stock |\n| Number of Shares | Amount | Number of Shares | Amount | Number of Shares | Amount | Additional Paid-in Capital | Share Subscription Payable | Accumulated Deficit | Total Stockholders' Equity |\n| Balance, June 30, 2018 | - | $ | - | 1,000,000 | $ | 1,000 | 813,188,020 | $ | 813,184 | $ | 26,166,323 | $ | 729,960 | $ | (27,238,871) | $ | 471,596 |\n| Shares issued for services and supplies | - | - | - | - | 8,574,809 | 8,575 | 103,231 | 52,725 | - | 164,531 |\n| Shares issued for cash | - | - | - | - | 57,616,666 | 57,616 | 163,384 | (169,000) | - | 52,000 |\n| Shares issued for note principal and interest | - | - | - | - | 3,200,000 | 3,200 | 40,640 | 31,500 | - | 75,340 |\n| Beneficial conversion features | - | - | - | - | - | - | 49,610 | - | - | 49,610 |\n| Net loss | - | - | - | - | - | - | - | - | (575,889) | (575,889) |\n| Balance, September 30, 2018 | - | $ | - | 1,000,000 | $ | 1,000 | 882,579,495 | $ | 882,575 | $ | 26,523,188 | $ | 645,185 | $ | (27,814,760) | $ | 237,188 |\n| Six Months Ended September 30, 2018 |\n| Preferred Stock | Series A Preferred Stock | Common Stock |\n| Number of Shares | Amount | Number of Shares | Amount | Number of Shares | Amount | Additional Paid-in Capital | Share Subscription Payable | Accumulated Deficit | Total Stockholders' Equity |\n| Balance, March 31, 2018 | - | $ | - | 1,000,000 | $ | 1,000 | 775,922,947 | $ | 775,919 | $ | 25,743,607 | $ | 636,565 | $ | (26,853,994) | $ | 303,097 |\n| Shares issued for services and supplies | - | - | - | - | 13,327,219 | 13,327 | 196,564 | 24,065 | - | 233,956 |\n| Shares issued for cash | - | - | - | - | 84,059,666 | 84,059 | 383,221 | (221,280) | - | 246,000 |\n| Shares issued for note principal and interest | - | - | - | - | 9,269,663 | 9,270 | 134,858 | 205,835 | - | 349,963 |\n| Beneficial conversion features | - | - | - | - | - | - | 64,938 | - | - | 64,938 |\n| Net loss | - | - | - | - | - | - | - | - | (960,766) | (960,766) |\n| Balance, September 30, 2018 | - | $ | - | 1,000,000 | $ | 1,000 | 882,579,495 | $ | 882,575 | $ | 26,523,188 | $ | 645,185 | $ | (27,814,760) | $ | 237,188 |\n| Three Months Ended September 30, 2019 |\n| Preferred Stock | Series A Preferred Stock | Common Stock |\n| Number of Shares | Amount | Number of Shares | Amount | Number of Shares | Amount | Additional Paid-in Capital | Share Subscription Payable | Accumulated Deficit | Total Stockholders' Equity |\n| Balance, June 30, 2019 | - | $ | - | 1,000,000 | $ | 1,000 | 1,167,098,176 | $ | 1,167,094 | $ | 27,591,983 | $ | 547,830 | $ | (29,966,570) | $ | (658,663) |\n| Shares issued for services and supplies | - | - | - | - | 36,500,000 | 36,500 | 277,000 | (176,250) | - | 137,250 |\n| Shares issued for cash | - | - | - | - | 188,688,996 | 188,689 | 101,706 | (70,795) | - | 219,600 |\n| Shares issued for accounts payable | - | - | - | - | - | - | - | - | - | - |\n| Shares issued for note principal and interest | - | - | - | - | 5,000,000 | 5,000 | 43,500 | 103,292 | - | 151,792 |\n| Shares issued for equipment | - | - | - | - | - | - | - | 6,160 | - | 6,160 |\n| Beneficial conversion features | - | - | - | - | - | - | - | - | - | - |\n| Net loss | - | - | - | - | - | - | - | - | (714,065) | (714,065) |\n| Balance, September 30, 2019 | - | $ | - | 1,000,000 | $ | 1,000 | 1,397,287,172 | 1,397,283 | $ | 28,014,189 | $ | 410,237 | $ | (30,680,635) | $ | (857,926) |\n| Six Months Ended September 30, 2019 |\n| Preferred Stock | Series A Preferred Stock | Common Stock |\n| Number of Shares | Amount | Number of Shares | Amount | Number of Shares | Amount | Additional Paid-in Capital | Share Subscription Payable | Accumulated Deficit | Total Stockholders' Equity |\n| Balance, March 31, 2019 | - | $ | - | 1,000,000 | $ | 1,000 | 1,011,848,975 | $ | 1,011,845 | $ | 27,064,698 | $ | 632,840 | $ | (29,127,372) | $ | (416,989) |\n| Shares issued for services and supplies | - | - | - | - | 49,069,207 | 49,069 | 481,896 | (155,550) | - | 375,415 |\n| Shares issued for cash | - | - | - | - | 302,733,990 | 302,734 | 215,811 | (93,400) | - | 425,145 |\n| Shares issued for accounts payable | - | - | - | - | 19,000,000 | 19,000 | 98,400 | (81,000) | - | 36,400 |\n| Shares issued for note principal and interest | - | - | - | - | 14,635,000 | 14,635 | 50,970 | 101,187 | - | 166,792 |\n| Shares issued for equipment | - | - | - | - | - | - | - | 6,160 | - | 6,160 |\n| Beneficial conversion features | - | - | - | - | - | - | 102,414 | - | - | 102,414 |\n| Net loss | - | - | - | - | - | - | - | (1,553,263) | (1,553,263) |\n| Balance, September 30, 2019 | - | $ | - | 1,000,000 | $ | 1,000 | 1,397,287,172 | $ | 1,397,283 | $ | 28,014,189 | $ | 410,237 | $ | (30,680,635) | $ | (857,926) |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n4\nMEXUS GOLD US AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(Unaudited)\n\n| Six Months Ended September 30, |\n| 2019 | 2018 |\n| CASH FLOWS FROM OPERATING ACTIVITIES |\n| Net loss | $ | (1,553,263) | $ | (960,766) |\n| Adjustments to reconcile net loss |\n| to net cash used in operating activities: |\n| Depreciation and amortization | 113,479 | 132,177 |\n| Gain on settlement of debt and accounts payable | 69,977 | (160,866) |\n| Stock-based compensation - services | 375,415 | 233,956 |\n| Non cash Interest expense | 426,902 | 323,696 |\n| Gain on sale of equipment | - | (10,000) |\n| Gain on change in fair value of derivative instrument | (235,229) | (98,371) |\n| Changes in operating assets and liabilities: |\n| Decrease (Increase) of other assets | 5,500 | - |\n| Accounts payable and accrued liabilities, including related parties | 99,339 | 46,104 |\n| NET CASH USED IN OPERTAING ACTIVITIES | (697,880) | (494,070) |\n| CASH FLOWS FROM INVESTING ACTIVITIES |\n| Purchase of equipment | (44,125) | (8,081) |\n| Purchase of equipment | - | 10,000 |\n| NET CASH (USED IN) PROVIDED BY INVESTING ACTIVITES | (44,125) | 1,919 |\n| CASH FLOWS FROM FINANCING ACTIVITIES |\n| Proceeds from issuance of notes payable | 320,000 | 222,000 |\n| Proceeds from issuance of notes payable - related party | 7,700 | 21,110 |\n| Payment of notes payable | (170,000) | (13,000) |\n| Proceeds from the issuance of convertible promissory notes | 412,500 | 75,000 |\n| Repayment of convertible promissory note | (215,719) | (183,333) |\n| Advances from related party | - | 4,312 |\n| Payment of advances from related party | - | (4,777) |\n| Proceeds from issuance of common stock, net | 425,145 | 246,000 |\n| NET CASH PROVIDED BY FINANCING ACTIVITIES | 779,626 | 367,312 |\n| DECREASE IN CASH | 37,621 | (124,839) |\n| CASH, BEGINNING OF PERIOD | 12,029 | 125,942 |\n| CASH, END OF PERIOD | $ | 49,650 | $ | 1,103 |\n| Supplemental disclosure of cash flow information: |\n| Interest paid | $ | 7,170 | $ | - |\n| Taxes paid | $ | - | $ | - |\n| Supplemental disclosure of non-cash investing and financing activities: |\n| Discount for beneficial conversion feature recognized on issuance of notes payable | $ | 102,414 | $ | 64,938 |\n| Shares issued for settlement of notes payable and interest | $ | 153,798 | $ | 209,074 |\n| Shares issued to settle accounts payable | $ | 36,400 | $ | 100,288 |\n| Note payable issued to settle accounts payable | $ | 66,754 | $ | - |\n| Shares issued in conjunction with the issuance of notes payable and convertible promissory note | $ | 8,500 | $ | 40,601 |\n| Initial value of embedded derivative liability | $ | 376,606 | $ | - |\n| Shares issued to purchase equipment | $ | 6,160 | $ | - |\n| Reclassification of equipment under construction to property and equipment | $ | 17,018 | $ | - |\n| Reclassification of equipment held for sale to property and equipment | $ | - | $ | 56,438 |\n| Reclassification of deposit on mineral property to property costs | $ | - | $ | 324,000 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n5\nMEXUS GOLD US AND SUBSIDARIES\nNotes to Condensed Consolidated Financial Statements\nSeptember 30, 2019\n(Unaudited)\n1. ORGANIZATION AND BUSINESS OF COMPANY\nMexus Gold US (the “Company”) was originally incorporated under the laws of the State of Colorado on June 22, 1990, as U.S.A. Connection, Inc. On October 28, 2005, the Company changed its’ name to Action Fashions, Ltd. On September 18, 2009, the Company changed its’ domicile to Nevada and changed its’ name to Mexus Gold US to better reflect the Company’s new planned principle business operations. The Company has a fiscal year end of March 31.\nThe Company is a mining company engaged in the evaluation, acquisition, exploration and advancement of gold, silver and copper projects in the State of Sonora, Mexico and the Western United States, as well as, the salvage of precious metals from identifiable sources.\n2. BASIS OF PREPARATION\nPursuant to the rules and regulations of the Securities and Exchange Commission for Form 10-Q, the unaudited condensed consolidated financial statements, footnote disclosures and other information normally included in condensed consolidated financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. The condensed consolidated financial statements contained in this report are unaudited but, in the opinion of management, reflect all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the condensed consolidated financial statements. All significant inter-company accounts and transactions have been eliminated in consolidation. The results of operations for any interim period are not necessarily indicative of results for the full year. The condensed consolidated balance sheet at March 31, 2019 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.\nThe preparation of unaudited condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Management reviews these estimates and assumptions on an ongoing basis using currently available information. Actual results could differ from those estimates. Three-month figures are not necessarily indicative of the results to be reported at the year end.\nBasis of Consolidation\nThe consolidated financial statements include the accounts of the Company and controlled subsidiaries, Mexus Gold Mining, S.A. de C.V. (“Mexus Gold Mining), Mexus Enterprises S.A. de C.V. (“Mexus Gold Enterprises”) and Mexus Gold MX S.A. DE C.V. (“Mexus Gold MX”). Significant intercompany accounts and transactions have been eliminated.\nUse of Estimates\nThe preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could materially differ from those estimates. Management believes that the estimates used are reasonable. The more significant estimates and assumptions by management include, among others, the accrual of potential liabilities, the assumptions used in valuing share-based instruments issued for services, valuation of derivative liabilities and the valuation allowance for deferred tax assets.\nCash and cash equivalents\nThe Company considers highly liquid financial instruments purchased with a maturity of three months or less to be cash equivalents.\n6\nMEXUS GOLD US AND SUBSIDARIES\nNotes to Condensed Consolidated Financial Statements\nSeptember 30, 2019\n(Unaudited)\n2. BASIS OF PREPARATION (CONTINUED)\nEquipment\nEquipment consists of mining tools and equipment, watercraft and vehicles which are depreciated on a straight-line basis over their expected useful lives as follows (see Note 4):\n\n| Mining tools and equipment | 7 years |\n| Watercraft | 7 years |\n| Vehicles | 3 years |\n\nEquipment under Construction\nEquipment under construction comprises mining equipment that is currently being fabricated and modified by the Company and is not presently in use. Equipment under construction totaled $17,018 and $17,018 as of September 30, 2019 and March 31, 2019, respectively. Equipment under construction at September 30, 2019 comprises a Hydraulic Drum 12YD, Skid Mounted Mill and Survey Winch Marine.\nExploration and Development Costs\nExploration costs incurred in locating areas of potential mineralization or evaluating properties or working interests with specific areas of potential mineralization are expensed as incurred. Development costs of proven mining properties not yet producing are capitalized at cost and classified as capitalized exploration costs under property, plant and equipment. Property holding costs are charged to operations during the period if no significant exploration or development activities are being conducted on the related properties. Upon commencement of production, capitalized exploration and development costs would be amortized based on the estimated proven and probable reserves benefited. Properties determined to be impaired or that are abandoned are written-down to the estimated fair value. Carrying values do not necessarily reflect present or future values.\nMineral Property Rights\nCosts of acquiring mining properties are capitalized upon acquisition. Mine development costs incurred either to develop new ore deposits, to expand the capacity of mines, or to develop mine areas substantially in advance of current production are also capitalized once proven and probable reserves exist and the property is a commercially mineable property. Costs incurred to maintain current production or to maintain assets on a standby basis are charged to operations. Costs of abandoned projects are charged to operations upon abandonment. The Company evaluates the carrying value of capitalized mining costs and related property and equipment costs, to determine if these costs are in excess of their recoverable amount whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. Evaluation of the carrying value of capitalized costs and any related property and equipment costs are based upon expected future cash flows and/or estimated salvage value in accordance with Accounting Standards Codification (ASC) 360-10-35-15, Impairment or Disposal of Long-Lived Assets.\nLong-Lived Assets\nIn accordance with ASC 360, Property Plant and Equipment the Company tests long-lived assets or asset groups for recoverability when events or changes in circumstances indicate that their carrying amount may not be recoverable. Circumstances which could trigger a review include, but are not limited to: significant decreases in the market price of the asset; significant adverse changes in the business climate or legal factors; accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of the asset; current period cash flow or operating losses combined with a history of losses or a forecast of continuing losses associated with the use of the asset; and current expectation that the asset will more likely than not be sold or disposed significantly before the end of its estimated useful life. Recoverability is assessed based on the carrying amount of the asset and its fair value which is generally determined based on the sum of the undiscounted cash flows expected to result from the use and the eventual disposal of the asset, as well as specific appraisal in certain instances. An impairment loss is recognized when the carrying amount is not recoverable and exceeds fair value.\n7\nMEXUS GOLD US AND SUBSIDARIES\nNotes to Condensed Consolidated Financial Statements\nSeptember 30, 2019\n(Unaudited)\n2. BASIS OF PREPARATION (CONTINUED)\nFair Value of Financial Instruments\nASC Topic 820 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements.\nIncluded in the ASC Topic 820 framework is a three level valuation inputs hierarchy with Level 1 being inputs and transactions that can be effectively fully observed by market participants spanning to Level 3 where estimates are unobservable by market participants outside of the Company and must be estimated using assumptions developed by the Company. The Company discloses the lowest level input significant to each category of asset or liability valued within the scope of ASC Topic 820 and the valuation method as exchange, income or use. The Company uses inputs which are as observable as possible and the methods most applicable to the specific situation of each company or valued item.\nThe Company's financial instruments consist of cash, accounts payable, accrued liabilities, advances, notes payable, and a promissory note payable. The carrying amount of these financial instruments approximate fair value due to either length of maturity or interest rates that approximate prevailing market rates unless otherwise disclosed in these financial statements.\nSecured convertible promissory note derivative liability is measured at fair value on a recurring basis using Level 3 inputs.\nInterest rate risk is the risk that the value of a financial instrument might be adversely affected by a change in the interest rates. The notes payable, loans payable and secured convertible promissory notes have fixed interest rates therefore the Company is exposed to interest rate risk in that they could not benefit from a decrease in market interest rates. In seeking to minimize the risks from interest rate fluctuations, the Company manages exposure through its normal operating and financing activities.\nDerivative Instruments\nAccounting standards require that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. A change in the market value of the financial instrument is recognized as a gain or loss in results of operations in the period of change.\nForeign Currency Translation\nThe Company’s functional and reporting currency is the United States dollar. Monetary assets and liabilities denominated in foreign currencies are translated to United States dollars in accordance with ASC 740, Foreign Currency Translation Matters, using the exchange rate prevailing at the balance sheet date. Gains and losses arising on translation or settlement of foreign currency denominated transactions or balances are included in the determination of income.\nTo the extent that the Company incurs transactions that are not denominated in its functional currency, they are undertaken in Mexican Pesos. The Company has not, as of the date of these financial statements, entered into derivative instruments to offset the impact of foreign currency fluctuations.\nComprehensive Loss\nASC 220, Comprehensive Income establishes standards for the reporting and display of comprehensive loss and its components in the consolidated financial statements. As at September 30, 2019 and 2018, the Company had no items that represent a comprehensive loss, and therefore has not included a schedule of comprehensive loss in the consolidated financial statements.\n8\nMEXUS GOLD US AND SUBSIDARIES\nNotes to Condensed Consolidated Financial Statements\nSeptember 30, 2019\n(Unaudited)\n2. BASIS OF PREPARATION (CONTINUED)\nIncome Taxes\nThe Company accounts for income taxes using the asset and liability method in accordance with ASC 740, “Accounting for Income Tax”. The asset and liability method provides that deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates and laws that will be in effect when the differences are expected to reverse. The Company records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized.\nAsset Retirement Obligations\nIn accordance with accounting standards for asset retirement obligations (ASC 410), the Company records the fair value of a liability for an asset retirement obligation (ARO) when there is a legal obligation associated with the retirement of a tangible long-lived asset and the liability can be reasonably estimated. The associated asset retirement costs are supposed to be capitalized as part of the carrying amount of the related mineral properties. As of September 30, 2019 and March 31, 2019, the Company has not recorded AROs associated with legal obligations to retire any of the Company’s mineral properties as the settlement dates are not presently determinable.\nRevenue Recognition\nIn accordance with ASC 606, revenue is recognized when a customer obtains control of promised goods or services. The amount of revenue recognized reflects the consideration to which we expect to be entitled to receive in exchange for these goods or services. The provisions of ASC 606 include a five-step process by which we determine revenue recognition, depicting the transfer of goods or services to customers in amounts reflecting the payment to which we expect to be entitled in exchange for those goods or services. ASC 606 requires us to apply the following steps: (1) identify the contract with the customer; (2) identify the performance obligations in the contract; (3) determine the transaction price; (4) allocate the transaction price to the performance obligations in the contract; and (5) recognize revenue when, or as, we satisfy the performance obligation.\nStock-based Compensation\nThe Company records stock based compensation in accordance with the guidance in ASC Topic 718 which requires the Company to recognize expenses related to the fair value of its employee stock option awards. This eliminates accounting for share-based compensation transactions using the intrinsic value and requires instead that such transactions be accounted for using a fair-value-based method. The Company recognizes the cost of all share-based awards on a graded vesting basis over the vesting period of the award.\nASC 505, \"Compensation-Stock Compensation\", establishes standards for the accounting for transactions in which an entity exchanges its equity instruments to non-employees for goods or services. Under this transition method, stock compensation expense includes compensation expense for all stock-based compensation awards granted on or after January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of ASC 505.\nPer Share Data\nNet loss per common share is computed by dividing net loss by the weighted average common shares outstanding during the period as defined by Financial Accounting Standards, ASC Topic 260, \"Earnings per Share\". Basic earnings per common share (“EPS”) calculations are determined by dividing net income by the weighted average number of shares of common stock outstanding during the year. Diluted earnings per common share calculations are determined by dividing net income by the weighted average number of common shares and dilutive common share equivalents outstanding. During periods when common stock equivalents, if any, are anti-dilutive they are not considered in the computation.\n9\nMEXUS GOLD US AND SUBSIDARIES\nNotes to Condensed Consolidated Financial Statements\nSeptember 30, 2019\n(Unaudited)\n2. BASIS OF PREPARATION (CONTINUED)\nAt September 30, 2019 and March 31, 2019, we excluded the outstanding securities summarized below, which entitle the holders thereof to acquire shares of common stock as their effect would have been anti-dilutive:\n\n| September 30, 2019 | March 31, 2019 |\n| Common stock issuable upon conversion of notes payable and convertible notes payable | 130,013,227 | 77,245,894 |\n| Common stock issuable to satisfy stock payable obligations | 42,863,388 | 105,502,659 |\n| Total | 172,876,615 | 182,748,553 |\n\nRecently Issued Accounting Pronouncements\nIn February 2016, the FASB issued ASU No. 2016-02, Leases. ASU 2016-02 requires a lessee to record a right of use asset and a corresponding lease liability on the balance sheet for all leases with terms longer than 12 months. ASU 2016-02 is effective for all interim and annual reporting periods beginning after December 15, 2018. Early adoption is permitted. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. The adoption of ASU 2016-02 on April 1, 2019 did not have a material impact since the Company on the date of adoption had short-term leases and elected not to apply the recognition requirement.\nOther recent accounting pronouncements issued by the FASB, including its Emerging Issues Task Force, the American Institute of Certified Public Accountants, and the Securities and Exchange Commission did not or are not believed by management to have a material impact on the Company's present or future consolidated financial statements.\n3. GOING CONCERN\nThe accompanying condensed consolidated financial statements have been prepared assuming the Company will continue as a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. During the six months ended September 30, 2019, the Company incurred a net loss of $1,553,263 and used cash in operating activities of $697,880, and at September 30, 2019, had an accumulated deficit of $30,680,635. At September 30, 2019, the Company is in the exploration stage and has not earned revenue from planned operations. These factors, among others, raise substantial doubt about the Company’s ability to continue as a going concern within one year of the date that the financial statements are issued. The Company’s independent registered public accounting firm, in their report on the Company’s financial statements for the year ending March 31, 2019, expressed substantial doubt about the Company’s ability to continue as a going concern.\nThe Company is dependent upon outside financing to continue operations. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. It is management’s plans to raise necessary funds through a private placement of its common stock to satisfy the capital requirements of the Company’s business plan. There is no assurance that the Company will be able to raise the necessary funds, or that if it is successful in raising the necessary funds, that the Company will successfully execute its business plan.\nThe condensed consolidated financial statements do not include any adjustments relating to the recoverability and classification of assets and/or liabilities that might be necessary should the Company be unable to continue as a going concern. The continuation as a going concern is dependent upon the ability of the Company to meet our obligations on a timely basis, and, ultimately to attain profitability.\n10\nMEXUS GOLD US AND SUBSIDARIES\nNotes to Condensed Consolidated Financial Statements\nSeptember 30, 2019\n(Unaudited)\n4. PROPERTY & EQUIPMENT\n\n| Cost | Accumulated Depreciation | September 30, 2019 Net Book Value | March 31, 2019 Net Book Value |\n| Mining tools and equipment | $ | 1,771,468 | $ | 1,454,722 | $ | 316,746 | $ | 363,710 |\n| Vehicles | 177,270 | 156,668 | 20,602 | 19,814 |\n| $ | 1,948,738 | $ | 1,611,390 | $ | 337,348 | $ | 383,524 |\n\nDepreciation expense for three and six months ended September 30, 2019 and 2018 was $53,689 and $64.789 and $113,479 and $132,177, respectively.\n5. ACCOUNTS PAYABLE – RELATED PARTIES\nDuring the six months ended September 30, 2019 and 2018, the Company incurred rent expense to Paul D. Thompson, the sole director and officer of the Company, of $22,800 and $22,800, respectively. At September 30, 2019 and March 31, 2019, $163,248 and $140,448 for this obligation is outstanding, respectively.\nCompensation\nOn July 2, 2015, the Company entered into a compensation agreement with Paul D. Thompson, the sole director and officer of the Company. Mr. Thompson is compensated $15,000 per month and has the option to take payment in Company stock valued at an average of 5 days closing price, cash payments or deferred payment in stock or cash. In addition, Mr. Thompson is due 2,000,000 shares of common stock at the end of each fiscal quarter. At September 30, 2019 and March 31, 2019, $248,768 and $294,256 of compensation due is included in accounts payable – related party, respectively and $32,600 for 2,000,000 shares and $32,600 for 2,000,000 shares of common stock due is included in share subscriptions payable, respectively.\n6. NOTES PAYABLE AND NOTES PAYABLE RELATED PARTY\nDuring the six months ended September 30, 2019, the Company issued the following notes payable:\ni)On April 5, 2019, the Company issued a promissory note (“Note”) for $41,000 in cash. The Note earns interest at 12% per annum, matures on April 6, 2020 and is convertible into shares of common stock of the Company, the option of the Holder, at $0.005 per share. This Note were initially recorded net of a debt discount of $41,000 for a beneficial conversion feature with a corresponding increase in additional paid-in capital of $41,000.\nii)On April 15, 2019, the Company issued a promissory note (“Note”) with a principal of amount of $66,754 bearing interest of 10% per annum to settle $66,754 in accounts payable due for accounting fees. The Note is due on June 30, 2020. The holder of the Note may convert principal and interest into shares of common stock of the Company at $0.005 per share. This Note were initially recorded net of a debt discount of $61,414 for a beneficial conversion feature with a corresponding increase in additional paid-in capital of $61,414.\niii)On May 14, 2019, the Company issued a promissory note (“Note”) for $90,000 in cash with a face value of $95,000. The face value of the Note was due on May 24, 2019 plus an additional 1,000,000 shares of common stock of the Company. On May 17, 2019 and June 17, 2019, the Company paid the Note holder $60,000 and $35,000, respectively. The 1,000,000 shares of common stock was valued at $8,500 ($0.0085 per share) and recorded as interest expense. An additional $270 was paid to reimburse the Holder for fees.\niv)On March 11, 2019, the Company entered into a loan agreement (“Note”) for $70,000 in cash with a term of one year and one day. Upon signing the Note, the Company agreed to issue 3,000,000 shares of common stock of the Company. In addition, the Company agreed to issue a warrant with an exercise price of $0.05 per share once the Note is fully settled. The Note also states that the Company will repay the Note from 5% of the net profit from the Santa Elena Caborca gold project net smelter royalty until the Note is paid in full. During the six months ended September 30, 2019, an additional $70,000 in cash was advanced in accordance with the terms of the Note.\n11\nMEXUS GOLD US AND SUBSIDARIES\nNotes to Condensed Consolidated Financial Statements\nSeptember 30, 2019\n(Unaudited)\n6. NOTES PAYABLE AND NOTES PAYABLE RELATED PARTY (CONTINUED)\nv)Promissory notes with $3,000 in principal that earn interest at 10% per annum and a term of nine months.\nvi)On July 18, 2019, the Company entered into a loan agreement (“Note”) for $105,000 in cash. The terms of the Note require the repayment of $75,000 in cash and the issuance of 200,000 shares of the Company on August 1, 2019. The balance of the Note is due in three equal monthly installment commencing September 1, 2019 with interest payment at 18% per annum.\nvii)On July 26, 2019, a promissory note with principal of $5,000 with interest payable of $350.\nviii)On August 9,2019, a promissory note with principal of $6,000 with total interest comprising of $1,300 in cash and 50,000 shares of common stock of the Company.\nDuring the six months ended September 30, 2019 and 2018, note principal of $52,000 and $41,500, respectively, was paid through the issuance of 18,150,000 and 8,761,153 shares of common stock, respectively. In addition, during the six months ended September 30, 2019 and 2018, the Company paid $170,000 and $13,000 in cash, respectively, to settle debt.\nAt September 30, 2019 and March 31, 2019, the carrying value of the notes totaled $759,866 (net of unamortized debt discount of $125,206 and $693,600 (net of unamortized debt discount of $94,127), respectively. At September 30, 2019, $456,682 of these notes were in default. There are no default provisions stated in these notes. At September 30, 2019 -and March 31, 2019, accrued interest of $54,750 and $31,332, respectively, is included in accounts payable and accrued liabilities.\nNotes payable – related party – At September 30, 2019 and March 31, 2019, notes payable – related party of $75,110 and $67,410, respectively, are due to Paul Thompson Sr., the sole officer and director of the Company. These notes bear interest from 0% to 12% per annum.\nInterest and amortization of debt discount was $71,336 and $187,727 for the six months ended September 30, 2019 and 2018, respectively.\nThe amount by which the if-converted value of notes payable exceeds principal of notes payable at September 30, 2019 is $74,190.\n7. PROMISSORY NOTE\nAt September 30, 2019 and March 31, 2019, outstanding Promissory Notes were $65,000 and $65,000, respectively. The Note bear interest of 4% per annum and are due on December 31, 2013. The Note is secured by all of Mexus Gold US shares of stock in Mexus Resources S.A. de C.V. and a personal guarantee of Paul D. Thompson. As of September 30, 2019, the Company has not made the scheduled payments and is in default on this promissory note. The default rate on the notes is seven percent. At September 30, 2019 and March 31, 2019, accrued interest of $34,520 and $31,117, respectively, is included in accounts payable and accrued liabilities.\n12\nMEXUS GOLD US AND SUBSIDARIES\nNotes to Condensed Consolidated Financial Statements\nSeptember 30, 2019\n(Unaudited)\n8. CONVERTIBLE PROMISSORY NOTES\nPower Up Lending Group Ltd.\nOn November 7, 2018, the Company issued a Convertible Promissory Note (“Note”) to Power Up Lending Group Ltd. (“Holder”) in the original principal amount of $78,000 less transaction costs of $2,500 bearing a 12% annual interest rate and maturing August 30, 2019 for $75,500 in cash. After 170 days after the issue date, this Note together with any unpaid accrued interest is convertible into shares of common stock of the Company at the Holder’s option at a variable conversion price calculated at 65% of the market price defined as the average of the lowest two trading prices during the fifteen trading day period ending on the latest complete trading day prior to the conversion date. The Company determined that upon issuance of the Note, the initial fair value of the embedded conversion feature was $50,690 which was recorded as a debt discount. The Company may repay the Note if repaid in cash within 30 days of date of issue at 110% of the original principal amount plus interest, between 31 days and 60 days at 115% of the original principal amount plus interest, between 61 days and 90 days at 120% of the original principal amount plus interest, between 91 days and 120 days at 125% of the original principal amount plus interest, between 121 days and 150 days at 130% of the original principal amount plus interest, and between 151 days and 170 days at 135% of the original principal amount plus interest. Thereafter, the Company does not have the right of prepayment. At March 31, 2019, the Note is recorded at an accreted value of $125,681 less unamortized debt discount of $48,879. On May 10, 2019, the Company paid $111,531 in cash to Power Up Lending Group Ltd. to fully settle the Note resulting in a gain on settlement of $15,471. Interest and amortization of debt discount was $50,203 for the six months ended September 30, 2019.\nOn January 25, 2019, the Company issued a Convertible Promissory Note (“Note”) to Power Up Lending Group Ltd. (“Holder”) in the original principal amount of $73,000 less transaction costs of $3,000 bearing a 12% annual interest rate and maturing November 15, 2019 for $70,000 in cash. After 170 days after the issue date, this Note together with any unpaid accrued interest is convertible into shares of common stock of the Company at the Holder’s option at a variable conversion price calculated at 65% of the market price defined as the average of the lowest two trading prices during the fifteen trading day period ending on the latest complete trading day prior to the conversion date. The Company determined that upon issuance of the Note, the initial fair value of the embedded conversion feature was $76,073, of which $70,000 was recorded as debt discount and the remainder of $6,073 was recorded expensed and included in gain (loss) on derivative liability. The Company may repay the Note in cash if repaid within 30 days of date of issue at 110% of the original principal amount plus interest, between 31 days and 60 days at 115% of the original principal amount plus interest, between 61 days and 90 days at 120% of the original principal amount plus interest, between 91 days and 120 days at 125% of the original principal amount plus interest, between 121 days and 150 days at 130% of the original principal amount plus interest, and between 151 days and 170 days at 135% of the original principal amount plus interest. At March 31, 2019, the Note is recorded at an accreted value of $114,708 less unamortized debt discount of $52,714. On July 18, 2019, the Company paid $104,188 in cash to Power Up Lending Group Ltd. to fully settle the Note resulting in a gain on settlement of $14,249. Interest and amortization of debt discount was $91,207 for the six months ended September 30, 2019.\nOn April 5, 2019, the Company issued a Convertible Promissory Note (“Note”) to Power Up Lending Group Ltd. (“Holder”) in the original principal amount of $88,000 less transaction costs of $3,000 bearing a 12% annual interest rate and maturing February 28, 2020 for $85,000 in cash. After 170 days after the issue date, this Note together with any unpaid accrued interest is convertible into shares of common stock of the Company at the Holder’s option at a variable conversion price calculated at 65% of the market price defined as the average of the lowest two trading prices during the fifteen trading day period ending on the latest complete trading day prior to the conversion date. The Company determined that upon issuance of the Note, the initial fair value of the embedded conversion feature was $74,311 which was recorded as a debt discount. The Company may repay the Note if repaid within 30 days of date of issue at 110% of the original principal amount plus interest, between 31 days and 60 days at 115% of the original principal amount plus interest, between 61 days and 90 days at 120% of the original principal amount plus interest, between 91 days and 120 days at 125% of the original principal amount plus interest, between 121 days and 150 days at 130% of the original principal amount plus interest, and between 151 days and 170 days at 135% of the original principal amount plus interest. At September 30, 2019, the Note is recorded at an accreted value of $143,307 less unamortized debt discount of $57,228. Interest and amortization of debt discount was $75,387 for the six months ended September 30, 2019.\n13\nMEXUS GOLD US AND SUBSIDARIES\nNotes to Condensed Consolidated Financial Statements\nSeptember 30, 2019\n(Unaudited)\n8. CONVERTIBLE PROMISSORY NOTES (CONTINUED)\nOn May 9, 2019, the Company issued a Convertible Promissory Note (“Note”) to Power Up Lending Group Ltd. (“Holder”) in the original principal amount of $83,000 less transaction costs of $3,000 bearing a 12% annual interest rate and maturing March 15, 2020 for $80,000 in cash. After 170 days after the issue date, this Note together with any unpaid accrued interest is convertible into shares of common stock of the Company at the Holder’s option at a variable conversion price calculated at 65% of the market price defined as the average of the lowest two trading prices during the fifteen trading day period ending on the latest complete trading day prior to the conversion date. The Company determined that upon issuance of the Note, the initial fair value of the embedded conversion feature was $77,741 which was recorded as a debt discount. The Company may repay the Note if repaid within 30 days of date of issue at 110% of the original principal amount plus interest, between 31 days and 60 days at 115% of the original principal amount plus interest, between 61 days and 90 days at 120% of the original principal amount plus interest, between 91 days and 120 days at 125% of the original principal amount plus interest, between 121 days and 150 days at 130% of the original principal amount plus interest, and between 151 days and 170 days at 135% of the original principal amount plus interest. At September 30, 2019, the Note is recorded at an accreted value of $133,738 less unamortized debt discount of $67,357. Interest and amortization of debt discount was $64,124 for the six months ended September 30, 2019.\nOn June 11, 2019, the Company issued a Convertible Promissory Note (“Note”) to Power Up Lending Group Ltd. (“Holder”) in the original principal amount of $42,500 less transaction costs of $2,500 bearing a 12% annual interest rate and maturing April 15, 2020 for $40,000 in cash. After 170 days after the issue date, this Note together with any unpaid accrued interest is convertible into shares of common stock of the Company at the Holder’s option at a variable conversion price calculated at 65% of the market price defined as the average of the lowest two trading prices during the fifteen trading day period ending on the latest complete trading day prior to the conversion date. The Company determined that upon issuance of the Note, the initial fair value of the embedded conversion feature was $38,450 which was recorded as a debt discount. The Company may repay the Note if repaid within 30 days of date of issue at 110% of the original principal amount plus interest, between 31 days and 60 days at 115% of the original principal amount plus interest, between 61 days and 90 days at 120% of the original principal amount plus interest, between 91 days and 120 days at 125% of the original principal amount plus interest, between 121 days and 150 days at 130% of the original principal amount plus interest, and between 151 days and 170 days at 135% of the original principal amount plus interest. At September 30, 2019, the Note is recorded at an accreted value of $67,771 less unamortized debt discount of $40,902. Interest and amortization of debt discount was $25,317 for the six months ended September 30, 2019.\nOn July 29, 2019, the Company issued a Convertible Promissory Note (“Note”) to Power Up Lending Group Ltd. (“Holder”) in the original principal amount of $85,000 less transaction costs of $2,500 bearing a 12% annual interest rate and maturing June 15, 2020 for $82,500 in cash. After 170 days after the issue date, this Note together with any unpaid accrued interest is convertible into shares of common stock of the Company at the Holder’s option at a variable conversion price calculated at 65% of the market price defined as the average of the lowest two trading prices during the fifteen trading day period ending on the latest complete trading day prior to the conversion date. The Company determined that upon issuance of the Note, the initial fair value of the embedded conversion feature was $105,696 which was recorded as a debt discount. The Company may repay the Note if repaid within 30 days of date of issue at 110% of the original principal amount plus interest, between 31 days and 60 days at 115% of the original principal amount plus interest, between 61 days and 90 days at 120% of the original principal amount plus interest, between 91 days and 120 days at 125% of the original principal amount plus interest, between 121 days and 150 days at 130% of the original principal amount plus interest, and between 151 days and 170 days at 135% of the original principal amount plus interest. At September 30, 2019, the Note is recorded at an accreted value of $133,478 less unamortized debt discount of $105,184. Interest and amortization of debt discount was $28,293 for the six months ended September 30, 2019.\n14\nMEXUS GOLD US AND SUBSIDARIES\nNotes to Condensed Consolidated Financial Statements\nSeptember 30, 2019\n(Unaudited)\n8. CONVERTIBLE PROMISSORY NOTES (CONTINUED)\nJSJ Investments Inc.\nOn September 16, 2019, the Company issued a Convertible Promissory Note (“Note”) to JSJ Investments Inc. (“Holder”) in the original principal amount of $142,000 less debt discount of $17,000 bearing a 6% annual interest rate and maturing September 16, 2020 for $125,000 in cash. After 180 days after the issue date, this Note together with any unpaid accrued interest is convertible into shares of common stock of the Company at the Holder’s option at a variable conversion price calculated at 35% discount to the average of the two lowest trading prices during the previous fifteen (15) trading days. The Company determined that upon issuance of the Note, the initial fair value of the embedded conversion feature was $103,604 which was recorded as a debt discount. The Company may repay the Note if repaid within 30 days of date of issue at 110% of the original principal amount plus interest, between 31 days and 60 days at 115% of the original principal amount plus interest, between 61 days and 90 days at 120% of the original principal amount plus interest, between 91 days and 120 days at 125% of the original principal amount plus interest, between 121 days and 150 days at 130% of the original principal amount plus interest, and between 151 days and 180 days at 135% of the original principal amount plus interest. At September 30, 2019, the Note is recorded at an accreted value of $218,964 less unamortized debt discount of $189,528. Interest and amortization of debt discount was $8,041 for the six months ended September 30, 2019.\n9. CONVERTIBLE PROMISSORY NOTE DERIVATIVE LIABILITY\nThe Convertible Promissory Notes (“Notes”) with Power Up Lending Group Ltd. and JSJ Investments Inc. was accounted for under ASC 815. The variable conversion price is not considered predominately based on a fixed monetary amount settleable with a variable number of shares due to the volatility and trading volume of the Company’s common stock. The Company’s convertible promissory notes derivative liabilities has been measured at fair value using the Black-Scholes model.\n\n| March 31, 2019 | April 5, 2019 | May 9, 2019 | June 11, 2019 | June 30, 2019 | July 29, 2019 | Sept. 16, 2019 | Sept. 30, 2019 |\n| Closing share price | $ | 0.0112 | $ | 0.0119 | $ | 0.0080 | $ | 0.0088 | $ | 0.01 | $ | 0.015 | $ | 0.0119 | $ | 0.0115 |\n| Conversion price | $ | 0.0100 | $ | 0.0100 | $ | 0.0063 | $ | 0.0071 | $ | 0.0075 | $ | 0.009 | $ | 0.0115 | $ | 0.0113 |\n| Risk free rate | 2.44% - 2.56% | 2.56% | 2.10% | 2.10% | 2.10% | 2.10% | 2.10% | 2.10% |\n| Expected volatility | 230% | 213% | 216% | 220% | 216% - 256% | 210% | 204% | 153% - 214% |\n| Dividend yield | 0% | 0% | 0% | 0% | 0% | 0% | 0% | 0% |\n| Expected life (years) | 0.42- 0.63 | 0.88 | 0.92 | 0.85 | 0.38 – 0.79 | 0.84 | 1.00 | 0.39 – 0.96 |\n\nThe inputs into the Black-Scholes models are as follows:\nThe fair value of the conversion option derivative liabilities is $254,467 and $113,091 at September 30, 2019 and March 31, 2019, respectively. The decrease (increase) in the fair value of the conversion option derivative liability for the three and six months ended September 30, 2019 and 2018 of $207,727 and 235,229 and $29,437 and $98,371, respectively, is recorded as a gain (loss) in the condensed consolidated statements of operations.\n10. CONTINGENT LIABILITIES\nAn asset retirement obligation is a legal obligation associated with the disposal or retirement of a tangible long-lived asset that results from the acquisition, construction or development, or the normal operations of a long-lived asset, except for certain obligations of lessees. While the Company, as of September 30, 2019, does not have a legal obligation associated with the disposal of certain chemicals used in its leaching process, the Company estimates it will incur costs up to $50,000 to neutralize those chemicals at the close of the leaching pond.\n15\nMEXUS GOLD US AND SUBSIDARIES\nNotes to Condensed Consolidated Financial Statements\nSeptember 30, 2019\n(Unaudited)\n11. STOCKHOLDERS’ EQUITY (DEFICIT)\nThe stockholders’ equity of the Company comprises the following classes of capital stock as of September 30, 2019 and March 31, 2019:\nPreferred Stock, $0.001 par value per share; 9,000,000 shares authorized, 0 issued and outstanding at September 30, 2019 and March 31, 2019.\nSeries A Convertible Preferred Stock (‘Series A Preferred Stock”), $0.001 par value share; 1,000,000 shares authorized: 1,000,000 shares issued and outstanding at September 30, 2019 and March 31, 2019.\nHolders of Series A Preferred Stock may convert one share of Series A Preferred Stock into ten shares of Common Stock. Holders of Series A Preferred Stock have the number of votes determined by multiplying (a) the number of Series A Preferred Stock held by such holder, (b) the number of issued and outstanding Series A Preferred Stock and Common Stock on a fully diluted basis, and (c) 0.000006.\nCommon Stock, par value of $0.001 per share; 2,000,000,000 shares authorized: 1,397,287,172 and 1,011,848,975 shares issued and outstanding at September 30, 2019 and March 31, 2019, respectively. Holders of Common Stock have one vote per share of Common Stock held.\nCommon Stock Issued\nOn April 17, 2019, the Company issued 53,799,286 shares of common stock to satisfy obligations under share subscription agreements of $47,600 for settlement of services, $4,392 for interest and $139,500 for cash receipts included in share subscriptions payable.\nOn April 30, 2019, the Company issued 15,444,439 shares of common stock to satisfy obligations under share subscription agreements of $7,000 for settlement of services and $15,500 for cash receipts included in share subscriptions payable.\nOn May 8, 2019, the Company issued 45,882,143 shares of common stock to satisfy obligations under share subscription agreements of $48,496 for settlement of services, $117,400 to settle accounts payable, $2,254 for interest and $32,100 for cash receipts included in share subscriptions payable.\nOn June 4, 2019, the Company issued 16,678,333 shares of common stock to satisfy obligations under share subscription agreements of $13,291 for settlement of services and $23,000 for cash receipts included in share subscriptions payable.\nOn June 18, 2019, the Company issued 23,445,000 shares of common stock to satisfy obligations under share subscription agreements of $101,078 for settlement of services, $18,050 for cash receipts, $6,500 to settle notes payable and $3,960 for interest included in share subscriptions payable.\nOn July 2, 2019, the Company issued 5,000,000 shares of common stock to satisfy obligations under share subscription agreements of $10,000 for cash receipts.\nOn July 9, 2019, the Company issued 17,314,000 shares of common stock to satisfy obligations under share subscription agreements of $57,200 for settlement of services and $20,785 for cash receipts included in share subscriptions payable.\nOn July 10, 2019, the Company issued 61,108,334 shares of common stock to satisfy obligations under share subscription agreements of $90,000 for settlement of services and $90,110 for cash receipts included in share subscriptions payable.\nOn July 22, 2019, the Company issued 22,083,332 shares of common stock to satisfy obligations under share subscription agreements for $25,500 for cash receipts included in share subscriptions payable.\nOn July 29, 2019, the Company cancelled 1,000,000 shares of common stock originally issued to satisfy obligations under share subscription agreements of $5,000 for cash receipts.\n16\nMEXUS GOLD US AND SUBSIDARIES\nNotes to Condensed Consolidated Financial Statements\nSeptember 30, 2019\n(Unaudited)\n11. STOCKHOLDERS’ EQUITY (DEFICIT) (CONTINUED)\nOn August 9, 2019, the Company issued 32,933,332 shares of common stock to satisfy obligations under share subscription agreements of $63,300 for settlement of services, $29,900 for cash receipts and $38,500 for interest included in share subscriptions payable.\nOn August 13, 2019, the Company issued 10,000,000 shares of common stock to satisfy obligations under share subscription agreements of $103,000 for settlement of services included in share subscriptions payable.\nOn August 20, 2019, the Company issued 39,583,332 shares of common stock to satisfy obligations under share subscription agreements of $56,700 for settlement of cash receipts included in share subscriptions payable.\nOn September 17, 2019, the Company issued 43,166,666 shares of common stock to satisfy obligations under share subscription agreements $62,400 for cash receipts and $10,000 for settlement of notes payable included in share subscriptions payable.\nCommon Stock Payable\nAs at September 30, 2019, the Company had total subscriptions payable for 42,863,388 shares of common stock for $77,582 in cash, shares of common stock for interest valued at $4,495, shares of common stock for services valued at $184,702, shares of common stock for notes payable of $137,298 and shares of common stock for equipment of $6,160.\n12. RELATED PARTY TRANSACTIONS\nDuring the six months ended September 30, 2019 and 2018, the Company entered into the following transactions with related parties:\nPaul D. Thompson, sole director and officer of the Company\nTaurus Gold, Inc., controlled by Paul D. Thompson\nAccounts payable – related parties – Note 5\nNotes payable – Note 6\n13. SUBSEQUENT EVENTS\nCommon Stock Issued\nOn October 1, 2019, the Company issued 19,912,499 shares of common stock to satisfy obligations under share subscription agreements of $37,200 for settlement of services, $25,200 for cash receipts, $3,384 for interest and $112,788 for the settlement of notes payable included in share subscriptions payable.\nOn October 29, 2019, the Company issued 29,999,850 shares of common stock to satisfy obligations under share subscription agreements of $200,000 for settlement of notes payable included in share subscriptions payable.\nOn November 1, 2019, the Company issued 3,804,348 shares of common stock to satisfy obligations under share subscription agreements of $53,350 for settlement of services included in share subscriptions payable.\nCommon Stock Payable\nFor the period of October 1, 2019 to November 14 2019, the Company issued subscriptions payable for 1,875,000 shares of common stock for $97,500 in cash ($0.0036 per share).\nFor the period of October 1, 2019 to November 14 2019, the Company issued subscriptions payable for 29,999,850 shares of common stock for $200,000 in services ($0.0067 per share).\n17\n\nITEM 2.\nMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nCautionary Statement Concerning Forward-Looking Statements\nThe following discussion and analysis should be read in conjunction with our audited consolidated financial statements and related notes included in this report. This report contains “forward-looking statements.” The statements contained in this report that are not historic in nature, particularly those that utilize terminology such as “may,” “will,” “should,” “expects,” “anticipates,” “estimates,” “believes,” or “plans” or comparable terminology are forward-looking statements based on current expectations and assumptions.\nVarious risks and uncertainties could cause actual results to differ materially from those expressed in forward-looking statements. Factors that could cause actual results to differ from expectations include, but are not limited to, those set forth under the section “Risk Factors” set forth in this report.\nThe forward-looking events discussed in this report, the documents to which we refer you and other statements made from time to time by us or our representatives, may not occur, and actual events and results may differ materially and are subject to risks, uncertainties and assumptions about us. For these statements, we claim the protection of the “bespeaks caution” doctrine. All forward-looking statements in this document are based on information currently available to us as of the date of this report, and we assume no obligation to update any forward-looking statements. Forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results to differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements.\nThe Company\nMexus Gold US is an exploration stage mining company engaged in the evaluation, acquisition, exploration and advancement of gold, silver and copper projects in the State of Sonora, Mexico. Mexus Gold US is dedicated to protect the environment and provide employment and education opportunities for the communities that it operates in.\nOur President and CEO, Paul Thompson, brings over 45 years’ experience in mining and mining development to Mexus Gold US. Mr. Thompson is currently recruiting additional management personnel for its Mexico and Nevada mining operations.\nOur executive offices are located at, 1805 N. Carson Street, #150, Carson City, Nevada 89701. Our telephone number is (916) 776 2166.\nWe were originally incorporated under the laws of the State of Colorado on June 22, 1990, as U.S.A. Connection, Inc. On September 18, 2009, we changed our domicile to Nevada and changed our name to Mexus Gold US to better reflect our new business operations. Our fiscal year end is March 31st.\nDescription of the Business of Mexus Gold US\nMexus Gold US is engaged in the evaluation, acquisition, exploration and advancement of gold exploration and development projects in the United Mexican States, as well as, the salvage of precious metals from identifiable sources. Our main activities in the near future will be comprised of our mining operations in Mexico. Our mining opportunities located in the State of Sonora, Mexico will provide us with projects to recover gold, silver, copper and other precious metals.\nIn addition, our management will look for opportunities to improve the value of the gold projects that we own or may acquire knowledge of or may acquire control through exploration drilling, introduction of technological innovations or acquisition with the goal of developing those properties into operating mines. We expect that emphasis on gold project acquisition and development will continue in the future.\nBusiness Strategy\nOur business plan was developed with the overriding goal of maximizing shareholder value through the exploration and development of our mineral properties, utilizing the extensive mining-related background and capabilities of our management consultants and advisors. To achieve this goal, our business plan focuses on the following prospective areas:\n18\nMining Operations\nWe classify our mineral properties into three categories: “Development Properties”, “Advanced Exploration Properties”, and “Other Exploration Properties”. Development Properties are properties where a decision to develop the property into a producing mine has been made. Advanced Exploration Properties are those properties where we retain a significant ownership interest or joint venture and where there has been sufficient drilling and analysis to identify and report proven and probable reserves or other mineralized material. We currently do not have a Development Property or Advanced Exploration Property. Other Exploration Properties are those that do not fall into the other categories. Please see below for information about our Other Exploration Properties.\nEffective March 31, 2011, we acquired Mexus Gold S.A. de C.V. (our wholly owned subsidiary) and began funding mining operations in Mexico. We have instituted a small placer processing operation to evaluate various areas of interest within the project lands.\nMaterial Mining Properties\nSanta Elena Prospect, (formerly known as the Caborca Project)\nOur Santa Elena Prospect is comprised of early-stage exploration, including limited production operations, on the concessions. Under the terms of the concession agreement we also will acquire the associated surface. This concession is situated in the State of Sonora, Mexico.\nOn April 16, 2018, Mexus Gold Mining S.A. de C.V., a subsidiary of Mexus, announced that it planned to terminate its joint venture agreement with MarMar Holdings (the “JV Agreement”). The JV Agreement outlined the contractual obligations of the parties at the Santa Elena project in Caborca, Sonora State, Mexico. The decision to terminate the JV Agreement was made due to MarMar’s failure to provide agreed funding, equipment and general operations for the project, as well as MarMar’s inability to meet environmental standards at the site. We do not anticipate any early termination penalties associated with the JV Agreement. On July 2, 2018, the Company announced that the agreement was officially terminated.\nWe intend to move forward with the Santa Elena project with proper equipment and personnel. Due to the lack of funding by MarMar, the Santa Elena site, a disappointing 8.5oz Au was produced in the last 22 months.\nThe Company has contracted with a security firm to provide 24-hour services at the Santa Elena site. Currently, there is equipment on site sufficient to produce an anticipated 500 tons a day and plans are in place to begin hiring staff with production beginning shortly thereafter. In addition, safety fencing will be installed and required site clean-up will occur that will satisfy any environmental concerns at the property. Two separate parties are running tests on the heap leach pad to determine the next steps to allow for recovery of gold and silver within the system.\nUsing previously developed geological mapping the company plans to mine the Julio quartz vein and the adjacent shear zone via open pit mining. The existing Julio vein, with depths to 30 meters and widths from 1 to 4 meters, has values ranging from 1.5 to 186 grams Au per ton. The adjacent shear zone carries values from .5 to 17 grams Au per ton. Mexus estimates that the shear zone will average 2.5 grams per ton gold equivalent with the Julio vein values being much higher. Additional equipment will be purchased which will enable the company to increase production to 1000 tons a day and beyond. Mexus intends to announce a non-dilutive capital raise plan in the very near future.\nUres Property Prospects (also known as 8 brothers/370 mine project)\nThe Ures Prospects, also situated in the State of Sonora, Mexico are the 370 Prospect, San Ramon Prospect, La Platosa Prospect, Edgar Prospect, Edgar II Prospect, Los Lareles Prospect, El Scorpio Prospect, and Ocho Hermanos Prospect.\nIn June 2018, Mexus completed its first test of the VAT leaching system and the Merrill Crowe gold recovery plant at the 8 brothers/370 mine project. The successful test produced 70 pounds of precipitate which is currently being dried and prepared for smelting. Results of this first run will be released soon. The material initially mined took longer to leach than expected. Mexus geologist, Cesar Lemas, has identified new material which has been column tested showing a 48 to 72 hour leach time. The company will mine and use this material going forward to accelerate recovery times.\nNon-Material Minting Properties\nSan Felix Mine Project (formerly known as the Mexus-Trinidad Joint Venture)\nIn March, 2014, we sold our 50% interest in the Joint Venture to Atzek Mineral S.A. de C.V (“Atzek”). Atzek is currently in default of the sale agreement.\n19\nEffective January 13, 2017, our wholly owned subsidiary, Mexus Gold Mining, S.A. de C.V., entered into a purchase agreement with Jesus Leopoldo Felix Mazon, Leonardo Elias Jaime Perez, and Elia Lizardi Perez, wherein we purchased a 50% interest in the “San Felix” mining site located in the La Alameda area of Caborca, State of Sonora, Mexico. The remaining 50% of the site is owned jointly by Mar Holdings S.A. de C.V. and Marco Antonio Martinez Mora. The San Felix mining site contains seven (7) concessions over an area of approximately 26,000 acres. During the year ended March 31, 2018, the Company recorded an impairment of mineral property for the San Felix Project of $75,000 because the requirement payment of $500,000 due on August 13, 2017 was not paid in accordance with the purchase agreement pending the receipt of certain required instruments from the Grantor by the Company.\nOther Operations\nCable Salvage Operation\nThe Company completed the first phase of its Cable Recovery Project in Alaskan waters. The cable which was recovered was smaller diameter cable which was excellent for testing the recovery equipment and vessels. The Company evaluated the project and conducted a mapping project and exploration activities in an attempt to identify larger cable.\nAt March 31, 2017, the Company ceased cable salvage operations in order to fully concentrate on Mexico operations.\nMergers and Acquisitions\nWe will routinely review merger and acquisition opportunities. An appropriate merger and acquisition opportunity must be accretive to the overall value of Mexus Gold US. Our primary focus will be on those opportunities involving precious metal production or near-term production with a secondary focus on other resource-based opportunities. Potential acquisition targets would include private and public companies or individual properties. Although our preference would be for candidates located in the United States and Mexico; Mexus Gold US will consider opportunities located in other countries where the geopolitical risk is acceptable.\nDescription of Mining Projects\nThe following properties are located in Mexico and owned by Mexus Gold S.A. de C.V., our wholly owned subsidiary:\nSanta Elena Prospects (formerly known as the Caborca Project)\nThe Company executed a revised Mineral Mining and Purchase Agreement, dated December 3, 2015, with the Concession Owners covering 2,225 acres located in the State of Sonora, Mexico. The Agreement is for a term of 25 years and specifies a purchase privilege, at the discretion of the Company, for all concessions in the amount of $2,000,000 absent the exercise of the purchase privilege a royalty of 40% for lode deposits and 25% for placer deposits and is credited to the purchase price. The Agreement specifies a delayed monthly royalty in the amount of $1,000 and the payment of the semi-annual concession tax.\n\n| Santa Elena Concessions |\n| No | CONCESSION NAME | TITLE NO | AREA HECTARE | DATE ISSUED | END DATE |\n| 1 | MARTHA ELENA | 221447 | 339.3811 | 10/2/2004 | 9/2/2054 |\n| 2 | JULIO II | 221448 | 59.0401 | 10/2/2004 | 9/2/2054 |\n| 3 | JULIO III | 231609 | 99.6381 | 3/25/2008 | 3/24/2058 |\n| 4 | JULIO IV | 231610 | 99.9687 | 3/25/2008 | 3/24/2058 |\n| 5 | JULIO V | 231611 | 100 | 3/25/2008 | 3/24/2058 |\n| 6 | JULIO VI | 231612 | 100 | 3/25/2008 | 3/24/2058 |\n| 7 | JULIO VII | 231613 | 100 | 3/25/2008 | 3/24/2058 |\n| Total Hectares | 898.028 |\n| Total Acres | 2,219.0755 |\n\nThe Company has conducted geological evaluation of the Santa Elena Prospects comprised of expanding the existing placer facility for the purpose of mineral evaluation, physical geological evaluations including the drilling of reverse circulation and core holes. Situated on the prospect area are caterpillars, haul trucks, maintenance trucks, power generators, pumps, tractor blade, truck mounted winch, water handling supplies and maintenance trailer with supplies. The prospect area is accessed from a state highway on existing roads. There is access to well water which is available for the current and future operations.\n20\nOn January 5, 2011, Mexus Gold Mining S.A. de C.V. entered into a Purchase Agreement to purchase the Santa Elena Prospect, formerly known as the Caborca Project. The Santa Elena Prospect consists of 7,400 acres (3,000 hectares) about 50 kilometers northwest of the City of Caborca, Sonora State, Mexico. The Caborca Project lies on claims filed by the owners of the Santa Elena Ranch, which controls the surface rights over the project claims. The claims lie near 112o 25' W, 31o 7.5\" N. These claims were visited near the end of January, 2011. On or about July 11, 2011, we acquired five additional claims surrounding the Santa Elena Prospect consisting of approximately 1,000 additional acres.\nWe have been unable to locate geologic maps of the area from the Government Geological Survey. However, pursuant to our investigation of the project, the claims were found to be underlain by an igneous complex. The rocks observed included many types of granitic rocks, exhibiting porphyrytic textures, gneissic and equigrannular textures. Quartz was variable. At times quartz \"eyes\" were observed, that is porphyrytic quartz which many workers consider to be indicative of a porphyry environment. In other localities, no quartz was evident. When no quartz was present, the rock was equigrannular. Quartz veining was evident throughout the claim group. A mine was developed along a major quartz vein, called the Julio 2 Mine with the vein being called the Julio Vein.\nThere are multiple exploration targets on the Santa Elena Prospect. The two most important are the quartz stockwork zone and the Julio vein system. The first target will be the quartz stockwork zone area. A limited drilling program has been conducted and completed. Production testing has been completed resulting in the construction of the surface production and recovery facilities.\nAccess to the Santa Elena prospect is via dirt road approximately two miles west of paved highway Mexico 1 and approximately 34 miles northwest of the town of Caborca, Sonora, Mexico.\nFIGURE 1 – SANTA ELENA PROJECT LOCATION MAP\n21\nExhibit 99.1 – PRELIMINARY REPORT AND FIRST STAGE MAPPING\nUres Property Prospects, being comprised of the following projects:\nOcho Hermanos – Guadalupe de Ures Project\nThe Guadalupe de Ures Project is accessed from Hermosillo by driving via good paved road for 60 kilometers to the town of Guadalupe de Ures and then for 15 kilometers over dirt roads to the prospects. A base camp has been established near the town of Guadalupe de Ures using mainly trailers for accommodation, workshops and kitchen facilities.\nFIGURE 2 - GUADALUPE DE URES PROJECT LOCATION MAP\nThe Ocho Hermanos Project (also called the Guadalupe de Ures Project) consists of the “Ocho Hermanos” and \"San Ramon\" claims which are covered by the Sales and Production Contract dated the 4th day of July, 2009 between “Minerales Ruta Dorado de RL de CV” (seller) and “Mexus Gold Mining S.A. de C.V.”, a wholly owned subsidiary of Mexus Gold US (buyer). The Ocho Hermanos Claim consists of 34.9940 hectares (1 acre = 0.4047 hectares) or 86.4690 acres while the San Ramon Claim consists of 80 hectares (197.6773 acres).(Figure 4).\nThe initial term of the agreement was 5 years. During the term Mexus must pay 40% of the net revenue received for minerals produced to the seller. At the conclusion of the 5 years, the lease could be purchased for USD 50,000. Upon expiration on July 4, 2014, Mexus renewed the agreement with an indefinite term. The renewed agreement requires Mexus to pay $1,500 per month and 20% to the total proceeds upon a sale of the rights.\nMinerales Ruta Dorado de RL de CV is a duly constituted Mexican Company and as such can hold mining claims in Mexico.\n22\nFIGURE 3 - OCHO HERMANOS\nPROJECT AREA CLAIM MAP\nWe did not perform any systematic sampling or any systematic drilling and because of this did not set up a formal QA/QC program. All of the samples were submitted to Certified Laboratories (ALS - Chemex in Hermosillo or American Assay in Reno, Nevada) which insert their own QA/QC samples/duplicates. Also the laboratories run duplicates and blanks from each batch fired. The sequence of events so far are the following:\nWe located a previously mined area with interesting values – Ocho Hermanos. Mexus began to submit characterization samples to the above noted assay laboratories, in order to determine the range of Au - Ag values present. Mexus then began an investigation into recovery options by using material taken from the areas with the better values.\nThe above work was completed before any systematic exploration was done because if no recovery method could be found relatively quickly, the project would move more slowly because of the lead time involved. Mexus began work on an Environmental Impact Statement for the likely operational area (a total of 4 hectares to begin). In order to complete the EIS, figures for estimated tonnages were submitted to cover the hoped for volume. To date, no suitable recovery method was found due primarily to the partial oxidation of the principally sulfide deposit.\nThe Environmental Permits run for 35 years so there is time for further investigation.\nThe main geologic feature of this project area is an apparent “manto” sulfide zone composed primarily of galena with some pyrite, arsenopyrite and possibly phyrrotite. Above this zone there is an oxide zone composed of iron and lead oxides. The sulfides themselves are partially oxidized. Reconnaissance and characterization samples taken indicated sporadically high gold and silver values. The deposit occurs in shallow water sediments (principally quartzites, with some limestone and shales) and can be best characterized as a skarn type deposit due to the presence of intrusive rocks within 1 kilometer.\nGiven the complex nature of the sulfide deposit and the partial oxidization of the material (indicated by the presence of yellow colored lead oxides), a satisfactory recovery method has not yet been found. Consequently, at this time, no further systematic work beyond the initial reconnaissance and characterization sampling has been completed. The entire project was essentially put on hold until a suitable recovery method is found, which is a continuing effort and at this time is being pursued by a member of the faculty at the University of Sonora in Hermosillo. The faculty member teaches metallurgy and assay practices at the University. After a suitable recovery method has been identified, the process will need to be confirmed by a certified metallurgical testing laboratory.\n23\nThe Environmental Permits detail all of the affected flora and fauna. The land is presently used for cattle grazing and the surface rights are owned by the community of Guadelupe de Ures. An agreement is in place with Mexus Gold Mining S.A. de C.V. for surface access and disturbance. The Environmental Permit concludes that no permanent damage or degradation of the present land use will result from the intended activity on the lands. At present, the Environmental Permits cover a total of 4 hectares - 3 hectares cover the initial site of the mineral as presently understood and 1 hectare is permitted for the erection of a suitable extraction plant.\nNo known contamination from past mining activities was found or is known to locals. The historic workings consisted of a few shallow adits and pits. In the course of obtaining the Environmental Permission the permit stipulated that properly lined ponds etc. must be used to prevent any potential surface or ground water contamination from any proposed activities.\nOnly separation is proposed to be conducted on site if found to be possible, while final metal recovery will be conducted at a properly licensed and certified metal refining facility. Current efforts to find suitable recovery methods are being conducted off site in a University laboratory. Up sizing the process, if found, will be completed by a licensed, certified metallurgical laboratory.\nFigures of the proposed permitted sites are attached. These were extracted from the environmental permit Application.\nFIGURE 4- MICROLOCALIZACION PROYECTO “URES MINING DISTRICT”\n24\nFIGURE 5 – LOCALIZACION DE AREAS DE EXTRACCION\nFIGURE 6 - PLANTA DE BENEFICIO\nAREA DE EXTRACCION\n370 Area Project\nThis zone is composed of a sedimentary sequence (limestone, quartzite, shale) intruded by dacite and diorite as well as rhyolite. The dacite exhibits argillic alterations as well as silicification (quartz veins). The entire area is well oxidized on the surface. This is an area of classic disseminated low grade gold and silver mineralization. Surface grab sample assays show 0.14 grams per ton to as high as 29.490 grams per ton gold. This area is an important area for potentially defining an open pit heap leach project.\nEl Scorpion Project Area\nThis area has several shear zones and veins which show copper and gold mineralization. Recent assays of an 84’ drill hole shows 1.750% per ton to .750% per ton of copper and 3.971 grams per ton to 0.072 grams per ton of gold. Another assay of rock sample from the area shows greater than 4.690% per ton copper. This land form distribution appears to be synonymous to the ideal porphyry deposit at Baja La Alumbrera, Argentina.\nLos Laureles\nLos Laureles is a vein type deposit mainly gold with some silver and copper. Recent assays from grab samples show gold values of 67.730 grams per ton gold, 38.4 grams per ton silver, 2,800 grams per ton copper.\n25\nAs of the date of this Report, we have opened up old workings at the Los Laureles claim and have discovered a gold carrying vein running north and south into the mountain to the south.\nThe San Felix Mine Project\nThe San Felix mining site contains seven (7) concessions over an area of approximately 26,000 acres located in the La Alameda area of Caborca, Sonora, Mexico. During the year ended March 31, 2018, the Company recorded an impairment of mineral property for the San Felix Project of $75,000 because the requirement payment of $500,000 due on August 13, 2017 was not paid in accordance with the purchase agreement pending the receipt of certain required instruments from the Grantor by the Company.\nEmployees\nWe have no employees at this time in the United States and Mexico. Consultants with specific skills are utilized to assist with various aspects of the requirements of activities such as project evaluation, property management, due diligence, acquisition initiatives, corporate governance and property management. If we complete our planned activation of the operations of the Mexican mining properties, our total workforce will be approximately 20 persons. Mr. Paul D. Thompson is our sole officer and director.\nCompetition\nWe compete with other mining companies in connection with the acquisition of gold properties. There is competition for the limited number of gold acquisition opportunities, some of which is with companies having substantially greater financial resources than Mexus Gold US. As a result, Mexus Gold US may have difficulty acquiring attractive gold projects at reasonable prices.\nManagement of Mexus Gold US believes that no single company has sufficient market power to affect the price or supply of gold in the world market.\nLegal Proceedings\nThere are no legal proceedings to which Mexus Gold US or Mexus Gold S.A. de C.V. is a party or of which any of our properties are the subject thereof.\nProperty Interests, Mining Claims and Risk\nProperty Interests and Mining Claims\nOur exploration activities and operations in Mexico are subject to the rules and regulations of the United Mexican States. The Ministry (Secretariat) of Mining is the Federal Mexican Government ministry charged with controlling all mining matters. A concession is granted on the acceptance of an application which identifies the specific minerals to be mined and description of the exact location of the lands to be mined. The concession is subject to a semiannual tax to continue the concession in good standing. Usually, our arrangements with a concessionaire describe specific period payments to the concessionaire and a royalty on the minerals recovered from mining operations. Where prospective mineral properties are identified by the Company, some type of conveyance of the mining rights and property acquisition agreement is necessary in order for us to explore or develop such property. Generally, these agreements take the form of long term mineral leases under which we acquire the right to explore and develop the property in exchange for periodic cash payments during the exploration and development phase and a royalty, usually expressed as a percentage of gross production or net profits derived from the leased properties if and when mines on the properties are brought into production. Other forms of acquisition agreements are exploration agreements coupled with options to purchase and joint venture agreements.\nReclamation\nWe may be required to mitigate long-term environmental impacts by stabilizing, contouring, re-sloping and re-vegetating various portions of a site after mining and mineral processing operations are completed. These reclamation efforts will be conducted in accordance with detailed plans, which must be reviewed and approved by the appropriate regulatory agencies.\nWhile the Company, as of March 31, 2019, does not have a legal obligation associated with the disposal of certain chemicals used in its leaching process, the Company estimates it will incur costs up to $50,000 to neutralize those chemicals at the close of the leaching pond.\n26\nRisk\nOur success depends on our ability to recover precious metals, process them, and successfully sell them for more than the cost of production. The success of this process depends on the market prices of metals in relation to our costs of production. We may not always be able to generate a profit on the sale of gold or other minerals because we can only maintain a level of control over our costs and have no ability to control the market prices. The total cash costs of production at any location are frequently subject to great variation from year to year as a result of a number of factors, such as the changing composition of ore grade or mineralized material production, and metallurgy and exploration activities in response to the physical shape and location of the ore body or deposit. In addition costs are affected by the price of commodities, such as fuel and electricity. Such commodities are at times subject to volatile price movements, including increases that could make production at certain operations less profitable. A material increase in production costs or a decrease in the price of gold or other minerals could adversely affect our ability to earn a profit on the sale of gold or other minerals. Our success depends on our ability to produce sufficient quantities of precious metals to recover our investment and operating costs.\nDistribution Methods of the Products\nThe end product of our operations will usually be doré bars. Doré is an alloy consisting of gold, silver and other precious metals. Doré is sent to refiners to produce bullion that meets the required market standard of 99.95% pure gold. Under the terms of refining agreements we expect to execute, the doré bars are refined for a fee and our share of the refined gold, silver and other metals are credited to our account or delivered to our buyers who will then use the refined metals for fabrication or held for investment purposes.\nGeneral Market\nThe general market for gold has two principal categories, being fabrication and investment. Fabricated gold has a variety of end uses, including jewelry, electronics, dentistry, industrial and decorative uses, medals, medallions and official coins. Gold investors buy gold bullion, official coins and jewelry. The supply of gold consists of a combination of current production from mining and the draw-down of existing stocks of gold held by governments, financial institutions, industrial organizations and private individuals.\nPatents, trademarks, licenses, franchises, concessions, royalty agreements, or labor contracts, including duration;\nWe do not have any designs or equipment which is copyrighted, trademarked or patented.\nEffect of existing or probable governmental regulations on the business\nGovernment Regulation\nMining operations and exploration activities in Mexico are subject to the Ministry of Mining federal laws and regulations which govern prospecting, development, mining, production, exports, taxes, labor standards, occupational health, waste disposal, protection of the environment, mine safety, hazardous substances and other matters. We have obtained or have pending applications for those licenses, permits or other authorizations currently required to conduct our exploration and other programs. We believe that Mexus Gold US is in compliance in all material respects with applicable mining, health, safety and environmental statutes and the regulations passed thereunder any jurisdiction in which we will operate. We are not aware of any current orders or directions relating to Mexus Gold US with respect to the foregoing laws and regulations.\nEnvironmental Regulation\nOur gold projects are subject to various Mexican federal laws and regulations governing protection of the environment. These laws are continually changing and, in general, are becoming more restrictive. It is our policy to conduct business in a way that safeguards public health and the environment. We believe that the actions and operations of Mexus Gold US will be conducted in material compliance with applicable laws and regulations. Changes to current Mexican federal laws and regulations where we operate currently, or in jurisdictions where we may operate in the future, could require additional capital expenditures and increased operating and/or reclamation costs. Although we are unable to predict what additional legislation, if any, might be proposed or enacted, additional regulatory requirements could impact the economics of our projects.\nResearch and Development\nWe do not foresee any immediate future research and development costs.\n27\nCosts and effects of compliance with environmental laws\nOur gold projects are subject to various federal and state laws and regulations governing protection of the environment. These laws are continually changing and, in general, are becoming more restrictive. It is our policy to conduct business in a way that safeguards public health and the environment. We believe that our operations are and will be conducted in material compliance with applicable laws and regulations. The economics of our current projects consider the costs and expenses associated with our compliance policy.\nChanges to current state or federal laws and regulations in Mexico, where we operate currently, or in jurisdictions where we may operate in the future, could require additional capital expenditures and increased operating and/or reclamation costs. Although we are unable to predict what additional legislation, if any, might be proposed or enacted, additional regulatory requirements could impact the economics of our projects.\nResults of Operations\nThe following management’s discussion and analysis of operating results and financial condition of Mexus Gold US is for the three and six months ended September 30, 2019 and 2018. All amounts herein are in U.S. dollars.\nThree Months Ended September 30, 2019 Compared with the Three Months Ended September 30, 2018\nWe had a net loss during the three months ended September 30, 2019 of $714,065 compared to a net loss of $575,889 during the same period in 2018. The increase in net loss is primarily attributable (i) an increase in exploration costs of $72,750 (ii) an increase in general and administrative services of $128,994 (iii) an increase in interest expense of $79,312 and (iv) an increase in loss on settlement of debt of $54,141. The increase in the net loss is partially offset by a gain on the change in the fair value of derivatives of $178,290.\nRevenue\nFor the three months ended September 30, 2019, we had revenues of $0 compared to $0 for the three months ended September 30, 2018.\nOperating Expenses\nTotal operating expenses increased to $587,785 for three months ended September 30, 2019, compared to $413,322 for the three months ended September 30, 2018. The increase in operating expenses was primarily due to increases in stock-based expense – consulting services and general and administration expense.\nOther Income (Expense)\nWe reported $126,280 of other expense during the three months ended September 30, 2019 compared to $162,567 of other income during the same period in 2018.\nChanges in other income (expense) is mainly attributable to an increase in gain on change in fair value of derivative liabilities which as partially offset by an increase in loss on settlement of debt and interest expense. The increase in interest expense is primarily due to the issuance of the convertible promissory notes to Power Up Lending Group Ltd. and JSJ Investments Inc.\nSix months Ended September 30, 2019 Compared with the Six months Ended September 30, 2018\nWe had a net loss during the six months ended September 30, 2019 of $1,553,263 compared to a net loss of $960,766 during the same period in 2018. The increase in net loss is primarily attributable (i) an increase in exploration costs of $44,608 (ii) an increase in general and administrative services of $152,908 (iii) an increase in stock-based expense – consulting services of $141,459 (iv) an increase in interest expense of $127,476 and (v) an increase in loss on settlement of debt of $230,843. The increase in the net loss is partially offset by a gain on the change in the fair value of derivatives of $136,858.\nRevenue\nFor the six months ended September 30, 2019, we had revenues of $0 compared to $0 for the six months ended September 30, 2018.\nOperating Expenses\nTotal operating expenses increased to $1,253,135 for six months ended September 30, 2019, compared to $897,760 for the six months ended September 30, 2018. The increase in operating expenses was primarily due to increases in stock-based expense – consulting services and general and administration expense.\n28\nOther Income (Expense)\nWe reported $300,128 of other expense during the six months ended September 30, 2019 compared to $63,006 of other income during the same period in 2018.\nChanges in other income (expense) is mainly attributable to an increase in interest expense and loss on settlement of debt which as partially offset by a gain on changes in fair value of derivative liabilities. The increase in interest expense is primarily due to the issuance of the convertible promissory notes to Power Up Lending Group Ltd. and JSJ Investments Inc.\nLiquidity and Capital Resources\nAt September 30, 2019, we had cash of $49,650 compared to cash of $12,029 at March 31, 2019.\nOur property and equipment decreased to $337,348 at September 30, 2019, compared to $383,524 at March 31, 2019. The decrease in equipment is largely due to depreciation expense of $113,479 during the six months ended September 30, 2019 and partially offset by $50,285 for the purchase of equipment and $17,018 transfer of equipment under construction to property and equipment.\nOur equipment under construction to $0 at September 30, 2019, compared to $17,018 at March 31, 2019.\nOur mineral properties increased to $829,947 at September 30, 2019, compared to $829,947 at March 31, 2019.\nTotal assets decrease to $1,216,945 at September 30, 2019, compared to $1,248,018 at March 31, 2019. The majority of the decrease in assets relates to a $113,479 of depreciation expense.\nOur total liabilities increased to $2,074,871 at September 30, 2019, compared to $1,665,007 as of March 31, 2019. The increase in our total liabilities can be primarily attributed to the issuance of notes payable and convertible promissory notes to Power Up Lending Group Ltd. and JSJ Investments Inc. along with the related convertible promissory note derivative liability.\nOur working capital deficit at September 30, 2019 and March 31, 2019 is $2,025,221 and $1,647,478, respectively.\nOur net cash used in operating activities for the six months ended September 30, 2019 and 2018 is $697,880 and $494,070, respectively. Our net loss for the six months ended September 30, 2019 of $1,553,263 was the main contributing factor for our negative cash flow offset mainly by depreciation and amortization of $113,479, stock-based compensation – services of $375,415 and non-cash interest expense of $426,902.\nOur net cash (used in) provided by investing activities for the six months ended September 30, 2019 and 2018 is $(44,125) and $1,919, respectively, mainly due to the purchase of equipment.\nOur net cash provided by financing activities for the six months ended September 30, 2019 and 2018 is $779,626 and $367,312, respectively, mainly due to issuance of notes payable, convertible promissory notes and common stock.\nThe Company is dependent upon outside financing to continue operations. It is management’s plans to raise necessary funds through a private placement of its common stock to satisfy the capital requirements of the Company’s business plan. There is no assurance that the Company will be able to raise the necessary funds, or that if it is successful in raising the necessary funds, that the Company will successfully execute its business plan.\nFuture goals\nThe Santa Elena Prospect (formerly known as Caborca Properties) has become our primary focus. The completion of the initial surface ground construction for a leaching production plant, being an expandable ore leaching pad, solution ponds and production recovery facility, has been tested and will be placed into production. The ore leaching pad has 35,000 tons of ore in place and will be increased in size on a continuing basis to realize the capacity of the production facility.\nTherefore, our goal for the current year is to increase the cash flow of the Company’s operations through (a) place the current facilities into full commercial production, (b) increase the mineralization of the ore pad from 1 gram per ton gold and 3 grams per ton silver and (c) increase the capacity of the leach pad.\nThe Company has now scheduled the installation of a crushing/milling recovery plant for the high grade Julio quartz deposit as a result of the values of the assay analysis from the deposit which range from .250 to 5.5 ounces of gold per ton.\n29\nTherefore, our goal for the current year is to increase the cash flow of the placer mining operation, continue the drilling program which began during 2011, initialize mining operations on the Julio quartz deposit while we conduct a thorough geological study by an independent geological firm of the future potential of other vein deposits located near the Julio deposit.\nForeign Currency Transactions\nThe majority of our operations are located in United States and most of our transactions are in the local currency. We plan to continue exploration activities in Mexico and therefore we will be exposed to exchange rate fluctuations. We do not trade in hedging instruments and a significant change in the foreign exchange rate between the United States Dollar and Mexican Peso could have a material adverse effect on our business, financial condition and results of operations.\nOff-balance Sheet Arrangements\nThe Company does not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.\n\nITEM 3.\nQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide this information.\nITEM 4(T). CONTROLS AND PROCEDURES\nWe conducted an evaluation, under the supervision and with the participation of management, including our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this quarterly report.\nBased on this evaluation, our chief executive officer and chief financial officer concluded that as of the evaluation date our disclosure controls and procedures were not effective. Our procedures were not designed to ensure that the information relating to our company required to be disclosed in our SEC reports is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms, and is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow for timely decisions regarding required disclosure. Management is currently evaluating the current disclosure controls and procedures in place to see where improvements can be made.\nITEM 5. OTHER INFORMATION\nManagement’s Report on Internal Control over Financial Reporting\nOur management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Our internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures are being made only in accordance with authorizations of management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of our assets that could have a material effect on the financial statements.\nUnder the supervision and with the participation of management, including our chief executive officer and chief financial officer, we conducted an evaluation of the effectiveness of our internal controls over financial reporting based on the framework in “Internal Control Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based upon this evaluation, management has concluded that our internal control over financial reporting was not effective as of September 30, 2019, to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms. Management identified the following material weaknesses in our internal control over financial reporting, which are indicative of many small companies with small staff: (i) we do not have an audit committee of the Board of Directors or a financial expert serving on the Board of Directors (ii) inadequate segregation of duties and effective risk assessment; and (iii) insufficient written policies and procedures for accounting and financial reporting with respect to the requirements and application of both US GAAP and SEC guidelines (iv) deficient design of our management information systems and information technology because the potential for unauthorized access to certain information systems and software applications existed during 2018 in several departments, including corporate accounting. Certain key controls for maintaining the overall integrity of systems and data processing were not properly designed and operating effectively.\n30\nTo remediate such weaknesses, we hope to implement the following changes during our fiscal year ending September 30, 2019: (i) appoint a financial expert and independent Directors to serve on the Board of Directors (ii) appoint additional qualified personnel to address inadequate segregation of duties, ineffective risk management and deficient design of our management information systems and information technology; and (iii) adopt sufficient written policies and procedures for accounting and financial reporting. The remediation efforts set out in (i), (ii) and (iii) are largely dependent upon our securing additional financing to cover the costs of implementing the changes required. If we are unsuccessful in securing such funds, remediation efforts may be adversely affected in a material manner.\nOur management, including our chief executive officer and chief financial officer, does not expect that our disclosure controls or our internal control over financial reporting, or any system we design or implement in the future, will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.\nChanges in Internal Control\nThere have not been any changes in our internal control over financial reporting during the three month period ended September 30, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n31\nPART II – OTHER INFORMATION\n\nITEM 1.\nLEGAL PROCEEDINGS\nWe are not subject to any legal proceedings responsive to this Item Number.\n\nITEM 2.\nUNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nOn July 2, 2019, the Company issued 5,000,000 shares of common stock to satisfy obligations under share subscription agreements of $10,000 for cash receipts.\nOn July 9, 2019, the Company issued 17,314,000 shares of common stock to satisfy obligations under share subscription agreements of $57,200 for settlement of services and $20,785 for cash receipts included in share subscriptions payable.\nOn July 10, 2019, the Company issued 61,108,334 shares of common stock to satisfy obligations under share subscription agreements of $90,000 for settlement of services and $90,110 for cash receipts included in share subscriptions payable.\nOn July 22, 2019, the Company issued 22,083,332 shares of common stock to satisfy obligations under share subscription agreements for $25,500 for cash receipts included in share subscriptions payable.\nOn July 29, 2019, the Company cancelled 1,000,000 shares of common stock originally issued to satisfy obligations under share subscription agreements of $5,000 for cash receipts.\nOn August 9, 2019, the Company issued 32,933,332 shares of common stock to satisfy obligations under share subscription agreements of $63,300 for settlement of services, $29,900 for cash receipts and $38,500 for interest included in share subscriptions payable.\nOn August 13, 2019, the Company issued 10,000,000 shares of common stock to satisfy obligations under share subscription agreements of $103,000 for settlement of services included in share subscriptions payable.\nOn August 20, 2019, the Company issued 39,583,332 shares of common stock to satisfy obligations under share subscription agreements of $56,700 for settlement of cash receipts included in share subscriptions payable.\nOn September 17, 2019, the Company issued 43,166,666 shares of common stock to satisfy obligations under share subscription agreements $62,400 for cash receipts and $10,000 for settlement of notes payable included in share subscriptions payable.\nThe issuance of securities described above were deemed to be exempt from registration under the Securities Act in reliance on Section 4(2) of the Securities Act of 1933 and Regulation D as transactions by an issuer not involving any public offering. The recipients of securities in each such transaction represented their intention to acquire the securities for investment only and not with a view to or for sale in connection with any distribution thereof, and appropriate legends were affixed to the share certificates and other instruments issued in such transactions. The sales of these securities were made without general solicitation or advertising.\nThe Company intends to use the proceeds from sale of the securities for the purchase of equipment for mining operations, mining machinery, supplies and payroll for operations, professional fees, and working capital.\nThere were no underwritten offerings employed in connection with any of the transactions set forth above.\n\nITEM 3.\nDEFAULT UPON SENIOR SECURITIES\nAt September 30, 2019 and March 31, 2019, the carrying value of the notes totaled $759,866 (net of unamortized debt discount of $125,206 and $693,600 (net of unamortized debt discount of $94,127), respectively. At September 30, 2019, $456,682 of these notes were in default. There are no default provisions stated in these notes. At September 30, 2019 -and March 31, 2019, accrued interest of $54,750 and $31,332, respectively, is included in accounts payable and accrued liabilities.\nAt September 30, 2019 and March 31, 2019, outstanding Promissory Notes were $65,000 and $65,000, respectively. The Note bear interest of 4% per annum and are due on December 31, 2013. The Note is secured by all of Mexus Gold US shares of stock in Mexus Resources S.A. de C.V. and a personal guarantee of Paul D. Thompson. As of September 30, 2019, the Company has not made the scheduled payments and is in default on this promissory note. The default rate on the notes is seven percent. At September 30, 2019 and March 31, 2019, accrued interest of $34,520 and $31,117, respectively, is included in accounts payable and accrued liabilities.\n32\n\nITEM 4.\nMINE SAFETY DISCLOSURES\nNot applicable.\n\nITEM 5.\nOTHER INFORMATION\nNone.\n\nITEM 6. EXHIBITS\n\n| Statements |\n| Condensed Consolidated Balance Sheets at September 30, 2019 (unaudited) and March 31, 2019 |\n| Condensed Consolidated Statements of Operations for the three and six months ended September 30, 2019 and 2018 (unaudited) |\n| Condensed Consolidated Statements of Stockholders’ Equity for the three and six months ended September 30, 2019 and 2018 (unaudited) |\n| Condensed Consolidated Statements of Cash Flows for the six months ended September 30, 2019 and 2018 (unaudited) |\n| Notes to Condensed Consolidated Financial Statements (unaudited) |\n| Schedules |\n| All schedules are omitted because they are not applicable or the required information is shown in the Financial Statements or notes thereto. |\n\n\n| Exhibit | Form | Filing | Filed with |\n| Exhibits | # | Type | Date | This Report |\n| Articles of Incorporation filed with the Secretary of State of Colorado on June 22, 1990 | 3.1 | 10-SB | 1/24/2007 |\n| Articles of Amendment to the Articles of Incorporation filed with the Secretary of State of Colorado on October 17, 2006 | 3.2 | 10-SB | 1/24/2007 |\n| Articles of Amendment to Articles of Incorporation filed with the Secretary of State of the State of Colorado on January 25, 2007 | 3.3 | 10KSB | 6/29/2007 |\n| Articles of Incorporation filed with the Secretary of State of Nevada on October 1, 2009 | 3.4 | 10-K | 7/27/2016 |\n| Certificate of Amendment filed with the Secretary of State of Nevada on March 9, 2016 | 3.5 | 10-K | 7/27/2016 |\n| Certificate of Designation filed with the Secretary of State of Nevada on August 8, 2011 | 3.6 | 10-K | 7/27/2016 |\n| Amended and Restated Bylaws dated December 30, 2005 | 3.7 | 10-SB | 1/24/2007 |\n| Code of Ethics | 14.1 | 10-KSB | 6/29/2007 |\n| Certification of Paul D. Thompson, pursuant to Rule 13a-14(a) | 31.1 | X |\n| Certification of Paul D. Thompson pursuant to 18 U.S.C Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | 32.1 | X |\n| Caborca Preliminary Report and First Stage Mapping | 99.1 | X |\n| XBRL Instance Document | 101.INS | X |\n| XBRL Taxonomy Extension Schema Document | 101.SCH | X |\n| XBRL Taxonomy Extension Calculation Linkbase Document | 101.CAL | X |\n| XBRL Taxonomy Extension Definition Linkbase Document | 101.DEF | X |\n| XBRL Taxonomy Extension Label Linkbase Document | 101.LAB | X |\n| XBRL Taxonomy Extension Presentation Linkbase Document | 101.PRE | X |\n\n33\nSignatures\nIn accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| November 19, 2019 |\n| /s/ Paul D. Thompson |\n| Paul D. Thompson |\n| Chief Executive Officer Chief Financial Officer Principal Accounting Officer Director |\n\n34\n</text>\n\nCan you calculate the total interest expense for the first six months of the fiscal year for Mexus Gold US and Subsidiaries from the promissory note with a principal of $6,000 issued on August 9, 2019, the outstanding Promissory Notes from September 30, 2019 and March 31, 2019, the Convertible Promissory Note issued to Power Up Lending Group Ltd., and the Convertible Promissory Note issued to JSJ Investments Inc.?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial Statements\n| Goldrich Mining Company |\n| (An Exploration Stage Company) |\n| Consolidated Balance Sheets | (Unaudited) |\n| March 31, | December 31, |\n| 2012 | 2011 |\n| ASSETS |\n| Current assets: |\n| Cash and cash equivalents | $ 213,259 | $ 585,694 |\n| Prepaid expenses | 101,431 | 83,489 |\n| Other current assets | 79,288 | 78,692 |\n| Total current assets | 393,978 | 747,875 |\n| Property, plant, equipment, and mining claims: |\n| Equipment, net of accumulated depreciation | 1,910,929 | 1,978,730 |\n| Mining properties and claims | 611,272 | 611,272 |\n| Total property, plant, equipment and mining claims | 2,522,201 | 2,590,002 |\n| Total assets | $ 2,916,179 | $ 3,337,877 |\n| LIABILITIES AND STOCKHOLDERS EQUITY |\n| Current liabilities: |\n| Accounts payable and accrued liabilities | $ 326,630 | $ 250,944 |\n| Related party payable | 29,130 | 30,405 |\n| Dividend payable on preferred stock | 22,083 | 22,083 |\n| Current portion of equipment notes payable | 242,261 | 237,873 |\n| Total current liabilities | 620,104 | 541,305 |\n| Long-term liabilities: |\n| Equipment notes payable | 131,351 | 193,565 |\n| Remediation liability and asset retirement obligation | 316,925 | 314,282 |\n| Total long-term liabilities | 448,276 | 507,847 |\n| Total liabilities | 1,068,380 | 1,049,152 |\n| Commitments and contingencies (Note 7) |\n| Stockholders' equity: |\n| Preferred stock; no par value, 9,000,000 |\n| shares authorized; no shares issued or outstanding | - | - |\n| Convertible preferred stock series A; 5% cumulative dividends, |\n| no par value, 1,000,000 shares authorized; 175,000 and 175,000 shares issued and outstanding, respectively, $350,000 and $350,000 liquidation preferences, respectively | 175,000 | 175,000 |\n| Common stock; $.10 par value, 200,000,000 shares authorized; 93,141,855 and 93,141,855 issued and outstanding, respectively | 9,314,185 | 9,314,185 |\n| Additional paid-in capital | 14,528,320 | 14,519,949 |\n| Deficit accumulated during the exploration stage | (22,169,706) | (21,720,409) |\n| Total stockholders equity | 1,847,799 | 2,288,725 |\n| Total liabilities and stockholders' equity | $ 2,916,179 | $ 3,337,877 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n3\n\n| Goldrich Mining Company |\n| (An Exploration Stage Company) |\n| Consolidated Statements of Operations (Unaudited) |\n| From Inception |\n| (March 26, 1959) |\n| Three Months Ended | Through |\n| March 31, | March 31, |\n| 2012 | 2011 | 2012 |\n| Income earned during the exploration stage: |\n| Gold sales and other | $ - | $ - | $ 2,542,079 |\n| Costs of gold sales | - | - | (1,858,843) |\n| Gross profit on gold sales | - | - | 683,236 |\n| Operating expenses: |\n| Mine preparation costs | - | - | 1,034,573 |\n| Exploration expense | 157,743 | 135,902 | 8,449,548 |\n| Depreciation, mining and exploration | 100,039 | 137,666 | 1,610,330 |\n| Management fees and salaries | 62,825 | 48,655 | 3,289,463 |\n| Professional services | 43,887 | 54,790 | 1,958,364 |\n| Other general and admin expense | 62,381 | 113,600 | 2,231,384 |\n| Office supplies and other expense | 1,990 | 6,301 | 390,251 |\n| Directors' fees | 6,400 | 15,200 | 776,675 |\n| Mineral property maintenance | 11,894 | 8,411 | 189,863 |\n| Reclamation and miscellaneous | 31 | 813 | 129,021 |\n| Loss on partnership venture | - | - | 53,402 |\n| Equipment repairs | - | - | 25,170 |\n| Loss (gain) on disposal of mining properties and equipment | - | (1,991) | 195,290 |\n| Total operating expenses | 447,190 | 519,347 | 20,333,334 |\n| Other (income) expense: |\n| Gain on legal judgment | - | - | (127,387) |\n| Royalties, net | - | - | (398,752) |\n| Lease and rental income | - | - | (99,330) |\n| Interest income | (31) | (133) | (286,605) |\n| Interest expense and finance costs | 2,744 | 49,259 | 1,411,525 |\n| Loss on settlement of debt | - | 1,623,489 | 1,946,684 |\n| Loss (gain) on foreign currency translation | (605) | (4,510) | 73,473 |\n| Total other (income) expense | 2,108 | 1,668,105 | 2,519,608 |\n| Net loss | $ 449,297 | $ 2,187,452 | $ 22,169,706 |\n| Preferred dividends | 4,448 | 10,458 |\n| Net loss available to common stockholders | $ 453,745 | $ 2,197,910 |\n| Net loss per common share basic and diluted | $ Nil | $ 0.04 |\n| Weighted average common |\n| shares outstanding-basic and diluted | 93,141,855 | 61,866,415 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n4\n| Goldrich Mining Company |\n| (An Exploration Stage Company) |\n| Consolidated Statements of Cash Flows (Unaudited) |\n| From Inception |\n| (March 26, 1959) |\n| Three Months Ended | Through |\n| March 31, | March 31, |\n| 2012 | 2011 | 2012 |\n| Cash flows from operating activities: |\n| Net loss | $ (449,297) | $ (2,187,452) | $ (22,169,706) |\n| Adjustments to reconcile net loss to net cash |\n| used in operating activities: |\n| Depreciation and amortization | 100,039 | 143,383 | 1,613,999 |\n| Loss on disposal of mining property | - | - | 196,276 |\n| Loss (gain) on sale of equipment | - | (1,991) | 2,397 |\n| Stock based compensation | 8,371 | 11,712 | 1,699,205 |\n| Compensation paid with equipment | - | 1,803 | 1,803 |\n| Common stock issued for interest | - | - | 196,110 |\n| Amortization of discount on notes payable in gold and |\n| associated warrants | - | 26,355 | 780,519 |\n| Amortization of discount on convertible |\n| debenture for beneficial conversion feature | - | - | 150,000 |\n| Amortization of deferred financing costs | - | - | 130,000 |\n| Gold delivered to satisfy notes payable | - | - | (273,974) |\n| Gold delivered in exchange for equipment | - | - | (10,966) |\n| Loss on settlement of debt | - | 1,623,489 | 1,946,684 |\n| Accretion of asset retirement obligation | 2,643 | - | 12,807 |\n| Change in: |\n| Prepaid expenses | (17,942) | 16,400 | (101,432) |\n| Other current assets | (596) | 11,983 | (79,288) |\n| Accounts payable and accrued liabilities | 75,686 | 126,646 | 336,631 |\n| Related party payable | (1,275) | 5,919 | 58,468 |\n| Deferred compensation | - | - | - |\n| Accrued commission payable | - | - | 277,523 |\n| Convertible success award, Walters LITS | - | - | 88,750 |\n| Accrued remediation costs | - | - | 55,000 |\n| Net cash used - operating activities | (282,371) | (221,753) | (15,089,194) |\n| Cash flows from investing activities: |\n| Receipts attributable to unrecovered |\n| promotional, exploratory, and development costs | - | - | 626,942 |\n| Proceeds from the sale of equipment | - | - | 64,624 |\n| Purchases of equipment, and unrecovered |\n| promotional and exploratory costs | (32,238) | (4,110) | (2,327,733) |\n| Additions to mining properties and claims - direct |\n| costs for claim staking and acquisition | - | - | (536,366) |\n| Net cash used - investing activities | (32,238) | (4,110) | (2,172,533) |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n5\n\n| Goldrich Mining Company |\n| (An Exploration Stage Company) |\n| Consolidated Statements of Cash Flows (Unaudited) Continued: |\n| From Inception |\n| (March 26, 1959) |\n| Three Months Ended | Through |\n| March 31, | March 31, |\n| 2012 | 2011 | 2012 |\n| Cash flows from financing activities: |\n| Proceeds from related party debt | $ - | $ - | $ 100,000 |\n| Payments on related party debt | - | - | (100,000) |\n| Proceeds from issuing convertible debenture, net | - | - | 900,000 |\n| Proceeds from issuance of common stock in connection |\n| with exercise of options and warrants | - | 255,666 | 3,101,498 |\n| Proceeds from issuance of common stock and warrants, |\n| net of offering costs | - | - | 12,638,584 |\n| Proceeds from notes payable in gold | - | - | 1,785,037 |\n| Payments on notes payable in gold | - | - | (190,941) |\n| Purchases of gold to satisfy notes payable in gold | - | - | (358,641) |\n| Proceeds from issuance of preferred stock | - | - | 475,000 |\n| Payments on capital leases and equipment notes payable | (57,826) | (53,709) | (867,377) |\n| Acquisitions of treasury stock | - | - | (8,174) |\n| Net cash provided - financing activities | (57,826) | 201,957 | 17,474,986 |\n| Net increase (decrease) in cash and cash equivalents | (372,435) | (23,906) | 213,259 |\n| Cash and cash equivalents, beginning of period | 585,694 | 342,871 | - |\n| Cash and cash equivalents, end of period | $ 213,259 | $ 318,965 | $ 213,259 |\n| Supplemental disclosures of cash flow information: |\n| Cash paid for interest | $ 7,712 | $ 11,806 | $ 143,887 |\n| Non-cash investing and financing activities: |\n| Mining claims purchased - common stock | $ - | $ - | $ 43,000 |\n| Additions to property, plant and equipment |\n| acquired through capital lease and notes payable | $ - | $ - | $ 1,240,988 |\n| Additions to property, plant and equipment paid in gold | $ - | $ - | $ 10,966 |\n| Accounts payable satisfied with equipment | $ - | $ 10,000 | $ 10,000 |\n| Related party liability converted to common stock | $ - | $ - | $ 301,086 |\n| Issuance of warrants for deferred financing |\n| costs of convertible debenture | $ - | $ - | $ 30,000 |\n| Issuance of common stock upon conversion of |\n| convertible debenture | $ - | $ - | $ 1,000,000 |\n| Issuance of common stock upon conversion of |\n| preferred shares | $ - | $ 250,000 | $ 300,000 |\n| Issuance of common stock upon conversion of |\n| notes payable in gold | $ - | $ 3,032,513 | $ 3,458,794 |\n| Warrants issued with notes payable in gold | $ - | $ - | $ 109,228 |\n| Notes payable satisfied with gold | $ - | $ - | $ 632,615 |\n| Capital lease satisfied with equipment notes payable | $ - | $ - | $ 335,190 |\n| Dividend payable on preferred stock | $ - | $ 22,083 | $ 22,083 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n6\nGoldrich Mining Company\n(An Exploration Stage Company)\nNotes to the Consolidated Financial Statements (unaudited)\n1.\nBASIS OF PRESENTATION:\nThe unaudited financial statements have been prepared by the Company in accordance with accounting principles generally accepted in the United States of America for interim financial information, as well as the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of the Company’s management, all adjustments (consisting of only normal recurring accruals) considered necessary for a fair presentation of the interim financial statements have been included. Operating results for the three-month period ended March 31, 2012 are not necessarily indicative of the results that may be expected for the full year ending December 31, 2012.\nFor further information refer to the financial statements and footnotes thereto in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.\nNet Loss Per Share\nBasic EPS is computed as net income available to common shareholders after dividends to preferred shareholders, divided by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur from common shares issuable through stock options, warrants, and other convertible debt and securities. The dilutive effect of vested convertible and exercisable securities would be:\n| March 31, | March 31, |\n| For periods ended | 2012 | 2011 |\n| Convertible preferred stock | 1,050,000 | 1,050,000 |\n| Stock options | 3,570,000 | 3,065,000 |\n| Warrants | 33,542,130 | 5,851,803 |\n| Total possible dilution | 38,162,130 | 9,966,803 |\n\nFor the three-month periods ended March 31, 2012 and March 31, 2011, the effect of the Company’s outstanding options and common stock equivalents would have been anti-dilutive.\nReclassifications\nCertain reclassifications have been made to conform prior periods’ presentation to the current presentation. These reclassifications have no effect on the results of operations or stockholders’ equity.\nUse of Estimates\nThe preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect certain reported amounts and disclosures. Significant estimates used in preparing these financial statements include those assumed in estimating the recoverability of the cost of mining claims, accrued remediation costs, fair value of warrants, and deferred tax assets and related valuation allowances. Actual results could differ from those estimates.\nFair Value Measures\nOur financial instruments consist principally of cash and equipment notes payable. These instruments do not require recurring re-measurement at fair value.\n7\nGoldrich Mining Company\n(An Exploration Stage Company)\nNotes to the Consolidated Financial Statements (unaudited)\n2.\nGOING CONCERN\nThe accompanying consolidated financial statements have been prepared under the assumption that the Company will continue as a going concern. The Company is an exploration stage company and has incurred losses since its inception and does not have sufficient cash at March 31, 2012 to fund normal operations and meet debt obligations for the next 12 months.\nThe Company currently has no historical recurring source of revenue and its ability to continue as a going concern is dependent on the Company’s ability to raise capital to fund its future exploration and working capital requirements or its ability to profitably execute a mining plan. The Company’s plans for the long-term return to and continuation as a going concern include financing the Company’s future operations through sales of its common stock and/or debt and the eventual profitable exploitation of its mining properties. Additionally, the current capital markets and general economic conditions in the United States are significant obstacles to raising the required funds. These factors raise substantial doubt about the Company’s ability to continue as a going concern.\nAs described in Note 8 Subsequent Events, the Company has entered into a joint venture agreement which will provide approximately $8.5 million of financing in the form of loans, funded expenses, capital equipment purchases and common stock purchases to fund mining activities on the Company’s alluvial deposits. Of this amount, $350,000 of common stock purchases has been completed prior to the filing of this report. The completion of this funding and a successful mining operation may provide the long-term financial strength for the Company to exit the going concern condition in future years.\nThe consolidated financial statements do not include any adjustments that might be necessary should the Company be unable to continue as a going concern. If the going concern basis was not appropriate for these financial statements, adjustments would be necessary in the carrying value of assets and liabilities, the reported expenses and the balance sheet classifications used.\n3.\nRELATED PARTY TRANSACTIONS\nA total of $11,338 interest is payable at March 31, 2012 to the Company’s former Chief Operating Officer in connection with the settlement of notes payable in gold settled in 2011 and $10,029 is payable to this officer in connection with consulting work that he provided during the three months ended March 31, 2012. These amounts are included in related party payable.\nAn amount of $11,628 had been accrued for fees due to the Company’s Chief Financial Officer at December 31, 2011. This total was paid in cash during 2012, and at March 31, 2012, $7,763 had been accrued for services performed during the three months ended March 31, 2012. This amount is included in related party payable.\nA total of $28,900 had been accrued for directors fees at December 31, 2011. For the three months ended March 31, 2012, an additional $6,400 has been accrued for services performed during the period, for a total of $35,300 which is included in accounts payable.\n4.\nNOTES PAYABLE IN GOLD\nDuring the year ended December 31, 2011, the Company settled all notes payable in gold as described below. After settlement, the Company had no further obligations under the notes payable in gold except $22,555 of accrued interest due under notes satisfied by delivery of gold. The total loss recognized for settlement for the year ended December 31, 2011 was $1,946,684, of which $1,623,489 was recognized in the quarter ended March 31, 2011.\n8\nGoldrich Mining Company\n(An Exploration Stage Company)\nNotes to the Consolidated Financial Statements (unaudited)\n5.\nEQUIPMENT NOTES PAYABLE\nThe principal amounts of the equipment notes due over coming years are as follows:\n| Year | Principal Due March 31, |\n| 2013 | $ 242,261 |\n| 2014 | 131,351 |\n| 2015 and thereafter | - |\n| Total | $ 373,612 |\n\n6.\nSTOCKHOLDERS’ EQUITY\nThe Company issued no securities during the three months ended March 31, 2012.\nThe following is a summary of warrants for March 31, 2012:\n| Shares | Exercise Price ($) | Expiration Date |\n| Class E Warrants: (Issued for Notes payable in gold) |\n| Outstanding and exercisable at January 1, 2011 | 457,518 | 0.65 | Feb to June 2013 (5) |\n| Warrants exercised February 18, 2011 | (35,000) | 0.20 |\n| Warrants expired in 2011 | (122,500) |\n| Outstanding and exercisable at December 31, 2011 | 300,018 |\n| Outstanding and exercisable at March 31, 2012 | 300,018 |\n| Class F Warrants: (Issued for Private Placement) |\n| Outstanding and exercisable at January 1, 2011 | 2,052,995 | 0.55 | March to August 2013 (5) |\n| Warrants exercised February 18, 2011 | (1,393,332) | 0.20 |\n| Outstanding and exercisable at December 31, 2011 | 659,663 |\n| Outstanding and exercisable at March 31, 2012 | 659,663 |\n\n| Class F-2 Warrants: (Issued for Commissions) |\n| Outstanding and exercisable at January 1, 2011 | 599,772 | 0.20 | December 3, 2013 (5) |\n| Outstanding and exercisable at December 31, 2011 | 599,772 |\n| Outstanding and exercisable at March 31, 2012 | 599,772 |\n| Class G Warrants: (for Private Placement) |\n| Outstanding and exercisable at January 1, 2011 | 4,169,850 | 0.36 | December 3 to 16, 2013 (5) |\n| Outstanding and exercisable at December 31, 2011 | 4,169,850 |\n| Outstanding and exercisable at March 31, 2012 | 4,169,850 |\n| Class H Warrants: (Issued for Private Placement) |\n| Warrants issued May 31, 2011 (1) | 5,125,936 | 0.30 | May 31, 2016 |\n| Outstanding and exercisable at December 31, 2011 | 5,125,936 |\n| Outstanding and exercisable at March 31, 2012 | 5,125,936 |\n| Class I Warrants: (Issued for Private Placement) |\n| Warrants issued May 31, 2011 (2) | 5,125,935 | 0.40 | May 31, 2016 |\n| Warrants issued July 29, 2011 (3) | 7,317,978 | 0.40 | July 29, 2016 |\n| Warrants issued November 21, 2011 (4) | 1,462,500 | 0.40 | November 21, 2016 |\n| Outstanding and exercisable at December 31, 2011 | 13,906,413 |\n| Outstanding and exercisable at March 31, 2012 | 13,906,413 |\n| Class J Warrants: (Issued for Private Placement) |\n| Warrants issued July 29, 2011 (3) | 7,317,978 | 0.30 | July 29, 2016 |\n| Warrants issued November 21, 2011 (4) | 1,462,500 | 0.30 | November 21, 2016 |\n| Outstanding and exercisable at December 31, 2011 | 8,780,478 |\n| Outstanding and exercisable at March 31, 2012 | 8,780,478 |\n| Weighted average exercise of warrants outstanding and weighted average exercise price at March 31, 2012 | 33,542,130 | 0.29 |\n\n(1)\nIncludes 196,297 warrants issued for commissions and finder’s fees.\n(2)\nIncludes 196,296 warrants issued for commissions and finder’s fees.\n(3)\nIncludes 412,549 warrants issued for commissions and finder’s fees for each of Class I and J Warrants.\n(4)\nIncludes 212,500 warrants issued for commissions and finder’s fees for each of Class I and J Warrants.\n(5)\nOn March 21, 2012, the expiration dates of warrants set to expire in 2012 were extended for one year beyond their original expiration dates. No other terms were modified.\nStock-Based Compensation:\nDuring 2011, the Company issued 545,000 options to employees and contractors working at our Chandalar property. Vesting milestones occurred in the Company’s fourth quarter of 2011 at which time 40,000 options were forfeited. The fair value of these options was determined using a Black Scholes model, resulting in a total fair value of $85,191 for these options. Of this value, $62,279 was recognized in the fourth quarter of 2011, when service and vesting milestones were reached.\nFor the three-month periods ended March 31, 2012 and 2011, the Company recognized share-based compensation for employees of $8,371 and $11,712, respectively. There remains $14,541 of unrecognized share-based compensation to be recognized over the coming four quarters.\n7.\nCOMMITMENTS AND CONTINGENCIES\nThe Company has a royalty commitment on claims purchased from the Anderson family. The Company is obligated to pay 2% of gold it mines from these claims to the Anderson partnership. The Company may, at its election, purchase the royalty from the Anderson Partnership no later than June 23, 2013 for a payment of $250,000. If the Company elects to purchase the royalty once notice has been given, payment is due within 30 days.\nDuring 2009 and 2010 the Company engaged in permitted open pit mining operations on Little Squaw Creek. The Small Mines permit on Little Squaw Creek restricts ground disturbance to a total maximum of ten acres and requires a specified reclamation plan for the disturbed area to be completed prior to additional acreage being disturbed. Reclamation bonding is mandatory for mines involving ground disturbances of more than five acres. The Company’s mining operations, including all associated infrastructures, have to-date disturbed approximately forty-six acres. The Company participates in the State Wide Bonding Pool for small miners, and has posted bonds for twenty acres of disturbance. Consequently, the Company is currently not in compliance with its Small Mines permit for Little Squaw Creek. The Company intends to achieve mining permit compliance by getting the Small Mines permit upgraded to, or re-issued as, an Individual Permit, which is required for all mining operations covering more than ten acres. An Individual Permit allows for as much mining ground disturbance as needed but the application process is more costly and time consuming and there is no guarantee that the Company will be granted an Individual Permit. The Company does not anticipate incurring any penalty for no longer being in compliance with the Small Mines permit. However, further expansion of Little Squaw Creek will be delayed until the Company obtains an Individual Permit. Until the Company obtains an Individual Permit for the Little Squaw Creek, the Company’s ability to produce gold at Little Squaw Creek will be restricted. This could impact the 2012 mining season.\n10\nGoldrich Mining Company\n(An Exploration Stage Company)\nNotes to the Consolidated Financial Statements (unaudited)\n8.\nSUBSEQUENT EVENTS\nOn April 3, 2012, we signed a binding Letter of Intent (“LOI”) to create a joint-venture company with NyacAU, LLC (“NyacAU”), an Alaskan private company, to bring our Chandalar placer gold properties in Alaska into production. Under the terms of the LOI, NyacAU will provide a funding package of loans and equity that, subject to the timing of production, are estimated to total approximately $8.5 million as described below. The loans are to be repaid to NyacAU from Goldrich’s share of future gold production by the joint venture.\nOn May 2, 2012, we signed the definitive agreement to create a joint-venture company with Nyac Gold, LLC. (“Nyac Gold”). GNP is the 50/50 joint-venture company formed by Goldrich and NyacAU and managed by NyacAU to mine our various placer properties at Chandalar.\nAs part of the Agreement, Goldrich and Nyac Gold, LLC formed a 50:50 joint venture, Goldrich NyacAU Placer, LLC (“GNP”), to operate the Chandalar placer mines, with Nyac Gold, LLC acting as managing partner. Once all loans have been repaid and working capital and budgeted reserves have been established, profits from the placer production will be paid out on a 50:50 basis to each of GNP’s partners. The Agreement covers production from all placers on Goldrich’s Chandalar property including, but not limited to, Little Squaw Creek, Big Squaw Creek, Big Creek and Tobin Creek, as well as all future properties within two miles of these claims or within the creek drainages to their termination that come from the Chandalar claim block.\nConcurrent with signing the Agreement, Goldrich formed Goldrich Placer LLC subsidiary and entered into a Lease Agreement (the “Lease”) with Goldrich Placer LLC for the exclusive right and license to explore for, develop, mine and control all placer gold located on or extracted from all of Goldrich’s mining claims at its Chandalar property. The Lease then includes an assignment of rights, title, interest responsibilities and obligations under the lease to GNP. The Lease shall continue until the cessation of operations, as defined in the Lease, or dissolution of GNP. The annual payment from Goldrich Placer LLC to Goldrich under the Lease is ten dollars ($10 US). Under terms of the operating agreement, GNP must meet minimum investment and production requirements.\nNyacAU’s funding includes an effectively non-interest bearing loan to GNP, sufficient in amount to bring the placers at Chandalar into commercial production. This amount is currently estimated to total $7.2 million, subject to timing of production, consisting of approximately $3.6 million for start-up costs, $2.4 million for capital expenditures for mining equipment as well as $1.2 million loaned to GNP and then paid to Goldrich to purchase mining equipment currently owned by Goldrich. Upon completion of loan advances, Goldrich will be secondarily responsible for repayment of 50% of the loan balances as a result of its 50% ownership of GNP, and repayment will be effected by distributing Goldrich’s portion of GNP earnings to NyacAU until the loan is paid in full. The loan will earn interest to NyacAU at the applicable short-term federal rate, currently 0.25%, but is effectively a non-interest bearing loan from Goldrich’s standpoint, as Goldrich will receive a special payment from GNP equal to the interest paid by GNP to NyacAU for Goldrich’s 50% ownership share of this loan. NyacAU has also agreed to advance Goldrich $0.95 million at the greater of prime plus 2% or 10% interest for direct drilling costs as part of Goldrich’s 2012 exploration program with Blackrock Drilling, a drilling company in which the owners of NyacAU have a majority interest. The balance of the funding package, $0.35 million, is to be provided by an equity financing for the purchase shares of Goldrich’s common stock by NyacAU. The price per share in the equity financing is $0.148 per share the 90-day weighted volume average price of Goldrich stock on the last business day proceeding the signing of the definitive documents for the joint venture agreement.\n11\nGoldrich Mining Company\n(An Exploration Stage Company)\nNotes to the Consolidated Financial Statements (unaudited)\n8.\nSUBSEQUENT EVENTS, CONTINUED\nA summary of the financing package is as follows:\n| Estimated 2012 Start-up Costs funding to GNP | $3,600,000 |\n| Estimated Capital Expenditures through GNP | 2,400,000 |\n| Estimated Purchase of Equipment from Goldrich through GNP | 1,200,000 |\n| Total Loan from NyacAU to GNP with Interest at 0.25%, for which Goldrich is 50% secondarily responsible as a result of its 50% ownership of GNP. Goldrichs share of future distributions from GNP income totaling $3,600,000 will be made to NyacAU to satisfy this loan. | 7,200,000 |\n| Loan from NyacAU to Goldrich with Interest at greater of prime plus 2% or 10% for exploration drilling. Goldrichs share of future distributions from GNP income totaling $950,000 will be made to NyacAU to satisfy this loan. | 950,000 |\n| To Be Paid Back by GNP From Production, a total of $4,550,000 will be made from Goldrichs share of future distributions of GNP income | 8,150,000 |\n| Equity Financing - Purchase shares of Goldrichs Common Stock | 350,000 |\n| Total Financing, of which $2,500,000 will be received by Goldrich to finance its 2012 exploration program and general corporate expenses | $8,500,000 |\n\nThe total amount financed by NyacAU will be affected by timing of payback from production. GNP will commence payments to NyacAU as soon as production begins. Subject to permitting, preparation for mining is expected to begin in June 2012.\nIn addition to the funding noted above, NyacAU has the option to lend GNP $0.25 million to purchase a 2% royalty that is currently on all production from certain Goldrich mining claims. The loan would carry interest at the greater of prime plus 2% or 10% and would be repaid from Goldrich’s portion of production. Goldrich would also have the exclusive right to purchase back the royalty at any time. The royalty would be extinguished upon payback of the loan or purchase by Goldrich.\nNyacAU, LLC is owned by the family of Dr. J. Michael James, which is also the owner of Nyac Gold LLC, one of the largest producers of placer gold in Alaska. As manager of NyacAU, Dr. James will be granted 300,000 five-year stock options at an exercise price of $0.20 per share from Goldrich’s employee stock incentive program.\n12\nItem 2. Management’s Discussion and Analysis of Financial Condition or Plan of Operation\nAs used in herein, the terms “Goldrich,” the “Company,” “we,” “us,” and “our” refer to Goldrich Mining Company.\nThis discussion and analysis contains forward-looking statements that involve known or unknown risks, uncertainties and other factors that may cause the actual results, performance, or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Except for historical information, the matters set forth herein, which are forward-looking statements, involve certain risks and uncertainties that could cause actual results to differ. Potential risks and uncertainties include, but are not limited to, unexpected changes in business and economic conditions; significant increases or decreases in gold prices; changes in interest and currency exchange rates; unanticipated grade changes; metallurgy, processing, access, availability of materials, equipment, supplies and water; results of current and future exploration and production activities; local and community impacts and issues; timing of receipt and maintenance of government approvals; accidents and labor disputes; environmental costs and risks; competitive factors, including competition for property acquisitions; and availability of external financing at reasonable rates or at all, and those set forth under the heading “Risk Factors” in our Form 10-K filed with the Securities and Exchange Commission (the “SEC”) on March 30, 2012. Forward- looking statements can be identified by terminology such as “may,” “will,” “should,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continues” or the negative of these terms or other comparable terminology. Although the Company believes that the expectations reflected in the forward-looking statements are reasonable, it cannot guarantee future results, levels of activity, performance or achievements. Forward-looking statements are made based on management’s beliefs, estimates, and opinions on the date the statements are made, and the Company undertakes no obligation to update such forward-looking statements if these beliefs, estimates, and opinions should change, except as required by law.\nThis discussion and analysis should be read in conjunction with the accompanying unaudited consolidated financial statements and related notes. The discussion and analysis of the financial condition and results of operations are based upon the unaudited consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of any contingent liabilities at the financial statement date and reported amounts of revenue and expenses during the reporting period. On an on-going basis the Company reviews its estimates and assumptions. The estimates were based on historical experience and other assumptions that the Company believes to be reasonable under the circumstances. Actual results are likely to differ from those estimates under different assumptions or conditions, but the Company does not believe such differences will materially affect our consolidated financial position or results of operations. Critical accounting policies, the policies the Company believes are most important to the presentation of its consolidated financial statements and require the most difficult, subjective and complex judgments, are outlined below in “Critical Accounting Policies,” and have not changed significantly.\nChandalar, Alaska\nThe Chandalar gold property is currently our main mineral property. It is an exploration stage property. We were attracted to the Chandalar district because of its similarities to productive mining districts, its past positive exploration results, and the opportunity to control multiple attractive gold quartz-vein prospects and adjacent unexplored target areas for large sediment hosted disseminated gold deposits. The gold potential of the Chandalar district is enhanced by similarities to important North American mesothermal or orogenic gold deposits, a common attribute being a tendency for the mineralization to continue for up to a mile or more at depth, barring structural offset. We believe that our dominant land control eliminates the risk of a potential competitor finding ore deposits located within adjacent claims. Summarily, the scale, number and frequency of the Chandalar district gold-bearing exposures and geochemical anomalies compare favorably to similar attributes of productive mining districts.\nGoing forward, our primary focus is development of our hard-rock (lode) exploration targets at Chandalar. Subject to sufficient financing, we plan a 15,000-foot diamond-core drilling program for the 2012 summer field season on the hard-rock exploration targets which are believed to be the sources of the alluvial gold. Drill hole depths would range from 300 to 700 feet, and the holes would be spread along a five-mile-long mineralized trend that our geological work has identified. The drilling targets are derived from concepts developed from the\n13\ntechnical data that point to the discovery potential for huge, low grade orogenic gold deposits. The Chandalar mineralization can best be classified as orogenic owing to the finely disseminated nature of the gold, close association with sulfides and deposition within a carbon-rich sedimentary host (Mikado phyllite). The phyllite is highly deformed as a result of tectonic processes. The original sedimentary rocks have been successively altered by multiple phases of metamorphic and hydrothermal alteration which has remobilized gold within the original carbonaceous sediments into axial fold structures, faults and quartz veins.\nThe Company maintains an extensive file of the prospecting and exploration of the Chandalar Mining district, cataloging documents dated as early as 1904. Most previous work was by mining companies and individuals who were focused on mining the gold placers and quartz veins but who conducted little systematic geologically-based exploration, which was focused on known vein exposures. There is no reliable accounting of the exploration expenditures over the entire hundred-year period; however, since we (new management) acquired the Company in 2003, $2.468 million of qualifying assessment work has been accomplished (excludes infrastructure, capital equipment, transport cost, and office support). In addition to work performed in the 2011 field season noted below, we completed two drill programs, a 7,763-foot reverse circulation, 39-hole reconnaissance-level lode exploration drill program in 2006 and a 15,304-foot, 107-hole reverse circulation placer evaluation drill program in 2007. We also geologically mapped about 40 identified prospect areas; collected and analyzed approximately 1,400 soil, 1,400 rock, 70 stream sediment and 11 water samples; completed a program of 45 trenches consisting of 5,937 feet, of which 4,954 feet was exposed bedrock, and collected of about 550 trench-wall channel samples; completed ground magnetometer survey grids of 15 prospect areas. We have collected and assayed a total of 3,431 surface samples at Chandalar. In addition, approximately 4,500 drill samples have been analyzed.\nThe Chandalar district has a history of prior production, but there has been only intermittent production over the years. Our 2007 exploration work discovered and partially drilled out a large placer gold deposit in the Little Squaw Creek drainage. In 2009, we opened the Little Squaw Creek Gold Mine as a test project. Favorable results led to the expansion of the mine in 2010.Production to date during the startup phase of the Little Squaw Creek Gold Mine amounts to 2,022 ounces of fine gold. This deposit is geologically characterized as an aggradational placer gold deposit. It is unusual in the sense that it is the only such known aggradational alluvial (or placer), gold deposit in Alaska, although many exist in Siberia. Our discovery contrasts to others in Alaska that are commonly known as bedrock placer gold deposits. Aggradational alluvial gold deposits contain gold particles disseminated through thick sections of unconsolidated stream gravels in contrast to bedrock placer deposits where thin, rich gold-bearing gravel pay streaks rest directly on bedrock surfaces. Aggradational placer gold deposits are generally more uniform and thus more conducive to bulk mining techniques permitting economies of scale. This contrasts with bedrock placer gold deposits where gold distribution tends to be erratic and highly variable. The plan view of our discovery is somewhat funnel-shaped, and as such has been divided into two distinct geomorphological zones: the Gulch, or narrower channel portion, and the Fan, or broad alluvial apron portion.\nIn 2011, we completed a diamond core drilling campaign along with a property-wide, grid-based soil sampling and a detailed airborne magnetometer survey. We completed a 25-hole, 4,404-meter (14,444-foot) exploratory program, using HQ size core, and tested six prospect areas (see map below) located along a 4-km (2.5-mile) long northeast trending belt of gold showings.\nThe results of the 2011 drill program are detailed in our Form 10-K for the year ended December 31, 2011.\nThe 2011 drilling results draw the Company to focus on two prospects – Aurora and Rock Glacier- which we believe are geologically associated and related to the same controlling mineralizing features. Intercepts include:\n·\n1.5 meters (5.0 feet) at 6.57 g/t Au in Hole LS11-0063 on the Aurora prospect;\n·\n2.1 meters (7.0 feet) at 6.02 g/t Au in Hole LS11-0041 on Rock Glacier\nThese and other intercepts are associated with much longer core runs of strongly anomalous gold (> 0.10 g/t Au) between 4.3 meters (14 feet) and 21.3 meters (70 feet) in length. Also worth noting, while constructing a\n14\nroad to a proposed drill site, the Company encountered two zones of shearing with sheeted and stockwork quartz veinlets, approximately 5 meters (16 feet) and 15 meters (49 feet) wide. These zones are located 135 meters vertically above and 200 meters southwest of Aurora drill holes #61 to #64. Representative continuous chip sampling of these zones yielded assays of 2.8 g/t gold and 2.1 g/t gold, respectively. The Company believes the mineralized Aurora drill hole intercepts may represent an extension of these zones and that additional drilling could extend these zones even further.\nThe extensive wide-spread precious metal system at Chandalar is hosted by carbonaceous, pyrrhotite-arsenopyrite-pyrite bearing schist. Significantly, extensive intercepts of hydrothermal alteration manifested by intense chloritization and strong silicification of the schist are associated with the mineralization, and are often geochemically anomalous (> 0.05 g/t) in gold as well. The gold mineralization is believed to be mainly controlled by fractures and shears of various orientations within the schist. Mineralized intercepts have now been intersected by drilling over a vertical elevation difference of 550 meters (1,800 feet), with the lowest exposure being in the northeast at the Aurora prospect which is close to the Little Squaw alluvial gold deposit. The metamorphic strata hosting the gold are severely eroded at the higher elevations and either dip to the north or are down faulted, or both.\nMap 1 – Location of the Chandalar, Alaska Mining District\nAdditional core drilling is necessary to assess the continuity and extent of outcropping and any projection from the gold-mineralized intercepts as well as determine the limits of the mineralizing system. In addition to drilling, the 2011 Chandalar gold exploration program included a grid soil sampling survey consisting of 1,153 samples for multi-element analyses. The airborne magnetometer program was flown along lines spaced 330 feet (100 meters) apart for 750 line miles (1,246 line kilometers) by Fugro Geophysical, generating the total magnetic field strength map for the entire Chandalar property. The Company’s geological field crews did the\n15\nreconnaissance grid soil sample program, taking the samples on a 330 foot (100 meters) by 1,300 foot (400 meter) or larger grid that covers about 11 square miles (about 28 sq. km), or about half the Chandalar property. The samples were then assayed for gold and other elements with the gold plotted in parts per billion (ppb) on the map. Scientific evaluation of the large amount of data generated by these surveys is ongoing with the purpose of better delineating known drilling targets and outlining new ones.\nFor a complete description of our Chandalar, Alaska project please see our Form 10-K for the year ended December 31, 2011.\nJoint Venture Agreement\nSubsequent to quarter ended March 31, 2012, on April 3, 2012, we signed an agreement with NyacAU to form a joint venture for the purpose of mining the alluvial gold deposits within the bounds of our Chandalar property. The agreement provides financing approximately $8.5 million of financing for bringing the alluvial deposit on Little Squaw Creek into production as well as financing the drilling activities of our 2012 exploration program. The terms of the agreement are described below in Subsequent Events.\nLocation, Access & Geography of Chandalar\nThe Chandalar mining district lies north of the Arctic Circle at latitude 67°30'. The district is about 190 air miles north of Fairbanks, Alaska and 48 air miles east-northeast of Coldfoot (see Map 1). The center of the district is approximately 70 miles north of the Arctic Circle. Access to our Chandalar mining camp at Squaw Lake is either by aircraft from Fairbanks, or during the winter season via a 100-mile-long ice road from Coldfoot through the community of Chandalar Lake to Squaw Lake.\nMap 2 – Chandalar Mining Claim Block\n16\nFor a complete description of the access & geography of Chandalar please see our Form 10-K for the year ended December 31, 2011.\nChandalar Mining Claims\nWe have a block of contiguous mining claims at Chandalar that cover a net area of about 22,858 acres (approximately 35.7 square miles) (Map 2), and which are maintained by us specifically for the exploration and possible exploitation of placer and lode gold deposits. The mining claims were located to secure most of the known gold bearing zones occurring within an area approximately five miles by eight miles. Within the claim block, we own in fee simple 426.5 acres as twenty-one federal lode claims, one patented federal placer claim, and one patented federal mill site. The 23 federal patented claims cover the most important of the known gold-bearing structures. In addition, there are 197 Traditional and MTRSC 40-acre State of Alaska. The 197 Traditional and MTRSC state mining claims provide exploration and mining rights to both lode and placer mineral deposits on an additional 22,432 acres of unpatented claims. Unlike federal mining claims, State of Alaska mining claims cannot be patented, but the locator has the exclusive right of possession and extraction of the minerals in or on the claim.\nFor a complete description of the Chandalar mining claims please see our Form 10-K for the year ended December 31, 2011.\nMap 3 – Gold Prospects and Geologic Structure of Chandalar\n17\nChandalar Geology and Mineralization\nA complete technical description of the Chandalar mining district, its geology and mineralization is included in our Form 10-K for the year ended December 31, 2011. In Map 3 above, we present graphical representation of both hard rock prospects and alluvial fans on which we are focusing varying degrees of exploration effort, as determined by exploration activities already completed in prior years.\nFor a complete description of prior years’ exploration activities, and the interpretations of exploration and drilling activities please see our Form 10-K for the years ended December 31, 2011, 2010, 2009 and previous years.\n2012 Exploration and Mining Plans\nIn 2012, we plan to continue our drilling plan which we began in 2011, modified to reflect data acquired in the 2011 field season. Our principal exploration target is the newly identified hard-rock stratabound gold target. Subject to obtaining sufficient financing, a 15,000-foot diamond-core drilling program consisting of approximately 20 to 25 drill holes to explore this structure is planned for the 2012 summer field season. The drilling would test a zone of schist, or sequence of schist beds, that our geologists have identified as fertile for discovery of a stratabound type of gold deposit. Our targeted drilling area is approximately 1,800 feet wide and over five miles long, where it ends under the Little Squaw Creek alluvial gold deposit. We believe the alluvial gold in Little Squaw Creek and all of the other creeks in the Chandalar district was derived from the erosion of this schist. An independent contractor would be used for the diamond-core drilling and independent certified laboratories would be used for analyses. The estimated cost for the entire program is approximately $1.5 to $2.0 million dollars.\nAdditionally, as described below in Subsequent Events, we have signed an agreement with NyacAU to form a joint venture for the purpose of mining the alluvial gold deposits within the bounds of our Chandalar property. The agreement provides financing approximately $8.5 million of financing for bringing the alluvial deposit on Little Squaw Creek into production as well as financing the drilling activities of our 2012 exploration program.\nOn May 7, 2012 the Company announced that the joint venture, Goldrich NyacAU Placer, LLC (“GNP”), successfully completed mobilizing the mining equipment needed to begin mining operations this summer at Chandalar, Alaska.\nThe equipment was delivered over a 90-mile winter trail by GNP contractors. In addition to equipment, provisions for a 30-man camp were delivered, including a water system, kitchen/mess hall, and recreation facilities. The total investment in equipment mobilized to site, including equipment previously purchased by Goldrich, now exceeds $5 million. Subject to obtaining the necessary permits, preparation for mining is expected to begin in June 2012. Production is anticipated to begin by June 2013, although some initial production may be achieved this year. Eventual production of approximately 10,000 ounces of fine gold per season is anticipated, but this could be significantly increased if a second gold recovery plant is put into production. Goldrich has not defined a mineral reserve according to SEC Industry Guide 7 criteria. However, based on drilling of the placer to date and the anticipated production rate, Goldrich estimates the mine life will be approximately 25 years and believes this may also be significantly extended with additional drilling.\nFinancial Condition and Liquidity\nWe are an exploration stage company and have incurred losses since our inception. We currently do not have sufficient cash to support the Company through 2012. We anticipate that we will incur the following expenses over the next 12 months as of March 31, 2012:\n1.\n$1.5 to $2.0 million for 2012 exploration plan\n2.\n$375,000 for payment of third-party debt obligations, primarily for equipment loans; and\n18\n3.\n$636,000 for general operating expenses\nThe $8.5 million financing described below in Subsequent Events includes $1.3 million for the 2012 exploration program and general operating costs in the form of financed drilling costs of $950,000 and cash proceeds of $350,000 from the sale of common shares. We anticipate we will need to raise approximately $1.2 million to $1.7 million in the next 12 months to completely fund our planned exploration expenditures, debt obligations and general working capital requirements. The Company plans to raise the financing through debt and/or equity placements. Failure to raise needed financing could result in us having to scale back or discontinue exploration activities or some or all of our business operations.\nGold prices are at or near record highs, but the current capital markets and general economic conditions in the United States may be obstacles to raising the required financing. We believe we will be able to secure sufficient financing for further operations and exploration activities of the Company but we cannot give assurance we will be successful in attracting financing on terms acceptable to us, if at all. To increase its access to financial markets, Goldrich intends to seek a listing of its shares on a recognized stock exchange in Canada in addition to its listing on the FINRA OTCBB in the United States.\nThe audit opinion and notes that accompany our consolidated financial statements for the year ended December 31, 2011, disclose a ‘going concern’ qualification as to our ability to continue in business. The consolidated financial statements for the year then ended have been prepared under the assumption that we will continue as a going concern. Such assumption contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As a result of continuing losses in 2011 and the first quarter of 2012, we have not yet successfully exited this going concern condition. As shown in the consolidated financial statements for the quarter ended March 31, 2012, we incurred losses and negative cash flows from operating activities for the quarter then ended, and at March 31, 2012, did not have sufficient cash reserves to meet debt obligations and cover normal operating expenditures for the following 12 months. These factors raise substantial doubt about our ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might be necessary should we be unable to continue as a going concern.\nWith the exception of gold sales revenue in 2009 and 2010, we currently have no historical recurring source of revenue sufficient to support on-going operations. Our continuation as a going concern is dependent upon our ability to generate sufficient cash flow to meet our obligations on a timely basis, to obtain additional financing as may be required, or to attain profitability in a gold extraction operation as anticipated by the formation of a joint venture as described in Subsequent Events. No assurances can be given, however, that we will be able to obtain any of these potential sources of cash. We currently require additional cash funding from outside sources to sustain existing operations and to meet current obligations and ongoing capital requirements. We have sufficient cash to fund our administrative operations until approximately August of 2012.\nOn March 31, 2012 we had total liabilities of $1,068,380 and total assets of $2,916,179. This compares to total liabilities of $1,049,152 and total assets of $3,337,877 on December 31, 2011. As of March 31, 2012, the Company’s liabilities consist of $316,925 for environmental remediation and asset retirement obligations, $373,612 in equipment notes payable, $326,630 of trade payables and accrued liabilities, $29,130 due to related parties, and $22,083 for dividends payable. Of these liabilities, $620,104 is due within 12 months, including $242,261 in the current portion of equipment notes payable. The increase in liabilities compared to December 31, 2011 is largely due to an increase in accounts payable and accrued liability resulting from the ramping up of activities in preparation for the 2012 exploration program, offset by a decrease resulting from scheduled payments on equipment notes. The decrease in total assets was due to reduced cash resulting from general and administrative expenses concurrent with no cash raised from financing activities, supplemented by capitalized prepaid insurance payments, and reduced by depreciation taken against capital equipment during the quarter ended March 31, 2012.\nOn March 31, 2012 we had negative working capital of $226,126 and stockholders’ equity of $1,847,799 compared to working capital of $206,570 and stockholders’ equity of $2,288,725 for the year ended December 31, 2011.\n19\nDuring the quarter ended March 31, 2012, we used cash from operating activities of $282,371 compared to $221,753 for the same quarter of 2011. A significant adjustment to net loss from operations to arrive at net cash used in operations for the quarter ended March 31, 2011 is the non-cash loss of $1,623,489 arising from the satisfaction of notes payable in gold, which did not recur in 2012. We had no gold sales revenue in the comparative quarters of March 31, 2012 and 2011. However, as a result of the joint venture mining agreement we signed subsequent to the end of the March 2012 quarter, we believe gold revenues can increase in future years in profitable mining operations, as executed by our joint venture partner. As we reach profitable levels of production, we may be able to fund some portion of our exploration and mining activities from internal sources. As of March 31, 2012, we had accumulated approximately $18.8 million in federal and state net operating losses, respectively, which may enable us to generate approximately $18.8 million in net income prior to incurring any significant income tax obligation. The net operating losses will expire in various amounts from 2012 through 2031.\nDuring the quarter ended March 31, 2012, we used cash of $32,238 in investing activities, compared to $4,110 used in the quarter ended March 31, 2011, each total representing purchases of equipment.\nDuring the quarter ended March 31, 2012, we used $57,826 cash in financing activities to make payments on capital equipment notes payable, compared to $201,957 cash provided during the quarter ended March 31, 2011, consisting of $255,666 cash raised through the exercise of warrants offset by $53,709 cash used to make payments on capital equipment notes payable.\nPrivate Placement Offerings\nWe completed no private placements of the Company’s securities made during the quarter ended March 31, 2012.\nSubsequent Events\nOn April 3, 2012, we signed a binding Letter of Intent (“LOI”) to create a joint-venture company (the “JV”) with NyacAU, LLC (“NyacAU”), an Alaskan private company, to bring our Chandalar placer gold properties in Alaska into production. Under the terms of the LOI, NyacAU will provide a funding package of loans and equity that, subject to the timing of production, are estimated to total approximately $8.5 million as described below. The loans are to be repaid to NyacAU from Goldrich’s share of future gold production by the joint venture.\nOn May 2, 2012, we signed the definitive agreement (“Agreement”) to create a joint-venture company with Nyac Gold, LLC. (“Nyac Gold”). Goldrich Nyac Placer, LLC (“GNP”) is the 50/50 joint-venture company formed by Goldrich and NyacAU and managed by NyacAU to mine our various placer properties at Chandalar.\nOnce all loans have been repaid and working capital and budgeted reserves have been established, profits from the placer production will be paid out on a 50/50 basis to each of GNP’s partners. The Agreement covers production from all placers on Goldrich’s Chandalar property including, but not limited to, Little Squaw Creek, Big Squaw Creek, Big Creek and Tobin Creek, as well as all future properties within two miles of these claims or within the creek drainages to their termination that come from the Chandalar claim block.\nConcurrent with signing the Agreement, Goldrich formed the Goldrich Placer LLC subsidiary and entered into a lease agreement (the “Lease”) with Goldrich Placer LLC for the exclusive right and license to explore for, develop, mine and control all placer gold located on or extracted from all of Goldrich’s mining claims at its Chandalar property. The Lease then includes an assignment of rights, title, interest responsibilities and obligations under the lease to GNP. The Lease shall continue until the cessation of operations, as defined in the Lease, or dissolution of GNP. The annual payment from Goldrich Placer LLC to Goldrich under the Lease is ten dollars ($10). Under terms of the operating agreement, GNP must meet minimum investment and production requirements.\n20\nNyacAU’s funding includes an effectively non-interest bearing loan to GNP, sufficient in amount to bring the placers at Chandalar into commercial production. This amount is currently estimated to total $7.2 million, subject to timing of production, consisting of approximately $3.6 million for start-up costs, $2.4 million for capital expenditures for mining equipment as well as $1.2 million loaned to GNP and then paid to Goldrich to purchase mining equipment currently owned by Goldrich. Upon completion of loan advances, Goldrich will be secondarily responsible for repayment of 50% of the loan balances as a result of its 50% ownership of GNP, and repayment will be effected by distributing Goldrich’s portion of GNP earnings to NyacAU until the loan is paid in full. The loan will earn interest to NyacAU at the applicable short-term federal rate, currently 0.25%, but is effectively a non-interest bearing loan from Goldrich’s standpoint, as Goldrich will receive a special payment from GNP equal to the interest paid by GNP to NyacAU for Goldrich’s 50% ownership share of this loan. NyacAU has also agreed to advance Goldrich $0.95 million at the greater of prime plus 2% or 10% interest for direct drilling costs as part of Goldrich’s 2012 exploration program with Blackrock Drilling, a drilling company in which the owners of NyacAU have a majority interest. The balance of the funding package, $0.35 million, is to be provided by an equity financing for the purchase shares of Goldrich’s common stock by NyacAU. The price per share in the equity financing is $0.148 per share, the 90-day weighted volume average price of Goldrich stock on the last business day proceeding the signing of the definitive documents for the joint venture agreement.\nA summary of the financing package is as follows:\n| Estimated 2012 Start-up Costs funding to GNP | $3,600,000 |\n| Estimated Capital Expenditures through GNP | 2,400,000 |\n| Estimated Purchase of Equipment from Goldrich through GNP | 1,200,000 |\n| Total Loan from NyacAU to GNP with Interest at 0.25%, for which Goldrich is 50% secondarily responsible as a result of its 50% ownership of GNP. Goldrichs share of future distributions from GNP income totaling $3,600,000 will be made to NyacAU to satisfy this loan. | 7,200,000 |\n| Loan from NyacAU to Goldrich with Interest at greater of prime plus 2% or 10% for exploration drilling. Goldrichs share of future distributions from GNP income totaling $950,000 will be made to NyacAU to satisfy this loan. | 950,000 |\n| To Be Paid Back by GNP From Production, a total of $4,550,000 will be made from Goldrichs share of future distributions of GNP income | 8,150,000 |\n| Equity Financing - Purchase shares of Goldrichs Common Stock | 350,000 |\n| Total Financing, of which $2,500,000 will be received by Goldrich to finance its 2012 exploration program and general corporate expenses | $8,500,000 |\n\nThe total amount financed by NyacAU will be affected by timing of payback from production. GNP will commence payments to NyacAU as soon as production begins. Subject to permitting, preparation for mining is expected to begin in June 2012. Production is anticipated to begin by June 2013, although it may begin as early as the summer of 2012. The operating season for placer mining in Alaska is generally mid-June through mid-September subject to weather. GNP anticipates eventual production of approximately 10,000 ounces of fine gold per season, but this could be significantly increased if a second wash plant is put into production. Goldrich has not defined a mineral reserve according to SEC Industry Guide 7 criteria. However, based on drilling of the placer to date and the anticipated production rate, Goldrich estimates the mine life will be approximately 25 years and believes this may also be significantly extended with additional drilling.\nIn addition to the funding noted above, NyacAU has the option to lend GNP $0.25 million to purchase a 2% royalty that is currently on all production from certain Goldrich mining claims. The loan would carry interest at the greater of prime plus 2% or 10% and would be repaid from Goldrich’s portion of production. Goldrich would also have the exclusive right to purchase back the royalty at any time. The royalty would be extinguished upon payback of the loan or purchase by Goldrich.\n21\nOur primary asset is the hard-rock exploration target at Chandalar and the terms of the LOI ensure we will retain access to all of its properties for exploration purposes. GNP will lease the mining rights to placer gold on our Chandalar properties, but a formula is provided for us to purchase back these rights if the property is needed for hard-rock mining or to the extent hard-rock exploration significantly interferes with placer mining.\nNyacAU, LLC is owned by the family of Dr. J. Michael James, which is also the owner of Nyac Gold LLC, one of the largest producers of placer gold in Alaska. Dr. James is a fourth-generation Alaskan whose family has roots in mining in the State going back to the early 1900’s. In addition to his mining interests, Dr. James is a respected physician and member of the business community in Anchorage. The manager of NyacAU, Dr. James will be granted 300,000 five-year stock options at an exercise price of $0.20 per share from Goldrich’s employee stock incentive program.\nAccording to the terms of the LOI, “placer” means minerals that are river sands or gravels bearing gold or valuable detrital minerals hosted in soils, alluvium (deposited by water), eluvium (deposited by wind), colluvium (deposited by gravity), or talus, and up to six (6) feet into associated bedrock, and the term “lode” means a mineral that occurs as veins, lodes, ledges, or other rock in place which contains base and precious metals, gems and semi-precious stones, and certain industrial minerals, including but not limited to gold, silver, cinnabar, lead, tin, copper, zinc, fluorite, barite, or other valuable deposits, and is not a deposit of placer, alluvial, eluvial, colluvial or aqueous origin.\nAs of the date of this filing, GNP has successfully completed mobilizing the mining equipment needed to begin mining operations this summer at Chandalar, Alaska.\nThe equipment was delivered over a 90-mile winter trail by GNP contractors. In addition to equipment, provisions for a 30-man camp were delivered, including a water system, kitchen/mess hall, and recreation facilities. The total investment in equipment mobilized to site, including equipment previously purchased by us, now exceeds $5 million. Subject to permitting, preparation for mining is expected to begin in June 2012. Production is anticipated to begin by June 2013, although it may begin as early as the summer of 2012. Eventual production of approximately 10,000 ounces of fine gold per season is anticipated, but this could be significantly increased if a second gold recovery plant is put into production. We have not defined a mineral reserve according to SEC Industry Guide 7 criteria. However, based on drilling of the placer to date and the anticipated production rate, we estimate the mine life will be approximately 25 years and believe this may also be significantly extended with additional drilling.\nOff-Balance Sheet Arrangements\nWe have no off-balance sheet arrangements.\nCritical Accounting Policies\nWe have identified our critical accounting policies, the application of which may materially affect the financial statements, either because of the significance of the financials statement item to which they relate, or because they require management’s judgment in making estimates and assumptions in measuring, at a specific point in time, events which will be settled in the future. The critical accounting policies, judgments and estimates which management believes have the most significant effect on the financial statements are set forth below:\n·\nEstimates of the recoverability of the carrying value of our mining and mineral property assets. We use publicly available pricing or valuation estimates of comparable property and equipment to assess the carrying value of our mining and mineral property assets. However, if future results vary materially from the assumptions and estimates used by us, we may be required to recognize an impairment in the assets’ carrying value.\n22\n·\nEstimates of our environmental liabilities. Our potential obligations in environmental remediations, asset retirement obligations or reclamation activities are considered critical due to the assumptions and estimates inherent in accruals of such liabilities, including uncertainties relating to specific reclamation and remediation methods and costs, the application and changing of environmental laws, regulations and interpretations by regulatory authorities.\nItem 3. Quantitative and Qualitative Disclosures about Market Risk\nNot applicable.\nItem 4. Controls and Procedures\nEvaluation of Disclosure Controls and Procedures\nAt the end of the period covered by this report, an evaluation was carried out under the supervision of, and with the participation of, the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a – 15(e) and Rule 15d – 15(e) of the Securities and Exchange Act of 1934, as amended (the “Exchange Act”)). Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that as of the end of the period covered by this report, the Company’s disclosure controls and procedures were adequately designed and effective, and that information required to be disclosed by the Company in its reports that it files or submits to the SEC under the Exchange Act, is recorded, processed, summarized and reported within the time period specified in applicable rules and forms.\nOur Chief Executive Officer and Chief Financial Officer have also determined that the disclosure controls and procedures are effective, and that material information required to be disclosed in our reports filed under the Exchange Act is accumulated and communicated to our management, including the Company’s Chief Executive Officer and Chief Financial Officer, to allow for accurate required disclosure to be made on a timely basis.\nChanges in internal controls over financial reporting\nDuring the period covered by this report, there have been no changes in the Company’s internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\n23\nPART II – OTHER INFORMATION\nItem 1. Legal Proceedings\nExcept as discussed below, there have been no material developments or rulings during the period ended March 31, 2012.\nWe continue to pursue resolution in the ongoing appeals by Mr. Delmer Ackels of rulings made in 2008 and 2009 in our favor concerning certain mining claims owned by us at our Chandalar property. Refer to our Form 10-K for the year ended December 31, 2011 for a complete description of legal proceedings.\nItem 1A. Risk Factors\nThere have been no changes to our risk factors as reported in our annual report on Form 10-K for the year ended December 31, 2011.\nItem 2. Unregistered Sales of Equity Securities and Use Of Proceeds\nWe completed no private placements of the Company’s securities made during the quarter ended March 31, 2012.\nItem 3. Defaults upon Senior Securities\nNone.\nItem 4. Mine Safety Disclosure\nOur exploration properties are subject to regulation by the Federal Mine Safety and Health Administration (\"MSHA\") under the Federal Mine Safety and Health Act of 1977 (the \"Mine Act\"). Pursuant to Section 1503(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (The \"Dodd-Frank Act\"), issuers that are operators, or that have a subsidiary that is an operator, of a coal or other mine in the United States are required to disclose in their periodic reports filed with the SEC information regarding specified health and safety violations, orders and citations, related assessments and legal actions, and mining-related fatalities. During the quarter ended March 31, 2012, we had no such specified health and safety violations, orders or citations, related assessments or legal actions, mining-related fatalities, or similar events in relation to our United States operations requiring disclosure pursuant to Section 1503(a) of the Dodd-Frank Act.\nItem 5. Other Information\nNone.\nItem 6. Exhibits\n| Exhibit No. | Document |\n| 31.1 | Certification of the Chief Executive Officer pursuant to Rule 13a-14 of the Exchange Act |\n| 31.2 | Certification of the Chief Financial Officer pursuant to Rule 13a-14 of the Exchange Act |\n| 32.1 | Certification of the Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2 | Certification of the Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS(1) | XBRL Instance Document |\n| 101.SCH(1) | XBRL Taxonomy Extension Schema Document |\n| 101.CAL(1) | XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF(1) | XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB(1) | XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE(1) | XBRL Taxonomy Extension Presentation Linkbase Document |\n\n(1)\nPursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Act of 1934 and otherwise are not subject to liability.\n24\nSIGNATURES\nIn accordance with Section 12 of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\nDate: May 15, 2012\nGOLDRICH MINING COMPANY\nBy /s/ William Schara\nWilliam Schara, Chief Executive Officer and President\nIn accordance with Section 12 of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\nDate: May 15, 2012\nGOLDRICH MINING COMPANY\nBy /s/ Ted R. Sharp\nTed R. Sharp, Chief Financial Officer\n25\n</text>\n\nWhat would be the adjusted net cash flow provided by financing activities from inception to March 31, 2012 in dollars if we consider the total loss recognized for settlement for the year ended December 31, 2011 as a negative cash flow and exclude this from the total cash provided by financing activities?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nITEM 1. FINANCIAL STATEMENTS (UNAUDITED)\nTraeger, Inc.\nCONDENSED CONSOLIDATED BALANCE SHEETS\n(unaudited)\n(in thousands, except unit amounts)\n| June 30,2021 | December 31,2020 |\n| ASSETS |\n| Current Assets |\n| Cash and cash equivalents | $ | 75,252 | $ | 11,556 |\n| Accounts receivable, net | 119,898 | 64,840 |\n| Inventories, net | 86,151 | 68,835 |\n| Prepaid expenses and other current assets | 11,084 | 13,776 |\n| Total current assets | 292,385 | 159,007 |\n| Property, plant, and equipment, net | 39,288 | 32,404 |\n| Goodwill | 256,838 | 256,838 |\n| Intangible assets, net | 523,225 | 539,841 |\n| Other long-term assets | 7,424 | 1,491 |\n| Total assets | $ | 1,119,160 | $ | 989,581 |\n| LIABILITIES AND MEMBERS’ EQUITY |\n| Current Liabilities |\n| Accounts payable | $ | 28,954 | $ | 21,673 |\n| Accrued expenses | 71,883 | 54,697 |\n| Line of credit | 8,000 | — |\n| Current portion of notes payable | 3,825 | 3,407 |\n| Current portion of capital leases | 410 | 296 |\n| Total current liabilities | 113,072 | 80,073 |\n| Notes payable, net of current portion | 493,434 | 433,605 |\n| Capital leases, net of current portion | 750 | 536 |\n| Other non-current liabilities | 341 | 327 |\n| Total liabilities | 607,597 | 514,541 |\n| Commitments and contingencies—See Note 8 |\n| Member’s equity |\n| 108,724,422 Member’s capital common units authorized, issued, and outstanding at June 30, 2021 and December 31, 2020 | — | — |\n| Member’s capital | 573,539 | 571,038 |\n| Accumulated deficit | ( 61,976 ) | ( 95,998 ) |\n| Total member’s equity | 511,563 | 475,040 |\n| Total liabilities and member’s equity | $ | 1,119,160 | $ | 989,581 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements\n1\nTraeger, Inc.\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME\n(unaudited)\n(in thousands, except unit and per unit amounts)\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Revenue | $ | 213,022 | $ | 153,190 | $ | 448,595 | $ | 266,973 |\n| Cost of revenue | 129,715 | 86,502 | 264,657 | 148,530 |\n| Gross profit | 83,307 | 66,688 | 183,938 | 118,443 |\n| Operating expense |\n| Sales and marketing | 47,269 | 20,985 | 78,120 | 37,703 |\n| General and administrative | 24,802 | 9,306 | 38,358 | 18,310 |\n| Amortization of intangible assets | 8,301 | 8,132 | 16,602 | 16,263 |\n| Total operating expense | 80,372 | 38,423 | 133,080 | 72,276 |\n| Income from operations | 2,935 | 28,265 | 50,858 | 46,167 |\n| Other income (expense), net: |\n| Interest expense | ( 7,877 ) | ( 9,063 ) | ( 15,689 ) | ( 18,248 ) |\n| Loss on extinguishment of debt | ( 1,957 ) | — | ( 1,957 ) | — |\n| Other income (expense) | 1,996 | 167 | 1,538 | ( 600 ) |\n| Total other expense, net | ( 7,838 ) | ( 8,896 ) | ( 16,108 ) | ( 18,848 ) |\n| Income (loss) before provision for income taxes | ( 4,903 ) | 19,369 | 34,750 | 27,319 |\n| Provision for income taxes | 4 | 516 | 728 | 547 |\n| Net income (loss) | $ | ( 4,907 ) | $ | 18,853 | $ | 34,022 | $ | 26,772 |\n| Comprehensive income (loss) | $ | ( 4,907 ) | $ | 18,853 | $ | 34,022 | $ | 26,772 |\n| Net income (loss) attributable to common unit holders | $ | ( 4,907 ) | $ | 18,853 | $ | 34,022 | $ | 26,772 |\n| Net income (loss) per unit, basic and diluted | $ | ( 0.05 ) | $ | 0.17 | $ | 0.31 | $ | 0.25 |\n| Weighted-average number of units outstanding, basic and diluted | 108,724,422 | 108,724,422 | 108,724,422 | 108,724,422 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements\n2\nTraeger, Inc.\nCONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN MEMBER’S EQUITY\n(unaudited)\n(in thousands, except unit amounts)\n| Three Months Ended June 30, 2021 and 2020 |\n| Common Units | Member’sCapital | AccumulatedDeficit | TotalMember’s Equity |\n| UnitsOutstanding | No ParValue |\n| Balance at March 31, 2021 | 108,724,422 | — | $ | 571,994 | $ | ( 57,069 ) | $ | 514,925 |\n| Equity-based compensation | — | — | 1,545 | — | 1,545 |\n| Net loss | — | — | — | ( 4,907 ) | ( 4,907 ) |\n| Balance at June 30, 2021 | 108,724,422 | — | $ | 573,539 | $ | ( 61,976 ) | $ | 511,563 |\n| Balance at March 31, 2020 | 108,724,422 | — | $ | 559,092 | $ | ( 119,681 ) | $ | 439,411 |\n| Equity-based compensation | — | — | 640 | — | 640 |\n| Net income | — | — | — | 18,853 | 18,853 |\n| Balance at June 30, 2020 | 108,724,422 | — | $ | 559,732 | $ | ( 100,828 ) | $ | 458,904 |\n| Six Months Ended June 30, 2021 and 2020 |\n| Common Units | Member’sCapital | AccumulatedDeficit | TotalMember’s Equity |\n| UnitsOutstanding | No ParValue |\n| Balance at December 31, 2020 | 108,724,422 | — | $ | 571,038 | $ | ( 95,998 ) | $ | 475,040 |\n| Equity-based compensation | — | — | 2,501 | — | 2,501 |\n| Net income | — | — | — | 34,022 | 34,022 |\n| Balance at June 30, 2021 | 108,724,422 | — | $ | 573,539 | $ | ( 61,976 ) | $ | 511,563 |\n| Balance at December 31, 2019 | 108,724,422 | — | $ | 558,478 | $ | ( 127,600 ) | $ | 430,878 |\n| Equity-based compensation | — | — | 1,254 | — | 1,254 |\n| Net income | — | — | — | 26,772 | 26,772 |\n| Balance at June 30, 2020 | 108,724,422 | — | $ | 559,732 | $ | ( 100,828 ) | $ | 458,904 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements\n3\nTraeger, Inc.\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(unaudited)\n(in thousands)\n| Six Months Ended June 30, |\n| 2021 | 2020 |\n| CASH FLOWS FROM OPERATING ACTIVITIES |\n| Net income | $ | 34,022 | $ | 26,772 |\n| Adjustments to reconcile net income to net cash provided by operating activities: |\n| Depreciation of property, plant and equipment | 4,497 | 3,326 |\n| Amortization of intangible assets | 16,942 | 16,593 |\n| Amortization of deferred financing costs | 1,373 | 1,344 |\n| Loss on disposal of property, plant and equipment | 51 | 50 |\n| Loss on extinguishment of debt | 1,957 | — |\n| Equity-based compensation expense | 2,501 | 1,254 |\n| Bad debt expense | 107 | — |\n| Unrealized loss on derivative contracts | 4,112 | 111 |\n| Change in operating assets and liabilities: |\n| Accounts receivable | ( 55,165 ) | ( 57,184 ) |\n| Inventories, net | ( 17,316 ) | 5,782 |\n| Prepaid expenses and other current assets | ( 1,420 ) | ( 1,908 ) |\n| Other long-term assets | ( 279 ) | — |\n| Accounts payable and accrued expenses | 24,798 | 16,398 |\n| Deferred rent | 13 | 34 |\n| Net cash provided by operating activities | 16,194 | 12,572 |\n| CASH FLOWS FROM INVESTING ACTIVITIES |\n| Purchase of property, plant, and equipment | ( 11,248 ) | ( 5,427 ) |\n| Acquisition of subsidiaries | — | ( 200 ) |\n| Capitalization of patent costs | ( 327 ) | ( 250 ) |\n| Proceeds from notes receivable | — | 21 |\n| Net cash used in investing activities | ( 11,575 ) | ( 5,856 ) |\n| CASH FLOWS FROM FINANCING ACTIVITIES |\n| Proceeds on line of credit | 65,000 | 57,000 |\n| Repayments on line of credit | ( 57,000 ) | ( 50,000 ) |\n| Proceeds from long-term debt | 510,000 | — |\n| Payment of deferred financing costs | ( 8,478 ) | ( 339 ) |\n| Repayments of long-term debt | ( 446,355 ) | ( 1,704 ) |\n| Principal payments on capital lease obligations | ( 184 ) | ( 154 ) |\n| Payment of deferred offering costs | ( 3,906 ) | — |\n| Net cash provided by financing activities | 59,077 | 4,803 |\n| Net increase in cash | 63,696 | 11,519 |\n| Cash at beginning of period | 11,556 | 7,077 |\n| CASH AT END OF PERIOD | $ | 75,252 | $ | 18,596 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements\n4\nTraeger, Inc.\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(unaudited)\n(in thousands)\n| (Continued) | Six Months Ended June 30, |\n| 2021 | 2020 |\n| SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: |\n| Cash paid during the period for interest | $ | 13,898 | $ | 12,113 |\n| Cash paid for income taxes | $ | 874 | $ | 76 |\n| NON-CASH FINANCING AND INVESTING ACTIVITIES |\n| Equipment purchased under capital leases | $ | 511 | $ | 257 |\n| Property, plant, and, equipment included in accounts payable | $ | 662 | $ | 1,264 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements\n5\nTraeger, Inc.\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n1 – DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION\nNature of Operations – TGPX Holdings I LLC and its wholly owned Subsidiaries (collectively “Traeger” or the “Company”) design, source, sell, and support wood pellet fueled barbeque grills sold to retailers, distributors, and direct to consumers. The Company produces and sells the pellets used to fire the grills and also sells Traeger-branded rubs, spices, and sauces, as well as grill accessories (including covers, barbeque tools, trays, liners, and merchandise). A significant portion of the Company’s sales are generated from customers throughout the United States (“U.S.”), and the Company continues to develop distribution in Canada and Europe. The Company’s headquarters are in Salt Lake City, Utah.\nIn July 2021, the Company effected a forward split of its 10 common units into 108,724,422 common units. All unit, per unit and related information presented in the accompanying consolidated financial statements have been retroactively adjusted, where applicable, to reflect the impact of the split of common units. As of June 30, 2021, the 108,724,422 common units in the Company were held by TGP Holdings LP and there were no potentially dilutive securities at the TGPX Holdings I LLC level. Accordingly, basic and diluted earnings per share presented on the Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) as of June 30, 2021 and 2020 are the same.\nImmediately prior to the effectiveness of the registration statement pertaining to the Company’s initial public offering (“IPO”) on July 28, 2021, the Company converted from a Delaware limited liability company into a Delaware corporation, and changed its name to Traeger, Inc. Pursuant to the statutory corporate conversion (the \"Corporate Conversion\"), all of the outstanding limited liability company interests of TGPX Holdings I LLC were converted into shares of common stock of Traeger, Inc., and TGP Holdings LP (the “Partnership”) became the holder of such shares of common stock of Traeger, Inc. In connection with the Corporate Conversion, the Partnership liquidated and distributed these shares of common stock to the holders of partnership interests in the Partnership in direct proportion to their respective interests in the Partnership based upon the value of Traeger, Inc. at the time of the IPO, with a value implied by the initial public offering price of the shares of common stock sold in the IPO. Based on the IPO price of $ 18.00 per share, following the Partnership’s liquidation and distribution, including the elimination of any fractional shares resulting therefrom, and the Corporate Conversion, the Company had 108,724,387 shares of common stock outstanding immediately prior to the IPO.\nPushdown Accounting – On September 25, 2017, AEA Investors LP, TCP Traeger Holdings SPV LLC, Ontario Limited, and other management and limited partners purchased a 100 % equity stake (the “Transaction”) in Traeger Pellet Grills Holdings LLC through a merger agreement in which TGP Holdings LP (“Purchaser”) was formed. TGPX Holdings I LLC was formed and became a wholly owned subsidiary of Purchaser on that date. Total consideration transferred by the Purchaser for the acquisition of Traeger Pellet Grills Holdings LLC was $ 954 million. The Company has applied pushdown accounting from the Transaction to recognize the fair value of assets acquired and liabilities assumed. This included recording newly established fair values for property, plant, and equipment and the recognition of identified intangibles and goodwill in the purchase price allocation.\nBasis of Presentation and Principles of Consolidation – The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (\"U.S. GAAP\") and with the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”) related to a quarterly report on Form 10-Q.\nThe year-end condensed consolidated balance sheet data was derived from the Company’s audited financial statements. These condensed consolidated financial statements should be read in conjunction with the Company's audited consolidated financial statements for the year ended December 31, 2020 included in the Company’s final prospectus for its IPO, filed pursuant to Rule 424(b) under the Securities Exchange Act of 1933, as amended, with the SEC on July 30, 2021 (the “Prospectus”).\nIn the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all normal and recurring adjustments necessary to fairly present the consolidated financial position, results of operations and cash flows for the interim periods presented. Operating results for the three and six months ended June 30, 2021 are not necessarily indicative of results that may be expected for any other interim period or for the year ending December 31, 2021.\nThe accompanying condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.\n6\nEmerging Growth Company Status – The Company is an “emerging growth company” as defined in the Jumpstart Our Business Startups Act of 2012 (“JOBS Act”). Under the JOBS Act, emerging growth companies can delay adopting new or revised financial accounting standards until such time as those standards apply to private companies. The Company has elected to use the extended transition period for complying with the adoption of new or revised accounting standards and as a result of this election, its financial statements may not be comparable to companies that comply with public company effective dates. The Company will remain an emerging growth company until the earliest of (i) the end of the fiscal year in which the market value of its common stock that is held by non-affiliates is at least $700 million as of the last business day of its most recently completed second fiscal quarter, (ii) the end of the fiscal year in which the Company has total annual gross revenues of $1.07 billion or more during such fiscal year, (iii) the date on which the Company issues more than $1.0 billion in non-convertible debt in a three-year period, or (iv) the end of the fiscal year in which the fifth anniversary of the Company’s IPO occurs, which will be December 31, 2026.\n2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nUse of Estimates – The preparation of these financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant estimates and the assumptions made by management that present the greatest amount of estimation uncertainty include business combination accounting for the fair value of assets acquired and liabilities assumed, customer credits and returns, obsolete inventory reserves, valuation and impairment of intangible assets including goodwill, unrealized positions on foreign currency derivatives and reserves for warranty. Actual results could differ from these estimates.\nConcentrations – Financial instruments that potentially subject the Company to concentrations of credit risk consist of cash in banks, trade accounts receivable and foreign currency contracts. Credit is extended to customers based on an evaluation of the customer’s financial condition and collateral is not generally required in the Company’s sales transactions. Three customers (each large U.S. retailers) that accounted for a significant portion of net sales are as follows:\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Customer A | 17 | % | 20 | % | 20 | % | 18 | % |\n| Customer B | 16 | % | 11 | % | 20 | % | 17 | % |\n| Customer C | 16 | % | 15 | % | 16 | % | 17 | % |\n\nAs of June 30, 2021, those same three customers accounted for a significant portion of trade accounts receivable of 15 %, 19 %, and 16 % for customers A, B, and C, respectively, compared to 18 %, 21 %, and 19 % as of December 31, 2020. Concentrations of credit risk exist to the extent credit terms are extended with these three large customers. A business failure on the part of any one the three customers could result in a material amount of exposure to the Company. No other single customer accounted for greater than 10% of the Company’s net sales for the three and six months ended June 30, 2021 and 2020, respectively. Additionally, no other single customer accounted for greater than 10% of trade accounts receivable as of June 30, 2021 and December 31, 2020.\nThe Company’s sales to dealers and distributors located outside the United States are generally denominated in U.S. dollars. The Company does have sales to certain dealers located in the European Union, the United Kingdom and Canada which are denominated in Euros, British Pounds and Canadian Dollars, respectively.\nThe Company relies on a limited number of suppliers for its contract manufacturing of grills and accessories. A significant disruption in the operations of certain of these manufacturers, or in the transportation of parts and accessories would impact the production of the Company’s products for a substantial period of time, which could have a material adverse effect on the Company’s business, financial condition and results of operations.\nRecently Issued Accounting Standards\nAs an “emerging growth company,” the Jumpstart Our Business Startups Act (“JOBS Act”), allows the Company to delay adoption of new or revised accounting pronouncements applicable to public companies until such pronouncements are made applicable to private companies. The Company has elected to use this extended transition period under the JOBS Act. There have been no material changes to the implementation or evaluation of “Recently Issued Accounting Standards” as described in the Company's annual audited financial statements for the period ended December 31, 2020.\n7\n3 – REVENUE\nThe following table disaggregates revenue by product category, geography, and sales channel for the periods indicated (in thousands):\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| Revenue by product category | 2021 | 2020 | 2021 | 2020 |\n| Grills | $ | 156,101 | $ | 111,419 | $ | 334,756 | $ | 194,593 |\n| Consumables | 41,178 | 32,221 | 81,991 | 56,015 |\n| Accessories | 15,743 | 9,550 | 31,848 | 16,365 |\n| Total revenue | $ | 213,022 | $ | 153,190 | $ | 448,595 | $ | 266,973 |\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| Revenue by geography | 2021 | 2020 | 2021 | 2020 |\n| North America | $ | 203,692 | $ | 149,642 | $ | 429,943 | $ | 259,080 |\n| Rest of world | 9,330 | 3,548 | 18,652 | 7,894 |\n| Total revenue | $ | 213,022 | $ | 153,190 | $ | 448,595 | $ | 266,973 |\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| Revenue by sales channel | 2021 | 2020 | 2021 | 2020 |\n| Retail | $ | 195,921 | $ | 137,526 | $ | 425,748 | $ | 245,905 |\n| Direct to consumer | 17,101 | 15,664 | 22,847 | 21,068 |\n| Total revenue | $ | 213,022 | $ | 153,190 | $ | 448,595 | $ | 266,973 |\n\n4 – BALANCE SHEET COMPONENTS\nAccounts receivable consists of the following (in thousands):\n| June 30,2021 | December 31,2020 |\n| Trade accounts receivable | $ | 137,977 | $ | 77,574 |\n| Allowance for doubtful accounts | ( 755 ) | ( 652 ) |\n| Reserve for returns, discounts and allowances | ( 17,324 ) | ( 12,082 ) |\n| Total accounts receivable, net | $ | 119,898 | $ | 64,840 |\n\nInventories consisted of the following (in thousands):\n| June 30,2021 | December 31,2020 |\n| Raw materials | $ | 3,629 | $ | 1,161 |\n| Work in process | 10,691 | 6,087 |\n| Finished goods | 71,831 | 61,587 |\n| Inventories, net | $ | 86,151 | $ | 68,835 |\n\nIncluded within inventories are adjustments of $ 0.0 million and $ 0.8 million at June 30, 2021 and December 31, 2020, respectively, to record inventory to net realizable value.\nAccrued expenses consisted of the following (in thousands):\n8\n| June 30,2021 | December 31,2020 |\n| Accrual for inventories in-transit | $ | 24,402 | $ | 27,012 |\n| Warranty accrual | 8,094 | 6,728 |\n| Accrued compensation and bonus | 4,995 | 6,179 |\n| Other | 34,392 | 14,778 |\n| Accrued expenses | $ | 71,883 | $ | 54,697 |\n\nThe changes in the Company’s warranty liability, included in accrued expenses on the accompanying condensed consolidated balance sheets, were as follows (in thousands):\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Warranty accrual, beginning of period | $ | 8,071 | $ | 5,132 | $ | 6,728 | $ | 4,798 |\n| Warranty claims | ( 2,205 ) | ( 2,062 ) | ( 3,666 ) | ( 3,256 ) |\n| Warranty costs accrued | 2,228 | 2,917 | 5,032 | 4,445 |\n| Warranty accrual, end of period | $ | 8,094 | $ | 5,987 | $ | 8,094 | $ | 5,987 |\n\n5 – DERIVATIVES\nThe Company is exposed to foreign currency exchange rate risk related to its purchases and international operations. The Company utilizes foreign currency contracts to manage foreign currency risk in purchasing inventory and capital equipment, and future settlement of foreign denominated assets and liabilities. The volume of the Company’s foreign currency contract activity is limited by the amount of transaction exposure in each foreign currency and the Company’s election as to whether to hedge the transactions. There are no derivative instruments entered into for speculative purposes.\nThe Company had outstanding foreign currency contracts as of June 30, 2021 and December 31, 2020. The Company did not elect hedge accounting for any of these contracts. All outstanding contracts are with the same counterparty and thus the fair market value of the contracts in an asset position are offset by the fair market value of the contracts in a liability position to reach a net position. For periods where the net position is an asset balance, the balance is recorded within prepaid expenses and other current assets on the consolidated balance sheet and for periods where the net position is a liability balance, the balance is recorded within derivative liabilities on the consolidated balance sheet. Changes in the net fair value of contracts are recorded in other expense, net in the consolidated statements of operations.\nThe Company’s only derivative transactions were foreign currency contracts. Gross and net balances from foreign currency contract positions were as follows (in thousands):\n| June 30,2021 | December 31,2020 |\n| Gross Asset Fair Value | $ | 2,148 | $ | 6,259 |\n| Gross Liability Fair Value | — | — |\n| Net Asset Fair Value | $ | 2,148 | $ | 6,259 |\n\nGains (losses) from foreign currency contracts were recorded in other income (expense), net within the accompanying consolidated statements of operations as follows (in thousands):\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Realized gain (loss) | $ | 2,899 | $ | 57 | $ | 5,448 | $ | ( 244 ) |\n| Unrealized gain (loss) | ( 763 ) | 389 | ( 4,112 ) | ( 111 ) |\n| Totals gains (loss) | $ | 2,136 | $ | 446 | $ | 1,336 | $ | ( 355 ) |\n\n6 – FAIR VALUE MEASUREMENTS\nFinancial assets and liabilities valued using Level 1 inputs are based on unadjusted quoted market prices within active markets. Financial assets and liabilities valued using Level 2 inputs are based primarily on observable trades and/or prices for similar\n9\nassets or liabilities in active or inactive markets. Financial assets and liabilities valued using Level 3 inputs are primarily valued using management’s assumptions about the assumptions market participants would utilize in pricing the asset or liability.\nThe following table presents information about the fair value measurement of the Company’s financial instruments (in thousands):\n| Financial Instruments Recorded at Fair Value on a Recurring Basis: | Fair ValueMeasurementLevel | As ofJune 30,2021 | As ofDecember 31,2020 |\n| Assets: |\n| Derivative assets—foreign currency contracts (1) | 2 | $ | 2,148 | $ | 6,259 |\n| Total assets | $ | 2,148 | $ | 6,259 |\n\n(1)Included in prepaid expenses and other current assets in the consolidated balance sheet\nTransfers of assets and liabilities among Level 1, Level 2 and Level 3 are recorded as of the actual date of the events or change in circumstances that caused the transfer. As of June 30, 2021 and December 31, 2020, there were no transfers between levels of the fair value hierarchy of the Company’s assets or liabilities measured at fair value.\nThe fair value of the Company’s derivative assets through its foreign currency contracts is based upon observable market-based inputs that reflect the present values of the differences between estimated future foreign currency rates versus fixed future settlement prices per the contracts, and therefore, are classified within Level 2.\nThe following financial instruments are recorded at their carrying amount (in thousands of dollars):\n| As of June 30, 2021 | As of December 31, 2020 |\n| Financial Instruments Recorded at Carrying Amount: | CarryingAmount | EstimatedFair Value | CarryingAmount | EstimatedFair Value |\n| Liabilities: |\n| Debt—First Lien (1) | $ | 510,000 | $ | 510,423 | $ | — | $ | — |\n| Debt—First Lien and Second Lien (2) | — | — | 446,355 | 439,253 |\n| Total liabilities | $ | 510,000 | $ | 510,423 | $ | 446,355 | $ | 439,253 |\n\n(1)Included in notes payable in the consolidated balance sheet. Due to the unobservable nature of the inputs these financial instruments are considered to be Level 3 instruments in the fair value hierarchy\n(2)The First Lien and Second Lien were refinanced and repaid on June 29, 2021.\n7 – DEBT AND FINANCING ARRANGEMENTS\nOn September 25, 2017, we entered into (i) a first lien credit agreement with various lenders (\"First Lien Credit Agreement\") and (ii) a second lien credit agreement with a syndicate of various lenders (\"Second Lien Credit Agreement\") and together with the First Lien Credit Agreement. On June 29, 2021, the Company refinanced its existing credit facilities and entered into a new First Lien Credit Agreement, as borrower, and Credit Suisse AG, Cayman Islands Branch, as administrative agent and collateral agent, and other lender parties thereto as joint lead arrangers and joint bookrunners (\"New First Lien Credit Agreement\"). The New First Lien Credit Agreement provides for a $ 560.0 million senior secured term loan facility (\"New First Lien Term Loan Facility\"), including a $ 50.0 million delayed draw term loan, and a $ 125.0 million revolving credit facility (\"New Revolving Credit Facility\").\nThe New First Lien Term Loan Facility accrues interest at a rate per annum that considers both fixed and floating components. The fixed component ranges from 3.00 % to 3.50 % per annum based on the consummation of a Qualifying Public Offering and our Public Debt Rating (each as defined in the New First Lien Credit Agreement). The floating component is based on the Eurocurrency Base Rate (as defined in the New First Lien Credit Agreement) for the relevant interest period. The New First Lien Term Loan Facility requires quarterly principal payments from December 2021 through June 2028, with any remaining unpaid principal and any accrued and unpaid interest due on the maturity date of June 29, 2028. The delayed draw term loan includes a variable commitment fee, which is based on the fixed interest rate and ranges from 0 % to the Applicable Rate (as defined in the New First Lien Credit Agreement). As of June 30, 2021, and the total principal amount outstanding on the New First Lien Term Loan Facility was $ 510.0 million, and the Company had not drawn on the delayed draw term loan.\n10\nLoans under the New Revolving Credit Facility, accrue interest at a rate per annum that considers both fixed and floating components. The fixed component ranges from 2.75 % to 3.50 % per annum based on the consummation of a Qualifying Public Offering and our most recently determined First Lien Net Leverage Ratio (as defined in the New First Lien Credit Agreement). The floating component is based on the Eurocurrency Base Rate for the relevant interest period. The New Revolving Credit Facility also has a variable commitment fee, which is based on our most recently determined First Lien Net Leverage Ratio and ranges from 0.25 % to 0.50 % per annum on undrawn amounts. Letters of credit may be issued under the New Revolving Credit Facility in an amount not to exceed $ 15.0 million which, when issued, lower the overall borrowing capacity of the facility. The New Revolving Credit Facility expires on June 29, 2026 and no principal payments are due before such date. As of June 30, 2021, there was no outstanding principal balance under the New Revolving Credit Facility.\nThe Company performed an analysis on a creditor-by-creditor basis for debt modifications and extinguishments to determine if repurchased debt was substantially different than debt issued to determine the appropriate accounting treatment of associated issuance costs. In connection with the refinancing, the Company recorded a $ 2.0 million loss from early extinguishment of debt in the condensed consolidated statements of operations and comprehensive income.\nIn connection with the New First Lien Credit Agreement, the Company paid financing costs totaling $ 8.4 million, of which $ 6.7 million related to the New First Lien Term Loan Facility and $ 1.7 million related to the New Revolving Credit Facility. The total financing costs included an original issue discount of $ 2.8 million. Costs incurred in connection with New First Lien Term Loan Facility were deferred and reflected net of notes payable and are amortized to interest expense utilizing the effective-interest method over the term of the loan. Costs incurred in connection with the delayed draw and revolving credit facility were deferred and recorded as other assets. These costs are being amortized to interest expense on a straight-line basis over the term of respective credit facilities.\nThe New First Lien Credit Agreement contains certain affirmative and negative covenants that limit our ability to, among other things, incur additional indebtedness or liens (with certain exceptions), make certain investments, engage in fundamental changes or transactions including changes of control, transfer or dispose of certain assets, make restricted payments (including dividends), engage in new lines of business, make certain prepayments and engage in certain affiliate transactions. In addition, we are subject to a financial covenant whereby we are required to maintain a First Lien Net Leverage Ratio (as defined in the New First Lien Credit Agreement) not to exceed 6.20 to 1.00. As of June 30, 2021, we were in compliance with the covenants under the prior Credit Facilities.\nAccounts Receivable Credit Facility\nOn June 29, 2021, we entered into Amendment No. 1 to the Receivables Financing Agreement (\"Amended Receivables Financing Agreement\") and increased the net borrowing capacity from the prior range of $ 30.0 million to $ 45.0 million up to $ 100.0 million. As of June 30, 2021, we had drawn down $ 8.0 million under this facility for general corporate and working capital purposes. We are required to pay an annual upfront fee for the facility, along with interest on outstanding cash advances of approximately 1.7 %, and an unused capacity charge that ranges from 0.25 % to 0.5 %. The facility is set to terminate on June 29, 2024.\n8 – COMMITMENTS AND CONTINGENCIES\nLegal Matters\nThe Company is subject to various claims, complaints and legal actions in the normal course of business. The Company does not believe it has any currently pending litigation of which the outcome will have a material adverse effect on its operations or financial position.\n9 – EQUITY-BASED COMPENSATION\nTGP Holdings LP established a management incentive equity pool, authorizing a maximum of 99,389 total units, or 15 % of the total authorized units, for purpose of compensatory awards to employees and certain directors of the Company. Under the Plan, eligible management employees and directors are granted a certain number of Class B Units of TGP Holdings LP which are considered to be profit interests. The participation threshold of the Class B Units is established for each grant based on the fair market value of TGP Holdings LP membership units at the date of the grant.\nThe Company recognized $ 1.5 million and $ 0.6 million for the three months ended June 30, 2021 and 2020, respectively of compensation expense in the accompanying condensed consolidated statements of operations. For the six months ended June 30, 2021 and 2020, the Company recognized compensation expense of $ 2.5 million and $ 1.3 million, respectively. As of June\n11\n30, 2021, total unrecognized compensation expense for unvested units totaled $ 4.4 million, and are expected to vest over a weighted average period of 2.4 years.\nAs the performance criteria related to the extraordinary performance units has not been achieved, and the achievement of the performance criteria has not been deemed to be probable at any time up to and including June 30, 2021, no equity-based compensation expense has been recorded related to these units. As of June 30, 2021, unrecognized compensation related to extraordinary performance units was $ 2.8 million.\n10 – INCOME TAXES\nFor the three months ended June 30, 2021 and 2020, the Company recorded a provision for income taxes of $ 0.0 million and $ 0.5 million, respectively. For the six months ended June 30, 2021 and 2020, the Company recorded a provision for income taxes of $ 0.7 million and $ 0.5 million, respectively.\nThe Company regularly evaluates the realizability of its deferred tax assets and establishes a valuation allowance if it is more likely than not that some or all the deferred tax assets will not be realized. In making such a determination, the Company considers all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, loss carryback and tax planning strategies. Generally, more weight is given to objectively verifiable evidence, such as the cumulative loss in recent years, as a significant piece of negative evidence to overcome.\n11 – RELATED PARTY TRANSACTIONS\nThe Company outsources a portion of its customer service and support through a third party who is an affiliate of the Company through common ownership. The total amount of expenses the Company recorded associated with such services totaled $ 4.2 million and $ 1.6 million for the six months ended June 30, 2021 and 2020, respectively. Amounts payable to the third party as of June 30, 2021 and December 31, 2020 was $ 1.7 million and $ 0.7 million, respectively.\n12 – EARNINGS (LOSS) PER UNIT\nThe Company discloses two calculations of earnings per member unit: basic earnings per unit and diluted earnings per unit. The numerator in calculating basic earnings per unit and diluted earnings per unit is consolidated net income. The denominator in calculating basic earnings per unit is the weighted average units outstanding. The denominator for diluted earnings per unit is the same as basic because there were no potential dilutive common units outstanding.\nThe computation of basic and diluted earnings per common unit is as follows (in thousands, except unit and per unit amounts):\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Net income (loss) available to members—basic and diluted | $ | ( 4,907 ) | $ | 18,853 | $ | 34,022 | $ | 26,772 |\n| Weighted average number of units—basic and diluted | 108,724,422 | 108,724,422 | 108,724,422 | 108,724,422 |\n| Earnings (loss) per unit—basic and diluted | $ | ( 0.05 ) | $ | 0.17 | $ | 0.31 | $ | 0.25 |\n\nThere were no potentially dilutive securities outstanding as of June 30, 2021 and June 30, 2020. Equity-based compensation awards are granted at a parent level above the Company’s consolidation results and the expense related to those awards is pushed down to the Company.\n13 - SUBSEQUENT EVENTS\nThe Company has evaluated subsequent events through September 9, 2021, the date the Condensed Consolidated Financial Statements were available to be issued.\nOn July 1, 2021, the Company acquired all of the equity interests of Apption Labs Limited and its subsidiaries. Apption Labs Limited specializes in the manufacture and design of innovative hardware and software related to small kitchen appliances. This acquisition will help facilitate the Company’s entry into the adjacent accessories market and bolster its existing portfolio with a complementary product. Total consideration for the acquisition included $ 60.0 million of cash paid at time of closing and up to $ 40 million in contingent consideration based on achievement of certain revenue thresholds for fiscal 2021 and 2022.\n12\nThe Company has not finalized its accounting for the Apption Labs acquisition as this transaction recently occurred on July 1, 2021 and therefore, is unable to disclose preliminary accounting. The assets and liabilities acquired or that will result from the acquisition, include cash, fixed assets, accounts receivable, inventory, technology, intangible assets, contingent liabilities, and goodwill. All areas of the purchase accounting are not yet finalized, including the valuation of i) receivables, ii) intangible assets; iii) deferred purchase consideration, iv) inventory, and v) fixed assets. Additionally, the purchase price allocation is provisional for income tax-related matters. The Company anticipates reporting the preliminary purchase accounting associated with the acquisition in connection with the filing of its third quarter 2021 financial statements.\nOn July 12, 2021, the Board approved the acceleration of vesting of all unvested and outstanding Class B unit awards, subject to the successful completion of an initial public offering of the Company. The approval for the acceleration of vesting was determined to be a modification. As a result, the Company evaluated each of the modified awards to determine the necessary accounting. At the time of the initial public offering, awards where vesting was probable prior to and after the modification, will result in an acceleration of the remaining expense based on the original grant date fair value and awards where vesting was not probable, will result in recognition of the fair value of the modified awards as of the modification date.\nThe Company has estimated the fair value of the Class B unit awards on the date of modification using the midpoint of the preliminary price range related to the initial public offering, after giving effect to the conversion of vested Class B units into shares of the Company’s common stock. The conversion of the Class B units into shares of common stock will be determined by applying the equity value associated with existing Class A and Class B units and assuming the equity value is distributed to each unit in accordance with the order of cash distributions required by the TGP Holdings LP limited partnership agreement.\nIn connection with the completion of the Company’s initial public offering, based on the initial public offering price of $ 18.00 per share the Company estimates that it will incur aggregate equity compensation expense of approximately $ 47.4 million as a result of the acceleration of vesting of the unvested Class B unit awards. Given the proximity of the modification to the initial public offering, the actual expense to be recorded by the Company will be based on the actual conversion of the Class B units into common stock and the valuation of the Company at time of the initial public offering.\nOn July 20, 2021, the Board approved 12,163,242 restricted stock unit (“RSU”) awards that became effective in connection with the completion of the Company’s initial public offering, which include RSUs granted to our Chief Executive Officer and to other employees, directors, and certain non-employees. The awards include a combination of time-based and performance based awards. The Company estimates the grant date fair value of the RSU awards to the Chief Executive Officer would be approximately $ 116.6 million, which would be expected to be recognized as compensation expense over a weighted average period of 4.94 years, and the grant date fair value of the RSU awards to other employees, directors, and certain non-employees would be approximately $ 73.2 million, which would be expected to be recognized as compensation expense over a weighted average period of 3.52 years.\nIn connection with the IPO, the board of directors and stockholders approved a certificate of incorporation to provide for 1,000,000,000 authorized shares of common stock with a par value of $ 0.0001 per share and 25,000,000 shares of preferred stock with a par value of $ 0.0001 per share.\nOn August 2, 2021, the Company completed the IPO in which the Company issued and sold 8,823,529 shares of common stock at a public offering price of $ 18.00 per share. The Company’s aggregate gross proceeds from the sale of shares in the IPO $ 158.8 million before underwriter discounts and commissions, fees and expenses of $ 18.3 million.\nOn August 11, 2021 the Company utilized proceeds received in connection with the initial public offering and repaid $ 130.8 million on its outstanding first lien term loan.\n13\nITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nThe following discussion and analysis of financial condition and operating results should be read together with our consolidated financial statements and the related notes and other financial information included elsewhere in this Quarterly Report on Form 10-Q, as well as our audited consolidated financial statements and the related notes included in our final prospectus for our initial public offering (the “IPO”), filed with the Securities and Exchange Commission (the “SEC”), on July 30, 2021 (the “Prospectus”). Some of the information contained in this discussion and analysis or set forth elsewhere in this Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. As a result of many important factors, such as those set forth in the “Risk Factors” section of this Quarterly Report on Form 10-Q, our actual results may differ materially from those anticipated in these forward-looking statements. For convenience of presentation some of the numbers have been rounded in the text below.\nOverview\nTraeger is the creator and category leader of the wood pellet grill, an outdoor cooking system that ignites all-natural hardwoods to grill, smoke, bake, roast, braise, and barbeque. Our grills are versatile and easy to use, empowering cooks of all skillsets to create delicious meals with a wood-fired flavor that cannot be replicated with gas, charcoal, or electric grills. Grills are at the core of our platform and are complemented by Traeger wood pellets, rubs, sauces, and accessories.\nOur marketing strategy has been instrumental in building our brand and driving customer advocacy and revenue. We have disrupted the outdoor cooking market and created a passionate community, the Traegerhood, which includes foodies, pitmasters, backyard heroes, moms and dads, professional athletes, outdoorsmen and outdoorswomen, and world-class chefs. This community, together with our various marketing initiatives, has helped to promote our brand and products to the wider consumer population and supported our efforts to redefine outdoor cooking as an experience accessible to everyone. We have an active online and social media presence and a content-rich website that drives significant customer engagement and brings our Traegerhood together. We also directly engage with our current and target customers by sponsoring and participating in a variety of events, including live shows, outdoor festivals, rodeos, music and film festivals, barbecue competitions, fishing tournaments, and retailer events. We believe the style and authenticity of our customer engagement reinforces our brand and drives new and existing customer interest in our products and community.\nOur revenue is primarily generated through the sale of our wood pellet grills, consumables, and accessories. We currently offer three series of grills – Pro, Ironwood and Timberline – as well as a selection of smaller, portable grills. Our grills are available in a number of different sizes and can be upgraded through a variety of accessories. A growing number of our grills feature WiFIRE technology, which allows users to monitor and adjust their grills remotely using our Traeger app. Our consumables include our wood pellets, which are made from natural, virgin hardwood and are available in a variety of flavors, as well as rubs, sauces, and other food items. Our accessories include grill covers, liners, tools, apparel and other ancillary items.\nWe sell our grills using an omnichannel distribution strategy that consists primarily of retail and direct to consumer (\"DTC\") channels. Our retail channel covers brick-and-mortar retailers, e-commerce platforms, and multichannel retailers, who, in turn, sell our grills to their end customers. Our retailers include Ace Hardware, Amazon.com, Costco, The Home Depot, and William Sonoma, among others, as well as a significant number of independent retailers that cater to local communities and specific categories, such as hardware, camping, outdoor, farm, ranch, barbecue and other categories. Our DTC channel covers sales directly to customers through our website and Traeger app, as well as certain country- and region-specific Traeger or distributor websites. Our consumables and accessories are available through the same channels as our grills.\nOver the last several years, we have made significant investments in our supply chain and manufacturing operations. Our supply chain includes third party manufacturers for our grills and accessories and pellet production facilities for our wood pellets that we own or lease. We work closely with our manufacturers to evolve on design, manufacturing process and product quality. Our grills are currently manufactured in China and Vietnam, and our wood pellets are produced at facilities located in New York, Oregon, Georgia, and Texas. We have entered into manufacturing agreements covering the supply of substantially all of our grills and accessories, pursuant to which we make purchases on a purchase order basis. We rely on several third-party suppliers for the components used in our grills, including integrated circuits, processors, and system on chips.\nWe believe our financial results have reflected our growth. Our revenue increased by 68.0% for the six months ended June 30, 2021 as compared to the six months ended June 30, 2020, and reached $448.6 million for the six months ended June 30, 2021, up from $267.0 million for the six months ended June 30, 2020. Our net income was $34.0 million for the six months ended June 30, 2021, compared to $26.8 million for the six months ended June 30, 2020. Our Adjusted EBITDA reached $91.1 million for the six months ended June 30, 2021, up from $67.9 million for the six months ended June 30, 2020. Adjusted\n14\nEBITDA is a non-GAAP financial measure. For a reconciliation of Adjusted EBITDA to the most directly comparable GAAP financial measure, information about why we consider Adjusted EBITDA useful and a discussion of the material risks and limitations of this measure, please see “non-GAAP Financial Measures” below.\nCorporate Conversion and Initial Public Offering\nImmediately prior to the effectiveness of our IPO registration statement on July 28, 2021, TGPX Holdings I LLC converted from a Delaware limited liability company into a Delaware corporation, and changed its name to Traeger, Inc. Pursuant to the statutory corporate conversion (the \"Corporate Conversion\"), all of the outstanding limited liability company interests of TGPX Holdings I LLC were converted into shares of common stock of Traeger, Inc., and TGP Holdings LP (the “Partnership”) became the hold of such shares of common stock of Traeger, Inc. In connection with the Corporate Conversion, the Partnership liquidated and distributed these shares of common stock to the holders of partnership interests in the Partnership in direct proportion to their respective interests in the Partnership based upon the value of Traeger, Inc. at the time of the IPO, with a value implied by the initial public offering price of the shares of common stock sold in the IPO. Based on the IPO price of $18.00 per share, following the Partnership’s liquidation and distribution, including the elimination of any fractional shares resulting therefrom, and the Corporate Conversion, we had 108,724,387 shares of common stock outstanding immediately prior to the IPO.\nOn August 2, 2021, we completed our IPO in which we issued and sold 8,823,529 shares of common stock at a public offering price of $18.00 per share, generating aggregate gross proceeds of $158.8 million before underwriter discounts and commissions, fees and expenses of $18.3 million. Additionally, certain selling stockholders sold an aggregate of 18,235,293 shares (including 3,529,411 shares pursuant to the underwriters’ exercise of their option to purchase additional shares).\nKey Factors Affecting Our Performance\nWe believe that our financial condition and results of operations have been, and will continue to be, affected by a number of factors, that present significant opportunities for us but also pose risks and challenges. For discussion of these factors, please see “Key Factors Affecting Our Performance” in the Management’s Discussion and Analysis section of our prospectus, dated July 28, 2021, and in Part II, Item 1A, “Risk Factors” of this Quarterly Report on Form 10-Q for the quarter ended June 30, 2021.\nNon-GAAP Financial Measures\nIn addition to our results and measures of performance determined in accordance with U.S. GAAP, we believe that certain non-GAAP financial measures are useful in evaluating and comparing our financial and operational performance over multiple periods, identifying trends affecting our business, formulating business plans and making strategic decisions.\nEach of Adjusted EBITDA and Adjusted Net Income is a key performance measure that our management uses to assess our financial performance and is also used for internal planning and forecasting purposes. We believe that these non-GAAP financial measures are useful to investors and other interested parties in analyzing our financial performance because it provides a comparable overview of our operations across historical periods. In addition, we believe that providing each of Adjusted EBITDA and Adjusted Net Income, together with a reconciliation of net income (loss) to each such measure, helps investors make comparisons between our company and other companies that may have different capital structures, different tax rates, and/or different forms of employee compensation. For example, due to finite-lived intangible assets included on our balance sheet following our corporate reorganization in 2017, we have significant non-cash amortization expense attributable to the nature of our capital structure.\nEach of Adjusted EBITDA and Adjusted Net Income is used by our management team as an additional measure of our performance for purposes of business decision-making, including managing expenditures, and evaluating potential acquisitions. Period-to-period comparisons of Adjusted EBITDA and Adjusted Net Income help our management identify additional trends in our financial results that may not be shown solely by period-to-period comparisons of net income or income from continuing operations. In addition, we may use Adjusted EBITDA in the incentive compensation programs applicable to some of our employees. Each of Adjusted EBITDA and Adjusted Net Income has inherent limitations because of the excluded items, and may not be directly comparable to similarly titled metrics used by other companies.\nWe calculate Adjusted EBITDA as net income (loss) adjusted to exclude provision for income taxes, other (income) expense, interest expense, depreciation and amortization, equity-based compensation, non-routine legal expenses, non-routine start-up costs, offering related expenses, and non-routine refinancing expenses. Other (income) expense are gains (losses) on disposal of property, plant and equipment, impairments of long-term assets, and unrealized gains (losses) from derivatives.\n15\nNon-routine legal expenses are primarily external legal expenses for litigation, patent and trademark defense, and legal costs related to an acquisition. Non-routine start-up costs represent investments in a new product category. Offering related expenses are primarily for legal and consulting costs incurred in connection with our IPO process. Adjusted EBITDA Margin represents Adjusted EBITDA as a percentage of revenue. Adjusted EBITDA and Adjusted EBITDA Margin should be viewed as measures of operating performance that are supplements to, and not substitutes for, operating income or loss, net earnings or loss and other U.S. GAAP measures of income (loss). The following table presents a reconciliation of net income (loss), the most directly comparable financial measure calculated in accordance with U.S. GAAP, to Adjusted EBITDA on a consolidated basis.\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| (dollars in thousands) |\n| Net income (loss) | $ | (4,907) | $ | 18,853 | $ | 34,022 | $ | 26,772 |\n| Adjusted to exclude the following: |\n| Provision for income taxes | 4 | 516 | 728 | 547 |\n| Other (income) expense | 2,720 | (351) | 6,068 | 166 |\n| Interest expense | 7,877 | 9,063 | 15,689 | 18,248 |\n| Depreciation and amortization | 10,740 | 10,119 | 21,439 | 19,947 |\n| Equity-based compensation | 1,545 | 640 | 2,501 | 1,254 |\n| Non-routine legal expenses | 1,512 | 434 | 2,754 | 976 |\n| Non-routine start-up costs | 2,980 | — | 2,980 | — |\n| Offering related expenses | 666 | — | 1,035 | — |\n| Non-routine refinancing expenses | 3,895 | — | 3,895 | — |\n| Adjusted EBITDA | $ | 27,032 | $ | 39,274 | $ | 91,111 | $ | 67,910 |\n| Revenue | 213,022 | 153,190 | 448,595 | 266,973 |\n| Net income (loss) as a percentage of revenue | (2.3) | % | 12.3 | % | 7.6 | % | 10.0 | % |\n| Adjusted EBITDA Margin | 12.7 | % | 25.6 | % | 20.3 | % | 25.4 | % |\n\nWe calculate Adjusted Net Income as net income (loss) adjusted to exclude other (income) expense, equity-based compensation, non-routine legal expenses, amortization of acquisition intangibles, non-routine start-up costs, offering related expenses, and non-routine refinancing expenses. Amortization of acquisition intangibles includes amortization expense associated with intangible assets recorded in connection with the 2017 acquisition of Traeger Pellet Grills Holdings LLC. Adjusted Net Income should be viewed as a measure of operating performance that is a supplement to, and not a substitute for, operating income or loss, net earnings or loss and other U.S. GAAP measures of income (loss). The following table presents a reconciliation of net income (loss), the most directly comparable financial measure calculated in accordance with U.S. GAAP, to Adjusted Net Income on a consolidated basis.\n16\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| (dollars in thousands) |\n| Net income (loss) | $ | (4,907) | $ | 18,853 | $ | 34,022 | $ | 26,772 |\n| Adjusted to exclude the following: |\n| Other (income) expense | 2,720 | (351) | 6,068 | 166 |\n| Equity-based compensation | 1,545 | 640 | 2,501 | 1,254 |\n| Non-routine legal expenses | 1,512 | 434 | 2,754 | 976 |\n| Amortization of acquisition intangibles | 8,253 | 8,253 | 16,507 | 16,507 |\n| Non-routine start-up costs | 2,980 | — | 2,980 | — |\n| Offering related expenses | 666 | — | 1,035 | — |\n| Non-routine refinancing expenses | 3,895 | — | 3,895 | — |\n| Tax impact of adjusting items | — | — | — | — |\n| Adjusted Net Income | $ | 16,664 | $ | 27,829 | $ | 69,762 | $ | 45,675 |\n\nImpact of COVID-19\nThe COVID-19 pandemic has caused various elements of disruption to economies, businesses, markets and communities around the globe. In the interest of public health, many governments closed physical stores and business locations deemed to be non-essential, which drove higher unemployment levels and resulted in the closure of certain businesses. The COVID-19 pandemic has had a variety of impacts to the businesses of our retailers and suppliers, as well as customer behavior and discretionary spending. Although we cannot predict when the United States and global economy will fully recover from the COVID-19 pandemic, we believe that our business is well positioned to attract new customers, capitalize on existing and growing trends in our industry and benefit from the revival of the economy and discretionary spending. Nevertheless, we do not have certainty that a full economic recovery will happen in the near future, and it is possible that the prolonging of the COVID-19 pandemic could have certain adverse effects on our business, financial condition, and results of operations. Furthermore, our growth in the past year may obscure the extent to which seasonality and other trends have affected our business and may continue to affect our business. For more information regarding the potential impact of the COVID-19 pandemic on our business, refer to Part II, Item 1A“Risk Factors” in this Quarterly Report on Form 10-Q.\nIn response to the COVID-19 pandemic, we quickly developed a plan of action that focused first on the health and safety of our employees. In March 2020, we implemented a work-from-home policy and began to establish safety measures at our wood pellet production facilities. Next, we took immediate action to protect our liquidity. These actions included reductions in discretionary spending and capital expenditures, a temporary hiring freeze, employee furloughs, and a reduction in our inventory purchase plan. At the end of the first quarter of 2020, we drew down the available capacity under our revolving credit facility to increase cash to sustain our operations. We also focused on business continuity across our value chain and operations, and made strategic pivots and reprioritized key initiatives to focus on our immediate response to the COVID-19 pandemic and maintain a nimble approach to our long-term strategy as we continued to monitor the situation. We have started to return a portion of our remote workforce to physical locations. We do not believe remote operations or our cost reduction initiatives have significantly impacted the productivity of our workforce or operations, or resulted in meaningful disruption to our sales activities or ongoing revenue generation.\nThe sale of our grills, consumables and accessories experienced considerable growth following the onset of the COVID-19 pandemic as people invested in recreational activities based around the home during periods of quarantine and limited public activities. At the beginning of the second quarter of 2020 as the impact of governmental pandemic-related measures on business activity took hold, we experienced sustained demand for our products as many of our specialty and hardware retailers were deemed essential by state and local governments and thus remained open to customers. In addition, consumer purchase behavior shifted to online retail, including our own website, which offset the impact of select store closures and stay-at-home orders. As the second quarter of 2020 progressed, we began experiencing significant demand across our distribution channels as customer interest in our products increased, retail stores began to reopen and online retail continued to benefit from favorable shifts in consumer purchase behavior. This strong demand continued throughout the second half of 2020, and we believe that this was a primary driver of our revenue growth during 2020. Together with the increased demand for our products, we experienced higher costs and supply chain delays as a result of restrictions or disruptions of transportation as a result of the pandemic. Late in the first quarter of 2020, we reduced inventory purchase orders as a precautionary measure against the unknown impact of the COVID-19 pandemic on the economy and our business and to improve financial flexibility.\n17\nThese actions, coupled with the overall strong demand during 2020, ultimately contributed to lower than expected inventory levels throughout the second half of 2020 and, in turn, resulted in inventory constraints in the second half of 2020 and continued into early 2021.\nComponents of Results of Operations\nRevenue\nWe derive substantially all of our revenue from the sale of grills, consumables, and accessories in North America, which includes the United States and Canada. We recognize revenue, net of product returns, for our grills, consumables, and accessories generally at the time of delivery to retailers through our retail channel and to customers through our DTC channel. Estimated product returns are recorded as a reduction of revenue at the time of recognition and are calculated based on product returns history, observable changes in return behavior, and expected returns based on sales volume and mix. We also have certain contractual programs that can give rise to elements of variable consideration, such as volume incentive rebates, with estimated amounts of credits recorded as a reduction to revenue.\nAlthough we experience demand for our products throughout the year, we believe there can be certain seasonal fluctuations in our revenue. We have typically experienced moderately higher levels of sales of our grills in the first and second quarters of the year as our retailers purchase inventory in advance of warmer weather, when demand for outdoor cooking products is the highest across our key markets. Higher sales also coincide with social events and national holidays, which occur during the same warm weather timeframe.\nGross Profit\nGross profit reflects revenue less cost of revenue. Cost of revenue consists of product costs, including the costs of components, costs of products from our third-party manufacturers, direct and indirect manufacturing costs across all products, packaging, inbound freight and duties, warehousing and fulfillment, warranty costs, product quality testing and inspection costs, excess and obsolete inventory write-downs, cloud-hosting costs for our WiFIRE connected grills, depreciation of tooling and manufacturing equipment, amortization of internal use software and patented technology, and certain employee-related expenses.\nWe calculate gross margin as gross profit divided by revenue. Gross margin can be impacted by several factors, including, in particular, product mix and sales channel mix. For example, gross margin on sales through our DTC channel is generally higher than gross margin on sales through our retail channel. If our DTC sales grow faster than sales from our retail channel, and if we are able to realize greater economies of scale or product cost improvements through engineering and sourcing, we would expect a favorable impact to overall gross margin over time. Additionally, gross margin on sales of certain of our products is higher than for others. If revenue from sales of wood pellets increased as a percentage of total revenue, we would expect to see an increase in overall gross margin. These favorable anticipated gross margin impacts may not be realized, or may be offset by other unfavorable gross margin factors. Additionally, any new products that we develop, or our planned expansion into new geographies, may impact our future gross margin. External factors beyond our control, such as duties and tariffs and costs of doing business in certain geographies can also impact gross margin.\nSales and Marketing\nSales and marketing expense consists primarily of the costs associated with advertising and marketing of our products and employee-related expenses, including salaries, benefits, and equity-based compensation expense, as well as sales incentives and professional services. These costs can include print, internet and television advertising, travel-related expenses, direct customer acquisition costs, costs related to conferences and events, and broker commissions. We expect our sales and marketing expense to increase on an absolute dollar basis for the foreseeable future as we continue to increase the scope of outreach to potential new customers to drive our revenue growth. We also anticipate that sales and marketing expense as a percentage of revenue will fluctuate from period to period based on revenue for such period and the timing of the expansion of our sales and marketing functions, as these activities may vary in scope and scale over future periods.\nGeneral and Administrative\nGeneral and administrative expense consists primarily of employee-related expenses and facilities for our executive, finance, accounting, legal, human resources, information technology and other administrative functions. General and administrative expense also includes fees for professional services, such as external legal, accounting, and information and technology services, and insurance.\n18\nIn addition, general and administrative expense includes research and development expenses incurred to develop and improve our future products and processes, which primarily consist of employee and facilities-related expenses, including salaries, benefits and equity-based compensation expense, as well as fees for professional services, costs related to prototype tooling and materials, and software platform costs. Research and development expense was $5.8 million and $2.5 million for the six months ended June 30, 2021 and 2020, respectively.\nWe expect general and administrative expense, including our research and development expenses and external legal and accounting expenses, to increase on an absolute dollar basis for the foreseeable future as we continue to increase investments to support our growth and develop new and enhance existing products and interactive software. We also anticipate increased administrative and compliance costs as a result of becoming a public company. We anticipate that general and administrative expense as a percentage of revenue will vary from period to period, but we expect to leverage these expenses over time as we grow our revenue.\nAmortization of Intangible Assets\nAmortization of intangible assets primarily consists of amortization of identified finite-lived customer relationship and trademark assets that were allocated a considerable portion of the purchase price from the corporate reorganization and acquisition of our business in 2017. These costs are amortized on a straight-line basis over 17 to 25 year useful lives and, as a result, amortization expense on these assets is expected to remain stable over the coming years. Future business acquisitions may result in incremental amortization of intangible assets acquired in any such transactions.\nTotal Other Income (Expense), Net\nTotal other income (expense), net consists of interest expense and other income (expense). Interest expense includes interest and other fees associated with our credit facilities and receivables financing agreement. Other income (expense) also consists of any gains (losses) on the sale of long-lived assets and from the foreign currency contracts that we use to manage our exposure to foreign currency exchange rate risk related to our purchases and international operations.\n19\nResults of Operations\nThe following tables summarize key components of our results of operations for the periods presented. The period-to-period comparisons of our historical results are not necessarily indicative of the results that may be expected in the future.\n| Three Months EndedJune 30, | Change | Six Months EndedJune 30, | Change |\n| 2021 | 2020 | Amount | % | 2021 | 2020 | Amount | % |\n| (unaudited) |\n| (dollars in thousands) |\n| Revenue | $ | 213,022 | $ | 153,190 | $ | 59,832 | 39.1 | % | $ | 448,595 | $ | 266,973 | $ | 181,622 | 68.0 | % |\n| Cost of revenue | 129,715 | 86,502 | 43,213 | 50.0 | % | 264,657 | 148,530 | 116,127 | 78.2 | % |\n| Gross profit | 83,307 | 66,688 | 16,619 | 24.9 | % | 183,938 | 118,443 | 65,495 | 55.3 | % |\n| Operating expense: |\n| Sales and marketing | 47,269 | 20,985 | 26,284 | 125.3 | % | 78,120 | 37,703 | 40,417 | 107.2 | % |\n| General and administrative | 24,802 | 9,306 | 15,496 | 166.5 | % | 38,358 | 18,310 | 20,048 | 109.5 | % |\n| Amortization of intangible assets | 8,301 | 8,132 | 169 | 2.1 | % | 16,602 | 16,263 | 339 | 2.1 | % |\n| Total operating expenses | 80,372 | 38,423 | 41,949 | 109.2 | % | 133,080 | 72,276 | 60,804 | 84.1 | % |\n| Income from operations | 2,935 | 28,265 | (25,330) | (89.6) | % | 50,858 | 46,167 | 4,691 | 10.2 | % |\n| Other income (expense), net: |\n| Interest expense | (7,877) | (9,063) | 1,186 | (13.1) | % | (15,689) | (18,248) | 2,559 | (14.0) | % |\n| Loss on extinguishment of debt | (1,957) | — | (1,957) | 100.0 | % | (1,957) | — | (1,957) | 100.0 | % |\n| Other income (expense) | 1,996 | 167 | 1,829 | n.m. | 1,538 | (600) | 2,138 | n.m. |\n| Total other income (expense), net | (7,838) | (8,896) | 1,058 | (11.9) | % | (16,108) | (18,848) | 2,740 | (14.5) | % |\n| Income (loss) before provision for income taxes | (4,903) | 19,369 | (24,272) | (125.3) | % | 34,750 | 27,319 | 7,431 | 27.2 | % |\n| Provision for income taxes | 4 | 516 | (512) | (99.2) | % | 728 | 547 | 181 | 33.1 | % |\n| Net income (loss) | $ | (4,907) | $ | 18,853 | $ | (23,760) | (126.0) | % | $ | 34,022 | $ | 26,772 | $ | 7,250 | 27.1 | % |\n\nComparison of the Three Months Ended June 30, 2021 and 2020\nRevenue\n| Three Months EndedJune 30, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Revenue: |\n| Grills | $ | 156,101 | $ | 111,419 | $ | 44,682 | 40.1 | % |\n| Consumables | 41,178 | 32,221 | 8,957 | 27.8 | % |\n| Accessories | 15,743 | 9,550 | 6,193 | 64.8 | % |\n| Total Revenue | $ | 213,022 | $ | 153,190 | $ | 59,832 | 39.1 | % |\n\nRevenue increased by $59.8 million, or 39.1%, to $213.0 million for the three months ended June 30, 2021 compared to $153.2 million for the three months ended June 30, 2020. This increase was driven by strong demand for our grills, consumables, and accessories.\nRevenue from our grills grew by $44.7 million, or 40.1%, to $156.1 million for the three months ended June 30, 2021 compared to $111.4 million for the three months ended June 30, 2020. This increase was driven by higher unit volume compared to the prior period.\nRevenue from our consumables grew by $9.0 million, or 27.8%, to $41.2 million for the three months ended June 30, 2021 compared to $32.2 million for the three months ended June 30, 2020. This increase was driven by repeating sales of wood\n20\npellets and other consumables from our installed base of grills, as well as increased unit volume associated with the expansion of our installed base of grills.\nRevenue from our accessories grew by $6.2 million, or 64.8%, to $15.7 million for the three months ended June 30, 2021 compared to $9.6 million for the three months ended June 30, 2020. This increase was driven by increased unit volume associated with the higher volume of grills sold.\nGross Profit\n| Three Months EndedJune 30, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Gross profit | $ | 83,307 | $ | 66,688 | $ | 16,619 | 24.9 | % |\n| Gross margin (Gross profit as a percentage of revenue) | 39.1 | % | 43.5 | % |\n\nGross profit increased by $16.6 million, or 24.9%, to $83.3 million for the three months ended June 30, 2021 compared to $66.7 million for the three months ended June 30, 2020. Gross margin as a percentage of revenue decreased to 39.1% for the three months ended June 30, 2021 from 43.5% for the three months ended June 30, 2020. The decrease in gross margin was driven by increased shipping costs and appreciation of the Chinese Renminbi relative to the U.S. Dollar.\nSales and Marketing\n| Three Months EndedJune 30, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Sales and marketing | $ | 47,269 | $ | 20,985 | $ | 26,284 | 125.3 | % |\n| As a percentage of revenue | 22.2 | % | 13.7 | % |\n\nSales and marketing expense increased by $26.3 million, or 125.3%, to $47.3 million for the three months ended June 30, 2021 compared to $21.0 million for the three months ended June 30, 2020. As a percentage of revenue, sales and marketing expense increased to 22.2% for the three months ended June 30, 2021 from 13.7% for the three months ended June 30, 2020. The increase in sales and marketing expense was driven by an increase in advertising costs to drive customer awareness, demand, and conversion, higher professional services expense primarily related to consulting and third-party customer service support, an increase in commission expense as sales increased and brand ambassadors performed a higher number of roadshows, and higher personnel-related expenses associated with an increase in headcount in our marketing, customer experience, and sales functions.\nGeneral and Administrative\n| Three Months EndedJune 30, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| General and administrative | $ | 24,802 | $ | 9,306 | $ | 15,496 | 166.5 | % |\n| As a percentage of revenue | 11.6 | % | 6.1 | % |\n\nGeneral and administrative expense increased by $15.5 million, or 166.5%, to $24.8 million for the three months ended June 30, 2021 compared to $9.3 million for the three months ended June 30, 2020. As a percentage of revenue, general and administrative expense increased to 11.6% for the three months ended June 30, 2021 from 6.1% for the three months ended June 30, 2020. The increase in general and administrative expense was driven by professional services fees related to third party costs incurred in connection with our refinancing of long-term debt and consulting services, higher personnel-related expenses associated with investments to build a team to support our current and future growth, and higher utilization of legal services.\n21\nAmortization of Intangible Assets\n| Three Months EndedJune 30, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Amortization of intangible assets | $ | 8,301 | $ | 8,132 | $ | 169 | 2.1 | % |\n| As a percentage of revenue | 3.9 | % | 5.3 | % |\n\nAmortization of intangible assets, substantially attributable to the 2017 acquisition of the Company, increased $0.2 million, or 2.1%, to $8.3 million for the three months ended June 30, 2021 compared to $8.1 million for the three months ended June 30, 2020.\nOther Expense, Net\n| Three Months EndedJune 30, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Interest expense | $ | (7,877) | $ | (9,063) | $ | (1,186) | (13.1) | % |\n| Loss on extinguishment of debt | (1,957) | — | 1,957 | 100.0 | % |\n| Other expense | 1,996 | 167 | (1,829) | n.m. |\n| Total other expense, net | $ | (7,838) | $ | (8,896) | $ | (1,058) | (11.9) | % |\n| As a percentage of revenue | 3.7 | % | 5.8 | % |\n\nTotal other expense, net decreased by $1.1 million, or 11.9%, to $7.8 million for the three months ended June 30, 2021 compared to $8.9 million for the three months ended June 30, 2020. This decrease was due primarily to gains recorded on derivative instruments and a lower applicable interest rate on our first lien term loan and lower interest rate expense from our revolving line of credit. In 2020, we increased borrowings under our revolving credit facility as we sought to preserve liquidity during the initial phase of the COVID-19 pandemic. The decrease was offset by a loss recognized associated with the refinancing of our long-term debt.\nComparison of the Six Months Ended June 30, 2021 and 2020\nRevenue\n| Six Months EndedJune 30, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Revenue: |\n| Grills | $ | 334,756 | $ | 194,593 | $ | 140,163 | 72.0 | % |\n| Consumables | 81,991 | 56,015 | 25,976 | 46.4 | % |\n| Accessories | 31,848 | 16,365 | 15,483 | 94.6 | % |\n| Total Revenue | $ | 448,595 | $ | 266,973 | $ | 181,622 | 68.0 | % |\n\nRevenue increased by $181.6 million, or 68.0%, to $448.6 million for the six months ended June 30, 2021 compared to $267.0 million for the six months ended June 30, 2020. This increase was driven by strong demand for our grills, consumables and accessories.\nRevenue from our grills grew by $140.2 million, or 72.0%, to $334.8 million for the six months ended June 30, 2021 compared to $194.6 million for the six months ended June 30, 2020. This increase was driven by higher unit volume compared to the prior year.\nRevenue from our consumables grew by $26.0 million, or 46.4%, to $82.0 million for the six months ended June 30, 2021 compared to $56.0 million for the six months ended June 30, 2020. This increase was driven by repeating sales of wood\n22\npellets and other consumables from our installed base of grills, as well as increased unit volume associated with the expansion of our installed base of grills.\nRevenue from our accessories grew by $15.5 million, or 94.6%, to $31.8 million for the six months ended June 30, 2021 compared to $16.4 million for the six months ended June 30, 2020. This increase was a driven by increased unit volume associated with the higher volume of grills sold.\nGross Profit\n| Six Months EndedJune 30, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Gross profit | $ | 183,938 | $ | 118,443 | $ | 65,495 | 55.3 | % |\n| Gross margin (Gross profit as a percentage of revenue) | 41.0 | % | 44.4 | % |\n\nGross profit increased by $65.5 million, or 55.3%, to $183.9 million for the six months ended June 30, 2021 compared to $118.4 million for the six months ended June 30, 2020. Gross margin as a percentage of revenue decreased to 41.0% for the year ended June 30, 2021 from 44.4% for the six months ended June 30, 2020. The decrease in gross margin was driven by increased shipping costs, appreciation of the Chinese Renminbi relative to the U.S. Dollar, and an increase in our use of contract manufacturing for the production of wood pellets, as we added third-party production to meet increased demand.\nSales and Marketing\n| Six Months EndedJune 30, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Sales and marketing | $ | 78,120 | $ | 37,703 | $ | 40,417 | 107.2 | % |\n| As a percentage of revenue | 17.4 | % | 14.1 | % |\n\nSales and marketing expense increased by $40.4 million, or 107.2%, to $78.1 million for the six months ended June 30, 2021 compared to $37.7 million for the six months ended June 30, 2020. As a percentage of revenue, sales and marketing expense increased to 17.4% for the six months ended June 30, 2021 from 14.1% for the six months ended June 30, 2020. The increase in sales and marketing expense was driven by an increase in advertising costs to drive customer awareness, demand, and conversion, higher professional services expense primarily related to third-party customer service support, an increase in commission expense as sales increased and brand ambassadors performed a higher number of roadshows, and higher personnel-related expenses associated with an increase in headcount in our marketing, customer experience, and sale functions.\nGeneral and Administrative\n| Six Months EndedJune 30, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| General and administrative | $ | 38,358 | $ | 18,310 | $ | 20,048 | 109.5 | % |\n| As a percentage of revenue | 8.6 | % | 6.9 | % |\n\nGeneral and administrative expense increased by $20.0 million, or 109.5%, to $38.4 million for the six months ended June 30, 2021 compared to $18.3 million for the six months ended June 30, 2020. As a percentage of revenue, general and administrative expense decreased to 8.6% for the six months ended June 30, 2021 from 6.9% for the six months ended June 30, 2020. The increase in general and administrative expense was driven by professional services fees related to third party costs incurred in connection with our refinancing of long-term debt and consulting services, higher personnel-related expenses associated with investments to build a team to support our current and future growth, and higher utilization of legal services.\nAmortization of Intangible Assets\n23\n| Six Months EndedJune 30, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Amortization of intangible assets | $ | 16,602 | $ | 16,263 | $ | 339 | 2.1 | % |\n| As a percentage of revenue | 3.7 | % | 6.1 | % |\n\nAmortization of intangible assets, substantially attributable to the 2017 acquisition of the Company, increased $0.3 million, or 2.1%, to $16.6 million for the six months ended June 30, 2021 compared to $16.3 million for the six months ended June 30, 2020.\nOther Expense, Net\n| Six Months EndedJune 30, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Interest expense | $ | (15,689) | $ | (18,248) | $ | 2,559 | (14.0) | % |\n| Loss on extinguishment of debt | (1,957) | — | (1,957) | 100.0 | % |\n| Other income (expense) | 1,538 | (600) | 2,138 | n.m. |\n| Total other income (expense), net | $ | (16,108) | $ | (18,848) | $ | 2,740 | (14.5) | % |\n| As a percentage of revenue | 3.6 | % | 7.1 | % |\n\nTotal other expense, net decreased by $2.7 million, or 14.5%, to $16.1 million for the six months ended June 30, 2021 compared to $18.8 million for the six months ended June 30, 2020. This decrease was due primarily to a lower applicable interest rate on our first lien term loan and lower interest rate expense from our revolving line of credit. In 2020, we increased borrowings under our revolving credit facility as we sought to preserve liquidity during the initial phase of the COVID-19 pandemic.\nLiquidity and Capital Resources\nHistorically, our cash requirements have principally been for working capital purposes, capital expenditures, and debt service payments. We have funded our operations through cash flows from operating activities, cash on hand, and borrowings under our credit facilities and receivables financing agreement.\nAs of June 30, 2021, we had cash and cash equivalents of $75.3 million, $125.0 million of available borrowing capacity under our New Revolving Credit Facility (as defined below) and $100.0 million of available borrowing capacity under our Receivables Financing Agreement (as defined below). As of June 30, 2021, the total principal amount outstanding under our new First Lien Term Loan Facility was $510.0 million. After giving effect to our IPO, our aggregate principal amount of indebtedness outstanding under our New Credit Facilities (as defined below) would have been approximately $379.2 million as of June 30, 2021. We believe that our existing cash and cash equivalents, availability under our New Revolving Credit Facility and Receivables Financing Agreement, and our cash flows from operating activities will be sufficient to fund our working capital requirements and planned capital expenditures, and to service our debt obligations, for at least the next 12 months. However, our future working capital requirements will depend on many factors, including our rate of revenue growth and profitability, the timing and size of future acquisitions, and the timing of introductions of new products and investments in our supply chain and implementation of technologies. We may from time to time seek to raise additional equity or debt financing to support our growth or in connection with the acquisition of complementary businesses. Any equity financing we may undertake could be dilutive to our existing stockholders, and any additional debt financing we may undertake could require debt service and financial and operational requirements that could adversely affect our business. There is no assurance we would be able to obtain future financing on acceptable terms or at all. In particular, the widespread COVID-19 pandemic has resulted in, and may continue to result in, significant disruption of global financial markets, reducing our ability to access capital. See Part II, Item 1A.“Risk Factors.”\nIn connection with the IPO, we granted restricted stock units (“RSUs”). Specifically, 7,782,957 shares of common stock are issuable in connection with the vesting of RSUs granted to our Chief Executive Officer (the “Chief Executive Officer\n24\nAward“) under our 2021 Incentive Award Plan (the “2021 Plan”), which awards became effective in connection with the IPO. In addition, 4,380,285 shares of common stock are issuable in connection with the vesting of RSUs granted to others (the “IPO RSUs” and, along with the Chief Executive Officer Award, the “IPO Awards”) under our 2021 Plan, including to our Chief Financial Officer and certain of our directors, which awards became effective in connection with the IPO. In light of the large number of RSUs subject to the IPO Awards, we anticipate that we will incur substantial stock-based compensation expenses and may expend substantial funds to satisfy tax withholding and remittance obligations related to these RSUs. The grant date fair value of the Chief Executive Officer Award is estimated to be approximately $116.6 million, which we estimate will be recognized as compensation expense over a weighted average period of 4.94 years, though could be earlier if the stock price goals are achieved earlier than we estimated. The grant date fair value of the IPO RSUs is estimated to be approximately $73.2 million, which we estimate will be recognized as compensation expense over a weighted average period of 3.52 years. We expect the stock-based compensation expense relating to these awards to adversely impact our future financial results.\nIn addition, in connection with the completion of the IPO, we estimate that we will incur aggregate equity compensation expense of approximately $47.4 million as a result of the acceleration of vesting of the unvested Class B unit awards issued by the TGP Holdings LP.\nCash Flows\nThe following table sets forth cash flow data for the periods indicated therein:\n| Six Months EndedJune 30, |\n| 2021 | 2020 |\n| (in thousands) |\n| Net cash provided by operating activities | $ | 16,194 | $ | 12,572 |\n| Net cash used in investing activities | (11,575) | (5,856) |\n| Net cash provided by financing activities | 59,077 | 4,803 |\n| Net increase in cash and cash equivalents | $ | 63,696 | $ | 11,519 |\n\nCash Flow from Operating Activities\nDuring the six months ended June 30, 2021, net cash provided by operating activities consisted of net income of $34.0 million and net non-cash adjustments to net income of $31.5 million, offset by net changes in operating assets and liabilities of $49.4 million. Non-cash adjustments consisted of depreciation of property, plant, and equipment of $4.5 million, amortization of intangible assets of $16.9 million, equity-based compensation of $2.5 million, and unrealized gains on foreign currency contracts of $4.1 million. The decrease in net cash from net changes in operating assets and liabilities during the six months ended June 30, 2021 was primarily due to an increase in accounts receivable of $55.2 million and an increase in inventories of $17.3 million, offset in part by an increase in accounts payable and accrued expenses of $24.8 million.\nDuring the six months ended June 30, 2020, net cash provided by operating activities consisted of net income of $26.8 million and net non-cash adjustments to net income of $22.7 million, offset by net changes in operating assets and liabilities of $36.9 million. Non-cash adjustments consisted of depreciation of property, plant, and equipment of $3.3 million, amortization of intangible assets of $16.6 million, equity-based compensation of $1.3 million, and amortization of deferred financing costs of $1.3 million. The decrease in net cash from net changes in operating assets and liabilities during the six months ended June 30, 2020 was primarily due to an increase in accounts receivable of $57.2 million, offset in part by a decrease in inventories of $5.8 million and an increase in accounts payable and accrued expenses of $16.4 million.\nCash Flow from Investing Activities\nDuring the six months ended June 30, 2021, net cash used in investing activities was $11.6 million. The cash flow used was driven by the purchase of property, plant, and equipment of $11.2 million primarily related to the purchase of tooling equipment, the purchase of wood pellet production equipment, and internal-use software and website developments costs.\nDuring the six months ended June 30, 2020, net cash used in investing activities was $5.9 million. The cash flow used was driven by the purchase of property, plant, and equipment of $5.4 million primarily related to internal-use software and website developments costs.\n25\nCash Flow from Financing Activities\nDuring the six months ended June 30, 2021, net cash provided by financing activities was $59.1 million. The cash flow provided was driven primarily by net proceeds from our New First Lien Term Loan Facility of $510.0 million partially offset by repayment of the First and Second Lien Agreements of $446.4 million.\nDuring the six months ended June 30, 2020, net cash provided by financing activities was $4.8 million. The cash flow provided was driven primarily by net proceeds from our line of credit of $7.0 million partially offset by principal repayments under our first lien term loan of $1.7 million.\nCredit Facilities\nOn September 25, 2017, we entered into (i) a first lien credit agreement with various lenders, or the First Lien Credit Agreement and (ii) a second lien credit agreement with various lenders, or the Second Lien Credit Agreement and together with the First Lien Credit Agreement, the Credit Agreements. On June 29, 2021, we refinanced our existing Credit Facilities and entered into a new first lien credit agreement, or the New First Lien Credit Agreement. The New First Lien Credit Agreement provides for a senior secured term loan facility, or the New First Lien Term Loan Facility, and a revolving credit facility, or the New Revolving Credit Facility and, together with the New First Lien Term Loan Facility, the New Credit Facilities.\nFirst Lien Credit Agreement\nThe First Lien Credit Agreement, as amended, provided for a $340.7 million senior secured term loan facility, or the First Lien Term Loan Facility, and a $67.0 million secured asset-based revolving credit facility, or the Revolving Credit Facility.\nThe First Lien Term Loan Facility, as amended, accrued interest at a rate per annum that considered both fixed and floating components. The fixed component ranged from 3.75% to 4.25% per annum based on our most recently determined First Lien Net Leverage Ratio (as defined in the First Lien Credit Agreement). The floating component was based on LIBOR for the relevant interest period, subject to a minimum LIBOR rate of 1.00%. The weighted average interest rate on the First Lien Term Loan Facility was 5.0% and 5.8% for each of the first six months of 2021 and 2020, respectively.\nLoans under the Revolving Credit Facility, as amended, accrued interest at a rate per annum that considered both fixed and floating components. The fixed component ranged from 3.75% to 4.25% per annum based on our most recently determined First Lien Net Leverage Ratio (as defined in the First Lien Credit Agreement).\nSecond Lien Credit Agreement\nThe Second Lien Credit Agreement provided for a $115.0 million senior secured term loan facility, or the Second Lien Term Loan Facility, which together with the First Lien Credit Facilities are referred to as the Credit Facilities. The Second Lien Term Loan Facility accrued interest at a rate per annum that considered both fixed and floating components. The fixed component was 8.5% per annum. The floating component was based on LIBOR for the relevant interest period, subject to a minimum LIBOR rate of 1.00%. The weighted average interest rate on the Second Lien Term Loan Facility was 9.5% and 10.0% for each of the first six months of 2021 and 2020, respectively.\nNew First Lien Credit Agreement\nOn June 29, 2021, we entered into a new first lien credit facility, or the New First Lien Credit Facility. The New First Lien Credit Facility provides for a $560.0 million New First Lien Term Loan Facility (including a $50.0 million delayed draw term loan) and a $125.0 million New Revolving Credit Facility.\nThe New First Lien Term Loan Facility accrues interest at a rate per annum that considers both fixed and floating components. The fixed component ranges from 3.00% to 3.50% per annum based on the consummation of a Qualifying Public Offering and our Public Debt Rating (each as defined in the New First Lien Credit Agreement). The floating component is based on the Eurocurrency Base Rate (as defined in the New First Lien Credit Agreement) for the relevant interest period. The First Lien Term Loan Facility requires quarterly principal payments from December 2021 through June 2028, with any remaining unpaid principal and any accrued and unpaid interest due on the maturity date of June 29, 2028. The delayed draw term loan includes a variable commitment fee, which is based on the fixed interest rate and ranges from 0% to the Applicable Rate (as defined in the New First Lien Credit Agreement). As of June 30, 2021, the total principal amount outstanding on the New First Lien Term Loan Facility was $510.0 million.\n26\nLoans under the New Revolving Credit Facility, accrue interest at a rate per annum that considers both fixed and floating components. The fixed component ranges from 2.75% to 3.50% per annum based on the consummation of a Qualifying Public Offering and our most recently determined First Lien Net Leverage Ratio (as defined in the New First Lien Credit Agreement). The floating component is based on the Eurocurrency Base Rate for the relevant interest period. The New Revolving Credit Facility also has a variable commitment fee, which is based on our most recently determined First Lien Net Leverage Ratio and ranges from 0.250% to 0.500% per annum on undrawn amounts. Letters of credit may be issued under the New Revolving Credit Facility in an amount not to exceed $15.0 million which, when issued, lower the overall borrowing capacity of the facility. The Revolving Credit Facility expires on June 29, 2026 and no principal payments are due before such date. As of June 30, 2021, there was no outstanding principal balance under the New Revolving Credit Facility.\nExcept as noted below, the Credit Facilities are collateralized by substantially all of the assets of TGP Holdings III LLC, TGPX Holdings II LLC, Traeger Pellet Grills Holdings LLC and certain subsidiaries of Traeger Pellet Grills Holdings LLC, including intellectual property, mortgages, along with the equity interest of each of these respective entities. The assets of Traeger SPE LLC, substantively consisting of our accounts receivable, collateralize the receivables financing agreement discussed below and do not collateralize the Credit Facilities. There are no guarantees from parent entities above TGPX Holdings I LLC.\nThe agreements contain certain affirmative and negative covenants that limit our ability to, among other things, incur additional indebtedness or liens (with certain exceptions), make certain investments, engage in fundamental changes or transactions including changes of control, transfer or dispose of certain assets, make restricted payments (including dividends), engage in new lines of business, make certain prepayments and engage in certain affiliate transactions. In addition, we are subject to a financial covenant whereby we are required to maintain a First Lien Net Leverage Ratio (as defined in the New First Lien Credit Agreement) not to exceed 6.20 to 1.00. As of June 30, 2021, we were in compliance with the covenants under the prior Credit Facilities.\nAccounts Receivable Credit Facility\nOn November 2, 2020, we entered into a receivables financing agreement, as amended, or the Receivables Financing Agreement. Pursuant to the Receivables Financing Agreement, we participate in a trade receivables securitization program administered by MUFG Bank Ltd. Through this arrangement, we have secured short-term capital requirements financing using outstanding accounts receivable balances as collateral, which have been contributed by us to a wholly owned subsidiary, Traeger SPE LLC. As a special purpose entity, or SPE, Traeger SPE LLC has been structured such that its assets (substantively the accounts receivable contributed by us to the SPE) are outside the reach of other creditors, including the lenders under our First Lien Credit Agreement and Second Lien Credit Agreement. While we provide services to the SPE through continuing involvement in the aspects of collection and cash application of the receivables, the receivables are owned by the SPE once contributed to it by us. We are the primary beneficiary and hold all equity interests of the SPE, thus we consolidate the SPE without any significant judgments.\nOn June 29, 2021, we entered into Amendment No. 1 to the Receivables Financing Agreement and increased the net borrowing capacity from the prior range of $30.0 million to $45.0 million up to $100.0 million. As of June 30, 2021, we had drawn down $8.0 million under this facility for general corporate and working capital purposes. Absent any cash advances that exceed the SPE’s available cash, the SPE collects proceeds from the receivables and transfers available cash to us on a regular basis. We are required to pay an annual upfront fee for the facility, along with interest on outstanding cash advances of approximately 1.7%, and an unused capacity charge that ranges from 0.25% to 0.5%. The facility is set to terminate on June 29, 2024.\nRecent Acquisitions\nOn July 1, 2021, we acquired all of the equity interests of Apption Labs Limited and its subsidiaries. Apption Labs Limited specializes in the manufacture and design of innovative hardware and software related to small kitchen appliances. Total consideration for the acquisition included $60.0 million of cash paid at time of closing and up to $40 million in contingent consideration based on achievement of certain revenue thresholds for fiscal 2021 and 2022.\nContractual Obligations\nThere have been no material changes to our contractual obligations as of June 30, 2021 from those disclosed in our prospectus, dated July 28, 2021. Refer to the Liquidity and Capital Resources section above to the unaudited condensed\n27\nconsolidated financial statements included in this Quarterly Report on Form 10-Q for a discussion of our debt and operating lease obligations, respectively.\nOff-Balance Sheet Arrangements\nWe do not have nor do we enter into off-balance sheet arrangements that had, or which are reasonably likely to have, a material effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.\nCritical Accounting Policies\nOur consolidated financial statements are prepared in accordance with U.S. GAAP. The preparation of our financial statements in conformity with U.S. GAAP requires us to make estimates and assumptions that affect certain reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period.\nOur critical accounting policies are described under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies” in our prospectus, dated July 28, 2021, and the notes to the unaudited condensed consolidated financial statements included in this Quarterly Report on Form 10-Q. During the six months ended June 30, 2021, there were no material changes to our critical accounting policies from those discussed in our prospectus, dated July 28, 2021.\nRecent Accounting Pronouncements\nFor information regarding recent accounting pronouncements, see Note 2 to the unaudited condensed consolidated financial statements included in this Quarterly Report on Form 10-Q.\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nWe are exposed to market risk in the ordinary course of business. Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in interest rates, foreign currency exchange risk, and commodity price risk. We do not hold or issue financial instruments for speculative or trading purposes.\nInterest Rate Risk\nWe had cash and cash equivalents of $75.3 million and $18.6 million as of June 30, 2021 and 2020. We hold cash and cash equivalents for working capital purposes. We do not have material exposure to market risk with respect to investments. We had $510.0 million and $454.5 million of outstanding debt as of June 30, 2021 and 2020, respectively. Certain amounts under our Credit Facilities accrue interest at a floating interest rate. Based on the outstanding balance of the Credit Facilities as of June 30, 2021, for every 100 basis point increase in the interest rates, we would incur approximately $5.1 million of additional annual interest expense. We currently do not hedge interest rate exposure. We may in the future hedge our interest rate exposure and may use swaps, caps, collars, structured collars or other common derivative financial instruments to reduce interest rate risk. It is difficult to predict the effect that future hedging activities would have on our operating results.\nForeign Currency Exchange Risk\nWe have foreign currency risks related to certain of our foreign subsidiaries, primarily in Europe and China. The operating expenses of these subsidiaries are recorded in the currency of the countries where these subsidiaries are located, which is primarily Euros and Chinese Renminbi. However, we believe that the exposure to foreign currency fluctuation from operating expenses is relatively minor at this time as the related costs do not constitute a significant portion of our total expenses.\nIn addition, our manufacturers and suppliers may incur costs, including labor costs, in other currencies. To the extent that exchange rates move unfavorably for our manufacturers and suppliers, they may seek to pass these additional costs on to us, which could have a material impact on our gross margin. In addition, a strengthening of the U.S. Dollar may increase the cost of our products to our customers outside of the United States. Our results of operations and cash flows are, therefore, subject to fluctuations due to changes in foreign currency exchange rates.\n28\nOur primary foreign currency exchange risk relates to the purchase of inventory from manufacturers denominated in Chinese Renminbi. We utilize foreign currency contracts to manage foreign currency risk in purchasing inventory and capital equipment, and future settlement of foreign denominated assets and liabilities. The volume of our foreign currency contract activity is limited by the amount of transaction exposure in each foreign currency and our election as to whether to hedge the respective transactions. We had outstanding foreign currency contracts as of June 30, 2021 and 2020, but did not elect hedge accounting for any of these contracts. All outstanding contracts are with the same counterparty and thus the fair market value of the contracts in an asset position are offset by the fair market value of the contracts in a liability position to reach a net position. For periods where the net position is an asset balance, the balance is recorded within prepaid expenses and other current assets on our consolidated balance sheet and for periods where the net position is a liability balance, the balance is recorded within derivative liabilities on the consolidated balance sheet. Changes in the net fair value of contracts are recorded in other income (expense), net in the consolidated statements of operations. At June 30, 2021 and 2020, the net asset fair value of our foreign currency contract positions was $2.1 million and $0.1 million, respectively. Gains and losses from these foreign currency contract positions were $1.3 million and $(0.4) million for the six months ended June 30, 2021 and 2020, respectively. At June 30, 2021, a 10% favorable or unfavorable exchange rate movement in the Chinese Renminbi in our portfolio of foreign currency contracts would have resulted in an incremental unrealized gain of approximately $5.1 million or loss of approximately $(4.2) million, respectively.\nCommodity Price Risk\nWe are exposed to commodity price fluctuations primarily as a result of the cost of steel that is used by our manufacturers. For example, steel is the primary raw material used in manufacturing of our grills. Under our current agreements with our primary contract manufacturers, we have the ability to periodically fix the cost of our grills so that the manufacturers bear the risk of steel price fluctuation for a period of time. During such periods, increases in the price of steel would not impact our costs. However, our business can be affected by sustained dramatic movements in steel prices.\nITEM 4. CONTROLS AND PROCEDURES\nLimitations on effectiveness of controls and procedures\nIn designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply judgment in evaluating the benefits of possible controls and procedures relative to their costs.\nEvaluation of disclosure controls and procedures\nOur management, with the participation of our principal executive officer and principal financial officer, evaluated, as of the end of the period covered by this Quarterly Report on Form 10-Q, the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Based on that evaluation, our principal executive officer and principal financial officer concluded that, as of June 30, 2021, our disclosure controls and procedures were effective at the reasonable assurance level.\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended June 30, 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\nPART II. OTHER INFORMATION\nITEM 1. LEGAL PROCEEDINGS\nWe are from time to time subject to various legal proceedings, claims, and governmental inspections, audits, or investigations that arise in the ordinary course of our business. We believe that the ultimate resolution of these matters would not be expected to have a material adverse effect on our business, financial condition, or operating results.\n29\nITEM 1A. RISK FACTORS\nOur business involves significant risks, some of which are described below. You should carefully consider the risks and uncertainties described below, together with all of the other information in this Quarterly Report on Form 10-Q, as well as our audited consolidated financial statements and related notes as disclosed in our prospectus, dated July 28, 2021, filed with the Securities and Exchange Commission (“SEC”) in accordance with Rule 424(b) of the Securities Act on July 30, 2021 (the “Prospectus”) in connection with our initial public offering (“IPO”). The risks and uncertainties described below are not the only ones we face. Additional risk and uncertainties that we are unaware of or that we deem immaterial may also become important factors that adversely affect our business. The realization of any of these risks and uncertainties could have a material adverse effect on our reputation, business, financial condition, results of operations, growth and future prospects as well as our ability to accomplish our strategic objectives. In that event, the market price of our common stock could decline and you could lose part or all of your investment.\nRisks Related to Our Business\nWe have incurred operating losses in the past, may incur operating losses in the future, and may not achieve or maintain profitability in the future.\nWe have incurred operating losses in the past and may continue to incur net losses in the future. For the year ended December 31, 2020, we had net income of $31.6 million. For the six months ended June 30, 2021, we had net income of $34.0 million, compared to net income of $26.8 million for the six months ended June 30, 2020. As of June 30, 2021, we had an accumulated deficit of $62.0 million. We expect our operating expenses to increase in the future as we continue our sales and marketing efforts, expand our operating and retail infrastructure, add content and software features to our platform, expand into new geographies, develop new products, and in connection with legal, accounting, and other expenses related to operating as a public company. These efforts and additional expenses may be more costly than we expect, and we cannot guarantee that we will be able to increase our revenue to offset our operating expenses. Our revenue growth may slow or our revenue may decline for a number of other reasons, including reduced demand for our products, increased competition, a decrease in the growth or reduction in size of our overall market, the impacts to our business from the COVID-19 pandemic, or if we cannot capitalize on growth opportunities. If our revenue does not grow at a greater rate than our operating expenses, we will not be able to achieve and maintain profitability.\nOur recent growth rates may not be sustainable or indicative of future growth and we expect our growth rate to slow.\nWe have experienced significant growth since our change of ownership in 2013. Our historical rate of growth may not be sustainable or indicative of our future rate of growth. We have also experienced increased demand for our products due to the impact that the COVID-19 pandemic has had on consumer behavior as a result of various stay-at-home orders and restrictions on dining options and restaurant closures. We cannot predict the extent to which or the length that such restrictions will remain in place or if and when consumer behavior will return to pre-pandemic levels. We believe that our continued revenue growth, as well as our ability to improve or maintain margins and profitability, will depend upon, among other factors, our ability to address the challenges, risks, and difficulties described elsewhere in this report and the extent to which our various products grow and contribute to our results of operations. We cannot provide assurance that we will be able to successfully manage any such challenges or risks to our future growth. In addition, our number of customers and markets may not continue to grow or may decline due to a variety of possible risks, including increased competition and the maturation of our business. Any of these factors could cause our revenue growth to decline and may adversely affect our margins and profitability. Failure to continue our revenue growth or improve margins would have a material adverse effect on our business, financial condition, and results of operations. You should not rely on our historical rate of revenue growth as an indication of our future performance.\nWe may be unable to manage our future growth effectively, which could make it difficult to execute our business strategy.\nWe have experienced rapid growth in our business operations and the scope and complexity of our business have increased substantially over the past several years. As a result, the number of our full-time employees increased from approximately 450 as of December 31, 2018 to approximately 740 as of June 30, 2021, and we have expanded our operations to include additional wood pellet production facilities and additional manufacturing and supply sources. We have only a limited history of operating our business at its current scale. We have made and expect to continue to make significant investments in our research and development efforts and in our sales and marketing organizations, including with respect to future product offerings, consumables, accessories, and services, and to expand our operations and infrastructure both domestically and internationally. This growth has placed, and may continue to place, significant demands on our management and our operational and financial infrastructure. For example, our customers increasingly rely on our support services to resolve any issues related to the use of our products and smart features. Providing a high-quality customer experience is vital to our success\n30\nin generating word-of-mouth referrals to drive sales, maintain, and expand our brand recognition and retain existing customers. The importance of high-quality support will increase as we expand our business and introduce new and/or enhanced products and offerings, especially if we face limited brand recognition in certain markets that leads to non-acceptance or delayed acceptance of our products and services by consumers. Our ability to manage our growth effectively and to integrate new employees, technologies and acquisitions into our existing business will require us to continue to expand our operational and financial infrastructure and to continue to retain, attract, train, motivate, and manage employees. Management of growth is particularly difficult as employees work from home as a result of the COVID-19 pandemic. Continued growth could strain our ability to develop and improve our operational, financial and management controls, enhance our reporting systems and procedures, recruit, train, and retain highly skilled personnel and maintain customer satisfaction. Additionally, if we do not effectively manage the growth of our business and operations, the quality of our products and content could suffer, which could negatively affect our reputation and brand, business, financial condition, and results of operations, and our corporate culture may be harmed.\nOur growth depends, in part, on our continued penetration and expansion into additional markets, and we may not be successful in doing so.\nWe believe that our future growth depends not only on continuing to reach our current core demographic, but also continuing to penetrate and broaden our retailer, customer, and distribution bases, including through online sales channels and our website, in the United States and international markets. In these markets, we have faced and may continue to face challenges that are different from those we currently encounter, including competitive, merchandising, distribution, hiring, legal and regulatory, and other difficulties, such as understanding and accurately predicting the demographics, preferences, and purchasing habits of consumers in these new geographic markets. We may encounter problems in our logistical operations, including our fulfillment and shipping functions, related to an increased demand from online sales channels. We have also encountered and may continue to encounter difficulties in attracting customers due to a lack of familiarity with or acceptance of our brand, or a resistance to paying for our premium products, particularly in international markets. We continue to evaluate marketing efforts and other strategies to expand our retailer, customer, and distribution bases. In addition, although we are continuing to invest in sales and marketing activities to further penetrate newer regions, we cannot assure you that we will be successful. If we are not successful, our business, financial condition, and results of operations may be harmed.\nOur business depends on maintaining and strengthening our brand to generate and maintain ongoing demand for our products, and a significant reduction in such demand could harm our results of operations.\nThe Traeger name and premium brand image are integral to the growth of our business, as well as to the implementation of our strategies for expanding our business. Our success depends on the value and reputation of our brand, which, in turn, depends on factors such as the quality, market fit, design, performance, and functionality of our physical and digital products, our communication and marketing activities, including live and digital advertising, social media, online content, and public relations, the image of our retailers’ floor spaces and e-commerce platform, and our management of the customer experience, including direct interfaces through customer service. Maintaining, promoting, and positioning our brand are important to expanding our customer base and will depend largely on the success of our marketing and merchandising efforts and our ability to provide consistent, high-quality customer experiences. We intend to continue making substantial investments in these areas in order to maintain and enhance our brand, and such investments may not be successful. Ineffective marketing, negative publicity, product diversion to unauthorized distribution channels, product or manufacturing defects, including defects that may cause fires or explosions, counterfeit products, unfair labor practices, and failure to protect the intellectual property rights in our brand are some of the potential threats to the strength of our brand, and those and other factors could rapidly and severely diminish customer confidence in us. Furthermore, these factors could cause our customers to lose the personal connection they feel with the Traeger brand. Moreover, the growing use of social and digital media by us, our customers and third parties increases the speed and extent that information or misinformation and opinions can be shared. We believe that maintaining and enhancing our brand image in our current markets and in new markets where we have limited brand recognition is important to expanding our customer base. If we are unable to maintain or enhance our brand in current or new markets, our growth strategy and results of operations could be harmed.\nIf we fail to cost-effectively attract new customers or retain our existing customers, we may not be able to increase sales.\nOur success depends on our ability to cost-effectively attract customers to our products and to retain our existing customers and encourage our customers to continue to utilize our products and content for their cooking needs. We must also increase general public awareness of our products, wood pellet grills, and the related cooking methodologies and techniques. For example, in order to increase customer awareness and expand our customer base, we must appeal to and attract customers who have historically associated grilling and outdoor cooking with traditional gas, charcoal, and electric grills and may have extensive experience in cooking with such devices. To effectively market our products, we must educate these customers about\n31\nthe various benefits of using our products and about cooking with wood pellet grills generally. We cannot assure you that we will be successful in changing customer behavior or cooking habits or that we will achieve broad market education or awareness. Even if we are able to raise awareness, customers may be slow in changing their habits and may be hesitant to use our products for a variety of reasons, including lack of experience with our products or cooking with wood pellet grills, price, competition and negative selling efforts from competitors and the perceptions regarding the time and complexity of using our products or learning new cooking techniques. Moreover, because our grills require sufficient outdoor space and ventilation to safely operate, even if we are successful in influencing customer behavior or cooking habits, many individuals may not be able to purchase our grills due to space constraints, particularly in high-density and non-suburban markets where residential outdoor space is limited.\nWe have made, and we expect that we will continue to make, significant investments in attracting new customers, including through the use of corporate partnerships, traditional, digital, and social media, and participation in, and sponsorship of, community events. Marketing campaigns can be expensive and may not result in the cost-effective acquisition of customers. We cannot assure you that any increase in our customer acquisition costs will result in any revenue growth. Further, as our brand becomes more widely known, future marketing campaigns may not attract new customers at the same rate as past campaigns. We believe that our paid and non-paid marketing initiatives have been critical in promoting customer awareness of our products and wood pellet grills, which in turn has driven demand for our products and increased the extent to which new and existing customers utilize our online content for cooking related information and resources. Any decrease in the success of our non-paid marketing initiatives, which primarily consist of customer advocacy and word-of-mouth referrals, may cause an increase in both our marketing and customer acquisition costs.\nOur paid marketing initiatives include television, search engine marketing, mail to consumers, email, display and dedicated in-store arrangements, radio, and magazine advertising and social media marketing. For example, we actively market our products through television and buy search advertising through search engines, such as Google and Bing, major mobile application stores and social media platforms such as Facebook and Instagram, and use internal analytics and external vendors for bid optimization and channel strategy. Our non-paid advertising efforts include search engine optimization, non-paid social media and e-mail marketing. Search engines frequently modify their search algorithms and these changes can cause our websites to receive less favorable placements, which could reduce the number of customers who visit our website or are directed to information about our products. The costs associated with advertising through search engines can also vary significantly from period to period, and have generally increased over time. We may be unable to modify our strategies in response to any future search algorithm changes made by the search engines, which could require a change in the strategy we use to generate customer traffic and drive customer interactions. In addition, our website must comply with search engine guidelines and policies, which are complex and may change at any time. If we fail to follow such guidelines and policies properly, search engines may rank our content lower in search results, penalize us or could remove our content altogether from their indices. Further, changes to third-party policies that limit our ability to deliver, target or measure the effectiveness of advertising, including changes by mobile operating system and browser providers such as Apple and Google, could reduce the effectiveness of our marketing.\nIf we are unable to attract new customers, or fail to do so in a cost-effective manner, our growth could be slower than we expect and our business will be harmed.\nOur business could be adversely affected if we fail to maintain product quality and product performance at an acceptable cost.\nIn order to maintain and increase revenue, we must produce high quality products at acceptable costs. If we are unable to maintain the quality and performance of our products at acceptable costs, our brand, the market acceptance of our products and our results of operations would suffer. As we periodically update our product lines and introduce changes to manufacturing processes or incorporate new materials and technologies, we may encounter unanticipated issues with product quality and product consistency or production and supply delays. For example, we have recently introduced products that incorporate smart features, including our WiFIRE technology, a cloud based, Wi-Fi controller that connects our grills to our Traeger app, enabling users to automate recipe steps and control and monitor their grill remotely. We also recently introduced D2 Direct Drive, an integrated, software-driven system that maintains grill temperature through variable speed fans and DC auger control. While we engage in product testing in an effort to identify and address any product quality issues before we introduce products to market, unanticipated product quality or performance issues may be identified after a product has been introduced and sold. As we continue to introduce new products and product enhancements, we expect the costs associated with such products and enhancements will continue to increase.\n32\nWe may be subject to product liability and warranty claims and product recalls that could result in significant direct or indirect costs, or we could experience greater product returns than expected, either of which could harm our reputation or brand and have an adverse effect on our business, financial condition, and results of operations.\nWe face the risk of exposure to product liability or other claims, including class action lawsuits, in the event our products are, or are alleged to be, defective or have resulted in harm to persons, including death, or to property as a result of product malfunction, fires, explosions or other causes. For example, we are aware of several situations in which our grills were investigated as the cause of a fire. Our grills may cause fires if not properly used or maintained, including fires caused by buildup of fats or grease, or if there are quality, manufacturing or design defects. Although we label our grills to warn of such risks, our sales could be reduced if our grills are considered dangerous to use or if they are implicated in causing personal injury, death or property damage. Additionally, we may experience food safety or food-borne illness incidents with our rubs or sauces. We may in the future incur significant liabilities if product liability lawsuits or regulatory enforcement actions against us are successful. We may also have to recall and/or replace defective products or parts, which could result loss of sales and increased costs related to such recall or replacement efforts, which could be material. Any losses not covered by insurance could have a material adverse effect on our business, financial condition, and results of operations. Real or perceived quality issues, including those arising in connection with product liability lawsuits, warranty claims or recalls, could also result in adverse publicity, which could harm our brand and reputation and cause our sales to decline. In addition, any such issues may be seized on by competitors in efforts to increase their market share.\nWe generally provide a minimum three-year limited warranty on our grills. The occurrence of any material defects in our grills could result in an increase in returns or make us liable for damages and warranty claims in excess of our current reserves, which could result in an adverse effect on our business prospects, liquidity, financial condition, and cash flows if returns or warranty claims were to materially exceed anticipated levels. In addition, we could incur significant costs to correct any defects, warranty claims, or other problems, including costs related to product recalls, and such costs may not be covered by insurance and could have a material adverse effect on our business, financial condition, and results of operations. Any negative publicity related to the perceived quality and safety of our products could affect our brand image, decrease consumer confidence and demand, and adversely affect our financial condition and results of operations. Also, while our warranty is limited to part replacement and returns, warranty claims may result in litigation, the occurrence of which could have an adverse effect on our business, financial condition, and results of operations.\nIn addition to warranties supplied by us, we may also offer the option for customers to purchase third-party extended warranty and services contracts in some markets, which creates an ongoing performance obligation over the warranty period. Extended warranties are regulated in the United States on a state level and are treated differently state by state. Outside the United States, regulations for extended warranties vary from country to country. Changes in interpretation of the insurance regulations or other laws and regulations concerning extended warranties on a federal, state, local, or international level may cause us to incur costs or have additional regulatory requirements to meet in the future. Our failure to comply with past, present, and future similar laws could result in reduced sales of our products, reputational damage, penalties, and other sanctions, which could have an adverse effect on our business, financial condition, and results of operations.\nWe operate in a highly competitive market and we may be unable to compete successfully against existing and future competitors.\nWe operate in a highly competitive business market, and compete with multiple companies in the outdoor cooking market within brick-and-mortar and online sales channels. Numerous other companies offer a wide variety of products, including traditional gas, charcoal and electric grills, consumables, and accessories, that compete with our grills, consumables, and accessories, including wood pellets that can be used with our grills. For example, we compete with established, well-known, and legacy grill brands, including Weber, among others, as well as numerous other companies that offer competing products. These competitors offer a broad array of grills at different price points, including traditional gas, charcoal and electric grill offerings, as well as a significant number of wood pellet grills. We also compete against other wood pellet grill brands, such as Dansons. Moreover, the outdoor cooking market is expanding to include alternatives beyond traditional grills, and we also compete against companies that manufacture griddles, such as Blackstone. We have experienced an increase in competitors and competing offerings of gas and charcoal grills, wood pellet grills, and other outdoor cooking devices in recent years.\nCompetition in our market is based on a number of factors including product quality, performance, durability, styling, brand image and recognition, and price, as well as the perceived taste and satisfaction to be attained in using a particular grill or cooking methodology.\nWe believe that we have been able to compete successfully largely on the basis of our premium brand, superior design capabilities, product development, product performance, ease of use, and on the breadth of our independent, regional, and\n33\nnational retailers, our growing online presence and our DTC channel. Our competitors may be able to develop and market high quality products that compete with our products, sell their products for lower prices, adapt to changes in customer needs and preferences more quickly, devote greater resources to the design, sourcing, distribution, marketing, and sale of their products, or generate greater brand recognition than us. In addition, as we expand into new product categories, we have faced, and will continue to face, different and, in some cases, more formidable competition. Many of our competitors and potential competitors have significant competitive advantages, including longer operating histories, the ability to leverage their sales efforts and marketing expenditures across a broader portfolio of products, global product distribution, larger and broader retailer bases, more established relationships with a larger number of suppliers and manufacturers, greater brand recognition, larger or more effective brand ambassador and endorsement relationships, greater online presence and appearing more prominently in internet search results, greater financial strength, larger research and development teams, larger marketing budgets, and more distribution and other resources than we do. Some of our competitors may aggressively discount their products or offer other attractive sales terms in order to gain market share, which could result in pricing pressures, reduced margins, or lost market share.\nWe also compete with providers of wood pellets for use in grilling, including well-known brands like Weber, Kingsford and Dansons, among others. These competitors offer a broad array of pellet types and flavors that can be used in our wood pellet grills. Similar to our experience regarding competition for our wood pellet grills, we have experienced an increase in competitors and competing offerings of wood pellets in recent years.\nIf we are not able to overcome these potential competitive challenges, effectively market our current and future products, and otherwise compete effectively against our current or potential competitors, our prospects, financial condition, and results of operations could be harmed.\nUse of social media and community ambassadors may materially and adversely affect our reputation or subject us to fines or other penalties.\nWe use third-party social media platforms as marketing tools, among other things. For example, we maintain Instagram, Facebook, Twitter, YouTube, and Pinterest accounts, as well as our own content on our website and Traeger app. We maintain relationships with many community ambassadors, which others may refer to as influencers, and engage in sponsorship initiatives. As existing e-commerce and social media platforms continue to rapidly evolve and new platforms develop, we must continue to maintain a presence on these platforms and establish presences on new or emerging popular social media platforms. If we are unable to cost-effectively use social media platforms as marketing tools or if the social media platforms we use do not evolve quickly enough for us to fully optimize such platforms, our ability to acquire new consumers and our financial condition may suffer. Furthermore, as laws and regulations rapidly evolve to govern the use of these platforms and devices, the failure by us, our employees, our network of community ambassadors, our sponsors or third parties acting at our direction (including retailers) to abide by applicable laws and regulations in the use of these platforms and devices or otherwise could subject us to regulatory investigations, class action lawsuits, liability, fines or other penalties and have a material adverse effect on our business, financial condition and results of operations.\nIn addition, an increase in the use of social media for marketing may cause an increase in the burden on us to monitor compliance of such materials, and increase the risk that such materials could contain problematic product or marketing claims in violation of applicable regulations. For example, in some cases, the Federal Trade Commission, or the FTC, has sought enforcement action where an endorsement has failed to clearly and conspicuously disclose a material relationship between a community ambassador and an advertiser. While we ask community ambassadors to comply with the FTC regulations and our guidelines, we do not regularly monitor what our community ambassadors post, and if we were held responsible for the content of their posts, we could be forced to alter our practices, which could have material adverse effect on our business, financial condition, and results of operations.\nNegative commentary regarding us, our products or community ambassadors, and other third parties who are affiliated with us may also be posted on social media platforms and may be adverse to our reputation or business. Community ambassadors with whom we maintain relationships could engage in behavior or use their platforms to communicate directly with our customers in a manner that reflects poorly on our brand and may be attributed to us or otherwise adversely affect us. It is not possible to prevent such behavior, and the precautions we take to detect this activity may not be effective in all cases. The harm may be immediate, without affording us an opportunity for redress or correction.\n34\nWe derive a significant majority of our revenue from sales of our wood pellet grills. A decline in sales of our grills would negatively affect our future revenue and results of operations.\nOur wood pellet grills are sold in highly competitive markets with limited barriers to entry. Introduction by competitors of comparable grills at lower price points, a decline in consumer spending, or other factors could result in a decline in our revenue derived from our grills, which may have a material adverse effect on our business, financial condition, and results of operations. Because we derive a significant majority of our revenue from the sales of our wood pellet grills, any material decline in sales of our grills would have a pronounced impact on our revenue and results of operations.\nA significant portion of our revenue is generated from sales of our products to retailers, and we derive a majority of our revenue from three retailers. A decline in demand from these retailers or failure by these retailers to perform their contractual obligations would cause our customer base, results of operations and business to suffer.\nWe generate a significant portion of our revenue through our retail channel, which includes sales to brick-and-mortar retailers, e-commerce platforms, and multichannel retailers, who, in turn, sell our products to their end consumers. In addition, we depend on a limited number of major retailers for a majority of our revenue. For example, in the year ended December 31, 2020, our three largest retailers accounted for 20%, 18%, and 16% of our revenue, respectively, with no other customer accounting for greater than 10% of our revenue for the year. In the six months ended June 30, 2021, our three largest retailers accounted for 20%, 20%, and 16% of our revenue, respectively, with no other customer accounting for greater than 10% of our revenue during the period. Although we generally do not have long-term contracts or purchase agreements with our retailers, we expect these major retailers to continue to make up a large portion of our revenue in the foreseeable future.\nOur retailers may decide to emphasize products from our competitors, to redeploy their retail floor space or digital placement to other product categories, or to take other actions that reduce their purchases of our products. Our financial performance depends in part on our ability to maintain our relationships with our retailers, particularly our major retailers, and drive end customers to their stores. The loss of all or a substantial portion of our sales to retailers, and our major retailers in particular, could have a material adverse effect on our business, financial condition, results of operations and cash flows by reducing cash flows and by limiting our ability to spread our fixed costs over a larger revenue base. We may make fewer sales to our retailers for a variety of reasons, including, but not limited to:\n•failure to accurately identify the needs of our retailers;\n•a lack of acceptance of new products, consumables, accessories, or services;\n•failure to obtain shelf space or prominent digital placement from our retailers;\n•loss of business relationships, including due to brand or reputational harm;\n•breaches of contracts with retailers, or our failure to enter into or renew our contracts or purchase orders with major retailers;\n•consolidation within the retail industry among retailers and retail chains;\n•reduced, delayed or material changes to the business requirements or operations of our retailers;\n•failure to fulfil orders from our retailers in full or on a timely basis;\n•strikes or other work stoppages affecting sales and inventory of our major retailers;\n•increasing competition by our competitors or the competitors of our major retailers that do not offer or sell our products;\n•store closures, decreased foot traffic, recession or other adverse effects resulting from public health crises such as the current COVID-19 pandemic (or other future pandemics or epidemics); or\n•general failure or bankruptcy of any of our major retailers.\nFurthermore, in depressed market conditions, retailers that we have entered into contracts with may not be able to perform their obligations under our contracts and/or may no longer need the amount of our products they have contracted for or may be able to obtain comparable products at a lower price. If economic, political, regulatory or financial market conditions deteriorate and/or our retailers experience a significant downturn in their business or financial condition, they may attempt to renegotiate, reject or declare force majeure under our contracts. Should any counterparty fail to honor its obligations under a contract with us, we could sustain losses, which could have a material adverse effect on our business, financial condition and results of operations. We may also decide to renegotiate our existing contracts on less favorable terms and/or at reduced volumes in order to preserve our relationships with our retailers.\n35\nUpon the expiration of contracts, retailers may decide not to recontract on terms as favorable to us as our current contracts, or at all. For example, our current customers may acquire wood pellet grills from other providers that offer more competitive pricing.\nWe cannot assure you that our retailers will continue to carry our current products or carry any new products that we develop. If these risks occur, they could harm our brand as well as our results of operations and financial condition. In addition, store closures, decreased foot traffic and recession resulting from the COVID-19 pandemic will adversely affect the performance and will likely adversely affect the financial condition of many of these customers. Some retailers may decide to stop selling wood pellet grills. Any reduction in the amount of wood pellet grills or other products purchased by our retailers, or our inability to renegotiate or replace our existing contracts on economically acceptable terms, could have a material adverse effect on our results of operations, business, and financial position.\nIf we are unable to anticipate customer preferences and successfully develop new, innovative, and updated products, services, and features, or if we fail to effectively manage the introduction of new products, services, and features, our business will suffer.\nThe market for our products is characterized by new product and service introductions, frequent enhancements to existing products, and changing customer demands, needs, and preferences. Our success depends on our ability to identify and originate trends and to anticipate and react to changing customer demands, needs, and preferences in a timely manner. Changes in customer preferences cannot be predicted with certainty. If we are unable to introduce new or enhanced products, services or features in a timely manner, or our new or enhanced products, services, and features are not widely accepted by customers, our competitors may introduce similar concepts faster than us, which could negatively affect our sales and growth. Moreover, new products, services, and features may not be accepted by customers, as preferences could shift rapidly to different types of cooking methodologies and techniques or away from our offerings altogether, and our future success depends in part on our ability to anticipate and respond to such changes. For instance, a shift in consumer tastes, dietary habits, and nutritional values, concerns regarding the health effects of foods typically cooked on our grills and shifts in preference from animal-based protein to plant-based protein products could reduce our sales or our market share, which would harm our business and financial condition. Similarly, a shift in consumer tastes regarding the flavors of our wood pellets or other consumables could impact our ability to drive recurring sales from such items, which could have an adverse impact on our growth and revenue. In addition, we may not be successful at introducing the Traeger experience into other categories in the food-at-home market.\nFailure to anticipate and respond in a timely manner to changing customer preferences could lead to, among other things, lower sales, pricing pressure, lower margins, discounting of our existing products and excess inventory levels. Even if we are successful in initiating or anticipating such preferences, our ability to adequately address or react to them will partially depend upon our continued ability to develop, introduce, and market innovative, high-quality products, services, and features. Development of new or enhanced products, services, accessories, and features may require significant time and financial resources, which could result in increased costs and a reduction in our margins. We may be unable to recoup the amount of such investments if our new or improved offerings do not gain widespread market acceptance. Moreover, we have experienced and may continue to experience delays in the development and introduction of new or enhanced products, services, accessories and features due to the effects of the current COVID-19 pandemic.\nMoreover, we must successfully manage introductions of new or enhanced products, services, and features, which could adversely impact the sales of our existing products. For instance, customers may choose to forgo purchasing existing products in advance of new product launches and we may experience higher returns from customers following the announcement of new products and features. As we introduce new or enhanced products, services and features, we may face additional challenges meeting regulatory and other compliance standards and managing a more complex supply chain and manufacturing process, including the time and cost associated with onboarding and overseeing additional suppliers, contract manufacturers, and logistics providers, among others. We may also face challenges managing the inventory of new or existing products, which could lead to excess inventory and discounting of such products. In addition, new or enhanced products and services may have varying selling prices and costs, including in comparison to legacy products, which could negatively impact our gross margins and results of operations.\nOur passion and focus on delivering a high-quality and engaging experience for our customers may not maximize short-term financial results, which may yield results that conflict with the market’s expectations and could result in our stock price being negatively affected.\nWe are passionate about continually enhancing the Traeger experience and community, with a focus on driving long-term customer engagement through innovation, immersive content, technologically advanced products, and community support, which may not necessarily maximize short-term financial results. We frequently make business decisions that may reduce our\n36\nshort-term financial results if we believe that the decisions are consistent with our goals to improve the Traeger experience and community, which we believe will improve our financial results over the long term. These decisions may not be consistent with the short-term expectations of our stockholders and may not produce the long-term benefits that we expect, in which case our customer engagement and our business, financial condition, and results of operations could be harmed.\nThe market for wood pellet grills is still in the early stages of growth and if it does not continue to grow, grows more slowly than we expect, or fails to grow as large as we expect, our business may be adversely affected.\nWhile wood pellet grills have been sold commercially since the 1980s, the market for wood pellet grills remained relatively small and niche until recently. The current broader market for wood pellet grills is relatively new and rapidly growing, and it is uncertain whether it will sustain high levels of demand and achieve wide market acceptance. Our success depends substantially on the willingness of customers to widely adopt the cooking methodologies and techniques associated with our products. To be successful, we must continue to educate customers about our products, and the related cooking methodologies and techniques, through significant investment and high-quality content that is superior to the content and cooking experiences provided by our competitors. Additionally, the market for grills and other cooking devices at large is heavily saturated, and the demand for and market acceptance of new products in the market is uncertain. It is difficult to predict the future growth rates, if any, and size of our market. We cannot assure you that our market will develop as expected, that broad public interest in wood pellet grills will continue, or that our products will be widely adopted. Furthermore, our grills require sufficient outdoor space and ventilation to safely operate, which limits our ability to sell or expand our presence in high-density, non-suburban markets. If the market for wood pellet grills does not develop, develops more slowly than expected, or becomes saturated with competitors, or if our products do not achieve market acceptance, our business, financial condition, and results of operations could be adversely affected.\nThe COVID-19 pandemic could adversely affect certain aspects of our business and negatively impact ability to access capital in the future.\nSince being reported in December 2019, COVID-19 has spread globally, including to every state in the United States, and has been declared a pandemic by the World Health Organization. The COVID-19 pandemic and preventative measures taken to contain or mitigate such have caused, and are continuing to cause, business slowdowns or shutdowns in affected areas and significant disruption in the financial markets both globally and in the United States, which could lead to a decline in discretionary spending by consumers, and in turn impact our business, sales, financial condition, and results of operations. The impacts include, but are not limited to:\n•the possibility of renewed retail store closures or reduced operating hours and/or decreased retail traffic;\n•disruption to our distribution centers and our third-party manufacturers and other vendors, including the effects of facility closures as a result of outbreaks of COVID-19 or measures taken by federal, state or local governments to reduce its spread, reductions in operating hours, labor shortages, and real time changes in operating procedures, including for additional cleaning and disinfection procedures;\n•difficulty in forecasting demand resulting in inventory constraints; and\n•significant disruption of global financial markets, which could have a negative impact on our ability to access capital in the future.\nThe COVID-19 pandemic has significantly impacted the global supply chain, with restrictions and limitations on related activities causing disruption and delay, along with increased raw material, storage, and shipping costs. These disruptions and delays have strained domestic and international supply chains, which have affected and could continue to negatively affect the flow or availability of certain products. Furthermore, significantly increased demand from online sales channels, including our website, has impacted our logistical operations, including our fulfillment and shipping functions, which has resulted in periodic delays in the delivery of our products. The further spread of COVID-19, and the requirements to take action to help limit the spread of the illness, could impact our ability to carry out our business as usual and may materially adversely impact global economic conditions, our business, results of operations, cash flows, and financial condition. For example, travel restrictions imposed as a result of the COVID-19 pandemic negatively impacted certain of our product development initiatives, as we were unable to visit certain third-party manufacturers to review processes and procedures for new products and product enhancements. The extent of the impact of COVID-19 on our business and financial results will depend on future developments, including the duration and severity of the outbreak (including the severity and transmission rates of new variants of the coronavirus) within the markets in which we and our manufacturers and suppliers operate, the timing, distribution, and efficacy of vaccines and other treatments, the related impact on consumer confidence and spending, and the effect of governmental regulations imposed in response to the pandemic, all of which are highly uncertain and ever-changing. While we have experienced an increase in demand for our products due to the impact that the COVID-19 pandemic has had on consumer\n37\nbehaviors, including due to various stay-at-home orders and restrictions on dining options and restaurant closures, this increased demand may not be sustained following the pandemic, or if economic conditions worsen, which would negatively impact consumer spending.\nThe sweeping nature of the COVID-19 pandemic makes it extremely difficult to predict how our business and operations will be affected over the long term. However, the likely overall economic impact of the pandemic is generally viewed as highly negative to the general economy. Any of the foregoing factors, or other cascading effects of the coronavirus pandemic, could materially increase our costs, negatively impact our sales and damage our results of operations and liquidity, possibly to a significant degree. The duration of any such impacts or likelihood of any similar future pandemics cannot be predicted.\nOur estimated addressable market is subject to inherent challenges and uncertainties. If we have overestimated the size of our addressable market, our future growth opportunities may be limited.\nOur U.S. total addressable market (\"TAM\"), as estimated in our Prospectus, is calculated based on an estimated percentage of households in the United States that have a grill, which is estimated based on internal and third-party market research, historical surveys, and interviews with market participants. Our U.S. serviceable addressable market (\"SAM\"), as estimated in our Prospectus, is based on internal survey analysis from a survey we conducted in March 2021 with approximately 4,200 consumers across the United States, Canada, the United Kingdom, and Germany, including 2,600 consumers in the United States, including 157 recent Traeger purchasers. As a result, each of our U.S. TAM and U.S. SAM is subject to significant uncertainty and is based on assumptions that may not prove to be accurate. Our estimates are based, in part, on third-party reports and are subject to significant assumptions and estimates. These estimates and forecasts relating to the size and expected growth of the markets in which we operate, and our penetration of those markets, may change or prove to be inaccurate. While we believe the information on which we base our U.S. TAM and U.S. SAM is generally reliable, such information is inherently imprecise. In addition, our expectations, assumptions and estimates of future opportunities are necessarily subject to a high degree of uncertainty and risk due to a variety of factors, including those described herein. If third-party or internally generated data prove to be inaccurate or we make errors in our assumptions based on that data, our future growth opportunities may be affected. If our addressable market, or the size of any of the various ancillary markets in which we operate, proves to be inaccurate, our future growth opportunities may be limited and there could be a material adverse effect on our prospects, business, financial condition, and results of operations.\nCompetitors have imitated and attempted to imitate, and will likely continue to imitate or attempt to imitate, our products, and technology. If we are unable to protect or preserve our brand image and proprietary rights, our business may be harmed.\nAs our business continues to expand, our competitors have imitated or attempted to imitate, and will likely continue to imitate or attempt to imitate, our product designs, functionality, and branding, which could harm our business and results of operations. Only a portion of the intellectual property used in the manufacture and design of our products is patented, and we therefore rely on other forms of protection, including trade and service marks, trade dress, trade secrets, and the strength of our brand. For example, the original patent for pellet grills, which was filed by Joe Traeger in 1986, expired in 2006. Following expiration of this patent, competitors introduced competing products with similar designs and technologies, and there are currently a significant number of wood pellet grills available from a variety of competitors, including Weber and Dansons, among others. We regard our patents, trade dress, trademarks, copyrights, trade secrets, and similar proprietary rights as critical to our success. We also rely on trade secret protection and confidentiality agreements with our employees, consultants, suppliers, manufacturers, and others to protect our proprietary rights. Nevertheless, the steps we take to protect our proprietary rights against infringement or other violation may be inadequate, and we may experience difficulty in effectively limiting the unauthorized use of our patents, trademarks, trade dress, and other intellectual property and proprietary rights worldwide. We also cannot guarantee that others will not independently develop technology with the same or similar function to any proprietary technology we rely on to conduct our business and differentiate ourselves from our competitors. As we continue to grow our business and strengthen our brand, we expect to experience increased counterfeiting of our products, including, among others, imitation and look-alike products and fraudulent website and distributors. Unauthorized use or invalidation of our patents, trademarks, copyrights, trade dress, trade secrets, or other intellectual property or proprietary rights may cause significant damage to our brand and harm our results of operations.\nWhile we actively develop and protect our intellectual property rights, there can be no assurance that we will be adequately protected in all countries in which we conduct our business or that we will prevail when defending our patent, trademark, and proprietary rights. Additionally, we could incur significant costs and management distraction in pursuing claims to enforce our intellectual property rights through litigation and defending any alleged counterclaims. If we are unable to protect or preserve the value of our patents, trade dress, trademarks, copyrights, or other intellectual property rights for any reason, or if we fail to maintain our brand image due to actual or perceived product or service quality issues, adverse publicity,\n38\ngovernmental investigations or litigation, or other reasons, our brand and reputation could be damaged, and our business may be harmed.\nOur revenue and profits depend on the level of customer spending for discretionary items, which is sensitive to general economic conditions and other factors.\nDemand for our premium products is significantly influenced by a number of economic factors affecting our customers and trends in customer spending. For example, demand for our grills is particularly sensitive to consumer spending levels as our grills can represent expensive purchases for consumers. There are a number of factors that influence consumer spending, including actual and perceived economic conditions, consumer confidence, disposable income, credit availability, unemployment, and tax rates in the markets where we sell our products. Consumers also have discretion as to where to spend their disposable income and may choose to purchase other items if we do not continue to provide authentic, compelling, and high-quality products at appropriate price points. As global economic conditions continue to be volatile and economic uncertainty remains, trends in discretionary spending also remain unpredictable and subject to declines. Any of these factors could harm discretionary spending, resulting in a reduction in demand for our products, decreased prices, and harm to our business and results of operations. Moreover, purchases of discretionary items, such as our premium products, tend to decline during recessionary periods when disposable income is lower or during other periods of economic instability or uncertainty, which may slow our growth more than we anticipate. A downturn in the economies in markets in which we sell our products, particularly in the United States, may materially harm our sales, profitability, and financial condition.\nOur results of operations may suffer if we do not accurately forecast demand for our products or successfully manage our inventory to match customer demand.\nTo ensure adequate inventory supply, we must forecast inventory needs and place orders with our manufacturers before firm orders are placed by our customers. If we fail to accurately forecast customer demand, we may experience excess inventory levels or a shortage of product to deliver to our customers. Factors that could affect our ability to accurately forecast demand for our products include: (a) an increase or decrease in demand for our products; (b) our failure to accurately forecast customer acceptance for our new products; (c) product introductions by competitors; (d) unanticipated changes in general market conditions or other factors, which may result in cancellations of orders or a reduction or increase in the rate of reorders or at-once orders placed by retailers; (e) the impact of unseasonable weather conditions; (f) weakening of economic conditions or consumer confidence in future economic conditions, which could reduce demand for discretionary items, such as our products; and (g) terrorism or acts of war, or the threat thereof, or political or labor instability or unrest, riots, public health crises such as the current COVID-19 pandemic (or other future pandemics or epidemics), which could adversely affect consumer confidence and spending or interrupt production and distribution of product and raw materials.\nInventory levels in excess of customer demand may result in inventory write-downs or write-offs and the sale of excess inventory at discounted prices or in less preferred distribution channels, which could impair our brand image and harm our margins. In addition, if we underestimate the demand for our products, our manufacturers may not be able to produce products to meet our requirements, and this could result in delays in the shipment of our products, lost sales, and damage to our reputation and retailer and distributor relationships. For example, late in the first quarter of 2020, we reduced inventory purchase orders as a precautionary measure against the unknown impact of the COVID-19 pandemic on the economy and our business and to improve financial flexibility. These actions, coupled with the overall strong demand during 2020, ultimately contributed to lower than expected inventory levels throughout the second half of 2020 and, in turn, resulted in inventory constraints in the second half of 2020 continuing into early 2021.\nSuch difficulty in forecasting demand, which we have encountered and may continue to encounter as a result of the COVID-19 pandemic, also makes it difficult to estimate our future results of operations and financial condition from period to period. A failure to accurately predict the level of demand for our products could adversely impact our profitability or cause us not to achieve our expected financial results.\nOur business may fluctuate as a result of seasonality and changes in weather conditions.\nWe have typically experienced moderately higher levels of sales of our grills in the first and second quarters of the year as our retailers purchase inventory in advance of warmer weather, when demand for outdoor cooking products is the highest across our key markets. Higher sales also coincide with social events and national holidays, which occur during the same timeframe. Although our products can be used year-round, unusually adverse weather conditions can negatively impact the timing of the sales of certain of our products, causing reduced sales and negatively impacting profitability when such conditions exist. Prolonged adverse weather conditions could significantly reduce our sales in one or more periods. These conditions may shift sales to subsequent reporting periods, cause our results of operations to fluctuate on a quarterly basis, or decrease overall\n39\nsales. Further, our quarterly results of operations in future fiscal years may fluctuate or otherwise be significantly affected as a result of the COVID-19 pandemic. The effect of the pandemic may exceed the quarterly changes in our results of operations that we have typically experienced from seasonality and weather conditions.\nIf our plan to increase sales through our direct to customer channel is not successful, our business and results of operations could be harmed.\nPart of our growth strategy involves increasing our DTC sales through our website and Traeger app. However, we have limited operating and compliance experience executing the retail component of this strategy, and our competitors may have a greater online presence and a more developed e-commerce platform than us. The level of customer traffic and volume of customer purchases through our websites or other e-commerce initiatives are substantially dependent on our ability to provide a content-rich and user-friendly website, a hassle-free customer experience, sufficient product availability, and reliable, timely delivery of our products. If we are unable to maintain and increase customers’ safe and effective use of our website or Traeger app, allocate sufficient product to our website or Traeger app, adequately protect our customers from fraudulent activity online, including third parties impersonating our products, and increase any sales through our DTC channel, our business, and results of operations could be harmed. Moreover, any failure or perceived failure by us to comply with applicable laws and regulations, including those associated with our website or the Traeger app, may result in governmental investigations or enforcement actions, litigation, claims or public statements against us by consumer advocacy groups or others.\nAs we expand our e-commerce platform across the geographies in which we sell our products, we may encounter different and evolving laws governing the operation and marketing of e-commerce websites, as well as the collection, storage, and use of information on customers interacting with those websites. We may incur additional costs and operational challenges in complying with these laws and regulations, and differences in these laws and regulations may cause us to operate our business differently, and less effectively, in different territories. If so, we may incur additional costs and may not fully realize the investment in our geographic expansion.\nWe have significant international operations and are exposed to risks associated with doing business globally.\nWe sell and distribute our products in many key international markets in Europe, North America, and elsewhere around the world. These activities have resulted and will continue to result in investments in inventory, accounts receivable, employees, corporate infrastructure and facilities. In addition, we source most of our products through manufacturing relationships involving suppliers and vendors located outside of the United States. The operation of foreign distribution in our international markets, as well as the management of relationships with manufacturers and foreign suppliers, will continue to require the dedication of management and other resources.\nAs a result of this international business, we are exposed to increased risks inherent in conducting business outside of the United States. These risks include the following:\n•adverse changes in foreign currency exchange rates can have a significant effect upon our results of operations, financial condition and cash flows;\n•increased difficulty in protecting our intellectual property rights and trade secrets, including litigation costs and the outcome of such litigation;\n•increased exposure to events that could impair our ability to operate internationally with third parties such as problems with such third parties’ operations, finances, insolvency, labor relations, manufacturing capabilities, costs, insurance, natural disasters or other catastrophic events;\n•unexpected legal or government action or changes in legal or regulatory requirements;\n•social, economic or political instability;\n•potential negative consequences from changes to taxation or tariff policies;\n•the effects of any anti-American sentiments on our brands or sales of our products;\n•increased difficulty in ensuring compliance by employees, agents and contractors with our policies as well as with the laws of multiple jurisdictions, including but not limited to the U.S. Foreign Corrupt Practices Act and the U.K. Bribery Act 2010, international environmental, health, and safety laws, and increasingly complex regulations relating to the conduct of international commerce, including import/export laws and regulations, economic sanctions laws and regulations and trade controls;\n40\n•increased difficulty in controlling and monitoring foreign operations from the United States, including increased difficulty in identifying and recruiting qualified personnel for our foreign operations; and\n•increased exposure to interruptions in land, air carrier, or vessel shipping services.\nWe have limited experience with international regulatory environments and market practices and may not be able to penetrate or successfully operate in any foreign markets we choose to enter. In addition, we may incur significant expenses as a result of our continued international expansion, and we may not be successful. We may face limited brand recognition in certain parts of the world that could lead to non-acceptance or delayed acceptance of our products and services by consumers in new markets. We may also face challenges to acceptance of our products and content in new markets. Our failure to successfully manage these risks could harm our international operations and have an adverse effect on our business, financial condition, and results of operations.\nWe are subject to governmental export and import controls, customs, and economic sanction laws that could subject us to liability and impair our ability to compete in international markets.\nThe United States and various foreign governments have imposed controls, export license requirements, and restrictions on the import or export of certain technologies, as well as customs and other import regulatory requirements. Our products may be subject to U.S. export controls. Compliance with applicable regulatory requirements regarding the import and export of our products may create delays in the introduction of our products in international markets, and, in some cases, prevent the export of our products to some countries altogether.\nFurthermore, U.S. export control laws and economic sanctions prohibit the provision of products and services to countries, governments, and persons targeted by U.S. sanctions. Even though we take precautions to prevent our products from being provided to targets of U.S. sanctions, our products could be provided to those targets or provided by our customers. Any such provision could have negative consequences, including government investigations, penalties, and reputational harm. Our failure to obtain required import or export approval for our products, or to comply with applicable laws and regulations with regard to our import and export activity, could harm our international and domestic sales and adversely affect our revenue.\nWe could be subject to future enforcement action with respect to compliance with governmental export and import controls, customs laws, and economic sanctions laws that result in penalties, costs, and restrictions on export privileges that could have an adverse effect on our business, financial condition, and results of operations.\nFailure to comply with anti-corruption and anti-money laundering laws, including the FCPA and similar laws associated with our activities outside of the United States, could subject us to penalties and other adverse consequences.\nWe operate a global business and may have direct or indirect interactions with officials and employees of government agencies or state-owned or government controlled entities. We are subject to the U.S. Foreign Corrupt Practices Act (\"FCPA\"), the U.S. domestic bribery statute contained in 18 U.S.C. § 201, the U.S. Travel Act, the USA PATRIOT Act, the U.K. Bribery Act, and possibly other anti-bribery and anti-money laundering laws in countries in which we conduct activities. These laws generally prohibit companies and their employees and third-party intermediaries from corruptly promising, authorizing, offering, or providing, directly or indirectly, improper payments of anything of value to government officials, political parties, and private-sector recipients for the purpose of obtaining or retaining business, directing business to any person, or securing any improper advantage. Certain laws, including the U.K. Bribery Act, also prohibit soliciting or receiving bribes or improper payments. In addition, U.S. public companies are required to maintain records that accurately and fairly represent their transactions and have an adequate system of internal accounting controls. In many foreign countries, including countries in which we may conduct business, it may be a local custom that businesses engage in practices that are prohibited by the FCPA or other applicable laws and regulations. We face significant risks if we or any of our directors, officers, employees, agents or other partners or representatives fail to comply with these laws and governmental authorities in the United States and elsewhere could seek to impose substantial civil and/or criminal fines and penalties which could have a material adverse effect on our business, reputation, results of operations, and financial condition.\nWe have implemented an anti-corruption compliance program and policies, procedures and training designed to foster compliance with these laws. However, our employees, contractors, and agents, and companies to which we outsource certain of our business operations, may take actions in violation of our policies or applicable law. Any such violation could have an adverse effect on our reputation, business, results of operations, and prospects.\nAny violation of the FCPA, other applicable anti-corruption laws, or anti-money laundering laws could result in whistleblower complaints, adverse media coverage, investigations, loss of export privileges, severe criminal or civil sanctions\n41\nand, in the case of the FCPA, suspension or debarment from U.S. government contracts, any of which could have a materially adverse effect on our reputation, business, results of operations, and prospects. In addition, responding to any enforcement action may result in a significant diversion of management’s attention and resources and significant defense costs and other professional fees.\nOur business could be adversely affected from an accident, safety incident, or workforce disruption. Our internal manufacturing processes and related activities, as well as our in-house warehousing and last-mile logistics activities, could expose us to significant personal injury claims that could subject us to substantial liability.\nThe COVID-19 pandemic increases our exposure to these risks; for example, various local government orders have been implemented in areas where we operate that require us to secure personal protective equipment, such as face masks and gloves, for our delivery teams, and to implement new methods of monitoring employee health, such as temperature checks. As these government orders have come down, a global shortage of personal protective equipment has resulted, and we have experienced delays and increased costs in obtaining these materials for our teams. Our inability to timely adapt to changing norms and requirements around maintaining a safe workplace during the COVID-19 pandemic could cause employee illness, accidents, or team discontent if it is perceived that we are failing to protect the health and safety of our employees. While we maintain liability insurance, the amount of such coverage may not be adequate to cover fully all claims, and we may be forced to bear substantial losses from an accident or safety incident resulting from our manufacturing, warehousing, or last-mile activities.\nWe are subject to payment-related risks that may result in higher operating costs or the inability to process payments, either of which could harm our business, financial condition and results of operations.\nFor sales through our DTC channel, as well as for sales to certain retailers through our retail channel, we accept a variety of payment methods, including credit cards, debit cards, electronic funds transfers, electronic payment systems, and gift cards, as applicable. Accordingly, we are, and will continue to be, subject to significant and evolving regulations and compliance requirements, including obligations to implement enhanced authentication processes that could result in increased costs and liability, and reduce the ease of use of certain payment methods. For certain payment methods, including credit and debit cards, as well as electronic payment systems, we pay interchange and other fees, which may increase over time. We rely on independent service providers for payment processing, including credit and debit cards. If these independent service providers become unwilling or unable to provide these services to us, or if the cost of using these providers increases, our business could be harmed. We and our payment processing providers are also subject to payment card association operating rules and agreements, including data security rules and agreements, certification requirements, and rules governing electronic funds transfers, which could change or be reinterpreted to make it difficult or impossible for us to comply. If we fail to comply with these rules, agreements or requirements, or if our data security systems are breached or compromised, we may be liable for losses incurred by card issuing banks or customers, subject to fines and higher transaction fees, lose our ability to accept credit or debit card payments from our customers, or process electronic fund transfers or facilitate other types of payments. Any failure to comply could significantly harm our brand, reputation, business, financial condition, and results of operations.\nIn the future, we may accept bitcoin or other forms of cryptocurrency as a form of payment for our products, subject to applicable laws, which we may or may not liquidate upon receipt. The prices of such assets have been in the past and may continue to be highly volatile, including as a result of various associated risks and uncertainties. If we hold such assets and their values decrease relative to our purchase prices, our financial condition may be harmed.\nOur revenue could decline due to changes in credit markets and decisions made by credit providers.\nCertain of our customers finance their purchase of our grills through third-party credit providers with whom we have existing relationships. If we are unable to maintain our relationships with our financing partners, there is no guarantee that we will be able to find replacement partners who will provide our customers with financing on similar terms, and our ability to sell our grills may be adversely affected. Further, reductions in consumer lending and the availability of consumer credit could limit the number of customers with the financial means to purchase our grills. Higher interest rates could increase our costs or the monthly payments for grills financed through other sources of consumer financing. In the future, we cannot be assured that third-party financing providers will continue to provide consumers with access to credit or that available credit limits will not be reduced. Such restrictions or reductions in the availability of consumer credit, or the loss of our relationship with our current financing partners, could have an adverse effect on our business, financial conditions, and results of operations.\n42\nCustomer demand for sustainably produced products could reduce buyers for our products and competition among buyers for our products, which may have a material adverse effect on our business, cash flows, and results of operations.\nSome of our customers have expressed a preference that certain of our products be made from raw materials sourced from forests certified to different standards, including standards of the Forest Stewardship Council (\"FSC\"). Additionally, some environmental organizations have targeted the wood pellet industry as harmful to the environment and encouraged consumers to opt for more environmentally friendly options. If customer demand for sustainably produced products (including FSC) increases, there may be reduced demand and we may only be able to charge lower prices for our products relative to our competitors who can supply products sourced from forests certified to such standards. Furthermore, if we and our competitors seek to comply with sustainability initiatives, including FSC, we could incur materially increased costs for our operations or be required to modify our existing operations, which would have a material adverse effect on our revenue, margins and cash flows. In addition, we may be unable to obtain the raw materials (particularly wood fiber from third parties for use at our wood pellet facilities) required to sustain our growth and satisfy our existing and future customer contracts. FSC, in particular, employs standards that are geographically variable and could cause a material reduction in our ability to source wood pellets, which would have a material adverse effect on our ability to execute our business plan and our results of operations.\nSignificant increases in the cost of raw materials for our wood pellet facilities or our suppliers suffering from operating or financial difficulties could adversely impact revenue and our ability to satisfy customer demand.\nWe purchase wood fiber from third parties for use at our wood pellet facilities. Our reliance on third parties to secure wood fiber exposes us to potential price volatility and unavailability of such raw materials, and the associated costs may exceed our ability to pass through such price increases to customers, which could adversely affect our gross margins. For example, the price of lumber has significantly increased in recent years. Further, delays or disruptions in obtaining wood fiber may result from a number of factors affecting our suppliers, including extreme weather or forest fires, production or delivery disruptions, inadequate logging capacity, labor disputes, impaired financial condition of a particular supplier, the inability of suppliers to comply with regulatory or sustainability requirements (including increased sustainability standards, such as the FSC) or decreased availability of raw materials. In addition, other companies, whether or not in our industry, could procure wood fiber within our procurement areas and adversely change regional market dynamics, resulting in insufficient quantities of raw material or higher prices. Any of these events or the impact on the availability of wood fiber could increase our operating costs or prevent us from selling our wood pellets in quantities that satisfy customer demand, and thereby could have a material adverse effect on our brand, reputation, business, financial condition, and results of operations.\nOur revenues, net income, and cash flow from operations are dependent to a significant extent on the pricing of our products and our continued ability to secure raw materials at adequate levels and acceptable prices. Therefore, if we are restricted from securing a sufficient amount of raw materials from third parties for a prolonged period of time, or if material damage to a significant portion of such third-party landowners’ standing timber were to occur, we could suffer materially adverse effects to our results of operations. Any interruption or delay in the supply of wood fiber, or our inability to obtain wood fiber at acceptable prices in a timely manner, could impair our ability to meet the demands of our customers, which could have a material adverse effect on our brand, reputation, business, financial condition, and results of operations.\nFailure to implement effective quality control systems at our wood pellet facilities could have a material adverse effect on our business and operations.\nThe performance and quality of our wood pellet products are important to the success of our business and can significantly impact the cooking experience of our grills and the taste of food cooked with our grills. To ensure consistent product quality, we must develop and implement improved quality control systems and quality training programs, and must otherwise promote and enforce employee adherence to our quality control policies and guidelines. We must also update such policies and guidelines and may be required to hire additional personnel and quality control specialists. We have a limited history in operating wood pellet manufacturing facilities at both our existing and planned scale and may experience challenges in implementing improvements to our processes and operations that are necessary to support future business needs, which further increases our risk with respect to quality controls. Any significant failure involving the development, implementation or maintenance of quality control systems and related programs could have a negative impact on our product quality and consistency, which could have a material adverse effect on our business, financial condition, results of operations and reputation.\n43\nAn increase in the price or a significant interruption in the supply of electricity could have a material adverse effect on our results of operations.\nOur wood pellet facilities use a substantial amount of electricity. The price and supply of electricity are unpredictable and can fluctuate significantly based on international, political and economic circumstances, as well as other events outside our control, such as changes in supply and demand due to weather conditions, regional production patterns and environmental concerns. In addition, potential climate change regulations or carbon or emissions taxes could result in higher production costs for electricity, which may be passed on to us in whole or in part and we may not have the ability to pass such costs through to the customer, which could adversely affect our gross margins. A significant increase in the price of electricity or an extended interruption in the supply of electricity to our production plants could have a material adverse effect on our results of operations and cash flows.\nIncreases in labor costs, potential labor disputes, and work stoppages or an inability to hire skilled manufacturing, sales, and other personnel could adversely affect our business.\nAn increase in labor costs, work stoppages or disruptions at our facilities or those of our suppliers or transportation service providers, or other labor disruptions, could decrease our sales and increase our expenses. In addition, although our employees are not represented by a union, our labor force may become subject to labor union organizing efforts, which could cause us to incur additional labor costs and increase the related risks that we now face. It is also possible that a union seeking to organize one subset of our employee population, such as the employees in our manufacturing facility, could also mount a corporate campaign, resulting in negative publicity or other actions that require attention by our management team and our employees. Negative publicity, work stoppages, or strikes by unions could have an adverse effect on our business, prospects, financial condition, and results of operations.\nThe competition for skilled manufacturing, sales and other personnel can be intense in the regions in which our wood pellet facilities are located. A significant increase in the salaries and wages paid in these regions or by competing employers could result in a reduction of our labor force, increases in the salaries and wages that we must pay or both. If we are unable to hire skilled manufacturing, sales, and other personnel, our ability to execute our business plan, and our results of operations, would suffer.\nOur wood pellet production operations are subject to operational hazards and downtimes or interruptions, which may have a material adverse effect on our business and results of operations.\nOur wood pellets are combustible products. Fires and explosions have occurred at similar entities. As a result, our business could be adversely affected by these and other operational hazards and could suffer catastrophic loss due to unanticipated events such as explosions, fires, natural disasters or severe weather conditions. Severe weather, such as floods, earthquakes, hurricanes, forest fires or other catastrophes, or climatic phenomena, such as drought, may impact our operations by causing weather-related damage to our wood pellet facilities and equipment. Such severe weather may also adversely affect the ability of our suppliers to provide us with the raw materials we require or the ability of vessels to load, transport, and unload our wood pellet products. In addition, our wood pellet facilities are subject to the risk of unexpected equipment failures. At our wood pellet facilities plants, our manufacturing processes are dependent upon critical pieces of equipment, and such equipment may, on occasion, be out of service as a result of such failures. As a result, we may experience material facility shutdowns or periods of reduced production, which could have a material adverse effect on our business and results of operations. Any interference with or curtailment of our wood pellet facilities and related production operations could result in a loss of productivity, an increase in our operating costs and decrease in revenue, which may have a material adverse effect on our business and results of operations.\nIn addition, we may not be fully insured against all risks incident to our wood pellet production operations, including the risk of our operations being interrupted due to severe weather and natural disasters. Furthermore, we may be unable to maintain or obtain insurance of the type and amount we desire at reasonable rates. As a result of market conditions, premiums and deductibles for certain of our insurance policies could escalate. In some instances, insurance could become unavailable or available only for reduced amounts of coverage. If we were to incur a significant liability for which we are not fully insured, it could have a material adverse effect on our financial condition and results of operations.\nOur wood pellet production operations are subject to stringent environmental and occupational health and safety laws and regulations that may expose us to significant costs and liabilities.\nOur wood pellet production operations are subject to stringent federal, regional, state, and local environmental, health and safety laws and regulations. These laws and regulations govern environmental protection, occupational health and safety, the\n44\nrelease or discharge of materials into the environment, air emissions, wastewater discharges, the investigation and remediation of contaminated sites and allocation of liability for cleanup of such sites. These laws and regulations may restrict or impact our business in many ways, including by requiring us to acquire permits or other approvals to conduct regulated activities; limiting our air emissions or wastewater discharges or requiring us to install costly equipment to control, reduce or treat such emissions or discharges; imposing requirements on the handling or disposal of wastes; impacting our ability to modify or expand our operations (for example, by limiting or prohibiting construction and operating activities in environmentally sensitive areas); and imposing health and safety requirements for worker protection. We may be required to make significant capital and operating expenditures to comply with these laws and regulations. Failure to comply with these laws and regulations may result in the assessment of administrative, civil, and criminal penalties, imposition of investigatory or remedial obligations, suspension or revocation of permits and the issuance of orders limiting or prohibiting some or all of our operations. Adoption of new or modified environmental laws and regulations may impair the operation of our wood pellet production operations, delay or prevent expansion of existing facilities or construction of new facilities and otherwise result in increased costs and liabilities, which may be material.\nCertain environmental laws, including the Comprehensive Environmental Response, Compensation, and Liability Act (\"CERCLA\"), and analogous state laws, impose strict as well as joint and several liability upon statutorily defined parties without regard to comparative fault. Under these laws, we may be required to remediate contaminated properties currently or formerly operated by us, or facilities of third parties that received waste generated by our wood pellet production operations. Such remediation obligations may be imposed regardless of whether such contamination resulted in whole or in part from the conduct of others and whether such contamination resulted from actions (by us or third parties) that complied with all applicable laws in effect at the time of those actions. Our facilities are located on sites that have been used for manufacturing activities for an extended period of time, which increases the possibility of contamination being present. In addition, claims for damages to persons or property, including natural resources, may result from the environmental, health, and safety impacts of our operations, including accidental spills or releases in the course of our operations or those of a third party. Although we are not presently aware of any material contamination on our properties or any material remediation liabilities, we cannot assure you that we will not be exposed to significant remediation obligations or liabilities in the future.\nClimate change legislation, regulatory initiatives and litigation could result in increased operating costs or, in some instances, adversely impact demand for our products.\nMany nations have agreed to limit emissions of greenhouse gas pursuant to the United Nations Framework Convention on Climate Change, also known as the “Kyoto Protocol,” and other initiatives. In December 2015, the United States and 194 other countries adopted the Paris Agreement, committing to work towards addressing climate change and agreeing to a monitoring and review process for greenhouse gas emissions. Although the United States withdrew from the Paris Agreement in November 2020, the United States officially rejoined the Paris Agreement in February 2021 following the change in Presidential administrations, and may in the future choose to join other international agreements targeting greenhouse gas emissions. In addition, in January 2021, President Biden issued an executive order directing all federal agencies to review and take action to address any federal regulations, orders, guidance documents, policies, and any similar agency actions promulgated during the prior administration that may be inconsistent with the current administration’s policies and to confront the climate crisis. President Biden also issued an executive order solely targeting climate change. The adoption of legislation or regulatory programs at the federal level, or other government action to reduce emissions of greenhouse gases, could require us to incur increased operating costs, such as costs to purchase and operate emissions control systems, to acquire emissions allowances or to comply with new regulatory or reporting requirements.\nMoreover, many U.S. states, either individually or through multi-state regional initiatives, have begun to address greenhouse gas emissions, primarily through the planned development of greenhouse gas emission inventories and/or regional greenhouse gas cap-and-trade programs. Certain states where our wood pellet facilities are located, including New York, have implemented climate change regulations and committed to reducing greenhouse gases. For example, New York recently implemented the Climate Leadership and Community Protection Act, which aims to reduce greenhouse gas emissions 40% below 1990 levels by 2030 and 85% below 1990 levels by 2050. Such regulations may increase the cost of operating such facilities or otherwise restrict the operations of such facilities, which could have an adverse impact on our business and operations.\nFurther, our markets may be affected by legislative initiatives and policies that promote or do not promote devices that have or share similar traits to our wood pellet grills, such as wood burning stoves and similar appliances. Certain jurisdictions have adopted or proposed local ordinances or policies restricting the use of a wide range of devices, which may encompass or cover the cooking mechanism utilized by our wood pellet grills. It remains uncertain whether or to what extent such restrictions could impact demand for our products or the ability of customers to use our grills in states or other jurisdictions that have adopted or may in the future adopt or implement such restrictions. The U.S. Environmental Protection Agency has issued\n45\nregulations that set particulate matter limits for certain wood-burning appliances that people use to heat their home. While these limits are not applicable to cook stoves such as wood-fired grills, the regulations impose labeling requirements that may be applicable and such regulations may be broadened in the future. These restrictions and the applicable requirements for permits or exemptions may vary significantly by location, and we may be unable to track or monitor all such restrictions in the markets in which we sell our products. Future changes to laws or policies relating to these or similar matters could reduce demand for our products and have a material adverse effect on our business, financial condition and results of operations.\nAs a producer and distributor of a variety of consumer products, we must comply with various federal, state, provincial, local and foreign laws relating to the materials, production, packaging, quality, labeling and distribution of our products, including various environmental and health and safety laws and regulations. For example, the electronic components of our products may be subject to restrictions regarding the raw materials used and end of life requirements such as the collection, recycling and recovery of wastes. Our food products must meet U.S. Food and Drug Administration (\"FDA\"), or parallel foreign requirements of safety for human consumption, labeling, processing and distribution under sanitary conditions and production in accordance with FDA “good manufacturing practices.” Should our products fail to comply with such laws and regulations or the interpretation or enforcement of such laws and regulations becomes more stringent, our costs could increase and changes to our products or operations could be required, which may have an adverse effect on our business, financial condition, results of operations or prospects.\nFederal, state, and local legislative and regulatory initiatives relating to forestry products and the potential for related litigation could result in increased costs, additional operating restrictions or delays for our suppliers, which could negatively impact our business, financial condition, and results of operations.\nCommercial forestry is regulated by complex regulatory frameworks at each of the federal, state, and local levels. Among other federal laws, the Clean Water Act and Endangered Species Act have been applied to commercial forestry operations through agency regulations and court decisions, as well as through the delegation to states to implement and monitor compliance with such laws. State forestry laws, as well as land use regulations and zoning ordinances at the local level, are also used to manage forests in the United States, as well as other regions from which we may need to source raw materials in the future. Any new or modified laws or regulations at any of these levels could have the effect of reducing forestry operations in areas where we procure our raw materials, and consequently may prevent us from purchasing raw materials in an economic manner, or at all. In addition, future regulation of, or litigation concerning, the use of timberlands, the protection of threatened or endangered species or their habitats, the promotion of forest biodiversity, and the response to and prevention of wildfires, as well as litigation, campaigns or other measures advanced by environmental activist groups, could also reduce the availability of the raw materials required for our operations and the production of our wood pellets.\nRegulatory authorities in the United States, European Union and elsewhere are increasingly regulating hazardous materials and other substances, and those regulations could affect sales of our products.\nLegislation and regulations concerning hazardous materials and other substances can restrict the sale of products and/or increase the cost of producing them. Some of our products are subject to restrictions under laws or regulations such as California’s Proposition 65 and the EU’s chemical substances directive. The EU “REACH” registration system requires us to perform studies of some of the materials used in our products and to register the information in a central database, increasing the cost of these products. As a result of such regulations, our ability to sell certain products may be curtailed and customers may avoid purchasing some products in favor of less regulated, less hazardous or less costly alternatives. It may be impractical for us to continue manufacturing heavily regulated products, and we may incur costs to shut down or transition such operations to alternative products. These circumstances could adversely affect our business, including our revenue and results of operations.\nRisks Related to Our Reliance on Third Parties\nWe rely on a limited number of third-party manufacturers, and problems with, or loss of, our suppliers or an inability to obtain raw materials could harm our business and results of operations.\nOur grills are produced by a limited number of third-party manufacturers. We face the risk that these third-party manufacturers may not produce and deliver our products on a timely basis or at all. Our reliance on a limited number of manufacturers for our products increases our risks, since we do not currently have alternative or replacement manufacturers for certain of our products beyond our existing manufacturers. In the event of interruption from our manufacturers or suppliers, we may not be able to increase capacity from other sources or develop alternate or secondary sources without incurring material additional costs and substantial delays, and we do not maintain sufficient inventory levels to mitigate the impact of such costs and delays. Further, certain of these manufacturers have developed specific processes and manufacturing procedures for certain\n46\nof our products, and such processes and procedures may not be easily transferred to other manufacturers, if at all. Furthermore, we expect that as we continue to introduce new products and product enhancements, our manufacturing costs will grow increasingly more complex and the cost will continue to increase. We have experienced, and will likely continue to experience, certain operational difficulties with our manufacturers. These difficulties include reductions in the availability of production capacity, errors in complying with product specifications, insufficient quality control, failures to meet production deadlines, failure to achieve our product quality standards, increases in costs of materials, and manufacturing or other business interruptions. The ability of our manufacturers to effectively satisfy our production requirements could also be impacted by manufacturer financial difficulty or damage to their operations caused by fire, terrorist attack, riots, natural disaster, public health issues such as the current COVID-19 pandemic (or other future pandemics or epidemics), or other events. In particular, the current COVID-19 outbreak has caused, and may continue to cause, interruptions in the development, manufacturing (including the sourcing of key components), and shipment of our products, which could adversely impact our revenue and results of operations. Such interruptions may be due to, among other things, temporary closures of manufacturing facilities, and other vendors and distributors in our supply chain, restrictions on travel or the import/export of goods and services from certain ports that we use, and local quarantines. The failure of any manufacturer or distributor to perform to our expectations could result in supply shortages or delays for certain products and harm our business.\nIf we experience significantly increased demand, or if we need to replace an existing manufacturer due to lack of performance, we may be unable to supplement or replace manufacturing capacity on a timely basis or on terms that are acceptable to us, which may increase our costs, reduce our margins, and harm our ability to deliver our products on time. For certain of our products, it may take a significant amount of time to identify and qualify a manufacturer that has the capability and resources to produce our products to our specifications in sufficient volume and satisfy our service and quality control standards. Accordingly, a loss of any of our significant manufacturers, suppliers or distributors could have an adverse effect on our business, financial condition, and results of operations.\nThe capacity of our manufacturers to produce our products is also dependent upon the availability of raw materials. Our manufacturers may not be able to obtain sufficient supply of raw materials, which could result in delays in deliveries of our products by our manufacturers or increased costs. Any shortage of raw materials or inability of a manufacturer to produce or ship our products in a timely manner, or at all, could impair our ability to ship orders of our products in a cost-efficient, timely manner and could cause us to miss the delivery requirements of our customers. As a result, we could experience cancellations of orders, refusals to accept deliveries, or reductions in our prices and margins, any of which could harm our financial performance, reputation, and results of operations.\nIf we fail to timely and effectively obtain shipments of products from our manufacturers and deliver products to our customers, including our retailers, our business, and results of operations could be harmed.\nOur business depends on our ability to source and distribute products in a timely manner. However, we cannot control all of the factors that might affect the timely and effective procurement of our products from our third-party manufacturers and the delivery of our products to our customers, including to retailers through our retail channel.\nOur third-party contract manufacturers ship most of our products to our third-party logistics providers, who have warehouses in California, Georgia, Texas and Washington, as well as operations in the Netherlands and Canada. The limited geographical scope of our distribution and fulfillment centers makes us vulnerable to natural disasters, weather-related disruptions, accidents, system failures, public health issues such as the current COVID-19 pandemic (or other future pandemics or epidemics), or other unforeseen events that could delay or impair our ability to fulfill orders to retail channel customers and/or ship products to DTC customers, which could harm our sales. We import our products, and we are also vulnerable to risks associated with products manufactured abroad, including, among other things: (a) risks of damage, destruction, or confiscation of products while in transit to our distribution centers; and (b) transportation and other delays in shipments, including as a result of heightened security screening, port congestion, and inspection processes or other port-of-entry limitations or restrictions in the United States. Failure to procure our products from our third-party manufacturers and deliver such products to our customers in a timely, effective, and economically viable manner could reduce our sales and gross margins, damage our brand, and harm our business.\nWe also rely on the timely and free flow of goods through open and operational ports from our suppliers and manufacturers. Labor disputes or disruptions at ports, our common carriers, or our suppliers or manufacturers could create significant risks for our business, particularly if these disputes result in work slowdowns, lockouts, strikes, or other disruptions during periods of significant importing or manufacturing, potentially resulting in delayed or canceled orders by customers, unanticipated inventory accumulation or shortages, and harm to our business, results of operations, and financial condition. In addition, we rely upon independent freight carriers for product shipments from our distribution centers to our customers. We\n47\nmay not be able to obtain sufficient freight capacity on a timely basis or at favorable shipping rates and, therefore, may not be able to receive products from suppliers or deliver products to customers in a timely and cost-effective manner.\nAccordingly, we are subject to the risks, including labor disputes, union organizing activity, inclement weather, public health crises such as the current COVID-19 pandemic (or other future pandemics or epidemics), and increased transportation costs, associated with our third-party manufacturers’ and carriers’ ability to provide products and services to meet our requirements. In addition, if the cost of fuel rises, the cost to deliver products may rise, which could harm our profitability.\nFluctuations in the cost and availability as well as delays of raw materials, equipment, labor, and transportation could cause manufacturing delays or increase our costs.\nThe price and availability of raw materials and key components used to manufacture our products, including electronic components, such as integrated circuits, processors and system on chips, components built into our unique specifications or that are single sourced, as well as manufacturing equipment, tooling, and wood fibers, may fluctuate significantly. In addition, the cost of labor at our third-party manufacturers could increase significantly. For example, manufacturers in China have experienced increased costs in recent years due to shortages of labor and fluctuations of the Chinese yuan in relation to the U.S. dollar. Additionally, the cost of logistics and transportation fluctuates in large part due to the price of oil, global demand and other geopolitical factors. Any fluctuations in the cost and availability of any of our raw materials or other sourcing or transportation costs related to our raw materials or products could harm our gross margins and our ability to meet customer demand. For example, disruptions to or increases in the cost of local, regional domestic or international transportation services for our products and other forms of infrastructure, such as electricity, due to shortages of vessels, barges, railcars or trucks, weather-related problems, flooding, droughts, accidents, mechanical difficulties, bankruptcy, strikes, lockouts, bottlenecks (such as the recent blockage of the Suez Canal in March 2021) or other events could increase our costs, temporarily impair our ability to deliver products to our customers on time or at all and might, in certain circumstances, constitute a force majeure event under our customer contracts, permitting our customers to suspend taking delivery of and paying for our products or resulting in a charge to us for our customers’ lost profits as a result of our failure to timely deliver our products. Relatedly, some of our contracts with our large retail customers subject us to financial penalties if we fail to ship an order that is on time or in full. If we are unable to successfully mitigate a significant portion of these product cost increases, fluctuations or delays, our results of operations could be harmed.\nIn addition, persistent disruptions in our access to infrastructure may force us to halt production as we reach storage capacity at our facilities. Accordingly, if the primary transportation services we use to transport our products are disrupted, and we are unable to find alternative transportation providers, it could have a material adverse effect on our results of operations, business, and financial position.\nMany of our products are manufactured by third parties outside of the United States, and our business may be harmed by legal, regulatory, economic, political, and public health risks associated with international trade and those markets.\nMany of our primary products are manufactured by entities located in China. In addition, we have a third-party manufacturer in Vietnam. Our reliance on suppliers and manufacturers in foreign markets creates risks inherent in doing business in foreign jurisdictions, including: (a) the burdens of complying with a variety of foreign laws and regulations, including trade and labor restrictions and laws relating to the importation and taxation of goods; (b) changes in the U.S. or international regulations requiring the enactment of more restrictive environmental regulations in markets where we manufacture our products, including China and/or Vietnam; (c) weaker protection for intellectual property and other legal rights than in the United States, and practical difficulties in enforcing intellectual property and other rights outside of the United States; (d) compliance with U.S. and foreign laws relating to foreign operations and business activities, including the FCPA and the UK Bribery Act (which generally prohibit U.S. companies from making improper payments to foreign officials for the purpose of obtaining or retaining business), regulations of the U.S. Office of Foreign Assets Control (\"OFAC\") (which generally restrict U.S. companies from operating in certain countries, or maintaining business relationships with certain restricted parties), U.S. anti-money laundering regulations, and similar laws that prohibit engaging in other corrupt and illegal practices; (e) economic and political instability and acts of terrorism in the countries where our suppliers are located; (f) public health crises, such as pandemics and epidemics, in the countries where our suppliers and manufacturers are located; (g) transportation interruptions or increases in transportation costs; and (h) the imposition of tariffs or non-tariff barriers on components and products that we import into the United States or other markets. For example, the ongoing COVID-19 pandemic has resulted in increased travel restrictions, supply chain disruptions, and extended shutdown of certain businesses around the globe. This public health crises or any further political developments or health concerns in markets in which our products are manufactured could result in social, economic, and labor instability, adversely affecting the supply of our products and, in turn, our business, financial condition, and results of operations. Further, we cannot assure you that our directors, officers, employees, representatives, manufacturers, or suppliers have not engaged and will not engage in conduct for which we\n48\nmay be held responsible, nor can we assure you that our manufacturers, suppliers, or other business partners have not engaged and will not engage in conduct that could materially harm their ability to perform their contractual obligations to us or even result in our being held liable for such conduct. Violations of the FCPA, the UK Bribery Act, OFAC regulations, or other export control, anti-corruption, anti-money laundering, and anti-terrorism laws or regulations may result in severe criminal or civil penalties, and we may be subject to other related liabilities, which could harm our business, financial condition, cash flows, and results of operations.\nChanges to United States trade policies that restrict imports or increase import tariffs may have a material adverse effect on our business.\nThere have been significant changes and proposed changes in recent years to U.S. trade policies, tariffs, and treaties affecting imports. For example, the United States has imposed supplemental tariffs of up to 25% on certain imports from China, as well as increased tariffs and import restrictions on products imported from various other countries. In response, China and other countries have imposed or proposed additional tariffs on certain exports from the United States. The United States is also investigating certain trade-related practices by Vietnam that could affect U.S. imports from that country, and has recently renegotiated the multilateral trading relationship between the United States, Canada, and Mexico, resulting in the replacement of the North American Free Trade Agreement (\"NAFTA\") with a new U.S.-Mexico-Canada Agreement (\"USMCA\").\nA significant proportion of our products are manufactured in China, Vietnam, and other regions outside of the United States. Accordingly, such U.S. policy changes have made it and may continue to make it difficult or more expensive for us to obtain certain products manufactured outside the United States, which could affect our revenue and profitability. Further tariff increases could require us to increase our prices, which could decrease customer demand for our products. Retaliatory tariff and trade measures imposed by other countries could affect our ability to export products and therefore adversely affect our revenue. Any of these factors could depress economic activity and restrict our access to suppliers or customers, and could have a material adverse effect on our business, financial condition, and results of operations and affect our strategy in China, Vietnam, and elsewhere around the world.\nWe depend on our retailers to display and present our products to customers, and our failure to maintain and further develop our relationships with our retailers could harm our business.\nThrough our retail channel, we sell a significant amount of our products through knowledgeable national, regional, and independent retailers. These retailers service customers by stocking and displaying our products, explaining our product attributes and capabilities, and sharing our brand story. Our relationships with these retailers are important to the authenticity of our brand and the marketing programs we continue to deploy. Our failure to maintain relationships with retailers and brand ambassadors at retailers, or financial difficulties experienced by these retailers, could harm our business.\nBecause we are a premium brand, our sales depend, in part, on retailers effectively displaying our products, including providing attractive space and point of purchase displays in their stores and e-commerce platforms, and training their sales personnel to sell our products. If retailers reduce or terminate those activities, we may experience reduced sales of our products, resulting in lower gross margins, which would harm our results of operations.\nInsolvency, credit problems or other financial difficulties that could confront our retailers or distributors could expose us to financial risk.\nWe sell to the large majority of retail channel customers on open account terms and do not require collateral or a security interest in the inventory we sell them. Consequently, our accounts receivable for our retail channel customers are unsecured. We also rely on third-party distributors to distribute our products to our retail channel and DTC customers. Insolvency, credit problems, or other financial difficulties confronting our retailers or distributors could expose us to financial risk. These actions could expose us to risks if our distributors are unable to distribute our products to our customers and/or if our retail channel customers are unable to pay for the products they purchase from us in a timely matter or at all. Financial difficulties of our retailers could also cause them to reduce their sales staff, use of attractive displays, number or size of stores, and the amount of floor space dedicated to our products. Any reduction in sales by, or loss of, our current retailers or customer demand, or credit risks associated with our retailers or distributors, could harm our business, results of operations, and financial condition.\nIf our independent suppliers and manufacturers do not comply with ethical business practices or with applicable laws and regulations, our reputation, business, and results of operations could be harmed.\nOur reputation and our customers’ willingness to purchase our products depend in part on our suppliers’, manufacturers’, and retailers’ compliance with ethical employment practices, such as with respect to child labor, wages and benefits, forced\n49\nlabor, discrimination, safe and healthy working conditions, and with all legal and regulatory requirements relating to the conduct of their businesses. We do not exercise control over our suppliers, manufacturers, and retailers and cannot guarantee their compliance with ethical and lawful business practices. If our suppliers, manufacturers, or retailers fail to comply with applicable laws, regulations, safety codes, employment practices, human rights standards, quality standards, environmental standards, production practices, or other obligations, norms, or ethical standards, our reputation and brand image could be harmed, and we could be exposed to litigation and additional costs that would harm our business, reputation, and results of operations.\nRisks Related to our Capital Structure, Indebtedness and Capital Requirements\nWe depend on cash generated from our operations to support our growth, and we may need to raise additional capital, which may not be available on terms acceptable to us or at all.\nWe primarily rely on cash flow generated from our sales to fund our current operations and our growth initiatives. As we expand our business, we will need significant cash from operations to purchase inventory, increase our product development, expand our manufacturer and supplier relationships, pay personnel, pay for the increased costs associated with operating as a public company, expand internationally, and further invest in our sales and marketing efforts. If our business does not generate sufficient cash flow from operations to fund these activities and sufficient funds are not otherwise available from our current or future credit facility, we may need additional equity or debt financing. If such financing is not available to us on satisfactory terms, our ability to operate and expand our business or to respond to competitive pressures could be harmed. Moreover, if we raise additional capital by issuing equity securities or securities convertible into equity securities, the ownership of our existing stockholders may be diluted. The holders of new securities may also have rights, preferences or privileges which are senior to those of existing holders of common stock. In addition, any indebtedness we incur may subject us to covenants that restrict our operations and will require interest and principal payments that could create additional cash demands and financial risk for us.\nOur ability to use our net operating loss carryforwards and certain other tax attributes may be limited.\nUtilization of our net operating loss carryforwards, or NOLs, and certain other tax attributes depends on many factors, including our future income, which cannot be assured. Section 382 of the Internal Revenue Code of 1986, as amended, or Section 382, generally imposes an annual limitation on the amount of taxable income that may be offset by NOLs and certain other tax attributes when a corporation has undergone an “ownership change” (generally, if the percentage of its stock owned by its “5-percent shareholders,” as defined in Section 382, increases by more than 50 percentage points (by value) over a three-year period). We are not aware of any existing restrictions or limitations on the use of our NOLs or other tax attributes under Section 382. However, we may undergo an ownership change in the future, including as a result of the combined effect of this and future offerings, which would result in an annual limitation under Section 382. The limitations arising from any ownership change may prevent utilization of our NOLs and certain other tax attributes.\nU.S. federal NOLs generated in taxable years beginning on or before December 31, 2017, or pre-2017 NOLs, are subject to expiration while U.S. federal and certain state NOLs generated in taxable years beginning after December 31, 2017, or post- 2017 NOLs, are not subject to expiration. Additionally, for taxable years beginning after December 31, 2020, the deductibility of federal post-2017 NOLs is limited to 80% of our taxable income in such year, where taxable income is determined without regard to the NOL for such post-2017 NOLs. For these and other reasons, we may not be able to realize a tax benefit from the use of our NOLs.\nTo the extent we are not able to offset our future taxable income with our NOLs or other tax attributes, this could adversely affect our operating results and cash flows.\nChanges in our effective tax rate or exposure to additional income tax liabilities could adversely affect our financial results.\nTaxation and tax policy changes, tax rate changes, new tax laws, revised tax law interpretations, and changes in accounting standards and guidance related to tax matters may cause fluctuations in our effective tax rate. For example, the Biden administration has proposed to increase the U.S. corporate income tax rate to 28% from 21%, increase the U.S. taxation of international business operations and impose a global minimum tax. Our effective tax rate may also be impacted by changes in the geographic mix of our earnings.\nOur substantial indebtedness could materially adversely affect our financial condition.\nAs of June 30, 2021, we had cash and cash equivalents of $75.3 million, $125.0 million of available borrowing capacity under the New Revolving Credit Facility, and $100.0 million available borrowing capacity our Receivables Financing Agreement. As of June 30, 2021, the total principal amount outstanding under our New First Lien Term Loan Facility was\n50\n$510.0 million. After giving effect to our IPO, our aggregate principal amount of indebtedness outstanding under our New Credit Facilities would have been approximately $379.2 million as of June 30, 2021. Our substantial indebtedness could have important consequences to the holders of our common stock, including the following:\n•making it more difficult for us to satisfy our obligations with respect to our other debt;\n•limiting our ability to obtain additional financing to fund future working capital, capital expenditures, acquisitions or other general corporate requirements;\n•requiring us to dedicate a substantial portion of our cash flows to debt service payments instead of other purposes, thereby reducing the amount of cash flows available for working capital, capital expenditures, acquisitions, and other general corporate purposes;\n•increasing our vulnerability to general adverse economic and industry conditions;\n•exposing us to the risk of increased interest rates as our borrowings under our New First Lien Term Loan Facility and New Revolving Credit Facility are at variable rates of interest;\n•limiting our flexibility in planning for and reacting to changes in the industry in which we compete;\n•placing us at a disadvantage compared to other, less leveraged competitors; and\n•increasing our cost of borrowing.\nThe New First Lien Term Loan Facility and New Revolving Credit Facility will mature on June 2028 and June 2026, respectively. We may need to refinance all or a portion of our indebtedness on or before the maturity thereof. We may not be able to obtain such financing on commercially reasonable terms or at all. Failure to refinance our indebtedness could have a material adverse effect on us.\nThe terms of our New First Lien Credit Agreement may restrict our current and future operations, including our ability to respond to changes or to take certain actions.\nOur New First Lien Credit Agreement contains a number of restrictive covenants that impose significant operating and financial restrictions on us and may limit our ability to engage in certain acts including, but not limited to, our ability to incur additional indebtedness or liens (with certain exceptions), make certain investments, engage in fundamental changes or transactions including changes of control, transfer or dispose of certain assets, make restricted payments (including dividends), engage in new lines of business, make certain prepayments and engage in certain affiliate transactions. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Credit Facilities.” As a result of these restrictions, we may be limited in how we conduct our business, unable to raise additional debt or equity financing to operate during general economic or business downturns, or unable to compete effectively or to take advantage of new business opportunities.\nA breach of the covenants or restrictions under our New First Lien Credit Agreement could result in a default or an event of default. Such a default may allow the creditors to accelerate the related debt and may result in the acceleration of any other debt to which a cross-acceleration or cross-default provision applies. In addition, an event of default would permit the lenders to terminate all commitments to extend further credit under such facility. Furthermore, if we were unable to repay the amounts due and payable, those lenders under each facility could proceed against the collateral granted to them to secure that indebtedness. In the event our lenders were to accelerate the repayment of our indebtedness, we and our subsidiaries may not have sufficient assets to repay that indebtedness. In exacerbated or prolonged circumstances, one or more of these events could result in our bankruptcy or liquidation.\nOur debt may be downgraded, which could have a material adverse effect on our business, financial condition, and results of operations.\nA reduction in the ratings that rating agencies assign to our short- and long-term debt may negatively impact our access to the debt capital markets and increase our cost of borrowing, which could have a material adverse effect on our business, financial condition, and results of operations.\nRisks Related to Intellectual Property, Information Technology, and Data Privacy\nRecent changes to patent laws in the United States and in foreign jurisdictions may limit our ability to obtain, defend, and/or enforce our patents.\n51\nThe U.S. Supreme Court has ruled on several patent cases in recent years, either narrowing the scope of patent protection available in certain circumstances or weakening the rights of patent owners in certain situations. In addition to increasing uncertainty with regard to our ability to obtain patents in the future, this combination of events has created uncertainty with respect to the value of patents, once obtained. Depending on actions by the U.S. Congress, the U.S. federal courts, and the United States Patent and Trademark Office, the laws and regulations governing patents could change in unpredictable ways that could weaken our ability to obtain new patents or to enforce patents that we have licensed or that we might obtain in the future. Similarly, changes in patent law and regulations in other countries or jurisdictions, changes in the governmental bodies that enforce them or changes in how the relevant governmental authority enforces patent laws or regulations may weaken our ability to obtain new patents or to enforce patents that we have licensed or that we may obtain in the future.\nIf our trademarks and trade names are not adequately protected, we may not be able to build name recognition in our markets of interest.\nIf our trademarks and trade names are not adequately protected, we may not be able to build name recognition in our target markets and our business may be adversely affected. At times, competitors may adopt trade names or trademarks similar to ours, thereby impeding our ability to build brand identity, possibly leading to market confusion and potentially requiring us to pursue legal action. In addition, there could be potential trade name or trademark infringement claims brought by owners of other registered trademarks or trademarks that incorporate variations of our unregistered trademarks or trade names. If we are unable to successfully register our trademarks and trade names and establish name recognition based on our trademarks and trade names, then we may not be able to compete effectively and our business may be adversely affected. Our efforts to enforce or protect our proprietary rights related to trademarks, domain names, copyrights, or other intellectual property may be ineffective and could result in substantial costs and diversion of resources and could adversely impact our financial condition or results of operations.\nOur success depends in part on our ability to operate without infringing on or misappropriating the proprietary rights of others, and if we are unable to do so we may be liable for damages.\nWe cannot be certain that United States or foreign patents or patent applications of other companies do not exist or will not be issued that would prevent us from commercializing our products. Third parties may sue us for allegedly infringing or misappropriating their patent or other intellectual property rights. Intellectual property litigation is costly. If we do not prevail in litigation, depending on the litigant, in addition to any damages we might have to pay, we could be required to cease the infringing activity or obtain a license requiring us to make royalty payments. It is possible that a required license may not be available to us on commercially acceptable terms, if at all. In addition, a required license may be non-exclusive, and therefore our competitors may have access to the same technology licensed to us. If we fail to obtain a required license or are unable to design around another company’s patent, we may be unable to make use of some of the affected products, or their features, which could reduce our revenues.\nThe defense costs and settlements for patent infringement lawsuits are not covered by insurance. Patent infringement lawsuits can take years to resolve. If we are not successful in our defenses or are not successful in obtaining dismissals of any such lawsuit and/or subsequent appeals, legal fees or settlement costs could have a material adverse effect on our results of operations and financial position.\nWe rely significantly on information technology, and any failure, inadequacy or interruption of that technology could harm our ability to effectively operate our business.\nOur business relies on information technology. Our ability to effectively manage and maintain our inventory and internal reports, and to ship products to customers and invoice them on a timely basis, depends significantly on our enterprise resource planning, warehouse management, and other information systems, including those operated by certain of our third-party partners. We also heavily rely on information systems to process financial and accounting information for financial reporting purposes. Any of these information systems could fail or experience a service interruption for a number of reasons, including computer viruses, programming errors, hacking or other unlawful activities, disasters or our failure to properly maintain system redundancy or protect, repair, maintain or upgrade our systems. The failure of our or our third-party partners’ information systems to operate effectively or to integrate with other systems, or a breach in security of these systems, could cause delays in product fulfillment and reduced efficiency of our operations, which could negatively impact our financial results. If we experienced any significant disruption to our financial information systems that we are unable to mitigate, our ability to timely report our financial results could be impacted, which could negatively impact our stock price. We also communicate electronically throughout the world with our employees and with third parties, such as customers, suppliers, vendors and consumers. A service interruption or shutdown could have a materially adverse impact on our operating activities and could\n52\nresult in reputational, competitive, and business harm. Remediation and repair of any failure, problem or breach of our key information systems could require significant capital investments.\nCyber attacks or data breaches could adversely affect our business, disrupt our operations, and negatively impact our business.\nThreats to network and data security are increasingly diverse and sophisticated. Despite our efforts and processes to prevent cyber-attacks and data breaches, our products and services, as well as our servers, computer and information systems, and those of third parties that we use in our operations are vulnerable to cybersecurity risks, including cyber-attacks such as viruses and worms, ransomware attacks, phishing attacks, denial-of-service attacks, physical or electronic break-ins, third-party or employee theft or misuse, and similar disruptions from unauthorized tampering with our servers and computer systems or those of third parties that we use in our operations, which could lead to interruptions, delays, loss of critical data, unauthorized access to customer and employee personal data, and loss of customer confidence. In addition, we may be the target of email scams that attempt to acquire personal information or company assets.\nDespite our efforts to implement security barriers to such threats, the techniques used by cyber threat actors change frequently and may be difficult to anticipate and detect. As a result, we may not be able to entirely mitigate these threats. Additionally, due to the current COVID-19 pandemic, there is an increased risk that we may experience cybersecurity-related incidents as a result of our employees, service providers, and third parties working remotely on less secure systems during government mandated shelter-in-place orders. Any cyber-attack that attempts to obtain our or our customers’ data and assets, disrupt our service, or otherwise access our systems, or those of third parties we use, if successful, could adversely affect our business, financial condition, and results of operations, be expensive to remedy, and damage our reputation. In addition, any such breaches may result in negative publicity, litigation and regulatory action or fines and adversely affect our brand, impacting demand for our products and services, and could have an adverse effect on our business, financial condition, and results of operations. The costs of mitigating cybersecurity risks are significant and are likely to increase in the future. These costs include, but are not limited to, retaining the services of cybersecurity providers; compliance costs arising out of existing and future cybersecurity, data protection and privacy laws and regulations; and costs related to maintaining redundant networks, data backups and other damage-mitigation measures.\nCertain aspects of the business, particularly our website, heavily depend on consumers entrusting personal financial information to be transmitted securely over public networks. We have experienced increasing e-commerce sales over the past several years, which increases our exposure to cybersecurity risks. We invest considerable resources in protecting the personal information of our customers but are still subject to the risks of security breaches and cyber incidents resulting in unauthorized access to stored personal information. Any breach of our cybersecurity measures could result in violation of privacy, security, and data protection laws and regulations, potential litigation, and a loss of confidence in our security measures, all of which could have a negative impact on our financial results and our reputation. In addition, a privacy breach could cause us to incur significant costs to restore the integrity of our system and could result in significant costs in government or regulator penalties and private litigation.\nWhile our insurance policies include liability coverage for certain of these matters, our insurance is subject to certain exclusions and exceptions, as well as retention amounts that could be substantial. If we experience a significant security incident, we could be subject to liability or other damages that exceed our insurance coverage and we cannot be certain that such insurance policies will continue to be available to us on economically reasonable terms, or at all, or that any insurer will not deny coverage as to any future claim. The successful assertion of one or more large claims against us that exceed available insurance coverage, or the occurrence of changes in our insurance policies, including premium increases or the imposition of sublimits, large deductible or co-insurance requirements, could have a material adverse effect on our results of operations, financial condition and cash flows.\nAny material disruption or breach of our information technology systems or those of third-party partners could materially damage our customer and business partner relationships and subject us to significant reputational, financial, legal, and operational consequences.\nWe depend on our information technology systems, as well as those of third parties, to design and develop new products, operate our website, host and manage our services, store data, process transactions, respond to user inquiries, and manage inventory and our supply chain as well as to conduct and manage other activities. Any material disruption or slowdown of our systems or those of third parties that we depend upon, including a disruption or slowdown caused by our or their failure to successfully manage significant increases in user volume or successfully upgrade our or their systems, system failures, viruses, ransomware, security breaches, or other causes, could cause information, including data related to orders, to be lost or delayed, which could result in delays in the delivery of products to retailers and customers or lost sales, which could reduce demand for\n53\nour products, harm our brand and reputation, and cause our sales to decline. If changes in technology cause our information systems, or those of third parties that we depend upon, to become obsolete, or if our or their information systems are inadequate to handle our growth, particularly as we increase sales through our website, we could damage our customer and business partner relationships and our business and results of operations could be harmed.\nWe interact with many of our consumers through our e-commerce platforms, and these systems face similar risks of interruption or attack. Consumers increasingly utilize these services to purchase our products and to engage with our brand. If we are unable to continue to provide consumers a user-friendly experience and evolve our platform to satisfy consumer preferences, the growth of our e-commerce business and our net revenues may be negatively impacted. If this software contains errors, bugs or other vulnerabilities which impede or halt service, this could result in damage to our reputation and brand, loss of users, or loss of revenue.\nWe collect, process, store, and use personal information and data, which subjects us to governmental regulation and other legal obligations related to privacy and security and our actual or perceived failure to comply with such obligations could harm our business.\nWe regularly collect, obtain, and transmit personal information about customers, employees, suppliers, and vendors in the course of conducting our business through our website, our app, and information technology systems.\nAs a result, we must comply with an increasingly complex and demanding regulatory environment, with frequent impositions of new and changing requirements enacted to protect business and personal data in the United States, Europe, and elsewhere. For example, among other cases, the California Consumer Privacy Act (CCPA) requires covered companies to provide new disclosures to California consumers and provide such consumers certain data protection and privacy rights, including the ability to opt-out of certain sales of personal information. The CCPA provides for civil penalties for violations, as well as a private right of action for certain data breaches. This private right of action may increase the likelihood of, and risks associated with, data breach litigation. A ballot initiative from privacy rights advocates intended to augment and expand the CCPA called the California Privacy Rights Act (CPRA) was passed in November 2020 and will take effect in January 2023 (with a look back to January 2022). The CPRA will significantly modify the CCPA, including by expanding consumers’ rights with respect to certain sensitive personal information. The CPRA also creates a new state agency that will be vested with authority to implement and enforce the CCPA and the CPRA. The Virginia Consumer Data Protection Act (VCDPA), which will go into effect in 2023, gives new data protection rights to Virginia residents and imposes additional obligations on controllers and processors of personal data. For example, like the CCPA, the VCDPA grants Virginia residents certain rights to access personal data that is being processed by the controller, the right to correct inaccuracies in that personal data and the right to require that their personal data be deleted by the data controller. In addition, Virginia residents will have the right to request a copy of their personal data in a format that permits them to transmit it to another data controller. Further, under the VCDPA, Virginia residents will have the right to opt out of the sale of their personal data, as well as the right to opt out of the processing of their personal data for targeted advertising. New legislation proposed or enacted in a number of U.S. states imposes, or has the potential to impose additional obligations on companies that collect, store, use, retain, disclose, transfer and otherwise process confidential, sensitive and personal information, and will continue to shape the data privacy environment nationally. State laws are changing rapidly and there is discussion in Congress of a new federal data protection and privacy law to which we would become subject if it is enacted\nWe are also subject to laws, regulations, and standards in many jurisdictions outside of the United States, which apply broadly to the collection, use, retention, security, disclosure, transfer and other processing of personal information. For example, in the European Economic Area, or EEA, the General Data Protection Regulation (GDPR) imposes stringent operational requirements for entities processing personal information and significant penalties for non-compliance. In particular, under the GDPR, fines of up to 20 million Euros or up to 4% of the annual global revenue of the noncompliant company, whichever is greater, could be imposed for violations of certain of the GDPR’s requirements. Such penalties are in addition to any civil litigation claims by data subjects and other regulatory actions that may be taken by competent authorities. As of January 1, 2021, we are also subject to the UK GDPR and UK Data Protection Act of 2018, which retains the GDPR in the United Kingdom’s national law and mirrors the fines under the GDPR.\nIn addition, we are subject to evolving EU and UK privacy laws on cookies and e-marketing. In the EU and the UK, regulators are increasingly focusing on compliance with current national laws that implement the ePrivacy Directive, and which are likely to be replaced by an EU regulation known as the ePrivacy Regulation, which will significantly increase fines for non-compliance. In the EU and the UK, informed consent is required for the placement of certain cookies or similar technologies on a customer’s or user’s device and for direct electronic marketing. The UK GDPR and the GDPR also impose conditions on obtaining valid consent, such as a prohibition on pre-checked consents and a requirement to ensure separate consents are sought for each type of cookie or similar technology. While the text of the ePrivacy Regulation is still under development, a recent\n54\nEuropean court decision and regulators’ recent guidance are driving increased attention to cookies and tracking technologies. If regulators start to enforce the strict approach in recent guidance, this could lead to substantial costs, require significant systems changes, limit the effectiveness of our marketing activities, divert the attention of our technology personnel, adversely affect our margins, increase costs and subject us to additional liabilities. Regulation of cookies and similar technologies, and any decline of cookies or similar online tracking technologies as a means to identify and potentially target customers and users, may lead to broader restrictions and impairments on our marketing and personalization activities and may negatively impact our efforts to understand our customers and users.\nThe above mentioned privacy laws also contain onerous requirements relating to data security. Although we rely on a variety of security measures to provide security for our processing, transmission, and storage of personal information and other confidential information, we are unable to assure that we will not experience future security breaches, given the increasingly sophisticated tools used by hackers, data thieves, and cyber criminals. Any breach of our network or vendor systems may result in the loss of confidential business and financial data or misappropriation of personal information, which could have a material adverse effect on our business, including unwanted media attention, damage to our reputation, litigation, fines, significant legal and remediation expenses, or regulatory action.\nWe make public statements about our use and disclosure of personal information through our privacy policy, information provided on our website and press statements. Although we endeavor to ensure that our public statements are complete, accurate and fully implemented, we may at times fail to do so or be alleged to have failed to do so. We may be subject to potential regulatory or other legal action if such policies or statements are found to be deceptive, unfair or misrepresentative of our actual practices. In addition, from time to time, concerns may be expressed about whether our products and services compromise the privacy of our users and others. Any concerns about our data privacy and security practices (even if unfounded), or any failure, real or perceived, by us to comply with our posted privacy policies or with any legal or regulatory requirements, standards, certifications or orders or other privacy or consumer protection-related laws and regulations applicable to us, could cause our users to reduce their use of our products and services.\nWhile we believe that we comply with industry standards and applicable laws and industry codes of conduct relating to privacy, security, and data protection in all material respects, there is no assurance that we will not be subject to claims that we have violated applicable laws or codes of conduct, that we will be able to successfully defend against such claims or that we will not be subject to significant fines and penalties in the event of non-compliance. Additionally, in the United States, to the extent multiple state-level laws are introduced with inconsistent or conflicting standards and there is no federal law to preempt such laws, compliance with such laws could be difficult and costly to achieve and we could be subject to fines and penalties in the event of non-compliance. Any failure or perceived failure by us to comply with applicable privacy, security, and data protection laws, rules, regulations, and standards, or with other obligations to which we may be or may become subject, may result in actions against us by governmental entities, private claims and litigations, fines, penalties, or other liabilities or result in orders or consent decrees forcing us to modify our business practices. As a result, we may incur significant costs to comply with laws regarding the protection and unauthorized disclosure of personal information, which could also negatively impact our operations, resulting in a material adverse effect on our business, financial condition and results of operations. Any such action could be expensive to defend, damage our reputation and adversely affect our business, results of operations, and financial condition.\nWe rely on operating system providers and app stores to support some of our products and services, including our app, and any disruption, deterioration or change in their services, policies, practices, guidelines and/or terms of service could have a material adverse effect on our reputation, business, financial condition and results of operations.\nThe success of some of our products and services depend upon the effective operation of certain mobile operating systems, networks and standards that are run by operating system providers and app stores (Providers). We do not control these Providers and as a result, we are subject to risks and uncertainties related to the actions taken, or not taken, by these Providers. We largely utilize Android-based and iOS-based technology for our Traeger app.\nThe Providers that control these operating systems frequently introduce new technology, and from time to time, they may introduce new operating systems or modify existing ones. Further, we are also subject to the policies, practices, guidelines, certifications and terms of service of Providers’ platforms on which we publish our Traeger app and content. These policies, guidelines and terms of service govern the promotion, distribution, content and operation generally of applications and content available through such Providers. Each Provider has broad discretion to change and interpret its terms of service, guidelines and policies, and those changes may have an adverse effect on our or our customers’ or users’ ability to use our products and services. A Provider may also change its fee structure, add fees associated with access to and use of its platform or app store, limit the use of personal information and other data for advertising purposes or restrict how users can share information on their platform or across other platforms. If we or our customers or users were to violate a Provider’s terms of service, guidelines,\n55\ncertifications or policies, or if a Provider believes that we or our customers or users have violated, its terms of service, guidelines, certifications or policies, then that Provider could limit or discontinue our or our customers’ or users’ access to its platform or app store. In some cases, these requirements may not be clear and our interpretation of the requirements may not align with the interpretation of the Provider, which could lead to inconsistent enforcement of these terms of service or policies against us or our customers or users and could also result in the Provider limiting or discontinuing access to its platform or app store. If our products and services were unable to work effectively on or with these operating systems, either because of technological or operational constraints or because the Provider impairs our ability to operate on their platform, this could have a material adverse effect on our business, financial condition and results of operations.\nIf any Providers, including either Google (for Android) or Apple (for iOS) stop providing us with access to their platform or infrastructure, fail to provide reliable access, cease operations, modify or introduce new systems or otherwise terminate services, the delay caused by qualifying and switching to other operating systems could be time consuming and costly and could materially and adversely affect our business, financial condition and results of operations. Any limitation on or discontinuation of our or our customers’ or users’ access to any Provider’s platform or app store could materially and adversely affect our business, financial condition, results of operations or otherwise require us to change the way we conduct our business.\nRisks Related to Our Common Stock\nOur stock price may be volatile or may decline regardless of our operating performance, resulting in substantial losses for investors.\nThe market price of our common stock may fluctuate significantly in response to numerous factors, many of which are beyond our control, including:\n•actual or anticipated fluctuations in our results of operations;\n•the financial projections we may provide to the public, any changes in these projections, or our failure to meet these projections;\n•failure of securities analysts to initiate or maintain coverage of us, changes in financial estimates or ratings by any securities analysts who follow us or our failure to meet these estimates or the expectations of investors;\n•announcements by us or our competitors of significant technical innovations, acquisitions, strategic partnerships, joint ventures, results of operations, or capital commitments;\n•changes in operating performance and stock market valuations of other retail companies generally, or those in our industry in particular;\n•price and volume fluctuations in the overall stock market, including as a result of the COVID-19 pandemic and trends in the economy as a whole;\n•changes in our board of directors or management;\n•sales of large blocks of our common stock, including sales by our principal stockholders, executive officers or directors;\n•lawsuits threatened or filed against us;\n•changes in laws or regulations applicable to our business;\n•changes in our capital structure, such as future issuances of debt or equity securities;\n•short sales, hedging, and other derivative transactions involving our capital stock;\n•general economic conditions in the United States;\n•other events or factors, including those resulting from war, incidents of terrorism, pandemics, or other public health emergencies or responses to these events; and\n•the other factors described in Part II, Item 1A, “Risk Factors.”\n56\nAnti-takeover provisions in our charter documents and under Delaware law could make an acquisition of us more difficult, limit attempts by our stockholders to replace or remove our current management and limit the market price of our common stock.\nProvisions in our certificate of incorporation and bylaws may have the effect of delaying or preventing a change of control or changes in our management, including the following:\n•amendments to certain provisions of our certificate of incorporation or amendments to our bylaws will generally require the approval of at least two-thirds of the voting power of our outstanding capital stock;\n•our staggered board;\n•at any time when the parties to our Stockholders Agreement beneficially own, in the aggregate, at least a majority of the voting power of our outstanding capital stock, our stockholders may take action by consent without a meeting, and at any time when the parties to our Stockholders Agreement beneficially own, in the aggregate, less than the majority of the voting power of our outstanding capital stock, our stockholders may not take action by written consent, but may only take action at a meeting of stockholders;\n•our certificate of incorporation does not provide for cumulative voting;\n•vacancies on our board of directors are able to be filled only by our board of directors and not by stockholders, subject to the rights granted pursuant to the New Stockholders Agreements;\n•a special meeting of our stockholders may only be called by the chairperson of our board of directors, our Chief Executive Officer or a majority of our board of directors;\n•our certificate of incorporation restricts the forum for certain litigation against us to Delaware or the federal courts, as applicable, unless we otherwise consent in writing;\n•our board of directors has the authority to issue shares of undesignated preferred stock, the terms of which may be established and shares of which may be issued without further action by our stockholders; and\n•advance notice procedures apply for stockholders (other than the parties to our New Stockholders Agreements for nominations made pursuant to the terms of the New Stockholders Agreements) to nominate candidates for election as directors or to bring matters before an annual meeting of stockholders.\nIn addition, we have opted out of Section 203 of the Delaware General Corporation Law, but our certificate of incorporation provides that engaging in any of a broad range of business combinations with any “interested stockholder” (generally defined as any person who, together with that person’s affiliates and associates, owns, 15% or more of our outstanding voting stock) for a period of three years following the date on which the stockholder became an “interested stockholder” is prohibited, provided, however, that, under our certificate of incorporation, the parties to our Stockholders Agreement and their respective affiliates are not be deemed to be interested stockholders regardless of the percentage of our outstanding voting stock owned by them, and accordingly are not be subject to such restrictions.\nThese provisions may frustrate or prevent any attempts by our stockholders to replace or remove our current management by making it more difficult for stockholders to replace members of our board of directors, which is responsible for appointing the members of our management. As a result, these provisions may adversely affect the market price and market for our common stock if they are viewed as limiting the liquidity of our stock or as discouraging takeover attempts in the future.\nA limited number of stockholders hold a substantial portion of our outstanding common stock, and their interests may conflict with our interests and the interests of other stockholders.\nImmediately following our IPO, funds or entities affiliated with each of AEA Investors (the “AEA Fund”), Ontario Teachers’ Pension Plan Board (“OTPP”) and Trilantic Capital Partners (“TCP”) owned approximately 64.8% of the voting power of our common stock. In addition, pursuant to the Stockholders Agreement between us and these investors, we agreed to nominate to our board of directors individuals designated by each of the AEA Fund, OTPP and TCP and each such investor has the right to designate directors for so long as they each beneficially own at least 5% of the aggregate number of shares of common stock outstanding immediately following our IPO. In addition, for so long as the AEA Fund, OTPP and TCP collectively beneficially own at least 30% of the aggregate number of shares of common stock outstanding immediately following the IPO, certain actions by us or any of our subsidiaries will require the prior written consent of each of the AEA Fund, OTPP and TCP so long as such stockholder is entitled to designate at least two directors for nomination to our board of directors. The actions that will require prior written consent include: (i) change in control transactions, (ii) acquiring or disposing of assets or any business enterprise or division thereof for consideration excess of $250.0 million in any single transaction or series of transactions, (iii) increasing or decreasing the size of our board of directors, (iv) terminating the\n57\nemployment of our chief executive officer or hiring a new chief executive officer, (v) initiating any liquidation, dissolution, bankruptcy or other insolvency proceeding involving us or any of our significant subsidiaries, and (vi) any transfer, issue, issuance, sale or disposition of any shares of common stock, other equity securities, equity-linked securities or securities that are convertible into equity securities of us or our subsidiaries to any person or entity that is a non-strategic financial investor in a private placement transaction or series of transactions.\nEven when the parties to our Stockholders Agreement cease to own shares of our stock representing a majority of the total voting power, for so long as such parties continue to own a significant percentage of our stock, they will still be able to significantly influence or effectively control the composition of our board of directors and the approval of actions requiring stockholder approval through their voting power. Accordingly, for such period of time, the parties to our Stockholders Agreement will have significant influence with respect to our management, business plans and policies. For instance, for so long as the AEA Fund, OTPP and TCP continue to own a significant percentage of our common stock, they may be able to cause or prevent a change of control of the Company or a change in the composition of our board of directors, and could preclude any unsolicited acquisition of the Company. The concentration of ownership could deprive us of what we perceive as an attractive business combination opportunity, or investors of an opportunity to receive a premium for their shares of common stock as part of a sale of the Company and ultimately may affect the market price of our common stock.\nFurther, our certificate of incorporation provides that the doctrine of “corporate opportunity” does not apply with respect to certain parties to our Stockholders Agreement or their affiliates (other than us and our subsidiaries), and any of their respective principals, members, directors, partners, stockholders, officers, employees or other representatives (other than any such person who is also our employee or an employee of our subsidiaries), or any director or stockholder who is not employed by us or our subsidiaries.\nFuture sales of shares by existing stockholders, including our principal stockholders, our officers or directors, could cause\nour stock price to decline.\nIf our existing stockholders sell, or indicate an intention to sell, substantial amounts of our common stock in the public market after the contractual lock-up agreements entered into in connection with the IPO expire and other restrictions on resale lapse, the trading price of our common stock could decline. Immediately following our IPO, our officers, directors and principal stockholders (greater than 5% stockholders) collectively owned approximately 73.3% of our issued and outstanding common stock. Subsequent sales of our shares by these stockholders could have the effect of lowering our stock price. The perceived risk associated with the possible sale of a large number of shares by these stockholders, or the adoption of significant short positions by hedge funds or other significant investors, could cause some of our stockholders to sell their stock, thus causing the price of our stock to decline. In addition, actual or anticipated downward pressure on our stock price due to actual or anticipated sales of stock by our directors or officers could cause other institutions or individuals to engage in short sales of our common stock, which may further cause the price of our stock to decline.\nFrom time to time our directors and executive officers may sell shares of our common stock on the open market. These sales will be publicly disclosed in filings made with the SEC. In the future, our directors and executive officers may sell a significant number of shares for a variety of reasons unrelated to the performance of our business. Our stockholders may perceive these sales as a reflection on management’ s view of the business and result in some stockholders selling their shares of our common stock. These sales could cause the price of our stock to drop.\nOur certificate of incorporation provides that the doctrine of “corporate opportunity” does not apply with respect to certain parties to our New Stockholders Agreements and any director or stockholder who is not employed by us or our subsidiaries.\nThe doctrine of corporate opportunity generally provides that a corporate fiduciary may not develop an opportunity using corporate resources, acquire an interest adverse to that of the corporation or acquire property that is reasonably incident to the present or prospective business of the corporation or in which the corporation has a present or expectancy interest, unless that opportunity is first presented to the corporation and the corporation chooses not to pursue that opportunity. The doctrine of corporate opportunity is intended to preclude officers or directors or other fiduciaries from personally benefiting from opportunities that belong to the corporation. Pursuant to our certificate of incorporation we renounced, to the fullest extent permitted by law and in accordance with Section 122(17) of the Delaware General Corporation Law, all interest and expectancy that we otherwise would be entitled to have in, and all rights to be offered an opportunity to participate in, any opportunity that may be presented to the AEA Fund, OTPP and TCP or their affiliates (other than us and our subsidiaries), and any of their respective principals, members, directors, partners, stockholders, officers, employees or other representatives (other than any such person who is also our employee or an employee of our subsidiaries), or any director or stockholder who is not employed by the AEA Fund, OTPP and TCP or their affiliates and any director or stockholder who is not employed by us or our subsidiaries, therefore, have no duty to communicate or present corporate opportunities to us, and have the right to either hold\n58\nany corporate opportunity for their (and their affiliates’) own account and benefit or to recommend, assign or otherwise transfer such corporate opportunity to persons other than us, including to any director or stockholder who is not employed by us or our subsidiaries. As a result, certain of our stockholders, directors and their respective affiliates are not prohibited from operating or investing in competing businesses. We, therefore, may find ourselves in competition with certain of our stockholders, directors or their respective affiliates, and we may not have knowledge of, or be able to pursue, transactions that could potentially be beneficial to us. Accordingly, we may lose a corporate opportunity or suffer competitive harm, which could negatively impact our business, operating results and financial condition.\nThe provision of our certificate of incorporation requiring exclusive forum in certain courts in the State of Delaware or the federal district courts of the United States for certain types of lawsuits may have the effect of discouraging lawsuits against our directors and officers.\nOur certificate of incorporation provides that, unless we otherwise consent in writing, (A) (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of a fiduciary duty owed by any current or former director, officer, other employee or stockholder of us to the us or the our stockholders, (iii) any action asserting a claim arising pursuant to any provision of the Delaware General Corporation Law, our certificate of incorporation or our bylaws (as either may be amended or restated) or as to which the Delaware General Corporation Law confers exclusive jurisdiction on the Court of Chancery of the State of Delaware or (iv) any action asserting a claim governed by the internal affairs doctrine of the law of the State of Delaware shall, to the fullest extent permitted by law, be exclusively brought in the Court of Chancery of the State of Delaware or, if such court does not have subject matter jurisdiction thereof, the federal district court of the State of Delaware; and (B) the federal district courts of the United States shall be the exclusive forum for the resolution of any complaint asserting a cause of action arising under the Securities Act; however, there is uncertainty as to whether a court would enforce such provision, and investors cannot waive compliance with federal securities laws and the rules and regulations thereunder. Notwithstanding the foregoing, the exclusive forum provision does not apply to claims seeking to enforce any liability or duty created by the Exchange Act or any other claim for which the federal courts of the United States have exclusive jurisdiction. The choice of forum provision may limit a stockholder’s ability to bring a claim in a judicial forum that it finds favorable for disputes with us or our directors, officers or other employees, which may discourage such lawsuits against us and our directors, officers, and other employees, although our stockholders will not be deemed to have waived our compliance with federal securities laws and the rules and regulations thereunder. Alternatively, if a court were to find the choice of forum provision contained in our certificate of incorporation to be inapplicable or unenforceable in an action, we may incur additional costs associated with resolving such action in other jurisdictions, which could harm our business, results of operations, and financial condition. Any person or entity purchasing or otherwise acquiring or holding any interest in shares of our capital stock shall be deemed to have notice of and consented to the forum provisions in our certificate of incorporation.\nWe are obligated to develop and maintain proper and effective internal control over financial reporting, and if we fail to develop and maintain an effective system of disclosure controls and internal control over financial reporting, our ability to produce timely and accurate financial statements or comply with applicable laws and regulations could be impaired.\nAs a public company, we are or will become subject to the reporting requirements of the Exchange Act, the Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the listing requirements of the New York Stock Exchange, and other applicable securities rules and regulations. Compliance with these rules and regulations will increase our legal and financial compliance costs, make some activities more difficult, time consuming, or costly, and increase demand on our systems and resources, particularly after we are no longer an emerging growth company. The Exchange Act requires, among other things, that we file annual, quarterly, and current reports with respect to our business and results of operations. The Sarbanes-Oxley Act requires, among other things, that we maintain effective disclosure controls and procedures and internal control over financial reporting. It may require significant resources and management oversight to maintain and, if necessary, improve our disclosure controls and procedures and internal control over financial reporting to meet this standard. As a result, management’s attention may be diverted from other business concerns, which could adversely affect our business and results of operations. Although we have already hired additional employees to comply with these requirements, we may need to hire more employees in the future or engage outside consultants, which would increase our costs and expenses\nAs a public company, we are also required, pursuant to Section 404 of the Sarbanes-Oxley Act, to furnish a report by management on, among other things, the effectiveness of our internal control over financial reporting commencing with our second annual report on Form 10-K. Effective internal control over financial reporting is necessary for us to provide reliable financial reports and, together with adequate disclosure controls and procedures, are designed to prevent fraud. Any failure to implement required new or improved controls, or difficulties encountered in their implementation, could cause us to fail to meet our reporting obligations. Ineffective internal controls could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our common stock.\n59\nThis assessment will need to include disclosure of any material weaknesses identified by our management in our internal control over financial reporting, as well as a statement that our independent registered public accounting firm has issued an opinion on the effectiveness of our internal control over financial reporting, provided that our independent registered public accounting firm will not be required to attest to the effectiveness of our internal control over financial reporting until our first annual report required to be filed with the SEC following the later of the date we are deemed to be an “accelerated filer” or a “large accelerated filer,” each as defined in the Exchange Act, or the date we are no longer an emerging growth company, as defined in the JOBS Act. An independent assessment of the effectiveness of our internal controls could detect problems that our management’s assessment might not. Undetected material weaknesses in our internal controls could lead to financial statement restatements and require us to incur the expense of remediation. We may need to undertake various actions to ensure compliance with applicable rules and regulations, such as implementing new or additional internal controls and procedures and hiring accounting or internal audit staff.\nWe are in the early stages of the costly and challenging process of compiling the system and processing documentation necessary to perform the evaluation needed to comply with Section 404. We may not be able to complete our evaluation, testing, and any required remediation in a timely fashion. During the evaluation and testing process, if we identify material weaknesses in our internal control over financial reporting, we will be unable to assert that our internal control over financial reporting is effective.\nIf we are unable to assert that our internal control over financial reporting is effective, or if our independent registered public accounting firm is unable to express an opinion on the effectiveness of our internal control, including as a result of the material weakness described above, we could lose investor confidence in the accuracy and completeness of our financial reports, which could cause the price of our common stock to decline, and we may be subject to investigation or sanctions by the SEC. In addition, if we are unable to continue to meet these requirements, we may not be able to remain listed on the New York Stock Exchange.\nIn addition, as we continue to scale and improve our operations, including our internal systems and processes, we are currently implementing, and in the future may seek to implement, a variety of critical systems, such as billing, human resource information systems and accounting systems. We cannot assure you that new systems, including any increases in scale or related improvements, will be successfully implemented or that appropriate personnel will be available to facilitate and manage these processes. Failure to implement necessary systems and procedures, transition to new systems and processes or hire the necessary personnel could result in higher costs, compromised internal reporting and processes and system errors or failures. For example, we are in the process of implementing a new product lifecycle management system, or PLM system, as a development tool to help us compile and analyze data related to the lifecycle of our products. The implementation and transition to any new critical system, including our new PLM system, or enhancements to existing systems, may be costly, require significant attention of many employees who would otherwise be focused on other aspects of our business and disruptive to our business if they do not work as planned or if we experience issues related to such implementation or transition, which could have a material adverse effect on our operations.\nWe anticipate incurring substantial stock-based compensation expense and incurring substantial obligations related to the vesting and settlement of RSUs granted in connection with the completion of our IPO, which may have an adverse effect on our financial condition and results of operations and may result in substantial dilution.\nIn light of the 7,782,957 RSUs subject to the Chief Executive Officer Award and the 4,380,285 RSUs subject to the IPO RSUs granted in connection with our IPO, we anticipate that we will incur substantial stock-based compensation expenses and may expend substantial funds to satisfy tax withholding and remittance obligations related to these RSUs. The 7,782,957 RSUs subject to the Chief Executive Officer Award received by Jeremy Andrus, our Chief Executive Officer, will vest based on (i) the achievement of performance goals, which we refer to as the PSU CEO Awards and (ii) time-based RSUs, which we refer to as the Time-Based RSU CEO Awards and together with the PSU CEO Awards, the Chief Executive Officer Award. The vesting of these awards is subject to the respective continued service or employment of Mr. Andrus through the applicable vesting date. The PSU CEO Awards granted to Mr. Andrus will become earned based on the achievement of stock price goals (measured as a volume-weighted stock price over 60 days) at any time until the tenth anniversary of the closing of our IPO. Mr. Andrus’ PSU CEO Award is divided into five tranches, with the first tranche having a stock price goal of 125% of the initial public offering price, and each of the next four stock prices goals equal to 125% of the immediately preceding stock price goal. To the extent earned, the PSU CEO Awards will vest if certain time-based vesting conditions are also met. The Time-Based RSU CEO Awards granted to Mr. Andrus will vest as to 20% of the underlying shares on each of the first, second, third, fourth and fifth anniversaries of the closing of the IPO, subject to Mr. Andrus’ continued service as our chief executive officer or executive chairman of our board of directors.\n60\nWe will record substantial stock-compensation expense for the IPO RSUs, the PSU CEO Awards and the Time-Based RSU CEO Awards. The grant date fair value of the PSU CEO Awards and the Time-Based RSU CEO Awards is estimated to be approximately $116.6 million, which we estimate will be recognized as compensation expense over a weighted average period of 4.94 years, though could be earlier if the stock price goals are achieved earlier than we estimated. The grant date fair value of the IPO RSUs is estimated to be approximately $73.2 million, which we estimate will be recognized as compensation expense over a weighted average period of 3.52 years. We expect the stock-based compensation expense relating to these awards to adversely impact our future financial results.\nWe are a “controlled company” within the meaning of the corporate governance standards of the New York Stock Exchange. As a result, we qualify for, and intend to rely on, exemptions from certain corporate governance standards. You will not have the same protections afforded to stockholders of companies that are subject to such requirements.\nThe AEA Fund, OTPP and TCP collectively control a majority of the voting power of shares eligible to vote in the election of our directors. Because more than 50% of the voting power in the election of our directors will be held by an individual, group, or another company, we will be a “controlled company” within the meaning of the corporate governance standards of the New York Stock Exchange. As a controlled company, we may elect not to comply with certain corporate governance requirements, including the requirements that, within one year of the date of the listing of our common stock:\n•a majority of our board of directors consists of “independent directors,” as defined under the rules of such exchange;\n•our board of directors has a compensation committee that is composed entirely of independent directors with a written charter addressing the committee’s purpose and responsibilities; and\n•our board of directors has a nominating and corporate governance committee that is composed entirely of independent directors with a written charter addressing the committee’s purpose and responsibilities.\nWe do not intend to rely on these exemptions, except for the exemption from the requirement that our compensation committee be composed entirely of independent directors. However, as long as we remain a “controlled company,” we may elect in the future to take advantage of any of these exemptions. As a result of any such election, our board of directors would not have a majority of independent directors, our compensation committee would not consist entirely of independent directors and our directors would not be nominated or selected by independent directors. Accordingly, you will not have the same protections afforded to stockholders of companies that are subject to all of the corporate governance requirements of the New York Stock Exchange rules.\nWe are an “emerging growth company” and are availing ourselves of reduced disclosure requirements applicable to emerging growth companies, which could make our common stock less attractive to investors.\nWe are an emerging growth company, as defined in the JOBS Act, and we are taking advantage of and may continue to take advantage of, for as long as five years following the completion of our IPO, certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies, including not being required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. In addition, under the JOBS Act, emerging growth companies can delay the adoption of certain new or revised accounting standards until those standards would otherwise apply to private companies.\nWe have elected to avail ourselves of this exemption from new or revised accounting standards and, therefore, we are not and will continue not to be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies or that have opted out of using such extended transition period, which may make comparison of our financial statements with those of other public companies more difficult. We cannot predict if investors will find our common stock less attractive because we are relying on these exemptions. If some investors find our common stock less attractive as a result, there may be a less active trading market for our common stock and our stock price may be more volatile.\nIf securities or industry analysts do not publish research or reports about our business, or they publish negative reports about our business, our share price, and trading volume could decline.\nThe trading market for our common stock will depend in part on the research and reports that securities or industry analysts publish about us or our business, our market, and our competitors. We do not have any control over these analysts. If one or more of the analysts who cover us downgrade our shares or change their opinion of our shares, our share price would\n61\nlikely decline. If one or more of these analysts cease coverage of us or fail to regularly publish reports on us, we could lose visibility in the financial markets, which could cause our share price or trading volume to decline.\nWe do not intend to pay dividends for the foreseeable future.\nWe currently intend to retain any future earnings to finance the operation and expansion of our business and we do not expect to declare or pay any dividends in the foreseeable future. As a result, stockholders must rely on sales of their common stock after price appreciation as the only way to realize any future gains on their investment.\nGeneral Risks\nWe may engage in merger and acquisition activities, which could require significant management attention, disrupt our business, dilute stockholder value, and adversely affect our results of operations.\nAs part of our business strategy, we have made and may in the future make investments in businesses, new technologies, services, and other assets and strategic investments that complement our business. For example, on July 1, 2021 we acquired all of the equity interested of Apption, which specializes in the manufacture and design of hardware and software related to small kitchen appliances, including the MEATER smart thermometer and related technology. We may not be able to find suitable acquisition candidates and we may not be able to complete acquisitions on favorable terms, if at all, in the future. If we do complete acquisitions, we may not ultimately strengthen our competitive position or achieve our goals, and any acquisitions we complete could be viewed negatively by our customers or investors. Moreover, an acquisition, investment, or business relationship may result in unforeseen operating difficulties and expenditures, including disrupting our ongoing operations, diverting management from their primary responsibilities, subjecting us to additional liabilities, increasing our expenses, and adversely impacting our business, financial condition, and results of operations. Moreover, we may be exposed to unknown liabilities and the anticipated benefits of any acquisition, investment, or business relationship may not be realized, if, for example, we fail to successfully integrate such acquisitions, or the technologies associated with such acquisitions, into our company.\nTo pay for any such acquisitions, we would have to use cash, incur debt, or issue equity securities, each of which may affect our financial condition or the value of our capital stock and could result in dilution to our stockholders. If we incur more debt it would result in increased fixed obligations and could also subject us to covenants or other restrictions that would impede our ability to manage our operations. Additionally, we may receive indications of interest from other parties interested in acquiring some or all of our business. The time required to evaluate such indications of interest could require significant attention from management, disrupt the ordinary functioning of our business, and could have an adverse effect on our business, financial condition, and results of operations.\nFrom time to time, we may be subject to legal proceedings, regulatory disputes, and governmental inquiries that could cause us to incur significant expenses, divert our management’s attention, and materially harm our business, financial condition, and results of operations.\nFrom time to time, we may be subject to claims, lawsuits, government investigations, and other proceedings involving products liability, competition, and antitrust, intellectual property, privacy, consumer protection, securities, tax, labor and employment, commercial disputes, and other matters that could adversely affect our business operations and financial condition. As we have grown, we have seen a rise in the number and significance of these disputes and inquiries, and we may face increased exposure to securities litigation as a public company. Litigation and regulatory proceedings that we are currently facing or could face, may be protracted and expensive, and the results are difficult to predict. Certain of these matters include speculative claims for substantial or indeterminate amounts of damages and include claims for injunctive relief. Additionally, our litigation costs could be significant. Adverse outcomes with respect to litigation or any of these legal proceedings may result in significant settlement costs or judgments, penalties, and fines, or require us to modify our products or services, make content unavailable, or require us to stop offering certain features, all of which could negatively affect our business, financial condition, and results of operations.\nThe results of litigation, investigations, claims, and regulatory proceedings cannot be predicted with certainty, and determining reserves for pending litigation and other legal and regulatory matters requires significant judgment. There can be no assurance that our expectations will prove correct, and even if these matters are resolved in our favor or without significant cash settlements, these matters, and the time and resources necessary to litigate or resolve them, could harm our business, financial condition, and results of operations\nOur financial results and future growth could be harmed by currency exchange rate fluctuations.\n62\nAs our international business grows, our results of operations could be adversely impacted by changes in foreign currency exchange rates, such as the British Pound and the Canadian Dollar, and we may transact in more foreign currencies in the future. Revenues and certain expenses in markets outside of the United States are recognized in local foreign currencies, and we are exposed to potential gains or losses from the translation of those amounts into U.S. dollars for consolidation into our financial statements. Similarly, we are exposed to gains and losses resulting from currency exchange rate fluctuations on transactions generated by our foreign subsidiaries in currencies other than their local currencies. In addition, the business of our independent manufacturers in China and Vietnam may also be disrupted by currency exchange rate fluctuations by making their purchases of raw materials more expensive and more difficult to finance. Changes in the value of foreign currencies relative to the U.S. dollar can affect our revenue and results of operations. As we increase the extent of our international operations, such foreign currency exchange rate fluctuations could make it more difficult to detect underlying trends in our business and results of operations, such as our margins and cash flows. From time to time, we use hedging strategies to reduce our exposure to currency fluctuations and may continue to use derivative instruments, such as foreign currency forward and option contracts, to hedge certain exposures to fluctuations in foreign currency exchange rates. Given the volatility of exchange rates, there can be no assurance that we will be able to effectively manage our currency transaction risks. The use of such hedging activities may not offset any or more than a portion of the adverse financial effects of unfavorable movements in foreign exchange rates over the limited time the hedges are in place and may introduce additional risks if we are unable to structure effective hedges with such instruments.\nOur future success depends on the continuing efforts of our management and key employees, and on our ability to attract and retain highly skilled personnel and senior management.\nWe depend on the talents and continued efforts of our senior management and key employees. The loss of members of our management or key employees may disrupt our business and harm our results of operations. Furthermore, our ability to manage further expansion will require us to continue to attract, motivate, and retain additional qualified personnel. Competition for this type of personnel is intense, and we may not be successful in attracting, integrating, and retaining the personnel required to grow and operate our business effectively. There can be no assurance that our current management team or any new members of our management team will be able to successfully execute our business and operating strategies.\nIf our estimates or judgments relating to our critical accounting policies prove to be incorrect or change significantly, our results of operations could be harmed.\nThe preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. These estimates form the basis for making judgments about the carrying values of assets, liabilities, and equity and the amount of sales and expenses that are not readily apparent from other sources. Our results of operations may be harmed if our assumptions change or if actual circumstances differ from those in our assumptions, which could cause our results of operations to fall below the expectations of securities analysts and investors and could result in a decline in our stock price.\nOur business is subject to the risk of earthquakes, fires, explosions, power outages, floods, forest fires, and other catastrophic events, and to interruption by problems such as terrorism, public health crises, cyberattacks, or failure of key information technology systems.\nOur business is vulnerable to damage or interruption from earthquakes, fires, explosions, floods, power losses, telecommunications failures, terrorist attacks, acts of war, riots, public health crises, human errors, criminal acts, and similar events. For example, a significant natural disaster or adverse weather event, such as an earthquake, fire, or flood, could harm our business, results of operations, and financial condition, and our insurance coverage may be insufficient to compensate us for losses that may occur. Our wood pellet production facility in New York is located in a flood zone and has experienced flooding and other damage in connection with adverse weather events, such as hurricanes and tropical storms. Most recently, this facility incurred damage as a result of a tropical storm and we continue to assess the extent of the damage and operations. In addition, the facilities of our suppliers and where our manufacturers produce our products are located in parts of Asia that frequently experience typhoons and earthquakes. Acts of terrorism and public health crises, such as the current COVID-19 pandemic (or other future pandemics or epidemics), could also cause disruptions in our or our suppliers’, manufacturers’, and logistics providers’ businesses or the economy as a whole. The COVID-19 pandemic has significantly impacted the global supply chain, with restrictions and limitations on related activities causing disruption and delay, and the likely overall impact of the COVID-19 pandemic is viewed as highly negative to the general economy. These disruptions and delays have strained certain domestic and international supply chains, which have affected and could continue to negatively affect the flow or availability of certain of our products. We may not have sufficient protection or recovery plans in some circumstances, such as natural disasters affecting locations where we have operations and equipment or store significant inventory. Our servers may also be\n63\nvulnerable to computer viruses, criminal acts, denial-of-service attacks, ransomware, and similar disruptions from unauthorized tampering with our computer systems, which could lead to interruptions, delays, or loss of critical data. As we rely heavily on our information technology and communications systems and the Internet to conduct our business and provide high-quality customer service, these disruptions could harm our ability to run our business and either directly or indirectly disrupt our suppliers’ or manufacturers’ businesses, which could harm our business, results of operations, and financial condition.\nWe are subject to many hazards and operational risks that can disrupt our business, some of which may not be insured or fully covered by insurance.\nOur operations are subject to many hazards and operational risks inherent to our business, including: (a) general business risks; (b) product liability; (c) product recall; and (d) damage to third parties, our infrastructure, or properties caused by fires, explosions, floods, and other natural disasters, power losses, telecommunications failures, terrorist attacks, riots, public health crises such as the current COVID-19 pandemic (and other future pandemics or epidemics), human errors, and similar events.\nOur insurance coverage may be inadequate to cover our liabilities related to such hazards or operational risks. For example, our insurance coverage does not cover us for business interruptions as they relate to the COVID-19 pandemic. In addition, we may not be able to maintain adequate insurance in the future at rates we consider reasonable and commercially justifiable, and insurance may not continue to be available on terms as favorable as our current arrangements. The occurrence of a significant uninsured claim or a claim in excess of the insurance coverage limits maintained by us could harm our business, results of operations, and financial condition.\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nRecent Sales of Unregistered Securities; Purchases of Equity Securities by the Issuer or Affiliated Purchaser\nNone.\nUse of Proceeds\nOn August 2, 2021, we completed our IPO in which we issued and sold 8,823,529 shares of common stock at a public offering price of $18.00 per share. We raised net proceeds of $140.5 million after deducting underwriter discounts and commissions, fees and expenses of $18.3 million. Additionally, certain selling stockholders sold an aggregate of 18,235,293 shares (including 3,529,411 shares pursuant to the underwriters’ exercise of their option to purchase additional shares) at the same price. All shares sold were registered pursuant to a registration statement on Form S-1 (File No. 333-257714), as amended (the “Registration Statement”), declared effective by the SEC on July 28, 2021. Morgan Stanley & Co, LLC acted as representative of the underwriters for the IPO. The IPO terminated after the sale of all securities registered pursuant to the Registration Statement. No payments for such expenses were made directly or indirectly to (i) any of our officers or directors or their associates, (ii) any persons owning 10% or more of any class of our equity securities or (iii) any of our affiliates.\nWe used approximately $130.8 million of the net proceeds to us from the IPO to prepay amounts outstanding under our New First Lien Term Loan Facility. There has been no material change in the expected use of the net proceeds from our IPO as described in our Prospectus.\nITEM 3. DEFAULTS UPON SENIOR SECURITIES\nNone.\nITEM 4. MINE SAFETY DISCLOSURES\nNot applicable.\nITEM 5. OTHER INFORMATION\nNone.\nITEM 6. Exhibits\n64\n| Incorporated by Reference |\n| Exhibit No. | Exhibit Description | Form | Date | Number | Filed/FurnishedHerewith |\n| 3.1 | Certificate of Incorporation of Traeger, Inc. | 8-K | 08/03/21 | 3.1 |\n| 3.2 | Bylaws of Traeger, Inc. | 8-K | 08/03/21 | 3.2 |\n| 4.1 | Form of Certificate of Common Stock. | S-1/A | 07/21/21 | 4.1 |\n| 4.2 | Stockholders Agreement. | 8-K | 08/03/21 | 10.2 |\n| 4.3 | Management Stockholders Agreement | 8-K | 08/03/21 | 10.3 |\n| 4.4 | Registration Rights Agreement | 8-K | 08/03/21 | 10.1 |\n| 10.1 | Form of Indemnification Agreement between Traeger, Inc. and its directors and officers | S-1 | 07/06/21 | 10.1 |\n| 10.2 | Traeger, Inc. 2021 Incentive Award Plan and related form agreements thereunder | S-1/A | 07/21/21 | 10.2 |\n| 10.3 | Form of Performance-Vesting Restricted Stock Unit Award Agreement (Andrus IPO Award) under 2021 Incentive Award Plan | S-1/A | 07/21/21 | 10.9 |\n| 10.4 | Form of Restricted Stock Unit Award Agreement (Andrus IPO Award) under 2021 Incentive Award Plan | S-1/A | 07/21/21 | 10.10 |\n| 10.5 | Form of Performance-Vesting Restricted Stock Unit Award Agreement (IPO Awards) under 2021 Incentive Award Plan | S-1/A | 07/21/21 | 10.11 |\n| 10.6 | Form of Restricted Stock Unit Award Agreement under 2021 Incentive Award Plan | S-1/A | 07/21/21 | 10.12 |\n| 10.7 | Form of Restricted Stock Unit Award Agreement (Deferred RSUs) under 2021 Incentive Award Plan | S-1/A | 07/21/21 | 10.14 |\n| 10.8 | Form of Option Award Agreement under 2021 Incentive Award Plan | S-1/A | 07/21/21 | 10.15 |\n| 10.9 | Traeger, Inc. Non-Employee Director Compensation Policy. | S-1/A | 07/21/21 | 10.3 |\n| 10.10 | Amendment to First Lien Credit Agreement by and among TGP Holdings III LLC, Traeger Pellet Grills Holdings LLC, TGPX Holdings II LLC, Credit Suisse AG, as administrative agent, and the lender parties thereto, dated August 18, 2021 | * |\n| 10.11 | Letter Agreement by and between Jeremy Andrus and Traeger, In. | * |\n| 31.1 | Certificate of Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) | * |\n| 31.2 | Certificate of Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) | * |\n| 32.1 | Certificate of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 | ** |\n| 32.2 | Certificate of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 | ** |\n| 101.INS | Inline XBRL Instance Document – the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. | * |\n\n65\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document | * |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document | * |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document | * |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document | * |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document | * |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) | * |\n\n* Filed herewith.\n** Furnished herewith.\n66\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n| TRAEGER, INC. |\n| Date: September 9, 2021 |\n| By: | /s/ Jeremy Andrus |\n| Name: | Jeremy Andrus |\n| Title: | Chief Executive Officer |\n| (Principal Executive Officer) |\n| Date: September 9, 2021 |\n| By: | /s/ Dominic Blosil |\n| Name: | Dominic Blosil |\n| Title: | Chief Financial Officer |\n| (Principal Financial Officer and Principal Accounting Officer) |\n\n67\n</text>\n\nWhat is the estimated ratio of the net income of 2020 to the end of 2021, assuming the growth rate continues for the rest of 2021?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nITEM 1.\nBUSINESS\n| Our CompanyLife at home has been at the heart of our business for 110 years – it is why we exist and why we are passionate about what we do. |\n\nWhirlpool Corporation (\"Whirlpool\"), the world's leading kitchen and laundry appliance company, was incorporated in 1955 under the laws of Delaware and was founded in 1911. Whirlpool manufactures products in 13 countries and markets products in nearly every country around the world. We have received worldwide recognition for accomplishments in a variety of business and social efforts, including leadership, diversity, innovative product design, business ethics, social responsibility and community involvement. We conduct our business through four operating segments, which we define based on geography. Whirlpool Corporation's operating and reportable segments consist of North America, Europe, Middle East and Africa (\"EMEA\"), Latin America and Asia. Whirlpool had approximately $19 billion in annual sales and approximately 78,000 employees in 2020.\nAs used herein, and except where the context otherwise requires, \"Whirlpool,\" \"the Company,\" \"we,\" \"us,\" and \"our\" refer to Whirlpool Corporation and its consolidated subsidiaries. The world's leading kitchen and laundry appliance company claim is based on most recently available publicly reported annual revenues among leading appliance manufacturers.\n3\nOur Strategic Architecture\nOur strategic architecture is the foundational component that drives our shareholder value creation. In 2020, our strategic architecture guided our response to unprecedented COVID-19-related uncertainty, which focused on keeping employees safe, plants operating, and liquidity accessible. Below are the key components of our strategic architecture.\nUnique Global Position\nWhirlpool Corporation is committed to delivering significant, long-term value to both our consumers and our shareholders. For consumers, we deliver value through innovative, high-quality products that solve everyday problems while saving time, energy and water. For our shareholders, we seek to deliver differentiated value through our four strategic pillars: global leading scale, best brand portfolio, proven track record of innovation and best cost position.\n4\n| Global Leading Scale | Best BrandPortfolio | Proven Track Record of Innovation | Best CostPosition |\n\nGlobal Leading Scale\nWe are the world's leading kitchen and laundry appliance company.\nOur leading position includes a balance of developed countries and emerging markets, including a leading position in many of the key countries in which we operate. We believe we are well positioned to continue to convert demand into profitable growth.\nBest Brand Portfolio\nWe have the best brand portfolio in the industry, including five brands with more than $1 billion in revenue.\nWe aim to position these desirable brands across many consumer segments. Our sales are led by our global brands, including Whirlpool and KitchenAid. Whirlpool is trusted throughout the world as a brand that delivers innovative care daily. Our KitchenAid brand brings a combination of innovation and design that inspires and fuels the passion of chefs, bakers and kitchen enthusiasts worldwide. These two brands are the backbone of our strategy to offer differentiated products that provide exceptional performance and desirable features while remaining affordable to consumers.\nAdditionally, we have a number of strong regional and local brands, including Maytag, Brastemp, Consul, Hotpoint*, Indesit, and Bauknecht. These brands add to our impressive depth and breadth of\nappliance offerings and help us provide products that are tailored to local consumer needs and preferences.\n•Whirlpool ownership of the Hotpoint brand in the EMEA and Asia Pacific regions is not affiliated with the Hotpoint brand sold in the Americas.\n5\nProven Track Record of Innovation\nWhirlpool Corporation has been responsible for a number of first-to-market innovations. These include the first electric wringer washer in 1911, the first residential stand mixer in 1919, the first countertop microwave in 1967 and the first energy and water efficient top-load washer in 1998. We are proud of our track record of innovation.\nWhile we are proud of that legacy, we are also committed to innovating for a new generation of consumers. Our world-class innovation pipeline has accelerated over the last few years, driven by consistent innovation funding and a passionate culture of employees focused on bringing new technologies to market. This year, we launched more than 100 new products throughout the world, and we are committed to further accelerating our pace of innovation, including our new global dishwasher architecture featuring the largest capacity 3rd rack dishwasher, Red Dot Award-winning built-in induction cooktop in Europe, new premium top load laundry in North America featuring the Load & Go dispenser, pretreat station and connected options, and lastly we entered the consumables detergent business with the launch of our ultra concentrated Swash detergent.\nAs the shift to digital continues, consumers continue to desire connected appliances which fit seamlessly into the larger home ecosystem. We are excited to bring new connected products and technologies to market, including voice control, food recognition and automatic laundry detergent replenishment. Whether developed internally or with one of our many collaborators, we believe these digitally-enabled products and services will increasingly enhance the appliance experience for our consumers.\nWhirlpool manufactures and markets a full line of major home appliances and related products. Our principal products are laundry appliances (including commercial laundry appliances), refrigerators and freezers, cooking appliances, dishwashers, mixers and other small domestic appliances. Prior to the divestiture of our Embraco business on July 1, 2019, we also produced compressors for refrigeration systems. The following chart provides the percentage of net sales for each of our product categories which accounted for 10% or more of our consolidated net sales over the last three years:\n6\nBest Cost Position\nAs the world's leading kitchen and laundry appliance company, we have a cost benefit on everything we do based on scale, and are committed to a relentless focus on cost efficiency. Our global scale enables our local-for-local production model. We are focused on producing as efficiently as possible and at scale throughout the world.\nAs the global environment continues to change, we believe our demonstrated ability to execute cost takeout allows us to effectively cope with macroeconomic challenges, and we see additional opportunities to further streamline our cost structure. For example, we are on a journey to reduce the complexity of our designs and product platforms. This initiative, among many others, will enable us to utilize increased modular production, improved scale in global procurement, and further streamline our day-to-day manufacturing operations.\nWe believe our cost position is clearly differentiated in the appliance industry and we are committed to even further improvement, creating strong levels of value for our shareholders, regardless of the external environment. In 2020, in response to COVID-19, we took immediate and decisive action as we announced and executed our cost take-out program, a key driver of our margin expansion during the year.\nValue Creation Framework\nOur long-term value creation framework is built upon the strong foundation we have in place: our industry-leading brand portfolio and robust product innovation pipeline, supported by our global operating platform and executed by our exceptional employees throughout the world. We measure these value-creation components by focusing on the following key metrics:\n| Profitable Growth | Margin Expansion | Cash Conversion |\n| Innovation-fueled growth at or abovethe market | Drive cost and price/mix to grow profitability | Asset efficiency converts profitable growth to cash |\n| ~3% | ~10% | 6%+ |\n| Annual OrganicNet Sales Growth | Ongoing EBIT Margin | FCF as % of Net Sales |\n\nCapital Allocation Strategy\nWe take a balanced approach to capital allocation by focusing on the following key metrics:\n| Fund innovation and Growth | Target |\n| Capital Expenditures | ~3% of net sales |\n| Research & Development | ~3% of net sales |\n| Mergers & Acquisitions | Pursue opportunistic M&A with high ROIC |\n\n7\n| Return to Shareholders | Target |\n| Dividends | ~30% of trailing 12-month ongoing net earnings |\n| Share Repurchase | Moderate share repurchases; ~$530M authorization remaining (1) |\n| Targeted Capital Structure | Maintain strong investment grade rating |\n| Gross Debt/EBITDA of 2.0x |\n\n(1)As of December 31, 2020\nWe remain confident in our ability to effectively manage our business through macroeconomic volatility and expect to continue delivering long-term value for our shareholders.\n8\nRegional Business Summary\n| North America | •In the United States, we market and distribute major home appliances and other consumer products primarily under the Whirlpool, Maytag, KitchenAid, JennAir, Amana, Roper, Affresh, Swash, everydrop and Gladiator brand names primarily to retailers, distributors and builders, as well as end consumers. We also market small domestic appliances under the KitchenAid brand name primarily to retailers and distributors •In Canada, we market and distribute major home appliances primarily under the Whirlpool, Maytag, JennAir, Amana, Speed Queen and KitchenAid brand names.•We sell some products to other manufacturers, distributors, and retailers for resale in North America under those manufacturers' and retailers' respective brand names. |\n| Europe, Middle East and Africa(EMEA) | •In Europe, we market and distribute our major home appliances primarily under the Whirlpool, Hotpoint*, Bauknecht, Indesit, Ignis, Maytag and Privileg brand names. We also market major home appliances and small domestic appliances under the KitchenAid brand name primarily to retailers and distributors.•We market and distribute products under the Whirlpool, Bauknecht, Maytag, Indesit, Amana and Ignis brand names to distributors and dealers in Africa and the Middle East; we exited our commercial operations in Turkey in the second quarter of 2019.•In addition to our operations in Western and Central Eastern Europe, and Russia, we have a manufacturing operation in Turkey and a sales subsidiary in Morocco. |\n| Latin America | •In Latin America, we produce, market and distribute our major home appliances, small domestic appliances and other consumer products primarily under the Consul, Brastemp, Whirlpool, KitchenAid, Acros, Maytag and Eslabon de Lujo brand names primarily to retailers, distributors and directly to consumers.•We also serve the countries of Bolivia, Paraguay, Uruguay, Venezuela, and certain Caribbean and Central America countries, where we manage appliances sales and distribution through accredited distributors.•In July 2019, our Latin America operations sold our compressors business to a third party. |\n| Asia | •In Asia, we have organized the marketing and distribution of our major home appliances and small domestic appliances in multiple countries, primarily China and India. •We market and distribute our products in Asia primarily under the Whirlpool, Maytag, KitchenAid, Ariston, Indesit, Bauknecht, Diqua, and Royalstar brand names through a combination of direct sales to appliance retailers and chain stores and through full-service distributors to a large network of retail stores. As our rights to use the Sanyo brand name expired in the fourth quarter of 2019 (with a limited right to sell existing inventories until the second quarter of 2020), we have facilitated brand transition with investment to drive Whirlpool brand awareness in China. |\n\n*Whirlpool ownership of the Hotpoint brand in the EMEA and Asia Pacific regions is not affiliated with the Hotpoint brand sold in the Americas.\n9\nCompetition\nCompetition in the major home appliance industry is intense, including competitors such as Arcelik, BSH (Bosch), Electrolux, Haier, Kenmore, LG, Mabe, Midea, Panasonic and Samsung, many of which are increasingly expanding beyond their existing manufacturing footprint. The competitive environment includes the impact of a changing retail environment, including the shifting of consumer purchase practices towards e-commerce and other channels. Moreover, our customer base includes large, sophisticated trade customers who have many choices and demand competitive products, services and prices. We believe that we can best compete in the current environment by focusing on introducing new and innovative products, building strong brands, enhancing trade customer and consumer value with our product and service offerings, optimizing our regional footprint and trade distribution channels, increasing productivity, improving quality, lowering costs, and taking other efficiency-enhancing measures.\nSeasonality\nThe Company's quarterly revenues have historically been affected by a variety of seasonal factors, including holiday-driven promotional periods. In each fiscal year, the Company's total revenue and operating margins are typically highest in the third and fourth quarter. In 2020, we realized a seasonality pattern that differed from historical periods due to the COVID-19 pandemic. In 2021, we expect the seasonality of revenues and operating margins to be altered by the pandemic.\nRaw Materials and Purchased Components\nWe are generally not dependent upon any one source for raw materials or purchased components essential to our business. In areas where a single supplier is used, alternative sources are generally available and can be developed within the normal manufacturing environment. Some supply disruptions and unanticipated costs may be incurred in transitioning to a new supplier if a prior single supplier relationship was abruptly interrupted or terminated. In the event of a disruption, we believe that we will be able to qualify and use alternate materials, sometimes at premium costs, and that such raw materials and components will be available in adequate quantities to meet forecasted production schedules. In 2020, our industry was impacted by COVID-19 pandemic related supply constraints with our suppliers, factories and logistics providers. In 2021, pandemic related supply constraints and disruptions may continue to impact our business operations.\nWorking Capital\nThe company maintains varying levels of working capital throughout the year to support business needs and customer requirements through various inventory management techniques, including demand forecasting and planning. We ended 2020 with an elevated backlog of orders that we expect to normalize throughout 2021. Please see the Financial Condition and Liquidity section of the “Management's Discussion and Analysis” section of this Annual Report on Form 10-K for additional information on our working capital requirements and processes.\nTrademarks, Licenses and Patents\nWe consider the trademarks, copyrights, patents, and trade secrets we own, and the licenses we hold, in the aggregate, to be a valuable asset. Whirlpool is the owner of a number of trademarks in the United States and foreign countries. The most important trademarks to North America are Whirlpool, Maytag, JennAir, KitchenAid and Amana. The most important trademarks to EMEA are Whirlpool, KitchenAid, Bauknecht, Indesit, Hotpoint* and Ignis. The most important trademarks to Latin America are Consul, Brastemp, Whirlpool, KitchenAid and Acros. The most important trademarks to Asia are Whirlpool and Royalstar (which is licensed to us). We receive royalties from licensing our trademarks to third parties to manufacture, sell and service certain products bearing the Whirlpool, Maytag, KitchenAid and Amana brand names. We continually apply for and obtain patents globally. The primary purpose in obtaining patents is to protect our designs, technologies, products and services.\n*Whirlpool ownership of the Hotpoint brand in the EMEA and Asia Pacific regions is not affiliated with the Hotpoint brand sold in the Americas.\n10\nGovernment Regulation and Protection of the Environment\nWe know that an environmentally sustainable Whirlpool is a more competitive Whirlpool — a company better positioned for long-term success. Our commitment to environmental responsibility is embedded in our operations, and is focused on our three pillars: sustainable plants, sustainable products, and sustainable practices. We comply with all laws and regulations regarding protection of the environment, and in many cases where laws and regulations are less restrictive, we have established and are following our own standards, consistent with our commitment to environmental responsibility.\nWe believe that we are in compliance, in all material respects, with presently applicable governmental provisions relating to environmental protection in the countries in which we have manufacturing operations. Compliance with these environmental laws and regulations did not have a material effect on capital expenditures, earnings, or our competitive position during 2020 and is not expected to be material in 2021.\nThe entire major home appliance industry, including Whirlpool, must contend with the adoption of stricter government energy and environmental standards. These standards have been and continue to be phased in over the past several years and include the general phase-out of ozone-depleting chemicals used in refrigeration, and energy and related standards for selected major appliances, regulatory restrictions on the materials content specified for use in our products by some jurisdictions and mandated recycling of our products at the end of their useful lives. Compliance with these various standards, as they become effective, will require some product redesign. However, we believe, based on our understanding of the current state of proposed regulations, that we will be able to develop, manufacture, and market products that comply with these regulations.\nWhirlpool participates in environmental assessments and cleanup at a number of locations globally. These include operating and non-operating facilities, previously owned properties and waste sites, including \"Superfund\" (under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA)) sites. However, based upon our evaluation of the facts and circumstances relating to these sites along with the evaluation of our technical consultants, we do not presently anticipate any material adverse effect on our financial statements arising out of the resolution of these matters or the resolution of any other known governmental proceeding regarding environmental protection matters.\nOur operations are also subject to numerous legal and regulatory requirements concerning product energy usage, data privacy, employment conditions and worksite health and safety. These requirements often provide broad discretion to government authorities, and they could be interpreted or revised in ways that delay production or make production more costly. The costs to comply, or associated with any noncompliance, are, or can be, significant and variable from period to period.\nAdditionally, in line with the guidelines provided by health organizations around the world and consistent with our commitment to employee health and safety as our highest priority, we have added various health and safety measures in our manufacturing, service, sales and administrative offices, warehouse and distribution spaces in response to the COVID-19 pandemic. These actions include provision of personal protection equipment to employees, increased manufacturing line spacing or protective barriers to accommodate physical distancing guidelines, temperature screening and increased enablement of remote working. We may incur significant COVID-19-related expenses for additional actions in the future, in line with our commitment to employee health and safety.\nHuman Capital Management\nAt Whirlpool, our values guide everything we do. We are committed to the highest standards of ethical and legal conduct and have created an environment where open and honest communication is the expectation, not the exception. We hold our employees to this standard and offer the same in return. Our Integrity Manual was created to help our employees follow our commitment to win the\n11\nright way. Additionally, our Supplier Code of Conduct formalizes the key principles under which Whirlpool’s suppliers are required to operate.\nOur Human Capital Strategy is built around three pillars:\nExtraordinary Performance\nOur employees are a critical driver of Whirlpool’s global business results. On December 31, 2020, Whirlpool employed approximately 78,000 employees across 13 countries, with 27 percent located within the United States. Outside of the United States, our largest employee populations were located within Brazil, Mexico and China. We regularly monitor various key performance indicators around the human capital priorities of attracting, retaining, and engaging our global talent. In addition, we enable the execution of our strategic priorities by providing all employees with access to training and development opportunities to improve critical skill sets.\nGreat People\nWe have a long tradition of measuring employee engagement through our annual employee engagement survey. In 2020, we migrated to a new survey platform to facilitate more frequent measurements of employee engagement and utilized the platform for a global well-being pulse survey strategy in response to COVID-19. We are committed to continued pulse surveys beginning in 2021 with coverage of broader engagement and well-being topics.\nWhirlpool offers a variety of programs globally to protect the health and safety of our employees. While we maintain targets for year-over-year reduction of the total recordable incident rate and serious injuries, our goal is always zero. In 2020, we focused on the immediate demands within the context of COVID-19 challenges. Where possible, employees were moved to a remote work environment. In addition, we implemented additional safeguards in our plants consistent with the guidelines provided by the Centers for Disease Control and Prevention (CDC) and other health organizations around the world.\nWinning Culture\nOur culture is underpinned by our enduring values, which have long been pillared by inclusion and diversity. Whirlpool has a history of prioritizing issues such as gender and racial equality among our people. For the past 18 years, Whirlpool Corporation has achieved a perfect 100 on the Corporate Equality Index, marking nearly two decades of commitment to inclusion in the workplace. This broad organizational commitment was again demonstrated in 2020 with extensive participation in our second annual global inclusion week. Additionally, Whirlpool’s employee resource groups (ERGs) continue to raise awareness for an inclusive culture, representing eight under-represented groups in North America; two in our Europe, Middle East, Africa region; four in the Latin America region; and one in Asia.\nAnd, importantly, in 2020 we furthered our commitment by establishing a pledge to Equality and Fairness for our United States Black colleagues. At its core, the pledge is a zero tolerance policy for racial marginalization within the Company. The pledge is a multi-year U.S. based action plan, with regular messaging across the entire organization. While our actions focus on our “four walls” and our local communities, we hope that these actions will have a ripple effect on society at large. In addition, Whirlpool Corporation announced that its Chairman and CEO Marc Bitzer is a founding member of OneTen, a coalition of leading executives with the mission to train, hire and advance one million Black Americans over the next 10 years into family-sustaining jobs with opportunities for advancement.\nFor additional information, please see Whirlpool’s investor website, and forthcoming 2021 Proxy Statement and Sustainability Report, which we expect to release in early March 2021. The contents of our Sustainability Report and investor website are not incorporated by reference into this Annual Report on Form 10-K or in any other report or document we file with the SEC.\n12\nOther Information\nFor information about the challenges and risks associated with our foreign operations, see \"Risk Factors\" under Item 1A.\nWhirlpool is a major supplier of laundry, refrigeration, cooking and dishwasher home appliances to Lowe's, a North American retailer. Net sales attributable to Lowe's in 2020, 2019 and 2018, were approximately 13%, 13% and 12%, respectively, of our consolidated net sales. Lowe's also represented approximately 14% of our consolidated accounts receivable as of December 31, 2020 and 2019, respectively. See Note 16 to the Consolidated Financial Statements.\nFor information on our global restructuring plans, and the impact of these plans on our operating segments, see Note 14 to the Consolidated Financial Statements.\nInformation About Our Executive Officers\nThe following table sets forth the names and ages of our executive officers on February 11, 2021, the positions and offices they held on that date, and the year they first became executive officers:\n| Name | Office | First Becamean ExecutiveOfficer | Age |\n| Marc R. Bitzer | Chairman of the Board, President and Chief Executive Officer | 2006 | 56 |\n| James W. Peters | Executive Vice President and Chief Financial Officer | 2016 | 51 |\n| João C. Brega | Executive Vice President and President, Whirlpool Latin America | 2012 | 57 |\n| Joseph T. Liotine | Executive Vice President and President, Whirlpool North America | 2014 | 48 |\n| Gilles Morel | Executive Vice President and President, Whirlpool Europe, Middle East & Africa | 2019 | 55 |\n| Shengpo (Samuel) Wu | Executive Vice President and President, Whirlpool Asia | 2019 | 54 |\n\nThe executive officers named above were elected by our Board of Directors to serve in the office indicated until the first meeting of the Board of Directors following the annual meeting of stockholders in 2021 and until a successor is chosen and qualified or until the executive officer's earlier resignation or removal. Each of our executive officers has held the position set forth in the table above or has served Whirlpool in various executive or administrative capacities for at least the past five years, except for Mr. Wu and Mr. Morel. Prior to joining Whirlpool in February 2017, Mr. Wu for the previous five years served as President and Chief Executive Officer, Asia Pacific, of Osram GmbH, and before joining Osram in 2012, worked for Honeywell Process Solutions and General Electric in various leadership roles. Prior to joining Whirlpool in April 2019, Mr. Morel served for two years as CEO of Northern and Central Europe for Groupe Savencia. Prior to that, he worked for 27 years at Mars Inc. in various leadership positions, most recently as Regional President, Europe & Eurasia for Mars Chocolate.\nAvailable Information\nFinancial results and investor information (including Whirlpool's Form 10-K, 10-Q, and 8-K reports) are accessible at Whirlpool's website: investors.whirlpoolcorp.com. Copies of our Form 10-K, 10-Q, and 8-K reports and amendments, if any, are available free of charge through our website on the same day they are filed with, or furnished to, the Securities and Exchange Commission.\nWe routinely post important information for investors on our website, whirlpoolcorp.com, in the \"Investors\" section. We also intend to update the Hot Topics Q&A portion of this webpage as a means of disclosing material, non-public information and for complying with our disclosure obligations under Regulation FD. Accordingly, investors should monitor the Investors section of our website, in addition to following our press releases, SEC filings, public conference calls,\n13\npresentations and webcasts. The information contained on, or that may be accessed through, our webpage is not incorporated by reference into, and is not a part of, this document.\nITEM 1A.\nRISK FACTORS\nThis report contains statements referring to Whirlpool that are not historical facts and are considered \"forward-looking statements\" within the meaning of the Private Securities Litigation Reform Act of 1995. These statements, which are intended to take advantage of the \"safe harbor\" provisions of the Private Securities Litigation Reform Act of 1995, are based on current projections about operations, industry conditions, financial condition and liquidity. Words that identify forward-looking statements include words such as \"may,\" \"could,\" \"will,\" \"should,\" \"possible,\" \"plan,\" \"predict,\" \"forecast,\" \"potential,\" \"anticipate,\" \"estimate,\" \"expect,\" \"project,\" \"intend,\" \"believe,\" \"may impact,\" \"on track,\" and words and terms of similar substance used in connection with any discussion of future operating or financial performance, an acquisition or merger, or our businesses. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. Those statements are not guarantees and are subject to risks, uncertainties, and assumptions that are difficult to predict. Therefore, actual results could differ materially and adversely from these forward-looking statements.\nWe have listed below what we believe to be the most significant pandemic-related, strategic, operational, financial, legal and compliance, and general risks relating to our business.\nCOVID-19 PANDEMIC RISKS\nOur financial condition and results of operations have been impacted and may in the future be adversely affected by the ongoing COVID-19 outbreak.\nWe continue to closely monitor the impact of the global COVID-19 pandemic on all aspects of our operations and regions, including its effect on our consumers, employees, trade customers, suppliers and distribution channels. In 2020, the pandemic created significant business disruption and economic uncertainty which adversely impacted our manufacturing operations, supply chain, and distribution channels. While the immediate impacts of the COVID-19 pandemic have been assessed, the long-term magnitude and duration of the disruption and resulting decline in global business activity remains uncertain. Many factors that have impacted us and others that will impact us in the future, such as availability of effective treatments and vaccines, are out of our control. The adverse impact of the pandemic is expected to continue and may materially affect our financial statements in future periods.\nThe impacts of the pandemic include, but are not limited to, the following:\n•Production shutdowns and slowdowns because of COVID as well as COVID-related government orders and supply or labor shortages, in individual or collective groups of factories in impacted countries, which have and could in the future result in increased costs and decreased efficiency, and which have and could impact our ability to respond to rapid changes in demand;\n•Uncertainty regarding the timing for our production facilities to return to pre-COVID operational speed and production capacity;\n•Lack of availability of component materials in our supply chain and an increase in raw material and component costs;\n•Recent and potential future reductions in trade customer sales volume, potential trade customer financial restructuring or insolvency, and increases in accounts receivable balances with our trade customer base;\n•Potential future impairment in value of certain tangible or intangible assets could be recorded as a result of weaker economic conditions;\n14\n•Significant disruption of global financial markets, which could have a negative impact on our ability to access capital in the future, and which, together with operational impacts noted above, necessitated certain liquidity creation and preservation actions as a precautionary measure in 2020;\n•Fluctuations in forecasted earnings before tax and corresponding volatility in our effective tax rate;\n•Uncertainty with respect to the application of economic stimulus legislation in the U.S. and abroad, including uncertainty regarding impacts to our current global tax positions and future tax planning;\n•Operational risk, including but not limited to data privacy and cybersecurity incidents, as a result of salaried workforce extended remote work arrangements, and operational delays as a result of salaried employee furlough and collective vacation actions in certain countries, and restrictions on employee travel;\n•Operational disruption if key employees terminate their employment or become ill, as well as diversion of our management team's attention from non-COVID-19 related matters;\n•Potential investigations, legal claims or litigation against us for actions we have taken or may take, or decisions we have made or may make, as a consequence of the pandemic; and\n•Potential delays in resolving pending legal matters as a result of court, administrative and other closures and delays in many of our regions.\nWe have not yet determined with certainty the extent to which our existing insurance will respond to these impacts. In addition, we cannot predict the impact that COVID-19 will have on our trade customers, suppliers, consumers, and each of their financial conditions; however, any material effect on these parties could adversely impact us. The impact of COVID-19 may also exacerbate other risks discussed in Item 1A. Risk Factors in this Annual Report on Form 10-K, any of which could have a material adverse effect on our financial statements.\nSTRATEGIC RISKS\nWe face intense competition in the major home appliance industry and failure to successfully compete could negatively affect our business and financial performance.\nEach of our operating segments operates in a highly competitive business environment and faces intense competition from a significant number of competitors, many of which have strong consumer brand equity. Several of these competitors, such as those set forth in the Business section of this annual report, are large, well-established companies, ranking among the Global Fortune 150. We also face competition that may be able to quickly adapt to changing consumer preferences, particularly in the connected appliance space. Moreover, our customer base includes large, sophisticated trade customers who have many choices and demand competitive products, services and prices, and which may in the future merge, consolidate, form alliances or further increase their relative purchasing scale. Competition in the global appliance industry is based on a number of factors including selling price, product features and design, consumer taste, performance, innovation, reputation, energy efficiency, service, quality, cost, distribution, and financial incentives, such as promotional funds, sales incentives, volume rebates and terms. Many of our competitors are increasingly expanding beyond their existing manufacturing footprints. Our competitors, especially global competitors with low-cost sources of supply and/or highly protected home countries outside the United States, have aggressively priced their products and/or introduced new products to increase market share and expand into new geographies. Many of our competitors have established and may expand their presence in the rapidly changing retail environment, including the shifting of consumer purchasing practices towards e-commerce and other channels, and the increasing global prevalence of direct-to-consumer sales models. In addition, technological innovation is a significant competitive factor for our products. If we are\n15\nunable to successfully compete in this highly competitive environment, our business and financial performance could be negatively affected.\nThe loss of, or substantial decline in, volume of sales to any of our key trade customers, major buying groups, and/or builders could adversely affect our financial performance.\nWe sell to a sophisticated customer base of large trade customers, including large domestic and international trade customers, that have significant leverage as buyers over their suppliers. Most of our products are not sold through long-term contracts, allowing trade customers to change volume among suppliers like us. As the trade customers continue to become larger through merger, consolidation or organic growth, they may seek to use their position to improve their profitability by various means, including improved efficiency, lower pricing, and increased promotional programs. If we are unable to meet their demand requirements, our volume growth and financial results could be negatively affected. We also continue to pursue direct-to-consumer sales globally, including the launch of direct-to-consumer sales on many of our brand websites in recent years, which may impact our relationships with existing trade customers. The loss or substantial decline in volume of sales to our key trade customers, major buying groups, builders, or any other trade customers to which we sell a significant amount of products, could adversely affect our financial performance. Additionally, the loss of market share or financial difficulties, including bankruptcy and financial restructuring, by these trade customers could have a material adverse effect on our financial statements.\nFailure to maintain our reputation and brand image could negatively impact our business.\nOur brands have worldwide recognition, and our success depends on our ability to maintain and enhance our brand image and reputation. Maintaining, promoting and growing our brands depends on our marketing efforts, including advertising and consumer campaigns, as well as product innovation. We could be adversely impacted if we fail to achieve any of these objectives or if, whether or not justified, the reputation or image of our company or any of our brands is tarnished or receives negative publicity. In addition, adverse publicity about regulatory or legal action against us, product safety, data privacy breaches or quality issues, or negative association with any one brand could damage our reputation and brand image, undermine our customers' confidence in us and reduce long-term demand for our products, even if the regulatory or legal action is unfounded or not material to our operations.\nIn addition, our success in maintaining, extending and expanding our brand image depends on our ability to adapt to a rapidly changing media environment, including an ever-increasing reliance on social media and online dissemination of advertising campaigns. Inaccurate or negative posts or comments about us on social networking and other websites that spread rapidly through such forums could seriously damage our reputation and brand image. If we do not maintain, extend and expand our brand image, then our financial statements could be materially and adversely affected.\nAn inability to effectively execute and manage our business objectives and global operating platform initiative could adversely affect our financial performance.\nThe highly competitive nature of our industry requires that we effectively execute and manage our business objectives including our global operating platform initiative. Our global operating platform initiative aims to reduce costs, expand margins, drive productivity and quality improvements, accelerate our rate of innovation, generate free cash flow and drive shareholder value. An inability to effectively control costs and drive productivity improvements could affect our profitability. In addition, an inability to provide high-quality, innovative products could adversely affect our ability to maintain or increase our sales, which could negatively affect our revenues and overall financial performance.\n16\nOur ability to understand consumers’ preferences and to timely identify, develop, manufacture, market, and sell products that meet customer demand could significantly affect our business.\nOur success is dependent on anticipating and appropriately reacting to changes in consumer preferences, including the shifting of consumer purchasing practices towards e-commerce, direct-to-consumer and other channels, and on successful new product development, including in the connected appliance space and the digital space (e.g. our Yummly recipe app), and process development and product relaunches in response to such changes. Our future results and our ability to maintain or improve our competitive position will depend on our capacity to gauge the direction of our key product categories and geographic regions and upon our ability to successfully and timely identify, develop, manufacture, market, and sell new or improved products in these changing environments.\nOur intellectual property rights are valuable, and any inability to protect them could reduce the value of our products, services and brands.\nWe consider our intellectual property rights, including patents, trademarks, copyrights and trade secrets, and the licenses we hold, to be a significant and valuable aspect of our business. We attempt to protect our intellectual property rights through a combination of patent, trademark, copyright and trade secret laws, as well as licensing agreements and third party nondisclosure and assignment agreements. Our failure to obtain protection for or adequately protect our trademarks, products, new features of our products, or our processes may diminish our competitiveness.\nWe have applied for intellectual property protection in the United States and other jurisdictions with respect to certain innovations and new products, design patents, product features, and processes. We cannot be assured that the U.S. Patent and Trademark Office or any similar authority in other jurisdictions will approve any of our patent applications. Additionally, the patents we own could be challenged or invalidated, others could design around our patents or the patents may not be of sufficient scope or strength to provide us with any meaningful protection or commercial advantage. Further, the laws of certain foreign countries in which we do business, or contemplate doing business in the future, do not recognize intellectual property rights or protect them to the same extent as United States law. These factors could weaken our competitive advantage with respect to our products, services, and brands in foreign jurisdictions, which could adversely affect our financial performance.\nMoreover, while we do not believe that any of our products infringe on enforceable intellectual property rights of third parties, others have in the past and may in the future assert intellectual property rights that cover some of our technology, brands, products, or services. Any litigation regarding patents or other intellectual property could be costly and time-consuming and could divert the attention of our management and key personnel from our business operations. Claims of intellectual property infringement might also require us to enter into costly license agreements or modify our products or services. We also may be subject to significant damages, injunctions against the development and sale of certain products or services, or limited in the use of our brands.\nOPERATIONAL RISKS\nWe face risks associated with our divestitures, acquisitions and other investments and risks associated with our increased presence in emerging markets.\nFrom time to time, we make strategic acquisitions or divestitures, investments and participate in joint ventures. For example, in 2019 we sold our Embraco compressor business. In addition, we acquired Indesit and a majority interest in Hefei Sanyo in 2014. These transactions, and other transactions that we have entered into or which we may enter into in the future, can involve significant challenges and risks, including that the transaction does not advance our business strategy or fails to produce a satisfactory return on our investment. We have encountered and may encounter difficulties in integrating acquisitions with our operations, undertaking post-\n17\nacquisition restructuring activities, applying our internal control processes to these acquisitions, managing strategic investments, and in overseeing the operations, systems and controls of acquired companies. Integrating acquisitions and carving out divestitures is often costly and may require significant attention from management. Furthermore, we may not realize the degree, or timing, of benefits we anticipate when we first enter into a transaction. While our evaluation of any potential transaction includes business, legal and financial due diligence with the goal of identifying and evaluating the material risks involved, our due diligence reviews may not identify all of the issues necessary to accurately estimate the cost and potential loss contingencies of a particular transaction, including potential exposure to regulatory sanctions resulting from an acquisition target's previous activities or costs associated with any quality issues with an acquisition target's legacy products. In addition, certain liabilities may be retained by Whirlpool when closing a facility, divesting an entity or selling physical assets, and such liabilities may be material. For example, we agreed to retain certain liabilities relating to Embraco antitrust, tax, environmental, labor and products in connection with the Embraco sale.\nOur growth plans include efforts to increase revenue from emerging markets, including through acquisitions. Local business practices in these countries may not comply with U.S. laws, local laws or other laws applicable to us or our compliance policies, and non-compliant practices may result in increased liability risks. For example, we may incur unanticipated costs, expenses or other liabilities as a result of an acquisition target's violation of applicable laws, such as the U.S. Foreign Corrupt Practices Act (FCPA) or similar worldwide anti-bribery laws in non-U.S. jurisdictions. We may incur unanticipated costs or expenses, including post-closing asset impairment charges, expenses associated with eliminating duplicate facilities, litigation, and other liabilities. For example, we incurred significant impairment and restructuring expenses in the years following our acquisition of Indesit in 2014. In addition, our recent and future acquisitions may increase our exposure to other risks associated with operating internationally, including foreign currency exchange rate fluctuations; political, legal and economic instability; inflation; changes in tax rates and tax laws; and work stoppages and labor relations.\nRisks associated with our international operations may decrease our revenues and increase our costs.\nFor the year ended December 31, 2020, sales outside our North America region represented approximately 42% of our net sales. We expect that international sales will continue to account for a significant percentage of our net sales. Accordingly, we face numerous risks associated with conducting international operations, any of which could negatively affect our financial performance. These risks include the following:\n•COVID-19-related shutdowns and other pandemic-related uncertainties in the countries in which we operate;\n•Political, legal, and economic instability and uncertainty;\n•Foreign currency exchange rate fluctuations;\n•Changes in foreign tax rules, regulations and other requirements, such as changes in tax rates and statutory and judicial interpretations of tax laws;\n•Changes in diplomatic and trade relationships, including sanctions resulting from the current political situation in countries in which we do business;\n•Inflation and/or deflation;\n•Changes in foreign country regulatory requirements, including data privacy laws;\n•Various import/export restrictions and disruptions and the availability of required import/export licenses;\n•Imposition of tariffs and other trade barriers;\n18\n•Managing widespread operations and enforcing internal policies and procedures such as compliance with U.S. and foreign anti-bribery, anti-corruption regulations and anti-money laundering, such as the FCPA, and antitrust laws;\n•Labor disputes and work stoppages at our operations and suppliers;\n•Government price controls;\n•Trade customer insolvency and the inability to collect accounts receivable; and\n•Limitations on the repatriation or movement of earnings and cash\nAs a U.S. corporation, we are subject to the FCPA, which may place us at a competitive disadvantage to foreign companies that are not subject to similar regulations. Additionally, any determination that we have violated the FCPA or other anti-corruption laws could have a material adverse effect on us.\nTerrorist attacks, cyber events, armed conflicts, civil unrest, natural disasters, governmental actions, epidemics and pandemics (including the impacts of COVID-19 discussed elsewhere in Risk Factors) have and could affect our domestic and international sales, disrupt our supply chain, and impair our ability to produce and deliver our products. Such events could directly impact our physical facilities or those of our suppliers or customers.\nWe have been and may be subject to information technology system failures, network disruptions, cybersecurity attacks and breaches in data security, which may materially adversely affect our operations, financial condition and operating results.\nWe depend on information technology to improve the effectiveness of our operations and to interface with our customers, consumers and employees, as well as to maintain financial accuracy and efficiency. In addition, we collect, store, have access to and otherwise process certain confidential or sensitive data, including proprietary business information, personal data or other information that is subject to privacy and security laws, regulations and/or customer-imposed controls. Our business processes and data sharing across functions, suppliers, and vendors is dependent on information technology integration. The failure of any systems, whether internal or third-party, during normal operation, system upgrades, implementations, or connections, could disrupt our operations by causing transaction errors, processing inefficiencies, delays or cancellation of customer orders, the loss of customers, impediments to the manufacture or shipment of products, other financial and business disruptions, or the loss of or damage to intellectual property and the personally identifiable data of consumers and employees.\nIn addition, we have outsourced certain information technology support services and administrative functions, such as system application maintenance and certain benefit plan administration functions, to third-party service providers and may outsource other functions in the future to achieve cost savings and efficiencies. If these service providers do not perform effectively, we may not achieve the expected cost savings and may incur additional costs to correct errors made by such service providers. Depending on the function involved, such errors may also lead to business disruption, processing inefficiencies or the loss of or damage to intellectual property and personally identifiable information through system compromise, or harm employee morale.\nOur information systems, or those of our third-party service providers, have been in the past and could be in the future impacted by inappropriate activity of parties intent on extracting or corrupting information or disrupting business processes, or by inadvertent data security-compromising activities by our employees or service providers. Such unauthorized access has in the past and could in the future disrupt our business and result in the loss of assets. Cyber attacks are becoming more sophisticated and include malicious software, including ransomware attacks, attempts to gain unauthorized access to data, and other electronic security breaches that have in the past and could in the future lead to disruptions in critical systems, unauthorized release of confidential or otherwise protected information, and corruption of data. Our growth in the areas of connected appliances and the \"Internet of Things,\" as well as our reliance on pandemic-driven\n19\nremote work arrangements, has increased these risks. These events have in the past and could in the future impact our customers, consumers, employees, third-parties and reputation and lead to financial losses from remediation actions, loss of business or potential liability or an increase in expense. While we have not experienced any material impacts from a cyber attack, any one or more future cyber attacks could have a material adverse effect on our financial statements.\nProduct-related liability or product recall costs could adversely affect our business and financial performance.\nWe have been and may be exposed to product-related liabilities, which in some instances may result in product redesigns, product recalls, or other corrective action. In addition, any claim, product recall or other corrective action that results in significant adverse publicity, particularly if those claims or recalls cause customers to question the safety or reliability of our products, may negatively affect our financial statements. For example, we have undertaken corrective action initiatives in EMEA related to certain legacy Indesit-designed washer and Indesit-produced dryers. We maintain product liability insurance, but it may not be adequate to cover losses related to product liability claims brought against us. Product liability insurance could become more expensive and difficult to maintain and may not be available on commercially reasonable terms, if at all. We may be involved in class action litigation or product recalls for which we generally have not purchased insurance, and may be involved in other litigation or events for which insurance products may have limitations.\nWe regularly engage in investigations of potential quality and safety issues as part of our ongoing effort to deliver quality products to our customers. We are currently investigating certain potential quality and safety issues globally, and as appropriate, we undertake to effect repair or replacement of appliances in the event that an investigation leads to the conclusion that such action is warranted. Actual costs of these and any future issues depend upon several factors, including the number of consumers who respond to a particular recall, repair and administrative costs, whether the cost of any corrective action is borne by us or the supplier, and, if borne by us, whether we will be successful in recovering our costs from the supplier. The actual costs incurred as a result of these issues and any future issues could have a material adverse effect on our financial statements.\nThe ability of suppliers to deliver parts, components and manufacturing equipment to our manufacturing facilities, and our ability to manufacture without disruption, could affect our global business performance.\nWe use a wide range of materials and components in the global production of our products, which come from numerous suppliers around the world. Because not all of our business arrangements provide for guaranteed supply and some key parts may be available only from a single supplier or a limited group of suppliers, we are subject to supply and pricing risk. In addition, certain proprietary component parts used in some of our products are provided by single-source unaffiliated third-party suppliers. We would be unable to obtain these proprietary components for an indeterminate period of time if these single-source suppliers were to cease or interrupt production or otherwise fail to supply these components to us, which could adversely affect our product sales and operating results. Our operations and those of our suppliers are subject to disruption for a variety of reasons, including COVID-19-related supplier plant shutdowns or slowdowns, work stoppages, labor relations, intellectual property claims against suppliers, financial issues such as supplier bankruptcy, information technology failures, and hazards such as fire, earthquakes, flooding, or other natural disasters. Insurance for certain disruptions may not be available, affordable or adequate. The effects of climate change, including extreme weather events, long-term changes in temperature levels and water availability may exacerbate these risks. Such disruption has in the past and could in the future interrupt our ability to manufacture certain products. Any significant disruption could negatively impact our financial statements.\n20\nOur ability to attract, develop and retain executives and other qualified employees is crucial to our results of operations and future growth.\nWe depend upon the continued services and performance of our key executives, senior management and skilled personnel, particularly professionals with experience in our business and operations and the home appliance industry. While we strive to attract, develop and retain these individuals through execution of our human capital strategy (see “Human Capital Management” in Item 1), we cannot be sure that any of these individuals will continue to be employed by us. In the case of talent losses, significant time is required to hire, develop and train skilled replacement personnel. We must also attract, develop, and retain individuals with the requisite engineering and technical expertise to develop new technologies and introduce new products, particularly as we increase investment in our digital and “Internet of Things” capabilities. An inability to hire, develop, transfer retained knowledge, engage and retain a sufficient number of qualified employees could materially hinder our business by, for example, delaying our ability to bring new products to market or impairing the success of our operations.\nA deterioration in labor relations could adversely impact our global business.\nAs of December 31, 2020, we had approximately 78,000 employees. We are subject to separate collective bargaining agreements with certain labor unions, as well as various other commitments regarding our workforce. We periodically negotiate with certain unions representing our employees and may be subject to work stoppages or may be unable to renew collective bargaining agreements on the same or similar terms, or at all. In addition, our global restructuring activities have in the past and may in the future be received negatively by governments and unions and attract negative media attention, which may delay the implementation of such plans. A deterioration in labor relations may have a material adverse effect on our financial statements.\nFINANCIAL RISKS\nFluctuations and volatility in the cost of raw materials and purchased components could adversely affect our operating results.\nThe sources and prices of the primary materials (such as steel, resins, and base metals) used to manufacture our products and components containing those materials are susceptible to significant global and regional price fluctuations due to supply and demand trends, transportation costs, labor costs, government regulations and tariffs, changes in currency exchange rates, price controls, the economic climate, and other unforeseen circumstances. In addition, we engage in contract negotiations and enter into commodity swap contracts to manage risk associated with certain commodities purchases. Significant increases in materials costs and other costs now and in the future could have a material adverse effect on our financial statements.\nForeign currency fluctuations may affect our financial performance.\nWe generate a significant portion of our revenue and incur a significant portion of our expenses in foreign currencies. Changes in the exchange rates of functional currencies of those operations affect the U.S. dollar value of our revenue and earnings from our foreign operations. We use currency forwards, net investment hedges, and options to manage our foreign currency transaction exposures. We cannot completely eliminate our exposure to foreign currency fluctuations, which may adversely affect our financial performance. In addition, because our consolidated financial results are reported in U.S. dollars, as we generate sales or earnings in other currencies, the translation of those results into U.S. dollars can result in a significant increase or decrease in the amount of those sales or earnings. Finally, the amount of legal contingencies related to foreign operations may fluctuate significantly based upon changes in exchange rates and usually cannot be managed with currency forwards, options or other arrangements. Such fluctuations in exchange rates can significantly increase or decrease the\n21\namount of any legal contingency related to our foreign operations and make it difficult to assess and manage the potential exposure.\nGoodwill and indefinite-lived intangible asset impairment charges have in the past and may in the future adversely affect our operating results.\nWe have a substantial amount of goodwill and indefinite-lived intangible assets, primarily trademarks, on our balance sheet. We test the goodwill and intangible assets for impairment on an annual basis and when events occur or circumstances change that indicate that the fair value of the reporting unit or intangible asset may be below its carrying amount. Fair value determinations require considerable judgment and are sensitive to inherent uncertainties and changes in estimates and assumptions regarding revenue growth rates, EBIT margins, capital expenditures, working capital requirements, tax rates, terminal growth rates, discount rates, royalty rates, benefits associated with a taxable transaction and synergies available to market participants. Declines in market conditions, a trend of weaker than anticipated financial performance for our reporting units or declines in projected revenue for our trademarks, a decline in our share price for a sustained period of time, an increase in the market-based weighted average cost of capital or a decrease in royalty rates, among other factors, are indicators that the carrying value of our goodwill or indefinite-life intangible assets may not be recoverable. We recorded an immaterial impairment charge related to other intangibles for the year ended December 31, 2020 and an impairment of $747 million related to goodwill ($579 million) and other intangibles ($168 million) for the year ended December 31, 2018 related to the EMEA reporting unit. We may in the future be required to record a goodwill or intangible asset impairment charge that, if incurred, could have a material adverse effect on our financial statements.\nImpairment of long-lived assets may adversely affect our operating results.\nOur long-lived asset groups are subject to an impairment assessment when certain triggering events or circumstances indicate that their carrying value may be impaired. If the carrying value exceeds our estimate of future undiscounted cash flows of the operations related to the asset group, an impairment is recorded for the difference between the carrying amount and the fair value of the asset group. The results of these tests for potential impairment may be adversely affected by unfavorable market conditions, our financial performance trends, or an increase in interest rates, among other factors. If as a result of the impairment test we determine that the fair value of any of our long-lived asset groups is less than its carrying amount, we may incur an impairment charge that could have a material adverse effect on our financial statements.\nWe face inventory valuation risk.\nWe write down product and component inventories that have become obsolete or do not meet anticipated demand or net realizable value. No assurance can be given that, given the unpredictable pace of product obsolescence and business conditions with trade customers and in general, we will not incur additional inventory related charges. Such charges could negatively affect our financial statements.\nSignificant differences between actual results and estimates of the amount of future funding for our pension plans and postretirement health care benefit programs, and significant changes in funding assumptions or significant increases in funding obligations due to regulatory changes, could adversely affect our financial results.\nWe have both funded and unfunded defined benefit pension plans that cover certain employees around the world. We also have unfunded postretirement health care benefit plans for eligible retired employees. The Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code, as amended, govern the funding obligations for our U.S. pension plans, which are our principal pension plans. Our U.S. defined benefit plans were frozen on or before December 31, 2006 for substantially all participants. Since 2007, U.S. employees have been eligible for an enhanced employer contribution under Whirlpool's defined contribution (401(k)) plan.\n22\nAs of December 31, 2020, our projected benefit obligations under our pension plans and postretirement health and welfare benefit programs exceeded the fair value of plan assets by an aggregate of approximately $0.7 billion, including $0.5 billion of which was attributable to pension plans and $0.2 billion of which was attributable to postretirement health care benefits. Estimates for the amount and timing of the future funding obligations of these pension plans and postretirement health and welfare benefit plans are based on various assumptions, including discount rates, expected long-term rate of return on plan assets, life expectancies and health care cost trend rates. These assumptions are subject to change based on changes in interest rates on high quality bonds, stock and bond market returns, health care cost trend rates and regulatory changes, all of which are largely outside our control. Significant differences in results or significant changes in assumptions may materially affect our postretirement obligations and related future contributions and expenses.\nChanges in the method of determining the London Interbank Offered Rate, or LIBOR, or the replacement of LIBOR with one or more alternative reference rates, could adversely affect our financial condition and results of operations.\nCertain of our financial obligations and instruments are or may be made at variable interest rates that use LIBOR (or metrics derived from or related to LIBOR) as a benchmark. On July 27, 2017, the United Kingdom's Financial Conduct Authority announced that it intends to stop persuading or compelling banks to submit LIBOR rates after 2021. On November 18, 2020, ICE Benchmark Administration (“IBA”) announced that all LIBOR rates for certain currencies (other than U.S. Dollar LIBOR (“USD LIBOR”) would cease publication at the end of 2021. On November 30, 2020, IBA announced that, following a consultation period, it intends to announce that for USD LIBOR, it intends to cease publication of 1-week and 2-month LIBOR at the end of 2021 and that it does not intend to cease publication of other tenors of USD LIBOR until June 30, 2023. Regulators are generally supportive of these announcements and confident that USD LIBOR will remain a “representative” rate pursuant to procedures to be adopted, which could include new or alternative methods of determining LIBOR.\nThe pending cessation of LIBOR for various currencies at the end of 2021 (and in 2023 for certain tenors of USD LIBOR) will also result in replacement rates being used more widely, including in the instruments documenting certain of our financial obligations. For example, in the U.S., a group convened by the Federal Reserve Board and the Federal Reserve Bank of New York, called the Alternative Reference Rate Committee (\"ARRC\") and comprised of a diverse set of private sector entities, has identified the Secured Overnight Financing Rate (or \"SOFR\") as its preferred alternative rate for the U.S. LIBOR and the Federal Reserve Bank of New York has begun publishing SOFR daily. Many banks in the U.S. have begun entering into transactions where interest is determined based on SOFR or plan to do so during the course of 2021, as recommended by ARRC and certain regulators. Additionally, many financial contracts, including some which govern our financial obligations, include replacement alternatives for LIBOR upon the cessation of LIBOR. It is possible that some U.S. lenders will elect to use alternative rates other than SOFR. Central banks in several other jurisdictions have also announced plans for alternative reference rates for other currencies.\nThe potential consequences of these changes cannot be fully predicted and could have an adverse impact on the market value for LIBOR-linked securities, loans, and other financial obligations or extensions of credit held by or due to us, and could adversely affect our financial statements. Changes in market interest rates may influence our financing costs, returns on financial investments and the valuation of derivative contracts and could reduce our earnings and cash flows. In addition, any transaction process could involve, among other things, increased volatility or illiquidity in markets for instruments that rely on LIBOR, reductions in the value of certain instruments, mismatches between rates in hedging documentation and in the documentation for the underlying obligation being hedged, increased borrowing costs, uncertainty under applicable documentation, and/or difficult and costly consent processes.\n23\nLEGAL & COMPLIANCE RISKS\nUnfavorable results of legal and regulatory proceedings could materially adversely affect our business and financial condition and performance.\nWe are subject to a variety of litigation and legal compliance risks relating to, among other things: products; intellectual property rights; income and indirect taxes; environmental matters; corporate matters; commercial matters; credit matters; competition laws; distribution, marketing and trade practice matters; customs and duties; occupational health and safety (including matters related to the COVID-19 pandemic), anti–bribery and anti–corruption regulations; energy regulations; data privacy regulations; financial and securities regulations; and employment and benefit matters. For example, we are currently disputing certain income and indirect tax related assessments issued by the Brazilian authorities (see Note 8 and Note 15); we are disputing a proposed IRS income tax assessment in the United States Sixth Circuit Court of Appeals (see Note 15); and we are disputing certain income and indirect tax assessments in various legal proceedings in Italy, India and other jurisdictions globally. Unfavorable outcomes regarding these assessments could have a material adverse effect on our financial statements in any particular reporting period. Results of legal and regulatory proceedings cannot be predicted with certainty and for some matters, such as class actions, no insurance is cost-effectively available. Regardless of merit, legal and regulatory proceedings may be both time-consuming and disruptive to our operations and could divert the attention of our management and key personnel from our business operations. Such proceedings could also generate significant adverse publicity and have a negative impact on our reputation and brand image, regardless of the existence or amount of liability. We estimate loss contingencies and establish accruals as required by generally accepted accounting principles, based on our assessment of contingencies where liability is deemed probable and reasonably estimable, in light of the facts and circumstances known to us at a particular point in time. Subsequent developments in legal proceedings, volatility in foreign currency exchange rates and other factors may affect our assessment and estimates of the loss contingency recorded and could result in an adverse effect on our results of operations in the period in which a liability would be recognized or cash flows for the period in which amounts would be paid. Actual results may significantly vary from our reserves. We may experience additional delays in resolving these matters as a result of COVID-19-related administrative and judicial system temporary delays.\nWe are subject to, and could be further subject to, governmental investigations or actions by other third parties.\nWe are subject to various federal, foreign and state laws, including antitrust and product-related laws and regulations, violations of which can involve civil or criminal sanctions. Responding to governmental investigations or other actions may be both time-consuming and disruptive to our operations and could divert the attention of our management and key personnel from our business operations. For example, the second part of a French Competition Authority investigation, which is expected to focus primarily on manufacturer interactions with retailers, is ongoing. The impact of these and other investigations and lawsuits could have a material adverse effect on our financial statements.\nChanges in the legal and regulatory environment, including data privacy, potential climate regulations and changes in taxes and tariffs, could limit our business activities, increase our operating costs, reduce demand for our products or result in litigation.\nThe conduct of our businesses, and the production, distribution, sale, advertising, labeling, safety, transportation and use of many of our products, are subject to various laws and regulations administered by federal, state and local governmental agencies in the United States, as well as to foreign laws and regulations administered by government entities and agencies in countries in which we operate. In addition, we operate in an environment in which there are different and potentially conflicting data privacy and data access laws in effect in the various U.S. states and foreign jurisdictions in which we operate and we must understand and comply with each law and standard in each of these jurisdictions while ensuring the data is secure. For example, the European Union’s General Data Protection Regulation, which became effective in May 2018, the\n24\nCalifornia Consumer Privacy Act of 2018, which came into effect on January 1, 2020, and the California Privacy Rights and Enforcement Act, which will become effective on January 1, 2023, collectively impose or will impose new regulatory data privacy standards for which we must comply. These laws and regulations may change, sometimes dramatically, as a result of political, economic or social events. Changes in laws, regulations or governmental policy and the related interpretations may alter the environment in which we do business and may impact our results or increase our costs or liabilities.\nIn addition, we incur and will continue to incur capital and other expenditures to comply with various laws and regulations, especially relating to the protection of the environment, human health and safety, and water and energy efficiency. Climate change regulations at the federal, state or local level or in international jurisdictions could require us to limit emissions, change our manufacturing processes or product offerings, or undertake other costly activities. We are also subject to global regulations related to chemical substances and materials in our products (such as the U.S. Toxic Substances Control Act), which may require us to modify the materials used in our products or undertake activities which may have a cost impact. There is also increased focus by governmental and non-governmental entities on sustainability matters. We have set rigorous science-based targets for greenhouse gas reductions and related sustainability goals, and any failure to achieve our sustainability goals or reduce our impact on the environment, any changes in the scientific or governmental metrics utilized to objectively measure success, or the perception that we have failed to act responsibly regarding climate change could result in negative publicity and adversely affect our business and reputation.\nAdditionally, we could be subjected to future liabilities, fines or penalties or the suspension of product production for failing to comply, or being alleged as failing to comply, with various laws and regulations, including environmental regulations. Cleanup obligations that might arise at any of our manufacturing sites or the imposition of more stringent environmental laws in the future could also adversely affect us.\nAdditionally, as a global company based in the United States, we are exposed to the impact of U.S. tax changes, especially those that affect the effective corporate income tax rate. In addition, the current domestic and international political environment, including government shutdowns and changes to U.S. policies related to global trade and tariffs, has resulted in uncertainty surrounding the future state of the global economy. Many of our most significant competitors are global companies, and in an escalating global trade conflict or the imposition of tariffs, their respective governments may impose regulations that are favorable to our competitors. The U.S. federal government may propose additional changes to international trade agreements, tariffs, taxes, and other government rules and regulations. These regulatory changes could significantly impact our business and financial performance. For additional information about our consolidated tax provision, see Note 15 to the Consolidated Financial Statements, and for additional information about global trade and tariffs, please see \"Other Matters\" in the Management's Discussion and Analysis section of this Annual Report on Form 10-K.\nGENERAL RISKS\nWe are exposed to risks associated with the uncertain global economy.\nThe current domestic and international political and economic environment are posing challenges to the industry in which we operate. A number of economic factors, including the impact of the COVID-19 pandemic, gross domestic product, availability of consumer credit, interest rates, consumer sentiment and debt levels, retail trends, housing starts, sales of existing homes, the level of mortgage refinancing and defaults, fiscal and credit market uncertainty, and foreign currency exchange rates, currency controls, inflation and deflation, generally affect demand for our products in the U.S. and other countries which we operate.\nEconomic uncertainty and related factors exacerbate negative trends in business and consumer spending and has caused and may cause certain customers to push out, cancel, or refrain from placing orders for our products. Uncertain market conditions, difficulties in obtaining capital, or\n25\nreduced profitability has caused and may cause some customers to scale back operations, exit markets, merge with other retailers, or file for bankruptcy protection and potentially cease operations, which can also result in lower sales and/or additional inventory. These conditions have affected and may similarly affect key suppliers, which could impair their ability to deliver parts and result in delays for our products or added costs.\nA decline in economic activity and conditions in certain areas in which we operate have had an adverse effect on our financial condition and results of operations in recent years, and future declines and adverse conditions could have a similar adverse effect. Regional, political and economic instability in countries in which we do business may adversely affect business conditions, disrupt our operations, and have an adverse effect on our financial condition and results of operations. For example, the effect of the UK's exit from the European Union (“Brexit”), despite their December 2020 trade agreement, remains uncertain and could adversely impact certain areas of our business, including, but not limited to, an increase in duties and delays in the delivery of products, and adverse impacts to our suppliers and financing institutions.\nUncertainty about future economic and industry conditions also makes it more challenging for us to forecast our operating results, make business decisions, and identify and prioritize the risks that may affect our businesses, sources and uses of cash, financial condition and results of operations. We may be required to implement additional cost reduction efforts, including restructuring activities, which may adversely affect our ability to capitalize on opportunities in a market recovery. In addition, our operations are subject to general credit, liquidity, foreign exchange, market and interest rate risks. Our ability to invest in our businesses, fund strategic acquisitions and refinance maturing debt obligations depends in part on access to the capital markets.\nIf we do not timely and appropriately adapt to changes resulting from the uncertain macroeconomic environment and industry conditions, or to difficulties in the financial markets, or if we are unable to continue to access the capital markets, our financial statements may be materially and adversely affected.\nITEM 1B.\nUNRESOLVED STAFF COMMENTS\nNone.\n26\nITEM 2.\nPROPERTIES\nOur principal executive offices are located in Benton Harbor, Michigan. On December 31, 2020, our principal manufacturing operations were carried on at 35 locations in 13 countries worldwide. We occupied a total of approximately 82 million square feet devoted to manufacturing, service, sales and administrative offices, warehouse and distribution space. Over 44 million square feet of such space was occupied under lease. Whirlpool properties include facilities which are suitable and adequate for the manufacture and distribution of Whirlpool's products.\nThe Company's principal manufacturing locations by operating segment were as follows:\n| Operating Segment | North America | Europe, Middle East and Africa | Latin America | Asia |\n| Manufacturing Locations | 10 | 11 | 9 | 5 |\n\nITEM 3.\nLEGAL PROCEEDINGS\nInformation regarding legal proceedings can be found in Note 8 to the Consolidated Financial Statements and is incorporated herein by reference.\nITEM 4.\nMINE SAFETY DISCLOSURES\nNot applicable.\n27\n| PART II |\n\nITEM 5.\nMARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES\nWhirlpool's common stock is listed on the New York Stock Exchange and the Chicago Stock Exchange under the ticker symbol WHR. As of February 5, 2021, the number of holders of record of Whirlpool common stock was approximately 8,409.\nOn July 25, 2017, our Board of Directors authorized an additional share repurchase program of up to $2 billion. For the year ended December 31, 2020, we repurchased 902,000 shares at an aggregate purchase price of approximately $121 million under this program. At December 31, 2020, there were approximately $531 million in remaining funds authorized under this program.\nShare repurchases are made from time to time on the open market as conditions warrant. These programs do not obligate us to repurchase any of our shares and they have no expiration date.\nThe following table summarizes repurchases of Whirlpool's common stock in the three months ended December 31, 2020:\n| Period (Millions of dollars, except number and price per share) | Total Number of Shares Purchased | Average Price Paid per Share | Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs | Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans |\n| October 1, 2020 through October 31, 2020 | — | $ | — | — | $ | 531 |\n| November 1, 2020 through November 30, 2020 | — | — | — | 531 |\n| December 1, 2020 through December 31, 2020 | — | — | — | $ | 531 |\n| Total | — | $ | — |\n\n28\nITEM 6.\nSELECTED FINANCIAL DATA\nFIVE-YEAR SELECTED FINANCIAL DATA\n| (Millions of dollars, except share and employee data) | 2020 | 2019 | 2018 | 2017 | 2016 |\n| CONSOLIDATED OPERATIONS |\n| Net sales | $ | 19,456 | $ | 20,419 | $ | 21,037 | $ | 21,253 | $ | 20,718 |\n| Gross margin | 3,850 | 3,533 | 3,537 | 3,602 | 3,692 |\n| Restructuring costs | 288 | 188 | 247 | 275 | 173 |\n| Impairment of goodwill and other intangibles | 7 | — | 747 | — | — |\n| (Gain) loss on sale and disposal of businesses | (7) | (437) | — | — | — |\n| Depreciation and amortization | 568 | 587 | 645 | 654 | 655 |\n| Operating profit | 1,623 | 1,571 | 279 | 1,136 | 1,368 |\n| Earnings (loss) before income taxes | 1,455 | 1,552 | (21) | 887 | 1,114 |\n| Net earnings (loss) | 1,071 | 1,198 | (159) | 337 | 928 |\n| Net earnings (loss) available to Whirlpool | 1,081 | 1,184 | (183) | 350 | 888 |\n| Capital expenditures | 410 | 532 | 590 | 684 | 660 |\n| Dividends paid | 311 | 305 | 306 | 312 | 294 |\n| Repurchase of common stock | 121 | 148 | 1,153 | 750 | 525 |\n| CONSOLIDATED FINANCIAL POSITION |\n| Current assets | $ | 9,015 | $ | 7,398 | $ | 7,898 | $ | 7,930 | $ | 7,339 |\n| Current liabilities | 8,330 | 8,369 | 9,678 | 8,505 | 7,662 |\n| Accounts receivable, inventories and accounts payable, net | 461 | 89 | 256 | 856 | 918 |\n| Property, net | 3,199 | 3,301 | 3,414 | 4,033 | 3,810 |\n| Total assets(1) | 20,350 | 18,881 | 18,347 | 20,038 | 19,153 |\n| Long-term debt | 5,059 | 4,140 | 4,046 | 4,392 | 3,876 |\n| Total debt(2) | 5,369 | 4,993 | 6,027 | 5,218 | 4,470 |\n| Whirlpool stockholders' equity | 3,799 | 3,195 | 2,291 | 4,198 | 4,773 |\n| PER SHARE DATA |\n| Basic net earnings (loss) available to Whirlpool | $ | 17.24 | $ | 18.60 | $ | (2.72) | $ | 4.78 | $ | 11.67 |\n| Diluted net earnings (loss) available to Whirlpool | 17.07 | 18.45 | (2.72) | 4.70 | 11.50 |\n| Dividends | 4.85 | 4.75 | 4.55 | 4.30 | 3.90 |\n| Book value(3) | 60.00 | 49.77 | 34.08 | 56.42 | 61.82 |\n| Closing Stock Price at December 31—NYSE | 180.49 | 147.53 | 106.87 | 168.64 | 181.77 |\n| KEY RATIOS |\n| Operating profit margin | 8.3 | % | 7.7 | % | 1.3 | % | 5.3 | % | 6.6 | % |\n| Pre-tax margin(4) | 7.5 | % | 7.6 | % | (0.1) | % | 4.2 | % | 5.4 | % |\n| Net margin(5) | 5.6 | % | 5.8 | % | (0.9) | % | 1.6 | % | 4.3 | % |\n| Return on average Whirlpool stockholders' equity(6) | 30.9 | % | 43.2 | % | (5.6) | % | 7.8 | % | 18.7 | % |\n| Return on average total assets(7) | 5.5 | % | 6.4 | % | (1.0) | % | 1.8 | % | 4.7 | % |\n| Current assets to current liabilities | 1.1 | 0.9 | 0.8 | 0.9 | 1.0 |\n| Total debt as a percent of invested capital(8) | 53.3 | % | 54.8 | % | 65.3 | % | 50.4 | % | 43.8 | % |\n| Price earnings ratio(9) | 10.6 | 8.0 | (39.3) | 35.9 | 15.8 |\n| OTHER DATA |\n| Common shares outstanding (in thousands): |\n| Average number - on a diluted basis | 63,317 | 64,199 | 67,225 | 74,400 | 77,211 |\n| Year-end common shares outstanding | 62,793 | 62,894 | 63,528 | 70,646 | 74,465 |\n| Year-end number of stockholders | 8,449 | 8,804 | 9,248 | 9,960 | 10,528 |\n| Year-end number of employees | 78,000 | 77,000 | 92,000 | 92,000 | 93,000 |\n| Five-year annualized total return to stockholders(10) | 7.3 | % | (2.7) | % | (5.1) | % | 13.0 | % | 33.6 | % |\n\n(1)Total assets for 2020 and 2019 includes the impact related to ASC 842 for leases adopted as of January 1, 2019. See Note 3 to the Consolidated Financial Statements for additional information.\n(2)Total debt includes notes payable, current maturities of long-term debt and long-term debt.\n(3)Total Whirlpool stockholders' equity divided by average number of shares on a diluted basis.\n29\n(4)Earnings (loss) before income taxes, as a percent of net sales. 2019 includes the effect of a $437 million gain on sale and disposal of businesses, a $180 million gain related to Brazil indirect tax credits and a $105 million charge related to product warranty expense on EMEA-produced washers. See Note 8, Note 11, Note 14 and Note 17 to the Consolidated Financial Statements for additional information. 2018 includes the effect of a $747 million impairment charge of goodwill and other intangibles and a $103 million charge related to the French Competition Authority (FCA) settlement agreement. See Note 6 and Note 8 to the Consolidated Financial Statements for additional information.\n(5)Net earnings (loss) available to Whirlpool, as a percent of net sales. 2019 includes the effect of a $437 million gain on sale and disposal of businesses, a $180 million gain related to Brazil indirect tax credits a $105 million charge related to product warranty expense on EMEA-produced washers. See Note 8, Note 11, Note 14 and Note 17 to the Consolidated Financial Statements for additional information. 2018 includes the effect of a $747 million impairment charge of goodwill and other intangibles and a $103 million charge related to the French Competition Authority (FCA) settlement agreement. See Note 6 and Note 8 to the Consolidated Financial Statements for additional information.\n(6)Net earnings (loss) available to Whirlpool, divided by average Whirlpool stockholders' equity. 2019 includes the effect of a $437 million gain on sale and disposal of businesses, a $180 million gain related to Brazil indirect tax credits and a $105 million charge related to product warranty expense on EMEA-produced washers. See Note 8, Note 11, Note 14 and Note 17 to the Consolidated Financial Statements for additional information. 2018 includes the effect of a $747 million impairment charge of goodwill and other intangibles and a $103 million charge related to the French Competition Authority (FCA) settlement agreement. See Note 6 and Note 8 to the Consolidated Financial Statements for additional information.\n(7)Net earnings (loss) available to Whirlpool, divided by average total assets. 2019 includes the effect of a $437 million gain on sale and disposal of businesses, a $180 million gain related to Brazil indirect tax credits and a $105 million charge related to product warranty expense on EMEA-produced washers. See Note 8, Note 11, Note 14 and Note 17 to the Consolidated Financial Statements for additional information. 2018 includes the effect of a $747 million impairment charge of goodwill and other intangibles and a $103 million charge related to the French Competition Authority (FCA) settlement agreement. See Note 6 and Note 8 to the Consolidated Financial Statements for additional information.\n(8)Total debt divided by total debt and total stockholders' equity.\n(9)Closing stock price divided by diluted net earnings (loss) available to Whirlpool.\n(10)Stock appreciation plus reinvested dividends, divided by share price at the beginning of the period.\nITEM 7.\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nThis Management Discussion and Analysis should be read in connection with the Consolidated Financial Statements, Notes to the Consolidated Financial Statements and Selected Financial Data included in this Form 10-K. Certain references to particular information in the Notes to the Consolidated Financial Statements are made to assist readers.\nOVERVIEW\nWhirlpool delivered full-year GAAP net earnings available to Whirlpool of $1.1 billion (net earnings margin of 5.6%), or $17.07 per share, compared to GAAP net earnings available to Whirlpool of $1.2 billion (net earnings margin of 5.8%), or $18.45 per share in the same prior-year period. On a GAAP basis, net earnings margins were impacted by increased restructuring costs. In the same prior-year period, the approximately $511 million gain on the sale of our Embraco compressor business favorably impacted net earnings available to Whirlpool. Solid cash provided by operating activities of $1.5 billion, compared to $1.2 billion in 2019, was driven by higher earnings and working capital improvement.\nDespite ongoing disruptions from COVID-19, Whirlpool delivered ongoing (non-GAAP) earnings per share of $18.55 and full-year ongoing EBIT margin of 9.1%, compared to $16.00 and 6.9% in the same prior-year period. These results were driven by positive price/mix, strong cost takeout, and raw material deflation, partially offset by increased brand investments and currency. In addition, we delivered record free cash flow (non-GAAP) of $1.2 billion in 2020, compared to $912 million in 2019, primarily driven by strong earnings and lower capital expenditures. Lastly, we strengthened our balance sheet and made strong progress toward our long-term gross debt leverage target. Please see \"Non-GAAP Financial Measures\" elsewhere in this Management's Discussion and Analysis for a reconciliation of these non-GAAP financial measures.\nWe are very pleased with the successful execution of our go-to-market initiatives, new product introductions and the successful execution of our cost-takeout program. Lastly, the strong actions\n30\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\ntaken in EMEA have returned the region to profitability, in line with our expectations, demonstrating the effectiveness of our strategic actions to date.\nOur strong 2020 results demonstrate the agility and resiliency of our business model and the effectiveness of our COVID-19 response plan. This momentum provides us confidence that we will continue to deliver on our long-term financial goals in 2021.\nRESULTS OF OPERATIONS\nThe following table summarizes the consolidated results of operations:\n| December 31, |\n| Consolidated - In Millions (except per share data) | 2020 | Better/(Worse) % | 2019 | Better/(Worse) % | 2018 |\n| Net sales | $ | 19,456 | (4.7)% | $ | 20,419 | (2.9)% | $ | 21,037 |\n| Gross margin | 3,850 | 9.0 | 3,533 | (0.1) | 3,537 |\n| Selling, general and administrative | 1,877 | 12.4 | 2,142 | 2.1 | 2,189 |\n| Restructuring costs | 288 | (53.1) | 188 | 23.9 | 247 |\n| Impairment of goodwill and other intangibles | 7 | nm | — | nm | 747 |\n| (Gain) loss on sale and disposal of businesses | (7) | nm | (437) | nm | — |\n| Interest and sundry (income) expense | (21) | (87.2) | (168) | nm | 108 |\n| Interest expense | 189 | (0.8) | 187 | 2.6 | 192 |\n| Income tax expense | 384 | (8.7) | 354 | nm | 138 |\n| Net earnings (loss) available to Whirlpool | 1,081 | (8.8) | 1,184 | nm | (183) |\n| Diluted net earnings (loss) available to Whirlpool per share | $ | 17.07 | (7.5)% | $ | 18.45 | nm | $ | (2.72) |\n\nnm: not meaningful\nConsolidated net sales for 2020 decreased 4.7% compared to 2019, primarily driven by the divestiture of the Embraco compressor business, lower volumes and unfavorable foreign currency, partially offset by the favorable impact of product price/mix. Organic net sales (non-GAAP) for 2020 increased 1.1% compared to 2019. Consolidated net sales for 2019 decreased 2.9% compared to 2018, primarily driven by the divestiture of the Embraco compressor business, unfavorable foreign currency and unit volume declines, partially offset by the favorable impact of product price/mix. Organic net sales for 2019 increased 1.6% compared to 2018.\nFor additional information regarding non-GAAP financial measures including organic net sales and net sales excluding the impact of foreign currency, see the Non-GAAP Financial Measures section of this Management's Discussion and Analysis.\n31\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\nThe chart below summarizes the balance of net sales by operating segment for 2020, 2019 and 2018, respectively.\nThe consolidated gross margin percentage for 2020 increased to 19.8% compared to 17.3% in 2019, primarily driven by the favorable impact of product price/mix, cost reduction initiatives, raw material deflation, and a gain on sale-leaseback, partially offset by unfavorable foreign currency and lower unit volumes. The consolidated gross margin percentage for 2019 increased to 17.3% compared to 16.8% in 2018, primarily driven by the favorable impact of product price/mix, cost reduction initiatives in the EMEA region and a gain on sale-leaseback, partially offset by lower unit volumes, cost inflation (raw material, tariff and freight costs) in the North America region, unfavorable foreign currency and product warranty expense related to certain EMEA-produced washers.\nOur operating segments are based upon geographical region and are defined as North America, EMEA, Latin America and Asia. These regions also represent our reportable segments. The chief operating decision maker evaluates performance based on each segment's earnings (loss) before interest and taxes (EBIT), which we define as operating profit less interest and sundry (income) expense and excluding restructuring costs, asset impairment charges and certain other items that management believes are not indicative of the region's ongoing performance, if any. See Note 16 to the Consolidated Financial Statements for additional information.\nThe following is a discussion of results for each of our operating segments. Each of our operating segments has been impacted by COVID-19 in the areas of manufacturing operations such as a decrease in production levels resulting in production level below normal capacity. Excess capacity costs were not material in 2020. Additionally, operating segments have been impacted by disruptions in supply chains, distribution channels, and demand, among other COVID-19 related impacts.\n32\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\nNORTH AMERICA\nNet Sales Summary\nNet sales for 2020 decreased 2.3% compared to 2019 primarily due to lower volumes. Excluding the impact of foreign currency, net sales decreased 2.3% in 2020. Net sales for 2019 increased 0.9% compared to 2018 primarily due to the favorable impact of product price/mix, partially offset by lower volumes. Excluding the impact of foreign currency, net sales increased 1.1% in 2019.\nEBIT Summary\nEBIT margin for 2020 was 15.8% compared to 12.7% for 2019. EBIT increased primarily due to the favorable impact of product price/mix, raw material deflation and cost reduction actions, partially offset by the impact of lower volumes. EBIT margin for 2019 was 12.7% compared to 11.8% for 2018. EBIT increased primarily due to the favorable impact of product price/mix, partially offset by cost inflation (raw material, tariffs and freight costs).\nEMEA\nNet Sales Summary\nNet sales for 2020 increased 2.1% compared to 2019 primarily due to the favorable impact of product price/mix, partially offset by the unfavorable impact of lower volumes. Excluding the impact of foreign currency, net sales increased 1.8% in 2020. Net sales for 2019 decreased 5.3% compared to 2018, primarily due to unfavorable impacts of foreign currency and product price/mix. Excluding the impact of foreign currency, net sales decreased 1.1% in 2019.\nEBIT Summary\nEBIT margin for 2020 was 0.0% compared to (0.7%) for 2019. EBIT increased primarily due to the cost reductions driven by fixed cost actions and favorable impact of raw material deflation, partially offset by foreign currency and increased marketing and technology investments. EBIT margin for 2019 was (0.7%) compared to (2.3%) for 2018. In 2019, EBIT increased primarily due to the favorable impact of cost reduction initiatives.\n33\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\nLATIN AMERICA\nNet Sales Summary\nNet sales for 2020 decreased 18.4% compared to 2019 primarily driven by the divestiture of the Embraco compressor business (completed in July 2019) and the unfavorable impact of foreign currency, partially offset by volume growth. Organic net sales increased 22.8% in 2020. Net sales for 2019 decreased 12.2% compared to 2018 primarily due to the divestiture of the Embraco compressor business and the unfavorable impact of foreign currency, partially offset by volume growth. Organic net sales Increased 9.3% in 2019.\nEBIT Summary\nEBIT margin for 2020 was 8.4% compared to 5.4% for 2019. EBIT increased primarily due to the favorable impact of product price/mix, raw material deflation and increased volumes, partially offset by the divestiture of the Embraco compressor business and the unfavorable impact of foreign currency. EBIT margin for 2019 was 5.4% compared to 5.8% for 2018. EBIT decreased primarily due to the divestiture of the Embraco compressor business and the unfavorable impact of foreign currency, partially offset by favorable product price/mix.\nASIA\nNet Sales Summary\nNet sales for 2020 decreased 16.5% compared to 2019 primarily due to lower volumes and the unfavorable impacts of foreign currency, partially offset by the favorable impact of product price/mix. Excluding the impact of foreign currency, net sales decreased 14.6% in 2020. Net sales for 2019 decreased 4.5% compared to 2018 primarily due to the unfavorable impacts of foreign currency and product price/mix, partially offset by volume growth. Excluding the impact of foreign currency, net sales decreased 1.5% in 2019.\nEBIT Summary\nEBIT margin for 2020 was (0.5)% compared to 2.2% for 2019. EBIT decreased primarily due to lower volumes and the unfavorable impacts of product price/mix, partially offset by cost takeout actions and raw material deflation. EBIT margin for 2019 was 2.2% compared to 5.2% for 2018. EBIT decreased primarily due to the unfavorable impacts of product price/mix and brand investments in China, partially offset by the favorable impacts of volume growth and cost productivity in India.\n34\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\nSelling, General and Administrative\nThe following table summarizes selling, general and administrative expenses as a percentage of sales by operating segment:\n| December 31, |\n| Millions of dollars | 2020 | As a %of Net Sales | 2019 | As a %of Net Sales | 2018 | As a %of Net Sales |\n| North America | $ | 733 | 6.5 | % | $ | 826 | 7.2 | % | $ | 787 | 6.9 | % |\n| EMEA | 472 | 10.8 | 497 | 11.6 | 564 | 12.4 |\n| Latin America | 233 | 9.0 | 306 | 9.6 | 369 | 10.2 |\n| Asia | 218 | 17.2 | 253 | 16.7 | 244 | 15.4 |\n| Corporate/other | 221 | — | 260 | — | 225 | — |\n| Consolidated | $ | 1,877 | 9.6 | % | $ | 2,142 | 10.5 | % | $ | 2,189 | 10.4 | % |\n\nConsolidated selling, general and administrative expenses as a percent of consolidated net sales in 2020 decreased compared to 2019 due to fixed cost actions and reduced investments in marketing. Consolidated selling, general and administrative expenses as a percent of consolidated net sales in 2019 is comparable to 2018.\nRestructuring\nWe incurred restructuring charges of $288 million, $188 million and $247 million for the years ended December 31, 2020, 2019 and 2018, respectively. For the full year 2021, we expect to incur approximately $100 million of restructuring charges, driven by our previously announced global cost reduction efforts.\nSee Note 14 to the Consolidated Financial Statements for additional information.\nImpairment of Goodwill and Other Intangibles\nWe recorded an immaterial impairment charge related to other intangibles for the year ended December 31, 2020 related to a brand in the EMEA reporting unit.\nWe recorded an impairment charge of $747 million related to goodwill ($579 million) and other intangibles ($168 million) for the year ended December 31, 2018 related to the EMEA reporting unit.\nSee Note 6 and Note 11 to the Consolidated Financial Statements and the Critical Accounting Policies and Estimates section of this Management's Discussion and Analysis for additional information.\n(Gain) Loss on Sale and Disposal of Businesses\nWe recorded a pre-tax gain of $511 million on the sale of the Embraco compressor business for the year ended December 31, 2019. The gain calculation is no longer subject to change, as amounts for working capital and other customary post-closing adjustments have been finalized. A $7 million gain related to final purchase price adjustments was recorded in the third quarter of 2020.\nWe recorded a loss of $74 million for the year ended December 31, 2019 related to charges on the sale of the South Africa business ($63 million) and costs associated with the exit of the Turkey domestic sales operations ($11 million).\nSee Note 17 to the Consolidated Financial Statements for additional information.\n35\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\nInterest and Sundry (Income) Expense\nInterest and sundry (income) expenses were $(21) million, $(168) million and $108 million for the years ended December 31, 2020, 2019 and 2018, respectively.\nInterest and sundry (income) expense decreased $147 million in 2020 compared to 2019, primarily due to the prior year effect of Brazil indirect tax credits and trade customer insolvency claim settlement, partially offset by the favorable impact of foreign currency.\nInterest and sundry income decreased $276 million in 2019 compared to 2018, primarily due to the effect of Brazil indirect tax credits recorded of $180 million, which reflects $196 million of indirect tax credits, net of related fees, partially offset by a trade customer insolvency claim settlement of €52.75 million (approximately $59 million as of December 31, 2019) and foreign currency.\nSee Note 8 to the Consolidated Financial Statements for additional information.\nInterest Expense\nInterest expense was $189 million, $187 million and $192 million for the years ended December 31, 2020, 2019 and 2018, respectively. Interest expense in 2020 was comparable to 2019 and 2018.\nIncome Taxes\nIncome tax expense was $384 million, $354 million and $138 million for the years ended December 31, 2020, 2019 and 2018, respectively. The increase in tax expense in 2020 compared to 2019 is primarily due to changes in valuation allowance, legal entity restructuring tax benefits, and earnings dispersion related to the sale of Embraco.\nThe increase in tax expense in 2019 compared to 2018 is primarily due to higher earnings before tax, reduced foreign tax credits and the sale of Embraco, partially offset by net reductions in valuation allowances, and impacts from a statutory legal entity restructuring. As part of ongoing efforts to reduce costs and simplify the Company's legal entity structure, the Company completed in 2019 a statutory legal entity restructuring within our EMEA business. The completion of the restructuring created a tax-deductible loss which was recognized in the fourth quarter of 2019, and resulted in a $147 million tax benefit.\nSee Note 15 to the Consolidated Financial Statements for additional information.\n36\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\nFORWARD-LOOKING PERSPECTIVE\nEarnings per diluted share presented below are net of tax, while each adjustment is presented on a pre-tax basis. The aggregate income tax impact of the taxable components of each adjustment is presented in the income tax impact line item at our anticipated 2021 full-year tax rate between 24.0% and 26.0%. Based on internal projections for the industry and broader economy, we currently estimate earnings per diluted share and industry demand for 2021 to be within the following ranges:\n| 2021 |\n| Current Outlook |\n| Estimated earnings per diluted share, for the year ending December 31, 2021 | $17.80 | — | $18.80 |\n| Including: |\n| Restructuring Expense | $(1.59) |\n| Income Tax Impact | $0.39 |\n| Industry demand |\n| North America | 4% | —% | 6% |\n| EMEA | 2% | —% | 4% |\n| Latin America | 2% | —% | 4% |\n| Asia | 6% | —% | 8% |\n\nFor the full-year 2021, we expect to generate cash from operating activities of $1.6 billion and free cash flow of $1 billion or more, including restructuring cash outlays of approximately $225 million and, with respect to free cash flow, capital expenditures of approximately $600 million.\nThe table below reconciles projected 2021 cash provided by operating activities determined in accordance with GAAP to free cash flow, a non-GAAP measure. Management believes that free cash flow provides stockholders with a relevant measure of liquidity and a useful basis for assessing Whirlpool's ability to fund its activities and obligations. There are limitations to using non-GAAP financial measures, including the difficulty associated with comparing companies that use similarly named non-GAAP measures whose calculations may differ from our calculations. For 2021 we define free cash flow as cash provided by operating activities less capital expenditures and including proceeds from the sale of assets/businesses. For additional information regarding non-GAAP financial measures, see the Non-GAAP Financial Measures section of Management's Discussion and Analysis.\n| 2021 |\n| Millions of dollars | Current Outlook |\n| Cash provided by operating activities(1) | $1,550 |\n| Capital expenditures and proceeds from sale of assets/businesses | (550) |\n| Free cash flow | $1,000+ |\n\n(1)Financial guidance on a GAAP basis for cash provided by (used in) financing activities and cash provided by (used in) investing activities has not been provided because in order to prepare any such estimate or projection, the Company would need to rely on market factors and certain other conditions and assumptions that are outside of its control.\nThe projections above are based on many estimates and are inherently subject to change based on future decisions made by management and the Board of Directors of Whirlpool, and significant economic, competitive and other uncertainties and contingencies.\nNON-GAAP FINANCIAL MEASURES\nWe supplement the reporting of our financial information determined under U.S. generally accepted accounting principles (GAAP) with certain non-GAAP financial measures, some of which we refer to as \"ongoing\" measures, including:\n•Earnings before interest and taxes (EBIT)\n•EBIT margin\n37\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\n•Ongoing EBIT\n•Ongoing earnings per diluted share\n•Ongoing EBIT margin\n•Sales excluding foreign currency\n•Organic net sales (net sales excluding foreign currency and Embraco)\n•Free cash flow\nOngoing measures, including ongoing earnings per diluted share and ongoing EBIT, exclude items that may not be indicative of, or are unrelated to, results from our ongoing operations and provide a better baseline for analyzing trends in our underlying businesses. EBIT margin is calculated by dividing EBIT by net sales. Ongoing EBIT margin is calculated by dividing ongoing EBIT by net sales for 2020, 2019 and 2018. Sales excluding foreign currency is calculated by translating the current period net sales, in functional currency, to U.S. dollars using the prior-year period's exchange rate compared to the prior-year period net sales. Organic net sales is calculated by excluding divestitures and foreign currency. Management believes that organic net sales and sales excluding foreign currency provides stockholders with a clearer basis to assess our results over time, excluding the impact of exchange rate fluctuations, and in the case of organic net sales, excluding the impact of our Embraco compressor business divested in July 2019. We also disclose segment EBIT, which we define as operating profit less interest and sundry (income) expense and excluding restructuring costs, asset impairment charges and certain other items, if any, that management believes are not indicative of the region's ongoing performance, as the financial metric used by the Company's Chief Operating Decision Maker to evaluate performance and allocate resources in accordance with ASC 280, Segment Reporting. Management believes that free cash flow provides stockholders with a relevant measure of liquidity and a useful basis for assessing Whirlpool's ability to fund its activities and obligations. The Company provides free cash flow related metrics, such as free cash flow as a percentage of net sales, as long-term management goals, not an element of its annual financial guidance, and as such does not provide a reconciliation of free cash flow to cash provided by (used in) operating activities, the most directly comparable GAAP measure, for these long-term goal metrics. Any such reconciliation would rely on market factors and certain other conditions and assumptions that are outside of the Company's control. Whirlpool does not provide a non-GAAP reconciliation for its other forward-looking long-term value creation and other goals, such as organic net sales, EBIT, and gross debt/EBITDA, as such reconciliation would rely on market factors and certain other conditions and assumptions that are outside of the company’s control.\nWe believe that these non-GAAP measures provide meaningful information to assist investors and stockholders in understanding our financial results and assessing our prospects for future performance, and reflect an additional way of viewing aspects of our operations that, when viewed with our GAAP financial measures, provide a more complete understanding of our business. Because non-GAAP financial measures are not standardized, it may not be possible to compare these financial measures with other companies' non-GAAP financial measures having the same or similar names. These non-GAAP financial measures should not be considered in isolation or as a substitute for reported net earnings (loss) available to Whirlpool, net sales, net earnings as a percentage of net sales (net earnings margin), net earnings (loss) per diluted share and cash provided by (used in) operating activities, the most directly comparable GAAP financial measures. We strongly encourage investors and stockholders to review our financial statements and publicly-filed reports in their entirety and not to rely on any single financial measure.\n38\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\nPlease refer to a reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures below.\n| Total Whirlpool Organic Net Sales Reconciliation:in millions | Twelve Months Ended December 31, |\n| 2020 | 2019 | Change |\n| Net sales | $ | 19,456 | $ | 20,419 | (4.7) | % |\n| Less: Embraco net sales | — | (635) |\n| Add-Back: currency | 551 | — |\n| Organic net sales | $ | 20,007 | $ | 19,784 | 1.1 | % |\n\n| Total Whirlpool Organic Net Sales Reconciliation:in millions | Twelve Months Ended December 31, |\n| 2019 | 2018 | Change |\n| Net sales | $ | 20,419 | $ | 21,037 | (2.9) | % |\n| Less: Embraco net sales | (635) | (1,135) |\n| Add-Back: currency | 430 | — |\n| Organic net sales | $ | 20,214 | $ | 19,902 | 1.6 | % |\n\n| Latin America Organic Net Sales Reconciliation:in millions | Twelve Months Ended December 31, |\n| 2020 | 2019 | Change |\n| Net sales | $ | 2,592 | $ | 3,177 | (18.4) | % |\n| Less: Embraco net sales | — | (635) |\n| Add-Back: currency | 530 | — |\n| Organic net sales | $ | 3,122 | $ | 2,542 | 22.8 | % |\n\n| Latin America Organic Net Sales Reconciliation:in millions | Twelve Months Ended December 31, |\n| 2019 | 2018 | Change |\n| Net sales | $ | 3,177 | $ | 3,618 | (12.2) | % |\n| Less: Embraco net sales | (635) | (1,135) |\n| Add-Back: currency | 171 | — |\n| Organic net sales | $ | 2,713 | $ | 2,483 | 9.3 | % |\n\n39\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\n| Ongoing Earnings Before Interest & Taxes (EBIT) Reconciliation:in millions | Twelve Months Ended December 31, |\n| 2020 | 2019 | 2018 |\n| Net earnings (loss) available to Whirlpool (1) | $ | 1,081 | $ | 1,184 | $ | (183) |\n| Net earnings (loss) available to noncontrolling interests | (10) | 14 | 24 |\n| Income tax expense | 384 | 354 | 138 |\n| Interest expense | 189 | 187 | 192 |\n| Earnings before interest & taxes | $ | 1,644 | $ | 1,739 | $ | 171 |\n| Restructuring expense | 288 | 188 | 247 |\n| Corrective action recovery | (14) | — | — |\n| Product warranty and liability (income) expense | (30) | 131 | — |\n| (Gain) loss on sale and disposal of businesses | (7) | (437) | — |\n| Sale-leaseback, real estate and receivable adjustments | (113) | (86) | — |\n| Trade customer insolvency claim settlement | — | 59 | — |\n| Brazil indirect tax credit | — | (180) | — |\n| Impairment of goodwill and intangibles | — | — | 747 |\n| France antitrust settlement | — | — | 103 |\n| Trade customer insolvency | — | — | 30 |\n| Divestiture related transition costs | — | — | 21 |\n| Ongoing EBIT(3) | $ | 1,768 | $ | 1,414 | $ | 1,319 |\n\n(1)Net earnings margin is approximately 5.6%, 5.8% and (0.9)% for the twelve months ended December 31, 2020, 2019 and 2018, respectively, and is calculated by dividing net earnings (loss) available to Whirlpool by consolidated net sales for the twelve months ended December 31, 2020, 2019 and 2018, respectively.\n(2)Ongoing EBIT margin is approximately 9.1%, 6.9% and 6.3% for the twelve months ended December 31, 2020, 2019 and 2018, respectively. Ongoing EBIT margin is calculated by dividing Ongoing EBIT by consolidated net sales for the twelve months ended December 31, 2020, 2019 and 2018, respectively.\n(3)Additional information about each of our adjustments for ongoing EBIT is available under Supplemental Information on our Investor Relations website at investors.whirlpoolcorp.com. The contents of this website are not incorporated by reference into this Annual Report on Form 10-K or in any other report or document we file with the SEC.\n| Ongoing Earnings Per Diluted Share Reconciliation: | Twelve Months Ended December 31, |\n| 2020 | 2019 |\n| Earnings per diluted share | $ | 17.07 | $ | 18.45 |\n| Restructuring expense | 4.54 | 2.93 |\n| Corrective action recovery | (0.22) | — |\n| Sale-leaseback, real estate and receivable adjustments | (1.77) | (1.34) |\n| (Gain) loss on sale and disposal of businesses | (0.10) | (6.79) |\n| Product warranty and liability expense | (0.47) | 2.04 |\n| Brazil indirect tax credit | — | (2.80) |\n| Trade customer insolvency claim settlement | — | 0.92 |\n| Income tax impact | (0.53) | 0.75 |\n| Normalized tax rate adjustment | 0.03 | 1.84 |\n| Ongoing earnings per diluted share | $ | 18.55 | $ | 16.00 |\n\n40\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\n| Free Cash Flow (FCF) Reconciliation: in millions | Twelve Months Ended December 31, |\n| 2020 | 2019 | 2018 |\n| Cash provided by (used in) operating activities | $ | 1,500 | $ | 1,230 | $ | 1,229 |\n| Capital expenditures | (410) | (532) | (590) |\n| Proceeds from sale of assets and businesses (5) | 166 | 1,174 | 160 |\n| Change in restricted cash (4) | (10) | 40 | 54 |\n| Repayment of term loan (5) | — | (1,000) | — |\n| Free cash flow | $ | 1,246 | $ | 912 | $ | 853 |\n| Cash provided by (used in) investing activities | $ | (237) | $ | 636 | $ | (399) |\n| Cash provided by (used in) financing activities | $ | (253) | $ | (1,424) | $ | (518) |\n\n(4)See Note 4 to the Consolidated Financial Statements for additional information\n(5)Proceeds from the sale of assets and business for the twelve months ended December 31, 2019 include $1.0 billion of net cash proceeds received to date for the sale of the Embraco compressor business; $1.0 billion of these proceeds were used to repay an outstanding term loan in August 2019.\nFINANCIAL CONDITION AND LIQUIDITY\nOur objective is to finance our business through operating cash flow and the appropriate mix of long-term and short-term debt. By diversifying the maturity structure, we avoid concentrations of debt, reducing liquidity risk. We have varying needs for short-term working capital financing as a result of the nature of our business. We regularly review our capital structure and liquidity priorities, which include funding innovation and growth through capital, research and development expenditures as well as opportunistic mergers and acquisitions; and providing returns to shareholders through dividends, share repurchases and maintaining our strong investment grade rating.\nOur short term potential uses of liquidity include funding our ongoing capital spending, restructuring activities, and returns to shareholders. We also have $298 million of term debt maturing in the next twelve months, and are currently evaluating our options in connection with this maturing debt, which may include repayment through refinancing, free cash flow generation, or cash on hand.\nThe Company had cash and cash equivalents of approximately $2.9 billion at December 31, 2020, of which approximately half was held by subsidiaries in foreign countries. For each of its foreign subsidiaries, the Company makes an assertion regarding the amount of earnings intended for permanent reinvestment, with the balance available to be repatriated to the United States. The cash held by foreign subsidiaries for permanent reinvestment is generally used to finance the subsidiaries' operational activities and expected future foreign investments. Our intent is to permanently reinvest these funds outside of the United States and our current plans do not demonstrate a need to repatriate the cash to fund our U.S. operations. However, if these funds were repatriated, we would be required to accrue and pay applicable United States taxes (if any) and withholding taxes payable to various countries. It is not practical to estimate the amount of the deferred tax liability associated with the repatriation of cash due to the complexity of its hypothetical calculation.\nAt December 31, 2020, we had cash or cash equivalents greater than 1% of our consolidated assets in the United States, China, Brazil, India and Mexico, which represented 6.5%, 1.7%, 1.7%, 1.4% and 1.4%, respectively. In addition, we had third-party accounts receivable outside of the United States greater than 1% of our consolidated assets in Brazil and Italy, which represented 1.8% and 1.1%, respectively . We continue to monitor general financial instability and uncertainty globally.\nNotes payable consists of short-term borrowings payable to banks and commercial paper, which are generally used to fund working capital requirements. At December 31, 2020, we had $12 million of notes payable outstanding. See Note 7 to the Consolidated Financial Statements for additional information.\n41\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\nWe monitor the credit ratings and market indicators of credit risk of our lending, depository, derivative counterparty banks and customers regularly, and take certain action to manage credit risk. We diversify our deposits and investments in short-term cash equivalents to limit the concentration of exposure by counterparty.\nIn 2018, Whirlpool of India Limited (Whirlpool India), a majority-owned subsidiary of Whirlpool Corporation, acquired a 49% equity interest in Elica PB India for $22 million. Whirlpool India has an option to acquire the remaining equity interest in the future for fair value, and the non-Whirlpool India shareholders of Elica PB India received an option to sell their remaining equity interest to Whirlpool India in the future for fair value, which could be material to the financial statements depending on the performance of the venture. We account for our minority interest under the equity method of accounting.\nWe continue to review customer conditions globally. At December 31, 2020, we had 173 million Brazilian reais (approximately $33 million at December 31, 2020) in short and long-term receivables due to us from Maquina de Vendas S.A., a trade customer in Brazil. In 2018, as part of their extrajudicial recovery plan, we agreed to receive payment of our outstanding receivable, plus interest, over eight years under a tiered payment schedule. During the third quarter of 2020, we received insurance proceeds of 129 million Brazilian reais (approximately $23 million at September 30, 2020) related to this matter. After consideration of the allowance for expected credit losses, we do not expect this matter to have a material impact on financial results in future periods.\nIn the past, when faced with a potential volume reduction from any one particular segment of our trade distribution network, we generally have been able to offset such declines through increased sales throughout our broad distribution network.\nFor additional information on transfers and servicing of financial assets, accounts payable outsourcing and guarantees, see Note 1 and Note 8 to the Consolidated Financial Statements.\nEmbraco Sale Transaction\nOn April 24, 2018, we and certain of our subsidiaries entered into a purchase agreement with Nidec Corporation, a leading manufacturer of electric motors incorporated under the laws of Japan, to sell our Embraco business unit (the \"Transaction\").\nOn June 26, 2019, Whirlpool and Nidec received the European Commission's final approval of the Transaction, and the parties closed the Transaction on July 1, 2019. At closing, pursuant to the purchase agreement and a subsequent agreement memorializing the purchase price adjustment, the Company received $1.1 billion inclusive of anticipated cash on hand at the time of closing, with final purchase price amounts subject to working capital and other customary post-closing adjustments. These adjustments have been finalized with an immaterial adjustment to the final purchase price amounts in 2020. Whirlpool has agreed to retain certain liabilities relating to tax, environmental, labor and products following closing of the Transaction.\nOn August 9, 2019, the Company repaid $1.0 billion pursuant to the Company's April 23, 2018 Term Loan Agreement by and among the Company, Citibank, N.A., as Administrative Agent, JPMorgan Chase Bank, N.A. as Syndication Agent, and certain other financial institutions, representing full repayment of amounts borrowed under the term loan. As previously disclosed, the Company agreed to repay this outstanding term loan amount with the net cash proceeds received from the sale of Embraco.\nFor additional information on the Embraco sale transaction, see Note 17 to the Consolidated Financial Statements.\n42\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\nShare Repurchase Program\nFor additional information about our share repurchase program, see Note 12 to the Consolidated Financial Statements.\nSources and Uses of Cash\nWe met our cash needs during 2020 through cash flows from operations, cash and cash equivalents, and financing arrangements. Our cash, cash equivalents and restricted cash at December 31, 2020 increased $982 million compared to the same period in 2019.\nThe following table summarizes the net increase (decrease) in cash, cash equivalents and restricted cash for the periods presented. Significant drivers of changes in our cash and cash equivalents balance during 2020 are discussed below:\nCash Flow Summary\n| Millions of dollars | 2020 | 2019 | 2018 |\n| Cash provided by (used in): |\n| Operating activities | $ | 1,500 | $ | 1,230 | $ | 1,229 |\n| Investing activities | (237) | 636 | (399) |\n| Financing activities | (253) | (1,424) | (518) |\n| Effect of exchange rate changes | (28) | (28) | (67) |\n| Net increase in cash, cash equivalents and restricted cash | $ | 982 | $ | 414 | $ | 245 |\n\nCash Flows from Operating Activities\nCash provided by operating activities in 2020 increased compared to 2019. The increase was primarily driven by strong cash earnings partially offset by working capital initiatives. Working capital was impacted by our ongoing accounts receivable and credit management actions, along with inventory management. Additionally, working capital was impacted by increased accounts payable driven by higher year end production levels, partially offset by the timing of our year end payment schedule.\nCash provided by operating activities in 2019 was comparable to 2018. The impact of working capital primarily includes inventory reductions efforts, credit management activities and the divestiture of the Embraco compressor business. Net earnings includes the non-cash impacts from the gain on sale and disposal of businesses.\nThe decrease in cash provided by operating activities during 2018 primarily reflects $350 million of discretionary pension funding, partially offset by the working capital impact from inventory reduction efforts, lower volumes and credit management activities. Net loss includes the non-cash impacts from impairment of goodwill and other intangibles.\nThe timing of cash flows from operations varies significantly throughout the year primarily due to changes in production levels, sales patterns, promotional programs, funding requirements, credit management, as well as receivable and payment terms. Depending on the timing of cash flows, the location of cash balances, as well as the liquidity requirements of each country, external sources of funding are used to support working capital requirements.\nCash Flows from Investing Activities\nThe increase in cash used in investing activities during 2020 primarily reflects the 2019 proceeds from the sale of the Embraco compressor business (approximately $1 billion), partially offset by a decrease in capital expenditures (approximately $122 million) and the proceeds from a real estate sale-leaseback transaction (approximately $139 million).\n43\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\nThe increase in cash provided by investing activities during 2019 primarily reflects proceeds from the sale of the Embraco compressor business (approximately $1 billion) along with proceeds from a real estate sale-leaseback transaction (approximately $140 million) and a decrease in capital expenditures (approximately $60 million)\nThe decrease in cash used in investing activities during 2018 primarily reflects proceeds from a real estate sale-leaseback transaction (approximately $130 million), a decrease in capital expenditures (approximately $95 million), and the proceeds related to held-to-maturity securities (approximately $60 million).\nCash Flows from Financing Activities\nThe decrease in cash used in financing activities during 2020 primarily reflects higher debt issuance proceeds (increase of approximately $300 million), lower repayments of long-term debt (increase of approximately $400 million) net effect of reduced short-term debt (increase of approximately $400 million). Short-term debt reflects the activity on the $1 billion term loan that was borrowed in 2018 and repaid in 2019, offset by the reduced need to fund working capital through short term debt.\nThe increase in cash used in financing activities during 2019 primarily reflects higher repayments of long-term debt (increase of approximately $550 million), net effect of changes in short-term debt (increase of approximately $1.4 billion), partially offset by lower share repurchase activity (decrease of approximately $1 billion). Short-term debt reflects the activity on the $1 billion term loan that was borrowed in 2018 and repaid in 2019, offset by changes in commercial paper for funding normal working capital requirements.\nThe decrease in cash used in financing activities during 2018 primarily reflects higher proceeds from borrowings of short-term debt (increase of approximately $300 million) and lower repayments of long-term debt (decrease of approximately $175 million), partially offset by higher share repurchase activity (increase of approximately $400 million). We also acquired a minority interest in Elica PB India.\nDividends paid in financing activities approximated $300 million during 2020, 2019 and 2018.\nFinancing Arrangements\nThe Company had total committed credit facilities of approximately $4.2 billion at December 31, 2020. The facilities are geographically diverse and reflect the Company's global operations. The Company believes these facilities are sufficient to support its global operations. We had no borrowings outstanding under the committed credit facilities at December 31, 2020 and 2019, respectively.\nSee Note 7 to the Consolidated Financial Statements for additional information.\nDividends\nIn October 2020, our Board of Directors approved a 4.2% increase in our quarterly dividend on our common stock to $1.25 per share from $1.20 per share.\n44\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\nCONTRACTUAL OBLIGATIONS AND FORWARD-LOOKING CASH REQUIREMENTS\nThe following table summarizes our expected cash outflows resulting from financial contracts and commitments:\n| Payments due by period |\n| Millions of dollars | Total | 2021 | 2022 & 2023 | 2024 & 2025 | Thereafter |\n| Long-term debt obligations(1) | $ | 7,448 | $ | 463 | $ | 831 | $ | 884 | $ | 5,270 |\n| Operating lease obligations(2) | 1,210 | 211 | 349 | 253 | 397 |\n| Purchase obligations(3) | 556 | 214 | 221 | 79 | 42 |\n| United States and foreign pension plans(4) | 107 | 18 | 37 | 40 | 12 |\n| Other postretirement benefits(5) | 136 | 25 | 49 | 19 | 43 |\n| Total(6) | $ | 9,457 | $ | 931 | $ | 1,487 | $ | 1,275 | $ | 5,764 |\n\n(1)Principal and interest payments related to long-term debt are included in the table above. See Note 7 to the Consolidated Financial Statements for additional information.\n(2)Operating lease obligations includes the impact of sale-leaseback transactions. See Note 1 to the Consolidated Financial Statements for additional information.\n(3)Purchase obligations include our \"take-or-pay\" contracts with materials vendors and minimum payment obligations to other suppliers.\n(4)Represents the minimum contributions required for foreign pension plans based on current interest rates, asset return assumptions, legislative requirements and other actuarial assumptions at December 31, 2020. See Note 9 to the Consolidated Financial Statements for additional information.\n(5)Represents our portion of expected benefit payments under our retiree healthcare plans.\n(6)This table does not include credit facility, short-term borrowings to banks and commercial paper borrowings. See Note 7 to the Consolidated Financial Statements for additional information. This table does not include future anticipated income tax settlements. See Note 15 to the Consolidated Financial Statements for additional information.\nOFF-BALANCE SHEET ARRANGEMENTS\nIn the ordinary course of business, we enter into agreements with financial institutions to issue bank guarantees, letters of credit and surety bonds. These agreements are primarily associated with unresolved tax matters in Brazil, as is customary under local regulations, and other governmental obligations and debt agreements. At December 31, 2020 and 2019, we had approximately $423 million and $333 million outstanding under these agreements, respectively.\nFor additional information about our off-balance sheet arrangements, see Note 1 and Note 8 to the Consolidated Financial Statements.\nCRITICAL ACCOUNTING POLICIES AND ESTIMATES\nThe preparation of financial statements, in conformity with GAAP, requires management to make certain estimates and assumptions. We periodically evaluate these estimates and assumptions, which are based on historical experience, changes in the business environment and other factors that management believes to be reasonable under the circumstances. Actual results may differ materially from these estimates.\n45\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\nPension and Other Postretirement Benefits\nAccounting for pensions and other postretirement benefits involves estimating the costs of future benefits and attributing the cost over the employee's expected period of employment. The determination of our obligation and expense for these costs requires the use of certain assumptions. Those key assumptions include the discount rate, expected long-term rate of return on plan assets, life expectancy, and health care cost trend rates. These assumptions are subject to change based on interest rates on high quality bonds, stock and bond markets and medical cost inflation, respectively. Actual results that differ from our assumptions are accumulated and amortized over future periods and therefore, generally affect our recognized expense and accrued liability in such future periods. While we believe that our assumptions are appropriate given current economic conditions and actual experience, significant differences in results or significant changes in our assumptions may materially affect our pension and other postretirement benefit obligations and related future expense.\nOur pension and other postretirement benefit obligations at December 31, 2020 and preliminary retirement benefit costs for 2021 were prepared using the assumptions that were determined as of December 31, 2020. The following table summarizes the sensitivity of our December 31, 2020 retirement obligations and 2021 retirement benefit costs of our United States plans to changes in the key assumptions used to determine those results:\n| Estimated increase (decrease) in |\n| Millions of dollars | PercentageChange | 2021 Expense | PBO/APBO(1)for 2020 |\n| United States Pension Plans |\n| Discount rate | +/-50bps | 1/(2) | (172)/190 |\n| Expected long-term rate of return on plan assets | +/-50bps | (13)/13 | – |\n| United States Other Postretirement Benefit Plan |\n| Discount rate | +/-50bps | 1/(1) | (7)/8 |\n\n(1)Projected benefit obligation (PBO) for pension plans and accumulated postretirement benefit obligation (APBO) for other postretirement benefit plans.\nThese sensitivities may not be appropriate to use for other years' financial results. Furthermore, the impact of assumption changes outside of the ranges shown above may not be approximated by using the above results. For additional information about our pension and other postretirement benefit obligations, see Note 9 to the Consolidated Financial Statements.\nIncome Taxes\nWe estimate our income taxes in each of the taxing jurisdictions in which we operate. This involves estimating actual current tax expense together with assessing any temporary differences resulting from the different treatment of certain items, such as the timing for recognizing expenses, for tax and accounting purposes. These differences may result in deferred tax assets or liabilities, which are included in our Consolidated Balance Sheets. We are required to assess the likelihood that deferred tax assets, which include net operating loss carryforwards, general business credits and deductible temporary differences, will be realizable in future years. Realization of our net operating loss and general business credit deferred tax assets is supported by specific tax planning strategies and, where possible, considers projections of future profitability. If recovery is not more likely than not, we provide a valuation allowance based on estimates of future taxable income in the various taxing jurisdictions, for the amount of deferred taxes that are ultimately realizable. If future taxable income is lower than expected or if tax planning strategies are not available as anticipated, we may record additional valuation allowances through income tax expense in the period such determination is made. Likewise, if we determine that we are able to realize our deferred tax assets in the future in excess of net recorded amounts, an adjustment to the deferred tax asset will benefit income tax expense in the period such determination is made.\n46\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\nAt December 31, 2020 and 2019, we had total deferred tax assets of $3.4 billion and $3.3 billion, respectively, net of valuation allowances of $214 million and $192 million, respectively. During 2019, the Company used proceeds from a bond offering to recapitalize various entities in EMEA which resulted in a reduction in the valuation allowance. In addition, the Company has established tax planning strategies and transfer pricing policies to provide sufficient future taxable income to realize these deferred tax assets. Our income tax expense has fluctuated considerably over the last five years. The tax expense has been influenced primarily by U.S. energy tax credits, foreign tax credits, audit settlements and adjustments, tax planning strategies, enacted legislation, and dispersion of global income. Future changes in the effective tax rate will be subject to several factors, including business profitability, tax planning strategies, and enacted tax laws.\nIn addition, we operate within multiple taxing jurisdictions and are subject to audit in these jurisdictions. These audits can involve complex issues, which may require an extended period of time to resolve and could result in outcomes that are unfavorable to the Company. For additional information about income taxes, see Note 1, Note 8 and Note 15 to the Consolidated Financial Statements.\nWarranty Obligations\nThe estimation of warranty obligations is determined in the same period that revenue from the sale of the related products is recognized. The warranty obligation is based on historical experience and represents our best estimate of expected costs at the time products are sold. Warranty accruals are adjusted for known or anticipated warranty claims as new information becomes available. New product launches require a greater use of judgment in developing estimates until historical experience becomes available. Future events and circumstances could materially change our estimates and require adjustments to the warranty obligations. For additional information about warranty obligations, see Note 8 to the Consolidated Financial Statements.\nGoodwill and Indefinite-Lived Intangibles\nCertain business acquisitions have resulted in the recording of goodwill and trademark assets which are not amortized. At December 31, 2020 and 2019, we had goodwill of approximately $2.5 billion and $2.4 billion, respectively. We have trademark assets with a carrying value of approximately $1.9 billion at December 31, 2020 and 2019, respectively.\nWe perform our annual impairment assessment for goodwill and other indefinite-lived intangible assets as of October 1st or more frequently if events or changes in circumstances indicate that the asset might be impaired. We consider qualitative factors to assess if it is more likely than not that the fair value for goodwill or indefinite-lived intangible assets is below the carrying amount. We may also elect to bypass the qualitative assessment and perform a quantitative assessment.\nIn conducting a qualitative assessment, the Company analyzes a variety of events or factors that may influence the fair value of the reporting unit or indefinite-lived intangible, including, but not limited to: the results of prior quantitative assessments performed; changes in the carrying amount of the reporting unit or indefinite-lived intangible; actual and projected revenue and EBIT margin; relevant market data for both the Company and its peer companies; industry outlooks; macroeconomic conditions; liquidity; changes in key personnel; and the Company's competitive position. Significant judgment is used to evaluate the totality of these events and factors to make the determination of whether it is more likely than not that the fair value of the reporting unit or indefinite-lived intangible is less than its carrying value.\nFor our annual impairment assessment as of October 1, 2020, the Company elected to bypass the qualitative assessment and perform a quantitative assessment to evaluate goodwill and certain brand trademarks. The Company elected to perform a qualitative assessment on the other indefinite-lived intangible assets noting no events that indicated that the fair value was less than the carrying value that would require a quantitative impairment assessment.\n47\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\nGoodwill Valuations\nIn performing a quantitative assessment, we estimate each reporting unit's fair value primarily by using the income approach. The income approach uses each reporting unit's projection of estimated operating results and cash flows that are discounted using a market participant discount rate based on a weighted-average cost of capital. The financial projections reflect management's best estimate of economic and market conditions over the five-year projected period including forecasted revenue growth, EBIT margin, tax rate, capital expenditures, depreciation and amortization and changes in working capital requirements. Other assumptions include discount rate and terminal growth rate. For one of our reporting units we use a blended approach that includes a market capitalization methodology given publicly available information and a discounted cash flow approach. The estimated fair value of each reporting unit is compared to their respective carrying values.\nAdditionally we validate our estimates of fair value under the income approach by comparing the values to fair value estimates using a market approach. A market approach estimates fair value by applying cash flow multiples to the operating performance of each reporting unit. The multiples are derived from comparable publicly traded companies with operating and investment characteristics similar to the reporting units. We also corroborate the fair value through a market capitalization reconciliation to determine whether the implied control premium is reasonable based on recent market transactions and other qualitative considerations.\nBased on the results of our annual quantitative assessment performed as of October 1, 2020, the fair values of our North America, Asia and Latin America reporting units exceeded their respective carrying values by 184%, 315% and 15%, respectively.\nBased on the quantitative assessment performed for the EMEA reporting unit, the fair value of the reporting unit exceeded its carrying value by 11%. The EMEA reporting unit has goodwill of approximately $329 million at December 31, 2020.\nIn evaluating the EMEA reporting unit, significant weight was provided to forecasted EBIT margins and the discount rate used in the discounted cash flow model, as we determined that these items have the most significant impact on the fair value of this reporting unit.\n•EBIT margins are expected to recover as we benefit from the recently announced strategic actions to rightsize and refocus our business, including improving our price/mix, driving share gains and executing on our cost takeout initiatives.\n•The 5-year average forecasted EBIT margin in the discounted cash flow model was approximately 3%.\n•We used a discount rate of 11.75% based on market participant assumptions.\nWe performed a sensitivity analysis on our EMEA reporting unit estimated fair value noting that a 100 basis point increase in the discount rate or a 10% reduction in the projected EBIT margins in the forecasted periods would result in an impairment charge of $18 million and $31 million, respectively.\nIf actual results are not consistent with management's estimates and assumptions, a material impairment charge of goodwill could occur, which would have a material adverse effect on our consolidated financial statements.\nIndefinite-Lived Intangible Valuations\nIn performing a quantitative assessment of indefinite-lived intangible assets other than goodwill, primarily trademarks, we estimate the fair value of these intangible assets using the relief-from-royalty method which requires assumptions related to projected revenues from our annual long-range plan; assumed royalty rates that could be payable if we did not own the trademark; and a market participant discount rate based on a weighted-average cost of capital. If the estimated fair value of the indefinite-lived intangible asset is less than its carrying value, we would recognize an impairment loss.\n48\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\nBased on our quantitative impairment assessment as of October 1, 2020, the carrying value of the Hotpoint* trademark exceeded its fair value by €6 million, approximately $7 million, and we recorded an intangible impairment charge in this amount during the fourth quarter of 2020. There were no other impairments of indefinite-lived intangible assets in 2020.\nBecause the fair value assigned to the Hotpoint* trademark is recorded as of October 1, 2020, future impairments could result if the brand experiences further deterioration in business performance or if there is a significant change in other qualitative or quantitative factors, including a change in the royalty rate or discount rate.\nThe fair value of the Indesit trademark exceeded its carrying value of €190 million ($232 million) by 10%. We expect future fiscal year net sales for this brand to improve as we stabilize volumes, recover market share and benefit from our new product investments in the EMEA region.\nThe fair values of the Maytag and JennAir trademarks exceeded their carrying values of $1,021 million and $304 million by approximately 9% and 3%, respectively. We expect net sales for these brands to improve as we recover temporary volume loss from COVID-19 related supply chain disruptions and continue to execute our brand leadership strategy and benefit from our new product investments.\nThe fair values of all other trademarks exceeded their carrying values by more than 10%.\nIn performing the quantitative assessment on these assets, significant assumptions used in our relief-from-royalty model included revenue growth rates, assumed royalty rates and the discount rate, which are discussed further below.\nRevenue growth rates relate to projected revenues from our financial planning and analysis process and vary from brand to brand. Adverse changes in the operating environment or our inability to grow revenues at the forecasted rates may result in a material impairment charge. We performed a sensitivity analysis on our estimated fair values noting a 10% reduction of forecasted revenues in the Maytag, JennAir and Indesit trademarks would result in an impairment charge of approximately $20 million, $22 million, and €12 million ($15 million) respectively. A 10% reduction of forecasted revenues in the Hotpoint* brand would result in an impairment charge of €13 million ($16 million), in addition to the €6 million ($7 million) impairment charge in 2020.\nIn determining royalty rates for the valuation of our trademarks, we considered factors that affect the assumed royalty rates that would hypothetically be paid by a market participant for the use of trademarks. The most significant factors in determining the assumed royalty rates include the overall role and importance of the trademarks in the particular industry, the profitability of the products utilizing the trademarks, and the position of the trademarked products in the given product category. Based on this analysis, we determined a royalty rate of 3%, 3.5%, 4% and 6% for our Indesit, Hotpoint*, Maytag and JennAir trademarks, respectively. We performed a sensitivity analysis on our estimated fair values for Indesit, Maytag and JennAir noting a 50 basis point reduction of the royalty rates from each brand would result in an impairment charge of approximately €15 million ($18 million), $46 million, and $17 million respectively. A 50 basis point reduction of the royalty rate from Hotpoint* would result in a $34 million (€28 million) impairment charge, in addition to the €6 million ($7 million) impairment charge in 2020.\nIn developing discount rates for the valuation of our trademarks, we used a market participant discount rate based on a weighted-average cost of capital, adjusted for higher relative level of risks associated with doing business in other countries, as applicable, as well as the higher relative levels of risks associated with intangible assets. Based on this analysis, we determined the discount rates to be 14.75%, 15%, 9.75%, and 10.25% for Indesit, Hotpoint*, Maytag, and JennAir respectively. We performed a sensitivity analysis on our estimated fair values for Hotpoint*, Maytag and JennAir noting a 100 basis point increase in the discount rate would result in an impairment charge of approximately €9 million ($11 million), $41 million and $31 million, respectively, and a 150 basis\n*Whirlpool ownership of the Hotpoint brand in the EMEA and Asia Pacific regions is not affiliated with the Hotpoint brand sold in the Americas.\n49\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\npoint increase in the discount rate for Indesit would result in an impairment charge of approximately\n€2 million ($2 million). Hotpoint’s* impairment would be in addition to the impairment charge in 2020.\nIf actual results are not consistent with management's estimate and assumptions, a material impairment charge of our trademarks could occur, which could have a material adverse effect on our consolidated financial statements.\nFor additional information about goodwill and indefinite-life intangible valuations, see Note 6 and Note 11 to the Consolidated Financial Statements.\nThe estimates of future cash flows used in determining the fair value of goodwill and intangible assets involve significant management judgment and are based upon assumptions about expected future operating performance, economic conditions, market conditions and cost of capital. Inherent in estimating the future cash flows are uncertainties beyond our control, such as changes in capital markets. The actual cash flows could differ materially from management's estimates due to changes in business conditions, operating performance and economic conditions.\nISSUED BUT NOT YET EFFECTIVE ACCOUNTING PRONOUNCEMENTS\nFor additional information regarding recently issued accounting pronouncements, see Note 1 to the Consolidated Financial Statements.\nOTHER MATTERS\nFor additional information regarding certain of our loss contingencies/litigation, see Note 8 to the Consolidated Financial Statements.\nGrenfell Tower\nOn June 23, 2017, London's Metropolitan Police Service released a statement that it had identified a Hotpoint–branded refrigerator as the initial source of the Grenfell Tower fire in West London. U.K. authorities are conducting investigations, including regarding the cause and spread of the fire. The model in question was manufactured by Indesit Company between 2006 and 2009, prior to Whirlpool's acquisition of Indesit in 2014. We are fully cooperating with the investigating authorities. Whirlpool was named as a defendant in a product liability suit in Pennsylvania federal court related to this matter. The federal court dismissed the case with prejudice in September 2020. The dismissal is being appealed. In December 2020, lawsuits related to Grenfell Tower were filed in the U.K. against approximately 20 defendants, including Whirlpool Corporation and certain Whirlpool subsidiaries. As these matters are ongoing, we cannot speculate on their eventual outcomes or potential impact on our financial statements; accordingly, we have not recorded any significant charges in 2019 or 2020. Additional claims may be filed related to this incident.\nAntidumping and Safeguard Petition\nAs previously reported, Whirlpool filed petitions in 2011 and 2015 alleging that Samsung, LG and Electrolux violated U.S. and international trade laws by dumping large residential washers into the U.S. Those petitions resulted in orders imposing antidumping duties on certain large residential washers imported from South Korea, Mexico, and China, and countervailing duties on certain large residential washers from South Korea. These orders could be subject to administrative reviews and possible appeals. In March 2019, the order covering certain large residential washers from Mexico was extended for an additional five years, while the order covering certain large residential washers from South Korea was revoked.\n*Whirlpool ownership of the Hotpoint brand in the EMEA and Asia Pacific regions is not affiliated with the Hotpoint brand sold in the Americas.\n50\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\nWhirlpool also filed a safeguard petition in May 2017 to address our concerns that Samsung and LG were evading U.S. trade laws by moving production from countries covered by antidumping orders. A safeguard remedy went into effect in February 2018, implementing tariffs on finished large residential washers and certain covered parts for three years. In January 2021, the remedy was extended for two years until February 2023. During the fourth year of the remedy, beginning February 7, 2021, the remedy imposes a 15% tariff on the first 1.2 million large residential washers imported into the United States (under tariff) and a 35% tariff on such imports in excess of 1.2 million, and also imposes a 35% tariff on washer tub, drum, and cabinet imports in excess of 110,000. Consistent with modifications to the order approved in 2020, the 1.2 million under tariff is allocated by quarter (300,000 large residential washers per quarter). We cannot speculate on the modification's impact in future quarters, which will depend on Samsung and LG's U.S. production capabilities and import plans.\nRaw Materials and Global Economy\nThe current domestic and international political environment have contributed to uncertainty surrounding the future state of the global economy. We have experienced raw material inflation in certain prior years based on the impact of U.S. tariffs and other global macroeconomic factors. We expect to experience significant raw material inflation and freight cost increases in 2021, which could require us to modify our current business practices and could have a material adverse effect on our financial statements in any particular reporting period.\nBrexit\nIn 2016, the U.K. held a referendum, the outcome of which was an expressed public desire to exit the European Union (“Brexit”), which has resulted in greater uncertainty related to the free movement of goods, services, people and capital between the U.K. and the EU. On January 31, 2020, the U.K. officially exited the European Union and entered into a transition period to negotiate the final terms of Brexit, and on December 30, 2020, the U.K. and EU signed a Trade and Cooperation Agreement to govern the relationship between the U.K. and EU going forward. Many potential future impacts of Brexit remain unclear and could adversely impact certain areas of our business, including, but not limited to, an increase in duties and delays in the delivery of products, and adverse impacts to our suppliers and financing institutions. In order to mitigate the risks associated with Brexit, we are preparing for potential adverse impacts by collaborating across Company functions and working with external partners to develop and revise the necessary contingency plans.\nFORWARD-LOOKING STATEMENTS\nThe Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements made by us or on our behalf. Certain statements contained in this annual report, including those within the forward-looking perspective section within this Management's Discussion and Analysis, and other written and oral statements made from time to time by us or on our behalf do not relate strictly to historical or current facts and may contain forward-looking statements that reflect our current views with respect to future events and financial performance. As such, they are considered \"forward-looking statements\" which provide current expectations or forecasts of future events. Such statements can be identified by the use of terminology such as \"may,\" \"could,\" \"will,\" \"should,\" \"possible,\" \"plan,\" \"predict,\" \"forecast,\" \"potential,\" \"anticipate,\" \"estimate,\" \"expect,\" \"project,\" \"intend,\" \"believe,\" \"may impact,\" \"on track,\" and similar words or expressions. Our forward-looking statements generally relate to our growth strategies, financial results, product development, and sales efforts. These forward-looking statements should be considered with the understanding that such statements involve a variety of risks and uncertainties, known and unknown, and may be affected by inaccurate assumptions. Consequently, no forward-looking statement can be guaranteed and actual results may vary materially.\nThis document contains forward-looking statements about Whirlpool Corporation and its consolidated subsidiaries (\"Whirlpool\") that speak only as of this date. Whirlpool disclaims any obligation to update these statements. Forward-looking statements in this document may include, but are not limited to, statements regarding future financial results, long-term value creation goals,\n51\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\nrestructuring expectations, productivity, raw material prices and the impact of COVID-19 on our operations. Many risks, contingencies and uncertainties could cause actual results to differ materially from Whirlpool's forward-looking statements. Among these factors are: (1) COVID-19 pandemic-related business disruptions and economic uncertainty; (2) intense competition in the home appliance industry reflecting the impact of both new and established global competitors, including Asian and European manufacturers, and the impact of the changing retail environment, including direct-to-consumer sales; (3) Whirlpool's ability to maintain or increase sales to significant trade customers and the ability of these trade customers to maintain or increase market share; (4) Whirlpool's ability to maintain its reputation and brand image; (5) the ability of Whirlpool to achieve its business objectives and leverage its global operating platform, and accelerate the rate of innovation; (6) Whirlpool’s ability to understand consumer preferences and successfully develop new products; (7) Whirlpool's ability to obtain and protect intellectual property rights; (8) acquisition and investment-related risks, including risks associated with our past acquisitions, and risks associated with our increased presence in emerging markets; (9) risks related to our international operations, including changes in foreign regulations, regulatory compliance and disruptions arising from political, legal and economic instability; (10) information technology system failures, data security breaches, data privacy compliance, network disruptions, and cybersecurity attacks; (11) product liability and product recall costs; (12) the ability of suppliers of critical parts, components and manufacturing equipment to deliver sufficient quantities to Whirlpool in a timely and cost-effective manner; (13) our ability to attract, develop and retain executives and other qualified employees; (14) the impact of labor relations; (15) fluctuations in the cost of key materials (including steel, resins, copper and aluminum) and components and the ability of Whirlpool to offset cost increases; (16) Whirlpool's ability to manage foreign currency fluctuations; (17) impacts from goodwill impairment and related charges; (18) triggering events or circumstances impacting the carrying value of our long-lived assets; (19) inventory and other asset risk; (20) health care cost trends, regulatory changes and variations between results and estimates that could increase future funding obligations for pension and postretirement benefit plans; (21) changes in LIBOR, or replacement of LIBOR with an alternative reference rate; (22) litigation, tax, and legal compliance risk and costs, especially if materially different from the amount we expect to incur or have accrued for, and any disruptions caused by the same; (23) the effects and costs of governmental investigations or related actions by third parties; (24) changes in the legal and regulatory environment including environmental, health and safety regulations, and taxes and tariffs; and (25) the uncertain global economy and changes in economic conditions which affect demand for our products.\nWe undertake no obligation to update any forward-looking statement, and investors are advised to review disclosures in our filings with the SEC. It is not possible to foresee or identify all factors that could cause actual results to differ from expected or historic results. Therefore, investors should not consider the foregoing factors to be an exhaustive statement of all risks, uncertainties, or factors that could potentially cause actual results to differ from forward-looking statements.\nAdditional information concerning these and other factors can be found in \"Risk Factors\" in Item 1A of this report.\nITEM 7A.\nQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nMARKET RISK\nWe have in place an enterprise risk management process that involves systematic risk identification and mitigation covering the categories of enterprise, strategic, financial, operational and compliance and reporting risks. The enterprise risk management process receives Board of Directors and management oversight, drives risk mitigation decision-making and is fully integrated into our internal audit planning and execution cycle.\nWe are exposed to market risk from changes in foreign currency exchange rates, domestic and foreign interest rates, and commodity prices, which can affect our operating results and overall financial condition. We manage exposure to these risks through our operating and financing\n52\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS - (CONTINUED)\nactivities and, when deemed appropriate, through the use of derivatives. Derivatives are viewed as risk management tools and are not used for speculation or for trading purposes. Derivatives are generally contracted with a diversified group of investment grade counterparties to reduce exposure to nonperformance on such instruments.\nWe use foreign currency forward contracts, currency options, currency swaps and cross-currency swaps to hedge the price risk associated with firmly committed and forecasted cross-border payments and receipts related to ongoing business and operational financing activities. At December 31, 2020, our most significant foreign currency exposures related to the Brazilian Real, Canadian Dollar and British Pound. We also use forward or option contracts to hedge our investment in the net assets of certain international subsidiaries to offset foreign currency translation adjustments related to our net investment in those subsidiaries. These foreign currency contracts are sensitive to changes in foreign currency exchange rates. At December 31, 2020, a 10% favorable or unfavorable exchange rate movement in each currency in our portfolio of foreign currency contracts would have resulted in an incremental unrealized gain of approximately $250 million or loss of approximately $273 million, respectively. Consistent with the use of these contracts to mitigate the effect of exchange rate fluctuations, such unrealized losses or gains would be offset by corresponding gains or losses, respectively, in the re-measurement of the underlying exposures.\nWe enter into interest rate swap and cross-currency swap agreements to manage our exposure to interest rate risk from probable long-term debt issuances or cross-currency debt. At December 31, 2020, a 100 basis point increase or decrease in interest rates would have resulted in an incremental unrealized gain of approximately $32 million or unrealized loss of approximately $91 million, respectively, related to these contracts.\nWe enter into commodity swap contracts to hedge the price risk associated with firmly committed and forecasted commodities purchases, the prices of which are not fixed directly through supply contracts. At December 31, 2020, a 10% favorable or unfavorable shift in commodity prices would have resulted in an incremental gain or loss of approximately $21 million, respectively, related to these contracts.\n53\nITEM 8.\nFINANCIAL STATEMENTS AND SUPPLEMENTARY DATA\n| PAGE |\n| FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA |\n| Consolidated Statements of Income (Loss) | 55 |\n| Consolidated Statements of Comprehensive Income (Loss) | 56 |\n| Consolidated Balance Sheets | 57 |\n| Consolidated Statements of Cash Flows | 58 |\n| Consolidated Statements of Changes in Stockholders' Equity | 59 |\n\n| PAGE |\n| NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS |\n| 1. | Significant Accounting Policies | 61 |\n| 2. | Revenue Recognition | 70 |\n| 3. | Leases | 73 |\n| 4. | Cash, Cash Equivalents and Restricted Cash | 75 |\n| 5. | Inventories | 75 |\n| 6. | Goodwill and Other Intangibles | 76 |\n| 7. | Financing Arrangements | 77 |\n| 8. | Commitments and Contingencies | 80 |\n| 9. | Pension and Other Postretirement Benefit Plans | 84 |\n| 10. | Hedges and Derivative Financial Instruments | 92 |\n| 11. | Fair Value Measurements | 96 |\n| 12. | Stockholders' Equity | 97 |\n| 13. | Share-Based Incentive Plans | 99 |\n| 14. | Restructuring Charges | 101 |\n| 15. | Income Taxes | 103 |\n| 16. | Segment Information | 107 |\n| 17. | Divestitures and Held for Sale | 109 |\n| 18. | Quarterly Results of Operations (Unaudited) | 111 |\n\n54\nWHIRLPOOL CORPORATION\nCONSOLIDATED STATEMENTS OF INCOME (LOSS)\nYear Ended December 31,\n(Millions of dollars, except per share data)\n| 2020 | 2019 | 2018 |\n| Net sales | $ | 19,456 | $ | 20,419 | $ | 21,037 |\n| Expenses |\n| Cost of products sold | 15,606 | 16,886 | 17,500 |\n| Gross margin | 3,850 | 3,533 | 3,537 |\n| Selling, general and administrative | 1,877 | 2,142 | 2,189 |\n| Intangible amortization | 62 | 69 | 75 |\n| Restructuring costs | 288 | 188 | 247 |\n| Impairment of goodwill and other intangibles | 7 | — | 747 |\n| (Gain) loss on sale and disposal of businesses | ( 7 ) | ( 437 ) | — |\n| Operating profit | 1,623 | 1,571 | 279 |\n| Other (income) expense |\n| Interest and sundry (income) expense | ( 21 ) | ( 168 ) | 108 |\n| Interest expense | 189 | 187 | 192 |\n| Earnings before income taxes | 1,455 | 1,552 | ( 21 ) |\n| Income tax expense (benefit) | 384 | 354 | 138 |\n| Net earnings | 1,071 | 1,198 | ( 159 ) |\n| Less: Net earnings (loss) available to noncontrolling interests | ( 10 ) | 14 | 24 |\n| Net earnings available to Whirlpool | $ | 1,081 | $ | 1,184 | $ | ( 183 ) |\n| Per share of common stock |\n| Basic net earnings available to Whirlpool | $ | 17.24 | $ | 18.60 | $ | ( 2.72 ) |\n| Diluted net earnings available to Whirlpool | $ | 17.07 | $ | 18.45 | $ | ( 2.72 ) |\n| Weighted-average shares outstanding (in millions) |\n| Basic | 62.7 | 63.7 | 67.2 |\n| Diluted | 63.3 | 64.2 | 67.2 |\n\nThe accompanying notes are an integral part of these Consolidated Financial Statements.\n55\nWHIRLPOOL CORPORATION\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)\nYear Ended December 31,\n(Millions of dollars)\n| 2020 | 2019 | 2018 |\n| Net earnings (loss) | $ | 1,071 | $ | 1,198 | $ | ( 159 ) |\n| Other comprehensive income (loss), before tax: |\n| Foreign currency translation adjustments | ( 385 ) | 54 | ( 272 ) |\n| Derivative instruments: |\n| Net gain (loss) arising during period | ( 43 ) | 71 | 77 |\n| Less: reclassification adjustment for gain (loss) included in net earnings (loss) | ( 126 ) | 88 | 107 |\n| Derivative instruments, net | 83 | ( 17 ) | ( 30 ) |\n| Defined benefit pension and postretirement plans: |\n| Prior service (cost) credit arising during period | 156 | 9 | ( 5 ) |\n| Net gain (loss) arising during period | ( 78 ) | ( 6 ) | ( 102 ) |\n| Less: amortization of prior service credit (cost) and actuarial (loss) | ( 93 ) | ( 49 ) | ( 59 ) |\n| Defined benefit pension and postretirement plans, net | 171 | 52 | ( 48 ) |\n| Other comprehensive income (loss), before tax | ( 131 ) | 89 | ( 350 ) |\n| Income tax benefit (expense) related to items of other comprehensive income (loss) | ( 60 ) | ( 12 ) | 5 |\n| Other comprehensive income (loss), net of tax | $ | ( 191 ) | $ | 77 | $ | ( 345 ) |\n| Comprehensive income (loss) | $ | 880 | $ | 1,275 | $ | ( 504 ) |\n| Less: comprehensive income (loss), available to noncontrolling interests | ( 8 ) | 14 | 26 |\n| Comprehensive income (loss) available to Whirlpool | $ | 888 | $ | 1,261 | $ | ( 530 ) |\n\nThe accompanying notes are an integral part of these Consolidated Financial Statements.\n56\nWHIRLPOOL CORPORATION\nCONSOLIDATED BALANCE SHEETS\nAt December 31,\n(Millions of dollars)\n| 2020 | 2019 |\n| Assets |\n| Current assets |\n| Cash and cash equivalents | $ | 2,924 | $ | 1,952 |\n| Accounts receivable, net of allowance of $ 132 and $ 132 , respectively | 3,109 | 2,198 |\n| Inventories | 2,187 | 2,438 |\n| Prepaid and other current assets | 795 | 810 |\n| Total current assets | 9,015 | 7,398 |\n| Property, net of accumulated depreciation of $ 6,780 and $ 6,444 , respectively | 3,199 | 3,301 |\n| Right of use assets | 989 | 921 |\n| Goodwill | 2,496 | 2,440 |\n| Other intangibles, net of accumulated amortization of $ 673 and $ 593 , respectively | 2,194 | 2,225 |\n| Deferred income taxes | 2,217 | 2,238 |\n| Other noncurrent assets | 240 | 358 |\n| Total assets | $ | 20,350 | $ | 18,881 |\n| Liabilities and stockholders' equity |\n| Current liabilities |\n| Accounts payable | $ | 4,834 | $ | 4,547 |\n| Accrued expenses | 637 | 652 |\n| Accrued advertising and promotions | 831 | 949 |\n| Employee compensation | 648 | 450 |\n| Notes payable | 12 | 294 |\n| Current maturities of long-term debt | 298 | 559 |\n| Other current liabilities | 1,070 | 918 |\n| Total current liabilities | 8,330 | 8,369 |\n| Noncurrent liabilities |\n| Long-term debt | 5,059 | 4,140 |\n| Pension benefits | 516 | 542 |\n| Postretirement benefits | 166 | 322 |\n| Lease liabilities | 838 | 778 |\n| Other noncurrent liabilities | 732 | 612 |\n| Total noncurrent liabilities | 7,311 | 6,394 |\n| Stockholders' equity |\n| Common stock, $ 1 par value, 250 million shares authorized, 113 million shares issued, and 63 million and 63 million shares outstanding, respectively | 113 | 112 |\n| Additional paid-in capital | 2,923 | 2,806 |\n| Retained earnings | 8,639 | 7,870 |\n| Accumulated other comprehensive loss | ( 2,811 ) | ( 2,618 ) |\n| Treasury stock, 50 and 49 million shares, respectively | ( 5,065 ) | ( 4,975 ) |\n| Total Whirlpool stockholders' equity | 3,799 | 3,195 |\n| Noncontrolling interests | 910 | 923 |\n| Total stockholders' equity | 4,709 | 4,118 |\n| Total liabilities and stockholders' equity | $ | 20,350 | $ | 18,881 |\n\nThe accompanying notes are an integral part of these Consolidated Financial Statements.\n57\nWHIRLPOOL CORPORATION\nCONSOLIDATED STATEMENTS OF CASH FLOWS\nYear Ended December 31,\n(Millions of dollars)\n| 2020 | 2019 | 2018 |\n| Operating activities |\n| Net earnings | $ | 1,071 | $ | 1,198 | $ | ( 159 ) |\n| Adjustments to reconcile net earnings to cash provided by (used in) operating activities: |\n| Depreciation and amortization | 568 | 587 | 645 |\n| Impairment of goodwill and other intangibles | 7 | — | 747 |\n| (Gain) loss on sale and disposal of businesses | ( 7 ) | ( 437 ) | — |\n| Changes in assets and liabilities: |\n| Accounts receivable | ( 940 ) | ( 87 ) | 79 |\n| Inventories | 241 | ( 39 ) | 73 |\n| Accounts payable | 341 | 140 | 210 |\n| Accrued advertising and promotions | ( 123 ) | 118 | 12 |\n| Accrued expenses and current liabilities | ( 287 ) | 22 | 162 |\n| Taxes deferred and payable, net | 156 | ( 116 ) | ( 67 ) |\n| Accrued pension and postretirement benefits | ( 30 ) | ( 81 ) | ( 434 ) |\n| Employee compensation | 303 | 106 | 44 |\n| Other | 200 | ( 181 ) | ( 83 ) |\n| Cash provided by (used in) operating activities | 1,500 | 1,230 | 1,229 |\n| Investing activities |\n| Capital expenditures | ( 410 ) | ( 532 ) | ( 590 ) |\n| Proceeds from sale of assets and business | 166 | 1,174 | 160 |\n| Proceeds from held-to-maturity securities | — | — | 60 |\n| Investment in related businesses | — | — | ( 25 ) |\n| Other | 7 | ( 6 ) | ( 4 ) |\n| Cash provided by (used in) investing activities | ( 237 ) | 636 | ( 399 ) |\n| Financing activities |\n| Net proceeds from borrowings of long-term debt | 1,033 | 700 | 705 |\n| Repayments of long-term debt | ( 569 ) | ( 949 ) | ( 386 ) |\n| Net proceeds (repayments) from short-term borrowings | ( 330 ) | ( 723 ) | 653 |\n| Dividends paid | ( 311 ) | ( 305 ) | ( 306 ) |\n| Repurchase of common stock | ( 121 ) | ( 148 ) | ( 1,153 ) |\n| Purchase of noncontrolling interest shares | — | — | ( 41 ) |\n| Common stock issued | 44 | 8 | 17 |\n| Other | 1 | ( 7 ) | ( 7 ) |\n| Cash provided by (used in) financing activities | ( 253 ) | ( 1,424 ) | ( 518 ) |\n| Effect of exchange rate changes on cash, cash equivalents and restricted cash | ( 28 ) | ( 28 ) | ( 67 ) |\n| Increase (decrease) in cash, cash equivalents and restricted cash | 982 | 414 | 245 |\n| Cash, cash equivalents and restricted cash at beginning of year | 1,952 | 1,538 | 1,293 |\n| Cash, cash equivalents and restricted cash at end of year | $ | 2,934 | $ | 1,952 | $ | 1,538 |\n| Supplemental disclosure of cash flow information |\n| Cash paid for interest | $ | 193 | $ | 194 | $ | 183 |\n| Cash paid for income taxes | $ | 229 | $ | 469 | $ | 206 |\n\nThe accompanying notes are an integral part of these Consolidated Financial Statements.\n58\nWHIRLPOOL CORPORATION\nCONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY\nYear ended December 31,\n(Millions of dollars)\n| Whirlpool Stockholders' Equity |\n| Total | RetainedEarnings | Accumulated Other Comprehensive Income (Loss) | Treasury Stock/Additional Paid-In-Capital | CommonStock | Non-ControllingInterests |\n| Balances, December 31, 2017 | $ | 5,128 | $ | 7,352 | $ | ( 2,331 ) | $ | ( 935 ) | $ | 112 | $ | 930 |\n| Comprehensive income |\n| Net earnings (loss) | ( 159 ) | ( 183 ) | — | — | — | 24 |\n| Other comprehensive income (loss) | ( 345 ) | — | ( 347 ) | — | — | 2 |\n| Comprehensive income | ( 504 ) | ( 183 ) | ( 347 ) | — | — | 26 |\n| Adjustment to beginning retained earnings | $ | 72 | $ | 72 |\n| Adjustment to beginning accumulated other comprehensive loss | $ | ( 17 ) | $ | ( 17 ) |\n| Stock issued (repurchased) | ( 1,160 ) | — | — | ( 1,124 ) | — | ( 36 ) |\n| Dividends declared | ( 314 ) | ( 308 ) | — | — | — | ( 6 ) |\n| Balances, December 31, 2018 | 3,205 | 6,933 | ( 2,695 ) | ( 2,059 ) | 112 | 914 |\n| Comprehensive income |\n| Net earnings (loss) | 1,198 | 1,184 | — | — | — | 14 |\n| Other comprehensive income (loss) | 77 | — | 77 | — | — | — |\n| Comprehensive income | 1,275 | 1,184 | 77 | — | — | 14 |\n| Adjustment to beginning retained earnings | 61 | 61 | — | — | — | — |\n| Stock issued (repurchased) | ( 110 ) | — | — | ( 110 ) | — | — |\n| Dividends declared | ( 313 ) | ( 308 ) | — | — | — | ( 5 ) |\n| Balances, December 31, 2019 | 4,118 | 7,870 | ( 2,618 ) | ( 2,169 ) | 112 | 923 |\n| Comprehensive income |\n| Net earnings | 1,071 | 1,081 | — | — | — | ( 10 ) |\n| Other comprehensive income (loss) | ( 191 ) | — | ( 193 ) | — | — | 2 |\n| Comprehensive income | 880 | 1,081 | ( 193 ) | — | — | ( 8 ) |\n| Stock issued (repurchased) | 28 | — | — | 27 | 1 | — |\n| Dividends declared | ( 317 ) | ( 312 ) | — | — | — | ( 5 ) |\n| Balances, December 31, 2020 | $ | 4,709 | $ | 8,639 | $ | ( 2,811 ) | $ | ( 2,142 ) | $ | 113 | $ | 910 |\n\nThe accompanying notes are an integral part of these Consolidated Financial Statements.\n59\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS\n60\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\n(1) SIGNIFICANT ACCOUNTING POLICIES\nGeneral Information\nWhirlpool Corporation, a Delaware corporation, manufactures products in 13 countries and markets products in nearly every country around the world under brand names such as Whirlpool, KitchenAid, Maytag, Consul, Brastemp, Amana, Bauknecht, JennAir, Indesit and Hotpoint*. We conduct our business through four operating segments, which we define based on geography. Whirlpool Corporation's operating and reportable segments consist of North America, Europe, Middle East and Africa (\"EMEA\"), Latin America and Asia.\nPrinciples of Consolidation\nThe consolidated financial statements are prepared in conformity with GAAP, and include all majority-owned subsidiaries. All material intercompany transactions have been eliminated upon consolidation. We do not consolidate the financial statements of any company in which we have an ownership interest of 50% or less, unless that company is deemed to be a variable interest entity (\"VIE\") of which we are the primary beneficiary. VIEs are consolidated when the company is the primary beneficiary of these entities and has the ability to directly impact the activities of these entities. Our primary business purpose and involvement with VIEs is for product development and distribution.\nRisks and Uncertainties\nCOVID-19 continues to spread throughout the United States and other countries across the world, and the duration and severity of the effects are currently unknown. The pandemic has impacted the Company and could materially impact our financial results in the future. The Consolidated Financial Statements presented herein reflect estimates and assumptions made by management at December 31, 2020 and for the twelve months ended December 31, 2020.\nSuch estimates and assumptions affect, among other things, the Company’s goodwill, long-lived asset and indefinite-lived intangible asset valuation; inventory valuation; valuation of deferred income taxes and income tax contingencies; and the allowance for expected credit losses and bad debt. Events and changes in circumstances arising after February 11, 2021, including those resulting from the impacts of COVID-19, will be reflected in management’s estimates for future periods.\nGoodwill and indefinite-lived intangible assets\nWe continue to monitor the significant global economic uncertainty as a result of COVID-19 to assess the outlook for demand for our products and the impact on our business and our overall financial performance. The goodwill in our EMEA reporting unit and our Indesit, Hotpoint* and Maytag trademarks continue to be at risk at December 31, 2020. In addition, we have concluded our JennAir trademark (carrying value of $ 304 million) to be at risk at December 31, 2020. The goodwill in our other reporting units or indefinite-lived intangible assets are not presently at risk for future impairment.\nThe potential impact of COVID-19 related demand disruptions, production impacts and supply constraint impacts on our operating results for the EMEA reporting unit in the short-term is uncertain, but we remain committed to the strategic actions necessary to realize the long-term forecasted EBIT margins and expect that the macroeconomic environment will recover in the medium to long-term. The potential negative demand effect on revenues for the Indesit, Hotpoint*, Maytag and JennAir trademarks are also uncertain given the volatile environment, but we expect that demand and production levels will continue to recover.\nA lack of recovery or further deterioration in market conditions, a sustained trend of weaker than expected financial performance in EMEA or for our Indesit, Hotpoint*, JennAir and Maytag trademarks or a significant decline in the Company’s market capitalization, among other factors,\n*Whirlpool ownership of the Hotpoint brand in the EMEA and Asia Pacific regions is not affiliated with the Hotpoint brand sold in the Americas.\n61\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nas a result of the COVID-19 pandemic or other unforeseen events could result in an impairment charge in future periods which could have a material adverse effect on our financial statements.\nUse of Estimates\nWe are required to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying Notes. The most significant assumptions are estimates in determining the fair value of goodwill and indefinite-lived intangible assets, legal contingencies, income taxes and pension and other postretirement benefits. Actual results could differ materially from those estimates.\nRevenue Recognition\nRevenue is recognized when performance obligations under the terms of a contract with our customers are satisfied, the sales price is determinable, and the risk and rewards of ownership are transferred. Generally the risk and rewards of ownership are transferred with the transfer of control of our products and services. For the majority of our sales, control is transferred to the customer as soon as products are shipped. For a portion of our sales, control is transferred to the customer upon receipt of products at the customer's location. Sales are net of allowances for product returns, which are based on historical return rates and certain promotions. See Note 2 to the Consolidated Financial Statements for additional information.\nSales Incentives\nThe cost of sales incentives is accrued at the date at which revenue is recognized by Whirlpool as a reduction of revenue. If new incentives are added after the product has been shipped, then they are accrued at that time, also as a reduction of revenue. These accrued promotions are recognized based on the expected value amount of incentives that will be ultimately claimed by trade customers or consumers. The expected value is the sum of probability-weighted amounts in a range of possible consideration amounts. If the amount of incentives cannot be reasonably estimated, an accrued promotion liability is recognized for the maximum potential amount. See Note 2 to the Consolidated Financial Statements for additional information.\nAccounts Receivable and Allowance for Expected Credit Losses\nWe carry accounts receivable at sales value less an allowance for expected credit losses. We estimate our expected credit losses primarily by using an aging methodology and establish customer-specific reserves for higher risk trade customers. Our expected credit losses are evaluated and controlled within each geographic region considering the unique credit risk specific to the country, marketplace and economic environment. We take into account a combination of specific customer circumstances, credit conditions, market conditions, reasonable and supportable forecasts of future economic conditions and the history of write-offs and collections in developing the reserve. The adoption of the new credit loss standard did not have a material impact on the Consolidated Financial Statements. We evaluate items on an individual basis when determining accounts receivable write-offs. In general, our policy is to not charge interest on trade receivables after the invoice becomes past due. A receivable is considered past due if payment has not been received within agreed upon invoice terms.\nTransfers and Servicing of Financial Assets\nIn an effort to manage economic and geographic trade customer risk, from time to time, the Company will transfer, primarily without recourse, accounts receivable balances of certain customers to financial institutions resulting in a nominal impact recorded in interest and sundry (income) expense. These transactions are accounted for as sales of the receivables resulting in the receivables being de-recognized from the Consolidated Balance Sheets.\nCertain arrangements include servicing of transferred receivables by Whirlpool. Under these arrangements the Company received cash proceeds of $ 0.6 billion and $ 1.0 billion during the twelve months ended December 31, 2020 and December 31, 2019, respectively, from the sales of accounts receivables. These transfers primarily do not require continuing involvement from the Company. Outstanding accounts receivable transferred under arrangements where the Company continues to\n62\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nservice the transferred asset were $ 30 million and $ 348 million as of December 31, 2020 and December 31, 2019, respectively.\nFreight and Warehousing Costs\nWe classify freight and warehousing costs within cost of products sold in our Consolidated Statements of Income (Loss).\nCash and Cash Equivalents\nAll highly liquid debt instruments purchased with an initial maturity of three months or less are considered cash equivalents. Short-term investments are primarily comprised of money market funds and highly liquid, low risk investments with initial maturities less than 90 days. See Note 11 to the Consolidated Financial Statements for additional information.\nRestricted Cash\nAs of December 31, 2020, restricted cash of $ 10 million represents contributions held as part of the Company's Charitable Foundation that was consolidated in 2020. As of December 31, 2019, the Company had no restricted cash. As of December 31, 2018, the Company had restricted cash of $ 40 million which represented cash required to be used to fund capital expenditures and technical resources to enhance Whirlpool China's research and development and working capital, as required by the terms of the Hefei Sanyo acquisition. See Note 4 to the Consolidated Financial Statements for additional information.\nFair Value Measurements\nWe measure fair value based on an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, a three-tiered fair value hierarchy is established, which prioritizes the inputs used in measuring fair value as follows: (Level 1) observable inputs such as quoted prices in active markets; (Level 2) inputs, other than the quoted prices in active markets that are observable, either directly or indirectly; and (Level 3) unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions. Certain investments are valued based on net asset value (NAV), which approximates fair value. Such basis is determined by referencing the respective fund's underlying assets. There are no unfunded commitments or other restrictions associated with these investments. We had Level 3 assets at December 31, 2020 and 2019 that included pension plan assets disclosed in Note 9 to the Consolidated Financial Statements. We had no Level 3 liabilities at December 31, 2020 and 2019, respectively.\nWe measured fair value for money market funds, available for sale investments and held-to-maturity securities using quoted market prices in active markets for identical or comparable assets. We measured fair value for derivative contracts, all of which have counterparties with high credit ratings, based on model driven valuations using significant inputs derived from observable market data. We also measured fair value for disposal groups held for sale based on the expected proceeds received from the sale. For assets measured at net asset values, we have no unfunded commitments or significant restraints. We measured fair value (non-recurring) for goodwill and other intangibles using a discounted cash flow model and a relief-from-royalty method, respectively, with inputs based on both observable and unobservable market data.\nInventories\nUnited States production inventories are stated at last-in, first-out (\"LIFO\") cost. Latin America and Asia inventories are stated at average cost. The remaining inventories are stated at first-in, first-out (\"FIFO\") cost. Costs include materials, labor and production overhead at normal production capacity. Costs do not exceed net realizable values. Changes in the amount that FIFO cost exceed LIFO cost are recognized in cost of goods sold. See Note 5 to the Consolidated Financial Statements for additional information about inventories.\n63\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nProperty\nProperty is stated at cost, net of accumulated depreciation. For production machinery and equipment, we record depreciation based on units produced, unless units produced drop below a minimum threshold at which point depreciation is recorded using the straight-line method, excluding property acquired from the Hefei Sanyo acquisition and certain property acquired from the Indesit acquisition in 2014. For non-production assets and assets acquired from Hefei Sanyo and certain production assets acquired from Indesit, we depreciate costs based on the straight-line method. Depreciation expense for property, including accelerated depreciation classified as restructuring expense in our Consolidated Statements of Income (Loss), was $ 506 million, $ 518 million and $ 570 million in 2020, 2019 and 2018, respectively.\nThe following table summarizes our property at December 31, 2020 and 2019:\n| Millions of dollars | 2020 | 2019 | Estimated Useful Life |\n| Land | $ | 92 | $ | 97 | n/a |\n| Buildings | 1,517 | 1,540 | 10 to 50 years |\n| Machinery and equipment | 8,370 | 8,108 | 3 to 20 years |\n| Accumulated depreciation | ( 6,780 ) | ( 6,444 ) |\n| Property plant and equipment, net | $ | 3,199 | $ | 3,301 |\n\nWe classify gains and losses associated with asset dispositions in the same line item as the underlying depreciation of the disposed asset in the Consolidated Statements of Income (Loss).\nDuring 2020, we primarily retired land and buildings related to a sale-leaseback transaction and machinery and equipment with a net book value of approximately $ 26 million that was no longer in use. During 2020, we recognized a gain of $ 113 million in cost of products sold ($ 74 million) and selling, general and administrative ($ 39 million) primarily related to the sale-leaseback transaction in the fourth quarter of 2020. These gains were related to manufacturing and warehousing operations and administrative offices, respectively. During 2019, we primarily retired land and buildings related to a sale-leaseback transaction and machinery and equipment with a net book value of approximately $ 41 million that was no longer in use. During 2019, we recognized a gain of $ 106 million in cost of products sold primarily related to the sale-leaseback transaction in the fourth quarter of 2019.\nDuring the twelve months ended December 31, 2020, we also disposed other buildings, machinery and equipment with a net book value of $ 25 million. The net gain on the other disposals were not material.\nWe record impairment losses on long-lived assets, excluding goodwill and indefinite-lived intangibles, when events and circumstances indicate the assets may be impaired and the estimated undiscounted future cash flows generated by those assets are less than their carrying amounts. There were no significant impairments recorded during 2020, 2019 and 2018.\nLeases\nWe determine if an arrangement contains a lease at contract inception and determine the lease term by assuming the exercise of those renewal options that are reasonably assured. Leases with an initial term of 12 months or less are not recorded in the Consolidated Balance Sheets and we recognize lease expense for these leases on a straight-line basis over the lease term. We elect to not separate lease and non-lease components for all leases.\nAs the Company's lease agreements normally do not provide an implicit interest rate, we apply the Company's incremental borrowing rate based on the information available at commencement date in determining the present value of future lease payments. Relevant information used in determining the Company's incremental borrowing rate includes the duration of the lease, location of the lease, and the Company's credit risk relative to risk-free market rates.\n64\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nCertain leases also include options to purchase the underlying asset at fair market value. If leased assets have leasehold improvements, typically the depreciable life of those leasehold improvements are limited by the expected lease term. Additionally, certain lease agreements include lease payment adjustments for inflation.\nSale-leaseback transactions\nIn the fourth quarter of 2020, the Company sold and leased back a group of non-core properties for net proceeds of approximately $ 139 million. The initial total annual rent for the properties is approximately $ 10 million per year over an initial 14 year lease term and is subject to annual rent increases. Under the terms of the lease agreement, the Company is responsible for all taxes, insurance and utilities and is required to adequately maintain the properties for the lease term. The Company has 4 sequential 5 -year renewal options.\nThe transaction met the requirements for sale-leaseback accounting. Accordingly, the Company recorded the sale of the properties, which resulted in a gain of approximately $ 113 million ($ 89 million, net of tax) recorded in cost of products sold ($ 74 million) and selling, general and administrative expense ($ 39 million) in the Consolidated Statements of Income (Loss). The related land and buildings were removed from property, plant and equipment, net and the appropriate right-of-use asset and lease liabilities of approximately $ 128 million were recorded in the Consolidated Balance Sheets.\nIn the fourth quarter of 2019, the Company sold and leased back a group of non-core properties for net proceeds of approximately $ 140 million. The initial total annual rent for the properties is approximately $ 10 million per year over an initial 12 year lease term and is subject to annual rent increases. Under the terms of the lease agreement, the Company is responsible for all taxes, insurance and utilities and is required to adequately maintain the properties for the lease term. The Company has five sequential five-year renewal options.\nThe transaction met the requirements for sale-leaseback accounting. Accordingly, the Company recorded the sale of the properties, which resulted in a gain of approximately $ 111 million ($ 88 million, net of tax) recorded in cost of products sold ($ 95 million) and selling, general and administrative expense ($ 16 million) in the Consolidated Statements of Income (Loss). The related land and buildings were removed from property, plant and equipment, net and the appropriate right-of-use asset and lease liabilities of approximately $ 108 million were recorded in the Consolidated Balance Sheets.\nGoodwill and Other Intangibles\nWe perform our annual impairment assessment for goodwill and indefinite-lived intangible assets as of October 1st and more frequently if indicators of impairment exist. We consider qualitative factors to assess if it is more likely than not that the fair value for goodwill or indefinite-lived intangible assets is below the carrying amount. We may also elect to bypass the qualitative assessment and perform a quantitative assessment.\nIn conducting a qualitative assessment, the Company analyzes a variety of events or factors that may influence the fair value of the reporting unit or indefinite-lived intangible asset, including, but not limited to: macroeconomic conditions, industry and market considerations, cost factors, overall financial performance, share price and other relevant factors.\nGoodwill\nWe have four reporting units for which we assess for impairment which also represent our operating segments and are defined as North America, EMEA, Latin America and Asia. In performing a quantitative assessment of goodwill, we estimate each reporting unit's fair value using the best information available to us, including market information and discounted cash flow projections, also referred to as the income approach. The income approach uses the reporting unit's projections of estimated operating results and cash flows that are discounted using a market participant discount rate based on a weighted-average cost of capital. Additionally, we validate our estimates of fair value\n65\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nunder the income approach by comparing the values to fair value estimates using a market approach.\nThere was no impairment of goodwill in 2020 and 2019. In 2018, we recorded an impairment charge on goodwill of $ 579 million. See Note 6 and Note 11 to the Consolidated Financial Statements for additional information about goodwill.\nIntangible Assets\nWe perform a quantitative assessment of other indefinite-lived intangible assets, which are primarily comprised of trademarks. We estimate the fair value of these intangible assets using the relief-from-royalty method, which primarily requires assumptions related to projected revenues from our long-range plan, assumed royalty rates that could be payable if we did not own the trademark, and a market participant discount rate based on a weighted-average cost of capital.\nOther definite-life intangible assets are amortized over their useful life and are assessed for impairment when impairment indicators are present.\nWe recorded an immaterial impairment charge on other intangibles in 2020 and $ 168 million in 2018. There was no impairment on other intangibles in 2019. See Note 6 and Note 11 to the Consolidated Financial Statements for additional information about other intangibles.\nSupply Chain Financing Arrangements\nThe Company has ongoing agreements globally with various third-parties to allow certain suppliers the opportunity to sell receivables due from us to participating financial institutions at the sole discretion of both the suppliers and the financial institutions. Additionally, in China, as a common practice, we pay suppliers with banker's acceptance drafts. Banker's acceptance drafts allow suppliers to sell their receivables to financial institutions at the sole discretion of both the supplier and the financial institution.\nWe have no economic interest in the sale of these receivables and no direct financial relationship with the financial institutions concerning these services. Our obligations to suppliers, including amounts due and scheduled payment terms, are not impacted. All outstanding balances under these programs are recorded in accounts payable on our Consolidated Balance Sheets. At December 31, 2020 and 2019, approximately $ 1.2 billion and $ 1.2 billion, respectively, have been issued to participating financial institutions.\nA downgrade in our credit rating or changes in the financial markets could limit the financial institutions’ willingness to commit funds to, and participate in, the programs. We do not believe such risk would have a material impact on our working capital or cash flows.\nDerivative Financial Instruments\nWe use derivative instruments designated as cash flow, fair value and net investment hedges to manage our exposure to the volatility in material costs, foreign currency and interest rates on certain debt instruments. Changes in the fair value of derivative assets or liabilities (i.e., gains or losses) are recognized depending upon the type of hedging relationship and whether a hedge has been designated. For those derivative instruments that qualify for hedge accounting, we designate the hedging instrument, based upon the exposure being hedged, as a cash flow hedge, fair value hedge, or a hedge of a net investment in a foreign operation. For a derivative instrument designated as a fair value hedge, the gain or loss on the derivative is recognized in earnings immediately with the offsetting gain or loss on the hedged item. For a derivative instrument designated as a cash flow hedge, the effective portion of the derivative's gain or loss is initially reported as a component of Other Comprehensive Income (Loss) and is subsequently recognized in earnings when the hedged exposure affects earnings. For a derivative instrument designated as a hedge of a net investment in a foreign operation, the effective portion of the derivative's gain or loss is reported in Other Comprehensive Income (Loss) as part of the cumulative translation adjustment. Changes in fair value of derivative instruments that do not qualify for hedge accounting are recognized immediately in current net earnings. See Note 10 to the Consolidated Financial Statements for additional information about hedges and derivative financial instruments.\n66\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nForeign Currency Translation and Transactions\nForeign currency denominated assets and liabilities are translated into United States dollars at exchange rates existing at the respective balance sheet dates. Translation adjustments resulting from fluctuations in exchange rates are recorded as a separate component of Accumulated Other Comprehensive Income (Loss). The results of operations of foreign subsidiaries are translated at the average exchange rates during the respective periods. Gains and losses resulting from foreign currency transactions are included in net earnings.\nResearch and Development Costs\nResearch and development costs are charged to expense and totaled $ 455 million, $ 541 million and $ 572 million in 2020, 2019 and 2018, respectively.\nAdvertising Costs\nAdvertising costs are charged to expense when the advertisement is first communicated and totaled $ 273 million, $ 335 million and $ 343 million in 2020, 2019 and 2018, respectively.\nIncome Taxes and Indirect Tax Matters\nWe account for income taxes using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences of temporary differences between the financial statement and tax basis of assets and liabilities using enacted rates. The effect of a change in tax rates on deferred tax assets is recognized in income in the period of the enactment date.\nWe recognize, primarily in other noncurrent liabilities, in the Consolidated Balance Sheets, the effects of uncertain income tax positions. Interest and penalties related to uncertain tax positions are reflected in income tax expense. We record liabilities, net of the amount, after determining it is more likely than not that the uncertain tax position will be sustained upon examination based on its technical merits. We accrue for indirect tax contingencies when we determine that a loss is probable and the amount or range of loss is reasonably estimable.\nProvision is made for taxes on undistributed earnings of foreign subsidiaries and related companies to the extent that such earnings are not deemed to be permanently invested.\nSee Note 15 to the Consolidated Financial Statements for additional information.\nStock Based Compensation\nStock based compensation expense is based on the grant date fair value and is expensed over the period during which an employee is required to provide service in exchange for the award (generally the vesting period). The Company's stock based compensation includes stock options, performance stock units, and restricted stock units, among other award types. The fair value of stock options are determined using the Black-Scholes option-pricing model, which incorporates assumptions regarding the risk-free interest rate, expected volatility, expected option life, expected forfeitures and dividend yield. Expected forfeitures are based on historical experience. Stock options are granted with an exercise price equal to the closing stock price on the date of grant. The fair value of restricted stock units and performance stock units is generally based on the closing market price of Whirlpool common stock on the grant date. Stock based compensation is recorded in selling, general and administrative expense on our Consolidated Statements of Income (Loss). See Note 13 to the Consolidated Financial Statements for additional information.\n67\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nBEFIEX Credits\nIn previous years, our Brazilian operations earned tax credits under the Brazilian government's export incentive program (BEFIEX). These credits reduced Brazilian federal excise taxes on domestic sales, resulting in an increase in the operations' recorded net sales in 2017. From 2018 on, these credits are reflected in interest and sundry income in line with ASC 606. There was no material change to timing or amount of revenue recognition. We recognized export credits as they were monetized. See Note 8 and Note 15 to the Consolidated Financial Statements for additional information.\nOut-of-Period Adjustment\nDuring the third quarter of 2019, we recorded a net adjustment of $ 34 million related to prior years resulting from the one time transition tax deemed repatriation on earnings of certain foreign subsidiaries that were previously tax deferred and related impacts. This adjustment resulted in a decrease of net earnings available to Whirlpool of $ 34 million and a decrease of $ 0.53 in diluted earnings per share. The Company determined the impact was immaterial to prior periods and is not material to the Consolidated Statements of Income (Loss) for the year ended December 31, 2019.\nIn addition, during the third quarter of 2019 we recorded an adjustment of $ 22 million related to the first quarter of 2019 resulting from other foreign subsidiary income items and corresponding tax credit impacts. The Consolidated Statements of Income (Loss) for the year ended December 31, 2019 is not impacted by this adjustment.\nRelated Party Transaction\nIn 2018, Whirlpool of India Limited (Whirlpool India), a majority-owned subsidiary of Whirlpool Corporation, acquired a 49 % equity interest in Elica PB India for $ 22 million. Whirlpool India has an option to acquire the remaining equity interest in the future for fair value, and the non-Whirlpool India shareholders of Elica PB India received an option to sell their remaining equity interest to Whirlpool India in the future for fair value, which could be material to the financial statements depending on the performance of the venture. We account for our minority interest under the equity method of accounting.\nIn the third quarter of 2019, we sold our 12.54 % ownership interest in Elica S.p.A., the parent of Elica PB India, for a nominal amount.\nAdoption of New Accounting Standards\nOn January 1, 2020 we adopted Accounting Standards Update (\"ASU\") No. 2016-13, \"Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.\" The guidance in ASU 2016-13 creates a new impairment standard replacing the current \"incurred loss\" model. The incurred loss model required that for a loss to be impaired and recognized on the financial statements it must be probable that it has been incurred at the measurement date. The new standard utilizes an \"expected credit loss\" model also referred to as \"the current expected credit loss\" (CECL) model. Under CECL, there is no threshold for impairment loss recognition, but it instead reflects a current estimate of all expected credit losses. The adoption of this standard did not have a material impact to the Consolidated Financial Statements.\nSee Note 3 to the Consolidated Financial Statements for additional information.\n68\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nWe adopted the following standards, none of which had a material impact on our Consolidated Financial Statements:\n| Standard | Effective Date |\n| 2018-13 | Fair Value Measurement (Topic 820) Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement | January 1, 2020 |\n| 2018-14 | Compensation - Retirement Benefits - Defined Benefit Plans - General (Subtopic 715-20): Disclosure Framework - Changes to the Disclosure Requirements for Defined Benefit Plans | January 1, 2020 |\n| 2018-15 | Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40) Customer's Accounting for Implementation Costs Incurred In a Cloud Computing Arrangement That Is a Service Contract | January 1, 2020 |\n| 2018-18 | Collaborative Arrangements (Topic 808) - Clarifying the Interaction between Topic 808 and Topic 606 | January 1, 2020 |\n\nAccounting Pronouncements Issued But Not Yet Effective\nIn March 2020, the FASB issued Update 2020-04, \"Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting\". The amendments in Update 2020-04 are elective and apply to all entities that have contracts, hedging relationships, and other transactions that reference LIBOR or another reference rate expected to be discontinued due to reference rate reform. The new guidance provides the following optional expedients: simplify accounting analyses under current U.S. GAAP for contract modifications, simplify the assessment of hedge effectiveness, allow hedging relationships affected by reference rate reform to continue and allow a one-time election to sell or transfer debt securities classified as held to maturity that reference a rate affected by reference rate reform. In January 2021, the FASB issued Update 2021-01, \"Reference Rate Reform (Topic 848): Scope\". The update provides additional optional guidance on the transition from LIBOR to include derivative instruments that use an interest rate for margining, discounting or contract price alignment. The standard will ease, if warranted, the requirements for accounting for the future effects of the rate reform. An entity may elect to apply the amendments prospectively through December 31, 2022. We continue to monitor the impact the discontinuance of LIBOR or another reference rate will have on our contracts, hedging relationships and other transactions.\nThe FASB has issued the following relevant standards, which are not expected to have a material impact on our Consolidated Financial Statements:\n| Standard | Effective Date |\n| 2019-12 | Income Taxes (Topic 740) - Simplifying the Accounting for Income Taxes | January 1, 2021 |\n| 2020-06 | Debt - Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging - Contracts in Entities Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entities Own Equity | January 1, 2022 |\n\nAll other issued and not yet effective accounting standards are not relevant to the Company.\n69\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\n(2) REVENUE RECOGNITION\nRevenue from Contracts with Customers\nIn accordance with Topic 606, revenue is recognized when performance obligations under the terms of a contract with our customer are satisfied; generally this occurs with the transfer of control of our products or services. Revenue is measured as the amount of consideration we expect to receive in exchange for transferring products or providing services. Certain customers may receive cash and/or non-cash incentives, which are accounted for as variable consideration. To achieve the core principle, the Company applies the following five steps:\n1. Identify the contract with a customer\nA contract with a customer exists when (i) the Company enters into an agreement with a customer that defines each party's rights regarding the products or services to be transferred and identifies the payment terms related to these products or services, (ii) both parties to the contract are committed to perform their respective obligations, (iii) the contract has commercial substance, and (iv) the Company determines that collection of substantially all consideration for products or services that are transferred is probable based on the customer's intent and ability to pay the promised consideration. The Company applies judgment in determining the customer's ability and intention to pay, which is based on a variety of factors including the customer's payment history or, in the case of a new customer, published credit and financial information pertaining to the customer.\n2. Identify the performance obligations in the contract\nPerformance obligations promised in a contract are identified based on the products or services that will be transferred to the customer that are both capable of being distinct, whereby the customer can benefit from the product or service either on its own or together with other resources that are readily available from third parties or from the Company, and are distinct in the context of the contract, whereby the transfer of the products or services is separately identifiable from other promises in the contract. To the extent a contract includes multiple promised products or services, the Company must apply judgment to determine whether promised products or services are capable of being distinct and distinct in the context of the contract. If these criteria are not met, the promised products or services are accounted for as a combined performance obligation. The Company has elected to account for shipping and handling activities as a fulfillment cost as permitted by the standard.\n3. Determine the transaction price\nThe transaction price is determined based on the consideration to which the Company will be entitled in exchange for transferring products or services to the customer. To the extent the transaction price is variable, revenue is recognized at an amount equal to the consideration to which the Company expects to be entitled. This estimate includes customer sales incentives which are accounted for as a reduction to revenue and estimated primarily using the expected value method. Determining the transaction price requires significant judgment, which is discussed by revenue category in further detail below.\nIn practice, we do not offer extended payment terms beyond one year to customers. As such, we do not adjust our consideration for financing arrangements.\n4. Allocate the transaction price to performance obligations in the contract\nIf the contract contains a single performance obligation, the entire transaction price is allocated to the single performance obligation. Contracts that contain multiple performance obligations require an allocation of the transaction price to each performance obligation based on a relative standalone selling price basis unless a portion of the variable consideration related to the contract is allocated\n70\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nentirely to a performance obligation. The Company determines standalone selling price based on the price at which the performance obligation is sold separately.\n5. Recognize revenue when or as the Company satisfies a performance obligation\nThe Company generally satisfies performance obligations at a point in time. Revenue is recognized based on the transaction price at the time the related performance obligation is satisfied by transferring a promised product or service to a customer. The impact to revenue related to prior period performance obligations in the twelve months ended December 31, 2020 is immaterial.\nDisaggregation of Revenue\nThe following table presents our disaggregated revenues by revenue source. We sell products within all major product categories in each operating segment. For additional information on the disaggregated revenues by geographical regions, see Note 16 to the Consolidated Financial Statements.\nRevenues related to our former compressor business were fully reflected in our Latin America segment through June 30, 2019. We completed the sale of our compressor business on July 1, 2019. For additional information on the sale of Embraco, see Note 17 to the Consolidated Financial Statements.\n| Twelve months ended |\n| Millions of dollars | 2020 | 2019 |\n| Major product categories: |\n| Laundry | $ | 5,675 | $ | 6,193 |\n| Refrigeration | 6,058 | 6,229 |\n| Cooking | 4,782 | 4,670 |\n| Dishwashing | 1,605 | 1,598 |\n| Total major product category net sales | $ | 18,120 | $ | 18,690 |\n| Compressors | — | 557 |\n| Spare parts and warranties | 913 | 979 |\n| Other | 423 | 193 |\n| Total net sales | $ | 19,456 | $ | 20,419 |\n\nThe impact to revenue related to prior period performance obligations was not material for the year ended December 31, 2020.\nMajor Product Category Sales\nWhirlpool Corporation manufactures and markets a full line of home appliances and related products and services. Our major product categories include the following: refrigeration, laundry, cooking, and dishwashing. The refrigeration product category includes refrigerators, freezers, ice makers and refrigerator water filters. The laundry product category includes laundry appliances and related laundry accessories. The cooking category includes cooking appliances and other small domestic appliances. The dishwashing product category includes dishwasher appliances and related accessories.\nFor product sales, we transfer control and recognize a sale when we ship the product from our manufacturing facility to our customer or when the customer receives the product based upon agreed shipping terms. Each unit sold is considered an independent, unbundled performance obligation. We do not have any additional performance obligations other than product sales that are material in the context of the contract. The amount of consideration we receive and revenue we recognize varies due to sales incentives and returns we offer to our customers. When we give our\n71\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\ncustomers the right to return eligible products, we reduce revenue for our estimate of the expected returns which is primarily based on an analysis of historical experience.\nSpare Parts & Warranties\nSpare parts are primarily sold to parts distributors and retailers, with a small number of sales to end consumers. For spare part sales, we transfer control and recognize a sale when we ship the product to our customer or when the customer receives product based upon agreed shipping terms. Each unit sold is considered an independent, unbundled performance obligation. We do not have any additional performance obligations other than spare part sales that are material in the context of the contract. The amount of consideration we receive and revenue we recognize varies due to sales incentives and returns we offer to our customers. When we give our customers the right to return eligible products, we reduce revenue for our estimate of the expected returns which is primarily based on an analysis of historical experience.\nWarranties are classified as either assurance type or service type warranties. A warranty is considered an assurance type warranty if it provides the consumer with assurance that the product will function as intended. A warranty that goes above and beyond ensuring basic functionality is considered a service type warranty. The Company offers certain limited warranties that are assurance type warranties and extended service arrangements that are service type warranties. Assurance type warranties are not accounted for as separate performance obligations under the revenue model. If a service type warranty is sold with a product or separately, revenue is recognized over the life of the warranty. The Company evaluates warranty offerings in comparison to industry standards and market expectations to determine appropriate warranty classification. Industry standards and market expectations are determined by jurisdictional laws, competitor offerings and customer expectations. Market expectations and industry standards can vary based on product type and geography. The Company primarily offers assurance type warranties.\nWhirlpool sells certain extended service arrangements separately from the sale of products. Whirlpool acts as a sales agent under some of these arrangements whereby the Company receives a fee that is recognized as revenue upon the sale of the extended service arrangement. The Company is also the principal for certain extended service arrangements. Revenue related to these arrangements is recognized ratably over the contract term.\nOther Revenue\nOther revenue sources include subscription arrangements and licenses as described below.\nThe Company has a water subscription business in our Latin America segment which provides the consumer with a water filtration system that is delivered to the consumer's home. Our water subscription contracts represent a performance obligation that is satisfied over time and revenue is recognized as the performance obligation is completed. The installation and maintenance of the water filtration system are not distinct services in the context of the contract (i.e. the customer views all activities associated with the arrangement as one singular value proposition). The contract term is generally less than one year for these arrangements and revenue is recognized based on the monthly invoiced amount which directly corresponds to the value of our performance completed to date.\nWe license our brands in arrangements that do not include other performance obligations. Whirlpool licensing provides a right of access to the Company's intellectual property throughout the license period. Whirlpool recognizes licensing revenue over the life of the license contract as the underlying sale or usage occurs. As a result, we recognize revenue for these contracts at the amount which directly corresponds to the value provided to the customer.\n72\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nCosts to Obtain or Fulfill a Contract\nWe do not capitalize costs to obtain a contract because a nominal number of contracts have terms that extend beyond one year. The Company does not have a significant amount of capitalized costs related to fulfillment.\nSales Tax and Indirect Taxes\nThe Company is subject to certain indirect taxes in certain jurisdictions including but not limited to sales tax, value added tax, excise tax and other taxes we collect concurrent with revenue-producing activities that are excluded from the transaction price, and therefore, excluded from revenue.\nAllowance for Expected Credit Losses and Bad Debt Expense\nWe estimate our expected credit losses primarily by using an aging methodology and establish customer-specific reserves for higher risk trade customers. Our expected credit losses are evaluated and controlled within each geographic region considering the unique credit risk specific to the country, marketplace and economic environment. We take into account past events, current conditions and reasonable and supportable forecasts in developing the reserve. The adoption of the new credit loss standard did not have a material impact on the Consolidated Financial Statements.\nThe following table summarizes our allowance for doubtful accounts by operating segment for the twelve months ended December 31, 2020.\n| Millions of dollars | December 31, 2019 | Charged to Earnings | Write-offs | Foreign Currency | December 31, 2020 |\n| Accounts receivable allowance |\n| North America | $ | 4 | $ | 4 | $ | ( 1 ) | $ | — | $ | 7 |\n| EMEA | 83 | 5 | ( 22 ) | 1 | 67 |\n| Latin America | 33 | 32 | ( 17 ) | ( 4 ) | 44 |\n| Asia | 12 | 1 | — | 1 | 14 |\n| $ | 132 | $ | 42 | $ | ( 40 ) | $ | ( 2 ) | $ | 132 |\n| Financing receivable allowance |\n| Latin America | $ | 29 | $ | — | $ | ( 2 ) | $ | — | $ | 27 |\n| Asia | 19 | — | — | 2 | 21 |\n| $ | 48 | $ | — | $ | ( 2 ) | $ | 2 | $ | 48 |\n| Consolidated | $ | 180 | $ | 42 | $ | ( 42 ) | $ | — | $ | 180 |\n\nWe recorded an immaterial amount of bad debt expense for the year ended December 31, 2020 and 2019, respectively.\n(3) LEASES\nLeases\nWe lease certain manufacturing facilities, warehouses/distribution centers, office space, land, vehicles, and equipment. At lease inception, we determine the lease term by assuming the exercise of those renewal options that are reasonably assured. Leases with an initial term of 12 months or less are not recorded in the Consolidated Balance Sheets and we recognize lease expense for these leases on a straight-line basis over the lease term. The Company had operating lease costs of approximately $ 236 million and $ 214 million for the years ended December 31, 2020 and December 31, 2019, respectively.\nNon-cancelable operating lease commitments that had not yet commenced were $ 49 million for the periods ended December 31, 2020 and December 31, 2019. These operating leases are expected to commence by the end of fiscal year 2021 with lease terms of up to 10 years.\n73\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nAt December 31, 2020, we have no material leases classified as financing leases and we have approximately $ 1.2 billion of non-cancellable operating lease commitments, excluding variable consideration. The undiscounted annual future minimum lease payments are summarized by year in the table below:\n| Maturity of Lease Liabilities | Operating Leases(in millions) |\n| 2021 | $ | 210 |\n| 2022 | 180 |\n| 2023 | 159 |\n| 2024 | 136 |\n| 2025 | 107 |\n| Thereafter | 369 |\n| Total lease payments | $ | 1,161 |\n| Less: interest | 149 |\n| Present value of lease liabilities | $ | 1,012 |\n\nThe long-term portion of the lease liabilities included in the amounts above is $ 838 million. The remainder of our lease liabilities are included in other current liabilities in the Consolidated Balance Sheets.\nAt December 31, 2020, the weighted average remaining lease term and weighted average discount rate for operating leases was 8 years and 4 %, respectively. At December 31, 2019 the weighted average remaining lease term and weighted average discount rate for operating leases was 7 years and 4 %, respectively.\nDuring the year ended December 31, 2020 the cash paid for amounts included in the measurement of the liabilities and the operating cash flows was $ 234 million. The right of use assets obtained in exchange for new liabilities was $ 315 million partially offset by $ 68 million in terminations for the year ended December 31, 2020.\nDuring the year ended December 31, 2019 the cash paid for amounts included in the measurement of the liabilities and the operating cash flows was $ 210 million. The right of use assets obtained in exchange for new liabilities was $ 298 million partially offset by $ 68 million in terminations for the year ended December 31, 2019.\nAs the Company's lease agreements normally do not provide an implicit interest rate, we apply the Company's incremental borrowing rate based on the information available at commencement date in determining the present value of future lease payments. Relevant information used in determining the Company's incremental borrowing rate includes the duration of the lease, location of the lease, and the Company's credit risk relative to risk-free market rates.\nMany of our leases include renewal options that can extend the lease term. The execution of those renewal options is at our sole discretion and reflected in the lease term when they are reasonably certain to be exercised.\nCertain leases also include options to purchase the underlying asset at fair market value. If leased assets have leasehold improvements, typically the depreciable life of those leasehold improvements are limited by the expected lease term. Additionally, certain lease agreements include lease payment adjustments for inflation.\nOur lease agreements do not contain any material residual value guarantees or material restrictive covenants, except for synthetic leases (see Synthetic lease arrangements).\nWe rent or sublease certain real estate to third parties. Our sublease portfolio primarily consists of operating leases within our warehouses, resulting in a nominal amount of sublease income for the years ended December 31, 2020 and December 31, 2019.\n74\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nRent expense under the Company's operating leases during the year ended December 31, 2018, prior to the Company's adoption of ASC 842, was $ 250 million.\nSynthetic lease arrangements\nWe have a number of synthetic lease arrangements with financial institutions for non-core properties. The leases contain provisions for options to purchase, extend the original term for additional periods or return the property. As of December 31, 2020, these arrangements include residual value guarantees of up to $ 220 million that could potentially come due in future periods. We do not believe it is probable that any amounts will be owed under these guarantees. Therefore, no amounts related to the residual value guarantees are included in the lease payments used to measure the right-of-use assets and lease liabilities. The residual value guarantee was not material to the Consolidated Financial Statements at December 31, 2019.\nThe majority of these leases are classified as operating leases. We have assessed the reasonable certainty of these provisions to determine the appropriate lease term. The leases were measured using our incremental borrowing rate and are included in our right of use assets and lease liabilities in the Consolidated Balance Sheets. Rental payments are calculated at the applicable LIBOR rate plus a margin. The impact to the Consolidated Balance Sheets and Consolidated Statements of Income (Loss) are nominal.\n(4) CASH, CASH EQUIVALENTS AND RESTRICTED CASH\nThe following table provides a reconciliation of cash, cash equivalents and restricted cash as reported within our Consolidated Statements of Cash Flows:\n| December 31, |\n| Millions of dollars | 2020 | 2019 | 2018 |\n| Cash and cash equivalents as presented in our Consolidated Balance Sheets | $ | 2,924 | $ | 1,952 | $ | 1,498 |\n| Restricted cash included in prepaid and other current assets | 10 | — | 40 |\n| Restricted cash included in other noncurrent assets | — | — | — |\n| Cash, cash equivalents and restricted cash as presented in our Consolidated Statements of Cash Flows | $ | 2,934 | $ | 1,952 | $ | 1,538 |\n\nSee Financial Condition and Liquidity in the Management's Discussion and Analysis section for additional information on cash and cash equivalents. See Significant Accounting Policies for additional information on restricted cash.\n(5) INVENTORIES\nThe following table summarizes our inventories at December 31, 2020 and 2019:\n| Millions of dollars | 2020 | 2019 |\n| Finished products | $ | 1,638 | $ | 1,979 |\n| Raw materials and work in process | 669 | 602 |\n| 2,307 | 2,581 |\n| Less: excess of FIFO cost over LIFO cost | ( 120 ) | ( 143 ) |\n| Total inventories | $ | 2,187 | $ | 2,438 |\n\nLIFO inventories represented 41 % and 43 % of total inventories at December 31, 2020 and 2019, respectively.\n75\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\n(6) GOODWILL AND OTHER INTANGIBLES\nGoodwill\nThe following table summarizes goodwill attributable to our reporting units for the periods presented:\n| Millions of dollars | NorthAmerica | EMEA | LatinAmerica | Asia | TotalWhirlpool |\n| Ending balance December 31, 2018 | $ | 1,693 | $ | 309 | $ | 33 | $ | 416 | $ | 2,451 |\n| Currency translation adjustment | 2 | ( 7 ) | — | ( 6 ) | ( 11 ) |\n| Ending balance December 31, 2019 | $ | 1,695 | $ | 302 | $ | 33 | $ | 410 | $ | 2,440 |\n| Currency translation adjustment | — | 27 | 1 | 28 | 56 |\n| Ending balance December 31, 2020 | $ | 1,695 | $ | 329 | $ | 34 | $ | 438 | $ | 2,496 |\n\n2020 and 2019 annual impairment assessment\nWe completed our annual impairment test for goodwill as of October 1, 2020 and 2019. The Company elected to bypass the qualitative assessment and perform a quantitative assessment to evaluate goodwill for all our reporting units. Based on the quantitative assessment we determined there was no impairment of goodwill.\nOther Intangible Assets\nThe following table summarizes other intangible assets for the period presented:\n| December 31, 2020 | December 31, 2019 |\n| Millions of dollars | Gross Carrying Amount | Accumulated Amortization | Net | Gross Carrying Amount | Accumulated Amortization | Net |\n| Other intangible assets, finite lives: |\n| Customer relationships (1) | $ | 647 | $ | ( 430 ) | $ | 217 | $ | 624 | $ | ( 377 ) | $ | 247 |\n| Patents and other (2) | 327 | ( 241 ) | 86 | 324 | ( 216 ) | 108 |\n| Total other intangible assets, finite lives | $ | 974 | $ | ( 671 ) | $ | 303 | $ | 948 | $ | ( 593 ) | $ | 355 |\n| Trademarks, indefinite lives (3) | 1,893 | ( 2 ) | 1,891 | 1,870 | — | 1,870 |\n| Total other intangible assets | $ | 2,867 | $ | ( 673 ) | $ | 2,194 | $ | 2,818 | $ | ( 593 ) | $ | 2,225 |\n\n(1)Customer relationships have an estimated useful life of 5 to 19 years.\n(2)Patents and other intangibles have an estimated useful life of 3 to 43 years.\n(3) Includes impairment charge of $ 7 million at December 31, 2020.\n2020 and 2019 annual impairment assessment\nWe completed our annual impairment assessment for other intangible assets as of October 1, 2020. The Company elected to bypass the qualitative assessment and perform a quantitative assessment to evaluate certain indefinite-lived intangible assets. Based on the results of the quantitative assessment, we recorded an immaterial intangible impairment charge in the EMEA region.\nWe completed our annual impairment assessment for other intangible assets as of October 1, 2019. The Company elected to bypass the qualitative assessment and perform a quantitative assessment to evaluate certain indefinite-life intangible assets. Based on the results of the quantitative assessment, we determined there was no impairment of intangible assets.\nSee Note 11 to the Consolidated Financial Statements for additional information.\nAmortization expense was $ 62 million, $ 69 million and $ 75 million for the years ended December 31, 2020, 2019 and 2018, respectively.\n76\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nThe following table summarizes our future estimated amortization expense by year:\n| Millions of dollars |\n| 2021 | $ | 59 |\n| 2022 | 49 |\n| 2023 | 41 |\n| 2024 | 28 |\n| 2025 | 21 |\n\n(7) FINANCING ARRANGEMENTS\nLong-Term Debt\nThe following table summarizes our long-term debt at December 31, 2020 and 2019:\n| Millions of dollars | 2020 | 2019 |\n| Senior Note - 0.63 %, maturing 2020 | $ | — | $ | 561 |\n| Senior Note - 4.85 %, maturing 2021 | 300 | 300 |\n| Senior Note - 4.70 %, maturing 2022 | 300 | 300 |\n| Senior Note - 3.70 %, maturing 2023 | 250 | 250 |\n| Senior Note - 4.00 %, maturing 2024 | 300 | 300 |\n| Senior Note - 3.70 %, maturing 2025 | 350 | 350 |\n| Senior Note - 1.25 %, maturing 2026(1) | 606 | 556 |\n| Senior Note - 1.10 %, maturing 2027(1) | 727 | 667 |\n| Senior Note - 0.50 %, maturing 2028(1) | 607 | — |\n| Senior Note - 4.75 %, maturing 2029 | 693 | 692 |\n| Senior Note - 5.15 %, maturing 2043 | 249 | 249 |\n| Senior Note - 4.50 %, maturing 2046 | 497 | 496 |\n| Senior Note - 4.60 %, maturing 2050 | 493 | — |\n| Other, net | ( 15 ) | ( 22 ) |\n| $ | 5,357 | $ | 4,699 |\n| Less current maturities | 298 | 559 |\n| Total long-term debt | $ | 5,059 | $ | 4,140 |\n\n(1)Euro denominated debt reflects impact of currency\nFor outstanding notes issued by our wholly-owned subsidiaries the debt is fully and unconditionally guaranteed by the Company.\nThe following table summarizes the contractual maturities of our long-term debt, including current maturities, at December 31, 2020:\n| Millions of dollars |\n| 2021 | $ | 298 |\n| 2022 | 297 |\n| 2023 | 247 |\n| 2024 | 297 |\n| 2025 | 347 |\n| Thereafter | 3,871 |\n| Long-term debt, including current maturities | $ | 5,357 |\n\n77\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nDebt Offering\nOn May 7, 2020, the Company completed its offering of $ 500 million in principal amount of 4.60 % Senior Notes due 2050 in a public offering pursuant to a registration statement on Form S-3 (File No. 333-224381). The notes were issued under an indenture dated March 20, 2000, between the Company, as issuer, and U.S. Bank National Association (as successor to Citibank, N.A.), as trustee. The notes contain covenants that limit the Company's ability to incur certain liens or enter into certain sale and lease-back transactions. In addition, if we experience a specific kind of change of control, we are required to make an offer to purchase all of the notes at a purchase price of 101 % of the principal amount thereof, plus accrued and unpaid interest. The Company used the net proceeds from the sale of the notes to repay a portion of the outstanding borrowings under the Company’s revolving credit facility, as amended and restated, dated as of August 6, 2019, among the Company, certain other borrowers, the lenders referred to therein, JPMorgan Chase Bank, N.A. as administrative agent and Citibank, N.A., as syndication agent.\nOn February 21, 2020, Whirlpool EMEA Finance S.à r.l., an indirect, wholly-owned finance subsidiary of Whirlpool Corporation, completed a bond offering consisting of € 500 million (approximately $ 540 million at closing) in principal amount of 0.50 % Senior Notes due in 2028 (the \"Notes\") in a public offering pursuant to a registration statement on Form S-3 (File No. 333-224381). The Notes were issued under an indenture, dated February 21, 2020, among Whirlpool EMEA Finance S.à r.l, as issuer, the Company, as parent guarantor, and U.S. Bank National Association, as trustee. Whirlpool Corporation has fully and unconditionally guaranteed the Notes on a senior unsecured basis. The Notes contain covenants that limit Whirlpool Corporation's ability to incur certain liens or enter into certain sale and lease-back transactions. In addition, if we experience a specific kind of change of control, we are required to make an offer to purchase all of the Notes at a purchase price of 101 % of the principal amount thereof, plus accrued and unpaid interest. The Company used the net proceeds from the sale of the Notes to redeem Whirlpool Corporation's 0.625 % Senior Notes due in 2020 (see Debt Repayment).\nOn February 26, 2019, the Company completed a bond offering consisting of $ 700 million in principal amount of 4.75 % Senior Notes due in 2029. The notes were issued under an indenture, dated March 20, 2000, between the Company, as issuer, and U.S. Bank National Association (as successor to Citibank N.A.), as trustee. The notes contain covenants that limit Whirlpool Corporation's ability to incur certain liens or enter into certain sale-leaseback transactions. In addition, if we experience a specific kind of change of control, we are required to make an offer to purchase all of the notes at a purchase price of 101 % of the principal amount thereof, plus accrued and unpaid interest. The notes are registered under the Securities Act of 1933, as amended, pursuant to our Registration Statement on Form S-3 (File No.333-224381). The Company used the net proceeds from the sale of the notes to repay the Whirlpool EMEA Finance Term Loan (see Debt Repayment).\nDebt Repayment\nOn March 12, 2020, € 500 million (approximately $ 566 million at repayment) of 0.625 % senior notes matured and were repaid.\nOn August 9, 2019, we repaid $ 1.0 billion pursuant to our April 23, 2018 Term Loan Agreement with Citibank, N.A., as Administrative Agent, and certain other financial institutions, representing full repayment of amounts borrowed under the term loan. As previously disclosed, we agreed to repay this term loan amount with the net cash proceeds received from the sale of our Embraco business unit to Nidec Corporation, which closed on July 1, 2019.\nOn February 27, 2019, we repaid € 600 million (approximately $ 673 million as of that date) pursuant to our June 5, 2018 Term Loan Agreement with Wells Fargo Bank, National Association, as Administrative Agent, and certain other financial institutions (the \"Whirlpool EMEA Finance Term Loan\"), representing full repayment of amounts borrowed under the Whirlpool EMEA Finance Term Loan.\n78\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nOn March 1, 2019, $ 250 million of 2.40 % senior notes matured and were repaid. On April 26, 2018, $ 363 million of 4.50 % senior notes matured and were repaid.\nCredit Facilities\nOn April 27, 2020, Whirlpool Corporation entered into a revolving 364-Day Credit Agreement (the “364-Day Facility”) by and among the Company, the lenders referred to therein, and Citibank, N.A. as Administrative Agent. The 364-Day Facility provides aggregate borrowing capacity of $ 500 million, and has a termination date of April 26, 2021. The interest and fee rates payable with respect to the 364-Day Facility based on the Company’s current debt rating are as follows: (1) the Eurodollar Margin is 1.625 %; (2) the spread over prime is 0.625 %; and (3) the unused commitment fee is 0.400 %. The 364-Day Facility contains customary covenants and warranties which are consistent with the Company’s $ 3.5 billion revolving credit facility, including, among other things, a debt to capitalization ratio of less than or equal to 0.65 as of the last day of each fiscal quarter, and a rolling twelve month interest coverage ratio required to be greater than or equal to 3.0 for each fiscal quarter. In addition, the covenants limit the Company’s ability to (or to permit any subsidiaries to), subject to various exceptions and limitations: (i) merge with other companies; (ii) create liens on its property; and (iii) incur debt at the subsidiary level.\nOn August 6, 2019, Whirlpool Corporation entered into a Fourth Amended and Restated Long-Term Credit Agreement (the \"Amended Long-Term Facility\") by and among the Company, certain other borrowers, the lenders referred to therein, JPMorgan Chase Bank, N.A. as Administrative Agent, and Citibank, N.A., as Syndication Agent. The Amended Long-Term Facility provides aggregate borrowing capacity of $ 3.5 billion, an increase of $ 500 million from the Company's prior amended and restated credit agreement. The Amended Long-Term Facility has a maturity date of August 6, 2024, unless earlier terminated.\nThe interest and fee rates payable with respect to the Amended Long-Term Facility based on our current debt rating are as follows: (1) the spread over EURIBOR is 1.125 %; (2) the spread over prime is 0.125 %; and (3) the ticking fee is 0.100 %. The Amended Long-Term Facility contains customary covenants and warranties including, among other things, a debt to capitalization ratio of less than or equal to 0.65 as of the last day of each fiscal quarter, and a rolling twelve month interest coverage ratio required to be greater than or equal to 3.0 for each fiscal quarter. In addition, the covenants limit our ability to (or to permit any subsidiaries to), subject to various exceptions and limitations: (i) merge with other companies; (ii) create liens on our property; (iii) incur debt at the subsidiary level.\nIn addition to the committed $ 3.5 billion Amended Long-Term Facility and the $ 500 million 364-day Credit Agreement, we have committed credit facilities in Brazil and India. The committed credit facilities in Brazil provide borrowings up to 1.0 billion Brazilian reais (approximately $ 192 million at December 31, 2020), maturing through 2022. On August 5, 2019 we terminated a € 250 million European revolving credit facility that we entered into in July 2015. The termination of this facility did not have a material impact on our Consolidated Financial Statements.\nWe had no borrowings outstanding under the committed credit facilities at December 31, 2020 and 2019, respectively.\nFacility Borrowings\nOn March 13, 2020, we initiated a borrowing of approximately $ 2.2 billion under the Amended Long-Term Facility, for which a portion of the proceeds from the borrowing were used to fund commercial paper repayment. We repaid $ 500 million of this Amended Long-Term Facility borrowing with the proceeds from our May 2020 Notes offering. We repaid an additional $ 500 million of this Amended Long-Term Facility borrowing by drawing on the full amount of the 364-Day Facility. As of December 31, 2020, all credit facility borrowings have been repaid.\nNotes Payable\nNotes payable, which consist of short-term borrowings payable to banks or commercial paper, are generally used to fund working capital requirements. The fair value of our notes payable approximates the carrying amount due to the short maturity of these obligations.\n79\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nIncluded in short-term borrowing at December 31, 2019 was $ 274 million of commercial paper that was repaid in early 2020.\nIncluded in short-term borrowings at December 31, 2018 were the proceeds of the $ 1.0 billion term loan, which were used to fund accelerated share repurchases through a modified Dutch auction tender offer in the second quarter of 2018. During the third quarter of 2019 we repaid the term loan with the proceeds from the sale of Embraco.\nThe following table summarizes the carrying value of notes payable at December 31, 2020 and 2019, respectively.\n| Millions of dollars | 2020 | 2019 |\n| Commercial paper | $ | — | $ | 274 |\n| Short-term borrowings to banks | 12 | 20 |\n| Total notes payable | $ | 12 | $ | 294 |\n\nSee Financial Condition and Liquidity in the Management's Discussion and Analysis section for additional information on notes payable.\n(8) COMMITMENTS AND CONTINGENCIES\nOTHER MATTERS\nEmbraco Antitrust Matters\nBeginning in February 2009, our former Embraco compressor business headquartered in Brazil (\"Embraco\") was notified of antitrust investigations of the global compressor industry by government authorities in various jurisdictions. Embraco resolved the government investigations and related claims in various jurisdictions and certain other claims remain pending.\nWhirlpool agreed to retain potential liabilities related to this matter following closing of the Embraco sale transaction. We continue to defend these actions. While it is currently not possible to reasonably estimate the aggregate amount of costs which we may incur in connection with these matters, such costs could have a material adverse effect on our financial statements in any particular reporting period.\nBEFIEX Credits and Other Brazil Tax Matters\nIn previous years, our Brazilian operations earned tax credits under the Brazilian government's export incentive program (BEFIEX). These credits reduced Brazilian federal excise taxes on domestic sales.\nIn December 2013, the Brazilian government reinstituted the monetary adjustment index applicable to BEFIEX credits that existed prior to July 2009, when the Brazilian government required companies to apply a different monetary adjustment index to BEFIEX credits. Whether use of the reinstituted index should be given retroactive effect for the July 2009 to December 2013 period was subject to review by the Brazilian courts. In the third quarter of 2017, the Brazilian Supreme Court ruled that the reinstituted index should be given retroactive effect for the July 2009 to December 2013 period, which ruling was subsequently affirmed by the Brazilian Supreme Court, and is now final. Based on this ruling, we were entitled to recognize $ 72 million in additional credits, which were recognized in prior periods. At December 31, 2020, no BEFIEX credits remain to be monetized.\nOur Brazilian operations have received tax assessments for income and social contribution taxes associated with certain monetized BEFIEX credits. We do not believe BEFIEX credits are subject to income or social contribution taxes. We believe these tax assessments are without merit and are vigorously defending our positions. We have not provided for income or social contribution taxes on these BEFIEX credits, and based on the opinions of tax and legal advisors, we have not accrued any amount related to these assessments at December 31, 2020. The total amount of outstanding tax\n80\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nassessments received for income and social contribution taxes relating to the BEFIEX credits, including interest and penalties, is approximately 2.0 billion Brazilian reais (approximately $ 381 million at December 31, 2020).\nRelying on existing Brazilian legal precedent, in 2003 and 2004, we recognized tax credits in an aggregate amount of $ 26 million, adjusted for currency, on the purchase of raw materials used in production (\"IPI tax credits\"). The Brazilian tax authority subsequently challenged the recording of IPI tax credits. No such credits have been recognized since 2004. In 2009, we entered into a Brazilian government program (\"IPI Amnesty\") which provided extended payment terms and reduced penalties and interest to encourage taxpayers to resolve this and certain other disputed tax credit amounts. As permitted by the program, we elected to settle certain debts through the use of other existing tax credits and recorded charges of approximately $ 34 million in 2009 associated with these matters. In July 2012, the Brazilian revenue authority notified us that a portion of our proposed settlement was rejected and we received tax assessments of 257 million Brazilian reais (approximately $ 49 million at December 31, 2020), reflecting interest and penalties to date. We believe these tax assessments are without merit and we are vigorously defending our position. The government's assessment in this case relies heavily on its arguments regarding taxability of BEFIEX credits for certain years, which we are disputing in one of the BEFIEX government assessment cases cited in the prior paragraph. Because the IPI Amnesty case is moving faster than the BEFIEX taxability case, we could be required to pay the IPI Amnesty assessment before obtaining a final decision in the BEFIEX taxability case.\nWe have received tax assessments from the Brazilian federal tax authorities relating to amounts allegedly due regarding unemployment/social security insurance taxes (PIS/COFINS) for tax credits recognized since 2007. These credits were recognized for inputs to certain manufacturing and other business processes. These assessments are being challenged at the administrative and judicial levels in Brazil. The total amount of outstanding tax assessments received for credits recognized for PIS/COFINS inputs is approximately 302 million Brazilian reais (approximately $ 58 million at December 31, 2020). We believe these tax assessments are without merit and are vigorously defending our positions. Based on the opinion of our tax and legal advisors, we have no t accrued any amount related to these assessments.\nIn addition to the BEFIEX, IPI tax credit and PIS/COFINS inputs matters noted above, other assessments issued by the Brazilian tax authorities related to indirect and income tax matters, and other matters, are at various stages of review in numerous administrative and judicial proceedings. The amounts related to these assessments will continue to be increased by monetary adjustments at the Selic rate, which is the benchmark rate set by the Brazilian Central Bank. In accordance with our accounting policies, we routinely assess these matters and, when necessary, record our best estimate of a loss. We believe these tax assessments are without merit and are vigorously defending our positions.\nLitigation is inherently unpredictable and the conclusion of these matters may take many years to ultimately resolve. We may experience additional delays in resolving these matters as a result of COVID-19-related administrative and judicial system temporary delays and closures in Brazil. Amounts at issue in potential future litigation could increase as a result of interest and penalties in future periods. Accordingly, it is possible that an unfavorable outcome in these proceedings could have a material adverse effect on our financial statements in any particular reporting period.\nICMS Credits\nWe also filed legal actions in Brazil to recover certain social integration and social contribution taxes paid over gross sales including ICMS receipts, which is a form of Value Added Tax in Brazil. During 2017, we sold the rights to certain portions of this litigation to a third party for 90 million Brazilian reais (approximately $ 27 million at December 31, 2017). In the first quarter of 2019, we received a favorable decision in the largest of these ICMS legal actions. This decision is final and not subject to appeals. Based on the opinion of our tax and legal advisors, we recognized a gain of approximately $ 84 million, after related taxes and fees and based on exchange rates then in effect, during the first quarter of 2019 in connection with this decision. This amount reflects approximately $ 142 million in\n81\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nindirect tax credits (\"credits\") that we are entitled to monetize in future periods, offset by approximately $ 58 million in taxes and fees, which have been paid.\nIn the second quarter of 2019, we received favorable final, non-appealable decisions in two smaller ICMS legal actions. Based on the opinion of our tax and legal advisors, we recognized a gain of approximately $ 35 million, after related taxes and fees and based on exchange rates then in effect, during the second quarter of 2019 in connection with this decision. This amount reflects approximately $ 54 million in credits that we are entitled to monetize in future periods, offset by approximately $ 19 million in taxes and fees, which have been paid.\nThe ICMS credits and related fees were recorded in interest and sundry (income) expense in our Consolidated Statements of Comprehensive Income (Loss). The Brazilian tax authorities have sought clarification before the Brazilian Supreme Court (in a leading case involving another taxpayer) of certain matters, including the amount of these credits (i.e., the gross rate or net credit amount), and certain other matters that could affect the rights of Brazilian taxpayers regarding these credits, and a scheduled hearing has been delayed and it is not known when such hearing will be rescheduled. If the Brazilian tax authorities challenge our rights to these credits, we may become subject to new litigation related to credits already monetized and/or disallowance of further credit monetization. Based on the opinions of our tax and legal advisors, we have not accrued any amounts related to potential future litigation regarding these credits.\nCompetition Investigation\nIn 2013, the French Competition Authority (\"FCA\") commenced an investigation of appliance manufacturers and retailers in France, including Whirlpool and Indesit. The FCA investigation was split into two parts, and in December 2018, we finalized settlement with the FCA on the first part for a total fine of € 102 million, with € 56 million attributable to Whirlpool's France business and € 46 million attributable to Indesit's France business. Payment of final amounts were made in 2019, including payment by Indesit's previous owners of € 17 million out of escrow to the Company. The second part of the FCA investigation, which is expected to focus primarily on manufacturer interactions with retailers, is ongoing. The Company is cooperating with this investigation.\nAlthough it is currently not possible to assess the impact, if any, that matters related to the FCA investigation may have on our financial statements, matters related to the FCA investigation could have a material adverse effect on our financial statements in any particular reporting period.\nTrade Customer Insolvency\nIn 2017, Alno AG and certain affiliated companies filed for insolvency protection in Germany. Bauknecht Hausgeräte GmbH, a subsidiary of the Company, was a long-standing supplier to Alno and certain of its affiliated companies. The Company was also a former indirect minority shareholder of Alno. In August 2018, the insolvency trustee asserted € 174.5 million in clawback and related claims against Bauknecht. In January 2020, we entered into an agreement to settle all potential claims that the insolvency trustee may have related to this matter, resulting in a one-time charge of € 52.75 million (approximately $ 59 million as of December 31, 2019), which was recorded in interest and sundry (income) expense in the Consolidated Statements of Income for the year ended December 31, 2019 and paid in 2020 as planned.\nOther Litigation\nSee Note 13 for information on certain U.S. income tax litigation. In addition, we are currently defending against two lawsuits that have been certified for treatment as class actions in U.S. federal court, relating to two top-load washing machine models. In December 2019, the court in one of these lawsuits entered summary judgment in Whirlpool's favor. That ruling remains subject to appeal, and the other lawsuit is ongoing. We believe the lawsuits are without merit and are vigorously defending them. Given the preliminary stage of the proceedings, we cannot reasonably estimate a range of loss, if any, at this time. The resolution of these matters could have a material adverse effect on our financial statements in any particular reporting period.\n82\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nWe are currently vigorously defending a number of other lawsuits related to the manufacture and sale of our products which include class action allegations, and may become involved in similar actions. These lawsuits allege claims which include negligence, breach of contract, breach of warranty, product liability and safety claims, false advertising, fraud, and violation of federal and state regulations, including consumer protection laws. In general, we do not have insurance coverage for class action lawsuits. We are also involved in various other legal actions arising in the normal course of business, for which insurance coverage may or may not be available depending on the nature of the action. We dispute the merits of these suits and actions, and intend to vigorously defend them. Management believes, based upon its current knowledge, after taking into consideration legal counsel's evaluation of such suits and actions, and after taking into account current litigation accruals, that the outcome of these matters currently pending against Whirlpool should not have a material adverse effect, if any, on our financial statements. We may experience additional delays in resolving these and other pending litigation matters as a result of COVID-19-related temporary court and administrative body closures and postponements.\nProduct Warranty and Legacy Product Corrective Action Reserves\nProduct warranty reserves are included in other current and other noncurrent liabilities in our Consolidated Balance Sheets. The following table summarizes the changes in total product warranty reserves for the periods presented:\n| Product Warranty |\n| Millions of dollars | 2020 | 2019 |\n| Balance at January 1 | $ | 383 | $ | 268 |\n| Issuances/accruals during the period | 226 | 350 |\n| Settlements made during the period/other(1) | ( 336 ) | ( 235 ) |\n| Balance at December 31 | $ | 273 | $ | 383 |\n| Current portion | $ | 184 | $ | 254 |\n| Non-current portion | 89 | 129 |\n| Total | $ | 273 | $ | 383 |\n\n(1)Includes updated reserve assumptions noted below.\nIn the normal course of business, we engage in investigations of potential quality and safety issues. As part of our ongoing effort to deliver quality products to consumers, we are currently investigating certain potential quality and safety issues globally. As necessary, we undertake to effect repair or replacement of appliances in the event that an investigation leads to the conclusion that such action is warranted.\nAs part of this process, we investigated incident reports associated with a particular component in certain Indesit-designed horizontal axis washers produced in EMEA. In January 2020, we commenced a product recall in the U.K. and Ireland for these EMEA-produced washers, for which the recall is ongoing. In the third quarter of 2019, we accrued approximately $ 105 million in estimated product warranty expense related to this matter. Reserve assumptions were updated in the fourth quarter of 2020 based on the latest available data including take rate assumptions and unit population resulting in a $ 30 million release to the reserve. This estimate is based on several assumptions which are inherently unpredictable and which we may need to materially revise in the future. For the year ended December 31, 2020, settlements of approximately $ 56 million have been incurred related to this product recall. In 2020, we recorded a benefit of $ 14 million related to a vendor recovery for this corrective action.\nFor the year ended December 31, 2019, we incurred approximately $ 26 million of additional product warranty expense related to our previously disclosed legacy Indesit dryer corrective action campaign in the U.K.. We continue to cooperate with the U.K. regulator, which continues to review the overall effectiveness of the corrective action campaign. For the year ended December 31, 2020, we incurred no additional material product warranty expense related to this campaign. We continue to\n83\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\ncooperate with the U.K. regulator, which continues to review the overall effectiveness of the modification program.\nGuarantees\nWe have guarantee arrangements in a Brazilian subsidiary. For certain creditworthy customers, the subsidiary guarantees customer lines of credit at commercial banks to support purchases following its normal credit policies. If a customer were to default on its line of credit with the bank, our subsidiary would be required to assume the line of credit and satisfy the obligation with the bank. At December 31, 2020 and December 31, 2019, the guaranteed amounts totaled 831 million Brazilian reais (approximately $ 160 million at December 31, 2020) and 577 million Brazilian reais (approximately $ 143 million at December 31, 2019), respectively. The fair value of these guarantees were nominal at December 31, 2020 and December 31, 2019. Our subsidiary insures against a significant portion of this credit risk for these guarantees, under normal operating conditions, through policies purchased from high-quality underwriters.\nWe provide guarantees of indebtedness and lines of credit for various consolidated subsidiaries. The maximum contractual amount of indebtedness and lines of credit available under these lines for consolidated subsidiaries totaled $ 3.5 billion at December 31, 2020 and $ 2.6 billion at December 31, 2019. Our total short-term outstanding bank indebtedness under guarantees was nominal at both December 31, 2020 and 2019.\nPurchase Obligations\nOur expected cash outflows resulting from non-cancellable purchase obligations are summarized by year in the table below:\n| Millions of dollars |\n| 2021 | $ | 214 |\n| 2022 | 132 |\n| 2023 | 89 |\n| 2024 | 53 |\n| 2025 | 26 |\n| Thereafter | 42 |\n| Total purchase obligations | $ | 556 |\n\n(9) PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS\nWe have funded and unfunded defined benefit pension plans that cover certain employees in North America, Europe, Asia and Brazil. The United States plans comprise the majority of our obligation. All but one of these plans are frozen for all participants. The primary formula for United States salaried employees covered under the qualified defined benefit plan was based on years of service and final average salary, while the primary formula for United States hourly employees covered under the defined benefit plans was based on specific dollar amounts for each year of service. There were multiple formulas for employees covered under the qualified and nonqualified defined benefit plans that were sponsored by Maytag, including a cash balance formula. We have foreign pension plans that accrue benefits. The plans generally provide benefit payments using a formula that is based upon employee compensation and length of service.\nIn addition, we sponsor an unfunded Supplemental Executive Retirement Plan that remains open to new participants and additional benefit accruals. This plan is nonqualified and provides certain key employees additional defined pension benefits that supplement those provided by the Company's other retirement plans.\nA defined contribution plan is being provided to all United States employees and is not classified within the net periodic benefit cost. The Company provides annual match and automatic company contributions, in cash or Company stock, of up to 7 % of employees' eligible pay. Our contributions during 2020, 2019 and 2018 were $ 83 million, $ 84 million and $ 81 million, respectively. $ 48 million\n84\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nof our Company matching contributions to our defined contribution plan during 2020 were made in Company stock from May 2020 to December 2020.\nWe provide postretirement health care benefits for eligible retired employees in the United States, Canada and Brazil. For our United States plan, which comprises the majority of our obligation, eligible retirees include those who were full-time employees with 10 years of service who attained age 55 while in service with us and those union retirees who met the eligibility requirements of their collective bargaining agreements. In general, the postretirement health and welfare benefit plans include cost-sharing provisions that limit our exposure for recent and future retirees and are contributory, with participants' contributions adjusted annually. In the United States, benefits for certain retiree populations follow a defined contribution model that allocates certain monthly or annual amounts to a retiree's account under the plan.\nDuring the third quarter of 2020, the Company announced changes to a postretirement medical benefit program for certain groups of retirees. These plan amendments are effective January 1, 2021 and reduce reimbursement amounts available under certain postretirement medical benefit programs and eliminate these benefits effective January 1, 2024 for these same retiree groups.\nDuring the second quarter of 2020, the Company announced changes to a postretirement medical benefit program for certain groups of active employees. These plan amendments were effective July 1, 2020 and reduced medical benefits for these pre-Medicare eligible and Medicare-eligible active employees who retire on or after July 1, 2020 and eliminate certain benefits effective January 1, 2024.\nThese plan amendments resulted in a reduction in the accumulated postretirement benefit obligation of approximately $ 156 million with a corresponding adjustment of $ 118 million in other comprehensive income, net of $ 39 million in deferred taxes for the nine months ended September 30, 2020. This amount is being amortized as a reduction of future net periodic cost over approximately 3.4 years, which represents the future remaining service period of eligible active employees. The interim plan remeasurement associated with these amendments resulted in an actuarial loss of $ 12 million recorded in the Other Comprehensive Income (Loss).\nFor additional information, see Note 12 to the Consolidated Financial Statements.\nThe plans are unfunded. We reserve the right to modify these benefits in the future.\n85\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nDefined Benefit - Pensions and Other Postretirement Benefit Plans\nObligations and Funded Status at End of Year\n| United StatesPension Benefits | ForeignPension Benefits | Other PostretirementBenefits |\n| Millions of dollars | 2020 | 2019 | 2020 | 2019 | 2020 | 2019 |\n| Funded status |\n| Fair value of plan assets | $ | 3,103 | $ | 2,934 | $ | 632 | $ | 593 | $ | — | $ | — |\n| Benefit obligations | 3,237 | 3,141 | 1,029 | 941 | 191 | 355 |\n| Funded status | $ | ( 134 ) | $ | ( 207 ) | $ | ( 397 ) | $ | ( 348 ) | $ | ( 191 ) | $ | ( 355 ) |\n| Amounts recognized in the consolidated balance sheets |\n| Noncurrent asset | $ | 37 | $ | — | $ | 14 | $ | 11 | $ | — | $ | — |\n| Current liability | ( 18 ) | ( 6 ) | ( 12 ) | ( 17 ) | ( 25 ) | ( 33 ) |\n| Noncurrent liability | ( 153 ) | ( 201 ) | ( 399 ) | ( 342 ) | ( 166 ) | ( 322 ) |\n| Amount recognized | $ | ( 134 ) | $ | ( 207 ) | $ | ( 397 ) | $ | ( 348 ) | $ | ( 191 ) | $ | ( 355 ) |\n| Amounts recognized in accumulated other comprehensive loss (pre-tax) |\n| Net actuarial loss | $ | 1,227 | $ | 1,329 | $ | 279 | $ | 234 | $ | 23 | $ | 15 |\n| Prior service (credit) cost | 1 | 1 | 3 | 4 | ( 140 ) | ( 16 ) |\n| Amount recognized | $ | 1,228 | $ | 1,330 | $ | 282 | $ | 238 | $ | ( 117 ) | $ | ( 1 ) |\n\nChange in Benefit Obligation\n| United StatesPension Benefits | ForeignPension Benefits | Other PostretirementBenefits |\n| Millions of dollars | 2020 | 2019 | 2020 | 2019 | 2020 | 2019 |\n| Benefit obligation, beginning of year | $ | 3,141 | $ | 3,033 | $ | 941 | $ | 834 | $ | 355 | $ | 356 |\n| Service cost | 3 | 2 | 6 | 6 | 4 | 6 |\n| Interest cost | 94 | 123 | 17 | 23 | 8 | 16 |\n| Plan participants' contributions | — | — | 1 | 1 | — | — |\n| Actuarial loss (gain) | 282 | 279 | 96 | 85 | 9 | 14 |\n| Benefits paid | ( 186 ) | ( 263 ) | ( 33 ) | ( 30 ) | ( 24 ) | ( 28 ) |\n| Plan amendments | — | — | — | 6 | ( 156 ) | ( 15 ) |\n| Transfer of liabilities | — | — | — | ( 2 ) | — | — |\n| Other adjustments | — | — | — | 11 | — | 7 |\n| Special termination benefit | — | — | — | — | — | — |\n| Settlements / curtailment (gain) | ( 97 ) | ( 33 ) | ( 37 ) | ( 13 ) | — | — |\n| Foreign currency exchange rates | — | — | 38 | 20 | ( 5 ) | ( 1 ) |\n| Reclassification of obligation to held for sale | — | — | — | — | — | — |\n| Benefit obligation, end of year | $ | 3,237 | $ | 3,141 | $ | 1,029 | $ | 941 | $ | 191 | $ | 355 |\n| Accumulated benefit obligation, end of year | $ | 3,222 | $ | 3,128 | $ | 987 | $ | 902 | N/A | N/A |\n\n86\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nChange in Plan Assets\n| United States Pension Benefits | ForeignPension Benefits | Other PostretirementBenefits |\n| Millions of dollars | 2020 | 2019 | 2020 | 2019 | 2020 | 2019 |\n| Fair value of plan assets, beginning of year | $ | 2,934 | $ | 2,676 | $ | 593 | $ | 518 | $ | — | $ | — |\n| Actual return on plan assets | 447 | 517 | 58 | 61 | — | — |\n| Employer contribution | 5 | 37 | 29 | 33 | 24 | 28 |\n| Plan participants' contributions | — | — | 1 | 1 | — | — |\n| Benefits paid | ( 186 ) | ( 263 ) | ( 33 ) | ( 30 ) | ( 24 ) | ( 28 ) |\n| Transfer of plan assets | — | — | — | ( 2 ) | — | — |\n| Other adjustments | — | — | — | 5 | — | — |\n| Settlements | ( 97 ) | ( 33 ) | ( 37 ) | ( 13 ) | — | — |\n| Foreign currency exchange rates | — | — | 21 | 20 | — | — |\n| Reclassification of plan assets to held for sale | — | — | — | — | — | — |\n| Fair value of plan assets, end of year | $ | 3,103 | $ | 2,934 | $ | 632 | $ | 593 | $ | — | $ | — |\n\nThe actuarial (gain) loss for all pension and other postretirement benefit plans in 2020 and 2019 was primarily related to a change in the discount rate used to measure the benefit obligation of those plans.\nComponents of Net Periodic Benefit Cost\n| United StatesPension Benefits | ForeignPension Benefits | Other PostretirementBenefits |\n| Millions of dollars | 2020 | 2019 | 2018 | 2020 | 2019 | 2018 | 2020 | 2019 | 2018 |\n| Service cost | $ | 3 | $ | 2 | $ | 2 | $ | 6 | $ | 6 | $ | 5 | $ | 4 | $ | 6 | $ | 7 |\n| Interest cost | 94 | 123 | 118 | 17 | 23 | 23 | 8 | 16 | 15 |\n| Expected return on plan assets | ( 165 ) | ( 177 ) | ( 170 ) | ( 30 ) | ( 29 ) | ( 32 ) | — | — | — |\n| Amortization: |\n| Actuarial loss | 62 | 47 | 53 | 12 | 8 | 9 | — | 1 | — |\n| Prior service cost (credit) | — | ( 2 ) | ( 3 ) | — | — | — | ( 28 ) | ( 16 ) | — |\n| Special termination benefit | — | — | — | — | — | — | — | — | — |\n| Curtailment (gain) / loss | — | — | — | — | — | ( 4 ) | ( 3 ) | — | — |\n| Settlement loss | 39 | 9 | — | 11 | 2 | 3 | — | — | — |\n| Net periodic benefit cost | $ | 33 | $ | 2 | $ | — | $ | 16 | $ | 10 | $ | 4 | $ | ( 19 ) | $ | 7 | $ | 22 |\n\nThe following table summarizes the net periodic cost recognized in operating profit and interest and sundry (income) expense for the years ending December 31, 2020, 2019 and 2018:\n| United StatesPension Benefits | ForeignPension Benefits | Other PostretirementBenefits |\n| Millions of dollars | 2020 | 2019 | 2018 | 2020 | 2019 | 2018 | 2020 | 2019 | 2018 |\n| Operating profit (loss) | $ | 3 | $ | 2 | $ | 2 | $ | 6 | $ | 6 | $ | 5 | $ | 4 | $ | 6 | $ | 7 |\n| Interest and sundry (income) expense | 30 | — | ( 2 ) | 10 | 4 | ( 1 ) | ( 23 ) | 1 | 15 |\n| Net periodic benefit cost | $ | 33 | $ | 2 | $ | — | $ | 16 | $ | 10 | $ | 4 | $ | ( 19 ) | $ | 7 | $ | 22 |\n\n87\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nOther Changes in Plan Assets and Benefit Obligations Recognized in Other Comprehensive Income (Loss) (Pre-Tax) in 2020\n| Millions of dollars | United StatesPension Benefits | ForeignPension Benefits | Other PostretirementBenefits |\n| Current year actuarial loss / (gain) | $ | — | $ | 69 | $ | 9 |\n| Actuarial (loss) recognized during the year | ( 101 ) | ( 24 ) | — |\n| Current year prior service cost (credit) | — | — | ( 156 ) |\n| Prior service credit (cost) recognized during the year | — | — | 32 |\n| Total recognized in other comprehensive income (loss) (pre-tax) | $ | ( 101 ) | $ | 45 | $ | ( 115 ) |\n| Total recognized in net periodic benefit costs and other comprehensive income (loss) (pre-tax) | $ | ( 68 ) | $ | 61 | $ | ( 134 ) |\n\nWe amortize actuarial losses and prior service costs (credits) over a period of up to 21 years and 13 years, respectively.\nAssumptions\nWeighted-Average Assumptions used to Determine Benefit Obligation at End of Year\n| United StatesPension Benefits | ForeignPension Benefits | Other PostretirementBenefits |\n| 2020 | 2019 | 2020 | 2019 | 2020 | 2019 |\n| Discount rate | 2.50 | % | 3.30 | % | 1.55 | % | 2.04 | % | 2.98 | % | 3.45 | % |\n| Rate of compensation increase | 4.50 | % | 4.50 | % | 3.47 | % | 3.10 | % | N/A | N/A |\n| Interest crediting rate for cash balance plans | 1.25 | % | 2.05 | % | 1.99 | % | 1.80 | % | N/A | N/A |\n\nWeighted-Average Assumptions used to Determine Net Periodic Cost\n| United StatesPension Benefits | ForeignPension Benefits | Other PostretirementBenefits |\n| 2020 | 2019 | 2018 | 2020 | 2019 | 2018 | 2020 | 2019 | 2018 |\n| Discount rate | 3.13 % | 4.30 % | 3.65 % | 2.04 % | 2.90 % | 2.57 % | 3.35 % | 4.80 % | 4.35 % |\n| Expected long-term rate of return on plan assets | 6.25 % | 6.50 % | 6.75 % | 5.39 % | 5.56 % | 5.81 % | N/A | N/A | N/A |\n| Rate of compensation increase | 4.50 % | 4.50 % | 4.50 % | 3.10 % | 3.29 % | 3.20 % | N/A | N/A | N/A |\n| Interest crediting rate for cash balance plans | 2.05 % | 3.05 % | 2.40 % | 1.80 % | 2.19 % | 2.16 % | N/A | N/A | N/A |\n| Health care cost trend rate |\n| Initial rate | N/A | N/A | N/A | N/A | N/A | N/A | 6.25% | 6.50 % | 6.50 % |\n| Ultimate rate | N/A | N/A | N/A | N/A | N/A | N/A | 5.00% | 5.00 % | 5.00 % |\n| Year that ultimate rate will be reached | N/A | N/A | N/A | N/A | N/A | N/A | 2025 | 2025 | 2025 |\n\n88\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nDiscount Rate\nFor our United States pension and postretirement benefit plans, the discount rate was selected using a hypothetical portfolio of high quality bonds outstanding at December 31 that would provide the necessary cash flows to match our projected benefit payments. For our foreign pension and postretirement benefit plans, the discount rate was primarily selected using high quality bond yields for the respective country or region covered by the plan.\nExpected Return on Plan Assets\nIn the United States, the expected return on plan assets is developed considering asset mix, historical asset class data and long-term expectations. The resulting weighted-average return was rounded to the nearest quarter of one percent and applied to the fair value of plan assets at December 31, 2020.\nFor foreign pension plans, the expected rate of return on plan assets was primarily determined by observing historical returns in the local fixed income and equity markets and computing the weighted average returns with the weights being the asset allocation of each plan.\nCash Flows\nFunding Policy\nOur funding policy is to contribute to our United States pension plans amounts sufficient to meet the minimum funding requirement as defined by employee benefit and tax laws, plus additional amounts which we may determine to be appropriate. In certain countries other than the United States, the funding of pension plans is not common practice. Contributions to our United States pension plans may be made in the form of cash or, in the case of defined contribution plan in narrow circumstances, company stock. We pay for retiree medical benefits as they are incurred.\nThere have been no contributions to the pension trust for our U.S. defined benefit plans during the twelve months ended December 31, 2020.\nExpected Employer Contributions to Funded Plans\n| Millions of dollars | United StatesPension Benefits | ForeignPension Benefits |\n| 2021 | $ | — | $ | 18 |\n\nExpected Benefit Payments\n| Millions of dollars | United StatesPension Benefits | ForeignPension Benefits | Other Postretirement Benefits |\n| 2021 | $ | 294 | $ | 39 | $ | 25 |\n| 2022 | 243 | 40 | 25 |\n| 2023 | 236 | 41 | 24 |\n| 2024 | 231 | 40 | 10 |\n| 2025 | 222 | 45 | 9 |\n| 2026-2030 | $ | 989 | $ | 234 | $ | 43 |\n\nPlan Assets\nOur overall investment strategy is to achieve an appropriate mix of investments for long-term growth and for near-term benefit payments with a wide diversification of asset types, fund strategies, and investment fund managers. The target allocation for our plans is approximately 20 % in growth assets and 80 % in immunizing fixed income securities, with exceptions for foreign pension plans. The fixed income securities duration is intended to match that of our United States pension liabilities.\n89\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nPlan assets are reported at fair value based on an exit price, representing the amount that would be received to sell an asset in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset. As a basis for considering such assumptions, a three-tiered fair value hierarchy is established, which prioritizes the inputs used in measuring fair value as follows: (Level 1) observable inputs such as quoted prices in active markets; (Level 2) inputs, other than the quoted prices in active markets that are observable, either directly or indirectly; and (Level 3) unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions. Certain investments are valued based on net asset value (NAV), which approximates fair value. Such basis is determined by referencing the respective fund's underlying assets. There are no unfunded commitments or other restrictions associated with these investments. We manage the process and approve the results of a third-party pricing service to value the majority of our securities and to determine the appropriate level in the fair value hierarchy.\n90\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nThe fair values of our pension plan assets at December 31, 2020 and 2019, by asset category were as follows:\n| December 31, |\n| Quoted prices(Level 1) | Other significantobservable inputs(Level 2) | Significantunobservable inputs(Level 3) | Net Asset Value | Total |\n| Millions of dollars | 2020 | 2019 | 2020 | 2019 | 2020 | 2019 | 2020 | 2019 | 2020 | 2019 |\n| Cash and cash equivalents | $ | — | $ | — | $ | 281 | $ | 24 | $ | — | $ | — | $ | — | $ | — | $ | 281 | $ | 24 |\n| Government and government agency securities (1) |\n| U.S. securities | — | — | 182 | 488 | — | — | — | — | 182 | 488 |\n| International securities | — | — | 99 | 97 | — | — | — | — | 99 | 97 |\n| Corporate bonds and notes (1) |\n| U.S. companies | — | — | 1,691 | 1,389 | — | — | — | — | 1,691 | 1,389 |\n| International companies | — | — | 279 | 277 | — | — | — | — | 279 | 277 |\n| Equity securities (2) |\n| U.S. companies | — | — | — | — | — | — | — | — | — | — |\n| International companies | 47 | 51 | — | — | — | — | — | — | 47 | 51 |\n| Mutual funds (3) | — | — | 108 | 128 | — | — | — | — | 108 | 128 |\n| Investments at net asset value |\n| U.S. equity securities (4) | — | — | — | — | — | — | 448 | 367 | 448 | 367 |\n| International equity securities (4) | — | — | — | — | — | — | 180 | 215 | 180 | 215 |\n| Short-term investment fund (4) | — | — | — | — | — | — | 24 | 15 | 24 | 15 |\n| International debt securities (5) | — | — | — | — | — | — | 208 | 251 | 208 | 251 |\n| International equity securities (5) | — | — | — | — | — | — | 53 | 59 | 53 | 59 |\n| Real estate (6) | — | — | — | — | — | — | 13 | 34 | 13 | 34 |\n| Limited partnerships (7) |\n| U.S. private equity investments | — | — | — | — | 38 | 53 | — | — | 38 | 53 |\n| Diversified fund of funds | — | — | — | — | 3 | 5 | — | — | 3 | 5 |\n| Emerging growth | — | — | — | — | 3 | 8 | — | — | 3 | 8 |\n| All other investments | — | — | 48 | 34 | — | — | 30 | 32 | 78 | 66 |\n| $ | 47 | $ | 51 | $ | 2,688 | $ | 2,437 | $ | 44 | $ | 66 | $ | 956 | $ | 973 | $ | 3,735 | $ | 3,527 |\n\n(1)Valued using pricing vendors who use proprietary models to estimate the price a dealer would pay to buy a security using significant observable inputs, such as interest rates, yield curves, and credit risk.\n(2)Valued using the closing stock price on a national securities exchange, which reflects the last reported sales price on the last business day of the year.\n(3)Valued using the net asset value (NAV) of the fund, which is based on the fair value of underlying securities. The fund primarily invests in a diversified portfolio of equity securities, fixed income debt securities and real estate issued by non-U.S. companies.\n91\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\n(4)Common and collective trust funds valued using the NAV of the fund, which is based on the fair value of underlying securities.\n(5)Fund of funds valued using the NAV of the fund, which is based on the fair value of underlying securities. International debt securities includes corporate bonds and notes and government and government agency securities.\n(6)Valued using the NAV of the fund, which is based on the fair value of underlying assets.\n(7)Valued at estimated fair value based on the proportionate share of the limited partnership's fair value, as determined by the general partner.\nFair Value Measurements Using Significant Unobservable Inputs (Level 3)\n| Millions of dollars | LimitedPartnerships |\n| Balance, December 31, 2019 | $ | 66 |\n| Realized gains (net) | 17 |\n| Unrealized losses (net) | ( 16 ) |\n| Purchases | — |\n| Settlements | ( 23 ) |\n| Balance, December 31, 2020 | $ | 44 |\n\nAdditional Information\nThe projected benefit obligation and fair value of plan assets for pension plans with a projected benefit obligation in excess of plan assets at December 31, 2020 and 2019 were as follows:\n| United StatesPension Benefits | ForeignPension Benefits |\n| Millions of dollars | 2020 | 2019 | 2020 | 2019 |\n| Projected benefit obligation | $ | 2,718 | $ | 2,622 | $ | 951 | $ | 844 |\n| Fair value of plan assets | $ | 2,547 | $ | 2,409 | $ | 546 | $ | 491 |\n\nThe projected benefit obligation, accumulated benefit obligation and fair value of plan assets for pension plans with an accumulated benefit obligation in excess of plan assets at December 31, 2020 and 2019 were as follows:\n| United StatesPension Benefits | ForeignPension Benefits |\n| Millions of dollars | 2020 | 2019 | 2020 | 2019 |\n| Projected benefit obligation | $ | 2,718 | $ | 2,622 | $ | 951 | $ | 800 |\n| Accumulated benefit obligation | 2,703 | 2,609 | 921 | 776 |\n| Fair value of plan assets | $ | 2,547 | $ | 2,409 | $ | 546 | $ | 450 |\n\n(10) HEDGES AND DERIVATIVE FINANCIAL INSTRUMENTS\nDerivative instruments are accounted for at fair value based on market rates. Derivatives where we elect hedge accounting are designated as either cash flow, fair value or net investment hedges. Derivatives that are not accounted for based on hedge accounting are marked to market through earnings. If the designated cash flow hedges are highly effective, the gains and losses are recorded in other comprehensive income (loss) and subsequently reclassified to earnings to offset the impact of the hedged items when they occur. In the event it becomes probable the forecasted transaction to which a cash flow hedge relates will not occur, the derivative would be terminated and the amount in accumulated other comprehensive income (loss) would be recognized in earnings. The fair value of the hedge asset or liability is present in either other current assets/liabilities or other noncurrent assets/liabilities on the Consolidated Balance Sheets and in other within cash provided by (used in) operating activities in the Consolidated Statements of Cash Flows.\n92\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nUsing derivative instruments means assuming counterparty credit risk. Counterparty credit risk relates to the loss we could incur if a counterparty were to default on a derivative contract. We generally deal with investment grade counterparties and monitor the overall credit risk and exposure to individual counterparties. We do not anticipate nonperformance by any counterparties. The amount of counterparty credit exposure is limited to the unrealized gains, if any, on such derivative contracts. We do not require nor do we post collateral on such contracts.\nHedging Strategy\nIn the normal course of business, we manage risks relating to our ongoing business operations including those arising from changes in commodity prices, foreign exchange rates and interest rates. Fluctuations in these rates and prices can affect our operating results and financial condition. We use a variety of strategies, including the use of derivative instruments, to manage these risks. We do not enter into derivative financial instruments for trading or speculative purposes.\nCommodity Price Risk\nWe enter into commodity derivative contracts on various commodities to manage the price risk associated with forecasted purchases of materials used in our manufacturing process. The objective of these hedges is to reduce the variability of cash flows associated with the forecasted purchase of commodities.\nForeign Currency and Interest Rate Risk\nWe incur expenses associated with the procurement and production of products in a limited number of countries, while we sell in the local currencies of a large number of countries. Our primary foreign currency exchange exposures result from cross-currency sales of products. As a result, we enter into foreign exchange contracts to hedge certain firm commitments and forecasted transactions to acquire products and services that are denominated in foreign currencies. We enter into certain undesignated non-functional currency asset and liability hedges that relate primarily to short-term payables, receivables, intercompany loans and dividends. When we hedge a foreign currency denominated payable or receivable with a derivative, the effect of changes in the foreign exchange rates are reflected currently in interest and sundry (income) expense for both the payable/receivable and the derivative. Therefore, as a result of the economic hedge, we do not elect hedge accounting.\nWe also enter into hedges to mitigate currency risk primarily related to forecasted foreign currency denominated expenditures, intercompany financing agreements and royalty agreements and designate them as cash flow hedges. Gains and losses on derivatives designated as cash flow hedges, to the extent they are included in the assessment of effectiveness, are recorded in other comprehensive income (loss) and subsequently reclassified to earnings to offset the impact of the hedged items when they occur.\nWe may enter into cross-currency interest rate swaps to manage our exposure relating to cross-currency debt. Outstanding notional amounts of cross-currency interest rate swap agreements were $ 1,275 million at December 31, 2020 and 2019, respectively.\nWe may enter into interest rate swap agreements to manage interest rate risk exposure. Our interest rate swap agreements, if any, effectively modify our exposure to interest rate risk, primarily through converting certain floating rate debt to a fixed rate basis, and certain fixed rate debt to a floating rate basis. These agreements involve either the receipt or payment of floating rate amounts in exchange for fixed rate interest payments or receipts, respectively, over the life of the agreements without an exchange of the underlying principal amounts. We may enter into swap rate lock agreements to effectively reduce our exposure to interest rate risk by locking in interest rates on probable long-term debt issuances. Outstanding notional amounts of interest rate swap agreements were $ 300 million at December 31, 2020 and 2019, respectively.\n93\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nNet Investment Hedging\nThe following table summarizes our foreign currency denominated debt and foreign exchange forwards/options designated as net investment hedges at December 31, 2020 and 2019:\n| Notional (local) | Notional (USD) | Current Maturity |\n| Instrument | 2020 | 2019 | 2020 | 2019 |\n| Senior note - 0.625 % | € | — | € | 500 | $ | — | $ | 561 | March 2020 |\n| Foreign exchange forwards/options | MXN | 7,200 | MXN | 7,200 | $ | 362 | $ | 382 | August 2022 |\n\nFor instruments that are designated and qualify as a net investment hedge, the effective portion of the instruments' gain or loss is reported as a component of other comprehensive income (loss) and recorded in accumulated other comprehensive loss. The gain or loss will be subsequently reclassified into net earnings when the hedged net investment is either sold or substantially liquidated. The remaining change in fair value of the hedge instruments represents the ineffective portion, which is immediately recognized in interest and sundry (income) expense on our Consolidated Statements of Income. As of December 31, 2020, there was no ineffectiveness on hedges designated as net investment hedges. Due to the volatility in the macroeconomic environment caused by the COVID-19 pandemic, we evaluated and dedesignated a nominal amount of certain foreign exchange cash flow hedges in the first quarter of 2020. No material amount was dedesignated during the twelve months ended December 31, 2020.\nThe following table summarizes our outstanding derivative contracts and their effects on our Consolidated Balance Sheets at December 31, 2020 and 2019:\n| Fair Value of | Type ofHedge |\n| Notional Amount | Hedge Assets | Hedge Liabilities | Maximum Term (Months) |\n| Millions of dollars | 2020 | 2019 | 2020 | 2019 | 2020 | 2019 | 2020 | 2019 |\n| Derivatives accounted for as hedges(1) |\n| Commodity swaps/options | $ | 215 | $ | 174 | $ | 39 | $ | 4 | $ | 4 | $ | 10 | (CF) | 30 | 21 |\n| Foreign exchange forwards/options | 3,028 | 3,177 | 58 | 94 | 110 | 84 | (CF/NI) | 134 | 32 |\n| Cross-currency swaps | 1,275 | 1,275 | 23 | 25 | 86 | 23 | (CF) | 98 | 110 |\n| Interest rate derivatives | 300 | 300 | — | 6 | 28 | — | (CF) | 53 | 65 |\n| Total derivatives accounted for as hedges | $ | 120 | $ | 129 | $ | 228 | $ | 117 |\n| Derivatives not accounted for as hedges |\n| Commodity swaps/options | $ | 1 | $ | 1 | $ | — | $ | — | $ | — | $ | — | N/A | 0 | 7 |\n| Foreign exchange forwards/options(2) | 4,161 | 3,182 | 25 | 15 | 96 | 22 | N/A | 12 | 12 |\n| Total derivatives not accounted for as hedges | $ | 25 | $ | 15 | $ | 96 | $ | 22 |\n| Total derivatives | $ | 145 | $ | 144 | $ | 324 | $ | 139 |\n| Current | $ | 103 | $ | 55 | $ | 152 | $ | 61 |\n| Noncurrent | 42 | 89 | 172 | 78 |\n| Total derivatives | $ | 145 | $ | 144 | $ | 324 | $ | 139 |\n\n(1)Derivatives accounted for as hedges are considered either cash flow (CF) or net investment (NI) hedges.\n94\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\n(2)Foreign exchange forwards/options have increased due to hedging of future intercompany loan.\nThe following tables summarize the effects of derivative instruments on our Consolidated Statements of Income (Loss) and Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2020 and 2019:\n| Gain (Loss)Recognized in OCI(Effective Portion) (3) |\n| Cash Flow Hedges - Millions of dollars | 2020 | 2019 |\n| Commodity swaps/options | $ | 22 | $ | ( 4 ) |\n| Foreign exchange forwards/options | 9 | 60 |\n| Cross-currency swaps | ( 40 ) | 9 |\n| Interest rate derivatives | ( 34 ) | 6 |\n| Net investment hedges - foreign currency | 1 | 5 |\n| $ | ( 42 ) | $ | 76 |\n| Location of Gain (Loss) Reclassified fromOCI into Earnings(Effective Portion) | Gain (Loss) Reclassified fromOCI into Earnings(Effective Portion)(4) |\n| Cash Flow Hedges - Millions of dollars | 2020 | 2019 |\n| Commodity swaps/options (3) | Cost of products sold | $ | ( 20 ) | $ | ( 22 ) |\n| Foreign exchange forwards/options | Net sales | 7 | ( 4 ) |\n| Foreign exchange forwards/options | Cost of products sold | 30 | 16 |\n| Foreign exchange forwards/options | Interest and sundry (income) expense | ( 54 ) | 73 |\n| Cross-currency swaps | Interest and sundry (income) expense | ( 89 ) | 26 |\n| Interest rate derivatives | Interest expense | — | ( 1 ) |\n| $ | ( 126 ) | $ | 88 |\n| Location of Gain (Loss) Recognized on Derivatives notAccounted for as Hedges | Gain (Loss) Recognized on Derivatives notAccounted for as Hedges (3) |\n| Derivatives not Accounted for as Hedges - Millions of dollars | 2020 | 2019 |\n| Foreign exchange forwards/options | Interest and sundry (income) expense | $ | ( 1 ) | $ | 30 |\n\n(3)Change in gain (loss) recognized in OCI (effective portion) is primarily driven by currency fluctuations and declines in commodity prices and interest rates compared to the prior year. The tax impact of the cash flow hedges was $( 16 ) million and $ 4 million in 2020 and 2019, respectively. The tax impact of the net investment hedges was $ 1 million and $ 2 million in 2020 and 2019, respectively.\n(4)Change in gain (loss) reclassified from OCI into earnings (effective portion) was primarily driven by fluctuations in currency and commodity prices and interest rates compared to prior year.\nFor cash flow hedges, the amount of ineffectiveness recognized in interest and sundry (income) expense was nominal during 2020 and 2019. There were no hedges designated as fair value in 2020 and 2019. The net amount of unrealized gain or loss on derivative instruments included in accumulated other comprehensive income (loss) related to contracts maturing and expected to be realized during the next twelve months is a gain of approximately $ 36 million at December 31, 2020.\n95\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\n(11) FAIR VALUE MEASUREMENTS\nFair value is measured based on an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions market participants would use in pricing an asset or liability. Assets and liabilities measured at fair value are based on a market valuation approach using prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. As a basis for considering such assumptions, a three-tiered fair value hierarchy is established, which prioritizes the inputs used in measuring fair value as follows: (Level 1) observable inputs such as quoted prices in active markets; (Level 2) inputs, other than the quoted prices in active markets that are observable, either directly or indirectly; and (Level 3) unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.\nThe non-recurring fair values represent only those assets whose carrying values were adjusted to fair value during the reporting period. See Note 6 to the Consolidated Financial Statements for additional information on the goodwill and other intangibles impairment during 2020.\nAssets and liabilities measured at fair value on a recurring basis at December 31, 2020 and 2019 are as follows:\n| Total Cost Basis | Quoted Prices InActive Markets forIdentical Assets(Level 1) | Significant OtherObservable Inputs(Level 2) | Total Fair Value |\n| Millions of dollars | 2020 | 2019 | 2020 | 2019 | 2020 | 2019 | 2020 | 2019 |\n| Short-term investments (1) | $ | 2,164 | $ | 1,308 | $ | 1,603 | $ | 398 | $ | 561 | $ | 910 | $ | 2,164 | $ | 1,308 |\n| Net derivative contracts | — | — | — | — | ( 179 ) | 5 | ( 179 ) | 5 |\n\n(1)Short-term investments are primarily comprised of money market funds and highly liquid, low risk investments with initial maturities less than 90 days.\nThe following table summarizes the valuation of our assets measured at fair value on a non-recurring basis as of December 31, 2020 which is the balance sheet date at the end of the period in which the impairment charge was recorded.\n| Fair Value |\n| Millions of dollars | Level 3 |\n| Measured at fair value on a non-recurring basis: | 2020 |\n| Assets: |\n| Indefinite-lived intangible assets (2) | 158 |\n| Total level 3 assets | $ | 158 |\n\n(2)Indefinite-lived intangible assets with a carrying amount of approximately $ 165 million were written down to a fair value of $ 158 million resulting in an impairment charge of $ 7 million.\nOther Intangible Assets\nThe relief-from-royalty method for the quantitative impairment assessment for other intangible assets in the EMEA reporting unit during the fourth quarter of 2020 utilized discount rates ranging from 14.75 % - 15 % and royalty rates ranging from 1.5 % - 3.5 %. Based on the quantitative impairment assessment performed, the carrying value of other intangible assets of Hotpoint* brand, exceeded its fair value, resulting in an impairment charge of € 6 million ($ 7 million) in 2020.\nSee Note 6 to the Consolidated Financial Statements for additional information.\n*Whirlpool ownership of the Hotpoint brand in the EMEA and Asia Pacific regions is not affiliated with the Hotpoint brand sold in the Americas.\n96\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nSouth Africa Business Disposal\nDuring the second quarter of 2019, we entered into an agreement to sell our South Africa business. At the time of the agreement we classified this disposal group as held for sale and recorded it at fair value because it was lower than the carrying amount. Fair value was estimated based on the cash purchase price (Level 2 input) and we recorded an impairment charge of $ 35 million for the write-down of the assets to the fair value of $ 5 million. During the third quarter of 2019, we completed the sale of our South Africa business and adjusted the loss on disposal based on the carrying amount at the closing date. The adjustment was not material to the Consolidated Financial Statements.\nSee Note 17 to the Consolidated Financial Statements for additional information.\nNaples Manufacturing Plant Restructuring Action\nIn the fourth quarter of 2020, the Company ceased production and exited the Naples, Italy manufacturing plant. In connection with these restructuring actions, we recorded an impairment charge of $ 43 million for the write-down of certain assets to their fair value of $ 0 in 2019. Fair value was based on a feasibility study considering future use internally and marketability externally (Level 2 input). These assets were fully impaired because they were determined to have no alternative use or salvage value and insufficient cash flows to support recoverability of the carrying amount.\nSee Note 14 to the Consolidated Financial Statements for additional information.\nOther Fair Value Measurements\nThe fair value of long-term debt (including current maturities) was $ 6.13 billion and $ 5.00 billion at December 31, 2020 and 2019, respectively, and was estimated using a discounted cash flow analysis based on incremental borrowing rates for similar types of borrowing arrangements (Level 2 input).\n(12) STOCKHOLDERS' EQUITY\nComprehensive Income (Loss)\nComprehensive income (loss) primarily includes (1) our reported net earnings (loss), (2) foreign currency translation, including net investment hedges, (3) changes in the effective portion of our open derivative contracts designated as cash flow hedges, (4) changes in our unrecognized pension and other postretirement benefits and (5) changes in fair value of our available for sale marketable securities (prior to the adoption of ASU 2016-01 in 2018).\n97\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nThe following table shows the components of accumulated other comprehensive income (loss) available to Whirlpool at December 31, 2018, 2019, and 2020, and the activity for the years then ended:\n| Millions of dollars | ForeignCurrency | DerivativeInstruments | Pension andPostretirementLiability | MarketableSecurities | Total |\n| December 31, 2017 | $ | ( 1,320 ) | $ | 11 | $ | ( 1,039 ) | $ | 17 | ( 2,331 ) |\n| Unrealized gain (loss) | ( 272 ) | ( 30 ) | — | — | ( 302 ) |\n| Unrealized actuarial gain(loss) and prior service credit (cost) | — | — | ( 48 ) | — | ( 48 ) |\n| Tax effect | ( 15 ) | 7 | 13 | — | 5 |\n| Other comprehensive income (loss), net of tax | ( 287 ) | ( 23 ) | ( 35 ) | — | ( 345 ) |\n| Less: Other comprehensive loss available to noncontrolling interests | 2 | — | — | — | 2 |\n| Other comprehensive income (loss) available to Whirlpool | ( 289 ) | ( 23 ) | ( 35 ) | — | ( 347 ) |\n| Adjustment to beginning accumulated other comprehensive loss | 21 | ( 21 ) | — | ( 17 ) | ( 17 ) |\n| December 31, 2018 | $ | ( 1,588 ) | $ | ( 33 ) | $ | ( 1,074 ) | $ | — | $ | ( 2,695 ) |\n| Unrealized gain (loss) | 54 | ( 17 ) | — | — | 37 |\n| Unrealized actuarial gain (loss) and prior service credit (cost) | — | — | 52 | — | 52 |\n| Tax effect | 2 | 4 | ( 18 ) | — | ( 12 ) |\n| Other comprehensive income (loss), net of tax | 56 | ( 13 ) | 34 | — | 77 |\n| Less: Other comprehensive loss available to noncontrolling interests | — | — | — | — | — |\n| Other comprehensive income (loss) available to Whirlpool | 56 | ( 13 ) | 34 | — | 77 |\n| December 31, 2019 | $ | ( 1,532 ) | $ | ( 46 ) | $ | ( 1,040 ) | $ | — | $ | ( 2,618 ) |\n| Unrealized gain (loss) | ( 385 ) | 83 | — | — | ( 302 ) |\n| Unrealized actuarial gain (loss) and prior service credit (cost) | — | — | 171 | — | 171 |\n| Tax effect | 1 | ( 16 ) | ( 45 ) | — | ( 60 ) |\n| Other comprehensive income (loss), net of tax | ( 384 ) | 67 | 126 | — | ( 191 ) |\n| Less: Other comprehensive loss available to noncontrolling interests | 2 | — | — | — | 2 |\n| Other comprehensive income (loss) available to Whirlpool | ( 386 ) | 67 | 126 | — | ( 193 ) |\n| December 31, 2020 | $ | ( 1,918 ) | $ | 21 | $ | ( 914 ) | $ | — | $ | ( 2,811 ) |\n\n98\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nNet Earnings per Share\nDiluted net earnings per share of common stock include the dilutive effect of stock options and other share-based compensation plans. Basic and diluted net earnings per share of common stock were calculated as follows:\n| Millions of dollars and shares | 2020 | 2019 | 2018 |\n| Numerator for basic and diluted earnings per share – net earnings (loss) available to Whirlpool | $ | 1,081 | $ | 1,184 | $ | ( 183 ) |\n| Denominator for basic earnings per share – weighted-average shares | 62.7 | 63.7 | 67.2 |\n| Effect of dilutive securities – stock-based compensation | 0.6 | 0.5 | — |\n| Denominator for diluted earnings per share – adjusted weighted-average shares | 63.3 | 64.2 | 67.2 |\n| Anti-dilutive stock options/awards excluded from earnings per share | 1.3 | 1.3 | 1.9 |\n\nDividends\nDividends per share paid to shareholders were $ 4.85 , $ 4.75 and $ 4.55 during 2020, 2019 and 2018, respectively.\nShare Repurchase Program\nOn July 25, 2017, our Board of Directors authorized an additional share repurchase program of up to $ 2 billion. For the year ended December 31, 2020, we repurchased 902,000 shares at an aggregate purchase price of approximately $ 121 million under this program. At December 31, 2020, there were approximately $ 531 million in remaining funds authorized under this program.\nShare repurchases are made from time to time on the open market as conditions warrant. The program does not obligate us to repurchase any of our shares and it has no expiration date.\n(13) SHARE-BASED INCENTIVE PLANS\nWe sponsor several share-based employee incentive plans. Share-based compensation expense for grants awarded under these plans was $ 67 million, $ 50 million and $ 51 million in 2020, 2019, and 2018, respectively. Related income tax benefits recognized in earnings were $ 9 million, $ 6 million and $ 9 million in 2020, 2019, and 2018, respectively.\nAt December 31, 2020, unrecognized compensation cost related to non-vested stock option and stock unit awards totaled $ 77 million. The cost of these non-vested awards is expected to be recognized over a weighted-average remaining vesting period of 28 months.\nShare-Based Employee Incentive Plans\nOn April 17, 2018, our stockholders approved the 2018 Omnibus Stock and Incentive Plan (\"2018 OSIP\"). This plan was adopted by our Board of Directors on February 20, 2018 and provides for the issuance of stock options, performance stock units, and restricted stock units, among other award types. No new awards may be granted under the 2018 OSIP after the tenth anniversary of the date that the stockholders approved the plan. However, the term and exercise of awards granted before then may extend beyond that date. At December 31, 2020, approximately 3.2 million shares remain available for issuance under the 2018 OSIP.\nStock Options\nEligible employees may receive stock options as a portion of their total compensation. Such options generally become exercisable over a 3-year period in substantially equal increments, expire 10 years from the date of grant and are subject to forfeiture upon termination of employment, other than by death, Disability, Retirement, or with the consent of the Committee (as defined in the award\n99\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nagreement). We use the Black-Scholes option-pricing model to measure the fair value of stock options granted to employees. Granted options have exercise prices equal to the market price of Whirlpool common stock on the grant date. The principal assumptions used in valuing options include: (1) risk-free interest rate - an estimate based on the yield of United States zero coupon securities with a maturity equal to the expected life of the option; (2) expected volatility - an estimate based on the historical volatility of Whirlpool common stock for a period equal to the expected life of the option; and (3) expected option life - an estimate based on historical experience. Stock options are expensed on a straight-line basis, net of estimated forfeitures. Based on the results of the model, the weighted-average grant date fair value of stock options granted for 2020, 2019, and 2018 were $ 29.53 , $ 27.89 and $ 38.34 , respectively, using the following assumptions:\n| Weighted Average Black-Scholes Assumptions | 2020 | 2019 | 2018 |\n| Risk-free interest rate | 1.4 | % | 2.5 | % | 2.6 | % |\n| Expected volatility | 29.3 | % | 28.5 | % | 28.2 | % |\n| Expected dividend yield | 3.2 | % | 3.4 | % | 2.6 | % |\n| Expected option life, in years | 5 | 5 | 5 |\n\nStock Option Activity\nThe following table summarizes stock option activity during 2020:\n| In thousands, except per share data | Numberof Options | Weighted-AverageExercise Price |\n| Outstanding at January 1 | 2,387 | $ | 144.01 |\n| Granted | 268 | 152.16 |\n| Exercised | ( 308 ) | 142.42 |\n| Canceled or expired | ( 79 ) | 172.70 |\n| Outstanding at December 31 | 2,268 | $ | 144.54 |\n| Exercisable at December 31 | 1,753 | $ | 142.38 |\n\nThe total intrinsic value of stock options exercised was $ 13 million, $ 4 million and $ 30 million for 2020, 2019, and 2018, respectively. The related tax benefits were $ 3 million, $ 1 million and $ 7 million for 2020, 2019, and 2018, respectively. Cash received from the exercise of stock options was $ 44 million, $ 8 million, and $ 17 million for 2020, 2019, and 2018, respectively.\nThe table below summarizes additional information related to stock options outstanding at December 31, 2020:\n| Options in thousands / dollars in millions, except per-share data | Outstanding Net ofExpected Forfeitures | OptionsExercisable |\n| Number of options | 2,169 | 1,753 |\n| Weighted-average exercise price per share | $ | 144.50 | $ | 142.38 |\n| Aggregate intrinsic value | $ | 85 | $ | 74 |\n| Weighted-average remaining contractual term, in years | 5 | 3 |\n\nStock Units\nEligible employees may receive restricted stock units or performance stock units as a portion of their total compensation.\nRestricted stock units are typically granted to selected management employees on an annual basis and vest over three years . Periodically, restricted stock units may be granted to selected employees based on special recognition or retention circumstances and generally vest from three years to seven years . Previously granted awards accrue dividend equivalents on outstanding units (in the\n100\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nform of additional stock units) based on dividends declared on Whirlpool common stock. These awards convert to unrestricted common stock at the conclusion of the vesting period.\nPerformance stock units are granted to management employees on an annual basis and generally vest at the end of a three year performance period, converting to unrestricted common stock at the conclusion of the vesting period. The final award may equal 0 % to 200 % of the target grant, based on Whirlpool performance results relative to pre-established goals.\nWe measure compensation cost for stock units based on the closing market price of Whirlpool common stock at the grant date, with adjustments for performance stock units to reflect the final award granted. The weighted average grant date fair values of awards granted during 2020, 2019, and 2018 were $ 141.38 , $ 127.26 and $ 157.09 , respectively. The total fair value of stock units vested during 2020, 2019, and 2018 was $ 37 million, $ 28 million and $ 29 million, respectively.\nThe following table summarizes stock unit activity during 2020:\n| Stock units in thousands, except per-share data | Number ofStock Units | Weighted- AverageGrant Date FairValue |\n| Non-vested, at January 1 | 805 | $ | 144.48 |\n| Granted | 550 | 141.38 |\n| Canceled | ( 108 ) | 133.51 |\n| Vested and transferred to unrestricted | ( 244 ) | 153.48 |\n| Non-vested, at December 31 | 1,003 | $ | 139.62 |\n\nNon-employee Director Equity Awards\nIn 2020, each non-employee director received an annual grant of unrestricted Whirlpool common stock, with the number of shares issued to the director determined by dividing $ 145,000 by the closing price of Whirlpool common stock on the date of the annual meeting of our stockholders.\n(14) RESTRUCTURING CHARGES\nWe periodically take action to improve operating efficiencies, typically in connection with business acquisitions or changes in the economic environment. Our footprint and headcount reductions and organizational integration actions relate to discrete, unique restructuring events, primarily reflected in the following plans:\nOn June 26, 2020, the Company committed to a workforce reduction plan in the United States, as part of the Company's continued cost reduction efforts. The workforce reduction plan included a voluntary retirement program and involuntary severance actions which were effective as of the end of the second quarter of 2020. These actions were substantially completed in 2020 and the Company incurred $ 102 million in employee termination costs related to these actions. The remaining cash settlement of $ 39 million will occur throughout 2021, 2022 and 2023.\nDuring the third quarter, the Company committed to additional workforce reductions outside of the United States, as part of the Company's previously announced continued cost reduction efforts. The company incurred $ 74 million of the approximately $ 148 million total costs in 2020 and the remaining expense will occur in 2021. Cash settlement of $ 50 million was paid in 2020 with the remaining cash settlement expected to be paid in 2021.\nOn May 31, 2019, we announced our intention to reconvert our Naples, Italy manufacturing plant and potentially sell the plant to a third party. On September 16, 2019, we entered into a preliminary agreement to sell the plant to a third-party purchaser and to support costs associated with the transition. In October 2019, we announced that, based on further discussions with unions and the Italian government, we would continue production at the Naples manufacturing plant in the near-term and resume negotiations with unions and the Italian government related to our exit of the plant. Our preliminary agreement to sell the plant to a third-party purchaser terminated in\n101\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\naccordance with its terms in March 2020. We ceased production in the plant and exited the facility in 2020 as previously disclosed.\nIn connection with this action, we have incurred approximately $ 131 million total costs comprised of $ 43 million in asset impairment costs, $ 22 million in other associated costs and $ 66 million in employee-related costs through December 31, 2020. The Company expects all of the remaining $ 71 million cash settlement to occur in 2021.\nIn 2018, we announced actions in EMEA to reduce fixed costs by $ 50 million. The initiatives primarily included headcount reductions throughout the EMEA region. Additionally, we exited domestic sales operations in Turkey in 2019. These combined actions from 2018-2020 totaled $ 83 million and were complete as of June 30, 2020.\nThe following tables summarize the changes to our restructuring liability for the years ended December 31, 2020 and 2019:\n| Millions of dollars | 12/31/2019 | Charges to Earnings | Cash Paid | Non-Cash and Other | 12/31/2020 |\n| Employee termination costs | $ | 57 | $ | 253 | $ | ( 165 ) | $ | — | $ | 145 |\n| Asset impairment costs | 8 | 1 | — | ( 1 ) | 8 |\n| Facility exit costs | — | 4 | ( 4 ) | — | — |\n| Other exit costs | 12 | 30 | ( 27 ) | 5 | 20 |\n| Total | $ | 77 | $ | 288 | $ | ( 196 ) | $ | 4 | $ | 173 |\n\n| Millions of dollars | 12/31/2018 | Charge to Earnings | Cash Paid | Non-cash and Other | 12/31/2019 |\n| Employee termination costs | $ | 84 | $ | 84 | $ | ( 111 ) | $ | — | $ | 57 |\n| Asset impairment costs | — | 74 | ( 7 ) | ( 59 ) | 8 |\n| Facility exit costs | ( 9 ) | 22 | ( 23 ) | — | — |\n| Other exit costs | 21 | 8 | ( 5 ) | ( 2 ) | 12 |\n| Total | $ | 96 | $ | 188 | $ | ( 146 ) | $ | ( 61 ) | $ | 77 |\n\nThe following table summarizes 2020 restructuring charges by operating segment:\n| Millions of dollars | 2020 Charges |\n| North America | $ | 81 |\n| EMEA | 154 |\n| Latin America | 20 |\n| Asia | 10 |\n| Corporate / Other | 23 |\n| Total | $ | 288 |\n\n102\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\n(15) INCOME TAXES\nIncome tax expense was $ 384 million, $ 354 million, and $ 138 million in 2020, 2019 and 2018, respectively. The increase in tax expense in 2020 compared to 2019 is primarily due to changes in valuation allowance, legal entity restructuring tax benefits, and earnings dispersion related to the sale of Embraco.\nThe increase in tax expense in 2019 compared to 2018 is primarily due to higher earnings before tax, reduced foreign tax credits and the sale of Embraco, offset by net reductions in valuation allowances, and impacts from a legal entity restructuring. As part of ongoing efforts to reduce costs and simplify the Company's legal entity structure, the Company has completed a statutory legal entity restructuring within our EMEA business. The completion of the restructuring created a tax-deductible loss which was recognized in the fourth quarter of 2019, and resulted in a $ 147 million tax benefit.\nThe following table summarizes the difference between an income tax benefit at the United States statutory rate of 21% in 2020, 2019, and 2018, respectively, and the income tax expense at effective worldwide tax rates for the respective periods:\n| Millions of dollars | 2020 | 2019 | 2018 |\n| Earnings (loss) before income taxes |\n| United States | $ | 1,028 | $ | 674 | $ | 729 |\n| Foreign | 427 | 878 | ( 750 ) |\n| Earnings (loss) before income taxes | $ | 1,455 | $ | 1,552 | $ | ( 21 ) |\n| Income tax (benefit) expense computed at United States statutory rate | $ | 306 | $ | 326 | $ | ( 4 ) |\n| U.S. government tax incentives | ( 17 ) | ( 21 ) | ( 11 ) |\n| Foreign government tax incentives, including BEFIEX | ( 20 ) | ( 13 ) | ( 21 ) |\n| Foreign tax rate differential | 30 | 70 | ( 24 ) |\n| U.S. foreign tax credits | ( 25 ) | ( 86 ) | ( 260 ) |\n| Valuation allowances | 15 | ( 150 ) | 75 |\n| State and local taxes, net of federal tax benefit | 40 | 42 | 23 |\n| Foreign withholding taxes | 8 | 54 | 24 |\n| U.S. tax on foreign dividends and subpart F income | 34 | 67 | 72 |\n| Settlements and changes in unrecognized tax benefits | 53 | 113 | 72 |\n| U.S. Transition Tax | — | 26 | 40 |\n| Changes in enacted tax rates | ( 6 ) | 42 | ( 54 ) |\n| Nondeductible goodwill | — | — | 139 |\n| Nondeductible fines & penalties | — | — | 30 |\n| Sale of Embraco | — | 58 | — |\n| Legal entity restructuring tax impact | ( 82 ) | ( 147 ) | — |\n| Other items, net | 48 | ( 27 ) | 37 |\n| Income tax computed at effective worldwide tax rates | $ | 384 | $ | 354 | $ | 138 |\n\n103\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nCurrent and Deferred Tax Provision\nThe following table summarizes our income tax (benefit) provision for 2020, 2019 and 2018:\n| 2020 | 2019 | 2018 |\n| Millions of dollars | Current | Deferred | Current | Deferred | Current | Deferred |\n| United States | $ | 90 | $ | 83 | $ | 203 | $ | 74 | $ | ( 70 ) | $ | 120 |\n| Foreign | 182 | ( 24 ) | 432 | ( 406 ) | 182 | ( 119 ) |\n| State and local | 42 | 11 | 42 | 9 | 12 | 13 |\n| $ | 314 | $ | 70 | $ | 677 | $ | ( 323 ) | $ | 124 | $ | 14 |\n| Total income tax expense | $ | 384 | $ | 354 | $ | 138 |\n\nUnited States Government Tax Legislation\nOn December 22, 2017, H.R.1 (the “Tax Cuts and Jobs Act”) was signed into law. Significant provisions impacting Whirlpool's 2017 and 2018 effective tax rate include the reduction in corporate tax rate from 35% to 21% effective in 2018, a one-time deemed repatriation (“Transition Tax”) on earnings of certain foreign subsidiaries that were previously tax deferred, and the creation of new taxes on certain foreign sourced earnings.\nAt December 31, 2017, pursuant to the SEC guidance under SAB118, the Company made a reasonable estimate of the provisional effects of the rate reduction on its existing deferred tax balances and the impact of the one-time Transition Tax. At December 31, 2018, the Company revised these estimated amounts and recognized an additional tax benefit in the amount of $ 54 million on the difference between the 2017 U.S. enacted tax rate of 35%, and the 2018 enacted tax rate of 21%, primarily related to a $ 350 million tax deductible pension plan contribution included on the Company's 2017 U.S. Corporation income tax return. The Company recognized additional tax expense of $ 95 million related to the Transition Tax, including $ 55 million of unrecognized tax benefits during the fourth quarter.\nFor the full year 2019, we recognized $ 26 million related to prior years resulting from the one time transition tax deemed repatriation on earnings of certain foreign subsidiaries that were previously tax deferred and related impacts. At December 31, 2019, we have recognized $ 299 million tax expense related to the Transition Tax, net of unrecognized tax benefits and other correlative adjustments. During 2019, the government issued additional clarifying regulations related to tax reform. As a result, the Company recorded an additional income tax liability related to an uncertain tax position in the amount of $ 117 million.\nUnited States Tax on Foreign Dividends\nWe have historically reinvested all unremitted earnings of the majority of our foreign subsidiaries and affiliates, and therefore have not recognized any U.S. deferred tax liability on those earnings. However, upon the enactment of the Tax Cuts and Jobs Act, the unremitted earnings and profits of our foreign subsidiaries and affiliates, subsequent to 1986, are subject to U.S. tax under the Transition Tax provision. Under the Transition Tax provision, the Company recognized a deemed remittance of $ 3.5 billion. The Company had cash and cash equivalents of approximately $ 2.9 billion at December 31, 2020, of which $ 1.6 billion was held by subsidiaries in foreign countries. Our intent is to permanently reinvest substantially all of these funds outside of the United States and our current plans do not demonstrate a need to repatriate the cash to fund our U.S. operations. However, if these funds were repatriated, they would likely not be subject to United States federal income tax under the previously taxed income or the dividend exemption rules. We would likely be required to accrue and pay United States state and local taxes and withholding taxes payable to various countries. It is not practicable to estimate the tax impact of the reversal of the outside basis difference, or the repatriation of cash due to the complexity of its hypothetical calculation.\n104\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nValuation Allowances\nAt December 31, 2020, we had net operating loss carryforwards of $ 5.9 billion, $ 512 million of which were U.S. state net operating loss carryforwards. Of the total net operating loss carryforwards, $ 3.7 billion do not expire, with substantially all of the remaining carryforwards expiring in various years through 2037. At December 31, 2020, we had $ 680 million of United States general business credit carryforwards available to offset future payments of federal income taxes, expiring between 2030 and 2040.\nWe routinely review the future realization of deferred tax assets based on projected future reversal of taxable temporary differences, available tax planning strategies and projected future taxable income. We have recorded a valuation allowance to reflect the net estimated amount of certain deferred tax assets associated with net operating loss and other deferred tax assets we believe will be realized. Our recorded valuation allowance of $ 214 million at December 31, 2020 consists of $ 126 million of net operating loss carryforward deferred tax assets and $ 88 million of other deferred tax assets. Our recorded valuation allowance was $ 192 million at December 31, 2019 and consisted of $ 111 million of net operating loss carryforward deferred tax assets and $ 81 million of other deferred tax assets. The increase in our valuation allowance includes $ 15 million recognized in net earnings, with the remaining change related to reclassification within our net deferred tax asset. During 2019, the Company used proceeds from a bond offering to recapitalize various entities in EMEA which resulted in a reduction in the valuation allowance. In addition, the Company has established tax planning strategies and transfer pricing policies to provide sufficient future taxable income to realize these deferred tax assets. We believe that it is more likely than not that we will realize the benefit of existing deferred tax assets, net of valuation allowances mentioned above.\n105\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nDeferred Tax Liabilities and Assets\nDeferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities used for financial reporting purposes and the amounts used for income tax purposes. The following table summarizes the significant components of our deferred tax liabilities and assets at December 31, 2020 and 2019:\n| Millions of dollars | 2020 | 2019 |\n| Deferred tax liabilities |\n| Intangibles | $ | 461 | $ | 439 |\n| Property, net | 196 | 175 |\n| Right of use assets | 265 | 238 |\n| LIFO inventory | 88 | 89 |\n| Other | 252 | 215 |\n| Total deferred tax liabilities | $ | 1,262 | $ | 1,156 |\n| Deferred tax assets |\n| U.S. general business credit carryforwards, including Energy Tax Credits | $ | 680 | $ | 787 |\n| Lease liabilities | 275 | 242 |\n| Pensions | 114 | 66 |\n| Loss carryforwards | 1,336 | 1,226 |\n| Postretirement obligations | 49 | 145 |\n| Foreign tax credit carryforwards | 25 | 39 |\n| Research and development capitalization | 121 | 133 |\n| Employee payroll and benefits | 118 | 96 |\n| Accrued expenses | 96 | 93 |\n| Product warranty accrual | 76 | 78 |\n| Receivable and inventory allowances | 112 | 72 |\n| Other | 646 | 574 |\n| Total deferred tax assets | 3,648 | 3,551 |\n| Valuation allowances for deferred tax assets | ( 214 ) | ( 192 ) |\n| Deferred tax assets, net of valuation allowances | 3,434 | 3,359 |\n| Net deferred tax assets | $ | 2,172 | $ | 2,203 |\n\n106\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nUnrecognized Tax Benefits\nThe following table represents a reconciliation of the beginning and ending amount of unrecognized tax benefits that if recognized would impact the effective tax rate, excluding federal benefits of state and local tax positions, and interest and penalties:\n| Millions of dollars | 2020 | 2019 | 2018 |\n| Balance, January 1 | $ | 394 | $ | 278 | $ | 219 |\n| Additions for tax positions of the current year | 17 | 20 | 21 |\n| Additions for tax positions of prior years | 21 | 138 | 60 |\n| Reductions for tax positions of prior years | ( 2 ) | ( 26 ) | ( 5 ) |\n| Settlements during the period | — | ( 4 ) | ( 8 ) |\n| Lapses of applicable statute of limitation | ( 3 ) | ( 12 ) | ( 9 ) |\n| Balance, December 31 | $ | 427 | $ | 394 | $ | 278 |\n\nInterest and penalties associated with unrecognized tax benefits resulted in a net expense of $ 10 million at December 31, 2020, a net benefit of $( 4 ) million and net expense of $ 2 million in 2019 and 2018, respectively. We have accrued a total of $ 52 million, $ 42 million and $ 46 million at December 31, 2020, 2019 and 2018, respectively.\nIt is reasonably possible that certain unrecognized tax benefits of $ 4 million could be settled with various related jurisdictions during the next 12 months.\nWe are in various stages of tax disputes (including audits, appeals and litigation) with certain governmental tax authorities. We establish liabilities for the difference between tax return provisions and the benefits recognized in our financial statements. Such amounts represent a reasonable provision for taxes ultimately expected to be paid, and may need to be adjusted over time as more information becomes known. We are no longer subject to any significant tax disputes (including audits, appeals and litigation) for the years before 2009 relating to US Federal income taxes and for the years before 2003 relating to any state, local or foreign income taxes.\nOther Income Tax Matters\nDuring its examination of Whirlpool’s 2009 U.S. federal income tax return, the IRS asserted that income earned by a Luxembourg subsidiary via its Mexican branch should be recognized as income on its 2009 U.S. federal income tax return. The Company believed the proposed assessment was without merit and contested the matter in United States Tax Court (U.S. Tax Court). Both Whirlpool and the IRS moved for partial summary judgment on this issue. On May 5, 2020, the U.S. Tax Court granted the IRS’s motion for partial summary judgment and denied Whirlpool’s. The Company has appealed the U.S. Tax Court decision to the United States Sixth Circuit Court of Appeals. The Company believes that it will be successful upon appeal and has not recorded any impact of the U.S. Tax Court’s decision in its consolidated financial statements.\n(16) SEGMENT INFORMATION\nOur reportable segments are based upon geographic region and are defined as North America, EMEA, Latin America and Asia. These regions also represent our operating segments. Each segment manufactures home appliances and related components, but serves strategically different marketplaces. The chief operating decision maker evaluates performance based upon each segment's earnings (loss) before interest and taxes (EBIT), which we define as operating profit less interest and sundry (income) expense and excluding restructuring costs, asset impairment charges and certain other items that management believes are not indicative of the region's ongoing performance, if any. Total assets by segment are those assets directly associated with the respective operating activities. The \"Other/Eliminations\" column primarily includes corporate expenses, assets and eliminations, as well as restructuring costs, asset impairments and certain other items that management believes are not indicative of the region's ongoing performance, if any. Intersegment\n107\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nsales are eliminated within each region except compressor sales out of Latin America through June 30, 2019, which are included in Other/Eliminations.\nSales to Lowe's, a North American retailer, represented approximately 13 %, 13 % and 12 % of our consolidated net sales in 2020, 2019 and 2018, respectively. Lowe's represented approximately 14 % of our consolidated accounts receivable as of December 31, 2020 and 2019, respectively.\nThe United States individually comprised at least 10% of consolidated net sales in 2020, 2019 and 2018 in the amounts of $ 10.3 billion, $ 10.7 billion and $ 10.6 billion, respectively.\nThe following table summarizes the countries that represent at least 10% of consolidated long-lived assets for the years ended December 31, 2020 and 2019. Long-lived assets includes property, plant and equipment and right-of-use assets at December 31, 2020 and 2019.\n| Millions of dollars | United States | Mexico | Italy | Poland | All Other Countries | Total |\n| 2020 |\n| Long-lived assets | $ | 1,790 | $ | 403 | $ | 526 | $ | 428 | $ | 1,040 | $ | 4,187 |\n| 2019 |\n| Long-lived assets | $ | 1,816 | $ | 431 | $ | 505 | $ | 422 | $ | 1,048 | $ | 4,222 |\n\n| OPERATING SEGMENTS |\n| Millions of dollars | NorthAmerica | EMEA | LatinAmerica | Asia | Other/Eliminations | TotalWhirlpool |\n| Net sales |\n| 2020 | $ | 11,210 | $ | 4,389 | $ | 2,592 | $ | 1,265 | $ | — | $ | 19,456 |\n| 2019 | 11,477 | 4,296 | 3,177 | 1,515 | ( 46 ) | 20,419 |\n| 2018 | 11,374 | 4,536 | 3,618 | 1,587 | ( 78 ) | 21,037 |\n| Intersegment sales |\n| 2020 | $ | 249 | $ | 93 | $ | 1,227 | $ | 379 | $ | ( 1,948 ) | $ | — |\n| 2019 | 238 | 83 | 1,321 | 334 | ( 1,976 ) | — |\n| 2018 | 267 | 101 | 1,313 | 358 | ( 2,039 ) | — |\n| Depreciation and amortization |\n| 2020 | $ | 193 | $ | 177 | $ | 62 | $ | 70 | $ | 66 | $ | 568 |\n| 2019 | 195 | 187 | 65 | 67 | 73 | 587 |\n| 2018 | 196 | 204 | 111 | 72 | 62 | 645 |\n| EBIT |\n| 2020 | $ | 1,766 | $ | 2 | $ | 219 | $ | ( 7 ) | $ | ( 336 ) | $ | 1,644 |\n| 2019 | 1,462 | ( 30 ) | 172 | 33 | 102 | 1,739 |\n| 2018 | 1,342 | ( 106 ) | 210 | 83 | ( 1,358 ) | 171 |\n| Total assets |\n| 2020 | $ | 7,511 | $ | 11,296 | $ | 4,244 | $ | 2,573 | $ | ( 5,274 ) | $ | 20,350 |\n| 2019 | 7,791 | 9,450 | 4,226 | 2,581 | ( 5,167 ) | 18,881 |\n| 2018 | 7,161 | 7,299 | 4,745 | 2,636 | ( 3,494 ) | 18,347 |\n| Capital expenditures |\n| 2020 | $ | 137 | $ | 116 | $ | 64 | $ | 50 | $ | 43 | $ | 410 |\n| 2019 | 179 | 124 | 97 | 80 | 52 | 532 |\n| 2018 | 180 | 154 | 110 | 71 | 75 | 590 |\n\n108\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nThe following table summarizes the reconciling items in the Other/Eliminations column for total EBIT for the periods presented:\n| Twelve Months Ended December 31, |\n| in millions | 2020 | 2019 | 2018 |\n| Items not allocated to segments: |\n| Restructuring costs | $ | ( 288 ) | $ | ( 188 ) | $ | ( 247 ) |\n| Corrective action recovery | 14 | — | — |\n| Gain (loss) on sale and disposal of businesses | 7 | 437 | — |\n| Product warranty and liability income (expense) | 30 | ( 131 ) | — |\n| Sale-leaseback, real estate and receivable adjustment | 113 | 86 | — |\n| Trade customer insolvency claim settlement | — | ( 59 ) | — |\n| Brazil indirect tax credit | — | 180 | — |\n| Impairment of goodwill and intangibles | — | — | ( 747 ) |\n| French antitrust settlement | — | — | ( 103 ) |\n| Trade customer insolvency | — | — | ( 30 ) |\n| Divestiture related transition costs | — | — | ( 21 ) |\n| Corporate expenses and other | ( 212 ) | ( 223 ) | ( 210 ) |\n| Total other/eliminations | $ | ( 336 ) | $ | 102 | $ | ( 1,358 ) |\n\nA reconciliation of our segment information for total EBIT to the corresponding amounts in the Consolidated Statements of Income (Loss) is shown in the table below for the periods presented:\n| Twelve Months Ended December 31, |\n| in millions | 2020 | 2019 | 2018 |\n| Operating profit | $ | 1,623 | $ | 1,571 | $ | 279 |\n| Interest and sundry (income) expense | ( 21 ) | ( 168 ) | 108 |\n| Total EBIT | $ | 1,644 | $ | 1,739 | $ | 171 |\n| Interest expense | 189 | 187 | 192 |\n| Income tax expense | 384 | 354 | 138 |\n| Net earnings (loss) | $ | 1,071 | $ | 1,198 | $ | ( 159 ) |\n| Less: Net earnings (loss) available to noncontrolling interests | ( 10 ) | 14 | 24 |\n| Net earnings (loss) available to Whirlpool | $ | 1,081 | $ | 1,184 | $ | ( 183 ) |\n\n(17) DIVESTITURES AND HELD FOR SALE\nWhirlpool China Partial Tender Offer\nOn August 25, 2020, Guangdong Galanz Household Appliances Manufacturing Co., Ltd. (“Galanz”) announced its intention to pursue a partial tender offer for majority control of Whirlpool China Co. Ltd. (“Whirlpool China”), a majority-owned subsidiary of the Company with shares listed on the Shanghai Stock Exchange. In its announcement, Galanz notes that it expects to offer RMB 5.23 per share (approximately $ 0.76 per share as of August 25, 2020) to obtain no less than 51 % and no more than 61 % of Whirlpool China’s outstanding shares. This share price offer is equal to the daily weighted average trading price for Whirlpool China stock over the 30 trading days prior to the announcement.\nThe Company is considering the terms of the offer and other aspects of this potential strategic relationship along with any potential impact on the Company's financial statements and other aspects of its operations. Formal partial tender offer is not expected until regulatory approvals are obtained, and the regulatory approval process remains ongoing. If an offer is launched, tender of our shares is subject to Company board approval of the transaction. We have not recorded any impact relating to this announcement as of December 31, 2020.\n109\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\nEmbraco Sale Transaction\nOn April 23, 2018, our Board of Directors approved the sale of Embraco and we subsequently entered into an agreement to sell the compressor business for a cash purchase price of $ 1.08 billion, subject to customary adjustments including for indebtedness, cash and working capital at closing.\nOn July 1, 2019, we completed the sale of Embraco and received cash proceeds of $ 1.1 billion inclusive of anticipated cash on hand at the time of closing. With the proceeds from this transaction, we repaid the outstanding term loan amount of approximately $ 1 billion as required under the April 23, 2018 Term Loan Agreement with Citibank, N.A., as Administrative Agent.\nIn connection with the sale, we recorded a pre-tax gain, net of transaction and other costs, of $ 511 million ($ 350 million net of taxes) during the twelve months ended December 31, 2019. The gain calculation is no longer subject to change, as amounts for working capital and other customary post-closing adjustments have been finalized. An immaterial adjustment related to final purchase price was recorded in 2020.\nEmbraco was reported within our Latin America reportable segment and met the criteria for held for sale accounting through the closing date. The operations of Embraco did not meet the criteria to be presented as discontinued operations. The assets and liabilities of Embraco were de-consolidated as of the closing date and there are no remaining carrying amounts in the Consolidated Balance Sheets at December 31, 2019.\nThe following table summarizes Embraco's earnings before income taxes for the twelve months ended December 31, 2020, 2019 and 2018:\n| Millions of dollars | 2020 | 2019 | 2018 |\n| Earnings before income taxes | $ | — | $ | 47 | $ | 53 |\n\nSouth Africa Business Disposal\nOn June 28, 2019, we entered into an agreement to sell our South Africa operations for a cash purchase price of $ 5 million, subject to customary adjustments at closing.\nOn September 5, 2019, we completed the sale of our South Africa operations. In connection with the sale, we finalized the loss on disposal of $ 63 million which is recorded in the year ended December 31, 2019. The loss includes a charge of $ 29 million for the write-down of the assets of the disposal group to fair value and $ 34 million of cumulative foreign currency translation adjustments included in the carrying amount of the disposal group to calculate the impairment.\nThe South Africa business was reported within our EMEA reportable segment and met the criteria for held for sale accounting through the closing date. The operations of South Africa did not meet the criteria to be presented as discontinued operations.\nSee Note 11 to the Consolidated Financial Statements for additional information.\nDivestiture of Turkey Domestic Sales Operations\nFor the year ended December 31, 2019, we incurred approximately $ 11 million of divestiture related costs, primarily inventory liquidation costs, related to the exit from our domestic sales operations in Turkey.\nSee Note 14 to the Consolidated Financial Statements for additional information.\n110\nNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)\n(18) QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)\n| Three months ended |\n| December 31, | September 30, | June 30, | March 31, |\n| Millions of dollars, except per share data | 2020(4) | 2019(3) | 2020 | 2019(2) | 2020 | 2019 | 2020 | 2019 |\n| Net sales | $ | 5,798 | $ | 5,382 | $ | 5,291 | $ | 5,091 | $ | 4,042 | $ | 5,186 | $ | 4,325 | $ | 4,760 |\n| Cost of products sold | 4,434 | 4,334 | 4,136 | 4,350 | 3,411 | 4,254 | 3,625 | 3,948 |\n| Gross margin | 1,364 | 1,048 | 1,155 | 741 | 631 | 932 | 700 | 812 |\n| Operating profit (loss) | 716 | 424 | 570 | 693 | 77 | 191 | 260 | 263 |\n| Interest and sundry (income) expense | 17 | 54 | ( 22 ) | ( 29 ) | ( 15 ) | ( 63 ) | ( 1 ) | ( 130 ) |\n| Net earnings (loss) | 501 | 288 | 398 | 364 | 25 | 72 | 147 | 474 |\n| Net earnings (loss) available to Whirlpool | 497 | 288 | 397 | 358 | 35 | 67 | 152 | 471 |\n| Per share of common stock:(1) |\n| Basic net earnings (loss) | $ | 7.90 | $ | 4.56 | $ | 6.35 | $ | 5.62 | $ | 0.55 | $ | 1.04 | $ | 2.42 | $ | 7.36 |\n| Diluted net earnings (loss) | 7.77 | 4.52 | 6.27 | 5.57 | 0.55 | 1.04 | 2.41 | 7.31 |\n| Dividends | 1.25 | 1.20 | 1.20 | 1.20 | 1.20 | 1.20 | 1.20 | 1.15 |\n\n(1)The quarterly earnings per share amounts will not necessarily add to the earnings per share computed for the year due to the method used in calculating per share data.\n(2)The operating profit and net earnings for the three months ended September 30, 2019 includes a gain on sale and disposal of businesses of $ 437 million, a $ 180 million gain related to Brazil indirect tax credits and a $ 105 million charge related to product warranty expense on EMEA- produced washers. See Note 8, Note 11, Note 14 and Note 17 to the Consolidated Financial Statements for additional information.\n(3)The gross margin for the three months ended December 31, 2019 includes a gain of $ 95 million related to a sale and leaseback transaction. See Note 1 to the Consolidated Financial Statements for additional information.\n(4)The gross margin for the three months ended December 31, 2020 includes a gain of $ 113 million related to a sale and leaseback transaction. See Note 1 to the Consolidated Financial Statements for additional information.\n111\nITEM 9.\nCHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE\nNone.\nITEM 9A.\nCONTROLS AND PROCEDURES\nDisclosure controls and procedures. Whirlpool maintains disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended (the \"Securities Exchange Act\")) that are designed to provide reasonable assurance that information required to be disclosed in our filings under the Securities Exchange Act is recorded, processed, summarized, and reported within the periods specified in the rules and forms of the SEC and that such information is accumulated and communicated to Whirlpool's management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.\nPrior to filing this report, we completed an evaluation under the supervision and with the participation of Whirlpool management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of December 31, 2020. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level as of December 31, 2020.\nManagement's annual report on internal control over financial reporting. Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 and the rules and regulations adopted pursuant thereto, we included a report of management's assessment of the effectiveness of our internal control over financial reporting as part of this report. Management's report is included on page 110 of this report under the caption entitled \"Management's Report on Internal Control Over Financial Reporting\" and is incorporated herein by reference.\nOur internal control over financial reporting as of December 31, 2020 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report, which is included on page 114 of this report under the caption entitled \"Report of Independent Registered Public Accounting Firm\" and is incorporated herein by reference.\nThere were no changes in our internal control over financial reporting during the quarter ended December 31, 2020 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\nITEM 9B.\nOTHER INFORMATION\nNone.\n112\n| PART III |\n\nITEM 10.\nDIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE\nInformation regarding our executive officers is included in ITEM 1 of PART I of this report under \"Information About Our Executive Officers.\"\nInformation regarding the background of the directors, matters related to the Audit Committee, Section 16(a) compliance, and the process by which our shareholders may recommend nominees to our Board of Directors can be found under the captions \"Directors and Nominees for Election as Directors,\" \"Board of Directors and Corporate Governance - Board of Directors and Committees,\" \"Delinquent Section 16(a) Reports,\" and \"Board of Directors and Corporate Governance - Director Nominations by Stockholders\" in the proxy statement, which will be filed pursuant to SEC Regulation 14A not later than 120 days after the end of the Company's fiscal year ended December 31, 2020 (\"Proxy Statement\").\nWe have adopted a code of ethics that applies to all of our employees, officers and directors, including our principal executive officer, principal financial officer and principal accounting officer. The text of our code of ethics, titled \"Our Integrity Manual\", is posted on our website at whirlpoolcorp.com/ethics. Whirlpool intends to disclose future amendments to, or waivers from, certain provisions of the code of ethics for executive officers and directors on this website within four business days following the date of such amendment or waiver. Stockholders may request a free copy of the Integrity Manual from:\nInvestor Relations\nWhirlpool Corporation\n2000 North M-63\nMail Drop 2609\nBenton Harbor, MI 49022-2692\nTelephone: (269) 923-2641\nWhirlpool has also adopted Corporate Governance Guidelines and written charters for its Audit, Finance, Human Resources and Corporate Governance and Nominating Committees, all of which are posted on our website: whirlpoolcorp.com (scroll to the bottom of the main page and click on \"Policies.\") Stockholders may request a free copy of the charters and guidelines from the address or telephone number set forth above.\nITEM 11.\nEXECUTIVE COMPENSATION\nInformation regarding compensation of our executive officers and directors can be found under the captions \"Non-employee Director Compensation,\" \"Compensation Discussion and Analysis,\" \"2020 Executive Compensation Tables,\" \"Pay Ratio Disclosure,\" \"Compensation Risk Assessment,\" and \"Human Resources Committee Interlocks and Insider Participation\" in the Proxy Statement, which is incorporated herein by reference. See also the information under the caption \"Human Resources Committee Report\" in the Proxy Statement, which is incorporated herein by reference; however, such information is only \"furnished\" hereunder and not deemed \"soliciting material\" or \"filed\" with the SEC or subject to Regulation 14A or 14C or to the liabilities of Section 18 of the Securities Exchange Act of 1934.\n113\nITEM 12.\nSECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS\nInformation regarding the security ownership of any person that we know to beneficially own more than 5% of Whirlpool stock and by each Whirlpool director, each Whirlpool named executive officer, and all directors and executive officers as a group, can be found under the captions \"Security Ownership\" and \"Beneficial Ownership\" in the Proxy Statement, which is incorporated herein by reference. Information relating to securities authorized under equity compensation plans can be found under the caption \"Equity Compensation Plan Information\" in the Proxy Statement, which is incorporated herein by reference.\nITEM 13.\nCERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE\nInformation regarding certain relationships and related transactions (if any) and the independence of Whirlpool's directors, can be found under the captions \"Related Person Transactions\" and \"Board of Directors and Corporate Governance - Board of Directors and Committees\" in the Proxy Statement, which is incorporated herein by reference.\nITEM 14.\nPRINCIPAL ACCOUNTING FEES AND SERVICES\nInformation regarding our auditors and the Audit Committee's pre-approval policies can be found under the caption \"Matters Relating to Independent Registered Public Accounting Firm\" in the Proxy Statement, which is incorporated herein by reference.\n114\n| PART IV |\n\nITEM 15.\nEXHIBITS, FINANCIAL STATEMENT SCHEDULES\n(a) The following documents are filed as a part of this report:\n1. Financial statements\n| PAGE |\n| Consolidated Statements of Income (Loss) | 55 |\n| Consolidated Statements of Comprehensive Income (Loss) | 56 |\n| Consolidated Balance Sheets | 57 |\n| Consolidated Statements of Cash Flows | 58 |\n| Consolidated Statements of Changes in Stockholders' Equity | 59 |\n| Notes to the Consolidated Financial Statements | 60 |\n| Report by Management on the Consolidated Financial Statements | 123 |\n| Report of Independent Registered Public Accounting Firm | 125 |\n\n2. Financial Statement Schedules - \"Schedule II - Valuation and Qualifying Accounts\" is contained on page 129 of this report. Certain schedules for which provisions are made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted.\n(b) The exhibits listed in the \"Exhibit Index\" is contained on page 115 of this report.\n(c) Individual financial statements of the registrant's affiliated foreign companies, accounted for by the equity method, have been omitted since no such company individually constitutes a significant subsidiary.\n| ITEM 16. | Form 10-K Summary |\n\nNone.\n115\nANNUAL REPORT ON FORM 10-K\nITEMS 15(a)(3) and 15(c)\nEXHIBIT INDEX\nYEAR ENDED DECEMBER 31, 2020\nThe following exhibits are submitted herewith or incorporated herein by reference in response to Items 15(a)(3) and 15(c). Each exhibit that is considered a management contract or compensatory plan or arrangement required to be filed pursuant to Item 15(a)(3) of Form 10-K is identified by a \"(Z).\"\n| Number and Description of Exhibit |\n| 2(i)** | Purchase Agreement dated April 24, 2018 by and among Whirlpool Corporation, certain subsidiaries thereof, and Nidec Corporation [Incorporated by reference from Exhibit 2.1 to the Company's Form 8-K (Commission file number 1-3932) filed on April 24, 2018] |\n| 2(ii)** | Amendment dated May 3, 2019 to Purchase Agreement dated April 24, 2018 by and among Whirlpool Corporation, certain subsidiaries thereof, and Nidec Corporation [Incorporated by reference from Exhibit 2.1 to the Company's Form 10-Q (Commission file number 1-3932) for the quarter ended June 30, 2019] |\n| 3(i) | Restated Certificate of Incorporation of Whirlpool Corporation (amended and restated as of April 22, 2009) [Incorporated by reference from Exhibit 3.1 to the Company's Form 8-K (Commission file number 1-3932) filed on April 23, 2009] |\n| 3(ii) | By-Laws of Whirlpool Corporation (amended and restated effective October 18, 2016) [Incorporated by reference from Exhibit 3.2 to the Company's Form 8-K (Commission file number 1-3932) filed on October 21, 2016] |\n| 4(i) | The registrant hereby agrees to furnish to the Securities and Exchange Commission, upon request, a copy of instruments defining the rights of holders of each issue of long-term debt of the registrant and its subsidiaries. |\n| 4(ii) | Indenture dated as of April 15, 1990 between Whirlpool Corporation and Citibank, N.A. [Incorporated by reference from Exhibit 4(a) to the Company's Registration Statement on Form S-3 (Commission file number 33-40249) filed on May 6, 1991] |\n| 4(iii) | Indenture dated as of March 20, 2000 between Whirlpool Corporation and U.S. Bank, National Association (as successor to Citibank, N.A.) [Incorporated by reference from Exhibit 4(a) to the Company's Registration Statement on Form S-3 (Commission file number 333-32886) filed on March 21, 2000] |\n| 4(iv) | Indenture dated as of June 15, 1987 between Maytag Corporation and The First National Bank of Chicago [Incorporated by reference from Maytag Corporation's Quarterly Report on Form 10-Q (Commission file number 1-00655) for the quarter ended June 30, 1987] |\n| 4(v) | Ninth Supplemental Indenture dated as of October 30, 2001 between Maytag Corporation and Bank One, National Association [Incorporated by reference from Exhibit 4.1 to Maytag Corporation's Form 8-K (Commission file number 1-00655) filed on October 31, 2001] |\n\n116\n| 4(vi) | Tenth Supplemental Indenture dated as of December 30, 2010, between Maytag Corporation, Whirlpool Corporation and The Bank of New York Mellon Trust Company, N.A. [Incorporated by reference from Exhibit 4(vi) to the Company's Annual Report on Form 10-K (Commission file number 1-3932) for the fiscal year ended December 31, 2010] |\n| 4(vii) | Indenture, dated November 2, 2016, among Whirlpool Finance Luxembourg S.à. r.l., Whirlpool Corporation and U.S. Bank National Association [Incorporated by reference from Exhibit 4.1 to the Company's Form 8-K (Commission file number 1-3932) filed on November 2, 2016] |\n| 4(viii)* | Description of Whirlpool Corporation's securities |\n| 4(ix) | Indenture, dated February 21, 2020, among Whirlpool EMEA Finance S.à. r.l., Whirlpool Corporation and U.S. National Bank Association [Incorporated by reference from Exhibit 4.1 to the Company’s Form 8-K (Commission file number 1-3932) filed on February 21, 2020]. |\n| 10(i)(a) | Fourth Amended and Restated Long Term Credit Agreement dated as of August 6, 2019 among Whirlpool Corporation, Whirlpool Europe B.V., Whirlpool Canada Holding Co., Whirlpool Global B.V., Whirlpool UK Appliances Limited, the other borrowers party thereto, the lenders party thereto, JPMorgan Chase Bank, N.A., as Administrative Agent, Citibank, N.A., as Syndication Agent, and BNP Paribas, Mizuho Bank, Ltd. and Wells Fargo Bank, National Association, as Documentation Agents [Incorporated by reference from Exhibit 10.2 to the Company's Form 10-Q (Commission file number 1-3932) for the quarter ended September 30, 2019] |\n| 10(i)(b) | 364-Day Credit Agreement dated as of April 27, 2020 among Whirlpool Corporation, the lenders party thereto, and Citibank, N.A., as Administrative Agent [Incorporated by reference from Exhibit 10.1 to the Company’s Form 10-Q (Commission file number 1-3932) for the quarter ended March 31, 2020]. |\n| 10(iii)(a) | Whirlpool Corporation Nonemployee Director Stock Ownership Plan (amended as of February 16, 1999, effective April 20, 1999) (Z) [Incorporated by reference from Exhibit A to the Company's Proxy Statement (Commission file number 1-3932) for the 1999 annual meeting of stockholders] |\n| 10(iii)(b) | Whirlpool Corporation Charitable Award Contribution and Additional Life Insurance Plan for Directors (effective April 20, 1993) (Z) [Incorporated by reference from Exhibit 10(iii)(p) to the Company's Annual Report on Form 10-K (Commission file number 1-3932) for the fiscal year ended December 31, 1994] |\n| 10(iii)(c) | Whirlpool Corporation Deferred Compensation Plan for Directors (as amended effective January 1, 1992 and April 20, 1993) (Z) [Incorporated by reference from Exhibit 10(iii)(f) to the Company's Annual Report on Form 10-K (Commission file number 1-3932) for the fiscal year ended December 31, 1993] |\n| 10(iii)(d) | Whirlpool Corporation Deferred Compensation Plan II for Non-Employee Directors (as amended and restated, effective January 1, 2009) (Z) [Incorporated by reference from Exhibit 10(iii)(e) to the Company's Annual Report on Form 10-K (Commission file number 1-3932) for the fiscal year ended December 31, 2008] |\n| 10(iii)(e) | Whirlpool Corporation Nonemployee Director Equity Plan (effective January 1, 2005) (Z) [Incorporated by reference from Exhibit 99.1 to the Company's Form 8-K (Commission file number 1-3932) filed on April 21, 2005] |\n\n117\n| 10(iii)(f) | Amendment of the Whirlpool Corporation Nonemployee Director Equity Plan (effective January 1, 2008) (Z) [Incorporated by reference to Exhibit 10(iii)(a) to the Company's Quarterly Report on Form 10-Q (Commission file number 1-3932) filed on April 24, 2008] |\n| 10(iii)(g) | Nonemployee Director Stock Option Form of Agreement (Z) [Incorporated by reference from Exhibit 10(iii)(b) to the Company's Quarterly Report on Form 10-Q (Commission file number 1-3932) filed on April 24, 2008] |\n| 10(iii)(h) | Nonemployee Director Stock Option Form of Agreement (Z) [Incorporated by reference from Exhibit 10.2 to the Company's Form 8-K (Commission file number 1-3932) filed on April 26, 2010] |\n| 10(iii)(i) | Whirlpool Corporation 2007 Omnibus Stock and Incentive Plan (effective January 1, 2007) (Z) [Incorporated by reference from Annex A to the Company's Proxy Statement (Commission file number 1-3932) for the 2007 annual meeting of stockholders filed on March 12, 2007] |\n| 10(iii)(j) | Omnibus Equity Plans 409A Amendment (effective December 19, 2008) (Z) [Incorporated by reference from Exhibit 10(iii)(n) to the Company's Annual Report on Form 10-K (Commission file number 1-3932) for the fiscal year ended December 31, 2008] |\n| 10(iii)(k) | Whirlpool Corporation 2010 Omnibus Stock and Incentive Plan (Z) [Incorporated by reference from Exhibit 10.1 to the Company's Form 8-K (Commission file number 1-3932) filed on April 26, 2010] |\n\n| 10(iii)(l) | Whirlpool Corporation Amended and Restated 2010 Omnibus Stock and Incentive Plan (Z) [Incorporated by reference from Exhibit 10.1 to the Company's Registration Statement on Form S-8 (Commission file number 333-187948) filed on April 16, 2013] |\n| 10(iii)(m) | Form of Agreement for the Whirlpool Corporation Career Stock Grant Program (pursuant to one or more of Whirlpool's Omnibus Stock and Incentive Plans) (Z) [Incorporated by reference from Exhibit 10(iii)(q) to the Company's Annual Report on Form 10-K (Commission file number 1-3932) for the fiscal year ended December 31, 1995] |\n| 10(iii)(n) | Form of Amendment to Whirlpool Corporation Career Stock Grant Agreement (Z) [Incorporated by reference from Exhibit 10(iii)(p) to the Company's Annual Report on Form 10-K (Commission file number 1-3932) for the fiscal year ended December 31, 2008] |\n| 10(iii)(o) | Form of Stock Option Grant Document for the Whirlpool Corporation Stock Option Program (pursuant to one or more of Whirlpool's Omnibus Stock and Incentive Plans)(Rev. 02/17/04) (Z) [Incorporated by reference from Exhibit 10(i) to the Company's Form 8-K (Commission file number 1-3932) filed on January 25, 2005] |\n| 10(iii)(p) | Form of Restricted Stock Unit Agreement (pursuant to one or more of Whirlpool's Omnibus Stock and Incentive Plans) (Z) [Incorporated by reference from Exhibit 10.1 to the Company's Form 8-K (Commission file number 1-3932) filed on June 21, 2010] |\n| 10(iii)(q) | Whirlpool Corporation 2010 Omnibus Stock and Incentive Plan Restricted Stock Unit Award (Z) [Incorporated by reference from Exhibit 10(iii)(a) to the Company's Form 10-Q (Commission file number 1-3932) for the quarter ended March 31, 2011] |\n\n118\n| 10(iii)(r) | Whirlpool Corporation 2010 Omnibus Stock and Incentive Plan Strategic Excellence Program Performance Unit Award (Z) [Incorporated by reference from Exhibit 10(iii)(b) to the Company's Form 10-Q (Commission file number 1-3932) for the quarter ended March 31, 2011] |\n| 10(iii)(s) | Whirlpool Corporation 2010 Omnibus Stock and Incentive Plan Strategic Excellence Program Stock Option Grant (Z) [Incorporated by reference from Exhibit 10(iii)(c) to the Company's Form 10-Q (Commission file number 1-3932) for the quarter ended March 31, 2011] |\n| 10(iii)(t) | Whirlpool Corporation 2010 Omnibus Stock and Incentive Plan Strategic Excellence Program Restricted Stock Unit Award (Z) [Incorporated by reference from Exhibit 10(iii)(d) to the Company's Form 10-Q (Commission file number 1-3932) for the quarter ended March 31, 2011] |\n| 10(iii)(u) | Whirlpool Corporation 2010 Omnibus Stock and Incentive Plan Strategic Excellence Program Stock Option Grant Document (Z) [Incorporated by reference from Exhibit 10(iii)(a) to the Company's form 10-Q (Commission file number 1-3932) for the quarter ended March 31, 2012] |\n| 10(iii)(v) | Whirlpool Corporation 2010 Omnibus Stock and Incentive Plan Strategic Excellence Program Performance Restricted Stock Unit / Performance Unit Grant Document (Z) [Incorporated by reference from Exhibit 10(iii)(b) to the Company's form 10-Q (Commission file number 1-3932) for the quarter ended March 31, 2012] |\n| 10(iii)(w) | Whirlpool Corporation Amended and Restated 2010 Omnibus Stock and Incentive Plan Strategic Excellence Program Performance Unit Award for Executive Chairman (Z) [Incorporated by reference from Exhibit 10.2 to the Company's Form 10-Q (Commission file number 1-3932) for the quarter ended March 31, 2018] |\n| 10(iii)(x) | Whirlpool Corporation 2018 Omnibus Stock and Incentive Plan (Z) [Incorporated by reference from Exhibit 10.1 to the Company's Form 8-K (Commission file number 1-3932) filed on April 18, 2018] |\n| 10(iii)(y) | Form of Compensation and Benefits Assurance Agreements (Z) [Incorporated by reference from Exhibit 10.1 to the Company's Form 8-K (Commission file number 1-3932) filed on August 23, 2010] |\n| 10(iii)(z) | Whirlpool Corporation Executive Deferred Savings Plan (as amended effective January 1, 1992) (Z) [Incorporated by reference from Exhibit 10(iii)(n) to the Company's Annual Report on Form 10-K (Commission file number 1-3932) for the fiscal year ended December 31, 1993] |\n| 10(iii)(aa) | Whirlpool Corporation Executive Deferred Savings Plan II (as amended and restated, effective January 1, 2009), including Supplement A, Whirlpool Executive Restoration Plan (as amended and restated, effective January 1, 2009) (Z) [Incorporated by reference from Exhibit 10(iii)(y) to the Company's Annual Report on Form 10-K (Commission file number 1-3932) for the fiscal year ended December 31, 2008] |\n| 10(iii)(bb) | Amendment to the Whirlpool Corporation Executive Deferred Savings Plan II (dated December 21, 2009) (Z) [Incorporated by reference from Exhibit 10(iii)(x) to the Company's Annual Report on Form 10-K (Commission file number 1-3932) for the fiscal year ended December 31, 2009] |\n\n119\n| 10(iii)(cc) | Whirlpool Retirement Benefits Restoration Plan (as amended and restated effective January 1, 2009) (Z) [Incorporated by reference from Exhibit 10(iii)(dd) to the Company's Annual Report on Form 10-K (Commission file number 1-3932) for the fiscal year ended December 31, 2008] |\n| 10(iii)(dd) | Whirlpool Supplemental Executive Retirement Plan (as amended and restated, effective January 1, 2009) (Z) [Incorporated by reference from Exhibit 10(iii)(ee) to the Company's Annual Report on Form 10-K (Commission file number 1-3932) for the fiscal year ended December 31, 2008] |\n| 10(iii)(ee) | Whirlpool Corporation Form of Indemnity Agreement (Z) [Incorporated by reference from Exhibit 10.1 to the Company's Form 8-K (Commission file number 1-3932) filed on February 23, 2006] |\n| 10(iii)(ff) | Whirlpool Corporation Performance Excellence Plan (Z) [Incorporated by reference from Exhibit 10(iii)(a) to the Company's Quarterly Report on Form 10-Q (Commission file number 1-3932) for the quarter ended March 31, 2014] |\n| 10(iii)(gg) | Whirlpool Corporation 2014 Executive Performance Excellence Plan (Z) [Incorporated by reference from Exhibit 10.1 to the Company's Form 8-K (Commission file number 1-3932) filed on April 17, 2014] |\n| 10(iii)(hh) | Agreement dated May 1, 2012 by and between Whirlpool Corporation and Mr. João Carlos Costa Brega (Z) [Incorporated by reference from Exhibit 10(iii)(ii) to the Company's Annual Report on Form 10-K (Commission file number 1-3932) for the fiscal year ended December 31, 2015] |\n| 10(iii)(ii) | Permanent Employment Contract dated April 1, 2019, between Whirlpool EMEA S.p.A. and Gilles Morel (Z) [Incorporated by reference from Exhibit 10(iii)(ii) to the Company’s Annual Report on Form 10-K (Commission file number 1-3932) for the fiscal year ended December 31, 2019] |\n| 10(iii)(jj) | Whirlpool Corporation 2018 Omnibus Stock and Incentive Plan Strategic Excellence Program Performance Restricted Stock Unit Award Document (Z) [Incorporated by reference from Exhibit 10.1 to the Company's Form 10-Q (Commission file number 1-3932) for the quarter ended March 31, 2019] |\n| 10(iii)(kk) | Whirlpool Corporation 2018 Omnibus Stock and Incentive Plan Strategic Excellence Program Stock Option Grant Document (Z) [Incorporated by reference from Exhibit 10.2 to the Company's Form 10-Q (Commission file number 1-3932) for the quarter ended March 31, 2019] |\n| 10(iii)(ll) | Whirlpool Corporation 2018 Omnibus Stock and Incentive Plan Strategic Excellence Program Restricted Stock Unit Award Document (Z) [Incorporated by reference from Exhibit 10.3 to the Company's Form 10-Q (Commission file number 1-3932) for the quarter ended March 31, 2019] |\n| 10(iii)(mm) | Aircraft Time Sharing Agreement dated as of July 29, 2019 by and between Whirlpool Corporation and Marc Bitzer [Incorporated by reference from Exhibit 10.1 to the Company's Form 10-Q (Commission file number 1-3932) for the quarter ended September 30, 2019] |\n| 21* | List of Subsidiaries |\n| 23* | Consent of Independent Registered Public Accounting Firm |\n\n120\n| 24* | Power of Attorney |\n| 31.1* | Certification of Chief Executive Officer, Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2* | Certification of Chief Financial Officer, Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32* | Certifications Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS* | XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document |\n| 101.SCH* | Inline XBRL Taxonomy Extension Schema Document |\n| 101.CAL* | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF* | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB* | Inline XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE* | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104* | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\n\n* Filed Herewith\n** Schedules (or similar attachments) have been omitted pursuant to Item 601(a)(5) of Regulation S-K. The Company will furnish supplementally copies of such omitted schedules (or similar attachments) to the Securities and Exchange Commission upon request.\n121\nSIGNATURES\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n| WHIRLPOOL CORPORATION(Registrant) |\n| By: | /s/ JAMES W. PETERS | February 11, 2021 |\n| James W. PetersExecutive Vice President and Chief Financial Officer |\n\nPursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated.\n| Signature | Title |\n| /s/ MARC R. BITZER | Chairman of the Board, President and Chief Executive Officer(Principal Executive Officer) |\n| Marc R. Bitzer |\n| /s/ JAMES W. PETERS | Executive Vice President and Chief Financial Officer(Principal Financial Officer) |\n| James W. Peters |\n| /s/ CHRISTOPHER S. CONLEY | Vice President and Corporate Controller(Principal Accounting Officer) |\n| Christopher S. Conley |\n| SAMUEL R. ALLEN* | Director |\n| Samuel R. Allen |\n| GREG CREED* | Director |\n| Greg Creed |\n| GARY T. DICAMILLO* | Director |\n| Gary T. DiCamillo |\n| DIANE M. DIETZ* | Director |\n| Diane M. Dietz |\n| GERRI T. ELLIOTT* | Director |\n| Gerri T. Elliott |\n| JENNIFER A. LACLAIR* | Director |\n| Jennifer A. LaClair |\n| JOHN D. LIU* | Director |\n| John D. Liu |\n| JAMES M. LOREE* | Director |\n| James M. Loree |\n| HARISH MANWANI* | Director |\n| Harish Manwani |\n| PATRICIA K. POPPE* | Director |\n| Patricia K. Poppe |\n| LARRY O. SPENCER* | Director |\n| Larry O. Spencer |\n| MICHAEL D. WHITE* | Director |\n| Michael D. White |\n\n| *By: | /s/ JAMES W. PETERS | Attorney-in-Fact | February 11, 2021 |\n| James W. Peters |\n\n122\nREPORT BY MANAGEMENT ON THE CONSOLIDATED FINANCIAL STATEMENTS\nThe management of Whirlpool Corporation has prepared the accompanying financial statements. The financial statements have been audited by Ernst & Young LLP, an independent registered public accounting firm, whose report, based upon their audits, expresses the opinion that these financial statements present fairly the consolidated financial position, statements of income and cash flows of Whirlpool and its subsidiaries in accordance with accounting principles generally accepted in the United States. Their audits are conducted in conformity with the auditing standards of the Public Company Accounting Oversight Board (United States).\nThe financial statements were prepared from the Company's accounting records, books and accounts which, in reasonable detail, accurately and fairly reflect all material transactions. The Company maintains a system of internal controls designed to provide reasonable assurance that the Company's books and records, and the Company's assets are maintained and accounted for, in accordance with management's authorizations. The Company's accounting records, compliance with policies and internal controls are regularly reviewed by an internal audit staff.\nThe audit committee of the Board of Directors of the Company is composed of six independent directors who, in the opinion of the board, meet the relevant financial experience, literacy, and expertise requirements. The audit committee provides independent and objective oversight of the Company's accounting functions and internal controls and monitors (1) the integrity of the Company's financial statements, (2) the Company's compliance with legal and regulatory requirements, (3) the independent registered public accounting firm's qualifications and independence, and (4) the performance of the Company's internal audit function and independent registered public accounting firm. In performing these functions, the committee has the responsibility to review and discuss the annual audited financial statements and quarterly financial statements and related reports with management and the independent registered public accounting firm, including the Company's disclosures under \"Management's Discussion and Analysis of Financial Condition and Results of Operations,\" to monitor the adequacy of financial disclosure. The committee also has the responsibility to retain and terminate the Company's independent registered public accounting firm and exercise the committee's sole authority to review and approve all audit engagement fees and terms and pre-approve the nature, extent, and cost of all non-audit services provided by the independent registered public accounting firm.\n| /s/ JAMES W. PETERS |\n| James W. Peters |\n| Executive Vice President and Chief Financial Officer |\n| February 11, 2021 |\n\n123\nMANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING\nThe management of Whirlpool Corporation is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a – 15(f) and 15d – 15(f) under the Securities Exchange Act of 1934. Whirlpool's internal control system is designed to provide reasonable assurance to Whirlpool's management and board of directors regarding the reliability of financial reporting and the preparation and fair presentation of published financial statements.\nAll internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.\nThe management of Whirlpool assessed the effectiveness of Whirlpool's internal control over financial reporting as of December 31, 2020. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control—Integrated Framework (2013 Framework). Based on the assessment and those criteria, management believes that Whirlpool maintained effective internal control over financial reporting as of December 31, 2020.\nWhirlpool's independent registered public accounting firm has issued an audit report on its assessment of Whirlpool's internal control over financial reporting. This report appears on page 114.\n| /s/ MARC R. BITZER | /s/ JAMES W. PETERS |\n| Marc R. Bitzer | James W. Peters |\n| Chairman of the Board, President and Chief Executive Officer | Executive Vice President and Chief Financial Officer |\n| February 11, 2021 | February 11, 2021 |\n\n124\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\nTo the Shareholders and Board of Directors of Whirlpool Corporation\nOpinion on the Financial Statements\nWe have audited the accompanying consolidated balance sheets of Whirlpool Corporation (the Company) as of December 31, 2020 and 2019, the related consolidated statements of income (loss), comprehensive income (loss), stockholders' equity and cash flows for each of the three years in the period ended December 31, 2020, and the related notes and financial statement schedule listed in the index at Item 15(a) (collectively referred to as the \"consolidated financial statements\"). In our opinion, the consolidated financial statements present fairly, in all material respects, the consolidated financial position of the Company at December 31, 2020 and 2019, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2020, in conformity with U.S. generally accepted accounting principles.\nWe also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 11, 2021 expressed an unqualified opinion thereon.\nBasis for Opinion\nThese financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.\nWe conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.\nCritical Audit Matters\nThe critical audit matters communicated below are matters arising from the current period audit of the consolidated financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the consolidated financial statements and (2) involved our especially challenging, subjective or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate.\n125\nValuation of Europe, Middle East, and Africa (EMEA) Reporting Unit Goodwill and Certain Indefinite Lived Intangible Assets\n| Description of the Matter | At December 31, 2020, the balance of the Company’s goodwill related to the EMEA reporting unit was $329 million and the balance of the Hotpoint and JennAir indefinite lived brand intangible asset was $158 million and $304 million, respectively. As discussed in Note 1, Note 6, and Note 11 to the consolidated financial statements, goodwill and indefinite lived intangible assets are tested for impairment at least annually or when impairment indicators are present at the reporting unit or intangible asset level, respectively. Auditing management’s assessment of the estimated fair value of the EMEA reporting unit goodwill was complex and required the involvement of valuation specialists due to the judgmental nature of the assumptions utilized in the valuation process. The fair value estimate was sensitive to significant assumptions such as revenue growth, EBIT margins and the discount rate. The estimate also included assumptions related to the terminal growth rate, tax rate, capital expenditures, depreciation and amortization and changes in working capital requirements. In addition, auditing management’s assessment of the estimated fair value of both the Hotpoint and JennAir indefinite lived brand intangible assets was complex and required the involvement of valuation specialists due to the judgmental nature of the assumptions used in the valuation process. The fair value estimate was sensitive to significant assumptions such as future revenue, royalty rate and discount rate. The estimate also included assumptions related to the tax rate. |\n| How We Addressed the Matter in Our Audit | We obtained an understanding, evaluated the design and tested the operating effectiveness of controls over the Company’s goodwill and indefinite lived intangible asset fair value assessment process. This included testing controls over management’s review over the projected financial information and other key assumptions used in the valuation model as well as controls over the carrying value of the EMEA reporting unit and both the Hotpoint and JennAir brand intangibles. To test the estimated fair value of goodwill related to the EMEA reporting unit as well as the Hotpoint and JennAir indefinite lived brand intangible assets, we performed audit procedures that included, among others, assessing methodologies used in the model and testing the significant assumptions discussed above. This included comparing the significant assumptions used by management to current industry and economic trends, changes to the Company’s business model, customer base or product mix and other relevant factors. We assessed the reasonableness of management’s projections used in the fair value calculation and obtained support for initiatives supporting these projections. We also compared previous forecasts to actual results to assess management’s forecasting process. For example, for forecasted revenue we compared the revenue growth assumptions to the Company’s historical growth rate, external economic and industry data, and various business plans designed to grow revenue. To assess the discount rate, we reviewed the methodology used by the Company and considered each input relative to current economic factors. We involved valuation specialists to assist in evaluating the key assumptions and methodologies. We performed sensitivity analyses of significant assumptions to evaluate the changes in the fair value of the EMEA reporting unit and the indefinite lived intangible assets that would result from changes in the assumptions. In addition, we tested the mathematical accuracy of the model. |\n\n126\nValuation of Unrecognized Income Tax Benefits and Indirect Tax Matters\n| Description of the Matter | As of December 31, 2020, the Company has Unrecognized Income Tax Benefits and indirect tax matters as described in Note 8 and Note 15 to the consolidated financial statements, respectively. These matters also include assessments disclosed in the BEFIEX Credits and Other Brazil Tax Matters section of Note 8 of $488 million related to Brazilian income tax and indirect tax matters. As described in Note 15, the Company has unrecognized tax benefits of $427 million. The Company records the benefits of an uncertain tax position in the consolidated financial statements after determining it is more likely than not that the uncertain tax position will be sustained upon examination based on its technical merits. The Company accrues liabilities for the contingencies which relate to indirect tax matters when a loss probable and the amount or range of loss is reasonably estimable. Auditing management’s accounting and disclosure for these unrecognized tax benefits and indirect tax matters was complex because the evaluation is based on interpretations of domestic and international tax laws, is subjective, requires significant judgment and often requires the use of subject matter resources to assist in the evaluation. |\n\n| How We Addressed the Matter in Our Audit | We identified and tested controls that address the risk of material misstatement relating to the valuation of these income tax and indirect tax matters. This included, among others, testing controls over the Company’s process to assess the technical merits and measurement of these positions. We also tested the Company’s process to determine the disclosure for these matters.With the assistance of our income tax professionals and subject matter resources, we performed audit procedures that included, among others, evaluating the technical merits, measurement and related disclosure for the Company’s positions. For example, we assessed the inputs utilized and the conclusions reached in the assessments performed by the management, and compared the methods used to alternative methods. We also reviewed certain legal opinions obtained from external advisors and internal legal counsel, examined the Company’s communications with the relevant tax authorities and read the minutes of the meetings of the committees of the board of directors. In addition, we used our knowledge of historical settlement activity, tax laws, and other market information to evaluate the technical merits of the Company’s positions. Furthermore, we monitored leading cases within the respective jurisdictions to determine if precedence set in those rulings impacted the Company’s cases and we monitored external sources for any information which could impact these cases. |\n\n127\nRevenue Recognition - Completeness and Valuation of Customer Sales Incentives (Promotions Liabilities)\n| Description of the Matter | At December 31, 2020, the Company’s accrued promotional liability was $831 million. As discussed in Note 2 to the consolidated financial statements, the Company recognizes a reduction to revenue and a corresponding accrued promotional liability based on the amount of customer sales incentives to be paid to trade customers. This estimate is accounted for as a reduction to revenue in the period incurred and primarily calculated using the expected value method. Auditing the accrued promotions liability was complex and subjective due to the large volume of activity, the manual nature of adjustments made to the liability in certain countries, and the inherent estimation uncertainty in the process performed to estimate the reduction to revenue and corresponding promotional liability. In addition, assessing the completeness of the accrual required significant auditor judgment. |\n| How We Addressed the Matter in Our Audit | We obtained an understanding, evaluated the design and tested the operating effectiveness of controls over the completeness and valuation of the reduction to revenue and corresponding promotional liability. For example, we tested controls over management’s review of adjustments to the accrual, as well as their review of significant assumptions to the accrual, including the validation of third-party sales data.Our audit procedures over completeness and valuation included, among others, testing a sample of key inputs to the promotional liability, including reviewing key customer contractual agreements and third-party sales data. We performed testing over activity subsequent to the balance sheet date to determine the impact, if any, these items have on the 2020 financial statements. In addition, to assess management’s estimation accuracy, we perform a lookback analysis which compares the amount accrued in the prior year to the amount subsequently paid. We also performed analytical procedures on a disaggregated level and performed inquiries of sales personnel and key finance management personnel. In addition, we sent confirmations to third parties, which included confirmation of the sales incentive amounts owed to customers. |\n\n/s/ Ernst & Young LLP\nWe have served as the Company's auditor since 1927.\nChicago, Illinois\nFebruary 11, 2021\n128\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\nTo the Shareholders and Board of Directors of Whirlpool Corporation\nOpinion on Internal Control over Financial Reporting\nWe have audited Whirlpool Corporation's internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, Whirlpool Corporation (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on the COSO criteria.\nWe also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2020 and 2019, the related consolidated statements of income (loss), comprehensive income (loss), stockholders' equity and cash flows for each of the three years in the period ended December 31, 2020, and the related notes and financial statement schedule listed in the index at Item 15(a) and our report dated February 11, 2021 expressed an unqualified opinion thereon.\nBasis for Opinion\nThe Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.\nWe conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.\nOur audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.\nDefinition and Limitations of Internal Control Over Financial Reporting\nA company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.\nBecause of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.\n/s/ Ernst & Young LLP\nChicago, Illinois\nFebruary 11, 2021\n129\nSCHEDULE II—VALUATION AND QUALIFYING ACCOUNTS\nWHIRLPOOL CORPORATION AND SUBSIDIARIES\nYears Ended December 31, 2020, 2019 and 2018\n(Millions of dollars)\n| COL. A | COL. B | COL. C | COL. D | COL. E |\n| Description | Balance at Beginningof Period | Charged to Cost andand Expenses | Deductions(1) | Balance at Endof Period |\n| Allowance for doubtful accounts |\n| Year Ended December 31, 2020: | $ | 132 | $ | 42 | $ | ( 42 ) | $ | 132 |\n| Year Ended December 31, 2019: | 136 | 16 | ( 20 ) | 132 |\n| Year Ended December 31, 2018: | 157 | 54 | ( 75 ) | 136 |\n| Deferred tax valuation allowance (2) |\n| Year Ended December 31, 2020: | $ | 192 | $ | 12 | $ | 10 | $ | 214 |\n| Year Ended December 31, 2019: | 348 | ( 150 ) | ( 6 ) | 192 |\n| Year Ended December 31, 2018: | 178 | 75 | 95 | 348 |\n\n(1)With respect to allowance for doubtful accounts, the amounts represent accounts charged off, net of translation adjustments and transfers. In 2018 the amount also includes an adjustment for Embraco compressor business, for additional information refer to Note 17 to the Consolidated Financial Statements. Recoveries were nominal for 2020, 2019 and 2018.\n(2)For additional information about our deferred tax valuation allowances, refer to Note 15 to the Consolidated Financial Statements.\n130\n[THIS PAGE INTENTIONALLY LEFT BLANK]\n</text>\n\nWhat is the average annual growth rate of free cash flow from 2018 to 2020 in percentage?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nFINANCIAL INFORMATION\nITEM 1. FINANCIAL STATEMENTS\nAMERICAN EDUCATION CENTER, INC. AND SUBSIDIARIES\nCONSOLIDATED BALANCE SHEETS\n\n| June 30, | December 31, |\n| ASSETS | 2018 | 2017 |\n| (Unaudited) | (Audited) |\n| Current assets: |\n| Cash | $ | 1,661,001 | $ | 2,720,985 |\n| Accounts receivable, net of allowance for doubtful accounts of $3,520,149 and $249,527 | 5,020,910 | 6,482,289 |\n| at June 30, 2018 and December 31, 2017, respectively |\n| Prepaid expenses | 362,912 | 307,014 |\n| Total current assets | 7,044,823 | 9,510,288 |\n| Noncurrent assets: |\n| Deferred compensation | 1,466,668 | 2,016,668 |\n| Deferred income taxes, net | 44,025 | 25,641 |\n| Intangible asset, net | 374,498 | 442,588 |\n| Security deposits | 266,021 | 266,021 |\n| Total noncurrent assets | 2,151,212 | 2,750,918 |\n| TOTAL ASSETS | $ | 9,196,035 | $ | 12,261,206 |\n| LIABILITIES AND STOCKHOLDERS' EQUITY |\n| Current liabilities: |\n| Accounts payable and accrued expenses | $ | 4,483,647 | $ | 4,070,001 |\n| Taxes payable | 454,466 | 775,220 |\n| Deferred revenue | 299,924 | 20,000 |\n| Advances from clients | 453 | 15,371 |\n| Loan from stockholders | - | - |\n| Total current liabilities | 5,238,490 | 4,880,592 |\n| Noncurrent liabilities: |\n| Deferred rent | 208,054 | 191,542 |\n| Long-term loan | 145,579 | 145,579 |\n| Total liabilities | 5,592,123 | 5,217,713 |\n| Stockholders’ equity: |\n| Preferred stock, $0.001 par value; |\n| 20,000,000 shares authorized; none issued | 500 | 500 |\n| Common stock, $0.001 par value; |\n| 180,000,000 shares authorized; 41,350,000 shares issued and outstanding |\n| at June 30, 2018 and December 31, 2017 | 41,350 | 41,350 |\n| Additional paid-in capital | 6,021,126 | 6,021,126 |\n| Retained earnings | (2,460,907 | ) | 973,764 |\n| Accumulated other comprehensive income | 1,843 | 6,753 |\n| Total stockholders' equity | 3,603,912 | 7,043,493 |\n| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY | $ | 9,196,035 | $ | 12,261,206 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 4 |\n\nAMERICAN EDUCATION CENTER, INC. AND SUBSIDIARIES\nCONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (UNAUDITED)\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2018 | 2017 | 2018 | 2017 |\n| Revenues | $ | 1,768,500 | $ | 5,704,693 | $ | 3,098,801 | $ | 15,163,399 |\n| Cost of revenues | 970,161 | 3,584,877 | 2,016,300 | 9,780,129 |\n| Gross profit | 798,339 | 2,119,816 | 1,082,501 | 5,383,270 |\n| Operating expenses: |\n| Selling and marketing | 49,415 | 1,377,232 | 63,415 | 2,570,003 |\n| General and administrative | 2,239,702 | 715,983 | 4,742,804 | 1,206,584 |\n| Total operating expenses | 2,289,117 | 2,093,215 | 4,806,219 | 3,776,587 |\n| (Loss) income from operations | (1,490,778 | ) | 26,601 | (3,723,718 | ) | 1,606,683 |\n| Other income | 144 | 2 | 672 | 2 |\n| Income before provision for income taxes | (1,490,634 | ) | 26,603 | (3,723,046 | ) | 1,606,685 |\n| Provision (benefit) for income taxes | 120,108 | 114,973 | (288,375 | ) | 465,258 |\n| Net (loss) income | $ | (1,610,742 | ) | $ | (88,370 | ) | $ | (3,434,671 | ) | $ | 1,141,427 |\n| Other comprehensive income |\n| Foreign currency translation loss | (16,394 | ) | - | (4,910 | ) | - |\n| Comprehensive (loss) income | $ | (1,627,136 | ) | (88,370 | ) | $ | (3,439,581 | ) | 1,141,427 |\n| (Loss) earnings per share - basic and diluted | $ | (0.04 | ) | $ | (0.00 | ) | $ | (0.08 | ) | $ | 0.03 |\n| Weighted average shares |\n| outstanding, basic and diluted | 41,350,000 | 41,350,000 | 41,350,000 | 41,350,000 |\n\nSee accompanying notes to consolidated financial statements.\n\n| 5 |\n\nAMERICAN EDUCATION CENTER, INC. AND SUBSIDIARIES\nCONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)\n\n| Six Months Ended June 30, |\n| 2018 | 2017 |\n| Cash flows from operating activities: |\n| Net (loss) income | $ | (3,434,671 | ) | $ | 1,141,427 |\n| Adjustments to reconcile net income to net cash |\n| (Used in) operating activities: |\n| Deferred tax (benefit) provision | (18,384 | ) | 61,669 |\n| Deferred rent expense | 16,512 | 17,770 |\n| Deferred compensation | 550,000 | 585,000 |\n| Bad debt expense | - | 45,300 |\n| Stock issued for services | - | - |\n| Provision for doubtful accounts | 3,270,622 | - |\n| Amortization expense | 68,090 | 68,091 |\n| Change in operating assets and liabilities: |\n| (Increase) in accounts receivable | (1,809,243 | ) | (3,844,260 | ) |\n| (Increase) decrease in prepaid expenses | (55,898 | ) | 26,923 |\n| Increase in accounts payable and accrued expenses | 413,646 | 806,223 |\n| (Decrease) increase in taxes payable | (320,754 | ) | 396,560 |\n| Increase in deferred revenue | 279,924 | 11,820 |\n| Decrease in advances from clients | (14,918 | ) | - |\n| Net cash (used in) operating activities | (1,055,074 | ) | (683,477 | ) |\n| Effect of exchange rates changes on cash | (4,910 | ) | - |\n| Net change in cash | (1,059,984 | ) | (683,477 | ) |\n| Cash at beginning of period | 2,720,985 | 2,290,429 |\n| Cash at end of period | $ | 1,661,001 | $ | 1,606,952 |\n| Supplemental disclosure of cash flow information |\n| Cash paid for income taxes | $ | 25,764 | $ | 6,940 |\n| Cash paid for interest | $ | 3,639 | $ | 7,389 |\n\nSee accompanying notes to consolidated financial statements.\n\n| 6 |\n\nAMERICAN EDUCATION CENTER, INC. AND SUBSIDIARIES\nCONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (UNAUDITED)\nFOR THE THREE MONTHS ENDED June 30, 2018\n\n| Accumulated |\n| Additional | other |\n| Common stock | Preferred Stock | paid-in | Retained | comprehensive |\n| Shares | Amount | Shares | Amount | capital | earnings | income | Total |\n| Balance as of December 31, 2017 | 41,350,000 | $ | 41,350 | 500,000 | $ | 500 | $ | 6,021,126 | $ | 973,764 | $ | 6,753 | $ | 7,043,493 |\n| Net loss | (3,434,671 | ) | (3,434,671 | ) |\n| Foreign currency translation loss | (4,910 | ) | (4,910 | ) |\n| Balance as of June 30, 2018 | 41,350,000 | $ | 41,350 | 500,000 | $ | 500 | $ | 6,021,126 | $ | (2,460,907 | ) | $ | 1,843 | $ | 3,603,912 |\n\nSee accompanying notes to consolidated financial statements.\n\n| 7 |\n\nAMERICAN EDUCATION CENTER, Inc. AND SUBSIDIARies\nNOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2018 AND 2017\n\n| 1. | ORGANIZATION AND BUSINESS |\n\nAmerican Education Center, Inc. (“AEC New York”) is a New York Corporation organized on November 8, 1999 and is licensed by the Education Department of the State of New York to engage in education related consulting services.\nOn May 7, 2014, the President and then sole shareholder of AEC New York formed a new company (“AEC Nevada”) in the State of Nevada with the same name. On May 31, 2014, the President and the sole shareholder of AEC New York exchanged his 200 shares for 10,563,000 shares of AEC Nevada. The share exchange resulted in AEC New York becoming a wholly owned subsidiary of AEC Nevada (hereinafter the “Company”).\nOn October 31, 2016, the Company completed an acquisition transaction through a share exchange with two stockholders of AEC Southern Management Co., Ltd. (“AEC Southern UK”), a company incorporated in December 2015 with a registered capital of 10,000 British Pounds pursuant to the laws of England and Wales. The Company acquired 100% of the outstanding shares of AEC Southern UK in exchange for 1,500,000 shares of its common stock valued at $210,000 (the “AEC Southern UK Share Exchange”). Prior to the consummation of AEC Southern UK Share Exchange, Ye Tian and Rongxia Wang held 51% and 49%, respectively, of ownership interest in AEC Southern UK. As a result of the AEC Southern UK Share Exchange, AEC Southern UK became a wholly owned subsidiary of the Company.\nAEC Southern UK holds 100% equity interest in AEC Southern Management Limited, a Hong Kong company (“AEC Southern HK”) incorporated on December 29, 2015, with a registered capital of HK$10,000. AEC Southern UK owns 100% equity interest in Qianhai Meijiao Education Consulting Management Co., Ltd., a foreign wholly owned subsidiary incorporated pursuant to PRC laws (“AEC Southern Shenzhen”) on March 29, 2016, with a registered capital of RMB 5,000,000.\n\n| 8 |\n\nAMERICAN EDUCATION CENTER, Inc. AND SUBSIDIARies\nNOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2018 AND 2017\n\n| 1. | ORGANIZATION AND BUSINESS (continued) |\n\nThe Company’s corporate structure is as follows:\nHeadquartered in New York with operations in People’s Republic of China (“PRC”) through its PRC operating entity, the Company operates two business segments:\n\n| (1) | AEC New York capitalizes on the rising demand of middle-class families in China for quality education and work experiences in the United States (“US”) and delivers customized high school and college placement and career advisory services to Chinese students wishing to study in the US. Its advisory services include language training, college admission advisory, on-campus advisory, internship and start-up advisory as well as student and family services. |\n\n\n| (2) | AEC Southern UK delivers customized corporate training and advisory services to corporate clients in China in the food industry on subjects such as human resource management, organizational management, and information on local food safety regulations. |\n\n\n| 9 |\n\nAMERICAN EDUCATION CENTER, Inc. AND SUBSIDIARies\nNOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2018 AND 2017\n\n| 2. | SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES |\n\nBasis of Consolidation and Presentation\nThe accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”). These unaudited consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation. In the opinion of management, all adjustments considered necessary to give a fair presentation have been included. Interim results are not necessarily indicative of full-year results. Certain prior year balances have been reclassified to conform to the current year’s presentation; none of these reclassifications had an impact on reported financial position or cash flows for any of the periods presented. The information in this Form 10-Q should be read in conjunction with information included in the Company’s annual report on Form 10-K for the fiscal year ended December 31, 2017 filed with the SEC on April 17, 2018.\nCash\nCash consists of all cash balances and liquid investments with an original maturity of three months or less are considered as cash equivalents.\nAccounts Receivable\nAccounts receivable are carried at net realizable value. The Company maintains an allowance for doubtful accounts, periodically evaluates its accounts receivable balances and makes general and/or specific allowances when there is doubt as to their collectability. In evaluating the collectability of individual receivable balances, the Company considers many factors, including the age of the balances, customers’ historical payment history, their current credit-worthiness and current economic trends. Accounts receivable are written off against the allowance only after exhaustive collection efforts. As of June 30, 2018 and December 31, 2017, the allowance for doubtful accounts was $3,520,149 and $249,527, respectively.\n\n| 10 |\n\nAMERICAN EDUCATION CENTER, Inc. AND SUBSIDIARIES\nNOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS\nFOR THE THREE AND six MONTHS ENDED June 30, 2018 AND 2017\n\n| 2. | SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) |\n\nForeign Currency Translation\nThe Company’s functional currency is US dollars. The company has two bank accounts located in the PRC. Translation adjustments arising from the use of different exchange rates from period to period are included as a separate component of accumulated other comprehensive income included in statements of changes in stockholders’ equity. Gain and losses from foreign currency transactions are included in the consolidated statements of operations and comprehensive income.\nRevenue Recognition\nRevenues are recognized when the following four criteria are met: (i) persuasive evidence of an arrangement exists, (ii) the service has been rendered, (iii) the fees are fixed or determinable, and (iv) collectability is reasonably assured. Revenue is stated net of discounts and sales related tax.\nAEC New York delivers customized high school and college placement, career advisory as well as student and family services. Fees related to such advisory services are generally paid to the Company in advance and they are recorded as deferred revenue. Revenues are recognized proportionally as services are rendered or upon completion.\nAEC Southern UK delivers customized corporate training and advisory services. It receives monthly non-refundable retainer payments and recognizes revenue when services are rendered. AEC Southern UK’s business operations in the PRC has been suffering high cost and operating expense, uncollectable accounts receivable and high net loss. Currently, AEC Southern UK is seeking solutions, namely optimization of training model, expanding advisory services, and may restructure business model if needed.\nIntangible Asset\nThe Company’s finite-lived intangible asset consists of a customized online campus system that was acquired from a third party. The system is used to provide online training for career advisory services and corporate training and advisory services. The asset was recorded at cost on the acquisition date and is amortized on a straight-line basis over its economic useful life.\nThe Company reviews its finite-lived intangible asset for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of the asset to be held and used is measured by a comparison of the carrying amount of an asset to its undiscounted future net cash flows expected to be generated by the asset. If such asset is not recoverable, a potential impairment loss is recognized to the extent the carrying amount of the asset exceeds its fair value. Fair value is generally determined using a discounted cash flow approach.\n\n| 11 |\n\nAMERICAN EDUCATION CENTER, Inc. AND SUBSIDIARIES\nNOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS\nFOR THE THREE AND six MONTHS ENDED june 30, 2018 AND 2017\n\n| 2. | SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) |\n\nStock-Based Compensation\nThe Company uses the fair value-based method for stock issued for services rendered and therefore all awards to employees and non-employees will be recorded at the market price on the date of the grant and expensed over the required period of services to be rendered.\nThe fair value of stock options issued to third party consultants and to employees, officers and directors are recorded in accordance with the measurement and recognition criteria of FASB ASC 505-50, “Equity-Based Payments to Non-Employees” and FASB ASC 718, “Compensation – Stock Based Compensation,” respectively.\nThe options are valued using the Black-Scholes valuation model. This model is affected by the Company’s stock price as well as assumptions regarding a number of subjective variables. These subjective variables include but are not limited to the Company’s expected stock price volatility over the expected term of the awards, and actual and projected stock option and warrant exercise behaviors and forfeitures.\nIncome Taxes\nThe Company accounts for income taxes in accordance with FASB ASC 740, “Income Taxes,” which requires the recognition of deferred income taxes for differences between the basis of assets and liabilities for financial statement and income tax purposes. Deferred tax assets and liabilities represent the future tax consequences for those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled. Deferred taxes are also recognized for operating losses that are available to offset future taxable income. A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized.\n\n| 12 |\n\nAMERICAN EDUCATION CENTER, Inc. AND SUBSIDIARIES\nNOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS\nFOR THE THREE AND six MONTHS ENDED june 30, 2018 AND 2017\n\n| 2. | SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) |\n\nIncome Taxes (continued)\nASC 740 also addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Under ASC 740, the Company may recognize the tax benefit from an uncertain tax position only if it is “more likely than not” that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position would be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. ASC 740 also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, and accounting for interest and penalties associated with tax positions. At June 30, 2018 and December 31, 2017, the Company does not have a liability for any unrecognized tax benefits.\nThe income tax laws of various jurisdictions in which the Company and its subsidiaries operate are summarized as follows:\nUnited States (“US”)\nOn December 22, 2017, the U.S. Tax Cuts and Jobs Act (TCJA) was signed into law. The TCJA results in significant revisions to the U.S. corporate income tax system, including a reduction in the U.S. corporate income tax rate, implementation of a territorial system and a one-time deemed repatriation tax on untaxed foreign earnings. Generally, the impacts of the new legislation would be required to be recorded in the period of enactment.\nThe Company is subject to corporate income tax in the US at 34% and 21%, respectively, for the year 2017 and 2018. Provisions for income taxes in the United States have been made for taxable income the Company had in the US for the three and six months ended 2017.\nUnited Kingdom (“UK”)\nAccording to current England and Wales income tax law, resident companies are taxable in the United Kingdom on their worldwide profits and subject to an opt-out for non-UK permanent establishments (PEs), while non-resident companies are subject to UK corporation tax only on the trading profits attributable to a UK PE, or the trading profits attributable to a trading of dealing in or developing UK land, plus UK income tax on any other UK source income.\nAEC Southern UK was incorporated in the United Kingdom and is governed by the income tax laws of England and Wales.\nSince AEC Southern UK had no PE in UK as December 31, 2017 and had no UK-Source income during 2017, the Company is not subject to tax on non-UK source income. The Company took full allowance of deferred tax assets which The Company does not expect to utilize in the near future.\nHong Kong\nAEC Southern HK was formed in Hong Kong. Pursuant to the income tax laws of Hong Kong, the Company is not subject to tax on non-Hong Kong source income.\nThe People’s Republic of China (“PRC”)\nAEC Southern Shenzhen was incorporated in the PRC. Pursuant to the income tax laws of China, the Company is not subject to tax on non-China source income.\n\n| 13 |\n\nAMERICAN EDUCATION CENTER, Inc. AND SUBSIDIARIES\nNOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS\nFOR THE THREE AND six MONTHS ENDED june 30, 2018 AND 2017\n\n| 2. | SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) |\n\nThe provisions of ASC 740-10-25, “Accounting for Uncertainty in Income Taxes,” prescribe a more-likely-than-not threshold for consolidated financial statement recognition and measurement of a tax position taken (or expected to be taken) in a tax return. This ASC also provides guidance on the recognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and related disclosures.\nFair Value Measurements\nFASB ASC 820, “Fair Value Measurement,” specifies a hierarchy of valuation techniques based upon whether the inputs to those valuation techniques reflect assumptions other market participants would use based upon market data obtained from independent sources (observable inputs). In accordance with ASC 820, the following summarizes the fair value hierarchy:\n\n| Level 1 Inputs – | Unadjusted quoted market prices for identical assets and liabilities in an active market that the Company has the ability to access. |\n| Level 2 Inputs – | Inputs other than the quoted prices in active markets that are observable either directly or indirectly. |\n| Level 3 Inputs – | Inputs based on prices or valuation techniques that are both unobservable and significant to the overall fair value measurements. |\n\nFASB ASC 820 requires the use of observable market data, when available, in making fair value measurements. When inputs used to measure fair value fall within different levels of the hierarchy, the level within which the fair value measurement is categorized is based on the lowest level input that is significant to the fair value measurement. Valuation techniques used need to maximize the use of observable inputs and minimize the use of unobservable inputs.\nThe Company did not identify any assets or liabilities that are required to be presented at fair value on a recurring basis. Non-derivative financial instruments include cash, accounts receivable, prepaid expenses, accounts payable and accrued expenses, taxes payable, and loan from stockholders. As of June 30, 2018 and December 31, 2017, the carrying values of these financial instruments approximated their fair values due to their short-term nature.\nUse of Estimates\nThe preparation of the unaudited consolidated financial statements in accordance with GAAP requires management to make estimates and assumptions that affect certain reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.\n\n| 14 |\n\nAMERICAN EDUCATION CENTER, Inc. AND SUBSIDIARIES\nNOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS\nFOR The THREE AND SIX MONTHS ENDED JUNE 30, 2018 AND 2017\n\n| 2. | SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) |\n\nEarnings (Loss) per Share\nEarnings (loss) per share is calculated in accordance with FASB ASC 260, “Earnings Per Share.” Basic earnings (loss) per share is based upon the weighted average number of common shares outstanding during the period. Diluted earnings per share is based on the assumption that all dilutive convertible shares and stock options are converted or exercised. Dilution is computed by applying the treasury stock method. Under this method, options and warrants are assumed to be exercised at the beginning of the period (or at the time of issuance, if later), and as if funds obtained thereby were used to purchase common stock at the average market price during the period. Options and warrants are only dilutive when the average market price of the underlying common stock exceeds the exercise price of the options or warrants because it is unlikely they would be exercised if the exercise price were higher than the market price.\n\n| 15 |\n\nAMERICAN EDUCATION CENTER, Inc. AND SUBSIDIARIES\nNOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2018 AND 2017\n\n| 3. | RECENTLY ISSUED ACCOUNTING STANDARDS |\n\nIn February 2016, the FASB issued ASU 2016-02, “Leases.” The new standard establishes a right-of-use (“ROU”) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. The Company is currently evaluating the impact of pending adoption of the new standard on its consolidated financial statements.\nIn May 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2017-09, Scope of Modification Accounting, which amends the scope of modification accounting for share-based payment arrangements and provides guidance on the types of changes to the terms or conditions of share-based payment awards to which an entity would be required to apply modification accounting under ASC 718. For all entities, this ASU is effective for annual reporting periods, including interim periods within those annual reporting periods, beginning after December 15, 2017. Early adoption is permitted, including adoption in any interim period. The adoption of this ASU is not expected to have a material effect on the Company’s consolidated financial statements.\nIn February 2018, the FASB issue ASU 2018-02, Income Statement – Reporting Comprehensive Income (Topic 220). The amendments in this update affect any entity that is required to apply the provisions of Topic 220, Income Statement—Reporting Comprehensive Income, and has items of other comprehensive income for which the related tax effects are presented in other comprehensive income as required by GAAP. The amendments in this Update are effective for all entities for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years.\nIn March 2018, the FASB issue ASU 2018-05: Income Taxes (Topic 740) that addresses the recognition of provisional amounts in the event that the accounting is not complete and a reasonable estimate can be made. The guidance allows for a measurement period of up to one year from the enactment date to finalize the accounting related to the TCJA.\nThe FASB has issued ASU No. 2014-09, Revenue from Contracts with Customers. This ASU supercedes the revenue recognition requirements in Accounting Standards Codification 605 - Revenue Recognition and most industry-specific guidance throughout the Codification. The standard requires that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. This ASU is effective for annual reporting periods beginning after December 15, 2016, including interim periods within the reporting period and should be applied retrospectively to each prior reporting period presented or retrospectively with the cumulative effect of initially applying the ASU recognized at the date of initial application. The Company has adopted ASU 2014-09 under the modified retrospective method in the first quarter of 2018. The Company has substantially completed a review of the new standard to its existing customer contracts. The Company does not believe the adoption of ASU 2014-09 would have a material effect on the Company’s consolidated financial statements.\n\n| 16 |\n\nAMERICAN EDUCATION CENTER, Inc. AND SUBSIDIARIES\nNOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2018 AND 2017\n\n| 4. | CONCENTRATION OF CREDIT AND BUSINESS RISK |\n\nThe Company maintains its cash accounts at two commercial banks in the US and two commercial banks in the PRC, respectively. The Federal Deposit Insurance Corporation covers funds held in US banks and it insures $250,000 per bank for the total of all depository accounts. Fund held in the PRC bank is covered by Deposit Insurance Ordinance (index: 000014349/2015-00031) that insures CNY¥500,000 for the total of all depository accounts. As of June 30, 2018, the Company’s US bank accounts had cash balances in excess of federally insured limits of approximately $822,687. The Company performs ongoing evaluation of its financial institutions to limit its concentration of risk exposure. Management believes this risk is not significant due to the financial strength of the financial institutions utilized by the Company.\nThe following table represents major customers that individually accounted for more than 10% of the Company’s gross revenue for the six months ended June 30, 2018 and 2017:\n\n| 2018 |\n| Gross Revenue | Percentage | Accounts Receivable | Percentage |\n| Customer 1 | $ | 777,400 | 25.1 | % | $ | 1,075,240 | 21.4 | % |\n| Customer 2 | 541,500 | 17.5 | % | 647,368 | 12.9 | % |\n| Customer 3 | 412,000 | 13.3 | % | 143,600 | 2.9 | % |\n| Customer 4 | 311,700 | 10.1 | % | 389,540 | 7.8 | % |\n\n\n| 2017 |\n| Gross Revenue | Percentage | Accounts Receivable | Percentage |\n| Customer 1 | $ | 8,441,956 | 55.7 | % | $ | 3,421,722 | 29.9 | % |\n| Customer 2 | 2,826,640 | 18.6 | % | 4,058,727 | 54.5 | % |\n| Customer 3 | 1,596,745 | 10.5 | % | 340,988 | 5.1 | % |\n\n\n| 17 |\n\nAMERICAN EDUCATION CENTER, Inc. AND SUBSIDIARIES\nNOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS\nFOR THE THREE AND six MONTHS ENDED june 30, 2018 AND 2017\n\n| 5. | SEGMENT REPORTING |\n\nOperating segments have been determined on the basis of reports reviewed by Chief Executive Officer (CEO) who is the chief operating decision maker of the Company. The CEO considers the business from a geographic perspective and assesses performance and allocates resources on this basis. The reportable segments are as follows:\nThe Company has two operating segments: AEC New York and AEC Southern UK.\n\n| · | AEC New York delivers placement, career and other advisory services Its advisory services include language training, admission advisory, on-campus advisory, internship and start-up advisory as well as other advisory services. |\n\n\n| · | AEC Southern UK delivers customized corporate training and advisory services to corporate clients in China in the food industry to help them comply with local food safety regulations and standards. |\n\nRevenues from external customers, gross profit, segment assets and liabilities for each business are as follows:\n\n| For the six months ended June 30, 2018 |\n| AEC New York | AEC Southern UK | Total |\n| Segment revenue: |\n| Corporate training & advisory | $ | - | $ | - | $ | - |\n| Placement advisory | 263,101 | - | 263,101 |\n| Career advisory | 601,500 | - | 601,500 |\n| Student & Family advisory | 2,234,200 | - | 2,234,200 |\n| Total revenue | $ | 3,098,801 | $ | - | $ | 3,098,801 |\n| Gross profit | $ | 1,082,501 | $ | - | $ | 1,082,501 |\n\n\n| For three months ended June 30, 2018 |\n| AEC New York | AEC Southern UK | Total |\n| Segment revenue: |\n| Corporate training & advisory | $ | - | $ | - | $ | - |\n| Placement advisory | 207,100 | - | 207,100 |\n| Career advisory | 440,500 | - | 440,500 |\n| Student & Family advisory | 1,120,900 | - | 1,120,900 |\n| Total revenue | $ | 1,768,500 | $ | - | $ | 1,768,500 |\n| Gross profit | $ | 798,339 | $ | - | $ | 798,339 |\n\n\n| 18 |\n\nAMERICAN EDUCATION CENTER, Inc. AND SUBSIDIARIES\nNOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS\nFOR THE THREE AND six MONTHS ENDED june 30, 2018 AND 2017\n\n| 5. | SEGMENT REPORTING (continued) |\n\n\n| For the six months ended June 30, 2017 |\n| AEC New York | AEC Southern UK | Total |\n| Segment revenue: |\n| Corporate training & advisory | $ | $ | 11,268,596 | $ | 11,268,596 |\n| Placement advisory | 536,208 | - | 536,208 |\n| Career advisory | 1,596,745 | - | 1,596,745 |\n| Student & Family advisory | $ | 1,761,850 | $ | - | $ | 1,761,850 |\n| Total revenue | $ | 3,894,803 | $ | 11,268,596 | $ | 15,163,399 |\n| Gross profit | $ | 1,308,483 | $ | 4,074,787 | $ | 5,383,270 |\n\n\n| For the three months ended June 30, 2017 |\n| AEC New York | AEC Southern UK | Total |\n| Segment revenue: |\n| Corporate training & advisory | $ | $ | 3,891,383 | $ | 3,891,383 |\n| Placement advisory | 476,770 | - | 476,770 |\n| Career advisory | 696,020 | - | 696,020 |\n| Student & Family advisory | $ | 640,520 | $ | - | $ | 640,520 |\n| Total revenue | $ | 1,813,310 | $ | 3,891,383 | $ | 5,704,693 |\n| Gross profit | $ | 848,319 | $ 1,271,497 | $ | 2,119,816 |\n\n\n| June 30, 2018 |\n| AEC New York | AEC Southern UK | Total |\n| Segment assets and liabilities: |\n| Segment assets | $ | 6,078,993 | $ | 3,117,042 | $ | 9,196,035 |\n| Segment liabilities | $ | 3,694,168 | $ | 1,897,955 | $ | 5,592,123 |\n\n\n| December 31, 2017 |\n| AEC New York | AEC Southern UK | Total |\n| Segment assets and liabilities: |\n| Segment assets | $ | 5,008,678 | $ | 7,252,528 | $ | 12,261,206 |\n| Segment liabilities | $ | 2,483,434 | $ | 2,734,279 | $ | 5,217,713 |\n\n\n| 19 |\n\nAMERICAN EDUCATION CENTER, Inc. AND SUBSIDIARIES\nNOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2018 AND 2017\n\n| 6. | DEFERRED COMPENSATION |\n\nOn October 31, 2016, 1,500,000 common shares were granted to AEC Southern UK’s CEO that are expected to vest over a three-year period commencing November 1, 2016. The shares were valued using the market price of the Company’s common stock on the grant date of $0.14 per share. On the grant date, $210,000 was recognized as deferred compensation, which will be expensed over the three-year vesting period using the straight-line method. On December 31, 2017, the remaining deferred compensation was expensed due to the resignation of AEC Southern UK’s CEO.\nOn December 31, 2016, 6,000,000 shares were granted to the AEC Southern UK’s Chairman and are expected to vest over a three-year period commencing November 1, 2016. The shares were valued using the market price of the Company’s common stock on the grant date of $0.55 per share. On December 31, 2016, $3,300,000 was recognized as deferred compensation, which will be expensed over the remaining two year and ten months using the straight-line method. As of June 30, 2018, the remaining deferred compensation was $1,466,668.\nFuture amortization of the deferred compensation is as follows:\n\n| Year Ending December 31, |\n| 2018 | 550,000 |\n| 2019 | 916,668 |\n| Total | $ | 1,466,668 |\n\nStock compensation expense was $275,000, $550,000, $292,500 and $585,000 for the three and six months ended June 30, 2018 and 2017, respectively.\n\n| 7. | SECURITY DEPOSITS |\n\nThe Company has security deposits with the landlord for its New York office of $266,021 as of June 30, 2018 and December 31, 2017.\n\n| 20 |\n\nAMERICAN EDUCATION CENTER, Inc. AND SUBSIDIARIES\nNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)\nFOR THE THREE AND six MONTHS ENDED june 30, 2018 AND 2017\n\n| 8. | INTANGIBLE ASSET, NET |\n\nThe Company’s customized online campus system is being amortized on a straight-line basis over four and a half years. The gross carrying amount and accumulated amortization of this asset as of June 30, 2018 and December 31, 2017 are as follows:\n\n| June 30, 2018 | December 31, 2017 |\n| Intangible asset | $ | 612,814 | $ | 612,814 |\n| Less: accumulated amortization | (238,316 | ) | (170,226 | ) |\n| Intangible asset - net | $ | 374,498 | $ | 442,588 |\n\nFor the three and six months ended June 30, 2018 and 2017, amortization expense was $34,035, $68,090, $34,036, and $68,091, respectively.\nThe following table is the future amortization expense to be recognized:\n\n| Year Ending December 31, |\n| 2018 | 68,091 |\n| 2019 | 136,181 |\n| 2020 | 136,181 |\n| 2021 | 34,045 |\n| Total | $ | 374,498 |\n\n\n| 21 |\n\nAMERICAN EDUCATION CENTER, Inc. AND SUBSIDIARIES\nNOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS\nFOR THE THREE AND six MONTHS ENDED june 30, 2018 AND 2017\n\n| 9. | DEFERRED REVENUE |\n\nThe Company receives advance payments for services to be performed and recognizes revenue when services have been rendered. The deferred revenue at June 30, 2018 and December 31, 2017 was $299,924 and $20,000, respectively.\n\n| 10. | RELATED-PARTY TRANSACTIONS |\n\nThe Company’s CEO has a 34% interest in Columbia International College, Inc. (“CIC”). The Company conducts no transaction with CIC between December 31, 2017 and June 30, 2018.\nThe Company’s CEO has a 40% interest in Wall Street Innovation Center, Inc. (“WSIC”), a company incorporated in the state of New York that focuses on career and business development activities. AEC New York’s Chief Operating Officer currently serves as the President/CEO of WSIC. In the course of delivering career advisory services, the Company has engaged WSIC to assist in certain career development activities. Included in accounts payable is an amount due to WSIC of $372 and $372 as of June 30, 2018 and December 31, 2017. Additionally, the Company had entered into a sublease agreement with WSIC in March 2016, which was subsequently terminated on June 30, 2017.\n\n| 22 |\n\nAMERICAN EDUCATION CENTER, Inc. AND SUBSIDIARIES\nNOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2018 AND 2017\n\n| 11. | LONG-TERM LOAN |\n\nOn December 1, 2014, an unrelated party loaned the Company $295,579, with interest at 10%. The Company repaid $150,000 on November 10, 2017. The remaining is to be repaid on December 13, 2019. Interest will be paid on the last day of each quarter from 2015 to 2019, except for the last payment on December 12, 2019. Interest expense for the three and six months ended June 30, 2018 and 2017 was $3,639, $7,279 and $7,389, $14,779 respectively.\n\n| 12. | LEASE COMMITMENTS |\n\nIn December 2014, the Company entered into a lease for office space with an unrelated party, expiring on July 31, 2025. The lease commenced on March 1, 2015 and the Company received two months of free rent. Due to free rent and escalating monthly rental payments, utilities, real estate taxes, insurance and other operating expenses, the lease is being recognized on a straight-line basis of $34,065 per month for financial statement purposes which creates deferred rent as shown on the balance sheets. In February 2016, the Company entered into a sublease agreement to lease space to WSIC for an annual rental of $250,000. The sublease income was netted against the Company’s rent expense. The sublease commenced on March 1, 2016 and terminated on June 30, 2017(see Note 10). Rent expense was approximately $102,195, $204,390 for the three and six months ended June 30, 2018.\nFuture minimum lease commitments are as follows:\n\n| Year Ending December 31, | Gross Lease Payment |\n| 2018 | 190,984 |\n| 2019 | 388,333 |\n| 2020 | 418,604 |\n| 2021 | 439,350 |\n| 2022 and thereafter | 1,666,383 |\n| Total | $ | 3,103,654 |\n\n\n| 23 |\n\nAMERICAN EDUCATION CENTER, Inc. AND SUBSIDIARIES\nNOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS\nFOR THE THREE AND Six MONTHS ENDED June 30, 2018 AND 2017\n\n| 13. | Income taxes |\n\nThe component of deferred tax assets at June 30, 2018 and December 31, 2017 is as follows:\n\n| June 30, 2018 | December 31, 2017 |\n| Net operating loss carryforwards | $ | (1,415 | ) | $ | - |\n| Allowance for doubtful accounts | 45,120 | 63,441 |\n| Accelerated Depreciation | 320 | (37,800 | ) |\n| Tax impact of foreign operations, net | - | - |\n| Deferred tax asset, net | $ | 44,025 | $ | 25,641 |\n\nThe Company’s subsidiary incorporated in the UK has unused net operating losses (“NOLs”) of $412,125 available for carry forward to future years for UK income tax reporting purposes.\nIn assessing the realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. A valuation allowance is provided for deferred tax assets if it is more likely than not these items will either expire before the Company is able to realize their benefits, or that future deductibility is uncertain.\nBased on the assessment, the Company has established a full valuation allowance against all of the deferred tax asset relating to UK NOLs because the Company is more likely than not to realize the benefit from the utilization of such NOL carry forwards.\nThe provision for income taxes for the three and six months ended June 30, 2018 and 2017 are as follows:\n\n| For the three months ended June 30, | For the six months ended June 30, |\n| 2018 | 2017 | 2018 | 2017 |\n| Current: |\n| Federal | $ | 24,969 | $ | 114,548 | $ | 24,969 | $ | 114,548 |\n| State | 18,843 | 66,196 | 18,843 | 66,196 |\n| Foreign | 40,639 | (65,771 | ) | (313,803 | ) | 222,845 |\n| Total current | 84,451 | 114,973 | (269,991 | ) | 403,589 |\n| Deferred: |\n| Federal | 6,294 | - | 20,432 | 39,083 |\n| State | 12,090 | - | 20,393 | 22,586 |\n| Foreign | 17,273 | - | (59,209 | ) | - |\n| Total deferred | 35,657 | - | (18,384 | ) | 61,669 |\n| Total | $ | 120,108 | $ | 114,973 | $ | (288,375 | ) | $ | 465,258 |\n\nThe Company conducts business globally and, as a result, files income tax returns in the US federal jurisdiction, state and city, and foreign jurisdictions. In the normal course of business, the Company is subject to examination by taxing authorities throughout the world, including jurisdictions in the US and UK. The Company is subject to income tax examinations of US federal, state, and city for 2017, 2016, and 2015 tax years and in the UK for 2017 and 2016. The Company is not currently under examination nor has it been notified by the authorities.\n\n| 24 |\n\nAMERICAN EDUCATION CENTER, Inc. AND SUBSIDIARIES\nNOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2018 AND 2017\n\n| 13. | Income taxes (continued) |\n\nA reconciliation of the provision for income taxes, with the amount computed by applying the statutory federal income tax rate for the six months ended June 30, 2018 and 2017 is as follows:\n\n| For the three months ended June 30, | For the six months ended June 30, |\n| 2018 | 2017 | 2018 | 2017 |\n| Tax at federal statutory rate | (21.0 | )% | 34.0 | % | (21.0 | )% | 34.0 | % |\n| State and local taxes, net of federal benefit | (11.0 | ) | 10.8 | (11.0 | ) | 10.8 |\n| Tax impact of foreign operations | 3.9 | (247.2 | ) | (10.0 | ) | (13.9 | ) |\n| Non-deductible/ non-taxable items | 36.2 | 634.6 | 34.3 | (1.9 | ) |\n| Total | 8.1 | % | 432.2 | % | (7.7 | )% | 29.0 | % |\n\n\n| 25 |\n\nAMERICAN EDUCATION CENTER, Inc. AND SUBSIDIARies\nNOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS\nFOR THE THREE AND six MONTHS ENDED june 30, 2018 AND 2017\n\n| 14. | STOCK OPTIONS |\n\nThe Company didn’t grant any options during the three and six months ended June 30, 2018.\nThe following is a summary of stock option activity:\n\n| Shares | Weighted Average Exercise Price | Weighted- Average Remaining Contractual Life | Aggregate Intrinsic Value |\n| Outstanding at December 31, 2017 | 3,200,000 | $ | 5.87 years | $ | - |\n| Granted | - | - | - |\n| Exercised | - | - | - |\n| Cancelled and expired | - | - | - |\n| Forfeited | - | - | - |\n| Outstanding at June 30, 2018 | 3,200,000 | $ | 2.45 | 5.37 years | $ | - |\n| Vested and expected to vest at June 30, 2018 | 1,203,333 | $ | 1.32 | 4.04 years | $ | - |\n| Exercisable at June 30, 2018 | 1,203,333 | $ | 1.32 | 4.04 years | $ | - |\n\nThe aggregate intrinsic value is calculated as the difference between the exercise price of the underlying awards and the quoted price of the Company’s common stock. There were no options exercised during the three and six months ended June 30, 2018.\nThere was no compensation expense related to all the above options because the value ascribed to these options was not material.\n\n| 15. | SUBSEQUENT EVENTS |\n\nThe Company’s management has performed subsequent events procedures through August 13, 2018, which is the date the financial statements were available to be issued. The following is the event that occurred after the three months ended June 30, 2018.\nBusiness Purchase\nOn July 10, 2018, (the “Effective Date”), American Education Center, Inc. (the “Company”) entered into a Business Purchase Agreement (the “Purchase Agreement”) with FIFPAC, Inc., a New Jersey corporation (the “Seller”), a 100% owner of American Institute of Financial Intelligence LLC, a New Jersey corporation (“AIFI” or the “Target”). Pursuant to the Purchase Agreement, on July 10, 2018, the Company issued 100,000 shares of the Company’s common stock (the “Consideration Shares”) to the Seller, in exchange for 51% equity ownership of the AIFI within 30 days from the Effective Date. The Seller has agreed to hold the Consideration Shares for 180 days following the Issuance Date (defined below) before selling any or all portion of the Consideration Shares. All of the securities referenced above are offered and issued in reliance upon the exemption from registration pursuant to the exemption from registration provided by Section 4(a)(2) of the Securities Act of 1933, as amended (the “Securities Act”) and Regulation D promulgated thereunder.\n\n| 26 |\n\n\nThe following discussion and analysis of financial condition and results of operations relates to the operations and financial condition reported in the unaudited consolidated financial statements of the Company for the three months and six months ended June 30, 2018 and 2017, and should be read in conjunction with such financial statements and related notes included in this report. Except for the historical information contained herein, the following discussion, as well as other information in this report, contain “forward-looking statements,” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are subject to the “safe harbor” created by those sections. Actual results and the timing of the events may differ materially from those contained in these forward-looking statements due to a number of factors, including those discussed in the “Forward-Looking Statements” set forth elsewhere in this Quarterly Report on Form 10-Q.\nOverview\nLeveraging our knowledge of the educational system and environment in the United States and our understanding of the market demands for education services in the PRC and its changing business economy, we specialize in the delivery of customized high school and college placement advisory services as well as career advisory services to Chinese students wishing to study and gain post-graduate work experiences in the United States. Our advisory services are specifically designed to address the educational needs of the rising middle-class families in China. The demand for our advisory services is primarily the result of China’s decades-long one-child policy, society’s focus and emphasis on children’s education, and families’ desire to gain access to U.S. colleges and universities as well as work experience in the U.S.\nAdditionally, recognizing the needs for enterprise training in China, since October 2016, we also deliver customized corporate training and advisory services to customers in China in the food industry to help them meet the related regulatory standards. The demand for such corporate training and advisory services in China has escalated in recent years and is driven mainly by China’s growing economy and desire to improve its competitiveness by meeting or setting international standards.\n\n| 27 |\n\nHeadquartered in New York with operations in PRC (People’s Republic of China), our key advisory services include:\n\n| · | Placement Advisory Services; |\n| · | Career Advisory Services; |\n| · | Student & Family Services; |\n| · | Other Recruitment & Placement Services; and |\n| · | Corporate Training & Advisory Services. |\n\nPlacement Advisory Services\nSince 1999, we have been delivering customized Language Training & Placement Advisory services to Chinese students. Our one-stop advisory service encompasses ESL training and assistance throughout the high school/college application and admission process.\nTargeting the needs of Chinese families in getting admissions to ivy league colleges, our Elite College Advisory service is designed to assist qualified Chinese students gain access and apply to prestigious colleges and universities in the US. Specifically, we arrange campus tours, provide tailored language training, offer guidance on interview and communication techniques, and follow-up on their applications.\nOnce students are admitted into their target universities, our advisory services include, among other things, assistance in connection with their application for a second major, transfers, housing accommodations, and accelerated degree application. To help students optimize their on-campus experience and enhance their leadership and social skills, we would enroll them into seminars and social events that we partner with scholars and universities, business and non-profit organizations. To help enrich their cultural experience, we would arrange extracurricular activities such as organized artistic endeavors including dance, music, painting, photography and other performance events.\nCareer Advisory Services\nOur Internship Advisory program focuses on student’s career development by helping them identify and secure suitable internship and part-time or full-time work opportunities that are appropriate for their educational background and experience level. Through this program, we strive to help students map and navigate their career path and counsel them on matters including academic improvement to career assistance. Our student customers have chances to communicate with professionals in the field and participate in real-world case studies.\nOur Start-up Advisory program is designed to provide incubator services to students and/or their families who desire to start or make an investment in a business in the US. Our services include (i) recommending alternative business development opportunities; (ii) assistance with business plan development; (iii) assistance with accounting and financial management, marketing, product and project design; and (iv) assistance in project financing.\nStudent & Family Advisory Services\nOur Student & Family Advisory Services are designed to assist our students and/or their families in the process of settling down in the U.S., so they can effectively focus on their studies.\nThrough our business partners, we assist the students’ families with purchasing real estate properties, organizing their personal financial management and investment needs, getting insurance and starting businesses. Our American Dream Program helps students’ families find good investment projects in the U.S. We also advise Chinese and corporate clients whose executives are moving to the U.S. for work. The scope of our services includes assistance with business consulting, relocation and other aspects of family support services.\n\n| 28 |\n\nOther Advisory Services\nThrough our Foreign Student Recruitment services, we assist universities in China to recruit students from the US. We customize this service based on our strategic relationship with college and universities in the US and the specific recruitment goals of these universities in China. The demand for our recruitment services is driven mainly by the lack of an established channel to attract students from the US and the needs by the Chinese universities to expand and diversify their student body.\nOur Foreign Educator Placement services are designed to meet the increasing demand for experienced educators and teachers from the US to teach in China. Such demand covers the need to recruit qualified US educators from Pre K-12 to teach in China.\nCorporate Training & Advisory Services\nOur Corporate Training & Advisory service is delivered by our wholly owned subsidiary, AEC Southern UK. We currently focus on corporate training in human resources management and organizational management for the general corporate market, as well as information sessions on local food industry regulations and the International Organization for Standardization (“ISO”). We advise on relevant training guidelines designed to further clients’ understanding of the pertinent compliance requirements, best practices, and/or relevant certification requirements.\nPursuant to Accounting Standard Codification 280 “Segment Reporting” (“ASC 280”), we have identified two reporting segments: AEC New York and AEC Southern UK. These two segments engage two sets of customers and vendors to generate revenue and incur expenses; they generate separate financial information; and based on their financial reports and other segment specific information, our chief operating decision maker determines the resources to be allocated and evaluates the performance, of each segment.\n\n| · | AEC New York capitalizes on the rising demand from the middle-class families in China for quality education and working experience in the United States. It delivers customized high school and college placement and career advisory services to Chinese students wishing to study in the US. Its advisory services include language training, admission advisory, on-campus advisory, internship and start-up advisory as well as student and family services. |\n\n\n| · | AEC Southern UK delivers customized corporate training services on subjects such as human resource management, organizational management, as well as information on local food safety regulations and the ISO. |\n\nPlease refer to our Form 10-K for fiscal 2017, which was filed on April 17, 2018 for more detailed information about our operations.\nSignificant Accounting Policies\nThe discussion and analysis of our consolidated financial condition and results of operations is based upon our unaudited consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (US GAAP). The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities. On an on-going basis, we evaluate our estimates including the allowance for doubtful accounts, income taxes and contingencies. We base our estimates on historical experience and on other assumptions that we believe to be reasonable under the circumstances, the results of which form our basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The consolidated financial statements are comprised of AEC Nevada and its wholly owned subsidiaries, AEC New York and AEC Southern UK. All significant intercompany accounts and transactions have been eliminated in consolidation.\nAs part of the process of preparing our unaudited consolidated financial statements, we are required to estimate our income taxes. This process involves estimating our current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. As of June 30, 2018, the Company does not have a liability for any unrecognized tax benefits.\n\n| 29 |\n\nWe cannot predict what future laws and regulations might be passed that could have a material effect on our results of operations. We assess the impact of significant changes in laws and regulations on a regular basis and update the assumptions and estimates used to prepare our unaudited consolidated financial statements when we deem it necessary.\nWe have determined significant accounting principles with policies that involve the most complex and subjective decisions or assessments. While our significant accounting policies are more fully described in Note 2 to our financial statements, we believe that the following accounting policies are the most critical to aid you in fully understanding and evaluating this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Both operating groups are reported under the same accounting policies/estimations.\nRevenue is recognized when the following criteria are met: (1) when persuasive evidence of an arrangement exists; (2) delivery of the services has occurred; (3) the fee is fixed or determinable; and (4) collectability of the resulting receivable is reasonably assured. Advisory services fees paid in advance will be reflected as deferred revenue, and they are recognized proportionally as services are completed. Fees related to compliance training and advisory services are recognized upon completion of such services.\nRecent Accounting Pronouncements\nIn February 2016, the FASB issued ASU 2016-02, “Leases.” The new standard establishes a right-of-use (“ROU”) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. The Company is currently evaluating the impact of pending adoption of the new standard on its consolidated financial statements.\nIn May 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2017-09, Scope of Modification Accounting, which amends the scope of modification accounting for share-based payment arrangements and provides guidance on the types of changes to the terms or conditions of share-based payment awards to which an entity would be required to apply modification accounting under ASC 718. For all entities, this ASU is effective for annual reporting periods, including interim periods within those annual reporting periods, beginning after December 15, 2017. Early adoption is permitted, including adoption in any interim period. The adoption of this ASU is not expected to have a material effect on the Company’s consolidated financial statements\nIn February 2018, the FASB issue ASU 2018-02, Income Statement– Reporting Comprehensive Income (Topic 220). The amendments in this update affect any entity that is required to apply the provisions of Topic 220, Income Statement—Reporting Comprehensive Income, and has items of other comprehensive income for which the related tax effects are presented in other comprehensive income as required by GAAP. The amendments in this Update are effective for all entities for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years.\nIn March 2018, the FASB issue ASU 2018-05: Income Taxes (Topic 740) that addresses the recognition of provisional amounts in the event that the accounting is not complete and a reasonable estimate can be made. The guidance allows for a measurement period of up to one year from the enactment date to finalize the accounting related to the TCJA.\n\n| 30 |\n\nThe FASB has issued ASU No. 2014-09, Revenue from Contracts with Customers. This ASU supersedes the revenue recognition requirements in Accounting Standards Codification 605 - Revenue Recognition and most industry-specific guidance throughout the Codification. The standard requires that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. This ASU is effective for annual reporting periods beginning after December 15, 2016, including interim periods within the reporting period and should be applied retrospectively to each prior reporting period presented or retrospectively with the cumulative effect of initially applying the ASU recognized at the date of initial application. The Company is currently evaluating the effect that this ASU will have on its condensed consolidated financial statements and related disclosures. The Company has not yet selected a transition method nor has it determined the effect of the standard on its ongoing financial reporting.\nThe Company has assessed all newly issued accounting pronouncements released during the three months ended June 30, 2018 and through the date of this filing, and believes that none of them will have a material impact on the Company’s financial statements when or if adopted.\nResults of Operations\nBelow we have included a discussion of our operating results and material changes in the periods covered by this Quarterly Report on Form 10-Q. For additional information on the potential risks associated with these initiatives and our operations, please refer to the Risk Factors sections in our annual report on Form 10-K for the year ended December 31, 2017.\nThree Months Ended June 30, 2018 as Compared to Three Months Ended June 30, 2017\n\n| For the three months ended June 30, |\n| 2018 | 2017 | Variance | % |\n| Key revenue streams: |\n| Corporate Training & Advisory Services | $ | - | $ | 3,891,383 | $ | (3,891,383 | ) | NM | % |\n| Placement Advisory Services | 207,100 | 476,770 | (269,670 | ) | (57 | ) |\n| Career Advisory Services | 440,500 | 696,020 | (255,520 | ) | (37 | ) |\n| Student & Family Advisory | 1,120,900 | 640,520 | 480,380 | 75 |\n| Total revenues | $ | 1,768,500 | $ | 5,704,693 | $ | (3,936,193 | ) | (69 | )% |\n| Gross Profit | $ | 798,339 | $ | 2,119,816 | $ | (1,321,477 | ) | (62 | )% |\n| Gross Margin | 45 | % | 37 | % |\n\nRevenue\n\n| · | Total revenues for the three months ended June 30, 2018 were $1,768,500, representing a decrease of $3,936,193, or 69% from $5,704,693 for the same period in 2017. The decrease was attributed mainly to the decrease in revenues from our corporate training and advisory services delivered by AEC Southern UK. Total revenues for the three months ended June 30, 2018 were entirely generated by the operations of AEC New York. |\n\n\n| 31 |\n\n\n| · | The decline in revenues from our corporate training & advisory services was primarily due to strict regulation of the People’s Bank of China (PBOC) and State Administration of Foreign Exchange (SAFE) on the flow of foreign exchange in and out of the PRC. We typically accept payments from our AEC Southern UK clients in the dollar denominations while AEC Southern UK clients are located in the PRC. In addition, service delivery was temporarily suspended due to our ongoing optimization of the training model to enhance the business as well as the expiration of agreement with one of the two clients of AEC Southern UK. The restricted flow of foreign exchange from the PRC and the inconsistent and generally unfavorable interpretation of the relevant regulations, and the rising costs of doing business in the PRC have negatively affected AEC Southern UK’s business operations in the PRC (People’s Republic of China). As such, AEC Southern UK has experienced high cost and operating expense, non-collectable accounts receivable and high net loss. Currently, AEC Southern UK is seeking solutions, namely adapting the corporate training services to be delivered via an online platform and planning to expand its corporate training offerings from the food industry to general management advisory services that may appeal to a wider range of businesses. AEC Southern UK is also open to restructuring its business model if needed. |\n\n\n| · | Our revenues from placement advisory services typically fluctuate as a result of seasonal or other factors related to the high school/college admission process. Revenues for the three months ended June 30, 2018 from our placement advisory services decreased by $269,670, or approximately 57% from $476,770 for the same period in 2017. The decrease in our placement advisory services was due to the allocation of our resources to elite college advisory services. Revenues for our career advisory services decreased by $255,520, or 37% from $696,020 for the same period in 2017, primarily due to decreased services requests. Revenues from student & family advisory services increased by $480,380 from $640,520 for the same period in 2017, mainly due to timing of services being requested. |\n\nGross Profit & Gross Margin\n\n| · | Our gross profit for the three months ended June 30, 2018 was $798,339, representing a decrease of $1,321,477, or 62% from $2,119,816 for the three months ended June 30, 2017. The decrease was attributed mainly to the temporary suspension of the delivery of corporate training and advisory services by AEC Southern UK, due to the restricted flow of foreign exchange, the ongoing optimization of the training model to enhance our business, as well as the expiration of a service agreement with one of the two clients of AEC Southern UK. |\n\n\n| · | Our gross margin was approximately 45% for the three months ended June 30, 2018, as compared to approximately 37% for the same period in 2017. As gross profit for this period was all generated from AEC New York, gross margin for AEC New York for the three months ended June 30, 2018 was decreased 2% from the same period in 2017. |\n\nOperating Expenses\n\n| · | Total operating expenses increased by $195,902 or 9% as compared to the three months ended June 30, 2017. The increase was attributed to higher general and administrative (G&A) expenses of approximately $500,000 from payroll expense, professional fee, and uncollectible accounts receivable. |\n\nIncome Tax Expense\n\n| · | Income tax expense of $120,108 for the three months ended June 30, 2018 is attributable mainly to net profits from AEC New York. |\n\nNet Loss\n\n| · | Net loss of $1,610,742 for the three months ended June 30, 2018 was due to the decrease in revenue due to AEC Southern’s suspension of operation and increased operating expense due to AEC Southern’s high expenses. |\n\n\n| 32 |\n\nSix Months Ended June 30, 2018 as Compared to Six Months Ended June 30, 2017\n\n| For the six months ended June 30, |\n| 2018 | 2017 | Variance | % |\n| Key revenue streams: |\n| Corporate Training & Advisory Services | $ | - | $ | 11,268,596 | $ | (11,268,596 | ) | NM | % |\n| Placement Advisory Services | 263,101 | 536,208 | (273,107 | ) | (51 | ) |\n| Career Advisory Services | 601,500 | 1,596,745 | (995,245 | ) | (62 | ) |\n| Student & Family Advisory | 2,234,200 | 1,761,850 | 472,350 | 27 |\n| Total revenues | $ | 3,098,801 | $ | 15,163,399 | $ | (12,064,598 | ) | (80 | )% |\n| Gross Profit | $ | 1,082,501 | $ | 5,383,270 | $ | (4,300,769 | ) | (80 | )% |\n| Gross Margin | 35 | % | 36 | % |\n\nRevenue\n\n| · | Total revenues for the six months ended June 30, 2018 were $3,098,801, representing a decrease of $12,064,598, or 80% from $15,163,399 for the same period in 2017. The decrease was attributed mainly to revenues from our corporate training and advisory services delivered by AEC Southern UK. Total revenues for the six months ended June 30, 2018 were entirely generated by the operations of AEC New York. |\n\n\n| · | The decline in revenue from our corporate training & advisory services was primarily due to the suspension of the services, as a response to the strict regulation of the People’s Bank of China (PBOC) and State Administration of Foreign Exchange (SAFE) on the flow of foreign exchange in and out of the PRC. We typically accept payments from our AEC Southern UK clients in the dollar denominations while AEC Southern UK clients are located in the PRC. In addition, service delivery was temporarily suspended due to our ongoing optimization of the training model to enhance the business as well as the expiration of agreement with one of the two clients of AEC Southern UK. The restricted flow of foreign exchange from the PRC and the inconsistent and generally unfavorable interpretation of the relevant regulations, and the rising costs of doing business in the PRC have negatively affected AEC Southern UK’s business operations in the PRC (People’s Republic of China). Since AEC Southern UK has been suffering high cost and operating expense, uncollectable accounts receivable and high net loss. Currently, AEC Southern UK is seeking solutions, namely implementing corporate training services into an online platform and planning to expand its corporate training offerings from the food industry to general management advisory services that may appeal to a wider range of businesses and restructuring business model if needed. |\n\n\n| · | Our revenues from placement advisory services normally fluctuate as a result of seasonal or other factors related to the high school/college admission process. Revenues from our placement advisory services decreased by $237,107, or approximately 51% from $536,208 for the same period in 2017. The decrease in our placement advisory services was due to the allocation of resources to elite college advisory services. Revenues for our career advisory services decreased by $995,245, or 62% from $1,596,745 for the same period in 2017, primarily due to decreased services requests. Revenues from student & family advisory services increased by $472,350 from $1,761,850 for the same period in 2017, mainly due to timing of services being requested. |\n\nGross Profit & Gross Margin\n\n| · | Our gross profit for the six months ended June 30, 2018 was $1,082,501, representing a decrease of $4,300,769, or 80% from $5,383,270 for the six months ended June 30, 2017. The decrease was attributed mainly to the delivery of corporate training and advisory services from AEC Southern UK. The service delivery was temporarily suspended due to the restricted flow of foreign exchange, the ongoing optimization of the training model to enhance our business, as well as the expiration of a service agreement with one of the two clients of AEC Southern UK. |\n\n\n| · | Our gross margin was approximately 35% for the six months ended June 30, 2018, as compared to approximately 36% for the same period in 2017. As gross profit for this period was all generated from AEC New York, gross margin for AEC New York for the six months ended June 30, 2018 decreased 1% from the same period in 2017. |\n\n\n| 33 |\n\nOperating Expenses\n\n| · | Total operating expenses increased by $1,029,632 or 27%, as compared to the six months ended June 30, 2017. The increase was attributed to higher general and administrative (G&A) expenses of approximately $1,000,000 from payroll expense, professional fee, and uncollectible accounts receivable. |\n\nIncome Tax Benefits\n\n| · | Income tax benefits of $288,375 for the six months ended June 30, 2018 represent the net effect of tax payable reversal and net loss for the period. |\n\nNet Loss\n\n| · | Net loss of $3,434,671 for the six months ended June 30, 2018 was due to the decrease in revenue and higher operating expense. |\n\nLiquidity and Capital Resources\nCash Flows and Working Capital\nAs of June 30, 2018, we had cash of $1,661,001, a decrease of $1,059,984 from $2,720,985 as of December 31, 2017. We have financed our operations primarily through cash flow from operating activities. We require cash for working capital, payment of accounts payables and accrued expenses, salaries, commissions and related benefits, and other operating expenses and income taxes. The following table sets forth a summary of our cash flows for the periods indicated.\n\n| Six months ended June 30, |\n| 2018 | 2017 | Variance | % |\n| Net cash used in operating activities | $ | (1,055,074 | ) | $ | (683,477 | ) | $ | (371,597 | ) | 54 | % |\n| Effect of exchange rates changes on cash | (4,910 | ) | - | (4,910 | ) | NM |\n| Net change in cash | $ | (1,059,984 | ) | $ | (683,477 | ) | $ | (376,507 | ) | 55 | % |\n\nCash Flow from Operating Activities\n\n| · | Net cash used in operating activities for the six months ended June 30, 2018 was $1,055,074, increased by $371,597, or 54% for the six months ended June 30, 2017. The increase in net cash used in operations in 2018 was primarily attributable to the combination of the following: paying service providers faster; tax benefit due to the net loss; and asset write-off due to the uncollectible accounts receivable. |\n\nCash Flow from Investing Activities\n\n| · | We had no cash flow from investing activities during the six months ended June 30, 2018 and 2017. |\n\nCash Flow in Financing Activities\n\n| · | We had no cash flow from financing activities during the six months ended June 30, 2018 and 2017. |\n\nWorking Capital\nThe following table sets forth our working capital.\n\n| June 30, | December 31, |\n| 2018 | 2017 | Variance | % |\n| Total current assets | $ | 7,044,823 | $ | 9,510,288 | $ | (2,465,465 | ) | (26 | ) |\n| Total current liabilities | 5,238,490 | 4,880,592 | 357,898 | 7 |\n| Working capital | $ | 1,806,333 | $ | 4,629,696 | $ | (2,823,363 | ) | (61 | )% |\n| Current ratio | 1.3 | 1.9 |\n\n\n| 34 |\n\n\n| · | As of June 30, 2018, we had working capital surplus of $1,806,333, a decrease of $2,823,363 from a working capital surplus of $4,629,696 as of December 31, 2017. The decrease in working capital surplus was attributable mainly to uncollectible accounts receivable from AEC Southern UK. |\n\n\n| · | We believe that our working capital will be sufficient to enable us to meet our cash requirements for the next 12 months. However, we may incur additional expenses as we seek to expand our operations by establishing additional representative offices in our major market—the PRC, increasing our marketing efforts, and hiring more personnel to support our growing operations. We believe we have adequate working capital to fund future growth activities. |\n\nOff-Balance Sheet Arrangements\nWe did not have, during the periods presented, and we are currently not party to, any off-balance sheet arrangements.\nSeasonality\nWe experience seasonality in business with students as chief customers, particularly AEC New York’s student consulting/college application business. The seasonality reflects the general trend of the industry of admissions and education related services, corresponding to the predominantly fall semester start dates of educational institutions. Our services are higher in the fourth and first quarters of our fiscal year than the other two quarters, reflecting the engagement for services of educational institutions admissions predominantly occurring in the fourth quarter and first quarter of a calendar year, and other consulting services corresponding to the beginning of the academic year, i.e. the fall semester.\nThere is no noticeable seasonality for consulting services for companies, namely company consulting services in AEC New York’s business and executive/staff training services in AEC Southern UK’s business.\nSubsequent Event\nThe following are a series of events that occurred after the three months ended June 30, 2018.\nBusiness Purchase\nOn July 10, 2018, we entered into a Business Purchase Agreement (the “Purchase Agreement”) with FIFPAC, Inc., a New Jersey corporation (the “Seller”), a 100% owner of American Institute of Financial Intelligence LLC, a New Jersey corporation (“AIFI” or the “Target”). Pursuant to the Purchase Agreement, on July 10, 2018, the Company issued 100,000 shares of the Company’s common stock (the “Consideration Shares”) to the Seller, in exchange for 51% equity ownership of the AIFI within 30 days from July 10, 2018.\n\nNot applicable.\n\n| 35 |\n\n\nEvaluation of Disclosure Control and Procedures.\nDisclosure controls are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Exchange Act, such as this Form 10-Q, is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the Chief Executive Officer (CEO), as appropriate to allow timely decisions regarding required disclosure.\nDuring the three months ended June 30, 2018, procedures have been established to ensure that all significant, non-routine events and pending transactions must be evaluated by our CEO for disclosures in our consolidated financial statements and public filings.\nWe performed an evaluation, under the supervision and with the participation of our management, including our CEO, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this Form 10-Q. Based on this evaluation, our CEO has concluded that, as of June 30, 2018, our disclosure controls and procedures were not effective to ensure that information required to be disclosed in reports filed under the Exchange Act is recorded, processed, summarized and reported properly within the time periods specified by the SEC, and did not provide reasonable assurance that information required to be disclosed by the Company in such reports would be accumulated and communicated to the Company’s management, including its CEO, as appropriate, to allow timely decisions regarding required disclosure. Such conclusion was based solely on the fact that the Company identified deficiencies in its internal control over financial reporting as of June 30, 2018. We have identified the following weaknesses and deficiencies in disclosure control and procedures.\nLack of financial expert - We currently do not have a CFO with significant U.S. publicly reporting company experience, nor do we have a financial expert in our management team.\nLack of segregation of duties - Our CEO has also acted as our interim CFO since February 5, 2018, when our previous CFO resigned from his position. Therefore, all accounting information is currently reviewed only by one person.\nOther deficiencies - We have limited administrative and accounting resources, outdated accounting software and generally weak accounting processes and internal control procedures. Additionally, we have inadequate segregation of duties in certain accounting processes, including the payroll, cash receipts and disbursements processes in our accounting system, partly as a result of our limited size and accounting staff. We are taking steps to remediate these issues and plan to have improved controls and documentation in place by December 31, 2018.\nChanges in internal control over financial reporting\nThere were no changes in the Company’s internal control over financial reporting that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\nPART II\nOTHER INFORMATION\n\nFrom time to time, we may become involved in various lawsuits and legal proceedings, which arise in the ordinary course of business. However, litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm business. We are currently not aware of any such legal proceedings or claims that will have, individually or in the aggregate, a material adverse effect on our business, financial condition or operating results.\n\n| 36 |\n\n\nNot applicable to a smaller reporting company.\n\nOn July 10, 2018 (the “Effective Date”), we entered into a Business Purchase Agreement (the “Purchase Agreement”) with FIFPAC, Inc., a New Jersey corporation (the “Seller”), a 100% owner of American Institute of Financial Intelligence LLC, a New Jersey corporation (“AIFI” or the “Target”). Pursuant to the Purchase Agreement, on July 10, 2018, we issued 100,000 shares of the Company’s common stock (the “Consideration Shares”) to the Seller, in exchange for a 51% equity ownership in AIFI within 30 days from the Effective Date. The Seller has agreed to hold the Consideration Shares for 180 days following July 10, 2018 before selling any or all portion of the Consideration Shares.\nIn July and August 2018, the Company has issued an aggregate of 449,900 shares of the Company’s common stock to 18 individuals who are either employees of the Company or have been service providers to the Company, for employment-based compensation or service provided, respectively.\nAll of the securities referenced above were offered and issued in reliance upon the exemption from registration pursuant to the exemption from registration provided by Section 4(a)(2) of the Securities Act of 1933, as amended (the “Securities Act”) and Regulation D promulgated thereunder.\n\nNot applicable.\n\nNot applicable.\n\nNone.\n\n\n| Exhibit No. | Description |\n| 3.1 | Articles of Incorporation dated May 6, 2014 (incorporated by reference to our Form S-1 Registration Statement, Exhibit 3.1, filed with the Securities and Exchange Commission on December 18, 2014) |\n| 3.2 | Bylaws (incorporated by reference to our Form S-1 Registration Statement, Exhibit 3.2, filed with the Securities and Exchange Commission on December 18, 2014) |\n| 3.3 | Certificate of Designation of Series A Convertible Preferred Stock, Exhibit 3.1, filed with the Securities and Exchange Commission on November 3, 2017) |\n| 4.1 | Specimen stock certificate (incorporated by reference to our Form S-1 Registration Statement, Exhibit 4.1, filed with the Securities and Exchange Commission on December 18, 2014) |\n| 10.1 | Implementation Agreement by and between American Education Center, Inc. and New Oriental Education & Tech Group GuangZhou Branch (incorporated by reference to Amendment No.2 to our Form S-1 Registration Statement, Exhibit 10.3, filed with the Securities and Exchange Commission on May 7, 2015) |\n| 10.2 | Loan Agreement by and between American Education Center, Inc. and Hilary Merchant Inc. (incorporated by reference to Form 10-Q, Exhibit 10.1, filed with the Securities and Exchange Commission on June 29, 2015) |\n| 10.3 | Agreement of Lease by and between American Education Center, Inc. and Fieldstone Capital Inc. (incorporated by reference to our Form 10-Q, Exhibit 10.2, filed with the Securities and Exchange Commission on June 29, 2015) |\n| 10.4 | Service Agreement by and between American Education Center, Inc. and AEC Southern (Shenzhen) Management Co., Ltd. (incorporated by reference to Form 8-K, Exhibit 10.1, filed with the Securities and Exchange Commission on January 6, 2017) |\n| 10.5 | Employment Agreement by and between American Education Center, Inc. and Max Pu Chen (incorporated by reference to Form 8-K, Exhibit 10.1, filed with the Securities and Exchange Commission on August 30, 2017) |\n| 10.6 | Employment Agreement by and between American Education Center, Inc. and Anthony S. Chan (incorporated by reference to Form 8-K, Exhibit 10.1, filed with the Securities and Exchange Commission on October 2, 2017) |\n| 10.7 | License Agreement by and between American Education Center, Inc. and Max P. Chen (incorporated by reference to Form 8-K, Exhibit 10.1, filed with the Securities and Exchange Commission on October 23, 2017) |\n| 10.8 | Strategic Partnership Agreement by and between American Education Center, Inc. and Oxbridge International Education Group (incorporated by reference to Form 8-K, Exhibit 99.2, filed with the Securities and Exchange Commission on December 5, 2017) |\n| 10.9 | Business Purchase Agreement by and between American Education Center, Inc. and FIFPAC, Inc. (incorporate by reference to our Form 8-K (filed No. 333-201029) filed with the Securities and Exchange Commission on July 12, 2018) |\n| 31.1 | Certification of Chief Executive Officer pursuant to Exchange Act Rule 13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 * |\n| 31.2 | Certification of Chief Financial Officer pursuant to Exchange Act Rule 13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 * |\n| 32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 ** |\n| 32.2 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 ** |\n| 99.1 | Termination Notice to the Implementation Agreement (incorporated by reference to Amendment No.2 to our Form S-1 Registration Statement, Exhibit 10.5, filed with the Securities and Exchange Commission on May 7 ,2015) |\n| 99.2 | Non-binding Letter of Intent by and between American Education Center, Inc. and AmeriChina Group (incorporated by reference to our Form 8-K (file No. 333-201029) filed with the Securities and Exchange Commission on May 9, 2018) |\n| 99.3 | Letter of Intent by and between American Education Center, Inc. and Shanghai Education Service Park (incorporated by reference to our Form 8-K (file No. 333-201029) filed with the Securities and Exchange Commission on May 15, 2018) |\n| 99.4 | Non-binding Letter of Intent by and between American Education Center, Inc. and Shanghai Open University (incorporated by reference to our Form 8-K (file No. 333-201029) filed with the Securities and Exchange Commission on July 27, 2018) |\n| 101.INS | XBRL Instance Document ** |\n| 101.SCH | XBRL Taxonomy Extension Schema Document ** |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document ** |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document ** |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document ** |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document ** |\n\n\n| * | Filed herewith. |\n| ** | Furnished herewith. |\n\n\n| 37 |\n\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| August 20, 2018 |\n| AMERICAN EDUCATION CENTER INC. |\n| By: | /s/ Max P. Chen |\n| Max P. Chen |\n| President, Sole Director, Chief Executive Officer, interim Chief Financial Officer and Secretary |\n| (Principal Executive Officer, Principal Financial |\n| Officer and Principal Accounting Officer) |\n\n\n| 38 |\n\n</text>\n\nWhat is the percentage change in the gross profit to revenue ratio for American Education Center, Inc. from the three months ended June 30, 2017 to the same period in 2018?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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doc-math
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"ground_truth": "Therefore, the answer is 21.48."
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docmath_40000_plus
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Condensed Financial Statements\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nCONDENSED BALANCE SHEETS\n\n| March 31, 2022 | December 31, 2021 |\n| (unaudited) |\n| Assets |\n| Current assets: |\n| Cash | $ | 320,628 | $ | 666,300 |\n| Prepaid expenses - current | 281,087 | 225,750 |\n| Total current assets | 601,715 | 892,050 |\n| Prepaid expenses - long-term | - | 47,412 |\n| Investments held in Trust Account | 281,067,324 | 281,049,184 |\n| Total Assets | $ | 281,669,039 | $ | 281,988,646 |\n| Liabilities, Class A Ordinary Shares Subject to Possible Redemption and Shareholders' Deficit |\n| Current liabilities: |\n| Accounts payable | $ | 160,750 | $ | 302,391 |\n| Accrued expenses | 1,090,004 | 968,262 |\n| Total current liabilities | 1,250,754 | 1,270,653 |\n| Deferred underwriting commissions | 9,836,207 | 9,836,207 |\n| Derivative warrant liabilities | 4,338,280 | 8,487,930 |\n| Total Liabilities | 15,425,241 | 19,594,790 |\n| Commitments and Contingencies (Note 5) |\n| Class A ordinary shares subject to possible redemption, $ 0.0001 par value; 28,103,449 shares at $ 10.00 per share as of March 31, 2022 and December 31, 2021 | 281,034,490 | 281,034,490 |\n| Shareholders' Deficit |\n| Preference shares, $ 0.0001 par value; 5,000,000 shares authorized; no shares issued or outstanding | - | - |\n| Class A ordinary shares, $ 0.0001 par value; 500,000,000 shares authorized; no non-redeemable shares issued or outstanding | - | - |\n| Class B ordinary shares, $ 0.0001 par value; 50,000,000 shares authorized; 7,025,862 shares issued and outstanding as of March 31, 2022 and December 31, 2021 | 703 | 703 |\n| Additional paid-in capital | - | - |\n| Accumulated deficit | ( 14,791,395 | ) | ( 18,641,337 | ) |\n| Total Shareholders' Deficit | ( 14,790,692 | ) | ( 18,640,634 | ) |\n| Total Liabilities, Class A Ordinary Shares Subject to Possible Redemption and Shareholders' Deficit | $ | 281,669,039 | $ | 281,988,646 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n1\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nUNAUDITED CONDENSED STATEMENTS OF OPERATIONS\n\n| For the Three Months Ended March 31, |\n| 2022 | 2021 |\n| General and administrative expenses | $ | 317,848 | $ | 101,668 |\n| Loss from operations | ( 317,848 | ) | ( 101,668 | ) |\n| Other income (expense) |\n| Change in fair value of derivative warrant liabilities | 4,149,650 | ( 205,000 | ) |\n| Financing costs - derivative warrant liabilities | - | ( 287,083 | ) |\n| Gain on investments held in Trust Account | 18,140 | 287 |\n| Net income (loss) | $ | 3,849,942 | $ | ( 593,464 | ) |\n| Weighted average shares outstanding of Class A ordinary shares, basic and diluted | 28,103,449 | 1,944,444 |\n| Basic and diluted net income (loss) per share, Class A ordinary shares | $ | 0.11 | $ | ( 0.07 | ) |\n| Weighted average shares outstanding of Class B ordinary shares, basic and diluted | 7,025,862 | 6,250,000 |\n| Basic and diluted net income (loss) per share, Class B ordinary shares | $ | 0.11 | $ | ( 0.07 | ) |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n2\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nUNAUDITED CONDENSED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (DEFICIT)\nFOR THE THREE MONTHS ENDED MARCH 31, 2022\n\n| Ordinary Shares | Additional | Total |\n| Class A | Class B | Paid-in | Accumulated | Shareholders' |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Deficit |\n| Balance - December 31, 2021 | - | $ | - | 7,025,862 | $ | 703 | $ | - | $ | ( 18,641,337 | ) | $ | ( 18,640,634 | ) |\n| Net income | - | - | - | - | - | 3,849,942 | 3,849,942 |\n| Balance - March 31, 2022 (unaudited) | - | $ | - | 7,025,862 | $ | 703 | $ | - | $ | ( 14,791,395 | ) | $ | ( 14,790,692 | ) |\n\nFOR THE THREE MONTHS ENDED MARCH 31, 2021\n\n| Ordinary Shares | Additional | Total |\n| Class A | Class B | Paid-in | Accumulated | Shareholders' |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Deficit |\n| Balance - December 31, 2020 | - | $ | - | 7,187,500 | $ | 719 | $ | 24,281 | $ | ( 9,414 | ) | $ | 15,586 |\n| Excess of cash received over fair value of private placement warrants | - | - | - | - | 3,360,000 | - | 3,360,000 |\n| Accretion of Class A ordinary shares to redemption amount | - | - | - | - | ( 3,384,281 | ) | ( 15,673,854 | ) | ( 19,058,135 | ) |\n| Net loss | - | - | - | - | - | ( 593,464 | ) | ( 593,464 | ) |\n| Balance - March 31, 2021 (unaudited) | - | $ | - | 7,187,500 | $ | 719 | $ | - | $ | ( 16,276,732 | ) | $ | ( 16,276,013 | ) |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n3\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nUNAUDITED CONDENSED STATEMENTS OF CASH FLOWS\n\n| For the Three Months Ended March 31, |\n| 2022 | 2021 |\n| Cash Flows from Operating Activities: |\n| Net income (loss) | $ | 3,849,942 | $ | ( 593,464 | ) |\n| Adjustments to reconcile net income (loss) to net cash used in operating activities: |\n| Change in fair value of derivative warrant liabilities | ( 4,149,650 | ) | 205,000 |\n| Financing costs - derivative warrant liabilities | - | 287,083 |\n| Gain on investments held in Trust Account | ( 18,140 | ) | ( 287 | ) |\n| Changes in operating assets and liabilities: |\n| Prepaid expenses | ( 7,925 | ) | ( 419,288 | ) |\n| Accounts payable | ( 56,641 | ) | 433,501 |\n| Accrued expenses | 121,742 | 37,484 |\n| Due to related party | - | 6,615 |\n| Net cash used in operating activities | ( 260,672 | ) | ( 43,356 | ) |\n| Cash Flows from Investing Activities: |\n| Cash deposited in Trust Account | - | ( 250,000,000 | ) |\n| Net cash used in investing activities | - | ( 250,000,000 | ) |\n| Cash Flows from Financing Activities: |\n| Proceeds from note payable to related party | - | 300,000 |\n| Repayment of note payable to related party | - | ( 300,000 | ) |\n| Proceeds received from initial public offering, gross | - | 250,000,000 |\n| Proceeds received from private placement | - | 7,000,000 |\n| Offering costs paid | ( 85,000 | ) | ( 5,124,408 | ) |\n| Net cash (used in) provided by financing activities | ( 85,000 | ) | 251,875,592 |\n| Net change in cash | ( 345,672 | ) | 1,832,236 |\n| Cash - beginning of the period | 666,300 | - |\n| Cash - end of the period | $ | 320,628 | $ | 1,832,236 |\n| Supplemental disclosure of noncash financing activities: |\n| Offering costs included in accounts payable | $ | - | $ | 85,810 |\n| Offering costs included in accrued expenses | $ | - | $ | 350,000 |\n| Deferred underwriting commissions | $ | - | $ | 8,750,000 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n4\nNote 1 - Description of Organization, Business Operations and Liquidity\nSupernova Partners Acquisition Company III, Ltd. (the “Company”) was incorporated as a Cayman Islands exempted company on December 24, 2020. The Company was formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses (the “Business Combination”). The Company is an emerging growth company and, as such, the Company is subject to all the risks associated with emerging growth companies.\nAs of March 31, 2022, the Company had not commenced any operations. All activity for the period from December 24, 2020 (inception) through March 31, 2022, relates to the Company’s formation and the initial public offering (the “Initial Public Offering”) described below, and since the Initial Public Offering, the search or an initial Business Combination. The Company will not generate any operating revenues until after the completion of its initial Business Combination, at the earliest. The Company generates non-operating income in the form of interest income on from the proceeds from the Initial Public Offering held in the trust account.\nThe Company’s sponsor is Supernova Partners III LLC, a Cayman Islands exempted company (the “Sponsor”). The registration statement for the Company’s Initial Public Offering was declared effective on March 22, 2021. On March 25, 2021, the Company consummated its Initial Public Offering of 25,000,000 units (the “Units” and, with respect to the Class A ordinary shares included in the Units being offered, the “Public Shares”), at $ 10.00 per Unit, generating gross proceeds of $ 250.0 million, and incurring offering costs of approximately $ 14.3 million, of which approximately $ 8.8 million was for deferred underwriting commissions (see Note 5).\nThe Company granted the underwriters in the IPO (the “Underwriters”) a 45-day option to purchase up to 3,750,000 additional Units to cover over-allotments, if any. The Underwriters exercised the over-allotment option in part and on April 1, 2021 purchased an additional 3,103,449 Units, generating gross proceeds of approximately $ 31.0 million (the “Over-Allotment”), and incurring additional offering costs of approximately $ 1.7 million in offering costs, of which approximately $ 1.1 million was for deferred underwriting fees.\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the private placement (“Private Placement”) of 3,500,000 warrants (each, a “Private Placement Warrant” and collectively, the “Private Placement Warrants”), at a price of $ 2.00 per Private Placement Warrant with the Sponsor, generating gross proceeds of $ 7.0 million (see Note 4).\nSimultaneously with the closing of the Over-Allotment on April 1, 2021, the Company consummated the second closing of the Private Placement, resulting in the purchase of an aggregate of an additional 310,345 Private Placement Warrants by the Sponsor, generating gross proceeds to the Company of approximately $ 621,000 .\nIn addition, the Sponsor agreed to forfeit up to 937,500 Class B ordinary shares, par value $ 0.0001 (the “Founder Shares”) to the extent that the over-allotment option was not exercised in full by the underwriters. The underwriters partially exercised their over-allotment option on April 1, 2021, and subsequently on May 9, 2021, the Sponsor forfeited 161,638 Class B ordinary shares.\nUpon the closing of the Initial Public Offering, the Over-Allotment, and the Private Placement, $ 281.0 million ($ 10.00 per Unit) of the net proceeds of the Initial Public Offering and certain of the proceeds of the Private Placement was placed in a trust account (“Trust Account”), located in the United States at J.P. Morgan Chase Bank, N.A., with American Stock Transfer & Trust Company acting as trustee, and invested only in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), with a maturity of 185 days or less or in any open-ended investment company that holds itself out as a money market fund selected by the Company meeting the conditions of paragraphs (d)(2), (d)(3) and (d)(4) of Rule 2a-7 of the Investment Company Act, as determined by the Company, until the earlier of: (i) the completion of a Business Combination and (ii) the distribution of the Trust Account as described below.\nThe Company’s management has broad discretion with respect to the specific application of the net proceeds of the Initial Public Offering and the sale of Private Placement Warrants, although substantially all of the net proceeds are intended to be applied generally toward consummating a Business Combination. There is no assurance that the Company will be able to complete a Business Combination successfully. The Company must complete one or more initial Business Combinations having an aggregate fair market value of at least 80 % of the assets held in the Trust Account (excluding the amount of any deferred underwriting discount held in trust) at the time of the signing of the agreement to enter into the initial Business Combination. However, the Company will only complete a Business Combination if the post-transaction company owns or acquires 50 % or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act.\n5\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nThe Company will provide its holders of its Public Shares (the “Public Shareholders”) with the opportunity to redeem all or a portion of their Public Shares upon the completion of a Business Combination either (i) in connection with a general meeting called to approve the Business Combination or (ii) by means of a tender offer. The decision as to whether the Company will seek shareholder approval of a Business Combination or conduct a tender offer will be made by the Company, solely in its discretion. The Public Shareholders will be entitled to redeem their Public Shares\nfor a pro rata portion of the amount then in the Trust Account (at $ 10.00 per Public Share). The per-share amount to be distributed to Public Shareholders who redeem their Public Shares will not be reduced by the deferred underwriting commissions the Company will pay to the underwriters (as discussed in Note 5). These Public Shares were classified as temporary equity in accordance with the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” In such case, the Company will proceed with a Business Combination if the Company has net tangible assets of at least $ 5,000,001 upon such consummation of a Business Combination and a majority of the shares voted are voted in favor of the Business Combination. If a shareholder vote is not required by law and the Company does not decide to hold a shareholder vote for business or other legal reasons, the Company will, pursuant to its amended and restated memorandum and articles of association (the “Amended and Restated Memorandum and Articles of Association”), conduct the redemptions pursuant to the tender offer rules of the U.S. Securities and Exchange Commission (“SEC”) and file tender offer documents with the SEC prior to completing a Business Combination. If, however, shareholder approval of the transactions is required by law, or the Company decides to obtain shareholder approval for business or legal reasons, the Company will offer to redeem shares in conjunction with a proxy solicitation pursuant to the proxy rules and not pursuant to the tender offer rules. Additionally, each Public Shareholder may elect to redeem their Public Shares irrespective of whether they vote for or against the proposed transaction. If the Company seeks shareholder approval in connection with a Business Combination, the initial shareholders (as defined below) agreed to vote their Founder Shares (as defined below in Note 4) and any Public Shares purchased during or after the Initial Public Offering in favor of a Business Combination. Subsequent to the consummation of the Initial Public Offering, the Company has adopted an insider trading policy which will require insiders to: (i) refrain from purchasing shares during certain blackout periods and when they are in possession of any material non-public information and (ii) to clear all trades with the Company’s legal counsel prior to execution. In addition, the initial shareholders agreed to waive their redemption rights with respect to their Founder Shares and Public Shares in connection with the completion of a Business Combination.\nNotwithstanding the foregoing, the Amended and Restated Memorandum and Articles of Association will provide that a Public Shareholder, together with any affiliate of such shareholder or any other person with whom such shareholder is acting in concert or as a “group” (as defined under Section 13 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), will be restricted from redeeming its shares with respect to more than an aggregate of 15 % or more of the Class A ordinary shares sold in the Initial Public Offering, without the prior consent of the Company.\nThe Company’s Sponsor, officers and directors (the “initial shareholders”) agreed not to propose an amendment to the Amended and Restated Memorandum and Articles of Association that would modify the substance or timing of the Company’s obligation to redeem 100 % of its Public Shares if the Company does not complete a Business Combination, unless the Company provides the Public Shareholders with the opportunity to redeem their Class A ordinary shares in conjunction with any such amendment.\nIf the Company is unable to complete a Business Combination within 24 months from the closing of the Initial Public Offering, or March 25, 2023 (the “Combination Period”), the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem\nthe Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including interest earned on the funds held in the Trust Account (less taxes payable and up to $ 100,000 of interest to pay dissolution expenses), divided by the number of then outstanding public shares, which redemption will completely extinguish Public Shareholders’ rights as shareholders (including the right to receive further liquidation\n6\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\ndistributions, if any) and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the remaining shareholders and the board of directors, liquidate and dissolve, subject, in the case of clauses (ii) and (iii), to the Company’s obligations under Cayman Islands law to provide for claims of creditors and in all cases subject to the other requirements of applicable law. There will be no redemption rights or liquidating distributions with respect to the warrants, which will expire worthless if the Company fails to complete its initial Business Combination within the Combination Period.\nThe Sponsor agreed to waive their liquidation rights with respect to the Founder Shares if the Company fails to complete a Business Combination within the Combination Period. However, if the Sponsor or members of the Company’s management team acquire Public Shares in or after the Initial Public Offering, they will be entitled to liquidating distributions from the Trust Account with respect to such Public Shares if the Company fails to complete a Business Combination within the Combination Period. The underwriters agreed to waive their rights to their deferred underwriting commission (see Note 5) held in the Trust Account in the event the Company does not complete a Business Combination within in the Combination Period and, in such event, such amounts will be included with the other funds held in the Trust Account that will be available to fund the redemption of the Public Shares. In the event of such distribution, it is possible that the per share value of the residual assets remaining available for distribution (including Trust Account assets) will be only $ 10.00 per share initially held in the Trust Account. In order to protect the amounts held in the Trust Account, the Sponsor agreed to be liable to the Company if and to the extent any claims by a vendor for services rendered or products sold to the Company, or a prospective target business with which the Company has discussed entering into a transaction agreement, reduce the amount of funds in the Trust Account. This liability will not apply with respect to any claims by a third party who executed a waiver of any right, title, interest or claim of any kind in or to any monies held in the Trust Account or to any claims under the Company’s indemnity of the underwriters of the Initial Public Offering against certain liabilities, including liabilities under the Securities Act of 1933, as amended (the “Securities Act”). Moreover, in the event that an executed waiver is deemed to be unenforceable against a third party, the Sponsor will not be responsible to the extent of any liability for such third-party claims. The Company will seek to reduce the possibility that the Sponsor will have to indemnify the Trust Account due to claims of creditors by endeavoring to have all vendors, service providers, except the independent registered public accounting firm, prospective target businesses or other entities with which the Company does business, execute agreements with the Company waiving any right, title, interest or claim of any kind in or to monies held in the Trust Account.\nGoing Concern\nAs of March 31, 2022, the Company had approximately $ 0.3 million in its operating bank account and a working capital deficit of approximately $ 0.6 million.\nThe Company has incurred and expects to incur significant costs in pursuit of its financing and acquisition plans. In connection with the Company’s assessment of going concern considerations, management has determined that the Company’s cash flow deficit raise substantial doubt about the Company’s ability to continue as a going concern within one year after the date that the unaudited condensed financial statements are issued. There is no assurance that the Company’s plans to consummate a Business Combination or raise additional funds will be successful within the Combination Period. The unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty.\nRisks and Uncertainties\nManagement continues to evaluate the impact of the COVID-19 global pandemic on the industry and has concluded that while it is reasonably possible that the virus could have a negative effect on the Company’s financial position, results of its operations, and/or search for a target company, the specific impact is not readily determinable as of the date of these unaudited condensed financial statements. The unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty.\n7\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nNote 2 - Basis of Presentation and Summary of Significant Accounting Policies\nBasis of Presentation\nThe accompanying unaudited condensed financial statements are presented in U.S. dollars in conformity with accounting principles generally accepted in the United States of America (“GAAP”) for financial information and pursuant to the rules and regulations of the SEC. Accordingly, they do not include all of the information and footnotes required by GAAP. In the opinion of management, the unaudited condensed financial statements reflect all adjustments, which include only normal recurring adjustments necessary for the fair statement of the balances and results for the periods presented. Operating results for the three months ended March 31, 2022 are not necessarily indicative of the results that may be expected for the year ending December 31, 2022.\nThe accompanying unaudited condensed financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Annual Report on Form 10-K filed by the Company with the SEC on March 25, 2022. In the Annual Report on Form 10-K the Company had a typographical error in the Accumulated deficit balance reported on the Company’s balance sheet as of December 31, 2021, whereby the reported accumulated deficit of $( 18 ) should have been reported as ($ 18,641,337 ). The accumulated deficit amount was reported correctly in the statements of changes in shareholders’ equity (deficit) for the year ended December 31, 2021 within the Annual Report on Form 10-K. The Company has corrected this typographical error in the accompanying unaudited condensed balance sheets.\nEmerging Growth Company\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the independent registered public accounting firm attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s unaudited condensed financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\nUse of Estimates\nThe preparation of unaudited condensed financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited condensed financial statements and the reported amounts of revenues and expenses during the reporting period. Making estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the unaudited condensed financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. Accordingly, the actual results could differ from those estimates.\n8\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nConcentration of Credit Risk\nFinancial instruments that potentially subject the Company to credit risk consist principally of cash and investments held in the Trust Account. Cash is maintained in accounts with financial institutions, which, at times may exceed the Federal Depository Insurance Corporation coverage limit of $ 250,000 , and investments held in the Trust Account. As of March 31, 2022 and December 31, 2021, the Company had not experienced losses on these accounts and management believes the Company is not exposed to significant risks on such accounts.\nCash and Cash Equivalents\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company had no cash equivalents as of March 31, 2022 and December 31, 2021.\nInvestments Held in the Trust Account\nThe Company’s portfolio of investments is comprised of U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, with a maturity of 185 days or less , or investments in money market funds that invest in U.S. government securities and generally have a readily determinable fair value, or a combination thereof. When the Company’s investments held in the Trust Account are comprised of U.S. government securities, the investments are classified as trading securities. When the Company’s investments held in the Trust Account are comprised of money market funds, the investments are recognized at fair value. Trading securities and investments in money market funds are presented on the condensed balance sheets at fair value at the end of each reporting period. Gains and losses resulting from the change in fair value of these securities is included in income on investments held in the Trust Account in the accompanying statements of operations. The estimated fair values of investments held in the Trust Account are determined using available market information.\nFair Value of Financial Instruments\nThe fair value of the Company’s assets and liabilities which qualify as financial instruments under the FASB ASC Topic 820, “Fair Value Measurements,” equal or approximate the carrying amounts represented in the condensed balance sheets.\nFair Value Measurements\nThe hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). These tiers consist of:\n\n| • | Level 1, defined as observable inputs such as quoted prices for identical instruments in active markets; |\n\n\n| • | Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable such as quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active; and |\n\n\n| • | Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions, such as valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable. |\n\nIn some circumstances, the inputs used to measure fair value might be categorized within different levels of the fair value hierarchy. In those instances, the fair value measurement is categorized in its entirety in the fair value hierarchy based on the lowest level input that is significant to the fair value measurement.\nDerivative Warrant Liabilities\nThe Company does not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks. The Company evaluates all of its financial instruments, including issued stock purchase warrants, to determine if such\n9\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\ninstruments are derivatives or contain features that qualify as embedded derivatives, pursuant to ASC Topic 480 “Distinguishing Liabilities from Equity” (“ASC 480”) and FASB ASC Topic 815, “Derivatives and Hedging” (“ASC 815”). The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity is re-assessed at the end of each reporting period.\nThe warrants issued in connection with the Initial Public Offering (the “Public Warrants”) and the Private Placement Warrants are recognized as derivative liabilities in accordance with ASC 815. Accordingly, the Company recognizes the warrant instruments as liabilities at fair value and adjusts the instruments to fair value at each reporting period. The liabilities are subject to re-measurement at each balance sheet date until exercised, and any change in fair value is recognized in the Company’s statements of operations. The fair value of the Public Warrants issued in connection with the Public Offering and Private Placement Warrants were initially measured at fair value using a Monte Carlo simulation model. Subsequent to the separate listing and trading of the Public Warrants the fair value of the Public Warrants has been measured based on the observable listed prices for such warrants and the fair value of the Private Warrants are measured using a Black-Scholes Option Pricing Model. Derivative warrant liabilities are classified as non-current liabilities as their liquidation is not reasonably expected to require the use of current assets or require the creation of current liabilities.\nOffering Costs Associated with the Initial Public Offering\nOffering costs consisted of legal, accounting, underwriting fees and other costs incurred through the Initial Public Offering that were directly related to the Initial Public Offering. Offering costs are allocated to the separable financial instruments issued in the Initial Public Offering based on a relative fair value basis, compared to total proceeds received. Offering costs associated with derivative warrant liabilities are expensed as incurred, presented as non-operating expenses in the statements of operations. Offering costs associated with the Class A ordinary shares were charged against the carrying value of the Class A ordinary shares upon the completion of the Initial Public Offering. The Company classifies deferred underwriting commissions as non-current liabilities as their liquidation is not reasonably expected to require the use of current assets or require the creation of current liabilities.\nClass A Ordinary Shares Subject to Possible Redemption\nThe Company accounts for its Class A ordinary shares subject to possible redemption in accordance with the guidance in ASC Topic 480 “Distinguishing Liabilities from Equity.” Class A ordinary shares subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable Class A ordinary shares (including Class A ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) are classified as temporary equity. At all other times, Class A ordinary shares are classified as shareholders’ equity. The Company’s Class A ordinary shares feature certain redemption rights that are considered to be outside of the Company’s control and subject to the occurrence of uncertain future events. Accordingly, as of March 31, 2022 and December 31, 2021, the Company had 28,103,449 Class A ordinary shares subject to possible redemption presented as temporary equity, outside of the shareholders’ equity section of the Company’s condensed balance sheets.\nUnder ASC 480-10-S99, the Company has elected to recognize changes in the redemption value immediately as they occur and adjust the carrying value of the security to equal the redemption value at the end of the reporting period. Effective with the closing of the Initial Public Offering (including exercise of the over-allotment option), the Company recognized the accretion from initial book value to redemption amount, which resulted in charges against additional paid-in capital (to the extent available) and accumulated deficit.\nShare-based Compensation\nThe transfer of the Founder Shares is in the scope of FASB ASC Topic 718, “Compensation-Stock Compensation” (“ASC 718”). Under ASC 718, stock-based compensation associated with equity-classified awards is measured at fair value upon the grant date. The Founders Shares were granted subject to a performance condition (i.e., the occurrence of a Business Combination). Compensation expense related to the Founders Shares is recognized only when the performance condition is probable of occurrence under the applicable accounting literature in this circumstance. As of the date of issuance of this Form 10-Q, the Company determined that a Business Combination is not considered probable, and, therefore, no stock-based compensation expense has been recognized. Stock-based compensation\n10\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nwould be recognized at the date a Business Combination is considered probable (i.e., upon completion of a Business Combination) in an amount equal to the number of Founders Shares that ultimately vest multiplied times the grant date fair value per share (unless subsequently modified) less the amount initially received for the purchase of the Founders Shares.\nIncome Taxes\nThe Company follows the asset and liability method of accounting for income taxes under ASC 740, “Income Taxes.” Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that included the enactment date. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.\nASC Topic 740 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The Company’s management determined that the Cayman Islands is the Company’s only major tax jurisdiction. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of March 31, 2022 and December 31, 2021. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position.\nThe Company is considered an exempted Cayman Islands company and is presently not subject to income taxes or income tax filing requirements in the Cayman Islands or the United States. As such, the Company’s tax provision was zero for the period presented. The Company’s management does not expect that the total amount of unrecognized tax benefits will materially change over the next twelve months.\nNet Income (Loss) Per Ordinary Share\nThe Company complies with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share.” The Company has two classes of shares, which are referred to as Class A ordinary shares and Class B ordinary shares. Income and losses are shared pro rata between the two classes of shares. Net income (loss) per ordinary share is calculated by dividing the net income (loss) by the weighted average shares of ordinary shares outstanding for the respective period.\nThe calculation of diluted net income (loss) per ordinary share does not consider the effect of the warrants issued in connection with the Initial Public Offering (including exercise of the over-allotment option) and the Private Placement to purchase an aggregate of 9,431,035 shares of Class A ordinary shares in the calculation of diluted income (loss) per share, because their exercise is contingent upon future events and their inclusion would be anti-dilutive under the treasury stock method. Accretion associated with the redeemable Class A ordinary shares is excluded from earnings per share as the redemption value approximates fair value.\nThe following table reflects presents a reconciliation of the numerator and denominator used to compute basic and diluted net loss per share for each class of ordinary shares:\n11\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\n\n| For the Three Months Ended March 31, |\n| 2022 | 2021 |\n| Class A | Class B | Class A | Class B |\n| Basic and diluted net income (loss) per ordinary share: |\n| Numerator: |\n| Allocation of net income (loss) - basic and diluted | $ | 3,079,954 | $ | 769,988 | $ | ( 140,822 | ) | $ | ( 452,642 | ) |\n| Denominator: |\n| Basic and diluted weighted average ordinary shares outstanding | 28,103,449 | 7,025,862 | 1,944,444 | 6,250,000 |\n| Basic and diluted net income (loss) per ordinary share | $ | 0.11 | $ | 0.11 | $ | ( 0.07 | ) | $ | ( 0.07 | ) |\n\nRecent Accounting Pronouncements\nThe Company’s management does not believe that any other recently issued, but not yet effective, accounting standards updates, if currently adopted, would have a material effect on the accompanying unaudited condensed financial statements.\nNote 3 - Initial Public Offering\nOn March 25, 2021, the Company consummated its Initial Public Offering of 25,000,000 Units, at $ 10.00 per Unit, generating gross proceeds of $ 250.0 million, and incurring offering costs of approximately $ 14.3 million, of which approximately $ 8.8 million was for deferred underwriting commissions.\nThe Company granted the Underwriters a 45-day option to purchase up to 3,750,000 additional Units to cover over-allotments, if any. The Underwriters partially exercised the over-allotment option and on April 1, 2021, purchased an additional 3,103,449 Units, generating gross proceeds of approximately $ 31.0 million, and incurring additional offering costs of approximately $ 1.7 million in offering costs, of which approximately $ 1.1 million was for deferred underwriting fees.\nEach Unit consists of one Class A ordinary share, and one-fifth of one redeemable warrant (each, a “Public Warrant”). Each Public Warrant entitles the holder to purchase one Class A ordinary share at a price of $ 11.50 per share, subject to adjustment (see Note 6).\nNote 4 - Related Party Transactions\nFounder Shares\nOn December 31, 2020, the Sponsor paid $ 25,000 to cover certain expenses of the Company in consideration of the Founder Shares. On January 14, 2021, the Company effected a share dividend of 1,437,500 Class B ordinary shares, resulting in an aggregate of 7,187,500 Class B ordinary shares outstanding. On March 1, 2021, our Sponsor transferred 28,750 Founder Shares to each of our five independent director nominees. The initial shareholders agreed to forfeit up to 937,500 Founder Shares to the extent that the over-allotment option is not exercised in full by the underwriters, so that the Founder Shares will represent 20 % of the Company’s issued and outstanding shares after the Initial Public Offering. On April 1, 2021, the underwriters partially exercised the over-allotment option to purchase an additional 3,103,449 Units. Subsequently, on May 9, 2021, the Sponsor forfeited 161,638 Class B ordinary shares.\nThe initial shareholders agreed, subject to limited exceptions, not to transfer, assign or sell any of their Founder Shares until the earlier to occur of: (i) one year after the completion of the initial Business Combination or (ii) the date following the completion of the initial Business Combination on which the Company completes a liquidation, merger, share exchange or other similar transaction that results in all of the shareholders having the right to exchange their ordinary shares for cash, securities or other property. Notwithstanding the foregoing, if the closing price of the Class A ordinary shares equals or exceeds $ 12.00 per share (as adjusted for share sub-divisions, share capitalizations, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing at least 120 days after the initial Business Combination, the Founder Shares will be released from the lockup.\n12\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nPrivate Placement Warrants\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the Private Placement of 3,500,000 Private Placement Warrants, at a price of $ 2.00 per Private Placement Warrant with the Sponsor, generating gross proceeds of $ 7.0 million.\nSimultaneously with the closing of the over-allotment on April 1, 2021, the Company consummated the second closing of the Private Placement, resulting in the purchase of an aggregate of an additional 310,345 Private Placement Warrants by the Sponsor, generating gross proceeds to the Company of approximately $ 621,000 .\nEach whole Private Placement Warrant is exercisable for one whole Class A ordinary share at a price of $ 11.50 per share. A portion of the proceeds from the Private Placement Warrants was added to the proceeds from the Initial Public Offering held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the Private Placement Warrants will expire worthless. The Private Placement Warrants will be non-redeemable except as described below in Note 6 and exercisable on a cashless basis so long as they are held by the Sponsor or its permitted transferees.\nThe Sponsor and the Company’s officers and directors agreed, subject to limited exceptions, not to transfer, assign or sell any of their Private Placement Warrants until 30 days after the completion of the initial Business Combination.\nRelated Party Loans\nOn December 31, 2020, the Sponsor agreed to loan the Company an aggregate of up to $ 300,000 to cover expenses related to the Initial Public Offering pursuant to a promissory note (the “Note”). This Note was non-interest bearing and payable upon the completion of the Initial Public Offering. The Company borrowed $ 300,000 under the Note and repaid the Note in full on March 25, 2021.\nIn addition, in order to fund working capital deficiencies or finance transaction costs in connection with a Business Combination, the Sponsor or an affiliate of the Sponsor, or certain of the Company’s officers and directors may, but are not obligated to, loan the Company funds as may be required (“Working Capital Loans”). If the Company completes a Business Combination, the Company will repay the Working Capital Loans out of the proceeds of the Trust Account released to the Company. Otherwise, the Working Capital Loans would be repaid only out of funds held outside the Trust Account. In the event that a Business Combination does not close, the Company may use a portion of the proceeds held outside the Trust Account to repay the Working Capital Loans, but no proceeds held in the Trust Account would be used to repay the Working Capital Loans. The Working Capital Loans would either be repaid upon consummation of a Business Combination, without interest, or, at the lender’s discretion, up to $ 1.5 million of such Working Capital Loans may be convertible into warrants of the post Business Combination entity at a price of $ 2.00 per warrant. The warrants would be identical to the Private Placement Warrants. Except for the foregoing, the terms of such Working Capital Loans, if any, have not been determined and no written agreements exist with respect to such loans. As of March 31, 2022 and December 31, 2021, the Company had no borrowings under the Working Capital Loans.\nAdministrative Services Agreement\nIn May 2022, the Company entered into an agreement effective on January 1, 2022 through the Company’s consummation of a Business Combination or its liquidation, to pay an affiliate of the Sponsor a sum of up to $ 7,500 per month, for office space, utilities, employee benefits and secretarial and administrative services. In the three months ended March 31, 2022, the Company paid approximately $ 7,000 in fees for these services, of which approximately $ 2,000 was charged to general and administrative expenses within the condensed statements of operations, and approximately $ 5,000 is included within prepaid expenses – current balance in the accompanying condensed balance sheets.\nNote 5 - Commitments and Contingencies\n13\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nRegistration and Shareholder Rights\nThe holders of Founder Shares, Private Placement Warrants and warrants that may be issued upon conversion of Working Capital Loans (and any Class A ordinary shares issuable upon the exercise of the Private Placement Warrants and warrants that may be issued upon conversion of Working Capital Loans) were entitled to registration rights pursuant to a registration and shareholder rights agreement signed upon consummation of the Initial Public Offering. These holders were entitled to certain demand and “piggyback” registration rights. However, the registration and shareholder rights agreement provided that the Company would not permit any registration statement filed under the Securities Act to become effective until the termination of the applicable lock-up period for the securities to be registered. The Company will bear the expenses incurred in connection with the filing of any such registration statements.\nUnderwriting Agreement\nThe underwriters were entitled to an underwriting discount of $ 0.20 per unit, or $ 5.0 million in the aggregate, paid upon the closing of the Initial Public Offering. In addition, $ 0.35 per unit, or approximately $ 8.8 million in the aggregate will be payable to the underwriters for deferred underwriting commissions. The deferred fee will become payable to the underwriters from the amounts held in the Trust Account solely in the event that the Company completes a Business Combination, subject to the terms of the underwriting agreement.\nThe Underwriters partially exercised the over-allotment option and on April 1, 2021 purchased an additional 3,103,449 Units, generating gross proceeds of approximately $ 31.0 million, and incurred additional offering costs of approximately $ 1.7 million in offering costs, of which approximately $ 1.1 million will be payable to the underwriters for additional deferred underwriting fees.\nNote 6 - Warrants\nAs of March 31, 2022 and December 31, 2021, the Company had 5,620,690 and 3,810,345 Public Placement Warrants and Private Placement Warrants outstanding.\nPublic Warrants may only be exercised for a whole number of shares. No fractional Public Warrants will be issued upon separation of the Units and only whole Public Warrants will trade. The Public Warrants will become exercisable 30 days after the completion of a Business Combination or provided in each case that the Company has an effective registration statement under the Securities Act covering the Class A ordinary shares issuable upon exercise of the Public Warrants and a current prospectus relating to them is available (or the Company permits holders to exercise their Public Warrants on a cashless basis and such cashless exercise is exempt from registration under the Securities Act). The Company agreed that as soon as practicable, but in no event later than 15 business days, after the closing of a Business Combination, the Company will use its best efforts to file with the SEC a registration statement for the registration, under the Securities Act, of the Class A ordinary shares issuable upon exercise of the Public Warrants. If the shares issuable upon exercise of the warrants are not registered under the Securities Act, the Company will be required to permit holders to exercise their warrants on a cashless basis. However, no warrant will be exercisable for cash or on a cashless basis, and the Company will not be obligated to issue any shares to holders seeking to exercise their warrants, unless the issuance of the shares upon such exercise is registered or qualified under the securities laws of the state of the exercising holder, or an exemption from registration is available. Notwithstanding the above, if the Company’s Class A ordinary shares are at the time of any exercise of a warrant not listed on a national securities exchange such that it satisfies the definition of a “covered security” under Section 18(b)(1) of the Securities Act, the Company may, at its option, require holders of Public Warrants who exercise their warrants to do so on a “cashless basis” in accordance with Section 3(a)(9) of the Securities Act and, in the event the Company elects, the Company will not be required to file or maintain in effect a registration statement, but the Company will use its best efforts to register or qualify the shares under applicable blue sky laws to the extent an exemption is not available.\nThe warrants have an exercise price of $ 11.50 per share, subject to adjustments, and will expire five years after the completion of a Business Combination or earlier upon redemption or liquidation. In addition, if (x) the Company issues additional Class A ordinary shares or equity-linked securities for capital raising purposes in connection with the closing of the initial Business Combination at an issue price or effective issue price of less than $ 9.20 per Class A\n14\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nordinary share (with such issue price or effective issue price to be determined in good faith by the board of directors and, in the case of any such issuance to the initial shareholders or their affiliates, without taking into account any Founder Shares held by the initial shareholders or such affiliates, as applicable, prior to such issuance) (the “Newly Issued Price”), (y) the aggregate gross proceeds from such issuances represent more than 60 % of the total equity proceeds, and interest thereon, available for the funding of the initial Business Combination on the date of the consummation of the initial Business Combination (net of redemptions), and (z) the volume weighted average trading price of Class A ordinary shares during the 10 trading day period starting on the trading day prior to the day on which the Company consummates its initial Business Combination (such price, the “Market Value”) is below $ 9.20 per share, then the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115 % of the higher of the Market Value and the Newly Issued Price, and the $ 18.00 per share redemption trigger price described under “Redemption of warrants when the price per Class A ordinary share equals or exceeds $18.00” and “Redemption of warrants when the price per Class A ordinary share equals or exceeds $ 10.00 “ will be adjusted (to the nearest cent) to be equal to 180 % of the higher of the Market Value and the Newly Issued Price, and the $ 10.00 per share redemption trigger price described under “Redemption of warrants when the price per Class A ordinary share equals or exceeds $10.00” will be adjusted (to the nearest cent) to be equal to the higher of the Market Value and the Newly Issued Price.\nThe Private Placement Warrants are identical to the Public Warrants underlying the Units sold in the Initial Public Offering, except that the Private Placement Warrants and the Class A ordinary shares issuable upon exercise of the Private Placement Warrants will not be transferable, assignable or salable until 30 days after the completion of a Business Combination, subject to certain limited exceptions. Additionally, except as described below, the Private Placement Warrants will be non-redeemable so long as they are held by the initial purchasers or such purchasers’ permitted transferees. If the Private Placement Warrants are held by someone other than the initial shareholders or their permitted transferees, the Private Placement Warrants will be redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants.\nRedemption of warrants when the price per Class A ordinary share equals or exceeds $18.00:\nOnce the warrants become exercisable, the Company may redeem the outstanding warrants (except as described herein with respect to the Private Placement Warrants):\n\n| • | in whole and not in part; and |\n\n\n| • | at a price of $ 0.01 per warrant; and |\n\n\n| • | upon a minimum of 30-days‘ prior written notice of redemption; and |\n\n\n| • | if, and only if, the last reported sale price (the “closing price”) of Class A ordinary shares equals or exceeds $ 18.00 per share (as adjusted) for any 20 trading days within a 30-trading day period ending on the third trading day prior to the date on which the Company sends the notice of redemption to the warrant holders. |\n\nThe Company will not redeem the warrants as described above unless an effective registration statement under the Securities Act covering the Class A ordinary shares issuable upon exercise of the warrants is effective and a current prospectus relating to those Class A ordinary shares is available throughout the 30-day redemption period. If and when the warrants become redeemable by the Company, it may exercise its redemption right even if the Company is unable to register or qualify the underlying securities for sale under all applicable state securities laws.\nRedemption of warrants when the price per Class A ordinary share equals or exceeds $10.00:\nOnce the warrants become exercisable, the Company may redeem the outstanding warrants:\n\n| • | in whole and not in part; and |\n\n15\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\n\n| • | upon a minimum of 30 days‘ prior written notice of redemption; provided that holders will be able to exercise their warrants on a cashless basis prior to redemption and receive that number of shares determined by reference to an agreed table based on the redemption date and the fair market value of Class A ordinary shares; and |\n\n\n| • | if, and only if, the closing price of Class A ordinary shares equals or exceeds $ 10.00 per Public Share (as adjusted) for any 20 trading days within the 30-trading day period ending three trading days before the Company sends the notice of redemption to the warrant holders; and |\n\n\n| • | if the closing price of the Class A ordinary shares for any 20 trading days within a 30-trading day period ending on the third trading day prior to the date on which the Company sends the notice of redemption to the warrant holders is less than $ 18.00 per Public Share (as adjusted), the Private Placement Warrants must also be concurrently called for redemption on the same terms as the outstanding Public Warrants, as described above. |\n\nThe “fair market value” of Class A ordinary shares for the above purpose shall mean the volume weighted average price of Class A ordinary shares during the 10 trading days immediately following the date on which the notice of redemption is sent to the holders of warrants. In no event will the warrants be exercisable in connection with this redemption feature for more than 0.361 Class A ordinary shares per warrant (subject to adjustment).\nIn no event will the Company be required to net cash settle any warrant. If the Company is unable to complete a Business Combination within the Combination Period and the Company liquidates the funds held in the Trust Account, holders of warrants will not receive any of such funds with respect to their warrants, nor will they receive any distribution from the Company’s assets held outside of the Trust Account with the respect to such warrants. Accordingly, the warrants may expire worthless.\nNote 7 - Class A Ordinary Shares Subject to Possible Redemption\nThe Company’s Class A ordinary shares feature certain redemption rights that are considered to be outside of the Company’s control and subject to the occurrence of future events. The Company is authorized to issue 500,000,000 shares of Class A ordinary shares with a par value of $ 0.0001 per share. Holders of the Company’s Class A ordinary shares are entitled to one vote for each share. As of March 31, 2022 and December 31, 2021, there were 28,103,449 shares of Class A ordinary shares outstanding, which were all subject to possible redemption and are classified outside of permanent equity in the condensed balance sheets.\nThe Class A ordinary shares subject to possible redemption reflected on the condensed balance sheets is reconciled on the following table:\n\n| Gross proceeds | $ | 281,034,490 |\n| Less: |\n| Proceeds allocated to Public Warrants | ( 5,633,100 | ) |\n| Class A ordinary shares issuance costs | ( 15,730,212 | ) |\n| Plus: |\n| Accretion of carrying value to redemption value | 21,363,312 |\n| Class A ordinary shares subject to possible redemption | $ | 281,034,490 |\n\nNote 8 - Shareholders’ Deficit\nPreference Shares - The Company is authorized to issue 5,000,000 preference shares, with a par value of $ 0.0001 per share, with such designations, voting and other rights and preferences as may be determined from time to time by the Company’s board of directors. As of March 31, 2022 and December 31, 2021, there were no preference shares issued or outstanding.\n16\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nClass A Ordinary Shares - The Company is authorized to issue 500,000,000 Class A ordinary shares with a par value of $ 0.0001 per share. As of March 31, 2022 and December 31, 2021, there were 28,103,449 and Class A ordinary shares issued and outstanding, all subject to possible redemption and classified as temporary equity (see Note 7).\nClass B Ordinary Shares - The Company is authorized to issue 50,000,000 Class B ordinary shares with a par value of $ 0.0001 per share. On December 31, 2020, the Company issued 5,750,000 Class B ordinary shares. On January 14, 2021, the Company effected a share dividend of 1,437,500 Class B ordinary shares resulting in an aggregate of 7,187,500 Class B ordinary shares outstanding. Of the 7,187,500 Class B ordinary shares outstanding, up to 937,500 shares were subject to forfeiture to the Company by the initial shareholders on a pro rata basis for no consideration to the extent that the underwriters’ over-allotment option is not exercised in full or in part, so that the initial shareholders will collectively own 20 % of the Company’s issued and outstanding ordinary shares after the Initial Public Offering. The underwriters partially exercised their over-allotment option on April 1, 2021, and subsequently on May 9, 2021, the Sponsor forfeited 161,638 Class B ordinary shares. As of March 31, 2022 and December 31, 2021, there were 7,025,862 Class B ordinary shares outstanding, none subject to forfeiture.\nOrdinary shareholders of record are entitled to one vote for each share held on all matters to be voted on by shareholders. Holders of the Class A ordinary shares and holders of the Class B ordinary shares will vote together as a single class on all matters submitted to a vote of shareholders, except as required by law.\nThe Class B ordinary shares will automatically convert into Class A ordinary shares concurrently with or immediately following the consummation of the initial Business Combination on a one-for-one basis, subject to adjustment for share sub-divisions, share capitalizations, reorganizations, recapitalizations and the like, and subject to further adjustment as provided herein . In the case that additional Class A ordinary shares or equity-linked securities are issued or deemed issued in connection with the initial Business Combination, the number of Class A ordinary shares issuable upon conversion of all Class B ordinary shares will equal, in the aggregate, 20 % of the total number of Class A ordinary shares outstanding after such conversion (after giving effect to any redemptions of Class A ordinary shares by Public Shareholders), including the total number of Class A ordinary shares issued, or deemed issued or issuable upon conversion or exercise of any equity-linked securities or rights issued or deemed issued, by the Company in connection with or in relation to the consummation of the initial Business Combination, excluding any Class A ordinary shares or equity-linked securities exercisable for or convertible into Class A ordinary shares issued, or to be issued, to any seller in the initial Business Combination and any Private Placement Warrants issued to the Sponsor, officers or directors upon conversion of Working Capital Loans; provided that such conversion of Class B ordinary shares will never occur on a less than one-for-one basis.\nNote 9 - Fair Value Measurements\nThe following table presents information about the Company’s financial assets and liabilities that are measured at fair value on a recurring basis as of March 31, 2022 and December 31, 2021, by level within the fair value hierarchy:\nMarch 31, 2022\n\n| Description | Quoted Prices in Active Markets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Other Unobservable Inputs (Level 3) |\n| Assets: |\n| Investments held in Trust Account - money market fund | $ | 281,067,324 | $ | - | $ | - |\n| Liabilities: |\n| Derivative warrant liabilities - Public Warrants | $ | 2,585,520 | $ | - | $ | - |\n| Derivative warrant liabilities - Private Warrants | $ | - | $ | - | $ | 1,752,760 |\n\nDecember 31, 2021\n17\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\n\n| Description | Quoted Prices in Active Markets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Other Unobservable Inputs (Level 3) |\n| Assets: |\n| Investments held in Trust Account - money market fund | $ | 281,049,184 | $ | - | $ | - |\n| Liabilities: |\n| Derivative warrant liabilities - Public Warrants | $ | 5,058,620 | $ | - | $ | - |\n| Derivative warrant liabilities - Private Warrants | $ | - | $ | - | $ | 3,429,310 |\n\nTransfers to/from Levels 1, 2, and 3 are recognized at the beginning of the reporting period. There were no transfers to/from Levels 1, 2, and 3 during the three months ended March 31, 2022 or 2021.\nLevel 1 assets include investments in money market funds invested in government securities. The Company uses inputs such as actual trade data, benchmark yields, quoted market prices from dealers or brokers, and other similar sources to determine the fair value of its investments.\nThe fair value of the Public Warrants issued in connection with the Public Offering and Private Placement Warrants were initially measured at fair value using a Monte Carlo simulation model. Subsequent to the separate listing and trading of the Public Warrants the fair value of the Public Warrants has been measured based on the observable listed prices for such warrants and the fair value of the Private Warrants are measured using a Black-Scholes Option Pricing Model. For the three months ended March 31, 2022 and 2021, the Company recognized a non-cash gain/(loss) resulting from a decrease/(increase) in the fair value of liabilities of approximately $ 4.1 million and ($ 205,000 ), respectively, presented as change in fair value of derivative liabilities on the accompanying unaudited condensed statements of operations.\nThe estimated fair value of the Private Placement Warrants and the Public Warrants prior to being separately listed and traded, is determined using Level 3 inputs. Inherent in a Monte Carlo simulation and the Black-Scholes Option Pricing Model are assumptions related to expected stock-price volatility, expected life, risk-free interest rate and dividend yield. The Company estimates the volatility of its ordinary share warrants based on implied volatility from the Company’s traded warrants and from historical volatility of select peer company’s ordinary shares that matches the expected remaining life of the warrants. The risk-free interest rate is based on the U.S. Treasury zero-coupon yield curve on the grant date for a maturity similar to the expected remaining life of the warrants. The expected life of the warrants is assumed to be equivalent to their remaining contractual term. The dividend rate is based on the historical rate, which the Company anticipates remaining at zero.\nThe following table provides quantitative information regarding Level 3 fair value measurement inputs at their measurement dates:\n\n| As of March 31, 2022 | As of December 31, 2021 |\n| Volatility | 5.75 % | 12.79 % |\n| Stock price | $ | 9.78 | $ | 9.75 |\n| Expected life of the options to convert | 5.91 | 6.16 |\n| Risk-free rate | 2.410 % | 1.373 % |\n| Dividend yield | 0.000 % | 0.000 % |\n\nThe changes in the fair value of Level 3 derivative warrant liabilities for the three months ended March 31, 2022 and 2021 are summarized as follows:\n18\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\n\n| 2022 | 2021 |\n| Derivative warrant liabilities at January 1 | $ | 3,429,310 | $ | - |\n| Issuance of Public Warrants - Level 3 | - | 5,000,000 |\n| Issuance of Private Warrants - Level 3 | - | 3,640,000 |\n| Change in fair value of derivative liabilities - Level 3 | ( 1,676,550 | ) | 205,000 |\n| Derivative warrant liabilities at March 31 | 1,752,760 | 8,845,000 |\n\nNote 10 – Subsequent Events\nManagement has evaluated subsequent events and transactions that occurred after the balance sheet date through the date the unaudited condensed financial statements were issued. Based upon this review, except for the administrative agreement entered disclosed in Note 4, the Company did not identify any subsequent events that would have required adjustment or disclosure in the unaudited condensed financial statements.\n19\n\nItem 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations.\nReferences to the “Company,” “Supernova Partners Acquisition Company III, Ltd.” “our,” “us” or “we” refer to Supernova Partners Acquisition Company III, Ltd. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the unaudited condensed financial statements and the notes thereto contained elsewhere in this report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\nCautionary Note Regarding Forward-Looking Statements\nThis Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act. We have based these forward-looking statements on our current expectations and projections about future events. These forward-looking statements are subject to known and unknown risks, uncertainties and assumptions about us that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other SEC filings.\nOverview\nWe are a blank check company incorporated as a Cayman Islands exempted company on December 24, 2020. We were formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses. We are an early stage and emerging growth company and, as such, we are subject to all of the risks associated with early stage and emerging growth companies.\nOur sponsor is Supernova Partners III LLC, a Cayman Islands exempted company (the “Sponsor”). The registration statement for our Initial Public Offering was declared effective on March 22, 2021. On March 25, 2021, we consummated its Initial Public Offering of 25,000,000 Units, at $10.00 per Unit, generating gross proceeds of $250.0 million, and incurring offering costs of approximately $14.3 million, of which approximately $8.8 million was for deferred underwriting commissions.\nWe granted the underwriters in the IPO a 45-day option to purchase up to 3,750,000 additional Units to cover over-allotments, if any. The Underwriters exercised the over-allotment option in part and on April 1, 2021 purchased an additional 3,103,449 Units to cover over-allotments, generating gross proceeds of approximately $31.0 million, and incurred additional offering costs of approximately $1.7 million in offering costs, of which approximately $1.1 million was for deferred underwriting fees.\nSimultaneously with the closing of the Initial Public Offering, we consummated the Private Placement of 3,500,000 warrants Private Placement Warrants, at a price of $2.00 per Private Placement Warrant with the Sponsor, generating gross proceeds of $7.0 million.\nSimultaneously with the closing of the Over-Allotment on April 1, 2021, we consummated the second closing of the Private Placement, resulting in the purchase of an aggregate of an additional 310,345 Private Placement Warrants by the Sponsor, generating gross proceeds to us of approximately $621,000.\nIn addition, the Sponsor agreed to forfeit up to 937,500 Class B ordinary shares, par value $0.0001 (the “Founder Shares”) to the extent that the over-allotment option is not exercised in full by the underwriters. The underwriters partially exercised their over-allotment option on April 1, 2021, and subsequently on May 9, 2021, the Sponsor forfeited 161,638 Class B ordinary shares.\nUpon the closing of the Initial Public Offering, Over-Allotment, and the Private Placement, approximately $281.0 million ($10.00 per Unit) of the net proceeds of the Initial Public Offering and certain of the proceeds of the Private Placement was placed in the Trust Account, located in the United States at J.P. Morgan Chase Bank, N.A., with\n20\nAmerican Stock Transfer & Trust Company acting as trustee, and invested only in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), with a maturity of 185 days or less or in any open-ended investment company that holds itself out as a money market fund selected by us meeting the conditions of paragraphs (d)(2), (d)(3) and (d)(4) of Rule 2a-7 of the Investment Company Act, as determined by us, until the earlier of: (i) the completion of a Business Combination and (ii) the distribution of the Trust Account as described below.\nOur management has broad discretion with respect to the specific application of the net proceeds of the Initial Public Offering and the sale of Private Placement Warrants, although substantially all of the net proceeds are intended to be applied generally toward consummating a Business Combination. There is no assurance that we will be able to complete a Business Combination successfully. We must complete one or more initial Business Combinations having an aggregate fair market value of at least 80% of the assets held in the Trust Account (excluding the amount of any deferred underwriting discount held in trust) at the time of the signing of the agreement to enter into the initial Business Combination. However, we will only complete a Business Combination if the post-transaction company owns or acquires 50% or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act.\nIf the Company is unable to complete a Business Combination within 24 months from the closing of the Initial Public Offering, or March 25, 2023 (the “Combination Period”), the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including interest earned on the funds held in the Trust Account (less taxes payable and up to $100,000 of interest to pay dissolution expenses), divided by the number of then outstanding public shares, which redemption will completely extinguish Public Shareholders’ rights as shareholders (including the right to receive further liquidation distributions, if any) and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the remaining shareholders and the board of directors, liquidate and dissolve, subject, in the case of clauses (ii) and (iii), to the Company’s obligations under Cayman Islands law to provide for claims of creditors and in all cases subject to the other requirements of applicable law. There will be no redemption rights or liquidating distributions with respect to the warrants, which will expire worthless if the Company fails to complete its initial Business Combination within the Combination Period.\nGoing Concern\nAs of March 31, 2022, we had approximately $0.3 million in our operating bank account and a working capital deficit of approximately $0.6 million.\nThe Company has incurred and expects to incur significant costs in pursuit of its financing and acquisition plans. In connection with the Company's assessment of going concern considerations, in accordance with Financial Accounting Standards Board Accounting Standards Update 2014-15, \"Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern,\" management has determined that the Company's cash flow deficit raise substantial doubt about the Company's ability to continue as a going concern within one year after the date that the unaudited condensed financial statements are issued. There is no assurance that the Company's plans to consummate a Business Combination or raise additional funds will be successful within the Combination Period. The unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty.\nRisks and Uncertainties\nWe continue to evaluate the impact of the COVID-19 pandemic and have concluded that the specific impact is not readily determinable as of the date of the balance sheet. The unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty.\n21\nResults of Operations\nOur entire activity since inception up to March 31, 2022 was in preparation for our formation and the Initial Public Offering and identifying a target company for a Business Combination. We will not be generating any operating revenues until the closing and completion of our initial business combination.\nFor the three months ended March 31, 2022, we had a net income of approximately $3.8 million, which consisted of approximately $0.3 million general and administrative expenses, offset by a gain of approximately $4.1 million from a change in fair value of derivative warrant liabilities and approximately a $18,000 gain on investments held in Trust Account.\nFor the three months ended March 31, 2021, we had a net loss of approximately $593,000, which consisted of approximately $102,000 in general and administrative expenses, approximately $287,000 in financing costs -derivative warrant liabilities and a charge of $205,000 from a change in fair value of derivative warrant liabilities, partially offset by a $287 gain on investments held in the Trust Account.\nLiquidity and Capital Resources\nFollowing the Initial Public Offering and Over-Allotment, a total of $281 million was placed in the Trust Account. We incurred approximately $16.1 million in transaction costs, including $9.8 million of deferred underwriting fees.\nFor the three months ended March 31, 2022, we used approximately $261,000 of cash for operating activities. Our net income included a $4.2 million non-cash gain from the change in the fair value of derivative warrant liabilities and approximately $18,000 gain on investment income held in the Trust account and was partially offset by changes in operating assets and liabilities of that provided approximately $57,000 of cash from operating activities. For the three months ended net cash flow from financing activities was $85,000 and related to remaining offering costs paid.\nFor the three months ended March 31, 2021, we used approximately $43,000 of cash for operating activities. Our net loss was impacted by $205,000 of a non-cash loss from the change in the fair value of derivative warrant liabilities, $287,000 of financing costs allocated to derivative liabilities, and a $287 gain on investment income held in the Trust account, and was partially offset by changes in operating assets and liabilities of that provided approximately $58,000 of cash from operating activities.\nAs of March 31, 2022, we had investments held in the Trust Account of approximately $281,067,000. We intend to use substantially all of the funds held in the Trust Account, including any amounts representing interest earned on the Trust Account, which interest shall be net of taxes payable and excluding deferred underwriting commissions, to complete our initial Business Combination. We may withdraw interest from the Trust Account to pay taxes, if any. To the extent that our share capital or debt is used, in whole or in part, as consideration to complete a Business Combination, the remaining proceeds held in the Trust Account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies.\nAs of March 31, 2022, we had cash of approximately $321,000 held outside of the Trust Account. We intend to use the funds held outside the Trust Account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, structure, negotiate and complete a Business Combination.\nContractual Obligations\nWe do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities. We do have an Administrative Support Agreement which was effective January 1, 2022 through the Company’s consummation of a Business Combination or its liquidation, to pay an affiliate of the Sponsor a sum of up to $7,500 per month, for office space, utilities, employee benefits and secretarial and administrative services.\nRegistration Rights\n22\nThe holders of Founder Shares, Private Placement Warrants and warrants that may be issued upon conversion of working capital loans (and any Class A ordinary shares issuable upon the exercise of the Private Placement Warrants and warrants that may be issued upon conversion of working capital loans) were entitled to registration rights pursuant to a registration rights agreement signed upon consummation of the Initial Public Offering. These holders were entitled to certain demand and “piggyback” registration rights. However, the registration rights agreement provided that we would not permit any registration statement filed under the Securities Act to become effective until the termination of the applicable lock-up period for the securities to be registered. We will bear the expenses incurred in connection with the filing of any such registration statements.\nUnderwriting Agreement\nThe underwriters were entitled to an underwriting discount of $0.20 per unit, or $5 million in the aggregate, paid upon the closing of the Initial Public Offering. In addition, $0.35 per unit, or approximately $8.8 million in the aggregate, will be payable to the underwriters for deferred underwriting commissions. The deferred fee will become payable to the underwriters from the amounts held in the Trust Account solely in the event that we complete a business combination, subject to the terms of the underwriting agreement.\nThe underwriters partially exercised the over-allotment option and on April 1, 2021, purchased an additional 3,103,449 Units, generating gross proceeds of approximately $31 million, and incurred additional offering costs of approximately $1.7 million in offering costs, of which approximately $1.1 million was for deferred underwriting fees.\nCritical Accounting Policies and Estimates\nDerivative Warrant Liabilities\nWe do not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks. We evaluate all of our financial instruments, including issued stock purchase warrants, to determine if such instruments are derivatives or contain features that qualify as embedded derivatives, pursuant to ASC Topic 480 “Distinguishing Liabilities from Equity” (“ASC 480”) and ASC Topic 815 “Derivatives and Hedging” (“ASC 815”). The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is re-assessed at the end of each reporting period.\nThe warrants issued in connection with the Initial Public Offering (the “Public Warrants”) and the Private Placement Warrants are recognized as derivative liabilities in accordance with ASC 815. Accordingly, the Company recognizes the warrant instruments as liabilities at fair value and adjust the instruments to fair value at each reporting period until exercised. The fair value of the Public Warrants issued in connection with the Public Offering and Private Placement Warrants were initially measured at fair value using a Monte Carlo simulation model. Subsequent to the separate listing and trading of the Public Warrants the fair value of the Public Warrants has been measured based on the observable listed prices for such warrants and the fair value of the Private Warrants are measured using a Black-Scholes Option Pricing Model. Derivative warrant liabilities are classified as non-current as their liquidation is not reasonably expected to require the use of current assets or require the creation of current liabilities.\nClass A Ordinary Shares Subject to Possible Redemption\nWe account for our Class A ordinary shares subject to possible redemption in accordance with the guidance in ASC Topic 480 “Distinguishing Liabilities from Equity” (“ASC 480”). Class A ordinary shares subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable Class A ordinary shares (including Class A ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, Class A ordinary shares are classified as shareholders’ equity. Our Class A ordinary shares feature certain redemption rights that are considered to be outside of our control and subject to the occurrence of uncertain future events. Accordingly, as of March 31, 2022 and December 31, 2021, 28,103,449 Class A ordinary shares subject to possible redemption are presented as temporary equity outside of the shareholders’ equity section of our condensed balance sheets.\nUnder ASC 480-10-S99, the Company has elected to recognize changes in the redemption value immediately as they occur and adjust the carrying value of the security to equal the redemption value at the end of the reporting period.\n23\nEffective with the closing of the Initial Public Offering (including exercise of the over-allotment option), we recognized the accretion from initial book value to redemption amount, which resulted in charges against additional paid-in capital (to the extent available) and accumulated deficit.\nNet Income (Loss) Per Ordinary Share\nWe comply with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share.” We have two classes of shares, which are referred to as Class A ordinary shares and Class B ordinary shares. Income and losses are shared pro rata between the two classes of shares. Net income (loss) per ordinary share is calculated by dividing the net income (loss) by the weighted average shares of ordinary shares outstanding for the respective period.\nThe calculation of diluted net income (loss) per ordinary share does not consider the effect of the warrants issued in connection with the Initial Public Offering (including exercise of the over-allotment option) and the Private Placement to purchase an aggregate of 9,431,035 shares of Class A ordinary shares in the calculation of diluted income (loss) per share, because their exercise is contingent upon future events. Accretion associated with the redeemable Class A ordinary shares is excluded from earnings per share as the redemption value approximates fair value.\nRecent Accounting Pronouncements\nThe Company’s management does not believe that any other recently issued, but not yet effective, accounting standards updates, if currently adopted, would have a material effect on the accompanying financial\nOff-Balance Sheet Financing Arrangements\nAs of March 31, 2022 and December 31, 2021, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K.\nJOBS Act\nThe JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We qualify as an “emerging growth company” and under the JOBS Act are allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) companies. We are electing to delay the adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As a result, the unaudited condensed financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates.\nAdditionally, we are in the process of evaluating the benefits of relying on the other reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, if, as an “emerging growth company,” we choose to rely on such exemptions we may not be required to, among other things, (i) provide an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404, (ii) provide all of the compensation disclosure that may be required of non‑emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (iii) comply with any requirement that may be adopted by the PCAOB regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the unaudited condensed financial statements (auditor discussion and analysis) and (iv) disclose certain executive compensation related items such as the correlation between executive compensation and performance and comparisons of the CEO’s compensation to median employee compensation. These exemptions will apply for a period of five years following the completion of our Initial Public Offering or until we are no longer an “emerging growth company,” whichever is earlier.\n\nItem 3.Quantitative and Qualitative Disclosures About Market Risk\nWe are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and are not required to provide the information otherwise required under this item.\n24\n\nItem 4.Controls and Procedures\nEvaluation of Disclosure Controls and Procedures\nUnder the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures as of the end of the fiscal quarter ended March 31, 2022, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer has concluded that during the period covered by this report, our disclosure controls and procedures were not effective as of March 31, 2022, because of a material weakness in our internal control over financial reporting. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. Specifically, our management has concluded that our control around the interpretation and accounting for certain complex financial instruments that we issued was not effectively designed or maintained. This material weakness resulted in the restatement of our interim financial statements for the quarters ended March 31, 2021 and June 30, 2021.\nDisclosure controls and procedures are designed to ensure that information required to be disclosed by us in our Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting that occurred during the fiscal quarter ended March 31, 2022, covered by this Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\nThe Chief Executive Officer and Chief Financial Officer performed additional accounting and financial analyses and other post-closing procedures including consulting with subject matter experts related to the accounting for certain complex financial instruments. Our management has expended, and will continue to expend, a substantial amount of effort and resources for the remediation and improvement of our internal control over financial reporting. While we have processes to properly identify and evaluate the appropriate accounting technical pronouncements and other literature for all significant or unusual transactions, we have expanded and will continue to improve these processes to ensure that the nuances of such transactions are effectively evaluated in the context of the increasingly complex accounting standards.\n25\nPART II - OTHER INFORMATION\n\nItem 1.Legal Proceedings\nNone.\n\nItem 1A.Risk Factors\nCertain factors may have a material adverse effect on our business, financial condition and results of operation. An investment in our securities involves a high degree of risk. You should consider carefully the risks and uncertainties described below, in addition to the other information contained herein and our other filings with the SEC, including our financial statements and related notes herein and our other filings with the SEC. In addition to the information set forth in this Quarterly Report on Form 10-Q, you should carefully consider the risk factors and other cautionary statements described under the heading “Risk Factors” in our final prospectus filed with the SEC on March 3, 2021, and our quarterly report on Form 10-Q for the quarter ended June 30, 2021 as filed with the SEC on August 6, 2021, which could materially affect our businesses, financial condition, or future results.. As of the date of this Quarterly Report on Form 10-Q, there have been no material changes in our risk factors from those described in our final prospectus and our quarterly report on Form 10-Q for the quarter ended June 30, 2021, except for the below risk factor. We may disclose changes to such factors or disclose additional factors from time to time in our future filings with the SEC.\nChanges in laws or regulations, or a failure to comply with any laws and regulations, may adversely affect our business, including our ability to negotiate and complete our initial business combination, and results of operations.\nWe are subject to laws and regulations enacted by national, regional and local governments. In particular, we will be required to comply with certain SEC and other legal requirements. Compliance with, and monitoring of, applicable laws and regulations may be difficult, time consuming and costly. Those laws and regulations and their interpretation and application may also change from time to time and those changes could have a material adverse effect on our business, investments and results of operations. In addition, a failure to comply with applicable laws or regulations, as interpreted and applied, could have a material adverse effect on our business, including our ability to negotiate and complete our initial business combination, and results of operations.\nOn March 30, 2022, the SEC issued proposed rules that would, among other items, impose additional disclosure requirements in initial public offerings by SPACs and business combination transactions involving SPACs and private operating companies; amend the financial statement requirements applicable to business combination transactions involving such companies; update and expand guidance regarding the general use of projections in SEC filings, as well as when projections are disclosed in connection with proposed business combination transactions; increase the potential liability of certain participants in proposed business combination transactions; and impact the extent to which SPACs could become subject to regulation under the Investment Company Act of 1940. These rules, if adopted, whether in the form proposed or in revised form, may materially adversely affect our business, including our ability to negotiate and complete our initial business combination and may increase the costs and time related thereto.\n\nItem 2.Unregistered Sales of Equity Securities and Use of Proceeds.\nNone.\n\nItem 3.Defaults upon Senior Securities\nNone.\n\nItem 4.Mine Safety Disclosures.\nNot applicable.\n\nItem 5.Other Information.\nNone.\n26\n\nItem 6.\nExhibits\n27\nPART I. FINANCIAL INFORMATION\nItem 1. Condensed Financial Statements\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nCONDENSED BALANCE SHEETS\n\n| March 31, 2022 | December 31, 2021 |\n| (unaudited) |\n| Assets |\n| Current assets: |\n| Cash | $ | 320,628 | $ | 666,300 |\n| Prepaid expenses - current | 281,087 | 225,750 |\n| Total current assets | 601,715 | 892,050 |\n| Prepaid expenses - long-term | - | 47,412 |\n| Investments held in Trust Account | 281,067,324 | 281,049,184 |\n| Total Assets | $ | 281,669,039 | $ | 281,988,646 |\n| Liabilities, Class A Ordinary Shares Subject to Possible Redemption and Shareholders' Deficit |\n| Current liabilities: |\n| Accounts payable | $ | 160,750 | $ | 302,391 |\n| Accrued expenses | 1,090,004 | 968,262 |\n| Total current liabilities | 1,250,754 | 1,270,653 |\n| Deferred underwriting commissions | 9,836,207 | 9,836,207 |\n| Derivative warrant liabilities | 4,338,280 | 8,487,930 |\n| Total Liabilities | 15,425,241 | 19,594,790 |\n| Commitments and Contingencies (Note 5) |\n| Class A ordinary shares subject to possible redemption, $ 0.0001 par value; 28,103,449 shares at $ 10.00 per share as of March 31, 2022 and December 31, 2021 | 281,034,490 | 281,034,490 |\n| Shareholders' Deficit |\n| Preference shares, $ 0.0001 par value; 5,000,000 shares authorized; no shares issued or outstanding | - | - |\n| Class A ordinary shares, $ 0.0001 par value; 500,000,000 shares authorized; no non-redeemable shares issued or outstanding | - | - |\n| Class B ordinary shares, $ 0.0001 par value; 50,000,000 shares authorized; 7,025,862 shares issued and outstanding as of March 31, 2022 and December 31, 2021 | 703 | 703 |\n| Additional paid-in capital | - | - |\n| Accumulated deficit | ( 14,791,395 | ) | ( 18,641,337 | ) |\n| Total Shareholders' Deficit | ( 14,790,692 | ) | ( 18,640,634 | ) |\n| Total Liabilities, Class A Ordinary Shares Subject to Possible Redemption and Shareholders' Deficit | $ | 281,669,039 | $ | 281,988,646 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n1\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nUNAUDITED CONDENSED STATEMENTS OF OPERATIONS\n\n| For the Three Months Ended March 31, |\n| 2022 | 2021 |\n| General and administrative expenses | $ | 317,848 | $ | 101,668 |\n| Loss from operations | ( 317,848 | ) | ( 101,668 | ) |\n| Other income (expense) |\n| Change in fair value of derivative warrant liabilities | 4,149,650 | ( 205,000 | ) |\n| Financing costs - derivative warrant liabilities | - | ( 287,083 | ) |\n| Gain on investments held in Trust Account | 18,140 | 287 |\n| Net income (loss) | $ | 3,849,942 | $ | ( 593,464 | ) |\n| Weighted average shares outstanding of Class A ordinary shares, basic and diluted | 28,103,449 | 1,944,444 |\n| Basic and diluted net income (loss) per share, Class A ordinary shares | $ | 0.11 | $ | ( 0.07 | ) |\n| Weighted average shares outstanding of Class B ordinary shares, basic and diluted | 7,025,862 | 6,250,000 |\n| Basic and diluted net income (loss) per share, Class B ordinary shares | $ | 0.11 | $ | ( 0.07 | ) |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n2\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nUNAUDITED CONDENSED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (DEFICIT)\nFOR THE THREE MONTHS ENDED MARCH 31, 2022\n\n| Ordinary Shares | Additional | Total |\n| Class A | Class B | Paid-in | Accumulated | Shareholders' |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Deficit |\n| Balance - December 31, 2021 | - | $ | - | 7,025,862 | $ | 703 | $ | - | $ | ( 18,641,337 | ) | $ | ( 18,640,634 | ) |\n| Net income | - | - | - | - | - | 3,849,942 | 3,849,942 |\n| Balance - March 31, 2022 (unaudited) | - | $ | - | 7,025,862 | $ | 703 | $ | - | $ | ( 14,791,395 | ) | $ | ( 14,790,692 | ) |\n\nFOR THE THREE MONTHS ENDED MARCH 31, 2021\n\n| Ordinary Shares | Additional | Total |\n| Class A | Class B | Paid-in | Accumulated | Shareholders' |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Deficit |\n| Balance - December 31, 2020 | - | $ | - | 7,187,500 | $ | 719 | $ | 24,281 | $ | ( 9,414 | ) | $ | 15,586 |\n| Excess of cash received over fair value of private placement warrants | - | - | - | - | 3,360,000 | - | 3,360,000 |\n| Accretion of Class A ordinary shares to redemption amount | - | - | - | - | ( 3,384,281 | ) | ( 15,673,854 | ) | ( 19,058,135 | ) |\n| Net loss | - | - | - | - | - | ( 593,464 | ) | ( 593,464 | ) |\n| Balance - March 31, 2021 (unaudited) | - | $ | - | 7,187,500 | $ | 719 | $ | - | $ | ( 16,276,732 | ) | $ | ( 16,276,013 | ) |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n3\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nUNAUDITED CONDENSED STATEMENTS OF CASH FLOWS\n\n| For the Three Months Ended March 31, |\n| 2022 | 2021 |\n| Cash Flows from Operating Activities: |\n| Net income (loss) | $ | 3,849,942 | $ | ( 593,464 | ) |\n| Adjustments to reconcile net income (loss) to net cash used in operating activities: |\n| Change in fair value of derivative warrant liabilities | ( 4,149,650 | ) | 205,000 |\n| Financing costs - derivative warrant liabilities | - | 287,083 |\n| Gain on investments held in Trust Account | ( 18,140 | ) | ( 287 | ) |\n| Changes in operating assets and liabilities: |\n| Prepaid expenses | ( 7,925 | ) | ( 419,288 | ) |\n| Accounts payable | ( 56,641 | ) | 433,501 |\n| Accrued expenses | 121,742 | 37,484 |\n| Due to related party | - | 6,615 |\n| Net cash used in operating activities | ( 260,672 | ) | ( 43,356 | ) |\n| Cash Flows from Investing Activities: |\n| Cash deposited in Trust Account | - | ( 250,000,000 | ) |\n| Net cash used in investing activities | - | ( 250,000,000 | ) |\n| Cash Flows from Financing Activities: |\n| Proceeds from note payable to related party | - | 300,000 |\n| Repayment of note payable to related party | - | ( 300,000 | ) |\n| Proceeds received from initial public offering, gross | - | 250,000,000 |\n| Proceeds received from private placement | - | 7,000,000 |\n| Offering costs paid | ( 85,000 | ) | ( 5,124,408 | ) |\n| Net cash (used in) provided by financing activities | ( 85,000 | ) | 251,875,592 |\n| Net change in cash | ( 345,672 | ) | 1,832,236 |\n| Cash - beginning of the period | 666,300 | - |\n| Cash - end of the period | $ | 320,628 | $ | 1,832,236 |\n| Supplemental disclosure of noncash financing activities: |\n| Offering costs included in accounts payable | $ | - | $ | 85,810 |\n| Offering costs included in accrued expenses | $ | - | $ | 350,000 |\n| Deferred underwriting commissions | $ | - | $ | 8,750,000 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n4\nNote 1 - Description of Organization, Business Operations and Liquidity\nSupernova Partners Acquisition Company III, Ltd. (the “Company”) was incorporated as a Cayman Islands exempted company on December 24, 2020. The Company was formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses (the “Business Combination”). The Company is an emerging growth company and, as such, the Company is subject to all the risks associated with emerging growth companies.\nAs of March 31, 2022, the Company had not commenced any operations. All activity for the period from December 24, 2020 (inception) through March 31, 2022, relates to the Company’s formation and the initial public offering (the “Initial Public Offering”) described below, and since the Initial Public Offering, the search or an initial Business Combination. The Company will not generate any operating revenues until after the completion of its initial Business Combination, at the earliest. The Company generates non-operating income in the form of interest income on from the proceeds from the Initial Public Offering held in the trust account.\nThe Company’s sponsor is Supernova Partners III LLC, a Cayman Islands exempted company (the “Sponsor”). The registration statement for the Company’s Initial Public Offering was declared effective on March 22, 2021. On March 25, 2021, the Company consummated its Initial Public Offering of 25,000,000 units (the “Units” and, with respect to the Class A ordinary shares included in the Units being offered, the “Public Shares”), at $ 10.00 per Unit, generating gross proceeds of $ 250.0 million, and incurring offering costs of approximately $ 14.3 million, of which approximately $ 8.8 million was for deferred underwriting commissions (see Note 5).\nThe Company granted the underwriters in the IPO (the “Underwriters”) a 45-day option to purchase up to 3,750,000 additional Units to cover over-allotments, if any. The Underwriters exercised the over-allotment option in part and on April 1, 2021 purchased an additional 3,103,449 Units, generating gross proceeds of approximately $ 31.0 million (the “Over-Allotment”), and incurring additional offering costs of approximately $ 1.7 million in offering costs, of which approximately $ 1.1 million was for deferred underwriting fees.\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the private placement (“Private Placement”) of 3,500,000 warrants (each, a “Private Placement Warrant” and collectively, the “Private Placement Warrants”), at a price of $ 2.00 per Private Placement Warrant with the Sponsor, generating gross proceeds of $ 7.0 million (see Note 4).\nSimultaneously with the closing of the Over-Allotment on April 1, 2021, the Company consummated the second closing of the Private Placement, resulting in the purchase of an aggregate of an additional 310,345 Private Placement Warrants by the Sponsor, generating gross proceeds to the Company of approximately $ 621,000 .\nIn addition, the Sponsor agreed to forfeit up to 937,500 Class B ordinary shares, par value $ 0.0001 (the “Founder Shares”) to the extent that the over-allotment option was not exercised in full by the underwriters. The underwriters partially exercised their over-allotment option on April 1, 2021, and subsequently on May 9, 2021, the Sponsor forfeited 161,638 Class B ordinary shares.\nUpon the closing of the Initial Public Offering, the Over-Allotment, and the Private Placement, $ 281.0 million ($ 10.00 per Unit) of the net proceeds of the Initial Public Offering and certain of the proceeds of the Private Placement was placed in a trust account (“Trust Account”), located in the United States at J.P. Morgan Chase Bank, N.A., with American Stock Transfer & Trust Company acting as trustee, and invested only in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), with a maturity of 185 days or less or in any open-ended investment company that holds itself out as a money market fund selected by the Company meeting the conditions of paragraphs (d)(2), (d)(3) and (d)(4) of Rule 2a-7 of the Investment Company Act, as determined by the Company, until the earlier of: (i) the completion of a Business Combination and (ii) the distribution of the Trust Account as described below.\nThe Company’s management has broad discretion with respect to the specific application of the net proceeds of the Initial Public Offering and the sale of Private Placement Warrants, although substantially all of the net proceeds are intended to be applied generally toward consummating a Business Combination. There is no assurance that the Company will be able to complete a Business Combination successfully. The Company must complete one or more initial Business Combinations having an aggregate fair market value of at least 80 % of the assets held in the Trust Account (excluding the amount of any deferred underwriting discount held in trust) at the time of the signing of the agreement to enter into the initial Business Combination. However, the Company will only complete a Business Combination if the post-transaction company owns or acquires 50 % or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act.\n5\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nThe Company will provide its holders of its Public Shares (the “Public Shareholders”) with the opportunity to redeem all or a portion of their Public Shares upon the completion of a Business Combination either (i) in connection with a general meeting called to approve the Business Combination or (ii) by means of a tender offer. The decision as to whether the Company will seek shareholder approval of a Business Combination or conduct a tender offer will be made by the Company, solely in its discretion. The Public Shareholders will be entitled to redeem their Public Shares\nfor a pro rata portion of the amount then in the Trust Account (at $ 10.00 per Public Share). The per-share amount to be distributed to Public Shareholders who redeem their Public Shares will not be reduced by the deferred underwriting commissions the Company will pay to the underwriters (as discussed in Note 5). These Public Shares were classified as temporary equity in accordance with the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” In such case, the Company will proceed with a Business Combination if the Company has net tangible assets of at least $ 5,000,001 upon such consummation of a Business Combination and a majority of the shares voted are voted in favor of the Business Combination. If a shareholder vote is not required by law and the Company does not decide to hold a shareholder vote for business or other legal reasons, the Company will, pursuant to its amended and restated memorandum and articles of association (the “Amended and Restated Memorandum and Articles of Association”), conduct the redemptions pursuant to the tender offer rules of the U.S. Securities and Exchange Commission (“SEC”) and file tender offer documents with the SEC prior to completing a Business Combination. If, however, shareholder approval of the transactions is required by law, or the Company decides to obtain shareholder approval for business or legal reasons, the Company will offer to redeem shares in conjunction with a proxy solicitation pursuant to the proxy rules and not pursuant to the tender offer rules. Additionally, each Public Shareholder may elect to redeem their Public Shares irrespective of whether they vote for or against the proposed transaction. If the Company seeks shareholder approval in connection with a Business Combination, the initial shareholders (as defined below) agreed to vote their Founder Shares (as defined below in Note 4) and any Public Shares purchased during or after the Initial Public Offering in favor of a Business Combination. Subsequent to the consummation of the Initial Public Offering, the Company has adopted an insider trading policy which will require insiders to: (i) refrain from purchasing shares during certain blackout periods and when they are in possession of any material non-public information and (ii) to clear all trades with the Company’s legal counsel prior to execution. In addition, the initial shareholders agreed to waive their redemption rights with respect to their Founder Shares and Public Shares in connection with the completion of a Business Combination.\nNotwithstanding the foregoing, the Amended and Restated Memorandum and Articles of Association will provide that a Public Shareholder, together with any affiliate of such shareholder or any other person with whom such shareholder is acting in concert or as a “group” (as defined under Section 13 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), will be restricted from redeeming its shares with respect to more than an aggregate of 15 % or more of the Class A ordinary shares sold in the Initial Public Offering, without the prior consent of the Company.\nThe Company’s Sponsor, officers and directors (the “initial shareholders”) agreed not to propose an amendment to the Amended and Restated Memorandum and Articles of Association that would modify the substance or timing of the Company’s obligation to redeem 100 % of its Public Shares if the Company does not complete a Business Combination, unless the Company provides the Public Shareholders with the opportunity to redeem their Class A ordinary shares in conjunction with any such amendment.\nIf the Company is unable to complete a Business Combination within 24 months from the closing of the Initial Public Offering, or March 25, 2023 (the “Combination Period”), the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem\nthe Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including interest earned on the funds held in the Trust Account (less taxes payable and up to $ 100,000 of interest to pay dissolution expenses), divided by the number of then outstanding public shares, which redemption will completely extinguish Public Shareholders’ rights as shareholders (including the right to receive further liquidation\n6\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\ndistributions, if any) and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the remaining shareholders and the board of directors, liquidate and dissolve, subject, in the case of clauses (ii) and (iii), to the Company’s obligations under Cayman Islands law to provide for claims of creditors and in all cases subject to the other requirements of applicable law. There will be no redemption rights or liquidating distributions with respect to the warrants, which will expire worthless if the Company fails to complete its initial Business Combination within the Combination Period.\nThe Sponsor agreed to waive their liquidation rights with respect to the Founder Shares if the Company fails to complete a Business Combination within the Combination Period. However, if the Sponsor or members of the Company’s management team acquire Public Shares in or after the Initial Public Offering, they will be entitled to liquidating distributions from the Trust Account with respect to such Public Shares if the Company fails to complete a Business Combination within the Combination Period. The underwriters agreed to waive their rights to their deferred underwriting commission (see Note 5) held in the Trust Account in the event the Company does not complete a Business Combination within in the Combination Period and, in such event, such amounts will be included with the other funds held in the Trust Account that will be available to fund the redemption of the Public Shares. In the event of such distribution, it is possible that the per share value of the residual assets remaining available for distribution (including Trust Account assets) will be only $ 10.00 per share initially held in the Trust Account. In order to protect the amounts held in the Trust Account, the Sponsor agreed to be liable to the Company if and to the extent any claims by a vendor for services rendered or products sold to the Company, or a prospective target business with which the Company has discussed entering into a transaction agreement, reduce the amount of funds in the Trust Account. This liability will not apply with respect to any claims by a third party who executed a waiver of any right, title, interest or claim of any kind in or to any monies held in the Trust Account or to any claims under the Company’s indemnity of the underwriters of the Initial Public Offering against certain liabilities, including liabilities under the Securities Act of 1933, as amended (the “Securities Act”). Moreover, in the event that an executed waiver is deemed to be unenforceable against a third party, the Sponsor will not be responsible to the extent of any liability for such third-party claims. The Company will seek to reduce the possibility that the Sponsor will have to indemnify the Trust Account due to claims of creditors by endeavoring to have all vendors, service providers, except the independent registered public accounting firm, prospective target businesses or other entities with which the Company does business, execute agreements with the Company waiving any right, title, interest or claim of any kind in or to monies held in the Trust Account.\nGoing Concern\nAs of March 31, 2022, the Company had approximately $ 0.3 million in its operating bank account and a working capital deficit of approximately $ 0.6 million.\nThe Company has incurred and expects to incur significant costs in pursuit of its financing and acquisition plans. In connection with the Company’s assessment of going concern considerations, management has determined that the Company’s cash flow deficit raise substantial doubt about the Company’s ability to continue as a going concern within one year after the date that the unaudited condensed financial statements are issued. There is no assurance that the Company’s plans to consummate a Business Combination or raise additional funds will be successful within the Combination Period. The unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty.\nRisks and Uncertainties\nManagement continues to evaluate the impact of the COVID-19 global pandemic on the industry and has concluded that while it is reasonably possible that the virus could have a negative effect on the Company’s financial position, results of its operations, and/or search for a target company, the specific impact is not readily determinable as of the date of these unaudited condensed financial statements. The unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty.\n7\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nNote 2 - Basis of Presentation and Summary of Significant Accounting Policies\nBasis of Presentation\nThe accompanying unaudited condensed financial statements are presented in U.S. dollars in conformity with accounting principles generally accepted in the United States of America (“GAAP”) for financial information and pursuant to the rules and regulations of the SEC. Accordingly, they do not include all of the information and footnotes required by GAAP. In the opinion of management, the unaudited condensed financial statements reflect all adjustments, which include only normal recurring adjustments necessary for the fair statement of the balances and results for the periods presented. Operating results for the three months ended March 31, 2022 are not necessarily indicative of the results that may be expected for the year ending December 31, 2022.\nThe accompanying unaudited condensed financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Annual Report on Form 10-K filed by the Company with the SEC on March 25, 2022. In the Annual Report on Form 10-K the Company had a typographical error in the Accumulated deficit balance reported on the Company’s balance sheet as of December 31, 2021, whereby the reported accumulated deficit of $( 18 ) should have been reported as ($ 18,641,337 ). The accumulated deficit amount was reported correctly in the statements of changes in shareholders’ equity (deficit) for the year ended December 31, 2021 within the Annual Report on Form 10-K. The Company has corrected this typographical error in the accompanying unaudited condensed balance sheets.\nEmerging Growth Company\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the independent registered public accounting firm attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s unaudited condensed financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\nUse of Estimates\nThe preparation of unaudited condensed financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited condensed financial statements and the reported amounts of revenues and expenses during the reporting period. Making estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the unaudited condensed financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. Accordingly, the actual results could differ from those estimates.\n8\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nConcentration of Credit Risk\nFinancial instruments that potentially subject the Company to credit risk consist principally of cash and investments held in the Trust Account. Cash is maintained in accounts with financial institutions, which, at times may exceed the Federal Depository Insurance Corporation coverage limit of $ 250,000 , and investments held in the Trust Account. As of March 31, 2022 and December 31, 2021, the Company had not experienced losses on these accounts and management believes the Company is not exposed to significant risks on such accounts.\nCash and Cash Equivalents\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company had no cash equivalents as of March 31, 2022 and December 31, 2021.\nInvestments Held in the Trust Account\nThe Company’s portfolio of investments is comprised of U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, with a maturity of 185 days or less , or investments in money market funds that invest in U.S. government securities and generally have a readily determinable fair value, or a combination thereof. When the Company’s investments held in the Trust Account are comprised of U.S. government securities, the investments are classified as trading securities. When the Company’s investments held in the Trust Account are comprised of money market funds, the investments are recognized at fair value. Trading securities and investments in money market funds are presented on the condensed balance sheets at fair value at the end of each reporting period. Gains and losses resulting from the change in fair value of these securities is included in income on investments held in the Trust Account in the accompanying statements of operations. The estimated fair values of investments held in the Trust Account are determined using available market information.\nFair Value of Financial Instruments\nThe fair value of the Company’s assets and liabilities which qualify as financial instruments under the FASB ASC Topic 820, “Fair Value Measurements,” equal or approximate the carrying amounts represented in the condensed balance sheets.\nFair Value Measurements\nThe hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). These tiers consist of:\n\n| • | Level 1, defined as observable inputs such as quoted prices for identical instruments in active markets; |\n\n\n| • | Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable such as quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active; and |\n\n\n| • | Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions, such as valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable. |\n\nIn some circumstances, the inputs used to measure fair value might be categorized within different levels of the fair value hierarchy. In those instances, the fair value measurement is categorized in its entirety in the fair value hierarchy based on the lowest level input that is significant to the fair value measurement.\nDerivative Warrant Liabilities\nThe Company does not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks. The Company evaluates all of its financial instruments, including issued stock purchase warrants, to determine if such\n9\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\ninstruments are derivatives or contain features that qualify as embedded derivatives, pursuant to ASC Topic 480 “Distinguishing Liabilities from Equity” (“ASC 480”) and FASB ASC Topic 815, “Derivatives and Hedging” (“ASC 815”). The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity is re-assessed at the end of each reporting period.\nThe warrants issued in connection with the Initial Public Offering (the “Public Warrants”) and the Private Placement Warrants are recognized as derivative liabilities in accordance with ASC 815. Accordingly, the Company recognizes the warrant instruments as liabilities at fair value and adjusts the instruments to fair value at each reporting period. The liabilities are subject to re-measurement at each balance sheet date until exercised, and any change in fair value is recognized in the Company’s statements of operations. The fair value of the Public Warrants issued in connection with the Public Offering and Private Placement Warrants were initially measured at fair value using a Monte Carlo simulation model. Subsequent to the separate listing and trading of the Public Warrants the fair value of the Public Warrants has been measured based on the observable listed prices for such warrants and the fair value of the Private Warrants are measured using a Black-Scholes Option Pricing Model. Derivative warrant liabilities are classified as non-current liabilities as their liquidation is not reasonably expected to require the use of current assets or require the creation of current liabilities.\nOffering Costs Associated with the Initial Public Offering\nOffering costs consisted of legal, accounting, underwriting fees and other costs incurred through the Initial Public Offering that were directly related to the Initial Public Offering. Offering costs are allocated to the separable financial instruments issued in the Initial Public Offering based on a relative fair value basis, compared to total proceeds received. Offering costs associated with derivative warrant liabilities are expensed as incurred, presented as non-operating expenses in the statements of operations. Offering costs associated with the Class A ordinary shares were charged against the carrying value of the Class A ordinary shares upon the completion of the Initial Public Offering. The Company classifies deferred underwriting commissions as non-current liabilities as their liquidation is not reasonably expected to require the use of current assets or require the creation of current liabilities.\nClass A Ordinary Shares Subject to Possible Redemption\nThe Company accounts for its Class A ordinary shares subject to possible redemption in accordance with the guidance in ASC Topic 480 “Distinguishing Liabilities from Equity.” Class A ordinary shares subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable Class A ordinary shares (including Class A ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) are classified as temporary equity. At all other times, Class A ordinary shares are classified as shareholders’ equity. The Company’s Class A ordinary shares feature certain redemption rights that are considered to be outside of the Company’s control and subject to the occurrence of uncertain future events. Accordingly, as of March 31, 2022 and December 31, 2021, the Company had 28,103,449 Class A ordinary shares subject to possible redemption presented as temporary equity, outside of the shareholders’ equity section of the Company’s condensed balance sheets.\nUnder ASC 480-10-S99, the Company has elected to recognize changes in the redemption value immediately as they occur and adjust the carrying value of the security to equal the redemption value at the end of the reporting period. Effective with the closing of the Initial Public Offering (including exercise of the over-allotment option), the Company recognized the accretion from initial book value to redemption amount, which resulted in charges against additional paid-in capital (to the extent available) and accumulated deficit.\nShare-based Compensation\nThe transfer of the Founder Shares is in the scope of FASB ASC Topic 718, “Compensation-Stock Compensation” (“ASC 718”). Under ASC 718, stock-based compensation associated with equity-classified awards is measured at fair value upon the grant date. The Founders Shares were granted subject to a performance condition (i.e., the occurrence of a Business Combination). Compensation expense related to the Founders Shares is recognized only when the performance condition is probable of occurrence under the applicable accounting literature in this circumstance. As of the date of issuance of this Form 10-Q, the Company determined that a Business Combination is not considered probable, and, therefore, no stock-based compensation expense has been recognized. Stock-based compensation\n10\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nwould be recognized at the date a Business Combination is considered probable (i.e., upon completion of a Business Combination) in an amount equal to the number of Founders Shares that ultimately vest multiplied times the grant date fair value per share (unless subsequently modified) less the amount initially received for the purchase of the Founders Shares.\nIncome Taxes\nThe Company follows the asset and liability method of accounting for income taxes under ASC 740, “Income Taxes.” Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that included the enactment date. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.\nASC Topic 740 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The Company’s management determined that the Cayman Islands is the Company’s only major tax jurisdiction. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of March 31, 2022 and December 31, 2021. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position.\nThe Company is considered an exempted Cayman Islands company and is presently not subject to income taxes or income tax filing requirements in the Cayman Islands or the United States. As such, the Company’s tax provision was zero for the period presented. The Company’s management does not expect that the total amount of unrecognized tax benefits will materially change over the next twelve months.\nNet Income (Loss) Per Ordinary Share\nThe Company complies with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share.” The Company has two classes of shares, which are referred to as Class A ordinary shares and Class B ordinary shares. Income and losses are shared pro rata between the two classes of shares. Net income (loss) per ordinary share is calculated by dividing the net income (loss) by the weighted average shares of ordinary shares outstanding for the respective period.\nThe calculation of diluted net income (loss) per ordinary share does not consider the effect of the warrants issued in connection with the Initial Public Offering (including exercise of the over-allotment option) and the Private Placement to purchase an aggregate of 9,431,035 shares of Class A ordinary shares in the calculation of diluted income (loss) per share, because their exercise is contingent upon future events and their inclusion would be anti-dilutive under the treasury stock method. Accretion associated with the redeemable Class A ordinary shares is excluded from earnings per share as the redemption value approximates fair value.\nThe following table reflects presents a reconciliation of the numerator and denominator used to compute basic and diluted net loss per share for each class of ordinary shares:\n11\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\n\n| For the Three Months Ended March 31, |\n| 2022 | 2021 |\n| Class A | Class B | Class A | Class B |\n| Basic and diluted net income (loss) per ordinary share: |\n| Numerator: |\n| Allocation of net income (loss) - basic and diluted | $ | 3,079,954 | $ | 769,988 | $ | ( 140,822 | ) | $ | ( 452,642 | ) |\n| Denominator: |\n| Basic and diluted weighted average ordinary shares outstanding | 28,103,449 | 7,025,862 | 1,944,444 | 6,250,000 |\n| Basic and diluted net income (loss) per ordinary share | $ | 0.11 | $ | 0.11 | $ | ( 0.07 | ) | $ | ( 0.07 | ) |\n\nRecent Accounting Pronouncements\nThe Company’s management does not believe that any other recently issued, but not yet effective, accounting standards updates, if currently adopted, would have a material effect on the accompanying unaudited condensed financial statements.\nNote 3 - Initial Public Offering\nOn March 25, 2021, the Company consummated its Initial Public Offering of 25,000,000 Units, at $ 10.00 per Unit, generating gross proceeds of $ 250.0 million, and incurring offering costs of approximately $ 14.3 million, of which approximately $ 8.8 million was for deferred underwriting commissions.\nThe Company granted the Underwriters a 45-day option to purchase up to 3,750,000 additional Units to cover over-allotments, if any. The Underwriters partially exercised the over-allotment option and on April 1, 2021, purchased an additional 3,103,449 Units, generating gross proceeds of approximately $ 31.0 million, and incurring additional offering costs of approximately $ 1.7 million in offering costs, of which approximately $ 1.1 million was for deferred underwriting fees.\nEach Unit consists of one Class A ordinary share, and one-fifth of one redeemable warrant (each, a “Public Warrant”). Each Public Warrant entitles the holder to purchase one Class A ordinary share at a price of $ 11.50 per share, subject to adjustment (see Note 6).\nNote 4 - Related Party Transactions\nFounder Shares\nOn December 31, 2020, the Sponsor paid $ 25,000 to cover certain expenses of the Company in consideration of the Founder Shares. On January 14, 2021, the Company effected a share dividend of 1,437,500 Class B ordinary shares, resulting in an aggregate of 7,187,500 Class B ordinary shares outstanding. On March 1, 2021, our Sponsor transferred 28,750 Founder Shares to each of our five independent director nominees. The initial shareholders agreed to forfeit up to 937,500 Founder Shares to the extent that the over-allotment option is not exercised in full by the underwriters, so that the Founder Shares will represent 20 % of the Company’s issued and outstanding shares after the Initial Public Offering. On April 1, 2021, the underwriters partially exercised the over-allotment option to purchase an additional 3,103,449 Units. Subsequently, on May 9, 2021, the Sponsor forfeited 161,638 Class B ordinary shares.\nThe initial shareholders agreed, subject to limited exceptions, not to transfer, assign or sell any of their Founder Shares until the earlier to occur of: (i) one year after the completion of the initial Business Combination or (ii) the date following the completion of the initial Business Combination on which the Company completes a liquidation, merger, share exchange or other similar transaction that results in all of the shareholders having the right to exchange their ordinary shares for cash, securities or other property. Notwithstanding the foregoing, if the closing price of the Class A ordinary shares equals or exceeds $ 12.00 per share (as adjusted for share sub-divisions, share capitalizations, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing at least 120 days after the initial Business Combination, the Founder Shares will be released from the lockup.\n12\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nPrivate Placement Warrants\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the Private Placement of 3,500,000 Private Placement Warrants, at a price of $ 2.00 per Private Placement Warrant with the Sponsor, generating gross proceeds of $ 7.0 million.\nSimultaneously with the closing of the over-allotment on April 1, 2021, the Company consummated the second closing of the Private Placement, resulting in the purchase of an aggregate of an additional 310,345 Private Placement Warrants by the Sponsor, generating gross proceeds to the Company of approximately $ 621,000 .\nEach whole Private Placement Warrant is exercisable for one whole Class A ordinary share at a price of $ 11.50 per share. A portion of the proceeds from the Private Placement Warrants was added to the proceeds from the Initial Public Offering held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the Private Placement Warrants will expire worthless. The Private Placement Warrants will be non-redeemable except as described below in Note 6 and exercisable on a cashless basis so long as they are held by the Sponsor or its permitted transferees.\nThe Sponsor and the Company’s officers and directors agreed, subject to limited exceptions, not to transfer, assign or sell any of their Private Placement Warrants until 30 days after the completion of the initial Business Combination.\nRelated Party Loans\nOn December 31, 2020, the Sponsor agreed to loan the Company an aggregate of up to $ 300,000 to cover expenses related to the Initial Public Offering pursuant to a promissory note (the “Note”). This Note was non-interest bearing and payable upon the completion of the Initial Public Offering. The Company borrowed $ 300,000 under the Note and repaid the Note in full on March 25, 2021.\nIn addition, in order to fund working capital deficiencies or finance transaction costs in connection with a Business Combination, the Sponsor or an affiliate of the Sponsor, or certain of the Company’s officers and directors may, but are not obligated to, loan the Company funds as may be required (“Working Capital Loans”). If the Company completes a Business Combination, the Company will repay the Working Capital Loans out of the proceeds of the Trust Account released to the Company. Otherwise, the Working Capital Loans would be repaid only out of funds held outside the Trust Account. In the event that a Business Combination does not close, the Company may use a portion of the proceeds held outside the Trust Account to repay the Working Capital Loans, but no proceeds held in the Trust Account would be used to repay the Working Capital Loans. The Working Capital Loans would either be repaid upon consummation of a Business Combination, without interest, or, at the lender’s discretion, up to $ 1.5 million of such Working Capital Loans may be convertible into warrants of the post Business Combination entity at a price of $ 2.00 per warrant. The warrants would be identical to the Private Placement Warrants. Except for the foregoing, the terms of such Working Capital Loans, if any, have not been determined and no written agreements exist with respect to such loans. As of March 31, 2022 and December 31, 2021, the Company had no borrowings under the Working Capital Loans.\nAdministrative Services Agreement\nIn May 2022, the Company entered into an agreement effective on January 1, 2022 through the Company’s consummation of a Business Combination or its liquidation, to pay an affiliate of the Sponsor a sum of up to $ 7,500 per month, for office space, utilities, employee benefits and secretarial and administrative services. In the three months ended March 31, 2022, the Company paid approximately $ 7,000 in fees for these services, of which approximately $ 2,000 was charged to general and administrative expenses within the condensed statements of operations, and approximately $ 5,000 is included within prepaid expenses – current balance in the accompanying condensed balance sheets.\nNote 5 - Commitments and Contingencies\n13\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nRegistration and Shareholder Rights\nThe holders of Founder Shares, Private Placement Warrants and warrants that may be issued upon conversion of Working Capital Loans (and any Class A ordinary shares issuable upon the exercise of the Private Placement Warrants and warrants that may be issued upon conversion of Working Capital Loans) were entitled to registration rights pursuant to a registration and shareholder rights agreement signed upon consummation of the Initial Public Offering. These holders were entitled to certain demand and “piggyback” registration rights. However, the registration and shareholder rights agreement provided that the Company would not permit any registration statement filed under the Securities Act to become effective until the termination of the applicable lock-up period for the securities to be registered. The Company will bear the expenses incurred in connection with the filing of any such registration statements.\nUnderwriting Agreement\nThe underwriters were entitled to an underwriting discount of $ 0.20 per unit, or $ 5.0 million in the aggregate, paid upon the closing of the Initial Public Offering. In addition, $ 0.35 per unit, or approximately $ 8.8 million in the aggregate will be payable to the underwriters for deferred underwriting commissions. The deferred fee will become payable to the underwriters from the amounts held in the Trust Account solely in the event that the Company completes a Business Combination, subject to the terms of the underwriting agreement.\nThe Underwriters partially exercised the over-allotment option and on April 1, 2021 purchased an additional 3,103,449 Units, generating gross proceeds of approximately $ 31.0 million, and incurred additional offering costs of approximately $ 1.7 million in offering costs, of which approximately $ 1.1 million will be payable to the underwriters for additional deferred underwriting fees.\nNote 6 - Warrants\nAs of March 31, 2022 and December 31, 2021, the Company had 5,620,690 and 3,810,345 Public Placement Warrants and Private Placement Warrants outstanding.\nPublic Warrants may only be exercised for a whole number of shares. No fractional Public Warrants will be issued upon separation of the Units and only whole Public Warrants will trade. The Public Warrants will become exercisable 30 days after the completion of a Business Combination or provided in each case that the Company has an effective registration statement under the Securities Act covering the Class A ordinary shares issuable upon exercise of the Public Warrants and a current prospectus relating to them is available (or the Company permits holders to exercise their Public Warrants on a cashless basis and such cashless exercise is exempt from registration under the Securities Act). The Company agreed that as soon as practicable, but in no event later than 15 business days, after the closing of a Business Combination, the Company will use its best efforts to file with the SEC a registration statement for the registration, under the Securities Act, of the Class A ordinary shares issuable upon exercise of the Public Warrants. If the shares issuable upon exercise of the warrants are not registered under the Securities Act, the Company will be required to permit holders to exercise their warrants on a cashless basis. However, no warrant will be exercisable for cash or on a cashless basis, and the Company will not be obligated to issue any shares to holders seeking to exercise their warrants, unless the issuance of the shares upon such exercise is registered or qualified under the securities laws of the state of the exercising holder, or an exemption from registration is available. Notwithstanding the above, if the Company’s Class A ordinary shares are at the time of any exercise of a warrant not listed on a national securities exchange such that it satisfies the definition of a “covered security” under Section 18(b)(1) of the Securities Act, the Company may, at its option, require holders of Public Warrants who exercise their warrants to do so on a “cashless basis” in accordance with Section 3(a)(9) of the Securities Act and, in the event the Company elects, the Company will not be required to file or maintain in effect a registration statement, but the Company will use its best efforts to register or qualify the shares under applicable blue sky laws to the extent an exemption is not available.\nThe warrants have an exercise price of $ 11.50 per share, subject to adjustments, and will expire five years after the completion of a Business Combination or earlier upon redemption or liquidation. In addition, if (x) the Company issues additional Class A ordinary shares or equity-linked securities for capital raising purposes in connection with the closing of the initial Business Combination at an issue price or effective issue price of less than $ 9.20 per Class A\n14\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nordinary share (with such issue price or effective issue price to be determined in good faith by the board of directors and, in the case of any such issuance to the initial shareholders or their affiliates, without taking into account any Founder Shares held by the initial shareholders or such affiliates, as applicable, prior to such issuance) (the “Newly Issued Price”), (y) the aggregate gross proceeds from such issuances represent more than 60 % of the total equity proceeds, and interest thereon, available for the funding of the initial Business Combination on the date of the consummation of the initial Business Combination (net of redemptions), and (z) the volume weighted average trading price of Class A ordinary shares during the 10 trading day period starting on the trading day prior to the day on which the Company consummates its initial Business Combination (such price, the “Market Value”) is below $ 9.20 per share, then the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115 % of the higher of the Market Value and the Newly Issued Price, and the $ 18.00 per share redemption trigger price described under “Redemption of warrants when the price per Class A ordinary share equals or exceeds $18.00” and “Redemption of warrants when the price per Class A ordinary share equals or exceeds $ 10.00 “ will be adjusted (to the nearest cent) to be equal to 180 % of the higher of the Market Value and the Newly Issued Price, and the $ 10.00 per share redemption trigger price described under “Redemption of warrants when the price per Class A ordinary share equals or exceeds $10.00” will be adjusted (to the nearest cent) to be equal to the higher of the Market Value and the Newly Issued Price.\nThe Private Placement Warrants are identical to the Public Warrants underlying the Units sold in the Initial Public Offering, except that the Private Placement Warrants and the Class A ordinary shares issuable upon exercise of the Private Placement Warrants will not be transferable, assignable or salable until 30 days after the completion of a Business Combination, subject to certain limited exceptions. Additionally, except as described below, the Private Placement Warrants will be non-redeemable so long as they are held by the initial purchasers or such purchasers’ permitted transferees. If the Private Placement Warrants are held by someone other than the initial shareholders or their permitted transferees, the Private Placement Warrants will be redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants.\nRedemption of warrants when the price per Class A ordinary share equals or exceeds $18.00:\nOnce the warrants become exercisable, the Company may redeem the outstanding warrants (except as described herein with respect to the Private Placement Warrants):\n\n| • | in whole and not in part; and |\n\n\n| • | at a price of $ 0.01 per warrant; and |\n\n\n| • | upon a minimum of 30-days‘ prior written notice of redemption; and |\n\n\n| • | if, and only if, the last reported sale price (the “closing price”) of Class A ordinary shares equals or exceeds $ 18.00 per share (as adjusted) for any 20 trading days within a 30-trading day period ending on the third trading day prior to the date on which the Company sends the notice of redemption to the warrant holders. |\n\nThe Company will not redeem the warrants as described above unless an effective registration statement under the Securities Act covering the Class A ordinary shares issuable upon exercise of the warrants is effective and a current prospectus relating to those Class A ordinary shares is available throughout the 30-day redemption period. If and when the warrants become redeemable by the Company, it may exercise its redemption right even if the Company is unable to register or qualify the underlying securities for sale under all applicable state securities laws.\nRedemption of warrants when the price per Class A ordinary share equals or exceeds $10.00:\nOnce the warrants become exercisable, the Company may redeem the outstanding warrants:\n\n| • | in whole and not in part; and |\n\n15\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\n\n| • | upon a minimum of 30 days‘ prior written notice of redemption; provided that holders will be able to exercise their warrants on a cashless basis prior to redemption and receive that number of shares determined by reference to an agreed table based on the redemption date and the fair market value of Class A ordinary shares; and |\n\n\n| • | if, and only if, the closing price of Class A ordinary shares equals or exceeds $ 10.00 per Public Share (as adjusted) for any 20 trading days within the 30-trading day period ending three trading days before the Company sends the notice of redemption to the warrant holders; and |\n\n\n| • | if the closing price of the Class A ordinary shares for any 20 trading days within a 30-trading day period ending on the third trading day prior to the date on which the Company sends the notice of redemption to the warrant holders is less than $ 18.00 per Public Share (as adjusted), the Private Placement Warrants must also be concurrently called for redemption on the same terms as the outstanding Public Warrants, as described above. |\n\nThe “fair market value” of Class A ordinary shares for the above purpose shall mean the volume weighted average price of Class A ordinary shares during the 10 trading days immediately following the date on which the notice of redemption is sent to the holders of warrants. In no event will the warrants be exercisable in connection with this redemption feature for more than 0.361 Class A ordinary shares per warrant (subject to adjustment).\nIn no event will the Company be required to net cash settle any warrant. If the Company is unable to complete a Business Combination within the Combination Period and the Company liquidates the funds held in the Trust Account, holders of warrants will not receive any of such funds with respect to their warrants, nor will they receive any distribution from the Company’s assets held outside of the Trust Account with the respect to such warrants. Accordingly, the warrants may expire worthless.\nNote 7 - Class A Ordinary Shares Subject to Possible Redemption\nThe Company’s Class A ordinary shares feature certain redemption rights that are considered to be outside of the Company’s control and subject to the occurrence of future events. The Company is authorized to issue 500,000,000 shares of Class A ordinary shares with a par value of $ 0.0001 per share. Holders of the Company’s Class A ordinary shares are entitled to one vote for each share. As of March 31, 2022 and December 31, 2021, there were 28,103,449 shares of Class A ordinary shares outstanding, which were all subject to possible redemption and are classified outside of permanent equity in the condensed balance sheets.\nThe Class A ordinary shares subject to possible redemption reflected on the condensed balance sheets is reconciled on the following table:\n\n| Gross proceeds | $ | 281,034,490 |\n| Less: |\n| Proceeds allocated to Public Warrants | ( 5,633,100 | ) |\n| Class A ordinary shares issuance costs | ( 15,730,212 | ) |\n| Plus: |\n| Accretion of carrying value to redemption value | 21,363,312 |\n| Class A ordinary shares subject to possible redemption | $ | 281,034,490 |\n\nNote 8 - Shareholders’ Deficit\nPreference Shares - The Company is authorized to issue 5,000,000 preference shares, with a par value of $ 0.0001 per share, with such designations, voting and other rights and preferences as may be determined from time to time by the Company’s board of directors. As of March 31, 2022 and December 31, 2021, there were no preference shares issued or outstanding.\n16\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nClass A Ordinary Shares - The Company is authorized to issue 500,000,000 Class A ordinary shares with a par value of $ 0.0001 per share. As of March 31, 2022 and December 31, 2021, there were 28,103,449 and Class A ordinary shares issued and outstanding, all subject to possible redemption and classified as temporary equity (see Note 7).\nClass B Ordinary Shares - The Company is authorized to issue 50,000,000 Class B ordinary shares with a par value of $ 0.0001 per share. On December 31, 2020, the Company issued 5,750,000 Class B ordinary shares. On January 14, 2021, the Company effected a share dividend of 1,437,500 Class B ordinary shares resulting in an aggregate of 7,187,500 Class B ordinary shares outstanding. Of the 7,187,500 Class B ordinary shares outstanding, up to 937,500 shares were subject to forfeiture to the Company by the initial shareholders on a pro rata basis for no consideration to the extent that the underwriters’ over-allotment option is not exercised in full or in part, so that the initial shareholders will collectively own 20 % of the Company’s issued and outstanding ordinary shares after the Initial Public Offering. The underwriters partially exercised their over-allotment option on April 1, 2021, and subsequently on May 9, 2021, the Sponsor forfeited 161,638 Class B ordinary shares. As of March 31, 2022 and December 31, 2021, there were 7,025,862 Class B ordinary shares outstanding, none subject to forfeiture.\nOrdinary shareholders of record are entitled to one vote for each share held on all matters to be voted on by shareholders. Holders of the Class A ordinary shares and holders of the Class B ordinary shares will vote together as a single class on all matters submitted to a vote of shareholders, except as required by law.\nThe Class B ordinary shares will automatically convert into Class A ordinary shares concurrently with or immediately following the consummation of the initial Business Combination on a one-for-one basis, subject to adjustment for share sub-divisions, share capitalizations, reorganizations, recapitalizations and the like, and subject to further adjustment as provided herein . In the case that additional Class A ordinary shares or equity-linked securities are issued or deemed issued in connection with the initial Business Combination, the number of Class A ordinary shares issuable upon conversion of all Class B ordinary shares will equal, in the aggregate, 20 % of the total number of Class A ordinary shares outstanding after such conversion (after giving effect to any redemptions of Class A ordinary shares by Public Shareholders), including the total number of Class A ordinary shares issued, or deemed issued or issuable upon conversion or exercise of any equity-linked securities or rights issued or deemed issued, by the Company in connection with or in relation to the consummation of the initial Business Combination, excluding any Class A ordinary shares or equity-linked securities exercisable for or convertible into Class A ordinary shares issued, or to be issued, to any seller in the initial Business Combination and any Private Placement Warrants issued to the Sponsor, officers or directors upon conversion of Working Capital Loans; provided that such conversion of Class B ordinary shares will never occur on a less than one-for-one basis.\nNote 9 - Fair Value Measurements\nThe following table presents information about the Company’s financial assets and liabilities that are measured at fair value on a recurring basis as of March 31, 2022 and December 31, 2021, by level within the fair value hierarchy:\nMarch 31, 2022\n\n| Description | Quoted Prices in Active Markets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Other Unobservable Inputs (Level 3) |\n| Assets: |\n| Investments held in Trust Account - money market fund | $ | 281,067,324 | $ | - | $ | - |\n| Liabilities: |\n| Derivative warrant liabilities - Public Warrants | $ | 2,585,520 | $ | - | $ | - |\n| Derivative warrant liabilities - Private Warrants | $ | - | $ | - | $ | 1,752,760 |\n\nDecember 31, 2021\n17\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\n\n| Description | Quoted Prices in Active Markets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Other Unobservable Inputs (Level 3) |\n| Assets: |\n| Investments held in Trust Account - money market fund | $ | 281,049,184 | $ | - | $ | - |\n| Liabilities: |\n| Derivative warrant liabilities - Public Warrants | $ | 5,058,620 | $ | - | $ | - |\n| Derivative warrant liabilities - Private Warrants | $ | - | $ | - | $ | 3,429,310 |\n\nTransfers to/from Levels 1, 2, and 3 are recognized at the beginning of the reporting period. There were no transfers to/from Levels 1, 2, and 3 during the three months ended March 31, 2022 or 2021.\nLevel 1 assets include investments in money market funds invested in government securities. The Company uses inputs such as actual trade data, benchmark yields, quoted market prices from dealers or brokers, and other similar sources to determine the fair value of its investments.\nThe fair value of the Public Warrants issued in connection with the Public Offering and Private Placement Warrants were initially measured at fair value using a Monte Carlo simulation model. Subsequent to the separate listing and trading of the Public Warrants the fair value of the Public Warrants has been measured based on the observable listed prices for such warrants and the fair value of the Private Warrants are measured using a Black-Scholes Option Pricing Model. For the three months ended March 31, 2022 and 2021, the Company recognized a non-cash gain/(loss) resulting from a decrease/(increase) in the fair value of liabilities of approximately $ 4.1 million and ($ 205,000 ), respectively, presented as change in fair value of derivative liabilities on the accompanying unaudited condensed statements of operations.\nThe estimated fair value of the Private Placement Warrants and the Public Warrants prior to being separately listed and traded, is determined using Level 3 inputs. Inherent in a Monte Carlo simulation and the Black-Scholes Option Pricing Model are assumptions related to expected stock-price volatility, expected life, risk-free interest rate and dividend yield. The Company estimates the volatility of its ordinary share warrants based on implied volatility from the Company’s traded warrants and from historical volatility of select peer company’s ordinary shares that matches the expected remaining life of the warrants. The risk-free interest rate is based on the U.S. Treasury zero-coupon yield curve on the grant date for a maturity similar to the expected remaining life of the warrants. The expected life of the warrants is assumed to be equivalent to their remaining contractual term. The dividend rate is based on the historical rate, which the Company anticipates remaining at zero.\nThe following table provides quantitative information regarding Level 3 fair value measurement inputs at their measurement dates:\n\n| As of March 31, 2022 | As of December 31, 2021 |\n| Volatility | 5.75 % | 12.79 % |\n| Stock price | $ | 9.78 | $ | 9.75 |\n| Expected life of the options to convert | 5.91 | 6.16 |\n| Risk-free rate | 2.410 % | 1.373 % |\n| Dividend yield | 0.000 % | 0.000 % |\n\nThe changes in the fair value of Level 3 derivative warrant liabilities for the three months ended March 31, 2022 and 2021 are summarized as follows:\n18\nSUPERNOVA PARTNERS ACQUISITION COMPANY III, LTD.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\n\n| 2022 | 2021 |\n| Derivative warrant liabilities at January 1 | $ | 3,429,310 | $ | - |\n| Issuance of Public Warrants - Level 3 | - | 5,000,000 |\n| Issuance of Private Warrants - Level 3 | - | 3,640,000 |\n| Change in fair value of derivative liabilities - Level 3 | ( 1,676,550 | ) | 205,000 |\n| Derivative warrant liabilities at March 31 | 1,752,760 | 8,845,000 |\n\nNote 10 – Subsequent Events\nManagement has evaluated subsequent events and transactions that occurred after the balance sheet date through the date the unaudited condensed financial statements were issued. Based upon this review, except for the administrative agreement entered disclosed in Note 4, the Company did not identify any subsequent events that would have required adjustment or disclosure in the unaudited condensed financial statements.\n19\nItem 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations.\nReferences to the “Company,” “Supernova Partners Acquisition Company III, Ltd.” “our,” “us” or “we” refer to Supernova Partners Acquisition Company III, Ltd. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the unaudited condensed financial statements and the notes thereto contained elsewhere in this report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\nCautionary Note Regarding Forward-Looking Statements\nThis Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act. We have based these forward-looking statements on our current expectations and projections about future events. These forward-looking statements are subject to known and unknown risks, uncertainties and assumptions about us that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other SEC filings.\nOverview\nWe are a blank check company incorporated as a Cayman Islands exempted company on December 24, 2020. We were formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses. We are an early stage and emerging growth company and, as such, we are subject to all of the risks associated with early stage and emerging growth companies.\nOur sponsor is Supernova Partners III LLC, a Cayman Islands exempted company (the “Sponsor”). The registration statement for our Initial Public Offering was declared effective on March 22, 2021. On March 25, 2021, we consummated its Initial Public Offering of 25,000,000 Units, at $10.00 per Unit, generating gross proceeds of $250.0 million, and incurring offering costs of approximately $14.3 million, of which approximately $8.8 million was for deferred underwriting commissions.\nWe granted the underwriters in the IPO a 45-day option to purchase up to 3,750,000 additional Units to cover over-allotments, if any. The Underwriters exercised the over-allotment option in part and on April 1, 2021 purchased an additional 3,103,449 Units to cover over-allotments, generating gross proceeds of approximately $31.0 million, and incurred additional offering costs of approximately $1.7 million in offering costs, of which approximately $1.1 million was for deferred underwriting fees.\nSimultaneously with the closing of the Initial Public Offering, we consummated the Private Placement of 3,500,000 warrants Private Placement Warrants, at a price of $2.00 per Private Placement Warrant with the Sponsor, generating gross proceeds of $7.0 million.\nSimultaneously with the closing of the Over-Allotment on April 1, 2021, we consummated the second closing of the Private Placement, resulting in the purchase of an aggregate of an additional 310,345 Private Placement Warrants by the Sponsor, generating gross proceeds to us of approximately $621,000.\nIn addition, the Sponsor agreed to forfeit up to 937,500 Class B ordinary shares, par value $0.0001 (the “Founder Shares”) to the extent that the over-allotment option is not exercised in full by the underwriters. The underwriters partially exercised their over-allotment option on April 1, 2021, and subsequently on May 9, 2021, the Sponsor forfeited 161,638 Class B ordinary shares.\nUpon the closing of the Initial Public Offering, Over-Allotment, and the Private Placement, approximately $281.0 million ($10.00 per Unit) of the net proceeds of the Initial Public Offering and certain of the proceeds of the Private Placement was placed in the Trust Account, located in the United States at J.P. Morgan Chase Bank, N.A., with\n20\nAmerican Stock Transfer & Trust Company acting as trustee, and invested only in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), with a maturity of 185 days or less or in any open-ended investment company that holds itself out as a money market fund selected by us meeting the conditions of paragraphs (d)(2), (d)(3) and (d)(4) of Rule 2a-7 of the Investment Company Act, as determined by us, until the earlier of: (i) the completion of a Business Combination and (ii) the distribution of the Trust Account as described below.\nOur management has broad discretion with respect to the specific application of the net proceeds of the Initial Public Offering and the sale of Private Placement Warrants, although substantially all of the net proceeds are intended to be applied generally toward consummating a Business Combination. There is no assurance that we will be able to complete a Business Combination successfully. We must complete one or more initial Business Combinations having an aggregate fair market value of at least 80% of the assets held in the Trust Account (excluding the amount of any deferred underwriting discount held in trust) at the time of the signing of the agreement to enter into the initial Business Combination. However, we will only complete a Business Combination if the post-transaction company owns or acquires 50% or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act.\nIf the Company is unable to complete a Business Combination within 24 months from the closing of the Initial Public Offering, or March 25, 2023 (the “Combination Period”), the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including interest earned on the funds held in the Trust Account (less taxes payable and up to $100,000 of interest to pay dissolution expenses), divided by the number of then outstanding public shares, which redemption will completely extinguish Public Shareholders’ rights as shareholders (including the right to receive further liquidation distributions, if any) and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the remaining shareholders and the board of directors, liquidate and dissolve, subject, in the case of clauses (ii) and (iii), to the Company’s obligations under Cayman Islands law to provide for claims of creditors and in all cases subject to the other requirements of applicable law. There will be no redemption rights or liquidating distributions with respect to the warrants, which will expire worthless if the Company fails to complete its initial Business Combination within the Combination Period.\nGoing Concern\nAs of March 31, 2022, we had approximately $0.3 million in our operating bank account and a working capital deficit of approximately $0.6 million.\nThe Company has incurred and expects to incur significant costs in pursuit of its financing and acquisition plans. In connection with the Company's assessment of going concern considerations, in accordance with Financial Accounting Standards Board Accounting Standards Update 2014-15, \"Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern,\" management has determined that the Company's cash flow deficit raise substantial doubt about the Company's ability to continue as a going concern within one year after the date that the unaudited condensed financial statements are issued. There is no assurance that the Company's plans to consummate a Business Combination or raise additional funds will be successful within the Combination Period. The unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty.\nRisks and Uncertainties\nWe continue to evaluate the impact of the COVID-19 pandemic and have concluded that the specific impact is not readily determinable as of the date of the balance sheet. The unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty.\n21\nResults of Operations\nOur entire activity since inception up to March 31, 2022 was in preparation for our formation and the Initial Public Offering and identifying a target company for a Business Combination. We will not be generating any operating revenues until the closing and completion of our initial business combination.\nFor the three months ended March 31, 2022, we had a net income of approximately $3.8 million, which consisted of approximately $0.3 million general and administrative expenses, offset by a gain of approximately $4.1 million from a change in fair value of derivative warrant liabilities and approximately a $18,000 gain on investments held in Trust Account.\nFor the three months ended March 31, 2021, we had a net loss of approximately $593,000, which consisted of approximately $102,000 in general and administrative expenses, approximately $287,000 in financing costs -derivative warrant liabilities and a charge of $205,000 from a change in fair value of derivative warrant liabilities, partially offset by a $287 gain on investments held in the Trust Account.\nLiquidity and Capital Resources\nFollowing the Initial Public Offering and Over-Allotment, a total of $281 million was placed in the Trust Account. We incurred approximately $16.1 million in transaction costs, including $9.8 million of deferred underwriting fees.\nFor the three months ended March 31, 2022, we used approximately $261,000 of cash for operating activities. Our net income included a $4.2 million non-cash gain from the change in the fair value of derivative warrant liabilities and approximately $18,000 gain on investment income held in the Trust account and was partially offset by changes in operating assets and liabilities of that provided approximately $57,000 of cash from operating activities. For the three months ended net cash flow from financing activities was $85,000 and related to remaining offering costs paid.\nFor the three months ended March 31, 2021, we used approximately $43,000 of cash for operating activities. Our net loss was impacted by $205,000 of a non-cash loss from the change in the fair value of derivative warrant liabilities, $287,000 of financing costs allocated to derivative liabilities, and a $287 gain on investment income held in the Trust account, and was partially offset by changes in operating assets and liabilities of that provided approximately $58,000 of cash from operating activities.\nAs of March 31, 2022, we had investments held in the Trust Account of approximately $281,067,000. We intend to use substantially all of the funds held in the Trust Account, including any amounts representing interest earned on the Trust Account, which interest shall be net of taxes payable and excluding deferred underwriting commissions, to complete our initial Business Combination. We may withdraw interest from the Trust Account to pay taxes, if any. To the extent that our share capital or debt is used, in whole or in part, as consideration to complete a Business Combination, the remaining proceeds held in the Trust Account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies.\nAs of March 31, 2022, we had cash of approximately $321,000 held outside of the Trust Account. We intend to use the funds held outside the Trust Account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, structure, negotiate and complete a Business Combination.\nContractual Obligations\nWe do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities. We do have an Administrative Support Agreement which was effective January 1, 2022 through the Company’s consummation of a Business Combination or its liquidation, to pay an affiliate of the Sponsor a sum of up to $7,500 per month, for office space, utilities, employee benefits and secretarial and administrative services.\nRegistration Rights\n22\nThe holders of Founder Shares, Private Placement Warrants and warrants that may be issued upon conversion of working capital loans (and any Class A ordinary shares issuable upon the exercise of the Private Placement Warrants and warrants that may be issued upon conversion of working capital loans) were entitled to registration rights pursuant to a registration rights agreement signed upon consummation of the Initial Public Offering. These holders were entitled to certain demand and “piggyback” registration rights. However, the registration rights agreement provided that we would not permit any registration statement filed under the Securities Act to become effective until the termination of the applicable lock-up period for the securities to be registered. We will bear the expenses incurred in connection with the filing of any such registration statements.\nUnderwriting Agreement\nThe underwriters were entitled to an underwriting discount of $0.20 per unit, or $5 million in the aggregate, paid upon the closing of the Initial Public Offering. In addition, $0.35 per unit, or approximately $8.8 million in the aggregate, will be payable to the underwriters for deferred underwriting commissions. The deferred fee will become payable to the underwriters from the amounts held in the Trust Account solely in the event that we complete a business combination, subject to the terms of the underwriting agreement.\nThe underwriters partially exercised the over-allotment option and on April 1, 2021, purchased an additional 3,103,449 Units, generating gross proceeds of approximately $31 million, and incurred additional offering costs of approximately $1.7 million in offering costs, of which approximately $1.1 million was for deferred underwriting fees.\nCritical Accounting Policies and Estimates\nDerivative Warrant Liabilities\nWe do not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks. We evaluate all of our financial instruments, including issued stock purchase warrants, to determine if such instruments are derivatives or contain features that qualify as embedded derivatives, pursuant to ASC Topic 480 “Distinguishing Liabilities from Equity” (“ASC 480”) and ASC Topic 815 “Derivatives and Hedging” (“ASC 815”). The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is re-assessed at the end of each reporting period.\nThe warrants issued in connection with the Initial Public Offering (the “Public Warrants”) and the Private Placement Warrants are recognized as derivative liabilities in accordance with ASC 815. Accordingly, the Company recognizes the warrant instruments as liabilities at fair value and adjust the instruments to fair value at each reporting period until exercised. The fair value of the Public Warrants issued in connection with the Public Offering and Private Placement Warrants were initially measured at fair value using a Monte Carlo simulation model. Subsequent to the separate listing and trading of the Public Warrants the fair value of the Public Warrants has been measured based on the observable listed prices for such warrants and the fair value of the Private Warrants are measured using a Black-Scholes Option Pricing Model. Derivative warrant liabilities are classified as non-current as their liquidation is not reasonably expected to require the use of current assets or require the creation of current liabilities.\nClass A Ordinary Shares Subject to Possible Redemption\nWe account for our Class A ordinary shares subject to possible redemption in accordance with the guidance in ASC Topic 480 “Distinguishing Liabilities from Equity” (“ASC 480”). Class A ordinary shares subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable Class A ordinary shares (including Class A ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, Class A ordinary shares are classified as shareholders’ equity. Our Class A ordinary shares feature certain redemption rights that are considered to be outside of our control and subject to the occurrence of uncertain future events. Accordingly, as of March 31, 2022 and December 31, 2021, 28,103,449 Class A ordinary shares subject to possible redemption are presented as temporary equity outside of the shareholders’ equity section of our condensed balance sheets.\nUnder ASC 480-10-S99, the Company has elected to recognize changes in the redemption value immediately as they occur and adjust the carrying value of the security to equal the redemption value at the end of the reporting period.\n23\nEffective with the closing of the Initial Public Offering (including exercise of the over-allotment option), we recognized the accretion from initial book value to redemption amount, which resulted in charges against additional paid-in capital (to the extent available) and accumulated deficit.\nNet Income (Loss) Per Ordinary Share\nWe comply with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share.” We have two classes of shares, which are referred to as Class A ordinary shares and Class B ordinary shares. Income and losses are shared pro rata between the two classes of shares. Net income (loss) per ordinary share is calculated by dividing the net income (loss) by the weighted average shares of ordinary shares outstanding for the respective period.\nThe calculation of diluted net income (loss) per ordinary share does not consider the effect of the warrants issued in connection with the Initial Public Offering (including exercise of the over-allotment option) and the Private Placement to purchase an aggregate of 9,431,035 shares of Class A ordinary shares in the calculation of diluted income (loss) per share, because their exercise is contingent upon future events. Accretion associated with the redeemable Class A ordinary shares is excluded from earnings per share as the redemption value approximates fair value.\nRecent Accounting Pronouncements\nThe Company’s management does not believe that any other recently issued, but not yet effective, accounting standards updates, if currently adopted, would have a material effect on the accompanying financial\nOff-Balance Sheet Financing Arrangements\nAs of March 31, 2022 and December 31, 2021, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K.\nJOBS Act\nThe JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We qualify as an “emerging growth company” and under the JOBS Act are allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) companies. We are electing to delay the adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As a result, the unaudited condensed financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates.\nAdditionally, we are in the process of evaluating the benefits of relying on the other reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, if, as an “emerging growth company,” we choose to rely on such exemptions we may not be required to, among other things, (i) provide an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404, (ii) provide all of the compensation disclosure that may be required of non‑emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (iii) comply with any requirement that may be adopted by the PCAOB regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the unaudited condensed financial statements (auditor discussion and analysis) and (iv) disclose certain executive compensation related items such as the correlation between executive compensation and performance and comparisons of the CEO’s compensation to median employee compensation. These exemptions will apply for a period of five years following the completion of our Initial Public Offering or until we are no longer an “emerging growth company,” whichever is earlier.\nItem 3.Quantitative and Qualitative Disclosures About Market Risk\nWe are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and are not required to provide the information otherwise required under this item.\n24\nItem 4.Controls and Procedures\nEvaluation of Disclosure Controls and Procedures\nUnder the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures as of the end of the fiscal quarter ended March 31, 2022, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer has concluded that during the period covered by this report, our disclosure controls and procedures were not effective as of March 31, 2022, because of a material weakness in our internal control over financial reporting. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. Specifically, our management has concluded that our control around the interpretation and accounting for certain complex financial instruments that we issued was not effectively designed or maintained. This material weakness resulted in the restatement of our interim financial statements for the quarters ended March 31, 2021 and June 30, 2021.\nDisclosure controls and procedures are designed to ensure that information required to be disclosed by us in our Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting that occurred during the fiscal quarter ended March 31, 2022, covered by this Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\nThe Chief Executive Officer and Chief Financial Officer performed additional accounting and financial analyses and other post-closing procedures including consulting with subject matter experts related to the accounting for certain complex financial instruments. Our management has expended, and will continue to expend, a substantial amount of effort and resources for the remediation and improvement of our internal control over financial reporting. While we have processes to properly identify and evaluate the appropriate accounting technical pronouncements and other literature for all significant or unusual transactions, we have expanded and will continue to improve these processes to ensure that the nuances of such transactions are effectively evaluated in the context of the increasingly complex accounting standards.\n25\nPART II - OTHER INFORMATION\nItem 1.Legal Proceedings\nNone.\nItem 1A.Risk Factors\nCertain factors may have a material adverse effect on our business, financial condition and results of operation. An investment in our securities involves a high degree of risk. You should consider carefully the risks and uncertainties described below, in addition to the other information contained herein and our other filings with the SEC, including our financial statements and related notes herein and our other filings with the SEC. In addition to the information set forth in this Quarterly Report on Form 10-Q, you should carefully consider the risk factors and other cautionary statements described under the heading “Risk Factors” in our final prospectus filed with the SEC on March 3, 2021, and our quarterly report on Form 10-Q for the quarter ended June 30, 2021 as filed with the SEC on August 6, 2021, which could materially affect our businesses, financial condition, or future results.. As of the date of this Quarterly Report on Form 10-Q, there have been no material changes in our risk factors from those described in our final prospectus and our quarterly report on Form 10-Q for the quarter ended June 30, 2021, except for the below risk factor. We may disclose changes to such factors or disclose additional factors from time to time in our future filings with the SEC.\nChanges in laws or regulations, or a failure to comply with any laws and regulations, may adversely affect our business, including our ability to negotiate and complete our initial business combination, and results of operations.\nWe are subject to laws and regulations enacted by national, regional and local governments. In particular, we will be required to comply with certain SEC and other legal requirements. Compliance with, and monitoring of, applicable laws and regulations may be difficult, time consuming and costly. Those laws and regulations and their interpretation and application may also change from time to time and those changes could have a material adverse effect on our business, investments and results of operations. In addition, a failure to comply with applicable laws or regulations, as interpreted and applied, could have a material adverse effect on our business, including our ability to negotiate and complete our initial business combination, and results of operations.\nOn March 30, 2022, the SEC issued proposed rules that would, among other items, impose additional disclosure requirements in initial public offerings by SPACs and business combination transactions involving SPACs and private operating companies; amend the financial statement requirements applicable to business combination transactions involving such companies; update and expand guidance regarding the general use of projections in SEC filings, as well as when projections are disclosed in connection with proposed business combination transactions; increase the potential liability of certain participants in proposed business combination transactions; and impact the extent to which SPACs could become subject to regulation under the Investment Company Act of 1940. These rules, if adopted, whether in the form proposed or in revised form, may materially adversely affect our business, including our ability to negotiate and complete our initial business combination and may increase the costs and time related thereto.\nItem 2.Unregistered Sales of Equity Securities and Use of Proceeds.\nNone.\nItem 3.Defaults upon Senior Securities\nNone.\nItem 4.Mine Safety Disclosures.\nNot applicable.\nItem 5.Other Information.\nNone.\n26\nItem 6.Exhibits.\n\n| Exhibit Number | Description |\n| 10.1 | Administrative Services Agreement, dated as of May 10, 2022, by and between Supernova Partners Acquisition Company III, Ltd. and Supernova Partners III LLC. |\n| 31.1* | Certification of Chief Executive Officer (Principal Executive Officer) Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2* | Certification of Chief Financial Officer (Principal Financial and Accounting Officer) Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32.1* | Certification of Chief Executive Officer (Principal Executive Officer) Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 32.2* | Certification of Chief Financial Officer (Principal Financial and Accounting Officer) Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 101.INS | Inline XBRL Instance Document |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104 | Cover Page Interactive Data File |\n\n\n| * | These certifications are furnished to the SEC pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and are deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, nor shall they be deemed incorporated by reference in any filing under the Securities Act of 1933, except as shall be expressly set forth by specific reference in such filing. |\n\n27\nSIGNATURE\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.\n\n| Dated: May 13, 2022 | Supernova Partners Acquisition Company III, Ltd. |\n| By: | /s/ Robert Reid |\n| Name: | Robert Reid |\n| Title: | Chief Executive Officer |\n| By: | /s/ Michael Clifton |\n| Name: | Michael Clifton |\n| Title: | Chief Financial Officer |\n\n28\n</text>\n\nIf the business combination completes, all the existing Private Placement Warrants are exercised at the stated price, and all the initial shareholders sell their Founder Shares at the current closing price of $12.00 per share, then what is the total capital that the company could raise in millions?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nJ.Jill, Inc.\nCONSOLIDATED BALANCE SHEETS (UNAUDITED)\n(in thousands, except share data)\n\n| August 1, 2020 | February 1, 2020 |\n| Assets |\n| Current assets: |\n| Cash | $ | 31,762 | $ | 21,527 |\n| Accounts receivable | 4,165 | 6,568 |\n| Inventories, net | 64,214 | 72,599 |\n| Prepaid expenses and other current assets | 44,095 | 22,256 |\n| Total current assets | 144,236 | 122,950 |\n| Property and equipment, net | 89,647 | 107,645 |\n| Intangible assets, net | 101,505 | 112,814 |\n| Goodwill | 59,697 | 77,597 |\n| Operating lease assets, net | 177,391 | 211,332 |\n| Other assets | 2,174 | 1,650 |\n| Total assets | $ | 574,650 | $ | 633,988 |\n| Liabilities and Shareholders’ Equity |\n| Current liabilities: |\n| Accounts payable | $ | 43,971 | $ | 43,053 |\n| Accrued expenses and other current liabilities | 69,559 | 42,712 |\n| Current portion of long-term debt | 233,352 | 2,799 |\n| Current portion of operating lease liabilities | 34,520 | 33,875 |\n| Borrowings under revolving credit facility | 31,800 | — |\n| Total current liabilities | 413,202 | 122,439 |\n| Long-term debt, net of discount and current portion | — | 231,200 |\n| Deferred income taxes | 16,285 | 31,034 |\n| Operating lease liabilities, net of current portion | 192,973 | 208,800 |\n| Other liabilities | 1,787 | 1,950 |\n| Total liabilities | 624,247 | 595,423 |\n| Commitments and contingencies (see Note 12) |\n| Shareholders’ Equity |\n| Common stock, par value $0.01 per share; 250,000,000 shares authorized; 44,802,370 and 44,288,127 shares issued and outstanding at August 1, 2020 and February 1, 2020, respectively | 448 | 443 |\n| Additional paid-in capital | 126,212 | 125,076 |\n| Accumulated (deficit) | (176,257 | ) | (86,954 | ) |\n| Total shareholders’ equity | (49,597 | ) | 38,565 |\n| Total liabilities and shareholders’ equity | $ | 574,650 | $ | 633,988 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n2\nJ.Jill, Inc.\nCONSOLIDATED STATEMENTS OF OPERATIONS AND\nCOMPREHENSIVE INCOME (LOSS) (UNAUDITED)\n(in thousands, except share and per share data)\n\n| For the Thirteen Weeks Ended | For the Twenty-Six Weeks Ended |\n| August 1, 2020 | August 3, 2019 | August 1, 2020 | August 3, 2019 |\n| Net sales | $ | 92,636 | $ | 180,744 | $ | 183,605 | $ | 357,196 |\n| Costs of goods sold | 37,616 | 75,403 | 78,420 | 135,599 |\n| Gross profit | 55,020 | 105,341 | 105,185 | 221,597 |\n| Selling, general and administrative expenses | 77,737 | 102,634 | 165,645 | 208,079 |\n| Impairment of long-lived assets | (893 | ) | 2,064 | 26,587 | 2,064 |\n| Impairment of goodwill | — | 88,428 | 17,900 | 88,428 |\n| Impairment of intangible assets | — | 7,000 | 6,620 | 7,000 |\n| Operating loss | (21,824 | ) | (94,785 | ) | (111,567 | ) | (83,974 | ) |\n| Interest expense, net | 4,244 | 5,019 | 8,887 | 10,026 |\n| Loss before provision for income taxes | (26,068 | ) | (99,804 | ) | (120,454 | ) | (94,000 | ) |\n| Income tax benefit | (7,034 | ) | (3,069 | ) | (31,151 | ) | (1,631 | ) |\n| Net loss and total comprehensive loss | $ | (19,034 | ) | $ | (96,735 | ) | $ | (89,303 | ) | $ | (92,369 | ) |\n| Net loss per common share attributable to common shareholders: |\n| Basic | $ | (0.43 | ) | $ | (2.21 | ) | $ | (2.00 | ) | $ | (2.12 | ) |\n| Diluted | $ | (0.43 | ) | $ | (2.21 | ) | $ | (2.00 | ) | $ | (2.12 | ) |\n| Weighted average number of common shares outstanding: |\n| Basic | 44,767,154 | 43,793,348 | 44,589,034 | 43,560,434 |\n| Diluted | 44,767,154 | 43,793,348 | 44,589,034 | 43,560,434 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n3\nJ.Jill, Inc.\nCONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (UNAUDITED)\n(in thousands, except common share data)\n\n| Additional | Total |\n| Common Stock | Paid-in | Accumulated | Shareholders’ |\n| Shares | Amount | Capital | (Deficit) | Equity |\n| Balance, February 1, 2020 | 44,288,127 | $ | 443 | $ | 125,076 | $ | (86,954 | ) | $ | 38,565 |\n| Vesting of restricted stock units | 691,008 | 7 | (7 | ) | — | — |\n| Shares withheld for net-share settlement of equity-based compensation | (204,934 | ) | (2 | ) | (135 | ) | — | (137 | ) |\n| Equity-based compensation | — | — | 676 | — | 676 |\n| Net Loss | — | — | — | (70,269 | ) | (70,269 | ) |\n| Balance, May 2, 2020 | 44,774,201 | $ | 448 | $ | 125,610 | $ | (157,223 | ) | $ | (31,165 | ) |\n| Vesting of restricted stock units | 39,804 | — | — | — | — |\n| Shares withheld for net-share settlement of equity-based compensation | (11,635 | ) | — | (13 | ) | — | (13 | ) |\n| Equity-based compensation | — | — | 615 | — | 615 |\n| Net loss | — | — | — | (19,034 | ) | (19,034 | ) |\n| Balance, August 1, 2020 | 44,802,370 | $ | 448 | $ | 126,212 | $ | (176,257 | ) | $ | (49,597 | ) |\n\n\n| Common Stock | Paid-in | Accumulated | Shareholders’ |\n| Shares | Amount | Capital | Earnings | Equity |\n| Balance, February 2, 2019 | 43,672,418 | $ | 437 | $ | 121,635 | $ | 91,723 | $ | 213,795 |\n| Adoption of ASU 2016-02 | — | — | — | 59 | 59 |\n| Special cash dividend ($1.15 per share) | — | — | — | (50,154 | ) | (50,154 | ) |\n| Vesting of restricted stock units | 734,474 | 7 | (7 | ) | — | — |\n| Shares withheld for net-share settlement of equity-based compensation | (239,117 | ) | (2 | ) | (1,266 | ) | — | (1,268 | ) |\n| Forfeiture of restricted stock awards | (69,978 | ) | (1 | ) | 1 | — | — |\n| Equity-based compensation | — | — | 1,202 | — | 1,202 |\n| Net income | — | — | — | 4,366 | 4,366 |\n| Balance, May 4, 2019 | 44,097,797 | $ | 441 | $ | 121,565 | $ | 45,994 | $ | 168,000 |\n| Forfeitable dividend | — | — | 107 | — | 107 |\n| Forfeiture of restricted stock awards | (92,685 | ) | (1 | ) | 1 | — | — |\n| Equity-based compensation | — | — | 1,214 | — | 1,214 |\n| Net loss | — | — | — | (96,735 | ) | (96,735 | ) |\n| Balance, August 3, 2019 | 44,005,112 | $ | 440 | $ | 122,887 | $ | (50,741 | ) | $ | 72,586 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n4\nJ.Jill, Inc.\nCONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)\n(in thousands)\n\n| For the Twenty-Six Weeks Ended |\n| August 1, 2020 | August 3, 2019 |\n| Net loss | $ | (89,303 | ) | $ | (92,369 | ) |\n| Operating activities: |\n| Adjustments to reconcile net income to net cash provided by operating activities |\n| Depreciation and amortization | 17,307 | 18,846 |\n| Impairment of goodwill and intangible assets | 24,520 | 95,428 |\n| Impairment of long-lived assets | 26,587 | 2,064 |\n| Adjustment for costs to exit retail stores | (402 | ) | — |\n| Loss on disposal of fixed assets | 256 | 14 |\n| Noncash amortization of deferred financing and debt discount costs | 812 | 827 |\n| Equity-based compensation | 1,291 | 2,416 |\n| Deferred rent incentives | (91 | ) | (88 | ) |\n| Deferred income taxes | (14,749 | ) | (6,627 | ) |\n| Changes in operating assets and liabilities: |\n| Accounts receivable | 2,403 | (1,990 | ) |\n| Inventories | 8,385 | 7,346 |\n| Prepaid expenses and other current assets | (21,838 | ) | (2,460 | ) |\n| Accounts payable | 1,108 | (1,812 | ) |\n| Accrued expenses | 27,810 | 1,733 |\n| Operating lease assets and liabilities | (772 | ) | 283 |\n| Other noncurrent assets and liabilities | (664 | ) | (75 | ) |\n| Net cash (used in) provided by operating activities | (17,340 | ) | 23,536 |\n| Investing activities: |\n| Purchases of property and equipment | (2,675 | ) | (7,904 | ) |\n| Net cash used in investing activities | (2,675 | ) | (7,904 | ) |\n| Financing activities: |\n| Borrowings under revolving credit facility | 33,000 | — |\n| Repayments of revolving credit facility | (1,200 | ) | — |\n| Repayments on debt | (1,399 | ) | (1,399 | ) |\n| Payments of withholding tax on net-share settlement of equity-based compensation plans | (151 | ) | (1,266 | ) |\n| Special dividend paid to shareholders | — | (50,154 | ) |\n| Forfeitable dividend | — | 107 |\n| Net cash provided by (used in) financing activities | 30,250 | (52,712 | ) |\n| Net change in cash | 10,235 | (37,080 | ) |\n| Cash: |\n| Beginning of Period | 21,527 | 66,204 |\n| End of Period | $ | 31,762 | $ | 29,124 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n5\nJ.Jill, Inc.\nNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)\n1. Description of Business\nJ.Jill, Inc., “J.Jill” or the “Company”, is a premier omnichannel retailer and nationally recognized women’s apparel brand committed to delighting customers with great wear-now product. The brand represents an easy, thoughtful and inspired style that reflects the confidence of remarkable women who live life with joy, passion and purpose. J.Jill offers a guiding customer experience through about 280 stores nationwide and a robust ecommerce platform. J.Jill is headquartered outside Boston.\n2. Summary of Significant Accounting Policies\nBasis of Presentation\nOur interim consolidated financial statements are unaudited. All significant intercompany balances and transactions have been eliminated in consolidation. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been omitted, in accordance with the rules of the Securities and Exchange Commission (the “SEC”) associated with reporting of interim period financial information. We consistently applied the accounting policies described in our 2019 Annual Report on Form 10-K (\"2019 Form 10-K\") in preparing these unaudited interim Consolidated Financial Statements. In the opinion of management, these interim consolidated financial statements contain all normal and recurring adjustments necessary to state fairly the financial position and results of operations of the Company. The consolidated balance sheet as of February 1, 2020 is derived from the audited consolidated balance sheet as of that date. The unaudited results of operations for the thirteen and twenty-six weeks ended August 1, 2020 are not necessarily indicative of future results or results to be expected for the full year ending January 30, 2021 (“Fiscal Year 2020”). You should read these statements in conjunction with our audited consolidated financial statements and related notes in our Annual Report on Form 10-K for the year ended February 1, 2020.\nCertain prior year amounts have been reclassified for consistency with the current year presentation of store impairment charges on the Consolidated Statements of Operations and Comprehensive (Income) Loss.\nSubstantial Doubt about the Company’s Ability to Continue as a Going Concern\nIn accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Update (“ASU”) 2014-15, “Presentation of Financial Statements - Going Concern,” the Company’s management evaluated whether there are conditions or events that raise substantial doubt about its ability to continue as a going concern within one year after the date of issuance of these financial statements. Although the following matters raise substantial doubt about the Company’s ability to continue as a going concern within one year after the date these financial statements have been issued, the Company’s consolidated financial statements have been prepared assuming that it will continue as a going concern.\nIn December 2019, COVID-19 emerged and has subsequently spread worldwide. The World Health Organization declared COVID-19 a pandemic on March 11, 2020 resulting in federal, state and local governments and private entities mandating various restrictions, including travel restrictions, restrictions on public gatherings, stay at home orders and advisories and quarantining of people who may have been exposed to the virus. After close monitoring and taking into consideration the guidance from federal, state and local governments, in an effort to mitigate the spread of COVID-19, effective March 18, 2020, the Company closed all of its stores and its offices with employees working remotely where possible. The Company began reopening its stores in May 2020, with all stores having been reopened by late June 2020; however, operations of the stores may again be restricted by local guidelines.\nAs a result of the COVID-19 pandemic, the Company’s revenues, results of operations and cash flows have been materially adversely impacted, which has resulted in a failure by us to comply with the financial covenants contained in our Asset Based Revolving Credit Agreement (“ABL Facility”) and Term Loan Agreement (“Term Loan”). Additionally, the inclusion of substantial doubt about the Company’s ability to continue as a going concern in the report of our independent registered public accounting firm on our financial statements for the fiscal year ended February 1, 2020 resulted in a violation of affirmative covenants under our ABL Facility and Term Loan. On June 15, 2020, the Company entered into two forbearance agreements (the “Forbearance Agreements”) with the lenders under its ABL Facility and Term Loan. The Forbearance Agreements are described in a Current Report on Form 8-K filed by the Company with the SEC on June 16, 2020, and available on the SEC’s Edgar website as well as the Company’s website, which includes the full text of the agreement as an exhibit. Under the Forbearance Agreements, the respective lenders agreed not to exercise any rights and remedies until July 16, 2020 so long as, among other things, the Company otherwise remained in compliance with its credit facilities and complied with the terms of the Forbearance Agreements. Subsequently, the Forbearance Agreements have been extended with the latest extension until September 26, 2020. The extensions of the Forbearance Agreements are described in\n6\nCurrent Reports on Forms 8-K filed by the Company with the SEC, and available on the SEC’s Edgar website as well as the Company’s website, which include the full text of the agreements as exhibits.\nOn September 1, 2020, the Company announced it entered into a Transaction Support Agreement (“TSA”) with lenders holding greater than 70% of the Company’s term loans (“Consenting Lenders”) and a majority of our shareholders on the principal terms of a financial restructuring (“Transaction”) that would result in a waiver of any past non-compliance with the terms of the Company’s credit facilities and provide the Company with additional liquidity. If the Transaction is consented to by the requisite term loan lenders, the Transaction will be consummated on an out-of-court basis. The out-of-court Transaction would extend the maturity of certain participating debt by two years, through May 2024. The Company is working actively with the Consenting Lenders to obtain the necessary consents.\nIn the event that the Transaction does not receive the consent of the term loan lenders representing 95% of the aggregate outstanding principal amount of the term loan claims under the Company’s existing Term Loan, the parties to the TSA have agreed to a prepackaged plan of reorganization under Chapter 11 of the United States Code (the “In-Court Transaction”) the key terms of which have been negotiated, including additional financing during the Chapter 11 process. While the Company hopes to receive the required consents to execute the out-of-court Transaction, the Company anticipates that as part of the In-Court Transaction all vendor claims would be unimpaired and paid in full.\nThe Company could experience other potential impacts as a result of the COVID-19 pandemic, including, but not limited to, additional charges from potential adjustments to the carrying amount of its inventory, goodwill, intangible assets, right-of-use assets and long-lived assets as well as additional store closures. Actual results may differ materially from the Company’s current estimates as the scope of the COVID-19 pandemic evolves, depending largely, though not exclusively, on the duration of the disruption to its business. These events contribute to conditions that raise substantial doubt about the Company’s ability to continue as a going concern within one year after the date these financial statements have been issued. Under the terms of the ABL Facility and Term Loan, substantial doubt about the Company’s ability to continue as a going concern is considered an event of default which allows the lenders to call the debt in advance of maturity.\nIn response to the COVID-19 pandemic, we have taken and continue to take aggressive and prudent actions to reduce expenses and defer payment of accounts payables and inventory purchases to preserve cash on-hand. These actions include, but are not limited to:\n| • | reduced staffing and operating hours at retail locations for a phase-in period upon reopening; |\n\n| • | base salary reductions for our senior leadership team and suspension of pay raise for corporate employees; |\n\n| • | extension of payment terms for all accounts payable, including merchandising vendors, other than those necessary to support our ecommerce business; |\n\n| • | withheld rent for April and May 2020 for all of our retail locations, and June 2020 for a portion of our retail locations, while opening discussions with our landlords for amended lease terms; |\n\n| • | eliminated approximately half of our catalogs and are considering implementing this as a permanent change; and |\n\n| • | significantly reduced planned capital expenditures. |\n\nAdditionally, we borrowed $33.0 million under our ABL Facility in March 2020, and currently have an outstanding balance of $31.8 million as of August 1, 2020. We have filed an income tax refund for $6.9 million, of which we have received $1.2 million, with the IRS and multiple state jurisdictions related to the provision under the Coronavirus Aid, Relief and Economic Security Act (“CARES Act”) enacted in March 2020 that provides numerous tax provisions and other stimulus measures, including temporary suspension of certain payment requirements for the employer-paid portion of social security taxes, the creation of certain refundable employee retention credits, and technical corrections from prior tax legislation for tax depreciation of certain qualified improvement property. The Company has elected to defer the employer-paid portion of social security taxes beginning with pay dates on and after April 1, 2020. We continue to evaluate the provisions of the CARES Act and the ways in which it could assist our business and improve our liquidity.\nIn late May 2020, the Company began reopening its stores and as of late June 2020, all of its stores have been reopened in accordance with local government guidelines. There is significant uncertainty around the current and potential future business disruptions related to COVID-19, as well as its impact on the U.S. economy, consumer willingness to visit malls and shopping centers, and employee willingness to staff our stores.\n7\nRecently Adopted Accounting Standards\nIn November 2018, the FASB issued ASU 2018-18 – Collaborative Arrangements (“Topic 808”), which clarifies the interaction between Topic 808 and Topic 606, Revenue from Contracts with Customers. The provisions of ASU 2018-18 are effective for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. ASU 2018-18 had no impact on the consolidated financial statements and related disclosures.\nRecently Issued Accounting Pronouncements\nIn December 2019, the FASB issued ASU 2019-12 – Income Tax Accounting (“Topic 740”), which simplifies the accounting for income taxes. The provisions of ASU 2019-12 are effective for fiscal years beginning after December 15, 2020, and interim periods within those fiscal years. The Company will be required to adopt this standard in the first quarter of Fiscal Year 2021. This standard is not expected to have a material impact on our consolidated financial statements and related disclosures.\n3. Revenues\nDisaggregation of Revenue\nThe Company sells its products directly to consumers and the Company earns royalties under its credit card agreement. The following table presents disaggregated revenues by source (in thousands):\n\n| For the Thirteen Weeks Ended | For the Twenty-Six Weeks Ended |\n| August 1, 2020 | August 3, 2019 | August 1, 2020 | August 3, 2019 |\n| Retail | $ | 26,304 | $ | 103,666 | $ | 61,397 | $ | 206,260 |\n| Direct | 66,332 | 77,078 | 122,208 | 150,936 |\n| Net revenues | $ | 92,636 | $ | 180,744 | $ | 183,605 | $ | 357,196 |\n\nContract Liabilities\nThe Company recognizes a contract liability when it has received consideration from the customer and has a future obligation to the customer. Total contract liabilities consisted of the following (in thousands):\n\n| August 1, 2020 | February 1, 2020 |\n| Contract liabilities: |\n| Signing bonus | $ | 435 | $ | 506 |\n| Unredeemed gift cards | 5,825 | 7,264 |\n| Total contract liabilities(1) | $ | 6,260 | $ | 7,770 |\n\n\n| (1) | Included in accrued expenses and other current liabilities on the Company's consolidated balance sheet. The short-term portion of the signing bonus is included in accrued expenses on the consolidated balance sheet as of August 1, 2020. |\n\nFor the thirteen and twenty-six weeks ended August 1, 2020, the Company recognized approximately $1.8 million and $4.0 million, respectively, of revenue related to gift card redemptions and breakage. For the thirteen and twenty-six weeks ended August 3, 2019, the Company recognized approximately $3.1 million and $6.5 million, respectively, of revenue related to gift card redemptions and breakage. Revenue recognized consists of gift cards that were part of the unredeemed gift card balance at the beginning of the period as well as gift cards that were issued during the period.\nPerformance Obligations\nThe Company has a remaining performance obligation of $0.4 million for a signing bonus related to the private label credit card agreement. The Company will recognize revenue over the remaining life of the contract as follows (in thousands):\n\n| Fiscal Year 2020 | Fiscal Year 2021 | Thereafter |\n| Signing bonus | $ | 70 | $ | 141 | $ | 224 |\n\nThis disclosure does not include revenue related to performance obligations from unredeemed gift cards, as substantially all gift cards are redeemed in the first year of issuance.\n8\n4. Other Income\nThe Company filed an insurance claim as a result of a cargo vessel fire on or about January 8, 2019, where contents of two containers carried J.Jill inventory. In July 2019, it was determined that the inventory onboard the cargo vessel was nonsalable, and the insurance claim was settled for $3.3 million. The Company recorded a gain of $2.4 million on insurance proceeds in selling, general and administrative expenses in the consolidated statement of operations and comprehensive income (loss) for the period ended August 3, 2019.\n5. Asset Impairments\nLong-lived Asset Impairments\nIn the first quarter of Fiscal Year 2020, the Company reduced the net carrying value of certain long-lived assets to their estimated fair value, which was determined using a discounted cash flows method. These impairment charges arose from the material adverse effect that the COVID-19 pandemic had on our results of operations, particularly with our store fleet. The Company incurred non-cash impairment charges of $6.7 million on leasehold improvements and $20.8 million on the right-of-use assets. During the second quarter of Fiscal Year 2020, the Company recorded a $1.3 million non-cash gain on the operating leases liabilities due to its decision to close certain retail stores. Approximately $0.9 million of the benefit related to leases that were included in the impairment on right-of-use assets recorded in the first quarter of Fiscal Year 2020; therefore, the benefit was recorded as a reduction of the previously recorded impairment.\nIn the second quarter of Fiscal Year 2019, the Company reduced the net carrying value of certain long-lived assets to their estimated fair value, determined using a discounted cash flows method. These impairment charges arose from the Company’s decision to vacate and sublease one floor of the corporate headquarters located in Quincy, Massachusetts. The Company incurred non-cash impairment charges of $0.3 million on leasehold improvements and $1.8 million on the right-of-use asset, which were recorded as impairment of long-lived assets in the consolidated statement of operations and comprehensive income (loss).\nGoodwill and Other Intangible Asset Impairments\nIn the first quarter of Fiscal Year 2020, the Company temporarily closed its retail locations due to the COVID-19 pandemic, which had a material adverse effect on our results of operations, financial position and liquidity and led to a significant decline in our net sales for the first quarter of Fiscal Year 2020, as well as an expected decline for the full Fiscal Year 2020. The Company concluded that these factors, as well as the decrease in stock price represented indicators of impairment and required the Company to test goodwill and indefinite-lived and definite-lived intangible assets for impairment during the first quarter of Fiscal Year 2020 (the “Impairment Test”).\nThe Company performed the Impairment Test using a quantitative approach. The Impairment Test was performed using the income approach (or discounted cash flows method) for goodwill, the relief-from-royalty method for indefinite-lived intangible assets and a recoverability analysis for definite-lived intangible assets. The estimated fair values of goodwill and indefinite-lived and definite-lived intangible assets were below their carrying values resulting in a $17.9 million impairment of goodwill, a $4.0 million impairment of the Company’s tradename (indefinite-lived intangible asset) and a $2.6 million impairment of the Company’s customer list (definite-lived intangible asset). The Company will perform its annual impairment assessment during the fourth quarter of Fiscal Year 2020, or sooner if an indicator of impairment is identified, and may incur further impairments based on the results of that assessment which may be material.\nThe most significant estimates and assumptions inherent in this approach are the preparation of revenue forecasts, selection of royalty and discount rates and a terminal year multiple. These assumptions are classified as Level 3 inputs. The methodology utilized for the Impairment Test has not changed materially from the prior year. The key assumptions used under the income approach and relief-from-royalty method include the following:\n| • | Future cash flow assumptions - The Company's projections for its reporting units were from historical experience and assumptions regarding future revenue growth and profitability trends. The Company's analyses incorporated an assumed period of cash flows of 5-10 years with a terminal value. |\n\n| • | Discount rate - The discount rate was based on an estimated weighted average cost of capital (\"WACC\") for each reporting unit. The components of WACC are the cost of equity and the cost of debt, each of which requires judgment by management to estimate. The Company developed its cost of equity estimate based on perceived risks and predictability of future cash flows. The WACC used to estimate the fair values of the Company's reporting units was within a range of 23.5% to 34%. A 1% change in this discount rate could result in an additional $5.0 million goodwill impairment charge. |\n\n9\n\n| • | Royalty rate - The royalty rates utilized consider external market evidence and internal financial metrics including a review of available returns after the consideration of property, plant and equipment, working capital and other intangible assets. The royalty rate used to estimate the available returns for the reporting units was within a range of 1% to 4%. |\n\nGiven that the impairment charge effectively adjusted the carrying value of the net assets to our estimated fair value as of the date of the impairment charge, the Company is at risk of future impairments in Fiscal Year 2020 if actual results differ from forecasted results or there are changes to these key assumptions used in estimating the fair value. Additionally, due to the impairments recorded during the current year, no material amount of cushion exists between the fair values and respective carrying values of the reporting units and tradename. As such, a change in forecasted discounted cash flows driven by changes in relevant assumptions, may result in further impairment charges.\nThe following table displays a rollforward of the carrying amount of goodwill from February 2, 2019 to August 1, 2020 (in thousands):\n\n| Goodwill at February 2, 2019 | $ | 197,026 |\n| Impairment losses | (119,429 | ) |\n| Balance, February 1, 2020 | 77,597 |\n| Impairment losses | (17,900 | ) |\n| Balance, August 1, 2020 | $ | 59,697 |\n\nThe accumulated goodwill impairment losses as of August 1, 2020 are $137.3 million.\nThe following table reflects the gross carrying amount and accumulated amortization and impairment for each major intangible asset:\n\n| August 1, 2020 | February 1, 2020 |\n| (in thousands) |\n| Weighted Average Useful Life (Years) | Gross | Accumulated Amortization/ Impairment | Carrying Amount | Gross | Accumulated Amortization/ Impairment | Carrying Amount |\n| Trade name | Indefinite | $ | 58,100 | $ | 16,100 | $ | 42,000 | $ | 58,100 | $ | 12,100 | $ | 46,000 |\n| Customer relationships | 13.2 | 134,200 | 74,695 | 59,505 | 134,200 | 67,386 | 66,814 |\n| Total intangible assets | $ | 192,300 | $ | 90,795 | $ | 101,505 | $ | 192,300 | $ | 79,486 | $ | 112,814 |\n\nThe accumulated customer relationship impairment loss as of August 1, 2020 is $2.6 million.\nIn the second quarter of Fiscal Year 2019, the Company reduced comparable sales outlook for the second quarter that led to a reduced full year forecast of earnings for Fiscal Year 2019. The Company concluded that these factors, as well as the decrease in stock price represented indicators of impairment and required the Company to test goodwill and indefinite-lived intangible assets for impairment during the second quarter of Fiscal Year 2019 (the “Q2 FY19 Impairment Test”).\nThe Company performed the Q2 FY19 Impairment Test using a quantitative approach with the assistance of an independent valuation firm. The Q2 FY19 Impairment Test was performed using the income approach (or discounted cash flows method) for goodwill and the relief-from-royalty method for indefinite-lived intangible assets. The estimated fair values of goodwill and indefinite-lived intangible assets were below carrying values resulting in an $88.4 million impairment of goodwill and a $7.0 million impairment of the Company’s tradename (indefinite-lived intangible asset).\n6. Restructuring Costs\nIn July 2019, the Company implemented a restructuring plan (the “2019 Restructuring Plan”) focused on cost reduction initiatives designed to execute against long-term strategies. The 2019 Restructuring Plan included headcount reductions primarily at the Company’s corporate headquarters in Quincy, Massachusetts and at the facility in Tilton, New Hampshire.\nAs a result of the 2019 Restructuring Plan, the Company recorded $1.6 million of restructuring costs in selling, general and administrative expenses in the consolidated statements of operations and comprehensive income. All restructuring costs were recognized in the second quarter of Fiscal Year 2019 and payments are anticipated to be complete in the third quarter of Fiscal Year 2020, ending on October 31, 2020.\n10\nThe following table summarizes the activity of the restructuring costs discussed above and related accruals recorded in accrued other and other current liabilities on the consolidated balance sheet (in thousands):\n\n| February 1, 2020 | Cash Payments | Adjustments | August 1, 2020 | Program Costs to Date August 1, 2020 |\n| Employee separation costs | $ | 216 | $ | 102 | $ | 85 | $ | 29 | $ | 1,402 |\n| Other | 39 | 1 | 38 | — | 195 |\n| Total restructuring costs | $ | 255 | $ | 103 | $ | 123 | $ | 29 | $ | 1,597 |\n\n7. Debt\nThe components of the Company’s outstanding Term Loan were as follows (in thousands):\n\n| August 1, 2020 | February 1, 2020 |\n| Term Loan | $ | 236,179 | $ | 237,579 |\n| Discount on debt and debt issuance costs | (2,827 | ) | (3,580 | ) |\n| Less: Current portion | (233,352 | ) | (2,799 | ) |\n| Net long-term debt | $ | — | $ | 231,200 |\n\nAdditionally, the Company borrowed $33.0 million under its ABL Facility in March 2020, and currently has an outstanding balance of $31.8 million as of August 1, 2020.\nAs a result of COVID-19 related store closures, the Company was unable to maintain compliance with certain of its non-financial and financial covenants for the period ended May 2, 2020. Additionally, the inclusion of substantial doubt about the Company’s ability to continue as a going concern in the report of our independent registered public accounting firm on our financial statements for the fiscal year ended February 1, 2020 resulted in a violation of affirmative covenants under our ABL Facility and Term Loan. On June 15, 2020, the Company entered into two forbearance agreements (the “Forbearance Agreements”) with the lenders under its ABL Facility and Term Loan. The Forbearance Agreements are described in a Current Report on Form 8-K filed by the Company with the SEC on June 16, 2020, and available on the SEC’s Edgar website as well as the Company’s website, which includes the full text of the agreement as an exhibit. Under the Forbearance Agreements, the respective lenders agreed not to exercise any rights and remedies until July 16, 2020 so long as, among other things, the Company otherwise remained in compliance with its credit facilities and complied with the terms of the Forbearance Agreements. Subsequently, the Forbearance Agreements were extended with the latest extension until September 26, 2020. The extensions of the Forbearance Agreements are described in Current Reports on Forms 8-K filed by the Company with the SEC, and available on the SEC’s Edgar website as well as the Company’s website, which include the full text of the agreements as exhibits.\nOn September 1, 2020, the Company announced it entered into a Transaction Support Agreement (“TSA”) with term loan lenders holding greater than 70% of the Company’s term loans (“Consenting Lenders”) and a majority of its shareholders on the principal terms of a financial restructuring (“Transaction”) that would result in a waiver of any past non-compliance with the terms of the Company’s credit facilities and provide the Company with additional liquidity. If the Transaction is consented to by the requisite term loan lenders, the Transaction will be consummated on an out-of-court basis. The out-of-court Transaction would extend the maturity of certain participating debt by two years, through May 2024. The Company is working actively with the Consenting Lenders to obtain the necessary consents.\nIn the event that the Transaction does not receive the consent of the term loan lenders representing 95.0% of the aggregate outstanding principal amount of the term loan claims under the Company’s existing Term Loan, the parties to the TSA have agreed to a prepackaged plan of reorganization under Chapter 11 of the United States Code (the “In-Court Transaction”) the key terms of which have been negotiated, including additional financing during the Chapter 11 process. While the Company hopes to receive the required consents to execute the out-of-court Transaction, the Company anticipates that as part of the In-Court Transaction all vendor claims would be unimpaired and paid in full. No assurances can be given as to the successful execution of the TSA or the level of consents which may be received from our lenders; therefore, we have classified our Term Loan as a current liability as of August 1, 2020.\n8. Income Taxes\nThe Company recorded an income tax benefit of $7.0 million and $31.2 million for the thirteen and twenty-six weeks ended August 1, 2020, respectively and $3.1 million and $1.6 million during the thirteen and twenty-six weeks ended August 3, 2019, respectively. The effective tax rate was 27.0% and 25.9% for the thirteen and twenty-six weeks ended August 1, 2020, respectively, and 3.1% and 1.7% for the thirteen and twenty-six weeks ended August 3, 2019, respectively.\n11\nThe effective tax rate for the thirteen and twenty-six weeks ended August 1, 2020 differs from the federal statutory rate of 21% primarily due to the impact of an anticipated benefit from the CARES Act, as well as the impact of state income taxes. These benefits were partially offset by the impact on the effective tax rate from the §162(m) officer compensation limitation on the thirteen and twenty-six weeks ended August 1, 2020, while the impact of the goodwill impairment charge, which has no associated tax benefit, also impacted the twenty-six week period. The CARES Act provides for net operating losses in Fiscal Year 2020 to be carried back to earlier tax years with higher tax rates than the current year. The effective tax rate for the thirteen and twenty-six weeks ended August 3, 2019 is lower than the federal statutory rate of 21% primarily due to goodwill impairment of $88.4 million as well as recurring items including §162(m) officer compensation limitation, stock compensation and state income taxes.\nDeferred tax assets and deferred tax liabilities are recognized based on temporary differences between the financial reporting and tax bases of assets and liabilities using statutory rates. Management of the Company has evaluated the positive and negative evidence bearing upon the realizability of its deferred tax assets. Under the applicable accounting standards, management has considered future reversals of existing taxable temporary differences to conclude there is sufficient positive evidence that it is more likely than not that the Company will not recognize part of the benefits of state net operating losses. Accordingly, a partial valuation allowance has been established against the Company’s state net operating loss carryover.\nAmong the changes to the U.S. federal income tax rules, the CARES Act modified net operating loss carryback rules that were eliminated by the 2017 Tax Cuts and Jobs Act, restored 100% bonus depreciation for qualified improvement property, increased the limit on the deduction for net interest expense and accelerated the time frame for refunds of alternative minimum tax (“AMT”) credits. The Company’s ability to elect bonus depreciation for the 2018 and 2019 tax years, carryback net operating losses to earlier years, and immediately refund AMT credits due to the enactment of the CARES Act resulted in an estimated tax refund of $6.9 million of which the Company has received $1.2 million. The Company has elected to defer the employer-paid portion of social security taxes beginning with pay dates on and after April 1, 2020. The Company will continue to evaluate the effects of the CARES Act as additional legislative guidance becomes available.\n9. Earnings Per Share\nThe following table summarizes the computation of basic and diluted net income per share attributable to common shareholders (in thousands, except share and per share data):\n\n| For the Thirteen Weeks Ended | For the Twenty-Six Weeks Ended |\n| August 1, 2020 | August 3, 2019 | August 1, 2020 | August 3, 2019 |\n| Numerator |\n| Net loss attributable to common shareholders: | $ | (19,034 | ) | $ | (96,735 | ) | $ | (89,303 | ) | $ | (92,369 | ) |\n| Denominator |\n| Weighted average number of common shares outstanding, basic: | 44,767,154 | 43,793,348 | 44,589,034 | 43,560,434 |\n| Dilutive effect of stock options and restricted shares: | — | — | — | — |\n| Weighted average number of common shares outstanding, diluted: | 44,767,154 | 43,793,348 | 44,589,034 | 43,560,434 |\n| Net loss per common share attributable to common shareholders, basic: | $ | (0.43 | ) | $ | (2.21 | ) | $ | (2.00 | ) | $ | (2.12 | ) |\n| Net loss per common share attributable to common shareholders, diluted: | $ | (0.43 | ) | $ | (2.21 | ) | $ | (2.00 | ) | $ | (2.12 | ) |\n\nThe weighted average common shares for the diluted earnings per share calculation exclude the impact of outstanding equity awards if the assumed proceeds per share of the award is in excess of the related fiscal period’s average price of the Company’s common stock. Such awards are excluded because they would have an antidilutive effect due to the Company having a net loss for the thirteen and twenty-six weeks ended August 1, 2020 and August 3, 2019. There were 2,463,688 antidilutive shares for the thirteen weeks ended August 1, 2020, and 4,224,437 antidilutive shares for the thirteen weeks ended August 3, 2019, of such awards excluded. There were 2,533,148 antidilutive shares for the twenty-six weeks ended August 1, 2020, and 2,775,635 antidilutive shares for the twenty-six weeks ended August 3, 2019, of such awards excluded.\n10. Equity-Based Compensation\nEquity-based compensation expense was $0.6 million for the thirteen weeks ended August 1, 2020, and $1.2 million for the thirteen weeks ended August 3, 2019. Equity-based compensation expense was $1.3 million for the twenty-six weeks ended August 1, 2020, and $2.4 million for the twenty-six weeks ended August 3, 2019.\n12\nSpecial Dividend\nOn March 6, 2019, the Company’s Board of Directors declared a special cash dividend (the “Special Dividend”) of $1.15 per share payable to shareholders of record as of March 19, 2019, of which $50.2 million was paid on April 1, 2019.\nIn connection with the Special Dividend, pursuant to anti-dilution provisions in the 2017 Omnibus Equity Incentive Plan (the “2017 Plan”), the Company adjusted outstanding equity awards in order to prevent dilution of such awards. Accordingly, the Company adjusted the number of outstanding unvested restricted stock units (“RSUs”) as of the payment date of the dividend with an additional number of RSUs (“Dividend Equivalent Units” or “DEUs”) equal to the quotient obtained by dividing (x) the product of the number of unvested RSUs as of the record date by the amount of the dividend per share, by (y) the fair market value of share on the payment date of the Special Dividend. The DEUs will follow the same vesting pattern as the RSUs. For holders of outstanding options as of March 19, 2019, the option strike price on such options was reduced by the per share amount of the Special Dividend. Holders of unvested Restricted Stock Awards (“RSAs”) received a forfeitable $1.15 per share dividend on unvested RSAs as of March 19, 2019.\n11. Related Party Transactions\nFor the thirteen and twenty-six weeks ended August 1, 2020 and the thirteen and twenty-six weeks ended August 3, 2019, the Company incurred an immaterial amount of related party transactions.\n12. Commitments and Contingencies\nLegal Proceedings\nThe Company is subject to various legal proceedings that arise in the ordinary course of business. Although the outcome of such proceedings cannot be predicted with certainty, management does not believe that the Company is presently party to any legal proceedings the resolution of which management believes would have a material adverse effect on the Company’s business, financial condition, operating results or cash flows. The Company establishes reserves for specific legal matters when the Company determines that the likelihood of an unfavorable outcome is probable, and the loss is reasonably estimable.\n13. Operating Leases\nAs of August 1, 2020, the Company leased certain retail stores, a distribution center, and office space. As of that same date, the Company did not have any finance leases and no operating leases containing material residual value guarantees or material restrictive covenants. Certain of the Company’s retail operating leases include variable rental payments based on a percentage of retail sales over contractual levels.\nSome retail leases include one or more options to renew, with renewal terms that can extend the lease term from one to fifteen years. The Company’s distribution center has renewal terms that can extend the lease term up to twenty years. The exercise of lease renewal options is at the Company’s sole discretion. As of August 1, 2020, the Company included options to renew that are reasonably certain to be exercised in the operating lease assets and liabilities.\nThe components of lease expense were as follows (in thousands):\n\n| Lease Cost | Classification | For the Thirteen Weeks Ended August 1, 2020 | For the Thirteen Weeks Ended August 3, 2019 | For the Twenty-Six Weeks Ended August 1, 2020 | For the Twenty-Six Weeks Ended August 3, 2019 |\n| Operating lease cost | SG&A Expenses | $ | 10,913 | $ | 11,820 | $ | 22,742 | $ | 23,372 |\n| Variable lease cost | SG&A Expenses | 478 | 774 | 896 | 1,540 |\n| Total lease cost | $ | 11,391 | $ | 12,594 | $ | 23,638 | $ | 24,912 |\n\nAdditionally, during the first quarter of Fiscal Year 2020, the Company reduced the net carrying value of certain long-lived assets to their estimated fair value, which was determined using a discounted cash flows method. These impairment charges arose from the material adverse effect the COVID-19 pandemic had on our results of operations, particularly with our store fleet. As part of these impairment charges, the Company incurred non-cash impairment charges of $6.7 million on leasehold improvements and $20.8 million on right-of-use assets. During the second quarter of Fiscal Year 2020, the Company recorded a $1.3 million non-cash gain on the operating lease liability due to its decision to close certain retail stores. Approximately $0.9 million of the benefit related to leases that were included in the impairment on right-of-use assets recorded in the first quarter of Fiscal Year 2020; therefore, the benefit was recorded as a reduction of the previously recorded impairment. Approximately $0.4 million of the benefit related to the adjustment to the right-of-use asset and operating lease liability of leases not previously impaired and was recorded in Selling, General and Administrative expenses.\n13\nAs a result of the COVID-19 related temporary store closures, the Company withheld rent payments for all of its retail locations in April and May 2020 and for some of its retail locations in June 2020. The Company successfully negotiated commercially reasonable lease concessions with the landlords of several of our leases during the second quarter of Fiscal Year 2020, which include combinations of abated and deferred rent payments as well as term extensions. The Company is actively negotiating with the landlords of its other leases, and the withheld rent payments for such leases amounted to approximately $17.1 million as of August 1, 2020, which we have included in accrued expenses and other current liabilities on the consolidated balance sheet. The Company does not anticipate any significant late payment penalties; therefore, we have not accrued any related expenses in the thirteen or twenty-six weeks ended August 1, 2020.\nThe Company has elected to apply the guidance provided by the FASB pertaining to lease concessions that are a result of the COVID-19 pandemic and accordingly does not evaluate the rights and obligations pertaining to concessions in each lease but rather accounts for them assuming that such provisions exist. For each lease that contains concessions that do not significantly increase our obligations, the Company has remeasured the lease consistent with resolving a contingency and therefore adjusted the timing and amount of the lease payments without changing our assumptions (i.e. discount rate and lease classification). The concessions within the qualifying agreements vary and may include combinations of abated and deferred rent payments as well as term extensions ranging from one to three months. During the thirteen weeks ended August 1, 2020, the Company’s qualifying agreements provided abated rent payments of $0.5 million and deferred rent payments of $0.3 million that are payable over no more than 15 months beginning as early as August 2020.\nFor the thirteen and twenty-six weeks ended August 1, 2020, total common area maintenance expense was $3.7 million and $7.4 million, respectively. Operating lease liabilities decreased $2.0 million for the thirteen weeks ended August 1, 2020 due to the COVID related lease modifications noted above but increased $1.1 million for the twenty-six weeks ended August 1, 2020 due to obtaining operating lease assets, partially offset by the COVID related lease modifications. For the thirteen and twenty-six weeks ended August 3, 2019, total common area maintenance expense was $3.6 million and $7.1 million, respectively, while operating lease liabilities arising from obtaining operating lease assets was $4.1 million and $9.6 million, respectively.\nFor the thirteen and twenty-six weeks ended August 1, 2020 total cash paid for amounts included in the measurement of operating lease liabilities was $8.1 million and $12.5 million, respectively. For the thirteen and twenty-six weeks ended August 3, 2019, the total cash paid for amounts included in the measurement of operating lease liabilities was $11.9 million, and $23.7 million, respectively.\n\n| Lease Term and Discount Rate | August 1, 2020 |\n| Weighted-average remaining lease term (in years) |\n| Operating leases | 6.9 |\n| Weighted-average discount rate |\n| Operating leases | 6.6 | % |\n\nMaturities of lease liabilities as of August 1, 2020 were as follows (in thousands):\n\n| Fiscal Year | Operating Leases(1) |\n| 2020 | $ | 20,633 |\n| 2021 | 47,653 |\n| 2022 | 43,358 |\n| 2023 | 40,185 |\n| 2024 | 34,830 |\n| Thereafter | 98,166 |\n| Subtotal | 284,825 |\n| Less: Imputed interest | 57,332 |\n| Present value of lease liabilities | $ | 227,493 |\n\n\n| (1) | There were no operating leases with legally binding minimum lease payments for leases signed but for which the Company has not taken possession. |\n\n14. Barter Arrangement\nThe Company entered into a bartering arrangement with Evergreen Trading, a vendor, where the Company provided inventory in exchange for media credits. During Q3 of Fiscal Year 2019, the Company exchanged $3.3 million of inventory for certain media credits. To account for the exchange, the Company recorded the transfer of the inventory asset as a reduction of inventory offset by a\n14\n$2.5 million decrease in reserves and an increase to a prepaid media asset of $2.0 million which is included in “Prepaid and other current assets” and “Other assets” on the accompanying consolidated balance sheet. A gain of $1.3 million was recorded upon shipment of the inventory. The Company had $2.0 million of unused media credits remaining as of August 1, 2020 that will be used over seven years.\nThe Company accounted for this barter transaction under ASC Topic No. 606 “Revenue from Contracts with Customers.” Barter transactions with commercial substance are recorded at the estimated fair value of the products exchanged unless the products received have a more readily determinable estimated fair value. Revenue associated with a barter transaction is recorded at the time of the exchange of the related assets.\n15. Subsequent Event\nForbearance Agreements\nOn June 15, 2020, the Company entered into two forbearance agreements (the “Forbearance Agreements”) with the lenders under its ABL Facility and Term Loan with respect to the noncompliance mentioned in Note 7. The Forbearance Agreements are described in a Current Report on Form 8-K filed by the Company with the SEC on June 16, 2020, and available on the SEC’s Edgar website as well as the Company’s website, which includes the full text of the agreement as an exhibit. Under the Forbearance Agreements, the respective lenders agreed not to exercise any rights and remedies until July 16, 2020 so long as, among other things, the Company otherwise remained in compliance with its credit facilities and complied with the terms of the Forbearance Agreements.\nSubsequently, the Forbearance Agreements have been extended with the latest extension until September 26, 2020. The extensions of the Forbearance Agreements are described in Current Reports on Forms 8-K filed by the Company with the SEC, and available on the SEC’s Edgar website as well as the Company’s website, which include the full text of the agreements as exhibits.\nTransaction Support Agreement\nOn September 1, 2020, the Company announced it entered into a TSA with Consenting Lenders on the principal terms of a Transaction that would result in a waiver of any past non-compliance with the terms of the Company’s credit facilities and provide the Company with additional liquidity.\nIf the Transaction is consented to by the requisite term loan lenders, the Transaction will be consummated on an out-of-court basis. The out-of-court Transaction would extend the maturity of certain participating debt by two years, or through May 2024, enabling the Company to strengthen its balance sheet and better position itself for long-term growth. The Company is working actively with the Consenting Lenders to obtain the necessary consents. In the event that the Transaction does not receive the required consents, the parties to the TSA have agreed to a prepackaged In-Court Transaction the key terms of which have been negotiated, including additional financing during the Chapter 11 process. While the Company hopes to receive the required consents to execute the out-of-court Transaction, the Company anticipates that as part of the In-Court Transaction all vendor claims would be unimpaired and paid in full.\n15\n\nItem 2.\nManagement’s Discussion and Analysis of\nFinancial Condition and Results of Operations\nThe following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes thereto included elsewhere in this Quarterly Report on Form 10-Q. The following discussion contains forward-looking statements that reflect our plans, estimates and assumptions. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause such differences are discussed in the sections of this Quarterly Report on Form 10-Q titled “Risk Factors” and “Special Note Regarding Forward-Looking Statements”.\nWe operate on a 52- or 53-week fiscal year that ends on the Saturday that is closest to January 31. Each fiscal year generally is comprised of four 13-week fiscal quarters, although in the years with 53 weeks, the fourth quarter represents a 14-week period. The fiscal years ending January 30, 2021 (“Fiscal Year 2020”) and fiscal year ended February 1, 2020 (“Fiscal Year 2019”) are both comprised of 52 weeks.\nOverview\nJ.Jill is a premier omnichannel retailer and nationally recognized women’s apparel brand committed to delighting customers with great wear-now product. The brand represents an easy, thoughtful and inspired style that reflects the confidence of remarkable women who live life with joy, passion and purpose. J.Jill offers a guiding customer experience through about 280 stores nationwide and a robust ecommerce platform. J.Jill is headquartered outside Boston.\nOur first and second quarter financial results of Fiscal Year 2020 were significantly impacted by the COVID-19 pandemic as our stores were temporarily closed beginning in mid-March 2020 with most of our stores being reopened by mid-June 2020, but with enhanced health and safety protocols. In response to the pandemic, we acted during the period to leverage our Direct channel, while focusing on cost management and improving our liquidity. We drew down $33.0 million on our ABL in the first quarter of Fiscal Year 2020 and ended our current quarter with a cash balance of approximately $32.0 million. After approaching our vendor community, we implemented extended payment terms for nearly all goods and services, and we withheld store rent payments beginning in April of 2020. These extensions and withholdings provided time for us to work on more longer-term solutions to help us through the pandemic. These solutions included cost reductions, including pay reductions for employees in our headquarters, furlough of store and some headquarter and distribution center staff, reductions in Marketing, reductions in Board of Directors fees, and reductions in other general expenses. Additionally, we have eliminated approximately half of our catalogs, which we are considering implementing as a permanent change. We have also been limiting investments in our ecommerce business to necessary website and supporting functions, and we have significantly reduced planned capital expenditures.\nThe COVID-19 global pandemic and resulting temporary store closures have had a material adverse effect on our operations, cash flows and liquidity. We have made significant progress reducing cash expenditures and maximizing cash receipts from our direct to consumer business channel such that our current base forecast projects sufficient liquidity over the coming 12 months; however, considerable risk remains related to the performance of stores, the resilience of the customer in an uncertain economic climate, and the possibility of a resurgence of COVID-19 related market impacts in the coming 12 months. If one or more of these risks materialize, we believe that our current sources of liquidity and capital may not be sufficient to finance our continued operations for at least the next 12 months. Under the terms of the asset based revolving credit agreement (“ABL Facility”) and term loan credit agreement (“Term Loan”), substantial doubt about the Company’s ability to continue as a going concern is considered an event of default which allows the lenders to call the debt in advance of maturity.\nWe have also filed an income tax refund for $6.9 million, of which we have received $1.2 million, with the IRS and multiple state jurisdictions related to the provision under the Coronavirus Aid, Relief and Economic Security Act (“CARES Act”) enacted in March 2020 that provides numerous tax provisions and other stimulus measures, including temporary suspension of certain payment requirements for the employer-paid portion of social security taxes, the creation of certain refundable employee retention credits, and technical corrections from prior tax legislation for tax depreciation of certain qualified improvement property. The Company has elected to defer the employer-paid portion of social security taxes beginning with pay dates on and after April 1, 2020. We continue to evaluate the provisions of the CARES Act and the ways in which it could assist our business and improve our liquidity.\nFactors Affecting Our Operating Results\nVarious factors are expected to continue to affect our results of operations going forward, including the following:\nOverall Economic Trends. Consumer purchases of clothing and other merchandise generally decline during recessionary periods and other periods when disposable income is adversely affected, and consequently our results of operations may be affected by general economic conditions. For example, reduced consumer confidence and lower availability and higher cost of consumer credit may reduce demand for our merchandise and may limit our ability to increase or sustain prices. The growth rate of the market could be affected by macroeconomic conditions in the United States.\n16\nConsumer Preferences and Fashion Trends. Our ability to maintain our appeal to existing customers and attract new customers depends on our ability to anticipate fashion trends. During periods in which we have successfully anticipated fashion trends, we have generally had more favorable results.\nCompetition. The retail industry is highly competitive and retailers compete based on a variety of factors, including design, quality, price and customer service. Levels of competition and the ability of our competitors to more accurately predict fashion trends and otherwise attract customers through competitive pricing or other factors may impact our results of operations.\nOur Strategic Initiatives. The ongoing implementation of strategic initiatives will continue to have an impact on our results of operations. These initiatives include our ecommerce site, which was re-platformed in Fiscal Year 2017, and our initiative to upgrade and enhance our information systems. Although initiatives of this nature are designed to create growth in our business and continuing improvement in our operating results, the timing of expenditures related to these initiatives, as well as our ability to successfully achieve the expected benefits of these initiatives, may affect our results of operations in future periods.\nPricing and Changes in Our Merchandise Mix. Our product offering changes from period to period, as do the prices at which goods are sold and the margins we are able to earn from the sales of those goods. The levels at which we are able to price our merchandise are influenced by a variety of factors, including the quality of our products, cost of production, prices at which our competitors are selling similar products and the willingness of our customers to pay for products.\nPotential Changes in Tax Laws and/or Regulations. Changes in tax laws in any of the multiple jurisdictions in which we operate, or adverse outcomes from tax audits that we may be subject to in any of the jurisdictions in which we operate, could adversely affect our business, financial condition and operating results. Additionally, any potential changes with respect to tax and trade policies, tariffs and government regulations affecting trade between the U.S. and other countries could adversely affect our business, as we source the majority of our merchandise from manufacturers located outside of the U.S.\nHow We Assess the Performance of Our Business\nIn assessing the performance of our business, we consider a variety of financial and operating metrics, including GAAP and non-GAAP measures, including the following:\nNet sales consist primarily of revenues, net of merchandise returns and discounts, generated from the sale of apparel and accessory merchandise through our Retail channel and Direct channel. Net sales also include shipping and handling fees collected from customers and royalty revenues and marketing reimbursements related to our private label credit card agreement. Revenue from our Retail channel is recognized at the time of sale and revenue from our Direct channel is recognized upon shipment of merchandise to the customer.\nNet sales are impacted by the size of our active customer base, product assortment and availability, marketing and promotional activities and the spending habits of our customers. Net sales are also impacted by the migration of single-channel customers to omnichannel customers who, on average, spend nearly three times more than single-channel customers.\nNumber of stores reflects all stores open at the end of a reporting period. In connection with opening new stores, we incur pre-opening costs. Pre-opening costs include expenses incurred prior to opening a new store and primarily consist of payroll, travel, training, marketing, initial opening supplies and costs of transporting initial inventory and fixtures to store locations, as well as occupancy costs incurred from the time of possession of a store site to the opening of that store. These pre-opening costs are included in selling, general and administrative expenses and are generally incurred and expensed within 30 days of opening a new store.\nGross profit is equal to our net sales less costs of goods sold. Gross profit as a percentage of our net sales is referred to as gross margin.\nCosts of goods sold includes the direct costs of sold merchandise, inventory shrinkage, and adjustments and reserves for excess, aged and obsolete inventory. We review our inventory levels on an ongoing basis to identify slow-moving merchandise and use product markdowns to liquidate these products. Changes in the assortment of our products may also impact our gross profit. The timing and level of markdowns are driven by customer acceptance of our merchandise. As a result, the reporting of our gross profit and gross margin may not be comparable to other companies.\nThe primary drivers of the costs of goods sold are raw materials, which fluctuate based on certain factors beyond our control, including labor conditions, transportation or freight costs, energy prices, currency fluctuations and commodity prices. We place orders with merchandise suppliers in United States dollars and, as a result, are not exposed to significant foreign currency exchange risk.\nSelling, general and administrative expenses include all operating costs not included in costs of goods sold. These expenses include all payroll and related expenses, occupancy costs, information systems costs and other operating expenses related to our stores and to our operations at our headquarters, including utilities, depreciation and amortization. These expenses also include marketing\n17\nexpense, including catalog production and mailing costs, warehousing, distribution and shipping costs, customer service operations, consulting and software services, professional services and other administrative costs.\nOur historical revenue growth has been accompanied by increased selling, general and administrative expenses. The most significant increases were in occupancy costs associated with retail store expansion, and in marketing and payroll investments.\nAdjusted EBITDA and Adjusted EBITDA Margin. Adjusted EBITDA represents net income plus net interest expense, provision (benefit) for income taxes, depreciation and amortization, the amortization of the step-up to fair value of merchandise inventory resulting from the application of a purchase accounting adjustment related to the Acquisition, certain Acquisition-related expenses, sponsor fees, equity-based compensation expense, goodwill and indefinite-lived intangible assets impairment, write-off of property and equipment and other non-recurring expenses, primarily consisting of outside legal and professional fees associated with certain non-recurring transactions and events. We present Adjusted EBITDA on a consolidated basis because management uses it as a supplemental measure in assessing our operating performance, and we believe that it is helpful to investors, securities analysts and other interested parties as a measure of our comparative operating performance from period to period. We also use Adjusted EBITDA as one of the primary methods for planning and forecasting overall expected performance of our business and for evaluating on a quarterly and annual basis actual results against such expectations. Further, we recognize Adjusted EBITDA as a commonly used measure in determining business value and as such, use it internally to report results. Adjusted EBITDA margin represents, for any period, Adjusted EBITDA as a percentage of net sales.\nWhile we believe that Adjusted EBITDA is useful in evaluating our business, Adjusted EBITDA is a non-GAAP financial measure that has limitations as an analytical tool. Adjusted EBITDA should not be considered an alternative to, or substitute for, net income (loss), which is calculated in accordance with GAAP. In addition, other companies, including companies in our industry, may calculate Adjusted EBITDA differently or not at all, which reduces the usefulness of Adjusted EBITDA as a tool for comparison. We recommend that you review the reconciliation of Adjusted EBITDA to net income, the most directly comparable GAAP financial measure, and the calculation of the resultant Adjusted EBITDA margin below and not rely solely on Adjusted EBITDA or any single financial measure to evaluate our business.\nReconciliation of Net Income to Adjusted EBITDA and Calculation of Adjusted EBITDA Margin\nThe following table provides a reconciliation of net income to Adjusted EBITDA and the calculation of Adjusted EBITDA margin for the periods presented.\n\n| For the Thirteen Weeks Ended | For the Twenty-Six Weeks Ended |\n| (in thousands) | August 1, 2020 | August 3, 2019 | August 1, 2020 | August 3, 2019 |\n| Statements of Operations Data: |\n| Net loss | $ | (19,034 | ) | $ | (96,735 | ) | $ | (89,303 | ) | $ | (92,369 | ) |\n| Interest expense, net | 4,244 | 5,019 | 8,887 | 10,026 |\n| Income tax benefit | (7,034 | ) | (3,069 | ) | (31,151 | ) | (1,631 | ) |\n| Depreciation and amortization | 8,277 | 9,396 | 17,313 | 18,848 |\n| Equity-based compensation expense(a) | 615 | 1,214 | 1,291 | 2,416 |\n| Write-off of property and equipment (b) | 244 | 8 | 256 | 14 |\n| Impairment of goodwill and other intangible assets | — | 95,428 | 24,520 | 95,428 |\n| Adjustment for costs to exit retail stores (c) | (402 | ) | — | (402 | ) | — |\n| Impairment of long-lived assets(d) | (893 | ) | 2,064 | 26,587 | 2,064 |\n| Other non-recurring expenses (e) | 7,523 | (740 | ) | 9,707 | (740 | ) |\n| Adjusted EBITDA | $ | (6,460 | ) | $ | 12,585 | $ | (32,295 | ) | $ | 34,056 |\n| Net sales | $ | 92,636 | $ | 180,744 | $ | 183,605 | $ | 357,196 |\n| Adjusted EBITDA margin | (7.0 | )% | 7.0 | % | (17.6 | )% | 9.5 | % |\n\n\n| (a) | Represents expenses associated with equity incentive instruments granted to our management and board of directors. Incentive instruments are accounted for as equity-classified awards with the related compensation expense recognized based on fair value at the date of the grants. |\n\n| (b) | Represents net gain or loss on the disposal of fixed assets. |\n\n| (c) | Represents non-cash gains associated with exiting store leases earlier than anticipated. |\n\n| (d) | Represents impairment of long-lived assets related to the right-of-use asset and leasehold improvements. For the thirteen weeks ended August 1, 2020, the Company recognized a benefit (or reversal of prior period impairment) caused by the adjustment of the operating lease liability related to stores that were permanently closed during the period. |\n\n| (e) | Represents items management believes are not indicative of ongoing operating performance. For the twenty-six weeks ended August 1, 2020, these expenses are primarily composed of legal and advisory costs and incremental one-time costs related to the COVID-19 pandemic, including supplies and cleaning expenses as well as hazard pay and benefits, as well as retention expenses. |\n\n18\nItems Affecting Comparability of Financial Results\nImpairment losses. Our Fiscal Year 2020 year-to-date results include impairment charges of $51.1 million for long-lived assets (operating lease right of use asset and leasehold improvements), goodwill and intangible assets. We had $97.5 million of impairment charges in Q2 of Fiscal Year 2019 for goodwill, intangible assets and long-lived assets. See Note 5, Asset Impairments, in Item I, Financial Statements, for additional information on these impairment losses.\nCOVID-19 impact. Our second quarter and year-to-date Fiscal Year 2020 financial results were significantly impacted by the COVID-19 pandemic as our stores were temporarily closed beginning in mid-March in efforts to stop the spread of the virus. Although the stores were temporarily closed and the Company lost revenues as a result, we continued to incur certain expenses, such as payroll and rent; therefore, ratios and other items may not be comparable to prior periods.\nResults of Operations\nThirteen weeks ended August 1, 2020 Compared to Thirteen weeks ended August 3, 2019\nThe following table summarizes our consolidated results of operations for the periods indicated:\n\n| For the Thirteen Weeks Ended | Change from the Thirteen Weeks Ended August 3, 2019 to the Thirteen Weeks |\n| August 1, 2020 | August 3, 2019 | Ended August 1, 2020 |\n| (in thousands) | Dollars | % of Net Sales | Dollars | % of Net Sales | $ Change | % Change |\n| Net sales | $ | 92,636 | 100.0 | % | $ | 180,744 | 100.0 | % | $ | (88,108 | ) | (48.7 | )% |\n| Costs of goods sold | 37,616 | 40.6 | % | 75,403 | 41.7 | % | (37,787 | ) | (50.1 | )% |\n| Gross profit | 55,020 | 59.4 | % | 105,341 | 58.3 | % | (50,321 | ) | (47.8 | )% |\n| Selling, general and administrative expenses | 77,737 | 83.9 | % | 102,634 | 56.8 | % | (24,897 | ) | (24.3 | )% |\n| Impairment of long-lived assets | (893 | ) | (1.0 | )% | 2,064 | 1.1 | % | (2,957 | ) | (143.2 | )% |\n| Impairment of goodwill | — | — | 88,428 | 48.9 | % | (88,428 | ) | 100.0 | % |\n| Impairment of other intangible assets | — | — | 7,000 | 3.9 | % | (7,000 | ) | 100.0 | % |\n| Operating loss | (21,824 | ) | (23.6 | )% | (94,785 | ) | (52.4 | )% | 72,961 | (77.0 | )% |\n| Interest expense, net | 4,244 | 4.6 | % | 5,019 | 2.8 | % | (775 | ) | (15.4 | )% |\n| Loss before provision for income taxes | (26,068 | ) | (28.1 | )% | (99,804 | ) | (55.2 | )% | 73,736 | (73.9 | )% |\n| Income tax benefit | (7,034 | ) | (7.6 | )% | (3,069 | ) | (1.7 | )% | (3,965 | ) | 129.2 | % |\n| Net loss | $ | (19,034 | ) | (20.5 | )% | $ | (96,735 | ) | (53.5 | )% | $ | 77,701 | (80.3 | )% |\n\nNet Sales\nNet sales for the thirteen weeks ended August 1, 2020 decreased $88.1 million, or 48.7%, to $92.6 from $180.7 million for the thirteen weeks ended August 3, 2019. At the end of those same periods, we operated 281 and 286 retail stores, respectively. The decrease in total net sales versus the prior year was primarily driven by the temporary closure of our stores, particularly at the beginning of the quarter ended August 1, 2020, as a response to the COVID-19 pandemic. Essentially all of our stores were reopened midway through the second quarter, following local mandates with reduced hours and enhanced health and safety protocols.\nOur Retail channel contributed 28.4% of our net sales in the thirteen weeks ended August 1, 2020 and 57.4% in the thirteen weeks ended August 3, 2019. Our Direct channel contributed 71.6% of our net sales in the thirteen weeks ended August 1, 2020 and 42.6% in the thirteen weeks ended August 3, 2019.\nGross Profit and Costs of Goods Sold\nGross profit for the thirteen weeks ended August 1, 2020 decreased $50.3 million, or 47.8%, to $55.0 million from $105.3 million for the thirteen weeks ended August 3, 2019. The gross margin for the thirteen weeks ended August 1, 2020 was 59.4% compared to 58.3% for the thirteen weeks ended August 3, 2019. The gross margin improvement was primarily due to a $2.4 million change in estimate during the thirteen weeks ended August 1, 2020 to reduce an accrual for potential future product liabilities. Additionally, higher promotions and markdown activity in the current year period were substantially offset by liquidation actions taken in the prior year period.\n19\nSelling, General and Administrative Expenses\nSelling, general and administrative expenses for the thirteen weeks ended August 1, 2020 decreased $24.9 million, or 24.3%, to $77.7 million from $102.6 million for the thirteen weeks ended August 3, 2019. The decrease was primarily driven by expense reduction actions taken in the first quarter ended May 2, 2020, which included a reduction in headcount, pay reductions, lower store payroll related to the temporary closure of our stores and lower marketing costs.\nAs a percentage of net sales, selling, general and administrative expenses were 83.9% for the thirteen weeks ended August 1, 2020 compared to 56.8% for the thirteen weeks ended August 3, 2019, driven by the reduced level of retail sales.\nInterest Expense, Net\nInterest expense, net, consists of interest expense on the Term Loan and ABL Facility, partially offset by interest earned on cash. Interest expense, net for the thirteen weeks ended August 1, 2020 decreased $0.8 million, or 15.4%, to $4.2 million from $5.0 million for the thirteen weeks ended August 3, 2019.\nIncome Tax Benefit\nThe income tax benefit was $7.0 million for the thirteen weeks ended August 1, 2020 compared to $3.1 million for the thirteen weeks ended August 3, 2019, while our effective tax rates for the same periods were 27.0% and 3.1%, respectively. The higher effective tax rate in the current period was driven by the anticipated benefit from the CARES Act, the impact on the effective tax rate and the impact of state income taxes, partially offset by the impact on the effective tax rate from §162(m) officer compensation limitation as well as the goodwill impairment charge, which has no associated tax benefit. The CARES Act provides for net operating losses in Fiscal Year 2020 to be carried back to earlier tax years with higher tax rates than the current year. The difference in the effective tax rates is also partially driven by the treatment of the impairment of goodwill and indefinite-lived intangible assets in the thirteen weeks ended August 3, 2019.\nTwenty-six weeks ended August 1, 2020 Compared to Twenty-six weeks ended August 3, 2019\nThe following table summarizes our consolidated results of operations for the periods indicated:\n\n| For the Twenty-Six Weeks Ended | Change from the Twenty-Six Weeks Ended August 3, 2019 to the Twenty-Six Weeks Ended August 1, 2020 |\n| (in thousands) | August 1, 2020 | August 3, 2019 |\n| Dollars | % of Net Sales | Dollars | % of Net Sales | $ Change | % Change |\n| Net sales | $ | 183,605 | 100.0 | % | $ | 357,196 | 100.0 | % | $ | (173,591 | ) | (48.6 | )% |\n| Costs of goods sold | 78,420 | 42.7 | % | 135,599 | 38.0 | % | (57,179 | ) | (42.2 | )% |\n| Gross profit | 105,185 | 57.3 | % | 221,597 | 62.0 | % | (116,412 | ) | (52.5 | )% |\n| Selling, general and administrative expenses | 165,645 | 90.2 | % | 208,079 | 58.3 | % | (42,434 | ) | (20.4 | )% |\n| Impairment of long-lived assets | 26,587 | 14.5 | % | 2,064 | 0.6 | % | 24,523 | 1188.1 | % |\n| Impairment of goodwill | 17,900 | 9.7 | % | 88,428 | 24.8 | % | (70,528 | ) | (79.8 | )% |\n| Impairment of other intangible assets | 6,620 | 3.6 | % | 7,000 | 2.0 | % | (380 | ) | (5.4 | )% |\n| Operating loss | (111,567 | ) | (60.8 | )% | (83,974 | ) | (23.5 | )% | (27,593 | ) | 32.9 | % |\n| Interest expense, net | 8,887 | 4.8 | % | 10,026 | 2.8 | % | (1,139 | ) | (11.4 | )% |\n| Loss before provision for income taxes | (120,454 | ) | (65.6 | )% | (94,000 | ) | (26.3 | )% | (26,454 | ) | 28.1 | % |\n| Income tax benefit | (31,151 | ) | (17.0 | )% | (1,631 | ) | (0.5 | )% | (29,520 | ) | 1809.9 | % |\n| Net loss | $ | (89,303 | ) | (48.6 | )% | $ | (92,369 | ) | (25.9 | )% | $ | 3,066 | (3.3 | )% |\n\nNet Sales\nNet sales for the twenty-six weeks ended August 1, 2020 decreased $173.6 million, or 48.6%, to $183.6 million from $357.2 million for the twenty-six weeks ended August 3, 2019. At the end of both of those same periods, we operated 281 and 286 retail stores, respectively. The decrease in total net sales versus the prior year was primarily driven by the temporary closure of our stores, particularly for the second half of the first quarter and the first half of the second quarter of Fiscal Year 2020, as a response to the COVID-19 pandemic. Essentially all of our stores were reopened midway through the second quarter, following local mandates with reduced hours and enhanced health and safety protocols.\n20\nOur Retail channel contributed 33.4% of our net sales in the twenty-six weeks ended August 1, 2020 and 57.7% in the twenty-six weeks ended August 3, 2019. Our Direct channel contributed 66.6% of our net sales in the twenty-six weeks ended August 1, 2020 and 42.3% in the twenty-six weeks ended August 3, 2019.\nGross Profit and Costs of Goods Sold\nGross profit for the twenty-six weeks ended August 1, 2020 decreased $116.4 million, or 52.5%, to $105.2 million from $221.6 million for the twenty-six weeks ended August 3, 2019. The gross margin for the twenty-six weeks ended August 1, 2020 was 57.3% compared to 62.0% for the twenty-six weeks ended August 3, 2019, largely driven by added promotions, markdowns, and liquidation actions to clear certain goods, particularly after the temporary closure of our stores, and a $3.0 million accrual for potential future liability payments to vendors for order cancellations which were issued as part of the Company’s COVID-19 response.\nSelling, General and Administrative Expenses\nSelling, general and administrative expenses for the twenty-six weeks ended August 1, 2020 decreased $42.4 million, or 20.4%, to $165.6 million from $208.1 million for the twenty-six weeks ended August 3, 2019. The decrease was primarily driven by expense reduction actions taken in Fiscal Year 2020, which included a reduction in headcount, pay reductions, lower store payroll related to the temporary closure of our stores and the subsequent reopening of the stores at lower staffing rates and reduced hours, and lower marketing costs.\nAs a percentage of net sales, selling, general and administrative expenses were 90.2% for the twenty-six weeks ended August 1, 2020 compared to 58.3% for the twenty-six weeks ended August 3, 2019, primarily driven by revenue decreases since the temporary closure of the Company’s stores as part of its COVID-19 response.\nInterest Expense, Net\nInterest expense, net, consists of interest expense on the Term Loan, partially offset by interest earned on cash. Interest expense for the twenty-six weeks ended August 1, 2020 decreased $1.1 million, or 11.4%, to $8.9 million from $10.0 million for the twenty-six weeks ended August 3, 2019.\nIncome Tax Benefit\nThe income tax benefit was $31.2 million for the twenty-six weeks ended August 1, 2020 compared to $1.6 million for the twenty-six weeks ended August 3, 2019. Our effective tax rates for the same periods were 25.9% and 1.7%, respectively. The higher effective tax rate in the current period was driven by the anticipated benefit from the CARES Act, the impact on the effective tax rate and the impact of state income taxes, partially offset by the impact on the effective tax rate from §162(m) officer compensation limitation as well as the goodwill impairment charge, which has no associated tax benefit. The CARES Act provides for net operating losses in Fiscal Year 2020 to be carried back to earlier tax years with higher tax rates than the current year. The difference in the effective tax rates is also partially driven by the treatment of the impairment of goodwill and indefinite-lived intangible assets in the twenty-six weeks ended August 3, 2019.\nLiquidity and Capital Resources\nGeneral\nThe COVID-19 global pandemic and resulting store closures have had a material adverse effect on our operations, cash flows and liquidity. We have made significant progress reducing cash expenditures and maximizing cash receipts from our direct to consumer business channel such that our current base forecast projects sufficient liquidity over the coming 12 months. However, considerable risk remains related to the performance of stores, the resilience of the customer in an uncertain economic climate, and the possibility of a resurgence of COVID-19 related market impacts in the coming 12 months. In addition, our lenders could instruct the administrative agent under such credit facilities to declare the principal of and accrued interest on all outstanding indebtedness immediately due and payable and terminate all remaining commitments and obligations under the credit facilities. If one or more of these risks materialize, we believe that our current sources of liquidity and capital will not be sufficient to finance our continued operations for at least the next 12 months.\nOur primary sources of liquidity and capital resources are cash generated from operating activities and availability under our ABL Facility, dated as of May 8, 2015, by and among Jill Holdings LLC, Jill Acquisition LLC, certain subsidiaries from time to time party thereto, the lenders party thereto and CIT Finance LLC as the administrative agent and collateral agent, as amended on May 27, 2016 by Amendment No. 1 thereto. The ABL Facility was further amended on August 22, 2018 by Amendment No. 2 to reduce the\n21\nfrequency of borrowing base certificate submissions as long as certain conditions are met. The ABL Facility was further amended on June 12, 2019 by Amendment No. 3 to extend the maturity of the ABL Facility to an initial maturity of May 8, 2023 so long as certain conditions related to the maturity of the term loan are met. On March 16, 2020, we borrowed an aggregate principal amount of $33.0 million under the ABL Facility. Our primary requirements for liquidity and capital are working capital and general corporate needs, including merchandise inventories, marketing, including catalog production and distribution, payroll, store occupancy costs and capital expenditures associated with opening new stores, remodeling existing stores and upgrading information systems and the costs of operating as a public company.\nAs discussed above, our liquidity has been materially adversely impacted by the COVID-19 pandemic. We have filed an income tax refund for $6.9 million, of which we have received $1.2 million, with the IRS related to the provision under the Coronavirus Aid, Relief and Economic Security Act (“CARES Act”) enacted in March 2020 that provides numerous tax provisions and other stimulus measures, including temporary suspension of certain payment requirements for the employer-paid portion of social security taxes, the creation of certain refundable employee retention credits, and technical corrections from prior tax legislation for tax depreciation of certain qualified improvement property. The Company has elected to defer the employer-paid portion of social security taxes beginning with pay dates on and after April 1, 2020. We continue to evaluate the provisions of the CARES Act and the ways in which it could assist our business and improve our liquidity.\nAs a result of the COVID-19 pandemic, the Company’s revenues, results of operations, and cash flows have been materially adversely impacted, and resulted in a failure by us to comply with the financial covenants contained in our ABL Facility and Term Loan agreements for the period ended August 1, 2020. This has led to substantial doubt about the Company’s ability to continue as a going concern. The inclusion of substantial doubt about the Company’s ability to continue as a going concern in the report of our independent registered public accounting firm on our accompanying financial statements for the fiscal year ended February 1, 2020 resulted in a violation of affirmative covenants under our ABL Facility and Term Loan agreements. As a result of the violation of affirmative covenants, lenders could exercise available remedies including, declaring the principal of and accrued interest on all outstanding indebtedness immediately due and payable and terminating all remaining commitments and obligations under the credit facilities.\nOn June 15, 2020, the Company entered into two forbearance agreements (the “Forbearance Agreements”) with the lenders under its ABL Facility and Term Loan. The Forbearance Agreements are described in a Current Report on Form 8-K filed by the Company with the SEC on June 16, 2020, and available on the SEC’s Edgar website as well as the Company’s website, which includes the full text of the agreement as an exhibit. Under the Forbearance Agreements, the respective lenders agreed not to exercise any rights and remedies until July 16, 2020 so long as, among other things, the Company otherwise remained in compliance with its credit facilities and complied with the terms of the Forbearance Agreements. Subsequently, the Forbearance Agreements were extended with the latest extension until September 26, 2020. The extensions of the Forbearance Agreements are described in Current Reports on Forms 8-K filed by the Company with the SEC, and available on the SEC’s Edgar website as well as the Company’s website, which include the full text of the agreements as exhibits.\nOn September 1, 2020, the Company announced it entered into a Transaction Support Agreement (“TSA”) with term loan lenders holding greater than 70% of the Company’s term loans (“Consenting Lenders”) and a majority of its shareholders on the principal terms of a financial restructuring (“Transaction”) that would result in a waiver of any past non-compliance with the terms of the Company’s credit facilities and provide the Company with additional liquidity. If the Transaction is consented to by the requisite term loan lenders, the Transaction will be consummated on an out-of-court basis. The out-of-court Transaction would extend the maturity of certain participating debt by two years, through May 2024. The Company is working actively with the Consenting Lenders to obtain the necessary consents.\nIn the event that the Transaction does not receive the required consents, the parties to the TSA have agreed to a prepackaged plan of reorganization under Chapter 11 of the United States Code (the “In-Court Transaction”) the key terms of which have been negotiated, including additional financing during the Chapter 11 process. While the Company hopes to receive the required consents to execute the out-of-court Transaction, the Company anticipates that as part of the In-Court Transaction all vendor claims would be unimpaired and paid in full.\nThe Company could experience other potential impacts as a result of the COVID-19 pandemic, including, but not limited to, additional charges from potential adjustments to the carrying amount of its inventory, goodwill, intangible assets, right-of-use assets and long-lived assets. Actual results may differ materially from the Company’s current estimates as the scope of the COVID-19 pandemic evolves, depending largely, though not exclusively, on the duration of the disruption to its business. Our future operating performance and our ability to service or extend our indebtedness will be subject to future economic conditions and to financial, business, and other factors, many of which are beyond our control.\nCapital expenditures were $2.7 million for the twenty-six weeks ended August 1, 2020 compared to $7.9 million for the twenty-six weeks ended August 3, 2019. The decrease in capital expenditures in Fiscal Year 2020 was due primarily to our efforts to reduce cash expenditures and preserve cash on-hand in the wake of the COVID-19 pandemic.\n22\nCash Flow Analysis\nThe following table shows our cash flows information for the periods presented:\n\n| For the Twenty-Six Weeks Ended |\n| (in thousands) | August 1, 2020 | August 3, 2019 |\n| Net cash (used in) provided by operating activities | $ | (17,340 | ) | $ | 23,536 |\n| Net cash used in investing activities | (2,675 | ) | (7,904 | ) |\n| Net cash provided by (used in) financing activities | 30,250 | (52,712 | ) |\n\nNet Cash (used in) provided by Operating Activities\nNet cash (used in) provided by operating activities declined by $40.9 million dollars as compared to the prior year as cash-related income was a use of cash in the current year due to the impact of temporarily closing the stores in response to the COVID-19 pandemic as compared to a source of cash in the prior year. The use of cash caused by the current year loss was substantially offset by working capital improvements due to withholding April and May 2020 rent payments at all of our retail locations, and June 2020 rent payments at a portion of retail locations, totaling approximately $17.1 million and extending payment terms with merchandising vendors.\nNet cash used in operating activities during the twenty-six weeks ended August 1, 2020 was $17.3 million. Key elements of cash used in operating activities were (i) net loss of $89.3 million, (ii) adjustments to reconcile net income to net cash provided by operating activities of $55.5 million, primarily driven by impairment of goodwill and indefinite-lived intangible assets, depreciation and amortization, partially offset by deferred income taxes, and (iii) a source of cash from net operating assets and liabilities of $16.4 million, primarily driven by increases in accounts payable and accrued liabilities.\nNet cash provided by operating activities during the twenty-six weeks ended August 3, 2019 was $23.5 million. Key elements of cash provided by operating activities were (i) net loss of $92.4 million, and (ii) adjustments to reconcile net income to net cash provided by operating activities of $112.9 million, primarily driven by depreciation and amortization and equity based compensation and noncash amortization of deferred financing and debt discount costs, partially offset by deferred income taxes, and (iii) use of cash from net operating assets and liabilities of $3.0 million, primarily driven by higher inventory, accounts receivable and prepaid expense and other current assets levels, partially offset by higher accrued expense levels.\nNet Cash used in Investing Activities\nNet cash used in investing activities during the twenty-six weeks ended August 1, 2020 was $2.7 million, representing purchases of property and equipment related investments in stores and information systems.\nNet cash used in investing activities during the twenty-six weeks ended August 3, 2019 was $7.9 million, representing purchases of property and equipment related investments in stores and information systems.\nNet Cash provided by (used in) Financing Activities\nNet cash provided by financing activities during the twenty-six weeks ended August 1, 2020 was $30.3 million, which was driven by the borrowing under the ABL Facility.\nNet cash used in financing activities during the twenty-six weeks ended August 3, 2019 was $52.7 million, which was driven primarily by the special dividend paid to shareholders.\nDividends\nOn April 1, 2019 the Company paid a special cash dividend of $50.2 million to the shareholders of J.Jill, Inc.\nThe payment of cash dividends in the future, if any, will be at the discretion of our board of directors and will depend upon such factors as earnings levels, capital requirements, restrictions imposed by applicable law, our overall financial condition, restrictions in our debt agreements, including our Term Loan and ABL Facility, and any other factors deemed relevant by our board of directors. As a holding company, our ability to pay dividends depends on our receipt of cash dividends from our operating subsidiaries, which may further restrict our ability to pay dividends as a result of restrictions on their ability to pay dividends to us under our Term Loan, our ABL Facility and under future indebtedness that we or they may incur.\n23\nCredit Facilities\nAt August 1, 2020 there was $31.8 million outstanding under the ABL Facility and at February 1, 2020 there were no loan amounts outstanding under the ABL Facility. At August 1, 2020 and February 1, 2020, the Company had outstanding letters of credit in the amount of $2.7 million and $1.7 million, respectively, and maximum additional borrowing capacity of $5.5 million and $38.3 million, respectively.\nContractual Obligations\nThe Company’s contractual obligations consist primarily of debt obligations, interest payments, operating leases and purchase orders for merchandise inventory. These contractual obligations impact the Company’s short-term and long-term liquidity and capital resource needs. During the twenty-six weeks ended August 1, 2020, as a result of COVID-19 related temporary store closures, the Company was unable to maintain compliance with certain of its non-financial and financial covenants.\nIn the absence of waivers from our lenders, our lenders could instruct the administrative agent under such credit facilities to exercise available remedies including, declaring the principal of and accrued interest on all outstanding indebtedness immediately due and payable and terminating all remaining commitments and obligations under the credit facilities. Although the lenders under our credit facilities may waive the defaults or forebear the exercise of remedies, they are not obligated to do so. Failure to obtain such a waiver would have a material adverse effect on the liquidity, financial condition and results of operations and may result in filing a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code in order to implement a restructuring plan. Our future operating performance and our ability to service or extend our indebtedness will be subject to future economic conditions and to financial, business, and other factors, many of which are beyond our control.\nContingencies\nWe are subject to various legal proceedings that arise in the ordinary course of business. Although the outcome of such proceedings cannot be predicted with certainty, management does not believe that we are presently party to any legal proceedings the resolution of which management believes would have a material adverse effect on our business, financial condition, operating results or cash flows. We establish reserves for specific legal matters when we determine that the likelihood of an unfavorable outcome is probable and the loss is reasonably estimable.\nOff-Balance Sheet Arrangements\nWe are not a party to any off-balance sheet arrangements.\nCritical Accounting Policies and Significant Estimates\nThe most significant accounting estimates involve a high degree of judgment or complexity. Management believes the estimates and judgments most critical to the preparation of our consolidated financial statements and to the understanding of our reported financial results include those made in connection with revenue recognition, including accounting for gift card breakage and estimated merchandise returns; estimating the value of inventory; impairment assessments for goodwill and other indefinite-lived intangible assets, and long-lived assets; and estimating equity-based compensation expense. Management evaluates its policies and assumptions on an ongoing basis.\nOur significant accounting policies related to these accounts in the preparation of our consolidated financial statements are described under the heading “Management Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies and Significant Estimates” in our Annual Report on Form 10-K for the fiscal year ended February 1, 2020. As of the date of this filing, there were no significant changes to any of the critical accounting policies and estimates previously described in our Annual Report on Form 10-K.\nRecent Accounting Pronouncements\nRefer to Note 2 to our unaudited consolidated financial statements included in this Quarterly Report on Form 10-Q, for recently adopted accounting standards, including the dates of adoption and estimated effects on our results of operations, financial position or cash flows.\n24\nSpecial Note Regarding Forward-Looking Statements\nThis Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are generally identified by the use of forward-looking terminology, including the terms “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “predict,” “project,” “should,” “target,” “will,” “would” and, in each case, their negative or other various or comparable terminology. All statements other than statements of historical facts contained in this Quarterly Report on Form 10-Q, including statements regarding our strategy, future operations, future financial position, future revenue, projected costs, prospects, plans, objectives of management and expected market growth are forward-looking statements.\nThese forward-looking statements involve known and unknown risks, uncertainties and other important factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Important factors that could cause actual results to differ materially from those in the forward-looking statements include, but are not limited to, the Company’s ability to consummate the Transaction, on the terms proposed or at all, including the Company’s ability to obtain requisite support of the Transaction from various stakeholders and to finalize the terms and documentation relating to the Transaction; the Company’s ability to comply with the terms of the TSA, including completing various stages of the restructuring within the dates specified therein; the effects of disruption from the proposed financial restructuring making it more difficult to maintain business, financing and operational relationships; the Company’s ability to achieve the potential benefits of the proposed financial restructuring; the impact of the COVID-19 epidemic and political unrest on the Company and the economy as a whole; the Company’s ability to adequately and effectively negotiate a long-term solution under its outstanding debt instruments; risks related to the Forbearance Agreements, including the duration of such agreements and the Company’s ability to meet its ongoing obligations under such agreements; the Company’s ability to take actions that are sufficient to eliminate the substantial doubt about its ability to continue as a going concern; the Company’s ability to develop a plan to regain compliance with the continued listing criteria of the NYSE; the NYSE’s acceptance of such plan; the Company’s ability to execute such plan and to continue to comply with applicable listing standards within the available cure period; risks arising from the potential suspension of trading of the Company’s common stock on the NYSE; regional, national or global political, economic, business, competitive, market and regulatory conditions, including risks regarding our ability to manage inventory or anticipate consumer demand; changes in consumer confidence and spending; our competitive environment; our failure to open new profitable stores or successfully enter new markets and other factors set forth under “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended February 1, 2020. All written and oral forward-looking statements made in connection with this Quarterly Report on Form 10-Q that are attributable to us or persons acting on our behalf are expressly qualified in their entirety by the Risk Factors set forth in our Annual Report on Form 10-K for the year ended February 1, 2020 and other cautionary statements included therein and herein.\nThese forward-looking statements reflect our views with respect to future events as of the date of this Quarterly Report on Form 10-Q and are based on assumptions and subject to risks and uncertainties. Given these uncertainties, you should not place undue reliance on these forward-looking statements. These forward-looking statements represent our estimates and assumptions only as of the date of this Quarterly Report on Form 10-Q and, except as required by law, we undertake no obligation to update or review publicly any forward-looking statements, whether as a result of new information, future events or otherwise after the date of this Quarterly Report on Form 10-Q. We anticipate that subsequent events and developments will cause our views to change. We qualify all of our forward-looking statements by these cautionary statements.\n25\n\nve Disclosures About Market Risk\nInterest Rate Risk\nWe are subject to interest rate risk in connection with borrowings under the Term Loan and ABL Facility, which bear interest at variable rates equal to LIBOR plus a margin as defined in the respective agreements described above. As of August 1, 2020, there was $31.8 million outstanding balance under the ABL Facility, and $2.7 million letters of credit outstanding. The undrawn borrowing availability under the ABL Facility was $5.5 million and the amount outstanding under the Term Loan had decreased to $236.2 million as a result of the scheduled repayments. We currently do not engage in any interest rate hedging activity. Based on the interest rate on the ABL Facility at August 1, 2020, and the schedule of outstanding borrowings under our Term Loan, a 10% change in our current interest rate would affect net income by $1.2 million during Fiscal Year 2020.\nImpact of Inflation\nOur results of operations and financial condition are presented based on historical cost. While it is difficult to accurately measure the impact of inflation due to the imprecise nature of the estimates required, we believe the effects of inflation, if any, on our results of operations and financial condition have been immaterial. We cannot assure you our business will not be affected in the future by inflation.\nEvaluation of Disclosure Controls and Procedures\nWe maintain disclosure controls and procedures that are designed to provide reasonable assurance that information required to be disclosed in the reports we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.\nAs previously disclosed in Item 9A of our Annual Report on Form 10-K for the Fiscal Year ended February 1, 2020, management identified a material weakness in the control activities environment component of internal control as the Company did not appropriately design and maintain controls related to the accounting for goodwill and tradename impairment. Specifically, control activities were not designed and maintained over the review of the carrying value of reporting units or assets used in the goodwill and tradename impairment valuation analysis.\nOur management, under the supervision of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this Quarterly Report on Form-10-Q. Because of the material weakness in our internal control over financial reporting previously disclosed in our Annual Report, our Chief Executive Officer and Chief Financial Officer concluded that, as of August 1, 2020, our disclosure controls and procedures were not effective.\nChanges to Internal Control over Financial Reporting\nThere were no significant changes in our internal control over financial reporting, (as defined in Rules 13a-15(e) and 15d-15(e) under the Act) during the fiscal quarter ended August 1, 2020. We concluded that the changes discussed below in “Remediation Plan” during the quarter ended August 1, 2020 have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\nRemediation Plan\nManagement is actively implementing a remediation plan to ensure the material weakness is fully remediated. The Company has taken and continues to take steps to strengthen our internal processes and controls associated with accounting for goodwill and tradename impairment.\nWe believe that these actions will effectively remediate the material weakness. However, until the remediated controls operate for a sufficient period of time and management has concluded, through testing, that these controls are operating effectively, the material weakness in our internal controls over financial reporting will not be considered remediated\n26\nLimitations on the Effectiveness of Controls and Procedures\nIn designing and evaluating our disclosure controls and procedures, our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable, not absolute, assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and our management is required to apply judgment in evaluating the benefits of possible controls and procedures relative to their costs. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.\n27\nPART II—OTHER INFORMATION\nWe are subject to various legal proceedings that arise in the ordinary course of business. Although the outcome of such proceedings cannot be predicted with certainty, management does not believe that we are presently party to any legal proceedings the resolution of which management believes would have a material adverse effect on our business, financial condition, operating results or cash flows. We establish reserves for specific legal matters when we determine that the likelihood of an unfavorable outcome is probable and the loss is reasonably estimable.\nThe updated risk factors below arose primarily due to the COVID-19 pandemic. Additional factors that could cause our actual results to differ materially from those in this report are described under the heading “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended February 1, 2020. Any of these factors could result in a significant or material adverse effect on our results of operations or financial condition. As of the date of this Quarterly Report on Form 10-Q, there have been no other material changes to the risk factors previously disclosed in our Annual Report on Form 10-K. However, additional risk factors not presently known to us or that we currently deem immaterial may also impair our business or results of operations and we may disclose changes to such factors or disclose additional factors from time to time in our future filings with the SEC.\nThe novel coronavirus (COVID-19) pandemic has disrupted and may further disrupt our business, which has and could further materially adversely affect our operations and business and financial results.\nThe novel coronavirus (COVID-19) pandemic has had a material adverse effect on our business. The extent to which the COVID-19 pandemic and other epidemics, disease outbreaks, or public health emergencies will impact our business, liquidity, financial condition, and results of operations, depends on numerous evolving factors that we may not be able to accurately predict or assess, including the duration and scope of the pandemic, epidemic, disease outbreak, or public health emergency; the negative impact on the economy; the short and longer-term impacts on the demand for retail and levels of consumer confidence; our ability to successfully navigate the impacts; government action, including restrictions on congregating in heavily populated areas, such as malls and shopping centers; and increased unemployment and reductions in consumer discretionary spending. Even if a virus or other disease does not spread significantly, the perceived risk of infection or health risk may damage our reputation and adversely affect our business, liquidity, financial condition, and results of operations.\nCertain scientists and medical experts have forecasted that a potential “second wave” of COVID-19 may occur in the U.S. in the late third quarter or the fourth quarter of calendar 2020 and continue into calendar 2021, and there is the risk that any second wave may be on a larger scale than the initial wave of COVID-19 that the U.S. has experienced and is currently experiencing. The sustained current outbreak and continued spread of COVID-19 has caused economic disruption, including wide scale unemployment, and it is possible that it could cause a global recession. There is a significant degree of uncertainty and lack of visibility as to the extent and duration of any such slowdown or recession.\nThe spread of COVID-19 has also caused us to modify our business practices (including employee travel, employee work locations, cancellation of physical participation in meetings, events and conferences, and social distancing measures), and we may take further actions as may be required by government authorities or that we determine are in the best interests of our employees, customers, partners, vendors, and suppliers. Work-from-home and other measures introduce additional operational risks, including cybersecurity risks, and have affected the way we conduct our business, which could have an adverse effect on our operations. There is no certainty that such measures will be sufficient to mitigate the risks posed by the virus, and illness and workforce disruptions could lead to unavailability of key personnel and harm our ability to perform critical functions.\nThe degree to which the COVID-19 pandemic impacts our results will depend on future developments, which are highly uncertain and cannot be predicted, including, but not limited to, the duration and spread of the outbreak, its severity, the possibility of a “second wave” of COVID-19, the actions to contain the virus or treat its impact, other actions taken by governments, businesses, and individuals in response to the virus and resulting economic disruption, and how quickly and to what extent normal economic and operating conditions can resume. We are similarly unable to predict the degree to which the pandemic will impact our customers, suppliers and other partners, and their financial conditions, but a material effect on these parties could also adversely affect us.\nWe are currently in non-compliance with the financial covenants in our credit agreements, which limits our liquidity and could result in an acceleration of the amounts we owe under the facilities.\nOur term loan credit agreement, dated as of May 8, 2015, by and among Jill Holdings, Inc. (as successor to Jill Holdings LLC), Jill Acquisition LLC, a wholly-owned subsidiary of us, the various lenders party thereto and Jefferies Finance LLC as the\n28\nadministrative agent, as amended on May 27, 2016 by Amendment No. 1 thereto (the “Term Loan Agreement”) and our ABL credit agreement, dated as of May 8, 2015, by and among Jill Holdings, Inc. (as successor to Jill Holdings LLC), Jill Acquisition LLC, certain subsidiaries from time to time party thereto, the lenders party thereto and CIT Finance LLC as the administrative agent and collateral agent, as amended on May 27, 2016 by Amendment No. 1 thereto, as further amended on August 22, 2018 by Amendment No. 2 to reduce the frequency of borrowing base certificate submissions as long as certain conditions are maintained and as further amended on June 12, 2019 by Amendment No. 3 to extend the term date to May 8, 2023 (the “ABL Facility” and, together with the Term Loan Agreement, the “Credit Agreements”), each contain, and any additional debt financing we may incur would likely contain, covenants that restrict our operations, including limitations on our ability to grant liens, incur additional debt, pay dividends, cause our subsidiaries to pay dividends to us, make certain investments and engage in certain merger, consolidation or asset sale transactions. Failure to maintain these covenants will have a significant impact on our operations.\nAs a result of COVID-19 related store closures, the Company was unable to maintain compliance with certain of its nonfinancial and financial covenants for the period ended May 2, 2020. Additionally, the inclusion of substantial doubt about the Company’s ability to continue as a going concern in the report of our independent registered public accounting firm on our financial statements for the fiscal year ended February 1, 2020 resulted in a violation of affirmative covenants under our Credit Agreements. On June 15, 2020, the Company entered into two forbearance agreements (the “Forbearance Agreements”) with the lenders under its ABL Facility and Term Loan. The Forbearance Agreements are described in a Current Report on Form 8-K filed by the Company with the SEC on June 16, 2020, and available on the SEC’s Edgar website as well as the Company’s website, which includes the full text of the agreement as an exhibit. Under the Forbearance Agreements, the respective lenders agreed not to exercise any rights and remedies until July 16, 2020 so long as, among other things, the Company otherwise remained in compliance with its credit facilities and complied with the terms of the Forbearance Agreements. Subsequently, the Forbearance Agreements were extended with the latest extension until September 26, 2020. The extensions of the Forbearance Agreements are described in Current Reports on Forms 8-K filed by the Company with the SEC, and available on the SEC’s Edgar website as well as the Company’s website, which include the full text of the agreements as exhibits.\nNone.\nNone.\nNot applicable.\nNone.\nThe exhibits listed on the Exhibit Index are filed or furnished as part of this Quarterly Report on Form 10-Q.\n29\nExhibit Index\n\n| Exhibit Number | Description |\n| 3.1 | Certificate of Incorporation of J.Jill, Inc. (incorporated by reference from Exhibit 3.1 to the Company’s Form 10-K, filed on April 28, 2017 (File No. 0001-38026)) |\n| 3.2 | Bylaws of J.Jill, Inc. (incorporated by reference from Exhibit 3.2 to the Company’s 10-K, filed on April 28, 2017 (File No.001-38026)) |\n| 10.1 | Forbearance Agreements, dated as of June 15, 2020 (incorporated by reference from Exhibit 10.1 and Exhibit 10.2 to the Company’s Form 8-K, filed on June 16, 2020 (File No. 001-38026)). |\n| 10.2 | Forbearance Agreements, dated as of July 15, 2020 (incorporated by reference from Exhibit 10.1 and Exhibit 10.2 to the Company’s Form 8-K, filed on July 16, 2020 (File No. 001-38026)). |\n| 10.3 | Forbearance Agreements, dated as of July 22, 2020 (incorporated by reference from Exhibit 10.1 and Exhibit 10.2 to the Company’s Form 8-K, filed on July 23, 2020 (File No. 001-38026)). |\n| 10.4 | Forbearance Agreements, dated as of July 29, 2020 (incorporated by reference from Exhibit 10.1 and Exhibit 10.2 to the Company’s Form 8-K, filed on July 30, 2020 (File No. 001-38026)). |\n| 10.5 | Forbearance Agreements, dated as of August 5, 2020 (incorporated by reference from Exhibit 10.1 and Exhibit 10.2 to the Company’s Form 8-K, filed on August 6, 2020 (File No. 001-38026)). |\n| 10.6 | Forbearance Agreements, dated as of August 12, 2020 (incorporated by reference from Exhibit 10.1 and Exhibit 10.2 to the Company’s Form 8-K, filed on August 13, 2020 (File No. 001-38026)). |\n| 10.7 | Forbearance Agreements, dated as of August 26, 2020 (incorporated by reference from Exhibit 10.1 and Exhibit 10.2 to the Company’s Form 8-K, filed on August 27, 2020 (File No. 001-38026)). |\n| 10.8 | Forbearance Agreements, dated as of August 31, 2020 (incorporated by reference from Exhibit 10.1 and Exhibit 10.2 to the Company’s Form 8-K, filed on September 1, 2020 (File No. 001-38026)). |\n| 10.9 | Transaction Support Agreement, dated as of August 31, 2020 (incorporated by reference from Exhibit 10.1 to the Company’s Form 8-K, filed on September 1, 2020 (File No. 001-38026)). |\n| 31.1 | Certification of Principal Executive Officer required by Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2 | Certification of Principal Financial Officer required by Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32.1* | Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 32.2* | Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 101.INS | XBRL Instance Document |\n| 101.SCH | XBRL Taxonomy Extension Schema Document |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document |\n\n\n| * | Furnished herewith. |\n\n30\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| J.Jill, Inc. |\n| Date: September 10, 2020 | By: | /s/ James Scully |\n| James Scully |\n| Interim Chief Executive Officer |\n| Date: September 10, 2020 | By: | /s/ Mark Webb |\n| Mark Webb |\n| Executive Vice President and Chief Financial Officer |\n\n31\n</text>\n\nWhat would be the total effect on net income during Fiscal Year 2020 if the current interest rate increased by 10% and there was an adverse judgment under one of the legal proceedings that resulted in a $0.8 million loss?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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doc-math
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{
"style": "rule",
"ground_truth": "Therefore, the answer is 2.0."
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"split": "test",
"index": 25,
"input_length": 29720
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docmath_40000_plus
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 3.\nQuantitative and Qualitative Disclosures About Market Risk\n48\nItem 4.\nControls and Procedures\n48\nPART II\nItem 1.\nLegal Proceedings\n49\nItem 1A.\nRisk Factors\n49\nItem 2.\nUnregistered Sales of Equity Securities and Use of Proceeds\n49\nItem 6.\nExhibits\n50\nSignature 51\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\nPART I\nItem 1. Condensed Consolidated Financial Statements\nCONDENSED CONSOLIDATED INCOME STATEMENTS\n(In millions, except per share amounts) (Unaudited)\n| Three Months Ended | Nine Months Ended |\n| September 30, 2018 | September 30, 2017 | September 30, 2018 | September 30, 2017 |\n| Net sales and revenue |\n| Automotive | $ | 32,276 | $ | 30,466 | $ | 98,242 | $ | 98,983 |\n| GM Financial | 3,515 | 3,157 | 10,408 | 8,890 |\n| Total net sales and revenue (Note 3) | 35,791 | 33,623 | 108,650 | 107,873 |\n| Costs and expenses |\n| Automotive and other cost of sales | 28,533 | 26,852 | 88,788 | 86,148 |\n| GM Financial interest, operating and other expenses | 3,064 | 2,892 | 9,074 | 8,133 |\n| Automotive and other selling, general and administrative expense | 2,584 | 2,303 | 7,172 | 7,136 |\n| Total costs and expenses | 34,181 | 32,047 | 105,034 | 101,417 |\n| Operating income | 1,610 | 1,576 | 3,616 | 6,456 |\n| Automotive interest expense | 161 | 151 | 470 | 430 |\n| Interest income and other non-operating income, net | 651 | 505 | 2,130 | 1,259 |\n| Equity income (Note 8) | 530 | 500 | 1,815 | 1,585 |\n| Income before income taxes | 2,630 | 2,430 | 7,091 | 8,870 |\n| Income tax expense (Note 15) | 100 | 2,316 | 1,085 | 3,637 |\n| Income from continuing operations | 2,530 | 114 | 6,006 | 5,233 |\n| Loss from discontinued operations, net of tax (Note 19) | — | 3,096 | 70 | 3,935 |\n| Net income (loss) | 2,530 | (2,982 | ) | 5,936 | 1,298 |\n| Net (income) loss attributable to noncontrolling interests | 4 | 1 | 34 | (11 | ) |\n| Net income (loss) attributable to stockholders | $ | 2,534 | $ | (2,981 | ) | $ | 5,970 | $ | 1,287 |\n| Net income (loss) attributable to common stockholders | $ | 2,503 | $ | (2,983 | ) | $ | 5,910 | $ | 1,285 |\n| Earnings per share (Note 18) |\n| Basic earnings per common share – continuing operations | $ | 1.77 | $ | 0.08 | $ | 4.24 | $ | 3.52 |\n| Basic loss per common share – discontinued operations | $ | — | $ | 2.14 | $ | 0.05 | $ | 2.65 |\n| Basic earnings (loss) per common share | $ | 1.77 | $ | (2.06 | ) | $ | 4.19 | $ | 0.87 |\n| Weighted-average common shares outstanding – basic | 1,412 | 1,445 | 1,410 | 1,483 |\n| Diluted earnings per common share – continuing operations | $ | 1.75 | $ | 0.08 | $ | 4.18 | $ | 3.46 |\n| Diluted loss per common share – discontinued operations | $ | — | $ | 2.11 | $ | 0.05 | $ | 2.61 |\n| Diluted earnings (loss) per common share | $ | 1.75 | $ | (2.03 | ) | $ | 4.13 | $ | 0.85 |\n| Weighted-average common shares outstanding – diluted | 1,431 | 1,472 | 1,431 | 1,507 |\n| Dividends declared per common share | $ | 0.38 | $ | 0.38 | $ | 1.14 | $ | 1.14 |\n\nCONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME\n| Three Months Ended | Nine Months Ended |\n| September 30, 2018 | September 30, 2017 | September 30, 2018 | September 30, 2017 |\n| Net income (loss) | $ | 2,530 | $ | (2,982 | ) | $ | 5,936 | $ | 1,298 |\n| Other comprehensive income (loss), net of tax (Note 17) |\n| Foreign currency translation adjustments and other | (209 | ) | 371 | (503 | ) | 572 |\n| Defined benefit plans | 59 | 1,213 | 286 | 973 |\n| Other comprehensive income (loss), net of tax | (150 | ) | 1,584 | (217 | ) | 1,545 |\n| Comprehensive income (loss) | 2,380 | (1,398 | ) | 5,719 | 2,843 |\n| Comprehensive (income) loss attributable to noncontrolling interests | 4 | 3 | 39 | (9 | ) |\n| Comprehensive income (loss) attributable to stockholders | $ | 2,384 | $ | (1,395 | ) | $ | 5,758 | $ | 2,834 |\n\nReference should be made to the notes to condensed consolidated financial statements.\n1\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\nCONDENSED CONSOLIDATED BALANCE SHEETS\n(In millions, except per share amounts) (Unaudited)\n| September 30, 2018 | December 31, 2017 |\n| ASSETS |\n| Current Assets |\n| Cash and cash equivalents | $ | 18,435 | $ | 15,512 |\n| Marketable securities (Note 4) | 5,916 | 8,313 |\n| Accounts and notes receivable, net | 10,376 | 8,164 |\n| GM Financial receivables, net (Note 5; Note 9 at VIEs) | 23,432 | 20,521 |\n| Inventories (Note 6) | 11,334 | 10,663 |\n| Equipment on operating leases, net (Note 7) | 474 | 1,106 |\n| Other current assets (Note 4; Note 9 at VIEs) | 4,881 | 4,465 |\n| Total current assets | 74,848 | 68,744 |\n| Non-current Assets |\n| GM Financial receivables, net (Note 5; Note 9 at VIEs) | 24,086 | 21,208 |\n| Equity in net assets of nonconsolidated affiliates (Note 8) | 9,155 | 9,073 |\n| Property, net | 38,655 | 36,253 |\n| Goodwill and intangible assets, net | 5,651 | 5,849 |\n| Equipment on operating leases, net (Note 7; Note 9 at VIEs) | 44,128 | 42,882 |\n| Deferred income taxes | 23,242 | 23,544 |\n| Other assets (Note 4; Note 9 at VIEs) | 5,946 | 4,929 |\n| Total non-current assets | 150,863 | 143,738 |\n| Total Assets | $ | 225,711 | $ | 212,482 |\n| LIABILITIES AND EQUITY |\n| Current Liabilities |\n| Accounts payable (principally trade) | $ | 25,147 | $ | 23,929 |\n| Short-term debt and current portion of long-term debt (Note 10) |\n| Automotive | 2,915 | 2,515 |\n| GM Financial (Note 9 at VIEs) | 27,950 | 24,450 |\n| Accrued liabilities | 28,104 | 25,996 |\n| Total current liabilities | 84,116 | 76,890 |\n| Non-current Liabilities |\n| Long-term debt (Note 10) |\n| Automotive | 13,048 | 10,987 |\n| GM Financial (Note 9 at VIEs) | 58,427 | 56,267 |\n| Postretirement benefits other than pensions (Note 13) | 5,832 | 5,998 |\n| Pensions (Note 13) | 11,119 | 13,746 |\n| Other liabilities | 12,261 | 12,394 |\n| Total non-current liabilities | 100,687 | 99,392 |\n| Total Liabilities | 184,803 | 176,282 |\n| Commitments and contingencies (Note 14) |\n| Equity (Note 17) |\n| Common stock, $0.01 par value | 14 | 14 |\n| Additional paid-in capital | 25,503 | 25,371 |\n| Retained earnings | 20,865 | 17,627 |\n| Accumulated other comprehensive loss | (8,321 | ) | (8,011 | ) |\n| Total stockholders’ equity | 38,061 | 35,001 |\n| Noncontrolling interests | 2,847 | 1,199 |\n| Total Equity | 40,908 | 36,200 |\n| Total Liabilities and Equity | $ | 225,711 | $ | 212,482 |\n\nReference should be made to the notes to condensed consolidated financial statements.\n2\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(In millions) (Unaudited)\n| Nine Months Ended |\n| September 30, 2018 | September 30, 2017 |\n| Cash flows from operating activities |\n| Income from continuing operations | $ | 6,006 | $ | 5,233 |\n| Depreciation and impairment of Equipment on operating leases, net | 5,633 | 4,947 |\n| Depreciation, amortization and impairment charges on Property, net | 4,390 | 4,137 |\n| Foreign currency remeasurement and transaction (gains) losses | 280 | (12 | ) |\n| Undistributed earnings of nonconsolidated affiliates, net | 185 | 370 |\n| Pension contributions and OPEB payments | (1,750 | ) | (1,109 | ) |\n| Pension and OPEB income, net | (940 | ) | (646 | ) |\n| Provision for deferred taxes | 680 | 3,517 |\n| Change in other operating assets and liabilities | (5,258 | ) | (6,061 | ) |\n| Net cash provided by operating activities – continuing operations | 9,226 | 10,376 |\n| Net cash provided by operating activities – discontinued operations | — | 64 |\n| Net cash provided by operating activities | 9,226 | 10,440 |\n| Cash flows from investing activities |\n| Expenditures for property | (6,562 | ) | (6,353 | ) |\n| Available-for-sale marketable securities, acquisitions | (2,313 | ) | (4,499 | ) |\n| Available-for-sale marketable securities, liquidations | 4,637 | 7,901 |\n| Purchases of finance receivables, net | (17,297 | ) | (15,134 | ) |\n| Principal collections and recoveries on finance receivables | 11,776 | 9,363 |\n| Purchases of leased vehicles, net | (13,051 | ) | (14,809 | ) |\n| Proceeds from termination of leased vehicles | 8,094 | 4,649 |\n| Other investing activities | (25 | ) | 93 |\n| Net cash used in investing activities – continuing operations | (14,741 | ) | (18,789 | ) |\n| Net cash provided by (used in) investing activities – discontinued operations (Note 19) | 166 | (3,972 | ) |\n| Net cash used in investing activities | (14,575 | ) | (22,761 | ) |\n| Cash flows from financing activities |\n| Net increase (decrease) in short-term debt | 1,695 | (374 | ) |\n| Proceeds from issuance of debt (original maturities greater than three months) | 32,801 | 43,048 |\n| Payments on debt (original maturities greater than three months) | (25,408 | ) | (26,034 | ) |\n| Payments to purchase common stock | (100 | ) | (2,994 | ) |\n| Proceeds from issuance of preferred stock (Note 17) | 1,753 | 985 |\n| Dividends paid | (1,690 | ) | (1,701 | ) |\n| Other financing activities | (439 | ) | (271 | ) |\n| Net cash provided by financing activities – continuing operations | 8,612 | 12,659 |\n| Net cash provided by financing activities – discontinued operations | — | 20 |\n| Net cash provided by financing activities | 8,612 | 12,679 |\n| Effect of exchange rate changes on cash, cash equivalents and restricted cash | (253 | ) | 362 |\n| Net increase in cash, cash equivalents and restricted cash | 3,010 | 720 |\n| Cash, cash equivalents and restricted cash at beginning of period | 17,848 | 15,160 |\n| Cash, cash equivalents and restricted cash at end of period | $ | 20,858 | $ | 15,880 |\n| Cash, cash equivalents and restricted cash – continuing operations at end of period (Note 4) | $ | 20,858 | $ | 15,315 |\n| Cash, cash equivalents and restricted cash – discontinued operations at end of period | $ | — | $ | 565 |\n| Significant Non-cash Investing and Financing Activity |\n| Non-cash property additions – continuing operations | $ | 4,284 | $ | 3,833 |\n| Non-cash proceeds on sale of discontinued operations (Note 19) | $ | — | $ | 808 |\n\nReference should be made to the notes to condensed consolidated financial statements.\n3\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENTS OF EQUITY\n| Common Stockholders’ | Noncontrolling Interests | Total Equity |\n| Common Stock | Additional Paid-in Capital | Retained Earnings | Accumulated Other Comprehensive Loss |\n| Balance at January 1, 2017 | $ | 15 | $ | 26,983 | $ | 26,168 | $ | (9,330 | ) | $ | 239 | $ | 44,075 |\n| Net income | — | — | 1,287 | — | 11 | 1,298 |\n| Other comprehensive income | — | — | — | 1,547 | (2 | ) | 1,545 |\n| Purchase of common stock | (1 | ) | (1,476 | ) | (1,517 | ) | — | — | (2,994 | ) |\n| Exercise of common stock warrants | — | 42 | — | — | — | 42 |\n| Issuance of preferred stock (Note 17) | — | — | — | — | 985 | 985 |\n| Stock based compensation | — | 293 | (25 | ) | — | — | 268 |\n| Cash dividends paid on common stock | — | — | (1,683 | ) | — | — | (1,683 | ) |\n| Dividends to noncontrolling interests | — | — | — | — | (18 | ) | (18 | ) |\n| Other | — | (60 | ) | — | — | 19 | (41 | ) |\n| Balance at September 30, 2017 | $ | 14 | $ | 25,782 | $ | 24,230 | $ | (7,783 | ) | $ | 1,234 | $ | 43,477 |\n| Balance at January 1, 2018 | $ | 14 | $ | 25,371 | $ | 17,627 | $ | (8,011 | ) | $ | 1,199 | $ | 36,200 |\n| Adoption of accounting standards (Note 1) | — | — | (1,046 | ) | (98 | ) | — | (1,144 | ) |\n| Net income | — | — | 5,970 | — | (34 | ) | 5,936 |\n| Other comprehensive loss | — | — | — | (212 | ) | (5 | ) | (217 | ) |\n| Issuance of preferred stock (Note 17) | — | — | — | — | 1,753 | 1,753 |\n| Purchase of common stock | — | (44 | ) | (56 | ) | — | — | (100 | ) |\n| Exercise of common stock warrants | — | 2 | — | — | — | 2 |\n| Cash dividends paid on common stock | — | — | (1,608 | ) | — | — | (1,608 | ) |\n| Dividends to noncontrolling interests | — | — | — | — | (106 | ) | (106 | ) |\n| Other | — | 174 | (22 | ) | — | 40 | 192 |\n| Balance at September 30, 2018 | $ | 14 | $ | 25,503 | $ | 20,865 | $ | (8,321 | ) | $ | 2,847 | $ | 40,908 |\n\nReference should be made to the notes to condensed consolidated financial statements.\n4\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\nNote 1. Nature of Operations and Basis of Presentation\nGeneral Motors Company (sometimes referred to in this Quarterly Report on Form 10-Q as we, our, us, ourselves, the Company, General Motors or GM) designs, builds and sells cars, trucks, crossovers and automobile parts worldwide. We also provide automotive financing services through General Motors Financial Company, Inc. (GM Financial). We analyze the results of our continuing operations through the following segments: GM North America (GMNA), GM International (GMI), GM Cruise and GM Financial. GM Cruise is our global segment designed to build, grow and invest in our autonomous ride-sharing vehicle business. As a result of the growing importance of our autonomous vehicle operations, we moved these operations from Corporate to GM Cruise and began presenting GM Cruise as a new reportable segment in the three months ended June 30, 2018. All periods presented have been recast to reflect the segment changes. Nonsegment operations and Maven, our ride- and car-sharing business, are classified as Corporate. Corporate includes certain centrally recorded income and costs such as interest, income taxes, corporate expenditures and certain nonsegment specific revenues and expenses.\nOn July 31, 2017 we closed the sale of the Opel and Vauxhall businesses and certain other assets in Europe (the Opel/Vauxhall Business) to Peugeot, S.A. (PSA Group). On October 31, 2017 we closed the sale of the European financing subsidiaries and branches (the Fincos, and together with the Opel/Vauxhall Business, the European Business) to Banque PSA Finance S.A. and BNP Paribas Personal Finance S.A. The European Business is presented as discontinued operations in our condensed consolidated financial statements for all periods presented. Unless otherwise indicated, information in this report relates to our continuing operations. Refer to Note 19 for additional information on our discontinued operations.\nThe accompanying condensed consolidated financial statements have been prepared in conformity with U.S. GAAP pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) for interim financial information. Accordingly they do not include all of the information and notes required by U.S. GAAP for complete financial statements. The accompanying condensed consolidated financial statements include all adjustments, which consist of normal recurring adjustments and transactions or events discretely impacting the interim periods, considered necessary by management to fairly state our results of operations, financial position and cash flows. The operating results for interim periods are not necessarily indicative of results that may be expected for any other interim period or for the full year. These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in our 2017 Form 10-K. Except for per share amounts or as otherwise specified, dollar amounts presented within tables are stated in millions. In the three months ended June 30, 2018 we changed the presentation of our condensed consolidated statements of cash flows to separately classify Depreciation and impairment of Equipment on operating leases, net and Depreciation, amortization and impairment charges on Property, net. We have made corresponding reclassifications to the comparable information for all periods presented.\nPrinciples of Consolidation The Principles of Consolidation supplements information presented in our 2017 Form 10-K for the adoption on January 1, 2018 of Accounting Standards Update (ASU) 2016-01, “Recognition and Measurement of Financial Assets and Financial Liabilities” (ASU 2016-01). We consolidate entities that we control due to ownership of a majority voting interest and we consolidate variable interest entities (VIEs) when we have variable interests and are the primary beneficiary. We continually evaluate our involvement with VIEs to determine when these criteria are met. Our share of earnings or losses of nonconsolidated affiliates is included in our consolidated operating results using the equity method of accounting when we are able to exercise significant influence over the operating and financial decisions of the affiliate. Beginning January 1, 2018 we no longer use the cost method of accounting.\nRecently Adopted Accounting Standards\nEffective January 1, 2018 we adopted ASU 2014-09, \"Revenue from Contracts with Customers\" as amended (ASU 2014-09), as incorporated into Accounting Standards Codification (ASC) 606, on a modified retrospective basis by recognizing a cumulative effect adjustment to the opening balance of Retained earnings. Under ASU 2014-09 sales incentives will now be recorded at the time of sale rather than at the later of sale or announcement, thereby resulting in the shifting of incentive amounts to an earlier quarter and fixed fee license arrangements will now be recognized when access to intellectual property is granted instead of over the contract period. We currently expect the retiming of quarterly incentive amounts to offset for the year ending December 31, 2018. Actual incentive spending is dependent upon future market conditions.\nBeginning January 1, 2018 certain transfers to daily rental companies are accounted for as sales when ownership of the vehicle is not expected to transfer back to us. Such transactions were previously accounted for as operating leases. Transfers that occurred prior to January 2018 continue to be accounted for as operating leases because at the original time of transfer an expectation existed that ownership of the vehicle would transfer back to us.\n5\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\nThe following table summarizes the financial statement line items within our condensed consolidated income statement and balance sheet significantly impacted by ASU 2014-09:\n| Three Months Ended September 30, 2018 |\n| As Reported | Balances without Adoption of ASC 606 | Effect of Change |\n| Income Statement |\n| Automotive net sales and revenue | $ | 32,276 | $ | 32,959 | $ | (683 | ) |\n| Income before income taxes | $ | 2,630 | $ | 3,321 | $ | (691 | ) |\n| Net income attributable to stockholders | $ | 2,534 | $ | 3,071 | $ | (537 | ) |\n\n| Nine Months Ended September 30, 2018 |\n| As Reported | Balances without Adoption of ASC 606 | Effect of Change |\n| Income Statement |\n| Automotive net sales and revenue | $ | 98,242 | $ | 97,961 | $ | 281 |\n| Automotive and other cost of sales | $ | 88,788 | $ | 87,749 | $ | 1,039 |\n| Income before income taxes | $ | 7,091 | $ | 7,661 | $ | (570 | ) |\n| Net income attributable to stockholders | $ | 5,970 | $ | 6,402 | $ | (432 | ) |\n\n| September 30, 2018 |\n| As Reported | Balances without Adoption of ASC 606 | Effect of Change |\n| Balance Sheet |\n| Equipment on operating leases, net | $ | 474 | $ | 1,428 | $ | (954 | ) |\n| Deferred income taxes | $ | 23,242 | $ | 22,661 | $ | 581 |\n| Accrued liabilities | $ | 28,104 | $ | 25,963 | $ | 2,141 |\n| Other liabilities | $ | 12,261 | $ | 12,657 | $ | (396 | ) |\n| Retained earnings | $ | 20,865 | $ | 22,633 | $ | (1,768 | ) |\n\nEffective January 1, 2018 we adopted ASU 2016-01, on a modified retrospective basis, with a $182 million cumulative effect adjustment recorded to the opening balance of Retained earnings to adjust an investment previously carried at cost to its fair value. ASU 2016-01 requires equity investments that are not accounted for under the equity method of accounting to be measured at fair value with changes recognized in Net income.\nIn the three months ended March 31, 2018 we adopted ASU 2017-12, \"Derivatives and Hedging (Topic 815), Targeted Improvements to Accounting for Hedging Activities\" (ASU 2017-12), on a modified retrospective basis and adopted ASU 2018-02, \"Income Statement-Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income” (ASU 2018-02), on a modified retrospective basis. ASU 2018-02 provides the option to reclassify stranded tax effects related to the U.S. Tax Cuts and Jobs Act of 2017 (the Tax Act) in accumulated other comprehensive income to retained earnings. The adjustment relates to the change in the U.S. corporate income tax rate. The cumulative effect of the adjustments to the opening balance of Retained earnings for these adopted standards was $108 million.\nThe following table summarizes the changes to our condensed consolidated balance sheet for the adoption of ASU 2014-09, ASU 2016-01, ASU 2017-12 and ASU 2018-02:\n6\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\n| December 31, 2017 | Adjustment due to ASU 2014-09 | Adjustment due to ASU 2016-01, ASU 2017-12 and ASU 2018-02 | January 1, 2018 |\n| Deferred income taxes | $ | 23,544 | $ | 444 | $ | (63 | ) | $ | 23,925 |\n| Other assets | $ | 4,929 | $ | 195 | $ | 242 | $ | 5,366 |\n| GM Financial short-term debt and current portion of long-term debt | $ | 24,450 | $ | — | $ | (13 | ) | $ | 24,437 |\n| Accrued liabilities | $ | 25,996 | $ | 2,328 | $ | — | $ | 28,324 |\n| Other liabilities | $ | 12,394 | $ | (235 | ) | $ | — | $ | 12,159 |\n| Retained earnings | $ | 17,627 | $ | (1,336 | ) | $ | 290 | $ | 16,581 |\n| Accumulated other comprehensive loss | $ | (8,011 | ) | $ | — | $ | (98 | ) | $ | (8,109 | ) |\n\nEffective January 1, 2018 we adopted ASU 2016-15, \"Statement of Cash Flows (Topic 230), Classification of Certain Cash Receipts and Payments\" (ASU 2016-15), which clarified guidance on the classification of certain cash receipts and payments in the statement of cash flows. The adoption of ASU 2016-15 did not have a material impact on our condensed consolidated financial statements and prior periods were not restated.\nEffective January 1, 2018 we adopted ASU 2017-07, \"Compensation - Retirement Benefits (Topic 715), Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost\" (ASU 2017-07) on a retrospective basis, which requires that the service cost component of net periodic pension and other postretirement benefits (OPEB) (income) expense be presented in the same income statement line item as other employee compensation costs. The remaining components of net periodic pension and OPEB (income) expense are now presented outside operating income. Amounts previously reflected in Operating income were reclassified to Interest income and other non-operating income, net in accordance with the provisions of ASU 2017-07. Refer to Note 13 for amounts that were reclassified.\nAccounting Standards Not Yet Adopted\nIn February 2016 the Financial Accounting Standards Board issued ASU 2016-02, \"Leases\" (ASU 2016-02), which requires us as the lessee to recognize most leases on the balance sheet thereby resulting in the recognition of right of use assets and lease obligations for those leases currently classified as operating leases. The accounting for leases where we are the lessor remains largely unchanged. We are continuing to assess the accounting and disclosure impact of ASU 2016-02 and refine our processes to permit adoption on January 1, 2019. We plan to elect the optional transition method as well as the package of practical expedients upon adoption. We expect the primary impact to our consolidated financial position upon adoption will be the recognition, on a discounted basis, of our minimum commitments under noncancelable operating leases on our consolidated balance sheets resulting in the recording of right of use assets and lease obligations. Our minimum commitments under noncancelable operating leases are not significantly different than those disclosed in our 2017 Form 10-K.\nIn June 2016 the FASB issued ASU 2016-13, \"Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments\" (ASU 2016-13), which requires entities to use a new impairment model based on Current Expected Credit Losses (CECL) rather than incurred losses. We plan to adopt ASU 2016-13 on January 1, 2020 on a modified retrospective basis, which will result in an increase to our allowance for credit losses and a decrease to Retained earnings as of the adoption date. Estimated credit losses under CECL will consider relevant information about past events, current conditions and reasonable and supportable forecasts, resulting in recognition of lifetime expected credit losses upon loan origination.\nNote 2. Significant Accounting Policies\nThe information presented on Revenue Recognition, Equipment on Operating Leases, Marketable Debt Securities, Equity Investments and Derivative Financial Instruments supplements the Significant Accounting Policies information presented in our 2017 Form 10-K for the adoption of our recently adopted accounting standards which became effective January 1, 2018. See our 2017 Form 10-K for a description of our significant accounting policies in effect prior to the adoption of the new accounting standards.\nRevenue Recognition We adopted ASU 2014-09, which requires us to recognize revenue when a customer obtains control rather than when we have transferred substantially all risks and rewards of a good or service. We adopted ASU 2014-09 by applying the modified retrospective method to all noncompleted contracts as of the date of adoption. See Note 1 for additional information\n7\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\npertaining to the adoption of ASU 2014-09. The comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods. The following accounting policies became effective upon the adoption of ASU 2014-09.\nAutomotive Automotive net sales and revenue represents the amount of consideration to which we expect to be entitled in exchange for vehicle, parts and accessories and services and other sales. The consideration recognized represents the amount received, typically shortly after the sale to a customer, net of estimated dealer and customer sales incentives we reasonably expect to pay. Significant factors in determining our estimates of incentives include forecasted sales volume, product type, product mix, customer behavior and assumptions concerning market conditions. Historical experience is also considered when establishing our future expectations. Subsequent adjustments to incentive estimates are possible as facts and circumstances change over time. When our customers have a right to return eligible parts and accessories, we consider the returns in our estimation of the transaction price. A portion of the consideration received is deferred for separate performance obligations, such as maintenance and vehicle connectivity, that will be provided to our customers at a future date. Taxes assessed by various government entities, such as sales, use and value-added taxes, collected at the time of the vehicle sale are excluded from Automotive net sales and revenue. Shipping and handling activities that occur after control of the vehicle transfers to the dealer are recognized at the time of sale and presented in Automotive and other cost of sales.\nVehicle, Parts and Accessories For the majority of vehicle and accessories sales our customers obtain control and we recognize revenue when the vehicle transfers to the dealer, which generally occurs when the vehicle is released to the carrier responsible for transporting it to a dealer. Revenue, net of estimated returns, is recognized on the sale of parts upon delivery to the customer.\nCertain transfers to daily rental companies are accounted for as sales, with revenue recognized at the time of transfer. Such transactions were previously accounted for as operating leases. At the time of transfer, we defer revenue for remarketing obligations, record a residual value guarantee and reflect a deposit liability for amounts expected to be returned once the remarketing services are complete. Deferred revenue is recognized in earnings upon completion of the remarketing service. Transfers that occurred prior to January 1, 2018 and future transfers containing a substantive purchase obligation continue to be accounted for as operating leases and rental income is recognized over the estimated term of the lease.\nUsed Vehicles Proceeds from the auction of vehicles returned from daily rental car companies are recognized in Automotive net sales and revenue upon transfer of control of the vehicle to the customer and the related vehicle carrying value is recognized in Automotive and other cost of sales.\nServices and Other Services and other revenue primarily consists of revenue from vehicle-related service arrangements and after-sale services such as maintenance, vehicle connectivity and extended service warranties. For those service arrangements that are bundled with a vehicle sale, a portion of the revenue from the sale is allocated to the service component and recognized as deferred revenue within Accrued liabilities or Other liabilities. We recognize revenue for bundled services and services sold separately as services are performed, typically over a period of less than three years.\nAutomotive Financing - GM Financial Finance charge income earned on receivables is recognized using the effective interest method. Fees and commissions (including incentive payments) received and direct costs of originating loans are deferred and amortized over the term of the related finance receivables using the effective interest method and are removed from the condensed consolidated balance sheets when the related finance receivables are sold, charged off or paid in full. Accrual of finance charge income on retail finance receivables is generally suspended on accounts that are more than 60 days delinquent, accounts in bankruptcy and accounts in repossession. Payments received on nonaccrual loans are first applied to any fees due, then to any interest due and then any remaining amounts are recorded to principal. Interest accrual generally resumes once an account has received payments bringing the delinquency to less than 60 days past due. Accrual of finance charge income on commercial finance receivables is generally suspended on accounts that are more than 90 days delinquent, upon receipt of a bankruptcy notice from a borrower, or where reasonable doubt exists about the full collectability of contractually agreed upon principal and interest. Payments received on nonaccrual loans are first applied to principal. Interest accrual resumes once an account has received payments bringing the account fully current and collection of contractual principal and interest is reasonably assured (including amounts previously charged off).\nIncome from operating lease assets, which includes lease origination fees, net of lease origination costs and incentives, is recorded as operating lease revenue on a straight-line basis over the term of the lease agreement.\nEquipment on Operating Leases Equipment on operating leases, net consists of vehicle leases to retail customers with lease terms of two to five years and vehicle sales to rental car companies that are expected to be repurchased in an average of seven\n8\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\nmonths. We are exposed to changes in the residual values of these assets. The residual values represent estimates of the values of the leased vehicles at the end of the lease contracts and are determined based on forecasted auction proceeds when there is a reliable basis to make such a determination. Realization of the residual values is dependent on the future ability to market the vehicles under prevailing market conditions. The adequacy of the estimate of the residual value is evaluated over the life of the arrangement and adjustments may be made to the extent the expected value of the vehicle changes. Adjustments may be in the form of revisions to the depreciation rate or recognition of an impairment charge. Impairment is determined to exist if an impairment indicator exists and the expected future cash flows, which include estimated residual values, are lower than the carrying amount of the vehicle's asset group. If the carrying amount is considered impaired an impairment charge is recorded for the amount by which the carrying amount exceeds fair value of the vehicle's asset group. Fair value is determined primarily using the anticipated cash flows, including estimated residual values. In our automotive finance operations when a leased vehicle is returned or repossessed the asset is recorded in Other assets at the lower of amortized cost or estimated selling price, less costs to sell. Upon disposition a gain or loss is recorded in GM Financial interest, operating and other expenses for any difference between the net book value of the leased asset and the proceeds from the disposition of the asset.\nMarketable Debt Securities We classify marketable debt securities as either available-for-sale or trading. Various factors, including turnover of holdings and investment guidelines, are considered in determining the classification of securities. Available-for-sale debt securities are recorded at fair value with unrealized gains and losses recorded net of related income taxes in Accumulated other comprehensive loss until realized. Trading debt securities are recorded at fair value with changes in fair value recorded in Interest income and other non-operating income, net. We determine realized gains and losses for all debt securities using the specific identification method.\nWe measure the fair value of our marketable debt securities using a market approach where identical or comparable prices are available and an income approach in other cases. If quoted market prices are not available, fair values of securities are determined using prices from a pricing service, pricing models, quoted prices of securities with similar characteristics or discounted cash flow models. These prices represent non-binding quotes. Our pricing service utilizes industry-standard pricing models that consider various inputs. We conduct an annual review of our pricing service and believe the prices received from our pricing service are a reliable representation of exit prices.\nAn evaluation is made quarterly to determine if unrealized losses related to non-trading investments in debt securities are other-than-temporary. Factors considered include the length of time and extent to which the fair value has been below cost, the financial condition and near-term prospects of the issuer and the intent to sell or likelihood to be forced to sell the debt security before any anticipated recovery.\nEquity Investments When events and circumstances warrant, equity investments accounted for under the equity method of accounting are evaluated for impairment. An impairment charge is recorded whenever a decline in value of an equity investment below its carrying amount is determined to be other-than-temporary. Impairment charges related to equity method investments are recorded in Equity income. Equity investments that are not accounted for under the equity method of accounting are measured at fair value with changes in fair value recorded in Interest income and other non-operating income, net.\nDerivative Financial Instruments The following changes to our accounting policies became effective upon adoption of ASU 2017-12.\nAutomotive Certain foreign currency and commodity forward contracts have been designated as cash flow hedges. The risk being hedged is the foreign currency and commodity price risk related to forecasted transactions. If the contract has been designated as a cash flow hedge, the change in the fair value of the cash flow hedge is deferred in Accumulated other comprehensive loss and is recognized in Automotive and other cost of sales along with the earnings effect of the hedged item when the hedged item affects earnings.\nAutomotive Financing - GM Financial Certain interest rate swap and foreign currency swap agreements have been designated as cash flow hedges. The risk being hedged is the foreign currency and interest rate risk related to forecasted transactions. If the contract has been designated as a cash flow hedge, the change in the fair value of the cash flow hedge is deferred in Accumulated other comprehensive loss and is recognized in GM Financial interest, operating and other expenses along with the earnings effect of the hedged item when the hedged item affects earnings. Changes in the fair value of amounts excluded from the assessment of effectiveness are recorded currently in earnings and are presented in the same income statement line as the earnings effect of the hedged item.\n9\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\nNote 3. Revenue\n| Three Months Ended September 30, 2018 |\n| GMNA | GMI | Corporate | Total Automotive | GM Financial | Eliminations | Total |\n| Vehicle, parts and accessories | $ | 26,273 | $ | 4,226 | $ | 2 | $ | 30,501 | $ | — | $ | (11 | ) | $ | 30,490 |\n| Used vehicles | 582 | 23 | — | 605 | — | (1 | ) | 604 |\n| Services and other | 795 | 333 | 54 | 1,182 | — | — | 1,182 |\n| Automotive net sales and revenue | 27,650 | 4,582 | 56 | 32,288 | — | (12 | ) | 32,276 |\n| Leased vehicle income | — | — | — | — | 2,501 | — | 2,501 |\n| Finance charge income | — | — | — | — | 917 | (2 | ) | 915 |\n| Other income | — | — | — | — | 100 | (1 | ) | 99 |\n| GM Financial net sales and revenue | — | — | — | — | 3,518 | (3 | ) | 3,515 |\n| Net sales and revenue | $ | 27,650 | $ | 4,582 | $ | 56 | $ | 32,288 | $ | 3,518 | $ | (15 | ) | $ | 35,791 |\n| Nine Months Ended September 30, 2018 |\n| GMNA | GMI | Corporate | Total Automotive | GM Financial | Eliminations | Total |\n| Vehicle, parts and accessories | $ | 79,029 | $ | 13,320 | $ | 12 | $ | 92,361 | $ | — | $ | (36 | ) | $ | 92,325 |\n| Used vehicles | 2,506 | 138 | — | 2,644 | — | (34 | ) | 2,610 |\n| Services and other | 2,434 | 730 | 143 | 3,307 | — | — | 3,307 |\n| Automotive net sales and revenue | 83,969 | 14,188 | 155 | 98,312 | — | (70 | ) | 98,242 |\n| Leased vehicle income | — | — | — | — | 7,445 | — | 7,445 |\n| Finance charge income | — | — | — | — | 2,667 | (5 | ) | 2,662 |\n| Other income | — | — | — | — | 305 | (4 | ) | 301 |\n| GM Financial net sales and revenue | — | — | — | — | 10,417 | (9 | ) | 10,408 |\n| Net sales and revenue | $ | 83,969 | $ | 14,188 | $ | 155 | $ | 98,312 | $ | 10,417 | $ | (79 | ) | $ | 108,650 |\n\nRevenue is measured as the amount of consideration we expect to receive in exchange for transferring goods or providing services. Adjustments to sales incentives for previously recognized sales were insignificant in the three and nine months ended September 30, 2018.\nContract liabilities in our Automotive segments consist primarily of maintenance, extended warranty and other service contracts. We recognized revenue of $426 million and $1.2 billion related to contract liabilities during the three and nine months ended September 30, 2018. We expect to recognize revenue of $560 million in the three months ending December 31, 2018 and $1.0 billion, $497 million and $600 million in the years ending December 31, 2019, 2020 and thereafter related to contract liabilities as of September 30, 2018.\nNote 4. Marketable and Other Securities\nThe following table summarizes the fair value of cash equivalents and marketable debt and equity securities which approximates cost:\n10\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\n| Fair Value Level | September 30, 2018 | December 31, 2017 |\n| Cash and cash equivalents |\n| Cash and time deposits(a) | $ | 7,144 | $ | 6,962 |\n| Available-for-sale debt securities |\n| U.S. government and agencies | 2 | 1,115 | 750 |\n| Corporate debt | 2 | 2,774 | 3,032 |\n| Sovereign debt | 2 | 2,033 | 1,954 |\n| Total available-for-sale debt securities – cash equivalents | 5,922 | 5,736 |\n| Money market funds(b) | 1 | 5,369 | 2,814 |\n| Total cash and cash equivalents | $ | 18,435 | $ | 15,512 |\n| Marketable debt securities |\n| U.S. government and agencies | 2 | $ | 1,229 | $ | 3,310 |\n| Corporate debt | 2 | 3,416 | 3,665 |\n| Mortgage and asset-backed | 2 | 685 | 635 |\n| Sovereign debt | 2 | 586 | 703 |\n| Total available-for-sale debt securities – marketable securities | $ | 5,916 | $ | 8,313 |\n| Restricted cash |\n| Cash and cash equivalents | $ | 198 | $ | 219 |\n| Money market funds | 1 | 2,225 | 2,117 |\n| Total restricted cash | $ | 2,423 | $ | 2,336 |\n| Available-for-sale debt securities included above with contractual maturities(c) |\n| Due in one year or less | $ | 6,777 |\n| Due between one and five years | 4,376 |\n| Total available-for-sale debt securities with contractual maturities | $ | 11,153 |\n\n__________\n| (a) | Includes $364 million that is designated exclusively to fund capital expenditures in GM Korea Company (GM Korea) at September 30, 2018. Refer to Note 17 for additional information. |\n\n| (b) | Includes $1.8 billion in GM Cruise at September 30, 2018. Refer to Note 17 for additional information. |\n\n| (c) | Excludes mortgage and asset-backed securities. |\n\nProceeds from the sale of investments classified as available-for-sale and sold prior to maturity were $1.7 billion and $3.7 billion in the three months ended September 30, 2018 and 2017 and $3.6 billion and $5.1 billion in the nine months ended September 30, 2018 and 2017. Net unrealized gains and losses on available-for-sale debt securities were insignificant in the three and nine months ended September 30, 2018 and 2017. Cumulative unrealized gains and losses on available-for-sale debt securities were insignificant at September 30, 2018 and December 31, 2017.\nInvestments in equity securities where market quotations are not available are accounted for at fair value primarily using Level 3 inputs. We recorded an unrealized gain of $142 million in Interest income and other non-operating income, net in the three months ended June 30, 2018 to adjust an investment in an equity security to a fair value of $884 million at June 30, 2018, which remained unchanged at September 30, 2018.\nThe following table provides a reconciliation of cash, cash equivalents and restricted cash reported within the condensed consolidated balance sheet to the total shown in the condensed consolidated statement of cash flows:\n| September 30, 2018 |\n| Cash and cash equivalents | $ | 18,435 |\n| Restricted cash included in Other current assets | 1,883 |\n| Restricted cash included in Other assets | 540 |\n| Total | $ | 20,858 |\n\n11\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\n| September 30, 2018 | December 31, 2017 |\n| Retail | Commercial | Total | Retail | Commercial | Total |\n| Finance receivables, collectively evaluated for impairment, net of fees | $ | 35,442 | $ | 10,601 | $ | 46,043 | $ | 30,486 | $ | 9,935 | $ | 40,421 |\n| Finance receivables, individually evaluated for impairment, net of fees | 2,308 | 67 | 2,375 | 2,228 | 22 | 2,250 |\n| GM Financial receivables | 37,750 | 10,668 | 48,418 | 32,714 | 9,957 | 42,671 |\n| Less: allowance for loan losses | (839 | ) | (61 | ) | (900 | ) | (889 | ) | (53 | ) | (942 | ) |\n| GM Financial receivables, net | $ | 36,911 | $ | 10,607 | $ | 47,518 | $ | 31,825 | $ | 9,904 | $ | 41,729 |\n| Fair value of GM Financial receivables utilizing Level 2 inputs | $ | 10,607 | $ | 9,904 |\n| Fair value of GM Financial receivables utilizing Level 3 inputs | $ | 36,551 | $ | 31,831 |\n\n| Three Months Ended | Nine Months Ended |\n| September 30, 2018 | September 30, 2017 | September 30, 2018 | September 30, 2017 |\n| Allowance for loan losses at beginning of period | $ | 873 | $ | 893 | $ | 942 | $ | 805 |\n| Provision for loan losses | 180 | 204 | 444 | 573 |\n| Charge-offs | (285 | ) | (287 | ) | (878 | ) | (858 | ) |\n| Recoveries | 130 | 135 | 398 | 420 |\n| Effect of foreign currency | 2 | 3 | (6 | ) | 8 |\n| Allowance for loan losses at end of period | $ | 900 | $ | 948 | $ | 900 | $ | 948 |\n\nThe allowance for loan losses on retail and commercial finance receivables included a collective allowance of $575 million and $611 million and a specific allowance of $325 million and $331 million at September 30, 2018 and December 31, 2017.\nRetail Finance Receivables We use proprietary scoring systems in the underwriting process that measure the credit quality of retail finance receivables using several factors, such as credit bureau information, consumer credit risk scores (e.g. FICO score or its equivalent) and contract characteristics. We also consider other factors such as employment history, financial stability and capacity to pay. Subsequent to origination we review the credit quality of retail finance receivables based on customer payment activity. At September 30, 2018 and December 31, 2017, 27% and 33% of retail finance receivables were from consumers with sub-prime credit scores, which are defined as FICO or equivalent scores of less than 620 at the time of loan origination.\nAn account is considered delinquent if a substantial portion of a scheduled payment has not been received by the date the payment was contractually due. The accrual of finance charge income had been suspended on delinquent retail finance receivables with contractual amounts due of $847 million and $778 million at September 30, 2018 and December 31, 2017. The following table summarizes the contractual amount of delinquent retail finance receivables, which is not significantly different than the recorded investment of the retail finance receivables:\n| September 30, 2018 | September 30, 2017 |\n| Amount | Percent of Contractual Amount Due | Amount | Percent of Contractual Amount Due |\n| 31-to-60 days delinquent | $ | 1,302 | 3.5 | % | $ | 1,176 | 3.6 | % |\n| Greater-than-60 days delinquent | 498 | 1.3 | % | 521 | 1.6 | % |\n| Total finance receivables more than 30 days delinquent | 1,800 | 4.8 | % | 1,697 | 5.2 | % |\n| In repossession | 53 | 0.1 | % | 55 | 0.2 | % |\n| Total finance receivables more than 30 days delinquent or in repossession | $ | 1,853 | 4.9 | % | $ | 1,752 | 5.4 | % |\n\n12\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\nRetail finance receivables classified as troubled debt restructurings and individually evaluated for impairment were $2.3 billion and $2.2 billion and the allowance for loan losses included $317 million and $328 million of specific allowances on these receivables at September 30, 2018 and December 31, 2017.\nCommercial Finance Receivables Our commercial finance receivables consist of dealer financings, primarily for inventory purchases. Proprietary models are used to assign a risk rating to each dealer. We perform periodic credit reviews of each dealership and adjust the dealership's risk rating, if necessary. Dealers in Group VI are subject to additional restrictions on funding, including suspension of lines of credit and liquidation of assets. The commercial finance receivables on non-accrual status were insignificant at September 30, 2018 and December 31, 2017. The following table summarizes the credit risk profile by dealer risk rating of the commercial finance receivables:\n| September 30, 2018 | December 31, 2017 |\n| Group I | – Dealers with superior financial metrics | $ | 2,077 | $ | 1,915 |\n| Group II | – Dealers with strong financial metrics | 3,905 | 3,465 |\n| Group III | – Dealers with fair financial metrics | 3,197 | 3,239 |\n| Group IV | – Dealers with weak financial metrics | 960 | 997 |\n| Group V | – Dealers warranting special mention due to elevated risks | 422 | 260 |\n| Group VI | – Dealers with loans classified as substandard, doubtful or impaired | 107 | 81 |\n| $ | 10,668 | $ | 9,957 |\n\nTransactions with GM Financial The following table shows transactions between our Automotive segments and GM Financial. These amounts are shown in GM Financial's condensed consolidated balance sheets and statements of income. All balance sheet amounts in the table below are eliminated. Income statement amounts may not fully eliminate due to timing.\n| September 30, 2018 | December 31, 2017 |\n| Condensed Consolidated Balance Sheets |\n| Commercial finance receivables, net due from GM consolidated dealers | $ | 437 | $ | 355 |\n| Direct-financing lease receivables from GM subsidiaries | $ | 125 | $ | 88 |\n| Subvention receivable(a) | $ | 735 | $ | 306 |\n| Commercial loan funding payable | $ | 86 | $ | 90 |\n\n| Three Months Ended | Nine Months Ended |\n| September 30, 2018 | September 30, 2017 | September 30, 2018 | September 30, 2017 |\n| Condensed Consolidated Statements of Income |\n| Interest subvention earned on finance receivables | $ | 142 | $ | 129 | $ | 409 | $ | 361 |\n| Leased vehicle subvention earned | $ | 827 | $ | 786 | $ | 2,438 | $ | 2,246 |\n\n__________\n| (a) | Cash paid by Automotive segments to GM Financial for subvention was $1.1 billion for the three months ended September 30, 2018 and 2017 and $2.8 billion and $3.3 billion for the nine months ended September 30, 2018 and 2017. |\n\nGM Financial’s Board of Directors declared a $375 million dividend on its common stock on October 26, 2018, which we received on October 30, 2018.\nNote 6. Inventories\n| September 30, 2018 | December 31, 2017 |\n| Total productive material, supplies and work in process | $ | 4,634 | $ | 4,203 |\n| Finished product, including service parts | 6,700 | 6,460 |\n| Total inventories | $ | 11,334 | $ | 10,663 |\n\nNote 7. Equipment on Operating Leases\n13\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\nEquipment on operating leases consists of leases to retail customers that are recorded as operating leases and vehicle sales to daily rental car companies with an actual or expected repurchase obligation.\n| September 30, 2018 | December 31, 2017 |\n| Equipment on operating leases | $ | 55,840 | $ | 53,947 |\n| Less: accumulated depreciation | (11,238 | ) | (9,959 | ) |\n| Equipment on operating leases, net(a) | $ | 44,602 | $ | 43,988 |\n\n__________\n| (a) | Includes $44.1 billion and $42.9 billion of GM Financial Equipment on operating leases, net at September 30, 2018 and December 31, 2017. |\n\nDepreciation expense related to Equipment on operating leases, net was $1.9 billion and $1.8 billion in the three months ended September 30, 2018 and 2017 and $5.6 billion and $4.9 billion in the nine months ended September 30, 2018 and 2017.\nThe following table summarizes minimum rental payments due to GM Financial on leases to retail customers:\n| Year Ending December 31, |\n| 2018 | 2019 | 2020 | 2021 | 2022 | Thereafter | Total |\n| Minimum rental receipts under operating leases | $ | 1,882 | $ | 6,260 | $ | 3,570 | $ | 1,077 | $ | 97 | $ | 6 | $ | 12,892 |\n\n| Three Months Ended | Nine Months Ended |\n| September 30, 2018 | September 30, 2017 | September 30, 2018 | September 30, 2017 |\n| Automotive China equity income | $ | 485 | $ | 459 | $ | 1,674 | $ | 1,472 |\n| Other joint ventures equity income | 45 | 41 | 141 | 113 |\n| Total Equity income | $ | 530 | $ | 500 | $ | 1,815 | $ | 1,585 |\n\nThere have been no significant ownership changes in our Automotive China joint ventures (Automotive China JVs) since December 31, 2017.\n| Three Months Ended | Nine Months Ended |\n| September 30, 2018 | September 30, 2017 | September 30, 2018 | September 30, 2017 |\n| Summarized Operating Data of Automotive China JVs |\n| Automotive China JVs' net sales | $ | 11,461 | $ | 12,161 | $ | 37,781 | $ | 34,177 |\n| Automotive China JVs' net income | $ | 999 | $ | 964 | $ | 3,370 | $ | 2,912 |\n\nDividends received from our nonconsolidated affiliates were insignificant and $382 million in the three months ended September 30, 2018 and 2017 and $2.0 billion in the nine months ended September 30, 2018 and 2017. We had undistributed earnings of $2.0 billion and $2.2 billion related to our nonconsolidated affiliates at September 30, 2018 and December 31, 2017.\nNote 9. Variable Interest Entities\nGM Financial uses special purpose entities (SPEs) that are considered VIEs to issue variable funding notes to third party bank-sponsored warehouse facilities or asset-backed securities to investors in securitization transactions. The debt issued by these VIEs is backed by finance receivables and leasing related assets transferred to the VIEs (Securitized Assets). GM Financial determined that it is the primary beneficiary of the SPEs because the servicing responsibilities for the Securitized Assets give GM Financial the power to direct the activities that most significantly impact the performance of the VIEs and the variable interests in the VIEs give GM Financial the obligation to absorb losses and the right to receive residual returns that could potentially be significant. The assets serve as the sole source of repayment for the debt issued by these entities. Investors in the notes issued by the VIEs do not have recourse to GM Financial or its other assets, with the exception of customary representation and warranty repurchase provisions and indemnities that GM Financial provides as the servicer. GM Financial is not required and does not currently intend to provide additional financial support to these SPEs. While these subsidiaries are included in GM Financial's condensed consolidated financial statements, they are separate legal entities and their assets are legally owned by them and are not available to GM Financial's creditors.\n14\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\nThe following table summarizes the assets and liabilities related to GM Financial's consolidated VIEs:\n| September 30, 2018 | December 31, 2017 |\n| Restricted cash – current | $ | 1,733 | $ | 1,740 |\n| Restricted cash – non-current | $ | 487 | $ | 527 |\n| GM Financial receivables, net of fees – current | $ | 16,502 | $ | 15,141 |\n| GM Financial receivables, net of fees – non-current | $ | 13,080 | $ | 12,944 |\n| GM Financial equipment on operating leases, net | $ | 21,252 | $ | 22,222 |\n| GM Financial short-term debt and current portion of long-term debt | $ | 19,086 | $ | 18,972 |\n| GM Financial long-term debt | $ | 20,392 | $ | 20,356 |\n\nGM Financial recognizes finance charge, leased vehicle and fee income on the Securitized Assets and interest expense on the secured debt issued in a securitization transaction and records a provision for loan losses to recognize probable loan losses inherent in the finance receivables.\n| September 30, 2018 | December 31, 2017 |\n| Carrying Amount | Fair Value | Carrying Amount | Fair Value |\n| Total automotive debt | $ | 15,963 | $ | 16,352 | $ | 13,502 | $ | 15,088 |\n| Fair value utilizing Level 1 inputs | $ | 13,971 | $ | 13,202 |\n| Fair value utilizing Level 2 inputs | $ | 2,381 | $ | 1,886 |\n\nIn April 2018 we amended and restated our two existing revolving credit facilities and entered into a third facility, increasing our aggregate borrowing capacity from $14.5 billion to $16.5 billion. These facilities consist of a 364-day, $2.0 billion facility, a three-year, $4.0 billion facility and a five-year, $10.5 billion facility. The facilities are available to us as well as certain wholly- owned subsidiaries, including GM Financial. The three-year, $4.0 billion facility allows for borrowings in U.S. Dollars and other currencies and includes a letter of credit sub-facility of $1.1 billion. The five-year, $10.5 billion facility allows for borrowings in U.S. Dollars and other currencies. The 364-day, $2.0 billion facility allows for borrowing in U.S. Dollars only. We have allocated the 364-day, $2.0 billion facility for exclusive use by GM Financial.\nIn September 2018 we issued $2.1 billion in aggregate principal amount of senior unsecured notes with an initial weighted average interest rate of 5.03% and maturity dates ranging from 2021 to 2049. The notes are governed by the same indenture that was used in past issuances, which contains terms and covenants customary of these types of securities including limitation on the amount of certain secured debt we may incur. The net proceeds from the issuance of these senior unsecured notes were used to repay $1.5 billion of debt in October 2018 upon maturity, pre-fund $584 million in certain mandatory contributions for our U.K. and Canada pension plans due in 2019 through 2021, and for other general corporate purposes.\n| September 30, 2018 | December 31, 2017 |\n| Carrying Amount | Fair Value | Carrying Amount | Fair Value |\n| Secured debt | $ | 39,722 | $ | 39,679 | $ | 39,887 | $ | 39,948 |\n| Unsecured debt | 46,655 | 47,062 | 40,830 | 41,989 |\n| Total GM Financial debt | $ | 86,377 | $ | 86,741 | $ | 80,717 | $ | 81,937 |\n| Fair value utilizing Level 2 inputs | $ | 84,693 | $ | 79,623 |\n| Fair value utilizing Level 3 inputs | $ | 2,048 | $ | 2,314 |\n\nSecured debt consists of revolving credit facilities and securitization notes payable. Most of the secured debt was issued by VIEs and is repayable only from proceeds related to the underlying pledged assets. Refer to Note 9 for additional information on GM Financial's involvement with VIEs. In the nine months ended September 30, 2018 GM Financial entered into new or renewed\n15\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\ncredit facilities with a total net additional borrowing capacity of $345 million, which had substantially the same terms as existing debt and GM Financial issued $16.3 billion in aggregate principal amount of securitization notes payable with an initial weighted average interest rate of 2.89% and maturity dates ranging from 2022 to 2026.\nUnsecured debt consists of senior notes, credit facilities and other unsecured debt. In the nine months ended September 30, 2018 GM Financial issued $7.2 billion in aggregate principal amount of senior notes with an initial weighted average interest rate of 3.17% and maturity dates ranging from 2020 to 2028.\nDuring the nine months ended September 30, 2018, GM Financial launched an unsecured commercial paper notes program in the U.S. At September 30, 2018, the principal amount outstanding of GM Financial's commercial paper in the U.S. was $1.5 billion.\nEach of the revolving credit facilities and the indentures governing GM Financial's notes contain terms and covenants including limitations on GM Financial's ability to incur certain liens.\nNote 11. Derivative Financial Instruments\nAutomotive The following table presents the notional amounts of derivative financial instruments in our automotive operations:\n| Fair Value Level | September 30, 2018 | December 31, 2017 |\n| Derivatives not designated as hedges(a) |\n| Foreign currency | 2 | $ | 2,970 | $ | 4,022 |\n| Commodity | 2 | 636 | 606 |\n| PSA warrants(b) | 2 | 46 | 48 |\n| Total derivative financial instruments | $ | 3,652 | $ | 4,676 |\n\n__________\n| (a) | The fair value of these derivative instruments at September 30, 2018 and December 31, 2017 and the gains/losses included in our condensed consolidated income statements for the three and nine months ended September 30, 2018 and 2017 were insignificant, unless otherwise noted. |\n\n| (b) | The fair value of the PSA warrants located in Other assets was $1.1 billion and $764 million at September 30, 2018 and December 31, 2017. We recorded gains in Interest income and other non-operating income, net of $171 million and an insignificant amount in the three months ended September 30, 2018 and 2017 and $324 million and an insignificant amount in the nine months ended September 30, 2018 and 2017. |\n\nWe estimate the fair value of the PSA warrants using a Black-Scholes formula. The significant inputs to the model include the PSA stock price and the estimated dividend yield. The estimated dividend yield is adjusted based on the terms of the Master Agreement with PSA Group dated March 5, 2017 (the Agreement). Refer to Exhibit 2.1 of our 2017 Form 10-K for additional details. Under the terms of the Agreement upon exercise of the warrants we are entitled to receive any dividends by PSA between the issuance date and the conversion date.\nGM Financial The following table presents the notional amounts of GM Financial's derivative financial instruments:\n| Fair Value Level | September 30, 2018 | December 31, 2017 |\n| Derivatives designated as hedges(a) |\n| Fair value hedges – interest rate contracts(b)(c) | 2 | $ | 10,510 | $ | 11,110 |\n| Cash flow hedges |\n| Interest rate contracts | 2 | 905 | 2,177 |\n| Foreign currency | 2 | 2,108 | 1,574 |\n| Derivatives not designated as hedges(a) |\n| Interest rate contracts(c)(d) | 2 | 93,162 | 81,938 |\n| Foreign currency | 2 | 1,858 | 1,201 |\n| Total derivative financial instruments | $ | 108,543 | $ | 98,000 |\n\n__________\n| (a) | The fair value of these derivative instruments at September 30, 2018 and December 31, 2017 and the gains/losses included in our condensed consolidated income statements and statements of comprehensive income for the three and nine months ended September 30, 2018 and 2017 were insignificant, unless otherwise noted. |\n\n16\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\n| (b) | The fair value of these derivative instruments located in Other liabilities was $510 million and $290 million at September 30, 2018 and December 31, 2017. The fair value of these derivative instruments located in Other assets was insignificant at September 30, 2018 and December 31, 2017. |\n\n| (c) | Amounts accrued for interest payments in a net receivable position are included in Other assets. Amounts accrued for interest payments in a net payable position are included in Other liabilities. |\n\n| (d) | The fair value of these derivative instruments located in Other assets was $551 million and $329 million at September 30, 2018 and December 31, 2017. The fair value of these derivative instruments located in Other liabilities was $670 million and $207 million at September 30, 2018 and December 31, 2017. |\n\nThe fair value for Level 2 instruments was derived using the market approach based on observable market inputs including quoted prices of similar instruments and foreign exchange and interest rate forward curves.\nThe following amounts were recorded in the condensed consolidated balance sheet related to items designated and qualifying as hedged items in fair value hedging relationships:\n| September 30, 2018 |\n| Carrying Amount of Hedged Items | Cumulative Amount of Fair Value Hedging Adjustments(a) |\n| GM Financial long-term debt | $ | 15,363 | $ | 735 |\n\n__________\n| (a) | Includes $178 million of adjustments remaining on hedged items for which hedge accounting has been discontinued. |\n\n| Three Months Ended | Nine Months Ended |\n| September 30, 2018 | September 30, 2017 | September 30, 2018 | September 30, 2017 |\n| Warranty balance at beginning of period | $ | 7,990 | $ | 8,890 | $ | 8,332 | $ | 9,069 |\n| Warranties issued and assumed in period – recall campaigns | 101 | 173 | 515 | 527 |\n| Warranties issued and assumed in period – product warranty | 542 | 481 | 1,599 | 1,586 |\n| Payments | (723 | ) | (787 | ) | (2,175 | ) | (2,382 | ) |\n| Adjustments to pre-existing warranties | (209 | ) | (317 | ) | (426 | ) | (405 | ) |\n| Effect of foreign currency and other | (8 | ) | 39 | (152 | ) | 84 |\n| Warranty balance at end of period | $ | 7,693 | $ | 8,479 | $ | 7,693 | $ | 8,479 |\n\nWe estimate our reasonably possible loss in excess of amounts accrued for recall campaigns to be insignificant at September 30, 2018. Refer to Note 14 for reasonably possible losses on Takata Corporation (Takata) matters.\nNote 13. Pensions and Other Postretirement Benefits\n| Three Months Ended September 30, 2018 | Three Months Ended September 30, 2017 |\n| Pension Benefits | Global OPEB Plans | Pension Benefits | Global OPEB Plans |\n| U.S. | Non-U.S. | U.S. | Non-U.S. |\n| Service cost | $ | 83 | $ | 33 | $ | 5 | $ | 79 | $ | 45 | $ | 4 |\n| Interest cost | 513 | 112 | 49 | 536 | 115 | 51 |\n| Expected return on plan assets | (972 | ) | (201 | ) | — | (919 | ) | (185 | ) | — |\n| Amortization of prior service cost (credit) | (1 | ) | 1 | (4 | ) | (1 | ) | 2 | (3 | ) |\n| Amortization of net actuarial (gains) losses | 2 | 35 | 14 | (2 | ) | 29 | 8 |\n| Curtailments, settlements and other | — | 18 | — | — | — | — |\n| Net periodic pension and OPEB (income) expense | $ | (375 | ) | $ | (2 | ) | $ | 64 | $ | (307 | ) | $ | 6 | $ | 60 |\n\n17\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\n| Nine Months Ended September 30, 2018 | Nine Months Ended September 30, 2017 |\n| Pension Benefits | Global OPEB Plans | Pension Benefits | Global OPEB Plans |\n| U.S. | Non-U.S. | U.S. | Non-U.S. |\n| Service cost | $ | 248 | $ | 138 | $ | 15 | $ | 237 | $ | 131 | $ | 14 |\n| Interest cost | 1,538 | 349 | 147 | 1,608 | 366 | 149 |\n| Expected return on plan assets | (2,917 | ) | (621 | ) | — | (2,757 | ) | (528 | ) | — |\n| Amortization of prior service cost (credit) | (3 | ) | 3 | (11 | ) | (3 | ) | 4 | (10 | ) |\n| Amortization of net actuarial (gains) losses | 7 | 109 | 40 | (5 | ) | 124 | 24 |\n| Curtailments, settlements and other | — | 18 | — | — | — | — |\n| Net periodic pension and OPEB (income) expense | $ | (1,127 | ) | $ | (4 | ) | $ | 191 | $ | (920 | ) | $ | 97 | $ | 177 |\n\nThe non-service cost components of the net periodic pension and OPEB income of $401 million and $369 million in the three months ended September 30, 2018 and 2017 and $1.2 billion and $1.0 billion in the nine months ended September 30, 2018 and 2017 are presented in Interest income and other non-operating income, net. We used the practical expedient for retrospective presentation of the 2017 non-service cost components in this disclosure. Refer to Note 1 for additional details on the adoption of ASU 2017-07.\nWe expect to contribute approximately $1.6 billion to our non-U.S. pension plans in 2018, inclusive of $584 million in contributions to pre-fund U.K. and Canada pension plans in the three months ended September 30, 2018 and approximately $300 million in payments of pension obligations for separated employees in Korea. Refer to Note 16 for additional information on the Korea payments.\nNote 14. Commitments and Contingencies\nLitigation-Related Liability and Tax Administrative Matters In the normal course of our business, we are named from time to time as a defendant in various legal actions, including arbitrations, class actions and other litigation. We identify below the material individual proceedings and investigations where we believe a material loss is reasonably possible or probable. We accrue for matters when we believe that losses are probable and can be reasonably estimated. At September 30, 2018 and December 31, 2017 we had accruals of $1.4 billion and $930 million in Accrued liabilities and Other liabilities. The increase is due primarily to matters related to the ignition switch recall. In many matters, it is inherently difficult to determine whether loss is probable or reasonably possible or to estimate the size or range of the possible loss. Accordingly adverse outcomes from such proceedings could exceed the amounts accrued by an amount that could be material to our results of operations or cash flows in any particular reporting period.\nProceedings Related to Ignition Switch Recall and Other Recalls In 2014 we announced various recalls relating to safety and other matters. Those recalls included recalls to repair ignition switches that could under certain circumstances unintentionally move from the “run” position to the “accessory” or “off” position with a corresponding loss of power, which could in turn prevent airbags from deploying in the event of a crash.\nEconomic-Loss Claims We are aware of over 100 putative class actions pending against GM in U.S. and Canadian courts alleging that consumers who purchased or leased vehicles manufactured by GM or Motors Liquidation Company (formerly known as General Motors Corporation) had been economically harmed by one or more of the 2014 recalls and/or the underlying vehicle conditions associated with those recalls (economic-loss cases). In general, these economic-loss cases seek recovery for purported compensatory damages, such as alleged benefit-of-the-bargain damages or damages related to alleged diminution in value of the vehicles, as well as punitive damages, injunctive relief and other relief.\nMany of the pending U.S. economic-loss claims have been transferred to, and consolidated in, a single federal court, the U.S. District Court for the Southern District of New York (Southern District). These plaintiffs have asserted economic-loss claims under federal and state laws, including claims relating to recalled vehicles manufactured by GM and claims asserting successor liability relating to certain recalled vehicles manufactured by Motors Liquidation Company. The Southern District has dismissed various of these claims, including claims under the Racketeer Influenced and Corrupt Organization Act, claims for recovery for alleged reduction in the value of plaintiffs' vehicles due to damage to GM’s reputation and brand as a result of the ignition switch matter, and claims of certain plaintiffs who purchased a vehicle before GM came into existence in July 2009. The Southern District also dismissed certain state law claims at issue.\n18\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\nIn August 2017 the Southern District granted our motion to dismiss the successor liability claims of plaintiffs in seven of the sixteen states at issue on the motion and called for additional briefing to decide whether plaintiffs' claims can proceed in the other nine states. In December 2017 the Southern District granted GM's motion and dismissed successor liability claims of plaintiffs in an additional state, but found that there are genuine issues of material fact that prevent summary judgment for GM in eight other states. In January 2018, GM moved for reconsideration of certain portions of the Southern District's December 2017 summary judgment ruling. That motion was granted in April 2018, dismissing plaintiffs' successor liability claims in any state where New York law applies.\nIn September 2018 the Southern District granted our motion to dismiss claims for lost personal time (in 41 out of 47 jurisdictions) and certain unjust enrichment claims, but denied our motion to dismiss plaintiffs’ economic loss claims in 27 jurisdictions. Significant summary judgment, class certification, and expert evidentiary motions remain at issue.\nPersonal Injury Claims We also are aware of several hundred actions pending in various courts in the U.S. and Canada alleging injury or death as a result of defects that may be the subject of the 2014 recalls (personal injury cases). In general, these cases seek recovery for purported compensatory damages, punitive damages and/or other relief. Since 2016, several bellwether trials of personal injury cases have taken place in the Southern District and in a Texas state court, which is administering a Texas state multi-district litigation (MDL). None of these trials resulted in a finding of liability against GM. We are currently preparing for two additional bellwether trials in the MDL pending in the Southern District.\nAppellate Litigation Regarding Successor Liability Ignition Switch Claims In 2016, the United States Court of Appeals for the Second Circuit held that the 2009 order of the U.S. Bankruptcy Court for the Southern District of New York (Bankruptcy Court) approving the sale of substantially all of the assets of Motors Liquidation Company to GM free and clear of, among other things, claims asserting successor liability for obligations owed by Motors Liquidation Company (successor liability claims) could not be enforced to bar claims against GM asserted by either plaintiffs who purchased used vehicles after the sale or against purchasers who asserted claims relating to the ignition switch defect, including pre-sale personal injury claims and economic-loss claims.\nContingently Issuable Shares Under the Amended and Restated Master Sale and Purchase Agreement between us and Motors Liquidation Company GM may be obligated to issue additional shares (Adjustment Shares) of our common stock if allowed general unsecured claims against the Motors Liquidation Company GUC Trust (GUC Trust), as estimated by the Bankruptcy Court, exceed $35.0 billion. The maximum number of Adjustment Shares issuable is 30 million shares (subject to adjustment to take into account stock dividends, stock splits and other transactions), which amounts to approximately $1.0 billion based on the GM share price as of October 12, 2018. The GUC Trust stated in public filings that allowed general unsecured claims were approximately $31.9 billion as of June 30, 2018. In 2016 and 2017 certain personal injury and economic loss plaintiffs filed motions in the Bankruptcy Court seeking authority to file late claims against the GUC Trust. In May 2018, the GUC Trust filed motions seeking the Bankruptcy Court’s approval of a proposed settlement with certain personal injury and economic loss plaintiffs, approval of a notice relating to that proposed settlement and estimation of alleged personal injury and economic loss late claims for the purpose of obtaining an order requiring GM to issue the maximum number of Adjustment Shares. GM vigorously contested each of these motions.\nIn September 2018 the Bankruptcy Court denied without prejudice the GUC Trust’s motions described above, finding that the settling parties first need to obtain class certification with respect to the economic loss late claims. The GUC Trust and certain plaintiffs may again attempt to obtain the maximum number of Adjustment Shares through another proposed settlement. We are unable to estimate any reasonably possible loss or range of loss that may result from this matter.\nSecurities and Derivative Matters In a putative shareholder class action filed in the United States District Court for the Eastern District of Michigan (Eastern District) on behalf of purchasers of our common stock from November 17, 2010 to July 24, 2014, the lead plaintiff alleged that GM and several current and former officers and employees made material misstatements and omissions relating to problems with the ignition switch and other matters in SEC filings and other public statements. In 2016 the Eastern District entered a judgment approving a class-wide settlement of the class action for $300 million. One shareholder filed an appeal of the decision approving the settlement. The United States Court of Appeals for the Sixth Circuit affirmed the judgment approving the settlement in November 2017. The objector subsequently filed petitions for rehearing and for en banc review before the entire Sixth Circuit. Both of those petitions were denied. The U.S. Supreme Court subsequently denied the objector's petition seeking appellate review.\nGovernment Matters In connection with the 2014 recalls, we have from time to time received subpoenas and other requests for information related to investigations by agencies or other representatives of U.S. federal, state and the Canadian governments. In March 2018, we conclusively resolved a civil action initiated by the Arizona Attorney General. GM is cooperating with all reasonable\n19\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\npending requests for information. Any existing governmental matters or investigations could in the future result in the imposition of damages, fines, civil consent orders, civil and criminal penalties or other remedies.\nDeferred Prosecution Agreement In September 2015, GM entered into the Deferred Prosecution Agreement (DPA) with the U.S. Attorney's Office of the Southern District of New York (U.S. Attorney's Office) regarding its investigation of the events leading up to certain recalls regarding faulty ignition switches.\nPursuant to the DPA we paid the United States $900 million as a financial penalty, and we agreed to retain an independent monitor to review and assess our policies, practices or procedures related to statements about motor vehicle safety, the provision of information to those responsible for recall decisions, recall processes and addressing known defects in certified pre-owned vehicles. In September 2018, the monitor completed his three-year term and the U.S. Attorney's Office filed a motion with the Southern District, seeking dismissal with prejudice of the two-count information. The Southern District granted the motion on September 19, 2018, dismissing the charges with prejudice.\nThe total amount accrued for the 2014 recalls at September 30, 2018 reflects amounts for a combination of settled but unpaid matters, and for the remaining unsettled investigations, claims and/or lawsuits relating to the ignition switch recalls and other related recalls to the extent that such matters are probable and can be reasonably estimated. The amounts accrued for those unsettled investigations, claims, and/or lawsuits represent a combination of our best single point estimates where determinable and, where no such single point estimate is determinable, our estimate of the low end of the range of probable loss with regard to such matters, if that is determinable. We believe it is probable that we will incur additional liabilities beyond what has already been accrued for at least a portion of the remaining matters, whether through settlement or judgment; however, we are currently unable to estimate an overall amount or range of loss because these matters involve significant uncertainties, including the legal theory or the nature of the investigations, claims and/or lawsuits, the complexity of the facts, the lack of documentation available to us with respect to particular cases or groups of cases, the results of any investigation or litigation and the timing of resolution of the investigation or litigations, including any appeals. We will continue to consider resolution of pending matters involving ignition switch recalls and other recalls where it makes sense to do so.\nGM Korea Wage Litigation GM Korea is party to litigation with current and former hourly employees in the appellate court and Incheon District Court in Incheon, Korea. The group actions, which in the aggregate involve more than 10,000 employees, allege that GM Korea failed to include bonuses and certain allowances in its calculation of Ordinary Wages due under Korean regulations. In 2012 the Seoul High Court (an intermediate level appellate court) affirmed a decision in one of these group actions involving five GM Korea employees which was contrary to GM Korea's position. GM Korea appealed to the Supreme Court of the Republic of Korea (Supreme Court). In 2014, the Supreme Court largely agreed with GM’s legal arguments and remanded the case to the Seoul High Court for consideration consistent with earlier Supreme Court precedent holding that while fixed bonuses should be included in the calculation of Ordinary Wages, claims for retroactive application of this rule would be barred under certain circumstances. In 2015, on reconsideration, the Seoul High Court held in GM Korea’s favor, after which the plaintiffs appealed to the Supreme Court. The Supreme Court has not yet rendered a decision. We estimate our reasonably possible loss in excess of amounts accrued to be approximately $580 million at September 30, 2018. Both the scope of claims asserted and GM Korea's assessment of any or all of the individual claim elements may change if new information becomes available or the legal or regulatory framework change.\nGM Korea is also party to litigation with current and former salaried employees over allegations relating to ordinary wages regulation and whether to include fixed bonuses in the calculation of ordinary wages. In 2017, the Seoul High Court held that certain workers are not barred from filing retroactive wage claims. GM Korea appealed this ruling to the Supreme Court. The Supreme Court has not yet rendered a decision. We estimate our reasonably possible loss in excess of amounts accrued to be approximately $160 million at September 30, 2018. Both the scope of claims asserted and GM Korea's assessment of any or all of the individual claim elements may change if new information becomes available or the legal or regulatory framework change.\nGM Korea is also party to litigation with current and former subcontract workers over allegations that they are entitled to the same wages and benefits provided to full-time employees, and to be hired as full-time employees. In May 2018 the Korean government issued an adverse ruling finding that GM Korea must hire certain current subcontract workers as full-time employees. GM Korea intends to appeal that decision. At September 30, 2018, we recorded an insignificant accrual covering certain asserted claims and claims that we believe are probable of assertion and for which liability is probable. We estimate that the reasonably possible loss in excess of amounts accrued for other current subcontract workers who may assert similar claims to be approximately $150 million at September 30, 2018. We are currently unable to estimate any possible loss or range of loss that may result from additional claims that may be asserted by former subcontract workers.\n20\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\nGM Brazil Indirect Tax Claim In March 2017 the Supreme Court of Brazil issued a decision concluding that a certain state value added tax should not be included in the calculation of federal gross receipts taxes. The decision reduces GM Brazil’s gross receipts tax prospectively and, potentially, retrospectively. The retrospective right to recover is under judicial review, and a decision for part of the claim could be rendered as soon as the end of 2018. If the Judicial Court grants retrospective recovery, we estimate potential recoveries of up to $1.2 billion. However, given the remaining uncertainty regarding the judicial resolution of this matter we are unable to assess the likelihood of any favorable outcome at this time. We have not recorded any amounts relating to the retrospective nature of this matter.\nOther Litigation-Related Liability and Tax Administrative Matters Various other legal actions, including class actions, governmental investigations, claims and proceedings are pending against us or our related companies or joint ventures, including matters arising out of alleged product defects; employment-related matters; product and workplace safety, vehicle emissions, including CO2 and nitrogen oxide, fuel economy, and related governmental regulations; product warranties; financial services; dealer, supplier and other contractual relationships; government regulations relating to payments to foreign companies; government regulations relating to competition issues; tax-related matters not subject to the provision of ASC 740, Income Taxes (indirect tax-related matters); product design, manufacture and performance; consumer protection laws; and environmental protection laws, including laws regulating air emissions, water discharges, waste management and environmental remediation.\nThere are several putative class actions pending against GM in federal courts in the U.S. and in the Provincial Courts in Canada alleging that various vehicles sold including model year 2011-2016 Duramax Diesel Chevrolet Silverado and GMC Sierra vehicles, violate federal and state emission standards. GM has also faced a series of additional lawsuits based primarily on allegations in the Duramax suit, including putative shareholder class actions claiming violations of federal securities law and a shareholder demand lawsuit. The securities lawsuits have been voluntarily dismissed. At this stage of these proceedings, we are unable to provide an evaluation of the likelihood that a loss will be incurred or an estimate of the amounts or range of possible loss.\nWe believe that appropriate accruals have been established for losses that are probable and can be reasonably estimated. It is possible that the resolution of one or more of these matters could exceed the amounts accrued in an amount that could be material to our results of operations. We also from time to time receive subpoenas and other inquiries or requests for information from agencies or other representatives of U.S. federal, state and foreign governments on a variety of issues.\nIndirect tax-related matters are being litigated globally pertaining to value added taxes, customs, duties, sales, property taxes and other non-income tax related tax exposures. The various non-U.S. labor-related matters include claims from current and former employees related to alleged unpaid wage, benefit, severance and other compensation matters. Certain administrative proceedings are indirect tax-related and may require that we deposit funds in escrow or provide an alternative form of security which may range from $200 million to $500 million at September 30, 2018. Some of the matters may involve compensatory, punitive or other treble damage claims, environmental remediation programs or sanctions that, if granted, could require us to pay damages or make other expenditures in amounts that could not be reasonably estimated at September 30, 2018. We believe that appropriate accruals have been established for losses that are probable and can be reasonably estimated. For indirect tax-related matters we estimate our reasonably possible loss in excess of amounts accrued to be up to approximately $900 million at September 30, 2018.\nTakata Matters In May 2016 the National Highway Traffic Safety Administration (NHTSA) issued an amended consent order requiring Takata to file defect information reports (DIRs) for previously unrecalled front airbag inflators that contain phased-stabilized ammonium nitrate-based propellant without a moisture absorbing desiccant on a multi-year, risk-based schedule through 2019 impacting tens of millions of vehicles produced by numerous automotive manufacturers. NHTSA concluded that the likely root cause of the rupturing of the airbag inflators is a function of time, temperature cycling and environmental moisture.\nAlthough we do not believe there is a safety defect at this time in any unrecalled GM vehicles within scope of the Takata DIRs, in cooperation with NHTSA we have filed Preliminary DIRs covering certain of our GMT900 vehicles, which are full-size pickup trucks and sport utility vehicles (SUVs). We have also filed petitions for inconsequentiality with respect to the vehicles subject to those Preliminary DIRs. NHTSA has consolidated our petitions and will rule on them at the same time.\nWhile these petitions have been pending, we have provided NHTSA with the results of our long-term studies and the studies performed by third-party experts, all of which form the basis for our determination that the inflators in these vehicles do not present an unreasonable risk to safety and that no repair should ultimately be required.\nWe believe these vehicles are currently performing as designed and ongoing testing continues to support the belief that the vehicles' unique design and integration mitigates against inflator propellant degradation and rupture risk. For example, the airbag inflators used in the vehicles are a variant engineered specifically for our vehicles, and include features such as greater venting,\n21\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\nunique propellant wafer configurations, and machined steel end caps. The inflators are packaged in the instrument panel in such a way as to minimize exposure to moisture from the climate control system. Also, these vehicles have features that minimize the maximum temperature to which the inflator will be exposed, such as larger interior volumes and standard solar absorbing windshields and side glass.\nAccordingly, no warranty provision has been made for any repair associated with our vehicles subject to the Preliminary DIRs and amended consent order. However, in the event we are ultimately obligated to repair the vehicles subject to current or future Takata DIRs under the amended consent order in the U.S., we estimate a reasonably possible impact to GM of approximately $1.2 billion.\nGM has recalled certain vehicles sold outside of the U.S. to replace Takata inflators in those vehicles. There are significant differences in vehicle and inflator design between the relevant vehicles sold internationally and those sold in the U.S. We continue to gather and analyze evidence about these inflators and to share our findings with regulators. Additional recalls, if any, could be material to our results of operations and cash flows. We continue to monitor the international situation.\nThrough October 15, 2018 we are aware of three putative class actions pending against GM in federal court in the U.S., one putative class action in Mexico and three putative class actions pending in various Provincial Courts in Canada arising out of allegations that airbag inflators manufactured by Takata are defective. At this early stage of these proceedings, we are unable to provide an evaluation of the likelihood that a loss will be incurred or an estimate of the amounts or range of possible loss.\nProduct Liability With respect to product liability claims (other than claims relating to the ignition switch recalls discussed above) involving our and General Motors Corporation products, we believe that any judgment against us for actual damages will be adequately covered by our recorded accruals and, where applicable, excess liability insurance coverage. In addition we indemnify dealers for certain product liability related claims including products sold by General Motors Corporation's dealers. At September 30, 2018 and December 31, 2017 liabilities of $557 million and $595 million were recorded in Accrued liabilities and Other liabilities for the expected cost of all known product liability claims plus an estimate of the expected cost for product liability claims that have already been incurred and are expected to be filed in the future for which we are self-insured. It is reasonably possible that our accruals for product liability claims may increase in future periods in material amounts, although we cannot estimate a reasonable range of incremental loss based on currently available information.\nGuarantees We enter into indemnification agreements for liability claims involving products manufactured primarily by certain joint ventures. These guarantees terminate in years ranging from 2018 to 2032 or upon the occurrence of specific events or are ongoing. We believe that the related potential costs incurred are adequately covered by our recorded accruals, which are insignificant. The maximum liability, calculated as future undiscounted payments, was $6.0 billion and $5.1 billion for these guarantees at September 30, 2018 and December 31, 2017, the majority of which relate to the indemnification agreements.\nWe provide vehicle repurchase guarantees and payment guarantees on commercial loans outstanding with third parties such as dealers. In some instances certain assets of the party whose debt or performance we have guaranteed may offset, to some degree, the amount of certain guarantees. Our payables to the party whose debt or performance we have guaranteed may also reduce the amount of certain guarantees. If vehicles are required to be repurchased under vehicle repurchase obligations, the total exposure would be reduced to the extent vehicles are able to be resold to another dealer.\nWe periodically enter into agreements that incorporate indemnification provisions in the normal course of business. It is not possible to estimate our maximum exposure under these indemnifications or guarantees due to the conditional nature of these obligations. Insignificant amounts have been recorded for such obligations as the majority of them are not probable or estimable at this time and the fair value of the guarantees at issuance was insignificant. Refer to Note 19 for additional information on our indemnification obligations to PSA Group under the Agreement.\nNote 15. Income Taxes\nFor interim income tax reporting we estimate our annual effective tax rate and apply it to our year to date ordinary income (loss). Tax jurisdictions with a projected or year to date loss for which a tax benefit cannot be realized are excluded. The tax effects of unusual or infrequently occurring items, including changes in judgment about valuation allowances and effects of changes in tax laws or rates, are reported in the interim period in which they occur. We have open tax years from 2008 to 2017 with various significant tax jurisdictions.\n22\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\nIn the three months ended September 30, 2018 Income tax expense of $100 million primarily resulted from tax expense attributable to entities included in our effective tax rate calculation, partially offset by a $157 million tax benefit from U.S. tax reform. In the three months ended September 30, 2017 Income tax expense of $2.3 billion primarily resulted from tax expense attributable to entities included in our effective tax rate calculation of $583 million including tax benefits from foreign dividends and $2.3 billion related to the establishment of a valuation allowance on deferred tax assets that will no longer be realizable as a result of the sale of the Opel/Vauxhall Business as described in Note 19, partially offset by tax benefits related to tax settlements.\nIn the nine months ended September 30, 2018 Income tax expense of $1.1 billion primarily resulted from tax expense attributable to entities included in our effective tax rate calculation, partially offset by a $157 million tax benefit from U.S. tax reform. In the nine months ended September 30, 2017 Income tax expense of $3.6 billion primarily resulted from tax expense attributable to entities included in our effective tax rate calculation of $2.1 billion including tax benefits from foreign dividends and $2.3 billion related to the establishment of a valuation allowance on deferred tax assets that will no longer be realizable as a result of the sale of the Opel/Vauxhall Business as described in Note 19, partially offset by tax benefits related to tax settlements.\nAt September 30, 2018 we had $22.4 billion of net deferred tax assets consisting of net operating losses and income tax credits, capitalized research expenditures and other timing differences that are available to offset future income tax liabilities, partially offset by valuation allowances.\nWe have $3.3 billion of net operating loss carryforwards in Germany that, as a result of reorganizations that took place in 2008 and 2009, are not currently recorded as deferred tax assets. As a result of a final European court decision in June 2018 and subject to final German statutory approval, we anticipate that these loss carryforwards may become available to reduce future taxable income in Germany. If this were to occur, deferred tax assets totaling $1.0 billion would be established for the loss carryforwards, and offsetting valuation allowances would also be established because the deferred tax assets would not meet the more likely than not realizability standard.\nThe Tax Act was signed into law on December 22, 2017. The Tax Act changed many aspects of U.S. corporate income taxation and included reduction of the corporate income tax rate from 35% to 21%, implementation of a territorial tax system and imposition of a tax on deemed repatriated earnings of foreign subsidiaries. We recognized the tax effects of the Tax Act in the three months ended December 31, 2017 and recorded $7.3 billion in tax expense. The tax expense relates almost entirely to the remeasurement of deferred tax assets to the 21% tax rate. In the three months ended September 30, 2018 we filed our 2017 U.S. federal income tax return and updated our year ended December 31, 2017 estimated tax expense of $7.3 billion to $7.1 billion, primarily related to the remeasurement of deferred tax assets to the 21% tax rate. We will continue to assess our provision for income taxes as future guidance is issued but do not anticipate significant revisions will be necessary. Any such revisions will be treated in accordance with the measurement period guidance outlined in Staff Accounting Bulletin No. 118.\nNote 16. Restructuring and Other Initiatives\nWe have executed various restructuring and other initiatives and we may execute additional initiatives in the future, if necessary, to streamline manufacturing capacity and other costs to improve the utilization of remaining facilities. To the extent these programs involve voluntary separations, no liabilities are generally recorded until offers to employees are accepted. If employees are involuntarily terminated, a liability is generally recorded at the communication date. Related charges are recorded in Automotive and other cost of sales and Automotive and other selling, general and administrative expense. The following table summarizes the reserves and charges related to restructuring and other initiatives, including postemployment benefit reserves and charges:\n| Three Months Ended | Nine Months Ended |\n| September 30, 2018 | September 30, 2017 | September 30, 2018 | September 30, 2017 |\n| Balance at beginning of period | $ | 274 | $ | 493 | $ | 227 | $ | 268 |\n| Additions, interest accretion and other | 8 | 43 | 600 | 333 |\n| Payments | (72 | ) | (75 | ) | (567 | ) | (150 | ) |\n| Revisions to estimates and effect of foreign currency | (3 | ) | (7 | ) | (53 | ) | 3 |\n| Balance at end of period | $ | 207 | $ | 454 | $ | 207 | $ | 454 |\n\nIn the nine months ended September 30, 2018 restructuring and other initiatives primarily included the closure of a facility and other restructuring actions in Korea. We recorded charges of $1.0 billion related to Korea in GMI, net of noncontrolling interests in the nine months ended September 30, 2018. These charges consisted of $537 million in non-cash asset impairments and other charges, not reflected in the table above, and $495 million in employee separation charges, which are reflected in the table above,\n23\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\nin the nine months ended September 30, 2018. We incurred $748 million in cash outflows resulting from these Korea restructuring actions primarily for employee separations and statutory pension payments in the nine months ended September 30, 2018.\nIn the nine months ended September 30, 2017 restructuring and other initiatives primarily included restructuring actions announced in the three months ended June 30, 2017 in GMI. These actions related primarily to the withdrawal of Chevrolet from the Indian and South African markets at the end of 2017 and the transition of our South Africa manufacturing operations to Isuzu Motors. We continue to manufacture vehicles in India for sale to certain export markets. We recorded charges of $460 million in GMI primarily consisting of $297 million of asset impairments, sales incentives, inventory provisions and other charges, not reflected in the table above, and $163 million of dealer restructurings, employee separations and other contract cancellation costs, which are reflected in the table above. We completed these programs in GMI in 2017. Other GMI restructuring programs reflected in the table above include separation and other programs in Australia, Korea and India and the withdrawal of the Chevrolet brand from Europe. Collectively, these programs had a total cost since inception in 2013 of $883 million through September 30, 2017 and $892 million through the completion of the programs in the year ended December 31, 2017.\nNote 17. Stockholders' Equity and Noncontrolling Interests\nWe had 2.0 billion shares of preferred stock and 5.0 billion shares of common stock authorized for issuance and 1.4 billion shares of common stock issued and outstanding at September 30, 2018 and December 31, 2017. In the nine months ended September 30, 2018 and 2017 we purchased three million and 86 million shares of our outstanding common stock for $100 million and $3.0 billion as part of the common stock repurchase program announced in March 2015, which our Board of Directors increased and extended in January 2016 and January 2017. Our total dividends paid on common stock were $537 million and $546 million in the three months ended September 30, 2018 and 2017 and $1.6 billion and $1.7 billion in the nine months ended September 30, 2018 and 2017.\nIn September 2018 GM Financial issued $500 million of Fixed-to-Floating Rate Cumulative Perpetual Preferred Stock, Series B, $0.01 par value, with a liquidation preference of $1,000 per share. The preferred stock is classified as noncontrolling interests on our condensed consolidated financial statements. Dividends will be paid semi-annually when declared starting March 30, 2019 at a fixed rate of 6.50%.\nIn September 2017 GM Financial issued $1.0 billion of Fixed-to-Floating Rate Cumulative Perpetual Preferred Stock, Series A, $0.01 par value, with a liquidation preference of $1,000 per share. The preferred stock is classified as noncontrolling interests on our condensed consolidated financial statements. Dividends are paid semi-annually when declared, which started March 30, 2018 at a fixed rate of 5.75%.\nGM Cruise Preferred Shares On May 31, 2018, we entered into a Purchase Agreement with SoftBank Vision Fund (AIV M1), L.P. (The Vision Fund). The Vision Fund subsequently assigned its rights and obligations under the Purchase Agreement to SoftBank Investment Holdings (UK) Limited (SoftBank). In June 2018, at the closing of the transactions contemplated by the Purchase Agreement, GM Cruise Holdings LLC (GM Cruise Holdings), our subsidiary, issued $900 million of convertible preferred shares (GM Cruise Preferred Shares) to SoftBank, representing 10.9% of GM Cruise Holdings' equity at closing. Immediately prior to the issuance of the GM Cruise Preferred Shares, we invested $1.1 billion in GM Cruise Holdings. When GM Cruise's autonomous vehicles are ready for commercial deployment, SoftBank is obligated to purchase additional GM Cruise Preferred Shares for $1.35 billion. All proceeds are designated exclusively for working capital and general corporate purposes of GM Cruise. Dividends are cumulative and accrue at an annual rate of 7% and are payable quarterly in cash or in-kind, at GM Cruise's discretion. The GM Cruise Preferred Shares are also entitled to participate in GM Cruise dividends above a defined threshold. Prior to an initial public offering, SoftBank is restricted from transferring the GM Cruise Preferred Shares until June 28, 2025.\nThe GM Cruise Preferred Shares are convertible into common stock of GM Cruise Holdings, at specified exchange ratios, at the option of SoftBank or upon occurrence of an initial public offering. The GM Cruise Preferred Shares are entitled to receive the greater of their carrying value or a pro-rata share of any proceeds or distributions upon the occurrence of a merger, sale, liquidation, or dissolution of GM Cruise Holdings. Beginning on June 28, 2025, SoftBank has the option to convert all of the GM Cruise Preferred Shares into our common stock at a conversion ratio that is indexed to the fair value of GM Cruise Holdings at the time of conversion. We have the option to settle the conversion feature with our common shares or cash, and in certain situations with nonredeemable, nonconvertible preferred shares. Beginning on June 28, 2025, we can call all, but not less than all of the GM Cruise Preferred Shares held by SoftBank at an amount equal to the greater of the original investment amount plus accrued distributions paid in-kind and the fair value of GM Cruise Holdings at the time of conversion. The GM Cruise Preferred Shares are classified as noncontrolling interests in our condensed consolidated financial statements.\n24\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\nGM Korea Preferred Shares In May 2018 the Korea Development Bank (KDB) agreed to purchase approximately $750 million of GM Korea’s Class B Preferred Shares from GM Korea (GM Korea Preferred Shares), $361 million of which was received in June 2018 with the remainder currently expected to be received in the three months ending December 31, 2018. Dividends on the GM Korea Preferred Shares are cumulative and accrue at an annual rate of 1%. GM Korea can call the preferred shares at their original issue price six years from the date of issuance and once called, the preferred shares can be converted into common shares of GM Korea at the option of the holder. The GM Korea Preferred Shares are classified as noncontrolling interests in our condensed consolidated financial statements. The KDB investment proceeds can only be used for purposes of funding capital expenditures in GM Korea. In conjunction with the GM Korea Preferred Share issuance we agreed to provide GM Korea future funding, if needed, not to exceed $2.8 billion through December 31, 2027, inclusive of $2.0 billion of planned capital expenditures through 2027.\nThe following table summarizes the significant components of Accumulated other comprehensive loss:\n| Three Months Ended | Nine Months Ended |\n| September 30, 2018 | September 30, 2017 | September 30, 2018 | September 30, 2017 |\n| Foreign Currency Translation Adjustments |\n| Balance at beginning of period | $ | (1,826 | ) | $ | (2,162 | ) | $ | (1,606 | ) | $ | (2,355 | ) |\n| Other comprehensive income (loss) and noncontrolling interests, net of reclassification adjustment, tax and impact of adoption of accounting standards(a)(b)(c) | (215 | ) | 370 | (435 | ) | 563 |\n| Balance at end of period | $ | (2,041 | ) | $ | (1,792 | ) | $ | (2,041 | ) | $ | (1,792 | ) |\n| Defined Benefit Plans |\n| Balance at beginning of period | $ | (6,290 | ) | $ | (7,208 | ) | $ | (6,398 | ) | $ | (6,968 | ) |\n| Other comprehensive income (loss) before reclassification adjustment, net of tax and impact of adoption of accounting standards(b)(c) | (4 | ) | 87 | 16 | (256 | ) |\n| Reclassification adjustment, net of tax(b)(d) | 63 | 1,126 | 151 | 1,229 |\n| Other comprehensive income, net of tax and impact of adoption of accounting standards(b)(c) | 59 | 1,213 | 167 | 973 |\n| Balance at end of period(e) | $ | (6,231 | ) | $ | (5,995 | ) | $ | (6,231 | ) | $ | (5,995 | ) |\n\n| (a) | The noncontrolling interests and reclassification adjustment were insignificant in the three and nine months ended September 30, 2018 and 2017. |\n\n| (b) | The income tax effect was insignificant in the three and nine months ended September 30, 2018 and 2017. |\n\n| (c) | Refer to Note 1 for additional information on adoption of accounting standards in 2018. |\n\n| (d) | $1.2 billion is included in the loss on sale of the Opel/Vauxhall Business in the three and nine months ended September 30, 2017. An insignificant amount is included in the computation of periodic pension and OPEB (income) expense in the three and nine months ended September 30, 2017. |\n\n| (e) | Consists primarily of unamortized actuarial loss on our defined benefit plans. Refer to the critical accounting estimates section of our 2017 Form 10-K for additional information. |\n\n25\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\n| Three Months Ended | Nine Months Ended |\n| September 30, 2018 | September 30, 2017 | September 30, 2018 | September 30, 2017 |\n| Basic earnings per share |\n| Income from continuing operations(a) | $ | 2,534 | $ | 115 | $ | 6,040 | $ | 5,222 |\n| Less: cumulative dividends on subsidiary preferred stock | (31 | ) | (2 | ) | (60 | ) | (2 | ) |\n| Income from continuing operations attributable to common stockholders | 2,503 | 113 | 5,980 | 5,220 |\n| Loss from discontinued operations, net of tax | — | 3,096 | 70 | 3,935 |\n| Net income (loss) attributable to common stockholders | $ | 2,503 | $ | (2,983 | ) | $ | 5,910 | $ | 1,285 |\n| Weighted-average common shares outstanding | 1,412 | 1,445 | 1,410 | 1,483 |\n| Basic earnings per common share – continuing operations | $ | 1.77 | $ | 0.08 | $ | 4.24 | $ | 3.52 |\n| Basic loss per common share – discontinued operations | $ | — | $ | 2.14 | $ | 0.05 | $ | 2.65 |\n| Basic earnings (loss) per common share | $ | 1.77 | $ | (2.06 | ) | $ | 4.19 | $ | 0.87 |\n| Diluted earnings per share |\n| Income from continuing operations attributable to common stockholders – diluted(a) | $ | 2,503 | $ | 113 | $ | 5,980 | $ | 5,220 |\n| Loss from discontinued operations, net of tax – diluted | $ | — | $ | 3,096 | $ | 70 | $ | 3,935 |\n| Net income (loss) attributable to common stockholders – diluted | $ | 2,503 | $ | (2,983 | ) | $ | 5,910 | $ | 1,285 |\n| Weighted-average common shares outstanding – basic | 1,412 | 1,445 | 1,410 | 1,483 |\n| Dilutive effect of warrants and awards under stock incentive plans | 19 | 27 | 21 | 24 |\n| Weighted-average common shares outstanding – diluted | 1,431 | 1,472 | 1,431 | 1,507 |\n| Diluted earnings per common share – continuing operations | $ | 1.75 | $ | 0.08 | $ | 4.18 | $ | 3.46 |\n| Diluted loss per common share – discontinued operations | $ | — | $ | 2.11 | $ | 0.05 | $ | 2.61 |\n| Diluted earnings (loss) per common share | $ | 1.75 | $ | (2.03 | ) | $ | 4.13 | $ | 0.85 |\n| Potentially dilutive securities(b) | 4 | 6 | 4 | 6 |\n\n__________\n| (a) | Net of Net (income) loss attributable to noncontrolling interests. |\n\n| (b) | Potentially dilutive securities attributable to outstanding stock options and Restricted Stock Units (RSUs) were excluded from the computation of diluted earnings per share (EPS) because the securities would have had an antidilutive effect. |\n\nNote 19. Discontinued Operations\nOn March 5, 2017 we entered into the Agreement to sell our European Business to PSA Group. On July 31, 2017 we closed the sale of our Opel/Vauxhall Business to PSA Group, and on October 31, 2017 we closed the sale of the Fincos to Banque PSA Finance S.A. and BNP Paribas Personal Finance S.A.\nThe net consideration paid at closing for the Opel/Vauxhall Business was $1.4 billion, consisting of (1) $1.1 billion in cash; and (2) $808 million in warrants in PSA Group; partially offset by (3) a $478 million de-risking premium payment made to PSA Group for assuming certain underfunded pension liabilities. During the three months ended September 30, 2017, our wholly owned subsidiary (the Seller) made payments to PSA Group, or one or more pension funding vehicles, of $3.4 billion with respect to net underfunded pension liabilities assumed by PSA Group, which included pension funding payments for active employees and the de-risking premium payment of $478 million. For a further description of the terms and conditions refer to Note 3 of our 2017 Form 10-K.\nThe total charge from the sale of the European Business was $6.2 billion, net of tax. During the three months ended September 30, 2017 we recognized a charge of $5.4 billion, of which $3.1 billion was recorded in Loss from discontinued operations, net of tax and $2.3 billion was recorded in Income tax expense, as a result of the sale of the Opel/Vauxhall Business. During the three months ended June 30, 2017 we recognized charges in Loss from discontinued operations, net of tax of $421 million for the cancellation of product programs resulting from the convergence of vehicle platforms between our European Business and PSA Group, a disposal loss of $324 million as a result of the Fincos being classified as held for sale and other insignificant charges.\nThe Seller agreed to indemnify PSA Group for certain losses resulting from any inaccuracy of the representations and warranties or breaches of our covenants included in the Agreement and for certain other liabilities including certain emissions and product liabilities. The Company entered into a guarantee for the benefit of PSA Group pursuant to which the Company agreed to guarantee the Seller's obligation to indemnify PSA Group. Certain of these indemnification obligations are subject to time limitations, thresholds and/or caps as to the amount of required payments. Although the sale reduced our vehicle presence in Europe, we may still be impacted by actions taken by regulators related to vehicles sold before the sale. In Germany, the Kraftfahrt-Bundesamt (KBA) recently issued an order converting Opel’s voluntary recall of certain vehicles with emission control systems into a mandatory recall for allegedly failing to comply with certain emissions regulations. In addition, at the KBA's request the German authorities recently re-opened a separate investigation that had previously been closed with no action. Opel is challenging the order of the KBA in court on the grounds that the emission control systems complied with the applicable regulations at the time the vehicles were manufactured, tested and sold.\nOpel voluntarily recalled and serviced many of these vehicles between 2017 and 2018 at its own expense, and this expense should not be transferred to the Seller because it was accounted for at the time of the sale. However, the Seller may be obligated to indemnify PSA Group for certain additional expenses resulting from the mandatory recall and related investigation, including potential litigation costs, settlements, judgments and potential fines. We are unable to estimate any reasonably possible loss or range of loss that may result from this matter.\nWe continue to purchase from and supply to PSA Group certain vehicles for a period of time following closing. Total net sales and revenue of $339 million and $1.5 billion and purchases and expenses of $297 million and $1.1 billion related to transactions with the Opel/Vauxhall Business were included in continuing operations during the three and nine months ended September 30, 2018. Cash payments of $1.5 billion and cash receipts of $1.9 billion were recorded in Net cash provided by (used in) operating activities – continuing operations related to transactions with the Opel/Vauxhall Business during the nine months ended September 30, 2018.\nThe following table summarizes the results of the European Business operations:\n26\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\n| Three Months Ended | Nine Months Ended |\n| September 30, 2018 | September 30, 2017 | September 30, 2018 | September 30, 2017 |\n| Automotive net sales and revenue | $ | — | $ | 1,553 | $ | — | $ | 11,257 |\n| GM Financial net sales and revenue | — | 147 | — | 414 |\n| Total net sales and revenue | — | 1,700 | — | 11,671 |\n| Automotive and other cost of sales | — | 1,583 | — | 11,049 |\n| GM Financial interest, operating and other expenses | — | 99 | — | 301 |\n| Automotive and other selling, general, and administrative expense | — | 134 | — | 813 |\n| Other expense items | — | 74 | — | 72 |\n| Loss from discontinued operations before taxes | — | 190 | — | 564 |\n| Loss on sale of discontinued operations before taxes(a) | — | 1,150 | 70 | 1,986 |\n| Total loss from discontinued operations before taxes | — | 1,340 | 70 | 2,550 |\n| Income tax expense(a)(b) | — | 1,756 | — | 1,385 |\n| Loss from discontinued operations, net of tax | $ | — | $ | 3,096 | $ | 70 | $ | 3,935 |\n\n__________\n| (a) | Total loss on sale of discontinued operations, net of tax was $3.1 billion and $3.7 billion for the three and nine months ended September 30, 2017. |\n\n| (b) | Includes $2.0 billion of deferred tax assets that transferred to PSA Group in the three and nine months ended September 30, 2017. |\n\nNote 20. Segment Reporting\nWe report segment information consistent with the way the chief operating decision maker evaluates the operating results and performance of the Company. As a result of the growing importance of our autonomous vehicle operations, we moved these operations from Corporate to GM Cruise and began presenting GM Cruise as a new reportable segment in the three months ended June 30, 2018. Our GMNA, GMI and GM Financial segments were not significantly impacted. All periods presented have been recast to reflect the changes.\nWe analyze the results of our business through the following segments: GMNA, GMI, GM Cruise and GM Financial. As discussed in Note 1, the European Business is presented as discontinued operations and is excluded from our segment results for all periods presented. The European Business was previously reported as our GM Europe (GME) segment and part of GM Financial. The chief operating decision maker evaluates the operating results and performance of our automotive segments and GM Cruise through earnings before interest and taxes (EBIT)-adjusted, which is presented net of noncontrolling interests. The chief operating decision maker evaluates GM Financial through earnings before income taxes-adjusted because interest income and interest expense are part of operating results when assessing and measuring the operational and financial performance of the segment. Each segment has a manager responsible for executing our strategic initiatives. While not all vehicles within a segment are individually profitable on a fully allocated cost basis, those vehicles attract customers to dealer showrooms and help maintain sales volumes for other, more profitable vehicles and contribute towards meeting required fuel efficiency standards. As a result of these and other factors, we do not manage our business on an individual brand or vehicle basis.\nSubstantially all of the cars, trucks, crossovers and automobile parts produced are marketed through retail dealers in North America and through distributors and dealers outside of North America, the substantial majority of which are independently owned. In addition to the products sold to dealers for consumer retail sales, cars, trucks and crossovers are also sold to fleet customers, including daily rental car companies, commercial fleet customers, leasing companies and governments. Fleet sales are completed through the dealer network and in some cases directly with fleet customers. Retail and fleet customers can obtain a wide range of after-sale vehicle services and products through the dealer network, such as maintenance, light repairs, collision repairs, vehicle accessories and extended service warranties.\nGMNA meets the demands of customers in North America with vehicles developed, manufactured and/or marketed under the Buick, Cadillac, Chevrolet and GMC brands. GMI primarily meets the demands of customers outside North America with vehicles developed, manufactured and/or marketed under the Buick, Cadillac, Chevrolet, GMC, and Holden brands. We also have equity ownership stakes in entities that meet the demands of customers in other countries, primarily China, with vehicles developed, manufactured and/or marketed under the Baojun, Buick, Cadillac, Chevrolet, Jiefang and Wuling brands. GM Cruise is our global\n27\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\nsegment designed to build, grow and invest in our autonomous ride-sharing vehicle business, and includes autonomous vehicle-related engineering and other costs.\nOur automotive operations' interest income and interest expense, Maven, legacy costs from the Opel/Vauxhall Business (primarily pension costs), corporate expenditures and certain nonsegment specific revenues and expenses are recorded centrally in Corporate. Corporate assets consist primarily of cash and cash equivalents, marketable securities, our investment in Lyft, Inc. (Lyft), PSA warrants, Maven vehicles and intercompany balances. Retained net underfunded pension liabilities related to the European Business are also recorded in Corporate. All intersegment balances and transactions have been eliminated in consolidation.\nThe following tables summarize key financial information by segment:\n| At and For the Three Months Ended September 30, 2018 |\n| GMNA | GMI | Corporate | Eliminations | Total Automotive | GM Cruise | GM Financial | Eliminations | Total |\n| Net sales and revenue | $ | 27,650 | $ | 4,582 | $ | 56 | $ | 32,288 | $ | — | $ | 3,518 | $ | (15 | ) | $ | 35,791 |\n| Earnings (loss) before interest and taxes-adjusted | $ | 2,825 | $ | 139 | $ | (94 | ) | $ | 2,870 | $ | (214 | ) | $ | 498 | $ | (1 | ) | $ | 3,153 |\n| Adjustments(a) | $ | — | $ | — | $ | (440 | ) | $ | (440 | ) | $ | — | $ | — | $ | — | (440 | ) |\n| Automotive interest income | 82 |\n| Automotive interest expense | (161 | ) |\n| Net (loss) attributable to noncontrolling interests | (4 | ) |\n| Income before income taxes | 2,630 |\n| Income tax expense | (100 | ) |\n| Income from continuing operations | 2,530 |\n| Loss from discontinued operations, net of tax | — |\n| Net loss attributable to noncontrolling interests | 4 |\n| Net income attributable to stockholders | $ | 2,534 |\n| Equity in net assets of nonconsolidated affiliates | $ | 77 | $ | 7,770 | $ | — | $ | — | $ | 7,847 | $ | — | $ | 1,308 | $ | — | $ | 9,155 |\n| Goodwill and intangibles | $ | 2,674 | $ | 939 | $ | 2 | $ | — | $ | 3,615 | $ | 679 | $ | 1,357 | $ | — | $ | 5,651 |\n| Total assets | $ | 110,245 | $ | 25,780 | $ | 28,194 | $ | (45,323 | ) | $ | 118,896 | $ | 2,567 | $ | 105,658 | $ | (1,410 | ) | $ | 225,711 |\n| Depreciation and amortization | $ | 1,251 | $ | 136 | $ | 12 | $ | — | $ | 1,399 | $ | 2 | $ | 1,904 | $ | — | $ | 3,305 |\n| Impairment charges | $ | — | $ | 2 | $ | 6 | $ | — | $ | 8 | $ | — | $ | — | $ | — | $ | 8 |\n| Equity income | $ | 2 | $ | 484 | $ | — | $ | — | $ | 486 | $ | — | $ | 44 | $ | — | $ | 530 |\n\n__________\n| (a) | Consists of charges for ignition switch related legal matters. |\n\n28\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\n| At and For the Three Months Ended September 30, 2017 |\n| GMNA | GMI | Corporate | Eliminations | TotalAutomotive | GM Cruise | GMFinancial | Eliminations | Total |\n| Net sales and revenue | $ | 24,819 | $ | 5,576 | $ | 80 | $ | 30,475 | $ | — | $ | 3,161 | $ | (13 | ) | $ | 33,623 |\n| Earnings (loss) before interest and taxes-adjusted | $ | 2,068 | $ | 389 | $ | (77 | ) | $ | 2,380 | $ | (165 | ) | $ | 310 | $ | (2 | ) | $ | 2,523 |\n| Adjustments | $ | — | $ | — | $ | — | $ | — | $ | — | $ | — | $ | — | — |\n| Automotive interest income | 59 |\n| Automotive interest expense | (151 | ) |\n| Net (loss) attributable to noncontrolling interests | (1 | ) |\n| Income before income taxes | 2,430 |\n| Income tax expense | (2,316 | ) |\n| Income from continuing operations | 114 |\n| Loss from discontinued operations, net of tax | (3,096 | ) |\n| Net loss attributable to noncontrolling interests | 1 |\n| Net loss attributable to stockholders | $ | (2,981 | ) |\n| Equity in net assets of nonconsolidated affiliates | $ | 82 | $ | 7,619 | $ | — | $ | — | $ | 7,701 | $ | — | $ | 1,119 | $ | — | $ | 8,820 |\n| Goodwill and intangibles | $ | 2,871 | $ | 980 | $ | 12 | $ | — | $ | 3,863 | $ | 620 | $ | 1,371 | $ | — | $ | 5,854 |\n| Total assets(a) | $ | 109,934 | $ | 27,832 | $ | 25,797 | $ | (39,731 | ) | $ | 123,832 | $ | 564 | $ | 106,142 | $ | (1,036 | ) | $ | 229,502 |\n| Depreciation and amortization | $ | 1,210 | $ | 166 | $ | 11 | $ | — | $ | 1,387 | $ | — | $ | 1,743 | $ | — | $ | 3,130 |\n| Impairment charges | $ | 10 | $ | 7 | $ | — | $ | — | $ | 17 | $ | — | $ | — | $ | — | $ | 17 |\n| Equity income | $ | 2 | $ | 457 | $ | — | $ | — | $ | 459 | $ | — | $ | 41 | $ | — | $ | 500 |\n\n__________\n| (a) | Assets in GM Financial include assets classified as held for sale. |\n\n| At and For the Nine Months Ended September 30, 2018 |\n| GMNA | GMI | Corporate | Eliminations | TotalAutomotive | GM Cruise | GMFinancial | Eliminations | Total |\n| Net sales and revenue | $ | 83,969 | $ | 14,188 | $ | 155 | $ | 98,312 | $ | — | $ | 10,417 | $ | (79 | ) | $ | 108,650 |\n| Earnings (loss) before interest and taxes-adjusted | $ | 7,728 | $ | 471 | $ | (187 | ) | $ | 8,012 | $ | (534 | ) | $ | 1,477 | $ | — | $ | 8,955 |\n| Adjustments(a) | $ | — | $ | (1,138 | ) | $ | (440 | ) | $ | (1,578 | ) | $ | — | $ | — | $ | — | (1,578 | ) |\n| Automotive interest income | 218 |\n| Automotive interest expense | (470 | ) |\n| Net (loss) attributable to noncontrolling interests | (34 | ) |\n| Income before income taxes | 7,091 |\n| Income tax expense | (1,085 | ) |\n| Income from continuing operations | 6,006 |\n| Loss from discontinued operations, net of tax | (70 | ) |\n| Net loss attributable to noncontrolling interests | 34 |\n| Net income attributable to stockholders | $ | 5,970 |\n| Depreciation and amortization | $ | 3,474 | $ | 426 | $ | 36 | $ | — | $ | 3,936 | $ | 5 | $ | 5,560 | $ | — | $ | 9,501 |\n| Impairment charges | $ | 53 | $ | 463 | $ | 6 | $ | — | $ | 522 | $ | — | $ | — | $ | — | $ | 522 |\n| Equity income | $ | 7 | $ | 1,667 | $ | — | $ | — | $ | 1,674 | $ | — | $ | 141 | $ | — | $ | 1,815 |\n\n__________\n| (a) | Consists of charges of $1.1 billion related to restructuring actions in Korea in GMI, which is net of noncontrolling interest, and charges of $440 million for ignition switch related legal matters in Corporate. |\n\n29\nGENERAL MOTORS COMPANY AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS —— (Continued)\n| At and For the Nine Months Ended September 30, 2017 |\n| GMNA | GMI | Corporate | Eliminations | TotalAutomotive | GM Cruise | GMFinancial | Eliminations | Total |\n| Net sales and revenue | $ | 82,594 | $ | 16,226 | $ | 306 | $ | 99,126 | $ | — | $ | 8,899 | $ | (152 | ) | $ | 107,873 |\n| Earnings (loss) before interest and taxes-adjusted | $ | 9,014 | $ | 884 | $ | (574 | ) | $ | 9,324 | $ | (455 | ) | $ | 895 | $ | (5 | ) | $ | 9,759 |\n| Adjustments(a) | $ | — | $ | (540 | ) | $ | (114 | ) | $ | (654 | ) | $ | — | $ | — | $ | — | (654 | ) |\n| Automotive interest income | 184 |\n| Automotive interest expense | (430 | ) |\n| Net income attributable to noncontrolling interests | 11 |\n| Income before income taxes | 8,870 |\n| Income tax expense | (3,637 | ) |\n| Income from continuing operations | 5,233 |\n| Loss from discontinued operations, net of tax | (3,935 | ) |\n| Net (income) attributable to noncontrolling interests | (11 | ) |\n| Net income attributable to stockholders | $ | 1,287 |\n| Depreciation and amortization | $ | 3,499 | $ | 535 | $ | 22 | $ | (1 | ) | $ | 4,055 | $ | 1 | $ | 4,757 | $ | — | $ | 8,813 |\n| Impairment charges | $ | 59 | $ | 207 | $ | 5 | $ | — | $ | 271 | $ | — | $ | — | $ | — | $ | 271 |\n| Equity income | $ | 8 | $ | 1,448 | $ | — | $ | — | $ | 1,456 | $ | — | $ | 129 | $ | — | $ | 1,585 |\n\n__________\n| (a) | Consists of charges of $460 million related to restructuring actions in India and South Africa in GMI, charges of $80 million associated with the deconsolidation of Venezuela in GMI and charges of $114 million for ignition switch related legal matters in Corporate. |\n\nNote 21. Subsequent Events\nOn October 3, 2018, GM Cruise Holdings entered into a Purchase Agreement with Honda Motor Co., Ltd. (Honda), pursuant to which Honda invested $750 million in GM Cruise Holdings in exchange for Class E Common Shares, representing 5.7% of the fully diluted equity of GM Cruise Holdings as of the same date. In addition, Honda agreed to contribute approximately $2.0 billion primarily in the form of a long-term annual fee to GM Cruise Holdings for certain rights to use GM Cruise Holdings' trade names and trademarks and the exclusive right to partner with GM Cruise Holdings to develop, deploy, and maintain a foreign market. The remaining contribution or funding will come in the form of shared development costs for certain components of a shared autonomous vehicle (SAV) that Honda, General Motors Holdings LLC and GM Cruise Holdings will jointly develop for deployment onto GM Cruise's autonomous vehicle network. All proceeds are designated exclusively for working capital and general corporate purposes of GM Cruise.\nOn October 31, 2018 we initiated a voluntary severance program for up to approximately 18,000 of our U.S., Canada and Mexico salaried employees and global executives. Program eligibility is dependent upon mutual agreement between the employee and GM. We are currently unable to estimate the utilization rate of this voluntary program, but we estimate the program will cost approximately $130 million for every 1,800, or about 10%, of candidates who voluntarily separate under the program. We expect the program to conclude and will record a charge in the three months ending December 31, 2018.\n* * * * * * *\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nBasis of Presentation This Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) should be read in conjunction with the accompanying condensed consolidated financial statements and the audited consolidated financial statements and notes thereto included in our 2017 Form 10-K.\nThe European Business is presented as discontinued operations in our condensed consolidated financial statements for all periods presented. Unless otherwise indicated, information in this report relates to our continuing operations.\nForward-looking statements in this MD&A are not guarantees of future performance and may involve risks and uncertainties that could cause actual results to differ materially from those projected. Refer to the \"Forward-Looking Statements\" section of this MD&A and the \"Risk Factors\" section of our 2017 Form 10-K for a discussion of these risks and uncertainties. Except for per share amounts or as otherwise specified, dollar amounts presented within tables are stated in millions.\nNon-GAAP Measures Unless otherwise indicated, our non-GAAP measures discussed in this MD&A are related to our continuing operations and not our discontinued operations. Our non-GAAP measures include EBIT-adjusted, presented net of noncontrolling interests, Core EBIT-adjusted, EPS-diluted-adjusted, effective tax rate-adjusted (ETR-adjusted), return on invested capital-adjusted (ROIC-adjusted) and adjusted automotive free cash flow. Our calculation of these non-GAAP measures may not be comparable to similarly titled measures of other companies due to potential differences between companies in the method of calculation. As a result, the use of these non-GAAP measures has limitations and should not be considered superior to, in isolation from, or as a substitute for, related U.S. GAAP measures.\nThese non-GAAP measures allow management and investors to view operating trends, perform analytical comparisons and benchmark performance between periods and among geographic regions to understand operating performance without regard to items we do not consider a component of our core operating performance. Furthermore, these non-GAAP measures allow investors the opportunity to measure and monitor our performance against our externally communicated targets and evaluate the investment decisions being made by management to improve ROIC-adjusted. Management uses these measures in its financial, investment and operational decision-making processes, for internal reporting and as part of its forecasting and budgeting processes. Further, our Board of Directors uses certain of these and other measures as key metrics to determine management performance under our performance-based compensation plans. For these reasons we believe these non-GAAP measures are useful for our investors.\nEBIT-adjusted EBIT-adjusted is presented net of noncontrolling interests and is used by management and can be used by investors to review our consolidated operating results because it excludes automotive interest income, automotive interest expense and income taxes as well as certain additional adjustments that are not considered part of our core operations. Examples of adjustments to EBIT include but are not limited to impairment charges on long-lived assets and other exit costs resulting from strategic shifts in our operations or discrete market and business conditions and costs arising from the ignition switch recall and related legal matters. For EBIT-adjusted and our other non-GAAP measures, once we have made an adjustment in the current period for an item, we will also adjust the related non-GAAP measure in any future periods in which there is a significant impact from the item.\nCore EBIT-adjusted Core EBIT-adjusted is used by management and can be used by investors to review our core consolidated operating results. Core EBIT-adjusted begins with EBIT-adjusted and excludes the EBIT-adjusted results of GM Cruise. Prior to the three months ended June 30, 2018, Core EBIT-adjusted excluded the EBIT-adjusted results of autonomous vehicle operations, including GM Cruise, Maven and our investment in Lyft. The measure was changed to align with segment reporting. All periods presented have been recast to reflect the changes.\n30\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\nEPS-diluted-adjusted EPS-diluted-adjusted is used by management and can be used by investors to review our consolidated diluted EPS results on a consistent basis. EPS-diluted-adjusted is calculated as net income attributable to common stockholders-diluted less income (loss) from discontinued operations on an after-tax basis, adjustments noted above for EBIT-adjusted and certain income tax adjustments divided by weighted-average common shares outstanding-diluted. Examples of income tax adjustments include the establishment or reversal of significant deferred tax asset valuation allowances.\nETR-adjusted ETR-adjusted is used by management and can be used by investors to review the consolidated effective tax rate for our core operations on a consistent basis. ETR-adjusted is calculated as Income tax expense less the income tax related to the adjustments noted above for EBIT-adjusted and the income tax adjustments noted above for EPS-diluted-adjusted divided by Income before income taxes less adjustments.\nROIC-adjusted ROIC-adjusted is used by management and can be used by investors to review our investment and capital allocation decisions. We define ROIC-adjusted as EBIT-adjusted for the trailing four quarters divided by ROIC-adjusted average net assets, which is considered to be the average equity balances adjusted for average automotive debt and interest liabilities, exclusive of capital leases; average net pension and OPEB liabilities; and average automotive and other net income tax assets during the same period. Adjustments to the average equity balances exclude assets and liabilities classified as either assets held for sale or liabilities held for sale.\nAdjusted automotive free cash flow Adjusted automotive free cash flow is used by management and can be used by investors to review the liquidity of our automotive operations and to measure and monitor our performance against our capital allocation program and evaluate our automotive liquidity against the substantial cash requirements of our automotive operations. We measure adjusted automotive free cash flow as automotive operating cash flow from continuing operations less capital expenditures adjusted for management actions. Management actions can include voluntary events such as discretionary contributions to employee benefit plans or nonrecurring specific events such as a plant closure that are considered special for EBIT-adjusted purposes. Refer to the \"Liquidity and Capital Resources\" section of this MD&A for additional information.\nThe following table reconciles Net income (loss) attributable to stockholders under U.S. GAAP to EBIT-adjusted:\n| Three Months Ended |\n| September 30, | June 30, | March 31, | December 31, |\n| 2018 | 2017 | 2018 | 2017 | 2018 | 2017 | 2017 | 2016 |\n| Net income (loss) attributable to stockholders | $ | 2,534 | $ | (2,981 | ) | $ | 2,390 | $ | 1,660 | $ | 1,046 | $ | 2,608 | $ | (5,151 | ) | $ | 1,835 |\n| Loss from discontinued operations, net of tax | — | 3,096 | — | 770 | 70 | 69 | 277 | 120 |\n| Income tax expense | 100 | 2,316 | 519 | 534 | 466 | 787 | 7,896 | 303 |\n| Automotive interest expense | 161 | 151 | 159 | 132 | 150 | 147 | 145 | 150 |\n| Automotive interest income | (82 | ) | (59 | ) | (72 | ) | (68 | ) | (64 | ) | (57 | ) | (82 | ) | (45 | ) |\n| Adjustments |\n| GMI restructuring(a) | — | — | 196 | 540 | 942 | — | — | — |\n| Ignition switch recall and related legal matters(b) | 440 | — | — | 114 | — | — | — | 235 |\n| Total adjustments | 440 | — | 196 | 654 | 942 | — | — | 235 |\n| EBIT-adjusted | $ | 3,153 | $ | 2,523 | $ | 3,192 | $ | 3,682 | $ | 2,610 | $ | 3,554 | $ | 3,085 | $ | 2,598 |\n\n_________\n| (a) | These adjustments were excluded because of a strategic decision to rationalize our core operations by exiting or significantly reducing our presence in various international markets to focus resources on opportunities expected to deliver higher returns. The adjustments primarily consist of supplier claims and employee separation charges in the three months ended June 30, 2018 and asset impairments and employee separation charges in the three months ended March 31, 2018, all in Korea. The adjustment in the three months ended June 30, 2017 primarily consists of asset impairments and other restructuring actions in India, South Africa and Venezuela. |\n\n| (b) | These adjustments were excluded because of the unique events associated with the ignition switch recall, which included various investigations, inquiries and complaints from constituents. |\n\nThe following table reconciles EBIT-adjusted to Core EBIT-adjusted:\n31\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\n| Three Months Ended | Nine Months Ended |\n| September 30, 2018 | September 30, 2017 | September 30, 2018 | September 30, 2017 |\n| EBIT-adjusted(a) | $ | 3,153 | $ | 2,523 | $ | 8,955 | $ | 9,759 |\n| EBIT loss-adjusted – GM Cruise | 214 | 165 | 534 | 455 |\n| Core EBIT-adjusted | $ | 3,367 | $ | 2,688 | $ | 9,489 | $ | 10,214 |\n\n________\n| (a) | Refer to the reconciliation of Net income (loss) attributable to stockholders under U.S. GAAP to EBIT-adjusted within this section of MD&A. |\n\nThe following table reconciles diluted earnings (loss) per common share under U.S. GAAP to EPS-diluted-adjusted:\n| Three Months Ended | Nine Months Ended |\n| September 30, 2018 | September 30, 2017 | September 30, 2018 | September 30, 2017 |\n| Amount | Per Share | Amount | Per Share | Amount | Per Share | Amount | Per Share |\n| Diluted earnings (loss) per common share | $ | 2,503 | $ | 1.75 | $ | (2,983 | ) | $ | (2.03 | ) | $ | 5,910 | $ | 4.13 | $ | 1,285 | $ | 0.85 |\n| Diluted loss per common share – discontinued operations | — | — | 3,096 | 2.11 | 70 | 0.05 | 3,935 | 2.61 |\n| Adjustments(a) | 440 | 0.31 | — | — | 1,578 | 1.10 | 654 | 0.43 |\n| Tax effect on adjustment(b) | (109 | ) | (0.08 | ) | — | — | (89 | ) | (0.06 | ) | (208 | ) | (0.14 | ) |\n| Tax adjustment(c) | (157 | ) | (0.11 | ) | 1,828 | 1.24 | (157 | ) | (0.11 | ) | 1,828 | 1.22 |\n| EPS-diluted-adjusted | $ | 2,677 | $ | 1.87 | $ | 1,941 | $ | 1.32 | $ | 7,312 | $ | 5.11 | $ | 7,494 | $ | 4.97 |\n\n________\n| (a) | Refer to the reconciliation of Net income (loss) attributable to stockholders under U.S. GAAP to EBIT-adjusted within this section of MD&A for the details of each individual adjustment. |\n\n| (b) | The tax effect of each adjustment is determined based on the tax laws and valuation allowance status of the jurisdiction to which the adjustment relates. |\n\n| (c) | In the three and nine months ended September 30, 2018, this adjustment consists of a tax benefit related to U.S. tax reform. In the three and nine months ended September 30, 2017, these adjustments consist of a tax expense related to the establishment of a valuation allowance on deferred tax assets that will no longer be realizable as a result of the sale of the Opel/Vauxhall Business, partially offset by tax benefits related to tax settlements. |\n\nThe following table reconciles our effective tax rate under U.S. GAAP to ETR-adjusted:\n| Three Months Ended | Nine Months Ended |\n| September 30, 2018 | September 30, 2017 | September 30, 2018 | September 30, 2017 |\n| Income before income taxes | Income tax expense | Effective tax rate | Income before income taxes | Income tax expense | Effective tax rate | Income before income taxes | Income tax expense | Effective tax rate | Income before income taxes | Income tax expense | Effective tax rate |\n| Effective tax rate | $ | 2,630 | $ | 100 | 3.8 | % | $ | 2,430 | $ | 2,316 | 95.3 | % | $ | 7,091 | $ | 1,085 | 15.3 | % | $ | 8,870 | $ | 3,637 | 41.0 | % |\n| Adjustments(a)(b) | 440 | 109 | — | — | 1,619 | 89 | 654 | 208 |\n| Tax adjustment(c) | 157 | (1,828 | ) | 157 | (1,828 | ) |\n| ETR-adjusted | $ | 3,070 | $ | 366 | 11.9 | % | $ | 2,430 | $ | 488 | 20.1 | % | $ | 8,710 | $ | 1,331 | 15.3 | % | $ | 9,524 | $ | 2,017 | 21.2 | % |\n\n________\n| (a) | Refer to the reconciliation of Net income (loss) attributable to stockholders under U.S. GAAP to EBIT-adjusted within this section of MD&A for the details of each individual adjustment. Net income attributable to noncontrolling interests for these adjustments of $41 million are included in the nine months ended September 30, 2018. |\n\n| (b) | The tax effect of each adjustment is determined based on the tax laws and valuation allowance status of the jurisdiction to which the adjustment relates. |\n\n| (c) | Refer to the reconciliation of diluted earnings (loss) per common share under U.S. GAAP to EPS-diluted-adjusted within this section of MD&A for adjustment details. We are assessing potential material tax benefits that may arise in the three months ending December 31, 2018 as a result of operational considerations and tax reform guidance. |\n\nWe define return on equity (ROE) as Net income (loss) attributable to stockholders for the trailing four quarters divided by average equity for the same period. Management uses average equity to provide comparable amounts in the calculation of ROE. The following table summarizes the calculation of ROE (dollars in billions):\n32\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\n| Four Quarters Ended |\n| September 30, 2018 | September 30, 2017 |\n| Net income (loss) attributable to stockholders | $ | 0.8 | $ | 3.1 |\n| Average equity(a) | $ | 36.3 | $ | 44.5 |\n| ROE | 2.3 | % | 7.0 | % |\n\n__________\n| (a) | Includes equity of noncontrolling interests where the corresponding earnings (loss) are included in EBIT-adjusted. |\n\nThe following table summarizes the calculation of ROIC-adjusted (dollars in billions):\n| Four Quarters Ended |\n| September 30, 2018 | September 30, 2017 |\n| EBIT-adjusted(a) | $ | 12.0 | $ | 12.4 |\n| Average equity(b) | $ | 36.3 | $ | 44.5 |\n| Add: Average automotive debt and interest liabilities (excluding capital leases) | 14.2 | 10.8 |\n| Add: Average automotive net pension & OPEB liability | 19.1 | 21.2 |\n| Less: Average automotive and other net income tax asset | (22.5 | ) | (31.7 | ) |\n| ROIC-adjusted average net assets | $ | 47.1 | $ | 44.8 |\n| ROIC-adjusted | 25.6 | % | 27.6 | % |\n\n__________\n| (a) | Refer to the reconciliation of Net income (loss) attributable to stockholders under U.S. GAAP to EBIT-adjusted within this section of MD&A. |\n\n| (b) | Includes equity of noncontrolling interests where the corresponding earnings (loss) are included in EBIT-adjusted. |\n\nOverview Our management team has adopted a strategic plan to transform GM into the world's most valued automotive company. Our plan includes several major initiatives that we anticipate will redefine the future of personal mobility through our zero crashes, zero emissions, zero congestion vision while also strengthening the core of our business: earning customers for life by delivering winning vehicles, leading the industry in quality and safety and improving the customer ownership experience; leading in technology and innovation, including electrification, autonomous, data monetization and connectivity; growing our brands; making tough, strategic decisions about which markets and products in which we will invest and compete; building profitable adjacent businesses and targeting 10% core margins on an EBIT-adjusted basis.\nIn addition to our EBIT-adjusted margin improvement goal, our overall financial targets include total annual operational and functional cost savings of $6.5 billion through 2018 compared to 2014 costs, of which approximately $6.2 billion has been realized as of September 30, 2018, and which will more than offset our planned incremental investments in brand building, engineering and technology as we launch new products; and execution of our capital allocation program as described in the \"Liquidity and Capital Resources\" section of this MD&A.\nFor the year ending December 31, 2018 we expect EPS-diluted and EPS-diluted-adjusted to be at the top of the range in the table below. These do not consider the potential future impact of adjustments on our expected financial results. The following table reconciles expected diluted earnings per common share under U.S. GAAP to expected EPS-diluted-adjusted:\n| Year Ending December 31, 2018 |\n| Diluted earnings per common share | $ 4.82-5.22 |\n| Diluted loss per common share – discontinued operations(a) | 0.05 |\n| Adjustments(b) | 1.10 |\n| Tax effect on adjustments(c) | (0.06 | ) |\n| Tax adjustment(d) | (0.11 | ) |\n| EPS-diluted-adjusted | $ 5.80-6.20 |\n\n__________\n| (a) | Refer to Note 19 to our condensed consolidated financial statements for further details. |\n\n| (b) | Refer to the reconciliation of Net income (loss) attributable to stockholders under U.S. GAAP to EBIT-adjusted within the Non-GAAP Measures section of this MD&A for the details of each individual adjustment. |\n\n| (c) | The tax effect of the adjustment is determined based on the tax laws and valuation allowance status of the jurisdiction in which the adjustment relates. |\n\n| (d) | Refer to the reconciliation of diluted earnings (loss) per common share under U.S. GAAP to EPS-diluted-adjusted within the Non-GAAP Measures section of this MD&A. |\n\nWe face continuing market, operating and regulatory challenges in a number of countries across the globe due to, among other factors, weak economic conditions, competitive pressures, our product portfolio offerings, heightened emissions standards, foreign exchange volatility, rising materials prices, trade policy and political uncertainty. As a result of these conditions, we continue to strategically assess our performance and ability to achieve acceptable returns on our invested capital, as well as our cost structure in order to maintain a low breakeven point. As we continue to assess our performance and the needs of our evolving business, additional restructuring and rationalization actions could be required. These additional restructuring and rationalization actions could give rise to future asset impairments or other charges which may have a material impact on our results of operations.\nGMNA Industry sales in North America were 16.1 million units in the nine months ended September 30, 2018, representing a decrease of 0.1% compared to the corresponding period in 2017. U.S. industry sales were 13.2 million units in the nine months ended September 30, 2018 and we expect industry unit sales of approximately 17 million for the full year.\nOur vehicle sales in the U.S., our largest market in North America, totaled 2.2 million units for market share of 16.4% in the nine months ended September 30, 2018, representing a decrease of 0.3 percentage points compared to the corresponding period in 2017. We continue to lead the U.S. industry in market share.\nWe are experiencing strong U.S. industry light vehicle sales and are continuing our focus on key product launches including our new full-size trucks and overall cost savings. However, we expect to continue to experience higher costs associated with commodities and tariffs, as well as pricing pressures. As a result we expect an EBIT-adjusted margin of approximately 9% to 10% in the year ending December 31, 2018. Based on our current cost structure, we continue to estimate GMNA’s breakeven point at the U.S. industry level to be in the range of 10.0 to 11.0 million units.\n33\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\nGMI China industry sales were 19.2 million units in the nine months ended September 30, 2018 representing a 0.5% decrease compared to the corresponding period in 2017. Our China retail volumes totaled 2.7 million units for market share of 13.9% in the nine months ended September 30, 2018, representing a decrease of 0.3 percentage points compared to the corresponding period in 2017. We continue to see strength in sales of our Cadillac and Chevrolet passenger vehicles and SUVs. Baojun and Wuling sales were impacted by the market slowdown in less developed cities and market shift away from mini commercial vehicles. Our Automotive China JVs generated equity income of $1.7 billion in the nine months ended September 30, 2018. We expect to see continued weakness in the industry for the remainder of 2018 and a continuation of pricing pressures, which will continue to pressure margins. We expect our vehicle sales performance in 2018 to be generally in line with the industry, driven by new vehicle launches, and we expect to sustain strong China equity income by focusing on improvements in vehicle mix, cost efficiencies, and downstream performance optimization.\nOutside of China, many markets across the segment continue to improve, resulting in industry sales of 19.9 million units, representing an increase of 5.2% in the nine months ended September 30, 2018 compared to the corresponding period in 2017. This increase was due primarily to increases in India and Brazil. Our retail vehicle sales totaled 0.9 million units for a market share of 4.4% in the nine months ended September 30, 2018, representing a decrease of 0.6 percentage points compared to the corresponding period in 2017.\nIn February 2018 we announced the closure of a facility and other restructuring actions in Korea. We recorded charges of $1.1 billion consisting of $0.6 billion in non-cash asset impairments and other charges and $0.5 billion in employee separation charges in the nine months ended September 30, 2018. We incurred $0.7 billion in cash outflows resulting from these Korea restructuring actions for employee separations and statutory pension payments in the nine months ended September 30, 2018. The charges are considered special for EBIT-adjusted, EPS-diluted-adjusted and adjusted automotive free cash flow reporting purposes. Refer to Note 16 to our condensed consolidated financial statements for information related to these restructuring actions.\nIn May 2018 KDB agreed to purchase approximately $0.75 billion of GM Korea Preferred Shares, $0.4 billion of which was received in June 2018 with the remainder currently expected to be received in the three months ending December 31, 2018. In October 2018 a representative of the KDB stated that while it currently plans to make the additional investment, it is subject to review depending on potential changes to its policy. Should the KDB decline to make the additional investment, we believe KDB would be in breach of its contractual commitments, would forfeit certain governance rights, and be subject to additional legal action to enforce its commitment. In addition, GM's obligations to maintain its ownership of GM Korea would terminate. In conjunction with the GM Korea Preferred Share issuance we agreed to provide GM Korea future funding, if needed, not to exceed $2.8 billion through December 31, 2027, inclusive of $2.0 billion of planned capital expenditures through 2027. The actions being taken to address GM Korea’s financial and operational performance have and may continue to result in litigation (including from KDB), negative publicity, business disruption, and labor unrest. Refer to Note 17 to our condensed consolidated financial statements for additional information.\nGM Cruise In June 2018 GM Cruise Holdings issued $0.9 billion of GM Cruise Preferred Shares to SoftBank, representing 10.9% of GM Cruise Holdings' equity at closing. Immediately prior to the issuance of the GM Cruise Preferred Shares, we invested $1.1 billion in GM Cruise Holdings. When GM Cruise's autonomous vehicles are ready for commercial deployment, SoftBank is obligated to purchase additional GM Cruise Preferred Shares for $1.35 billion. All proceeds are designated exclusively for working capital and general corporate purposes of GM Cruise. Refer to Note 17 to our condensed consolidated financial statements for additional information.\nIn October 2018 GM Cruise Holdings issued $0.75 billion of GM Cruise Holdings Class E Common Shares to Honda, representing 5.7% of the fully diluted equity of GM Cruise Holdings at closing. In addition, Honda agreed to contribute approximately $2.0 billion primarily in the form of a long-term annual fee to GM Cruise Holdings for certain rights to use GM Cruise Holdings' trade names and trademarks and the exclusive right to partner with GM Cruise Holdings to develop, deploy, and maintain a foreign market. The remaining contribution or funding will come in the form of shared development costs for certain components of a SAV that Honda, General Motors Holdings LLC and GM Cruise Holdings will jointly develop for deployment onto GM Cruise's autonomous vehicle network. All proceeds are designated exclusively for working capital and general corporate purposes of GM Cruise.\nCorporate Beginning in 2012 through October 12, 2018, we purchased an aggregate of 507 million shares of our outstanding common stock under our common stock repurchase programs for $16.3 billion.\nThe ignition switch recall has led to various inquiries, investigations, subpoenas, requests for information and complaints from agencies or other representatives of U.S. federal, state and Canadian governments. In addition, these and other recalls have resulted in a number of claims and lawsuits. Such lawsuits and investigations could in the future result in the imposition of material damages,\n34\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\nfines, civil consent orders, civil and criminal penalties or other remedies. Refer to Note 14 to our condensed consolidated financial statements for additional information.\nOn October 31, 2018 we initiated a voluntary severance program for up to approximately 18,000 of our U.S., Canada and Mexico salaried employees and global executives. Program eligibility is dependent upon mutual agreement between the employee and GM. We are currently unable to estimate the utilization rate of this voluntary program, but we estimate the program will cost approximately $0.1 billion for every 1,800, or about 10%, of candidates who voluntarily separate under the program. We expect the program to conclude and will record a charge in the three months ending December 31, 2018. In addition, we are evaluating other initiatives to reduce structural costs including, but not limited to, an involuntary severance program. Charges will be considered special for EBIT-adjusted, EPS diluted-adjusted and Adjusted automotive free cash flow purposes.\nTakata Matters In May 2016 NHTSA issued an amended consent order requiring Takata to file DIRs for previously unrecalled front airbag inflators that contain phased-stabilized ammonium nitrate-based propellant without a moisture absorbing desiccant on a multi-year, risk-based schedule through 2019 impacting tens of millions of vehicles produced by numerous automotive manufacturers. NHTSA concluded that the likely root cause of the rupturing of the airbag inflators is a function of time, temperature cycling and environmental moisture.\nAlthough we do not believe there is a safety defect at this time in any unrecalled GM vehicles within scope of the Takata DIRs, in cooperation with NHTSA we have filed Preliminary DIRs covering certain of our GMT900 vehicles, which are full-size pickup trucks and SUVs. We have also filed petitions for inconsequentiality with respect to the vehicles subject to those Preliminary DIRs. NHTSA has consolidated our petitions and will rule on them at the same time.\nWhile these petitions have been pending, we have provided NHTSA with the results of our long-term studies and the studies performed by third-party experts, all of which form the basis for our determination that the inflators in these vehicles do not present an unreasonable risk to safety and that no repair should ultimately be required.\nWe believe these vehicles are currently performing as designed and ongoing testing continues to support the belief that the vehicles' unique design and integration mitigates against inflator propellant degradation and rupture risk. For example, the airbag inflators used in the vehicles are a variant engineered specifically for our vehicles, and include features such as greater venting, unique propellant wafer configurations, and machined steel end caps. The inflators are packaged in the instrument panel in such a way as to minimize exposure to moisture from the climate control system. Also, these vehicles have features that minimize the maximum temperature to which the inflator will be exposed, such as larger interior volumes and standard solar absorbing windshields and side glass.\nAccordingly, no warranty provision has been made for any repair associated with our vehicles subject to the Preliminary DIRs and amended consent order. However, in the event we are ultimately obligated to repair the vehicles subject to current or future Takata DIRs under the amended consent order in the U.S., we estimate a reasonably possible impact to GM of approximately $1.2 billion.\nGM has recalled certain vehicles sold outside of the U.S. to replace Takata inflators in those vehicles. There are significant differences in vehicle and inflator design between the relevant vehicles sold internationally and those sold in the U.S. We continue to gather and analyze evidence about these inflators and to share our findings with regulators. Additional recalls, if any, could be material to our results of operations and cash flows. We continue to monitor the international situation.\nContingently Issuable Shares Under the Amended and Restated Master Sale and Purchase Agreement between us and Motors Liquidation Company, GM may be obligated to issue Adjustment Shares of our common stock if allowed general unsecured claims against the GUC Trust, as estimated by the Bankruptcy Court, exceed $35.0 billion. Refer to Note 14 to our condensed consolidated financial statements for a description of the contingently issuable Adjustment Shares.\nVehicle Sales The principal factors that determine consumer vehicle preferences in the markets in which we operate include overall vehicle design, price, quality, available options, safety, reliability, fuel economy and functionality. Market leadership in individual countries in which we compete varies widely.\nWe present both wholesale and retail vehicle sales data to assist in the analysis of our revenue and our market share. Wholesale vehicle sales data, which represents sales directly to dealers and others, including sales to fleet customers, is the measure that correlates to our revenue from the sale of vehicles, which is the largest component of Automotive net sales and revenue. Wholesale vehicle sales exclude vehicles sold by joint ventures. In the nine months ended September 30, 2018, 35.4% of our wholesale vehicle sales volume was generated outside the U.S. The following table summarizes total wholesale vehicle sales of new vehicles by automotive segment (vehicles in thousands):\n| Three Months Ended | Nine Months Ended |\n| September 30, 2018 | September 30, 2017 | September 30, 2018 | September 30, 2017 |\n| GMNA(a) | 843 | 74.5 | % | 762 | 70.4 | % | 2,659 | 76.1 | % | 2,596 | 73.4 | % |\n| GMI(b) | 289 | 25.5 | % | 321 | 29.6 | % | 836 | 23.9 | % | 939 | 26.6 | % |\n| Total | 1,132 | 100.0 | % | 1,083 | 100.0 | % | 3,495 | 100.0 | % | 3,535 | 100.0 | % |\n| Discontinued operations | — | 90 | — | 696 |\n\n__________\n| (a) | Wholesale vehicle sales related to transactions with the European Business were insignificant for all periods presented. |\n\n| (b) | Wholesale vehicle sales include 37 and 131 vehicles related to transactions with the European Business for the three and nine months ended September 30, 2017. |\n\nRetail vehicle sales data, which represents sales to end customers based upon the good faith estimates of management, including sales to fleet customers, does not correlate directly to the revenue we recognize during the period. However retail vehicle sales data is indicative of the underlying demand for our vehicles. Market share information is based primarily on retail vehicle sales volume. In countries where retail vehicle sales data is not readily available, other data sources such as wholesale or forecast volumes are used to estimate retail vehicle sales to end customers.\nRetail vehicle sales data includes all sales by joint ventures on a total vehicle basis, not based on the percentage of ownership in the joint venture. Certain joint venture agreements in China allow for the contractual right to report vehicle sales of non-GM trademarked vehicles by those joint ventures. Retail vehicle sales data includes vehicles used by dealers under courtesy transportation programs. Certain fleet sales that are accounted for as operating leases are included in retail vehicle sales at the time of delivery to daily rental car companies. The following table summarizes total industry retail sales, or estimated sales where retail sales volume is not available, of vehicles and our related competitive position by geographic region (vehicles in thousands):\n35\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\n| Three Months Ended | Nine Months Ended |\n| September 30, 2018 | September 30, 2017 | September 30, 2018 | September 30, 2017 |\n| Industry | GM | Market Share | Industry | GM | Market Share | Industry | GM | Market Share | Industry | GM | Market Share |\n| North America |\n| United States | 4,394 | 695 | 15.8 | % | 4,512 | 781 | 17.3 | % | 13,204 | 2,169 | 16.4 | % | 13,118 | 2,196 | 16.7 | % |\n| Other | 977 | 139 | 14.2 | % | 1,012 | 144 | 14.2 | % | 2,899 | 404 | 13.9 | % | 2,995 | 423 | 14.1 | % |\n| Total North America(a) | 5,371 | 834 | 15.5 | % | 5,524 | 925 | 16.7 | % | 16,103 | 2,573 | 16.0 | % | 16,113 | 2,619 | 16.3 | % |\n| Asia/Pacific, Middle East and Africa |\n| China(b) | 6,364 | 836 | 13.1 | % | 6,905 | 982 | 14.2 | % | 19,244 | 2,680 | 13.9 | % | 19,336 | 2,748 | 14.2 | % |\n| Other(c) | 5,472 | 132 | 2.4 | % | 5,358 | 149 | 2.8 | % | 16,579 | 379 | 2.3 | % | 15,881 | 468 | 2.9 | % |\n| Total Asia/Pacific, Middle East and Africa(a) | 11,836 | 968 | 8.2 | % | 12,263 | 1,131 | 9.2 | % | 35,823 | 3,059 | 8.5 | % | 35,217 | 3,216 | 9.1 | % |\n| South America |\n| Brazil | 679 | 113 | 16.6 | % | 600 | 107 | 17.8 | % | 1,846 | 303 | 16.4 | % | 1,620 | 283 | 17.5 | % |\n| Other | 465 | 61 | 13.1 | % | 517 | 73 | 14.1 | % | 1,508 | 203 | 13.4 | % | 1,448 | 205 | 14.1 | % |\n| Total South America(a) | 1,144 | 174 | 15.2 | % | 1,117 | 180 | 16.1 | % | 3,354 | 506 | 15.1 | % | 3,068 | 488 | 15.9 | % |\n| Total in GM markets | 18,351 | 1,976 | 10.8 | % | 18,904 | 2,236 | 11.8 | % | 55,280 | 6,138 | 11.1 | % | 54,398 | 6,323 | 11.6 | % |\n| Total Europe | 4,768 | 1 | — | % | 4,394 | 83 | 1.9 | % | 15,207 | 3 | — | % | 14,586 | 684 | 4.7 | % |\n| Total Worldwide(d) | 23,119 | 1,977 | 8.6 | % | 23,298 | 2,319 | 10.0 | % | 70,487 | 6,141 | 8.7 | % | 68,984 | 7,007 | 10.2 | % |\n| United States |\n| Cars | 1,295 | 137 | 10.6 | % | 1,573 | 179 | 11.4 | % | 4,086 | 432 | 10.6 | % | 4,709 | 541 | 11.5 | % |\n| Trucks | 1,354 | 326 | 24.1 | % | 1,277 | 347 | 27.2 | % | 3,954 | 992 | 25.1 | % | 3,702 | 948 | 25.6 | % |\n| Crossovers | 1,745 | 232 | 13.3 | % | 1,662 | 255 | 15.4 | % | 5,164 | 745 | 14.4 | % | 4,707 | 707 | 15.0 | % |\n| Total United States | 4,394 | 695 | 15.8 | % | 4,512 | 781 | 17.3 | % | 13,204 | 2,169 | 16.4 | % | 13,118 | 2,196 | 16.7 | % |\n| China(b) |\n| SGMS | 416 | 497 | 1,284 | 1,307 |\n| SGMW and FAW-GM | 420 | 485 | 1,396 | 1,441 |\n| Total China | 6,364 | 836 | 13.1 | % | 6,905 | 982 | 14.2 | % | 19,244 | 2,680 | 13.9 | % | 19,336 | 2,748 | 14.2 | % |\n\n| (a) | Sales of Opel/Vauxhall outside of Europe were insignificant in the three and nine months ended September 30, 2018 and 2017. |\n\n| (b) | Our China sales include the Automotive China JVs SAIC General Motors Sales Co., Ltd. (SGMS), SAIC GM Wuling Automobile Co., Ltd. (SGMW) and FAW-GM Light Duty Commercial Vehicle Co., Ltd. (FAW-GM). We use estimated vehicle registrations data as the basis for calculating industry volume and market share in China. |\n\n| (c) | Includes Industry and GM sales in India and South Africa. As of December 31, 2017 we have ceased sales of Chevrolet for the domestic markets in India and South Africa. |\n\n| (d) | We do not currently export vehicles to Cuba, Iran, North Korea, Sudan, or Syria. Accordingly these countries are excluded from industry sales data and corresponding calculation of market share. |\n\nIn the nine months ended September 30, 2018 we estimate we had the largest retail market share in North America and South America, and the number three market share in the Asia/Pacific, Middle East and Africa region, which included the number two market share in China.\nThe sales and market share data provided in the table above includes both fleet vehicle sales and sales to retail customers. Certain fleet transactions, particularly sales to daily rental car companies, are generally less profitable than sales to retail customers. Prior to January 1, 2018 a significant portion of the sales to daily rental car companies were recorded as operating leases under U.S. GAAP with no recognition of revenue at the date of initial delivery due to guaranteed repurchase obligations. Beginning January 1, 2018, a significant portion of the sales to daily rental car companies are recorded as sales. The following table summarizes estimated fleet sales and those sales as a percentage of total retail vehicle sales (vehicles in thousands):\n36\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\n| Three Months Ended | Nine Months Ended |\n| September 30, 2018 | September 30, 2017 | September 30, 2018 | September 30, 2017 |\n| GMNA | 169 | 160 | 565 | 501 |\n| GMI | 136 | 159 | 328 | 355 |\n| Total fleet sales | 305 | 319 | 893 | 856 |\n| Fleet sales as a percentage of total retail vehicle sales | 15.4 | % | 14.3 | % | 14.5 | % | 13.5 | % |\n\nThe following table summarizes United States fleet sales (vehicles in thousands):\n| Three Months Ended | Nine Months Ended |\n| September 30, 2018 | September 30, 2017 | September 30, 2018 | September 30, 2017 |\n| Daily rental sales | 76 | 74 | 229 | 191 |\n| Other fleet sales | 67 | 62 | 246 | 226 |\n| Total fleet sales | 143 | 136 | 475 | 417 |\n\nGM Financial Summary and Outlook GM Financial has expanded its leasing and prime lending programs in North America; therefore, leasing and prime lending have become a larger percentage of the originations and retail portfolio balance. Used vehicle prices have held at similar levels through September 30, 2018 compared to 2017. We anticipate seasonal weakness in used vehicle prices for the three months ending December 31, 2018, and expect a decrease between 4% and 5% in 2019 compared to 2018, due primarily to continued increases in the industry supply of used vehicles. The following table summarizes the estimated residual value as well as the number of units included in GM Financial equipment on operating leases, net by vehicle type (units in thousands):\n| September 30, 2018 | December 31, 2017 |\n| Residual Value | Units | Percentage | Residual Value | Units | Percentage |\n| Cars | $ | 5,119 | 399 | 23.3 | % | $ | 5,701 | 450 | 27.2 | % |\n| Trucks | 7,410 | 300 | 17.6 | % | 7,173 | 285 | 17.3 | % |\n| Crossovers | 14,796 | 901 | 52.7 | % | 13,723 | 818 | 49.5 | % |\n| SUVs | 4,156 | 110 | 6.4 | % | 3,809 | 99 | 6.0 | % |\n| Total | $ | 31,481 | 1,710 | 100.0 | % | $ | 30,406 | 1,652 | 100.0 | % |\n\nGM Financial's retail penetration in North America increased to 45% in the nine months ended September 30, 2018 from 40% in the corresponding period in 2017, due primarily to further alignment with GM and greater dealer engagement. In the nine months ended September 30, 2018 GM Financial's revenue consisted of leased vehicle income of 72%, retail finance charge income of 22% and commercial finance charge income of 4%. We believe that offering a comprehensive suite of financing products will generate incremental sales of our vehicles, drive incremental GM Financial earnings and help support our sales throughout various economic cycles.\nConsolidated Results We review changes in our results of operations under five categories: volume, mix, price, cost and other. Volume measures the impact of changes in wholesale vehicle volumes driven by industry volume, market share and changes in dealer stock levels. Mix measures the impact of changes to the regional portfolio due to product, model, trim, country and option penetration in current year wholesale vehicle volumes. Price measures the impact of changes related to Manufacturer’s Suggested Retail Price and various sales allowances. Cost includes primarily: (1) material and freight; (2) manufacturing, engineering, advertising, administrative and selling and warranty expense; and (3) non-vehicle related activity. Other includes primarily foreign exchange and non-vehicle related automotive revenues as well as equity income or loss from our nonconsolidated affiliates. Refer to the regional sections of this MD&A for additional information. We adopted ASU 2014-09 on a modified retrospective basis effective January 1, 2018. The impacts of the new standard are reflected in this MD&A. Refer to Note 1 of our condensed consolidated financial statements for additional information.\n37\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\nTotal Net Sales and Revenue\n| Three Months Ended | Favorable/ (Unfavorable) | % | Variance Due To |\n| September 30, 2018 | September 30, 2017 | Volume | Mix | Price | Other |\n| (Dollars in billions) |\n| GMNA | $ | 27,650 | $ | 24,819 | $ | 2,831 | 11.4 | % | $ | 2.4 | $ | (0.4 | ) | $ | 0.9 | $ | (0.1 | ) |\n| GMI | 4,582 | 5,576 | (994 | ) | (17.8 | )% | $ | (0.5 | ) | $ | (0.2 | ) | $ | 0.1 | $ | (0.4 | ) |\n| Corporate | 56 | 80 | (24 | ) | (30.0 | )% | $ | — | $ | — |\n| Automotive | 32,288 | 30,475 | 1,813 | 5.9 | % | $ | 1.9 | $ | (0.6 | ) | $ | 1.0 | $ | (0.5 | ) |\n| GM Financial | 3,518 | 3,161 | 357 | 11.3 | % | $ | 0.4 |\n| Eliminations | (15 | ) | (13 | ) | (2 | ) | (15.4 | )% | $ | — |\n| Total net sales and revenue | $ | 35,791 | $ | 33,623 | $ | 2,168 | 6.4 | % | $ | 1.9 | $ | (0.6 | ) | $ | 1.0 | $ | (0.2 | ) |\n\n| Nine Months Ended | Favorable/ (Unfavorable) | % | Variance Due To |\n| September 30, 2018 | September 30, 2017 | Volume | Mix | Price | Other |\n| (Dollars in billions) |\n| GMNA | $ | 83,969 | $ | 82,594 | $ | 1,375 | 1.7 | % | $ | 1.9 | $ | (1.8 | ) | $ | 1.0 | $ | 0.2 |\n| GMI | 14,188 | 16,226 | (2,038 | ) | (12.6 | )% | $ | (1.5 | ) | $ | — | $ | 0.3 | $ | (0.8 | ) |\n| Corporate | 155 | 306 | (151 | ) | (49.3 | )% | $ | — | $ | (0.1 | ) |\n| Automotive | 98,312 | 99,126 | (814 | ) | (0.8 | )% | $ | 0.4 | $ | (1.8 | ) | $ | 1.3 | $ | (0.7 | ) |\n| GM Financial | 10,417 | 8,899 | 1,518 | 17.1 | % | $ | 1.5 |\n| Eliminations | (79 | ) | (152 | ) | 73 | 48.0 | % | $ | (0.1 | ) | $ | 0.1 |\n| Total net sales and revenue | $ | 108,650 | $ | 107,873 | $ | 777 | 0.7 | % | $ | 0.4 | $ | (1.9 | ) | $ | 1.3 | $ | 0.9 |\n\nAutomotive and Other Cost of Sales\n| Three Months Ended | Favorable/ (Unfavorable) | % | Variance Due To |\n| September 30, 2018 | September 30, 2017 | Volume | Mix | Cost | Other |\n| (Dollars in billions) |\n| GMNA | $ | 23,708 | $ | 21,466 | $ | (2,242 | ) | (10.4 | )% | $ | (1.7 | ) | $ | (0.1 | ) | $ | (0.4 | ) | $ | (0.1 | ) |\n| GMI | 4,587 | 5,238 | 651 | 12.4 | % | $ | 0.4 | $ | 0.1 | $ | (0.1 | ) | $ | 0.3 |\n| Corporate | 42 | — | (42 | ) | n.m. | $ | — | $ | — | $ | (0.1 | ) |\n| GM Cruise | 209 | 159 | (50 | ) | (31.4 | )% | $ | (0.1 | ) |\n| Eliminations | (13 | ) | (11 | ) | 2 | 18.2 | % | $ | — |\n| Total automotive and other cost of sales | $ | 28,533 | $ | 26,852 | $ | (1,681 | ) | (6.3 | )% | $ | (1.3 | ) | $ | 0.1 | $ | (0.6 | ) | $ | 0.2 |\n\n__________\nn.m. = not meaningful\n38\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\n| Nine Months Ended | Favorable/ (Unfavorable) | % | Variance Due To |\n| September 30, 2018 | September 30, 2017 | Volume | Mix | Cost | Other |\n| (Dollars in billions) |\n| GMNA | $ | 72,798 | $ | 69,690 | $ | (3,108 | ) | (4.5 | )% | $ | (1.3 | ) | $ | — | $ | (1.7 | ) | $ | — |\n| GMI | 15,410 | 16,023 | 613 | 3.8 | % | $ | 1.3 | $ | 0.1 | $ | (1.0 | ) | $ | 0.2 |\n| Corporate | 138 | 143 | 5 | 3.5 | % | $ | — | $ | 0.2 | $ | (0.2 | ) |\n| GM Cruise | 514 | 439 | (75 | ) | (17.1 | )% | $ | (0.1 | ) |\n| Eliminations | (72 | ) | (147 | ) | (75 | ) | (51.0 | )% | $ | 0.1 | $ | (0.1 | ) |\n| Total automotive and other cost of sales | $ | 88,788 | $ | 86,148 | $ | (2,640 | ) | (3.1 | )% | $ | (0.1 | ) | $ | 0.2 | $ | (2.7 | ) | $ | — |\n\nIn the three months ended September 30, 2018 unfavorable Cost was due primarily to: (1) increased raw material and freight costs related to carryover vehicles of $0.5 billion; (2) increased other costs of $0.3 billion primarily related to engineering and manufacturing; and (3) increased material costs of $0.2 billion related to vehicles launched within the last twelve months incorporating significant exterior and/or interior changes (Majors); partially offset by (4) favorable material performance of $0.3 billion related to carryover vehicles. In the three months ended September 30, 2018 favorable Other was due to the foreign currency effect of $0.2 billion resulting primarily from the weakening of the Brazilian Real against the U.S. Dollar.\nIn the nine months ended September 30, 2018 unfavorable Cost was due primarily to: (1) increased raw material and freight costs related to carryover vehicles of $1.0 billion; (2) increased material costs of $1.0 billion related to Majors; (3) increased other costs of $1.0 billion primarily related to manufacturing and engineering; and (4) net increase in charges of $0.7 billion primarily related to asset impairments and employee separation costs in Korea in 2018, partially offset by restructuring actions in India and South Africa in 2017; partially offset by (5) favorable material performance of $0.8 billion related to carryover vehicles. In the nine months ended September 30, 2018 Other remained flat due to favorable foreign currency effect resulting from the weakening of the Brazilian Real and other currencies, offset by unfavorable foreign currency effect resulting from the strengthening of various currencies against the U.S. Dollar.\nAutomotive and other selling, general and administrative expense\n| Three Months Ended | Favorable/ (Unfavorable) | Nine Months Ended | Favorable/ (Unfavorable) |\n| September 30, 2018 | September 30, 2017 | % | September 30, 2018 | September 30, 2017 | % |\n| Automotive and other selling, general and administrative expense | $ | 2,584 | $ | 2,303 | $ | (281 | ) | (12.2 | )% | $ | 7,172 | $ | 7,136 | $ | (36 | ) | (0.5 | )% |\n\nIn the three months ended September 30, 2018 Automotive and other selling, general and administrative expense increased due primarily to charges of $0.4 billion for ignition switch related legal matters.\nIn the nine months ended September 30, 2018 Automotive and other selling, general and administrative expense increased due primarily to an increase in charges of $0.3 billion for ignition switch related legal matters; partially offset by decreased advertising costs of $0.2 billion.\nInterest Income and Other Non-operating Income, net\n| Three Months Ended | Favorable/ (Unfavorable) | Nine Months Ended | Favorable/ (Unfavorable) |\n| September 30, 2018 | September 30, 2017 | % | September 30, 2018 | September 30, 2017 | % |\n| Interest income and other non-operating income, net | $ | 651 | $ | 505 | $ | 146 | 28.9 | % | $ | 2,130 | $ | 1,259 | $ | 871 | 69.2 | % |\n\nIn the nine months ended September 30, 2018 Interest income and other non-operating income, net increased due primarily to: (1) favorable revaluation of investments of $0.4 billion; (2) increased non-service pension and OPEB income of $0.2 billion; and (3) $0.2 billion from licensing agreements.\nIncome Tax Expense\n39\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\n| Three Months Ended | Favorable/ (Unfavorable) | Nine Months Ended | Favorable/ (Unfavorable) |\n| September 30, 2018 | September 30, 2017 | % | September 30, 2018 | September 30, 2017 | % |\n| Income tax expense | $ | 100 | $ | 2,316 | $ | 2,216 | 95.7 | % | $ | 1,085 | $ | 3,637 | $ | 2,552 | 70.2 | % |\n\nIn the three months ended September 30, 2018 Income tax expense decreased due primarily to: (1) the absence of the 2017 valuation allowance establishment related to the sale of the Opel/Vauxhall Business which was partially offset by tax benefits related to tax settlements; and (2) changes resulting from U.S. tax reform.\nIn the nine months ended September 30, 2018 Income tax expense decreased due primarily to: (1) the absence of the 2017 valuation allowance establishment related to the sale of the Opel/Vauxhall Business which was partially offset by tax benefits related to foreign dividends and tax settlements; (2) the changes resulting from U.S. tax reform; and (3) a decrease in pretax earnings.\nGM North America\n| Three Months Ended | Favorable / (Unfavorable) | % | Variance Due To |\n| September 30, 2018 | September 30, 2017 | Volume | Mix | Price | Cost | Other |\n| (Dollars in billions) |\n| Total net sales and revenue | $ | 27,650 | $ | 24,819 | $ | 2,831 | 11.4 | % | $ | 2.4 | $ | (0.4 | ) | $ | 0.9 | $ | (0.1 | ) |\n| EBIT-adjusted | $ | 2,825 | $ | 2,068 | $ | 757 | 36.6 | % | $ | 0.7 | $ | (0.5 | ) | $ | 0.9 | $ | (0.3 | ) | $ | (0.2 | ) |\n| EBIT-adjusted margin | 10.2 | % | 8.3 | % | 1.9 | % |\n| (Vehicles in thousands) |\n| Wholesale vehicle sales | 843 | 762 | 81 | 10.6 | % |\n\n| Nine Months Ended | Favorable / (Unfavorable) | % | Variance Due To |\n| September 30, 2018 | September 30, 2017 | Volume | Mix | Price | Cost | Other |\n| (Dollars in billions) |\n| Total net sales and revenue | $ | 83,969 | $ | 82,594 | $ | 1,375 | 1.7 | % | $ | 1.9 | $ | (1.8 | ) | $ | 1.0 | $ | 0.2 |\n| EBIT-adjusted | $ | 7,728 | $ | 9,014 | $ | (1,286 | ) | (14.3 | )% | $ | 0.6 | $ | (1.8 | ) | $ | 1.0 | $ | (1.3 | ) | $ | 0.2 |\n| EBIT-adjusted margin | 9.2 | % | 10.9 | % | (1.7 | )% |\n| (Vehicles in thousands) |\n| Wholesale vehicle sales | 2,659 | 2,596 | 63 | 2.4 | % |\n\nGMNA Total Net Sales and Revenue In the three months ended September 30, 2018 Total net sales and revenue increased due primarily to: (1) increased net wholesale volumes due to an increase in sales of crossover vehicles, partially offset by a decrease in sales of passenger cars; and (2) favorable pricing for carryover vehicles of $0.5 billion and Majors of $0.4 billion, inclusive of new revenue standard impacts; partially offset by (3) unfavorable mix associated with an increase in sales of crossover vehicles and trim and other mix, partially offset by a decrease in sales of passenger cars.\nIn the nine months ended September 30, 2018 Total net sales and revenue increased due primarily to: (1) increased net wholesale volumes due to an increase in sales of crossover and fleet vehicles, partially offset by a decrease in sales of passenger cars and planned downtime for full-size trucks; and (2) favorable pricing for Majors of $1.4 billion, partially offset by unfavorable pricing for carryover vehicles of $0.3 billion, inclusive of new revenue standard impacts; partially offset by (3) unfavorable mix due to vehicle mix, fleet customer, trim and other mix.\nGMNA EBIT-Adjusted In the three months ended September 30, 2018 EBIT-adjusted increased due primarily to: (1) favorable pricing; and (2) increased net wholesale volumes; partially offset by (3) unfavorable mix; and (4) unfavorable Cost due to increased raw material and freight costs of $0.4 billion and increased vehicle content for Majors of $0.2 billion, partially offset by favorable materials performance of $0.3 billion related to carryover vehicles.\nIn the nine months ended September 30, 2018 EBIT-adjusted decreased due primarily to: (1) unfavorable mix due to fleet customer mix, vehicle mix, an increase in sales of fleet vehicles, trim and other mix; and (2) unfavorable Cost primarily due to increased vehicle content for Majors of $1.1 billion, increased raw material and freight costs of $0.9 billion, partially offset by favorable materials performance of $0.8 billion related to carryover vehicles; partially offset by (3) favorable pricing; and (4) increased net wholesale volumes.\n40\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\nGM International\n| Three Months Ended | Favorable / (Unfavorable) | Variance Due To |\n| September 30, 2018 | September 30, 2017 | % | Volume | Mix | Price | Cost | Other |\n| (Dollars in billions) |\n| Total net sales and revenue | $ | 4,582 | $ | 5,576 | $ | (994 | ) | (17.8 | )% | $ | (0.5 | ) | $ | (0.2 | ) | $ | 0.1 | $ | (0.4 | ) |\n| EBIT-adjusted | $ | 139 | $ | 389 | $ | (250 | ) | (64.3 | )% | $ | (0.1 | ) | $ | (0.1 | ) | $ | 0.1 | $ | — | $ | (0.2 | ) |\n| EBIT-adjusted margin | 3.0 | % | 7.0 | % | (4.0 | )% |\n| Equity income — Automotive China | $ | 485 | $ | 459 | $ | 26 | 5.7 | % |\n| EBIT (loss)-adjusted — excluding Equity income | $ | (346 | ) | $ | (70 | ) | $ | (276 | ) | n.m. |\n| (Vehicles in thousands) |\n| Wholesale vehicle sales | 289 | 321 | (32 | ) | (10.0 | )% |\n\n__________\nn.m. = not meaningful\n| Nine Months Ended | Favorable / (Unfavorable) | Variance Due To |\n| September 30, 2018 | September 30, 2017 | % | Volume | Mix | Price | Cost | Other |\n| (Dollars in billions) |\n| Total net sales and revenue | $ | 14,188 | $ | 16,226 | $ | (2,038 | ) | (12.6 | )% | $ | (1.5 | ) | $ | — | $ | 0.3 | $ | (0.8 | ) |\n| EBIT-adjusted | $ | 471 | $ | 884 | $ | (413 | ) | (46.7 | )% | $ | (0.3 | ) | $ | 0.1 | $ | 0.3 | $ | (0.1 | ) | $ | (0.4 | ) |\n| EBIT-adjusted margin | 3.3 | % | 5.4 | % | (2.1 | )% |\n| Equity income — Automotive China | $ | 1,674 | $ | 1,472 | $ | 202 | 13.7 | % |\n| EBIT (loss)-adjusted — excluding Equity income | $ | (1,203 | ) | $ | (588 | ) | $ | (615 | ) | n.m. |\n| (Vehicles in thousands) |\n| Wholesale vehicle sales | 836 | 939 | (103 | ) | (11.0 | )% |\n\n__________\nn.m. = not meaningful\nThe vehicle sales of our Automotive China JVs are not recorded in Total net sales and revenue. The results of our joint ventures are recorded in Equity income, which is included in EBIT-adjusted above.\nGMI Total Net Sales and Revenue In the three months ended September 30, 2018 Total net sales and revenue decreased due primarily to: (1) decreased wholesale volumes in Korea due to the closure of a facility; (2) unfavorable mix primarily in Asia/Pacific; and (3) unfavorable Other due primarily to the foreign currency effect resulting from the weakening of the Brazilian Real and Argentine Peso against the U.S. Dollar.\nIn the nine months ended September 30, 2018 Total net sales and revenue decreased due primarily to: (1) decreased wholesale volumes in Korea due to the closure of a facility and in Asia/Pacific due to the withdrawal from the Indian and South African markets in 2017; and (2) unfavorable Other due primarily to the foreign currency effect resulting from the weakening of the Brazilian Real and Argentine Peso against the U.S. Dollar; partially offset by (3) favorable pricing related to carryover vehicles in Argentina and Brazil.\nGMI EBIT-Adjusted In the three months ended September 30, 2018 EBIT-adjusted decreased due primarily to: (1) decreased wholesale volumes; and (2) unfavorable Other due primarily to the foreign currency effect resulting from the weakening of the Brazilian Real and Argentine Peso against the U.S. Dollar.\nIn the nine months ended September 30, 2018 EBIT-adjusted decreased due primarily to: (1) decreased wholesale volumes; and (2) unfavorable Other due primarily to the foreign currency effect resulting from the weakening of the Argentine Peso and Brazilian Real against the U.S. Dollar; partially offset by (3) favorable pricing.\n41\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\nWe view the Chinese market as important to our global growth strategy and are employing a multi-brand strategy led by our Buick, Chevrolet and Cadillac brands. In the coming years we plan to leverage our global architectures to increase the number of product offerings under the Buick, Chevrolet and Cadillac brands in China and continue to grow our business under the local Baojun and Wuling brands, with Baojun focusing its expansion in less developed cities and markets. We operate in the Chinese market through a number of joint ventures and maintaining strong relationships with our joint venture partners is an important part of our China growth strategy.\nThe following table summarizes certain key operational and financial data for the Automotive China JVs (vehicles in thousands):\n| Three Months Ended | Nine Months Ended |\n| September 30, 2018 | September 30, 2017 | September 30, 2018 | September 30, 2017 |\n| Wholesale vehicles including vehicles exported to markets outside of China | 921 | 963 | 2,930 | 2,842 |\n| Total net sales and revenue | $ | 11,461 | $ | 12,161 | $ | 37,781 | $ | 34,177 |\n| Net income | $ | 999 | $ | 964 | $ | 3,370 | $ | 2,912 |\n\nGM Cruise\n| Three Months Ended | Favorable / (Unfavorable) | % | Nine Months Ended | Favorable / (Unfavorable) | % |\n| September 30, 2018 | September 30, 2017 | September 30, 2018 | September 30, 2017 |\n| EBIT (loss)-adjusted | $ | (214 | ) | $ | (165 | ) | $ | (49 | ) | (29.7 | )% | $ | (534 | ) | $ | (455 | ) | $ | (79 | ) | (17.4 | )% |\n\nGM Cruise EBIT (Loss)-Adjusted In the three and nine months ended September 30, 2018 EBIT (loss)-adjusted increased due primarily to increased engineering costs as we progress towards the commercialization of an autonomous ride-sharing fleet.\nGM Financial\n| Three Months Ended | Increase / (Decrease) | % | Nine Months Ended | Increase/ (Decrease) | % |\n| September 30, 2018 | September 30, 2017 | September 30, 2018 | September 30, 2017 |\n| Total revenue | $ | 3,518 | $ | 3,161 | $ | 357 | 11.3 | % | $ | 10,417 | $ | 8,899 | $ | 1,518 | 17.1 | % |\n| Provision for loan losses | $ | 180 | $ | 204 | $ | (24 | ) | (11.8 | )% | $ | 444 | $ | 573 | $ | (129 | ) | (22.5 | )% |\n| Earnings before income taxes-adjusted | $ | 498 | $ | 310 | $ | 188 | 60.6 | % | $ | 1,477 | $ | 895 | $ | 582 | 65.0 | % |\n| Average debt outstanding (dollars in billions) | $ | 85.6 | $ | 79.0 | $ | 6.6 | 8.4 | % | $ | 83.6 | $ | 73.3 | $ | 10.3 | 14.1 | % |\n| Effective rate of interest paid | 3.9 | % | 3.4 | % | 0.5 | % | 3.8 | % | 3.5 | % | 0.3 | % |\n\nGM Financial Revenue In the three months ended September 30, 2018 Total revenue increased due primarily to increased leased vehicle income of $0.3 billion due to a larger lease portfolio.\nIn the nine months ended September 30, 2018 Total revenue increased due primarily to increased leased vehicle income of $1.2 billion due to a larger lease portfolio.\nGM Financial Earnings Before Income Taxes-Adjusted In the three months ended September 30, 2018 Earnings before income taxes-adjusted increased due primarily to increased net leased vehicle income of $0.3 billion due primarily to a larger lease portfolio, partially offset by an increase in interest expense due primarily to an increase in average debt outstanding resulting from growth in the loan and lease portfolios as well as rising benchmark interest rates.\nIn the nine months ended September 30, 2018 Earnings before income taxes-adjusted increased due primarily to increased net leased vehicle income of $0.7 billion due primarily to a larger lease portfolio, partially offset by an increase in interest expense due primarily to an increase in average debt outstanding resulting from growth in the loan and lease portfolios as well as rising benchmark interest rates.\nLiquidity and Capital Resources We believe that our current level of cash and cash equivalents, marketable securities and availability under our revolving credit facilities will be sufficient to meet our liquidity needs. We expect to have substantial cash\n42\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\nrequirements going forward which we plan to fund through total available liquidity and cash flows generated from operations and future debt issuances. We also maintain access to the capital markets and may issue debt or equity securities from time to time, which may provide an additional source of liquidity. Our future uses of cash, which may vary from time to time based on market conditions and other factors, are focused on three objectives: (1) reinvest in our business; (2) maintain a strong investment-grade balance sheet; and (3) return available cash to shareholders. Our known future material uses of cash include, among other possible demands: (1) capital expenditures of approximately $8.5 billion annually as well as payments for engineering and product development activities; (2) payments associated with previously announced vehicle recalls, the settlements of the multi-district litigation and any other recall-related contingencies; (3) payments to service debt and other long-term obligations, including discretionary and mandatory contributions to our pension plans; (4) dividend payments on our common stock that are declared by our Board of Directors; and (5) payments to purchase shares of our common stock authorized by our Board of Directors.\nOur liquidity plans are subject to a number of risks and uncertainties, including those described in the \"Forward-Looking Statements\" section of this MD&A and the “Risk Factors” section of our 2017 Form 10-K, some of which are outside of our control.\nWe continue to monitor and evaluate opportunities to strengthen our competitive position over the long-term while maintaining a strong investment-grade balance sheet. These actions may include opportunistic payments to reduce our long-term obligations such as our pension plans, as well as the possibility of acquisitions, dispositions, investments with joint venture partners and strategic alliances that we believe would generate significant advantages and substantially strengthen our business. In September 2018 we made $0.6 billion in contributions to pre-fund U.K. and Canada pension plans.\nOur senior management evaluates our capital allocation program on an ongoing basis and recommends any modifications to the program to our Board of Directors, not less than once annually. Management reaffirmed and our Board of Directors approved the capital allocation program, which includes reinvesting in our business at an average target ROIC-adjusted rate of 20% or greater, maintaining a strong investment-grade balance sheet, including a target average Automotive cash balance of $18 billion, and returning available cash to shareholders.\nAs part of our capital allocation program, our Board of Directors authorized programs to purchase $9 billion in aggregate of our common stock which were completed in the three months ended September 30, 2016 and 2017. We announced in January 2017 that our Board of Directors had authorized the purchase of up to an additional $5 billion of our common stock with no expiration date, subsequent to completing the remaining portion of the previously announced programs. We completed $1.6 billion of the $5 billion program through September 30, 2018, which included $0.1 billion purchased in the three months ended March 31, 2018 in conjunction with the sale of GM common stock by the UAW Retiree Medical Benefits Trust. From inception of the program in 2015 through October 12, 2018 we had purchased an aggregate of 302 million shares of our outstanding common stock under our common stock repurchase program for $10.6 billion. We returned total cash to shareholders of $1.7 billion, consisting of dividends paid on our common stock and purchases of our common stock in the nine months ended September 30, 2018.\nAutomotive Liquidity Total available liquidity includes cash, cash equivalents, marketable securities and funds available under credit facilities. The amount of available liquidity is subject to intra-month and seasonal fluctuations and includes balances held by various business units and subsidiaries worldwide that are needed to fund their operations. There have been no significant changes in the management of our liquidity, including the allocation of our available liquidity, the composition of our portfolio and our investment guidelines since December 31, 2017. Refer to the “Liquidity and Capital Resources” section of MD&A in our 2017 Form 10-K.\nWe use credit facilities as a mechanism to provide additional flexibility in managing our global liquidity. At December 31, 2017 the total size of our credit facilities was $14.5 billion which consisted principally of our two primary revolving credit facilities. In April 2018 we amended and restated our two existing revolving credit facilities and entered into a third facility, increasing our aggregate borrowing capacity from $14.5 billion to $16.5 billion. These facilities consist of a 364-day, $2.0 billion facility, a three-year, $4.0 billion facility and a five-year, $10.5 billion facility. The facilities are available to us as well as certain wholly-owned subsidiaries, including GM Financial. The three-year, $4.0 billion facility allows for borrowings in U.S. Dollars and other currencies and includes a letter of credit sub-facility of $1.1 billion. The five-year, $10.5 billion facility allows for borrowings in U.S. Dollars and other currencies. The 364-day, $2.0 billion facility allows for borrowing in U.S. Dollars only. We have allocated the 364-day, $2.0 billion facility for exclusive use by GM Financial. Total automotive available credit under the facility remains unchanged at $14.5 billion.\nWe did not have any borrowings against our primary facilities, but had letters of credit outstanding under our sub-facility of $0.4 billion at September 30, 2018 and December 31, 2017. GM Financial did not have any borrowings outstanding against our credit facility designated for their exclusive use at September 30, 2018 or the remainder of our revolving credit facilities at\n43\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\nSeptember 30, 2018 and December 31, 2017. We had intercompany loans from GM Financial of $0.6 billion and $0.4 billion at September 30, 2018 and December 31, 2017, which consisted primarily of commercial loans to dealers we consolidate, and we had no intercompany loans to GM Financial. Refer to Note 5 of our condensed consolidated financial statements for additional information.\nIn May 2018 we entered into an agreement with KDB to fund capital expenditure requirements of GM Korea. As part of the agreement KDB agreed to purchase GM Korea Preferred Shares of approximately $0.75 billion, and we agreed to provide future funding to GM Korea if needed, not to exceed $2.8 billion through December 31, 2027, inclusive of $2.0 billion of planned capital expenditures through 2027. Refer to Note 17 to our condensed consolidated financial statements for further details.\nIn September 2018 we issued $2.1 billion in aggregate principal amount of senior unsecured notes with an initial weighted average interest rate of 5.03% and maturity dates ranging from 2021 to 2049. The notes are governed by the same indenture that was used in past issuances, which contains terms and covenants customary of these types of securities including limitation on the amount of certain secured debt we may incur. The net proceeds from the issuance of these senior unsecured notes were used to repay $1.5 billion of debt in October 2018 upon maturity, pre-fund $0.6 billion in certain mandatory contributions for our U.K. and Canada pension plans due in 2019 through 2021, and for other general corporate purposes.\nGM Financial’s Board of Directors declared a $0.4 billion dividend on its common stock on October 26, 2018, which we received on October 30, 2018. Future dividends from GM Financial will depend on a number of factors including business and economic conditions, its financial condition, earnings, liquidity requirements and leverage ratio.\nThe following table summarizes our available liquidity (dollars in billions):\n| September 30, 2018 | December 31, 2017 |\n| Automotive cash and cash equivalents | $ | 12.1 | $ | 11.2 |\n| Marketable securities | 5.9 | 8.3 |\n| Automotive cash, cash equivalents and marketable securities(a)(b) | 18.0 | 19.6 |\n| GM Cruise cash and cash equivalents(c) | 1.8 | — |\n| Available liquidity | 19.8 | 19.6 |\n| Available under credit facilities | 14.1 | 14.1 |\n| Total available liquidity(a) | $ | 33.9 | $ | 33.6 |\n\n__________\n| (a) | Amounts do not add due to rounding. |\n\n| (b) | Includes $0.4 billion that is designated exclusively to fund capital expenditures in GM Korea at September 30, 2018. Refer to Note 17 to our condensed consolidated financial statements for further details. |\n\n| (c) | Amounts are designated exclusively for the use of GM Cruise. Refer to Note 17 to our condensed consolidated financial statements for further details. |\n\nThe following table summarizes the changes in our Automotive available liquidity (excluding GM Cruise, dollars in billions):\n| Nine Months Ended September 30, 2018 |\n| Operating cash flow | $ | 5.4 |\n| Capital expenditures | (6.5 | ) |\n| Dividends paid and payments to purchase common stock | (1.7 | ) |\n| Issuance of senior unsecured notes | 2.1 |\n| GM investment in GM Cruise | (1.1 | ) |\n| Proceeds from KDB Investment in GM Korea | 0.4 |\n| Other non-operating | (0.1 | ) |\n| Total change in automotive available liquidity | $ | (1.5 | ) |\n\nAutomotive Cash Flow (Dollars in Billions)\n44\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\n| Nine Months Ended | Change |\n| September 30, 2018 | September 30, 2017 |\n| Operating Activities |\n| Income from continuing operations | $ | 5.2 | $ | 5.1 | $ | 0.1 |\n| Depreciation, amortization and impairment charges | 4.5 | 4.3 | 0.2 |\n| Pension and OPEB activities | (2.7 | ) | (1.8 | ) | (0.9 | ) |\n| Working capital | (2.4 | ) | (2.4 | ) | — |\n| Accrued and other liabilities and income taxes | 1.7 | 1.4 | 0.3 |\n| Undistributed earnings of nonconsolidated affiliates, net | 0.3 | 0.5 | (0.2 | ) |\n| Other | (1.2 | ) | 0.5 | (1.7 | ) |\n| Net automotive cash provided by operating activities | $ | 5.4 | $ | 7.6 | $ | (2.2 | ) |\n\nIn the nine months ended September 30, 2018 the decrease in Net automotive cash provided by operating activities was due primarily to: (1) unfavorable pre-tax earnings of $2.3 billion; (2) unfavorable Pension and OPEB activities due primarily to pension contributions of $0.6 billion made to our U.K. and Canada pension plans; and (3) unfavorable Other due to the increase in units returned from rental car companies of $0.7 billion and several other insignificant items; partially offset by (4) receivables factoring with external sources and re-timing of subvention payments with third parties of $0.7 billion; and (5) re-timing of subvention payments and receivables factoring with GM Financial of $0.4 billion. Refer to Note 5 of our condensed consolidated financial statements for transactions with GM Financial.\n\n| Nine Months Ended | Change |\n| September 30, 2018 | September 30, 2017 |\n| Investing Activities |\n| Capital expenditures | $ | (6.5 | ) | $ | (6.3 | ) | $ | (0.2 | ) |\n| Acquisitions and liquidations of marketable securities, net | 2.3 | 3.4 | (1.1 | ) |\n| GM investment in GM Cruise | (1.1 | ) | — | (1.1 | ) |\n| Other | (0.2 | ) | (0.3 | ) | 0.1 |\n| Net automotive cash used in investing activities | $ | (5.5 | ) | $ | (3.2 | ) | $ | (2.3 | ) |\n\n| Nine Months Ended | Change |\n| September 30, 2018 | September 30, 2017 |\n| Financing Activities |\n| Issuance of senior unsecured notes | $ | 2.1 | $ | 3.0 | $ | (0.9 | ) |\n| Dividends paid and payments to purchase common stock | (1.7 | ) | (4.7 | ) | 3.0 |\n| Proceeds from KDB investment in GM Korea | 0.4 | — | 0.4 |\n| Other | 0.2 | (0.3 | ) | 0.5 |\n| Net automotive cash provided by (used in) financing activities | $ | 1.0 | $ | (2.0 | ) | $ | 3.0 |\n\nAdjusted Automotive Free Cash Flow\nWe measure adjusted automotive free cash flow as automotive operating cash flow from continuing operations less capital expenditures adjusted for management actions. For the nine months ended September 30, 2018, net automotive cash provided by operating activities under U.S. GAAP was $5.4 billion, capital expenditures were $6.5 billion, and an add-back adjustment for management actions related to restructuring in Korea was $0.7 billion.\nFor the nine months ended September 30, 2017, net automotive cash provided by operating activities under U.S. GAAP was $7.6 billion, capital expenditures were $6.3 billion, and there were no adjustments for management actions.\n45\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\nStatus of Credit Ratings We receive ratings from four independent credit rating agencies: DBRS Limited, Fitch Rating, Moody's Investor Service and Standard & Poor's. In March 2018 DBRS Limited revised their outlook to Positive from Stable. All other credit ratings remained unchanged since December 31, 2017.\nGM Cruise Liquidity\nThe following table summarizes the changes in our GM Cruise available liquidity (dollars in billions):\n| Nine Months Ended September 30, 2018 |\n| Operating cash flow | $ | (0.4 | ) |\n| Issuance of GM Cruise Preferred Shares to SoftBank | 0.9 |\n| GM investment in GM Cruise | 1.1 |\n| Other non-operating | 0.2 |\n| Total change in GM Cruise available liquidity | $ | 1.8 |\n\nWhen GM Cruise's autonomous vehicles are ready for commercial deployment, SoftBank is obligated to purchase additional GM Cruise Preferred Shares for $1.35 billion.\nGM Cruise Cash Flow (Dollars in Billions)\n| Nine Months Ended | Change |\n| September 30, 2018 | September 30, 2017 |\n| Net cash used in operating activities | $ | (0.4 | ) | $ | (0.3 | ) | $ | (0.1 | ) |\n| Net cash provided by financing activities | $ | 2.2 | $ | 0.4 | $ | 1.8 |\n\nIn the nine months ended September 30, 2018 Net cash provided by financing activities increased due primarily to the GM investment in GM Cruise and proceeds from the issuance of GM Cruise Preferred Shares to SoftBank.\nAutomotive Financing – GM Financial Liquidity GM Financial's primary sources of cash are finance charge income, leasing income and proceeds from the sale of terminated leased vehicles, servicing fees, net distributions from credit facilities, securitizations, secured and unsecured borrowings and collections and recoveries on finance receivables. GM Financial's primary uses of cash are purchases of retail finance receivables and leased vehicles, the funding of commercial finance receivables, repayment of secured and unsecured debt, funding credit enhancement requirements in connection with securitizations and secured debt facilities, operating expenses and interest costs. GM Financial continues to monitor and evaluate opportunities to optimize its liquidity position and the mix of its debt between secured and unsecured debt. In September 2018 GM Financial issued $0.5 billion of Fixed-to-Floating Rate Cumulative Perpetual Preferred Stock, Series B, $0.01 par value, with a liquidation preference of $1,000 per share. In September 2017 GM Financial issued $1.0 billion of Fixed-to-Floating Rate Cumulative Perpetual Preferred Shares, Series A, $0.01 par value, with a liquidation preference of $1,000 per share. Refer to Note 17 to our condensed consolidated financial statements for further details. The following table summarizes GM Financial's available liquidity (dollars in billions):\n| September 30, 2018 | December 31, 2017 |\n| Cash and cash equivalents | $ | 4.5 | $ | 4.3 |\n| Borrowing capacity on unpledged eligible assets | 17.4 | 12.5 |\n| Borrowing capacity on committed unsecured lines of credit | 0.4 | 0.1 |\n| Borrowing capacity on revolving credit facility, exclusive to GM Financial | 2.0 | — |\n| Total GM Financial available liquidity | $ | 24.3 | $ | 16.9 |\n\nIn the nine months ended September 30, 2018 available liquidity increased due primarily to an increase in receivables eligible to be pledged and a decrease in advances outstanding on secured revolving credit facilities. In addition, GM Financial added $2.0 billion in borrowing capacity on our credit facility as described in the Automotive Liquidity section of this MD&A.\nGM Financial did not have any borrowings outstanding against our credit facility designated for their exclusive use or the remainder of our revolving credit facilities at September 30, 2018. GM Financial's borrowing ability was revised with our amended and restated credit facilities in April 2018. Refer to the Automotive Liquidity section of this MD&A for additional details.\n46\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\nGM Financial Cash Flow (Dollars in Billions)\n| Nine Months Ended | Change |\n| September 30, 2018 | September 30, 2017 |\n| Net cash provided by operating activities | $ | 5.3 | $ | 4.8 | $ | 0.5 |\n| Net cash used in investing activities | $ | (11.7 | ) | $ | (17.6 | ) | $ | 5.9 |\n| Net cash provided by financing activities | $ | 6.8 | $ | 14.6 | $ | (7.8 | ) |\n\nIn the nine months ended September 30, 2018 Net cash provided by operating activities increased due primarily to an increase in net leased vehicle income, partially offset by increased interest expense and operating expenses.\nIn the nine months ended September 30, 2018 Net cash used in investing activities decreased due primarily to: (1) increased proceeds from the termination of leased vehicles of $3.4 billion; (2) increased collections on finance receivables of $2.6 billion; (3) decreased purchases of leased vehicles of $1.8 billion; partially offset by (4) increased purchases and funding of finance receivables of $1.9 billion.\nIn the nine months ended September 30, 2018 Net cash provided by financing activities decreased due primarily to a decrease in borrowings, net of payments, of $7.2 billion and a decrease in the issuance of preferred stock of $0.5 billion.\nCritical Accounting Estimates The condensed consolidated financial statements are prepared in conformity with U.S. GAAP, which requires the use of estimates, judgments and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses in the periods presented. We believe the accounting estimates employed are appropriate and the resulting balances are reasonable; however, due to the inherent uncertainties in developing estimates, actual results could differ from the original estimates, requiring adjustments to these balances in future periods. The critical accounting estimates that affect the condensed consolidated financial statements and the judgments and assumptions used are consistent with those described in the MD&A section in our 2017 Form 10-K, as supplemented by the subsequent discussion of sales incentives for the adoption of ASU 2014-09. Refer to Note 1 to our condensed consolidated financial statements for additional information on the adoption of ASU 2014-09.\nSales Incentives The estimated effect of sales incentives offered to dealers and end customers is recorded as a reduction of Automotive net sales and revenue at the time of sale. There may be numerous types of incentives available at any particular time. Incentive programs are generally brand specific, model specific or sales region specific and are for specified time periods, which may be extended. Significant factors used in estimating the cost of incentives include forecasted sales volume, product type, product mix, customer behavior and assumptions concerning market conditions. Historical experience is also considered when establishing our future expectations. A change in any of these factors affecting the estimate could have a significant effect on recorded sales incentives. Subsequent adjustments to incentive estimates are possible as facts and circumstances change over time, which could affect the revenue previously recognized in Automotive net sales and revenue.\nForward-Looking Statements In this report and in reports we subsequently file and have previously filed with the SEC on Forms 10-K and 10-Q and file or furnish on Form 8-K, and in related comments by our management, we use words like “anticipate,” “appears,” “approximately,” “believe,” “continue,” “could,” “designed,” “effect,” “estimate,” “evaluate,” “expect,” “forecast,” “goal,” “initiative,” “intend,” “may,” “objective,” “outlook,” “plan,” “potential,” “priorities,” “project,” “pursue,” “seek,” “should,” “target,” “when,” “will,” “would,” or the negative of any of those words or similar expressions to identify forward-looking statements that represent our current judgment about possible future events. In making these statements we rely on assumptions and analysis based on our experience and perception of historical trends, current conditions and expected future developments as well as other factors we consider appropriate under the circumstances. We believe these judgments are reasonable, but these statements are not guarantees of any events or financial results, and our actual results may differ materially due to a variety of important factors, both positive and negative. These factors, which may be revised or supplemented in subsequent reports on SEC Forms 10-Q and 8-K, include among others the following: (1) our ability to deliver new products, services and customer experiences in response to new participants in the automotive industry; (2) our ability to timely fund and introduce new and improved vehicle models that are able to attract a sufficient number of consumers; (3) the success of our crossovers, SUVs and full-size pickup trucks; (4) our ability to reduce the costs associated with the manufacture and sale of electric vehicles; (5) global automobile market sales volume, which can be volatile; (6) our significant business in China which subjects us to unique operational, competitive and regulatory risks; (7) our joint ventures, which we cannot operate solely for our benefit and over which we may have limited control; (8) the international scale and footprint of our operations which exposes us to a variety of political, economic and regulatory risks, including the risk of changes in government leadership and laws (including tax laws), economic tensions between governments and changes in international trade policies, new barriers to entry and changes to or withdrawals from free trade agreements, changes in foreign exchange rates, economic downturns in foreign countries, differing local product preferences and product requirements,\n47\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\ncompliance with U.S. and foreign countries' export controls and economic sanctions, differing labor regulations and difficulties in obtaining financing in foreign countries; (9) any significant disruption at one of our manufacturing facilities could disrupt our production schedule; (10) the ability of our suppliers to deliver parts, systems and components without disruption and at such times to allow us to meet production schedules; (11) prices of raw materials used by us and our suppliers; (12) our highly competitive industry, which is characterized by excess manufacturing capacity and the use of incentives and the introduction of new and improved vehicle models by our competitors; (13) the possibility that competitors may independently develop products and services similar to ours and there are no guarantees that our intellectual property rights would prevent competitors from independently developing or selling those products or services; (14) our ability to manage risks related to security breaches and other disruptions to our vehicles, information technology networks and systems; (15) our ability to comply with extensive laws and regulations applicable to our industry, including those regarding fuel economy and emissions; (16) costs and risks associated with litigation and government investigations; (17) the cost and effect on our reputation of product safety recalls and alleged defects in products and services; (18) our ability to successfully and cost-effectively restructure our operations in various countries, including Korea with minimal disruption to our supply chain and operations, globally; (19) our ability to realize production efficiencies and to achieve reductions in costs; (20) our continued ability to develop captive financing capability through GM Financial; and (21) significant increases in our pension expense or projected pension contributions resulting from changes in the value of plan assets or the discount rate applied to value the pension liabilities or mortality or other assumption changes. A further list and description of these risks, uncertainties and other factors can be found in our 2017 Form 10-K and our subsequent filings with the SEC.\nWe caution readers not to place undue reliance on forward-looking statements. We undertake no obligation to update publicly or otherwise revise any forward-looking statements, whether as a result of new information, future events or other factors that affect the subject of these statements, except where we are expressly required to do so by law.\n* * * * * * *\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\nThere have been no significant changes in our exposure to market risk since December 31, 2017. Refer to Item 7A of our 2017 Form 10-K.\n* * * * * * *\nItem 4. Controls and Procedures\nDisclosure Controls and Procedures We maintain disclosure controls and procedures designed to provide reasonable assurance that information required to be disclosed in reports filed under the Securities Exchange Act of 1934, as amended (Exchange Act), is recorded, processed, summarized and reported within the specified time periods and accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosures.\nOur management, with the participation of our CEO and CFO, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) promulgated under the Exchange Act) at September 30, 2018. Based on this evaluation required by paragraph (b) of Rules 13a-15 or 15d-15, our CEO and CFO concluded that our disclosure controls and procedures were effective as of September 30, 2018.\nChanges in Internal Control over Financial Reporting There have not been any changes in our internal control over financial reporting during the three months ended September 30, 2018 that have materially affected, or are reasonably likely to materially affect our internal control over financial reporting.\n* * * * * * *\n48\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\nPART II\nItem 1. Legal Proceedings\nRefer to the discussion in the \"Litigation-Related Liability and Tax Administrative Matters\" section in Note 14 to our condensed consolidated financial statements and the 2017 Form 10-K for information relating to legal proceedings.\n* * * * * * *\nItem 1A. Risk Factors\nWe face a number of significant risks and uncertainties in connection with our operations. Our business and the results of our operations and financial condition could be materially adversely affected by these risk factors. There have been no material changes to the Risk Factors disclosed in our 2017 Form 10-K.\n* * * * * * *\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nPurchases of Equity Securities The following table summarizes our purchases of common stock in the three months ended September 30, 2018:\n| Total Number of Shares Purchased(a) | Weighted Average Price Paid per Share | Total Number of SharesPurchased Under Announced Programs | Approximate Dollar Value of Shares ThatMay Yet be Purchased Under Announced Programs |\n| July 1, 2018 through July 31, 2018 | 318,228 | $ | 41.22 | — | $3.4 billion |\n| August 1, 2018 through August 31, 2018 | 110,372 | $ | 36.69 | — | $3.4 billion |\n| September 1, 2018 through September 30, 2018 | 31,978 | $ | 36.36 | — | $3.4 billion |\n| Total | 460,578 | $ | 39.80 | — |\n\n__________\n| (a) | Shares purchased consist of shares retained by us for the payment of the exercise price upon the exercise of warrants and shares delivered by employees or directors to us for the payment of taxes resulting from issuance of common stock upon the vesting of RSUs, Performance Stock Units and Restricted Stock Awards relating to compensation plans. Refer to our 2017 Form 10-K for additional details on warrants outstanding and employee stock incentive plans. |\n\n* * * * * * *\n49\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\nItem 6. Exhibits\n| Exhibit Number | Exhibit Name |\n| 3.1 | General Motors Company Amended and Restated Bylaws, as amended August 14, 2018, incorporated by reference to Exhibit 3.1 to the Current Report on Form 8-K of General Motors Company filed August 20, 2018 | Incorporated by Reference |\n| 4.1 | Fifth Supplemental Indenture, dated as of September 10, 2018, to the Indenture, dated as of September 27, 2013, between General Motors Company, as issuer, and The Bank of New York Mellon, as Trustee, incorporated by reference to Exhibit 4.2 to the Current Report on Form 8-K of General Motors Company filed September 10, 2018 | Incorporated by Reference |\n| 4.2 | Calculation Agency Agreement, dated as of September 10, 2018, between General Motors Company and The Bank of New York Mellon, as calculation agent, incorporated by reference to Exhibit 4.3 to the Current Report on Form 8-K of General Motors Company filed September 10, 2018 | Incorporated by Reference |\n| 31.1 | Section 302 Certification of the Chief Executive Officer | Filed Herewith |\n| 31.2 | Section 302 Certification of the Chief Financial Officer | Filed Herewith |\n| 32 | Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | Furnished with this Report |\n| 101.INS | XBRL Instance Document | Filed Herewith |\n| 101.SCH | XBRL Taxonomy Extension Schema Document | Filed Herewith |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document | Filed Herewith |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document | Filed Herewith |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document | Filed Herewith |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document | Filed Herewith |\n\n* * * * * * *\n50\nGENERAL MOTORS COMPANY AND SUBSIDIARIES\nSIGNATURE\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n| GENERAL MOTORS COMPANY (Registrant) |\n| By: | /s/ CHRISTOPHER T. HATTO |\n| Christopher T. Hatto, Vice President, Controller and Chief Accounting Officer |\n| Date: | October 31, 2018 |\n\n51\n</text>\n\nAssuming that future dividends from GM Financial remain similar to the one declared and that the business and economic conditions, financial condition, earnings, liquidity requirements and leverage ratio remain reasonable, what would be the total available liquidity by the end of the month if we also consider the changes in Automotive and GM Cruise available liquidity for nine months extrapolated to a month factor? (in billions)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nFINANCIAL STATEMENTS\nTISHMAN SPEYER INNOVATION CORP. II\nCONDENSED BALANCE SHEETS\n\n| March 31,2021(Unaudited) | December 31,2020 |\n| Assets |\n| Current assets: |\n| Cash | $ | 1,030,164 | $ | 1,975 |\n| Prepaid expenses | 651,069 | |\n| Deferred offering costs associated with IPO | | 228,025 |\n| Total current assets | $ | 1,681,233 | $ | 230,000 |\n| Cash and Cash Equivalents Held in Trust account | 300,002,054 | |\n| Total assets | 301,683,287 | 230,000 |\n| Liabilities and Stockholders Equity |\n| Current liabilities: |\n| Accounts payable and accrued expenses | $ | 394,286 | $ | 205,998 |\n| Total current liabilities | 394,286 | 205,998 |\n| Warrant Liabilities | 18,535,346 | |\n| Deferred underwriters discount | 10,500,000 | |\n| Total liabilities | 29,429,632 | 205,998 |\n| Commitments |\n| Common stock subject to possible redemption, 26,725,365 shares at redemption value at March 31, 2021 | 267,253,650 | |\n| Stockholders equity: |\n| Preferred stock, $0.0001 par value; 2,500,000 shares authorized; no shares issued and outstanding | | |\n| Class A common stock, $0.0001 par value; 250,000,000 shares authorized; 3,274,635 shares and 0 shares issued and outstanding at March 31, 2021 and December 31, 2020, respectively | 327 | |\n| Class B common stock, $0.0001 par value; 25,000,000 shares authorized; 7,500,000 and 8,625,000 shares issued and outstanding at March 31, 2021 and December 31, 2020, respectively | 750 | 863 |\n| Additional paid-in capital | 7,077,023 | 24,137 |\n| Accumulated deficit | (2,078,095 | ) | (998 | ) |\n| Total stockholders equity | 5,000,005 | 24,002 |\n| Total liabilities and stockholders equity | $ | 301,683,287 | $ | 230,000 |\n\nSee accompanying notes to unaudited condensed financial statements.\n1\nTISHMAN SPEYER INNOVATION CORP. II CONDENSED STATEMENT OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH 31, 2021 (Unaudited) Formation and operating costs $ 218,393 Loss from operations (218,393 ) Other Income (Loss) Interest earned on Trust Account 2,054 Change in fair value of warrant liabilities (1,339,063 ) Offering expenses related to warrant issuance (521,695 ) Total other income (loss) (1,858,704 ) Net loss $ (2,077,097 ) Weighted average shares outstanding, basic and diluted – Class A common stock 14,333,333 Basic and diluted net income per common share – Class A common stock $ 0.00 Weighted average shares outstanding, basic and diluted – Class B common stock 7,500,000 Basic and diluted net loss per common share – Class B common stock $ (0.28 ) See accompanying notes to unaudited condensed financial statements. 2 TISHMAN SPEYER INNOVATION CORP. II CONDENSED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY FOR THE THREE MONTHS ENDED MARCH 31, 2021 (Unaudited) Common Stock Additional Paid-In Capital Accumulated Deficit Total Stockholders’ Equity Class A Class B Shares Amount Shares Amount Balance as of December 31, 2020 — $ — 8,625,000 $ 863 $ 24,137 $ (998 ) $ 24,002 Sale of Units in Initial Public Offering, net of underwriting fees, offering costs and fair value of public warrants 30,000,000 3,000 — — 274,303,750 — 274,306,750 Forfeiture of Class B shares by Sponsor — — (1,125,000 ) (113 ) 113 — — Class A common stock subject to possible redemption (26,725,365 ) (2,673 ) — — (267,250,977 ) — (267,253,650 ) Net loss — — — — — (2,077,097 ) (2,077,097 ) Balance as of March 31, 2021 3,274,635 $ 327 7,500,000 $ 750 $ 7,077,023 $ (2,078,095 ) $ 5,000,005 See accompanying notes to unaudited condensed financial statements. 3 TISHMAN SPEYER INNOVATION CORP. II CONDENSED STATEMENT OF CASH FLOWS FOR THE THREE MONTHS ENDED MARCH 31, 2021 (Unaudited) Cash Flows from Operating Activities: Net loss $ (2,077,097 ) Adjustments to reconcile net loss to net cash used in operating activities: Interest earned on trust account (2,054 ) Change in fair value of warrant liabilities 1,339,063 Offering costs allocated to warrants 521,695 Changes in current assets and current liabilities: Prepaid expenses (651,069 ) Accounts payable and accrued expenses 394,286 Net cash used in operating activities (475,176 ) Cash Flows from Investing Activities: Investment of cash into trust account (300,000,000 ) Net cash used in investing activities (300,000,000 ) Cash Flows from Financing Activities: Proceeds from Initial Public Offering, net of underwriters’ discount 294,000,000 Proceeds from issuance of Private Placement Warrants 8,000,000 Payments of offering costs (496,635 ) Net cash provided by financing activities 301,503,365 Net Change in Cash 1,028,189 Cash – Beginning of Period 1,975 Cash – End of Period $ 1,030,164 Supplemental Disclosure of Non-cash Financing Activities: Initial value of Class A common stock subject to possible redemption, as corrected $ 268,490,170 Change in value of Class A common stock subject to possible redemption $ (1,236,520 ) Deferred underwriters’ discount payable charged to additional paid-in capital $ 10,500,000 See accompanying notes to unaudited condensed financial statements. 4 TISHMAN SPEYER INNOVATION CORP. II NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED) Note 1 — Organization and Business Operations Organization and General Tishman Speyer Innovation Corp. II (the “Company”) was incorporated in Delaware on November 12, 2020. The Company was formed for the purpose of entering into a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses (a “Business Combination”). While the Company may pursue an acquisition opportunity in any industry or geographic region, the Company intends to focus its search on identifying a prospective target that can benefit from the Company’s sponsor’s leading brand, operational expertise, and global network in the real estate industry, including real estate adjacent Proptech businesses. The Company is an early stage and emerging growth company and, as such, the Company is subject to all of the risks associated with early stage and emerging growth companies. The Company has selected December 31 as its fiscal year end. As of March 31, 2021, the Company had not yet commenced any operations. All activity through March 31, 2021, relates to the Company’s formation and the Initial Public Offering (“IPO”) described below, and subsequent to the IPO, to the Company’s search for a target to consummate a Business Combination. The Company will not generate any operating revenues until after the completion of its Business Combination, at the earliest. The Company will generate non-operating income in the form of interest income on cash and cash equivalents from the proceeds derived from the IPO. The Company’s sponsor is Tishman Speyer Innovation Sponsor II, L.L.C. (the “Sponsor”). Financing The registration statement for the Company’s IPO was declared effective on February 11, 2021 (the “Effective Date”). On February 17, 2021, the Company consummated the IPO of 30,000,000 units (the “Units” and, with respect to the common stock included in the Units being offered, the “public share”), at $10.00 per Unit, generating gross proceeds of $300,000,000, which is discussed in Note 3. Simultaneously with the closing of the IPO, the Company consummated the sale of 5,333,334 warrants (the “Private Placement Warrant”), at a price of $1.50 per Private Placement Warrant, which is discussed in Note 4. Transaction costs amounted to $17,018,662 consisting of $6,000,000 of underwriting fee, $10,500,000 of deferred underwriting fee and $518,662 of other offering costs. Of the total transaction cost, $521,695 was expensed as non-operating expenses in that statement of operations with the rest of the offering cost charged to stockholders’ equity. The transaction costs were allocated based on the relative fair value basis, compared to the total offering proceeds, between the fair value of the public warrant liabilities and the Class A common stock. Trust Account Following the closing of the IPO on February 17, 2021, an amount of $300,000,000 from the net proceeds of the sale of the Units in the IPO and the sale of the Private Placement Warrants was placed in a trust account (“Trust Account”) which is invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, with a maturity of 185 days or less or in any open-ended investment company that holds itself out as a money market fund meeting the conditions of Rule 2a-7 of the Investment Company Act, as determined by the Company. Except with respect to interest earned on the funds held in the trust account that may be released to the Company to pay its tax obligations, the proceeds from the IPO and the sale of the Private Placement Warrants will not be released from the trust account until the earliest of (a) the completion of the Company’s initial business combination, (b) the redemption of any public shares properly submitted in connection with a stockholder vote to amend the Company’s amended and restated certificate of incorporation, and (c) the redemption of the Company’s public shares if the Company is unable to complete the initial business combination within 24 months from the closing of the IPO, subject to applicable law. The proceeds deposited in the trust account could become subject to the claims of the Company’s creditors, if any, which could have priority over the claims of the Company’s public stockholders. 5 TISHMAN SPEYER INNOVATION CORP. II NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED) Initial Business Combination The Company’s management has broad discretion with respect to the specific application of the net proceeds of the IPO, although substantially all of the net proceeds are intended to be generally applied toward consummating a business combination. The Company’s business combination must be with one or more target businesses that together have a fair market value equal to at least 80% of the balance in the Trust Account (as defined below) (net of taxes payable) at the time of the signing an agreement to enter into a business combination. However, the Company will only complete a business combination if the post-business combination company owns or acquires 50% or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act. There is no assurance that the Company will be able to successfully effect a business combination. The Company will provide its public stockholders with the opportunity to redeem all or a portion of their public shares upon the completion of the initial business combination either (i) in connection with a stockholder meeting called to approve the initial business combination or (ii) by means of a tender offer. The decision as to whether the Company will seek stockholder approval of a proposed initial business combination or conduct a tender offer will be made by the Company, solely in its discretion. The stockholders will be entitled to redeem their shares for a pro rata portion of the amount then on deposit in the Trust Account (initially $10.00 per share, plus any pro rata interest earned on the funds held in the Trust Account and not previously released to the Company to pay its tax obligations). The shares of common stock subject to redemption is recorded at a redemption value and classified as temporary equity upon the completion of the IPO, in accordance with Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” In such case, the Company will proceed with a business combination if the Company has net tangible assets of at least $5,000,001 either immediately prior to or upon consummation of a business combination and, if the Company seeks stockholder approval, a majority of the issued and outstanding shares voted are voted in favor of the business combination. The Company will have 24 months from the closing of the IPO (with the ability to extend with stockholder approval) to consummate a business combination (the “Combination Period”). However, if the Company is unable to complete a business combination within the Combination Period, the Company will redeem 100% of the outstanding public shares for a pro rata portion of the funds held in the Trust Account, equal to the aggregate amount then on deposit in the trust account including interest earned on the funds held in the trust account and not previously released to the Company, divided by the number of then outstanding public shares, subject to applicable law and as further described in the registration statement, and then seek to dissolve and liquidate. The Company’s Sponsor, officers and directors have agreed to (i) waive their redemption rights with respect to their founder shares, private placement shares and public shares in connection with the completion of the initial business combination, (ii) waive their redemption rights with respect to their founder shares and public shares in connection with a stockholder vote to approve an amendment to the Company’s amended and restated certificate of incorporation, and (iii) waive their rights to liquidating distributions from the trust account with respect to their founder shares and private placement shares if the Company fails to complete the initial business combination within the Combination Period. 6 TISHMAN SPEYER INNOVATION CORP. II NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED) The Sponsor has agreed that it will be liable to the Company if and to the extent any claims by a third party for services rendered or products sold to the Company, or a prospective target business with which the Company has entered into a written letter of intent, confidentiality or similar agreement or business combination agreement, reduce the amount of funds in the trust account to below the lesser of (i) $10.00 per public share and (ii) the actual amount per public share held in the trust account as of the date of the liquidation of the trust account, if less than $10.00 per share due to reductions in the value of the trust assets, less taxes payable, provided that such liability will not apply to any claims by a third party or prospective target business who executed a waiver of any and all rights to the monies held in the trust account (whether or not such waiver is enforceable) nor will it apply to any claims under the Company’s indemnity of the underwriters of the IPO against certain liabilities, including liabilities under the Securities Act. However, the Company has not asked its Sponsor to reserve for such indemnification obligations, nor has the Company independently verified whether its Sponsor has sufficient funds to satisfy its indemnity obligations and believe that the Sponsor’s only assets are securities of the Company. Therefore, the Company cannot assure that its Sponsor would be able to satisfy those obligations. Liquidity As of March 31, 2021, the Company had cash outside the Trust Account of $1,030,164 available for working capital needs. All remaining cash held in the Trust Account are generally unavailable for the Company’s use, prior to an initial business combination, and is restricted for use either in a Business Combination or to redeem common stock. As of March 31, 2021, none of the amount in the Trust Account was available to be withdrawn as described above. Through March 31, 2021, the Company’s liquidity needs were satisfied through receipt of $25,000 from the sale of the founder shares and the remaining net proceeds from the IPO and the sale of Private Placement Warrants. The Company anticipates that the $1,030,164 outside of the Trust Account as of March 31, 2021, will be sufficient to allow the Company to operate for at least the next 12 months from the issuance of the financial statements, assuming that a Business Combination is not consummated during that time. Until consummation of its Business Combination, the Company will be using the funds not held in the Trust Account, and any additional Working Capital Loans (as defined in Note 5) from the initial stockholders, the Company’s officers and directors, or their respective affiliates (which is described in Note 5), for identifying and evaluating prospective acquisition candidates, performing business due diligence on prospective target businesses, traveling to and from the offices, plants or similar locations of prospective target businesses, reviewing corporate documents and material agreements of prospective target businesses, selecting the target business to acquire and structuring, negotiating and consummating the Business Combination. The Company does not believe it will need to raise additional funds in order to meet the expenditures required for operating its business. However, if the Company’s estimates of the costs of undertaking in-depth due diligence and negotiating business combination is less than the actual amount necessary to do so, the Company may have insufficient funds available to operate its business prior to the business combination. Moreover, the Company will need to raise additional capital through loans from its Sponsor, officers, directors, or third parties. None of the Sponsor, officers or directors are under any obligation to advance funds to, or to invest in, the Company. If the Company is unable to raise additional capital, it may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of its business plan, and reducing overhead expenses. The Company cannot provide any assurance that new financing will be available to it on commercially acceptable terms, if at all. 7 TISHMAN SPEYER INNOVATION CORP. II NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED) Correction of previously issued Financial Statement The Company corrected certain line items related to the previously audited balance sheet as of February 17, 2021 in the Form 8-K filed with the SEC on February 23, 2021 related to misstatements identified in improperly applying accounting guidance on certain warrants, recognizing them as components of equity instead of a derivative warrant liability under the guidance of ASC 815-40, “Derivatives and Hedging - Contracts on an Entity’s Own Equity” (“ASC 815-40”). The following balance sheet items as of February 17, 2021 were impacted: an increase of $17.5 million in Warrant liabilities, a decrease of $17.5 million in the amount of Class A ordinary shares subject to redemption, an increase of $0.5 million in additional paid-in capital and an increase of $0.5 million in accumulated deficit. Risks and Uncertainties Management is continuing to evaluate the impact of the COVID-19 pandemic on the industry and has concluded that while it is reasonably possible that the virus could have a negative effect on the Company’s financial position, results of operations and/or the Company’s ability to consummate a Business Combination, the specific impact is not readily determinable as of the date of these financial statements. The financial statements do not include any adjustments that might results from the outcome of this uncertainty. 8 TISHMAN SPEYER INNOVATION CORP. II NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED) Note 2 — Significant Accounting Policies Basis of Presentation The accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 8 of Regulation S-X of the U.S. Securities and Exchange Commission (“SEC”). Certain information or footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted, pursuant to the rules and regulations of the SEC for interim financial reporting. Accordingly, they do not include all the information and footnotes necessary for a complete presentation of financial position, results of operations, or cash flows. In the opinion of management, the accompanying unaudited condensed financial statements include all adjustments, consisting of a normal recurring nature, which are necessary for a fair presentation of the financial position, operating results and cash flows for the periods presented. The accompanying unaudited condensed financial statements should be read in conjunction with the Company’s prospectus for its IPO as filed with the SEC on February 12, 2021, as well as the Company’s Current Report on Form 8-K filed with the SEC on February 17, 2021. The interim results for the three months ended March 31, 2021 are not necessarily indicative of the results to be expected for the year ending December 31, 2021 or for any future interim periods. Emerging Growth Company Status The Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act of 1933, as amended, (the “Securities Act”), as modified by the Jumpstart our Business Startups Act of 2012, (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. Further, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used. 9 TISHMAN SPEYER INNOVATION CORP. II NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED) Use of Estimates The preparation of financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. One of the more significant accounting estimates included in these financial statements is the determination of the fair value of the warrant liability. Such estimates may be subject to change as more current information becomes available, and accordingly, the actual results could differ significantly from those estimates Cash and Cash Equivalents The Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. At March 31, 2021, the Company’s cash equivalents consisted solely of amounts held in the Trust Account. At December 31, 2020, the Company had no cash equivalents. Cash and Cash Equivalents Held in Trust Account At March 31, 2021, the Trust Account had $300,002,054 held in cash and cash equivalents. During period January 1, 2021 to March 31, 2021, the Company did not withdraw any of interest income from the Trust Account to pay its tax obligations. Concentration of Credit Risk Financial instruments that potentially subject the Company to concentrations of credit risk consist of a cash account in a financial institution, which, at times, may exceed the Federal Depository Insurance Coverage of $250,000. At March 31, 2021, the Company has not experienced losses on this account. 10 TISHMAN SPEYER INNOVATION CORP. II NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED) Class A Common Stock Subject to Possible Redemption The Company accounts for its Class A common stock subject to possible redemption in accordance with the guidance in ASC Topic 480 “Distinguishing Liabilities from Equity.” Class A common stock subject to mandatory redemption (if any) are classified as a liability instrument and are measured at fair value. Conditionally redeemable common stock (including common stock that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) are classified as temporary equity. At all other times, common stock are classified as stockholders’ equity. The Company’s common stock feature certain redemption rights that are considered to be outside of the Company’s control and subject to the occurrence of uncertain future events. Accordingly, as of March 31, 2021, 26,725,365 shares of Class A common stock subject to possible redemption are presented at redemption value as temporary equity, outside of the stockholders’ equity section of the Company’s condensed balance sheet. Net Loss per Common Share The Company complies with accounting and disclosure requirements ASC Topic 260, “Earnings Per Share.” The Company’s statements of operations include a presentation of loss per share for Class A common stock subject to possible redemption in a manner similar to the two-class method of income (loss) per share. Net income per common stock, basic and diluted for Class A common stock is calculated by dividing the interest income earned on the Trust Account totaling $2,054 for the three months ended March 31, 2021, net of income and or franchise tax expense, by the weighted average number of Class A common stock outstanding since original issuance. Net loss per common stock, basic and diluted for Class B common stock is calculated by dividing the net income, adjusted for income attributable to Class A common stock, by the weighted average number of Class B common stock outstanding for the period. Class B common stock includes the Founder Shares as these shares do not have any redemption features and do not participate in the income earned on the Trust Account. The Company did not have any dilutive securities and other contracts that could, potentially, be exercised or converted into ordinary shares and then share in the earnings of the Company. As a result, diluted loss per share is the same as basic loss per share for the period presented. Below is a reconciliation of the net loss per common stock: For the Quarter ended March 31, 2021 Redeemable Class A Common Stock Numerator: Earnings allocable to Redeemable Class A Common Stock Interest Income $ 2,054 Less: interest available to pay taxes (2,054 ) Net Earning $ — Denominator: Weighted Average Redeemable Class A Common Stock Redeemable Class A Common Stock, Basic and Diluted 14,333,333 Earnings/Basic and Diluted Redeemable Class A Common Stock $ 0.00 Non-Redeemable Class B Common Stock Numerator: Net Income minus Redeemable Net Earnings Net Income (Loss) $ (2,077,097 ) Redeemable Net Earnings $ — Non-Redeemable Net Loss $ (2,077,097 ) Denominator: Weighted Average Non-Redeemable Class B Common Stock Non-Redeemable Class B Common Stock, Basic and Diluted 7,500,000 Loss/Basic and Diluted Non-Redeemable Common Stock $ (0.28 ) 11 TISHMAN SPEYER INNOVATION CORP. II NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED) Offering Costs The Company complies with the requirements of the ASC 340-10-S99-1 and SEC Staff Accounting Bulletin (“SAB”) Topic 5A - “Expenses of Offering”. Offering costs consist principally of professional and registration fees incurred through the balance sheets date that are related to the IPO and that were charged to stockholders’ equity upon the completion of the IPO. Accordingly, on February 17, 2021, offering costs totaling $17,018,662 have been charged to stockholders’ equity (consisting of $6,000,000 of underwriting fee, $10,500,000 of deferred underwriting fee and $518,695 of other offering costs). Of the total transaction cost, $521,695 was reclassified to expense as a non-operating expense in the statement of operations with the rest of the offering cost charged to stockholders’ equity. The transaction costs were allocated based on the relative fair value basis, compared to the total offering proceeds, between the fair value of the public warrant liabilities and the Class A common stock. Fair Value of Financial Instruments The fair value of the Company’s assets and liabilities, which qualify as financial instruments under the Financial Accounting Standards Board (“FASB”) ASC 820, “Fair Value Measurements and Disclosures,” approximates the carrying amounts represented in the condensed balance sheets. Derivative Warrant Liabilities The Company does not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks. The Company evaluates all of its financial instruments, including issued stock purchase warrants, to determine if such instruments are derivatives or contain features that qualify as embedded derivatives, pursuant to ASC 480 and ASC 815-15. The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is re-assessed at the end of each reporting period. The Company accounts for its 11,333,334 warrants issued in connection with its IPO (6,000,000) and Private Placement (5,333,334) as derivative warrant liabilities in accordance with ASC 815-40. Accordingly, the Company recognizes the warrant instruments as liabilities at fair value and adjusts the instruments to fair value at each reporting period. The liabilities are subject to re-measurement at each balance sheet date until exercised, and any change in fair value is recognized in the Company’s statement of operations. The fair value of warrants issued by the Company in connection with the IPO and Private Placement has been estimated using Monte-Carlo simulations at each measurement date. 12 TISHMAN SPEYER INNOVATION CORP. II NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED) Income Taxes The Company accounts for income taxes under ASC 740 Income Taxes (“ASC 740”). ASC 740 requires the recognition of deferred tax assets and liabilities for both the expected impact of differences between the financial statement and tax basis of assets and liabilities and for the expected future tax benefit to be derived from tax loss and tax credit carry forwards. ASC 740 additionally requires a valuation allowance to be established when it is more likely than not that all or a portion of deferred tax assets will not be realized. The tax provision for the three months ended March 31, 2021 has been deemed to be immaterial, as well as the deferred tax assets as of March 31, 2021 and December 31, 2021. ASC 740 also clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. ASC 740 also provides guidance on derecognition, classification, interest and penalties, accounting in interim period, disclosure and transition. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of March 31, 2021 and December 31, 2020. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position. The Company has identified the United States as its only “major” tax jurisdiction. The Company may be subject to potential examination by federal and state taxing authorities in the areas of income taxes. These potential examinations may include questioning the timing and amount of deductions, the nexus of income among various tax jurisdictions and compliance with federal and state tax laws. The Company’s management does not expect that the total amount of unrecognized tax benefits will materially change over the next twelve months. Recent Accounting Standards In August 2020, the FASB issued Accounting Standard Update (the “ASU”) No. 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity, which simplifies accounting for convertible instruments by removing major separation models required under current GAAP. The ASU also removes certain settlement conditions that are required for equity-linked contracts to qualify for the derivative scope exception and it also simplifies the diluted earnings per share calculation in certain areas. The Company early adopted the ASU on January 1, 2021. Adoption of the ASU did not impact the Company’s financial position, results of operations or cash flows. Management does not believe that any recently issued, but not effective, accounting standards, if currently adopted, would have a material effect on the Company’s financial statements. Note 3 — Initial Public Offering On February 17, 2021, the Company sold 30,000,000 Units at a price of $10.00 per Unit. Each Unit consists of one share of Class A common stock, par value $0.0001 per share and one-fifth of one redeemable warrant (each, a “Public Warrant”). Each whole Public Warrant entitles the holder to purchase one share of Class A common stock at a price of $11.50 per share, subject to adjustment (see Note 6). 13 TISHMAN SPEYER INNOVATION CORP. II NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED) Note 4 — Private Placement Warrants Simultaneously with the closing of the IPO, the Sponsor purchased an aggregate of 5,333,334 Private Placement Warrants, at a price of $1.50 per Private Placement Warrant, for an aggregate purchase price of $8,000,000. A portion of the proceeds from the Private Placement Warrants were added to the net proceeds from the IPO held in the Trust Account. Each Private Placement Warrant is exercisable to purchase one share of Class A common stock at $11.50 per share. The initial stockholders, including the Sponsor, have agreed, subject to limited exceptions, not to transfer, assign or sell any of the Founder Shares until the earlier to occur of: (i) one year after the completion of the initial Business Combination and (ii) the date following the completion of the initial Business Combination on which the Company completes a liquidation, merger, capital stock exchange or other similar transaction that results in all of the Company’s stockholders having the right to exchange their common stock for cash, securities or other property. Notwithstanding the foregoing, if the closing price of the Company’s Class A common stock equals or exceeds $12.00 per share (as adjusted for stock splits, stock capitalizations, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing at least 150 days after the initial Business Combination, the Founder Shares will be released from the lock-up. Note 5 — Related Party Transactions Founder Shares On November 18, 2020, the Sponsor paid an aggregate price of $25,000 in exchange for the issuance of 8,625,000 shares of Class B common stock (the “Founder Shares”). On November 24, 2020, the Sponsor forfeited 5,750,000 Founder Shares to the Company. On January 22, 2021, the Company effected a 2.5-for-1 Class B common stock split, resulting in aggregate Founders Shares outstanding of 7,187,500. On February 12, 2021, the Company effected a 1.2-for-1 Class B common stock split, resulting in aggregate Founders Shares outstanding of 8,625,000. The underwriters did not exercise the overallotment option, and as a result, the Sponsor forfeited 1,125,000 Founders Shares on March 28, 2021, resulting in 7,500,000 Founders Shares issued and outstanding at March 31, 2021. The Company’s initial stockholders have agreed not to transfer, assign or sell any of their founder shares until the earlier to occur of (A) one year after the completion of the Company’s initial business combination and (B) the date on which the Company completes a liquidation, merger, capital stock exchange or other similar transaction after the Company’s initial business combination that results in all of the Company’s stockholders having the right to exchange their Class A common stock for cash, securities or other property; except to certain permitted transferees and under certain circumstances as described herein under “Principal Stockholders — Transfers of Founder Shares and Private Placement Warrants”. Any permitted transferees will be subject to the same restrictions and other agreements of the Company’s initial stockholders with respect to any founder shares. The Company refers to such transfer restrictions as the lock-up. Notwithstanding the foregoing, the founder shares will be released from the lockup if the closing price of the Company’s Class A common stock equals or exceeds $12.00 per share (as adjusted for stock splits, stock capitalizations, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing at least 150 days after the company’s initial business combination. 14 TISHMAN SPEYER INNOVATION CORP. II NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED) Promissory Note — Related Party The Sponsor had agreed to loan the Company an aggregate of up to $300,000 to be used for the payment of costs related to the IPO. The promissory note was non-interest bearing, unsecured and was repaid at the closing of the IPO. As of March 31, 2021 and December 31, 2020, there was no outstanding balance under the note. Administrative Support Agreement Commencing on the IPO and through the earlier of the consummation of the initial Business Combination and the Company’s liquidation, the Company will reimburse an affiliate of the Sponsor for office space, secretarial and administrative services provided to the Company in the amount of $10,000 per month. For the three months ended March 31, 2021, the Company has incurred $14,286 in expense under the support agreement. Working Capital Loans In addition, in order to finance transaction costs in connection with a Business Combination, the Sponsor or an affiliate of the Sponsor, or certain of the Company’s officers and directors may, but are not obligated to, loan the Company funds as may be required (“Working Capital Loans”). If the Company completes a Business Combination, the Company would repay the Working Capital Loans out of the proceeds of the Trust Account released to the Company. Otherwise, the Working Capital Loans would be repaid only out of funds held outside the Trust Account. In the event that a Business Combination does not close, the Company may use a portion of proceeds held outside the Trust Account to repay the Working Capital Loans but no proceeds held in the Trust Account would be used to repay the Working Capital Loans. Except for the foregoing, the terms of such Working Capital Loans, if any, have not been determined and no written agreements exist with respect to such loans. The Working Capital Loans would either be repaid upon consummation of a Business Combination or, at the lender’s discretion, up to $1,500,000 of such Working Capital Loans may be convertible into warrants of the post Business Combination entity at a price of $1.50 per warrant. The warrants would be identical to the Private Placement Warrants. As of March 31, 2021 and December 31, 2020, the Company had no borrowings under the Working Capital Loans. Note 6 — Commitments and Contingencies Registration Rights The holders of Founder Shares, Private Placement Warrants and warrants that may be issued upon conversion of Working Capital Loans, if any, (and any shares of Class A common stock issuable upon the exercise of the Private Placement Warrants and warrants that may be issued upon conversion of Working Capital Loans and upon conversion of the Founder Shares) will be entitled to registration rights pursuant to a registration rights agreement to be signed prior to the consummation of the IPO. These holders will be entitled to certain demand and “piggyback” registration rights. The Company will bear the expenses incurred in connection with the filing of any such registration statements. The registration rights agreement will not provide for any maximum cash penalties nor any penalties connected with delays in registering the Company’s common stock. 15 TISHMAN SPEYER INNOVATION CORP. II NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED) Underwriting Agreement On February 17, 2021, the underwriters were paid cash underwriting commissions of 2% of the gross proceeds of the IPO, totaling $6,000,000. In addition, $0.35 per unit, or approximately $10,500,000 in the aggregate, will be payable to the underwriters for deferred underwriting commissions. The deferred commissions will become payable to the underwriters from the amounts held in the Trust Account solely in the event that the Company completes a Business Combination, subject to the terms of the underwriting agreement. Note 7 — Stockholders’ Equity Preferred Stock — The Company is authorized to issue a total of 2,500,000 shares of preferred stock at par value of $0.0001 each. At March 31, 2021 and December 31, 2020, there were no shares of preferred stock issued or outstanding. Class A Common Stock — The Company is authorized to issue a total of 250,000,000 shares of Class A common stock at par value of $0.0001 each. At March 31, 2021, there were 3,274,635 shares issued and outstanding (excluding 26,725,365 shares subject to possible redemption). At December 31, 2020, there were no shares issued and outstanding. Class B Common Stock — The Company is authorized to issue a total of 25,000,000 shares of Class B common stock at par value of $0.0001 each. At March 31, 2021, there were 7,500,000 shares of Class B common stock issued and outstanding. At December 31, 2020, there were 8,625,000 shares issued and outstanding. Stockholders of record are entitled to one vote for each share held on all matters to be voted on by stockholders. Prior to the initial Business Combination, holders of Class B common stock will have the right to elect all of the Company’s directors and may remove members of the Company’s board of directors for any reason. On any other matter submitted to a vote of stockholders, holders of Class A common stock and holders of Class B common stock will vote together as a single class on all matters submitted to a vote of the Company’s stockholders except as required by law or stock exchange rule. The Class B common stock will automatically convert into Class A common stock at the time of the initial Business Combination, or earlier at the option of the holder, on a one-for-one basis, subject to adjustment for stock splits, stock dividends, reorganizations, recapitalizations and the like, and subject to further adjustment as provided herein. In the case that additional shares of Class A common stock or equity-linked securities are issued or deemed issued in connection with the initial Business Combination, the number of shares of Class A common stock issuable upon conversion of all Founder Shares will equal, in the aggregate, on an as-converted basis, 20% of the total number of shares of Class A common stock outstanding after such conversion (after giving effect to any redemptions of shares of Class A common stock by Public Stockholders), including the total number of shares of Class A common stock issued, or deemed issued or issuable upon conversion or exercise of any equity-linked securities or rights issued or deemed issued, by the Company in connection with or in relation to the consummation of the initial Business Combination, excluding any shares of Class A common stock or equity-linked securities or rights exercisable for or convertible into shares of Class A common stock issued, or to be issued, to any seller in the initial Business Combination and any Private Placement Warrants issued to the Sponsor, officers or directors upon conversion of Working Capital Loans, provided that such conversion of Founder Shares will never occur on a less than one-for-one basis. 16 TISHMAN SPEYER INNOVATION CORP. II NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED) Note 8 — Warrants Public Warrants may only be exercised for a whole number of shares. No fractional Public Warrants will be issued upon separation of the Units and only whole Public Warrants will trade. The Public Warrants will become exercisable on the later of (a) 30 days after the completion of a Business Combination or (b) 12 months from the closing of the IPO; provided in each case that the Company has an effective registration statement under the Securities Act covering the shares of Class A common stock issuable upon exercise of the Public Warrants and a current prospectus relating to them is available (or the Company permits holders to exercise their Public Warrants on a cashless basis and such cashless exercise is exempt from registration under the Securities Act). The Company has agreed that as soon as practicable, but in no event later than 15 business days, after the closing of a Business Combination, the Company will use its commercially reasonable efforts to file with the SEC a registration statement for the registration, under the Securities Act, of the shares of Class A common stock issuable upon exercise of the Public Warrants. The Company will use its commercially reasonable efforts to cause the same to become effective and to maintain the effectiveness of such registration statement, and a current prospectus relating thereto, until the expiration of the Public Warrants in accordance with the provisions of the warrant agreement. Notwithstanding the above, if the Class A common stock is at the time of any exercise of a warrant not listed on a national securities exchange such that it satisfies the definition of a “covered security” under Section 18(b)(1) of the Securities Act, the Company may, at its option, require holders of Public Warrants who exercise their warrants to do so on a “cashless” basis, and, in the event the Company so elects, the Company will not be required to file or maintain in effect a registration statement, but the Company will be required to use its commercially reasonable efforts to register or qualify the shares under applicable blue sky laws to the extent an exemption is not available. The Public Warrants will expire five years after the completion of a Business Combination or earlier upon redemption or liquidation. The warrants will expire five years after the completion of a Business Combination or earlier upon redemption or liquidation. If (x) the Company issues additional shares of Class A common stock or equity-linked securities for capital raising purposes in connection with the closing of its initial Business Combination at an issue price or effective issue price of less than $9.20 per share of Class A common stock (with such issue price or effective issue price to be determined in good faith by the Company’s board of directors and, in the case of any such issuance to the initial stockholders or their affiliates, without taking into account any Founder Shares held by the initial stockholders or such affiliates, as applicable, prior to such issuance), (y) the aggregate gross proceeds from such issuances represent more than 50% of the total equity proceeds, and interest thereon, available for the funding of the initial Business Combination (net of redemptions), and (z) the volume weighted average trading price of the Class A common stock during the 10 trading day period starting on the trading day after the day on which the Company consummates the initial Business Combination (such price, the “Market Value”) is below $9.20 per share, the exercise price of the Warrants will be adjusted (to the nearest cent) to be equal to 115% of the higher of the Market Value and the Newly Issued Price, the $18.00 per share redemption trigger price of the Warrants will be adjusted (to the nearest cent) to be equal to 180% of the higher of the Market Value and the Newly Issued Price, and the $10.00 per share redemption trigger price of the Warrants will be adjusted (to the nearest cent) to be equal to the higher of the Market Value and the Newly Issued Price. The Private Placement Warrants are identical to the Public Warrants, except that the Private Placement Warrants and the shares of Class A common stock issuable upon exercise of the Private Placement Warrants will not be transferable, assignable or salable until 30 days after the completion of a Business Combination, subject to certain limited exceptions. Additionally, the Private Placement Warrants will be non-redeemable so long as they are held by the Sponsor or its permitted transferees. If the Private Placement Warrants are held by someone other than the Sponsor or its permitted transferees, the Private Placement Warrants will be redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants. 17 TISHMAN SPEYER INNOVATION CORP. II NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED) The Company may call the Public Warrants for redemption: • in whole and not in part; • at a price of $0.01 per warrant; • upon a minimum of 30 days’ prior written notice of redemption; and • if, and only if, the last sales price of the Class A common stock equals or exceeds $18.00 per share on each of 20 trading days within the 30-trading day period ending on the third business day prior to the date on which the Company sends the notice of redemption to the warrant holders. In addition, the Company may call the Public Warrants for redemption: • in whole and not in part; • at $0.10 per warrant provided that holders will be able to exercise their warrants on a cashless basis prior to redemption and receive a certain number of shares of Class A common stock, based on the fair market value of the Class A common stock; • if, and only if, the closing price of Class A common stock equals or exceeds $10.00 per share for any 20 trading days within the 30-trading day period ending three trading days before the notice of redemption is sent to the warrant holders; and • if the closing price of Class A common stock for any 20 trading days within a 30-trading day period ending on the third trading day prior to the date on which the notice of redemption is sent to the warrant holders is less than $18.00 per share, the private placement warrants must also be concurrently called for redemption on the same terms as the outstanding public warrants. In no event will the Company be required to net cash settle any warrant. If the Company is unable to complete a Business Combination within the Combination Period and the Company liquidates the funds held in the Trust Account, holders of warrants will not receive any of such funds with respect to their warrants, nor will they receive any distribution from the Company’s assets held outside of the Trust Account with the respect to such warrants. Accordingly, the warrants may expire worthless. 18 TISHMAN SPEYER INNOVATION CORP. II NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED) Note 9 — Fair Value Measurements Fair value is defined as the price that would be received for sale of an asset or paid for transfer of a liability, in an orderly transaction between market participants at the measurement date. GAAP establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). These tiers include: • Level 1, defined as observable inputs such as quoted prices (unadjusted) for identical instruments in active markets; • Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable such as quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active; and • Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions, such as valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable. The following table presents information about the Company’s assets and liabilities that are measured at fair value on a recurring basis at March 31, 2021 and indicates the fair value hierarchy of the valuation inputs the Company utilized to determine such fair value: March 31, 2021 Carrying Value (Level 1) (Level 2) (Level 3) Assets: Cash and Cash equivalents held in Trust Account $ 300,002,054 $ 300,002,054 $ — $ — Liabilities: Warrant liabilities $ 18,535,346 $ — $ — $ 18,535,346 The Company utilizes a Monte Carlo simulation model to value the warrants at each reporting period, with changes in fair value recognized in the statement of operations. The estimated fair value of the warrant liability is determined using Level 3 inputs. Inherent in a binomial options pricing model are assumptions related to expected share-price volatility, expected life, risk-free interest rate and dividend yield. The Company estimates the volatility of its ordinary shares based on historical volatility that matches the expected remaining life of the warrants. The risk-free interest rate is based on the U.S. Treasury zero-coupon yield curve on the grant date for a maturity similar to the expected remaining life of the warrants. The expected life of the warrants is assumed to be equivalent to their remaining contractual term. The dividend rate is based on the historical rate, which the Company anticipates to remain at zero. The aforementioned warrant liabilities are not subject to qualified hedge accounting. There were no transfers between Levels 1, 2 or 3 during the three months ended March 31, 2021. 19 TISHMAN SPEYER INNOVATION CORP. II NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED) The following table provides quantitative information regarding Level 3 fair value measurements: At March 31, 2021 Stock price $ 9.62 Strike price $ 11.50 Term (in years) 5.92 Volatility 24.4 % Risk-free rate 1.14 % Dividend yield 0.0 % The following table provides a reconciliation of changes in fair value of the beginning and ending balances for our assets and liabilities classified as level 3: Warrant Liability Fair value at January 1, 2021 $ — Initial value at IPO date 17,509,557 Change in fair value 1,025,789 Fair Value at March 31, 2021 $ 18,535,346 Note 10 — Subsequent Events The Company evaluated subsequent events and transactions that occurred after the condensed balance sheets date through May 25, 2021, which is the date on which these financial statements were issued. Based upon this review, the Company did not identify any subsequent events that would have required adjustment or disclosure in the financial statements. 20\nReferences in this report to “we,” “us” or the “Company” refer to Tishman Speyer Innovation Corp. II, a Delaware corporation, to our “management” or our “management team” refer to our officers and directors, and references to the “Sponsor” refer to Tishman Speyer Innovation Sponsor II, L.L.C., a Delaware limited liability company. “Tishman Speyer” refers to Tishman Speyer Properties, L.P., a New York limited partnership, and the parent of our Sponsor. References to our “initial stockholders” refer to our Sponsor and to our independent directors, Joshua Kazam, Jennifer Rubio, Ned Segal and Michelangelo Volpi. Refer to the glossary at the end of this report for additional terms.\nSpecial Note Regarding Forward-Looking Statements\nThis discussion contains forward-looking statements reflecting our current expectations, estimates and assumptions concerning events and financial trends that may affect our future operating results or financial position. Our forward-looking statements include, but are not limited to, statements regarding our or our management team’s expectations, hopes, beliefs, intentions or strategies regarding the future. In addition, any statements that refer to projections, forecasts or other characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. The words “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intends,” “may,” “might,” “plan,” “possible,” “potential,” “predict,” “project,” “should,” “would” and similar expressions may identify forward-looking statements, but the absence of these words does not mean that a statement is not forward-looking. The forward-looking statements contained in this report are based on our current expectations and beliefs concerning future developments and their potential effects on us. There can be no assurance that future developments affecting us will be those that we have anticipated. A number of factors could cause actual events, performance or results to differ materially from the events, performance and results discussed in the forward-looking statements. For information identifying important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements, please refer to the “Risk Factors” section of the final prospectus for our initial public offering filed with the SEC. Except as expressly required by applicable securities law, the Company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.\nOverview\nWe are a blank check company, originally incorporated in Delaware on November 12, 2020, and formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination.\nFollowing the closing of our initial public offering (the “IPO”), on February 17, 2021, $300,000,000 ($10.00 per Unit) from the net proceeds of the sale of the Units in the IPO and the sale of the Private Placement Warrants was placed in the Trust Account and invested only in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, with a maturity of 185 days or less, or in money market funds meeting certain conditions under Rule 2a-7 promulgated under the Investment Company Act which invest only in direct U.S. government treasury obligations, until the earlier of: (i) the completion of a Business Combination, (ii) the redemption of any Public Shares properly submitted in connection with a stockholder vote to amend the Company’s amended and restated certificate of incorporation, and (iii) the redemption of the Company’s Public Shares if the Company is unable to complete the initial Business Combination by February 17, 2023, subject to applicable law. The proceeds deposited in the Trust Account could become subject to the claims of the Company’s creditors, if any, which could have priority over the claims of the Company’s public stockholders.\nOur management has broad discretion with respect to the specific application of the net proceeds of the IPO and the sale of Private Placement Warrants, although substantially all of the net proceeds are intended to be applied generally toward consummating a Business Combination.\nResults of Operations\nAs of March 31, 2021, we had not commenced any operations. All activity for the period from January 1, 2021 through March 31, 2021, relates to our formation and IPO, and, subsequent to the IPO, our search for a target to\n21\nconsummate a Business Combination. We will not generate any operating revenues until after the completion of a Business Combination, at the earliest. We will generate non-operating income in the form of interest income from the proceeds derived from the IPO and placed in the Trust Account (defined below). For the period from January 1, 2021 through March 31, 2021, we had a net loss of $2,077,097, consisting mostly of change in fair value of warrant liabilities of $1,339,063, offering expenses related to warrant issuance of $521,695, and formation costs of $218,393. Liquidity and Capital Resources As of March 31, 2021, we had cash outside our trust account of $1,030,164, available for working capital needs. All remaining cash was held in the trust account and is generally unavailable for our use, prior to an initial business combination. We intend to use substantially all of the funds held in the Trust Account, including any amounts representing interest earned on the Trust Account (excluding deferred underwriting commissions) to complete our Business Combination. We may withdraw interest to pay our taxes. We estimate our annual franchise tax obligations, based on the number of shares of our common stock authorized and outstanding after the completion of the IPO, to be $200,000, which is the maximum amount of annual franchise taxes payable by us as a Delaware corporation per annum, which we may pay from funds from the IPO held outside of the Trust Account or from interest earned on the funds held in the Trust Account and released to us for this purpose. Our annual income tax obligations will depend on the amount of interest and other income earned on the amounts held in the Trust Account. We expect the interest earned on the amount in the Trust Account will be sufficient to pay our income taxes. To the extent that our equity or debt is used, in whole or in part, as consideration to complete our Business Combination, the remaining proceeds held in the Trust Account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies. Further, our Sponsor, officers and directors or their respective affiliates may, but are not obligated to, loan us funds as may be required (the “Working Capital Loans”). If we complete a Business Combination, we would repay the Working Capital Loans out of the proceeds of the Trust Account released to us. Otherwise, the Working Capital Loans would be repaid only out of funds held outside the Trust Account. In the event that a Business Combination does not close, we may use a portion of proceeds held outside the Trust Account to repay the Working Capital Loans but no proceeds held in the Trust Account would be used to repay the Working Capital Loans. Except for the foregoing, the terms of such Working Capital Loans, if any, have not been determined and no written agreements exist with respect to such loans. The Working Capital Loans would either be repaid upon consummation of a Business Combination or, at the lender’s discretion, up to $1,500,000 of such Working Capital Loans may be convertible into warrants of the post Business Combination entity at a price of $1.50 per warrant. The warrants would be identical to the Private Placement Warrants. To date, we had no borrowings under the Working Capital Loans. We do not believe we will need to raise additional funds in order to meet the expenditures required for operating our business. However, if our estimates of the costs of identifying a target business, undertaking in-depth due diligence and negotiating a Business Combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our Business Combination. In order to fund working capital deficiencies or finance transaction costs in connection with an intended Business Combination, our Sponsor or an affiliate of our Sponsor or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If we complete our Business Combination, we would repay such loaned amounts. In the event that our Business Combination does not close, we may use a portion of the working capital held outside the Trust Account to repay such loaned amounts but no proceeds from our Trust Account would be used for such repayment. Up to $1,500,000 of such loans may be convertible into warrants of the post business combination entity at a price of $1.50 per warrant at the option of the lender. The warrants would be identical to the Private Placement Warrants. The terms of such loans, if any, have not been determined and no written agreements exist with respect to such loans. Prior to the completion of our Business Combination, we do not expect to seek loans from parties other than our Sponsor or an affiliate of our Sponsor as we do not believe third parties will be willing to loan such funds and provide a waiver against any and all rights to seek access to funds in our Trust Account. 22 Off-Balance Sheet Financing Arrangements We did not have any off-balance sheet arrangement as of March 31, 2021. Contractual Obligations As of March 31, 2021, we did not have any long-term debt, capital or operating lease obligations. We entered into an administrative services agreement pursuant to which we will pay our Sponsor for office space and secretarial and administrative services provided to members of our management team, in an amount not to exceed $10,000 per month. Critical Accounting Policies and Estimates The preparation of condensed financial statements and related disclosures in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have identified the following critical accounting policies: Derivative Warrant Liabilities We do not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks. We evaluate all of our financial instruments, including issued stock purchase warrants, to determine if such instruments are derivatives or contain features that qualify as embedded derivatives, pursuant to ASC 480 and ASC 815-15. The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is re-assessed at the end of each reporting period. We account for our 11,333,334 warrants issued in connection with its IPO (6,000,000) and Private Placement (5,333,334) as derivative warrant liabilities in accordance with ASC 815-40. Accordingly, we recognize the warrant instruments as liabilities at fair value and adjusts the instruments to fair value at each reporting period. The liabilities are subject to re-measurement at each balance sheet date until exercised, and any change in fair value is recognized in our statement of operations. The fair value of warrants issued by us in connection with the IPO and Private Placement has been estimated using Monte-Carlo simulations at each measurement date. Class A Common Stock Subject to Possible Redemption We account for our common stock subject to possible redemption in accordance with the guidance in the Financial Accounting Standards Board’s Accounting Standards Codification Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable Class A common stock (including Class A common stock that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, Class A common stock is classified as stockholders’ equity. Our Class A common stock feature certain redemption rights that are considered to be outside of our control and subject to the occurrence of uncertain future events. Accordingly, at March 31, 2021, 26,725,365 shares of Class A common stock subject to possible redemption are presented as temporary equity, outside of the stockholders’ equity section of our balance sheet. Net Loss Per Common Share Net income (loss) per common stock is computed by dividing net income (loss) by the weighted average number of common stock outstanding for each of the periods. The calculation of diluted income (loss) per common stock does not consider the effect of the warrants issued in connection with the (i) IPO, and (ii) Private Placement Warrants since the exercise of the warrants are contingent upon the occurrence of future events and the inclusion of such warrants would be anti-dilutive. The warrants are exercisable to purchase 5,333,334 shares of Class A common stock in the aggregate. 23 Our statements of operations include a presentation of income (loss) per share for Class A common stock subject to possible redemption in a manner similar to the two-class method of income (loss) per common stock. Net income per common stock, basic and diluted, for redeemable Class A common stock is calculated by dividing the interest income earned on the Trust Account, by the weighted average number of redeemable Class A common stock outstanding since original issuance. Net loss per common stock, basic and diluted, for non-redeemable Class B common stock is calculated by dividing the net income (loss), adjusted for income attributable to redeemable Class B common stock, by the weighted average number of non-redeemable Class B common stock outstanding for the periods. Non-redeemable Class B common stock include the Founder Shares as these common stocks do not have any redemption features and do not participate in the income earned on the Trust Account. Recent Accounting Standards In August 2020, the FASB issued Accounting Standard Update (the “ASU”) No. 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity, which simplifies accounting for convertible instruments by removing major separation models required under current GAAP. The ASU also removes certain settlement conditions that are required for equity-linked contracts to qualify for the derivative scope exception and it also simplifies the diluted earnings per share calculation in certain areas. The Company early adopted the ASU on January 1, 2021. Adoption of the ASU did not impact the Company’s financial position, results of operations or cash flows. Management does not believe that any recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on our condensed financial statements. 24\nAs a “smaller reporting company,” we are not required to provide the information called for by this Item.\nEvaluation of Disclosure Controls and Procedures\nDisclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in Company reports filed or submitted under the Exchange Act is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.\nAs required by Rules 13a-15 and 15d-15 under the Exchange Act, our Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of March 31, 2021. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, due solely to the material weakness we have identified in our internal control over financial reporting described below, our disclosure controls and procedures (as defined in Rules 13a-15 (e) and 15d-15 (e) under the Exchange Act) were not effective.\nA material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented, or detected and corrected on a timely basis. We became aware of the need to change the classification of our warrants when the SEC issued a statement entitled “Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (“SPACs”)” on April 12, 2021. As a result, our management concluded that there was a material weakness in internal control over financial reporting as of March 31, 2021. In light of the material weakness, we performed additional analysis as deemed necessary to ensure that our financial statements were prepared in accordance with U.S. generally accepted accounting principles.\nChanges in Internal Control over Financial Reporting\nDuring the most recently completed fiscal quarter, there has been no change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting as the circumstances that led to the errors in our financial statements described in this Quarterly Report had not yet been identified. While we have processes to identify and appropriately apply applicable accounting requirements, we plan to enhance our system of evaluating and implementing the accounting standards that apply to our financial statements, including through enhanced analyses by our personnel and third-party professionals with whom we consult regarding complex accounting applications. We can offer no assurance that our remediation plan will ultimately have the intended effects.\n25\nPART II – OTHER INFORMATION\nAs of March 31, 2021, to the knowledge of our management, there was no material litigation, arbitration or governmental proceeding pending against us or any members of our management team in their capacity as such, and we and the members of our management team have not been subject to any such proceeding.\nOur warrants are accounted for as liabilities and the changes in value of our warrants could have a material effect on our financial results.\nASC 815 provides for the remeasurement of the fair value of such derivatives at each balance sheet date, with a resulting non-cash gain or loss related to the change in the fair value being recognized in earnings (loss) in the statement of operations. As a result of the recurring fair value measurement, our financial statements and results of operations may fluctuate quarterly, based on factors, which are outside of our control. Due to the recurring fair value measurement, we expect that we will recognize non-cash gains or losses on our warrants each reporting period and that the amount of such gains or losses could be material. The impact of changes in fair value on earnings may have an adverse effect on the market price of our securities. In addition, potential targets may seek a special purpose acquisition company that does not have warrants that are accounted for as a warrant liability, which may make it more difficult for us to consummate an initial business combination.\nWe have identified a material weakness in our internal control over financial reporting. If we are unable to develop and maintain an effective system of internal control over financial reporting, we may not be able to accurately report our financial results in a timely manner, which may adversely affect investor confidence in us and materially and adversely affect our business and operating results.\nFollowing the SEC Statement, and after consultation with our independent registered public accounting firm, our management and our audit committee concluded that, in light of the SEC Statement, it was appropriate to restate our previously issued audited balance sheet as of February 17, 2021 to account for our warrants as liabilities measured at fair value, rather than equity securities. As a result of these events, we have identified a material weakness in our internal control over financial reporting. See Part I, Item 4 “Controls and Procedures” of this Quarterly Report.\nEffective internal controls are necessary for us to provide reliable financial reports and prevent fraud. We continue to evaluate steps to remediate the material weakness. If we identify any new material weakness in the future, any such newly identified material weakness could limit our ability to prevent or detect a misstatement of our accounts or disclosures that could result in a material misstatement of our annual or interim financial statements. In such case, we may be unable to maintain compliance with securities law requirements regarding timely filing of periodic reports in addition to applicable stock exchange listing requirements, investors may lose confidence in our financial reporting and the price of our securities may decline as a result. We cannot assure you that the measures we have taken to date, or any measures we may take in the future, will be sufficient to avoid potential future material weaknesses.\nOn February 17, 2021, we consummated our initial public offering (“IPO”) of 30,000,000 Units. The Units were sold at an offering price of $10.00 per Unit, generating total gross proceeds of $300,000,000 (before underwriting discounts and commissions and offering expenses). Each Unit consisted of one share of Class A common stock of the Company, par value $0.0001 per share, and one-fifth of one redeemable warrant of the Company. BofA Securities, Inc. and Allen & Company LLC acted as book-running managers of the offering. The securities sold in the offering were registered under the Securities Act on a registration statement on Form S-1 (No. 333- 252423). The SEC declared the registration statement effective on February 11, 2021.\nSimultaneously with the consummation of the IPO, we consummated a private placement of 5,333,334 Private Placement Warrants to our Sponsor at a price of $1.50 per Private Placement Warrant, generating total proceeds of $8,000,000. Such securities were issued pursuant to the exemption from registration contained in Section 4(a)(2) of the Securities Act.\n26\nThe Private Placement Warrants are the same as the warrants underlying the Units sold in the IPO, except that Private Placement Warrants are not transferable, assignable or salable until 30 days after the completion of a Business Combination, subject to certain limited exceptions. Additionally, the Private Placement Warrants are exercisable on a cashless basis and are non-redeemable so long as they are held by the initial purchasers or their permitted transferees. Of the gross proceeds received from the IPO and the Private Placement Warrants, $300,000,000 was placed in the Trust Account. Transaction costs of the IPO amounted to $17,018,662, consisting of $6,000,000 of underwriting commissions, $10,500,000 of deferred underwriting commissions and $518,662 of other offering costs. For a description of the use of the proceeds generated in our IPO, see Part I, Item 2 of this Quarterly Report.\nNot applicable.\nNot applicable.\nNone.\n\n| ExhibitNumber | Description |\n| 3.1 | Amended and Restated Certificate of Incorporation (incorporated by reference to Exhibit 3.2 to the Companys Current Report on Form 8-K filed with the SEC on February 17, 2021). |\n| 3.2 | Certificate of Amendment to the Amended and Restated Certificate of Incorporation (incorporated by reference to Exhibit 3.1 to the Companys Current Report on Form 8-K filed with the SEC on February 17, 2021). |\n| 3.3 | Bylaws (incorporated by reference to Exhibit 3.3 to the Companys Current Report on Form 8-K filed with the SEC on February 17, 2021). |\n| 4.1 | Warrant Agreement, dated February 11, 2021, by and between the Company and Continental Stock Transfer & Trust Company, as warrant agent (incorporated by reference to Exhibit 4.1 to the Companys Current Report on Form 8-K filed with the SEC on February 17, 2021). |\n| 10.1 | Letter Agreement, dated February 11, 2021, by and among the Company, its executive officers, its directors and Tishman Speyer Innovation Sponsor II, L.L.C. (incorporated by reference to Exhibit 10.1 to the Companys Current Report on Form 8-K filed with the SEC on February 17, 2021). |\n| 10.2 | Investment Management Trust Agreement, dated February 11, 2021, by and between the Company and Continental Stock Transfer & Trust Company, as trustee (incorporated by reference to Exhibit 10.2 to the Companys Current Report on Form 8-K filed with the SEC on February 17, 2021). |\n| 10.3 | Registration Rights Agreement, dated February 11, 2021, by and among the Company, Tishman Speyer Innovation Sponsor II, L.L.C. and the other holders party thereto (incorporated by reference to Exhibit 10.3 to the Companys Current Report on Form 8-K filed with the SEC on February 17, 2021). |\n\n27\n10.4 Private Placement Warrants Purchase Agreement, dated February 11, 2021, by and between the Company and Tishman Speyer Innovation Sponsor II, L.L.C. (incorporated by reference to Exhibit 10.4 to the Company’s Current Report on Form 8-K filed with the SEC on February 17, 2021). 10.5 Form of Indemnity Agreement between the Company and each of the officers and directors of the Company (incorporated by reference to Exhibit 10.5 to the Company’s Current Report on Form 8-K filed with the SEC on February 17, 2021). 10.6 Administrative Services Agreement, dated February 11, 2021, between the Company and Tishman Speyer Innovation Sponsor II, L.L.C. (incorporated by reference to Exhibit 10.6 to the Company’s Current Report on Form 8-K filed with the SEC on February 17, 2021). 10.7 Promissory Note issued to Tishman Speyer Innovation Sponsor II, L.L.C. (incorporated by reference to Exhibit 10.6 to the Company’s Registration Statement on Form S-1 filed with the SEC on January 26, 2021). 10.8 Securities Subscription Agreement between the Registrant and Tishman Speyer Innovation Sponsor II, L.L.C. (incorporated by reference to Exhibit 10.7 to the Company’s Registration Statement on Form S-1 filed with the SEC on January 26, 2021). 31.1 Certification of Chief Executive Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Chief Financial Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 101.INS XBRL Instance Document 101.SCH XBRL Taxonomy Extension Schema Document 101.CAL XBRL Taxonomy Extension Calculation Linkbase Document 101.DEF XBRL Taxonomy Extension Definition Linkbase Document 101.LAB XBRL Taxonomy Extension Label Linkbase Document 101.PRE XBRL Taxonomy Extension Presentation Linkbase Document 28 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. TISHMAN SPEYER INNOVATION CORP. II By: /s/ Paul A. Galiano Name: Paul A. Galiano Dated: May 25, 2021 Title: Chief Operating Officer, Chief Financial Officer and Director (Principal Accounting Officer) 29 GLOSSARY As used in this report, unless otherwise noted or the context otherwise requires, references to: “Business Combination” are to a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination involving the Company and one or more businesses; “Class A common stock” are to the shares of the Company’s Class A common stock, par value $0.0001 per share; “Class B common stock” are to the shares of the Company’s Class B common stock, par value $0.0001 per share; “common stock” are to the Company’s Class A common stock and Class B common stock; “Company” are to Tishman Speyer Innovation Corp. II, a Delaware corporation; “Exchange Act” are to the Securities Exchange Act of 1934, as amended; “Founder Shares” are to the shares of the Class B common stock and Class A common stock issued upon the automatic conversion thereof at the time of the Company’s initial business combination; “GAAP” are to generally accepted accounting principles in the United States, as applied on a consistent basis; “initial stockholders” are to holders of the Founder Shares; “Investment Company Act” are to the Investment Company Act of 1940, as amended; “IPO” are to the initial public offering by the Company, which closed on November 13, 2020; “Private Placement Warrants” are to the warrants issued to the Sponsor in a private placement simultaneously with the closing of the IPO; “Public Shares” are to shares of our Class A common stock sold as part of the units in the IPO (whether they were purchased in the IPO or thereafter in the open market); “public stockholders” are to the holders of the Public Shares, including the Sponsor and management team to the extent the Sponsor and/or members of its management team purchase Public Shares provided that the Sponsor’s and each member of its management team’s status as a “public stockholder” will only exist with respect to such Public Shares; “Sarbanes-Oxley Act” are to the Sarbanes-Oxley Act of 2002; “SEC” are to the U.S. Securities and Exchange Commission; “Sponsor” are to Tishman Speyer Innovation Sponsor II, L.L.C., a Delaware limited liability company; “Tishman Speyer” are to Tishman Speyer Properties, L.P., a New York limited partnership, and the parent of the Sponsor; and “Trust Account” are trust account established by the Company for the benefit of its stockholders at J.P. Morgan Chase Bank, N.A. Unless specified otherwise, amounts in this report are presented in United States (“U.S.”) dollars. Defined terms in the financial statements contained in this report have the meanings ascribed to them in the financial statements. 30\n</text>\n\nWhat is the total expense to raise funds from the initial public offering (IPO) and private placement assuming a flat rate of 5% underwriters fee was charged on the private placement proceeds in dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nITEM 1. Financial Statements\nICONIC BRANDS, INC. AND SUBSIDIARIES\nCONSOLIDATED FINANCIAL STATEMENTS\nTHREE MONTHS ENDED MARCH 31, 2022 AND 2021\n\n| 4 |\n\n\n| ICONIC BRANDS, INC. AND SUBSIDIARIES |\n| CONDENSED CONSOLIDATED BALANCE SHEETS |\n| (Unaudited) |\n| March 31, 2022 | December 31, 2021 |\n| ASSETS |\n| Current assets: |\n| Cash | $ | 7,589,114 | $ | 2,190,814 |\n| Accounts receivable | 4,030,076 | 852,321 |\n| Inventory | 3,181,719 | 1,228,351 |\n| Prepaid expense and other current assets | 528,071 | 74,517 |\n| Total current assets | 15,328,980 | 4,346,003 |\n| Right-of-use assets, net | 5,491,085 | 3,074,864 |\n| Leasehold improvements, furniture, and equipment, net | 7,312,012 | 5,556,964 |\n| Intangible assets | 20,812,986 | 21,609,586 |\n| Goodwill | 15,976,877 | 15,976,877 |\n| Other assets | 223,779 | 142,362 |\n| Total assets | $ | 65,145,719 | $ | 50,706,656 |\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\n| Current liabilities: |\n| Accounts payable and accrued expenses | $ | 4,482,141 | $ | 2,713,046 |\n| Notes payable | 5,045,466 | 5,045,466 |\n| Factoring liability | 1,960,604 | - |\n| Deferred revenue | 145,694 | 135,034 |\n| Other current liabilities | 132,234 | 132,234 |\n| Current portion of operating lease liability | 562,202 | 380,487 |\n| Contingent consideration | - | 8,244,642 |\n| Total current liabilities | 12,328,341 | 16,650,909 |\n| Operating lease liability, long term | 5,225,683 | 2,835,828 |\n| Notes payable, long term | 147,001 | 147,001 |\n| Contingent consideration, long term | 20,204,505 | 11,959,863 |\n| Total liabilities | 37,905,530 | 31,593,601 |\n| Stockholders’ and members’ equity: |\n| Preferred stock, $ 0.001 par value; authorized 100,000,000 shares: |\n| Series A-2, 38,180 shares issued and outstanding at March 31, 2022; 26,623 shares issued and outstanding at December 31, 2021 | 38 | 27 |\n| Common stock, $ 0.001 par value; authorized 2,000,000,000 shares, 97,086,968 issued and outstanding at March 31, 2022 and 90,542,764 issued and outstanding at December 31, 2021 | 97,088 | 90,544 |\n| Additional paid-in capital | 68,021,374 | 56,749,055 |\n| Accumulated deficit | ( 40,019,265 | ) | ( 36,961,344 | ) |\n| Noncontrolling interests | ( 859,046 | ) | ( 765,227 | ) |\n| Total stockholders’ equity | 27,240,189 | 19,113,055 |\n| Total liabilities and stockholders’ equity | $ | 65,145,719 | $ | 50,706,656 |\n| See accompanying notes to Unaudited Condensed Consolidated Financial Statements. |\n\n\n| 5 |\n\n\n| ICONIC BRANDS, INC. AND SUBSIDIARIES |\n| CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS |\n| (Unaudited) |\n| Three months ended March 31, |\n| 2022 | 2021 |\n| REVENUE |\n| Sales | $ | 4,046,797 | $ | 634,533 |\n| Cost of goods sold | 2,205,039 | 318,633 |\n| Gross Profit | 1,841,758 | 315,900 |\n| OPERATING EXPENSES |\n| General and administrative expenses | 4,458,387 | 873,970 |\n| Selling and marketing | 351,977 | 121,168 |\n| Total operating expenses | 4,810,364 | 995,138 |\n| Loss from operations | ( 2,968,606 | ) | ( 679,238 | ) |\n| Other income (expense): |\n| Gain on forgiveness of PPP loan | - | 28,458 |\n| Interest expense | ( 183,134 | ) | - |\n| Total other income (expense) | ( 183,134 | ) | 28,458 |\n| Net loss | $ | ( 3,151,740 | ) | $ | ( 650,780 | ) |\n| Net (loss) income attributable to noncontrolling interests in subsidiaries | ( 93,819 | ) | 16,174 |\n| Net (loss) attributable to Iconic Brands, Inc. | ( 3,057,921 | ) | ( 666,954 | ) |\n| Basic and diluted loss per share | $ | ( 0.03 | ) | $ | ( 0.04 | ) |\n| Weighted average number of shares outstanding | 94,923,294 | 16,309,048 |\n| See accompanying notes to Unaudited Condensed Consolidated Financial Statements. |\n\n\n| 6 |\n\n\n| ICONIC BRANDS, INC. AND SUBSIDIARIES |\n| CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY |\n| (Unaudited) |\n\n\n| Series A Preferred stock | Series E Preferred stock | Series F Preferred stock | Series G Preferred stock | Series A-2 Preferred stock | Common stock | Treasury stock | Additional paid-in | Noncontrolling | Accumulated |\n| Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | capital | Subtotal | interests | Deficit | Total |\n| Balance, December 31, 2020 | 1 | 1 | 2,115,224 | 2,115 | 2,414 | 2,413,750 | 1,475 | 1,475,000 | - | - | 17,268,881 | 17,269 | ( 1,000,000 | ) | ( 516,528 | ) | 22,430,430 | 25,822,037 | ( 1,152,810 | ) | ( 26,497,350 | ) | ( 1,828,123 | ) |\n| Issuance of common stock in exchange for services rendered and to be rendered | - | - | - | - | - | - | - | - | - | - | 401,670 | 402 | - | - | 180,350 | 180,752 | - | - | 180,752 |\n| Retirement of treasury stock | - | - | - | - | - | - | - | - | - | - | ( 1,000,000 | ) | ( 1,000 | ) | 1,000,000 | 516,528 | ( 515,528 | ) | - | - | - | - |\n| Net loss | - | - | - | - | - | - | - | - | - | - | - | - | - | - | - | - | 16,174 | ( 666,954 | ) | ( 650,780 | ) |\n| Balance, March 31, 2021 | 1 | 1 | 2,115,224 | 2,115 | 2,414 | 2,413,750 | 1,475 | 1,475,000 | - | - | 16,670,551 | 16,671 | - | - | 22,095,252 | 26,002,789 | ( 1,136,636 | ) | ( 27,164,304 | ) | ( 2,298,151 | ) |\n| Balance, December 31, 2021 | - | - | - | - | - | - | - | - | 26,623 | 27 | 90,542,764 | 90,544 | - | - | 56,749,055 | 56,839,626 | ( 765,227 | ) | ( 36,961,344 | ) | 19,113,055 |\n| Common stock and Series A-2 Preferred stock issued for Cash, net of fees | - | - | - | - | - | - | - | - | 12,258 | 12 | 4,301,004 | 4,301 | - | - | 10,993,763 | 10,998,076 | - | - | 10,998,076 |\n| Conversion of Series A-2 Preferred Stock for Common Stock | - | - | - | - | - | - | - | - | ( 701 | ) | ( 1 | ) | 2,243,200 | 2,243 | - | - | ( 2,242 | ) | (0 | ) | - | - | (0 | ) |\n| Equity-based compensation | - | - | - | - | - | - | - | - | - | - | - | - | - | - | 280,798 | 280,798 | - | - | 280,798 |\n| Net loss | - | - | - | - | - | - | - | - | - | - | - | - | - | - | - | - | ( 93,819 | ) | ( 3,057,921 | ) | ( 3,151,740 | ) |\n| Balance, March 31, 2022 | - | - | - | - | - | - | - | - | 38,180 | 38 | 97,086,968 | 97,088 | - | - | 68,021,374 | 68,118,500 | ( 859,046 | ) | ( 40,019,265 | ) | ( 27,240,189 | ) |\n\nSee accompanying notes to Unaudited Condensed Consolidated Financial Statements.\n\n| 7 |\n\n\n| ICONIC BRANDS, INC. AND SUBSIDIARIES |\n| CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS |\n| (Unaudited) |\n| Three months ended March 31, |\n| 2022 | 2021 |\n| CASH FLOWS FROM OPERATING ACTIVITIES: |\n| Net loss | $ | ( 3,151,740 | ) | $ | ( 650,780 | ) |\n| Adjustment to reconcile net loss to net cash used in operating activities: |\n| Depreciation and amortization | 78,348 | 3,546 |\n| Amortization of operating lease right-of-use assets | 201,253 | - |\n| Gain on forgiveness of PPP loan | - | ( 28,458 | ) |\n| Amortization of intangibles | 796,600 | - |\n| Equity based compensation | 280,798 | 180,752 |\n| Change in allowance for doubtful accounts | 47,000 | - |\n| Change in operating assets and liabilities: |\n| Accounts receivable | ( 3,244,755 | ) | 106,940 |\n| Inventory | ( 1,953,368 | ) | ( 83,482 | ) |\n| Operating lease liabilities | ( 45,904 | ) | - |\n| Accounts payable and accrued expenses | 1,769,095 | 370,182 |\n| Prepaid expense and other current assets | ( 453,554 | ) | - |\n| Other assets | ( 81,417 | ) | - |\n| Deferred revenue | 10,660 | - |\n| Net cash used in operating activities | ( 5,726,984 | ) | ( 101,300 | ) |\n| CASH FLOWS USED IN INVESTING ACTIVITIES: |\n| Additions to leasehold improvements, furniture, and equipment | ( 1,833,396 | ) | - |\n| CASH FLOWS FROM FINANCING ACTIVITIES: |\n| Common stock and Series A-2 Preferred stock issued for Cash, net of fees | 10,998,076 | - |\n| Proceeds from factoring arrangement | 1,960,604 | - |\n| Loans payable to officer and affiliated entity | - | ( 11,921 | ) |\n| Net cash provided by (used in) financing activities | 12,958,680 | ( 11,921 | ) |\n| Net increase in cash | 5,398,300 | ( 113,221 | ) |\n| Cash at beginning of year | 2,190,814 | 457,041 |\n| Cash at end of year | $ | 7,589,114 | $ | 343,820 |\n| SUPPLEMENTAL DISCLOSURE OF CASH AND NON-CASH TRANSACTIONS: |\n| Cash paid for interest | $ | - | $ | - |\n| Purchase and retirement of treasury stock | $ | - | $ | 516,528 |\n| Recognition of right of use asset - operating lease | $ | 2,617,474 | $ | - |\n| Conversion of Series A-2 Preferred Stock for Common Stock | $ | 2,242 | $ | - |\n| See accompanying notes to Unaudited Condensed Consolidated Financial Statements. |\n\n\n| 8 |\n\nIconic Brands, Inc. and Subsidiaries\nNotes to Consolidated Financial Statements\n(Unaudited)\n1. ORGANIZATION AND NATURE OF BUSINESS\nIconic Brands, Inc., (“the Company”, or “Iconic”), was incorporated in the State of Nevada on October 21, 2005. As of March 31, 2022, the subsidiaries of Iconic are wholly-owned TopPop LLC (“TopPop”) and United Spirits Inc., (“United”), 54 % owned BiVi LLC (“BiVi”) and Bellissima Spirits LLC (“Bellissima”) and 60% owned Empire Wine and Spirits LLC (“Empire”) which was organized on February 4, 2022.\nBiVi is the brand owner of “BiVi 100 percent Sicilian Vodka,” and Bellissima is the brand owner of Bellissima sparkling wines. BiVi was organized in Nevada on May 4, 2015. Bellissima was organized in Nevada on November 23, 2015.\nOn July 26, 2021, the Company acquired 100 % of TopPop. TopPop is organized as a limited liability company in the State of New Jersey on September 5, 2019. TopPop’s primary operation is the manufacture and packaging of alcohol and non-alcohol single-serve, shelf-stable, ready-to-freeze ice pops. TopPop began operations in December 2019 (see note 3). On July 26, 2021, the company purchased all the outstanding stock of United.\nEmpire was organized in the State of Nevada on February 4, 2022. During the first quarter ended March 31, 2022, there was no business activity or transactions.\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\n(a) Principles of Consolidation\nThe consolidated financial statements include the accounts of Iconic, its two 54 % owned subsidiaries BiVi and Bellissima, 60% owned Empire, and its wholly-owned subsidiaries United and TopPop, (collectively, the “Company”). All inter-company balances and transactions have been eliminated in consolidation.\n(b) Use of Estimates\nThe preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.\n(c) Fair Value of Financial Instruments\nGenerally accepted accounting principles require disclosing the fair value of financial instruments to the extent practicable for financial instruments which are recognized or unrecognized in the balance sheet. The fair value of the financial instruments disclosed herein is not necessarily representative of the amount that could be realized or settled, nor does the fair value amount consider the tax consequences of realization or settlement.\nIn assessing the fair value of financial instruments, the Company uses a variety of methods and assumptions, which are based on estimates of market conditions and risks existing at the time. For certain instruments, including cash and cash equivalents, accounts receivable, accounts payable and accrued expenses, and notes payable, it was estimated that the carrying amount approximated fair value because of the short maturities of these instruments.\n\n| 9 |\n\nAccounting guidance on fair value measurements requires that financial assets and liabilities be classified and disclosed in one of the following categories of the fair value hierarchy:\nLevel 1 – Based on unadjusted quoted prices for identical assets or liabilities in an active market.\nLevel 2 – Based on observable market-based inputs or unobservable inputs that are corroborated by market data.\nLevel 3 – Based on unobservable inputs that reflect the entity’s own assumptions about the assumptions that a market participant would use in pricing the asset or liability.\nWe did not have any transfers between levels during the periods presented.\nThe following table sets forth the Company’s assets and liabilities which are measured at fair value on a recurring basis by level within the fair value hierarchy. The only financial instrument measured at fair value is the contingent consideration:\n\n| As of March 31, 2022 and December 31, 2021 |\n| Quoted Prices in active markets (Level 1) | Significant other observable inputs (Level 2) | Significant unobservable inputs (Level 3) |\n| Contingent consideration | $ | - | $ | - | $ | 20,204,505 |\n\nThe fair value of the contingent consideration is based on the projected earnings of the business.\n(d) Cash\nThe total amount of bank deposits (checking and savings accounts) that was not insured by the FDIC at March 31, 2022 was $ 6,789,306 .\n(e) Accounts Receivable, Net of Allowance for Doubtful Accounts\nThe Company extends unsecured credit to customers in the ordinary course of business but mitigates risk by performing credit checks and by actively pursuing past due accounts. The allowance for doubtful accounts is based on customer historical experience and the aging of the related accounts receivable. At March 31, 2022 and December 31, 2021, the allowance for doubtful accounts was $ 47,000 and $ 0 , respectively.\n(f) Inventories\nInventories are stated at the lower of cost (first-in, first-out method) or market, with due consideration given to obsolescence and to slow moving items. Inventories at March 31, 2022 and December 31, 2021 consist of cases of BiVi Vodka and cases of Bellissima sparkling wines purchased from our Italian suppliers and cases of alcoholic beverages. TopPop inventory consists of raw materials, work in process and finished goods relating to the production cycle.\n\n| 10 |\n\n(g) Revenue Recognition\nIt is the Company’s policy that revenues from product sales are recognized in accordance with Accounting Standards Codification (“ASC 606”) “Revenue Recognition.” Five basic steps must be followed to recognize revenue; (1) Identify contract(s) with a customer that creates enforceable rights and obligations; (2) Identify performance obligations in the contract, such as promises to transfer goods or services to a customer; (3) Determine the transaction price, (i.e. the amount of consideration in a contract to which an entity believes it is entitled in exchange for transferring promised goods or services to a customer); (4) Allocate the transaction price to the performance obligations in the contract, which requires the Company to allocate the transaction price to each performance obligation on the basis of the relative standalone selling prices of each distinct good or services promised in the contract; and (5) Recognize revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service to a customer. The amount of revenue recognized is the amount allocated to the satisfied performance obligation. Adoption of ASC 606 has not changed the timing and nature of the Company’s revenue recognition and there has been no material effect on the Company’s consolidated financial statements.\nOur revenue (referred to in our consolidated financial statements as “sales”) consists primarily of the sale of wine and spirits imported for cash or otherwise agreed-upon credit terms. Our customers consist primarily of retailers. Our revenue generating activities have a single performance obligation and are recognized at the point in time when control transfers and our obligation has been fulfilled, which is when the related goods are shipped or delivered to the customer, depending upon the method of distribution, and shipping terms. We have elected to treat shipping as a fulfillment activity. Revenue is measured as the amount of consideration we expect to receive in exchange for the sale of our product. The Company has no obligation to accept the return of products sold other than for replacement of damaged products. Other than quantity price discounts negotiated with customers prior to billing and delivery (which are reflected as a reduction in sales), the Company does not offer any sales incentives or other rebate arrangements to customers. Revenue associated with manufacturing and packaging business is recognized at a point in time when obligations under the terms of a contact with a customer are satisfied.\n(h) Shipping and Handling Costs\nShipping and handling costs to deliver product to customers are reported as operating expenses in the accompanying statements of operations. Shipping and handling costs to purchase inventory are capitalized and expensed to cost of sales when revenue is recognized on the sale of product to customers.\n(i) Equity-Based Compensation\nEquity-based compensation is accounted for at fair value in accordance with ASC Topic 718, “Compensation-Stock Compensation”. For the three months ended March 31, 2022 and 2021, equity-based compensation was $ 280,798 and $ 180,752 , respectively.\n(j) Income Taxes\nIncome taxes are accounted for under the assets and liability method. Current income taxes are provided in accordance with the laws of the respective taxing authorities. Deferred income taxes are provided for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is not more likely than not that some portion or all of the deferred tax assets will be realized.\n\n| 11 |\n\n(k) Net Loss per Share\nBasic net loss per shares of common stock is computed on the basis of the weighted average number of shares of common stock outstanding during the period of the financial statements.\nDiluted net loss per share of common stock is computed on the basis of the weighted average number of shares of common stock and dilutive securities (such as stock options, warrants, and convertible securities) outstanding. At March 31, 2022 and 2021, the Company had 25,620,245 and 32,564,030 potentially dilutive shares of common stock related to common stock options and warrants, respectively, as determined using the treasury stock method. Dilutive securities having an anti-dilutive effect on diluted net loss per share are excluded from the calculation.\n(l) Recently Issued Accounting Pronouncements\nCertain other accounting pronouncements have been issued by the FASB and other standard setting organizations which are not yet effective and have not yet been adopted by the Company. The impact on the Company’s financial position and results of operations from adoption of these standards is not expected to be material.\nOn August 5, 2020, the FASB issued ASU No. 2020-06 which simplifies the accounting for certain financial instruments with characteristics of liabilities and equity, including convertible instruments and contracts on an entity’s own equity. ASU 2020-06 simplifies the guidance in U.S. GAAP on the issuer’s accounting for convertible debt instruments. Such guidance includes multiple disparate sets of classification, measurement, and derecognition requirements whose interactions are complex. ASU 2020-06 is effective for annual periods beginning after December 15, 2021 and interim periods within those annual periods, with early adoption permitted. An entity that elects early adoption must adopt all the amendments in the same period. Most amendments within this ASU are required to be applied on a prospective basis, while certain amendments must be applied on a retrospective or modified retrospective basis. The adoption of this new guidance did not have a material impact on our financial statements.\n(m) Business Acquisition Accounting\nThe Company applies the acquisition method of accounting for those that meet the criteria of a business combination. The Company allocates the purchase price of its business acquisition based on the fair value of identifiable tangible and intangible assets. The difference between the total cost of the acquisition and the sum of the fair values of acquired tangible and identifiable intangible assets less liabilities is recorded as goodwill. Transaction costs are expensed as incurred in general and administrative expenses.\n(l) Leasehold improvements, furniture, and equipment, net\nLeasehold improvements, furniture, and equipment are recorded at cost. Depreciation of furniture and fixtures is provided using the straight-line method, generally over the terms of the lease. Repairs and maintenance expenditures, which do not extend the useful lives of the related assets, are expensed as incurred. Depreciation of machinery and equipment is based on the estimated useful lives of the assets\n3. ACQUISITION OF TOPPOP\nOn July 26, 2021, the Company entered into an acquisition agreement (the “TopPop Acquisition Agreement”) with TopPop, and each of FrutaPop LLC (“Frutapop”), Innoaccel Investments LLC (“Innoaccel”) and Thomas Martin (“Martin” and, together with Frutapop and Innoaccel, the “TopPop Members”), pursuant to which the TopPop Members sold to the Company and the Company acquired, all of the issued and outstanding membership interests of TopPop.\nTopPop is a brand owner and contract manufacturing and packaging company specializing in flexible packaging solutions in the food, beverage and health categories. Its first branded and contract products are alcohol-infused ice pops. Its manufacturing facility in Marlton, New Jersey is registered by the Federal Drug Administration and holds a Safe Quality Food certification.\n\n| 12 |\n\nUpon consummation of the acquisition contemplated by the TopPop Acquisition Agreement, the TopPop Members received, in the aggregate: (a) $ 3,694,273 in cash by transfer of immediately available funds, (b) 26,009,600 shares of Company’s common stock, par value $ 0.001 per share, which shares were valued in the aggregate at $ 10,143,744 , or $ 0.39 per share, (c) $ 5,042,467 aggregate principal amount of promissory notes of the Company (the “Promissory Notes”) and (d) future additional cash payments as earnout consideration (the “Total Consideration”). The earn-out payments, if any, will be made (i) following the 12-month period commencing on August 1, 2021 (the “First Year”), in an amount (the “First Year Earn-out Amount”) equal to each TopPop Member’s pro rata portion of the excess, if any, of: (A) 1.96 times TopPop’s EBITDA for the First Year over (B) the aggregate amount of the Promissory Notes repaid in cash during the First Year; provided, however, no First Year Earn-out Amount shall be payable if (i)(A) does not exceed (i)(B); and (ii) following the 12-month period commencing on August 1, 2022 (the “Second Year”), in an amount (the “Second Year Earn-out Amount”) equal to each TopPop Member’s pro rata portion of the excess, if any, of: (A) 1.96 times TopPop’s EBITDA for the Second Year over (B) the aggregate amount of the Promissory Notes repaid in cash during the Second Year; provided, however, no Second Year Earn-out Amount shall be payable if (ii)(A) does not exceed (ii)(B). The earn-out payments shall be made, at the election of each TopPop Member, in cash or in shares of common stock or a combination thereof, less any reserve for possible indemnification payments, provided that not less than 45 % of the value of each earn-out payment shall be paid in common stock. If paid in shares of common stock, such shares shall be valued at the then-prevailing market rate.\nThe Company originally calculated the First Year Earn-out Amount to be $8,244,642 and the Second Year Earn-out Amount to be $11,959,863. In connection with the requirement to record the contingent consideration at fair value for every reporting period, information as of and during the period ended March 31, 2022 required the Company to conclude that there will be no contingent consideration required to be made at the end of the First Year, while the entire amount of contingent consideration previously recorded will be required to be made at the end of the Second Year. This is the result of delays in the revenue targets but no material changes in the underlying projections previously used in connection with the valuation of such contingent consideration. Therefore, the Company estimates that the total contingent consideration is $20,204,505 and will be owed at the end of the Second Year.\nThe Promissory Notes bear interest at the rate of 10 % per annum and mature on July 26, 2022. The Promissory Notes are not subject to pre-payment penalties; however, the Company may not pre-pay any amount on any Promissory Note without pre-paying a pro-rata portion of all Promissory Notes. In connection with the Promissory Notes, the Company granted to the TopPop Members a security interest in all of the Company’s membership interests of TopPop pursuant to certain pledge agreements with each of the TopPop Members, each dated July 26, 2021. The Promissory Notes are not convertible into equity securities of the Company. Under the terms of the Promissory Notes, there is a five-day grace period to July 31, 2022 before an event of default occurs. Upon an event of default, the holders may exercise all rights and remedies available under the terms of the Promissory Notes or applicable laws, including to foreclose on certain collateral consisting of the membership interests of TopPop. The Company is currently in discussions with holders regarding possible solutions for the payment of the Promissory Notes, including the possible extension for an additional year.\nThe Company accounted for the Acquisition of TopPop as a business combination using the purchase method of accounting as prescribed in Accounting Standards Codification 805, Business Combinations (“ASC 805”) and ASC 820 – Fair Value Measurements and Disclosures (“ASC 820”). In accordance with ASC 805 and ASC 820, we used our best estimates and assumptions to accurately assign fair value to the tangible assets acquired, identifiable intangible assets and liabilities assumed as of the acquisition dates. Goodwill as of the acquisition date is measured as the excess of purchase consideration over the fair value of tangible and identifiable intangible assets acquired and liabilities assumed.\n\n| 13 |\n\nFair value of the acquisition\nThe following table summarizes the allocation of the purchase price as of the TopPop acquisition:\n\n| Purchase price: |\n| Cash, net of cash acquired | $ | 3,694,273 |\n| Fair value of common stock | 10,143,744 |\n| Contingent consideration | 20,204,505 |\n| Note payable | 5,042,467 |\n| Total purchase price | 39,084,989 |\n| Assets acquired: |\n| Accounts receivable | 5,432,608 |\n| Furniture and equipment | 1,848,580 |\n| Inventory | 1,194,936 |\n| Equipment deposit | 320,810 |\n| Security deposit | 131,529 |\n| Tradename / Trademarks | 6,867,000 |\n| IP/Technology | 849,000 |\n| Non-compete agreement | 807,200 |\n| Customer Base | 14,414,000 |\n| Total assets acquired: | 31,865,663 |\n| Liabilities assumed: |\n| Accounts payable | ( 2,435,412 | ) |\n| Notes payable | ( 5,927,380 | ) |\n| Deferred revenue | ( 394,759 | ) |\n| Total Liabilities assumed | ( 8,757,551 | ) |\n| Net assets acquired | 23,108,112 |\n| Excess purchase price “Goodwill” | $ | 15,976,877 |\n\nThe excess purchase price has been recorded as “goodwill” included as part of “Intangible assets” in the amount of $ 15,976,877 . The estimated useful life of the identifiable intangible assets is four to ten years. The goodwill is amortizable for tax purposes.\nSee Note 14 for the required pro forma information related to the business combination.\n\n| 14 |\n\nIntangible assets\n\n| Intangible assets consist of the following: |\n| Estimated Useful | March 31, | December 31, |\n| Lives | 2022 | 2021 |\n| Tradename - Trademarks | 5 years | $ | 6,867,000 | $ | 6,867,000 |\n| Intellectual Property | 5 years | 849,000 | 849,000 |\n| Customer Base | 10 years | 14,414,000 | 14,414,000 |\n| Non-Competes | 4 years | 807,200 | 807,200 |\n| 22,937,200 | 22,937,200 |\n| Less: accumulated amortization | 2,124,214 | 1,327,614 |\n| $ | 20,812,986 | $ | 21,609,586 |\n\nIntangible assets are amortized on a straight-line basis over the useful lives of the assets. Amortization expense amounted to $ 796,600 and $ 0 for the three months ended March 31, 2022 and 2021, respectively.\n\n| Future amortization of intangible assets for the remainder of the current fiscal year and the next five years and thereafter: | Amount |\n| Remainder of the year ended December 31, 2022 | $ | 2,389,800 |\n| 2023 | 3,186,400 |\n| 2024 | 3,186,400 |\n| 2025 | 3,102,317 |\n| 2026 | 2,341,600 |\n| Thereafter | 6,606,469 |\n| Total | $ | 20,812,986 |\n\n4. LEASEHOLD IMPROVEMENTS, FURNITURE, AND EQUIPMENT, NET\n\n| Leasehold improvements, furniture, and equipment, net consisted of the following: |\n| March 31, | December 31, |\n| 2022 | 2021 |\n| Machinery and equipment | $ | 6,950,296 | $ | 5,352,009 |\n| Leasehold improvements | 269,976 | 154,389 |\n| Supplies | 221,639 | 140,004 |\n| Furniture and fixtures | 74,068 | 36,181 |\n| 7,515,979 | 5,682,583 |\n| Less accumulated depreciation | ( 203,967 | ) | ( 125,619 | ) |\n| $ | 7,312,012 | $ | 5,556,964 |\n\nDepreciation expense related to leasehold improvements, furniture, and equipment amounted to $78,348 and $3,546 for the three months ended March 31, 2022 and 2021, respectively.\n\n| 15 |\n\n5. INVENTORIES\nInventories consisted of:\n| March 31,2022 | December 31,2021 |\n| Finished goods: |\n| Bellissima brands | $ | 686,942 | $ | 384,717 |\n| TopPop | 1,017,136 | 728,305 |\n| Total finished goods | 1,704,078 | 1,113,022 |\n| Work-in-process: |\n| TopPop | 822,328 | 88,066 |\n| Raw materials: |\n| TopPop | 254,713 | 27,263 |\n| Bellissima brands | 400,600 | - |\n| Total raw materials | 655,313 | 27,263 |\n| Total | $ | 3,181,719 | $ | 1,228,351 |\n\n6. ACCOUNTS PAYABLE AND ACCRUED EXPENSES\nAccounts payable and accrued expenses consisted of:\n\n| March 31, 2022 | December 31, 2021 |\n| Accounts payable | $ | 3,374,900 | $ | 1,671,161 |\n| Accrued officers’ compensation | 762,239 | 780,701 |\n| Accrued royalties | 161,244 | 178,013 |\n| Other | 183,758 | 83,171 |\n| Total | $ | 4,482,141 | $ | 2,713,046 |\n\n7. NOTES PAYABLE\nAs of March 31, 2022, notes payable consisted of a $ 150,000 SBA note and the $ 5,042,467 notes to former owners of TopPop.\n\n| The future payments on principal of notes payable are as follows: | Amount |\n| Remainder of the year ended December 31, 2022 | $ | 5,045,466 |\n| Year ending December 31, 2023 | 3,114 |\n| Year ending December 31, 2024 | 3,233 |\n| Year ending December 31, 2025 | 3,356 |\n| Year ending December 31, 2026 | 3,484 |\n| Thereafter | 133,814 |\n| Total | $ | 5,192,467 |\n\nIn connection with the July 2021 acquisition of 100 % of the equity of TopPop, on July 26, 2021, the Company issued to the sellers promissory notes in the aggregate principal amount of $ 4,900,000 (the “TopPop Notes”). The TopPop Notes bear interest at the rate of 10 % per annum, matured on July 26, 2022 and are secured by all of the outstanding membership interest in TopPop. Holders of approximately $ 3.55 million of these notes have agreed to extend the term for 30 days and have indicated that they will not seek cash settlement prior to August 2023.The Company has not received any demand for payment on any of the other notes.\n\n| 16 |\n\n8. FACTORING LIABILITY\nDuring the three months ended March 31, 2022, the Company entered into a purchase and sale agreement with Prestige Capital Finance, LLC (“Prestige”). Under the agreement, Prestige buys all of the Company’s right, title, and interest in specific accounts receivable. Prestige has full recourse against the Company for advances if payments are not received for any reason. All credit risk is borne by the Company and not by Prestige. Prestige pays a down payment to the Company of 80 % of the face value of the specified receivables. The maximum outstanding balance of the advance is $ 2,000,000 . Prestige’s final purchase price of the accounts receivable is at a discount which is deducted from the face value of each account upon collection. The discount fee is based upon the number of days the account receivable is outstanding from the date of the down payment. The discount fee ranges from 1.95% if the receivable is paid within 30 days to 5.85% if paid within 90 days, plus an additional 1.5% for each 10-day period thereafter until the account is paid in full .\nThe outstanding balance is secured by an interest in virtually all assets of the Company, with a first security interest in accounts receivable. The agreement remains in effect through January10, 2023 and will be automatically renewed for successive periods of one year each unless either party terminates the agreement in writing at least 60 days prior to the expiration of the initial term or any renewal term. Prestige may cancel the agreement at any time upon 60 days’ notice.\nThe Company accounts for this agreement as a financing arrangement, with the down payments recorded as debt and repayment made when the applicable receivable is collected. As of March 31, 2022, there was an outstanding balance of $ 1,960,604 and accrued interest of $ 56,883 .\n9. CAPITAL STOCK\nPreferred Stock and Common Stock\nOn July 26, 2021, the Company filed a Certificate of Designation, Preferences and Rights of the Series A-2 Convertible Preferred Stock, par value $0.001 per share (“Series A-2 Preferred Stock”) with the Secretary of State of Nevada, designating up to 45,000 shares of the Company’s preferred stock as Series A-2 Preferred Stock. The holders shall be entitled to receive, and the Company shall pay, dividends on shares of Series A-2 Preferred Stock equal (on an as-if-converted-to common stock basis) to and in the same form as dividends actually paid on shares of common stock when, as and if such dividends are paid on shares of common stock. The Series A-2 Preferred Stock shall have no voting rights.\nOn January 5, 2022, the Company closed the second tranche of the equity financing and issued 12,258 shares of Series A-2 Preferred Stock, 4,301,004 shares of common stock and warrants to purchase 40,018,583 shares of common stock for gross proceeds of approximately $ 12.2 million and net proceeds of approximately $ 10.9 million after deduction of placement agent commissions and expenses of the offering. Such net proceeds are expected to be used by the Company for domestic and international expansion of its Bellissima brand, the expansion of the production facilities of the Company’s TopPop subsidiary, new product launches, marketing, and other general working capital purposes.\nBetween January 2022 and March 2022, stockholders converted 701 shares of Series A-2 Preferred Stock into 2,243,200 shares of common stock, par value $.001 per share, at $ 0.31 per share.\nOn March 23, 2021, the Company issued 401,670 shares of its common stock to an investors relations firm for services rendered to the Company. The $ 180,752 fair value of the 401,670 shares of common stock was expensed as investors relations in the three months ended March 31, 2021.\nWarrants\nIn connection with the second tranche of the equity financing, on January 5, 2022, the Company granted 40,018,583 warrants to purchase common stock. The warrants expire in five years and have an exercise price of $ 0.31 per share.\nA summary of warrant activity for the period December 31, 2021, to March 31, 2022, as follows:\n\n| Warrants | Weighted Average Exercise Price | Weighted Average Contractual Term Outstanding |\n| Outstanding at December 31, 2021 | 87,593,083 | $ | 0.31 | 4.23 |\n| Granted | 40,018,583 | 0.31 | 4.77 |\n| Outstanding at March 31, 2022 | 127,611,666 | 0.31 | 4.46 |\n\n\n| 17 |\n\nOptions\nDuring the three months ended March 31, 2022, the Company recognized $ 280,798 of expense for the option awards. There were no options outstanding as of March 31, 2021.\nThe following table summarizes the activity of our stock options for the three months ended March 31, 2022:\n\n| Shares | Weighted AverageExercise Price | Weighted Average Contractual Term Outstanding |\n| Outstanding at December 31, 2021 | 7,408,200 | $ | 0.45 | 9.79 |\n| Granted | - | - | - |\n| Exercised | - | - | - |\n| Forfeited or expired | - | - | - |\n| Outstanding at March 31, 2022 | 7,408,200 | 0.45 | 9.54 |\n\nThe aggregate intrinsic value of outstanding options as of December 31, 2021 was $ 298,544 . The outstanding options had no aggregate intrinsic value as of March 31, 2022. The intrinsic value is calculated as the difference between the market value and the exercise price of the shares on balance sheet date. The market values based on the closing bid price as of March 31, 2022 and December 31, 2021 was $ 0.39 and $ 0.49 , respectively.\nAs of March 31, 2022, there was approximately $ 2,800,000 of unrecognized compensation cost related to unvested stock options granted and outstanding, net of estimated forfeitures. The cost is expected to be recognized on a weighted average basis over a period of approximately three years.\n10. LEASES\nOn November 12, 2019, TopPop executed a lease agreement with Plymouth 4 East Stow LLC to rent approximately 26,321 square feet of warehouse space in Marlton, NJ. The lease provided a term of five years commencing upon January 1, 2020 and terminating on December 31, 2024 . The lease also provided for a monthly payment to Plymouth 4 East Stow LLC for common area use of $ 4,430 and a security deposit to the Landlord of $ 45,864 .\nEffective November 6, 2020, TopPop executed a lease agreement with Warehouse4Biz LLC to rent approximately 14,758 square feet of warehouse space in Bellmawr, NJ. The lease provided a lease term of two years commencing upon December 1, 2020 and terminating on November 30, 2022 . The lease provided a security deposit to Warehouse4Biz LLC of $ 20,734 .\nOn January 1, 2021, Iconic executed a cancellable Lease Agreement with Dan Kay International (an entity controlled by Richard DeCicco) for the lease of the Company’s office and warehouse space in North Amityville, NY. The agreement has a term of three years from January 1, 2021 to January 1, 2024 and provides for monthly rent of $ 4,893 .\nEffective May 19, 2021, TopPop executed a lease agreement with Industrial Opportunities II LLC to rent approximately 63,347 square feet of warehouse space in Pennsauken, NJ. The lease provided a lease term of 76 months commencing upon September 1, 2021 and terminating on December 31, 2027 . The lease provided a security deposit to Industrial Opportunities II LLC of $ 64,931 .\nEffective February 9, 2022, TopPop executed a lease agreement to rent approximately 82,000 square feet of warehouse space in Pennsauken, NJ. The lease provided a lease term of 74 months (the first two months are rent free) commencing upon February 9, 2022 and terminating on March 31, 2028 . The lease provided a security deposit to the landlord of $ 92,250 Per the lease agreement, TopPop was also required to post an additional deposit of $ 184,500 . On May 31, 2022, TopPopsent the deposit to an escrow account held by the landlord’s counsel.\n\n| 18 |\n\nThe future undiscounted minimum lease payments under the noncancellable leases for the remainder of the current fiscal year and the next five years and thereafter are as follows:\n\n| As of March 31, 2022 |\n| Remainder of the year ended December 31, 2022 | $ | 915,669 |\n| Year ending December 31, 2023 | 1,168,312 |\n| Year ending December 31, 2024 | 1,142,884 |\n| Year ending December 31, 2025 | 1,177,170 |\n| Year ending December 31, 2026 | 1,212,485 |\n| Thereafter | 2,673,963 |\n| Total undiscounted finance lease payments | $ | 8,290,483 |\n| Less: Imputed interest | 2,502,598 |\n| Present value of finance lease liabilities | 5,787,885 |\n\nThe operating lease liabilities of $ 5,787,885 and $ 3,216,315 as of March 31, 2022 and December 31, 2021, respectively, represents the discounted (at a 10 % estimated incremental borrowing rate) value of the future lease payments at March 31, 2022 and December 31, 2021. The Company’s weighted-average remaining lease term relating to its operating leases is 5.47 years.\nFor the quarters ended March 31, 2022 and 2021, occupancy expense attributed to these leases were $ 450,138 and $ 25,508 , respectively\n11. COMMITMENTS AND CONTINGENCIES\na. Iconic Guarantees\nOn May 26, 2015, BiVi entered into a license agreement with Neighborhood Licensing, LLC (the “BiVi Licensor”), an entity owned by Chazz Palminteri (“Palminteri”), to use Palminteri’s endorsement, signature and other intellectual property owned by the BiVi Licensor. The Company has agreed to guarantee and act as surety for BiVi’s obligations under certain sections of the license agreement and to indemnify the BiVi Licensor and Palminteri against third party claims.\nOn November 12, 2015, Bellissima Spirits entered into a license agreement with Christie Brinkley, Inc. (the “Bellissima Licensor”), an entity owned by Christie Brinkley (“Brinkley”), to use Brinkley’s endorsement, signature, and other intellectual property owned by the Bellissima Licensor. The Company has agreed to guarantee and act as surety for Bellissima’s obligations under certain sections of the license agreement and to indemnify the Bellissima Licensor and Brinkley against third party claims.\n\n| 19 |\n\nb. Royalty Obligations of BiVi and Bellissima\nPursuant to the license agreement with the Bivi Licensor (see Note 11a. above), BiVi is obligated to pay the BiVi Licensor a Royalty Fee equal to 5% of monthly gross sales of BiVi Brand products payable monthly subject to an annual Minimum Royalty Fee of $ 100,000 in year 1, $ 150,000 in year 2, $ 165,000 in year 3, $ 181,500 in year 4, $ 199,650 in year 5, and $ 219,615 in year 6 and each subsequent year. The Minimum Royalty Fee has been waived until such time as the parties agree to reinstate the Minimum Royalty Fee. As of the date of this filing, the Minimum Royalty Fee was not reinstated.\nPursuant to the license agreement and Amendment No. 1 to the license agreement effective September 30, 2017 with the Bellissima Licensor (see Note 11a. above), Bellissima is obligated to pay the Bellissima Licensor a Royalty Fee equal to 10% of monthly gross sales (12.5% for sales in excess of defined Case Break Points) of Bellissima Brand products payable monthly. The Bellissima Licensor has the right to terminate the endorsement if Bellissima fails to sell 10,000 cases of Bellissima Brand products in year 1, 15,000 cases in year 2, or 20,000 cases in year 3 and each subsequent year . These appropriate thresholds were met during the year.\nc. Brand Licensing Agreement relating to Hooters Marks\nOn July 23, 2018, United executed a Brand Licensing Agreement (the “Hooters Agreement”) with HI Limited Partnership (the “Licensor”). The Hooters Agreement provides United a license to use certain “Hooters” Marks to manufacture, market, distribute, and sell alcoholic products.\nOn November 1, 2021, the Company amended its agreement with Hooters (the “Amended Hooters Agreement”) which will be effective until December 31, 2025 with an option to extend until 2028. Under the Amended Hooters Agreement, the Company must pay Hooters 10% of net sales of all products during the term.\nd. Marketing and Order Processing Services Agreement\nDuring October 2019, United executed a Marketing and Order Processing Services Agreement (the “QVC Agreement”) with QVC, Inc. (“QVC”). Among other things, the QVC Agreement provides for United’s grant to QVC of an exclusive worldwide right to promote the Bellissima products through direct response television programs.\nThe initial license period commenced October 2019 and expires in December 2021 (i.e., two years after first airing of a Bellissima product). Unless either party notifies the other party in writing at least 30 days prior to the end of the Initial License Period or any Renewal License Period of its intent to terminate the QVC Agreement, the License continually renews for additional two-year periods. The license automatically renewed on January 1, 2022.\nThe QVC Agreement provides for United’s payment of “Marketing Fees” (payable no less than monthly) to QVC in amounts agreed to between United and QVC from time to time. For the three months ended March 31, 2022 and 2021, the Marketing Fees expense (payable to QVC) was $ 36,027 and $ 81,102 , respectively, and the direct response sales generated from QVC programs was $ 142,689 and $ 405,510 , respectively.\ne. Concentration of sales\nFor the three months ended March 31, 2022 and 2021, sales consisted of:\n\n| 2022 | 2021 |\n| Bellissima product line: |\n| QVC direct response sales | $ | 142,689 | $ | 405,510 |\n| Other | 390,406 | 206,732 |\n| Total Bellissima | 533,095 | 612,242 |\n| TopPop | 3,513,702 | - |\n| Hooters product line | - | 22,291 |\n| Total | $ | 4,046,797 | $ | 634,533 |\n\nTopPop’s sales to one customer consisted of 92 % and 65 % of its total sales for the three months ended March 31, 2022 and 2021, respectively. As of March 31, 2022 and December 31, 2021, 93 % and 9 %, respectively, of TopPop’s accounts receivables were from that same customer.\nf. Commission Agreements\nOn July 10, 2019, the Company executed a Commission Agreement with CAA-GBA USA, LLC (“CAA-GBG”). The agreement provides CAA-GBG to receive 5% revenue generated with respect to the co-packing or related manufacturing deal for Anheuser-Busch, LLC. Additionally, CAA-GBG is also entitled to receive 5% of revenue for new business identified. The initial agreement expired on July 31, 2021 and automatically renews every year. No commissions were incurred under this agreement since the date of acquisition of TopPop (July 26, 2021) through March 31, 2022 . On May 23, 2022,CAA-GBG received notice of termination and the Commission Agreement will end on July 31, 2022.\nEffective December 11, 2019, the Company executed a Commission Agreement with Christopher J. Connolly. Mr. Connolly had agreed to provide sales representation services to Company for alcohol ice pop packing opportunities in exchange for commission. The agreement provides a commission 5% of gross revenue collected. The initial term is one year from the effective date. The agreement will renew automatically for 1-year terms unless the agreement is terminated. The Company has decided to keep this agreement in place and no commissions were incurred under this agreement since the date of acquisition of TopPop (July 26, 2021) through March 31, 2022 .\n\n| 20 |\n\n12. RELATED PARTY TRANSACTIONS\nOn December 6, 2019 the Company executed a Financial Services Agreement with InnoAccel, a controlling member of the TopPop. InnoAccel had agreed to provide financial and administrative services for the company in exchange for hourly compensations.\nThe Company has agreed to keep this agreement in place and for the three months ended March 31, 2022 the Company has recorded consulting expense of $ 45,000 .\n13. SEGMENT REPORTING\nFASB Codification Topic 280, Segment Reporting, establishes standards for reporting financial and descriptive information about an enterprise’s reportable segments. The Company has two reportable segments: sale of branded alcoholic beverages and specialty packaging. The segments are determined based on several factors, including the nature of products and services, the nature of production processes, customer base, delivery channels and similar economic characteristics.\nAn operating segment’s performance is evaluated based on its pre-tax operating contribution, or segment income. Segment income is defined as net sales less cost of sales, segment selling, general and administrative expenses, research and development costs and stock-based compensation. It does not include other charges (income), net and interest and other, net.\n\n| Branded Beverages | Specialty Packaging (TopPop) | Corporate | Total |\n| Balance sheet at March 31, 2022 |\n| Assets | $ | 9,339,214 | $ | 55,806,505 | $ | - | $ | 65,145,719 |\n| Liabilities | $ | 2,361,276 | $ | 35,544,254 | $ | - | $ | 37,905,530 |\n| Balance sheet at December 31, 2021 |\n| Assets | $ | 2,925,694 | $ | 47,780,962 | $ | - | $ | 50,706,656 |\n| Liabilities | $ | 2,447,005 | $ | 29,146,596 | $ | - | $ | 31,593,601 |\n| Income Statement for the three months ended March 31, 2022: | Branded Beverages | Specialty Packaging | Corporate | Total |\n| Net Sales | $ | 533,095 | $ | 3,513,702 | $ | - | $ | 4,046,797 |\n| Cost of sales | $ | 214,341 | $ | 1,990,698 | $ | - | $ | 2,205,039 |\n| Total operating expenses | $ | 1,617,885 | $ | 2,834,905 | $ | 357,574 | $ | 4,810,364 |\n| Loss from operations | $ | ( 1,299,131 | ) | $ | ( 1,311,901 | ) | $ | ( 357,574 | ) | $ | ( 2,968,606 | ) |\n| Interest expense | $ | - | $ | 183,134 | $ | - | $ | 183,134 |\n| Depreciation and amortization | $ | 1,141 | $ | 77,207 | $ | - | $ | 78,348 |\n| Income Statement for the three months ended March 31, 2021: |\n| Net Sales | $ | 634,533 | $ | - | $ | - | $ | 634,533 |\n| Cost of Goods Sold | $ | 318,633 | $ | - | $ | - | $ | 318,633 |\n| Total operating expenses | $ | 891,388 | $ | - | $ | 103,750 | $ | 995,138 |\n| Loss from operations | $ | ( 575,488 | ) | $ | - | $ | ( 103,750 | ) | $ | ( 679,238 | ) |\n| Depreciation and amortization | $ | 3,546 | $ | - | $ | - | $ | 3,546 |\n\n\n| 21 |\n\n14. PROFORMA FINANCIAL STATEMENTS (UNAUDITED)\nUnaudited Supplemental Pro Forma Data\nUnaudited pro forma results of operations for the quarters ended March 31, 2022 and 2021:\n\n| Quarter EndedMarch 31, 2022 | Quarter EndedMarch 31, 2021 |\n| Sales | $ | 4,046,797 | $ | 3,002,597 |\n| Cost of sales | 2,205,039 | 1,753,016 |\n| Gross Profit | 1,841,758 | 1,249,581 |\n| General and administrative expenses | 4,458,387 | 2,773,708 |\n| Selling and marketing | 351,977 | 197,029 |\n| Total operating expenses | 4,810,364 | 2,970,737 |\n| Operating income (loss) | ( 2,968,606 | ) | ( 1,721,156 | ) |\n| Interest expense | ( 183,134 | ) | ( 384,544 | ) |\n| Gain on forgiveness of PPP loan | - | 28,458 |\n| Total other expense | ( 183,134 | ) | ( 356,086 | ) |\n| Net Loss | $ | ( 3,151,740 | ) | $ | ( 2,077,242 | ) |\n| Net (loss) income attributable to noncontrolling interests in subsidiaries | ( 93,819 | ) | 16,174 |\n| Net Loss attributable to common stockholders: | $ | ( 3,057,921 | ) | $ | ( 2,093,416 | ) |\n| Basic and Diluted Loss Per Common Share | $ | ( 0.03 | ) | $ | ( 0.13 | ) |\n| Weighted Average Shares Outstanding- basic and diluted | 94,923,294 | 86,624,446 |\n\nThese pro forma results are based on estimates and assumptions, which the Company believes are reasonable. They are not necessarily indicative of our consolidated results of operations in future periods or the results that actually would have been realized had we been a combined company during the periods presented. The pro forma results include adjustments in the quarter ended March 31, 2021, related to amortization of acquired intangible assets of $ 796,601 , interest expense on notes payable of $ 122,500 , and officer compensation of $ 127,384 . There are no proforma adjustments for the period ending March 31, 2022.\n15. SUBSEQUENT EVENTS\nPursuant to an amended licensing agreement entered into on April 22, 2022, the Company will grant 1,500,000 options to purchase common stock, subject to approval by the Board of Directors of Iconic, and subject to approval of Iconic’s stock option and grant plan (as may be amended from time to time, the “Plan”) by its stockholders. The exercise price per share of the Option will be equal to the fair market value of Iconic’s common stock on the date the Option is granted, as determined in good faith by its Board of Directors. The Option will be subject to the terms and conditions, including vesting terms (two year vesting in equal quarterly installments), as set forth in a stock option agreement. As of the date of this filing, the options were not yet granted.\nAs of April 15, 2022, the Company was late in filing its Annual Report on Form 10-K for the year ended December 31, 2021, which was filed on June 15, 2022. As of May 20, 2022 the Company was late in filing it Quarterly Report on Form 10-Q for the period ended March 31, 2022 and under the terms of the Securities Purchase Agreement signed on July 26, 2021, the Company will incur a late filing penalty. Once the late filing is completed, the penalty will be calculated at a monthly rate of 1 % of the subscription amount of the Securities offering.\nOn July 1, 2022, under the terms of the Certificate of Designation for the Series A2 Preferred Stock filed on July 26, 2021, the Company calculated that it is obligated to pay a one-time 6% dividend on the subscription value of the initially issued Series A-2 Preferred Stock. On July 19, 2022, the Company issued shares of common stock to satisfy this dividend requirement and has calculated the number of shares to be issued as 8,810,826 at $ 0.37 per share.\n\n| 22 |\n\n\nITEM 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations\nOur Management’s Discussion and Analysis contains not only statements that are historical facts, but also statements that are forward-looking (within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934). Forward-looking statements are, by their very nature, uncertain and risky. These risks and uncertainties include international, national and local general economic and market conditions; demographic changes; our ability to sustain, manage, or forecast growth; our ability to successfully make and integrate acquisitions; existing government regulations and changes in, or the failure to comply with, government regulations; adverse publicity; competition; fluctuations and difficulty in forecasting operating results; changes in business strategy or development plans; business disruptions; the ability to attract and retain qualified personnel; the ability to protect technology; and other risks that might be detailed from time to time in our filings with the Securities and Exchange Commission (the “SEC”).\nAlthough the forward-looking statements in this Quarterly Report reflect the good faith judgment of our management, such statements can only be based on facts and factors currently known by them. Consequently, and because forward-looking statements are inherently subject to risks and uncertainties, the actual results and outcomes may differ materially from the results and outcomes discussed in the forward-looking statements. You are urged to carefully review and consider the various disclosures made by us in this report and in our other reports as we attempt to advise interested parties of the risks and factors that may affect our business, financial condition, and results of operations and prospects.\nYou should read the following discussion and analysis of our financial condition and plan of operations together with and our consolidated financial statements and the related notes appearing elsewhere in this Quarterly Report on Form 10-Q. In addition to historical information, this discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, those discussed in the section titled “Risk Factors” included elsewhere in this Quarterly Report on Form 10-Q and the risks described in Part I. Item 1A. Risk Factors,” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2021. All amounts in this report are in U.S. dollars, unless otherwise noted.\nSummary Overview\nWe are engaged in the development and sale of alcohol and non-alcohol brands that are “better-for-you” (“BFY”) and “better-for-the-planet”. TopPop, our wholly owned subsidiary, produces low calorie, “ready to go” products, ready-to-freeze (“RTF”) products and ready-to-drink (“RTD”) products in sustainable, flexible and stand-up pouch packaging. TopPop also produces “cocktails-to-go” pouches and alcohol ice-pops. Our brands include “Bellissima” by Christie Brinkley, a premium BFY collection of Prosecco, Sparkling Wines, and Still Wines, all certified vegan and made with organic grapes. Bellissima is strategically positioned with its Zero Sugar Wines. We operate in multiple states, sell and distribute across the globe and have Fortune 500 customers that include some of the world’s largest alcohol beverage companies and brands. United is our 100% owned subsidiary that sells our Bellissima, Bella, Sonja Sangria and other alcohol beverages to state distributors. United holds all applicable state and federal licenses in order to sell these products to state distributors in accordance with the United States three tier distribution platform.\n\n| 23 |\n\nWe have expertise in developing, from product inception to wholesale distribution or direct to consumer through the QVC distribution channel, and in branding alcohol beverages for our company and for third parties. We market and place products into national distribution through long-standing industry relationships approximately 45 national or regional alcoholic beverage distributors. We currently market and sell the following product lines:\n\n| · | Bellissima Prosecco – these products comprise a line of all-natural and vegan Prosecco and Sparkling Wines made with organic grapes, including a Zero Sugar, Zero Carb option, a DOC Brut and a Sparkling Rose. The Bellissima line of Prosecco and Sparkling Wines includes two new flavor profiles, a Zero Sugar/Zero Carb Sparkling Rose and a Rose Prosecco; |\n| · | Bellissima Zero Sugar Still Wines – this line of five still wines was launched in March 2022 and are certified vegan and are made with organic grapes. |\n| · | Bella Sprizz Aperitifs – these products comprise a line of aperitifs consisting of three different expressions, a classic Italian aperitif, an all-natural elderflower aperitif and a classic Italian bitter; |\n| · | Sonja Sangria – a celebrity Sangria that we have sold since the second quarter of 2021. This product is actively being marketed but does not represent a significant part of our sales; |\n| · | Ready-to-Freeze and Ready-to-Drink Alcoholic Products – these products are currently produced under contract for third-party national and regional brands and for our Boozy Pops® product line; and |\n| · | BiVi Vodka – a celebrity-branded vodka that we have sold since 2018 under the brand “BiVi 100 percent Sicilian Vodka” and which currently does not represent a material portion of our sales. |\n\nIn addition, we develop and market private label spirits for established domestic and international chains.\nAs a result of our July 2021 acquisition of 100% of the equity of TopPop, we are now a vertically integrated company that develops, produces and distributes alcoholic brands. TopPop is a premier product development, contract manufacturing and packaging company that specializes in flexible packaging applications in the food, beverage and health categories. It has the federal and state licenses necessary to manufacture and blend malt, wine and spirits-based products. In June 2020, TopPop opened a 27,000-square-foot FDA-approved manufacturing facility in Marlton, New Jersey with a Safe Quality Food certification. In September 2021, TopPop leased an additional 65,000 square feet facility for manufacturing in Pennsauken, New Jersey. Construction is now complete, and the facility reached full-scale production capability at the end of March 2022. The facility includes approximately $4 million of high-speed packaging equipment and is expected to triple our production capacity.\nFor its first product line, TopPop identified the single serve, RTD and RTF as an opportunity for product and packaging innovation. TopPop introduced an alcohol-infused ice pop in June 2020 and began marketing the concept to major alcohol companies. In addition, it developed its own product line trademarked under the name BoozyPopz® which is expected to be sold through e-commerce platforms and wholesaled directly to sports and entertainment venues. TopPop manufactured approximately eight million ice pops from its launch in June 2020 through December 31, 2020 and manufactured approximately 42 million ice pops during the year ended December 31, 2021. TopPop has also developed a pipeline for the single serve, RTD alcohol cocktail market and anticipates launching a line of products in this market in 2022. TopPop designs and markets flexible packaging for its RTD and RTF products with formulations that are low calorie and contain healthy and natural ingredients. With the opening of TopPop’s new facility at the end of the first quarter of 2022, we expect to have the capacity to manufacture over 150 million units by the end of 2022.\n\n| 24 |\n\nWe believe TopPop brings to us additional synergies and opportunities for cross-promoting new and existing products to a broader customer base and better positions our company to establish and support our brands and to create sustainable packaging solutions to the consumable goods market. We believe our focus on lifestyle branding and the rising “Better-for-You,” “Better-for-the-Planet” consumer categories has made us a leader in developing celebrity brands worldwide, such as our Bellissima Prosecco by Christie Brinkley. Our mission is to be an industry leader in the brand development, marketing and sales of alcoholic beverages and related products by capitalizing on our ability to procure products from around the world and to develop unique and innovative packaging to create brand and product line extensions. We plan to leverage our relationships to add value to our products and to create brand awareness in unbranded niche categories.\nRecent Developments\nCOVID-19\nAs a result of COVID-19, we have seen a shift away from the traditional brick-and-mortar business to a direct-to-consumer business. Although we expect brick-and-mortar to rebound, we also expect the director-to-consumer model to stay post-COVID-19, as consumers embrace the convenience of having their alcoholic beverages delivered to their doorstep. As we expand our relationship with QVC and our own direct-to-consumer platform through our website, we believe we are well positioned to execute on this opportunity.\nTopPop Acquisition\nOn July 26, 2021, we completed the acquisition of TopPop. In connection with such acquisition, the former TopPop members received, in the aggregate(a) $3,694,273 in cash, net of cash acquired, by transfer of immediately available funds, (b) 26,009,600 shares of our common stock, which shares were valued in the aggregate at $10,143,744, or $0.39 per share, (c) $5,042,467 aggregate principal amount of our promissory notes and (d) future additional payments as earnout consideration valued at $20,204,505 to be paid in cash and stock. The earn-out payments, if any, will be made (i) following the 12-month period commencing on August 1, 2021, in an aggregate amount equal to the excess, if any, of: (A) 1.96 times TopPop’s EBITDA for the period over (B) the aggregate amount of the closing promissory notes repaid in cash during period; provided, however, no such amount shall be payable if (i)(A) does not exceed (i)(B); and (ii) following the 12-month period commencing on August 1, 2022, in an aggregate amount equal to the excess, if any, of: (A) 1.96 times TopPop’s EBITDA for such period over (B) the aggregate amount of the closing promissory notes repaid in cash during the period; provided, however, no such amount shall be payable if (ii)(A) does not exceed (ii)(B). The earn-out payments will be made, at the election of each former TopPop member, in cash or in shares of our common stock or a combination thereof, less any reserve for possible indemnification payments, provided that not less than 45% of the value of each earn-out payment shall be paid in common stock. If paid in shares of common stock, such shares shall be valued at the then-prevailing market rate.\nSeries A-2 Convertible Preferred Stock Financing\nOn July 26, 2021, we entered into securities purchase agreements dated as of July 26, 2021 with certain accredited investors for the sale of our newly-created Series A-2 Preferred Stock, shares of common stock, and warrants to purchase shares of common stock.\n\n| 25 |\n\nPursuant to the purchase agreements, the shares of Series A-2 Preferred Stock, common stock and warrants were sold in two tranches, the first of which closed on July 26, 2021 for gross proceeds of $18,372,354 for the sale of an aggregate of 18,800 shares of Series A-2 Preferred Stock, an aggregate of 6,711,997 shares of common stock, and warrants to purchase an aggregate of 73,338,203 shares of common stock. Of the $18,372,354 gross proceeds we received upon the closing of the first tranche, $15,603,385 was paid in cash net of fees of $2,808,320.\nThe second tranche closed on January 5, 2022 in which the Company issued 12,257.76 shares of Series A-2 Preferred Stock, 4,301,004 shares of common stock and warrants to purchase 40,018,583 shares of common stock for gross proceeds of approximately $12.2 million and net proceeds of approximately $11 million after deducting placement agent commissions and expenses of the offering. Such net proceeds are expected to be used by the Company for domestic and international expansion of its Bellissima brand, the expansion of the production facilities of TopPop, new product launches, marketing, and other general working capital purposes.\nThe warrants are exercisable for a period of five years from the date of issuance at an exercise price of $0.3125 per share. The Warrants may be exercised on a cashless basis if the shares of common stock underlying the warrants are not then registered for resale pursuant to an effective registration statement under the Securities Act.\nIn connection with this offering, we entered into a Placement Agency Agreement with Dawson James Securities, Inc. (the “Placement Agent”), pursuant to which at the closing of the first tranche under the purchase agreements we paid to the Placement Agent a cash fee in the amount of $2,050,000 and at the closing of the second tranche under the purchase agreements we paid to the Placement Agent a cash fee in the amount of $1,150,000. In addition, we agreed to pay to the Placement Agent a fee in connection with any cash exercise of any of the Warrants in an amount equal to 10% of the cash amount received by us upon any such exercise. Pursuant to the Placement Agency Agreement, as additional consideration for the services of the Placement Agent, we also issued to the Placement Agent or its designees in connection with the closing of the first tranche under the purchase agreements 2,194 shares of Series A-2 Preferred Stock and an additional 1,096 shares of Series A-2 Preferred Stock in connection with the closing of the second tranche under the purchase agreements. The fees paid to the Placement Agent were accounted for as financing costs and reduces the additional paid in capital from the financing.\n\n| 26 |\n\nAmended and Restated LLC Agreements of Bellissima Spirits LLC and BiVi LLC\nOn July 26, 2021, we, and each other member identified therein, including Mr. DeCicco and Rosanne Faltings, our vice president of sales and a member of the Board, entered into an Amended and Restated Limited Liability Company Agreement dated as of July 26, 2021 of Bellissima and BiVi. Such agreement provides that the manager of Bellissima and BiVi, currently Mr. DeCicco, may cause Bellissima and BiVi to make distributions of available cash flow to the members pro rata in accordance with their cash flow ratios, of which we are entitled to 100% of any such distribution of available cash flow. Such agreement also provides that the manager shall cause Bellissima and BiVi to make distributions of net proceeds attributable to certain capital events to members pro rata in accordance with their membership interest percentage, of which we are entitled to 54% of any such distribution of net proceeds and Mr. DeCicco and Ms. Faltings are entitled to 15.34% and 15.33%, respectively. Transfers of membership interests in Bellissima and BiVi are generally restricted and such agreement provides for preemptive rights, rights of first refusal, and rights of co-sale, in each case, in accordance with the terms and conditions set forth therein.\nOn April 22, 2022 we entered into a Second Amended and Restated Limited Liability Company Agreement of Bellissima, which provides that upon (i) a sale of all or substantially all of our assets, (ii) a change of control of us, (iii) a sale of equity following which our shareholders immediately prior to such transaction do not own, immediately following such transaction, a majority of the voting and economic rights in us, or (iv) a merger, consolidation or similar transaction involving us, each of Mr. DeCicco and Ms. Faltings will be entitled to sell their interest in Bellissima to us in exchange for the value of their equity interest in Bellissima that they would have received upon the sale of their equity interest in Bellissima, upon the sale of Bellissima, which value will be determined by an independent third-party appraiser.\nResults of Operations for the Three Months Ended March 31, 2022 and 2021\nIntroduction\nWe had sales of $4,046,797 for the three months ended March 31, 2022, and $634,533 for the three months ended March 31, 2021, an increase of $3,412,264. Our operating expenses were $ 4,810,364 for the three months ended March 31, 2022, compared to $995,138 for the three months ended March 31, 2021, an increase of $3,815,226 or approximately 383%. Our net operating loss was $2,968,606 for the three months ended March 31, 2022, compared to $679,238 for the three months ended March 31, 2021, an increase of $2,289,368 or approximately 337%. A significant amount of these increases relate to the inclusion of the results of TopPop for the three months ended March 31, 2022 and are detailed below.\n\n| 27 |\n\nRevenues and Net Operating Loss\nOur operations for the three months ended March 31, 2022, and 2021 were as follows:\n\n| ICONIC BRANDS, INC. |\n| CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS |\n| (Unaudited) |\n| Three Months Ended March 31, |\n| 2022 | 2021 | Increase / Decrease |\n| REVENUE |\n| Sales | $ | 4,046,797 | $ | 634,533 | $ | 3,412,264 |\n| Cost of goods sold | 2,205,039 | 318,633 | 1,886,406 |\n| Gross Profit | 1,841,758 | 315,900 | 1,525,858 |\n| OPERATING EXPENSES |\n| Officers’ compensation | 225,461 | 103,750 | 121,711 |\n| Professional and consulting fees | 536,911 | 158,903 | 378,008 |\n| Royalties | 33,231 | 99,128 | (65,897 | ) |\n| Fulfillment costs | 122,820 | 140,000 | (17,180 | ) |\n| Travel and entertainment | 87,755 | 12,843 | 74,912 |\n| Other operating expenses, including occupancy | 3,452,209 | 359,346 | 3,092,863 |\n| General and administrative expenses: | 4,458,387 | 873,970 | 3,584,417 |\n| Selling and marketing | 351,977 | 121,168 | 230,809 |\n| Total operating expenses | 4,810,364 | 995,138 | 3,815,226 |\n| Loss from operations | (2,968,606 | ) | (679,238 | ) | (2,289,368 | ) |\n| Other income (expense): |\n| Interest expense | (183,134 | ) | - | (183,134 | ) |\n| Gain on forgiveness of PPP loan | - | 28,458 | (28,458 | ) |\n| Total other income (expense) | (183,134 | ) | 28,458 | (211,592 | ) |\n| Net loss | $ | (3,151,740 | ) | $ | (650,780 | ) | $ | (2,500,960 | ) |\n| Net (loss) income attributable to noncontrolling interests in subsidiaries | $ | (93,819 | ) | $ | 16,174 | $ | (109,993 | ) |\n| Net (loss) attributable to Iconic Brands, Inc. | $ | (3,057,921 | ) | $ | (666,954 | ) | $ | (2,390,967 | ) |\n\nSales\nOur sales are comprised of sales of BiVi Sicilian Vodka, Bellissima Prosecco and Sparkling Wine, the line of Hooters brand products and our ready to freeze (“RTF”) TopPop products. Sales were $4,046,797 for the three months ended March 31, 2022, and $634,533 for the three months ended March 31, 2021, an increase of $3,412,264 or 538%.\nThe increase is due primarily to a $3,513,702 in sales from our newly acquired TopPop products.\nCost of Sales\nCost of sales was $2,205,039, or approximately 54% of sales, for the three months ended March 31, 2022 and $318,633, or approximately 50% of sales, for the three months ended March 31, 2021. Cost of sales includes the cost of the products purchased from our suppliers, freight-in costs and import duties. The significant increase in cost of goods as a percentage of sales, year over year, is due to the change in product mix in 2021 as a result of our TopPop acquisition. Cost of goods for the three months ended March 31, 2022 for our alcohol sales remains at approximately 40%, which is similar to the prior year, while the costs associated with our TopPop acquisition were approximately 51% during the three months ended March 31, 2022.\n\n| 28 |\n\nOfficers’ Compensation\nOfficers’ compensation was $225,461 for the three months ended March 31, 2022 and $103,750 for the three months ended March 31, 2021. This increase of $121,711 was due to the hiring of additional executives.\nProfessional and Consulting Fees\nProfessional and consulting fees were $536,911 for the three months ended March 31, 2022 and $158,903 for the three months ended March 31, 2021, an increase of $378,008. Professional and consulting fees consist primarily of legal and, accounting and auditing services. The increase was primarily related to costs in 2022 incurred by newly-acquired TopPop.\nRoyalties\nWe expensed royalties of $33,231 for the three months ended March 31, 2022 compared to $99,128 for the three months ended March 31, 2021, a decrease of $65,897. Royalties decreased due primarily to lack of Hooters sales in 2022 compared to 2021.\nFulfillment costs\nFulfillment costs expenses were $122,820 for the three months ended March 31, 2022 and $140,000 for the three months ended March 31, 2021. The decrease was related to lower QVC sales in 2022 compared to 2021.\nTravel and Entertainment\nTravel and entertainment expenses were $87,755 for the three months ended March 31, 2022 and $12,843 for the three months ended March 31, 2021, an increase of $74,912. The increase was a result of limited travel during the three months ended March 31, 2021 due to the COVID-19 environment. During the three months ended March 31, 2022, our personnel attended numerous product development events.\nOther Operating Expenses\nOther operating expenses were $3,452,209 for the three months ended March 31, 2022 and $359,346 for the three months ended March 31, 2021, an increase of $3,092,863 or approximately 861%. The increase was primarily related to $796,600 of amortization of intangibles, and $280,798 of equity based compensation expense and approximately $1.9 million of general and administrative expenses of newly-acquired TopPop which consists of approximately $896,000 of payroll and related expenses and approximately $400,000 of rent expense.\nSelling and marketing\nMarketing and advertising expenses were $351,977 for the three months ended March 31, 2022, and $121,168 for the three months ended March 31, 2021, an increase of $230,809. The increase resulted from spending to increase the visibility of our products through website design and distributor promotions.\nNet operating loss\nWe had a loss from operations of $2,968,606 for the three months ended March 31, 2022 and $679,238 for the three months ended March 31, 2021, an increase of $2,289,368 or approximately 337%. In the categories above there were non-cash expenses that totaled $1,403,999 and are included in the loss of from operations of $2,968,606 as compared to a loss from operations in 2021 of $679,238, which included non-cash items of $155,840.\n\n| 29 |\n\nOther Income and Expense\nWe had interest expense of $183,134 for the three months ended March 31, 2022 and gain on forgiveness of PPP loan of $28,458 for the three months ended March 31, 2021.\nNet (income) loss attributable to Noncontrolling Interests in Subsidiaries\nNet income (loss) attributable to noncontrolling interests in subsidiaries represented 49% of the net loss of Bellissima and BiVi (of which we own 51%) and is accounted for as a reduction in the net loss attributable to our Company. Net loss for the three months ended March 31, 2022 was $93,819 compared to a net income of $16,174 for the three months ended March 31, 2021.\nNet Loss Attributable to Iconic Brands, Inc.\nThe net loss attributable to Iconic was $3,057,921 for the three months ended March 31, 2022 and $666,954 for the three months ended March 31, 2021, an increase of $2,390,967 or approximately 358%. The net loss from Iconic increased primarily as a result of the items described above.\nLiquidity and Capital Resources\nIntroduction\nDuring the three months ended March 31, 2022 and 2021, we had negative operating cash flows. Our cash on hand as of March 31, 2022, was $7,589,114. We raised $11 million, net of fees, through the funding of the second tranche of the equity financing on January 5, 2022. We have strong medium- to long-term cash needs. We anticipate that these needs will be satisfied through our cash flows from operations and additional financing activities, as necessary. Furthermore, of the $4,458,387 of general and administrative expenses, $1,403,999 was non-cash related and we expect to increase sales in future periods.\nOur cash, current assets, total assets, current liabilities, and total liabilities as of March 31, 2022 and December 31, 2021, respectively, were as follows:\n\n| March 31, | December 31, |\n| 2022 | 2021 | Change |\n| Cash | $ | 7,589,114 | $ | 2,190,814 | $ | 5,398,300 |\n| Total Current Assets | 15,328,980 | 4,346,003 | 10,982,977 |\n| Total Assets | 65,145,719 | 50,706,656 | 14,439,063 |\n| Total Current Liabilities | 12,328,341 | 16,650,909 | (4,322,568 | ) |\n| Total Liabilities | $ | 37,905,530 | $ | 31,593,601 | $ | 6,311,929 |\n\nOur cash increased $5,398,300 and total current assets increased $10,982,977. Our total current liabilities decreased $4,322,568, which represents our recognition of the contingent consideration from current to noncurrent liability of approximately $8.2 million, partially offset by increase in accounts payable and notes payable. Our total liabilities increased $6,311,929 as a result of an increase in operating lease liability of $2.6 million from the new TopPop lease, an increase of approximately $2 million in notes payable and an increase in accounts payable and accrued expenses of approximately $1.8 million. Our stockholders’ equity increased from $19,113,055 to $27,240,189 due primarily to recognition of certain intangible assets associated with the TopPop acquisition (see full Balance Sheet for comparison).\nIn order to repay our obligations in full or in part when due, we may be required to raise significant capital from other sources and to execute on our business plans for TopPop. There is no assurance that we will be successful in these efforts.\nCash Requirements\nOur cash on hand as of June 30, 2022 was approximately $4,839,000. We anticipate that the funding from financing activities and product sales will be enough to sustain us for the next 12 months. In addition, holders approximately $3.55 million of the TopPop Notes have indicated that they will not seek cash settlement prior to August 2023. The Company has not received any demand for payment on any of the other notes.\n\n| 30 |\n\nSources and Uses of Cash\nOperations\nOur net cash used in operating activities for the three months ended March 31, 2022 and 2021 was $5,726,984 and $101,300, respectively, an increase of $5,625,684. Changes to working capital included increases of $3,177,755 related to accounts receivable and $1,953,368 for inventory, partially offset by a decrease of $1,769,095 related to accounts payable and accrued expenses. The net loss was further offset by non-cash transactions of $280,798 related to equity compensation, $796,600 related to amortization of intangibles, $201,253 of amortization of right of use assets and $78,348 of depreciation of fixed assets.\nInvestments\nFor the three months ended March 31, 2022 we used cash for investing activities of $1,833,396 for the purchase of fixed assets and leasehold improvements. There was no cash used during the three months ended March 31, 2021.\nFinancing\nOur net cash provided from financing activities for the three months ended March 31, 2022 was $12,958,680 compared to cash used of $11,921 for the three months ended March 31, 2021. The large inflow of cash in 2022 resulted from the Financing Transaction (detailed herein under “Recent Developments”) of the second tranche on January 5, 2022.\n\nITEM 3 Quantitative and Qualitative Disclosures About Market Risk\nAs a smaller reporting company, we are not required to provide the information required by this Item.\n\nITEM 4 Controls and Procedures\n(a) Disclosure Controls and Procedures\nWe carried out an evaluation, under the supervision and with the participation of our management, including our Principal Executive Officer and our Principal Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined) in Exchange Act Rules 13a - 15(c) and 15d - 15(e). Based upon that evaluation, our Principal Executive Officer and our Principal Financial Officer concluded that, as of the end of the period covered in this report, our disclosure controls and procedures were not effective because of the material weaknesses in our internal control over financial reporting as described in Item 9A in our Annual Report on Form 10-K for the fiscal ended December 31, 2021, filed with the SEC on June 15, 2022.\nOur Principal Executive Officer and our Principal Financial Officer do not expect that our disclosure controls or internal controls will prevent all error and all fraud. Although our disclosure controls and procedures were designed to provide reasonable assurance of achieving their objectives and our Principal Executive Officer and our Principal Financial Officer have determined that our disclosure controls and procedures are effective at doing so, a control system, no matter how well conceived and operated, can provide only reasonable, not absolute assurance that the objectives of the system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented if there exists in an individual a desire to do so. There can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.\nFurthermore, smaller reporting companies face additional limitations. Smaller reporting companies employ fewer individuals and find it difficult to properly segregate duties. Often, one or two individuals control every aspect of the company’s operation and are in a position to override any system of internal control. Additionally, smaller reporting companies tend to utilize general accounting software packages that lack a rigorous set of software controls.\n(b) Changes in Internal Control over Financial Reporting\nNo change in our system of internal control over financial reporting occurred during the period covered by this report, the three month period ended March 31, 2022, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\n\n| 31 |\n\nPART II - OTHER INFORMATION\n\nITEM 1 Legal Proceedings\nFrom time to time, we may be subject to litigation and claims arising in the ordinary course of business. We are not currently a party to any material legal proceedings and we are not aware of any pending or threatened legal proceeding against us that we believe will have a material adverse effect on our business, operating results, cash flows or financial condition.\nOn April 7, 2022, the Office of the Attorney General of the State of New Jersey, Department of Law and Public Safely, Division of Alcoholic Beverage Control issued to TopPop a Notice of Charges (the “Notice”) wherein the New Jersey Division of Alcoholic Beverage Control Board (the “Division”) alleged that TopPop has committed certain violations of its permit issued by the Division for TopPop’s manufacturing facilities located in Marlton, New Jersey. In the Notice, the Division alleged that TopPop (i) allowed such manufacturing facilities to be used in furtherance of, or to aid, an illegal activity or enterprise, and (ii) sold and delivered, or allowed the sale, service, delivery and consumption, of alcoholic beverages beyond the scope of TopPop’s license, and conducted business with companies outside the scope of the license in an area which was not designated or described by TopPop in its license application as a place to be licensed for such sale, service or delivery of alcoholic beverages. The total penalty sought by the Division is a 90-day suspension of TopPop’s permit for that manufacturing facility.\nWe are in preliminary discussions with the Division regarding a possible settlement of these proceedings. We intend to investigate the claims of the Division and, depending upon our findings, to seek a mutually acceptable resolution to this matter. Although the results of our investigation and of our future discussions with the Division cannot be predicted with certainty, we plan to vigorously pursue a settlement option and believe that the final outcome of this matter will not have a material adverse effect on our business, results of operations or financial condition.\n\nITEM 1A Risk Factors\nThere have been no material changes in our risk factors from those disclosed in “Part I. Item 1A. Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2021 except for the risk noted below. The risk factors described in our Annual Report on Form 10-K could materially affect our business operations, financial condition, or liquidity. Additional risks and uncertainties not currently known to us or that we currently believe are immaterial may also impair our business operations, financial condition, and liquidity.\nWe are currently in default on our 10% promissory notes, and if we are unable to resolve such default, it could have an adverse impact on our business, results of operations and financial condition and is likely to negatively impact the price of our common stock.\nIn connection with our July 2021 acquisition of 100% of the equity of TopPop, on July 26, 2021, we issued to the sellers promissory notes in the aggregate principal amount of $4,900,000 (the “TopPop Notes”). The TopPop Notes bear interest at the rate of 10% per annum, matured on July 26, 2022 and are secured by all of the outstanding membership interest in TopPop. Under the terms of the TopPop Notes, we have a five-day grace period to July 31, 2022 before an event of default under the TopPop Notes occurs. Upon an event of default under the TopPop Notes, the holders of such TopPop Notes may exercise all rights and remedies available under the terms of the TopPop Notes or applicable laws, including to foreclose on certain collateral consisting of the membership interests of TopPop. On July 26, 2022, the total principal amount outstanding under the TopPop Notes was $4,900,000, exclusive of accrued and unpaid interest.\nWe are currently in discussions with holders of the TopPop Notes regarding possible solutions for the payment of the TopPop Notes, including the possible extension of the maturity date of the TopPop Notes for an additional year. There can be no assurance that our discussions will be successful and if we are not successful in finding an acceptable resolution to the existing default or the impending event of default, the noteholders will be able to seek judgement for the full amount due and may seek to foreclose on our assets. If this occurs, any such remedy will have a material adverse effect on our business, results of operations and financial condition and is likely to negatively impact the price of our common stock. Holders of approximately $3.55 million of these notes have agreed to extend the term for 30 days and have indicated that they will not seek cash settlement prior to August 2023.\n\nITEM 2 Unregistered Sales of Equity Securities and Use of Proceeds\nWe had no unregistered sales of equity securities during the three months ended March 31, 2022 that have not been previously disclosed.\n\nITEM 3 Defaults Upon Senior Securities\nNone.\n\nITEM 4 Mine Safety Disclosures\nNot applicable.\n\nITEM 5 Other Information\nNone.\n\n| 32 |\n\n\nITEM 6 Exhibits\n(a) Exhibits\n\n| Incorporated by Reference |\n| Exhibit No. | Description of Exhibits | Form | Filing Date | Exhibit Number |\n| 31.1 | Certification by Principal Executive Officer pursuant to Exchange Act Rule 13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2 | Certification by Principal Financial Officer pursuant to Exchange Act Rule 13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1 | Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2 | Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS | Inline XBRL Instance Document (the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document). |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document. |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document. |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document. |\n| 101.LAB | Inline XBRL Taxonomy Extension Labels Linkbase Document. |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document. |\n| 104 | Cover Page Interactive Data File (formatted as inline XBRL and contained in Exhibit 101). |\n\n\n| 33 |\n\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| Iconic Brands, Inc. |\n| Dated: August 2, 2022 | By: | /s/ Tom Martin |\n| Tom Martin |\n| Its: | Chief Executive Officer |\n\n\n| Dated: August 2, 2022 | By: | /s/ David Allen |\n| David Allen |\n| Its: | Chief Financial Officer |\n\n\n| 34 |\n\n\n</text>\n\nHow much total interest will the company have to pay under the new agreement until August 2023 in dollars if the company managed to extend the TopPop Notes' maturity date for one more year?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"ground_truth": "Therefore, the answer is 980000.0."
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docmath_20000_40000
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Interim Financial Statements.\nQUANTUM FINTECH ACQUISITION CORPORATION\nCONDENSED BALANCE SHEETS\nUNAUDITED\n\n| June 30, 2021 | December 31, 2020 |\n| ASSETS |\n| Current assets |\n| Cash | $ | 307,252 | $ | 21,868 |\n| Prepaid expenses | 518,917 | 20,833 |\n| Total Current Assets | 826,169 | 42,701 |\n| Deferred offering costs | — | 157,919 |\n| Marketable securities held in Trust Account | 201,259,829 | — |\n| TOTAL ASSETS | $ | 202,085,998 | $ | 200,620 |\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\n| Current liabilities |\n| Accounts payable and accrued expenses | $ | 278,660 | $ | 940 |\n| Accrued offering costs | 15,450 | 50,000 |\n| Promissory note – related party | — | 130,100 |\n| Total Current Liabilities | 294,110 | 181,040 |\n| Warrant liability | 4,061,063 | — |\n| Total Liabilities | 4,355,173 | 181,040 |\n| Commitments |\n| Common stock subject to possible redemption 19,272,141 and no shares at redemption value at June 30, 2021 and December 31, 2020, respectively | 192,730,822 | — |\n| Stockholders’ Equity |\n| Preferred stock, $ 0.0001 par value; 1,000,000 shares authorized; none issued or outstanding | — | — |\n| Common stock, $ 0.0001 par value; 100,000,000 shares authorized; 5,884,109 and 5,031,250 shares issued and outstanding (excluding 19,272,141 and no shares subject to possible redemption) at June 30, 2021 and December 31, 2020, respectively | 589 | 503 |\n| Additional paid-in capital | 5,873,598 | 24,497 |\n| Accumulated deficit | ( 874,184 | ) | ( 5,420 | ) |\n| Total Stockholders’ Equity | 5,000,003 | 19,580 |\n| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY | $ | 202,085,998 | $ | 200,620 |\n\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\n1\nQUANTUM FINTECH ACQUISITION CORPORATION\nCONDENSED STATEMENTS OF OPERATIONS\n(UNAUDITED)\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2021 |\n| Operating and formation costs | $ | 394,945 | $ | 632,468 |\n| Loss from operations | ( 394,945 | ) | ( 632,468 | ) |\n| Other (expense) income: |\n| Change in fair value of warrant liability | ( 2,215,125 | ) | ( 246,125 | ) |\n| Interest earned on marketable securities held in Trust Account | 19,530 | 19,530 |\n| Unrealized loss on marketable securities held in Trust Account | ( 20,486 | ) | ( 9,701 | ) |\n| Other (expense) income, net | ( 2,216,081 | ) | ( 236,296 | ) |\n| Loss before provision for income taxes | ( 2,611,026 | ) | ( 868,764 | ) |\n| (Provision) benefit for income taxes | — | — |\n| Net loss | $ | ( 2,611,026 | ) | $ | ( 868,764 | ) |\n| Basic and diluted weighted average shares outstanding, Common stock subject to redemption | 19,533,138 | 19,416,244 |\n| Basic and diluted net loss per share, Common stock subject to redemption | $ | 0.00 | $ | 0.00 |\n| Basic and diluted weighted average shares outstanding, Non-redeemable common stock | 5,623,112 | 5,438,347 |\n| Basic and diluted net loss per share, Non-redeemable common stock | $ | ( 0.46 | ) | $ | ( 0.16 | ) |\n\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\n2\nQUANTUM FINTECH ACQUISITION CORPORATION\nCONDENSED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY\nTHREE AND SIX MONTHS ENDED JUNE 30, 2021\n(UNAUDITED)\n\n| Class A Common Stock | Additional Paid-in | Retained Earnings (Accumulated | Total Stockholders’ |\n| Shares | Amount | Capital | Deficit) | Equity |\n| Balance — January 1, 2021 | 5,031,250 | $ | 503 | $ | 24,497 | $ | ( 5,420 | ) | $ | 19,580 |\n| Sale of 20,125,000 Units, net of underwriting discounts, initial value of public warrant and other offering costs | 20,125,000 | 2,013 | 196,239,809 | — | 196,241,822 |\n| Cash paid in excess of fair value for Private Warrants | — | — | 2,338,187 | — | 2,338,187 |\n| Common stock subject to possible redemption | ( 19,533,138 | ) | ( 1,953 | ) | ( 195,339,895 | ) | — | ( 195,341,848 | ) |\n| Net income | — | — | — | 1,742,262 | 1,742,262 |\n| Balance – March 31, 2021 | 5,623,112 | $ | 563 | $ | 3,262,598 | $ | 1,736,842 | $ | 5,000,003 |\n| Common stock subject to possible redemption | 260,997 | 26 | 2,611,000 | — | 2,611,026 |\n| Net loss | — | — | — | ( 2,611,026 | ) | ( 2,611,026 | ) |\n| Balance – June 30, 2021 | 5,884,109 | $ | 589 | $ | 5,873,598 | $ | ( 874,184 | ) | $ | 5,000,003 |\n\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\n3\nQUANTUM FINTECH ACQUISITION CORPORATION\nCONDENSED STATEMENT OF CASH FLOWS\nSIX MONTHS ENDED JUNE 30, 2021\n(UNAUDITED)\n\n| Cash Flows from Operating Activities: |\n| Net loss | $ | ( 868,764 | ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: |\n| Change in fair value of warrant liability | 246,125 |\n| Transaction costs incurred in connection with warrant liability | 9,348 |\n| Unrealized loss on marketable securities held in Trust Account | 9,701 |\n| Interest earned on marketable securities held in Trust Account | ( 19,530 | ) |\n| Changes in operating assets and liabilities: |\n| Prepaid expenses | ( 498,084 | ) |\n| Accounts payable, accrued expenses, and accrued offering costs | 272,720 |\n| Net cash used in operating activities | ( 848,484 | ) |\n| Cash Flows from Investing Activities: |\n| Investment of cash in Trust Account | ( 201,250,000 | ) |\n| Net cash used in investing activities | ( 201,250,000 | ) |\n| Cash Flows from Financing Activities: |\n| Proceeds from sale of Units, net of underwriting discounts paid | 196,721,875 |\n| Proceeds from sale of Private Placement Warrants | 6,153,125 |\n| Proceeds from promissory note – related party | 23,957 |\n| Repayment of promissory note – related party | ( 154,057 | ) |\n| Payment of offering costs | ( 361,032 | ) |\n| Net cash provided by financing activities | 202,383,868 |\n| Net Change in Cash | 285,384 |\n| Cash – Beginning of period | 21,868 |\n| Cash – End of period | $ | 307,252 |\n| Non-Cash investing and financing activities: |\n| Initial classification of warrant liability | $ | 3,814,938 |\n| Offering costs included in accrued offering costs | $ | 15,450 |\n| Initial classification of common stock subject to possible redemption | $ | 193,588,000 |\n| Change in value of common stock subject to possible redemption | $ | ( 857,178 | ) |\n\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\n4\nQUANTUM FINTECH ACQUISITION CORPORATION\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nJUNE 30, 2021\n(Unaudited)\nNOTE 1. DESCRIPTION OF ORGANIZATION AND BUSINESS OPERATIONS\nQuantum FinTech Acquisition Corporation (the “Company”) was incorporated in Delaware on October 1, 2020. The Company is a blank check company formed for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities (the “Business Combination”). The Company is an early stage and emerging growth company and, as such, the Company is subject to all of the risks associated with early stage and emerging growth companies.\nAs of June 30, 2021, the Company had not commenced any operations. All activity through June 30, 2021 relates to the Company’s formation, the initial public offering (“Initial Public Offering”), which is described below, and subsequent to the Initial Public Offering, identifying a target company for a Business Combination. The Company will not generate any operating revenues until after the completion of a Business Combination, at the earliest. The Company will generate non-operating income in the form of interest income from the proceeds derived from the Initial Public Offering.\nThe registration statement for the Company’s Initial Public Offering were declared effective on February 4, 2021. On February 9, 2021, the Company consummated the Initial Public Offering of 17,500,000 units (the “Units” and, with respect to the shares of common stock included in the Units sold, the “Public Shares”), at $ 10.00 per Unit, generating gross proceeds of $ 175,000,000 , which is described in Note 3.\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the sale of 5,562,500 warrants (each, a “Private Warrant” and, collectively, the “Private Warrants”) at a price of $ 1.00 per Private Warrant in a private placement to Quantum Ventures LLC (“Quantum Ventures”), who purchased 4,450,000 Private Warrants and Chardan Quantum LLC (“Chardan Quantum” and together with Quantum Ventures, the “Co-Sponsors”) who purchased 1,112,500 Private Warrants, generating gross proceeds of $ 5,562,500 , which is described in Note 4.\nFollowing the closing of the Initial Public Offering on February 9, 2021, an amount of $ 175,000,000 ($ 10.00 per Unit) from the net proceeds of the sale of the Units in the Initial Public Offering and the sale of the Private Warrants was placed in a trust account (the “Trust Account”), invested in U.S. government treasury bills, notes or bonds having a maturity of 185 days or less and/or (ii) in money market funds meeting certain conditions under Rule 2a-7 of the Investment Company Act of 1940, as amended (the “Investment Company Act”), as determined by the Company, until the earlier of: (i) the consummation of a Business Combination or (ii) the distribution of the funds in the Trust Account to the Company’s stockholders, as described below.\nOn February 12, 2021, the underwriters fully exercised their over-allotment option, resulting in an additional 2,625,000 Units issued for an aggregate amount of $ 26,250,000 . In connection with the underwriters’ full exercise of their over-allotment option, the Company also consummated the sale of an additional 590,625 Private Warrants at $ 1.00 per Private Warrant, generating total proceeds of $ 590,625 . A total of $ 26,250,000 was deposited into the Trust Account, bringing the aggregate proceeds held in the Trust Account to $ 201,250,000 .\nTransaction costs amounted to $ 5,017,526 , consisting of $ 4,528,125 of underwriting fees, and $ 489,401 of other offering costs.\nThe Company’s management has broad discretion with respect to the specific application of the net proceeds of the Initial Public Offering and the sale of the Private Warrants, although substantially all of the net proceeds are intended to be applied generally toward consummating a Business Combination. There is no assurance that the Company will be able to complete a Business Combination successfully. The Company must complete a Business Combination having an aggregate fair market value of at least 80 % of the assets held in the Trust Account (as defined below) (excluding the taxes payable on income earned on the Trust Account) at the time of the agreement to enter into an initial Business Combination. The Company will only complete a Business Combination if the post-transaction company owns or acquires 50 % or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act of 1940, as amended (the “Investment Company Act”).\nThe Company will provide its holders of the outstanding Public Shares (the “public stockholders”) with the opportunity to redeem all or a portion of their Public Shares upon the completion of a Business Combination either (i) in connection with a stockholder meeting called to approve the Business Combination or (ii) by means of a tender offer. The decision as to whether the Company will seek stockholder approval of a Business Combination or conduct a tender offer will be made by the Company, solely in its discretion. The public stockholders will be entitled to redeem their Public Shares for a pro rata portion of the amount then in the Trust Account (initially anticipated to be $ 10.00 per Public Share, plus any pro rata interest earned on the funds held in the Trust Account and not previously released to the Company to pay its tax obligations). There will be no redemption rights upon the completion of a Business Combination with respect to the Company’s warrants.\n5\nQUANTUM FINTECH ACQUISITION CORPORATION\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nJUNE 30, 2021\n(Unaudited)\nThe Company will proceed with a Business Combination if the Company has net tangible assets of at least $ 5,000,001 immediately prior to or upon such consummation of a Business Combination and, if the Company seeks stockholder approval, a majority of the shares voted are voted in favor of the Business Combination. If a stockholder vote is not required by law and the Company does not decide to hold a stockholder vote for business or other legal reasons, the Company will, pursuant to its Amended and Restated Certificate of Incorporation (the “Amended and Restated Certificate of Incorporation”), conduct the redemptions pursuant to the tender offer rules of the U.S. Securities and Exchange Commission (“SEC”) and file tender offer documents with the SEC containing substantially the same information as would be included in a proxy statement prior to completing a Business Combination. If, however, stockholder approval of the transaction is required by law, or the Company decides to obtain stockholder approval for business or legal reasons, the Company will offer to redeem shares in conjunction with a proxy solicitation pursuant to the proxy rules and not pursuant to the tender offer rules. If the Company seeks stockholder approval in connection with a Business Combination, Quantum Ventures has agreed to vote its Founder Shares and any Public Shares purchased during or after the Initial Public Offering (a) in favor of approving a Business Combination and (b) not to redeem any shares in connection with a stockholder vote to approve a Business Combination or sell any shares to the Company in a tender offer in connection with a Business Combination. Additionally, each public stockholder may elect to redeem their Public Shares irrespective of whether they vote for or against the proposed transaction or don’t vote at all.\nThe Co-Sponsors and the other holders of the Company’s shares prior to the Initial Public Offering (the “initial stockholders”) have agreed (A) to vote their Founder Shares (See Note 5) and any Public Shares in favor of a Business Combination, (B) not to propose, or vote in favor of, prior to and unrelated to a Business Combination, an amendment to the Company’s Amended and Restated Certificate of Incorporation that would affect the substance or timing of the Company’s redemption obligation to redeem all Public Shares if the Company cannot complete a Business Combination within 18 months (August 9, 2022) (or 24 months from the closing of the Initial Public Offering (February 9, 2023) if the Company has executed a letter of intent, agreement in principle or definitive agreement for a Business Combination by August 9, 2022) unless the Company provides public stockholders an opportunity to redeem their Public Shares in conjunction with any such amendment, (C) not to convert any shares (including the Founder Shares) into the right to receive cash from the Trust Account in connection with a stockholder vote to approve the Company’s Business Combination or sell any shares to the Company in a tender offer in connection with a Business Combination, and (D) that the Founder Shares shall not participate in any liquidating distribution upon winding up if a Business Combination is not consummated.\nThe Company will have until August 9, 2022 (or February 9, 2023, as applicable) to complete a Business Combination (the “Combination Period”). If the Company is unable to complete a Business Combination within the Combination Period, the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account including interest earned on the funds held in the Trust Account and not previously released to the Company to pay taxes, dissolution expenses up to $100,00, divided by the number of then outstanding Public Shares, which redemption will completely extinguish public stockholders’ rights as stockholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the Company’s remaining stockholders and the Company’s board of directors, dissolve and liquidate, subject in each case to the Company’s obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law. There will be no redemption rights or liquidating distributions with respect to the Company’s warrants, which will expire worthless if the Company fails to complete a Business Combination within the Combination Period.\nThe initial stockholders have agreed to waive their liquidation rights with respect to the Founder Shares if the Company fails to complete a Business Combination within the Combination Period. However, if the initial stockholders acquire Public Shares in or after the Initial Public Offering, such Public Shares will be entitled to liquidating distributions from the Trust Account if the Company fails to complete a Business Combination within the Combination Period. In the event of such distribution, it is possible that the per share value of the assets remaining available for distribution will be less than the Initial Public Offering price per Unit ($ 10.00 ).\nIn order to protect the amounts held in the Trust Account, Quantum Ventures has agreed to be liable to the Company if and to the extent any claims by a third party for services rendered or products sold to the Company, or a prospective target business with which the Company has discussed entering into a transaction agreement, reduce the amount of funds in the Trust Account to below $ 10.00 per Public Share, except as to any claims by a third party who executed a valid and enforceable agreement with the Company waiving any right, title, interest or claim of any kind they may have in or to any monies held in the Trust Account and except as to any claims under the Company’s indemnity of the underwriters of Initial Public Offering against certain liabilities, including liabilities under the Securities Act of 1933, as amended (the “Securities Act”). Moreover, in the event that an executed waiver is deemed to be unenforceable against a third party, the insiders will not be responsible to the extent of any liability for such third-party claims. The Company has sought and will continue to seek to reduce the possibility that the insiders will have to indemnify the Trust Account due to claims of creditors by endeavoring to have all vendors, service providers (except the Company’s independent registered public accounting firm), prospective target businesses or other entities with which the Company does business, execute agreements with the Company waiving any right, title, interest or claim of any kind in or to monies held in the Trust Account.\nLiquidity and Management’s Plan\nAs of June 30, 2021, the Company had $ 307,252 in its operating bank accounts, $ 201,259,829 in marketable securities held in the Trust Account to be used for a Business Combination or to repurchase or redeem stock in connection therewith and a working capital of $ 615,392 , excluding Delaware franchise taxes of approximately $ 83,000 . As of June 30, 2021, $ 9,829 of the amount on deposit in the Trust Account represented interest income and unrealized losses on marketable securities, which is available to the Company for working capital needs. Through June 30, 2021, the Company had not withdrawn any amounts from the Trust Account for such needs.\nIn March 2021, the Sponsor committed to provide the Company an aggregate of $ 500,000 in loans in connection with the Working Capital Loans as described in Note 5. The Company may raise additional capital through loans or additional investments from the Sponsors or its stockholders, officers, directors, or third parties. The Company’s officers and directors and the Sponsors may, but are not obligated to (except as described above), loan the Company funds, from time to time, in whatever amount they deem reasonable in their sole discretion, to meet the Company’s working capital needs.\n6\nQUANTUM FINTECH ACQUISITION CORPORATION\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nJUNE 30, 2021\n(Unaudited)\nBased on the foregoing, the Company believes it will have sufficient cash to meet its needs through the earlier of consummation of a Business Combination or one year and one day from the date of issuance of these financial statements.\nRisks and Uncertainties\nManagement continues to evaluate the impact of the COVID-19 pandemic and has concluded that while it is reasonably possible that the virus could have a negative effect on the Company’s financial position, results of its operations and/or search for a target company, the specific impact is not readily determinable as of the date of the financial statements. These financial statements do not include any adjustments that might result from the outcome of this uncertainty.\nNOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nBasis of Presentation\nThe accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 8 of Regulation S-X of the SEC. Certain information or footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted, pursuant to the rules and regulations of the SEC for interim financial reporting. Accordingly, they do not include all the information and footnotes necessary for a complete presentation of financial position, results of operations, or cash flows. In the opinion of management, the accompanying unaudited condensed financial statements include all adjustments, consisting of a normal recurring nature, which are necessary for a fair presentation of the financial position, operating results and cash flows for the periods presented.\nThe accompanying unaudited condensed financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the period ended December 31, 2020, as filed with the SEC on March 31, 2021. The interim results for the three and six months ended June 30, 2021 are not necessarily indicative of the results to be expected for the year ending December 31, 2021 or for any future periods.\nEmerging Growth Company\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the independent registered public accounting firm attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statement with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\nUse of Estimates\nThe preparation of the condensed financial statements in conformity with GAAP requires the Company’s management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.\nMaking estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. Accordingly, the actual results could differ significantly from those estimates.\n7\nQUANTUM FINTECH ACQUISITION CORPORATION\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nJUNE 30, 2021\n(Unaudited)\nCash and Cash Equivalents\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did not have any cash equivalents as of June 30, 2021 and December 31, 2020.\nMarketable Securities Held in Trust Account\nAt June 30, 2021, substantially all of the assets held in the Trust Account were held in money market funds which are invested primarily in U.S. Treasury securities.\nOffering Costs\nOffering costs consisted of legal, accounting, and other expenses incurred through the balance sheet date that were directly related to the Initial Public Offering. Offering costs amounting to $ 5,008,178 were charged to stockholders’ equity upon the completion of the Initial Public Offering, and $ 9,348 of the offering costs were related to the warrant liability and charged to the statement of operations.\nWarrant Liability\nThe Company accounts for warrants as either equity-classified or liability-classified instruments based on an assessment of the warrant’s specific terms and applicable authoritative guidance in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 480, Distinguishing Liabilities from Equity (“ASC 480”) and ASC 815, Derivatives and Hedging (“ASC 815”). The assessment considers whether the warrants are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and whether the warrants meet all of the requirements for equity classification under ASC 815, including whether the warrants are indexed to the Company’s own ordinary shares, among other conditions for equity classification. This assessment, which requires the use of professional judgment, is conducted at the time of warrant issuance and as of each subsequent quarterly period end date while the warrants are outstanding.\nFor issued or modified warrants that meet all of the criteria for equity classification, the warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all the criteria for equity classification, the warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of the warrants are recognized as a non-cash gain or loss on the statements of operations. The fair value of the private warrants was estimated using a Binomial lattice model approach (see Note 9).\nCommon Stock Subject to Possible Redemption\nThe Company accounts for its common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including Common stock that features redemption rights that is either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. The Company’s common stock features certain redemption rights that are considered to be outside of the Company’s control and subject to occurrence of uncertain future events. Accordingly, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders’ equity section of the Company’s condensed balance sheets.\nIncome Taxes\nThe Company follows the asset and liability method of accounting for income taxes under ASC 740, “Income Taxes.” Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statements carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that included the enactment date. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.\nASC 740 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more likely than not to be sustained upon examination by taxing authorities. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of June 30, 2021 and December 31, 2020. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position. The Company is subject to income tax examinations by major taxing authorities since inception. The effective tax rate differs from the statutory tax rate of 21 % for the three and six months ended June 30, 2021, due to the valuation allowance recorded on the Company’s net operating losses.\n8\nQUANTUM FINTECH ACQUISITION CORPORATION\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nJUNE 30, 2021\n(Unaudited)\nNet income per Common Share\nNet income per share is computed by dividing net income by the weighted-average number of shares of common stock outstanding during the period, excluding shares of common stock subject to forfeiture. The Company has not considered the effect of the warrants sold in the Initial Public Offering and private placement to purchase an aggregate of 16,215,625 shares in the calculation of diluted loss per share, since the exercise of the warrants are contingent upon the occurrence of future events and the inclusion of such warrants would be anti-dilutive.\nThe Company’s statement of operations includes a presentation of loss per share for common stock subject to possible redemption in a manner similar to the two-class method of loss per share. Net loss per common share, basic and diluted, for Common stock subject to possible redemption is calculated by dividing the proportionate share of income or loss on marketable securities held by the Trust Account, net of applicable franchise and income taxes, by the weighted average number of shares of Common stock subject to possible redemption outstanding since original issuance.\nNet loss per share, basic and diluted, for non-redeemable common stock is calculated by dividing the net income, adjusted for income or loss on marketable securities attributable to Common stock subject to possible redemption, by the weighted average number of non-redeemable shares of common stock outstanding for the period.\nNon-redeemable common stock includes Founder Shares and non-redeemable shares of common stock as these shares do not have any redemption features. Non-redeemable common stock participates in the income or loss on marketable securities based on non-redeemable shares’ proportionate interest.\nThe following table reflects the calculation of basic and diluted net loss per common share (in dollars, except per share amounts):\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2021 |\n| Common stock subject to possible redemption |\n| Numerator: Earnings allocable to Common stock subject to possible redemption |\n| Interest income and unrealized gain (losses) on marketable securities held in Trust Account, net | $ | ( 915 | ) | $ | 9,829 |\n| Less income available to pay franchise and income taxes | — | ( 9,829 | ) |\n| Net loss attributable to Common stock subject to possible redemption | $ | ( 915 | ) | $ | — |\n| Denominator: Weighted Average Common stock subject to possible redemption |\n| Basic and diluted weighted average shares outstanding, Common stock subject to possible redemption | 19,533,138 | 19,416,244 |\n| Basic and diluted net income per share, Common stock subject to possible redemption | $ | — | $ | — |\n| Non-Redeemable Common Stock |\n| Numerator: Net Loss minus Net Earnings allocable to Common stock subject to possible redemption |\n| Net loss | $ | ( 2,611,026 | ) | $ | ( 868,764 | ) |\n| Less: Net loss allocable to Common stock subject to possible redemption | 915 | — |\n| Non-Redeemable Net Loss allocable to Non-Redeemable Common Stock | $ | ( 2,610,111 | ) | $ | ( 868,764 | ) |\n| Denominator: Weighted Average Non-redeemable Common stock |\n| Basic and diluted weighted average shares outstanding, Non-redeemable Common stock | 5,623,112 | 5,438,347 |\n| Basic and diluted net loss per share, Non-redeemable Common stock | $ | ( 0.46 | ) | $ | ( 0.16 | ) |\n\nConcentration of Credit Risk\nFinancial instruments that potentially subject the Company to concentrations of credit risk consist of cash accounts in a financial institution, which, at times may exceed the Federal Depository Insurance Coverage of $ 250,000 . The Company has not experienced losses on these accounts.\nFair Value of Financial Instruments\nThe fair value of the Company’s assets and liabilities, which qualify as financial instruments under ASC Topic 820, “Fair Value Measurement,” approximates the carrying amounts represented in the accompanying condensed balance sheets, primarily due to their short-term nature.\n9\nQUANTUM FINTECH ACQUISITION CORPORATION\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nJUNE 30, 2021\n(Unaudited)\nFair Value Measurements\nFair value is defined as the price that would be received for sale of an asset or paid for transfer of a liability, in an orderly transaction between market participants at the measurement date. GAAP establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). These tiers include:\n● Level 1, defined as observable inputs such as quoted prices (unadjusted) for identical instruments in active markets;\n● Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable such as quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active; and\n● Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions, such as valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable.\nIn some circumstances, the inputs used to measure fair value might be categorized within different levels of the fair value hierarchy. In those instances, the fair value measurement is categorized in its entirety in the fair value hierarchy based on the lowest level input that is significant to the fair value measurement.\nDerivative Financial Instruments\nThe Company evaluates its financial instruments to determine if such instruments are derivatives or contain features that qualify as embedded derivatives in accordance with ASC Topic 815, “Derivatives and Hedging”. For derivative financial instruments that are accounted for as liabilities, the derivative instrument is initially recorded at its fair value on the grant date and is then re-valued at each reporting date, with changes in the fair value reported in the statements of operations. The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is evaluated at the end of each reporting period. Derivative liabilities are classified in the balance sheet as current or non-current based on whether or not net-cash settlement or conversion of the instrument could be required within 12 months of the balance sheet date.\nRecent Accounting Standards\nExcept as noted below, management does not believe that any recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on the Company’s condensed financial statements.\nIn August 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2020-06, Derivatives and Hedging — Contracts in Entity’s Own Equity (Subtopic 815-40) (“ASU 2020-06”) to simplify accounting for certain financial instruments. ASU 2020-06 eliminates the current models that require separation of beneficial conversion and cash conversion features from convertible instruments and simplifies the derivative scope exception guidance pertaining to equity classification of contracts in an entity’s own equity. The new standard also introduces additional disclosures for convertible debt and freestanding instruments that are indexed to and settled in an entity’s own equity. ASU 2020-06 amends the diluted earnings per share guidance, including the requirement to use the if-converted method for all convertible instruments. ASU 2020-06 is effective for the Company on January 1, 2024, and should be applied on a full or modified retrospective basis, with early adoption permitted beginning on January 1, 2021. The Company is currently assessing the impact, if any, that ASU 2020-06 would have on its financial position, results of operations or cash flows.\nNOTE 3. PUBLIC OFFERING\nPursuant to the Initial Public Offering, the Company sold 20,125,000 Units, inclusive of 2,625,000 Units sold to the underwriters on February 12, 2021 upon the underwriters’ election to fully exercise their over-allotment option, at a purchase price of $ 10.00 per Unit. Each Unit will consist of one share of common stock and one redeemable warrant (“Public Warrant”). Each Public Warrant will entitle the holder to purchase one-half share of common stock at an exercise price of $11.50 per share (see Note 8).\nNOTE 4. PRIVATE PLACEMENT\nSimultaneously with the closing of the Initial Public Offering, Quantum Ventures purchased an aggregate of 4,450,000 Private Warrants and Chardan Quantum purchased 1,112,500 Private Warrants, in each case, at a price of $ 1.00 per Private Warrant, for an aggregate purchase price of $ 5,562,500 , in a private placement. On February 12, 2021, in connection with the underwriters’ election to fully exercise their over-allotment option, the Company sold an additional 590,625 Private Warrants to the Co-Sponsors, at a price of $ 1.00 per Private Warrant, generating gross proceeds of $ 590,625 . Each Private Warrant entitles the holder to purchase one share of common stock at a price of $11.50 per full share, subject to adjustment (see Note 8). The proceeds from the Private Warrants were added to the proceeds from the Initial Public Offering to be held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the proceeds from the sale of the Private Warrants will be used to fund the redemption of the Public Shares (subject to the requirements of applicable law).\n10\nQUANTUM FINTECH ACQUISITION CORPORATION\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nJUNE 30, 2021\n(Unaudited)\nNOTE 5. RELATED PARTY TRANSACTIONS\nFounder Shares\nOn October 23, 2020, Quantum Ventures purchased 4,312,500 shares (the “Founder Shares”) of the Company’s common stock for an aggregate price of $ 25,000 . In January 2021, Quantum Ventures sold 813,500 Founder Shares to Chardan Quantum and 35,000 Founder Shares to each of the Company’s directors and director nominees, in each case at the original price per share, resulting in Quantum Ventures holding a balance of 3,254,000 Founder Shares. On February 4, 2021, the Company effected a stock dividend of 718,750 shares with respect to its common stock, resulting in the initial stockholders holding an aggregate of 5,031,250 Founder Shares. The Founder Shares include an aggregate of up to 656,250 shares subject to forfeiture to the extent that the underwriters’ over-allotment is not exercised in full or in part, so that the initial stockholders will collectively own 20 % of the Company’s issued and outstanding shares after the Initial Public Offering (assuming the initial stockholders do not purchase any Public Shares in the Initial Public Offering). As a result of the underwriters’ election to fully exercise their over-allotment option on February 12, 2021, no Founder Shares are currently subject to forfeiture.\nThe initial stockholders have agreed, subject to certain limited exceptions, not to transfer, assign or sell any of the Founder Shares until (1) with respect to 50% of the Founder Shares, the earlier of six months after the completion of a Business Combination and the date on which the closing price of the common stock equals or exceeds $12.50 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing after a Business Combination and (2) with respect to the remaining 50% of the Founder Shares, six months after the completion of a Business Combination, or earlier, in either case, if, subsequent to a Business Combination, the Company completes a liquidation, merger, stock exchange or other similar transaction which results in all of the Company’s stockholders having the right to exchange their shares of common stock for cash, securities or other property.\nThe sale of the Founders Shares to the Company’s directors and director nominees is in the scope of FASB ASC Topic 718, “Compensation-Stock Compensation” (“ASC 718”). Under ASC 718, stock-based compensation associated with equity-classified awards is measured at fair value upon the grant date. The fair value of the 245,000 shares granted to the Company’s directors and director nominees was $1,462,650 or $5.97 per share. The Founders Shares were granted subject to a performance condition (i.e., the occurrence of a Business Combination). Compensation expense related to the Founders Shares is recognized only when the performance condition is probable of occurrence under the applicable accounting literature in this circumstance. As of June 30, 2021, the Company determined that a Business Combination is not considered probable, and, therefore, no stock-based compensation expense has been recognized. Stock-based compensation would be recognized at the date a Business Combination is considered probable (i.e., upon consummation of a Business Combination) in an amount equal to the number of Founders Shares times the grant date fair value per share (unless subsequently modified) less the amount initially received for the purchase of the Founders Shares.\nAdministrative Services Agreement\nThe Company agreed, commencing on February 4, 2021, to pay Quantum Ventures a total of $ 10,000 per month for office space, utilities and secretarial support. Upon completion of the Business Combination or the Company’s liquidation, the Company will cease paying these monthly fees. For the three and six months ended June 30, 2021, the Company incurred and paid $ 30,000 and $ 50,000 , respectively, in fees for these services, which are included in the operating and formation costs in the accompanying condensed statements of operations.\nPromissory Note — Related Party\nOn October 1, 2020, the Company issued an unsecured promissory note to Quantum Ventures (the “Promissory Note”), pursuant to which the Company may borrow up to an aggregate principal amount of $ 200,000 . The Promissory Note is non-interest bearing and payable on the earlier of (i) January 31, 2021 and (ii) the completion of the Initial Public Offering. As of June 30, 2021 and December 31, 2020, there was no balance and $ 130,100 , respectively, outstanding under the Promissory Note. The outstanding amount of $ 154,057 was repaid at the closing of the Initial Public Offering on February 9, 2021, and there have been no additional borrowing through June 30, 2021.\nRelated Party Loans\nIn order to finance transaction costs in connection with a Business Combination, Quantum Ventures or an affiliate of Quantum Ventures, or certain of the Company’s officers and directors may, but are not obligated to, loan the Company funds as may be required (“Working Capital Loans”). Such Working Capital Loans would be evidenced by promissory notes. The notes may be repaid upon completion of a Business Combination, without interest, or, at the lender’s discretion, up to $1,500,000 of notes may be converted upon completion of a Business Combination into warrants at a price of $1.00 per warrant. Such warrants would be identical to the Private Warrants. In the event that a Business Combination does not close, the Company may use a portion of proceeds held outside the Trust Account to repay the Working Capital Loans but no proceeds held in the Trust Account would be used to repay the Working Capital Loans.\nThrough the date of this filing, there have been no amounts advanced to the Company under the Working Capital Loans.\n11\nQUANTUM FINTECH ACQUISITION CORPORATION\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nJUNE 30, 2021\n(Unaudited)\nNOTE 6. COMMITMENTS\nRegistration Rights\nPursuant to a registration rights agreement entered into on February 4, 2021, the holders of the Founder Shares, as well as the holders of the Private Warrants (and underlying securities) and any warrants issued in payment of Working Capital Loans made to Company (and underlying securities) will have registration and stockholder rights pursuant to an agreement to be signed prior to or on the effective date of the Initial Public Offering. The holders of a majority of these securities are entitled to make up to two demands that the Company register such securities. The holders of the majority of the insider shares can elect to exercise these registration rights at any time commencing three months prior to the date on which these shares of common stock are to be released from escrow. The holders of a majority of the Private Warrants (and underlying securities) can elect to exercise these registration rights at any time after the consummation of a Business Combination. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the consummation of a Business Combination. The registration and stockholder rights agreement does not contain liquidating damages or other cash settlement provisions resulting from delays in registering the Company’s securities. The Company will bear the expenses incurred in connection with the filing of any such registration statements.\nUnderwriting Agreement\nThe Company granted the underwriters a 45-day option to purchase up to 2,625,000 additional Units to cover over-allotments at the Initial Public Offering price, less the underwriting discounts and commissions. On February 12, 2021, the underwriter’s elected to fully exercise the over-allotment option to purchase an additional 2,625,000 Public Units at a price of $ 10.00 per Public Unit.\nBusiness Combination Marketing Agreement\nThe Company engaged the underwriters as advisors in connection with a Business Combination to assist the Company in holding meetings with its stockholders to discuss the potential Business Combination and the target business’s attributes, introduce the Company to potential investors that are interested in purchasing the Company’s securities in connection with the potential Business Combination, assist the Company in obtaining stockholder approval for the Business Combination and assist the Company with its press releases and public filings in connection with the Business Combination. The Company will pay the underwriters the marketing fee for such services upon the consummation of our initial business combination in an amount equal to, in the aggregate, 3.5 % of the gross proceeds of the Initial Public offering or $ 7,043,750 .\nNOTE 7. STOCKHOLDERS’ EQUITY\nPreferred Stock — The Company is authorized to issue 1,000,000 shares of preferred stock with a par value of $ 0.0001 per share with such designations, voting and other rights and preferences as may be determined from time to time by the Company’s board of directors. At June 30, 2021 and December 31, 2020, there were no shares of preferred stock issued or outstanding.\nCommon stock — The Company is authorized to issue 100,000,000 shares of common stock with a par value of $ 0.0001 per share. Holders of the Company’s common stock are entitled to one vote for each share. At June 30, 2021, there were 5,884,109 shares of Common stock issued and outstanding, excluding 19,272,141 shares of Common stock subject to possible redemption. At December 31, 2020, there were 5,031,250 shares of Common stock issued and outstanding.\n12\nQUANTUM FINTECH ACQUISITION CORPORATION\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nJUNE 30, 2021\n(Unaudited)\nNOTE 8. WARRANTS\nAs of June 30, 2021, there are 10,062,500 Public Warrants outstanding that are classified and accounted for as equity instruments. The Public Warrants will become exercisable on the later of (a) the completion of a Business Combination or (b) one year from the closing of the Initial Public Offering. No Public Warrants will be exercisable for cash unless the Company has an effective and current registration statement covering the shares of common stock issuable upon exercise of the warrants and a current prospectus relating to such shares of common stock. Notwithstanding the foregoing, if a registration statement covering the shares of common stock issuable upon exercise of the Public Warrants is not effective within 120 days from the closing of a Business Combination, warrant holders may, until such time as there is an effective registration statement and during any period when the Company shall have failed to maintain an effective registration statement, exercise warrants on a cashless basis pursuant to an available exemption from registration under the Securities Act. The Public Warrants will expire five years after the completion of a Business Combination or earlier upon redemption or liquidation.\nOnce the warrants become exercisable, the Company may redeem the Public Warrants:\n\n| ● | in whole and not in part; |\n| ● | at a price of $0.01 per warrant; |\n| ● | at any time after the warrants become exercisable; |\n| ● | upon not less than 30 days’ prior written notice of redemption; |\n| ● | if, and only if, the reported last sale price of the shares of common stock equals or exceeds $16.50 per share (as adjusted for stock splits, stock dividends, reorganizations and recapitalizations), for any 20 trading days within a 30 trading day period ending on the third business day prior to the notice of redemption to warrant holders; and |\n| ● | if, and only if, there is a current registration statement in effect with respect to the shares of common stock underlying the warrants at the time of redemption and for the entire 30-day trading period referred to above and continuing each day thereafter until the date of redemption. |\n\nIf the Company calls the Public Warrants for redemption, management will have the option to require all holders that wish to exercise the Public Warrants to do so on a “cashless basis,” as described in the warrant agreement. The exercise price and number of shares of common stock issuable upon exercise of the warrants may be adjusted in certain circumstances including in the event of a stock dividend, or recapitalization, reorganization, merger or consolidation. However, except as described below, the warrants will not be adjusted for issuance of common stock at a price below its exercise price. Additionally, in no event will the Company be required to net cash settle the warrants. If the Company is unable to complete a Business Combination within the Combination Period and the Company liquidates the funds held in the Trust Account, holders of warrants will not receive any of such funds with respect to their warrants, nor will they receive any distribution from the Company’s assets held outside of the Trust Account with the respect to such warrants. Accordingly, the warrants may expire worthless.\nIn addition, if (x) the Company issues additional common stock or equity-linked securities for capital raising purposes in connection with the closing of a Business Combination at an issue price or effective issue price of less than $9.20 per share of common stock (with such issue price or effective issue price to be determined in good faith by the Company’s board of directors and, in the case of any such issuance to the initial stockholders or their affiliates, without taking into account any Founder Shares or Private Warrants held by the initial stockholders or their affiliates, as applicable, prior to such issuance) (the “Newly Issued Price”), (y) the aggregate gross proceeds from such issuances represent more than 60% of the total equity proceeds, and interest thereon, available for the funding of a Business Combination on the date of the consummation of a Business Combination (net of redemptions), and (z) the volume weighted average trading price of its common stock during the 20 trading day period starting on the trading day prior to the day on which the Company consummates its Business Combination (such price, the “Market Value”) is below $9.50 per share, the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115% of the higher of the Market Value and Newly Issued Price, and the $16.50 per share redemption trigger price will be adjusted (to the nearest cent) to be equal to 165% of the higher of the Market Value and the Newly Issued Price.\nAs of June 30, 2021, there are 6,153,125 Private Warrants to purchase an equal number of common shares that are outstanding that are classified and accounted for as derivative liabilities. Under this accounting treatment, the Company is required to measure the fair value of the Private Warrants at the end of each reporting period as well as re-evaluate the treatment of the Private Warrants and recognize changes in the fair value from the prior period in the Company’s operating results for the current period. The Private Warrants are identical to the Public Warrants underlying the Units sold in the Initial Public Offering, except that (i) each private warrant is exercisable for one share of common stock at an exercise price of $ 11.50 per share, the Private Warrants and the shares of common stock issuable upon the exercise of the Private Warrants will not be transferable, assignable or saleable until after the completion of a Business Combination, subject to certain limited exceptions. Additionally, the Private Warrants will be exercisable for cash or on a cashless basis, at the holder’s option, and will be non-redeemable so long as they are held by the initial purchasers or their permitted transferees. If the Private Warrants are held by someone other than the initial purchasers or their permitted transferees, the Private Warrants will be redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants.\n13\nQUANTUM FINTECH ACQUISITION CORPORATION\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nJUNE 30, 2021\n(Unaudited)\nNOTE 9. FAIR VALUE MEASUREMENTS\nAt June 30, 2021, assets held in the Trust Account were comprised of $ 201,259,829 in money market funds which are primarily invested in U.S. Treasury securities. During the three and six months ended June 30, 2021, the Company did not withdraw any interest income from the Trust Account.\nThe following table presents information about the Company’s assets and liabilities that are measured at fair value on a recurring basis at June 30, 2021, and indicates the fair value hierarchy of the valuation inputs the Company utilized to determine such fair value:\n\n| Description | Level | June 30, 2021 |\n| Assets: |\n| Marketable securities held in Trust Account | 1 | $ | 201,259,829 |\n| Liabilities: |\n| Warrant liability – Private Warrants | 3 | $ | 4,061,063 |\n\nThe Private Warrants were accounted for as liabilities in accordance with ASC 815-40 and are presented within warrant liabilities on our balance sheets. The warrant liabilities are measured at fair value at inception and on a recurring basis, with changes in fair value presented within change in fair value of warrant liabilities in the consolidated statements of operations.\nThe Private Placement Warrants were initially and as of the end of each subsequent report period, valued using a lattice model, specifically a binomial lattice model incorporating the Cox-Ross-Rubenstein methodology, which is considered to be a Level 3 fair value measurement. The primary unobservable input utilized in determining the fair value of the Private Placement Warrants is the expected volatility of our ordinary shares. The expected volatility of the Company’s ordinary shares was determined based on the implied volatility of the Public Warrants.\n14\nQUANTUM FINTECH ACQUISITION CORPORATION\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nJUNE 30, 2021\n(Unaudited)\nThe key inputs into the binomial lattice model for the Private Warrants were as follows:\n\n| Input | February 9, 2021 (Initial Measurement) and February 12, 2021 (over- allotment exercise) | June 30, 2021 |\n| Market price of public shares | $ | 9.39 | $ | 9.75 |\n| Risk-free rate | 0.54 | % | 0.86 | % |\n| Dividend yield | 0.00 | % | 0.00 | % |\n| Volatility | 14.1 | % | 12.9 | % |\n| Exercise price | $ | 11.50 | $ | 11.50 |\n| Effective expiration date | 6/20/26 | 6/21/26 |\n\nThe following table presents the changes in the fair value of warrant liabilities:\n\n| Private Placement |\n| Fair value as of January 1, 2021 | $ | — |\n| Initial measurement on February 9, 2021 | 3,448,750 |\n| Exercising of underwriters’ over-allotment on February 12, 2021 | 366,188 |\n| Change in valuation inputs or other assumptions | 246,125 |\n| Fair value as of June 30, 2021 | $ | 4,061,063 |\n\nThere were no transfers between levels during the three and six months ended June 30, 2021.\nNOTE 10. SUBSEQUENT EVENTS\nThe Company evaluated subsequent events and transactions that occurred after the balance sheet date up to the date that the condensed financial statements were issued. Based upon this review, the Company did not identify any subsequent events that would have required adjustment or disclosure in the condensed financial statements.\n15\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nReferences in this quarterly report on Form 10-Q (the “Quarterly Report”) to “we,” “us” or the “Company” refer to Quantum FinTech Acquisition Corporation. References to our “management” or our “management team” refer to our officers and directors, and references to the “Co-Sponsors” refer to Quantum Ventures LLC (“Quantum Ventures”) and Chardan Quantum LLC (“Chardan Quantum”). The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Quarterly Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\nSpecial Note Regarding Forward-Looking Statements\nThis Quarterly Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) that are not historical facts and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. All statements, other than statements of historical fact included in this Quarterly Report including, without limitation, statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. Words such as “expect,” “believe,” “anticipate,” “intend,” “estimate,” “seek” and variations and similar words and expressions are intended to identify such forward-looking statements. Such forward-looking statements relate to future events or future performance, but reflect management’s current beliefs, based on information currently available. A number of factors could cause actual events, performance or results to differ materially from the events, performance and results discussed in the forward-looking statements. For information identifying important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements, please refer to the Risk Factors section of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2020 (“Annual Report on Form 10-K”) filed with the U.S. Securities and Exchange Commission (the “SEC”). The Company’s securities filings can be accessed on the EDGAR section of the SEC’s website at www.sec.gov. Except as expressly required by applicable securities law, the Company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.\nOverview\nWe are a blank check company formed under the laws of the State of Delaware on October 1, 2020 for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities (“Business Combination”). We intend to effectuate our Business Combination using cash from the proceeds of the Initial Public Offering (defined below) and the sale of the Private Warrants, our capital stock, debt or a combination of cash, stock and debt.\nWe expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete a Business Combination will be successful.\nResults of Operations\nWe have neither engaged in any operations nor generated any revenues to date. Our only activities through June 30, 2021 were formation, the initial public offering (“Initial Public Offering”), which is described below, and subsequent to the Initial Public Offering, identifying a target company for a Business Combination. We do not expect to generate any operating revenues until after the completion of our Business Combination. We generate non-operating income in the form of interest income on marketable securities held in the Trust Account. We incur expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses.\nFor the three months ended June 30, 2021, we had a net loss of $2,611,026, which consists of operating costs of $394,945, change in fair value of warrant liability of $2,215,125 and an unrealized loss on marketable securities held in our Trust Account of $20,486, partially offset by interest earned on marketable securities held in Trust Account of $19,530.\nFor the six months ended June 30, 2021, we had a net loss of $868,764, which consists of the change in fair value of warrant liability of $246,125 and an interest earned on marketable securities held in Trust Account of $19,530, partially offset by unrealized loss on marketable securities held in our Trust Account of $9,701 and operating costs of $632,468.\nLiquidity and Capital Resources\nOn February 9, 2021, we consummated the Initial Public Offering of 17,500,000 units, each unit consisting of one share of common stock, par value $0.0001 per share, and one warrant to purchase one-half of one share of common stock at an exercise price of $11.50 (the “Units”), at $10.00 per Unit, generating gross proceeds of $175,000,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of 5,562,500 Private Warrants at a price of $1.00 per Private Warrant in a private placement to the Co-Sponsors, generating gross proceeds of $5,562,500.\nOn February 12, 2021, in connection with the underwriters’ exercise of their over-allotment option in full, we consummated the sale of an additional 2,625,000 Units at a price of $10.00 per Unit, generating total gross proceeds of $26,250,000. In addition, we also consummated the sale of an additional 590,625 Private Warrants at $1.00 per Private Warrant, generating gross proceeds of $590,625.\nFollowing the Initial Public Offering, the full exercise of the over-allotment option, and the sale of the Private Warrants, a total of $201,250,000 was placed in the Trust Account. We incurred $5,017,526 in Initial Public Offering related costs, including $4,528,125 of underwriting fees and $489,401 of other costs.\n16\nFor the six months ended June 30, 2021, cash used in operating activities was $848,484. Net loss of $868,764 was affected by unrealized loss on marketable securities held in the Trust Account of $9,701, interest earned on marketable securities held in the Trust Account of $19,530, the change in fair value of warrant liability of $246,125 and transaction costs allocate to the warrant liabilities of $9,348. Changes in operating assets and liabilities used $225,364 of cash for operating activities.\nAs of June 30, 2021, we had marketable securities of $201,259,829 (including $9,829 of interest income, net of unrealized loss) held in a trust (the “Trust Account”), invested in U.S. government treasury bills, notes or bonds having a maturity of 185 days or less and/or (ii) in money market funds meeting certain conditions under Rule 2a-7 of the Investment Company Act of 1940, as amended (the “Investment Company Act”), as determined by the Company. Interest income on the balance in the Trust Account may be used by us to pay taxes and dissolution expenses up to $100,000. Through June 30, 2021, we have not withdrawn any interest earned from the Trust Account.\nWe intend to use substantially all of the funds held in the Trust Account, including any amounts representing interest earned on the Trust Account (less income taxes payable), to complete our Business Combination. To the extent that our capital stock or debt is used, in whole or in part, as consideration to complete our Business Combination, the remaining proceeds held in the Trust Account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies.\nAs of June 30, 2021, we had cash of $307,252. We intend to use the funds held outside the Trust Account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, and structure, negotiate and complete a Business Combination.\nIn order to fund working capital deficiencies or finance transaction costs in connection with a Business Combination, Quantum Ventures or an affiliate of Quantum Ventures, or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If we complete a Business Combination, we would repay such loaned amounts. In the event that a Business Combination does not close, we may use a portion of the working capital held outside the Trust Account to repay such loaned amounts but no proceeds from our Trust Account would be used for such repayment. Up to $1,500,000 of such loans may be convertible into warrants at a price of $1.00 per warrant. The warrants would be identical to the Private Warrants. Through the date of this filing, there have been no amounts advanced to the Company under the Working Capital Loans.\nIn March 2021, the Sponsor committed to provide the Company an aggregate of $500,000 in loans in connection with the Working Capital Loans as described in Note 5. The Company may raise additional capital through loans or additional investments from the Sponsors or its stockholders, officers, directors, or third parties. The Company’s officers and directors and the Sponsors may, but are not obligated to (except as described above), loan the Company funds, from time to time, in whatever amount they deem reasonable in their sole discretion, to meet the Company’s working capital needs. Through the date of this filing, there have been no amounts advanced to the Company under the Working Capital Loans.\nBased on the foregoing, the Company believes it will have sufficient cash to meet its needs through the earlier of consummation of a Business Combination or one year and one day from the date of issuance of these financial statements.\nOff-Balance Sheet Arrangements\nWe have no obligations, assets or liabilities, which would be considered off-balance sheet arrangements as of June 30, 2021. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets.\nContractual obligations\nWe do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities, other than an agreement to pay Quantum Ventures a monthly fee of $10,000 for office space, utilities and secretarial support. We began incurring these fees on February 4, 2021 and will continue to incur these fees monthly until the earlier of the completion of the Business Combination and our liquidation.\nWe have engaged Chardan Capital Markets LLC, the representative of the underwriters in the Initial Public Offering (“Chardan”), as an advisor in connection with a Business Combination to assist the Company in holding meetings with its stockholders to discuss the potential Business Combination and the target business’s attributes, introduce the Company to potential investors that are interested in purchasing the Company’s securities in connection with the potential Business Combination, assist the Company in obtaining stockholder approval for the Business Combination and assist the Company with its press releases and public filings in connection with the Business Combination.\n17\nCritical Accounting Policies\nThe preparation of condensed financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have identified the following critical accounting policies:\nWarrant Liability\nWe account for warrants as either equity-classified or liability-classified instruments based on an assessment of the warrant’s specific terms and applicable authoritative guidance in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 480, Distinguishing Liabilities from Equity (“ASC 480”) and ASC 815, Derivatives and Hedging (“ASC 815”). The assessment considers whether the warrants are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and whether the warrants meet all of the requirements for equity classification under ASC 815, including whether the warrants are indexed to our own common stock, among other conditions for equity classification. This assessment, which requires the use of professional judgment, is conducted at the time of warrant issuance and as of each subsequent quarterly period end date while the warrants are outstanding. We have concluded that the Public Warrants should be classified as equity instruments, and the Private Warrants should be classified as liability instruments.\nFor issued or modified warrants that meet all of the criteria for equity classification, the warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all the criteria for equity classification, the warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of the warrants are recognized as a non-cash gain or loss on the statements of operations.\nCommon Stock Subject to Possible Redemption\nWe account for our common stock subject to possible conversion in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption is classified as a liability instrument and measured at fair value. Conditionally redeemable common stock (including common stock that features redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. Our common stock features certain redemption rights that are considered to be outside of our control and subject to occurrence of uncertain future events. Accordingly, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders’ equity section of our condensed balance sheets.\nNet Loss Per Common Share\nWe apply the two-class method in calculating earnings or loss per share, as applicable. Net loss per common share, basic and diluted for Common stock subject to possible redemption is calculated by dividing the interest income earned on the Trust Account, net of applicable taxes, if any, by the weighted average number of shares of Common stock subject to possible redemption outstanding for the period. Net loss or income per common share, basic and diluted for non-redeemable common stock is calculated by dividing total net loss less income attributable to Common stock subject to possible redemption, by the weighted average number of shares of non-redeemable common stock outstanding for the period presented.\nRecent Accounting Standards\nManagement does not believe that any recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on our condensed financial statements.\nIn August 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2020-06, Derivatives and Hedging — Contracts in Entity’s Own Equity (Subtopic 815-40) (“ASU 2020-06”) to simplify accounting for certain financial instruments. ASU 2020-06 eliminates the current models that require separation of beneficial conversion and cash conversion features from convertible instruments and simplifies the derivative scope exception guidance pertaining to equity classification of contracts in an entity’s own equity. The new standard also introduces additional disclosures for convertible debt and freestanding instruments that are indexed to and settled in an entity’s own equity. ASU 2020-06 amends the diluted earnings per share guidance, including the requirement to use the if-converted method for all convertible instruments. ASU 2020-06 is effective for the company on January 1, 2024, and should be applied on a full or modified retrospective basis, with early adoption permitted beginning on January 1, 2021. We are currently assessing the impact, if any, that ASU 2020-06 would have on its financial position, results of operations or cash flows.\n18\n\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\nNot required for smaller reporting companies.\n\nItem 4. Controls and Procedures\nEvaluation of Disclosure Controls and Procedures\nDisclosure controls and procedures are designed to ensure that information required to be disclosed by us in our Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.\nUnder the supervision and with the participation of our management, including our principal executive officer and principal financial and accounting officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures as of the end of the fiscal quarter ended June 30, 2021, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act. Based on this evaluation and in light of the material weakness in internal controls described below, our principal executive officer and principal financial and accounting officer have concluded that during the period covered by this report, our disclosure controls and procedures were not effective. In our quarterly report on Form 10-Q for the quarter ended March 31, 2021 (“Q1 Form 10-Q”), we disclosed that our internal control over financial reporting did not result in the proper accounting classification of the Private Warrants and public warrants we issued in February 2021 which, due to its impact on our financial statements, we determined to be a material weakness. This error in classification was brought to our attention only when the SEC issued a Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (“SPACs”) dated April 12, 2021 (the “SEC Statement”). The SEC Statement addressed certain accounting and reporting considerations related to warrants of a kind similar to those we issued at the time of our initial public offering in February 2021. Upon further evaluation, we concluded that our Public Warrants should be classified as equity instruments instead of derivative liabilities. As a result, on July 9, 2021, we filed an amendment to our Q-1 Form 10-Q to restate our financial statements as of and for the three months ended March 31, 2021 (the “Restatement”). Due to the events that led to the Restatement, a material weakness in our internal controls also exists as it related to the accounting for our Public Warrants which should have remained classified as equity instruments.\nChanges in Internal Control over Financial Reporting\nThere was no change in our internal control over financial reporting that occurred during the fiscal quarter ended June 30, 2021 covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting, other than as described herein. Management has implemented remediation steps to address the material weakness and to improve our internal control over financial reporting. Specifically, we enhanced the supervisory review of accounting procedures in this financial reporting area and expanded and improved our review process for complex securities and related accounting standards. As of June 30, 2021, this had not been fully remediated.\n19\nPART II - OTHER INFORMATION\n\nItem 1. Legal Proceedings\nNone\n\nItem 1A. Risk Factors\nFactors that could cause our actual results to differ materially from those in this report include the risk factors described in our Annual Report on Form 10-K filed with the SEC. As of the date of this Quarterly Report, there have been no material changes to the risk factors disclosed in our Annual Report on Form 10-K filed with the SEC, except for the below:\nOur Private Warrants are accounted for as liabilities and the changes in value of our Private Warrants could have a material effect on our financial results.\nOn April 12, 2021, the staff of the SEC (the “SEC Staff”) issued the SEC Statement, wherein the SEC Staff expressed its view that certain terms and conditions common to SPAC warrants may require the warrants to be classified as liabilities on the SPAC’s balance sheet as opposed to being treated as equity. Specifically, the SEC Statement focused on certain settlement terms and provisions related to certain tender offers following a business combination, which terms are similar to those contained in the warrant agreement governing our warrants. As a result of the SEC Statement, we reevaluated the accounting treatment of our warrants, and pursuant to the guidance in ASC 815, Derivatives and Hedging (“ASC 815”), determined the Private Warrants should be classified as derivative liabilities measured at fair value on our balance sheet, with any changes in fair value to be reported each period in earnings on our statement of operations.\nAs a result of the recurring fair value measurement, our financial statements may fluctuate quarterly, based on factors which are outside of our control. Due to the recurring fair value measurement, we expect that we will recognize non-cash gains or losses on our warrants each reporting period and that the amount of such gains or losses could be material.\nWe have identified a material weakness in our internal control over financial reporting as of June 30, 2021. If we are unable to develop and maintain an effective system of internal control over financial reporting, we may not be able to accurately report our financial results in a timely manner, which may adversely affect investor confidence in us and materially and adversely affect our business and operating results.\nFollowing this issuance of the SEC Statement, after consultation with our independent registered public accounting firm, our management and our audit committee concluded that, in light of the SEC Statement, we identified a material weakness in our internal control over financial reporting. In connection with the Restatement, management and our audit committee concluded that a material weakness also exists as it relates to the accounting for our public warrants presented in the Q1 Form 10-Q.\nA material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented, or detected and corrected on a timely basis.\nEffective internal controls are necessary for us to provide reliable financial reports and prevent fraud. We continue to evaluate steps to remediate the material weakness. These remediation measures may be time consuming and costly and there is no assurance that these initiatives will ultimately have the intended effects.\nIf we identify any new material weaknesses in the future, any such newly identified material weakness could limit our ability to prevent or detect a misstatement of our accounts or disclosures that could result in a material misstatement of our annual or interim financial statements. In such case, we may be unable to maintain compliance with securities law requirements regarding timely filing of periodic reports in addition to applicable stock exchange listing requirements, investors may lose confidence in our financial reporting and our stock price may decline as a result. We cannot assure you that the measures we have taken to date, or any measures we may take in the future, will be sufficient to avoid potential future material weaknesses.\nWe, and following our initial business combination, the post-business combination company, may face litigation and other risks as a result of the material weakness in our internal control over financial reporting.\nAs a result of the material weakness in our internal controls over financial reporting described above, the change in accounting for the Private Warrants, the Restatement and other matters raised or that may in the future be raised by the SEC, we face potential for litigation or other disputes which may include, among others, claims invoking the federal and state securities laws, contractual claims or other claims arising from the material weaknesses in our internal control over financial reporting and the preparation of our financial statements. As of the date of this Quarterly Report, we have no knowledge of any such litigation or dispute. However, we can provide no assurance that such litigation or dispute will not arise in the future. Any such litigation or dispute, whether successful or not, could have a material adverse effect on our business, results of operations and financial condition or our ability to complete a Business Combination.\n20\n\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\nFor a description of the use of the proceeds generated in our Initial Public Offering and private placement, see Part I, Item 2 of this Quarterly Report. There has been no material change in the planned use of the proceeds from the Initial Public Offering and private placement as is described in the Company’s final prospectus related to the Initial Public Offering.\n\nItem 3. Defaults Upon Senior Securities\nNone.\n\nItem 4. Mine Safety Disclosures\nNone.\n\nItem 5. Other Information\nNone.\n21\n\nItem 6. Exhibits\nThe following exhibits are filed as part of, or incorporated by reference into, this Quarterly Report.\n\n| No. | Description of Exhibit |\n| 31.1* | Certification of Chief Executive Officer (Principal Executive Officer) required by Rule 13a-14(a) or Rule 15d-14(a). |\n| 31.2* | Certification of Chief Financial Officer (Principal Financial and Accounting Officer) required by Rule 13a-14(a) or Rule 15d-14(a). |\n| 32.1** | Certification of Chief Executive Officer required by Rule 13a-14(b) or Rule 15d-14(b) and 18 U.S.C. 1350. |\n| 32.2** | Certification of Chief Executive Officer and Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(b) and 18 U.S.C. 1350. |\n| 101.INS | Inline XBRL Instance Document. |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document. |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document. |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document. |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document. |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document. |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101). |\n\n\n| * | Filed herewith. |\n| ** | Furnished herewith. |\n\n22\nSIGNATURES\nIn accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| QUANTUM FINTECH ACQUISITION CORPORATION |\n| Date: August 23, 2021 | By: | /s/ John Schaible |\n| Name: | John Schaible |\n| Title: | Chief Executive Officer |\n| (Principal Executive Officer) |\n| Date: August 23, 2021 | By: | /s/ Miguel Leon |\n| Name: | Miguel Leon |\n| Title: | Chief Financial Officer |\n| (Principal Financial and Accounting Officer) |\n\n23\n\n</text>\n\nWhat will be the total par value of preferred and common stock that holders of the common stock, subject to possible redemption, and public warrants receive, if all warrants are converted into common stock at a ratio of 1:1, in dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"ground_truth": "Therefore, the answer is 1768.53."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nGeneral\nThe following discussion and analysis should be read in conjunction with our financial statements and related footnotes for the year ended July 31, 2010 included in our Annual Report on Form 10-K. The discussion of results, causes and trends should not be construed to imply any conclusion that such results or trends will necessarily continue in the future.\nOverview\nOn July 8, 2005, pursuant to a Share Exchange Agreement with Worldwide Business Solutions Incorporated, a Colorado corporation (“WBSI”), we acquired all of the issued and outstanding capital stock of WBSI, in exchange for 2,573,335 shares of our common stock. As a result of this share exchange, shareholders of WBSI as a group owned approximately 76.8% of the shares then outstanding, and WBSI became our wholly-owned subsidiary.\nFor accounting purposes, the acquisition of WBSI has been accounted for as a recapitalization of WBSI. Since we had only minimal assets and no operations, the recapitalization has been accounted for as the sale of 778,539 shares of WBSI common stock for our net liabilities at the time of the transaction. Therefore, the historical financial information prior to the date of the recapitalization is the financial information of WBSI.\nEffective July 31, 2007, we filed a Certificate of Change Pursuant to NRS 78.209, which decreased the number of our authorized shares of common stock from 100,000,000 to 33,333,333 and reduced the number of common shares issued and outstanding from 17,768,607 to 5,923,106. All shares and per share amounts in our consolidated financial statements and related notes have been retroactively adjusted to reflect the one-for-three reverse stock split for all periods presented.\nOn July 31, 2007, we acquired 100% of the issued and outstanding shares of Centric in exchange for 2,250,000 shares of our common stock. As a result of the acquisition, Centric became our wholly-owned subsidiary and the results of its operations have been included in our consolidated financial statements since the date of acquisition.\nWe currently devote substantially all of our efforts to financial planning, raising capital and developing markets as we continue to be in the development stage.\nPlan of Operations\nWe previously announced our agreement to purchase the manufacturing equipment that had been used in the operations of Jasmim Glass Corporation of Marinha Grande, Portugal. We had expected the acquisition to be completed by February 2011. On March 16, 2011, Worldwide Strategies Incorporated ended discussions to proceed with the acquisition.\nOn April 28, 2011, we accepted a proposal from Euzkadi Corporation of America, S.A. (“Euzkadi”) to enter into a business combination transaction. It is proposed that Euzkadi would acquire 80% of the then issued and outstanding shares of Worldwide in exchange for all of the issued and outstanding shares of Euzkadi. Consummation of this proposed transaction will be contingent upon the satisfaction of several conditions, including the completion of a satisfactory due diligence investigation and the completion of an audit of Euzkadi’s financial statements that meet the requirements of the reporting rules and regulations of the Securities and Exchange Commission.\nOther than the possible acquisition transaction described above, we do not have any definitive proposals for business operations, merger or acquisition. We are in discussions with other firms but have nothing finalized at this time. We must raise additional capital to support our ongoing existence while we search for such opportunities. If we complete any acquisition or merger transactions, we will need to raise additional capital to support the new business. We cannot assure you that we will be able to complete additional financings successfully.\n11\nSignificant Accounting Policies and Estimates\nOur discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to the valuation of accounts receivable and inventories, the impairment of long-lived assets, any potential losses from pending litigation and deferred tax assets or liabilities. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions; however, we believe that our estimates, including those for the above-described items, are reasonable.\nDevelopment Stage. We are in the development stage in accordance with Statements of Financial Accounting Standards (SFAS) No. 7 “Accounting and Reporting by Development Stage Enterprises”. As of April 30, 2011, we had devoted substantially all of our efforts to financial planning, raising capital and developing markets.\nStock-based Compensation. We account for compensation expense for our stock-based compensation plans using the fair value method prescribed in FASB ASC 718, “Stock Compensation,” which requires us to recognize the cost of services received in exchange for awards of equity instruments based on the grant-date fair value of the awards. The fair value of each option grant is estimated on the date of grant using the Black-Scholes method.\nLoss per common share. We report net loss per share using a dual presentation of basic and diluted loss per share. Diluted net loss per share utilizes the average market price per share when applying the treasury stock method in determining common stock equivalents. As of April 30, 2011, after recognition of the one-for-three reverse stock split, there were 6,261,356 and 1,383,336 vested common stock options and warrants outstanding, respectively, which were excluded from the calculation of net loss per share-diluted because they were antidilutive.\nNew accounting pronouncements\nNote 1 to the consolidated financial statements includes a complete description of new accounting pronouncements applicable to our Company.\nResults of Operations\nThree Months Ended April 30, 2011 and 2010. Salaries, benefits and payroll taxes totaled $26,875 for each of the three-month periods ended April 30, 2011 and 2010.\nWe did not incur any stock-based compensation expense during the three-month periods ended April 30, 2011 and 2010.\nProfessional and consulting fees totaled $10,244 and $15,135 for the three-month periods ended April 30, 2011 and 2010.\nTravel expenses totaled $11,172 and $6,520 during the three-month periods ended April 30, 2011 and 2010.\nContract labor expenses totaled $18,750 for each of the three-month periods ended April 30, 2011 and 2010.\nInsurance expenses totaled $-0- and $8,472 during the three-month periods ended April 30, 2011 and 2010.\n12\nDepreciation of $-0- and $155 was recorded during the three-month periods ended April 30, 2011 and 2010. All of our equipment is now fully depreciated and, therefore, we did not incur any depreciation expense for the current period.\nOther general and administrative expenses totaled $1,991 and $511 during the three-month periods ended April 30, 2011 and 2010.\nWe recorded $65,974 and $1,726 in interest expense for the three-month periods ended April 30, 2011 and 2010. Effective April 30, 2009, we converted many of our outstanding debts into preferred stock. However, since November 2009, we have issued convertible promissory notes totaling $119,000 that accrue interest at rates ranging from 8% to 10%. In addition, we financed the purchase of insurance policies in the amount of $22,400 in February 2010 for an effective annual interest rate is 9.47%.\nOur net loss was $135,006 and $78,144 for three-month periods ended April 30, 2011 and 2010.\nNine Months Ended April 30, 2011 and 2010. Salaries, benefits and payroll taxes totaled $80,625 for each of the nine-month periods ended April 30, 2011 and 2010.\nWe did not incur any stock-based compensation expense during the nine-month periods ended April 30, 2011 and 2010.\nProfessional and consulting fees totaled $40,952 and $58,610 for the nine-month periods ended April 30, 2011 and 2010.\nTravel expenses totaled $29,606 and $12,446 during the nine-month periods ended April 30, 2011 and 2010.\nContract labor expenses totaled $56,250 for each of the nine-month periods ended April 30, 2011 and 2010.\nInsurance expenses totaled $11,200 and $16,545 during the nine-month periods ended April 30, 2011 and 2010.\nDepreciation of $51 and $464 was recorded during the nine-month periods ended April 30, 2011 and 2010. All of our equipment is now fully depreciated and, therefore, we did not incur any depreciation expense for the three-months ended April 30, 2011.\nOther general and administrative expenses totaled $4,269 and $7,086 during the nine-month periods ended April 30, 2011 and 2010.\nWe recorded $107,260 and $2,849 in interest expense for the nine-month periods ended April 30, 2011 and 2010. Effective April 30, 2009, we converted many of our outstanding debts into preferred stock. However, since November 2009, we have issued convertible promissory notes totaling $119,000 that accrue interest at rates ranging from 8% to 10%. In addition, we financed the purchase of insurance policies in the amount of $22,400 in February 2010 for an effective annual interest rate is 9.47%.\nOur net loss was $330,213 and $234,875 for nine-month periods ended April 30, 2011 and 2010.\nMarch 1, 2005 (inception) to April 30, 2011. For the period from March 1, 2005 (inception) to April 30, 2011, we were engaged primarily in raising capital to implement our business plan. Accordingly, we have earned revenue of only $34,518. We incurred expenses for professional and consulting fees, salaries and payroll taxes, stock-based compensation, travel, contract labor, insurance, interest and other expenses resulting in an accumulated loss of $7,189,157. Almost half of the cumulative net loss is due to the recognition of non-cash stock-based compensation expense for issuing shares, options, and warrants to employees and third parties in the amount of $3,401,203. As we develop our business plan, we expect that cash generated through operations will replace many of the non-cash transaction structures currently utilized to implement our business plan.\n13\nLiquidity and Capital Resources\nSince inception, we have relied on the sale of equity capital and debt instruments to fund working capital and the costs of developing our business plan. We used $18,228 of cash in operating activities with $4,000 being provided by financing activities. We have a working capital deficit of $458,430 at April 30, 2011, as compared to $584,136 at July 31, 2010.\nAs discussed above, we have had minimal revenues and have accumulated a deficit of $7,189,157 since inception. Furthermore, we have not commenced our planned principal operations. Our future is dependent upon our ability to obtain equity and/or debt financing and upon future profitable operations from the development of our business plan.\nGoing Concern\nOur significant operating losses raise substantial doubt about our ability to continue as a going concern. Historically, we have been able to raise additional capital sufficient to continue as a going concern. However, there can be no assurance that this additional capital will be sufficient for us to implement our business plan or achieve profitability in our operations. Additional equity or debt financing will be required to continue as a going concern. Without such additional capital, there is doubt as to whether we will continue as a going concern.\nOff Balance Sheet Arrangements\nWe do not have any material off balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.\n\nItem 3. Quantitative and Qualitative Disclosures about Market Risk\nNot required for smaller reporting companies.\n\nItem 4. Controls and Procedures\nAs required by SEC rules, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures at the end of the period covered by this report. This evaluation was carried out under the supervision and with the participation of our management, including our principal executive officer and principal financial officer. Based on this evaluation, these officers have concluded that the design and operation of our disclosure controls and procedures are effective to ensure that all required information is presented in our quarterly report.\nDisclosure controls and procedures are our controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file under the Exchange Act is accumulated and communicated to our management, including principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure.\nDuring our last fiscal quarter, there were no changes in our internal control over financial reporting or in other factors that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n14\nPart II. OTHER INFORMATION\n\nItem 1. Legal Proceedings\nNone.\n\nItem 1A. Risk Factors\nNot required of smaller reporting companies.\n\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nIn April 2011, the registrant issued 105,000 shares of its common stock to one accredited investor in exchange for a three-month extension of the maturity date of a promissory note in the principal amount of $50,000. The shares were issued at $0.04 pursuant to the terms of the note, but were valued at $8,400 ($0.08 per share) based on the fair value of the shares when they were issued.\nIn April 2011, the registrant issued 11,250 shares of its common stock to one accredited investor for interest expense. The shares were issued at $0.04 pursuant to the terms of the note, but were valued at $900 ($0.08 per share) based on the fair value of the shares when they were issued.\nNo underwriters were used in the above stock transactions. We relied upon the exemption from registration contained in Regulation S, Section 4(2) and/or Rule 506 of the Securities Act of 1933, as the investors were deemed to be sophisticated with respect to the investment in the securities due to their financial condition and involvement in our business. A restrictive legend was placed on the certificates evidencing the securities issued.\n\nItem 3. Defaults Upon Senior Securities\nNone.\nItem 4. (Removed and Reserved)\nNone.\n\nItem 5. Other Information\nNone.\n\nItem 6. Exhibits\n\n| Regulation S-K Number | Exhibit |\n| 2.1 | Share Exchange Agreement by and between Worldwide Strategies Incorporated, Centric Rx, Inc., Jim Crelia, Jeff Crelia, J. Jireh, Inc. and Canada Pharmacy Express, Ltd. dated as of June 28, 2007 (1) |\n| 3.1 | Amended and Restated Articles of Incorporation (2) |\n| 3.2 | Amended Bylaws (2) |\n| 3.3 | Articles of Exchange Pursuant to NRS 92A.200 effective July 31, 2007 (3) |\n| 3.4 | Certificate of Change Pursuant to NRS 78.209 effective July 31, 2007 (3) |\n| 3.5 | Certificate of Designation Pursuant to NRS 78.1955 effective December 8, 2008 (4) |\n| 3.6 | Amendment to Certificate of Designation Pursuant to NRS 78.1955 effective December 15, 2008 (5) |\n| 10.1 | 2005 Stock Plan (2) |\n| 10.2 | Employment Agreement with James P.R. Samuels dated October 12, 2007 (6) |\n| 10.3 | Employment Agreement with W. Earl Somerville dated October 12, 2007 (6) |\n| 31.1 | Rule 13a-14(a) Certification of James P.R. Samuels |\n| 31.2 | Rule 13a-14(a) Certification of W. Earl Somerville |\n| Regulation S-K Number | Exhibit |\n| 32.1 | Certification of James P.R. Samuels Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act Of 2002 |\n| 32.2 | Certification of W. Earl Somerville Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act Of 2002 |\n\n_______________________\n\n| (1) | Filed as an exhibit to the Current Report on Form 8-K dated June 28, 2007, filed July 2, 2007. |\n\n| (2) | Filed as an exhibit to the initial filing of the registration statement on Form SB-2, File No. 333-129398, on November 2, 2005. |\n\n| (3) | Filed as an exhibit to the Current Report on Form 8-K dated July 31, 2007, filed August 6, 2007. |\n\n| (4) | Filed as an exhibit to the Current Report on Form 8-K dated December 8, 2008, filed December 10, 2008. |\n\n| (5) | Filed as an exhibit to the Current Report on Form 8-K dated December 15, 2008, filed December 17, 2008. |\n\n| (6) | Filed as an exhibit to the Annual Report on Form 10-KSB, File No. 000-52362, on November 2, 2007. |\n\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| WORLDWIDE STRATEGIES INCORPORATED |\n| Date: June 14, 2011 | By: | /s/ James P.R. Samuels |\n| James P.R. Samuels |\n| Chief Executive Officer |\n| (Principal Executive Officer) |\n| Date: June 14, 2011 | By: | /s/ W. Earl Somerville |\n| W. Earl Somerville |\n| Chief Financial Officer, Secretary and Treasurer |\n| (Principal Financial Officer and Principal Accounting Officer) |\n\n16\n\n</text>\n\nWhat is the ratio of the total net loss for the three-month periods ended April 30, 2011 and 2010 to the net loss for nine-month periods ended April 30, 2011 and 2010 in ratio form 1:1?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"ground_truth": "Therefore, the answer is 0.377197887762614."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nITEM 1. CONDENSED FINANCIAL STATEMENTS\nIGNYTE ACQUISITION CORP.\nCONDENSED BALANCE SHEETS\n| June 30, 2021 | December 31, 2020 |\n| (unaudited) |\n| Assets |\n| Cash | $ | 550,470 | $ | 25,425 |\n| Prepaid expense and other current assets | 181,923 | - |\n| Total current assets | 732,393 | 25,425 |\n| Deferred offering costs | - | 81,575 |\n| Cash and securities held in Trust Account | 57,504,345 | - |\n| Total Assets | $ | 58,236,738 | $ | 107,000 |\n| Liabilities and Stockholders' Equity |\n| Current liabilities: |\n| Accrued expenses | $ | 12,656 | $ | - |\n| Due to related party | 51,953 | 310 |\n| Promissory note - related party | - | 80,000 |\n| Total current liabilities | 64,609 | 80,310 |\n| Warrant liabilities | 1,875,000 | - |\n| Total liabilities | 1,939,609 | 80,310 |\n| Commitments and Contingencies(8) |\n| Common stock subject to possible redemption, 5,129,712 shares at redemption value | 51,297,120 | - |\n| Stockholders' Equity: |\n| Preferred stock, $ 0.0001 par value; 1,000,000 shares authorized; none issued and outstanding | - | - |\n| Common stock, $ 0.0001 par value; 50,000,000 shares authorized; 2,157,788 shares and 0 shares issued and outstanding (excluding 5,129,712 shares and 0 shares subject to possible redemption) at June 30, 2021 and December 31, 2020, respectively | 216 | 154 |\n| Additional paid-in capital | 4,730,179 | 26,846 |\n| Retained earnings (Accumulated deficit) | 269,614 | ( 310 | ) |\n| Total stockholders' equity | 5,000,009 | 26,690 |\n| Total Liabilities and Stockholders' Equity | $ | 58,236,738 | $ | 107,000 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n1\nIGNYTE ACQUISITION CORP.\nUNAUDITED CONDENSED STATEMENTS OF OPERATIONS\n| For the Three Months Ended | For the Six Months Ended |\n| June 30, 2021 | June 30, 2021 |\n| Formation and operating costs | $ | 110,980 | $ | 309,421 |\n| Loss from operations | ( 110,980 | ) | ( 309,421 | ) |\n| Other income |\n| Change in fair value of warrants | 725,000 | 575,000 |\n| Trust interest income | 2,087 | 4,345 |\n| Total other income | 727,087 | 579,345 |\n| Net income | $ | 616,107 | $ | 269,924 |\n| Basic and diluted weighted average shares outstanding, common stock subject to redemption | 5,068,102 | 4,183,046 |\n| Basic and diluted net loss per share | $ | 0.00 | $ | 0.00 |\n| Basic and diluted weighted average shares outstanding, common stock | 2,219,398 | 2,053,694 |\n| Basic and diluted net loss per share | $ | 0.28 | $ | 0.13 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n2\nIGNYTE ACQUISITION CORP.\nUNAUDITED CONDENSED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY\n| Common Stock | Additional Paid-in Capital | Retained Earnings(Accumulated Deficit) | Total Stockholders' Equity |\n| Shares | Amount |\n| Balance as of December 31, 2020 | 1,537,500 | $ | 154 | $ | 26,846 | $ | ( 310 | ) | $ | 26,690 |\n| Sale of 5,000,000 and 750,000 Units on February 1, 2021 and February 2, 2021 through IPO and over-allotment, respectively | 5,750,000 | 575 | 57,499,425 | - | 57,500,000 |\n| Sale of 2,350,000 and 150,000 Placement Warrants on February 1, 2021 and February 2, 2021, respectively, net of fair value of warrant liabilities | - | - | 50,000 | - | 50,000 |\n| Underwriting fee | - | - | ( 1,150,000 | ) | - | ( 1,150,000 | ) |\n| Other offering expenses | - | - | ( 399,485 | ) | - | ( 399,485 | ) |\n| Net loss | - | - | - | ( 346,183 | ) | ( 346,183 | ) |\n| Common stock subject to possible redemption | ( 5,068,201 | ) | ( 507 | ) | ( 50,680,513 | ) | - | ( 50,681,020 | ) |\n| Balance as of March 31, 2021 | 2,219,398 | 222 | 5,346,273 | ( 346,493 | ) | 5,000,002 |\n| Change in value of common stock subject to possible redemption | ( 61,610 | ) | ( 6 | ) | ( 616,094 | ) | ( 616,100 | ) |\n| Net income | 616,107 | 616,107 |\n| Balance as of June 30, 2021 (unaudited) | 2,157,788 | $ | 216 | $ | 4,730,179 | $ | 269,614 | $ | 5,000,009 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n3\nIGNYTE ACQUISITION CORP.\nUNAUDITED CONDENSED STATEMENT OF CASH FLOWS\n| For the Six Months Ended |\n| June 30, 2021 |\n| Cash flows from Operating Activities: |\n| Net income | $ | 269,924 |\n| Adjustments to reconcile net income to net cash used in operating activities: |\n| Increase in fair value of warrants | ( 575,000 | ) |\n| Interest earned on marketable securities held in Trust Account | ( 4,345 | ) |\n| Changes in current assets and current liabilities: |\n| Prepaid expenses | ( 181,923 | ) |\n| Accrued offering costs and expenses | 12,656 |\n| Due to related party | 51,643 |\n| Net cash used in operating activities | ( 427,045 | ) |\n| Cash Flows from Investing Activities: |\n| Purchase of investment held in Trust Account | ( 57,500,000 | ) |\n| Net cash used in investing activities | ( 57,500,000 | ) |\n| Cash flows from Financing Activities: |\n| Proceeds from Initial Public Offering, net of underwriters' fees | 56,350,000 |\n| Proceeds from private placement | 2,500,000 |\n| Repayment of promissory note to related party | ( 80,000 | ) |\n| Payments of offering costs | ( 317,910 | ) |\n| Net cash provided by financing activities | 58,452,090 |\n| Net change in cash | 525,045 |\n| Cash, beginning of the period | 25,425 |\n| Cash, end of the period | $ | 550,470 |\n| Supplemental disclosure of noncash investing and financing activities: |\n| Initial value of Common stock subject to possible redemption, as revised | $ | 51,023,118 |\n| Change in value of Common stock subject to possible redemption | $ | 274,002 |\n| Initial fair value of warrant liabilities | $ | 2,450,000 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n4\nIGNYTE ACQUISITION CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nNote 1 — Organization and Business Operations\nOrganization and General\nIgnyte Acquisition Corp. (the “Company”) is a newly organized blank check company incorporated as a Delaware corporation on August 6, 2020. The Company was incorporated for the purpose of effecting a merger, stock exchange, asset acquisition, stock purchase, reorganization or other similar business combination with one or more businesses (the “Business Combination”).\nThe Company has selected December 31 as its fiscal year end.\nThe Company is an early stage and emerging growth company and, as such, the Company is subject to all of the risks associated with early stage and emerging growth companies.\nAs of June 30, 2021, the Company had not commenced any operations. All activity for the period from August 6, 2020 (inception) through June 30, 2021 relates to the Company's formation and the initial public offering (“IPO”), which is described below. The Company will not generate any operating revenues until after the completion of its initial Business Combination, at the earliest. The Company will generate non-operating income in the form of interest income on cash and cash equivalents from the proceeds derived from the IPO.\nThe Company's sponsor is Ignyte Sponsor LLC (the “Sponsor”), a Delaware limited liability company (the “Sponsor”).\nFinancing\nThe registration statement for the Company's IPO was declared effective on January 27, 2021 (the “Effective Date”). On February 1, 2021, the Company consummated the IPO of 5,000,000 units (the “Units” and, with respect to the shares of common stock included in the Units being offered, the “Public Shares”), at $ 10.00 per Unit, generating gross proceeds of $ 50,000,000 , which is discussed in Note 4.\nSimultaneously with the closing of the IPO, the Company consummated the sale of 2,350,000 Private Placement Warrants (the “Private Placement Warrants”) at a price of $ 1.00 per Private Placement Warrant in a private placement to the Sponsor, generating total gross proceeds of $ 2,350,000 .\nOn February 2, 2021, the underwriters purchased an additional 750,000 Units to exercise its over-allotment option in full at a purchase price of $ 10.00 per Unit, generating gross proceeds of $ 7,500,000 . Simultaneously with the closing of the full exercise of the over-allotment option, the Company completed the private sale of an aggregate of 150,000 Private Placement Warrants to the Sponsor, at a purchase price of $ 1.00 per Private Placement Warrant, generating gross proceeds of $ 150,000 . A total of $ 7,500,000 was placed in the Trust Account after the payment of $ 150,000 underwriting discount.\nTransaction costs amounted to $ 1,549,485 consisting of $1,150,000 of underwriting discount and $ 399,485 of other offering costs. In addition, $ 975,465 of cash was held outside of the Trust Account (as defined below) and is available for working capital purposes.\nTrust Account\nFollowing the closing of the IPO, on February 1, 2021, $50,000,000 ($10.00 per Unit) from the net proceeds of the sale of the Units in the IPO and the sale of the Private Placement Warrants was held in a Trust Account (“Trust Account”), and will invest only in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, having a maturity of 185 days or less or in money market funds meeting certain conditions under Rule 2a-7 promulgated under the Investment Company Act which invest only in direct U.S. government treasury obligations. Except with respect to interest earned on the funds held in the Trust Account that may be released to the Company to pay income tax obligations, the proceeds from the IPO will not be released from the Trust Account until the earlier of the completion of a Business Combination or the Company's redemption of 100 % of the outstanding Public Shares if it has not completed a Business Combination in the required time period. The proceeds held in the Trust Account may be used as consideration to pay the sellers of a target business with which the Company completes a Business Combination. Any amounts not paid as consideration to the sellers of the target business may be used to finance operations of the target business.\n5\nInitial Business Combination\nIn connection with any proposed Business Combination, the Company will either (1) seek stockholders approval of the initial Business Combination at a meeting called for such purpose at which stockholders may seek to convert their shares, regardless of whether they vote for or against the proposed Business Combination or don't vote at all, into their pro rata share of the aggregate amount then on deposit in the Trust Account (net of taxes payable), or (2) provide its stockholders with the opportunity to sell their shares to the Company by means of a tender offer (and thereby avoid the need for a stockholder vote) for an amount equal to their pro rata share of the aggregate amount then on deposit in the Trust Account (net of taxes payable), in each case subject to the limitations described herein. The decision as to whether the Company will seek stockholders approval of a proposed Business Combination or will allow stockholders to sell their shares to the Company in a tender offer will be made by the Company, solely in its discretion,\nThe shares of Common Stock subject to redemption will be recorded at a redemption value and classified as temporary equity upon the completion of the IPO, in accordance with Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” In such case, the Company will proceed with a Business Combination if the Company has net tangible assets of at least $ 5,000,001 upon such consummation of a Business Combination and, if the Company seeks stockholder approval, a majority of the issued and outstanding shares voted are voted in favor of the Business Combination.\nThe Company will have 21 months from the closing of the IPO to complete the initial Business Combination (the “Combination Period”). However, if the Company is unable to complete the initial Business Combination within the Combination Period, the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem 100% of the outstanding public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including interest earned on the funds held in the Trust Account and not previously released to the Company but net of taxes payable ( and less up to $ 50,000 of interest to pay dissolution expenses), divided by the number of then outstanding public shares, which redemption will completely extinguish public stockholders' rights as stockholders (including the right to receive further liquidation distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the Company's remaining stockholders and the Company's board of directors, liquidate and dissolve, subject (in the case of (ii) and (iii) above) to the Company's obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law.\nThe Sponsor, officers and directors have agreed (i) to vote any shares owned by them in favor of any proposed Business Combination, (ii) not to convert any shares in connection with a stockholder vote to approve a proposed initial Business Combination or sell any shares to the Company in a tender offer in connection with a proposed initial Business Combination, (iii) that the founders' shares will not participate in any liquidating distributions from the Company's Trust Account upon winding up if a Business Combination is not consummated.\nThe Sponsor has agreed that it will be liable to ensure that the proceeds in the Trust Account are not reduced below $10.00 per share by the claims of target businesses or claims of vendors or other entities that are owed money by the Company for services rendered or contracted for or products sold to the Company. The agreement entered into by the Sponsor specifically provides for two exceptions to the indemnity it has given: it will have no liability (1) as to any claimed amounts owed to a target business or vendor or other entity who has executed an agreement with the Company waiving any right, title, interest or claim of any kind they may have in or to any monies held in the Trust Account, or (2) as to any claims for indemnification by the underwriters of the Proposed Public Offering against certain liabilities, including liabilities under the Securities Act. However, the Company has not asked its Sponsor to reserve for such indemnification obligations, nor has it independently verified whether the Sponsor has sufficient funds to satisfy its indemnity obligations and believe that the Sponsor's only assets are securities of the Company. Therefore, the Company believes it is unlikely that the Sponsor will be able to satisfy its indemnification obligations if it is required to do so.\nLiquidity and Capital Resources\nAs of June 30, 2021, the Company had $ 550,470 in its operating bank account, and working capital of $ 667,784 .\nPrior to the completion of the Initial Public Offering, the Company's liquidity needs had been satisfied through a payment from the Sponsor of $ 25,000 (see Note 6) for the Founder Shares to cover certain offering costs, the loan under an unsecured promissory note from the Sponsor of $ 80,000 (see Note 6), and the net proceeds from the consummation of the Private Placement not held in the Trust Account. In addition, in order to finance transaction costs in connection with a Business Combination, the Company's Sponsor or an affiliate of the Sponsor or the Company's officers and directors or their affiliates may, but are not obligated to, provide the Company Working Capital Loans (see Note 6). To date, there were no amounts outstanding under any Working Capital Loans.\nBased on the foregoing, management believes that the Company will have sufficient working capital and borrowing capacity to meet its needs through the earlier of the consummation of a Business Combination or one year from this filing. Over this time period, the Company will be using these funds for paying existing accounts payable, identifying and evaluating prospective initial Business Combination candidates, performing due diligence on prospective target businesses, paying for travel expenditures, selecting the target business to merge with or acquire, and structuring, negotiating and consummating the Business Combination.\n6\nNote 2 — Revision of Previously Issued Financial Statements\nOn April 12, 2021, the Staff of the Securities and Exchange Commission together issued a statement regarding the accounting and reporting considerations for warrants issued by special purpose acquisition companies entitled \"Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (\"SPACs\")\" (the \"SEC Statement\"). Specifically, the SEC Statement focused on certain settlement terms and provisions related to certain tender offers following a Business Combination, which terms are similar to those contained in the warrant agreement, dated as of January 27, 2021, between the Company and Continental Stock Transfer & Trust Company, a New York corporation, as warrant agent (the \"Warrant Agreement\").\nHistorically, the warrants were reflected as a component of equity as opposed to liabilities on the balance sheets and the statements of operations did not include the subsequent non-cash changes in estimated fair value of the Warrants, based on the application of FASB ASC Topic 815-40, Derivatives and Hedging, Contracts in Entity's Own Equity (“ASC 815-40). The views expressed in the SEC Staff Statement were not consistent with the Company's historical interpretation of the specific provisions within its warrant agreement and the Company's application of ASC 815-40 to the warrant agreement. the Company reevaluated the accounting treatment of (i) the 2,875,000 Public Warrants and (ii) the 2,500,000 Private Placement Warrants (See Note 4 and Note 5). Based on this reassessment, management determined that the private warrants should be classified as liabilities measured at fair value upon issuance, with subsequent changes in fair value reported in the Company Statement of Operations each reporting period.\nThe Company's management and the audit committee of the Company's Board of Directors concluded that it is appropriate to revise the Company's previously issued audited balance sheet as of February 1, 2021 as previously reported in its Form 8-K.\nThe following tables summarize the effect of the restatement on each balance sheet line item as of the date:\n| As Previously Reported | Adjustment | As Revised |\n| Balance Sheet at February 1, 2021 |\n| Warrant Liabilities | $ | - | $ | 2,303,000 | $ | 2,303,000 |\n| Total Liabilities | 426,200 | 2,303,000 | 2,729,200 |\n| Common stock subject to possible redemption | 45,973,118 | ( 2,303,000 ) | 43,670,118 |\n| Common stock | 194 | 23 | 217 |\n| Additional paid-in capital | 5,004,203 | ( 23 ) | 5,004,180 |\n| Accumulated deficit | $ | ( 4,396 ) | $ | - | $ | ( 4,396 ) |\n| Total Stockholders' Equity | 5,000,001 | - | 5,000,001 |\n| Number of shares subject to redemption | 4,597,312 | ( 230,300 ) | 4,367,012 |\n\nNote 3 — Summary of Significant Accounting Policies\nBasis of Presentation\nThe accompanying unaudited condensed financial statements are presented in U.S. dollars in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for financial information and pursuant to the rules and regulations of the SEC. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP. In the opinion of management, the unaudited condensed financial statements reflect all adjustments, which include only normal recurring adjustments necessary for the fair statement of the balances and results for the periods presented. Operating results for the period for the six months ended June 30, 2021 are not necessarily indicative of the results that may be expected through December 31, 2021.\nThe accompanying unaudited condensed financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Form 10-K filed by the Company with the SEC.\n7\nEmerging Growth Company\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act of 1933, as amended, (the “Securities Act”), as modified by the Jumpstart our Business Startups Act of 2012, (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statement with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\nUse of Estimates\nThe preparation of unaudited condensed financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited condensed financial statements and the reported amounts of expenses during the reporting period. Making estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the unaudited condensed financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. Actual results could differ from those estimates.\nCash and Cash Equivalents\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did not have any cash equivalents as of June 30, 2021 and December 31, 2020.\nMarketable Securities Held in Trust Account\nAt June 30, 2021, the assets held in the Trust Account were invested in money market funds.\nFair Value Measurements\nFASB ASC Topic 820 “Fair Value Measurements and Disclosures” (“ASC 820”) defines fair value, the methods used to measure fair value and the expanded disclosures about fair value measurements. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between the buyer and the seller at the measurement date. In determining fair value, the valuation techniques consistent with the market approach, income approach and cost approach shall be used to measure fair value. ASC 820 establishes a fair value hierarchy for inputs, which represent the assumptions used by the buyer and seller in pricing the asset or liability. These inputs are further defined as observable and unobservable inputs. Observable inputs are those that buyer and seller would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs reflect the Company’s assumptions about the inputs that the buyer and seller would use in pricing the asset or liability developed based on the best information available in the circumstances.\nThe fair value hierarchy is categorized into three levels based on the inputs as follows:\nLevel 1 — Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access. Valuation adjustments and block discounts are not being applied. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these securities does not entail a significant degree of judgment.\nLevel 2 — Valuations based on (i) quoted prices in active markets for similar assets and liabilities, (ii) quoted prices in markets that are not active for identical or similar assets, (iii) inputs other than quoted prices for the assets or liabilities, or (iv) inputs that are derived principally from or corroborated by market through correlation or other means.\nLevel 3 — Valuations based on inputs that are unobservable and significant to the overall fair value measurement.\nThe fair value of the Company’s certain assets and liabilities, which qualify as financial instruments under ASC 820, “Fair Value Measurements and Disclosures,” approximates the carrying amounts represented in the balance sheet. The fair values of cash, prepaid assets, and accounts payable are estimated to approximate the carrying values as of December 31, 2020 due to the short maturities of such instruments.\n8\nThe Company’s warrant liabilities are based on a valuation model utilizing management judgment and pricing inputs from observable and unobservable markets with less volume and transaction frequency than active markets. Significant deviations from these estimates and inputs could result in a material change in fair value. In some circumstances, the inputs used to measure fair value might be categorized within different levels of the fair value hierarchy. In those instances, the fair value measurement is categorized in its entirety in the fair value hierarchy based on the lowest level input that is significant to the fair value measurement. See Note 7 for additional information on assets and liabilities measured at fair value.\nConcentration of Credit Risk\nFinancial instruments that potentially subject the Company to concentrations of credit risk consist of a cash account in a financial institution, which, at times, may exceed the Federal Depository Insurance Coverage of $ 250,000 . At June 30, 2021 and December 31, 2020, the Company has not experienced losses on this account and management believes the Company is not exposed to significant risks on such account.\nCommon Stock Subject to Possible Redemption\nThe Company accounts for its common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption (if any) is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. The Company’s common stock feature certain redemption rights that is considered to be outside of the Company’s control and subject to the occurrence of uncertain future events. Accordingly, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders’ equity section of the Company’s balance sheet.\nNet Income Per Common Share\nNet income per common share is computed by dividing net income by the weighted average number of common stock outstanding for each of the periods. The calculation of diluted net income per common share does not include warrants since the inclusion of such warrants would be anti-dilutive.\nThe Company's statement of operations includes a presentation of income per share for common stock subject to possible redemption in a manner similar to the two-class method of income per common share. Net income per common share, basic and diluted, for redeemable common stock is calculated by dividing the interest income earned on the Trust Account, by the weighted average number of redeemable common stock outstanding since original issuance. Net income per common share, basic and diluted, for non-redeemable common stock is calculated by dividing the net income, adjusted for income attributable to redeemable common stock, by the weighted average number of non-redeemable common stock outstanding for the periods. Non-redeemable common stock includes the founder shares as these shares do not have any redemption features and do not participate in the income earned on the Trust Account.\n| For the Three Months Ended | For the Six Months Ended |\n| June 30, 2021 | June 30, 2021 |\n| Common stock subject to possible redemption |\n| Numerator: net income allocable to common stock subject to possible redemption |\n| Interest income on marketable securities held in trust | $ | 1,862 | $ | 3,876 |\n| Less: interest available to be withdrawn for payment of taxes | - | - |\n| Net income allocable to common stock subject to possible redemption | 1,862 | 3,876 |\n| Denominator: Weighted average redeemable common stock |\n| Redeemable common stock, basic and diluted | 5,068,102 | 4,183,046 |\n| Basic and diluted net income per share, redeemable common stock | $ | - | $ | - |\n| Non-redeemable common stock |\n| Numerator: net income minus redeemable net earnings |\n| Net income | $ | 616,107 | $ | 269,924 |\n| Redeemable net earnings | ( 1,862 ) | ( 3,876 ) |\n| Non-redeemable net income | 614,245 | 266,048 |\n| Denominator: Weighted average non-redeemable basic and diluted weighted average shares outstanding, common stock | 2,219,398 | 2,053,694 |\n| Basic and diluted net income per share, common stock | $ | 0.28 | $ | 0.13 |\n\n9\nOffering Costs associated with the Initial Public Offering\nThe Company complies with the requirements of the ASC 340-10-S99-1 and SEC Staff Accounting Bulletin (“SAB”) Topic 5A - “Expenses of Offering”. Offering costs consist principally of professional and registration fees incurred through the balance sheet date that are related to the IPO and were charged to stockholders' equity upon the completion of the IPO. Accordingly, as of February 1, 2021, offering costs in the aggregate of $ 1,549,485 have been charged to stockholders' equity (consisting of $1,150,000 of underwriting discount and $ 399,485 of other offering costs).\nWarrant Liabilities\nThe Company accounts for the Public Warrants and Private Warrants (as defined in Note 4 and 5) collectively (“Warrants”), as either equity or liability-classified instruments based on an assessment of the specific terms of the Warrants and the applicable authoritative guidance in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 815, Derivatives and Hedging (“ASC 815”). The assessment considers whether the Warrants meet all of the requirements for equity classification under ASC 815, including whether the Warrants are indexed to the Company’s own ordinary shares and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of the Company’s control, among other conditions for equity classification. This assessment, which requires the use of professional judgment, is conducted at the time of issuance of the Warrants and as of each subsequent quarterly period end date while the Warrants are outstanding.\nFor issued or modified warrants that meet all of the criteria for equity classification, such warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all the criteria for equity classification, such warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of liability-classified warrants are recognized as a non-cash gain or loss on the statements of operations.\nThe Company accounts for the Private Warrants in accordance with ASC 815-40 under which the Private Warrants do not meet the criteria for equity classification and must be recorded as liabilities. The fair value of the Private Warrants has been estimated using the Monte Carlo simulation model. See Note 7 for further discussion of the pertinent terms of the Warrants used to determine the value of the Private Warrants and Representative’s Warrants.\nThe Company evaluated the Public Warrants in accordance with ASC 815-40, “Derivatives and Hedging — Contracts in Entity’s Own Equity” and concluded that they met the criteria for equity classification and are required to be recorded as part a component of additional paid-in capital at the time of issuance.\nIncome Taxes\nThe Company follows the asset and liability method of accounting for income taxes under ASC 740, “Income Taxes.” Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statements carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that included the enactment date. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.\n10\nASC 740 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more likely than not to be sustained upon examination by taxing authorities. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of June 30, 2021. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position. The Company is subject to income tax examinations by major taxing authorities since inception.\nRisks and Uncertainties\nOn January 30, 2020, the World Health Organization (“WHO”) announced a global health emergency because of a new strain of coronavirus (the ”COVID-19 outbreak”). In March 2020, the WHO classified the COVID-19 outbreak as a pandemic, based on the rapid increase in exposure globally. The full impact of the COVID-19 outbreak continues to evolve. The impact of the COVID-19 outbreak on the Company’s financial position will depend on future developments, including the duration and spread of the outbreak and related advisories and restrictions. These developments and the impact of the COVID-19 outbreak on the financial markets and the overall economy are highly uncertain and cannot be predicted. If the financial markets and/or the overall economy are impacted for an extended period, the Company’s financial position may be materially adversely affected. Additionally, the Company’s ability to complete an initial Business Combination may be materially adversely affected due to significant governmental measures being implemented to contain the COVID-19 outbreak or treat its impact, including travel restrictions, the shutdown of businesses and quarantines, among others, which may limit the Company’s ability to have meetings with potential investors or affect the ability of a potential target company’s personnel, vendors and service providers to negotiate and consummate an initial Business Combination in a timely manner. The Company’s ability to consummate an initial Business Combination may also be dependent on the ability to raise additional equity and debt financing, which may be impacted by the COVID-19 outbreak and the resulting market downturn. The financial statement does not include any adjustments that might result from the outcome of this uncertainty.\nRecent Accounting Standards\nManagement does not believe that any recently issued, but not effective, accounting standards, if currently adopted, would have a material effect on the Company’s financial statement.\nNote 4 — Initial Public Offering\nOn February 1, 2021, the Company sold 5,000,000 Units, at a purchase price of $ 10.00 per Unit. Each Unit consists of one share of common stock and one-half of one warrant to purchase one share of common stock (“Public Warrant”). Each whole Public Warrant entitles the holder to purchase one share of common stock at a price of $ 11.50 per share, subject to adjustment.\nOn February 2, 2021, the Underwriters exercised the over-allotment option in full to purchase 750,000 Units (the “Over-Allotment Units”), generating an aggregate of gross proceeds of $ 7,500,000 , and incurred $ 150,000 in underwriting fees.\nPublic Warrants\nEach whole warrant entitles the holder to purchase one share of Common Stock at a price of $11.50 per share, subject to adjustment as discussed herein. The warrants will become exercisable 30 days after the completion of the Company's initial Business Combination. However, no warrants will be exercisable for cash unless the Company has an effective and current registration statement covering the shares of common stock issuable upon exercise of the warrants and a current prospectus relating to such shares of common stock. Notwithstanding the foregoing, if a registration statement covering the shares of common stock issuable upon exercise of the public warrants is not effective within a specified period following the consummation of the initial Business Combination, warrant holders may, until such time as there is an effective registration statement and during any period when the Company shall have failed to maintain an effective registration statement, exercise warrants on a cashless basis pursuant to the exemption provided by Section 3(a)(9) of the Securities Act, provided that such exemption is available. If that exemption, or another exemption, is not available, holders will not be able to exercise their warrants on a cashless basis. In the event of such cashless exercise, each holder would pay the exercise price by surrendering the warrants for that number of shares of common stock equal to the quotient obtained by dividing (x) the product of the number of shares of common stock underlying the warrants, multiplied by the difference between the exercise price of the warrants and the “fair market value” (defined below) by (y) the fair market value. The “fair market value” for this purpose will mean the average reported last sale price of the shares of common stock for the 5 trading days ending on the trading day prior to the date of exercise. The warrants will expire on the fifth anniversary of the completion of an initial Business Combination, at 5:00 p.m., New York City time, or earlier upon redemption or liquidation.\n11\nThe Company may call the warrants for redemption (excluding the Private Placement Warrants and any warrants underlying additional units issued to the Sponsor, initial stockholders, officers, directors or their affiliates in payment of Working Capital Loans made to the Company)\n•\nin whole and not in part;\n•\nat a price of $ 0.01 per warrant;\n•\nat any time after the warrants become exercisable,\n•\nupon not less than 30 days’ prior written notice of redemption to each warrant holder; and\n•\nif, and only if, the reported last sale price of the Common Stock equals or exceeds $ 18.00 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations) for any 20 trading days within a 30-trading day period commencing at any time after the warrants become exercisable and ending on the third business day prior to the notice of redemption to warrant holders; and\n•\nif, and only if, there is a current registration statement in effect with respect to the shares of common stock underlying such warrants.\nIf the Company calls the warrants for redemption as described above, the Company's management will have the option to require all holders that wish to exercise warrants to do so on a “cashless basis.” In such event, each holder would pay the exercise price by surrendering the warrants for that number of shares of common stock equal to the quotient obtained by dividing (x) the product of the number of shares of common stock underlying the warrants, multiplied by the difference between the exercise price of the warrants and the “fair market value” (defined below) by (y) the fair market value. The “fair market value” for this purpose shall mean the average reported last sale price of the shares of common stock for the 5 trading days ending on the third trading day prior to the date on which the notice of redemption is sent to the holders of warrants.\nIn addition, if (x) the Company issue additional shares of Common Stock or equity-linked securities for capital raising purposes in connection with the closing of the initial Business Combination at an issue price or effective issue price of less than $ 9.20 per share of common stock (with such issue price or effective issue price to be determined in good faith by the Company's board of directors, and in the case of any such issuance to the Sponsor, initial stockholders or their affiliates, without taking into account any founders' shares held by them prior to such issuance), (y) the aggregate gross proceeds from such issuances represent more than 60% of the total equity proceeds, and interest thereon, available for the funding of the initial Business Combination on the date of the consummation of the initial Business Combination (net of redemptions), and (z) the Market Value is below $9.20 per share, the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115% of the greater of (i) the Market Value or (ii) the price at which the Company issues the additional shares of common stock or equity-linked securities.\nNote 5 — Private Placement\nSimultaneously with the closing of the IPO, the Sponsor purchased an aggregate of 2,350,000 Private Placement Warrants at a price of $ 1.00 per Private Placement Warrant, for an aggregate purchase price of $ 2,350,000 , in a private placement (the “Private Placement”). Each Private Placement Warrant will entitle the holder to purchase one share of common stock at a price of $11.50 per share, subject to adjustment. The proceeds from the Private Placement Warrants was added to the proceeds from the IPO held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the proceeds from the sale of the Private Placement Warrants held in the Trust Account will be used to fund the redemption of the Public Shares (subject to the requirements of applicable law) and the Private Placement Warrants will expire worthless.\nThe Private Placement Warrants are identical to the Warrants underlying the Units sold in the IPO, except that the Private Placement Warrants are non-redeemable and may be exercised on a cashless basis, in each case so long as they continue to be held by the initial purchasers or their permitted transferees. Further, the Sponsor has agreed not to transfer, assign, or sell the Private Placement Warrants (including the shares of Common Stock issuable upon the exercise of the Private Placement Warrants), except to certain permitted transferees, until after the consummation of the Company's initial business combination.\nSimultaneously with the closing of the exercise of the over-allotment option, the Company completed the private sale (the “Private Placement”) of an aggregate of 150,000 private placement warrants (the “Private Placement Warrants”) to Ignyte Sponsor LLC, a Delaware limited liability company (the “Sponsor”), at a purchase price of $ 1.00 per Private Placement Warrant, generating gross proceeds of $ 150,000 .\n12\nNote 6 — Related Party Transactions\nFounder Shares\nOn August 12, 2020, the Sponsor paid $ 25,000 , or approximately $ 0.02 per share, to cover certain offering costs in consideration for 1,437,500 shares of Common Stock, par value $ 0.0001 (the “Founder Shares”). Up to 187,500 Founder Shares are subject to forfeiture by the Sponsor depending on the extent to which the underwriters' over-allotment option is exercised. On February 2, 2021, the underwriter exercised its over-allotment option in full, hence, the 187,500 Founder Shares are no longer subject to forfeiture since then.\nThe founders' shares were placed into an escrow account maintained in New York, New York by Continental Stock Transfer & Trust Company, acting as escrow agent. Subject to certain limited exceptions, these shares will not be transferred, assigned, sold or released from escrow (subject to certain limited exceptions set forth below) (i) with respect to 50% of such shares, for a period ending on the earlier of the one-year anniversary of the date of the consummation of the initial Business Combination and the date on which the closing price of the Company's common stock equals or exceeds $12.50 per share (as adjusted for share splits, share dividends, reorganizations and recapitalizations) for any 20 trading days within a 30-trading day period following the consummation of the initial Business Combination and (ii) with respect to the remaining 50% of such shares, for a period ending on the one-year anniversary of the date of the consummation of the initial Business Combination, or earlier, in either case, if, subsequent to the initial Business Combination, the Company consummates a liquidation, merger, stock exchange or other similar transaction which results in all of the Company's stockholders having the right to exchange their shares of common stock for cash, securities or other property.\nPromissory Note — Related Party\nOn November 20, 2020, the Company's executive officers loaned the Company $ 80,000 to be used for a portion of the expenses of the IPO. These loans are non-interest bearing, unsecured and are due at the earlier of June 30, 2021 or the closing of the IPO. As of February 1, 2021, the Company repaid the note in full.\nDue to Related Party\nAs of June 30, 2021, the amount due to related party is $ 51,953 which represent the accrual of administrative service fee $ 51,643 from January 26, 2021 to June 30, 2021 and formation cost $ 310 paid by the Officer.\nRelated Party Loans\nIn order to meet the Company’s working capital needs following the consummation of the IPO the Sponsor, officers, directors initial stockholders or their affiliates may, but are not obligated to, loan the Company funds (“Working Capital Loans”), from time to time or at any time, in whatever amount they deem reasonable in their sole discretion. Each loan would be evidenced by a promissory note. The notes would either be paid upon consummation of the initial Business Combination, without interest, or, at holder’s discretion, up to $ 1,500,000 of the notes may be converted into warrants at a price of $ 1.00 per warrant. The warrants would be identical to the Private Placement Warrants. In the event that the initial Business Combination does not close, the Company may use a portion of the working capital held outside the Trust Account to repay such loaned amounts, but no proceeds from the Trust Account would be used for such repayment. As of June 30, 2021 and December 31, 2020, no such Working Capital Loans were outstanding.\nAdministrative Service Fee\nThe Company has agreed, commencing on the date of the securities of the Company are first listed on The Nasdaq Capital Market (the “Listing Date”), to pay the Sponsor $ 10,000 per month for office space, utilities and secretarial support. Upon completion of the initial Business Combination or the Company's liquidation, the Company will cease paying these monthly fees. The Company accrued $ 51,643 and $ 30,000 for the administrative service fee for the period from the Listing Date to June 30, 2021and for the three months ended June 30, 2021.\nNote 7 — Recurring Fair Value Measurements\nThe following table presents information about the Company's assets and liabilities that were measured at fair value on a recurring basis as of June 30, 2021, and indicates the fair value hierarchy of the valuation techniques the Company utilized to determine such fair value.\n13\n| June 30, 2021 | Quoted Prices In Active Markets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Other Unobservable Inputs (Level 3) |\n| Assets: |\n| U.S. Money Market held in Trust Account | $ | 57,504,345 | $ | 57,504,345 | $ | - | $ | - |\n| $ | 57,504,345 | $ | 57,504,345 | $ | - | $ | - |\n| Liabilities: |\n| Warrant liabilities-Private Placement Warrants | $ | 1,875,000 | $ | - | $ | - | $ | 1,875,000 |\n| $ | 1,875,000 | $ | - | $ | - | $ | 1,875,000 |\n\nThe following table sets forth a summary of the changes in the fair value of the warrant liabilities for the period from August 6, 2020 (Inception) through June 30, 2021:\n| Warrant Liability |\n| Fair value as of February 1, 2021 | $ | 2,303,000 |\n| Issuance of private warrants in connection with over-allotment as of February 2, 2021 | 147,000 |\n| Change in fair value (1) | ( 575,000 ) |\n| Fair value as of June 30, 2021 | $ | 1,875,000 |\n\n(1) Represents the non-cash gain on the change in valuation of Private Warrants and is included in the change in fair value of warrant liability on the statement of operations.\nAt June 30, 2021, the Public Warrants were determined to contain none of the features requiring liability treatment; therefore, the Public warrants were not included in the fair value reporting.\nThe Private Warrants were valued using a Modified Black Scholes Model. The Private Warrants are considered to be a Level 3 fair value measurements due to the use of unobservable inputs. The Black Scholes Model can be modified to value SPAC Private Warrants by discounting the Acquisition Date warrant value to the Valuation Date and multiplying the present value by the probability of a future transaction occurring.\nTransfers to/from Levels 1, 2 and 3 are recognized at the end of the reporting period. There were no transfers between levels for the period from January 1, 2021 through June 30, 2021.\nThe following table provides quantitative information regarding Level 3 fair value measurements for Private Warrants as of June 30, 2021 and February 1, 2021.\n| June 30, 2021 | February 1, 2021 |\n| Exercise price | $ | 11.50 | $ | 11.50 |\n| Share price | $ | 9.68 | $ | 10.00 |\n| Volatility | 14.25 | % | 19.00 | % |\n| Expected life | 5 .00 | 5 .00 |\n| Risk-free rate | 0.87 | % | 0.42 | % |\n| Dividend yield | - | % | - | % |\n\nNote 8 — Commitments and Contingencies\nRegistration Rights\nThe holders of the founders’ shares issued and outstanding on the date of the IPO, as well as the holders of the representative shares, Private Placement Warrants and any warrants the Company’s Sponsor, officers, directors or their affiliates may be issued in payment of Working Capital Loans made to the Company (and all underlying securities), will be entitled to registration rights pursuant to an agreement signed on January 27, 2021. The holders of a majority of these securities are entitled to make up to two demands that the Company registers such securities. The holders of the majority of the founders’ shares can elect to exercise these registration rights at any time commencing three months prior to the date on which these shares of common stock are to be released from escrow. The holders of a majority of the representative shares, Private Placement Warrants and warrants issued to the Company’s Sponsor, officers, directors or their affiliates in payment of Working Capital Loans made to the Company (or underlying securities) can elect to exercise these registration rights at any time after the Company consummates a Business Combination. Notwithstanding anything to the contrary, EarlyBirdCapital may only make a demand on one occasion and only during the five-year period beginning on the Effective Date of the registration statement of which the IPO forms a part. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the Company’s consummation of a Business Combination; provided, however, that EarlyBirdCapital may participate in a “piggyback” registration only during the seven-year period beginning on the Effective Date of the registration statement of which the IPO forms a part. The Company will bear the expenses incurred in connection with the filing of any such registration statements.\n14\nUnderwriting Agreement\nThe underwriters have a 45-day option beginning February 1, 2021 to purchase up to an additional 750,000 units to cover over-allotments, if any, at the IPO price less the underwriting discounts.\nThe Company issued to the underwriter (and/or its designees) (the “Representative”) 100,000 shares of common stock for $ 0.0001 per share (the “Representative Shares”). The Company estimated the fair value of the stock to be $ 2,000 based upon the price of the founder shares issued to the Sponsor. The stock were treated as underwriters’ compensation and charged directly to shareholders’ equity. The underwriter (and/or its designees) agreed (i) to waive their conversion rights (or right to participate in any tender offer) with respect to such shares in connection with the completion of our initial business combination and (ii) to waive their rights to liquidating distributions from the trust account with respect to such shares if we fail to complete our initial business combination within 21 months from the closing of this offering.\nOn February 1, 2021, the Company paid a fixed underwriting fee of $ 1,000,000 .\nOn February 2, 2021, the underwriters purchased an additional 750,000 units to exercise its over-allotment option in full. The proceeds of $ 7,500,000 from the over-allotment was deposited in the Trust Account after deducting the underwriting discounts.\nBusiness Combination Marketing Agreement\nThe Company has engaged underwriters as advisors in connection with its Business Combination to assist it in holding meetings with the stockholders to discuss the potential Business Combination and the target business’s attributes, introduce the Company to potential investors that are interested in purchasing the Company’s securities in connection with the potential Business Combination, assist the Company in obtaining stockholder approval for the Business Combination and assist the Company with its press releases and public filings in connection with the Business Combination. The Company will pay the Marketing Fee for such services upon the consummation of the initial Business Combination in an amount equal to, in the aggregate, 3.5 % of the gross proceeds of the IPO, or $ 2,012,500 including the proceeds from the full exercise of the over-allotment option on February 2, 2021.\nRight of First Refusal\nIf the Company determines to pursue any equity, equity-linked, debt or mezzanine financing relating to or in connection with a Business Combination or after a Business Combination, then EarlyBirdCapital shall have the right, but not the obligation, to act as book running manager, placement agent and/or arranger, as the case may be, in any and all such financing or financings and to receive at least 25 % of the aggregate gross spread or fees from any and all such financings. This right of first refusal extends from the February 1, 2021 until the earlier of twelve (12) months after the consummation of an initial Business Combination or the liquidation of the Trust Account if the Company fails to consummate a Business Combination during the required time period.\nNote 9 — Stockholder’s Equity\nPreferred Stock — The Company is authorized to issue 1,000,000 shares of preferred stock with a par value of $ 0.0001 and with such designations, voting and other rights and preferences as may be determined from time to time by the Company's board of directors. At June 30, 2021 and December 31, 2021, there were no shares of preferred stock issued or outstanding.\nCommon Stock — The Company is authorized to issue 50,000,000 shares of common stock with a par value of $ 0.0001 per share. On August 12, 2020, the Sponsor paid $ 25,000 , or approximately $ 0.02 per share, to cover certain offering costs in consideration for 1,437,500 shares of Common Stock, par value $ 0.0001 . Of the 1,437,500 shares of common stock, an aggregate of up to 187,500 shares are subject to forfeiture to the Company for no consideration to the extent that the underwriters' over-allotment option is not exercised in full or in part, so that the initial stockholders will collectively own 20 % of the Company's issued and outstanding common stock after the IPO. On February 2, 2021, the underwriter exercised its over-allotment option in full, hence, the 187,500 Founder Shares are no longer subject to forfeiture since then. In August 2020, the Company also issued to designees of EarlyBirdCapital an aggregate of 100,000 shares of common stock (“representative shares”), at a price of $ 0.0001 per share. As of June 30, 2021 and December 31, 2020, there were 2,157,788 and 1,537,500 shares of common stock issued and outstanding, respectively.\n15\nCommon stockholders of record are entitled to one vote for each share held on all matters to be voted on by stockholders. In connection with any vote held to approve the initial Business Combination, the initial stockholders, as well as all of the Company’s officers and directors, have agreed to vote their respective shares of common stock owned by them immediately prior to the IPO and any shares purchased in the IPO or following the IPO in the open market in favor of the proposed Business Combination.\nNote 10 — Subsequent Events\nThe Company evaluated subsequent events and transactions that occurred after the balance sheet date up to the date that the unaudited condensed financial statements were issued.\n16\n\nITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nReferences to the “Company,” “us,” “our” or “we” refer to Ignyte Acquisition Corp.. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our unaudited condensed financial statements and related notes included herein.\nCautionary Note Regarding Forward-Looking Statements\nAll statements other than statements of historical fact included in this Report including, without limitation, statements under this “Management's Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company's financial position, business strategy and the plans and objectives of management for future operations, are forward- looking statements. When used in this Report, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or the Company's management, identify forward-looking statements. Such forward-looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company's management. Actual results could differ materially from those contemplated by the forward- looking statements as a result of certain factors detailed in our filings with the SEC. All subsequent written or oral forward-looking statements attributable to us or persons acting on the Company's behalf are qualified in their entirety by this paragraph.\nThe following discussion and analysis of our financial condition and results of operations should be read in conjunction with the unaudited condensed financial statements and the notes thereto contained elsewhere in this Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\nOverview\nWe are an early-stage blank check company incorporated as a Delaware corporation and formed for the purpose of effecting an initial business combination.\nWe leverage the more than nine decades of combined operational and financial experience of our management team and board of directors who are both established e-commerce entrepreneurs and sophisticated investors. We believe our extensive industry experience and proven ability to source, acquire, grow and revitalize companies will provide our management team with a robust and consistent flow of acquisition opportunities. Our management team and board's broad relationships across multiple networks, including leading consumer and technology company founders, executives of private and public companies, leading M&A investment banks and private equity firms, as well as their ability to engage early with founder-led businesses represents a differentiated advantage to successfully source transaction opportunities. Our team has been immersed in the same ecosystem as the current founders of private companies who are making decisions on how to build currency for future growth and monetization.\nWhile we may pursue an initial business combination target in any business, industry or geographical location, we are focusing our search primarily within the consumer-facing e-commerce sector. We are capitalizing on the ability of our management team to identify, acquire and operate a business or businesses that can benefit from our management team and board's established relationships and operating experience. Our management team has extensive experience in identifying and executing strategic investments and has done so successfully in several sectors, particularly in digital consumer-facing businesses. Over time, we believe that all companies will need to deploy an omni-commerce strategy to succeed, and we will leverage our management team and board's unique experience to successfully develop our business target's omni-commerce.\nResults of Operations\nOur entire activity since inception up to June 30, 2021 relates to our formation, the Initial Public Offering and, since the closing of the Initial Public Offering, a search for a Business Combination candidate. We will not be generating any operating revenues until the closing and completion of our initial Business Combination, at the earliest.\nFor the three months ended June 30, 2021, we had net income of $616,107, which consisted of $2,087 in interest earned on marketable securities held in the Trust Account, and $725,000 in unrealized gain on change in fair value of warrants, offset by $110,980 in formation and operating costs.\nFor the six months ended June 30, 2021, we had net income of $269,924, which consisted of $4,345 in interest earned on marketable securities held in the Trust Account, and $575,000 in unrealized gain on change in fair value of warrants, offset by $309,421 in formation and operating costs.\n17\nLiquidity and Capital Resources\nAs of June 30, 2021, we had $550,470 in its operating bank account, and working capital of $667,784.\nPrior to the completion of the Initial Public Offering, our liquidity needs had been satisfied through a payment from the Sponsor of $25,000 (see Note 6) for the Founder Shares to cover certain offering costs, the loan under an unsecured promissory note from the Sponsor of $80,000, and the net proceeds from the consummation of the Private Placement not held in the Trust Account. In addition, in order to finance transaction costs in connection with a Business Combination, our Sponsor or an affiliate of the Sponsor or our officers and directors or their affiliates may, but are not obligated to, provide us Working Capital Loans. To date, there were no amounts outstanding under any Working Capital Loans.\nWe anticipate that the $550,470 outside of the Trust Account as of June 30, 2021, will be sufficient to allow the Company to operate for at least the next 12 months from the issuance of the financial statements, assuming that a Business Combination is not consummated during that time.\nBased on the foregoing, management believes that we will have sufficient working capital and borrowing capacity to meet our needs through the earlier of the consummation of a Business Combination or one year from this filing. Over this time period, we will be using these funds for paying existing accounts payable, identifying and evaluating prospective initial Business Combination candidates, performing due diligence on prospective target businesses, paying for travel expenditures, selecting the target business to merge with or acquire, and structuring, negotiating and consummating the Business Combination.\nCritical Accounting Policies and Estimates\nThe preparation of the unaudited condensed financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited condensed financial statements and the reported amounts of expenses during the reporting period. Actual results could differ from those estimates. We have identified the following as our critical accounting policies:\nWarrant Liabilities\nWe account for the Warrants, as either equity or liability-classified instruments based on an assessment of the specific terms of the Warrants and the applicable authoritative guidance in FASB ASC 815, Derivatives and Hedging ASC 815. The assessment considers whether the Warrants meet all of the requirements for equity classification under ASC 815, including whether the Warrants are indexed to the Company's own ordinary shares and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of the Company's control, among other conditions for equity classification. This assessment, which requires the use of professional judgment, was conducted at the time of issuance of the Warrants and will continue as of each subsequent quarterly period end date while the Warrants are outstanding.\nFor issued or modified warrants that meet all of the criteria for equity classification, such warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all the criteria for equity classification, such warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of liability-classified warrants are recognized as a non-cash gain or loss on the statements of operations.\nCommon Stock Subject to Possible Redemption\nThe Company accounts for its common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption (if any) is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company's control) is classified as temporary equity. At all other times, common stock is classified as stockholders' equity. The Company's common stock feature certain redemption rights that is considered to be outside of the Company's control and subject to the occurrence of uncertain future events. Accordingly, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders' equity section of the Company's balance sheet.\nNet Income Per Common Share\nNet income per common share is computed by dividing net income by the weighted average number of common stock outstanding for each of the periods. The calculation of diluted net income per common share does not include warrants since the inclusion of such warrants would be anti-dilutive.\nThe Company's statement of operations includes a presentation of income per share for common stock subject to possible redemption in a manner similar to the two-class method of income per common share. Net income per common share, basic and diluted, for\n18\nredeemable common stock is calculated by dividing the interest income earned on the Trust Account, by the weighted average number of redeemable common stock outstanding since original issuance. Net income per common share, basic and diluted, for non-redeemable common stock is calculated by dividing the net income, adjusted for income attributable to redeemable common stock, by the weighted average number of non-redeemable common stock outstanding for the periods. Non-redeemable common stock includes the founder shares as these common stock do not have any redemption features and do not participate in the income earned on the Trust Account.\nOff-Balance Sheet Arrangements\nAs of June 30, 2021, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K.\n\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nAs of June 30, 2021, we were not subject to any market or interest rate risk. Following the consummation of our Initial Public Offering, the net proceeds received into the Trust Account, have been invested in U.S. government treasury bills, notes or bonds with a maturity of 180 days or less or in certain money market funds that invest solely in US treasuries. Due to the short-term nature of these investments, we believe there will be no associated material exposure to interest rate risk.\nITEM 4. CONTROLS AND PROCEDURES\nDisclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Co-Chief Executive Officers and Chief Financial Officer, to allow timely decisions regarding required disclosure.\nEvaluation of Disclosure Controls and Procedures\nAs required by Rules 13a-15 and 15d-15 under the Exchange Act, our Co-Chief Executive Officers and Chief Financial Officer carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2021. Based upon their evaluation, our Co-Chief Executive Officers and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15 (e) and 15d-15 (e) under the Exchange Act) continued to be ineffective with respect to the classification of the Company's Warrants as components of equity instead of as derivative liabilities and the re-classification of the Company's Class A ordinary shares between temporary and permanent equity. Any failure to maintain effective disclosure controls could adversely impact our ability to report our financial results on a timely and accurate basis, which could have adverse consequences, including with respect to the continued listing of our securities.\nDisclosure controls and procedures are designed to ensure that information required to be disclosed by us in our Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.\nChanges in Internal Control Over Financial Reporting\nDuring the fiscal quarter ended March 31, 2021, management identified a material weakness in internal controls related to the accounting for warrants issued in connection with our initial public offering, as described above, which material weakness continued to exist during the most recent fiscal quarter ended June 30, 2021. While we have processes to identify and appropriately apply applicable accounting requirements, we plan to enhance our system of evaluating and implementing the accounting standards that apply to our financial statements, including through enhanced analyses by our personnel and third-party professionals with whom we consult regarding complex accounting applications. The elements of our remediation plan can only be accomplished over time, and we can offer no assurance that these initiatives will ultimately have the intended effects.\n19\nPART II – OTHER INFORMATION\n\nITEM 1. LEGAL PROCEEDINGS.\nNone.\n\nITEM 1A. RISK FACTORS.\nFactors that could cause our actual results to differ materially from those in this report include the risk factors described in our Annual Report on Form 10-K for the year ended December 31, 2020 filed with the SEC on April 15, 2021, as amended on Form 10-K/A filed with the SEC on April 19, 2021. As of the date of this Report there have been no material changes to the risk factors disclosed in our Annual Report filed with the SEC.\n\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.\nNone.\n\nITEM 3. DEFAULTS UPON SENIOR SECURITIES.\nNone.\n\nITEM 4. MINE SAFETY DISCLOSURES.\nNot applicable.\n\nITEM 5. OTHER INFORMATION.\nOn May 28, 2021, we received a notice from Nasdaq Regulation, or Nasdaq, indicating that we were not in compliance with Nasdaq Listing Rule 5250(c)(1) as a result of our failure to timely file our Quarterly Report on Form 10-Q for the quarter ended March 31, 2021, which we refer to as the Form 10-Q, with the Securities and Exchange Commission, or SEC. The notice provided that we must submit a plan to regain compliance with Nasdaq Listing Rule 5250(c)(1) by July 26, 2021. Alternatively, we were permitted to regain compliance with the Nasdaq listing standards at any time prior to that date by filing the Form 10-Q with the SEC. We subsequently filed the Form 10-Q with the SEC on July 26, 2021.\nOn August 6, 2021, we received a notice from Nasdaq stating that, based on the Form 10-Q filing on July 26, 2021, we had regained compliance with the Nasdaq listing standards.\n\nITEM 6. EXHIBITS.\nThe following exhibits are filed as part of, or incorporated by reference into, this Quarterly Report on Form 10-Q.\n\n| No. | Description of Exhibit |\n| 31.1* | Certification of Principal Executive Officer Pursuant to Securities Exchange Act Rules 13a-14(a) and 15(d)-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2* | Certification of Principal Financial Officer Pursuant to Securities Exchange Act Rules 13a-14(a) and 15(d)-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1** | Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2** | Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS* | Inline XBRL Instance Document |\n| 101.CAL* | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.SCH* | Inline XBRL Taxonomy Extension Schema Document |\n| 101.DEF* | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB* | Inline XBRL Taxonomy Extension Labels Linkbase Document |\n| 101.PRE* | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\n\n\n| * | Filed herewith. |\n| ** | Furnished. |\n\n20\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| IGNYTE ACQUISITION CORP. |\n| Date: August 16, 2021 | By: | /s/David Rosenburg |\n| David Rosenberg |\n| Co-Chief Executive Officer (Principal Executive Officer) |\n\n\n| IGNYTE ACQUISITION CORP. |\n| Date: August 16, 2021 | By: | /s/ Steven Kaplan |\n| Steven Kaplan |\n| Chief Financial Officer (Principal Financial and Accounting Officer) |\n\n21\n</text>\n\nWhat is the difference between the total net income for both redeemable and non-redeemable common stock and the total offering costs from the IPO in the first half of 2021 in dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"ground_truth": "Therefore, the answer is -1279561.0."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial Statements (Unaudited)\nCONTEXTLOGIC INC.\nCONDENSED CONSOLIDATED BALANCE SHEETS\n(in millions, except par value)\n\n| As of March 31, | As of December 31, |\n| 2021 | 2020 |\n| (Unaudited) |\n| Assets |\n| Current assets: |\n| Cash and cash equivalents | $ | 1,620 | $ | 1,965 |\n| Marketable securities | 154 | 164 |\n| Funds receivable | 65 | 83 |\n| Prepaid expenses and other current assets | 88 | 102 |\n| Total current assets | 1,927 | 2,314 |\n| Property and equipment, net | 23 | 25 |\n| Right-of-use assets | 39 | 43 |\n| Marketable securities | — | 4 |\n| Other assets | 10 | 11 |\n| Total assets | $ | 1,999 | $ | 2,397 |\n| Liabilities and Stockholders’ Equity |\n| Current liabilities: |\n| Accounts payable | $ | 291 | $ | 434 |\n| Merchants payable | 381 | 454 |\n| Refunds liability | 54 | 77 |\n| Accrued liabilities | 309 | 367 |\n| Total current liabilities | 1,035 | 1,332 |\n| Lease liabilities, non-current | 34 | 38 |\n| Total liabilities | 1,069 | 1,370 |\n| Commitments and contingencies (Note 7) |\n| Stockholders’ equity: |\n| Preferred stock, $ 0.0001 par value: 100 shares authorized as of March 31, 2021 and December 31, 2020; No shares issued and outstanding as of March 31, 2021 and December 31, 2020 | — | — |\n| Common stock, $ 0.0001 par value: 3,500 ( 3,000 Class A, 500 Class B) shares authorized as of March 31, 2021 and December 31, 2020; 618 ( 501 Class A, 117 Class B) and 587 ( 478 Class A, 109 Class B) shares issued and outstanding as of March 31, 2021 and December 31, 2020 | — | — |\n| Additional paid-in capital | 3,243 | 3,210 |\n| Accumulated other comprehensive income (loss) | ( 1 | ) | 1 |\n| Accumulated deficit | ( 2,312 | ) | ( 2,184 | ) |\n| Total stockholders’ equity | 930 | 1,027 |\n| Total liabilities and stockholders’ equity | $ | 1,999 | $ | 2,397 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n1\nCONTEXTLOGIC INC.\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\n(in millions, except per share data)\n(Unaudited)\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| Revenue | $ | 772 | $ | 440 |\n| Cost of revenue | 335 | 156 |\n| Gross profit | 437 | 284 |\n| Operating expenses: |\n| Sales and marketing | 470 | 295 |\n| Product development | 51 | 25 |\n| General and administrative | 42 | 18 |\n| Total operating expenses | 563 | 338 |\n| Loss from operations | ( 126 | ) | ( 54 | ) |\n| Other income (expense), net: |\n| Interest and other income, net | — | 3 |\n| Remeasurement of redeemable convertible preferred stock warrant liability | — | ( 15 | ) |\n| Loss before provision for income taxes | ( 126 | ) | ( 66 | ) |\n| Provision for income taxes | 2 | — |\n| Net loss | ( 128 | ) | ( 66 | ) |\n| Net loss per share, basic and diluted | $ | ( 0.21 | ) | $ | ( 0.62 | ) |\n| Weighted-average shares used in computing net loss per share, basic and diluted | 619 | 106 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n2\nCONTEXTLOGIC INC.\nCONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS\n(in millions)\n(Unaudited)\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| Net loss | $ | ( 128 | ) | $ | ( 66 | ) |\n| Other comprehensive loss: |\n| Net unrealized holding losses on derivatives | ( 2 | ) | — |\n| Comprehensive loss | $ | ( 130 | ) | $ | ( 66 | ) |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n3\nCONTEXTLOGIC INC.\nCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\n(in millions)\n(Unaudited)\n\n| Three Months Ended March 31, 2021 |\n| Common Stock | Additional Paid-in | Accumulated Other | Accumulated | Total Stockholders’ |\n| Shares | Amount | Capital | Comprehensive Income | Deficit | Equity |\n| Balances as of December 31, 2020 | 587 | $ | — | $ | 3,210 | $ | 1 | $ | ( 2,184 | ) | $ | 1,027 |\n| Issuance of common stock upon exercise of options for cash | 2 | — | 1 | — | — | 1 |\n| Issuance of common stock upon settlement of restricted stock units, net of tax | 29 | — | ( 5 | ) | — | — | ( 5 | ) |\n| Stock-based compensation | — | — | 37 | — | — | 37 |\n| Other comprehensive loss, net | — | — | — | ( 2 | ) | — | ( 2 | ) |\n| Net loss | — | — | — | — | ( 128 | ) | ( 128 | ) |\n| Balances as of March 31, 2021 | 618 | $ | — | $ | 3,243 | $ | ( 1 | ) | $ | ( 2,312 | ) | $ | 930 |\n\n\n| Three Months Ended March 31, 2020 |\n| Redeemable Convertible Preferred Stock | Common Stock | Additional Paid-in | Accumulated | Total Stockholders’ |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Deficit |\n| Balances as of December 31, 2019 | 422 | $ | 1,536 | 103 | $ | — | $ | — | $ | ( 1,439 | ) | $ | ( 1,439 | ) |\n| Issuance of common stock upon exercise of options for cash | — | — | 3 | — | 1 | — | 1 |\n| Net loss and comprehensive loss | — | — | — | — | — | ( 66 | ) | ( 66 | ) |\n| Balances as of March 31, 2020 | 422 | $ | 1,536 | 106 | $ | — | $ | 1 | $ | ( 1,505 | ) | $ | ( 1,504 | ) |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n4\nCONTEXTLOGIC INC.\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(in millions)\n(Unaudited)\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| Cash flows from operating activities: |\n| Net loss | $ | ( 128 | ) | $ | ( 66 | ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: |\n| Depreciation and amortization | 2 | 2 |\n| Non-cash lease expense | 4 | 2 |\n| Stock-based compensation expense | 37 | — |\n| Remeasurement of redeemable convertible preferred stock warrant liability | — | 15 |\n| Other | ( 3 | ) | — |\n| Changes in operating assets and liabilities: |\n| Funds receivable | 18 | 8 |\n| Prepaid expenses, other current and noncurrent assets | 16 | 7 |\n| Accounts payable | ( 143 | ) | 31 |\n| Merchants payable | ( 73 | ) | ( 122 | ) |\n| Accrued and refund liabilities | ( 69 | ) | 3 |\n| Lease liabilities | ( 4 | ) | ( 2 | ) |\n| Other current and noncurrent liabilities | ( 11 | ) | ( 7 | ) |\n| Net cash used in operating activities | ( 354 | ) | ( 129 | ) |\n| Cash flows from investing activities: |\n| Purchases of marketable securities | ( 53 | ) | ( 73 | ) |\n| Maturities of marketable securities | 67 | 132 |\n| Net cash provided by investing activities | 14 | 59 |\n| Cash flows from financing activities: |\n| Payment of taxes related to RSU settlement and other financing activities, net | ( 5 | ) | 1 |\n| Net cash provided by (used in) financing activities | ( 5 | ) | 1 |\n| Net decrease in cash, cash equivalents and restricted cash | ( 345 | ) | ( 69 | ) |\n| Cash, cash equivalents and restricted cash at beginning of period | 1,965 | 754 |\n| Cash, cash equivalents and restricted cash at end of period | $ | 1,620 | $ | 685 |\n| Reconciliation of cash, cash equivalents, and restricted cash to the condensed consolidated balance sheets: |\n| Cash and cash equivalents | $ | 1,620 | $ | 675 |\n| Restricted cash included in other assets in the condensed consolidated balance sheets | — | 10 |\n| Total cash, cash equivalents and restricted cash | $ | 1,620 | $ | 685 |\n| Supplemental cash flow disclosures: |\n| Cash paid for income taxes, net of refunds | $ | 2 | $ | — |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n5\nCONTEXTLOGIC INC.\nNotes to Unaudited Condensed Consolidated Financial Statements\nNOTE 1. OVERVIEW, BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES\nContextLogic Inc. (“Wish” or the “Company”) is an ecommerce company that provides a shopping experience that is mobile-first and discovery-based, which connects merchants’ products to users based on user preferences. The Company generates revenue from marketplace and logistics services provided to merchants.\nThe Company was incorporated in the state of Delaware in June 2010 and is headquartered in San Francisco, California, with operations in Canada, China and the Netherlands.\nInitial Public Offering\nIn December 2020, the Company completed its initial public offering (“IPO”) of Class A common stock, in which it sold 46 million shares. The shares were sold at an IPO price of $ 24.00 per share for net proceeds of approximately $ 1.1 billion, after deducting underwriting discounts and commissions of approximately $ 52 million. Additionally, the Company incurred approximately $ 6 million of offering costs, net of reimbursements. Following the IPO, the Company has two classes of authorized common stock, Class A common stock, which entitles holders to one vote per share, and Class B common stock, which entitles holders to 20 votes per share.\nBasis of Presentation and Consolidation\nThe accompanying condensed consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles (“U.S. GAAP”). The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. The condensed consolidated financial statements are unaudited, but include all adjustments of a normal recurring nature necessary for a fair presentation of our quarterly results. The consolidated balance sheet as of December 31, 2020 is derived from audited financial statements, however, it does not include all of the information and footnotes required by U.S. GAAP for complete financial statements. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes in our Annual Report on Form 10-K for the year ended December 31, 2020, which was filed with the Securities and Exchange Commission (“SEC”) on March 25, 2021.\nUse of Estimates\nThe preparation of condensed consolidated financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the condensed consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. These estimates form the basis for judgments the Company makes about the carrying values of its assets and liabilities that are not readily available from other sources. These estimates include, but are not limited to, fair value of financial instruments, useful lives of long-lived assets, fair value of derivative instruments, incremental borrowing rate applied to lease accounting, contingent liabilities, redemption probabilities associated with Wish Cash, allowances for refunds and chargebacks and uncertain tax positions. As of March 31, 2021, the effects of the ongoing COVID-19 pandemic on the Company’s business, results of operations, and financial condition continue to evolve. As a result, many of the Company’s estimates and assumptions required increased judgment and these estimates may change materially in future periods.\nSegments\nThe Company manages its operations and allocates resources as a single operating segment. Further, the Company manages, monitors and reports its financials as a single reporting segment. The Company’s chief operating decision-maker is its Chief Executive Officer who makes operating decisions, assesses financial performance and allocates resources based on condensed consolidated financial information. As such, the Company has determined that it operates in one reportable segment.\n6\nConcentrations of Risk\nCredit Risk — Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents, funds receivable, marketable securities and derivative financial instruments. The Company’s cash and cash equivalents are held on deposit with creditworthy institutions. Although the Company’s deposits exceed federally insured limits, the Company has not experienced any losses in such accounts. The Company invests its excess cash in money market accounts, U.S. Treasury notes, U.S. Treasury bills, commercial paper and corporate bonds. The Company is exposed to credit risk in the event of a default by the financial institutions holding its cash, cash equivalents and marketable securities for the amounts reflected on the condensed consolidated balance sheets. The Company’s investment policy limits investments to certain types of debt securities issued by the U.S. government, its agencies and institutions with investment-grade credit ratings and places restrictions on maturities and concentration by type and issuer.\nThe Company's derivative financial instruments expose it to credit risk to the extent that the counterparties may be unable to meet the terms of the arrangement. The Company seeks to mitigate such risk by limiting its counterparties to, and by spreading the risk across, major financial institutions. In addition, the potential risk of loss with any one counterparty resulting from this type of credit risk is monitored on a monthly basis. The Company is not required to pledge, nor is it entitled to receive, collateral related to its foreign exchange derivative transactions.\nThe Company is exposed to credit risk in the event of a default by its Payment Service Providers (“PSPs”). The Company does not generate revenue from PSPs. Significant changes in the Company’s relationship with its PSPs could adversely affect users’ ability to process transactions on the Company’s marketplaces, thereby impacting the Company’s operating results.\nThe following PSPs each represented 10% or more of the Company’s funds receivable balance:\n\n| March 31, | December 31, |\n| 2021 | 2020 |\n| PSP 1 | 61 | % | 56 | % |\n| PSP 2 | 27 | % | 27 | % |\n\nServices Risk — The Company serves all of its users using third-party data center and hosting providers. The Company has disaster recovery protocols at the third-party service providers. Even with these procedures for disaster recovery in place, access to the Company’s service could be significantly interrupted, resulting in an adverse effect on its operating results and financial position. No significant interruptions of service were known to have occurred during the three months ended March 31, 2021 and 2020.\nSummary of Significant Accounting Policies\nThere have been no changes to the Company’s significant accounting policies described in its Annual Report on Form 10-K for the year ended December 31, 2020, filed with the SEC on March 25, 2021, that have had a material impact on its condensed consolidated financial statements.\nAccounting Pronouncements\nThe Company has reviewed recent accounting pronouncements and concluded they are either not applicable to the business or no material impact is expected on the condensed consolidated financial statements as a result of future adoption.\nNOTE 2. DISAGGREGATION OF REVENUE\nThe Company generates revenue from marketplace and logistics services provided to merchants. Revenue is recognized as the Company transfers control of promised goods or services to its users in an amount that reflects the consideration the Company expects to be entitled to in exchange for those goods or services. The Company considers both the merchant and the user to be customers. The Company evaluates whether it is appropriate to recognize revenue on a gross or net basis based upon its evaluation of whether the Company obtains control of the specified goods or services by considering if it is primarily responsible for fulfillment of the promise, has inventory risk, has latitude in establishing pricing and selecting suppliers, among other factors. Based on these factors, marketplace revenue is generally recognized on a net basis and logistics revenue is generally recognized on a gross basis. Revenue excludes any amounts collected on behalf of third parties, including indirect taxes.\nMarketplace revenue includes commission fees collected in connection with user purchases of the merchants’ products. The commission fees vary depending on factors such as user location, demand, product type, and dynamic\n7\npricing. The Company recognizes revenue when a user’s order is processed and the related order information has been made available to the merchant. Commission fees are recognized net of estimated refunds and chargebacks. Marketplace revenue also includes ProductBoost revenue for displaying a merchant’s selected products in preferential locations within the Company’s marketplace. The Company recognizes revenue when the merchants’ selected products are displayed. The Company refers to its marketplace revenue, excluding ProductBoost revenue, as its core marketplace revenue.\nThe Company’s logistics offering for merchants is designed for direct end-to-end single order shipment from a merchant’s location to the user. Logistics services include transportation and delivery of the merchant’s products to the user. Merchants are required to prepay for logistics services on a per order basis. The Company recognizes revenue over time as the merchant simultaneously receives and consumes the logistics services benefit as the services are performed. The Company uses an output method of progress based on days in transit as it best depicts the Company’s progress toward complete satisfaction of the performance obligation.\nThe following table shows the disaggregated revenue for the applicable periods:\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Core marketplace revenue | $ | 477 | $ | 340 |\n| ProductBoost revenue | 50 | 44 |\n| Marketplace revenue | 527 | 384 |\n| Logistics revenue | 245 | 56 |\n| Revenue | $ | 772 | $ | 440 |\n\nRefer to Note 11 – Geographical Information for the disaggregated revenue by geographical location.\nNote 3. FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENT\nThe Company’s financial instruments consist of cash equivalents, marketable securities, funds receivable, derivative instruments, accounts payable, accrued liabilities and merchants payable. Cash equivalents’ carrying value approximates fair value at the balance sheet dates, due to the short period of time to maturity. Marketable securities and derivative instruments are recognized at fair value. Funds receivable, accounts payable, accrued liabilities and merchants payable carrying values approximate fair value due to the short time to the expected receipt or payment date.\nAssets and liabilities recognized at fair value on a recurring basis in the condensed consolidated balance sheets consisting of cash equivalents, marketable securities and derivative instruments are categorized based upon the level of judgment associated with the inputs used to measure their fair values. Fair value is defined as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.\n8\nFinancial assets and liabilities subject to fair value measurements on a recurring basis and the level of inputs used in such measurements are as follows:\n\n| March 31, 2021 |\n| Total | Level 1 | Level 2 | Level 3 |\n| (in millions) |\n| Financial assets: |\n| Cash equivalents: |\n| Money market funds | $ | 97 | $ | 97 | $ | — | $ | — |\n| Marketable securities: |\n| U.S. Treasury bills | $ | 35 | $ | — | $ | 35 | $ | — |\n| Commercial paper | 62 | — | 62 | — |\n| Corporate bonds | 52 | — | 52 | — |\n| Non-US government | 5 | — | 5 | — |\n| Total marketable securities | $ | 154 | $ | — | $ | 154 | $ | — |\n| Total financial assets | $ | 251 | $ | 97 | $ | 154 | $ | — |\n| Financial liabilities: |\n| Accrued liabilities: |\n| Derivative liabilities | $ | 2 | $ | — | $ | 2 | $ | — |\n| Total financial liabilities | $ | 2 | $ | — | $ | 2 | $ | — |\n\n\n| December 31, 2020 |\n| Total | Level 1 | Level 2 | Level 3 |\n| (in millions) |\n| Financial assets: |\n| Cash equivalents: |\n| Money market funds | $ | 35 | $ | 35 | $ | — | $ | — |\n| U.S. Treasury bills | 30 | — | 30 | — |\n| Commercial paper | 9 | — | 9 | — |\n| Total cash equivalents | $ | 74 | $ | 35 | $ | 39 | $ | — |\n| Marketable securities: |\n| U.S. Treasury bills | $ | 38 | $ | — | $ | 38 | $ | — |\n| Commercial paper | 49 | — | 49 | — |\n| Corporate bonds | 81 | — | 81 | — |\n| Total marketable securities | $ | 168 | $ | — | $ | 168 | $ | — |\n| Prepaid and other current assets: |\n| Derivative assets | $ | 3 | $ | — | $ | 3 | $ | — |\n| Total financial assets | $ | 245 | $ | 35 | $ | 210 | $ | — |\n| Financial liabilities: |\n| Accrued liabilities: |\n| Derivative liabilities | $ | 4 | $ | — | $ | 4 | $ | — |\n| Total financial liabilities | $ | 4 | $ | — | $ | 4 | $ | — |\n\nThe Company classifies cash equivalents and marketable securities within Level 1 or Level 2 because the Company uses quoted market prices or alternative pricing sources and models utilizing market observable inputs to determine their fair value. The derivative asset and liability related to the Company’s foreign currency derivative contracts are classified within Level 2 of the fair value hierarchy as the valuation inputs are based on quoted prices and market observable data of similar instruments in active markets, including currency spot and forward rates.\n9\nThe following table summarizes the contractual maturities of the Company’s marketable securities:\n\n| March 31, | December 31, |\n| 2021 | 2020 |\n| Amortized Cost | Estimated Fair Value | Amortized Cost | Estimated Fair Value |\n| (in millions) |\n| Due within one year | $ | 154 | $ | 154 | $ | 164 | $ | 164 |\n| Due after one year through five years | — | — | 4 | 4 |\n| Total marketable securities | $ | 154 | $ | 154 | $ | 168 | $ | 168 |\n\nAll of the Company’s available-for-sale marketable securities are subject to a periodic evaluation for a credit loss allowance and impairment review. The Company did not identify any of its available-for-sale marketable securities requiring an allowance for credit loss or as other-than-temporarily impaired in any of the periods presented. Additionally, the unrealized net gain and net loss on available-for-sale marketable securities as of March 31, 2021 and December 31, 2020 were immaterial.\nNOTE 4. BALANCE SHEET COMPONENTS\nAccrued Liabilities\nAccrued liabilities consist of the following:\n\n| March 31, | December 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Vendor services | $ | 90 | $ | 121 |\n| Deferred revenue | 26 | 37 |\n| Wish Cash liability | 48 | 48 |\n| Other | 145 | 161 |\n| Total accrued liabilities | $ | 309 | $ | 367 |\n\nNOTE 5. DERIVATIVE FINANCIAL INSTRUMENTS\nThe Company conducts business in certain foreign currencies throughout its worldwide operations, and various entities hold monetary assets or liabilities, earn revenues, or incur costs in currencies other than the entity’s functional currency. As a result, the Company is exposed to foreign exchange gains or losses which impact the Company’s operating results. The Company bills its users based on their local currencies, primarily in U.S. dollars and Euros, and the Company makes payments to the merchants in China for products sold on the Wish platform in Renminbi, which creates exposure to currency rate fluctuations. The Company hedges these cash flow exposures to reduce the risk that its earnings and cash flows will be adversely affected by changes in exchange rates. As part of the Company’s foreign currency risk mitigation strategy, the Company enters into derivative contracts and foreign exchange forward contracts with up to twelve months in duration to hedge exposures for variability in U.S.-dollar equivalent of non-U.S.-dollar denominated cash flows associated with its forecasted revenue related transactions.\nThe Company’s derivatives transactions are not collateralized and do not include collateralization agreements with counterparties. The Company does not use derivative financial instruments for speculative or trading purposes.\n10\nVolume of Derivative Activity\nTotal gross notional amounts for outstanding derivatives (recognized at fair value) as of the end of period consist of the following:\n\n| March 31, 2021 | December 31, 2020 |\n| (in millions) |\n| Cash flow hedges | $ | 250 | $ | 600 |\n| Non-designated hedges | 219 | 422 |\n| Total | $ | 469 | $ | 1,022 |\n\nFair Value of Derivative Financial Instruments\n\n| March 31, 2021 | December 31, 2020 |\n| Assets(1) | Liabilities(2) | Assets(1) | Liabilities(2) |\n| (in millions) |\n| Derivative designated as hedging instruments |\n| Cash flow hedges | $ | — | $ | 2 | $ | 3 | $ | 2 |\n| Derivative not designated as hedging instruments |\n| Foreign currency forward contracts | $ | — | $ | — | $ | — | $ | 2 |\n| Total derivatives | $ | — | $ | 2 | $ | 3 | $ | 4 |\n\n(1) Derivative assets are included in prepaid and other current assets in the condensed consolidated balance sheets.\n(2) Derivative liabilities are included in accrued liabilities in the condensed consolidated balance sheets.\nDerivatives in Cash Flow Hedging Relationships\nThe changes in accumulated other comprehensive income resulting from cash flow hedging were as follows:\n\n| As of March 31, 2021 | As of December 31, 2020 |\n| (in millions) |\n| Balance beginning of the period | $ | 2 | $ | — |\n| Other comprehensive income before reclassifications | 7 | 9 |\n| Amounts recognized in core marketplace revenue and reclassified out of accumulated other comprehensive income | ( 9 | ) | ( 7 | ) |\n| Balance at the end of the period | $ | — | $ | 2 |\n\nThe Company recognizes changes in fair value of the cash flow hedges of foreign currency denominated merchants payable in accumulated other comprehensive loss in its consolidated balance sheets until the forecasted transaction occurs. When the forecasted transaction affects earnings, the Company reclassifies the related gain or loss on the cash flow hedge to core marketplace revenue. All amounts in other comprehensive income at period end are expected to be reclassified to earnings within 12 months. In the event the underlying forecasted transaction does not occur, or it becomes probable that it will not occur, the Company reclassifies the gain or loss on the related cash flow hedge from accumulated other comprehensive loss to core marketplace revenue. For the three months ended March 31, 2021, there were no net gains or losses recognized in core marketplace revenue relating to hedges of forecasted transactions that did not occur. The Company did not have a hedging program during the three months ended March 31, 2020.\nThe Company classifies cash flows related to its cash flow hedges as operating activities in its condensed consolidated statements of cash flows.\nDerivatives Not Designated as Hedging Instruments\nThe net gains on the change in fair value of the Company’s foreign exchange forward contracts not designated as hedging instruments were approximately $ 4 million for the three months ended March 31, 2021 and were recognized in other income (expense), net in the condensed consolidated statement of operations. The Company did not have a hedging program during the three months ended March 31, 2020.\n11\nThe Company classifies cash flows related to its non-designated hedging instruments as operating activities in its condensed consolidated statements of cash flows.\nNOTE 6. OPERATING LEASES\nThe Company leases its facilities and data center co-locations under operating leases with various expiration dates through 2025 .\nTotal operating lease cost was $ 4 million and $ 3 million for the three months ended March 31, 2021 and 2020, respectively. Short-term lease costs and variable lease costs and sublease income were not material.\nAs of March 31, 2021 and December 31, 2020, the Company’s condensed consolidated balance sheets included right-of-use assets in the amount of $ 39 million and $ 43 million, respectively, and lease liabilities in the amount of $ 14 million and $ 14 million in accrued liabilities, respectively, and $ 34 million and $ 38 million in lease liabilities, non-current, respectively.\nAs of March 31, 2021 and December 31, 2020, the weighted-average remaining lease term was 3.7 years and 3.9 years, respectively, and the weighted-average discount rate used to determine the net present value of the lease liabilities was 6 %.\nSupplemental cash flow information for the Company’s operating leases were as follows:\n\n| March 31, | March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Cash paid for amounts included in the measurement of lease liabilities: |\n| Operating cash flows from operating leases | $ | 4 | $ | 3 |\n\nThe maturities of the Company’s operating lease liabilities are as follows:\n\n| March 31, |\n| 2021 |\n| Year ending December 31, | (in millions) |\n| 2021 (remaining nine months) | $ | 12 |\n| 2022 | 15 |\n| 2023 | 11 |\n| 2024 | 10 |\n| 2025 | 5 |\n| Total lease payments | 53 |\n| Less: imputed interest | ( 5 | ) |\n| Present value of lease liabilities | $ | 48 |\n\nNOTE 7. COMMITMENTS AND CONTINGENCIES\nRevolving Credit Facility\nIn November 2020, the Company entered into a five-year $ 280 million senior secured revolving credit facility (the “Revolving Credit Facility”) to, among other things, permit the Company to increase its aggregate commitments by up to $ 100 million, if an accordion option is exercised and provided the Company is able to secure additional lender commitments and satisfy certain other conditions, and to enter into letters of credit from time to time, which reduces its borrowing capacity under the Revolving Credit Facility. Interest on any borrowings under the Revolving Credit Facility accrues at either adjusted LIBOR plus 1.50 % or at an alternative base rate plus 0.50 %, at the Company’s election, and the Company is required to pay a commitment fee that accrues at 0.25 % per annum on the unused portion of the aggregate commitments under the Revolving Credit Facility. The Company is required to pay a fee that accrues at 1.50 % per annum on the average daily amount available to be drawn under any letters of credit outstanding under the Revolving Credit Facility.\n12\nThe Revolving Credit Facility contains customary conditions to borrowing, events of default and covenants, including covenants that restrict the Company’s ability (and the ability of certain of the Company’s subsidiaries) to incur indebtedness, grant liens, make certain fundamental changes and asset sales, make distributions to stockholders, make investments or engage in transactions with affiliates. It also contains a minimum liquidity financial covenant of $ 350 million, which includes unrestricted cash and any available borrowing capacity under the Revolving Credit Facility. The obligations under the Revolving Credit Facility are secured by liens on substantially all of the Company’s domestic assets and are guaranteed by any material domestic subsidiaries, subject to customary exceptions. A standby letter of credit in the amount of approximately $ 10 million has been issued under the Revolving Credit Facility in conjunction with the lease of the Company’s headquarters in San Francisco, California. As of March 31, 2021, the Company had no t made any borrowings under the Revolving Credit Facility and it was in compliance with the related covenants.\nPurchase Obligations\nDuring 2019, the Company amended a marketing arrangement which increased the total commitment under the agreement and extended the arrangement to July 31, 2021. As of March 31, 2021, the remaining commitment under the amended agreement was $ 5 million, which is payable in 2021 .\nEffective September 1, 2019, the Company entered into an amendment to a colocation and cloud services arrangement committing the Company to make payments of $ 120 million for services over 3 years. As of March 31, 2021, the remaining commitment under this amended agreement was approximately $ 35 million and is payable within the next two years .\nLegal Contingencies\nAs of March 31, 2021 and December 31, 2020, there were no legal contingency matters that arose in the ordinary course of business, either individually or in aggregate, that would have a material adverse effect on the financial position, results of operations, or cash flows of the Company. Given the unpredictable nature of legal proceedings, the Company bases its estimate on the information available at the time of the assessment. As additional information becomes available, the Company reassesses the potential liability and may revise the estimate.\nNOTE 8. EQUITY Award activity and STOCK-based compensation\nEquity Award Activity\nA summary of activity under the equity plans and related information is as follows:\n\n| Options Outstanding | RSUs Outstanding |\n| Number of Options | Weighted- Average Exercise Price | Weighted- Average Remaining Contractual Term (In Years) | Number of RSUs |\n| (in millions) | (in millions) |\n| Balances at December 31, 2020 | 75 | $ | 0.234 | 3.2 | 30 |\n| Granted | — | $ | — | 1 |\n| Vested(1) | — | $ | — | ( 3 | ) |\n| Exercised | ( 2 | ) | $ | 0.154 | — |\n| Balances at March 31, 2021(2) | 73 | $ | 0.236 | 3.0 | 28 |\n\n\n| (1) | For the three months ended March 31, 2021, approximately 3 million RSUs vested upon satisfying both the service and liquidity vesting conditions. The shares remained unreleased as of March 31, 2021 due to the lock-up provisions related to the Company’s IPO. |\n\n| (2) | Outstanding RSUs as of March 31, 2021 include 10 million units of CEO Performance Award. |\n\nThe weighted-average grant date fair value of restricted stock units (“RSUs”) granted during the three months ended March 31, 2021 was $ 22.01 per share.\n13\nStock-Based Compensation Expense\nTotal stock-based compensation expense included in the condensed consolidated statements of operations is as follows:\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Cost of revenue | $ | 5 | $ | — |\n| Sales and marketing | 3 | — |\n| Product development | 15 | — |\n| General and administrative | 14 | — |\n| Total stock-based compensation | $ | 37 | $ | — |\n\nThe Company will recognize the remaining $ 134 million and $ 72 million of unrecognized stock-based compensation expense over a weighted-average period of approximately 1.32 years and 3.84 years related to RSUs and CEO Performance Award, respectively.\nEmployee Stock Purchase Plan\nThe Company’s Employee Stock Purchase Plan (“ESPP”) allows eligible employees to purchase shares of the Company’s Class A common stock at a discount through payroll deductions of up to 15 % of eligible compensation, subject to caps of $ 25,000 in any calendar year and 2,500 shares on any purchase date. The ESPP provides for 24 -month offering periods, generally beginning in November and May of each year, and each offering period consists of four six-month purchase periods. The initial offering period began on January 1, 2021 and will end in November 2022. The first purchase under the ESPP will be in May 2021 .\nOn each purchase date, participating employees will purchase Class A common stock at a price per share equal to 85 % of the lesser of the fair market value of the Company’s Class A common stock on (i) the first trading day of the applicable offering period and (2) the last trading day of each purchase period in the applicable offering period. If the stock price of the Company's Class A common stock on any purchase date in an offering period is lower than the stock price on the enrollment date of that offering period, the offering period will immediately reset after the purchase of shares on such purchase date and automatically roll into a new offering period.\nThe Company uses the Black-Scholes option pricing model to determine the fair value of shares to be purchased under the 2020 Employee Stock Purchase Plan (“ESPP”) with the following assumptions on the date of grant:\n\n| Three Months Ended |\n| March 31, 2021 |\n| Expected term (in years) | 0.38 to 1.88 |\n| Risk free interest rate | 0.09% to 0.13% |\n| Volatility | 46.45% to 62.28% |\n| Dividend yield | — |\n| Estimated fair value per ESPP share | $4.14 to $8.05 |\n\nNOTE 9. INCOME TAXES\nThe Company’s tax provision for the interim periods is determined using an estimate of the annual effective tax rate, adjusted for discrete items, if any, that arise during the period. Each quarter, the Company assesses its estimate of the annual effective tax rate, and if the estimated annual effective tax rate changes, the Company makes a cumulative adjustment in the period of change.\nThe Company’s quarterly tax provision and the estimate of the annual effective tax rate is subject to fluctuation due to several factors, including variability in pre-tax earnings, the geographic distribution of the pre-tax earnings, tax law\n14\nchanges, non-deductible expenses, such as stock-based compensation, and changes in the estimate of the valuation allowance.\nThe provision for income taxes was $ 2 million for the three months ended March 31, 2021 and was insignificant for the three months ended March 31, 2020. The year-over-year increase in provision for income taxes was primarily related to international operations. The Company continues to maintain a valuation allowance on its domestic net deferred tax assets which is excluded from the annual effective tax rate estimate.\nThe Company had immaterial unrecognized tax benefits as of March 31, 2021 and December 31, 2020, fully offset by a valuation allowance. These unrecognized tax benefits, if recognized, would no t affect the effective tax rate. No interest or penalties were incurred during the years ended March 31, 2021 and 2020.\nThe Company files income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions. The Company is not currently under examination by income tax authorities in federal, state or other jurisdictions. All tax returns will remain open for examination by the federal and state authorities for three and four years , respectively, from the date of utilization of any net operating loss or credits. Certain tax years are subject to foreign income tax examinations by tax authorities until the statute of limitations expire.\n15\nNOTE 10. Net loss per share\nBasic net income (loss) per share is computed using the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is computed by giving effect to potentially dilutive common stock equivalents outstanding during the period, as their effect would be dilutive. Potentially dilutive common shares include participating securities and shares issuable upon the exercise of stock options, the exercise of common stock warrants, the vesting of RSUs and each purchase under the 2020 ESPP, under the treasury stock method.\nIn loss periods, basic net loss per share and diluted net loss per share are the same, as the effect of potential common shares is anti-dilutive and therefore excluded.\nThe rights, including the liquidation and dividend rights, of the holders of Class A and Class B common stock are identical, except with respect to voting. As the liquidation and dividend rights are identical, the Company’s undistributed earnings or losses are allocated on a proportionate basis among the holders of both Class A and Class B common stock. As a result, the net income (loss) per share attributed to common stockholders will, therefore, be the same for both Class A and Class B common stock on an individual or combined basis.\nThe following table sets forth the computation of basic and diluted net loss per share:\n\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (in millions, except per share data) |\n| Numerator: |\n| Net loss | $ | ( 128 | ) | $ | ( 66 | ) |\n| Denominator: |\n| Weighted-average shares used in computing net loss per share, basic and diluted | 619 | 106 |\n| Net loss per share, basic and diluted | $ | ( 0.21 | ) | $ | ( 0.62 | ) |\n\nThe following outstanding shares of potentially dilutive securities were excluded from the computation of diluted net loss per share because including them would have had an anti-dilutive effect:\n\n| As of March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Redeemable convertible preferred stock, all series | — | 422 |\n| Series B warrant | — | 10 |\n| Warrant to purchase common stock | 1 | 1 |\n| Common stock options outstanding | 73 | 77 |\n| Unvested RSUs outstanding(1) | 28 | 44 |\n| Employee Stock Purchase Plan | 1 | — |\n| Total | 103 | 554 |\n\n\n| (1) | Unvested RSUs outstanding as of March 31, 2021 included 10 million units of CEO Performance Award. |\n\n16\nNOTE 11. GEOGRAPHICAL INFORMATION\nThe Company believes it is relevant to disclose geographical revenue information on both a demand basis, determined by the ship-to address of the user, and on a supply basis, determined by the location of the merchants’ operations.\nCore marketplace revenue by geographic area based on the ship-to address of the user is as follows:\n\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Europe | $ | 235 | 49 | % | $ | 159 | 47 | % |\n| North America(1) | 186 | 39 | % | 126 | 37 | % |\n| South America | 18 | 4 | % | 23 | 7 | % |\n| Other | 38 | 8 | % | 32 | 9 | % |\n| Core marketplace revenue | $ | 477 | 100 | % | $ | 340 | 100 | % |\n\n\n| (1) | United States accounted for $ 156 million and $ 103 million of core marketplace revenue for the three months ended March 31, 2021 and 2020, respectively. |\n\nChina accounted for substantially all of marketplace and logistics revenue during the three months ended March 31, 2021 and 2020 based on the location of the merchants’ operations.\nThe Company’s long-lived tangible assets, which consist of property and equipment, net and operating lease right-of-use assets, net, located in the United States were 87 % of the total long-lived tangible assets as of March 31, 2021 and December 31, 2020. The long-lived tangible assets outside the United States were located in China, Canada and the Netherlands.\n17\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nThe following discussion and analysis of our financial condition, results of operations and cash flows should be read in conjunction with (1) the unaudited condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q and (2) the audited condensed consolidated financial statements and notes thereto and management’s discussion and analysis of financial condition and results of operations for the year ended December 31, 2020 included in our Annual Report on Form 10-K filed on March 25, 2021. This discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under the heading \"Risk Factors\" in Part I, Item 1A of our Annual Report on Form 10-K for our year ended December 31, 2020. See also \"Special Note Regarding Forward-Looking Statements\" above.\nFinancial Results for the Three Months Ended March 31, 2021\n| • | Total revenue was $772 million, an increase of 75% year-over-year. |\n\n| • | Total cost of revenue and expenses were $898 million, including stock-based compensation expense of $37 million and $7 million of employer payroll taxes related to stock-based compensation. |\n\n| • | Loss from operations was $126 million. |\n\n| • | Net loss was $128 million. |\n\n| • | Adjusted EBITDA was a loss of $79 million or 10% of total revenue. |\n\n| • | Cash and cash equivalents and marketable securities were $1.8 billion. |\n\nAs of March 31, 2021, we had an accumulated deficit of $2.3 billion. We expect losses from operations to continue for the foreseeable future as we incur costs and expenses related to brand development, expansion of market share, continued development of our mobile shopping marketplace infrastructure and development of other businesses.\nCOVID-19\nThe outbreak of coronavirus disease 2019 (“COVID-19”) has affected businesses worldwide, as of the date of filing of this Quarterly Report, and continues to impact the major markets in which we operate. The COVID-19 pandemic has resulted in significant governmental measures being implemented to control the spread of the virus, and our operations as well as the operations of our third-party merchants and users have been and will continue to be disrupted by varying individual and governmental responses to COVID-19 around the world, such as business shutdowns, stay-at-home directives, travel restrictions, border closures, and other travel or health-related restrictions as well as by absenteeism, quarantines, self-isolations, office and factory closures, delays on deliveries, and disruptions to ports and other freight infrastructure. These restrictions may cause consumers and businesses to reduce their activities and their spending, have caused a slowdown in the global economy and have had, and may continue to have, a negative impact on our operations. If these conditions continue, sales volumes may decrease and we may, among other issues, experience or continue to experience delays in product development, a decreased ability to support our merchants, disruptions in sales, delivery and logistics, each of which could have a negative impact on our ability to meet shipment commitments and on our revenue and profitability.\nOur Financial Model\nOur business benefits from powerful network effects, fueled by our data advantage and massive scale. As more users join Wish, attracted by our affordable value proposition and shopping experience, we are able to increase revenue potential for our merchants. As more merchants succeed on Wish, more merchants join the platform and grow their businesses with Wish, broadening our product selection, which in turn improves user experience. By developing a strategy focused on users and merchants, we align user and merchant success with the success of our financial model. The growth in users and merchants generates more data, further strengthens our data advantage and creates an even better experience for everyone on our platform, in turn attracting more users and high-quality merchants.\nOur model relies on cost-effectively adding new users, converting those users into buyers and improving engagement and monetization of those buyers on Wish over time as well as adding new merchants, delivering economic success for those merchants, and having those merchants use more of our end-to-end platform.\n18\nKey Financial and Performance Metrics\nIn addition to the measures presented in our condensed consolidated financial statements, we monitor the following key metrics and other financial information to measure our performance, identify trends affecting our business, and make strategic decisions.\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| MAU | 101 | 109 |\n| LTM Active Buyers | 61 | 63 |\n| Adjusted EBITDA | $ | (79 | ) | $ | (51 | ) |\n| Adjusted EBITDA Margin | (10 | )% | (12 | )% |\n| Free Cash Flow | $ | (354 | ) | $ | (129 | ) |\n\nMonthly Active Users\nWe define MAUs as the number of unique users that visited the Wish platform, either on our mobile app, mobile web, or on a desktop, during the month. MAUs for a given reporting period equal the average of the MAUs for that period. An active user is identified by a unique email-address; a single person can have multiple user accounts via multiple email addresses. The change in MAUs in a reported period captures both the inflow of new users as well as the outflow of existing users who did not visit the platform in a given month. We view the number of MAUs as key driver of revenue growth as well as a key indicator of user engagement and awareness of our brand.\nMAUs decreased approximately 7% from the three months ended March 31, 2020 to the three months ended March 31, 2021, primarily driven by the decision to de-emphasize user acquisition in some emerging markets outside of Europe and North America where we faced logistical challenges due to the pandemic and to emphasize higher LTV users within the same value-conscious consumer category in many of the more developed markets.\nLTM Active Buyers\nAs of the last date of each reported period, we determine our number of unique active buyers by counting the total number of individual users who have placed at least one order on the Wish platform, either on our mobile app, mobile web, or on a desktop, during the preceding 12 months. We, however, exclude from the computation those buyers whose order is cancelled before the item is shipped and the purchase price is refunded. The number of Active Buyers is an indicator of our ability to attract and monetize a large user base to our platform and of our ability to convert visits into purchases. We believe that increasing our Active Buyers will be a significant driver to our future revenue growth.\nLTM Active Buyers decreased approximately 3% from the three months ended March 31, 2020 to the three months ended March 31, 2021, primarily due to our actions to de-emphasize low value items, which tend to have high conversion rates but unfavorable economics.\nA Note About Metrics\nThe numbers for some of our metrics, including MAUs, are calculated and tracked with internal tools, which are not independently verified by any third party. We use these metrics to assess the growth and health of our overall business. While these numbers are based on what we believe to be reasonable estimates of our user or merchant base for the applicable period of measurement, there are inherent challenges in measurement as the methodologies used require significant judgment and may be susceptible to algorithm or other technical errors. In addition, we regularly review and adjust our processes for calculating metrics to improve their accuracy, and our estimates may change due to improvements or changes in technology or our methodology.\n19\nNon-GAAP Financial Measures\nAdjusted EBITDA and Adjusted EBITDA Margin\nWe provide Adjusted EBITDA, a non-GAAP financial measure that represents our net income (loss) adjusted to exclude; interest and other income (expense), net (which includes foreign exchange gain or loss, foreign exchange forward contracts gain or loss and gain or loss on one-time non-operating transactions); provision or benefit for income taxes;, depreciation and amortization; stock-based compensation expense and related payroll taxes; remeasurement of redeemable convertible preferred stock warrant liability and other items. Additionally, we provide Adjusted EBITDA Margin, a non-GAAP financial measure that represents Adjusted EBITDA divided by revenue. Below is a reconciliation of Adjusted EBITDA to net loss, the most directly comparable GAAP financial measure.\nWe have included Adjusted EBITDA and Adjusted EBITDA Margin in this report because they are key measures used by our management and board of directors to understand and evaluate our operating performance and trends and how we are allocating internal resources, to prepare and approve our annual budget and to develop short- and long-term operating plans. We also believe that the exclusion of certain items in calculating Adjusted EBITDA can provide a useful measure for period-to-period comparisons of our business as it removes the impact of non-cash items and certain variable charges.\nAdjusted EBITDA has limitations as an analytical measure, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are:\n| • | although depreciation and amortization are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future, and Adjusted EBITDA does not reflect cash capital expenditure requirements for such replacements or for new capital expenditure requirements; |\n\n| • | Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs; |\n\n| • | Adjusted EBITDA does not consider the impact of stock-based compensation and related payroll taxes; |\n\n| • | Adjusted EBITDA does not reflect tax payments that may represent a reduction in cash available to us; and |\n\n| • | other companies, including companies in our industry, may calculate Adjusted EBITDA differently, which reduces its usefulness as a comparative measure. |\n\nBecause of these limitations, you should consider Adjusted EBITDA and Adjusted EBITDA Margin alongside other financial performance measures, including various cash flow metrics, net income (loss) and our other GAAP results.\nThe following table reflects the reconciliation of net loss to Adjusted EBITDA and net loss as a percentage of revenue to Adjusted EBITDA margin for each of the periods indicated:\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Revenue | $ | 772 | $ | 440 |\n| Net loss | (128 | ) | (66 | ) |\n| Net loss as a percentage of revenue | (17 | )% | (15 | )% |\n| Excluding: |\n| Interest and other expense (income), net | — | (3 | ) |\n| Provision for income taxes | 2 | — |\n| Depreciation and amortization | 2 | 2 |\n| Stock-based compensation expense | 37 | — |\n| Employer payroll taxes related to stock-based compensation expense | 7 | — |\n| Remeasurement of redeemable convertible preferred stock warrant liability | — | 15 |\n| Recurring other items | 1 | 1 |\n| Adjusted EBITDA | $ | (79 | ) | $ | (51 | ) |\n| Adjusted EBITDA margin | (10 | )% | (12 | )% |\n\n20\nFree Cash Flow\nWe also provide Free Cash Flow, a non-GAAP financial measure that represents net cash provided by (used in) operating activities less purchases of property and equipment. We believe that Free Cash Flow is an important measure since we use third parties to host our services and therefore we do not incur significant capital expenditures to support revenue generating activities.\nFree Cash Flow has limitations as an analytical measure, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are:\n| • | it is not a substitute for net cash provided by (used in) operating activities; |\n\n| • | other companies may calculate Free Cash Flow or similarly titled non-GAAP measures differently or may use other measures to evaluate their performance, all of which could reduce the usefulness of free cash flow as a tool for comparison; and |\n\n| • | the utility of free cash flow is further limited as it does not reflect our future contractual commitments and does not represent the total increase or decrease in our cash balance for any given period. |\n\nBecause of these limitations, you should consider Free Cash Flow alongside other financial performance measures, such as net cash provided by (used in) operating activities, net income (loss) and our other GAAP results.\nThe following table reflects the reconciliation of net cash provided by (used in) operating activities to Free Cash Flow for each of the periods indicated:\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Cash used in operating activities | $ | (354 | ) | $ | (129 | ) |\n| Less: |\n| Purchases of property and equipment | — | — |\n| Free Cash Flow | $ | (354 | ) | $ | (129 | ) |\n\nResults of Operations\nThe following table shows our results of operations for the periods presented and express the relationship of certain line items as a percentage of revenue for those periods. The period-to-period comparison of financial results is not necessarily indicative of future results.\n\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Revenue | $ | 772 | $ | 440 |\n| Cost of revenue(1) | 335 | 156 |\n| Gross profit | 437 | 284 |\n| Operating expenses: |\n| Sales and marketing(1) | 470 | 295 |\n| Product development(1) | 51 | 25 |\n| General and administrative(1) | 42 | 18 |\n| Total operating expenses | 563 | 338 |\n| Loss from operations | (126 | ) | (54 | ) |\n| Other income (expense), net |\n| Interest and other income, net | — | 3 |\n| Remeasurement of convertible preferred stock warrant liability | — | (15 | ) |\n| Loss before provision for income taxes | (126 | ) | (66 | ) |\n| Provision for income taxes | 2 | — |\n| Net loss | $ | (128 | ) | $ | (66 | ) |\n\n21\n\n| (1) | Includes stock-based compensation expense as follows: |\n\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Cost of revenue | $ | 5 | $ | — |\n| Sales and marketing | 3 | — |\n| Product development | 15 | — |\n| General and administrative | 14 | — |\n| Total stock-based compensation | $ | 37 | $ | — |\n\nThe following table presents the components of our condensed consolidated statements of operations as a percentage of revenue:\n\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| Revenue | 100 | % | 100 | % |\n| Cost of revenue | 43 | % | 35 | % |\n| Gross profit | 57 | % | 65 | % |\n| Operating expenses: |\n| Sales and marketing | 61 | % | 67 | % |\n| Product development | 7 | % | 6 | % |\n| General and administrative | 6 | % | 4 | % |\n| Total operating expenses | 74 | % | 77 | % |\n| Loss from operations | (17 | )% | (12 | )% |\n| Other income (expense), net: |\n| Interest and other income (expense), net | — | 1 | % |\n| Remeasurement of convertible preferred stock warrant liability | — | (3 | )% |\n| Loss before provision for income taxes | (17 | )% | (15 | )% |\n| Provision for income taxes | — | — |\n| Net loss | (17 | )% | (15 | )% |\n\nComparison of Three Months Ended March 31, 2021 and March 31, 2020\nRevenue\n\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | $ | % |\n| (in millions) |\n| Core marketplace revenue(1) | $ | 477 | $ | 340 | $ | 137 | 40 | % |\n| ProductBoost revenue | 50 | 44 | 6 | 14 | % |\n| Marketplace revenue | 527 | 384 | 143 | 37 | % |\n| Logistics revenue | 245 | 56 | 189 | 338 | % |\n| Revenue | $ | 772 | $ | 440 | $ | 332 | 75 | % |\n\n\n| (1) | Core marketplace revenue for the three months ended March 31, 2021 included approximately $9 million net gains from our cash flow hedging program. We did not have a hedging program during the three months ended March 31, 2020. |\n\nRevenue increased $332 million, or 75%, to $772 million for the three months ended March 31, 2021 as compared to $440 million for the three months ended March 31, 2020. This increase was attributable to both increased marketplace and logistics revenue.\n22\nMarketplace revenue increased $143 million, or 37% to $527 million for the three months ended March 31, 2021, as compared to $384 million for the three months ended March 31, 2020. This increase was primarily due to our efforts to improve buyer monetization and lower refunds. This increase was also partially driven by increased merchant utilization of our ProductBoost service.\nLogistics revenue increased $189 million, or 338% to $245 million for the three months ended March 31, 2021, as compared to $56 million for the three months ended March 31, 2020. This increase was primarily due to accelerated merchant adoption of our logistics offerings, as well as the expansion of our A+ program, in which Wish manages first mile collection from merchants to warehousing operations all the way to last mile delivery to the buyer.\nCost of Revenue and Gross Margin\n\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | $ | % |\n| (in millions) |\n| Cost of revenue | $ | 335 | $ | 156 | $ | 179 | 115 | % |\n| Percentage of revenue | 43 | % | 35 | % |\n| Gross Margin | 57 | % | 65 | % |\n\nCost of revenue increased $179 million, or 115%, to $335 million for the three months ended March 31, 2021, as compared to $156 million for the three months ended March 31, 2020, primarily due to costs related to the increased volume of logistics services provided and increased headcount. The increase was also driven by a $6 million stock-based compensation expense and related employer payroll taxes that we recognized in connection with the settlement of vested RSUs for our employees involved in infrastructure, merchant support, and logistics functions.\nThe gross margin decreased to 57% for the three months ended March 31, 2021 from 65% for the three months ended March 31, 2020, primarily due to increased volume of logistics services provided and the fact that logistics gross margin was at significantly lower rate than marketplace gross margin.\nSales and Marketing\n\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | $ | % |\n| (in millions) |\n| Sales and marketing | $ | 470 | $ | 295 | $ | 175 | 59 | % |\n| Percentage of revenue | 61 | % | 67 | % |\n\nSales and marketing expense increased $175 million, or 59%, to $470 million for the three months ended March 31, 2021, compared to $295 million for the three months ended March 31, 2020. The increase in sales and marketing expenses consisted primarily of incremental digital advertising spend associated with increased pricing from our largest vendors. To a lesser extent, the increase was also driven by a $4 million stock-based compensation expense and related employer payroll taxes that we recognized in connection with the settlement of vested RSUs, for our employees involved in marketing, user support, and business development functions. We anticipate that sales and marketing expenses will continue to be our most significant operating expense in the future and our overall profitability will depend on the success of our investments in sales and marketing.\nProduct Development\n\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | $ | % |\n| (in millions) |\n| Product development | $ | 51 | $ | 25 | $ | 26 | 104 | % |\n| Percentage of revenue | 7 | % | 6 | % |\n\nProduct development expense increased $26 million, or 104%, to $51 million for the three months ended March 31, 2021, as compared to $25 million for the three months ended March 31, 2020, primarily as a result of an increase in\n23\nemployee-related costs driven by increased headcount and an $18 million stock-based compensation expense and related employer payroll taxes that we recognized in connection with the settlement of vested RSUs, for our employees involved in product development activities. The increase was also, to a lesser extent, driven by expenses associated with data warehousing, processing and analytics.\nGeneral and Administrative\n\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | $ | % |\n| (in millions) |\n| General and administrative | $ | 42 | $ | 18 | $ | 24 | 133 | % |\n| Percentage of revenue | 6 | % | 4 | % |\n\nGeneral and administrative expense increased $24 million, or 133%, to $42 million for the three months ended March 31, 2021, as compared to $18 million for the three months ended March 31, 2020. The increase was primarily related to a $16 million stock-based compensation expense and related employer payroll taxes that we recognized in connection with the settlement of vested RSUs and increases in expenses associated with being a publicly listed company.\nRemeasurement of Redeemable Convertible Preferred Stock Warrant Liability\n\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | $ | % |\n| (in millions) |\n| Remeasurement of redeemable convertible preferred stock warrant liability | $ | — | $ | (15 | ) | $ | 15 | (100 | )% |\n| Percentage of revenue | — | (3 | )% |\n\nThe $15 million expense that we recognized during the three months ended March 31, 2020 was related to the change in fair value of the redeemable convertible preferred stock warrant liability. There was no remeasurement charge recognized during the three months ended March 31, 2021 because immediately prior to the completion of our IPO in December 2020, the outstanding redeemable convertible preferred stock warrant was net exercised. The fair value of the warrant at the time of exercise was reclassified into the Company’s Class A common stock and additional paid-in capital.\nProvision for Income Taxes\n\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | $ | % |\n| (in millions) |\n| Provision for income taxes | $ | 2 | $ | — | $ | 2 | — |\n| Percentage of revenue | — | — |\n\nProvision for income taxes increased $2 million for the three months ended March 31, 2021 compared to the three months ended March 31, 2020. The change in provision for income taxes was due primarily to an increase of taxes for our international operations.\nLiquidity and Capital Resources\nAs of March 31, 2021, we had cash, cash equivalents and marketable securities of $1.8 billion, a majority of which were held in cash deposits and money market funds, and were held for working capital purposes. We believe that our existing cash, cash equivalents and marketable securities will be sufficient to meet our anticipated cash needs for at least the next 12 months. Additional future financing may be necessary to fund our operations and there can be no assurance that, if needed, we will be able to secure additional debt or equity financing on terms acceptable to us or at all, especially in light of the market volatility and uncertainty as a result of the COVID-19 pandemic. Although we believe we have adequate sources of liquidity over the long term, the success of our operations, the global economic outlook, and the pace of\n24\nsustainable growth in our markets, in each case, in light of the market volatility and uncertainty as a result of the COVID-19 pandemic, among other factors, could impact our business and liquidity.\nNovember 2020 Credit Facility\nIn November 2020, we entered into the Revolving Credit Facility which enables us to borrow up to $280 million. The Revolving Credit Facility contains an accordion option which, if exercised and provided we are able to secure additional lender commitments and satisfy certain other conditions, would allow us to increase the aggregate commitments by up to $100 million. As of March 31, 2021, we had not made any borrowings under the Revolving Credit Facility. Refer to Note 7 to our condensed consolidated financial statements in Item 1 of Part I, “Financial Information” for additional details related to the Revolving Credit Facility.\nCash Flows\n\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Cash provided by (used in): |\n| Operating activities | $ | (354 | ) | $ | (129 | ) |\n| Investing activities | 14 | 59 |\n| Financing activities | (5 | ) | 1 |\n\nNet Cash Provided by (Used in) Operating Activities\nOur cash flows from operations are largely dependent on the amount of revenue we generate. Net cash provided by operating activities in each period presented has been influenced by changes in funds receivable, prepaid expenses, and other current and noncurrent assets, accounts payable, merchants payable, accrued and refund liabilities, lease liabilities, and other current and noncurrent liabilities.\nNet cash used in our operating activities for the three months ended March 31, 2021 was $354 million. This was primarily driven by our net loss of $128 million and $266 million unfavorable net working capital changes, which was partially offset by non-cash expenses, such as stock-based compensation expense of $37 million. Unfavorable working capital movement was mainly driven by accounts payable and merchants payable. Accounts payable decreased by $143 million primarily due to shorter vendor payment terms. Due to the COVID-19 pandemic, we were able to negotiate favorable payment terms with certain key digital advertising partners (45 days and 60 days). The payment terms with these key digital advertising partners reverted back to 30 days when the favorable terms expired on December 31, 2020. Merchants payable decreased by $73 million primarily driven by lower volumes in the first quarter of 2021 compared to the fourth quarter of 2020 due to seasonality and higher percentage of shipments through our A+ program which accelerated the payment of merchants payable due to higher delivery confirmation rates. Other decreases in unfavorable working capital movement were driven by refunds and accrued liabilities.\nNet cash used in our operating activities for the three months ended March 31, 2020 was $129 million. This was primarily driven by our net loss of $66 million and a $122 million decrease in merchants payable, which was partially offset by non-cash expenses, such as the remeasurement of redeemable convertible preferred stock warrant liability of $15 million, which was further offset by a $31 million increase in accounts payable.\nNet Cash Provided by (Used in) Investing Activities\nOur primary investing activities have consisted of investing excess cash balances in marketable securities.\nNet cash provided by investing activities was $14 million for the three months ended March 31, 2021. This was primarily due to $67 million of maturities of marketable securities, partially offset by $53 million purchases of marketable securities.\nNet cash generated from investing activities was $59 million for the three months ended March 31, 2020. This was primarily due to $132 million maturities of marketable securities, partially offset by $73 million purchases of marketable securities.\n25\nNet Cash Provided by (Used in) Financing Activities\nNet cash used in our financing activities was $5 million for the three months ended March 31, 2021 primarily due to tax payments related to RSU settlement.\nNet cash provided by financing activities was $1 million for the three months ended March 31, 2020 and was related to proceeds from stock option exercises.\nOff Balance Sheet Arrangements\nFor the three months ended March 31, 2021 and 2020, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.\nContingencies\nWe are involved in claims, lawsuits, government investigations, and proceedings arising from the ordinary course of our business. We record a provision for a liability when we believe that it is both probable that a liability has been incurred, and the amount can be reasonably estimated. Significant judgment is required to determine both probability and the estimated amount. Such legal proceedings are inherently unpredictable and subject to significant uncertainties, some of which are beyond our control. Should any of these estimates and assumptions change or prove to be incorrect, it could have a material impact on our results of operations, financial position, and cash flows.\nCritical Accounting Policies\nThe preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate our estimates, including those listed below. We base our estimates on historical facts and various other assumptions that we believe to be reasonable at the time the estimates are made. Actual results could differ from those estimates.\nOur critical accounting policies are as follows:\n| • | Revenue recognition; |\n\n| • | Operating lease obligations; |\n\n| • | Stock-based compensation; and |\n\n| • | Income taxes. |\n\nOur critical accounting policies are important to the portrayal of our financial condition and results of operations, and require us to make judgments and estimates about matters that are inherently uncertain.\nThere have been no material changes to our critical accounting policies and estimates as compared to those described in our Annual Report on Form 10-K for the year ended December 31, 2020, filed with the SEC on March 25, 2021.\nRecent Accounting Pronouncements\nSee Note 1 of Part I, Item 1 of this Quarterly Report on Form 10-Q for a full description of recent accounting pronouncements.\nItem 3. Quantitative and Qualitative Disclosures About Market Risk.\nWe have operations both within the U.S. and internationally, and we are exposed to market risks in the ordinary course of our business, including the effects of interest rate changes and foreign currency fluctuations. Information relating to quantitative and qualitative disclosures about these market risks is described below.\n26\nInterest Rate Sensitivity\nCash, cash equivalents and marketable securities as of March 31, 2021 were held primarily in cash deposits and money market funds. The fair value of our cash, cash equivalents, and investments would not be significantly affected by either an increase or decrease in interest rates due mainly to the short-term nature of these instruments. A 100 basis point increase or decrease in our current interest rates would have increased or decreased our interest income by $18 million for the three months ended March 31, 2021.\nForeign Currency Risk\nWe transact business in various foreign countries and are, therefore, subject to risk of foreign currency exchange rate fluctuations. We have established a foreign currency risk management policy to provide process and procedures for managing this risk. We use natural hedging techniques first to net off existing foreign currency exposures. For the remaining exposure, we may enter into short term foreign currency derivative contracts, including forward contracts to hedge exposures associated with monetary assets and liabilities, mainly merchants payable, and cash flows denominated in non-functional currencies.\nThe credit risk of our foreign currency derivative contracts is minimized since contracts are not concentrated with any one financial institution and all contracts are only placed with large financial institutions. The gains and losses on foreign currency derivative contracts generally offset the losses and gains on the assets, liabilities and transactions hedged. The fair value of currency derivative contracts is reported in the condensed consolidated balance sheets. The majority of these foreign exchange contracts expire in less than three months and all expire within one year. Refer to Note 5 to our condensed consolidated financial statements in Item 1 of Part I, “Financial Statements” for more information related to our derivative financial instruments.\nBased on our overall currency rate exposures as of March 31, 2021, including the derivative financial instruments intended to hedge the nonfunctional currency-denominated monetary assets, liabilities and cash flows, and other factors, a 10% appreciation or depreciation of the U.S. dollar from its cross-functional rates would not be expected, in the aggregate, to have a material effect on our financial position, results of operations and cash flows in the near-term.\nInflation Risk\nWe do not believe that inflation has had a material effect on our business, financial condition, or results of operations.\nItem 4. Controls and Procedures.\nEvaluation of Disclosure Controls and Procedures\nUnder the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, as of the end of the period covered by this report. Based on management’s evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective at a reasonable assurance level.\nIn designing and evaluating our disclosure controls and procedures, management recognizes that any disclosure controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting identified in connection with the evaluation required by Rules 13a-15(d) and 15d-15(d) of the Exchange Act that occurred during the three months ended March 31, 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n27\nPART II—OTHER INFORMATION\nItem 1. Legal Proceedings.\nInformation with respect to this item may be found in Note 7, Commitments and Contingencies, in our Notes to Unaudited Condensed Consolidated Financial Statements included in Part I, Item 1, of this Quarterly Report on Form 10-Q, which information is incorporated herein by reference.\nItem 1A. Risk Factors.\nYou should carefully consider the risks and uncertainties described under the heading \"Risk Factors\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2020 (the \"2020 Form 10-K\"), together with all of the other information contained in this Quarterly Report on Form 10-Q, including our condensed consolidated financial statements and related notes, before making a decision to invest in our Class A common stock. Additional risks and uncertainties that we are unaware of, or that we currently believe are not material, may also become important factors that affect our business. These risk factors could materially and adversely affect our business, financial condition and results of operations, and the market price of our ordinary shares could decline. These risk factors do not identify all risks that we face – our operations could also be affected by factors that are not presently known to us or that we currently consider to be immaterial to our operations. Due to risks and uncertainties, known and unknown, our past financial results may not be a reliable indicator of future performance and historical trends should not be used to anticipate results or trends in future periods. There have been no additional material changes from the risks and uncertainties previously disclosed under the \"Risk Factors\" section in our 2020 Form 10-K.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\n(a) Unregistered Sales of Equity Securities\nNone\n(b) Use of Proceeds\nOur IPO of Class A common stock was effected through a Registration Statement on Form S-1 (File Nos. 333-250531), which was declared or became effective on December 15, 2020. There has been no material change in the use of proceeds from our IPO as described in our final prospectus dated December 15, 2020 filed with the Securities and Exchange Commission, or SEC, pursuant to Rule 424(b) of the Securities Act of 1933, as amended, or the Securities Act.\nItem 6. Exhibits.\n\n| Exhibit Number | Description |\n| 31.1* | Certification of Principal Executive Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2* | Certification of Principal Financial Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32.1** | Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 32.2** | Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 101.INS* | Inline XBRL Instance Document – the instance document does not appear in the Interactive Data File because XBRL tags are embedded within the Inline XBRL document. |\n| 101.SCH* | Inline XBRL Taxonomy Extension Schema Document |\n| 101.CAL* | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF* | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB* | Inline XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE* | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104* | Cover Page Interactive Data File (embedded within the Inline XBRL document) |\n\n\n| * | Filed herewith. |\n\n| ** | Furnished herewith. |\n\n28\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| ContextLogic Inc. |\n| Date: May 12, 2021 | By: | /s/ Rajat Bahri |\n| Rajat Bahri |\n| Chief Financial Offer |\n| (Principal Financial Officer) |\n\n29\n</text>\n\nWhat is the change in percentage of net loss from the three months ended March 31, 2020 to that ended March 31, 2021?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1 - Condensed Consolidated Financial Statements (unaudited)\nAlbertsons Companies, Inc. and Subsidiaries\nCondensed Consolidated Balance Sheets\n(in millions, except share data)\n(unaudited)\n| September 11,2021 | February 27,2021 |\n| ASSETS |\n| Current assets |\n| Cash and cash equivalents | $ | 2,849.8 | $ | 1,717.0 |\n| Receivables, net | 544.7 | 550.9 |\n| Inventories, net | 4,179.1 | 4,301.3 |\n| Other current assets | 414.7 | 418.8 |\n| Total current assets | 7,988.3 | 6,988.0 |\n| Property and equipment, net | 9,201.1 | 9,412.7 |\n| Operating lease right-of-use assets | 5,861.3 | 6,015.6 |\n| Intangible assets, net | 2,181.3 | 2,108.8 |\n| Goodwill | 1,200.2 | 1,183.3 |\n| Other assets | 912.1 | 889.6 |\n| TOTAL ASSETS | $ | 27,344.3 | $ | 26,598.0 |\n| LIABILITIES |\n| Current liabilities |\n| Accounts payable | $ | 3,554.2 | $ | 3,487.3 |\n| Accrued salaries and wages | 1,492.3 | 1,474.7 |\n| Current maturities of long-term debt and finance lease obligations | 211.5 | 212.4 |\n| Current maturities of operating lease obligations | 621.7 | 605.3 |\n| Other current liabilities | 1,190.0 | 1,052.5 |\n| Total current liabilities | 7,069.7 | 6,832.2 |\n| Long-term debt and finance lease obligations | 8,129.1 | 8,101.2 |\n| Long-term operating lease obligations | 5,464.1 | 5,548.0 |\n| Deferred income taxes | 598.3 | 533.7 |\n| Other long-term liabilities | 2,524.1 | 2,659.5 |\n| Commitments and contingencies |\n| Series A convertible preferred stock, $ 0.01 par value; 1,750,000 shares authorized, 924,000 shares issued and outstanding as of September 11, 2021 and February 27, 2021 | 844.3 | 844.3 |\n| Series A-1 convertible preferred stock, $ 0.01 par value; 1,410,000 shares authorized, 826,000 shares issued and outstanding as of September 11, 2021 and February 27, 2021 | 754.8 | 754.8 |\n| STOCKHOLDERS' EQUITY |\n| Undesignated preferred stock, $ 0.01 par value; 96,840,000 shares authorized, no shares issued as of September 11, 2021 and February 27, 2021 | — | — |\n| Class A common stock, $ 0.01 par value; 1,000,000,000 shares authorized, 586,668,103 and 585,574,666 shares issued as of September 11, 2021 and February 27, 2021, respectively | 5.9 | 5.9 |\n| Class A-1 convertible common stock, $ 0.01 par value; 150,000,000 shares authorized, no shares issued as of September 11, 2021 and February 27, 2021 | — | — |\n| Additional paid-in capital | 1,936.1 | 1,898.9 |\n| Treasury stock, at cost, 120,009,647 shares held as of September 11, 2021 and February 27, 2021 | ( 1,907.0 ) | ( 1,907.0 ) |\n| Accumulated other comprehensive income | 78.7 | 63.5 |\n| Retained earnings | 1,846.2 | 1,263.0 |\n| Total stockholders' equity | 1,959.9 | 1,324.3 |\n| TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY | $ | 27,344.3 | $ | 26,598.0 |\n\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\n3\nAlbertsons Companies, Inc. and SubsidiariesCondensed Consolidated Statements of Operations and Comprehensive Income (in millions, except per share data)(unaudited)\n| 12 weeks ended | 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Net sales and other revenue | $ | 16,505.7 | $ | 15,757.6 | $ | 37,775.1 | $ | 38,509.2 |\n| Cost of sales | 11,788.7 | 11,182.7 | 26,867.1 | 27,162.8 |\n| Gross profit | 4,717.0 | 4,574.9 | 10,908.0 | 11,346.4 |\n| Selling and administrative expenses | 4,231.3 | 4,031.2 | 9,734.9 | 9,800.6 |\n| (Gain) loss on property dispositions and impairment losses, net | ( 0.2 ) | ( 18.3 ) | 0.1 | 12.0 |\n| Operating income | 485.9 | 562.0 | 1,173.0 | 1,533.8 |\n| Interest expense, net | 109.3 | 128.6 | 262.6 | 309.2 |\n| Loss on debt extinguishment | — | 49.1 | — | 49.1 |\n| Other income, net | ( 18.9 ) | ( 11.4 ) | ( 62.4 ) | ( 8.3 ) |\n| Income before income taxes | 395.5 | 395.7 | 972.8 | 1,183.8 |\n| Income tax expense | 100.3 | 111.2 | 232.8 | 313.1 |\n| Net income | $ | 295.2 | $ | 284.5 | $ | 740.0 | $ | 870.7 |\n| Other comprehensive income, net of tax |\n| Recognition of pension gain | 15.1 | 10.1 | 15.2 | 10.9 |\n| Other | — | 0.3 | — | 1.2 |\n| Other comprehensive income | $ | 15.1 | $ | 10.4 | $ | 15.2 | $ | 12.1 |\n| Comprehensive income | $ | 310.3 | $ | 294.9 | $ | 755.2 | $ | 882.8 |\n| Net income per Class A common share |\n| Basic net income per Class A common share | $ | 0.55 | $ | 0.52 | $ | 1.27 | $ | 1.57 |\n| Diluted net income per Class A common share | 0.52 | 0.49 | 1.26 | 1.49 |\n| Weighted average Class A common shares outstanding |\n| Basic | 465.3 | 477.3 | 465.2 | 529.2 |\n| Diluted | 573.0 | 582.9 | 470.6 | 583.3 |\n\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\n4\nAlbertsons Companies, Inc. and SubsidiariesCondensed Consolidated Statements of Cash Flows(in millions)(unaudited)\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 |\n| Cash flows from operating activities: |\n| Net income | $ | 740.0 | $ | 870.7 |\n| Adjustments to reconcile net income to net cash provided by operating activities: |\n| Loss on property dispositions and impairment losses, net | 0.1 | 12.0 |\n| Depreciation and amortization | 883.2 | 808.8 |\n| Operating lease right-of-use assets amortization | 333.0 | 309.3 |\n| LIFO expense | 29.1 | 23.2 |\n| Deferred income tax | 43.0 | 2.8 |\n| Contributions to pension and post-retirement benefit plans, net of (income) expense | ( 47.5 ) | ( 68.9 ) |\n| (Gain) loss on interest rate swaps and commodity hedges, net | ( 7.5 ) | 25.9 |\n| Amortization and write-off of deferred financing costs | 11.1 | 11.2 |\n| Loss on debt extinguishment | — | 49.1 |\n| Equity-based compensation expense | 49.0 | 28.3 |\n| Other | ( 21.2 ) | ( 28.7 ) |\n| Changes in operating assets and liabilities: |\n| Receivables, net | ( 6.4 ) | ( 21.7 ) |\n| Inventories, net | 93.0 | 62.2 |\n| Accounts payable, accrued salaries and wages and other accrued liabilities | 229.2 | 585.4 |\n| Operating lease liabilities | ( 249.3 ) | ( 228.4 ) |\n| Self-insurance assets and liabilities | 36.3 | 24.2 |\n| Other operating assets and liabilities | 22.6 | 255.4 |\n| Net cash provided by operating activities | 2,137.7 | 2,720.8 |\n| Cash flows from investing activities: |\n| Business acquisitions, net of cash acquired | ( 23.5 ) | — |\n| Payments for property, equipment and intangibles, including payments for lease buyouts | ( 822.5 ) | ( 702.9 ) |\n| Proceeds from sale of long-lived assets | 24.6 | 20.6 |\n| Other investing activities | 30.9 | ( 4.8 ) |\n| Net cash used in investing activities | ( 790.5 ) | ( 687.1 ) |\n| Cash flows from financing activities: |\n| Proceeds from issuance of long-term debt | — | 3,500.0 |\n| Payments on long-term borrowings | ( 0.5 ) | ( 3,388.5 ) |\n| Payments of obligations under finance leases | ( 32.2 ) | ( 32.9 ) |\n| Payment of redemption premium on debt extinguishment | — | ( 41.4 ) |\n| Payments for debt financing costs | — | ( 15.6 ) |\n| Dividends paid on common stock | ( 93.0 ) | — |\n| Dividends paid on convertible preferred stock | ( 59.1 ) | — |\n| Proceeds from convertible preferred stock | — | 1,680.0 |\n| Third party issuance costs on convertible preferred stock | — | ( 80.9 ) |\n| Treasury stock purchase, at cost | — | ( 1,680.0 ) |\n| Employee tax withholding on vesting of restricted stock units | ( 11.8 ) | ( 6.7 ) |\n| Other financing activities | ( 17.8 ) | ( 14.7 ) |\n| Net cash used in financing activities | ( 214.4 ) | ( 80.7 ) |\n| Net increase in cash and cash equivalents and restricted cash | 1,132.8 | 1,953.0 |\n| Cash and cash equivalents and restricted cash at beginning of period | 1,767.6 | 478.9 |\n| Cash and cash equivalents and restricted cash at end of period | $ | 2,900.4 | $ | 2,431.9 |\n\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\n5\nAlbertsons Companies, Inc. and SubsidiariesCondensed Consolidated Statements of Stockholders' Equity(in millions, except share data)(unaudited)\n| Class A Common Stock | Additional paid in capital | Treasury Stock | Accumulated other comprehensive income | Retained earnings | Total stockholders' equity |\n| Shares | Amount | Shares | Amount |\n| Balance as of February 27, 2021 | 585,574,666 | $ | 5.9 | $ | 1,898.9 | 120,009,647 | $ | ( 1,907.0 ) | $ | 63.5 | $ | 1,263.0 | $ | 1,324.3 |\n| Equity-based compensation | — | — | 22.2 | — | — | — | — | 22.2 |\n| Shares issued and employee tax withholding on vesting of restricted stock units | 945,942 | — | ( 10.0 ) | — | — | — | — | ( 10.0 ) |\n| Cash dividends declared on common stock | — | — | — | — | — | — | ( 46.5 ) | ( 46.5 ) |\n| Dividends accrued on convertible preferred stock | — | — | — | — | — | — | ( 36.4 ) | ( 36.4 ) |\n| Net income | — | — | — | — | — | — | 444.8 | 444.8 |\n| Other comprehensive income, net of tax | — | — | — | — | — | 0.1 | — | 0.1 |\n| Other activity | — | — | — | — | — | — | ( 0.1 ) | ( 0.1 ) |\n| Balance as of June 19, 2021 | 586,520,608 | $ | 5.9 | $ | 1,911.1 | 120,009,647 | $ | ( 1,907.0 ) | $ | 63.6 | $ | 1,624.8 | $ | 1,698.4 |\n| Equity-based compensation | — | — | 26.8 | — | — | — | — | 26.8 |\n| Shares issued and employee tax withholding on vesting of restricted stock units | 147,495 | — | ( 1.8 ) | — | — | — | — | ( 1.8 ) |\n| Cash dividends declared on common stock | — | — | — | — | — | — | ( 46.5 ) | ( 46.5 ) |\n| Dividends accrued on convertible preferred stock | — | — | — | — | — | — | ( 27.3 ) | ( 27.3 ) |\n| Net income | — | — | — | — | — | — | 295.2 | 295.2 |\n| Other comprehensive income, net of tax | — | — | — | — | — | 15.1 | — | 15.1 |\n| Balance as of September 11, 2021 | 586,668,103 | $ | 5.9 | $ | 1,936.1 | 120,009,647 | $ | ( 1,907.0 ) | $ | 78.7 | $ | 1,846.2 | $ | 1,959.9 |\n\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\n6\nAlbertsons Companies, Inc. and SubsidiariesCondensed Consolidated Statements of Stockholders' Equity(in millions, except share data)(unaudited)\n| Class A Common Stock | Additional paid in capital | Treasury Stock | Accumulated other comprehensive loss | Retained earnings | Total stockholders' equity |\n| Shares | Amount | Shares | Amount |\n| Balance as of February 29, 2020 | 582,997,251 | $ | 5.8 | $ | 1,824.3 | 3,671,621 | $ | ( 25.8 ) | $ | ( 118.5 ) | $ | 592.3 | $ | 2,278.1 |\n| Issuance of common stock to Company's parents | 1,312,859 | — | — | — | — | — | — | — |\n| Equity-based compensation | — | — | 19.0 | — | — | — | — | 19.0 |\n| Employee tax withholding on vesting of restricted stock units | — | — | ( 6.2 ) | — | — | — | — | ( 6.2 ) |\n| Repurchase of common stock | — | — | — | 101,611,736 | ( 1,680.0 ) | — | — | ( 1,680.0 ) |\n| Dividends accrued on convertible preferred stock | — | — | — | — | — | — | ( 3.9 ) | ( 3.9 ) |\n| Net income | — | — | — | — | — | — | 586.2 | 586.2 |\n| Other comprehensive income, net of tax | — | — | — | — | — | 1.7 | — | 1.7 |\n| Balance as of June 20, 2020 | 584,310,110 | $ | 5.8 | $ | 1,837.1 | 105,283,357 | $ | ( 1,705.8 ) | $ | ( 116.8 ) | $ | 1,174.6 | $ | 1,194.9 |\n| Equity-based compensation | — | — | 9.3 | — | — | — | — | 9.3 |\n| Shares issued and employee tax withholding on vesting of restricted stock units | 22,101 | — | ( 0.5 ) | — | — | — | — | ( 0.5 ) |\n| Equity reclassification | — | — | 30.0 | — | — | — | — | 30.0 |\n| Dividends accrued on convertible preferred stock | — | — | — | — | — | — | ( 26.9 ) | ( 26.9 ) |\n| Net income | — | — | — | — | — | — | 284.5 | 284.5 |\n| Other comprehensive loss, net of tax | — | — | — | — | — | 10.4 | — | 10.4 |\n| Other activity | — | — | ( 0.1 ) | — | — | — | — | ( 0.1 ) |\n| Balance as of September 12, 2020 | 584,332,211 | $ | 5.8 | $ | 1,875.8 | 105,283,357 | $ | ( 1,705.8 ) | $ | ( 106.4 ) | $ | 1,432.2 | $ | 1,501.6 |\n\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\n7\nAlbertsons Companies, Inc. and SubsidiariesNotes to Condensed Consolidated Financial Statements(unaudited)\nNOTE 1 - BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nBasis of Presentation\nThe accompanying interim Condensed Consolidated Financial Statements include the accounts of Albertsons Companies, Inc. and its subsidiaries (the \"Company\"). All significant intercompany balances and transactions were eliminated. The Condensed Consolidated Balance Sheet as of February 27, 2021 is derived from the Company's annual audited Consolidated Financial Statements, which should be read in conjunction with these Condensed Consolidated Financial Statements and which are included in the Company's Annual Report on Form 10-K for the fiscal year ended February 27, 2021, filed with the Securities and Exchange Commission (the \"SEC\") on April 28, 2021. Certain information in footnote disclosures normally included in annual financial statements was condensed or omitted for the interim periods presented in accordance with accounting principles generally accepted in the United States of America (\"GAAP\"). In the opinion of management, the interim data includes all adjustments, consisting of normal recurring adjustments, necessary for a fair statement of the results for the interim periods. The interim results of operations and cash flows are not necessarily indicative of those results and cash flows expected for the year. The Company' s results of operations are for the 12 and 28 weeks ended September 11, 2021 and September 12, 2020.\nSignificant Accounting Policies\nRestricted cash: Restricted cash is included in Other current assets or Other assets depending on the remaining term of the restriction and primarily relates to funds held in escrow. The Company had $ 50.6 million of restricted cash as of September 11, 2021 and February 27, 2021.\nInventories, net: Substantially all of the Company's inventories consist of finished goods valued at the lower of cost or market and net of vendor allowances. The Company uses either item-cost or the retail inventory method to value inventory before application of any last-in, first-out (\"LIFO\") reserve. Interim LIFO inventory costs are based on management's estimates of expected year-end inventory levels and inflation rates. The Company recorded LIFO expense of $ 14.6 million and $ 10.1 million for the 12 weeks ended September 11, 2021 and September 12, 2020, respectively, and $ 29.1 million and $ 23.2 million for the 28 weeks ended September 11, 2021 and September 12, 2020, respectively.\nEquity-based compensation: Equity-based compensation expense recognized in the Condensed Consolidated Statements of Operations (in millions):\n| 12 weeks ended | 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| RSUs | $ | 24.9 | $ | 8.0 | $ | 44.6 | $ | 25.8 |\n| RSAs | 1.9 | 1.3 | 4.4 | 2.5 |\n| Total equity-based compensation expense | $ | 26.8 | $ | 9.3 | $ | 49.0 | $ | 28.3 |\n| Total related tax benefit | $ | 6.4 | $ | 2.0 | $ | 11.5 | $ | 6.6 |\n\nAs of September 11, 2021, there was $ 126.2 million of unrecognized costs related to 11.5 million unvested granted restricted stock units (\"RSUs\"). That cost is expected to be recognized over a weighted average period of 1.8 years. As of September 11, 2021, there was $ 7.3 million of unrecognized costs related to 1.0 million unvested granted restricted common stock (\"RSAs\"). That cost is expected to be recognized over a weighted average period of 1.9 years.\nIncome taxes: Income tax expense was $ 100.3 million, representing a 25.4 % effective tax rate, for the 12 weeks ended September 11, 2021. Income tax expense was $ 111.2 million, representing a 28.1 % effective tax rate, for the\n8\n12 weeks ended September 12, 2020. The decrease in the effective tax rate was primarily driven by nondeductible transaction-related costs incurred during the 12 weeks ended September 12, 2020.\nIncome tax expense was $ 232.8 million, representing a 23.9 % effective tax rate, for the 28 weeks ended September 11, 2021. Income tax expense was $ 313.1 million, representing a 26.4 % effective tax rate, for the 28 weeks ended September 12, 2020. The decrease in the effective income tax rate was primarily driven by the recognition of discrete state income tax benefits during the 28 weeks ended September 11, 2021 and certain nondeductible transaction-related costs incurred during the 28 weeks ended September 12, 2020.\nSegments: The Company and its subsidiaries offer grocery products, general merchandise, health and beauty care products, pharmacy, fuel and other items and services in its stores or through digital channels. The Company's operating divisions are geographically based, have similar economic characteristics and similar expected long-term financial performance. The Company's operating segments and reporting units are its 12 operating divisions, which are reported in one reportable segment. Each reporting unit constitutes a business for which discrete financial information is available and for which management regularly reviews the operating results. Across all operating segments, the Company operates primarily one store format. Each division offers through its stores and digital channels the same general mix of products with similar pricing to similar categories of customers, has similar distribution methods, operates in similar regulatory environments and purchases merchandise from similar or the same vendors.\nRevenue Recognition: Revenues from the retail sale of products are recognized at the point of sale or delivery to the customer, net of returns and sales tax. Pharmacy sales are recorded upon the customer receiving the prescription. Third-party receivables from pharmacy sales were $ 236.0 million and $ 262.5 million as of September 11, 2021 and February 27, 2021, respectively, and are recorded in Receivables, net. For digital related sales, which primarily include home delivery and Drive Up & Go curbside pickup, revenues are recognized upon either pickup in store or delivery to the customer and may include revenue for separately charged delivery services. The Company records a contract liability when rewards are earned by customers in connection with the Company's loyalty programs. As rewards are redeemed or expire, the Company reduces the contract liability and recognizes revenue. The contract liability balance was immaterial as of September 11, 2021 and February 27, 2021.\nThe Company records a contract liability when it sells its own proprietary gift cards. The Company records a sale when the customer redeems the gift card. The Company's gift cards do not expire. The Company reduces the contract liability and records revenue for the unused portion of gift cards (\"breakage\") in proportion to its customers' pattern of redemption, which the Company determined to be the historical redemption rate. The Company's contract liability related to gift cards was $ 76.2 million as of September 11, 2021 and $ 98.1 million as of February 27, 2021. Breakage amounts were immaterial for the 12 and 28 weeks ended September 11, 2021 and September 12, 2020, respectively.\n9\nDisaggregated Revenues\nThe following table represents sales revenue by type of similar product (dollars in millions):\n| 12 weeks ended | 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Amount (1) | % of Total | Amount (1) | % of Total | Amount (1) | % of Total | Amount (1) | % of Total |\n| Non-perishables (2) | $ | 7,268.5 | 44.0 | % | $ | 7,126.6 | 45.2 | % | $ | 16,538.8 | 43.8 | % | $ | 17,910.4 | 46.5 | % |\n| Perishables (3) | 6,823.2 | 41.3 | 6,654.1 | 42.2 | 15,735.8 | 41.6 | 16,209.7 | 42.1 |\n| Pharmacy | 1,253.4 | 7.6 | 1,171.8 | 7.5 | 2,982.0 | 7.9 | 2,726.7 | 7.1 |\n| Fuel | 918.5 | 5.6 | 570.8 | 3.6 | 1,967.8 | 5.2 | 1,160.0 | 3.0 |\n| Other (4) | 242.1 | 1.5 | 234.3 | 1.5 | 550.7 | 1.5 | 502.4 | 1.3 |\n| Net sales and other revenue | $ | 16,505.7 | 100.0 | % | $ | 15,757.6 | 100.0 | % | $ | 37,775.1 | 100.0 | % | $ | 38,509.2 | 100.0 | % |\n\n(1) Digital related sales are included in the categories to which the revenue pertains.\n(2) Consists primarily of general merchandise, grocery and frozen foods.\n(3) Consists primarily of produce, dairy, meat, deli, floral and seafood.\n(4) Consists primarily of wholesale revenue to third parties, commissions and other miscellaneous revenue.\nRecently issued accounting standards: In June 2020, the FASB issued ASU 2020-06, \"Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity's Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity's Own Equity\" (\"ASU 2020-06\"). ASU 2020-06 simplifies the accounting for certain convertible instruments, amends guidance on derivative scope exceptions for contracts in an entity's own equity and modifies the guidance on diluted earnings per share calculations as a result of these changes. ASU 2020-06 will take effect for public entities for annual reporting periods beginning after December 15, 2021, and interim periods within those fiscal years. Early adoption is permitted. The Company is currently evaluating the effect of this standard on its Consolidated Financial Statements.\nNOTE 2 - FAIR VALUE MEASUREMENTS\nThe accounting guidance for fair value established a framework for measuring fair value and established a three-level valuation hierarchy for disclosure of fair value measurement. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability at the measurement date. The three levels are defined as follows:\nLevel 1 - Quoted prices in active markets for identical assets or liabilities;\nLevel 2 - Inputs other than quoted prices included within Level 1 that are either directly or indirectly observable; and\nLevel 3 - Unobservable inputs in which little or no market activity exists, requiring an entity to develop its own assumptions that market participants would use to value the asset or liability.\nFair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.\n10\nThe following table presents assets and liabilities which were measured at fair value on a recurring basis as of September 11, 2021 (in millions):\n| Fair Value Measurements |\n| Total | Quoted prices in active markets for identical assets(Level 1) | Significantobservableinputs(Level 2) | Significantunobservableinputs(Level 3) |\n| Assets: |\n| Short-term investments (1) | $ | 14.7 | $ | 5.0 | $ | 9.7 | $ | — |\n| Non-current investments (2) | 92.6 | 19.5 | 73.1 | — |\n| Derivative contracts (3) | 10.0 | — | 10.0 | — |\n| Total | $ | 117.3 | $ | 24.5 | $ | 92.8 | $ | — |\n| Liabilities: |\n| Derivative contracts (4) | $ | 26.3 | $ | — | $ | 26.3 | $ | — |\n| Total | $ | 26.3 | $ | — | $ | 26.3 | $ | — |\n\n(1) Primarily relates to Mutual Funds (Level 1) and Certificates of Deposit (Level 2). Included in Other current assets.\n(2) Primarily relates to investments in publicly traded stock (Level 1) and U.S. Treasury Notes and Corporate Bonds (Level 2). Included in Other assets.\n(3) Primarily relates to derivative contracts. Included in Other assets.\n(4) Primarily relates to interest rate swaps. Included in Other current liabilities.\nThe following table presents assets and liabilities which were measured at fair value on a recurring basis as of February 27, 2021 (in millions):\n| Fair Value Measurements |\n| Total | Quoted prices in active markets for identical assets(Level 1) | Significantobservableinputs(Level 2) | Significantunobservableinputs(Level 3) |\n| Assets: |\n| Short-term investments (1) | $ | 11.9 | $ | 4.4 | $ | 7.5 | $ | — |\n| Non-current investments (2) | 110.2 | 40.3 | 69.9 | — |\n| Total | $ | 122.1 | $ | 44.7 | $ | 77.4 | $ | — |\n| Liabilities: |\n| Derivative contracts (3) | $ | 40.0 | $ | — | $ | 40.0 | $ | — |\n| Total | $ | 40.0 | $ | — | $ | 40.0 | $ | — |\n\n(1) Primarily relates to Mutual Funds (Level 1) and Certificates of Deposit (Level 2). Included in Other current assets.\n(2) Primarily relates to investments in publicly traded stock (Level 1) and U.S. Treasury Notes and Corporate Bonds (Level 2). Included in Other assets.\n(3) Primarily relates to interest rate swaps. Included in Other current liabilities.\nThe estimated fair value of the Company's debt, including current maturities, was based on Level 2 inputs, being market quotes or values for similar instruments, and interest rates currently available to the Company for the issuance of debt with similar terms and remaining maturities as a discount rate for the remaining principal payments. As of September 11, 2021, the fair value of total debt was $ 8,325.6 million compared to the carrying value of $ 7,815.0 million, excluding debt discounts and deferred financing costs. As of February 27, 2021, the fair value of total debt was $ 8,150.7 million compared to the carrying value of $ 7,815.5 million, excluding debt discounts and deferred financing costs.\n11\nAssets Measured at Fair Value on a Non-Recurring Basis\nThe Company measures certain assets at fair value on a non-recurring basis, including long-lived assets and goodwill, which are evaluated for impairment. Long-lived assets include store-related assets such as property and equipment and certain intangible assets. The inputs used to determine the fair value of long-lived assets and a reporting unit are considered Level 3 measurements due to their subjective nature.\nNOTE 3 - DERIVATIVE FINANCIAL INSTRUMENTS\nThe aggregate notional amount of the Company's interest rate swaps as of September 11, 2021 and February 27, 2021, were $ 1,553.0 million and $ 1,653.0 million, respectively, of which none were designated as cash flow hedges as defined by GAAP.\nActivity related to interest rate swaps consisted of the following (in millions):\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | Location of loss recognized from derivatives |\n| Loss on undesignated portion of interest rate swaps | $ | — | $ | ( 0.4 ) | Other income, net |\n\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | Location of loss recognized from derivatives |\n| Loss on undesignated portion of interest rate swaps | $ | ( 0.3 ) | $ | ( 19.4 ) | Other income, net |\n\nNOTE 4 - LONG-TERM DEBT AND FINANCE LEASE OBLIGATIONS\nThe Company's long-term debt and finance lease obligations as of September 11, 2021 and February 27, 2021, net of unamortized debt discounts of $ 43.0 million and $ 44.8 million, respectively, and deferred financing costs of $ 63.6 million and $ 69.8 million, respectively, consisted of the following (in millions):\n| September 11,2021 | February 27,2021 |\n| Senior Unsecured Notes due 2023 to 2030, interest rate range of 3.25 % to 7.50 % | $ | 6,686.5 | $ | 6,680.5 |\n| Safeway Inc. Notes due 2021 to 2031, interest rate range of 4.75 % to 7.45 % | 504.4 | 504.3 |\n| New Albertsons L.P. Notes due 2026 to 2031, interest rate range of 6.52 % to 8.70 % | 470.9 | 469.1 |\n| Other financing obligations | 29.2 | 29.4 |\n| Mortgage notes payable, secured | 17.4 | 17.6 |\n| Finance lease obligations | 632.2 | 612.7 |\n| Total debt | 8,340.6 | 8,313.6 |\n| Less current maturities | ( 211.5 ) | ( 212.4 ) |\n| Long-term portion | $ | 8,129.1 | $ | 8,101.2 |\n\nSenior Unsecured Notes\nOn October 1, 2021, subsequent to the end of the 12 weeks ended September 11, 2021, the Company provided notice to the holders and trustee, of its election to redeem all of the $ 200.0 million aggregate principal amount currently outstanding of the Company's 5.750 % Senior Unsecured Notes due 2025 (the \"2025 Notes\"). The 2025 Notes will be redeemed on November 1, 2021 (the \"Redemption Date\"), using cash on hand, at a redemption price of 101.438 % of the principal amount thereof plus accrued and unpaid interest on the 2025 Notes to, but excluding, the Redemption Date.\n12\nABL Facility\nAs of September 11, 2021 and February 27, 2021, there were no amounts outstanding under the Company's asset-based loan facility (\"ABL Facility\"), and letters of credit (\"LOC\") issued under the LOC sub-facility were $ 323.8 million and $ 354.6 million, respectively.\nNOTE 5 - EMPLOYEE BENEFIT PLANS\nPension and Other Post-Retirement Benefits\nThe following tables provide the components of net pension and post-retirement (income) expense (in millions):\n| 12 weeks ended |\n| Pension | Other post-retirement benefits |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Estimated return on plan assets | $ | ( 24.5 ) | $ | ( 23.7 ) | $ | — | $ | — |\n| Service cost | 5.1 | 3.5 | — | — |\n| Interest cost | 9.7 | 12.6 | 0.1 | 0.1 |\n| Amortization of prior service cost | — | — | — | 0.4 |\n| Amortization of net actuarial loss (gain) | 0.2 | 0.5 | ( 0.1 ) | ( 0.1 ) |\n| Settlement (gain) loss | ( 14.3 ) | 3.0 | — | — |\n| (Income) expense, net | $ | ( 23.8 ) | $ | ( 4.1 ) | $ | — | $ | 0.4 |\n\n| 28 weeks ended |\n| Pension | Other post-retirement benefits |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Estimated return on plan assets | $ | ( 57.2 ) | $ | ( 55.2 ) | $ | — | $ | — |\n| Service cost | 12.0 | 8.3 | — | — |\n| Interest cost | 22.7 | 29.2 | 0.2 | 0.2 |\n| Amortization of prior service cost | 0.1 | 0.1 | — | 1.0 |\n| Amortization of net actuarial loss (gain) | 0.5 | 1.1 | ( 0.3 ) | ( 0.3 ) |\n| Settlement (gain) loss | ( 14.3 ) | 3.0 | — | — |\n| (Income) expense, net | $ | ( 36.2 ) | $ | ( 13.5 ) | $ | ( 0.1 ) | $ | 0.9 |\n\nThe Company contributed $ 9.2 million and $ 11.2 million to its defined pension plans and post-retirement benefit plans during the 12 and 28 weeks ended September 11, 2021, respectively. For the 12 and 28 weeks ended September 12, 2020, the Company contributed $ 1.7 million and $ 56.3 million, respectively. At the Company's discretion, additional funds may be contributed to the defined benefit pension plans that are determined to be beneficial to the Company. The Company currently anticipates contributing an additional $ 26.1 million to these plans for the remainder of fiscal 2021.\nDuring the 12 and 28 weeks ended September 11, 2021, the Company purchased a group annuity policy and transferred $ 203.5 million of pension plan assets to an insurance company, thereby reducing the Company's defined benefit pension obligations by $ 205.4 million. As a result of the annuity purchase, the Company recorded a settlement gain of $ 11.1 million during the 12 and 28 weeks ended September 11, 2021.\n13\nDefined Contribution Plans and Supplemental Retirement Plans\nTotal contributions expensed for defined contribution plans (401(k) plans) were $ 26.4 million and $ 16.3 million for the 12 weeks ended September 11, 2021 and September 12, 2020, respectively. For the 28 weeks ended September 11, 2021 and September 12, 2020, total contributions expensed were $ 42.6 million and $ 38.1 million, respectively.\nMultiemployer Pension Plans\nARP Act: The American Rescue Plan Act (\"ARP Act\") was signed into law on March 11, 2021. The ARP Act establishes a special financial assistance program for financially troubled multiemployer pension plans. Under the ARP Act, eligible multiemployer plans can apply to receive a one-time cash payment in the amount projected by the Pension Benefit Guaranty Corporation (\"PBGC\") to pay pension benefits through the plan year ending 2051. On July 9, 2021, the PBGC issued its interim final rule with respect to the special financial assistance program. The PBGC interim final rule provides direction on the application requirements, identifies which plans will have priority, eligibility requirements, the determination of the amount of financial assistance to be provided and establishes conditions and restrictions that apply to plans that receive the assistance. The Company is evaluating the interim final rule and has submitted comments during the 30-day comment period. The Company's evaluation includes any potential impact to the Company's Excess Plan as defined in and further described in \"Part II—Item 8. Financial Statements and Supplemental Data—Note 12\" of the Company's Annual Report on Form 10-K for the fiscal year ended February 27, 2021.\nNOTE 6 - COMMITMENTS AND CONTINGENCIES AND OFF BALANCE SHEET ARRANGEMENTS\nGuarantees\nCalifornia Department of Industrial Relations: On January 21, 2014, the Company entered into a Collateral Substitution Agreement with the California Self-Insurers' Security Fund to provide collateral related to certain California self-insured workers' compensation obligations pursuant to applicable regulations. The collateral not covered by the California Self-Insurers' Security Fund is covered by surety bonds for the benefit of the State of California Office of Self-Insurance Plans. A portion of the surety bonds is covered by irrevocable LOCs. The collateral requirements are adjusted annually based on semi-annual filings of an actuarial study reflecting liabilities as of December 31 of each year reduced by claim closures and settlements. The related LOC was $ 22.6 million as of September 11, 2021 and $ 40.1 million as of February 27, 2021, respectively.\nLease Guarantees: The Company may have liability under certain operating leases that were assigned to third parties. If any of these third parties fail to perform their obligations under the leases, the Company could be responsible for the lease obligation, including as a result of the economic dislocation caused by the response to the COVID-19 pandemic. Because of the wide dispersion among third parties and the variety of remedies available, the Company believes that if an assignee became insolvent, it would not have a material effect on the Company's financial condition, results of operations or cash flows.\nThe Company also provides guarantees, indemnifications and assurances pursuant to contractual obligations in the ordinary course of its business.\nLegal Proceedings\nThe Company is subject from time to time to various claims and lawsuits arising in the ordinary course of business, including lawsuits involving trade practices, lawsuits alleging violations of state and/or federal wage and hour laws (including alleged violations of meal and rest period laws and alleged misclassification issues), real estate disputes as well as other matters. Some of these claims or suits purport or may be determined to be class actions and/or seek substantial damages. It is the opinion of the Company's management that although the amount of liability with\n14\nrespect to certain of the matters described herein cannot be ascertained at this time, any resulting liability of these and other matters, including any punitive damages, will not have a material adverse effect on the Company's business or financial condition.\nThe Company continually evaluates its exposure to loss contingencies arising from pending or threatened litigation and believes it has made provisions where the loss contingency is probable and can be reasonably estimated. Nonetheless, assessing and predicting the outcomes of these matters involves substantial uncertainties. Management currently believes that the aggregate range of reasonably possible loss for the Company's exposure in excess of the amount accrued is expected to be immaterial to the Company. It remains possible that despite management's current belief, material differences in actual outcomes or changes in management's evaluation or predictions could arise that could have a material effect on the Company's financial condition, results of operations or cash flows.\nERISA Litigation: Two lawsuits were brought against Safeway Inc. (\"Safeway\") and the Safeway Benefits Plan Committee (the \"Benefit Plans Committee,\" and together with Safeway, the \"Safeway Benefits Plans Defendants\") and other third parties alleging breaches of fiduciary duty under the Employee Retirement Income Security Act of 1974, as amended (\"ERISA\") with respect to Safeway's 401(k) Plan (the \"Safeway 401(k) Plan\"). On July 14, 2016, a complaint was filed in the United States District Court for the Northern District of California by a participant in the Safeway 401(k) Plan individually and on behalf of the Safeway 401(k) Plan. An amended complaint was filed on November 18, 2016. On August 25, 2016, a second complaint was filed in the United States District Court for the Northern District of California by another participant in the Safeway 401(k) Plan individually and on behalf of all others similarly situated against the Safeway Benefits Plans Defendants and against the Safeway 401(k) Plan's former record-keepers. An amended complaint was filed on September 16, 2016, and a second amended complaint was filed on November 21, 2016. In general, both lawsuits alleged that the Safeway Benefits Plans Defendants breached their fiduciary duties under ERISA regarding the selection of investments offered under the Safeway 401(k) Plan and the fees and expenses related to those investments. All parties filed summary judgment motions which were heard and taken under submission on August 16, 2018. Plaintiffs' motions were denied, and defendants' motions were granted in part and denied in part. Bench trials for both matters were set for May 6, 2019. A settlement in principle was reached before trial. On September 13, 2019, settlement papers were filed with the Court along with a motion for preliminary approval of the settlement. A hearing for preliminary approval was set for November 20, 2019, but the Court vacated the hearing. The Court issued an order on March 30, 2020 requesting some minor changes to the notice procedures, and plaintiffs submitted an amended motion for preliminary approval. On September 8, 2020, the Court granted plaintiffs' amended motion, and a final approval hearing was held on April 26, 2021, at which time the Court took the matter under submission. On July 19, 2021, the Court issued a final order approving the settlement. In August 2021, a settlement fund was established with funds from insurers. A settlement administrator is now managing the calculation and payment of settlement provisions to class members.\nFalse Claims Act: The Company has received a civil investigative demand dated February 28, 2020 from the United States Attorney for the Southern District of New York in connection with a False Claims Act (\"FCA\") investigation relating to the Company's dispensing practices regarding insulin pen products. The investigation seeks documents regarding the Company's policies, practices and procedures, as well as dispensing data, among other things. The Company has cooperated with the U.S. Attorney in the investigation. The Company is currently unable to determine the probability of the outcome of this matter or the range of possible loss, if any.\nTwo qui tam actions alleging violations of the FCA have also been filed against the Company and its subsidiaries. Violations of the FCA are subject to treble damages and penalties of up to a specified dollar amount per false claim.\nIn United States ex rel. Proctor v. Safeway, filed in the United States District Court for the Central District of Illinois, the relator alleges that Safeway overcharged federal government healthcare programs by not providing the federal government, as part of its usual and customary prices, the benefit of discounts given to customers in pharmacy membership discount and price-matching programs. The relator filed his complaint under seal on November 11, 2011, and the complaint was unsealed on August 26, 2015. The relator amended the complaint on\n15\nMarch 31, 2016. On June 12, 2020, the Court granted Safeway's motion for summary judgment, holding that the relator could not prove that Safeway acted with the intent required under the FCA, and judgment was issued on June 15, 2020. On July 10, 2020, the relator filed a motion to alter or amend the judgment and to supplement the record, which Safeway opposed. On November 13, 2020, the Court denied relator's motion, and on December 11, 2020, relator filed a notice of appeal. The appeal is now pending in the Seventh Circuit Court of Appeals. Oral argument took place September 9, 2021.\nIn United States ex rel. Schutte and Yarberry v. SuperValu, New Albertson's, Inc., et al., also filed in the Central District of Illinois, the relators allege that defendants (including various subsidiaries of the Company) overcharged federal government healthcare programs by not providing the federal government, as a part of usual and customary prices, the benefit of discounts given to customers who requested that defendants match competitor prices. The complaint was originally filed under seal and amended on November 30, 2015. On August 5, 2019, the Court granted relators' motion for partial summary judgment, holding that price-matched prices are the usual and customary prices for those drugs. On July 1, 2020, the Court granted the defendants' motions for summary judgment and dismissed the case, holding that the relator could not prove that defendants acted with the intent required under the FCA. Judgment was issued on July 2, 2020. On July 9, 2020, the relators filed a notice of appeal. Oral argument was held on January 19, 2021. On August 12, 2021, the Court of Appeals for the Seventh Circuit affirmed the grant of summary judgment in the Company's favor. On September 23, 2021, the relators filed a petition for rehearing en banc with the Seventh Circuit. The Company's response to the petition for rehearing is due by November 9, 2021.\nIn both of the above cases, the federal government previously investigated the relators' allegations and declined to intervene. The relators elected to pursue their respective cases on their own and in each case have alleged FCA damages in excess of $ 100 million before trebling and excluding penalties. The Company is vigorously defending each of these matters and believes each of these cases is without merit. The Company has recorded an estimated liability for these matters.\nOpioid Litigation: The Company is one of dozens of companies that have been named in various lawsuits alleging that defendants contributed to the national opioid epidemic. At present, the Company is named in over 80 suits pending in various state courts as well as in the United States District Court for the Northern District of Ohio, where over 2,000 cases have been consolidated as Multi-District Litigation (\"MDL\") pursuant to 28 U.S.C. §1407. Most of these cases have been stayed pending bellwether trials. At present, the most active case is a matter in New Mexico state court where we have been in active discovery and where a September 2022 trial date has been set. The MDL Court and a state court in Utah are currently considering position statements from the parties in connection with scheduling bellwether trials and it is likely that the Company may be included in one or more of those anticipated bellwether trials. The Company is vigorously defending these matters and believes that these cases are without merit. At this stage in the proceedings, the Company is unable to determine the probability of the outcome of these matters or the range of reasonably possible loss, if any.\nCalifornia Air Resources Board: Upon the inspection by the California Air Resources Board (\"CARB\") of several of the Company's stores in California, it was determined that the Company failed certain paperwork and other administrative requirements. As a result of the inspections, the Company proactively undertook a broad evaluation of the record keeping and administrative practices at all of its stores in California. In connection with this evaluation, the Company retained a third party to conduct an audit and correct deficiencies identified across its California store base. The Company is working with CARB to resolve these compliance issues and comply with governing regulations, and that work is ongoing. CARB has made an opening demand regarding potential fines and penalties. On July 7, 2021, the parties entered into a settlement agreement for which the Company has recorded an estimated liability.\nFACTA: On May 31, 2019, a putative class action complaint entitled Martin v. Safeway was filed in the California Superior Court for the County of Alameda, alleging the Company failed to comply with the Fair and Accurate Credit Transactions Act (\"FACTA\") by printing receipts that failed to adequately mask payment card numbers as\n16\nrequired by FACTA. The plaintiff claims the violation was \"willful\" and exposes the Company to statutory damages provided for in FACTA. The Company has answered the complaint and is vigorously defending the matter. On January 8, 2020, the Company commenced mediation discussions with plaintiff's counsel and reached a settlement in principle on February 24, 2020. The parties will seek court approval of the settlement. The Company has recorded an estimated liability for this matter.\nOther Commitments\nIn the ordinary course of business, the Company enters into various supply contracts to purchase products for resale and purchase and service contracts for fixed asset and information technology commitments. These contracts typically include volume commitments or fixed expiration dates, termination provisions and other standard contractual considerations.\nNOTE 7 - OTHER COMPREHENSIVE INCOME OR LOSS\nTotal comprehensive earnings are defined as all changes in stockholders' equity during a period, other than those from investments by or distributions to the stockholders. Generally, for the Company, total comprehensive income or loss equals net income plus or minus adjustments for pension and other post-retirement liabilities. Total comprehensive earnings represent the activity for a period net of tax.\nWhile total comprehensive earnings are the activity in a period and are largely driven by net earnings in that period, accumulated other comprehensive income or loss (\"AOCI\") represents the cumulative balance of other comprehensive income, net of tax, as of the balance sheet date. Changes in the AOCI balance by component are shown below (in millions):\n| 28 weeks ended September 11, 2021 |\n| Total | Pension and Post-retirement benefit plans | Other |\n| Beginning balance | $ | 63.5 | $ | 61.3 | $ | 2.2 |\n| Other comprehensive income before reclassifications | 34.3 | 34.3 | — |\n| Amounts reclassified from accumulated other comprehensive income | ( 14.0 ) | ( 14.0 ) | — |\n| Tax expense | ( 5.1 ) | ( 5.1 ) | — |\n| Current-period other comprehensive income, net of tax | 15.2 | 15.2 | — |\n| Ending balance | $ | 78.7 | $ | 76.5 | $ | 2.2 |\n\n| 28 weeks ended September 12, 2020 |\n| Total | Pension and Post-retirement benefit plans | Other |\n| Beginning balance | $ | ( 118.5 ) | $ | ( 121.7 ) | $ | 3.2 |\n| Other comprehensive income before reclassifications | 11.1 | 9.6 | 1.5 |\n| Amounts reclassified from accumulated other comprehensive income | 4.9 | 4.9 | — |\n| Tax expense | ( 3.9 ) | ( 3.6 ) | ( 0.3 ) |\n| Current-period other comprehensive income, net of tax | 12.1 | 10.9 | 1.2 |\n| Ending balance | $ | ( 106.4 ) | $ | ( 110.8 ) | $ | 4.4 |\n\n17\nNOTE 8 - NET INCOME PER CLASS A COMMON SHARE\nThe Company calculates basic and diluted net income per Class A common share using the two-class method. The two-class method is an allocation formula that determines net income per Class A common share for each share of Class A common stock and the Company's Series A-1 convertible preferred stock (\"Series A-1 preferred stock\") and Series A convertible preferred stock (\"Series A preferred stock\" and together with the Series A-1 preferred stock, the \"Convertible Preferred Stock\"), a participating security, according to dividends declared and participation rights in undistributed earnings. Under this method, all earnings (distributed and undistributed) are allocated to Class A common shares and Convertible Preferred Stock based on their respective rights to receive dividends. The holders of Convertible Preferred Stock participate in cash dividends that the Company pays on its common stock to the extent that such cash dividends exceed $ 206.25 million per fiscal year. In applying the two-class method to interim periods, the Company allocates income to its quarterly periods independently and discretely from its year-to-date and annual periods. Basic net income per Class A common share is computed by dividing net income allocated to Class A common stockholders by the weighted average number of Class A common shares outstanding for the period, including Class A common shares to be issued with no prior remaining contingencies prior to issuance. Diluted net income per Class A common share is computed based on the weighted average number of shares of Class A common stock outstanding during each period, plus potential Class A common shares considered outstanding during the period, as long as the inclusion of such awards is not antidilutive. Potential Class A common shares consist of unvested RSUs and RSAs and Convertible Preferred Stock, using the more dilutive of either the two-class method or as-converted stock method. Performance-based RSUs are considered dilutive when the related performance criterion has been met.\n18\nThe components of basic and diluted net income per Class A common share were as follows (in millions, except per share data):\n| 12 weeks ended | 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Basic net income per Class A common share |\n| Net income | $ | 295.2 | $ | 284.5 | $ | 740.0 | $ | 870.7 |\n| Accrued dividends on Convertible Preferred Stock | ( 27.3 ) | ( 26.9 ) | ( 63.7 ) | ( 30.8 ) |\n| Earnings allocated to Convertible Preferred Stock | ( 11.0 ) | ( 9.0 ) | ( 84.2 ) | ( 9.0 ) |\n| Net income allocated to Class A common stockholders - Basic | $ | 256.9 | $ | 248.6 | $ | 592.1 | $ | 830.9 |\n| Weighted average Class A common shares outstanding - Basic (1) | 465.3 | 477.3 | 465.2 | 529.2 |\n| Basic net income per Class A common share | $ | 0.55 | $ | 0.52 | $ | 1.27 | $ | 1.57 |\n| Diluted net income per Class A common share |\n| Net income allocated to Class A common stockholders - Basic | $ | 256.9 | $ | 248.6 | $ | 592.1 | $ | 830.9 |\n| Accrued dividends on Convertible Preferred Stock | 27.3 | 26.9 | — | 30.8 |\n| Earnings allocated to Convertible Preferred Stock | 11.0 | 9.0 | — | 9.0 |\n| Net income allocated to Class A common stockholders - Diluted | $ | 295.2 | $ | 284.5 | $ | 592.1 | $ | 870.7 |\n| Weighted average Class A common shares outstanding - Basic (1) | 465.3 | 477.3 | 465.2 | 529.2 |\n| Dilutive effect of: |\n| Restricted stock units and awards | 6.1 | 4.0 | 5.4 | 4.3 |\n| Convertible Preferred Stock (2) | 101.6 | 101.6 | — | 49.8 |\n| Weighted average Class A common shares outstanding - Diluted (3) | 573.0 | 582.9 | 470.6 | 583.3 |\n| Diluted net income per Class A common share | $ | 0.52 | $ | 0.49 | $ | 1.26 | $ | 1.49 |\n\n(1) There were 0.3 million Class A common shares remaining to be issued for the 12 and 28 weeks ended September 11, 2021 compared to 0.4 million Class A common shares remaining to be issued for the 12 and 28 weeks ended September 12, 2020.\n(2) Reflects the number of shares of Convertible Preferred Stock issued, if converted into common stock for the period outstanding. For the 28 weeks ended September 11, 2021, 101.6 million potential common shares outstanding related to Convertible Preferred Stock were antidilutive.\n(3) There were no potential Class A common shares outstanding related to RSUs and RSAs that were antidilutive for the 12 and 28 weeks ended September 11, 2021. There were no potential Class A common shares outstanding related to RSUs and RSAs that were antidilutive for the 12 and 28 weeks ended September 12, 2020.\n19\nItem 2\n-\nManagement's Discussion and Analysis of Financial Condition and Results of Operations\nSPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS\nThis Form 10-Q contains \"forward-looking statements\" within the meaning of the federal securities laws. The \"forward-looking statements\" include our current expectations, assumptions, estimates and projections about our business and our industry. They include statements relating to our future operating or financial performance which the Company believes to be reasonable at this time. You can identify forward-looking statements by the use of words such as \"outlook,\" \"may,\" \"should,\" \"could,\" \"estimates,\" \"predicts,\" \"potential,\" \"continue,\" \"anticipates,\" \"believes,\" \"plans,\" \"expects,\" \"future\" and \"intends\" and similar expressions which are intended to identify forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors, some of which are beyond our control and difficult to predict, including, among others, changes in macroeconomic conditions, the retail consumer behavior and environment and the Company's industry, failure to achieve productivity initiatives, increased rates of food price inflation and factors related to the continued impact of the COVID-19 pandemic, about which there are still many unknowns, including its duration, recurrence, new virus strains, status and effectiveness of vaccinations, duration and scope of related government orders, financial assistance programs, mandates and regulations and the extent of the overall impact to our business and the communities we serve. Such risks and uncertainties could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements. In evaluating forward-looking statements, you should carefully consider the risks and uncertainties more fully described in the \"Risk Factors\" section or other sections in our reports filed with the SEC including the most recent annual report on Form 10-K and any subsequent periodic reports on Form 10-Q and current reports on Form 8-K. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements and risk factors. Forward-looking statements contained in this Form 10-Q reflect our view only as of the date of this Form 10-Q. We undertake no obligation, other than as required by law, to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.\nAs used in this Form 10-Q, unless the context otherwise requires, references to \"Albertsons,\" the \"Company,\" \"we,\" \"us\" and \"our\" refer to Albertsons Companies, Inc. and, where appropriate, its subsidiaries.\nNON-GAAP FINANCIAL MEASURES\nWe define EBITDA as generally accepted accounting principles (\"GAAP\") earnings (net loss) before interest, income taxes, depreciation and amortization. We define Adjusted EBITDA as earnings (net loss) before interest, income taxes, depreciation and amortization, further adjusted to eliminate the effects of items management does not consider in assessing our ongoing core performance. We define Adjusted net income as GAAP Net income adjusted to eliminate the effects of items management does not consider in assessing our ongoing core performance. We define Adjusted net income per Class A common share as Adjusted net income divided by the weighted average diluted Class A common shares outstanding, as adjusted to reflect all restricted stock units (\"RSUs\") and restricted common stock (\"RSAs\") outstanding at the end of the period. We define Net Debt as total debt (which includes finance lease obligations and is net of deferred financing costs and original issue discount) minus unrestricted cash and cash equivalents and we define Net Debt Ratio as the ratio of Net Debt to Adjusted EBITDA for the rolling 52 or 53 week period. See \"Results of Operations\" for further discussion and a reconciliation of Adjusted EBITDA, Adjusted net income and Adjusted net income per Class A common share.\nEBITDA, Adjusted EBITDA, Adjusted net income and Adjusted net income per Class A common share (collectively, the \"Non-GAAP Measures\") are performance measures that provide supplemental information we believe is useful to analysts and investors to evaluate our ongoing results of operations, when considered alongside other GAAP measures such as Net income, operating income and gross profit. These Non-GAAP Measures exclude\n20\nthe financial impact of items management does not consider in assessing our ongoing core operating performance, and thereby provide useful measures to analysts and investors of our operating performance on a period-to-period basis. Other companies may have different definitions of Non-GAAP Measures and provide for different adjustments, and comparability to our results of operations may be impacted by such differences. We also use Adjusted EBITDA and Net Debt Ratio for board of director and bank compliance reporting. Our presentation of Non-GAAP Measures should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items.\nNon-GAAP Measures should not be considered as measures of discretionary cash available to us to invest in the growth of our business. We compensate for these limitations by relying primarily on our GAAP results and using Non-GAAP Measures only for supplemental purposes.\n21\nSECOND QUARTER OF FISCAL 2021 OVERVIEW\nGiven the significant variations that occurred in our business during fiscal 2020 due to the COVID-19 pandemic, we provide a supplemental comparison of the 12 and 28 weeks ended September 11, 2021 (\"second quarter of fiscal 2021\" and \"first 28 weeks of fiscal 2021\") to the 12 and 28 weeks ended September 7, 2019 (\"second quarter of fiscal 2019\" and \"first 28 weeks of fiscal 2019\") for certain financial measures to demonstrate the two-year growth in our business in addition to comparisons to the 12 and 28 weeks ended September 12, 2020 (\"second quarter of fiscal 2020\" and \"first 28 weeks of fiscal 2020\").\nAs of September 11, 2021, we operated 2,278 retail food and drug stores with 1,725 pharmacies, 401 associated fuel centers, 22 dedicated distribution centers and 20 manufacturing facilities. With a strong consumer environment, we continue to make significant progress against all of our strategic priorities, including in-store excellence, accelerating our digital and omni-channel capabilities, increasing productivity and strengthening our talent and culture. Identical sales increased 1.5%, excluding fuel, during the second quarter of fiscal 2021, resulting in two-year stacked identical sales growth of 15.3%. We continue to gain market share in food market, and in Multi Outlet (\"MULO\") we are up on a two-year basis and down marginally on a one-year basis. Food market generally includes traditional supermarkets while MULO includes most food market, drug, mass merchants, club, dollar and military stores that sell food.\nUnderscoring our strong omni-channel capabilities that allow customers to complete their shopping with us in any way they want, our digital initiatives continue to resonate with our customers, as evidenced by our sustained sales levels in the second quarter of fiscal 2021, digital sales increasing 5% compared to the second quarter of fiscal 2020 and a two-year stacked growth of 248%. During the second quarter of fiscal 2021, we expanded our Drive Up & Go curbside pickup service to approximately 1,900 locations and offer delivery services across more than 2,000 of our stores. In our delivery service, we have expanded first party locations, and continue to work with third party services to engage with customers on the platform of their choice. In addition to our continuing partnership with Instacart, we have expanded our partnership with DoorDash to offer on-demand grocery delivery service where customers can receive a broad assortment in under one hour. We also recently launched a similar partnership with Uber, where customers can order a full assortment of groceries on the Uber platform.\nWith ongoing benefit enhancements, we continue to achieve significant success with our just for U loyalty program, which drives higher sales and customer retention, with membership growing 17% in the second quarter of fiscal 2021 compared to the second quarter of fiscal 2020, reaching 27.5 million members. Within the program, the number of actively engaged members, those that redeemed fuel or grocery rewards during the second quarter of fiscal 2021, increased by almost 9% compared to the second quarter of fiscal 2020, and our retention rate of actively engaged members was 93% in the second quarter of fiscal 2021.\nDuring the second quarter of fiscal 2021 we continued to roll out our Own Brands across all our banners, launching 85 new products and generating strong growth as our sales penetration increased by 60 basis points to 25.2% compared to the second quarter of fiscal 2020. We also continue to make significant progress on productivity initiatives, including promotional effectiveness, purchasing and procurement, labor efficiency and shrink.\nOur capital allocation strategy balances investing for the future, strengthening our balance sheet and returns to shareholders through a combination of dividends and opportunistic share repurchases. Capital expenditures were approximately $823 million during the first 28 weeks of fiscal 2021 as we opened seven new stores and completed 76 upgrades and remodels. Our balance sheet remains strong with a Net Debt Ratio of 1.3x as of the end of the second quarter of fiscal 2021. Capital returns to shareholders during the first 28 weeks of fiscal 2021 included our $0.10 per share quarterly dividend. On October 18, 2021, subsequent to the end of the second quarter of fiscal 2021, we announced a 20% increase to our quarterly dividend, which is now $0.12 per share of Class A common stock.\n22\nIn addition, we have continued to partner with the Department of Health and Human Services and local health authorities to administer COVID-19 vaccines to our local communities and, as of October 12, 2021, have administered approximately 7.5 million doses.\nSecond quarter of fiscal 2021 highlights\nIn summary, our financial and operating highlights for the second quarter of fiscal 2021 include:\n•Identical sales increase of 1.5%; two-year identical sales stacked growth was 15.3%\n•Digital sales increased 5%; on a two-year stacked basis digital sales growth was 248%\n•Net income of $295 million, or $0.52 per Class A common share\n•Adjusted net income of $370 million, or $0.64 per Class A common share\n•Adjusted EBITDA of $965 million\n•Opened one new store and completed 43 remodel projects\n•Launched 153 new Drive Up & Go locations\nStores\nThe following table shows stores operating, acquired, opened and closed during the periods presented:\n| 12 weeks ended | 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Stores, beginning of period | 2,278 | 2,252 | 2,277 | 2,252 |\n| Acquired (1) | — | — | 1 | — |\n| Opened | 1 | 2 | 6 | 2 |\n| Closed | (1) | (2) | (6) | (2) |\n| Stores, end of period | 2,278 | 2,252 | 2,278 | 2,252 |\n\n(1) The 28 weeks ended September 11, 2021 includes one store acquired from Kings and Balducci's that transferred to us subsequent to the end of the fourth quarter of fiscal 2020.\nThe following table summarizes our stores by size:\n| Number of stores | Percent of Total | Retail Square Feet (1) |\n| Square Footage | September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Less than 30,000 | 223 | 204 | 9.8 | % | 9.1 | % | 5.1 | 4.7 |\n| 30,000 to 50,000 | 786 | 781 | 34.5 | % | 34.6 | % | 32.9 | 32.8 |\n| More than 50,000 | 1,269 | 1,267 | 55.7 | % | 56.3 | % | 75.0 | 74.8 |\n| Total Stores | 2,278 | 2,252 | 100.0 | % | 100.0 | % | 113.0 | 112.3 |\n\n(1) In millions, reflects total square footage of retail stores operating at the end of the period.\n23\nRESULTS OF OPERATIONS\nComparison of Second Quarter of Fiscal 2021 and First 28 Weeks of Fiscal 2021 to Second Quarter of Fiscal 2020 and First 28 Weeks of Fiscal 2020:\nThe following tables and related discussion set forth certain information and comparisons regarding the components of our Condensed Consolidated Statements of Operations for the second quarter of fiscal 2021 and first 28 weeks of fiscal 2021 to the second quarter of fiscal 2020 and first 28 weeks of fiscal 2020 (in millions, except per share data).\n| 12 weeks ended |\n| September 11,2021 | % of Sales | September 12,2020 | % of Sales |\n| Net sales and other revenue | $ | 16,505.7 | 100.0 | % | $ | 15,757.6 | 100.0 | % |\n| Cost of sales | 11,788.7 | 71.4 | 11,182.7 | 71.0 |\n| Gross profit | 4,717.0 | 28.6 | 4,574.9 | 29.0 |\n| Selling and administrative expenses | 4,231.3 | 25.6 | 4,031.2 | 25.6 |\n| Gain on property dispositions and impairment losses, net | (0.2) | — | (18.3) | (0.1) |\n| Operating income | 485.9 | 3.0 | 562.0 | 3.5 |\n| Interest expense, net | 109.3 | 0.7 | 128.6 | 0.8 |\n| Loss on debt extinguishment | — | — | 49.1 | 0.3 |\n| Other income, net | (18.9) | (0.1) | (11.4) | (0.1) |\n| Income before income taxes | 395.5 | 2.4 | 395.7 | 2.5 |\n| Income tax expense | 100.3 | 0.6 | 111.2 | 0.7 |\n| Net income | $ | 295.2 | 1.8 | % | $ | 284.5 | 1.8 | % |\n| Basic net income per Class A common share | $ | 0.55 | $ | 0.52 |\n| Diluted net income per Class A common share | 0.52 | 0.49 |\n| 28 weeks ended |\n| September 11,2021 | % of Sales | September 12,2020 | % of Sales |\n| Net sales and other revenue | $ | 37,775.1 | 100.0 | % | $ | 38,509.2 | 100.0 | % |\n| Cost of sales | 26,867.1 | 71.1 | 27,162.8 | 70.5 |\n| Gross profit | 10,908.0 | 28.9 | 11,346.4 | 29.5 |\n| Selling and administrative expenses | 9,734.9 | 25.8 | 9,800.6 | 25.5 |\n| Loss on property dispositions and impairment losses, net | 0.1 | — | 12.0 | — |\n| Operating income | 1,173.0 | 3.1 | 1,533.8 | 4.0 |\n| Interest expense, net | 262.6 | 0.7 | 309.2 | 0.8 |\n| Loss on debt extinguishment | — | — | 49.1 | 0.1 |\n| Other income, net | (62.4) | (0.2) | (8.3) | — |\n| Income before income taxes | 972.8 | 2.6 | 1,183.8 | 3.1 |\n| Income tax expense | 232.8 | 0.6 | 313.1 | 0.8 |\n| Net income | $ | 740.0 | 2.0 | % | $ | 870.7 | 2.3 | % |\n| Basic net income per Class A common share | $ | 1.27 | $ | 1.57 |\n| Diluted net income per Class A common share | 1.26 | 1.49 |\n\nNet Sales and Other Revenue\nNet sales and other revenue increased 4.7% to $16,505.7 million for the second quarter of fiscal 2021 from $15,757.6 million for the second quarter of fiscal 2020. The increase in Net sales and other revenue was primarily driven by our 1.5% increase in identical sales, which includes an increase in pharmacy sales, partially from\n24\nadministering COVID-19 vaccines, an increase in sales related to the stores acquired and opened since the second quarter of fiscal 2020 and higher fuel sales.\nNet sales and other revenue decreased 1.9% to $37,775.1 million for the first 28 weeks of fiscal 2021 from $38,509.2 million for the first 28 weeks of fiscal 2020. The decrease in Net sales and other revenue was primarily driven by our 5.3% decrease in identical sales, which was partially offset by an increase in pharmacy sales, primarily from administering COVID-19 vaccines, and an increase in sales related to the stores opened since the first 28 weeks of fiscal 2020 and higher fuel sales.\nIdentical Sales, Excluding Fuel\nIdentical sales include stores operating during the same period in both the current year and the prior year, comparing sales on a daily basis. Direct to consumer digital sales are included in identical sales, and fuel sales are excluded from identical sales. Acquired stores become identical on the one-year anniversary date of the acquisition. Identical sales for the 12 and 28 weeks ended September 11, 2021 and the 12 and 28 weeks ended September 12, 2020, respectively, were:\n| 12 weeks ended | 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Identical sales, excluding fuel | 1.5% | 13.8% | (5.3)% | 21.0% |\n\nGross Profit\nGross profit represents the portion of Net sales and other revenue remaining after deducting Cost of sales during the period, including purchase and distribution costs. These costs include, among other things, purchasing and sourcing costs, inbound freight costs, product quality testing costs, warehouse and distribution costs, Own Brands program costs and digital-related delivery and handling costs. Advertising, promotional expenses and vendor allowances are also components of Cost of sales.\nGross profit margin decreased to 28.6% during the second quarter of fiscal 2021 compared to 29.0% during the second quarter of fiscal 2020. Excluding the impact of fuel, gross profit margin was flat compared to the second quarter of fiscal 2020, primarily due to higher product, supply chain and advertising costs, offset by benefits related to productivity initiatives, favorable product mix and improved pharmacy margins related to administering COVID-19 vaccines.\nGross profit margin decreased to 28.9% during the first 28 weeks of fiscal 2021 compared to 29.5% during the first 28 weeks of fiscal 2020. Excluding the impact of fuel, gross profit margin increased five basis points compared to the first 28 weeks of fiscal 2020. The increase in gross profit margin was primarily driven by productivity initiatives, favorable product mix and improved pharmacy margins related to administering COVID-19 vaccines, partially offset by sales deleverage and higher product and supply chain costs.\nSelling and Administrative Expenses\nSelling and administrative expenses consist primarily of store level costs, including wages, employee benefits, rent, depreciation and utilities, in addition to certain back-office expenses related to our corporate and division offices.\nSelling and administrative expenses were 25.6% of Net sales and other revenue during the second quarter of fiscal 2021 and the second quarter of fiscal 2020. Excluding the impact of fuel, Selling and administrative expenses as a percentage of Net sales and other revenue increased 55 basis points during the second quarter of fiscal 2021 compared to the second quarter of fiscal 2020. The increase in Selling and administrative expenses as a percentage\n25\nof Net sales and other revenue was primarily attributable to employee costs, depreciation and other expenses related to our investments in our digital and omni-channel capabilities and strategic priorities. The increase in employee costs was the result of additional labor related to reopening fresh departments, market-driven retail wage rate increases and higher equity-based compensation expense. These increases were partially offset by lower COVID-19 related costs and execution of productivity initiatives.\nSelling and administrative expenses increased to 25.8% of Net sales and other revenue during the first 28 weeks of fiscal 2021 compared to 25.5% of Net sales and other revenue for the first 28 weeks of fiscal 2020. Excluding the impact of fuel, Selling and administrative expenses as a percentage of Net sales and other revenue increased 90 basis points during the first 28 weeks of fiscal 2021 compared to the first 28 weeks of fiscal 2020. The increase in Selling and administrative expenses as a percentage of Net sales and other revenue was primarily attributable to sales deleverage, together with higher employee costs, depreciation and other expenses related to our investments in our digital and omni-channel capabilities and strategic priorities. The increase in employee costs was the result of additional labor related to reopening of fresh departments, market-driven retail wage rate increases and higher equity-based compensation expense. These increases were partially offset by lower COVID-19 related costs and execution of productivity initiatives.\n(Gain) Loss on Property Dispositions and Impairment Losses, Net\nFor the second quarter of fiscal 2021, net gain on property dispositions and impairment losses was $0.2 million, primarily driven by $6.2 million of gains from the sale of assets, partially offset by $6.0 million of intangible asset impairment. For the second quarter of fiscal 2020, net gain on property dispositions and impairment losses was $18.3 million, primarily driven by $20.0 million of gains from the sale of assets, partially offset by $1.7 million of asset impairments.\nFor the first 28 weeks of fiscal 2021, net loss on property dispositions and impairment losses was $0.1 million, primarily driven by $15.9 million of asset impairments, primarily related to right-of-use assets and intangible assets, partially offset by $15.8 million of gains from the sale of assets. For the first 28 weeks of fiscal 2020, net loss on property dispositions and impairment losses was $12.0 million, primarily driven by $22.8 million of asset impairments, primarily related to right-of-use assets, partially offset by $10.8 million of gains from the sale of assets.\nInterest Expense, Net\nInterest expense, net was $109.3 million during the second quarter of fiscal 2021 compared to $128.6 million during the second quarter of fiscal 2020. The decrease in interest expense was primarily attributable to lower average outstanding borrowings and lower average interest rates. The weighted average interest rate during the second quarter of fiscal 2021 was 5.4%, excluding deferred financing costs and original issue discount, compared to 6.0% during the second quarter of fiscal 2020.\nInterest expense, net was $262.6 million during the first 28 weeks of fiscal 2021 compared to $309.2 million during the first 28 weeks of fiscal 2020. The decrease in interest expense was primarily attributable to lower average outstanding borrowings and lower average interest rates. The weighted average interest rate during first 28 weeks of fiscal 2021 was 5.5%, excluding deferred financing costs and original issue discount, compared to 6.0% during the first 28 weeks of fiscal 2020.\n26\nLoss of Debt Extinguishment\nThere was no loss on debt extinguishment during both the second quarter of fiscal 2021 and first 28 weeks of fiscal 2021, compared to loss on debt extinguishment of $49.1 million during both the second quarter of fiscal 2020 and first 28 weeks of fiscal 2020. The loss on debt extinguishment during the second quarter and first 28 weeks of fiscal 2020 primarily consisted of a redemption premium payment and write-off of debt discounts associated with the redemption of the Company's 6.625% Senior Unsecured Notes due 2024 (the \"2024 Notes\").\nOther Income, Net\nFor the second quarter of fiscal 2021, Other income, net was $18.9 million compared to $11.4 million for the second quarter of fiscal 2020. Other income, net during the second quarter of fiscal 2021 was primarily driven by non-service cost components of net pension and post-retirement expense and income related to our equity investment, partially offset by unrealized losses from non-operating investments. Other income, net during the second quarter of fiscal 2020 was primarily driven by non-service cost components of net pension and post-retirement expense and income related to our equity investment.\nFor the first 28 weeks of fiscal 2021, Other income, net was $62.4 million compared to $8.3 million for the first 28 weeks of fiscal 2020. Other income, net during the first 28 weeks of fiscal 2021 was primarily driven by non-service cost components of net pension and post-retirement expense, realized gains from non-operating investments and income related to our equity investment, partially offset by unrealized losses from non-operating investments. Other income, net during the first 28 weeks of fiscal 2020 was primarily driven by non-service cost components of net pension and post-retirement expense and income related to our equity investment, partially offset by recognized losses on interest rate swaps and unrealized losses from non-operating investments.\nIncome Taxes\nIncome tax expense was $100.3 million, representing a 25.4% effective tax rate, for the second quarter of fiscal 2021. Income tax expense was $111.2 million, representing a 28.1% effective tax rate, for the second quarter of fiscal 2020. The decrease in the effective tax rate was primarily driven by nondeductible transaction-related costs incurred during the second quarter of fiscal 2020.\nIncome tax expense was $232.8 million, representing a 23.9% effective tax rate, for the first 28 weeks of fiscal 2021. Income tax expense was $313.1 million, representing a 26.4% effective tax rate, for the first 28 weeks of fiscal 2020. The decrease in the effective income tax rate was primarily driven by the recognition of discrete state income tax benefits during the first 28 weeks of fiscal 2021 and certain nondeductible transaction-related costs incurred during the first 28 weeks of fiscal 2020.\nWe currently expect our annual effective tax rate for fiscal 2021 to be in the range of approximately 23% to 24%.\nNet Income and Adjusted Net Income\nNet income was $295.2 million, or $0.52 per Class A common share, during the second quarter of fiscal 2021 compared to $284.5 million, or $0.49 per Class A common share, during the second quarter of fiscal 2020. Adjusted net income was $369.5 million, or $0.64 per Class A common share, during the second quarter of fiscal 2021 compared to $356.4 million, or $0.60 per Class A common share, during the second quarter of fiscal 2020.\nNet income was $740.0 million, or $1.26 per Class A common share, during the first 28 weeks of fiscal 2021 compared to $870.7, or $1.49 per Class A common share, during the first 28 weeks of fiscal 2020. Adjusted net income was $887.0 million, or $1.53 per Class A common share, during the first 28 weeks of fiscal 2021 compared to $1,157.6 million, or $1.95 per Class A common share, during the first 28 weeks of fiscal 2020.\n27\nAdjusted EBITDA\nFor the second quarter of fiscal 2021, Adjusted EBITDA was $965.4 million, or 5.8% of Net sales and other revenue, compared to $948.4 million, or 6.0% of Net sales and other revenue, for the second quarter of fiscal 2020. The increase in Adjusted EBITDA was primarily the result of an increase in Net sales and other revenue, partially offset by an increase in Selling and administrative expenses. For the first 28 weeks of fiscal 2021, Adjusted EBITDA was $2,273.5 million, or 6.0% of Net sales and other revenue, compared to $2,639.4 million, or 6.9% of Net sales and other revenue for the first 28 weeks of fiscal 2020. The decrease in Adjusted EBITDA was primarily the result of a decrease in Net sales and other revenue.\nSupplemental Two-Year Results - Comparison of Second Quarter of Fiscal 2021 to Second Quarter of Fiscal 2019\nThe following table provides a comparison of the second quarter of fiscal 2021 to the second quarter of fiscal 2019 for certain financial measures, including a compounded annual growth rate (\"CAGR\"), to demonstrate the two-year growth in our business. We believe these supplemental comparisons provide meaningful and useful information to investors about the trends in our business relative to pre-COVID-19 pandemic periods. These comparisons should not be reviewed in isolation or considered substitutes for our financial results included elsewhere in this Form 10-Q.\n| Second Quarter of Fiscal 2021 Supplemental Two-Year Results |\n| Identical sales two-year stacked (1) | 15.3 | % |\n| Net income per Class A common share two-year CAGR (2) | 1.0 | % |\n| Adjusted net income per Class A common share two-year CAGR | 94.0 | % |\n| Net income two-year CAGR (2) | 0.1 | % |\n| Adjusted net income two-year CAGR | 93.0 | % |\n| Adjusted EBITDA two-year CAGR | 30.4 | % |\n| Margins: |\n| Gross profit (1) | Increased 85 basis points |\n| Selling and administrative expenses (1) | Decreased 120 basis points |\n\n(1) Excluding fuel.\n(2) The net income per Class A common share two-year CAGR and net income two-year CAGR are impacted by gains related to sale leaseback transactions in the second quarter of fiscal 2019.\nNet sales and other revenue was $16.5 billion during the second quarter of fiscal 2021 compared to $14.2 billion during the second quarter of fiscal 2019. The increase in sales compared to the second quarter of fiscal 2019 was primarily due to the 15.3% increase in two-year stacked identical sales. Identical sales were driven in part by the 248% two-year stacked increase in digital sales.\nGross profit margin was 28.6% during the second quarter of fiscal 2021 compared to 27.8% during the second quarter of fiscal 2019. Excluding the impact of fuel, gross profit margin increased by approximately 85 basis points compared to the second quarter of fiscal 2019, primarily driven by sales leverage, improvements in shrink expense, productivity initiatives and improved pharmacy margins related to administering COVID-19 vaccines, partially offset by growth in digital sales and an increase in supply chain costs and COVID-19 expenses.\n28\nSelling and administrative expenses were 25.6% of sales during the second quarter of fiscal 2021 compared to 26.8% of sales for the second quarter of fiscal 2019. Excluding the impact of fuel, selling and administrative expenses as a percentage of sales decreased approximately 120 basis points primarily due to sales leverage and the execution of productivity initiatives, partially offset by increases in employee costs and other expenses related to our investments in our digital and omni-channel capabilities and strategic priorities and increased market driven retail wage rates, higher equity-based compensation expense as well as incremental COVID-19 expenses.\n29\nReconciliation of Non-GAAP Measures\nThe following tables reconcile Net income to Adjusted net income, and Net income per Class A common share to Adjusted net income per Class A common share (in millions, except per share data):\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Numerator: |\n| Net income | $ | 295.2 | $ | 284.5 | $ | 294.8 |\n| Adjustments: |\n| (Gain) loss on interest rate and commodity hedges, net (d) | (1.2) | 1.4 | — |\n| Facility closures and transformation (1)(b) | 14.8 | 6.1 | — |\n| Acquisition and integration costs (2)(b) | 3.4 | 2.2 | 7.5 |\n| Equity-based compensation expense (b) | 26.8 | 9.3 | 6.5 |\n| (Gain) loss on property dispositions and impairment losses, net (3) | (0.2) | (18.3) | (435.5) |\n| LIFO expense (a) | 14.6 | 10.1 | 5.8 |\n| Government-mandated incremental COVID-19 pandemic related pay (4)(b) | 18.3 | — | — |\n| Civil disruption related costs (5)(b) | — | (1.9) | — |\n| Transaction and reorganization costs related to Convertible Preferred Stock issuance and initial public offering (b) | — | 4.1 | — |\n| Amortization of debt discount and deferred financing costs (c) | 4.7 | 4.7 | 35.4 |\n| Loss on debt extinguishment | — | 49.1 | 23.1 |\n| Amortization of intangible assets resulting from acquisitions (b) | 11.5 | 13.1 | 68.9 |\n| Miscellaneous adjustments (6)(f) | 5.1 | 13.3 | 24.3 |\n| Tax impact of adjustments to Adjusted net income | (23.5) | (21.3) | 68.4 |\n| Adjusted net income | $ | 369.5 | $ | 356.4 | $ | 99.2 |\n| Denominator: |\n| Weighted average Class A common shares outstanding - diluted | 573.0 | 582.9 | 580.6 |\n| Adjustments: |\n| Restricted stock units and awards (7) | 8.1 | 9.6 | 7.6 |\n| Adjusted weighted average Class A common shares outstanding - diluted | 581.1 | 592.5 | 588.2 |\n| Adjusted net income per Class A common share - diluted | $ | 0.64 | $ | 0.60 | $ | 0.17 |\n| Supplemental Two-Year CAGR: |\n| Net income two-year CAGR | 0.1 | % |\n| Adjusted net income two-year CAGR | 93.0 | % |\n\n30\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Net income per Class A common share - diluted | $ | 0.52 | $ | 0.49 | $ | 0.51 |\n| Non-GAAP adjustments (8) | 0.13 | 0.12 | (0.33) |\n| Restricted stock units and awards (7) | (0.01) | (0.01) | (0.01) |\n| Adjusted net income per Class A common share - diluted | $ | 0.64 | $ | 0.60 | $ | 0.17 |\n| Supplemental Two-Year CAGR: |\n| Net income per Class A common share two-year CAGR | 1.0 | % |\n| Adjusted net income per Class A common share two-year CAGR | 94.0 | % |\n\nThe following table is a reconciliation of Adjusted net income to Adjusted EBITDA:\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Adjusted net income (9) | $ | 369.5 | $ | 356.4 | $ | 99.2 |\n| Tax impact of adjustments to Adjusted net income | 23.5 | 21.3 | (68.4) |\n| Income tax expense | 100.3 | 111.2 | 81.9 |\n| Amortization of debt discount and deferred financing costs (c) | (4.7) | (4.7) | (35.4) |\n| Interest expense, net | 109.3 | 128.6 | 177.5 |\n| Amortization of intangible assets resulting from acquisitions (b) | (11.5) | (13.1) | (68.9) |\n| Depreciation and amortization (e) | 379.0 | 348.7 | 381.7 |\n| Adjusted EBITDA | $ | 965.4 | $ | 948.4 | $ | 567.6 |\n| Supplemental Two-Year CAGR: |\n| Adjusted EBITDA two-year CAGR | 30.4 | % |\n\n(1) Includes costs related to closures of operating facilities and third-party consulting fees related to our strategic priorities and associated business transformation.\n(2) Related to conversion activities and related costs associated with integrating acquired businesses. Also includes expenses related to management fees in prior periods paid in connection with acquisition and financing activities.\n(3) Primarily due to gains related to sale leaseback transactions in the second quarter of fiscal 2019.\n(4) Represents incremental pay that is legislatively required in certain municipalities in which we operate.\n(5) Primarily includes costs related to store damage, inventory losses and community support as a result of the civil disruption during late May 2020 and early June 2020 in certain markets.\n31\n(6) Miscellaneous adjustments include the following (see table below):\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Non-cash lease-related adjustments | $ | 1.0 | $ | (0.1) | $ | 4.4 |\n| Lease and lease-related costs for surplus and closed stores | 6.5 | 10.8 | 5.2 |\n| Net realized and unrealized (gain) loss on non-operating investments | 12.8 | 0.2 | 10.8 |\n| Other (i) | (15.2) | 2.4 | 3.9 |\n| Total miscellaneous adjustments | $ | 5.1 | $ | 13.3 | $ | 24.3 |\n\n(i) Primarily includes adjustments for pension settlement gain, certain legal and regulatory accruals, unconsolidated equity investments and certain contract termination costs.\n(7) Represents incremental unvested RSUs and unvested RSAs to adjust the diluted weighted average Class A common shares outstanding during each respective period to the fully outstanding RSUs and RSAs as of the end of each respective period.\n(8) Reflects the per share impact of Non-GAAP adjustments for each period. See the reconciliation of Net income to Adjusted net income above for further details.\n(9) See the reconciliation of Net income to Adjusted net income above for further details.\nNon-GAAP adjustment classifications within the Consolidated Statement of Operations:\n(a) Cost of sales\n(b) Selling and administrative expenses\n(c) Interest expense, net\n(d) (Gain) loss on interest rate and commodity hedges, net:\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Cost of sales | $ | (1.2) | $ | 1.0 | $ | — |\n| Other income, net | — | 0.4 | — |\n| Total (Gain) loss on interest rate and commodity hedges, net | $ | (1.2) | $ | 1.4 | $ | — |\n\n(e) Depreciation and amortization:\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Cost of sales | $ | 36.0 | $ | 40.1 | $ | 38.0 |\n| Selling and administrative expenses | 343.0 | 308.6 | 343.7 |\n| Total Depreciation and amortization | $ | 379.0 | $ | 348.7 | $ | 381.7 |\n\n(f) Miscellaneous adjustments:\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Selling and administrative expenses | $ | 3.4 | $ | 9.9 | $ | 9.6 |\n| Other income, net | 1.7 | 3.4 | 14.7 |\n| Total Miscellaneous adjustments | $ | 5.1 | $ | 13.3 | $ | 24.3 |\n\n32\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Numerator: |\n| Net income | $ | 740.0 | $ | 870.7 | $ | 343.8 |\n| Adjustments: |\n| (Gain) loss on interest rate and commodity hedges, net (d) | (7.5) | 25.9 | 0.3 |\n| Facility closures and transformation (1)(b) | 35.6 | 15.9 | — |\n| Acquisition and integration costs (2)(b) | 6.9 | 8.5 | 33.6 |\n| Equity-based compensation expense (b) | 49.0 | 28.3 | 17.6 |\n| Loss (gain) on property dispositions and impairment losses, net (3) | 0.1 | 12.0 | (464.0) |\n| LIFO expense (a) | 29.1 | 23.2 | 16.3 |\n| Discretionary COVID-19 pandemic related costs (4)(b) | — | 89.9 | — |\n| Government-mandated incremental COVID-19 pandemic related pay (5)(b) | 47.4 | — | — |\n| Civil disruption related costs (6)(b) | — | 13.0 | — |\n| Transaction and reorganization costs related to Convertible Preferred Stock issuance and initial public offering (b) | — | 24.4 | — |\n| Amortization of debt discount and deferred financing costs (c) | 11.1 | 11.2 | 43.8 |\n| Loss on debt extinguishment | — | 49.1 | 65.8 |\n| Amortization of intangible assets resulting from acquisitions (b) | 27.6 | 30.6 | 161.7 |\n| Miscellaneous adjustments (7)(f) | (5.7) | 47.4 | 33.1 |\n| Tax impact of adjustments to Adjusted net income | (46.6) | (92.5) | 23.7 |\n| Adjusted net income | $ | 887.0 | $ | 1,157.6 | $ | 275.7 |\n| Denominator: |\n| Weighted average Class A common shares outstanding - diluted | 470.6 | 583.3 | 580.0 |\n| Adjustments: |\n| Convertible Preferred Stock (8) | 101.6 | — | — |\n| Restricted stock units and awards (9) | 8.8 | 9.2 | 8.2 |\n| Adjusted weighted average Class A common shares outstanding - diluted | 581.0 | 592.5 | 588.2 |\n| Adjusted net income per Class A common share - diluted | $ | 1.53 | $ | 1.95 | $ | 0.47 |\n| Supplemental Two-Year CAGR: |\n| Net income two-year CAGR | 46.7 | % |\n| Adjusted net income two-year CAGR | 79.4 | % |\n\n33\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Net income per Class A common share - diluted | $ | 1.26 | $ | 1.49 | $ | 0.59 |\n| Convertible Preferred Stock (8) | 0.03 | — | — |\n| Non-GAAP adjustments (10) | 0.26 | 0.49 | (0.11) |\n| Restricted stock units and awards (9) | (0.02) | (0.03) | (0.01) |\n| Adjusted net income per Class A common share - diluted | $ | 1.53 | $ | 1.95 | $ | 0.47 |\n| Supplemental Two-Year CAGR: |\n| Net income per Class A common share two-year CAGR | 46.1 | % |\n| Adjusted net income per Class A common share two-year CAGR | 80.4 | % |\n\nThe following table is a reconciliation of Adjusted net income to Adjusted EBITDA:\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Adjusted net income (11) | $ | 887.0 | $ | 1,157.6 | $ | 275.7 |\n| Tax impact of adjustments to Adjusted net income | 46.6 | 92.5 | (23.7) |\n| Income tax expense | 232.8 | 313.1 | 97.6 |\n| Amortization of debt discount and deferred financing costs (c) | (11.1) | (11.2) | (43.8) |\n| Interest expense, net | 262.6 | 309.2 | 402.7 |\n| Amortization of intangible assets resulting from acquisitions (b) | (27.6) | (30.6) | (161.7) |\n| Depreciation and amortization (e) | 883.2 | 808.8 | 897.6 |\n| Adjusted EBITDA | $ | 2,273.5 | $ | 2,639.4 | $ | 1,444.4 |\n| Supplemental Two-Year CAGR: |\n| Adjusted EBITDA two-year CAGR | 25.5 | % |\n\n(1) Includes costs related to closures of operating facilities and third-party consulting fees related to our strategic priorities and associated business transformation.\n(2) Related to conversion activities and related costs associated with integrating acquired businesses. Also includes expenses related to management fees in prior periods paid in connection with acquisition and financing activities.\n(3) Primarily due to gains related to sale leaseback transactions in the second quarter of fiscal 2019.\n(4) Includes $53 million of charitable contributions to our communities for hunger relief and $36.9 million in final reward payments to front-line associates at the end of the first quarter of fiscal 2020.\n(5) Represents incremental pay that is legislatively required in certain municipalities in which we operate.\n(6) Primarily includes costs related to store damage, inventory losses and community support as a result of the civil disruption during late May 2020 and early June 2020 in certain markets.\n34\n(7) Miscellaneous adjustments include the following (see table below):\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Non-cash lease-related adjustments | $ | 3.1 | $ | 1.9 | $ | 6.3 |\n| Lease and lease-related costs for surplus and closed stores | 16.7 | 29.5 | 12.0 |\n| Net realized and unrealized (gain) loss on non-operating investments | (9.7) | 4.7 | 7.5 |\n| Other (i) | (15.8) | 11.3 | 7.3 |\n| Total miscellaneous adjustments | $ | (5.7) | $ | 47.4 | $ | 33.1 |\n\n(i) Primarily includes adjustments for pension settlement gain, certain legal and regulatory accruals, unconsolidated equity investments and certain contract termination costs.\n(8) Represents the conversion of Convertible Preferred Stock to the fully outstanding as-converted Class A common shares as of the end of each respective period, for periods in which the Convertible Preferred Stock is antidilutive under GAAP.\n(9) Represents incremental unvested RSUs and unvested RSAs to adjust the diluted weighted average Class A common shares outstanding during each respective period to the fully outstanding RSUs and RSAs as of the end of each respective period.\n(10) Reflects the per share impact of Non-GAAP adjustments for each period. See the reconciliation of Net income to Adjusted net income above for further details.\n(11) See the reconciliation of Net income to Adjusted net income above for further details.\nNon-GAAP adjustment classifications within the Consolidated Statement of Operations:\n(a) Cost of sales\n(b) Selling and administrative expenses\n(c) Interest expense, net\n35\n(d) (Gain) loss on interest rate and commodity hedges, net:\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Cost of sales | $ | (7.8) | $ | 6.5 | $ | 0.3 |\n| Other income, net | 0.3 | 19.4 | — |\n| Total (Gain) loss on interest rate and commodity hedges, net | $ | (7.5) | $ | 25.9 | $ | 0.3 |\n\n(e) Depreciation and amortization:\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Cost of sales | $ | 86.8 | $ | 94.1 | $ | 90.0 |\n| Selling and administrative expenses | 796.4 | 714.7 | 807.6 |\n| Total Depreciation and amortization | $ | 883.2 | $ | 808.8 | $ | 897.6 |\n\n(f) Miscellaneous adjustments:\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Selling and administrative expenses | $ | 10.2 | $ | 34.7 | $ | 16.7 |\n| Other income, net | (15.9) | 12.7 | 16.4 |\n| Total Miscellaneous adjustments | $ | (5.7) | $ | 47.4 | $ | 33.1 |\n\nLIQUIDITY AND CAPITAL RESOURCES\nThe following table sets forth the major sources and uses of cash and cash equivalents and restricted cash for each period (in millions):\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 |\n| Cash and cash equivalents and restricted cash at end of period | $ | 2,900.4 | $ | 2,431.9 |\n| Cash flows provided by operating activities | 2,137.7 | 2,720.8 |\n| Cash flows used in investing activities | (790.5) | (687.1) |\n| Cash flows used in financing activities | (214.4) | (80.7) |\n\nNet Cash Provided by Operating Activities\nNet cash provided by operating activities was $2,137.7 million for the first 28 weeks of fiscal 2021 compared to $2,720.8 million for the first 28 weeks of fiscal 2020. The decrease in cash flow from operations compared to the first 28 weeks of fiscal 2020 was due to changes in working capital primarily related to accounts payable as our business experienced significantly elevated demand during the first 28 weeks of fiscal 2020 and a deferral of approximately $270 million of the employer-paid portion of social security taxes in the first 28 weeks of fiscal 2020 together with lower EBITDA during the first 28 weeks of fiscal 2021. These decreases were partially offset by less cash paid for interest and income taxes of $94 million and $72 million, respectively, $75 million payment for the UFCW & Employers Midwest Pension Fund settlement in the first 28 weeks of fiscal 2020 and a decrease of $45.1 million in contributions to our defined benefit pension plans and post-retirement benefit plans.\n36\nNet Cash Used by Investing Activities\nNet cash used in investing activities was $790.5 million for the first 28 weeks of fiscal 2021 compared to $687.1 million for the first 28 weeks of fiscal 2020.\nFor the first 28 weeks of fiscal 2021, cash used in investing activities consisted primarily of payments for property and equipment of $822.5 million and payments for business acquisitions of $23.5 million, partially offset by proceeds from the sale of long-lived assets of $24.6 million. Payments for property and equipment in the first 28 weeks of fiscal 2021 included the opening of six new stores, completion of 76 remodels and increased investment in our digital technology. For the first 28 weeks of fiscal 2020, cash used in investing activities consisted primarily of payments for property and equipment of $702.9 million. Payments for property and equipment in the first 28 weeks of fiscal 2020 included the completion of 132 remodels and continued investment in our digital technology. For the full fiscal year of 2021, we expect capital expenditures to be in the range of $1.9 billion to $2.0 billion.\nNet Cash Used in Financing Activities\nNet cash used in financing activities was $214.4 million during the first 28 weeks of fiscal 2021 compared to $80.7 million during the first 28 weeks of fiscal 2020.\nNet cash used in financing activities during the first 28 weeks of fiscal 2021 consisted primarily of dividends paid on our Class A common stock and Convertible Preferred Stock. Net cash used in financing activities during the first 28 weeks of fiscal 2020 consisted primarily of the $1.5 billion issuance of new Senior Unsecured Notes and $1.25 billion aggregate redemption of 2024 Notes and 2025 Notes, the $2.0 billion borrowing and subsequent repayment of the ABL Facility, the issuance of the Convertible Preferred Stock and the repurchase of outstanding Class A common stock.\nLiquidity and Factors Affecting Liquidity\nWe estimate our liquidity needs over the next 12 months to be in the range of $4.75 billion to $5.25 billion, which includes anticipated requirements for incremental working capital, capital expenditures, pension obligations, interest payments and scheduled principal payments of debt, dividends on Class A common stock and Convertible Preferred Stock, operating leases and finance leases. Based on current operating trends, we believe that cash flows from operating activities and other sources of liquidity, including borrowings under our ABL Facility, will be adequate to meet our liquidity needs for the next 12 months and for the foreseeable future. We believe we have adequate cash flow to continue to respond effectively to competitive conditions. In addition, we may enter into refinancing and sale leaseback transactions from time to time. There can be no assurance, however, that our business will continue to generate cash flow at or above current levels or that we will maintain our ability to borrow under our ABL Facility.\nThe holders of Convertible Preferred Stock are entitled to a quarterly dividend at a rate per annum of 6.75% of the liquidation preference per share of the Convertible Preferred Stock. On March 15, 2021, June 15, 2021 and September 15, 2021, we declared quarterly cash dividends of $29.5 million, respectively, to holders of the Convertible Preferred Stock, which was paid on March 31, 2021, June 30, 2021 and September 30, 2021, respectively. In addition, the holders of Convertible Preferred Stock will participate in cash dividends that we pay on our common stock to the extent that such cash dividends exceed $206.25 million per fiscal year.\n37\nWe have established a dividend policy pursuant to which we intend to pay a quarterly dividend on our Class A common stock. During the first 28 weeks of fiscal 2021, we paid quarterly cash dividends of $0.10 per share of Class A common stock on May 10, 2021 and August 10, 2021, to stockholders of record as of the close of business on April 26, 2021 and July 26, 2021, respectively. On October 18, 2021, subsequent to the end of the second quarter of fiscal 2021, we announced a 20% increase to our quarterly dividend, which is now $0.12 per share of Class A common stock, payable on November 12, 2021 to stockholders of record as of the close of business on October 29, 2021.\nAs of September 11, 2021, we had no borrowings outstanding under out ABL Facility and total availability of $3,483.1 million (net of letter of credit usage).\nMultiemployer Pension Plans\nThe American Rescue Plan Act (\"ARP Act\") establishes a special financial assistance program for financially troubled multiemployer pension plans. Under the ARP Act, eligible multiemployer plans can apply to receive a one-time cash payment in the amount projected by the Pension Benefit Guaranty Corporation (\"PBGC\") to pay pension benefits through the plan year ending 2051. The payment received by the multiemployer plan under this special financial assistance program would not be considered a loan and would not need to be paid back. Any financial assistance received by the multiemployer plan would need to be segregated from the other assets of the multiemployer plans and invested in investment grade bonds or other investments permitted by the PBGC.\nOf the 27 multiemployer plans to which we contribute, 16 plans are classified as \"Critical\" or \"Critical and Declining\" and are potentially eligible for special financial assistance under the ARP Act. Though the amount of financial assistance that each of these 16 plans could receive will vary by plan, we currently estimate that these 16 plans represent over 90% of the $4.7 billion we estimated as our share of the underfunding of the 27 plans. On July 9, 2021, the PBGC issued its interim final rule with respect to the special financial assistance program. The PBGC interim final rule provides direction on the application requirements, identifies which plans will have priority, eligibility requirements, the determination of the amount of financial assistance to be provided and establishes conditions and restrictions that apply to plans that receive assistance. We are evaluating the interim final rule and have submitted comments during the 30-day comment period, and we expect the special financial assistance program to provide funding for the multiemployer plans to which we contribute to remain solvent through the next 25 to 30 years.\nCRITICAL ACCOUNTING POLICIES\nThe preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. We have chosen accounting policies that we believe are appropriate to report accurately and fairly our operating results and financial position, and we apply those accounting policies in a fair and consistent manner. See the Critical Accounting Policies section included in our Annual Report on Form 10-K for the fiscal year ended February 27, 2021, filed with the SEC on April 28, 2021, for a discussion of our significant accounting policies.\nRECENTLY ISSUED AND RECENTLY ADOPTED ACCOUNTING STANDARDS\nSee Note 1 - Basis of presentation and summary of significant accounting policies of our unaudited interim Condensed Consolidated Financial Statements located elsewhere in this Form 10-Q.\n38\nItem 3\n-\nQuantitative and Qualitative Disclosures About Market Risk\nThere have been no material changes in our exposure to market risk from the information provided in our Annual Report on Form 10-K for the fiscal year ended February 27, 2021, filed with the SEC on April 28, 2021.\nItem 4 - Controls and Procedures\nBased on their evaluation of our disclosure controls and procedures (as defined in Rules 13a-15 and 15d-15 under the Securities Exchange Act of 1934 (the \"Exchange Act\")) as of the end of the period covered by this Form 10-Q, our Principal Executive Officer and Principal Financial Officer concluded our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms and is accumulated and communicated to management, including our Principal Executive Officer and Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting during the second quarter of fiscal 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n39\nPART II - OTHER INFORMATION\nItem 1 - Legal Proceedings\nThe Company is subject from time to time to various claims and lawsuits arising in the ordinary course of business, including lawsuits involving trade practices, lawsuits alleging violations of state and/or federal wage and hour laws (including alleged violations of meal and rest period laws and alleged misclassification issues), real estate disputes as well as other matters. Some of these claims or suits purport or may be determined to be class actions and/or seek substantial damages. It is the opinion of the Company's management that although the amount of liability with respect to certain of the matters described in this Form 10-Q cannot be ascertained at this time, any resulting liability of these and other matters, including any punitive damages, will not have a material adverse effect on the Company's business or financial condition. See the matters under the caption Legal Proceedings in Note 6 - Commitments and contingencies and off balance sheet arrangements in the unaudited interim Condensed Consolidated Financial Statements located elsewhere in this Form 10-Q.\nItem 1A - Risk Factors\nThere have been no material changes to the risk factors previously included in our Annual Report on Form 10-K for the fiscal year ended February 27, 2021, filed with the SEC on April 28, 2021, under the heading \"Risk Factors.\"\nItem 2 - Unregistered Sales of Equity Securities and Use of Proceeds\n(a) Unregistered Sales of Equity Securities\nNone.\n(b) Use of Proceeds\nNone.\n(c) Purchases of Equity Securities\nNone.\nItem 3 - Defaults Upon Senior Securities\nNone.\nItem 4 - Mine Safety Disclosures\nNot Applicable.\nItem 5 - Other Information\nNone.\n40\nItem 6 - Exhibits\n3.1 Certificate of Amendment to the Amended and Restated Certificate of Incorporation of Albertsons Companies, Inc.\n10.1 Employment Agreement, dated as of August 4, 2021, by and between Albertsons Companies, Inc. and Sharon McCollam (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on August 11, 2021)\n31.1 Certification of the Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002\n31.2 Certification of the Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002\n32.1 Certification of the Principal Executive Officer and of the Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002\nEXHIBIT 101.INS - Inline XBRL Instance Document\nEXHIBIT 101.SCH - Inline XBRL Taxonomy Extension Schema Document\nEXHIBIT 101.CAL - Inline XBRL Taxonomy Extension Calculation Linkbase Document\nEXHIBIT 101.DEF - Inline XBRL Taxonomy Extension Definition Linkbase Document\nEXHIBIT 101.LAB - Inline XBRL Taxonomy Extension Label Linkbase Document\nEXHIBIT 101.PRE - Inline XBRL Taxonomy Extension Presentation Linkbase Document\nEXHIBIT 104 - Cover Page Interactive Data File (embedded within the Inline XBRL document)\n41\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n| Albertsons Companies, Inc.(Registrant) |\n| Date: | October 20, 2021 | By: | /s/ Vivek Sankaran |\n| Vivek Sankaran |\n| Chief Executive Officer and Director(Principal Executive Officer) |\n\n| Date: | October 20, 2021 | By: | /s/ Sharon McCollam |\n| Sharon McCollam |\n| President and Chief Financial Officer(Principal Financial Officer) |\n\n42\n</text>\n\nWhat is the rate of increase in total debt as a percentage of total assets from February 27, 2021 to September 11, 2021 in percent?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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doc-math
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"ground_truth": "Therefore, the answer is -2.3942768229509377."
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docmath_40000_plus
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1.\nFinancial Statements\nConsolidated Balance Sheets September 30, 2015 (unaudited)\nand December 31, 2014 1\nConsolidated Statements of Operations and Comprehensive Income (Loss) for the\nthree and nine months ended September 30, 2015 and 2014 (unaudited) 2\nConsolidated Statements of Changes in Shareholders' Equity for the three and\nnine months ended September 30, 2015 and 2014 (unaudited) 3\nConsolidated Statements of Cash Flows for the nine months ended\nSeptember 30, 2015 and 2014 (unaudited) 4\nNotes to Consolidated Interim Financial Statements (unaudited) 5\nItem 2. Management's Discussion and Analysis of Financial Condition and\nResults of Operation 30\nItem 3. Quantitative and Qualitative Disclosures About Market Risk 57\nItem 4. Controls and Procedures 58\nPART II\nOTHER INFORMATION\n\n| Item 1. | Legal Proceedings | 58 |\n| Item 1A. | Risk Factors | 58 |\n| Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 59 |\n| Item 3. | Defaults Upon Senior Securities | 59 |\n| Item 4. | Mine Safety Disclosures | 59 |\n| Item 5. | Other Information | 59 |\n| Item 6. | Exhibits | 60 |\n\nEVEREST RE GROUP, LTD.\nCONSOLIDATED BALANCE SHEETS\n\n| September 30, | December 31, |\n| (Dollars and share amounts in thousands, except par value per share) | 2015 | 2014 |\n| (unaudited) |\n| ASSETS: |\n| Fixed maturities - available for sale, at market value | $ | 13,490,960 | $ | 13,101,067 |\n| (amortized cost: 2015, $13,301,713; 2014, $12,831,159) |\n| Fixed maturities - available for sale, at fair value | - | 1,509 |\n| Equity securities - available for sale, at market value (cost: 2015, $127,411; 2014, $148,326) | 112,999 | 140,210 |\n| Equity securities - available for sale, at fair value | 1,357,311 | 1,447,820 |\n| Short-term investments | 1,615,045 | 1,705,932 |\n| Other invested assets (cost: 2015, $669,686; 2014, $601,925) | 669,686 | 601,925 |\n| Cash | 401,226 | 437,474 |\n| Total investments and cash | 17,647,227 | 17,435,937 |\n| Accrued investment income | 107,199 | 111,075 |\n| Premiums receivable | 1,663,425 | 1,397,983 |\n| Reinsurance receivables | 831,635 | 670,854 |\n| Funds held by reinsureds | 272,775 | 228,192 |\n| Deferred acquisition costs | 364,947 | 398,408 |\n| Prepaid reinsurance premiums | 193,122 | 154,177 |\n| Income taxes | 270,607 | 184,762 |\n| Other assets | 331,374 | 236,436 |\n| TOTAL ASSETS | $ | 21,682,311 | $ | 20,817,824 |\n| LIABILITIES: |\n| Reserve for losses and loss adjustment expenses | $ | 9,965,963 | $ | 9,720,813 |\n| Future policy benefit reserve | 59,580 | 59,820 |\n| Unearned premium reserve | 1,717,422 | 1,728,745 |\n| Funds held under reinsurance treaties | 83,137 | 3,932 |\n| Commission reserves | 79,904 | 87,990 |\n| Other net payable to reinsurers | 199,528 | 139,841 |\n| Losses in course of payment | 298,577 | 157,527 |\n| 4.868% Senior notes due 6/1/2044 | 400,000 | 400,000 |\n| 6.6% Long term notes due 5/1/2067 | 238,367 | 238,364 |\n| Accrued interest on debt and borrowings | 12,341 | 3,537 |\n| Equity index put option liability | 52,247 | 47,022 |\n| Unsettled securities payable | 65,147 | 41,092 |\n| Other liabilities | 271,086 | 316,469 |\n| Total liabilities | 13,443,299 | 12,945,152 |\n| NONCONTROLLING INTERESTS: |\n| Redeemable noncontrolling interests - Mt. Logan Re | 752,692 | 421,552 |\n| Commitments and contingencies (Note 9) |\n| SHAREHOLDERS' EQUITY: |\n| Preferred shares, par value: $0.01; 50,000 shares authorized; |\n| no shares issued and outstanding | - | - |\n| Common shares, par value: $0.01; 200,000 shares authorized; (2015) 68,585 |\n| and (2014) 68,336 outstanding before treasury shares | 686 | 683 |\n| Additional paid-in capital | 2,094,850 | 2,068,807 |\n| Accumulated other comprehensive income (loss), net of deferred income tax expense |\n| (benefit) of ($2,899) at 2015 and $20,715 at 2014 | (112,231 | ) | 48,317 |\n| Treasury shares, at cost; 25,500 shares (2015) and 23,650 shares (2014) | (2,810,878 | ) | (2,485,897 | ) |\n| Retained earnings | 8,313,893 | 7,819,210 |\n| Total shareholders' equity attributable to Everest Re Group | 7,486,320 | 7,451,120 |\n| TOTAL LIABILITIES, NONCONTROLLING INTERESTS AND SHAREHOLDERS' EQUITY | $ | 21,682,311 | $ | 20,817,824 |\n| The accompanying notes are an integral part of the consolidated financial statements. |\n\n1\nEVEREST RE GROUP, LTD.\nCONSOLIDATED STATEMENTS OF OPERATIONS\nAND COMPREHENSIVE INCOME (LOSS)\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands, except per share amounts) | 2015 | 2014 | 2015 | 2014 |\n| (unaudited) | (unaudited) |\n| REVENUES: |\n| Premiums earned | $ | 1,413,640 | $ | 1,389,998 | $ | 4,053,115 | $ | 3,806,805 |\n| Net investment income | 115,511 | 142,143 | 363,140 | 396,524 |\n| Net realized capital gains (losses): |\n| Other-than-temporary impairments on fixed maturity securities | (20,445 | ) | (106 | ) | (62,701 | ) | (495 | ) |\n| Other-than-temporary impairments on fixed maturity securities |\n| transferred to other comprehensive income (loss) | - | - | - | - |\n| Other net realized capital gains (losses) | (139,526 | ) | (9,342 | ) | (131,953 | ) | 71,189 |\n| Total net realized capital gains (losses) | (159,971 | ) | (9,448 | ) | (194,654 | ) | 70,694 |\n| Net derivative gain (loss) | (11,428 | ) | 1,855 | (5,225 | ) | 3,968 |\n| Other income (expense) | 17,413 | 11,332 | 59,561 | (5,835 | ) |\n| Total revenues | 1,375,165 | 1,535,880 | 4,275,937 | 4,272,156 |\n| CLAIMS AND EXPENSES: |\n| Incurred losses and loss adjustment expenses | 888,097 | 837,757 | 2,401,223 | 2,192,863 |\n| Commission, brokerage, taxes and fees | 300,048 | 290,519 | 882,132 | 820,208 |\n| Other underwriting expenses | 70,667 | 63,113 | 195,282 | 172,165 |\n| Corporate expenses | 5,924 | 9,958 | 17,312 | 18,802 |\n| Interest, fees and bond issue cost amortization expense | 8,990 | 12,424 | 27,006 | 28,970 |\n| Total claims and expenses | 1,273,726 | 1,213,771 | 3,522,955 | 3,233,008 |\n| INCOME (LOSS) BEFORE TAXES | 101,439 | 322,109 | 752,982 | 1,039,148 |\n| Income tax expense (benefit) | (6,133 | ) | 20,856 | 70,868 | 137,948 |\n| NET INCOME (LOSS) | $ | 107,572 | $ | 301,253 | $ | 682,114 | $ | 901,200 |\n| Net (income) loss attributable to noncontrolling interests | (19,019 | ) | (26,337 | ) | (61,526 | ) | (42,167 | ) |\n| NET INCOME (LOSS) ATTRIBUTABLE TO EVEREST RE GROUP | $ | 88,553 | $ | 274,916 | $ | 620,588 | $ | 859,033 |\n| Other comprehensive income (loss), net of tax: |\n| Unrealized appreciation (depreciation) (\"URA(D)\") on securities arising during the period | (91,059 | ) | (74,074 | ) | (144,335 | ) | 65,318 |\n| Reclassification adjustment for realized losses (gains) included in net income (loss) | 24,596 | (5,684 | ) | 59,526 | (1,641 | ) |\n| Total URA(D) on securities arising during the period | (66,463 | ) | (79,758 | ) | (84,809 | ) | 63,677 |\n| Foreign currency translation adjustments | (32,505 | ) | (34,974 | ) | (80,508 | ) | (38,374 | ) |\n| Benefit plan actuarial net gain (loss) for the period | - | - | - | - |\n| Reclassification adjustment for amortization of net (gain) loss included in net income (loss) | 1,556 | 825 | 4,769 | 2,366 |\n| Total benefit plan net gain (loss) for the period | 1,556 | 825 | 4,769 | 2,366 |\n| Total other comprehensive income (loss), net of tax | (97,412 | ) | (113,907 | ) | (160,548 | ) | 27,669 |\n| Other comprehensive (income) loss attributable to noncontrolling interests | - | - | - | - |\n| Total other comprehensive income (loss), net of tax attributable to Everest Re Group | (97,412 | ) | (113,907 | ) | (160,548 | ) | 27,669 |\n| COMPREHENSIVE INCOME (LOSS) | $ | (8,859 | ) | $ | 161,009 | $ | 460,040 | $ | 886,702 |\n| EARNINGS PER COMMON SHARE ATTRIBUTABLE TO EVEREST RE GROUP: |\n| Basic | $ | 2.02 | $ | 6.05 | $ | 14.04 | $ | 18.64 |\n| Diluted | 2.00 | 6.00 | 13.92 | 18.47 |\n| Dividends declared | 0.95 | 0.75 | 2.85 | 2.25 |\n| The accompanying notes are an integral part of the consolidated financial statements. |\n\n2\nEVEREST RE GROUP, LTD.\nCONSOLIDATED STATEMENTS OF\nCHANGES IN SHAREHOLDERS' EQUITY\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands, except share and dividends per share amounts) | 2015 | 2014 | 2015 | 2014 |\n| (unaudited) | (unaudited) |\n| COMMON SHARES (shares outstanding): |\n| Balance, beginning of period | 44,192,526 | 45,691,015 | 44,685,637 | 47,543,132 |\n| Issued during the period, net | 29,398 | 29,622 | 248,665 | 344,761 |\n| Treasury shares acquired | (1,137,473 | ) | (470,807 | ) | (1,849,851 | ) | (2,638,063 | ) |\n| Balance, end of period | 43,084,451 | 45,249,830 | 43,084,451 | 45,249,830 |\n| COMMON SHARES (par value): |\n| Balance, beginning of period | $ | 685 | $ | 683 | $ | 683 | $ | 680 |\n| Issued during the period, net | 1 | - | 3 | 3 |\n| Balance, end of period | 686 | 683 | 686 | 683 |\n| ADDITIONAL PAID-IN CAPITAL: |\n| Balance, beginning of period | 2,084,636 | 2,052,682 | 2,068,807 | 2,029,774 |\n| Share-based compensation plans | 10,214 | 7,274 | 26,043 | 30,182 |\n| Balance, end of period | 2,094,850 | 2,059,956 | 2,094,850 | 2,059,956 |\n| ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS), |\n| NET OF DEFERRED INCOME TAXES: |\n| Balance, beginning of period | (14,819 | ) | 299,304 | 48,317 | 157,728 |\n| Net increase (decrease) during the period | (97,412 | ) | (113,907 | ) | (160,548 | ) | 27,669 |\n| Balance, end of period | (112,231 | ) | 185,397 | (112,231 | ) | 185,397 |\n| RETAINED EARNINGS: |\n| Balance, beginning of period | 8,267,038 | 7,281,023 | 7,819,210 | 6,765,967 |\n| Net income (loss) attributable to Everest Re Group | 88,553 | 274,916 | 620,588 | 859,033 |\n| Dividends declared ($0.95 per share in third quarter 2015 and $2.85 year-to-date |\n| per share in 2015 and $0.75 per share in third quarter 2014 and $2.25 |\n| year-to-date per share in 2014) | (41,698 | ) | (33,973 | ) | (125,905 | ) | (103,034 | ) |\n| Balance, end of period | 8,313,893 | 7,521,966 | 8,313,893 | 7,521,966 |\n| TREASURY SHARES AT COST: |\n| Balance, beginning of period | (2,610,878 | ) | (2,310,824 | ) | (2,485,897 | ) | (1,985,873 | ) |\n| Purchase of treasury shares | (200,000 | ) | (74,991 | ) | (324,981 | ) | (399,942 | ) |\n| Balance, end of period | (2,810,878 | ) | (2,385,815 | ) | (2,810,878 | ) | (2,385,815 | ) |\n| TOTAL SHAREHOLDERS' EQUITY, END OF PERIOD | $ | 7,486,320 | $ | 7,382,187 | $ | 7,486,320 | $ | 7,382,187 |\n| The accompanying notes are an integral part of the consolidated financial statements. |\n\n3\nEVEREST RE GROUP, LTD.\nCONSOLIDATED STATEMENTS OF CASH FLOWS\n\n| Nine Months Ended |\n| September 30, |\n| (Dollars in thousands) | 2015 | 2014 |\n| (unaudited) |\n| CASH FLOWS FROM OPERATING ACTIVITIES: |\n| Net income (loss) | $ | 682,114 | $ | 901,200 |\n| Adjustments to reconcile net income to net cash provided by operating activities: |\n| Decrease (increase) in premiums receivable | (274,198 | ) | (255,645 | ) |\n| Decrease (increase) in funds held by reinsureds, net | 33,255 | (6,929 | ) |\n| Decrease (increase) in reinsurance receivables | (202,329 | ) | (256,458 | ) |\n| Decrease (increase) in income taxes | (61,627 | ) | (14,696 | ) |\n| Decrease (increase) in prepaid reinsurance premiums | (46,633 | ) | (101,478 | ) |\n| Increase (decrease) in reserve for losses and loss adjustment expenses | 347,729 | 172,511 |\n| Increase (decrease) in future policy benefit reserve | (240 | ) | (1,879 | ) |\n| Increase (decrease) in unearned premiums | 1,455 | 255,537 |\n| Increase (decrease) in other net payable to reinsurers | 67,550 | 101,984 |\n| Increase (decrease) in losses in course of payment | 142,418 | 165,105 |\n| Change in equity adjustments in limited partnerships | (12,725 | ) | (24,438 | ) |\n| Distribution of limited partnership income | 42,625 | 41,165 |\n| Change in other assets and liabilities, net | 18,573 | (32,114 | ) |\n| Non-cash compensation expense | 16,150 | 14,720 |\n| Amortization of bond premium (accrual of bond discount) | 38,770 | 38,010 |\n| Amortization of underwriting discount on senior notes | 3 | 43 |\n| Net realized capital (gains) losses | 194,654 | (70,694 | ) |\n| Net cash provided by (used in) operating activities | 987,544 | 925,944 |\n| CASH FLOWS FROM INVESTING ACTIVITIES: |\n| Proceeds from fixed maturities matured/called - available for sale, at market value | 1,687,589 | 1,638,278 |\n| Proceeds from fixed maturities matured/called - available for sale, at fair value | - | 875 |\n| Proceeds from fixed maturities sold - available for sale, at market value | 1,146,000 | 1,050,082 |\n| Proceeds from fixed maturities sold - available for sale, at fair value | 1,824 | 23,856 |\n| Proceeds from equity securities sold - available for sale, at market value | 22,120 | 11,174 |\n| Proceeds from equity securities sold - available for sale, at fair value | 439,692 | 452,514 |\n| Distributions from other invested assets | 41,782 | 59,264 |\n| Proceeds from sale of subsidiary (net of cash disposed) | 3,934 | - |\n| Cost of fixed maturities acquired - available for sale, at market value | (3,583,990 | ) | (3,729,423 | ) |\n| Cost of fixed maturities acquired - available for sale, at fair value | (234 | ) | (23,684 | ) |\n| Cost of equity securities acquired - available for sale, at market value | (6,581 | ) | (11,873 | ) |\n| Cost of equity securities acquired - available for sale, at fair value | (460,965 | ) | (262,871 | ) |\n| Cost of other invested assets acquired | (140,923 | ) | (120,911 | ) |\n| Net change in short-term investments | 83,584 | (284,822 | ) |\n| Net change in unsettled securities transactions | (18,242 | ) | 13,496 |\n| Net cash provided by (used in) investing activities | (784,410 | ) | (1,184,045 | ) |\n| CASH FLOWS FROM FINANCING ACTIVITIES: |\n| Common shares issued during the period, net | 9,896 | 15,465 |\n| Purchase of treasury shares | (324,981 | ) | (399,942 | ) |\n| Net proceeds from issuance of senior notes | - | 400,000 |\n| Third party investment in redeemable noncontrolling interest | 296,848 | 136,200 |\n| Dividends paid to shareholders | (125,905 | ) | (103,034 | ) |\n| Dividends paid on third party investment in redeemable noncontrolling interest | (67,233 | ) | (10,334 | ) |\n| Net cash provided by (used in) financing activities | (211,375 | ) | 38,355 |\n| EFFECT OF EXCHANGE RATE CHANGES ON CASH | (28,007 | ) | 10,167 |\n| Net increase (decrease) in cash | (36,248 | ) | (209,579 | ) |\n| Cash, beginning of period | 437,474 | 611,382 |\n| Cash, end of period | $ | 401,226 | $ | 401,803 |\n| SUPPLEMENTAL CASH FLOW INFORMATION: |\n| Income taxes paid (recovered) | $ | 123,234 | $ | 146,560 |\n| Interest paid | 18,039 | 15,150 |\n| The accompanying notes are an integral part of the consolidated financial statements. |\n\n4\nNOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)\nFor the Three and Nine Months Ended September 30, 2015 and 2014\n1. GENERAL\nEverest Re Group, Ltd. (\"Group\"), a Bermuda company, through its subsidiaries, principally provides reinsurance and insurance in the U.S., Bermuda and international markets. As used in this document, \"Company\" means Group and its subsidiaries.\nEffective February 27, 2013, the Company established a new subsidiary, Mt. Logan Re Ltd. (\"Mt. Logan Re\") and effective July 1, 2013, Mt. Logan Re established separate segregated accounts and issued non-voting redeemable preferred shares to capitalize the segregated accounts. Accordingly, the financial position and operating results for Mt. Logan Re are consolidated with the Company and the non-controlling interests in Mt. Logan Re's operating results and equity are presented as separate captions in the Company's financial statements.\nEffective July 13, 2015, the Company sold all of the outstanding shares of capital stock of a wholly-owned subsidiary entity, Mt. McKinley Insurance Company (\"Mt. McKinley\"), to Clearwater Insurance Company. The operating results of Mt. McKinley through July 13, 2015 are included within the Company's financial statements.\n2. BASIS OF PRESENTATION\nThe unaudited consolidated financial statements of the Company for the three and nine months ended September 30, 2015 and 2014 include all adjustments, consisting of normal recurring accruals, which, in the opinion of management, are necessary for a fair statement of the results on an interim basis. Certain financial information, which is normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America (\"GAAP\"), has been omitted since it is not required for interim reporting purposes. The December 31, 2014 consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by GAAP. The results for the three and nine months ended September 30, 2015 and 2014 are not necessarily indicative of the results for a full year. These financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto for the years ended December 31, 2014, 2013 and 2012 included in the Company's most recent Form 10-K filing.\nAll intercompany accounts and transactions have been eliminated.\nApplication of Recently Issued Accounting Standard Changes.\nNo accounting standards or guidance have been issued recently that would have a material impact on the Company's financial statements or financial reporting process.\n5\n3. INVESTMENTS\nThe amortized cost, market value and gross unrealized appreciation and depreciation of available for sale, fixed maturity, equity security investments, carried at market value and other-than-temporary impairments (\"OTTI\") in accumulated other comprehensive income (\"AOCI\") are as follows for the periods indicated:\n\n| At September 30, 2015 |\n| Amortized | Unrealized | Unrealized | Market | OTTI in AOCI |\n| (Dollars in thousands) | Cost | Appreciation | Depreciation | Value | (a) |\n| Fixed maturity securities |\n| U.S. Treasury securities and obligations of |\n| U.S. government agencies and corporations | $ | 337,271 | $ | 15,725 | $ | (70 | ) | $ | 352,926 | $ | - |\n| Obligations of U.S. states and political subdivisions | 683,715 | 32,087 | (1,523 | ) | 714,279 | - |\n| Corporate securities | 4,964,570 | 118,763 | (76,396 | ) | 5,006,937 | 2,006 |\n| Asset-backed securities | 437,376 | 2,575 | (1,554 | ) | 438,397 | - |\n| Mortgage-backed securities |\n| Commercial | 277,907 | 7,697 | (795 | ) | 284,809 | - |\n| Agency residential | 2,392,937 | 39,295 | (6,165 | ) | 2,426,067 | - |\n| Non-agency residential | 971 | 53 | (46 | ) | 978 | - |\n| Foreign government securities | 1,285,006 | 60,837 | (44,882 | ) | 1,300,961 | (2 | ) |\n| Foreign corporate securities | 2,921,960 | 115,881 | (72,235 | ) | 2,965,606 | 39 |\n| Total fixed maturity securities | $ | 13,301,713 | $ | 392,913 | $ | (203,666 | ) | $ | 13,490,960 | $ | 2,043 |\n| Equity securities | $ | 127,411 | $ | 3,509 | $ | (17,921 | ) | $ | 112,999 | $ | - |\n\n\n| At December 31, 2014 |\n| Amortized | Unrealized | Unrealized | Market | OTTI in AOCI |\n| (Dollars in thousands) | Cost | Appreciation | Depreciation | Value | (a) |\n| Fixed maturity securities |\n| U.S. Treasury securities and obligations of |\n| U.S. government agencies and corporations | $ | 221,052 | $ | 10,290 | $ | (304 | ) | $ | 231,038 | $ | - |\n| Obligations of U.S. states and political subdivisions | 783,129 | 41,969 | (626 | ) | 824,472 | - |\n| Corporate securities | 4,626,002 | 143,889 | (62,906 | ) | 4,706,985 | (6,910 | ) |\n| Asset-backed securities | 340,761 | 1,691 | (1,230 | ) | 341,222 | - |\n| Mortgage-backed securities |\n| Commercial | 231,439 | 10,675 | (429 | ) | 241,685 | - |\n| Agency residential | 2,157,182 | 37,555 | (11,573 | ) | 2,183,164 | - |\n| Non-agency residential | 2,734 | 54 | (57 | ) | 2,731 | - |\n| Foreign government securities | 1,488,144 | 71,177 | (26,866 | ) | 1,532,455 | - |\n| Foreign corporate securities | 2,980,716 | 109,673 | (53,074 | ) | 3,037,315 | - |\n| Total fixed maturity securities | $ | 12,831,159 | $ | 426,973 | $ | (157,065 | ) | $ | 13,101,067 | $ | (6,910 | ) |\n| Equity securities | $ | 148,326 | $ | 3,831 | $ | (11,947 | ) | $ | 140,210 | $ | - |\n\n(a) Represents the amount of OTTI recognized in AOCI. Amount includes unrealized gains and losses on impaired securities relating to changes in the value of such securities subsequent to the impairment measurement date.\n6\nThe amortized cost and market value of fixed maturity securities are shown in the following table by contractual maturity. Mortgage-backed securities are generally more likely to be prepaid than other fixed maturity securities. As the stated maturity of such securities may not be indicative of actual maturities, the totals for mortgage-backed and asset-backed securities are shown separately.\n\n| At September 30, 2015 | At December 31, 2014 |\n| Amortized | Market | Amortized | Market |\n| (Dollars in thousands) | Cost | Value | Cost | Value |\n| Fixed maturity securities – available for sale: |\n| Due in one year or less | $ | 1,080,129 | $ | 1,088,140 | $ | 1,183,247 | $ | 1,189,416 |\n| Due after one year through five years | 5,906,738 | 5,991,760 | 5,646,466 | 5,726,277 |\n| Due after five years through ten years | 2,377,276 | 2,382,188 | 2,270,073 | 2,313,672 |\n| Due after ten years | 828,380 | 878,621 | 999,257 | 1,102,900 |\n| Asset-backed securities | 437,376 | 438,397 | 340,761 | 341,222 |\n| Mortgage-backed securities: |\n| Commercial | 277,906 | 284,809 | 231,439 | 241,685 |\n| Agency residential | 2,392,937 | 2,426,067 | 2,157,182 | 2,183,164 |\n| Non-agency residential | 971 | 978 | 2,734 | 2,731 |\n| Total fixed maturity securities | $ | 13,301,713 | $ | 13,490,960 | $ | 12,831,159 | $ | 13,101,067 |\n\nThe changes in net unrealized appreciation (depreciation) for the Company's investments are derived from the following sources for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Increase (decrease) during the period between the market value and cost |\n| of investments carried at market value, and deferred taxes thereon: |\n| Fixed maturity securities | $ | (71,706 | ) | $ | (87,859 | ) | $ | (89,616 | ) | $ | 70,010 |\n| Fixed maturity securities, other-than-temporary impairment | (253 | ) | (261 | ) | 8,954 | (180 | ) |\n| Equity securities | (4,415 | ) | (3,287 | ) | (6,295 | ) | 3,327 |\n| Change in unrealized appreciation (depreciation), pre-tax | (76,374 | ) | (91,407 | ) | (86,957 | ) | 73,157 |\n| Deferred tax benefit (expense) | 9,919 | 11,649 | 5,563 | (9,480 | ) |\n| Deferred tax benefit (expense), other-than-temporary impairment | (8 | ) | - | (3,415 | ) | - |\n| Change in unrealized appreciation (depreciation), |\n| net of deferred taxes, included in shareholders' equity | $ | (66,463 | ) | $ | (79,758 | ) | $ | (84,809 | ) | $ | 63,677 |\n\nThe Company frequently reviews all of its fixed maturity, available for sale securities for declines in market value and focuses its attention on securities whose fair value has fallen below 80% of their amortized cost at the time of review. The Company then assesses whether the decline in value is temporary or other-than-temporary. In making its assessment, the Company evaluates the current market and interest rate environment as well as specific issuer information. Generally, a change in a security's value caused by a change in the market, interest rate or foreign exchange environment does not constitute an other-than-temporary impairment, but rather a temporary decline in market value. Temporary declines in market value are recorded as unrealized losses in accumulated other comprehensive income (loss). If the Company determines that the decline is other-than-temporary and the Company does not have the intent to sell the security; and it is more likely than not that the Company will not have to sell the security before recovery of its cost basis, the carrying value of the investment is written down to fair value. The fair value adjustment that is credit or foreign exchange related is recorded in net realized capital gains (losses) in the Company's consolidated statements of operations and comprehensive income (loss). The fair value adjustment that is non-credit related is recorded as a component of other comprehensive income (loss), net of tax, and is included in accumulated other comprehensive income (loss) in the Company's consolidated balance sheets.\n7\nThe Company's assessments are based on the issuers current and expected future financial position, timeliness with respect to interest and/or principal payments, speed of repayments and any applicable credit enhancements or breakeven constant default rates on mortgage-backed and asset-backed securities, as well as relevant information provided by rating agencies, investment advisors and analysts.\nThe majority of the Company's equity securities available for sale at market value are primarily comprised of mutual fund investments whose underlying securities consist of fixed maturity securities. When a fund's value reflects an unrealized loss, the Company assesses whether the decline in value is temporary or other-than-temporary. In making its assessment, the Company considers the composition of its portfolios and their related markets, reports received from the portfolio managers and discussions with portfolio managers. If the Company determines that the declines are temporary and it has the ability and intent to continue to hold the investments, then the declines are recorded as unrealized losses in accumulated other comprehensive income (loss). If declines are deemed to be other-than-temporary, then the carrying value of the investment is written down to fair value and recorded in net realized capital gains (losses) in the Company's consolidated statements of operations and comprehensive income (loss).\nRetrospective adjustments are employed to recalculate the values of asset-backed securities. All of the Company's asset-backed and mortgage-backed securities have a pass-through structure. Each acquisition lot is reviewed to recalculate the effective yield. The recalculated effective yield is used to derive a book value as if the new yield were applied at the time of acquisition. Outstanding principal factors from the time of acquisition to the adjustment date are used to calculate the prepayment history for all applicable securities. Conditional prepayment rates, computed with life to date factor histories and weighted average maturities, are used in the calculation of projected prepayments for pass-through security types.\nThe tables below display the aggregate market value and gross unrealized depreciation of fixed maturity and equity securities, by security type and contractual maturity, in each case subdivided according to length of time that individual securities had been in a continuous unrealized loss position for the periods indicated:\n\n| Duration of Unrealized Loss at September 30, 2015 By Security Type |\n| Less than 12 months | Greater than 12 months | Total |\n| Gross | Gross | Gross |\n| Unrealized | Unrealized | Unrealized |\n| (Dollars in thousands) | Market Value | Depreciation | Market Value | Depreciation | Market Value | Depreciation |\n| Fixed maturity securities - available for sale |\n| U.S. Treasury securities and obligations of |\n| U.S. government agencies and corporations | $ | 201 | $ | (1 | ) | $ | 1,844 | $ | (69 | ) | $ | 2,045 | $ | (70 | ) |\n| Obligations of U.S. states and political subdivisions | 20,162 | (316 | ) | 35,460 | (1,207 | ) | 55,622 | (1,523 | ) |\n| Corporate securities | 1,323,515 | (51,785 | ) | 425,091 | (24,611 | ) | 1,748,606 | (76,396 | ) |\n| Asset-backed securities | 89,526 | (674 | ) | 44,765 | (880 | ) | 134,291 | (1,554 | ) |\n| Mortgage-backed securities |\n| Commercial | 44,260 | (795 | ) | - | - | 44,260 | (795 | ) |\n| Agency residential | 343,504 | (2,182 | ) | 382,730 | (3,983 | ) | 726,234 | (6,165 | ) |\n| Non-agency residential | 176 | (2 | ) | 44 | (44 | ) | 220 | (46 | ) |\n| Foreign government securities | 299,055 | (22,177 | ) | 183,387 | (22,705 | ) | 482,442 | (44,882 | ) |\n| Foreign corporate securities | 699,077 | (40,165 | ) | 279,126 | (32,070 | ) | 978,203 | (72,235 | ) |\n| Total fixed maturity securities | $ | 2,819,476 | $ | (118,097 | ) | $ | 1,352,447 | $ | (85,569 | ) | $ | 4,171,923 | $ | (203,666 | ) |\n| Equity securities | - | - | 97,871 | (17,921 | ) | 97,871 | (17,921 | ) |\n| Total | $ | 2,819,476 | $ | (118,097 | ) | $ | 1,450,318 | $ | (103,490 | ) | $ | 4,269,794 | $ | (221,587 | ) |\n\n8\n\n| Duration of Unrealized Loss at September 30, 2015 By Maturity |\n| Less than 12 months | Greater than 12 months | Total |\n| Gross | Gross | Gross |\n| Unrealized | Unrealized | Unrealized |\n| (Dollars in thousands) | Market Value | Depreciation | Market Value | Depreciation | Market Value | Depreciation |\n| Fixed maturity securities |\n| Due in one year or less | $ | 85,547 | $ | (4,021 | ) | $ | 83,375 | $ | (12,950 | ) | $ | 168,922 | $ | (16,971 | ) |\n| Due in one year through five years | 1,220,223 | (50,689 | ) | 577,851 | (41,640 | ) | 1,798,074 | (92,329 | ) |\n| Due in five years through ten years | 924,605 | (51,295 | ) | 208,989 | (20,624 | ) | 1,133,594 | (71,919 | ) |\n| Due after ten years | 111,635 | (8,439 | ) | 54,693 | (5,448 | ) | 166,328 | (13,887 | ) |\n| Asset-backed securities | 89,526 | (674 | ) | 44,765 | (880 | ) | 134,291 | (1,554 | ) |\n| Mortgage-backed securities | 387,940 | (2,979 | ) | 382,774 | (4,027 | ) | 770,714 | (7,006 | ) |\n| Total fixed maturity securities | $ | 2,819,476 | $ | (118,097 | ) | $ | 1,352,447 | $ | (85,569 | ) | $ | 4,171,923 | $ | (203,666 | ) |\n\nThe aggregate market value and gross unrealized losses related to investments in an unrealized loss position at September 30, 2015 were $4,269,794 thousand and $221,587 thousand, respectively. The market value of securities for the single issuer whose securities comprised the largest unrealized loss position at September 30, 2015, did not exceed 0.2% of the overall market value of the Company's fixed maturity securities. In addition, as indicated on the above table, there was no significant concentration of unrealized losses in any one market sector. The $118,097 thousand of unrealized losses related to fixed maturity securities that have been in an unrealized loss position for less than one year were generally comprised of domestic and foreign corporate securities, as well as foreign government securities. The majority of these unrealized losses are attributable to net unrealized foreign exchange losses, $44,092 thousand, as the U.S. dollar has strengthened against other currencies and unrealized losses in the energy sector, $43,353 thousand, as falling oil prices have disrupted the market values for this sector, particularly for oil exploration, production and servicing companies. The $85,569 thousand of unrealized losses related to fixed maturity securities in an unrealized loss position for more than one year related primarily to foreign and domestic corporate securities, foreign government securities and agency residential mortgage-backed securities. Of these unrealized losses, $60,407 thousand related to securities that were rated investment grade by at least one nationally recognized statistical rating organization. There was no gross unrealized depreciation for mortgage-backed securities related to sub-prime and alt-A loans. In all instances, there were no projected cash flow shortfalls to recover the full book value of the investments and the related interest obligations. The mortgage-backed securities still have excess credit coverage and are current on interest and principal payments.\nThe Company, given the size of its investment portfolio and capital position, does not have the intent to sell these securities; and it is more likely than not that the Company will not have to sell the security before recovery of its cost basis. In addition, all securities currently in an unrealized loss position are current with respect to principal and interest payments.\n9\nThe tables below display the aggregate market value and gross unrealized depreciation of fixed maturity and equity securities, by security type and contractual maturity, in each case subdivided according to length of time that individual securities had been in a continuous unrealized loss position for the periods indicated:\n\n| Duration of Unrealized Loss at December 31, 2014 By Security Type |\n| Less than 12 months | Greater than 12 months | Total |\n| Gross | Gross | Gross |\n| Unrealized | Unrealized | Unrealized |\n| (Dollars in thousands) | Market Value | Depreciation | Market Value | Depreciation | Market Value | Depreciation |\n| Fixed maturity securities - available for sale |\n| U.S. Treasury securities and obligations of |\n| U.S. government agencies and corporations | $ | 13,187 | $ | (20 | ) | $ | 26,897 | $ | (284 | ) | $ | 40,084 | $ | (304 | ) |\n| Obligations of U.S. states and political subdivisions | 20,428 | (242 | ) | 18,199 | (384 | ) | 38,627 | (626 | ) |\n| Corporate securities | 1,245,830 | (55,388 | ) | 362,320 | (7,518 | ) | 1,608,150 | (62,906 | ) |\n| Asset-backed securities | 192,253 | (1,230 | ) | - | - | 192,253 | (1,230 | ) |\n| Mortgage-backed securities |\n| Commercial | 28,191 | (123 | ) | 9,777 | (306 | ) | 37,968 | (429 | ) |\n| Agency residential | 141,807 | (172 | ) | 678,972 | (11,401 | ) | 820,779 | (11,573 | ) |\n| Non-agency residential | - | - | 266 | (57 | ) | 266 | (57 | ) |\n| Foreign government securities | 235,725 | (15,415 | ) | 139,200 | (11,451 | ) | 374,925 | (26,866 | ) |\n| Foreign corporate securities | 567,905 | (36,926 | ) | 290,234 | (16,148 | ) | 858,139 | (53,074 | ) |\n| Total fixed maturity securities | $ | 2,445,326 | $ | (109,516 | ) | $ | 1,525,865 | $ | (47,549 | ) | $ | 3,971,191 | $ | (157,065 | ) |\n| Equity securities | 50,285 | (4,068 | ) | 73,994 | (7,879 | ) | 124,279 | (11,947 | ) |\n| Total | $ | 2,495,611 | $ | (113,584 | ) | $ | 1,599,859 | $ | (55,428 | ) | $ | 4,095,470 | $ | (169,012 | ) |\n\n\n| Duration of Unrealized Loss at December 31, 2014 By Maturity |\n| Less than 12 months | Greater than 12 months | Total |\n| Gross | Gross | Gross |\n| Unrealized | Unrealized | Unrealized |\n| (Dollars in thousands) | Market Value | Depreciation | Market Value | Depreciation | Market Value | Depreciation |\n| Fixed maturity securities |\n| Due in one year or less | $ | 98,021 | $ | (5,166 | ) | $ | 80,002 | $ | (8,174 | ) | $ | 178,023 | $ | (13,340 | ) |\n| Due in one year through five years | 1,233,244 | (68,124 | ) | 518,613 | (12,761 | ) | 1,751,857 | (80,885 | ) |\n| Due in five years through ten years | 679,374 | (28,529 | ) | 187,717 | (10,734 | ) | 867,091 | (39,263 | ) |\n| Due after ten years | 72,436 | (6,172 | ) | 50,518 | (4,116 | ) | 122,954 | (10,288 | ) |\n| Asset-backed securities | 192,253 | (1,230 | ) | - | - | 192,253 | (1,230 | ) |\n| Mortgage-backed securities | 169,998 | (295 | ) | 689,015 | (11,764 | ) | 859,013 | (12,059 | ) |\n| Total fixed maturity securities | $ | 2,445,326 | $ | (109,516 | ) | $ | 1,525,865 | $ | (47,549 | ) | $ | 3,971,191 | $ | (157,065 | ) |\n\nThe aggregate market value and gross unrealized losses related to investments in an unrealized loss position at December 31, 2014 were $4,095,470 thousand and $169,012 thousand, respectively. The market value of securities for the single issuer whose securities comprised the largest unrealized loss position at December 31, 2014, did not exceed 0.2% of the overall market value of the Company's fixed maturity securities. In addition, as indicated on the above table, there was no significant concentration of unrealized losses in any one market sector. The $109,516 thousand of unrealized losses related to fixed maturity securities that have been in an unrealized loss position for less than one year were generally comprised of domestic and foreign corporate securities, as well as foreign government securities. The majority of these unrealized losses are attributable to unrealized losses in the energy sector, $58,891 thousand, as falling oil prices disrupted the market values for this sector, particularly for oil exploration, production and servicing companies during the fourth quarter of 2014 and unrealized foreign exchange losses, $34,687 thousand, as the U.S. dollar has strengthened against other currencies. The $47,549 thousand of unrealized losses related to fixed maturity securities in an unrealized loss position for more than one year related primarily to foreign and domestic corporate securities, foreign government securities and agency residential mortgage-backed securities. Of these unrealized losses, $42,884 thousand related to securities that were rated investment grade by at least one nationally recognized statistical rating organization. The gross unrealized depreciation for mortgage-backed securities included $15 thousand related to sub-prime and alt-A loans. In all instances, there were no projected cash flow shortfalls to recover\n10\nthe full book value of the investments and the related interest obligations. The mortgage-backed securities still have excess credit coverage and are current on interest and principal payments.\nThe components of net investment income are presented in the table below for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Fixed maturities | $ | 108,134 | $ | 115,057 | $ | 326,970 | $ | 348,872 |\n| Equity securities | 11,090 | 11,086 | 35,783 | 36,111 |\n| Short-term investments and cash | 381 | 295 | 1,084 | 1,202 |\n| Other invested assets |\n| Limited partnerships | 370 | 21,690 | 13,993 | 25,658 |\n| Other | (242 | ) | 869 | 1,366 | 3,220 |\n| Gross investment income before adjustments | 119,733 | 148,997 | 379,196 | 415,063 |\n| Funds held interest income (expense) | 2,569 | 1,817 | 8,162 | 6,875 |\n| Future policy benefit reserve income (expense) | (300 | ) | (471 | ) | (1,402 | ) | (915 | ) |\n| Gross investment income | 122,002 | 150,343 | 385,956 | 421,023 |\n| Investment expenses | (6,491 | ) | (8,200 | ) | (22,816 | ) | (24,499 | ) |\n| Net investment income | $ | 115,511 | $ | 142,143 | $ | 363,140 | $ | 396,524 |\n\nThe Company records results from limited partnership investments on the equity method of accounting with changes in value reported through net investment income. Due to the timing of receiving financial information from these partnerships, the results are generally reported on a one month or quarter lag. If the Company determines there has been a significant decline in value of a limited partnership during this lag period, a loss will be recorded in the period in which the Company identifies the decline.\nThe Company had contractual commitments to invest up to an additional $469,064 thousand in limited partnerships at September 30, 2015. These commitments will be funded when called in accordance with the partnership agreements, which have investment periods that expire, unless extended, through 2020.\nThe components of net realized capital gains (losses) are presented in the table below for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Fixed maturity securities, market value: |\n| Other-than-temporary impairments | $ | (20,445 | ) | $ | (106 | ) | $ | (62,701 | ) | $ | (495 | ) |\n| Gains (losses) from sales | (5,218 | ) | 7,311 | (15,812 | ) | 3,668 |\n| Fixed maturity securities, fair value: |\n| Gains (losses) from sales | (17 | ) | 82 | 25 | 1,022 |\n| Gains (losses) from fair value adjustments | - | (938 | ) | 56 | (938 | ) |\n| Equity securities, market value: |\n| Gains (losses) from sales | (3,573 | ) | (181 | ) | (4,455 | ) | (1,235 | ) |\n| Equity securities, fair value: |\n| Gains (losses) from sales | (13,646 | ) | (1,823 | ) | (13,041 | ) | (1,873 | ) |\n| Gains (losses) from fair value adjustments | (117,087 | ) | (13,792 | ) | (98,741 | ) | 70,548 |\n| Short-term investments gains (losses) | 15 | (1 | ) | 15 | (3 | ) |\n| Total net realized capital gains (losses) | $ | (159,971 | ) | $ | (9,448 | ) | $ | (194,654 | ) | $ | 70,694 |\n\nThe Company recorded as net realized capital gains (losses) in the consolidated statements of operations and comprehensive income (loss) both fair value re-measurements and write-downs in the value of securities deemed to be impaired on an other-than-temporary basis as displayed in the table above. The Company had no other-than-temporary impaired securities where the impairment had both a credit and non-credit component.\n11\nThe proceeds and split between gross gains and losses, from sales of fixed maturity and equity securities, are presented in the table below for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Proceeds from sales of fixed maturity securities | $ | 414,538 | $ | 446,699 | $ | 1,147,824 | $ | 1,073,938 |\n| Gross gains from sales | 11,826 | 12,821 | 37,525 | 28,828 |\n| Gross losses from sales | (17,061 | ) | (5,428 | ) | (53,312 | ) | (24,138 | ) |\n| Proceeds from sales of equity securities | $ | 156,593 | $ | 150,124 | $ | 461,812 | $ | 463,688 |\n| Gross gains from sales | 5,250 | 2,545 | 18,890 | 13,047 |\n| Gross losses from sales | (22,469 | ) | (4,549 | ) | (36,386 | ) | (16,155 | ) |\n\n4. DERIVATIVES\nThe Company sold seven equity index put option contracts, based on two indices, in 2001 and 2005, which remain outstanding. The Company sold these equity index put options as insurance products with the intent of achieving a profit. These equity index put option contracts meet the definition of a derivative under FASB guidance and the Company's position in these equity index put option contracts is unhedged. Accordingly, these equity index put option contracts are carried at fair value in the consolidated balance sheets with changes in fair value recorded in the consolidated statements of operations and comprehensive income (loss).\nThe Company sold six equity index put option contracts, based on the Standard & Poor's 500 (\"S&P 500\") index, for total consideration, net of commissions, of $22,530 thousand. At September 30, 2015, fair value for these equity index put option contracts was $41,809 thousand. Based on historical index volatilities and trends and the September 30, 2015 S&P 500 index value, the Company estimates the probability that each equity index put option contract of the S&P 500 index falling below the strike price on the exercise date to be less than 23%. The theoretical maximum payouts under these six equity index put option contracts would occur if on each of the exercise dates the S&P 500 index value were zero. At September 30, 2015, the present value of these theoretical maximum payouts using a 3% discount factor was $429,402 thousand. Conversely, if the contracts had all expired on September 30, 2015, with the S&P index at $1,920.03, there would have been no settlement amount.\nThe Company sold one equity index put option contract based on the FTSE 100 index for total consideration, net of commissions, of $6,706 thousand. At September 30, 2015, fair value for this equity index put option contract was $10,438 thousand. Based on historical index volatilities and trends and the September 30, 2015 FTSE 100 index value, the Company estimates the probability that the equity index put option contract of the FTSE 100 index will fall below the strike price on the exercise date to be less than 51%. The theoretical maximum payout under the equity index put option contract would occur if on the exercise date the FTSE 100 index value was zero. At September 30, 2015, the present value of the theoretical maximum payout using a 3% discount factor and current exchange rate was $43,896 thousand. Conversely, if the contract had expired on September 30, 2015, with the FTSE index at ₤6,061.60, there would have been no settlement amount.\nThe fair value of the equity index put options can be found in the Company's consolidated balance sheets as follows:\n\n| (Dollars in thousands) |\n| Derivatives not designated as | Location of fair value | At | At |\n| hedging instruments | in balance sheets | September 30, 2015 | December 31, 2014 |\n| Equity index put option contracts | Equity index put option liability | $ | 52,247 | $ | 47,022 |\n| Total | $ | 52,247 | $ | 47,022 |\n\n12\nThe change in fair value of the equity index put option contracts can be found in the Company's statement of operations and comprehensive income (loss) as follows:\n\n| (Dollars in thousands) | Three Months Ended | Nine Months Ended |\n| Derivatives not designated as | Location of gain (loss) in statements of | September 30, | September 30, |\n| hedging instruments | operations and comprehensive income (loss) | 2015 | 2014 | 2015 | 2014 |\n| Equity index put option contracts | Net derivative gain (loss) | $ | (11,428 | ) | $ | 1,855 | $ | (5,225 | ) | $ | 3,968 |\n| Total | $ | (11,428 | ) | $ | 1,855 | $ | (5,225 | ) | $ | 3,968 |\n\n5. FAIR VALUE\nGAAP guidance regarding fair value measurements address how companies should measure fair value when they are required to use fair value measures for recognition or disclosure purposes under GAAP and provides a common definition of fair value to be used throughout GAAP. It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly fashion between market participants at the measurement date. In addition, it establishes a three-level valuation hierarchy for the disclosure of fair value measurements. The valuation hierarchy is based on the transparency of inputs to the valuation of an asset or liability. The level in the hierarchy within which a given fair value measurement falls is determined based on the lowest level input that is significant to the measurement, with Level 1 being the highest priority and Level 3 being the lowest priority.\nThe levels in the hierarchy are defined as follows:\n\n| Level 1: | Inputs to the valuation methodology are observable inputs that reflect unadjusted quoted prices for identical assets or liabilities in an active market; |\n\n\n| Level 2: | Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument; |\n\n\n| Level 3: | Inputs to the valuation methodology are unobservable and significant to the fair value measurement. |\n\nThe Company's fixed maturity and equity securities are primarily managed by third party investment asset managers. The investment asset managers obtain prices from nationally recognized pricing services. These services seek to utilize market data and observations in their evaluation process. They use pricing applications that vary by asset class and incorporate available market information and when fixed maturity securities do not trade on a daily basis the services will apply available information through processes such as benchmark curves, benchmarking of like securities, sector groupings and matrix pricing. In addition, they use model processes, such as the Option Adjusted Spread model to develop prepayment and interest rate scenarios for securities that have prepayment features.\nIn limited instances where prices are not provided by pricing services or in rare instances when a manager may not agree with the pricing service, price quotes on a non-binding basis are obtained from investment brokers. The investment asset managers do not make any changes to prices received from either the pricing services or the investment brokers. In addition, the investment asset managers have procedures in place to review the reasonableness of the prices from the service providers and may request verification of the prices. In addition, the Company continually performs analytical reviews of price changes and tests the prices on a random basis to an independent pricing source. No material variances were noted during these price validation procedures. In limited situations, where financial markets are inactive or illiquid, the Company may use its own assumptions about future cash flows and risk-adjusted discount rates to determine fair value. Due to the unavailability of prices for one private placement security, the Company valued the security at $6,125 thousand at September 30, 2015 and made no such adjustments at December 31, 2014.\n13\nThe Company internally manages a small public equity portfolio which had a fair value at September 30, 2015 and December 31, 2014 of $226,322 thousand and $196,980 thousand, respectively, and all prices were obtained from publically published sources.\nEquity securities denominated in U.S. currency with quoted prices in active markets for identical assets are categorized as level 1 since the quoted prices are directly observable. Equity securities traded on foreign exchanges are categorized as level 2 due to the added input of a foreign exchange conversion rate to determine fair or market value. The Company uses foreign currency exchange rates published by nationally recognized sources.\nAll categories of fixed maturity securities listed in the tables below are generally categorized as level 2, since a particular security may not have traded but the pricing services are able to use valuation models with observable market inputs such as interest rate yield curves and prices for similar fixed maturity securities in terms of issuer, maturity and seniority. For foreign government securities and foreign corporate securities, the fair values provided by the third party pricing services in local currencies, and where applicable, are converted to U.S. dollars using currency exchange rates from nationally recognized sources.\nThe fixed maturities with fair values categorized as level 3 result when prices are not available from the nationally recognized pricing services. The asset managers will then obtain non-binding price quotes for the securities from brokers. The single broker quotes are provided by market makers or broker-dealers who are recognized as market participants in the markets in which they are providing the quotes. The prices received from brokers are reviewed for reasonableness by the third party asset managers and the Company. If the broker quotes are for foreign denominated securities, the quotes are converted to U.S. dollars using currency exchange rates from nationally recognized sources. Historically, most of the level 3 fixed maturities have resulted from new issuances and the third party prices services have not yet included the issuance in their data base. Generally, in subsequent measurement periods, the issuances will be included in the data base and the fair value will transfer to level 2.\nThe composition and valuation inputs for the presented fixed maturities categories are as follows:\n\n| · | U.S. Treasury securities and obligations of U.S. government agencies and corporations are primarily comprised of U.S. Treasury bonds and the fair value is based on observable market inputs such as quoted prices, reported trades, quoted prices for similar issuances or benchmark yields; |\n\n\n| · | Obligations of U.S. states and political subdivisions are comprised of state and municipal bond issuances and the fair values are based on observable market inputs such as quoted market prices, quoted prices for similar securities, benchmark yields and credit spreads; |\n\n\n| · | Corporate securities are primarily comprised of U.S. corporate and public utility bond issuances and the fair values are based on observable market inputs such as quoted market prices, quoted prices for similar securities, benchmark yields and credit spreads; |\n\n\n| · | Asset-backed and mortgage-backed securities fair values are based on observable inputs such as quoted prices, reported trades, quoted prices for similar issuances or benchmark yields and cash flow models using observable inputs such as prepayment speeds, collateral performance and default spreads; |\n\n\n| · | Foreign government securities are comprised of global non-U.S. sovereign bond issuances and the fair values are based on observable market inputs such as quoted market prices, quoted prices for similar securities and models with observable inputs such as benchmark yields and credit spreads and then, where applicable, converted to U.S. dollars using an exchange rate from a nationally recognized source; |\n\n\n| · | Foreign corporate securities are comprised of global non-U.S. corporate bond issuances and the fair values are based on observable market inputs such as quoted market prices, quoted prices for similar securities and models with observable inputs such as benchmark yields and credit spreads and then, where applicable, converted to U.S. dollars using an exchange rate from a nationally recognized source. |\n\n14\nThe Company's liability for equity index put options is categorized as level 3 since there is no active market for these seven long dated equity put options. The fair values for these options are calculated by the Company using an industry accepted pricing model, Black-Scholes. The model inputs and assumptions are: risk free interest rates, equity market indexes values, volatilities and dividend yields and duration. The model results are then adjusted for the Company's credit default swap rate. All of these inputs and assumptions are updated quarterly. One of the option contacts is in British Pound Sterling so the fair value for this contract is converted to U.S. dollars using an exchange rate from a nationally recognized source.\nThe following table presents the fair value measurement levels for all assets and liabilities, which the Company has recorded at fair value (fair and market value) as of the periods indicated:\n\n| Fair Value Measurement Using: |\n| Quoted Prices |\n| in Active | Significant |\n| Markets for | Other | Significant |\n| Identical | Observable | Unobservable |\n| Assets | Inputs | Inputs |\n| (Dollars in thousands) | September 30, 2015 | (Level 1) | (Level 2) | (Level 3) |\n| Assets: |\n| Fixed maturities, market value |\n| U.S. Treasury securities and obligations of |\n| U.S. government agencies and corporations | $ | 352,926 | $ | - | $ | 352,926 | $ | - |\n| Obligations of U.S. States and political subdivisions | 714,279 | - | 714,279 | - |\n| Corporate securities | 5,006,937 | - | 4,999,371 | 7,566 |\n| Asset-backed securities | 438,397 | - | 438,397 | - |\n| Mortgage-backed securities |\n| Commercial | 284,809 | - | 284,809 | - |\n| Agency residential | 2,426,067 | - | 2,426,067 | - |\n| Non-agency residential | 978 | - | 978 | - |\n| Foreign government securities | 1,300,961 | - | 1,300,961 | - |\n| Foreign corporate securities | 2,965,606 | - | 2,959,481 | 6,125 |\n| Total fixed maturities, market value | 13,490,960 | - | 13,477,269 | 13,691 |\n| Fixed maturities, fair value | - | - | - | - |\n| Equity securities, market value | 112,999 | 97,871 | 15,128 | - |\n| Equity securities, fair value | 1,357,311 | 1,267,765 | 89,546 | - |\n| Liabilities: |\n| Equity index put option contracts | $ | 52,247 | $ | - | $ | - | $ | 52,247 |\n\nThere were no transfers between Level 1 and Level 2 for the nine months ended September 30, 2015.\n15\nThe following table presents the fair value measurement levels for all assets and liabilities, which the Company has recorded at fair value (fair and market value) as of the periods indicated:\n\n| Fair Value Measurement Using: |\n| Quoted Prices |\n| in Active | Significant |\n| Markets for | Other | Significant |\n| Identical | Observable | Unobservable |\n| Assets | Inputs | Inputs |\n| (Dollars in thousands) | December 31, 2014 | (Level 1) | (Level 2) | (Level 3) |\n| Assets: |\n| Fixed maturities, market value |\n| U.S. Treasury securities and obligations of |\n| U.S. government agencies and corporations | $ | 231,038 | $ | - | $ | 231,038 | $ | - |\n| Obligations of U.S. States and political subdivisions | 824,472 | - | 824,472 | - |\n| Corporate securities | 4,706,985 | - | 4,706,985 | - |\n| Asset-backed securities | 341,222 | - | 341,222 | - |\n| Mortgage-backed securities |\n| Commercial | 241,685 | - | 233,088 | 8,597 |\n| Agency residential | 2,183,164 | - | 2,183,164 | - |\n| Non-agency residential | 2,731 | - | 2,731 | - |\n| Foreign government securities | 1,532,455 | - | 1,532,455 | - |\n| Foreign corporate securities | 3,037,315 | - | 3,030,149 | 7,166 |\n| Total fixed maturities, market value | 13,101,067 | - | 13,085,304 | 15,763 |\n| Fixed maturities, fair value | 1,509 | - | 1,509 | - |\n| Equity securities, market value | 140,210 | 124,295 | 15,915 | - |\n| Equity securities, fair value | 1,447,820 | 1,337,396 | 110,424 | - |\n| Liabilities: |\n| Equity index put option contracts | $ | 47,022 | $ | - | $ | - | $ | 47,022 |\n\n16\nThe following tables present the activity under Level 3, fair value measurements using significant unobservable inputs by asset type, for the periods indicated:\n\n| Three Months Ended September 30, 2015 | Nine Months Ended September 30, 2015 |\n| Corporate | Foreign | Corporate | Foreign |\n| (Dollars in thousands) | Securities | Corporate | Total | Securities | CMBS | Corporate | Total |\n| Beginning balance | $ | 1,958 | $ | 7,837 | $ | 9,795 | $ | - | $ | 8,597 | $ | 7,166 | $ | 15,763 |\n| Total gains or (losses) (realized/unrealized) |\n| Included in earnings | (8 | ) | 62 | 54 | (4 | ) | - | 177 | 173 |\n| Included in other comprehensive income (loss) | (137 | ) | (1,287 | ) | (1,424 | ) | (139 | ) | - | (1,216 | ) | (1,355 | ) |\n| Purchases, issuances and settlements | 1,723 | - | 1,723 | 3,651 | - | - | 3,651 |\n| Transfers in and/or (out) of Level 3 | 4,030 | (487 | ) | 3,543 | 4,058 | (8,597 | ) | (2 | ) | (4,541 | ) |\n| Ending balance | $ | 7,566 | $ | 6,125 | $ | 13,691 | $ | 7,566 | $ | - | $ | 6,125 | $ | 13,691 |\n| The amount of total gains or losses for the period |\n| included in earnings (or changes in net assets) |\n| attributable to the change in unrealized gains |\n| or losses relating to assets still held |\n| at the reporting date | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - |\n| (Some amounts may not reconcile due to rounding.) |\n\n\n| Three Months Ended September 30, 2014 | Nine Months Ended September 30, 2014 |\n| Corporate | Asset-backed | Foreign | Non-agency | Agency | Corporate | Asset-backed | Foreign | Non-agency | Agency |\n| (Dollars in thousands) | Securities | Securities | Corporate | RMBS | RMBS | Total | Securities | Securities | Corporate | RMBS | RMBS | Total |\n| Beginning balance | $ | - | $ | 3,000 | $ | - | $ | 259 | $ | - | $ | 3,259 | $ | - | $ | 5,299 | $ | 481 | $ | 347 | $ | - | $ | 6,127 |\n| Total gains or (losses) (realized/unrealized) |\n| Included in earnings | - | 1,203 | - | 187 | - | 1,390 | - | 1,259 | 18 | 329 | - | 1,606 |\n| Included in other comprehensive income (loss) | 42 | (201 | ) | (62 | ) | (114 | ) | - | (335 | ) | 42 | (126 | ) | (82 | ) | (138 | ) | - | (304 | ) |\n| Purchases, issuances and settlements | 1,274 | 22,797 | 4,517 | (332 | ) | 29,845 | 58,101 | 1,274 | 21,303 | 4,038 | (538 | ) | 29,845 | 55,922 |\n| Transfers in and/or (out) of Level 3 | - | (1,431 | ) | - | - | - | (1,431 | ) | - | (2,367 | ) | - | - | - | (2,367 | ) |\n| Ending balance | $ | 1,316 | $ | 25,368 | $ | 4,455 | $ | - | $ | 29,845 | $ | 60,984 | $ | 1,316 | $ | 25,368 | $ | 4,455 | $ | - | $ | 29,845 | $ | 60,984 |\n| The amount of total gains or losses for the period |\n| included in earnings (or changes in net assets) |\n| attributable to the change in unrealized gains |\n| or losses relating to assets still held |\n| at the reporting date | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - |\n| (Some amounts may not reconcile due to rounding.) |\n\nThe net transfers to/(from) level 3, fair value measurements using significant unobservable inputs, of $4,541 thousand and $2,367 thousand of investments for the nine months ended September 30, 2015 and 2014, respectively, primarily relate to securities that were priced using single non-binding broker quotes as of December 31, 2014 and 2013, respectively. The securities were subsequently priced using a recognized pricing service as of September 30, 2015 and 2014, and were classified as level 2 as of those dates.\n17\nThe following table presents the activity under Level 3, fair value measurements using significant unobservable inputs for equity index put option contracts, for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Liabilities: |\n| Balance, beginning of period | $ | 40,819 | $ | 33,309 | $ | 47,022 | $ | 35,423 |\n| Total (gains) or losses (realized/unrealized) |\n| Included in earnings | 11,428 | (1,855 | ) | 5,225 | (3,968 | ) |\n| Included in other comprehensive income (loss) | - | - | - | - |\n| Purchases, issuances and settlements | - | - | - | - |\n| Transfers in and/or (out) of Level 3 | - | - | - | - |\n| Balance, end of period | $ | 52,247 | $ | 31,455 | $ | 52,247 | $ | 31,455 |\n| The amount of total gains or losses for the period included in earnings |\n| (or changes in net assets) attributable to the change in unrealized |\n| gains or losses relating to liabilities still held at the reporting date | $ | - | $ | - | $ | - | $ | - |\n| (Some amounts may not reconcile due to rounding.) |\n\n6. REDEEMABLE NONCONTROLLING INTERESTS – MT. LOGAN RE\nMt. Logan Re is a Class 3 insurer registered in Bermuda effective February 27, 2013 under The Segregated Accounts Companies Act 2000 and 100% of the voting common shares are owned by Group. Separate segregated accounts have been established effective July 1, 2013 and non-voting, redeemable preferred shares have been issued to capitalize the segregated accounts. Each segregated account will invest in a diversified set of catastrophe exposures, diversified by risk/peril and across different geographic regions globally. The financial statements for Mt. Logan Re are consolidated with the Company with adjustments reflected for the third party noncontrolling interests reflected as separate captions in the Company's financial statements.\nThe following table presents the activity for redeemable noncontrolling interests in the consolidated balance sheets for the periods indicated:\n\n| Nine Months Ended | Twelve Months Ended |\n| September 30, | December 31, |\n| (Dollars in thousands) | 2015 | 2014 |\n| Redeemable noncontrolling interests - Mt. Logan Re, beginning of period | $ | 421,552 | $ | 93,378 |\n| Unaffiliated third party investments during period, net | 336,848 | 279,200 |\n| Net income (loss) attributable to noncontrolling interests | 61,526 | 59,307 |\n| Dividends paid on third party investment in redeemable noncontrolling interest | (67,233 | ) | (10,334 | ) |\n| Redeemable noncontrolling interests - Mt. Logan Re, end of period | $ | 752,692 | $ | 421,552 |\n| (Some amounts may not reconcile due to rounding.) |\n\nIn addition, the Company has invested $50,000 thousand in the segregated accounts from inception to date.\nThe Company expects its participation level in the segregated funds to fluctuate over time.\n7. CAPITAL TRANSACTIONS\nOn July 9, 2014, the Company renewed its shelf registration statement on Form S-3ASR with the Securities and Exchange Commission (the \"SEC\"), as a Well Known Seasoned Issuer. This shelf registration statement can be used by Group to register common shares, preferred shares, debt securities, warrants, share purchase contracts and share purchase units; by Holdings to register debt securities and by Everest Re Capital Trust III (\"Capital Trust III\") to register trust preferred securities.\n18\n8. EARNINGS PER COMMON SHARE\nBasic earnings per share are calculated by dividing net income by the weighted average number of common shares outstanding. Diluted earnings per share reflect the potential dilution that would occur if options granted under various share-based compensation plans were exercised resulting in the issuance of common shares that would participate in the earnings of the entity.\nNet income (loss) attributable to Everest Re Group per common share has been computed as per below, based upon weighted average common basic and dilutive shares outstanding.\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands, except per share amounts) | 2015 | 2014 | 2015 | 2014 |\n| Net income (loss) attributable to Everest Re Group per share: |\n| Numerator |\n| Net income (loss) attributable to Everest Re Group | $ | 88,553 | $ | 274,916 | $ | 620,588 | $ | 859,033 |\n| Less: dividends declared-common shares and nonvested common shares | (41,698 | ) | (33,973 | ) | (125,905 | ) | (103,034 | ) |\n| Undistributed earnings | 46,855 | 240,943 | 494,683 | 755,999 |\n| Percentage allocated to common shareholders (1) | 99.0 | % | 98.9 | % | 98.9 | % | 99.0 | % |\n| 46,364 | 238,407 | 489,434 | 748,273 |\n| Add: dividends declared-common shareholders | 41,293 | 33,631 | 124,638 | 101,993 |\n| Numerator for basic and diluted earnings per common share | $ | 87,657 | $ | 272,038 | $ | 614,072 | $ | 850,266 |\n| Denominator |\n| Denominator for basic earnings per weighted-average common shares | 43,361 | 44,941 | 43,728 | 45,615 |\n| Effect of dilutive securities: |\n| Options | 367 | 415 | 392 | 426 |\n| Denominator for diluted earnings per adjusted weighted-average common shares | 43,728 | 45,356 | 44,120 | 46,041 |\n| Per common share net income (loss) |\n| Basic | $ | 2.02 | $ | 6.05 | $ | 14.04 | $ | 18.64 |\n| Diluted | $ | 2.00 | $ | 6.00 | $ | 13.92 | $ | 18.47 |\n| (1) | Basic weighted-average common shares outstanding | 43,361 | 44,941 | 43,728 | 45,615 |\n| Basic weighted-average common shares outstanding and nonvested common shares expected to vest | 43,820 | 45,419 | 44,197 | 46,086 |\n| Percentage allocated to common shareholders | 99.0 | % | 98.9 | % | 98.9 | % | 99.0 | % |\n| (Some amounts may not reconcile due to rounding.) |\n\nThere were no anti-diluted options outstanding for the three and nine months ended September 30, 2015 and 2014.\nAll outstanding options expire on or between February 21, 2017 and September 19, 2022.\n9. CONTINGENCIES\nIn the ordinary course of business, the Company is involved in lawsuits, arbitrations and other formal and informal dispute resolution procedures, the outcomes of which will determine the Company's rights and obligations under insurance and reinsurance agreements. In some disputes, the Company seeks to enforce its rights under an agreement or to collect funds owing to it. In other matters, the Company is resisting attempts by others to collect funds or enforce alleged rights. These disputes arise from time to time and are ultimately resolved through both informal and formal means, including negotiated resolution, arbitration and litigation. In all such matters, the Company believes that its positions are legally and commercially reasonable. The Company considers the statuses of these proceedings when determining its reserves for unpaid loss and loss adjustment expenses.\n19\nAside from litigation and arbitrations related to these insurance and reinsurance agreements, the Company is not a party to any other material litigation or arbitration.\nThe Company has entered into separate annuity agreements with The Prudential Insurance of America (\"The Prudential\") and an additional unaffiliated life insurance company in which the Company has either purchased annuity contracts or become the assignee of annuity proceeds that are meant to settle claim payment obligations in the future. In both instances, the Company would become contingently liable if either The Prudential or the unaffiliated life insurance company were unable to make payments related to the respective annuity contract.\nThe table below presents the estimated cost to replace all such annuities for which the Company was contingently liable for the periods indicated:\n\n| At September 30, | At December 31, |\n| (Dollars in thousands) | 2015 | 2014 |\n| The Prudential | $ | 142,661 | $ | 142,653 |\n| Unaffiliated life insurance company | 32,414 | 31,964 |\n\n10. OTHER COMPREHENSIVE INCOME (LOSS)\nThe following tables present the components of comprehensive income (loss) in the consolidated statements of operations for the periods indicated:\n\n| Three Months Ended September 30, 2015 | Nine Months Ended September 30, 2015 |\n| (Dollars in thousands) | Before Tax | Tax Effect | Net of Tax | Before Tax | Tax Effect | Net of Tax |\n| Unrealized appreciation (depreciation) (\"URA(D)\") on securities - temporary | $ | (105,356 | ) | $ | 14,558 | $ | (90,798 | ) | $ | (178,878 | ) | $ | 29,004 | $ | (149,874 | ) |\n| URA(D) on securities - OTTI | (253 | ) | (8 | ) | (261 | ) | 8,954 | (3,415 | ) | 5,539 |\n| Reclassification of net realized losses (gains) included in net income (loss) | 29,235 | (4,639 | ) | 24,596 | 82,967 | (23,441 | ) | 59,526 |\n| Foreign currency translation adjustments | (47,298 | ) | 14,793 | (32,505 | ) | (104,542 | ) | 24,034 | (80,508 | ) |\n| Benefit plan actuarial net gain (loss) | - | - | - | - | - | - |\n| Reclassification of benefit plan liability amortization included in net income (loss) | 2,393 | (837 | ) | 1,556 | 7,336 | (2,567 | ) | 4,769 |\n| Total other comprehensive income (loss) | $ | (121,279 | ) | $ | 23,867 | $ | (97,412 | ) | $ | (184,163 | ) | $ | 23,615 | $ | (160,548 | ) |\n\n\n| Three Months Ended September 30, 2014 | Nine Months Ended September 30, 2014 |\n| (Dollars in thousands) | Before Tax | Tax Effect | Net of Tax | Before Tax | Tax Effect | Net of Tax |\n| Unrealized appreciation (depreciation) (\"URA(D)\") on securities - temporary | $ | (84,122 | ) | $ | 10,309 | $ | (73,813 | ) | $ | 75,275 | $ | (9,777 | ) | $ | 65,498 |\n| URA(D) on securities - OTTI | (261 | ) | - | (261 | ) | (180 | ) | - | (180 | ) |\n| Reclassification of net realized losses (gains) included in net income (loss) | (7,024 | ) | 1,340 | (5,684 | ) | (1,938 | ) | 297 | (1,641 | ) |\n| Foreign currency translation adjustments | (38,998 | ) | 4,024 | (34,974 | ) | (42,998 | ) | 4,624 | (38,374 | ) |\n| Benefit plan actuarial net gain (loss) | - | - | - | - | - | - |\n| Reclassification of benefit plan liability amortization included in net income (loss) | 1,269 | (444 | ) | 825 | 3,640 | (1,274 | ) | 2,366 |\n| Total other comprehensive income (loss) | $ | (129,136 | ) | $ | 15,229 | $ | (113,907 | ) | $ | 33,799 | $ | (6,130 | ) | $ | 27,669 |\n\n20\nThe following table presents details of the amounts reclassified from AOCI for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, | Affected line item within the statements of |\n| AOCI component | 2015 | 2014 | 2015 | 2014 | operations and comprehensive income (loss) |\n| (Dollars in thousands) |\n| URA(D) on securities | $ | 29,235 | $ | (7,024 | ) | $ | 82,967 | $ | (1,938 | ) | Other net realized capital gains (losses) |\n| (4,639 | ) | 1,340 | (23,441 | ) | 297 | Income tax expense (benefit) |\n| $ | 24,596 | $ | (5,684 | ) | $ | 59,526 | $ | (1,641 | ) | Net income (loss) |\n| Benefit plan net gain (loss) | $ | 2,393 | $ | 1,269 | $ | 7,336 | $ | 3,640 | Other underwriting expenses |\n| (837 | ) | (444 | ) | (2,567 | ) | (1,274 | ) | Income tax expense (benefit) |\n| $ | 1,556 | $ | 825 | $ | 4,769 | $ | 2,366 | Net income (loss) |\n\nThe following table presents the components of accumulated other comprehensive income (loss), net of tax, in the consolidated balance sheets for the periods indicated:\n\n| Nine Months Ended | Twelve Months Ended |\n| September 30, | December 31, |\n| (Dollars in thousands) | 2015 | 2014 |\n| Beginning balance of URA (D) on securities | $ | 223,250 | $ | 201,154 |\n| Current period change in URA (D) of investments - temporary | (90,348 | ) | 28,767 |\n| Current period change in URA (D) of investments - non-credit OTTI | 5,539 | (6,671 | ) |\n| Ending balance of URA (D) on securities | 138,441 | 223,250 |\n| Beginning balance of foreign currency translation adjustments | (99,947 | ) | (4,530 | ) |\n| Current period change in foreign currency translation adjustments | (80,508 | ) | (95,417 | ) |\n| Ending balance of foreign currency translation adjustments | (180,455 | ) | (99,947 | ) |\n| Beginning balance of benefit plan net gain (loss) | (74,986 | ) | (38,896 | ) |\n| Current period change in benefit plan net gain (loss) | 4,769 | (36,090 | ) |\n| Ending balance of benefit plan net gain (loss) | (70,217 | ) | (74,986 | ) |\n| Ending balance of accumulated other comprehensive income (loss) | $ | (112,231 | ) | $ | 48,317 |\n\n11. CREDIT FACILITIES\nThe Company has two active credit facilities for a total commitment of up to $1,100,000 thousand, providing for the issuance of letters of credit and/or unsecured revolving credit lines. The following table presents the costs incurred in connection with the two credit facilities for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Credit facility fees incurred | $ | 132 | $ | 132 | $ | 431 | $ | 527 |\n\n21\nThe terms and outstanding amounts for each facility are discussed below:\nGroup Credit Facility\nEffective June 22, 2012, Group, Bermuda Re and Everest International entered into a four year, $800,000 thousand senior credit facility with a syndicate of lenders, which amended and restated in its entirety the July 27, 2007, five year, $850,000 thousand senior credit facility. Both the June 22, 2012 and July 27, 2007 senior credit facilities, which have similar terms, are referred to as the \"Group Credit Facility\". Wells Fargo Corporation (\"Wells Fargo Bank\") is the administrative agent for the Group Credit Facility, which consists of two tranches. Tranche one provides up to $200,000 thousand of unsecured revolving credit for liquidity and general corporate purposes, and for the issuance of unsecured standby letters of credit. The interest on the revolving loans shall, at the Company's option, be either (1) the Base Rate (as defined below) or (2) an adjusted London Interbank Offered Rate (\"LIBOR\") plus a margin. The Base Rate is the higher of (a) the prime commercial lending rate established by Wells Fargo Bank, (b) the Federal Funds Rate plus 0.5% per annum or (c) the one month LIBOR Rate plus 1.0% per annum. The amount of margin and the fees payable for the Group Credit Facility depends on Group's senior unsecured debt rating. Tranche two exclusively provides up to $600,000 thousand for the issuance of standby letters of credit on a collateralized basis.\nThe Group Credit Facility requires Group to maintain a debt to capital ratio of not greater than 0.35 to 1 and to maintain a minimum net worth. Minimum net worth is an amount equal to the sum of $4,249,963 thousand plus 25% of consolidated net income for each of Group's fiscal quarters, for which statements are available ending on or after January 1, 2012 and for which consolidated net income is positive, plus 25% of any increase in consolidated net worth during such period attributable to the issuance of ordinary and preferred shares, which at September 30, 2015, was $5,277,454 thousand. As of September 30, 2015, the Company was in compliance with all Group Credit Facility covenants.\nThe following table summarizes the outstanding letters of credit and/or borrowings for the periods indicated:\n\n| (Dollars in thousands) | At September 30, 2015 | At December 31, 2014 |\n| Bank | Commitment | In Use | Date of Expiry | Commitment | In Use | Date of Expiry |\n| Wells Fargo Bank Group Credit Facility | Tranche One | $ | 200,000 | $ | - | $ | 200,000 | $ | - |\n| Tranche Two | 600,000 | 456,379 | 12/31/2015 | 600,000 | 444,012 | 12/31/2015 |\n| Total Wells Fargo Bank Group Credit Facility | $ | 800,000 | $ | 456,379 | $ | 800,000 | $ | 444,012 |\n\nBermuda Re Letter of Credit Facility\nEffective December 31, 2014, Bermuda Re renewed its $300,000 thousand letter of credit issuance facility with Citibank N.A. referred to as the \"Bermuda Re Letter of Credit Facility\", which commitment is reconfirmed annually with updated fees. The Bermuda Re Letter of Credit Facility provides for the issuance of up to $300,000 thousand of secured letters of credit to collateralize reinsurance obligations as a non-admitted reinsurer. The interest on drawn letters of credit shall be (A) 0.35% per annum of the principal amount of issued standard letters of credit (expiry of 15 months or less) and (B) 0.45% per annum of the principal amount of issued extended tenor letters of credit (expiry maximum of up to 60 months). The commitment fee on undrawn credit shall be 0.15% per annum.\nThe following table summarizes the outstanding letters of credit for the periods indicated:\n\n| (Dollars in thousands) | At September 30, 2015 | At December 31, 2014 |\n| Bank | Commitment | In Use | Date of Expiry | Commitment | In Use | Date of Expiry |\n| Citibank Bilateral Letter of Credit Agreement | $ | 300,000 | $ | 3,672 | 11/24/2015 | $ | 300,000 | $ | 112 | 8/30/2015 |\n| 65,013 | 12/31/2015 | 3,672 | 11/24/2015 |\n| 2,681 | 12/31/2016 | 70,922 | 12/31/2015 |\n| 173 | 8/30/2017 | 2,014 | 12/31/2016 |\n| 119,002 | 9/30/2019 | 149,353 | 12/30/2018 |\n| Total Citibank Bilateral Agreement | $ | 300,000 | $ | 190,541 | $ | 300,000 | $ | 226,073 |\n\n22\nHoldings Credit Facility - Expired\nEffective August 15, 2011, the Company entered into a three year, $150,000 thousand unsecured revolving credit facility, referred to as the \"Holdings Credit Facility\", which expired on August 15, 2014. The Company decided not to renew the Holdings Credit Facility at expiration.\n12. REINSURANCE AND TRUST AGREEMENTS\nCertain subsidiaries of Group have established trust agreements, which effectively use the Company's investments as collateral, as security for assumed losses payable to certain non-affiliated ceding companies. At September 30, 2015, the total amount on deposit in trust accounts was $404,008 thousand.\nOn April 24, 2014, the Company entered into two collateralized reinsurance agreements with Kilimanjaro Re Limited (\"Kilimanjaro\"), a Bermuda based special purpose reinsurer, to provide the Company with catastrophe reinsurance coverage. These agreements are multi-year reinsurance contracts which cover specified named storm and earthquake events. The first agreement provides up to $250,000 thousand of reinsurance coverage from named storms in specified states of the Southeastern United States. The second agreement provides up to $200,000 thousand of reinsurance coverage from named storms in specified states of the Southeast, Mid-Atlantic and Northeast regions of the United States and Puerto Rico as well as reinsurance coverage from earthquakes in specified states of the Southeast, Mid-Atlantic, Northeast and West regions of the United States, Puerto Rico and British Columbia.\nOn November 18, 2014, the Company entered into a collateralized reinsurance agreement with Kilimanjaro Re to provide the Company with catastrophe reinsurance coverage. This agreement is a multi-year reinsurance contract which covers specified earthquake events. The agreement provides up to $500,000 thousand of reinsurance coverage from earthquakes in the United States, Puerto Rico and Canada.\nKilimanjaro has financed the various property catastrophe reinsurance coverage by issuing catastrophe bonds to unrelated, external investors. On April 24, 2014, Kilimanjaro issued $450,000 thousand of variable rate notes (\"Series 2014-1 Notes\"). On November 18, 2014, Kilimanjaro issued $500,000 thousand of variable rate notes (\"Series 2014-2 Notes\"). The proceeds from the issuance of the Series 2014-1 Notes and the Series 2014-2 Notes are held in reinsurance trust throughout the duration of the applicable reinsurance agreements and invested solely in US government money market funds with a rating of at least \"AAAm\" by Standard & Poor's.\n13. SENIOR NOTES\nThe table below displays Holdings' outstanding senior notes. Market value is based on quoted market prices, but due to limited trading activity, these senior notes are considered Level 2 in the fair value hierarchy.\n\n| September 30, 2015 | December 31, 2014 |\n| Consolidated Balance | Consolidated Balance |\n| (Dollars in thousands) | Date Issued | Date Due | Principal Amounts | Sheet Amount | Market Value | Sheet Amount | Market Value |\n| 4.868% Senior notes | 06/05/2014 | 06/01/2044 | $ | 400,000 | $ | 400,000 | $ | 388,768 | $ | 400,000 | $ | 404,892 |\n| 5.40% Senior notes | 10/12/2004 | 10/15/2014 | 250,000 | - | - | - | - |\n\nOn June 5, 2014, Holdings issued $400,000 thousand of 30 year senior notes at 4.868%, which will mature on June 1, 2044. Interest will be paid semi-annually on June 1 and December 1 of each year. The proceeds from the issuance have been used in part to pay off the $250,000 thousand of 5.40% senior notes which matured on October 15, 2014.\n23\nInterest expense incurred in connection with these senior notes is as follows for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Interest expense incurred | $ | 4,868 | $ | 8,256 | $ | 14,604 | $ | 16,385 |\n\n14. LONG TERM SUBORDINATED NOTES\nThe table below displays Holdings' outstanding fixed to floating rate long term subordinated notes. Market value is based on quoted market prices, but due to limited trading activity, these subordinated notes are considered Level 2 in the fair value hierarchy.\n\n| Maturity Date | September 30, 2015 | December 31, 2014 |\n| Original | Consolidated Balance | Consolidated Balance |\n| (Dollars in thousands) | Date Issued | Principal Amount | Scheduled | Final | Sheet Amount | Market Value | Sheet Amount | Market Value |\n| 6.6% Long term subordinated notes | 04/26/2007 | $ | 400,000 | 05/15/2037 | 05/01/2067 | $ | 238,367 | $ | 218,281 | $ | 238,364 | $ | 246,312 |\n\nDuring the fixed rate interest period from May 3, 2007 through May 14, 2017, interest will be at the annual rate of 6.6%, payable semi-annually in arrears on November 15 and May 15 of each year, commencing on November 15, 2007, subject to Holdings' right to defer interest on one or more occasions for up to ten consecutive years. During the floating rate interest period from May 15, 2017 through maturity, interest will be based on the 3 month LIBOR plus 238.5 basis points, reset quarterly, payable quarterly in arrears on February 15, May 15, August 15 and November 15 of each year, subject to Holdings' right to defer interest on one or more occasions for up to ten consecutive years. Deferred interest will accumulate interest at the applicable rate compounded semi-annually for periods prior to May 15, 2017, and compounded quarterly for periods from and including May 15, 2017.\nHoldings can redeem the long term subordinated notes prior to May 15, 2017, in whole but not in part at the applicable redemption price, which will equal the greater of (a) 100% of the principal amount being redeemed and (b) the present value of the principal payment on May 15, 2017 and scheduled payments of interest that would have accrued from the redemption date to May 15, 2017 on the long term subordinated notes being redeemed, discounted to the redemption date on a semi-annual basis at a discount rate equal to the treasury rate plus an applicable spread of either 0.25% or 0.50%, in each case plus accrued and unpaid interest. Holdings may redeem the long term subordinated notes on or after May 15, 2017, in whole or in part at 100% of the principal amount plus accrued and unpaid interest; however, redemption on or after the scheduled maturity date and prior to May 1, 2047 is subject to a replacement capital covenant. This covenant is for the benefit of certain senior note holders and it mandates that Holdings receive proceeds from the sale of another subordinated debt issue, of at least similar size, before it may redeem the subordinated notes. Effective upon the maturity of the Company's 5.40% senior notes on October 15, 2014, the Company's 4.868% senior notes, due on June 1, 2044, have become the Company's long term indebtedness that ranks senior to the long term subordinated notes.\nOn March 19, 2009, Group announced the commencement of a cash tender offer for any and all of the 6.60% fixed to floating rate long term subordinated notes. Upon expiration of the tender offer, the Company had reduced its outstanding debt by $161,441 thousand.\nInterest expense incurred in connection with these long term subordinated notes is as follows for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Interest expense incurred | $ | 3,937 | $ | 3,937 | $ | 11,811 | $ | 11,811 |\n\n24\n15. SEGMENT REPORTING\nThe U.S. Reinsurance operation writes property and casualty reinsurance and specialty lines of business, including Marine, Aviation, Surety and Accident and Health (\"A&H\") business, on both a treaty and facultative basis, through reinsurance brokers, as well as directly with ceding companies primarily within the U.S. The International operation writes non-U.S. property and casualty reinsurance through Everest Re's branches in Canada and Singapore and through offices in Brazil, Miami and New Jersey. The Bermuda operation provides reinsurance and insurance to worldwide property and casualty markets through brokers and directly with ceding companies from its Bermuda office and reinsurance to the United Kingdom and European markets through its UK branch and Ireland Re. The Insurance operation writes property and casualty insurance directly and through general agents, brokers and surplus lines brokers within the U.S. and Canada. The Mt. Logan Re segment represents business written for the segregated accounts of Mt. Logan Re, which were formed on July 1, 2013. The Mt. Logan Re business represents a diversified set of catastrophe exposures, diversified by risk/peril and across different geographical regions globally.\nThese segments, with the exception of Mt. Logan Re, are managed independently, but conform with corporate guidelines with respect to pricing, risk management, control of aggregate catastrophe exposures, capital, investments and support operations. Management generally monitors and evaluates the financial performance of these operating segments based upon their underwriting results. The Mt. Logan Re segment is managed independently and seeks to write a diverse portfolio of catastrophe risks for each segregated account to achieve desired risk and return criteria.\nUnderwriting results include earned premium less losses and loss adjustment expenses (\"LAE\") incurred, commission and brokerage expenses and other underwriting expenses. We measure our underwriting results using ratios, in particular loss, commission and brokerage and other underwriting expense ratios, which, respectively, divide incurred losses, commissions and brokerage and other underwriting expenses by premiums earned.\nMt. Logan Re's business is sourced through operating subsidiaries of the Company; however, the activity is only reflected in the Mt. Logan Re segment. For other inter-affiliate reinsurance, business is generally reported within the segment in which the business was first produced, consistent with how the business is managed.\nExcept for Mt. Logan Re, the Company does not maintain separate balance sheet data for its operating segments. Accordingly, the Company does not review and evaluate the financial results of its operating segments based upon balance sheet data.\n25\nThe following tables present the underwriting results for the operating segments for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| U.S. Reinsurance | September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Gross written premiums | $ | 537,483 | $ | 640,660 | $ | 1,464,840 | $ | 1,573,776 |\n| Net written premiums | 511,238 | 615,078 | 1,383,647 | 1,536,114 |\n| Premiums earned | $ | 488,485 | $ | 559,488 | $ | 1,480,427 | $ | 1,478,258 |\n| Incurred losses and LAE | 225,944 | 249,004 | 699,575 | 701,473 |\n| Commission and brokerage | 121,050 | 123,432 | 364,005 | 339,166 |\n| Other underwriting expenses | 13,718 | 12,118 | 37,054 | 33,054 |\n| Underwriting gain (loss) | $ | 127,773 | $ | 174,934 | $ | 379,793 | $ | 404,565 |\n\n\n| Three Months Ended | Nine Months Ended |\n| International | September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Gross written premiums | $ | 354,871 | $ | 406,254 | $ | 966,091 | $ | 1,181,513 |\n| Net written premiums | 318,478 | 352,608 | 896,872 | 977,235 |\n| Premiums earned | $ | 291,396 | $ | 320,020 | $ | 935,228 | $ | 958,399 |\n| Incurred losses and LAE | 229,013 | 236,559 | 630,752 | 604,166 |\n| Commission and brokerage | 70,894 | 73,143 | 226,321 | 215,716 |\n| Other underwriting expenses | 9,128 | 8,758 | 25,292 | 24,683 |\n| Underwriting gain (loss) | $ | (17,639 | ) | $ | 1,560 | $ | 52,863 | $ | 113,834 |\n\n\n| Three Months Ended | Nine Months Ended |\n| Bermuda | September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Gross written premiums | $ | 267,035 | $ | 205,342 | $ | 605,365 | $ | 573,793 |\n| Net written premiums | 251,678 | 189,447 | 557,453 | 548,210 |\n| Premiums earned | $ | 222,240 | $ | 181,754 | $ | 616,241 | $ | 546,699 |\n| Incurred losses and LAE | 154,327 | 108,961 | 372,572 | 310,602 |\n| Commission and brokerage | 52,980 | 48,421 | 151,356 | 140,968 |\n| Other underwriting expenses | 9,457 | 9,360 | 27,045 | 25,805 |\n| Underwriting gain (loss) | $ | 5,476 | $ | 15,012 | $ | 65,268 | $ | 69,324 |\n\n\n| Three Months Ended | Nine Months Ended |\n| Insurance | September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Gross written premiums | $ | 489,124 | $ | 364,111 | $ | 1,173,012 | $ | 911,242 |\n| Net written premiums | 418,960 | 310,690 | 1,022,389 | 802,431 |\n| Premiums earned | $ | 360,742 | $ | 290,518 | $ | 888,711 | $ | 742,038 |\n| Incurred losses and LAE | 262,328 | 239,823 | 662,052 | 557,047 |\n| Commission and brokerage | 50,268 | 40,418 | 127,125 | 114,535 |\n| Other underwriting expenses | 35,677 | 31,311 | 99,232 | 83,672 |\n| Underwriting gain (loss) | $ | 12,469 | $ | (21,034 | ) | $ | 302 | $ | (13,216 | ) |\n\n26\n\n| Three Months Ended | Nine Months Ended |\n| Mt. Logan Re | September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Gross written premiums | $ | 72,200 | $ | 50,334 | $ | 183,694 | $ | 109,163 |\n| Net written premiums | 60,903 | 49,757 | 153,281 | 98,666 |\n| Premiums earned | $ | 50,777 | $ | 38,218 | $ | 132,508 | $ | 81,411 |\n| Incurred losses and LAE | 16,485 | 3,410 | 36,272 | 19,575 |\n| Commission and brokerage | 4,856 | 5,105 | 13,325 | 9,823 |\n| Other underwriting expenses | 2,687 | 1,566 | 6,659 | 4,951 |\n| Underwriting gain (loss) | $ | 26,749 | $ | 28,137 | $ | 76,252 | $ | 47,062 |\n\nThe following table reconciles the underwriting results for the operating segments to income before taxes as reported in the consolidated statements of operations and comprehensive income (loss) for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Underwriting gain (loss) | $ | 154,828 | $ | 198,609 | $ | 574,478 | $ | 621,569 |\n| Net investment income | 115,511 | 142,143 | 363,140 | 396,524 |\n| Net realized capital gains (losses) | (159,971 | ) | (9,448 | ) | (194,654 | ) | 70,694 |\n| Net derivative gain (loss) | (11,428 | ) | 1,855 | (5,225 | ) | 3,968 |\n| Corporate expenses | (5,924 | ) | (9,958 | ) | (17,312 | ) | (18,802 | ) |\n| Interest, fee and bond issue cost amortization expense | (8,990 | ) | (12,424 | ) | (27,006 | ) | (28,970 | ) |\n| Other income (expense) | 17,413 | 11,332 | 59,561 | (5,835 | ) |\n| Income (loss) before taxes | $ | 101,439 | $ | 322,109 | $ | 752,982 | $ | 1,039,148 |\n\nThe Company produces business in the U.S., Bermuda and internationally. The net income deriving from and assets residing in the individual foreign countries in which the Company writes business are not identifiable in the Company's financial records. Based on gross written premium, the table below presents the largest country, other than the U.S., in which the Company writes business, for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| United Kingdom gross written premium | $ | 212,039 | $ | 199,052 | $ | 565,143 | $ | 536,928 |\n\nNo other country represented more than 5% of the Company's revenues.\n16. SHARE-BASED COMPENSATION PLANS\nFor the three months ended September 30, 2015, share-based compensation awards granted were 4,720 restricted shares, granted on September 9, 2015, with a fair value of $176.37 per share.\n27\n17. RETIREMENT BENEFITS\nThe Company maintains both qualified and non-qualified defined benefit pension plans and a retiree health plan for its U.S. employees employed prior to April 1, 2010.\nNet periodic benefit cost for U.S. employees included the following components for the periods indicated:\n\n| Pension Benefits | Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Service cost | $ | 3,203 | $ | 2,460 | $ | 9,398 | $ | 7,381 |\n| Interest cost | 2,758 | 2,542 | 7,926 | 7,625 |\n| Expected return on plan assets | (2,904 | ) | (2,822 | ) | (8,710 | ) | (8,468 | ) |\n| Amortization of prior service cost | 4 | 13 | 15 | 38 |\n| Amortization of net (income) loss | 2,312 | 1,173 | 6,824 | 3,356 |\n| FAS 88 settlement charge | - | 5,269 | - | 5,269 |\n| Net periodic benefit cost | $ | 5,373 | $ | 8,635 | $ | 15,453 | $ | 15,201 |\n\n\n| Other Benefits | Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Service cost | $ | 498 | $ | 407 | $ | 1,498 | $ | 1,221 |\n| Interest cost | 329 | 342 | 987 | 1,026 |\n| Amortization of net (income) loss | 76 | 82 | 497 | 246 |\n| Net periodic benefit cost | $ | 903 | $ | 831 | $ | 2,982 | $ | 2,493 |\n\nThe Company did not make any contributions to the qualified pension benefit plan for the three and nine months ended September 30, 2015 and 2014.\n18. INCOME TAXES\nThe Company is domiciled in Bermuda and has significant subsidiaries and/or branches in Canada, Ireland, Singapore, the United Kingdom, and the United States. The Company's Bermuda domiciled subsidiaries are exempt from income taxation under Bermuda law until 2035. Pre-tax income generated by Group's non-Bermuda subsidiaries and the UK branch of Bermuda is subject to applicable federal, foreign, state and local taxes on corporations. Company subsidiaries domiciled in the US as well as the Canadian and Singapore branches of Everest Re generate US pre-tax income (loss). Foreign domiciled subsidiaries, including the UK branch of Bermuda Re, generate non-US pre-tax income (loss). Fluctuations in US and non-US pre-tax income (loss) primarily result from the impact of catastrophe losses and realized investment gains (losses).\nFor interim reporting periods, the company is generally required to use the annualized effective tax rate (\"AETR\") method, as prescribed by ASC 740-270, Interim Reporting, to calculate its income tax provision. Under this method, the AETR is applied to the interim year-to-date pre-tax income to determine the income tax expense or benefit for the year-to-date period. The income tax expense or benefit for a quarter represents the difference between the year-to-date income tax expense or benefit for the current year-to-date period less such amount for the immediately preceding year-to-date period. Management considers the impact of all known events in its estimation of the Company's annual pre-tax income and AETR.\n19. DISPOSITIONS\nOn July 13, 2015, the Company closed its agreement to sell all of the outstanding shares of capital stock of Mt. McKinley, a Delaware domiciled insurance company and wholly-owned subsidiary of the Company to Clearwater Insurance Company, a Delaware domiciled insurance company. The Company received $20,156 thousand in cash for Mt. McKinley and did not recognize any realized gain or loss from the sale.\n28\nConcurrently with the closing, the Company entered into a retrocession treaty with an affiliate of Clearwater Insurance Company. Per the retrocession treaty, the Company retroceded 100% of the liabilities associated with certain Mt. McKinley policies, which had been reinsured by Everest Reinsurance (Bermuda), Ltd. (\"Everest Re Bermuda\"), a wholly-owned subsidiary of the Company. As consideration for entering into the retrocession treaty, Everest Re Bermuda transferred cash of $140,279 thousand, an amount equal to the net loss reserves as of the closing date. The maximum liability retroceded under the retrocession treaty will be $440,279 thousand, equal to the retrocession payment plus $300,000 thousand. The Company will retain liability for any amounts exceeding the maximum liability retroceded under the retrocession treaty.\n20. SUBSEQUENT EVENTS\nThe Company is currently negotiating two additional reinsurance agreements with Kilimanjaro to provide the Company with catastrophe reinsurance coverage. Kilimanjaro will fund the catastrophe reinsurance coverage through the issuance of two classes of catastrophe reinsurance bonds.\n29\n\nITEM 2.\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION\n| Three Months Ended | Percentage | Nine Months Ended | Percentage |\n| September 30, | Increase/ | September 30, | Increase/ |\n| (Dollars in millions) | 2015 | 2014 | (Decrease) | 2015 | 2014 | (Decrease) |\n| Gross written premiums | $ | 1,720.7 | $ | 1,666.7 | 3.2 | % | $ | 4,393.0 | $ | 4,349.5 | 1.0 | % |\n| Net written premiums | 1,561.3 | 1,517.6 | 2.9 | % | 4,013.6 | 3,962.7 | 1.3 | % |\n| REVENUES: |\n| Premiums earned | $ | 1,413.6 | $ | 1,390.0 | 1.7 | % | $ | 4,053.1 | $ | 3,806.8 | 6.5 | % |\n| Net investment income | 115.5 | 142.1 | -18.7 | % | 363.1 | 396.5 | -8.4 | % |\n| Net realized capital gains (losses) | (160.0 | ) | (9.4 | ) | NM | (194.7 | ) | 70.7 | NM |\n| Net derivative gain (loss) | (11.4 | ) | 1.9 | NM | (5.2 | ) | 4.0 | -231.7 | % |\n| Other income (expense) | 17.4 | 11.3 | 53.6 | % | 59.6 | (5.8 | ) | NM |\n| Total revenues | 1,375.2 | 1,535.9 | -10.5 | % | 4,275.9 | 4,272.2 | 0.1 | % |\n| CLAIMS AND EXPENSES: |\n| Incurred losses and loss adjustment expenses | 888.1 | 837.8 | 6.0 | % | 2,401.2 | 2,192.9 | 9.5 | % |\n| Commission, brokerage, taxes and fees | 300.0 | 290.5 | 3.3 | % | 882.1 | 820.2 | 7.5 | % |\n| Other underwriting expenses | 70.7 | 63.1 | 12.0 | % | 195.3 | 172.2 | 13.4 | % |\n| Corporate expenses | 5.9 | 10.0 | -40.5 | % | 17.3 | 18.8 | -7.9 | % |\n| Interest, fees and bond issue cost amortization expense | 9.0 | 12.4 | -27.6 | % | 27.0 | 29.0 | -6.8 | % |\n| Total claims and expenses | 1,273.7 | 1,213.8 | 4.9 | % | 3,523.0 | 3,233.0 | 9.0 | % |\n| INCOME (LOSS) BEFORE TAXES | 101.4 | 322.1 | -68.5 | % | 753.0 | 1,039.1 | -27.5 | % |\n| Income tax expense (benefit) | (6.1 | ) | 20.9 | -129.4 | % | 70.9 | 137.9 | -48.6 | % |\n| NET INCOME (LOSS) | $ | 107.6 | $ | 301.3 | -64.3 | % | $ | 682.1 | $ | 901.2 | -24.3 | % |\n| Net (income) loss attributable to noncontrolling interests | (19.0 | ) | (26.3 | ) | -27.8 | % | (61.5 | ) | (42.2 | ) | 45.9 | % |\n| NET INCOME (LOSS) ATTRIBUTABLE TO EVEREST RE GROUP | $ | 88.6 | $ | 274.9 | -67.8 | % | $ | 620.6 | $ | 859.0 | -27.8 | % |\n| RATIOS: | Point Change | Point Change |\n| Loss ratio | 62.8 | % | 60.3 | % | 2.5 | 59.2 | % | 57.6 | % | 1.6 |\n| Commission and brokerage ratio | 21.2 | % | 20.9 | % | 0.3 | 21.8 | % | 21.5 | % | 0.3 |\n| Other underwriting expense ratio | 5.0 | % | 4.5 | % | 0.5 | 4.8 | % | 4.6 | % | 0.2 |\n| Combined ratio | 89.0 | % | 85.7 | % | 3.3 | 85.8 | % | 83.7 | % | 2.1 |\n| At | At | Percentage |\n| September 30, | December 31, | Increase/ |\n| (Dollars in millions, except per share amounts) | 2015 | 2014 | (Decrease) |\n| Balance sheet data: |\n| Total investments and cash | $ | 17,647.2 | $ | 17,435.9 | 1.2 | % |\n| Total assets | 21,682.3 | 20,817.8 | 4.2 | % |\n| Loss and loss adjustment expense reserves | 9,966.0 | 9,720.8 | 2.5 | % |\n| Total debt | 638.4 | 638.4 | 0.0 | % |\n| Total liabilities | 13,443.3 | 12,945.2 | 3.8 | % |\n| Redeemable noncontrolling interests - Mt. Logan Re | 752.7 | 421.6 | 78.6 | % |\n| Shareholders' equity | 7,486.3 | 7,451.1 | 0.5 | % |\n| Book value per share | 173.76 | 166.75 | 4.2 | % |\n| (NM, not meaningful) |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional (a) | $ | 848.1 | 60.1 | % | $ | - | 0.0 | % | $ | 848.1 | 60.1 | % |\n| Catastrophes | 40.0 | 2.7 | % | - | 0.0 | % | 40.0 | 2.7 | % |\n| Total | $ | 888.1 | 62.8 | % | $ | - | 0.0 | % | $ | 888.1 | 62.8 | % |\n| 2014 |\n| Attritional (a) | $ | 807.3 | 58.1 | % | $ | 0.5 | 0.0 | % | $ | 807.8 | 58.1 | % |\n| Catastrophes | 30.0 | 2.2 | % | - | 0.0 | % | 30.0 | 2.2 | % |\n| Total | $ | 837.3 | 60.3 | % | $ | 0.5 | 0.0 | % | $ | 837.8 | 60.3 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 40.8 | 2.0 | pts | $ | (0.5 | ) | - | pts | $ | 40.3 | 2.0 | pts |\n| Catastrophes | 10.0 | 0.5 | pts | - | - | pts | 10.0 | 0.4 | pts |\n| Total segment | $ | 50.8 | 2.5 | pts | $ | (0.5 | ) | - | pts | $ | 50.3 | 2.5 | pts |\n| Nine Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional (a) | $ | 2,332.1 | 57.5 | % | $ | (0.8 | ) | 0.0 | % | $ | 2,331.3 | 57.5 | % |\n| Catastrophes | 80.0 | 2.0 | % | (10.0 | ) | -0.3 | % | 70.0 | 1.7 | % |\n| Total | $ | 2,412.1 | 59.5 | % | $ | (10.8 | ) | -0.3 | % | $ | 2,401.2 | 59.2 | % |\n| 2014 |\n| Attritional (a) | $ | 2,120.8 | 55.7 | % | $ | (2.9 | ) | -0.1 | % | $ | 2,117.9 | 55.6 | % |\n| Catastrophes | 75.0 | 2.0 | % | - | 0.0 | % | 75.0 | 2.0 | % |\n| Total | $ | 2,195.8 | 57.7 | % | $ | (2.9 | ) | -0.1 | % | $ | 2,192.9 | 57.6 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 211.3 | 1.8 | pts | $ | 2.1 | 0.1 | pts | $ | 213.4 | 1.9 | pts |\n| Catastrophes | 5.0 | - | pts | (10.0 | ) | (0.3 | ) | pts | (5.0 | ) | (0.3 | ) | pts |\n| Total segment | $ | 216.3 | 1.8 | pts | $ | (7.9 | ) | (0.2 | ) | pts | $ | 208.3 | 1.6 | pts |\n| (a) Attritional losses exclude catastrophe losses. |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in millions) | 2015 | 2014 | 2015 | 2014 |\n| Fixed maturities | $ | 108.1 | $ | 115.1 | $ | 327.0 | $ | 348.9 |\n| Equity securities | 11.1 | 11.1 | 35.8 | 36.1 |\n| Short-term investments and cash | 0.4 | 0.3 | 1.1 | 1.2 |\n| Other invested assets |\n| Limited partnerships | 0.4 | 21.7 | 14.0 | 25.7 |\n| Other | (0.2 | ) | 0.9 | 1.4 | 3.2 |\n| Gross investment income before adjustments | 119.7 | 149.0 | 379.2 | 415.1 |\n| Funds held interest income (expense) | 2.6 | 1.8 | 8.2 | 6.9 |\n| Future policy benefit reserve income (expense) | (0.3 | ) | (0.5 | ) | (1.4 | ) | (0.9 | ) |\n| Gross investment income | 122.0 | 150.3 | 386.0 | 421.0 |\n| Investment expenses | (6.5 | ) | (8.2 | ) | (22.8 | ) | (24.5 | ) |\n| Net investment income | $ | 115.5 | $ | 142.1 | $ | 363.1 | $ | 396.5 |\n| (Some amounts may not reconcile due to rounding.) |\n| At | At |\n| September 30, | December 31, |\n| 2015 | 2014 |\n| Imbedded pre-tax yield of cash and invested assets | 3.0% | 3.0% |\n| Imbedded after-tax yield of cash and invested assets | 2.5% | 2.6% |\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| 2015 | 2014 | 2015 | 2014 |\n| Annualized pre-tax yield on average cash and invested assets | 2.7% | 3.4% | 2.8% | 3.2% |\n| Annualized after-tax yield on average cash and invested assets | 2.2% | 2.7% | 2.3% | 2.7% |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (Dollars in millions) | 2015 | 2014 | Variance | 2015 | 2014 | Variance |\n| Gains (losses) from sales: |\n| Fixed maturity securities, market value: |\n| Gains | $ | 11.8 | $ | 12.7 | $ | (0.9 | ) | $ | 37.5 | $ | 27.5 | $ | 10.0 |\n| Losses | (17.0 | ) | (5.5 | ) | (11.5 | ) | (53.3 | ) | (23.9 | ) | (29.4 | ) |\n| Total | (5.2 | ) | 7.3 | (12.5 | ) | (15.8 | ) | 3.7 | (19.5 | ) |\n| Fixed maturity securities, fair value: |\n| Gains | - | 0.1 | (0.1 | ) | - | 1.3 | (1.3 | ) |\n| Losses | - | - | - | - | (0.3 | ) | 0.3 |\n| Total | - | 0.1 | (0.1 | ) | - | 1.0 | (1.0 | ) |\n| Equity securities, market value: |\n| Gains | - | - | - | - | - | - |\n| Losses | (3.6 | ) | (0.1 | ) | (3.5 | ) | (4.5 | ) | (1.2 | ) | (3.3 | ) |\n| Total | (3.6 | ) | (0.1 | ) | (3.5 | ) | (4.5 | ) | (1.2 | ) | (3.3 | ) |\n| Equity securities, fair value: |\n| Gains | 5.3 | 2.5 | 2.8 | 18.9 | 13.0 | 5.9 |\n| Losses | (18.9 | ) | (4.4 | ) | (14.5 | ) | (31.9 | ) | (14.9 | ) | (17.0 | ) |\n| Total | (13.6 | ) | (1.9 | ) | (11.7 | ) | (13.0 | ) | (1.9 | ) | (11.1 | ) |\n| Total net realized capital gains (losses) from sales: |\n| Gains | 17.1 | 15.4 | 1.7 | 56.4 | 41.9 | 14.5 |\n| Losses | (39.5 | ) | (10.0 | ) | (29.5 | ) | (89.7 | ) | (40.3 | ) | (49.4 | ) |\n| Total | (22.5 | ) | 5.4 | (27.9 | ) | (33.3 | ) | 1.6 | (34.9 | ) |\n| Other-than-temporary impairments: | (20.4 | ) | (0.1 | ) | (20.3 | ) | (62.7 | ) | (0.5 | ) | (62.2 | ) |\n| Gains (losses) from fair value adjustments: |\n| Fixed maturity securities, fair value | - | (0.9 | ) | 0.9 | 0.1 | (0.9 | ) | 1.0 |\n| Equity securities, fair value | (117.1 | ) | (13.8 | ) | (103.3 | ) | (98.7 | ) | 70.5 | (169.2 | ) |\n| Total | (117.1 | ) | (14.7 | ) | (102.4 | ) | (98.7 | ) | 69.6 | (168.3 | ) |\n| Total net realized capital gains (losses) | $ | (160.0 | ) | $ | (9.4 | ) | $ | (150.6 | ) | $ | (194.7 | ) | $ | 70.7 | $ | (265.4 | ) |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\n| Gross written premiums | $ | 537.5 | $ | 640.7 | $ | (103.2 | ) | -16.1 | % | $ | 1,464.8 | $ | 1,573.8 | $ | (108.9 | ) | -6.9 | % |\n| Net written premiums | 511.2 | 615.1 | (103.8 | ) | -16.9 | % | 1,383.6 | 1,536.1 | (152.5 | ) | -9.9 | % |\n| Premiums earned | $ | 488.5 | $ | 559.5 | $ | (71.0 | ) | -12.7 | % | $ | 1,480.4 | $ | 1,478.3 | $ | 2.2 | 0.1 | % |\n| Incurred losses and LAE | 225.9 | 249.0 | (23.1 | ) | -9.3 | % | 699.6 | 701.5 | (1.9 | ) | -0.3 | % |\n| Commission and brokerage | 121.1 | 123.4 | (2.4 | ) | -1.9 | % | 364.0 | 339.2 | 24.8 | 7.3 | % |\n| Other underwriting expenses | 13.7 | 12.1 | 1.6 | 13.2 | % | 37.1 | 33.1 | 4.0 | 12.1 | % |\n| Underwriting gain (loss) | $ | 127.8 | $ | 174.9 | $ | (47.2 | ) | -27.0 | % | $ | 379.8 | $ | 404.6 | $ | (24.8 | ) | -6.1 | % |\n| Point Chg | Point Chg |\n| Loss ratio | 46.3 | % | 44.5 | % | 1.8 | 47.3 | % | 47.5 | % | (0.2 | ) |\n| Commission and brokerage ratio | 24.8 | % | 22.1 | % | 2.7 | 24.6 | % | 22.9 | % | 1.7 |\n| Other underwriting expense ratio | 2.7 | % | 2.1 | % | 0.6 | 2.4 | % | 2.2 | % | 0.2 |\n| Combined ratio | 73.8 | % | 68.7 | % | 5.1 | 74.3 | % | 72.6 | % | 1.7 |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 225.5 | 46.2 | % | $ | 0.5 | 0.2 | % | $ | 226.0 | 46.4 | % |\n| Catastrophes | 0.2 | 0.0 | % | (0.3 | ) | -0.1 | % | (0.1 | ) | -0.1 | % |\n| Total segment | $ | 225.7 | 46.2 | % | $ | 0.2 | 0.1 | % | $ | 225.9 | 46.3 | % |\n| 2014 |\n| Attritional | $ | 246.7 | 44.1 | % | $ | 1.3 | 0.2 | % | $ | 248.1 | 44.3 | % |\n| Catastrophes | - | 0.0 | % | 0.9 | 0.2 | % | 0.9 | 0.2 | % |\n| Total segment | $ | 246.7 | 44.1 | % | $ | 2.3 | 0.4 | % | $ | 249.0 | 44.5 | % |\n| Variance 2015/2014 |\n| Attritional | $ | (21.2 | ) | 2.1 | pts | $ | (0.8 | ) | - | pts | $ | (22.1 | ) | 2.1 | pts |\n| Catastrophes | 0.2 | - | pts | (1.2 | ) | (0.3 | ) | pts | (1.0 | ) | (0.3 | ) | pts |\n| Total segment | $ | (21.0 | ) | 2.1 | pts | $ | (2.1 | ) | (0.3 | ) | pts | $ | (23.1 | ) | 1.8 | pts |\n| Nine Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 732.4 | 49.5 | % | $ | (24.3 | ) | -1.6 | % | $ | 708.1 | 47.9 | % |\n| Catastrophes | 0.2 | 0.0 | % | (8.8 | ) | -0.6 | % | (8.5 | ) | -0.6 | % |\n| Total segment | $ | 732.6 | 49.5 | % | $ | (33.1 | ) | -2.2 | % | $ | 699.6 | 47.3 | % |\n| 2014 |\n| Attritional | $ | 691.3 | 46.8 | % | $ | 2.3 | 0.2 | % | $ | 693.6 | 46.9 | % |\n| Catastrophes | 6.3 | 0.4 | % | 1.5 | 0.1 | % | 7.8 | 0.5 | % |\n| Total segment | $ | 697.7 | 47.2 | % | $ | 3.8 | 0.3 | % | $ | 701.5 | 47.5 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 41.1 | 2.7 | pts | $ | (26.6 | ) | (1.8 | ) | pts | $ | 14.5 | 1.0 | pts |\n| Catastrophes | (6.1 | ) | (0.4 | ) | pts | (10.3 | ) | (0.7 | ) | pts | (16.3 | ) | (1.1 | ) | pts |\n| Total segment | $ | 34.9 | 2.3 | pts | $ | (36.9 | ) | (2.5 | ) | pts | $ | (1.9 | ) | (0.2 | ) | pts |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\n| Gross written premiums | $ | 354.9 | $ | 406.3 | $ | (51.4 | ) | -12.6 | % | $ | 966.1 | $ | 1,181.5 | $ | (215.4 | ) | -18.2 | % |\n| Net written premiums | 318.5 | 352.6 | (34.1 | ) | -9.7 | % | 896.9 | 977.2 | (80.4 | ) | -8.2 | % |\n| Premiums earned | $ | 291.4 | $ | 320.0 | $ | (28.6 | ) | -8.9 | % | $ | 935.2 | $ | 958.4 | $ | (23.2 | ) | -2.4 | % |\n| Incurred losses and LAE | 229.0 | 236.6 | (7.5 | ) | -3.2 | % | 630.8 | 604.2 | 26.6 | 4.4 | % |\n| Commission and brokerage | 70.9 | 73.1 | (2.2 | ) | -3.1 | % | 226.3 | 215.7 | 10.6 | 4.9 | % |\n| Other underwriting expenses | 9.1 | 8.8 | 0.4 | 4.2 | % | 25.3 | 24.7 | 0.6 | 2.5 | % |\n| Underwriting gain (loss) | $ | (17.6 | ) | $ | 1.6 | $ | (19.2 | ) | NM | $ | 52.9 | $ | 113.8 | $ | (61.0 | ) | -53.6 | % |\n| Point Chg | Point Chg |\n| Loss ratio | 78.6 | % | 73.9 | % | 4.7 | 67.4 | % | 63.0 | % | 4.4 |\n| Commission and brokerage ratio | 24.3 | % | 22.9 | % | 1.4 | 24.2 | % | 22.5 | % | 1.7 |\n| Other underwriting expense ratio | 3.2 | % | 2.7 | % | 0.5 | 2.7 | % | 2.6 | % | 0.1 |\n| Combined ratio | 106.1 | % | 99.5 | % | 6.6 | 94.3 | % | 88.1 | % | 6.2 |\n| (NM, not meaningful) |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 195.5 | 67.1 | % | $ | 0.4 | 0.1 | % | $ | 195.9 | 67.2 | % |\n| Catastrophes | 34.4 | 11.8 | % | (1.3 | ) | -0.4 | % | 33.1 | 11.4 | % |\n| Total segment | $ | 229.9 | 78.9 | % | $ | (0.9 | ) | -0.3 | % | $ | 229.0 | 78.6 | % |\n| 2014 |\n| Attritional | $ | 213.0 | 66.5 | % | $ | (4.6 | ) | -1.4 | % | $ | 208.4 | 65.1 | % |\n| Catastrophes | 29.3 | 9.2 | % | (1.2 | ) | -0.4 | % | 28.1 | 8.8 | % |\n| Total segment | $ | 242.3 | 75.7 | % | $ | (5.8 | ) | -1.8 | % | $ | 236.6 | 73.9 | % |\n| Variance 2015/2014 |\n| Attritional | $ | (17.5 | ) | 0.6 | pts | $ | 5.0 | 1.5 | pts | $ | (12.5 | ) | 2.1 | pts |\n| Catastrophes | 5.1 | 2.6 | pts | (0.1 | ) | - | pts | 5.0 | 2.6 | pts |\n| Total segment | $ | (12.4 | ) | 3.2 | pts | $ | 4.9 | 1.5 | pts | $ | (7.5 | ) | 4.7 | pts |\n| Nine Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 565.2 | 60.4 | % | $ | (2.7 | ) | -0.3 | % | $ | 562.5 | 60.1 | % |\n| Catastrophes | 71.3 | 7.6 | % | (3.1 | ) | -0.3 | % | 68.2 | 7.3 | % |\n| Total segment | $ | 636.6 | 68.0 | % | $ | (5.8 | ) | -0.6 | % | $ | 630.8 | 67.4 | % |\n| 2014 |\n| Attritional | $ | 548.2 | 57.1 | % | $ | (4.7 | ) | -0.5 | % | $ | 543.5 | 56.6 | % |\n| Catastrophes | 63.9 | 6.7 | % | (3.3 | ) | -0.3 | % | 60.6 | 6.4 | % |\n| Total segment | $ | 612.1 | 63.8 | % | $ | (8.0 | ) | -0.8 | % | $ | 604.2 | 63.0 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 17.0 | 3.3 | pts | $ | 2.0 | 0.2 | pts | $ | 19.0 | 3.5 | pts |\n| Catastrophes | 7.4 | 0.9 | pts | 0.2 | - | pts | 7.6 | 0.9 | pts |\n| Total segment | $ | 24.5 | 4.2 | pts | $ | 2.2 | 0.2 | pts | $ | 26.6 | 4.4 | pts |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\n| Gross written premiums | $ | 267.0 | $ | 205.3 | $ | 61.7 | 30.0 | % | $ | 605.4 | $ | 573.8 | $ | 31.6 | 5.5 | % |\n| Net written premiums | 251.7 | 189.4 | 62.2 | 32.8 | % | 557.5 | 548.2 | 9.2 | 1.7 | % |\n| Premiums earned | $ | 222.2 | $ | 181.8 | $ | 40.5 | 22.3 | % | $ | 616.2 | $ | 546.7 | $ | 69.5 | 12.7 | % |\n| Incurred losses and LAE | 154.3 | 109.0 | 45.4 | 41.6 | % | 372.6 | 310.6 | 62.0 | 20.0 | % |\n| Commission and brokerage | 53.0 | 48.4 | 4.6 | 9.4 | % | 151.4 | 141.0 | 10.4 | 7.4 | % |\n| Other underwriting expenses | 9.5 | 9.4 | 0.1 | 1.0 | % | 27.0 | 25.8 | 1.2 | 4.8 | % |\n| Underwriting gain (loss) | $ | 5.5 | $ | 15.0 | $ | (9.5 | ) | -63.5 | % | $ | 65.3 | $ | 69.3 | $ | (4.1 | ) | -5.9 | % |\n| Point Chg | Point Chg |\n| Loss ratio | 69.4 | % | 59.9 | % | 9.5 | 60.5 | % | 56.8 | % | 3.7 |\n| Commission and brokerage ratio | 23.8 | % | 26.6 | % | (2.8 | ) | 24.6 | % | 25.8 | % | (1.2 | ) |\n| Other underwriting expense ratio | 4.3 | % | 5.2 | % | (0.9 | ) | 4.3 | % | 4.7 | % | (0.4 | ) |\n| Combined ratio | 97.5 | % | 91.7 | % | 5.8 | 89.4 | % | 87.3 | % | 2.1 |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 153.4 | 69.0 | % | $ | - | 0.0 | % | $ | 153.4 | 69.0 | % |\n| Catastrophes | - | 0.0 | % | 0.9 | 0.4 | % | 0.9 | 0.4 | % |\n| Total segment | $ | 153.4 | 69.0 | % | $ | 0.9 | 0.4 | % | $ | 154.3 | 69.4 | % |\n| 2014 |\n| Attritional | $ | 108.8 | 59.8 | % | $ | - | 0.0 | % | $ | 108.8 | 59.8 | % |\n| Catastrophes | - | 0.0 | % | 0.2 | 0.1 | % | 0.2 | 0.1 | % |\n| Total segment | $ | 108.8 | 59.8 | % | $ | 0.2 | 0.1 | % | $ | 109.0 | 59.9 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 44.6 | 9.2 | pts | $ | - | - | pts | $ | 44.6 | 9.2 | pts |\n| Catastrophes | - | - | pts | 0.7 | 0.3 | pts | 0.7 | 0.3 | pts |\n| Total segment | $ | 44.6 | 9.2 | pts | $ | 0.7 | 0.3 | pts | $ | 45.4 | 9.5 | pts |\n| Nine Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 376.5 | 61.1 | % | $ | (5.2 | ) | -0.8 | % | $ | 371.3 | 60.3 | % |\n| Catastrophes | - | 0.0 | % | 1.3 | 0.2 | % | 1.3 | 0.2 | % |\n| Total segment | $ | 376.5 | 61.1 | % | $ | (3.9 | ) | -0.6 | % | $ | 372.6 | 60.5 | % |\n| 2014 |\n| Attritional | $ | 313.7 | 57.4 | % | $ | (5.0 | ) | -0.9 | % | $ | 308.7 | 56.5 | % |\n| Catastrophes | - | 0.0 | % | 1.9 | 0.3 | % | 1.9 | 0.3 | % |\n| Total segment | $ | 313.7 | 57.4 | % | $ | (3.1 | ) | -0.6 | % | $ | 310.6 | 56.8 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 62.8 | 3.7 | pts | $ | (0.2 | ) | 0.1 | pts | $ | 62.6 | 3.8 | pts |\n| Catastrophes | - | - | pts | (0.6 | ) | (0.1 | ) | pts | (0.6 | ) | (0.1 | ) | pts |\n| Total segment | $ | 62.8 | 3.7 | pts | $ | (0.8 | ) | - | pts | $ | 62.0 | 3.7 | pts |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\n| Gross written premiums | $ | 489.1 | $ | 364.1 | $ | 125.0 | 34.3 | % | $ | 1,173.0 | $ | 911.2 | $ | 261.8 | 28.7 | % |\n| Net written premiums | 419.0 | 310.7 | 108.3 | 34.8 | % | 1,022.4 | 802.4 | 220.0 | 27.4 | % |\n| Premiums earned | $ | 360.7 | $ | 290.5 | $ | 70.2 | 24.2 | % | $ | 888.7 | $ | 742.0 | $ | 146.7 | 19.8 | % |\n| Incurred losses and LAE | 262.3 | 239.8 | 22.5 | 9.4 | % | 662.1 | 557.0 | 105.0 | 18.9 | % |\n| Commission and brokerage | 50.3 | 40.4 | 9.9 | 24.4 | % | 127.1 | 114.5 | 12.6 | 11.0 | % |\n| Other underwriting expenses | 35.7 | 31.3 | 4.4 | 13.9 | % | 99.2 | 83.7 | 15.6 | 18.6 | % |\n| Underwriting gain (loss) | $ | 12.5 | $ | (21.0 | ) | $ | 33.5 | -159.3 | % | $ | 0.3 | $ | (13.2 | ) | $ | 13.5 | -102.3 | % |\n| Point Chg | Point Chg |\n| Loss ratio | 72.7 | % | 82.5 | % | (9.8 | ) | 74.5 | % | 75.1 | % | (0.6 | ) |\n| Commission and brokerage ratio | 13.9 | % | 13.9 | % | - | 14.3 | % | 15.4 | % | (1.1 | ) |\n| Other underwriting expense ratio | 9.9 | % | 10.8 | % | (0.9 | ) | 11.2 | % | 11.3 | % | (0.1 | ) |\n| Combined ratio | 96.5 | % | 107.2 | % | (10.7 | ) | 100.0 | % | 101.8 | % | (1.8 | ) |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 262.9 | 72.9 | % | $ | (0.9 | ) | -0.3 | % | $ | 262.1 | 72.6 | % |\n| Catastrophes | - | 0.0 | % | 0.2 | 0.1 | % | 0.2 | 0.1 | % |\n| Total segment | $ | 262.9 | 72.9 | % | $ | (0.6 | ) | -0.2 | % | $ | 262.3 | 72.7 | % |\n| 2014 |\n| Attritional | $ | 236.1 | 81.2 | % | $ | 3.7 | 1.3 | % | $ | 239.8 | 82.5 | % |\n| Catastrophes | - | 0.0 | % | - | 0.0 | % | - | 0.0 | % |\n| Total segment | $ | 236.1 | 81.2 | % | $ | 3.7 | 1.3 | % | $ | 239.8 | 82.5 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 26.8 | (8.3 | ) | pts | $ | (4.6 | ) | (1.6 | ) | pts | $ | 22.3 | (9.9 | ) | pts |\n| Catastrophes | - | - | pts | 0.2 | 0.1 | pts | 0.2 | 0.1 | pts |\n| Total segment | $ | 26.8 | (8.3 | ) | pts | $ | (4.3 | ) | (1.5 | ) | pts | $ | 22.5 | (9.8 | ) | pts |\n| Nine Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 630.5 | 70.9 | % | $ | 31.5 | 3.6 | % | $ | 662.0 | 74.5 | % |\n| Catastrophes | - | 0.0 | % | 0.1 | 0.0 | % | 0.1 | 0.0 | % |\n| Total segment | $ | 630.5 | 70.9 | % | $ | 31.6 | 3.6 | % | $ | 662.1 | 74.5 | % |\n| 2014 |\n| Attritional | $ | 552.5 | 74.5 | % | $ | 4.5 | 0.6 | % | $ | 557.0 | 75.1 | % |\n| Catastrophes | - | 0.0 | % | 0.1 | 0.0 | % | 0.1 | 0.0 | % |\n| Total segment | $ | 552.5 | 74.5 | % | $ | 4.6 | 0.6 | % | $ | 557.0 | 75.1 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 78.0 | (3.6 | ) | pts | $ | 27.0 | 3.0 | pts | $ | 105.0 | (0.6 | ) | pts |\n| Catastrophes | - | - | pts | - | - | pts | - | - | pts |\n| Total segment | $ | 78.0 | (3.6 | ) | pts | $ | 27.0 | 3.0 | pts | $ | 105.0 | (0.6 | ) | pts |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\n| Gross written premiums | $ | 72.2 | $ | 50.3 | $ | 21.9 | 43.4 | % | $ | 183.7 | $ | 109.2 | $ | 74.5 | 68.3 | % |\n| Net written premiums | 60.9 | 49.8 | 11.1 | 22.4 | % | 153.3 | 98.7 | 54.6 | 55.4 | % |\n| Premiums earned | $ | 50.8 | $ | 38.2 | $ | 12.6 | 32.9 | % | $ | 132.5 | $ | 81.4 | $ | 51.1 | 62.8 | % |\n| Incurred losses and LAE | 16.5 | 3.4 | 13.1 | NM | 36.3 | 19.6 | 16.7 | 85.3 | % |\n| Commission and brokerage | 4.9 | 5.1 | (0.2 | ) | -4.9 | % | 13.3 | 9.8 | 3.5 | 35.7 | % |\n| Other underwriting expenses | 2.7 | 1.6 | 1.1 | 71.6 | % | 6.7 | 5.0 | 1.7 | 34.5 | % |\n| Underwriting gain (loss) | $ | 26.7 | $ | 28.1 | $ | (1.4 | ) | -4.9 | % | $ | 76.3 | $ | 47.1 | $ | 29.2 | 62.0 | % |\n| Point Chg | Point Chg |\n| Loss ratio | 32.5 | % | 8.9 | % | 23.6 | 27.4 | % | 24.0 | % | 3.4 |\n| Commission and brokerage ratio | 9.6 | % | 13.4 | % | (3.8 | ) | 10.1 | % | 12.1 | % | (2.0 | ) |\n| Other underwriting expense ratio | 5.2 | % | 4.1 | % | 1.1 | 5.0 | % | 6.1 | % | (1.1 | ) |\n| Combined ratio | 47.3 | % | 26.4 | % | 20.9 | 42.5 | % | 42.2 | % | 0.3 |\n| (NM, not meaningful) |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 10.7 | 21.1 | % | $ | - | 0.0 | % | $ | 10.7 | 21.1 | % |\n| Catastrophes | 5.4 | 10.5 | % | 0.4 | 0.9 | % | 5.8 | 11.4 | % |\n| Total segment | $ | 16.1 | 31.6 | % | $ | 0.4 | 0.9 | % | $ | 16.5 | 32.5 | % |\n| 2014 |\n| Attritional | $ | 2.7 | 7.2 | % | $ | - | 0.0 | % | $ | 2.7 | 7.2 | % |\n| Catastrophes | 0.7 | 1.7 | % | - | 0.0 | % | 0.7 | 1.7 | % |\n| Total segment | $ | 3.4 | 8.9 | % | $ | - | 0.0 | % | $ | 3.4 | 8.9 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 8.0 | 13.9 | pts | $ | - | - | pts | $ | 8.0 | 13.9 | pts |\n| Catastrophes | 4.7 | 8.8 | pts | 0.4 | 0.9 | pts | 5.1 | 9.7 | pts |\n| Total segment | $ | 12.7 | 22.7 | pts | $ | 0.4 | 0.9 | pts | $ | 13.1 | 23.6 | pts |\n| Nine Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 27.4 | 20.7 | % | $ | - | 0.0 | % | $ | 27.4 | 20.7 | % |\n| Catastrophes | 8.4 | 6.4 | % | 0.4 | 0.3 | % | 8.8 | 6.7 | % |\n| Total segment | $ | 35.8 | 27.1 | % | $ | 0.4 | 0.3 | % | $ | 36.3 | 27.4 | % |\n| 2014 |\n| Attritional | $ | 15.0 | 18.4 | % | $ | - | 0.0 | % | $ | 15.0 | 18.4 | % |\n| Catastrophes | 4.7 | 5.8 | % | (0.2 | ) | -0.2 | % | 4.5 | 5.6 | % |\n| Total segment | $ | 19.8 | 24.2 | % | $ | (0.2 | ) | -0.2 | % | $ | 19.6 | 24.0 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 12.4 | 2.3 | pts | $ | - | - | pts | $ | 12.4 | 2.3 | pts |\n| Catastrophes | 3.7 | 0.6 | pts | 0.6 | 0.5 | pts | 4.3 | 1.1 | pts |\n| Total segment | $ | 16.0 | 2.9 | pts | $ | 0.6 | 0.5 | pts | $ | 16.7 | 3.4 | pts |\n| (Some amounts may not reconcile due to rounding.) |\n| (Dollars in millions) | At September 30, 2015 | At December 31, 2014 |\n| Fixed maturities, market value | $ | 13,491.0 | 76.4 | % | $ | 13,101.1 | 75.1 | % |\n| Fixed maturities, fair value | - | 0.0 | % | 1.5 | 0.0 | % |\n| Equity securities, market value | 113.0 | 0.6 | % | 140.2 | 0.8 | % |\n| Equity securities, fair value | 1,357.3 | 7.7 | % | 1,447.8 | 8.3 | % |\n| Short-term investments | 1,615.0 | 9.2 | % | 1,705.9 | 9.8 | % |\n| Other invested assets | 669.7 | 3.8 | % | 601.9 | 3.5 | % |\n| Cash | 401.2 | 2.3 | % | 437.5 | 2.5 | % |\n| Total investments and cash | $ | 17,647.2 | 100.0 | % | $ | 17,435.9 | 100.0 | % |\n| (Some amounts may not reconcile due to rounding.) |\n| At | At |\n| September 30, 2015 | December 31, 2014 |\n| Fixed income portfolio duration (years) | 3.0 | 2.9 |\n| Fixed income composite credit quality | A1 | A1 |\n| Imbedded end of period yield, pre-tax | 3.0% | 3.0% |\n| Imbedded end of period yield, after-tax | 2.5% | 2.6% |\n| Nine Months Ended | Twelve Months Ended |\n| September 30, 2015 | December 31, 2014 |\n| Fixed income portfolio total return | 1.4% | 3.5% |\n| Barclay's Capital - U.S. aggregate index | 1.1% | 6.0% |\n| Common equity portfolio total return | -5.0% | 10.4% |\n| S&P 500 index | -5.3% | 13.7% |\n| Other invested asset portfolio total return | 4.1% | 11.8% |\n| At September 30, 2015 |\n| Case | IBNR | Total | % of |\n| (Dollars in millions) | Reserves | Reserves | Reserves | Total |\n| U.S. Reinsurance | $ | 1,290.2 | $ | 2,013.9 | $ | 3,304.1 | 33.2 | % |\n| International | 775.7 | 1,069.5 | 1,845.3 | 18.5 | % |\n| Bermuda | 862.4 | 1,225.5 | 2,087.8 | 20.9 | % |\n| Insurance | 1,001.0 | 1,249.8 | 2,250.8 | 22.6 | % |\n| Mt. Logan Re | 18.4 | 38.7 | 57.1 | 0.6 | % |\n| Total excluding A&E | 3,947.7 | 5,597.4 | 9,545.1 | 95.8 | % |\n| A&E | 236.1 | 184.8 | 420.9 | 4.2 | % |\n| Total including A&E | $ | 4,183.8 | $ | 5,782.2 | $ | 9,966.0 | 100.0 | % |\n| (Some amounts may not reconcile due to rounding.) |\n| At December 31, 2014 |\n| Case | IBNR | Total | % of |\n| (Dollars in millions) | Reserves | Reserves | Reserves | Total |\n| U.S. Reinsurance | $ | 1,409.5 | $ | 1,925.4 | $ | 3,334.9 | 34.3 | % |\n| International | 902.5 | 868.6 | 1,771.0 | 18.2 | % |\n| Bermuda | 783.9 | 1,108.2 | 1,892.0 | 19.5 | % |\n| Insurance | 968.3 | 1,250.4 | 2,218.6 | 22.8 | % |\n| Mt. Logan Re | 13.0 | 15.0 | 28.0 | 0.3 | % |\n| Total excluding A&E | 4,077.1 | 5,167.5 | 9,244.6 | 95.1 | % |\n| A&E | 251.1 | 225.1 | 476.2 | 4.9 | % |\n| Total including A&E | $ | 4,328.2 | $ | 5,392.6 | $ | 9,720.8 | 100.0 | % |\n| (Some amounts may not reconcile due to rounding.) |\n| At | At |\n| September 30, | December 31, |\n| (Dollars in millions) | 2015 | 2014 |\n| Gross reserves | $ | 420.9 | $ | 476.2 |\n| Reinsurance receivable | (113.2 | ) | (18.0 | ) |\n| Net reserves | $ | 307.6 | $ | 458.2 |\n| (Some amounts may not reconcile due to rounding.) |\n| Bermuda Re (1) | Everest Re (2) |\n| At December 31, | At December 31, |\n| (Dollars in millions) | 2014 | 2013 | 2014 | 2013 |\n| Regulatory targeted capital | $ | 2,050.0 | $ | 2,154.6 | $ | 1,209.6 | $ | 1,094.6 |\n| Actual capital | $ | 2,748.0 | $ | 2,712.2 | $ | 2,893.0 | $ | 2,814.3 |\n| Impact of Interest Rate Shift in Basis Points |\n| At September 30, 2015 |\n| -200 | -100 | 0 | 100 | 200 |\n| (Dollars in millions) |\n| Total Market/Fair Value | $ | 15,883.0 | $ | 15,507.1 | $ | 15,106.0 | $ | 14,677.4 | $ | 14,235.5 |\n| Market/Fair Value Change from Base (%) | 5.1 | % | 2.7 | % | 0.0 | % | -2.8 | % | -5.8 | % |\n| Change in Unrealized Appreciation |\n| After-tax from Base ($) | $ | 657.8 | $ | 340.0 | $ | - | $ | (364.4 | ) | $ | (740.2 | ) |\n| Impact of Percentage Change in Equity Fair/Market Values |\n| At September 30, 2015 |\n| (Dollars in millions) | -20% | -10% | 0% | 10% | 20% |\n| Fair/Market Value of the Equity Portfolio | $ | 1,176.2 | $ | 1,323.3 | $ | 1,470.3 | $ | 1,617.3 | $ | 1,764.4 |\n| After-tax Change in Fair/Market Value | $ | (201.7 | ) | $ | (100.9 | ) | $ | - | $ | 100.9 | $ | 201.7 |\n\nITEM 3.\nQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nMarket Risk Instruments. See \"Liquidity and Capital Resources - Market Sensitive Instruments\" in PART I – ITEM 2.\n57\nITEM 4.\nCONTROLS AND PROCEDURES\nAs of the end of the period covered by this report, our management carried out an evaluation, with the participation of the Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the \"Exchange Act\")). Based on their evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission's rules and forms. Our management, with the participation of the Chief Executive Officer and Chief Financial Officer, also conducted an evaluation of our internal control over financial reporting to determine whether any changes occurred during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Based on that evaluation, there has been no such change during the quarter covered by this report.\nPART II\n\nITEM 1.\nLEGAL PROCEEDINGS\nIn the ordinary course of business, the Company is involved in lawsuits, arbitrations and other formal and informal dispute resolution procedures, the outcomes of which will determine the Company's rights and obligations under insurance and reinsurance agreements. In some disputes, the Company seeks to enforce its rights under an agreement or to collect funds owing to it. In other matters, the Company is resisting attempts by others to collect funds or enforce alleged rights. These disputes arise from time to time and are ultimately resolved through both informal and formal means, including negotiated resolution, arbitration and litigation. In all such matters, the Company believes that its positions are legally and commercially reasonable. The Company considers the statuses of these proceedings when determining its reserves for unpaid loss and loss adjustment expenses.\nAside from litigation and arbitrations related to these insurance and reinsurance agreements, the Company is not a party to any other material litigation or arbitration.\n\nITEM 1A.\nRISK FACTORS\nNo material changes.\n58\nITEM 2.\nUNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nIssuer Purchases of Equity Securities.\n| Issuer Purchases of Equity Securities |\n| (a) | (b) | (c) | (d) |\n| Maximum Number (or |\n| Total Number of | Approximate Dollar |\n| Shares (or Units) | Value) of Shares (or |\n| Purchased as Part | Units) that May Yet |\n| Total Number of | of Publicly | Be Purchased Under |\n| Shares (or Units) | Average Price Paid | Announced Plans or | the Plans or |\n| Period | Purchased | per Share (or Unit) | Programs | Programs (1) |\n| July 1 - 31, 2015 | 1,756 | $ | 183.2850 | - | 5,631,185 |\n| August 1 - 31, 2015 | 514,629 | $ | 177.4608 | 514,629 | 5,116,556 |\n| September 1 - 30, 2015 | 626,078 | $ | 174.4833 | 622,844 | 4,493,712 |\n| Total | 1,142,463 | $ | - | 1,137,473 | 4,493,712 |\n\n(1) On September 21, 2004, the Company's board of directors approved an amended share repurchase program authorizing the Company and/or its subsidiary Holdings to purchase up to an aggregate of 5,000,000 of the Company's common shares through open market transactions, privately negotiated transactions or both. On July 21, 2008; February 24, 2010; February 22, 2012; May 15, 2013; and November 19, 2014, the Company's executive committee of the Board of Directors has approved subsequent amendments to the share repurchase program authorizing the Company and/or its subsidiary Holdings, to purchase up to a current aggregate of 30,000,000 of the Company's shares (recognizing that the number of shares authorized for repurchase has been reduced by those shares that have already been purchased) in open market transactions, privately negotiated transactions or both.\n\nITEM 3.\nDEFAULTS UPON SENIOR SECURITIES\nNone.\n\nITEM 4.\nMINE SAFETY DISCLOSURES\nNot applicable.\n\nITEM 5\n.\nOTHER INFORMATION\nNone.\n59\nITEM 6.\nEXHIBITS\n\n| Exhibit Index: |\n| Exhibit No. | Description |\n| 31.1 | Section 302 Certification of Dominic J. Addesso |\n| 31.2 | Section 302 Certification of Craig Howie |\n| 32.1 | Section 906 Certification of Dominic J. Addesso and Craig Howie |\n| 101.INS | XBRL Instance Document |\n| 101.SCH | XBRL Taxonomy Extension Schema |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase |\n| 101.LAB | XBRL Taxonomy Extension Labels Linkbase |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase |\n\n60\nEverest Re Group, Ltd.\nSignatures\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n| Everest Re Group, Ltd. |\n| (Registrant) |\n| /S/ CRAIG HOWIE |\n| Craig Howie |\n| Executive Vice President and |\n| Chief Financial Officer |\n| (Duly Authorized Officer and Principal Financial Officer) |\n\n\n</text>\n\nWhat is the percent change in the total outstanding amount of the Citibank Bilateral Letter of Credit Agreement from September 30, 2015 to December 31, 2014?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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doc-math
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"style": "rule",
"ground_truth": "Therefore, the answer is -15.72."
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docmath_20000_40000
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nITEM 1. BUSINESS\nOverview\nHambrecht Asia Acquisition Corp. (“we”, “us”, “our” or the “Company”) is a Cayman Islands blank check company formed on July 18, 2007 to complete a business combination with one or more operating businesses that have its or their primary operations in the PRC. Our efforts in identifying a prospective target business will not be limited to a particular industry. We intend to effect a business combination using cash from the proceeds of our initial public offering and the private placements of the sponsors’ warrants, our capital stock, debt or a combination of cash, stock and debt. On March 7, 2008, we completed a private placement of 1,550,000 warrants (“Founder Warrants”). On March 12, 2008, we consummated our initial public offering of 4,000,000 units. On March 31, 2008, the underwriters of our initial public offering exercised their over-allotment option for a total of an additional 239,300 units (over and above the 4,000,000 units sold in the initial public offering) for an aggregate offering of 4,239,300 units (together the “IPO”). Each unit consists of one share of common stock and one redeemable common stock purchase warrant, resulting in a total of 4,239,300 common shares (“IPO Shares”) and 4,239,300 warrants (“IPO Warrants”) which are publicly held. The units were sold at an offering price of $8.00 per unit and the Founder Warrants we sold at an offering price of $1.00 per warrant, generating total gross proceeds of $35,464,400. Broadband Capital Management LLC acted as lead underwriter.\nThe net proceeds from the IPO and private placement, after deducting certain offering expenses of approximately $2,784,873 (including underwriting discounts of approximately $2,374,008), were approximately $32,679,527. Approximately $33,527,396 (or approximately $7.91 per IPO Share) of the proceeds from the IPO and the private placement was placed in a trust account for our benefit, which includes $1,187,004 of the underwriter’s compensation which will be paid to them only in the event of a business combination. The remaining $339,135 was not placed in the trust account. We will not be able to access the amounts held in the trust account until we consummate a business combination, except for up to $700,000 (plus up to an additional $350,000 if approved by our shareholders in connection with the extension of the period in which we must complete our initial business combination to March 12, 2011) in interest earned on the funds in the trust account, which may be released from the trust to us to be used for working capital. As of June 30, 2009, there was approximately $33,799,000 held in the trust account (or approximately $7.92 per IPO Share), and approximtely $286,000 of interest eanred on the trust account balance had been released to us for working capital purposes.\nInvestment Opportunities in China\nOpportunities for market expansion have emerged for businesses with operations in China due to certain changes in the PRC’s political, economic and social policies as well as certain fundamental changes affecting the PRC and his neighboring countries. We believe that China represents both a favorable environment for making acquisitions and an attractive operating environment for a target business for several reasons, including:\n\n| § | prolonged economic expansion within China, including gross domestic product growth of approximately 16.5% on average over the last 25 years, including 17.7% in 2004, 15.0% in 2005 and 14.7% in 2006 (National Bureau of Statistics of China) (China Statistical Yearbook – 2007, http://www.stats.gov.cn/tjsj/ndsj/2007/indexeh.htm, viewed February 24, 2009); |\n\n\n| § | increased government focus within China on privatizing assets, improving foreign trade and encouraging business and economic activity; |\n\n\n| § | the recent entry of China into the World Trade Organization, the sole global international organization dealing with the rules of trade between nations, which may lead to a reduction on tariffs for industrial products, a reduction in trade restrictions and an increase in trading with the United States. |\n\nWe believe that these factors and others should enable us to acquire a target business with growth potential on favorable terms.\n3\nEffecting a Business Combination\nWe intend to utilize the cash proceeds of the IPO and the private placement, our capital securities, debt or a combination of these as the consideration to be paid in a business combination. While substantially all of the net proceeds of the IPO are allocated to completing a business combination, the proceeds are not otherwise designated for more specific purposes. If the business combination is paid for using equity or debt securities, we may apply the cash released to us from the trust account for general corporate purposes, including for maintenance or expansion of operations of the acquired business or businesses, the payment of principal or interest due on indebtedness incurred in consummating our initial business combination, to fund the purchase of other companies, or for working capital. We may engage in a business combination with a company that does not require significant additional capital but is seeking a public trading market for its shares and that wants to merge with an already public company to add the experience of the public company’s management team to its company and to avoid the risk that market conditions will not be favorable for an initial public offering at the time this offering is ready to be sold, despite the fact that merging with us would require similar disclosures and, potentially, a similar timeframe as an initial public offering. We may seek to effect a business combination with more than one target business, although our limited resources may serve as a practical limitation on our ability to do so.\nPrior to consummation of a business combination, we will seek to have all vendors, prospective target businesses or other entities that we may engage, which we refer to as potential contracted parties or a potential contracted party, execute agreements with us waiving any right, title, interest or claim of any kind in or to any monies held in the trust account for the benefit of our public shareholders. There is no assurance that we will be able to get waivers from our vendors and there is no assurance that such waivers will be enforceable by operation of law or that creditors would be prevented from bringing claims against the trust. In the event that a potential contracted party were to refuse to execute such a waiver, we will execute an agreement with that entity only if our management first determines that we would be unable to obtain, on a reasonable basis, substantially similar services or opportunities from another entity willing to execute such a waiver. Examples of instances where we may engage a third party that refused to execute a waiver would be the engagement of a third party consultant whose particular expertise or skills are believed by management to be superior to those of other consultants that would agree to execute a waiver or a situation where management does not believe it would be able to find a provider of required services willing to provide the waiver. If we are unable to complete a business combination and are forced to dissolve and liquidate, each of our pre-initial public offering shareholders other than Stephen N. Cannon, will, by agreement, be personally liable (each in an amount proportional to the number of shares owned as compared to both of them as a group, except that John Wang and Robert Eu will indemnify us for the portion of the indemnification obligation attributable to the portion of our shares owned by Stephen N. Cannon) to ensure that the proceeds in the trust account are not reduced by the claims of prospective target businesses, vendors or other entities that are owed money by us for services rendered or products sold to us. Under these circumstances, our board of directors would have a fiduciary obligation to our shareholders to bring a claim against each of our pre-initial public offering shareholders other than Stephen N. Cannon to enforce their liability obligation.\nSubject to the requirement that a target business or businesses have a fair market value of at least 80% of the balance in the trust account (excluding deferred underwriting discounts and commissions of $1,187,004 and taxes payable) at the time of our initial business combination, we have virtually unrestricted flexibility in identifying and selecting one or more prospective target businesses.\nWe focus on potential target businesses with valuations between $70 million and $150 million. We believe that our available working capital, together with the issuance of additional equity and/or the issuance of debt, would support the acquisition of such a target business. The mix of additional equity and/or debt would depend on many factors. The proposed funding for any such business combination would be disclosed in the proxy statement relating to the required shareholder approval.\nAfter completion of the IPO, we began contacting investment bankers, private equity firms and other business contacts in order to generate ideas about a suitable business combination. We also received unsolicited inquiries from several investment banking firms, private equity firms and other business intermediaries. We informed these contacts that we were seeking an operating business for our initial business combination. We have not retained an investment banking firm or fairness or valuation advisor to conduct a formal search for a business combination. Criteria for suitability included our management’s assessment of the competitive strengths and weaknesses of the potential business targets, the strength of the management team, and the quality of the assets to be acquired.\n4\nWe may pay fees or compensation to third parties for their efforts in introducing us to potential target businesses. We may seek to engage someone to assist in finding a potential target business if our management feels that they need assistance to find a suitable target business. If a finder approaches us on an unsolicited basis, our management would decide whether to work with that finder (and pay a finders’ fee) depending on the potential target business such finder proposes. Such payments are typically, although not always, calculated as a percentage of the dollar value of the transaction. We have not anticipated use of a particular percentage fee, but instead will seek to negotiate the smallest reasonable percentage fee consistent with the attractiveness of the opportunity and the alternatives, if any, that are then available to us. We may make such payments to entities we engage for this purpose or entities that approach us on an unsolicited basis. Payment of finders’ fees is customarily tied to consummation of a transaction and certainly would be tied to a completed transaction in the case of an unsolicited proposal. Although it is possible that we may pay finders’ fees in the case of an uncompleted transaction, we consider this possibility to be extremely remote. In no event will we pay any of our directors or officers or any entity with which they are affiliated any finder’s fee or other compensation for services rendered to us prior to or in connection with the consummation of a business combination. In addition, none of our officers or directors will receive any finder’s fee, consulting fees or any similar fees from any person or entity in connection with any business combination involving us. Following such business combination, however, our officers or directors may receive compensation or fees including compensation approved by the board of directors for customary director’s fees for our directors that remain following such business combination. Our directors have advised us that they will not take an offer regarding their compensation or fees following a business combination into consideration when determining which target businesses to pursue.\nWe anticipate structuring a business combination to acquire 100% of the equity interests or assets of the target business. We may, however, structure a business combination to acquire less than 100% of such interests or assets of the target business but will not acquire less than a controlling interest (which would be greater than 50% of the voting securities of the target business). If we acquire only a controlling interest in a target business or businesses, the portion of such business that we acquire must have a fair market value equal to at least 80% of the amount in the trust account, (excluding deferred underwriting discounts and commissions and taxes payable), as described above. If we determine to simultaneously acquire several businesses and such businesses are owned by different sellers, we will need for each of such sellers to agree that our purchase of his business is contingent on the simultaneous closings of the other acquisitions, which may make it more difficult for us, and delay our ability, to complete the business combination. With multiple acquisitions, we could also face additional risks, including additional burdens and costs with respect to possible multiple negotiations and due diligence investigations (if there are multiple sellers) and the additional risks associated with the subsequent integration of the operations and services or products of the acquired companies in a single operating business.\nIn recent months, there has been severe volatility and overall significant declines in the international capital markets and a freezing of the international credit markets that together have led to severe constraints in private flows of capital and an acutely negative impact on the operating results of companies in a wide range of industries and geographic sectors. Declining valuations of potential target businesses and uncertainty regarding the future may make it more difficult for us to reach agreement on a business combination that satisfies our requirements and the lack of available credit sources may adversely impact our ability to structure a transaction in the most advantageous manner. In addition, certain of our shareholders may experience pressure to vote against any business combination that we may propose in order to liquidate their investment and free up their capital, without regard to the merits of any such transaction.\n5\nGovernment regulations\nGovernment regulations relating to foreign exchange controls\nThe principal regulation governing foreign exchange in China is the Foreign Currency Administration Rules (IPPS), as amended. Under these rules, the Renminbi, China’s currency, is freely convertible for trade and service related foreign exchange transactions (such as normal purchases and sales of goods and services from providers in foreign countries), but not for direct investment, loan or investment in securities outside of China without the prior approval of the State Administration for Foreign Exchange (“SAFE”) of China. Foreign investment enterprises (“FIEs”) are required to apply to the SAFE for “Foreign Exchange Registration Certificates for FIEs.” Following a business combination, involving a change of equity ownership of a PRC operating entity or through contractual arrangements with a PRC operating entity our subsidiary will likely be an FIE as a result of our ownership structure. With such registration certificates, which need to be renewed annually, FIEs are allowed to open foreign currency accounts including a “basic account” and “capital account.” Currency translation within the scope of the “basic account,” such as remittance of foreign currencies for payment of dividends, can be effected without requiring the approval of the SAFE. However, conversion of currency in the “capital account,” including capital items such as direct investment, loans and securities, still require approval of the SAFE. This prior approval may delay or impair our ability to operate following a business combination. On November 21, 2005, the SAFE issued Circular No. 75 on “Relevant Issues Concerning Foreign Exchange Control on Domestic Residents’ Corporate Financing and Roundtrip Investment Through Offshore Special Purpose Vehicles.” Circular No. 75 confirms that the use of offshore special purpose vehicles as holding companies for PRC investments are permitted as long as proper foreign exchange registrations are made with the SAFE.\nGovernment regulations relating to taxation\nPrior to January 1, 2008, the standard enterprise income tax rate was 33%, which consisted of a 30% national income tax and a 3% local surcharge, for a company’s domestic and overseas incomes.\nA new tax law, the PRC Enterprise Income Tax Law (“New EIT Law”), took effect on January 1, 2008. Under the new tax law, companies are subject to a uniform tax rate of 25%. The New EIT Law provides a five-year transition period starting from its effective date for those enterprises which were established before the promulgation date of the new tax law and which were entitled to a preferential lower tax rate under the then-effective tax laws or regulations. The New EIT Law significantly curtails tax incentives granted to foreign-invested enterprises under the previous tax law. The New EIT Law, however, (i) reduces the top rate of EIT from 33% to 25%, (ii) permits companies to continue to enjoy their existing tax incentives, subject to certain transitional phase-out rules, and (iii) introduces new tax incentives, subject to various qualification criteria. The New EIT Law and its implementing rules permit certain “high and new technology enterprises” to enjoy a reduced 15% EIT rate. Under the phase-out rules, enterprises established before the promulgation date of the New EIT Law and which were granted preferential EIT treatment under the then effective tax laws or regulations may continue to enjoy their preferential tax treatments until their expiration and will gradually transition to the uniform 25% EIT rate over a five-year transition period.\nAdditionally, under the New EIT Law, an income tax rate for dividends payable to non-PRC investors and derived from sources within the PRC may be increased to 20%. It is currently unclear in what circumstances a source will be considered as located within the PRC.\nThe new tax law provides only a framework of the enterprise tax provisions, leaving many details on the definitions of numerous terms as well as the interpretation and specific applications of various provisions unclear and unspecified.\nCompetition\nIn identifying, evaluating and selecting a target business for a business combination, we may encounter intense competition from other entities having a business objective similar to ours including other blank check companies, private equity groups and leveraged buyout funds, and operating businesses seeking acquisitions. Many of these entities are well established and have extensive experience identifying and effecting business combinations directly or through affiliates. Moreover, many of these competitors possess greater financial, technical, human and other resources than us. While we believe there are numerous potential target businesses with which we could combine, our ability to acquire larger target businesses will be limited by our available financial resources. This inherent limitation gives others an advantage in pursuing the acquisition of a target business. Furthermore:\n\n| § | our obligation to seek shareholder approval of our initial business combination or obtain necessary financial information may delay the consummation of a transaction; |\n\n6\n| § | our obligation to redeem for cash ordinary shares held by our public shareholders who vote against the business combination and exercise their redemption rights may reduce the resources available to us for a business combination; |\n\n\n| § | our outstanding warrants, and the future dilution they potentially represent, may not be viewed favorably by certain target businesses; and |\n\n\n| § | the requirement to acquire an operating business that has a fair market value equal to at least 80% of the balance of the trust account at the time of the acquisition (excluding deferred underwriting discounts and commissions of $1,187,004 and taxes payable) could require us to acquire the assets of several operating businesses at the same time, all of which sales would be contingent on the closings of the other sales, which could make it more difficult to consummate the business combination. |\n\nAny of these factors may place us at a competitive disadvantage in successfully negotiating a business combination.\nEmployees\nWe currently have three officers. These individuals are not obligated to devote any specific number of hours to our business and intend to devote only as much time as they deem necessary to our business. We intend to hire employees and/or consultants, possibly including certain full time employees and/or consultants, in order to assist us in the search, due diligence for and consummation of a business combination.\nEnforcement of Civil Liabilities\nWe are registered under the laws of the Cayman Islands by way of continuation as an exempted company with limited liability. We are registered in the Cayman Islands because of certain benefits associated with being a Cayman Islands corporation, such as political and economic stability, an effective judicial system, a favorable tax system, the absence of foreign exchange control or currency restrictions and the availability of professional and support services. However, the Cayman Islands has a less developed body of securities laws as compared to the United States and provides protections for investors to a significantly lesser extent. In addition, Cayman Islands companies do not have standing to sue before the federal courts of the United States.\nSubstantially all of our assets are located outside the United States. In addition, a majority of our directors and officers are nationals or residents of jurisdictions other than the United States and all or a substantial portion of their assets are located outside the United States. As a result, it may be difficult for investors to effect service of process within the United States upon us or these persons, or to enforce against us or them judgments obtained in United States courts, including judgments predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States. It may also be difficult for you to enforce in U.S. courts judgments obtained in U.S. courts based on the civil liability provisions of the U.S. federal securities laws against us, our officers and directors.\nWe have not appointed any agent to receive service of process with respect to any action brought against us in the United States District Court for the Southern District of New York under the federal securities laws of the United States or of any state in the United States or any action brought against us in the Supreme Court of the State of New York in the County of New York under the securities laws of the State of New York.\nWe believe that there is uncertainty as to whether the courts of the Cayman Islands or the PRC would, respectively, (1) recognize or enforce judgments of United States courts obtained against us or our directors or officers predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States, or (2) entertain original actions brought in the Cayman Islands or the PRC against us or our directors or officers predicated upon the securities laws of the United States or any state in the United States.\n\nITEM 1A. RISK FACTORS\nAs a smaller reporting company, we are not required to include this information in our transition report on Form 10-K.\n7\nITEM 1B. UNRESOLVED STAFF COMMENTS\nAs a smaller reporting company, we are not required to include this information in our transition report on Form 10-K.\n\nITEM 2. PROPERTIES\nWe currently maintain our executive offices at 13/F Tower 2, New World Tower, 18 Queens Road Central, Hong Kong. The cost for this space is included in the $7,500 per-month fee paid to Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, for office space, administrative services and secretarial support. We believe, based on rents and fees for similar services in Hong Kong, that the fees that will be charged by Hambrecht Eu Capital Management LLC is at least as favorable as we could have obtained from unaffiliated persons.\n\nITEM 3. LEGAL PROCEEDINGS\nThere is no litigation currently pending or threatened against us or any of our directors in their capacity as such.\n\nITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS\nNo matters were submitted to a vote of our shareholders during the quarter ended June 30, 2009.\n8\nPART II\n\nITEM 5. MARKET FOR COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.\nMarket Price Information\nThe shares of our common stock, warrants and units are traded on the OTC Bulletin Board, or OTCBB, under the symbols “HMAQF,” “HMAWF” and “HMAUF,” respectively. Each unit consists of one ordinary share and one warrant. Each warrant entitles the holder to purchase one ordinary share at a price of $5.00 commencing on the later of our consummation of a business combination or one year from the date of the IPO prospectus, provided in each case that there is an effective registration statement covering the ordinary shares underlying the warrants in effect. The warrants will expire five years from the date of the IPO, unless earlier redeemed. Our common stock and warrants commenced to trade separately from April 9, 2008.\nThe following table sets forth, for the calendar quarters indicated, the quarterly high and low bid information prices for our common stock, warrants and units as reported on the OTCBB, such over the counter market quotation reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.\n\n| Units | Ordinary Shares | Warrants |\n| High | Low | High | Low | High | Low |\n| Third Quarter of 2009 | $ | 7.65 | $ | 7.52 | $ | 7.98 | $ | 7.58 | $ | 0.16 | $ | 0.11 |\n| Second Quarter of 2009 | $ | 7.25 | $ | 7.25 | $ | 7.65 | $ | 7.35 | $ | 0.55 | $ | 0.05 |\n| First Quarter of 2009 | $ | 7.90 | $ | 7.00 | $ | 7.49 | $ | 7.10 | $ | 0.20 | $ | 0.05 |\n| Fourth Quarter of 2008 | $ | 7.15 | $ | 6.50 | $ | 7.00 | $ | 6.21 | $ | 0.42 | $ | 0.13 |\n| Third Quarter of 2008 | $ | 7.90 | $ | 7.60 | $ | 7.37 | $ | 6.85 | $ | 0.73 | $ | 0.50 |\n| Second Quarter of 2008 | $ | 7.90 | $ | 7.60 | $ | 7.16 | $ | 6.95 | $ | 0.85 | $ | 0.60 |\n| First Quarter of 2008 | $ | 8.15 | $ | 7.85 | - | - | - | - |\n\nNumber of Holders of Common Stock.\nThe number of holders of record of our Common Stock on January 21, 2010 was 10, which does not include beneficial owners of our securities.\nDividends.\nThere were no cash dividends or other cash distributions made by us during the fiscal year ended June 30, 2009. Future dividend policy will be determined by our Board of Directors based on our earnings, financial condition, capital requirements and other then existing conditions. It is anticipated that cash dividends will not be paid to the holders of our common stock in the foreseeable future.\n9\nRecent Sales of Unregistered Securities.\nOn July 18, 2007, John Wang, Robert J. Eu and Stephen N. Cannon purchased an aggregate of 1,150,000 of our ordinary shares (which includs 90,174 ordinary shares that were subsequently redeemed because the underwriters did not fully exercise their over-allotment option) for an aggregate purchase price of $25,000. Mr. Cannon subsequently transferred all of the shares he purchased to the Cannon Family Irrevocable Trust, of which Mr. Cannon is the sole trustee. Such shares were issued in connection with our organization pursuant to the exemption from registration contained in Section 4(2) of the Securities Act as they were sold in transactions not involving a public offering to a limited number of sophisticated, wealthy individuals. No underwriting commissions or offering discounts were paid with respect to such sales.\nOn February 21, 2008, John Wang, Robert Eu and the Cannon Family Irrevocable Trust transferred an aggregate of 463,334 shares to W.R. Hambrecht + Co., LLC, Shea Ventures LLC, Marbella Capital Partners Ltd., AEX Enterprises Limited and the Hambrecht 1980 Revocable Trust, each of which entities is an accredited investor for an aggregate purchase price of $10,193.35 or $0.022 per share. All such transfers were exempt from registration pursuant to Sections 4(1) and 4(2) of the Securities Act, due to the limited number of individuals involved, their status as accredited investors and transfer restrictions and legends on the share certificates.\nOn March 7, 2008, AEX Enterprises Limited, W.R. Hambrecht + Co., LLC and the Hambrecht 1980 Revocable Trust, companies controlled by Elizabeth B. Hambrecht, wife of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and William R. Hambrecht, Mr. Eu’s father-in-law, Shea Ventures LLC, a company controlled by Edmund H. Shea Jr. and Marbella Capital Partners Ltd., a company controlled by John Wang, our Chief Executive Officer, agreed to invest an aggregate of $1,550,000 in us in the form of private placement warrants to purchase 1,550,000 ordinary shares at a price of $1.00 per warrant. Elizabeth B. Hambrecht owns approximately 25% and William R. Hambrecht controls (through a trust of which he is the trustee) approximately 38% of the voting shares of AEX Enterprises Limited. William Hambrecht is a controlling person of the voting shares of W.R. Hambrecht + Co., LLC and is the trustee of the Hambrecht 1980 Revocable Trust. The proceeds of the sale of the warrants were placed in the trust account established for our benefit in connection with our IPO.\nOn March 31, 2008, following the partial exercise of the over-allotment option by the underwriters of the IPO, we cancelled an aggregate of 90,174 ordinary shares held by Robert J. Eu, Cannon Family Irrevocable Trust and WR Hambrecht + Co., LLC.\nOn December 21, 2008, AEX Enterprises Limited transferred an aggregate of 441,666 warrants to AEX Capital, LLC, for no consideration. Such transfer was exempt from registration pursuant to Sections 4(1) and 4(2) of the Securities Act, due to the limited number of individuals involved, their status as accredited investors and transfer restrictions and legends on the share certificates.\nIn each of the foregoing sales of securities the purchasers were our officers and directors or affiliates of our officers and directors and therefore had access to all relevant information about us when choosing to invest in our securities. As of January 21, 2010, these securities were held by the persons or entities as set forth in the following table:\n| Name | Ordinary Shares | Warrants |\n| John Wang | 230,000 | 0 |\n| W.R. Hambrecht + Co., LLC(1) | 178,275 | 25,000 |\n| Cannon Family Irrevocable Trust (2) | 173,275 | 0 |\n| Robert J. Eu | 173,275 | 0 |\n| AEX Enterprises Limited(3) | 88,333 | 0 |\n| Hambrecht 1980 Revocable Trust(4) | 88,333 | 441,667 |\n| Shea Ventures LLC(5) | 88,333 | 441,667 |\n| Marbella Capital Partners Ltd.(6) | 40,000 | 200,000 |\n| AEX Capital, LLC(7) | 0 | 441,666 |\n| Total: | 1,059,824 | 1,550,000 |\n\n10\n\n| (1) | William R. Hambrecht is the controlling person of W.R. Hambrecht + Co., LLC. |\n\n| (2) | Mr. Cannon is the sole Trustee of Cannon Family Irrevocable Trust. |\n\n| (3) | Elizabeth B. Hambrecht, Robert Eu’s wife, and William R. Hambrecht control AEX Enterprises Limited. |\n\n| (4) | William R. Hambrecht is the trustee of the Hambrecht 1980 Revocable Trust. |\n\n| (5) | Edmund H. Shea Jr. is the controlling person of Shea Ventures LLC. |\n\n| (6) | John Wang is the controlling person of Marbella Capital Partners Ltd. |\n\n| (7) | Elizabeth B. Hambrecht, Robert Eu’s wife, and Robert J. Eu control AEX Capital, LLC. |\n\nRepurchases of Equity Securities.\nNone.\nUse of Proceeds\nOn March 7, 2008, we completed a private placement of 1,550,000 warrants. On March 12, 2008, we consummated our initial public offering of 4,000,000 units. On March 31, 2008, the underwriters of our initial public offering exercised their over-allotment option for a total of an additional 239,300 units (over and above the 4,000,000 units sold in the initial public offering) for an aggregate offering of 4,239,300 units. Each unit consists of one share of common stock and one redeemable common stock purchase warrant. Each warrant entitles the holder to purchase from us one share of our common stock at an exercise price of $5.00. The units were sold at an offering price of $8.00 per unit and the warrants we sold at an offering price of $1.00 per warrant, generating total gross proceeds of $35,464,400. Broadband Capital Management LLC acted as lead underwriter. The securities sold in our initial public offering were registered under the Securities Act of 1933 on a registration statement on Form S-1 (No. 333-146147). The Securities and Exchange Commission declared the registration statement effective on March 7, 2008.\nWe incurred a total of $2,374,008 in underwriting discounts and commissions, of which $1,187,004 has been placed in the trust account. Such portion of the underwriter’s compensation will only be paid to the underwriters in the event that we consummate a business combination. The total expenses in connection with the sale of our warrants in the private placement and the initial public offering were $2,784,873.\nAfter deducting the underwriting discounts and commissions and the offering expenses, the total net proceeds to us from the private placement and the initial public offering were approximately $32,679,527. Approximately $33,527,396 (or approximately $7.91 per unit sold in our initial public offering) of the proceeds from the initial public offering and the private placement was placed in a Trust Account for our benefit and the remaining proceeds are available to be used to provide for business, legal and accounting due diligence on prospective business combinations and continuing general and administrative expenses. The Trust Account contains $1,187,004 of the underwriter’s compensation which will be paid to them only in the event of a business combination. The amounts held in the trust account may only be used by us upon the consummation of a business combination, except that we may use up to $700,000 (or $1,050,000 if approved by our shareholders) of the interest earned on the trust account to fund our working capital prior to a business combination. As of June 30, 2009, there was $ 33,838,155 held in the trust account, which includes deferred underwriting fees of $1,187,004. Through June 30, 2009, approximately $286,000 of interest earned on the trust account balance has been released to us for working capital purpose.\n\nITEM 6. SELECTED FINANCIAL DATA\nAs a smaller reporting company, we are not required to include this information in our transition report on Form 10-K.\n11\nITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nThe following discussion should be read in conjunction with the financial statements and related notes contained herein and the information included in our other filings with the SEC. This discussion includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements in this Transition Report on Form 10-K other than statements of historical fact are forward-looking statements. These forward-looking statements involve known and unknown risks and uncertainties. Our actual results may differ materially from those projected or assumed in such forward-looking statements. Among the factors that could cause actual results to differ materially are our being a development stage company with no operating history, our dependence on key personnel some of whom may join us following a business combination, our personnel allocating their time to other businesses and potentially having conflicts of interest with our business, our potentially being unable to obtain additional financing to complete a business combination and the ownership of our securities being concentrated. All forward-looking statements included in this document are made as of the date of this report, based on information available to us as of such date. We assume no obligation to update any forward-looking statement.\nOverview\nWe are a blank check company formed under the laws of the Cayman Islands on July 18, 2007. We were formed to acquire one or more operating businesses through a merger, stock exchange, asset acquisition or similar business combination or control through contractual arrangements having its primary operations in the People’s Republic of China, or PRC. We will not seek to acquire a business with its primary operations outside of the PRC.\nThe company has entered into a letter of intent with a company for a business combination. The target is a company with its principal business operations in the People’s Republic of China. Pursuant to the Company’s Amended and Restated Memorandum and Articles of Association, the execution of the letter of intent affords the Company a six-month extension for completion of a business combination, until March 12, 2010 However if we anticipate that we will not be able to consummate a business combination by March 12, 2010, we may seek shareholder approval to extend the period of time to consummate a business combination until March 12, 2011. In order to extend the period of March 12, 2011, (i) public shareholders must approve the extension and (ii) public shareholders owning no more than one share less than 30% of the shares sold in this offering may have exercised their redemption rights.\nResults of Operations for the Six Month Transition Period Ended June 30, 2009\nWe incurred a net loss of $87,677 for the six month period ended June 30, 2009 due to both a decrease in the interest earned on the Trust Account which did not exceed our expenses for the period, and an increase in expenses related to professional services. Until we enter into a business combination, we will not have any operating revenues.\nOverall, for the six month period ended June 30, 2009, we incurred $25,002 of insurance expense from the amortization of our pre-paid D&O insurance policy, $45,000 of rent expense and other operating costs of $114,868.\nFor the six months ended June 30, 2009, our trust account earned interest of $97,193 and our funds outside of the trust account did not earn interest income.\nResults of Operations for the Six Month Period Ended June 30, 2008\nWe had a net gain of $11,449 for the six month period ended June 30, 2008.\nOverall for six month period ended June 30, 2008, we incurred $16,668 of insurance expense from the amortization of our pre-paid D&O insurance policy, $45,000 of rent expense and other operating costs of $95,015.\n12\nFor the six months ended June 30, 2008, our trust account earned interest of $173,106.\nResults of Operations for the Year Ended December 31, 2008\nWe reported net income of $236,505 for the year ended December 31, 2008 due to interest earned on the trust account. Until we enter into a business combination, we will not have any operating revenues.\nFor the year ended December 31, 2008, we incurred $37,503 of insurance expense from the amortization of our pre-paid D&O insurance policy, $97,500 of rent, administrative services and secretary support expense and other operating costs of $132,384.\nFor the year ended December 31, 2008, our trust account earned gross interest of $510,361. $239,110 of this interest was withdrawn from the trust account to fund working capital and $271,251 remained in the trust account.\nResults of Operations for the Year Ended December 31, 2007\nWe reported a net loss of $21,736 for the year ended December 31, 2007 due to start-up expenses. Until we enter into a business combination, we will not have any operating revenues.\nFor the year ended December 31, 2007, we incurred $15,000 of rent as well as formation and administrative costs of $6,736.\nFor the year ended December 31, 2007, we did not earn any interest from our trust account.\nLiquidity and Capital Resources\nOn March 7, 2008, we completed a private placement of 1,550,000 warrants to AEX Enterprises Limited, a company controlled by Elizabeth B. Hambrecht, wife of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and William R. Hambrecht, Robert Eu’s father-in-law, W.R. Hambrecht + Co., LLC and the Hambrecht 1980 Revocable Trust, each an entity controlled by William Hambrecht, Shea Ventures LLC, a company controlled by Edmund H. Shea Jr., and Marbella Capital Partners Ltd., a company owned by John Wang, our Chief Executive Officer, and received net proceeds of $1,550,000. On March 12, 2008, we consummated our initial public offering of 4,000,000 units. On March 31, 2008, the underwriters of our initial public offering exercised a portion of their over-allotment option, for a total of an additional 239,300 units (over and above the 4,000,000 units sold in the initial public offering) for an aggregate offering of 4,239,300 units (collectively the “IPO”). Each unit in the public offering consisted of one share of common stock and one redeemable common stock purchase warrant. Each warrant entitles the holder to purchase from us one share of our common stock at an exercise price of $5.00. Our common stock and warrants started trading separately as of April 9, 2008.\nThe net proceeds from the sale of our warrants and units, after deducting certain offering expenses of approximately $2,784,873, including underwriting discounts of approximately $2,374,008, were approximately $32,679,527. Approximately $33,527,396 of the proceeds from the IPO and the private placement was placed in a trust account for our benefit, which includes $1,187,004 of the underwriter’s compensation which will be paid to them only in the event of a business combination. The remaining $339,135 was not held in the trust account. Except for up to $700,000 (plus up to and additional $350,000 if approved by our shareholders in connection with the extension of the period in which we must complete our initial business combination to March 12, 2011) in interest that is earned on the funds contained in the trust account that may be released to us to be used as working capital, we will not be able to access the amounts held in the trust until we consummate a business combination. The amounts held outside of the trust account are available to be used by us to provide for business, legal and accounting due diligence on prospective acquisitions and continuing general and administrative expenses. From July 18, 2007 (the date of our inception) through June 30, 2009, we had operating expenses of $473,993. From January 1, 2009 through June 30, 2009, we had operating expenses of $184,870. The net proceeds deposited into the trust fund remain on deposit in the trust account earning interest. Other than $700,000 (or $1,050,000 if approved by our shareholders) in interest which we may use to fund working capital, the amounts held in the trust account may only be used by us upon the consummation of a business combination. As of December 31, 2008, we had 33,798,651 held in the trust account and as of June 30, 2009 there was $33,838,155 held in the trust account, which includes deferred underwriting fees of $1,187,004. Additionally, as of June 30, 2009, we had $30,271 outside the trust account to fund our working capital requirements. Through June 30, 2009, approximately $286,000 of interest earned on the trust account balance has been released to us for working capital purpose.\n13\nWe will use substantially all of the net proceeds of our IPO to acquire one or more target businesses, and will use a portion of the interest earned on the trust account together with the funds not held in trust to identify and evaluate prospective target businesses, to select one or more target businesses, and to structure, negotiate and consummate the business combination. We do not believe we will need to raise additional funds following our IPO in order to meet the expenditures required for operating our business. However, we may need to raise additional funds through a private offering of debt or equity securities if such funds were required to consummate a business combination. Such debt securities may include a working capital revolving debt facility or a longer term debt facility. Subject to compliance with applicable securities laws, we would only consummate such financing simultaneously with the consummation of a business combination.\nCommencing on November 15, 2007, we began incurring a fee of approximately $7,500 per month for office space.\nOff-Balance Sheet Arrangements\nWe have never entered into any off-balance sheet financing arrangements and have never established any special purpose entities. We have not guaranteed any debt or commitments of other entities or entered into any options on non-financial assets.\nContractual Obligations\nWe do not have any long term debt, capital lease obligations, operating lease obligations, purchase obligations or other long term liabilities, except for our agreement with Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, for office space, administrative services and secretarial support pursuant to which we pay a monthly fee of $7,500.\n\nITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nMarket risk is the sensitivity of income to changes in interest rates, foreign exchanges, commodity prices, equity prices, and other market-driven rates or prices. We are not presently engaged in and, if a suitable business target is not identified by us prior to the prescribed liquidation date of the trust fund, we may not engage in, any substantive commercial business. Accordingly, we are not and, until such time as we consummate a business combination, we will not be, exposed to risks associated with foreign exchange rates, commodity prices, equity prices or other market-driven rates or prices. The net proceeds of our IPO held in the trust fund have been invested only in money market funds meeting certain conditions under Rule 2a-7 promulgated under the Investment Company Act of 1940. Given our limited risk in our exposure to money market funds, we do not view the interest rate risk to be significant.\n\nITEM 8. FINANCIAL AND SUPPLEMENTAL DATA\nFinancial statements are attached hereto beginning with page F-1\n\nITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE\nNone.\n14\nITEM 9A(T). CONTROLS AND PROCEDURES\nDisclosure Controls and Procedures\nAn evaluation of the effectiveness of our disclosure controls and procedures as of June 30, 2009 was made under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective as of the end of the period covered by this report.\nDisclosure Controls and Procedures are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. During the most recently completed fiscal quarter, there has been no significant change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\nManagement’s Report on Internal Control Over Financial Reporting\nOur internal control over financial reporting is a process designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer and effected by our board of directors to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of our financial statements for external reporting purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that in reasonable detail accurately reflect the transactions and dispositions of our assets; provide reasonable assurance that transactions are recorded as necessary to permit preparation of our financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with the authorization of our board of directors and management; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements.\nUnder the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation under the criteria established in Internal Control – Integrated Framework, our management concluded that our internal control over financial reporting was effective as of June 30, 2009.\nThis Transition Report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit us to provide only management’s report in this Transition Report.\n\nITEM 9B. OTHER INFORMATION\nNone.\n15\nPART III\n\nITEM 10. DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE\nDirectors and Executive Officer\nOur current directors and executive officers are as follows:\n| Name | Age | Position |\n| John Wang | 39 | Chief Executive Officer, President and Director |\n| Robert J. Eu | 46 | Chairman of the Board, |\n| Hao Wu | 35 | Chief Financial Officer, Secretary and Director |\n| Hong Xiang Liu | 44 | Director |\n\nJohn Wang has been our Chief Executive Officer, President and a director since our inception. Mr. Wang has over twelve years of investment banking and consulting experience. Since November 2004, Mr. Wang has been the Managing Director of Marbella Capital Partners Ltd., a financial advisory firm based in Shanghai which he founded. From January 2000 to November 2004, he helped develop and establish the U.S. operations of SBI USA as Executive Vice President of SBI E2-Capital (HK) Limited and was a Managing Director and Chief Operating Officer of SBI E2-Capital (USA) Ltd. Prior to SBI, from 1997 to 1999, he managed Accenture Consulting’s Greater China communications, media, and high tech strategy practice, where he acted as consultant to China Mobile’s IPO in 1997, among other high profile projects. From 1994 to 1997 he was also the lead telecom analyst covering Greater China and Southeast Asia for Pyramid Research, a Cambridge Massachusetts based emerging market telecom research firm that is part of the Economist Intelligence Unit. Last year, he advised on four late-stage deals that closed, of which one has already gone public in Hong Kong and another, Yingli Green Energy (NYSE: YGE), completed its IPO and listing on the New York Stock Exchange on June 8, 2007. Mr. Wang currently sits on the Board of Hong Kong Stock Exchange listed Wuyi International Pharmaceutical Company Limited (HKSE: 1889). Mr. Wang holds a Bachelor of Arts degree in international relations from Tufts University and is a graduate of the Washington International Studies Program at St. Catherine’s College at Oxford University. He has an M.A.L.D. in international law and business from The Fletcher School of Law and Diplomacy and is a graduate of the Private Equity course at Harvard Business School.\nRobert J. Eu has been our Chairman of the Board, Secretary and director since our inception. He has been our Chief Financial Officer since February 21, 2008. Since 1998, Mr. Eu has served as a Managing Director for W.R. Hambrecht + Co., LLC (“WR Hambrecht + Co”) a San Francisco-based investment bank. Mr. Eu founded WR Hambrecht + Co’s investment banking practice in Asia in 2003. Prior to WR Hambrecht + Co, Mr. Eu was a Managing Director of H&Q Asia Pacific from 1992 until 1998, an affiliate of Hambrecht & Quist, where he co-founded its Hong Kong office and China investment practice. In 1996, Mr. Eu led the buy-out and de-listing of Eu Yang Sang (Hong Kong) Limited from the Hong Kong stock exchange and the company is now listed on the Singapore Stock Exchange (SGX:EYSI). Mr. Eu has been a director of Eu Yang Sang since 1997. In 1992, prior to working at H&Q Asia Pacific, Mr. Eu was the Business Development Manager for Eu Yang Sang (Hong Kong) Limited, a manufacturer and retailer of Traditional Chinese medicine. Mr. Eu has been a director and the Chairman of AEX Enterprises Limited (“AEX Enterprises”) since 2003. AEX Enterprises’ primary operating subsidiary is Boom Securities (H.K.) Limited (“Boom Securities”). Boom Securities is a licensed broker / dealer regulated by the Securities and Futures Commission (SFC) of Hong Kong and headquartered in Hong Kong. Mr. Eu worked for Citibank from 1987 until 1992 in the Private Banking Group in Hong Kong. Mr. Eu is a graduate of Northwestern University with a B.A. in History.\nHao Wu has been our Chief Financial Officer, Secretary and Director since September 4, 2009. He has been the Executive Vice President of Marbella Capital Partners, a boutique California/Shanghai based investment and advisory company that focuses on investing on Chinese deals in the growth and late stage, since January 2008. Prior to that, he was the finance director in B&Q Holding Co. Ltd., a leading home improvement retail company in China, from July 2006 until December 2007. Prior to B&Q, Mr. Wu worked for Fortune Tech group Co. Ltd. as the finance director from March 2004 until June 2006. He started his career in Unilever China as a management trainee. David holds a Bachelor of Science degree from the management school of Shanghai Jiao Tong University. Mr. Wu is employed by Marbella Capital Partners, which is controlled by John Wang, our Chief Executive Officer and a Director. Mr. Wu is not a party to any transactions listed in Item 404(a) of Regulation S\n16\nHong Xiang Liu has been one of our directors since September 4, 2009. He has been the director of Jiangsu Performing Art & Culture Enterprises Inc. Ltd., a real estate developer in China, Jiangsu province, since July 2007. Prior to this, he was the Chief Executive Officer and Executive Director of Tongda Energy Limited, a piped gas provider & operator in 11 cities across China, from October 2002 until July 2007. From 1988 to September 2002, Mr. Liu held various positions in China Construction Bank. His last appointment was as Vice General manager of the Enterprise Banking Department, China Construction Bank, Beijing Branch. Mr. Liu received his Bachelor of Engineering (Infrastructure Management) from Tianjin University and was accredited as a senior economist by China Construction Bank in 1998. Mr. Liu is not a party to any transactions listed in Item 404(a) of Regulation S-K.\nBoard Committees\nThe board of directors is currently composed of four individuals and we do not have any committees, and, therefore, the entire board of directors performs the functions of the Audit Committee. It is intended that the board of directors will establish an Audit Committee upon the consummation of a business combination. The board of directors will take all reasonable actions to ensure that one of the members of the Audit Committee will be an “audit committee financial expert,” as such term is defined in the rules of the Securities and Exchange Commission. We are currently listed on the OTC Bulletin Board and are therefore not required to have a nominating committee or a compensation committee. We will evaluate establishing such committees in the future. There have been no changes to the procedures by which stockholders may recommend nominees to our board of directors.\nCode of Ethics\nWe currently do not have a formal code of ethics. Upon consummation of a business combination, we intend to adopt a code of ethics that applies to our principal executive officer, principal financial officer, principal accounting officer or controller or persons performing similar functions.\nSection 16(a) Beneficial Ownership Reporting Compliance\nSection 16(a) of the Securities Exchange Act requires our directors, executive officers and persons who own more than 10% of our common stock to file reports of ownership and changes in ownership of our common stock with the Securities and Exchange Commission. Directors, executive officers and persons who own more than 10% of our common stock are required by Securities and Exchange Commission regulations to furnish to us copies of all Section 16(a) forms they file.\nBased solely on our review of such forms furnished to us and written representations from certain reporting persons, we believe that all filing requirements applicable to our executive officers, directors and greater than 10% beneficial owners were complied with during 2009.\nLegal Proceedings\nJohn Wang, our Chief Executive Officer and President, who had been named a defendant in two lawsuits which were dismissed by the court in a summary judgement for the defendants. John Wang had been named as a defendant along with two other named individuals, SBI-USA, LLC, a U.S. investment firm, and several of SBI-USA’s subsidiaries. The lawsuits alleged several claims, including violation of federal civil RICO statutes, securities fraud, breach of escrow agreement and breach of fiduciary duty. The plaintiffs generally alleged that SBI-USA, through one of the other named defendants, breached the terms of an escrow agreement and distributed shares of common stock held for the benefit of a third party to the detriment of the plaintiffs. The complaints did not specify the damages sought but one suit claimed damages in excess of $1,600,000 and the other includes claims for damages in excess of $400,000. The first lawsuit was filed on June 8, 2007 and the second lawsuit was filed on December 7, 2007. Mr. Wang does not know if any additional lawsuits will be filed. Mr. Wang and the other defendants denied any wrongdoing in connection with the allegations in the complaints. On March 14, 2008, the lawsuits were dismissed by the court in a summary judgment for the defendants. The plaintiffs have filed a notice of their intent to appeal, and to date have requested and received extensions of time from the court to file a formal appeal brief, but have yet to do so.\n17\n\nITEM 11. EXECUTIVE COMPENSATION\nWe agreed to pay Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and Elizabeth B. Hambrecht, Mr. Eu’s wife, a total of $7,500 per month for office space, administrative services and secretarial support for the period from November 15, 2007 until the earlier of our consummation of a business combination or our liquidation. This arrangement was agreed to by Hambrecht Eu Capital Management LLC for our benefit and is not intended to provide Mr. Eu compensation. We believe that such fees are at least as favorable as we could have obtained from an unaffiliated third party.\nOther than the fees paid to Hambrecht Eu Capital Management LLC, we do not currently pay any cash fees to our officers and directors, nor do we pay their expenses in attending board meetings.\n\nITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT\nThe following table sets forth information regarding the beneficial ownership of our ordinary shares as of January 21, 2010 by:\n\n| § | each person known by us to be the beneficial owner of more than 5% of our outstanding ordinary shares; |\n\n\n| § | each of our officers and directors; and |\n\n\n| § | all our officers and directors as a group. |\n\nUnless otherwise indicated, we believe that all persons named in the table have sole voting and investment power with respect to all ordinary shares beneficially owned by them.\n| Number of Ordinary | Approx. Percentage |\n| Shares | of Outstanding |\n| Name and Address of Beneficial Owner(1) | Beneficially Owned | Ordinary Shares |\n| John Wang(2) | 270,000 | 5.1 | % |\n| Robert J. Eu(3) | 261,608 | 4.9 | % |\n| Stephen N. Cannon(4) | 173,275 | 3.3 | % |\n| Hao Wu | — | — |\n| Hong Xiang Liu | — | — |\n| William R. Hambrecht(5) | 354,941 | 6.7 | % |\n| W.R. Hambrecht + Co., LLC(6) | 178,275 | 3.4 | % |\n| Shea Ventures LLC(7) | 88,333 | 1.7 | % |\n| Marbella Capital Partners Ltd.(8) | 40,000 | * |\n| AEX Enterprises Limited(9) | 88,333 | 1.7 | % |\n| Hambrecht 1980 Revocable Trust(10) | 88,333 | 1.7 | % |\n| Loeb Arbitrage Management, LLC(11) | 483,872 | 9.13 | % |\n| HBK Investments L.P. (12) | 423,900 | 8.0 | % |\n| Integrated Core Strategies (US) LLC (13) | 520,500 | 9.8 | % |\n| Genesis Capital Advisors LLC. (14) | 367,500 | 6.9 | % |\n\n18\n| Number of Ordinary | Approx. Percentage |\n| Shares | of Outstanding |\n| Name and Address of Beneficial Owner(1) | Beneficially Owned | Ordinary Shares |\n| Bulldog Investors (15) | 300,000 | 5.7 | % |\n| Yarika Partners, L.P. (16) | 284,225 | 5.4 | % |\n| All directors and executive officer as a group (4 individuals) | 704,883 | 13.3 | % |\n\n* Less than 1%\n(1). Except as otherwise provided below, the address for each of our beneficial owners is 13/F Tower 2, New World Tower, 18 Queens Road Central, Hong Kong.\n(2). The number of shares beneficially owned includes the ordinary shares held by Marbella Capital Partners.\n(3). Includes ordinary shares held by AEX Enterprises Limited.\n(4). The ordinary shares beneficially owned by Stephen N. Cannon are held by the Cannon Family Irrevocable Trust, of which Mr. Cannon is the sole trustee.\n(5). Consists of ordinary shares held by W.R. Hambrecht + Co., LLC, AEX Enterprises Limited and the Hambrecht 1980 Revocable Trust.\n(6). William R. Hambrecht is the controlling person of W.R. Hambrecht + Co., LLC. Its address is Pier 1, Bay 3, San Francisco, CA 94111.\n(7). Edmund H. Shea Jr. is the controlling person of Shea Ventures LLC. Its address is P.O. Box 489, 655 Brea Canyon Rd. Walnut, CA 91788.\n(8). John Wang is the controlling person of Marbella Capital Partners Ltd.\n(9). Elizabeth B. Hambrecht, Robert Eu’s wife, and William R. Hambrecht control AEX Enterprises Limited. Its address is Suite 802, 8/F AIA Tower, 183 Electric Road, North Point, Hong Kong.\n(10). William R. Hambrecht is the trustee of the Hambrecht 1980 Revocable Trust. Its address is Pier 1, Bay 3, San Francisco, CA 94111.\n(11). Based on a 13G filed on November 10, 2009. The business address of Loeb Arbirtage Management, LLC is 61 Broadway, 24th Floor, New York, NY 10006. Loeb Arbirtage Management, LLC is a registered investment adviser. Loeb Arbirtage Management, LLC may invest on behalf of itself and clients for which it has investment discretion. Loeb Arbitrage Fund’s general partner is Loeb Arbitrage Management, LLC. Loeb Offshore Fund Ltd.’s registered investment advisor is Loeb Offshore Management, LLC.\n(12). Based on a 13G/A filed on January 28, 2009. The business address of HBK Investments L.P. is 2101 Cedar Springs Road Suite 700, Dallas, TX 75201. HBK Investments L.P. has delegated discretion to vote and dispose of the Securities to HBK Services LLC. HBK Services may, from time to time, delegate discretion to vote and dispose of certain of the securities to HBK New York LLC, a Delaware limited liability company, HBK Virginia LLC, a Delaware limited liability company, and/or HBK Europe Management LLP, a limited liability partnership organized under the laws of the United Kingdom (collectively, the “Subadvisors”). Each of HBK Services and the Subadvisors is under common control with HBK Investments L.P. Jamiel A. Akhtar, Richard L. Booth, David C. Haley, Lawrence H. Lebowitz, and William E. Rose are each managing members of HBK Management LLC.\n19\n(13). Based on a 13G/A filed on January 29, 2009. The business address of Integrated Core Strategies (US) LLC is c/o Millennium Management, LLC 666 Fifth Avenue 8th Floor, New York, NY 10103. Millennium Management LLC, a Delaware limited liability company (“Millennium Management”), is the general partner of the managing member of Integrated Core Strategies and may be deemed to have shared voting control and investment discretion over securities owned by Integrated Core Strategies. Israel A. Englander is the managing member of Millennium Management. Consequently, Mr. Englander may also be deemed to have shared voting control and investment discretion over securities owned by Integrated Core Strategies.\n(14). Based on a 13G/A filed on February 17, 2009. The business address of Genesis Capital Advisors LLC is 255 Huguenot Street, Suite 1103, New Rochelle, NY 10801. Jaime Hartman, Ethan Benovitz and Daniel Saks are the managing members of Genesis. As a result, Messrs. Hartman, Benovitz and Saks may be deemed to have shared voting control and investment discretion over securities deemed to be beneficially owned by Genesis.\n(15). Based on a 13G filed on August 1, 2008. The business address of Bulldog Investors is Park 80 West, Plaza Two, Saddle Brook, NJ 07663. Phillip Goldstein and Andrew Dakos are principals of Bulldog Investors.\n(16). Based on a 13G filed on October 21, 2009. The business address of Yakira Parterns, L.P. is 991 Post Road East Westport, CT 06880. Mr. Bruce M. Kallins is the managing member of Yakira Partners, L.P.\nAll 1,059,825 Founder Shares owned by our Founders have been placed in escrow with Continental Stock Transfer & Trust Company, as escrow agent, pursuant to an escrow agreement.\n\nITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTORS INDEPENDENCE\nOn July 18, 2007, John Wang, Robert J. Eu and Stephen N. Cannon purchased an aggregate of 1,150,000 of our ordinary shares (which includs 90,174 ordinary shares that we redeemed on March 31, 2008 because the IPO underwriters did not exercise their over-allotment option in full) for an aggregate purchase price of $25,000. Mr. Cannon subsequently transferred all of the shares he purchased to the Cannon Family Irrevocable Trust, of which Mr. Cannon is the sole trustee.\nOn February 21, 2008, John Wang, Robert Eu and the Cannon Family Irrevocable Trust transferred an aggregate of 463,334 shares to W.R. Hambrecht + Co., LLC, Shea Ventures LLC, Marbella Capital Partners Ltd., AEX Enterprises Limited and the Hambrecht 1980 Revocable Trust, each of which entities is an accredited investor for an aggregate purchase price of 10,193.35 or $0.022 per share.\nOn March 7, 2008, AEX Enterprises Limited, W.R. Hambrecht + Co., LLC and the Hambrecht 1980 Revocable Trust, companies controlled by Elizabeth B. Hambrecht, wife of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and William R. Hambrecht, Mr. Eu’s father-in-law, Shea Ventures LLC, a company controlled by Edmund H. Shea Jr. and Marbella Capital Partners Ltd., a company controlled by John Wang, our Chief Executive Officer, agreed to invest an aggregate of $1,550,000 in us in the form of private placement warrants to purchase 1,550,000 ordinary shares at a price of $1.00 per warrant. Elizabeth B. Hambrecht owns approximately 25% and William R. Hambrecht controls (through a trust of which he is the trustee) approximately 38% of the voting shares of AEX Enterprises Limited. William Hambrecht is a controlling person of the voting shares of W.R. Hambrecht + Co., LLC and is the trustee of the Hambrecht 1980 Revocable Trust. The proceeds of the sale of the warrants were placed in the trust account established for our benefit in connection with our IPO.\nOn March 31, 2008, following the partial exercise of the over-allotment option by the underwriters of the IPO, we cancelled an aggregate of 90,174 ordinary shares held by Robert J. Eu, Cannon Family Irrevocable Trust and WR Hambrecht + Co., LLC.\nOn December 21, 2008, AEX Enterprises Limited transferred an aggregate of 441,666 warrants to AEX Capital, LLC, for no consideration. Such transfer was exempt from registration pursuant to Sections 4(1) and 4(2) of the Securities Act, due to the limited number of individuals involved, their status as accredited investors and transfer restrictions and legends on the share certificates.\n20\nIn each of the foregoing sales of securities the purchasers were our officers and directors or affiliates of our officers and directors and therefore had access to all relevant information about us when choosing to invest in our securities. As of January 21, 2010, these securities were held by the persons or entities as set forth in the following table:\n\n| Name | Ordinary Shares | Warrants |\n| John Wang | 230,000 | 0 |\n| W.R. Hambrecht + Co., LLC(1) | 178,275 | 25,000 |\n| Cannon Family Irrevocable Trust (2) | 173,275 | 0 |\n| Robert J. Eu | 173,275 | 0 |\n| AEX Enterprises Limited(3) | 88,333 | 0 |\n| Hambrecht 1980 Revocable Trust(4) | 88,333 | 441,667 |\n| Shea Ventures LLC(5) | 88,333 | 441,667 |\n| Marbella Capital Partners Ltd.(6) | 40,000 | 200,000 |\n| AEX Capital, LLC(7) | 0 | 441,666 |\n| Total: | 1,059,824 | 1,550,000 |\n\n\n| (1) | William R. Hambrecht is the controlling person of W.R. Hambrecht + Co., LLC. |\n\n| (2) | Mr. Cannon is the sole Trustee of Cannon Family Irrevocable Trust. |\n\n| (3) | Elizabeth B. Hambrecht, Robert Eu’s wife, and William R. Hambrecht control AEX Enterprises Limited. |\n\n| (4) | William R. Hambrecht is the trustee of the Hambrecht 1980 Revocable Trust. |\n\n| (5) | Edmund H. Shea Jr. is the controlling person of Shea Ventures LLC. |\n\n| (6) | John Wang is the controlling person of Marbella Capital Partners Ltd. |\n\n| (7) | Elizabeth B. Hambrecht, Robert Eu’s wife, and Robert J. Eu control AEX Capital, LLC. |\n\nPursuant to a registration rights agreement between us and our pre-initial public offering shareholders and warrant holders such shareholders and warrant holders will be entitled to certain registration rights. Specifically, (i) the private placement warrants and the underlying ordinary shares will be entitled to certain registration rights immediately after the consummation of a business combination; and (ii) the ordinary shares will be entitled to certain registration rights one year from the consummation of a business combination. We are only required to use our best efforts to cause a registration statement relating to the resale of such securities to be declared effective and, once effective, only to use our best efforts to maintain the effectiveness of the registration statement. The holders of warrants do not have the rights or privileges of holders of our ordinary shares or any voting rights until such holders exercise their respective warrants and receive ordinary shares. Certain persons and entities that receive any of the above described securities from our founders will, under certain circumstances, be entitled to the registration rights described herein. We will bear the expenses incurred in connection with the filing of any such registration statements. In the event that we breach our obligations under the registration rights agreement, we could be obligated to purchase the securities owned by our pre-initial public offering shareholders for the then fair market value of the securities.\nWe agreed to pay Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and Elizabeth Hambrecht, Mr. Eu’s wife, a total of $7,500 per month for office space, administrative services and secretarial support for the period from November 15, 2007 until the earlier of our consummation of a business combination or our liquidation. This arrangement was agreed to by Hambrecht Eu Capital Management LLC for our benefit and is not intended to provide Mr. Eu compensation. We believe that such fees are at least as favorable as we could have obtained from an unaffiliated third party.\nWe will reimburse our officers and directors for any reasonable out-of-pocket business expenses incurred by them in connection with certain activities on our behalf such as identifying and investigating possible target businesses and business combinations. Subject to availability of proceeds not placed in the trust account and the interest income on the balance in the trust account to be released to us from time to time, there is no limit on the amount of out-of-pocket expenses that could be incurred. This formula was a result of a negotiation between us and the underwriters and was meant to help maximize the amount of money in the trust account that would be returned to the investors if we do not consummate a business combination within the permitted time. Our board of directors will review and approve all expense reimbursements made to our directors with the interested director or directors abstaining from such review and approval. To the extent such out-of-pocket expenses exceed the available proceeds not deposited in the trust account, such out-of-pocket expenses would not be reimbursed by us unless we consummate a business combination.\n21\nOther than the $7,500 per month administrative fee and reimbursable out-of-pocket expenses payable to Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and Elizabeth Hambrecht, Mr. Eu’s wife, no fees of any kind, including finders and consulting fees, will be paid to any of our directors who owned our ordinary shares prior to our IPO, or to any of their respective affiliates for services rendered to us prior to or with respect to the business combination.\nAfter a business combination, any of our directors who remain with us may be paid consulting, management or other fees from the combined company with any and all amounts being fully disclosed to shareholders, to the extent then known, in the proxy solicitation materials furnished to our shareholders. It is unlikely that the amount of such compensation will be known at the time of a shareholder meeting held to consider a business combination, as it will be up to the directors of the post-combination business to determine executive and director compensation. In this event, such compensation will be publicly disclosed at the time of its determination in a Current Report on Form 8-K, as required by the SEC.\nAll ongoing and future transactions between us and any of our directors or their respective affiliates, including loans by our directors, will be on terms believed by us at that time, based upon other similar arrangements known to us, to be no less favorable than are available from unaffiliated third parties. Such transactions or loans, including any forgiveness of loans, will require prior approval in each instance by a majority of our uninterested “independent” directors, to the extent we have independent directors, or the members of our board who do not have an interest in the transaction, in either case who had access, at our expense, to our attorneys or independent legal counsel. It is our intention to obtain estimates from unaffiliated third parties for similar goods or services to ascertain whether such transactions with affiliates are on terms that are no less favorable to us than are otherwise available from such unaffiliated third parties. If a transaction with an affiliated third party were found to be on terms less favorable to us than with an unaffiliated third party, we would not engage in such transaction.\nDirector Independence\nOur Board of Directors has not determined if any of our directors qualifies as independent. Our Board of Directors will make a determination about independence after the business combination is consummated. We do not have an audit committee, nominating committee or compensation committee and therefore the entire Board of Directors performs those functions for us.\n\nITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES\nRothstein Kass & Company, P.C. audited our financial statements for the years ended June 30, 2009; December 31, 2008 and 2007:\nAudit Fees\nFees for audit services provided by Rothstein Kass & Company, P.C. totaled approximately $55,000 in 2009, including fees associated with the audit of the annual financial statements for the fiscal year ended June 30, 2009 and the reviews of the Company’s quarterly reports on Form 10-Q.\nFees for audit services provided by Rothstein Kass & Company, P.C. totaled approximately $55,000 in 2008, including fees associated with the audit of the annual financial statements for the fiscal year ended December 31, 2008 and the reviews of the Company’s quarterly reports on Form 10-Q.\nFees for audit services provided by Rothstein Kass & Company, P.C. totaled approximately $80,000 in 2007, including fees associated with the audit of the annual financial statements for the fiscal year ended December 31, 2007, the audit of the financial statements as of August 31, 2007, the audit of the Company’s balance sheet at March 18, 2008 included in the Current Report on Form 8-K, and for services performed in connection with the Company’s registration statement on Form S-1 initially filed in 2007.\n22\nAudit-Related Fees\nRothstein Kass & Company, P.C. did not bill any fees for services rendered to us during fiscal years 2009, 2008 and 2007 for Audit-related services in connection with the audit or review of our financial statements.\nTax Fees\nRothstein Kass & Company, P.C. did not bill any fees for tax services, including tax compliance, tax advice, and tax planning, during fiscal years 2009, 2008 and 2007.\nAll Other Fees\nThere were no fees billed by Rothstein Kass & Company, P.C. for other professional services rendered during the fiscal years 2009, 2008 or 2007.\nPre-Approval of Services\nWe do not have an audit committee. As a result, our board of directors performs the duties of an audit committee. Our board of directors evaluates and approves in advance the scope and cost of the engagement of an auditor before the auditor renders the audit and non-audit services. We do not rely on pre-approval policies and procedures.\n23\nPART IV\n\nITEM 15. EXHIBITS\n| (a) | (1) | Financial Statements |\n\nBalance Sheets\nStatement of Operations\nStatement of Shareholders’ Equity\nStatement of Cash Flows\n| (2) | Schedules |\n\nNone.\n| (b) | Exhibits |\n\nThe following Exhibits are filed as part of this report\n| Exhibit No. | Description |\n| 3.1 | Memorandum of Association (1) |\n| 3.2 | Amended and Restated Articles of Association (1) |\n| 4.1 | Specimen Unit Certificate (1) |\n| 4.2 | Specimen Common Share Certificate (1) |\n| 4.3 | Specimen Public Warrant Certificate (1) |\n| 4.4 | Specimen Private Warrant Certificate (1) |\n| 4.5 | Form of Warrant Agreement between Continental Stock Transfer & Trust Company and the Registrant (1) |\n| 4.6 | Form of Unit Purchase Option (1) |\n| 10.1 | Form of Letter Agreement by John Wang (1) |\n| 10.2 | Form of Letter Agreement by Robert J. Eu (1) |\n| 10.3 | Form of Letter Agreement by Stephen N. Cannon (1) |\n| 10.4 | Form of Letter Agreement by Lee S. Ting (1) |\n| 10.5 | Form of Letter Agreement by AEX Enterprises Limited (1) |\n| 10.6 | Form of Letter Agreement by Feng Zhang (1) |\n| 10.7 | Investment Management Trust Agreement between Continental Stock Transfer & Trust Company and the Registrant |\n| 10.8 | Form of Securities Escrow Agreement between the Registrant, Continental Stock Transfer & Trust Company, the founding shareholders and the founders (1) |\n| 10.9 | Form of Services Agreement between the Registrant and Hambrecht Eu Capital Management LLC (1) |\n| 10.10 | Form of Registration Rights Agreement among the Registrant, the founding shareholders and the founders (1) |\n| 10.11 | Revolving Credit Agreement between the Registrant and Robert Eu (1) |\n| 10.12 | Promissory Note between Registrant and Robert Eu (1) |\n| 10.13 | Form of Warrant Purchase Agreement between the Registrant and AEX Enterprises Limited (1) |\n| 10.14 | Form of Right of First Refusal Agreement between the Registrant, Marbella Capital Partners and AEX Enterprises Limited (1) |\n| 31.1 | Certification of the Chief Executive Officer (Principal Executive Officer) pursuant to Rule 13a-14(a) of the Securities Exchange Act, as amended |\n| 31.2 | Certification of the Chief Financial Officer (Principal Financial Officer) pursuant to Rule 13a-14(a) of the Securities Exchange Act, as amended |\n| 32.1 | Certification of the Chief Executive Officers pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2 | Certification of the Chief Financial Officers pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n\n(1) Incorporated by reference to the Registrant’s Registration Statement on Form S-1 (File No. 333-146147).\n24\nSIGNATURES\nPursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant had duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n| January 22, 2010 | HAMBRECHT ASIA ACQUISITION CORP. |\n| By: | /s/ John Wang |\n| John Wang |\n| Chief Executive Officer, President and Director |\n| (Principal Executive Officer) |\n| January 22, 2010 | By: | /s/ Hao Wu |\n| Hao Wu |\n| Chief Financial Officer, Secretary and Director |\n| (Principal Financial and Accounting Officer) |\n\nPursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.\n| January 22, 2010 | By: | /s/ John Wang |\n| John Wang |\n| Chief Executive Officer, President and |\n| Director (Principal Executive Officer) |\n| January 22, 2010 | By: | /s/ Robert J. Eu |\n| Robert J. Eu |\n| Chairman of Board |\n| January 22, 2010 | By: | /s/ Hao Wu |\n| Hao Wu |\n| Chief Financial Officer, Secretary and Director |\n| (Principal Financial and Accounting Officer) |\n| January 22, 2010 | By: | /s/ Hong Xiang Liu |\n| Hong Xiang Liu |\n| Director |\n\n25\nHambrecht Asia Acquisition Corp.\n(a corporation in the development stage)\nINDEX TO FINANCIAL STATEMENTS\n| Page |\n| Report of Independent Registered Public Accounting Firm | F-2 |\n| Financial Statements: |\n| Balance Sheets | F-3 |\n| Statements of Operations | F-4 |\n| Statements of Shareholders’ Equity | F-5 |\n| Statements of Cash Flows | F-6 |\n| Notes to Financial Statements | F-7 |\n\nF-1\nReport of Independent Registered Public Accounting Firm\nTo the Board of Directors and Stockholders of\nHambrecht Asia Acquisition Corporation\nWe have audited the accompanying balance sheets of Hambrecht Asia Acquisition Corporation (a corporation in the development stage) (the “Company”) as of June 30, 2009 and December 31, 2008 and 2007, and the related statements of operations and cash flows for the six months ended June 30, 2009, the year ended December 31, 2008, the period from July 18, 2007 (date of inception) to December 31, 2007 and the periods from July 18, 2007 (date of inception) to June 30, 2009, and shareholders’ equity for the period from July 18, 2007 (date of inception) to June 30, 2009. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.\nWe conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.\nIn our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of June 30, 2009 and December 31, 2008, and the results of its operations and its cash flows for the six months ended June 30, 2009, the year ended December 31, 2008, the period from July 18, 2007 (date of inception) to December 31, 2007 and the periods from July 18, 2007 (date of inception) to June 30, 2009, and shareholders’ equity for the period from July 18, 2007 (date of inception) to June 30, 2009, in conformity with U.S. generally accepted accounting principles.\nThe accompanying financial statements have been prepared assuming that Hambrecht Asia Acquisition Corporation will continue as a going concern. As discussed in Note 7 to the financial statements, Hambrecht Asia Acquisition Corporation will face a mandatory liquidation if a business combination is not consummated by March 12, 2010, which raises substantial doubt about its ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.\nRoseland, New Jersey\nJanuary 22, 2010\n/s/ Rothstein Kass & Company, P.C.\nF-2\nHambrecht Asia Acquisition Corp.\n(a corporation in the development stage)\nBalance Sheets\n| June 30,2009 | December 31, 2008 | December 31, 2007 |\n| ASSETS |\n| Current assets |\n| Cash | $ | 30,271 | $ | 100,312 | $ | 101,671 |\n| Prepaid expenses | 95,686 | 108,330 | 183,254 |\n| Total current assets | 125,957 | 208,642 | 284,925 |\n| Other asset | — |\n| Investments held in the trust account | 33,838,155 | 33,798,651 |\n| Total assets | $ | 33,964,112 | $ | 34,007,293 | $ | 284,925 |\n| LIABILITIES AND SHAREHOLDERS’ EQUITY |\n| Current liabilities |\n| Accrued expenses | $ | 76,275 | $ | 31,780 | $ | — |\n| Note payable, shareholder | 281,661 |\n| — |\n| Total current liabilities | 76,275 | 31,780 | 281,661 |\n| Long-term liabilities |\n| Deferred underwriting fees, net of $356,101 subject to forfeiture in the event of possible redemption | 830,903 | 830,903 | — |\n| Ordinary shares, subject to possible redemption, (1,271,788 shares at redemption value of $7.92 per share) | 10,072,561 | 10,072,561 | — |\n| Shareholders’ equity |\n| Ordinary shares, $.001 par value, 50,000,000 shares authorized; 5,299,125, 5,299,125 and 1,150,000 shares issued and outstanding as of June 30, 2009, December 31, 2008 and December 31, 2007 (which includes 1,271,788, 1,271,788 shares and 0 shares respectively subject to possible redemption) | 5,299 | 5,299 | 1,150 |\n| Additional paid-in capital | 22,851,981 | 22,851,981 | 23,850 |\n| Earnings (deficit) accumulated during the development stage | 127,093 | 214,769 | (21,736 | ) |\n| Total shareholders’ equity | 22,984,373 | 23,072,049 | 3,264 |\n| Total liabilities and shareholders’ equity | $ | 33,964,112 | $ | 34,007,293 | $ | 284,925 |\n\nSee accompanying notes to financial statements.\nF-3\nHambrecht Asia Acquisition Corp.\n(a corporation in the development stage)\nStatements of Operations\n\n| For the Period Ended June 30, 2009 (six months) | For the Period Ended June 30, 2008 (six months) (unaudited) | Period from July 18,2007 (inception) to June 30,2009 | For the Year ended December 31,2008 | Period from July 18, 2007 to December 31,2007 |\n| Revenues | $ | — | $ | — | $ | — | $ | — | $ | — |\n| Formation and administrative costs | 184,870 | 156,683 | 473,993 | 267,387 | 21,736 |\n| Loss from operations | (184,870 | ) | (156,683 | ) | (473,993 | ) | (267,387 | ) | (21,736 | ) |\n| Interest income, net | 97,193 | 168,133 | 601,085 | 503,892 | — |\n| Net income (loss) | (87,677 | ) | 11,449 | 127,093 | 236,505 | (21,736 | ) |\n| Weighted average number of ordinary shares subject to possible redemption, basic and diluted | 1,271,788 | 808,223 | 793,378 | 1,037,742 | — |\n| Income (loss) per ordinary share subject to possible redemption, basic and diluted | $ | (0.07 | ) | $ | 0.01 | $ | 0.16 | $ | — | $ | — |\n| Weighted average number of ordinary shares outstanding (not subject to possible redemption) , basic | 4,027,337 | 3,789,581 | 3,085,775 | 3,503,402 | 1,150,000 |\n| Income (loss) per ordinary share not subject to possible redemption, basic | $ | (0.02 | ) | $ | 0.00 | $ | 0.04 | $ | 0.07 | $ | (0.02 | ) |\n| Weighted average number of ordinary shares outstanding (not subject to possible redemption), diluted | 4,027,337 | 5,164,193 | 4,267,656 | 5,213,337 | 1,150,000 |\n| Income (loss) per ordinary share not subject to possible redemption, diluted | $ | (0.02 | ) | $ | 0.00 | $ | 0.03 | $ | 0.05 | $ | (0.02 | ) |\n\nSee accompanying notes to financial statements.\nF-4\nHambrecht Asia Acquisition Corp.\n(a corporation in the development stage)\nStatements of Shareholders’ Equity\nFor the Period July 18, 2007 (date of inception) to June 30, 2009\n| Ordinary Shares | Earnings |\n| Shares | Amount | Additional Paid-in Capital | (Deficit) Accumulated During the Development Stage | TotalShareholders’ Equity |\n| Balances at July 18, 2007 | — | $ | — | $ | — | $ | — | $ | — |\n| Sale of units issued to founders on July 18, 2007 at approximately $0.02 per share | 1,150,000 | 1,150 | 23,850 | 25,000 |\n| Net loss | (21,736 | ) | (21,736 | ) |\n| Balances at December 31, 2007 | 1,150,000 | $ | 1,150 | $ | 23,850 | $ | (21,736 | ) | $ | 3,264 |\n| Proceeds from sale of warrants in a private placement to initial shareholders | 1,550,000 | 1,550,000 |\n| Sale of 4,000,000 units at $8.00 per unit in the public offering, net of underwriters’ discount and offering expenses (1,199,999 shares subject to possible redemption) | 4,000,000 | 4,000 | 29,550,348 | 29,554,348 |\n| Sale of 239,300 units at $8.00 per unit in the public offering from partial exercise of underwriters’ overallotment option, net of underwriters’ discount and offering expenses (71,789 shares subject to possible redemption) | 239,300 | 239 | 1,800,344 | 1,800,583 |\n| Forfeiture of founders shares from partial exercise of underwriters’ overallotment option | (90,175 | ) | (90 | ) | (90 | ) |\n| Proceeds subject to possible redemption of 1,271,788 shares at a redemption value of $7.92 per share | (10,072,561 | ) | (10,072,561 | ) |\n| Net income | 236,505 | 236,505 |\n| Balances at December 31, 2008 | 5,299,125 | $ | 5,299 | $ | 22,851,981 | $ | 214,769 | $ | 23,072,049 |\n| Net loss | (87,677 | ) | (87,677 | ) |\n| Balances at June 30, 2009 | 5,299,125 | $ | 5,299 | $ | 22,851,981 | $ | 127,093 | $ | 22,984,373 |\n\nSee accompanying notes to financial statements.\nF-5\nHambrecht Asia Acquisition Corp.\n(a corporation in the development stage)\nStatements of Cash Flows\n| For the PeriodEnded June 30,2009 (sixmonths) | For the PeriodEnded June 30,2008 (sixmonths) (unaudited) | Period from July18,2007(inception) toJune 30,2009 | For the Yearended December31,2008 | Period from July18, 2007 toDecember31,2007 |\n| Cash flows from operating activities: |\n| Net income (loss) | $ | (87,677 | ) | $ | 11,449 | $ | 127,093 | $ | 236,505 | $ | (21,736 | ) |\n| Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |\n| Change in operating assets and liabilities: |\n| Accrued expenses | 44,494 | 94,063 | 76,275 | 31,780 |\n| Prepaid expenses and other current asset | 12,644 | 49,922 | (95,686 | ) | (108,330 | ) |\n| Net cash provided by (used in) operating activities | (30,538 | ) | 155,434 | 107,682 | 159,955 | (21,736 | ) |\n| Cash used in investing activities: |\n| Proceeds from the public offering deposited in trust account | — | (33,527,400 | ) | (33,527,400 | ) | (33,527,400 | ) | — |\n| Interest income re-invested in trust account | (85,836 | ) | (173,102 | ) | (510,361 | ) | (510,361 | ) | — |\n| Redemption from the trust account | 46,332 | 65,709 | 285,442 | 239,110 | — |\n| Net cash used in investing activities | (39,504 | ) | (33,634,793 | ) | (33,838,155 | ) | (33,798,651 | ) | — |\n| Cash flows from financing activities: |\n| Proceeds from sale of ordinary shares to founders | — | — | 25,000 | — | 25,000 |\n| Proceeds from shareholder’s note payable | $ | — | $ | — | $ | 281,661 | $ | — | $ | 281,661 |\n| Proceeds from warrants purchased in private placement | — | 1,550,000 | 1,550,000 | 1,550,000 | — |\n| Proceeds from initial public offering | $ | — | $ | 32,000,000 | $ | 32,000,000 | $ | 32,000,000 | $ | — |\n| Proceeds from exercise of underwriters overallotment option | — | 1,914,400 | 1,914,400 | 1,914,400 | — |\n| Repayment of shareholder’s note payable | — | — | (281,661 | ) | (281,661 | ) | — |\n| Payment of underwriters’ fee and offering cost of initial public offering | — | (1,728,656 | ) | (1,728,656 | ) | (1,545,402 | ) | (183,254 | ) |\n| Net cash provided by financing activities | — | 33,454,083 | 33,760,744 | 33,637,337 | 123,407 |\n| Net increase (decrease) in cash | (70,042 | ) | (25,276 | ) | 30,271 | (1,359 | ) | 101,671 |\n| Cash at beginning of the period | 100,312 | 101,671 | — | 101,671 | — |\n| Cash at end of the period | $ | 30,271 | $ | 76,395 | $ | 30,271 | $ | 100,312 | $ | 101,671 |\n| Supplemental schedule of non-cash financing activities: |\n| Deferred underwriting fees, net | $ | — | $ | 830,903 | $ | 830,903 | $ | 830,903 | $ | — |\n| Ordinary shares subject to possible redemption | $ | — | $ | 10,072,561 | $ | 10,072,561 | $ | 10,072,561 | $ | — |\n\nSee accompanying notes to financial statements.\nF-6\nHambrecht Asia Acquisition Corp.\n(a corporation in the development stage)\nNotes to Financial Statements\nNOTE 1—ORGANIZATION AND BUSINESS OPERATIONS\nHambrecht Asia Acquisition Corp. (a corporation in the development stage) (the “Company”) was incorporated in the Cayman Islands on July 18, 2007 with an authorized share capital of 50,000,000 ordinary shares (par value $0.001 per share). The Company’s founders contributed $25,000 to the formation of the Company and were issued 1,150,000 ordinary shares. The Company was formed to acquire, through a stock exchange, asset acquisition or other similar business combination, one or more operating businesses having its primary operations located in the People’s Republic of China (“Business Combination”). The Company is considered to be in the development stage as defined in “Accounting and Reporting By Development Stage Enterprises”, and is subject to the risks associated with activities of development stage companies. The Company’s operations, if a Business Combination is consummated outside the United States, will be subject to local government regulations and to the uncertainties of the economic and political conditions of those areas.\nOn December 9, 2009 the Board of Directors of Hambrecht Asia Acquisition Corp. (the \"Company\") authorized a change in the Company's fiscal year end to June 30 from December 31. The Company reports its financial results for the six month transition period of December 31, 2008 through June 30, 2009 on a Transition Report on Form 10-K. After filing the Transition Report, the Company’s next fiscal year end will be June 30, 2010.\nAs of June 30, 2009, the Company had not commenced any operations or generated any revenues. All activity from the period July 18, 2007 (date of inception) through March 31, 2008 relates to the Company’s formation and its initial public offering as described below. Subsequent to that date to the present the Company has sought a target business to acquire. The Company will not generate any operating revenue until after the completion of the Business combination, at the earliest. The Company currently generates non-operating income from interest income earned on the investments held in a trust account (the “Trust Account”), from the proceeds derived from the public offering.\nThe registration statement for the Company’s initial public offering (the “Offering”) described in Note 3 was declared effective on March 7, 2008. The Company consummated the Offering on March 12, 2008 and immediately prior to such Offering, sold an aggregate of 1,550,000 warrants at $1.00 per warrant to certain officers and affiliates of the Company in a private placement (the “Private Placement”) described in Note 4. On March 31 2008, the underwriters of the Offering exercised their over-allotment option for a total of an additional 239,300 units. The net proceeds of the Offering and the Private Placement are intended to be generally applied toward consummating a business combination with one or more operating businesses having their primary operations in the People’s Republic of China (“Business Combination”). Net proceeds of $33,537,396 from the Offering, including the exercise of the underwriters’ over-allotment option, and the Private Placement are held in a Trust Account and will only be released to the Company upon the earlier of: (i) the consummation of a business combination; or (ii) the Company’s liquidation, except to satisfy shareholder conversion rights. The Trust Account includes the deferred underwriting discount from the Offering of up to $1,187,004 which will be paid to the underwriters upon consummation of a business combination, as described in Note 6. Additionally, up to an aggregate of $700,000, plus up to an additional $350,000 during the Extended Period (as described below) if approved by shareholders, of interest earned on the Trust Account balance (net of any taxes paid or payable) may be released to the Company to fund operating activities. Through June 30, 2009, approximately $286,000 of interest earned on the Trust Account balance has been released to the Company.\nOn September 4, 2009, the Company issued a press release announcing that it has entered into a letter of intent with a company for a business combination. The target is a company with its principal business operations in the People’s Republic of China. The Company, after signing a definitive agreement for the acquisition of a target business, is required to submit such transaction for shareholder approval. In the event that shareholders owning 30% or more of the shares sold in the Offering vote against the business combination and exercise their conversion rights described below, the business combination will not be consummated. All of the Company’s shareholders prior to the Offering, have agreed to vote their pre-initial public offering ordinary shares in accordance with the vote of the majority of the shares voted by all shareholders of the Company who purchased their shares in the Offering or the aftermarket (“Public Shareholders”) with respect to any business combination. After consummation of a business combination, these voting safeguards will no longer be applicable.\nF-7\nIn the event that the Company does not complete a business combination by March 12, 2010, or March 12, 2011 if extension is approved by the shareholders, the Company will be dissolved and the proceeds held in the Trust Account, plus certain interest, less certain costs, will be distributed to the Company’s public shareholders. If the Company receives Public Shareholder approval for the Extended Period and holders of 30% or more of the shares held by Public Shareholders do not vote against the Extended Period and elect to convert their ordinary shares in connection with the vote for the Extended Period, the Company will then have an additional 12 months in which to complete the initial business combination. If the Extended Period is approved, the Company will still be required to seek Public Shareholder approval before completing a business combination. In the event there is no business combination within the 24-month deadline (assuming the Extended Period is not approved) described above, the Company will dissolve and distribute to its Public Shareholders, in proportion to their respective equity interests, the amount held in the Trust Account, and any remaining net assets, after the distribution of the Trust Account. The Company’s corporate existence will automatically cease at the end of the 36-month period if the Company has not received shareholder approval for an initial business combination. In the event of liquidation, the per share value of the residual assets remaining available for distribution (including Trust Account assets) may be less than the initial public offering price per share in the Offering.\nWith respect to a business combination which is approved and consummated or a vote on the Extended Period which is approved, any Public Shareholders who voted against the business combination or Extended Period may contemporaneously with or prior to such vote exercise their conversion right and their ordinary shares would be cancelled and returned to the status of authorized but unissued shares. The per share conversion price will equal the amount in the Trust Account (including interest therein), calculated as of two business days prior to the consummation of the proposed business combination or vote on Extended Period, divided by the number of common shares sold in the Offering and partial exercise of the over-allotment option.\nA Public Shareholder’s election to convert ordinary shares in connection with the vote on the Extended Period will only be honored if the Extended Period is approved. Public Shareholders who vote their shares against the Extended Period and exercise their conversion rights, will not be able to vote these shares with respect to the initial business combination. All other Public Shareholders will be able to vote on the initial business combination.\nNOTE 2 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nBasis of Presentation:\nThe accompanying financial statements are presented in U.S. dollars and have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and pursuant to the accounting and disclosure rules and regulations of the Securities and Exchange Commission (the ‘SEC”). In the opinion of management, the accompanying financial statements reflect all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the Company’s financial statements.\nInvestments held in the Trust Account:\nThe amounts held in the Trust Account as of June 30, 2009 represent substantially all of the proceeds of the Offering plus partial exercise of the underwriters’ over-allotment option, the private placement and interest earned on the trust to date, and are classified as restricted assets since such amounts can only be used by the Company in connection with the consummation of a Business Combination. The funds held in the Trust Account are invested in a money market fund that invests in US and state government and government agency debt securities.\nF-8\nFair value of financial instruments:\nThe Company does not enter into financial instruments for trading or speculative purposes. The carrying amounts of financial instruments classified as current assets and current liabilities as disclosed in the accompanying balance sheets, approximate their fair value due to their short maturities.\nUse of estimates:\nThe preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.\nIncome taxes:\nUnder current Cayman Islands laws, the Company is not subject to income taxes or capital gains, and there is no Cayman Islands withholding tax imposed upon payments of dividends by the Company to its shareholders. In the future, the Company’s tax rate will be impacted by acquisitions of non-Cayman subsidiaries governed by the respective local income tax laws. Accordingly, no provision for income taxes has been made in the accompanying statements of operations.\nEffective January 1, 2007, the Company adopted the provisions of “Accounting for Uncertainty in Income Taxes”. There were no unrecognized tax benefits as of June 30, 2009. The provision prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. No amounts were accrued for the payment of interest and penalties at June 30, 2009. Management is currently unaware of any issues under review that could result in significant payments, accruals or material deviation from its position.\nOrdinary shares subject to possible redemption:\nAs discussed in Note 1, the Company will only proceed with a Business Combination if: (1) it is approved by a majority of the votes cast by the Company’s public shareholders; and (2) public shareholders holding less than 30% (1,271,788) of the ordinary shares sold in the Offering and partial exercise of the over-allotment option, choose to exercise their redemption rights thereby receiving their per share interest in the Trust Account. In accordance with FASB’s Emerging Issues Task Force (EITF) Topic No. D-98, “Classification and Measurement of Redeemable Securities”, the Company has classified 1,271,788 shares of its ordinary shares outside of permanent equity as “Ordinary shares subject to redemption,” at a redemption price of $7.92 per share as of June 30, 2009 . The Company will recognize changes in the conversion value as they occur and will adjust the carrying value of the ordinary shares subject to conversion to be equal to its conversion value at the end of each reporting period.\nIncome (loss) per ordinary share:\nBasic income per common share is computed by dividing net income by the weighted average common shares outstanding for the period. Diluted income per common share reflects the potential dilution that could occur if warrants were to be exercised or converted or otherwise resulted in the issuance of ordinary shares that then shared in the earnings of the entity.\nFor the period ended (six months) June 30, 2009, and for the period from July 18, 2007 (inception) to June 30, 2009, the Company had potentially dilutive securities in the form of 7,129,125 warrants, and 5,299,125 warrants issued as part of the Units (as defined below) in the Offering. Of the total warrants outstanding for the periods then ended, approximately 2,328,422 and 1,181,881, respectively, represent incremental shares of ordinary share, based on their assumed redemption, to be included in the weighted average number of shares of ordinary share outstanding (not subject to possible redemption) for the calculation of diluted income per ordinary share. The Company uses the “treasury stock method” to calculate potential dilutive shares, as if they were redeemed for ordinary share at the beginning of the period.\nF-9\nThe Company’s statements of operations includes a presentation of income per ordinary share subject to possible redemption in a manner similar to the two-class method of income per share. Basic and diluted income amount for the maximum number of shares subject to possible redemption is calculated by dividing the net interest attributable to common shares subject to redemption by the weighted average number of shares subject to possible redemption. Basic and diluted net income (loss) per share amount for the shares outstanding not subject to possible redemption is calculated by dividing the net income (loss) exclusive of the net interest income attributable to ordinary share subject to redemption by the weighted average number of shares not subject to possible redemption.\nNewly Adopted Accounting Pronouncements:\nIn December 2007, the FASB issued “Business Combinations”, which requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction; establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; and requires the acquirer to disclose to investors, and other users, all of the information they need to evaluate and understand the nature and financial effect of the business combination. “Business Combinations” will be effective for acquisitions with a date on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. We will apply “Business Combinations” for any of our applicable acquisitions beginning January 1, 2009.\nIn December 2007, the FASB issued “Noncontrolling Interests in Consolidated Financial Statements”, which requires the recognition of a noncontrolling interest (minority interest) as equity in the consolidated financial statements and separate from the parent’s equity; the inclusion of the amount of net income attributable to the noncontrolling interest in consolidated income on the face of the income statement; and a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. This guidance will be effective for the fiscal years beginning on or after December 15, 2008. We will apply to any applicable transactions beginning January 1, 2009.\nIn March 2008, the FASB issued “Disclosures about Derivative Instruments and Hedging Activities”, which is intended to improve financial standards for derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. Entities are required to provide enhanced disclosures about: (a) how and why an entity uses derivative instruments; (b) how derivative instruments and related hedged items are accounted for and its related interpretations; and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. It is effective for financial statements issued for fiscal years beginning after November 15, 2008, with early adoption encouraged. The adoption of this statement is not expected to have a material effect on the Company’s results of operations or financial position; however, it could impact future transactions entered into by the Company.\nOn April 9, 2009, the FASB issued the guidance of “Interim Disclosures about Fair Value of Financial Instruments” to require disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements. The guidance also amends Accounting Principles Board Opinion-Interim Financial Reporting, to require those disclosures in summarized financial information at interim reporting periods. The guidance shall be effective for interim reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. An entity may early adopt this if certain requirements are met. This guidance does not require disclosures for earlier periods presented for comparative purposes at initial adoption. In periods after initial adoption, this guidance requires comparative disclosures only for periods ending after initial adoption. The adoption of this guidance did not have a significant impact on the Company’s financial statements or related footnotes.\nF-10\nOn April 9, 2009, the FASB issued the guidance of “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly”, to affirms that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction; clarifies and includes additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is not active; eliminates the proposed presumption that all transactions are distressed (not orderly) unless proven otherwise. The guidance instead requires an entity to base its conclusion about whether a transaction was not orderly on the weight of the evidence. In addition, this guidance requires an entity to disclose a change in valuation technique (and the related inputs) resulting from the application of it and to quantify its effects, if practicable. This guidance is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009 if certain requirements are met. It must be applied prospectively and retrospective application is not permitted. The adoption of this guidance did not have a significant impact on the Company’s financial statements or related footnotes.\nOn April 9, 2009, the FASB issued “Recognition and Presentation of Other-Than-Temporary Impairments”, to be intended to bring consistency to the timing of impairment recognition, and provide improved disclosures about the credit and noncredit components of impaired debt securities that are not expected to be sold. The measure of impairment in comprehensive income remains fair value. The guidance also requires increased and more timely disclosures regarding expected cash flows, credit losses, and an aging of securities with unrealized losses. This guidance shall be effective for interim and annual reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. Earlier adoption for periods ending before March 15, 2009, is not permitted. If an entity elects to adopt early either “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly”, or “Interim Disclosures about Fair Value of Financial Instruments”, the entity also is required to adopt early this guidance. Additionally, if an entity elects to adopt early , it is required to adopt “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly”. This guidance does not require disclosures for earlier periods presented for comparative purposes at initial adoption. In periods after initial adoption, this guidance requires comparative disclosures only for periods ending after initial adoption. The adoption did not have a significant impact on the Company’s financial statement or footnotes.\nOn May 28, 2009, the FASB issued the guidance regarding subsequent events, which we adopted on a prospective basis beginning April 1, 2009. The guidance is intended to establish general standards of accounting and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. It requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for selecting that date. The application of the pronouncement did not have an impact on our financial position, results of operations or cash flows. These financial statements were approved by management and were issued on January 22, 2010. Subsequent events have been evaluated through this date.\nRecently Issued Accounting Pronouncements\nIn June 2009, the Financial Accounting Standards Board issued the statement of “Accounting Standards Codification TM and the Hierarchy of Generally Accepted Accounting Principles This statement confirmed that the FASB Accounting Standards Codification (the “Codification”) will become the single official source of authoritative U.S. GAAP (other than guidance issued by the SEC), superseding existing FASB, American Institute of Certified Public Accountants, Emerging Issues Task Force (“EITF”), and related literature. After that date, only one level of authoritative U.S. GAAP will exist. All other literature will be considered non-authoritative. The Codification does not change U.S. GAAP; instead, it introduces a new structure that is organized in an easily accessible, user-friendly online research system. The Codification, which changes the referencing of financial standards, becomes effective for interim and annual periods ending on or after September 15, 2009.. The Company has adopted this standard and did not have any substantive impact on our financial statements or related footnotes.\nManagement does not believe that any other recently issued, but no yet effective accounting standards, if currently adopted, would have a material effect on the accompanying financial statements.\nNOTE 3—PUBLIC OFFERING\nOn March 7, 2008, the Company sold 4,000,000 units in the Offering at a price of $8.00 per unit. On March 31, 2008, the Company consummated the closing of an additional 239,300 units which were subject to the over-allotment option. Each unit consists of one share of the Company’s ordinary shares, $0.001 par value, and one warrant. Each warrant will entitle the holder to purchase from the Company one of the Company’s ordinary shares at an exercise price of $5.00 per share commencing on the later of: (i) The consummation of the Business Combination, or (ii) March 7, 2009. The warrants will be exercisable only if the Company continues to provide for an effective registration statement covering the ordinary shares issueable upon exercise of the warrants. In no event will the holder of a warrant be entitled to receive a net cash settlement or other consideration in lieu of physical settlement in shares of the Company’s ordinary shares.\nF-11\nThe warrants expire on March 7, 2013, unless earlier redeemed. The warrants included in the units sold in the Offering are redeemable, at the Company’s option, in whole and not in part at a price of $0.01 per warrant upon a minimum of 30 days’ notice after the warrants become exercisable, only in the event that the last sale price of the ordinary shares exceeds $11.50 per share for any 20 trading days within a 30-trading day period.\nThe purchased warrants are recognized in additional paid-in-capital within shareholders’ equity since, under the terms of the warrants, the Company cannot be required to settle or redeem them for cash.\nNOTE 4—RELATED PARTY TRANSACTIONS\nThe Company has agreed to pay Hambrecht-Eu Capital, a company owned and managed by the Company’s Chairman of the Board, Chief Financial Officer and Secretary, $7,500 per month for office space and general and administrative services including secretarial support commencing on November 15, 2007 and continuing (i) until the consummation by the Company of a business combination (as described in Note 1), (ii) 18 months from commencement of the Offering if the Company does not effect a Business Combination, (iii) 24 months from the consummation of the Offering if a letter of intent, agreement in principle or definitive agreement, has been executed within 18 months of commencement of the Offering and the Company has not effected a business combination, or (iv) 36 months from the consummation of the Offering if an extension has been approved by the Company’s shareholders under certain circumstances.\nAEX Enterprises Limited, W.R. Hambrecht + Co., LLC and the Hambrecht 1980 Revocable Trust, companies controlled by Elizabeth B. Hambrecht, wife of Robert Eu, one of the Company’s founders and the Company’s Chairman, Chief Financial Officer and Secretary and William R. Hambrecht, Robert Eu’s father-in-law, Shea Ventures LLC, a company controlled by Edmund H. Shea Jr. and Marbella Capital Partners Ltd., a company controlled by John Wang, our Chief Executive Officer, purchased an aggregate of 1,550,000 warrants at a price of $1.00 per warrant ($1,550,000 in the aggregate) in a private placement immediately prior to the initial public offering (“private placement warrants”). Elizabeth B. Hambrecht owns approximately 25% and William R. Hambrecht controls (through a trust of which he is trustee) approximately 38% of the voting shares of AEX Enterprises Limited. William Hambrecht is a controlling person of W.R. Hambrecht + Co., LLC and is the trustee of the Hambrecht 1980 Revocable Trust. The proceeds from the sale of the private placement warrants were added to the proceeds from the Offering and are held in the Trust Account pending the Company’s consummation of a Business Combination. If the Company does not complete a Business Combination that meets the criteria described in the Offering, then the $1,550,000 purchase price of the private placement warrants will become part of any liquidating distribution to the Company’s public shareholders following the Company’s liquidation and dissolution and the private placement warrants will expire worthless.\nThe private placement warrants will be non-redeemable so long as they are held by the original holders of the warrants, the pre-initial public offering shareholders and directors or their permitted transferees. In addition, pursuant to the registration rights agreement, the holders of the private placement warrants and the underlying ordinary shares will be entitled to certain registration rights immediately after the consummation of the initial business combination and the warrants may be exercised on a cashless basis if held by the original holder, the pre-initial public offering shareholder and director or their permitted transferees. With those exceptions, the private placement warrants have terms and provisions that are otherwise identical to those of the warrants sold as part of the units in the Offering.\nThe sale of private placement warrants did not result in the recognition of stock-based compensation expense because the private placement warrants were sold at or above fair market value.\nAEX Enterprises Limited, W.R. Hambrecht + Co., LLC, the Hambrecht 1980 Revocable Trust, Shea Ventures LLC and Marbella Capital Partners Ltd. have agreed, subject to certain exceptions, not to transfer, assign or sell any of its private placement warrants until after the Company consummates a Business Combination. However, prior to the consummation of a business combination, the original holders of the warrants will be permitted to transfer their private placement warrants in certain limited circumstances, such as to the Company’s officers and directors, and other persons or entities associated with such persons, but the transferees receiving such private placement warrants will be subject to the same sale restrictions imposed on such entity.\nF-12\nRobert Eu, one of the Company’s founders, had provided to the Company advances totaling approximately $282,000 to pay a portion of the expenses of the Offering for the SEC registration fee, FINRA registration fee, and accounting and legal fees and expenses. The note was payable on demand with interest at 4% per annum. The note, plus interest of approximately $5,000, was repaid out of the proceeds of the Offering on March 12, 2008.\nNOTE 5—FAIR VALUE MEASUREMENTS\nThe Company complies with Fair Value Measurements, for its financial assets and liabilities that are re-measured and reported at fair value at each reporting period, and non-financial assets and liabilities that are re-measured and reported at fair value at least annually.\nThe following tables present information about the Company’s assets that are measured at fair value on a recurring basis as of June 30, 2009 and December 31, 2008, and indicates the fair value hierarchy of the valuation techniques the Company utilized to determine such fair value. In general, fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities. Fair values determined by Level 2 inputs utilize data points that are observable such as quoted prices, interest rates and yield curves. Fair values determined by Level 3 inputs are unobservable data points for the asset or liability, and includes situations where there is little, if any, market activity for the asset or liability:\nFair Value of Financial Assets as of June 30, 2009\n| Description | June 30, 2009 | Quoted Prices in Active Markets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) |\n| Assets: |\n| Cash equivalents | $ | 30,271 | $ | 30,271 | $ | — | $ | — |\n| Cash equivalents held in Trust Account | 33,838,155 | 33,838,155 | — | — |\n| Total | $ | 33,868,426 | $ | 33,868,426 | $ | — | $ | — |\n\nFair Value of Financial Assets as of December 31, 2008\n| Description | December 31, 2008 | Quoted Prices in Active Markets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) |\n| Assets: |\n| Cash equivalents | $ | 100,312 | $ | 100,312 | $ | — | $ | — |\n| Cash equivalents held in Trust Account | 33,798,651 | 33,798,651 | — | — |\n| Total | $ | 33,898,963 | $ | 33,898,963 | $ | — | $ | — |\n\nF-13\nThe fair values of the Company’s cash equivalents and cash and cash equivalents held on the Trust Account are determined through market, observable and corroborated sources.\nNOTE 6— COMMITMENTS AND UNDERWRITERS’ COMPENSATION\nThe Company consummated the Offering on March 12, 2008 and paid to the underwriters a $1,120,000 underwriting fee, representing 3.5% of the gross proceeds, and is committed to pay up to an additional $1,120,000, currently held in the Trust Account, representing an additional deferred underwriting fee of 3.5%, payable upon the Company’s consummation of a Business Combination.\nOn March 31, 2008, the underwriters exercised their over-allotment option and purchased from the Company an additional 239,300 units. The Company paid to the underwriters a $67,004 underwriting discount, representing 3.5% of the over-allotment gross proceeds, and is committed to pay up to an additional $67,004, currently held in the Trust Account, representing an additional deferred underwriting discount of 3.5%, payable upon the Company’s consummation of a Business Combination.\nThe Company also issued and sold to the underwriters on the closing date an option, as an additional compensation to purchase up to an aggregate of 280,000 units for an aggregate purchase price of $100. The Option shall be exercisable, in whole or in part, commencing on the later of the consummation of a Business Combination or six months from March 7, 2008 and expiring on March 7, 2013 at an initial exercise price of $10.00 per Unit.\nThe Company has determined based upon a Black-Scholes- Merton option pricing model, that the estimated fair value of the option on the date of sale would be approximately $3.36 per unit or an aggregate of approximately $941,000, assuming an expected term of five years, estimated volatility of 51.51% and a risk-free interest rate of 3.38%. Given the parameters used in the computation of the value of the option change over time, the actual fair value of the option on the date of sale is expected to be different from the estimated fair value computed above.\nThe volatility calculation of 51.51% is based on the latest five year average prior to the Offering, volatility of 62 companies drawn from the Shanghai Stock Exchange Composite Index that had market capitalizations between $70 million and $150 million. Because the Company does not have a trading history, the Company estimated the potential volatility of its ordinary share price, which will depend on a number of factors which cannot be ascertained at this time. The Company used the annualized volatility of the historical volatilities for a period of time equal in length to the term of the option because the Company believes that the volatility of these companies is a reasonable benchmark to use in estimating the expected volatility for the Company’s ordinary share post-Business Combination. Although an expected life of five years was taken into account for purposes of assigning value to this option, if the Company does not consummate a Business Combination within the prescribed time period and liquidates, this option would become worthless.\nPursuant to Rule 2710(g)(1) of FINRA Conduct Rule, the option to purchase 280,000 units is deemed to be underwriting compensation and therefore upon exercise, the underlying ordinary shares and warrants are subject to a 180-day lock-up. Additionally, the option may not be sold, transferred, assigned, pledged or hypothecated for a one-year period (including the foregoing 180-day period) following the date of the Offering.\nNOTE 7 — GOING CONCERN\nOn September 4, 2009, the Company has issued a press release announcing that it has entered into a letter of intent with a company for a business combination. The target is a company with its principal business operations in the People’s Republic of China. Pursuant to the Company’s Amended and Restated Memorandum and Articles of Association, the execution of the letter of intent affords the Company a six-month extension for completion of a business combination, until March 12, 2010.\nF-14\nThe consummation of the business combination is subject to, among other things, execution of a definitive agreement and required stockholder approval. There can be no assurance that a business combination will be consummated. However, if we anticipate that we will not be able to consummate a business combination by March 12, 2010, we may seek shareholder approval to extend the period of time to consummate a business combination until March 12, 2011. If we are unable to complete the business combination by March 12, 2010, or March 12, 2011 if extension period approved, our purposes and powers will be limited to dissolving, liquidating and winding up. Also contained in our articles of association is the requirement that our board of directors, to the fullest extent permitted by law, consider a resolution to dissolve our company at that time. Consistent with such obligations, our board of directors will seek shareholder approval for any such plan of distribution, and our pre-initial public offering shareholders and directors have agreed to vote in favor of such dissolution and liquidation. This provision will be amended only in connection with, and upon consummation of, its initial business combination by such date. The accompanying financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern and is required to liquidate.\nF-15\n\n</text>\n\nWhat is the total capital generated by the company through various activities from July 18, 2007 to June 30, 2009, excluding net income and assuming the interest income re-invested in the trust account was paid out to increase capital instead of being reinvested, in USD?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1 Financial Statements\nFast Lane Holdings, Inc.\nBalance Sheet\n\n| As of March 31, 2019 (Unaudited) | As of December 31, 2018 |\n| TOTAL ASSETS | $ | - | $ | - |\n| LIABILITIES AND STOCKHOLDERS’ DEFICIT |\n| CURRENT LIABILITIES: |\n| Accrued expenses | $ | 300 | $ | 5,550 |\n| Total current liabilities | 300 | 5,550 |\n| TOTAL LIABILITIES | $ | 300 | $ | 5,550 |\n| STOCKHOLDERS' DEFICIT: |\n| Preferred stock ($.001 par value, 20,000,000 shares authorized, 5,000 issued and outstanding as of March 31, 2019 and December 31, 2018) | 5 | 5 |\n| Common stock ($.001 par value, 500,000,000 shares authorized, 72,948,316 issued and outstanding as of March 31, 2019 and December 31, 2018) | 72,948 | 72,948 |\n| Additional paid in capital | (66,401) | (72,648) |\n| Accumulated deficit | (6,852) | (5,855) |\n| Total Stockholders' deficit | (300) | (5,550) |\n| TOTAL LIABILITIES &STOCKHOLDERS’ DEFICIT | $ | - | $ | - |\n\nThe accompanying notes are an integral part of these unaudited financial statements.\n\n| 4 |\n\n\n| Fast Lane Holdings, Inc. Statement of Operations (Unaudited) |\n| For Three Months Ended March 31, 2019 |\n| Operating expenses |\n| General and administrative expenses | $ | 997 |\n| Total operating expenses | 997 |\n| Net loss | $ | (997) |\n| Basic and Diluted net loss per common share | $ | (0.00) |\n| Weighted average number of common shares outstanding - Basic and Diluted | 72,948,316 |\n\nThe accompanying notes are an integral part of these unaudited financial statements.\n\n| 5 |\n\n\n| Fast Lane Holdings, Inc. Statement of Changes in Stockholders' Deficit For the period from December 6, 2018 (date of inception) to March 31, 2019 (Unaudited) |\n| Preferred Shares (Series A) | Par Value Preferred Shares (Series A) | Common Shares | Par Value Common Shares | Additional Paid-in Capital | Accumulated Deficit | Total |\n| Date of Inception, December 6, 2018 | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - |\n| Shares issued in Reorganization | 5,000 | 5 | 72,948,316 | 72,948 | (72,953) | - | - |\n| Expenses paid on behalf of the Company and contributed to capital | - | - | - | - | 305 | - | 305 |\n| Net loss | - | - | - | - | (5,855) | (5,855) |\n| Balances, December 31, 2018 | 5,000 | $ | 5 | 72,948,316 | $ | 72,948 | $ | (72,648) | $ | (5,855) | $ | (5,550) |\n| Expenses paid on behalf of the Company and contributed to capital | - | - | - | - | 6,247 | - | 6,247 |\n| Net loss | - | - | - | - | - | (997) | (997) |\n| Balances, March 31, 2019 | 5,000 | $ | 5 | 72,948,316 | $ | 72,948 | $ | (66,401) | $ | (6,852) | $ | (300) |\n\nThe accompanying notes are an integral part of these unaudited financial statements.\n\n| 6 |\n\nFast Lane Holdings, Inc.\nStatement of Cash Flows\n(Unaudited)\n\n| For the Three Months Ended March 31, 2019 |\n| CASH FLOWS FROM OPERATING ACTIVITIES |\n| Net loss | $ | (997) |\n| Adjustment to reconcile net loss to net cash used in operating activities: |\n| Expenses contributed to capital | 6,247 |\n| Changes in current assets and liabilities: |\n| Accrued expenses | (5,250) |\n| Net cash used in operating activities | - |\n| Net change in cash | $ | - |\n| Beginning cash balance | - |\n| Ending cash balance | $ | - |\n| SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: |\n| Interest paid | $ | - |\n| Income taxes paid | $ | - |\n\nThe accompanying notes are an integral part of these unaudited financial statements.\n\n| 7 |\n\nFast Lane Holdings, Inc.\nNotes to Unaudited Financial Statements\nNote 1 – Organization and Description of Business\nFast Lane Holdings, Inc. (we, us, our, or the \"Company\") was incorporated on December 6, 2018 in the State of Delaware. The Company was created for the sole purpose of participating in a Delaware holding company reorganization with Giant Motorsports Delaware Inc. (“GMOS Delaware”), a Delaware corporation incorporated on December 6, 2018 and parent company of Fast Lane Holding, Inc. and Giant Motorsports Merger Sub, Inc., a Delaware corporation incorporated on December 6, 2018 and a wholly owned subsidiary of Fast Lane Holdings, Inc. pursuant to Section 251(g) of the General Corporation Law of the state of Delaware, (the “DGCL”).\nOn December 6, 2018, Paul Moody was appointed Chief Executive Officer, Chief Financial Officer, and Director of Fast Lane Holdings, Inc., Giant Motorsports Delaware, Inc. and Giant Motorsports Merger Sub, Inc.\nOn December 28, 2018, Giant Motorsports, Inc. (“GMOS Nevada”), a Nevada corporation merged with and into GMOS Delaware, a wholly owned subsidiary of GMOS Nevada with GMOS Delaware as the surviving corporation. The sole purpose to merge GMOS Nevada with and into GMOS Delaware was to re-domesticate GMOS Nevada from Nevada to Delaware.\nOn December 28, 2018, Giant Motorsports Delaware, Inc. completed a holding company reorganization pursuant to Section 251(g) of the DGCL by merging with and into its indirect wholly owned subsidiary known as Giant Motorsports Merger Sub, Inc. with Giant Motorsports Delaware, Inc. as the surviving corporation and becoming a wholly owned subsidiary of Fast Lane Holdings, Inc. Fast Lane Holdings, Inc. as successor issuer to Giant\nMotorsports, Inc. continued to trade in the OTC MarketPlace under the previous ticker symbol “GMOS” until the new ticker symbol “FLHI” for the Company was released into the OTC MarketPlace on January 10, 2019. Concurrently, the Company cancelled all of its stock held in GMOS Delaware.\nThe Company intends to serve as a vehicle to affect an asset acquisition, merger, exchange of capital stock or other business combination with a domestic or foreign business. As of December 31, 2018, the Company had not yet commenced any operations.\nThe Company has elected December 31st as its year end.\nNote 2 – Summary of Significant Accounting Policies\nBasis of Presentation\nThis summary of significant accounting policies is presented to assist in understanding the Company's financial statements. These accounting policies conform to accounting principles, generally accepted in the United States of America, and have been consistently applied in the preparation of the financial statements.\nUse of Estimates\nThe preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. In the opinion of management, all adjustments necessary in order to make the financial statements not misleading have been included. Actual results could differ from those estimates.\nCash and Cash Equivalents\nThe Company considers all highly liquid investments with an original maturity of three months or less when purchased to be cash equivalents. Cash and cash equivalents at March 31, 2019 and December 31, 2018 were $0 for both periods.\n\n| 8 |\n\nIncome Taxes\nThe Company accounts for income taxes under ASC 740, “Income Taxes.” Under the asset and liability method of ASC 740, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statements carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period the enactment occurs. A valuation allowance is provided for certain deferred tax assets if it is more likely than not that the Company will not realize tax assets through future operations. No deferred tax assets or liabilities were recognized at March 31, 2019 and December 31, 2018.\nBasic Earnings (Loss) Per Share\nThe Company computes basic and diluted earnings (loss) per share in accordance with ASC Topic 260, Earnings per Share. Basic earnings (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the reporting period. Diluted earnings (loss) per share reflects the potential dilution that could occur if stock options and other commitments to issue common stock were exercised or equity awards vest resulting in the issuance of common stock that could share in the earnings of the Company.\nThe Company does not have any potentially dilutive instruments as of March 31, 2019 and, thus, anti-dilution issues are not applicable.\nFair Value of Financial Instruments\nThe Company’s balance sheet includes certain financial instruments. The carrying amounts of current assets and current liabilities approximate their fair value because of the relatively short period of time between the origination of these instruments and their expected realization.\nASC 820, Fair Value Measurements and Disclosures, defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820 also establishes a fair value hierarchy that distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are described below:\n- Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.\n- Level 2 - Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, including quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates); and inputs that are derived principally from or corroborated by observable market data by correlation or other means.\n- Level 3 - Inputs that are both significant to the fair value measurement and unobservable.\nFair value estimates discussed herein are based upon certain market assumptions and pertinent information available to management as of March 31, 2019. The respective carrying value of certain on-balance-sheet financial instruments approximated their fair values due to the short-term nature of these instruments. These financial instruments include accrued expenses.\n\n| 9 |\n\nRelated Parties\nThe Company follows ASC 850, Related Party Disclosures, for the identification of related parties and disclosure of related party transactions.\nShare-Based Compensation\nASC 718, “Compensation – Stock Compensation”, prescribes accounting and reporting standards for all share-based payment transactions in which employee services are acquired. Transactions include incurring liabilities, or issuing or offering to issue shares, options, and other equity instruments such as employee stock ownership plans and stock appreciation rights. Share-based payments to employees, including grants of employee stock options, are recognized as compensation expense in the financial statements based on their fair values. That expense is recognized over the period during which an employee is required to provide services in exchange for the award, known as the requisite service period (usually the vesting period).\nThe Company accounts for stock-based compensation issued to non-employees and consultants in accordance with the provisions of ASC 505-50, “Equity – Based Payments to Non-Employees.” Measurement of share-based payment transactions with non-employees is based on the fair value of whichever is more reliably measurable: (a) the goods or services received; or (b) the equity instruments issued. The fair value of the share-based payment transaction is determined at the earlier of performance commitment date or performance completion date.\nThe Company had no stock-based compensation plans as of March 31, 2019.\nThe Company’s stock based compensation for the periods ended March 31, 2019 and December 31, 2018 was $0 for both periods.\nRecently Issued Accounting Pronouncements\nIn February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). ASU 2016-02 is amended by ASU 2018-01, ASU2018-10, ASU 2018-11, ASU 2018-20 and ASU 2019-01, which FASB issued in January 2018, July 2018, July 2018, December 2018 and March 2019, respectively (collectively, the amended ASU 2016-02). The amended ASU 2016-02 requires lessees to recognize on the balance sheet a right-of-use asset, representing its right to use the underlying asset for the lease term, and a lease liability for all leases with terms greater than 12 months. The recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee have not significantly changed from current GAAP. The amended ASU 2016-02 retains a distinction between finance leases (i.e. capital leases under current GAAP) and operating leases. The classification criteria for distinguishing between finance leases and operating leases will be substantially similar to the classification criteria for distinguishing between capital leases and operating leases under current GAAP. The amended ASU 2016-02 also requires qualitative and quantitative disclosures designed to assess the amount, timing, and uncertainty of cash flows arising from leases. A modified retrospective transition approach is permitted to be used when an entity adopts the amended ASU 2016-02, which includes a number of optional practical expedients that entities may elect to apply.\nWe have no assets and or leases and do not believe we will be impacted in the foreseeable future by the newly adopted accounting standard(s) mentioned above.\nThe Company has implemented all new accounting pronouncements that are in effect and that may impact its financial statements and does not believe that there are any other new pronouncements that have been issued that might have a material impact on its financial position or results of operations.\nNote 3 – Going Concern\nThe Company’s financial statements are prepared in accordance with generally accepted accounting principles applicable to a going concern that contemplates the realization of assets and liquidation of liabilities in the normal course of business.\nThe Company demonstrates adverse conditions that raise substantial doubt about the Company's ability to continue as a going concern for one year following the issuance of these financial statements. These adverse conditions are negative financial trends, specifically operating loss, working capital deficiency, and other adverse key financial ratios.\nThe Company has not established any source of revenue to cover its operating costs. Management plans to fund operating expenses with related party contributions to capital. There is no assurance that management's plan will be successful. The financial statements do not include any adjustments relating to the recoverability and classification of recorded assets, or the amounts and classification of liabilities that might be necessary in the event that the Company cannot continue as a going concern.\nNote 4 – Income Taxes\nThe Company has not recognized an income tax benefit for its operating losses generated based on uncertainties concerning its ability to generate taxable income in future periods. The tax benefit for the period presented is offset by a valuation allowance established against deferred tax assets arising from the net operating losses, the realization of which could not be considered more likely than not. In future periods, tax benefits and related deferred tax assets will be recognized when management considers realization of such amounts to be more likely than not. As of March 31, 2019, the Company has incurred a net loss of approximately $6,852 which resulted in a net operating loss for income tax purposes. The loss results in a deferred tax asset of approximately $1,439 at the effective statutory rate of 21%. The deferred tax asset has been off-set by an equal valuation allowance. Given our inception on December 6, 2018, and our fiscal year end of December 31, 2018, we have completed only one taxable fiscal year.\nNote 5 – Commitments and Contingencies\nThe Company follows ASC 450-20, Loss Contingencies, to report accounting for contingencies. Liabilities for loss contingencies arising from claims, assessments, litigation, fines and penalties and other sources are recorded when it is probable that a liability has been incurred and the amount of the assessment can be reasonably estimated. There were no commitments or contingencies as of March 31, 2019.\nNote 6 – Accrued Expenses\nAccrued expenses totaled $300 as of March 31, 2019 and $5,550 as of December 31, 2018 and consisted primarily of professional fees for both periods.\nNote 7 – Shareholder Equity\nPreferred Stock\nThe authorized preferred stock of the Company consists of 20,000,000 shares with a par value of $0.001. There are 5,000,000 shares of Series “A” convertible Preferred Stock issued and outstanding as of March 31, 2019 and December 31, 2018.\nOn June 29, 2018, the Company issued 2,550 shares of Series “A” convertible Preferred Stock to Giant Consulting Services, LLC (“GCS”), a Wyoming Limited Liability Company, for helping the Company locate an acquisition or merger candidate. Jeffrey DeNunzio is the controlling member and Paul Moody, our sole director, is the Manager of GCS. The preferred stock is convertible into one share of common stock. The preferred stock has no voting rights in the Company other than the right to vote upon a change to its class rights, privileges or designations by the majority vote of the Series “A” convertible preferred class shareholders. The Board of Directors may, in the future, issue additional classes of preferred stock which shall have attributes and rights as determined by the Board of Directors at that time.\nCommon Stock\nThe authorized common stock of the Company consists of 500,000,000 shares with a par value of $0.001. There were 72,948,316 shares of common stock issued and outstanding as of March 31, 2019 and December 31, 2018.\nOn June 29, 2018, 60,000,000 common shares were issued by GMOS Nevada to GCS for development of the Company’s business plan.\nOn December 28, 2018, each share of capital stock of GMOS Delaware issued and outstanding immediately prior to the holding company reorganization was automatically converted into one fully paid and non-assessable share of capital stock of the Company.\nThe outstanding common shares were originally issued by GMOS Nevada prior to reorganization and are now listed as converted shares for the Company.\nAdditional Paid-In Capital\nThe Company’s sole officer and director, Paul Moody, paid expenses on behalf of the company totaling $305 as of December 31, 2018. During the three months ended March 31, 2019, Mr. Moody paid expenses on behalf of the company totaling $6,247. The $6,552 in total payments are considered a contribution to the company with no expectation of repayment and is posted as additional paid-in capital.\nNote 8 – Related-Party Transactions\nOffice Space\nWe utilize the home office space and equipment of our management at no cost.\nNote 9 – Subsequent Events\nManagement has reviewed financial transactions for the Company subsequent to the quarter ended March 31, 2019 and has found that there was nothing material to disclose.\n\n| 10 |\n\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations is designed to provide a reader of the financial statements with a narrative report on our financial condition, results of operations, and liquidity. This discussion and analysis should be read in conjunction with the attached unaudited Financial Statements and notes thereto and our Registration Statement on Form 10-12G, which contains audited Financial Statements and notes thereto for the period ended December 31, 2018. The following discussion contains forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations, and intentions. Our actual results could differ materially from those discussed in the forward-looking statements. Please also see the cautionary language at the beginning of this Quarterly Report regarding forward-looking statements.\nCorporate History\nFast Lane Holdings, Inc. (we, us, our, or the \"Company\") was incorporated on December 6, 2018 in the State of Delaware. The Company was created for the sole purpose of participating in a Delaware holding company reorganization pursuant to Section 251(g) of the General Corporation Law of the state of Delaware, (the “DGCL”) with Giant Motorsports Delaware Inc. (“GMOS Delaware”), a Delaware corporation incorporated on December 6, 2018 and parent company of Fast Lane Holdings, Inc.; and Giant Motorsports Merger Sub, Inc., a Delaware corporation incorporated on December 6, 2018 and a wholly owned subsidiary of Fast Lane Holdings, Inc. .\nOn December 6, 2018, Paul Moody was appointed Chief Executive Officer, Chief Financial Officer, and Director of Fast Lane Holdings, Inc., Giant Motorsports Delaware, Inc. and Giant Motorsports Merger Sub, Inc.\nOn December 28, 2018, Giant Motorsports, Inc. (“GMOS Nevada”), a Nevada corporation merged with and into GMOS Delaware, a wholly owned subsidiary of GMOS Nevada with GMOS Delaware as the surviving corporation. The sole purpose to merge GMOS Nevada with and into GMOS Delaware was to re-domesticate GMOS Nevada from Nevada to Delaware.\nOn December 28, 2018, Giant Motorsports Delaware, Inc. completed the holding company reorganization by merging with and into its indirect wholly owned subsidiary known as Giant Motorsports Merger Sub, Inc. with Giant Motorsports Delaware, Inc. as the surviving corporation and becoming a wholly owned subsidiary of Fast Lane Holdings, Inc. Fast Lane Holdings, Inc. as successor issuer to Giant Motorsports, Inc. continued to trade in the OTC MarketPlace under the previous ticker symbol “GMOS” until the new ticker symbol “FLHI” for the Company was released into the OTC MarketPlace on January 10, 2019. The Company was given a new CUSIP Number by CUSIP Global Services for its common stock of 31189D109. Concurrently, the Company cancelled all of its stock held in GMOS Delaware resulting in GMOS Delaware becoming a stand-alone company.\nThe Company intends to serve as a vehicle to affect an asset acquisition, merger, exchange of capital stock or other business combination with a domestic or foreign business. As of December 31, 2018, the Company had not yet commenced any operations.\n| 11 |\n\nBusiness Overview\nThe Company, based on current and proposed business activities, is considered a “blank check” company. The SEC defines a “blank check” company as “any development stage company that is issuing a penny stock, within the meaning of Section 3(a)(51)-1 of the Exchange Act, and that has no specific business plan or purpose, or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies or other entity or person.” Pursuant to Rule 12b-2 promulgated under the Exchange Act, the Company also qualifies as a shell company, because it has no or nominal assets (other than cash) and no or nominal operations. In addition, many states have enacted statutes, rules, and regulations limiting the sale of securities of “blank check” companies in their respective jurisdictions.\nIn addition, the Company is an “emerging growth company” (“EGC”), that is exempt from certain financial disclosure and governance requirements for up to five years as defined in the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), that eases restrictions on the sale of securities, and increases the number of stockholders a company must have before becoming subject to the SEC’s reporting and disclosure rules. We have elected to use the extended transition period for complying with new or revised accounting standards under Section 102(b)(2) of the Jobs Act, that allows us to delay the adoption of new or revised accounting standards that have different effective dates for public and private companies until those standards apply to private companies. As a result of this election, our financial statements may not be comparable to companies that comply with public company effective dates.\nThe Company intends to serve as a vehicle to affect an asset acquisition, merger, exchange of capital stock or other business combination with a domestic or foreign business. As of December 31, 2018 and March 31, 2019, the Company had not yet commenced any substantive operations.\nWe do not currently engage in any business activities that provide cash flow. The costs of investigating and analyzing business combinations and opportunities for the next 12 months and beyond such time will be paid with money in our treasury, if any, or with additional amounts, as necessary, to be loaned to or invested in us by our stockholders, management, or other investors. At this time, we are entirely reliant upon cash contributions made by our officers and directors to pay for any and all expenses.\n\n| 12 |\n\nWe have negative working capital, a stockholder deficit, and have no source of revenues. These conditions raise substantial doubt about our ability to continue as a going concern. For the foreseeable future, we will be devoting our efforts to exploring and evaluating business opportunities, which may include merger or acquisition candidates. Our ability to continue as a going concern is dependent upon our ability to develop additional sources of capital, locate and complete a merger with another company or otherwise commence business operations, and ultimately, achieve profitable operations.\nLiquidity and Capital Resources\nWe have no known demands or commitments and are not aware of any events or uncertainties as of March 31, 2019 that will result in or that are reasonably likely to materially increase or decrease our current liquidity.\nAs of March 31, 2019, the Company had no assets. The Company’s current liabilities as March 31, 2019 totaled $250, which consisted of accrued expenses.\nThe Company had no cash flows from operating activities for the three months ended March 31, 2019. The Company has generated no revenues since inception. The Company is dependent upon the receipt of capital investment or other financing to fund its ongoing operations and to execute its business plan. In addition, the Company is dependent upon certain related parties to provide continued funding and capital resources. If continued funding and capital resources are unavailable at reasonable terms, the Company may not be able to implement its plan of operations. The Company can provide no assurance that it can continue to satisfy its cash requirements for at least the next twelve months.\nResults of Operations\nThe Company has not conducted any substantive operations since inception. The Company intends to serve as a vehicle to affect an asset acquisition, merger, exchange of capital stock or other business combination with a domestic or foreign business.\nFor the three months ended March 31, 2019, the Company had a net loss of $922, which consisted of general and administrative expenses.\nOff-Balance Sheet Arrangements\nWe do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources that is material to investors.\n\n| 13 |\n\nEmerging Growth Company\nAs an EGC under the JOBS Act, the Company has elected to use the extended transition period for complying with new or revised accounting standards under Section 102(b)(1) of the JOBS Act. This election allows us to delay the adoption of new or revised accounting standards that have different effective dates for public and private companies until those standards apply to private companies. As a result of our election, our financial statements may not be comparable to companies that comply with public company effective dates.\n\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide the information required by this Item.\n\nEvaluation of Disclosure Controls and Procedures\nPaul Moody is our sole officer and director.\nUnder the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, Paul Moody, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of March 31, 2019, the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer, Paul Moody, concluded that because of material weakness in our internal control over financial reporting, our disclosure controls and procedures were not effective as of March 31, 2019.\nDisclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act, is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitations, controls and procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and our principal financial officer, to allow timely decisions regarding required disclosure.\nChances in Internal Control over Financial Reporting\nDuring the fiscal quarter ended March 31, 2019, there was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\n\n| 14 |\n\nPART II OTHER INFORMATION\n\nItem 1. Legal Proceedings\nThere are no material pending legal proceedings as defined by Item 103 of Regulation S-K, to which we are a party or of which any of our property is the subject, other than ordinary routine litigation incidental to the Company’s business.\n\nItem 1A. Risk Factors\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide the information required by this Item.\n\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nNone.\n\nItem 3. Defaults Upon Senior Securities\nNone.\n\nItem 4. Mine Safety Disclosures\nNone.\n\nItem 5. Other Information\nNone.\n\n| 15 |\n\n\nItem 6. Exhibits\nThe following exhibits are filed herewith as a part of this report.\n\n| Exhibit Number | Description |\n| 3.1 | Certificate of Incorporation, which was filed as Exhibit 3.1 to our Registration Statement on Form 10-12G/A filed with the Securities and Exchange Commission on April 24, 2019, and is incorporated herein by reference thereto. |\n| 3.2 | Bylaws, which were filed as Exhibit 3.2 to our Registration Statement on Form 10-12G/A filed with the Securities and Exchange Commission on April 24, 2019, and is incorporated herein by reference thereto. |\n| 31.1 | Certification of Chief Executive Officer and Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934* |\n| 32.1 | Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of Chapter 63 of Title 18 of the United States Code* |\n| 101.INS | XBRL Instance Document * |\n| 101.SCH | XBRL Taxonomy Extension Schema Document * |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document * |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document * |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document * |\n| 101.PRE | XBRL Taxonomy Presentation Linkbase Document * |\n\n*filed herewith\n\n| 16 |\n\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| Fast Lane HOLDINGS, INC. |\n| Date: May 10, 2019 | By: | /s/ Paul Moody |\n| Paul Moody |\n| Chief Executive Officer, and Chief Financial Officer |\n\n17\n\n</text>\n\nWhat is the percentage change in the company's net operating loss for income tax purposes from December 31, 2018 to March 31, 2019?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nPart 1. Financial Information.\nItem 1. Financial Statements.\n\n| March 31, 2019 | December 31, 2018* |\n| ASSETS |\n| Investments: |\n| Investments available for sale: |\n| Fixed maturities, at fair value (amortized cost $158,812,233 and $160,895,869) | $ | 163,906,663 | $ | 160,960,784 |\n| Equity securities, at fair value (cost $34,883,412 and $34,885,107) | 82,450,417 | 67,664,482 |\n| Equity securities, at cost | 12,133,745 | 12,118,617 |\n| Mortgage loans on real estate at amortized cost | 10,703,553 | 9,069,111 |\n| Investment real estate | 51,530,162 | 52,518,577 |\n| Notes receivable | 26,595,336 | 23,717,312 |\n| Policy loans | 9,117,979 | 9,204,222 |\n| Total investments | 356,437,855 | 335,253,105 |\n| Cash and cash equivalents | 19,049,555 | 20,150,162 |\n| Accrued investment income | 1,887,094 | 2,119,882 |\n| Reinsurance receivables: |\n| Future policy benefits | 26,091,199 | 26,117,936 |\n| Policy claims and other benefits | 4,142,345 | 4,053,882 |\n| Cost of insurance acquired | 5,428,250 | 5,622,227 |\n| Property and equipment, net of accumulated depreciation | 581,680 | 688,567 |\n| Income tax receivable | - | 279,333 |\n| Other assets | 355,673 | 1,263,242 |\n| Total assets | $ | 413,973,651 | $ | 395,548,336 |\n| LIABILITIES & SHAREHOLDERS' EQUITY |\n| Liabilities: |\n| Policy liabilities and accruals: |\n| Future policyholder benefits | $ | 252,418,038 | $ | 253,852,368 |\n| Policy claims and benefits payable | 4,335,480 | 4,267,481 |\n| Other policyholder funds | 430,413 | 372,072 |\n| Dividend and endowment accumulations | 14,586,502 | 14,608,838 |\n| Income taxes payable | 333,283 | - |\n| Deferred income taxes | 13,231,079 | 9,113,480 |\n| Other liabilities | 6,105,232 | 6,257,387 |\n| Total liabilities | 291,440,027 | 288,471,626 |\n| Shareholders' equity: |\n| Common stock - no par value, stated value $.001 per share. Authorized 7,000,000 shares - 3,296,547 and 3,295,870 shares outstanding | 3,297 | 3,296 |\n| Additional paid-in capital | 36,585,277 | 36,567,865 |\n| Retained earnings | 81,353,780 | 69,708,901 |\n| Accumulated other comprehensive income | 3,949,134 | 62,495 |\n| Total UTG shareholders' equity | 121,891,488 | 106,342,557 |\n| Noncontrolling interests | 642,136 | 734,153 |\n| Total shareholders' equity | 122,533,624 | 107,076,710 |\n| Total liabilities and shareholders' equity | $ | 413,973,651 | $ | 395,548,336 |\n\n| Three Months Ended |\n| March 31, | March 31, |\n| 2019 | 2018 |\n| Revenue: |\n| Premiums and policy fees | $ | 2,503,205 | $ | 2,649,971 |\n| Ceded reinsurance premiums and policy fees | (517,055 | ) | (738,965 | ) |\n| Net investment income | 3,112,024 | 3,068,118 |\n| Other income | 63,838 | 60,935 |\n| Revenue before net investment gains (losses) | 5,162,012 | 5,040,059 |\n| Net investment gains (losses): |\n| Other-than-temporary impairments | - | - |\n| Other realized investment gains, net | 1,113,698 | 534,242 |\n| Change in fair value of equity securities | 14,787,631 | 4,129,236 |\n| Total net investment gains (losses) | 15,901,329 | 4,663,478 |\n| Total revenue | 21,063,341 | 9,703,537 |\n| Benefits and other expenses: |\n| Benefits, claims and settlement expenses: |\n| Life | 3,427,200 | 4,168,794 |\n| Ceded reinsurance benefits and claims | (474,622 | ) | (688,412 | ) |\n| Annuity | 197,670 | 256,884 |\n| Dividends to policyholders | 103,599 | 126,999 |\n| Commissions and amortization of deferred policy acquisition costs | (24,542 | ) | (40,571 | ) |\n| Amortization of cost of insurance acquired | 193,977 | 201,516 |\n| Operating expenses | 2,144,389 | 2,085,819 |\n| Total benefits and other expenses | 5,567,671 | 6,111,029 |\n| Income before income taxes | 15,495,670 | 3,592,508 |\n| Income tax expense | 3,697,058 | 905,763 |\n| Net income | 11,798,612 | 2,686,745 |\n| Net income attributable to noncontrolling interests | (153,733 | ) | (29,500 | ) |\n| Net income attributable to common shareholders | $ | $ 11,644,879 | $ | $ 2,657,245 |\n| Amounts attributable to common shareholders |\n| Basic income per share | $ | $ 3.53 | $ | $ 0.80 |\n| Diluted income per share | $ | $ 3.53 | $ | $ 0.80 |\n| Basic weighted average shares outstanding | 3,297,353 | 3,325,111 |\n| Diluted weighted average shares outstanding | 3,297,353 | 3,325,111 |\n\n| Three Months Ended |\n| March 31, | March 31, |\n| 2019 | 2018 |\n| Net income | $ | 11,798,612 | $ | 2,686,745 |\n| Other comprehensive income (loss): |\n| Unrealized holding gains (losses) arising during period, pre-tax | 4,934,851 | (4,285,303 | ) |\n| Tax (expense) benefit on unrealized holding gains (losses) arising during the period | (1,036,319 | ) | 899,914 |\n| Unrealized holding gains (losses) arising during period, net of tax | 3,898,532 | (3,385,389 | ) |\n| Less reclassification adjustment for gains included in net income | (15,055 | ) | - |\n| Tax expense for gains included in net income | 3,162 | - |\n| Reclassification adjustment for gains included in net income, net of tax | (11,893 | ) | - |\n| Subtotal: Other comprehensive income (loss), net of tax | 3,886,639 | (3,385,389 | ) |\n| Comprehensive income (loss) | 15,685,251 | (698,644 | ) |\n| Less comprehensive income attributable to noncontrolling interests | (153,733 | ) | (29,500 | ) |\n| Comprehensive income (loss) attributable to UTG, Inc. | $ | 15,531,518 | $ | (728,144 | ) |\n\n| Common Stock | Additional Paid-In Capital | Retained Earnings | Accumulated Other Comprehensive Income | Noncontrolling Interest | Total Shareholders' Equity |\n| Balance at December 31, 2018 | $ | 3,296 | 36,567,865 | 69,708,901 | 62,495 | 734,153 | $ | 107,076,710 |\n| Common stock issued during year | 8 | 229,792 | - | - | - | 229,800 |\n| Treasury shares acquired | (7 | ) | (212,380 | ) | - | - | - | (212,387 | ) |\n| Net income attributable to common shareholders | - | - | 11,644,879 | - | - | 11,644,879 |\n| Unrealized holding income on securities net of noncontrolling interest and reclassification adjustment and taxes | - | - | - | 3,886,639 | - | 3,886,639 |\n| Contributions | - | - | - | - | - | - |\n| Distributions | - | - | - | - | (245,750 | ) | (245,750 | ) |\n| Gain attributable to noncontrolling interest | - | - | - | - | 153,733 | 153,733 |\n| Balance at March 31, 2019 | $ | 3,297 | 36,585,277 | 81,353,780 | 3,949,134 | 642,136 | $ | 122,533,624 |\n| Common Stock | Additional Paid-In Capital | Retained Earnings | Accumulated Other Comprehensive Income | Noncontrolling Interest | Total Shareholders' Equity |\n| Balance at December 31, 2017 | $ | 3,333 | 37,536,164 | 39,040,456 | 32,952,338 | 899,227 | $ | 110,431,518 |\n| Adoption of Accounting Standards Update No 2016-01 | - | - | 18,277,328 | (18,277,328 | ) | - | - |\n| January 1, 2018 | 3,333 | 37,536,164 | 57,317,784 | 14,675,010 | 899,227 | 110,431,518 |\n| Common stock issued during year | 9 | 229,991 | - | - | - | 230,000 |\n| Treasury shares acquired | (24 | ) | (600,216 | ) | - | - | - | (600,240 | ) |\n| Net income attributable to common shareholders | - | - | 2,657,245 | - | - | 2,657,245 |\n| Unrealized holding income on securities net of noncontrolling interest and reclassification adjustment and taxes | - | - | - | (3,385,389 | ) | - | (3,385,389 | ) |\n| Contributions | - | - | - | - | - | - |\n| Distributions | - | - | - | - | (146 | ) | (146 | ) |\n| Gain attributable to noncontrolling interest | - | - | - | - | 29,500 | 29,500 |\n| Balance at March 31, 2018 | $ | 3,318 | 37,165,939 | 59,975,029 | 11,289,621 | 928,581 | $ | 109,362,488 |\n\n| Three Months Ended |\n| March 31, | March 31, |\n| 2019 | 2018 |\n| Cash flows from operating activities: |\n| Net income attributable to common shareholders | $ | 11,644,879 | $ | 2,657,245 |\n| Adjustments to reconcile net income to net cash used in operating activities: |\n| Amortization (accretion) of investments | (39,703 | ) | 17,036 |\n| Realized investment gains, net | (1,113,698 | ) | (534,242 | ) |\n| Change in fair value of equity securities | (14,787,631 | ) | (4,129,236 | ) |\n| Amortization of cost of insurance acquired | 193,977 | 201,516 |\n| Depreciation | 323,406 | 275,143 |\n| Net income attributable to noncontrolling interest | 153,733 | 29,500 |\n| Charges for mortality and administration of universal life and annuity products | (1,619,743 | ) | (1,650,201 | ) |\n| Interest credited to account balances | 1,029,303 | 883,563 |\n| Change in accrued investment income | 232,788 | (357,576 | ) |\n| Change in reinsurance receivables | (61,726 | ) | 35,546 |\n| Change in policy liabilities and accruals | (772,518 | ) | (6,961 | ) |\n| Change in income taxes receivable (payable) | 612,616 | 12,974 |\n| Change in other assets and liabilities, net | 3,839,857 | 5,894,257 |\n| Net cash provided by (used in) operating activities | (364,460 | ) | 3,328,564 |\n| Cash flows from investing activities: |\n| Proceeds from investments sold and matured: |\n| Fixed maturities available for sale | 2,023,974 | 14,515 |\n| Equity securities | 33,075 | 103,298 |\n| Mortgage loans | 1,945,760 | 2,009,715 |\n| Real estate | 3,045,226 | 7,941,649 |\n| Notes receivable | 1,537,984 | 563,926 |\n| Policy loans | 410,831 | 366,847 |\n| Short-term investments | - | 850,000 |\n| Total proceeds from investments sold and matured | 8,996,850 | 11,849,950 |\n| Cost of investments acquired: |\n| Fixed maturities available for sale | - | (4,971,517 | ) |\n| Equity securities | (46,509 | ) | (7,957,471 | ) |\n| Mortgage loans | (3,575,500 | ) | - |\n| Real estate | (1,174,688 | ) | (6,006,130 | ) |\n| Notes receivable | (4,416,008 | ) | - |\n| Policy loans | (324,587 | ) | (405,337 | ) |\n| Short-term investments | - | (850,000 | ) |\n| Total cost of investments acquired | (9,537,292 | ) | (20,190,455 | ) |\n| Net cash used in investing activities | (540,442 | ) | (8,340,505 | ) |\n| Cash flows from financing activities: |\n| Policyholder contract deposits | 1,264,011 | 1,149,533 |\n| Policyholder contract withdrawals | (1,231,379 | ) | (1,245,743 | ) |\n| Purchase of treasury stock | (212,387 | ) | (600,240 | ) |\n| Issuance of stock | 229,800 | 230,000 |\n| Non controlling contributions (distributions) of consolidated subsidiary | (245,750 | ) | (146 | ) |\n| Net cash used in financing activities | (195,705 | ) | (466,596 | ) |\n| Net decrease in cash and cash equivalents | (1,100,607 | ) | (5,478,537 | ) |\n| Cash and cash equivalents at beginning of period | 20,150,162 | 25,434,199 |\n| Cash and cash equivalents at end of period | $ | 19,049,555 | $ | 19,955,662 |\n\nUTG, Inc. Notes to Condensed Consolidated Financial Statements\nNote 1 – Basis of Presentation\nThe accompanying Condensed Consolidated Balance Sheet as of December 31, 2018, which has been derived from audited consolidated financial statements, and the unaudited interim Condensed Consolidated Financial Statements include the accounts of UTG, Inc. (the “Parent”) and its subsidiaries (collectively with the Parent, the “Company”). All significant intercompany accounts and transactions have been eliminated in consolidation. The accompanying Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 8 of regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for audited annual financial statements. The information furnished includes all adjustments and accruals of a normal recurring nature, which in the opinion of Management, are necessary for a fair presentation of the results for the interim periods. The unaudited Condensed Consolidated Financial Statements included herein and these related notes should be read in conjunction with the Company’s consolidated financial statements, and the notes thereto, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018. The Company’s results of operations for the three-month period ended March 31, 2019 are not necessarily indicative of the results that may be expected for the year ending December 31, 2019 or for any other future period.\nThis document at times will refer to the Registrant’s largest shareholder, Mr. Jesse T. Correll and certain companies controlled by Mr. Correll. Mr. Correll holds a majority ownership of First Southern Funding, LLC (“FSF”), a Kentucky corporation, and First Southern Bancorp, Inc. (“FSBI”), a financial services holding company. FSBI operates through its 100% owned subsidiary bank, First Southern National Bank (“FSNB”). Banking activities are conducted through multiple locations within south-central and western Kentucky. Mr. Correll is Chief Executive Officer and Chairman of the Board of Directors of UTG and is currently UTG’s largest shareholder through his ownership control of FSF, FSBI and affiliates. At March 31, 2019, Mr. Correll owns or controls directly and indirectly approximately 65.26% of UTG’s outstanding stock. UTG’s life insurance subsidiary, Universal Guaranty Life Insurance Company (“UG”), has several wholly-owned and majority-owned subsidiaries. The subsidiaries were formed to hold certain real estate investments. The real estate investments were placed into the limited liability companies and partnerships to provide additional protection to the policyholders and to UG.\nNote 2 – Recently Issued Accounting Standards\nDuring the three months ended March 31, 2019, there were no additions to or changes in the critical accounting policies disclosed in the 2018 Form 10-K.\nNote 3 – Investments Available for Sale Securities – Fixed Maturity Securities The Company’s insurance subsidiary is regulated by insurance statutes and regulations as to the type of investments they are permitted to make, and the amount of funds that may be used for any one type of investment.\n| March 31, 2019 | Original or Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Fair Value |\n| Investments available for sale: |\n| Fixed maturities |\n| U.S. Government and govt. agencies and authorities | $ | 25,652,896 | $ | 221,161 | $ | (98,738 | ) | $ | 25,775,319 |\n| U.S. special revenue and assessments | 16,350,071 | 545,717 | 0 | 16,895,788 |\n| All other corporate bonds | 116,809,266 | 5,163,923 | (737,633 | ) | 121,235,556 |\n| $ | 158,812,233 | $ | 5,930,801 | $ | (836,371 | ) | $ | 163,906,663 |\n| December 31, 2018 | Original or Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Fair Value |\n| Investments available for sale: |\n| Fixed maturities |\n| U.S. Government and govt. agencies and authorities | $ | 25,649,410 | $ | 149,006 | $ | (138,222 | ) | $ | 25,660,194 |\n| U.S. special revenue and assessments | 16,350,486 | 334,300 | (4,406 | ) | 16,680,380 |\n| All other corporate bonds | 118,895,973 | 2,569,287 | (2,845,050 | ) | 118,620,210 |\n| $ | 160,895,869 | $ | 3,052,593 | $ | (2,987,678 | ) | $ | 160,960,784 |\n\n| Fixed Maturities Available for Sale March 31, 2019 | Amortized Cost | Fair Value |\n| Due in one year or less | $ | 6,498,983 | $ | 6,525,131 |\n| Due after one year through five years | 51,055,408 | 53,028,854 |\n| Due after five years through ten years | 50,690,937 | 53,501,649 |\n| Due after ten years | 50,566,905 | 50,851,029 |\n| Total | $ | 158,812,233 | $ | 163,906,663 |\n\n| March 31, 2019 | Less than 12 months | 12 months or longer | Total |\n| Fair value | Unrealized losses | Fair value | Unrealized losses | Fair value | Unrealized losses |\n| U.S. Government and govt. agencies and authorities | $ | - | - | 5,578,536 | (98,738 | ) | 5,578,536 | $ | (98,738 | ) |\n| All other corporate bonds | 3,555,300 | (6,923 | ) | 26,553,550 | (730,710 | ) | 30,108,850 | (737,633 | ) |\n| Total fixed maturities | $ | 3,555,300 | (6,923 | ) | 32,132,086 | (829,448 | ) | 35,687,386 | $ | (836,371 | ) |\n| December 31, 2018 | Less than 12 months | 12 months or longer | Total |\n| Fair value | Unrealized losses | Fair value | Unrealized losses | Fair value | Unrealized losses |\n| U.S. Government and govt. agencies and authorities | $ | 6,429,700 | (49,904 | ) | 1,592,679 | (88,318 | ) | 8,022,379 | $ | (138,222 | ) |\n| U.S. special revenue and assessments | 4,023,920 | (4,406 | ) | - | - | 4,023,920 | (4,406 | ) |\n| All other corporate bonds | 49,270,729 | (2,033,507 | ) | 15,337,739 | (811,543 | ) | 64,608,468 | (2,845,050 | ) |\n| Total fixed maturities | $ | 59,724,349 | (2,087,817 | ) | 16,930,418 | (899,861 | ) | 76,654,767 | $ | (2,987,678 | ) |\n\n| Less than 12 months | 12 months or longer | Total |\n| As of March 31, 2019 |\n| Fixed maturities | 2 | 14 | 16 |\n| As of December 31, 2018 |\n| Fixed maturities | 30 | 10 | 40 |\n\nSubstantially all of the unrealized losses on fixed maturities and equity securities at March 31, 2019 and December 31, 2018 are attributable to changes in market interest rates and general disruptions in the credit market subsequent to purchase. The Company does not currently intend to sell nor does it expect to be required to sell any of the securities in an unrealized loss position. Based upon the Company’s expected continuation of receipt of contractually required principal and interest payments and its intent and ability to retain the securities until price recovery, as well as the Company’s evaluation of other relevant factors, the Company deems these securities to be temporarily impaired as of March 31, 2019 and December 31, 2018. Net Investment Gains (Losses)\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Realized gains on available-for-sale investments: |\n| Sales of fixed maturities | $ | 15,055 | $ | - |\n| Sales of equity securities | - | - |\n| Sales of real estate | 1,098,643 | - |\n| Other | - | 534,242 |\n| Total realized gains | 1,113,698 | 534,242 |\n| Realized losses on available-for-sale investments: |\n| Sales of fixed maturities | - | - |\n| Sales of equity securities | - | - |\n| Sales of real estate | - | - |\n| Other-than-temporary impairments | - | - |\n| Other | - | - |\n| Total realized losses | - | - |\n| Net realized investment gains (losses) | 1,113,698 | 534,242 |\n| Change in fair value of equity securities: |\n| Realized gains (losses) on equity securities sold during the period | - | - |\n| Change in fair value of equity securities held at the end of the period | 14,787,631 | 4,129,236 |\n| Change in fair value of equity securities | 14,787,631 | 4,129,236 |\n| Net investment gains (losses) | $ | 15,901,329 | $ | 4,663,478 |\n| Change in net unrealized gains (losses) on available-for-sale investments included in other comprehensive income: |\n| Fixed maturities | $ | 4,934,851 | $ | (4,285,303 | ) |\n| Equity securities | - | - |\n| Net increase (decrease) | $ | 4,934,851 | $ | (4,285,303 | ) |\n\nOther-Than-Temporary Impairments The Company regularly reviews its investment securities for factors that may indicate that a decline in fair value of an investment is other than temporary. The factors considered by Management in its regular review to identify and recognize other-than-temporary impairment losses on fixed maturities include, but are not limited to: the length of time and extent to which the fair value has been less than cost; the Company’s intent to sell, or be required to sell, the debt security before the anticipated recovery of its remaining amortized cost basis; the financial condition and near-term prospects of the issuer; adverse changes in ratings announced by one or more rating agencies; subordinated credit support, whether the issuer of a debt security has remained current on principal and interest payments; current expected cash flows; whether the decline in fair value appears to be issuer specific or, alternatively, a reflection of general market or industry conditions, including the effect of changes in market interest rates. If the Company intends to sell a debt security, or it is more likely than not that it would be required to sell a debt security before the recovery of its amortized cost basis, the entire difference between the security’s amortized cost basis and its fair value at the balance sheet date would be recognized by a charge to other-than-temporary losses in the Condensed Consolidated Statements of Operations. Management regularly reviews its real estate portfolio in comparison to appraisal valuations and current market conditions for indications of other-than-temporary impairments. If a decline in value is judged by Management to be other-than-temporary, a loss is recognized by a charge to other-than-temporary impairment losses in the Consolidated Statements of Operations. The Company did not recognize any other-than-temporary impairments during the first quarter of 2018 or 2019. Cost Method Investments The Company held equity investments with an aggregate cost of $12,133,745 and $12,118,617 at March 31, 2019 and December 31, 2018, respectively. These equity investments were not reported at fair value because it is not practicable to estimate their fair values due to insufficient information being available. Management did not identify any events or changes in circumstances that might have a significant adverse effect on the reported value of those investments. Based on Management's evaluation of the expected cash flow of the investments, and the Company's ability and intent to hold the investments for a reasonable period of time, the Company does not deem an other-than-temporary impairment necessary at March 31, 2019.\nMortgage Loans The Company, from time to time, acquires mortgage loans through participation agreements with FSNB. FSNB has been able to provide the Company with additional expertise and experience in underwriting commercial and residential mortgage loans, which provide more attractive yields than the traditional bond market. The Company is able to receive participations from FSNB for three primary reasons: 1) FSNB has already reached its maximum lending limit to a single borrower, but the borrower is still considered a suitable risk; 2) the interest rate on a particular loan may be fixed for a long period that is more suitable for UG given its asset-liability structure; and 3) FSNB’s loan growth might at times outpace its deposit growth, resulting in FSNB participating such excess loan growth rather than turning customers away. For originated loans, the Company’s Management is responsible for the final approval of such loans after evaluation. Before a new loan is issued, the applicant is subject to certain criteria set forth by Company Management to ensure quality control. These criteria include, but are not limited to, a credit report, personal financial information such as outstanding debt, sources of income, and personal equity. Once the loan is approved, the Company directly funds the loan to the borrower. The Company bears all risk of loss associated with the terms of the mortgage with the borrower. During the first quarter of 2019 and 2018, the Company acquired $3,575,500 and $0 in mortgage loans, respectively. FSNB services the majority of the Company’s mortgage loan portfolio. The Company pays FSNB a .25% servicing fee on these loans and a one-time fee at loan origination of .50% of the original loan cost to cover costs incurred by FSNB relating to the processing and establishment of the loan.\n| 2019 | 2018 |\n| Maximum rate | Minimum rate | Maximum rate | Minimum rate |\n| Farm Loans | 5.00% | 5.00% | 5.00% | 5.00% |\n| Commercial Loans | 7.50% | 4.00% | 7.50% | 4.00% |\n| Residential Loans | 8.00% | 8.00% | 8.00% | 8.00% |\n\nMost mortgage loans are first position loans. Loans issued are generally limited to no more than 80% of the appraised value of the property. The Company has in place a monitoring system to provide Management with information regarding potential troubled loans. Letters are sent to each mortgagee when the loan becomes 30 days or more delinquent. Management is provided with a monthly listing of loans that are 60 days or more past due along with a brief description of what steps are being taken to resolve the delinquency. All loans 90 days or more past due are placed on a non-performing status and classified as delinquent loans. Quarterly, coinciding with external financial reporting, the Company reviews each delinquent loan and determines how each delinquent loan should be classified. Management believes the current internal controls surrounding the mortgage loan selection process provide a quality portfolio with minimal risk of foreclosure and/or negative financial impact. Changes in the current economy could have a negative impact on the loans, including the financial stability of the borrowers, the borrowers’ ability to pay or to refinance, the value of the property held as collateral and the ability to find purchasers at favorable prices. Interest accruals are analyzed based on the likelihood of repayment. In no event will interest continue to accrue when accrued interest along with the outstanding principal exceeds the net realizable value of the property. The Company does not utilize a specified number of days delinquent to cause an automatic non-accrual status. A mortgage loan reserve is established and adjusted based on Management's quarterly analysis of the portfolio and any deterioration in value of the underlying property which would reduce the net realizable value of the property below its current carrying value. The mortgage loan reserve was $0 at March 31, 2019 and December 31, 2018.\n| March 31, 2019 | December 31, 2018 |\n| In good standing | $ | 8,829,640 | $ | 7,169,272 |\n| Overdue interest over 90 days | 1,873,913 | 1,899,839 |\n| Total mortgage loans | $ | 10,703,553 | $ | 9,069,111 |\n\nInvestment Real Estate Real estate acquired through foreclosure, consisting of properties obtained through foreclosure proceedings or acceptance of a deed in lieu of foreclosure, is reported on an individual asset basis at the lower of cost or fair value, less disposal costs. Fair value is determined on the basis of current appraisals, comparable sales, and other estimates of value obtained principally from independent sources. When properties are acquired through foreclosure, any excess of the loan balance at the time of foreclosure over the fair value of the real estate held as collateral is recognized and charged to the Consolidated Statements of Operations. Based upon Management’s evaluation of the real estate acquired through foreclosure, additional expense is recorded when necessary in an amount sufficient to reflect any declines in estimated fair value. Gains and losses recognized on the disposition of the properties are recorded as realized gains and losses in the Condensed Consolidated Statements of Operations. Notes Receivable Notes receivable represent collateral loans and promissory notes issued by the Company and are reported at their unpaid principal balances, adjusted for valuation allowances. Valuation allowances are established for impaired loans when it is probable that contractual principal and interest will not be collected. The valuation allowance as of March 31, 2019 and December 31, 2018 was $0. Interest accruals are analyzed based on the likelihood of repayment. The Company does not utilize a specified number of days delinquent to cause an automatic non-accrual status. Before a new note is issued, the applicant is subject to certain criteria set forth by Company Management to ensure quality control. Once the note is approved, the Company directly funds the note to the borrower. Several of the notes have participation agreements in place, whereas the Company has reduced its investment in the note receivable by participating a portion of the note to a third party. Similar to the mortgage loans, FSNB services several of the notes receivable. The Company, and the participants in the notes, share in the risk of loss associated with the terms of the note with the borrower, based upon their ownership percentage in the note. The Company has in place a monitoring system to provide Management with information regarding potential troubled loans.\nNote 4 – Fair Value Measurements The Company measures its assets and liabilities recorded at fair value in the Condensed Consolidated Balance Sheets based on the framework set forth in the GAAP fair value accounting guidance. The framework establishes a fair value hierarchy of three levels based upon the transparency of information used in measuring the fair value of assets or liabilities as of the measurement date. The fair value hierarchy prioritizes the inputs in the valuation techniques used to measure fair value into three categories. Level 1 – Valuation is based upon quoted prices for identical assets or liabilities in active markets that the Company is able to access. Level 1 fair value is not subject to valuation adjustments. Level 2 – Valuation is based upon quoted prices for similar assets and liabilities in active markets or quoted prices for identical or similar instruments in markets that are not active. In addition, the Company may use various valuation techniques or pricing models that use observable inputs to measure fair value. Level 3 – Valuation is based upon unobservable inputs that are supported by little or no market activity and are significant to the fair value of the assets or liabilities. Unobservable inputs reflect the Company’s own assumptions about the inputs that market participants would use in pricing the asset or liability. The Company determines the existence of an active market for an asset or liability based on its judgment as to whether transactions for the asset or liability occur in such market with sufficient frequency and volume to provide reliable pricing information. If the Company concludes that there has been a significant decrease in the volume and level of activity for an investment in relation to normal market activity for such investment, adjustments to transactions and quoted prices are made to estimate fair value. The inputs used in the valuation techniques employed by the Company are provided by nationally recognized pricing services, external investment managers and internal resources. To assess these inputs, the Company’s review process includes, but is not limited to, quantitative analysis including benchmarking, initial and ongoing evaluations of methodologies used by external parties to calculate fair value, and ongoing evaluations of fair value estimates based on the Company’s knowledge and monitoring of market conditions. The Company periodically reviews the pricing service provider’s policies and procedures for valuing securities. The assumptions underlying the valuations from external service providers, including unobservable inputs, are generally not readily available as this information is often deemed proprietary. Accordingly, the Company is unable to obtain comprehensive information regarding these assumptions and methodologies. The Company’s investments in fixed maturity securities available for sale, equity securities and trading securities assets and liabilities are carried at fair value. The following are the Company’s methodologies and valuation techniques for assets and liabilities measured at fair value. Fixed maturities available for sale mainly consist of U.S. treasury securities and corporate debt securities. The Company employs a market approach to the valuation of securities where there are sufficient market transactions involving identical or comparable assets. If sufficient market data is not available for identical or comparable assets, the Company uses an income approach to valuation. The majority of the financial instruments included in fixed maturity securities available for sale are evaluated utilizing observable inputs; accordingly, they are categorized in either Level 1 or Level 2 of the fair value hierarchy. However, in instances where significant inputs utilized in valuation of the securities are unobservable, the securities are categorized in Level 3 of the fair value hierarchy. Corporate securities primarily include fixed rate corporate bonds. Inputs utilized in connection with the Company’s valuation techniques relating to this class of securities include recently executed transactions, market price quotations, benchmark yields and issuer spreads. Corporate securities are categorized in Level 2 of the fair value hierarchy. U.S. treasury securities are based on quoted prices in active markets and are generally categorized in Level 1 of the fair value hierarchy. Equity securities consist of common and preferred stocks mainly in private equity investments, financial institutions and publicly traded corporations. Equity securities for which there is sufficient market data are categorized as Level 1 or 2 in the fair value hierarchy. For the equity securities in which quoted market prices are not available, the Company uses industry standard pricing methodologies, including discounted cash flow models that may incorporate various inputs such as payment expectations, risk of the investment, market data, and health of the underlying company. The inputs are based upon Management's assumptions and available market information. When evidence is believed to support a change to the carrying value from the transaction price, adjustments are made to reflect the expected cash flows, material events and market data. These investments are included in Level 3 of the fair value hierarchy.\n| Level 1 | Level 2 | Level 3 | Total |\n| Assets |\n| Fixed Maturities, available for sale | $ | 25,775,319 | $ | 137,696,500 | $ | 434,844 | $ | 163,906,663 |\n| Equity Securities | 37,355,757 | 12,176,923 | 32,917,737 | 82,450,417 |\n| Total | $ | 63,131,076 | $ | 149,873,423 | $ | 33,352,581 | $ | 246,357,080 |\n| Level 1 | Level 2 | Level 3 | Total |\n| Assets |\n| Fixed Maturities, available for sale | $ | 25,660,194 | $ | 134,865,746 | $ | 434,844 | $ | 160,960,784 |\n| Equity Securities | 27,634,283 | 10,557,031 | 29,473,168 | 67,664,482 |\n| Total | $ | 53,294,477 | $ | 145,422,777 | $ | 29,908,012 | $ | 228,625,266 |\n\n| Fixed Maturities, Available for Sale | Equity Securities | Total |\n| Balance at December 31, 2018 | $ | 434,844 | $ | 29,473,168 | $ | 29,908,012 |\n| Total unrealized gain or (losses): |\n| Included in net income (loss) | - | 3,444,569 | 3,444,569 |\n| Included in other comprehensive income | - | - | - |\n| Purchases | - | - | - |\n| Sales | - | - | - |\n| Balance at March 31, 2019 | $ | 434,844 | $ | 32,917,737 | $ | 33,352,581 |\n| March 31, 2019 | December 31, 2018 |\n| Change in fair value of equity securities included in net income (loss) relating to assets held | $ | 3,444,569 | $ | 4,633,751 |\n\nThe Level 3 securities include collateralized debt obligations of trust preferred securities issued by banks and insurance companies and certain equity securities with unobservable inputs. The Company computed fair value of Level 3 equity investments based on a review of current financial information, earnings trends and similar companies in the same industries. There were no transfers in or out of Level 3 as of March 31, 2019. Transfers occur when there is a change in the availability of observable market information. Certain assets are not carried at fair value on a recurring basis, including investments such as mortgage loans and policy loans. Accordingly, such investments are only included in the fair value hierarchy disclosure when the investment is subject to re-measurement at fair value after initial recognition and the resulting re-measurement is reflected in the Consolidated Financial Statements.\n| March 31, 2019 | December 31, 2018 |\n| Assets | Carrying Amount | Estimated Fair Value | Carrying Amount | Estimated Fair Value |\n| Equity securities | $ | 12,133,745 | $ | 12,133,745 | $ | 12,118,617 | $ | 12,118,617 |\n| Mortgage loans on real estate | 10,703,553 | 10,703,553 | 9,069,111 | 9,069,111 |\n| Investment real estate | 51,530,162 | 51,530,162 | 52,518,577 | 52,518,577 |\n| Notes receivable | 26,595,336 | 26,595,336 | 23,717,312 | 23,717,312 |\n| Policy loans | 9,117,979 | 9,117,979 | 9,204,222 | 9,204,222 |\n| Cash and cash equivalents | 19,049,555 | 19,049,555 | 20,150,162 | 20,150,162 |\n\nThe above estimated fair value amounts have been determined based upon the following valuation methodologies. Considerable judgment was required to interpret market data in order to develop these estimates. Accordingly, the estimates are not necessarily indicative of the amounts which could be realized in a current market exchange. The use of different market assumptions or estimation methodologies may have a material effect on the fair value amounts. The fair values of mortgage loans on real estate are estimated using discounted cash flow analyses and interest rates being offered for similar loans to borrowers with similar credit ratings. The inputs used to measure the fair value of our mortgage loans on real estate are classified as Level 3 within the fair value hierarchy. A portion of the mortgage loans balance consists of discounted mortgage loans. The Company has historically purchased non-performing discounted mortgage loans at a deep discount through an auction process led by the Federal Government. In general, the discounted loans are non-performing and there is a significant amount of uncertainty surrounding the timing and amount of cash flows to be received by the Company. Accordingly, the Company records its investment in the discounted loans at its original purchase price, which Management believes approximates fair value. The inputs used to measure the fair value of our discounted mortgage loans are classified as Level 3 within the fair value hierarchy Investment real estate is recorded at the lower of the net investment in the real estate or the fair value of the real estate less costs to sell. The determination of fair value assessments are performed on a periodic, non-recurring basis by external appraisal and assessment of property values by Management. The inputs used to measure the fair value of our investment real estate are classified as Level 3 within the fair value hierarchy. Notes receivable are carried at their unpaid principal balances, which approximates fair value. The inputs used to measure the fair value of the loans are classified as Level 3 within the fair value hierarchy. Policy loans are carried at the aggregate unpaid principal balances in the Condensed Consolidated Balance Sheets which approximate fair value, and earn interest at rates ranging from 4% to 8%. Individual policy liabilities in all cases equal or exceed outstanding policy loan balances. The inputs used to measure the fair value of our policy loans are classified as Level 3 within the fair value hierarchy. The carrying amount of cash and cash equivalents in the Condensed Consolidated Balance Sheets approximates fair value given the highly liquid nature of the instruments. The inputs used to measure the fair value of our cash and cash equivalents are classified as Level 1 within the fair value hierarchy. The carrying amount of short term investments in the Condensed Consolidated Balance Sheets approximates fair value. The inputs used to measure the fair value of our short term investments are classified as Level 3 within the fair value hierarchy.\nNote 5 – Credit Arrangements\n| Instrument | Issue Date | Maturity Date | Revolving Credit Limit | December 31, 2018 | Borrowings | Repayments | March 31, 2019 |\n| Lines of Credit: |\n| UTG | 11/20/2013 | 11/20/2019 | $ | 8,000,000 | - | - | - | - |\n| UG | 6/2/2015 | 5/10/2019 | 10,000,000 | - | - | - | - |\n\nThe UTG line of credit carries interest at a fixed rate of 5.125% and is payable monthly. As collateral, UTG has pledged 100% of the common voting stock of its wholly owned subsidiary, Universal Guaranty Life Insurance Company. The Company is currently in the process of renewing this line of credit. During May of 2018, the Federal Home Loan Bank approved UG’s Cash Management Advance Application (“CMA”). The CMA gives the Company the option of selecting a variable rate of interest for up to 90 days or a fixed rate for a maximum of 30 days. The variable rate CMA is prepayable at any time without a fee, while the fixed CMA is not prepayable prior to maturity. The Company is currently in the process of renewing the CMA.\nNote 6 – Shareholders’ Equity Stock Repurchase Program – The Board of Directors of UTG has authorized the repurchase in the open market or in privately negotiated transactions of UTG's common stock. At a meeting of the Board of Directors in September of 2018, the Board of Directors of UTG authorized the repurchase of up to an additional $1.5 million of UTG's common stock, for a total repurchase of up to $16.0 million of UTG's common stock in the open market or in privately negotiated transactions. Company Management has broad authority to operate the program, including the discretion of whether to purchase shares and the ability to suspend or terminate the program. Open market purchases are made based on the last available market price but may be limited. During the three months ended March 31, 2019, the Company repurchased 6,955 shares through the stock repurchase program for $212,387. Through March 31, 2019, UTG has spent $14,076,115 million in the acquisition of 1,147,061 shares under this program. During 2019, the Company issued 7,632 shares of stock to management and employees as compensation at a cost of $229,800. These awards are determined at the discretion of the Board of Directors. Earnings Per Share Calculations Earnings per share are based on the weighted average number of common shares outstanding during each period. For the three months ended March 31, 2019 and 2018, diluted earnings per share were the same as basic earnings per share since the Company had no dilutive instruments outstanding.\nNote 7 – Commitments and Contingencies The insurance industry has experienced a number of civil jury verdicts which have been returned against life and health insurers in the jurisdictions in which the Company does business involving the insurers' sales practices, alleged agent misconduct, failure to properly supervise agents, and other matters. Some of the lawsuits have resulted in the award of substantial judgments against the insurer, including material amounts of punitive damages. In some states, juries have substantial discretion in awarding punitive damages in these circumstances. In the normal course of business, the Company is involved from time to time in various legal actions and other state and federal proceedings. Management is of the opinion that the ultimate disposition of the matters will not have a materially adverse effect on the Company’s results of operations or financial position. Under the insurance guaranty fund laws in most states, insurance companies doing business in a participating state can be assessed up to prescribed limits for policyholder losses incurred by insolvent or failed insurance companies. Although the Company cannot predict the amount of any future assessments, most insurance guaranty fund laws currently provide that an assessment may be excused or deferred if it would threaten an insurer's financial strength. Mandatory assessments may be partially recovered through a reduction in future premium tax in some states. The Company does not believe such assessments will be materially different from amounts already provided for in the condensed consolidated financial statements, though the Company has no control over such assessments.\n| Total Funding Commitment | Unfunded Commitment |\n| RLF III, LLC | $ | 4,000,000 | $ | 398,120 |\n| Sovereign’s Capital, LP Fund I | 500,000 | 24,493 |\n| Sovereign's Capital, LP Fund II | 1,000,000 | 240,566 |\n| Sovereign's Capital, LP Fund III | 1,000,000 | 900,000 |\n| Barton Springs Music, LLC | 1,750,000 | 1,158,500 |\n| Master Mineral Holdings III, LP | 4,000,000 | 530,312 |\n\nDuring 2006, the Company committed to invest in RLF III, LLC (“RLF”), which makes land-based investments in undervalued assets. RLF makes capital calls as funds are needed for continued land purchases. During 2012, the Company committed to invest in Sovereign’s Capital, LP Fund I (“Sovereign’s”), which invests in companies in emerging markets. Sovereign’s makes capital calls to investors as funds are needed. During 2015, the Company committed to invest in Sovereign’s Capital, LP Fund II (“Sovereign’s II”), which invests in companies in emerging markets. Sovereign’s II makes capital calls to investors as funds are needed. During 2018, the Company committed to invest in Sovereign’s Capital, LP Fund III (“Sovereign’s III”), which invests in companies in emerging markets. Sovereign’s III makes capital calls to investors as funds are needed. During 2018, the Company committed to invest in Barton Springs Music, LLC (“Barton”), which invests in music royalties. Barton makes capital calls to its investors as funds are needed to acquire the royalty rights. During 2018, the Company committed to invest in Master Mineral Holdings III, LP (“MMH”), which purchases land for leasing opportunities to those looking to harvest natural resources. MMH makes capital calls to its investors as funds are needed for continued land purchases.\nNote 8 – Other Cash Flow Disclosures\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Interest | $ | - | $ | - |\n| Federal income tax | - | - |\n\nNote 9 – Concentrations of Credit Risk The Company maintains cash balances in financial institutions that at times may exceed federally insured limits. The Company maintains its primary operating cash accounts with First Southern National Bank, an affiliate of the largest shareholder of UTG, Mr. Jesse Correll, the Company’s CEO and Chairman. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risk on cash and cash equivalents. Because UTG serves primarily individuals located in four states, the ability of our customers to pay their insurance premiums is impacted by the economic conditions in these areas. As of March 31, 2019 and 2018 , approximately 55% and 56%, respectively, of the Company’s total direct premium was collected from Illinois, Ohio, Texas and West Virginia. Thus, results of operations are heavily dependent upon the strength of these economies. The Company reinsures that portion of insurance risk which is in excess of its retention limits. Retention limits range up to $125,000 per life. Life insurance ceded represented 20% of total life insurance in force at March 31, 2019 and December 31, 2018, respectively. Insurance ceded represented 24% and 29% of premium income for the three months ended March 31, 2019 and 2018, respectively. The Company would be liable for the reinsured risks ceded to other companies to the extent that such reinsuring companies are unable to meet their obligations. The Company owns a variety of investments associated with the oil and gas industry. These investments represent approximately 28% and 25% of the Company's total invested assets as of March 31, 2019 and December 31, 2018, respectively.\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nThe following is Management's discussion and analysis of the financial condition and results of operations of UTG, Inc. and its subsidiaries (collectively with the Parent, the \"Company\"). The following discussion of the financial condition and results of operations of the Company should be read in conjunction with, and is qualified in its entirety by reference to, the Consolidated Financial Statements of the Company and the related Notes thereto appearing in the Company's annual report on Form 10-K for the year ended December 31, 2018, as filed with the Securities and Exchange Commission, and our unaudited Condensed Consolidated Financial Statements and related Notes thereto appearing elsewhere in this quarterly report.\nCautionary Statement Regarding Forward-Looking Statements\nThis report on Form 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are intended to be covered by the safe harbors created by those laws. We have based our forward-looking statements on our current expectations and projections about future events. Our forward-looking statements include information about possible or assumed future results of operations. All statements, other than statements of historical facts, included or incorporated by reference in this report that address activities, events or developments that we expect or anticipate may occur in the future, including such things as the growth of our business and operations, our business strategy, competitive strengths, goals, plans, future capital expenditures and references to future successes may be considered forward-looking statements. Also, when we use words such as \"anticipate,\" \"believe,\" \"estimate,\" \"expect,\" \"intend,\" \"plan,\" \"probably,\" or similar expressions, we are making forward-looking statements.\nNumerous risks and uncertainties may impact the matters addressed by our forward-looking statements, any of which could negatively and materially affect our future financial results and performance.\nAlthough we believe that the assumptions underlying our forward-looking statements are reasonable, any of these assumptions, and, therefore, the forward-looking statements based on these assumptions, could themselves prove to be inaccurate. In light of the significant uncertainties inherent in the forward-looking statements that are included in this report, our inclusion of this information is not a representation by us or any other person that our objectives and plans will be achieved. In light of these risks, uncertainties and assumptions, any forward-looking event discussed in this report may not occur. Our forward-looking statements speak only as of the date made, and we undertake no obligation to update or review any forward-looking statement, whether as a result of new information, future events or other developments, unless the securities laws require us to do so.\nOverview\nUTG, Inc., a Delaware corporation, is a life insurance holding company. The Company's dominant business is individual life insurance, which includes the servicing of existing insurance policies in force, the acquisition of other companies in the life insurance business and the administration and processing of life insurance business for other entities. The Company's focus for the future includes growing the administrative portion of the business.\nCritical Accounting Policies\nThe preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect reported amounts and related disclosures. Actual results could differ significantly from those estimates. The Company has identified certain estimates that involve a higher degree of judgment and are subject to a significant degree of variability. The Company's critical accounting policies and the related estimates considered most significant by Management are disclosed in the Company's Annual Report on Form 10-K for the year ended December 31, 2018. Management has identified the accounting policies related to cost of insurance acquired, assumptions and judgments utilized in determining if declines in fair values of investments are other-than-temporary, and valuation methods for investments that are not actively traded as those, due to the judgments, estimates and assumptions inherent in those policies, are critical to an understanding of the Company's Condensed Consolidated Financial Statements and this Management's Discussion and Analysis.\nDuring the three months ended March 31, 2019, there were no additions to or changes in the critical accounting policies disclosed in the 2018 Form 10-K.\nResults of Operations\nOn a consolidated basis, the Company reported net income attributable to common shareholders' of approximately $11.6 million and $2.7 million for the three-month periods ended March 31, 2019 and 2018, respectively.\nRevenues\nThe Company reported total revenues of approximately $21.1 million for the three-month period ended March 31, 2019, an increase of approximately $11.4 million as compared to the same period in 2018. The variance in total revenues from the prior year to the current year is mainly attributable to the increase in the change in the fair value of equity securities.\nPremium and policy fee revenues, net of reinsurance, were comparable for the three-months ended March 31, 2019 and 2018. The Company writes minimal new business. Premium and policy fee revenues, net of reinsurance, represented 10% and 20% of the Company's revenues as of March 31, 2019 and 2018, respectively.\nThe following table summarizes the Company's investment performance.\n\n| Three Months Ended March 31, |\n| 2019 | 2018 |\n| Net investment income | $ | 3,112,024 | $ | 3,068,118 |\n| Net investment gains | $ | 15,901,329 | $ | 4,663,478 |\n| Change in net unrealized investment gains (losses) on available-for-sale securities, pre-tax | $ | 4,934,851 | $ | (4,285,303 | ) |\n\nThe following table reflects net investment income of the Company:\n\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Fixed maturities available for sale | $ | 1,589,985 | $ | 1,837,844 |\n| Equity securities | 668,108 | 532,067 |\n| Trading securities | (111,693 | ) | - |\n| Mortgage loans | 118,612 | 214,558 |\n| Real estate | 784,532 | 449,546 |\n| Notes receivable | 435,155 | 386,782 |\n| Policy loans | 141,552 | 150,081 |\n| Short-term | 41,364 | 48,172 |\n| Cash and cash equivalents | - | 12,434 |\n| Total consolidated investment income | 3,667,615 | 3,631,484 |\n| Investment expenses | (555,591 | ) | (563,366 | ) |\n| Consolidated net investment income | $ | 3,112,024 | $ | 3,068,118 |\n\nNet investment income represented 15% and 32% of the Company's total revenues as of March 31, 2019 and 2018, respectively. Net investment was comparable in the majority of the investment categories when comparing the first quarter 2019 activity to the same quarter in 2018.\nInvestment income from the real estate investment portfolio is up approximately $335,000 in the current year as compared to the same period in the prior year. The increase is not attributable to one specific investment or event. Several of the Company's real estate holdings produced more income in the current your as compared to the same period in the prior year. Income is expected to vary from quarter to quarter depending on the activity occurring in relation to each property.\nThe Company reported net investment gains of approximately $15.9 million and $4.7 million for the three-month periods ended March 31, 2019 and 2018, respectively. Realized investment gains of approximately $1.1 million and $534,000 were recognized by the Company during the first quarter of 2019 and 2018, respectively. These gains are the result of the Company selling a parcel of real estate in 2018 and 2019.\nRealized investment gains are the result of one-time events and are expected to vary from quarter to quarter.\nThe 2019 investment gains mainly consist of approximately $14.8 million in unrealized gains related to the change in the fair value of equity securities. For the same period in 2018, the Company reported approximately $4.1 million of unrealized gains related to the change in the fair value of equity securities.\nThe Company has seen significant unrealized gains on its equity investments during 2018 and 2019. A significant portion of these gains are from two equity holdings, both in the area of oil and gas. While the Company has had very strong unrealized gains during 2018 and 2019, a pull back in the stock market, particularly in the oil and gas arena, could slow these gains or even result in future period unrealized losses. Management believes these equity investments continue to be solid investments for the Company and have further growth potential; however, changes in market conditions could cause volatility in market prices.\nIn summary, the Company's basis for future revenue growth is expected to come from the following primary sources: conservation of business currently in-force, the maximization of investment earnings and the acquisition of other companies or policy blocks in the life insurance business. Management has placed a significant emphasis on the development of these revenue sources to enhance these opportunities.\nExpenses\nThe Company reported total benefits and other expenses of approximately $5.6 million for the three-month period ended March 31, 2019, a decrease of approximately 9% from the same period in 2018. Benefits, claims and settlement expenses represented approximately 59% and 63% of the Company's total expenses for the three-month periods ended March 31, 2019 and 2018, respectively. The other major expense category of the Company is operating expenses, which represented approximately 39% and 34% of the Company's total expenses for the three-month periods ended March 31, 2019 and 2018, respectively.\nLife benefits, claims and settlement expenses, net of reinsurance benefits and claims, decreased approximately 16% in the three-month period ended March 31, 2019, compared to the same period in 2018. Policy claims vary from period to period and therefore, fluctuations in mortality are to be expected and are not considered unusual by Management.\nNet amortization of cost of insurance acquired decreased 4% during the three-month period ended March 31, 2019 compared to the same period in 2018. Cost of insurance acquired is established when an insurance company is acquired or when the Company acquires a block of in-force business. The Company assigns a portion of its cost to the right to receive future profits from insurance contracts existing at the date of the acquisition. Cost of insurance acquired is amortized with interest in relation to expected future profits, including direct charge-offs for any excess of the unamortized asset over the projected future profits. The interest rates may vary due to risk analysis performed at the time of acquisition on the business acquired. The Company utilizes a 12% discount rate on the remaining unamortized business. The amortization is adjusted retrospectively when estimates of current or future gross profits to be realized from a group of products are revised. Amortization of cost of insurance acquired is particularly sensitive to changes in interest rate spreads and persistency of certain blocks of insurance in-force. This expense is expected to decrease, unless the Company acquires a new block of business.\nOperating expenses increased approximately 3% in the three-month period ended March 31, 2019 as compared to the same period in 2018. Overall, expenses were comparable in all of the major expense categories.\nManagement continues to place significant emphasis on expense monitoring and cost containment. Maintaining administrative efficiencies directly impacts net income.\nFinancial Condition\nInvestment Information\nInvestments represent approximately 86% and 85% of total assets at March 31, 2019 and December 31, 2018, respectively. Accordingly, investments are the largest asset group of the Company. The Company's insurance subsidiary is regulated by insurance statutes and regulations as to the type of investments that it is permitted to make and the amount of funds that may be used for any one type of investment. In light of these statutes and regulations, the majority of the Company's investment portfolio is invested in a diverse set of securities.\nAs of March 31, 2019, the carrying value of fixed maturity securities in default as to principal or interest was immaterial in the context of consolidated assets, shareholders' equity or results from operations. To provide additional flexibility and liquidity, the Company has identified all fixed maturity securities as \"investments available for sale\". Investments available-for-sale are carried at market, with changes in market value charged directly to shareholders' equity. Changes in the market value of available for sale securities resulted in a net unrealized gain of approximately $3.9 million and a net unrealized loss of approximately $3.4 million for the three-month periods ended March 31, 2019 and 2018, respectively. The variance in the net unrealized gains and losses is the result of normal market fluctuations and lower interest rates.\nCapital Resources\nTotal shareholders' equity increased by approximately 14% as of March 31, 2019 compared to December 31, 2018. The increase is mainly attributable to an increase in retained earnings, which is the result of the current year net income reported by the Company.\nThe Company's investments are predominately in fixed maturity investments such as bonds, which provide sufficient return to cover future obligations. The Company carries all of its fixed maturity holdings as available for sale, which are reported in the Condensed Consolidated Financial Statements at their market value.\nLiquidity\nThe Company has two principal needs for cash - the insurance company's contractual obligations to policyholders and the payment of operating expenses. Cash and cash equivalents represented 5% total assets as of March 31, 2019 and December 31, 2018. Fixed maturities as a percentage of total assets were approximately 40% and 41% as of March 31, 2019 and December 31, 2018, respectively.\nThe Company currently has access to funds for operating liquidity. UTG has an $8 million revolving credit note with Illinois National Bank. At March 31, 2019, the Company had no outstanding borrowings against the UTG line of credit. UG has a $10 million line of credit with the Federal Home Loan Bank. At March 31, 2019, the Company had no outstanding borrowings against the UG line of credit\nFuture policy benefits are primarily long-term in nature and therefore, the Company's investments are predominantly in long-term fixed maturity investments such as bonds and mortgage loans which provide sufficient return to cover these obligations. Many of the Company's products contain surrender charges and other features which reward persistency and penalize the early withdrawal of funds.\nFor the three months ended March 31, 2019 and 2018, operating activities used cash of approximately $364,000 and provided cash of approximately $3.3 million, respectively. Sources of operating cash flows of the Company, as with most insurance entities, is comprised primarily of premiums received on life insurance products and income earned on investments. Uses of operating cash flows consist primarily of payments of benefits to policyholders and beneficiaries and operating expenses. The Company has not marketed any significant new products for several years.\nThe Company used cash in investing activities of approximately $540,000 and $8.3 million for the three month periods ended March 31, 2019 and 2018, respectively. The net cash provided by or used in investing activities is expected to vary from quarter to quarter depending on market conditions and Management’s ability to find and negotiate favorable investment contracts.\nUTG is a holding Company that has no day-to-day operations of its own. Funds required to meet its expenses, generally costs associated with maintaining the Company in good standing with states in which it does business are primarily provided by its subsidiaries. On a parent only basis, UTG's cash flow is dependent on Management fees received from its insurance subsidiary, stockholder dividends from its subsidiary and earnings received on cash balances. At March 31, 2019, substantially all of the consolidated shareholders' equity represented net assets of its subsidiary. The Company's insurance subsidiary has maintained adequate statutory capital and surplus. The payment of cash dividends to shareholders by UTG is not legally restricted. However, the state insurance department regulates insurance Company dividend payments where the Company is domiciled. No dividends were paid to shareholders in 2018 or the three-month period ended March 31, 2019.\nUG is an Ohio domiciled insurance company, which requires notification within five business days to the insurance commissioner following the declaration of any ordinary dividend and at least ten calendar days prior to payment of such dividend. Ordinary dividends are defined as the greater of: a) prior year statutory net income or b) 10% of statutory capital and surplus. For the year ended December 31, 2018, UG had statutory net income of approximately $6.2 million. At December 31, 2018 UG's statutory capital and surplus amounted to approximately $60 million. Extraordinary dividends (amounts in excess of ordinary dividend limitations) require prior approval of the insurance commissioner and are not restricted to a specific calculation. During 2018 , UG paid UTG ordinary dividends of $5 million. During the second quarter of 2019, UG paid UTG a dividend of $2 million. UTG used the dividends received during 2018 and 2019 for general operations of the Company.\n\nITEM 4. CONTROLS AND PROCEDURES\nThe Company maintains a set of disclosure controls and procedures designed to ensure that information required to be disclosed in reports that it files or submits under the Securities Exchange Act of 1934, as amended (the Exchange Act), is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. In addition, the disclosure controls and procedures ensure that information required to be disclosed is accumulated and communicated to Management, including the principal executive officer and principal financial officer, allowing timely decisions regarding required disclosure. Under the supervision and with the participation of our Management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Exchange Act. Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.\nPART II. OTHER INFORMATION\n\nITEM 1. LEGAL PROCEEDINGS\nNONE\n\nITEM 1A. RISK FACTORS\nNONE\n\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nNONE\n\nITEM 3. DEFAULTS UPON SENIOR SECURITIES\nNONE\n\nITEM 4. MINE SAFETY DISCLOSURES\nNONE\n\nITEM 5. OTHER INFORMATION\nNONE\n\nITEM 6. EXHIBITS\n\n| *31.1 | Certification of Jesse T. Correll, Chief Executive Officer and Chairman of the Board of UTG, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| *31.2 | Certification of Theodore C. Miller, Chief Financial Officer, Senior Vice President and Corporate Secretary of UTG, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| *32.1 | Certificate of Jesse T. Correll, Chief Executive Officer and Chairman of the Board of UTG, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| *32.2 | Certificate of Theodore C. Miller, Chief Financial Officer, Senior Vice President and Corporate Secretary of UTG, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| **101 | Interactive Data File |\n\n*Filed herewith\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\nUTG, INC.\n(Registrant)\n\n| Date: | May 14, 2019 | By | /s/ James P. Rousey |\n| James P. Rousey |\n| President and Director |\n\n\n| Date: | May 14, 2019 | By | /s/ Theodore C. Miller |\n| Theodore C. Miller |\n| Senior Vice President |\n| and Chief Financial Officer |\n\nEXHIBIT INDEX\n\n| Exhibit Number | Description |\n| *31.1 | Certification of Jesse T. Correll, Chief Executive Officer and Chairman of the Board of UTG, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| *31.2 | Certification of Theodore C. Miller, Chief Financial Officer, Senior Vice President and Corporate Secretary of UTG, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| *32.1 | Certificate of Jesse T. Correll, Chief Executive Officer and Chairman of the Board of UTG, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| *32.2 | Certificate of Theodore C. Miller, Chief Financial Officer, Senior Vice President and Corporate Secretary of UTG, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| **101 | Interactive Data File |\n\n* Filed herewith\n\n</text>\n\nWhat is the return on equity (ROE) for the year ended March 31, 2019, considering the net income for the three months ended March 31, 2019, and total shareholders' equity at the end of 2019 and 2018 in percentages?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"ground_truth": "Therefore, the answer is 41.11."
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docmath_20000_40000
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nPART I. FINANCIAL INFORMATION\nItem 1. Financial Statements.\nQUADRO ACQUISITION ONE CORP.\nCONDENSED BALANCE SHEETS\n\n| June 30, 2023 | December 31, 2022 |\n| (Unaudited) |\n| Assets |\n| Current assets: |\n| Cash | $ | — | $ | 964 |\n| Prepaid expenses | — | 33,402 |\n| Total current assets | — | 34,366 |\n| Cash and investments held in Trust Account | 26,731,243 | 233,304,515 |\n| Total Assets | $ | 26,731,243 | $ | 233,338,881 |\n| Liabilities, Class A Ordinary Shares Subject to Possible Redemption and Shareholders’ Deficit |\n| Current liabilities: |\n| Accounts payable | $ | 436,656 | $ | 107,269 |\n| Accrued expenses | 145,452 | 29,718 |\n| Extension loan - related party | 270,000 | — |\n| Advance from related parties | 188,722 | — |\n| Note payable - related party | 400,000 | 318,700 |\n| Total current liabilities | 1,440,830 | 455,687 |\n| Derivative liabilities - warrants | 809,673 | 30,167 |\n| Deferred underwriting commissions | 2,817,500 | 2,817,500 |\n| Total liabilities | 5,068,003 | 3,303,354 |\n| Commitments and Contingencies |\n| Class A ordinary shares subject to possible redemption, $ 0.001 par value; 2,548,153 and 23,000,000 shares at approximately $ 10.45 and $ 10.14 per share redemption value as of June 30, 2023 and December 31, 2022, respectively | 26,631,243 | 233,204,515 |\n| Shareholders’ Deficit: |\n| Class A ordinary shares, $ 0.001 par value; 200,000,000 shares authorized; 6,250,000 and 0 non-redeemable shares issued or outstanding as of June 30, 2023 and December 31, 2022, respectively | 6,250 | — |\n| Class B ordinary shares, $ 0.001 par value; 10,000,000 shares authorized; 0 and 6,250,000 shares issued and outstanding as of June 30, 2023 and December 31, 2022, respectively | — | 6,250 |\n| Accumulated deficit | ( 4,974,253 | ) | ( 3,175,238 | ) |\n| Total shareholders’ deficit | ( 4,968,003 | ) | ( 3,168,988 | ) |\n| Total Liabilities, Class A Ordinary Shares Subject to Possible Redemption and Shareholders’ Deficit | $ | 26,731,243 | $ | 233,338,881 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n1\nQUADRO ACQUISITION ONE CORP.\nUNAUDITED CONDENSED STATEMENTS OF OPERATIONS\n\n| For the Three Months Ended June 30, | For the Six Months Ended June 30, |\n| 2023 | 2022 | 2023 | 2022 |\n| Operating expenses |\n| General and administrative expenses | $ | 160,237 | $ | 106,509 | $ | 749,509 | $ | 299,896 |\n| Loss from operations | ( 160,237 | ) | ( 106,509 | ) | ( 749,509 | ) | ( 299,896 | ) |\n| Other income: |\n| Change in fair value of derivative assets and liabilities | ( 538,173 | ) | 863,544 | ( 779,506 | ) | 5,117,082 |\n| Income from investments held in Trust Account | 240,284 | — | 1,681,266 | — |\n| Unrealized gain from investments held in Trust Account | — | 292,182 | — | 312,752 |\n| Net (loss) income | $ | ( 458,126 | ) | $ | 1,049,217 | $ | 152,251 | $ | 5,129,938 |\n| Weighted average shares outstanding of Class A ordinary shares, basic and diluted | 8,798,153 | 23,000,000 | 13,551,176 | 23,000,000 |\n| Basic and diluted net (loss) income per share, Class A ordinary shares | $ | ( 0.05 | ) | $ | 0.04 | $ | 0.01 | $ | 0.18 |\n| Weighted average shares outstanding of Class B ordinary shares, basic and diluted | — | 6,250,000 | 1,041,667 | 6,250,000 |\n| Basic and diluted net (loss) income per share, Class B ordinary shares | $ | — | $ | 0.04 | $ | 0.01 | $ | 0.18 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n2\nQUADRO ACQUISITION ONE CORP.\nUNAUDITED CONDENSED STATEMENTS OF CHANGES IN SHAREHOLDERS’ DEFICIT\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2023\n\n| Ordinary Shares | Additional | Total |\n| Class A | Class B | Paid-in | Accumulated | Shareholders’ |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Deficit |\n| Balance - December 31, 2022 | — | $ | — | 6,250,000 | $ | 6,250 | $ | — | $ | ( 3,175,238 | ) | $ | ( 3,168,988 | ) |\n| Conversion of Class B ordinary shares to Class A ordinary shares | 6,250,000 | 6,250 | ( 6,250,000 | ) | ( 6,250 | ) | — | — | — |\n| Accretion on Class A ordinary shares subject to possible redemption amount | — | — | — | — | — | ( 1,560,982 | ) | ( 1,560,982 | ) |\n| Net income | — | — | — | — | — | 610,377 | 610,377 |\n| Balance - March 31, 2023 (unaudited) | 6,250,000 | 6,250 | — | — | — | ( 4,125,843 | ) | ( 4,119,593 | ) |\n| Accretion on Class A ordinary shares subject to possible redemption amount | — | — | — | — | — | ( 390,284 | ) | ( 390,284 | ) |\n| Net loss | — | — | — | — | — | ( 458,126 | ) | ( 458,126 | ) |\n| Balance - June 30, 2023 (unaudited) | 6,250,000 | $ | 6,250 | — | $ | — | $ | — | $ | ( 4,974,253 | ) | $ | ( 4,968,003 | ) |\n\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2022\n\n| Ordinary Shares | Additional | Total |\n| Class A | Class B | Paid-in | Accumulated | Shareholders’ |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Deficit |\n| Balance - December 31, 2021 | — | $ | — | 6,250,000 | $ | 6,250 | $ | — | $ | ( 13,769,504 | ) | $ | ( 13,763,254 | ) |\n| Net income | — | — | — | — | — | 4,080,721 | 4,080,721 |\n| Balance - March 31, 2022 (unaudited) | — | — | 6,250,000 | 6,250 | — | ( 9,688,783 | ) | ( 9,682,533 | ) |\n| Accretion on Class A ordinary shares subject to possible redemption amount | — | — | — | — | — | ( 251,264 | ) | ( 251,264 | ) |\n| Net income | — | — | — | — | — | 1,049,217 | 1,049,217 |\n| Balance - June 30, 2022 (unaudited) | — | $ | — | 6,250,000 | $ | 6,250 | $ | — | $ | ( 8,890,830 | ) | $ | ( 8,884,580 | ) |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n3\nQUADRO ACQUISITION ONE CORP.\nUNAUDITED CONDENSED STATEMENTS OF CASH FLOWS\n\n| For the Six Months Ended June 30, |\n| 2023 | 2022 |\n| Cash Flows from Operating Activities: |\n| Net income | $ | 152,251 | $ | 5,129,938 |\n| Adjustments to reconcile net income to net cash used in operating activities: |\n| Change in fair value of derivative assets and liabilities | 779,506 | ( 5,117,082 | ) |\n| Income from cash and investments held in Trust Account | ( 1,681,266 | ) | — |\n| Unrealized gain from investments held in Trust Account | — | ( 312,752 | ) |\n| Changes in operating assets and liabilities: |\n| Prepaid expenses | 33,402 | 105,379 |\n| Accounts payable | 346,708 | 12,240 |\n| Accounts payable - related party | ( 17,321 | ) | ( 17,321 | ) |\n| Accrued expenses | 115,734 | ( 60,094 | ) |\n| Net cash used in operating activities | ( 270,986 | ) | ( 259,692 | ) |\n| Cash Flows from Investing Activities: |\n| Cash deposited in Trust Account | ( 270,000 | ) | — |\n| Cash withdrawn from Trust Account in connection with redemption | 208,524,538 | — |\n| Net cash provided by investing activities | 208,254,538 | — |\n| Cash Flows from Financing Activities: |\n| Proceeds from related party advance | 188,722 | — |\n| Proceeds from extension loan | 270,000 | — |\n| Proceeds from note payable to related party | 81,300 | — |\n| Proceeds from promissory note to related party | — | 318,700 |\n| Offering costs paid | — | ( 70,000 | ) |\n| Redemption of Ordinary shares | ( 208,524,538 | ) | — |\n| Net cash used in financing activities | ( 207,984,516 | ) | 248,700 |\n| Net change in cash | ( 964 | ) | ( 10,992 | ) |\n| Cash - beginning of the period | 964 | 63,676 |\n| Cash - end of the period | $ | — | $ | 52,684 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n4\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nNote 1 - Description of Organization, Business Operations and Going Concern\nQuadro Acquisition One Corp. (the “Company”, formerly known as Kismet Acquisition Two Corp.) is a blank check company incorporated as a Cayman Islands exempted company on September 15, 2020. The Company was incorporated for the purpose of acquiring, engaging in a share exchange, share reconstruction and amalgamation, contractual control arrangement with, purchasing all or substantially all of the assets of, or engaging in any other similar initial business combination with one or more businesses or entities that the Company has not yet identified (“Business Combination”).\nAs of June 30, 2023, the Company had not yet commenced operations. All activity for the period from September 15, 2020 (inception) through June 30, 2023, relates to the Company’s formation and the initial public offering (the “Initial Public Offering” or “IPO”), which is described below, and since the Initial Public Offering, the search for a potential target. The Company will not generate any operating revenues until after the completion of its initial Business Combination, at the earliest. The Company generates non-operating income in the form of interest income on investments held in Trust Account (as defined below) from the proceeds derived from the Initial Public Offering and the sale of the Private Placement Warrants (as defined below).\nThe Company’s sponsor was Kismet Sponsor Limited, a British Virgin Islands company (the “Prior Sponsor”). The Registration Statement for the Initial Public Offering on Form S-1 initially filed with the U.S. Securities and Exchange Commission (“SEC”) on January 26, 2021, as amended (File No. 333- 252419), was declared effective on February 17, 2021 (the “Registration Statement”). On February 22, 2021, the Company consummated its Initial Public Offering of 23,000,000 units (the “Units” and, with respect to the Class A Ordinary shares included in the Units sold, the “Public Shares”), including 3,000,000 additional Units to cover over-allotments (the “Over-Allotment Units”), at $ 10.00 per Unit, generating gross proceeds of $ 230.0 million, and incurring offering costs of approximately $ 13.1 million, of which approximately $ 8.1 million was for deferred underwriting commissions (see Note 6).\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the private placement (“Private Placement”) of 4,400,000 warrants (each, a “Private Placement Warrant” and collectively, the “Private Placement Warrants”), at a price of $ 1.50 per Private Placement Warrant with the Prior Sponsor, generating gross proceeds of $ 6.6 million, and incurring offering costs of approximately $ 7,000 (see Note 4).\nOn June 15, 2022, the Prior Sponsor transferred 6,250,000 Class B ordinary shares and 4,400,000 Private Placement Warrants held by the Prior Sponsor to Quadro Sponsor LLC, a Delaware limited liability company and wholly owned subsidiary of the Prior Sponsor (the “New Sponsor” or “Sponsor”). On June 30, 2022, the Prior Sponsor transferred all the membership interests of the New Sponsor to Quadro IH DMCC (“Quadro”), a company registered in Dubai Multi Commodities Centre in the United Arab Emirates (the “Sponsor Transaction”). In connection with the Sponsor Transaction, the Prior Sponsor also assigned to the New Sponsor all of its rights and obligations under the (i) Letter Agreement, dated as of February 17, 2021, (ii) Registration Rights Agreement (as defined in Note 5) and (iii) Promissory Note (as defined below). In addition, the Company and Kismet Capital Group LLC (“Kismet LLC”) mutually terminated the Administrative Services Agreement, dated February 17, 2021 (the “Administrative Services Agreement”). As a result, the Company is no longer obligated to pay a $ 10,000 monthly fee to Kismet LLC pursuant to the Administrative Services Agreement.\nUpon the closing of the Initial Public Offering and the Private Placement, $ 230.0 million ($ 10.00 per Unit) of the net proceeds of the Initial Public Offering and certain of the proceeds of the Private Placement were placed in a trust account (“Trust Account”) with Continental Stock Transfer & Trust Company (“Continental”) acting as trustee and invested in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds meeting certain conditions under Rule 2a-7 under the Investment Company Act of 1940 (the “Investment Company Act”), which invest only in direct U.S. government treasury obligations, as determined by the Company, until the earlier of (i) the completion of a Business Combination and (ii) the distribution of the Trust Account as described below.\nThe Company’s management has broad discretion with respect to the specific application of the net proceeds of its Initial Public Offering and the sale of Private Placement Warrants, although substantially all of the net proceeds are intended to be applied generally toward consummating a Business Combination. The Company’s initial Business Combination must be with one or more operating businesses or assets with a fair market value equal to at least 80 % of the net assets held in the Trust Account (excluding the deferred underwriting commissions and taxes payable, if any, on the income accrued on the Trust Account) at the time the Company signs a definitive agreement in connection with the initial Business Combination. However, the Company will only complete a Business Combination if the post-transaction company owns or acquires 50 % or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act.\n5\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nThe Company will provide its holders of the Public Shares (the “Public Shareholders”) with the opportunity to redeem all or a portion of their Public Shares upon the completion of a Business Combination either (i) in connection with a shareholder meeting called to approve the Business Combination or (ii) by means of a tender offer. The decision as to whether the Company will seek shareholder approval of a Business Combination or conduct a tender offer will be made by the Company, solely in its discretion. The Public Shareholders will be entitled to redeem their Public Shares for a pro rata portion of the amount then in the Trust Account (initially at $ 10.00 per share, plus any pro rata interest earned on the funds held in the Trust Account and not previously released to the Company to pay its tax obligations). The per-share amount to be distributed to Public Shareholders who redeem their Public Shares will not be reduced by the deferred underwriting commissions the Company will pay to the underwriters (see Note 6). These Public Shares were recorded at a redemption value and classified as temporary equity upon the completion of the Initial Public Offering, in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 480, “Distinguishing Liabilities from Equity” (“ASC 480”). In such case, the Company will proceed with a Business Combination if the Company has net tangible assets of at least $ 5,000,001 upon such consummation of a Business Combination and a majority of the shares are voted in favor of the Business Combination. If a shareholder vote is not required by law and the Company does not decide to hold a shareholder vote for business or other legal reasons, the Company will, pursuant to the amended and restated memorandum and articles of association which were adopted by the Company upon the consummation of the Initial Public Offering (the “Memorandum and Articles of Association”), conduct the redemptions pursuant to the tender offer rules of the SEC, and file tender offer documents with the SEC prior to completing a Business Combination. If, however, a shareholder approval of the transactions is required by law, or the Company decides to obtain shareholder approval for business or legal reasons, the Company will offer to redeem shares in conjunction with a proxy solicitation pursuant to the proxy rules and not pursuant to the tender offer rules. Additionally, each Public Shareholder may elect to redeem their Public Shares irrespective of whether they vote for or against the proposed transaction. If the Company seeks shareholder approval in connection with a Business Combination, the holder of the Founder Shares (as defined in Note 5) prior to the Initial Public Offering (the “Initial Shareholder”) agreed to vote its Founder Shares and any Public Shares purchased during or after the Initial Public Offering in favor of a Business Combination. In addition, the Initial Shareholder agreed to waive its redemption rights with respect to their Founder Shares and Public Shares in connection with the completion of a Business Combination.\nNotwithstanding the foregoing, the Memorandum and Articles of Association provides that a Public Shareholder, together with any affiliate of such shareholder or any other person with whom such shareholder is acting in concert or as a “group” (as defined under Section 13 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), will be restricted from redeeming its shares with respect to more than an aggregate of 20 % or more of the Class A Ordinary shares sold in the Initial Public Offering, without the prior consent of the Company.\nThe Company’s Sponsor, executive officers, directors and director nominees agreed not to propose an amendment to the Memorandum and Articles of Association that would affect the substance or timing of the Company’s obligation to provide for the redemption of its Public Shares in connection with a Business Combination or to redeem 100 % of its Public Shares if the Company does not complete a Business Combination, unless the Company provides the Public Shareholders with the opportunity to redeem their Class A ordinary shares in conjunction with any such amendment.\nThe Company initially had until February 22, 2023 (the “Original Termination Date”) to complete the initial Business Combination. On February 20, 2023, the Company held the 2023 Extraordinary General Meeting at which the shareholders of the Company approved to extend the date by which the Company must consummate an initial Business Combination to April 22, 2023 and to allow the Company’s board, without another shareholder vote, to extend Combination Date on a monthly basis up to seven times for an additional one month each time until November 22, 2023, or a total of up to nine months after the Original Termination Date (the “Extension”).\nIn connection with the Extension, the Sponsor or its designees contributed to the Company as a loan the initial contribution of $ 120,000 (the “Initial Extension Loan”) in February 2023 for the portion of the extension ending on April 22, 2023. The Sponsor will also loan the company extension contributions of $ 60,000 per month for each subsequent calendar month (commencing on April 22, 2023 and on the 22nd day of each subsequent month) until November 22, 2023, or portion thereof, that is needed to complete an initial Business Combination, which amount will be deposited into the Trust Account (together with the Initial Extension Loan, the “Extension Loans”). On each of May 11, 2023 and June 6, 2023, the Company deposited an additional $ 60,000 , for an aggregate of $ 120,000 into the Trust Account to extend the date by which it has to consummate an initial Business Combination to June 22, 2023. On each of June 30, 2023 and July 11, 2023, the Company deposited an additional $ 30,000 , for an aggregate of $ 60,000 into the Trust Account to extend the date by which it has to consummate an initial Business Combination to July 22, 2023. On August 7, 2023, the Company deposited an additional $ 60,000 into the Trust Account to extend the date by which it has to consummate an initial business combination to August 22, 2023.\nIn connection with the Extension, shareholders holding 20,451,847 Class A ordinary shares exercised their right to redeem those shares for cash at an approximate price of $ 10.20 per share for an aggregate of approximately $ 208.5 million.\nOn January 31, 2023, the Company issued an aggregate of 6,250,000 Class A ordinary shares to the Sponsor, upon the conversion of an equal number of Class B ordinary shares held by the Sponsor (the “Conversion”). The 6,250,000 Class A ordinary shares issued in connection with the Conversion are subject to the same restrictions as applied to the Class B ordinary shares before the Conversion, including, among others, certain transfer restrictions, waiver of redemption rights and the obligation to vote in favor of an initial Business Combination as described in the prospectus for the Company’s initial public offering. Following the Conversion, there are 29,250,000 Class A ordinary shares issued and outstanding and no Class B ordinary shares issued and outstanding. As a result of the Conversion, the Sponsor held 21.4 % of the outstanding Class A ordinary shares.\n6\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nOn February 10, 2023, the Company instructed Continental to liquidate the investments held in the Trust Account and instead to hold the funds in the Trust Account in an interest-bearing demand deposit account at Morgan Stanley, with Continental continuing to act as trustee, until the earlier of the consummation of the Company’s initial Business Combination or the Company’s liquidation. As a result, following the liquidation of investments in the Trust Account, the remaining proceeds from the Initial Public Offering and Private Placement are no longer invested in U.S. government securities or money market funds.\nIf the Company is unable to complete a Business Combination by August 22, 2023 (or November 22, 2023 if the Company fully extends the time to complete a Business Combination, the “Combination Period”), the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem all Public Shares then outstanding at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including any amounts representing interest earned on the Trust Account, less any interest released to the Company for the payment of taxes, if any (and less up to $ 100,000 in interest reserved for expenses in connection with the Company’s dissolution), divided by the number of then outstanding Public Shares, which redemption will completely extinguish Public Shareholders’ rights as shareholders (including the right to receive further liquidation distributions, if any), and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the remaining shareholders and the Company’s board of directors, liquidate and dissolve, subject in the case of clauses (ii) and (iii) to the Company’s obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law.\nIn connection with the redemption of 100 % of the Company’s outstanding Public Shares for a portion of the funds held in the Trust Account, each holder will receive a full pro rata portion of the amount then in the Trust Account, plus any pro rata interest earned on the funds held in the Trust Account and not previously released to the Company to pay the Company’s taxes payable (less up to $ 100,000 of interest to pay dissolution expenses).\nThe Initial Shareholder agreed to waive its liquidation rights with respect to the Founder Shares if the Company fails to complete a Business Combination within the Combination Period. However, if the Initial Shareholder should acquire Public Shares in or after the Initial Public Offering, it will be entitled to liquidating distributions from the Trust Account with respect to such Public Shares if the Company fails to complete a Business Combination within the Combination Period. The underwriters agreed to waive their rights to their deferred underwriting commission (see Note 6) held in the Trust Account in the event the Company does not complete a Business Combination within the Combination Period, and, in such event, such amounts will be included with the funds held in the Trust Account that will be available to fund the redemption of the Public Shares. In the event of such distribution, it is possible that the per share value of the residual assets remaining available for distribution (including Trust Account assets) will be only $10.00 per share initially held in the Trust Account. In order to protect the amounts held in the Trust Account, the Sponsor agreed that it will be liable to the Company if and to the extent any claims by a third party for services rendered or products sold to the Company, or a prospective target business with which the Company has entered into a written letter of intent, confidentiality or other similar agreement or business combination agreement, reduce the amount of funds in the Trust Account to below the lesser of (i) $10.00 per Public Share and (ii) the actual amount per Public Share held in the Trust Account as of the date of the liquidation of the Trust Account, if less than $10.00 per share due to reductions in the value of the trust assets, less taxes payable, provided that such liability will not apply to any claims by a third party or prospective target business who executed a waiver of any and all rights to the monies held in the Trust Account (whether or not such waiver is enforceable) nor will it apply to any claims under the Company’s indemnity of the underwriters of the Initial Public Offering against certain liabilities, including liabilities under the Securities Act of 1933, as amended (the “Securities Act”). In the event that an executed waiver is deemed to be unenforceable against a third party, the Sponsor will not be responsible to the extent of any liability for such third-party claims. The Company will seek to reduce the possibility that the Sponsor will have to indemnify the Trust Account due to claims of creditors by endeavoring to have vendors, service providers (except the Company’s independent registered public accounting firm), prospective target businesses or other entities with which the Company does business, execute agreements with the Company waiving any right, title, interest or claim of any kind in or to monies held in the Trust Account.\n7\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nLiquidity and Going Concern\nAs of June 30, 2023, the Company had $ 0 in its operating bank account and working capital deficit of approximately $ 1.4 million.\nThe Company’s liquidity needs to date have been satisfied through a contribution of $ 25,000 from the Prior Sponsor to cover certain expenses in exchange for the issuance of the Founder Shares, a loan of approximately $ 111,000 from the Prior Sponsor pursuant to the IPO Note (as defined in Note 5), and a portion of the proceeds from the consummation of the Private Placement not held in the Trust Account. The Company repaid the IPO Note in full on February 24, 2021. In addition, in order to finance transaction costs in connection with a Business Combination, the Sponsor or an affiliate of the Sponsor, or certain of the Company’s officers and directors may, but are not obligated to, provide the Company Working Capital Loans (as defined in Note 5). As of June 30, 2023 and December 31, 2022, there were no amounts outstanding under any Working Capital Loans.\nOn April 13, 2022, the Company issued an unsecured promissory note in the amount of up to $ 200,000 to the Prior Sponsor (the “Promissory Note”). On May 25, 2022, the Company and the Prior Sponsor amended the Promissory Note agreement and increased the principal amount to $ 400,000 . The Promissory Note bears no interest and is due and payable within one year from the date of the first drawdown of the amended and restated note, or June 7, 2023. On June 30, 2022, the Prior Sponsor assigned all of its rights and obligations under the Promissory Note to the New Sponsor in connection with the Sponsor Transaction. As of June 30, 2023, the Company has fully drawn $ 400,000 under the Promissory Note. As of June 30, 2023 and December 31, 2022, approximately $ 400,000 and $ 319,000 were outstanding under the Promissory Note, respectively.\nThe Company may need to raise additional capital through loans or additional investments from its Sponsor, its officers or directors or their affiliates. The Company’s officers, directors and Sponsor, or their affiliates, may, but are not obligated to, loan the Company funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet the Company’s working capital needs. Accordingly, the Company may not be able to obtain additional financing. If the Company is unable to raise additional capital, it may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, reducing overhead expenses, and extending the terms and due dates of certain accrued expenses and other liabilities. The Company cannot provide any assurance that new financing will be available to it on commercially acceptable terms, if at all. In connection with the Company’s assessment of going concern considerations in accordance with FASB ASC Topic 205-40, “Presentation of Financial Statements - Going Concern” (“ASC 205-40”), management has determined that the liquidity condition, mandatory liquidation and subsequent dissolution raises substantial doubt about the Company’s ability to continue as a going concern. Management continues to seek to complete a Business Combination prior to the mandatory liquidation date. No adjustments have been made to the carrying amounts of assets or liabilities should the Company be required to liquidate after November 22, 2023. The accompanying financial statements do not include any adjustment that might be necessary if the Company is unable to continue as a going concern.\nNote 2 - Basis of Presentation and Summary of Significant Accounting Policies\nBasis of Presentation\nThe accompanying unaudited condensed financial statements are presented in U.S. dollars in conformity with accounting principles generally accepted in the United States of America (“GAAP”) for financial information and pursuant to the rules and regulations of the SEC. Accordingly, certain disclosures included in the annual financial statements have been condensed or omitted from the accompanying unaudited condensed financial statements as they are not required for interim financial statements under GAAP and the rules of the SEC. In the opinion of management, the accompanying unaudited condensed financial statements reflect all adjustments, which include only normal recurring adjustments necessary for the fair statement of the balances and results for the periods presented. Operating results for the three and six months ended June 30, 2023 are not necessarily indicative of the results that may be expected through December 31, 2023 or any future period.\nThe accompanying unaudited condensed financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Annual Report on Form 10-K for the fiscal year ended December 31, 2022, as filed by the Company with the SEC on April 18, 2023 (the “2022 Annual Report”).\n8\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nEmerging Growth Company\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the independent registered public accounting firm attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that an emerging growth company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such an election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the accompanying unaudited condensed financial statements with another public company that is neither an emerging growth company nor an emerging growth company that has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\nUse of Estimates\nThe preparation of the accompanying unaudited condensed financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited condensed financial statements and the reported amounts of revenues and expenses during the reporting periods. Making estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the accompanying unaudited condensed financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. One of the more significant accounting estimates included in the accompanying unaudited condensed financial statements is the determination of the fair value of the derivative liabilities. Accordingly, the actual results could differ from those estimates.\nCash and Cash Equivalents\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company had no cash equivalents as of June 30, 2023 and December 31, 2022.\nConcentration of Credit Risk\nFinancial instruments that potentially subject the Company to concentrations of credit risk consist of cash accounts in a financial institution, which, regularly exceed the Federal Deposit Insurance Corporation coverage limit of $ 250,000 . Any loss incurred or a lack of access to such funds could have a significant adverse impact on the Company’s financial condition, results of operations, and cash flows.\nCash and Investments Held in the Trust Account\nThe Company classifies its U.S. Treasury and equivalent securities as held to maturity in accordance with FASB Accounting Standard Codification (“ASC”) Topic 320, “Investments – Debt and Equity Securities.” Held-to-maturity securities are those securities which the Company has the ability and intent to hold until maturity. Held-to-maturity treasury securities are recorded at amortized cost on the accompanying consolidated balance sheets and adjusted for the amortization or accretion of premiums or discounts.\nAt June 30, 2023, substantially all of the assets held in the Trust Account were held in cash. At December 31, 2022, substantially all of the assets held in the Trust Account were held in money market funds which invest primarily in U.S. Treasury securities. The money market funds are presented at fair value within the accompanying consolidated balance sheets, and fair value of the investments in the Trust Account is equal to the amortized cost basis of the money market funds.\nFair Value of Financial Instruments\nThe fair value of the Company’s assets and liabilities which qualify as financial instruments under the FASB ASC Topic 820, “Fair Value Measurements,” equal or approximate the carrying amounts represented in the condensed balance sheets.\n9\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nFair Value Measurements\n“Fair value” is defined as “the price that would be received for sale of an asset or paid for transfer of a liability, in an orderly transaction between market participants at the measurement date.” GAAP establishes a three-tier fair value hierarchy, which prioritizes inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). These tiers consist of:\n\n| ● | Level 1, defined as observable inputs such as quoted prices (unadjusted) for identical instruments in active markets; |\n\n\n| ● | Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable such as quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active; and |\n\n\n| ● | Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions, such as valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable. |\n\nIn some circumstances, the inputs used to measure fair value might be categorized within different levels of the fair value hierarchy. In those instances, the fair value measurement is categorized in its entirety in the fair value hierarchy based on the lowest level input that is significant to the fair value measurement.\nDerivative Liabilities\nThe Company does not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks. The Company evaluates all of its financial instruments, including issued warrants, to determine if such instruments are derivatives or contain features that qualify as embedded derivatives, pursuant to ASC 480 and ASC 815-15. The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is re-assessed at the end of each reporting period.\nThe Company accounts for its warrants issued in connection with its Initial Public Offering and Private Placement and units that may be issued in connection with a forward purchase agreement (the “Forward Purchase Units”) as derivative liabilities in accordance with ASC 815-40. Accordingly, the Company recognizes the instruments as liabilities at fair value and adjusts the instruments to fair value at the end of each reporting period. The liabilities are subject to re-measurement at each balance sheet date until exercised, and any change in fair value of derivative liabilities is recognized in the Company’s unaudited condensed statements of operations. The fair value of warrants issued in connection with the Initial Public Offering was initially measured using Monte-Carlo simulation and has subsequently been measured on the market price of such warrants at each measurement date when separately listed and traded. The fair value of warrants issued in connection with the Private Placement was initially measured using Black-Scholes Option Pricing Model and subsequently using the market value of the public warrants. The fair value of the Forward Purchase Units has been measured using the John C Hull’s Options, Futures and Other Derivatives model at each measurement date.\nOffering Costs Associated with the Initial Public Offering\nOffering costs consisted of legal, accounting, underwriting fees and other costs incurred through the Initial Public Offering that were directly related to the Initial Public Offering. Offering costs are allocated to the separable financial instruments issued in the Initial Public Offering based on a relative fair value basis, compared to total proceeds received. Offering costs associated with derivative liabilities are expensed as incurred, presented as non-operating expenses in the statements of operations in the period that the costs occurred. Offering costs associated with the Class A ordinary shares were charged against the carrying value of the Class A ordinary shares upon the completion of the Initial Public Offering. The Company classifies deferred underwriting commissions as non-current liabilities as their liquidation is not reasonably expected to require the use of current assets or require the creation of current liabilities.\nClass A Ordinary Shares Subject to Possible Redemption\nThe Company accounts for its Class A ordinary shares subject to possible redemption in accordance with the guidance in ASC Topic 480 “Distinguishing Liabilities from Equity.” Class A ordinary shares subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable Class A ordinary shares (including Class A ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) are classified as temporary equity. At all other times, Class A ordinary shares are classified as shareholders’ equity. The Company’s Class A ordinary shares feature certain redemption rights that are considered to be outside of the Company’s control and subject to the occurrence of uncertain future events. Accordingly, as of June 30, 2023 and December 31, 2022, 2,548,153 and 23,000,000 Class A Ordinary Shares subject to possible redemption are presented as temporary equity, outside of the shareholders’ deficit section of the accompanying condensed balance sheets, respectively.\n10\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nThe Company recognizes changes in redemption value immediately as they occur and adjusts the carrying value of the Class A ordinary shares subject to possible redemption to equal the redemption value at the end of each reporting period. This method would view the end of the reporting period as if it were also the redemption date for the security. Effective with the closing of the Initial Public Offering, the Company recognized the accretion from initial book value to redemption amount, which resulted in charges against additional paid-in capital (to the extent available) and accumulated deficit.\nShare-Based Compensation\nThe Company complies with the accounting and disclosure requirement of ASC Topic 718, “Compensation – Stock Compensation.” Share-based compensation to employees and non-employees is recognized over the requisite service period based on the estimated grant-date fair value of the awards. Share-based awards with graded-vesting schedules are recognized on a straight-line basis over the requisite service period for each separately vesting portion of the award. The Company recognizes the expense for share-based compensation awards subject to performance-based milestone vesting over the remaining service period when management determines that achievement of the milestone is probable. Management evaluates when the achievement of a performance-based milestone is probable based on the expected satisfaction of the performance conditions at each reporting date. Share-based compensation will be recognized in general and administrative expense in the statements of operations. The Company issued option awards that contain both a performance condition and service condition. The option awards vest upon the consummation of the initial Business Combination and will expire in five years after the date on which they first become exercisable. The Company has determined that the consummation of an initial Business Combination is a performance condition subject to significant uncertainty. As such, the achievement of the performance is not deemed to be probable of achievement until the consummation of the event, and therefore no compensation has been recognized for the period from inception to June 30, 2023.\nIncome Taxes\nFASB ASC Topic 740, “Income Taxes,” prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The Company’s management determined that the Cayman Islands is the Company’s only major tax jurisdiction. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of June 30, 2023 and December 31, 2022. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position.\nThere is currently no taxation imposed on income by the Government of the Cayman Islands. In accordance with Cayman federal income tax regulations, income taxes are not levied on the Company. Consequently, income taxes are not reflected in the accompanying unaudited condensed financial statements. The Company’s management does not expect that the total amount of unrecognized tax benefits will materially change over the next twelve months.\nNet (Loss) Income per Ordinary Share\nThe Company complies with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share.” The Company has two classes of shares, which are referred to as Class A ordinary shares and Class B ordinary shares. Income and losses are shared pro rata between the two classes of shares. Net (loss) income per ordinary share is calculated by dividing the net (loss) income by the weighted average number of ordinary shares outstanding for the respective period.\nThe calculation of diluted net (loss) income per ordinary share does not consider the effect of the warrants underlying the Units sold in the Initial Public Offering and the Private Placement Warrants to purchase an aggregate of 12,066,667 Class A ordinary shares since their exercise is contingent upon future events. As a result, diluted net (loss) income per share is the same as basic net (loss) income per share for the three and six months ended June 30, 2023 and 2022. Accretion associated with the redeemable Class A ordinary shares is excluded from earnings per share as the redemption value approximates fair value.\n11\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nThe table below presents a reconciliation of the numerator and denominator used to compute basic and diluted net (loss) income per share for each class of Ordinary Shares:\n\n| For the Three Months Ended June 30, |\n| 2023 | 2022 |\n| Class A | Class B | Class A | Class B |\n| Numerator: |\n| Allocation of net (loss) income | $ | ( 458,126 | ) | $ | — | $ | 825,025 | $ | 224,192 |\n| Denominator: |\n| Weighted average ordinary shares outstanding, basic and diluted | 8,798,153 | — | 23,000,000 | 6,250,000 |\n| Basic and diluted net (loss) income per ordinary share | $ | ( 0.05 | ) | $ | — | $ | 0.04 | $ | 0.04 |\n\n\n| For the Six Months Ended June 30, |\n| 2023 | 2022 |\n| Class A | Class B | Class A | Class B |\n| Numerator: |\n| Allocation of net income | $ | 141,383 | $ | 10,868 | $ | 4,033,797 | $ | 1,096,141 |\n| Denominator: |\n| Weighted average ordinary shares outstanding, basic and diluted | 13,551,176 | 1,041,667 | 23,000,000 | 6,250,000 |\n| Basic and diluted net income per ordinary share | $ | 0.01 | $ | 0.01 | $ | 0.18 | $ | 0.18 |\n\nRecent Accounting Pronouncements\nThe Company’s management does not believe that any recently issued, but not yet effective, accounting standards updates, if currently adopted, would have a material effect on the accompanying unaudited condensed financial statements.\nNote 3 - Initial Public Offering\nOn February 22, 2021, the Company consummated its Initial Public Offering of 23,000,000 Units, including 3,000,000 Over-Allotment Units, at $ 10.00 per Unit, generating gross proceeds of $ 230.0 million, and incurring offering costs of approximately $ 13.1 million, of which approximately $ 8.1 million was for deferred underwriting commissions.\nEach Unit consists of one Class A ordinary share and one-third of one redeemable warrant (“Public Warrant”). Each whole Public Warrant will entitle the holder to purchase one Class A ordinary share at an exercise price of $ 11.50 per share, subject to adjustment (see Note 7).\nNote 4 - Private Placement\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the Private Placement of 4,400,000 Private Placement Warrants, at a price of $ 1.50 per Private Placement Warrant with the Prior Sponsor, generating gross proceeds of $ 6.6 million, and incurring offering costs of approximately $ 7,000 . On June 15, 2022, the Prior Sponsor transferred 4,400,000 Private Placement Warrants to the New Sponsor.\nEach whole Private Placement Warrant is exercisable for one whole Class A ordinary share at a price of $ 11.50 per share. A portion of the proceeds from the sale of the Private Placement Warrants to the Prior Sponsor was added to the proceeds from the Initial Public Offering held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the Private Placement Warrants will expire worthless. The Private Placement Warrants will be non-redeemable for cash and exercisable on a cashless basis so long as they are held by the Sponsor or its permitted transferees.\nThe Sponsor agreed, subject to limited exceptions, not to transfer, assign or sell any of its Private Placement Warrants until 30 days after the completion of the initial Business Combination.\n12\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nNote 5 - Related Party Transactions\nForward Purchase Agreement\nIn connection with the consummation of the Initial Public Offering, the Company entered into a forward purchase agreement (the “Forward Purchase Agreement”) with the Prior Sponsor, which provides for the purchase of $ 20.0 million Forward Purchase Units, which at the option of the Prior Sponsor, can be increased to $ 50.0 million, with each Forward Purchase Unit consisting of one Class A ordinary share (the “Forward Purchase Shares”) and one-third of one warrant to purchase one Class A ordinary share at $ 11.50 per share (the “Forward Purchase Warrants,” together with the Forward Purchase Units and the Forward Purchase Shares, the “Forward Purchase Securities”), for a purchase price of $ 10.00 per Forward Purchase Unit, in a private placement to occur concurrently with the closing of the initial Business Combination. The purchase under the Forward Purchase Agreement is required to be made regardless of whether any Class A ordinary shares are redeemed by the Public Shareholders. The Forward Purchase Securities will be issued only in connection with the closing of the initial Business Combination. The proceeds from the sale of Forward Purchase Securities may be used as part of the consideration to the sellers in the initial Business Combination, expenses in connection with the initial Business Combination or for working capital in the post-transaction company. The Company does not intend to implement the forward purchase agreement, and on April 17, 2023, the Company sent a notice of mutual termination of the forward purchase agreement to the prior sponsor. The Company classified the Forward Purchase Units as derivative instruments on the accompanying condensed balance sheets. The initial value of the Forward Purchase Units was insignificant, and the Company recognized a loss in the change in the fair value of the derivative assets (liabilities) of approximately $ 0 and $ 0 for the three and six months ended June 30, 2023, respectively, and approximately $ 19,000 and $ 49,000 for the three and six months ended June 30, 2022, respectively.\nFounder Shares\nOn September 21, 2020, the Company issued 4,812,500 Class B ordinary shares, par value $ 0.001 per share (the “Founder Shares”) to the Prior Sponsor. On September 23, 2020, the Prior Sponsor paid an aggregate of $ 25,000 for certain expenses on behalf of the Company in exchange for issuance of the Founder Shares. On January 25, 2021, the Company effected a stock dividend of 1,437,500 shares with respect to Class B ordinary shares, resulting in an aggregate of 6,250,000 Founder Shares outstanding. The Prior Sponsor agreed to forfeit up to an aggregate of 750,000 Founder Shares, on a pro rata basis, to the extent that the option to purchase additional Units was not exercised in full by the underwriters, so that the Founder Shares would represent 20 % of the Company’s issued and outstanding shares after the Initial Public Offering plus the 2,000,000 Forward Purchase Shares underlying the Forward Purchase Units (which at the option of the Prior Sponsor can be increased to up to 5,000,000 Forward Purchase Shares). On February 22, 2021, the underwriter fully exercised its over-allotment option; thus, these 750,000 Founder Shares were no longer subject to forfeiture.\nOn June 15, 2022, the Prior Sponsor transferred all 6,250,000 Founder Shares to the New Sponsor.\nThe New Sponsor agreed not to transfer, assign or sell any of its Founder Shares until the earlier to occur of (i) one year after the date of the consummation of the initial Business Combination, or earlier if, subsequent to the initial Business Combination, (x) the last reported sale price of the Class A ordinary shares equals or exceeds $ 12.00 per share (as adjusted for share splits, share dividends, reorganizations and recapitalizations) for any 20 trading days within any 30-trading day period commencing at least 150 days after the initial Business Combination or (y) the Company consummates a subsequent liquidation, merger, stock exchange or other similar transaction which results in all of the shareholders having the right to exchange their Ordinary shares for cash, securities or other property.\nRelated Party Loans\nOn September 23, 2020, the Prior Sponsor agreed to loan the Company up to $ 250,000 to cover costs related to the Initial Public Offering pursuant to a promissory note, which was later amended on January 22, 2021 (the “IPO Note”). The IPO Note was non-interest bearing, unsecured and due upon the closing of the Initial Public Offering. As of February 22, 2021, the Company borrowed approximately $ 111,000 under the IPO Note. The Company repaid the IPO Note in full on February 24, 2021. Subsequent to the repayment, the facility was no longer available to the Company.\n13\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nIn addition, in order to finance transaction costs in connection with a Business Combination, the Sponsor, members of the Company’s founding team or any of their affiliates may, but are not obligated to, loan the Company funds as may be required (“Working Capital Loans”). If the Company completes a Business Combination, the Company would repay the Working Capital Loans out of the proceeds of the Trust Account released to the Company. Otherwise, the Working Capital Loans would be repaid only out of funds held outside the Trust Account. In the event that a Business Combination does not close, the Company may use a portion of proceeds held outside the Trust Account to repay the Working Capital Loans but no proceeds held in the Trust Account would be used to repay the Working Capital Loans. The Working Capital Loans would either be repaid upon consummation of a Business Combination, without interest, or, at the lenders’ discretion, up to $ 1.5 million of such Working Capital Loans may be convertible into warrants of the post Business Combination entity at a price of $ 1.50 per warrant. The warrants would be identical to the Private Placement Warrants. Except for the foregoing, the terms of such Working Capital Loans, if any, have not been determined and no written agreements exist with respect to such loans. As of June 30, 2023 and December 31, 2022, the Company had no borrowings under any Working Capital Loans.\nOn April 13, 2022, the Company issued the Promissory Note to the Prior Sponsor for an aggregate of up to $ 200,000 . On May 25, 2022, the Prior Sponsor amended the Promissory Note agreement and increased the principal amount to $ 400,000 . The Promissory Note bears no interest, may be prepaid at any time and is due and payable within one year from the date of the first drawdown of the amended and restated note, or June 7, 2023. On June 30, 2022, the Prior Sponsor assigned all of its rights and obligations under the Promissory Note to the New Sponsor in connection with the Sponsor Transaction. As of June 30, 2023, the Company has fully drawn $ 400,000 under the Promissory Note. As of June 30, 2023 and December 31, 2022, approximately $ 400,000 and $ 319,000 were outstanding under the Promissory Note, respectively.\nExtension Loan\nPursuant to the Extension, as described in Note 1, the Sponsor or its designees contributed to the Company as a loan the initial contribution of $ 120,000 in February 2023 for the portion of the extension ending on April 22, 2023. The Sponsor will also loan the company extension contributions of $ 60,000 per month for each subsequent calendar month (commencing on April 22, 2023 and on the 22nd day of each subsequent month) until November 22, 2023, or portion thereof, that is needed to complete an initial Business Combination, which amount will be deposited into the Trust Account. As of June 30, 2023, the Company has drawn $ 270,000 on the Extension Loan and deposited it into the Trust Account.\nRelated Party Advance\nFor the three and six months ended June 30, 2023, the Sponsor had paid $ 164,081 and $ 188,722 , respectively, of expenses on behalf on Company, which are included in advance from related parties in the accompanying condensed balance sheets as of June 30, 2023.\nAdministrative Services Agreement\nCommencing on February 17, 2021, through the earlier of consummation of the initial Business Combination and the liquidation, the Company agreed to pay Kismet LLC, an affiliate of the Prior Sponsor, $ 10,000 per month for office space, utilities, secretarial support and administrative services.\nOn June 30, 2022, in connection with the Sponsor Transaction, the Company and Kismet LLC mutually terminated the Administrative Services Agreement. As a result, the Company is no longer obligated to pay a $ 10,000 monthly fee pursuant to the Administrative Services Agreement.\nDirector Compensation\nCommencing on February 18, 2021, the Company paid its initial directors $ 40,000 each. On May 25, 2022, Mr. Verdi Israelyan, a former director, waived his right to receive a payment of $ 40,000 . The Company also granted two of its independent directors, Messrs. Tompsett and Zilber, an option each to purchase 40,000 Class A ordinary shares at an exercise price of $ 10.00 per share, which will vest upon the consummation of the initial Business Combination and will expire five years after the date on which it first became exercisable Further, following the approval of the Extension, the compensation committee of the Company’s board of directors has approved the transfers by the Sponsor of (a) 15,000 Founder Shares to each of Messrs. Zilber and Tourevski and (b) 20,000 Founder Shares to Mr. Tompsett as additional compensation, which transfers will take place prior to the closing of the initial Business Combination. Both the Founder Shares and the options granted to the directors are subject to forfeiture in the event a director ceases to serve on the Company’s board prior to the closing of a Business Combination. In addition, the Sponsor, executive officers and directors, or any of their respective affiliates will be reimbursed for any out-of-pocket expenses incurred in connection with activities on the Company’s behalf such as identifying potential target businesses and performing due diligence on suitable Business Combinations. The Company’s audit committee reviews, on a quarterly basis, all payments that are made to the Sponsor, officers or directors, or the Company’s or their affiliates.\nOn May 25, 2022, one of the Company’s former directors waived his right to receive a payment of $ 40,000 and the Company recorded approximately $ 0 of director compensation during three and six months ended June 30, 2023 , and approximately $( 12,000 ) and $ 3,000 of director compensation during the three and six months ended June 30, 2022, respectively. As of June 30, 2023 and December 31, 2022, the Company had no amounts outstanding in relation to the director compensation.\n14\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nDeparture and Appointment of Officers\nOn June 30, 2022, concurrently with the Sponsor Transaction, Ivan Tavrin, Chief Executive Officer and Chairman of the Company’s board of directors, resigned as Chairman and Chief Executive Officer of the Company, and as the Company’s principal financial and accounting officer.\nEffective June 30, 2022, the Company’s board of directors appointed Mr. Dimitri Elkin to serve as the Company’s Chief Executive Officer. Mr. Elkin is also serving as the Company’s principal financial and accounting officer.\nOn September 5, 2022, Verdi Israelyan, resigned from the board of directors of the Company. Mr. Israelyan resignation was not the result of any dispute or disagreement with the Company or the Company’s board of directors on any matter relating to the Company’s operations, policies or practices. On March 27, 2023, the board of directors elected Konstantin Tourevski as a director and as a member of the audit committees to fill the vacancy caused by the resignation of Mr. Israelyan.\nNote 6 - Commitments and Contingencies\nRegistration Rights\nThe holders of the Founder Shares and Private Placement Warrants (and any Class A ordinary shares issuable upon the exercise of the Private Placement Warrants and warrants that may be issued upon conversion of Working Capital Loans) were entitled to registration rights pursuant to a registration rights agreement dated February 17, 2021 (the “Registration Rights Agreement”). The holders of these securities are entitled to make up to three demands, excluding short form demands, that the Company register such securities. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the completion of the initial Business Combination. The Company will bear the expenses incurred in connection with the filing of any such registration statements. On June 30, 2022, in connection with the Sponsor Transaction, the Prior Sponsor assigned to the New Sponsor all of its rights and obligations under the Registration Rights Agreement.\nPursuant to the Forward Purchase Agreement, the Company agreed to use its commercially reasonable efforts (i) to file within 30 days after the closing of the initial Business Combination a registration statement with the SEC for a secondary offering of the Forward Purchase Shares and the Forward Purchase Warrants (and underlying Class A Ordinary Shares), (ii) to cause such registration statement to be declared effective promptly thereafter but in no event later than sixty (60) days after the initial filing, and (iii) to maintain the effectiveness of such registration statement until the earliest of (A) the date on the Prior Sponsor or its assignees cease to hold the securities covered thereby and (B) the date all of the securities covered thereby can be sold publicly without restriction or limitation under Rule 144 under the Securities Act. In addition, the Forward Purchase Agreement provides for “piggy-back” registration rights to the holders of Forward Purchase Securities to include their securities in other registration statements filed by the Company.\nUnderwriting Agreement\nThe Company granted the underwriters a 45-day option from February 17, 2021, to purchase up to 3,000,000 additional Units at the Initial Public Offering price less the underwriting discounts and commissions. On February 22, 2021, the underwriters fully exercised their over-allotment option.\nThe underwriters were entitled to an underwriting discount of $ 0.20 per Unit, or $ 4.6 million in the aggregate, paid upon the closing of the Initial Public Offering. In addition, $ 0.35 per Unit, or approximately $ 8.1 million in the aggregate will be payable to the underwriters for deferred underwriting commissions. The deferred fee will become payable to the underwriters from the amounts held in the Trust Account solely in the event that the Company completes a Business Combination, subject to the terms of the underwriting agreement.\nOn August 11, 2022 and September 6, 2022, two of the underwriters in the initial public offering irrevocably waived their rights to receive an aggregate of approximately $ 5.2 million of deferred underwriting discounts due under the underwriting agreements consummated in connection with the initial public offering. The Company recognized the portion allocated to Public Shares of approximately $ 5.0 million as an adjustment to the carrying value of the Class A ordinary shares subject to possible redemption and the remaining balance of approximately $ 0.2 million as a gain from extinguishment of deferred underwriting commissions allocated to derivative warrant liabilities.\nRisks and Uncertainties\nManagement continues to evaluate the impact of the COVID-19 pandemic on the industry and has concluded that while it is reasonably possible that the virus could have a negative effect on the Company’s financial position, results of its operations and/or search for a target company, the specific impact is not readily determinable as of the date of these unaudited condensed financial statements. The accompanying unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty.\n15\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nIn February 2022, a military conflict started between Russia and Ukraine. The ongoing military conflict between Russia and Ukraine has provoked strong reactions from the United States, the United Kingdom, the European Union and various other countries around the world, including the imposition of broad financial and economic sanctions against Russia. Further, the precise effects of the ongoing military conflict and these sanctions on the global economies remain uncertain as of the date of the accompanying unaudited condensed financial statements. The specific impact on the Company’s financial condition, results of operations, and cash flows is also not determinable as of the date of the accompanying unaudited condensed financial statements.\nNote 7 - Warrants\nAs of June 30, 2023 and December 31, 2022, 7,666,667 Public Warrants and 4,400,000 Private Placement Warrants were outstanding.\nPublic Warrants may only be exercised for a whole number of Class A Ordinary Shares. No fractional Public Warrants will be issued upon separation of the Units and only whole Public Warrants will trade. The Public Warrants will become exercisable on the later of (a) 30 days after the completion of a Business Combination or (b) 12 months from the closing of the Initial Public Offering; provided in each case that the Company has an effective registration statement under the Securities Act covering the Class A Ordinary Shares issuable upon exercise of the Public Warrants and a current prospectus relating to them is available and such shares are registered, qualified or exempt from registration under the securities, or blue sky, laws of the state of residence of the holder (or the Company permits holders to exercise their warrants on a cashless basis under certain circumstances). The Company agreed that as soon as practicable, but in no event later than 15 business days after the closing of the initial Business Combination, the Company will use commercially reasonable efforts to file with the SEC and have an effective registration statement covering the Class A Ordinary Shares issuable upon exercise of the warrants and to maintain a current prospectus relating to those Class A Ordinary Shares until the warrants expire or are redeemed, as specified in the warrant agreement. If a registration statement covering the Class A Ordinary Shares issuable upon exercise of the warrants is not effective by the 60th day after the closing of the initial Business Combination, warrant holders may, until such time as there is an effective registration statement and during any period when the Company will have failed to maintain an effective registration statement, exercise warrants on a “cashless basis” in accordance with Section 3(a)(9) of the Securities Act or another exemption. Notwithstanding the above, if the Class A Ordinary Shares are at the time of any exercise of a warrant not listed on a national securities exchange such that they satisfy the definition of a “covered security” under Section 18(b)(1) of the Securities Act, the Company may, at its option, require holders of Public Warrants who exercise their warrants to do so on a “cashless basis” and, in the event the Company so elects, the Company will not be required to file or maintain in effect a registration statement, and in the event the Company does not so elect, it will use commercially reasonable efforts to register or qualify the shares under applicable blue sky laws to the extent an exemption is not available.\nThe warrants have an exercise price of $11.50 per share, subject to adjustments, and will expire five years after the completion of a Business Combination or earlier upon redemption or liquidation. In addition, if (x) the Company issues additional Class A Ordinary Shares or equity-linked securities for capital raising purposes in connection with the closing of the initial Business Combination at an issue price or effective issue price of less than $9.20 per Class A Ordinary Share (with such issue price or effective issue price to be determined in good faith by the Company’s board of directors and, in the case of any such issuance to the Sponsor or an affiliate of the Sponsor, without taking into account any Founder Shares held by the Sponsor or an affiliate of the Sponsor, as applicable, prior to such issuance) (the “Newly Issued Price”), (y) the aggregate gross proceeds from such issuances represent more than 60% of the total equity proceeds, and interest thereon, available for the funding of the initial Business Combination on the date of the completion of the initial Business Combination (net of redemptions), and (z) the volume-weighted average trading price of the Class A Ordinary Shares during the 20 trading day period starting on the trading day prior to the day on which the Company completes its initial Business Combination (such price, the “Market Value”) is below $9.20 per share, the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115% of the higher of the Market Value and the Newly Issued Price, and the $10.00 and $18.00 per share redemption trigger prices described under “Redemption of warrants when the price per Class A Ordinary Share equals or exceeds $18.00” and “Redemption of warrants when the price per Class A Ordinary Share equals or exceeds $10.00” will be adjusted (to the nearest cent) to be equal to 100% and 180% of the higher of the Market Value and the Newly Issued Price, respectively.\n16\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nThe Private Placement Warrants are identical to the Public Warrants underlying the Units sold in the Initial Public Offering, except that the Private Placement Warrants and the Class A Ordinary Shares issuable upon exercise of the Private Placement Warrants will not be transferable, assignable or sellable until 30 days after the completion of a Business Combination, subject to certain limited exceptions. Additionally, the Private Placement Warrants will be non-redeemable so long as they are held by the initial purchaser or such purchaser’s permitted transferees. If the Private Placement Warrants are held by someone other than the Initial Shareholder or its permitted transferees, the Private Placement Warrants will be redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants.\nRedemption of Warrants When the Price per Class A Ordinary Share Equals or Exceeds $ 18.00\nOnce the warrants become exercisable, the Company may call the outstanding warrants (excluding the Private Placement Warrants), in whole and not in part, at a price of $ 0.01 per warrant:\n\n| ● | upon a minimum of 30 days’ prior written notice of redemption; and |\n\n\n| ● | if, and only if, the last reported sale price of the Class A Ordinary Shares equals or exceeds $ 18.00 per share (as adjusted) for any 20 trading days within a 30 trading day period ending three business days before the Company sends the notice of redemption to the warrant holders (the “Reference Value”). |\n\nThe Company will not redeem the warrants as described above unless a registration statement under the Securities Act covering the Class A Ordinary Shares issuable upon exercise of the warrants is then effective and a current prospectus relating to those Class A Ordinary Shares is available throughout the 30-trading day redemption period.\nRedemption of Warrants When the Price per Class A Ordinary Share Equals or Exceeds $ 10.00\nOnce the warrants become exercisable, the Company may redeem the outstanding warrants, in whole and not in part, at a price of $ 0.10 per warrant:\n\n| ● | upon a minimum of 30 days’ prior written notice of redemption provided that holders will be able to exercise their warrants on a cashless basis prior to redemption and receive that number of Class A Ordinary Shares to be determined by reference to an agreed table based on the redemption date and the “fair market value” of Class A Ordinary Shares; and |\n\n\n| ● | if, and only if, and only if, the Reference Value equals or exceeds $ 10.00 per Public Share (as adjusted), and |\n\n\n| ● | if the Reference Value is less than $ 18.00 per share (as adjusted), the Private Placement Warrants must also be concurrently called for redemption on the same terms as the outstanding Public Warrants, as described above. |\n\nThe “fair market value” of Class A Ordinary Shares for the above purpose shall mean the volume-weighted average price of the Class A Ordinary Shares for the 10 trading days immediately following the date on which the notice of redemption is sent to the holders of warrants. In no event will the warrants be exercisable in connection with this redemption feature for more than 0.361 Class A Ordinary Shares per warrant (subject to adjustment).\nIn no event will the Company be required to net cash settle any warrant. If the Company is unable to complete a Business Combination within the Combination Period and the Company liquidates the funds held in the Trust Account, holders of warrants will not receive any of such funds with respect to their warrants, nor will they receive any distribution from the Company’s assets held outside of the Trust Account with the respect to such warrants. Accordingly, the warrants may expire worthless.\n17\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nNote 8 - Class A Ordinary Shares Subject to Possible Redemption\nThe Class A ordinary shares feature certain redemption rights that are considered to be outside of the Company’s control and subject to the occurrence of future events. The Company is authorized to issue 200,000,000 Class A ordinary shares with a par value of $ 0.001 per share. Holders of the Class A ordinary shares are entitled to one vote for each share. In connection with such shareholders’ meeting, shareholders holding 20,451,847 Class A ordinary shares exercised their right to redeem those shares for cash at an approximate price of $ 10.20 per share for an aggregate of approximately $ 208.5 million. As of June 30, 2023 and December 31, 2022, there were 2,548,153 and 23,000,000 Class A Ordinary Shares outstanding, respectively, which were all subject to possible redemption and are classified outside of permanent equity in the accompanying condensed balance sheets.\nThe Class A Ordinary Shares subject to possible redemption reflected on the accompanying condensed balance sheets are reconciled on the following table:\n\n| Gross proceeds received from Initial Public Offering | $ | 230,000,000 |\n| Less: |\n| Fair value of Public Warrants at issuance | ( 6,823,334 | ) |\n| Offering costs allocated to Class A ordinary shares | ( 12,685,596 | ) |\n| Plus: |\n| Accretion on Class A ordinary shares subject to possible redemption | 19,508,930 |\n| Class A ordinary shares subject to possible redemption as of December 31, 2021 | 230,000,000 |\n| Plus: |\n| Waiver of Class A ordinary shares issuance costs | 5,077,217 |\n| Less: |\n| Accretion on Class A ordinary shares subject to possible redemption | ( 1,872,702 | ) |\n| Class A ordinary shares subject to possible redemption as of December 31, 2022 | 233,204,515 |\n| Less: |\n| Redemptions | ( 208,524,538 | ) |\n| Plus: |\n| Accretion on Class A ordinary shares subject to possible redemption | 1,560,982 |\n| Class A ordinary shares subject to possible redemption as of March 31, 2023 | 26,240,959 |\n| Plus: |\n| Accretion on Class A ordinary shares subject to possible redemption | 390,284 |\n| Class A ordinary shares subject to possible redemption as of June 30, 2023 | $ | 26,631,243 |\n\nNote 9 - Shareholders’ Deficit\nClass A Ordinary Shares\nThe Company is authorized to issue 200,000,000 Class A Ordinary Shares with a par value of $ 0.001 per share. Holders of the Class A Ordinary Shares are entitled to one vote for each share. As of June 30, 2023 and December 31, 2022, there were 6,250,000 and 0 Class A Ordinary Shares issued and outstanding, excluding 2,548,153 and 23,000,000 which were subject to possible redemption and included as temporary equity, respectively (see Note 8).\nClass B Ordinary Shares\nThe Company is authorized to issue 10,000,000 Class B Ordinary Shares with a par value of $ 0.001 per share. As of June 30, 2023 and December 31, 2022, there were 0 and 6,250,000 Class B Ordinary Shares issued and outstanding, respectively.\nOrdinary shareholders of record are entitled to one vote for each share held on all matters to be voted on by shareholders. Except as described below, holders of Class A ordinary shares and holders of Class B ordinary shares vote together as a single class on all matters submitted to a vote of the shareholders except as required by law.\nThe Class B ordinary shares will automatically convert into Class A ordinary shares at the time of the initial Business Combination or earlier at the option of the holders thereof at a ratio such that the number of Class A ordinary shares issuable upon conversion of all Founder Shares will equal, in the aggregate, on an as-converted basis, 20 % of the sum of (i) the total number of the Ordinary Shares issued and outstanding upon completion of the Initial Public Offering, plus (ii) the total number of Class A ordinary shares issued or deemed issued or issuable upon conversion or exercise of any equity-linked securities or rights issued or deemed issued by the Company in connection with or in relation to the completion of the initial Business Combination (including the Forward Purchase Shares, but not the Forward Purchase Warrants), excluding any Class A ordinary shares or equity-linked securities exercisable for or convertible into Class A ordinary shares issued, deemed issued, or to be issued, to any seller in the initial Business Combination and any Private Placement Warrants issued to the Sponsor or any of its affiliates or any member of the Company’s management team upon conversion of Working Capital Loans. In no event will the Class B ordinary shares convert into Class A ordinary shares at a rate of less than one-to-one.\n18\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nNote 10 - Fair Value Measurements\nThe following tables present information about the Company’s assets and liabilities that are measured at fair value on a recurring basis as of June 30, 2023 and December 31, 2022 and indicates the fair value hierarchy of the valuation techniques that the Company utilized to determine such fair value.\n\n| Fair Value Measured as of June 30, 2023 |\n| Level 1 | Level 2 | Level 3 |\n| Liabilities: |\n| Derivative liabilities - Public Warrants | $ | — | $ | 514,433 | $ | — |\n| Derivative liabilities - Private Placement Warrants | $ | — | $ | 295,240 | $ | — |\n\n\n| Fair Value Measured as of December 31, 2022 |\n| Level 1 | Level 2 | Level 3 |\n| Assets |\n| Investments held in Trust Account - U.S. Treasury Securities | $ | 233,304,515 | $ | — | $ | — |\n| Liabilities: |\n| Derivative liabilities - Public Warrants | $ | — | $ | 19,167 | $ | — |\n| Derivative liabilities - Private Placement Warrants | $ | — | $ | 11,000 | $ | — |\n\nTransfers to/from Levels 1, 2, and 3 are recognized in the beginning of the reporting period. The estimated fair value of the Public Warrants was transferred from a Level 3 measurement to a Level 1 fair value measurement in April 2021, when the Public Warrants were separately listed and traded. The estimated fair value of the Private Placement Warrants was transferred from a Level 3 measurement to a Level 2 fair value measurement during the year ended December 31, 2021. The estimated fair value of the Public Warrants transferred to a Level 2 measurement during the quarter ending December 31, 2022 due to low trading volume. There were no transfers to/from Levels 1, 2, and 3 during the three and six months ended June 30, 2023.\nLevel 1 assets include investments in mutual funds that invest solely in U.S. government securities. The Company uses inputs such as actual trade data, quoted market prices from dealers or brokers, and other similar sources to determine the fair value of its investments.\nThe fair value of the Public Warrants was initially measured using a Monte-Carlo simulation and has subsequently been measured based on the market price of such warrants at each measurement date when separately listed and traded. The fair value of the Private Placement Warrants was initially measured using a Black-Scholes Option Pricing Model and subsequently using the market value of the Public Warrants. For the three months ended June 30, 2023 and 2022, the Company recognized a decrease/(increase) in the fair value of derivative warrant liabilities of approximately $( 538,000 ) and $ 845,000 , and approximately $( 780,000 ) and $ 5.1 million for the six months ended June 30, 2023 and 2022, respectively, presented on the accompanying condensed statements of operations.\nThe Company utilized John C. Hull’s Options, Futures, and Other Derivatives model to estimate the fair value of the Forward Purchase Units at each measurement date up until September 30, 2023. As the Company does not intend to implement the forward purchase agreement, the Company determined the fair value of the Forward Purchase Units as of June 30, 2023 and December 31, 2022 was deminimis. There was no change in fair value of the Forward Purchase Units for the three and six months ended June 30, 2023. The Company recognized expense in the change in fair value of the Forward Purchase Units of approximately $ 19,000 and $ 49,000 for the three and six months ended June 30, 2022, respectively.\n19\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nThe change in the fair value of the Level 3 derivative warrant liabilities for three and six months ended March 31, 2022 is summarized as follows:\n\n| Derivative assets (liabilities) as of January 1, 2022 | $ | 88,970 |\n| Change in fair value of derivative assets and liabilities | 30,204 |\n| Derivative assets (liabilities) as of March 31, 2022 | 119,174 |\n| Change in fair value of derivative assets and liabilities | 18,877 |\n| Derivative assets (liabilities) as of June 30, 2022 | $ | 138,051 |\n\nNote 11 - Subsequent Events\nManagement has evaluated subsequent events to determine if events or transactions occurring after the balance sheet date through the date the accompanying unaudited condensed financial statements were issued. Based upon this review, the Company did not, other than the below, identify any subsequent event that would have required adjustment or disclosure in the accompanying unaudited condensed financial statements.\nOn July 11, 2023 and August 7, 2023, pursuant to the Extension, as described in Note 1, the Sponsor or its designees contributed to the Company as a loan an additional contribution of $ 30,000 and $ 60,000 , respectively, into the trust to extend the date of which it has to consummate an initial business combination to August 22, 2023.\n20\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.\nReferences to the “Company,” “Quadro Acquisition One Corp.,” “our,” “us” or “we” refer to Quadro Acquisition One Corp. (formerly known as Kismet Acquisition Two Corp.). The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the unaudited condensed financial statements and the notes thereto under “Item 1. Financial Statements”. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\nCautionary Note Regarding Forward-Looking Statements\nAll statements other than statements of historical fact included in this Quarterly Report on Form 10-Q for the quarter ended June 30, 2023 (this “Report”) including, without limitation, statements under this “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward- looking statements. When used in this Report, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or our management, identify forward-looking statements. Such forward-looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company’s management. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors detailed in our filings with the SEC. All subsequent written or oral forward-looking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph.\nOverview\nWe are a blank check company incorporated as a Cayman Islands exempted company on September 15, 2020. We were incorporated for the purpose of engaging in an initial business combination with one or more businesses. We are an emerging growth company and, as such, we are subject to all of the risks associated with emerging growth companies.\nOur sponsor is Quadro Sponsor LLC, a Delaware limited liability company. The registration statement for our initial public offering was declared effective on February 17, 2021. On February 22, 2021, we consummated our initial public offering of 23,000,000 units, including 3,000,000 additional units to cover the underwriters’ over-allotment option, at $10.00 per unit, generating gross proceeds of $230.0 million, and incurring offering costs of approximately $13.1 million, of which approximately $8.1 million was for deferred underwriting commissions.\nSimultaneously with the closing of our initial public offering, we consummated the private placement of 4,400,000 warrants, at a price of $1.50 per private placement warrant, to our prior sponsor, generating gross proceeds of $6.6 million, and incurring offering costs of approximately $7,000.\nUpon the closing of the initial public offering and the private placement, $230.0 million ($10.00 per unit) of the net proceeds of the initial public offering and a portion of the proceeds of the private placement were placed in a trust account, with Continental acting as trustee, and invested in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds meeting certain conditions under Rule 2a-7 under the Investment Company Act, which invest only in direct U.S. government treasury obligations, as determined by us, until the earlier of: (i) the completion of a business combination and (ii) the distribution of the trust account as described below.\nOn February 10, 2023, we instructed Continental to liquidate the investments held in the trust account and instead to hold the funds in the trust account in an interest-bearing demand deposit account at Morgan Stanley, with Continental continuing to act as trustee, until the earlier of the consummation of our initial business combination or our liquidation. As a result, following the liquidation of investments in the trust account, the remaining proceeds from the initial public offering and private placement are no longer invested in U.S. government securities or money market funds.\nOur management has broad discretion with respect to the specific application of the net proceeds of our initial public offering and the private placement, although substantially all of the net proceeds are intended to be applied generally toward consummating a business combination. Our initial business combination must be with one or more operating businesses or assets with a fair market value equal to at least 80% of the net assets held in the trust account (excluding the deferred underwriting commissions and taxes payable, if any, on the income accrued on the trust account) at the time we sign a definitive agreement in connection with the initial business combination. However, we will only complete a business combination if the post-transaction company owns or acquires 50% or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act.\nIf we are unable to complete a business combination by the Termination Date, we will (i) cease all operations except for the purpose of winding up; (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account, including interest earned on the funds held in the trust account and not previously released to us to pay our taxes that were paid by us or are payable by us, if any (less up to $100,000 of interest to pay dissolution expenses), divided by the number of the then-outstanding public shares, which redemption will completely extinguish public shareholders’ rights as shareholders (including the right to receive further liquidation distributions, if any); and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the remaining shareholders and the board of directors, liquidate and dissolve, subject in the case of clauses (ii) and (iii) to our obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law.\n21\nRecent Developments\nOn January 31, 2023, we issued an aggregate of 6,250,000 Class A ordinary shares to the sponsor, upon the conversion of an equal number of Class B ordinary shares held by the sponsor in the Founder Conversion. The 6,250,000 Class A ordinary shares issued in connection with the Founder Conversion are subject to the same restrictions as applied to the Class B ordinary shares before the Founder Conversion, including, among others, certain transfer restrictions, waiver of redemption rights and the obligation to vote in favor of an initial business combination as described in the prospectus for the initial public offering.\nOn February 20, 2023, we held the 2023 Extraordinary General Meeting at which our shareholders approved an amendment to our amended and restated memorandum and articles of association to extend the date by which we must consummate an initial business combination to April 22, 2023, and to allow our board, without another shareholder vote, to extend the Termination Date on a monthly basis up to seven times for an additional one month each time until November 22, 2023, or a total of up to nine months after the Original Termination Date (the “Extension”). In connection with the vote to approve the Extension Amendment, the holders of 20,451,847 Class A ordinary shares properly exercised their right to redeem their shares for cash at a redemption price of approximately $10.20 per share, for an aggregate redemption amount of approximately $208,524,538, in connection with the Extension Amendment.\nIn connection with the Extension, our sponsor or its designees contributed to us as a loan the initial contribution of $120,000 (the “Initial Extension Loan”) in February 2023 for the portion of the Extension ending on April 22, 2023. Our sponsor will also loan us extension contributions of $60,000 per month for each subsequent calendar month (commencing on April 22, 2023 and on the 22nd day of each subsequent month) until November 22, 2023, or portion thereof, that is needed to complete an initial business combination, which amount will be deposited into the trust account (together with the Initial Extension Loan, the “Extension Loans”). The amount of the Extension Loans will not bear interest and will be repayable by us to the sponsor or its designees upon consummation of an initial business combination. In the event that a business combination does not close, we may use a portion of proceeds held outside the trust account to repay the Extension Loans, but no proceeds held in the trust account would be used to repay the Extension Loans.\nFollowing the Founder Conversion and the redemptions in connection with the Extension, there were 8,798,153 Class A ordinary shares issued and outstanding and no Class B Ordinary Shares issued and outstanding.\nAt the 2023 Extraordinary General Meeting, our shareholders also approved our company’s name change from Kismet Acquisition Two Corp. to Quadro Acquisition One Corp. to better reflect the Sponsor Transaction.\nOn March 27, 2023, our board of directors elected Konstantin Tourevski as a director and as a member of the audit committee to fill the vacancy caused by the resignation of Verdi Israelyan.\nLiquidity and Capital Resources\nAs of June 30, 2023, we had $0 in our operating bank account and working capital deficit of approximately $1.4 million.\nOur liquidity needs to date have been satisfied through a contribution of $25,000 from the prior sponsor to cover certain expenses in exchange for the issuance of the founder shares, a loan of approximately $111,000 from the prior sponsor pursuant to the First Note originally issued on September 23, 2020 and amended on January 22, 2021, and a portion of the proceeds from the consummation of the private placement not held in the trust account. We repaid the First Note in full on February 24, 2021. Subsequent to the repayment, the facility was no longer available to us. In addition, in order to finance transaction costs in connection with a business combination, the sponsor or an affiliate of the sponsor, or certain of our officers and directors may, but are not obligated to, provide us working capital loans in order to finance transaction costs in connection with a business combination. As of June 30, 2023 and December 31, 2022, there were no amounts outstanding under any working capital loans.\n22\nOn April 13, 2022, we issued the Second Note, a promissory note in the amount of up to $200,000 to the prior sponsor. On May 25, 2022, we and the prior sponsor amended and restated the Second Note and increased the principal amount to $400,000. The promissory note bears no interest and is due and payable within one year from the date of the first drawdown of the amended and restated note, or June 7, 2023. On June 30, 2022, the prior sponsor assigned all of its rights and obligations under the promissory note to our sponsor in connection with the Sponsor Transaction. As of June 30, 2023, we have fully drawn $400,000 under the Promissory Note. As of June 30, 2023 and December 31, 2022, approximately $400,000 and $319,000 were outstanding under the Promissory Note, respectively.\nWe may need to raise additional capital through loans or additional investments from our sponsor, our officers or directors or their affiliates. Our sponsor, officers, directors and or their affiliates, may, but are not obligated to, loan our company funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet our working capital needs. Accordingly, we may not be able to obtain additional financing. If we are unable to raise additional capital, we may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, reducing overhead expenses, and extending the terms and due dates of certain accrued expenses and other liabilities. We cannot provide any assurance that new financing will be available to it on commercially acceptable terms, if at all. In connection with our assessment of going concern considerations in accordance with ASC Topic 205-40, “Presentation of Financial Statements – Going Concern,” we have determined that the liquidity condition, mandatory liquidation and subsequent dissolution raises substantial doubt about our ability to continue as a going concern. Management continues to seek to complete a business combination prior to the mandatory liquidation date. No adjustments have been made to the carrying amounts of assets or liabilities should we be required to liquidate by November 22, 2023.\nContractual Obligations\nAdministrative Services Agreement\nWe do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities, except that, commencing on February 17, 2021, through the earlier of consummation of the initial business combination and the liquidation, we agreed to pay Kismet LLC, an affiliate of our prior sponsor, $10,000 per month for office space, utilities, secretarial support and administrative services.\nOn June 30, 2022, in connection with the Sponsor Transaction, the Company and Kismet LLC mutually terminated the Administrative Services Agreement. As a result, the Company is no longer obligated to pay a $10,000 monthly fee pursuant to the Administrative Services Agreement.\nResults of Operations\nOur entire activity since inception up to June 30, 2023, was in preparation for our formation and our initial public offering, and since the completion of our initial public offering, the search for business combination candidates. We will not be generating any operating revenues until the closing and completion of our initial business combination at the earliest.\nFor the three months ended June 30, 2023, we had net loss of approximately $458,000, which consisted of a non-operating loss of approximately $538,000 resulting from the change in fair value of derivative assets and liabilities and approximately $160,000 general and administrative expenses, partially offset by approximately $240,000 of income from investments held in trust account.\nFor the three months ended June 30, 2022, we had net income of approximately $1.0 million, which consisted of a non-operating gain of approximately $864,000 resulting from the change in fair value of derivative assets and liabilities and approximately $292,000 of net gain on the investments held in the Trust Account, partially offset by approximately $107,000 general and administrative expenses.\nFor the six months ended June 30, 2023, we had net income of approximately $152,000, which consisted of approximately $1.7 million of income from investments held in trust account, partially offset by a non-operating loss of approximately $780,000 resulting from the change in fair value of derivative assets and liabilities and approximately $750,000 general and administrative expenses.\nFor the six months ended June 30, 2022, we had net income of approximately $5.1 million, which consisted of a non-operating gain of approximately $5.1 million resulting from the change in fair value of derivative assets and liabilities and approximately $313,000 of net gain on the investments held in the Trust Account, partially offset by approximately $300,000 general and administrative expenses.\n23\nCommitments and Contingencies\nRegistration Rights\nThe holders of the founder shares, private placement warrants, and warrants that may be issued upon conversion of working capital loans (and any Class A ordinary shares issuable upon the exercise of the private placement warrants and warrants that may be issued upon conversion of working capital loans) are entitled to registration rights pursuant to a registration rights agreement dated February 17, 2021. The holders of these securities are entitled to make up to three demands, excluding short form demands, that we register such securities. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the completion of the initial business combination. We will bear the expenses incurred in connection with the filing of any such registration statements.\nPursuant to the forward purchase agreement (described below), we agreed to use our commercially reasonable efforts (i) to file within 30 days after the closing of the initial business combination a registration statement with the SEC for a secondary offering of the forward purchase shares and the forward purchase warrants (and underlying Class A ordinary shares), (ii) to cause such registration statement to be declared effective promptly thereafter but in no event later than sixty (60) days after the initial filing, and (iii) to maintain the effectiveness of such registration statement until the earliest of (A) the date on which our sponsor or its assignees cease to hold the securities covered thereby and (B) the date all of the securities covered thereby can be sold publicly without restriction or limitation under Rule 144 under the Securities Act. In addition, the forward purchase agreement provides for “piggy-back” registration rights to the holders of forward purchase securities to include their securities in other registration statements filed by us.\nForward Purchase Agreement\nIn connection with the consummation of our initial public offering, we entered into a forward purchase agreement with our prior sponsor, which provides for the purchase of $20.0 million of forward purchase units, which at the option of our prior sponsor can be increased to $50.0 million, with each forward purchase unit consisting of one Class A ordinary share and one-third of one warrant to purchase one Class A ordinary share at $11.50 per share, for a purchase price of $10.00 per forward purchase unit, in a private placement to occur concurrently with the closing of the initial business combination. The purchase under the forward purchase agreement is required to be made regardless of whether any Class A ordinary shares are redeemed by the public shareholders. The forward purchase securities will be issued only in connection with the closing of the initial business combination. The proceeds from the sale of forward purchase securities may be used as part of the consideration to the sellers in the initial business combination, expenses in connection with the initial business combination or for working capital in the post-transaction company. We do not intend to implement the forward purchase agreement, and on April 17, 2023, we sent a notice of mutual termination of the forward purchase agreement to the prior sponsor.\nUnderwriting Agreement\nWe granted the underwriters a 45-day option from February 17, 2021, to purchase up to 3,000,000 additional units at our initial public offering price less the underwriting discounts and commissions. On February 22, 2021, the underwriters fully exercised their over-allotment option.\nThe underwriters were entitled to an underwriting discount of $0.20 per unit, or approximately $4.6 million in the aggregate, paid upon the closing of our initial public offering. In addition, $0.35 per unit, or approximately $8.1 million in the aggregate will be payable to the underwriters for deferred underwriting commissions. The deferred fee will become payable to the underwriters from the amounts held in the trust account solely in the event that we complete an initial business combination, subject to the terms of the underwriting agreement.\nOn August 11, 2022 and September 6, 2022, two of the underwriters in the initial public offering irrevocably waived their rights to receive an aggregate of approximately $5.2 million of deferred underwriting discounts due under the underwriting agreements consummated in connection with the initial public offering. We recognized the portion allocated to Public Shares of approximately $5.0 million as an adjustment to the carrying value of the Class A ordinary shares subject to possible redemption and the remaining balance of approximately $0.2 million as a gain from extinguishment of deferred underwriting commissions allocated to derivative warrant liabilities.\n24\nCritical Accounting Policies and Estimates\nDerivative Assets and Liabilities\nWe do not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks. We evaluate all of our financial instruments, including issued stock purchase warrants, to determine if such instruments are derivatives or contain features that qualify as embedded derivatives, pursuant to ASC Topic 480, “Distinguishing Liabilities from Equity” (“ASC 480”) and ASC Topic 815-15, “Derivatives and Hedging”. The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is re-assessed at the end of each reporting period.\nWe account for our public warrants, private placement warrants and forward purchase units as derivative assets/liabilities in accordance with ASC 815-40, “Derivatives and Hedging”. Accordingly, we recognize the warrants and forward purchase units as assets/liabilities at fair value and adjust the instruments to fair value at each reporting period. The liabilities are subject to re-measurement at each balance sheet date until exercised, and any change in fair value of derivative assets and liabilities is recognized in our statements of operations. The fair value of our public warrants was initially measured using Monte-Carlo simulation and subsequently been measured on the market price of such warrants when separately listed and traded at each measurement date. The fair value of the private placement warrants was initially measured using Black-Scholes Option Pricing Model and subsequently using the market value of the public warrants. The fair value of the forward purchase units has been measured using the John C Hull’s Options, Futures and Other Derivatives model at each measurement date.\nClass A Ordinary Shares Subject to Possible Redemption\nWe account for the Class A ordinary shares subject to possible redemption in accordance with the guidance in ASC 480. Class A ordinary shares subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable Class A ordinary shares (including Class A ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, Class A ordinary shares are classified as shareholders’ equity. Our Class A ordinary shares feature certain redemption rights that are considered to be outside of our control and subject to the occurrence of uncertain future events. Accordingly, as of June 30, 2023 and December 31, 2022, 2,548,153 and 23,000,000 Class A Ordinary Shares subject to possible redemption, respectively, are presented as temporary equity, outside of the shareholders’ deficit section of the condensed balance sheets under “Item 1. Financial Statements”.\nWe recognize changes in redemption value immediately as they occur and adjust the carrying value of the Class A ordinary shares subject to possible redemption to equal the redemption value at the end of each reporting period. Effective with the closing of the initial public offering, we recognized the accretion from initial book value to redemption amount, which resulted in charges against additional paid-in capital (to the extent available) and accumulated deficit.\nNet (Loss) Income per Ordinary Share\nWe comply with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share.” We have two classes of shares, Class A ordinary shares and Class B ordinary shares. Income and losses are shared pro rata between the two classes of shares. Net (loss) income per ordinary share is calculated by dividing the net (loss) income by the weighted average number of ordinary shares outstanding for the respective period.\nThe calculation of diluted net (loss) income per ordinary share does not consider the effect of the warrants issued in connection with our initial public offering and the private placement to purchase an aggregate of 12,066,667 Class A ordinary shares because their exercise is contingent upon future events. Accretion associated with the redeemable Class A ordinary shares is excluded from (losses) earnings per share as the redemption value approximates fair value.\n25\nShare-Based Compensation\nWe comply with the accounting and disclosure requirement of ASC Topic 718, “Compensation - Stock Compensation.” We record share-based compensation to employees and non-employees over the requisite service period based on the estimated grant-date fair value of the awards. Share-based awards with graded-vesting schedules are recognized on a straight-line basis over the requisite service period for each separately vesting portion of the award. We recognize the expense for share-based compensation awards subject to performance-based milestone vesting over the remaining service period when management determines that achievement of the milestone is probable. Management evaluates when the achievement of a performance-based milestone is probable based on the expected satisfaction of the performance conditions at each reporting date. Share-based compensation will be recognized in general and administrative expense in the statements of operations. We issued option awards that contain both a performance condition and service condition. The option awards vest upon the consummation of the initial business combination and will expire in five years after the date on which they first become exercisable. We have determined that the consummation of an initial business combination is a performance condition subject to significant uncertainty. As such, the achievement of the performance is not deemed to be probable of achievement until the consummation of the event, and therefore no compensation has been recognized for the period from inception to June 30, 2023.\nRecent Accounting Pronouncements\nManagement does not believe that any recently issued, but not yet effective, accounting standards updates, if currently adopted, would have a material effect on the accompanying unaudited condensed financial statements.\nOff-Balance Sheet Arrangements and Contractual Obligations\nAs of June 30, 2023, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K and did not have any commitments or contractual obligations.\nJOBS Act\nThe JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We qualify as an “emerging growth company” and under the JOBS Act are allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) companies. We are electing to delay the adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As a result, the financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates.\nAdditionally, we are in the process of evaluating the benefits of relying on the other reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, if, as an “emerging growth company,” we choose to rely on such exemptions we may not be required to, among other things, (i) provide an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404, (ii) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (iii) comply with any requirement that may be adopted by the PCAOB regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis) and (iv) disclose certain executive compensation related items such as the correlation between executive compensation and performance and comparisons of the CEO’s compensation to median employee compensation. These exemptions will apply for a period of five years following the completion of our initial public offering or until we are no longer an “emerging growth company,” whichever is earlier.\nFactors That May Adversely Affect our Results of Operations\nOur results of operations and our ability to complete an initial business combination may be adversely affected by various factors that could cause economic uncertainty and volatility in the financial markets, many of which are beyond our control. Our business could be impacted by, among other things, downturns in the financial markets or in economic conditions, increases in oil prices, inflation, increases in interest rates, supply chain disruptions, declines in consumer confidence and spending, the ongoing effects of the COVID-19 pandemic, including resurgences and the emergence of new variants, and geopolitical instability, such as the military conflict in Ukraine. We cannot at this time fully predict the likelihood of one or more of the above events, their duration or magnitude or the extent to which they may negatively impact our business and our ability to complete an initial business combination.\n26\n\nItem 3. Quantitative and Qualitative Disclosures About Market Risk.\nWe are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act, and are not required to provide the information otherwise required under this item.\n\nItem 4. Controls and Procedures.\nEvaluation of Disclosure Controls and Procedures\nDisclosure controls and procedures are controls and other procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is accumulated and communicated to management, including our principal executive officer and principal financial officer (our “Certifying Officer”), to allow timely decisions regarding required disclosure.\nAs of June 30, 2023, as required by Rules 13a-15 and 15d-15 under the Exchange Act, our principal executive officer and principal financial and accounting officer carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were not effective because of a material weakness in our internal control over financial reporting. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis. Specifically, the Company’s management has concluded that our control around the interpretation and accounting for extinguishment of a significant contingent obligation was not effectively designed or maintained. In light of this material weakness, we performed additional analysis as deemed necessary to ensure that our financial statements were prepared in accordance with GAAP. Accordingly, management believes that the unaudited condensed financial statements included in this Quarterly Report on Form 10-Q present fairly in all material respects our financial position, results of operations and cash flows for the period presented.\nWe do not expect that our disclosure controls and procedures will prevent all errors and all instances of fraud. Disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Further, the design of disclosure controls and procedures must reflect the fact that there are resource constraints, and the benefits must be considered relative to their costs. Because of the inherent limitations in all disclosure controls and procedures, no evaluation of disclosure controls and procedures can provide absolute assurance that we have detected all our control deficiencies and instances of fraud, if any. The design of disclosure controls and procedures also is based partly on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.\nManagement has implemented remediation steps to improve our internal control over financial reporting. Specifically, we expanded and improved our review process for related accounting standards. We plan to further improve this process by enhancing access to accounting literature, identification of third-party professionals with whom to consult regarding complex accounting applications and consideration of additional staff with the requisite experience and training to supplement existing accounting professionals.\nChanges in Internal Control Over Financial Reporting\nOther than the above, there have been no changes to our internal control over financial reporting during the quarter ended June 30, 2023 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n27\nPART II - OTHER INFORMATION\n\nItem 1. Legal Proceedings.\nTo the knowledge of our management team, there is no litigation currently pending or contemplated against us, any of our officers or directors in their capacity as such or against any of our property.\n\nItem 1A. Risk Factors.\nAs a smaller reporting company under Rule 12b-2 of the Exchange Act, we are not required to include risk factors in this Report. However, as of the date of this Report, other than as set forth below, there have been no material changes with respect to those risk factors previously disclosed in our (i) Registration Statement, (ii) Annual Report on Form 10-K for the year ended December 31, 2021, as filed with the SEC on March 31, 2022, (iii) Quarterly Reports on Form 10-Q for the quarterly periods ended March 31, 2021, June 30, 2021, September 30, 2021, March 31, 2022, June 30, 2022 and September 30, 2022, as filed with the SEC on June 25, 2021, August 13, 2021, November 22, 2021, May 9, 2022, August 15, 2022, and November 14, 2022, respectively, (iv) Definitive Proxy Statement on Schedule 14A, as filed with the SEC on January 31, 2023, and (v) our 2022 Annual Report. Any of these factors could result in a significant or material adverse effect on our results of operations or financial condition. Additional risks could arise that may also affect our business or ability to consummate an initial Business Combination. We may disclose changes to such risk factors or disclose additional risk factors from time to time in our future filings with the SEC.\nTo mitigate the risk that we might be deemed to be an investment company for purposes of the Investment Company Act, we have instructed the trustee, on February 10, 2023, to liquidate the investments held in the Trust Account and instead to hold the funds in the Trust Account in an interest bearing demand deposit account at Morgan Stanley until the earlier of the consummation of our initial Business Combination or our liquidation. As a result, we may receive less interest on the funds held in the Trust Account than the interest we would have received pursuant to our original Trust Account investments, which could reduce the dollar amount our public shareholders would receive upon any redemption or liquidation of the Company.\nThe funds in the Trust Account had, since our IPO, been held only in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds investing solely in U.S. government treasury obligations and meeting certain conditions under Rule 2a-7 under the Investment Company Act. However, to mitigate the risk of us being deemed to be an unregistered investment company (including under the subjective test of Section 3(a)(1)(A) of the Investment Company Act) and thus subject to regulation under the Investment Company Act, we have instructed the trustee, on February 10, 2023, to liquidate the U.S. government treasury obligations or money market funds held in the Trust Account and thereafter to hold all funds in the Trust Account in an interest bearing demand deposit account at Morgan Stanley until the earlier of the consummation of our initial Business Combination or the liquidation of the Company. Following such liquidation, we may receive less interest on the funds held in the Trust Account than the interest we would have received pursuant to our original trust account investments. However, interest previously earned on the funds held in the Trust Account still may be released to us to pay our taxes, if any, and certain other expenses as permitted. As a result, our decision to liquidate the securities held in the Trust Account and thereafter to hold all funds in the Trust Account in an interest bearing demand deposit account at Morgan Stanley could reduce the dollar amount our public shareholders would receive upon any redemption or liquidation of the Company.\nMarket conditions, economic uncertainty or downturns could adversely affect our business, financial condition, operating results and our ability to consummate a Business Combination.\nIn recent years, the United States and other markets have experienced cyclical or episodic downturns, and worldwide economic conditions remain uncertain, including as a result of the COVID-19 pandemic, supply chain disruptions, the Ukraine-Russia conflict, instability in the U.S. and global banking systems, rising fuel prices, increasing interest rates or foreign exchange rates and high inflation and the possibility of a recession. A significant downturn in economic conditions may make it more difficult for us to consummate a Business Combination.\n28\nWe cannot predict the timing, strength, or duration of any future economic slowdown or any subsequent recovery generally, or in any industry. If the conditions in the general economy and the markets in which we operate worsen from present levels, our business, financial condition, operating results and our ability to consummate a Business Combination could be adversely affected. For example, in January 2023, the outstanding national debt of the U.S. government reached its statutory limit. The U.S. Department of the Treasury (the “Treasury Department”) has announced that, since then, it has been using extraordinary measures to prevent the U.S. government’s default on its payment obligations, and to extend the time that the U.S. government has to raise its statutory debt limit or otherwise resolve its funding situation. The failure by Congress to raise the federal debt ceiling could have severe repercussions within the U.S. and to global credit and financial markets. If Congress does not raise the debt ceiling, the U.S. government could default on its payment obligations, or experience delays in making payments when due. A payment default or delay by the U.S. government, or continued uncertainty surrounding the U.S. debt ceiling, could result in a variety of adverse effects for financial markets, market participants and U.S. and global economic conditions. In addition, U.S. debt ceiling and budget deficit concerns have increased the possibility a downgrade in the credit rating of the U.S. government and could result in economic slowdowns or a recession in the U.S. Although U.S. lawmakers have passed legislation to raise the federal debt ceiling on multiple occasions, ratings agencies have lowered or threatened to lower the long-term sovereign credit rating on the United States as a result of disputes over the debt ceiling. The impact of a potential downgrade to the U.S. government’s sovereign credit rating or its perceived creditworthiness could adversely affect economic conditions, as well as our business, financial condition, operating results and our ability to consummate a Business Combination.\nIf our initial Business Combination involves a company organized under the laws of a state of the United States, it is possible a 1% U.S. federal excise tax will be imposed on us in connection with redemptions of our common stock after or in connection with such initial Business Combination.\nOn August 16, 2022, the Inflation Reduction Act of 2022 became law in the United States, which, among other things, imposes a 1% excise tax on the fair market value of certain repurchases (including certain redemptions) of stock by publicly traded domestic (i.e., United States) corporations (and certain non-U.S. corporations treated as “surrogate foreign corporations”). The excise tax will apply to stock repurchases occurring in 2023 and beyond. The amount of the excise tax is generally 1% of the fair market value of the shares of stock repurchased at the time of the repurchase. The Treasury Department has been given authority to provide regulations and other guidance to carry out, and prevent the abuse or avoidance of, the excise tax; however, only limited guidance has been issued to date.\nAs an entity incorporated as a Cayman Islands exempted company, the 1% excise tax is not expected to apply to redemptions of our Class A ordinary shares (absent any regulations and other additional guidance that may be issued in the future with retroactive effect).\nHowever, in connection with an initial Business Combination involving a company organized under the laws of the United States, it is possible that we domesticate and continue as a Delaware corporation prior to certain redemptions and, because our securities are trading on the Nasdaq Capital Market, it is possible that we will be subject to the excise tax with respect to any subsequent redemptions, including redemptions in connection with the initial Business Combination, that are treated as repurchases for this purpose (other than, pursuant to recently issued guidance from the Treasury Department, redemptions in complete liquidation of the company). In all cases, the extent of the excise tax that may be incurred will depend on a number of factors, including the fair market value of our stock redeemed, the extent such redemptions could be treated as dividends and not repurchases, and the content of any regulations and other additional guidance from the Treasury Department that may be issued and applicable to the redemptions. Issuances of stock by a repurchasing corporation in a year in which such corporation repurchases stock may reduce the amount of excise tax imposed with respect to such repurchase. The excise tax is imposed on the repurchasing corporation itself, not the stockholders from which stock is repurchased. The imposition of the excise tax as a result of redemptions in connection with the initial Business Combination could, however, reduce the amount of cash available to pay redemptions or reduce the cash contribution to the target business in connection with our initial Business Combination, which could cause the other shareholders of the combined company to economically bear the impact of such excise tax.\n29\n\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\nNone. For a description of the use of proceeds generated in our Initial Public Offering and the Private Placement, see Part II, Item 2 of our Quarterly Report on Form 10-Q for the quarter ended March 31, 2021, as filed with the SEC on June 25, 2021. There has been no material change in the planned use of the proceeds from our Initial Public Offering and the Private Placement as described in the Registration Statement.\n\nItem 3. Defaults Upon Senior Securities.\nNone.\n\nItem 4. Mine Safety Disclosures\nNot applicable.\n\nItem 5. Other Information.\nNone.\n\nItem 6. Exhibits\nThe following exhibits are filed as part of, or incorporated by reference into, this Report.\n\n| Exhibit Number | Description of Exhibit |\n| 31.1 | Certification of the Principal Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |\n| 31.2 | Certification of the Principal Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |\n| 32.1 | Certification of the Principal Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.** |\n| 32.2 | Certification of the Principal Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.** |\n| 101.INS | Inline XBRL Instance Document.* |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document.* |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document.* |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document.* |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document.* |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document.* |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101).* |\n\n\n| * | Filed herewith. |\n\n\n| ** | Furnished herewith. |\n\n30\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| Dated: August 14, 2023 | QUADRO ACQUISITION ONE CORP. |\n| By: | /s/ Dimitri Elkin |\n| Name: | Dimitri Elkin |\n| Title: | Chief Executive Officer |\n\n31\n\n</text>\n\nWhat is the total amount of loans that the company borrowed and to be repaid by June 30, 2023, including the IPO Note, Working Capital Loans, Promissory Note, Extension Loan, and Related Party Advance in dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nPART I. FINANCIAL INFORMATION\nITEM 1. FINANCIAL STATEMENTS\nEV Energy Partners, L.P.\nCondensed Consolidated Balance Sheets\n(In thousands, except number of units)\n(Unaudited)\n\n| June 30, | December 31, |\n| 2011 | 2010 |\n| ASSETS |\n| Current assets: |\n| Cash and cash equivalents | $ | 26,392 | $ | 23,127 |\n| Accounts receivable: |\n| Oil, natural gas and natural gas liquids revenues | 36,600 | 27,742 |\n| Related party | 3,967 | – |\n| Other | 300 | 441 |\n| Derivative asset | 51,215 | 55,100 |\n| Assets held for sale | 11,402 | – |\n| Other current assets | 1,047 | 1,158 |\n| Total current assets | 130,923 | 107,568 |\n| Oil and natural gas properties, net of accumulated depreciation, depletion and amortization; June 30, 2011, $210,073; December 31, 2010, $176,897 | 1,300,294 | 1,324,240 |\n| Other property, net of accumulated depreciation and amortization; June 30, 2011, $536; December 31, 2010, $465 | 1,495 | 1,567 |\n| Long–term derivative asset | 26,576 | 51,497 |\n| Other assets | 7,533 | 1,885 |\n| Total assets | $ | 1,466,821 | $ | 1,486,757 |\n| LIABILITIES AND OWNERS’ EQUITY |\n| Current liabilities: |\n| Accounts payable and accrued liabilities: |\n| Third party | $ | 27,642 | $ | 20,678 |\n| Related party | – | 182 |\n| Liabilities related to assets held for sale | 2,895 | – |\n| Derivative liability | 1,178 | 1,943 |\n| Total current liabilities | 31,715 | 22,803 |\n| Asset retirement obligations | 68,266 | 67,175 |\n| Long–term debt | 480,183 | 619,000 |\n| Long–term liabilities | 988 | 3,048 |\n| Long–term derivative liability | 6,594 | 784 |\n| Commitments and contingencies |\n| Owners’ equity: |\n| Common unitholders – 34,173,650 units and 30,510,313 units issued and outstanding as of June 30, 2011 and December 31, 2010, respectively | 887,843 | 779,327 |\n| General partner interest | (8,768 | ) | (5,380 | ) |\n| Total owners’ equity | 879,075 | 773,947 |\n| Total liabilities and owners’ equity | $ | 1,466,821 | $ | 1,486,757 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n2\nEV Energy Partners, L.P.\nCondensed Consolidated Statements of Operations\n(In thousands, except per unit data)\n(Unaudited)\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2011 | 2010 | 2011 | 2010 |\n| Revenues: |\n| Oil, natural gas and natural gas liquids revenues | $ | 68,109 | $ | 39,431 | $ | 127,730 | $ | 78,027 |\n| Transportation and marketing–related revenues | 1,484 | 1,476 | 2,885 | 3,054 |\n| Total revenues | 69,593 | 40,907 | 130,615 | 81,081 |\n| Operating costs and expenses: |\n| Lease operating expenses | 17,949 | 14,869 | 35,311 | 26,301 |\n| Cost of purchased natural gas | 1,120 | 1,095 | 2,170 | 2,315 |\n| Dry hole and exploration costs | 441 | – | 844 | – |\n| Production taxes | 3,119 | 1,673 | 5,770 | 3,800 |\n| Asset retirement obligations accretion expense | 970 | 764 | 1,936 | 1,274 |\n| Depreciation, depletion and amortization | 18,443 | 13,436 | 36,007 | 25,520 |\n| General and administrative expenses | 7,132 | 5,825 | 15,725 | 10,549 |\n| Impairment of oil and natural gas properties | 5,078 | – | 6,666 | – |\n| Gain on sale of oil and natural gas properties | – | (4,388 | ) | – | (3,824 | ) |\n| Total operating costs and expenses | 54,252 | 33,274 | 104,429 | 65,935 |\n| Operating income | 15,341 | 7,633 | 26,186 | 15,146 |\n| Other income (expense), net: |\n| Realized gains on derivatives, net | 14,242 | 13,901 | 27,784 | 21,866 |\n| Unrealized gains (losses) on derivatives, net | 17,422 | (2,158 | ) | (35,633 | ) | 30,502 |\n| Interest expense | (8,124 | ) | (3,269 | ) | (13,283 | ) | (5,372 | ) |\n| Other income, net | 313 | 252 | 233 | 393 |\n| Total other income (expense), net | 23,853 | 8,726 | (20,899 | ) | 47,389 |\n| Income before income taxes | 39,194 | 16,359 | 5,287 | 62,535 |\n| Income taxes | (31 | ) | (79 | ) | (113 | ) | (131 | ) |\n| Net income | $ | 39,163 | $ | 16,280 | $ | 5,174 | $ | 62,404 |\n| General partner’s interest in net income, including incentive distribution rights | $ | 3,728 | $ | 2,624 | $ | 5,982 | $ | 5,836 |\n| Limited partners’ interest in net income (loss) | $ | 35,435 | $ | 13,656 | $ | (808 | ) | $ | 56,568 |\n| Net income (loss) per limited partner unit: |\n| Basic | $ | 1.03 | $ | 0.50 | $ | (0.02 | ) | $ | 2.14 |\n| Diluted | $ | 1.03 | $ | 0.50 | $ | (0.02 | ) | $ | 2.14 |\n| Weighted average limited partner units outstanding: |\n| Basic | 34,294 | 27,210 | 33,002 | 26,403 |\n| Diluted | 34,534 | 27,264 | 33,002 | 26,438 |\n| Distributions declared per unit | $ | 0.761 | $ | 0.757 | $ | 1.521 | $ | 1.513 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n3\nEV Energy Partners, L.P.\nCondensed Consolidated Statements of Changes in Owners’ Equity\n(In thousands, except number of units)\n(Unaudited)\n\n| Common Unitholders | General Partner Interest | Total Owners’ Equity |\n| Balance, December 31, 2010 | $ | 779,327 | $ | (5,380 | ) | $ | 773,947 |\n| Conversion of 80,534 vested phantom units | 3,508 | – | 3,508 |\n| Proceeds from public equity offering, net of underwriters discount and offering costs of $308 | 146,800 | – | 146,800 |\n| Contributions from general partner | – | 3,191 | 3,191 |\n| Distributions | (49,291 | ) | (6,682 | ) | (55,973 | ) |\n| Equity–based compensation | 2,428 | – | 2,428 |\n| Net income | 5,071 | 103 | 5,174 |\n| Balance, June 30, 2011 | $ | 887,843 | $ | (8,768 | ) | $ | 879,075 |\n\n\n| Common Unitholders | General Partner Interest | Total Owners’ Equity |\n| Balance, December 31, 2009 | $ | 548,160 | $ | (729 | ) | $ | 547,431 |\n| Conversion of 84,842 vested phantom units | 2,580 | – | 2,580 |\n| Proceeds from public equity offering, net of underwriters discount and offering costs of $154 | 92,616 | – | 92,616 |\n| Contributions from general partner | – | 1,977 | 1,977 |\n| Distributions | (38,284 | ) | (5,149 | ) | (43,433 | ) |\n| Equity–based compensation | 827 | – | 827 |\n| Net income | 61,156 | 1,248 | 62,404 |\n| Balance, June 30, 2010 | $ | 667,055 | $ | (2,653 | ) | $ | 664,402 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n4\nEV Energy Partners, L.P. Condensed Consolidated Statements of Cash Flows (In thousands) (Unaudited)\n| Six Months Ended June 30, |\n| 2011 | 2010 |\n| Cash flows from operating activities: |\n| Net income | $ | 5,174 | $ | 62,404 |\n| Adjustments to reconcile net income to net cash flows provided by operating activities: |\n| Asset retirement obligations accretion expense | 1,936 | 1,274 |\n| Depreciation, depletion and amortization | 36,007 | 25,520 |\n| Equity–based compensation cost | 3,877 | 2,103 |\n| Impairment of oil and natural gas properties | 6,666 | – |\n| Gain on sale of oil and natural gas properties | – | (3,824 | ) |\n| Noncash derivative activity | 30,951 | (30,502 | ) |\n| Amortization of discount on long–term debt | 183 | – |\n| Amortization of deferred loan costs | 554 | 275 |\n| Other, net | 56 | (1 | ) |\n| Changes in operating assets and liabilities: |\n| Accounts receivable | (12,866 | ) | (4,098 | ) |\n| Other current assets | 111 | 2,625 |\n| Accounts payable and accrued liabilities | 7,630 | 879 |\n| Long–term liabilities | – | (734 | ) |\n| Other, net | (149 | ) | (119 | ) |\n| Net cash flows provided by operating activities | 80,130 | 55,802 |\n| Cash flows from investing activities: |\n| Acquisition of oil and natural gas properties | 3,101 | (147,769 | ) |\n| Development of oil and natural gas properties | (33,686 | ) | (8,170 | ) |\n| Proceeds from sale of oil and natural gas properties | 1,170 | 4,471 |\n| Settlements from acquired derivatives | 2,834 | – |\n| Earnest money received for sale of oil and natural gas properties | 900 | – |\n| Net cash flows used in investing activities | (25,681 | ) | (151,468 | ) |\n| Cash flows from financing activities: |\n| Long–term debt borrowings | – | 138,000 |\n| Repayment of long–term debt borrowings | (431,500 | ) | (95,000 | ) |\n| Proceeds from debt offering | 292,500 | – |\n| Loan costs incurred | (6,202 | ) | (8 | ) |\n| Proceeds from public equity offering | 147,108 | 92,770 |\n| Offering costs | (308 | ) | (154 | ) |\n| Contributions from general partner | 3,191 | 1,977 |\n| Distributions paid | (55,973 | ) | (43,433 | ) |\n| Net cash flows (used in) provided by financing activities | (51,184 | ) | 94,152 |\n| Increase (decrease) in cash and cash equivalents | 3,265 | (1,514 | ) |\n| Cash and cash equivalents – beginning of period | 23,127 | 18,806 |\n| Cash and cash equivalents – end of period | $ | 26,392 | $ | 17,292 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n5\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements\nNOTE 1. ORGANIZATION AND NATURE OF BUSINESS\nNature of Operations\nEV Energy Partners, L.P. (“we,” “our” or “us”) is a publicly held limited partnership that engages in the acquisition, development and production of oil and natural gas properties. Our general partner is EV Energy GP, L.P. (“EV Energy GP”), a Delaware limited partnership, and the general partner of our general partner is EV Management, LLC (“EV Management”), a Delaware limited liability company. EV Management is a wholly owned subsidiary of EnerVest, Ltd. (“EnerVest”), a Texas limited partnership. EnerVest and its affiliates also have a significant interest in us through their 71.25% ownership of EV Energy GP which, in turn, owns a 2% general partner interest in us and all of our incentive distribution rights.\nBasis of Presentation\nOur unaudited condensed consolidated financial statements included herein have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, certain information and disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. We believe that the presentations and disclosures herein are adequate to make the information not misleading. The unaudited condensed consolidated financial statements reflect all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the interim periods. The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the full year. These interim financial statements should be read in conjunction with our Annual Report on Form 10–K for the year ended December 31, 2010.\nAll intercompany accounts and transactions have been eliminated in consolidation. In the Notes to Unaudited Condensed Consolidated Financial Statements, all dollar and unit amounts in tabulations are in thousands of dollars and units, respectively, unless otherwise indicated.\nNOTE 2. EQUITY–BASED COMPENSATION\nWe grant various forms of equity–based awards to employees, consultants and directors of EV Management and its affiliates who perform services for us. These equity–based awards consist primarily of phantom units and performance units.\nWe account for the phantom units issued prior to 2009 as liability awards, and the fair value of these phantom units is remeasured at the end of each reporting period based on the current market price of our common units until settlement. Prior to settlement, compensation cost is recognized for these phantom units based on the proportionate amount of the requisite service period that has been rendered to date. We account for the phantom units issued beginning in 2009 as equity awards, and we estimated the fair value of these phantom units using the Black–Scholes option pricing model. We account for the performance units as equity awards, and we estimated the fair value of these performance units using the Monte Carlo simulation model.\nThe following table presents the compensation costs recognized in our unaudited condensed consolidated statements of operations:\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2011 | 2010 | 2011 | 2010 |\n| Liability awards | $ | 526 | $ | 608 | $ | 1,449 | $ | 1,276 |\n| Equity awards | 1,214 | 429 | 2,428 | 827 |\n| Total | $ | 1,740 | $ | 1,037 | $ | 3,877 | $ | 2,103 |\n\nThese costs are included in “General and administrative expenses” in our unaudited condensed consolidated statements of operations.\nIn January 2011, the performance criterion was achieved with respect to the remaining 0.1 million performance units.\n6\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nAs of June 30, 2011, total unrecognized compensation costs related to the unvested liability awards and equity awards and the period over which they are expected to be recognized are as follows:\n\n| Unrecognized Compensation Expense | Weighted Average Period (in years) |\n| Liability awards | $ | 3,355 | 1.5 |\n| Equity awards | 15,175 | 3.2 |\n\nNOTE 3. ACQUISITIONS\nIn April 2011, we received a final purchase price settlement of $1.9 million related to our acquisition of oil and natural gas properties in the Mid–Continent area in September 2010.\nIn June 2011, we received a final purchase price settlement of $2.2 million related to our acquisition of oil and natural gas properties in the Barnett Shale in December 2010.\nIn June 2011, we, along with certain institutional partnerships managed by EnerVest, acquired additional oil and natural gas properties in the Barnett Shale. We acquired a 31.02% proportional interest in these properties for $1.0 million.\nNOTE 4. RISK MANAGEMENT\nOur business activities expose us to risks associated with changes in the market price of oil, natural gas and natural gas liquids. In addition, our floating rate credit facility exposes us to risks associated with changes in interest rates. As such, future earnings are subject to fluctuation due to changes in the market prices of oil, natural gas and natural gas liquids and interest rates. We use derivatives to reduce our risk of changes in the prices of oil, natural gas and natural gas liquids and interest rates. Our policies do not permit the use of derivatives for speculative purposes.\nWe have elected not to designate any of our derivatives as hedging instruments. Accordingly, changes in the fair value of our derivatives are recorded immediately to net income as “Unrealized gains (losses) on derivatives, net” in our unaudited condensed consolidated statements of operations.\nAs of June 30, 2011, we had entered into oil commodity contracts with the following terms:\n\n| Period Covered | Hedged Volume (MBbls) | Weighted Average Fixed Price | Weighted Average Floor Price | Weighted Average Ceiling Price |\n| Swaps – July 2011 through December 2011 | 209.4 | $ | 95.01 | $ | $ |\n| Collars – July 2011 through December 2011 | 236.6 | 105.66 | 156.16 |\n| Swaps –2012 | 625.7 | 96.45 |\n| Collars – 2012 | 456.8 | 104.54 | 156.77 |\n| Swaps –2013 | 994.5 | 86.46 |\n| Swaps – 2014 | 897.2 | 91.90 |\n\n7\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nAs of June 30, 2011, we had entered into natural gas commodity contracts with the following terms:\n\n| Period Covered | Hedged Volume (MmmBtus) | Weighted Average Fixed Price | Weighted Average Floor Price | Weighted Average Ceiling Price |\n| Swaps – July 2011 through December 2011 | 8,322.9 | $ | 6.67 | $ | $ |\n| Collars – July 2011 through December 2011 | 3,330.6 | 7.54 | 9.90 |\n| Swaps –2012 | 14,307.6 | 6.84 |\n| Collars – 2012 | 6,618.7 | 7.94 | 9.90 |\n| Swaps – 2013 | 18,797.5 | 5.77 |\n| Swaps – 2014 | 14,600.0 | 5.75 |\n| Swaps – 2015 | 14,600.0 | 6.00 |\n\nAs of June 30, 2011, we had entered into natural gas liquids commodity contracts with the following terms:\n\n| Period Covered | Hedged Volume (MBbls) | Weighted Average Fixed Price |\n| Ethane (MBbls): |\n| Swaps – July 2011 through December 2011 | 188.6 | $ | 20.06 |\n| Propane (MBbls): |\n| Swaps – July 2011 through December 2011 | 112.7 | 49.77 |\n\nAs of June 30, 2011, we had entered into natural gas basis swaps with the following terms:\n\n| Period Covered | Floating Index 1 | Floating Index 2 | Hedged Volume (MmmBtus) | Spread |\n| July 2011 through December 2011 | NYMEX | Dominion Appalachia | 174.4 | $ | 0.1975 |\n| July 2011 through December 2011 | NYMEX | Appalachia Columbia | 47.7 | 0.1500 |\n\nAs of June 30, 2011, we had entered into interest rate swaps with the following terms:\n\n| Period Covered | Notional Amount | Floating Rate | Fixed Rate |\n| July 2011 – July 2012 | $ | 90,000 | 1 Month LIBOR | 4.157 | % |\n| July 2011 – September 2012 | 40,000 | 1 Month LIBOR | 2.145 | % |\n| July 2012 – July 2015 | 110,000 | 1 Month LIBOR | 3.315 | % |\n\n8\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nThe fair value of these derivatives was as follows:\n\n| Asset Derivatives | Liability Derivatives |\n| June 30, 2011 | December 31, 2010 | June 30, 2011 | December 31, 2010 |\n| Commodity contracts | $ | 89,564 | $ | 123,655 | $ | 10,620 | $ | 7,633 |\n| Interest rate swaps | – | – | 8,925 | 12,152 |\n| Total fair value | 89,564 | 123,655 | 19,545 | 19,785 |\n| Netting arrangements | (11,773 | ) | (17,058 | ) | (11,773 | ) | (17,058 | ) |\n| Net recorded fair value | $ | 77,791 | $ | 106,597 | $ | 7,772 | $ | 2,727 |\n| Location of derivatives in our unaudited condensed consolidated balance sheets: |\n| Derivative asset | $ | 51,215 | $ | 55,100 | $ | – | $ | – |\n| Long–term derivative asset | 26,576 | 51,497 | – | – |\n| Derivative liability | – | – | 1,178 | 1,943 |\n| Long–term derivative liability | – | – | 6,594 | 784 |\n| $ | 77,791 | $ | 106,597 | $ | 7,772 | $ | 2,727 |\n\nThe following table presents the impact of derivatives and their location within the unaudited condensed consolidated statements of operations:\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2011 | 2010 | 2011 | 2010 |\n| Realized gains on derivatives, net: |\n| Commodity contracts (1) | $ | 11,388 | $ | 16,044 | $ | 27,070 | $ | 26,167 |\n| Interest rate swaps (2) | 2,854 | (2,143 | ) | 714 | (4,301 | ) |\n| Total | $ | 14,242 | $ | 13,901 | $ | 27,784 | $ | 21,866 |\n| Unrealized gains (losses) on derivatives, net: |\n| Commodity contracts | $ | 20,380 | $ | (1,189 | ) | $ | (34,181 | ) | $ | 32,701 |\n| Interest rate swaps (2) | (2,958 | ) | (969 | ) | (1,452 | ) | (2,199 | ) |\n| Total | $ | 17,422 | $ | (2,158 | ) | $ | (35,633 | ) | $ | 30,502 |\n\n\n| (1) | Realized gains for the three months and six months ended June 30, 2011 exclude $1.4 million and $2.9 million, respectively, related to the initial value of derivatives acquired in our December 2010 acquisition of oil and natural gas properties that have been relieved through the settlement of such derivatives. |\n\n\n| (2) | In June 2011, we terminated three of our interest rate swaps and reclassified the $4.7 million non–cash gain from “Unrealized gains (losses) on derivatives, net” to “Realized gains on derivatives, net.” |\n\n9\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nNOTE 5. FAIR VALUE MEASUREMENTS\nRecurring Basis\nThe following table presents the fair value hierarchy table for our assets and liabilities that are required to be measured at fair value on a recurring basis:\n\n| Fair Value at Reporting Date Using: |\n| June 30, 2011 | Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) |\n| Derivative assets: |\n| Commodity contracts | $ | 89,564 | $ | – | $ | 89,564 | $ | – |\n| Derivative liabilities: |\n| Commodity contracts | $ | 10,620 | $ | – | $ | 10,620 | $ | – |\n| Interest rate swaps | 8,925 | – | 8,925 | – |\n| Total derivative liabilities | $ | 19,545 | $ | – | $ | 19,545 | $ | – |\n| Fair Value at Reporting Date Using: |\n| December 31, 2010 | Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) |\n| Derivative assets: |\n| Commodity contracts | $ | 123,655 | $ | – | $ | 123,655 | $ | – |\n| Derivative liabilities: |\n| Commodity contracts | $ | 7,633 | $ | – | $ | 7,633 | $ | – |\n| Interest rate swaps | 12,152 | – | 12,152 | – |\n| Total derivative liabilities | $ | 19,785 | $ | – | $ | 19,785 | $ | – |\n\nOur derivatives consist of over–the–counter (“OTC”) contracts which are not traded on a public exchange. These derivatives are indexed to active trading hubs for the underlying commodity and are commonly used in the energy industry and offered by a number of financial institutions and large energy companies.\nAs the fair value of these derivatives is based on inputs using market prices obtained from independent brokers or determined using quantitative models that use as their basis readily observable market parameters that are actively quoted and can be validated through external sources, including third party pricing services, brokers and market transactions, we have categorized these derivatives as Level 2. We value these derivatives based on observable market data for similar instruments. This observable data includes the forward curves for commodity prices based on quoted market prices and prospective volatility factors related to changes in the forward curves and yield curves based on money market rates and interest rate swap data. Our estimates of fair value have been determined at discrete points in time based on relevant market data. These estimates involve uncertainty and cannot be determined with precision. There were no changes in valuation techniques or related inputs in the three months ended June 30, 2011.\nNonrecurring Basis\nIn March 2011, in conjunction with the sale of oil and natural gas properties, we incurred impairment charges of $1.5 million as oil and natural gas properties with a net cost basis of $2.7 million were written down to their fair value of $1.2 million.\n10\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nIn June 2011, we incurred impairment charges of $5.2 million as oil and natural gas properties with a net cost basis of $13.7 million were written down to their fair value of $8.5 million.\nFinancial Instruments\nThe estimated fair values of our financial instruments have been determined at discrete points in time based on relevant market information. Our financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities, derivatives and long–term debt. The carrying amounts of our financial instruments other than derivatives and long–term debt approximate fair value because of the short–term nature of the items. Derivatives are recorded at fair value (see Note 4). The carrying value of debt outstanding under our credit facility approximates fair value because the credit facility’s variable interest rate resets frequently and approximates current market rates available to us. As of June 30, 2011, the estimated fair value of our senior notes due 2019 was $303.0 million, which differs from the carrying value of $292.7 million. The fair value of our senior notes due 2019 was estimated using quoted markets prices based on trades of such debt as of June 30, 2011.\nNOTE 6. ASSET RETIREMENT OBLIGATIONS\nWe record an asset retirement obligation (“ARO”) and capitalize the asset retirement cost in oil and natural gas properties in the period in which the retirement obligation is incurred based upon the fair value of an obligation to perform site reclamation, dismantle facilities or plug and abandon wells. After recording these amounts, the ARO is accreted to its future estimated value using an assumed cost of funds and the additional capitalized costs are depreciated on a unit–of–production basis. The changes in the aggregate ARO are as follows:\n\n| Balance as of December 31, 2010 | $ | 68,430 |\n| Liabilities incurred | 311 |\n| Accretion expense | 1,936 |\n| Revisions in estimated cash flows | 3,118 |\n| Settlements and divestitures | (4,275 | ) |\n| Balance as of June 30, 2011 | $ | 69,520 |\n\nAs of both June 30, 2011 and December 31, 2010, $1.3 million of our ARO is classified as current and is included in “Accounts payable and accrued liabilities” in our unaudited condensed consolidated balance sheets.\nNOTE 7. LONG–TERM DEBT\nLong–term debt consisted of the following:\n\n| June 30, 2011 | December 31, 2010 |\n| Credit facility | $ | 187,500 | $ | 619,000 |\n| 8.0% senior notes due 2019 | 300,000 | – |\n| Unamortized discount | (7,317 | ) | – |\n| Long–term debt | $ | 480,183 | $ | 619,000 |\n\nCredit Facility\nOn April 26, 2011, we replaced our existing $700.0 million credit facility with a $1.0 billion credit facility that expires in April 2016. Borrowings under the facility are secured by a first priority lien on substantially all of our assets and the assets of our subsidiaries. We may use borrowings under the facility for acquiring and developing oil and natural gas properties, for working capital purposes, for general corporate purposes and for funding distributions to partners. We also may use up to $100.0 million of available borrowing capacity for letters of credit. The facility requires the maintenance of a current ratio (as defined in the facility) of greater than 1.0 and a ratio of total debt to earnings plus interest expense, taxes, depreciation, depletion and amortization expense and exploration expense of no greater than 4.25 to 1.0. As of June 30, 2011, we were in compliance with these financial covenants.\n11\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nBorrowings under the facility bear interest at a floating rate based on, at our election, a base rate or the London Inter–Bank Offered Rate plus applicable premiums based on the percent of the borrowing base that we have outstanding (weighted average effective interest rate of 3.49% at June 30, 2011).\nBorrowings under the facility may not exceed a “borrowing base” determined by the lenders under the facility based on our oil and natural gas reserves. As of June 30, 2011, the borrowing base under the facility was $600.0 million. The borrowing base is subject to scheduled redeterminations as of April 1 and October 1 of each year with an additional redetermination once per calendar year at our request or at the request of the lenders and with one calculation that may be made at our request during each calendar year in connection with material acquisitions or divestitures of properties.\n8.0% Senior Notes due 2019\nOn March 22, 2011, we issued $300.0 million in aggregate principal amount of 8.0% senior unsecured notes due 2019 (the “Notes”) at an offering price equal to 100% of par. The Notes were sold in a private placement to eligible purchasers in a transaction exempt from the registration requirements of the Securities Act of 1933, as amended.\nWe received net proceeds of $291.6 million, after deducting the discount of $7.5 million and offering expenses of $0.9 million. We used the net proceeds to repay indebtedness under our existing credit facility. The discount and the offering expenses are being amortized over the life of the Notes. The amortization is included in “Interest expense” on our unaudited condensed consolidated statements of operations.\nThe Notes were issued under an indenture dated March 22, 2011, (the “Indenture”), mature April 15, 2019, and bear interest at 8.0%. Interest is payable semi–annually beginning October 15, 2011. The Notes are general unsecured obligations and are effectively junior in right of payment to any of our secured indebtedness to the extent of the value of the collateral securing such indebtedness.\nThe Notes are unconditionally guaranteed, jointly and severally, on a senior unsecured basis, by all of our existing subsidiaries other than EV Energy Finance Corp. (“Finance”), which is a co–issuer of the Notes. Neither we nor Finance have material independent assets or operations apart from the assets and operations of our subsidiaries.\nThe Indenture provides that, prior to April 15, 2014, we may redeem up to 35% of the aggregate principal amount of the Notes with the net proceeds of a public or private equity offering at a redemption price of 108.0% of the principal amount redeemed, plus accrued and unpaid interest, provided that:\n\n| · | at least 65% of the aggregate principal amount of Notes issued under the Indenture remains outstanding immediately after the occurrence of such redemption; and |\n\n\n| · | the redemption occurs within 180 days of the date of the closing of such public or private equity offering. |\n\nOn and after April 15, 2015, we may redeem all or a part of the Notes, at the redemption prices (expressed as percentages of principal amount) set forth below, plus accrued and unpaid interest, if any, on the Notes to be redeemed to the applicable redemption date, if redeemed during the twelve–month period beginning on April 15 of the years indicated below:\n\n| Year | Percentage |\n| 2015 | 104.0 | % |\n| 2016 | 102.0 | % |\n| 2017 and thereafter | 100.0 | % |\n\n12\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nPrior to April 15, 2015, we may redeem all or part of the Notes at a redemption price equal to the sum of:\n\n| · | the principal amount thereof, plus |\n\n\n| · | the Make Whole Premium (as defined in the Indenture) at the redemption date, plus accrued and unpaid interest, if any, to the redemption date. |\n\nThe Indenture also provides that, if a change of control (as defined in the Indenture) occurs, the holders have a right to require us to repurchase all or part of the Notes at a redemption price equal to 101%, plus accrued and unpaid interest.\nThe Indenture contains covenants that, among other things, limit our ability to: (i) pay distributions on, purchase or redeem our common units or redeem our subordinated debt; (ii) make investments; (iii) incur or guarantee additional indebtedness or issue certain types of equity securities; (iv) create certain liens; (v) sell assets; (vi) consolidate, merge or transfer all or substantially all of our assets; (vii) enter into intercompany agreements that restrict distributions or other payments from our restricted subsidiaries to us; (viii) engage in transactions with affiliates; and (ix) create unrestricted subsidiaries.\nNOTE 8. COMMITMENTS AND CONTINGENCIES\nWe are involved in disputes or legal actions arising in the ordinary course of business. We do not believe the outcome of such disputes or legal actions will have a material effect on our unaudited condensed consolidated financial statements, and no amounts have been accrued at June 30, 2011 or December 31, 2010.\nNOTE 9. OWNERS’ EQUITY\nUnits Outstanding\nAt June 30, 2011, owner’s equity consists of 34,173,650 common units, representing a 98% limited partnership interest in us, and a 2% general partnership interest.\nIssuance of Units\nIn January 2011, the following equity–based awards vested:\n\n| Phantom units accounted for as liability awards (1) | 80,534 |\n| Phantom units accounted for as equity awards | 70,610 |\n| Performance units | 80,000 |\n| Total units vested | 231,144 |\n| Performance units settled in cash | (17,807 | ) |\n| Units converted to common units | 213,337 |\n\n\n| (1) | These phantom units vested at a fair value of $3.5 million. |\n\nIn conjunction with the vesting of these units, we received a contribution of $0.2 million by our general partner to maintain its 2% interest in us.\nOn March 9, 2011, we closed a public offering of 3.45 million of our common units at an offering price of $44.42 per common unit. We received net proceeds of $149.8 million, including a contribution of $3.0 million by our general partner to maintain its 2% interest in us. We used a portion of the net proceeds to repay indebtedness outstanding under our credit facility.\n13\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nCash Distributions\nThe following sets forth the distributions we paid during the six months ended June 30, 2011:\n\n| Date Paid | Period Covered | Distribution per Unit | Total Distribution |\n| February 14, 2011 | October 1, 2010 – December 31, 2010 | $ | 0.759 | $ | 26,477 |\n| May 13, 2011 | January 1, 2011 – March 31, 2011 | 0.760 | 29,496 |\n| $ | 55,973 |\n\nOn July 28, 2011, the board of directors of EV Management declared a $0.761 per unit distribution for the second quarter of 2011 on all common units. The distribution of $29.5 million is to be paid on August 12, 2011 to unitholders of record at the close of business on August 8, 2011.\nNOTE 10. NET INCOME (LOSS) PER LIMITED PARTNER UNIT\nThe following sets forth the calculation of net income (loss) per limited partner unit:\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2011 | 2010 | 2011 | 2010 |\n| Net income | $ | 39,163 | $ | 16,280 | $ | 5,174 | $ | 62,404 |\n| Less: |\n| Incentive distribution rights | (2,945 | ) | (2,298 | ) | (5,879 | ) | (4,588 | ) |\n| General partner’s 2% interest in net income | (783 | ) | (326 | ) | (103 | ) | (1,248 | ) |\n| Limited partners’ interest in net income (loss) | $ | 35,435 | $ | 13,656 | $ | (808 | ) | 56,568 |\n| Weighted average limited partner units outstanding: |\n| Common units | 34,174 | 27,060 | 32,880 | 26,249 |\n| Performance units (1) | 120 | 150 | 122 | 154 |\n| Denominator for basic net income (loss) per limited partner unit | 34,294 | 27,210 | 33,002 | 26,403 |\n| Dilutive phantom units (2) | 240 | 54 | – | 35 |\n| Total | 34,534 | 27,264 | 33,002 | 26,438 |\n| Net income (loss) per limited partner unit: |\n| Basic | $ | 1.03 | $ | 0.50 | $ | (0.02 | ) | $ | 2.14 |\n| Diluted | $ | 1.03 | $ | 0.50 | $ | (0.02 | ) | $ | 2.14 |\n\n\n| (1) | Our earned but unvested performance units are considered to be participating securities for purposes of calculating our net income (loss) per limited partner unit and, accordingly, are included in the basic computation as such. |\n\n\n| (2) | Phantom units accounted for as equity awards totaling 0.5 million units were not included in the computation of diluted net income (loss) per limited partner unit because the effect would have been anti-dilutive for the six months ended June 30, 2011. |\n\nNOTE 11. RELATED PARTY TRANSACTIONS\nPursuant to an omnibus agreement, we paid EnerVest $2.8 million and $2.3 million in the three months ended June 30, 2011 and 2010, respectively, and $5.5 million and $4.3 million in the six months ended June 30, 2011 and 2010, respectively, in monthly administrative fees for providing us general and administrative services. These fees are based on an allocation of charges between EnerVest and us based on the estimated use of such services by each party, and we believe that the allocation method employed by EnerVest is reasonable and reflective of the estimated level of costs we would have incurred on a standalone basis. These fees are included in general and administrative expenses in our unaudited condensed consolidated statements of operations.\n14\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nWe have entered into operating agreements with EnerVest whereby a wholly owned subsidiary of EnerVest acts as contract operator of the oil and natural gas wells and related gathering systems and production facilities in which we own an interest. We reimbursed EnerVest $3.4 million and $3.2 million in the three months ended June 30, 2011 and 2010, respectively, and $7.2 million and $5.7 million in the six months ended June 30, 2011 and 2010, respectively, for direct expenses incurred in the operation of our wells and related gathering systems and production facilities and for the allocable share of the costs of EnerVest employees who performed services on our properties. As the vast majority of such expenses are charged to us on an actual basis (i.e., no mark–up or subsidy is charged or received by EnerVest), we believe that the aforementioned services were provided to us at fair and reasonable rates relative to the prevailing market and are representative of the costs that would have been incurred on a standalone basis. These costs are included in lease operating expenses in our unaudited condensed consolidated statements of operations. Additionally, in its role as contract operator, this EnerVest subsidiary also collects proceeds from oil and natural gas sales and distributes them to us and other working interest owners.\nNOTE 12. OTHER SUPPLEMENTAL INFORMATION\nSupplemental cash flows and non–cash transactions were as follows:\n\n| Six Months Ended June 30, |\n| 2011 | 2010 |\n| Supplemental cash flows information: |\n| Cash paid for interest | $ | 5,595 | $ | 4,755 |\n| Cash paid for income taxes | 250 | 245 |\n| Non–cash transactions: |\n| Costs for development of oil and natural gas properties in accounts payable and accrued liabilities | 5,241 | 2,533 |\n\nNOTE 13. NEW ACCOUNTING STANDARDS\nIn May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011–04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This ASU represents the converged guidance of the FASB and the International Accounting Standards Board on fair value measurement, and has resulted in common requirements for measuring fair value and for disclosing information about fair value measurements, including a consistent meaning of the term “fair value.” The provisions of ASU 2011–04 are applicable to interim and annual reporting periods subsequent to December 15, 2011. We will adopt the new requirements for our Form 10–K for the year ending December 31, 2011.\nNo other new accounting pronouncements issued or effective during the six months ended June 30, 2011 have had or are expected to have a material impact on our unaudited condensed consolidated financial statements.\nNOTE 14. SUBSEQUENT EVENT\nIn July 2011, we sold oil and natural gas properties for $8.5 million. We received a non–refundable deposit of $0.9 million in June 2011 and the remainder of the proceeds upon the closing of the sale. These oil and natural gas properties and the related ARO have been classified as “Assets held for sale” and “Liabilities related to assets held for sale” on our unaudited consolidated condensed balance sheet.\nIn July 2011, we agreed, subject to the execution of a final purchase and sale agreement, to acquire oil and natural gas properties from certain institutional partnerships managed by EnerVest for $34.3 million, subject to customary closing conditions and purchase price adjustments. The acquisition is expected to close in August 2011.\nWe evaluated subsequent events for appropriate accounting and disclosure through the date these unaudited condensed consolidated financial statements were issued.\n15\nITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our unaudited condensed consolidated financial statements and the related notes thereto, as well as our Annual Report on Form 10–K for the year ended December 31, 2010.\nOVERVIEW\nWe are a Delaware limited partnership formed in April 2006 by EnerVest to acquire, produce and develop oil and natural gas properties. Our general partner is EV Energy GP, a Delaware limited partnership, and the general partner of our general partner is EV Management, a Delaware limited liability company.\nOur properties are located in the Barnett Shale, the Appalachian Basin (primarily in Ohio and West Virginia), the Mid-Continent area in Oklahoma, Texas, Arkansas, Kansas and Louisiana, the San Juan Basin, the Monroe Field in Louisiana, the Permian Basin, Central and East Texas (which includes the Austin Chalk area), and Michigan. As of December 31, 2010, we had estimated net proved reserves of 12.9 MMBbls of oil, 27.5 MMBbls of natural gas liquids and 575.2 Bcf of natural gas, or 817.3 Bcfe, and a standardized measure of $1,020.2 million.\nCURRENT DEVELOPMENTS\nIn March 2011, we closed a public offering of 3.45 million common units at an offering price of $44.42 per common unit. We received net proceeds of $149.8 million, including a contribution of $3.0 million by our general partner to maintain its 2% interest in us. We used a portion of the net proceeds to repay indebtedness outstanding under our credit facility.\nIn March 2011, we issued $300.0 million in aggregate principal amount of 8.0% senior unsecured notes due 2019. We received net proceeds of $291.6 million, after deducting the discount of $7.5 million and offering expenses of $0.9 million. We used the net proceeds to repay indebtedness outstanding under our credit facility.\nIn April 2011, we entered into a second amended and restated $1.0 billion credit facility that expires in April 2016. The facility requires the maintenance of a current ratio (as defined in the facility) of greater than 1.0 and a ratio of total debt to earnings plus interest expense, taxes, depreciation, depletion and amortization expense and exploration expense of no greater than 4.25 to 1.0. The borrowing base, which was initially set at $600.0 million, is subject to scheduled redeterminations every six months beginning October 1, 2011.\nIn July 2011, we agreed, subject to the execution of a final purchase and sale agreement, to acquire oil and natural gas properties from certain institutional partnerships managed by EnerVest for $34.3 million, subject to customary closing conditions and purchase price adjustments. The acquisition is expected to close in August 2011.\nBUSINESS ENVIRONMENT\nOur primary business objective is to provide stability and growth in cash distributions per unit over time. The amount of cash we can distribute on our units principally depends upon the amount of cash generated from our operations, which will fluctuate from quarter to quarter based on, among other things:\n| · | the prices at which we will sell our oil, natural gas liquids and natural gas production; |\n\n\n| · | our ability to hedge commodity prices; |\n\n\n| · | the amount of oil, natural gas liquids and natural gas we produce; and |\n\n\n| · | the level of our operating and administrative costs. |\n\nOil and natural gas prices are expected to be volatile in the future. Factors affecting the price of oil include worldwide economic conditions, geopolitical activities, worldwide supply disruptions, weather conditions, actions taken by the Organization of Petroleum Exporting Countries and the value of the U.S. dollar in international currency markets. Factors affecting the price of natural gas include the discovery of substantial accumulations of natural gas in unconventional reservoirs due to technological advancements necessary to commercially produce these unconventional reserves, North American weather conditions, industrial and consumer demand for natural gas, storage levels of natural gas and the availability and accessibility of natural gas deposits in North America.\n16\nIn order to mitigate the impact of changes in oil and natural gas prices on our cash flows, we are a party to derivatives, and we intend to enter into derivatives in the future to reduce the impact of oil and natural gas price volatility on our cash flows. By removing a significant portion of this price volatility on our future oil and natural gas production through December 2015, we have mitigated, but not eliminated, the potential effects of changing oil and natural gas prices on our cash flows from operations for those periods. If commodity prices are depressed for an extended period of time, it could alter our acquisition and development plans, and adversely affect our growth strategy and ability to access additional capital in the capital markets.\nThe primary factors affecting our production levels are capital availability, our ability to make accretive acquisitions, the success of our drilling program and our inventory of drilling prospects. In addition, as initial reservoir pressures are depleted, production from our wells decreases. We attempt to overcome this natural decline through a combination of drilling and acquisitions. Our future growth will depend on our ability to continue to add reserves through drilling and acquisitions in excess of production. We will maintain our focus on the costs to add reserves through drilling and acquisitions as well as the costs necessary to produce such reserves. Our ability to add reserves through drilling is dependent on our capital resources and can be limited by many factors, including our ability to timely obtain drilling permits and regulatory approvals. Any delays in drilling, completion or connection to gathering lines of our new wells will negatively impact our production, which may have an adverse effect on our revenues and, as a result, cash available for distribution.\nWe focus our efforts on increasing oil and natural gas reserves and production while controlling costs at a level that is appropriate for long–term operations. Our future cash flows from operations are dependent upon our ability to manage our overall cost structure.\nRESULTS OF OPERATIONS\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2011 | 2010 | 2011 | 2010 |\n| Production data: |\n| Oil (MBbls) | 241 | 171 | 449 | 297 |\n| Natural gas liquids (MBbls) | 272 | 178 | 542 | 360 |\n| Natural gas (MMcf) | 6,999 | 4,734 | 14,003 | 8,719 |\n| Net production (MMcfe) | 10,080 | 6,831 | 19,951 | 12,665 |\n| Average sales price per unit: |\n| Oil (Bbl) | $ | 98.63 | $ | 73.20 | $ | 94.58 | $ | 73.73 |\n| Natural gas liquids (Bbl) | 54.80 | 40.23 | 51.45 | 42.91 |\n| Natural gas (Mcf) | 4.20 | 4.16 | 4.10 | 4.66 |\n| Mcfe | 6.76 | 5.77 | 6.40 | 6.16 |\n| Average unit cost per Mcfe: |\n| Production costs: |\n| Lease operating expenses | $ | 1.78 | $ | 2.18 | $ | 1.77 | $ | 2.08 |\n| Production taxes | 0.31 | 0.24 | 0.29 | 0.30 |\n| Total | 2.09 | 2.42 | 2.06 | 2.38 |\n| Asset retirement obligations accretion expense | 0.10 | 0.11 | 0.10 | 0.10 |\n| Depreciation, depletion and amortization | 1.83 | 1.97 | 1.80 | 2.02 |\n| General and administrative expenses | 0.71 | 0.85 | 0.79 | 0.83 |\n\n17\nThree Months Ended June 30, 2011 Compared with the Three Months Ended June 30, 2010\nNet income for the three months ended June 30, 2011 was $39.2 million compared with $16.3 million for the three months ended June 30, 2010. This improvement reflects (i) a $28.7 million increase in revenues due to increased production primarily from our acquisitions of oil and natural gas properties in 2010 and higher prices for oil, natural gas and natural gas liquids and (ii) a $19.6 million increase in non–cash changes in the fair value of our derivatives, partially offset by (iii) an $11.5 million increase in operating expenses mainly related to the properties acquired in 2010, (iv) an impairment loss of $5.1 million related to the write–down of oil and natural gas properties to their fair value (compared with a $4.4 million gain on the sale of oil and natural gas properties in the three months ended June 30, 2010), and (v) a $4.9 million increase in interest expense.\nOil, natural gas and natural gas liquids revenues for the three months ended June 30, 2011 totaled $68.1 million, an increase of $28.7 million compared with the three months ended June 30, 2010. This increase was the result of $21.6 million related to increased production and $7.1 million related to higher prices for oil, natural gas and natural gas liquids.\nLease operating expenses for the three months ended June 30, 2011 increased $3.1 million compared with the three months ended June 30, 2010 primarily as the result of $5.8 million related to our 2010 acquisitions and our expanded development drilling program partially offset by $0.4 million due to a lower unit cost per Mcfe for our December 2010 acquisition of oil and natural gas properties in the Barnett Shale and $2.3 million ($0.34 per Mcfe) of lease operating expenses in the three months ended June 30, 2010 associated with oil in tanks acquired in the March 2010 acquisition that was sold in the three months ended June 30, 2010. Lease operating expenses per Mcfe were $1.78 in the three months ended June 30, 2011 compared with $2.18 in the three months ended June 30, 2010. Production taxes, which are generally based on a percentage of our oil, natural gas and natural gas liquids revenues, for the three months ended June 30, 2011 increased $1.4 million compared with the three months ended June 30, 2010 primarily as the result of $1.0 million due to increased production and $0.4 million due to higher average realized prices. Production taxes for the three months ended June 30, 2011 were $0.31 per Mcfe compared with $0.24 per Mcfe for the three months ended June 30, 2010. Asset retirement obligations accretion expense for the three months ended June 30, 2011 increased $0.2 million compared with the three months ended June 30, 2010 primarily due to the oil and natural gas properties that we acquired in 2010. Asset retirement obligations accretion expense for the three months ended June 30, 2011 was $0.10 per Mcfe compared with $0.11 per Mcfe for the three months ended June 30, 2010. Depreciation, depletion and amortization for the three months ended June 30, 2011 increased $5.0 million compared with the three months ended June 30, 2010 primarily due to $5.9 million from higher production offset by a decrease of $0.9 million due to a lower average DD&A rate per unit. The lower average DD&A rate per unit reflects the effect of our acquisitions of oil and natural gas properties in 2010. Depreciation, depletion and amortization for the three months ended June 30, 2011 was $1.83 per Mcfe compared with $1.97 per Mcfe for the three months ended June 30, 2010.\nGeneral and administrative expenses for the three months ended June 30, 2011 totaled $7.1 million, an increase of $1.3 million compared with the three months ended June 30, 2010. This increase is primarily the result of $1.0 million of higher compensation costs primarily related to our equity–based compensation plans and $0.5 million of higher fees paid to EnerVest under the omnibus agreement due to an increase in operations from our acquisitions of oil and natural gas properties in 2010 partially offset by a $0.2 million decrease in acquisition due diligence costs. General and administrative expenses were $0.71 per Mcfe in the three months ended June 30, 2011 compared with $0.85 per Mcfe in the three months ended June 30, 2010.\nDuring the three months ended June 30, 2011, we incurred impairment charges of $5.1 million to write down oil and natural gas properties to their fair value. During the three months ended June 30, 2011 and 2010, we recorded cash settlements of $9.5 million and $13.9 million, respectively, as realized gains on derivatives, net, as the contract prices for our derivatives exceeded the underlying market price for that period. In June 2011, we also terminated three of our interest rate swaps and recorded a non–cash realized gain of $4.7 million, which represented the value of these interest rate swaps on the date of termination. The terminated interest rate swaps were rolled over into three new interest rate swaps with a value of $5.2 million at inception. Unrealized gains (losses) on derivatives, net represent the change in the fair value of our open derivatives during the period. In the three months ended June 30, 2011, the fair value of our open derivatives increased from a net asset of $49.3 million at March 31, 2011 to a net asset of $70.0 million at June 30, 2011. In the three months ended June 30, 2010, the fair value of our open derivatives decreased from a net asset of $125.8 million at March 31, 2010 to a net asset of $123.6 million at June 30, 2010.\n18\nInterest expense for the three months ended June 30, 2011 increased $4.9 million compared with the three months ended June 30, 2010 primarily due to increases of $2.4 million from a higher weighted average long–term debt balance and $2.5 million due to a higher weighted average effective interest rate attributable to our 8% senior notes due 2019.\nSix Months Ended June 30, 2011 Compared with the Six Months Ended June 30, 2010\nNet income for the six months ended June 30, 2011 was $5.2 million compared with $62.4 million for the six months ended June 30, 2010. This change reflects (i) a $49.5 million increase in revenues due to increased production primarily from our acquisitions of oil and natural gas properties in 2010 and higher prices for oil and natural gas liquids and (ii) a $5.9 million increase in realized gains on derivatives, partially offset by (iii) a.$66.1 million decrease in non–cash changes in the fair value of our derivatives, (iv) a $28.0 million increase in operating expenses mainly related to the properties acquired in 2010, (v) a $7.9 million increase in interest expense and (vi) an impairment loss of $6.7 million related to the write–down of oil and natural gas properties to their fair value (compared with a $3.8 million gain on the sale of oil and natural gas properties in the six months ended June 30, 2010).\nOil, natural gas and natural gas liquids revenues for the six months ended June 30, 2011 totaled $127.7 million, an increase of $49.7 million compared with the six months ended June 30, 2010. This increase was the result of $45.3 million related to increased production and $4.4 million related to higher prices for oil and natural gas liquids.\nLease operating expenses for the six months ended June 30, 2011 increased $9.0 million compared with the six months ended June 30, 2010 primarily as the result of $12.9 million related to our 2010 acquisitions and our expanded development drilling program partially offset by $1.5 million due to a lower unit cost per Mcfe for our December 2010 acquisition of oil and natural gas properties in the Barnett Shale and $2.3 million ($0.18 per Mcfe) of lease operating expenses in the six months ended June 30, 2010 associated with oil in tanks acquired in the March 2010 acquisition that was sold in the six months ended June 30, 2010. Lease operating expenses per Mcfe were $1.77 in the six months ended June 30, 2011 compared with $2.08 in the six months ended June 30, 2010. Production taxes for the six months ended June 30, 2011 increased $2.0 million compared with the six months ended June 30, 2010 primarily as the result of $2.1 million due to increased production partially offset by $0.1 million due to lower average realized prices for natural gas. Production taxes for the six months ended June 30, 2011 were $0.29 per Mcfe compared with $0.30 per Mcfe for the six months ended June 30, 2010. Asset retirement obligations accretion expense for the six months ended June 30, 2011 increased $0.7 million compared with the six months ended June 30, 2010 primarily due to the oil and natural gas properties that we acquired in 2010. Asset retirement obligations accretion expense for both the six months ended June 30, 2011 and June 30, 2010 was $0.10 per Mcfe. Depreciation, depletion and amortization for the six months ended June 30, 2011 increased $10.5 million compared with the six months ended June 30, 2010 primarily due to $13.1 million from higher production offset by a decrease of $2.8 million due to a lower average DD&A rate per unit. The lower average DD&A rate per unit reflects the effect of our acquisitions of oil and natural gas properties in 2010. Depreciation, depletion and amortization for the six months ended June 30, 2011 was $1.80 per Mcfe compared with $2.02 per Mcfe for the six months ended June 30, 2010.\nGeneral and administrative expenses for the six months ended June 30, 2011 totaled $15.7 million, an increase of $5.2 million compared with the six months ended June 30, 2010. This increase is primarily the result of (i) $3.5 million of higher compensation costs primarily related to our equity–based compensation plans, (ii) $1.3 million of higher fees paid to EnerVest under the omnibus agreement due to an increase in operations from our acquisitions of oil and natural gas properties in 2010, and (iii) an overall increase in costs related to our significant growth. General and administrative expenses were $0.79 per Mcfe in the six months ended June 30, 2011 compared with $0.83 per Mcfe in the six months ended June 30, 2010.\nDuring the six months ended June 30, 2011, we incurred impairment charges of $6.7 million to write down oil and natural gas properties to their fair value. During the six months ended June 30, 2011 and 2010, we recorded cash settlements of $23.1 million and $21.9 million, respectively, as realized gains on derivatives, net, as the contract prices for our derivatives exceeded the underlying market price for that period. In June 2011, we also terminated three of our interest rate swaps and recorded a non–cash realized gain of $4.7 million, which represented the value of these interest rate swaps on the date of termination. The terminated interest rate swaps were rolled over into three new interest rate swaps with a value of $5.2 million at inception.\n19\nUnrealized gains (losses) on derivatives, net represent the change in the fair value of our open derivatives during the period. In the six months ended June 30, 2011, the fair value of our open derivatives decreased from a net asset of $103.9 million at December 31, 2010 to a net asset of $70.0 million at June 30, 2011. In the six months ended June 30, 2010, the fair value of our open derivatives increased from a net asset of $93.1 million at December 31, 2009 to a net asset of $123.6 million at June 30, 2010.\nInterest expense for the six months ended June 30, 2011 increased $7.9 million compared with the six months ended June 30, 2010 primarily due to an increase of $5.8 million from a higher weighted average long–term debt balance and an increase of $2.1 million due to a higher weighted average effective interest rate attributable to our 8% senior notes due 2019.\nLIQUIDITY AND CAPITAL RESOURCES\nHistorically, our primary sources of liquidity and capital have been issuances of equity and debt securities, borrowings under our credit facility and cash flows from operations. Our primary uses of cash have been acquisitions of oil and natural gas properties and related assets, development of our oil and natural gas properties, distributions to our partners and working capital needs. For 2011, we believe that cash on hand and net cash flows generated from operations will be adequate to fund our capital budget and satisfy our short–term liquidity needs. We may also utilize various financing sources available to us, including the issuance of equity or debt securities through public offerings or private placements, to fund our acquisitions and long–term liquidity needs. Our ability to complete future offerings of equity or debt securities and the timing of these offerings will depend upon various factors including prevailing market conditions and our financial condition.\nIn the past we accessed the equity and debt markets to finance our significant acquisitions. While we have been successful in accessing the public equity and debt markets earlier this year and in prior years, any disruptions in the financial markets may limit our ability to access the public equity or debt markets in the future.\nLong–term Debt\nIn April 2011, we replaced our existing $700.0 million credit facility with a $1.0 billion credit facility that expires in April 2016. Borrowings under the facility may not exceed a “borrowing base” determined by the lenders based on our oil and natural gas reserves. As of June 30, 2011, the borrowing base was $600.0 million, and we had $187.5 million outstanding.\nIn March 2011, we issued $300.0 million in aggregate principal amount of 8.0% senior notes due 2019 and received net proceeds of approximately $291.6 million. We used the net proceeds to repay indebtedness outstanding under our credit facility. As of June 30, 2011, we had $300.0 million of notes outstanding. These notes are recorded on our unaudited condensed consolidated balance sheet as $292.7 million, which is net of the unamortized discount of $7.3 million.\nFor additional information about our long–term debt, such as interest rates and covenants, please see “Item 1. Condensed Consolidated Financial Statements (Unaudited)” contained herein.\nCash and Short–term Investments\nAt June 30, 2011, we had $26.4 million of cash and short–term investments, which included $22.0 million of short–term investments. With regard to our short–term investments, we invest in money market accounts with major financial institutions.\nCounterparty Exposure\nAt June 30, 2011, our open derivative contracts were in a net receivable position with a fair value of $70.0 million. All of our derivative contracts are with major financial institutions who are also lenders under our credit facility. Should one of these financial counterparties not perform, we may not realize the benefit of some of our derivative contracts and we could incur a loss. As of June 30, 2011, all of our counterparties have performed pursuant to their commodity derivative contracts.\n20\nCash Flows\nCash flows provided (used) by type of activity were as follows:\n\n| Six Months Ended June 30, |\n| 2011 | 2010 |\n| Operating activities | $ | 80,130 | $ | 55,802 |\n| Investing activities | (25,681 | ) | (151,468 | ) |\n| Financing activities | (51,184 | ) | 94,152 |\n\nOperating Activities\nCash flows from operating activities were $80.1 million and $55.8 million in the six months ended June 30, 2011 and 2010, respectively. The increase was primarily due to higher production and prices for oil and natural gas liquids, partially offset by higher operating expenses.\nInvesting Activities\nOur principal recurring investing activity is the acquisition and development of oil and natural gas properties. During the six months ended June 30, 2011, we spent $1.0 million for the acquisition of oil and natural gas properties and $33.7 million for development of our oil and natural gas properties. In addition, we received $4.1 million in final purchase price settlements, $2.8 million from settlements of derivatives acquired in our December 2010 acquisition of oil and natural gas properties and $1.2 million in proceeds from the sale of oil and natural gas properties.\nDuring the six months ended June 30, 2010, we spent $147.8 million on the acquisitions of oil and natural gas properties and $8.2 million for the development of our oil and natural gas properties. In addition, we received $4.5 million from the sales of oil and natural gas properties.\nFinancing Activities\nDuring the six months ended June 30, 2011, we received net proceeds of $146.8 million from our public equity offering in March 2011, and we received contributions of $3.2 million from our general partner in order to maintain its 2% interest in us. We also received net proceeds of $291.6 million from our debt offering in March 2011, after deducting offering expenses of $0.9 million. We used the proceeds from these offerings to repay $431.5 million of borrowings outstanding under our credit facility. In addition, we paid distributions of $56.0 million to holders of our common units and our general partner and $5.3 million in loan costs related to our new $1.0 billion credit facility.\nDuring the six months ended June 30, 2010, we received net proceeds of $92.6 million from our public equity offering in February 2010, and we received contributions of $2.0 million from our general partner in order to maintain its 2% interest in us. We borrowed $138.0 million under our credit facility to finance our acquisition of oil and natural gas properties in March 2010 and we repaid $95.0 million of borrowings outstanding under our credit facility with proceeds from our public equity offering and cash flows from operations. In addition, we paid distributions of $43.4 million to holders of our common units and our general partner.\nFORWARD–LOOKING STATEMENTS\nThis Form 10–Q contains forward–looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act (each a “forward–looking statement”). These forward–looking statements relate to, among other things, the following:\n\n| · | our future financial and operating performance and results; |\n\n\n| · | our business strategy; |\n\n\n| · | our estimated net proved reserves and standardized measure; |\n\n\n| · | market prices; |\n\n21\n\n| · | our future derivative activities; and |\n\n\n| · | our plans and forecasts. |\n\nWe have based these forward–looking statements on our current assumptions, expectations and projections about future events.\nThe words “anticipate,” “believe,” “ensure,” “expect,” “if,” “intend,” “estimate,” “project,” “forecasts,” “predict,” “outlook,” “aim,” “will,” “could,” “should,” “would,” “may,” “likely” and similar expressions, and the negative thereof, are intended to identify forward–looking statements. These statements discuss future expectations, contain projections of results of operations or of financial condition or state other “forward–looking” information. We do not undertake any obligation to update or revise publicly any forward–looking statements, except as required by law. These statements also involve risks and uncertainties that could cause our actual results or financial condition to materially differ from our expectations in this Form 10–Q including, but not limited to:\n\n| · | fluctuations in prices of oil and natural gas; |\n\n\n| · | significant disruptions in the financial markets; |\n\n\n| · | future capital requirements and availability of financing; |\n\n\n| · | uncertainty inherent in estimating our reserves; |\n\n\n| · | risks associated with drilling and operating wells; |\n\n\n| · | discovery, acquisition, development and replacement of oil and natural gas reserves; |\n\n\n| · | cash flows and liquidity; |\n\n\n| · | timing and amount of future production of oil and natural gas; |\n\n\n| · | availability of drilling and production equipment; |\n\n\n| · | marketing of oil and natural gas; |\n\n\n| · | developments in oil and natural gas producing countries; |\n\n\n| · | competition; |\n\n\n| · | general economic conditions; |\n\n\n| · | governmental regulations; |\n\n\n| · | receipt of amounts owed to us by purchasers of our production and counterparties to our derivative financial instrument contracts; |\n\n\n| · | hedging decisions, including whether or not to enter into derivative financial instruments; |\n\n\n| · | events similar to those of September 11, 2001; |\n\n\n| · | actions of third party co–owners of interest in properties in which we also own an interest; |\n\n\n| · | fluctuations in interest rates and the value of the U.S. dollar in international currency markets; and |\n\n\n| · | our ability to effectively integrate companies and properties that we acquire. |\n\n22\nAll of our forward–looking information is subject to risks and uncertainties that could cause actual results to differ materially from the results expected. Although it is not possible to identify all factors, these risks and uncertainties include the risk factors and the timing of any of those risk factors identified in the “Risk Factors” section included in Item 1A of our Annual Report on Form 10–K for the year ended December 31, 2010. This document is available through our web site or through the SEC’s Electronic Data Gathering and Analysis Retrieval System at http://www.sec.gov.\nOur revenues, operating results, financial condition and ability to borrow funds or obtain additional capital depend substantially on prevailing prices for oil and natural gas. Declines in oil or natural gas prices may materially adversely affect our financial condition, liquidity, ability to obtain financing and operating results. Lower oil or natural gas prices also may reduce the amount of oil or natural gas that we can produce economically. A decline in oil and/or natural gas prices could have a material adverse effect on the estimated value and estimated quantities of our oil and natural gas reserves, our ability to fund our operations and our financial condition, cash flows, results of operations and access to capital. Historically, oil and natural gas prices and markets have been volatile, with prices fluctuating widely, and they are likely to continue to be volatile.\n\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nWe are exposed to certain market risks that are inherent in our financial statements that arise in the normal course of business. We may enter into derivative instruments to manage or reduce market risk, but do not enter into derivative agreements for speculative purposes.\nWe do not designate these or plan to designate future derivative instruments as hedges for accounting purposes. Accordingly, the changes in the fair value of these instruments are recognized currently in earnings.\nCommodity Price Risk\nOur major market risk exposure is to prices for oil, natural gas and natural gas liquids. These prices have historically been volatile. As such, future earnings are subject to change due to changes in these prices. Realized prices are primarily driven by the prevailing worldwide price for oil and regional spot prices for natural gas production. We have used, and expect to continue to use, oil, natural gas and natural gas liquids commodity contracts to reduce our risk of changes in the prices of oil, natural gas and natural gas liquids. Pursuant to our risk management policy, we engage in these activities as a hedging mechanism against price volatility associated with pre–existing or anticipated sales of oil, natural gas and natural gas liquids.\nWe have entered into commodity contracts to hedge significant amounts of our anticipated oil, natural gas and natural gas liquids production through December 2015. As of June 30, 2011, we have commodity contracts covering approximately 53% of our production attributable to our estimated net proved reserves from July 2011 through December 2015, as estimated in our reserve report prepared by third party engineers using prices, costs and other assumptions required by SEC rules. Our actual production will vary from the amounts estimated in our reserve reports, perhaps materially.\nThe fair value of our commodity contracts and basis swaps at June 30, 2011 was a net asset of $78.9 million. A 10% change in oil, natural gas and natural gas liquids prices with all other factors held constant would result in a change in the fair value (generally correlated to our estimated future net cash flows from such instruments) of our oil and natural gas commodity contracts and basis swaps of approximately $60 million. Please see “Item 1. Condensed Consolidated Financial Statements (Unaudited)” contained herein for additional information.\nInterest Rate Risk\nOur floating rate credit facility also exposes us to risks associated with changes in interest rates and as such, future earnings are subject to change due to changes in these interest rates. If interest rates on our facility increased by 1%, interest expense for the six months ended June 30, 2011 would have increased by approximately $1.8 million. Please see “Item 1. Condensed Consolidated Financial Statements (Unaudited)” contained herein for additional information.\n23\nITEM 4. CONTROLS AND PROCEDURES\nEvaluation of Disclosure Controls and Procedures\nIn accordance with Exchange Act Rule 13a–15 and 15d–15, we carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of June 30, 2011 to provide reasonable assurance that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Our disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.\nChange in Internal Controls Over Financial Reporting\nThere have not been any changes in our internal controls over financial reporting that occurred during the quarterly period ended June 30, 2011 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.\nPART II. OTHER INFORMATION\n\nITEM 1. LEGAL PROCEEDINGS\nWe are involved in disputes or legal actions arising in the ordinary course of business. We do not believe the outcome of such disputes or legal actions will have a material effect on our unaudited condensed consolidated financial statements.\n\nITEM 1A. RISK FACTORS\nThere have been no material changes with respect to the risk factors disclosed in our Annual Report on Form 10–K for the year ended December 31, 2010.\n\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nNone.\n\nITEM 3. DEFAULTS UPON SENIOR SECURITIES\nNone.\nITEM 4. (Removed and Reserved)\n\nITEM 5. OTHER INFORMATION\nNone.\n\nITEM 6. EXHIBITS\nThe exhibits listed below are filed or furnished as part of this report:\n\n| 10.1 | Credit Agreement, dated as of April 26, 2011 by and among EV Energy Partners, L.P., EV Properties, L.P., and JPMorgan Chase Bank, N.A. as Administrative Agent for the lenders named therein. (Incorporated by reference from Exhibit 10.1 to EV Energy Partners L.P.’s current report on Form 8–K filed with the SEC on April 29, 2011). |\n\n\n| +31.1 | Rule 13a-14(a)/15d–14(a) Certification of Chief Executive Officer. |\n\n24\n\n| +31.2 | Rule 13a-14(a)/15d–14(a) Certification of Chief Financial Officer. |\n\n\n| +32.1 | Section 1350 Certification of Chief Executive Officer |\n\n\n| +32.2 | Section 1350 Certification of Chief Financial Officer |\n\n\n| ++101 | Interactive Data Files |\n\n\n| + | Filed herewith |\n\n\n| ++ | Pursuant to Rule 406T of Regulation S–T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Act of 1934, as amended, and otherwise are not subject to liability. |\n\n25\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| EV Energy Partners, L.P. |\n| (Registrant) |\n| Date: August 9, 2011 | By: | /s/ MICHAEL E. MERCER |\n| Michael E. Mercer |\n| Senior Vice President and Chief Financial Officer |\n\n26\nEXHIBIT INDEX\n\n| 10.1 | Credit Agreement, dated as of April 26, 2011 by and among EV Energy Partners, L.P., EV Properties, L.P., and JPMorgan Chase Bank, N.A. as Administrative Agent for the lenders named therein. (Incorporated by reference from Exhibit 10.1 to EV Energy Partners L.P.’s current report on Form 8–K filed with the SEC on April 29, 2011). |\n\n\n| +31.1 | Rule 13a-14(a)/15d–14(a) Certification of Chief Executive Officer. |\n\n\n| +31.2 | Rule 13a-14(a)/15d–14(a) Certification of Chief Financial Officer. |\n\n\n| +32.1 | Section 1350 Certification of Chief Executive Officer |\n\n\n| +32.2 | Section 1350 Certification of Chief Financial Officer |\n\n\n| ++101 | Interactive Data Files |\n\n+ Filed herewith\n\n| ++ | Pursuant to Rule 406T of Regulation S–T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Act of 1934, as amended, and otherwise are not subject to liability. |\n\n\n</text>\n\nWhat is the total capital cost, combining both the offering cost of the senior notes and interest payment in the first year, in million dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nPART I. Financial Information\nItem 1. Financial Statements\nConsolidated Condensed Statements of Operations\n(Unaudited)\nELI LILLY AND COMPANY AND SUBSIDIARIES\n(Dollars and shares in millions, except per-share data)\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Revenue (Note 2) | $ | 6,941.6 | $ | 6,772.8 | $ | 21,239.6 | $ | 20,318.5 |\n| Costs, expenses, and other: |\n| Cost of sales | 1,579.1 | 1,430.8 | 5,081.7 | 5,262.6 |\n| Research and development | 1,802.9 | 1,705.3 | 5,194.9 | 5,032.4 |\n| Marketing, selling, and administrative | 1,614.2 | 1,577.9 | 4,797.2 | 4,839.6 |\n| Acquired in-process research and development and development milestones (Note 3) | 62.4 | 177.6 | 668.4 | 532.4 |\n| Asset impairment, restructuring, and other special charges (Note 5) | 206.5 | — | 206.5 | 211.6 |\n| Other–net, (income) expense (Note 11) | 111.0 | 635.9 | 580.9 | 124.3 |\n| 5,376.1 | 5,527.5 | 16,529.6 | 16,002.9 |\n| Income before income taxes | 1,565.5 | 1,245.3 | 4,710.0 | 4,315.6 |\n| Income taxes (Note 7) | 113.8 | 135.2 | 402.9 | 460.0 |\n| Net income | $ | 1,451.7 | $ | 1,110.1 | $ | 4,307.1 | $ | 3,855.6 |\n| Earnings per share: |\n| Basic | $ | 1.61 | $ | 1.22 | $ | 4.78 | $ | 4.25 |\n| Diluted | $ | 1.61 | $ | 1.22 | $ | 4.76 | $ | 4.23 |\n| Shares used in calculation of earnings per share: |\n| Basic | 900.7 | 906.7 | 901.8 | 907.7 |\n| Diluted | 903.8 | 910.8 | 904.5 | 911.7 |\n\nSee notes to consolidated condensed financial statements.\n5\nConsolidated Condensed Statements of Comprehensive Income\n(Unaudited)\nELI LILLY AND COMPANY AND SUBSIDIARIES\n(Dollars in millions)\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Net income | $ | 1,451.7 | $ | 1,110.1 | $ | 4,307.1 | $ | 3,855.6 |\n| Other comprehensive income (loss), net of tax (Note 10) | ( 8.1 ) | 114.4 | 47.3 | 323.7 |\n| Comprehensive income | $ | 1,443.6 | $ | 1,224.5 | $ | 4,354.4 | $ | 4,179.3 |\n\nSee notes to consolidated condensed financial statements.\n6\nConsolidated Condensed Balance Sheets\nELI LILLY AND COMPANY AND SUBSIDIARIES\n(Dollars in millions)\n| September 30, 2022 | December 31, 2021 |\n| Assets | (Unaudited) |\n| Current Assets |\n| Cash and cash equivalents (Note 6) | $ | 2,617.4 | $ | 3,818.5 |\n| Short-term investments (Note 6) | 124.7 | 90.1 |\n| Accounts receivable, net of allowances of $ 17.7 (2022) and $ 22.5 (2021) | 6,715.3 | 6,672.8 |\n| Other receivables | 1,609.5 | 1,454.4 |\n| Inventories | 3,831.1 | 3,886.0 |\n| Prepaid expenses and other | 2,741.9 | 2,530.6 |\n| Total current assets | 17,639.9 | 18,452.4 |\n| Investments (Note 6) | 2,574.6 | 3,212.6 |\n| Goodwill | 3,891.6 | 3,892.0 |\n| Other intangibles, net | 7,124.1 | 7,691.9 |\n| Deferred tax assets | 2,384.3 | 2,489.3 |\n| Property and equipment, net of accumulated depreciation of $ 10,074.0 (2022) and $ 9,976.7 (2021) | 9,311.3 | 8,985.1 |\n| Other noncurrent assets | 4,535.7 | 4,082.7 |\n| Total assets | $ | 47,461.5 | $ | 48,806.0 |\n| Liabilities and Equity |\n| Current Liabilities |\n| Short-term borrowings and current maturities of long-term debt | $ | 1,744.6 | $ | 1,538.3 |\n| Accounts payable | 1,683.2 | 1,670.6 |\n| Employee compensation | 984.1 | 958.1 |\n| Sales rebates and discounts | 8,568.4 | 6,845.8 |\n| Dividends payable | — | 885.5 |\n| Income taxes payable | 685.6 | 126.9 |\n| Other current liabilities | 1,986.9 | 3,027.5 |\n| Total current liabilities | 15,652.8 | 15,052.7 |\n| Other Liabilities |\n| Long-term debt | 14,143.8 | 15,346.4 |\n| Accrued retirement benefits (Note 8) | 1,832.5 | 1,954.1 |\n| Long-term income taxes payable | 3,641.7 | 3,920.0 |\n| Deferred tax liabilities | 171.9 | 1,733.7 |\n| Other noncurrent liabilities | 1,852.9 | 1,644.3 |\n| Total other liabilities | 21,642.8 | 24,598.5 |\n| Commitments and Contingencies (Note 9) |\n| Eli Lilly and Company Shareholders' Equity |\n| Common stock | 594.1 | 596.3 |\n| Additional paid-in capital | 6,829.0 | 6,833.4 |\n| Retained earnings | 10,006.5 | 8,958.5 |\n| Employee benefit trust | ( 3,013.2 ) | ( 3,013.2 ) |\n| Accumulated other comprehensive loss (Note 10) | ( 4,295.8 ) | ( 4,343.1 ) |\n| Cost of common stock in treasury | ( 50.5 ) | ( 52.7 ) |\n| Total Eli Lilly and Company shareholders' equity | 10,070.1 | 8,979.2 |\n| Noncontrolling interests | 95.8 | 175.6 |\n| Total equity | 10,165.9 | 9,154.8 |\n| Total liabilities and equity | $ | 47,461.5 | $ | 48,806.0 |\n\nSee notes to consolidated condensed financial statements.\n7\nConsolidated Condensed Statements of Equity\n(Unaudited)\nELI LILLY AND COMPANY AND SUBSIDIARIES\n| Equity of Eli Lilly and Company Shareholders |\n| (Dollars in millions, except per-share data, and shares in thousands) | Common Stock | AdditionalPaid-inCapital | RetainedEarnings | Employee Benefit Trust | Accumulated Other Comprehensive Loss | Common Stock in Treasury(1) | Noncontrolling Interests |\n| Shares | Amount | Shares | Amount |\n| Balance at July 1, 2021 | 957,038 | $ | 598.1 | $ | 6,669.2 | $ | 8,530.1 | $ | ( 3,013.2 ) | $ | ( 6,287.1 ) | 463 | $ | ( 52.7 ) | $ | 219.1 |\n| Net income (loss) | 1,110.1 | ( 22.6 ) |\n| Other comprehensive income, net of tax | 114.4 |\n| Issuance of stock under employee stock plans, net | 14 | 0.1 | ( 1.3 ) |\n| Stock-based compensation | 90.1 |\n| Other | ( 0.8 ) | 0.6 |\n| Balance at September 30, 2021 | 957,052 | $ | 598.2 | $ | 6,758.0 | $ | 9,639.4 | $ | ( 3,013.2 ) | $ | ( 6,172.7 ) | 463 | $ | ( 52.7 ) | $ | 197.1 |\n| Balance at July 1, 2022 | 950,619 | $ | 594.1 | $ | 6,746.0 | $ | 8,556.0 | $ | ( 3,013.2 ) | $ | ( 4,287.7 ) | 450 | $ | ( 50.5 ) | $ | 114.5 |\n| Net income (loss) | 1,451.7 | ( 15.7 ) |\n| Other comprehensive loss, net of tax | ( 8.1 ) |\n| Issuance of stock under employee stock plans, net | 8 | ( 2.1 ) |\n| Stock-based compensation | 85.1 |\n| Other | ( 1.2 ) | ( 3.0 ) |\n| Balance at September 30, 2022 | 950,627 | $ | 594.1 | $ | 6,829.0 | $ | 10,006.5 | $ | ( 3,013.2 ) | $ | ( 4,295.8 ) | 450 | $ | ( 50.5 ) | $ | 95.8 |\n\n(1) As of September 30, 2022, there was $ 3.25 billion remaining under our $ 5.00 billion share repurchase program authorized in May 2021.\nSee notes to consolidated condensed financial statements.\n8\n| Equity of Eli Lilly and Company Shareholders |\n| (Dollars in millions, except per-share data, and shares in thousands) | Common Stock | AdditionalPaid-inCapital | RetainedEarnings | Employee Benefit Trust | Accumulated Other Comprehensive Loss | Common Stock in Treasury(1) | Noncontrolling Interests |\n| Shares | Amount | Shares | Amount |\n| Balance at January 1, 2021 | 957,077 | $ | 598.2 | $ | 6,778.5 | $ | 7,830.2 | $ | ( 3,013.2 ) | $ | ( 6,496.4 ) | 487 | $ | ( 55.7 ) | $ | 183.6 |\n| Net income | 3,855.6 | 25.2 |\n| Other comprehensive income, net of tax | 323.7 |\n| Cash dividends declared per share: $ 1.70 | ( 1,542.9 ) |\n| Retirement of treasury shares | ( 2,467 ) | ( 1.5 ) | ( 498.5 ) | ( 2,467 ) | 500.0 |\n| Purchase of treasury shares | 2,467 | ( 500.0 ) |\n| Issuance of stock under employee stock plans, net | 2,442 | 1.5 | ( 287.1 ) | ( 24 ) | 3.0 |\n| Stock-based compensation | 267.5 |\n| Other | ( 0.9 ) | ( 5.0 ) | ( 11.7 ) |\n| Balance at September 30, 2021 | 957,052 | $ | 598.2 | $ | 6,758.0 | $ | 9,639.4 | $ | ( 3,013.2 ) | $ | ( 6,172.7 ) | 463 | $ | ( 52.7 ) | $ | 197.1 |\n| Balance at January 1, 2022 | 954,116 | $ | 596.3 | $ | 6,833.4 | $ | 8,958.5 | $ | ( 3,013.2 ) | $ | ( 4,343.1 ) | 463 | $ | ( 52.7 ) | $ | 175.6 |\n| Net income (loss) | 4,307.1 | ( 63.7 ) |\n| Other comprehensive income, net of tax | 47.3 |\n| Cash dividends declared per share: $ 1.96 | ( 1,765.9 ) |\n| Retirement of treasury shares | ( 5,607 ) | ( 3.5 ) | ( 1,496.5 ) | ( 5,607 ) | 1,500.0 |\n| Purchase of treasury shares | 5,607 | ( 1,500.0 ) |\n| Issuance of stock under employee stock plans, net | 2,118 | 1.3 | ( 282.6 ) | ( 13 ) | 2.2 |\n| Stock-based compensation | 278.2 |\n| Other | 3.3 | ( 16.1 ) |\n| Balance at September 30, 2022 | 950,627 | $ | 594.1 | $ | 6,829.0 | $ | 10,006.5 | $ | ( 3,013.2 ) | $ | ( 4,295.8 ) | 450 | $ | ( 50.5 ) | $ | 95.8 |\n\n(1) As of September 30, 2022, there was $ 3.25 billion remaining under our $ 5.00 billion share repurchase program authorized in May 2021.\nSee notes to consolidated condensed financial statements.\n9\nConsolidated Condensed Statements of Cash Flows\n(Unaudited)\nELI LILLY AND COMPANY AND SUBSIDIARIES\n(Dollars in millions)\n\n| Nine Months Ended September 30, |\n| 2022 | 2021 |\n| Cash Flows from Operating Activities |\n| Net income | $ | 4,307.1 | $ | 3,855.6 |\n| Adjustments to Reconcile Net Income to Cash Flows from Operating Activities: |\n| Depreciation and amortization | 1,147.5 | 1,101.9 |\n| Change in deferred income taxes | ( 2,195.6 ) | ( 709.8 ) |\n| Debt extinguishment loss (Note 6) | — | 405.2 |\n| Stock-based compensation expense | 278.2 | 267.5 |\n| Net investment (gains) losses | 676.4 | ( 271.1 ) |\n| Acquired in-process research and development | 252.0 | 498.3 |\n| Other changes in operating assets and liabilities, net of acquisitions and divestitures | 821.5 | ( 548.1 ) |\n| Other non-cash operating activities, net | 217.6 | 504.7 |\n| Net Cash Provided by Operating Activities | 5,504.7 | 5,104.2 |\n| Cash Flows from Investing Activities |\n| Net purchases of property and equipment | ( 1,353.6 ) | ( 1,018.4 ) |\n| Proceeds from sales and maturities of short-term investments | 83.1 | 46.6 |\n| Purchases of short-term investments | ( 65.0 ) | ( 27.9 ) |\n| Proceeds from sales of noncurrent investments | 251.6 | 537.2 |\n| Purchases of noncurrent investments | ( 474.1 ) | ( 710.1 ) |\n| Cash paid for acquisitions, net of cash acquired (Note 3) | — | ( 747.4 ) |\n| Purchases of in-process research and development | ( 574.8 ) | ( 460.6 ) |\n| Other investing activities, net | ( 268.3 ) | ( 2.7 ) |\n| Net Cash Used for Investing Activities | ( 2,401.1 ) | ( 2,383.3 ) |\n| Cash Flows from Financing Activities |\n| Dividends paid | ( 2,651.4 ) | ( 2,313.5 ) |\n| Net change in short-term borrowings | 1,741.3 | ( 1.5 ) |\n| Proceeds from issuance of long-term debt | — | 2,410.8 |\n| Repayments of long-term debt | ( 1,560.0 ) | ( 1,905.3 ) |\n| Purchases of common stock | ( 1,500.0 ) | ( 500.0 ) |\n| Other financing activities, net | ( 295.2 ) | ( 295.3 ) |\n| Net Cash Used for Financing Activities | ( 4,265.3 ) | ( 2,604.8 ) |\n| Effect of exchange rate changes on cash and cash equivalents | ( 39.4 ) | 15.0 |\n| Net decrease in cash and cash equivalents | ( 1,201.1 ) | 131.1 |\n| Cash and cash equivalents at January 1 | 3,818.5 | 3,657.1 |\n| Cash and Cash Equivalents at September 30 | $ | 2,617.4 | $ | 3,788.2 |\n\nSee notes to consolidated condensed financial statements.\n10\nNotes to Consolidated Condensed Financial Statements\n(Tables present dollars in millions, except per-share data)\nNote 1: Basis of Presentation and Implementation of New Financial Accounting Standard\nWe have prepared the accompanying unaudited consolidated condensed financial statements in accordance with the requirements of Form 10-Q and, therefore, they do not include all information and footnotes necessary for a fair presentation of financial position, results of operations, and cash flows in conformity with accounting principles generally accepted in the United States (GAAP). In our opinion, the consolidated condensed financial statements reflect all adjustments (including those that are normal and recurring) that are necessary for a fair presentation of the results of operations for the periods shown. In preparing financial statements in conformity with GAAP, we must make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosures at the date of the financial statements and during the reporting period. Actual results could differ from those estimates.\nThe information included in this Quarterly Report on Form 10-Q should be read in conjunction with our consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the year ended December 31, 2021. We issue our financial statements by filing them with the Securities and Exchange Commission and have evaluated subsequent events up to the time of the filing of this Quarterly Report on Form 10-Q.\nCertain reclassifications have been made to prior periods in the consolidated condensed financial statements and accompanying notes to conform with the current presentation.\nAll per-share amounts, unless otherwise noted in the footnotes, are presented on a diluted basis; that is, based on the weighted-average number of common shares outstanding plus the effect of incremental shares from our stock-based compensation programs.\nWe operate as a single operating segment engaged in the discovery, development, manufacturing, marketing, and sales of pharmaceutical products worldwide. A global research and development organization and a supply chain organization are responsible for the discovery, development, manufacturing, and supply of our products. Regional commercial organizations market, distribute, and sell the products. The business is also supported by global corporate staff functions. Our determination that we operate as a single segment is consistent with the financial information regularly reviewed by the chief operating decision maker for purposes of evaluating performance, allocating resources, setting incentive compensation targets, and planning and forecasting for future periods.\nResearch and Development Expenses and Acquired In-Process Research and Development (IPR&D) and Development Milestones\nResearch and development costs are expensed as incurred. Research and development costs consist of expenses incurred in performing research and development activities, including but not limited to, compensation and benefits, facilities and overhead expense, clinical trial expense, and fees paid to contract research organizations.\nAcquired IPR&D and development milestones include the initial costs of externally developed IPR&D projects, acquired directly in a transaction other than a business combination, that do not have an alternative future use. Additionally, milestone payment obligations related to these transactions that are incurred prior to regulatory approval of the compound are expensed when the event triggering an obligation to pay the milestone occurs.\nImplementation of New Financial Accounting Standard\nAccounting Standards Update 2021-01, Reference Rate Reform, provides for temporary optional expedients and exceptions in applying current GAAP to contracts, hedging relationships, and other transactions affected by the transition from the use of the London Interbank Offered Rate (LIBOR) to an alternative reference rate. The standard is currently applicable to contracts entered into before January 1, 2023. We adopted the standard in the first quarter of 2022. The adoption did not have a material impact on our consolidated condensed financial statements.\n11\nNote 2: Revenue\nThe following table summarizes our revenue recognized in our consolidated condensed statements of operations:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Net product revenue | $ | 6,119.2 | $ | 6,189.0 | $ | 19,123.0 | $ | 18,579.5 |\n| Collaboration and other revenue(1) | 822.4 | 583.8 | 2,116.6 | 1,739.0 |\n| Revenue | $ | 6,941.6 | $ | 6,772.8 | $ | 21,239.6 | $ | 20,318.5 |\n\n(1) Collaboration and other revenue associated with prior period transfers of intellectual property was $ 43.3 million and $ 130.9 million during the three and nine months ended September 30, 2022, respectively, and $ 62.1 million and $ 136.1 million during the three and nine months ended September 30, 2021, respectively.\nWe recognize revenue primarily from two different types of contracts, product sales to customers (net product revenue) and collaborations and other arrangements. Revenue recognized from collaborations and other arrangements includes our share of profits from the collaborations, as well as royalties, upfront and milestone payments we receive under these types of contracts. See Note 4 for additional information related to our collaborations and other arrangements. Collaboration and other revenue disclosed above includes the revenue from the Jardiance® and Trajenta® families of products resulting from our collaboration with Boehringer Ingelheim discussed in Note 4. Substantially all of the remainder of collaboration and other revenue is related to contracts accounted for as contracts with customers.\nAdjustments to Revenue\nAdjustments to increase revenue recognized as a result of changes in estimates for our most significant United States (U.S.) sales returns, rebates, and discounts liability balances for products shipped in previous periods were 3 percent of U.S. revenue for the three months ended September 30, 2022 and less than 1 percent of U.S. revenue during the nine months ended September 30, 2022 and the three and nine months ended September 30, 2021.\nContract Liabilities\nOur contract liabilities result from arrangements where we have received payment in advance of performance under the contract and do not include sales returns, rebates, and discounts. Changes in contract liabilities are generally due to either receipt of additional advance payments or our performance under the contract.\nThe following table summarizes contract liability balances:\n| September 30, 2022 | December 31, 2021 |\n| Contract liabilities | $ | 232.5 | $ | 262.6 |\n\nDuring the three and nine months ended September 30, 2022 and 2021, revenue recognized from contract liabilities as of the beginning of the respective year was not material. Revenue expected to be recognized in the future from contract liabilities as the related performance obligations are satisfied is not expected to be material in any one year.\n12\nDisaggregation of Revenue\nThe following table summarizes revenue by product for the three months ended September 30, 2022 and 2021:\n| Three Months Ended September 30, |\n| 2022 | 2021 |\n| U.S. | Outside U.S. | Total | U.S. | Outside U.S. | Total |\n| Revenue—to unaffiliated customers: |\n| Diabetes: |\n| Trulicity® | $ | 1,418.3 | $ | 432.0 | $ | 1,850.4 | $ | 1,201.4 | $ | 398.8 | $ | 1,600.1 |\n| Jardiance(1) | 350.9 | 222.4 | 573.3 | 221.2 | 169.2 | 390.4 |\n| Humalog® (2) | 248.1 | 198.8 | 447.0 | 347.3 | 279.4 | 626.7 |\n| Humulin® | 169.5 | 68.7 | 238.2 | 193.4 | 93.4 | 286.7 |\n| Basaglar® | 124.8 | 68.1 | 193.0 | 114.7 | 78.1 | 192.8 |\n| Mounjaro® | 97.3 | 90.0 | 187.3 | — | — | — |\n| Other diabetes | 79.7 | 94.0 | 173.4 | 65.0 | 112.2 | 177.4 |\n| Total diabetes | 2,488.6 | 1,174.0 | 3,662.6 | 2,143.0 | 1,131.1 | 3,274.1 |\n| Oncology: |\n| Verzenio® | 414.8 | 202.9 | 617.7 | 199.6 | 135.9 | 335.5 |\n| Cyramza® | 87.5 | 144.6 | 232.1 | 84.8 | 168.6 | 253.4 |\n| Erbitux® | 126.3 | 18.7 | 144.9 | 114.0 | 20.3 | 134.3 |\n| Alimta® | 64.6 | 54.8 | 119.4 | 297.2 | 159.8 | 457.0 |\n| Tyvyt® | — | 76.8 | 76.8 | — | 125.6 | 125.6 |\n| Other oncology | 39.5 | 62.8 | 102.4 | 35.3 | 65.1 | 100.3 |\n| Total oncology | 732.7 | 560.6 | 1,293.3 | 730.9 | 675.3 | 1,406.1 |\n| Immunology: |\n| Taltz® | 493.8 | 186.1 | 679.9 | 422.2 | 170.9 | 593.1 |\n| Olumiant® (3) | 22.9 | 160.0 | 182.9 | 194.0 | 212.9 | 406.9 |\n| Other immunology | — | 3.6 | 3.6 | — | 4.9 | 4.9 |\n| Total immunology | 516.7 | 349.7 | 866.4 | 616.2 | 388.7 | 1,004.9 |\n| Neuroscience: |\n| Emgality® | 114.0 | 54.6 | 168.5 | 99.9 | 40.1 | 140.0 |\n| Zyprexa® | 8.0 | 73.4 | 81.4 | 13.0 | 88.7 | 101.7 |\n| Cymbalta® | 7.8 | 54.9 | 62.7 | 7.0 | 125.1 | 132.0 |\n| Other neuroscience | 16.0 | 44.5 | 60.6 | 24.7 | 51.6 | 76.5 |\n| Total neuroscience | 145.8 | 227.4 | 373.2 | 144.6 | 305.5 | 450.2 |\n| Other: |\n| COVID-19 antibodies(4) | 386.6 | — | 386.6 | 215.5 | 1.6 | 217.1 |\n| Forteo® | 112.7 | 64.4 | 177.1 | 109.6 | 91.3 | 200.9 |\n| Cialis® | 8.1 | 107.7 | 115.7 | ( 6.5 ) | 137.4 | 130.9 |\n| Other | 30.9 | 35.7 | 66.6 | 36.3 | 52.4 | 88.8 |\n| Total other | 538.3 | 207.8 | 746.0 | 354.9 | 282.7 | 637.7 |\n| Revenue | $ | 4,422.1 | $ | 2,519.4 | $ | 6,941.6 | $ | 3,989.6 | $ | 2,783.3 | $ | 6,772.8 |\n\nNumbers may not add due to rounding.\n(1) Jardiance revenue includes Glyxambi®, Synjardy®, and Trijardy® XR.\n(2) Humalog revenue includes insulin lispro.\n(3) Olumiant revenue includes sales for baricitinib that were made pursuant to Emergency Use Authorization (EUA) or similar regulatory authorizations.\n(4) COVID-19 antibodies include sales for bamlanivimab administered alone, for bamlanivimab and etesevimab administered together, and for bebtelovimab and were made pursuant to EUAs or similar regulatory authorizations.\n13\nThe following table summarizes revenue by product for the nine months ended September 30, 2022 and 2021:\n| Nine Months Ended September 30, |\n| 2022 | 2021 |\n| U.S. | Outside U.S. | Total | U.S. | Outside U.S. | Total |\n| Revenue—to unaffiliated customers: |\n| Diabetes: |\n| Trulicity | $ | 4,162.4 | $ | 1,341.1 | $ | 5,503.5 | $ | 3,465.7 | $ | 1,122.5 | $ | 4,588.2 |\n| Humalog(1) | 855.8 | 656.4 | 1,512.3 | 1,009.0 | 842.3 | 1,851.3 |\n| Jardiance(2) | 831.4 | 622.4 | 1,453.7 | 566.8 | 492.1 | 1,058.9 |\n| Humulin | 562.3 | 223.1 | 785.4 | 633.5 | 290.3 | 923.8 |\n| Basaglar | 339.9 | 218.8 | 558.7 | 423.3 | 226.8 | 650.1 |\n| Mounjaro | 109.9 | 93.3 | 203.2 | — | — | — |\n| Other diabetes | 195.6 | 276.5 | 472.2 | 185.7 | 302.6 | 488.3 |\n| Total diabetes | 7,057.3 | 3,431.6 | 10,489.0 | 6,284.0 | 3,276.6 | 9,560.6 |\n| Oncology: |\n| Verzenio | 1,100.5 | 575.1 | 1,675.6 | 582.1 | 363.7 | 945.8 |\n| Cyramza | 259.3 | 434.3 | 693.6 | 266.3 | 496.3 | 762.5 |\n| Alimta | 490.5 | 200.5 | 691.1 | 911.9 | 714.7 | 1,626.6 |\n| Erbitux | 361.0 | 47.4 | 408.3 | 357.7 | 45.9 | 403.7 |\n| Tyvyt | — | 235.8 | 235.8 | — | 340.2 | 340.2 |\n| Other oncology | 124.1 | 186.5 | 310.6 | 83.7 | 169.9 | 253.6 |\n| Total oncology | 2,335.4 | 1,679.6 | 4,015.0 | 2,201.7 | 2,130.7 | 4,332.4 |\n| Immunology: |\n| Taltz | 1,212.6 | 561.6 | 1,774.2 | 1,071.6 | 493.8 | 1,565.4 |\n| Olumiant(3) | 104.6 | 520.1 | 624.7 | 236.5 | 572.6 | 809.1 |\n| Other immunology | 0.1 | 12.1 | 12.1 | 15.2 | 14.5 | 29.7 |\n| Total immunology | 1,317.3 | 1,093.8 | 2,411.0 | 1,323.3 | 1,080.9 | 2,404.2 |\n| Neuroscience: |\n| Emgality | 330.8 | 144.4 | 475.2 | 313.5 | 102.2 | 415.7 |\n| Zyprexa | 26.2 | 235.5 | 261.7 | 28.3 | 264.5 | 292.8 |\n| Cymbalta | 25.0 | 194.3 | 219.3 | 30.3 | 454.0 | 484.3 |\n| Other neuroscience | 62.0 | 142.7 | 204.7 | 81.0 | 154.0 | 235.0 |\n| Total neuroscience | 444.0 | 716.9 | 1,160.9 | 453.1 | 974.7 | 1,427.8 |\n| Other: |\n| COVID-19 antibodies(4) | 1,970.9 | 14.7 | 1,985.5 | 949.5 | 226.7 | 1,176.2 |\n| Cialis | 25.8 | 454.7 | 480.4 | ( 3.1 ) | 541.8 | 538.7 |\n| Forteo | 261.4 | 191.7 | 453.0 | 330.1 | 287.7 | 617.8 |\n| Other | 119.4 | 125.1 | 244.8 | 96.5 | 164.3 | 260.8 |\n| Total other | 2,377.5 | 786.2 | 3,163.7 | 1,373.0 | 1,220.5 | 2,593.5 |\n| Revenue | $ | 13,531.5 | $ | 7,708.1 | $ | 21,239.6 | $ | 11,635.1 | $ | 8,683.4 | $ | 20,318.5 |\n\nNumbers may not add due to rounding.\n(1) Humalog revenue includes insulin lispro.\n(2) Jardiance revenue includes Glyxambi, Synjardy, and Trijardy XR.\n(3) Olumiant revenue includes sales for baricitinib that were made pursuant to EUA or similar regulatory authorizations.\n(4) COVID-19 antibodies include sales for bamlanivimab administered alone, for bamlanivimab and etesevimab administered together, and for bebtelovimab and were made pursuant to EUAs or similar regulatory authorizations.\n14\nThe following table summarizes revenue by geographical area:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Revenue—to unaffiliated customers(1): |\n| U.S. | $ | 4,422.1 | $ | 3,989.6 | $ | 13,531.5 | $ | 11,635.1 |\n| Europe | 1,056.4 | 1,098.6 | 3,224.8 | 3,629.6 |\n| Japan | 487.7 | 595.0 | 1,352.3 | 1,832.2 |\n| China | 343.4 | 400.3 | 1,102.0 | 1,285.0 |\n| Other foreign countries | 632.0 | 689.4 | 2,029.1 | 1,936.7 |\n| Revenue | $ | 6,941.6 | $ | 6,772.8 | $ | 21,239.6 | $ | 20,318.5 |\n\nNumbers may not add due to rounding.\n(1) Revenue is attributed to the countries based on the location of the customer.\nNote 3: Acquisitions\nWe engage in various forms of business development activities to enhance our product pipeline, including acquisitions, collaborations, investments, and licensing arrangements. In connection with these arrangements, our partners may be entitled to future royalties and/or commercial milestones based on sales should products be approved for commercialization and/or milestones based on the successful progress of compounds through the development process.\nIn January 2021, we completed the acquisition of Prevail Therapeutics Inc. (Prevail). This transaction, as further discussed below in Acquisition of a Business, was accounted for as a business combination under the acquisition method of accounting. Under this method, the assets acquired and liabilities assumed were recorded at their respective fair values as of the acquisition date in our consolidated condensed financial statements. The determination of estimated fair value required management to make significant estimates and assumptions. The excess of the purchase price over the fair value of the acquired net assets, where applicable, has been recorded as goodwill. The results of operations of this acquisition is included in our consolidated condensed financial statements from the date of acquisition.\nWe also acquired assets in development which are further discussed below in Asset Acquisitions. Upon each acquisition, the cost allocated to acquired IPR&D is immediately expensed if the compound has no alternative future use. Milestone payment obligations incurred prior to regulatory approval of the compound are expensed when the event triggering an obligation to pay the milestone occurs. We recognized acquired IPR&D and development milestone charges of $ 62.4 million and $ 668.4 million for the three and nine months ended September 30, 2022, respectively, and $ 177.6 million and $ 532.4 million for the three and nine months ended September 30, 2021, respectively.\nAcquisition of a Business\nPrevail Acquisition\nOverview of Transaction\nIn January 2021, we acquired all shares of Prevail for a purchase price that included $ 22.50 per share in cash (or an aggregate of $ 747.4 million, net of cash acquired) plus one non-tradable contingent value right (CVR) per share. The CVR entitles Prevail stockholders up to an additional $ 4.00 per share in cash (or an aggregate of approximately $ 160 million) payable, subject to certain terms and conditions, upon the first regulatory approval of a Prevail product in one of the following countries: U.S., Japan, United Kingdom, Germany, France, Italy, or Spain. To achieve the full value of the CVR, such regulatory approval must occur by December 31, 2024. If such regulatory approval occurs after December 31, 2024, the value of the CVR will be reduced by approximately 8.3 cents per month until December 1, 2028, at which point the CVR will expire without payment.\nUnder the terms of the agreement, we acquired potentially disease-modifying AAV9-based gene therapies for patients with neurodegenerative diseases. The acquisition established a new modality for drug discovery and development, extending our research efforts through the creation of a gene therapy program that is being anchored by Prevail's portfolio of assets. The lead gene therapies in clinical development that we acquired were PR001 for patients with Parkinson's disease with GBA1 mutations and neuronopathic Gaucher disease and PR006 for patients with frontotemporal dementia with GRN mutations. Both PR001 and PR006 were granted Fast Track designation from the U.S. Food and Drug Administration (FDA).\n15\nAssets Acquired and Liabilities Assumed\nThe following table summarizes the amounts recognized for assets acquired and liabilities assumed as of the acquisition date:\n| Estimated Fair Value at January 22, 2021 |\n| Cash | $ | 90.5 |\n| Acquired IPR&D(1) | 824.0 |\n| Goodwill(2) | 126.8 |\n| Deferred tax liabilities | ( 106.0 ) |\n| Other assets and liabilities, net | ( 31.5 ) |\n| Acquisition date fair value of consideration transferred | 903.8 |\n| Less: |\n| Cash acquired | ( 90.5 ) |\n| Fair value of CVR liability(3) | ( 65.9 ) |\n| Cash paid, net of cash acquired | $ | 747.4 |\n\n(1) Acquired IPR&D intangibles primarily relate to PR001. In the third quarter of 2022, we impaired the intangible asset related to PR001. See Note 5 for additional information.\n(2) The goodwill recognized from this acquisition is not deductible for tax purposes.\n(3) See Note 6 for a discussion on the estimation of the CVR liability.\nWe are unable to provide the results of operations for the three and nine months ended September 30, 2022 and 2021 attributable to Prevail as those operations were substantially integrated into our legacy business.\nPro forma information has not been included as this acquisition did not have a material impact on our consolidated condensed statements of operations for the three and nine months ended September 30, 2021.\nAsset Acquisitions\nThe following table summarizes our significant asset acquisitions during the nine months ended September 30, 2022 and 2021:\n| Counterparty | Compound(s), Therapy or Asset | Acquisition Month | Phase of Development(1) | Acquired IPR&D Expense |\n| BioMarin Pharmaceutical Inc. | Priority Review Voucher | February 2022 | Not applicable | $ | 110.0 |\n| Rigel Pharmaceuticals, Inc. | R552, a receptor-interacting serine/threonine-protein kinase 1 (RIPK1) inhibitor, for the potential treatment of autoimmune and inflammatory diseases | March 2021 | Phase I | 125.0 |\n| Precision Biosciences, Inc. | Potential in vivo therapies for genetic disorders | January 2021 | Pre-clinical | 107.8 |\n\n(1) The phase of development presented is as of the date of the arrangement and represents the phase of development of the most advanced asset acquired, where applicable.\nIn connection with our acquisition of Petra Pharma Corporation (Petra), we were required to make milestone payments to Petra shareholders contingent upon the occurrence of certain future events linked to the success of the mutant-selective PI3Kα inhibitor. In the second quarter of 2022, we entered into agreements with substantially all Petra shareholders to acquire their rights to receive any future milestone payments in exchange for a one-time payment. As a result of these agreements, we recognized a charge of $ 333.8 million as a development milestone during the nine months ended September 30, 2022. Any remaining contingent milestones payments linked to the success of the mutant-selective PI3Kα are not expected to be material. We recognized no other significant development milestones during the three and nine months ended September 30, 2022 and 2021.\n16\nSubsequent Event - Akouos, Inc. (Akouos) Acquisition\nOn October 17, 2022, we entered into a definitive agreement to acquire Akouos. Pursuant to the terms of the agreement, we have commenced a tender offer to acquire all outstanding shares of Akouos for a purchase price of $ 12.50 per share in cash (an aggregate of approximately $ 487 million), payable at closing, plus one non-tradable CVR per share that will entitle the holder to receive up to an additional $ 3.00 per CVR in cash (an aggregate of up to approximately $ 123 million) upon the achievement of certain specified milestones. The acquisition will expand our gene therapy portfolio to include potential treatments for hearing loss and other inner ear conditions. The acquisition is not subject to any financing condition and is expected to close in the fourth quarter of 2022, subject to customary closing conditions, including receipt of required antitrust clearance and the tender of a majority of the outstanding shares of Akouos's common stock.\nNote 4: Collaborations and Other Arrangements\nWe often enter into collaborative and other similar arrangements to develop and commercialize drug candidates. Collaborative activities may include research and development, marketing and selling (including promotional activities and physician detailing), manufacturing, and distribution. These arrangements often require milestone as well as royalty or profit-share payments, contingent upon the occurrence of certain future events linked to the success of the asset in development, as well as expense reimbursements from or payments to the collaboration partner. See Note 2 for amounts of collaboration and other revenue recognized from these types of arrangements.\nOperating expenses for costs incurred pursuant to these arrangements are reported in their respective expense line item, net of any payments due to or reimbursements due from our collaboration partners, with such reimbursements being recognized at the time the party becomes obligated to pay. Each collaboration is unique in nature, and our more significant arrangements are discussed below.\nBoehringer Ingelheim Diabetes Collaboration\nWe and Boehringer Ingelheim have a global agreement to jointly develop and commercialize a portfolio of diabetes compounds. Currently included in the collaboration are Boehringer Ingelheim's oral diabetes products: Jardiance, Glyxambi, Synjardy, Trijardy XR, Trajenta, and Jentadueto® as well as our basal insulin, Basaglar. Glyxambi, Synjardy, and Trijardy XR are included in the Jardiance product family. Jentadueto is included in the Trajenta product family.\nIn connection with the regulatory approvals of Jardiance, Trajenta, and Basaglar in the U.S., Europe, and Japan, milestone payments made for Jardiance and Trajenta were capitalized as intangible assets and are being amortized to cost of sales, and milestone payments received for Basaglar were recorded as contract liabilities and are being amortized to collaboration and other revenue. The milestones pertaining to Jardiance and Trajenta are being amortized through their respective term under the collaboration, which, depending on country or region, is determined based on the latest to occur of (a) a defined number of years following launch date, (b) the expiration of the compound patent, or (c) the expiration of marketing authorization exclusivity. The milestones pertaining to Basaglar are being amortized through 2029. The table below summarizes the net milestones capitalized with respect to the Jardiance and Trajenta families of products and the net milestones deferred with respect to Basaglar as of September 30, 2022 and December 31, 2021:\n| Net Milestones Capitalized (Deferred)(1) |\n| September 30, 2022 | December 31, 2021 |\n| Jardiance | $ | 121.2 | $ | 136.1 |\n| Trajenta | 69.6 | 88.5 |\n| Basaglar | ( 135.3 ) | ( 149.3 ) |\n\n(1) This represents the amounts that have been capitalized (deferred) from the start of this collaboration through the end of the reporting period, net of amount amortized.\n17\nFor the Jardiance product family, we and Boehringer Ingelheim share equally the ongoing development and commercialization costs in the most significant markets, and we record our portion of the development and commercialization costs as research and development expense and marketing, selling, and administrative expense, respectively. We receive a royalty on net sales of Boehringer Ingelheim's products in the most significant markets and recognize the royalty as collaboration and other revenue. Boehringer Ingelheim is entitled to potential performance payments depending on the net sales of the Jardiance product family; therefore, our reported revenue for Jardiance may be reduced by any potential performance payments we make related to this product family. The royalty received by us related to the Jardiance product family may also be increased or decreased depending on whether net sales for this product family exceed or fall below certain thresholds. We pay to Boehringer Ingelheim a royalty on net sales for Basaglar in the U.S. We record our sales of Basaglar to third parties as net product revenue with the royalty payments made to Boehringer Ingelheim recorded as cost of sales.\nThe following table summarizes our collaboration and other revenue recognized with respect to the Jardiance and Trajenta families of products and net product revenue recognized with respect to Basaglar:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Jardiance | $ | 573.3 | $ | 390.4 | $ | 1,453.7 | $ | 1,058.9 |\n| Basaglar | 193.0 | 192.8 | 558.7 | 650.1 |\n| Trajenta | 103.8 | 96.1 | 293.0 | 279.9 |\n\nOlumiant\nWe have a worldwide license and collaboration agreement with Incyte Corporation (Incyte), which provides us the development and commercialization rights to baricitinib, branded and trademarked as Olumiant, and certain follow-on compounds, for the treatment of inflammatory and autoimmune diseases and COVID-19. Incyte has the right to receive tiered, double digit royalty payments on worldwide net sales with rates ranging up to 20 percent. Incyte has the right to receive an additional royalty ranging up to the low teens on worldwide net sales for the treatment of COVID-19 that exceed a specified aggregate worldwide net sales threshold. The agreement calls for payments by us to Incyte associated with certain development, success-based regulatory, and sales-based milestones.\nIn connection with the regulatory approvals of Olumiant in the U.S., Europe, and Japan, as well as achievement of a sales-based milestone, milestone payments of $ 330.0 million and $ 260.0 million were capitalized as intangible assets as of September 30, 2022 and December 31, 2021, respectively, and are being amortized to cost of sales through the term of the collaboration. This represents the cumulative amounts that have been capitalized from the start of this collaboration through the end of each reporting period.\nAs of September 30, 2022, Incyte is eligible to receive up to $ 100.0 million of additional payments from us in potential sales-based milestones.\nWe record our sales of Olumiant, including sales of baricitinib that were made pursuant to EUA or similar regulatory authorizations, to third parties as net product revenue with the royalty payments made to Incyte recorded as cost of sales. The following table summarizes our net product revenue recognized with respect to Olumiant:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Olumiant | $ | 182.9 | $ | 406.9 | $ | 624.7 | $ | 809.1 |\n\n18\nCOVID-19 Antibodies\nWe have a worldwide license and collaboration agreement with AbCellera Biologics Inc. (AbCellera) to co-develop therapeutic antibodies for the potential prevention and treatment of COVID-19, including bamlanivimab and bebtelovimab, for which we hold development and commercialization rights. AbCellera has the right to receive tiered royalty payments on worldwide net sales of bamlanivimab and bebtelovimab with percentages ranging in the mid-teens to mid-twenties. Royalty payments made to AbCellera are recorded as cost of sales.\nWe have a license and collaboration agreement with Shanghai Junshi Biosciences Co., Ltd. (Junshi Biosciences) to co-develop therapeutic antibodies for the potential prevention and treatment of COVID-19, including etesevimab, for which we hold development and commercialization rights outside of mainland China and the Special Administrative Regions of Hong Kong and Macau, and for which Junshi Biosciences currently maintains all rights in mainland China and the Special Administrative Regions of Hong Kong and Macau. Junshi Biosciences has the right to receive royalty payments in the mid-teens on our net sales of etesevimab. Junshi Biosciences received certain development, success-based regulatory and sales-based milestones. Capitalized regulatory and sales-based milestones were fully amortized to cost of sales as of September 30, 2022.\nPursuant to EUAs or similar regulatory authorizations, we recognized net product revenue associated with our sales of our COVID-19 antibodies of $ 386.6 million and $ 1.99 billion for the three and nine months ended September 30, 2022, respectively, and $ 217.1 million and $ 1.18 billion for the three and nine months ended September 30, 2021, respectively.\nSintilimab Injection\nWe have a collaboration agreement with Innovent Biologics, Inc. (Innovent) to jointly develop and commercialize sintilimab injection in China, where it is branded and trademarked as Tyvyt. In connection with regulatory approvals for Tyvyt in China, milestone payments of $ 120.0 million and $ 40.0 million were capitalized as intangible assets as of September 30, 2022 and December 31, 2021, respectively, and are being amortized to cost of sales through the term of the collaboration. This represents the cumulative amounts that have been capitalized from the start of this collaboration through the end of each reporting period. As of September 30, 2022, Innovent is eligible to receive up to $ 115.0 million in success-based regulatory and sales-based milestones.\nWe record our sales of Tyvyt to third parties as net product revenue, with payments made to Innovent for its portion of the gross margin reported as cost of sales. We report as collaboration and other revenue our portion of the gross margin for Tyvyt sales made by Innovent to third parties. The following table summarizes our revenue recognized in China with respect to Tyvyt:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Tyvyt | $ | 76.8 | $ | 125.6 | $ | 235.8 | $ | 340.2 |\n\nIn 2020, we obtained an exclusive license for sintilimab injection from Innovent for geographies outside of China, which was subsequently terminated and rights have reverted to Innovent in October 2022.\nLebrikizumab\nWe have a worldwide license agreement with F. Hoffmann-La Roche Ltd and Genentech, Inc. (collectively, Roche), which provides us the worldwide development and commercialization rights to lebrikizumab. Roche has the right to receive tiered royalty payments on future worldwide net sales ranging in percentages from high single digits to high teens if the product is successfully commercialized. As of September 30, 2022, Roche is eligible to receive up to $ 180.0 million of payments from us contingent upon the achievement of success-based regulatory milestones and up to $ 1.03 billion in a series of sales-based milestones, contingent upon the commercial success of lebrikizumab.\nWe have a license agreement with Almirall, S.A. (Almirall), under which Almirall licensed the rights to develop and commercialize lebrikizumab for the treatment or prevention of dermatology indications, including, but not limited to, atopic dermatitis in Europe. We have the right to receive tiered royalty payments on future net sales in Europe ranging in percentages from low double digits to low twenties if the product is successfully commercialized. As of September 30, 2022, we are eligible to receive additional payments of $ 85.0 million from Almirall contingent upon the achievement of success-based regulatory milestones and up to $ 1.25 billion in a series of sales-based milestones, contingent upon the commercial success of lebrikizumab. There were no remaining contract liabilities as of September 30, 2022. As of December 31, 2021, contract liabilities were not material. During the three and nine months ended September 30, 2022 and 2021, collaboration and other revenue recognized was not material.\n19\nNote 5: Asset Impairment, Restructuring, and Other Special Charges\nThe components of the charges included in asset impairment, restructuring, and other special charges in our consolidated condensed statements of operations are described below.\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Severance | $ | — | $ | — | $ | — | $ | 11.5 |\n| Asset impairment and other special charges | 206.5 | — | 206.5 | 200.1 |\n| Total asset impairment, restructuring, and other special charges | $ | 206.5 | $ | — | $ | 206.5 | $ | 211.6 |\n\nAsset impairment, restructuring, and other special charges recognized during the three and nine months ended September 30, 2022 were primarily related to an intangible asset impairment for GBA1 Gene Therapy (PR001), acquired in the Prevail acquisition, as a result of changes in key assumptions used in the valuation due to delays in estimated launch timing.\nAsset impairment, restructuring, and other special charges recognized during the nine months ended September 30, 2021 were primarily related to an intangible asset impairment of $ 108.1 million resulting from the sale of the rights to Qbrexza®, as well as acquisition and integration costs associated with the acquisition of Prevail.\nWe recognized a net inventory impairment charge related to our COVID-19 antibodies of $ 435.1 million during the nine months ended September 30, 2021 in cost of sales in our consolidated condensed statements of operations. As part of our response to the COVID-19 pandemic, and at the request of the U.S. and international governments, we invested in large-scale manufacturing of COVID-19 antibodies at risk, in order to ensure rapid access to patients around the world. As the COVID-19 pandemic evolved during 2021, we incurred a net inventory impairment charge primarily due to the combination of changes to demand from U.S. and international governments, including changes to our agreement with the U.S. government, and near-term expiry dates of COVID-19 antibodies.\nNote 6: Financial Instruments\nFinancial instruments that potentially subject us to credit risk consist principally of trade receivables and interest-bearing investments. Wholesale distributors of life science products account for a substantial portion of our trade receivables; collateral is generally not required. We seek to mitigate the risk associated with this concentration through our ongoing credit-review procedures and insurance. A large portion of our cash is held by a few major financial institutions. We monitor our exposures with these institutions and do not expect any of these institutions to fail to meet their obligations. In accordance with documented corporate risk-management policies, we monitor the amount of credit exposure to any one financial institution or corporate issuer. We are exposed to credit-related losses in the event of nonperformance by counterparties to risk-management instruments but do not expect any counterparties to fail to meet their obligations given their investment grade credit ratings.\nWe consider all highly liquid investments with a maturity of three months or less from the date of purchase to be cash equivalents. The cost of these investments approximates fair value.\nOur equity investments are accounted for using three different methods depending on the type of equity investment:\n•Investments in companies over which we have significant influence but not a controlling interest are accounted for using the equity method, with our share of earnings or losses reported in other-net, (income) expense.\n•For equity investments that do not have readily determinable fair values, we measure these investments at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for the identical or similar investment of the same issuer. Any change in recorded value is recorded in other-net, (income) expense.\n•Our public equity investments are measured and carried at fair value. Any change in fair value is recognized in other-net, (income) expense.\nWe review equity investments other than public equity investments for indications of impairment and observable price changes on a regular basis.\n20\nOur derivative activities are initiated within the guidelines of documented corporate risk-management policies and are intended to offset losses and gains on the assets, liabilities, and transactions being hedged. Management reviews the correlation and effectiveness of our derivatives on a quarterly basis.\nFor derivative instruments that are designated and qualify as fair value hedges, the derivative instrument is marked to market, with gains and losses recognized currently in income to offset the respective losses and gains recognized on the underlying exposure. For derivative instruments that are designated and qualify as cash flow hedges, gains and losses are reported as a component of accumulated other comprehensive loss and reclassified into earnings in the same period the hedged transaction affects earnings. For derivative and non-derivative instruments that are designated and qualify as net investment hedges, the foreign currency translation gains or losses due to spot rate fluctuations are reported as a component of accumulated other comprehensive loss. Derivative contracts that are not designated as hedging instruments are recorded at fair value with the gain or loss recognized in earnings during the period of change.\nWe may enter into foreign currency forward or option contracts to reduce the effect of fluctuating currency exchange rates (principally the euro, British pound, Chinese yuan, and Japanese yen). Foreign currency derivatives used for hedging are put in place using the same or like currencies and duration as the underlying exposures. Forward and option contracts are principally used to manage exposures arising from subsidiary trade and loan payables and receivables denominated in foreign currencies. These contracts are recorded at fair value with the gain or loss recognized in other–net, (income) expense. We may enter into foreign currency forward and option contracts and currency swaps as fair value hedges of firm commitments. Forward contracts generally have maturities not exceeding 12 months. At September 30, 2022, we had outstanding foreign currency forward commitments to purchase 1.69 billion U.S. dollars and sell 1.71 billion euro; commitments to purchase 2.24 billion euro and sell 2.24 billion U.S. dollars; commitments to purchase 239.5 million U.S. dollars and sell 1.63 billion Chinese yuan; commitments to purchase 82.1 million U.S. dollars and sell 11.86 billion Japanese yen; and commitments to purchase 182.1 million British pounds and sell 206.9 million U.S. dollars, which all have settlement dates within 180 days.\nForeign currency exchange risk is also managed through the use of foreign currency debt, cross-currency interest rate swaps, and foreign currency forward contracts. Our foreign currency-denominated notes had carrying amounts of $ 6.23 billion and $ 7.90 billion as of September 30, 2022 and December 31, 2021, respectively, of which $ 4.94 billion and $ 5.79 billion have been designated as, and are effective as, economic hedges of net investments in certain of our foreign operations as of September 30, 2022 and December 31, 2021, respectively. At September 30, 2022, we had outstanding cross-currency swaps with notional amounts of $ 1.56 billion swapping U.S. dollars to euro and $ 1.00 billion swapping Swiss francs to U.S. dollars which have settlement dates ranging through 2028. Our cross-currency interest rate swaps, for which a majority convert a portion of our U.S. dollar-denominated fixed-rate debt to foreign-denominated fixed-rate debt, have also been designated as, and are effective as, economic hedges of net investments. At September 30, 2022, we had outstanding foreign currency forward contracts to sell 1.34 billion euro with settlement dates ranging through 2023, which have been designated as, and are effective as, economic hedges of net investments.\nIn the normal course of business, our operations are exposed to fluctuations in interest rates which can vary the costs of financing, investing, and operating. We seek to address a portion of these risks through a controlled program of risk management that includes the use of derivative financial instruments. The objective of controlling these risks is to limit the impact of fluctuations in interest rates on earnings. Our primary interest-rate risk exposure results from changes in short-term U.S. dollar interest rates. In an effort to manage interest-rate exposures, we strive to achieve an acceptable balance between fixed- and floating-rate debt and investment positions and may enter into interest rate swaps or collars to help maintain that balance.\nInterest rate swaps or collars that convert our fixed-rate debt to a floating rate are designated as fair value hedges of the underlying instruments. Interest rate swaps or collars that convert floating-rate debt to a fixed rate are designated as cash flow hedges. Interest expense on the debt is adjusted to include the payments made or received under the swap agreements. Cash proceeds from or payments to counterparties resulting from the termination of interest rate swaps are classified as operating activities in our consolidated condensed statements of cash flows. At September 30, 2022, substantially all of our total long-term debt is at a fixed rate. We have converted approximately 10 percent of our long-term fixed-rate notes to floating rates through the use of interest rate swaps.\n21\nWe also may enter into forward-starting interest rate swaps, which we designate as cash flow hedges, as part of any anticipated future debt issuances in order to reduce the risk of cash flow volatility from future changes in interest rates. The change in fair value of these instruments is recorded as part of other comprehensive income (loss) and, upon completion of a debt issuance and termination of the swap, is amortized to interest expense over the life of the underlying debt. As of September 30, 2022, the total notional amounts of forward-starting interest rate contracts in designated cash flow hedging instruments were $ 1.75 billion, which have settlement dates ranging between 2023 and 2025.\nEffective September 15, 2022, we increased our 364-day credit facility from $ 2.00 billion to $ 4.00 billion, which will expire in September 2023, and is available to support our commercial paper program. We have not drawn against the $ 4.00 billion 364-day credit facility as of September 30, 2022.\nIn September 2021, we issued euro-denominated notes consisting of € 600.0 million of 0.50 percent fixed-rate notes due in September 2033, with interest to be paid annually. The net proceeds from the offering have been, and will continue to be, used to fund, in whole or in part, eligible projects designed to advance one or more of our environmental, social, and governance objectives.\nIn September 2021, we issued euro-denominated notes consisting of € 500.0 million of 1.125 percent fixed-rate notes due in September 2051 and € 700.0 million of 1.375 percent fixed-rate notes due in September 2061, with interest to be paid annually, and British pound-denominated notes consisting of £ 250.0 million of 1.625 percent fixed-rate notes due in September 2043, with interest to be paid annually. We paid $ 1.91 billion of the net cash proceeds from the offering to purchase and redeem certain higher interest rate U.S. dollar-denominated notes with an aggregate principal amount of $ 1.50 billion, resulting in a debt extinguishment loss of $ 405.2 million. This loss was included in other net, (income) expense in our consolidated condensed statement of operations during the three and nine months ended September 30, 2021. The $ 1.50 billion principal amount of higher interest rate U.S. dollar-denominated notes that were redeemed primarily included $ 541.8 million of 3.95 percent notes due 2049, $ 408.7 million of 4.15 percent notes due 2059, and $ 219.4 million of 3.375 percent notes due 2029. We used the remaining net proceeds from the offering to prefund certain 2022 debt maturities and for general corporate purposes.\nThe Effect of Risk-Management Instruments on the Consolidated Condensed Statements of Operations\nThe following effects of risk-management instruments were recognized in other–net, (income) expense:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Fair value hedges: |\n| Effect from hedged fixed-rate debt | $ | ( 62.9 ) | $ | ( 10.1 ) | $ | ( 215.7 ) | $ | ( 60.5 ) |\n| Effect from interest rate contracts | 62.9 | 10.1 | 215.7 | 60.5 |\n| Cash flow hedges: |\n| Effective portion of losses on interest rate contracts reclassified from accumulated other comprehensive loss | 4.1 | 4.2 | 12.3 | 12.5 |\n| Cross-currency interest rate swaps | 33.1 | 10.0 | 75.0 | 58.1 |\n| Net (gains) losses on foreign currency exchange contracts not designated as hedging instruments | 129.6 | 50.8 | 280.7 | 110.6 |\n| Total | $ | 166.8 | $ | 65.0 | $ | 368.0 | $ | 181.2 |\n\nDuring the three and nine months ended September 30, 2022 and 2021, the amortization of losses related to the portion of our risk management hedging instruments, fair value hedges, and cash flow hedges that was excluded from the assessment of effectiveness was not material.\n22\nThe Effect of Risk-Management Instruments on Other Comprehensive Income (Loss)\nThe effective portion of risk-management instruments that was recognized in other comprehensive income (loss) is as follows:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Net investment hedges: |\n| Foreign currency-denominated notes | $ | 435.1 | $ | 119.0 | $ | 822.8 | $ | 268.8 |\n| Cross-currency interest rate swaps | 92.1 | 66.7 | 171.4 | 170.8 |\n| Foreign currency forward contracts | 107.8 | — | 121.4 | — |\n| Cash flow hedges: |\n| Forward-starting interest rate swaps | 57.5 | 19.4 | 337.7 | 149.3 |\n| Cross-currency interest rate swaps | 19.9 | 3.1 | 38.4 | 22.5 |\n\nDuring the next 12 months, we expect to reclassify $ 16.7 million of pretax net losses on cash flow hedges from accumulated other comprehensive loss to other–net, (income) expense. During the three and nine months ended September 30, 2022 and 2021, the amounts excluded from the assessment of hedge effectiveness recognized in other comprehensive income (loss) were not material.\n23\nFair Value of Financial Instruments\nThe following tables summarize certain fair value information at September 30, 2022 and December 31, 2021 for assets and liabilities measured at fair value on a recurring basis, as well as the carrying amount and amortized cost of certain other investments:\n| Fair Value Measurements Using |\n| CarryingAmount | Cost(1) | Quoted Prices in Active Markets for Identical Assets(Level 1) | Significant OtherObservable Inputs(Level 2) | SignificantUnobservableInputs(Level 3) | FairValue |\n| September 30, 2022 |\n| Cash equivalents | $ | 1,246.8 | $ | 1,246.8 | $ | 1,239.2 | $ | 7.6 | $ | — | $ | 1,246.8 |\n| Short-term investments: |\n| U.S. government and agency securities | $ | 43.0 | $ | 43.5 | $ | 43.0 | $ | — | $ | — | $ | 43.0 |\n| Corporate debt securities | 51.7 | 51.8 | — | 51.7 | — | 51.7 |\n| Asset-backed securities | 3.0 | 3.0 | — | 3.0 | — | 3.0 |\n| Other securities | 27.0 | 27.0 | — | 14.8 | 12.2 | 27.0 |\n| Short-term investments | $ | 124.7 |\n| Noncurrent investments: |\n| U.S. government and agency securities | $ | 131.4 | $ | 148.3 | $ | 131.4 | $ | — | $ | — | $ | 131.4 |\n| Corporate debt securities | 206.4 | 232.5 | — | 206.4 | — | 206.4 |\n| Mortgage-backed securities | 143.1 | 156.1 | — | 143.1 | — | 143.1 |\n| Asset-backed securities | 43.6 | 45.5 | — | 43.6 | — | 43.6 |\n| Other securities | 152.5 | 96.3 | — | 39.5 | 113.0 | 152.5 |\n| Marketable equity securities | 549.1 | 416.1 | 549.1 | — | — | 549.1 |\n| Equity investments without readily determinable fair values(2) | 583.7 |\n| Equity method investments(2) | 764.8 |\n| Noncurrent investments | $ | 2,574.6 |\n| December 31, 2021 |\n| Cash equivalents | $ | 2,379.5 | $ | 2,379.5 | $ | 2,361.0 | $ | 18.5 | $ | — | $ | 2,379.5 |\n| Short-term investments: |\n| U.S. government and agency securities | $ | 25.7 | $ | 25.6 | $ | 25.7 | $ | — | $ | — | $ | 25.7 |\n| Corporate debt securities | 43.7 | 43.7 | — | 43.7 | — | 43.7 |\n| Mortgage-backed securities | 0.2 | 0.2 | — | 0.2 | — | 0.2 |\n| Asset-backed securities | 6.2 | 6.2 | — | 6.2 | — | 6.2 |\n| Other securities | 14.3 | 14.3 | — | — | 14.3 | 14.3 |\n| Short-term investments | $ | 90.1 |\n| Noncurrent investments: |\n| U.S. government and agency securities | $ | 137.0 | $ | 136.8 | $ | 137.0 | $ | — | $ | — | $ | 137.0 |\n| Corporate debt securities | 235.3 | 232.7 | — | 235.3 | — | 235.3 |\n| Mortgage-backed securities | 109.8 | 108.1 | — | 109.8 | — | 109.8 |\n| Asset-backed securities | 23.1 | 23.1 | — | 23.1 | — | 23.1 |\n| Other securities | 108.1 | 22.2 | — | — | 108.1 | 108.1 |\n| Marketable equity securities | 1,279.7 | 487.0 | 1,279.7 | — | — | 1,279.7 |\n| Equity investments without readily determinable fair values(2) | 548.1 |\n| Equity method investments(2) | 771.5 |\n| Noncurrent investments | $ | 3,212.6 |\n\n(1) For available-for-sale debt securities, amounts disclosed represent the securities' amortized cost.\n(2) Fair value disclosures are not applicable for equity method investments and investments accounted for under the measurement alternative for equity investments.\n24\n| Fair Value Measurements Using |\n| CarryingAmount | Quoted Prices in Active Markets for Identical Assets(Level 1) | SignificantOther Observable Inputs(Level 2) | SignificantUnobservableInputs(Level 3) | FairValue |\n| Short-term commercial paper borrowings |\n| September 30, 2022 | $ | ( 1,741.3 ) | $ | — | $ | ( 1,738.0 ) | $ | — | $ | ( 1,738.0 ) |\n| December 31, 2021 | — | — | — | — | — |\n| Long-term debt, including current portion |\n| September 30, 2022 | $ | ( 14,147.1 ) | $ | — | $ | ( 11,848.6 ) | $ | — | $ | ( 11,848.6 ) |\n| December 31, 2021 | ( 16,884.7 ) | — | ( 18,157.7 ) | — | ( 18,157.7 ) |\n\n25\n| Fair Value Measurements Using |\n| CarryingAmount | Quoted Prices in Active Markets for Identical Assets(Level 1) | SignificantOther Observable Inputs(Level 2) | SignificantUnobservableInputs(Level 3) | FairValue |\n| September 30, 2022 |\n| Risk-management instruments: |\n| Interest rate contracts designated as fair value hedges: |\n| Other noncurrent liabilities | $ | ( 140.2 ) | $ | — | $ | ( 140.2 ) | $ | — | $ | ( 140.2 ) |\n| Interest rate contracts designated as cash flow hedges: |\n| Other noncurrent assets | 355.2 | — | 355.2 | — | 355.2 |\n| Cross-currency interest rate contracts designated as net investment hedges: |\n| Other receivables | 81.6 | — | 81.6 | — | 81.6 |\n| Other noncurrent assets | 116.9 | — | 116.9 | — | 116.9 |\n| Cross-currency interest rate contracts designated as cash flow hedges: |\n| Other noncurrent assets | 8.3 | — | 8.3 | — | 8.3 |\n| Other noncurrent liabilities | ( 12.9 ) | — | ( 12.9 ) | — | ( 12.9 ) |\n| Foreign exchange contracts designated as net investment hedges: |\n| Other receivables | 108.2 | — | 108.2 | — | 108.2 |\n| Other current liabilities | ( 2.9 ) | — | ( 2.9 ) | — | ( 2.9 ) |\n| Foreign exchange contracts not designated as hedging instruments: |\n| Other receivables | 48.1 | — | 48.1 | — | 48.1 |\n| Other current liabilities | ( 93.5 ) | — | ( 93.5 ) | — | ( 93.5 ) |\n| Contingent consideration liability: |\n| Other noncurrent liabilities | ( 42.1 ) | — | — | ( 42.1 ) | ( 42.1 ) |\n| December 31, 2021 |\n| Risk-management instruments: |\n| Interest rate contracts designated as fair value hedges: |\n| Other receivables | $ | 4.8 | $ | — | $ | 4.8 | $ | — | $ | 4.8 |\n| Other noncurrent assets | 78.3 | — | 78.3 | — | 78.3 |\n| Other noncurrent liabilities | ( 7.6 ) | — | ( 7.6 ) | — | ( 7.6 ) |\n| Interest rate contracts designated as cash flow hedges: |\n| Other noncurrent assets | 49.2 | — | 49.2 | — | 49.2 |\n| Other noncurrent liabilities | ( 31.7 ) | — | ( 31.7 ) | — | ( 31.7 ) |\n| Cross-currency interest rate contracts designated as net investment hedges: |\n| Other noncurrent assets | 31.3 | — | 31.3 | — | 31.3 |\n| Other current liabilities | ( 1.2 ) | — | ( 1.2 ) | — | ( 1.2 ) |\n| Cross-currency interest rate contracts designated as cash flow hedges: |\n| Other noncurrent assets | 33.2 | — | 33.2 | — | 33.2 |\n| Other noncurrent liabilities | ( 1.3 ) | — | ( 1.3 ) | — | ( 1.3 ) |\n| Foreign exchange contracts not designated as hedging instruments: |\n| Other receivables | 9.9 | — | 9.9 | — | 9.9 |\n| Other current liabilities | ( 35.3 ) | — | ( 35.3 ) | — | ( 35.3 ) |\n| Contingent consideration liabilities: |\n| Other noncurrent liabilities | ( 70.5 ) | — | — | ( 70.5 ) | ( 70.5 ) |\n\n26\nRisk-management instruments above are disclosed on a gross basis. There are various rights of setoff associated with certain of the risk-management instruments above that are subject to enforceable master netting arrangements or similar agreements. Although various rights of setoff and master netting arrangements or similar agreements may exist with the individual counterparties to the risk-management instruments above, individually, these financial rights are not material.\nWe determine our Level 1 and Level 2 fair value measurements based on a market approach using quoted market values, significant other observable inputs for identical or comparable assets or liabilities, or discounted cash flow analyses. Level 3 fair value measurements for other investment securities are determined using unobservable inputs, including the investments' cost adjusted for impairments and price changes from orderly transactions. Fair values are not readily available for certain equity investments measured under the measurement alternative.\nAs of September 30, 2022, we had approximately $ 854 million of unfunded commitments to invest in venture capital funds, which we anticipate will be paid over a period of up to 10 years.\nContingent consideration liability relates to our liability arising in connection with the CVR issued as a result of the Prevail acquisition. The fair value of the CVR liability was estimated using a discounted cash flow analysis and Level 3 inputs, including projections representative of a market participant's view of the expected cash payment associated with the first potential regulatory approval of a Prevail compound in the applicable countries based on probabilities of technical success, timing of the potential approval events for the compounds, and an estimated discount rate. See Note 3 for additional information related to the CVR arrangement.\nThe table below summarizes the contractual maturities of our investments in debt securities measured at fair value as of September 30, 2022:\n| Maturities by Period |\n| Total | Less Than1 Year | 1-5Years | 6-10Years | More Than10 Years |\n| Fair value of debt securities | $ | 622.2 | $ | 97.7 | $ | 197.8 | $ | 121.0 | $ | 205.7 |\n\nThe net gains (losses) recognized in our consolidated condensed statements of operations for equity securities were $( 123.3 ) million and $( 667.6 ) million for the three and nine months ended September 30, 2022, respectively, and $( 246.8 ) million and $ 270.1 million for the three and nine months ended September 30, 2021, respectively. The net gains (losses) recognized for the three and nine months ended September 30, 2022 and 2021 on equity securities sold during the respective periods were not material.\nWe adjust our equity investments without readily determinable fair values based upon changes in the equity instruments' values resulting from observable price changes in orderly transactions for an identical or similar investment of the same issuer. Downward adjustments resulting from an impairment are recorded based upon impairment considerations, including the financial condition and near term prospects of the issuer, general market conditions, and industry specific factors. Adjustments recorded for the three and nine months ended September 30, 2022 and 2021 were not material.\nA summary of the amount of unrealized gains and losses in accumulated other comprehensive loss and the fair value of available-for-sale securities in an unrealized gain or loss position follows:\n| September 30, 2022 | December 31, 2021 |\n| Unrealized gross gains | $ | 0.1 | $ | 9.7 |\n| Unrealized gross losses | 51.6 | 5.2 |\n| Fair value of securities in an unrealized gain position | 13.8 | 250.7 |\n| Fair value of securities in an unrealized loss position | 578.8 | 290.2 |\n\nWe periodically assess our investment in available-for-sale securities for impairment losses and credit losses. The amount of credit losses are determined by comparing the difference between the present value of future cash flows expected to be collected on these securities and the amortized cost. Factors considered in assessing credit losses include the position in the capital structure, vintage and amount of collateral, delinquency rates, current credit support, and geographic concentration. Impairment and credit losses related to available-for-sale securities were not material for the three and nine months ended September 30, 2022 and 2021.\n27\nAs of September 30, 2022, the available-for-sale securities in an unrealized loss position include primarily fixed-rate debt securities of varying maturities, which are sensitive to changes in the yield curve and other market conditions. Approximately 95 percent of the fixed-rate debt securities in a loss position are investment-grade debt securities. As of September 30, 2022, we do not intend to sell, and it is not more likely than not that we will be required to sell, the securities in a loss position before the market values recover or the underlying cash flows have been received, and there is no indication of a material default on interest or principal payments for our debt securities.\nActivity related to our available-for-sale securities was as follows:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Proceeds from sales | $ | 50.5 | $ | 49.6 | $ | 115.6 | $ | 137.3 |\n| Realized gross gains on sales | — | 0.4 | 0.2 | 2.2 |\n| Realized gross losses on sales | 7.5 | 0.3 | 9.0 | 1.1 |\n\nRealized gains and losses on sales of available-for-sale investments are computed based upon specific identification of the initial cost adjusted for any other-than-temporary declines in fair value that were recorded in earnings.\nAccounts Receivable Factoring Arrangements\nWe have entered into accounts receivable factoring agreements with financial institutions to sell certain of our non-U.S. accounts receivable. These transactions are accounted for as sales and result in a reduction in accounts receivable because the agreements transfer effective control over, and risk related to, the receivables to the buyers. Our factoring agreements do not allow for recourse in the event of uncollectibility, and we do not retain any interest in the underlying accounts receivable once sold. We derecognized $ 356.8 million and $ 550.5 million of accounts receivable as of September 30, 2022 and December 31, 2021, respectively, under these factoring arrangements. The costs of factoring such accounts receivable on our consolidated condensed results of operations for the three and nine months ended September 30, 2022 and 2021 were not material.\nNote 7: Income Taxes\nThe effective tax rates were 7.3 percent and 8.6 percent for the three and nine months ended September 30, 2022, respectively, reflecting the favorable tax impact of the implementation of a provision in the Tax Cuts and Jobs Act (2017 Tax Act) that requires capitalization and amortization of research and development expenses for tax purposes starting in 2022, net investment losses on equity securities, and an intangible asset impairment charge. We expect our effective tax rate to be approximately 13 percent to 14 percent for 2022 if the capitalization and amortization of research and development expenses provision of the 2017 Tax Act is deferred or repealed by the U.S. Congress effective for 2022.\nThe effective tax rate was 10.9 percent for the three months ended September 30, 2021, reflecting the favorable tax impact of a debt extinguishment loss and of net investment losses on equity securities, partially offset by a net discrete tax detriment. The effective tax rate was 10.7 percent for the nine months ended September 30, 2021, reflecting the favorable tax impact of a net discrete tax benefit, a debt extinguishment loss, and a net inventory impairment charge related to our COVID-19 antibodies.\nThe U.S. examination of tax years 2016-2018 began in the fourth quarter of 2019 and remains ongoing. The resolution of this audit period will likely extend beyond the next 12 months.\n28\nNote 8: Retirement Benefits\nNet pension and retiree health benefit (income) cost included the following components:\n| Defined Benefit Pension Plans |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Components of net periodic benefit cost: |\n| Service cost | $ | 87.1 | $ | 92.5 | $ | 264.4 | $ | 277.8 |\n| Interest cost | 98.9 | 84.5 | 299.0 | 253.6 |\n| Expected return on plan assets | ( 235.1 ) | ( 237.5 ) | ( 711.6 ) | ( 712.7 ) |\n| Amortization of prior service cost | 0.6 | 1.0 | 1.9 | 3.2 |\n| Recognized actuarial loss | 85.3 | 121.9 | 256.8 | 366.3 |\n| Net periodic benefit cost | $ | 36.8 | $ | 62.4 | $ | 110.5 | $ | 188.2 |\n\n| Retiree Health Benefit Plans |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Components of net periodic benefit income: |\n| Service cost | $ | 11.7 | $ | 12.4 | $ | 35.0 | $ | 37.0 |\n| Interest cost | 9.4 | 8.1 | 28.4 | 24.4 |\n| Expected return on plan assets | ( 38.0 ) | ( 36.5 ) | ( 114.1 ) | ( 109.6 ) |\n| Amortization of prior service benefit | ( 13.7 ) | ( 14.9 ) | ( 41.1 ) | ( 44.7 ) |\n| Recognized actuarial loss | 0.2 | 0.8 | 0.7 | 2.4 |\n| Net periodic benefit income | $ | ( 30.4 ) | $ | ( 30.1 ) | $ | ( 91.1 ) | $ | ( 90.5 ) |\n\nNote 9: Contingencies\nWe are involved in various lawsuits, claims, government investigations and other legal proceedings that arise in the ordinary course of business. These claims or proceedings can involve various types of parties, including governments, competitors, customers, suppliers, service providers, licensees, employees, or shareholders, among others. These matters may involve patent infringement, antitrust, securities, pricing, sales and marketing practices, environmental, commercial, contractual rights, licensing obligations, health and safety matters, consumer fraud, employment matters, product liability and insurance coverage, among others. The resolution of these matters often develops over a long period of time and expectations can change as a result of new findings, rulings, appeals or settlement arrangements. Legal proceedings that are significant or that we believe could become significant or material are described below.\nWe believe the legal proceedings in which we are named as defendants are without merit and we are defending against them vigorously. It is not possible to determine the final outcome of these matters, and we cannot reasonably estimate the maximum potential exposure or the range of possible loss in excess of amounts accrued for any of these matters; however, we believe that the resolution of all such matters will not have a material adverse effect on our consolidated financial position or liquidity, but could possibly be material to our consolidated results of operations in any one accounting period.\nLitigation accruals, environmental liabilities, and the related estimated insurance recoverables are reflected on a gross basis as liabilities and assets, respectively, on our consolidated condensed balance sheets. With respect to the product liability claims currently asserted against us, we have accrued for our estimated exposures to the extent they are both probable and reasonably estimable based on the information available to us. We accrue for certain product liability claims incurred but not filed to the extent we can formulate a reasonable estimate of their costs. We estimate these expenses based primarily on historical claims experience and data regarding product usage. Legal defense costs expected to be incurred in connection with significant product liability loss contingencies are accrued when both probable and reasonably estimable.\nBecause of the nature of pharmaceutical products, it is possible that we could become subject to large numbers of additional product liability and related claims in the future. Due to a very restrictive market for litigation liability insurance, we are self-insured for litigation liability losses for all our currently and previously marketed products.\n29\nPatent Litigation\nAlimta European Patent Litigation\nIn Europe, Alimta (pemetrexed) was protected by a patent through June 2021. A number of legal proceedings that were initiated prior to patent expiration are ongoing.\nEmgality Patent Litigation\nWe are a named defendant in litigation filed by Teva Pharmaceuticals International GMBH and Teva Pharmaceuticals USA, Inc. (collectively, Teva) in the U.S. District Court for the District of Massachusetts seeking a ruling that various claims in three different Teva patents would be infringed by our launch and continued sales of Emgality for the prevention of migraine in adults. Trial began in October 2022. In June 2021, we were named as a defendant in a second litigation filed by Teva in the U.S. District Court for the District of Massachusetts seeking a ruling that two of Teva's patents, which are directed toward use of the active ingredient in Emgality to treat migraine, would be infringed by our continued sales of Emgality. We challenged these two patents by filing requests for Inter Partes Review with the Patent Trial and Appeal Board (PTAB) and in October 2022, the PTAB granted our requests.The corresponding district court litigation is stayed while this PTAB proceeding is ongoing.\nJardiance Patent Litigation\nIn November 2018, Boehringer Ingelheim, our partner in marketing and development of Jardiance, initiated U.S. patent litigation in the U.S. District Court of Delaware alleging infringement arising from submissions of Abbreviated New Drug Applications (ANDA) by a number of generic companies seeking approval to market generic versions of Jardiance, Glyxambi, and Synjardy in accordance with the procedures set out in the Drug Price Competition and Patent Term Restoration Act of 1984 (the Hatch-Waxman Act). Particularly with respect to Jardiance, the generic companies' ANDAs seek approval to market generic versions of Jardiance prior to the expiration of the relevant patents, and allege that certain patents, including in some allegations the compound patent, are invalid or would not be infringed. We are not a party to this litigation. This litigation has been stayed.\nTaltz Patent Litigation\nIn April 2021, we petitioned the High Court of Ireland to declare invalid a patent that Novartis Pharma AG (Novartis) purchased from Genentech, Inc. in 2020. Novartis responded by filing a claim against us alleging patent infringement related to our commercialization of Taltz and seeking damages for past infringement and an injunction against future infringement.\nIn April 2021, Novartis petitioned the Court of Rome Intellectual Property Division for a preliminary injunction (PI) against us related to our commercialization of Taltz in Italy. In May 2021, We commenced patent revocation proceedings against Novartis before the Court of Milan’s IP Division where we also sought a declaration of non-infringement. Novartis counter-claimed for patent infringement and sought a permanent injunction. A hearing on the PI request before the Court of Rome Intellectual Property Division took place in May 2022 and in July 2022, the court rejected Novartis' request.\nIn November 2021, Novartis petitioned the Swiss Federal Patent Court for a PI and a permanent injunction in main infringement proceedings against us related to our commercialization of Taltz in Switzerland. We petitioned the court to revoke the patent and for a declaration of non-infringement. In April 2022, Novartis withdrew its PI request.\nIn January 2022, we commenced an action in the Hague District Court asking for a judgment that a Novartis Dutch patent is not infringed by our commercialization of Taltz in the Netherlands and is invalid. In October 2022, Novartis filed a counterclaim for infringement and sought a permanent injunction.\nIn October 2022, we entered into a settlement and mutual release agreement with Novartis, which resolves the above-described disputes. Without any admission of liability or wrongdoing, we and Novartis have agreed to mutual releases for past claims and mutual covenants not to sue the other in relation to Taltz and the patents Novartis purchased from Genentech.\n30\nZyprexa Canada Patent Litigation\nBeginning in the mid-2000s, several generic companies in Canada challenged the validity of our Zyprexa compound patent. In 2012, the Canadian Federal Court of Appeals denied our appeal of a lower court's decision that certain patent claims were invalid for lack of utility. In 2013, Apotex Inc. and Apotex Pharmachem Inc. (collectively, Apotex) brought claims against us in the Ontario Superior Court of Justice at Toronto for damages related to our enforcement of the Zyprexa compound patent under Canadian regulations governing patented drugs. Apotex seeks compensation based on novel legal theories under the Statute of Monopolies, Trademark Act, and common law. In March 2021, the Ontario Superior Court granted our motion for summary judgment, thereby dismissing Apotex's case. Apotex appealed that ruling to the Court of Appeal for Ontario in April 2021. In August 2022, the Court dismissed the appeal and in October 2022, Apotex appealed the decision. This matter is ongoing.\nProduct Liability Litigation\nByetta® Product Liability\nWe have been named as a defendant in over 500 Byetta product liability lawsuits in the U.S. that were first initiated in March 2009 and involved over 800 plaintiffs. These lawsuits have been filed in various state and federal jurisdictions, including California state court (coordinated in Los Angeles County Superior Court), and various federal courts, the majority of which are coordinated in a multi-district litigation (MDL) in the U.S. District Court for the Southern District of California. The majority of these suits contain allegations that Byetta caused or contributed to the plaintiffs' cancer (primarily pancreatic cancer or thyroid cancer). The federal MDL and coordinated California state trial courts granted summary judgment in our favor on claims pertaining to pancreatic cancer, and the plaintiffs have dismissed Lilly from their appeal of the MDL ruling (the parties still await the order of judgment in the Los Angeles County Superior Court). Most of the MDL and state court lawsuits have been dismissed as of November 2022.\nEnvironmental Proceedings\nUnder the Comprehensive Environmental Response, Compensation, and Liability Act, commonly known as \"Superfund,\" we have been designated as one of several potentially responsible parties with respect to the cleanup of fewer than 10 sites. Under Superfund, each responsible party may be jointly and severally liable for the entire amount of the cleanup.\nOther Matters\n340B Litigation and Investigations\nWe are the plaintiff in a lawsuit filed in January 2021 in the U.S. District Court for the Southern District of Indiana against the U.S. Department of Health and Human Services (HHS), the Secretary of HHS, the Health Resources and Services Administration (HRSA), and the Administrator of HRSA. The lawsuit challenges the HHS's December 30, 2020 advisory opinion stating that drug manufacturers are required to deliver discounts under the 340B program to all contract pharmacies. We seek a declaratory judgment that the defendants violated the Administrative Procedures Act and the U.S. Constitution, a preliminary injunction enjoining implementation of the administrative dispute resolution process created by defendants and, with it, their application of the advisory opinion, and other related relief. In March 2021, the court entered an order preliminarily enjoining the government's enforcement of the administrative dispute resolution process against us. In May 2021, HRSA notified us that it determined that our policy was contrary to the 340B statute. In response, in May 2021, we filed a motion for preliminary injunction and temporary restraining order requesting that the U.S. District Court for the Southern District of Indiana enjoin defendants from taking any action against us relating to the 340B drug pricing program until after the court issues a final judgment on the aforementioned litigation. In May 2021, the court denied our motion for a temporary restraining order but deferred resolution of our motion for preliminary injunction. In June 2021, the defendants withdrew the HHS December 30, 2020 advisory opinion. In July 2021, the court held oral argument on the parties' cross motions for summary judgment, the defendants' motion to dismiss, and our motion for preliminary injunction related to HRSA's May 2021 enforcement letter. In October 2021, the court denied the defendants' motion to dismiss, and granted in part and denied in part the parties' cross motions for summary judgment. Both parties filed notices of appeal related to the court's summary judgment order. Oral argument took place in October 2022 in the U.S. Court of Appeals for the Seventh Circuit. This matter is ongoing.\nIn January 2021, we, along with other pharmaceutical manufacturers, were named as a defendant in a petition currently pending before the HHS Administrative Dispute Resolution Panel. Petitioner seeks declaratory and other injunctive relief related to the 340B program. As described above, the U.S. District Court for the Southern District of Indiana has entered a preliminary injunction enjoining the government's enforcement of this administrative dispute resolution process against us.\n31\nIn July 2021, we, along with Sanofi-Aventis U.S., LLC (Sanofi), Novo Nordisk Inc. (Novo Nordisk), and AstraZeneca Pharmaceuticals LP, were named as a defendant in a purported class action lawsuit filed in the U.S. District Court for the Western District of New York by Mosaic Health, Inc. alleging antitrust and unjust enrichment claims related to the defendants' 340B distribution programs. We, with Sanofi and Novo Nordisk, filed a motion to dismiss the lawsuit, which was granted in September 2022. In October 2022, the plaintiffs filed a motion for leave to amend their complaint. This matter is ongoing.\nWe received a civil investigative subpoena in February 2021 from the Office of the Attorney General for the State of Vermont relating to the sale of pharmaceutical products to Vermont covered entities under the 340B program. We are cooperating with this subpoena.\nBranchburg Manufacturing Facility\nIn May 2021, we received a subpoena from the U.S. Department of Justice requesting the production of certain documents relating to our manufacturing site in Branchburg, New Jersey. We are cooperating with the subpoena.\nBrazil Litigation – Cosmopolis Facility\nLabor Attorney Litigation\nFirst initiated in 2008, our subsidiary in Brazil, Eli Lilly do Brasil Limitada (Lilly Brasil), is named in a Public Civil Action brought by the Labor Public Attorney (LPA) for the 15th Region in the Labor Court of Paulinia, State of Sao Paulo, Brazil, (the Labor Court) alleging possible harm to employees and former employees caused by alleged exposure to soil and groundwater contaminants at a former Lilly Brasil manufacturing facility in Cosmopolis, Brazil, operated by the company between 1977 and 2003. In May 2014, the Labor Court judge ruled against Lilly Brasil, ordering it to undertake several remedial and compensatory actions including health coverage for a class of individuals and certain of their children. In July 2018, the appeals court (TRT) generally affirmed our appeal of the Labor Court's ruling, which included a liquidated award of 300 million Brazilian real, which, when adjusted for inflation and the addition of pre and post judgment interest using the current Central Bank of Brazil's special system of clearance and custody rate, is approximately one billion Brazilian real (approximately $ 185 million as of September 30, 2022). In August 2019, Lilly Brasil filed an appeal to the superior labor court (TST) and in June 2021, the TRT published its decision on the admissibility of Lilly Brasil's appeal, allowing the majority of the elements, which were allowed to proceed in June 2021; elements not proceeding are subject to an interlocutory appeal to the TST that was filed in June 2021. In September 2019, the TRT stayed a number of elements of its trial court decision pending the determination of Lilly Brasil's appeal to the TST.\nIn June 2019 and September 2020, the LPA filed applications in the Labor Court for enforcement of certain remedies granted by the TRT in its July 2018 decision, requested restrictions on Lilly Brasil’s assets in Brazil, and required Lilly Brasil and Antibióticos do Brasil Ltda. (ABL) to submit a list of potential beneficiaries of the Public Civil Action. In July 2019, the Labor Court issued a ruling requiring a freeze of Lilly Brasil’s immovable property or, alternatively, a security deposit or lien of 500 million Brazilian real, which ruling was subsequently limited in scope and the security was reduced to 100 million Brazilian real. ABL and LPA appealed the June 2021 Labor Court ruling to the TST, which appeal is under review. The Labor Court is currently assessing the status of Lilly Brasil’s and ABL’s compliance with such portion of the July 2018 TRT decision and an inspection in the industrial plant is expected. These matters are ongoing.\nIndividual Former Employee Litigation\nLilly Brasil is also named in over 20 pending lawsuits filed in the Labor Court by individual former employees making similar claims. These individual lawsuits are at various stages in the litigation process.\nPuerto Rico Tax Matter\nIn May 2013, the Municipality of Carolina in Puerto Rico (Municipality) filed a lawsuit against us alleging noncompliance with respect to a contract with the Municipality and seeking a declaratory judgment. In December 2020, the Puerto Rico Appellate Court (AP) reversed the summary judgment previously granted by the Court of First Instance (CFI) in our favor, dismissing the Municipality's complaint in its entirety. The AP remanded the case to the CFI for trial on the merits. The trial began in May 2022; however, the Municipality filed a new motion requesting the CFI to award damages. The request was denied by the CFI in our favor and the Municipality filed for revision at the AP, which we opposed, staying the case. This matter is ongoing.\n32\nEastern District of Pennsylvania Pricing (Average Manufacturer Price) Inquiry\nIn November 2014, we, along with another pharmaceutical manufacturer, were named as co-defendants in United States et al. ex rel. Streck v. Takeda Pharm. Am., Inc., et al., which was filed in November 2014 and unsealed in the U.S. District Court for the Northern District of Illinois. The complaint alleges that the defendants should have treated certain credits from distributors as retroactive price increases and included such increases in calculating average manufacturer prices. Following a trial in August 2022, the jury returned a verdict in favor of the plaintiff. The case is proceeding with post-trial motions after which the court will enter final judgment in the case. This matter is ongoing.\nHealth Choice Alliance\nWe are named as a defendant in two lawsuits filed in Texas and New Jersey state courts in October 2019 seeking damages under the Texas Medicaid Fraud Prevention Act and New Jersey Medicaid False Claims Act, respectively, for certain patient support programs related to our products Humalog, Humulin, and Forteo. The Texas state court action has been stayed. The New Jersey state court action was dismissed with prejudice pending an ongoing appeal before the Appellate Division of the New Jersey Superior Court. This matter is ongoing.\nPricing Litigation\nIn December 2017 and February 2018, we, along with Sanofi and Novo Nordisk, were named as defendants in a consolidated purported class action lawsuit, In re. Insulin Pricing Litigation and in MSP Recovery Claims, Series, LLC et al. v. Sanofi Aventis U.S. LLC et al., both filed in the U.S. District Court for the District of New Jersey. The cases relate to insulin pricing and seek damages or other relief under various theories, including state consumer protection laws, common law fraud, unjust enrichment, and the Federal Racketeer Influenced and Corrupt Organization Act (federal RICO Act). In both cases, the court dismissed claims under the federal RICO Act and certain state laws. In April 2021, the plaintiffs in In re. Insulin Pricing Litigation amended their complaint to allege additional state law claims for civil conspiracy and violations of state RICO statutes. The court allowed the Arizona RICO statute and certain state civil conspiracy law claims to proceed. Additionally in 2020, we, along with Sanofi, Novo Nordisk, CVS, Express Scripts, and Optum, have been sued in a putative class action, FWK Holdings, LLC v. Novo Nordisk Inc., et al., filed in the same court, for alleged violations of the federal RICO Act as well as the New Jersey RICO Act and antitrust law. The same group of defendants, along with Medco Health and United Health Group, also have been sued in other purported class actions in the same court, Rochester Drug Co-Operative Inc. v. Eli Lilly & Co. et al. and Value Drug Co. v. Eli Lilly & Co. et al., which were both initiated in March 2020, with the plaintiffs seeking damages for alleged violations of the federal RICO Act. In September 2020, the U.S. District Court for the District of New Jersey granted plaintiffs' motion to consolidate FWK Holdings, LLC v. Novo Nordisk Inc., et al., Rochester Drug Co-Operative Inc. v. Eli Lilly & Co. et al., and Value Drug Co. v. Eli Lilly & Co. et al. In July 2021, the U.S. District Court for the District of New Jersey dismissed the three antitrust claims alleged by plaintiffs in the consolidated litigation and denied dismissal of the federal RICO Act claims.\nIn October 2018, the Minnesota Attorney General's Office initiated litigation against us, Sanofi, and Novo Nordisk, State of Minnesota v. Sanofi-Aventis U.S. LLC et al., in the U.S. District Court for the District of New Jersey, seeking damages for unjust enrichment, violations of various Minnesota state consumer protection laws, and the federal RICO Act. In March 2021, the U.S. District Court for the District of New Jersey dismissed with prejudice the Minnesota Attorney General's federal RICO claims and false advertising claims under state law; the consumer fraud and other related state law claims remain ongoing. Additionally, in May 2019, the Kentucky Attorney General's Office filed a complaint against us, Sanofi, and Novo Nordisk, Commonwealth of Kentucky v. Novo Nordisk, Inc. et al., in Kentucky state court, alleging violations of the Kentucky consumer protection law, false advertising, and unjust enrichment.\nIn June 2021, the Mississippi Attorney General's Office initiated litigation against us, Sanofi, Novo Nordisk, Evernorth/ESI, CVS/Caremark, and United/Optum in the Hinds County, Mississippi Chancery Court, alleging state law consumer protection, unjust enrichment, and civil conspiracy claims. After the case was removed to federal court, we, along with the other defendants, filed a motion to dismiss the lawsuit, which was denied. This matter is ongoing.\nIn May 2022, the state of Arkansas filed suit against us Sanofi, Novo Nordisk, ESI, CVS/Caremark/Aetna, and Optum, asserting state law consumer protection, civil conspiracy, and unjust enrichment claims. The case has been removed to federal court and is ongoing.\nIn September 2022, the County of Albany, New York filed a suit against us, Sanofi, Novo Nordisk, Evernorth/ESI, CVS/Caremark and United/Optum asserting violations of federal RICO statute and state law claims for deceptive trade practices, unjust enrichment, and civil conspiracy. This matter is ongoing.\n33\nIn September 2022, the State of Montana filed a suit against us, Sanofi, Novo Nordisk, Evernorth/ESI, Medco Health Solutions, CVS/Caremark and Optum asserting violations of the Montana Unfair Practices and Consumer Protection Act, unjust enrichment, and civil conspiracy. This matter is ongoing.\nInvestigations, Subpoenas, and Inquiries\nIn connection with the pricing and sale of our insulin and other products, we have been subject to various investigations and received subpoenas, civil investigative demand requests, information requests, interrogatories, and other inquiries from various governmental entities. These include subpoenas from the New York and Vermont Attorney General Offices, civil investigative demands from the Washington, New Mexico, Colorado, Illinois, Ohio Attorney General Offices, the Department of Justice and the Federal Trade Commission, as well as information requests from the Mississippi, Washington D.C., California, Florida, Hawaii, and Nevada Attorney General Offices. In January 2022, the Michigan Attorney General filed a petition in Michigan state court seeking authorization to investigate Lilly for potential violations of the Michigan Consumer Protection Act (MCPA), and a complaint seeking a declaratory judgment that the Attorney General has authority to investigate Lilly's sale of insulin under the MCPA. The court authorized the proposed investigation and the issuance of civil investigative subpoenas. In April 2022, the parties entered into a stipulation providing that the State will not issue any civil investigative subpoena to us under the MCPA until the declaratory judgment action is resolved. In July 2022, the court dismissed the case in its entirety. The Michigan Attorney General filed a notice of appeal and an application to obtain review by the Michigan Supreme Court, which remain pending.\nWe received a request in January 2019 from the House of Representatives' Committee on Oversight and Reform seeking commercial information and business records related to the pricing of insulin products, among other issues. We also received similar requests from the Senate Finance Committee and the Senate Committee on Health, Education, Labor, and Pensions, and separate requests from the House Committee on Energy and Commerce majority and minority members. In January 2021, the Senate Finance Committee released a report summarizing the findings of its investigation. In December 2021 the House of Representatives' Committee on Oversight and Reform majority and minority staffs released separate reports with findings from their investigations into drug pricing, including of insulin products.\nWe are cooperating with all of the aforementioned investigations, subpoenas, and inquiries.\nResearch Corporation Technologies, Inc.\nIn April 2016, we were named as a defendant in litigation filed by Research Corporation Technologies, Inc. (RCT) in the U.S. District Court for the District of Arizona. RCT is seeking damages for breach of contract, unjust enrichment, and conversion related to processes used to manufacture certain products, including Humalog and Humulin. In October 2021, the court issued a summary judgment decision finding in favor of RCT on certain issues, including with respect to a disputed royalty. Both parties filed motions for reconsideration, which were denied. We filed supplemental summary judgment motions. A trial date has not been set. Potential damages payable under the litigation, if finally awarded after an appeal, could be material but are not currently reasonably estimable. This matter is ongoing.\n34\nNote 10: Other Comprehensive Income (Loss)\nThe following tables summarize the activity related to each component of other comprehensive income (loss) during the three months ended September 30, 2022 and 2021:\n| (Amounts presented net of taxes) | Foreign Currency Translation Gains (Losses) | Unrealized Net Gains (Losses) on Securities | Defined Benefit Pension and Retiree Health Benefit Plans | Effective Portion of Cash Flow Hedges | Accumulated Other Comprehensive Loss |\n| Balance at July 1, 2022 | $ | ( 1,844.2 ) | $ | ( 27.9 ) | $ | ( 2,443.2 ) | $ | 27.6 | $ | ( 4,287.7 ) |\n| Other comprehensive income (loss) before reclassifications | ( 165.1 ) | ( 24.9 ) | 47.8 | 63.0 | ( 79.2 ) |\n| Net amount reclassified from accumulated other comprehensive loss | — | 13.5 | 57.2 | 0.4 | 71.1 |\n| Net other comprehensive income (loss) | ( 165.1 ) | ( 11.4 ) | 105.0 | 63.4 | ( 8.1 ) |\n| Balance at September 30, 2022 | $ | ( 2,009.3 ) | $ | ( 39.3 ) | $ | ( 2,338.2 ) | $ | 91.0 | $ | ( 4,295.8 ) |\n\n| (Amounts presented net of taxes) | Foreign Currency Translation Gains (Losses) | Unrealized Net Gains (Losses) on Securities | Defined Benefit Pension and Retiree Health Benefit Plans | Effective Portion of Cash Flow Hedges | Accumulated Other Comprehensive Loss |\n| Balance at July 1, 2021 | $ | ( 1,516.2 ) | $ | 9.1 | $ | ( 4,569.9 ) | $ | ( 210.1 ) | $ | ( 6,287.1 ) |\n| Other comprehensive income (loss) before reclassifications | ( 8.0 ) | ( 2.4 ) | 18.6 | 16.8 | 25.0 |\n| Net amount reclassified from accumulated other comprehensive loss | — | 0.1 | 86.0 | 3.3 | 89.4 |\n| Net other comprehensive income (loss) | ( 8.0 ) | ( 2.3 ) | 104.6 | 20.1 | 114.4 |\n| Balance at September 30, 2021 | $ | ( 1,524.2 ) | $ | 6.8 | $ | ( 4,465.3 ) | $ | ( 190.0 ) | $ | ( 6,172.7 ) |\n\nThe following tables summarize the activity related to each component of other comprehensive income (loss) during the nine months ended September 30, 2022 and 2021:\n| (Amounts presented net of taxes) | Foreign Currency Translation Gains (Losses) | Unrealized Net Gains (Losses) on Securities | Defined Benefit Pension and Retiree Health Benefit Plans | Effective Portion of Cash Flow Hedges | Accumulated Other Comprehensive Loss |\n| Balance at January 1, 2022 | $ | ( 1,550.2 ) | $ | 3.7 | $ | ( 2,583.6 ) | $ | ( 213.0 ) | $ | ( 4,343.1 ) |\n| Other comprehensive income (loss) before reclassifications | ( 459.7 ) | ( 55.5 ) | 72.9 | 297.2 | ( 145.1 ) |\n| Net amount reclassified from accumulated other comprehensive loss | 0.6 | 12.5 | 172.5 | 6.8 | 192.4 |\n| Net other comprehensive income (loss) | ( 459.1 ) | ( 43.0 ) | 245.4 | 304.0 | 47.3 |\n| Balance at September 30, 2022 | $ | ( 2,009.3 ) | $ | ( 39.3 ) | $ | ( 2,338.2 ) | $ | 91.0 | $ | ( 4,295.8 ) |\n\n| (Amounts presented net of taxes) | Foreign Currency Translation Gains (Losses) | Unrealized Net Gains (Losses) on Securities | Defined Benefit Pension and Retiree Health Benefit Plans | Effective Portion of Cash Flow Hedges | Accumulated Other Comprehensive Loss |\n| Balance at January 1, 2021 | $ | ( 1,427.5 ) | $ | 14.8 | $ | ( 4,751.0 ) | $ | ( 332.7 ) | $ | ( 6,496.4 ) |\n| Other comprehensive income (loss) before reclassifications | ( 96.7 ) | ( 8.8 ) | 27.2 | 132.8 | 54.5 |\n| Net amount reclassified from accumulated other comprehensive loss | — | 0.8 | 258.5 | 9.9 | 269.2 |\n| Net other comprehensive income (loss) | ( 96.7 ) | ( 8.0 ) | 285.7 | 142.7 | 323.7 |\n| Balance at September 30, 2021 | $ | ( 1,524.2 ) | $ | 6.8 | $ | ( 4,465.3 ) | $ | ( 190.0 ) | $ | ( 6,172.7 ) |\n\n35\nThe tax effects on the net activity related to each component of other comprehensive income (loss) were as follows:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| Tax benefit (expense) | 2022 | 2021 | 2022 | 2021 |\n| Foreign currency translation gains/losses | $ | ( 133.3 ) | $ | ( 39.0 ) | $ | ( 234.2 ) | $ | ( 92.3 ) |\n| Unrealized net gains/losses on securities | 3.4 | 0.8 | 13.1 | 3.8 |\n| Defined benefit pension and retiree health benefit plans | ( 22.4 ) | ( 28.2 ) | ( 73.2 ) | ( 79.7 ) |\n| Effective portion of cash flow hedges | ( 16.9 ) | ( 5.4 ) | ( 80.8 ) | ( 37.9 ) |\n| Benefit (expense) for income taxes allocated to other comprehensive income (loss) items | $ | ( 169.2 ) | $ | ( 71.8 ) | $ | ( 375.1 ) | $ | ( 206.1 ) |\n\nExcept for the tax effects of foreign currency translation gains and losses related to our foreign currency-denominated notes, cross-currency interest rate swaps, and other foreign currency exchange contracts designated as net investment hedges (see Note 6), income taxes were not provided for foreign currency translation. Generally, the assets and liabilities of foreign operations are translated into U.S. dollars using the current exchange rate. For those operations, changes in exchange rates generally do not affect cash flows; therefore, resulting translation adjustments are made in shareholders' equity rather than in the consolidated condensed statements of operations.\nReclassifications out of accumulated other comprehensive loss were as follows:\n| Details about Accumulated Other Comprehensive Loss Components | Three Months Ended September 30, | Nine Months Ended September 30, | Affected Line Item in the Consolidated Condensed Statements of Operations |\n| 2022 | 2021 | 2022 | 2021 |\n| Amortization of retirement benefit items: |\n| Prior service benefits, net | $ | ( 13.1 ) | $ | ( 13.9 ) | $ | ( 39.2 ) | $ | ( 41.5 ) | Other–net, (income) expense |\n| Actuarial losses, net | 85.5 | 122.7 | 257.5 | 368.7 | Other–net, (income) expense |\n| Total before tax | 72.4 | 108.8 | 218.3 | 327.2 |\n| Tax benefit | ( 15.2 ) | ( 22.8 ) | ( 45.8 ) | ( 68.7 ) | Income taxes |\n| Net of tax | 57.2 | 86.0 | 172.5 | 258.5 |\n| Other, net of tax | 13.9 | 3.4 | 19.9 | 10.7 | Other–net, (income) expense |\n| Total reclassifications, net of tax | $ | 71.1 | $ | 89.4 | $ | 192.4 | $ | 269.2 |\n\nNote 11: Other–Net, (Income) Expense\nOther–net, (income) expense consisted of the following:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Interest expense | $ | 81.5 | $ | 83.6 | $ | 247.6 | $ | 258.4 |\n| Interest income | ( 20.1 ) | ( 7.0 ) | ( 37.3 ) | ( 18.0 ) |\n| Net investment (gains) losses on equity securities (Note 6) | 123.3 | 246.8 | 667.6 | ( 270.1 ) |\n| Retirement benefit plans | ( 92.4 ) | ( 72.6 ) | ( 280.0 ) | ( 217.1 ) |\n| Debt extinguishment loss (Note 6) | — | 405.2 | — | 405.2 |\n| Other (income) expense | 18.7 | ( 20.1 ) | ( 17.0 ) | ( 34.1 ) |\n| Other–net, (income) expense | $ | 111.0 | $ | 635.9 | $ | 580.9 | $ | 124.3 |\n\n36\nItem 2. Management's Discussion and Analysis of Results of Operations and Financial Condition\nResults of Operations\n(Tables present dollars in millions, except per-share data)\nGeneral\nManagement's discussion and analysis of results of operations and financial condition is intended to assist the reader in understanding and assessing significant changes and trends related to the results of operations and financial position of our consolidated company. This discussion and analysis should be read in conjunction with the consolidated condensed financial statements and accompanying footnotes in Part I, Item 1 of this Quarterly Report on Form 10-Q. Certain statements in this Part I, Item 2 of this Quarterly Report on Form 10-Q constitute forward-looking statements. Various risks and uncertainties, including those discussed in \"Forward-Looking Statements\" in this Quarterly Report on Form 10-Q and \"Risk Factors\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2021, may cause our actual results, financial position, and cash generated from operations to differ materially from these forward-looking statements.\nExecutive Overview\nThis section provides an overview of our financial results, recent product and late-stage pipeline developments, and other matters affecting our company and the pharmaceutical industry. Earnings per share (EPS) data are presented on a diluted basis.\nCOVID-19 Pandemic\nIn response to the COVID-19 pandemic, we have focused on maintaining a supply of our medicines; reducing the strain on the medical system; developing treatments for COVID-19; protecting the health, safety, and well-being of our employees; supporting our communities; and ensuring affordability of and access to our medicines, particularly insulin.\nWe have received various regulatory authorizations, including Emergency Use Authorizations (EUA), for our COVID-19 therapies. We supplied the United States (U.S.) government approximately 810,000 doses of bebtelovimab during the nine months ended September 30, 2022. Beginning in the third quarter of 2022 and in collaboration with the U.S. government, we have made bebtelovimab commercially available for purchase by U.S. states/territories, hospitals, and certain other providers. We do not anticipate any further U.S. government orders. The U.S. Food and Drug Administration (FDA) has revised, and may in the future revise, any EUA for our COVID-19 therapies in response to the prevalence of variants against which our therapies have varying degrees of efficacy, including the new BQ variants. Based on early data, we do not believe that bebtelovimab will neutralize against the new BQ variants.\nThe COVID-19 pandemic has, and may continue to, adversely impact our business and operations. Strain on global transportation, logistics, manufacturing, and labor markets, including as aggravated by the pandemic and global unrest, the focus of resources on COVID-19, protective measures implemented to control the spread of COVID-19, and an increase in overall demand in our industry for certain resources and medicines, resulting in changed buying patterns, increased costs, and constrained supply, have negatively impacted and may continue to negatively impact the development, manufacturing, supply, distribution, and sales of our medicines.\nThe degree to which the COVID-19 pandemic and related challenges impact the development, manufacturing, supply, distribution, and sale of our medicines will depend on developments that are highly uncertain and beyond our knowledge or control.\n37\nProduct Supply\nContinued strong demand for Trulicity® in U.S. and international markets, partially due to the ongoing limited availability of competitor therapies, has challenged, and is expected to continue to challenge, our ability to meet demand in most international markets. In the U.S., as demand for Trulicity has continued to exceed historical levels, we anticipate tight supplies will persist until additional manufacturing capacity is operationalized, and U.S. wholesalers may experience intermittent restocking delays of Trulicity orders. Outside the U.S., we have implemented certain actions to minimize the impact to existing patients, but we expect to experience intermittent disruptions in our supply of Trulicity in international markets.\nIn addition, the uptake of Mounjaro® for type 2 diabetes following its launch in the U.S. has been very strong. We continue to carefully monitor demand, incretin competitor availability, and supply with a focus on access for Type 2 diabetes patients.\nWe anticipate that additional internal and contracted manufacturing capacity will become fully operational around the world in the next several years, with significant expansion in 2023, as part of our ongoing efforts to meet the significant demand for our incretin medicines.\nSee \"Risk Factors\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2021 for additional information on risk factors that could impact our business and operations.\nFinancial Results\nThe following table summarizes our key operating results:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | Percent Change | 2022 | 2021 | Percent Change |\n| Revenue | $ | 6,941.6 | $ | 6,772.8 | 2 | $ | 21,239.6 | $ | 20,318.5 | 5 |\n| Gross margin | 5,362.5 | 5,342.0 | — | 16,157.9 | 15,055.9 | 7 |\n| Gross margin as a percent of revenue | 77.3 | % | 78.9 | % | 76.1 | % | 74.1 | % |\n| Research and development | $ | 1,802.9 | $ | 1,705.3 | 6 | $ | 5,194.9 | $ | 5,032.4 | 3 |\n| Marketing, selling, and administrative | 1,614.2 | 1,577.9 | 2 | 4,797.2 | 4,839.6 | (1) |\n| Acquired in-process research and development (IPR&D) and development milestones | 62.4 | 177.6 | (65) | 668.4 | 532.4 | 26 |\n| Asset impairment, restructuring, and other special charges | 206.5 | — | NM | 206.5 | 211.6 | (2) |\n| Other–net, (income) expense | 111.0 | 635.9 | (83) | 580.9 | 124.3 | NM |\n| Net income | 1,451.7 | 1,110.1 | 31 | 4,307.1 | 3,855.6 | 12 |\n| EPS - diluted | 1.61 | 1.22 | 32 | 4.76 | 4.23 | 13 |\n\nNM - not meaningful\nRevenue increased for the three and nine months ended September 30, 2022, driven by increased volume, partially offset by lower realized prices and the unfavorable impact of foreign exchange rates. Research and development expenses increased for the three and nine months ended September 30, 2022, primarily driven by higher development expenses for late-stage assets, partially offset by lower development expenses for COVID-19 antibodies and the favorable impact of foreign exchange rates. Marketing, selling, and administrative expenses increased for the three months ended September 30, 2022, primarily driven by increased costs associated with the launch of Mounjaro, partially offset by the favorable impact of foreign exchange rates. Marketing, selling, and administrative expenses decreased for the nine months ended September 30, 2022, primarily driven by the favorable impact of foreign exchange rates as well as reduced marketing costs in the first half of 2022, partially offset by increased costs associated with the launch of Mounjaro.\n38\nThe following highlighted items also affect comparisons of our financial results for the three and nine months ended September 30, 2022 and 2021:\n2022\nAcquired IPR&D and Development Milestones (See Note 3 to the consolidated condensed financial statements)\n•We recognized $62.4 million and $668.4 million of acquired IPR&D and development milestones for the three and nine months ended September 30, 2022, respectively. The charges for the nine months ended September 30, 2022 included the buy-out of substantially all future obligations that were contingent upon the occurrence of certain events linked to the success of our mutant-selective PI3kα inhibitor and a purchase of a Priority Review Voucher.\nAsset Impairment, Restructuring, and Other Special Charges (See Note 5 to the consolidated condensed financial statements)\n•We recognized charges of $206.5 million for the three and nine months ended September 30, 2022, primarily related to an intangible asset impairment for GBA1 Gene Therapy (PR001) due to changes in estimated launch timing.\nOther-Net, (Income) Expense (See Note 11 to the consolidated condensed financial statements)\n•We recognized $123.3 million and $667.6 million of net investment losses on equity securities for the three and nine months ended September 30, 2022, respectively.\n2021\nCost of Sales (See Note 5 to the consolidated condensed financial statements)\n•We recognized a net inventory impairment charge related to our COVID-19 antibodies of $435.1 million for the nine months ended September 30, 2021. As part of our response to the COVID-19 pandemic, and at the request of the U.S. and international governments, we invested in large-scale manufacturing of COVID-19 antibodies at risk, in order to ensure rapid access to patients around the world. As the COVID-19 pandemic evolved during 2021, we incurred a net inventory impairment charge primarily due to the combination of changes to demand from U.S. and international governments, including changes to our agreement with the U.S. government, and near-term expiry dates of COVID-19 antibodies.\nAcquired IPR&D and Development Milestones (See Note 3 to the consolidated condensed financial statements)\n•We recognized $177.6 million and $532.4 million of acquired IPR&D and development milestones for the three and nine months ended September 30, 2021, respectively. The charges for the nine months ended September 30, 2021 included acquired IPR&D charges resulting from business development transactions with Rigel Pharmaceuticals, Inc. (Rigel) and Precision Biosciences, Inc. (Precision).\nAsset Impairment, Restructuring, and Other Special Charges (See Note 5 to the consolidated condensed financial statements)\n•We recognized charges of $211.6 million for the nine months ended September 30, 2021, primarily related to an intangible asset impairment resulting from the sale of the rights to Qbrexza®, as well as acquisition and integration costs associated with the acquisition of Prevail Therapeutics Inc. (Prevail).\nOther-Net, (Income) Expense (See Note 11 to the consolidated condensed financial statements)\n•We recognized a debt extinguishment loss of $405.2 million related to the repurchase of debt for the three and nine months ended September 30, 2021.\n•We recognized $246.8 million of net investment losses on equity securities for the three months ended September 30, 2021. We recognized $270.1 million of net investment gains on equity securities for the nine months ended September 30, 2021.\n39\nLate-Stage Pipeline\nOur long-term success depends on our ability to continually discover or acquire, develop, and commercialize innovative new medicines. We currently have approximately 45 new medicine candidates in clinical development or under regulatory review, and a larger number of projects in the discovery phase.\nThe following certain new molecular entities (NMEs) are currently in Phase II or Phase III clinical trials or have been submitted for regulatory review or have received regulatory approval in the U.S., Europe, or Japan. The following table reflects the status of these NMEs, including certain other developments since our Annual Report on Form 10-K for the year ended December 31, 2021.\n| Compound | Indication | Status | Developments |\n| Diabetes |\n| Tirzepatide (Mounjaro) | Type 2 diabetes | Approved | Approved in the U.S. in the second quarter of 2022 and in Europe and Japan in the third quarter of 2022. |\n| Heart failure with preserved ejection fraction | Phase III | Phase III trials are ongoing. |\n| Obesity | Phase III | Granted FDA Fast Track designation(1) in October 2022. Announced in the second quarter of 2022 that the initial Phase III trial met co-primary and all key secondary endpoints. Phase III trials are ongoing. |\n| Obstructive sleep apnea | Phase III | Phase III trial initiated in the third quarter of 2022. |\n| Nonalcoholic steatohepatitis | Phase II | Phase II trial is ongoing. |\n| Basal Insulin-Fc | Type 1 and 2 diabetes | Phase III | Phase III trials initiated in the first, second, and third quarters of 2022. |\n| Orforglipron (GLP-1R NPA) | Obesity | Phase II | Phase II trials are ongoing. |\n| Type 2 diabetes |\n| Retatrutide (GGG Tri-Agonist) | Obesity | Phase II | Phase II trials are ongoing. |\n| Type 2 diabetes |\n| Immunology |\n| Lebrikizumab(2) | Atopic dermatitis | Submitted | Granted FDA Fast Track designation(1). Submitted in the U.S. in the third quarter of 2022 and in Europe in October 2022. Phase III trials are ongoing. |\n| Mirikizumab | Ulcerative colitis | Submitted | Submitted in the U.S. in first quarter of 2022 and in Europe and Japan in the second quarter of 2022. |\n| Crohn's Disease | Phase III | Phase III trials are ongoing. |\n| ANGPTL3 siRNA | Cardiovascular disease | Phase II | Phase II trial initiated in the third quarter of 2022. |\n| BTLA MAB Agonist | Systemic lupus erythematosus | Phase II | Phase II trial initiated in the second quarter of 2022. |\n| CXCR1/2 Ligands Monoclonal Antibody | Hidradenitis suppurativa | Phase II | Phase II trial is ongoing. |\n| Peresolimab (PD-1 MAB Agonist) | Rheumatoid arthritis | Phase II | Phase II trial is ongoing. |\n| Rezpegaldesleukin (IL-2 Conjugate) | Systemic lupus erythematosus | Phase II | Phase II trial is ongoing. |\n\n40\n| Compound | Indication | Status | Developments |\n| Neuroscience |\n| Donanemab | Early Alzheimer's disease | Submitted | Granted FDA Breakthrough Therapy designation(3). Submitted in the U.S. in the second quarter of 2022. Received Priority Review designation under the accelerated approval pathway. Phase III trials are ongoing. |\n| Preclinical Alzheimer's disease | Phase III | Phase III trial is ongoing. |\n| Remternetug | Early Alzheimer's disease | Phase III | Phase III trial initiated in the third quarter of 2022. |\n| Solanezumab | Preclinical Alzheimer's disease | Phase III | Phase III trial is ongoing. |\n| GBA1 Gene Therapy (PR001) | Parkinson's disease | Phase II | Granted FDA Fast Track designation(1). Phase II trial is ongoing. |\n| GRN Gene Therapy (PR006) | Frontotemporal dementia | Phase II | Granted FDA Fast Track designation(1). Phase II trial is ongoing. |\n| O-GlcNAcase Inh | Alzheimer's disease | Phase II | Phase II trial is ongoing. |\n| SSTR4 Agonist | Pain | Phase II | Phase II trials are ongoing. |\n| TRPA1 Antagonist | Pain | Phase II | Phase II trials are ongoing. |\n| PACAP38 Antibody | Migraine | Discontinued | In the third quarter of 2022 based on the results of the Phase II trial, we discontinued development. |\n| Oncology |\n| Selpercatinib (Retevmo®) | Lung cancer | Approved(4) | Phase III trials are ongoing. In the third quarter of 2022, the FDA granted accelerated approval in tumor-agnostic RET fusion-positive advanced or metastatic solid tumors and traditional approval in locally advanced or metastatic RET fusion-positive non-small cell lung cancer. |\n| Thyroid cancer | Approved(4) | Phase III trial is ongoing. |\n| Pirtobrutinib (LOXO-305) | Mantle cell lymphoma | Submitted | Submitted in the U.S. in second quarter of 2022. Received Priority Review designation under the accelerated approval pathway. Phase III trial is ongoing. |\n| Chronic lymphocytic leukemia | Phase III | Phase III trials are ongoing. |\n| B-cell malignancies | Phase II | Phase II trial is ongoing. |\n| Imlunestrant | ER+HER2- metastatic breast cancer | Phase III | Phase III trial is ongoing. |\n\n(1) Fast Track designation is designed to facilitate the development and expedite the review of medicines to treat serious conditions and fill an unmet medical need.\n(2) In collaboration with Almirall, S.A. in Europe.\n(3) Breakthrough Therapy designation is designed to expedite the development and review of potential medicines that are intended to treat a serious condition where preliminary clinical evidence indicates that the treatment may demonstrate substantial improvement over available therapy on a clinically significant endpoint.\n(4) Continued approval may be contingent on verification and description of clinical benefit in confirmatory Phase III trials.\n41\nOur pipeline also contains several new indication line extension (NILEX) products. The following certain NILEX products for use in the indication described are currently in Phase II or Phase III clinical trials or have been submitted for regulatory review or have received regulatory approval in the U.S., Europe, or Japan. The following table reflects the status of these NILEX products, including certain other developments since our Annual Report on Form 10-K for the year ended December 31, 2021.\n| Compound | Indication | Status | Developments |\n| Diabetes |\n| Empagliflozin (Jardiance®)(1) | Heart failure with preserved ejection fraction | Approved | Approved in the U.S. and Europe in the first quarter of 2022 and in Japan in the second quarter of 2022. |\n| Chronic kidney disease | Phase III | Granted FDA Fast Track designation(2). In the first quarter of 2022 the Independent Data Monitoring Committee recommended stopping the Phase III trial early due to clear positive efficacy. |\n| Immunology |\n| Baricitinib (Olumiant®) | Alopecia areata | Approved | Approved in the U.S., Europe, and Japan in the second quarter of 2022. |\n| COVID-19 | Approved | Approved in the U.S. in the second quarter of 2022. |\n| Oncology |\n| Abemaciclib (Verzenio®) | Prostate cancer | Phase III | Phase III trials are ongoing. |\n\n(1) In collaboration with Boehringer Ingelheim.\n(2) Fast Track designation is designed to facilitate the development and expedite the review of medicines to treat serious conditions and fill an unmet medical need.\nOther Matters\nPatent Matters\nWe depend on patents or other forms of intellectual property protection for most of our revenue, cash flows, and earnings.\nFollowing the June 2021 loss of patent exclusivity for Alimta® in Europe and Japan, we faced, and expect to continue to face, generic competition that has rapidly and severely eroded revenue, and we expect will continue to erode revenue from current levels. In addition, as a result of the entry of multiple generics in the U.S. following the loss of patent and pediatric exclusivity in May 2022, we began facing, and expect to continue to face, additional generic competition that has eroded revenue, and we expect will continue to rapidly and severely erode revenue from current levels. This decline in revenue has had and will have a material adverse effect on our consolidated results of operations and cash flows. See Note 9 to the consolidated condensed financial statements for a description of legal proceedings currently pending regarding certain of our patents.\nOur compound patents for Humalog® (insulin lispro) have expired in the U.S. and major international markets, and we have also introduced lower-priced versions of Humalog as part of our insulin affordability solutions. A competitor has a similar version of insulin lispro in the U.S. and in certain European markets. Due to the impact of competition and pricing pressure in the U.S. and some international markets, we expect that lower revenue due to realized price decline will continue over time.\nOur formulation and use patents for Forteo® have expired in major markets. We expect further decline in revenue as a result of the entry of generic and biosimilar competition due to the loss of patent exclusivity in major markets.\nForeign Currency Exchange Rates\nAs a global company, we face foreign currency risk exposure from fluctuating currency exchange rates, primarily the U.S. dollar against the euro, Japanese yen, and Chinese yuan. While we seek to manage a portion of these exposures through hedging and other risk management techniques, significant fluctuations in currency rates can have a material impact, either positive or negative, on our consolidated results of operations in any given period. During the three and nine months ended September 30, 2022, revenue was unfavorably impacted by 4 percent and 3 percent, respectively, due to foreign exchange rates. While there is uncertainty in the future movements in foreign exchange rates, fluctuations in these rates have, and we currently expect in the near-term future will, adversely impact our consolidated results of operations and cash flows.\n42\nTrends Affecting Pharmaceutical Pricing, Reimbursement, and Access\nGlobal concern over access to and affordability of pharmaceutical products continues to drive regulatory and legislative debate and action, as well as worldwide cost containment efforts by governmental authorities. Such measures include the use of mandated discounts, price reporting requirements, mandated reference prices, restrictive formularies, changes to available intellectual property protections, as well as other efforts. In August 2022, the U.S. government enacted the Inflation Reduction Act (IRA). Among other measures, the IRA will allow the U.S. Department of Health and Human Services to effectively set prices for certain single-source drugs and biologics reimbursed under Medicare Part B and Part D. Generally, these government prices apply nine (medicines approved under a New Drug Application) or thirteen (medicines approved under a Biologics License Application) years following initial FDA approval and will be capped at a statutory ceiling price that is likely to represent a significant discount from average prices to wholesalers and direct purchasers. It is too soon to tell how the U.S. government will set these prices as the law specifies a ceiling price, but not a minimum or floor price. One or more significant Lilly products may be selected, which would have the effect of accelerating revenue erosion prior to patent expiry. The effect of reducing prices and reimbursement for certain of our products could significantly impact our business and consolidated results of operations.\nOther of the IRA’s provisions provide for penalties on drug manufacturers that increase prices of certain Medicare Part B and Part D medicines at a rate greater than the rate of inflation and replace the Part D coverage gap discount program with a new manufacturer discounting program. Manufacturers that fail to comply with the IRA may be subject to various penalties, including civil monetary penalties. The IRA takes effect progressively starting in 2023, with the first government set prices effective in 2026. The IRA may meaningfully influence our and pharmaceutical industry business strategies. In particular it may reduce the attractiveness of investment in small molecule innovation. Provisions of the IRA may be subject to legal challenges or other reformation, and the full effect of the IRA on our business and the pharmaceutical industry remains uncertain. Additional policies, regulations, legislation, or enforcement, including those proposed and/or pursued by the U.S. Congress and executive branch of the U.S. administration and other regulatory authorities worldwide, could adversely impact our business and consolidated results of operations.\nConsolidation of private payors in the U.S. has also significantly impacted the market for pharmaceuticals by increasing payor leverage in negotiating manufacturer price concessions and pharmacy reimbursement rates. Furthermore, restrictive or unfavorable pricing, coverage, or reimbursement determinations for our medicines or product candidates by governments, regulatory agencies, courts, or private payers, such as the Centers for Medicare & Medicaid Services' National Coverage Determination for monoclonal antibodies for the treatment of Alzheimer's Disease, may adversely impact our business and consolidated results of operations. We expect that these actions may intensify and could particularly affect certain products, such as insulin, as governments manage and emerge from the COVID-19 pandemic, which could adversely affect our business. In addition, we are engaged in litigation and investigations related to our 340B program and access to insulin that, if resolved adversely to us, could negatively impact our business and consolidated results of operations. It is not currently possible to predict the overall potential adverse impact to us or the general pharmaceutical industry of continued cost containment efforts worldwide.\nEvolving regulatory priorities have also intensified governmental scrutiny of our operations and our industry, including with respect to current Good Manufacturing Practices, quality assurance, and similar regulations, and increased focus on business combinations in our industry. Any regulatory issues concerning these matters could lead to regulatory and legal actions, product recalls and seizures, fines and penalties, interruption of production leading to product shortages, import bans or denials of import certifications, delays or denials in the approvals of new products or supplemental approvals of current products pending resolution of the issues, impediments to the completion of business combinations, and reputational harm, any of which would adversely affect our business.\nSee \"Business - Regulations and Private Payer Actions Affecting Pharmaceutical Pricing, Reimbursement, and Access\" in Part I, Item 1 and \"Risk Factors\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2021. See also Note 9 to the consolidated condensed financial statements.\n43\nTax Matters\nWe are subject to income taxes and various other taxes in the U.S. and in many foreign jurisdictions; therefore, changes in both domestic and international tax laws or regulations have affected and may affect our effective tax rate, results of operations, and cash flows. In 2017, the U.S. enacted the Tax Cuts and Jobs Act (the 2017 Tax Act), which contains a provision that requires capitalization and amortization of research and development expenses for tax purposes starting in 2022. Previously, these expenses could be deducted in the year incurred. The implementation of this provision has increased, and is expected to continue to increase, our 2022 cash payments of income taxes and subsequently decrease our cash payments of income taxes moderately over the five-year amortization period. We expect the implementation of this provision to impact our 2022 cash payments of income taxes by up to $1.50 billion. For the three and nine months ended September 30, 2022, the implementation of this provision favorably impacted other tax items that decreased our effective tax rate by approximately 4 percentage points. If this provision of the 2017 Tax Act is deferred or repealed by the U.S. Congress effective for 2022, we expect our effective tax rate to be approximately 13 percent to 14 percent for 2022.\nThe U.S. and countries around the world are actively considering and enacting tax law changes. Tax proposals have been introduced by the U.S. Congress and the U.S. administration containing significant changes, including increases to the tax rates at which both domestic and foreign income of U.S. companies would be taxed. In addition, tax authorities in the U.S. and other jurisdictions in which we do business routinely examine our tax returns and are intensifying their scrutiny and examinations of profit allocations among jurisdictions. Further, actions taken with respect to tax-related matters by associations, such as the Organisation for Economic Co-operation and Development and the European Commission, could influence tax laws in countries in which we operate. Changes to existing tax law and increased scrutiny by tax authorities in the U.S. and other jurisdictions could adversely impact our future consolidated results of operations and cash flows.\nAcquisitions\nWe opportunistically invest in external research and technologies that we believe complement and strengthen our own efforts. These investments can take many forms, including acquisitions, collaborations, investments, and licensing arrangements. We view our business development activity as a way to enhance our pipeline and strengthen our business.\nSee Note 3 to the consolidated condensed financial statements for further discussion regarding our recent acquisitions.\n44\nRevenue\nThe following table summarizes our revenue activity by region:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | Percent Change | 2022 | 2021 | Percent Change |\n| U.S. | $ | 4,422.1 | $ | 3,989.6 | 11 | $ | 13,531.5 | $ | 11,635.1 | 16 |\n| Outside U.S. | 2,519.4 | 2,783.3 | (9) | 7,708.1 | 8,683.4 | (11) |\n| Revenue | $ | 6,941.6 | $ | 6,772.8 | 2 | $ | 21,239.6 | $ | 20,318.5 | 5 |\n\nNumbers may not add due to rounding.\nThe following are components of the change in revenue compared with the prior year:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 vs. 2021 | 2022 vs. 2021 |\n| U.S. | Outside U.S. | Consolidated | U.S. | Outside U.S. | Consolidated |\n| Volume | 15 | % | 13 | % | 14 | % | 20 | % | 7 | % | 15 | % |\n| Price | (4) | (12) | (7) | (4) | (11) | (7) |\n| Foreign exchange rates | — | (11) | (4) | — | (7) | (3) |\n| Percent change | 11 | % | (9) | % | 2 | % | 16 | % | (11) | % | 5 | % |\n\nNumbers may not add due to rounding.\nIn the U.S. for the three and nine months ended September 30, 2022, the increase in volume was primarily driven by COVID-19 antibodies, Trulicity, Verzenio, Jardiance, Taltz®, and Mounjaro, partially offset by decreased volume for Alimta, resulting from the entry of multiple generics in the second quarter of 2022, and for Olumiant, due to the decline in utilization for COVID-19 treatment. In the U.S. for the three and nine months ended September 30, 2022, the decrease in realized prices was primarily driven by Humalog, due to a list price reduction of insulin lispro injection and unfavorable segment mix, and by Trulicity, due to unfavorable segment mix and higher contracted rebates. In the U.S. for the three months ended September 30, 2022, the decrease in realized prices for Trulicity was partially offset by changes to estimates for rebates and discounts.\nOutside the U.S. for the three and nine months ended September 30, 2022, the increase in volume was primarily driven by Verzenio, Trulicity, Tyvyt®, Jardiance, and Taltz, partially offset by Alimta and Cymbalta® resulting from generic competition. Additionally outside the U.S. for the three and nine months ended September 30, 2022, we recognized revenue related to a sales collaboration agreement for the right to sell and distribute Mounjaro in Japan. Outside the U.S. for the nine months ended September 30, 2022, the increase in volume was also partially offset by decreased sales of COVID-19 antibodies and the sale of the rights to Cialis® in China in the second quarter of 2021. Outside the U.S. for the three and nine months ended September 30, 2022, the decrease in realized prices was primarily driven by the impact of government pricing in China from the National Reimbursement Drug List (NRDL) formulary for certain products, particularly Tyvyt and Verzenio, and volume-based procurement (VBP) for Humalog.\n45\n| Three Months Ended September 30, |\n| 2022 | 2021 |\n| Product | U.S. | Outside U.S. | Total | Total | Percent Change |\n| Trulicity | $ | 1,418.3 | $ | 432.0 | $ | 1,850.4 | $ | 1,600.1 | 16 |\n| Taltz | 493.8 | 186.1 | 679.9 | 593.1 | 15 |\n| Verzenio | 414.8 | 202.9 | 617.7 | 335.5 | 84 |\n| Jardiance(1) | 350.9 | 222.4 | 573.3 | 390.4 | 47 |\n| Humalog(2) | 248.1 | 198.8 | 447.0 | 626.7 | (29) |\n| COVID-19 antibodies(3) | 386.6 | — | 386.6 | 217.1 | 78 |\n| Humulin® | 169.5 | 68.7 | 238.2 | 286.7 | (17) |\n| Cyramza® | 87.5 | 144.6 | 232.1 | 253.4 | (8) |\n| Basaglar® | 124.8 | 68.1 | 193.0 | 192.8 | — |\n| Mounjaro | 97.3 | 90.0 | 187.3 | — | NM |\n| Olumiant(4) | 22.9 | 160.0 | 182.9 | 406.9 | (55) |\n| Forteo | 112.7 | 64.4 | 177.1 | 200.9 | (12) |\n| Emgality® | 114.0 | 54.6 | 168.5 | 140.0 | 20 |\n| Erbitux® | 126.3 | 18.7 | 144.9 | 134.3 | 8 |\n| Alimta | 64.6 | 54.8 | 119.4 | 457.0 | (74) |\n| Cialis | 8.1 | 107.7 | 115.7 | 130.9 | (12) |\n| Zyprexa® | 8.0 | 73.4 | 81.4 | 101.7 | (20) |\n| Tyvyt | — | 76.8 | 76.8 | 125.6 | (39) |\n| Cymbalta | 7.8 | 54.9 | 62.7 | 132.0 | (53) |\n| Other products | 166.1 | 240.5 | 406.7 | 447.7 | (9) |\n| Revenue | $ | 4,422.1 | $ | 2,519.4 | $ | 6,941.6 | $ | 6,772.8 | 2 |\n\nNumbers may not add due to rounding.\nNM - not meaningful\n(1) Jardiance revenue includes Glyxambi®, Synjardy®, and Trijardy® XR.\n(2) Humalog revenue includes insulin lispro.\n(3) COVID-19 antibodies include sales for bamlanivimab administered alone, for bamlanivimab and etesevimab administered together, and for bebtelovimab and were made pursuant to EUAs or similar regulatory authorizations.\n(4) Olumiant revenue includes sales for baricitinib that were made pursuant to EUA or similar regulatory authorizations.\n46\n| Nine Months Ended September 30, |\n| 2022 | 2021 |\n| Product | U.S. | Outside U.S. | Total | Total | Percent Change |\n| Trulicity | $ | 4,162.4 | $ | 1,341.1 | $ | 5,503.5 | $ | 4,588.2 | 20 |\n| COVID-19 antibodies(1) | 1,970.9 | 14.7 | 1,985.5 | 1,176.2 | 69 |\n| Taltz | 1,212.6 | 561.6 | 1,774.2 | 1,565.4 | 13 |\n| Verzenio | 1,100.5 | 575.1 | 1,675.6 | 945.8 | 77 |\n| Humalog(2) | 855.8 | 656.4 | 1,512.3 | 1,851.3 | (18) |\n| Jardiance(3) | 831.4 | 622.4 | 1,453.7 | 1,058.9 | 37 |\n| Humulin | 562.3 | 223.1 | 785.4 | 923.8 | (15) |\n| Cyramza | 259.3 | 434.3 | 693.6 | 762.5 | (9) |\n| Alimta | 490.5 | 200.5 | 691.1 | 1,626.6 | (58) |\n| Olumiant(4) | 104.6 | 520.1 | 624.7 | 809.1 | (23) |\n| Basaglar | 339.9 | 218.8 | 558.7 | 650.1 | (14) |\n| Cialis | 25.8 | 454.7 | 480.4 | 538.7 | (11) |\n| Emgality | 330.8 | 144.4 | 475.2 | 415.7 | 14 |\n| Forteo | 261.4 | 191.7 | 453.0 | 617.8 | (27) |\n| Erbitux | 361.0 | 47.4 | 408.3 | 403.7 | 1 |\n| Zyprexa | 26.2 | 235.5 | 261.7 | 292.8 | (11) |\n| Tyvyt | — | 235.8 | 235.8 | 340.2 | (31) |\n| Cymbalta | 25.0 | 194.3 | 219.3 | 484.3 | (55) |\n| Mounjaro | 109.9 | 93.3 | 203.2 | — | NM |\n| Other products | 501.1 | 743.0 | 1,244.2 | 1,267.3 | (2) |\n| Revenue | $ | 13,531.5 | $ | 7,708.1 | $ | 21,239.6 | $ | 20,318.5 | 5 |\n\nNumbers may not add due to rounding.\nNM - not meaningful\n(1) COVID-19 antibodies include sales for bamlanivimab administered alone, for bamlanivimab and etesevimab administered together, and for bebtelovimab and were made pursuant to EUAs or similar regulatory authorizations.\n(2) Humalog revenue includes insulin lispro.\n(3) Jardiance revenue includes Glyxambi, Synjardy, and Trijardy XR.\n(4) Olumiant revenue includes sales for baricitinib that were made pursuant to EUA or similar regulatory authorizations.\nRevenue of Trulicity, a treatment for type 2 diabetes and to reduce the risk of major adverse cardiovascular events in adult patients with type 2 diabetes and established cardiovascular disease or multiple cardiovascular risk factors, increased 18 percent in the U.S. during the three months ended September 30, 2022, driven by increased demand, partially offset by lower realized prices. The lower realized prices in the U.S. for the three months ended September 30, 2022 were due to unfavorable segment mix and higher contracted rebates, partially offset by changes to estimates for rebates and discounts. Revenue in the U.S. increased 20 percent during the nine months ended September 30, 2022, driven by increased demand, partially offset by lower realized prices due to unfavorable segment mix and higher contracted rebates. Revenue outside the U.S. increased 8 percent and 19 percent during the three and nine months ended September 30, 2022, respectively, driven by increased demand, partially offset by the unfavorable impact of foreign exchange rates and, to a lesser extent, lower realized prices.\n47\nRevenue of COVID-19 antibodies, treatments for mild to moderate COVID-19 for higher-risk patients and for post-exposure prophylaxis in certain individuals for the prevention of SARS-CoV-2 infection, was $386.6 million and $1.97 billion in the U.S. during the three and nine months ended September 30, 2022, respectively. Revenue outside the U.S. was not material during the three and nine months ended September 30, 2022. The availability of superior or competitive therapies, including therapies that can be administered more easily, or preventative measures, such as vaccines, coupled with the unpredictable nature of pandemics, have and could further negatively impact or eliminate demand for these COVID-19 antibodies. The FDA has revised, and may in the future revise, any EUA for our COVID-19 antibodies in response to the prevalence of variants against which our antibodies have varying degrees of efficacy, including the new BQ variants. Based on early data, we do not believe that bebtelovimab will neutralize against the new BQ variants. We supplied the U.S. government approximately 810,000 doses of bebtelovimab during the nine months ended September 30, 2022. Beginning in the third quarter of 2022 and in collaboration with the U.S. government, we have made bebtelovimab commercially available for purchase by U.S. states/territories, hospitals, and certain other providers. We do not anticipate any further U.S. government orders.\nRevenue of Taltz, a treatment for moderate-to-severe plaque psoriasis, active psoriatic arthritis, ankylosing spondylitis, and active non-radiographic axial spondyloarthritis, increased 17 percent and 13 percent in the U.S. during the three and nine months ended September 30, 2022, respectively, driven by increased demand, partially offset by lower realized prices. Revenue outside the U.S. increased 9 percent and 14 percent during the three and nine months ended September 30, 2022, respectively, driven by increased volume, partially offset by unfavorable impact of foreign exchange rates and lower realized prices.\nRevenue of Verzenio, a treatment for HR+, HER2- metastatic breast cancer and high risk early breast cancer, increased $215.1 million and $518.4 million in the U.S. during the three and nine months ended September 30, 2022, respectively, primarily driven by increased demand. Revenue outside the U.S. increased 49 percent and 58 percent during the three and nine months ended September 30, 2022, respectively, driven by increased demand, partially offset by lower realized prices due to the impact of the NRDL formulary in China and the unfavorable impact of foreign exchange rates.\nRevenue of Humalog, an injectable human insulin analog for the treatment of diabetes, decreased 29 percent and 15 percent in the U.S. during the three and nine months ended September 30, 2022, respectively, driven by lower realized prices due to a list price reduction of insulin lispro injection and unfavorable segment mix. Revenue outside the U.S. decreased 29 percent and 22 percent during the three and nine months ended September 30, 2022, respectively, driven by lower realized prices due to the impact of VBP in China and the unfavorable impact of foreign exchange rates. Due to the impact of competition and pricing pressure in the U.S. and some international markets, we expect that lower revenue due to realized price decline will continue over time.\nRevenue of Jardiance, a treatment for type 2 diabetes, to reduce the risk of cardiovascular death in adult patients with type 2 diabetes and established cardiovascular disease, and to reduce the risk of cardiovascular death and hospitalization for heart failure in adults with heart failure, regardless of left ventricular ejection fraction, increased 59 percent and 47 percent in the U.S. during the three and nine months ended September 30, 2022, respectively, primarily driven by increased demand. The increase in revenue in the U.S. during the three months ended September 30, 2022 was also driven by changes to estimates for rebates and discounts. Revenue outside the U.S. increased 31 percent and 26 percent during the three and nine months ended September 30, 2022, respectively, primarily driven by increased demand, partially offset by the unfavorable impact of foreign exchange rates. See Note 4 to the consolidated condensed financial statements for information regarding our collaboration with Boehringer Ingelheim involving Jardiance.\nRevenue of Alimta, a treatment for various cancers, decreased 78 percent and 46 percent in the U.S. during the three and nine months ended September 30, 2022, respectively, primarily driven by decreased demand due to the entry of multiple generics in the second quarter of 2022. Revenue outside the U.S. decreased 66 percent and 72 percent during the three and nine months ended September 30, 2022, respectively, largely driven by decreased demand due to generic competition. Following the June 2021 loss of patent exclusivity for Alimta in Europe and Japan, we faced, and expect to continue to face, generic competition that has rapidly and severely eroded revenue, and we expect will continue to erode revenue from current levels. In addition, as a result of the entry of multiple generics in the U.S. following the loss of patent and pediatric exclusivity in May 2022, we began facing, and expect to continue to face, additional generic competition that has eroded revenue, and we expect will continue to rapidly and severely erode revenue from current levels. See \"Executive Overview - Other Matters- Patent Matters\" for additional information.\n48\nGross Margin, Costs, and Expenses\nGross margin as a percent of revenue decreased 1.6 percentage points to 77.3 percent and increased 2.0 percentage points to 76.1 percent for the three and nine months ended September 30, 2022, respectively. The decrease in the gross margin percent for the three months ended September 30, 2022 was primarily driven by a benefit in the gross margin for the three months ended September 30, 2021 due to the partial reversal of inventory impairment charges related to our COVID-19 antibodies that were recognized in the first and second quarters of 2021. The partial reversal of inventory impairment charges related to our COVID-19 antibodies was driven by an unexpected increase in our COVID-19 antibodies sales as the COVID-19 pandemic evolved during the third quarter of 2021. The increase in gross margin percent for the nine months ended September 30, 2022 was primarily driven by a net inventory impairment charge related to our COVID-19 antibodies recognized in 2021. Additionally, for the three and nine months ended September 30, 2022, lower realized prices and increased expenses due to inflation and logistics costs were offset by favorable product mix, including the impact of lower sales of Olumiant for the treatment of COVID-19, and the favorable impact of foreign exchange rates.\nResearch and development expenses increased 6 percent to $1.80 billion and 3 percent to $5.19 billion for the three and nine months ended September 30, 2022, respectively, primarily driven by higher development expenses for late-stage assets, partially offset by lower development expenses for COVID-19 antibodies and the favorable impact of foreign exchange rates.\nMarketing, selling, and administrative expenses increased 2 percent to $1.61 billion for the three months ended September 30, 2022, primarily driven by increased costs associated with the launch of Mounjaro, partially offset by the favorable impact of foreign exchange rates. Marketing, selling, and administrative expenses decreased 1 percent to $4.80 billion for the nine months ended September 30, 2022, primarily driven by the favorable impact of foreign exchange rates as well as reduced marketing costs in the first half of 2022, partially offset by increased costs associated with the launch of Mounjaro.\nWe plan to take compensatory actions to improve retention and address wage inflation which will impact our costs and consolidated results of operations.\nWe recognized $62.4 million and $668.4 million of acquired IPR&D and development milestones for the three and nine months ended September 30, 2022, respectively. The charges for the nine months ended September 30, 2022 included the buy-out of substantially all future obligations that were contingent upon the occurrence of certain events linked to the success of our mutant-selective PI3kα inhibitor and a purchase of a Priority Review Voucher. We recognized $177.6 million and $532.4 million of acquired IPR&D and development milestones for the three and nine months ended September 30, 2021, respectively. The charges for the nine months ended September 30, 2021 included acquired IPR&D charges from business development transactions with Rigel and Precision. See Note 3 to the consolidated condensed financial statements for additional information.\nWe recognized asset impairment, restructuring, and other special charges of $206.5 million for the three and nine months ended September 30, 2022, primarily related to an intangible asset impairment for GBA1 Gene Therapy (PR001) due to changes in estimated launch timing. There were no asset impairment, restructuring, and other special charges recognized for the three months ended September 30, 2021. We recognized asset impairment, restructuring, and other special charges of $211.6 million for the nine months ended September 30, 2021, primarily related to an intangible asset impairment resulting from the sale of the rights to Qbrexza, as well as acquisition and integration costs associated with the acquisition of Prevail. See Note 5 to the consolidated condensed financial statements for additional information.\nOther–net, (income) expense was expense of $111.0 million and $580.9 million for the three and nine months ended September 30, 2022, respectively, compared with expense of $635.9 million and $124.3 million for the three and nine months ended September 30, 2021, respectively. The decrease in other expense for the three months ended September 30, 2022 was primarily driven by a debt extinguishment loss of $405.2 million related to the repurchase of debt in 2021, as well as lower net investment losses on equity securities in 2022 compared to 2021. The increase in other expense for the nine months ended September 30, 2022 was primarily driven by net investment losses on equity securities in 2022 compared with net investment gains on equity securities in 2021, partially offset by a debt extinguishment loss of $405.2 million related to the repurchase of debt in 2021.\n49\nThe effective tax rates were 7.3 percent and 8.6 percent for the three and nine months ended September 30, 2022, respectively, reflecting the favorable tax impact of the implementation of a provision in the 2017 Tax Act that requires capitalization and amortization of research and development expenses for tax purposes starting in 2022, net investment losses on equity securities, and an intangible asset impairment charge. We expect our effective tax rate to be approximately 13 percent to 14 percent for 2022 if the capitalization and amortization of research and development expenses provision of the 2017 Tax Act is deferred or repealed by the U.S. Congress effective for 2022.\nThe effective tax rate was 10.9 percent for the three months ended September 30, 2021, reflecting the favorable tax impact of a debt extinguishment loss and of net investment losses on equity securities, partially offset by a net discrete tax detriment. The effective tax rate was 10.7 percent for the nine months ended September 30, 2021, reflecting the favorable tax impact of a net discrete tax benefit, a debt extinguishment loss, and a net inventory impairment charge related to our COVID-19 antibodies.\nFinancial Condition and Liquidity\nWe believe our available cash and cash equivalents, together with our ability to generate operating cash flow and our access to short-term and long-term borrowings, are sufficient to fund our existing and planned capital requirements. For a discussion of our capital requirements, see \"Management's Discussion and Analysis of Results of Operations and Financial Condition\" in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2021.\nWe plan to invest more than $2 billion over several years in two new facilities in Lebanon, Indiana to manufacture existing and future products and more than $1 billion over several years in a new facility in Concord, North Carolina to manufacture parenteral (injectable) products and devices. We plan to invest more than 400 million euro over several years in a new facility in Limerick, Ireland to expand our manufacturing network for biologic active ingredients. These investments, and other capital investments that support our operations, will result in capital expenditures being higher than recent historical levels for the next several years.\nCash and cash equivalents decreased to $2.62 billion as of September 30, 2022, compared with $3.82 billion as of December 31, 2021. Refer to the consolidated condensed statements of cash flows for additional information on the significant sources and uses of cash for the nine months ended September 30, 2022 and 2021.\nIn addition to our cash and cash equivalents, we held total investments of $2.70 billion and $3.30 billion as of September 30, 2022 and December 31, 2021, respectively. See Note 6 to the consolidated condensed financial statements for additional information.\nAs of September 30, 2022, total debt was $15.89 billion, a decrease of $996.3 million compared with $16.88 billion as of December 31, 2021. See Note 6 to the consolidated condensed financial statements for additional information.\nAs of September 30, 2022, we had a total of $7.26 billion of unused committed bank credit facilities, $7.00 billion of which is available to support our commercial paper program. We believe that amounts accessible through existing commercial paper markets should be adequate to fund short-term borrowing needs.\nDuring the nine months ended September 30, 2022, we repurchased $1.50 billion of shares under our $5.00 billion share repurchase program authorized in May 2021. As of September 30, 2022, we had $3.25 billion remaining under this program.\nDuring the nine months ended September 30, 2022, we paid dividends of $2.65 billion, or $2.94 per share, to our shareholders. In October 2022, we declared a dividend for the fourth quarter of 2022 of $0.98 per share on outstanding common stock. The dividend of approximately $882 million is payable on December 9, 2022 to shareholders of record at the close of business on November 15, 2022.\nSee \"Executive Overview - Other Matters - Patent Matters\" for information regarding recent losses of patent protection.\nBoth domestically and abroad, we continue to monitor the potential impacts of the economic environment; the creditworthiness of our wholesalers and other customers, including foreign government-backed agencies and suppliers; the uncertain impact of health care legislation; various international government funding levels; and fluctuations in interest rates, foreign currency exchange rates (see \"Executive Overview - Other Matters - Foreign Currency Exchange Rates\"), and fair values of equity securities.\n50\nCritical Accounting Estimates\nFor a discussion of our critical accounting estimates, refer to \"Management's Discussion and Analysis of Results of Operations and Financial Condition\" in Part II, Item 7 and the notes to our consolidated financial statements in Part II, Item 8 of our Annual Report on Form 10-K for the year ended December 31, 2021. See also Note 1 to the consolidated condensed financial statements. There have been no material changes to our critical accounting estimates since our Annual Report on Form 10-K for the year ended December 31, 2021.\nAvailable Information on our Website\nWe make available through our company website, free of charge, our company filings with the Securities and Exchange Commission (SEC) as soon as reasonably practicable after we electronically file them with, or furnish them to, the SEC. The reports we make available include annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements, registration statements, and any amendments to those documents.\nThe website link to our SEC filings is investor.lilly.com/financial-information/sec-filings.\nWe routinely post important information for investors in the “Investors” section of our website, www.lilly.com. We may use our website as a means of disclosing material, non-public information and for complying with our disclosure obligations under Regulation FD. Accordingly, investors should monitor the “Investors” section of our website, in addition to following our press releases, filings with the SEC, public conference calls, presentations, and webcasts. We may also use social media channels to communicate with investors and the public about our business, products and other matters, and those communications could be deemed to be material information. The information contained on, or that may be accessed through, our website or social media channels, is not incorporated by reference into, and is not a part of, this Quarterly Report on Form 10-Q.\n51\nItem 4. Controls and Procedures\n(a)Evaluation of Disclosure Controls and Procedures. Under applicable Securities and Exchange Commission (SEC) regulations, management of a reporting company, with the participation of the principal executive officer and principal financial officer, must periodically evaluate the company's \"disclosure controls and procedures,\" which are defined generally as controls and other procedures of a reporting company designed to ensure that information required to be disclosed by the reporting company in its periodic reports filed with the SEC (such as this Quarterly Report on Form 10-Q) is recorded, processed, summarized, and reported on a timely basis.\nOur management, with the participation of David A. Ricks, president and chief executive officer, and Anat Ashkenazi, executive vice president and chief financial officer, evaluated our disclosure controls and procedures (as such terms are defined in our Annual Report on Form 10-K for the year ended December 31, 2021) as of September 30, 2022, and concluded that they were effective.\n(b)Changes in Internal Controls. During the third quarter of 2022, there were no changes in our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n52\nPART II. Other Information\nItem 1. Legal Proceedings\nWe are a party to various currently pending legal actions, government investigations, and environmental proceedings. See Note 9 to the consolidated condensed financial statements for information on various legal proceedings.\nThis Item should be read in conjunction with \"Legal Proceedings\" in Part I, Item 3 of our Annual Report on Form 10-K for the year ended December 31, 2021.\nItem 1A. Risk Factors\nOur material risk factors are disclosed in \"Risk Factors\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2021. There have been no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2021.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nInformation relating to the principal market for our common stock and related shareholder matters is described in \"Management's Discussion and Analysis of Results of Operations and Financial Condition\" in Part II, Item 7 and in \"Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters\" in Part III, Item 12 of our Annual Report on Form 10-K for the year ended December 31, 2021.\nThe following table summarizes the activity related to repurchases of our equity securities during the three months ended September 30, 2022:\n| Period | Total Number ofShares Purchased(in thousands) | Average Price Paid per Share | Total Number of SharesPurchased as Part ofPublicly AnnouncedPlans or Programs(in thousands) | Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs (in millions) |\n| July 2022 | — | $ | — | — | $ | 3,250.0 |\n| August 2022 | — | — | — | 3,250.0 |\n| September 2022 | — | — | — | 3,250.0 |\n| Total | — | — | — |\n\nDuring the three months ended September 30, 2022, we did not repurchase any shares under our $5.00 billion share repurchase program authorized in May 2021.\n53\nItem 6. Exhibits\nThe following documents are filed as a part of this Quarterly Report:\n| Exhibit | Description |\n| EXHIBIT 3.1 | Amended Articles of Incorporation are incorporated by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K filed on May 4, 2022 |\n| EXHIBIT 3.2 | Bylaws, as amended, are incorporated by reference to Exhibit 3.2 to the Company's Current Report on Form 8-K filed on May 4, 2022 |\n| EXHIBIT 10.1 | Form of Performance Award under the 2002 Lilly Stock Plan (with non-compete)(1) |\n| EXHIBIT 10.2 | Form of Shareholder Value Award under the 2002 Lilly Stock Plan (with non-compete)(1) |\n| EXHIBIT 10.3 | Form of Relative Value Award under the 2002 Lilly Stock Plan (with non-compete)(1) |\n| EXHIBIT 31.1 | Rule 13a-14(a) Certification of David A. Ricks, Chair, President, and Chief Executive Officer |\n| EXHIBIT 31.2 | Rule 13a-14(a) Certification of Anat Ashkenazi, Executive Vice President and Chief Financial Officer |\n| EXHIBIT 32. | Section 1350 Certification |\n| EXHIBIT 101. | Interactive Data Files (embedded within the Inline XBRL document) |\n| EXHIBIT 104. | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\n\nLong-term debt instruments under which the total amount of securities authorized does not exceed 10 percent of our consolidated assets are not filed as exhibits to this Quarterly Report. We will furnish a copy of these agreements to the Securities and Exchange Commission upon request.\nSignatures\nPursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.\n| ELI LILLY AND COMPANY |\n| (Registrant) |\n| Date: | November 1, 2022 | /s/ Anat Ashkenazi |\n| Anat Ashkenazi |\n| Executive Vice President and Chief Financial Officer |\n| Date: | November 1, 2022 | /s/ Donald A. Zakrowski |\n| Donald A. Zakrowski |\n| Senior Vice President, Finance, and Chief Accounting Officer |\n\n54\n</text>\n\nWhat is the difference in net income as a percentage of cash provided by operating activities between the years 2022 and 2021 in percentages?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"ground_truth": "Therefore, the answer is 2.7062535908033993."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial Statements (unaudited).\n4\nEmbark Technology, Inc.\nCondensed Consolidated Balance Sheets\n(in thousands, except share and per share data)\n(unaudited)\n| March 31,2022 | December 31,2021 |\n| Assets |\n| Current assets: |\n| Cash and cash equivalents | $ | 244,488 | $ | 264,615 |\n| Restricted cash, short-term | 65 | 130 |\n| Prepaid expenses and other current assets | 12,005 | 12,746 |\n| Total current assets | 256,558 | 277,491 |\n| Restricted cash, long-term | 812 | 275 |\n| Property, equipment and software, net | 11,086 | 9,637 |\n| Operating lease right-of-use assets | 6,099 | — |\n| Other assets | 3,722 | 3,596 |\n| Total assets | $ | 278,277 | $ | 290,999 |\n| Liabilities and stockholders’ equity |\n| Current liabilities: |\n| Accounts payable | $ | 4,099 | $ | 2,497 |\n| Accrued expenses and other current liabilities | 6,151 | 3,142 |\n| Current portion of operating lease liabilities | 1,948 | — |\n| Short-term notes payable | 357 | 358 |\n| Total current liabilities | 12,555 | 5,997 |\n| Long-term notes payable | 641 | 722 |\n| Warrant liability | 27,264 | 49,419 |\n| Non-current portion of operating lease liabilities | 4,438 | — |\n| Other long-term liability | 111 | 50 |\n| Long-term deferred rent | — | 177 |\n| Total liabilities | 45,009 | 56,365 |\n| Commitments and contingencies (Note 10) |\n| Stockholders’ equity: |\n| Preferred stock, $ 0.0001 par value; 10,000,000 shares authorized, none issued and none outstanding as of March 31, 2022 and December 31, 2021 | — | — |\n| Class A common stock, $ 0.0001 par value; 4,000,000,000 shares authorized, 362,832,986 shares issued as of March 31, 2022; 4,000,000,000 shares authorized, 362,832,986 shares issued as of December 31, 2021 | 36 | 36 |\n| Class B common stock, $ 0.0001 par value; 100,000,000 shares authorized, 87,078,981 shares issued as of March 31, 2022 and December 31, 2021 | 9 | 9 |\n| Additional paid-in capital | 434,573 | 417,492 |\n| Accumulated deficit | ( 201,350 ) | ( 182,903 ) |\n| Total stockholders’ equity | 233,268 | 234,634 |\n| Total liabilities and stockholders’ equity | $ | 278,277 | $ | 290,999 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n5\nEmbark Technology, Inc.\nCondensed Consolidated Statements of Operations\n(in thousands, except share and per share data)\n(unaudited)\n| Three Months Ended March 31, |\n| 2022 | 2021 |\n| Operating expenses: |\n| Research and development | $ | 18,695 | $ | 6,231 |\n| General and administrative | 21,926 | 2,290 |\n| Total operating expenses | 40,621 | 8,521 |\n| Loss from operations | ( 40,621 ) | ( 8,521 ) |\n| Other income (expense): |\n| Change in fair value of warrant liability | 22,156 | — |\n| Other income | 26 | 9 |\n| Interest income | 13 | 30 |\n| Interest expense | ( 21 ) | — |\n| Loss before provision for income taxes | ( 18,447 ) | ( 8,482 ) |\n| Net loss | $ | ( 18,447 ) | $ | ( 8,482 ) |\n| Net loss attributable to common stockholders, basic and diluted | $ | ( 18,447 ) | $ | ( 8,482 ) |\n| Net loss per share attributable to common stockholders: |\n| Basic and diluted, Class A and Class B | $ | ( 0.04 ) | $ | ( 0.18 ) |\n| Weighted-average shares used in computing net loss per share attributable to common stockholders: |\n| Basic and diluted | 452,623,022 | 47,538,331 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n6\nEmbark Technology, Inc.\nCondensed Consolidated Statements of Comprehensive Loss\n(in thousands)\n(unaudited)\n| Three Months Ended March 31, |\n| 2022 | 2021 |\n| Net loss | $ | ( 18,447 ) | $ | ( 8,482 ) |\n| Other comprehensive loss (net of tax): |\n| Unrealized losses on available-for-sale securities, net | — | ( 19 ) |\n| Comprehensive loss | $ | ( 18,447 ) | $ | ( 8,501 ) |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n7\nEmbark Technology, Inc.\nCondensed Consolidated Statements of Preferred Stock and Stockholder’s Equity\n(in thousands, except number of shares)\n(unaudited)\n| Preferred Stock | Founders Preferred Stock | Common Stock | Class A | Class B | Warrants | Additional Paid-in Capital | Accumulated Deficit | Accumulated Other Comprehensive Income (Loss) | TotalStockholders'Equity |\n| Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount |\n| Balance at January 1, 2022 | — | $ | — | — | $ | — | — | $ | — | 362,832,986 | $ | 36 | 87,078,781 | $ | 9 | 23,153,266 | $ | 417,492 | $ | ( 182,903 ) | $ | — | $ | 234,634 |\n| Shares issued upon exercise of stock options | — | — | — | — | — | — | — | — | — | — | — | 372 | — | — | 372 |\n| Vesting of early exercised options | — | — | — | — | — | — | — | — | — | — | — | 11 | — | — | 11 |\n| Stock-based compensation | — | — | — | — | — | — | — | — | — | — | — | 16,698 | — | — | 16,698 |\n| Net loss | — | — | — | — | — | — | — | — | — | — | — | — | ( 18,447 ) | — | ( 18,447 ) |\n| Balance at March 31, 2022 | — | $ | — | — | $ | — | — | $ | — | 362,832,986 | $ | 36 | 87,078,781 | $ | 9 | 23,153,266 | $ | 434,573 | $ | ( 201,350 ) | $ | — | $ | 233,268 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n8\nEmbark Technology, Inc.\nCondensed Consolidated Statements of Preferred Stock and Stockholder’s Equity\n(in thousands, except number of shares)\n(unaudited)\n| Preferred Stock | Founders Preferred Stock | Common Stock | Class A | Class B | Warrants | Additional Paid-in Capital | Accumulated Deficit | Accumulated Other Comprehensive Income (Loss) | TotalStockholders'Equity |\n| Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount |\n| Balance at January 1, 2021 | 260,582,311 | $ | 1 | 484,912 | $ | — | 141,216,455 | $ | — | — | $ | — | — | $ | — | — | $ | 129,449 | $ | ( 58,690 ) | $ | 45 | $ | 70,805 |\n| Shares issued upon exercise of stock options | — | — | — | — | 1,244,349 | — | — | — | — | — | — | 94 | — | — | 94 |\n| Vesting of early exercised options | — | — | — | — | — | — | — | — | — | — | — | 5 | — | — | 5 |\n| Stock-based compensation | — | — | — | — | — | — | — | — | — | — | — | 598 | — | — | 598 |\n| Issuance of common stock warrants | — | — | — | — | — | — | — | — | — | — | — | 83 | — | — | 83 |\n| Other comprehensive loss | — | — | — | — | — | — | — | — | — | — | — | — | — | ( 19 ) | ( 19 ) |\n| Net loss | — | — | — | — | — | — | — | — | — | — | — | — | ( 8,482 ) | — | ( 8,482 ) |\n| Balance at March 31, 2021 | 260,582,311 | $ | 1 | 484,912 | $ | — | 142,460,804 | $ | — | — | $ | — | — | $ | — | — | $ | 130,229 | $ | ( 67,172 ) | $ | 26 | $ | 63,084 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n9\nEmbark Technology, Inc.\nCondensed Consolidated Statements of Cash Flows\n(in thousands)\n(unaudited)\n| Three Months Ended March 31, |\n| 2022 | 2021 |\n| Cash flows from operating activities |\n| Net loss | $ | ( 18,447 ) | $ | ( 8,482 ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: |\n| Depreciation and amortization | 383 | 222 |\n| Amortization expense - right-of-use assets - operating leases | 488 | — |\n| Stock-based compensation, net of amounts capitalized | 16,602 | 562 |\n| Issuance of warrants for services | — | 83 |\n| Change in fair value of warrants | ( 22,156 ) | — |\n| Net amortization of premiums and accretion of discounts on investments | — | 120 |\n| Changes in operating assets and liabilities: |\n| Prepaid expenses and other current assets | 682 | 29 |\n| Other assets | ( 126 ) | ( 65 ) |\n| Accounts payable | 1,644 | 264 |\n| Other long-term liabilities | 60 | — |\n| Accrued expenses and other current liabilities | 2,645 | 476 |\n| Net cash used in operating activities | ( 18,225 ) | ( 6,791 ) |\n| Cash flows from investing activities |\n| Maturities of investments | — | 18,243 |\n| Purchase of property, equipment and software | ( 1,717 ) | ( 973 ) |\n| Net cash provided by (used in) investing activities | ( 1,717 ) | 17,270 |\n| Cash flows from financing activities |\n| Payment towards notes payable | ( 81 ) | ( 66 ) |\n| Proceeds from exercise of stock options | 372 | 94 |\n| Repurchase of early exercised stock options | ( 4 ) | — |\n| Net cash provided by (used in) financing activities | 287 | 28 |\n| Net increase (decrease) in cash, cash equivalents and restricted cash | ( 19,655 ) | 10,507 |\n| Cash, cash equivalents and restricted cash at beginning of period | 265,020 | 11,460 |\n| Cash, cash equivalents and restricted cash at end of period | $ | 245,365 | $ | 21,967 |\n| Supplemental disclosures of cash flow information: |\n| Cash paid during the year for interest | $ | 18 | $ | 16 |\n| Supplemental schedule of noncash investing and financing activities |\n| Acquisition of property, equipment and software in accounts payable | $ | 284 | $ | 176 |\n| Acquisition of trucks by assuming notes payable | $ | — | $ | 278 |\n| Right-of-use assets obtained in exchange for lease obligations | $ | 6,587 | $ | — |\n| Stock-based compensation capitalized into internally developed software | $ | 156 | $ | 36 |\n| Vesting of early exercised stock options | $ | 15 | $ | 5 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n10\nNotes to Condensed Consolidated Financial Statements\n1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION\nEmbark Technology, Inc. was originally incorporated in Delaware on September 25, 2020 under the name Northern Genesis Acquisition Corp. II (“NGA”). The Company was formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. On November 10, 2021 (the “Closing Date”), the Company (at such time named Northern Genesis Acquisition Corp. II) consummated the business combination (the “Business Combination”) pursuant to the Agreement and Plan of Merger, dated June 22, 2021 with the pre-Business Combination company, Embark Trucks, Inc. (“Embark Trucks”). In connection with the consummation of the Business Combination, the Company changed its name from Northern Genesis Acquisition Corp. II to Embark Technology, Inc. and became the parent entity of Embark Trucks.\nThe Merger was accounted for as a reverse recapitalization with Embark as the accounting acquirer and NGA as the acquired company for accounting purposes. Accordingly, all historical financial information presented in the financial statements represent the accounts of Embark as if Embark is the predecessor to the Company. The shares and net loss per common share, prior to the Merger, have been retroactively restated as shares reflecting the exchange ratio established in the Merger (approximately 2.98 shares of Company Class A common stock for 1 share of Embark Class A common stock).\nThe principal activities of Embark Technology, Inc. (“Embark” or the “Company”) include design and development of autonomous driving software for the truck freight industry. The Company is headquartered in San Francisco, California and was incorporated in the State of Delaware in 2016. Other than Embark Trucks, the Company has no subsidiaries as of March 31, 2022.\nThe Company has devoted substantially all of its resources to develop its autonomous truck technology, to enable and expand its route models - transfer point and direct-to-customer, to expand its partnerships with shippers and carriers, to raising capital, and providing general and administrative support for these operations. The Company has not generated revenues from its principal operations through March 31, 2022.\nPrior to the Merger, NGA ordinary shares and warrants were traded on the New York Stock Exchange (“NYSE”) under the ticker symbols “NGAB” and “NGAB.WS”, respectively. On the Closing Date, the Company’s Class A common stock and warrants began trading on the NASDAQ under the ticker symbols “EMBK” and “EMBKW”, respectively. One of the primary purposes of the Merger was to provide a platform for Embark Trucks to gain access to the U.S. capital markets.\nBasis of Presentation\nThe accompanying financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and pursuant to the regulations of the U.S. Securities and Exchange Commission (“SEC”).\nUnaudited Interim Financial Information\nThese interim Unaudited Condensed Consolidated Financial Statements should be read in conjunction with the audited financial statements and notes thereto contained in Embark’s Annual Report. The condensed consolidated balance sheet at December 31, 2021, has been derived from the audited financial statements at that date, but does not include all disclosures, including notes, required by GAAP for complete financial statements. In management’s opinion, the unaudited interim financial statements have been prepared on the same basis as the annual financial statements and include all adjustments, which include only normal recurring adjustments, necessary for the fair presentation of the Company’s financial position as of March 31, 2022 and the Company’s results of operations and cash flows for the three months ended March 31, 2022 and 2021. The interim results are not necessarily indicative of the results for any future interim period or for the entire year.\nBusiness Combination\nThe Company entered into the Merger Agreement with NGA, a special purpose acquisition company, on June 22, 2021. On November 10, 2021, as part of the Business Combination, Merger Sub, a newly formed subsidiary of NGA, merged with and into Embark Trucks. In connection with the consummation of the Business Combination, the separate\n11\ncorporate existence of Merger Sub ceased; Embark Trucks survived and became a wholly owned subsidiary of NGA, which was renamed Embark Technology, Inc.\nThe Business Combination was accounted for as a reverse recapitalization, in accordance with GAAP. Under the guidance in ASC 805, Embark was treated as the “acquired” company for financial reporting purposes. Embark Trucks was deemed the accounting predecessor of the combined business, and Embark Technology, Inc., as the parent company of the combined business, was the successor SEC registrant, meaning that Embark’s financial statements for previous periods will be disclosed in the registrant’s periodic reports filed with the SEC. The Business Combination had a significant impact on Embark’s reported financial position and results as a consequence of the reverse recapitalization. The most significant changes in Embark’s reported financial position and results were a net increase in cash of $ 243.9 million, net of transaction costs for the Business Combination of $ 70.2 million. As of March 31, 2022 and December 31, 2021, the Company had warrant liabilities of $ 27.3 million and $ 49.4 million, respectively.\nLiquidity and Capital Resources\nOn November 10, 2021, Embark consummated the Business Combination, generating net increase in cash of $ 243.9 million, net of transaction costs for the Business Combination of $ 70.2 million.\nThe Company has incurred losses from operations since inception. The Company incurred net losses of $ 18.4 million and $ 8.5 million for the three months ended March 31, 2022 and 2021, respectively, and accumulated deficit amounts to $ 201.4 million and $ 182.9 million as of March 31, 2022 and December 31, 2021, respectively. Net cash used in operating activities was $ 18.2 million and $ 6.8 million for the three months ended March 31, 2022 and 2021, respectively.\nThe Company’s liquidity is based on its ability to enhance its operating cash flow position, obtain capital financing from equity interest investors and borrow funds to fund its general operations, research and development activities and capital expenditures. As of March 31, 2022 and December 31, 2021, the Company’s balance of cash and cash equivalents was $ 244.5 million and $ 264.6 million, respectively.\nBased on cash flow projections from operating and financing activities and existing balance of cash and cash equivalents and investments, management is of the opinion that the Company has sufficient funds for sustainable operations, and it will be able to meet its payment obligations from operations and debt related commitments for at least one year from the issuance date of these financial statements. Based on the above considerations, the Company’s financial statements have been prepared on a going concern basis, which contemplates the realization of assets and liquidation of liabilities during the normal course of operations.\nThe Company’s ability to continue as a going concern is dependent on management’s ability to control operating costs and demonstrate progress against its technical roadmap. This involves developing new capabilities for the Embark Driver software and improving the reliability and performance of the software on public roads. Demonstrating ongoing technical progress will enable the Company to obtain funds from outside sources of financing, including financing from equity interest investors and borrow funds to fund its general operations, research and development activities and capital expenditures.\nEmerging Growth Company\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the independent registered public accounting firm attestation requirements of Section 404 of the Sarbanes- Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies, but\n12\nany such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\nSegment Information\nUnder Accounting Standards Codification (“ASC 280”), Segment Reporting, operating segments are defined as components of an enterprise where discrete financial information is available that is evaluated regularly by the chief operating decision-maker (“CODM”), in deciding how to allocate resources and in assessing performance. The Company operates in one segment, the truck business unit, which is focused on enhancing self-driving truck software technology. Therefore, the Company’s chief executive officer, who is also the CODM, makes decisions and manages the Company’s operations as a single operating segment for purposes of allocating resources and evaluating financial performance. All long-lived assets are maintained in, and all losses are attributable to, the United States of America.\nConcentration of Risks\nEmbark’s financial instruments that are exposed to concentrations of credit risk consist primarily of cash and cash equivalents and restricted cash. Embark maintains its cash and cash equivalents, restricted cash and investments with high-quality financial institutions with investment-grade ratings. A majority of the cash balances are with U.S. banks and are insured to the extent defined by the Federal Deposit Insurance Corporation.\nImpact of COVID-19\nThe outbreak of the novel coronavirus COVID-19, which was declared a global pandemic by the World Health Organization on March 11, 2020 has led to adverse impacts on the U.S. and global economies and has impacted and continues to impact the Company’s supply chain, and operations. Even though the Company has taken measures to adapt to operating in this challenging environment, the pandemic could further affect the Company’s operations and the operations of, partners, suppliers and vendors due to additional shelter- in-place and other governmental orders, facility closures, travel and logistics restrictions, or other factors as circumstances continue to evolve. In response to this pandemic, many jurisdictions in which the Company operates issued stay-at-home orders and other measures aimed at slowing the spread of the virus. While the Company remains open in accordance with guidance from local authorities, the Company experienced a temporary pause in testing of its research and development truck fleet and operations in response to the stay- at-home orders in calendar year 2021. The impacts from stay-at-home orders and other updated local government indoor operation measures are no longer impacting the Company’s operations in 2021, however, there remains uncertainty around the potential disruptions the pandemic could cause looking forward. The Company has instituted policies across its offices to ensure compliance with these updated guidelines. At current, these changes have not impacted the Company’s operations. In response to the Delta and Omicron variants, local governments updated their guidelines for indoor operations. Therefore, the related financial impact and duration cannot be reasonably estimated at this time.\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nUse of Estimates\nThe preparation of financial statements in conformity with GAAP requires management to make certain estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the balance sheet date, as well as reported amounts of expenses during the reporting period.\nThe Company’s most significant estimates and judgments involve the useful lives of long-lived assets, the recoverability of long-lived assets, the incremental borrowing rate (“IBR”) applied in lease accounting, the capitalization of software development costs, the valuation of the Company’s stock-based compensation, including the valuation of warrants to purchase the Company’s stock and the valuation allowance for income taxes. Management bases its estimates on historical experience and on various other assumptions believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results could differ from those estimates.\n13\nCash, Cash Equivalents and Restricted Cash\nThe Company considers all highly liquid investments purchased with original maturities of three months or less to be cash equivalents. As of March 31, 2022 and December 31, 2021, the Company had $ 244.5 million and $ 264.6 million of cash and cash equivalents, respectively.\nThe Company maintains letters of credit to secure leases of the Company’s offices and facilities. A portion of the Company’s cash is collateralized in conjunction with the letter of credit and is classified as restricted cash on the Company’s condensed consolidated balance sheets. As of March 31, 2022 and December 31, 2021, the Company had $ 0.9 million and $ 0.4 million in restricted cash, respectively. At the end of each year of the lease, the face amount of the letter of credit is reduced by a fixed amount of approximately $ 0.1 million and reclassified into cash and cash equivalents on the Company’s condensed consolidated balance sheets. The Company determines short-term or long-term classification based on the expected duration of the restriction.\nThe reconciliation of cash and cash equivalents and restricted cash and cash equivalents to amounts presented in the condensed consolidated statements of cash flows are as follows (in thousands):\n| As of March 31, | As of December 31, |\n| 2022 | 2021 | 2021 |\n| Cash and cash equivalents | 244,488 | 21,562 | 264,615 |\n| Restricted cash, short-term | 65 | 65 | 130 |\n| Restricted cash, long-term | 812 | 340 | 275 |\n| Total cash, cash equivalents and restricted cash | 245,365 | 21,967 | 265,020 |\n\nFair Value of Financial Instruments\nThe Company’s financial instruments consist of cash and cash equivalents, restricted cash, prepaid expenses and other current assets, accounts payable and accrued expenses, short-term and long-term notes payable and other current liabilities. The assets and liabilities that were measured at fair value on a recurring basis are cash equivalents and warrant liabilities. The Company believes that the carrying values of the remaining financial instruments approximate their fair values. The Company applies fair value accounting in accordance with ASC 820, Fair Value Measurements for valuation of financial instruments. ASC 820 provides a framework for measuring fair value under GAAP that expands disclosures about fair value measurements, establishes a fair value hierarchy, and requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The three levels of the fair value hierarchy are summarized as follows:\nLevel 1 — Fair value is based on observable inputs such as quoted prices for identical assets or liabilities in active markets.\nLevel 2 — Fair value is determined using quoted prices for similar assets or liabilities in active markets or quoted prices for identical or similar assets or liabilities in markets that are not active or are directly or indirectly observable.\nLevel 3 — Fair value is determined using one or more significant inputs that are unobservable in active markets at the measurement date, such as an option pricing model, discounted cash flow, or similar technique.\nPublic and Private Warrants\nAs part of NGA’s initial public offering on October 13, 2020, NGA issued to third party investors 41.4 million units, consisting of one share of Class A common stock of NGA and one-third of one warrant, at a price of $ 10.00 per unit. Each whole warrant entitles the holder to purchase one share of Class A common stock at an exercise price of $ 11.50 per share (the \"Public Warrants\"). Further, NGA completed the private sale of 6.7 million warrants to NGA's sponsor at a purchase price of $ 1.50 per warrant (the \"Private Warrants\"). Each Private Warrant allows the sponsor to purchase one share of Class A common stock at $ 11.50 per share. Subsequent to the Business Combination, 13.8 million Public Warrants and 6.7 million Private Warrants remained outstanding as of March 31, 2022.\n14\nThe Private Placement Warrants are identical to the Public Warrants underlying the Units sold in the Initial Public Offering, except that the Private Placement Warrants and the Class A common stock issuable upon the exercise of the Private Placement Warrants did not become transferable, assignable or salable until 30 days after the completion of a Business Combination, subject to certain limited exceptions. Additionally, the Private Placement Warrants are exercisable on a cashless basis and are non-redeemable so long as they are held by the initial purchasers or their permitted transferees. If the Private Placement Warrants are held by someone other than the initial purchasers or their permitted transferees, the Private Placement Warrants are redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants.\nThe Company evaluated the Public and Private Warrants under ASC 815-40, Derivatives and Hedging-Contracts in Entity's Own Equity, and concluded that they do not meet the criteria to be classified in stockholders' equity. Since the Public and Private Warrants meet the definition of a derivative under ASC 815, the Company recorded these warrants as liabilities on the balance sheet at fair value upon the closing of the Business Combination, with subsequent changes in their respective fair values recognized in the condensed consolidated statement of operations and comprehensive income (loss) at each reporting date.\nConvertible Notes and Derivatives\nThe Company accounts for its derivatives in accordance with, ASC 815-10, Derivatives and Hedging, or ASC 815-15, Embedded Derivatives, depending on the nature of the derivative instrument. ASC 815 requires each contract that is not a derivative in its entirety be assessed to determine whether it contains embedded derivatives that are required to be bifurcated and accounted for as a derivative financial instrument. The embedded derivative is bifurcated from the host contract and accounted for as a freestanding derivative if the combined instrument is not accounted for in its entirety at fair value with changes in fair value recorded in earnings, the terms of the embedded derivative are not clearly and closely related to the economic characteristics of the host contract, and a separate instrument with the same terms as the embedded derivative would qualify as a derivative instrument. Embedded derivatives are measured at fair value and remeasured at each subsequent reporting period, and recorded within convertible notes, net on the accompanying Balance Sheets and changes in fair value recorded in other expense within the Statements of Operations. Upon the consummation of the Merger, the related convertible note liability was extinguished. As of March 31, 2022, the Company held no derivative instruments.\nProperty, Equipment and Software\nProperty, equipment and software is stated at cost less accumulated depreciation. Repair and maintenance costs are expensed as incurred. Depreciation and amortization are recorded on a straight-line basis over each asset’s estimated useful life.\n| Property, Equipment and Software | Useful life (years) |\n| Machinery and equipment | 5 years |\n| Electronic equipment | 3 years |\n| Vehicles and vehicle hardware | 3 – 7 years |\n| Leasehold improvements | Shorter of useful life or lease term |\n| Furniture and fixtures | 7 years |\n| Developed software | 2 – 4 years |\n\nLeases\nThe Company determines if a contract contains a lease at inception of the arrangement based on whether the Company has the right to obtain substantially all of the economic benefits from the use of an identified asset and whether the Company has the right to direct the use of an identified asset in exchange for consideration, which relates to an asset which the Company does not own. Right of use (“ROU”) assets represent the Company’s right to use an underlying asset for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from the lease. ROU assets are recognized as the lease liability, adjusted for lease incentives received. Lease liabilities are recognized at the present value of the future lease payments at the lease commencement date. The interest rate used to determine the present value of the future lease payments is the Company’s incremental borrowing rate (“IBR”), because the interest rate implicit in most of its leases is not readily determinable. The IBR is a hypothetical rate based on the Company’s understanding of what its credit rating would be to borrow and resulting interest we would pay to borrow an amount equal to the lease\n15\npayments in a similar economic environment over the lease term on a collateralized basis. Lease payments may be fixed or variable; however, only fixed payments or in-substance fixed payments are included in the Company’s lease liability calculation. Variable lease payments may include costs such as common area maintenance, utilities, real estate taxes or other costs. Variable lease payments are recognized in operating expenses in the period in which the obligation for those payments are incurred.\nOperating leases are included in operating lease ROU assets, operating lease liabilities, current and operating lease liabilities, non-current on the Company’s condensed consolidated balance sheets. For operating leases, lease expense is recognized on a straight-line basis in operations over the lease term. The Company elected the practical expedient not to separate non-lease components from lease components, therefore, the Company accounts for lease and non-lease components as a single lease component. The Company also elected the short-term lease recognition practical expedient for all leases that qualify.\nImpairment of Long-Lived Assets\nThe Company reviews its long-lived assets for impairment annually, or whenever events or circumstances indicate that the carrying amount of an asset may not be fully recoverable. The Company assesses the recoverability of these assets by comparing the carrying amount of such assets or asset group to the future undiscounted cash flows it expects the assets or asset group to generate. The Company recognizes an impairment loss if the sum of the expected long-term undiscounted cash flows that the long-lived asset is expected to generate is less than the carrying amount of the long-lived asset being evaluated.\nIncome Taxes\nThe Company accounts for income taxes using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.\nA valuation allowance is provided when it is more likely than not that some portion or all of a deferred tax asset will not be realized. Due to the Company’s lack of earnings history, the net deferred tax assets have been fully offset by a valuation allowance as of March 31, 2022 and December 31, 2021. Uncertain tax positions taken or expected to be taken in a tax return are accounted for using the more likely than not threshold for financial statement recognition and measurement.\nStock-based Compensation\nStock-based compensation expense related to stock option awards, restricted stock units (“RSUs”) and performance stock units (“PSUs”) granted to employees, directors and non-employees based on estimated grant-date fair values. For stock option awards, the Company uses the straight-line method to allocate compensation expense to reporting periods over each optionee’s requisite service period, which is generally the vesting period, and estimates the fair value of share-based awards to employees and directors using the Black-Scholes option- pricing model. The Black-Scholes model requires the input of subjective assumptions, including expected volatility, expected dividend yield, expected term, risk-free rate of return and the stock price of the underlying common shares on the date of grant. The fair value of each RSU is based on the fair value of the Company’s common stock on the date of grant. The related stock-based compensation is recognized on a graded vesting basis as the RSU awards are associated with a performance condition. For PSU awards, the Company uses the graded vesting to allocate compensation expense, as the PSU awards are associated with market conditions, over the holder’s derived service period, and estimates the fair value of the PSU awards using the Monte Carlo simulation. The Company accounts for the effect of forfeitures as they occur.\nInternal Use Software\nThe Company capitalizes certain costs associated with creating and enhancing internally developed software related to the Company’s technology infrastructure and such costs are recorded within property, equipment and software, net. These costs include personnel and related employee benefit expenses for employees who are directly associated with and who devote time to software development projects. Software development costs that do not qualify for capitalization are expensed as incurred and recorded in research and development expense in the Statements of Operations and comprehensive income (loss).\n16\nSoftware development activities typically consist of three stages: (1) the planning phase; (2) the application and infrastructure development stage; and (3) the post implementation stage. Costs incurred in the planning and post implementation phases, including costs associated with training and repairs and maintenance of the developed technologies, are expensed as incurred. The Company capitalizes costs associated with software developed when the preliminary project stage is completed, management implicitly or explicitly authorizes and commits to funding the project and it is probable that the project will be completed and perform as intended. Costs incurred in the application and infrastructure development phases, including significant enhancements and upgrades, are capitalized. Capitalization ends once a project is substantially complete, and the software is ready for its intended purpose. Software development costs are depreciated using a straight-line method over the estimated useful life, commencing when the software is ready for its intended use. The straight-line recognition method approximates the manner in which the expected benefit will be derived. Internal use software is tested for impairment in accordance with the Company’s long- lived assets impairment policy.\nResearch and Development Expense\nResearch and development expense consist of outsourced engineering services, allocated facilities costs, depreciation, internal engineering and development expenses, materials, labor and stock-based compensation related to development of the Company’s products and services. Research and development costs are expensed as incurred except for amounts capitalized to internal-use software.\nGeneral, and Administrative Expenses\nGeneral, and administrative expense consist of personnel costs, allocated facilities expenses, depreciation and amortization, travel, and business development costs.\nChange in fair value of warrant liability\nChange in fair value of warrant liability represents the change in fair value of Public, Private, Working Capital and Forward Purchase Agreement (“FPA”) Warrants. For each reporting period, Embark will determine the fair value of the warrant liability, and record a corresponding non-cash benefit or non-cash charge, due to a decrease or increase, respectively, in the calculated warrant liability.\nOther Income\nAs part of the Company’s research and development activities, we contract with shippers and freight carriers to transfer freight between the Company’s transfer hubs in return for cash consideration. Transferring freight with the Company’s research and development truck fleet are not and will not be considered an output of the Company’s ordinary activities. Consideration received from such arrangements is presented as other income in the Company’s Condensed Consolidated Statement of Operations.\nInterest Income\nInterest income primarily consists of investment and interest income from marketable securities, long- term investments and the Company’s cash and cash equivalents.\nInterest Expense\nInterest expense consisted primarily of interest on the Company’s various truck financing arrangements.\nNet Loss Per Share\nPrior to the Merger and prior to effecting the recapitalization, the Company had one class of common stock. Subsequent to the Merger, the Company has two classes of common stock: Class A and Class B common stock. The rights of the holders of Class A and Class B common stock are identical, including the liquidation and dividend rights, except with respect to electing members of the Board of Directors and voting rights. As the liquidation and dividend rights are identical, undistributed earnings and losses are allocated on a proportionate basis and the resulting net loss per share attributable to common stockholders are the same for both Class A and Class B common stock on an individual and combined basis.\n17\nBasic and diluted net loss per share attributable to common stockholders is presented in conformity with the two-class method required for participating securities. Net loss is attributed to common stockholders and participating securities based on their participation rights. Net loss attributable to common stockholders is not allocated to the redeemable convertible preferred stock as the holders of the redeemable convertible preferred stock do not have a contractual obligation to share in any losses. No dividends were declared or paid for the three months ended March 31, 2022 and March 31, 2021. No preferred stock was outstanding as of March 31, 2022.\nUnder the two-class method, basic net loss per share attributable to common stockholders is computed by dividing the net loss attributable to common stockholders by the weighted-average number of shares of common stock outstanding during the period.\nDiluted earnings per share attributable to common stockholders adjusts basic earnings per share for the potentially dilutive impact of redeemable convertible preferred stock, stock options, and warrants. As the Company has reported losses for all periods presented, all potentially dilutive securities including preferred stock, stock options, and warrants, are antidilutive and accordingly, basic net loss per share equals diluted net loss per share.\nComprehensive Income (Loss)\nComprehensive income (loss) is defined as the total change in stockholders’ equity during the period other than from transactions with stockholders. Comprehensive income (loss) consists of net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) is comprised of unrealized gains or losses on investments classified as available-for-sale.\nRecently Adopted Accounting Pronouncements\nIn February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which requires lessees to recognize leases on-balance sheet and disclose key information about leasing arrangements. The Company adopted “ASC 842” on January 1, 2022, using the modified retrospective transition method, specifically the \"Comparatives under ASC 840 approach\", and used the effective date as the date of initial application. The Company elected the “package of practical expedients,” which permits Embark not to reassess under ASC 842 its prior conclusions about lease identification, lease classification and initial direct costs. The Company also elected the use of hindsight in determining the lease term and in assessing impairment of the entity’s right-of-use assets. Upon adoption of the new leasing standard on January 1, 2022, the Company recognized right-of-use assets of $ 4.4 million and lease liabilities of $ 4.5 million, respectively, which are related to its various operating leases (Note 10). The difference between the right-of-use assets and lease liabilities is primarily attributed to the elimination of deferred rent. There was no adjustment to the opening balance of accumulated deficit as a result of the adoption of ASC 842.\nIn December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes, which is intended to simplify various aspects related to accounting for income taxes. The adoption of ASU 2019-12 is effective for the Company beginning January 1, 2022. The adoption of this standard did not have a material impact to its financial statements.\nIn May 2021, the FASB issued ASU 2021-04, Modification of equity-classified written call options. ASU 2021-04 provides clarification and reduces diversity in an issuer’s accounting for certain modifications or exchanges of freestanding equity-classified written call options, such as warrants, that remain equity classified after modification or exchange. This guidance will be effective for us on January 1, 2022 with early adoption permitted and will be applied prospectively. The adoption of ASU 2021-04 is effective for the Company beginning January 1, 2022. The adoption of this standard did not have a material impact to its financial statements.\nRecently Issued Accounting Pronouncements\nAs an emerging growth company (“EGC”), the Jumpstart Our Business Startups Act (“JOBS Act”) allows the Company to delay adoption of new or revised accounting pronouncements applicable to public companies until such pronouncements are applicable to private companies. The Company has elected to use this extended transition period under the JOBS Act until such time the Company is no longer considered to be an EGC. The adoption dates discussed below reflect this election.\n18\nIn June 2016, the FASB issued ASU 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses of Financial Instruments, which, together with subsequent amendments, amends the requirement on the measurement and recognition of expected credit losses for financial assets held. ASU 2016-13 is effective for the Company beginning January 1, 2023, with early adoption permitted. The Company is currently in the process of evaluating the effects of this pronouncement on the Company’s financial statements and does not expect it to have a material impact on its consolidated financial statements.\nIn August 2020, the FASB issued ASU 2020-06, Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging — Contracts in Entity’s Own Equity (Subtopic 815- 40): Accounting for convertible instruments and contracts in an entity’s own equity. The ASU simplifies accounting for convertible instruments by removing certain separation models required under current GAAP. The ASU also removes certain settlement conditions that are required for equity contracts to qualify for the derivative scope exception, and it revises the guidance in ASC 260, Earnings Per Share, to require entities to calculate diluted earnings per share for convertible instruments by using the if-converted method. The amendments are effective for the Company beginning January 1, 2024, including interim periods within those fiscal years. Early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. The Company is currently assessing the impact of this standard on its consolidated financial statements.\nIn October 2020, the FASB issued ASU No. 2020-10, Codification Improvements, which updates various codification topics by clarifying or improving disclosure requirements to align with the SEC’s regulations. For the Company, the ASU No. 2020-10 will be effective for annual reporting periods beginning after December 15, 2021 and interim periods within fiscal years beginning after December 15, 2022. The Company is currently evaluating the impact the adoption of this standard on its consolidated financial statements.\n3. BALANCE SHEET COMPONENTS\nPrepaid Expenses and Other Current Assets\nPrepaid expenses and other current assets consisted of the following as of March 31, 2022 and December 31, 2021, respectively (in thousands):\n| March 31,2022 | December 31,2021 |\n| (unaudited) |\n| Prepaid insurance | $ | 6,890 | $ | 7,459 |\n| Prepaid software | 2,224 | 2,564 |\n| Income tax receivable | 494 | 494 |\n| Short-term deposits | 570 | 448 |\n| Prepaid salary | 476 | 279 |\n| Prepaid warrant | 876 | 936 |\n| Other | 475 | 566 |\n| Total prepaid expenses and other current assets | $ | 12,005 | $ | 12,746 |\n\n19\nProperty, Equipment and Software\nProperty, equipment and software consist of the following as of March 31, 2022 and December 31, 2021, respectively (in thousands):\n| March 31,2022 | December 31,2021 |\n| (unaudited) |\n| Machinery and equipment | $ | 406 | $ | 344 |\n| Electronic equipment | 578 | 413 |\n| Vehicles and vehicle hardware | 6,929 | 6,268 |\n| Leasehold improvements | 278 | 258 |\n| Developed software | 6,108 | 5,184 |\n| Other | 27 | 26 |\n| Property, equipment and software, gross | 14,326 | 12,493 |\n| Less: accumulated depreciation and amortization | ( 3,240 ) | ( 2,856 ) |\n| Total property, equipment and software, net | $ | 11,086 | $ | 9,637 |\n\nDepreciation and amortization expense for the three months ended March 31, 2022 and 2021 was $ 0.4 million and $ 0.2 million, respectively.\nOther Assets\nOther assets consist of the following as of March 31, 2022 and December 31, 2021, respectively (in thousands):\n| March 31,2022 | December 31,2021 |\n| (unaudited) |\n| Intangible assets | $ | 3 | $ | 4 |\n| Long-term deposits | 3,719 | 3,592 |\n| Total Other Assets | $ | 3,722 | $ | 3,596 |\n\nAccrued Expenses and Other Current Liabilities\nAccrued expenses and other current liabilities consisted of the following as of March 31, 2022 and December 31, 2021, respectively (in thousands):\n| March 31,2022 | December 31,2021 |\n| (unaudited) |\n| Accrued payroll expenses | $ | 3,189 | $ | 823 |\n| Accrued legal expenses | 696 | 124 |\n| Accrued transaction costs | 1,092 | 1,092 |\n| Other | 1,174 | 1,103 |\n| Total accrued expenses and other current liabilities | $ | 6,151 | $ | 3,142 |\n\n4. FAIR VALUE MEASUREMENTS\n20\nThe carrying value and fair value of the Company’s financial instruments as of March 31, 2022 and December 31, 2021, respectively, are as follows:\n| As of March 31, 2022(in thousands) |\n| Level 1 | Level 2 | Level 3 | Total |\n| (unaudited) |\n| Assets |\n| Cash equivalents: |\n| United States money market funds | $ | 13,349 | $ | — | $ | — | $ | 13,349 |\n| Liabilities |\n| Warrant liabilities - FPA warrants | $ | 760 | $ | — | $ | — | $ | 760 |\n| Warrant liabilities - public warrants | $ | 15,732 | $ | — | $ | — | $ | 15,732 |\n| Warrant liabilities - working capital warrants | $ | — | $ | — | $ | 2,480 | $ | 2,480 |\n| Warrant liabilities - private warrants | $ | — | $ | — | $ | 8,292 | $ | 8,292 |\n\n| As of December 31, 2021(in thousands) |\n| Level 1 | Level 2 | Level 3 | Total |\n| Assets |\n| Cash equivalents: |\n| United States money market funds | $ | 22,349 | $ | — | $ | — | $ | 22,349 |\n| Liabilities |\n| Warrant liabilities - FPA warrants | $ | 1,337 | $ | — | $ | — | $ | 1,337 |\n| Warrant liabilities - public warrants | $ | 27,669 | $ | — | $ | — | $ | 27,669 |\n| Warrant liabilities - working capital warrants | $ | — | $ | — | $ | 4,700 | $ | 4,700 |\n| Warrant liabilities - private warrants | $ | — | $ | — | $ | 15,714 | $ | 15,714 |\n\nAs of March 31, 2022, there was no transfer from Level 2 to Level 3. As of December 31, 2021, transfers from Level 2 to Level 3 of the fair value hierarchy were $ 15.5 million for Private and Public Warrants.\nThe fair value of the above liability classified Public, Private, Working Capital and FPA Warrants have been measured based on the listed market price of such warrants on November 10, 2021. The FPA warrants and public warrants were valued using the public price as of March 31, 2022. The Private and Working Capital warrants were fair valued using the Black Scholes Option Pricing Model as of March 31, 2022. For the three months ended March 31, 2022, the Company recognized income in the condensed consolidated statement of operations resulting from a change in the fair value of warrants of approximately $ 22.2 million, presented as other income (expense) on the accompanying condensed consolidated statement of operations.\n5. STOCKHOLDERS’ EQUITY\nShares Authorized and Issued\nAs of March 31, 2022, the Company had authorized a total of 4,110,000,000 shares for issuance with 4,000,000,000 shares designated as Class A common stock, 100,000,000 shares designated as Class B common stock and 10,000,000 shares designated as preferred stock.\nAs of March 31, 2022, the Company had 362,832,986 issued as Class A common stock and 87,078,981 issued as Class B common stock.\n21\nPreferred Stock\nAs of March 31, 2022, there were 10,000,000 shares of preferred stock authorized and no shares of preferred and founders preferred stock was issued or outstanding. The Company’s preferred stock, as of March 31, 2022, does not contain any mandatory redemption features, nor are they redeemable at the option of the holder.\nClass A and Class B Common Stock\nThe Company’s Board of Directors has authorized two class of common stock, Class A and Class B. Holders of Class A and Class B common stock are not entitled to preemptive or other similar subscription rights to purchase any of Embark Technology’s securities.\nClass A common stock is neither convertible nor redeemable. Class B common stock is convertible into Class A common stock. Unless Embark Technology’s board of directors determines otherwise, Embark Technology will issue all of Embark Technology’s capital stock in certificated form. The Embark Founders held all outstanding shares of Class B common stock up on consummation of the Business Combination.\nIn connection with the merger with NGA on November 10, 2021, the Embark Founders exchanged 87,078,981 shares of Founder's common stock, which were entitled to one vote per share, into the same number of shares of Class B common stock, which are entitled to ten votes per share. The Company recorded the incremental value of $ 13.6 million associated with this transaction as stock-based compensation in general and administrative expenses.\nThe significant rights, privileges and preferences of common stock as of March 31, 2022 are as follows:\nLiquidation Preference\nIf Embark Technology is involved in voluntary or involuntary liquidation, dissolution or winding up of Embark’s affairs, or a similar event, each holder of Embark Common Stock will participate pro rata in all assets remaining after payment of liabilities, subject to prior distribution rights of Embark Technology preferred stock, if any, then outstanding.\nDividends\nEach holder of shares of Embark Common Stock is entitled to the payment of dividends and other distributions as may be declared by the Board from time to time out of Embark’s assets or funds legally available for dividends or other distributions. These rights are subject to the preferential rights of the holders of Embark’s Preferred Stock, if any, and any contractual limitations on Embark’s ability to declare and pay dividends.\nVoting\nEach holder of Class A common stock is entitled to one vote per share on each matter submitted to a vote of stockholders, as provided by the Second Amended and Restated Certificate of Incorporation of Northern Genesis Acquisition Corp. II (the “Charter”). Each holder of Class B common stock is entitled to ten votes per share on each matter submitted to a vote of stockholders, as provided by the Embark Charter. Following the Business Combination, holders of Class B Common Stock have the ability to control the business affairs of Embark. Embark’s Amended and Restated Bylaws (the “Bylaws”) provide that the holders of a majority of the capital stock issued and outstanding and entitled to vote thereat, present in person or represented by proxy, will constitute a quorum at all meetings of the stockholders for the transaction of business. When a quorum is present, the affirmative vote of a majority of the votes cast is required to take action, unless otherwise specified by law, the Bylaws or the Charter, and except for the election of directors, which is determined by a plurality vote. There are no cumulative voting rights.\n6. WARRANTS\n22\nAs of March 31, 2022, the following warrants were issued and outstanding:\n| Description | Classification | Issue Date | Warrants Outstanding | Fair Value Price Per Share | Exercise Price per Share | Expiration |\n| FPA warrants (1) | Liability | November 10, 2021 | 666,663 | $ | 1.14 | $ | 11.50 | November 10, 2026 |\n| Public warrants | Liability | November 10, 2021 | 13,799,936 | $ | 1.14 | $ | 11.50 | November 10, 2026 |\n| Private warrants | Liability | November 10, 2021 | 6,686,667 | $ | 1.24 | $ | 11.50 | November 10, 2026 |\n| Working capital warrants | Liability | November 10, 2021 | 2,000,000 | $ | 1.24 | $ | 11.50 | November 10, 2026 |\n\n(1)FPA are the “Forward Purchase Agreements” entered into, or amended and restated, by NGA on April 21, 2021\nThe Company determined the FPA, Public, Private and Working Capital warrants to be classified as a liability and fair valued the warrants on the issuance date using the publicly available price for the warrants, of $ 41.2 million. The fair value of the FPA and Public warrants were remeasured as of the reporting date with the change in value reflected as part of Other Expense.\nThe fair value of $ 27.3 million of Private and Working Capital warrants was determined using the Black-Scholes option valuation model using the following assumptions for values as of March 31, 2022:\n| Risk – free interest rate | 2.43 % |\n| Expected term (in years) | 4.61 |\n| Expected dividend yield | 0 % |\n| Expected volatility | 45.0 % |\n\nThe Company estimates the volatility of its warrants based on a combination of volatility from the Company’s traded warrants and from historical volatility of select peer company’s common stock that matches the expected remaining life of the warrants. The risk-free interest rate is based on the U.S. Treasury zero-coupon yield curve on the grant date for a maturity similar to the expected remaining life of the warrants. The expected life of the warrants is assumed to be equivalent to their remaining contractual term. The dividend rate is based on the historical rate, which the Company anticipates remaining at zero .\n7. STOCK-BASED COMPENSATION EXPENSE\nStock Option Plan\nIn connection with the Business Combination, the Company adopted the 2021 Incentive Award Plan (the “2021 Plan”), under which the Company grants cash and equity incentive awards to directors, employees (including named executive officers) and consultants in order to attract, motivate and retain the talent for which the Company competes. The Company terminated the 2016 Stock Plan, provided that the outstanding awards previously granted under the 2016 Plan continue to remain outstanding under the 2016 Plan. Under the 2021 Plan, as of March 31, 2022, the Company has authorized to issue a maximum number of 58,713,535 shares of Class A common stock, with annual increases beginning January 1, 2022 and ending on and including January 1, 2031 of 5 % of the aggregate number of shares of Class A common stock outstanding on the last day of the preceding calendar year.\nEmbark Trucks adopted the 2016 Stock Plan in October 2016 (the “2016 Plan”). The 2016 Plan authorized the grant of incentive stock options, non-statutory stock options, and restricted stock awards to employees, directors, and consultants. The 2016 Plan also initially reserved 993,542 shares of common stock ( 8,941,878 shares post-split in June 2018) for issuance and designated forfeited option shares to be returned to the option reserve. Options may be early exercised and are exercisable for a term of 10 years from the date of grant. As of March 31, 2022, the Company had registered 79,742,504 shares to be reserved for option grants, RSUs and PSUs previously issued under the 2016 Plan. The Company will not issue additional awards under the 2016 Plan.\n23\nStock Option Valuation\nThe Company utilizes the Black-Scholes option pricing model for estimating the fair value of options granted, which requires the input of highly subjective assumptions.\nThe Company calculates the fair value of each option grant on the grant date using the following assumptions:\nExpected Term — The Company uses the simplified method when calculating expected term due to insufficient historical exercise data.\nExpected Volatility — As the Company’s shares are not actively traded, the volatility is based on a benchmark of comparable companies within the automotive and energy storage industries.\nExpected Dividend Yield — The dividend rate used is zero as the Company does not have a history of paying dividends on its common stock and does not anticipate doing so in the foreseeable future.\nRisk-Free Interest Rate — The interest rates used are based on the implied yield available on U.S. Treasury zero-coupon issues with an equivalent remaining term equal to the expected life of the award.\n| Three Months Ended March 31, |\n| 2022 | 2021 |\n| Risk-free interest rate | n/a | 0.55 – 1.10 % |\n| Expected term (in years) | n/a | 5.47 – 6.07 |\n| Expected dividend yield | n/a | 0 % |\n| Expected volatility | n/a | 36.88 – 51.52 % |\n\nThe company did not grant any stock options for the three months ended March 31, 2022.\nOption Activity\nChanges in stock options are as follows:\n| Number ofOutstanding Options | Weighted Average Exercise Price Per Share | WeightedAverageRemaining Contractual Term (years) | AggregateIntrinsic (in thousands) |\n| Outstanding at December 31, 2021 | 25,358,455 | $ | 0.20 | 6.9 | $ | 215,093 |\n| Exercised | ( 3,615,572 ) | 0.11 | $ | 20,770 |\n| Repurchased | 13,984 | 0.29 |\n| Cancelled | ( 277,235 ) | 0.59 |\n| Outstanding at March 31, 2022 | 21,479,632 | $ | 0.21 | 6.7 | $ | 121,910 |\n| Vested and exercisable as of March 31, 2022 | 15,271,274 | $ | 0.13 | 6.0 | $ | 88,014 |\n\nThe aggregate intrinsic value in the above table is calculated as the difference between the estimated fair value of the Company's common stock price and the exercise price of the stock options. The company did not grant any stock options for the three months ended March 31, 2022. The weighted average grant date fair value per share for the stock option grants during the three months ended March 31, 2021 was $ 1.88 . As of March 31, 2022, the total unrecognized compensation related to unvested stock option awards granted was $ 5.02 million, which the Company expects to recognize over a weighted-average period of approximately 2.4 years.\nRestricted Stock Units\nPrior to the Business Combination, Embark Trucks also granted employees RSUs which are subject to performance and service-based vesting conditions. As the Company went public upon the completion of the Business Combination in November 2021, the performance condition had been met. The RSUs generally vest over either a four year period with\n24\n25 % of the awarded vesting after the first-year anniversary and one-thirty sixth of the remainder of the award vesting monthly thereafter. Vesting is contingent upon such employee’s continued service on such vesting date. RSUs are generally subject to forfeiture if employment terminates prior to the release of vesting restrictions. The Company may grant RSUs with different vesting terms from time to time.\nFor the three months ended March 31, 2022, the Company recognized $ 12.9 million stock-based expense associated with such RSUs. For the three months ended March 31, 2021, the Company did not recognize any stock-based expense associated with such RSUs as the performance condition had not been satisfied until November 10, 2021. As of March 31, 2022, there was $ 41.0 million unrecognized stock-based compensation expense related to outstanding RSUs granted to employees, with a weighted-average remaining vesting period of 3.9 years.\nA summary of the Company’s RSU activities and related information is as follows:\n| Number of Shares | Weighted AverageGrant date FairValue Per Share |\n| Balance as of December 31, 2021 | 9,616,774 | $ | 8.44 |\n| Forfeited | ( 111,572 ) | 8.96 |\n| Vested | ( 187,977 ) | 8.36 |\n| Balance as of March 31, 2022 | 9,317,225 | $ | 8.43 |\n\nPerformance Stock Units\nDuring 2021, Embark Trucks granted PSUs to its employees. The PSUs are subject to certain market and performance-based conditions which require the Company to become a registered public company and meet market conditions that are based on the Company achieving six different valuation tranches as derived from the achievement of escalating share price thresholds of $ 20.00 , $ 35.00 , $ 50.00 , $ 65.00 , $ 80.00 and $ 100.00 (calculated based on the 90-day volume weighted average price or, in the event of a change in control, the fair market value based on the terms of such change in control) following the first anniversary of the consummation of the Business Combination. The market condition can be achieved over ten years in relation to the pre-money valuation prior to the Business Combination. Once the performance condition has been achieved or is considered probably of being achieved, the related stock-based compensation is recognized based on a graded attribution method.\nFor the three months ended March 31, 2022, the Company recognized $ 2.6 million stock-based expense associated with such PSUs. For the three months ended March 31, 2021, the Company did not recognize any stock-based expense associated with such PSUs as the performance condition had not been satisfied until November 10, 2021. As of March 31, 2022, there was $ 81.0 million unrecognized stock-based compensation expense related to outstanding PSUs granted to employees, with a weighted-average remaining vesting period of 8.1 years.\nThe Company’s PSUs activity for the three months ended March 31, 2022 was as follows:\n| Number of Shares | Weighted AverageGrant date FairValue Per Share |\n| Balance as of December 31, 2021 | 44,715,756 | $ | 1.97 |\n| Granted | — | — |\n| Forfeited | — | — |\n| Vested | — | — |\n| Balance as of March 31, 2022 | 44,715,756 | $ | 1.97 |\n\nCommon Stock Units\nThe Company is obligated to issue shares of Class A common stock upon the vesting of certain restricted stock awards that resulted from Embark Trucks warrants that were issued prior to the Business Combination. Pursuant to the terms of\n25\nthese warrant awards, the restricted stock awards were issued for services at the time of consummation of the Business Combination, and are subject to service vesting terms, with the shares being subject to cancellation. The pre-Business Combination warrants were exercised in their entirety on a cashless basis, with the unvested shares being excluded from the stockholders’ equity and becoming subject to the service vesting condition going forward. Early exercises are reclassified to additional paid-in capital as the Company’s cancellation right lapses. The number of unvested shares of Class A common stock were 1,347,848 as of March 31, 2022.\nAs of March 31, 2022, there was $ 3.8 million unrecognized stock-based compensation expense related to outstanding Common Stock Units (“CSUs”) granted to non-employees, with a weighted-average remaining vesting period of 2.16 years.\nThe Company's CSUs activity for the three months ended March 31, 2022 was as follows:\n| Number of Shares | Weighted AverageGrant date FairValue Per Share |\n| Balance as of December 31, 2021 | 1,481,065 | $ | 2.48 |\n| Granted | — | — |\n| Forfeited | — | $ | — |\n| Vested | ( 133,217 ) | 2.48 |\n| Balance as of March 31, 2022 | 1,347,848 | $ | 2.48 |\n\nThe following table presents the impact of stock-based compensation expense on the condensed consolidated statements of operations for the three months ended March 31, 2022 and 2021, respectively (in thousands):\n| Three Months Ended March 31, |\n| 2022 | 2021 |\n| Research and development | $ | 3,765 | $ | 311 |\n| General, and administrative | 12,837 | 251 |\n| Total stock-based compensation expense | $ | 16,602 | $ | 562 |\n\nTotal stock-based compensation that was capitalized into internally developed software asset was $ 0.2 million and nil during the three months ended March 31, 2022 and 2021, respectively.\n8. RETIREMENT SAVINGS PLAN\nThe Company sponsored a savings plan available to all eligible employees, which qualifies under Section 401(k) of the Internal Revenue Code. Employees may contribute to the plan amounts of their pre-tax salary subject to statutory limitations. The Company does not currently offer a match and has not provided a match as of March 31, 2022.\n9. NOTES PAYABLE\nOn February 18, 2021 and January 5, 2021, the Company entered into financing agreement to finance the purchase of trucks that the Company utilizes for research and development. The financing agreements consisted of a loan of $ 0.1 million and $ 0.1 million at an interest rate equal to 6.99 % and 7.50 % per annum, with a maturity date of April 1, 2026 and January 19, 2027, respectively. The Company makes equal monthly installment payments over the term of each financing arrangement which are allocated between interest and principal.\nOn February 19, 2018, January 28, 2019, and May 23, 2019, the Company entered into financing agreements to finance the purchase of trucks that the Company utilizes for research and development. The financing agreements consisted of a loan of $ 0.3 million, $ 0.4 million, and $ 0.5 million at an interest rate equal to 8.25 % per annum, with a maturity date of March 5, 2023, February 14, 2024, and June 12, 2024, respectively. The Company makes equal monthly installment payments over the term of each financing arrangement which are allocated between interest and principal.\n26\nThe Company entered into a financing agreement on August 2, 2016 to finance the purchase of trucks that the Company utilizes for research and development. The financing agreements consisted of a loan of $ 0.1 million at an interest rate equal to 12.5 % per annum, with a maturity date of August 9, 2020. The Company makes equal monthly installment payments over the term of the financing arrangement, which is allocated between interest and principal.\nNotes payable as of March 31, 2022 and December 31, 2021 are $ 1.0 million and $ 1.1 million, respectively.\nThe following table presents future payments of principal as of March 31, 2022 (in thousands):\n| Years Ended December 31, | Amounts |\n| 2022 (remaining nine months) | $ | 273 |\n| 2023 | 313 |\n| 2024 | 176 |\n| 2025 | 111 |\n| 2026 and thereafter | 125 |\n| Total future payments | $ | 998 |\n\n10. COMMITMENTS AND CONTINGENCIES\nLegal Proceedings\nThe Company is subject to legal and regulatory actions that arise from time to time in the ordinary course of business. The assessment as to whether a loss is probable or reasonably possible, and as to whether such loss or a range of such loss is estimable, often involves significant judgment about future events. In the opinion of management, all such matters are not expected to have a material effect on the financial position, results of operations or cash flows of the Company. However, the outcome of litigation is inherently uncertain. There is no material pending or threatened litigation against the Company that remains outstanding as of March 31, 2022 and December 31, 2021.\nOperating leases\nThe Company’s leases primarily include corporate offices. The lease term of operating leases vary from less than a year to seven years . The Company has leases that include one or more options to extend the lease term to a total term of ten years as well as options to terminate the lease within one year. The Company’s lease terms may include options to extend or terminate the lease when it is reasonably certain that it will exercise such options. The Company’s lease agreements generally do not contain any residual value guarantees or restrictive covenants.\nThe components of lease expense were as follows (in thousands):\n| Three Months Ended March 31, 2022 |\n| Lease cost |\n| Operating lease cost | $ | 600 |\n| Short-term lease cost (1) | 102 |\n| Total lease cost | $ | 702 |\n\n(1) The Company elected to account for short-term leases in accordance with ASC 842. ASC 842 defines a short-term lease as a lease whose lease term, at commencement, is 12 months or less and that does not include a purchase option whose exercise is reasonable certain. The Company will recognize the lease payments in profit or loss on a straight-line basis over the lease term.\n27\nSupplemental cash flow information related to leases was as follows (in thousands):\n| Three Months Ended March 31, 2022 |\n| Other Information |\n| Cash paid for amounts included in the measurement of lease liabilities: |\n| Operating cash flows used in operating leases | $ | 477 |\n| Right-of-use assets obtained in exchange for lease obligations |\n| Operating lease liabilities | $ | 6,587 |\n\nSupplemental balance sheet information related to leases was as follows (in thousands, except lease term and discount rate):\n| March 31,2022 |\n| Assets |\n| Operating lease right-of-use assets | $ | 6,099 |\n| Liabilities |\n| Operating lease liability, current | $ | 1,948 |\n| Operating lease liability, non-current | $ | 4,438 |\n| Total operating lease liability | $ | 6,386 |\n\n| March 31,2022 |\n| Weighted Average Lease Term (in years) |\n| Operating Leases | 3.38 |\n| Weighted Average Discount Rate |\n| Operating Leases | 5.69 | % |\n\nTotal future minimum lease payments over the term of the lease as of March 31, 2022, are as follows (in thousands):\n| Years Ended December 31, | Operating leases |\n| 2022 (remaining nine months) | 1,723 |\n| 2023 | 2,108 |\n| 2024 | 1,976 |\n| 2025 | 548 |\n| 2026 | 563 |\n| 2027 and thereafter | 142 |\n| Total undiscounted lease payments | $ | 7,060 |\n| Less: imputed interest | ( 674 ) |\n| Total lease liabilities | $ | 6,386 |\n\nAs of March 31, 2022, the Company entered into additional operating leases for an office and a truck transfer point of $ 25.8 million, and $ 0.6 million respectively. These operating leases will commence in fiscal 2022 with lease terms of seven years and five years respectively, and contain options to renew and extend the terms of up to 60 months and 12 for each renewal, respectively.\n28\n11. NET LOSS PER SHARE\nThe following table sets forth the computation of the basic and diluted net loss per share attributable to common stockholders for the three months ended March 31, 2022 and 2021, respectively (in thousands, except share and per share data).\n| Three Months Ended March 31, |\n| 2022 | 2021 |\n| Numerator: |\n| Net loss | $ | ( 18,447 ) | $ | ( 8,482 ) |\n| Net loss attributable to common stockholders | $ | ( 18,447 ) | $ | ( 8,482 ) |\n| Denominator: |\n| Net loss per share attributable to Class A and Class B common stockholders, basic and diluted | $ | ( 0.04 ) | $ | ( 0.18 ) |\n| Weighted-average shares used in computing net loss per share attributable to common stockholders, basic and diluted | 452,623,022 | 47,538,331 |\n| Class A | 365,544,041 | n/a* |\n| Class B | 87,078,981 | n/a* |\n\n*Prior to the Merger and prior to effecting the recapitalization in 2021, the Company had one class of common stock. Subsequent to the Merger, the Company has two classes of common stock: Class A and Class B common stock.\nSince the Company was in a loss position for all periods presented, basic net loss per share is the same as diluted net loss per share for all periods as the inclusion of all potential common shares outstanding would have been anti-dilutive.\nThe following weighted-average outstanding common stock equivalents were excluded from the computation of diluted net loss per share attributable to common stockholders for the periods presented because including them would have been anti-dilutive.\n| March 31, |\n| 2022 | 2021 |\n| Founders Preferred shares | — | 162,558 |\n| Series A-1 convertible preferred shares | — | 3,654,873 |\n| Series A-2 convertible preferred shares | — | 5,372,703 |\n| Series A-3 convertible preferred shares | — | 2,485,296 |\n| Series A-4 convertible preferred shares | — | 590,688 |\n| Series A-5 convertible preferred shares | — | 2,680,236 |\n| Series A-6 convertible preferred shares | — | 3,647,817 |\n| Series A-7 convertible preferred shares | — | 15,139,917 |\n| Series B convertible preferred shares | — | 32,834,601 |\n| Series C convertible preferred shares | — | 20,949,454 |\n| Outstanding options | 21,479,632 | 8,975,275 |\n| Warrants issued and outstanding | 23,153,266 | 857,142 |\n| Restricted stock units | 9,317,225 | — |\n| Common stock units | 1,347,848 | — |\n| Performance stock units | 44,715,756 | — |\n| Total | 100,013,727 | 97,350,560 |\n\n12. SUBSEQUENT EVENTS\nOn April 1, 2022, Tyler Hardy filed a putative securities class action lawsuit against Embark and certain of our executive officers and the former executive officers of Northern Genesis Acquisition Corp., captioned Hardy v. Embark\n29\nTechnology, Inc., et al., Case No. 3:22-cv-02090-JSC, in the United States District Court for the Northern District of California, purportedly on behalf of a class consisting of those who purchased or otherwise acquired Embark common stock between January 12, 2021 and January 5, 2022. The complaint alleges that defendants made false and/or misleading statements in violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. Plaintiff Hardy does not quantify any damages in the complaint, but in addition to attorneys’ fees and costs, seeks to recover damages on behalf of himself and other persons who purchased or otherwise acquired Embark stock during the putative class period at allegedly inflated prices and purportedly sufferance financial harm as a result.\nEmbark disputes the allegations in the above-reference matter, intends to defend the matter vigorously, and believes that the claims are without merit. Legal and regulatory proceedings, including the above-reference matter, may be based on complex claims involving substantial uncertainties and unascertainable damages. Accordingly, it is not possible to determine the probability of loss or estimate damages for the above-referenced matter, and therefore, Embark has not established reserves for this proceeding. When Embark determines that a loss is both probable and reasonable estimable, Embark will record a liability, and, if the liability is material, will disclose the amount of the liability reserved. Given that such proceedings are subject to uncertainty, there can be no assurance that legal proceedings individually or in the aggregate will not have a material adverse effect on our business, results of operations, financial condition or cash flows.\n30\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nYou should read the following discussion and analysis of our financial condition and results of operations together with our condensed consolidated financial statements and the related notes appearing elsewhere in this Quarterly Report on Form 10-Q and the Annual Report. In addition to the historical financial information, this discussion contains forward-looking statements that involve risk, assumptions and uncertainties, such as statements of our plans, objectives, expectations, intentions, forecasts and projections. Our actual results and the timing of selected events could differ materially from those discussed in these forward-looking statements as a result of several factors. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Quarterly Report on Form 10-Q, particularly in the section titled “Forward-Looking Statements” above, and in the section entitled “Risk Factors” in the Annual Report.\nOverview\nEmbark develops technologically advanced autonomous driving software for the truck freight industry and offers a carefully constructed business model that is expected to provide the industry with the most attractive path to adopting autonomous driving. Specifically, Embark has developed a Software as a Service (“SaaS”) platform designed to interoperate with a broad range of truck OEM platforms, forgoing complicated and logistically challenging truck building or hardware manufacturing operations in favor of focusing on a superior driving technology. At scale, domestic fleets will be able to access Embark technology via a subscription software license selected as an option at the time they specify the build of new semi-trucks.\nHeadquartered in San Francisco, California, Embark’s history as the industry’s longest running autonomous truck driving program is replete with technological firsts that include, but are not limited to:\n•the first coast-to-coast autonomous truck drive,\n•the first to reach 100,000 autonomous miles on public roads, and\n•the first to successfully open autonomous transfer points for human- autonomous vehicle (“AV”) handoff.\nEmbark’s founding team includes roboticists and its broader team includes numerous computer scientists, many with advanced degrees and experience at other leading robotics and autonomous vehicle companies and academic programs. Embark intends to rapidly scale its engineering team to build on its industry-leading technology position.\nEmbark has also spent considerable time and effort refining its business model. Embark is initially deploying its technology in a very focused manner, targeting freight highway miles between transfer points located next to metropolitan areas in the lower “Sunbelt” region of the U.S., leaving the “last mile” of driving to and from the transfer points to the industry’s highly skilled human drivers. Embark’s strategy is distinct from other industry players which seek to provide more complicated “end to end” autonomous driving that would entirely displace human drivers and potentially place these companies in competition with the industry’s carriers. Unlike those competitors, Embark anticipates working with the industry’s existing players to help them bring autonomous driving technology to market on their own terms. In addition, Embark believes its solution will be the safest and most reliable in the industry because of its disciplined geographic focus and emphasis on software development, which stands in contrast to Embark’s competitors that focus on multiple markets simultaneously, manufacturing autonomous trucks and/or competing directly with semi-truck OEMs or legacy carriers.\nEmbark currently targets the growing $730 billion U.S. truck freight market, and its initial commercial phase targets 236 billion serviceable miles within this market. The freight industry that Embark serves has had to face significant pressures from the growth of e-commerce and the well-documented shortage of skilled drivers, and therefore has powerful incentives to adopt autonomous driving solutions to both improve capacity and reduce costs. In addition, Embark’s cooperative model has already had traction with many of the industry’s leading fleets.\nThe Business Combination\nEmbark entered into the Merger Agreement with NGA, a special purpose acquisition company, on June 22, 2021. On November 10, 2021, pursuant to the Merger Agreement, Merger Sub, a newly formed subsidiary of NGA, merged with and into Embark Trucks (the “Business Combination”). In connection with the consummation of the Business Combination, the separate corporate existence of Merger Sub ceased; Embark Trucks survived and became a wholly owned subsidiary of NGA, which was renamed Embark Technology, Inc.\n31\nThe Business Combination was accounted for as a reverse recapitalization, in accordance with GAAP. Under the guidance in ASC 805, Embark was treated as the “acquired” company for financial reporting purposes. Embark Trucks was deemed the accounting predecessor of the combined business, and Embark Technology, Inc., as the parent company of the combined business, was the successor SEC registrant, meaning that our financial statements for previous periods will be disclosed in the registrant’s periodic reports filed with the SEC. The Business Combination had a significant impact on Embark’s reported financial position and results as a consequence of the reverse recapitalization. The most significant changes in Embark’s reported financial position and results are a net increase in cash of $243.9 million, net of transaction costs for the Business Combination of $70.2 million. As of March 31, 2022 and December 31, 2021, the Company had warrant liabilities of $27.3 million and $49.4 million, respectively. The Company recorded the change in fair value in warrant liabilities were recorded in the other income (expense) on the condensed consolidated statement of operations.\nAs a result of the Business Combination, Embark became an SEC-registered and Nasdaq-listed company, which required Embark to hire additional personnel and implement procedures and processes to address public company regulatory requirements and customary practices. Embark incurs additional annual expenses as a public company for, among other things, directors’ and officers’ liability insurance, director fees, and additional internal and external accounting, legal and administrative resources.\nRecent Developments Affecting Comparability\nCOVID-19 Impact and the Conflict in Ukraine\nIn March 2020, the World Health Organization declared the 2019 novel coronavirus (“COVID-19”) a global pandemic. In the United States, as part of government-imposed restrictions, Embark was forced to temporarily pause fleet testing and operations in 2020. Embark also implemented a work-from-home policy for most of its non-operations team. However, a select group of workers remained on-site to continue advancing testing work for its test fleet. Since then, Embark has resumed its fleet testing and operations and has increased headcount to match its research and development requirements.\nThe future impact of the COVID-19 pandemic on Embark’s operational and financial performance will depend on certain developments, including the duration and end of the pandemic and the occurrence of future outbreaks from new variants, impact on Embark’s research and development efforts, and effect on Embark’s suppliers, all of which are uncertain and cannot be predicted. Public and private sector policies and initiatives to reduce the transmission of COVID-19 and disruptions to Embark’s operations and the operations of Embark’s third-party suppliers, along with the related global slowdown in economic activity, may result in increased costs. It is possible that the COVID-19 pandemic, the measures that have been taken or that may be taken by the federal, state, local authorities and businesses affected by government-mandated business closures, vaccination mandates and the resulting economic impact may materially and adversely affect Embark’s business, results of operations, cash flows and financial positions.\nWhile we have limited direct business exposure in Russia, Belarus and Ukraine, the Russian military actions and the resulting sanctions could adversely affect the global economy, as well as further disrupt the supply chain. A major disruption in the global economy and supply chain could have a material adverse effect on our business, partners, prospects, financial condition, results of operations, and cash flows. The extent and duration of the military action, sanctions, and resulting market and/or supply disruptions are impossible to predict, but could be substantial.\nKey Factors Affecting Embark’s Operating Performance\nEmbark’s financial condition, results of operations, and future success depend on several factors that present significant opportunities for Embark but also pose risks and challenges, including those set forth the section entitled “Risk Factors” in this quarterly report, the section entitled “Risk Factors” in the Annual Report and in as set forth below:\nEmbark’s Ability to Achieve Key Technical Milestones and Deliver a Commercial Product\nEmbark’s growth will depend on the introduction of Embark Driver and Embark Guardian products which will drive demand from potential customers. Embark has developed a platform agnostic interface, Embark Universal Interface, which will serve as the foundation to utilize Embark Driver and Guardian products in trucks manufactured by a broad range of OEMs. Embark’s ability to introduce its products will be driven by a variety of factors including Embark’s research and development fleet size, the number of autonomous miles driven (measured as the number of miles driven by Embark’s research & development fleet as well as partner fleet autonomous miles), and the ability to provide a safe and sustainable\n32\nsolution based on information gathered from the operation of Embark’s research and development fleet. Embark develops most key technologies in-house to achieve a rapid pace of innovation and tests it extensively through research and development fleet operations. Embark expects an increase in research and development fleet size in the foreseeable future to allow it to strategically focus on innovations, which it believes will help solidify its overall solution to customers and partners. To date, Embark has not generated any revenue and until its products reach commercialization, autonomous miles driven will be comprised of autonomous miles driven by its research and development fleet and the fleet of its partners. Embark believes that as the number of autonomous miles driven increases, the data will continually feed improvements to the platform, allowing it to innovate and introduce new products to the market and increase adoption of its products in the future.\nEmbark’s Ability to Expand its Coverage Map Across the United States\nEmbark’s long-term growth potential will benefit from strategic network expansion across the United States. Network breadth is measured by the number of transfer points on Embark’s coverage map, which are representative of the cities which Embark plans to support. Embark expects to achieve significant network growth by partnering with key real-estate partners which will enable it to quickly bring their properties into its coverage map. Additionally, Embark will partner with carriers and shippers who currently move, or have in the past moved, a significant amount of freight on Embark’s network to add their properties to the network. Embark believes that expanding its network will enable it to create a significant and sustainable competitive advantage. Embark believes that the continued growth of its partnerships will improve user experience and drive more users to its platform, which it believes will allow it to further densify its coverage map and reinforce rapid network growth. Embark will apply a highly scalable model nationally, with a tailored approach to each state, driven by the regulatory environment and local market dynamics. Embark believes that this will allow it to expand rapidly and efficiently across different geographies, while maintaining a high level of control over the specific strategy within each state.\nEmbark’s Ability to Expand its Partner Network\nThe growth of Embark’s business model is focused on driving the adoption of its technical products and maximizing their use across Embark’s partners’ operations. This is achieved by working closely with carrier management teams to prepare them to deploy and scale autonomous trucks. In April 2021, Embark formally announced the Embark Partner Development Program (PDP), which serves as the basis of its partnership network. The PDP is comprised of carriers and shippers from across the freight ecosystem working with Embark to refine and scale Embark’s offerings. Most recently, Embark announced the industry-first Truck Transfer Program to place Embark technology in the hands of Knight-Swift drivers.\nAdoption and Support of Autonomous Technology in the Freight Industry\nEmbark’s business model is supported by a large addressable market that Embark believes will benefit from the introduction of autonomous trucking technology. The freight industry is currently facing significant challenges, notably driver shortages and utilization limitations, which it believes it will address through its product offerings. Embark has identified participants from across the freight ecosystem who have expressed support for Embark’s offerings and the potential solutions they provide to the challenges they are facing.\nWhile Embark has confirmed general market support, the long-term success of its business model is dependent on broad scale adoption and support of autonomous trucking technology. Embark has engaged with notable partners in the freight industry who Embark believes will lead the industry in adopting autonomous vehicle technology. As Embark onboards more partners, it will increase miles driven by partners, which Embark believes will serve to validate its product offerings and generate interest and confidence from other partners. Embark believes customers will be motivated to integrate Embark’s technology to be price competitive with other freight participants who have achieved efficiencies with it.\nKey Components of Embark’s Results of Operations\nThe following discussion describes certain line items in Embark’s condensed consolidated statements of operations.\n33\nOperating Expenses\nOperating expenses consist of research and development expenses and general and administrative expenses. Personnel-related costs are the most significant component of Embark’s operating expenses and include salaries, benefits, and stock-based compensation expenses.\nEmbark’s full-time employee headcount in research and development has grown from 172 as of December 31, 2021 to 242 as of March 31, 2022 and in general and administrative functions has grown from 59 as of December 31, 2021 to 62 as of March 31, 2022. Embark expects to continue to hire new employees to support our growth. The timing of these additional hires could materially affect Embark’s operating expenses in any particular period.\nEmbark expects to continue to invest substantial resources to support its growth and anticipates that each of the following categories of operating expenses will increase in absolute dollar amounts for the foreseeable future.\nResearch and Development Expenses\nResearch and development expenses consist primarily of salaries, employee benefits, stock-based compensation expenses and travel expenses related to Embark’s engineers performing research and development activities to originate, develop and enhance Embark’s products. Additional expenses include consulting charges, component purchases, software licenses and other costs for performing research and development on Embark’s software products.\nGeneral and Administrative Expenses\nGeneral and administrative expenses consist primarily of salaries, employee benefits, stock-based compensation expenses, and travel expenses related to Embark’s executives, finance team, and the administrative employees. They also consists of legal, accounting, consulting, and professional fees, rent and lease expenses pertaining to Embark’s offices, business insurance costs and other costs. Embark expects its general and administrative expenses to increase for the foreseeable future as it scales headcount with the growth of its business, and as a result of operating as a public company, including as a result of compliance with the rules and regulations of the SEC, legal, audit, tax and other administrative and professional services.\nResults of Operations\nThe results of operations presented below should be reviewed in conjunction with the financial statements and notes included elsewhere in this Quarterly Report on Form 10-Q. The following table sets forth Embark’s results of operations data for the periods presented (in thousands):\nComparisons for the three months ended March 31, 2022 and 2021\nThe following table sets forth Embark’s condensed consolidated results of operations data for the periods presented (in thousands):\n| Three Months Ended | $ | % |\n| 2022 | 2021 | Change | Change |\n| Operating expenses: |\n| Research and development | $ | 18,695 | $ | 6,231 | $ | 12,464 | 200.0 | % |\n| General and administrative | 21,926 | 2,290 | 19,636 | 857.5 | % |\n| Total operating expenses | 40,621 | 8,521 | 32,100 | 376.7 | % |\n| Loss from operations | (40,621) | (8,521) | (32,100) | 376.7 | % |\n| Other income, net | 22,174 | 39 | 22,135 | N.M. |\n| Loss before provision for income taxes | (18,447) | (8,482) | (9,965) | 117.5 | % |\n| Provision for income taxes | — | — | — | N.M. |\n| Net loss | $ | (18,447) | $ | (8,482) | $ | (9,965) | 117.5 | % |\n\n_________________________________________________\nN.M. — Percentage change not meaningful\n34\nResearch and Development Expenses\nResearch and development expense increased by $12.5 million in the three months ended March 31, 2022, compared to the three months ended March 31, 2021. The increase was primarily due to $8.8 million higher headcount expenses including stock-based compensation, salaries and employee benefits, related to continued expansion of Embark’s research and development team, a $0.2 million increase in infrastructure expenditure related to increased R&D activities, a $0.3 million increase in prototype truck hardware expenses, a $1.8 million increase in general R&D costs primarily driven by engineering software & subscription costs and a $0.2 million increase in computer and equipment expenditure related to an increase in Embark’s research and development team.\nGeneral and Administrative Expense\nGeneral and administrative expense increased by $19.6 million in the three months ended March 31, 2022, compared to the three months ended March 31, 2021. The increase was primarily due to $16.5 million higher headcount expenses including stock-based compensation, salaries and employee benefits, related to growth in the business, a $0.5 million increase in occupancy expenses related to additional leases, a $0.2 million increase in fleet operation expenses due to increased activity, a $0.6 million increase in insurance expenses and a $0.3 million increase in travel and events expenditure.\nOther income (expense), net\nOther income increased by $22.1 million in the three months ended March 31, 2022 compared to the three months ended March 31, 2021. The increase was primarily due to the change in the estimated fair value of Public, Private, Working Capital and FPA Warrants of $22.2 million.\nLiquidity and Capital Resources\nSince Embark’s inception, it has financed its operations primarily through the sale of shares of common stock and preferred stock.\nIn connection with the Business Combination, a convertible promissory note (the “Convertible Note”) issued by Embark in April 2021 was converted in exchange for 3,774,951 shares of Embark Class A common stock. As of March 31, 2022, Embark had outstanding debt of $1.0 million from a financing of freight trucks that it utilizes for research and development. Embark makes monthly installment payments on its truck financing arrangements. The truck financings have varying maturities between March 2023 and January 2027. Embark’s principal uses of cash in recent periods have been to fund its operations, invest in research and development, repay borrowings, and make investments in accordance with its investments policy.\nEmbark believes existing cash and other components of working capital will be sufficient to meet its needs for at least the next 12 months. Embark’s long-term capital requirements will depend on many factors including timing and extent of spending to support research and development efforts as well as general and administrative activities for the business. If, at any time, Embark determines it requires more capital to execute upon its business plan, and /or that market conditions are favorable, Embark may seek additional equity or debt financing. Additionally, in the event Embark may in the future enter into arrangements to acquire or invest in related products, technologies, software and services, and Embark may need to seek additional equity or debt financing to support such growth. As of March 31, 2022, there were future minimum lease payments of $7.1 million.\nEmbark currently transports shipments using its research and development truck fleet, demonstrating proof of concept and paving the way for commercialization and revenue generating operations in the future. However, Embark has not earned any revenue to date, and had $244.5 million in cash and cash equivalents and an accumulated deficit of $201.4 million as of March 31, 2022. To the extent Embark is unable to commercialize its technology as expected, its liquidity may be negatively impacted.\nEmbark’s ability to continue as a going concern is dependent on management’s ability to control operating costs and demonstrate progress against its technical roadmap. This involves developing new capabilities for the Embark Driver software and improving the reliability and performance of the software on public roads. Demonstrating ongoing technical progress will enable Embark to obtain funds from outside sources of financing, including financing from equity interest investors and borrow funds to fund its general operations, research and development activities and capital expenditures.\n35\nThe following table shows Embark’s cash flows from operating activities, investing activities and financing activities for the stated periods:\n| Three Months Ended March 31, |\n| 2022 | 2021 |\n| Net cash (used in) provided by: | (unaudited) |\n| Operating activities | $ | (18,225) | $ | (6,791) |\n| Investing activities | $ | (1,717) | $ | 17,270 |\n| Financing activities | $ | 287 | $ | 28 |\n\nOperating Activities\nNet cash used in operating activities for the three months ended March 31, 2022 was $18.2 million, an increase of $11.4 million from $6.8 million for the three months ended March 31, 2021. The increase was primarily due to an increase of $10.0 million net loss for the three months ended March 31, 2022 compared to the three months ended March 31, 2021. In addition, the increase was partially attributable to $5.7 million of non-cash adjustments to net loss, including $0.6 million of depreciation and amortization, $22.2 million of change in fair value of warrant liability, as well as $16.0 million of stock-based compensation, and partially offset by $4.2 million net cash increase by changes in Embark’s operating assets and liabilities, which was primarily attributable to accounts payable, accrued expenses and other current liabilities primarily due to overall growth and timing of payables.\nInvesting Activities\nNet cash used in investing activities for the three months ended March 31, 2022 was $1.7 million, a decrease of $19.0 million from $17.3 million of net cash provided by investing activities for the three months ended March 31, 2021. The decrease was primarily due to a decrease of $18.2 million in proceeds received from maturities of investments, and an increase in purchase of property, equipment, and software of $0.7 million.\nFinancing Activities\nNet cash provided by financing activities for the three months ended March 31, 2022 was $0.3 million compared to $28,000 of net cash used in investing activities for the three months ended March 31, 2021. The increase was primarily due to an increase of $0.3 million in proceeds received from the exercise of employee stock options.\nFinancing Arrangements\nThere have been no material changes outside the ordinary course of business in Embark’s financing arrangements as previously disclosed in Embark’s Annual Report.\nOff-Balance Sheet Arrangements\nEmbark did not have any off-balance sheet arrangements as of March 31, 2022.\nCritical Accounting Policies and Significant Management Estimates\nThe preparation financial statements in conformity with generally accepted accounting principles requires management to make judgments, estimates and assumptions in the preparation of Embark’s financial statements and accompanying notes. Actual results could differ from those estimates. There have been no material changes to Embark’s critical accounting policies or estimates during the three months ended March 31, 2022, from those discussed in Embark’s Annual Report.\nRecent Accounting Pronouncements\n36\nFor information on recently issued accounting pronouncements, refer to Note 2. Summary of Significant Accounting Policies in Embark’s condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.\nJOBS Act Accounting Election\nEmbark is an emerging growth company (EGC), as defined in the JOBS Act. Under the JOBS Act, EGCs can delay adopting new or revised accounting standards until such time as those standards apply to private companies. Embark intends to elect to adopt new or revised accounting standards under private company adoption timelines. Accordingly, the timing of Embark’s adoption of new or revised accounting standards will not be the same as other public companies that are not emerging growth companies or that have opted out of using such extended transition period.\nItem 3. Quantitative and Qualitative Disclosures About Market.\nEmbark is exposed to certain market risks as part of its ongoing business operations.\nCredit Risk\nEmbark is exposed to credit risk on its investment portfolio. Investments that potentially subject us to credit risk consist principally of cash and investments in debt securities. Embark places cash and cash equivalents with financial institutions with high credit standing and excess cash in marketable investment grade debt securities.\nInterest Rate Risk\nEmbark is exposed to interest rate risk on its investment portfolio. Investments that potentially subject Embark to interest rate risk consist principally of cash and investments in debt securities. As of March 31, 2022, Embark has cash and cash equivalents of $244.5 million, consisting of U.S. Treasury securities and interest-bearing money market accounts for which the fair market value would be affected by changes in the general level of U.S. interest rates. However, due to the short-term maturities and the low-risk profile of Embark’s investments, an immediate 10% change in interest rates would not have a material effect on the fair market value of its cash, cash equivalents, and investments.\nInflation Risk\nEmbark is exposed to impact of wage inflation, and has experienced wage inflation during 2021. Although wages have increased during 2021, and the continuing supply chain crisis and geopolitical conflict in Ukraine may contribute to continuing inflation, Embark does not believe that inflation has had a material effect on its business, results of operations, or financial condition. If Embark’s costs were to become subject to more significant inflationary pressures before we commercialize and sell our technology, we will not be able to offset such higher costs through price increases. Embark’s inability to do so could harm its business, results of operations, and financial condition.\nItem 4. Controls and Procedures\nEvaluation of Disclosure Controls and Procedures\nOur management, with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, our CEO and CFO concluded that, as of March 31, 2022, due to the material weakness described in the Annual Report, our disclosure controls and procedures were not effective.\nAs disclosed in Part II, Item 9A, “Controls and Procedures” in our Annual Report, we identified a material weakness in our internal control over financial reporting resulting from a lack of sufficient number of qualified personnel within our accounting function who possessed an appropriate level of expertise to effectively perform the following functions:\n•identify, select and apply GAAP sufficiently to provide reasonable assurance that transactions were being appropriately recorded; and\n37\n•assess risk and design appropriate control activities over information technology systems and financial and reporting processes necessary to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements.\nStatus of remediation efforts\nIn response to the material weaknesses identified and described above, our management, with the oversight of the Audit Committee of our Board of Directors, will continue through 2022 to dedicate significant efforts and resources to further improve our control environment and to take steps to remediate these material weaknesses.\nChanges in Internal Control Over Financial Reporting\nExcept for changes in connection with our implementation of the remediation measures or as described above, there were no changes in our internal control over financial reporting during the three months ended March 31, 2022, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n38\nPart II - OTHER INFORMATION\nItem 1. Legal Proceedings\nFrom time to time, Embark may be involved in actions, claims, suits, and other proceedings in the ordinary course of its business. In addition, from time to time, third parties may in the future assert intellectual property infringement claims against Embark in the form of letters and other forms of communication. Litigation or any other legal or administrative proceeding, regardless of the outcome, can result in substantial cost and diversion of its resources, including its management’s time and attention. Such matters are subject to uncertainty and there can be no assurance that such legal proceedings will not have a material adverse effect on our business, the results of operations, financial position or cash flows.\nOn April 1, 2022, Tyler Hardy filed a putative securities class action lawsuit against Embark and certain of our executive officers and the former executive officers of Northern Genesis Acquisition Corp., captioned Hardy v. Embark Technology, Inc., et al., Case No. 3:22-cv-02090-JSC, in the United States District Court for the Northern District of California, purportedly on behalf of a class consisting of those who purchased or otherwise acquired Embark common stock between January 12, 2021 and January 5, 2022. The complaint alleges that defendants made false and/or misleading statements in violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. Plaintiff Hardy does not quantify any damages in the complaint, but in addition to attorneys’ fees and costs, seeks to recover damages on behalf of himself and other persons who purchased or otherwise acquired Embark stock during the putative class period at allegedly inflated prices and purportedly suffered financial harm as a result.\nEmbark disputes the allegations in the above-reference matter, intends to defend the matter vigorously, and believes that the claims are without merit. Legal and regulatory proceedings, including the above-referenced matter, may be based on complex claims involving substantial uncertainties and unascertainable damages. Accordingly, it is not possible to determine the probability of loss or estimate damages for the above-referenced matter, and therefore, Embark has not established reserves for this proceeding. When Embark determines that a loss is both probable and reasonably estimable, Embark will record a liability, and, if the liability is material, will disclose the amount of the liability reserved. Given that such proceedings are subject to uncertainty, there can be no assurance that legal proceedings individually or in the aggregate will not have a material adverse effect on our business, results of operations, financial condition or cash flows.\nItem 1A. Risk Factors\nThere are no material changes to the risk factors discussed in Embark’s Annual Report under the heading “Risk Factors.” You should carefully consider these risks, together with management’s discussion and analysis of Embark’s financial condition and results of operations in conjunction with the condensed consolidated financial statements and the notes thereto included elsewhere in this Quarterly Report on Form 10-Q. If any of the events contemplated should occur, Embark’s business, results of operations, financial condition and cash flows could suffer significantly.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nNone.\nItem 3. Defaults Upon Senior Securities\nNone.\nItem 4. Mine Safety Disclosures\nNot Applicable.\nItem 5. Other Information\nNone.\n39\nItem 6. Exhibits\n| Incorporated by Reference |\n| ExhibitNumber | Description | Form | File No. | Date | Exhibit | Filed Herewith |\n| 2.1+ | Agreement and Plan of Merger, dated as of June 22, 2021, by and among Northern Genesis Acquisition Corp. II, NGAB Merger Sub Inc. and Embark Trucks Inc. | 8-K | 001-39881 | 6/23/2021 | 2.1 |\n| 3.1 | Second Amended and Restated Certificate of Incorporation of Northern Genesis Acquisition Corp. II. | 8-K | 001-39881 | 11/17/2021 | 3.1 |\n| 3.2 | Amended and Restated Bylaws of Embark Technology, Inc. | 8-K | 001-39881 | 11/17/2021 | 3.2 |\n| 4.1 | Specimen Warrant Certificate of Embark Technology, Inc. | S-4 | 333-257647 | 10/13/2021 | 4.5 |\n| 4.2 | Specimen Class A Common Stock Certificate of Embark Technology, Inc. | S-4 | 333-257647 | 10/13/2021 | 4.6 |\n| 4.3 | Warrant Agreement, dated as of January 12, 2021, by and among Northern Genesis Acquisition Corp. II and Continental Stock Transfer & Trust Company, as warrant agent. | 8-K | 001-39881 | 1/19/2021 | 4.1 |\n| 31.1** | Certification of Principal Executive Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | X |\n| 31.2** | Certification of Principal Financial Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | X |\n| 32.1** | Certification of Principal Executive Officer and Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | X |\n| 101.INS | Inline XBRL Instance Document – the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRIL document. | X |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document. | X |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document. | X |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document. | X |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document. | X |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document. | X |\n| 104 | Cover Page Interactive Data File - the cover page interactive data file does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL Document. | X |\n\n________________________\n* Filed herewith.\n** Furnished herewith. The certifications attached as Exhibit 31.1, Exhibit 31.2 and Exhibit 32.1 that accompanies this Quarterly Report on Form 10-Q is deemed furnished and not filed with the Securities and Exchange Commission and is not to be incorporated by reference into any filing of Embark Technology, Inc. under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this Quarterly Report on Form 10-Q, irrespective of any general incorporation language contained in such filing.\n+ Schedules and exhibits have been omitted pursuant to Item 601(b)(2) of Regulation S-K. The Registrant agrees to furnish supplementally a copy of any omitted schedule or exhibit to the SEC upon request.\n40\nSIGNATURES\nPursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the registrant has duly caused this Quarterly Report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized, on May 11, 2022.\n| EMBARK TECHNOLOGY, INC. |\n| By: | /s/ Alex Rodrigues |\n| Name: | Alex Rodrigues |\n| Title: | Chief Executive Officer |\n| (Principal Executive Officer) |\n\n| EMBARK TECHNOLOGY, INC. |\n| By: | /s/ Richard Hawwa |\n| Name: | Richard Hawwa |\n| Title: | Chief Financial Officer |\n| (Principal Financial and Principal Accounting) |\n\n41\n</text>\n\nWhat is the year on year percentage change in the Accumulated Deficit for the first quarter of 2022 compared to the first quarter of 2021?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial Statements\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED BALANCE SHEETS\n\n| June 30, | December 31, |\n| 2023 | 2022 |\n| (unaudited) |\n| Assets |\n| Current Assets |\n| Cash | $ | 810,139 | $ | 300,185 |\n| Accounts receivable, net of allowance of $ 14,600 and $ 21,229 at June 30, 2023 and December 31, 2022, respectively | 58,944 | 106,156 |\n| Accounts receivable - related parties, net of allowance of $ 470,516 and $ 339,503 at June 30, 2023 and December 31, 2022, respectively | 1,075,102 | 1,115,816 |\n| Accounts receivable | 1,075,102 | 1,115,816 |\n| Mortgages receivable, net of allowance $ 55,682 and $ 46,424 at June 30, 2023 and December 31, 2022, respectively | 729,833 | 586,631 |\n| Inventory | 1,960,988 | 1,888,962 |\n| Real estate lots held for sale | 445,412 | 559,487 |\n| Prepaid expenses and other current assets | 423,658 | 461,637 |\n| Total Current Assets | 5,504,076 | 5,018,874 |\n| Long Term Assets |\n| Mortgages receivable, non-current portion, net of allowance of $ 178,541 and $ 150,126 at June 30, 2023 and December 31, 2022, respectively | 3,091,222 | 3,278,617 |\n| Advances to employees | 281,783 | 282,055 |\n| Property and equipment, net | 7,857,485 | 7,621,257 |\n| Operating lease right-of-use asset | 1,335,698 | 1,449,442 |\n| Prepaid foreign taxes, net | 985,470 | 916,823 |\n| Intangible assets, net | 108,967 | 69,787 |\n| Deposits, non-current | 54,713 | 56,130 |\n| Total Assets | $ | 19,219,414 | $ | 18,692,985 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 1 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED BALANCE SHEETS, CONTINUED\n\n| June 30, | December 31, |\n| 2023 | 2022 |\n| (unaudited) |\n| Liabilities and Stockholders’ Equity |\n| Current Liabilities |\n| Accounts payable | $ | 691,739 | $ | 917,270 |\n| Accrued expenses, current portion | 1,258,163 | 1,664,816 |\n| Deferred revenue | 1,368,921 | 1,373,906 |\n| Operating lease liabilities, current portion | 220,416 | 202,775 |\n| Loans payable, current portion | 252,014 | 164,656 |\n| Convertible debt obligations, net, current portion | 3,372,291 | - |\n| Derivative liability, current portion | 2,088,617 |\n| Other current liabilities | 80,200 | 100,331 |\n| Total Current Liabilities | 9,332,361 | 4,423,754 |\n| Long Term Liabilities |\n| Accrued expenses, non-current portion | 81,638 | 66,018 |\n| Operating lease liabilities, non-current portion | 1,212,641 | 1,328,408 |\n| Loans payable, non-current portion | 90,468 | 91,665 |\n| Convertible debt obligations, net, non-current portion | 84,674 | 1,991,459 |\n| Derivative liability | 52,500 | - |\n| Total Liabilities | 10,854,282 | 7,901,304 |\n| Commitments and Contingencies (Note 15) | - | - |\n| Stockholders’ Equity |\n| Preferred stock, 902,670 shares authorized | - | - |\n| Common stock, par value $ 0.01 per share; 150,000,000 shares authorized; 6,809,348 and 3,653,401 shares issued and 6,809,067 and 3,653,120 shares outstanding as of June 30, 2023 and December 31, 2022, respectively | 68,091 | 36,534 |\n| Additional paid-in capital | 144,532,185 | 139,123,642 |\n| Accumulated other comprehensive loss | ( 10,920,361 | ) | ( 10,842,569 | ) |\n| Accumulated deficit | ( 125,268,428 | ) | ( 117,479,571 | ) |\n| Treasury stock, at cost, 281 shares at June 30, 2023 and December 31, 2022 | ( 46,355 | ) | ( 46,355 | ) |\n| Total Stockholders’ Equity | 8,365,132 | 10,791,681 |\n| Total Liabilities and Stockholders’ Equity | $ | 19,219,414 | $ | 18,692,985 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 2 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\n(unaudited)\n\n| 2023 | 2022 | 2023 | 2022 |\n| For the Three Months Ended | For the Six Months Ended |\n| June 30, | June 30, |\n| 2023 | 2022 | 2023 | 2022 |\n| Sales | $ | 710,975 | $ | 405,335 | $ | 1,158,742 | $ | 830,932 |\n| Cost of sales | ( 668,619 | ) | ( 533,466 | ) | ( 961,918 | ) | ( 771,593 | ) |\n| Gross profit (loss) | 42,356 | ( 128,131 | ) | 196,824 | 59,339 |\n| Operating Expenses |\n| Selling and marketing | 213,157 | 333,410 | 447,736 | 505,230 |\n| General and administrative | 1,710,505 | 1,928,892 | 3,467,193 | 3,674,126 |\n| Depreciation and amortization | 104,281 | 49,000 | 213,487 | 95,219 |\n| Total operating expenses | 2,027,943 | 2,311,302 | 4,128,416 | 4,274,575 |\n| Loss from Operations | ( 1,985,587 | ) | ( 2,439,433 | ) | ( 3,931,592 | ) | ( 4,215,236 | ) |\n| Other Expense (Income) |\n| Interest income | ( 64,375 | ) | ( 26,552 | ) | ( 114,719 | ) | ( 30,404 | ) |\n| Interest expense | 1,065,620 | 694,708 | 1,667,912 | 1,452,780 |\n| Other income, related party | ( 75,000 | ) | ( 75,000 | ) | ( 150,000 | ) | ( 150,000 | ) |\n| Loss on extinguishment of debt | 32,094 | 2,105,119 | 416,081 | 2,105,119 |\n| Gains from foreign currency translation | ( 102,916 | ) | ( 43,005 | ) | ( 214,708 | ) | ( 225,927 | ) |\n| Change in fair value of derivative liability | 2,141,117 | - | 2,141,117 | - |\n| Inducement expense | - | 198,096 | - | 198,096 |\n| Total other expense | 2,996,540 | 2,853,366 | 3,745,683 | 3,349,664 |\n| Net Loss | ( 4,982,127 | ) | ( 5,292,799 | ) | ( 7,677,275 | ) | ( 7,564,900 | ) |\n| Net loss attributable to non-controlling interest | - | - | - | 72,261 |\n| Net Loss Attributable to Common Stockholders | $ | ( 4,982,127 | ) | $ | ( 5,292,799 | ) | $ | ( 7,677,275 | ) | $ | ( 7,492,639 | ) |\n| Net Loss per Common Share |\n| Basic and Diluted | $ | ( 0.80 | ) | $ | ( 4.80 | ) | $ | 1.41 | ) | $ | ( 7.59 | ) |\n| Weighted Average Number of Common Shares Outstanding: |\n| Basic and Diluted | 6,236,737 | 1,103,130 | 5,453,539 | 987,109 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 3 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME\n(unaudited)\n\n| 2023 | 2022 | 2023 | 2022 |\n| For the Three Months Ended | For the Six Months Ended |\n| June 30, | June 30, |\n| 2023 | 2022 | 2023 | 2022 |\n| Net loss | $ | ( 4,982,127 | ) | $ | ( 5,292,799 | ) | $ | ( 7,677,275 | ) | $ | ( 7,564,900 | ) |\n| Other comprehensive (loss) income : |\n| Foreign currency translation adjustments | ( 37,993 | ) | 358,056 | ( 77,792 | ) | 621,462 |\n| Comprehensive loss | $ | ( 5,020,120 | ) | $ | ( 4,934,743 | ) | $ | ( 7,755,067 | ) | $ | ( 6,943,438 | ) |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 4 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDER’S EQUITY\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2023\n(unaudited)\n\n| Common Stock | Treasury Stock | Additional Paid-In | Accumulated Other Comprehensive | Accumulated | Total Stockholders’ |\n| Shares | Amount | Shares | Amount | Capital | Loss | Deficit | Equity |\n| Balance - January 1, 2023 | 3,653,401 | $ | 36,534 | 281 | $ | ( 46,355 | ) | $ | 139,123,642 | $ | ( 10,842,569 | ) | $ | ( 117,479,571 | ) | - | - | $ | 10,791,681 |\n| Cumulative effect of change upon adoption of ASU 2016-13 | - | - | - | - | - | - | ( 111,582 | ) | - | - | ( 111,582 | ) |\n| Stock-based compensation: |\n| Options | - | - | - | - | 38,834 | - | - | 38,834 |\n| Restricted stock units | 3,890 | 39 | - | - | 79,383 | - | - | 79,422 |\n| Common stock issued for 401(k) employer matching | 24,160 | 242 | - | - | 32,375 | - | - | 32,617 |\n| Shares issued under the New ELOC, net of offering costs [1] | 364,430 | 3,644 | - | - | 437,765 | - | - | 441,409 |\n| Relative fair value of warrants issued with 2023 Note, net of issuance costs [2] | - | - | - | - | 1,506,319 | - | - | 1,506,319 |\n| Warrants issued for modification of GGH Notes | - | - | - | - | 134,779 | - | - | 134,779 |\n| Reduction of warrant exercise price on new debt issuance | - | - | - | - | 63,502 | - | - | 63,502 |\n| Shares issued upon conversion of debt and interest | 833,333 | 8,333 | - | - | 1,563,220 | - | - | 1,571,553 |\n| Common stock issued for cash in private placement | 591,000 | 5,910 | - | - | 585,090 | - | - | 591,000 |\n| Cashless warrant exercise | 51,305 | 513 | - | - | ( 513 | ) | - | - | - |\n| True-up adjustment | 281 | - | - | - | - | - | - | - |\n| Net loss | - | - | - | - | - | - | ( 2,695,148 | ) | - | - | ( 2,695,148 | ) |\n| Other comprehensive loss | - | - | - | - | - | ( 39,799 | ) | - | ( 39,799 | ) |\n| Balance - March 31, 2023 | 5,521,800 | 55,215 | 281 | ( 46,355 | ) | 143,564,396 | ( 10,882,368 | ) | ( 120,286,301 | ) | - | - | 12,404,587 |\n| Stock-based compensation: |\n| Options | - | - | - | - | 38,834 | - | - | 38,834 |\n| Restricted stock units | - | - | - | - | 74,978 | - | - | 74,978 |\n| Shares issued under the New ELOC, net of offering costs [3] | 458,768 | 4,588 | - | - | 287,009 | - | - | 291,597 |\n| Shares issued upon conversion of debt and interest | 828,780 | 8,288 | - | - | 566,968 | - | - | 575,256 |\n| Net loss | - | - | - | - | - | - | ( 4,982,127 | ) | - | - | ( 4,982,127 | ) |\n| Other comprehensive loss | - | - | - | - | - | ( 37,993 | ) | - | ( 37,993 | ) |\n| Balance - June 30, 2023 | 6,809,348 | $ | 68,091 | 281 | $ | ( 46,355 | ) | $ | 144,532,185 | $ | ( 10,920,361 | ) | $ | ( 125,268,428 | ) | - | - | $ | 8,365,132 |\n\n\n| [1] | Includes gross proceeds of $ 480,670 , less $ 39,261 offering costs |\n\n| [2] | Represents $ 1,609,935 relative fair value of warrants, less $ 103,616 of allocable issuance costs |\n\n| [3] | Includes gross proceeds of $ 316,953 , less $ 25,356 offering costs |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 5 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDER’S EQUITY\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2022\n(unaudited)\n\n| Common Stock | Treasury Stock | Additional Paid-In | Accumulated Other Comprehensive | Accumulated | Gaucho Group Holdings Stockholders’ | Non- controlling | Total Stockholders’ |\n| Shares | Amount | Shares | Amount | Capital | Loss | Deficit | Deficiency | Interest | Equity |\n| Balance - January 1, 2022 | 823,496 | $ | 8,235 | 281 | $ | ( 46,355 | ) | $ | 121,633,826 | $ | ( 11,607,446 | ) | $ | ( 95,726,534 | ) | $ | 14,261,726 | $ | ( 169,882 | ) | $ | 14,091,844 |\n| Stock-based compensation: |\n| Options | - | - | - | - | 72,700 | - | - | 72,700 | 10,354 | 83,054 |\n| Common stock issued for 401(k) employer matching | 1,040 | 10 | - | - | 27,811 | - | - | 27,821 | - | 27,821 |\n| Common stock issued for purchase of minority interest | 86,899 | 869 | - | - | ( 232,658 | ) | - | - | ( 231,789 | ) | 231,789 | - |\n| Common stock issued for acquisition of GDS | 106,952 | 1,070 | - | - | 2,193,583 | - | - | 2,194,653 | - | 2,194,653 |\n| Common stock issued for purchase of domain name | 1,250 | 13 | - | - | 39,587 | - | - | 39,600 | - | 39,600 |\n| Warrants issued for modification of convertible debt principal | - | - | - | - | 731,856 | - | - | 731,856 | - | 731,856 |\n| Net loss | - | - | - | - | - | - | ( 2,199,840 | ) | ( 2,199,840 | ) | ( 72,261 | ) | ( 2,272,101 | ) |\n| Other comprehensive income | - | - | - | - | - | 263,406 | - | 263,406 | - | 263,406 |\n| Balance - March 31, 2022 | 1,019,637 | 10,197 | 281 | ( 46,355 | ) | 124,466,705 | ( 11,344,040 | ) | ( 97,926,374 | ) | 15,160,133 | - | 15,160,133 |\n| Balance | 1,019,637 | 10,197 | 281 | ( 46,355 | ) | 124,466,705 | ( 11,344,040 | ) | ( 97,926,374 | ) | 15,160,133 | - | 15,160,133 |\n| Stock-based compensation: |\n| Options | - | - | - | - | 87,134 | - | - | 87,134 | - | 87,134 |\n| Common stock | 54,214 | 542 | - | - | 524,458 | - | - | 525,000 | - | 525,000 |\n| Shares issued upon conversion of debt and interest | 74,589 | 746 | - | - | 1,521,851 | - | - | 1,522,597 | - | 1,522,597 |\n| Inducement loss on debt conversions | - | - | - | - | 198,096 | - | - | 198,096 | - | 198,096 |\n| Substantial premium on convertible debt | - | - | - | - | 1,683,847 | - | - | 1,683,847 | - | 1,683,847 |\n| Common stock issued for cash, net of offering costs | 50,049 | 500 | - | - | 510,846 | - | - | 511,346 | - | 511,346 |\n| Common stock issued upon exchange of subsidiary stock options | 183,942 | 1,839 | - | - | ( 1,839 | ) | - | - | - | - | - |\n| True up adjustment | 41 | - | - | - | - | - | - | - | - | - |\n| Net loss | - | - | - | - | - | - | ( 5,292,799 | ) | ( 5,292,799 | ) | - | ( 5,292,799 | ) |\n| Other comprehensive income | - | - | - | - | - | 358,056 | - | 358,056 | - | 358,056 |\n| Balance - June 30, 2022 | 1,382,472 | $ | 13,824 | 281 | $ | ( 46,355 | ) | $ | 128,991,098 | $ | ( 10,985,984 | ) | $ | ( 103,219,173 | ) | $ | 14,753,410 | $ | - | $ | 14,753,410 |\n| Balance | 1,382,472 | $ | 13,824 | 281 | $ | ( 46,355 | ) | $ | 128,991,098 | $ | ( 10,985,984 | ) | $ | ( 103,219,173 | ) | $ | 14,753,410 | $ | - | $ | 14,753,410 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 6 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(unaudited)\n\n| 2023 | 2022 |\n| For the Six Months Ended |\n| June 30, |\n| 2023 | 2022 |\n| Cash Flows from Operating Activities |\n| Net loss | $ | ( 7,677,275 | ) | $ | ( 7,564,900 | ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: |\n| Stock-based compensation: |\n| 401(k) stock | 5,908 | 22,384 |\n| Common stock | - | 525,000 |\n| Stock options and warrants | 77,668 | 170,188 |\n| Restricted stock units | 154,400 | - |\n| Noncash lease expense | 113,744 | 107,343 |\n| Gain on foreign currency translation | ( 214,708 | ) | ( 225,927 | ) |\n| Depreciation and amortization | 213,487 | 95,219 |\n| Amortization of debt discount | 1,079,034 | 1,061,936 |\n| Provision for credit losses | 57,104 | 28,848 |\n| Provision for obsolete inventory | 99,323 | - |\n| Change in fair value of derivative liability | 2,141,117 |\n| Loss on extinguishment of debt | 416,081 | 2,105,119 |\n| Inducement expense | - | 198,096 |\n| Decrease (increase) in assets: |\n| Accounts receivable and mortgages receivable | ( 126,017 | ) | ( 137,652 | ) |\n| Employee advances | ( 571 | ) | 4,964 |\n| Inventory | ( 57,274 | ) | ( 84,917 | ) |\n| Deposits | 1,417 | - |\n| Prepaid expenses and other current assets | ( 30,668 | ) | ( 201,778 | ) |\n| Increase (decrease) in liabilities: |\n| Accounts payable and accrued expenses | ( 162,671 | ) | 774,709 |\n| Operating lease liabilities | ( 98,126 | ) | ( 82,296 | ) |\n| Deferred revenue | ( 4,985 | ) | 517,741 |\n| Other liabilities | ( 20,131 | ) | ( 68,633 | ) |\n| Total Adjustments | 3,644,132 | 4,810,344 |\n| Net Cash Used in Operating Activities | ( 4,033,143 | ) | ( 2,754,556 | ) |\n| Cash Flow from Investing Activities |\n| Cash paid to acquire Gaucho Development S.R.L., net of cash acquired | - | ( 7,560 | ) |\n| Purchase of property and equipment | ( 438,895 | ) | ( 1,677,082 | ) |\n| Purchase of intangible asset | ( 50,000 | ) | ( 34,999 | ) |\n| Net Cash Used in Investing Activities | ( 488,895 | ) | ( 1,719,641 | ) |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 7 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED\n(unaudited)\n\n| For the Six Months Ended |\n| June 30, |\n| 2023 | 2022 |\n| Cash Flow from Financing Activities |\n| Proceeds from loans payable | 185,000 | - |\n| Repayments of loans payable | ( 58,718 | ) | ( 53,333 | ) |\n| Proceeds from common stock issued for cash | 591,000 | 511,346 |\n| Proceeds from the issuance of convertible debt | 5,000,000 | - |\n| Financing costs in connection with the issuance of convertible debt | ( 321,803 | ) | - |\n| Repayments of convertible debt obligations | ( 862,541 | ) | - |\n| Redemption premiums paid on convertible debt obligations | ( 156,160 | ) | - |\n| Proceeds from issuance of shares under the New ELOC, net of offering costs [1] | 733,006 | - |\n| Net Cash Provided by Financing Activities | 5,109,784 | 458,013 |\n| Effect of Exchange Rate Changes on Cash | ( 77,792 | ) | 621,462 |\n| Net (Decrease) Increase in Cash | 509,954 | ( 3,394,722 | ) |\n| Cash - Beginning of Period | 300,185 | 3,649,407 |\n| Cash - End of Period | $ | 810,139 | $ | 254,685 |\n| Supplemental Disclosures of Cash Flow Information: |\n| Interest paid | $ | 561,876 | $ | 140,355 |\n| Income taxes paid | $ | - | $ | - |\n| Non-Cash Investing and Financing Activity |\n| Equity issued to satisfy accrued stock-based compensation obligation | $ | 32,617 | $ | 27,821 |\n| Equity issued as consideration for intangible assets | $ | - | $ | 39,600 |\n| Equity issued for purchase of non-controlling interest | $ | - | $ | 231,789 |\n| Equity issued for acquisition of Gaucho Development, S.R.L. | $ | - | $ | 2,194,653 |\n| Warrants issued and debt principal exchanged upon modification of convertible debt | $ | - | $ | 731,856 |\n| Shares issued upon conversion of debt and interest | $ | 2,146,809 | $ | 1,522,597 |\n| Common stock and restricted stock units in GGH issued upon exchange of GGI options | $ | - | $ | 1,576,648 |\n| Cashless warrant exercise | $ | 513 | $ | - |\n| Relative fair value of warrants issued with 2023 Note, net of allocable issuance costs [2] | $ | 1,506,319 | $ | - |\n| Warrants issued and debt principal exchanged upon modification of convertible debt | $ | 63,502 | $ | - |\n\n\n| [1] | Gross proceeds of $ 797,623 , less offering costs of $ 64,617 |\n\n| [2] | Represents $ 1,609,935 relative fair value of warrants, less $ 103,616 in allocable issuance costs |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 8 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\n1. BUSINESS ORGANIZATION AND NATURE OF OPERATIONS\nOrganization and Operations\nThrough its subsidiaries, Gaucho Group Holdings, Inc. (“Company”, “GGH”), a Delaware corporation that was incorporated on April 5, 1999, currently invests in, develops, and operates a collection of luxury assets, including real estate development, fine wines, and a boutique hotel in Argentina, as well as an e-commerce platform for the sale of high-end fashion and accessories.\nAs wholly owned subsidiaries of GGH, InvestProperty Group, LLC (“IPG”), Algodon Global Properties, LLC (“AGP”) and Gaucho Ventures I – Las Vegas, LLC (“GVI”) operate as holding companies that invest in, develop and operate global real estate and other lifestyle businesses such as wine production and distribution, golf, tennis, and restaurants. GGH operates its properties through its ALGODON® brand. IPG and AGP have invested in two ALGODON® brand projects located in Argentina. The first project is Algodon Mansion, a Buenos Aires-based luxury boutique hotel property that opened in 2010 and is owned by the Company’s subsidiary, The Algodon – Recoleta, SRL (“TAR”). The second project is the redevelopment, expansion and repositioning of a Mendoza-based winery and golf resort property now called Algodon Wine Estates (“AWE”), the integration of adjoining wine producing properties, and the subdivision of a portion of this property for residential development. (“GDS”). GVI is a party to an agreement with LVH Holdings (“LVH”) to develop a project in Las Vegas, Nevada.\nOn February 3, 2022, the Company acquired additional real estate through the acquisition of 100 % ownership in Hollywood Burger Argentina S.R.L., now Gaucho Development S.R.L.\nGGH also manufactures, distributes, and sells high-end luxury fashion and accessories through its subsidiary, Gaucho Group, Inc. (“GGI”). GGH held a 79 % ownership interest in GGI through March 28, 2022, at which time GGH acquired the remaining 21 % ownership interest in GGI. See Non-Controlling Interest, below.\nNon-Controlling interest\nAs a result of a 2019 conversion of certain convertible debt into shares of Gaucho Group, Inc. (“GGI”) common stock, GGI investors obtained a 21 % ownership interest in GGI, which was recorded as a non-controlling interest. The profits and losses of GGI for the period from January 1, 2022 through March 28, 2022 are allocated between the controlling interest and the non-controlling interest in the same proportions as their membership interest. On March 28, 2022, the Company issued 86,899 shares of its common stock to the minority holders of GGI, in exchange for the remaining 21 % ownership of GGI. Consequently, the Company owns 100 % of the outstanding common stock of GGI.\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nThere have been no material changes to the Company’s significant accounting policies as set forth in the Company’s audited consolidated financial statements included in the annual report on Form 10-K for the year ended December 31, 2022, except as disclosed below.\n\n| 9 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nBasis of Presentation\nThe accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information. Accordingly, they do not include all of the information and disclosures required by accounting principles generally accepted in the United States of America for annual financial statements. In the opinion of management, such statements include all adjustments (consisting only of normal recurring items) which are considered necessary for a fair presentation of the unaudited condensed consolidated financial statements of the Company as of June 30, 2023 and for the three and six months ended June 30, 2023 and 2022. The results of operations for the three and six months ended June 30, 2023 are not necessarily indicative of the operating results for the full year. It is suggested that these unaudited condensed consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2022, filed with the Securities and Exchange Commission (“SEC”) on April 17, 2023.\nOn November 4, 2022, the Company effected a reverse stock split in a ratio of 1 share of common stock for 12 issued shares of common stock. As a result of the reverse stock split, prior period shares and per share amounts appearing in the accompanying condensed consolidated financial statements and all references in this Quarterly Report to our common stock, as well as amounts per share of our common stock, have been retroactively restated as if the reverse stock split occurred at the beginning of the period presented.\nGoing Concern and Management’s Liquidity Plans\nThe accompanying condensed consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The condensed financial statements do not include any adjustments relating to the recoverability and classification of asset amounts or the classification of liabilities that might be necessary should the company be unable to continue as a going concern.\nAs of June 30, 2023, the Company had cash and a working capital deficit of approximately $ 810,000 and $ 3.8 million, respectively. During the six months ended June 30, 2023 and 2022, the Company incurred net losses of approximately $ 7.7 million and $ 7.6 million, respectively, and used cash in operating activities of approximately $ 4.0 million and $ 2.8 million, respectively. Further, as of June 30, 2023, approximately $ 4.8 million owed in connection with the Company’s convertible debt matures on February 21, 2024 , and approximately $ 252,000 represents the current portion of the Company’s loans payable which are payable on demand or for which payments are due within twelve months after June 30, 2023. During the six months ended June 30, 2023, the Company funded its operations with proceeds from a convertible debt financing of $ 5.0 million, proceeds of $ 733,000 from draws on the Company’s equity line of credit, $ 185,000 of proceeds from a loan payable and $ 591,000 from the sale of common stock.\n\n| 10 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nThe Company’s operating needs include the planned costs to operate its business, including amounts required to fund working capital and capital expenditures. Based upon projected revenues and expenses, the Company believes that it may not have sufficient funds to operate for the next twelve months from the date these financial statements are made available. Since inception, the Company’s operations have primarily been funded through proceeds received from equity and debt financings. The Company believes it has access to capital resources and continues to evaluate additional financing opportunities. There is no assurance that the Company will be able to obtain funds on commercially acceptable terms, if at all. There is also no assurance that the amount of funds the Company might raise will enable the Company to complete its development initiatives or attain profitable operations. The aforementioned factors raise substantial doubt about the Company’s ability to continue as a going concern for a period of one year from the issuance of these financial statements.\nHighly Inflationary Status in Argentina\nThe Company recorded gains on foreign currency transactions of approximately $ 103,000 and $ 215,000 during the three and six months ended June 30, 2023, respectively, and approximately $ 43,000 and $ 226,000 during the three and six months ended June 30, 2022, respectively, as a result of the net monetary liability position of its Argentine subsidiaries.\nConcentrations\nThe Company maintains cash with major financial institutions. Cash held in US bank institutions is currently insured by the Federal Deposit Insurance Corporation (“FDIC”) up to $ 250,000 at each institution. No similar insurance or guarantee exists for cash held in Argentina bank accounts. There were aggregate uninsured cash balances of approximately $ 519,000 at June 30, 2023, of which approximately $ 378,000 represents cash held in Argentine bank accounts.\nRevenue Recognition\nThe Company recognizes revenue in accordance with ASC Topic 606, Revenue from Contracts with Customers. ASC Topic 606 provides a single comprehensive model to use in accounting for revenue arising from contracts with customers, and gains and losses arising from transfers of non-financial assets including sales of property and equipment, real estate, and intangible assets.\nThe Company earns revenues from the sale of real estate lots, as well as hospitality, food and beverage, other related services, and from the sale of clothing and accessories. The Company recognizes revenue when goods or services are transferred to customers in an amount that reflects the consideration which it expects to receive in exchange for those goods or services. In determining when and how revenue is recognized from contracts with customers, the Company performs the following five-step analysis: (i) identification of contract with customer; (ii) determination of performance obligations; (iii) measurement of the transaction price; (iv) allocation of the transaction price to the performance obligations; and (v) recognition of revenue when (or as) the Company satisfies each performance obligation.\n\n| 11 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nThe following table summarizes the revenue recognized in the Company’s condensed consolidated statements of operations:\nSCHEDULE OF DISAGGREGATION OF REVENUE\n| 2023 | 2022 | 2023 | 2022 |\n| For the Three Months Ended | For the Six Months Ended |\n| June 30, | June 30, |\n| 2023 | 2022 | 2023 | 2022 |\n| Real estate sales | $ | 154,959 | $ | - | $ | 154,959 | $ | 184,658 |\n| Hotel rooms and events | 218,838 | 144,123 | 464,525 | 283,222 |\n| Restaurants | 56,989 | 40,323 | 136,007 | 57,593 |\n| Winemaking | 45,918 | 32,880 | 75,741 | 59,689 |\n| Agricultural | 162,764 | 153,531 | 162,764 | 181,029 |\n| Golf, tennis and other | 29,126 | 28,366 | 56,983 | 53,467 |\n| Clothes and accessories | 42,381 | 6,112 | 107,763 | 11,274 |\n| Total revenues | $ | 710,975 | $ | 405,335 | $ | 1,158,742 | $ | 830,932 |\n\nRevenue from the sale of food, wine, agricultural products, clothes and accessories is recorded when the customer obtains control of the goods purchased. Revenues from hospitality and other services are recognized as earned at the point in time that the related service is rendered, and the performance obligation has been satisfied. Revenues from gift card sales are recognized when the card is redeemed by the customer. The Company does not adjust revenue for the portion of gift card values that is not expected to be redeemed (“breakage”) due to the lack of historical data. Revenue from real estate lot sales is recorded when the lot is deeded, and legal ownership of the lot is transferred to the customer.\nThe timing of the Company’s revenue recognition may differ from the timing of payment by its customers. A receivable is recorded when revenue is recognized prior to payment and the Company has an unconditional right to payment. Alternatively, when payment precedes the provision of the related services, the Company records deferred revenue until the performance obligations are satisfied. Deferred revenues associated with real estate lot sale deposits are recognized as revenues (along with any outstanding balance) when the lot sale closes, and the deed is provided to the purchaser. Other deferred revenues primarily consist of deposits accepted by the Company in connection with agreements to sell barrels of wine, advance deposits received for grapes and other agricultural products, and hotel deposits. Wine barrel and agricultural product advance deposits are recognized as revenues (along with any outstanding balance) when the product is shipped to the purchaser. Hotel deposits are recognized as revenue upon occupancy of rooms, or the provision of services.\nContracts related to the sale of wine, agricultural products and hotel services have an original expected length of less than one year. The Company has elected not to disclose information about remaining performance obligations pertaining to contracts with an original expected length of one year or less, as permitted under the guidance.\n\n| 12 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nAs of June 30, 2023 and December 31, 2022, the Company had deferred revenue of $ 1,368,921 and $ 1,373,906 , respectively, consisting of $ 1,332,695 and $ 1,179,654 , respectively, associated with real estate lot sale deposits, $ 36,225 and $ 44,252 , respectively, related to hotel deposits and $ 0 and $ 150,000 , respectively, related to prepaid management fees received.\nNet Loss per Common Share\nBasic loss per common share is computed by dividing net loss attributable to GGH common stockholders by the weighted average number of common shares outstanding during the period. Diluted loss per common share is computed by dividing net loss attributable to common stockholders by the weighted average number of common shares outstanding, plus the impact of common shares, if dilutive, resulting from the exercise of outstanding stock options and warrants and the conversion of convertible instruments.\nThe following securities are excluded from the calculation of weighted average dilutive common shares because their inclusion would have been anti-dilutive:\nSCHEDULE OF ANTIDILUTIVE SECURITIES EXCLUDED FROM COMPUTATION OF EARNINGS PER SHARE\n| 2023 | 2022 |\n| As of June 30, |\n| 2023 | 2022 |\n| Options | 34,806 | 561,027 |\n| Warrants | 4,839,254 | 2,024,166 |\n| Unvested restricted stock units | 516,277 | - |\n| Convertible debt | 12,516,374 | [1] | 5,479,255 | [2] |\n| Total potentially dilutive shares | 17,906,711 | 8,064,448 |\n\n\n| [1] | Represents shares issuable upon conversion of $ 4,893,983 of convertible debt, $ 734,097 of redemption premium and $ 8,293 of related accrued interest outstanding as of June 30, 2023, at a conversion price of $ 0.4503 per share, which represents the conversion price in effect as of June 30, 2023. The conversion price of such debt is variable and is not subject to a floor price (see Note 10, Convertible Debt Obligations). |\n| [2] | Represents shares issuable upon conversion of principal and interest outstanding in the aggregate amount of $ 5,205,292 at a conversion price of $ 0.95 per share. |\n\nSequencing Policy\nUnder ASC 815, the Company has adopted a sequencing policy, whereby, in the event that reclassification of contracts from equity to assets or liabilities is necessary pursuant to ASC 815 due to the Company’s inability to demonstrate it has sufficient authorized shares as a result of certain securities with a potentially indeterminable number of shares or the Company’s total potentially dilutive shares exceed the Company’s authorized share limit, shares will be allocated on the basis of the earliest issuance date of potentially dilutive instruments, with the earliest grants receiving the first allocation of shares. Pursuant to ASC 815, issuances of securities granted as compensation in a share-based payment arrangement are not subject to the sequencing policy.\n\n| 13 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nDerivative Instruments\nThe Company evaluates its convertible instruments to determine if those contracts or embedded components of those contracts qualify as derivative financial instruments to be separately accounted for in accordance with Topic 815 “Derivatives and Hedging” (“ASC 815”) of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”). The accounting treatment of derivative financial instruments requires that the Company record any bifurcated embedded features at their fair values as of the inception date of the agreement and at fair value as of each subsequent balance sheet date. Any change in fair value is recorded in earnings each period as non-operating, non-cash income or expense. The Company reassesses the classification of its derivative instruments at each balance sheet date. If the classification changes as a result of events during the period, the contract is reclassified as of the date of the event that caused the reclassification. Bifurcated embedded features are recorded upon note issuance at their initial fair values which create additional debt discount to the host instrument.\nRecently Adopted Accounting Pronouncements\nIn June 2016, the FASB issued ASU No. 2016-13 “Financial Instruments – Credit Losses (Topic 326)” and also issued subsequent amendments to the initial guidance under ASU 2018-19, ASU 2019-04, ASU 2019-05 and ASU 2020-02 (collectively Topic 326). Topic 326 requires the measurement and recognition of expected credit losses for financial assets held at amortized cost. This replaces the existing incurred loss model with an expected loss model and requires the use of forward-looking information to calculate credit loss estimates. The Company adopted the provisions of this ASU on January 1, 2023 using the modified retrospective method for all financial assets measured at amortized cost. Results for reporting periods beginning after December 31, 2022 are presented under Topic 326 while prior period amounts continue to be reported in accordance with previously applicable GAAP. The Company recorded an adjustment to accumulated deficit of $ 111,582 as of January 1, 2023 for the cumulative effect of adopting Topic 326.\nReclassifications\nCertain reclassifications have been made to prior period amounts to conform to the current period financial statement presentation.\n3. MORTGAGES RECEIVABLE\nThe Company offers loans to purchasers in connection with the sale of real estate lots. The loans bear interest at 7.2 % per annum and terms generally range from eight to ten years. Principal and interest for each loan is billed and receivable on a monthly basis. The loans are secured by a first mortgage lien on the property purchased by the borrower. Mortgages receivable include the related interest receivable and are presented at amortized cost, less bad debt allowances, in the condensed consolidated financial statements.\nManagement evaluates each loan individually on a quarterly basis, to assess collectability and estimate a reserve for past due amounts. Management recorded an additional provision for uncollectible accounts in the amount of $ 37,673 for the six months ended June 30, 2023. The total allowance for uncollectable mortgages as of June 30, 2023 and December 31, 2022 was $ 234,223 and $ 196,550 , respectively. Past due principal amounts of $ 346,680 and $ 254,683 are included in mortgages, receivable, current as of June 30, 2023 and December 31, 2022, respectively. In the case of each of the past due loans, the Company believes that the value of the collateral exceeds the outstanding balance on the loan, plus accrued interest.\n\n| 14 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nThe following represents the maturities of mortgages receivable as of June 30, 2023:\nSCHEDULE OF MATURITIES OF MORTGAGES RECEIVABLE\n| July 1 through December 31, 2023 | $ | 776,657 |\n| For the years ended December 31, |\n| 2024 | 381,532 |\n| 2025 | 409,927 |\n| 2026 | 440,436 |\n| 2027 | 473,215 |\n| 2028 | 480,227 |\n| Thereafter | 1,093,286 |\n| Gross Receivable | 4,055,278 |\n| Less: Allowance | ( 234,223 | ) |\n| Net Receivable | $ | 3,821,055 |\n\nAs of June 30, 2023 and December 31, 2022, no single borrower had loans outstanding representing more than 10 % of the total balance of mortgages receivable.\nThe Company recorded interest income from mortgages receivable of $ 109,816 and $ 28,654 for the six months ended June 30, 2023 and 2022, respectively. As of June 30, 2023 and December 31, 2022, there is $ 261,919 and $ 185,197 , respectively, of interest receivable included in mortgages receivable on the accompanying condensed consolidated balance sheets.\n4. INVENTORY\nInventory at June 30, 2023 and December 31, 2022 was comprised of the following:\nSCHEDULE OF INVENTORY\n| June 30, 2023 | December 31, 2022 |\n| Vineyard in process | $ | 240,619 | $ | 516,096 |\n| Wine in process | 1,031,823 | 797,862 |\n| Finished wine | 42,370 | 40,735 |\n| Clothes and accessories | 720,569 | 552,581 |\n| Other | 125,665 | 82,423 |\n| Inventory gross | 2,161,046 | 1,989,697 |\n| Less: Reserve for obsolescence | ( 200,058 | ) | ( 100,735 | ) |\n| Total | $ | 1,960,988 | $ | 1,888,962 |\n\nThe Company recorded a provision for obsolete inventory in the amount of $ 93,389 and $ 99,323 during the three and six months ended June 30, 2023, respectively. There was no provision for obsolete inventory recognized during the three and six months ended June 30, 2022.\n\n| 15 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\n5. INTANGIBLE ASSETS\nOn February 3, 2022, the Company purchased the domain name Gaucho.com, in exchange for cash consideration of $ 34,999 and 15,000 shares of common stock valued at $ 39,600 (see Note 14 – Stockholders’ Equity, Common Stock). The domain name is being amortized over its useful life of 15 years.\nOn June 15, 2023, the Company purchased a music video to be used in certain marketing mediums for $ 50,000 in cash. The music video is being amortized over its useful life of 3 years.\nThe Company recognized $ 5,410 and $ 10,819 of amortization expense during the three and six months ended June 30, 2023, respectively, related to the domain name. The Company recognized $ 1,489 and $ 2,072 of amortization expense during the three and six months ended June 30, 2022, respectively, related to the domain name. Future amortization of the Company’s intangible asset is as follows:\nSCHEDULE OF INTANGIBLE ASSETS FUTURE AMORTIZATION\n| July 1 through December 31, 2023 | $ | 10,819 |\n| For the years ended December 31, |\n| 2024 | 21,640 |\n| 2025 | 21,640 |\n| 2026 | 4,973 |\n| 2027 | 4,973 |\n| 2028 | 4,973 |\n| Thereafter | 39,949 |\n| Total | $ | 108,967 |\n\n6. FAIR VALUE OF FINANCIAL INSTRUMENTS\nFair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In determining fair value, the Company often utilizes certain assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and/or the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated, or developed by the Company. The fair value hierarchy ranks the quality and reliability of the information used to determine fair values. Financial assets and liabilities carried at fair value are classified and disclosed in one of the following three categories:\nLevel 1 - Valued based on quoted prices at the measurement date for identical assets or liabilities trading in active markets. Financial instruments in this category generally include actively traded equity securities.\nLevel 2 - Valued based on (a) quoted prices for similar assets or liabilities in active markets; (b) quoted prices for identical or similar assets or liabilities in markets that are not active; (c) inputs other than quoted prices that are observable for the asset or liability; or (d) from market corroborated inputs. Financial instruments in this category include certain corporate equities that are not actively traded or are otherwise restricted.\nLevel 3 - Valued based on valuation techniques in which one or more significant inputs is not readily observable. Included in this category are certain corporate debt instruments, certain private equity investments, and certain commitments and guarantees.\nThe carrying amounts of the Company’s short-term financial instruments including cash, accounts receivable, advances and loans to employees, prepaid taxes and expenses, accounts payable, accrued expenses and other liabilities approximate fair value due to the short-term nature of these instruments. The carrying value of the Company’s loans payable, debt obligations, convertible debt obligations and derivative liability approximate fair value, as they bear terms and conditions comparable to market for obligations with similar terms and maturities.\n\n| 16 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\n7. ACCRUED EXPENSES\nAccrued expenses are comprised of the following:\nSCHEDULE OF ACCRUED EXPENSES\n| June 30, | December 31, |\n| 2023 | 2022 |\n| Accrued compensation and payroll taxes | $ | 542,659 | $ | 652,943 |\n| Accrued taxes payable - Argentina | 189,722 | 270,239 |\n| Accrued interest | 141,303 | 78,368 |\n| Other accrued expenses | 384,479 | 663,266 |\n| Accrued expenses, current | 1,258,163 | 1,664,816 |\n| Accrued payroll tax obligations, non-current | 81,638 | 66,018 |\n| Total accrued expenses | $ | 1,339,801 | $ | 1,730,834 |\n\nOn November 27, 2020, the Company entered into various payment plans, pursuant to which it agreed to pay its Argentine payroll tax obligations over a period of 60 to 120 months. The current portion of payments due under the plan is $ 84,929 and $ 209,938 as of June 30, 2023 and December 31, 2022, respectively, which is included in accrued taxes payable – Argentina, above. The non-current portion of accrued payroll tax obligations represents payments under the plan that are scheduled to be paid after twelve months. The Company incurred interest expense of $ 64,283 and $ 81,587 during the three and six months ended June 30, 2023, respectively, and incurred interest expense of $ 28,690 and $ 33,177 during the three and six months ended June 30, 2022, respectively, related to these payment plans.\n8. DEFERRED REVENUE\nDeferred revenue is comprised of the following:\nSCHEDULE OF DEFERRED REVENUES\n| June 30, 2023 | December 31, 2022 |\n| Real estate lot sales deposits | $ | 1,332,695 | $ | 1,179,654 |\n| Prepaid management fees | - | 150,000 |\n| Other | 36,226 | 44,252 |\n| Total | $ | 1,368,921 | $ | 1,373,906 |\n\n\n| 17 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nThe Company accepts deposits in conjunction with agreements to sell real estate building lots at Algodon Wine Estates in the Mendoza wine region of Argentina. These lot sale deposits are generally denominated in U.S. dollars. The Company received deposits for eleven additional lots and recorded deferred revenues in the amount of $ 308,000 during the six months ended June 30, 2023. Revenue is recorded when the sale closes, and the deeds are issued. The Company recorded the sale of one lot and recorded revenue in the amount of $ 154,959 during the three and six months ended June 30, 2023.\n9. LOANS PAYABLE\nThe Company’s loans payable are summarized below:\nSCHEDULE OF LOANS PAYABLE\n| June 30, | December 31, |\n| 2023 | 2022 |\n| EIDL | $ | 92,527 | $ | 93,541 |\n| 2018 Loan | 40,678 | 111,137 |\n| 2022 Loan | 24,277 | 51,643 |\n| 2023 Loan | 185,000 | - |\n| Total Loans Payable | 342,482 | 256,321 |\n| Less: current portion | 252,014 | 164,656 |\n| Loans Payable, non-current | $ | 90,468 | $ | 91,665 |\n\nOn January 9, 2023, the Company received $ 185,000 in proceeds on the issuance of a one-year, non-convertible promissory note with a February 20, 2024 maturity date. The note bears interest at a rate of 8 % per annum. In addition, during the six months ended June 30, 2023, the Company made principal payments in the amount of $ 42,066 on the 2018 Loan payable, $ 15,638 on the 2022 Loan payable and $ 1,014 on the EIDL loan.\nThe Company incurred interest expense related to the loans payable in the amount of $ 33,248 and $ 36,514 during the three and six months ended June 30, 2023, respectively, and incurred interest expense related to the loans payable in the amount of $ 2,986 and $ 6,378 during the three and six months ended June 30, 2022. Other decreases in loan balances are the result of changes in exchange rates during the period. As of June 30, 2023 and December 31, 2022, there is accrued interest of $ 15,996 and $ 9,437 , respectively, related to the Company’s loans payable.\n\n| 18 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\n10. CONVERTIBLE DEBT OBLIGATIONS\nAmounts owed pursuant to the Company’s convertible debt obligations are as follows:\nSCHEDULE OF CONVERTIBLE NOTES\n| GGH Notes | 2023 Note | Total Principal | Debt Discount | Convertible debt, net of discount |\n| Balance at January 1, 2023 | $ | 1,997,909 | $ | - | $ | 1,997,909 | $ | ( 6,450 | ) | $ | 1,991,459 |\n| Note issued | - | 5,617,978 | 5,617,978 | ( 2,509,601 | ) | 3,108,377 |\n| Debt principal converted to common stock: | ( 1,335,439 | ) | ( 523,925 | ) | ( 1,859,364 | ) | - | ( 1,859,364 | ) |\n| Principal repayments | ( 662,470 | ) | ( 200,071 | ) | ( 862,541 | ) | - | ( 862,541 | ) |\n| Amortization of debt discount | - | - | - | 1,079,034 | 1,079,034 |\n| Balance at June 30, 2023 | $ | - | $ | 4,893,982 | $ | 4,893,982 | $ | ( 1,437,017 | ) | $ | 3,456,965 |\n| Less: current portion | - | 4,773,982 | 4,773,982 | ( 1,401,781 | ) | 3,372,201 |\n| Equals: convertible debt, non-current | $ | - | $ | 120,000 | $ | 120,000 | $ | ( 35,236 | ) | $ | 84,764 |\n\nGGH Convertible Notes\nOn February 2, 2023, the Company and the holders of the remaining GGH Notes entered into a fourth letter agreement (“Letter Agreement #4). Pursuant to Letter Agreement #4, the parties agreed to reduce the conversion price of the GGH Notes to the lower of: (i) the closing sale price on the trading day immediately preceding the conversion date; and (ii) the average closing sale price of the common stock for the five trading days immediately preceding the conversion date. The conversion price is not subject to a floor price. Between February 3 and February 15, 2023, the holders elected to convert $ 1,571,553 in principal and interest, of which $ 1,335,439 , $ 124,049 , and $ 112,065 was principal, interest and premium paid on conversion, into 833,333 shares of common stock at prices ranging from $ 1.45 and $ 2.40 . The premium paid on conversion of the GGH Notes was recorded as a loss on extinguishment.\nOn February 8, 2023, the Company and the holders of the remaining GGH Notes entered into a fifth letter agreement (“Letter Agreement #5). Pursuant to Letter Agreement #5, the parties agreed to extend the maturity date of the notes from February 9, 2023 to February 28, 2023.\nOn February 20, 2023, the Company entered into another exchange agreement (the “Exchange Agreement #4”) with the remaining holders of the GGH Notes, pursuant to which warrants for the purchase up to an aggregate of 150,000 shares of the Company’s common stock at an exercise price of $ 1.00 were issued as consideration for extending the maturity date in connection with Letter Agreement #5. The warrants have a grant date fair value of $ 134,779 and expire on the second anniversary of the date of issuance. Because the value of the new warrants was deemed to be substantial as compared to the $ 662,470 remaining principal of the GGH Notes, the transaction was accounted for as an extinguishment of old notes which were replaced with the new note. The fair value of the warrants was recorded as a loss on extinguishment and is reflected under Other Expense (Income) in the accompanying condensed consolidated statement of operations.\nOn February 21, 2023, the Company redeemed the remaining GGH Notes for $ 905,428 , which includes the $ 662,470 of principal, $ 118,909 of accrued interest and $ 124,049 of redemption premium, the latter of which was charged to extinguishment loss.\n\n| 19 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\n2023 Convertible Note\nOn February 21, 2023, the Company entered into a securities purchase agreement (the “SPA”) with an institutional investor, (the “Investor”) pursuant to which the Company received proceeds of $ 5,000,000 in exchange for a senior secured convertible note (the “2023 Note”) of the Company in the aggregate original principal amount of $ 5,617,978 , and a three-year common stock purchase warrant exercisable into an aggregate of 3,377,099 shares of common stock of the Company at an exercise price equal to $ 1.34 (the “2023 Note Warrant”). In addition to other terms, conditions and rights, both the Company and the Investor have the right to initiate additional closings for up to $ 5 million of cash for additional 2023 Notes and warrants.\nPursuant to the SPA, the exercise price of certain warrants for the purchase of 62,500 common shares exercisable at $ 21.00 per share and warrants for the purchase of 43,814 shares exercisable at $ 6.00 per share was reduced to $ 1.00 per share. The increase in the value of the warrants in the aggregate amount of $ 63,502 as a result of the reduction in exercise price was recorded as debt discount on the 2023 Note.\nThe 2023 Note is convertible into shares of common stock of the Company at a conversion price equal to the lower of (i) $ 1.34 (subject to adjustment for standard anti-dilution events, the non-exempt issuance of common stock for less than $ 1.34 per share and the issuance of additional variable price securities); (ii) the trading price on the day immediately prior to conversion or (iii) the average trading price of the Company’s common stock for the 5 days preceding conversion (collectively the “Conversion Price”), subject to a floor price of $0.27. If the Conversion Price in effect on the date of conversion is less than $ 0.27 , the Investor is entitled to a cash true up payment equal to the difference between the conversion dollar amount and the value of shares issued upon conversion (the “Cash True Up Provision”).\nThe 2023 Note matures on the first anniversary of the issuance date (the “Maturity Date”) and bears interest at a rate of 7 % per annum, which is payable either in cash monthly, or by way of inclusion in the accrued interest in the conversion amount on the conversion date. Interest includes a make-whole amount equal to the additional interest that would accrue if the entire 2023 Note principal remained outstanding through the Maturity Date.\nThe 2023 Note is redeemable at the Company’s election, so long as the Company is not in default, at the greater of (a) 115 % of the conversion amount, or (b) the amount equal to the shares issuable times the greatest closing price from the redemption notice date through the date the Company makes the redemption payment. The minimum redemption amount is $ 500,000 and the Company can only deliver one redemption notice in a 20-day period.\nUpon an event of default on the 2023 Note, the Conversion Price is reduced to the lesser of (a) $1.34 (subject to adjustment as described above); (b) 80% of the volume-weighted average price on the day preceding receipt of the conversion notice; or (c) 80% of the average of the three lowest volume-weighted average prices over the fifteen trading days which precede receipt of the conversion notice, subject to a floor price of $ 0.27 (the “Event of Default Conversion Price”). In addition, the Investor may require the Company to redeem the 2023 Note using the same formula that would be used for a Company-initiated redemption, described above.\nThe Event of Default Conversion Price represents a redemption feature, which was bifurcated from the debt host and recorded as a derivative liability. As of the date of issuance of the 2023 Note, management had estimated that the probability of an event of default was negligible; accordingly, the fair value of the derivative liability was de minimis at the date of issuance.\n\n| 20 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nPursuant to the terms of the 2023 Note, the Company must pay, convert or redeem one quarter of the initial principal, plus any outstanding interest and make-whole amount by each three-month anniversary of the issuance date. As of June 30, 2023, the Company is in default on the 2023 Note as a result of not making the required quarterly payment due on May 21, 2023. Consequently, the Company remeasured the derivative liability and recorded a change in fair value of the derivative liability of $ 2,141,117 during the three and six months ended June 30, 2023.\nThe following table sets forth a summary of the changes in the fair value of the derivative liability that are measured at fair value on a recurring basis:\nSUMMARY OF THE CHANGES IN THE FAIR VALUE OF DERIVATIVE LIABILITIES\n| Balance as of January 1, 2023 | $ | - |\n| Fair value of derivative liability upon issuance of 2023 Note | - |\n| Change in fair value of derivative liability | 2,141,117 |\n| Balance as of June 30, 2023 | 2,141,117 |\n| Less: current portion of derivative liability | 2,088,617 |\n| Equals: derivative liability, non-current portion | $ | 52,500 |\n\nThe Company incurred financing costs of $ 321,803 in connection with the SPA, of which $ 218,187 was allocated to the 2023 Note and recorded as debt discount and $ 103,616 was allocated to the 2023 Note Warrant and charged against additional paid-in capital.\nUpon the issuance of the 2023 Note, the Company recorded a debt discount at issuance in the aggregate amount $ 2,509,601 , consisting of (i) the $ 617,978 difference between the aggregate principal amount of the 2023 Note and the cash proceeds received, (ii) financing costs in the aggregate amount of $ 218,187 , (iii) value of warrant modification of $ 63,502 , and (iv) the $ 1,609,935 relative fair value of the 2023 Note Warrant. The debt discount is being amortized using the effective interest method over the term of the 2023 Note.\nDuring the six months ended June 30, 2023, the Company made redemption payments in the aggregate amount of $ 246,186 related to the 2023 Note, which included principal repayments of $ 200,070 , accrued interest of $ 14,005 and redemption premiums of $ 32,094 . The Company recorded a loss on extinguishment for the amount of redemption premiums paid.\nDuring the three and six months ended June 30, 2023, a total of $ 575,256 , which included principal of $ 523,925 , accrued interest of $ 38,254 and conversion premiums of $ 13,077 , was converted into 828,780 shares at conversion prices between $ 0.46 and $ 0.78 per share.\nInterest Expense on Convertible Debt Obligations\nThe Company incurred total interest expense of $ 987,037 and $ 661,695 related to its convertible debt obligations during the three months ended June 30, 2023 and 2022, respectively. The Company incurred total interest expense of $ 1,553,077 and $ 1,410,926 related to its convertible debt obligations during the six months ended June 30, 2023 and 2022, respectively.\nInterest expense during the three months ended June 30, 2023 and 2022 consists of (i) $ 211,260 and $ 151,200 , respectively, of make-whole interest accrued at 7 % per annum; (ii) $ 58,907 and $ 0 , respectively, of incremental default interest, respectively, and (iv) amortization of debt discount in the amount of $ 716,867 and $ 510,495 , respectively, during the six months ended June 30, 2023.\nInterest expense during the six months ended June 30, 2023 and 2022 consists of (i) $ 415,135 and $ 348,990 , respectively, of make-whole interest accrued at 7 % per annum; (ii) $ 58,907 and $ 0 , respectively, of incremental default interest, respectively, and (iv) amortization of debt discount in the amount of $ 1,079,033 and $ 1,061,936 , respectively, during the six months ended June 30, 2023.\nSee Note 17 - Subsequent Events.\n\n| 21 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\n11. SEGMENT DATA\nThe Company’s financial position and results of operations are classified into three reportable segments, consistent with how the CODM makes decisions about resource allocation and assesses the Company’s performance.\n\n| ● | Real Estate Development, through AWE and TAR, including hospitality and winery operations, which support the ALGODON® brand. |\n| ● | Fashion (e-commerce), through GGI, including the manufacture and sale of high-end fashion and accessories sold through an e-commerce platform. |\n| ● | Corporate, consisting of general corporate overhead expenses not directly attributable to any one of the business segments. |\n\nThe following tables present segment information for the three months ended June 30, 2023 and 2022:\nSCHEDULE OF SEGMENT INFORMATION\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\n| For the Three Months Ended June 30, 2023 | For the Six Months Ended June 30, 2023 |\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\n| Revenues | $ | 670,594 | $ | 40,381 | $ | - | $ | 710,975 | $ | 1,052,979 | $ | 105,763 | $ | - | $ | 1,158,742 |\n| Revenues from Foreign Operations | $ | 670,594 | $ | - | $ | - | $ | 670,594 | $ | 1,052,979 | $ | - | $ | - | $ | 1,052,979 |\n| Loss from Operations | $ | ( 123,767 | ) | $ | ( 463,126 | ) | $ | ( 1,398,694 | ) | $ | ( 1,985,587 | ) | $ | ( 457,771 | ) | $ | ( 955,325 | ) | $ | ( 2,518,496 | ) | $ | ( 3,931,592 | ) |\n\n\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\n| For the Three Months Ended June 30, 2022 | For the Six Months Ended June 30, 2022 |\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\n| Revenues | $ | 399,223 | $ | 6,112 | $ | - | $ | 405,335 | $ | 819,658 | $ | 11,274 | $ | - | $ | 830,932 |\n| Revenues from Foreign Operations | $ | 399,223 | $ | - | $ | - | $ | 399,223 | $ | 819,658 | $ | - | $ | - | $ | 819,658 |\n| Loss from Operations | $ | ( 1,339,272 | ) | $ | ( 341,668 | ) | $ | ( 758,493 | ) | $ | ( 2,439,433 | ) | $ | ( 1,725,125 | ) | $ | ( 700,201 | ) | $ | ( 1,789,910 | ) | $ | ( 4,215,236 | ) |\n\n\n| 22 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nThe following tables present segment information as of June 30, 2023 and December 31, 2022:\n\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\n| As of June 30, 2023 | As of December 31, 2022 |\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\n| Total Property and Equipment, net | $ | 6,586,322 | $ | 1,271,163 | $ | - | $ | 7,857,485 | $ | 6,234,856 | $ | 1,369,205 | $ | 17,196 | $ | 7,621,257 |\n| Total Property and Equipment, net in Foreign Countries | $ | 6,586,322 | $ | - | $ | - | $ | 6,586,322 | $ | 6,234,856 | $ | - | $ | - | $ | 6,234,856 |\n| Total Assets | $ | 14,282,151 | $ | 3,330,807 | $ | 1,606,456 | $ | 19,219,414 | $ | 13,504,914 | $ | 3,522,415 | $ | 1,665,656 | $ | 18,692,985 |\n\n12. RELATED PARTY TRANSACTIONS\nAccounts Receivable – Related Parties\nAs of June 30, 2023 and December 31, 2022 the Company had accounts receivable – related parties of $ 1,075,102 and $ 1,115,816 net of allowances for expected credit losses of $ 470,516 and $ 339,503 , respectively, representing the net realizable value of advances made to, and expense sharing obligations receivable from, separate entities under common management. During the three and six months ended June 30, 2023, the Company made advances in the amount of $ 0 and $ 85,644 , respectively, to the related entities. During the three and six months ended June 30, 2022, the Company made advances in the amount of $ 0 and $ 36,000 , respectively to the related entities. During the three and six months ended June 30, 2023, the Company received repayments in the amount of $ 237,813 and $ 367,813 , respectively, from the related entities. During the three and six months ended June 30, 2022, the Company received repayments in the amount of $ 583,000 and $ 703,000 , respectively, from the related entities. Receivables recorded in the amount of $ 383,529 and $ 417,413 in connection with an expense sharing agreement during the six months ended June 30, 2023 and 2022 are discussed below.\nThe Company recorded credit losses related to accounts receivable, related parties of $ 0 and $ 19,431 during the three and six months ended June 30, 2023, respectively. The Company recorded credit losses of $ 0 during the three and six months ended June 30, 2022. Credit losses are recorded as bad debt expense which is reflected in the general and administrative expenses on the on the accompanying unaudited consolidated statements of operations.\nExpense Sharing\nOn April 1, 2010, the Company entered into an agreement with a Related Party to share expenses such as office space, support staff, professional services, and other operating expenses (the “Related Party ESA”). During the six months ended June 30, 2023 and 2022, the Company recorded a contra-expense of $ 383,529 and $ 417,413 , respectively, related to the reimbursement of general and administrative expenses as a result of the agreement. During the three months ended June 30, 2023 and 2022, the Company recorded a contra-expense of $ 208,103 and $ 189,188 , respectively, related to the reimbursement of general and administrative expenses as a result of the agreement.\n\n| 23 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nManagement Fee Income\nThe Company earns management fees of $ 75,000 per quarter from LVH. A member of the Company’s board of directors is the managing member of SLVH, LLC, and holds a 20 % membership interest in SLVH. SLVH owns 88 % of the limited liability interest of LVH.\nAmendment to LVH Limited Liability Company Agreement\nOn June 30, 2023, the Company through its wholly owned subsidiary, GVI, executed a Fourth Amendment to the Amended and Restated Limited Liability Company Agreement of LVH to extend the outside date for execution of the ground lease from June 30, 2023 to December 29, 2023.\n13. BENEFIT CONTRIBUTION PLAN\nThe Company sponsors a 401(k) profit-sharing plan (“401(k) Plan”) that covers substantially all of its employees in the United States. The 401(k) Plan provides for a discretionary annual contribution, which is allocated in proportion to compensation. In addition, each participant may elect to contribute to the 401(k) Plan by way of a salary deduction.\nA participant is always fully vested in their account, including the Company’s contribution. For the six months ended June 30, 2023 and 2022, the Company recorded a charge associated with its contribution of $ 9,208 and $ 22,384 , respectively. For the three months ended June 30, 2023 and 2022, the Company recorded a charge associated with its contribution of $ 3,300 and $ 3,408 , respectively. This charge has been included as a component of general and administrative expenses in the accompanying condensed consolidated statements of operations. The Company issues shares of its common stock to settle these obligations based on the fair value of its common stock on the date the shares are issued. During the six months ended June 30, 2023, the Company issued 24,160 shares at $ 1.35 per share in satisfaction of $ 32,617 of 401(k) contribution liabilities. During the six months ended June 30, 2022, the Company issued 1,040 shares at $ 26.76 per share in satisfaction of $ 27,821 of 401(k) contribution liabilities.\n14. STOCKHOLDERS’ EQUITY\nCommon Stock\nOn February 2, 2023, the Company issued 51,305 shares of common stock upon the cashless exercise of 134,730 warrants at exercise prices ranging from $ 2.40 and $ 3.82 .\nOn February 10, 2023, the Company sold 591,000 shares of common stock and warrants to purchase 147,750 shares at an exercise price of $ 1.00 for aggregate proceeds of $ 591,000 . The warrants are immediately exercisable and expire two years from the date of issuance.\nDuring the six months ended June 30, 2023, the Company sold an aggregate of 823,198 shares of the Company’s common stock for gross proceeds of $ 797,623 less placement agent fees of $ 64,617 pursuant to a Common Stock Purchase Agreement (the “New ELOC”).\nSee Note 10 – Convertible Debt Obligations for additional details regarding common shares issued during the three and six months ended June 30, 2023.\nAccumulated Other Comprehensive Loss\nFor the three and six months ended June 30, 2023, the Company recorded a loss of $ 37,993 and $ 77,792 , respectively, and for the three and six months ended June 30, 2022, the Company recorded a gain of $ 358,056 and $ 621,462 , respectively, related to foreign currency translation adjustments as accumulated other comprehensive income, primarily related to fluctuations in the Argentine peso to United States dollar exchange rates (see Note 2 – Summary of Significant Accounting Policies, Highly Inflationary Status in Argentina).\n\n| 24 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nWarrants\nA summary of warrant activity during the six months ended June 30, 2023 is presented below:\nSUMMARY OF WARRANTS ACTIVITY\n| Number of Warrants | Weighted Average Exercise Price | Weighted Average Remaining Life in Years | Intrinsic Value |\n| Outstanding, January 1, 2023 | 1,299,135 | $ | 5.77 |\n| Issued | 3,674,849 | 1.31 |\n| Exercised | ( 134,730 | ) | 3.36 |\n| Expired | - | - |\n| Canceled | - | - |\n| Outstanding, June 30, 2023 | 4,839,254 | $ | 2.15 | 2.1 | $ | - |\n| Exercisable, June 30, 2023 | 4,839,254 | $ | 2.15 | 2.1 | $ | - |\n\nSee Common Stock, above, and Note 10 – Convertible Debt Obligations for additional details regarding warrants issued during the six months ended June 30, 2023.\nA summary of outstanding and exercisable warrants as of June 30, 2023 is presented below:\nSCHEDULE OF WARRANTS OUTSTANDING AND EXERCISABLE\n| Warrants Outstanding | Warrants Exercisable |\n| Exercise Price | Exercisable Into | Outstanding Number of Warrants | Weighted Average Remaining Life in Years | Exercisable Number of Warrants |\n| $ | 1.00 | Common Stock | 404,064 | 1.6 | 404,064 |\n| $ | 1.34 | Common Stock | 3,377,099 | 2.7 | 3,377,099 |\n| $ | 3.82 | Common Stock | 454,588 | 0.2 | 454,588 |\n| $ | 6.00 | Common Stock | 602,225 | 0.5 | 602,225 |\n| $ | 90.00 | Common Stock | 1,278 | 2.6 | 1,278 |\n| Total | 4,839,254 | 2.1 | 4,839,254 |\n\n\n| 25 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nRestricted Stock Units\nA summary of RSU activity during the six months ended June 30, 2023 is presented below:\nSCHEDULE OF RESTRICTED STOCK UNITS AND WEIGHTED AVERAGE GRANT DATE FAIR VALUES\n| Weighted Average |\n| Number of | Grant Date Value |\n| RSUs | Per Share |\n| RSUs non-vested January 1, 2023 | 511,500 | $ | 1.16 |\n| Granted | 10,000 | 1.31 |\n| Vested | ( 3,890 | ) | 1.31 |\n| Forfeited | ( 1,333 | ) | 1.16 |\n| RSUs non-vested June 30, 2023 | 516,277 | $ | 1.16 |\n\nOn January 23, 2023, the Company granted 10,000 restricted stock units (“RSUs”) to certain employees and advisors for their service, of which 3,890 RSUs vested on the grant date and 3,055 RSUs will vest on each of the next two anniversaries of the date of the grant.\nDuring the three and six months ended June 30, 2023, the Company recorded stock-based compensation expense of $ 74,978 and $ 154,400 respectively, related to the amortization of RSUs. No expense related to the amortization of RSUs was recorded for the three or six months ended June 30, 2022.\nStock Options\nNo stock options were granted during the six months ended June 30, 2023 or the six months ended June 30, 2022. The following table presents information related to GGH stock options outstanding as of June 30, 2023:\nSCHEDULE OF STOCK OPTION ACTIVITY\n| Weighted | Weighted |\n| Average | Average |\n| Number of | Exercise | Remaining | Intrinsic |\n| Options | Price | Term (Years) | Value |\n| Outstanding, January 1, 2023 | 40,612 | 85.35 |\n| Granted | - | - |\n| Exercised | - | - |\n| Expired | ( 5,806 | ) | 138.60 |\n| Forfeited | - | - |\n| Outstanding, June 30, 2023 | 34,806 | $ | 76.47 | 1.1 | $ | - |\n| Exercisable, June 30, 2023 | 29,698 | $ | 75.78 | 1.0 | $ | - |\n\n\n| 26 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nDuring the three and six months ended June 30, 2023, the Company recorded stock-based compensation expense of $ 38,834 and $ 77,668 , respectively, and during the three and six months ended June 30, 2022, the Company recorded stock-based compensation expense of $ 57,403 and $ 130,103 , respectively, related to the amortization of options for the purchase of GGH common stock.\nThe Company recorded no stock-based compensation expense related to options for the purchase of GGI common stock for the three and six months ended June 30, 2023 as all of the GGI options were exchanged and cancelled as of June 22, 2022. For the three and six months ended June 30, 2022, the Company recorded stock-based compensation expense of $ 29,731 and $ 40,085 , respectively, related to the options for the purchase of GGI common stock.\nStock-based compensation expense is reflected in general and administrative expenses (classified in the same manner as the grantees’ wage compensation) in the accompanying condensed consolidated statements of operations. As of June 30, 2023, there was $ 91,921 of unrecognized stock-based compensation expense related to stock option grants that will be amortized over a weighted average period of 1.1 years.\n15. COMMITMENTS AND CONTINGENCIES\nLegal Matters\nThe Company may be involved in litigation and arbitrations from time to time in the ordinary course of business. At the present time, the Company is not involved in any ongoing litigation. The Company records legal costs associated with loss contingencies as incurred. Settlements are accrued when, and if, they become probable and estimable.\n16. LEASES\nOn April 8, 2021, GGI entered into a lease agreement to lease a retail space in Miami, Florida for 7 years, which expires May 1, 2028 . As of June 30, 2023, the lease had a remaining term of approximately 4.8 years. Lease payments begin at $26,758 per month and escalate 3% every year over the duration of the lease. The Company was granted rent abatements of 15% for the first year of the lease term, and 10% for the second and third year of the lease term. The Company was required to pay a $ 56,130 security deposit.\nAs of June 30, 2023, the Company had no leases that were classified as a financing lease.\nTotal operating lease expense was $ 82,965 and $ 165,931 during the three and six months ended June 30, 2023, respectively, and $ 82,965 and $ 165,931 during the three and six months ended June 30, 2022, respectively. Lease expenses are recorded in general and administrative expenses on the accompanying condensed consolidated statements of operations.\n\n| 27 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nSupplemental cash flow information related to leases was as follows:\nSCHEDULE OF SUPPLEMENTAL CASH FLOWS INFORMATION RELATED TO LEASES\n| For the Six Months Ended June 30, |\n| 2023 | 2022 |\n| Cash paid for amounts included in the measurement of lease liabilities: |\n| Operating cash flows from operating leases | $ | 98,125 | $ | 82,296 |\n| Right-of-use assets obtained in exchange for lease obligations: |\n| Operating leases | $ | - | $ | - |\n| Weighted Average Remaining Lease Term: |\n| Operating leases | 4.8 | 5.8 |\n| Weighted Average Discount Rate: |\n| Operating leases | 7.0 | % | 7.0 | % |\n\nFuture minimum lease commitments are as follows:\nSCHEDULE OF FUTURE MINIMUM LEASE COMMITMENT\n| For the period July 1 through December 31, 2023 | $ | 153,290 |\n| For the years ended December 31, |\n| 2024 | 336,102 |\n| 2025 | 357,881 |\n| 2026 | 368,617 |\n| 2027 | 365,004 |\n| 2028 | 120,463 |\n| Total future minimum lease payments | 1,701,357 |\n| Less: imputed interest | ( 268,300 | ) |\n| Net future minimum lease payments | 1,433,057 |\n| Less: operating lease liabilities, current portion | 220,416 |\n| Operating lease liabilities, non-current portion | $ | 1,212,641 |\n\nThe Company is the lessor of a building and land that it purchased in connection with acquisition of GDS, pursuant to an operating lease which expires on August 31, 2031. At the end of the leases, the lessee may enter into a new lease or return the asset, which would be available to the Company for releasing. The Company recorded lease revenue of $ 10,937 and $ 21,565 during the three and six months ended June 30, 2023, respectively, related to this lease agreement. The Company recorded lease revenue of $ 10,594 and $ 14,339 during the three and six months ended June 30, 2022, respectively, related to this lease agreement.\n17. SUBSEQUENT EVENTS\nThere have been no subsequent events that occurred during the period subsequent to the date of these condensed consolidated financial statements that would require adjustment to our disclosure in the condensed consolidated financial statements as presented, except as described below:\n2023 Convertible Note\nOn July 3, 2023, $ 120,000 of principal, $ 9,979 of interest, and $ 19,467 of premium owed in connection with the 2023 Note were converted into 329,416 shares of common stock of the Company at a conversion price of $ 0.4538 per share.\nOn August 11, 2023, the Company and the Investor entered into a letter agreement pursuant to which, among other things: i) the Investor agreed to forbear from issuing an Event of Default Notice and Event of Default Redemption Notice; (ii) the requirement in the 2023 Note to pay interest monthly in cash is waived for payments due August 1, 2023 through December 31, 2023; (iii) the application of the default interest rate on the 2023 Note is waived for the period from May 21, 2023 through December 31, 2023, (iv) the requirement for the Company to prepay, redeem, or convert one quarter the initial principal owe on the 2023 Note, plus any outstanding interest and make-whole amount by each three-month anniversary of the issuance date.is waived through December 31, 2023; (v) the Company adjusted the exercise price of the 2023 Note Warrant from $1.34 to $0.45; and (vi) the Investor may continue to convert the 2023 Note at the Alternate Conversion Price or at $0.45.\nBoard Compensation\nOn July 14, 2023, the Company issued a total of 270,272 shares at $ 0.555 per share for a total value of $ 150,000 to the non-executive directors of the Company as compensation for service as members of the Board of Directors of the Company for the first half of 2023.\n\n| 28 |\n\n\n\nThe following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and notes thereto included herein. In connection with, and because we desire to take advantage of, the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, we caution readers regarding certain forward-looking statements in the following discussion and elsewhere in this report and in any other statement made by, or on our behalf, whether or not in future filings with the Securities and Exchange Commission. Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results or other developments. Forward looking statements are necessarily based upon estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control and many of which, with respect to future business decisions, are subject to change. These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on our behalf. Words such as “anticipate,” “estimate,” “plan,” “continuing,” “ongoing,” “expect,” “believe,” “intend,” “may,” “will,” “should,” “could,” and similar expressions are used to identify forward-looking statements. We disclaim any obligation to update forward-looking statements.\nUnless the context requires otherwise, references in this document to “GGH”, “we”, “our”, “us” or the “Company” are to Gaucho Group Holdings, Inc. and its subsidiaries.\nPlease note that because we qualify as an emerging growth company and as a smaller reporting company, we have elected to follow the smaller reporting company rules in preparing this Quarterly Report on Form 10-Q.\nOverview\nGaucho Group Holdings, Inc. (“GGH” or the “Company”) positions its e-commerce leather goods, accessories, and fashion brand, Gaucho – Buenos Aires™, as one of luxury, creating a platform for the global consumer to access their piece of Argentine style and high-end products. With a concentration on leather goods, ready-to-wear and accessories, this is the luxury brand in which Argentina finds its contemporary expression. During the first quarter of 2022, the Company launched Gaucho Casa, a Home & Living line of luxury textiles and home accessories, which will be marketed and sold on the Gaucho – Buenos Aires e-commerce platform. Gaucho Casa challenges traditional lifestyle collections with its luxury textiles and home accessories rooted in the singular spirit of the gaucho aesthetic. GGH seeks to grow its direct-to-consumer online products to global markets in the United States, Asia, the United Kingdom, Europe, and Argentina. We intend to focus on e-commerce and scalability of the Gaucho – Buenos Aires and Gaucho Casa brands, as real estate in Argentina is politically sensitive.\nGGH’s goal is to become recognized as the LVMH (“Louis Vuitton Moët Hennessy”) of South America’s leading luxury brands. Through one of its wholly owned subsidiaries, GGH also owns and operates legacy investments in the boutique hotel, hospitality and luxury vineyard property markets. This includes a golf, tennis and wellness resort, as well as an award-winning wine production company concentrating on Malbecs and Malbec blends. Utilizing these wines as its ambassador, GGH seeks to further develop its legacy real estate, which includes developing residential vineyard lots located within its resort.\nAs a result of the COVID-19 pandemic, we terminated the corporate office lease and senior management now works remotely. GGH’s local operations are managed by professional staff with substantial hotel, hospitality and resort experience in Buenos Aires and San Rafael, Argentina.\n\n| 29 |\n\n\nRecent Developments and Trends\nWhile the World Health Organization declared an end to the COVID-19 global health emergency on May 5, 2023, we continue to closely monitor the outbreak of COVID-19 and the related impact on our operations, financial position and cash flows, as well as the impact on our employees. Due to the continued fluidity of this situation, and the magnitude and duration of the pandemic, its impact on our future operations and liquidity remains uncertain as of the date of this report.\nWe have faced, and may continue to face, significant cost inflation, specifically in raw materials and other supply chain costs due to increased demand for raw materials and the broad disruption of the global supply chain associated with the impact of COVID-19. International conflicts or other geopolitical events, including the 2022 Russian invasion of Ukraine, may further contribute to increased supply chain costs due to shortages in raw materials, increased costs for transportation and energy, disruptions in supply chains, and heightened inflation. Further escalation of geopolitical tensions may also lead to changes to foreign exchange rates and financial markets, any of which may adversely affect our business and supply chain, and consequently our results of operation. While there could ultimately be a material impact on the operations and liquidity of the Company, at the time of issuance, the impact could not be determined.\nDuring the three months ended June 30, 2023, the Company and the holder of a senior secured convertible note of the Company (the “2023 Note”) converted an aggregate of $575,256 of principal, interest and conversion premiums, and the Company issued an aggregate of 828,780 shares upon conversion.\nOn June 30, 2023, the Company through its wholly owned subsidiary, Gaucho Ventures I – Las Vegas, LLC (“GVI”), executed a Fourth Amendment to the Amended and Restated Limited Liability Company Agreement of LVH Holdings LLC (“LVH”) to extend the outside date for execution of the ground lease from June 30, 2023 to December 29, 2023.\nOn July 3, 2023, the Company and the holder of the 2023 Note converted an aggregate of $149,446 of principal, interest and conversion premiums and the Company issued an aggregate of 329,416 shares upon conversion.\nOn July 14, 2023, the Company issued a total of 270,272 shares at $0.555 per share for a total value of $150,000 to the non-executive directors of the Company as compensation for service as members of the Board of Directors of the Company for the first half of 2023.\nConsolidated Results of Operations\nThree months ended June 30, 2023 compared to the three months ended June 30, 2022\nOverview\nWe reported a net loss of approximately $5.0 million and $5.3 million for the three months ended June 30, 2023 and 2022, respectively.\nRevenues\nRevenues from operations were approximately $711,000 and $405,000 during the three months ended June 30, 2023 and 2022, respectively, reflecting an increase of approximately $306,000 or 76%. The overall increase in sales was driven by increases in hotel, restaurant and wine revenues of approximately $443,000, an increase of approximately $143,000 in lot sales, an increase of agricultural sales of approximately $178,000, and an increase in clothes, accessories and other sales of approximately $61,000, resulting from the easing of COVID restrictions and the Argentine government’s efforts to promote tourism and revitalize local businesses, and from the opening of our flagship retail store in Miami. These revenue increases were partially offset by a decrease of approximately $519,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\n\n| 30 |\n\n\nGross profit\nWe generated a gross profit of approximately $42,000 for the three months ended June 30, 2023 and a gross loss of approximately $128,000 for the three months ended June 30, 2022, representing an increase in gross profit of approximately $170,000 or 133%, primarily resulting from profits earned from the sale of real estate lots during the period.\nCost of sales, which consists of real estate lots, raw materials, direct labor and indirect labor associated with our business activities, increased by approximately $136,000 or 26%, from approximately $533,000 for the three months ended June 30, 2022 to approximately $669,000 for the three months ended June 30, 2023. The increase in cost of sales resulted from the increases in hotel, restaurant and wine costs of approximately $335,000, an increase in clothes, accessories and other costs of approximately $124,000, and an increase of approximately $102,000 in costs associated with lot sales, which correspond to the increases in the related revenues as discussed above. In addition, a higher number of agricultural sales, which are sold at a loss, provided an increase of approximately $199,000 in cost of sales. These increases in cost of sales were partially offset by a decrease of approximately $625,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\nSelling and marketing expenses\nSelling and marketing expenses were approximately $213,000 and $333,000 for the three months ended June 30, 2023 and 2022, respectively, representing a decrease of $120,000 or 36%, primarily related to lower GGI advertising and marketing expenses for GGI’s new retail space as well as the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\nGeneral and administrative expenses\nGeneral and administrative expenses were approximately $1,711,000 and $1,929,000 for the three months ended June 30, 2023 and 2022, respectively, representing a decrease of $218,000 or 11%. Decreases of approximately $225,000 in employee compensation, and approximately $759,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar were partially offset by increases of approximately $482,000 in professional and consulting fees (primarily business development and investor relations consulting) and approximately $284,000 in other aggregated expenses that are not individually material.\nDepreciation and amortization expense\nDepreciation and amortization expense was approximately $104,000 and $49,000 during the three months ended June 30, 2023 and 2022, respectively, representing an increase of $55,000 or 112%, related to new asset purchases.\nInterest income\nInterest income was approximately $64,000 and $27,000 during the three months ended June 30, 2023 and 2022, respectively, representing an increase of $37,000 or 137%, related to the increase in mortgages receivable.\nInterest expense\nInterest expense was approximately $1,066,000 and $695,000 during the three months ended June 30, 2023 and 2022, respectively, representing an increase of $371,000 or 53%. The increase is primarily related to a rise in the interest and debt discount related to convertible debt issued during February 2023.\n\n| 31 |\n\n\nOther income, related party\nOther income of approximately $75,000 during the three months ended June 30, 2023 and 2022 represents the management fee earned from LVH.\nLoss on extinguishment of debt\nLoss on extinguishment of debt in the aggregate amount of $32,094 during the three months ended June 30, 2023 consists of extinguishment loss recognized related to premiums paid on the cash redemption of convertible debt. Loss on extinguishment of debt in the aggregate amount of $2,105,119 during the three months ended June 30, 2022 consists of extinguishment loss recognized upon the reduction of the conversion price on the GGH Notes during the second quarter of 2022.\nGains from foreign currency translation\nThe Company recorded gains from foreign currency translation of approximately $103,000 and $43,000 during the three months ended June 30, 2023 and 2022, respectively. The increase of approximately $60,000 in gains from foreign currency translation is due to the fluctuation in the Argentine peso to United States dollar exchange rates.\nChange in fair value of derivative liability\nThe Company recorded a change in fair value of derivative liability of approximately $2,141,000 and $0 during the three months ended June 30, 2023 and 2022, respectively. The change in fair value during the six months ended June 30, 2023 is associated with the default of the 2023 Convertible Note as of June 30, 2023.\nInducement expense\nInducement expense decreased to $0 for the three months ended June 30, 2023 from approximately $198,000 during the three months ended June 30, 2022. Inducement expense during the three months ended June 30, 2022 resulted from a temporary reduction in the conversion price on convertible debt.\nSix months ended June 30, 2023 compared to the six months ended June 30, 2022\nOverview\nWe reported a net loss of approximately $7.7 million and $7.6 million for the six months ended June 30, 2023 and 2022, respectively.\nRevenues\nRevenues from operations were approximately $1,159,000 and $831,000 during the six months ended June 30, 2023 and 2022, respectively, reflecting an increase of approximately $328,000 or 39%. The overall increase in sales was driven by increases in hotel, restaurant and wine revenues of approximately $863,000, increases in agricultural revenues of $122,000, and increases in clothes, accessories and other sales of approximately $145,000 resulting from the easing of COVID restrictions and the Argentine government’s efforts to promote tourism and revitalize local businesses, and from the opening of our flagship retail store in Miami. These revenue increases were partially offset by a decrease in lot sales of approximately $42,000 and approximately $760,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\n\n| 32 |\n\n\nGross profit\nWe generated a gross profit of approximately $197,000 and $59,000 for the six months ended June 30, 2023 and 2022, respectively, representing an increase of approximately $138,000 or 234%. The increase in gross profit during the six months ended June 30, 2023 is primarily related to hotel sales during the period. The Company’s hotel was being renovated during the first half of 2022, resulting in limited revenues, with fixed costs related to hotel operations.\nCost of sales, which consists of real estate lots, raw materials, direct labor and indirect labor associated with our business activities, increased by approximately $190,000 or 25%, from approximately $772,000 for the six months ended June 30, 2022 to approximately $962,000 for the six months ended June 30, 2023. The increase in cost of sales includes increases in hotel, restaurant and wine costs of approximately $534,000, an increase in clothes, accessories and other costs of approximately $166,000, and an increase of approximately $75,000 in costs associated with lot sales, which correspond to the increases in the related revenues as discussed above. In addition, a higher number of agricultural sales, which are sold at a loss, provided an increase of approximately $158,000 in cost of sales. These increases in cost of sales were partially offset by a decrease of approximately $743,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\nSelling and marketing expenses\nSelling and marketing expenses were approximately $448,000 and $505,000 for the six months ended June 30, 2023 and 2022, respectively, representing a decrease of approximately $57,000 or 11%, primarily related to lower GGI advertising and marketing expenses for GGI’s new retail space as well as the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\nGeneral and administrative expenses\nGeneral and administrative expenses were approximately $3,467,000 and $3,674,000 for the six months ended June 30, 2023 and 2022, respectively, representing a decrease of $207,000 or 6%. A decrease of approximately $739,000 resulting from gains recognized on transactions denominated in foreign currency, as well as a decrease of approximately $460,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar were partially offset by increases of approximately $596,000 in professional and consulting fees (primarily business development and investor relations consulting), approximately $85,000 of compensation expense, as well as approximately $307,000 in other aggregated expenses that are not individually material. Gains recognized on transactions denominated in a foreign currency result from the difference between the official exchange rate, and the actual exchange rate applied to the peso.\nDepreciation and amortization expense\nDepreciation and amortization expense was approximately $213,000 and $95,000 during the six months ended June 30, 2023 and 2022, respectively, representing an increase of $118,000 or 124%, related to new asset purchases.\nInterest income\nInterest income was approximately $115,000 and $30,000 during the six months ended June 30, 2023 and 2022, respectively, representing an increase of $85,000 or 283% as the result of increases in mortgages receivable during the period.\nInterest expense\nInterest expense was approximately $1,668,000 and $1,453,000 during the six months ended June 30, 2023 and 2022, respectively, representing an increase of $215,000 or 15%. The increase is primarily related to a rise in the interest and debt discount related to convertible debt issued during February 2023.\nOther income\nOther income of approximately $150,000 during the six months ended June 30, 2023 and 2022 represents the management fee received from LVH.\n\n| 33 |\n\n\nGains from foreign currency translation.\nThe Company recorded gains from foreign currency translation of approximately $215,000 and $226,000 during the six months ended June 30, 2023 and 2022, respectively, as the result of the highly inflationary status of Argentina. The decrease of approximately $11,000 in gains from foreign currency translation is due to the fluctuation in the Argentine peso to United States dollar exchange rates.\nLoss on extinguishment of debt\nLoss on extinguishment of debt was approximately $416,000 during the six months ended June 30, 2023, as compared to approximately $2.1 million during the six months ended June 30, 2022. Loss on extinguishment of debt during the six months ended June 30, 2023 in the approximate amount of $416,000 is comprised of (i) premium paid on the conversion of GGH Notes of approximately $112,000, (ii) premium paid on the cash redemption of GGH Notes of approximately $124,000, (iii) premium paid on the 2023 Note for cash redemption of principal in the amount of approximately $32,000; (iv) premium in the amount of approximately $13,000 paid on the conversion an aggregate of $87,179 of principal and interest owed on the 2023 Note, and (iv) the fair value of approximately $135,000 in warrants issued in the exchange agreement for the GGH Notes (See Note 10—Convertible Debt Obligations for additional details).\nLiquidity and Capital Resources\nWe measure our liquidity a variety of ways, including the following:\n\n| June 30, 2023 | December 31, 2022 |\n| (unaudited) |\n| Cash | $ | 810,139 | $ | 300,185 |\n| Working capital (deficiency) | $ | (3,828,285 | ) | $ | 595,120 |\n| Convertible debt obligations | $ | 4,893,983 | $ | 1,997,909 |\n| Loans payable | $ | 342,482 | $ | 256,321 |\n\nCash requirements for our current liabilities include approximately $2.0 million for accounts payable and accrued expenses, approximately $220,000 for lease liabilities, and approximately $332,000 for loans payable and other current liabilities. We also have convertible debt obligations in the approximate amount of $4.8 million which, if not converted prior to maturity, are due on February 21, 2024. Cash requirements for our long-term liabilities include approximately $1.2 million for operating lease liabilities, approximately $90,000 in loans payable, and approximately $82,000 of long-term accrued expenses.\nDuring the six months ended June 30, 2023, we financed a portion of our activities from proceeds derived from debt and equity financings. A significant portion of the funds have been used to cover working capital needs and personnel, office expenses and various consulting and professional fees.\nNet cash used in operating activities for the six months ended June 30, 2023 and 2022 amounted to approximately $4,033,000 and $2,755,000, respectively. During the six months ended June 30, 2023, the net cash used in operating activities was primarily attributable to the net loss of approximately $7.7 million adjusted for approximately $4.1 million of net non-cash expenses, and approximately $0.5 million of cash used to fund changes in the levels of operating assets and liabilities. During the six months ended June 30, 2022, the net cash used in operating activities was primarily attributable to the net loss of approximately $7.6 million adjusted for approximately $4.1 million of net non-cash expenses, and approximately $0.7 million of cash used to fund changes in the levels of operating assets and liabilities.\nCash used in investing activities for the six months ended June 30, 2023 and 2022 amounted to approximately $489,000 and $1,720,000, respectively, resulting primarily from the purchase of property and equipment in the approximate amount of $438,000 and $1,677,000 million, respectively, and approximately $50,000 and $35,000 respectively, used to purchase certain intangible assets.\n\n| 34 |\n\n\nNet cash provided by financing activities for the six months ended June 30, 2023 and 2022 amounted to approximately $5.1 million and $0.5 million, respectively. For the six months ended June 30, 2023, the net cash provided by financing activities resulted from approximately $4.7 million in net proceeds from the issuance of debt, $0.6 million in proceeds from the issuance of common stock in a private placement, approximately $0.7 million in proceeds from the issuance of stock under the New ELOC and $0.2 million in proceeds from the issuance of a note payable, partially offset by the repayment of convertible debt obligations and related redemption premiums in the approximate amount of $1.0 million, and repayment of loans payable of approximately $0.1 million. Net cash used in financing activities for the six months ended June 30, 2022 resulted from approximately $0.5 million of cash proceeds from the sale of commons stock, partially offset by approximately $0.1 million in repayments of loans payable.\nAs of June 30, 2023, the Company had cash and a working capital deficit of approximately $810,000 and $3,109,000, respectively. During the six months ended June 30, 2023 and 2022, the Company incurred net losses of approximately $7.7 million and $7.6 million, respectively, and used cash in operating activities of approximately $4.0 million and $2.8 million, respectively. Further, as of June 30, 2023, approximately $4.8 million owed in connection with the Company’s convertible debt matures on February 21, 2024, and approximately $0.3 million represents the current portion of the Company’s loans payable which are payable on demand or for which payments are due within twelve months after June 30, 2023. During the six months ended June 30, 2023, the Company funded its operations with net proceeds from convertible debt financing of approximately $4.7 million, proceeds of approximately $0.7 million from draws on the Company’s equity line of credit, and $0.6 million from the sale of common stock.\nThe Company’s operating needs include the planned costs to operate its business, including amounts required to fund working capital and capital expenditures. Based upon projected revenues and expenses, the Company believes that it may not have sufficient funds to operate for the next twelve months from the date these financial statements are made available. Since inception, the Company’s operations have primarily been funded through proceeds received from equity and debt financings. The Company believes it has access to capital resources and continues to evaluate additional financing opportunities. There is no assurance that the Company will be able to obtain funds on commercially acceptable terms, if at all. There is also no assurance that the amount of funds the Company might raise will enable the Company to complete its development initiatives or attain profitable operations. The aforementioned factors raise substantial doubt about the Company’s ability to continue as a going concern.\nAvailability of Additional Funds\nAs a result of our financings, we have been able to sustain operations. However, we will need to raise additional capital in order to meet our future liquidity needs for operating expenses and capital expenditures, including GGI inventory production, continued development of the GGI e-commerce platform, expansion of our winery and additional investments in real estate development. If we are unable to obtain adequate funds on reasonable terms, we may be required to significantly curtail or discontinue operations.\nOff-Balance Sheet Arrangements\nNone.\nContractual Obligations\nAs a smaller reporting company, we are not required to provide the information requested by paragraph (a)(5) of this Item.\nCritical Accounting Policies and Estimates\nThere are no material changes from the critical accounting policies, estimates and new accounting pronouncements set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” set forth in our Annual Report on Form 10-K filed with the SEC on April 17, 2023, except as described below. Please refer to that document for disclosures regarding the critical accounting policies related to our business.\n\n| 35 |\n\n\nConvertible Promissory Notes\nThe Company evaluates its convertible instruments to determine if those contracts or embedded components of those contracts qualify as derivative financial instruments to be separately accounted for in accordance with Topic 815 “Derivatives and Hedging” (“ASC 815”) of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”). The accounting treatment of derivative financial instruments requires that the Company record any bifurcated embedded features at their fair values as of the inception date of the agreement and at fair value as of each subsequent balance sheet date. Any change in fair value is recorded in earnings each period as non-operating, non-cash income or expense. The Company reassesses the classification of its derivative instruments at each balance sheet date. If the classification changes as a result of events during the period, the contract is reclassified as of the date of the event that caused the reclassification. Bifurcated embedded features are recorded upon note issuance at their initial fair values which create additional debt discount to the host instrument.\nSequencing Policy\nUnder ASC 815, we have adopted a sequencing policy, whereby, in the event that reclassification of contracts from equity to assets or liabilities is necessary pursuant to ASC 815 due to the Company’s inability to demonstrate it has sufficient authorized shares as a result of certain securities with a potentially indeterminable number of shares or the Company’s total potentially dilutive shares exceed the Company’s authorized share limit, shares will be allocated on the basis of the earliest issuance date of potentially dilutive instruments, with the earliest grants receiving the first allocation of shares. Pursuant to ASC 815, issuances of securities granted as compensation in a share-based payment arrangement are not subject to the sequencing policy.\n\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, we are not required to provide the information required by this Item.\n\nDisclosure Controls and Procedures\nOur management carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer (who is our Principal Executive Officer) and our Chief Financial Officer (who is our Principal Financial Officer and Principal Accounting Officer), of the effectiveness of the design of our disclosure controls and procedures (as defined by Exchange Act Rules 13a-15(e) or 15d-15(e)) as of June 30, 2023, pursuant to Exchange Act Rule 13a-15(b). Based upon that evaluation, our Principal Executive Officer and Principal Financial Officer concluded that our disclosure controls and procedures were not effective as of June 30, 2023, resulting from a lack of segregation of duties due to our small size, and lack of testing of the operating effectiveness of the controls.\n\n| 36 |\n\n\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting identified in management’s evaluation pursuant to Rules 13a-15(d) or 15d-15(d) of the Exchange Act during the quarter ended June 30, 2023 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\nInherent Limitations of Controls\nManagement does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all errors and all fraud. Controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or deterioration in the degree of compliance with the policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.\n\n| 37 |\n\n\nPART II - OTHER INFORMATION\n\nFrom time to time, the Company and its subsidiaries and affiliates are subject to litigation and arbitration claims incidental to its business. Such claims may not be covered by its insurance coverage, and even if they are, if claims against GGH and its subsidiaries are successful, they may exceed the limits of applicable insurance coverage. We are not involved in any litigation that we believe is likely, individually or in the aggregate, to have a material adverse effect on our condensed consolidated financial condition, results of operations or cash flows.\n\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, we are not required to provide information required by this Item. However, our current risk factors are set forth in Item 1A of the Company’s Annual Report on Form 10-K as filed with the SEC on April 17, 2023 and in Item 1A of the Company’s Quarterly Report on Form 10-Q as filed with the SEC on May 19, 2023.\nOur stock has been trading below $1.00 and our failure to maintain compliance with Nasdaq’s continued listing requirements could result in the delisting of our common stock.\nOur common stock is currently listed for trading on The Nasdaq Capital Market. We must satisfy the continued listing requirements of The Nasdaq Stock Market LLC (or Nasdaq), to maintain the listing of our common stock on The Nasdaq Capital Market.\nOn June 1, 2023, the Company received a deficiency letter from the Listing Qualifications Department (the “Staff”) of the Nasdaq Stock Market notifying the Company that, for the preceding 30 consecutive business days, the closing bid price for the Company’s common stock was trading below the minimum $1.00 per share requirement for continued inclusion on The Nasdaq Capital Market pursuant to Nasdaq Listing Rule 5450(a)(1) (the “Bid Price Requirement”). The notification has no immediate effect on the Company’s Nasdaq listing and the Company’s common stock will continue to trade on Nasdaq under the ticker symbol “VINO.”\nIn accordance with Nasdaq Rules, the Company was provided with an initial period of 180 calendar days, or until November 28, 2023 (the “Compliance Date”), to regain compliance with the Bid Price Requirement. If at any time before the Compliance Date the closing bid price for the Company’s common stock is at least $1.00 for a minimum of 10 consecutive business days, the Staff will provide the Company written confirmation of compliance with the Bid Price Requirement.\nIf the Company does not regain compliance with the Bid Price Requirement by the Compliance Date, the Company may be eligible for an additional 180 calendar day compliance period. To qualify, the Company would then be required to meet the continued listing requirement for market value of publicly held shares and all other initial listing standards for The Nasdaq Capital Market, with the exception of the Bid Price Requirement, and will need to provide written notice of its intention to cure the deficiency during the additional 180 calendar day compliance period, which compliance could be achieved by effecting a reverse stock split, if necessary. If the Company does not regain compliance with the Bid Price Requirement by the Compliance Date and is not eligible for an additional compliance period at that time, the Staff will provide written notification to the Company that its common stock will be subject to delisting. At that time, the Company may appeal the Staff’s delisting determination to a Nasdaq Hearings Panel.\n\n| 38 |\n\n\nThe Company is holding its Annual General Meeting on August 24, 2023, at which, among other things, the Company has requested stockholder approval to grant the Board of Directors discretion (if necessary to prevent the delisting of the Company’s common stock on Nasdaq) on or before June 30, 2024, to implement a reverse stock split of the outstanding shares of common stock in a range from one-for-two (1:2) up to one-for-ten (1:10), or anywhere between, while maintaining the number of authorized shares of common stock at 150,000,000 shares, as required for Nasdaq listing. The Company will need shareholders representing a majority of the outstanding shares of the Company to approve this proposal, which is not guaranteed.\nIf our common stock were delisted from Nasdaq, trading of our common stock would most likely take place on an over-the-counter market established for unlisted securities, such as the OTCQB or the Pink Market maintained by OTC Markets Group Inc. An investor would likely find it less convenient to sell, or to obtain accurate quotations in seeking to buy, our common stock on an over-the-counter market, and many investors would likely not buy or sell our common stock due to difficulty in accessing over-the-counter markets, policies preventing them from trading in securities not listed on a national exchange or other reasons. In addition, as a delisted security, our common stock would be subject to SEC rules as a “penny stock”, which impose additional disclosure requirements on broker-dealers. The regulations relating to penny stocks, coupled with the typically higher cost per trade to the investor of penny stocks due to factors such as broker commissions generally representing a higher percentage of the price of a penny stock than of a higher-priced stock, would further limit the ability of investors to trade in our common stock. In addition, delisting would materially and adversely affect our ability to raise capital on terms acceptable to us, or at all, and may result in the potential loss of confidence by investors, suppliers, customers and employees and fewer business development opportunities. For these reasons and others, delisting would adversely affect the liquidity, trading volume and price of our common stock, causing the value of an investment in us to decrease and having an adverse effect on our business, financial condition and results of operations, including our ability to attract and retain qualified employees and to raise capital.\nThe Company is currently in default under one of its convertible promissory notes, which allows the holder to redeem all or a portion of the Note.\nPursuant to the 2023 Purchase Agreement and Notes, as of May 21, 2023, the Company failed to prepay, redeem or convert one quarter of the initial principal and interest on the Notes. The holder may require the Company to redeem all or a portion of the Notes by written notice, which would have a material adverse effect on the Company. On August 11, 2023, the Company and the holder of the Notes entered into an agreement (the “Letter Agreement”) pursuant to which, among other things: the holder agreed to forbear from issuing an event of default notice and event of default redemption notice through December 31, 2023. See Item 5 for additional information.\nIf LVH does not sign a ground lease by December 29, 2023, LVH will be dissolved and we may not receive a complete return of our investment.\nCurrently, the Company, through its wholly-owned subsidiary, Gaucho Ventures I – Las Vegas, LLC (“GVI”), contributed total capital of $7.0 million to LVH Holdings LLC (“LVH”) to develop a project in Las Vegas, Nevada and received 396 limited liability company interests, representing an 11.9% equity interest in LVH. Pursuant to the Fourth Amendment to the Amended and Restated Limited Liability Company Agreement of LVH dated June 30, 2023, if a ground lease for the premises within which the luxury hotel, casino, entertainment and retail project will be developed and constructed has not been executed by LVH on or before December 29, 2023, then as promptly as reasonably practicable after such date, LVH will be liquidated and dissolved.\nAs of June 30, 2023, LVH has used our cash contribution to LVH for land improvement expenses, such as architectural, legal, engineering, and accounting fees. Should LVH be liquidated and dissolved on or before December 29, 2023, we most likely will not receive our entire contribution back from LVH and may lose our entire investment.\n\n| 39 |\n\n\n\nEquity Line of Credit\nPursuant to the Purchase Agreement with Tumim Capital dated November 8, 2022, the Company requested draw-downs and issued shares of common stock and received gross proceeds of the following for the three months ended June 30, 2023: (i) April 19, 2023, the Company issued 195,970 shares of common stock to Tumim for gross proceeds of $144,339; and (ii) on May 5, 2023, the Company issued 262,798 shares of common stock to Tumim for gross proceeds of $172,614. No general solicitation was used, and a commission of 8% of the total gross proceeds was paid to Benchmark Investments, Inc. pursuant to the Underwriting Agreement between the Company and Kingswood Capital Markets, a division of Benchmark Investments, Inc., f/k/a EF Hutton, dated February 16, 2021. The Company relied on the exemptions from registration available under Section 4(a)(2) and/or Rule 506(b) of Regulation D of the Securities Act, in connection with the sales. A Form D was filed with the SEC on November 21, 2022.\n\nPursuant to the 2023 Purchase Agreement and Notes, as of each three-month anniversary of the Notes, the Company was required to prepay, redeem or convert one quarter of the initial principal and interest on the Notes. The Company did not meet that requirement as of May 21, 2023, which is the first three-month anniversary. The Company is required to deliver notice of default to the holder within one (1) business day. The holder may require the Company to redeem all or a portion of the Notes by written notice. On August 11, 2023, the Company and the holder of the Notes entered into an agreement pursuant to which, among other things: the holder agreed to forbear from issuing an event of default notice and event of default redemption notice through December 31, 2023. See Item 5 for additional information.\n\nNot applicable.\n\nSpecial Meeting of Stockholders\nOn May 8, 2023, the Company held a special stockholder meeting (the “Special Meeting”) at 12:00 p.m. Eastern Time at which a quorum was present. At the Special Meeting, a proposal to approve, for purposes of complying with Nasdaq Listing Rule 5635(d), the full issuance and exercise of shares of our common stock to be issued pursuant to that certain Securities Purchase Agreement, dated February 21, 2023 (the “Purchase Agreement”), that certain senior secured convertible promissory note dated February 21, 2023 (the “Note”), that certain common stock purchase warrant dated February 21, 2023 (the “Warrants”), and that certain Registration Rights Agreement, dated February 21, 2023 (the “Registration Rights Agreement”) by and between the Company and an institutional investor was approved by the stockholders.\nAnnual General Meeting\nOn June 29, 2023, the Company filed a Preliminary Proxy Statement on Form 14-A, a Definitive Proxy Statement on Form 14-A on July 10, 2023, and additional definitive proxy materials on Form 14-A on July 11, 2023, which request stockholder approval of the following proposals: (i) To elect two (2) Class III nominees to the board of directors (Scott L. Mathis and William A. Allen) to hold office for a three-year term; (ii) to grant the Board of Directors discretion (if necessary to prevent the delisting of the Company’s common stock on Nasdaq) on or before June 30, 2024, to implement a reverse stock split of the outstanding shares of common stock in a range from one-for-two (1:2) up to one-for-ten (1:10), or anywhere between, while maintaining the number of authorized shares of common stock at 150,000,000 shares, as required for Nasdaq listing; (iii) to conduct an advisory vote on executive compensation; (iv) to conduct an advisory vote on the frequency of advisory votes on executive compensation; and (v) to ratify and approve the appointment of Marcum LLP as the Company’s independent registered accounting firm for the year ended December 31, 2023.\n\n| 40 |\n\n\nLVH Holdings LLC\nOn June 30, 2023, the Company, through its wholly owned subsidiary, Gaucho Ventures I – Las Vegas, LLC (“GVI”), executed a Fourth Amendment to the Amended and Restated Limited Liability Company Agreement of LVH Holdings LLC (“LVH”) to extend the outside date for execution of the ground lease from June 30, 2023 to December 29, 2023.\nAs previously disclosed, on June 16, 2021, the Company, through GVI, entered into the Amended and Restated Limited Liability Company Agreement of LVH; on November 16, 2022, entered into the First Amendment to the Amended and Restated Limited Liability Company Agreement of LVH; on June 7, 2022, entered into the Second Amendment to the Amended and Restated Limited Liability Company Agreement of LVH; and on December 12, 2022, entered into the Third Amendment to the Amended and Restated Limited Liability Company Agreement of LVH.\nAs of the date of the Fourth Amendment to the Amended and Restated Limited Liability Company Agreement, GVI and SLVH LLC comprise all of the members of LVH.\nBoard Compensation\nOn July 14, 2023, the Company issued a total of 270,272 shares at $0.555 per share to the non-executive directors of the Company as compensation for service as members of the Board of Directors of the Company for the first half of 2023. For this sale of securities, no general solicitation was used, no commissions were paid, all persons were accredited investors, and the Company relied on the exemption from registration available under Section 4(a)(2) and/or Rule 506(b) of Regulation D promulgated under the Securities Act with respect to transactions by an issuer not involving any public offering. A Form D was filed with the SEC on July 28, 2023.\nConvertible Promissory Notes\nAs previously reported on our Current Report on Form 8-K filed on February 21, 2023, the Company and an institutional investor (the “Holder”) entered into that certain Securities Purchase Agreement, dated as of February 21, 2023 (the “Securities Purchase Agreement”) and the Company issued to the Holder a senior secured convertible note (the “Note”) and warrant to purchase 3,377,099 shares of common stock of the Company (the “Warrant” and together with the Securities Purchase Agreement and the Note, the “Note Documents”).\nFor the full description of the Note Documents, please refer to our Current Report on Form 8-K and the exhibits attached thereto as filed with the SEC on February 21, 2023.\nAs previously reported on our Current Report on Form 8-K filed on August 11, 2023, an Event of Default occurred with respect to the Note. As a result, on August 11, 2023, the Company and the Holder entered into an agreement (the “Letter Agreement”) pursuant to which, among other things: (i) the Holder agreed to forbear from issuing an Event of Default Notice and Event of Default Redemption Notice; (ii) the Holder waived the requirement in the Note to pay Interest on the Note monthly in cash for a certain period of time; (iii) the Holder agreed to waive application of the Default Rate in Note for a certain period of time; (iv) the Holder agreed to waive the requirement in the Note for the Company to prepay, redeem, or convert one quarter of the initial Principal and Interest on the Note by each three (3) month anniversary of the Issuance Date for a certain period of time; (v) the Company adjusted the exercise price of the Warrant from $1.34 to $0.45; and (vi) the Holder may continue to convert the Note at the Alternate Conversion Price or at $0.45.\nAll terms not defined herein shall refer to the defined terms in the Note Documents.\nSee also Items 1A and 3 above.\n\n| 41 |\n\n\n\nThe following documents are being filed with the Commission as exhibits to this Current Report on Form 10-Q.\n\n| Exhibit | Description |\n| 1.1 | Underwriting Agreement, dated February 16, 2021 (5) |\n| 1.2 | Warrant Agreement, including the form of Warrant, made as of February 19, 2021, between the Company and Continental. (6) |\n| 3.1 | Amended and Restated Certificate of Incorporation filed with the Delaware Secretary of State effective November 4, 2022 (15) |\n| 3.2 | Amended and Restated Bylaws (1) |\n| 3.3 | Amendment to the Company’s Amended and Restated Bylaws as approved on July 8, 2019 (4) |\n| 4.1 | 2016 Stock Option Plan. (2) |\n| 4.2 | First Amendment to 2016 Stock Option Plan as adopted by the Board of Directors on October 20, 2016. (2) |\n| 4.3 | 2018 Equity Incentive Plan. (3) |\n| 4.4 | Amendment to the Company’s 2018 Equity Incentive Plan as approved by the Board of Directors on May 13, 2019 and the stockholders on July 8, 2019 (4) |\n| 4.5 | Amendment to the Company’s 2018 Equity Incentive Plan as approved by the Board of Directors on July 12, 2021 and the stockholders on August 26, 2021 (14) |\n| 4.6 | Amendment to the Company’s 2018 Equity Incentive Plan as approved by the Board of Directors on July 1, 2022 and the stockholders on August 30, 2022 (20) |\n| 4.7 | Underwriters’ Warrant (5) |\n| 4.8 | Form of Warrant (11) |\n| 4.9 | Form Amended and Restated Warrant (17) |\n| 4.10 | Form Warrant (18) |\n| 4.11 | Form Warrant (21) |\n| 4.12 | Form Warrant (25) |\n| 4.13 | Form Warrant (26) |\n| 10.1 | Employment Agreement by and between the Company and Scott L. Mathis dated September 28, 2015 (24) |\n| 10.2 | Retention Bonus Agreement by and between the Company and Scott L. Mathis dated March 29, 2020 (7) |\n| 10.3 | Employment Agreement by and between the Company and its Chief Financial Officer dated December 14, 2022 (23) |\n| 10.4 | Commercial Lease Agreement between Gaucho Group, Inc. and Design District Development Partners, LLC, dated April 8, 2021 (8) |\n| 10.5 | Amended and Restated Limited Liability Company Agreement of LVH Holdings LLC, dated June 16, 2021 (9) |\n| 10.6 | First Amendment to Amended and Restated Limited Liability Agreement dated November 16, 2021 (10) |\n| 10.7 | Second Amendment to Amended and Restated Limited Liability Agreement dated June 7, 2022 (13) |\n| 10.8 | Third Amendment to Amended and Restated Limited Liability Agreement dated June 7, 2022 (22) |\n| 10.9 | Common Stock Purchase Agreement by and between Gaucho Group Holdings, Inc. and Tumim Stone Capital LLC, dated November 8, 2022 (19) |\n| 10.10 | Registration Rights Agreement by and between Gaucho Group Holdings, Inc. and Tumim Stone Capital LLC, dated November 8, 2022 (16) |\n| 10.11 | Securities Purchase Agreement dated February 21, 2023 (26) |\n| 10.12 | Form of Senior Secured Convertible Note Issued by the Company (26) |\n| 10.13 | Form of Security and Pledge Agreement (26) |\n| 10.14 | Form of Stockholder Pledge Agreement (26) |\n| 10.15 | Form of Registration Rights Agreement (26) |\n| 10.16 | Fourth Amendment to Amended and Restated Limited Liability Agreement dated June 30, 2023 (28) |\n| 10.17 | Letter Agreement, dated as of August 11, 2023, by and among the Company and the subscriber listed therein (29) |\n| 22.1 | Subsidiary guarantors and issuers of guaranteed securities and affiliates whose securities collateralize securities of the registrant (12) |\n| 31.1 | Certification of Principal Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act.* |\n| 31.2 | Certification of Principal Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act.* |\n| 32 | Certification of the Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002** |\n| 99.1 | Algodon Wine Estates Property Map (27) |\n| 101.INS | Inline XBRL Instance Document* |\n| 101.SCH | Inline XBRL Schema Document* |\n| 101.CAL | Inline XBRL Calculation Linkbase Document* |\n| 101.DEF | Inline XBRL Definition Linkbase Document* |\n| 101.LAB | Inline XBRL Label Linkbase Document* |\n| 101.PRE | Inline XBRL Presentation Linkbase Document* |\n| 104 | Cover Page Interactive Data File (embedded within the Inline XBRL document) * |\n\n\n| 42 |\n\n\n\n| 1. | Incorporated by reference from the Company’s Registration of Securities Pursuant to Section 12(g) on Form 10 dated May 14, 2014. |\n| 2. | Incorporated by reference from the Company’s Annual Report on Form 10-K, filed on March 31, 2017. |\n| 3. | Incorporated by reference from the Company’s Quarterly Report on Form 10-Q, filed on November 19, 2018. |\n| 4. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on July 9, 2019. |\n| 5. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on February 18, 2021. |\n| 6. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on February 22, 2021. |\n| 7. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on April 1, 2020. |\n| 8. | Incorporated by reference to the Company’s Annual Report on Form 10-K filed on April 12, 2021. |\n| 9. | Incorporated by reference to the Company’s Quarterly Report on Form 10-Q filed on August 16, 2021. |\n| 10. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on November 17, 2021. |\n| 11. | Incorporated by reference to the Company’s Current Report on Form 8-K as filed on March 1, 2022. |\n| 12. | Incorporated by reference to the Company’s Annual Report on Form 10-K, filed on April 14, 2022. |\n| 13. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on June 8, 2022. |\n| 14. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on August 31, 2021. |\n| 15. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on November 3, 2022. |\n| 16. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on November 9, 2022. |\n| 17. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on October 24, 2022. |\n| 18. | Incorporated by reference to the Company’s Amended Current Report on Form 8-K/A, filed on September 8, 2022. |\n| 19. | Incorporated by reference to the Company’s Current Report as amended on Form 8-K/A, filed on November 14, 2022. |\n| 20. | Incorporated by reference to the Company’s Quarterly Report on Form 10-Q, filed on November 18, 2022. |\n| 21. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on December 1, 2022. |\n| 22. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on December 13, 2022. |\n| 23. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on December 15, 2022. |\n| 24. | Incorporated by reference to the Company’s Quarterly Report on Form 10-Q, filed on November 16, 2015. |\n| 25. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on February 21, 2023. |\n| 26. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on February 21, 2023. |\n| 27. | Incorporated by reference to the Company’s Annual Report on Form 10-K, filed on April 17, 2023. |\n| 28. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on July 5, 2023. |\n| 29. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on August 11, 2023. |\n| * | Filed herewith. |\n| ** | Furnished, not filed herewith. |\n\n\n| 43 |\n\n\nSIGNATURES\nPursuant to the requirements of Section 12 of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| Date: August 14, 2023 | GAUCHO GROUP HOLDINGS, INC. |\n| By: |\n| Scott L. Mathis |\n| Chief Executive Officer |\n| By: |\n| Maria Echevarria |\n| Chief Financial Officer and Chief Operating Officer |\n\n\n| 44 |\n\n\n</text>\n\nIf the company can maintain its current cash inflows and outflows in the future, how many months can the company continue to operate while paying off its convertible debt obligations, excluding the cash requirements for current liabilities and long-term liabilities?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nASSISTED 4 LIVING, INC.\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\nCONDENSED CONSOLIDATED BALANCE SHEETS\n(UNAUDITED)\n\n| March 31, 2021 | December 31, 2020 |\n| ASSETS |\n| Current assets: |\n| Cash | $ | 3,441,841 | $ | 345,982 |\n| Accounts receivable, net allowance for doubtful accounts | 102,020 | 97,073 |\n| Prepaid expenses and other current assets | 408,397 | 207,592 |\n| Assets of discontinued operations | 45,777 | - |\n| Total current assets | 3,998,035 | 650,647 |\n| Lease right of use asset | 3,917,812 | 3,977,988 |\n| Goodwill | 3,431,148 | 3,431,148 |\n| Leasehold improvements, net of accumulated amortization | 2,571,910 | 2,614,391 |\n| Property and equipment, net | 152,376 | 128,475 |\n| Total assets | $ | 14,071,281 | $ | 10,802,649 |\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\n| Current liabilities: |\n| Notes payable, net of discounts current | $ | 393,899 | $ | 2,385,010 |\n| Accrued interest, included related party | 95,079 | 48,601 |\n| Accounts payable and accrued expenses | 572,891 | 148,180 |\n| Loan payable – other | 66,851 | 63,907 |\n| Lease liability - current portion | 198,759 | 189,397 |\n| Liability to issue shares of common stock | 2,325,000 | - |\n| Deferred revenue | 25,703 | 25,703 |\n| Liabilities of discontinued operations | 53,929 | - |\n| Total current liabilities | 3,732,111 | 2,860,798 |\n| Lease liability - net of current portion | 3,821,666 | 3,864,321 |\n| Notes payable, net of discounts and current portion | 298,498 | 322,490 |\n| Total liabilities | 7,852,275 | 7,047,609 |\n| Stockholders’ equity: |\n| Common stock, par value $ 0.0001 ; 100,000,000 shares authorized, 35,395,418 and 4,165,418 issued and outstanding at March 31, 2021 and December 31, 2020, respectively | 3,540 | 417 |\n| Additional paid-in capital | 10,500,222 | 7,460,348 |\n| Subscription receivable | - | ( 30 | ) |\n| Accumulated deficit | ( 4,284,756 | ) | ( 3,705,695 | ) |\n| Total stockholders’ equity | 6,219,006 | 3,755,040 |\n| Total liabilities and stockholders’ equity | $ | 14,071,281 | $ | 10,802,649 |\n\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\n\n| F-1 |\n\nASSISTED 4 LIVING, INC.\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\n(UNAUDITED)\n\n| 2021 | 2020 |\n| For the Three Months Ended March 31, |\n| 2021 | 2020 |\n| Program revenue | $ | 601,115 | $ | - |\n| Rental income | 5,625 | - |\n| Other revenue | 185 | 915 |\n| Net revenue | 606,925 | 915 |\n| Cost of services provided | 232,460 | - |\n| Gross profit | 374,465 | 915 |\n| Operating expenses |\n| Salaries and payroll expense | 293,114 | 245,712 |\n| General and administrative | 298,200 | 99,083 |\n| Lease expense | 141,675 | 24,061 |\n| Professional fees | 95,691 | 62,800 |\n| Marketing and advertising | 5,670 | 12,631 |\n| Depreciation and amortization expense | 50,583 | - |\n| Total operating expenses | 884,933 | 444,287 |\n| Loss from operations | ( 510,468 | ) | ( 443,372 | ) |\n| Other expense |\n| Interest expense | ( 59,516 | ) | ( 3 | ) |\n| Total other expense | ( 59,516 | ) | ( 3 | ) |\n| LOSS FROM CONTINUING OPERATIONS BEFORE PROVISION FOR INCOME TAXES AND LOSS FROM DISCONTINUED OPERATIONS | ( 569,984 | ) | ( 443,375 | ) |\n| Income taxes | - | - |\n| LOSS FROM CONTINUING OPERATIONS BEFORE DISCONTINUED OPERATIONS | ( 569,984 | ) | ( 443,375 | ) |\n| LOSS FROM DISCONTINUED OPERATIONS | ( 9,077 | ) | - |\n| Net loss | $ | ( 579,061 | ) | $ | ( 443,375 | ) |\n| Loss per share - basic and diluted - Continuing operations | $ | ( 0.08 | ) | $ | ( 0.11 | ) |\n| Loss per share - basic and diluted - Discontinued operations | $ | ( 0.00 | ) | $ | - |\n| Weighted average number of shares outstanding - basic and diluted | 7,288,419 | 4,008,443 |\n\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\n\n| F-2 |\n\nASSISTED 4 LIVING, INC.\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\nCONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY\nFOR THE THREE MONTHS ENDED MARCH 31, 2020 AND 2021\n(UNAUDITED)\n\n| Shares | Amount | Capital | Receivable | Deficit | Total |\n| Common Stock | Additional | Total |\n| Number of | paid-in | Subscription | Accumulated | stockholders’ |\n| shares | Amount | Capital | Receivable | deficit | deficit |\n| For the Three Months Ended March 31, 2020 |\n| Balance at December 31, 2019 | 4,008,443 | 401 | 6,618,364 | ( 170 | ) | ( 2,407,760 | ) | 4,210,835 |\n| Collection on subscription receivable |\n| Shares issuable for Banyan Acquisition |\n| Shares issuable for Banyan Acquisition, shares |\n| Net loss for the period | - | - | - | - | ( 443,375 | ) | ( 443,375 | ) |\n| Balance at March 31, 2020 | 4,008,443 | 401 | 6,618,364 | ( 170 | ) | ( 2,851,135 | ) | 3,767,460 |\n| For the Three months ended March 31, 2021 |\n| - | - | - |\n| Balance at December 31, 2020 | 4,165,418 | 417 | 7,460,348 | ( 30 | ) | ( 3,705,695 | ) | 3,755,040 |\n| Collection on subscription receivable | - | - | - | 30 | - | 30 |\n| Shares issued for Acquisition | 31,230,000 | 3,123 | 3,039,874 | - | - | 3,042,997 |\n| Net loss for the period | - | - | - | ( 579,061 | ) | ( 579,061 | ) |\n| Balance at March 31, 2021 | 35,395,418 | 3,540 | 10,500,222 | - | ( 4,284,756 | ) | 6,219,006 |\n\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\n\n| F-3 |\n\nASSISTED 4 LIVING, INC.\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(UNAUDITED)\n\n| 2021 | 2020 |\n| For the Three Months Ended March 31, |\n| 2021 | 2020 |\n| Cash flows from operating activities |\n| Net loss | $ | ( 579,061 | ) | $ | ( 443,375 | ) |\n| Adjustments to reconcile net loss to cash used in operating activities: |\n| Net loss from discontinued operations | ( 9,077 | ) | - |\n| Non-cash operating lease expense | 26,883 | ( 4,070 | ) |\n| Depreciation and amortization | 50,583 | - |\n| (Increase) decrease in assets |\n| Prepaid expenses | ( 200,805 | ) | 4,564 |\n| Accounts receivable | ( 4,947 | ) | - |\n| Increase (decrease) in liabilities |\n| Accounts payable | - | ( 13,420 | ) |\n| Accrued payroll and other expenses | 441,940 | 28,544 |\n| Accrued interest | 46,478 | - |\n| Cash used in operating activities | ( 228,006 | ) | ( 427,757 | ) |\n| Cash flows from investing activities |\n| Cash from acquisition | 3,042,997 | - |\n| Purchase of property and equipment | ( 32,003 | ) | - |\n| Cash provided by investing activities | 3,010,994 | - |\n| Cash flows from financing activities |\n| Repayment of principal on notes payable to individuals and companies | ( 15,103 | ) | - |\n| Proceeds from the sale of common stock issued and issuable | 325,030 | 139 |\n| Proceeds from other notes payable | 2,944 | 11,746 |\n| Cash provided by financing activities | 312,871 | 11,885 |\n| Net increase (decrease) in cash | 3,095,859 | ( 415,872 | ) |\n| Cash, beginning of year | 345,982 | 4,044,700 |\n| Cash, end of period | $ | 3,441,841 | $ | 3,628,828 |\n| SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: |\n| Interest paid | $ | 13,037 | $ | - |\n| Taxes paid |\n| NON-CASH ITEMS |\n| Recognition of lease liability and right of use asset at inception | $ | - | $ | 1,897,995 |\n| Conversion of notes payable and accrued interest for common stock | $ | 2,000,000 | $ | - |\n\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\n\n| F-4 |\n\nASSISTED 4 LIVING, INC.\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\nNOTE 1 – ORGANIZATION AND DESCRIPTION OF BUSINESS\nAssisted 4 Living, Inc. (“the Company,” “we”, “our” or “us”) was incorporated in the state of Nevada on May 24, 2017 and is based in Sarasota, Florida. The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America (“GAAP”), and the Company’s fiscal year end is December 31.\nAs discussed in NOTE 4, on March 23, 2021, we entered into a Plan of Merger with our wholly-owned subsidiary, BPCC Acquisition, Inc., a Florida corporation (“Merger Sub”) and Banyan Pediatric Care Centers, Inc. (“Banyan”). Under the terms of the Plan of Merger, Merger Sub merged with and into Banyan with Banyan surviving the merger (the “Surviving Entity”) and becoming a wholly-owned subsidiary of the Company (the “Merger”). Pursuant to the Merger, we succeeded to the business of Banyan. The Merger has been treated as a recapitalization and reverse acquisition of the Company for financial accounting purposes, and Banyan is considered the acquirer for financial reporting purposes. This means that the Company’s historical financial statements before the Merger have been replaced with the historical financial statements of Banyan before the Merger in this Quarterly Report and future filings with the SEC\nThrough Banyan, we operate three pediatric extended care centers (“PPECs”) is southwest Florida. A PPEC is a nurse-staffed pediatric day care center for medically complex children age birth to 21 years. Our staff includes Registered Nurses (RNs), Licensed Practical Nurses (LPNs), Certified Nursing Assistants (CNAs) and Caregivers, who attend to the children’s medical conditions throughout the day in classroom, dining, play, and clinical settings. Banyan is fully licensed and accepts Florida Medicaid.\nWe are headquartered at 6801 Energy Court, Suite 201 Sarasota, Florida 34240.\nThe corporate website is www.assisted4living.com.\nCOVID-19\nIn March 2020, the World Health Organization declared the outbreak of COVID-19 as a pandemic based on the rapid increase in global exposure. COVID-19 continues to spread throughout the world. We are closely monitoring developments and are taking steps to mitigate the potential risks related to the COVID-19 pandemic to the Company, its employees, as well as its residential and consulting clients.\nTo date COVID-19 has not substantially negatively impacted our revenues or operations. Our evaluations of our practices, procedures, and operations, related to COVID-19, is ongoing. Additional updates to policies, procedures and operations will occur as best practices are adopted and as we deem necessary or advisable, or as further governmental guidance or regulations are implemented.\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nBasis of Presentation\nThe accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with GAAP for interim financial statements and with the instructions to Form 10-Q and Regulation S-X of the United States Securities and Exchange Commission (“SEC”). Accordingly, they do not contain all information and footnotes required by accounting principles generally accepted in the United States of America for annual financial statements.\nIn the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all the adjustments necessary (consisting only of normal recurring accruals) to present the financial position of the Company as of March 31, 2021 and the results of operations and cash flows for the periods presented. The results of operations for the three months ended March 31, 2021 are not necessarily indicative of the operating results for the full fiscal year or any future period. These unaudited condensed consolidated financial statements should be read in conjunction with the condensed consolidated financial statements and related notes thereto included in the Company’s Annual Report on Form 10-K filed with the SEC on March 1, 2021. As of March 23, 2021 we had discontinued operations reflected in the accompanying unaudited condensed consolidated financial statements. As a result of the Plan of Merger completed on March 23, 2021 (see NOTE 4) we have changed our year end reporting period from November to December.\n\n| F-5 |\n\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)\nBasis of Consolidation\nThese condensed consolidated financial statements include the accounts of the Company and the wholly-owned subsidiaries, Banyan Pediatric Care Centers, Inc, Banyan Pediatric Care Centers – OPS, LLC, Banyan Pediatric Care Centers – St. Petersburg, LLC, Banyan Pediatric Care Centers, - Pasco, LLC and Banyan Pediatric Care Centers – Sarasota, LLC and the discontinued operations of Assisted 2 Live, Inc., the wholly owned subsidiary that was discontinued as of March 23, 2021. All material intercompany balances and transactions have been eliminated.\nCash and Cash Equivalents\nThe Company considers all short-term investments with an original maturity of three months or less to be cash equivalents. The Company had no cash equivalents at March 31, 2021 and December 31, 2020.\nAccounts Receivable\nAccounts receivable primarily consists of amounts due from third-party payers (non-governmental), governmental payers and private pay patients and is recorded net of allowances for doubtful accounts and contractual discounts. The Company’s ability to collect outstanding receivables is critical to its results of operations and cash flows. Accordingly, accounts receivable reported in the Company’s condensed consolidated financial statements is recorded at the net amount expected to be received. The Company’s primary collection risks are (i) the risk of overestimation of net revenues at the time of billing that may result in the Company receiving less than the recorded receivable, (ii) the risk of non-payment as a result of commercial insurance companies’ denial of claims, (iii) the risk that patients will fail to remit insurance payments to the Company when the commercial insurance company pays out-of-network claims directly to the patient, (iv) resource and capacity constraints that may prevent the Company from handling the volume of billing and collection issues in a timely manner, (v) the risk that patients do not pay the Company for their self-pay balances (including co-pays, deductibles and any portion of the claim not covered by insurance) and (vi) the risk of non-payment from uninsured patients.\nThe Company’s accounts receivable from third-party payers are recorded net of estimated contractual adjustments and allowances from third-party payers, which are estimated based on the historical trend of the Company’s facilities’ cash collections and contractual write-offs, accounts receivable aging, established fee schedules, relationships with payers and procedure statistics. While changes in estimated reimbursement from third-party payers remain a possibility, the Company expects that any such changes would be minimal and, therefore, would not have a material effect on the Company’s financial condition or results of operations. The Company’s collection policies and procedures are based on the type of payor, size of claim and estimated collection percentage for each patient account. The Company analyzes accounts receivable at each of the facilities to ensure the proper collection and aged category. The operating systems generate reports that assist in the collection efforts by prioritizing patient accounts. Collection efforts include direct contact with insurance carriers or patients and written correspondence.\nAllowance for Doubtful Accounts, Contractual and Other Discounts\nManagement estimates the allowance for contractual and other discounts based on its historical collection experience and contracted relationship with the payers. The services authorized and provided and related reimbursement are often subject to interpretation and negotiation that could result in payments that differ from the Company’s estimates. The Company’s allowance for doubtful accounts is based on historical experience, but management also takes into consideration the age of accounts, creditworthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts. An account may be written-off only after the Company has pursued collection efforts or otherwise determines an account to be uncollectible. Uncollectible balances are written-off against the allowance. Recoveries of previously written-off balances are credited to income when the recoveries are made.\nFair Value of Financial Instruments\nThe carrying amount of accounts receivable and accounts payable approximate their respective fair values due to the short- term nature. The carrying amount of the line of credit and note payable approximates fair values due to their market interest rates. Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents and accounts receivable.\nProperty and Equipment\nProperty and equipment are stated at cost, less accumulated depreciation. Additions and improvements to property and equipment are capitalized at cost. Depreciation of owned assets and amortization of leasehold improvements are computed using the straight-line method over the shorter of the estimated useful lives of the related assets or the lease term. The cost of assets sold or retired, and the related accumulated depreciation are removed from the accounts and any resulting gains or losses are reflected in other income (expense) for the year. Expenditures for maintenance and repairs are charged to expense as incurred.\n\n| F-6 |\n\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)\nGoodwill\nOur goodwill represents the excess of the purchase price over the fair value of the net identifiable assets acquired in business combinations. The goodwill generated from the business combinations is primarily related to the value placed on the employee workforce and expected synergies. Judgment is involved in determining if an indicator or change in circumstances relating to impairment has occurred. Such changes may include, among others, a significant decline in expected future cash flows, a significant adverse change in the business climate, and unforeseen competition. There was no goodwill impairment for the years presented.\nThe Company tests goodwill for impairment on an annual basis, and when events or circumstances indicate the fair value of a reporting unit may be below its carrying value.\nLong-Lived Assets\nLong-lived assets are evaluated for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. There were no impairments of long-lived assets for the years presented.\nAdvertising and Marketing\nThe Company uses advertising and marketing to promote its services. Advertising and marketing costs are expensed as incurred.\nNet Loss Per Share\nBasic net loss per common share is computed by dividing net loss applicable to common stockholders by the weighted-average number of common shares outstanding during the period. Diluted net loss per common share is determined using the weighted-average of common shares outstanding during the period, adjusted for the dilutive effect of common stock equivalents, consisting of the conversion option embedded in convertible debt. The weighted-average number of common shares outstanding excludes common stock equivalents because their inclusion would have an anti-dilutive effect.\nIncome Taxes\nThe Company uses the liability method of accounting for income taxes. Under the liability method, deferred tax assets and liabilities are determined based on differences between financial reporting and the tax basis of assets, liabilities, the carry forward of operating losses and tax credits, and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. An allowance against deferred tax assets is recorded when it is more likely than not that such tax benefits will not be realized.\nAny future benefit arising from losses have been offset by a valuation allowance. Accordingly, no provision for income taxes is reflected in the condensed consolidated financial statements. The Company records a liability for uncertain tax positions when it is probable that a loss has been incurred and the amount can be reasonably estimated. Interest and penalties related to income tax matters, if any, would be recognized as a component of income tax expense. At March 31, 2021 and December 31, 2020, the Company had no liabilities for uncertain tax positions. The Company continually evaluates expiring statutes of limitations, audits, proposed settlements, changes in tax law and new authoritative rulings. Currently, the tax years subsequent to 2017 are open and subject to examination by the taxing authorities.\n\n| F-7 |\n\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)\nUse of Estimates and Assumptions\nThe preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. The estimates and judgments will also affect the reported amounts for certain revenues and expenses during the reporting period. Actual results could differ from these good faith estimates and judgments.\nRevenue Recognition\nWe follow ASC 606, “Revenue from Contracts with Customers.” Revenues are recognized when promised goods or services are transferred to a customer, in an amount that reflects the consideration that we expect to receive in exchange for those goods or services. We derive our revenues from the rendering of services, such as skilled nursing services. The five-step model defined by ASC 606 requires us to: (i) identify our contracts with customers, (ii) identify our performance obligations under those contracts, (iii) determine the transaction prices of those contracts, (iv) allocate the transaction prices to our performance obligations in those contracts and (v) recognize revenue when each performance obligation under those contracts is satisfied.\nReimbursement rates to provide skilled nursing services in our PPEC facilities are determined by the Medicaid program. Fees are billed to the Medicaid program and other payors weekly following the Medicaid billing guidelines.\nReclassification\nCertain amounts from prior periods have been reclassified to conform to the current period presentation.\nNOTE 3 – ACCRUED LIABILITIES\nOur accrued liabilities at March 31, 2021 and December 31, 2020 consisted of the following:\nSCHEDULE OF ACCRUED LIABILITIES\n| March 31, 2021 | December 31, 2020 |\n| Accounts payable | $ | 70,675 | $ | 16,298 |\n| Credit card | - | 1,050 |\n| Accrued expenses | 354,193 | 130,832 |\n| Accrued salary | 139,952 | - |\n| Payroll tax payable | 8,070 | - |\n| Accrued Liabilities | $ | 572,890 | $ | 148,180 |\n\n\n| F-8 |\n\nNOTE 4 – BANYAN MERGER\nOn March 23, 2021, we entered into a Plan of Merger with Merger Sub and Banyan. Under the terms of the Plan of Merger, Merger Sub merged with and into Banyan with Banyan as the Surviving Entity and wholly-owned subsidiary of the Company. The Merger was effective on March 23, 2021.\nThe Merger has been treated as a recapitalization and reverse acquisition of the Company for financial accounting purposes, and Banyan is considered the acquirer for accounting purposes. This means that the Company’s historical financial statements before the Merger have been replaced with the historical financial statements of Banyan.\nIn connection with the Merger, we issued 4,165,418 shares of our common stock in exchange for 49,984,649 outstanding shares of Banyan’s common stock held by 64 shareholders, based on an exchange ratio of one (1) share of our common stock for every twelve (12) shares of Banyan common stock. We also issued a warrant to purchase 75,000 shares of our common stock (the “Warrant”) in exchange for a warrant to purchase 900,000 shares of Banyan’s common stock. The Warrant is held by one investor and is exercisable for cash only until May 2, 2030 at an exercise price of $ 0.38 per share. The number of shares of common stock deliverable upon exercise of the Warrant contains provisions for standard anti-dilution adjustments.\nThe Surviving Entity assumed Banyan’s $ 2,300,000 of outstanding debt, and the $ 2,000,000 of such debt that was convertible into 20,000,000 shares of Banyan common stock was converted at $ 0.50 per share into 4,000,000 shares of our common stock, effective as of March 30, 2021. The remaining $ 300,000 of outstanding debt, evidenced by a promissory note dated November 6, 2020 (the “Note”), accrues interest at the annual rate of 12 %. Interest is payable on the sixth day of each month in the amount of $ 3,000 until the maturity date of the Note on November 6, 2021 , at which time, the remaining principal balance, if any, is due and payable.\n\n| F-9 |\n\nNOTE 5 – DISCONTINUED OPERATIONS\nOn April 30, 2021, our Board of Directors (the “Board”) approved the discontinuance of our wholly-owned subsidiary, Assisted 2 Live, Inc. (the “Discontinued Subsidiary”). The operations of the Discontinued Subsidiary are reflected on our condensed consolidated statement of operations from the date of the Merger as a loss from discontinued operations in the amount of $ 9,077 .\nThe April 30, 2021 Board decision was the result of the Purchase and Sale Option Agreement (the “Option Agreement”) with Romulus Barr (“Barr”) which we entered into on November 7, 2020. The Option Agreement provided us with the option to sell all of our interest in Assisted 2 Live, Inc., consisting of 1,000 shares of common stock of the Discontinued Subsidiary, to Barr in exchange for 200,000 shares of our common stock (the “Shares”) held by Barr. The returned Shares were cancelled, and included in authorized but unissued shares of common stock of the Company. The number of issued and outstanding shares of common stock was decreased by 200,000 as of April 30, 2021.\nThe following table presents the aggregate carrying amounts of the classes of assets and liabilities of discontinued operations for the three months ended:\nSUMMARY OF CARRYING AMOUNTS OF ASSETS AND LIABILITIES AND CASH FLOWS OF DISCONTINUED OPERATIONS\n| March 31, 2021 | December 31, 2020 |\n| Current assets of discontinued operations | $ | 15,928 | $ | - |\n| Non-current assets of discontinued operations | 29,849 | - |\n| $ | 45,777 | $ | - |\n| Current liabilities of discontinued operations | $ | 53,929 | $ | - |\n| $ | 53,929 | $ | - |\n\nThe following table presents cash flows of discontinued operations for the three months ended March 31:\n\n| 2021 | 2020 |\n| Net cash used in discontinued operating activities | $ | ( 14,386 | ) | $ | - |\n| Net cash from discontinued investing activities | - | - |\n| Net cash from discontinued financing activities | - | - |\n| $ | ( 14,386 | ) | $ | - |\n\n\n| Three months ended March 31, |\n| 2021 | 2020 |\n| Net revenues | $ | 5,362 | $ | - |\n| Cost of net revenues | - | - |\n| Gross profit | 5,362 | - |\n| Operating expenses: |\n| Salary and tax expense | 12,890 | - |\n| General and administrative | 763 | - |\n| Lease expense | 733 | - |\n| Total operating expenses | 14,386 | - |\n| Income from operations of discontinued operations | ( 9,024 | ) | - |\n| Interest and other, net | ( 53 | ) | - |\n| Income from discontinued operations before income taxes | ( 9,077 | ) | - |\n| Provision for income taxes | - | - |\n| Income from discontinued operations, net of income taxes | $ | ( 9,077 | ) | $ | - |\n\n\n| F-10 |\n\nNOTE 6 – NOTES PAYABLE\nNotes payable at March 31, 2021 and December 31, 2020 consisted of the following:\nSCHEDULE OF NOTES PAYABLE\n| March 31, 2021 | December 31, 2020 |\n| (Unaudited) |\n| a. Excel Family Partners, LLLP / Banyan Pediatric Investment, Inc. (Sep 2020) | $ | - | $ | 2,000,000 |\n| b. NuView Trust Co. (Nov 2020) | 300,000 | 300,000 |\n| c. Grand Trinity Plaza, LLC (Dec 2020) | 392,397 | 407,500 |\n| $ | 692,397 | $ | 2,707,500 |\n\n\n| a) | On September 18, 2020, through Banyan, we entered into a Convertible Note and Securities Purchase Agreement with two investors for the aggregate principal in the amount of $ 2,000,000 . The note had a maturity date of September 18, 2022 and an interest rate of 8 % to be paid quarterly. The principal was funded by two investors (“Purchasers”), both related parties. Excel Family Partners, LLLP invested $ 1,500,000 and Banyan Pediatric Investments, LLC invested $ 500,000 . The proceeds of this note were used for operational expenses and for the payment of the remainder of the buildout of the Pasco County and the Sarasota locations. Written consent from shareholders holding a majority of the issued and outstanding shares of common stock of Banyan was obtained, not including such shares currently held by the Purchasers or their affiliates, consenting to the note contemplated hereby, in a form and substance acceptable to the Purchasers, in their respective reasonable discretion. Both Purchasers were permitted to convert their respective portions of the note at a conversion price of $ 0.10 per share. Subsequent to the Merger (see NOTE 4), the Board revised the conversion price of the note to $ 0.50 per share. Effective March 30, 2021 the Purchasers exercised their right to convert all outstanding principal. As of March 31, 2021 and December 31, 2020, there was $ 90,740 and $ 45,589 of accrued interest, respectively and is reflected in accrued interest balances on the condensed consolidated balance sheet at March 31, 2021 and December 31, 2020. |\n\n\n| b) | On November 6, 2020, through Banyan, we entered into a one-year note in the principal amount of $ 300,000 with NuView Trust Company. The note has a 12 % interest rate with interest only payments until date of maturity. The proceeds of this no were used for operational expenses and for the payment of the remainder of the buildout of the Pasco County and the Sarasota locations. As of March 31, 2021 and December 31, 2020 there was no accrued interest. (see NOTE 4) |\n\n\n| c) | On December 15, 2020, through Banyan Pediatric Care Centers – Pasco, LLC, we entered into a note payable with Grand Trinity Plaza, LLC in the principal amount of $ 407,500 , which is guaranteed by Banyan. The term of the note is 48 months with an interest rate of 6 %. The maturity date of the note is January 1, 2025 . The note is in conjunction with the 84 -month facility lease for the Pasco County location, pursuant to which the landlord also provided the construction of the buildout and financed $ 407,500 of the construction costs. |\n\nNOTE 7 – LEASEHOLD IMPROVEMENTS\nThe Company had the following leasehold improvements as of March 31, 2021 and December 31, 2020:\nSCHEDULE OF LEASESHOLD IMPROVEMENTS\n| March 31, 2021 | December 31, 2020 | Amortization Period |\n| Leasehold improvements | $ | 2,669,047 | $ | 2,669,047 | 15 - 17 years |\n| Less: amortization | ( 97,137 | ) | ( 54,656 | ) |\n| Net | $ | 2,571,910 | $ | 2,614,391 |\n\nDuring the year ended December 31, 2020, we recorded $ 2,669,047 of leasehold improvements. These amounts include costs related to the build out of the Sarasota location in the amount of $ 1,245,950 . These costs will be amortized over the expected term of the lease including extensions that management expects to be 15 years. We also recorded costs in the amount of $ 1,021,793 related to the New Port Richey location buildout. The expected amortization of the improvements for the New Port Richey location is 17 years. Also recorded were $ 401,303 of improvements as part of the St. Petersburg-Kidz Club Acquisition. The expected amortization of the improvements for the St. Petersburg location is 15 years.\nAmortization expense for the three months ended March 31, 2021 and 2020 was $ 42,481 and $ 0 , respectively.\n\n| F-11 |\n\nNOTE 8 – OPERATING LEASES\nOn August 24, 2019, through Banyan Pediatric Care Centers-Sarasota, LLC, we entered into an operating lease with Northeast Plaza Venture I, LLC for the premises located in the Northeast Plaza Shopping Center located on the Northeast corner of 17th Street & Lockwood Ridge Road, in the County of Sarasota, Florida. The initial term of the lease is five years with minimum annual rent of $ 180,000 . The landlord granted rent abatement for this lease until February 24, 2020 . The lease end date, including two successive 5 -year renewal options, is January 31, 2035. A right of use asset and lease liability in the amount of $ 1,899,869 associated with this lease was recognized. This lease is treated as an operating lease for accounting purposes.\nOn October 15, 2019, through Banyan, we entered into an assignment and assumption of lease agreement with The Kidz Club – St. Pete, LLC whereby we assumed approximately 12,137 square feet of space at the southeast corner of 3rd Avenue S. and 9th Street N., Webb’s Plaza, St. Petersburg, FL 33701. The minimum annual rent for the first year of the lease was $ 113,681 . The current lease termination date, with extensions expected to be exercised, is October 31, 2024 . Upon the exercise of each extension the base rent shall increase by 1.5 %. This assignment of lease was subject to the terms of the Asset Purchase Agreement with The Kidz Club-St. Pete, LLC. A right of use asset and lease liability in the amount of $ 875,539 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\nEffective April 1, 2020, through Banyan Pediatric Care Centers – Pasco, LLC, we entered into an 84 -month facility lease with Grand Trinity Plaza, LLC for the premises located in the shopping center known as the Grand Trinity Plaza located in New Port Richey, Florida. The initial term of the lease had a minimum annual base rent of $ 94,500 . The landlord granted rent abatement until September 2020. The lease end date, including two successive 5 -year renewals is August 31, 2037. A right of use asset and lease liability in the amount of $ 1,143,743 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\nOn June 9, 2020, through Banyan, we entered into a 63 -month copier lease with Dex Imaging. The lease was for one copier and a printer. The minimum annual lease payment is $ 5,376 with annual increases not to exceed 12 % annually. This lease will auto renew in 12 -month increments. The equipment under this lease has a fixed $1 payment buyout option . This equipment was purchased for the St. Petersburg location. A right of use asset and lease liability in the amount of $ 16,066 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\nOn August 25, 2020, through Banyan, we entered into a 60 -month financing agreement with Ascentium Capital LLC for two 2020 Turtletop Terra Transit passenger buses for the St. Petersburg location. This lease is considered an operating lease for accounting purposes because the lease period is less than the economic life of the asset being leased . Minimum annual rent payments under this lease are $ 24,859 . At our discretion, we may exercise a purchase option, by giving written notice no later than 30 days but not more than 120 days before the expiration of the initial term. The purchase option price is $ 23,920 for each bus, based on reasonably predicted fair market value. A right of use asset and lease liability in the amount of $ 102,393 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\nOn October 20, 2020, through Banyan, we entered into a 60 -month financing agreement with Ascentium Capital LLC for a 2020 Eldorado National Advance 220 p/t 14 passenger bus for the St. Petersburg location. This lease is considered an operating lease for accounting purposes because the lease period is less than the economic life of the asset being leased . Minimum annual rent payments under this lease are $ 13,381 . At our discretion, we may exercise a purchase option, by giving written notice no later than 180 days but not more than 360 days before the expiration of the initial term. The purchase option price is $ 12,891 based on reasonably predicted fair market value. A right of use asset and lease liability in the amount of $ 55,345 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\nIn accordance with ASC 842, we recorded the operating lease right of use asset and lease liability as follows:\nSCHEDULE OF OPERATING LEASE RIGHT OF USE ASSET AND LEASE LIABILITY\n| March 31, 2021 | December 31,2020 |\n| Right of Use (ROU) asset | $ | 3,917,812 | $ | 3,977,988 |\n\n\n| March 31, 2021 | December 31, 2020 |\n| Operating lease liability: |\n| Current | $ | 198,759 | $ | 189,397 |\n| Non-Current | 3,821,666 | 3,864,321 |\n| Total | $ | 4,020,425 | $ | 4,053,718 |\n\n\n| F-12 |\n\nNOTE 8 – OPERATING LEASES (CONTINUED)\nMaturity of Operating Lease Liability for fiscal year ended December 31,\nSCHEDULE OF MATURITY OF OPERATING LEASE LIABILITY\n| 2021 |\n| 2021 (nine months) | $ | 156,105 |\n| 2022 | 213,747 |\n| 2023 | 232,829 |\n| 2024 | 251,264 |\n| 2025 | 267,134 |\n| After 2025 | 2,899,346 |\n| Total lease liability | $ | 4,020,425 |\n\nInformation associated with the measurement of our remaining operating lease obligations as of March 31, 2021 is as follows:\nThe operating leases range from a term of 2.48 years to 16.68 years with a weighted average lease term of 13.35 years.\nThe weighted average discount rate is 6.07 %.\nThe lease expense for the three months ended March 31, 2021 and 2020 was $ 141,675 and $ 24,061 , respectively.\nNOTE 9 - EQUITY\nPreferred Stock\nWe have authorized 25,000,000 preferred shares with a par value of 0.0001 per share. The Board is authorized to divide the authorized preferred shares into one or more series, each of which shall be so designated as to distinguish the shares thereof from the shares of all other series and classes. As of March 31, 2021 and December 31, 2020, we had no classes of preferred shares designated.\nCommon Stock\nWe have authorized 100,000,000 common shares with a par value of $ 0.0001 per share. Each common share entitles the holder to one vote, in person or proxy, on any matter on which action of the stockholders of the corporation is sought. As of March 31, 2021, we had 35,395,418 common shares issued and outstanding.\n\n| F-13 |\n\nNOTE 9 – EQUITY (CONTINUED)\nFiscal Year 2021\nOn March 23, 2021, we entered into a Plan of Merger with Banyan (See NOTE 4).\nIn connection with the Merger, we issued 4,165,418 shares of our common stock in exchange for 49,984,649 outstanding shares of Banyan’s common stock held by 64 shareholders, based on an exchange ratio of one (1) share of our common stock for every twelve (12) shares of Banyan common stock.\nIn conjunction with the Merger, the previously issued 31,230,000 shares of common stock of the Company prior to the Merger were deemed issued for the Merger.\nDuring the period of February 11, 2021 through March 31, 2021 we issued shares of common stock at $ 0.50 per share for an aggregate consideration of $ 3,540,000\nOn March 31, 2021, we had recorded a liability to issue shares in the amount of $ 325,000 to record stock purchases of 650,000 common shares at $ 0.50 per share that were to be issued in the following month, April 2021. On March 30, 2021, the Noteholders of the $ 2,000,000 convertible note exercised their right to convert the note (see NOTE 4). The shares were not issued as of March 31,2021. The conversion was recorded as a liability to issue shares in the amount of $ 2,000,000 , as reflected on our condensed consolidated balance sheet.\nFiscal Year 2020\nDuring the year ended December 31, 2020, $ 140 was received against a subscription receivable balance for the 2019 authorization of the issuance of Founders shares. On December 31, 2020, we had a subscription receivable of $ 30 for shares issued where payments were not received.\nOn September 19, 2020, we issued 2,000,000 restricted common shares to a noteholder for the conversion of $ 500,000 of note principal.\nWarrants\nIn association with the September 27, 2019 Asset Purchase Agreement (The Kidz Club St Pete, LLC), we issued 75,000 common stock warrants (post-merger exchange adjusted) having an exercise price of $ 0.38 per share. These warrants have an expiration of September 27, 2029 .\nSCHEDULE OF WARRANTS OUTSTANDING\n| Weighted |\n| Weighted- | Average |\n| Average | Remaining | Aggregate |\n| Exercise | Contractual | Intrinsic |\n| Shares | Price | Term | Value |\n| Outstanding at January 1, 2020 | - | - | - | $ | - |\n| Granted | 75,000 | $ | 0.38 | 10.0 Years | $ | - |\n| Expired | - | - | - |\n| Exercised | - | - | - |\n| Outstanding at December 31, 2020 | 75,000 | $ | 0.38 | 9.74 Years | $ | - |\n| Outstanding at January 1, 2020 | 75,000 | 0.38 | 9.74 Years | - |\n| Granted | - | - | - |\n| Expired | - | - | - |\n| Exercised | - | - | - |\n| Outstanding and exercisable March 31, 2020 | 75,000 | $ | 0.38 | 9.49 Years | $ | - |\n\n\n| F-14 |\n\nNOTE 10 – RELATED PARTY TRANSACTIONS\nOn February 1, 2021 (the “Effective Date”), we signed an employment agreement with our new CEO, Louis Collier (“Collier”). Collier will be paid a base salary of $ 400,000 , which will be reassessed and renegotiated in good faith after we are profitable over a fiscal year. Collier will also receive a signing bonus of $ 150,000 , which will be payable as follows: $ 50,000 within five days of the Effective Date (paid); $ 50,000 within 90 days of the Effective Date; and $ 50,000 within 180 days of the Effective Date. Collier will also be issued 1,250,000 phantom shares within ten days after the approval and adoption a Phantom Equity Plan. The phantom shares will be subject to a phantom unit interest award agreement, which will set forth the vesting of the phantom shares.\nOn March 23, 2021, we entered into a Plan of Merger (See NOTE 4) whereas we assumed debt of $ 2,000,000 that was convertible into 20,000,000 shares of common stock. After the Merger the debt was converted into 4,000,000 restricted common shares of the Company at $ 0.50 per share. One of the debt holders is majority owned by a director of the Company. As of March 31, 2021, these shares were not issued and are reflected as share liability on our condensed consolidated balance sheet.\nDuring the three months ended March 31, 2021 and 2020, we compensated members of the Board $ 20,769 and $ 0 , respectively.\nAs of March 31, 2021, we had accrued payroll of $ 60,000 and accrued interest on that payroll in the amount of $ 4,340 for the President and the Chief Financial Officer of Banyan. These unpaid amounts were the result of 2020 furloughed salaries. Interest is being accrued on these unpaid balances effective May 15, 2020 at a rate of 8 % per annum and is reflected in accrued interest balance as of March 31, 2021 and December 31, 2020 on the condensed consolidated balance sheet. Accrued salaries of $ 60,000 is reflected in accrued liabilities at March 31, 2021 and December 31, 2020 on the condensed consolidated balance sheet.\nNOTE 11 – SUBSEQUENT EVENTS\nWe have evaluated subsequent events from March 31, 2021 through the date these financial statements were issued and determined the following events require disclosure:\nSubsequent to March 31, 2021, we issued additional shares of restricted common stock as follow: (i) 1,150,000 shares to five (5) investors at a price of $ 0.50 per share for aggregate proceeds of $ 575,000 , including $ 325,000 issuance to satisfy the liability to issue shares; and (ii) 4,000,000 shares for note conversion.\nOn April 30, 2021, pursuant to the Option Agreement, the number of issued and outstanding shares of common stock was decreased by 200,000 (see NOTE 5).\nDiscontinued Operations\nSee NOTE 5 – DISCONTINUED OPERATIONS regarding the discontinuance of the operations in our wholly-owned subsidiary, Assisted 2 Live, Inc.\nTrillium Healthcare Group, LLC\nOn April 29, 2021, we entered into a Third Amendment (the “Third Amendment”) to a Membership Interest Purchase Agreement dated as of January 29, 2021 (the “Purchase Agreement”), by and among the Company, Richard T. Mason (“Mason”), G. Shayne Bench (“Bench”) and Trillium Healthcare Group, LLC, a Florida limited liability company (“Trillium”) to acquire all of the issued and outstanding ownership interests of Fairway Healthcare Properties, LLC and Trillium Healthcare Consulting, LLC from Trillium.\nAmong other things, the Third Amendment extends the date to May 28, 2021, after which either party may terminate the Purchase Agreement if the closing has not yet occurred.\n\n| F-15 |\n\n\nThe following discussion and analysis of our results of operations and financial condition for period ended March 31, 2021, should be read in conjunction with our consolidated financial statements and the related notes and the other financial information that are included elsewhere in this Quarterly Report. This discussion includes forward-looking statements based upon current expectations that involve risks and uncertainties, such as our plans, objectives, expectations, and intentions. Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results, or other developments. Forward-looking statements are based upon estimates, forecasts, and assumptions that are inherently subject to significant business, economic, and competitive uncertainties and contingencies, many of which are beyond our control and many of which, with respect to future business decisions, are subject to change. These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements. Actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of a number of factors. We use words such as “anticipate,” “estimate,” “plan,” “project,” “continuing,” “ongoing,” “expect,” “believe,” “intend,” “may,” “will,” “should,” “could,” and similar expressions to identify forward-looking statements.\nAs used in this quarterly report, the terms “we,” “us,” “our” and the “Company” means, collectively, Assisted 4 Living, Inc. (“A4L””) and its wholly-owned subsidiaries, Banyan Pediatric Care Centers, Inc, Banyan Pediatric Care Centers – OPS, LLC, Banyan Pediatric Care Centers – St Petersburg, LLC, Banyan Pediatric Care Centers – Sarasota, LLC and Banyan Pediatric Care Centers – Pasco, LLC, unless otherwise indicated.\nGeneral Overview\nA4L was incorporated in Nevada on May 24, 2017, with an objective to operate as a facilitator of assisted living projects and related services. On March 23, 2021, A4L entered into a Plan of Merger (the “Plan of Merger”) with its wholly-owned subsidiary, BPCC Acquisition, Inc., a Florida corporation (“Merger Sub”), and Banyan Pediatric Care Centers, Inc., a Florida corporation (“Banyan”).\nUnder the terms of the Plan of Merger, Merger Sub merged with and into Banyan with Banyan surviving the merger and becoming a wholly-owned subsidiary of A4L (the “Merger”).\nA4L also had a wholly-owned subsidiary, Assisted 2 Live, Inc., a Florida corporation (“A2L”), which was incorporated on June 15, 2017. On April 30, 2021, the Board of Directors of A4L approved the discontinuance of the operations in A2L. The operations of A2L are reflected on our condensed consolidated statement of operations for the last eight days of the three month period ended March 31, 2021 as a loss from discontinued operations.\nOur principal executive office is located at 6801 Energy Court, Suite 201 Sarasota, Florida 34240 and our telephone number is (855) 668-3331. Our office is provided to us at no charge by our largest shareholder and former President. Our corporate website is www.assisted4living.com.\nWe have not been subject to any bankruptcy, receivership or similar proceeding.\n\n| 3 |\n\nOur Current Business\nBanyan was organized under the laws of the State of Florida on January 15, 2019 for the purpose of providing health care services for medically fragile and chronically ill children. Specifically, to open and operate Prescribed Pediatric Extended Care (“PPEC”) centers in the State of Florida. Our PPEC centers provide, among other services, daily medical care for medically fragile and chronically ill children whose current locations are in Florida.\nPPEC centers provide up to 12 hours of daily care for families struggling with the unique and complex medical needs of their children and allow the parents of children with special needs some independence and the opportunity to still pursue their professional goals.\nOn May 1, 2020, we acquired a PPEC facility located in St. Petersburg, FL. The facility is licensed to provide PPEC services for up to 81 children. All State and County accreditations to run the facility through January 2022 are in place.\nOn October 12, 2019, we entered into a lease for commercial real estate in New Port Richey Florida. The lease commenced on September 1, 2020 with an initial term of 7 years. Construction for this location has been completed and we are in the process of applying for the necessary licenses and certifications to provide PPEC services at this location.\nOn August 24, 2019, we entered into a lease for commercial real estate in Sarasota Florida. The lease commenced on February 1, 2020 with an initial term of 5 years. Construction for this location has been completed and we are in the process of applying for the necessary licenses and certifications to provide PPEC services at this location.\nRegulatory Matters\nHealth care operations are highly regulated by both state and federal government agencies. Regulation of health care services is an ever-evolving area of law that varies from jurisdiction to jurisdiction. Regulatory agencies generally have discretion to issue regulations and interpret and enforce laws and rules. Changes in applicable laws, statutes, regulations and interpretive guidance occur frequently. In addition, government agencies may impose taxes, fees or other assessments upon Banyan at any time.\nBanyan is also subject to certain state laws prohibiting the payment of remuneration for patient or business referrals and the provision of services where a financial relationship exists between a referring person or entity and the entity providing the service. Federal laws governing our activities include regulation under the Medicare and Medicaid programs. Federal fraud and abuse laws prohibit or restrict, among other things, the payment of remuneration to parties in a position to influence or cause the referral of patients or business, as well as the filing of false claims. Government enforcement authorities have become increasingly active in recent years in their review and scrutiny of various sectors of the health care industry.\nChanges in or new interpretations of these laws could have an adverse effect on our methods and costs of doing business. Further, failure by Banyan to comply with such laws could adversely affect the ability to continue to provide, or receive reimbursement for, our services, and could subject Banyan and its officers and employees to civil and criminal penalties. There can be no assurance that Banyan will not encounter regulatory impediments that could adversely affect the ability to open facilities or to expand the services currently planned to provide at the facilities.\n\n| 4 |\n\nHIPAA, HITECH Act, State Privacy Laws and Breach Notification Laws.\nHIPAA and the regulations adopted under HIPAA are intended to improve the portability and continuity of health insurance coverage and simplify the administration of health insurance claims and related transactions.\nThe HITECH Act modified certain provisions of HIPAA by, among other things, extending the privacy and security provisions to business associates, mandating new regulations around electronic health records, expanding enforcement mechanisms, and increasing penalties for violations.\nOn January 25, 2013, the U.S. Department of Health and Human Services (“HHS”), as required by the HITECH Act, issued the Final Omnibus Rules that provide final modifications to HIPAA rules to implement the HITECH Act.\nThe HITECH Act also contains a number of provisions that provide incentives for states to initiate certain programs related to health care and health care technology, such as electronic health records. While provisions such as these will not apply to us directly, states wishing to apply for grants under the HITECH Act, or otherwise participating in such programs, may impose new health care technology requirements on us through our expected contracts with state Medicaid agencies.\nAll health plans are considered covered entities subject to HIPAA. HIPAA generally requires health plans, as well as their providers and vendors, to: (1) protect patient privacy and safeguard individually identifiable health information; and (2) establish the capability to receive and transmit electronically certain administrative health care transactions, such as claims payments, in a standardized format.\nSpecifically, the HIPAA Privacy Rule regulates use and disclosure of individually identifiable health information, known as “protected health information” (“PHI”). The HIPAA Security Rule requires covered entities to implement administrative, physical and technical safeguards to protect the security of electronic PHI. Certain provisions of the security and privacy regulations apply to business associates (entities that handle PHI on behalf of covered entities), and business associates are subject to direct liability for violation of these provisions. Furthermore, a covered entity may be subject to penalties as a result of a business associate violating HIPAA, if the business associate is found to be an agent of the covered entity.\nCovered entities must report breaches of unsecured PHI to affected individuals without unreasonable delay, but not to exceed 60 days of discovery of the breach by a covered entity or its agents. Notification must also be made to HHS and, in certain situations involving large breaches, to the media. HHS is required to publish on its website a list of all covered entities that report a breach involving more than 500 individuals. All non-permitted uses or disclosures of unsecured PHI are presumed to be breaches unless the covered entity or business associate establishes that there is a low probability the information has been compromised. Various state laws and regulations may also require us to notify affected individuals in the event of a data breach involving individually identifiable information.\nHIPAA violations by covered entities may result in civil and criminal penalties. Covered entities could face civil monetary penalties up to an annual maximum of $1,500,000 for uncorrected violations based on willful neglect. HHS enforces the regulations and performs audits to confirm compliance. Investigations of violations that indicate willful neglect, for which penalties are mandatory, are statutorily required. HHS may also resolve HIPAA violations through informal means, such as allowing a covered entity to implement a corrective action plan, but HHS has the discretion to move directly to impose monetary penalties and is required to impose penalties for violations resulting from willful neglect. In addition, state attorneys general are authorized to bring civil actions seeking either injunctions or damages in response to violations of HIPAA privacy and security regulations that threaten the privacy of state residents.\nBanyan enforces a HIPAA compliance plan, which complies with the HIPAA privacy and security regulations. Banyan also has dedicated resources to monitor compliance with our HIPAA compliance program.\n\n| 5 |\n\nBanyan, its providers, and certain of its vendors are also subject to numerous other privacy and security laws and regulations at the federal and state levels. Banyan remains subject to any federal or state privacy-related laws that are more restrictive than the privacy regulations issued under HIPAA. These laws vary and violations may result in additional penalties.\nFraud and Abuse Laws. Federal and state enforcement authorities have prioritized the investigation and prosecution of health care fraud, waste and abuse. Fraud, waste and abuse prohibitions encompass a wide range of operating activities, including kickbacks or other inducements for referral of members, billing for unnecessary medical services by a provider and improper marketing and violation of patient privacy rights. Companies involved in public health care programs such as Medicaid and Medicare are required to maintain compliance programs to detect and deter fraud, waste and abuse, and are often the subject of fraud, waste and abuse investigations and audits. The regulations and contractual requirements applicable to participants in these public-sector programs are complex and subject to change. Although Banyan has structured a compliance program with care in an effort to meet all statutory and regulatory requirements, our policies and procedures will be continuously under review and subject to updates and our training and education programs will always be evolving. We intend to invest significant resources towards our compliance efforts.\nFalse Claims Act. We are subject to federal and state laws and regulations that apply to the submission of information and claims to various agencies. For example, the federal False Claims Act provides, in part, that the federal government may bring a lawsuit against any person or entity who it believes has knowingly presented, or caused to be presented, a false or fraudulent request for payment from the federal government, or who has made a false statement or used a false record to get a claim approved. The federal government has taken the position that claims presented in violation of the federal anti-kickback statute may be considered a violation of the federal False Claims Act. Violations of the False Claims Act are punishable by treble damages and penalties of up to a specified dollar amount per false claim. In addition, a special provision under the False Claims Act allows a private person (for example, a “whistleblower” such as a disgruntled former associate, competitor or member) to bring an action under the False Claims Act on behalf of the government alleging that an entity has defrauded the federal government and permits the private person to share in any settlement of, or judgment entered in, the lawsuit. A number of states, including Florida, have adopted false claims acts that are similar to the federal False Claims Act.\nMedicare and Medicaid Regulations. As a provider of services under the Medicare and Medicaid programs (the “Programs”), we are subject to federal and state laws and regulations governing reimbursement procedures and practices. These laws include the Medicare and Medicaid fraud and abuse statutes and regulations which, among other provisions, prohibit the payment or receipt of any form of remuneration in return for referring business or patients to providers for which payments are made by a governmental health care program. Violation of these laws may result in civil and criminal penalties, including substantial fines, loss of the right to participate in the Programs and imprisonment of responsible individuals. In addition, HIPAA expanded the federal government’s fraud and abuse enforcement powers. Among other provisions, HIPAA expands the federal government’s authority to prosecute fraud and abuse beyond Medicare and Medicaid to all payors; makes exclusion from the Programs mandatory for a minimum of five years for any felony conviction relating to fraud; requires that organizations contracting with another organization or individual take steps to be informed as to whether the organization or individual is excluded from Medicare and Medicaid participation; and enhances civil penalties by increasing the amount of fines permitted. These laws also include a prohibition on referrals contained in the Omnibus Budget Reconciliation Act of 1989, which prohibits referrals by physicians to clinical laboratories where the physician has a financial interest, and further prohibitions contained in the Omnibus Budget Reconciliation Act of 1993, which prohibits such referrals for a more extensive range of services, including durable medical equipment. Various federal and state laws impose civil and criminal penalties against participants in the Programs who make false claims for payment for services or otherwise engage in false billing practices.\nMany state laws prohibit the payment or receipt or the offer of anything of value in return for, or to induce, a referral for health care goods or services. In addition, there are several other statutes that, although they do not explicitly address payments for referrals, could be interpreted as prohibiting the practice. While similar in many respects to the federal laws, these state laws vary from state to state, are often vague and have sometimes been interpreted inconsistently by courts and regulatory agencies. Private insurers and various state enforcement agencies have also increased their scrutiny of health care providers’ practices and claims.\n\n| 6 |\n\nThere can be no assurance that Banyan will not become the subject of a regulatory or other investigation or proceeding or that our interpretations of applicable health care laws and regulations will not be challenged. The defense of any such challenge could result in substantial cost to us, diversion of management’s time and attention, and could have a material adverse effect on The Company.\nThe Social Security Act, as amended by HIPAA, provides for the mandatory exclusion of providers and related persons from participation in the Programs if the individual or entity has been convicted of a criminal offense related to the delivery of an item or service under the Programs or relating to neglect or abuse of patients. Further, individuals or entities may be, but are not required to be, excluded from the Programs in circumstances including, but not limited to, convictions relating to fraud; obstruction of an investigation of a controlled substance; license revocation or suspension; filing claims for excessive charges or unnecessary services or failure to furnish medically necessary services; or ownership or control by an individual who has been excluded from the Programs, against whom a civil monetary penalty related to the Programs has been assessed, or who has been convicted of a crime described in this section. The illegal remuneration provisions of the Social Security Act make it a felony to solicit, receive, offer to pay, or pay any kickback, bribe, or rebate in return for referring a patient for any item or service, or in return for purchasing, leasing or ordering any good, service or item, for which payment may be made under the Programs. Other provisions in HIPAA proscribe false statements in billing and in meeting reporting requirements and in representations made with respect to the conditions or operations of providers. A violation of the illegal remuneration statute is a felony and may result in the imposition of criminal penalties, including imprisonment for up to five years and/or a fine of up to $25,000. Further, a civil action to exclude a provider from participation in the Programs could occur. There are also other civil and criminal statutes applicable to the industry, such as those governing false billings and the health care/services offenses contained in HIPAA, including health care/services fraud, theft or embezzlement, false statements and obstruction of criminal investigation of offenses. Criminal sanctions for these health care criminal offenses can be severe, including imprisonment for up to 20 years.\nResults of Operations\nCOVID-19\nIn March 2020, the World Health Organization declared the outbreak of COVID-19 as a pandemic based on the rapid increase in global exposure. COVID-19 continues to spread throughout the world. We are closely monitoring developments and taking steps to mitigate the potential risks related to the COVID-19 pandemic to the Company, its employees, as well as its residential and consulting clients.\nTo date COVID-19 has not substantially negatively impacted our revenues or operations. Our evaluations of our practices, procedures, and operations, related to COVID-19, is ongoing. Additional updates to policies, procedures and operations will occur as best practices are adopted and as we deem necessary or advisable, or as further governmental guidance or regulations are implemented.\nThe following summary of our operations should be read in conjunction with our unaudited financial statements for the three months ended March 31, 2021 which are included in this quarterly report.\nFor the three months ended March 31, 2021 compared to the three months ended March 31, 2020\n\n| Three Months Ended March 31, |\n| 2021 | 2020 | Change |\n| Revenue | $ | 606,925 | $ | 915 | $ | 606,010 |\n| Cost of services | 232,460 | - | 232,460 |\n| Operating expenses | 884,933 | 444,287 | 440,646 |\n| Other expense | (59,516 | ) | (3 | ) | (59,513 | ) |\n| Net Loss from continuing operations | $ | (569,984 | ) | $ | (443,375 | ) | $ | (126,609 | ) |\n\nWe recognized revenue of $606,925 for the three months ended March 31, 2021 compared to $915 for the three months ended March 31, 2020. The first operating facility began in May of 2020 with the acquisition of the St. Petersburg location and revenues began being reported at that time.\n\n| 7 |\n\nOperating expenses for the three months ended March 31, 2021 increased to $884,933 from $444,287 from the three months ended March 31, 2020. Operating expenses consist of salary expenses, general and administrative and professional fees. The increase in operating expense was primarily due to the acquisition of the St. Petersburg location in May of 2020 increasing general and administrative costs by $199,117 and an increase in lease expense of $117,614 from additional leases entered into during 2020.\nOther expenses consist of an increase in interest expense from notes entered into starting September 2020.\nOur net loss for the three months ended March 31, 2021 increased to 569,984 from $443,375 for the three months ended March 31, 2020 as net result of the factors mentioned above.\nLiquidity and Capital Resources\nThe following table provides selected financial data about us as of March 31, 2021 and December 31, 2020.\n\n| March 31, | December 30, |\n| 2021 | 2020 | Change |\n| Cash | $ | 3,441,841 | $ | 345,982 | $ | 3,095,859 |\n| Current assets | $ | 3,998,035 | $ | 650,647 | $ | 3,347,388 |\n| Current liabilities | 4,030,609 | 3,183,288 | 847,321 |\n| Working capital | $ | (32,574) | $ | (2,532,641) | $ | 2,500,067 |\n\nAs of March 31, 2021, our working capital increased $2,500,067, primarily due to an increase in cash offset by an increase in current liabilities.\nAs of March 31, 2021 and December 31, 2020, current assets consisted of cash, accounts receivable and other current assets. The increase in cash was primarily due to the issuance of 7,080,000 shares of restricted common stock at a purchase price of $0.50 per share for an aggregate amount of $3,540,000.\nAs of March 31, 2021, current liabilities consisted of notes and loans payable in the amount of $759,248, accrued interest of $95,079, accrued expenses of $572,891, lease liability of $198,759, share liability of $2,325,000, deferred revenue of $25,703 and liabilities from discontinued operations of $53,929.\nCash Flows\n\n| March 31, | March 31, |\n| 2021 | 2020 | Change |\n| Cash used in operating activities | $ | (228,006 | ) | $ | (427,757 | ) | $ | 199,751 |\n| Cash provided by investing activities | 3,010,994 | - | 3,010,994 |\n| Cash provided by financing activities | 312,871 | 11,885 | 300,986 |\n| Net change in cash for period | $ | 3,095,859 | $ | (415,872 | ) | $ | 3,511,731 |\n\nCash flow from Operating Activities\nDuring the three months ended March 31, 2021, we used $228,006 for operating activities compared to $427,757 cash used for operating activities during the three months ended March 31, 2020. The change in cash used for operating activities is due to an increase in non-cash lease operating expense, depreciation and amortization, accrued interest, and liabilities as well as $53,929 in liabilities from discontinued operations for the three months ended March 31, 2021.\nCash flow from Financing Activities\nThe cash flow from financing activities in the three months ended March 31, 2021 is $312,871, and $0 for the three months ended March 31, 2020. The increase is primarily due to $325,030 cash received for restricted common stock to be issued.\nCash flow from Investing Activities\nThe cash flow from investing activities for the three months ended March 31, 2021 was $3,010,994, and $0 for the three months ended March 31, 2020. This is primarily due to the cash from the first-time consolidation of the Company as a result of the Merger.\nCritical Accounting Policies\nWe prepare our financial statements in conformity with GAAP, which requires management to make certain estimates and apply judgments. We base our estimates and judgments on historical experience, current trends and other factors that management believes to be important at the time the financial statements are prepared. On a regular basis, we review our accounting policies and how they are applied and disclosed in our financial statements.\nWhile we believe that the historical experience, current trends, and other factors considered support the preparation of our financial statements in conformity with GAAP, actual results could differ from our estimates and such differences could be material.\nSee Note 2 - Significant Accounting Policies and the unaudited condensed consolidated financial statements that are included in this Report.\n\n| 8 |\n\nOff Balance Sheet Arrangements\nWe do not engage in any activities involving variable interest entities or off-balance sheet arrangements.\n\nAs a “smaller reporting company,” we are not required to provide the information required by this Item.\n\nItem 4. Controls and Procedures\nEvaluation of Disclosure Controls and Procedures\nWe maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Securities Exchange Act of 1934, as amended (the “Exchange Act”) reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, we recognize that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.\nAs further discussed below, we carried out an evaluation, under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act. Based on that evaluation, our chief executive officer and chief financial officer concluded that, because of certain material weaknesses in our internal control over financial reporting our disclosure controls and procedures as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act were not effective as of March 31, 2021. The material weaknesses relate to the absence of in-house accounting personnel with the ability to properly account for complex transactions and a lack of separation of duties between accounting and other functions.\nWe hired a consulting firm to advise on technical issues related to U.S. GAAP as related to the maintenance of our accounting books and records and the preparation of our consolidated financial statements. Although we are aware of the risks associated with not having dedicated accounting personnel, we are also at an early stage in the development of our business. We anticipate expanding our accounting functions with dedicated staff and improving our internal accounting procedures and separation of duties when we can absorb the costs of such expansion and improvement with additional capital resources. In the meantime, management will continue to observe and assess our internal accounting function and make necessary improvements whenever they may be required. If our remedial measures are insufficient to address the material weakness, or if additional material weaknesses or significant deficiencies in our internal control over financial reporting are discovered or occur in the future, our consolidated financial statements may contain material misstatements, and we could be required to restate our financial results. In addition, if we are unable to successfully remediate this material weakness and if we are unable to produce accurate and timely financial statements, our stock price may be adversely affected, and we may be unable to maintain compliance with applicable stock exchange listing requirements.\nOur management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act. Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Because of its inherent limitations, internal control over financial reporting may not prevent or detect all misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Based on our evaluation under the framework in Internal Control—Integrated Framework (2013), our management concluded that, because of certain material weaknesses in our internal control over financial reporting our disclosure controls and procedures as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act were not effective as of March 31, 2021.\n\n| 9 |\n\nChanges in Internal Control over Financial Reporting\nThere have been no changes in our internal control over financial reporting during the quarter ended March 31, 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\nPART II - OTHER INFORMATION\n\nFrom time to time, we may become involved in litigation relating to claims arising out of its operations in the normal course of business. We are not involved in any pending legal proceeding or litigation and, to the best of our knowledge, no governmental authority is contemplating any proceeding to which we area party or to which any of our properties is subject, which would reasonably be likely to have a material adverse effect on us.\n\nAs a “smaller reporting company,” we are not required to provide the information required by this Item.\n\nDuring the quarterly period ended March 31, 2021, we sold an aggregate of 7,080,000 shares of our common stock to 35 investors at a price of $0.50 per share for an aggregate purchase price of $3,540,000. The offers, sales and issuances of shares were deemed to be exempt from registration under the Securities Act of 1933, as amended (the “Securities Act”), in reliance on Section 4(a)(2) of the Securities Act and Rule 506(b) of Regulation D promulgated thereunder, as transactions by an issuer not involving a public offering. The recipients of shares in each of these transactions acquired the shares for investment only and not with a view to or for sale in connection with any distribution thereof and represented to us that they could bear the risks of the investment and could hold the securities for an indefinite period of time, and appropriate legends were affixed to the shares issued in these transactions. Each of the recipients of shares in these transactions represented to us in connection with their purchase that they were an accredited investor within the meaning of Rule 501 of Regulation D under the Securities Act.\n\n\n| Exhibit No. | Description |\n| 2.1 | Plan of Merger by and among Assisted 4 Living, Inc., BPCC Acquisition, Inc. and Banyan Pediatric Care Centers, Inc. dated March 23, 2021. (Previously filed on March 29, 2021 as Exhibit 2.1 of the Company’s Current Report on Form 8-K) |\n| 31.1 | Certification of Principal Executive Officer filed pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2 | Certification of Principal Financial Officer filed pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1 | Certification of Chief Executive Officer furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2 | Certification of Chief Financial Officer furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS | XBRL Instance Document |\n| 101.SCH | XBRL Taxonomy Extension Schema Document |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document |\n\n\n| 10 |\n\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| ASSISTED 4 LIVING, INC. |\n| (Registrant) |\n| Dated: May 18, 2021 | /s/ Louis Collier |\n| Louis Collier |\n| Chief Executive Officer (principal executive officer) |\n\n\n| 11 |\n\n</text>\n\nWhat is the growth rate of the shareholders' deficit from the period of three months ended March 31, 2020 to the same period in 2021 in percentage?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nTITAN COMPUTER SERVICES, INC.\n(UNAUDITED)\nContents\n\n| Page |\n| Condensed Consolidated Financial Statements (unaudited) |\n| Condensed Consolidated Balance Sheets as of March 31, 2018 (unaudited) and December 31, 2017 | 4 |\n| Condensed Consolidated Statements of Operations for the three months ended March 31, 2018 (unaudited) | 5 |\n| Condensed Consolidated Statement of Cash Flows for the three months ended March 31, 2018 (unaudited) | 6 |\n| Notes to Condensed Consolidated Financial Statements (unaudited) | 7-16 |\n\n3\n\n| TITAN COMPUTER SERVICES, INC. |\n| and Subsidiary |\n| Condensed Consolidated Balance Sheets |\n\n\n| March 31, | December 31, |\n| 2018 | 2017 |\n| (unaudited) |\n| ASSETS |\n| Current assets |\n| Cash | $ | 18,667 | $ | 24,867 |\n| Prepaid expense | 4,166 | 4,167 |\n| Total current assets | 22,833 | 29,034 |\n| Fixed assets, net | 7,842 | 8,713 |\n| Intangible assets, net | 11,824 | 11,977 |\n| Total assets | $ | 42,499 | $ | 49,724 |\n| LIABILITIES AND STOCKHOLDERS’ DEFICIT |\n| Current liabilities |\n| Notes payable - related party | $ | 60,000 | $ | - |\n| Accounts payable - related party | 7,707 | 4,167 |\n| Accrued expenses | 221,993 | 189,198 |\n| Accrued expenses - related party | 9,923 | - |\n| Shareholder’s advance | 26,764 | 26,764 |\n| Total current liabilities | 326,387 | 220,129 |\n| Total liabilities | 326,387 | 220,129 |\n| Commitments and contingencies - Note 6 |\n| Stockholders’ deficit |\n| Preferred stock - no par value, 5,000,000 shares authorized, no shares issued and outstanding at March 31, 2018 and December 31, 2017, respectively | - | - |\n| Common stock - no par value, 70,000,000 shares authorized, 22,803,659 and 21,728,659 shares issued, issuable, and outstanding at March 31, 2018 and December 31, 2017, respectively | 1,717,894 | 269,769 |\n| Additional paid in capital | (149,769 | ) | (149,769 | ) |\n| Accumulated deficit | (1,852,013 | ) | (290,405 | ) |\n| Total stockholders’ deficit | (283,888 | ) | (170,405 | ) |\n| Total liabilities and stockholders’ deficit | $ | 42,499 | $ | 49,724 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n4\n\n| TITAN COMPUTER SERVICES, INC. |\n| and Subsidiary |\n| Condensed Consolidated Statement of Operations |\n| For the three months ended March 31, 2018 |\n| (unaudited) |\n\n\n| Revenue | $ | - |\n| Operating expenses |\n| Professional fees | 12,900 |\n| Corporate expenses | 13,559 |\n| Salary expenses | 31,250 |\n| Stock-based compensation | 1,448,125 |\n| Other general and administrative expenses | 39,748 |\n| Total operating expenses | 1,545,582 |\n| Loss from operations | (1,545,582 | ) |\n| Other income (expenses) |\n| Interest expense | (16,026 | ) |\n| Total other income (expenses) | (16,026 | ) |\n| Net loss | $ | (1,561,608 | ) |\n| Earnings per share - basic and fully diluted | $ | (0.07 | ) |\n| Weighted average number of shares of common stock - basic and fully diluted | 22,768,103 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n5\n\n| TITAN COMPUTER SERVICES, INC. |\n| and Subsidiary |\n| Condensed Consolidated Statement of Cash Flows |\n| For the three months ended March 31, 2018 |\n| (unaudited) |\n\n\n| Cash flows from operating activities: |\n| Net loss | $ | (1,561,608 | ) |\n| Adjustments to reconcile net loss to net cash used in operations: |\n| Depreciation expense | 871 |\n| Amortization expense | 153 |\n| Stock-based compensation | 1,448,125 |\n| Change in assets and liabilities: |\n| Accrued expenses | 30,233 |\n| Accrued expenses - related party | 16,026 |\n| Net cash used in operating activities | (66,200 | ) |\n| Cash flows from financing activities: |\n| Proceeds from notes payable - related party | 60,000 |\n| Net cash provided by financing activities | 60,000 |\n| Net decrease in cash | (6,200 | ) |\n| Cash at beginning of period | 24,867 |\n| Cash at end of period | $ | 18,667 |\n| Supplemental disclosure of cash flow information: |\n| Cash paid for interest | $ | - |\n| Cash paid for taxes | $ | - |\n\n\n| The accompanying notes are an integral part of these consolidated financial statements. |\n| The financial statements only reflect the current year as the Company was established on May 18, 2017. |\n\n6\nTITAN COMPUTER SERVICES, INC.\nAnd Subsidiary\nNotes to the Condensed Consolidated Financial Statements\nMarch 31, 2018\n(unaudited)\nNOTE 1 – NATURE OF OPERATIONS\nCompany Background\nTitan Computer Services, Inc. (the “Company,” “we,” “us,” “our,” or “Altitude - NY”), was incorporated in the State of New York on July 13, 1994.\nOn June 27, 2017, the Company successfully closed a Share Exchange transaction (“Share Exchange”) with the shareholders of Altitude International, Inc, (“Altitude”) a Wisconsin corporation. Altitude was incorporated on May 18, 2017 under the laws of the state of Wisconsin. Altitude will operate through Northern, Central, and South America sales by way of its sole distribution agreement with Woodway Inc. to execute the current business plan of athletic training industry, specifically altitude training. Our objective is to be recognized as one of the upper tier specialty altitude training equipment providers.\nEffective February 13, 2018, majority of the shareholders of the Company approved the following changes to the Company’s Articles of Incorporation:\nAmend the Bylaws to Permit a Simple Majority Vote and Allow for the Appointment of up to Seven\nArticle II Section 10 of the Company’s Bylaws stated, “Any action required or permitted to be taken by the Shareholders thereof may be taken without a meeting if all Shareholders entitled to vote thereon consent in writing to the adoption of a resolution authorizing the action except as otherwise permitted by the Certificate of Incorporation.”\nThe Bylaws were amended to allow for a simple majority vote as permitted by §615 of the New York Business Corporation Law. The amended section shall read, “Any action required or permitted to be taken by the Shareholders thereof may be taken without a meeting if a majority of the Shareholders entitled to vote thereon consent in writing to the adoption of a resolution authorizing the action.”\nArticle III Section 2 of the Company’s Bylaws provided that the number of Directors constituting the entire Board “shall not be less than one nor more than three, as may be fixed by resolution of the Board of Director.” The Bylaws were amended to allow for additional directors as proposed herein (up to four) and to allow for additional directors as the Company grows (up to seven). The amended section shall include the number “seven” instead of “three” as the maximum number of directors.\nName Change from “Titan Computer Services, Inc.” to “Altitude International, Inc.”\nOn February 13, 2018, the majority of the shareholders of the Company approved the amendment to the Articles of Incorporation to change the Company’s name from “Titan Computer Services, Inc.” to “Altitude International, Inc.” The purpose of the name change will help further our brand identity and will reflect the major focus of our business operations, the manufacturing and distribution of products in the athletic training industry, specifically altitude training. The filing of the name change with the state of New York has not been completed as of the date of this report. Once processed by New York, the Company will apply for a name and symbol change with FINRA.\nNature of Operations\nThe product designs to be licensed from Sporting Edge UK, Ltd (“Sporting Edge UK”) are proven and cover a wide range of room sizes. The only requirement is to change from metric to imperial sizes where necessary.\nThere are three unique elements to the Altitude product:\n\n| · | Sophisticated Touch Screen control systems capable of integrating the control of simulated altitude, temperature and humidity. |\n\n\n| · | A unique design of Air Separation Unit with only a single active part that provides for ultra-reliable operation and a design life of greater than fifteen years. |\n\n\n| · | Proven training protocols that allow the desired training benefits to be achieved. |\n\n7\nAltitude has leased space in the Woodway facility in Waukesha, Wisconsin to undertake the manufacture of systems. The work will primarily consist of the assembly of components into the unique licensed designs. Initial recruitment of technically-capable persons will be necessary, followed by short training blocks to pass on the required skills. At least one person is likely to visit the UK to see systems in operation and obtain hands-on experience of the manufacturing requirement. Woodway is an engineering-based company and provides the perfect environment to establish an operation which is in many ways similar to their own. In addition, many aspects of infrastructure – goods handling, welfare facilities, etc. – can be accessed immediately without expense to Altitude.\nRecapitalization of Altitude\nOn June 27, 2017, the Company entered into a share exchange transaction with Altitude which resulted in a change of control of the Company. Pursuant to the terms of the Share Exchange, the Company agreed to issue 6,102,000 shares of its common stock to all the individual shareholders of Altitude on a pro rata basis (one to one share exchange). In exchange for this stock issuance, the Company received 100% of the outstanding shares of Altitude. Following this Share Exchange, Altitude became a wholly-owned subsidiary of Titan. There was a cancellation of 14,700,000 shares of common stock of the Company that was held by the Company’s former majority stockholder as part of the share exchange agreement, which all had a net effect of a decrease of 8,598,000 shares in the Company’s outstanding shares. The business, assets and liabilities of the Company changed as a result of this reverse acquisition to Altitude’s business plan.\nThis share exchange transaction resulted in those shareholders obtaining a majority voting interest in –the Company and control of the Board of Directors of the Company. Generally accepted accounting principles require that the Company whose shareholders retain the majority interest and control in a combined business be treated as the acquirer for accounting purposes, resulting in a reverse acquisition with Altitude as the accounting acquirer and the Company as the acquired party. Accordingly, the share exchange transaction has been accounted for as a recapitalization of Altitude, whereby is deemed to be the continuing, surviving entity for accounting purposes but through reorganization, has deemed to have adopted the capital structure of Altitude - NY. The equity section of the accompanying condensed consolidated financial statements has been restated to reflect the recapitalization of the Company due to the reverse acquisition.\nAccordingly, all references to common shares of Altitude’s common stock have been restated to reflect the equivalent number of the Company’s common shares. In other words, the 6,102,000 Altitude shares outstanding at the time of the share exchange are restated to 21,228,659 common shares (prior to the 500,000 common share capital raise mentioned below that was conducted after the share exchange agreement), as of June 27, 2017. Each share of Altitude is accordingly restated at a multiple of approximately 3.48 shares of the Company for the weighted average shares outstanding for the loss per share calculations in the accompanying condensed consolidated statement of operations.\nThe book value of the net assets that for accounting purposes, were deemed to have been acquired by Altitude from the Company, as of the date of acquisition (June 27, 2017) were $0, after the waiver of all debts from officers and third parties.\nA condition to the closing of the Share Exchange Agreement was raising $100,000 in the Company. On June 27, 2017, the Company issued 500,000 shares of its common stock to an accredited investor pursuant to a Subscription Agreement for $100,000, or $0.20 per share which was kept at escrow account. During the recapitalization, the Company incurred legal fees of $12,500 which was paid through the attorney’s escrow account and recorded as transaction costs which were netted against the $100,000 proceeds.\nAltitude International, Inc.\nAltitude International, Inc. (“Altitude”) was incorporated on May 18, 2017 under the laws of the state of Wisconsin with 100,000,000 authorized common stock with $0.001 par value. On May 18, 2017, 6,102,000 shares of common stock at $0.001 (par) were issued as founder shares, valued at a total of $6,102 to 15 individuals, including Mr. Dave Vincent who is the majority equity interest shareholder and the director of the Company. These shares were issued for future potential services from these various individuals and as of the date of this issuance, no value was placed on these future potential services and were therefore recorded at par value as stock-based compensation to the founders.\nOn June 27, 2017, after the closing of certain Stock Purchase Agreements, in private sale transaction and the Share Exchange Agreement, a change of control of the Company occurred, see recapitalization of Altitude mentioned above. Dave Vincent was the majority shareholder of the Company, owning 51.3 % of the issued and outstanding common shares of –the Company. See Notes 6 and 8.\nAltitude will operate through Northern, Central, and South America sales by way of its sole distribution agreement with Woodway Inc. to execute the current business plan of athletic training industry, specifically altitude training. Our objective is to be recognized as one of the upper tier specialty altitude training equipment providers.\n8\nChanges in Management and the Board of Directors\nOn June 27, 2017, pursuant to the Closing of the Share Exchange Agreement, Mr. Dave Vincent was appointed as the Company’s new CEO and Abraham Rosenblum resigned as CEO. Additionally, Mr. Vincent and Mr. Robert Kanuth were appointed as directors of the Company and Mr. Robert Klein resigned. On October 20, 2017, Greg Whyte was appointed to fill the vacancy as a director of the Company. On January 8, 2018, Joseph B. Frost was appointed to serve as the Chief Operating Officer and on February 13, 2018 Lesley Visser and Joseph B. Frost were elected to serve on the Board of Directors.\nNOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nBasis of presentation\nThe Company follows the accrual basis of accounting in accordance with generally accepted accounting principles in the United States of America and has a year-end of December 31.\nThe preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.\nManagement further acknowledges that it is solely responsible for adopting sound accounting practices, establishing and maintaining a system of internal accounting control and preventing and detecting fraud. The Company’s system of internal accounting control is designed to assure, among other items, that 1) recorded transactions are valid; 2) valid transactions are recorded; and 3) transactions are recorded in the proper period in a timely manner to produce financial statements which present fairly the financial condition, results of operations and cash flows of the Company for the respective periods being presented.\nGoing Concern and Liquidity\nWe have incurred recurring losses since inception and expect to continue to incur losses as a result of legal and professional fees and our corporate general and administrative expenses. At March 31, 2018, we had $18,667 in cash. Our net losses incurred for the three months ended March 31, 2018 amounted to $1,561,608 and working capital deficit was $303,554 at March 31, 2018. As a result, there is substantial doubt about our ability to continue as a going concern. In the event that we are unable to generate sufficient cash from our operating activities or raise additional funds, we may be required to delay, reduce or severely curtail our operations or otherwise impede our on-going business efforts, which could\nhave a material adverse effect on our business, operating results, financial condition and long-term prospects. The Company expects to seek to obtain additional funding through increased revenues and future financings. There can be no assurance as to the availability or terms upon which such financing and capital might be available.\nPrinciples of Consolidation\nThe consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Altitude. All significant intercompany balances and transactions have been eliminated in the consolidation. The consolidated financial statements included herein, presented in accordance with United States generally accepted accounting principles (“GAAP”) and stated in United States dollars, have been prepared by the Company, pursuant to the rules and regulations of the Securities and Exchange Commission.\nUse of Estimates\nThe preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.\nSignificant Estimates, Risks and Concentrations\nThese accompanying financial statements include some amounts that are based on management’s best estimates and judgments. The most significant estimates relate to the valuation of the software rights and redeemable common stock liability. It is reasonably possible that the above-mentioned estimate and others may be adjusted as more current information becomes available, and any adjustment could be significant in future reporting periods.\n9\nThe Company is dependent on its ability to handle rapidly substantial quantities of data and transactions on computer-based networks and the capacity, reliability and security of the electronic delivery systems and the Internet. Any significant failure or interruption of these systems could cause our systems to operate slowly or interrupt service for periods of time and could have a material adverse effect on our business and results of our operations. The Company may experience shortage of capacity and increased costs associated with such usage. These events may affect our ability to store, handle and deliver data and services to our customers.\nCash and Cash Equivalents\nThe Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents.\nProperty, Plant and Equipment\nProperty and equipment are stated at cost, net of accumulated depreciation. Expenditures that extend the life, increase the capacity, or improve the efficiency of property and equipment are capitalized, while expenditures for repairs and maintenance are expensed as incurred. Depreciation is recognized using the straight-line method over the following approximate useful lives:\nMachinery and equipment\n3-5 Years\nIntangible Assets\nCosts incurred to file patent applications and acquired intangibles are capitalized when the Company believes that there is a high likelihood that the patent will be issued and there will be future economic benefit associated with the patent. These costs will be amortized on a straight-line basis over a 20 years life from the date of patent filing. All costs associated with abandoned patent applications are expensed. In addition, the Company will review the carrying value of patents for indicators of impairment on a periodic basis and if it determines that the carrying value is impaired, it values the patent at fair value. As of March 31, 2018, carrying value of patent was $11,824.\nIn accordance with the provisions of the applicable authoritative guidance, the Company’s long-lived assets and amortizable intangible assets are tested for impairment whenever events or changes in circumstances indicate that their carrying value may not be recoverable. The Company assesses the recoverability of such assets by determining whether their carrying value can be recovered through undiscounted future operating cash flows, including its estimates of revenue driven by assumed market segment share and estimated costs. If impairment is indicated, the\nCompany measures the amount of such impairment by comparing the fair value to the carrying value. The amortization of the trademark was not significant for the period ended March 31, 2018.\nImpairment of Long-Lived Assets\nThe Company’s long-lived assets and other assets (consisting of property and equipment) are reviewed for impairment in accordance with the guidance of the FASB ASC Topic 360-10, Property, Plant, and Equipment, and FASB ASC Topic 205, Presentation of Financial Statements. Long lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the undiscounted future net cash flows expected to be generated by that asset. If the carrying amount of an asset exceeds its estimated future undiscounted cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. For the three months ended March 31, 2018, the Company had not experienced impairment losses on its long-lived assets.\nRevenue Recognition\nThe Company recognizes revenue in accordance with ASC 605 Revenue Recognition (“ASC 605”). Revenue is recognized when all of the following four criteria are met: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services rendered, (3) the fee is fixed and determinable, and (4) collectability is reasonably assured. Determining whether and when some of these criteria have been satisfied often involves assumptions and judgments that can have a significant impact on the timing and amount of revenue we report.\nAdvertising Costs\nAdvertising costs are expensed as incurred. Advertising costs for the three months ended March 31, 2018 was $0.\n10\nStock-Based Compensation\nThe Company accounts for stock-based instruments issued to employees in accordance with ASC Topic 718. ASC Topic 718 requires companies to recognize in the statement of operations the grant-date fair value of stock options and other equity-based compensation issued to employees. The value of the portion of an award that is ultimately expected to vest is recognized as an expense over the requisite service periods using the straight-line attribution method. The Company accounts for non-employee share-based awards in accordance with the measurement and recognition provisions ASC Topic 505-50. The Company estimates the fair value of stock options at the grant date by using the Black-Scholes option-pricing model.\nFair Value of Financial Instruments\nThe book values of cash, prepaid expenses, and accounts payable approximate their respective fair values due to the short-term nature of these instruments. The fair value hierarchy under GAAP distinguishes between assumptions based on market data (observable inputs) and an entity’s own assumptions (unobservable inputs).\nThe hierarchy consists of three levels\n\n| · | Level one — Quoted market prices in active markets for identical assets or liabilities; |\n| · | Level two — Inputs other than level one inputs that are either directly or indirectly observable; and |\n| · | Level three — Unobservable inputs developed using estimates and assumptions, which are developed by the reporting entity and reflect those assumptions that a market participant would use. |\n\nDetermining which category an asset or liability falls within the hierarchy requires significant judgment. We evaluate our hierarchy disclosures each quarter.\nEarnings (Loss) Per Share\nBasic earnings (loss) per share are computed by dividing the net income by the weighted-average number of shares of common stock and common stock equivalents (primarily outstanding options and warrants). Common stock equivalents represent the dilutive effect of the assumed exercise of the outstanding stock options and warrants, using the treasury stock method. The calculation of fully diluted earnings per share assumes the dilutive effect of the exercise of outstanding options and warrants at either the beginning of the respective period presented or the date of issuance, whichever is later.\nIncome Taxes\nThe Company accounts for income taxes in accordance with FASB ASC 740, “Income Taxes”. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statements carrying amounts of existing assets and liabilities and loss carry-forwards and their respective tax bases.\nDeferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income (loss) in the years in which those temporary differences are expected to be recovered or settled.\nThe effect of a change in tax rules on deferred tax assets and liabilities is recognized in operations in the year of change. A valuation allowance is recorded when it is “more likely-than-not” that a deferred tax asset will not be realized.\nTax benefits of uncertain tax positions are recognized only if it is more likely than not that the Company will be able to sustain a position taken on an income tax return. The Company has no liability for uncertain tax positions as of December 31, 2017. Interest and penalties in any, related to unrecognized tax benefits would be recognized as interest expense. The Company does not have any accrued interest or penalties associated with unrecognized tax benefits, nor was any significant interest expense recognized during the three months ended March 31, 2018.\nOn December 22, 2017, the United States Government passed new tax legislation that, among other provisions, will lower the corporate tax rate from 35% to 21%. In addition to applying the new lower corporate tax rate in 2018 and thereafter to any taxable income we may have, the legislation affects the way we can use and carry forward net operating losses previously accumulated and results in a revaluation of deferred tax assets recorded on our balance sheet. Given that the deferred tax assets are offset by a full valuation allowance, these changes will have no net impact on the Company’s financial position and net loss. However, if and when we become profitable, we will receive a reduced benefit from such deferred tax assets. Had this legislation been effective prior to our December 31, 2017, fiscal year-end, the effect of the legislation would have been a reduction in deferred tax assets and the corresponding valuation allowance.\n11\nContingencies\nCertain conditions may exist as of the date the financial statements are issued, which may result in a loss to the Company, but which will only be resolved when one or more future events occur or fail to occur. The Company’s management and its legal counsel assess such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or unasserted claims that may result in such proceedings, the Company’s legal counsel evaluates the perceived merits of any legal proceedings or unasserted claims as well as the perceived merits of the amount of relief sought or expected to be sought therein.\nIf the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s financial statements. If the assessment indicates that a potentially material loss contingency is not probable, but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, together with an estimate of the range of possible loss if determinable and material, would be disclosed.\nLoss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the nature of the guarantee would be disclosed.\nEffect of Recent Accounting Pronouncements\nGoing Concern\nASU 2014-15 – “Presentation of Financial Statements—Going Concern—Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (“ASU 2014-15”).” In August 2014, FASB issued guidance that requires management to perform interim and annual assessments of an entity’s ability to continue as a going concern within one year of the date the financial statements are issued. An entity must provide certain disclosures if conditions or events raise substantial doubt about the entity’s ability to continue as a going concern. The updated accounting guidance was effective for the Company on March 31, 2018. We have implemented this new accounting standard and we will update our liquidity disclosures as necessary.\nRecent Accounting Pronouncements\nRecently-Issued Accounting Standards: Management does not believe that any recently issued, but not yet effective, accounting standards if currently adopted would have a material effect on the accompanying financial statements.\nFinancial Instruments\nIn January 2016, the FASB issued ASU No. 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”), which updates certain aspects of recognition, measurement, presentation and disclosure of financial instruments. ASU 2016-01 will be effective for the Company beginning in its first quarter of 2019. The Company does not believe the adoption of ASU 2016-01 will have a material impact on its consolidated financial statements.\nIn June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which modifies the measurement of expected credit losses of certain financial instruments. ASU 2016-13 will be effective for the Company beginning in its first quarter of 2021 and early adoption is permitted. The Company does not believe the adoption of ASU 2016-13 will have a material impact on its consolidated financial statements.\nLeases\nIn February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”), which modified lease accounting for both lessees and lessors to increase transparency and comparability by recognizing lease assets and lease liabilities by lessees for those leases classified as operating leases under previous accounting standards and disclosing key information about leasing arrangements. ASU 2016-02 will be effective for the Company beginning in its first quarter of 2020, and early adoption is permitted. The Company is currently evaluating the timing of its adoption and the impact of adopting ASU 2016-02 on its financial statements.\nStock Compensation\nIn March 2016, the FASB issued ASU No. 2016-09, Compensation – Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”), which simplified certain aspects of the accounting for share-based payment transactions, including income taxes, classification of awards and classification on the statement of cash flows. ASU 2016-09 will be effective for the Company beginning in its first quarter of 2018. The Company is currently evaluating the impact of adopting ASU 2016-09 on its consolidated financial statements.\n12\nIncome Taxes\nIn October 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-16, Income Taxes (Topic 740): Intra-Entity Transfer of Assets Other than Inventory (“ASU 2016-16”), which requires the recognition of the income tax consequences of an intra-entity transfer of an asset, other than inventory, when the transfer occurs. ASU 2016-06 will be effective for the Company in its first quarter of 2019. The Company is currently evaluating the impact of adopting ASU 2016-16 on its consolidated financial statements.\nRevenue Recognition\nIn May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”), which amends the existing accounting standards for revenue recognition. ASU 2014-09 is based on principles that govern the recognition of revenue at an amount an entity expects to be entitled when products are transferred to customers. ASU 2014-09 will be effective for the Company beginning in its first quarter of 2019, and early adoption is permitted.\nSubsequently, the FASB has issued the following standards related to ASU 2014-09: ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (“ASU 2016-08”); ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing (“ASU 2016-10”); and ASU No. 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients (“ASU 2016-12”). The Company must adopt ASU 2016-08, ASU 2016-10 and ASU 2016-12 with ASU 2014-09 (collectively, the “new revenue standards”).\nThe new revenue standards may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of adoption. The Company currently expects to adopt the new revenue standards in its first quarter of 2018 utilizing the full retrospective transition method. The Company is evaluating the effect of the adoption of the new revenue recognition standard as to whether it will have a material impact on its consolidated financial statements.\nNOTE 3 – FIXED ASSETS\nThe Company has fixed assets related to office equipment. The depreciation of the equipment is over a three-year period. As of March 31, 2018, and December 31, 2017, the Company had fixed assets, net of accumulated depreciation, of $7,842 and $8,713, respectively. The fixed assets are as follows:\n\n| March 31, | December 31, |\n| 2018 | 2017 |\n| Office equipment | $ | 10,455 | $ | 10,455 |\n| Total fixed assets | 10,455 | 10,455 |\n| Less: Accumulated depreciation | 2,613 | 1,742 |\n| Fixed assets, net | $ | 7,842 | $ | 8,713 |\n\nDepreciation of the office equipment for the three months ended March 31, 2018 was $871.\nNOTE 4 – INTANGIBLE ASSETS - TRADEMARK\nThe Company has intangible assets related to a trademark. The amortization of the intangible asset is over a twenty-year period. As of March 31, 2018, and December 31, 2017, the Company had intangible assets, net of accumulated amortization, of $11,824 and $11,977, respectively. The intangible assets are as follows:\n\n| March 31, | December 31, |\n| 2018 | 2017 |\n| Trademark | $ | 12,284 | $ | 12,284 |\n| Total intangible assets | 12,284 | 12,284 |\n| Less: Accumulated amortization | 460 | 307 |\n| Intangible assets, net | $ | 11,824 | $ | 11,977 |\n\nAmortization expense of the trademark for the three months ended March 31, 2018 was $153.\n13\nNOTE 5 – NOTES PAYABLE\n\n| Notes payable |\n| March 31, 2018 | December 31, 2017 |\n| Accrued | Accrued |\n| Principal | Interest | Total | Principal | Interest | Total |\n| Dave Vincent | $ | 20,000 | $ | 581 | $ | 20,581 | $ | - | $ | - | $ | - |\n| Joseph B. Frost | 40,000 | 679 | 40,679 | - | - | - |\n| Total | $ | 60,000 | $ | 1,260 | $ | 61,260 | $ | - | $ | - | $ | - |\n\nOn February 7, 2018, Dave Vincent, the Company’s majority shareholder and director, loaned the Company $20,000 in the form of a promissory note. The note bears interest of 20% and has the term of one year, at which time all principal and interest will be paid in a balloon payment. As of March 31, 2018, the accrued interest was $581, and the principal balance was $20,000. See Note 7.\nOn March 2, 2018, Joseph B. Frost, a director, loaned the Company $40,000 in the form of a promissory note. The note bears interest of 20% and has the term of one year, at which time all principal and interest will be paid in a balloon payment. As of March 31, 2018, the accrued interest was $679, and the principal balance was $40,000. See Note 7.\nNOTE 6 – COMMITMENTS AND CONTINGENCIES\nThe Company is subject, from time to time, to claims by third parties under various legal disputes. The defense of such claims, or any adverse outcome relating to any such claims, could have a material adverse effect on the Company’s liquidity, financial condition and cash flows. As of May 14, 2018, the Company did not have any legal actions pending against it.\nOn June 27, 2017, Altitude entered a license agreement with Sporting Edge UK (see Note 1), Sporting Edge UK is the sole and exclusive owner of and has the right to license to licensee the ability to manufacture and sell rights to the full range of membrane-based systems for the production of reduced oxygen environments and associated services as well as the use of patents and trademarks held by Sporting Edge UK or Mr. David Vincent.\nSporting Edge UK agreed to grant the licensee exclusive right and license to the Manufacturing and Sales Rights in the Territory including the Continent of North America, Central America and the Continent of South America. On the effective date of this agreement and for a period of 5 years thereafter, the Company (“Licensee”) shall pay upfront payment of $10,000 to Licensor annually. In addition, commencing on the sixth anniversary of the effective date the licensee shall pay continuing royalty fees on all sales of product manufactured using the IP. The royalty payable shall be calculated as 0.5% of the Sale Price. The Company recorded the payment due of $4,167 under Prepaid expenses and accounts payable as of December 31, 2017.\nNOTE 7 – RELATED PARTY TRANSACTIONS\nAs of December 31, 2017, the balance due to our current CEO, David Vincent, was recorded under shareholder’s advance of $26,764, which is a verbal agreement, non-interest bearing, unsecured and payable on demand. These advances included $10,455 of acquisition of office equipment and $12,284 of acquisition of trademark which were disclosed at supplemental disclosure of non-cash flow investing activities of the statement of cash flow. On February 9, 2018, the Board of Directors changed the arrangement whereas the advance would begin accruing interest at the rate of 20%.\nAltitude has an oral agreement with its Chairman of the Board, Robert Kanuth, in which it will provide for reimbursement of private airline travel expenses incurred on behalf of the Company, for his use of an aircraft in which he has an interest in. These travel expenses totaled $123,750 for the period ended December 31, 2017 and is included in accrued expenses at March 31, 2018. In January 2018, the Board of Directors issued a one-time bonus to Mr. Kanuth, in the amount of $7,525, to compensate for the significant payable and what would have been interest. Additionally, the open balance will accrue interest at the rate of 20% per annum and, as of March 31, 2018, the accrued interest was $6,103.\nOn January 2, 2018, the Company issued 1,000,000 shares of common stock to Joseph B. Frost, the Company’s Chief Operating Officer, under his employment agreement. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $1,350,000. See Note 8.\n14\nOn February 7, 2018, Dave Vincent, the Company’s majority shareholder and director, loaned the Company $20,000 in the form of a promissory note. The note bears interest of 20% and has the term of one year, at which time all principal and interest will be paid in a balloon payment. As of March 31, 2018, the accrued interest was $581, and the principal balance was $20,000. See Note 5.\nOn March 2, 2018, Joseph B. Frost, a director, loaned the Company $40,000 in the form of a promissory note. The note bears interest of 20% and has the term of one year, at which time all principal and interest will be paid in a balloon payment. As of March 31, 2018, the accrued interest was $679, and the principal balance was $40,000. See Note 5.\nNOTE 8 – STOCKHOLDERS’ EQUITY\nPreferred Stock\nOn February 5, 2015, the Board of Directors of the Company authorized 5,000,000 shares of preferred stock with no par value. Each share of the preferred stock is entitled to one vote and is convertible into one share of common stock.\nAs of March 31, 2018, and December 31, 2017, the Company has no preferred stock issued and outstanding.\nCommon Stock\nAltitude was incorporated on May 18, 2017 under the laws of the state of Wisconsin with 100,000,000 authorized common stock with $0.001 par value.\nOn June 12, 2017, Altitude issued 6,102,000 shares of its common stock at par value of $0.001 per share as founder shares for future potential services from 15 individuals, including David Vincent, who is the majority equity interest shareholder and the director of the Company, with a total recorded at par value of $6,102.\nOn June 27, 2017, the Company entered into a share exchange transaction with Altitude and the shareholders of Altitude. Pursuant to the terms of the Share Exchange, the Company agreed to issue 6,102,000 shares of its common stock to the individual shareholders of Altitude on a pro rata basis in exchange for receive 100% of the shares of Altitude. Following the Share Exchange, Altitude became a wholly-owned subsidiary of the Company. See Note 1.\nPrior to the Share Exchange Agreement, there were 22,828,659 shares of common stock of the Company issued and outstanding, 14,700,000 of which were cancelled on June 27, 2017. As consideration for the Share Exchange Agreement, the shareholders of Altitude received a total of 6,102,000 restricted shares of –the Company, proportionate to their shareholdings in Altitude.\nOn June 27, 2017, the date of closing of the Share Exchange Agreement, the Company issued 500,000 shares of its common stock to an accredited investor pursuant to a Subscription Agreement for $100,000, or $0.20 per share. Total proceed received was $87,500 after paying transaction costs of $12,500. Immediately following the Share Exchange agreement, there will are 21,728,659 shares of common stock issued and outstanding and no shares of preferred stock outstanding.\nOn January 1, 2018, the Company was contractually obligated to issue its legal counsel 37,500 shares of common stock for legal work to date. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $50,625.\nOn January 1, 2018, the Company was contractually obligated to issue its legal counsel 12,500 shares of common stock for legal work for January 2018. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $16,875.\nOn January 2, 2018, the Company issued 1,000,000 shares of common stock to Joseph B. Frost, the Company’s Chief Operating Officer, under his employment agreement. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $1,350,000. See Note 7.\nOn February 1, 2018, the Company was contractually obligated to issue its legal counsel 12,500 shares of common stock for legal work for February 2018. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $16,875.\nOn March 1, 2018, the Company was contractually obligated to issue its legal counsel 12,500 shares of common stock for legal work for March 2018. The common stock of the Company is thinly traded and had a value of $1.10 per share, therefore the Company recorded the transaction at $13,750. As of March 31, 2018, these shares had not been issued.\n15\nAs of March 31, 2018, and December 31, 2017, the Company has 22,803,659 and 21,728,659 shares of no par common stock issued, issuable, and outstanding.\nStock Option Plan\nOn February 13, 2018, the Company’s shareholders and Board of Directors approved the 2017 Incentive Stock Plan.\nNOTE 9 – INCOME TAXES\nAs of March 31, 2018, and December 31, 2017, the Company has net operating loss carry forwards of $403,890 and $290,405. The carry forward expires through the year 2038. The Company’s net operating loss carry forwards may be subject to annual limitations, which could reduce or defer the utilization of the losses as a result of an ownership change as defined in Section 382 of the Internal Revenue Code.\nThe Company’s tax expense differs from the “expected” tax expense for Federal income tax purposes (computed by applying the United States Federal tax rate of 21% to loss before taxes for fiscal year 2018 and 34% to loss before taxes for fiscal year 2017), as follows:\n\n| March 31, | December 31, |\n| 2018 | 2017 |\n| Tax expense (benefit) at the statutory rate | $ | (23,832 | ) | $ | (60,985 | ) |\n| State income taxes, net of federal income tax benefit |\n| Change in valuation allowance | 23,832 | 60,985 |\n| Total | $ | - | $ | - |\n\nThe tax effects of the temporary differences between reportable financial statement income and taxable income are recognized as deferred tax assets and liabilities.\nThe tax year 2017 remains to examination by federal agencies and other jurisdictions in which it operates.\nThe tax effect of significant components of the Company’s deferred tax assets and liabilities at March 31, 2018 and December 31, 2017, are as follows:\n\n| March 31, | December 31, |\n| 2018 | 2017 |\n| Deferred tax assets: |\n| Net operating loss carryforward | $ | 84,817 | $ | 60,985 |\n| Timing differences | - | - |\n| Total gross deferred tax assets | 84,817 | 60,985 |\n| Less: Deferred tax asset valuation allowance | (84,817 | ) | (60,985 | ) |\n| Total net deferred taxes | $ | - | $ | - |\n\nIn assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment.\nBecause of the historical earnings history of the Company, the net deferred tax assets for 2018 and 2017 were fully offset by a 100% valuation allowance. The valuation allowance for the remaining net deferred tax assets was $84,817 and $60,985 as of March 31, 2018 and December 31, 2017, respectively.\nOn December 22, 2017, the United States Government passed new tax legislation that, among other provisions, will lower the corporate tax rate from 34% to 21%. In addition to applying the new lower corporate tax rate in 2018 and thereafter to any taxable income we may have, the legislation affects the way we can use and carry forward net operating losses previously accumulated and results in a revaluation of deferred tax assets recorded on our balance sheet. Given that the deferred tax assets are offset by a full valuation allowance, these changes will have no net impact on the Company’s financial position and net loss. However, if and when we become profitable, we will receive a reduced benefit from such deferred tax assets. Had this legislation been effective prior to our December 31, 2017, fiscal year-end, the effect of the legislation would have been a reduction in deferred tax assets and the corresponding valuation allowance.\n16\n\nResults of Operations\nFor the three months ended March 31, 2018 Revenue The Company had no revenue for the three months ended March 31, 2018. Operating Expenses The Company had operating expenses of $1,545,582 for the three months ended March 31, 2018, which primarily consisted of stock-based compensation of $1,448,125. Net Loss The Company had a net loss of $1,561,608 for the three months ended March 31, 2018. The net loss was primarily to the abovementioned effect. Liquidity and Capital Resources As of March 31, 2018, the Company had cash and cash equivalents of $18,667. We do not have sufficient resources to effectuate our business. We expect to incur a minimum of $320,000 in expenses during the next twelve months of operations. We estimate that these expenses will be comprised primarily of general expenses including overhead, legal and accounting fees.\nWe used cash in operations of $66,200 for the three months ended March 31, 2018. The negative cash flow from operating activities for the three months ended March 31, 2018 is attributable to the Company’s net loss from operations of $1,561,608 primarily due to the issuance of common stock for services ($1,448,125).\nWe used cash in investing or financing activities of $0 for the three months ended March 31, 2018.\nWe had cash provided by financing activities of $60,000 for the three months ended March 31, 2018, consisting of loans from Dave Vincent and Joseph B. Frost.\nWe will have to raise funds to pay for our expenses. We may have to borrow money from shareholders or issue debt or equity or enter into a strategic arrangement with a third party. There can be no assurance that additional capital will be available to us. We currently have no arrangements or understandings with any person to obtain funds through bank loans, lines of credit or any other sources. Since we have no such arrangements or plans currently in effect, our inability to raise funds for our operations will have a severe negative impact on our ability to remain a viable company.\nPlan of Operation\nThe Company will produce systems under license from Sporting Edge UK Ltd. These systems include the control of simulated altitude as a minimum and often the simultaneous control of temperature and humidity, providing a full environmental capability. Also included in the license are the Training Protocols that Sporting Edge has established to ensure that the optimum results are achieved by athletes using the altitude facilities. The Company will lease space in the Woodway facility in Waukesha to undertake the manufacture of systems. This will consist primarily of manufacturing space, but with a small office content. The work will primarily consist of the assembly of components into the unique licensed designs. Initial recruitment of technically capable persons will be necessary, followed by short training blocks to pass on the required skills. At least one person is likely to visit the UK to see systems in operation and obtain hands-on experience of the manufacturing requirement. Woodway is an engineering-based company and so is a perfect environment in which to establish an operation which is in many ways similar to their own. In addition, many aspects of infrastructure – goods handling, welfare facilities, etc. – can be accessed immediately without expense to Altitude.\nThe Company has two approaches to penetrating the market.\n| · | The Company has appointed Woodway as the sole Distributor for North, South and Central America. This provides access to every professional Sports Club, College and University as well as many Hospitals and Military facilities. As a result, the time and cost associated with establishing and operating a sales force is avoided. |\n\n\n| · | The Company also has Board members and Company Ambassadors who are able to access key, top level decision makers via their personal contact networks. |\n\n17\nA demonstration Altitude Room has been installed at the Woodway facility in Waukesha to allow effective demonstration of the physiological changes brought about be reduced oxygen air. Customer support and installation activities will be carried out in association with the existing network of Woodway Service Centers. Once again, the cost and time of establishing such a network is avoided whilst ensuring that the vital support element is in place.\nCommercial operations will center in Florida where a second demonstration facility will be located, working in association with an existing top end Fitness facility.\nOff-balance Sheet Arrangements\nWe do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.\n\nNot required.\n\nEvaluation of Disclosure Controls and Procedures\nThe Securities and Exchange Commission defines the term “disclosure controls and procedures” to mean a company’s controls and other procedures of an issuer that are designed to ensure that information required to be disclosed in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Securities Exchange Act of 1934 is accumulated and communicated to the issuer’s management, including its chief executive and chief financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. The Company maintains such a system of controls and procedures in an effort to ensure that all information which it is required to disclose in the reports it files under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified under the SEC’s rules and forms and that information required to be disclosed is accumulated and communicated to the chief executive and interim chief financial officer to allow timely decisions regarding disclosure.\nAs of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures are not effective as of such date. The Chief Executive Officer and Chief Financial Officer have determined that the Company continues to have the following deficiencies which represent a material weakness:\n\n| · | The Company does not have independent directors; |\n| · | Lack of in-house personnel with the technical knowledge to identify and address some of the reporting issues surrounding certain complex or non-routine transactions. With material, complex and non-routine transactions, management has and will continue to seek guidance from third-party experts and/or consultants to gain a thorough understanding of these transactions; |\n| · | Insufficient personnel resources within the accounting function to segregate the duties over financial transaction processing and reporting; and |\n| · | Insufficient written policies and procedures over accounting transaction processing and period end financial disclosure and reporting processes. |\n| · | To remediate our internal control weaknesses, management intends to implement the following measures: |\n| · | As funding permits, the Company will add sufficient accounting personnel to properly segregate duties and to effect a timely, accurate preparation of the financial statements. |\n| · | The Company will hire staff technically proficient at applying U.S. GAAP to financial transactions and reporting. |\n| · | Upon the hiring of additional accounting personnel, the Company will develop and maintain adequate written accounting policies and procedures. |\n\n18\nThe additional hiring is contingent upon The Company’s efforts to obtain additional funding through equity or debt and the results of its operations. Management hopes to secure funds in the coming fiscal year but provides no assurances that it will be able to do so.\nLimitations on the Effectiveness of Controls\nThe Company’s officers do not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of the control system must reflect that there are resource constraints and that the benefits must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Changes in Internal Control Over Financial Reporting During the fiscal quarter covered by this Quarterly Report, there has been no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\n19\nPART II. OTHER INFORMATION\n\nNone.\n\nNot required.\n\nDuring the quarter ending March 31, 2018, the Company issued the following unregistered securities. These securities were issued in reliance upon the exemption from registration provided by Section 4(2) of the Securities Act of 1933, as amended, Regulation D promulgated thereunder as there was no general solicitation, and the transactions did not involve a public offering.\nEffective as of January 2, 2018, the Company issued 1,000,000 shares of the Company’s common stock to the Chief Operating Officer of the Company as payment for services rendered pursuant to an employment agreement.\nOn January 1, 2018, the Company issued 50,000 shares of the Company’s common stock to its legal counsel as payment for services rendered pursuant to an engagement agreement.\nEffective February 1, 2018, the Company issued 12,500 shares of the Company’s common stock to its legal counsel as payment for services rendered pursuant to an engagement agreement.\nNone.\n\nNot applicable.\n\nNone.\n20\n\n\n| Exhibit |\n| Number | Description |\n| 3.1 | Articles of Incorporation (incorporated by reference from the Company’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on January 19, 2016). |\n| 3.1.1 | Amended Articles of Incorporation (incorporated by reference from the Company’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on January 19, 2016). |\n| 3.1.2 | Articles of Incorporation of Altitude International (incorporated by reference to the form 8-K filed by the Company on July 3, 2017). |\n| 3.2 | Amended Articles of Incorporation (incorporated by reference from the Company’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on January 19, 2016). |\n| 10.1 | Share Exchange Agreement (incorporated by reference to exhibit 10.1 to the form 8-K filed by the Company on July 3, 2017). |\n| 10.2 | Licensing Agreement (incorporated by reference to exhibit 10.2 to the form 8-K filed by the Company on July 3, 2017). |\n| 10.3 | Sole Distribution Agreement (incorporated by reference to exhibit 10.3 to the form 8-K filed by the Company on July 3, 2017). |\n| 31.1 | Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2 | Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 32.2 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 101 INS | XBRL Instance Document |\n| 101 SCH | XBRL Taxonomy Extension Schema Document |\n| 101 CAL | XBRL Taxonomy Calculation Linkbase Document |\n| 101 DEF | XBRL Taxonomy Extension Definition Linkbase Document |\n| 101 LAB | XBRL Taxonomy Labels Linkbase Document |\n| 101 PRE | XBRL Taxonomy Presentation Linkbase Document |\n\n21\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| SIGNATURE | TITLE | DATE |\n| /s/ Dave Vincent | Principal Executive Officer and Principal Financial and Accounting Officer | May 21, 2018 |\n| Dave Vincent |\n\n22\n</text>\n\nWhat is the total net value of fixed assets and intangible assets at the end of Q2 2018 (June 30, 2018) in dollars if the yearly depreciation rate of both fixed assets and intangible assets stays unchanged?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial Statements\nPOOL CORPORATION\nConsolidated Statements of Income\n(Unaudited)\n(In thousands, except per share data)\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Net sales | $ | 597,456 | $ | 585,900 |\n| Cost of sales | 422,825 | 419,827 |\n| Gross profit | 174,631 | 166,073 |\n| Selling and administrative expenses | 136,245 | 132,532 |\n| Operating income | 38,386 | 33,541 |\n| Interest and other non-operating expenses, net | 6,616 | 3,527 |\n| Income before income taxes and equity earnings | 31,770 | 30,014 |\n| Income tax benefit | (802 | ) | (1,279 | ) |\n| Equity earnings in unconsolidated investments, net | 65 | 46 |\n| Net income | $ | 32,637 | $ | 31,339 |\n| Earnings per share: |\n| Basic | $ | 0.83 | $ | 0.78 |\n| Diluted | $ | 0.80 | $ | 0.75 |\n| Weighted average shares outstanding: |\n| Basic | 39,479 | 40,370 |\n| Diluted | 40,696 | 41,862 |\n| Cash dividends declared per common share | $ | 0.45 | $ | 0.37 |\n\nThe accompanying Notes are an integral part of the Consolidated Financial Statements.\n1\nPOOL CORPORATION\nConsolidated Statements of Comprehensive Income\n(Unaudited)\n(In thousands)\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Net income | $ | 32,637 | $ | 31,339 |\n| Other comprehensive (loss) income: |\n| Foreign currency translation gains | 214 | 976 |\n| Change in unrealized (losses) gains on interest rate swaps, net of change in taxes of $90 and $(275) | (269 | ) | 824 |\n| Total other comprehensive (loss) income | (55 | ) | 1,800 |\n| Comprehensive income | $ | 32,582 | $ | 33,139 |\n\nThe accompanying Notes are an integral part of the Consolidated Financial Statements.\n2\nPOOL CORPORATION\nConsolidated Balance Sheets\n(In thousands, except share data)\n| March 31, | March 31, | December 31, |\n| 2019 | 2018 | 2018 (1) |\n| (Unaudited) | (Unaudited) |\n| Assets |\n| Current assets: |\n| Cash and cash equivalents | $ | 28,581 | $ | 8,803 | $ | 16,358 |\n| Receivables, net | 72,352 | 75,889 | 69,493 |\n| Receivables pledged under receivables facility | 240,775 | 238,707 | 138,308 |\n| Product inventories, net | 815,742 | 703,793 | 672,579 |\n| Prepaid expenses and other current assets | 16,116 | 23,714 | 18,506 |\n| Total current assets | 1,173,566 | 1,050,906 | 915,244 |\n| Property and equipment, net | 107,690 | 109,310 | 106,964 |\n| Goodwill | 188,478 | 189,759 | 188,472 |\n| Other intangible assets, net | 11,744 | 12,926 | 12,004 |\n| Equity interest investments | 1,200 | 1,150 | 1,213 |\n| Operating lease assets | 177,293 | — | — |\n| Other assets | 18,379 | 15,615 | 16,974 |\n| Total assets | $ | 1,678,350 | $ | 1,379,666 | $ | 1,240,871 |\n| Liabilities and stockholders’ equity |\n| Current liabilities: |\n| Accounts payable | $ | 472,487 | $ | 467,795 | $ | 237,835 |\n| Accrued expenses and other current liabilities | 47,658 | 45,504 | 58,607 |\n| Short-term borrowings and current portion of long-term debt | 21,734 | 20,786 | 9,168 |\n| Current operating lease liabilities | 55,744 | — | — |\n| Total current liabilities | 597,623 | 534,085 | 305,610 |\n| Deferred income taxes | 29,368 | 24,947 | 29,399 |\n| Long-term debt, net | 677,243 | 547,324 | 657,593 |\n| Other long-term liabilities | 26,469 | 23,525 | 24,679 |\n| Non-current operating lease liabilities | 122,770 | — | — |\n| Total liabilities | 1,453,473 | 1,129,881 | 1,017,281 |\n| Stockholders’ equity: |\n| Common stock, $0.001 par value; 100,000,000 shares authorized;39,679,157, 40,568,775 and 39,506,067 shares issued andoutstanding at March 31, 2019, March 31, 2018 andDecember 31, 2018, respectively | 40 | 41 | 40 |\n| Additional paid-in capital | 463,522 | 437,878 | 453,193 |\n| Retained deficit | (227,633 | ) | (182,580 | ) | (218,646 | ) |\n| Accumulated other comprehensive loss | (11,052 | ) | (5,554 | ) | (10,997 | ) |\n| Total stockholders’ equity | 224,877 | 249,785 | 223,590 |\n| Total liabilities and stockholders’ equity | $ | 1,678,350 | $ | 1,379,666 | $ | 1,240,871 |\n\n(1) Derived from audited financial statements.\nThe accompanying Notes are an integral part of the Consolidated Financial Statements.\n3\nPOOL CORPORATION\nCondensed Consolidated Statements of Cash Flows\n(Unaudited)\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Operating activities |\n| Net income | $ | 32,637 | $ | 31,339 |\n| Adjustments to reconcile net income to net cash provided by (used in) operating activities: |\n| Depreciation | 6,649 | 6,299 |\n| Amortization | 375 | 470 |\n| Share-based compensation | 3,259 | 3,321 |\n| Equity earnings in unconsolidated investments, net | (65 | ) | (46 | ) |\n| Other | 512 | 681 |\n| Changes in operating assets and liabilities, net of effects of acquisitions: |\n| Receivables | (103,122 | ) | (117,377 | ) |\n| Product inventories | (128,206 | ) | (168,518 | ) |\n| Prepaid expenses and other assets | (1,427 | ) | (3,843 | ) |\n| Accounts payable | 230,030 | 222,285 |\n| Accrued expenses and other current liabilities | (11,838 | ) | (18,760 | ) |\n| Net cash provided by (used in) operating activities | 28,804 | (44,149 | ) |\n| Investing activities |\n| Acquisition of businesses, net of cash acquired | (9,370 | ) | (578 | ) |\n| Purchases of property and equipment, net of sale proceeds | (6,739 | ) | (14,639 | ) |\n| Net cash used in investing activities | (16,109 | ) | (15,217 | ) |\n| Financing activities |\n| Proceeds from revolving line of credit | 206,190 | 148,335 |\n| Payments on revolving line of credit | (253,249 | ) | (170,012 | ) |\n| Proceeds from asset-backed financing | 80,100 | 80,000 |\n| Payments on asset-backed financing | (13,500 | ) | (20,000 | ) |\n| Proceeds from short-term borrowings and current portion of long-term debt | 13,713 | 10,798 |\n| Payments on short-term borrowings and current portion of long-term debt | (1,148 | ) | (848 | ) |\n| Payments of deferred and contingent acquisition consideration | (311 | ) | (265 | ) |\n| Payments of deferred financing costs | — | (8 | ) |\n| Proceeds from stock issued under share-based compensation plans | 7,071 | 7,808 |\n| Payments of cash dividends | (17,819 | ) | (15,011 | ) |\n| Purchases of treasury stock | (23,097 | ) | (2,592 | ) |\n| Net cash (used in) provided by financing activities | (2,050 | ) | 38,205 |\n| Effect of exchange rate changes on cash and cash equivalents | 1,578 | 24 |\n| Change in cash and cash equivalents | 12,223 | (21,137 | ) |\n| Cash and cash equivalents at beginning of period | 16,358 | 29,940 |\n| Cash and cash equivalents at end of period | $ | 28,581 | $ | 8,803 |\n\nThe accompanying Notes are an integral part of the Consolidated Financial Statements.\n4\nPOOL CORPORATION\nConsolidated Statements of Changes in Stockholders’ Equity\n(Unaudited)\n(In thousands)\n| Common Stock | AdditionalPaid-In | Retained | AccumulatedOtherComprehensive |\n| Shares | Amount | Capital | Deficit | Loss | Total |\n| Balance at December 31, 2018 | 39,506 | $ | 40 | $ | 453,193 | $ | (218,646 | ) | $ | (10,997 | ) | $ | 223,590 |\n| Net income | — | — | — | 32,637 | — | 32,637 |\n| Foreign currency translation | — | — | — | — | 214 | 214 |\n| Interest rate swaps, net of the change in taxes of $90 | — | — | — | — | (269 | ) | (269 | ) |\n| Repurchases of common stock, net of retirements | (155 | ) | (1 | ) | — | (23,096 | ) | — | (23,097 | ) |\n| Share-based compensation | — | — | 3,259 | — | — | 3,259 |\n| Adoption of ASU 2016-02 | — | — | — | (709 | ) | — | (709 | ) |\n| Issuance of shares under share-based compensation plans | 328 | 1 | 7,070 | — | — | 7,071 |\n| Declaration of cash dividends | — | — | — | (17,819 | ) | — | (17,819 | ) |\n| Balance at March 31, 2019 | 39,679 | $ | 40 | $ | 463,522 | $ | (227,633 | ) | $ | (11,052 | ) | $ | 224,877 |\n\n| Common Stock | AdditionalPaid-In | Retained | AccumulatedOtherComprehensive |\n| Shares | Amount | Capital | Deficit | Loss | Total |\n| Balance at December 31, 2017 | 40,212 | $ | 40 | $ | 426,750 | $ | (196,316 | ) | $ | (7,328 | ) | $ | 223,146 |\n| Net income | — | — | — | 31,339 | — | 31,339 |\n| Foreign currency translation | — | — | — | — | 976 | 976 |\n| Interest rate swaps, net of the change in taxes of $(275) | — | — | — | — | 824 | 824 |\n| Repurchases of common stock, net of retirements | (18 | ) | — | — | (2,592 | ) | — | (2,592 | ) |\n| Share-based compensation | — | — | 3,321 | — | — | 3,321 |\n| Issuance of shares under share-based compensation plans | 375 | 1 | 7,807 | — | — | 7,808 |\n| Declaration of cash dividends | — | — | — | (15,011 | ) | — | (15,011 | ) |\n| Other | — | — | — | — | (26 | ) | (26 | ) |\n| Balance at March 31, 2018 | 40,569 | $ | 41 | $ | 437,878 | $ | (182,580 | ) | $ | (5,554 | ) | $ | 249,785 |\n\n5\nPOOL CORPORATION\nNotes to Consolidated Financial Statements\n(Unaudited)\nNote 1 – Summary of Significant Accounting Policies\nPool Corporation (the Company, which may be referred to as we, us or our) prepared the unaudited interim Consolidated Financial Statements following U.S. generally accepted accounting principles (GAAP) and the requirements of the Securities and Exchange Commission (SEC) for interim financial information. As permitted under those rules, we have condensed or omitted certain footnotes and other financial information required for complete financial statements.\nThe Consolidated Financial Statements include all normal and recurring adjustments that are necessary for a fair presentation of our financial position and operating results. All significant intercompany accounts and intercompany transactions have been eliminated.\nA description of our significant accounting policies is included in our 2018 Annual Report on Form 10-K. You should read the interim Consolidated Financial Statements in conjunction with the Consolidated Financial Statements and accompanying notes in our 2018 Annual Report on Form 10-K. The results for our three month period ended March 31, 2019 are not necessarily indicative of the expected results for our fiscal year ending December 31, 2019.\nNewly Adopted Accounting Pronouncements\nOn January 1, 2019, we adopted Accounting Standards Update (ASU) 2016-02, Leases (Topic 842) and all the related amendments, which are codified into Accounting Standards Codification (ASC) 842. The adoption of ASU 2016-02 significantly increased assets and liabilities on our Consolidated Balance Sheets as we recorded a right-of-use asset and corresponding liability for each of our existing operating leases. We adopted this guidance using the modified retrospective approach by recognizing a cumulative adjustment to retained earnings on the adoption date, which was not material. Additionally, we elected to apply the practical expedient that allows us to exclude comparative presentation; thus, we did not restate our prior period balance sheets to reflect the new guidance.\nWe recorded operating lease assets and operating lease liabilities of approximately $175.7 million and $181.6 million, respectively, as of January 1, 2019. The difference between the operating lease assets and operating lease liabilities primarily represents our straight-line rent liability of $5.1 million recorded under previous accounting guidance. Under ASU 2016-02, this liability is considered a reduction of the operating lease asset. We recorded the remaining difference between our operating lease assets and operating lease liabilities, net of the deferred tax impact, as an adjustment to retained earnings. Additionally, we reclassified prepaid rent of $4.9 million as of January 1, 2019 to our operating lease asset resulting in a balance of $180.6 million as of the adoption date.\nThe adoption of this guidance did not materially impact our results of operations or cash flows. See Commitments and Contingencies within this note below for additional information regarding our adoption of this new guidance.\nOn January 1, 2019, we adopted ASU 2017-12, Derivatives and Hedging (Topic 815), Targeted Improvements to Accounting for Hedging Activities. This new standard expands and refines hedge accounting for both financial and non-financial risk components, aligns the recognition and presentation of the effects of hedging instruments and hedge items in the financial statements and includes certain targeted improvements to ease the application of current guidance related to the assessment of hedge effectiveness. The adoption of this guidance did not impact our results of operations, statement of financial position or cash flows.\nCommitments and Contingencies\nWe lease facilities for our corporate and administrative offices, sales centers and centralized shipping locations under operating leases that expire in various years through 2032. Most of our leases contain five-year terms with renewal options that allow us to extend the lease term beyond the initial period, subject to terms agreed upon at lease inception. Based on our leasing practices and contract negotiations, we determined that we are not reasonably certain to exercise the renewal options and, as such, we have not included optional renewal periods in our measurement of operating lease assets, liabilities and expected lease terms.\nWe elected to apply the package of practical expedients available within ASU 2016-02, which is intended to provide some relief to issuers. Electing this option allowed us to retain our existing assessment of whether an arrangement is or contains a lease, is classified as an operating or financing lease and contains initial direct costs. We also elected the practical expedients that allow us to exclude short-term leases from our Consolidated Balance Sheets and to combine lease and non-lease components.\n6\nFor leases with step rent provisions whereby the rental payments increase incrementally over the life of the lease, we recognize expense on a straight-line basis determined by the total lease payments over the lease term. To the extent we determine that future obligations related to real estate taxes, insurance and other lease components are variable, we exclude them from the measurement of our operating lease assets and liabilities.\nSome of our real estate agreements include rental payments adjusted periodically for inflation. Our lease agreements do not contain any material residual value guarantees or material restrictive covenants.\nThe table below presents expense associated with facility and vehicle operating leases (in thousands):\n| Three Months Ended |\n| March 31, |\n| Lease Cost | Classification | 2019 | 2018 |\n| Operating lease cost (1) | Selling and administrative expenses | $ | 15,070 | $ | 14,553 |\n| Variable lease cost | Selling and administrative expenses | 3,259 | 3,021 |\n\n(1) Includes short-term lease cost, which is not material\nBased on our lease portfolio as of March 31, 2019, the table below sets forth the approximate future lease payments related to operating leases with initial terms of one year or more (in thousands):\n| 2019 | $ | 38,389 |\n| 2020 | 50,443 |\n| 2021 | 39,184 |\n| 2022 | 29,883 |\n| 2023 | 18,089 |\n| Thereafter | 17,554 |\n| Total lease payments | 193,542 |\n| Less: interest | 15,028 |\n| Present value of lease liabilities | 178,514 |\n\nTo calculate the present value of our lease liabilities, we determined our incremental borrowing rate based on the effective interest rate on our unsecured syndicated senior credit facility (the Credit Facility) adjusted for a collateral feature similar to that of our leased properties. The table below presents the weighted-average remaining lease term (years) of our operating leases and the weighted-average discount rate used in the above calculation:\n| March 31, |\n| Lease Term and Discount Rate | 2019 |\n| Weighted-average remaining lease term (years) |\n| Operating leases | 5.21 |\n| Weighted-average discount rate |\n| Operating leases | 3.5 | % |\n\n7\nThe table below presents the amount of cash paid for amounts included in the measurement of lease liabilities (in thousands):\n| Three Months Ended |\n| March 31, |\n| 2019 |\n| Operating cash flows for lease liabilities | $ | 14,080 |\n\nWe lease corporate and administrative offices from Northpark Corporate Center, LLC (NCC), an entity in which we have held a 50% ownership interest since May 2005. NCC owns and operates an office building in Covington, Louisiana. As of March 31, 2019, we occupy approximately 60,293 square feet of office space and we pay rent of $97,976 per month. Our lease term ends in May 2025. We recorded rent expense of $0.3 million for each of the three month periods ended March 31, 2019 and March 31, 2018.\nIncome Taxes\nWe reduce federal and state income taxes payable by the tax benefits associated with the exercise of nonqualified stock options and the lapse of restrictions on restricted stock awards. To the extent realized tax deductions exceed the amount of previously recognized deferred tax benefits related to share-based compensation, we record an excess tax benefit. We record all excess tax benefits as a component of income tax benefit or expense on the Consolidated Statements of Income in the period in which stock options are exercised or restrictions on awards lapse. We recorded excess tax benefits of $8.8 million in the first three months of 2019 compared to $9.0 million in the same period of 2018.\nRetained Deficit\nWe account for the retirement of treasury shares as a reduction of retained earnings (deficit). As of March 31, 2019, the Retained deficit on our Consolidated Balance Sheets reflects cumulative net income, the cumulative impact of adjustments for changes in accounting pronouncements, treasury share retirements since the inception of our share repurchase programs of $1,449.9 million and cumulative dividends of $512.9 million.\nAccumulated Other Comprehensive Loss\nThe table below presents the components of our Accumulated other comprehensive loss balance (in thousands):\n| March 31, | December 31, |\n| 2019 | 2018 | 2018 |\n| Foreign currency translation adjustments | $ | (12,208 | ) | $ | (6,528 | ) | $ | (12,422 | ) |\n| Unrealized gains on interest rate swaps, net of tax (1) | 1,156 | 974 | 1,425 |\n| Accumulated other comprehensive loss | $ | (11,052 | ) | $ | (5,554 | ) | $ | (10,997 | ) |\n\n| (1) | In February 2018, the Financial Accounting Standards Board (FASB) issued guidance that allows entities the option to reclassify the tax effects related to items in accumulated other comprehensive income (loss) to retained earnings (deficit) if deemed to be stranded in accumulated other comprehensive income (loss) due to U.S. tax reform. We do not have any material amounts stranded in Accumulated other comprehensive loss as a result of U.S. tax reform. |\n\n8\nRecent Accounting Pronouncements Pending Adoption\n| Standard | Description | Effective Date | Effect on Financial Statements and Other Significant Matters |\n| ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments | Changes the way companies evaluate credit losses for most financial assets and certain other instruments. For trade and other receivables, held-to-maturity debt securities, loans and other instruments, entities will be required to use a new forward-looking “expected loss” model to evaluate impairment, potentially resulting in earlier recognition of allowances for losses. The new standard also requires enhanced disclosures, including the requirement to disclose the information used to track credit quality by year of origination for most financing receivables. The guidance must be applied using a cumulative-effect transition method. | Annual periods beginning after December 15, 2019 | We are currently evaluating the effect this will have on our financial position, results of operations and related disclosures. |\n| ASU 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment | Eliminates the requirement to calculate the implied fair value of goodwill to measure a goodwill impairment charge (commonly referred to as Step 2 under the current guidance). Rather, the measurement of a goodwill impairment charge will be based on the excess of a reporting unit’s carrying value over its fair value (Step 1 under the current guidance). This guidance should be applied prospectively. | Annual and interim impairment tests performed in periods beginning after December 15, 2019 | We are currently evaluating the effect this will have on our financial position, results of operations and related disclosures. |\n\nNote 2 – Earnings Per Share\nWe calculate basic earnings per share (EPS) by dividing Net income by the weighted average number of common shares outstanding. We include outstanding unvested restricted stock awards of our common stock in the basic weighted average share calculation. Diluted EPS reflects the dilutive effects of potentially dilutive securities, which include in-the-money outstanding stock options and shares to be purchased under our employee stock purchase plan. Using the treasury stock method, the effect of dilutive securities includes these additional shares of common stock that would have been outstanding based on the assumption that these potentially dilutive securities had been issued.\nStock options with exercise prices that are higher than the average market prices of our common stock for the periods presented are excluded from the diluted EPS calculation because the effect is anti-dilutive.\n9\nThe table below presents the computation of EPS, including the reconciliation of basic and diluted weighted average shares outstanding (in thousands, except EPS):\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Net income | $ | 32,637 | $ | 31,339 |\n| Weighted average shares outstanding: |\n| Basic | 39,479 | 40,370 |\n| Effect of dilutive securities: |\n| Stock options and employee stock purchase plan | 1,217 | 1,492 |\n| Diluted | 40,696 | 41,862 |\n| Earnings per share: |\n| Basic | $ | 0.83 | $ | 0.78 |\n| Diluted | $ | 0.80 | $ | 0.75 |\n| Anti-dilutive stock options excluded from diluted earnings per share computations | 65 | 85 |\n\nNote 3 – Acquisitions\nIn January 2019, we acquired the distribution assets of W.W. Adcock, Inc., a wholesale distributor of swimming pool products, equipment, parts and supplies adding two locations in Pennsylvania, one location in North Carolina and one location in Virginia.\nIn November 2018, we acquired the distribution assets of Turf & Garden, Inc., a wholesale distributor of irrigation products and landscape maintenance equipment, parts and supplies with three locations in Virginia and one location in North Carolina.\nWe have completed our acquisition accounting for these acquisitions, subject to adjustments for standard holdback provisions per the terms of the purchase agreements, which are not material.\nIn January 2018, we acquired the distribution assets of Tore Pty. Ltd. (doing business as Pool Power), a wholesale distributor of pool and spa equipment in South Australia, with one distribution center in Adelaide, Australia. We have completed our acquisition accounting for this acquisition.\nThese acquisitions did not have a material impact on our financial position or results of operations, either individually or in the aggregate.\nNote 4 – Fair Value Measurements and Interest Rate Swaps\nOur assets and liabilities that are measured at fair value on a recurring basis include the unrealized gains or losses on our interest rate swap contracts and contingent consideration related to recent acquisitions. The three levels of the fair value hierarchy under the accounting guidance are described below:\n| Level 1 | Inputs to the valuation methodology are unadjusted quoted prices for identical assets or liabilities in active markets. |\n\n| Level 2 | Inputs to the valuation methodology include: |\n\n| • | quoted prices for similar assets or liabilities in active markets; |\n\n| • | quoted prices for identical or similar assets or liabilities in inactive markets; |\n\n| • | inputs other than quoted prices that are observable for the asset or liability; or |\n\n10\n| • | inputs that are derived principally from or corroborated by observable market data by correlation or other means. |\n\n| Level 3 | Inputs to the valuation methodology are unobservable and significant to the fair value measurement. |\n\nThe table below presents the estimated fair values of our interest rate swap contracts, our forward-starting interest rate swap contract and our contingent consideration liabilities (in thousands):\n| Fair Value at March 31, |\n| 2019 | 2018 |\n| Level 2 |\n| Unrealized gains on interest rate swaps | $ | 1,785 | $ | 2,451 |\n| Level 3 |\n| Contingent consideration liabilities | $ | 833 | $ | 1,617 |\n\nInterest Rate Swaps\nWe utilize interest rate swap contracts and forward-starting interest rate swap contracts to reduce our exposure to fluctuations in variable interest rates for future interest payments on our unsecured syndicated senior credit facility (the Credit Facility).\nFor determining the fair value of our interest rate swap and forward-starting interest rate swap contracts, we use significant other observable market data or assumptions (Level 2 inputs) that we believe market participants would use in pricing similar assets or liabilities, including assumptions about counterparty risk. Our fair value estimates reflect an income approach based on the terms of the interest rate swap contracts and inputs corroborated by observable market data including interest rate curves. We include unrealized gains in Prepaid expenses and other current assets and unrealized losses in Accrued expenses and other current liabilities on the Consolidated Balance Sheets.\nWe recognize any differences between the variable interest rate payments and the fixed interest rate settlements from our swap counterparties as an adjustment to interest expense over the life of the swaps. If determined to be effective cash flow hedges, we record the changes in the estimated fair value of the swaps to Accumulated other comprehensive loss on our Consolidated Balance Sheets. To the extent our interest rate swaps are determined to be ineffective, we recognize the changes in the estimated fair value of our swaps in Interest and other non-operating expenses, net on our Consolidated Statements of Income.\nWe currently have three interest rate swap contracts in place, which became effective on October 19, 2016. These swaps were previously forward-starting contracts that were amended in October 2015 to bring the fixed rates per our forward-starting contracts in line with current market rates at that time and extend the hedged period for future interest payments on our Credit Facility. As amended, these swap contracts terminate on November 20, 2019. In the first three months of 2019, we recognized a loss of $0.2 million as a result of ineffectiveness.\nThe following table provides additional details related to each of these amended swap contracts:\n| Derivative | Amendment Date | NotionalAmount(in millions) | FixedInterestRate |\n| Interest rate swap 1 | October 1, 2015 | $75.0 | 2.273% |\n| Interest rate swap 2 | October 1, 2015 | $25.0 | 2.111% |\n| Interest rate swap 3 | October 1, 2015 | $50.0 | 2.111% |\n\nFor the three interest rate swap contracts in effect at March 31, 2019, a portion of the change in the estimated fair value between periods relates to future interest expense. Recognition of the change in fair value between periods attributable to accrued interest is reclassified from Accumulated other comprehensive loss on the Consolidated Balance Sheets to Interest and other non-operating expenses, net on the Consolidated Statements of Income. These amounts were not material in the three month periods ended March 31, 2019 and March 31, 2018.\n11\nIn July 2016, we entered into an additional forward-starting interest rate swap contract to extend the hedged period for future interest payments on our Credit Facility to its maturity date at that time. This swap contract will convert the variable interest rate to a fixed interest rate on borrowings under the Credit Facility. This contract becomes effective on November 20, 2019 and terminates on November 20, 2020. The following table provides additional details related to this swap contract:\n| Derivative | Inception Date | NotionalAmount(in millions) | FixedInterestRate |\n| Forward-starting interest rate swap | July 6, 2016 | $150.0 | 1.1425% |\n\nFailure of our swap counterparties would result in the loss of any potential benefit to us under our swap agreements. In this case, we would still be obligated to pay the variable interest payments underlying our debt agreements. Additionally, failure of our swap counterparties would not eliminate our obligation to continue to make payments under our existing swap agreements if we continue to be in a net pay position.\nOur interest rate swap and forward-starting interest rate swap contracts are subject to master netting arrangements. According to our accounting policy, we do not offset the fair values of assets with the fair values of liabilities related to these contracts.\nOther\nThe carrying values of cash, receivables, accounts payable and accrued liabilities approximate fair value due to the short maturity of those instruments (Level 1 inputs). The carrying value of long-term debt approximates fair value (Level 3 inputs). Our determination of the estimated fair value reflects a discounted cash flow model using our estimates, including assumptions related to borrowing rates (Level 3 inputs).\nNote 5 – Debt\nThe table below presents the components of our debt (in thousands):\n| March 31, |\n| 2019 | 2018 |\n| Variable rate debt |\n| Short-term borrowings | $ | 13,714 | $ | 12,263 |\n| Current portion of long-term debt: |\n| Australian credit facility | 8,020 | 8,523 |\n| Short-term borrowings and current portion of long-term debt | 21,734 | 20,786 |\n| Long-term portion: |\n| Revolving credit facility | 503,073 | 388,762 |\n| Receivables securitization facility | 175,100 | 160,000 |\n| Less: financing costs, net | 930 | 1,438 |\n| Long-term debt, net | 677,243 | 547,324 |\n| Total debt | $ | 698,977 | $ | 568,110 |\n\nOur accounts receivable securitization facility (the Receivables Facility) provides for the sale of certain of our receivables to a wholly owned subsidiary (the Securitization Subsidiary). The Securitization Subsidiary transfers variable undivided percentage interests in the receivables and related rights to certain third-party financial institutions in exchange for cash proceeds, limited to the applicable funding capacities.\nWe account for the sale of the receivable interests as a secured borrowing on our Consolidated Balance Sheets. The receivables subject to the agreement collateralize the cash proceeds received from the third-party financial institutions. We classify the entire outstanding balance as Long-term debt on our Consolidated Balance Sheets as we intend and have the ability to refinance the obligations on a long‑term basis. We present the receivables that collateralize the cash proceeds separately as Receivables pledged under receivables facility on our Consolidated Balance Sheets.\n12\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nYou should read the following discussion in conjunction with Management’s Discussion and Analysis included in our 2018 Annual Report on Form 10-K.\nFor a discussion of our base business calculations, see the Results of Operations section below.\nCautionary Statement for Purposes of the “Safe Harbor” Provisions of the Private Securities Litigation Reform Act of 1995\nThis report contains forward-looking information that involves risks and uncertainties. Our forward‑looking statements express our current expectations or forecasts of possible future results or events, including projections of earnings and other financial performance measures, statements of management’s expectations regarding our plans and objectives and industry, general economic and other forecasts of trends, future dividend payments and share repurchases, and other matters. Forward-looking statements speak only as of the date of this filing, and we undertake no obligation to update or revise such statements to reflect new circumstances or unanticipated events as they occur. You can identify these statements by the fact that they do not relate strictly to historic or current facts and often use words such as “anticipate,” “estimate,” “expect,” “intend,” “believe,” “will likely result,” “outlook,” “project,” “may,” “can,” “plan,” “target,” “potential,” “should” and other words and expressions of similar meaning.\nNo assurance can be given that the expected results in any forward-looking statement will be achieved, and actual results may differ materially due to one or more factors, including the sensitivity of our business to weather conditions, changes in the economy and the housing market, our ability to maintain favorable relationships with suppliers and manufacturers, competition from other leisure product alternatives and mass merchants, excess tax benefits or deficiencies recognized under ASU 2016-09 and other risks detailed in our 2018 Annual Report on Form 10-K. For these statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act.\nOVERVIEW\nFinancial Results\nWe produced solid results in the first quarter of 2019 despite wetter and cooler conditions throughout most of the quarter in some of our major markets. Our team’s strong execution, coupled with modest top line growth, delivered favorable results in the quarter.\nNet sales increased 2% to $597.5 million in the first quarter of 2019 compared to $585.9 million in the first quarter of 2018, while base business sales grew 1%. Cooler and wetter weather, particularly in the western United States, combined with a later Easter holiday adversely impacted first quarter sales. Pool openings and normal spring early buys from customers in seasonal markets are influenced by the timing of the Easter holiday. In addition, sales were negatively impacted approximately 2% by the loss of a selling day compared to the first quarter of 2018 and 1% from unfavorable foreign currency exchange rate fluctuations.\nGross profit increased 5% to $174.6 million in the first quarter of 2019 from $166.1 million in the same period in 2018. Base business gross profit improved 4% over the first quarter of 2018, including a negative currency exchange impact of 1%. Gross margin increased 90 basis points to 29.2% in the first quarter of 2019 compared to 28.3% in the first quarter of 2018, reflecting benefits from our strategic inventory purchases in 2018 and lower customer early buys in the first quarter of 2019.\nSelling and administrative expenses (operating expenses) increased 3% to $136.2 million in the first quarter of 2019 compared to the first quarter of 2018. Base business operating expenses were up 1% over the comparable 2018 period including a 1% currency benefit. As a percentage of net sales, base business operating expenses increased to 22.6% in the first quarter of 2019 compared to 22.5% in the first quarter of 2018.\nOperating income for the first quarter of 2019 increased to $38.4 million, up 14% compared to the same period in 2018. Operating margin was 6.4% in the first quarter of 2019 and 5.7% in the same period in 2018, while base business operating margin improved 90 basis points from the prior year to 6.7% in the first quarter of 2019.\nWe recorded an $8.8 million tax benefit from Accounting Standards Update (ASU) 2016-09, Improvements to Employee Share-Based Payment Accounting, in the quarter ended March 31, 2019 compared to a tax benefit of $9.0 million realized in the same period of 2018.\n13\nNet income was $32.6 million in the first quarter of 2019 compared to $31.3 million in the first quarter of 2018. Earnings per share increased 7% to $0.80 per diluted share in the three months ended March 31, 2019 compared to $0.75 per diluted share in the same period of 2018. The benefit from ASU 2016-09 increased diluted earnings per share by $0.21 and $0.22 in the first quarters of 2019 and 2018, respectively. Excluding the impact from ASU 2016-09 in both periods, earnings per diluted share increased 11% to $0.59 in the first quarter of 2019 compared to $0.53 in the first quarter of 2018.\nReferences to product line and product category data throughout this report generally reflect data related to the North American swimming pool market, as it is more readily available for analysis and represents the largest component of our operations.\nFinancial Position and Liquidity\nAs of March 31, 2019, total net receivables, including pledged receivables, remained flat compared to March 31, 2018. Our days sales outstanding (DSO), as calculated on a trailing four quarters basis, was 29.8 days at March 31, 2019 and 30.1 days at March 31, 2018. Our allowance for doubtful accounts balance was $5.6 million at March 31, 2019 and $4.0 million at March 31, 2018.\nNet inventory levels grew 16% compared to levels at March 31, 2018. The increase of $111.9 million in inventory reflects strategic inventory purchases we made in the second half of 2018 in advance of greater than normal vendor price increases, inventory from acquired businesses and normal business growth, as well as the slower start to the season. The inventory reserve was $8.5 million at March 31, 2019 and $7.4 million at March 31, 2018. Our inventory turns, as calculated on a trailing four quarters basis, were 3.1 times at March 31, 2019 and 3.5 times at March 31, 2018.\nTotal debt outstanding at March 31, 2019 was $699.0 million, up 23% compared to total debt at March 31, 2018 primarily to fund business driven working capital growth, acquisitions and share repurchases over the past 12 months.\nCurrent Trends and Outlook\nFor a detailed discussion of trends through 2018, see the Current Trends and Outlook section of Management’s Discussion and Analysis included in Part II, Item 7 of our 2018 Annual Report on Form 10-K.\nAs a result of the additional tax benefits realized from ASU 2016-09 in the first quarter of 2019 beyond what was included in our initial earnings guidance range, we are updating our 2019 earnings guidance to a range of $6.09 to $6.39 from $6.05 to $6.35 per diluted share. Other than the additional $0.04 per diluted share tax benefit, our earnings expectation for 2019 remains unchanged.\nConsistent with our original 2019 projections, we expect base business sales growth of approximately 7% to 9% for 2019 and expect gross margin will be similar to 2018. Unfavorable weather impacts, the loss of a selling day and a later Easter holiday in 2019 led to delayed pool openings, lower customer early buys and lower construction and remodeling activity. We believe these factors negatively impacted our first quarter of 2019 sales by an estimated $30.0 to $45.0 million but will lead to increased sales growth later in the year, depending on customer capacity and weather.\nWe expect a slight improvement in our gross margin in the second quarter of 2019 as we sell through the strategic inventory purchases we made in the second half of 2018; we expect margins to decline in the fourth quarter of 2019 in comparison to the same quarter in the prior year due to a difficult comparison.\nWe expect base business operating expenses will grow at a rate of approximately 60% of gross margin growth for the year, which will enable us to achieve operating margin improvement of approximately 20 to 40 basis points for the full year of 2019 compared to 2018.\nAs discussed further in Results of Operations below, our average outstanding debt for the three months ended March 31, 2019 increased 31% over the same period last year, and given the increase in the 30-Day LIBOR, our effective interest rate increased approximately 70 basis points between periods. Based on these trends, we expect Interest and other non-operating expenses, net will increase for the full year of 2019 compared to 2018.\nWe expect our annual effective tax rate (excluding the benefit from ASU 2016-09) for 2019 will approximate 25.5%, which is consistent with 2018 and a reduction compared to our historical rate of approximately 38.5% due to the impact of U.S. tax reform.\nOur effective tax rate is dependent on our results of operations and may change if actual results differ materially from our current expectations, particularly any significant changes in our geographic mix. Due to ASU 2016-09, we expect our effective tax rate will fluctuate from quarter to quarter, particularly in periods when employees elect to exercise their vested stock options or when restrictions on share-based awards lapse. We recorded an $8.8 million tax benefit from ASU 2016-09 for the three months ended\n14\nMarch 31, 2019. Additional tax benefits could be recognized related to stock option exercises in 2019 from grants that expire in years after 2019, for which we have not included any expected benefits in our guidance. The estimated impact related to ASU 2016-09 is subject to several assumptions which can vary significantly, including our estimated share price and the periods in which our employees will exercise vested stock options.\nExcluding the impact of timing differences from our strategic inventory purchases made in the second half of 2018, we expect cash provided by operations will approximate net income for the 2019 fiscal year. We anticipate that we may use approximately $150.0 million to $200.0 million in cash for share repurchases in 2019, subject to additional authorization by our Board of Directors.\nRESULTS OF OPERATIONS\nAs of March 31, 2019, we conducted operations through 369 sales centers in North America, Europe, South America and Australia.\nThe following table presents information derived from the Consolidated Statements of Income expressed as a percentage of net sales:\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Net sales | 100.0 | % | 100.0 | % |\n| Cost of sales | 70.8 | 71.7 |\n| Gross profit | 29.2 | 28.3 |\n| Operating expenses | 22.8 | 22.6 |\n| Operating income | 6.4 | 5.7 |\n| Interest and other non-operating expenses, net | 1.1 | 0.6 |\n| Income before income taxes and equity earnings | 5.3 | % | 5.1 | % |\n\nWe have included the results of operations from the acquisitions in 2019 and 2018 in our consolidated results since the acquisition dates.\nThree Months Ended March 31, 2019 Compared to Three Months Ended March 31, 2018\nThe following table breaks out our consolidated results into the base business component and the excluded component (sales centers excluded from base business):\n| (Unaudited) | Base Business | Excluded | Total |\n| (in thousands) | Three Months Ended | Three Months Ended | Three Months Ended |\n| March 31, | March 31, | March 31, |\n| 2019 | 2018 | 2019 | 2018 | 2019 | 2018 |\n| Net sales | $ | 587,320 | $ | 582,822 | $ | 10,136 | $ | 3,078 | $ | 597,456 | $ | 585,900 |\n| Gross profit | 171,706 | 165,334 | 2,925 | 739 | 174,631 | 166,073 |\n| Gross margin | 29.2 | % | 28.4 | % | 28.9 | % | 24.0 | % | 29.2 | % | 28.3 | % |\n| Operating expenses | 132,548 | 131,250 | 3,697 | 1,282 | 136,245 | 132,532 |\n| Expenses as a % of net sales | 22.6 | % | 22.5 | % | 36.5 | % | 41.7 | % | 22.8 | % | 22.6 | % |\n| Operating income (loss) | 39,158 | 34,084 | (772 | ) | (543 | ) | 38,386 | 33,541 |\n| Operating margin | 6.7 | % | 5.8 | % | (7.6 | )% | (17.6 | )% | 6.4 | % | 5.7 | % |\n\n15\nIn our calculation of base business results, we have excluded the following acquisitions for the periods identified:\n| Acquired | AcquisitionDate | NetSales CentersAcquired | PeriodsExcluded |\n| W.W. Adcock, Inc. (1) | January 2019 | 4 | January - March 2019 |\n| Turf & Garden, Inc. (1) | November 2018 | 4 | January - March 2019 |\n| Tore Pty. Ltd. (Pool Power) (1) | January 2018 | 1 | January - March 2019 andJanuary - March 2018 |\n| Chem Quip, Inc. (1) | December 2017 | 5 | January - March 2019 and January - March 2018 |\n| Intermark | December 2017 | 1 | January - February 2019 and January - February 2018 |\n\n| (1) | We acquired certain distribution assets of each of these companies. |\n\nWhen calculating our base business results, we exclude sales centers that are acquired, closed, or opened in new markets for a period of 15 months. We also exclude consolidated sales centers when we do not expect to maintain the majority of the existing business and existing sales centers that are consolidated with acquired sales centers.\nWe generally allocate corporate overhead expenses to excluded sales centers on the basis of their net sales as a percentage of total net sales. After 15 months of operations, we include acquired, consolidated and new market sales centers in the base business calculation including the comparative prior year period.\nThe table below summarizes the changes in our sales center count during the first three months of 2019:\n| December 31, 2018 | 364 |\n| Acquired locations | 4 |\n| New locations, existing markets | 2 |\n| Consolidated location | (1 | ) |\n| March 31, 2019 | 369 |\n\nNet Sales\n| Three Months Ended |\n| March 31, |\n| (in millions) | 2019 | 2018 | Change |\n| Net sales | $ | 597.5 | $ | 585.9 | $ | 11.6 | 2% |\n\nNet sales increased 2% in the first quarter of 2019 compared to the first quarter of 2018, with base business sales up 1% for the period. Cooler and wetter weather, particularly in the western United States, combined with a later Easter holiday adversely impacted first quarter sales. Pool openings and normal spring early buys from customers in seasonal markets are influenced by the timing of the Easter holiday. In addition, sales were negatively impacted approximately 2% by the loss of a selling day compared to the first quarter of 2018 and 1% from unfavorable foreign currency exchange rate fluctuations.\nThe following factors benefited our sales (listed in order of estimated magnitude):\n| • | inflationary product cost increases (estimated at approximately 2% above our historical average of 1% to 2%); |\n\n| • | strong demand for discretionary products, as evidenced by improvements in sales growth rates for product offerings such as building materials (see discussion below); |\n\n| • | acquisitions; and |\n\n| • | market share gains, particularly in building materials and commercial products (see discussion below). |\n\n16\nWe believe that sales growth rates for certain product offerings, such as equipment and building materials, evidence increased spending in traditionally discretionary areas, such as pool construction, pool remodeling and equipment upgrades. In the first quarter of 2019, sales for equipment, which includes swimming pool heaters, pumps, lights and filters, remained relatively flat compared to the same period last year. These products collectively represented approximately 30% of net sales for the period. Sales of building materials grew 8% compared to the first quarter of 2018 and represented approximately 13% of net sales in the first quarter of 2019.\nSales to customers who service large commercial swimming pools such as hotels, universities and community recreational facilities are included in the appropriate existing product categories, and growth in this area is reflected in the numbers above. Sales to these customers represented approximately 6% of our consolidated net sales for the first quarter of 2019 and increased 2% compared to the first quarter of 2018.\nGross Profit\n| Three Months Ended |\n| March 31, |\n| (in millions) | 2019 | 2018 | Change |\n| Gross profit | $ | 174.6 | $ | 166.1 | $ | 8.5 | 5% |\n| Gross margin | 29.2 | % | 28.3 | % |\n\nThe increase in gross margin between periods primarily reflects benefits from strategic inventory purchases in the second half of 2018 and lower customer early buys in the first quarter of 2019.\nOperating Expenses\n| Three Months Ended |\n| March 31, |\n| (in millions) | 2019 | 2018 | Change |\n| Operating expenses | $ | 136.2 | $ | 132.5 | $ | 3.7 | 3% |\n| Operating expenses as a % of net sales | 22.8 | % | 22.6 | % |\n\nOperating expenses increased 3% in the first quarter of 2019 compared to the first quarter of 2018, with base business operating expenses up approximately 1% compared to the same period last year. This increase is largely due to growth-driven increases in labor expenses and increased facility costs offset by a 1% benefit from foreign currency exchange rate fluctuations.\nInterest and Other Non-Operating Expenses, Net\nInterest and other non-operating expenses, net for the first quarter of 2019 increased $3.1 million compared to the first quarter of 2018. The increase mostly reflects higher debt levels and higher interest rates between periods. Our weighted average effective interest rate increased to 3.7% for the first quarter of 2019 from 3.0% for the first quarter of 2018 on higher average outstanding debt of $674.6 million versus $515.9 million for the respective periods.\nIncome Taxes\nOur effective income tax rate was a 2.5% benefit for the three months ended March 31, 2019, compared to a 4.3% benefit for the three months ended March 31, 2018. We recorded an $8.8 million tax benefit from ASU 2016-09 in the quarter ended March 31, 2019 compared to a benefit of $9.0 million realized in the same period last year. Excluding the benefits from ASU 2016-09, our effective tax rate was 25.1% and 25.7% for the first quarters of 2019 and 2018, respectively.\nNet Income and Earnings Per Share\nNet income increased 4% to $32.6 million in the first quarter of 2019 compared to the first quarter of 2018. Earnings per diluted share increased to $0.80 in the first quarter of 2019 versus $0.75 per diluted share for the comparable 2018 period. The benefit from ASU 2016-09 increased diluted earnings per share by $0.21 and $0.22 in the first quarters of 2019 and 2018, respectively. Excluding the impact from ASU 2016-09 in both periods, earnings per diluted share increased 11% to $0.59 in the first quarter of 2019 compared to $0.53 in the first quarter of 2018.\n17\nSeasonality and Quarterly Fluctuations\nOur business is highly seasonal. In general, sales and operating income are highest during the second and third quarters, which represent the peak months of both swimming pool use and installation and irrigation and landscape installations and maintenance. Sales are substantially lower during the first and fourth quarters, when we may incur net losses. In 2018, we generated approximately 62% of our net sales and 81% of our operating income in the second and third quarters of the year.\nWe typically experience a build-up of product inventories and accounts payable during the winter months in anticipation of the peak selling season. Excluding borrowings to finance acquisitions and share repurchases, our peak borrowing usually occurs during the second quarter, primarily because extended payment terms offered by our suppliers typically are payable in April, May and June, while our peak accounts receivable collections typically occur in June, July and August.\nThe following table presents certain unaudited quarterly data for the first quarter of 2019, the four quarters of 2018 and the fourth, third and second quarters of 2017. We have included income statement and balance sheet data for the most recent eight quarters to allow for a meaningful comparison of the seasonal fluctuations in these amounts. In our opinion, this information reflects all normal and recurring adjustments considered necessary for a fair presentation of this data. Due to the seasonal nature of our industry, the results of any one or more quarters are not necessarily a good indication of results for an entire fiscal year or of continuing trends.\n| (Unaudited) | QUARTER |\n| (in thousands) | 2019 | 2018 | 2017 |\n| First | Fourth | Third | Second | First | Fourth | Third | Second |\n| Statement of Income Data |\n| Net sales | $ | 597,456 | $ | 543,082 | $ | 811,311 | $ | 1,057,804 | $ | 585,900 | $ | 510,183 | $ | 743,401 | $ | 988,163 |\n| Gross profit | 174,631 | 160,442 | 235,003 | 308,655 | 166,073 | 145,398 | 216,606 | 289,664 |\n| Operating income | 38,386 | 25,970 | 92,337 | 162,042 | 33,541 | 17,259 | 81,928 | 154,186 |\n| Net income | 32,637 | 16,811 | 69,261 | 117,049 | 31,339 | 25,665 | 48,783 | 94,620 |\n| Balance Sheet Data |\n| Total receivables, net | $ | 313,127 | $ | 207,801 | $ | 287,773 | $ | 404,415 | $ | 314,596 | $ | 196,265 | $ | 262,796 | $ | 370,285 |\n| Product inventories, net | 815,742 | 672,579 | 609,983 | 606,583 | 703,793 | 536,474 | 484,287 | 542,805 |\n| Accounts payable | 472,487 | 237,835 | 204,706 | 300,232 | 467,795 | 245,249 | 209,062 | 273,309 |\n| Total debt | 698,977 | 666,761 | 580,703 | 657,120 | 568,110 | 519,650 | 564,573 | 553,480 |\n\nWe expect that our quarterly results of operations will continue to fluctuate depending on the timing and amount of revenue contributed by new and acquired sales centers. Based on our peak summer selling season, we generally open new sales centers and close or consolidate sales centers, when warranted, either in the first quarter before the peak selling season begins or in the fourth quarter after the peak selling season ends.\n18\nWeather is one of the principal external factors affecting our business. The table below presents some of the possible effects resulting from various weather conditions.\n| Weather | Possible Effects |\n| Hot and dry | • | Increased purchases of chemicals and suppliesfor existing swimming pools |\n| • | Increased purchases of above-ground pools andirrigation products |\n| Unseasonably cool weather or extraordinary amounts of rain | • | Fewer pool and irrigation and landscape installations |\n| • | Decreased purchases of chemicals and supplies |\n| • | Decreased purchases of impulse items such asabove-ground pools and accessories |\n| Unseasonably early warming trends in spring/late cooling trends in fall | • | A longer pool and landscape season, thus positively impacting our sales |\n| (primarily in the northern half of the U.S. and Canada) |\n| Unseasonably late warming trends in spring/early cooling trends in fall | • | A shorter pool and landscape season, thus negatively impacting our sales |\n| (primarily in the northern half of the U.S. and Canada) |\n\nWeather Impacts on 2019 and 2018 Results\nWetter and cooler-than-normal temperatures to begin the year hindered our first quarter of 2019 sales growth. Much of the western United States, particularly California and Arizona, experienced cold to record cold temperatures in January and February. The latter half of March benefited from warmer weather throughout most of the country and provided some relief from the slow start earlier in the year. The first quarter of 2018 experienced similar, though less significant, unfavorable weather in certain markets, leading to adverse conditions in 2019 compared to 2018.\n19\nLIQUIDITY AND CAPITAL RESOURCES\nLiquidity is defined as the ability to generate adequate amounts of cash to meet short-term and long-term cash needs. We assess our liquidity in terms of our ability to generate cash to fund our operating activities, taking into consideration the seasonal nature of our business. Significant factors which could affect our liquidity include the following:\n| • | cash flows generated from operating activities; |\n\n| • | the adequacy of available bank lines of credit; |\n\n| • | the quality of our receivables; |\n\n| • | acquisitions; |\n\n| • | dividend payments; |\n\n| • | capital expenditures; |\n\n| • | changes in income tax laws and regulations; |\n\n| • | the timing and extent of share repurchases; and |\n\n| • | the ability to attract long-term capital with satisfactory terms. |\n\nOur primary capital needs are seasonal working capital requirements and other general corporate purposes, including acquisitions, dividend payments and share repurchases. Our primary sources of working capital are cash from operations supplemented by borrowings, which have historically been sufficient to support our growth and finance acquisitions. The same principles apply to funds used for capital expenditures and share repurchases.\nWe prioritize our use of cash based on investing in our business, maintaining a prudent debt structure, including a modest amount of debt, and returning cash to our shareholders through dividends and share repurchases. Our specific priorities for the use of cash are as follows:\n| • | capital expenditures primarily for maintenance and growth of our sales center structure, technology-related investments and fleet vehicles; |\n\n| • | strategic acquisitions executed opportunistically; |\n\n| • | payment of cash dividends as and when declared by our Board of Directors (Board); |\n\n| • | repayment of debt to maintain an average total leverage ratio (as defined below) between 1.5 and 2.0; and |\n\n| • | repurchases of our common stock under our Board-authorized share repurchase program. |\n\nCapital expenditures were 1.1% of net sales in 2018 and 1.4% of net sales in both 2017 and 2016. Our higher capital spending in 2017 and 2016 related to expanding our facilities and purchasing delivery vehicles to address growth. Over the last five years, capital expenditures have averaged roughly 1.0% of net sales. Going forward, we project capital expenditures will continue to approximate this average.\nSources and Uses of Cash\nThe following table summarizes our cash flows (in thousands):\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Operating activities | $ | 28,804 | $ | (44,149 | ) |\n| Investing activities | (16,109 | ) | (15,217 | ) |\n| Financing activities | (2,050 | ) | 38,205 |\n\nCash provided by operating activities increased $73.0 million during the first three months of 2019 compared to the first three months of 2018 primarily due to payments for pre-price increase inventory purchases in 2018 ahead of the 2019 season, which resulted in decreased inventory purchases in the first quarter of 2019.\nCash used in investing activities for the first three months of 2019 increased compared to the first three months of 2018 primarily due to the acquisition of W.W. Adcock, Inc. which we completed in January 2019.\nCash used in financing activities increased for the first three months of 2019 compared to the first three months of 2018, which reflects a $20.5 million increase in share repurchases as well as a $16.2 million decrease in amounts provided by net borrowings.\n20\nFuture Sources and Uses of Cash\nRevolving Credit Facility\nOur Credit Facility provides for $750.0 million in borrowing capacity under a five-year unsecured revolving credit facility and includes sublimits for the issuance of swingline loans and standby letters of credit. Pursuant to an accordion feature, the aggregate maximum principal amount of the commitments under the Credit Facility may be increased at our request and with agreement by the lenders by up to $75.0 million, to a total of $825.0 million. The Credit Facility matures on September 29, 2022. We intend to use the Credit Facility for general corporate purposes, for future share repurchases and to fund future growth initiatives.\nAt March 31, 2019, there was $503.1 million outstanding, a $4.8 million standby letter of credit outstanding and $242.1 million available for borrowing under the Credit Facility. We utilize interest rate swap contracts and forward-starting interest rate swap contracts to reduce our exposure to fluctuations in variable interest rates for future interest payments on the Credit Facility. As of March 31, 2019, we had three interest rate swap contracts in place that became effective on October 19, 2016. These swap contracts were previously forward-starting and were amended in October 2015 to bring the fixed rates per our forward-starting contracts in line with current market rates and extend the hedged period for future interest payments on our Credit Facility. Now effective, these amended swap contracts convert the Credit Facility’s variable interest rate to fixed rates of 2.273% on a notional amount of $75.0 million and 2.111% on two separate notional amounts, one $25.0 million and the other $50.0 million, totaling $75.0 million. Interest expense related to the notional amounts under these swap contracts is based on the fixed rates plus the applicable margin on the Credit Facility. These interest rate swap contracts will terminate on November 20, 2019.\nIn July 2016, we entered into a forward-starting interest rate swap contract to extend the hedged period for future interest payments on our Credit Facility to its maturity date at that time. This swap contract will convert the Credit Facility’s variable interest rate to a fixed rate of 1.1425% on a notional amount of $150.0 million. The contract becomes effective on November 20, 2019 and terminates on November 20, 2020.\nThe weighted average effective interest rate for the Credit Facility as of March 31, 2019 was approximately 3.5%, excluding commitment fees.\nFinancial covenants on the Credit Facility include maintenance of a maximum average total leverage ratio and a minimum fixed charge coverage ratio. As of March 31, 2019, the calculations of these two covenants are detailed below:\n| • | Maximum Average Total Leverage Ratio. On the last day of each fiscal quarter, our average total leverage ratio must be less than 3.25 to 1.00. Average Total Leverage Ratio is the ratio of the trailing twelve months (TTM) Average Total Funded Indebtedness plus the TTM Average Accounts Securitization Proceeds divided by the TTM EBITDA (as those terms are defined in the Credit Facility). As of March 31, 2019, our average total leverage ratio equaled 1.80 (compared to 1.72 as of December 31, 2018) and the TTM average total debt amount used in this calculation was $646.7 million. |\n\n| • | Minimum Fixed Charge Coverage Ratio. On the last day of each fiscal quarter, our fixed charge ratio must be greater than or equal to 2.25 to 1.00. Fixed Charge Ratio is the ratio of the TTM EBITDAR divided by TTM Interest Expense paid or payable in cash plus TTM Rental Expense (as those terms are defined in the Credit Facility). As of March 31, 2019, our fixed charge ratio equaled 5.17 (compared to 5.33 as of December 31, 2018) and TTM Rental Expense was $57.8 million. |\n\nThe Credit Facility also limits the declaration and payment of dividends on our common stock to no more than 50% of the preceding year’s Net Income (as defined in the Credit Facility), provided no default or event of default has occurred and is continuing, or would result from the payment of dividends. Additionally, we may declare and pay quarterly dividends notwithstanding that the aggregate amount of dividends paid would be in excess of the 50% limit described above so long as (i) the amount per share of such dividends does not exceed the amount per share paid during the most recent fiscal year in which we were in compliance with the 50% limit and (ii) our Average Total Leverage Ratio is less than 3.00 to 1.00 both immediately before and after giving pro forma effect to such dividends. Further, dividends must be declared and paid in a manner consistent with our past practice.\nUnder the Credit Facility, we may repurchase shares of our common stock provided no default or event of default has occurred and is continuing, or would result from the repurchase of shares, and our maximum average total leverage ratio (determined on a pro forma basis) is less than 2.50 to 1.00. Other covenants include restrictions on our ability to grant liens, incur indebtedness, make investments, merge or consolidate, and sell or transfer assets. Failure to comply with any of our financial covenants or any other terms of the Credit Facility could result in higher interest rates on our borrowings or the acceleration of the maturities of our outstanding debt.\n21\nReceivables Securitization Facility\nOur two-year accounts receivable securitization facility (the Receivables Facility) offers us a lower cost form of financing, with a peak funding capacity of up to $295.0 million between May 1 and June 30, which includes an additional seasonal funding capacity that is available between March 1 and July 31. Other funding capacities range from $95.0 million to $280.0 million throughout the remaining months of the year.\nThe Receivables Facility provides for the sale of certain of our receivables to a wholly owned subsidiary (the Securitization Subsidiary). The Securitization Subsidiary transfers variable undivided percentage interests in the receivables and related rights to certain third-party financial institutions in exchange for cash proceeds, limited to the applicable funding capacities. Upon payment of the receivables by customers, rather than remitting to the financial institutions the amounts collected, we retain such collections as proceeds for the sale of new receivables until payments become due.\nThe Receivables Facility contains terms and conditions (including representations, covenants and conditions precedent) customary for transactions of this type. Additionally, an amortization event will occur if we fail to maintain a maximum average total leverage ratio (average total funded debt/EBITDA) of 3.25 to 1.00 and a minimum fixed charge coverage ratio (EBITDAR/cash interest expense plus rental expense) of 2.25 to 1.00.\nAt March 31, 2019, there was $175.1 million outstanding under the Receivables Facility at a weighted average effective interest rate of 3.3%, excluding commitment fees.\nCompliance and Future Availability\nAs of March 31, 2019, we believe we were in compliance with all covenants and financial ratio requirements under our Credit Facility and our Receivables Facility. We believe we will remain in compliance with all covenants and financial ratio requirements throughout the next twelve months. For additional information regarding our debt arrangements, see Note 5 of “Notes to Consolidated Financial Statements,” included in Part II, Item 8 of our 2018 Annual Report on Form 10-K.\nWe believe we have adequate availability of capital to fund present operations and the current capacity to finance any working capital needs that may arise. We continually evaluate potential acquisitions and hold discussions with acquisition candidates. If suitable acquisition opportunities arise that would require financing, we believe that we have the ability to finance any such transactions.\nAs of April 25, 2019, $49.2 million of the current Board-authorized amount under our share repurchase program remained available. We expect to repurchase additional shares on the open market from time to time depending on market conditions. We plan to fund these repurchases with cash provided by operations and borrowings under the Credit and Receivables Facilities.\nCRITICAL ACCOUNTING ESTIMATES\nWe prepare our Consolidated Financial Statements in accordance with U.S. generally accepted accounting principles (GAAP), which require management to make estimates and assumptions that affect reported amounts and related disclosures. Management identifies critical accounting estimates as:\n| • | those that require the use of assumptions about matters that are inherently and highly uncertain at the time the estimates are made; and |\n\n| • | those for which changes in the estimates or assumptions, or the use of different estimates and assumptions, could have a material impact on our consolidated results of operations or financial condition. |\n\nManagement has discussed the development, selection and disclosure of our critical accounting estimates with the Audit Committee of our Board. For a description of our critical accounting estimates that require us to make the most difficult, subjective or complex judgments, please see our 2018 Annual Report on Form 10-K. We have not changed these policies from those previously disclosed.\nRecent Accounting Pronouncements\nSee Note 1 of “Notes to Consolidated Financial Statements,” included in Item 1 of this Form 10-Q for detail.\n22\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\nInterest Rate Risk\nThere have been no material changes during the three months ended March 31, 2019 from what we reported in our 2018 Annual Report on Form 10-K. For additional information on our interest rate risk, refer to “Quantitative and Qualitative Disclosures about Market Risk” included in Part II, Item 7A. in our 2018 Annual Report on Form 10-K.\nCurrency Risk\nThere have been no material changes during the three months ended March 31, 2019 from what we reported in our 2018 Annual Report on Form 10-K. For additional information on our currency risk, refer to “Quantitative and Qualitative Disclosures about Market Risk” included in Part II, Item 7A. in our 2018 Annual Report on Form 10-K.\nItem 4. Controls and Procedures\nThe term “disclosure controls and procedures” is defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the Act). The rules refer to the controls and other procedures designed to ensure that information required to be disclosed in reports that we file or submit under the Act is (1) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and (2) accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. As of March 31, 2019, management, including the CEO and CFO, performed an evaluation of the effectiveness of our disclosure controls and procedures. Based on that evaluation, management, including the CEO and CFO, concluded that as of March 31, 2019, our disclosure controls and procedures were effective.\nWe maintain a system of internal control over financial reporting that is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. Based on the most recent evaluation, we have concluded that no change in our internal control over financial reporting occurred during the last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\n23\nPART II. OTHER INFORMATION\nItem 1. Legal Proceedings\nFrom time to time, we are subject to various claims and litigation arising in the ordinary course of business, including product liability, personal injury, commercial, contract and employment matters. While the outcome of any litigation is inherently unpredictable, based on currently available facts we do not believe that the ultimate resolution of any of these matters will have a material adverse impact on our financial condition, results of operations or cash flows.\nItem 1A. Risk Factors\nThere have been no material changes from the risk factors disclosed in Part I, Item 1A “Risk Factors” in our 2018 Annual Report on Form 10-K.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nThe table below summarizes the repurchases of our common stock in the first quarter of 2019:\n| Period | Total Number of Shares Purchased (1) | Average Price Paid per Share | Total Number ofShares Purchasedas Part of Publicly Announced Plan (2) | Maximum ApproximateDollar Value of SharesThat May Yet be Purchased Under the Plan (3) |\n| January 1 - 31, 2019 | 116,946 | $ | 147.77 | 116,946 | $ | 52,498,367 |\n| February 1 - 28, 2019 | 28,513 | $ | 152.25 | 22,019 | $ | 49,200,474 |\n| March 1 - 31, 2019 | 9,401 | $ | 156.98 | — | $ | 49,200,474 |\n| Total | 154,860 | $ | 149.15 | 138,965 |\n\n| (1) | These shares may include shares of our common stock surrendered to us by employees in order to satisfy minimum tax withholding obligations in connection with certain exercises of employee stock options or lapses upon vesting of restrictions on previously restricted share awards, and/or to cover the exercise price of such options granted under our share-based compensation plans. There were 15,895 shares surrendered for this purpose in the first quarter of 2019. |\n\n| (2) | In May 2018, our Board authorized an additional $200.0 million under our share repurchase program for the repurchase of shares of our common stock in the open market at prevailing market prices or in privately negotiated transactions. |\n\n| (3) | As of April 25, 2019, $49.2 million of the authorized amount remained available under our current share repurchase program. |\n\n24\nItem 6. Exhibits\nExhibits filed as part of this report are listed below.\n| Incorporated by Reference |\n| No. | Description | Filed/ Furnished with thisForm 10-Q | Form | File No. | Date Filed |\n| 3.1 | Restated Certificate of Incorporation of the Company. | 10-Q | 000-26640 | 8/9/2006 |\n| 3.2 | Amended and Restated Bylaws of the Company. | 8-K | 000-26640 | 2/8/2019 |\n| 4.1 | Form of certificate representing shares of common stock of the Company. | 8-K | 000-26640 | 5/19/2006 |\n| 31.1 | Certification by Mark W. Joslin pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | X |\n| 31.2 | Certification by Peter D. Arvan pursuant to Rule 13a-14(a) and 15d‑14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | X |\n| 32.1 | Certification by Peter D.Arvan and Mark W. Joslin furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | X |\n| 101.INS | + | XBRL Instance Document | X |\n| 101.SCH | + | XBRL Taxonomy Extension Schema Document | X |\n| 101.CAL | + | XBRL Taxonomy Extension Calculation Linkbase Document | X |\n| 101.DEF | + | XBRL Taxonomy Extension Definition Linkbase Document | X |\n| 101.LAB | + | XBRL Taxonomy Extension Label Linkbase Document | X |\n| 101.PRE | + | XBRL Taxonomy Extension Presentation Linkbase Document | X |\n\n+ Attached as Exhibit 101 to this report are the following items formatted in XBRL (Extensible Business Reporting Language):\n| 1. | Consolidated Statements of Income for the three months ended March 31, 2019 and March 31, 2018; |\n\n| 2. | Consolidated Statements of Comprehensive Income for the three months ended March 31, 2019 and March 31, 2018; |\n\n| 3. | Consolidated Balance Sheets at March 31, 2019, December 31, 2018 and March 31, 2018; |\n\n| 4. | Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2019 and |\n\nMarch 31, 2018;\n| 5. | Consolidated Statements of Changes in Stockholders’ Equity for the three months ended March 31, 2019 and |\n\nMarch 31, 2018; and\n| 6. | Notes to Consolidated Financial Statements. |\n\n25\nSIGNATURE\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on April 30, 2019.\n| POOL CORPORATION |\n| By: | /s/ Mark W. Joslin |\n| Mark W. Joslin |\n| Senior Vice President and Chief Financial Officer, and duly authorized signatory on behalf of the registrant |\n\n26\n</text>\n\nHow much should the company anticipate to pay for operating lease liabilities in 2021 if the inflation rate for that year is projected to be 2% (in thousands)?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n| Item 1. | Financial Statements. |\n\nDonegal Group Inc. and Subsidiaries\nConsolidated Balance Sheets\n\n| September 30,2016 | December 31,2015 |\n| (Unaudited) |\n| Assets |\n| Investments |\n| Fixed maturities |\n| Held to maturity, at amortized cost | $ | 332,272,969 | $ | 310,258,704 |\n| Available for sale, at fair value | 515,821,393 | 501,393,559 |\n| Equity securities, available for sale, at fair value | 46,311,943 | 37,260,821 |\n| Investment in affiliate | 40,145,067 | 38,476,708 |\n| Short-term investments, at cost, which approximates fair value | 9,251,153 | 13,432,482 |\n| Total investments | 943,802,525 | 900,822,274 |\n| Cash | 32,130,534 | 28,139,144 |\n| Accrued investment income | 6,817,760 | 5,991,197 |\n| Premiums receivable | 165,761,900 | 141,267,411 |\n| Reinsurance receivable | 259,428,626 | 259,728,113 |\n| Deferred policy acquisition costs | 57,404,289 | 52,108,388 |\n| Deferred tax asset, net | 14,721,101 | 19,443,807 |\n| Prepaid reinsurance premiums | 127,431,503 | 113,522,505 |\n| Property and equipment, net | 6,705,671 | 7,027,143 |\n| Federal income taxes receivable | 1,823,273 | 1,487,656 |\n| Goodwill | 5,625,354 | 5,625,354 |\n| Other intangible assets | 958,010 | 958,010 |\n| Other | 1,453,864 | 1,713,413 |\n| Total assets | $ | 1,624,064,410 | $ | 1,537,834,415 |\n| Liabilities and Stockholders Equity |\n| Liabilities |\n| Unpaid losses and loss expenses | $ | 594,267,943 | $ | 578,205,109 |\n| Unearned premiums | 476,432,783 | 429,493,203 |\n| Accrued expenses | 21,067,170 | 22,460,475 |\n| Reinsurance balances payable | 3,058,225 | 3,480,406 |\n| Borrowings under lines of credit | 74,000,000 | 81,000,000 |\n| Cash dividends declared | | 3,511,881 |\n| Subordinated debentures | 5,000,000 | 5,000,000 |\n| Accounts payable - securities | 540,311 | 582,560 |\n| Due to affiliate | 3,978,958 | 3,557,177 |\n| Other | 1,710,209 | 2,155,036 |\n| Total liabilities | 1,180,055,599 | 1,129,445,847 |\n| Stockholders Equity |\n| Preferred stock, $.01 par value, authorized 2,000,000 shares; none issued | | |\n| Class A common stock, $.01 par value, authorized 40,000,000 shares, issued 24,189,133 and 23,501,805 shares and outstanding 21,186,545 and 20,499,217 shares | 241,892 | 235,018 |\n| Class B common stock, $.01 par value, authorized 10,000,000 shares, issued 5,649,240 shares and outstanding 5,576,775 shares | 56,492 | 56,492 |\n| Additional paid-in capital | 231,885,764 | 219,525,301 |\n| Accumulated other comprehensive income | 6,340,292 | 773,744 |\n| Retained earnings | 246,710,728 | 229,024,370 |\n| Treasury stock, at cost | (41,226,357 | ) | (41,226,357 | ) |\n| Total stockholders equity | 444,008,811 | 408,388,568 |\n| Total liabilities and stockholders equity | $ | 1,624,064,410 | $ | 1,537,834,415 |\n\nSee accompanying notes to consolidated financial statements.\n1\nDonegal Group Inc. and Subsidiaries Consolidated Statements of Income (Unaudited) Three Months Ended September 30, 2016 2015 Revenues: Net premiums earned $ 166,809,851 $ 153,096,075 Investment income, net of investment expenses 5,581,238 5,399,080 Net realized investment gains (losses) (includes $1,018,415 and ($754,050) accumulated other comprehensive income (loss) reclassifications) 1,018,415 (754,050 ) Lease income 163,779 178,827 Installment payment fees 1,380,024 1,473,447 Equity in earnings of Donegal Financial Services Corporation 357,956 408,405 Total revenues 175,311,263 159,801,784 Expenses: Net losses and loss expenses 111,174,963 102,233,708 Amortization of deferred policy acquisition costs 27,524,000 25,036,000 Other underwriting expenses 28,340,135 24,155,566 Policyholder dividends 1,143,026 886,210 Interest 473,917 188,000 Other expenses 226,183 301,367 Total expenses 168,882,224 152,800,851 Income before income tax expense 6,429,039 7,000,933 Income tax expense (includes $356,446 and ($263,918) income tax expense (benefit) from reclassification items) 1,615,635 1,314,102 Net income $ 4,813,404 $ 5,686,831 Earnings per common share: Class A common stock - basic $ 0.19 $ 0.21 Class A common stock - diluted $ 0.18 $ 0.21 Class B common stock - basic and diluted $ 0.16 $ 0.18 Donegal Group Inc. and Subsidiaries Consolidated Statements of Comprehensive Income (Unaudited) Three Months Ended September 30, 2016 2015 Net income $ 4,813,404 $ 5,686,831 Other comprehensive (loss) income, net of tax Unrealized (loss) gain on securities: Unrealized holding (loss) gain during the period, net of income tax (benefit) expense of ($595,724) and 463,221 (1,106,346 ) 860,268 Reclassification adjustment for (gains) losses included in net income, net of income tax expense (benefit) of $356,446 and ($263,918) (661,969 ) 490,132 Other comprehensive (loss) income (1,768,315 ) 1,350,400 Comprehensive income $ 3,045,089 $ 7,037,231 See accompanying notes to consolidated financial statements. 2 Donegal Group Inc. and Subsidiaries Consolidated Statements of Income (Unaudited) Nine Months Ended September 30, 2016 2015 Revenues: Net premiums earned $ 487,227,767 $ 450,083,676 Investment income, net of investment expenses 16,471,630 15,505,429 Net realized investment gains (includes $2,204,533 and $682,932 accumulated other comprehensive income reclassifications) 2,204,533 682,932 Lease income 514,768 568,552 Installment payment fees 4,109,550 4,473,905 Equity in earnings of Donegal Financial Services Corporation 698,658 1,276,692 Total revenues 511,226,906 472,591,186 Expenses: Net losses and loss expenses 309,946,943 296,012,311 Amortization of deferred policy acquisition costs 80,034,000 73,872,000 Other underwriting expenses 81,557,159 73,192,072 Policyholder dividends 2,729,595 2,491,919 Interest 1,286,279 908,615 Other expenses 1,179,660 1,704,680 Total expenses 476,733,636 448,181,597 Income before income tax expense 34,493,270 24,409,589 Income tax expense (includes $771,587 and $239,026 income tax expense from reclassification items) 9,246,299 5,403,395 Net income $ 25,246,971 $ 19,006,194 Earnings per common share: Class A common stock - basic $ 0.98 $ 0.71 Class A common stock - diluted $ 0.95 $ 0.69 Class B common stock - basic and diluted $ 0.88 $ 0.63 Donegal Group Inc. and Subsidiaries Consolidated Statements of Comprehensive Income (Unaudited) Nine Months Ended September 30, 2016 2015 Net income $ 25,246,971 $ 19,006,194 Other comprehensive income (loss), net of tax Unrealized gain (loss) on securities: Unrealized holding gain (loss) during the period, net of income tax expense (benefit) of $3,768,959 and ($1,141,726) 6,999,494 (2,120,347 ) Reclassification adjustment for gains included in net income, net of income tax expense of $771,587 and $239,026 (1,432,946 ) (443,906 ) Other comprehensive income (loss) 5,566,548 (2,564,253 ) Comprehensive income $ 30,813,519 $ 16,441,941 See accompanying notes to consolidated financial statements. 3 Donegal Group Inc. and Subsidiaries Consolidated Statement of Stockholders’ Equity (Unaudited) Nine Months Ended September 30, 2016 Class A Shares Class B Shares Class A Amount Class B Amount Additional Paid-In Capital Accumulated Other Comprehensive Income Retained Earnings Treasury Stock Total Stockholders’ Equity Balance, December 31, 2015 23,501,805 5,649,240 $ 235,018 $ 56,492 $ 219,525,301 $ 773,744 $ 229,024,370 $ (41,226,357 ) $ 408,388,568 Issuance of common stock 104,271 — 1,043 — 1,389,022 — — — 1,390,065 Share-based compensation 583,057 5,831 10,396,351 10,402,182 Net income — — — — — — 25,246,971 — 25,246,971 Cash dividends declared — — — — — — (6,985,523 ) — (6,985,523 ) Grant of stock options — — — — 575,090 — (575,090 ) — — Other comprehensive income — — — — — 5,566,548 — — 5,566,548 Balance, September 30, 2016 24,189,133 5,649,240 $ 241,892 $ 56,492 $ 231,885,764 $ 6,340,292 $ 246,710,728 $ (41,226,357 ) $ 444,008,811 See accompanying notes to consolidated financial statements. 4 Donegal Group Inc. and Subsidiaries Consolidated Statements of Cash Flows (Unaudited) Nine Months Ended September 30, 2016 2015 Cash Flows from Operating Activities: Net income $ 25,246,971 $ 19,006,194 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation, amortization and other non-cash items 5,365,877 2,890,128 Net realized investment gains (2,204,533 ) (682,932 ) Equity in earnings of Donegal Financial Services Corporation (698,658 ) (1,276,692 ) Changes in assets and liabilities: Losses and loss expenses 16,062,834 30,888,062 Unearned premiums 46,939,580 32,671,922 Premiums receivable (24,494,489 ) (13,301,356 ) Deferred acquisition costs (5,295,901 ) (5,212,051 ) Deferred income taxes 1,725,335 225,409 Reinsurance receivable 299,487 (6,254,559 ) Prepaid reinsurance premiums (13,908,998 ) (1,631,341 ) Accrued investment income (826,563 ) (929,722 ) Due to affiliate 421,781 (1,655,351 ) Reinsurance balances payable (422,181 ) (3,900,348 ) Current income taxes (335,617 ) 242,849 Accrued expenses (1,393,305 ) (601,830 ) Other, net (185,278 ) (1,943,559 ) Net adjustments 21,049,371 29,528,629 Net cash provided by operating activities 46,296,342 48,534,823 Cash Flows from Investing Activities: Purchases of fixed maturities, held to maturity (35,461,529 ) (18,483,546 ) Purchases of fixed maturities, available for sale (127,113,153 ) (132,823,136 ) Purchases of equity securities, available for sale (10,753,187 ) (9,011,957 ) Maturity of fixed maturities: Held to maturity 13,603,700 22,416,840 Available for sale 64,406,512 56,293,130 Sales of fixed maturities, available for sale 52,032,208 23,485,311 Sales of equity securities, available for sale 5,068,287 2,704,425 Net purchases of property and equipment (260,968 ) (78,292 ) Net decrease in investment in affiliate — 675,100 Net sales (purchases) of short-term investments 4,181,329 (4,302,571 ) Net cash used in investing activities (34,296,801 ) (59,124,696 ) Cash Flows from Financing Activities: Cash dividends paid (10,497,404 ) (10,762,609 ) Issuance of common stock 9,489,253 17,106,300 Purchase of treasury stock — (904,675 ) Payments on lines of credit (7,000,000 ) (9,500,000 ) Borrowings under lines of credit — 4,000,000 Net cash used in financing activities (8,008,151 ) (60,984 ) Net increase (decrease) in cash 3,991,390 (10,650,857 ) Cash at beginning of period 28,139,144 35,578,509 Cash at end of period $ 32,130,534 $ 24,927,652 Cash paid during period - Interest $ 1,001,870 $ 757,175 Net cash paid during period - Taxes $ 8,255,000 $ 4,500,000 See accompanying notes to consolidated financial statements. 5 DONEGAL GROUP INC. AND SUBSIDIARIES (Unaudited) Notes to Consolidated Financial Statements 1 - Organization Donegal Mutual Insurance Company (“Donegal Mutual”) organized us as an insurance holding company on August 26, 1986. Our insurance subsidiaries, Atlantic States Insurance Company (“Atlantic States”), Southern Insurance Company of Virginia (“Southern”), Le Mars Insurance Company (“Le Mars”), the Peninsula Insurance Group (“Peninsula”), which consists of Peninsula Indemnity Company and The Peninsula Insurance Company, Sheboygan Falls Insurance Company (“Sheboygan”) and Michigan Insurance Company (“MICO”), write personal and commercial lines of property and casualty coverages exclusively through a network of independent insurance agents in certain Mid-Atlantic, Midwestern, New England and Southern states. We also own 48.2% of the outstanding stock of Donegal Financial Services Corporation (“DFSC”), a grandfathered unitary savings and loan holding company that owns Union Community Bank (“UCB”), a state savings bank. Donegal Mutual owns the remaining 51.8% of the outstanding stock of DFSC. We have four segments: our investment function, our personal lines of insurance, our commercial lines of insurance and our investment in DFSC. The personal lines products of our insurance subsidiaries consist primarily of homeowners and private passenger automobile policies. The commercial lines products of our insurance subsidiaries consist primarily of commercial automobile, commercial multi-peril and workers’ compensation policies. At September 30, 2016, Donegal Mutual held approximately 47% of our outstanding Class A common stock and approximately 83% of our outstanding Class B common stock. This ownership provides Donegal Mutual with approximately 73% of the total voting power of our outstanding common stock. We believe Donegal Mutual’s voting control of us benefits us for the reasons we describe in our Annual Reports on Form 10-K and in our proxy statements. Our insurance subsidiaries and Donegal Mutual have interrelated operations due to a pooling agreement and other intercompany agreements and transactions. While each company maintains its separate corporate existence, our insurance subsidiaries and Donegal Mutual conduct business together as the Donegal Insurance Group. As such, Donegal Mutual and our insurance subsidiaries share the same business philosophy, the same management, the same employees and the same facilities and offer the same types of insurance products. Atlantic States, our largest subsidiary, participates in a pooling agreement with Donegal Mutual. Under the pooling agreement, Donegal Mutual and Atlantic States pool their insurance business and each company receives an allocated percentage of the pooled business. Atlantic States has an 80% share of the results of the pooled business, and Donegal Mutual has a 20% share of the results of the pooled business. The same executive management and underwriting personnel administer products, classes of business underwritten, pricing practices and underwriting standards of Donegal Mutual and our insurance subsidiaries. In addition, as the Donegal Insurance Group, Donegal Mutual and our insurance subsidiaries share a combined business plan to achieve market penetration and underwriting profitability objectives. The products our insurance subsidiaries and Donegal Mutual market are generally complementary, thereby allowing the Donegal Insurance Group to offer a broader range of products to a given market and to expand the Donegal Insurance Group’s ability to service an entire personal lines or commercial lines account. Distinctions within the products Donegal Mutual and our insurance subsidiaries offer relate generally to specific risk profiles targeted within similar classes of business, such as preferred tier products versus standard tier products, but we do not allocate all of the standard risk gradients to one company. Therefore, the underwriting profitability of the business the individual companies write directly will vary. However, as the risk characteristics of all business Donegal Mutual and Atlantic States write directly are homogenized within the underwriting pool, Donegal Mutual and Atlantic States share the underwriting results in proportion to their respective participation in the pool. Pooled business represents the predominant percentage of the net underwriting activity of both Donegal Mutual and Atlantic States. On July 18, 2013, our board of directors authorized a share repurchase program pursuant to which we have the authority to purchase up to 500,000 additional shares of our Class A common stock at prices prevailing from time to time in the open market subject to the provisions of applicable rules of the SEC and in privately negotiated transactions. We did not purchase any shares of our Class A common stock under this program during the nine months ended September 30, 2016. We purchased 57,658 shares of our Class A common stock under this program during the nine months ended September 30, 2015. We have purchased a total of 57,658 shares of our Class A common stock under this program from its inception through September 30, 2016. 6 2 - Basis of Presentation Our financial information for the interim periods included in this Form 10-Q Report is unaudited; however, our financial information we include in this Form 10-Q Report reflects all adjustments, consisting only of normal recurring adjustments that, in the opinion of our management, are necessary for a fair presentation of our financial position, results of operations and cash flows for those interim periods. Our results of operations for the nine months ended September 30, 2016 are not necessarily indicative of the results of operations we expect for the year ending December 31, 2016. You should read the interim financial statements we include in this Form 10-Q Report in conjunction with the financial statements and the notes to our financial statements contained in our Annual Report on Form 10-K for the year ended December 31, 2015. 3 - Earnings Per Share We have two classes of common stock, which we refer to as our Class A common stock and our Class B common stock. Our certificate of incorporation provides that whenever our board of directors declares a dividend on our Class B common stock, our board of directors shall simultaneously declare a dividend on our Class A common stock that is payable to the holders of our Class A common stock at the same time and as of the same record date at a rate that is at least 10% greater than the rate at which our board of directors declared a dividend on our Class B common stock. Accordingly, we use the two-class method to compute our earnings per common share. The two-class method is an earnings allocation formula that determines earnings per share separately for each class of common stock based on dividends we have declared and an allocation of our remaining undistributed earnings using a participation percentage that reflects the dividend rights of each class. The table below presents for the periods indicated a reconciliation of the numerators and denominators we used to compute basic and diluted net income per share for each class of our common stock: Three Months Ended September 30, 2016 2015 Class A Class B Class A Class B (in thousands, except per share data) Basic net income per share: Numerator: Allocation of net income $ 3,901 $ 912 $ 4,663 $ 1,024 Denominator: Weighted-average shares outstanding 21,078 5,577 22,442 5,577 Basic net income per share $ 0.19 $ 0.16 $ 0.21 $ 0.18 Diluted net income per share: Numerator: Allocation of net income $ 3,901 $ 912 $ 4,663 $ 1,024 Denominator: Number of shares used in basic computation 21,078 5,577 22,442 5,577 Weighted-average shares effect of dilutive securities Add: Director and employee stock options 831 — 242 — Number of shares used in diluted computation 21,909 5,577 22,684 5,577 Diluted net income per share $ 0.18 $ 0.16 $ 0.21 $ 0.18 7 Nine Months Ended September 30, 2016 2015 Class A Class B Class A Class B (in thousands, except per share data) Basic net income per share: Numerator: Allocation of net income $ 20,329 $ 4,918 $ 15,502 $ 3,504 Denominator: Weighted-average shares outstanding 20,791 5,577 21,996 5,577 Basic net income per share $ 0.98 $ 0.88 $ 0.71 $ 0.63 Diluted net income per share: Numerator: Allocation of net income $ 20,329 $ 4,918 $ 15,502 $ 3,504 Denominator: Number of shares used in basic computation 20,791 5,577 21,996 5,577 Weighted-average shares effect of dilutive securities Add: Director and employee stock options 560 — 400 — Number of shares used in diluted computation 21,351 5,577 22,396 5,577 Diluted net income per share $ 0.95 $ 0.88 $ 0.69 $ 0.63 We did not include outstanding options to purchase the following number of shares of Class A common stock in our computation of diluted earnings per share because the exercise price of the options exceeded the average market price of our Class A common stock during the applicable periods: Three Months Ended September 30, Nine Months Ended September 30, 2016 2015 2016 2015 Number of options to purchase Class A shares excluded — 4,014,501 — — 4 - Reinsurance Atlantic States and Donegal Mutual have participated in a pooling agreement since 1986 under which each company places all of its direct written premiums into the pool the pooling agreement established, and Atlantic States and Donegal Mutual then share the underwriting results of the pool in accordance with the terms of the pooling agreement. Atlantic States has an 80% share of the results of the pool, and Donegal Mutual has a 20% share of the results of the pool. Our insurance subsidiaries and Donegal Mutual purchase certain third-party reinsurance on a combined basis. Le Mars, MICO, Peninsula and Sheboygan also purchase separate third-party reinsurance that provides coverage that we believe is commensurate with their relative size and risk exposures. Our insurance subsidiaries use several different reinsurers, all of which, consistent with the requirements of our insurance subsidiaries and Donegal Mutual, have an A.M. Best rating of A- (Excellent) or better or, with respect to foreign reinsurers, have a financial condition that, in the opinion of our management, is equivalent to a company with at least an A- rating from A.M. Best. The following information describes the external reinsurance our insurance subsidiaries have in place for 2016: • excess of loss reinsurance, under which Donegal Mutual and our insurance subsidiaries recover, through a series of reinsurance agreements, losses over a set retention (generally $1.0 million), and • catastrophe reinsurance, under which Donegal Mutual and our insurance subsidiaries recover, through a series of reinsurance agreements, 100% of an accumulation of many losses resulting from a single event, including natural 8 disasters, over a set retention (generally $5.0 million) and after exceeding an annual aggregate deductible (generally $1.0 million) up to aggregate losses of $170.0 million per occurrence. Our insurance subsidiaries and Donegal Mutual also purchase facultative reinsurance to cover exposures in excess of the covered limits of their third-party reinsurance agreements. In addition to the pooling agreement and third-party reinsurance, our insurance subsidiaries have various reinsurance agreements with Donegal Mutual. We have made no significant changes to our third-party reinsurance or the reinsurance agreements between our insurance subsidiaries and Donegal Mutual during the nine months ended September 30, 2016. 5 - Investments The amortized cost and estimated fair values of our fixed maturities and equity securities at September 30, 2016 were as follows: Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value (in thousands) Held to Maturity U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 59,254 $ 3,130 $ 7 $ 62,377 Obligations of states and political subdivisions 122,203 14,292 4 136,491 Corporate securities 86,582 3,360 598 89,344 Mortgage-backed securities 64,234 2,425 — 66,659 Totals $ 332,273 $ 23,207 $ 609 $ 354,871 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value (in thousands) Available for Sale U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 36,009 $ 368 $ 2 $ 36,375 Obligations of states and political subdivisions 184,068 10,219 11 194,276 Corporate securities 88,826 2,156 141 90,841 Mortgage-backed securities 190,936 3,444 51 194,329 Fixed maturities 499,839 16,187 205 515,821 Equity securities 41,806 4,917 411 46,312 Totals $ 541,645 $ 21,104 $ 616 $ 562,133 At September 30, 2016, our holdings of obligations of states and political subdivisions included general obligation bonds with an aggregate fair value of $229.6 million and an amortized cost of $213.6 million. Our holdings at September 30, 2016 also included special revenue bonds with an aggregate fair value of $101.2 million and an amortized cost of $92.7 million. With respect to both categories of those bonds at September 30, 2016, we held no securities of any issuer that constituted more than 10% of our holdings of either bond category. Education bonds and water and sewer utility bonds represented 62% and 24%, respectively, of our total investments in special revenue bonds based on the carrying values of these investments at September 30, 2016. Many of the issuers of the special revenue bonds we held at September 30, 2016 have the authority to impose ad valorem taxes. In that respect, many of the special revenue bonds we held at September 30, 2016 were similar to general obligation bonds. 9 The amortized cost and estimated fair values of our fixed maturities and equity securities at December 31, 2015 were as follows: Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value (in thousands) Held to Maturity U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 51,194 $ 1,544 $ — $ 52,738 Obligations of states and political subdivisions 119,115 10,828 119 129,824 Corporate securities 65,307 816 1,561 64,562 Mortgage-backed securities 74,643 1,181 149 75,675 Totals $ 310,259 $ 14,369 $ 1,829 $ 322,799 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value (in thousands) Available for Sale U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 37,080 $ 160 $ 51 $ 37,189 Obligations of states and political subdivisions 223,769 13,151 364 236,556 Corporate securities 73,474 350 1,012 72,812 Mortgage-backed securities 154,687 1,045 896 154,836 Fixed maturities 489,010 14,706 2,323 501,393 Equity securities 35,765 2,269 773 37,261 Totals $ 524,775 $ 16,975 $ 3,096 $ 538,654 At December 31, 2015, our holdings of obligations of states and political subdivisions included general obligation bonds with an aggregate fair value of $256.9 million and an amortized cost of $241.1 million. Our holdings also included special revenue bonds with an aggregate fair value of $109.5 million and an amortized cost of $101.8 million. With respect to both categories of bonds, we held no securities of any issuer that comprised more than 10% of that category at December 31, 2015. Education bonds and water and sewer utility bonds represented 57% and 26%, respectively, of our total investments in special revenue bonds based on their carrying values at December 31, 2015. Many of the issuers of the special revenue bonds we held at December 31, 2015 have the authority to impose ad valorem taxes. In that respect, many of the special revenue bonds we held are similar to general obligation bonds. We made reclassifications from available for sale to held to maturity of certain fixed maturities at fair value on November 30, 2013. We segregated within accumulated other comprehensive income the net unrealized losses of $15.1 million arising prior to the November 30, 2013 reclassification date for fixed maturities we reclassified from available for sale to held to maturity. We are amortizing this balance over the remaining life of the related securities as an adjustment to yield in a manner consistent with the accretion of discount on the same fixed maturities. We recorded amortization of $1.0 million and $905,446 in accumulated other comprehensive income during the nine months ended September 30, 2016 and 2015, respectively. At September 30, 2016 and December 31, 2015, net unrealized losses of $11.3 million and $12.3 million, respectively, remained within accumulated other comprehensive income. 10 We show below the amortized cost and estimated fair value of our fixed maturities at September 30, 2016 by contractual maturity. Expected maturities may differ from contractual maturities because issuers of the securities may have the right to call or prepay obligations with or without call or prepayment penalties. Amortized Cost Estimated Fair Value (in thousands) Held to maturity Due in one year or less $ 9,643 $ 9,657 Due after one year through five years 42,967 44,275 Due after five years through ten years 86,925 92,926 Due after ten years 128,504 141,354 Mortgage-backed securities 64,234 66,659 Total held to maturity $ 332,273 $ 354,871 Available for sale Due in one year or less $ 36,476 $ 37,158 Due after one year through five years 115,204 119,709 Due after five years through ten years 105,689 109,631 Due after ten years 51,534 54,994 Mortgage-backed securities 190,936 194,329 Total available for sale $ 499,839 $ 515,821 Gross realized gains and losses from investments before applicable income taxes for the three and nine months ended September 30, 2016 and 2015 were as follows: Three Months Ended September 30, Nine Months Ended September 30, 2016 2015 2016 2015 (in thousands) Gross realized gains: Fixed maturities $ 289 $ 7 $ 2,129 $ 974 Equity securities 1,170 30 1,226 733 1,459 37 3,355 1,707 Gross realized losses: Fixed maturities 22 27 280 105 Equity securities 419 764 870 919 441 791 1,150 1,024 Net realized gains (losses) $ 1,018 $ (754 ) $ 2,205 $ 683 We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at September 30, 2016 as follows: Less Than 12 Months More Than 12 Months Fair Value Unrealized Losses Fair Value Unrealized Losses (in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 2,988 $ 9 $ — $ — Obligations of states and political subdivisions 4,248 13 722 2 Corporate securities 21,006 205 2,911 534 Mortgage-backed securities 20,567 49 831 2 Equity securities 4,515 308 163 103 Totals $ 53,324 $ 584 $ 4,627 $ 641 11 We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at December 31, 2015 as follows: Less Than 12 Months More Than 12 Months Fair Value Unrealized Losses Fair Value Unrealized Losses (in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 10,168 $ 51 $ — $ — Obligations of states and political subdivisions 19,437 483 — — Corporate securities 69,482 1,615 11,324 958 Mortgage-backed securities 105,300 876 7,538 168 Equity securities 9,245 773 — — Totals $ 213,632 $ 3,798 $ 18,862 $ 1,126 We make estimates concerning the valuation of our investments and the recognition of other-than-temporary declines in the value of our investments. For equity securities, we write down the investment to its fair value, and we reflect the amount of the write-down as a realized loss in our results of operations when we consider the decline in value of an individual equity security investment to be other than temporary. We monitor all investments individually for other-than-temporary declines in value. Generally, we assume there has been an other-than-temporary decline in value if an individual equity security has depreciated in value by more than 20% of our original cost and has been in such an unrealized loss position for more than six months. We held seven equity securities that were in an unrealized loss position at September 30, 2016. Based upon our analysis of general market conditions and underlying factors impacting these equity securities, we considered these declines in value to be temporary. With respect to a debt security that is in an unrealized loss position, we first assess if we intend to sell the debt security. If we determine we intend to sell the debt security, we recognize the impairment loss in our results of operations. If we do not intend to sell the debt security, we determine whether it is more likely than not that we will be required to sell the debt security prior to recovery. If we determine it is more likely than not that we will be required to sell the debt security prior to recovery, we recognize an impairment loss in our results of operations. If we determine it is more likely than not that we will not be required to sell the debt security prior to recovery, we then evaluate whether a credit loss has occurred. We determine whether a credit loss has occurred by comparing the amortized cost of the debt security to the present value of the cash flows we expect to collect. If we expect a cash flow shortfall, we consider that a credit loss has occurred. If we determine that a credit loss has occurred, we consider the impairment to be other than temporary. We then recognize the amount of the impairment loss related to the credit loss in our results of operations, and we recognize the remaining portion of the impairment loss in our other comprehensive income, net of applicable taxes. In addition, we may write down securities in an unrealized loss position based on a number of other factors, including when the fair value of an investment is significantly below its cost, when the financial condition of the issuer of a security has deteriorated, the occurrence of industry, issuer or geographic events that have negatively impacted the value of a security and rating agency downgrades. We held 55 debt securities that were in an unrealized loss position at September 30, 2016. Based upon our analysis of general market conditions and underlying factors impacting these debt securities, we considered these declines in value to be temporary. We amortize premiums and discounts on debt securities over the life of the security as an adjustment to yield using the effective interest method. We compute realized investment gains and losses using the specific identification method. We amortize premiums and discounts on mortgage-backed debt securities using anticipated prepayments. We account for our investment in affiliate using the equity method of accounting. Under this method, we record our investment at cost, with adjustments for our share of our affiliate’s earnings and losses as well as changes in the equity of our affiliate due to unrealized gains and losses. Our investment in affiliate represents our 48.2% ownership interest in DFSC. We include our share of DFSC’s net income in our results of operations. We have compiled the following summary financial information for DFSC at September 30, 2016 and December 31, 2015 and for the three and nine months ended September 30, 2016 and 2015, respectively, from the financial statements of DFSC. The financial information of DFSC at September 30, 2016 and 2015 and for the three and nine months then ended is unaudited. 12 Balance sheets: September 30, 2016 December 31, 2015 (in thousands) Total assets $ 522,118 $ 507,139 Total liabilities $ 438,942 $ 427,423 Stockholders’ equity 83,176 79,716 Total liabilities and stockholders’ equity $ 522,118 $ 507,139 Three Months Ended September 30, Nine Months Ended September 30, Income statements: 2016 2015 2016 2015 (in thousands) Net income $ 742 $ 847 $ 1,449 $ 2,372 13 6 - Segment Information We evaluate the performance of our personal lines and commercial lines segments based upon the underwriting results of our insurance subsidiaries using statutory accounting principles (“SAP”) that various state insurance departments prescribe or permit. Our management uses SAP to measure the performance of our insurance subsidiaries instead of United States generally accepted accounting principles (“GAAP”). Financial data by segment for the three and nine months ended September 30, 2016 and 2015 is as follows: Three Months Ended September 30, 2016 2015 (in thousands) Revenues: Premiums earned Commercial lines $ 75,571 $ 66,456 Personal lines 91,239 86,640 GAAP premiums earned 166,810 153,096 Net investment income 5,581 5,399 Realized investment gains (losses) 1,018 (754 ) Equity in earnings of DFSC 358 408 Other 1,544 1,653 Total revenues $ 175,311 $ 159,802 Income before income taxes: Underwriting (loss) income: Commercial lines $ 3,701 $ 4,447 Personal lines (5,861 ) (3,727 ) SAP underwriting (loss) income (2,160 ) 720 GAAP adjustments 788 65 GAAP underwriting (loss) income (1,372 ) 785 Net investment income 5,581 5,399 Realized investment gains (losses) 1,018 (754 ) Equity in earnings of DFSC 358 408 Other 844 1,163 Income before income taxes $ 6,429 $ 7,001 14 Nine Months Ended September 30, 2016 2015 (in thousands) Revenues: Premiums earned Commercial lines $ 218,405 $ 193,036 Personal lines 268,823 257,048 GAAP premiums earned 487,228 450,084 Net investment income 16,472 15,505 Realized investment gains 2,205 683 Equity in earnings of DFSC 699 1,277 Other 4,623 5,042 Total revenues $ 511,227 $ 472,591 Income before income taxes: Underwriting income (loss): Commercial lines $ 14,118 $ 6,449 Personal lines (6,953 ) (6,499 ) SAP underwriting income (loss) 7,165 (50 ) GAAP adjustments 5,795 4,565 GAAP underwriting income 12,960 4,515 Net investment income 16,472 15,505 Realized investment gains 2,205 683 Equity in earnings of DFSC 699 1,277 Other 2,157 2,430 Income before income taxes $ 34,493 $ 24,410 7 - Borrowings Lines of Credit In July 2016, we renewed our existing credit agreement with Manufacturers and Traders Trust Company (“M&T”) relating to a $60.0 million unsecured, revolving line of credit. The line of credit expires in July 2019. We have the right to request a one-year extension of the credit agreement as of each anniversary date of the credit agreement. At September 30, 2016, we had $39.0 million in outstanding borrowings and had the ability to borrow an additional $21.0 million at interest rates equal to M&T’s current prime rate or the then current LIBOR rate plus 2.25%. The interest rate on our outstanding borrowings from M&T is adjustable quarterly, and, at September 30, 2016, that interest rate was 2.78%. We pay a fee of 0.2% per annum on the loan commitment amount regardless of usage. The credit agreement requires our compliance with certain covenants. These covenants include minimum levels of our net worth, leverage ratio, statutory surplus and the A.M. Best ratings of our insurance subsidiaries. We were in compliance with all requirements of the M&T credit agreement during the nine months ended September 30, 2016. MICO is a member of the Federal Home Loan Bank (“FHLB”) of Indianapolis. Through its membership, MICO has the ability to issue debt to the FHLB of Indianapolis in exchange for cash advances. MICO had no outstanding borrowings with the FHLB of Indianapolis at September 30, 2016. The table below presents the amount of FHLB of Indianapolis stock MICO purchased, collateral pledged and assets related to MICO’s membership at September 30, 2016. FHLB of Indianapolis stock purchased and owned $ 236,700 Collateral pledged, at par (carrying value $2,180,650) 2,177,558 Borrowing capacity currently available 2,143,057 Atlantic States is a member of the FHLB of Pittsburgh. Through its membership, Atlantic States has the ability to issue debt to the FHLB of Pittsburgh in exchange for cash advances. Atlantic States had $35.0 million in outstanding advances at 15 September 30, 2016. The interest rate on the advances was .59% at September 30, 2016. The table below presents the amount of FHLB of Pittsburgh stock Atlantic States purchased, collateral pledged and assets related to Atlantic States’ membership in the FHLB of Pittsburgh at September 30, 2016. FHLB of Pittsburgh stock purchased and owned $ 1,574,700 Collateral pledged, at par (carrying value $36,058,067) 36,085,816 Borrowing capacity currently available 310,732 Subordinated Debentures Donegal Mutual holds a $5.0 million surplus note that MICO issued to increase MICO’s statutory surplus. The surplus note carries an interest rate of 5.00%, and any repayment of principal or payment of interest on the surplus note requires prior approval of the Michigan Department of Insurance and Financial Services. 8 - Share–Based Compensation We measure all share-based payments to employees, including grants of stock options, and use a fair-value-based method for the recording of related compensation expense in our consolidated statements of income. In determining the expense we record for stock options granted to directors and employees of our subsidiaries and affiliates, we estimate the fair value of each option award on the date of grant using the Black-Scholes option pricing model. The significant assumptions we utilize in applying the Black-Scholes option pricing model are the risk-free interest rate, the expected term, the dividend yield and the expected volatility. We charged compensation expense related to our stock compensation plans against income before income taxes of $414,696 and $598,516 for the three months ended September 30, 2016 and 2015, respectively, with a corresponding income tax benefit of $145,143 and $209,481, respectively. We charged compensation expense related to our stock compensation plans against income before income taxes of $2.0 million and $1.9 million for the nine months ended September 30, 2016 and 2015, respectively, with a corresponding income tax benefit of $710,584 and $671,607, respectively. At September 30, 2016, we had $2.0 million of unrecognized compensation expense related to nonvested share-based compensation granted under our stock compensation plans. We expect to recognize this compensation expense over a weighted average period of approximately 1.3 years. We received cash from option exercises under all stock compensation plans during the three months ended September 30, 2016 and 2015 of $3.7 million and $181,488, respectively. We received cash from option exercises under all stock compensation plans during the nine months ended September 30, 2016 and 2015 of $7.8 million and $13.7 million, respectively. We realized actual tax benefits for the tax deductions related to option exercises of $243,656 and $4,802 for the three months ended September 30, 2016 and 2015, respectively. We realized actual tax benefits for the tax deductions related to option exercises of $521,852 and $424,537 for the nine months ended September 30, 2016 and 2015, respectively. 9 - Fair Value Measurements We account for financial assets using a framework that establishes a hierarchy that ranks the quality and reliability of the inputs, or assumptions, we use in the determination of fair value, and we classify financial assets and liabilities carried at fair value in one of the following three categories: Level 1 – quoted prices in active markets for identical assets and liabilities; Level 2 – directly or indirectly observable inputs other than Level 1 quoted prices; and Level 3 – unobservable inputs not corroborated by market data. For investments that have quoted market prices in active markets, we use the quoted market price as fair value and include these investments in Level 1 of the fair value hierarchy. We classify publicly-traded equity securities as Level 1. When quoted market prices in active markets are not available, we base fair values on quoted market prices of comparable instruments or price estimates we obtain from independent pricing services and include these investments in Level 2 of the fair value hierarchy. We classify our fixed maturity investments as Level 2. Our fixed maturity investments consist of U.S. Treasury 16 securities and obligations of U.S. government corporations and agencies, obligations of states and political subdivisions, corporate securities and mortgage-backed securities. We present our investments in available-for-sale fixed maturity and equity securities at estimated fair value. The estimated fair value of a security may differ from the amount that could be realized if we sold the security in a forced transaction. In addition, the valuation of fixed maturity investments is more subjective when markets are less liquid, increasing the potential that the estimated fair value does not reflect the price at which an actual transaction would occur. We utilize nationally recognized independent pricing services to estimate fair values or obtain market quotations for substantially all of our fixed maturity and equity investments. These pricing services utilize market quotations for fixed maturity and equity securities that have quoted prices in active markets. For fixed maturity securities that generally do not trade on a daily basis, the pricing services prepare estimates of fair value measurements based predominantly on observable market inputs. The pricing services do not use broker quotes in determining the fair values of our investments. Our investment personnel review the estimates of fair value the pricing services provide to determine if the estimates we obtain from the pricing services are representative of fair values based upon our investment personnel’s general knowledge of the market, their research findings related to unusual fluctuations in value and their comparison of such values to execution prices for similar securities. Our investment personnel regularly monitor the market, current trading ranges for similar securities and the pricing of specific investments. Our investment personnel review all pricing estimates that we receive from the pricing services against their expectations with respect to pricing based on fair market curves, security ratings, coupon rates, security type and recent trading activity. Our investment personnel review documentation with respect to the pricing services’ pricing methodology that they obtain periodically to determine if the primary pricing sources, market inputs and pricing frequency for various security types are reasonable. At September 30, 2016, we received two estimates per security from the pricing services, and we priced substantially all of our Level 1 and Level 2 investments using those prices. In our review of the estimates the pricing services provided at September 30, 2016, we did not identify any material discrepancies, and we did not make any adjustments to the estimates the pricing services provided. We present our cash and short-term investments at estimated fair value. We classify these items as Level 1. The carrying values we report in our balance sheet for premium receivables and reinsurance receivables and payables for premiums and paid losses and loss expenses approximate their fair values. The carrying amounts we report in our balance sheet for our subordinated debentures and borrowings under lines of credit approximate their fair values. We classify these items as Level 3. We evaluate our assets and liabilities on a recurring basis to determine the appropriate level at which to classify them for each reporting period. The following table presents our fair value measurements for our investments in available-for-sale fixed maturity and equity securities at September 30, 2016: Fair Value Measurements Using Fair Value Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) (in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 36,375 $ — $ 36,375 $ — Obligations of states and political subdivisions 194,276 — 194,276 — Corporate securities 90,841 — 90,841 — Mortgage-backed securities 194,329 — 194,329 — Equity securities 35,167 35,167 — — Total investments in the fair value hierarchy 550,988 35,167 515,821 — Investment measured at net asset value 11,145 — — — Totals $ 562,133 $ 35,167 $ 515,821 $ — We did not transfer any investments between Levels 1 and 2 during the nine months ended September 30, 2016. 17 The following table presents our fair value measurements for our investments in available-for-sale fixed maturity and equity securities at December 31, 2015: Fair Value Measurements Using Fair Value Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) (in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 37,189 $ — $ 37,189 $ — Obligations of states and political subdivisions 236,556 — 236,556 — Corporate securities 72,812 — 72,812 — Mortgage-backed securities 154,836 — 154,836 — Equity securities 26,727 26,727 — — Total investments in the fair value hierarchy 528,120 26,727 501,393 — Investment measured at net asset value 10,534 — — — Totals $ 538,654 $ 26,727 $ 501,393 $ — 10 - Income Taxes At September 30, 2016 and December 31, 2015, respectively, we had no material unrecognized tax benefits or accrued interest and penalties. Tax years 2013 through 2016 remained open for examination at September 30, 2016. We provide a valuation allowance when we believe it is more likely than not that we will not realize some portion of our tax assets. We established a valuation allowance of $440,778 related to a portion of the net operating loss carryforward of Le Mars at January 1, 2004. We have determined that we are not required to establish a valuation allowance for our other deferred tax assets of $43.4 million and $42.7 million at September 30, 2016 and December 31, 2015, respectively, because it is more likely than not that we will realize these deferred tax assets through reversals of existing temporary differences, future taxable income and the implementation of tax planning strategies. Our deferred tax assets include a net operating loss carryforward of $3.6 million related to Le Mars, which will begin to expire in 2020 if not previously utilized. This carryforward is subject to an annual limitation in the amount that we can use in any one year of approximately $376,000. Our deferred tax assets also include an alternative minimum tax credit carryforward of $7.6 million with an indefinite life. 11 - Impact of New Accounting Standards In May 2014, the Financial Accounting Standards Board (the “FASB”) issued guidance that requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. While the guidance will replace most existing GAAP revenue recognition guidance, the scope of the guidance excludes insurance contracts. The new standard is effective on January 1, 2018. The standard permits the use of either the retrospective or the cumulative effect transition method. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In February 2015, the FASB issued a new standard that amends the current consolidation guidance affecting both the variable interest entity (“VIE”) and voting interest entity (“VOE”) consolidation models. The standard does not add or remove any of the characteristics in determining if an entity is a VIE or a VOE, but rather, the standard enhances assessment of some of these characteristics. The new standard was effective on December 15, 2015. The adoption of this new guidance did not have a significant impact on our financial position, results of operations or cash flows. In May 2015, the FASB issued guidance that removes the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value per share practical expedient. The guidance also removes the requirement to make certain disclosures for all investments that are eligible to be measured at fair value using the net asset value per share practical expedient. The guidance instead limits disclosure to investments for which the entity has elected to measure fair value using that practical expedient. The guidance was effective for annual reporting periods beginning after December 15, 2015, and interim reporting periods within those annual reporting periods. The adoption of this new guidance did not have a significant impact on our financial position, results of operations or cash flows. 18 In May 2015, the FASB issued guidance that requires entities to provide additional disclosures about their liability for unpaid claims and claim adjustment expenses to increase the transparency of significant estimates. The guidance also requires entities to disclose information about significant changes in methodologies and assumptions used to calculate the liability for unpaid claims and claim adjustment expenses, including the reasons for the changes and the effects on the entities’ financial statements, and the timing, frequency and severity of claims. The guidance also requires entities to disclose a rollforward of the liability for unpaid claims and claim adjustment expenses for annual and interim reporting periods. The guidance is effective for annual reporting periods beginning after December 15, 2015, and interim reporting periods within annual reporting periods beginning after December 15, 2016. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In January 2016, the FASB issued guidance that generally requires entities to measure equity investments at fair value and recognize changes in fair value in their results of operations. The guidance also simplifies the impairment assessment of equity investments without readily determinable fair values by requiring entities to perform a qualitative assessment to identify impairment. The FASB issued other disclosure and presentation improvements related to financial instruments within the guidance. The guidance is effective for annual and interim reporting periods beginning after December 15, 2017. As a result of this guidance, we will reflect changes in the fair value of our equity investments in our results of operations beginning January 1, 2018. In February 2016, the FASB issued guidance that requires lessees to recognize leases, including operating leases, on the lessee’s balance sheet, unless a lease is considered a short-term lease. The guidance also requires entities to make new judgments to identify leases. The guidance is effective for annual and interim reporting periods beginning after December 15, 2018 and permits early adoption. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In March 2016, the FASB issued guidance that simplifies and improves several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities and classification on the statement of cash flows. The guidance is effective for annual and interim reporting periods beginning after December 15, 2016. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In June 2016, the FASB issued guidance that amends previous guidance on the impairment of financial instruments by adding an impairment model that allows an entity to recognize expected credit losses as an allowance rather than impairments as credit losses are incurred. The new guidance is intended to reduce complexity and result in a more timely recognition of expected credit losses. The guidance is effective for annual and interim reporting periods beginning after December 15, 2019. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In August 2016, the FASB issued guidance that clarifies how certain cash receipts and cash payments shall be presented and classified in the statement of cash flows. This guidance addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. The guidance is effective for annual and interim reporting periods beginning after December 15, 2017. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. 19\nWe recommend that you read the following information in conjunction with the historical financial information and the footnotes to that financial information we include in this Quarterly Report on Form 10-Q. We also recommend you read Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2015.\nCritical Accounting Policies and Estimates\nWe combine our financial statements with those of our insurance subsidiaries and present our financial statements on a consolidated basis in accordance with GAAP.\nOur insurance subsidiaries make estimates and assumptions that can have a significant effect on amounts and disclosures we report in our financial statements. The most significant estimates relate to the reserves of our insurance subsidiaries for property and casualty insurance unpaid losses and loss expenses, the valuation of investments and the determination of other-than-temporary investment impairments and the policy acquisition costs of our insurance subsidiaries. While we believe our estimates and the estimates of our insurance subsidiaries are appropriate, the ultimate amounts of these liabilities may differ from the estimates we provided. We regularly review our methods for making these estimates and we reflect any adjustment we consider necessary in our current consolidated results of operations.\nLiability for Unpaid Losses and Loss Expenses\nLiabilities for losses and loss expenses are estimates at a given point in time of the amounts an insurer expects to pay with respect to incurred policyholder claims based on facts and circumstances the insurer knows at that point in time. At the time of establishing its estimates, an insurer recognizes that its ultimate liability for losses and loss expenses will exceed or be less than such estimates. Our insurance subsidiaries base their estimates of liabilities for losses and loss expenses on assumptions as to future loss trends, expected claims severity, judicial theories of liability and other factors. However, during the loss adjustment period, our insurance subsidiaries may learn additional facts regarding individual claims, and, consequently, it often becomes necessary for our insurance subsidiaries to refine and adjust their estimates for these liabilities. We reflect any adjustments to our insurance subsidiaries’ liabilities for losses and loss expenses in our consolidated results of operations in the period in which our insurance subsidiaries make the changes in estimates.\nOur insurance subsidiaries maintain liabilities for the payment of losses and loss expenses with respect to both reported and unreported claims. Our insurance subsidiaries establish these liabilities for the purpose of covering the ultimate costs of settling all losses, including investigation and litigation costs. Our insurance subsidiaries base the amount of their liability for reported losses primarily upon a case-by-case evaluation of the type of risk involved, knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss the policyholder incurred. Our insurance subsidiaries determine the amount of their liability for unreported claims and loss expenses on the basis of historical information by line of insurance. Our insurance subsidiaries account for inflation in the reserving function through analysis of costs and trends and reviews of historical reserving results. Our insurance subsidiaries monitor their liabilities closely and recompute them periodically using new information on reported claims and a variety of statistical techniques. Our insurance subsidiaries do not discount their liabilities for losses and loss expenses.\nReserve estimates can change over time because of unexpected changes in assumptions related to our insurance subsidiaries’ external environment and, to a lesser extent, assumptions related to our insurance subsidiaries’ internal operations. For example, our insurance subsidiaries have experienced a decrease in claims frequency on workers’ compensation claims during the past several years while the severity of these claims has gradually increased. These trend changes give rise to greater uncertainty as to the pattern of future loss settlements on workers’ compensation claims. Related uncertainties regarding future trends include the cost of medical technologies and procedures and changes in the utilization of medical procedures. Assumptions related to our insurance subsidiaries’ external environment include the absence of significant changes in tort law and the legal environment that increase liability exposure, consistency in judicial interpretations of insurance coverage and policy provisions and the rate of loss cost inflation. Internal assumptions include consistency in the recording of premium and loss statistics, consistency in the recording of claims, payment and case reserving methodology, accurate measurement of the impact of rate changes and changes in policy provisions, consistency in the quality and characteristics of business written within a given line of business and consistency in reinsurance coverage and collectability of reinsured losses, among other items. To the extent our insurance subsidiaries determine that underlying factors impacting their assumptions have changed, our insurance subsidiaries make adjustments in their reserves that they consider appropriate for such changes. Accordingly, our insurance subsidiaries’ ultimate liability for unpaid losses and loss expenses will likely differ\n20\nfrom the amount recorded at September 30, 2016. For every 1% change in our insurance subsidiaries’ estimate for loss and loss expense reserves, net of reinsurance recoverable, the effect on our pre-tax results of operations would be approximately $3.4 million. The establishment of appropriate liabilities is an inherently uncertain process and we can provide no assurance that our insurance subsidiaries’ ultimate liability will not exceed our insurance subsidiaries’ loss and loss expense reserves and have an adverse effect on our results of operations and financial condition. Furthermore, we cannot predict the timing, frequency and extent of adjustments to our insurance subsidiaries’ estimated future liabilities, because the historical conditions and events that serve as a basis for our insurance subsidiaries’ estimates of ultimate claim costs may change. As is the case for substantially all property and casualty insurance companies, our insurance subsidiaries have found it necessary in the past to increase their estimated future liabilities for losses and loss expenses in certain periods and, in other periods, their estimates of future liabilities have exceeded their actual liabilities. Changes in our insurance subsidiaries’ estimates of their liability for losses and loss expenses generally reflect actual payments and their evaluation of information received since the prior reporting date. Excluding the impact of severe weather events, our insurance subsidiaries have noted stable amounts in the number of claims incurred and a slight downward trend in the number of claims outstanding at period ends relative to their premium base in recent years across most of their lines of business. However, the amount of the average claim outstanding has increased gradually over the past several years as the United States property and casualty insurance industry has experienced increased litigation trends and economic conditions that have extended the estimated length of disabilities and contributed to increased medical loss costs. We have also experienced a general slowing of settlement rates in litigated claims. Our insurance subsidiaries could have to make further adjustments to their estimates in the future. However, on the basis of our insurance subsidiaries’ internal procedures, which analyze, among other things, their prior assumptions, their experience with similar cases and historical trends such as reserving patterns, loss payments, pending levels of unpaid claims and product mix, as well as court decisions, economic conditions and public attitudes, we believe that our insurance subsidiaries have made adequate provision for their liability for losses and loss expenses. Atlantic States’ participation in the pool with Donegal Mutual exposes Atlantic States to adverse loss development on the business of Donegal Mutual that the pool includes. However, pooled business represents the predominant percentage of the net underwriting activity of both companies, and Donegal Mutual and Atlantic States share proportionately any adverse risk development of the pooled business. The business in the pool is homogeneous and each company has a pro-rata share of the entire pool. Since substantially all of the business of Atlantic States and Donegal Mutual is pooled and the results shared by each company according to its participation level under the terms of the pooling agreement, the intent of the underwriting pool is to produce a more uniform and stable underwriting result from year to year for each company than either would experience individually and to spread the risk of loss between the companies. 21 Donegal Mutual and our insurance subsidiaries operate together as the Donegal Insurance Group and share a combined business plan designed to achieve market penetration and underwriting profitability objectives. The products our insurance subsidiaries and Donegal Mutual offer are generally complementary, thereby allowing Donegal Insurance Group to offer a broader range of products to a given market and to expand Donegal Insurance Group’s ability to service an entire personal lines or commercial lines account. Distinctions within the products of Donegal Mutual and our insurance subsidiaries generally relate to specific risk profiles targeted within similar classes of business, such as preferred tier products compared to standard tier products, but we do not allocate all of the standard risk gradients to one company. Therefore, the underwriting profitability of the business the individual companies write directly will vary. However, because the pool homogenizes the risk characteristics of all business Donegal Mutual and Atlantic States write directly and each company shares the results according to each company’s participation percentage, each company realizes its percentage share of the underwriting results of the pool. Our insurance subsidiaries’ unpaid liability for losses and loss expenses by major line of business at September 30, 2016 and December 31, 2015 consisted of the following: September 30, 2016 December 31, 2015 (in thousands) Commercial lines: Automobile $ 55,079 $ 53,938 Workers’ compensation 105,873 99,212 Commercial multi-peril 59,279 54,395 Other 3,639 3,119 Total commercial lines 223,870 210,664 Personal lines: Automobile 97,102 93,923 Homeowners 16,947 15,816 Other 2,122 1,651 Total personal lines 116,171 111,390 Total commercial and personal lines 340,041 322,054 Plus reinsurance recoverable 254,227 256,151 Total liability for unpaid losses and loss expenses $ 594,268 $ 578,205 We have evaluated the effect on our insurance subsidiaries’ unpaid loss and loss expense reserves and our stockholders’ equity in the event of reasonably likely changes in the variables we consider in establishing the loss and loss expense reserves of our insurance subsidiaries. We established the range of reasonably likely changes based on a review of changes in accident-year development by line of business and applied those changes to our insurance subsidiaries’ loss reserves as a whole. The selected range does not necessarily indicate what could be the potential best or worst case or the most likely scenario. The following table sets forth the estimated effect on our insurance subsidiaries’ unpaid loss and loss expense reserves and our stockholders’ equity in the event of reasonably likely changes in the variables we considered in establishing the loss and loss expense reserves of our insurance subsidiaries: Percentage Change in Loss and Loss Expense Reserves Net of Reinsurance Adjusted Loss and Loss Expense Reserves Net of Reinsurance at September 30, 2016 Percentage Change in Stockholders’ Equity at September 30, 2016(1) Adjusted Loss and Loss Expense Reserves Net of Reinsurance at December 31, 2015 Percentage Change in Stockholders’ Equity at December 31, 2015(1) (dollars in thousands) (10.0)% $ 306,037 5.0 % $ 289,849 5.1 % (7.5) 314,538 3.7 297,900 3.8 (5.0) 323,039 2.5 305,951 2.6 (2.5) 331,540 1.2 314,003 1.3 Base 340,041 — 322,054 — 2.5 348,542 (1.2 ) 330,105 (1.3 ) 5.0 357,043 (2.5 ) 338,157 (2.6 ) 7.5 365,544 (3.7 ) 346,208 (3.8 ) 10.0 374,045 (5.0 ) 354,259 (5.1 ) (1) Net of income tax effect. 22 Statutory Combined Ratios We evaluate our insurance operations by monitoring certain key measures of growth and profitability. In addition to using GAAP-based performance measurements, we also utilize certain non-GAAP financial measures that we believe are valuable in managing our business and for comparison to our peers. These non-GAAP measures are underwriting income, combined ratio and net premiums written. An insurance company’s statutory combined ratio is a standard measure of underwriting profitability. This ratio is the sum of the ratio of calendar-year incurred losses and loss expenses to premiums earned; the ratio of expenses incurred for commissions, premium taxes and underwriting expenses to net premiums written and the ratio of dividends to policyholders to premiums earned. The combined ratio does not reflect investment income, federal income taxes or other non-operating income or expense. A combined ratio of less than 100 percent generally indicates underwriting profitability. The statutory combined ratio differs from the GAAP combined ratio. In calculating the GAAP combined ratio, we do not deduct installment payment fees from incurred expenses, and we base the expense ratio on premiums earned instead of premiums written. Differences between our GAAP loss ratios reported in our financial statements and our insurance subsidiaries’ statutory loss ratios result from anticipating salvage and subrogation recoveries for the GAAP loss ratios but not for the statutory loss ratios. The following table sets forth our insurance subsidiaries’ statutory combined ratios by major line of business for the three and nine months ended September 30, 2016 and 2015: Three Months Ended September 30, Nine Months Ended September 30, 2016 2015 2016 2015 Commercial lines: Automobile 110.8 % 118.0 % 106.5 % 106.1 % Workers’ compensation 86.8 79.1 85.3 89.0 Commercial multi-peril 94.7 92.2 88.5 93.2 Total commercial lines 94.3 92.0 90.3 93.2 Personal lines: Automobile 105.9 98.8 102.6 100.0 Homeowners 101.5 108.0 97.1 101.7 Total personal lines 103.6 101.4 99.9 99.8 Total commercial and personal lines 99.5 97.4 95.6 96.9 Investments We make estimates concerning the valuation of our investments and the recognition of other-than-temporary declines in the value of our investments. For equity securities, we write down an individual investment to its fair value and we reflect the amount of the write-down as a realized loss in our results of operations when we consider the decline in value of the individual investment to be other than temporary. We individually monitor all investments for other-than-temporary declines in value. Generally, we assume there has been an other-than-temporary decline in value if an individual equity security has depreciated in value by more than 20% of our original cost and has been in such an unrealized loss position for more than six months. We held seven equity securities that were in an unrealized loss position at September 30, 2016. Based upon our analysis of general market conditions and underlying factors impacting these equity securities, we considered these declines in value to be temporary. With respect to a debt security that is in an unrealized loss position, we first assess if we intend to sell the debt security. If we determine we intend to sell the debt security, we recognize the impairment loss in our results of operations. If we do not intend to sell the debt security, we determine whether it is more likely than not that we will be required to sell the debt security prior to recovery. If we determine it is more likely than not that we will be required to sell the debt security prior to recovery, we recognize an impairment loss in our results of operations. If we determine it is more likely than not that we will not be required to sell the debt security prior to recovery, we then evaluate whether a credit loss has occurred. We determine whether a credit loss has occurred by comparing the amortized cost of the debt security to the present value of the cash flows we expect to collect on the debt security. If we expect a cash flow shortfall, we consider that a credit loss has occurred. If we determine that a credit loss has occurred, we consider the impairment to be other than temporary. We then recognize the amount of the impairment loss related to the credit loss in our results of operations, and we recognize the remaining portion of the impairment loss in our other comprehensive income, net of applicable taxes. In addition, we may write down securities in an unrealized loss position based on a number of other factors, including when the fair value of an investment is significantly below its cost, when the financial condition of the issuer of a security has deteriorated, the occurrence of industry, company or geographic events that have negatively impacted the value of a security or rating agency 23 downgrades. We held 55 debt securities that were in an unrealized loss position at September 30, 2016. Based upon our analysis of general market conditions and underlying factors impacting these debt securities, we considered these declines in value to be temporary. We did not recognize any impairment losses in our results of operations for the first nine months of 2016 or 2015. We present our investments in available-for-sale fixed maturity and equity securities at estimated fair value. The estimated fair value of a security may differ from the amount we could realize if we sold the security in a forced transaction. In addition, the valuation of fixed maturity investments is more subjective when markets are less liquid, increasing the potential that the estimated fair value does not reflect the price at which an actual transaction would occur. We utilize nationally recognized independent pricing services to estimate fair values or obtain market quotations for substantially all of our fixed maturity and equity investments. The pricing services utilize market quotations for fixed maturity and equity securities that have quoted prices in active markets. For fixed maturity securities that generally do not trade on a daily basis, the pricing services prepare estimates of fair value measurements based predominantly on observable market inputs. The pricing services do not use broker quotes in determining the fair values of our investments. Our investment personnel review the estimates of fair value the pricing services provide to determine if the estimates we obtain from the pricing services are representative of fair values based upon the general market knowledge of our investment personnel, their research findings related to unusual fluctuations in value and their comparison of such values to execution prices for similar securities. Our investment personnel monitor the market and are familiar with current trading ranges for similar securities and pricing of specific investments. Our investment personnel review all pricing estimates that we receive from the pricing services against their expectations with respect to pricing based on fair market curves, security ratings, coupon rates, security type and recent trading activity. Our investment personnel review documentation with respect to the pricing services’ pricing methodology that they obtain periodically to determine if the primary pricing sources, market inputs and pricing frequency for various security types are reasonable. At September 30, 2016, we received two estimates per security from the pricing services, and we priced substantially all of our Level 1 and Level 2 investments using those prices. In our review of the estimates the pricing services provided at September 30, 2016, we did not identify any material discrepancies, and we did not make any adjustments to the estimates the pricing services provided. Policy Acquisition Costs Our insurance subsidiaries defer their policy acquisition costs, consisting primarily of commissions, premium taxes and certain other underwriting costs that relate directly to the successful acquisition of insurance policies. We amortize these costs over the period in which our insurance subsidiaries earn the related premiums. The method we follow in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. This method gives effect to the premiums to be earned, related investment income, losses and loss expenses and certain other costs we expect to incur as our insurance subsidiaries earn the premiums. Results of Operations - Three Months Ended September 30, 2016 Compared to Three Months Ended September 30, 2015 Net Premiums Written. Our insurance subsidiaries’ net premiums written for the three months ended September 30, 2016 were $171.9 million, an increase of $13.0 million, or 8.2%, from the $158.9 million of net premiums written for the third quarter of 2015. We attribute the increase to the impact of premium rate increases and an increase in the writing of commercial lines of business. Personal lines net premiums written increased $5.2 million, or 5.6%, for the third quarter of 2016 compared to the third quarter of 2015. The increase was attributable primarily to premium rate increases our insurance subsidiaries implemented throughout 2015 and 2016. Commercial lines net premiums written increased $7.8 million, or 12.0%, for the third quarter of 2016 compared to the third quarter of 2015. The increase was primarily attributable to premium rate increases and increased writings of new commercial accounts. Net Premiums Earned. Our insurance subsidiaries’ net premiums earned for the third quarter of 2016 were $166.8 million, an increase of $13.7 million, or 9.0%, compared to $153.1 million for the third quarter of 2015, reflecting increases in net premiums written during 2016 and 2015. Our insurance subsidiaries earn premiums and recognize them as revenue over the terms of their policies, which are one year or less in duration. Therefore, increases or decreases in net premiums earned generally reflect increases or decreases in net premiums written in the preceding 12-month period compared to the comparable period one year earlier. Investment Income. Our net investment income increased to $5.6 million for the third quarter of 2016, compared to $5.4 million for the third quarter of 2015. We attribute the increase primarily to an increase in average invested assets. 24 Net Realized Investment Gains (Losses). Net realized investment gains for the third quarter of 2016 were $1.0 million, compared to net realized investment losses of $754,050 for the third quarter of 2015. The net realized investment gains for the third quarter of 2016 resulted primarily from unrealized gains within a limited partnership that invests in equity securities. The net realized investment losses for the third quarter of 2015 resulted primarily from unrealized losses within the limited partnership. We did not recognize any impairment losses in our investment portfolio during the third quarters of 2016 or 2015. Equity in Earnings of DFSC. Our equity in the earnings of DFSC was $357,956 for the third quarter of 2016, compared to $408,405 for the third quarter of 2015. Losses and Loss Expenses. Our insurance subsidiaries’ loss ratio, which is the ratio of incurred losses and loss expenses to premiums earned, for the third quarter of 2016 was 66.6%, a slight decrease from our insurance subsidiaries’ loss ratio of 66.8% for the third quarter of 2015. On a statutory basis, our insurance subsidiaries’ commercial lines loss ratio was 62.5% for the third quarter of 2016, compared to 62.3% for the third quarter of 2015, primarily due to an increase in the workers’ compensation loss ratio. The personal lines statutory loss ratio of our insurance subsidiaries increased to 70.4% for the third quarter of 2016, compared to 69.9% for the third quarter of 2015, primarily due to an increase in the personal automobile loss ratio. Our insurance subsidiaries experienced favorable loss reserve development of approximately $1.6 million during the third quarter of 2016 in their reserves for prior accident years, compared to unfavorable loss reserve development of approximately $1.5 million during the third quarter of 2015. The improvement in loss reserve development patterns occurred primarily within our insurance subsidiaries’ commercial multi-peril and personal automobile reserves. Underwriting Expenses. The expense ratio for an insurance company is the ratio of policy acquisition costs and other underwriting expenses to premiums earned. The expense ratio of our insurance subsidiaries was 33.5% for the third quarter of 2016, compared to 32.1% for the third quarter of 2015. We attribute the 2016 increase primarily to higher underwriting incentive costs in the third quarter of 2016 compared to the third quarter of 2015. Combined Ratio. The combined ratio represents the sum of the loss ratio, the expense ratio and the dividend ratio, which is the ratio of policyholder dividends incurred to premiums earned. Our insurance subsidiaries’ combined ratios were 100.8% and 99.5% for the three months ended September 30, 2016 and 2015, respectively. Interest Expense. Our interest expense for the third quarter of 2016 was $473,917, compared to $188,000 for the third quarter of 2015. We attribute the increase to higher average borrowings during the third quarter of 2016 compared to the third quarter of 2015. Income Taxes. Income tax expense was $1.6 million for the third quarter of 2016, representing an effective tax rate of 25.1%, compared to income tax expense of $1.3 million for the third quarter of 2015, representing an effective tax rate of 18.8% . The effective tax rate in both periods represented an estimate based on our projected annual taxable income. The increase in the effective tax rate reflects our expectation that tax-exempt interest income will represent a lesser proportion of our 2016 taxable income compared to 2015. Net Income and Earnings Per Share. Our net income for the third quarter of 2016 was $4.8 million, or $.18 per share of Class A common stock on a diluted basis and $.16 per share of Class B common stock, compared to net income of $5.7 million, or $.21 per share of Class A common stock and $.18 per share of Class B common stock, for the third quarter of 2015. We had 21.2 million and 22.4 million Class A shares outstanding at September 30, 2016 and 2015, respectively. We had 5.6 million Class B shares outstanding at the end of both periods. Results of Operations - Nine Months Ended September 30, 2016 Compared to Nine Months Ended September 30, 2015 Net Premiums Written. Our insurance subsidiaries’ net premiums written for the nine months ended September 30, 2016 were $520.3 million, an increase of $39.2 million, or 8.1%, from the $481.1 million of net premiums written for the comparable period of 2015. We attribute the increase to the impact of premium rate increases and an increase in the writing of commercial lines of business. Personal lines net premiums written increased $13.4 million, or 5.0%, for the first nine months of 2016 compared to the first nine months of 2015. The increase was attributable primarily to premium rate increases our insurance subsidiaries implemented throughout 2015 and 2016. Commercial lines net premiums written increased $25.8 million, or 12.1%, for the first nine months of 2016 compared to the first nine months of 2015. The increase was primarily attributable to premium rate increases and increased writings of new commercial accounts. Net Premiums Earned. Our insurance subsidiaries’ net premiums earned for the first nine months of 2016 were $487.2 million, an increase of $37.1 million, or 8.3%, compared to $450.1 million for the first nine months of 2015, reflecting increases in net premiums written during 2016 and 2015. Our insurance subsidiaries earn premiums and recognize them as 25 revenue over the terms of their policies, which are one year or less in duration. Therefore, increases or decreases in net premiums earned generally reflect increases or decreases in net premiums written in the preceding 12-month period compared to the comparable period one year earlier. Investment Income. Our net investment income increased to $16.5 million for the first nine months of 2016, compared to $15.5 million for the first nine months of 2015. We attribute the increase primarily to an increase in average invested assets. Net Realized Investment Gains. Net realized investment gains for the first nine months of 2016 were $2.2 million, compared to $682,932 for the first nine months of 2015. The net realized investment gains for the first nine months of 2016 and 2015 resulted primarily from calls and strategic sales of fixed maturities and equity securities within our investment portfolio. We did not recognize any impairment losses in our investment portfolio during the first nine months of 2016 or 2015. Equity in Earnings of DFSC. Our equity in the earnings of DFSC was $698,658 for the first nine months of 2016, compared to $1.3 million for the first nine months of 2015. Losses and Loss Expenses. Our insurance subsidiaries’ loss ratio, which is the ratio of incurred losses and loss expenses to premiums earned, for the first nine months of 2016 was 63.6%, a decrease from our insurance subsidiaries’ loss ratio of 65.8% for the first nine months of 2015. On a statutory basis, our insurance subsidiaries’ commercial lines loss ratio was 59.4% for the first nine months of 2016, compared to 62.7% for the first nine months of 2015, primarily due to decreases in the commercial multi-peril and workers’ compensation loss ratios. The personal lines statutory loss ratio of our insurance subsidiaries decreased to 67.2% for the first nine months of 2016, compared to 68.1% for the first nine months of 2015, primarily due to a decrease in the homeowners loss ratio. Our insurance subsidiaries experienced unfavorable loss reserve development of approximately $2.1 million during the first nine months of 2016 in their reserves for prior accident years, compared to approximately $4.8 million during the first nine months of 2015. The improvement in loss reserve development patterns occurred primarily within our insurance subsidiaries’ workers’ compensation reserves. Underwriting Expenses. The expense ratio for an insurance company is the ratio of policy acquisition costs and other underwriting expenses to premiums earned. The expense ratio of our insurance subsidiaries was 33.2% for the first nine months of 2016, compared to 32.7% for the first nine months of 2015. We attribute the 2016 increase primarily to higher underwriting incentive costs related to the lower loss ratio in the first nine months of 2016 compared to the first nine months of 2015. Combined Ratio. The combined ratio represents the sum of the loss ratio, the expense ratio and the dividend ratio, which is the ratio of policyholder dividends incurred to premiums earned. Our insurance subsidiaries’ combined ratios were 97.3% and 99.0% for the nine months ended September 30, 2016 and 2015, respectively. Interest Expense. Our interest expense for the first nine months of 2016 was $1.3 million, compared to $908,615 for the first nine months of 2015. We attribute the increase to higher average borrowings during the first nine months of 2016 compared to the first nine months of 2015. Income Taxes. Income tax expense was $9.2 million for the first nine months of 2016, representing an effective tax rate of 26.8%, compared to income tax expense of $5.4 million for the first nine months of 2015, representing an effective tax rate of 22.1% . The effective tax rate in both periods represented an estimate based on our projected annual taxable income. The increase in the effective tax rate reflects our expectation that tax-exempt interest income will represent a lesser proportion of our 2016 taxable income compared to 2015. Net Income and Earnings Per Share. Our net income for the first nine months of 2016 was $25.2 million, or $.95 per share of Class A common stock on a diluted basis and $.88 per share of Class B common stock, compared to net income of $19.0 million, or $.69 per share of Class A common stock on a diluted basis and $.63 per share of Class B common stock, for the first nine months of 2015. We had 21.2 million and 22.4 million Class A shares outstanding at September 30, 2016 and 2015, respectively. We had 5.6 million Class B shares outstanding at the end of both periods. Liquidity and Capital Resources Liquidity is a measure of an entity’s ability to secure enough cash to meet its contractual obligations and operating needs as such obligations and needs arise. Our major sources of funds from operations are the net cash flows we generate from our insurance subsidiaries’ underwriting results, investment income and investment maturities. 26 Our operations have historically generated sufficient net positive cash flow to fund our commitments and add to our investment portfolio, thereby increasing future investment returns and enhancing our liquidity. The impact of the pooling agreement between Donegal Mutual and Atlantic States has historically been cash-flow positive because of the consistent underwriting profitability of the pool. Donegal Mutual and Atlantic States settle their respective obligations to each other under the pool monthly, thereby resulting in cash flows substantially similar to the cash flows that would result from each company writing the business directly. We have not experienced any unusual variations in the timing of claim payments associated with the loss reserves of our insurance subsidiaries. We maintain significant liquidity in our investment portfolio in the form of readily marketable fixed maturities, equity securities and short-term investments. We structure our fixed-maturity investment portfolio following a “laddering” approach, so that projected cash flows from investment income and principal maturities are evenly distributed from a timing perspective, thereby providing an additional measure of liquidity to meet our obligations should an unexpected variation occur in the future. Our operating activities provided net cash flows in the first nine months of 2016 and 2015 of $46.3 million and $48.5 million, respectively. At September 30, 2016, we had $39.0 million in outstanding borrowings under our line of credit with M&T and had the ability to borrow an additional $21.0 million at interest rates equal to M&T’s current prime rate or the then current LIBOR rate plus 2.25%. The interest rate on these borrowings was 2.78% at September 30, 2016. At September 30, 2016, Atlantic States had $35.0 million in outstanding advances with the FHLB of Pittsburgh. The interest rate on these advances was .59% at September 30, 2016. The following table shows our expected payments for significant contractual obligations at September 30, 2016: Total Less than 1 year 1-3 years 4-5 years After 5 years (in thousands) Net liability for unpaid losses and loss expenses of our insurance subsidiaries $ 340,041 $ 158,779 $ 155,378 $ 12,372 $ 13,512 Subordinated debentures 5,000 — — — 5,000 Borrowings under lines of credit 74,000 35,000 39,000 — — Total contractual obligations $ 419,041 $ 193,779 $ 194,378 $ 12,372 $ 18,512 We estimate the date of payment for the net liability for unpaid losses and loss expenses of our insurance subsidiaries based on historical experience and expectations of future payment patterns. We show the liability net of reinsurance recoverable on unpaid losses and loss expenses to reflect expected future cash flows related to such liability. Amounts Atlantic States assumes pursuant to the pooling agreement with Donegal Mutual represent a substantial portion of our insurance subsidiaries’ gross liability for unpaid losses and loss expenses, and amounts Atlantic States cedes pursuant to the pooling agreement represent a substantial portion of our insurance subsidiaries’ reinsurance recoverable on unpaid losses and loss expenses. We include cash settlement of Atlantic States’ assumed liability from the pool in monthly settlements of pooled activity, as we net amounts ceded to and assumed from the pool. Although Donegal Mutual and we do not anticipate any changes in the pool participation levels in the foreseeable future, any such change would be prospective in nature and therefore would not impact the timing of expected payments by Atlantic States for its percentage share of pooled losses occurring in periods prior to the effective date of such change. We discuss in Note 7 – Borrowings our estimate of the timing of the amounts for the borrowings under our lines of credit based on their contractual maturities. The borrowings under our lines of credit carry interest rates that vary as we discuss in Note 7 – Borrowings. Based upon the interest rates in effect at September 30, 2016, our annual interest cost associated with the borrowings under our lines of credit is approximately $1.3 million. For every 1% change in the interest rate associated with the borrowings under our lines of credit, the effect on our annual interest cost would be approximately $740,000. We discuss in Note 7 – Borrowings our estimate of the timing of the amounts for the subordinated debentures based on their contractual maturity. The subordinated debentures carry an interest rate of 5%, and any repayment of principal or payment of interest on the subordinated debentures requires prior approval of the Michigan Department of Insurance and Financial Services. Our annual interest cost associated with the subordinated debentures is approximately $250,000. On July 18, 2013, our board of directors authorized a share repurchase program pursuant to which we have the authority to purchase up to 500,000 additional shares of our Class A common stock at prices prevailing from time to time in the open market subject to the provisions of applicable rules of the SEC and in privately negotiated transactions. We did not purchase any shares of our Class A common stock under this program during the nine months ended September 30, 2016. We purchased 27 57,658 shares of our Class A common stock under this program during the nine months ended September 30, 2015. We have purchased a total of 57,658 shares of our Class A common stock under this program from its inception through September 30, 2016. On October 20, 2016, our board of directors declared quarterly cash dividends of 13.75 cents per share of our Class A common stock and 12.00 cents per share of our Class B common stock, payable on November 15, 2016 to our stockholders of record as of the close of business on November 1, 2016. We are not subject to any restrictions on our payment of dividends to our stockholders, although there are state law restrictions on the payment of dividends by our insurance subsidiaries to us. Dividends from our insurance subsidiaries are our principal source of cash for payment of dividends to our stockholders. Our insurance subsidiaries are subject to regulations that restrict the payment of dividends from statutory surplus and may require prior approval of their domiciliary insurance regulatory authorities. Our insurance subsidiaries are also subject to risk based capital (“RBC”) requirements that limit their ability to pay dividends to us. Our insurance subsidiaries’ statutory capital and surplus at December 31, 2015 exceeded the amount of statutory capital and surplus necessary to satisfy regulatory requirements, including the RBC requirements, by a significant margin. Our insurance subsidiaries paid $9.5 million in dividends to us during the first nine months of 2016. Amounts remaining available for distribution to us as dividends from our insurance subsidiaries without prior approval of their domiciliary insurance regulatory authorities in 2016 are $18.8 million from Atlantic States, $1.3 million from Southern, $1.1 million from Le Mars, $4.2 million from Peninsula, $325,412 from Sheboygan and $619,953 from MICO, or a total of approximately $26.3 million. At September 30, 2016, we had no material commitments for capital expenditures. Equity Price Risk Our portfolio of marketable equity securities, which we carry on our consolidated balance sheets at estimated fair value, has exposure to the risk of loss resulting from an adverse change in prices. We manage this risk by having our investment staff perform an analysis of prospective investments and regular reviews of our portfolio of equity securities. Credit Risk Our portfolio of fixed-maturity securities and, to a lesser extent, our portfolio of short-term investments is subject to credit risk, which we define as the potential loss in market value resulting from adverse changes in the borrower’s ability to repay its debt. We manage this risk by having our investment staff perform an analysis of prospective investments and regular reviews of our portfolio of fixed-maturity securities. We also limit the percentage and amount of our total investment portfolio that we invest in the securities of any one issuer. Our insurance subsidiaries provide property and casualty insurance coverages through independent insurance agencies. We bill the majority of this business directly to the insured, although we bill a portion of our commercial business through licensed insurance agents to whom our insurance subsidiaries extend credit in the normal course of business. Because the pooling agreement does not relieve Atlantic States of primary liability as the originating insurer, Atlantic States is subject to a concentration of credit risk arising from the business it cedes to Donegal Mutual. Our insurance subsidiaries maintain reinsurance agreements with Donegal Mutual and with a number of other major unaffiliated authorized reinsurers. Impact of Inflation We establish property and casualty insurance premium rates before we know the amount of unpaid losses and loss expenses or the extent to which inflation may impact such losses and expenses. Consequently, our insurance subsidiaries attempt, in establishing rates, to anticipate the potential impact of inflation.\nOur market risk generally represents the risk of gain or loss that may result from the potential change in the fair value of the securities we hold in our investment portfolio as a result of fluctuations in prices and interest rates and, to a lesser extent, our debt obligations. We manage our interest rate risk by maintaining an appropriate relationship between the average duration of our investment portfolio and the approximate duration of our liabilities, i.e., policy claims of our insurance subsidiaries and our debt obligations.\n28\nThere have been no material changes to our quantitative or qualitative market risk exposure from December 31, 2015 through September 30, 2016.\nEvaluation of Disclosure Controls and Procedures\nOur management, with the participation of our Chief Executive Officer and our Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Based on such evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that, at September 30, 2016, our disclosure controls and procedures were effective in recording, processing, summarizing and reporting, on a timely basis, information we are required to disclose in the reports that we file or submit under the Exchange Act, and our disclosure controls and procedures were also effective to ensure that information we disclose in the reports we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, to allow timely decisions regarding required disclosure.\nChanges in Internal Control Over Financial Reporting\nThere has been no change in our internal control over financial reporting during the quarter covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to affect materially, our internal control over financial reporting.\nSafe Harbor Statement Under the Private Securities Litigation Reform Act of 1995\nWe base all statements contained in this Quarterly Report on Form 10-Q that are not historic facts on our current expectations. Such statements are forward-looking in nature (as defined in the Private Securities Litigation Reform Act of 1995) and necessarily involve risks and uncertainties. Forward-looking statements we make may be identified by our use of words such as “will,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “seeks,” “estimates” and similar expressions. Our actual results could vary materially from our forward-looking statements. The factors that could cause our actual results to vary materially from the forward-looking statements we have previously made include, but are not limited to, our ability to maintain profitable operations, the adequacy of the loss and loss expense reserves of our insurance subsidiaries, business and economic conditions in the areas in which we and our insurance subsidiaries operate, interest rates, competition from various insurance and other financial businesses, terrorism, the availability and cost of reinsurance, adverse and catastrophic weather events, legal and judicial developments, changes in regulatory requirements, our ability to integrate and manage successfully the companies we may acquire from time to time and the other risks that we describe from time to time in our filings with the SEC. We disclaim any obligation to update such statements or to announce publicly the results of any revisions that we may make to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.\n29\nPart II. Other Information\nNone.\nOur business, results of operations and financial condition, and, therefore, the value of our Class A common stock and our Class B common stock, are subject to a number of risks. For a description of certain risks, we refer to “Risk Factors” in our 2015 Annual Report on Form 10-K we filed with the SEC on March 18, 2016. There have been no material changes in the risk factors we disclosed in that Form 10-K Report during the nine months ended September 30, 2016.\nNone.\nNone.\nItem 4. Removed and Reserved.\nNone.\n30\n\n\n| Exhibit No. | Description |\n| Exhibit 31.1 | Certification of Chief Executive Officer |\n| Exhibit 31.2 | Certification of Chief Financial Officer |\n| Exhibit 32.1 | Statement of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 of Title 18 of the United States Code |\n| Exhibit 32.2 | Statement of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of Title 18 of the United States Code |\n| Exhibit 101.INS | XBRL Instance Document |\n| Exhibit 101.SCH | XBRL Taxonomy Extension Schema Document |\n| Exhibit 101.PRE | XBRL Taxonomy Presentation Linkbase Document |\n| Exhibit 101.CAL | XBRL Taxonomy Calculation Linkbase Document |\n| Exhibit 101.LAB | XBRL Taxonomy Label Linkbase Document |\n| Exhibit 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\n\n31\nSignatures Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. DONEGAL GROUP INC. November 7, 2016 By: /s/ Kevin G. Burke Kevin G. Burke, President and Chief Executive Officer November 7, 2016 By: /s/ Jeffrey D. Miller Jeffrey D. Miller, Executive Vice President and Chief Financial Officer\n</text>\n\nWhat is the annual growth rate of the company's total investments from December 31, 2015 to September 30, 2016 in percent?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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doc-math
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"ground_truth": "Therefore, the answer is 6.411694352303821."
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docmath_40000_plus
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1.\nFinancial Statements.\nConsolidated Balance Sheets 4\nConsolidated Statements of Operations 5\nConsolidated Statements of Comprehensive Income (Loss) 7\nConsolidated Statements of Equity 8\nConsolidated Statements of Cash Flows 12\nNotes to the Consolidated Financial Statements 14\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 40\nItem 3. Quantitative and Qualitative Disclosures About Market Risk 51\nItem 4. Controls and Procedures 53\nPART II. OTHER INFORMATION\nItem 1. Legal Proceedings 54\nItem 1A. Risk Factors 54\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds 54\nItem 3. Defaults Upon Senior Securities 54\nItem 4. Mine Safety Disclosures 54\nItem 5. Other Information 54\nItem 6. Exhibits 55\nSignatures 56\n3\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSAS OF JUNE 30, 2021 [UNAUDITED] AND DECEMBER 31, 2020[IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\n| June 30, 2021 | December 31, 2020 |\n| Assets: |\n| Investment in Hotel Properties, Net of Accumulated Depreciation | $ | 1,699,230 | $ | 1,784,838 |\n| Investment in Unconsolidated Joint Ventures | 5,936 | 6,633 |\n| Cash and Cash Equivalents | 69,083 | 16,637 |\n| Escrow Deposits | 11,067 | 6,970 |\n| Hotel Accounts Receivable | 5,539 | 5,690 |\n| Due from Related Parties | 1,552 | 2,641 |\n| Intangible Assets, Net of Accumulated Amortization of $ 6,827 and $ 6,840 | 1,465 | 1,739 |\n| Right of Use Assets | 43,467 | 44,126 |\n| Other Assets | 20,395 | 15,494 |\n| Hotel Assets Held for Sale | — | 96,220 |\n| Total Assets | $ | 1,857,734 | $ | 1,980,988 |\n| Liabilities and Equity: |\n| Line of Credit | $ | 118,684 | $ | 133,053 |\n| Term Loans, Net of Unamortized Deferred Financing Costs (Note 5) | 495,657 | 681,744 |\n| Unsecured Notes Payable, Net of Unamortized Discount and Unamortized Deferred Financing Costs (Note 5) | 193,725 | 50,789 |\n| Mortgages Payable, Net of Unamortized Premium and Unamortized Deferred Financing Costs | 304,426 | 330,848 |\n| Lease Liabilities | 53,455 | 53,852 |\n| Accounts Payable, Accrued Expenses and Other Liabilities | 49,088 | 58,453 |\n| Dividends and Distributions Payable | 6,044 | — |\n| Total Liabilities | $ | 1,221,079 | $ | 1,308,739 |\n| Redeemable Noncontrolling Interests - Consolidated Joint Venture (Note 1) | $ | 1,968 | $ | — |\n| Equity: |\n| Shareholders' Equity: |\n| Preferred Shares: $ .01 Par Value, 29,000,000 Shares Authorized, 3,000,000 Series C, 7,701,700 Series D and 4,001,514 Series E Shares Issued and Outstanding at June 30, 2021 and December 31, 2020, with Liquidation Preferences of $ 25.00 Per Share (Note 1) | $ | 147 | $ | 147 |\n| Common Shares: Class A, $ .01 Par Value, 104,000,000 Shares Authorized at June 30, 2021 and December 31, 2020; 39,217,475 and 38,843,482 Shares Issued and Outstanding at June 30, 2021 and December 31, 2020, respectively | 392 | 389 |\n| Common Shares: Class B, $ .01 Par Value, 1,000,000 Shares Authorized, None Issued and Outstanding at June 30, 2021 and December 31, 2020 | — | — |\n| Accumulated Other Comprehensive Loss | ( 11,024 ) | ( 19,275 ) |\n| Additional Paid-in Capital | 1,153,657 | 1,150,985 |\n| Distributions in Excess of Net Income | ( 557,157 ) | ( 509,243 ) |\n| Total Shareholders' Equity | 586,015 | 623,003 |\n| Noncontrolling Interests (Note 1) | 48,672 | 49,246 |\n| Total Equity | 634,687 | 672,249 |\n| Total Liabilities and Equity | $ | 1,857,734 | $ | 1,980,988 |\n\nThe Accompanying Notes Are an Integral Part of These Consolidated Financial Statements.\n4\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\n| Three Months Ended June 30, | Six months ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Revenue: |\n| Hotel Operating Revenues: |\n| Room | $ | 56,539 | $ | 15,139 | $ | 95,889 | $ | 86,222 |\n| Food & Beverage | 7,230 | 136 | 10,304 | 10,211 |\n| Other Operating Revenues | 6,314 | 2,137 | 11,043 | 10,917 |\n| Other Revenues | 13 | 29 | 25 | 228 |\n| Total Revenues | 70,096 | 17,441 | 117,261 | 107,578 |\n| Operating Expenses: |\n| Hotel Operating Expenses: |\n| Room | 12,350 | 3,622 | 21,548 | 22,714 |\n| Food & Beverage | 5,409 | 721 | 8,282 | 11,342 |\n| Other Operating Expenses | 23,551 | 14,035 | 43,660 | 49,841 |\n| Insurance recoveries in excess of property loss | ( 711 ) | — | ( 711 ) | — |\n| Hotel Ground Rent | 1,064 | 1,058 | 2,164 | 2,121 |\n| Real Estate and Personal Property Taxes and Property Insurance | 9,466 | 9,969 | 19,537 | 19,911 |\n| General and Administrative (including Share Based Payments of $ 2,589 and $ 1,799 and $ 4,758 and $ 4,255 for the three and six months ended June 30, 2021 and 2020, respectively) | 5,287 | 4,187 | 10,231 | 10,021 |\n| Terminated Transaction Costs | 36 | — | 390 | — |\n| Loss on Impairment of Assets | 222 | 1,069 | 222 | 1,069 |\n| Depreciation and Amortization | 21,014 | 24,322 | 42,816 | 48,510 |\n| Total Operating Expenses | 77,688 | 58,983 | 148,139 | 165,529 |\n| Operating Loss | ( 7,592 ) | ( 41,542 ) | ( 30,878 ) | ( 57,951 ) |\n| Interest Income | 4 | 2 | 5 | 38 |\n| Interest Expense | ( 14,982 ) | ( 13,481 ) | ( 28,411 ) | ( 26,488 ) |\n| Other Income (Expense) | ( 84 ) | ( 385 ) | 377 | ( 457 ) |\n| Gain on Disposition of Hotel Properties | — | — | 48,352 | — |\n| Loss on Debt Extinguishment | ( 129 ) | — | ( 3,069 ) | — |\n| Loss Before Results from Unconsolidated Joint Venture Investments and Income Taxes | ( 22,783 ) | ( 55,406 ) | ( 13,624 ) | ( 84,858 ) |\n| Loss from Unconsolidated Joint Ventures | ( 589 ) | ( 502 ) | ( 1,247 ) | ( 1,520 ) |\n| Loss Before Income Taxes | ( 23,372 ) | ( 55,908 ) | ( 14,871 ) | ( 86,378 ) |\n| Income Tax Benefit (Expense) | ( 151 ) | ( 15,872 ) | 438 | ( 11,374 ) |\n| Net Loss | ( 23,523 ) | ( 71,780 ) | ( 14,433 ) | ( 97,752 ) |\n| Loss Allocated to Noncontrolling Interests - Common Units | 2,945 | 7,164 | 2,623 | 10,061 |\n| (Income) Loss Allocated to Noncontrolling Interests - Consolidated Joint Venture | ( 1,968 ) | 3,196 | ( 1,810 ) | 3,196 |\n| Preferred Distributions | ( 6,044 ) | ( 6,044 ) | ( 12,087 ) | ( 12,088 ) |\n| Net Loss Applicable to Common Shareholders | $ | ( 28,590 ) | $ | ( 67,464 ) | $ | ( 25,707 ) | $ | ( 96,583 ) |\n\nThe Accompanying Notes Are an Integral Part of These Consolidated Financial Statements.\n5\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Earnings Per Share: |\n| BASIC |\n| Loss from Continuing Operations Applicable to Common Shareholders | $ | ( 0.73 ) | $ | ( 1.75 ) | $ | ( 0.66 ) | $ | ( 2.50 ) |\n| DILUTED |\n| Loss from Continuing Operations Applicable to Common Shareholders | $ | ( 0.73 ) | $ | ( 1.75 ) | $ | ( 0.66 ) | $ | ( 2.50 ) |\n| Weighted Average Common Shares Outstanding: |\n| Basic | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\n| Diluted* | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\n\n* Income (Loss) allocated to noncontrolling interest in Hersha Hospitality Limited Partnership (the “Operating Partnership” or “HHLP”) has been excluded from the numerator and the Class A common shares issuable upon any redemption of the Operating Partnership’s common units of limited partnership interest (“Common Units”) and the Operating Partnership’s vested LTIP units (“Vested LTIP Units”) have been omitted from the denominator for the purpose of computing diluted earnings per share because the effect of including these shares and units in the numerator and denominator would have no impact. In addition, potentially dilutive common shares, if any, have been excluded from the denominator if they are anti-dilutive to income (loss) applicable to common shareholders.\nThe following table summarizes potentially dilutive securities that have been excluded from the denominator for the purpose of computing diluted earnings per share:\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Common Units and Vested LTIP Units | 4,279,355 | 3,943,319 | 4,314,347 | 3,891,032 |\n| Unvested Stock Awards and LTIP Units Outstanding | 939,591 | 547,315 | 581,989 | 267,443 |\n| Contingently Issuable Share Awards | 408,202 | 185,754 | 594,125 | 680,979 |\n| Total Potentially Dilutive Securities Excluded from the Denominator | 5,627,148 | 4,676,388 | 5,490,461 | 4,839,454 |\n\nThe Accompanying Notes Are an Integral Part of These Consolidated Financial Statements.\n6\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS]\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Net Loss | $ | ( 23,523 ) | $ | ( 71,780 ) | $ | ( 14,433 ) | $ | ( 97,752 ) |\n| Other Comprehensive Income (Loss) |\n| Change in Fair Value of Derivative Instruments | 2,539 | ( 2,020 ) | 9,004 | ( 33,146 ) |\n| Reclassification Adjustment for Change in Fair Value of Derivative Instruments Included in Net Income (Loss) | ( 141 ) | 1,228 | 159 | 2,205 |\n| Total Other Comprehensive Income (Loss) | $ | 2,398 | $ | ( 792 ) | $ | 9,163 | $ | ( 30,941 ) |\n| Comprehensive Loss | ( 21,125 ) | ( 72,572 ) | ( 5,270 ) | ( 128,693 ) |\n| Less: Comprehensive Loss Attributable to Noncontrolling Interests - Common Units | 2,712 | 7,270 | 1,711 | 12,895 |\n| Less: Comprehensive (Income) Loss Attributable to Noncontrolling Interests - Consolidated Joint Venture | ( 1,968 ) | 3,196 | ( 1,810 ) | 3,196 |\n| Less: Preferred Distributions | ( 6,044 ) | ( 6,044 ) | ( 12,087 ) | ( 12,088 ) |\n| Comprehensive Loss Attributable to Common Shareholders | $ | ( 26,425 ) | $ | ( 68,150 ) | $ | ( 17,456 ) | $ | ( 124,690 ) |\n\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\n7\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF EQUITYFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARES]\n| Redeemable Noncontrolling Interests | Shareholders' Equity | Noncontrolling Interests |\n| Consolidated Joint Venture ($) | Common Shares | Class A Common Shares ($) | Class B Common Shares ($) | Preferred Shares | Preferred Shares ($) | Additional Paid-In Capital ($) | Accumulated Other Comprehensive Loss ($) | Distributions in Excess of Net Income ($) | Total Shareholders' Equity ($) | Common Units and LTIP Units | Common Units and LTIP Units ($) | Total Equity ($) |\n| Balance at March 31, 2021 | — | 39,132,307 | 391 | — | 14,703,214 | 147 | 1,154,579 | ( 12,509 ) | ( 530,535 ) | 612,073 | 5,943,014 | 49,172 | 661,245 |\n| Dividends and Distributions declared: |\n| Preferred Shares | — | — | — | — | — | — | — | — | ( 6,044 ) | ( 6,044 ) | — | — | ( 6,044 ) |\n| Share Based Compensation: |\n| Grants | — | 85,168 | 1 | — | — | — | 365 | — | — | 366 | 19,477 | 65 | 431 |\n| Amortization | — | — | — | — | — | — | 681 | — | — | 681 | 1,468 | 2,149 |\n| Change in Fair Value of Derivative Instruments | — | — | — | — | — | — | — | 1,485 | — | 1,485 | — | 912 | 2,397 |\n| Adjustment to Record Noncontrolling Interest at Redemption Value | 1,968 | — | — | — | — | — | ( 1,968 ) | — | — | ( 1,968 ) | — | — | ( 1,968 ) |\n| Net Loss | — | — | — | — | — | — | — | — | ( 20,578 ) | ( 20,578 ) | — | ( 2,945 ) | ( 23,523 ) |\n| Balance at June 30, 2021 | 1,968 | 39,217,475 | 392 | — | 14,703,214 | 147 | 1,153,657 | ( 11,024 ) | ( 557,157 ) | 586,015 | 5,962,491 | 48,672 | 634,687 |\n\n8\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF EQUITYFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARES]\n| Redeemable Noncontrolling Interests | Shareholders' Equity | Noncontrolling Interests |\n| Consolidated Joint Venture ($) | Common Shares | Class A Common Shares ($) | Class B Common Shares ($) | Preferred Shares | Preferred Shares ($) | Additional Paid-In Capital ($) | Accumulated Other Comprehensive Loss ($) | Distributions in Excess of Net Income ($) | Total Shareholders' Equity ($) | Common Units and LTIP Units | Common Units and LTIP Units ($) | Total Equity ($) |\n| Balance at March 31, 2020 | 3,196 | 38,673,242 | 387 | — | 14,703,214 | 147 | 1,145,450 | ( 26,411 ) | ( 362,777 ) | 756,796 | 4,279,946 | 59,162 | 815,958 |\n| Issuance Costs | — | — | — | — | — | — | ( 10 ) | — | — | ( 10 ) | — | — | ( 10 ) |\n| Share Based Compensation: |\n| Grants | — | 116,129 | 1 | — | — | — | — | — | — | 1 | 1,101,924 | — | 1 |\n| Amortization | — | — | — | — | — | — | 655 | — | — | 655 | — | 3,823 | 4,478 |\n| Change in Fair Value of Derivative Instruments | — | — | — | — | — | — | — | ( 686 ) | — | ( 686 ) | — | ( 106 ) | ( 792 ) |\n| Adjustment to Record Noncontrolling Interest at Redemption Value | ( 3,196 ) | — | — | — | — | — | 3,196 | — | — | 3,196 | — | — | 3,196 |\n| Net Income | — | — | — | — | — | — | — | — | ( 64,616 ) | ( 64,616 ) | ( 7,164 ) | ( 71,780 ) |\n| Balance at June 30, 2020 | — | 38,789,371 | 388 | — | 14,703,214 | 147 | 1,149,291 | ( 27,097 ) | ( 427,393 ) | 695,336 | 5,381,870 | 55,715 | 751,051 |\n\n9\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF EQUITYFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARES]\n| Redeemable Noncontrolling Interests | Shareholders' Equity | Noncontrolling Interests |\n| Consolidated Joint Venture ($) | Common Shares | Class A Common Shares ($) | Class B Common Shares ($) | Preferred Shares | Preferred Shares ($) | Additional Paid-In Capital ($) | Accumulated Other Comprehensive Loss ($) | Distributions in Excess of Net Income ($) | Total Shareholders' Equity ($) | Common Units and LTIP Units | Common Units and LTIP Units ($) | Total Equity ($) |\n| Balance at December 31, 2020 | — | 38,843,482 | 389 | — | 14,703,214 | 147 | 1,150,985 | ( 19,275 ) | ( 509,243 ) | 623,003 | 5,392,808 | 49,246 | 672,249 |\n| Unit Conversion | — | 225,000 | 2 | — | — | — | 2,870 | — | — | 2,872 | ( 225,000 ) | ( 2,872 ) | — |\n| Dividends and Distributions declared: |\n| Preferred Shares | — | — | — | — | — | — | — | — | ( 36,262 ) | ( 36,262 ) | — | — | ( 36,262 ) |\n| Share Based Compensation: |\n| Grants | — | 148,993 | 1 | — | — | — | 356 | — | — | 357 | 794,683 | 1,683 | 2,040 |\n| Amortization | — | — | — | — | — | — | 1,414 | — | — | 1,414 | 2,326 | 3,740 |\n| Change in Fair Value of Derivative Instruments | — | — | — | — | — | — | — | 8,251 | — | 8,251 | — | 912 | 9,163 |\n| Equity Contribution to Consolidated Joint Venture | 158 | — | — | — | — | — | — | — | — | — | — | — | — |\n| Adjustment to Record Noncontrolling Interest at Redemption Value | 1,968 | — | — | — | — | — | ( 1,968 ) | — | — | ( 1,968 ) | — | — | ( 1,968 ) |\n| Net Income | ( 158 ) | — | — | — | — | — | — | — | ( 11,652 ) | ( 11,652 ) | — | ( 2,623 ) | ( 14,275 ) |\n| Balance at June 30, 2021 | 1,968 | 39,217,475 | 392 | — | 14,703,214 | 147 | 1,153,657 | ( 11,024 ) | ( 557,157 ) | 586,015 | 5,962,491 | 48,672 | 634,687 |\n\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\n10\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF EQUITYFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARES]\n| Redeemable Noncontrolling Interests | Shareholders' Equity | Noncontrolling Interests |\n| Consolidated Joint Venture ($) | Common Shares | Class A Common Shares ($) | Class B Common Shares ($) | Preferred Shares | Preferred Shares ($) | Additional Paid-In Capital ($) | Accumulated Other Comprehensive Loss ($) | Distributions in Excess of Net Income ($) | Total Shareholders' Equity ($) | Common Units and LTIP Units | Common Units and LTIP Units ($) | Total Equity ($) |\n| Balance at December 31, 2019 | 3,196 | 38,652,650 | 387 | — | 14,703,214 | 147 | 1,144,808 | 1,010 | ( 338,695 ) | 807,657 | 4,279,946 | 64,144 | 871,801 |\n| Unit Conversion | — | — | — | — | — | — | ( 30 ) | — | — | ( 30 ) | — | — | ( 30 ) |\n| Dividends and Distributions declared: |\n| Preferred Shares | — | — | — | — | — | — | — | — | ( 1,007 ) | ( 1,007 ) | — | — | ( 1,007 ) |\n| Dividend Reinvestment Plan | — | 1,094 | — | — | — | — | 14 | — | — | 14 | — | — | 14 |\n| Share Based Compensation: |\n| Grants | — | 135,627 | 1 | — | — | — | — | — | — | 1 | 1,101,924 | — | 1 |\n| Amortization | — | — | — | — | — | — | 1,303 | — | — | 1,303 | — | 4,466 | 5,769 |\n| Change in Fair Value of Derivative Instruments | — | — | — | — | — | — | — | ( 28,107 ) | — | ( 28,107 ) | — | ( 2,834 ) | ( 30,941 ) |\n| Adjustment to Record Noncontrolling Interest at Redemption Value | ( 3,196 ) | — | — | — | — | — | 3,196 | — | — | 3,196 | — | — | 3,196 |\n| Net Loss | — | — | — | — | — | — | — | — | ( 87,691 ) | ( 87,691 ) | ( 10,061 ) | ( 97,752 ) |\n| Balance at June 30, 2020 | — | 38,789,371 | 388 | — | 14,703,214 | 147 | 1,149,291 | ( 27,097 ) | ( 427,393 ) | 695,336 | 5,381,870 | 55,715 | 751,051 |\n\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\n11\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSFOR THE SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS]\n| Six Months Ended June 30, |\n| 2021 | 2020 |\n| Operating Activities: |\n| Net Loss | $ | ( 14,433 ) | $ | ( 97,752 ) |\n| Adjustments to Reconcile Net Loss to Net Cash Provided by Operating Activities: |\n| Gain on Disposition of Hotel Properties | ( 48,352 ) | — |\n| Loss on Impairment of Assets | 222 | 1,069 |\n| Insurance recoveries in excess of property loss | ( 711 ) | — |\n| Junior Note PIK Interest Added to Principal | 2,514 | — |\n| Deferred Taxes | ( 499 ) | 11,390 |\n| Depreciation | 42,642 | 48,273 |\n| Amortization | 2,594 | 1,116 |\n| Loss on Debt Extinguishment | 634 | — |\n| Equity in Loss of Unconsolidated Joint Ventures | 1,247 | 1,520 |\n| Loss Recognized on Change in Fair Value of Derivative Instrument | 159 | 2,205 |\n| Share Based Compensation Expense | 4,758 | 4,255 |\n| Change in Assets and Liabilities: |\n| (Increase) Decrease in: |\n| Hotel Accounts Receivable | 151 | 5,412 |\n| Other Assets | ( 4,055 ) | 4,884 |\n| Due from Related Parties | 1,089 | 3,750 |\n| Increase (Decrease) in: |\n| Accounts Payable, Accrued Expenses and Other Liabilities | 4,933 | ( 2,479 ) |\n| Net Cash Used in Operating Activities | $ | ( 7,107 ) | $ | ( 16,357 ) |\n| Investing Activities: |\n| Capital Expenditures | ( 5,374 ) | ( 15,612 ) |\n| Hotel Development Projects | — | 21 |\n| Proceeds from Disposition of Hotel Properties | 163,583 | — |\n| Contributions to Unconsolidated Joint Ventures | ( 550 ) | ( 600 ) |\n| Net Cash Provided by (Used in) Investing Activities | $ | 157,659 | $ | ( 16,191 ) |\n\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\n12\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSFOR THE SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS]\n| Six Months Ended June 30, |\n| 2021 | 2020 |\n| Financing Activities: |\n| (Repayments) Borrowings on Line of Credit, Net | $ | ( 14,369 ) | $ | 47,000 |\n| Payments on Term Loans | ( 187,024 ) | — |\n| Proceeds from Notes Payable | 144,750 | — |\n| Principal Repayment of Mortgages | ( 1,353 ) | ( 650 ) |\n| Proceeds of Paycheck Protection Program (\"PPP\") Loans | — | 18,936 |\n| Repayment of PPP Loans | — | ( 18,936 ) |\n| Deferred Financing Costs | ( 5,795 ) | ( 2,104 ) |\n| Dividends Paid on Common Shares | — | ( 10,809 ) |\n| Dividends Paid on Preferred Shares | ( 30,218 ) | ( 6,044 ) |\n| Distributions Paid on Common Units and LTIP Units | — | ( 1,198 ) |\n| Other Financing Activities | — | ( 30 ) |\n| Net Cash (Used in) Provided by Financing Activities | $ | ( 94,009 ) | $ | 26,165 |\n| Net Increase (Decrease) in Cash, Cash Equivalents, and Restricted Cash | $ | 56,543 | $ | ( 6,383 ) |\n| Cash, Cash Equivalents, and Restricted Cash - Beginning of Period | 23,607 | 36,985 |\n| Cash, Cash Equivalents, and Restricted Cash - End of Period | $ | 80,150 | $ | 30,602 |\n\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\n13\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 1 - BASIS OF PRESENTATION\nThe accompanying unaudited consolidated financial statements of Hersha Hospitality Trust (“we,” “us,” “our” or the “Company”) have been prepared in accordance with U.S. generally accepted accounting principles (“US GAAP”) for interim financial information and with the general instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required by US GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals), considered necessary for a fair presentation have been included. Operating results for the three and six months ended June 30, 2021 are not necessarily indicative of the results that may be expected for the year ending December 31, 2021 or any future period. Accordingly, readers of these consolidated interim financial statements should refer to the Company’s audited financial statements prepared in accordance with US GAAP, and the related notes thereto, for the year ended December 31, 2020, which are included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2020, as certain footnote disclosures normally included in financial statements prepared in accordance with US GAAP have been condensed or omitted from this report pursuant to the rules of the Securities and Exchange Commission.\nWe are a self-administered Maryland real estate investment trust that was organized in May 1998 and completed our initial public offering in January 1999. Our common shares are traded on the New York Stock Exchange (the “NYSE”) under the symbol “HT.” We own our hotels and our investments in joint ventures through our operating partnership, Hersha Hospitality Limited Partnership (“HHLP” or “the Partnership”), for which we serve as the sole general partner. As of June 30, 2021, we owned an approximate 86.8 % partnership interest in HHLP, including a 1.0 % general partnership interest.\nPrinciples of Consolidation and Presentation\nThe accompanying consolidated financial statements have been prepared in accordance with US GAAP and include all of our accounts as well as accounts of the Partnership, subsidiary partnerships and our wholly owned Taxable REIT Subsidiary Lessee (“TRS Lessee”), 44 New England Management Company. All significant inter-company amounts have been eliminated.\nConsolidated properties are either wholly owned or owned less than 100% by the Partnership and are controlled by the Company as general partner of the Partnership. Properties owned in joint ventures are also consolidated if the determination is made that we are the primary beneficiary in a variable interest entity (“VIE”) or we maintain control of the asset through our voting interest in the entity.\nVariable Interest Entities\nWe evaluate each of our investments and contractual relationships to determine whether they meet the guidelines for consolidation. To determine if we are the primary beneficiary of a VIE, we evaluate whether we have a controlling financial interest in that VIE. An enterprise is deemed to have a controlling financial interest if it has i) the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance, and ii) the obligation to absorb losses of the VIE that could be significant to the VIE or the rights to receive benefits from the VIE that could be significant to the VIE. Control can also be demonstrated by the ability of a member to manage day-to-day operations, refinance debt and sell the assets of the partnerships without the consent of the other member and the inability of the members to replace the managing member. Based on our examination, there have been no changes to the operating structure of our legal entities during the three and six months ended June 30, 2021 and, therefore, there are no changes to our evaluation of VIE's as presented within our annual report presented on Form 10-K for the year ended December 31, 2020.\n14\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\nNOTE 1 - BASIS OF PRESENTATION (CONTINUED)\nNoncontrolling Interest\nWe classify the noncontrolling interests of our common units of limited partnership interest in HHLP (“Common Units”), and Long Term Incentive Plan Units (“LTIP Units”) as equity. LTIP Units are a separate class of limited partnership interest in the Operating Partnership that are convertible into Common Units under certain circumstances. The noncontrolling interest of Common Units and LTIP Units totaled $ 48,672 as of June 30, 2021 and $ 49,246 as of December 31, 2020. As of June 30, 2021, there were 5,962,491 Common Units and LTIP Units outstanding with a fair market value of $ 64,156 , based on the price per share of our common shares on the NYSE on such date. In accordance with the partnership agreement of HHLP, holders of these Common Units may redeem them for cash unless we, in our sole and absolute discretion, elect to issue common shares on a one -for-one basis in lieu of paying cash.\nNet income or loss attributed to Common Units and LTIP Units is included in net income or loss but excluded from net income or loss applicable to common shareholders in the consolidated statements of operations.\nWe are party to a joint venture that owns the Ritz-Carlton Coconut Grove, FL, in which our joint venture partner has a noncontrolling equity interest of 15 % in the property. Hersha Holding RC Owner, LLC, the owner entity of the Ritz-Carlton Coconut Grove joint venture (\"Ritz Coconut Grove\"), will distribute income based on cash available for distribution which will be distributed as follows: (1) to us until we receive a cumulative return on our contributed senior common equity interest, currently at 8 %, and (2) then to the owner of the noncontrolling interest until they receive a cumulative return on their contributed junior common equity interest, currently at 8 %, and (3) then 75 % to us and 25 % to the owner of the noncontrolling interest until we both receive a cumulative return on our contributed senior common equity interest, currently at 12 %, and (4) finally, any remaining operating profit shall be distributed 70 % to us and 30 % to the owner of the noncontrolling interest. Additionally, the noncontrolling interest in the Ritz Coconut Grove has the right to put their ownership interest to us for cash consideration at any time during the life of the venture. The balance sheets and financial results of the Ritz Coconut Grove are included in our consolidated financial statements and book value of the noncontrolling interest in the Ritz Coconut Grove is classified as temporary equity within our Consolidated Balance Sheets. The noncontrolling interest in the Ritz Coconut Grove is measured at the greater of historical cost or the put option redemption value. For the three and six months ended June 30, 2021, based on the income allocation methodology described above, the noncontrolling interest in this joint venture was allocated losses of $ 0 and $ 158 , respectively. For the three and six months ended June 30, 2020, based on the income allocation methodology described above, the noncontrolling interest in this joint venture was allocated loss of $ 0 . This is recorded as part of the Loss Allocated to Noncontrolling Interests line item within the Consolidated Statements of Operations. On June 30, 2021, we reclassified $ 1,968 from Additional Paid in Capital to Redeemable Noncontrolling Interests - Consolidated Joint Venture to value the noncontrolling interest at the put option redemption value of $ 1,968 .\nShareholders’ Equity\n| Dividend Per Share (1) |\n| Shares Outstanding | Six Months Ended June 30, |\n| Series | June 30, 2021 | December 31, 2020 | Aggregate Liquidation Preference | Distribution Rate | 2021 | 2020 |\n| Series C | 3,000,000 | 3,000,000 | $ | 75,000 | 6.875 | % | $ | 2.5782 | $ | — |\n| Series D | 7,701,700 | 7,701,700 | $ | 192,500 | 6.500 | % | $ | 2.4378 | $ | — |\n| Series E | 4,001,514 | 4,001,514 | $ | 100,000 | 6.500 | % | $ | 2.4378 | $ | — |\n| Total | 14,703,214 | 14,703,214 |\n\n15\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\nNOTE 1 - BASIS OF PRESENTATION (CONTINUED)\n(1) During the six months ended June 30, 2020, we suspended the payment of our preferred dividends. During the six months ended June 30, 2021, the Company paid cash dividends on the Company's Series C, Series D and Series E cumulative redeemable preferred stock reflecting accrued and unpaid dividends for the dividend periods ended April 15, 2020, July 15, 2020, October 15, 2020 and January 15, 2021. In addition, the Company paid a cash dividend on all Series of cumulative redeemable preferred stock for the first dividend period ending April 15, 2021 and declared a similar cash dividend for the second dividend period ending July 15, 2021, which is payable July 15, 2021 to holders of record as of July 1, 2021.\nLiquidity and Management's Plan\nDue to the COVID-19 pandemic and the effects of travel restrictions both globally and in the United States, the hospitality industry has experienced drastic drops in demand. The global impact of the pandemic has been rapidly evolving and, in the United States, certain states and cities, including most of the states and cities where we own properties, have reacted by instituting various restrictive measures such as quarantines, restrictions on travel, school closings, \"stay at home\" rules and restrictions on types of business that may continue to operate. We believe the ongoing effects of the COVID-19 pandemic on our operations have had, and will continue to have a material negative impact on our financial results and liquidity, and such negative impact may continue beyond the containment of the pandemic.\nIn February of 2021, we entered into an unsecured notes facility that provided net proceeds of $ 144,750 and access to an incremental $ 50,000 , which can be drawn through September 30, 2021. The initial net proceeds of $ 144,750 provided by this facility, along with a portion of the proceeds from asset sales, were used to repay amounts outstanding under our senior secured credit facility and our two secured term loans and allowed us to negotiate amendments to this senior facility. The amendments to the senior secured credit facility and two secured term loans eliminated term loan maturities until August of 2022, waived all financial covenants through March 31, 2022, established accommodative covenant testing methodology through December 31, 2022, enabled the Company to pay down the accrual of the Company's preferred dividends, allow the ongoing preferred dividend accrual to be kept current, and provided additional liquidity to be used at the Company's discretion.\nWe cannot assure you that our assumptions used to estimate our liquidity requirements will be correct because the lodging industry has not previously experienced such an abrupt and drastic reduction in hotel demand, and as a consequence, our ability to be predictive is uncertain. In addition, the magnitude, duration, and speed of the pandemic is uncertain and we cannot estimate when travel demand will recover. Based on the amendments, the Company believes that it has sufficient liquidity to meet its obligations for the next twelve months.\nInvestment in Hotel Properties\nInvestments in hotel properties are recorded at cost. Improvements and replacements are capitalized when they extend the useful life of the asset. Costs of repairs and maintenance are expensed as incurred. Depreciation is computed using the straight-line method over the estimated useful life of up to 40 years for buildings and improvements, two to seven years for furniture, fixtures and equipment. We are required to make subjective assessments as to the useful lives of our properties for purposes of determining the amount of depreciation to record on an annual basis with respect to our investments in hotel properties. These assessments have a direct impact on our net income because if we were to shorten the expected useful lives of our investments in hotel properties we would depreciate these investments over fewer years, resulting in more depreciation expense and lower net income on an annual basis.\nIdentifiable assets, liabilities, and noncontrolling interests related to hotel properties acquired are recorded at fair value. Estimating techniques and assumptions used in determining fair values involve significant estimates and judgments. These estimates and judgments have a direct impact on the carrying value of our assets and liabilities which can directly impact the amount of depreciation expense recorded on an annual basis and could have an impact on our assessment of potential impairment of our investment in hotel properties.\nWe consider a hotel to be held for sale when management and our independent trustees commit to a plan to sell the property, the property is available for sale, management engages in an active program to locate a buyer for the property and it is probable the sale will be completed within a year of the initiation of the plan to sell. We evaluate each disposition to determine whether we need to classify the disposition as discontinued operations. We generally include the operations of a hotel that was sold or a hotel that has been classified as held for sale in continuing operations unless the sale represents a strategic shift that will have a major impact on our future operations and financial results. We anticipate that most of our hotel dispositions will not be classified as discontinued operations as most will not fit this definition.\n16\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\nNOTE 1 - BASIS OF PRESENTATION (CONTINUED)\nBased on the occurrence of certain events or changes in circumstances, we review the recoverability of the property’s carrying value. Such events or changes in circumstances include the following:\n•a significant decrease in the market price of a long-lived asset;\n•a significant adverse change in the extent or manner in which a long-lived asset is being used or in its physical condition;\n•a significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset, including an adverse action or assessment by a regulator;\n•an accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset;\n•a current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset; and\n•a current expectation that, it is more likely than not that, a long-lived asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life.\nWe review our portfolio on an ongoing basis to evaluate the existence of any of the aforementioned events or changes in circumstances that would require us to test for recoverability. In general, our review of recoverability is based on an estimate of the future undiscounted cash flows, excluding interest charges, expected to result from the property’s use and eventual disposition. These estimates consider factors such as expected future operating income, market and other applicable trends and residual value expected, as well as the effects of hotel demand, competition and other factors. Other assumptions used in the review of recoverability include the holding period and expected terminal capitalization rate. If impairment exists due to the inability to recover the carrying value of a property, an impairment loss is recorded to the extent that the carrying value exceeds the estimated fair value of the property. We are required to make subjective assessments as to whether there are impairments in the values of our investments in hotel properties.\nAs of June 30, 2021, based on our analysis, we have determined that the estimated future cash flow of each of the properties in our portfolio is sufficient to recover its respective carrying value, after recording an impairment charge prior to the disposition of the Duane Street hotel.\n17\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\nNOTE 1 - BASIS OF PRESENTATION (CONTINUED)\nNew Accounting Pronouncements\nIn March 2020, the Financial Accounting Standards Board (\"FASB\") issued ASU No. 2020-4, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting and in January 2021, the FASB issued 2021-01, Reference Rate Reform (Topic 848), Scope, which further clarified the scope of the reference rate reform optional practical expedients and exceptions outlined in Topic 848. As a result of identified structural risks of interbank offered rates, in particular, the London Interbank Offered Rate (LIBOR), reference rate reform is underway to identify alternative reference rates that are more observable or transaction based. The update provides guidance in accounting for changes in contracts, hedging relationships, and other transactions as a result of this reference rate reform. The optional expedients and exceptions contained within these updates, in general, only apply to contract amendments and modifications entered into prior to January 1, 2023. The provisions of these updates that will most likely affect our financial reporting process related to modifications of contracts with lenders and the related hedging contracts associated with each respective modified borrowing contract. In general, the provisions of these updates would impact the Company by allowing, among other things, the following:\n•Allowing modifications of debt contracts with lenders that fall under the guidance of ASC Topic 470 to be accounted for as a non-substantial modification and not be considered a debt extinguishment.\n•Allowing a change to contractual terms of a hedging instrument in conjunction with reference rate reform to not require a dedesignation of the hedging relationship.\n•Allowing a change to the interest rate used for margining, discounting, or contract price alignment for a derivative that is a cash flow hedge to not be considered a change to the critical terms of the hedge and will not require a dedesignation of the hedging relationship.\nWe have not entered into any contract modifications yet, as it directly relates to reference rate reform but we anticipate having to undertake such modifications in the future as a majority of our contracts with lenders and hedging counterparties are indexed to LIBOR. While we anticipate the impact of this update to be to the benefit of the Company, we are still evaluating the overall impact to the Company.\n18\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 2 - INVESTMENT IN HOTEL PROPERTIES\nInvestment in hotel properties consists of the following at June 30, 2021 and December 31, 2020:\n\n| June 30, 2021 | December 31, 2020 |\n| Land | $ | 478,413 | $ | 488,463 |\n| Buildings and Improvements | 1,557,840 | 1,611,144 |\n| Furniture, Fixtures and Equipment | 271,977 | 281,440 |\n| Construction in Progress | 1,489 | 987 |\n| 2,309,719 | 2,382,034 |\n| Less Accumulated Depreciation | ( 610,489 ) | ( 597,196 ) |\n| Total Investment in Hotel Properties * | $ | 1,699,230 | $ | 1,784,838 |\n\n* The net book value of investment in hotel property at Ritz Coconut Grove, which is a variable interest entity, is $ 40,937 and $ 42,487 at June 30, 2021 and December 31, 2020, respectively.\nAcquisitions\nFor the six months ended June 30, 2021 and 2020, we acquired no hotel properties.\nHotel Dispositions\nFor the six months ended June 30, 2020, we had no hotel dispositions. During the six months ended June 30, 2021, we had the following hotel dispositions:\n| Hotel | AcquisitionDate | DispositionDate | Consideration | Gain onDisposition |\n| Courtyard San Diego, CA | 05/30/2013 | 02/19/2021 | $ | 64,500 | $ | 5,037 |\n| The Capitol Hill Hotel Washington, DC | 04/15/2011 | 03/09/2021 | 51,000 | 12,990 |\n| Holiday Inn Express Cambridge, MA | 05/03/2006 | 03/09/2021 | 32,000 | 20,281 |\n| Residence Inn Miami Coconut Grove, FL | 06/12/2013 | 03/10/2021 | 31,000 | 10,005 |\n| Duane Street Hotel (1) | 01/04/2008 | 05/13/2021 | 18,000 | — |\n| 2021 Total | $ | 48,313 |\n\n(1)During the second quarter of 2020, the Company determined that the carrying value of the Duane Street hotel exceeded the anticipated net proceeds from sale, resulting in a $ 1,069 impairment charge recorded during the second quarter of 2020. We recorded an additional impairment charge of $ 147 prior to the disposition of the hotel property during the six months ended June 30, 2021.\n19\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 2 – INVESTMENT IN HOTEL PROPERTIES (CONTINUED)\nAssets Held For Sale\nWe classified the assets of the Duane Street Hotel, the Residence Inn Coconut Grove and the Courtyard San Diego as held for sale as of December 31, 2020, all of which closed during the six months ended June 30, 2021.\nThe table below shows the balances for the properties that were classified as assets held for sale as of December 31, 2020:\n| December 31, 2020 |\n| Land | $ | 28,015 |\n| Buildings and Improvements | 93,314 |\n| Furniture, Fixtures and Equipment | 15,469 |\n| 136,798 |\n| Less Accumulated Depreciation | ( 40,578 ) |\n| Assets Held for Sale | $ | 96,220 |\n\n20\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 3 - INVESTMENT IN UNCONSOLIDATED JOINT VENTURES\nAs of June 30, 2021 and December 31, 2020, our investment in unconsolidated joint ventures consisted of the following:\n\n| Joint Venture | Hotel Properties | Percent Owned | June 30, 2021 | December 31, 2020 |\n| Cindat Hersha Owner JV, LLC | Hilton and IHG branded hotels in NYC | 31.2 | % | * | $ | — | $ | — |\n| Hiren Boston, LLC | Courtyard by Marriott, South Boston, MA | 50 | % | 29 | 219 |\n| SB Partners, LLC | Holiday Inn Express, South Boston, MA | 50 | % | — | — |\n| SB Partners Three, LLC | Home2 Suites, South Boston, MA | 50 | % | 5,907 | 6,414 |\n| $ | 5,936 | $ | 6,633 |\n\n*On February 7, 2021, all of the assets of the properties owned by this joint venture were transferred to the mezzanine lender of Cindat Hersha Owner JV, LLC. As a result, upon dissolution of the venture, we will no longer maintain an interest in this venture.\nIncome/Loss Allocation\nPrior to February 7, 2021, based on the income allocation methodology within Cindat Hersha Owner JV, LLC, the Company had absorbed cumulative losses equal to our accounting basis in the joint venture resulting in a $ 0 investment balance in the table above as of December 31, 2020, however, we maintained a positive equity balance within the venture. This difference is due to the difference in our basis inside the venture versus our basis outside of the venture, which is explained later in this note.\nFor SB Partners, LLC, Hiren Boston, LLC, and SB Partners Three, LLC, income or loss is allocated to us and our joint venture partners consistent with the allocation of cash distributions in accordance with the joint venture agreements. This results in an income allocation consistent with our percentage of ownership interests.\nAny difference between the carrying amount of any of our investments noted above and the underlying equity in net assets is amortized over the expected useful lives of the properties and other intangible assets.\n21\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 3 – INVESTMENT IN UNCONSOLIDATED JOINT VENTURES (CONTINUED)\nLoss recognized during the three and six months ended June 30, 2021 and 2020, for our investments in unconsolidated joint ventures is as follows:\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Hiren Boston, LLC | $ | ( 354 ) | $ | ( 477 ) | $ | ( 689 ) | $ | ( 880 ) |\n| SB Partners, LLC | ( 50 ) | — | ( 50 ) | ( 600 ) |\n| SB Partners Three, LLC | ( 185 ) | ( 25 ) | ( 508 ) | ( 40 ) |\n| Loss from Unconsolidated Joint Venture Investments | $ | ( 589 ) | $ | ( 502 ) | $ | ( 1,247 ) | $ | ( 1,520 ) |\n\nThe following tables set forth the total assets, liabilities, equity and components of net income or loss, including the Company’s share, related to the unconsolidated joint ventures discussed above as of June 30, 2021 and December 31, 2020 and for the three and six months ended June 30, 2021 and 2020.\nBalance Sheets\n\n| June 30, 2021 | December 31, 2020 |\n| Assets |\n| Investment in Hotel Properties, Net | $ | 65,956 | $ | 581,452 |\n| Other Assets | 14,126 | 32,048 |\n| Total Assets | $ | 80,082 | $ | 613,500 |\n| Liabilities and Equity |\n| Mortgages and Notes Payable | $ | 65,457 | $ | 452,284 |\n| Other Liabilities | 14,939 | 42,197 |\n| Equity: |\n| Hersha Hospitality Trust | 4,099 | 5,699 |\n| Joint Venture Partner(s) | ( 4,413 ) | 113,452 |\n| Accumulated Other Comprehensive Loss | — | ( 132 ) |\n| Total Equity | ( 314 ) | 119,019 |\n| Total Liabilities and Equity | $ | 80,082 | $ | 613,500 |\n\n22\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 3 – INVESTMENT IN UNCONSOLIDATED JOINT VENTURES (CONTINUED)\nStatements of Operations\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Room Revenue | $ | 1,888 | $ | 5,588 | $ | 4,143 | $ | 16,932 |\n| Other Revenue | 125 | — | 242 | 787 |\n| Operating Expenses | ( 1,205 ) | ( 3,265 ) | ( 3,015 ) | ( 11,613 ) |\n| Lease Expense | ( 245 ) | ( 170 ) | ( 516 ) | ( 354 ) |\n| Property Taxes and Insurance | ( 382 ) | ( 3,154 ) | ( 1,948 ) | ( 6,438 ) |\n| General and Administrative | ( 26 ) | ( 553 ) | ( 247 ) | ( 1,516 ) |\n| Depreciation and Amortization | ( 1,300 ) | ( 3,925 ) | ( 3,612 ) | ( 7,840 ) |\n| Interest Expense | ( 642 ) | ( 5,582 ) | ( 3,334 ) | ( 11,869 ) |\n| Loss on Dissolution of Joint Venture | — | — | ( 112,429 ) | — |\n| Net Loss | $ | ( 1,787 ) | $ | ( 11,061 ) | $ | ( 120,716 ) | $ | ( 21,911 ) |\n\nThe following table is a reconciliation of our share in the unconsolidated joint ventures’ equity to our investment in the unconsolidated joint ventures as presented on our balance sheets as of June 30, 2021 and December 31, 2020.\n| June 30, 2021 | December 31, 2020 |\n| Our share of equity recorded on the joint ventures' financial statements | $ | 4,099 | $ | 5,699 |\n| Adjustment to reconcile our share of equity recorded on the joint ventures' financial statements to our investment in unconsolidated joint ventures(1) | 1,837 | 934 |\n| Investment in Unconsolidated Joint Ventures | $ | 5,936 | $ | 6,633 |\n\n(1) Adjustment to reconcile our share of equity recorded on the joint ventures' financial statements to our investment in unconsolidated joint ventures consists of the following:\n•the difference between our basis in the investment in joint ventures and the equity recorded on the joint ventures' financial statements;\n•accumulated amortization of our equity in joint ventures that reflects the difference in our portion of the fair value of joint ventures' assets on the date of our investment when compared to the carrying value of the assets recorded on the joint ventures’ financial statements (this excess or deficit investment is amortized over the life of the properties, and the amortization is included in Income (Loss) from Unconsolidated Joint Venture Investments on our consolidated statement of operations); and\n• cumulative impairment of our investment in joint ventures not reflected on the joint ventures' financial statements, if any.\n23\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 4 - OTHER ASSETS\nOther Assets\nOther Assets consisted of the following at June 30, 2021 and December 31, 2020:\n| June 30, 2021 | December 31, 2020 |\n| Deferred Financing Costs | $ | 1,783 | $ | 2,395 |\n| Prepaid Expenses | 9,540 | 5,692 |\n| Investment in Statutory Trusts | 1,548 | 1,548 |\n| Investment in Non-Hotel Property and Inventories | 2,318 | 2,443 |\n| Deposits with Unaffiliated Third Parties | 2,456 | 2,561 |\n| Deferred Tax Asset, Net of Valuation Allowance of $ 23,438 and $ 23,591 , respectively | 499 | — |\n| Other | 2,251 | 855 |\n| $ | 20,395 | $ | 15,494 |\n\nDeferred Financing Costs – This category represents financing costs paid by the Company to establish our Line of Credit. These costs have been capitalized and will amortize to interest expense over the term of the Line of Credit.\nPrepaid Expenses – Prepaid expenses include amounts paid for property tax, insurance and other expenditures that will be expensed in the next twelve months.\nInvestment in Statutory Trusts – We have an investment in the common stock of Hersha Statutory Trust I and Hersha Statutory Trust II.\nInvestment in Non-Hotel Property and Inventories – This category represents the costs paid and capitalized by the Company for items such as office leasehold improvements, furniture and equipment, and property inventories.\nDeposits with Unaffiliated Third Parties – These deposits represent deposits made by the Company with unaffiliated third parties for items such as lease security deposits, utility deposits, and deposits with unaffiliated third party management companies.\nDeferred Tax Asset – We have recorded a valuation allowance resulting in net deferred tax assets of $ 499 as of June 30, 2021. We have considered various factors, including future reversals of existing taxable temporary differences, future projected taxable income and tax planning strategies in determining a valuation allowance for our deferred tax assets, and we believe that it is more likely than not that we will not be able to realize the net deferred tax assets in the future, and a valuation allowance for the entire deferred tax asset has been recorded, with the exception of a city net operating loss that we believe that we will be able to realize.\n24\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT\nMortgages\nMortgages payable at June 30, 2021 and December 31, 2020 consisted of the following:\n| June 30, 2021 | December 31, 2020 |\n| Mortgage Indebtedness | $ | 305,911 | $ | 332,264 |\n| Net Unamortized Premium | 127 | 354 |\n| Net Unamortized Deferred Financing Costs | ( 1,612 ) | ( 1,770 ) |\n| Mortgages Payable | $ | 304,426 | $ | 330,848 |\n\nNet Unamortized Deferred Financing Costs associated with entering into mortgage indebtedness are deferred and amortized over the life of the mortgages. Net Unamortized Premiums are also amortized over the remaining life of the loans. Mortgage indebtedness balances are subject to fixed and variable interest rates, which ranged from 2.75 % to 6.30 % as of June 30, 2021.\nOur mortgage indebtedness contains various financial and non-financial covenants customarily found in secured, non-recourse financing arrangements. Our mortgage loans typically require that specified debt service coverage ratios be maintained with respect to the financed properties before we can exercise certain rights under the loan agreements relating to such properties. If the specified criteria are not satisfied, the lender may be able to escrow cash flow generated by the property securing the applicable mortgage loan. We have determined that all debt covenants contained in the loan agreements securing our consolidated hotel properties with the exception of two mortgages were met as of June 30, 2021.\nDuring the six months ended June 30, 2021, we refinanced the outstanding mortgages secured by the Hilton Garden Inn 52nd Street, the Courtyard Los Angeles Westside, the Hilton Garden Inn Tribeca, and the Hyatt Union Square, which resulted in $ 90 of debt modification expense.\nAs of June 30, 2021, the maturity dates for the outstanding mortgage loans ranged from September 2021 to September 2025. One mortgage with a total principal balance of $ 21,663 will mature within the next twelve months. We are in active discussions with lenders to refinance this mortgage with property level debt prior to its maturity.\n25\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT (CONTINUED)\nCredit Facilities\nWe maintain three secured credit arrangements which aggregate to $ 747,481 with Citigroup Global Markets Inc., Wells Fargo Bank, Inc. and various other lenders. Our credit agreement (the \"Credit Agreement\") provides for a $ 442,404 senior secured credit facility (“Credit Facility”). The Credit Facility consists of a $ 250,000 senior secured revolving line of credit (“Line of Credit”) and a $ 192,404 senior secured term loan (\"First Term Loan\"), and expires on August 10, 2022.\nWe maintain another credit agreement which provides for a $ 278,846 senior secured term loan agreement (“Second Term Loan”) and expires on September 10, 2024.\nA separate credit agreement provides for a $ 26,231 senior secured term loan agreement (“Third Term Loan” and collectively with the Credit Agreement and the Second Term Loan, the \"Credit Agreements\") and expires on August 10, 2022. Management intends to explore options including, but not limited to, additional asset sales, the refinancing of debt and the offering of equity or equity-linked securities prior to the maturity of the First Term Loan and the Third Term Loan on August 10, 2022.\nOn February 17, 2021, the Company signed amendments to the Credit Agreements which resulted in debt extinguishment expense $2,977. Debt extinguishment expense consists of $ 635 of debt extinguishment losses and $ 2,342 of debt modification losses. The signed amendments to the Credit Agreements, among other things, provide for:\n•an extension of the maturity date of the Third Term Loan to August 10, 2022;\n•a limited waiver of financial covenants through March 31, 2022; and\n•the ability to borrow up to $ 174,729 , inclusive of amounts already outstanding, under the Line of Credit, the proceeds of which may only be used to fund certain costs and expenses.\nCertain conditions, such as minimum liquid assets in an aggregate amount of at least $ 30,000 , and certain negative covenants and restrictions that are considered normal and customary, must be met on a recurring basis as outlined within the amendments.\nThe amendments to the Credit Agreements make certain other amendments to financial covenants in place beginning in the second quarter of 2022:\n•a fixed charge coverage ratio of not less than 1.20 to 1.00 (was 1.50 to 1.00);\n•a maximum leverage ratio of not more than 65 % (was 60 %); and\n•a new financial covenant that requires the borrowing base leverage ratio to not exceed 60 % at any time.\nThe amount that we can borrow at any given time under our Line of Credit, and the individual term loans (each a “Term Loan” and together the “Term Loans”) is governed by certain operating metrics of designated hotel properties known as borrowing base assets. As of June 30, 2021, the following hotel properties secured the amended facilities under the Credit Agreements:\n26\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT (CONTINUED)\n| - Courtyard by Marriott Brookline, Brookline, MA | - Hampton Inn, Washington, DC |\n| - The Envoy Boston Seaport, Boston, MA | - Ritz-Carlton Georgetown, Washington, DC |\n| - The Boxer, Boston, MA | - Hilton Garden Inn, M Street, Washington, DC |\n| - Hampton Inn Seaport, Seaport, New York, NY | - The Winter Haven Hotel Miami Beach, Miami, FL |\n| - Holiday Inn Express Chelsea, 29th Street, New York, NY | - The Blue Moon Hotel Miami Beach, Miami, FL |\n| - Gate Hotel JFK Airport, New York, NY | - Cadillac Hotel & Beach Club, Miami, FL |\n| - Hilton Garden Inn JFK Airport, New York, NY | - The Parrot Key Hotel & Villas, Key West, FL |\n| - NU Hotel, Brooklyn, New York, NY | - TownePlace Suites, Sunnyvale, CA |\n| - Hyatt House White Plains, White Plains, NY | - The Ambrose Hotel, Santa Monica, CA |\n| - Hampton Inn Center City/ Convention Center, Philadelphia, PA | - The Pan Pacific Hotel Seattle, Seattle, WA |\n| - The Rittenhouse, Philadelphia, PA | - Mystic Marriott Hotel & Spa, Groton, CT |\n| - Philadelphia Westin, Philadelphia, PA |\n\nThe interest rate for borrowings under the Line of Credit and Term Loans are based on a pricing grid with a range of one month U.S. LIBOR plus a spread. The following table summarizes the balances outstanding and interest rate spread for each borrowing:\n| Outstanding Balance |\n| Borrowing | Spread | June 30, 2021 | December 31, 2020 |\n| Line of Credit | 1.50 % to 2.25 % | $ | 118,684 | $ | 133,053 |\n| Term Loans: |\n| First Term Loan | 1.45 % to 2.20 % | $ | 192,404 | $ | 202,158 |\n| Second Term Loan | 1.35 % to 2.00 % | 278,846 | 292,983 |\n| Third Term Loan | 1.45 % to 2.20 % | 26,231 | 189,365 |\n| Deferred Loan Costs | ( 1,824 ) | ( 2,762 ) |\n| Total Term Loans | $ | 495,657 | $ | 681,744 |\n\nPrior to the amendments noted above, the Credit Agreements included certain financial covenants and required that we maintain: (1) a minimum tangible net worth (calculated as total assets, plus accumulated depreciation, less total liabilities, intangibles and other defined adjustments) of $ 1,119,500 , plus an amount equal to 75 % of the net cash proceeds of all issuances and primary sales of equity interests of the parent guarantor or any of its subsidiaries consummated following the closing date; (2) annual distributions not to exceed 95 % of adjusted funds from operations; and (3) certain financial ratios, including the following:\n•a fixed charge coverage ratio of not less than 1.50 to 1.00;\n•a maximum leverage ratio of not more than 60 %; and\n•a maximum secured debt leverage ratio of 45 %.\nThe weighted average interest rate, inclusive of the effect of derivative instruments, on the Credit Agreements was 3.92 % and 4.23 %, and 3.73 % and 4.21 %, for the three and six months ended June 30, 2021 and 2020, respectively.\n27\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT (CONTINUED)\nNotes Payable\nNotes payable at June 30, 2021 and December 31, 2020 consisted of the following:\n| June 30, 2021 | December 31, 2020 |\n| Notes Payable | $ | 204,062 | $ | 51,548 |\n| Net Unamortized Discount | ( 4,899 ) | — |\n| Net Unamortized Deferred Financing Costs | ( 5,438 ) | ( 759 ) |\n| Notes Payable | $ | 193,725 | $ | 50,789 |\n\nStatutory Trust I and Statutory Trust II Notes Payable\nWe have two junior subordinated notes payable in the aggregate amount of $ 51,548 related to the Hersha Statutory Trusts pursuant to indenture agreements which will mature on July 30, 2035, but may be redeemed at our option, in whole or in part, prior to maturity in accordance with the provisions of the indenture agreements. The $ 25,774 of notes issued to each of Hersha Statutory Trust I and Hersha Statutory Trust II bear interest at a variable rate of LIBOR plus 3 % per annum. This rate resets 2 business days prior to each quarterly payment. The related deferred financing costs are amortized over the life of the notes payable. The weighted average interest rate on our two junior subordinated notes payable was 3.19 % and 4.08 % for the three months ended June 30, 2021 and 2020, respectively, and 3.20 % and 4.45 % for the six months ended June 30, 2021 and 2020, respectively.\nJunior Notes Payable\nOn February 17, 2021, the Company entered into a note purchase agreement (the “Purchase Agreement”) with several purchasers (the “Purchasers”). The Company agreed to issue and sell to the Purchasers an initial $ 150,000 aggregate principal amount (the “Initial Notes”) of the Company’s 9.50 % Unsecured PIK Toggle Notes due 2026 (the “Notes”), and an incremental $ 50,000 aggregate principal amount of the Notes that can be drawn at the Company’s discretion, subject to certain conditions, in minimum installments of $ 25,000 on or prior to September 30, 2021.\nThe Initial Notes were issued on February 23, 2021. The Notes will mature on February 23, 2026. The Notes bear interest at a rate of 9.50 % per year, payable in arrears on June 30, September 30, December 31 and March 31 of each year, beginning on June 30, 2021. For any interest period ending on or prior to March 31, 2022, the Issuer, in its sole discretion may elect to pay interest (a) in cash at a rate per annum equal to 4.75 % per annum, and (b) in kind at a rate per annum equal to 4.75 % per annum (“PIK Interest”). Any PIK Interest will be paid by increasing the principal amount of the Notes at the end of the applicable interest period by the amount of such PIK Interest. We elected the PIK Interest option for the interest period ended June 30, 2021, increasing the principal balance $ 2,514 to $ 152,514 as of June 30, 2021.\nThe Notes may not be redeemed prior to February 23, 2022. The notes may be redeemed during the 12 month period beginning February 23, 2022 and the 12 month period beginning February 23, 2023, at a redemption price equal to 104 % and 102 % of the principal amount of the Notes being redeemed, respectively. After February 23, 2024, the notes may be redeemed at the principal amount.\nThe Notes are subject to representations, warranties, covenants, terms and conditions customary for transactions of this type, including limitations on liens, incurrence of new debt, investments, mergers and asset dispositions, covenants to preserve corporate existence and comply with laws and default provisions.\nThe Company may only use the net proceeds from the issuance of the Notes in accordance with the mandatory prepayment waterfalls, which includes the repayment of outstanding borrowings under the Credit Agreement and use for certain other general corporate purposes.\n28\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT (CONTINUED)\nInterest Expense\nThe table below shows the interest expense incurred by the Company during the three and six months ended June 30, 2021 and 2020:\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Mortgage Loans Payable | $ | 2,680 | $ | 3,031 | $ | 5,415 | $ | 6,516 |\n| Interest Rate Swap Contracts on Mortgages | 627 | 552 | 1,230 | 585 |\n| Unsecured Notes Payable | 4,311 | 532 | 6,248 | 1,160 |\n| Credit Facility and Term Loans | 3,754 | 5,370 | 8,122 | 12,404 |\n| Interest Rate Swap Contracts on Credit Agreements | 2,417 | 3,133 | 4,841 | 4,219 |\n| Deferred Financing Costs Amortization | 1,088 | 702 | 2,380 | 1,267 |\n| Other | 105 | 161 | 175 | 337 |\n| Total Interest Expense | $ | 14,982 | $ | 13,481 | $ | 28,411 | $ | 26,488 |\n\n29\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 6 – LEASES\nWe own five hotels within our consolidated portfolio of hotels where we do not own the land on which the hotels reside, rather we lease the land from an unrelated third-party lessor. All of our land leases are classified as operating leases and have initial terms with extension options that range from May 2062 to October 2103. We also have two additional office space leases with terms ranging from March 2023 to December 2027.\nThe components of lease costs for the three months ended June 30, 2021 and 2020 were as follows:\n| Three Months Ended June 30, 2021 | Three Months Ended June 30, 2020 |\n| Ground Lease | Office Lease | Total | Ground Lease | Office Lease | Total |\n| Operating lease costs | $ | 1,050 | $ | 121 | $ | 1,171 | $ | 1,050 | $ | 121 | $ | 1,171 |\n| Variable lease costs | 14 | 83 | 97 | 8 | 87 | 95 |\n| Total lease costs | $ | 1,064 | $ | 204 | $ | 1,268 | $ | 1,058 | $ | 208 | $ | 1,266 |\n\nThe components of lease costs for the six months ended June 30, 2021 and 2020 were as follows:\n| Six months ended June 30, 2021 | Six months ended June 30, 2020 |\n| Ground Lease | Office Lease | Total | Ground Lease | Office Lease | Total |\n| Operating lease costs | $ | 2,126 | $ | 242 | $ | 2,368 | $ | 2,100 | $ | 242 | $ | 2,342 |\n| Variable lease costs | 38 | 167 | 205 | 21 | 154 | 175 |\n| Total lease costs | $ | 2,164 | $ | 409 | $ | 2,573 | $ | 2,121 | $ | 396 | $ | 2,517 |\n\nOther information related to leases as of and for the six months ended June 30, 2021 and 2020 is as follows:\n| June 30, 2021 | June 30, 2020 |\n| Cash paid from operating cash flow for operating leases | $ | 2,246 | $ | 1,951 |\n| Weighted average remaining lease term | 64.2 | 64.2 |\n| Weighted average discount rate | 7.87 | % | 7.86 | % |\n\n30\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 7 – COMMITMENTS AND CONTINGENCIES AND RELATED PARTY TRANSACTIONS\nManagement Agreements\nOur wholly-owned TRS, 44 New England Management Company, and certain of our joint venture entities engage eligible independent contractors in accordance with the requirements for qualification as a REIT under the Internal Revenue Code of 1986, as amended, including Hersha Hospitality Management Limited Partnership (“HHMLP”), as the property managers for hotels it leases from us pursuant to management agreements. HHMLP is owned, in part, by certain executives and trustees of the Company. Our management agreements with HHMLP provide for a term of five years and are subject to early termination upon the occurrence of defaults and certain other events described therein. As required under the REIT qualification rules, HHMLP must qualify as an “eligible independent contractor” during the term of the management agreements. Under the management agreements, HHMLP generally pays the operating expenses of our hotels. All operating expenses or other expenses incurred by HHMLP in performing its authorized duties are reimbursed or borne by our TRS to the extent the operating expenses or other expenses are incurred within the limits of the applicable approved hotel operating budget. HHMLP is not obligated to advance any of its own funds for operating expenses of a hotel or to incur any liability in connection with operating a hotel. Management agreements with other unaffiliated hotel management companies have similar terms.\nFor its services, HHMLP receives a base management fee and, if a hotel exceeds certain thresholds, an incentive management fee. The base management fee for a hotel is due monthly and is equal to 3 % of gross revenues associated with each hotel managed for the related month. The incentive management fee, if any, for a hotel is due annually in arrears on the ninetieth day following the end of each fiscal year and is based upon the financial performance of the hotels. For the three and six months ended June 30, 2021 and 2020, base management fees incurred to HHMLP totaled $ 1,745 and $ 564 , and $ 2,925 and $ 2,933 , respectively, and are recorded as Hotel Operating Expenses. For the three and six months ended June 30, 2021 and 2020, we did no t incur incentive management fees.\nFranchise Agreements\nOur branded hotel properties are operated under franchise agreements assumed by the hotel property lessee. The franchise agreements have 10 to 20 year terms, but may be terminated by either the franchisee or franchisor on certain anniversary dates specified in the agreements. The franchise agreements require annual payments for franchise royalties, reservation, and advertising services, and such payments are based upon percentages of gross room revenue. These payments are paid by the hotels and charged to expense as incurred. Franchise fee expenses for the three and six months ended June 30, 2021 and 2020 were $ 2,465 and $ 775 , and $ 4,287 and $ 4,603 , respectively, and are recorded in Hotel Operating Expenses. The initial fees incurred to enter into the franchise agreements are amortized over the life of the franchise agreements.\nAccounting and Information Technology Fees\nEach of the wholly-owned hotels and consolidated joint venture hotel properties managed by HHMLP incurs a monthly accounting and information technology fee. Monthly fees for accounting services are between $ 2 and $ 3 per property and monthly information technology fees range from $ 1 to $ 2 per property. For the three and six months ended June 30, 2021 and 2020, the Company incurred accounting fees of $ 277 and $ 319 , and $ 590 and $ 644 , respectively. For the three and six months ended June 30, 2021 and 2020, the Company incurred information technology fees of $ 90 and $ 103 , and $ 191 and $ 208 , respectively. Accounting fees and information technology fees are included in Hotel Operating Expenses.\nCapital Expenditure Fees\nHHMLP charges a 5 % fee on certain capital expenditures and pending renovation projects at the properties as compensation for procurement services related to capital expenditures and for project management of renovation projects. For the three and six months ended June 30, 2021 and 2020, we incurred fees of $ 78 and $ 56 , and $ 197 and $ 956 , respectively, which were capitalized with the cost of capital expenditures.\n31\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 7 – COMMITMENTS AND CONTINGENCIES AND RELATED PARTY TRANSACTIONS (CONTINUED)\nAcquisitions from Affiliates\nWe have entered into an option agreement with certain of our officers and trustees such that we obtain a right of first refusal to purchase any hotel owned or developed in the future by these individuals or entities controlled by them at fair market value. This right of first refusal would apply to each party until one year after such party ceases to be an officer or trustee of the Company. Our Acquisition Committee of the Board of Trustees is comprised solely of independent trustees, and the purchase prices and all material terms of the purchase of hotels from related parties are approved by the Acquisition Committee.\nHotel Supplies\nFor the three and six months ended June 30, 2021 and 2020, we incurred charges for hotel supplies of $ 0 and $ 11 , and $ 1 and $ 63 , respectively. For the three and six months ended June 30, 2021 and 2020, we incurred charges for capital expenditure purchases of $ 86 and $ 176 , and $ 220 and $ 1,056 , respectively. These purchases were made from Hersha Purchasing and Design, a hotel supply company owned, in part, by certain executives and trustees of the Company. Hotel supplies are expensed and included in Hotel Operating Expenses on our consolidated statements of operations, and capital expenditure purchases are included in investment in hotel properties on our consolidated balance sheets.\nInsurance Services\nPrior to January 1, 2021, the Company utilized the services of the Hersha Group, a risk management business owned, in part, by certain executives and trustees of the Company. The Hersha Group provided consulting and procurement services to the Company related to the placement of property and casualty insurance, placement of general liability insurance, and for claims handling for our hotel properties. Beginning January 1, 2021, these services were provided by a third-party service provider. For the three and six months ended June 30, 2020, the total cost of property insurance that we paid through the Hersha Group were $ 1,388 and $ 2,984 , respectively. This amount paid to the Hersha Group included insurance premiums and brokerage fees as compensation for brokerage services.\nRestaurant Lease Agreements with Independent Restaurant Group\nThe Company enters into lease agreements with a number of restaurant management companies for the lease of restaurants located within our hotels. The Company previously entered into lease agreements with Independent Restaurant Group (\"IRG\") for restaurants at three of its hotel properties. Jay H. Shah and Neil H. Shah, executive officers and/or trustees of the Company, collectively own a 70.0 % interest in IRG. The Company’s restaurant lease agreements with IRG generally provided for a term of five years and the payment of base rents and percentage rents, which were based on IRG’s revenue in excess of defined thresholds. Effective April 1, 2020, each of these lease agreements became a management agreement between the Company and IRG, subject to the supervision of HHMLP, as property manager. At the time of the conversion of the lease agreements to management agreements there was rent due of $ 103 , which was forgiven due to the impact of the COVID-19 pandemic on the operations of our hotels and IRG's restaurants. For the six months ended June 30, 2021 and 2020, we did no t recognize any revenue from IRG.\nDue From Related Parties\nThe due from related parties balance as of June 30, 2021 and December 31, 2020 was approximately $ 1,552 and $ 2,641 , respectively. The balances primarily consisted of working capital deposits made to HHMLP and other entities owned, in part, by certain executives and trustees of the Company.\nDue to Related Parties\nThe balance due to related parties as of June 30, 2021 and December 31, 2020 was $ 0 .\n32\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 8 – FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS\nFair Value Measurements\nOur determination of fair value measurements are based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, we utilize a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).\nLevel 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Level 2 inputs are inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs may include quoted prices for similar assets and liabilities in active markets, as well as inputs that are observable for the asset or liability (other than quoted prices), such as interest rates, foreign exchange rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liabilities, which are typically based on an entity’s own assumptions, as there is little, if any, related market activity. In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.\nAs of June 30, 2021, the Company’s derivative instruments represented the only financial instruments measured at fair value. Currently, the Company uses derivative instruments, such as interest rate swaps and caps, to manage its interest rate risk. The valuation of these instruments is determined using widely accepted valuation techniques, including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs.\nWe incorporate credit valuation adjustments to appropriately reflect both our own nonperformance risk and the respective counter-party’s nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, we have considered the impact of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts and guarantees.\nAlthough we have determined that the majority of the inputs used to value our derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with our derivatives utilize Level 3 inputs, such as estimates of current credit spreads, to evaluate the likelihood of default by us and the counter-parties. However, as of June 30, 2021 we have assessed the significance of the effect of the credit valuation adjustments on the overall valuation of our derivative positions and have determined that the credit valuation adjustments are not significant to the overall valuation of our derivatives. As a result, we have determined that our derivative valuations in their entirety are classified in Level 2 of the fair value hierarchy.\nDerivative Instruments\nThe Company’s objective in using derivatives is to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps and interest rate caps as part of its cash flow hedging strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts in exchange for fixed-rate payments over the life of the agreements without exchange of the underlying principal amount. Interest rate caps designated as cash flow hedges limit the Company’s exposure to increased cash payments due to increases in variable interest rates. The table on the following page presents our derivative instruments as of June 30, 2021 and December 31, 2020.\n33\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 8 – FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS (CONTINUED)\n| Estimated Fair Value |\n| (Liability) Balance |\n| Hedged Debt | Type | Strike Rate | Effective Date | Derivative Contract Maturity Date | Notional Amount | June 30, 2021 | December 31, 2020 |\n| Term Loan Instruments: |\n| Credit Facility | Swap | 1.341 | % | 1-Month LIBOR + 2.20 % | October 3, 2019 | August 2, 2021 | 150,000 | $ | ( 165 ) | $ | ( 1,070 ) |\n| Credit Facility (1) | Swap | 1.316 | % | 1-Month LIBOR + 2.20 % | September 3, 2019 | August 2, 2021 | 43,900 | ( 47 ) | ( 307 ) |\n| Credit Facility | Swap | 1.824 | % | 1-Month LIBOR + 2.20 % | September 3, 2019 | August 10, 2022 | 103,500 | ( 1,944 ) | ( 2,793 ) |\n| Credit Facility | Swap | 1.824 | % | 1-Month LIBOR + 2.20 % | September 3, 2019 | August 10, 2022 | 103,500 | ( 1,944 ) | ( 2,793 ) |\n| Credit Facility | Swap | 1.460 | % | 1-Month LIBOR + 2.00 % | September 10, 2019 | September 10, 2024 | 300,000 | ( 8,790 ) | ( 13,286 ) |\n| Mortgages: |\n| Annapolis Waterfront Hotel, MD | Cap | 3.350 | % | 1-Month LIBOR + 2.65 % | May 1, 2018 | May 1, 2021 | 28,000 | — | — |\n| Hyatt, Union Square, New York, NY | Swap | 1.870 | % | 1-Month LIBOR + 2.30 % | June 7, 2019 | June 7, 2023 | 56,000 | ( 1,743 ) | ( 2,305 ) |\n| Hilton Garden Inn Tribeca, New York, NY | Swap | 1.768 | % | 1-Month LIBOR + 2.25 % | July 25, 2019 | July 25, 2024 | 22,725 | ( 869 ) | ( 1,222 ) |\n| Hilton Garden Inn Tribeca, New York, NY | Swap | 1.768 | % | 1-Month LIBOR + 2.25 % | July 25, 2019 | July 25, 2024 | 22,725 | ( 869 ) | ( 1,222 ) |\n| Hilton Garden Inn 52nd Street, New York, NY | Swap | 1.540 | % | 1-Month LIBOR + 2.30 % | December 4, 2019 | December 4, 2022 | 44,325 | ( 869 ) | ( 1,186 ) |\n| Courtyard, LA Westside, Culver City, CA (2) | Swap | 0.495 | % | 1-Month LIBOR + 3.75 % | June 1, 2020 | August 1, 2021 | 35,000 | ( 12 ) | ( 75 ) |\n| $ | ( 17,252 ) | $ | ( 26,259 ) |\n\n(1) During the six months ended June 30, 2021, we dedesignated this swap as a cash flow hedge and recorded expense of $ 330 accordingly.\n(2) Subsequent to June 30, 2021, we entered into an interest rate cap for this debt, which is effective on August 1, 2021.\nThe fair value of our interest rate swaps is included in accounts payable, accrued expenses and other liabilities at June 30, 2021 and December 31, 2020.\nThe net change related to derivative instruments designated as cash flow hedges recognized as unrealized gains and losses reflected on our consolidated balance sheet in accumulated other comprehensive income was a gain of $ 2,398 and a loss of $ 792 for the three months ended June 30, 2021 and 2020, respectively, and a gain of $ 9,163 and a loss of $ 30,941 for the six months ended June 30, 2021 and 2020, respectively.\n34\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 8 – FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS (CONTINUED)\nAmounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are made on the Company’s variable-rate derivatives. The change in net unrealized gains/losses on cash flow hedges reflects a reclassification of $( 141 ) and $ 1,228 and $ 159 and $ 2,205 of net unrealized gains from accumulated other comprehensive income as an increase/decrease to interest expense for the three and six months ended June 30, 2021 and 2020, respectively. For the next twelve months ending June 30, 2022, we estimate that an additional $ 10,059 will be reclassified as an increase to interest expense.\nFair Value of Debt\nWe estimate the fair value of our fixed rate debt and the credit spreads over variable market rates on our variable rate debt by discounting the future cash flows of each instrument at estimated market rates or credit spreads consistent with the maturity of the debt obligation with similar credit policies. Credit spreads take into consideration general market conditions and maturity. The inputs utilized in estimating the fair value of debt are classified in Level 2 of the fair value hierarchy. As of June 30, 2021, the carrying value and estimated fair value of our debt was $ 1,112,492 and $ 1,141,023 respectively. As of December 31, 2020, the carrying value and estimated fair value of our debt was $ 1,196,434 and $ 1,176,625 , respectively.\n35\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 9 – SHARE BASED PAYMENTS\nOur shareholders approved the Hersha Hospitality Trust 2012 Equity Incentive Plan, as amended, (the “2012 Plan”) for the purpose of attracting and retaining executive officers, employees, trustees and other persons and entities that provide services to the Company.\nThe Short Term Incentive Program (\"STIP\") and the Long-Term Incentive Program (\"LTIP\") were incentive compensation programs the Compensation Committee of our Board of Trustees established to align executive compensation with the performance of the Company. Prior to 2019, executives participated in our legacy incentive compensation programs, including the Multi-Year Long Term Equity Incentive Program (\"Multi-Year EIP\").\nOn March 17, 2021, based on the achievement of certain metrics established under the 2020 STIP for the performance period ended December 31, 2020, the Compensation Committee awarded 519,732 LTIP Units. The awards issued pursuant to the STIP vest on December 31, 2022, the two year anniversary following the end of the performance period.\nOn March 3, 2021, the Compensation Committee approved the 2021 LTIP in which 50 % of the awards provide for time based vesting and the remaining 50 % are issuable based on the Company's achievement of a certain level of (1) absolute total shareholder return ( 37.5 % of the award), (2) relative total shareholder return as compared to the Company’s peer\ngroup ( 37.5 % of the award), and (3) relative growth in revenue per available room (\"RevPar\") compared to the Company’s peer group ( 25.0 % of the award). On March 17, 2021, the Compensation Committee awarded 247,689 LTIP Units related to the time based portion of the plan. These Units will vest over a three year period from January 1, 2021 to December 31, 2023. The 50 % market-based portion of the 2021 LTIP has a three-year performance period which commenced on January 1, 2021 and ends December 31, 2023. As of June 30, 2021, no shares or LTIP Units have been issued to the executive officers in settlement of 2021 LTIP market-based awards.\nThe LTIP Units awarded under both the 2020 STIP and the 2021 LTIP were determined by dividing the dollar amount of award earned by $ 8.43 , the per share volume weighted average trading price of the Company’s common shares on the NYSE for the 20 trading days prior to December 31, 2020.\n| LTIP Unit Awards | Restricted Share Awards | Share Awards |\n| Number of Units | Weighted Average Grant Date Fair Value | Number of Restricted Shares | Weighted Average Grant Date Fair Value | Number of Shares | Weighted Average Grant Date Fair Value |\n| Unvested Balance as of December 31, 2020 | 898,126 | $ | 6.15 | 202,878 | $ | 7.87 | — |\n| Granted | 794,683 | 12.86 | 116,743 | 10.18 | 32,460 | 11.31 |\n| Vested | ( 13,512 ) | 12.23 | ( 239,736 ) | 7.73 | ( 32,460 ) | 11.31 |\n| Forfeited | — | N/A | ( 150 ) | 11.31 | — | N/A |\n| Unvested Balance as of June 30, 2021 | 1,679,297 | $ | 9.28 | 79,735 | $ | 11.68 | — |\n\n36\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 9 – SHARE BASED PAYMENTS (CONTINUED)\n| Share BasedCompensation Expense | UnearnedCompensation |\n| For the Three Months Ended | For the Six Months Ended | As of |\n| June 30, 2021 | June 30, 2020 | June 30, 2021 | June 30, 2020 | June 30, 2021 | December 31, 2020 |\n| Issued Awards |\n| LTIP Unit Awards | $ | 1,534 | $ | 1,142 | $ | 3,258 | $ | 2,951 | $ | 8,049 | $ | 1,842 |\n| Restricted Share Awards | 254 | 342 | 422 | 674 | 762 | 276 |\n| Share Awards | 367 | — | 367 | — | — | — |\n| Unissued Awards |\n| Market Based | 434 | 315 | 711 | 630 | 3,019 | 1,933 |\n| Performance Based | — | — | — | — | — | — |\n| Total | $ | 2,589 | $ | 1,799 | $ | 4,758 | $ | 4,255 | $ | 11,830 | $ | 4,051 |\n\nThe weighted-average period of which the unrecognized compensation expense will be recorded is approximately 2.0 years for LTIP Unit Awards and 1.1 years for Restricted Share Awards.\n| 2021 | 2022 | 2023 | 2024 |\n| LTIP Unit Awards | 960,046 | 595,406 | 61,921 | 61,924 |\n| Restricted Share Awards | — | 66,202 | 10,533 | 3,000 |\n| 960,046 | 661,608 | 72,454 | 64,924 |\n\n37\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 10 – EARNINGS PER SHARE\nThe following table is a reconciliation of the income or loss (numerator) and the weighted average shares (denominator) used in the calculation of basic and diluted earnings per common share. The computation of basic and diluted earnings per share is presented below.\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| NUMERATOR: |\n| Basic and Diluted* |\n| Net Loss | $ | ( 23,523 ) | $ | ( 71,780 ) | $ | ( 14,433 ) | $ | ( 97,752 ) |\n| Loss allocated to Noncontrolling Interests | 977 | 10,360 | 813 | 13,257 |\n| Distributions to Preferred Shareholders | ( 6,044 ) | ( 6,044 ) | ( 12,087 ) | ( 12,088 ) |\n| Net loss applicable to Common Shareholders | $ | ( 28,590 ) | $ | ( 67,464 ) | $ | ( 25,707 ) | $ | ( 96,583 ) |\n| DENOMINATOR: |\n| Weighted average number of common shares - basic | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\n| Effect of dilutive securities: |\n| Restricted Stock Awards and LTIP Units (unvested) | — | — | — | — |\n| Contingently Issued Shares and Units | — | — | — | — |\n| Weighted average number of common shares - diluted | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\n\n*Income (loss) allocated to noncontrolling interest in HHLP has been excluded from the numerator and Common Units and Vested LTIP Units have been omitted from the denominator for the purpose of computing diluted earnings per share since including these amounts in the numerator and denominator would have no impact. In addition, potentially dilutive common shares, if any, have been excluded from the denominator if they are anti-dilutive to income (loss) applicable to common shareholders.\n38\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 11 – CASH FLOW DISCLOSURES AND NON CASH INVESTING AND FINANCING ACTIVITIES\nInterest paid during the six months ended June 30, 2021 and 2020 totaled $ 20,052 and $ 21,488 , respectively. Net Cash paid on Interest Rate Derivative contracts during the six months ended June 30, 2021 and 2020 totaled $ 6,259 and $ 1,505 , respectively. Cash paid for income taxes during the six months ended June 30, 2021 and 2020 totaled $ 60 and $ 233 , respectively. The following non-cash investing and financing activities occurred during the six months ended June 30, 2021 and 2020:\n| 2021 | 2020 |\n| Common Shares issued as part of the Dividend Reinvestment Plan | $ | — | $ | 14 |\n| Issuance of share based payments | 13,103 | 6,404 |\n| Accrued payables for capital expenditures placed into service | 230 | 1,398 |\n| Adjustment to Record Noncontrolling Interest at Redemption Value | 1,968 | ( 3,196 ) |\n\nThe following table provides a reconciliation of cash, cash equivalents, and restricted cash reported within the consolidated balance sheets that sum to the total of the same such amounts shown in the consolidated statements of cash flows for the six months ended June 30, 2021 and 2020:\n| 2021 | 2020 |\n| Cash and cash equivalents | $ | 69,083 | $ | 23,228 |\n| Escrowed cash | 11,067 | 7,374 |\n| Total cash, cash equivalents, and restricted cash shown in the consolidated statements of cash flows | $ | 80,150 | $ | 30,602 |\n\nAmounts included in restricted cash represent those required to be set aside in escrow by contractual agreement with various lenders for the payment of specific items such as property insurance, property tax, and capital expenditures.\n39\nItem 2.\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations\nCautionary Statement Regarding Forward Looking Statements\nThis report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including, without limitation, statements containing the words, “believe,” “expect,” “anticipate,” “estimate,” “plan,” “continue,” “intend,” “should,” “may” and words of similar import. Such forward-looking statements relate to future events, our plans, strategies, prospects and future financial performance, and involve known and unknown risks that are difficult to predict, uncertainties and other factors which may cause our actual results, performance or achievements or industry results to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Readers should specifically consider the various factors identified in this report and other reports filed by us with the U.S. Securities and Exchange Commission (the \"SEC\"), including, but not limited to those discussed in the sections entitled “Risk Factors” and \"Management's Discussion and Analysis of Financial Conditions and Results of Operations\" of our Annual Report on Form 10-K for the year ended December 31, 2020 and in this Quarterly Report on Form 10-Q, that could cause actual results to differ. Statements regarding the following subjects are forward-looking by their nature:\n● our business or investment strategy;\n● our projected operating results;\n● our ability to generate positive cash flow from operations;\n● our distribution policy;\n● our liquidity and management's plans with respect thereto;\n● completion of any pending transactions;\n● our ability to maintain existing financing arrangements, including compliance with covenants and our ability to obtain future financing arrangements or refinance or extend the maturity of existing financing arrangements as they come due;\n● our ability to negotiate with lenders;\n● our understanding of our competition;\n● market trends;\n● projected capital expenditures;\n● the impact of and changes to various government programs, including in response to the novel coronavirus, or COVID-19, including those specifically affecting New York City;\n● the efficacy of any treatment for COVID-19;\n● our access to capital on the terms and timing we expect;\n● the restoration of public confidence in domestic and international travel;\n● permanent structural changes in demand for conference centers by business and leisure clientele; and\n● our ability to dispose of selected hotel properties on the terms and timing we expect, if at all.\nForward-looking statements are based on our beliefs, assumptions and expectations, taking into account all information currently available to us. These beliefs, assumptions and expectations are subject to risks and uncertainties and can change as a result of many possible events or factors, not all of which are known to us. If a change occurs, our business, financial condition, liquidity and results of operations may vary materially from those expressed in our forward-looking statements. Readers should not place undue reliance on forward-looking statements.\nImportant factors that we think could cause our actual results to differ materially from expected results are summarized below. One of the most significant factors, however, is the ongoing impact of the current outbreak of the novel coronavirus on the United States, regional and global economies, the broader financial markets, our customers and employees, governmental responses thereto and the operation changes we have and may implement in response thereto. The current outbreak of COVID-19 has also impacted, and is likely to continue to impact, directly or indirectly, many other important factors below.\nNew factors emerge from time to time, and it is not possible for us to predict which factors will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. In particular, it is difficult to fully assess the impact of COVID-19 at this time due to, among other factors, uncertainty regarding the severity and duration of the outbreak domestically and internationally, and the possibility of additional subsequent widespread outbreaks and variant strains and the impacts of actions taken in response, and the effectiveness of federal, state and local governments’ efforts to contain the spread of COVID-19 and respond to its direct and indirect impact on the U.S. economy and economic activity.\n40\nThe following non-exclusive list of factors could also cause actual results to vary from our forward-looking statements:\n● general volatility of the capital markets and the market price of our common shares;\n● changes in our business or investment strategy;\n● availability, terms and deployment of capital;\n● changes in our industry and the market in which we operate, interest rates, or the general economy;\n● decreased international travel because of geopolitical events, including terrorism and current U.S. government policies such as immigration policies, border closings, and travel bans related to COVID-19;\n● the degree and nature of our competition;\n● financing risks, including (i) the risk of leverage and the corresponding risk of default on our mortgage loans and other debt, including default with respect to applicable covenants, (ii) potential inability to obtain waivers of covenants or refinance or extend the maturity of existing indebtedness and (iii) our ability to negotiate with lenders;\n● levels of spending in the business, travel and leisure industries, as well as consumer confidence;\n● declines in occupancy, average daily rate and RevPAR and other hotel operating metrics;\n● hostilities, including future terrorist attacks, or fear of hostilities that affect travel;\n● financial condition of, and our relationships with, our joint venture partners, third-party property managers, and franchisors;\n● increased interest rates and operating costs;\n● ability to complete development and redevelopment projects;\n● risks associated with potential dispositions of hotel properties;\n● availability of and our ability to retain qualified personnel;\n● decreases in tourism due to pandemics, geopolitical instability or changes in foreign exchange rates;\n● our failure to maintain our qualification as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended, or the \"Code\";\n● environmental uncertainties and risks related to natural disasters and increases in costs to insure against those risks;\n● changes in real estate and zoning laws and increases in real property tax rates;\n● the uncertainty and economic impact of pandemics, epidemics, or other public health emergencies or fear of such events, such as the recent outbreak of COVID-19, including with respect to New York City;\n● the current COVID-19 pandemic had, and will continue to have, adverse effects on our financial conditions, results of operations, cash flows, and performance for an indefinite period of time. Future pandemics may also have adverse effects on our financial condition, results of operations, cash flows, and performance;\n● world events impacting the ability or desire of people to travel may lead to a decline in demand for hotels; and\n● the factors discussed in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2020 under the headings “Risk Factors” and \"Management's Discussion and Analysis of Financial Condition and Results of Operations\" and in other reports we file with the SEC from time to time.\nThese factors are not necessarily all of the important factors that could cause our actual results, performance or achievements to differ materially from those expressed in or implied by any of our forward-looking statements. Other unknown or unpredictable factors, many of which are beyond our control, also could harm our results, performance or achievements.\nAll forward-looking statements contained in this report are expressly qualified in their entirety by the cautionary statements set forth above. Forward-looking statements speak only as of the date they are made, and we do not undertake or assume any obligation to update publicly any of these statements to reflect actual results, new information or future events, changes in assumptions or changes in other factors affecting forward-looking statements, except to the extent required by applicable laws. If we update one or more forward-looking statements, no inference should be drawn that we will make additional updates with respect to those or other forward-looking statements.\nBACKGROUND\nAs of June 30, 2021, we owned interests in 36 hotels in major urban gateway markets including New York, Washington DC, Boston, Philadelphia, San Diego, Los Angeles, Seattle, and Miami, including 32 wholly-owned hotels, 1 hotel through our interest in a consolidated joint venture, and interests in 3 hotels owned through unconsolidated joint ventures. We have elected to be taxed as a REIT for federal income tax purposes, beginning with the taxable year ended December 31, 1999. For purposes of the REIT qualification rules, we cannot directly operate any of our hotels. Instead, we must lease our hotels to a third party lessee or to a TRS, provided that the TRS engages an eligible independent contractor to manage the\n41\nhotels. As of June 30, 2021, we have leased all of our hotels to a wholly-owned TRS, a joint venture owned TRS, or an entity owned by our wholly-owned TRS. Each of these TRS entities will pay qualifying rent, and the TRS entities have entered into management contracts with qualified independent managers, including HHMLP, with respect to our hotels. We intend to lease all newly acquired hotels to a TRS. The TRS structure enables us to participate more directly in the operating performance of our hotels. The TRS directly receives all revenue from, and funds all expenses relating to, hotel operations. The TRS is also subject to income tax on its earnings.\nOVERVIEW\nWe started to realize the effects from the global economic slowdown caused by the COVID-19 pandemic in March of 2020. As a result of the COVID-19 pandemic and subsequent government mandates and health official recommendations, hotel demand has been substantially reduced across the United States.\nFollowing the government mandates and health official recommendations, and after evaluating the cost of running our respective properties at low occupancy levels versus closing the properties, we originally closed 21 hotel properties and dramatically reduced staffing at the hotels that remained open and at the corporate level; however, we have subsequently reopened all of our consolidated hotels. The reopening of our consolidated hotels provided us the opportunity to capture incremental demand through the end of 2020 and we believe we are prepared to capture market share during the early stages of an economic recovery in 2021.\nIn addition to our focus on strategically reopening hotels and driving occupancy at these hotels, we have remained focused on executing expense mitigation measures and shoring up our liquidity position as we continue to face a challenging operating environment. We suspended our common and preferred dividends in 2020 and during the six months ended June 30, 2021, we paid approximately $24.2 million in preferred dividend arrearage that was not paid in 2020. We also deferred certain planned capital expenditures for 2020 and we will continue to reduce capital expenditures in 2021 with planned allocations estimated between $15.0 and $18.0 million. In February 2021, the Company entered into an unsecured notes facility that provided net proceeds of $144.75 million at closing. An incremental $50 million may be drawn, at the Company’s discretion, in minimum installments of $25.0 million, at any point on or prior to September 30, 2021. The initial net proceeds of $144.75 million provided by this facility, along with a portion of the proceeds from asset sales, were used to repay amounts outstanding under our Credit Facility, allowing us to amend our Credit Facility on February 17, 2021, eliminating maturities under the Credit Facility until August of 2022. The Credit Facility amendment also waived all financial covenants through March 31, 2022, established accommodative covenant testing methodology through December 31, 2022, and provided additional liquidity at the Company’s discretion.\nThe manner in which the ongoing COVID-19 pandemic will be resolved or the manner that the hospitality and tourism industries will return to historical performance norms, and whether the economy will contract or grow are not reasonably predictable. As a result, there can be no assurances that we will be able to achieve the hotel operating metrics or the results at our properties we have forecasted. Factors that might contribute to less-than-anticipated performance include those described under the headings “Risk Factors” and \"Management's Discussion and Analysis of Financial Condition and Results of Operations\" in our Annual Report on Form 10-K for the year ended December 31, 2020 and other documents that we may file with the SEC in the future. We will continue to cautiously monitor lodging demand and rates, our third-party hotel managers, and our performance generally.\n42\nSUMMARY OF OPERATING RESULTS\nCOMPARISON OF THE THREE MONTHS ENDED JUNE 30, 2021 AND 2020\n(dollars in thousands, except ADR, RevPAR, and per share data)\nRevenue\nOur total revenues for the three months ended June 30, 2021 consisted of hotel operating revenues and other revenue. Hotel operating revenues were approximately 99% of total revenues for the three months ended June 30, 2021 and 2020. Hotel operating revenues are recorded for wholly-owned hotels that are leased to our wholly owned TRS and hotels owned through joint venture or other interests that are consolidated in our financial statements. Hotel operating revenues increased $52,671, or 302.5%, to $70,083 for the three months ended June 30, 2021 compared to $17,412 for the same period in 2020. This increase is primarily attributable to an increase in demand across our portfolio in 2021 as the comparable period in 2020 was at the nadir of the reduction in operations across our portfolio due to the decrease in demand caused by the COVID-19 pandemic. The increase in demand is partially offset by the sale of five hotels during the six months ended June 30, 2021 and the sale of one hotel in December of 2020. Total revenues for the three months ended June 30, 2020 includes hotel operating revenue for these six hotels for the entire period.\nExpenses\nTotal hotel operating expenses increased 124.8% to approximately $41,310 for the three months ended June 30, 2021 from $18,378 for the three months ended June 30, 2020. The increase in hotel operating expenses is due to increased operations at our hotels for the three months ended June 30, 2021 as we had temporary closed certain of our hotels and reduced operations at the remaining hotels as a result of the decrease in demand caused by the COVID-19 pandemic during the comparable period in 2020. This increase in hotel operating expense is partially offset by the sale of hotels noted above.\nDepreciation and amortization decreased by 13.6%, or $3,308, to $21,014 for the three months ended June 30, 2021 from $24,322 for the three months ended June 30, 2020. The decrease is primarily attributable to the disposition of the Sheraton Wilmington in December 2020, and the Courtyard San Diego, the Residence Inn Coconut Grove, the Capitol Hill Hotel, the Holiday Inn Express Cambridge, and the Duane Street Hotel in the first half of 2021.\nReal estate and personal property tax and property insurance decreased $503, or 5.0%, for the three months ended June 30, 2021 when compared to the same period in 2020. This decrease is primarily driven by reductions in real estate tax expense due to the sale of hotels noted above. The decrease is partially offset by increased real estate tax that had been re-assessed by the applicable taxing authority, resulting in increases in real estate tax expense for the quarter as we cumulatively catch up, in certain instances, our estimated tax accruals at the time the new assessment is received. We typically experience increases in tax assessments and tax rates as the economy improves which could be offset by reductions resulting from successful real estate tax appeals. The Company regularly appeals property taxes but cannot predict property tax reductions from real estate tax appeals.\nGeneral and administrative expense increased by 26.3%, or approximately $1,100, from $4,187 for the three months ended June 30, 2020 to $5,287 for the same period in 2021. General and administrative expense includes expenses related to payroll, rents, and other corporate level administrative costs as well as non-cash share based payments issued as incentive compensation to the Company’s trustees, executives, and employees. Expenses related to non-cash share based compensation increased $790 when comparing the three months ended June 30, 2021 to the same period in 2020. This increase resulted primarily from an increase in the valuation of certain market based award programs and a difference in the timing of share based compensation recognition. In addition, during the three months ended June 30, 2020, we executed cost containment strategies in our payroll and other administrative costs. Please refer to “Note 9 – Share Based Payments” of the notes to the consolidated financial statements for more information about our share based compensation.\nOperating Loss\nOperating loss for the three months ended June 30, 2021 was $7,592 compared to operating loss of $41,542 during the same period in 2020. The decrease in our operating loss of $33,950 is primarily due to an increase in demand during the three months ended June 30, 2021 as compared to the same period in 2020 when we had temporary closed certain of our hotels and reduced operations at the remaining hotels as a result of the decrease in demand caused by the COVID-19 pandemic.\n43\nInterest Expense\nInterest expense increased $1,501 from $13,481 for the three months ended June 30, 2020 to $14,982 for the three months ended June 30, 2021. The primary driver of the increased interest expense is due to the issuance of the Junior Notes, which is partially offset by a decrease in interest expense on our term loans and decreases in the amortization of our interest rate hedges. Resulting primarily from the proceeds of the sales of assets, the balance of our borrowings, excluding discounts and deferred costs, have decreased by $57,256 in total between June 30, 2020 and June 30, 2021.\nIncome Tax Benefit\nDuring the three months ended June 30, 2021, the Company recorded an income tax expense of $151 compared to an income tax expense of $15,872 for the three months ended June 30, 2020. After considering various factors, including future reversals of existing taxable temporary differences, future taxable income and tax planning strategies, we believe that as of June 30, 2021, it is not more likely than not that we will be able to realize our net deferred tax asset and therefore, maintained the full valuation allowance that was established during the second quarter of 2020, with the exception of a city net operating loss that we believe that we will be able to realize. As a result, the balance of our net deferred tax asset at June 30, 2021 is $499. Absent the valuation allowance, the amount of income tax expense or benefit that the Company typically records depends mostly on the amount of taxable income or loss that is generated by our consolidated taxable REIT subsidiaries (“TRS”).\nNet Loss Applicable to Common Shareholders\nNet loss applicable to common shareholders for the three months ended June 30, 2021 was $28,590 compared to net loss of $67,464 during the same period in 2020. This decrease is primarily due to an increase in demand during the three months ended June 30, 2021 as compared to the same period in 2020, as discussed above, partially offset by increased interest expense during the three months ended June 30, 2021, as discussed above.\nCOMPARISON OF THE SIX MONTHS ENDED JUNE 30, 2021 AND 2020\n(dollars in thousands, except ADR, RevPAR, and per share data)\nRevenue\nOur total revenues for the six months ended June 30, 2021 consisted of hotel operating revenues and other revenue. Hotel operating revenues were approximately 99% of total revenues for the six months ended June 30, 2021 and 2020. Hotel operating revenues are recorded for wholly-owned hotels that are leased to our wholly owned TRS and hotels owned through joint venture or other interests that are consolidated in our financial statements. Hotel operating revenues increased $9,886, or 9.2%, to $117,236 for the six months ended June 30, 2021 compared to $107,350 for the same period in 2020. This increase is attributable to an increase in RevPAR across our portfolio during the six months ended June 30, 2021 as compared to the six months ended June 30, 2020, when beginning in March 2020, we experienced a significant decrease in demand caused by the COVID-19 pandemic. The increase in demand is partially offset by the sale of five hotels during the six months ended June 30, 2021 and the sale of one hotel in December of 2020. Total revenues for the six months ended June 30, 2020 includes hotel operating revenue for these six hotels for the entire period.\nExpenses\nTotal hotel operating expenses decreased 12.4% to approximately $73,490 for the six months ended June 30, 2021 from $83,897 for the six months ended June 30, 2020. The decrease in hotel operating expenses is attributable to the cost saving measures implemented to mitigate the impact of the decrease in demand in 2020, as well the sale of hotels noted above.\nDepreciation and amortization decreased by 11.7%, or $5,694, to $42,816 for the six months ended June 30, 2021 from $48,510 for the six months ended June 30, 2020 due to the dispositions noted above.\nReal estate and personal property tax and property insurance decreased $374, or 1.9%, for the six months ended June 30, 2021 when compared to the same period in 2020, which is primarily due to the sale of hotels noted above. This decrease is partially offset by an increase in real estate taxes at our remaining hotels as a result of properties that had been re-assessed by the applicable taxing authority, resulting in increases in real estate tax expense. We typically experience increases in tax assessments and tax rates as the economy improves which could be offset by reductions resulting from successful real estate tax appeals. In general, our property insurance costs continue to rise annually.\n44\nGeneral and administrative expense increased by 2.1%, or $210 from $10,021 for the six months ended June 30, 2020 to $10,231 for the same period in 2021. General and administrative expense includes expenses related to payroll, rents, and other corporate level administrative costs as well as non-cash share based payments issued as incentive compensation to the Company’s trustees, executives, and employees. Expenses related to non-cash share based compensation increased $503 when comparing the six months ended June 30, 2021 to 2020, which was partially offset by the execution of our cost containment strategies in other administrative costs. The increase in shared based compensation resulted primarily from an increase in the valuation of certain market based award programs and a difference in the timing of shared based compensation recognition. Please refer to “Note 9 – Share Based Payments” of the notes to the consolidated financial statements for more information about our share based compensation.\nOperating Loss\nOperating loss for the six months ended June 30, 2021 was $30,878 compared to operating loss of $57,951 during the same period in 2020. Our decrease in operating loss was largely the result of a decrease in hotel operating expenses for the six months ended June 30, 2021 and an increase in hotel operating revenues, which is the result of an increase in demand across our portfolio, while maintaining certain cost containment strategies in place due to the COVID-19 pandemic. Additionally, we had a decrease in depreciation and amortization expense during the first half of 2021 compared to 2020 as a result of the disposals noted above.\nInterest Expense\nInterest expense increased $1,923 from $26,488 for the six months ended June 30, 2020 to $28,411 for the six months ended June 30, 2021. The balance of our borrowings, excluding discounts and deferred costs, has decreased by $57,256 in total between June 30, 2020 and June 30, 2021. However, we experienced an increase in our weighted average interest rate, driven by the unsecured junior notes payable facility we entered into in February 2021, and increased interest expense related to the amortization of additional deferred costs incurred during the six months ended June 30, 2021. Proceeds from the junior notes payable were used to reduce borrowings under our secured credit facility and term loans.\nIncome Tax Expense\nDuring the six months ended June 30, 2021, the Company recorded an income tax benefit of $438 compared to an income tax expense of $11,374 for the six months ended June 30, 2020. After considering various factors, including future reversals of existing taxable temporary differences, future taxable income and tax planning strategies, we believe that as of June 30, 2021, it is not more likely than not that we will be able to realize our net deferred tax asset and therefore, maintained the full valuation allowance that was established during the second quarter of 2020, with the exception of a city net operating loss that we believe that we will be able to realize. As a result, the balance of our net deferred tax asset at June 30, 2021 is $499. Absent the valuation allowance, the amount of income tax expense or benefit that the Company typically records depends mostly on the amount of taxable income or loss that is generated by our consolidated taxable REIT subsidiaries (“TRS”).\nNet Loss Applicable to Common Shareholders\nNet loss applicable to common shareholders for the six months ended June 30, 2021 was $25,707 compared to net loss of $96,583 during the same period in 2020, resulting in a decreased loss of $70,876. This decrease in loss is primarily related to gain on hotel dispositions of $48,352, as well as a decrease in operating loss.\n45\nLIQUIDITY, CAPITAL RESOURCES, AND EQUITY OFFERINGS\n(dollars in thousands, except per share data)\nPotential Sources of Capital\nOur organizational documents do not limit the amount of indebtedness that we may incur. Our ability to incur additional debt is dependent upon a number of factors, including the current state of the overall credit markets, our degree of leverage and borrowing restrictions imposed by existing lenders. Our ability to raise funds through the issuance of debt and equity securities is dependent upon, among other things, capital market volatility, risk tolerance of investors, general market conditions for REITs and market perceptions related to the Company’s ability to generate cash flow and positive returns on its investments.\nIn addition, our mortgage indebtedness contains various financial and non-financial covenants customarily found in secured, nonrecourse financing arrangements. If the specified criteria are not satisfied, the lender may be able to escrow cash flow generated by the property securing the applicable mortgage loan. At June 30, 2021, we failed our debt service coverage ratio (\"DSCR\") requirement related to two of our mortgage borrowings. After considering the effect of the COVID-19 pandemic on our consolidated operations, it is possible that we could fail certain financial covenants within certain property-level mortgage borrowings. For mortgages with financial covenants, the lenders' remedy of a covenant failure would be a requirement to escrow funds for the purpose of meeting our future debt payment obligations.\nIn February 2021, the Company entered into a junior unsecured notes facility (“Junior Notes”) that provided net proceeds of $144,750 at closing. An incremental $50,000 may be drawn, at the Company’s discretion, in minimum installments of $25,000 at any point on or prior to September 30, 2021. The Junior Notes bear interest at a rate of 9.50%, of which half, or 4.75%, will be paid in cash with the remaining half added to the principal of the note through March 31, 2022 at our discretion. The Junior Notes mature in February of 2026 and are non-callable through February 2022. The Junior Notes are callable at 104% beginning February of 2022, 102% beginning in February 2023, and at par any time beginning in February 2024.\nThe net proceeds of $144,750 provided by the Junior Notes, along with a portion of the proceeds from asset sales, were used to repay amounts outstanding under the Credit Facility, the Second Term Loan, and the Third Term Loan. The Junior Notes and asset sales that closed in the first quarter of 2021 allowed the Company to execute amendments to Credit Agreements governing the Credit Facility, the Second Term Loan, and the Third Term Loan. These amendments eliminated term loan maturities until August of 2022, waived all financial covenants through March 31, 2022, established accommodative covenant testing methodology through December 31, 2022, enabled the Company to pay down the accrual of the Company’s preferred dividends and allow the ongoing preferred dividend accrual to be kept current, and provided additional liquidity at the Company’s discretion.\nOur secured debt facilities aggregate to $747,481 which is comprised of a $442,404 senior credit facility and two term loans totaling $305,077. The credit facility (“Credit Facility”) contains a $192,404 term loan (“First Term Loan”) and a $250,000 revolving line of credit (“Line of Credit”), and expires on August 10, 2022. As of June 30, 2021, we had $118,684 outstanding under the Line of Credit. Our two additional term loans are $278,846 (“Second Term Loan”) and $26,231 (“Third Term Loan”), which mature on September 10, 2024 and August 10, 2022, respectively.\nWe will continue to monitor our debt maturities to manage our liquidity needs. However, no assurances can be given that we will be successful in refinancing all or a portion of our future debt obligations due to factors beyond our control or that, if refinanced, the terms of such debt will not vary from the existing terms. As of June 30, 2021, we have $23,431 of indebtedness due on or before June 30, 2022. We currently expect that cash requirements for all debt that is not refinanced by our existing lenders for which the maturity date is not extended will be met through a combination of cash on hand, refinancing the existing debt with new lenders, draws on the Line of Credit or Junior Notes and the issuance of our securities.\nIn addition to the incurrence of debt and the offering of equity securities, dispositions of property may serve as additional capital resources and sources of liquidity. We may recycle capital from stabilized assets or from sales of non-core hotels in secondary and tertiary markets. Capital from these types of transactions is intended to be redeployed into high growth acquisitions, share buybacks, or to pay down existing debt.\n46\nAcquisitions\nDuring the six months ended June 30, 2021, we acquired no hotel properties. We intend to invest in additional hotels only as suitable opportunities arise and adequate sources of capital are available. We expect that future investments in hotels will depend upon and will be financed by, in whole or in part, our existing cash, the proceeds from additional issuances of common or preferred shares, proceeds from the sale of assets, issuances of Common Units, issuances of preferred units or other securities or borrowings secured by hotel assets and under our Line of Credit.\nDispositions\nDuring the six months ended June 30, 2021, we disposed of five hotel properties for an aggregate sales price of $196,500 resulting in a gain on disposition of $48,313. The net proceeds were used to repay existing debt.\nOperating Liquidity and Capital Expenditures\nWe expect to meet our short-term liquidity requirements generally through net cash provided by operations, existing cash balances and, if necessary, short-term borrowings under the Line of Credit. We believe that the net cash provided by operations in the coming year and borrowings drawn on the Line of Credit will be adequate to fund the Company’s operating requirements, monthly recurring debt service and the payment of dividends in accordance with REIT requirements of the Code.\nTo qualify as a REIT, we must distribute annually at least 90% of our taxable income. This distribution requirement limits our ability to retain earnings and requires us to raise additional capital in order to grow our business and acquire additional hotel properties. However, there is no assurance that we will be able to borrow funds or raise additional equity capital on terms acceptable to us, if at all. In addition, we cannot guarantee that we will be able to make distributions to our shareholders.\nWe will seek to satisfy long-term liquidity requirements through various sources of capital, including borrowings under the Line of Credit and through secured, non-recourse mortgage financings with respect to our unencumbered hotel properties. In addition, we may seek to raise capital through public or private offerings of our securities. Certain factors may have a material adverse effect on our ability to access these capital sources, including our degree of leverage, the value of our unencumbered hotel properties and borrowing restrictions imposed by lenders or franchisors. We will continue to analyze which source of capital is most advantageous to us at any particular point in time, but financing may not be consistently available to us on terms that are attractive, or at all.\nSpending on capital improvements during the six months ended June 30, 2021 decreased when compared to spending on capital improvements during the six months ended June 30, 2020. During the six months ended June 30, 2021, we spent $5,374 on capital expenditures to renovate, improve or replace assets at our hotels. This compares to $15,612 during the same period in 2020. These capital expenditures were undertaken to comply with brand mandated improvements and to initiate projects that we believe will generate a return on investment. We may spend additional amounts, if necessary, to comply with the requirements of any franchise license under which any of our hotels operate and otherwise to the extent we deem such expenditures to be prudent. We are also obligated to fund the cost of certain capital improvements to our hotels.\nWe expect to use operating cash flow, borrowings under the Line of Credit, and proceeds from issuances of our securities and hotel dispositions to pay for the cost of capital improvements and any furniture, fixture and equipment requirements.\n47\nCASH FLOW ANALYSIS\n(dollars in thousands, except per share data)\nComparison of the Six Months Ended June 30, 2021 and 2020\nNet cash used in operating activities decreased $9,250 from $16,357 for the six months ended June 30, 2020 to $7,107 for the comparable period in 2021. The increase in cash flow is primarily attributable to an increase in hotel property cash flow as a result of an increase in demand since the onset of the COVID-19 pandemic.\nNet cash provided by investing activities for the six months ended June 30, 2021 was $157,659 compared to net cash used in investing activities of $16,191 for the six months ended June 30, 2020. The following items are the major contributing factors for the change in investing cash flows:\n•Proceeds of $163,583 received related to the disposition of the Courtyard San Diego, the Capitol Hill Hotel, the Holiday Inn Express Cambridge, the Residence Inn Coconut Grove, and the Duane Street Hotel during the six months ended June 30, 2021.\n•An increase in comparative cash flows of $10,217 related to a decrease in spending on capital expenditures and hotel development projects for the six months ended June 30, 2021 compared to 2020.\n•An increase in comparative cash flows of $50 related to contributions of $600 to unconsolidated joint ventures for the six months ended June 30, 2020 compared to contributions of $550 for the six months ended June 30, 2021.\nNet cash used in financing activities for the six months ended June 30, 2021 was $94,009 compared to net cash provided by financing activities for the six months ended June 30, 2020 of $26,165. The following items are the major contributing factors for the change in financing cash flows:\n•The primary use of cash was the payment of $187,024 of outstanding borrowings under the Term Loan agreements. We received proceeds of $144,750 from the issuance of the Junior Notes, a portion of which, in addition to the proceeds received from the hotel dispositions noted above, were used to pay down the Term Loans.\n•An increase in mortgage payments of $703 for the six months ended June 30, 2021 as compared to the six months ended June 30, 2020.\n•Payment of $5,795 of deferred financing costs for the six months ended June 30, 2021 which primarily relate to the Junior Notes issuance noted above, as compared to the payment of $2,104 during the six months ended June 30, 2020.\n•A decrease in comparative cash flows as we drew $47,000 on our Line of Credit during the six months ended June 30, 2020 when compared to $14,369 in net repayments during the same period in 2021.\n•An increase in cash payments of $12,167 related to dividends paid. During the six months ended June 30, 2021, our executed amendments to the Credit Agreements allowed for the payment of the total arrearage of unpaid cash dividends due on each of our 6.875% Series C Cumulative Redeemable Preferred Shares, 6.50% Series D Cumulative Redeemable Preferred Shares and 6.50% Series E Cumulative Redeemable Preferred Shares of approximately $24,174, which was paid on March 26, 2021, as well as dividends of $6,044 on these preferred shares in April 2021. During the six months ended June 30, 2020 we paid dividends of $6,044 on these preferred shares and $12,007 on our Common Shares, Common Units and LTIP Units.\nOFF BALANCE SHEET ARRANGEMENTS\nThe Company does not have off balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.\n48\nFUNDS FROM OPERATIONS\n(in thousands, except share data)\nThe National Association of Real Estate Investment Trusts (“NAREIT”) developed Funds from Operations (“FFO”) as a non-GAAP financial measure of performance of an equity REIT in order to recognize that income-producing real estate historically has not depreciated on the basis determined under GAAP. We calculate FFO applicable to common shares and Common Units in accordance with the December 2018 Financial Standards White Paper of NAREIT, which we refer to as the White Paper. The White Paper defines FFO as net income (loss) (computed in accordance with GAAP) excluding depreciation and amortization related to real estate, gains and losses from the sale of certain real estate assets, gains and losses from change in control, and impairment write-downs of certain real estate assets and investments in entities when the impairment is directly attributable to decreases in the value of depreciable real estate held by an entity. Our interpretation of the NAREIT definition is that noncontrolling interest in net income (loss) should be added back to (deducted from) net income (loss) as part of reconciling net income (loss) to FFO. Our FFO computation may not be comparable to FFO reported by other REITs that do not compute FFO in accordance with the NAREIT definition, or that interpret the NAREIT definition differently than we do.\nThe GAAP measure that we believe to be most directly comparable to FFO, net income (loss) applicable to common shareholders, includes loss from the impairment of certain depreciable assets, our investment in unconsolidated joint ventures and land, depreciation and amortization expenses, gains or losses on property sales, noncontrolling interest and preferred dividends. In computing FFO, we eliminate these items because, in our view, they are not indicative of the results from our property operations. We determined that the loss from the impairment of certain depreciable assets including investments in unconsolidated joint ventures and land, was driven by a measurable decrease in the fair value of certain hotel properties and other assets as determined by our analysis of those assets in accordance with applicable GAAP. As such, these impairments have been eliminated from net loss to determine FFO.\nFFO does not represent cash flows from operating activities in accordance with GAAP and should not be considered an alternative to net income as an indication of the Company’s performance or to cash flow as a measure of liquidity or ability to make distributions. We consider FFO to be a meaningful, additional measure of operating performance because it excludes the effects of the assumption that the value of real estate assets diminishes predictably over time, and because it is widely used by industry analysts as a performance measure. We show both FFO from consolidated hotel operations and FFO from unconsolidated joint ventures because we believe it is meaningful for the investor to understand the relative contributions from our consolidated and unconsolidated hotels. The display of both FFO from consolidated hotels and FFO from unconsolidated joint ventures allows for a detailed analysis of the operating performance of our hotel portfolio by management and investors. We present FFO applicable to common shares and Common Units because our Common Units are redeemable for common shares. We believe it is meaningful for the investor to understand FFO applicable to all common shares and Common Units.\n49\nThe following table reconciles FFO for the periods presented to the most directly comparable GAAP measure, net income, for the same periods (dollars in thousands):\n| Three Months Ended | Six Months Ended |\n| June 30, 2021 | June 30, 2020 | June 30, 2021 | June 30, 2020 |\n| Net loss applicable to common shareholders | $ | (28,590) | $ | (67,464) | $ | (25,707) | $ | (96,583) |\n| Loss allocated to noncontrolling interest | (977) | (10,360) | (813) | (13,257) |\n| Loss from unconsolidated joint ventures | 589 | 502 | 1,247 | 1,520 |\n| Gain on disposition of hotel properties | — | — | (48,352) | — |\n| Loss from impairment of depreciable assets | 222 | 1,069 | 222 | 1,069 |\n| Depreciation and amortization | 21,014 | 24,322 | 42,816 | 48,510 |\n| Funds from consolidated hotel operations applicable to common shareholders and Partnership Units | (7,742) | (51,931) | (30,587) | (58,741) |\n| Loss from unconsolidated joint ventures | (589) | (502) | (1,247) | (1,520) |\n| Unrecognized pro rata interest in loss (1) | (318) | (511) | (814) | (361) |\n| Depreciation and amortization of difference between purchase price and historical cost (2) | 21 | 21 | 42 | 42 |\n| Interest in depreciation and amortization of unconsolidated joint ventures (3) | 652 | 393 | 1,282 | 796 |\n| Funds from unconsolidated joint ventures operations applicable to common shareholders and Partnership Units | (234) | (599) | (737) | (1,043) |\n| Funds from Operations applicable to common shareholders and Partnership Units | $ | (7,976) | $ | (52,530) | $ | (31,324) | $ | (59,784) |\n| Weighted Average Common Shares and Common Units |\n| Basic | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\n| Diluted | 44,724,968 | 43,286,310 | 44,525,168 | 43,426,465 |\n\n(1) For U.S. GAAP reporting purposes, our interest in the joint venture's loss is not recognized since our U.S. GAAP basis in the joint venture has been reduced to $0. Our interest in FFO from the joint venture equals our percentage ownership in the venture's FFO, including loss we have not recognized for U.S. GAAP reporting.\n(2) Adjustment made to add depreciation of purchase price in excess of historical cost of the assets in the unconsolidated joint venture at the time of our investment.\n(3) Adjustment made to add our interest in real estate related depreciation and amortization of our unconsolidated joint ventures.\nINFLATION\nOperators of hotel properties, in general, possess the ability to adjust room rates daily to reflect the effects of inflation. However, competitive pressures may limit the ability of our management companies to raise room rates. Additionally, our management companies will face challenges to raise room rates to reflect the impact of inflation until there is a substantial economic recovery from the COVID-19 pandemic.\nCRITICAL ACCOUNTING POLICIES AND ESTIMATES\nRefer to Note 1 – Basis of Presentation of the notes to our consolidated financial statements included herein for information regarding critical accounting policies and estimates.\n50\nItem 3. Quantitative and Qualitative Disclosures About Market Risk (in thousands, except per share data)\nOur primary market risk exposure is to changes in interest rates on our variable rate debt. As of June 30, 2021, we are exposed to interest rate risk with respect to variable rate borrowings under our Line of Credit, certain variable rate mortgages, and notes payable. As of June 30, 2021, we had total variable rate debt outstanding of $233,077 with a weighted average interest rate of 2.94%. The effect of a 100 basis point increase or decrease in the interest rate on our variable rate debt outstanding as of June 30, 2021 would be an increase or decrease in our interest expense for the three and six months ended June 30, 2021 of $577 and $1,198, respectively.\nOur interest rate risk objectives are to limit the impact of interest rate fluctuations on earnings and cash flows and to lower our overall borrowing costs. To achieve these objectives, we manage our exposure to fluctuations in market interest rates for a portion of our borrowings through the use of fixed rate debt instruments to the extent that reasonably favorable rates are obtainable with such arrangements. We have also entered into derivative financial instruments such as interest rate swaps or caps, and in the future may enter into treasury options or locks, to mitigate our interest rate risk on a related financial instrument or to effectively lock the interest rate on a portion of our variable rate debt. As of June 30, 2021, we have ten interest rate swaps related to debt on Hilton Garden Inn, 52nd Street, New York, NY; Courtyard, LA Westside, Culver City, CA; Hyatt Union Square, New York, NY; Hilton Garden Inn Tribeca, New York, NY; and our Credit Facility. We do not intend to enter into derivative or interest rate transactions for speculative purposes.\nAs of June 30, 2021, approximately 79.3% of our outstanding consolidated long-term indebtedness was subject to fixed rates or effectively capped, while 20.7% of our outstanding long term indebtedness is subject to floating rates, including borrowings under our Line of Credit. The majority of our floating rate debt and any corresponding derivative instruments are indexed to various tenors of LIBOR.\nOn March 5, 2021, the Financial Conduct Authority (“FCA”) announced that USD LIBOR will no longer be published after June 30, 2023. This announcement has several implications, including setting the spread that may be used to automatically convert contracts from LIBOR to the Secured Overnight Financing Rate (\"SOFR\"). Additionally, banking regulators are encouraging banks to discontinue new LIBOR debt issuances by December 31, 2021.\nThe Company anticipates that LIBOR will continue to be available at least until June 30, 2023. Any changes adopted by the FCA or other governing bodies in the method used for determining LIBOR may result in a sudden or prolonged increase or decrease in reported LIBOR. If that were to occur, our interest payments could change. In addition, uncertainty about the extent and manner of future changes may result in interest rates and/or payments that are higher or lower than if LIBOR were to remain available in its current form.\nThe Company is monitoring and evaluating the related risks that arise in connection with transitioning contracts to an alternative rate, including any resulting value transfer that may occur, and are likely to vary by contract. The value of loans, securities, or derivative instruments tied to LIBOR, as well as interest rates on our current or future indebtedness, may also be impacted if LIBOR is limited or discontinued. For some instruments the method of transitioning to an alternative reference rate may be challenging, especially if we cannot agree with the respective counterparty about how to make the transition.\nWhile we expect LIBOR to be available in substantially its current form until at least June 30, 2023, it is possible that LIBOR will become unavailable prior to that point. This could result, for example, if sufficient banks decline to make submissions to the LIBOR administrator. In that case, the risks associated with the transition to an alternative reference rate will be accelerated and magnified.\nAlternative rates and other market changes related to the replacement of LIBOR, including the introduction of financial products and changes in market practices, may lead to risk modeling and valuation challenges, such as adjusting interest rate accrual calculations and building a term structure for an alternative rate.\nThe introduction of an alternative rate also may create additional basis risk and increased volatility as alternative rates are phased in and utilized in parallel with LIBOR.\nAdjustments to systems and mathematical models to properly process and account for alternative rates will be required, which may strain the model risk management and information technology functions and result in substantial incremental costs for the company.\nChanges in market interest rates on our fixed-rate debt impact the fair value of the debt, but such changes have no impact on interest expense incurred. If interest rates rise 100 basis points and our fixed rate debt balance remains constant, we expect the fair value of our debt to decrease. The sensitivity analysis related to our fixed-rate debt assumes an immediate 100 basis point move in interest rates from their June 30, 2021 levels, with all other variables held constant. A 100 basis point increase in market interest rates would cause the fair value of our fixed-rate debt outstanding at June 30, 2021 to be\n51\napproximately $1,114,810 and a 100 basis point decrease in market interest rates would cause the fair value of our fixed-rate debt outstanding at June 30, 2021 to be approximately $1,168,182.\nWe regularly review interest rate exposure on our outstanding borrowings in an effort to minimize the risk of interest rate fluctuations. For debt obligations outstanding as of June 30, 2021, the following table presents expected principal repayments and related weighted average interest rates by expected maturity dates:\n| 2021 | 2022 - 2023 | 2024 - 2025 | Thereafter | Total |\n| Fixed Rate Debt | $ | 23,431 | $ | 346,889 | $ | 381,977 | $ | 140,764 | $ | 893,061 |\n| Weighted Average Interest Rate | 4.84 | % | 5.27 | % | 8.94 | % | 9.50 | % | 7.14 | % |\n| Floating Rate Debt | $ | 298 | $ | 1,240 | $ | 61,306 | $ | 51,548 | $ | 114,392 |\n| Weighted Average Interest Rate | 3.29 | % | 3.30 | % | 3.10 | % | 3.10 | % | 3.20 | % |\n| $ | 23,729 | $ | 348,129 | $ | 443,283 | $ | 192,312 | $ | 1,007,453 |\n| Line of Credit | $ | — | $ | 118,684 | $ | — | $ | — | $ | 118,684 |\n| Weighted Average Interest Rate | — | 2.50 | % | — | — | 2.50 | % |\n| $ | 23,729 | $ | 466,813 | $ | 443,283 | $ | 192,312 | $ | 1,126,137 |\n\n52\nItem 4. Controls and Procedures\nBased on the most recent evaluation, the Company’s Chief Executive Officer and Chief Financial Officer believe the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) were effective as of June 30, 2021.\nThere were no changes to the Company’s internal controls over financial reporting during the three months ended June 30, 2021, that materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.\n53\nPART II. OTHER INFORMATION\nItem 1. Legal Proceedings.\nNone.\nItem 1A. Risk Factors.\nThere have been no material changes from our risk factors as previously reported in our Annual Report on Form 10-K for the year ended December 31, 2020.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\nNone.\n\nItem 3. Defaults Upon Senior Securities.\nNone.\nItem 4. Mine Safety Disclosures.\nNot Applicable.\nItem 5. Other Information.\nNone.\n54\nItem 6. Exhibits.\n| Exhibit No. |\n| 31.1 | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |\n| 31.2 | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |\n| 32.1 | Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.* |\n| 32.2 | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.* |\n| 101.INS | The instance document does not appear in the interactive data file because its XBRL tags are embedded within the inline XBRL document |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document* |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document* |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document* |\n| 101.LAB | Inline XBRL Taxonomy Extension Labels Linkbase Document* |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document* |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\n| * | Filed herewith |\n| + | Compensatory plan or arrangement |\n\n55\nSIGNATURES\n\n| HERSHA HOSPITALITY TRUST |\n| July 28, 2021 | /s/ Ashish R. Parikh |\n| Ashish R. Parikh |\n| Chief Financial Officer(Principal Financial Officer) |\n\n56\n</text>\n\nWhat is the percentage change in Total Shareholders' Equity from December 31, 2020, to June 30, 2021?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nPART I\nFINANCIAL INFORMATION\nThis quarterly report contains forward-looking statements within the meaning of the U.S. federal securities laws. We intend these forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in the United States securities laws. In some cases, these statements can be identified by the use of forward-looking words such as “may”, “should”, “could”, “anticipate”, “estimate”, “expect”, “plan”, “believe”, “predict”, “potential” and “intend”. Forward-looking statements contained in this report may include information regarding our estimates of losses related to catastrophes and other large losses, measurements of potential losses in the fair value of our investment portfolio and derivative contracts, our expectations regarding pricing and other market conditions, our growth prospects, and valuations of the potential impact of movements in interest rates, equity prices, credit spreads and foreign currency rates. Forward-looking statements only reflect our expectations and are not guarantees of performance.\nThese statements involve risks, uncertainties and assumptions. Accordingly, there are or will be important factors that could cause actual results to differ materially from those indicated in such statements. We believe that these factors include, but are not limited to, the following:\n| • | the occurrence and magnitude of natural and man-made disasters, |\n\n| • | actual claims exceeding our loss reserves, |\n\n| • | general economic, capital and credit market conditions, |\n\n| • | the failure of any of the loss limitation methods we employ, |\n\n| • | the effects of emerging claims, coverage and regulatory issues, including uncertainty related to coverage definitions, limits, terms and conditions, |\n\n| • | the failure of our cedants to adequately evaluate risks, |\n\n| • | inability to obtain additional capital on favorable terms, or at all, |\n\n| • | the loss of one or more key executives, |\n\n| • | a decline in our ratings with rating agencies, |\n\n| • | loss of business provided to us by our major brokers, |\n\n| • | changes in accounting policies or practices, |\n\n| • | the use of industry catastrophe models and changes to these models, |\n\n| • | changes in governmental regulations, |\n\n| • | increased competition, |\n\n| • | changes in the political environment of certain countries in which we operate or underwrite business including the United Kingdom’s expected withdrawal from the European Union, |\n\n| • | fluctuations in interest rates, credit spreads, equity prices and/or currency values, and |\n\n| • | the other matters set forth under Item 1A, ‘Risk Factors’ and Item 7, ‘Management’s Discussion and Analysis of Financial Condition and Results of Operations’ included in our Annual Report on Form 10-K for the year ended December 31, 2015. |\n\nWe undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.\n3\nITEM 1. CONSOLIDATED FINANCIAL STATEMENTS\n\n| Page |\n| Consolidated Balance Sheets at September 30, 2016 (Unaudited) and December 31, 2015 | 5 |\n| Consolidated Statements of Operations for the three and nine months ended September 30, 2016 and 2015 (Unaudited) | 6 |\n| Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2016 and 2015 (Unaudited) | 7 |\n| Consolidated Statements of Changes in Shareholders' Equity for the nine months ended September 30, 2016 and 2015 (Unaudited) | 8 |\n| Consolidated Statements of Cash Flows for the nine months ended September 30, 2016 and 2015 (Unaudited) | 9 |\n| Notes to Consolidated Financial Statements (Unaudited) | 10 |\n| Note 1 - Basis of Presentation and Accounting Policies | 10 |\n| Note 2 - Segment Information | 12 |\n| Note 3 - Investments | 14 |\n| Note 4 - Fair Value Measurements | 22 |\n| Note 5 - Derivative Instruments | 32 |\n| Note 6 - Reserve for Losses and Loss Expenses | 35 |\n| Note 7 - Share-Based Compensation | 36 |\n| Note 8 - Earnings Per Common Share | 38 |\n| Note 9 - Shareholders' Equity | 39 |\n| Note 10 - Commitments and Contingencies | 40 |\n| Note 11 - Other Comprehensive Income (Loss) | 41 |\n| Note 12 - Subsequent Event | 42 |\n\n4\nAXIS CAPITAL HOLDINGS LIMITED\nCONSOLIDATED BALANCE SHEETS\nSEPTEMBER 30, 2016 (UNAUDITED) AND DECEMBER 31, 2015\n\n| 2016 | 2015 |\n| (in thousands) |\n| Assets |\n| Investments: |\n| Fixed maturities, available for sale, at fair value(Amortized cost 2016: $11,462,399; 2015: $11,897,639) | $ | 11,566,860 | $ | 11,719,749 |\n| Equity securities, available for sale, at fair value(Cost 2016: $600,604; 2015: $575,776) | 644,344 | 597,998 |\n| Mortgage loans, held for investment, at amortized cost and fair value | 332,753 | 206,277 |\n| Other investments, at fair value | 847,262 | 816,756 |\n| Equity method investments | 111,295 | 10,932 |\n| Short-term investments, at amortized cost and fair value | 39,877 | 34,406 |\n| Total investments | 13,542,391 | 13,386,118 |\n| Cash and cash equivalents | 848,200 | 988,133 |\n| Restricted cash and cash equivalents | 229,063 | 186,618 |\n| Accrued interest receivable | 71,096 | 73,729 |\n| Insurance and reinsurance premium balances receivable | 2,694,976 | 1,967,535 |\n| Reinsurance recoverable on unpaid and paid losses | 2,336,741 | 2,096,104 |\n| Deferred acquisition costs | 545,618 | 471,782 |\n| Prepaid reinsurance premiums | 582,551 | 396,201 |\n| Receivable for investments sold | 2,285 | 26,478 |\n| Goodwill and intangible assets | 85,501 | 86,858 |\n| Other assets | 283,969 | 302,335 |\n| Total assets | $ | 21,222,391 | $ | 19,981,891 |\n| Liabilities |\n| Reserve for losses and loss expenses | $ | 9,874,807 | $ | 9,646,285 |\n| Unearned premiums | 3,453,655 | 2,760,889 |\n| Insurance and reinsurance balances payable | 461,519 | 356,417 |\n| Senior notes | 992,633 | 991,825 |\n| Payable for investments purchased | 141,245 | 9,356 |\n| Other liabilities | 272,874 | 350,237 |\n| Total liabilities | 15,196,733 | 14,115,009 |\n| Shareholders’ equity |\n| Preferred shares | 625,000 | 627,843 |\n| Common shares (2016: 176,575; 2015: 176,240 shares issued and2016: 88,439; 2015: 96,066 shares outstanding) | 2,206 | 2,202 |\n| Additional paid-in capital | 2,307,866 | 2,241,388 |\n| Accumulated other comprehensive income (loss) | 98,505 | (188,465 | ) |\n| Retained earnings | 6,430,573 | 6,194,353 |\n| Treasury shares, at cost (2016: 88,136; 2015: 80,174 shares) | (3,438,492 | ) | (3,010,439 | ) |\n| Total shareholders’ equity | 6,025,658 | 5,866,882 |\n| Total liabilities and shareholders’ equity | $ | 21,222,391 | $ | 19,981,891 |\n\nSee accompanying notes to Consolidated Financial Statements.5\nAXIS CAPITAL HOLDINGS LIMITED\nCONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015\n| Three months ended | Nine months ended |\n| 2016 | 2015 | 2016 | 2015 |\n| (in thousands, except for per share amounts) |\n| Revenues |\n| Net premiums earned | $ | 934,415 | $ | 919,341 | $ | 2,783,746 | $ | 2,764,605 |\n| Net investment income | 116,923 | 45,685 | 257,818 | 226,336 |\n| Other insurance related income | 5,944 | 1,158 | 4,850 | 12,319 |\n| Termination fee received | — | 280,000 | — | 280,000 |\n| Net realized investment gains (losses): |\n| Other-than-temporary impairment (\"OTTI\") losses | (4,247 | ) | (32,301 | ) | (20,346 | ) | (62,762 | ) |\n| Other realized investment gains (losses) | 9,452 | (37,656 | ) | (19,949 | ) | (60,856 | ) |\n| Total net realized investment gains (losses) | 5,205 | (69,957 | ) | (40,295 | ) | (123,618 | ) |\n| Total revenues | 1,062,487 | 1,176,227 | 3,006,119 | 3,159,642 |\n| Expenses |\n| Net losses and loss expenses | 532,328 | 560,387 | 1,663,584 | 1,652,868 |\n| Acquisition costs | 189,810 | 182,744 | 559,570 | 537,549 |\n| General and administrative expenses | 142,906 | 144,727 | 439,554 | 456,451 |\n| Foreign exchange gains | (13,795 | ) | (28,088 | ) | (69,781 | ) | (69,200 | ) |\n| Interest expense and financing costs | 12,839 | 12,918 | 38,586 | 38,114 |\n| Reorganization and related expenses | — | 45,867 | — | 45,867 |\n| Total expenses | 864,088 | 918,555 | 2,631,513 | 2,661,649 |\n| Income before income taxes and interest in income (loss) of equity method investments | 198,399 | 257,672 | 374,606 | 497,993 |\n| Income tax expense | 9,352 | 30 | 7,712 | 1,155 |\n| Interest in loss of equity method investments | (2,434 | ) | — | (2,434 | ) | — |\n| Net income | 186,613 | 257,642 | 364,460 | 496,838 |\n| Preferred share dividends | 9,969 | 10,022 | 29,906 | 30,066 |\n| Net income available to common shareholders | $ | 176,644 | $ | 247,620 | $ | 334,554 | $ | 466,772 |\n| Per share data |\n| Net income per common share: |\n| Basic net income | $ | 1.97 | $ | 2.52 | $ | 3.64 | $ | 4.69 |\n| Diluted net income | $ | 1.96 | $ | 2.50 | $ | 3.61 | $ | 4.65 |\n| Weighted average number of common shares outstanding - basic | 89,621 | 98,226 | 91,852 | 99,464 |\n| Weighted average number of common shares outstanding - diluted | 90,351 | 99,124 | 92,579 | 100,468 |\n| Cash dividends declared per common share | $ | 0.35 | $ | 0.29 | $ | 1.05 | $ | 0.87 |\n\nSee accompanying notes to Consolidated Financial Statements.6\nAXIS CAPITAL HOLDINGS LIMITED\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015\n| Three months ended | Nine months ended |\n| 2016 | 2015 | 2016 | 2015 |\n| (in thousands) |\n| Net income | $ | 186,613 | $ | 257,642 | $ | 364,460 | $ | 496,838 |\n| Other comprehensive income (loss), net of tax: |\n| Available for sale investments: |\n| Unrealized investment gains (losses) arising during the period | 36,336 | (99,711 | ) | 238,656 | (176,938 | ) |\n| Adjustment for reclassification of net realized investment gains (losses) and OTTI losses recognized in net income | (2,642 | ) | 74,810 | 42,620 | 128,770 |\n| Unrealized investment gains (losses) arising during the period, net of reclassification adjustment | 33,694 | (24,901 | ) | 281,276 | (48,168 | ) |\n| Foreign currency translation adjustment | 1,722 | (14,626 | ) | 5,694 | (23,851 | ) |\n| Total other comprehensive income (loss), net of tax | 35,416 | (39,527 | ) | 286,970 | (72,019 | ) |\n| Comprehensive income | $ | 222,029 | $ | 218,115 | $ | 651,430 | $ | 424,819 |\n\nSee accompanying notes to Consolidated Financial Statements.7\nAXIS CAPITAL HOLDINGS LIMITED\nCONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (UNAUDITED)\nFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015\n| 2016 | 2015 |\n| (in thousands) |\n| Preferred shares |\n| Balance at beginning of period | $ | 627,843 | $ | 627,843 |\n| Shares repurchased | (2,843 | ) | — |\n| Balance at end of period | 625,000 | 627,843 |\n| Common shares (par value) |\n| Balance at beginning of period | 2,202 | 2,191 |\n| Shares issued | 4 | 11 |\n| Balance at end of period | 2,206 | 2,202 |\n| Additional paid-in capital |\n| Balance at beginning of period | 2,241,388 | 2,285,016 |\n| Shares issued - common shares | (4 | ) | 2,472 |\n| Cost of treasury shares reissued | (19,647 | ) | (17,674 | ) |\n| Settlement of accelerated share repurchase | 60,000 | (60,000 | ) |\n| Stock options exercised | — | 558 |\n| Share-based compensation expense | 26,129 | 19,906 |\n| Balance at end of period | 2,307,866 | 2,230,278 |\n| Accumulated other comprehensive income (loss) |\n| Balance at beginning of period | (188,465 | ) | (45,574 | ) |\n| Unrealized gains (losses) on available for sale investments, net of tax: |\n| Balance at beginning of period | (149,585 | ) | (28,192 | ) |\n| Unrealized gains (losses) arising during the period, net of reclassification adjustment | 281,276 | (48,168 | ) |\n| Non-credit portion of OTTI losses | — | — |\n| Balance at end of period | 131,691 | (76,360 | ) |\n| Cumulative foreign currency translation adjustments, net of tax: |\n| Balance at beginning of period | (38,880 | ) | (17,382 | ) |\n| Foreign currency translation adjustments | 5,694 | (23,851 | ) |\n| Balance at end of period | (33,186 | ) | (41,233 | ) |\n| Balance at end of period | 98,505 | (117,593 | ) |\n| Retained earnings |\n| Balance at beginning of period | 6,194,353 | 5,715,504 |\n| Net income | 364,460 | 496,838 |\n| Preferred share dividends | (29,906 | ) | (30,066 | ) |\n| Common share dividends | (98,334 | ) | (88,379 | ) |\n| Balance at end of period | 6,430,573 | 6,093,897 |\n| Treasury shares, at cost |\n| Balance at beginning of period | (3,010,439 | ) | (2,763,859 | ) |\n| Shares repurchased for treasury | (449,086 | ) | (264,076 | ) |\n| Cost of treasury shares reissued | 21,033 | 17,674 |\n| Balance at end of period | (3,438,492 | ) | (3,010,261 | ) |\n| Total shareholders’ equity | $ | 6,025,658 | $ | 5,826,366 |\n\nSee accompanying notes to Consolidated Financial Statements.8\nAXIS CAPITAL HOLDINGS LIMITED\nCONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)\nFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015\n| 2016 | 2015 |\n| (in thousands) |\n| Cash flows from operating activities: |\n| Net income | $ | 364,460 | $ | 496,838 |\n| Adjustments to reconcile net income to net cash provided by operating activities: |\n| Net realized investment losses | 40,295 | 123,618 |\n| Net realized and unrealized gains on other investments | (23,117 | ) | (17,616 | ) |\n| Amortization of fixed maturities | 51,660 | 75,645 |\n| Interest in loss of equity method investments | 2,434 | — |\n| Other amortization and depreciation | 17,370 | 26,219 |\n| Share-based compensation expense, net of cash payments | 28,580 | 25,435 |\n| Changes in: |\n| Accrued interest receivable | 3,286 | 7,128 |\n| Reinsurance recoverable balances | (163,212 | ) | (158,362 | ) |\n| Deferred acquisition costs | (73,759 | ) | (77,348 | ) |\n| Prepaid reinsurance premiums | (184,648 | ) | (69,016 | ) |\n| Reserve for loss and loss expenses | 216,828 | 212,066 |\n| Unearned premiums | 682,686 | 380,610 |\n| Insurance and reinsurance balances, net | (623,170 | ) | (330,128 | ) |\n| Other items | (74,383 | ) | 7,841 |\n| Net cash provided by operating activities | 265,310 | 702,930 |\n| Cash flows from investing activities: |\n| Purchases of: |\n| Fixed maturities | (6,624,573 | ) | (8,110,841 | ) |\n| Equity securities | (295,827 | ) | (240,415 | ) |\n| Mortgage loans | (131,087 | ) | (129,431 | ) |\n| Other investments | (177,500 | ) | (61,591 | ) |\n| Equity method investments | (103,548 | ) | — |\n| Short-term investments | (81,479 | ) | (34,147 | ) |\n| Proceeds from the sale of: |\n| Fixed maturities | 6,067,663 | 6,797,585 |\n| Equity securities | 296,182 | 112,794 |\n| Other investments | 170,111 | 244,353 |\n| Short-term investments | 67,408 | 112,694 |\n| Proceeds from redemption of fixed maturities | 977,852 | 1,107,175 |\n| Proceeds from redemption of short-term investments | 8,185 | 22,337 |\n| Proceeds from the repayment of mortgage loans | 4,808 | — |\n| Purchase of other assets | (19,055 | ) | (18,401 | ) |\n| Change in restricted cash and cash equivalents | (42,445 | ) | 27,996 |\n| Net cash provided by (used in) investing activities | 116,695 | (169,892 | ) |\n| Cash flows from financing activities: |\n| Repurchase of common shares | (389,086 | ) | (332,097 | ) |\n| Dividends paid - common shares | (100,670 | ) | (89,611 | ) |\n| Dividends paid - preferred shares | (29,940 | ) | (30,066 | ) |\n| Repurchase of preferred shares | (2,843 | ) | — |\n| Proceeds from issuance of common shares | 8 | 3,042 |\n| Net cash used in financing activities | (522,531 | ) | (448,732 | ) |\n| Effect of exchange rate changes on foreign currency cash and cash equivalents | 593 | (13,883 | ) |\n| Increase (decrease) in cash and cash equivalents | (139,933 | ) | 70,423 |\n| Cash and cash equivalents - beginning of period | 988,133 | 921,830 |\n| Cash and cash equivalents - end of period | $ | 848,200 | $ | 992,253 |\n\nSupplemental disclosures of cash flow information: Total consideration paid for a quota share and adverse development reinsurance cover was $170 million of which $92 million was settled by transfer of securities and was treated as a non cash activity on the Consolidated Statement of Cash Flows.\nSee accompanying notes to Consolidated Financial Statements.9\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)\n| 1. | BASIS OF PRESENTATION AND ACCOUNTING POLICIES |\n\nBasis of Presentation\nThese interim consolidated financial statements include the accounts of AXIS Capital Holdings Limited (“AXIS Capital”) and its subsidiaries (herein referred to as “we,” “us,” “our,” or the “Company”).\nThe consolidated balance sheet at September 30, 2016 and the consolidated statements of operations, comprehensive income, shareholders' equity and cash flows for the periods ended September 30, 2016 and 2015 have not been audited. The balance sheet at December 31, 2015 is derived from our audited financial statements.\nThese financial statements have been prepared in accordance with U.S. Generally Accepted Accounting Principles (“U.S. GAAP”) for interim financial information and with the Securities and Exchange Commission's (“SEC”) instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. In the opinion of management, these financial statements reflect all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of our financial position and results of operations for the periods presented. The results of operations for any interim period are not necessarily indicative of the results for a full year. All inter-company accounts and transactions have been eliminated.\nThe following information should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2015. Tabular dollar and share amounts are in thousands, except per share amounts. All amounts are reported in U.S. dollars. To facilitate comparison of information across periods, certain reclassifications have been made to prior year amounts to conform to the current year's presentation. These reclassifications did not impact our results of operations, financial condition or liquidity.\nSignificant Accounting Policies\nThere were no notable changes in our significant accounting policies subsequent to our Annual Report on Form 10-K for the year ended December 31, 2015, with the exception of the addition of accounting policies for equity method investments and retroactive accounting noted below.\nEquity Method Investments\nInvestments in which the Company has significant influence over the operating and financial policies of the investee are classified as equity method investments and are accounted for using the equity method of accounting. In applying the equity method of accounting, investments are initially recorded at cost and are subsequently adjusted based on the Company’s proportionate share of net income or loss of the investee. Adjustments are based on the most recently available financial information from the investee.Changes in the carrying value of such investments are recorded in net income as interest in income (loss) of equity method investments.\nRetroactive Reinsurance\nRetroactive reinsurance reimburses a ceding company for liabilities incurred as a result of past insurable events covered under contracts subject to the reinsurance. In certain instances, reinsurance contracts cover losses both on a prospective basis and on a retroactive basis and where practical the Company bifurcates the prospective and retrospective elements of these reinsurance contracts and accounts for each element separately. Initial gains in connection with retroactive reinsurance contracts are deferred and amortized into income over the settlement period while losses are recognized immediately. When changes in the estimated amount recoverable from the reinsurer or in the timing of receipts related to that amount occur, a cumulative amortization adjustment is recognized in earnings in the period of the change so that the deferred gain reflects the balance that would have existed had the revised estimate been available at the inception of the reinsurance transaction.\nNew Accounting Standards Adopted in 2016\nShare-Based Compensation\nEffective January 1, 2016, the Company adopted the Accounting Standards Update (\"ASU\") 2014-12, \"Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could be Achieved after the Requisite Service Period\" issued by the Financial Accounting Standards Board (the \"FASB\"). This guidance requires that compensation costs be recognized in the period in which it becomes probable that the performance target will be achieved and to represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered. This guidance was issued to clarify treatment where there was a divergence in accounting practice and its adoption did not impact our results of operations, financial condition or liquidity.\nDebt Issuance Costs\nEffective January 1, 2016, the Company adopted ASU 2015-03, \"Simplifying the Presentation of Debt Issuance Costs\" issued by the FASB. This guidance requires the debt issuance costs related to a recognized debt liability to be presented in the balance sheet as a direct deduction from the debt liability rather than as an asset. This guidance was issued to simplify the presentation of debt issuance costs and to resolve conflicting guidance. This guidance did not impact our results of operations, financial condition or liquidity.\nInvestments Measured Using The Net Asset Value Per Share (\"NAV\") Practical Expedient\nEffective January 1, 2016, the Company adopted ASU 2015-07, \"Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or its Equivalent)\" issued by the FASB. This guidance eliminated the requirement to categorize investments measured using the net asset value (\"NAV\") practical expedient in the fair value hierarchy table. As this new guidance related solely to disclosures, the adoption did not impact our results of operations, financial condition or liquidity. The updated disclosures have been provided in Note 4 'Fair Value Measurements'.\nRecently Issued Accounting Standards Not Yet Adopted\nLeases\nIn February 2016, the FASB issued guidance that provides a new comprehensive model for lease accounting. The guidance will require most leases to be recognized on the balance sheet by recording a right-of-use asset and a corresponding lease liability. This guidance is effective for reporting periods beginning after December 15, 2018, and interim periods within those fiscal years with early adoption permitted. The Company is currently evaluating the impact of this guidance on our results of operations, financial condition and liquidity.\nTransition To Equity Method Of Accounting\nIn March 2016, the FASB issued new guidance eliminating the requirement that an investor retrospectively apply equity method accounting when an existing investment qualifies for equity method accounting. The guidance is effective for annual periods beginning after December 15, 2016, and interim periods within those fiscal years with early adoption permitted. The guidance will be adopted on a prospective basis. The adoption of this guidance is not expected to materially impact our results of operations, financial condition or liquidity.\nShare-Based Compensation Accounting\nIn March 2016, the FASB issued new guidance that will change the accounting for certain aspects of share-based compensation payments to employees. The guidance will require all income tax effects of awards to be recognized in the income statement when the awards vest or are settled. The guidance will also allow employers to increase the amounts withheld to cover income taxes on\n10\n| 1. | BASIS OF PRESENTATION AND ACCOUNTING POLICIES (CONTINUED) |\n\nshare-based compensation awards without requiring liability classification. Additionally, companies will be required to elect whether they will account for award forfeitures by recognizing forfeitures only as they occur or by estimating the number of awards expected to be forfeited. This guidance is effective for annual periods beginning after December 15, 2016, and interim periods within those fiscal years with early adoption permitted. The Company is currently evaluating the impact of this guidance on our results of operations, financial condition and liquidity.\nCredit Losses\nIn June 2016, the FASB issued a new credit loss standard that changes the impairment model for most financial assets and certain other instruments. The guidance will replace the current \"incurred loss\" approach with a more forward looking \"expected loss\" model for instruments measured at amortized cost and will require entities to record allowances for available-for-sale debt securities rather than reduce the carrying amount. This guidance is effective for annual periods beginning after December 15, 2019, and interim periods within those fiscal years. Early adoption is permitted for annual periods beginning after December 15, 2018, and interim periods within those fiscal years. The Company is currently evaluating the impact of this guidance on our results of operations, financial condition and liquidity.\nCash Flows\nIn August 2016, the FASB issued new guidance to clarify how certain cash receipts and cash payments should be classified on the statement of cash flows. This guidance is effective for annual periods beginning after December 15, 2017, and interim periods within those fiscal years with early adoption permitted. The adoption of this guidance is not expected to impact our results of operations, financial condition or liquidity.\n11\n| 2. | SEGMENT INFORMATION |\n\nOur underwriting operations are organized around our global underwriting platforms, AXIS Insurance and AXIS Re. Therefore we have determined that we have two reportable segments, insurance and reinsurance. We do not allocate our assets by segment, with the exception of goodwill and intangible assets, as we evaluate the underwriting results of each segment separately from the results of our investment portfolio.\nThe following tables summarize the underwriting results of our reportable segments, as well as the carrying values of allocated goodwill and intangible assets:\n| 2016 | 2015 |\n| Three months ended and at September 30, | Insurance | Reinsurance | Total | Insurance | Reinsurance | Total |\n| Gross premiums written | $ | 675,430 | $ | 284,532 | $ | 959,962 | $ | 606,704 | $ | 329,879 | $ | 936,583 |\n| Net premiums written | 433,131 | 162,300 | 595,431 | 381,118 | 296,099 | 677,217 |\n| Net premiums earned | 444,691 | 489,724 | 934,415 | 444,550 | 474,791 | 919,341 |\n| Other insurance related income | 39 | 5,905 | 5,944 | 542 | 616 | 1,158 |\n| Net losses and loss expenses | (273,226 | ) | (259,102 | ) | (532,328 | ) | (283,272 | ) | (277,115 | ) | (560,387 | ) |\n| Acquisition costs | (61,755 | ) | (128,055 | ) | (189,810 | ) | (69,118 | ) | (113,626 | ) | (182,744 | ) |\n| General and administrative expenses | (84,588 | ) | (29,635 | ) | (114,223 | ) | (85,814 | ) | (35,309 | ) | (121,123 | ) |\n| Underwriting income | $ | 25,161 | $ | 78,837 | 103,998 | $ | 6,888 | $ | 49,357 | 56,245 |\n| Corporate expenses | (28,683 | ) | (23,604 | ) |\n| Net investment income | 116,923 | 45,685 |\n| Net realized investment gains (losses) | 5,205 | (69,957 | ) |\n| Foreign exchange gains | 13,795 | 28,088 |\n| Interest expense and financing costs | (12,839 | ) | (12,918 | ) |\n| Termination fee received | — | 280,000 |\n| Reorganization and related expenses | — | (45,867 | ) |\n| Income before income taxes and interest in income (loss) of equity method investments | $ | 198,399 | $ | 257,672 |\n| Net loss and loss expense ratio | 61.4 | % | 52.9 | % | 57.0 | % | 63.7 | % | 58.4 | % | 61.0 | % |\n| Acquisition cost ratio | 13.9 | % | 26.1 | % | 20.3 | % | 15.5 | % | 23.9 | % | 19.9 | % |\n| General and administrative expense ratio | 19.1 | % | 6.1 | % | 15.3 | % | 19.4 | % | 7.4 | % | 15.7 | % |\n| Combined ratio | 94.4 | % | 85.1 | % | 92.6 | % | 98.6 | % | 89.7 | % | 96.6 | % |\n| Goodwill and intangible assets | $ | 85,501 | $ | — | $ | 85,501 | $ | 87,329 | $ | — | $ | 87,329 |\n\n12\n| 2. | SEGMENT INFORMATION (CONTINUED) |\n\n| 2016 | 2015 |\n| Nine months ended and at September 30, | Insurance | Reinsurance | Total | Insurance | Reinsurance | Total |\n| Gross premiums written | $ | 2,112,796 | $ | 2,126,762 | $ | 4,239,558 | $ | 1,970,554 | $ | 1,833,374 | $ | 3,803,928 |\n| Net premiums written | 1,433,058 | 1,855,529 | 3,288,587 | 1,352,122 | 1,727,185 | 3,079,307 |\n| Net premiums earned | 1,322,649 | 1,461,097 | 2,783,746 | 1,344,339 | 1,420,266 | 2,764,605 |\n| Other insurance related income (loss) | (57 | ) | 4,907 | 4,850 | 811 | 11,508 | 12,319 |\n| Net losses and loss expenses | (853,771 | ) | (809,813 | ) | (1,663,584 | ) | (866,580 | ) | (786,288 | ) | (1,652,868 | ) |\n| Acquisition costs | (184,982 | ) | (374,588 | ) | (559,570 | ) | (200,493 | ) | (337,056 | ) | (537,549 | ) |\n| General and administrative expenses | (252,652 | ) | (99,980 | ) | (352,632 | ) | (261,924 | ) | (110,701 | ) | (372,625 | ) |\n| Underwriting income | $ | 31,187 | $ | 181,623 | 212,810 | $ | 16,153 | $ | 197,729 | 213,882 |\n| Corporate expenses | (86,922 | ) | (83,826 | ) |\n| Net investment income | 257,818 | 226,336 |\n| Net realized investment losses | (40,295 | ) | (123,618 | ) |\n| Foreign exchange gains | 69,781 | 69,200 |\n| Interest expense and financing costs | (38,586 | ) | (38,114 | ) |\n| Termination fee received | — | 280,000 |\n| Reorganization and related expenses | — | (45,867 | ) |\n| Income before income taxes and interest in income (loss) of equity method investments | $ | 374,606 | $ | 497,993 |\n| Net loss and loss expense ratio | 64.6 | % | 55.4 | % | 59.8 | % | 64.5 | % | 55.4 | % | 59.8 | % |\n| Acquisition cost ratio | 14.0 | % | 25.6 | % | 20.1 | % | 14.9 | % | 23.7 | % | 19.4 | % |\n| General and administrative expense ratio | 19.0 | % | 6.9 | % | 15.8 | % | 19.5 | % | 7.8 | % | 16.5 | % |\n| Combined ratio | 97.6 | % | 87.9 | % | 95.7 | % | 98.9 | % | 86.9 | % | 95.7 | % |\n| Goodwill and intangible assets | $ | 85,501 | $ | — | $ | 85,501 | $ | 87,329 | $ | — | $ | 87,329 |\n\n13\n| 3. | INVESTMENTS |\n\na) Fixed Maturities and Equities\nThe amortized cost or cost and fair values of our fixed maturities and equities were as follows:\n| AmortizedCost orCost | GrossUnrealizedGains | GrossUnrealizedLosses | FairValue | Non-creditOTTIin AOCI(5) |\n| At September 30, 2016 |\n| Fixed maturities |\n| U.S. government and agency | $ | 1,542,943 | $ | 22,349 | $ | (2,415 | ) | $ | 1,562,877 | $ | — |\n| Non-U.S. government | 620,601 | 4,799 | (43,344 | ) | 582,056 | — |\n| Corporate debt | 4,516,290 | 87,184 | (34,974 | ) | 4,568,500 | — |\n| Agency RMBS(1) | 2,473,832 | 49,661 | (762 | ) | 2,522,731 | — |\n| CMBS(2) | 877,732 | 18,546 | (2,003 | ) | 894,275 | — |\n| Non-Agency RMBS | 71,842 | 1,636 | (1,648 | ) | 71,830 | (870 | ) |\n| ABS(3) | 1,234,292 | 4,028 | (2,724 | ) | 1,235,596 | — |\n| Municipals(4) | 124,867 | 4,215 | (87 | ) | 128,995 | — |\n| Total fixed maturities | $ | 11,462,399 | $ | 192,418 | $ | (87,957 | ) | $ | 11,566,860 | $ | (870 | ) |\n| Equity securities |\n| Common stocks | $ | 379 | $ | 38 | $ | (348 | ) | $ | 69 |\n| Exchange-traded funds | 463,655 | 41,611 | (1,060 | ) | 504,206 |\n| Bond mutual funds | 136,570 | 3,499 | — | 140,069 |\n| Total equity securities | $ | 600,604 | $ | 45,148 | $ | (1,408 | ) | $ | 644,344 |\n| At December 31, 2015 |\n| Fixed maturities |\n| U.S. government and agency | $ | 1,673,617 | $ | 1,545 | $ | (23,213 | ) | $ | 1,651,949 | $ | — |\n| Non-U.S. government | 809,025 | 2,312 | (72,332 | ) | 739,005 | — |\n| Corporate debt | 4,442,315 | 16,740 | (96,286 | ) | 4,362,769 | — |\n| Agency RMBS(1) | 2,236,138 | 22,773 | (9,675 | ) | 2,249,236 | — |\n| CMBS(2) | 1,088,595 | 3,885 | (9,182 | ) | 1,083,298 | — |\n| Non-Agency RMBS | 99,989 | 1,992 | (973 | ) | 101,008 | (875 | ) |\n| ABS(3) | 1,387,919 | 952 | (17,601 | ) | 1,371,270 | — |\n| Municipals(4) | 160,041 | 2,319 | (1,146 | ) | 161,214 | — |\n| Total fixed maturities | $ | 11,897,639 | $ | 52,518 | $ | (230,408 | ) | $ | 11,719,749 | $ | (875 | ) |\n| Equity securities |\n| Common stocks | $ | — | $ | — | $ | — | $ | — |\n| Exchange-traded funds | 447,524 | 31,211 | (4,762 | ) | 473,973 |\n| Bond mutual funds | 128,252 | — | (4,227 | ) | 124,025 |\n| Total equity securities | $ | 575,776 | $ | 31,211 | $ | (8,989 | ) | $ | 597,998 |\n\n| (1) | Residential mortgage-backed securities (RMBS) originated by U.S. agencies. |\n\n| (2) | Commercial mortgage-backed securities (CMBS). |\n\n| (3) | Asset-backed securities (ABS) include debt tranched securities collateralized primarily by auto loans, student loans, credit cards, and other asset types. This asset class also includes collateralized loan obligations (CLOs) and collateralized debt obligations (CDOs). |\n\n| (4) | Municipals include bonds issued by states, municipalities and political subdivisions. |\n\n| (5) | Represents the non-credit component of the other-than-temporary impairment (OTTI) losses, adjusted for subsequent sales, maturities and redemptions. It does not include the change in fair value subsequent to the impairment measurement date. |\n\n14\n| 3. | INVESTMENTS (CONTINUED) |\n\nIn the normal course of investing activities, we actively manage allocations to non-controlling tranches of structured securities (variable interests) issued by VIEs. These structured securities include RMBS, CMBS and ABS and are included in the above table. Additionally, within our other investments portfolio, we also invest in limited partnerships (hedge funds, direct lending funds, real estate funds and private equity funds) and CLO equity tranched securities, which are all variable interests issued by VIEs (see Note 3(c)). For these variable interests, we do not have the power to direct the activities that are most significant to the economic performance of the VIEs therefore we are not the primary beneficiary of any of these VIEs. Our maximum exposure to loss on these interests is limited to the amount of our investment. We have not provided financial or other support with respect to these structured securities other than our original investment.\nContractual Maturities\nThe contractual maturities of fixed maturities are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.\n| AmortizedCost | FairValue | % of TotalFair Value |\n| At September 30, 2016 |\n| Maturity |\n| Due in one year or less | $ | 363,821 | $ | 356,706 | 3.0 | % |\n| Due after one year through five years | 3,809,515 | 3,801,104 | 32.9 | % |\n| Due after five years through ten years | 2,286,970 | 2,330,895 | 20.2 | % |\n| Due after ten years | 344,395 | 353,723 | 3.1 | % |\n| 6,804,701 | 6,842,428 | 59.2 | % |\n| Agency RMBS | 2,473,832 | 2,522,731 | 21.8 | % |\n| CMBS | 877,732 | 894,275 | 7.7 | % |\n| Non-Agency RMBS | 71,842 | 71,830 | 0.6 | % |\n| ABS | 1,234,292 | 1,235,596 | 10.7 | % |\n| Total | $ | 11,462,399 | $ | 11,566,860 | 100.0 | % |\n| At December 31, 2015 |\n| Maturity |\n| Due in one year or less | $ | 291,368 | $ | 289,571 | 2.5 | % |\n| Due after one year through five years | 4,217,515 | 4,142,802 | 35.3 | % |\n| Due after five years through ten years | 2,263,684 | 2,181,525 | 18.6 | % |\n| Due after ten years | 312,431 | 301,039 | 2.6 | % |\n| 7,084,998 | 6,914,937 | 59.0 | % |\n| Agency RMBS | 2,236,138 | 2,249,236 | 19.2 | % |\n| CMBS | 1,088,595 | 1,083,298 | 9.2 | % |\n| Non-Agency RMBS | 99,989 | 101,008 | 0.9 | % |\n| ABS | 1,387,919 | 1,371,270 | 11.7 | % |\n| Total | $ | 11,897,639 | $ | 11,719,749 | 100.0 | % |\n\n15\n| 3. | INVESTMENTS (CONTINUED) |\n\nGross Unrealized Losses\nThe following table summarizes fixed maturities and equities in an unrealized loss position and the aggregate fair value and gross unrealized loss by length of time the security has continuously been in an unrealized loss position:\n| 12 months or greater | Less than 12 months | Total |\n| FairValue | UnrealizedLosses | FairValue | UnrealizedLosses | FairValue | UnrealizedLosses |\n| At September 30, 2016 |\n| Fixed maturities |\n| U.S. government and agency | $ | 55,000 | $ | (1,635 | ) | $ | 422,681 | $ | (780 | ) | $ | 477,681 | $ | (2,415 | ) |\n| Non-U.S. government | 104,441 | (24,061 | ) | 254,694 | (19,283 | ) | 359,135 | (43,344 | ) |\n| Corporate debt | 285,848 | (26,202 | ) | 639,722 | (8,772 | ) | 925,570 | (34,974 | ) |\n| Agency RMBS | 80,375 | (556 | ) | 121,203 | (206 | ) | 201,578 | (762 | ) |\n| CMBS | 99,004 | (1,260 | ) | 173,795 | (743 | ) | 272,799 | (2,003 | ) |\n| Non-Agency RMBS | 10,184 | (1,306 | ) | 5,187 | (342 | ) | 15,371 | (1,648 | ) |\n| ABS | 518,647 | (2,253 | ) | 50,402 | (471 | ) | 569,049 | (2,724 | ) |\n| Municipals | 2,384 | (18 | ) | 15,567 | (69 | ) | 17,951 | (87 | ) |\n| Total fixed maturities | $ | 1,155,883 | $ | (57,291 | ) | $ | 1,683,251 | $ | (30,666 | ) | $ | 2,839,134 | $ | (87,957 | ) |\n| Equity securities |\n| Common stocks | $ | — | $ | — | $ | 31 | $ | (348 | ) | $ | 31 | $ | (348 | ) |\n| Exchange-traded funds | 6,153 | (425 | ) | 39,097 | (635 | ) | 45,250 | (1,060 | ) |\n| Bond mutual funds | — | — | — | — | — | — |\n| Total equity securities | $ | 6,153 | $ | (425 | ) | $ | 39,128 | $ | (983 | ) | $ | 45,281 | $ | (1,408 | ) |\n| At December 31, 2015 |\n| Fixed maturities |\n| U.S. government and agency | $ | 84,179 | $ | (7,622 | ) | $ | 1,474,202 | $ | (15,591 | ) | $ | 1,558,381 | $ | (23,213 | ) |\n| Non-U.S. government | 170,269 | (50,841 | ) | 317,693 | (21,491 | ) | 487,962 | (72,332 | ) |\n| Corporate debt | 340,831 | (33,441 | ) | 2,845,375 | (62,845 | ) | 3,186,206 | (96,286 | ) |\n| Agency RMBS | 64,792 | (1,609 | ) | 1,073,566 | (8,066 | ) | 1,138,358 | (9,675 | ) |\n| CMBS | 75,627 | (1,579 | ) | 659,480 | (7,603 | ) | 735,107 | (9,182 | ) |\n| Non-Agency RMBS | 5,283 | (210 | ) | 43,199 | (763 | ) | 48,482 | (973 | ) |\n| ABS | 562,599 | (11,158 | ) | 667,448 | (6,443 | ) | 1,230,047 | (17,601 | ) |\n| Municipals | 14,214 | (310 | ) | 64,104 | (836 | ) | 78,318 | (1,146 | ) |\n| Total fixed maturities | $ | 1,317,794 | $ | (106,770 | ) | $ | 7,145,067 | $ | (123,638 | ) | $ | 8,462,861 | $ | (230,408 | ) |\n| Equity securities |\n| Common stocks | $ | — | $ | — | $ | — | $ | — | $ | — | $ | — |\n| Exchange-traded funds | 2,331 | (313 | ) | 110,972 | (4,449 | ) | 113,303 | (4,762 | ) |\n| Bond mutual funds | — | — | 124,025 | (4,227 | ) | 124,025 | (4,227 | ) |\n| Total equity securities | $ | 2,331 | $ | (313 | ) | $ | 234,997 | $ | (8,676 | ) | $ | 237,328 | $ | (8,989 | ) |\n\n16\n| 3. | INVESTMENTS (CONTINUED) |\n\nFixed Maturities\nAt September 30, 2016, 935 fixed maturities (2015: 2,314) were in an unrealized loss position of $88 million (2015: $230 million), of which $13 million (2015: $39 million) was related to securities below investment grade or not rated.\nAt September 30, 2016, 399 (2015: 383) securities had been in a continuous unrealized loss position for 12 months or greater and had a fair value of $1,156 million (2015: $1,318 million). Following our credit impairment review, we concluded that these securities as well as the remaining securities in an unrealized loss position in the above table were temporarily impaired at September 30, 2016, and were expected to recover in value as the securities approach maturity. Further, at September 30, 2016, we did not intend to sell these securities in an unrealized loss position and it is more likely than not that we will not be required to sell these securities before the anticipated recovery of their amortized costs.\nEquity Securities\nAt September 30, 2016, 20 securities (2015: 35) were in an unrealized loss position of $1 million (2015: $9 million).\nAt September 30, 2016, 5 securities (2015: 1) were in a continuous unrealized loss position for 12 months or greater. Based on our impairment review process and our ability and intent to hold these securities for a reasonable period of time sufficient for a full recovery, we concluded that the above equities in an unrealized loss position were temporarily impaired at September 30, 2016.\nb) Mortgage Loans\n| September 30, 2016 | December 31, 2015 |\n| Carrying Value | % of Total | Carrying Value | % of Total |\n| Mortgage Loans held-for-investment: |\n| Commercial | $ | 332,753 | 100 | % | $ | 206,277 | 100 | % |\n| 332,753 | 100 | % | 206,277 | 100 | % |\n| Valuation allowances | — | — | % | — | — | % |\n| Total Mortgage Loans held-for-investment | $ | 332,753 | 100 | % | $ | 206,277 | 100 | % |\n\nFor commercial mortgage loans, the primary credit quality indicator is the debt service coverage ratio (which compares a property’s net operating income to amounts needed to service the principal and interest due under the loan, generally, the lower the debt service coverage ratio, the higher the risk of experiencing a credit loss) and the loan-to-value ratio (loan-to-value ratios compare the unpaid principal balance of the loan to the estimated fair value of the underlying collateral, generally, the higher the loan-to-value ratio, the higher the risk of experiencing a credit loss). The debt service coverage ratio and loan-to-value ratio, as well as the values utilized in calculating these ratios, are updated annually, on a rolling basis.\nWe have a high quality mortgage portfolio with debt service coverage ratios in excess of 1.1x and loan-to-value ratios of less than 70%; there are no credit losses associated with the commercial mortgage loans that we hold at September 30, 2016.\nThere are no past due amounts at September 30, 2016.\n17\n| 3. | INVESTMENTS (CONTINUED) |\n\nc) Other Investments\nThe following table provides a breakdown of our investments in hedge funds, direct lending funds, private equity funds, real estate funds, CLO Equities and other privately held investments, together with additional information relating to the liquidity of each category:\n| Fair Value | Redemption Frequency(if currently eligible) | Redemption Notice Period |\n| At September 30, 2016 |\n| Long/short equity funds | $ | 139,460 | 16 | % | Quarterly, Semi-annually, Annually | 45-60 days |\n| Multi-strategy funds | 281,153 | 33 | % | Quarterly, Semi-annually | 60-95 days |\n| Event-driven funds | 94,012 | 11 | % | Quarterly, Annually | 45-60 days |\n| Leveraged bank loan funds | — | — | % | n/a | n/a |\n| Direct lending funds | 125,002 | 15 | % | n/a | n/a |\n| Private equity funds | 89,170 | 11 | % | n/a | n/a |\n| Real estate funds | 11,782 | 1 | % | n/a | n/a |\n| CLO - Equities | 63,783 | 8 | % | n/a | n/a |\n| Other privately held investments | 42,900 | 5 | % | n/a | n/a |\n| Total other investments | $ | 847,262 | 100 | % |\n| At December 31, 2015 |\n| Long/short equity funds | $ | 154,348 | 19 | % | Quarterly, Semi-annually, Annually | 45-60 days |\n| Multi-strategy funds | 355,073 | 43 | % | Quarterly, Semi-annually | 60-95 days |\n| Event-driven funds | 147,287 | 18 | % | Quarterly, Annually | 45-60 days |\n| Leveraged bank loan funds | 65 | — | % | n/a | n/a |\n| Direct lending funds | 90,120 | 11 | % | n/a | n/a |\n| Private equity funds | — | — | % | n/a | n/a |\n| Real estate funds | 4,929 | 1 | % | n/a | n/a |\n| CLO - Equities | 64,934 | 8 | % | n/a | n/a |\n| Other privately held investments | — | — | % | n/a | n/a |\n| Total other investments | $ | 816,756 | 100 | % |\n\nn/a - not applicable\nThe investment strategies for the above funds are as follows:\n| • | Long/short equity funds: Seek to achieve attractive returns primarily by executing an equity trading strategy involving both long and short investments in publicly-traded equities. |\n\n| • | Multi-strategy funds: Seek to achieve above-market returns by pursuing multiple investment strategies to diversify risks and reduce volatility. This category includes funds of hedge funds which invest in a large pool of hedge funds across a diversified range of hedge fund strategies. |\n\n| • | Event-driven funds: Seek to achieve attractive returns by exploiting situations where announced or anticipated events create opportunities. |\n\n| • | Leveraged bank loan funds: Seek to achieve attractive returns by investing primarily in bank loan collateral that has limited interest rate risk exposure. |\n\n18\n| 3. | INVESTMENTS (CONTINUED) |\n\n| • | Direct lending funds: Seek to achieve attractive risk-adjusted returns, including current income generation, by investing in funds which provide financing directly to borrowers. |\n\n| • | Real estate funds: Seek to achieve attractive risk-adjusted returns by making and managing investments in real estate and real estate securities and businesses. |\n\n| • | Private equity funds: Seek to achieve attractive risk-adjusted returns by investing in private transactions over the course of several years. |\n\nTwo common redemption restrictions which may impact our ability to redeem our hedge funds are gates and lockups. A gate is a suspension of redemptions which may be implemented by the general partner or investment manager of the fund in order to defer, in whole or in part, the redemption request in the event the aggregate amount of redemption requests exceeds a predetermined percentage of the fund's net assets which may otherwise hinder the general partner or investment manager's ability to liquidate holdings in an orderly fashion in order to generate the cash necessary to fund extraordinarily large redemption payouts. A lockup period is the initial amount of time an investor is contractually required to hold the security before having the ability to redeem. During 2016 and 2015, neither of these restrictions impacted our redemption requests. At September 30, 2016, $87 million (2015: $66 million), representing 17% (2015: 10%) of our total hedge funds, relate to holdings where we are still within the lockup period. The expiration of these lockup periods range from September 2016 to March 2019.\nAt September 30, 2016, we have $189 million (2015: $222 million) of unfunded commitments within our other investments portfolio relating to our future investments in direct lending funds. Once the full amount of committed capital has been called by the General Partner of each of these funds, the assets will not be fully returned until the completion of the fund's investment term. These funds have investment terms ranging from 5-10 years and the General Partners of certain funds have the option to extend the term by up to three years.\nAt September 30, 2016, we have $12 million (2015: $12 million) of unfunded commitments as a limited partner in a multi-strategy hedge fund. Once the full amount of committed capital has been called by the General Partner, the assets will not be fully returned until the completion of the fund's investment term which ends in March, 2019. The General Partner then has the option to extend the term by up to three years.\nAt September 30, 2016, we have $90 million (2015: $95 million) of unfunded commitments as a limited partner in a fund which invests in real estate and real estate securities and businesses. The fund is subject to a three year commitment period and a total fund life of eight years during which time we are not eligible to redeem our investment.\nDuring 2016, we made a $135 million commitment as a limited partner in a private equity fund. At September 30, 2016, $40 million of our commitment remains unfunded and the current fair value of the funds called to date are included in the private equity funds line of the table above. The fund invests in underlying private equity funds and the life of the fund is subject to the dissolution of the underlying funds. We expect the overall holding period to be over ten years.\nDuring 2015, we made a $50 million commitment as a limited partner of a bank revolver opportunity fund. The fund is subject to an investment term of seven years and the General Partners have the option to extend the term by up to two years. At September 30, 2016, this commitment remains unfunded. It is not anticipated that the full amount of this fund will be drawn.\n19\n| 3. | INVESTMENTS (CONTINUED) |\n\nd) Equity Method Investments\nDuring 2016, we paid $104 million including direct transaction costs to acquire 18% of the common equity of Harrington Reinsurance Holdings Limited (\"Harrington\"), the parent company of Harrington Re Ltd. (\"Harrington Re\"), an independent reinsurance company jointly sponsored by AXIS Capital and The Blackstone Group L.P. (\"Blackstone\"). Through long-term service agreements, AXIS Capital will serve as Harrington Re's reinsurance underwriting manager and Blackstone will serve as exclusive investment management service provider. As an investor, we expect to benefit from underwriting profit generated by Harrington Re and the income and capital appreciation Blackstone seeks to deliver through its investment management services. In addition, we have entered into an arrangement with Blackstone under which underwriting and investment related fees will be shared equally. Harrington is not a variable interest entity and given that we exercise significant influence over this investee we account for our ownership in Harrington under the equity method of accounting. The Company's proportionate share of the underlying equity in net assets resulted in a basis difference of $5 million which represents initial transactions costs.\nThe Company also has investments in other equity method investments with a carrying value of $9 million.\ne) Net Investment Income\nNet investment income was derived from the following sources:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Fixed maturities | $ | 75,827 | $ | 75,980 | $ | 229,423 | $ | 220,066 |\n| Other investments | 38,248 | (27,421 | ) | 25,770 | 17,616 |\n| Equity securities | 4,633 | 3,445 | 12,843 | 7,795 |\n| Mortgage loans | 2,191 | 482 | 5,683 | 776 |\n| Cash and cash equivalents | 3,768 | 993 | 7,071 | 3,770 |\n| Short-term investments | 337 | 83 | 708 | 277 |\n| Gross investment income | 125,004 | 53,562 | 281,498 | 250,300 |\n| Investment expenses | (8,081 | ) | (7,877 | ) | (23,680 | ) | (23,964 | ) |\n| Net investment income | $ | 116,923 | $ | 45,685 | $ | 257,818 | $ | 226,336 |\n\n20\n| 3. | INVESTMENTS (CONTINUED) |\n\nf) Net Realized Investment Gains (Losses)\nThe following table provides an analysis of net realized investment gains (losses):\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Gross realized gains |\n| Fixed maturities and short-term investments | $ | 26,211 | $ | 12,126 | $ | 67,833 | $ | 44,853 |\n| Equities | 5,570 | 232 | 18,804 | 447 |\n| Gross realized gains | 31,781 | 12,358 | 86,637 | 45,300 |\n| Gross realized losses |\n| Fixed maturities and short-term investments | (21,908 | ) | (54,867 | ) | (90,702 | ) | (111,432 | ) |\n| Equities | (576 | ) | (1,559 | ) | (15,923 | ) | (1,952 | ) |\n| Gross realized losses | (22,484 | ) | (56,426 | ) | (106,625 | ) | (113,384 | ) |\n| Net OTTI recognized in earnings | (4,247 | ) | (32,301 | ) | (20,346 | ) | (62,762 | ) |\n| Change in fair value of investment derivatives(1) | 155 | 6,412 | 39 | 7,228 |\n| Net realized investment gains (losses) | $ | 5,205 | $ | (69,957 | ) | $ | (40,295 | ) | $ | (123,618 | ) |\n\n(1) Refer to Note 5 – Derivative Instruments\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Fixed maturities: |\n| Non-U.S. government | $ | 2,456 | $ | 1,295 | $ | 2,953 | $ | 2,717 |\n| Corporate debt | 1,791 | 20,587 | 14,833 | 38,396 |\n| Non-Agency RMBS | — | — | — | 4 |\n| ABS | — | 84 | — | 124 |\n| 4,247 | 21,966 | 17,786 | 41,241 |\n| Equity Securities |\n| Exchange-traded funds | — | 10,335 | 2,560 | 10,335 |\n| Bond mutual funds | — | — | — | 11,186 |\n| — | 10,335 | 2,560 | 21,521 |\n| Total OTTI recognized in earnings | $ | 4,247 | $ | 32,301 | $ | 20,346 | $ | 62,762 |\n\n21\n| 3. | INVESTMENTS (CONTINUED) |\n\nThe following table provides a roll forward of the credit losses, before income taxes, for which a portion of the OTTI was recognized in AOCI:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Balance at beginning of period | $ | 1,513 | $ | 1,564 | $ | 1,506 | $ | 1,531 |\n| Credit impairments recognized on securities not previously impaired | — | — | — | — |\n| Additional credit impairments recognized on securities previously impaired | — | — | 7 | 33 |\n| Change in timing of future cash flows on securities previously impaired | — | — | — | — |\n| Intent to sell of securities previously impaired | — | — | — | — |\n| Securities sold/redeemed/matured | (33 | ) | (43 | ) | (33 | ) | (43 | ) |\n| Balance at end of period | $ | 1,480 | $ | 1,521 | $ | 1,480 | $ | 1,521 |\n\ng) Reverse Repurchase Agreements\nAt September 30, 2016, we held $160 million (December 31, 2015: $30 million) of reverse repurchase agreements. These loans are fully collateralized, are generally outstanding for a short period of time and are presented on a gross basis as part of cash and cash equivalents on our consolidated balance sheet. The required collateral for these loans is either cash or U.S. Treasuries at a minimum rate of 102% of the loan principal. Upon maturity, we receive principal and interest income. We monitor the estimated fair value of the securities loaned and borrowed on a daily basis with additional collateral obtained as necessary throughout the duration of the transaction.\nFair Value Hierarchy\nFair value is defined as the price to sell an asset or transfer a liability (i.e. the “exit price”) in an orderly transaction between market participants. We use a fair value hierarchy that gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data. The level in the hierarchy within which a given fair value measurement falls is determined based on the lowest level input that is significant to the measurement. The hierarchy is broken down into three levels as follows:\n| • | Level 1 - Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that we have the ability to access. |\n\n| • | Level 2 - Valuations based on quoted prices in active markets for similar assets or liabilities, quoted prices for identical assets or liabilities in inactive markets, or for which significant inputs are observable (e.g. interest rates, yield curves, prepayment speeds, default rates, loss severities, etc.) or can be corroborated by observable market data. |\n\n| • | Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement. The unobservable inputs reflect our own judgments about assumptions that market participants might use. |\n\nThe availability of observable inputs can vary from financial instrument to financial instrument and is affected by a wide variety of factors including, for example, the type of financial instrument, whether the financial instrument is new and not yet established in the marketplace, and other characteristics particular to the transaction. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires significantly more judgment.\nAccordingly, the degree of judgment exercised by management in determining fair value is greatest for instruments categorized in Level 3. In periods of market dislocation, the observability of prices and inputs may be reduced for many instruments. This may lead us to change the selection of our valuation technique (from market to cash flow approach) or may cause us to use multiple valuation techniques to estimate the fair value of a financial instrument. This circumstance could cause an instrument to be reclassified between levels within the fair value hierarchy.\nWe used the following valuation techniques including significant inputs and assumptions in estimating the fair value of our financial instruments as well as the general classification of such financial instruments pursuant to the above fair value hierarchy.\nFixed Maturities\nAt each valuation date, we use the market approach valuation technique to estimate the fair value of our fixed maturities portfolio, when possible. This market approach includes, but is not limited to, prices obtained from third party pricing services for identical or comparable securities and the use of “pricing matrix models” using observable market inputs such as yield curves, credit risks and spreads, measures of volatility, and prepayment speeds. Pricing from third party pricing services is sourced from multiple vendors, when available, and we maintain a vendor hierarchy by asset type based on historical pricing experience and vendor expertise. When prices are unavailable from pricing services, we obtain non-binding quotes from broker-dealers who are active in the corresponding markets.\nThe valuation techniques including significant inputs generally used to determine the fair value of our fixed maturities by asset class as well as the classification in the fair value hierarchy are described in detail below.\nU.S. government and agency\nU.S. government and agency securities consist primarily of bonds issued by the U.S. Treasury and mortgage pass-through agencies such as the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation and the Government National Mortgage Association. As the fair values of U.S. Treasury securities are based on unadjusted market prices in active markets, these securities are classified within Level 1. The fair values of U.S. government agency securities are priced using the spread above the risk-free yield curve. As the yields for the risk-free yield curve and the spreads for these securities are observable market inputs, the fair values of U.S. government agency securities are classified within Level 2.\n22\n| 4. | FAIR VALUE MEASUREMENTS |\n\nNon-U.S. government\nNon-U.S. government securities comprise bonds issued by non-U.S. governments and their agencies along with supranational organizations (collectively also known as sovereign debt securities). The fair values of these securities are based on prices obtained from international indices or a valuation model which uses inputs including interest rate yield curves, cross-currency basis index spreads, and country credit spreads for structures similar to the sovereign bond in terms of issuer, maturity and seniority. As the significant inputs are observable market inputs, the fair value of non-U.S. government securities are classified within Level 2.\nCorporate debt\nCorporate debt securities consist primarily of investment-grade debt of a wide variety of corporate issuers and industries. The fair values of these securities are generally determined using the spread above the risk-free yield curve. These spreads are generally obtained from the new issue market, secondary trading and broker-dealer quotes. As these spreads and the yields for the risk-free yield curve are observable market inputs, the fair values of corporate debt securities are classified within Level 2. Where pricing is unavailable from pricing services, we obtain non-binding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. In this event, securities are classified within Level 3.\nAgency RMBS\nAgency RMBS securities consist of bonds issued by the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation and the Government National Mortgage Association. The fair values of these securities are priced using a mortgage pool specific model which uses daily inputs from the active to be announced market and the spread associated with each mortgage pool based on vintage. As the significant inputs are observable market inputs, the fair values of Agency RMBS securities are classified within Level 2.\nCMBS\nCMBS include mostly investment-grade bonds originated by non-agencies. The fair values of these securities are determined using a pricing model which uses dealer quotes and other available trade information along with security level characteristics to determine deal specific spreads. As the significant inputs are observable market inputs, the fair values of CMBS securities are classified within Level 2. Where pricing is unavailable from pricing services, we obtain non-binding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. In this event, securities are classified within Level 3.\nNon-Agency RMBS\nNon-Agency RMBS include mostly investment-grade bonds originated by non-agencies. The fair values of these securities are determined using an option adjusted spread model or other relevant models, which use inputs including available trade information or broker quotes, prepayment and default projections based on historical statistics of the underlying collateral and current market data. As the significant inputs are observable market inputs, the fair values of Non-Agency RMBS securities are classified within Level 2.\nABS\nABS include mostly investment-grade bonds backed by pools of loans with a variety of underlying collateral, including automobile loan receivables, student loans, credit card receivables, and CLO Debt originated by a variety of financial institutions. The fair values of ABS are priced using a model which uses prepayment speeds and spreads sourced primarily from the new issue market. As the significant inputs used to price ABS are observable market inputs, the fair values of ABS are classified within Level 2. Where pricing is unavailable from pricing services, we obtain non-binding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. In this event, securities are classified within Level 3.\n23\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\nMunicipals\nMunicipals comprise revenue and general obligation bonds issued by U.S. domiciled state and municipal entities. The fair values of these securities are determined using spreads obtained from broker-dealers, trade prices and the new issue market. As the significant inputs used to price the municipals are observable market inputs, municipals are classified within Level 2.\nEquity Securities\nEquity securities include common stocks, exchange-traded funds and bond mutual funds. As the fair values of common stocks and exchange-traded funds are based on unadjusted quoted market prices in active markets, these securities are classified within Level 1.\nAs bond mutual funds have daily liquidity with redemption based on the NAV of the funds, the fair values of these securities are classified within Level 2.\nOther Investments\nAt September 30, 2016, our investments in CLO - Equities were classified within Level 3 as we estimated the fair value for these securities using an income approach valuation technique (discounted cash flow model) due to the lack of observable and relevant trades in the secondary markets.\nOther privately held securities include convertible preferred shares, convertible notes and notes payable. In the reporting period of investment, the cost of these investments approximates fair value. In subsequent measurement periods, a discounted cash flow model is used to determine the fair value of these securities. These securities are classified within Level 3.\nShort-Term Investments\nShort-term investments primarily comprise highly liquid securities with maturities greater than three months but less than one year from the date of purchase. These securities are classified within Level 2 because these securities are typically not actively traded due to their approaching maturity and, as such, their amortized cost approximates fair value.\nDerivative Instruments\nOur foreign currency forward contracts, interest rate swaps and commodity contracts are customized to our economic hedging strategies and trade in the over-the-counter derivative market. We use the market approach valuation technique to estimate the fair value for these derivatives based on significant observable market inputs from third party pricing vendors, non-binding broker-dealer quotes and/or recent trading activity. Accordingly, we classified these derivatives within Level 2.\nWe also participate in non-exchange traded derivative-based risk management products addressing weather risks. We use observable market inputs and unobservable inputs in combination with industry or internally-developed valuation and forecasting techniques to determine fair value. We classify these instruments within Level 3.\nInsurance-linked Securities\nInsurance-linked securities comprise an investment in a catastrophe bond. We obtain non-binding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. These securities are classified within Level 3.\nCash Settled Awards\nCash settled awards comprise restricted stock units that form part of our compensation program. Although the fair value of these awards is determined using observable quoted market prices in active markets, the stock units themselves are not actively traded. Accordingly, we have classified these liabilities within Level 2.\n24\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\nThe tables below present the financial instruments measured at fair value on a recurring basis for the periods indicated:\n| Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | Fair value based on NAV practical expedient | Total Fair Value |\n| At September 30, 2016 |\n| Assets |\n| Fixed maturities |\n| U.S. government and agency | $ | 1,522,246 | $ | 40,631 | $ | — | $ | — | $ | 1,562,877 |\n| Non-U.S. government | — | 582,056 | — | — | 582,056 |\n| Corporate debt | — | 4,499,408 | 69,092 | — | 4,568,500 |\n| Agency RMBS | — | 2,522,731 | — | — | 2,522,731 |\n| CMBS | — | 885,355 | 8,920 | — | 894,275 |\n| Non-Agency RMBS | — | 71,830 | — | — | 71,830 |\n| ABS | — | 1,235,596 | — | — | 1,235,596 |\n| Municipals | — | 128,995 | — | — | 128,995 |\n| 1,522,246 | 9,966,602 | 78,012 | — | 11,566,860 |\n| Equity securities |\n| Common stocks | 69 | — | — | — | 69 |\n| Exchange-traded funds | 504,206 | — | — | — | 504,206 |\n| Bond mutual funds | — | 140,069 | — | — | 140,069 |\n| 504,275 | 140,069 | — | — | 644,344 |\n| Other investments |\n| Hedge funds | — | — | — | 514,625 | 514,625 |\n| Direct lending funds | — | — | — | 125,002 | 125,002 |\n| Private equity funds | — | — | — | 89,170 | 89,170 |\n| Real estate funds | — | — | — | 11,782 | 11,782 |\n| Other privately held investments | — | — | 42,900 | — | 42,900 |\n| CLO - Equities | — | — | 63,783 | — | 63,783 |\n| — | — | 106,683 | 740,579 | 847,262 |\n| Short-term investments | — | 39,877 | — | — | 39,877 |\n| Other assets |\n| Derivative instruments (see Note 5) | — | 4,469 | 2,488 | — | 6,957 |\n| Insurance-linked securities | — | — | 25,283 | — | 25,283 |\n| Total Assets | $ | 2,026,521 | $ | 10,151,017 | $ | 212,466 | $ | 740,579 | $ | 13,130,583 |\n| Liabilities |\n| Derivative instruments (see Note 5) | $ | — | $ | 4,411 | $ | 8,184 | $ | — | $ | 12,595 |\n| Cash settled awards (see Note 7) | — | 34,288 | — | — | 34,288 |\n| Total Liabilities | $ | — | $ | 38,699 | $ | 8,184 | $ | — | $ | 46,883 |\n\n25\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\n| Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | Fair value based on NAV practical expedient | Total Fair Value |\n| At December 31, 2015 |\n| Assets |\n| Fixed maturities |\n| U.S. government and agency | $ | 1,632,355 | $ | 19,594 | $ | — | $ | — | $ | 1,651,949 |\n| Non-U.S. government | — | 739,005 | — | — | 739,005 |\n| Corporate debt | — | 4,324,251 | 38,518 | — | 4,362,769 |\n| Agency RMBS | — | 2,249,236 | — | — | 2,249,236 |\n| CMBS | — | 1,072,376 | 10,922 | — | 1,083,298 |\n| Non-Agency RMBS | — | 101,008 | — | — | 101,008 |\n| ABS | — | 1,371,270 | — | — | 1,371,270 |\n| Municipals | — | 161,214 | — | — | 161,214 |\n| 1,632,355 | 10,037,954 | 49,440 | — | 11,719,749 |\n| Equity securities |\n| Common stocks | — | — | — | — | — |\n| Exchange-traded funds | 473,973 | — | — | — | 473,973 |\n| Bond mutual funds | — | 124,025 | — | — | 124,025 |\n| 473,973 | 124,025 | — | — | 597,998 |\n| Other investments |\n| Hedge funds | — | — | — | 656,773 | 656,773 |\n| Direct lending funds | — | — | — | 90,120 | 90,120 |\n| Private equity funds | — | — | — | — | — |\n| Real estate funds | — | — | — | 4,929 | 4,929 |\n| Other privately held investments | — | — | — | — | — |\n| CLO - Equities | — | — | 27,257 | 37,677 | 64,934 |\n| — | — | 27,257 | 789,499 | 816,756 |\n| Short-term investments | — | 34,406 | — | — | 34,406 |\n| Other assets |\n| Derivative instruments (see Note 5) | — | 2,072 | 4,395 | — | 6,467 |\n| Insurance-linked securities | — | — | 24,925 | — | 24,925 |\n| Total Assets | $ | 2,106,328 | $ | 10,198,457 | $ | 106,017 | $ | 789,499 | $ | 13,200,301 |\n| Liabilities |\n| Derivative instruments (see Note 5) | $ | — | $ | 7,692 | $ | 10,937 | $ | — | $ | 18,629 |\n| Cash settled awards (see Note 7) | — | 33,215 | — | — | 33,215 |\n| Total Liabilities | $ | — | $ | 40,907 | $ | 10,937 | $ | — | $ | 51,844 |\n\nDuring 2016 and 2015, there were no transfers between Levels 1 and 2.\n26\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\nExcept certain fixed maturities and insurance-linked securities priced using broker-dealer quotes (underlying inputs are not available), the following table quantifies the significant unobservable inputs we have used in estimating fair value at September 30, 2016 for our investments classified as Level 3 in the fair value hierarchy.\n| Fair Value | Valuation Technique | Unobservable Input | Range | Weighted Average |\n| Other investments - CLO - Equities | $ | 35,594 | Discounted cash flow | Default rates | 4.0% | 4.0% |\n| Loss severity rate | 35.0% - 53.5% | 35.4% |\n| Collateral spreads | 3.6% - 4.0% | 4.0% |\n| Estimated maturity dates | 2 - 6 years | 6 years |\n| 28,189 | Liquidation value | Fair value of collateral | 100% | 100% |\n| Discount margin | 0.1% - 19.1% | 2.4% |\n| Other investments - Other privately held investments | 42,900 | Discounted cash flow | Discount rate | 5.0% - 8.0% | 7.2% |\n| Derivatives - Weather derivatives, net | $ | (5,696 | ) | Simulation model | Weather curve | 1 - 2294(1) | n/a (2) |\n| Weather standard deviation | 1 - 1029(1) | n/a (2) |\n\n(1) Measured in Heating Degree Days (\"HDD\") which is the number of degrees the daily temperature is below a reference temperature. The cumulative HDD for the duration of the derivatives contract is compared to the strike value to determine the necessary settlement.\n| (2) | Due to the diversity of the portfolio, the range of unobservable inputs can be widespread; therefore, presentation of a weighted average is not useful. Weather parameters may include various temperature and/or precipitation measures that will naturally vary by geographic location of each counterparty's operations. |\n\nThe CLO - Equities market continues to be mostly inactive with only a small number of transactions being observed and fewer still involving transactions in our CLO - Equities. Accordingly, we use models to estimate the fair value of our investments in CLO - Equities. Given that all of our direct investments in CLO - Equities are past their reinvestment period, there is uncertainty over the remaining time to maturity. As such our direct investments in CLO - Equities are valued at the lower of the liquidation value and fair value based on an internally developed discounted cash flow model.\nThe liquidation valuation is based on the fair value of the net underlying collateral which is determined by applying market discount margins by credit quality bucket. An increase (decrease) in the market discount margin would result in a decrease (increase) in value of our CLO - Equities. Regarding the discounted cash flow model, the default and loss severity rates are the most judgmental unobservable market inputs to which the valuation of CLO - Equities is most sensitive. A significant increase (decrease) in either of these significant inputs in isolation would result in lower (higher) fair value estimates for direct investments in our CLO - Equities and, in general, a change in default rate assumptions will be accompanied by a directionally similar change in loss severity rate assumptions. Collateral spreads and estimated maturity dates are less judgmental inputs as they are based on the historical average of actual spreads and the weighted average life of the current underlying portfolios, respectively. A significant increase (decrease) in either of these significant inputs in isolation would result in higher (lower) fair value estimates for direct investments in our CLO - Equities. In general, these inputs have no significant interrelationship with each other or with default and loss severity rates.\nOn a quarterly basis, our valuation process for CLO - Equities includes a review of the underlying collateral along with related discount margins by credit quality bucket used in the liquidation valuation and a review of the underlying cash flows and key assumptions used in the discounted cash flow model. We review and update the above significant unobservable inputs based on information obtained from secondary markets, including information received from the managers of our CLO - Equities portfolio.\nIn order to assess the reasonableness of the inputs we use in our models, we maintain an understanding of current market conditions, historical results, as well as emerging trends that may impact future cash flows. In addition,we update the assumptions we use in our models through regular communication with industry participants and ongoing monitoring of the deals in which we participate (e.g. default and loss severity rate trends).\n27\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\nOther privately held securities are initially valued at cost which approximates fair value. In subsequent measurement periods, a discounted cash flow model is used to determine the fair value of these securities. These models include inputs specific to each investment. The inputs used in the fair value measurement include dividend or interest rates and a discount rate. The discount rate is judgmental and the most significant unobservable input used in the valuation of the other privately held securities. Significant increases (decreases) in this input in isolation could result in a significantly higher (lower) fair value measurement. In order to assess the reasonableness of the inputs we use in our models, we maintain an understanding of current market conditions, historical results, as well as investee specific information that may impact future cash flows.\nWeather derivatives relate to non-exchange traded risk management products addressing weather risks. We use observable market inputs and unobservable inputs in combination with industry or internally-developed valuation and forecasting techniques to determine fair value. The models may reference market price information for similar instruments. The pricing models are internally reviewed by Risk Management personnel prior to implementation and are reviewed periodically thereafter.\nObservable and unobservable inputs to these models vary by contract type but would typically include the following:\n| • | Observable inputs: market prices for similar instruments, notional price, option strike price, term to expiry, contractual limits; |\n\n| • | Unobservable inputs: correlation; and |\n\n| • | Both observable and unobservable inputs: weather curves, weather standard deviation. |\n\nIn general, weather curves are the most significant contributing input to fair value determination. Changes in this variable can result in higher or lower fair value depending on the underlying position. In addition, changes in any or all of the unobservable inputs identified above may contribute positively or negatively to overall portfolio value. The correlation input will quantify the interrelationship, if any, amongst the other variables.\n28\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\n| OpeningBalance | TransfersintoLevel 3 | Transfersout ofLevel 3 | Included inearnings (1) | Includedin OCI (2) | Purchases | Sales | Settlements/Distributions | ClosingBalance | Change inunrealizedinvestmentgain/(loss) (3) |\n| Three months ended September 30, 2016 |\n| Fixed maturities |\n| Corporate debt | $ | 62,022 | $ | — | $ | — | $ | (9 | ) | $ | 100 | $ | 7,563 | $ | — | $ | (584 | ) | $ | 69,092 | $ | — |\n| CMBS | 10,210 | — | — | — | (48 | ) | — | — | (1,242 | ) | 8,920 | — |\n| ABS | — | — | — | — | — | — | — | — | — | — |\n| 72,232 | — | — | (9 | ) | 52 | 7,563 | — | (1,826 | ) | 78,012 | — |\n| Other investments |\n| Other privately held investments | 41,755 | — | — | (355 | ) | — | 1,500 | — | — | 42,900 | (355 | ) |\n| CLO - Equities | 65,883 | — | — | 8,419 | — | — | — | (10,519 | ) | 63,783 | 8,419 |\n| 107,638 | — | — | 8,064 | — | 1,500 | — | (10,519 | ) | 106,683 | 8,064 |\n| Other assets |\n| Derivative instruments | 5 | — | — | 665 | — | 1,818 | — | — | 2,488 | 665 |\n| Insurance-linked securities | 25,025 | — | — | 258 | — | — | — | — | 25,283 | 258 |\n| 25,030 | — | — | 923 | — | 1,818 | — | — | 27,771 | 923 |\n| Total assets | $ | 204,900 | $ | — | $ | — | $ | 8,978 | $ | 52 | $ | 10,881 | $ | — | $ | (12,345 | ) | $ | 212,466 | $ | 8,987 |\n| Other liabilities |\n| Derivative instruments | $ | 1,978 | $ | — | $ | — | $ | (169 | ) | $ | — | $ | 6,384 | $ | — | $ | (9 | ) | $ | 8,184 | $ | 335 |\n| Total liabilities | $ | 1,978 | $ | — | $ | — | $ | (169 | ) | $ | — | $ | 6,384 | $ | — | $ | (9 | ) | $ | 8,184 | $ | 335 |\n| Nine months ended September 30, 2016 |\n| Fixed maturities |\n| Corporate debt | $ | 38,518 | $ | 20,412 | $ | (1,955 | ) | $ | (988 | ) | $ | 1,188 | $ | 17,107 | $ | (4,015 | ) | $ | (1,175 | ) | $ | 69,092 | $ | — |\n| CMBS | 10,922 | — | — | — | (134 | ) | — | — | (1,868 | ) | 8,920 | — |\n| ABS | — | — | — | — | — | — | — | — | — | — |\n| 49,440 | 20,412 | (1,955 | ) | (988 | ) | 1,054 | 17,107 | (4,015 | ) | (3,043 | ) | 78,012 | — |\n| Other investments |\n| Other privately held investments | — | — | — | (1,505 | ) | — | 44,405 | — | — | 42,900 | (1,505 | ) |\n| CLO - Equities | 27,257 | 36,378 | — | 17,431 | — | — | — | (17,283 | ) | 63,783 | 17,431 |\n| 27,257 | 36,378 | — | 15,926 | — | 44,405 | — | (17,283 | ) | 106,683 | 15,926 |\n| Other assets |\n| Derivative instruments | 4,395 | — | — | 3,255 | — | 3,623 | — | (8,785 | ) | 2,488 | 669 |\n| Insurance-linked securities | 24,925 | — | — | 358 | — | — | — | — | 25,283 | 358 |\n| 29,320 | — | — | 3,613 | — | 3,623 | — | (8,785 | ) | 27,771 | 1,027 |\n| Total assets | $ | 106,017 | $ | 56,790 | $ | (1,955 | ) | $ | 18,551 | $ | 1,054 | $ | 65,135 | $ | (4,015 | ) | $ | (29,111 | ) | $ | 212,466 | $ | 16,953 |\n| Other liabilities |\n| Derivative instruments | $ | 10,937 | $ | — | $ | — | $ | 2,445 | $ | — | $ | 7,189 | $ | — | $ | (12,387 | ) | $ | 8,184 | $ | 457 |\n| Total liabilities | $ | 10,937 | $ | — | $ | — | $ | 2,445 | $ | — | $ | 7,189 | $ | — | $ | (12,387 | ) | $ | 8,184 | $ | 457 |\n\n29\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\n| OpeningBalance | TransfersintoLevel 3 | Transfersout ofLevel 3 | Included inearnings (1) | Includedin OCI (2) | Purchases | Sales | Settlements/Distributions | ClosingBalance | Change inunrealizedinvestmentgain/(loss) (3) |\n| Three months ended September 30, 2015 |\n| Fixed maturities |\n| Corporate debt | $ | 43,008 | $ | — | $ | — | $ | (2 | ) | $ | 300 | $ | 22,821 | $ | — | $ | (4,403 | ) | $ | 61,724 | $ | — |\n| CMBS | 21,900 | — | (9,902 | ) | — | (219 | ) | — | — | (461 | ) | 11,318 | — |\n| ABS | 110 | — | — | — | — | — | — | (3 | ) | 107 | — |\n| 65,018 | — | (9,902 | ) | (2 | ) | 81 | 22,821 | — | (4,867 | ) | 73,149 | — |\n| Other investments |\n| Other privately held investments | — | — | — | — | — | — | — | — | — | — |\n| CLO - Equities | 36,921 | — | — | 1,192 | — | — | — | (3,118 | ) | 34,995 | 1,192 |\n| 36,921 | — | — | 1,192 | — | — | — | (3,118 | ) | 34,995 | 1,192 |\n| Other assets |\n| Derivative instruments | 240 | — | — | 35 | — | — | — | (240 | ) | 35 | 35 |\n| Insurance-linked securities | 24,837 | — | — | 175 | — | — | — | — | 25,012 | 175 |\n| 25,077 | — | — | 210 | — | — | — | (240 | ) | 25,047 | 210 |\n| Total assets | $ | 127,016 | $ | — | $ | (9,902 | ) | $ | 1,400 | $ | 81 | $ | 22,821 | $ | — | $ | (8,225 | ) | $ | 133,191 | $ | 1,402 |\n| Other liabilities |\n| Derivative instruments | $ | 818 | $ | — | $ | — | $ | (331 | ) | $ | — | $ | 6,475 | $ | — | $ | — | $ | 6,962 | $ | (331 | ) |\n| Total liabilities | $ | 818 | $ | — | $ | — | $ | (331 | ) | $ | — | $ | 6,475 | $ | — | $ | — | $ | 6,962 | $ | (331 | ) |\n| Nine months ended September 30, 2015 |\n| Fixed maturities |\n| Corporate debt | $ | 15,837 | $ | — | $ | — | $ | (2 | ) | $ | 724 | $ | 54,445 | $ | — | $ | (9,280 | ) | $ | 61,724 | $ | — |\n| CMBS | 17,763 | 5,072 | (9,902 | ) | — | (543 | ) | — | — | (1,072 | ) | 11,318 | — |\n| ABS | 40,031 | — | (39,851 | ) | — | 105 | — | — | (178 | ) | 107 | — |\n| 73,631 | 5,072 | (49,753 | ) | (2 | ) | 286 | 54,445 | — | (10,530 | ) | 73,149 | — |\n| Other investments |\n| Other privately held investments | — | — | — | — | — | — | — | — | — | — |\n| CLO - Equities | 37,046 | — | — | 7,930 | — | — | — | (9,981 | ) | 34,995 | 7,930 |\n| 37,046 | — | — | 7,930 | — | — | — | (9,981 | ) | 34,995 | 7,930 |\n| Other assets |\n| Derivative instruments | 111 | — | — | (792 | ) | — | — | — | 716 | 35 | 35 |\n| Insurance-linked securities | — | — | — | 12 | — | 25,000 | — | — | 25,012 | 12 |\n| 111 | — | — | (780 | ) | — | 25,000 | — | 716 | 25,047 | 47 |\n| Total assets | $ | 110,788 | $ | 5,072 | $ | (49,753 | ) | $ | 7,148 | $ | 286 | $ | 79,445 | $ | — | $ | (19,795 | ) | $ | 133,191 | $ | 7,977 |\n| Other liabilities |\n| Derivative instruments | $ | 15,288 | $ | — | $ | — | $ | (12,053 | ) | $ | — | $ | 8,698 | $ | — | $ | (4,971 | ) | $ | 6,962 | $ | (318 | ) |\n| Total liabilities | $ | 15,288 | $ | — | $ | — | $ | (12,053 | ) | $ | — | $ | 8,698 | $ | — | $ | (4,971 | ) | $ | 6,962 | $ | (318 | ) |\n\n| (1) | Gains and losses included in earnings on fixed maturities are included in net realized investment gains (losses). Gains and (losses) included in earnings on other investments are included in net investment income. Gains (losses) on weather derivatives included in earnings are included in other insurance-related income. |\n\n| (2) | Gains and losses included in other comprehensive income (“OCI”) on fixed maturities are included in unrealized gains (losses) arising during the period. |\n\n| (3) | Change in unrealized investment gain (loss) relating to assets held at the reporting date. |\n\nThe transfers into and out of fair value hierarchy levels reflect the fair value of the securities at the end of the reporting period.\n30\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\nTransfers into Level 3 from Level 2\nThere were no transfers to Level 3 from Level 2 made during the three months ended September 30, 2016 and 2015.\nThe transfers to Level 3 from Level 2 made during the nine months ended September 30, 2016 were primarily due to the lack of observable market inputs and multiple quotes from pricing vendors and broker-dealers for certain fixed maturities and as the result of a change in valuation methodology relating to our CLO equity fund. An income approach valuation technique (discounted cash flow model) is used to estimate fair value at September 30, 2016. As the NAV practical expedient is no longer used the CLO equity fund is now categorized within the fair value hierarchy.\nThe transfers to Level 3 from Level 2 made during the nine months ended September 30, 2015 were primarily due to the lack of observable market inputs and multiple quotes from pricing vendors and broker-dealers for certain fixed maturities.\nTransfers out of Level 3 into Level 2\nThere were no transfers to Level 2 from Level 3 made during the three months ended September 30, 2016. The transfers to Level 2 from Level 3 made during the nine months ended September 30, 2016 were primarily due to the availability of observable market\ninputs and quotes from pricing vendors on certain fixed maturities.\nThe transfers to Level 2 from Level 3 made during the three and nine months ended September 30, 2015 were primarily due to the availability of observable market inputs and quotes from pricing vendors on certain fixed maturities and CLO Debt securities.\nMeasuring the Fair Value of Other Investments Using Net Asset Valuations\nAs a practical expedient, we estimate fair values for hedge funds, direct lending funds, private equity funds and real estate funds using NAVs as advised by external fund managers or third party administrators. For each of these funds, the NAV is based on the manager's or administrator's valuation of the underlying holdings in accordance with the fund's governing documents and in accordance with U.S. GAAP.\nIf there is a reporting lag between the current period end and reporting date of the latest available fund valuation for any hedge fund, we estimate the change in fair value by starting with the most recently available fund valuation and adjusting for return estimates as well as any subscriptions, redemptions and distributions that took place during the current period. Return estimates are obtained from the relevant fund managers. Accordingly, we do not typically have a reporting lag in our fair value measurements for these funds. Historically, our valuation estimates incorporating these return estimates have not significantly diverged from the subsequently received NAVs.\nFor private equity funds, direct lending funds and the real estate fund, valuation statements are typically released on a three month reporting lag therefore the Company estimates fair value of these funds by starting with the prior quarter-end fund valuations and adjusting for capital calls, redemptions, drawdowns and distributions. Return estimates are not available from the relevant fund managers for these funds. Accordingly, we typically have a reporting lag in our fair value measurements for these funds.\nThe Company often does not have access to financial information relating to the underlying securities held within the funds, therefore management is unable to corroborate the fair values placed on the securities underlying the asset valuations provided by the fund manager or fund administrator. To address this, on a quarterly basis, we perform a number of monitoring procedures to assess the quality of the information provided by managers and administrators. These procedures include, but are not limited to, regular review and discussion of each fund's performance with its manager, regular evaluation of fund performance against applicable benchmarks and the backtesting of our fair value estimates against subsequently received NAVs. Backtesting involves comparing our previously reported values for each individual fund against NAVs per audited financial statements (for year-end values) and final NAVs from fund managers and fund administrators (for interim values).\nThe fair value of our hedge funds, direct lending funds, private equity funds and real estate funds are measured using the NAV practical expedient and therefore have not been categorized with the fair value hierarchy.\n31\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\nFinancial Instruments Not Carried at Fair Value\nU.S. GAAP guidance over disclosures about the fair value of financial instruments are also applicable to financial instruments not carried at fair value, except for certain financial instruments, including insurance contracts.\nThe carrying values of cash equivalents (including restricted amounts), accrued investment income, receivable for investments sold, certain other assets, payable for investments purchased and certain other liabilities approximated their fair values at September 30, 2016, due to their respective short maturities. As these financial instruments are not actively traded, their respective fair values are classified within Level 2.\nThe carrying value of mortgage loans held-for-investment approximated their fair value at September 30, 2016, as the loans are within their first two years of issue. The estimated fair value of mortgage loans is primarily determined by estimating expected future cash flows and discounting them using current interest rates for similar mortgage loans with similar credit risk, or is determined from pricing for similar loans. As mortgage loans are not actively traded, their respective fair values are classified within Level 3.\nAt September 30, 2016, our senior notes are recorded at amortized cost with a carrying value of $993 million (2015: $992 million) and have a fair value of $1,083 million (2015: $1,058 million). The fair values of these securities were obtained from a third party pricing service and pricing was based on the spread above the risk-free yield curve. These spreads are generally obtained from the new issue market, secondary trading and broker-dealer quotes. As these spreads and the yields for the risk-free yield curve are observable market inputs, the fair values of our senior notes are classified within Level 2.\n| 5. | DERIVATIVE INSTRUMENTS |\n\nThe following table summarizes the balance sheet classification of derivatives recorded at fair values. The notional amount of derivative contracts represents the basis upon which pay or receive amounts are calculated and is presented in the table to quantify the volume of our derivative activities. Notional amounts are not reflective of credit risk.\nNone of our derivative instruments are designated as hedges under current accounting guidance.\n| September 30, 2016 | December 31, 2015 |\n| DerivativeNotionalAmount | DerivativeAssetFairValue(1) | DerivativeLiabilityFairValue(1) | DerivativeNotionalAmount | DerivativeAssetFairValue(1) | DerivativeLiabilityFairValue(1) |\n| Relating to investment portfolio: |\n| Foreign exchange forward contracts | $ | 40,367 | $ | 279 | $ | 17 | $ | 198,406 | $ | 490 | $ | 837 |\n| Interest rate swaps | — | — | — | — | — | — |\n| Relating to underwriting portfolio: |\n| Foreign exchange forward contracts | 560,477 | 25 | 4,394 | 692,023 | 1,582 | 6,855 |\n| Weather-related contracts | 59,436 | 2,488 | 8,184 | 51,395 | 4,395 | 10,937 |\n| Commodity contracts | 181,000 | 4,165 | — | — | — | — |\n| Total derivatives | $ | 6,957 | $ | 12,595 | $ | 6,467 | $ | 18,629 |\n\n| (1) | Asset and liability derivatives are classified within other assets and other liabilities in the Consolidated Balance Sheets. |\n\n32\n| 5. | DERIVATIVE INSTRUMENTS (CONTINUED) |\n\nOffsetting Assets and Liabilities\nOur derivative instruments are generally traded under International Swaps and Derivatives Association master netting agreements, which establish terms that apply to all transactions. In the event of a bankruptcy or other stipulated event, master netting agreements provide that individual positions be replaced with a new amount, usually referred to as the termination amount, determined by taking into account market prices and converting into a single currency. Effectively, this contractual close-out netting reduces credit exposure from gross to net exposure. The table below presents a reconciliation of our gross derivative assets and liabilities to the net amounts presented in our Consolidated Balance Sheets, with the difference being attributable to the impact of master netting agreements.\n| September 30, 2016 | December 31, 2015 |\n| Gross Amounts | Gross Amounts Offset | NetAmounts(1) | Gross Amounts | Gross Amounts Offset | NetAmounts(1) |\n| Derivative assets | $ | 9,370 | $ | (2,413 | ) | $ | 6,957 | $ | 14,336 | $ | (7,869 | ) | $ | 6,467 |\n| Derivative liabilities | $ | 15,008 | $ | (2,413 | ) | $ | 12,595 | $ | 26,498 | $ | (7,869 | ) | $ | 18,629 |\n\n| (1) | Net asset and liability derivatives are classified within other assets and other liabilities in the Consolidated Balance Sheets. |\n\nRefer to Note 3 - Investments for information on reverse repurchase agreements.\nDerivative Instruments not Designated as Hedging Instruments\na) Relating to Investment Portfolio\nForeign Currency Risk\nWithin our investment portfolio we are exposed to foreign currency risk. Accordingly, the fair values for our investment portfolio are partially influenced by the change in foreign exchange rates. We may enter into foreign exchange forward contracts to manage the effect of this foreign currency risk. These foreign currency hedging activities are not designated as specific hedges for financial reporting purposes.\nInterest Rate Risk\nOur investment portfolio contains a large percentage of fixed maturities which exposes us to significant interest rate risk. As part of our overall management of this risk, we may use interest rate swaps.\nb) Relating to Underwriting Portfolio\nForeign Currency Risk\nOur (re)insurance subsidiaries and branches operate in various foreign countries. Consequently, some of our business is written in currencies other than the U.S. dollar and, therefore, our underwriting portfolio is exposed to significant foreign currency risk. We manage foreign currency risk by seeking to match our foreign-denominated net liabilities under (re)insurance contracts with cash and investments that are denominated in such currencies. We may also use derivative instruments, specifically forward contracts and currency options, to economically hedge foreign currency exposures.\n33\n| 5. | DERIVATIVE INSTRUMENTS (CONTINUED) |\n\nWeather Risk\nWe write derivative-based risk management products designed to address weather risks with the objective of generating profits on a portfolio basis. The majority of this business consists of receiving a payment at contract inception in exchange for bearing the risk of variations in a quantifiable weather-related phenomenon, such as temperature. Where a client wishes to minimize the upfront payment, these transactions may be structured as swaps or collars. In general, our portfolio of such derivative contracts is of short duration, with contracts being predominantly seasonal in nature. In order to economically hedge a portion of this portfolio, we may also purchase weather derivatives.\nCommodity Risk\nWithin our (re)insurance portfolio we are exposed to commodity price risk. We may hedge a portion of this price risk by entering into commodity derivative contracts.\nThe total unrealized and realized gains (losses) recognized in earnings for derivatives not designated as hedges were as follows:\n| Location of Gain (Loss) Recognized in Income on Derivative | Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Derivatives not designated as hedging instruments |\n| Relating to investment portfolio: |\n| Foreign exchange forward contracts | Net realized investment gains (losses) | $ | 155 | $ | 6,412 | $ | 39 | $ | 11,234 |\n| Interest rate swaps | Net realized investment gains (losses) | — | — | — | (4,006 | ) |\n| Relating to underwriting portfolio: |\n| Foreign exchange forward contracts | Foreign exchange losses (gains) | (182 | ) | (5,210 | ) | (2,958 | ) | (21,494 | ) |\n| Weather-related contracts | Other insurance related income (losses) | 833 | 307 | 809 | 11,274 |\n| Commodity contracts | Other insurance related income (losses) | 1,799 | (33 | ) | 1,499 | (923 | ) |\n| Total | $ | 2,605 | $ | 1,476 | $ | (611 | ) | $ | (3,915 | ) |\n\n34\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)6. RESERVE FOR LOSSES AND LOSS EXPENSES\nThe following table presents a reconciliation of our beginning and ending gross reserve for losses and loss expenses and net reserve for unpaid losses and loss expenses for the periods indicated:\n| Nine months ended September 30, | 2016 | 2015 |\n| Gross reserve for losses and loss expenses, beginning of period | $ | 9,646,285 | $ | 9,596,797 |\n| Less reinsurance recoverable on unpaid losses, beginning of period | (2,031,309 | ) | (1,890,280 | ) |\n| Net reserve for unpaid losses and loss expenses, beginning of period | 7,614,976 | 7,706,517 |\n| Net incurred losses and loss expenses related to: |\n| Current year | 1,887,715 | 1,818,672 |\n| Prior years | (224,131 | ) | (165,804 | ) |\n| 1,663,584 | 1,652,868 |\n| Net paid losses and loss expenses related to: |\n| Current year | (233,124 | ) | (185,953 | ) |\n| Prior years | (1,334,772 | ) | (1,293,776 | ) |\n| (1,567,896 | ) | (1,479,729 | ) |\n| Foreign exchange and other | (112,649 | ) | (183,360 | ) |\n| Net reserve for unpaid losses and loss expenses, end of period | 7,598,015 | 7,696,296 |\n| Reinsurance recoverable on unpaid losses, end of period | 2,276,792 | 2,007,287 |\n| Gross reserve for losses and loss expenses, end of period | $ | 9,874,807 | $ | 9,703,583 |\n\nWe write business with loss experience generally characterized as low frequency and high severity in nature, which can result\nin volatility in our financial results. During the nine months ended September 30, 2016 and 2015, we recognized aggregate net losses and loss expenses, net of reinstatement premiums of $145 million and $90 million, respectively, in relation to catastrophe and weather-related events.\nDuring April 2016, the Company entered into a quota share and adverse development cover reinsurance agreement, a retroactive contract which was deemed to have met the established criteria for retroactive reinsurance accounting. Foreign exchange and other includes reinsurance recoverables of $159 million related to this reinsurance agreement.\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Insurance | $ | 20,688 | $ | 2,444 | $ | 43,181 | $ | 21,225 |\n| Reinsurance | 55,331 | 42,681 | 180,950 | 144,579 |\n| Total | $ | 76,019 | $ | 45,125 | $ | 224,131 | $ | 165,804 |\n\nThe majority of the net favorable prior year reserve development in each period related to short-tail reserve classes. Net favorable prior year reserve development for professional, reinsurance liability and motor reserve classes also contributed in the three and nine months ended September 30, 2016.\n35\n| 6. | RESERVE FOR LOSSES AND LOSS EXPENSES (CONTINUED) |\n\nOur short tail business includes the underlying exposures in the property and other, marine and aviation reserving classes within our insurance segment and the property and other reserving class within our reinsurance segment. Development from these classes contributed $41 million and $38 million of the total net favorable prior year reserve development for the three months ended September 30, 2016 and 2015, respectively. For the nine months ended September 30, 2016 and 2015, these short-tail lines contributed $116 million and $112 million, respectively, of net favorable prior year reserve development. The net favorable prior year reserve development for these classes primarily reflected the recognition of better than expected loss emergence.\nOur medium-tail business consists primarily of professional insurance and reinsurance reserve classes, credit and political risk insurance reserve class and the credit and surety reinsurance reserve class. In the three and nine months ended September 30, 2016, the professional reserve classes contributed net favorable prior year reserve development of $12 million and $28 million, respectively. In the nine months ended September 30, 2015, the reinsurance professional reserve class contributed $25 million of net favorable development. The net favorable prior year development on these reserve classes continued to reflect the generally favorable experience on earlier accident years as we continued to transition to more experience based methods on these years. As our loss experience has generally been better than expected, this resulted in the recognition of net favorable prior year reserve development. In the three and nine months ended September 30, 2015, the insurance professional reserve class recorded net adverse prior year reserve development of $15 million and $16 million, respectively. This adverse development was primarily the result of strengthening in our Australian book of business during the third quarter of 2015.\nIn the three and nine months ended September 30, 2015, the credit and surety reserve class recorded net favorable prior year reserve development of $7 million and $19 million, respectively. This net favorable prior year reserve development reflected the recognition of generally better than expected loss emergence.\nIn the nine months ended September 30, 2015, we recorded net adverse prior year reserve development of $15 million in our credit and political risk reserve class relating to an increase in our loss portfolio estimates.\nOur long-tail business consists primarily of liability and motor reserve classes. Our motor and liability reinsurance reserve classes contributed additional net favorable prior year reserve development of $17 million and $20 million in the three months ended September 30, 2016 and 2015, respectively. For the nine months ended September 30, 2016 and 2015, these long-tail reserve classes contributed $72 million and $64 million, respectively. The net favorable prior year reserve development for the motor reserve class related to favorable loss emergence trends on several classes of business spanning multiple accident years. The net favorable prior year reserve development for the liability reinsurance reserve class primarily reflected the progressively increased weight given by management to experience based indications on older accident years, which has generally been favorable. In the three and nine months ended September 30, 2015, we recorded net adverse prior year reserve development of $6 million and $23 million, respectively, in our insurance liability reserve class related primarily to an increase in loss estimates for specific individual claim reserves, as well as a higher frequency of large auto liability claims.\nOur September 30, 2016 net reserves for losses and loss expenses includes estimated amounts for numerous catastrophe events. We caution that the magnitude and/or complexity of losses arising from certain of these events, in particular the Fort McMurray wildfires, Storm Sandy, the 2011 Japanese earthquake and tsunami, the three New Zealand earthquakes and the Tianjin port explosion, inherently increases the level of uncertainty and, therefore, the level of management judgment involved in arriving at our estimated net reserves for losses and loss expenses. As a result, our actual losses for these events may ultimately differ materially from our current estimates.\n| 7. | SHARE-BASED COMPENSATION |\n\nFor the three months ended September 30, 2016, we incurred share-based compensation costs of $14 million (2015: $11 million) and recorded associated tax benefits of $3 million (2015: $3 million). For the nine months ended September 30, 2016, we incurred share-based compensation costs of $50 million (2015: $41 million) and recorded associated tax benefits of $11 million (2015: $11 million).\nThe total fair value of restricted stock, restricted stock units and cash settled awards vested during the nine months ended September 30, 2016 was $66 million (2015: $73 million). At September 30, 2016 there were $104 million of unrecognized compensation costs, which are expected to be recognized over the weighted average period of 2.4 years.\n36\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)7. SHARE-BASED COMPENSATION (CONTINUED)\nAwards to settle in shares\nThe following table provides a reconciliation of the beginning and ending balance of nonvested restricted stock (including restricted stock units) for the nine months ended September 30, 2016:\n| Performance-based Stock Awards | Service-based Stock Awards |\n| Number ofRestrictedStock | Weighted AverageGrant DateFair Value | Number ofRestrictedStock | Weighted AverageGrant DateFair Value(1) |\n| Nonvested restricted stock - beginning of period | 201 | $ | 49.24 | 1,954 | $ | 43.34 |\n| Granted | 104 | 53.80 | 586 | 53.81 |\n| Vested | (48 | ) | 45.38 | (779 | ) | 39.26 |\n| Forfeited | — | — | (94 | ) | 47.03 |\n| Nonvested restricted stock - end of period | 257 | $ | 52.04 | 1,667 | $ | 48.77 |\n\n(1) Fair value is based on the closing price of our common shares on the New York Stock Exchange on the day of the grant.\nCash-settled awards\nThe following table provides a reconciliation of the beginning and ending balance of nonvested cash settled restricted stock units for the nine months ended September 30, 2016:\n| Performance-based Cash Settled RSUs | Service-based Cash Settled RSUs |\n| Number ofRestrictedStock Units | Number ofRestrictedStock Units |\n| Nonvested restricted stock units - beginning of period | 70 | 1,433 |\n| Granted | 18 | 494 |\n| Vested | (32 | ) | (371 | ) |\n| Forfeited | — | (94 | ) |\n| Nonvested restricted stock units - end of period | 56 | 1,462 |\n\nAt September 30, 2016, the corresponding liability for cash-settled units, included in other liabilities on the Consolidated Balance Sheets, was $34 million (2015: $23 million).\n37\n| 8. | EARNINGS PER COMMON SHARE |\n\nThe following table sets forth the comparison of basic and diluted earnings per common share:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Basic earnings per common share |\n| Net income | $ | 186,613 | $ | 257,642 | $ | 364,460 | $ | 496,838 |\n| Less: preferred share dividends | 9,969 | 10,022 | 29,906 | 30,066 |\n| Net income available to common shareholders | 176,644 | 247,620 | 334,554 | 466,772 |\n| Weighted average common shares outstanding - basic(1) | 89,621 | 98,226 | 91,852 | 99,464 |\n| Basic earnings per common share | $ | 1.97 | $ | 2.52 | $ | 3.64 | $ | 4.69 |\n| Diluted earnings per common share |\n| Net income available to common shareholders | $ | 176,644 | $ | 247,620 | $ | 334,554 | $ | 466,772 |\n| Weighted average common shares outstanding - basic(1) | 89,621 | 98,226 | 91,852 | 99,464 |\n| Share based compensation plans | 730 | 898 | 727 | 1,004 |\n| Weighted average common shares outstanding - diluted(1) | 90,351 | 99,124 | 92,579 | 100,468 |\n| Diluted earnings per common share | $ | 1.96 | $ | 2.50 | $ | 3.61 | $ | 4.65 |\n| Anti-dilutive shares excluded from the dilutive computation | — | — | 226 | 219 |\n\n| (1) | On August 17, 2015, the Company entered into an Accelerated Share Repurchase (“ASR”) agreement (see 'Note 9 - Shareholders' Equity' for additional detail). The weighted-average number of shares outstanding used in the computation of basic and diluted earnings per share reflects the Company’s receipt of 4,149,378 common shares delivered to the Company on August 20, 2015, and 1,358,380 common shares delivered to the company on January 15, 2016 under the Company's ASR agreement. |\n\n38\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)9. SHAREHOLDERS' EQUITY\nThe following table presents our common shares issued and outstanding:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Shares issued, balance at beginning of period | 176,575 | 176,206 | 176,240 | 175,478 |\n| Shares issued | — | 16 | 335 | 744 |\n| Total shares issued at end of period | 176,575 | 176,222 | 176,575 | 176,222 |\n| Treasury shares, balance at beginning of period | (85,921 | ) | (75,922 | ) | (80,174 | ) | (76,052 | ) |\n| Shares repurchased | (2,252 | ) | (4,257 | ) | (8,499 | ) | (4,607 | ) |\n| Shares reissued from treasury | 37 | 6 | 537 | 486 |\n| Total treasury shares at end of period | (88,136 | ) | (80,173 | ) | (88,136 | ) | (80,173 | ) |\n| Total shares outstanding | 88,439 | 96,049 | 88,439 | 96,049 |\n\nTreasury Shares\nThe following table presents our share repurchases:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| In the open market: |\n| Total shares(1) | 2,232 | 4,248 | 8,236 | 4,264 |\n| Total cost | $ | 124,948 | $ | 245,658 | $ | 434,948 | $ | 246,490 |\n| Average price per share(2) | $ | 56.00 | $ | 57.83 | $ | 52.81 | $ | 57.80 |\n| From employees: |\n| Total shares | 20 | 9 | 263 | 343 |\n| Total cost | $ | 1,088 | $ | 489 | $ | 14,137 | $ | 17,586 |\n| Average price per share(2) | $ | 54.13 | $ | 55.59 | $ | 53.68 | $ | 51.28 |\n| Total shares repurchased: |\n| Total shares | 2,252 | 4,257 | 8,499 | 4,607 |\n| Total cost | $ | 126,036 | $ | 246,147 | $ | 449,085 | $ | 264,076 |\n| Average price per share(2) | $ | 55.98 | $ | 57.83 | $ | 52.84 | $ | 57.32 |\n\n(1) The nine months ended September 30, 2016 includes 1,358,380 common shares acquired under the accelerated share repurchase program (see below for more detail).\n(2) Calculated using whole figures.\n39\n| 9. | SHAREHOLDERS' EQUITY (CONTINUED) |\n\nAccelerated Share Repurchase Program\nOn August 17, 2015, the Company entered into an Accelerated Share Repurchase agreement with Goldman, Sachs & Co. (“Goldman Sachs”) to repurchase an aggregate of $300 million of the Company’s ordinary shares under an accelerated share repurchase program.\nDuring August, 2015, under the terms of this agreement, the Company paid $300 million to Goldman Sachs and initially repurchased 4,149,378 ordinary shares. The initial shares acquired represented 80% of the $300 million total paid to Goldman Sachs and were calculated using the Company’s stock price at activation of the program. The ASR program is accounted for as an equity transaction. Accordingly, as at December 31, 2015, $240 million of common shares repurchased were included as treasury shares in the Consolidated Balance Sheet with the remaining $60 million included as a reduction to additional paid-in capital.\nOn January 15, 2016, Goldman Sachs early terminated the ASR agreement and delivered 1,358,380 additional common shares to the Company, resulting in the reduction from additional paid-in capital of $60 million being reclassified to treasury shares. In total, the Company repurchased 5,507,758 common shares under the ASR agreement at an average price of $54.47.\nSeries B Preferred Shares\nOn January 27, 2016 we redeemed the remaining 28,430 Series B preferred shares, for an aggregate liquidation preference of $3 million.\n| 10. | COMMITMENTS AND CONTINGENCIES |\n\nReinsurance Agreements\nWe purchase reinsurance coverage for various lines of our business. The minimum reinsurance premiums are contractually due in advance on a quarterly basis. Accordingly at September 30, 2016, we have unrecorded outstanding reinsurance purchase commitments of $33 million, of which $3 million is due in 2016 while the remaining $30 million is due in 2017. Actual payments under the reinsurance contracts will depend on the underlying subject premium and may exceed the minimum premium.\nInvestments\nRefer 'Note 3 - Investments' for information on commitments related to our other investments.\n40\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)11. OTHER COMPREHENSIVE INCOME (LOSS)\n| 2016 | 2015 |\n| Before Tax Amount | Tax (Expense) Benefit | Net of Tax Amount | Before Tax Amount | Tax (Expense) Benefit | Net of Tax Amount |\n| Three months ended September 30, |\n| Available for sale investments: |\n| Unrealized investment gains (losses) arising during the period | $ | 40,125 | $ | (3,789 | ) | $ | 36,336 | $ | (102,810 | ) | $ | 3,099 | $ | (99,711 | ) |\n| Adjustment for reclassification of net realized investment gains (losses) and OTTI losses recognized in net income | (5,050 | ) | 2,408 | (2,642 | ) | 76,368 | (1,558 | ) | 74,810 |\n| Unrealized investment gains (losses) arising during the period, net of reclassification adjustment | 35,075 | (1,381 | ) | 33,694 | (26,442 | ) | 1,541 | (24,901 | ) |\n| Non-credit portion of OTTI losses | — | — | — | — | — | — |\n| Foreign currency translation adjustment | 1,722 | — | 1,722 | (14,626 | ) | — | (14,626 | ) |\n| Total other comprehensive income (loss), net of tax | $ | 36,797 | $ | (1,381 | ) | $ | 35,416 | $ | (41,068 | ) | $ | 1,541 | $ | (39,527 | ) |\n| Nine months ended September 30, |\n| Available for sale investments: |\n| Unrealized investment gains (losses) arising during the period | $ | 263,235 | $ | (24,579 | ) | $ | 238,656 | $ | (183,822 | ) | $ | 6,884 | $ | (176,938 | ) |\n| Adjustment for reclassification of net realized investment gains and OTTI losses recognized in net income | 40,338 | 2,282 | 42,620 | 130,858 | (2,088 | ) | 128,770 |\n| Unrealized investment gains (losses) arising during the period, net of reclassification adjustment | 303,573 | (22,297 | ) | 281,276 | (52,964 | ) | 4,796 | (48,168 | ) |\n| Non-credit portion of OTTI losses | — | — | — | — | — | — |\n| Foreign currency translation adjustment | 5,694 | — | 5,694 | (23,851 | ) | — | (23,851 | ) |\n| Total other comprehensive income (loss), net of tax | $ | 309,267 | $ | (22,297 | ) | $ | 286,970 | $ | (76,815 | ) | $ | 4,796 | $ | (72,019 | ) |\n\nReclassifications out of AOCI into net income available to common shareholders were as follows:\n| Amount Reclassified from AOCI(1) |\n| Details About AOCI Components | Consolidated Statement of Operations Line Item That Includes Reclassification | Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Unrealized investment gains (losses) on available for sale investments |\n| Other realized investment gains (losses) | $ | 9,297 | $ | (44,067 | ) | $ | (19,992 | ) | $ | (68,096 | ) |\n| OTTI losses | (4,247 | ) | (32,301 | ) | (20,346 | ) | (62,762 | ) |\n| Total before tax | 5,050 | (76,368 | ) | (40,338 | ) | (130,858 | ) |\n| Income tax (expense) benefit | (2,408 | ) | 1,558 | (2,282 | ) | 2,088 |\n| Net of tax | $ | 2,642 | $ | (74,810 | ) | $ | (42,620 | ) | $ | (128,770 | ) |\n\n| (1) | Amounts in parentheses are debits to net income available to common shareholders. |\n\n41\n| 12. | SUBSEQUENT EVENT |\n\nIn October 2016, the landfall of Hurricane Matthew impacted the Caribbean, southeastern United States and Canada, causing catastrophic loss of life, property damage and flooding.\nOur preliminary after-tax net loss estimate for this event is in the range of $45 million to $60 million. The Company's loss estimate is primarily based on a ground-up assessment of losses from individual contracts and treaties exposed to the affected regions, including preliminary information from clients, brokers and loss adjusters. Industry insured loss estimates, market share analyses and catastrophe modeling analyses were also taken into account where appropriate.\nDue to the nature of this event, including the complexity of loss assessment, factors contributing to the losses and the preliminary nature of the information available to prepare these estimates, the actual net ultimate amount of losses for this event may be materially different from this current estimate.\nITEM 2.\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nThe following is a discussion and analysis of our financial condition and results of operations. This should be read in conjunction with the consolidated financial statements and related notes included in Item 1 of this report and also our Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended December 31, 2015. Tabular dollars are in thousands, except per share amounts. Amounts in tables may not reconcile due to rounding differences.\n\n| Page |\n| Third Quarter 2016 Financial Highlights | 43 |\n| Executive Summary | 44 |\n| Underwriting Results – Group | 49 |\n| Results by Segment: For the three and nine months ended September 30, 2016 and 2015 | 57 |\n| i) Insurance Segment | 57 |\n| ii) Reinsurance Segment | 61 |\n| Other Expenses (Revenues), Net | 64 |\n| Net Investment Income and Net Realized Investment Gains (Losses) | 65 |\n| Cash and Investments | 67 |\n| Liquidity and Capital Resources | 70 |\n| Critical Accounting Estimates | 72 |\n| New Accounting Standards | 72 |\n| Off-Balance Sheet and Special Purpose Entity Arrangements | 72 |\n| Non-GAAP Financial Measures | 72 |\n\n42\nTHIRD QUARTER 2016 FINANCIAL HIGHLIGHTS\nThird Quarter 2016 Consolidated Results of Operations\n\n| • | Net income available to common shareholders of $177 million, or $1.97 per common share and $1.96 per diluted common share |\n\n| • | Operating income of $161 million, or $1.78 per diluted common share(1) |\n\n| • | Gross premiums written of $1.0 billion |\n\n| • | Net premiums written of $595 million, impacted by a large new retrocessional cover entered into with Harrington Re Ltd. |\n\n| • | Net premiums earned of $934 million |\n\n| • | Net favorable prior year reserve development of $76 million |\n\n| • | Estimated catastrophe and weather-related pre-tax net losses, net of reinstatement premiums, of $22 million compared to $43 million during the third quarter of 2015 |\n\n| • | Underwriting income of $104 million and combined ratio of 92.6% |\n\n| • | Net investment income of $117 million |\n\n| • | Net realized investment gains of $5 million |\n\n| • | Foreign exchange gains of $14 million |\n\nThird Quarter 2016 Consolidated Financial Condition\n| • | Total cash and investments of $14.6 billion; fixed maturities, cash and short-term securities comprise 87% of total cash and investments and have an average credit rating of AA- |\n\n| • | Total assets of $21.2 billion |\n\n| • | Reserve for losses and loss expenses of $9.9 billion and reinsurance recoverable of $2.3 billion |\n\n| • | Total debt of $1.0 billion and the debt to total capital ratio of 14.1% |\n\n| • | Repurchased 2.3 million common shares. At October 27, 2016 the remaining authorization under the repurchase program approved by our Board of Directors was $375 million |\n\n| • | Common shareholders’ equity of $5.4 billion and diluted book value per common share of $59.77 |\n\n| (1) | Operating income is a non-GAAP financial measure as defined in SEC Regulation G. Refer to ‘Non-GAAP Financial Measures’ for reconciliation to nearest GAAP financial measure (net income available to common shareholders). |\n\n43\nEXECUTIVE SUMMARY\nBusiness Overview\nWe are a Bermuda-based global provider of specialty lines insurance and treaty reinsurance products with operations in Bermuda, the United States, Europe, Singapore, Canada, Latin America and the Middle East. Our underwriting operations are organized around our two global underwriting platforms, AXIS Insurance and AXIS Re.\nOur mission is to provide our clients and distribution partners with a broad range of risk transfer products and services and meaningful capacity, backed by significant financial strength. We manage our portfolio holistically, aiming to construct the optimum consolidated portfolio of funded and unfunded risks, consistent with our risk appetite and development of our franchise. We nurture an ethical, entrepreneurial and disciplined culture that promotes outstanding client service, intelligent risk taking and the achievement of superior risk-adjusted returns for our shareholders. We believe that the achievement of our objectives will position us as a global leader in specialty risks. Our execution on this strategy in the first nine months of 2016 included:\n| • | continued growth of our accident and health lines, which is focused on specialty accident and health products; |\n\n| • | growth of our Weather and Commodity Markets business unit which offers parametric risk management solutions to clients |\n\nwhose profit margins are exposed to adverse weather and commodity price risks;\n| • | growth of our syndicate at Lloyd's which provides us with access to Lloyd's worldwide licenses and an extensive distribution network. During the first quarter of 2016 we commenced writing business through our underwriting division at Lloyd's in China; |\n\n| • | continued rebalancing of our portfolio towards less-volatile lines of business that carry attractive rates; and |\n\n| • | continued expansion of our broad range of third-party capital capabilities through: |\n\n| • | Our investment in Harrington Reinsurance Holdings Limited (\"Harrington\"), the parent company of Harrington Re Ltd. (\"Harrington Re\"), an independent reinsurance company jointly sponsored by AXIS Capital and The Blackstone Group L.P. (\"Blackstone\"). Harrington Re’s strategy is to combine a multi-line reinsurance portfolio with a diversified allocation to alternative investment strategies to earn attractive risk-adjusted returns. Harrington plans to develop a portfolio that optimizes the risk-reward characteristics of both assets and liabilities, leveraging the respective strengths of AXIS Capital and Blackstone while deploying a disciplined and fully integrated approach to both underwriting and investing; |\n\n| • | AXIS Ventures Reinsurance Limited, which manages capital for investors interested in deploying funds directly into the property-catastrophe and other short-tail business; and |\n\n| • | increased use of available reinsurance and retrocessional protection to optimize the risk-adjusted returns on our portfolio. |\n\n44\nResults of Operations\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Underwriting income: |\n| Insurance | $ | 25,161 | 265% | $ | 6,888 | $ | 31,187 | 93% | $ | 16,153 |\n| Reinsurance | 78,837 | 60% | 49,357 | 181,623 | (8%) | 197,729 |\n| Net investment income | 116,923 | 156% | 45,685 | 257,818 | 14% | 226,336 |\n| Net realized investment gains (losses) | 5,205 | nm | (69,957 | ) | (40,295 | ) | (67%) | (123,618 | ) |\n| Other expenses, net | (37,079 | ) | nm | (8,464 | ) | (63,439 | ) | 18% | (53,895 | ) |\n| Termination fee received | — | nm | 280,000 | — | nm | 280,000 |\n| Reorganization and related fees | — | nm | (45,867 | ) | — | nm | (45,867 | ) |\n| Interest in loss of equity method investments | (2,434 | ) | nm | — | (2,434 | ) | nm | — |\n| Net income | 186,613 | (28%) | 257,642 | 364,460 | (27%) | 496,838 |\n| Preferred share dividends | (9,969 | ) | (1%) | (10,022 | ) | (29,906 | ) | (1%) | (30,066 | ) |\n| Net income available to common shareholders | $ | 176,644 | (29%) | $ | 247,620 | $ | 334,554 | (28%) | $ | 466,772 |\n| Operating income | $ | 160,689 | 215% | $ | 51,031 | $ | 309,450 | 10% | $ | 280,682 |\n\nnm – not meaningful\nUnderwriting Results\nTotal underwriting income in the three months ended September 30, 2016 was $104 million, an increase of $48 million compared to $56 million in the three months ended September 30, 2015. The increase in underwriting income was primarily driven by an increase in net favorable prior year development, decreased catastrophe and weather-related losses, lower general and administrative expenses and an increase in other insurance related income, partially offset by an increase in the current accident year loss ratio excluding catastrophe and weather-related losses.\nThe reinsurance segment underwriting income increased by $29 million in the three months ended September 30, 2016, compared to the three months ended September 30, 2015. The increase in underwriting income was primarily driven by decreased catastrophe and weather-related losses, an increase in net favorable prior year development, lower general and administrative expenses and an increase in other insurance related income, partially offset by an increase in the acquisition cost ratio.\nThe insurance segment underwriting income increased by $18 million in the three months ended September 30, 2016, compared to the three months ended September 30, 2015. The increase in underwriting income was primarily due to an increase in net favorable prior year development and a decrease in the acquisition cost ratio, partially offset by an increase in the current accident year loss ratio excluding catastrophe and weather-related losses.\nTotal underwriting income in the nine months ended September 30, 2016 was $213 million, a decrease of $1 million compared to $214 million in the nine months ended September 30, 2015. The decrease in underwriting income was primarily driven by increased catastrophe and weather-related losses, an increase in the acquisition cost ratio and a decrease in other insurance income, partially offset by an increase in net favorable prior year development and lower general and administrative expenses.\nThe reinsurance segment underwriting income decreased by $16 million in the nine months ended September 30, 2016, compared to the nine months ended September 30, 2015. The decrease in underwriting income was primarily driven by an increase in the acquisition cost ratio, increased catastrophe and weather-related losses and a decrease in other insurance related income, partially offset by an increase in net favorable prior year development and lower general and administrative expenses.\nThe insurance segment underwriting income increased by $15 million in the nine months ended September 30, 2016, compared to the nine months ended September 30, 2015. The increase in underwriting income was primarily due to an increase in net favorable prior year development, a decrease in the acquisition cost ratio and lower general and administrative expenses, partially offset by increased catastrophe and weather-related losses.\n45\nNet Investment Income\nNet investment income in the three months ended September 30, 2016 was $117 million, an increase of $71 million compared to $46 million in the three months ended September 30, 2015. The increase was primarily driven by our other investments. These investments generated a gain of $38 million in the three months ended September 30, 2016, compared to a loss of $27 million in three months ended September 30, 2015. Net investment income for the nine months ended September 30, 2016 was $258 million, an increase of $31 million compared to the same period in 2015. The increase was mainly attributable to income from fixed maturities and other investments. Income from fixed maturities increased as a result of an emphasis on longer duration assets and income from other investments increased as a result of improved valuations on our CLO - Equity holdings.\nNet Realized Investment Gains (Losses)\nRealized gains were $5 million in the three months ended September 30, 2016 compared to realized losses of $70 million for the same period of 2015. The gains were mainly attributable to corporates, agency MBS, CMBS and ETFs which benefited from improvements in pricing in 2016. The realized losses in the three months ended September 30, 2015 were attributable to foreign currency losses on non-U.S. denominated securities as a result of the strengthening of the U.S. dollar and other-than-temporary impairment (\"OTTI\") charges. Realized losses were $40 million in the nine months ended September 30, 2016, compared to realized losses of $124 million for the same period of 2015. The losses for the three and nine months ended September 30, 2016 and 2015 were primarily attributable to foreign currency losses on non-U.S. denominated securities as a result of the strengthening of the U.S. dollar and OTTI charges.\nOther Revenues (Expenses), Net\nCorporate expenses increased to $29 million for the three months ended September 30, 2016, from $24 million for the three months ended September 30, 2015. The increase is primarily attributable to the net reimbursement of PartnerRe Ltd. (\"PartnerRe\") merger-related expenses benefiting 2015 and senior executive transition costs in 2016, partially offset by reorganization related expenses adverse to 2015. For the nine months ended September 30, 2016, corporate expenses increased to $87 million compared to $84 million in the same period in 2015. The slight increase is attributable to adjustments to senior leadership executive stock-compensation awards benefiting 2015, senior executive transition costs in 2016, and an increase in personnel costs in 2016, partially offset by expenses attributable to the proposed merger with PartnerRe and reorganization related expenses adverse to 2015.\nThe foreign exchange gains for the three and nine months ended September 30, 2016 of $14 million and $70 million, respectively, were primarily driven by the depreciation of the pound sterling against the U.S dollar. The foreign exchange gains of $28 million for the three months ended September 30, 2015 were primarily driven by depreciation of the pound sterling and the Australian dollar against the U.S. dollar, while the foreign exchange gains for the nine months ended September 30, 2015 of $69 million were primarily driven by the depreciation of the euro, pound sterling and Australian dollar.\nThe financial results for the three months ended September 30, 2016 resulted in a tax expense of $9 million, compared to an expense of nil for the three months ended September 30, 2015. Operations in the nine months ended September 30, 2016 resulted in a tax expense of $8 million compared to a tax expense of $1 million in the nine months ended September 30, 2015. The effective tax rate, which drives the tax expense, can vary between periods depending on the distribution of net income amongst tax jurisdictions, as well as other factors. The primary driver of the increase in both periods is the generation of consolidated pre-tax net income in our operations in Europe compared to net losses in 2015.\nTermination Fee Received\nDuring the third quarter of 2015, the Company announced that we had accepted a request from PartnerRe to terminate the Agreement and Plan of Amalgamation (the \"Amalgamation Agreement\") with the Company. PartnerRe paid the Company $315 million to immediately terminate the Amalgamation Agreement, the amount was comprised of a termination fee of $280 million and a reimbursement of merger related expenses of $35 million.\n46\nReorganization and Related Expenses\nDuring the third quarter of 2015, the Company implemented a number of profitability enhancement initiatives which resulted in a recognition of reorganization and related expenses of $46 million and additional corporate expenses of $5 million in the Consolidated Statement of Operations in the three months ended September 30, 2015.\nInterest in Loss of Equity Method Investments\nInterest in losses of equity method investments represents the Company’s aggregate share of losses related to investments in which the Company has significant influence over the operating and financial policies of the investee.\nOutlook\nManagement expects to achieve an increase in gross premiums written in 2016, with variances between our lines of business within the operating segments driven by market conditions and available opportunities, as we maintain our focus on diversification and pursuit of those opportunities that will expand our reach in areas where we believe the returns to be most attractive. We also expect the increase in gross premiums written to be substantially offset by greater cessions of risk to reinsurers and third party capital partners.\nCompetitive conditions continue to impact worldwide insurance markets with greatest pressures impacting catastrophe exposed property and certain global specialty lines of business. We also observed greater competitiveness for large accounts compared to smaller risks. These competitive pressures have led to price reductions across most lines of business, with decreases in international markets generally more severe than those observed in the United States. We expect this trend to continue in the short-term but believe that there are still attractive risks in the market. In this challenging market environment, we are focusing on lines and markets that remain adequately priced or continue to deliver price increases and those that provide opportunities for profitable growth. Where necessary we also continue to shift our business mix toward smaller, less volatile risk accounts which we believe will enable us to achieve a better, more stable attritional loss experience with lower severity.\nThe reinsurance markets' trading environment remains challenging in the majority of lines of business and geographical regions. The market continues to be influenced by excess capacity, strong balance sheets of established market participants and a consolidation of reinsurance purchasing. Despite these conditions we observed recent favorable trends which we expect to impact our business including many cedants reducing the size of their reinsurer panels, some moderation of pricing pressures, increased resistance to demands for greater commission rates as well as more generous terms and conditions, an increase in the number of cedants looking to buy more reinsurance protection and Solvency II-driven opportunities. These factors, combined with AXIS customer-centric approach and opportunities in specific lines of business and geographies allow us to execute on our targeted growth strategy. We continue to address the difficult market conditions by taking actions to protect the quality and profitability of our existing book, targeting larger shares of the more attractive treaties, managing the overall volatility of our reinsurance book, and expanding our already strong group of third party capital partners with whom to share our risks and earn fee income.\n47\nFinancial Measures\nWe believe the following financial indicators are important in evaluating our performance and measuring the overall growth in value generated for our common shareholders:\n| Three months ended and at September 30, | Nine months ended and at September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| ROACE (annualized)(1) | 13.2 | % | 18.8 | % | 8.4 | % | 12.0 | % |\n| Operating ROACE (annualized)(2) | 12.0 | % | 3.9 | % | 7.8 | % | 7.2 | % |\n| DBV per common share(3) | $ | 59.77 | $ | 53.68 | $ | 59.77 | $ | 53.68 |\n| Cash dividends declared per common share | 0.35 | 0.29 | 1.05 | 0.87 |\n| Increase in diluted book value per common share adjusted for dividends | $ | 2.50 | $ | 2.16 | $ | 6.74 | $ | 4.67 |\n\n| (1) | Return on average common equity (“ROACE”) is calculated by dividing annualized net income available to common shareholders for the period by the average shareholders’ equity determined by using the common shareholders’ equity balances at the beginning and end of the period. |\n\n| (2) | Operating ROACE is calculated by dividing annualized operating income for the period by the average common shareholders’ equity determined by using the common shareholders’ equity balances at the beginning and end of the period. Annualized operating ROACE is a non-GAAP financial measure as defined in SEC Regulation G. Refer to‘Non-GAAP Financial Measures’ for additional information and reconciliation to the nearest GAAP financial measure (ROACE). |\n\n| (3) | Diluted book value (“DBV”) per common share represents total common shareholders’ equity divided by the number of common shares and diluted common share equivalents outstanding, determined using the treasury stock method. Cash settled awards are excluded from the denominator. |\n\nReturn on Equity\nThe decrease in ROACE in the three months ended September 30, 2016, compared to the three months ended September 30, 2015, was primarily driven by the termination fee received from PartnerRe in the third quarter of 2015, partially offset by net realized gains in the current quarter compared to net realized losses in the same period in 2015, an increase in net investment income and underwriting income in the current quarter compared to the same period in 2015 and reorganization and related expenses incurred in the third quarter of 2015.\nThe increase in operating ROACE for the three months ended September 30, 2016, compared to the three months ended September 30, 2015 was primarily driven by an increase in net investment income and underwriting income in the three months ended September 30, 2016 compared to the same period in 2015.\nThe decrease in ROACE in the nine months ended September 30, 2016, compared to the nine months ended September 30, 2015, was primarily driven by the termination fee received from PartnerRe in the third quarter of 2015, partially offset by a decrease in net realized losses and an increase in net investment income in the nine months ended September 30, 2016 compared to the same period in 2015 and reorganization and related expenses incurred in the third quarter of 2015.\nThe increase in operating ROACE in the nine months ended September 30, 2016, compared to the nine months ended September 30, 2015, was primarily driven by an increase in net investment income in the nine months ended September 30, 2016 compared to the same period in 2015.\nDiluted Book Value per Common Share\nOur diluted book value per common share increase of 11% from $53.68 at September 30, 2015, to $59.77 at September 30, 2016, primarily reflected the generation of $469 million in net income available to common shareholders over the past twelve months and the increase over the last twelve months in unrealized gains on investments which are included in accumulated other comprehensive income, which was partially offset by common share dividends declared.\n48\nDiluted Book Value per Common Share Adjusted for Dividends\nOur diluted book value per common share adjusted for dividends increased by $2.50, or 4%, per common share for the three month period ended September 30, 2016 and $7.49, or 14%, per common share over the past twelve months.\nTaken together, we believe that growth in diluted book value per common share and common share dividends declared represent the total value created for our common shareholders. As companies in the insurance industry have differing dividend payout policies, we believe investors use the diluted book value per common share adjusted for dividends metric to measure comparable performance across the industry.\nDuring the three and nine months ended September 30, 2016, total value created consisted primarily of our net income and an increase in unrealized gains on investments, reported in accumulated other comprehensive income.\nDuring the three and nine months ended September 30, 2015, total value created consisted primarily of our net income, partially offset by an increase in unrealized losses on investments and foreign exchange translation adjustment losses included in accumulated other comprehensive income.\nUNDERWRITING RESULTS – GROUP\nThe following table provides our group underwriting results for the periods indicated. Underwriting income is a pre-tax measure of underwriting profitability that takes into account net premiums earned and other insurance related income as revenues and net losses and loss expenses, acquisition costs and underwriting-related general and administrative costs as expenses.\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Revenues: |\n| Gross premiums written | $ | 959,962 | 2% | $ | 936,583 | $ | 4,239,558 | 11% | $ | 3,803,928 |\n| Net premiums written | 595,431 | (12%) | 677,217 | 3,288,587 | 7% | 3,079,307 |\n| Net premiums earned | 934,415 | 2% | 919,341 | 2,783,746 | 1% | 2,764,605 |\n| Other insurance related income | 5,944 | 413% | 1,158 | 4,850 | (61%) | 12,319 |\n| Expenses: |\n| Current year net losses and loss expenses | (608,347 | ) | (605,512 | ) | (1,887,715 | ) | (1,818,672 | ) |\n| Prior year reserve development | 76,019 | 45,125 | 224,131 | 165,804 |\n| Acquisition costs | (189,810 | ) | (182,744 | ) | (559,570 | ) | (537,549 | ) |\n| Underwriting-related general and administrative |\n| expenses(1) | (114,223 | ) | (121,123 | ) | (352,632 | ) | (372,625 | ) |\n| Underwriting income(2) | $ | 103,998 | 85% | $ | 56,245 | $ | 212,810 | (1%) | $ | 213,882 |\n| General and administrative expenses(1) | $ | 142,906 | $ | 144,727 | $ | 439,554 | $ | 456,451 |\n| Income before income taxes and interest in income (loss) of equity method investments(2) | $ | 198,399 | $ | 257,672 | $ | 374,606 | $ | 497,993 |\n\n| (1) | Underwriting-related general and administrative expenses is a non-GAAP measure as defined in SEC Regulation G. Our total general and administrative expenses also included corporate expenses of $28,683 and $23,604 for the three months ended September 30, 2016 and 2015, respectively, and $86,922 and $83,826 for the nine months ended September 30, 2016 and 2015, respectively. Refer to 'Other Expenses (Revenues), Net' for additional information related to these corporate expenses. Also, refer to 'Non-GAAP Financial Measures' for further information. |\n\n| (2) | Underwriting income is a non-GAAP financial measure as defined in SEC Regulation G. Refer to Item 1, Note 2 to the Consolidated Financial Statements for a reconciliation of underwriting income to the nearest GAAP financial measure (income before income taxes and interest in income (loss) of equity method investments) for the periods indicated above. Also, refer to 'Non-GAAP Financial Measures' for additional information related to the presentation of underwriting income. |\n\n49\nUNDERWRITING REVENUES\nPremiums Written:\n| Gross Premiums Written |\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Insurance | $ | 675,430 | 11% | $ | 606,704 | $ | 2,112,796 | 7% | $ | 1,970,554 |\n| Reinsurance | 284,532 | (14%) | 329,879 | 2,126,762 | 16% | 1,833,374 |\n| Total | $ | 959,962 | 2% | $ | 936,583 | $ | 4,239,558 | 11% | $ | 3,803,928 |\n| % ceded |\n| Insurance | 36% | (1) pts | 37% | 32% | 1 pts | 31% |\n| Reinsurance | 43% | 33 pts | 10% | 13% | 7 pts | 6% |\n| Total | 38% | 10 pts | 28% | 22% | 3 pts | 19% |\n| Net Premiums Written |\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Insurance | $ | 433,131 | 14% | $ | 381,118 | $ | 1,433,058 | 6% | $ | 1,352,122 |\n| Reinsurance | 162,300 | (45%) | 296,099 | 1,855,529 | 7% | 1,727,185 |\n| Total | $ | 595,431 | (12%) | $ | 677,217 | $ | 3,288,587 | 7% | $ | 3,079,307 |\n\nGross premiums written in the three and nine months ended September 30, 2016, increased by $23 million or 2% (3% on a constant currency basis(1)) and $436 million or 11% (13% on a constant currency basis) compared to the three and nine months ended September 30, 2015, respectively. The increase for the three months ended September 30, 2016 compared to the same period in 2015 was due to an increase in the insurance segment, partially offset by a decrease in the reinsurance segment. The increase for the nine months ended September 30, 2016 compared to the same period in 2015 was due to increases in both our reinsurance and insurance segments.\nOur reinsurance segment's gross premiums written decreased by $45 million or 14% (13% on a constant currency basis) and increased by $293 million, or 16% (19% on a constant currency basis) in the three and nine months ended September 30, 2016, compared to the same periods in 2015, respectively. The decrease in the reinsurance segment gross written premiums in the three months ended September 30, 2016, compared to the same period of 2015 was primarily driven by timing differences impacting our professional and liability lines. The increase in the reinsurance segment gross written premiums in the nine months ended September 30, 2016, compared to the same period of 2015 was impacted by an increase in the level of premiums written on a multi-year basis. This increase in multi-year contracts increased the amount of premium recorded in the current period relating to future years compared to the same period in 2015. The increase in the nine months ended September 30, 2016 compared to the same period in 2015 was partially offset by foreign exchange movements as the strength of the U.S. dollar drove comparative premium decreases in treaties denominated in foreign currencies. After adjusting for the impact of the multi-year contracts and foreign exchange movements, our reinsurance segment gross premiums written increased by $204 million in the nine months ended September 30, 2016, compared to the same period in 2015. The growth was driven by new business in our liability, marine and other, catastrophe, professional as well as our credit and surety lines, with favorable treaty restructurings and timing differences also contributing to increased premium written in our liability and professional lines. These increases were partially offset by a decrease in our property lines primarily driven by non-renewals and decreases in the line sizes on several treaties.\n| (1) | Amounts presented on a constant currency basis are “non-GAAP financial measures” as defined in Regulation G. The constant currency basis is calculated by applying the average foreign exchange rate from the current year to the prior year balance. |\n\n50\nOur insurance segment's gross written premiums increased by $69 million or 11% (12% on a constant currency basis) and $142 million or 7% (8% on a constant currency basis) in the three and nine months ended September 30, 2016, compared to the same periods of 2015. Increased premiums written were reported in both periods in our accident and health and property lines primarily related to new business. The increase in the nine months ended September 30, 2016, compared to the same period in 2015 was partially offset by decreased premiums written in our marine lines and the impact of our exit from retail insurance operations in Australia.\nIn the three and nine months ended September 30, 2016, the ceded ratio increased by 10% and 3%, compared to the three and nine months ended September 30, 2015, respectively, with the increases primarily attributable to the reinsurance segment. The reinsurance segment ceded ratio increased in the three and nine months ended September 30, 2016 compared to the same periods in 2015, largely due to a new retrocessional cover entered into with Harrington Re.\nNet Premiums Earned:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | %Change | 2016 | 2015 | %Change |\n| Insurance | $ | 444,691 | 48 | % | $ | 444,550 | 48 | % | —% | $ | 1,322,649 | 48 | % | $ | 1,344,339 | 49 | % | (2%) |\n| Reinsurance | 489,724 | 52 | % | 474,791 | 52 | % | 3% | 1,461,097 | 52 | % | 1,420,266 | 51 | % | 3% |\n| Total | $ | 934,415 | 100 | % | $ | 919,341 | 100 | % | 2% | $ | 2,783,746 | 100 | % | $ | 2,764,605 | 100 | % | 1% |\n\nChanges in net premiums earned reflect period to period changes in net premiums written and business mix, together with normal variability in premium earning patterns.\nNet premiums earned increased by 2% (4% on a constant currency basis) and 1% (4% on a constant currency basis) in the three and nine months ended September 30, 2016, compared to the same periods in 2015, respectively. The increases were driven by the reinsurance segment in both periods, with a reduction in the insurance segment for the nine months ended September 30, 2016 compared to the same period in 2015, partially offsetting the increase in the reinsurance segment.\nThe increase in the reinsurance segment for both periods was primarily driven by strong premium growth in our liability, marine and other as well as our catastrophe lines in recent periods together with favorable premium adjustments impacting our credit and surety lines. The growth for both periods was partially offset by increased premiums ceded in our catastrophe and property lines, as well as the impact on our liability and professional lines of the new retrocession to Harrington Re.\nThe decrease in the insurance segment for the nine months ended September 30, 2016, compared to the same period in 2015, was primarily driven by an increase in our professional lines' ceded reinsurance programs, decreased business written in our marine lines and the impact of our exit from retail insurance operations in Australia, partially offset by growth in premiums written in recent periods in our accident and health lines.\nOther Insurance Related Income (Loss):\nThe increase in other insurance related income of $5 million in the three months ended September 30, 2016, compared to the same period in 2015, reflected fees from strategic capital partners and favorable fair value adjustments to economic hedges purchased to protect our agriculture line of business against fluctuations in commodity prices. The decrease in other insurance related income of $7 million in the nine months ended September 30, 2016, compared to the same period in 2015, reflected the impact of the realized gains on our weather and commodities derivative portfolio in the nine months ended September 30, 2015 compared to an immaterial impact in the nine months ended September 30, 2016, partially offset by third party capital fees and favorable fair value adjustments to economic hedges purchased to protect our agriculture line of business against fluctuations in commodity prices.\n51\nUNDERWRITING EXPENSES\nThe following table provides a breakdown of our combined ratio:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % PointChange | 2015 | 2016 | % PointChange | 2015 |\n| Current accident year loss ratio | 65.1 | % | (0.8) | 65.9 | % | 67.8 | % | 2.0 | 65.8 | % |\n| Prior year reserve development | (8.1 | %) | (3.2) | (4.9 | %) | (8.0 | %) | (2.0) | (6.0 | %) |\n| Acquisition cost ratio | 20.3 | % | 0.4 | 19.9 | % | 20.1 | % | 0.7 | 19.4 | % |\n| General and administrative expense ratio(1) | 15.3 | % | (0.4) | 15.7 | % | 15.8 | % | (0.7) | 16.5 | % |\n| Combined ratio | 92.6 | % | (4.0) | 96.6 | % | 95.7 | % | — | 95.7 | % |\n\n| (1) | The general and administrative expense ratio includes corporate expenses not allocated to reportable segments of 3.1% and 2.6% for the three months ended September 30, 2016 and 2015, respectively, and 3.1% and 3.0% for the nine months ended September 30, 2016 and 2015, respectively. These costs are further discussed in the ‘Other Expenses (Revenues), Net’ section. |\n\nCurrent Accident Year Loss Ratio:\nThe current accident year loss ratio decreased to 65.1% in the three months ended September 30, 2016 from 65.9% in the same period in 2015, while the current accident year loss ratio increased to 67.8% in the nine months ended September 30, 2016 from 65.8% in the same period in 2015.\nThe decrease for the three months ended September 30, 2016 compared to the same period in 2015 was impacted by a lower level of catastrophe and weather-related losses and the increase for the nine months ended September 30, 2016 compared to the same period in 2015 was impacted by an increased level of catastrophe and weather-related losses. During the three and nine months ended September 30, 2016, we incurred $22 million, or 2.3 points, and $145 million, or 5.3 points, respectively, in pre-tax catastrophe and weather-related losses, net of reinstatement premiums, attributable to the weather-related events, Fort McMurray wildfires, the Japanese and Ecuadorian earthquakes, North Calgary hailstorm and European floods. Comparatively, during the three and nine months ended September 30, 2015 we incurred $43 million, or 4.7 points, and $90 million, or 3.3 points, respectively.\nAfter adjusting for the impact of the catastrophe and weather-related losses, our current accident year loss ratios in the three and nine months ended September 30, 2016, were 62.8% and 62.5%, respectively, compared to 61.2% and 62.5% in the three and nine months ended September 30, 2015, respectively. The increase in the current accident year loss ratios after adjusting for the impact of the catastrophe and weather-related losses for the three months ended September 30, 2016, compared to the same period in 2015, was mainly due to business mix changes as well as the ongoing adverse impact of rate and trend, partially offset by a decrease in the mid-size loss experience in our insurance marine and property lines. The current accident year loss ratio after adjusting for the impact of the catastrophe and weather-related losses for the nine months ended September 30, 2016 was comparable to the same periods in 2015. The adverse impact of rate and trend together with business mix changes were offset by a decrease in the mid-size loss experience in our insurance marine and property lines.\nPrior Year Reserve Development:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Insurance | $ | 20,688 | $ | 2,444 | $ | 43,181 | $ | 21,225 |\n| Reinsurance | 55,331 | 42,681 | 180,950 | 144,579 |\n| Total | $ | 76,019 | $ | 45,125 | $ | 224,131 | $ | 165,804 |\n\n52\nOverview\nThe majority of the net favorable prior year reserve development in each period related to short-tail reserve classes. Net favorable prior year reserve development for professional, reinsurance liability and motor reserve classes also contributed in the three and nine months ended September 30, 2016.\nOur short tail business includes the underlying exposures in the property and other, marine and aviation reserving classes within our insurance segment and the property and other reserving class within our reinsurance segment . Development from these classes contributed $41 million and $38 million of the total net favorable prior year reserve development for the three months ended September 30, 2016 and 2015, respectively. For the nine months ended September 30, 2016 and 2015, these short-tail lines contributed $116 million and $112 million, respectively, of net favorable prior year reserve development. The net favorable prior year reserve development for these classes primarily reflected the recognition of better than expected loss emergence.\nOur medium-tail business consists primarily of professional insurance and reinsurance reserve classes, credit and political risk insurance reserve class and the credit and surety reinsurance reserve class. In the three and nine months ended September 30, 2016, the professional reserve classes contributed net favorable prior year reserve development of $12 million and $28 million, respectively. In the nine months ended September 30, 2015, the reinsurance professional reserve class contributed $25 million of net favorable development. The net favorable prior year development on these reserve classes continued to reflect the generally favorable experience on earlier accident years as we continued to transition to more experience based methods on these years. As our loss experience has generally been better than expected, this resulted in the recognition of net favorable prior year reserve development. In the three and nine months ended September 30, 2015, the insurance professional reserve class recorded net adverse prior year reserve development of $15 million and $16 million, respectively. This adverse development was primarily the result of strengthening in our Australian book of business during the third quarter of 2015.\nIn the three and nine months ended September 30, 2015, the credit and surety reserve class recorded net favorable prior year reserve development of $7 million and $19 million, respectively. This net favorable prior year reserve development reflected the recognition of generally better than expected loss emergence.\nIn the nine months ended September 30, 2015, we recorded net adverse prior year reserve development of $15 million in our credit and political risk reserve class relating to an increase in our loss portfolio estimates.\nOur long-tail business consists primarily of liability and motor reserve classes. Our motor and liability reinsurance reserve classes contributed additional net favorable prior year reserve development of $17 million and $20 million in the three months ended September 30, 2016 and 2015, respectively. For the nine months ended September 30, 2016 and 2015, these long-tail reserve classes contributed $72 million and $64 million, respectively. The net favorable prior year reserve development for the motor reserve class related to favorable loss emergence trends on several classes of business spanning multiple accident years. The net favorable prior year reserve development for the liability reinsurance reserve class primarily reflected the progressively increased weight given by management to experience based indications on older accident years, which has generally been favorable. In the three and nine months ended September 30, 2015, we recorded net adverse prior year reserve development of $6 million and $23 million, respectively, in our insurance liability reserve class related primarily to an increase in loss estimates for specific individual claim reserves, as well as a higher frequency of large auto liability claims.\nWe caution that conditions and trends that impacted the development of our liabilities in the past may not necessarily occur in the future.\nEstimates of Significant Catastrophe Events\nOur September 30, 2016 net reserves for losses and loss expenses includes estimated amounts for numerous catastrophe events. We caution that the magnitude and/or complexity of losses arising from certain of these events, in particular the Fort McMurray wildfires, Storm Sandy, the 2011 Japanese earthquake and tsunami, the three New Zealand earthquakes and the Tianjin port explosion, inherently increases the level of uncertainty and, therefore, the level of management judgment involved in arriving at our estimated net reserves for losses and loss expenses. As a result, our actual losses for these events may ultimately differ materially from our current estimates.\n53\nOur estimated net losses in relation to the catastrophe events described above were derived from ground-up assessments of our in-force contracts and treaties providing coverage in the affected regions. These assessments take into account the latest information available from clients, brokers and loss adjusters. In addition, we consider industry insured loss estimates, market share analyses and catastrophe modeling analyses, when appropriate. Our estimates remain subject to change, as additional loss data becomes available.\nThe following sections provide further details on prior year reserve development by segment, reserving class and accident year.\nInsurance Segment:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Property and other | $ | 10,061 | $ | 20,518 | $ | 24,048 | $ | 49,705 |\n| Marine | 4,682 | 2,831 | 8,382 | 23,156 |\n| Aviation | 517 | 667 | 437 | 2,884 |\n| Credit and political risk | (25 | ) | (28 | ) | (232 | ) | (15,427 | ) |\n| Professional lines | 3,378 | (15,279 | ) | 8,956 | (15,887 | ) |\n| Liability | 2,075 | (6,265 | ) | 1,590 | (23,206 | ) |\n| Total | $ | 20,688 | $ | 2,444 | $ | 43,181 | $ | 21,225 |\n\nIn the three months ended September 30, 2016, we recognized $21 million of net favorable prior year reserve development, the principal components of which were:\n| • | $10 million of net favorable prior year reserve development on property and other business, driven by better than expected loss emergence, primarily driven by reductions in mid-size loss estimates impacting accident year 2015 and favorable loss experience in our accident and health lines impacting accident year 2014. |\n\n| • | $5 million of net favorable prior year reserve development on marine business, driven by better than expected loss emergence, primarily driven by reductions in mid-size loss estimates impacting accident year 2015. |\n\nIn the three months ended September 30, 2015, we recognized $2 million of net favorable prior year reserve development, the principal components of which were:\n| • | $21 million of net favorable prior year reserve development on property and other business, driven by better than expected loss emergence including reserve reductions related to Storm Sandy of $15 million. |\n\n| • | $6 million of net adverse prior year reserve development on liability business, primarily related to a higher frequency of large auto liability claims in accident year 2014. |\n\n| • | $15 million of net adverse prior year reserve development on professional lines business, predominately reflecting reserve strengthening resulting from updated actuarial assumptions for our Australian professional lines and impacting accident years 2010 to 2014, partially offset by favorable development in certain US professional lines. |\n\nIn the nine months ended September 30, 2016, we recognized $43 million of net favorable prior year reserve development, the principal components of which were:\n| • | $24 million of net favorable prior year reserve development on property and other business, driven by better than expected loss emergence primarily related to accident year 2014. |\n\n| • | $9 million of net favorable prior year reserve development on professional lines business, driven by better than expected development related to various accident years, partially offset by reserve strengthening relating to updated information on one specific claim impacting accident year 2010. |\n\n54\n| • | $8 million of net favorable prior year reserve development on marine business, driven by better than expected loss emergence, primarily driven by reductions in mid-size loss estimates impacting accident year 2015. |\n\nIn the nine months ended September 30, 2015, we recognized $21 million of net favorable prior year development, the principal components of which were:\n| • | $50 million of net favorable prior year reserve development on property and other business, related to the 2012 and 2013 accident years and driven by better than expected loss emergence, including reserve reductions related to Storm Sandy of $16 million. |\n\n| • | $23 million of net favorable prior year reserve development on marine business, largely related to better than expected loss emergence in our energy offshore business spanning multiple years, particularly accident year 2014. |\n\n| • | $15 million of net adverse prior year reserve development on credit and political risk business, related to updated information on one specific claim impacting accident year 2014. |\n\n| • | $16 million of net adverse prior year reserve development on professional lines business, predominately reflecting reserve strengthening resulting from updated actuarial assumptions for our Australian professional lines and impacting accident years 2010 to 2014, partially offset by favorable development in certain US professional lines. |\n\n| • | $23 million of net adverse prior year reserve development on liability business, related to strengthening of specific individual claim reserves and a higher frequency of large auto liability claims in accident year 2014. |\n\nReinsurance Segment:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Property and other | $ | 25,831 | $ | 14,115 | $ | 83,522 | $ | 36,120 |\n| Credit and surety | 3,900 | 7,051 | 6,761 | 18,851 |\n| Professional lines | 8,761 | 1,250 | 18,918 | 25,331 |\n| Motor | 6,653 | 8,997 | 39,794 | 27,321 |\n| Liability | 10,186 | 11,268 | 31,955 | 36,956 |\n| Total | $ | 55,331 | $ | 42,681 | $ | 180,950 | $ | 144,579 |\n\nIn the three months ended September 30, 2016, we recognized $55 million of net favorable prior year reserve development, the principal components of which were:\n| • | $26 million of net favorable prior year reserve development on property and other business, related to the 2011 through 2015 accident years driven by better than expected loss emergence including a reserve reduction of $7 million related to Storm Sandy. |\n\n| • | $10 million of net favorable prior year reserve development on liability business, primarily related to the 2007 through 2010 accident years, for reasons discussed in the overview. |\n\n| • | $9 million of net favorable prior year reserve development on professional lines business, primarily related to the 2005 through 2010 accident years, for reasons discussed in the overview. |\n\n| • | $7 million of net favorable prior year reserve development on motor business, related to non-proportional business spanning multiple accident years, driven by better than expected loss emergence. |\n\nIn the three months ended September 30, 2015, we recognized $43 million of net favorable prior year reserve development, the principal components of which were:\n55\n| • | $14 million of net favorable prior year reserve development on property and other business, related to multiple prior accident years and driven by better than expected loss emergence. |\n\n| • | $11 million of net favorable prior year reserve development on liability business, primarily related to the 2003 through 2010 accident years, for reasons discussed in the overview. |\n\n| • | $9 million of net favorable prior year reserve development on motor business, largely related to favorable loss emergence trends on several classes spanning multiple accident years. |\n\n| • | $7 million of net favorable prior year reserve development on credit and surety business, related to the 2012 accident year and driven by additional information obtained about a specific claim. |\n\nIn the nine months ended September 30, 2016, we recognized $181 million of net favorable prior year reserve development, the principal components of which were:\n| • | $84 million of net favorable prior year development on property and other business, primarily related to the 2010 through 2015 accident years driven by better than expected loss emergence. |\n\n| • | $40 million of net favorable prior year reserve development on motor business, primarily related to non-proportional business spanning multiple accident years, driven by better than expected loss emergence. |\n\n| • | $32 million of net favorable prior year reserve development on liability business, primarily related to the 2006 through 2011 accident years, for reasons discussed in the overview. |\n\n| • | $19 million of net favorable prior year reserve development on professional lines business, primarily related to the 2005 through 2010 accident years, for reasons discussed in the overview. |\n\nIn the nine months ended September 30, 2015, we recognized $145 million of net favorable prior year reserve development, the principal components of which were:\n| • | $37 million of net favorable prior year reserve development on liability business, primarily related to the 2003 through 2010 accident years, for reasons discussed in the overview. |\n\n| • | $36 million of net favorable prior year reserve development on property and other business, spanning a number of accident years and driven by better than expected loss emergence. Included in this net development is $20 million of adverse development on agriculture reserves relating to loss developments on the 2014 accident year driven by lower than expected crop yields reported for two specific treaties. |\n\n| • | $27 million of net favorable prior year reserve development on motor business, predominantly related to non-proportional business in accident years 2011 and prior, driven by better than expected loss emergence. |\n\n| • | $25 million of net favorable prior year reserve development on professional lines business, primarily related to the 2009 through 2010 accident years, for reasons discussed in the overview. |\n\n\n| • | $19 million of net favorable prior year reserve development on credit and surety business, spanning multiple accident years and driven by better than expected loss emergence, as well as additional information obtained about a specific claim. |\n\nAcquisition Cost Ratio: The increase in the acquisition cost ratio in the three and nine months ended September 30, 2016 to 20.3% and 20.1%, respectively, compared to 19.9% and 19.4% in the three and nine months ended September 30, 2015, respectively, was driven by increases in our reinsurance segment. The reinsurance segment's increase in the three months ended September 30, 2016 compared to the same period in 2015 was primarily due to the impact of retrocessional contracts, an increase in the amount of business being written on a proportional basis, higher acquisition costs in certain lines of business and fees from strategic capital partners which were a benefit in 2015. The reinsurance segment's increase in the nine months ended September 30, 2016 compared to the same period in 2015 was primarily due to an increase in the amount of business being written on a proportional basis, higher acquisition costs in certain lines of business and the impact of retrocessional contracts.\n56\nGeneral and Administrative Expense Ratio: The general and administrative expense ratio in the three and nine months ended September 30, 2016, decreased to 15.3% and 15.8%, respectively, compared to 15.7% and 16.5% in the three and nine months ended September 30, 2015, respectively. The decrease in the expense ratio in the three months ended September 30, 2016 compared to the same period in 2015 was primarily attributable to growth in net premiums earned, reorganization related expenses adverse to 2015 and increased fees from strategic capital partners, partially offset by the net reimbursement of PartnerRe merger-related expenses benefiting 2015 and senior executive transition costs in 2016. The decrease in the expense ratio in the nine months ended September 30, 2016 compared to the same period in 2015 was primarily driven by growth in net earned premiums, increased fees from strategic capital partners, decreased personnel costs and expenses attributable to the proposed merger with PartnerRe and reorganization related expenses adverse to 2015, partially offset by adjustments to senior leadership executive stock-compensation awards benefiting 2015 and senior executive transition costs in 2016.\nRESULTS BY SEGMENT\nINSURANCE SEGMENT\nResults from our insurance segment were as follows:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Revenues: |\n| Gross premiums written | $ | 675,430 | 11% | $ | 606,704 | $ | 2,112,796 | 7% | $ | 1,970,554 |\n| Net premiums written | 433,131 | 14% | 381,118 | 1,433,058 | 6% | 1,352,122 |\n| Net premiums earned | 444,691 | —% | 444,550 | 1,322,649 | (2%) | 1,344,339 |\n| Other insurance related income (loss) | 39 | (93%) | 542 | (57 | ) | nm | 811 |\n| Expenses: |\n| Current year net losses and loss expenses | (293,914 | ) | (285,716 | ) | (896,952 | ) | (887,805 | ) |\n| Prior year reserve development | 20,688 | 2,444 | 43,181 | 21,225 |\n| Acquisition costs | (61,755 | ) | (69,118 | ) | (184,982 | ) | (200,493 | ) |\n| General and administrative expenses | (84,588 | ) | (85,814 | ) | (252,652 | ) | (261,924 | ) |\n| Underwriting income | $ | 25,161 | 265% | $ | 6,888 | $ | 31,187 | 93% | $ | 16,153 |\n| Ratios: | % PointChange | % PointChange |\n| Current year loss ratio | 66.1 | % | 1.8 | 64.3 | % | 67.8 | % | 1.8 | 66.0 | % |\n| Prior year reserve development | (4.7 | %) | (4.1) | (0.6 | %) | (3.2 | %) | (1.7) | (1.5 | %) |\n| Acquisition cost ratio | 13.9 | % | (1.6) | 15.5 | % | 14.0 | % | (0.9) | 14.9 | % |\n| General and administrative expense ratio | 19.1 | % | (0.3) | 19.4 | % | 19.0 | % | (0.5) | 19.5 | % |\n| Combined ratio | 94.4 | % | (4.2) | 98.6 | % | 97.6 | % | (1.3) | 98.9 | % |\n\nnm – not meaningful\n57\nGross Premiums Written:\nThe following table provides gross premiums written by line of business:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | % Change | 2016 | 2015 | % Change |\n| Property | $ | 164,605 | 25 | % | $ | 139,488 | 24 | % | 18% | $ | 522,380 | 24 | % | $ | 465,929 | 24 | % | 12% |\n| Marine | 33,677 | 5 | % | 38,817 | 6 | % | (13%) | 191,298 | 9 | % | 215,885 | 11 | % | (11%) |\n| Terrorism | 9,394 | 1 | % | 11,192 | 2 | % | (16%) | 28,090 | 1 | % | 25,737 | 1 | % | 9% |\n| Aviation | 9,684 | 1 | % | 10,222 | 2 | % | (5%) | 37,111 | 2 | % | 29,755 | 2 | % | 25% |\n| Credit and Political Risk | 5,423 | 1 | % | 8,542 | 1 | % | (37%) | 34,299 | 2 | % | 29,640 | 2 | % | 16% |\n| Professional Lines | 204,926 | 30 | % | 196,218 | 32 | % | 4% | 590,417 | 28 | % | 598,370 | 30 | % | (1%) |\n| Liability | 108,447 | 16 | % | 104,666 | 17 | % | 4% | 310,797 | 15 | % | 300,204 | 15 | % | 4% |\n| Accident and Health | 139,274 | 21 | % | 97,559 | 16 | % | 43% | 398,404 | 19 | % | 305,034 | 15 | % | 31% |\n| Total | $ | 675,430 | 100 | % | $ | 606,704 | 100 | % | 11% | $ | 2,112,796 | 100 | % | $ | 1,970,554 | 100 | % | 7% |\n\nGross premiums written in the three months ended September 30, 2016, increased by $69 million or 11% (12% on a constant currency basis) compared to the three months ended September 30, 2015. The increase was primarily attributable to growth in our accident and health and property lines related to new business opportunities.\nGross premiums written in the nine months ended September 30, 2016 increased by $142 million or 7% (8% on a constant currency basis) compared to the nine months ended September 30, 2015. The increase was primarily attributable to increases in our accident and health and property lines driven by new business. These increases were partially offset by a decrease in our marine and professional lines. Our marine lines decreased primarily due to reduced new business opportunities, lower rates and timing differences. The professional lines' decrease was due to the impact of our exit from retail insurance operations in Australia, as mentioned above in the quarterly results.\nPremiums Ceded: In the three and nine months ended September 30, 2016, premiums ceded were $242 million, or 36% of gross premiums written and $680 million, or 32% of gross premiums written, respectively, compared to $226 million, or 37% of gross premiums written and $618 million or 31% of gross premiums written, in the three and nine months ended September 30, 2015, respectively. The decrease in the ceded ratio for the three months ended September 30, 2016 compared to the same period in 2015 was primarily driven by changes in our accident and health line, partially offset by increased premiums ceded in our liability and professional lines. The increase in the ceded ratio for the nine months ended September 30, 2016 compared to the same period in 2015 was primarily driven by increased ceded premiums in our professional lines, partially offset by changes in our accident and health line.\n58\nNet Premiums Earned:\nThe following table provides net premiums earned by line of business:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | % Change | 2016 | 2015 | % Change |\n| Property | $ | 106,578 | 25 | % | $ | 112,017 | 27 | % | (5%) | $ | 312,804 | 23 | % | $ | 324,720 | 24 | % | (4%) |\n| Marine | 36,218 | 8 | % | 36,837 | 8 | % | (2%) | 113,693 | 9 | % | 143,878 | 11 | % | (21%) |\n| Terrorism | 8,276 | 2 | % | 7,985 | 2 | % | 4% | 26,011 | 2 | % | 26,565 | 2 | % | (2%) |\n| Aviation | 9,015 | 2 | % | 9,982 | 2 | % | (10%) | 33,528 | 3 | % | 32,097 | 2 | % | 4% |\n| Credit and Political Risk | 12,274 | 3 | % | 14,671 | 3 | % | (16%) | 42,661 | 3 | % | 45,993 | 3 | % | (7%) |\n| Professional Lines | 126,574 | 28 | % | 148,110 | 33 | % | (15%) | 386,241 | 29 | % | 451,944 | 34 | % | (15%) |\n| Liability | 42,205 | 9 | % | 41,817 | 9 | % | 1% | 126,429 | 10 | % | 120,181 | 9 | % | 5% |\n| Accident and Health | 103,551 | 23 | % | 73,131 | 16 | % | 42% | 281,282 | 21 | % | 198,961 | 15 | % | 41% |\n| Total | $ | 444,691 | 100 | % | $ | 444,550 | 100 | % | —% | $ | 1,322,649 | 100 | % | $ | 1,344,339 | 100 | % | (2%) |\n\nNet premiums earned in the three months ended September 30, 2016, were comparable (up 2% on a constant currency basis) to the three months ended September 30, 2015, driven by growth in premiums written in recent periods, primarily in our accident and health lines, offset by an increase in our professional lines' ceded reinsurance programs. Net premiums earned in the nine months ended September 30, 2015 decreased by $22 million or 2% (comparable on a constant currency basis) compared to the nine months ended September 30, 2015. The decrease in net premiums earned in the nine months ended September 30, 2016 compared to the same period in 2015 was primarily driven by an increase in our professional lines' ceded reinsurance programs, a reduction in business written in our marine lines and the impact of our exit from retail insurance operations in Australia partially offset by growth in our accident and health lines.\nLoss Ratio:\nThe table below shows the components of our loss ratio:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % PointChange | 2015 | 2016 | % PointChange | 2015 |\n| Current accident year | 66.1 | % | 1.8 | 64.3 | % | 67.8 | % | 1.8 | 66.0 | % |\n| Prior year reserve development | (4.7 | %) | (4.1) | (0.6 | %) | (3.2 | %) | (1.7) | (1.5 | %) |\n| Loss ratio | 61.4 | % | (2.3) | 63.7 | % | 64.6 | % | 0.1 | 64.5 | % |\n\n59\nCurrent Accident Year Loss Ratio:\nThe current accident year loss ratios increased to 66.1% and 67.8% in the three and nine months ended September 30, 2016, respectively, from 64.3% and 66.0% in the three and nine months ended September 30, 2015, respectively.\nDuring the three and nine months ended September 30, 2016, we incurred $15 million, or 3.3 points, and $73 million, or 5.5 points, respectively, in pre-tax catastrophe and weather-related losses related to the U.S. weather events, Japanese earthquake and Fort McMurray wildfires. Comparatively, during the three and nine months ended September 30, 2015 we incurred $19 million, or 4.3 points, and $45 million, or 3.4 points, respectively.\nAfter adjusting for the impact of the catastrophe and weather-related losses, our current accident year loss ratios in the three and nine months ended September 30, 2016, were 62.8% and 62.3%, respectively, compared to 60.0% and 62.7% in the three and nine months ended September 30, 2015, respectively. The increases in the current accident year loss ratios after adjusting for the impact of the catastrophe and weather-related losses for the three and nine months ended September 30, 2016 compared to the same periods in 2015 was driven by the adverse impact of rate and trend on most lines of business and changes in business mix, partially offset by a decrease in the mid-size loss experience particularly in our marine and property lines.\nRefer to the ‘Prior Year Reserve Development’ section for further details.\nAcquisition Cost Ratio: The decrease in the acquisition cost ratio in the three and nine months ended September 30, 2016 compared to the three and nine months ended September 30, 2015, was driven by an increase in ceding commissions following the expansion of our professional lines' ceded reinsurance programs and a lower acquisition cost ratio in our accident and health line resulting from a change in business mix.\nGeneral and Administrative Expense Ratio: The decrease in the general and administrative expense ratio in the nine months ended September 30, 2016 compared nine months ended September 30, 2015 primarily reflected a decrease in personnel expenses and a reduction in the allocation of certain corporate expenses.\n60\nREINSURANCE SEGMENT\nResults from our reinsurance segment were as follows:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Revenues: |\n| Gross premiums written | $ | 284,532 | (14%) | $ | 329,879 | $ | 2,126,762 | 16% | $ | 1,833,374 |\n| Net premiums written | 162,300 | (45%) | 296,099 | 1,855,529 | 7% | 1,727,185 |\n| Net premiums earned | 489,724 | 3% | 474,791 | 1,461,097 | 3% | 1,420,266 |\n| Other insurance related income | 5,905 | nm | 616 | 4,907 | (57%) | 11,508 |\n| Expenses: |\n| Current year net losses and loss expenses | (314,433 | ) | (319,796 | ) | (990,763 | ) | (930,867 | ) |\n| Prior year reserve development | 55,331 | 42,681 | 180,950 | 144,579 |\n| Acquisition costs | (128,055 | ) | (113,626 | ) | (374,588 | ) | (337,056 | ) |\n| General and administrative expenses | (29,635 | ) | (35,309 | ) | (99,980 | ) | (110,701 | ) |\n| Underwriting income | $ | 78,837 | 60% | $ | 49,357 | $ | 181,623 | (8%) | $ | 197,729 |\n| Ratios: | % PointChange | % PointChange |\n| Current year loss ratio | 64.2 | % | (3.2) | 67.4 | % | 67.8 | % | 2.3 | 65.5 | % |\n| Prior year reserve development | (11.3 | %) | (2.3) | (9.0 | %) | (12.4 | %) | (2.3) | (10.1 | %) |\n| Acquisition cost ratio | 26.1 | % | 2.2 | 23.9 | % | 25.6 | % | 1.9 | 23.7 | % |\n| General and administrative expense ratio | 6.1 | % | (1.3) | 7.4 | % | 6.9 | % | (0.9) | 7.8 | % |\n| Combined ratio | 85.1 | % | (4.6) | 89.7 | % | 87.9 | % | 1.0 | 86.9 | % |\n\nnm – not meaningful\nGross Premiums Written:\nThe following table provides gross premiums written by line of business for the periods indicated:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | % Change | 2016 | 2015 | % Change |\n| Catastrophe | $ | 46,338 | 16 | % | $ | 56,693 | 18 | % | (18%) | $ | 316,692 | 15 | % | $ | 283,562 | 15 | % | 12% |\n| Property | 61,957 | 22 | % | 67,539 | 20 | % | (8%) | 283,555 | 13 | % | 307,809 | 17 | % | (8%) |\n| Professional Lines | 19,479 | 7 | % | 45,509 | 14 | % | (57%) | 235,094 | 11 | % | 204,685 | 11 | % | 15% |\n| Credit and Surety | 36,174 | 13 | % | 23,390 | 7 | % | 55% | 315,102 | 15 | % | 230,958 | 13 | % | 36% |\n| Motor | 13,344 | 5 | % | 21,359 | 6 | % | (38%) | 338,403 | 16 | % | 333,245 | 18 | % | 2% |\n| Liability | 91,387 | 32 | % | 111,361 | 34 | % | (18%) | 365,380 | 17 | % | 258,862 | 14 | % | 41% |\n| Agriculture | 1,286 | — | % | (3,303 | ) | (1 | %) | nm | 151,315 | 7 | % | 139,135 | 8 | % | 9% |\n| Engineering | 13,588 | 5 | % | 4,397 | 1 | % | 209% | 56,719 | 3 | % | 58,163 | 3 | % | (2%) |\n| Marine and Other | 979 | — | % | 2,934 | 1 | % | (67%) | 64,502 | 3 | % | 16,955 | 1 | % | 280% |\n| Total | $ | 284,532 | 100 | % | $ | 329,879 | 100 | % | (14%) | $ | 2,126,762 | 100 | % | $ | 1,833,374 | 100 | % | 16% |\n\nGross premiums written decreased by $45 million and increased by $293 million in the three and nine months ended September 30, 2016, compared to the same periods in 2015, respectively.\n61\nThe decrease in gross premiums written in the three months ended September 30, 2016 compared to the same period in 2015, was primarily driven by our professional and liability lines, largely due to timing differences.\nThe increase in gross premiums written in the nine months ended September 30, 2016 compared to the same period in 2015, was impacted by treaties written on a multi-year basis. In the nine months ended September 30, 2016, the reinsurance segment reported an increase in the level of multi-year contracts written compared to the same period in 2015. This increase in multi-year contracts increased the amount of premium recorded in the current periods relating to future years compared to the same periods in 2015, most notably in the credit & surety and liability lines. On a comparative basis the impact of the multi-year premiums resulted in an increase in gross premiums written of $141 million in the nine months ended September 30, 2016, compared to the same period in 2015. The increase in written premiums was partially offset by the impact of foreign exchange movements in the nine months ended September 30, 2016, compared to the same period in 2015, as the strength of the U.S. dollar drove comparative premium decreases in the treaties denominated in foreign currencies. Foreign exchange movements resulted in a relative decrease of $52 million in gross premiums written in the nine months ended September 30, 2016, compared to the same period in 2015.\nAfter adjusting for the impact of multi-year contracts and on a constant currency basis, our gross premiums written increased by $204 million, or 11% in the nine months ended September 30, 2016, compared to the same period in 2015. The growth was driven by increases in our liability, marine and other, catastrophe, professional as well as our credit and surety lines primarily driven by new business. Favorable treaty restructurings and timing differences also contributed to the increases in liability and professional lines. These increases were partially offset by a decrease in our property lines, primarily relating to non-renewals and decreases in line sizes on several treaties.\nPremiums Ceded: In the three and nine months ended September 30, 2016, the ratio of ceded premium to gross written premium increased to 43% and 13%, respectively, from 10% and 6% in the three and nine months ended September 30, 2015, respectively. The increase for the three months ended September 30, 2016 compared to the prior period, was due to the impact of a new retrocessional cover entered into with Harrington Re which increased premiums ceded in our liability and professional lines. The increase for the nine months ended September 30, 2016 compared to the prior period was largely due to the new retrocessions to Harrington Re and increased premiums ceded in our catastrophe and property business.\nNet Premiums Earned:\nThe following table provides net premiums earned by line of business:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | % Change | 2016 | 2015 | % Change |\n| Catastrophe | $ | 48,799 | 10 | % | $ | 51,116 | 11 | % | (5%) | $ | 151,416 | 12 | % | $ | 165,840 | 12 | % | (9%) |\n| Property | 71,649 | 15 | % | 78,343 | 17 | % | (9%) | 208,179 | 14 | % | 235,828 | 17 | % | (12%) |\n| Professional Lines | 73,109 | 15 | % | 81,986 | 17 | % | (11%) | 225,813 | 15 | % | 231,024 | 16 | % | (2%) |\n| Credit and Surety | 67,430 | 14 | % | 59,601 | 13 | % | 13% | 192,135 | 13 | % | 182,508 | 13 | % | 5% |\n| Motor | 77,786 | 16 | % | 72,893 | 15 | % | 7% | 232,383 | 16 | % | 228,433 | 16 | % | 2% |\n| Liability | 80,137 | 16 | % | 77,441 | 16 | % | 3% | 247,103 | 17 | % | 218,829 | 15 | % | 13% |\n| Agriculture | 36,704 | 7 | % | 33,684 | 7 | % | 9% | 106,251 | 7 | % | 101,335 | 7 | % | 5% |\n| Engineering | 18,573 | 4 | % | 15,128 | 3 | % | 23% | 51,024 | 3 | % | 43,133 | 3 | % | 18% |\n| Marine and Other | 15,537 | 3 | % | 4,599 | 1 | % | 238% | 46,793 | 3 | % | 13,336 | 1 | % | 251% |\n| Total | $ | 489,724 | 100 | % | $ | 474,791 | 100 | % | 3% | $ | 1,461,097 | 100 | % | $ | 1,420,266 | 100 | % | 3% |\n\nNet premiums earned increased by $15 million or 3% (7% on a constant currency basis) and $41 million or 3% (7% on a constant currency basis) in the three and nine months ended September 30, 2016, compared to the same periods in 2015, respectively.\nThe increase for both periods was primarily driven by the growth in the business written in our liability, marine and other as well as our catastrophe lines in recent periods together with a favorable premium adjustments impacting our credit and surety lines. The growth for both periods was partially offset by increased premiums ceded in our catastrophe and property lines, as well as the impact on our liability and professional lines of the new retrocession to Harrington Re.\n62\nOther Insurance Related Income (Losses):\nThe increase in other insurance related income of $5 million in the three months ended September 30, 2016, compared to the same period in 2015, reflected fees from strategic capital partners and favorable fair value adjustments to economic hedges purchased to protect our agriculture line of business against fluctuations in commodity prices. The decrease in other insurance related income of $7 million in the nine months ended September 30, 2016, compared to the same period in 2015, reflected the impact of the realized gains on our weather and commodities derivative portfolio in the nine months ended September 30, 2015 compared to an immaterial impact in the nine months ended September 30, 2016, partially offset by fees from strategic capital partners and favorable fair value adjustments to economic hedges purchased to protect our agriculture line of business against fluctuations in commodity prices.\nLoss Ratio:\nThe table below shows the components of our loss ratio:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % PointChange | 2015 | 2016 | % PointChange | 2015 |\n| Current accident year | 64.2 | % | (3.2) | 67.4 | % | 67.8 | % | 2.3 | 65.5 | % |\n| Prior year reserve development | (11.3 | %) | (2.3) | (9.0 | %) | (12.4 | %) | (2.3) | (10.1 | %) |\n| Loss ratio | 52.9 | % | (5.5) | 58.4 | % | 55.4 | % | — | 55.4 | % |\n\nCurrent Accident Year Loss Ratio:\nThe current accident year loss ratio decreased to 64.2% in the three months ended September 30, 2016 from 67.4% in the same period in 2015, while the current accident year loss ratio increased to 67.8% in the nine months ended September 30, 2016 from 65.5% in the same period in 2015.\nThe decrease for the three months ended September 30, 2016 compared to the same period in 2015 was impacted by a lower level of catastrophe and weather-related losses and the increase for the nine months ended September 30, 2016 compared to the same period in 2015 was impacted by an increased level of catastrophe and weather-related losses. During the three and nine months ended September 30, 2016, we incurred $7 million, or 1.5 points, and $72 million, or 5.0 points, respectively, in pre-tax catastrophe and weather-related losses, net of reinstatement premiums, attributable to the weather-related events, Fort McMurray wildfires, the Japanese and Ecuadorian earthquakes, North Calgary hailstorm and European floods. Comparatively, during the three and nine months ended September 30, 2015 we incurred $24 million, or 5.1 points, and $45 million, or 3.2 points, respectively.\nAfter adjusting for the impact of the catastrophe and weather-related losses, our current accident year loss ratios in the three and nine months ended September 30, 2016, were 62.7% and 62.8%, respectively, compared to 62.3% in both the three and nine months ended September 30, 2015. The increases in the current accident year loss ratios after adjusting for the impact of the catastrophe and weather-related losses for the three and nine months ended September 30, 2016 compared to the same periods in 2015 was mainly due to the ongoing adverse impact of rate and trend, partially offset by the recognition of better than expected recent attritional loss experience across our long tail lines of business.\nRefer ‘Prior Year Reserve Development’ for further details.\nAcquisition Cost Ratio: The acquisition cost ratio increased in both the three and nine months ended September 30, 2016 compared to the same periods in 2015. The increase in the three months ended September 30, 2016 was primarily due to the impact of retrocessional contracts, an increase in the amount of business being written on a proportional basis together with higher acquisition costs in certain lines of business and fees from strategic capital partners which were a benefit in 2015. The increase in the nine months ended September 30, 2016 compared to the same period in 2015 was primarily due to an increase in the amount of business being written on a proportional basis, higher acquisition costs in certain lines of business and the impact of retrocessional contracts.\n63\nGeneral and Administrative Expense Ratio: The general and administrative expense ratio decreased in both the three and nine months ended September 30, 2016 compared to the same periods in 2015. The decrease in the general and administrative expense ratio primarily reflects lower personnel expense, benefits of arrangements with our strategic capital partners and the impact of increased net earned premiums.\nOTHER EXPENSES (REVENUES), NET\nThe following table provides a breakdown of our other expenses (revenues), net:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Corporate expenses | $ | 28,683 | 22% | $ | 23,604 | $ | 86,922 | 4% | $ | 83,826 |\n| Foreign exchange gains | (13,795 | ) | (51%) | (28,088 | ) | (69,781 | ) | 1% | (69,200 | ) |\n| Interest expense and financing costs | 12,839 | (1%) | 12,918 | 38,586 | 1% | 38,114 |\n| Income tax expense | 9,352 | nm | 30 | 7,712 | nm | 1,155 |\n| Total | $ | 37,079 | nm | $ | 8,464 | $ | 63,439 | 18% | $ | 53,895 |\n\nnm – not meaningful\nCorporate Expenses: Our corporate expenses include holding company costs necessary to support our worldwide insurance and reinsurance operations and costs associated with operating as a publicly-traded company. As a percentage of net premiums earned, corporate expenses were 3.1% for the three and nine months ended September 30, 2016, compared to 2.6% and 3.0%, respectively, for the same periods of 2015. The increase in corporate expenses in the three month period ended September 30, 2016 is primarily attributable to the net reimbursement of PartnerRe merger-related expenses benefiting 2015 and senior executive transition costs in 2016, partially offset by reorganization related expenses adverse to 2015. The slight increase in corporate expenses in the nine month period ended September 30, 2016 is attributable to adjustments to senior leadership executive stock-compensation awards benefiting 2015, senior executive transition costs in 2016 and an increase in personnel costs in 2016, partially offset by expenses attributable to the proposed merger with PartnerRe and reorganization related expenses adverse to 2015.\nForeign Exchange Gains: Some of our business is written in currencies other than the U.S. dollar. The foreign exchange gains for the periods presented were largely driven by the re-measurement of our net insurance related liabilities. The foreign exchange gains for the three and nine months ended September 30, 2016 were primarily driven by the depreciation of pound sterling against the U.S dollar. Comparatively, the foreign exchange gains for the three months ended September 30, 2015 were primarily driven by depreciation of the pound sterling and the Australian dollar against the U.S. dollar. The foreign exchange gains for the nine months ended September 30, 2015 were primarily driven by the depreciation of the euro, pound sterling and Australian dollar.\nIncome Tax Expense: Income tax expense primarily results from income generated by our foreign operations in the United States and Europe. Our effective tax rate, which is calculated as income tax expense divided by net income before tax including interest in loss of equity method investments, was 4.8% and 2.1% in the three and nine months ended September 30, 2016, and was insignificant and 0.2% in the three and nine months ended September 30, 2015. This effective rate can vary between periods depending on the distribution of net income amongst tax jurisdictions, as well as other factors. The primary driver of the current quarter and year-to-date increase is the generation of consolidated pre-tax net income in our operations in Europe compared to a net loss in each of these periods in 2015.\n64\nNET INVESTMENT INCOME AND NET REALIZED INVESTMENT GAINS (LOSSES)\nNet Investment Income\nThe following table provides a breakdown of income earned from our cash and investment portfolio by major asset class:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Fixed maturities | $ | 75,827 | —% | $ | 75,980 | $ | 229,423 | 4% | $ | 220,066 |\n| Other investments | 38,248 | nm | (27,421 | ) | 25,770 | 46% | 17,616 |\n| Equity securities | 4,633 | 34% | 3,445 | 12,843 | 65% | 7,795 |\n| Mortgage loans | 2,191 | nm | 482 | 5,683 | nm | 776 |\n| Cash and cash equivalents | 3,768 | nm | 993 | 7,071 | 88% | 3,770 |\n| Short-term investments | 337 | nm | 83 | 708 | 156% | 277 |\n| Gross investment income | 125,004 | 133% | 53,562 | 281,498 | 12% | 250,300 |\n| Investment expense | (8,081 | ) | 3% | (7,877 | ) | (23,680 | ) | (1%) | (23,964 | ) |\n| Net investment income | $ | 116,923 | 156% | $ | 45,685 | $ | 257,818 | 14% | $ | 226,336 |\n| Pre-tax yield:(1) |\n| Fixed maturities | 2.7% | 2.5% | 2.6% | 2.4% |\n\nnm - not meaningful\n| (1) | Pre-tax yield is annualized and calculated as net investment income divided by the average month-end amortized cost balances for the periods indicated. |\n\nFixed Maturities\nThe net investment income increase for the nine months ended September 30, 2016 attributable to fixed maturities was due to an emphasis on longer duration assets and an improvement in CPI adjustments following a reduction in our exposure to treasury inflation-protected securities.\nOther Investments\nThe following table provides a breakdown of total net investment income from other investments:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Hedge, direct lending, private equity and real estate funds | $ | 29,459 | $ | (23,483 | ) | $ | 6,127 | $ | 10,357 |\n| Other privately held investments | 370 | — | 177 | — |\n| CLO - Equities | 8,419 | (3,938 | ) | 19,466 | 7,259 |\n| Total net investment income from other investments | $ | 38,248 | $ | (27,421 | ) | $ | 25,770 | $ | 17,616 |\n| Pre-tax return on other investments(1) | 4.5 | % | (3.3 | %) | 3.1 | % | 2.0 | % |\n\n| (1) | The pre-tax return on other investments is non-annualized and calculated by dividing total net investment income from other investments by the average month-end fair value balances held for the periods indicated. |\n\nThe total net investment income from other investments increased for the three and nine months ended September 30, 2016 compared to the same periods in 2015 due to an improvement in the performance of the global equity markets which translated into higher valuations on our hedge funds. CLO - Equities also benefited from an increase in the valuation of the underlying collateral balances.\n65\nNet Realized Investment Gains (Losses)\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| On sale of investments: |\n| Fixed maturities and short-term investments | $ | 4,303 | $ | (42,741 | ) | $ | (22,869 | ) | $ | (66,579 | ) |\n| Equity securities | 4,994 | (1,327 | ) | 2,881 | (1,505 | ) |\n| 9,297 | (44,068 | ) | (19,988 | ) | (68,084 | ) |\n| OTTI charges recognized in earnings | (4,247 | ) | (32,301 | ) | (20,346 | ) | (62,762 | ) |\n| Change in fair value of investment derivatives | 155 | 6,412 | 39 | 7,228 |\n| Net realized investment gains (losses) | $ | 5,205 | $ | (69,957 | ) | $ | (40,295 | ) | $ | (123,618 | ) |\n\nOn sale of investments\nGenerally, sales of individual securities occur when there are changes in the relative value, credit quality or duration of a particular issue. We may also sell to rebalance our investment portfolio in order to change exposure to particular asset classes or sectors. Net realized investment gains in the three months ended September 30, 2016 are reflective of the improvement in pricing of our fixed maturities and equities. Net realized investment losses in the nine months ended September 30, 2016 are primarily due to foreign exchange losses on non-U.S. denominated securities, as a result of the strengthening of the U.S. dollar.\nOTTI charges\nFor the three months ended September 30, 2016, OTTI charges were driven by impairments on corporate debt securities and losses on non-U.S. denominated securities as a result of the decline in foreign exchange rates against the U.S. dollar. The nine months ended September 30, 2016 also included impairments on high yield corporate debt securities which are exposed to the energy sector and exchange-traded funds (ETFs) which are unlikely to recover in the near term.\nChange in fair value of investment derivatives\nFrom time to time, we may economically hedge the foreign exchange exposure of non-U.S. denominated securities by entering into foreign exchange forward contracts.\n66\nTotal Return\nThe following table provides a breakdown of the total return on cash and investments for the period indicated:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Net investment income | $ | 116,923 | $ | 45,685 | $ | 257,818 | $ | 226,336 |\n| Net realized investments gains (losses) | 5,205 | (69,957 | ) | (40,295 | ) | (123,618 | ) |\n| Change in net unrealized gains (losses) | 35,075 | (26,441 | ) | 303,573 | (52,965 | ) |\n| Interest in loss of equity method investments | (2,434 | ) | — | (2,434 | ) | — |\n| Total | $ | 154,769 | $ | (50,713 | ) | $ | 518,662 | $ | 49,753 |\n| Average cash and investments(1) | $ | 14,470,231 | $ | 14,893,376 | $ | 14,457,978 | $ | 14,919,752 |\n| Total return on average cash and investments, pre-tax: |\n| Inclusive of investment related foreign exchange movements | 1.1 | % | (0.3 | %) | 3.6 | % | 0.3 | % |\n| Exclusive of investment related foreign exchange movements | 1.1 | % | (0.1 | %) | 3.9 | % | 0.9 | % |\n\n| (1) | The average cash and investments balance is calculated by taking the average of the month-end fair value balances held for the periods indicated. |\n\nCASH AND INVESTMENTS\nThe table below provides a breakdown of our cash and investments:\n| September 30, 2016 | December 31, 2015 |\n| Fair Value | Fair Value |\n| Fixed maturities | $ | 11,566,860 | $ | 11,719,749 |\n| Equities | 644,344 | 597,998 |\n| Mortgage loans | 332,753 | 206,277 |\n| Other investments | 847,262 | 816,756 |\n| Equity method investments | 111,295 | 10,932 |\n| Short-term investments | 39,877 | 34,406 |\n| Total investments | $ | 13,542,391 | $ | 13,386,118 |\n| Cash and cash equivalents(1) | $ | 1,077,263 | $ | 1,174,751 |\n\n| (1) | Includes restricted cash and cash equivalents of $229 million and $187 million at September 30, 2016 and at December 31, 2015, respectively. |\n\nThe $156m increase in the fair value of our total investments was driven by the downward shift in sovereign yield curves and the tightening of credit spreads on both investment grade and high-yield corporate debt. This was partially offset by the funding of financing and operating activities.\n67\nThe following provides a further analysis on our investment portfolio by asset classes:\nFixed Maturities\nThe following provides a breakdown of our investment in fixed maturities:\n| September 30, 2016 | December 31, 2015 |\n| Fair Value | % of Total | Fair Value | % of Total |\n| Fixed maturities: |\n| U.S. government and agency | $ | 1,562,877 | 14 | % | $ | 1,651,949 | 14 | % |\n| Non-U.S. government | 582,056 | 5 | % | 739,005 | 6 | % |\n| Corporate debt | 4,568,500 | 39 | % | 4,362,769 | 37 | % |\n| Agency RMBS | 2,522,731 | 22 | % | 2,249,236 | 19 | % |\n| CMBS | 894,275 | 8 | % | 1,083,298 | 9 | % |\n| Non-Agency RMBS | 71,830 | — | % | 101,008 | 1 | % |\n| ABS | 1,235,596 | 11 | % | 1,371,270 | 12 | % |\n| Municipals(1) | 128,995 | 1 | % | 161,214 | 2 | % |\n| Total | $ | 11,566,860 | 100 | % | $ | 11,719,749 | 100 | % |\n| Credit ratings: |\n| U.S. government and agency | $ | 1,562,877 | 14 | % | $ | 1,651,949 | 14 | % |\n| AAA(2) | 4,359,640 | 38 | % | 4,266,673 | 36 | % |\n| AA | 1,165,958 | 10 | % | 1,273,941 | 11 | % |\n| A | 1,770,161 | 15 | % | 2,065,192 | 18 | % |\n| BBB | 1,607,798 | 14 | % | 1,442,938 | 12 | % |\n| Below BBB(3) | 1,100,426 | 9 | % | 1,019,056 | 9 | % |\n| Total | $ | 11,566,860 | 100 | % | $ | 11,719,749 | 100 | % |\n\n| (1) | Includes bonds issued by states, municipalities, and political subdivisions. |\n\n| (2) | Includes U.S. government-sponsored agency RMBS and CMBS. |\n\n| (3) | Non-investment grade and non-rated securities. |\n\nAt September 30, 2016, our fixed maturities had a weighted average credit rating of AA- (2015: AA-) and an average duration of 3.2 years (2015: 3.3 years). When incorporating short-term investments and cash and cash equivalents into the calculation (bringing the total to $12.5 billion), the average credit rating would be AA- (2015: AA-) and duration would be 2.9 years (2015: 3.0 years).\nDuring the year, net unrealized investment gains (losses) on fixed maturities moved from a net unrealized investment loss of $178 million at December 31, 2015 to a net unrealized gain of $104 million at September 30, 2016.\nEquities\nNet unrealized investment gains on equities increased from $22 million at December 31, 2015 to $44 million at September 30, 2016, an increase of $22 million due to an improvement in valuations reflective of performance of the global equity markets.\nMortgage Loans\nDuring the year, we increased our investment in commercial mortgage loans from $206 million to $333 million, an increase of $127m. The commercial mortgage loans are high quality and collateralized by a variety of commercial properties and are diversified both geographically throughout the United States and by property type to reduce the risk of concentration.\n68\nOther Investments\nThe composition of our other investments portfolio is summarized as follows:\n| September 30, 2016 | December 31, 2015 |\n| Hedge funds |\n| Long/short equity funds | $ | 139,460 | 16 | % | $ | 154,348 | 19 | % |\n| Multi-strategy funds | 281,153 | 33 | % | 355,073 | 43 | % |\n| Event-driven funds | 94,012 | 11 | % | 147,287 | 18 | % |\n| Leveraged bank loan funds | — | — | % | 65 | — | % |\n| Total hedge funds | 514,625 | 60 | % | 656,773 | 80 | % |\n| Direct lending funds | 125,002 | 15 | % | 90,120 | 11 | % |\n| Private equity funds | 89,170 | 11 | % | — | — | % |\n| Real estate funds | 11,782 | 1 | % | 4,929 | 1 | % |\n| Total hedge, direct lending and real estate funds | 740,579 | 87 | % | 751,822 | 92 | % |\n| Other privately held investments | 42,900 | 5 | % | — | — | % |\n| CLO - Equities | 63,783 | 8 | % | 64,934 | 8 | % |\n| Total other investments | $ | 847,262 | 100 | % | $ | 816,756 | 100 | % |\n\nThe $142 million decrease in the fair value of our total hedge funds in 2016 was driven by $138 million of net redemptions and $4 million of price depreciation.\nWe have made total commitments of $310 million to managers of direct lending funds, of which $121 million of our total commitment has been called to date.\nWe have also made a total commitment of $60 million as a limited partner in a multi-strategy hedge fund, of which $48 million has been called to date.\nWe have made a total commitment of $100 million to a real estate fund, of which $10 million has been called to date.\nDuring 2016, we made a total commitment of $135 million to a private equity fund, of which $95 million has been called to date.\nEquity Method Investments\nDuring 2016, we paid $104 million including direct transactions costs to acquire 18% of the common equity of Harrington, the parent company of Harrington Re, an independent reinsurance company jointly sponsored by AXIS Capital and Blackstone. Harrington is not a variable interest entity and given that we exercise significant influence over this investee we account for our ownership in Harrington under the equity method of accounting.\nThe Company also has investments in other equity method investments with a carrying value of $9 million.\n69\nLIQUIDITY AND CAPITAL RESOURCES\nRefer to the ‘Liquidity and Capital Resources’ section included under Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2015 for a general discussion of our liquidity and capital resources.\nThe following table summarizes our consolidated capital as at:\n| September 30, 2016 | December 31, 2015 |\n| Senior notes | $ | 992,633 | $ | 991,825 |\n| Preferred shares | 625,000 | 627,843 |\n| Common equity | 5,400,658 | 5,239,039 |\n| Shareholders’ equity | 6,025,658 | 5,866,882 |\n| Total capital | $ | 7,018,291 | $ | 6,858,707 |\n| Ratio of debt to total capital | 14.1 | % | 14.5 | % |\n| Ratio of debt and preferred equity to total capital | 23.0 | % | 23.6 | % |\n\nWe finance our operations with a combination of debt and equity capital. Our debt to total capital and debt and preferred equity to total capital ratios provide an indication of our capital structure, along with some insight into our financial strength. A company with higher ratios in comparison to industry average may show weak financial strength because the cost of its debts may adversely affect results of operations and/or increase its default risk. We believe that our financial flexibility remains strong.\nPreferred Shares\nOn January 27, 2016 we redeemed the remaining 28,430 Series B preferred shares, for an aggregate liquidation preference of\n$3 million.\n70\nCommon Equity\n| Nine months ended September 30, | 2016 |\n| Common equity - opening | $ | 5,239,039 |\n| Net income | 364,460 |\n| Shares repurchased for treasury | (449,086 | ) |\n| Change in unrealized appreciation on available for sale investments, net of tax | 281,276 |\n| Settlement of accelerated share repurchase | 60,000 |\n| Common share dividends | (98,334 | ) |\n| Preferred share dividends | (29,906 | ) |\n| Share-based compensation expense recognized in equity | 26,129 |\n| Foreign currency translation adjustment | 5,694 |\n| Cost of treasury shares reissued | 1,386 |\n| Common equity - closing | $ | 5,400,658 |\n\nDuring the nine months ended September 30, 2016, we repurchased 8.5 million common shares, including 7.1 million of common shares repurchased for a total of $389 million (including $375 million pursuant to our Board-authorized share repurchase program and $14 million relating to shares purchased in connection with the vesting of restricted stock awards granted under our 2007 Long-Term Equity Compensation Plan), and 1.4 million common shares acquired under the ASR which terminated on January 15, 2016. At October 27, 2016, the remaining authorization under the common share repurchase program approved by our Board of Directors was $375 million (refer to Part II, Item 2 'Unregistered Sales of Equity Securities and Use of Proceeds' for additional information).\nWe continue to expect that cash flows generated from our operations, combined with the liquidity provided by our investment portfolio, will be sufficient to cover our required cash outflows and other contractual commitments through the foreseeable future.\n71\nCRITICAL ACCOUNTING ESTIMATES\nOur Consolidated Financial Statements include certain amounts that are inherently uncertain and judgmental in nature. As a result, we are required to make assumptions and best estimates in order to determine the reported values. We consider an accounting estimate to be critical if: (1) it requires that significant assumptions be made in order to deal with uncertainties and (2) changes in the estimate could have a material impact on our results of operations, financial condition or liquidity.\nAs disclosed in our 2015 Annual Report on Form 10-K, we believe that the material items requiring such subjective and complex estimates are our:\n| • | reserves for losses and loss expenses; |\n\n| • | reinsurance recoverable balances; |\n\n| • | premiums; |\n\n| • | fair value measurements for our financial assets and liabilities; and |\n\n| • | assessments of other-than-temporary impairments. |\n\nWe believe that the critical accounting estimates discussion in Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2015, continues to describe the significant estimates and judgments included in the preparation of our Consolidated Financial Statements.\nNEW ACCOUNTING STANDARDS\nRefer to Item 1, Note 1 'Basis of Presentation and Accounting policies' to the Consolidated Financial Statements and Item 8, Note 2 'Significant Accounting Policies' to the Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2015, for a discussion of recently issued accounting pronouncements that we have not yet adopted.\nOFF-BALANCE SHEET AND SPECIAL PURPOSE ENTITY ARRANGEMENTS\nAt September 30, 2016, we have not entered into any off-balance sheet arrangements, as defined by Item 303(a)(4) of Regulation S-K.\nNON-GAAP FINANCIAL MEASURES\nIn this report, we present operating income, consolidated underwriting income, underwriting-related general and administrative expenses and amounts presented on a constant currency basis, which are “non-GAAP financial measures” as defined in Regulation G.\nOperating income represents after-tax operational results without consideration of after-tax net realized investment gains (losses), foreign exchange losses (gains), termination fee received and reorganization and related expenses. We also present diluted operating income per common share and operating return on average common equity (“operating ROACE”), which are derived from the non-GAAP operating income measure.\nConsolidated underwriting income is a pre-tax measure of underwriting profitability that takes into account net premiums earned and other insurance related income as revenues and net losses and loss expenses, acquisition costs and underwriting-related general and administrative costs as expenses. Underwriting-related general and administrative expenses include those general and administrative expenses that are incremental and/or directly attributable to our individual underwriting operations. While these measures are presented in Item 1, Note 2 to our Consolidated Financial Statements, they are considered non-GAAP financial measures when presented elsewhere on a consolidated basis.\nAmounts presented on a constant currency basis are calculated by applying the average foreign exchange rate from the current year to prior year amounts.\n72\nOperating income, diluted operating income per common share and operating ROACE can be reconciled to the nearest GAAP financial measures as follows:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Net income available to common shareholders | $ | 176,644 | $ | 247,620 | $ | 334,554 | $ | 466,772 |\n| Net realized investment (gains) losses, net of tax(1) | (2,726 | ) | 67,897 | 42,667 | 119,442 |\n| Foreign exchange gains, net of tax(2) | (13,229 | ) | (27,410 | ) | (67,771 | ) | (68,456 | ) |\n| Termination fee received(3) | — | (280,000 | ) | — | (280,000 | ) |\n| Reorganization and related expenses, net of tax(4) | — | 42,924 | — | 42,924 |\n| Operating income | $ | 160,689 | $ | 51,031 | $ | 309,450 | $ | 280,682 |\n| Earnings per common share - diluted | $ | 1.96 | $ | 2.50 | $ | 3.61 | $ | 4.65 |\n| Net realized investment (gains) losses, net of tax | (0.03 | ) | 0.68 | 0.46 | 1.19 |\n| Foreign exchange gains, net of tax | (0.15 | ) | (0.28 | ) | (0.73 | ) | (0.69 | ) |\n| Termination fee received | — | (2.82 | ) | — | (2.79 | ) |\n| Reorganization and related expenses, net of tax | — | 0.43 | — | 0.43 |\n| Operating income per common share - diluted | $ | 1.78 | $ | 0.51 | $ | 3.34 | $ | 2.79 |\n| Weighted average common shares and common share equivalents - diluted(5) | 90,351 | 99,124 | 92,579 | 100,468 |\n| Average common shareholders’ equity | $ | 5,369,921 | $ | 5,259,619 | $ | 5,319,849 | $ | 5,195,901 |\n| ROACE (annualized) | 13.2 | % | 18.8 | % | 8.4 | % | 12.0 | % |\n| Operating ROACE (annualized) | 12.0 | % | 3.9 | % | 7.8 | % | 7.2 | % |\n\n| (1) | Tax cost (benefit) of $2,479 and ($2,060) for the three months ended September 30, 2016 and 2015, respectively, and $2,372 and ($4,176) for the nine months ended September 30, 2016 and 2015, respectively. Tax impact is estimated by applying the statutory rates of applicable jurisdictions, after consideration of other relevant factors including the ability to utilize capital losses. |\n\n| (2) | Tax cost of $566 and $678 for the three months ended September 30, 2016 and 2015, respectively, and $2,010 and $744 for the nine months ended September 30, 2016 and 2015, respectively. Tax impact is estimated by applying the statutory rates of applicable jurisdictions, after consideration of other relevant factors including the tax status of specific foreign exchange transactions. |\n\n| (3) | Tax impact is nil. |\n\n| (4) | Tax benefit of nil and $2,943 for the three months ended September 30, 2016 and 2015, respectively, and nil and $2,943 for the nine months ended September 30, 2016 and 2015, respectively. Tax impact is estimated by applying the statutory rates of applicable jurisdictions, reflecting the jurisdictional apportionment and related tax treatment of the individual components of the reorganization and related expenses. |\n\n| (5) | Refer to Item 1, Note 8 to our Consolidated Financial Statements for further details on the dilution calculation. |\n\nA reconciliation of consolidated underwriting income to income before income taxes (the nearest GAAP financial measure) can be found in Item 1, Note 2 to the Consolidated Financial Statements. Underwriting-related general and administrative expenses are reconciled to general and administrative expenses (the nearest GAAP financial measure) within 'Underwriting Results - Group'.\nWe present our results of operations in the way we believe will be most meaningful and useful to investors, analysts, rating agencies and others who use our financial information to evaluate our performance. This includes the presentation of “operating income”, (in total and on a per share basis), “annualized operating ROACE” (which is based on the “operating income” measure) and “consolidated underwriting income”, which incorporates “underwriting-related general and administrative expenses”.\nOperating Income\nAlthough the investment of premiums to generate income and realized investment gains (losses) is an integral part of our operations, the determination to realize investment gains (losses) is independent of the underwriting process and is heavily influenced by the availability of market opportunities. Furthermore, many users believe that the timing of the realization of investment gains (losses) is somewhat opportunistic for many companies.\n73\nForeign exchange losses (gains) in our Consolidated Statements of Operations are primarily driven by the impact of foreign exchange rate movements on net insurance related-liabilities. However, this movement is only one element of the overall impact of foreign exchange rate fluctuations on our financial position. In addition, we recognize unrealized foreign exchange losses (gains) on our available-for-sale investments in other comprehensive income and foreign exchange losses (gains) realized upon the sale of these investments in net realized investments gains (losses). These unrealized and realized foreign exchange rate movements generally offset a large portion of the foreign exchange losses (gains) reported separately in earnings, thereby minimizing the impact of foreign exchange rate movements on total shareholders' equity. As such, the Statement of Operations foreign exchange losses (gains) in isolation are not a fair representation of the performance of our business.\nThe termination fee received represents the break-up fee paid by PartnerRe Ltd. following the cancellation of the amalgamation agreement with AXIS Capital and is not indicative of future revenues of the Company.\nReorganization and related expenses are primarily driven by business decisions, the nature and timing of which is unrelated to the underwriting process and which are not representative of underlying business performance.\nIn this regard, certain users of our financial statements evaluate earnings excluding after-tax net realized investment gains (losses) and foreign exchange losses (gains) to understand the profitability of recurring sources of income.\nWe believe that showing net income available to common shareholders exclusive of net realized gains (losses), foreign exchange losses (gains), termination fee received and reorganization and related expenses reflects the underlying fundamentals of our business. In addition, we believe that this presentation enables investors and other users of our financial information to analyze performance in a manner similar to how our management analyzes the underlying business performance. We also believe this measure follows industry practice and, therefore, facilitates comparison of our performance with our peer group. We believe that equity analysts and certain rating agencies that follow us, and the insurance industry as a whole, generally exclude these items from their analyses for the same reasons.\nConsolidated Underwriting Income/Underwriting-Related General and Administrative Expenses\nCorporate expenses include holding company costs necessary to support our worldwide insurance and reinsurance operations and costs associated with operating as a publicly-traded company. As these costs are not incremental and/or directly attributable to our individual underwriting operations, we exclude them from underwriting-related general and administrative expenses and, therefore, consolidated underwriting income. Interest expense and financing costs primarily relate to interest payable on our senior notes and are excluded from consolidated underwriting income for the same reason.\nWe evaluate our underwriting results separately from the performance of our investment portfolio. As such, we believe it appropriate to exclude net investment income and net realized investment gains (losses) from our underwriting profitability measure.\nAs noted above, foreign exchange losses (gains) in our Consolidated Statements of Operations primarily relate to our net insurance-related liabilities. However, we manage our investment portfolio in such a way that unrealized and realized foreign exchange rate losses (gains) on our investment portfolio generally offset a large portion of the foreign exchange losses (gains) arising from our underwriting portfolio. As a result, we believe that foreign exchange losses (gains) are not a meaningful contributor to our underwriting performance and, therefore, exclude them from consolidated underwriting income.\nThe termination fee received represents the break-up fee received on the cancellation of the amalgamation agreement between PartnerRe Ltd. and AXIS Capital and should be excluded from consolidated underwriting income since it is not related to underwriting operations.\nReorganization and related expenses are driven by business decisions, the nature and timing of which are unrelated to the underwriting process and for this reason they are excluded from consolidated underwriting income.\nWe believe that presentation of underwriting-related general and administrative expenses and consolidated underwriting income provides investors with an enhanced understanding of our results of operations, by highlighting the underlying pre-tax profitability of our underwriting activities.\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nRefer to Item 7A included in our 2015 Form 10-K. With the exception of the changes in exposure to foreign currency risk presented below, there have been no material changes to this item since December 31, 2015.\nForeign Currency Risk\nThe table below provides a sensitivity analysis of our total net foreign currency exposures.\n| AUD | NZD | CAD | EUR | GBP | JPY | Other | Total |\n| At September 30, 2016 |\n| Net managed assets (liabilities), excluding derivatives | $ | 85,933 | $ | (6,574 | ) | $ | 74,859 | $ | (159,487 | ) | $ | (59,745 | ) | $ | 21,593 | $ | 132,185 | $ | 88,764 |\n| Foreign currency derivatives, net | (79,700 | ) | 7,287 | (80,621 | ) | 204,334 | 5,836 | (26,126 | ) | 11,790 | 42,800 |\n| Net managed foreign currency exposure | 6,233 | 713 | (5,762 | ) | 44,847 | (53,909 | ) | (4,533 | ) | 143,975 | 131,564 |\n| Other net foreign currency exposure | 2,060 | — | — | 22,881 | 1,011 | — | 68,969 | 94,921 |\n| Total net foreign currency exposure | $ | 8,293 | $ | 713 | $ | (5,762 | ) | $ | 67,728 | $ | (52,898 | ) | $ | (4,533 | ) | $ | 212,944 | $ | 226,485 |\n| Net foreign currency exposure as a percentage of total shareholders’ equity | 0.1 | % | — | % | (0.1 | %) | 1.1 | % | (0.9 | %) | (0.1 | %) | 3.5 | % | 3.8 | % |\n| Pre-tax impact of net foreign currency exposure on shareholders’ equity given a hypothetical 10% rate movement(1) | $ | 829 | $ | 71 | $ | (576 | ) | $ | 6,773 | $ | (5,290 | ) | $ | (453 | ) | $ | 21,294 | $ | 22,648 |\n\n| (1) | Assumes 10% change in underlying currencies relative to the U.S. dollar. |\n\nTotal Net Foreign Currency Exposure\nAt September 30, 2016, our total net foreign currency exposure was $226 million net long, driven by increases in our exposures to the euro and other non-core currencies primarily due to new business written during the first nine months of 2016.\nITEM 4. CONTROLS AND PROCEDURES\nThe Company’s management has performed an evaluation, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the “Exchange Act”)) as of September 30, 2016. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of September 30, 2016, our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and is accumulated and communicated to\n74\nmanagement, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.\nThe Company’s management has performed an evaluation, with the participation of the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of changes in the Company’s internal control over financial reporting that occurred during the three months ended September 30, 2016. Based upon that evaluation, there were no changes in our internal control over financial reporting that occurred during the three months ended September 30, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\nPART II OTHER INFORMATION\n\nITEM 1. LEGAL PROCEEDINGS\nFrom time to time, we are subject to routine legal proceedings, including arbitrations, arising in the ordinary course of business. These legal proceedings generally relate to claims asserted by or against us in the ordinary course of insurance or reinsurance operations; estimated amounts payable under such proceedings are included in the reserve for losses and loss expenses in our Consolidated Balance Sheets.\nWe are not a party to any material legal proceedings arising outside the ordinary course of business.\nITEM 1A. RISK FACTORS\nThere were no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2015.\n75\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nThe following table presents information regarding the number of shares we repurchased during the three months ended September 30, 2016:\nISSUER PURCHASES OF EQUITY SECURITIES\nCommon Shares\n| Period | Total Numberof SharesPurchased | AveragePrice PaidPer Share | Total Number of SharesPurchased as Part ofPublicly AnnouncedPlans or Programs(1) | Maximum Number (or ApproximateDollar Value) of Shares That May Yet BePurchased Under the Announced Plansor Programs(2) |\n| July 1-31, 2016 | 127 | $55.45 | 108 | $494.0 million |\n| August 1-31, 2016 | 1,552 | $55.88 | 1,552 | $407.3 million |\n| September 1-30, 2016 | 572 | $56.36 | 571 | $375.1 million |\n| Total | 2,251 | 2,231 | $375.1 million |\n\n| (1) | From time to time, we purchase shares in connection with the vesting of restricted stock awards granted to our employees under our 2007 Long-Term Equity Compensation Plan. The purchase of these shares is separately authorized and is not part of our Board-authorized share repurchase program, described below. |\n\n| (2) | On December 7, 2015, our Board of Directors authorized a share repurchase plan to repurchase up to $750 million of our common shares through to December 31, 2016. The share repurchase authorization which became effective on December 31, 2015, replaced the previous plan which had $444 million available through the end of 2016. Share repurchases may be effected from time to time in the open market or privately negotiated transactions, depending on market conditions. |\n\nITEM 5. OTHER INFORMATION\nDisclosure of Certain Activities Under Section 13(r) of the Securities Exchange Act of 1934\nSection 13(r) of the Securities Exchange Act of 1934, as amended, requires issuers to disclose in their annual and quarterly reports whether they or any of their affiliates knowingly engaged in certain activities with Iran or with individuals or entities that are subject to certain sanctions under U.S. law. Issuers are required to provide this disclosure even where the activities, transactions or dealings are conducted outside of the United States in compliance with applicable law.\nAs and when allowed by the applicable law and regulations, certain of our non-U.S. subsidiaries provide treaty reinsurance coverage to non-U.S. insurers of marine, aviation and energy risks on a worldwide basis, and as a result, these underlying reinsurance portfolios may have some exposure to Iran. In addition, we underwrite insurance and facultative reinsurance on a global basis to non-U.S. insureds and reinsureds for marine, aviation and energy risks. Coverage provided to non-Iranian business may indirectly cover an exposure in Iran. For example, certain of our operations underwrite global marine hull and cargo policies that provide coverage for vessels navigating into and out of ports worldwide, including Iran. For the quarter ended September 30, 2016, no premium has been allocated or apportioned to activities relating to Iran. As we believe these activities are permitted under applicable laws and regulations, we intend for our non-U.S. subsidiaries to continue to provide such coverage to the extent permitted by applicable law.\n76\nITEM 6. EXHIBITS\n| 3.1 | Certificate of Incorporation and Memorandum of Association (incorporated by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-1(Amendment No. 1) (No. 333-103620) filed on April 16, 2003). |\n| 3.2 | Amended and Restated Bye-Laws (incorporated by reference to Exhibit 4.2 to the Company’s Registration Statement on Form S-8 filed on May 15, 2009). |\n| 4.1 | Specimen Common Share Certificate (incorporated by reference to Exhibit 4.1 to the Company’s Registration Statement on Form S-1 (Amendment No. 3) (No. 333-103620) filed on June 10, 2003). |\n| 4.2 | Certificate of Designations establishing the specific rights, preferences, limitations and other terms of the Series C Preferred Shares (incorporated by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K filed on March 19, 2012). |\n| 4.3 | Certificate of Designations establishing the specific rights, preferences, limitations and other terms of the Series D Preferred Shares (incorporated by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K filed on May 20, 2013). |\n| 10.1 | Amendment No. 1 to Employment Agreement dated June 23, 2014 by and between Peter W. Wilson and AXIS Specialty U.S. Services, Inc. effective September 21, 2016 (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed on September 27, 2016). |\n| †31.1 | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| †31.2 | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| †32.1 | Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| †32.2 | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| †101 | The following financial information from AXIS Capital Holdings Limited’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2016 formatted in XBRL: (i) Consolidated Balance Sheets at September 30, 2016 and December 31, 2015; (ii) Consolidated Statements of Operations for the three and nine months ended September 30, 2016 and 2015; (iii) Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2016 and 2015; (iv) Consolidated Statements of Changes in Shareholders' Equity for the nine months ended September 30, 2016 and 2015; (v) Consolidated Statements of Cash Flows for the nine months ended September 30, 2016 and 2015; and (vi) Notes to Consolidated Financial Statements, tagged as blocks of text and in detail. |\n\n| † | Filed herewith. |\n\nThe agreements and other documents filed as exhibits to this report are not intended to provide factual information or other disclosure other than with respect to the terms of the agreements or other documents themselves, and you should not rely on them for that purpose. In particular, any representations and warranties made by us in these agreements or other documents were made solely within the specific context of the relevant agreement or document and may not describe the actual state of affairs as of the date they were made or at any other time.\n77\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\nDated: October 27, 2016\n\n| AXIS CAPITAL HOLDINGS LIMITED |\n| By: | /S/ ALBERT BENCHIMOL |\n| Albert Benchimol |\n| President and Chief Executive Officer |\n| /S/ JOSEPH HENRY |\n| Joseph Henry |\n| Executive Vice President and Chief Financial Officer |\n| (Principal Financial Officer) |\n\n78\n</text>\n\nWhat would the return on investment be if the net investment income from the third quarter was invested in acquiring new common shares (in percent)?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nPART I—FINANCIAL INFORMATION\nItem 1. Condensed Consolidated Financial Statements.\nUnaudited Condensed Consolidated Balance Sheets\n\n| As of | June 30, 2022 | December 31, 2021 |\n| ASSETS |\n| Current assets: |\n| Cash and cash equivalents | $ | 149,824 | $ | 905,051 |\n| Accounts receivable, net of allowance for doubtful accounts of $ 0 and $ 0 , respectively | 1,293 | - |\n| Inventories, net | 102,981 | 88,877 |\n| Prepaid expense and other current assets | 220,113 | 191,838 |\n| Total current assets | 474,211 | 1,185,766 |\n| Property and equipment, net | 1,181,365 | 1,110,890 |\n| Operating lease right-of-use asset | 2,937,437 | 2,466,873 |\n| Total assets | $ | 4,593,013 | $ | 4,763,529 |\n| LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT) |\n| Current liabilities: |\n| Accounts payable | $ | 158 | $ | 45,748 |\n| Accrued expenses and current liabilities | 171,070 | 124,535 |\n| Line of credit | 594,529 | - |\n| Loans payable to financial institutions – current portion | - | 98,475 |\n| Loans payable to shareholders | 150,000 | - |\n| Loan payable, emergency injury disaster loan (EIDL) – current portion | 10,760 | 7,957 |\n| Loan payable, payroll protection program (PPP) – current portion | 39,169 | 42,345 |\n| Equipment loan payable – current portion | 6,312 | 15,989 |\n| Operating lease liabilities – current portion | 655,603 | 578,419 |\n| Total current liabilities | 1,627,601 | 913,468 |\n| Loans payable to financial institutions – net of current portion | - | 23,228 |\n| Loan payable, emergency injury disaster loan (EIDL), net of current portion | 489,240 | 492,043 |\n| Loan payable, payroll protection program (PPP), net of current portion | 127,969 | 124,793 |\n| Operating lease liabilities, net of current portion | 2,427,168 | 2,011,702 |\n| Total liabilities | 4,671,978 | 3,565,234 |\n| Commitments and Contingencies |\n| Stockholders’ equity (deficit) |\n| Common Stock, $ 0.0001 par value, 40,000,000 shares authorized; 11,679,523 and 11,634,523 shares issued and outstanding at June 30, 2022 and December 31, 2021 | 1,168 | 1,163 |\n| Preferred Stock, $ 0.0001 par value, 1,000,000 shares authorized; no shares issued and outstanding at June 30, 2022 and December 31, 2021 | - | - |\n| Additional paid-in capital | 9,899,031 | 9,674,036 |\n| Accumulated deficit | ( 9,979,164 | ) | ( 8,476,904 | ) |\n| Total stockholders’ equity (deficit) | ( 78,965 | ) | 1,198,295 |\n| Total liabilities and stockholders’ equity | $ | 4,593,013 | $ | 4,763,529 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n1\nUnaudited Condensed Consolidated Statements of Operations\n\n| Six Months Ended June 30, | Three Months Ended June 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Net revenues: |\n| Stores | $ | 1,511,952 | $ | 851,785 | $ | 775,956 | $ | 475,824 |\n| Wholesale and online | 29,674 | 28,336 | 12,520 | 15,368 |\n| Total net revenues | 1,541,626 | 880,121 | 788,476 | 491,192 |\n| Operating costs and expenses: |\n| Product, food and drink costs—stores | 563,906 | 270,148 | 278,952 | 135,452 |\n| Cost of sales—wholesale and online | 12,997 | 12,412 | 5,484 | 6,732 |\n| General and administrative | 2,468,447 | 1,226,951 | 1,432,432 | 656,310 |\n| Total operating costs and expenses | 3,045,350 | 1,509,511 | 1,716,868 | 798,494 |\n| Loss from operations | ( 1,503,724 | ) | ( 629,390 | ) | ( 928,392 | ) | ( 307,302 | ) |\n| Other income (expense): |\n| Other income | 16,440 | - | 1,440 | - |\n| Interest expense | ( 14,976 | ) | ( 5,773 | ) | ( 10,196 | ) | ( 382 | ) |\n| Total other income (expense), net | 1,464 | ( 5,773 | ) | ( 8,756 | ) | ( 382 | ) |\n| Loss before income taxes | ( 1,502,260 | ) | ( 635,163 | ) | ( 937,148 | ) | ( 307,684 | ) |\n| Provision for income taxes | - | - | - | - |\n| Net loss | $ | ( 1,502,260 | ) | $ | ( 635,163 | ) | $ | ( 937,148 | ) | $ | ( 307,684 | ) |\n| Loss per share: |\n| Basic and diluted | $ | ( 0.13 | ) | ( 0.06 | ) | ( 0.08 | ) | ( 0.03 | ) |\n| Weighted average number of common shares outstanding: |\n| Basic and diluted | 11,642,550 | 10,282,669 | 11,667,545 | 10,380,944 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n2\nUnaudited Condensed Consolidated Stockholders’ Equity (Deficit)\n\n| Common Stock | Preferred Stock | Additional Paid-in | Subscription of Common | Accumulated | Total Shareholders’ |\n| Shares | Amount | Shares | Amount | Capital | Stock | Deficit | Deficit |\n| Balance as of December 31, 2021 | 11,634,523 | $ | 1,163 | - | $ | - | $ | 9,674,036 | $ | - | $ | ( 8,476,904 | ) | $ | 1,198,295 |\n| Net loss | - | - | - | - | - | - | ( 565,112 | ) | ( 565,112 | ) |\n| Balance as of March 31, 2022 | 11,634,523 | $ | 1,163 | - | $ | - | $ | 9,674,036 | $ | - | $ | ( 9,042,016 | ) | $ | 633,183 |\n| Stock compensation | 45,000 | 5 | - | - | 224,995 | - | - | 225,000 |\n| Net loss | - | - | - | - | - | - | ( 937,148 | ) | ( 937,148 | ) |\n| Balance as of June 30, 2022 | 11,679,523 | $ | 1,168 | - | $ | - | $ | 9,899,031 | $ | - | $ | ( 9,979,164 | ) | $ | ( 78,965 | ) |\n\n\n| Common Stock | Preferred Stock | Additional Paid-in | Subscription of Common | Accumulated | Total Shareholders’ |\n| Shares | Amount | Shares | Amount | Capital | Stock | Deficit | Deficit |\n| Balance as of December 31, 2020 | 10,443,721 | $ | 1,045 | - | $ | - | $ | 4,733,063 | $ | ( 450,000 | ) | $ | ( 5,036,504 | ) | $ | ( 752,396 | ) |\n| Net loss | - | - | - | - | - | - | ( 327,479 | ) | ( 327,479 | ) |\n| Payments received for prior year subscription | - | - | - | - | - | 450,000 | - | 450,000 |\n| Stock issued for store acquisition | 232,558 | 23 | - | - | 149,977 | - | - | 150,000 |\n| Balance as of March 31, 2021 | 10,676,279 | $ | 1,068 | - | $ | - | $ | 4,883,040 | $ | - | $ | ( 5,363,983 | ) | $ | ( 479,875 | ) |\n| Net loss | - | - | - | - | - | - | ( 307,684 | ) | ( 307,684 | ) |\n| Stock subscription | 30,950 | 3 | - | - | 154,747 | ( 154,750 | ) | - | - |\n| Payments received for prior year subscription | - | - | - | - | - | 103,500 | - | 103,500 |\n| Balance as of June 30, 2021 | 10,707,229 | $ | 1,071 | - | $ | - | $ | 5,037,787 | $ | ( 51,250 | ) | $ | ( 5,671,667 | ) | $ | ( 684,059 | ) |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n3\nUnaudited Condensed Consolidated Statements of Cash Flows\n\n| For the Six Months Ended June 30, | 2022 | 2021 |\n| Cash flows from operating activities: |\n| Net loss | $ | ( 1,502,260 | ) | $ | ( 635,163 | ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: |\n| Stock compensation | 225,000 | - |\n| Operating lease | 22,086 | 20,559 |\n| Depreciation | 97,922 | 81,926 |\n| Changes in operating assets and liabilities: |\n| Accounts receivable | ( 1,293 | ) | ( 269 | ) |\n| Inventories | ( 14,104 | ) | ( 7,245 | ) |\n| Prepaid expense and other current assets | ( 28,275 | ) | ( 65,083 | ) |\n| Accounts payable | ( 45,590 | ) | 49,508 |\n| Accrued expenses and current liabilities | 46,535 | 17,415 |\n| Net cash used in operating activities | ( 1,199,979 | ) | ( 538,352 | ) |\n| Cash flows from investing activities: |\n| Purchases of property and equipment | ( 168,397 | ) | ( 167,152 | ) |\n| Reacquisition of store | - | ( 150,000 | ) |\n| Net cash used in investing activities | ( 168,397 | ) | ( 317,152 | ) |\n| Cash flows from financing activities: |\n| Proceeds from issuance of common stock | - | 553,499 |\n| Proceeds from line of credit | 594,529 | - |\n| Proceeds from loan payable to shareholders | 150,000 | 533,127 |\n| Repayment of loans | ( 121,703 | ) | ( 210,453 | ) |\n| Repayment of equipment loan payable | ( 9,677 | ) | ( 9,594 | ) |\n| Net cash provided by financing activities | 613,149 | 866,579 |\n| Net (decrease) increase in cash | ( 755,227 | ) | 11,075 |\n| Cash at beginning of period | 905,051 | 128,568 |\n| Cash at end of period | $ | 149,824 | $ | 139,643 |\n| Supplemental disclosures of non-cash financing activities: |\n| Issuance of common shares for repurchase of store | $ | - | $ | 150,000 |\n| Issuance of common shares for compensation | $ | 225,000 | $ | - |\n| Supplemental disclosure of cash flow information: |\n| Cash paid during the years for: |\n| Lease liabilities | $ | 435,635 | $ | 224,988 |\n| Interest | $ | 367 | $ | 5,773 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n4\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n1. NATURE OF OPERATIONS\nReborn Coffee, Inc. (“Reborn”) was incorporated in the State of Florida in January 2018. In July 2022, Reborn was migrated from Florida to Delaware, and filed a certificate of incorporation with the Secretary of State of the State of Delaware having the same capitalization structure as the Florida predecessor entity. Reborn has the following wholly owned subsidiaries:\n\n| ● | Reborn Global Holdings, Inc. (“Reborn Holdings”), a California Corporation incorporated in November 2014. Reborn Holdings is engaged in the operation of wholesale distribution and retail coffee stores in California to sell a variety of coffee, tea, Reborn brand name water and other beverages along with bakery and dessert products. |\n\n\n| ● | Reborn Coffee Franchise, LLC (the “Reborn Coffee Franchise”), a California limited liability corporation formed in December 2020, is a franchisor providing premier roaster specialty coffee to franchisees or customers. Reborn Coffee Franchise continues to develop the Reborn Coffee system for the establishment and operation of Reborn Coffee stores using one or more Reborn Coffee marks. The franchisee obtains a license to develop and operate a store under the strict compliance with terms of the agreement. The specific rights the franchisee is granted is to develop, own, and/or operate franchisee’s Reborn Coffee stores. The non-refundable initial franchise fee is $ 20,000 . In addition, the franchisee is required to pay the company a royalty fee equal to 5 % of the weekly gross sales of their respective store. |\n\nReborn Coffee, Inc., Reborn Global Holdings, Inc., and Reborn Coffee Franchise, LLC will be collectively referred as the “Company”.\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nReporting\nThe unaudited condensed consolidated financial statements include Reborn Coffee, Inc. and its wholly owned subsidiaries as of June 30, 2022 and December 31, 2021 and for the three and six month periods ended June 30, 2022 and 2021.\nBasis of Presentation and Consolidation\nThe accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”) as promulgated in the United States of America. The consolidated financial statements include Reborn Coffee, Inc. and its wholly owned subsidiaries. All intercompany accounts, transactions, and profits have been eliminated upon consolidation.\nReverse Stock Split\nIn June 2022, the Company approved (a) the conversion of all Class B Common Stock into Class A Common Stock, (b) a 1 for 100 reverse stock split , and (c) an amendment to Articles of Incorporation to eliminate Class B and to change “Class A” to simply “common stock”. All share and earnings per share information have been retroactively adjusted to reflect the stock split and the incremental par value of the newly issued shares was recorded with the offset to additional paid-in capital.\nGoing Concern\nThe accompanying unaudited condensed consolidated financial statements have been prepared assuming the Company will continue as a going concern, which contemplates, among other things, the realization of assets and satisfaction of liabilities in the normal course of business. The Company had an accumulated deficit of $ 9,979,164 at June 30, 2022, had a net loss of $ 1,502,260 for the six-month period ended June 30, 2022 and net cash used in operating activities of $ 1,199,979 for the six-month period ended June 30, 2022. These matters raise substantial doubt about the Company’s ability to continue as a going concern.\n5\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\nWhile the Company is attempting to expand operations and increase revenues, the Company’s cash position may not be significant enough to support the Company’s daily operations. Management intends to raise additional funds by way of public or private offerings. Management believes that the actions presently being taken to further implement its business plan and generate revenues provide the opportunity for the Company to continue as a going concern. While management believes in the viability of its strategy to generate revenues and in its ability to raise additional funds, there can be no assurances to that effect or if available, on terms acceptable to the Company. The ability of the Company to continue as a going concern is dependent upon the Company’s ability to further implement its business plan and generate additional profit. Compared to the revenue for the six-month period ended June 30, 2021, however, net revenue for the six-month period ended June 30, 2022 has increased from $ 880,121 to $ 1,541,626 , and the Company expects consistent increase in sales with the opening of more stores. In August 2022, the Company consummated its initial public offering (the “IPO”) of 1,440,000 shares of its common stock at a public offering price of $ 5.00 per share, generating gross proceeds of $ 7,200,000 . The initial public offering is summarized in Note 12 to the unaudited condensed consolidated financial statements.\nThe unaudited condensed consolidated financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.\nUse of Estimates\nThe preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States (“U.S. GAAP”) requires the Company to make estimates and assumptions that affect the amounts reported in our consolidated financial statements and the accompanying notes. Such estimates include accounts receivables, accrued liabilities, income taxes, long-lived assets, and deferred tax valuation allowances. These estimates generally involve complex issues and require management to make judgments, involve analysis of historical and future trends that can require extended periods of time to resolve, and are subject to change from period to period. In all cases, actual results could differ materially from estimates.\nRevenue Recognition\nThe Company recognizes revenue in accordance with Accounting Standards Codification (“ASC”) 606, Revenue from Contracts with Customers. The Company’s net revenue primarily consists of revenues from its retail stores and wholesale and online store. Accordingly, the Company recognizes revenue as follows:\n\n| ● | Retail Store Revenue |\n\nRetail store revenues are recognized when payment is tendered at the point of sale. Retail store revenues are reported net of sales, use or other transaction taxes that are collected from customers and remitted to taxing authorities. Sales taxes that are payable are recorded as accrued as other current liabilities. Retail store revenue makes up approximately 98 % of the Company’s total revenue.\n\n| ● | Wholesale and Online Revenue |\n\nWholesale and online revenues are recognized when the products are delivered, and title passes to the customers or to the wholesale distributors. When customers pick up products at the Company’s warehouse, or distributed to the wholesale distributors, the title passes, and revenue is recognized. Wholesale revenues make up approximately 2 % of the Company’s total revenue.\n\n| ● | Royalties and Other Fees |\n\nFranchise revenues consists of royalties and other franchise fees. Royalties are based on a percentage of franchisee’s weekly gross sales revenue at 5 %. The Company recognizes the royalties as the underlying sales occur. The Company recorded revenue from royalties of $ 0 for the six-month periods ended June 30, 2022 and 2021. Other fees are earned as incurred and the Company did not have any other fee revenue for the six-month periods ended June 30, 2022 and 2021.\nShipping and Handling Costs\nThe Company incurred freight out cost and is included in the Company’s cost of sales - wholesale and online.\n6\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\nGeneral and Administrative Expense\nGeneral and administrative expense includes store-related expense as well as the Company’s corporate headquarters’ expenses.\nAdvertising Expense\nAdvertising costs are expensed as incurred. Advertising expenses amounted to $ 20,513 and $ 50,160 for the six-month periods ended June 30, 2022 and 2021, respectively, and is recorded under general and administrative expenses in the accompanying consolidated statements of operations.\nPre-opening Costs\nPre-opening costs for new stores, consist primarily of store and leasehold improvements, and are capitalized and depreciated over the shorter of the useful life of the improvement or the lease term, including renewal periods that are reasonably assured.\nAccounts Receivable\nAccounts receivables are stated net of allowance for doubtful accounts. The allowance for doubtful accounts is determined primarily on the basis of past collection experience and general economic conditions. The Company determines terms and conditions for its customers based on volume transacted by the customer, customer creditworthiness and past transaction history. At June 30, 2022 and December 31, 2021, allowance for doubtful accounts was $ 0 and $ 0 , respectively. The Company does not have any off-balance sheet exposure related to its customers.\nInventories\nInventories consisted primarily of coffee beans, drink products, and supplies which are recorded at cost or at net realizable value.\nProperty and Equipment\nProperty and equipment are recorded at cost. Maintenance and repairs are charged to expense as incurred. Depreciation and amortization are provided using both the straight-line and declining balance methods over the following estimated useful lives:\n\n| Furniture and fixtures | 5 - 7 Years |\n| Store construction | Lesser of the lease term or the estimated useful lives of the improvements, generally 6 years |\n| Leasehold improvement | Lesser of the lease term or the estimated useful lives of the improvements, generally 6 years |\n\nWhen assets are retired or disposed of, the cost and accumulated depreciation thereon are removed, and any resulting gains or losses are included in the consolidated statements of operations. Leasehold improvements are amortized using the straight-line method over the estimated life of the asset, not to exceed the length of the lease. Repair and maintenance costs are expensed as incurred.\nOperating Leases\nThe Company adopted FASB Accounting Standards Codification, or ASC, Topic 842, Leases (“ASC 842”) which requires the recognition of the right-of-use assets and relating operating and finance lease liabilities on the balance sheet. Under ASC 842, all leases are required to be recorded on the balance sheet and are classified as either operating leases or finance leases. The lease classification affects the expense recognition in the income statement. Operating lease charges are recorded entirely in operating expenses. Finance lease charges are split, where amortization of the right-of-use asset is recorded in operating expenses and an implied interest component is recorded in interest expense.\nEarnings Per Share\nFinancial Accounting Standard Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 260, Earnings Per Share, requires a reconciliation of the numerator and denominator of the basic and diluted earnings (loss) per share (EPS) computations.\n7\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\nBasic earnings (loss) per share are computed by dividing net earnings available to common shareholders by the weighted-average number of common shares outstanding during the period. Diluted earnings (loss) per share is computed similar to basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common shares had been issued and if the additional common shares were dilutive. In periods where losses are reported, the weighted-average number of common stock outstanding excludes common stock equivalents, because their inclusion would be anti-dilutive.\nThe Company did not have any dilutive shares for the three and six month periods ended June 30, 2022 and 2021.\nSegment Reporting\nFASB ASC Topic 280, Segment Reporting, requires public companies to report financial and descriptive information about their reportable operating segments. The Company’s management identifies operating segments based on how the Company’s management internally evaluate separate financial information, business activities and management responsibility. At the current time, the Company has only one reportable segment, consisting of both the wholesale and retail sales of coffee, water, and other beverages. The Company’s franchisor subsidiary was not material as of and for the three and six month periods ended June 30, 2022 and 2021.\nLong-lived Assets\nIn accordance with FASB ASC Topic 360, Property, Plant, and Equipment, the Company reviews for impairment of long-lived assets and certain identifiable intangibles whenever events or circumstances indicate that the carrying amount of assets may not be recoverable. The Company considers the carrying value of assets may not be recoverable based upon our review of the following events or changes in circumstances: the asset’s ability to continue to generate income from operations and positive cash flow in future periods; loss of legal ownership or title to the assets; significant changes in our strategic business objectives and utilization of the asset; or significant negative industry or economic trends. An impairment loss would be recognized when estimated future cash flows expected to result from the use of the asset are less than its carrying amount. As of June 30, 2022 and December 31, 2021, the Company was not aware of any events or changes in circumstances that would indicate that the long-lived assets are impaired.\nFair Value of Financial Instruments\nThe Company records its financial assets and liabilities at fair value, which is defined under the applicable accounting standards as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measure date. The Company uses valuation techniques to measure fair value, maximizing the use of observable outputs and minimizing the use of unobservable inputs. The standard describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value which are the following:\nLevel 1 – Quoted prices in active markets for identical assets or liabilities.\nLevel 2 – Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.\nLevel 3 – Inputs include management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. The inputs are unobservable in the market and significant to the instrument’s valuation.\nAs of June 30, 2022 and December 31, 2021, the Company believes that the carrying value of accounts receivable, accounts payable, accrued expenses, and other current assets and liabilities approximate fair value due to the short maturity of theses financial instruments. The financial statements do not include any financial instruments at fair value on a recurring or non-recurring basis.\n8\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\nIncome Taxes\nIncome taxes are provided for the tax effects of transactions reported in the financial statements and consisted of taxes currently due and deferred taxes. Deferred taxes are recognized for the differences between the basis of assets and liabilities for financial statement and income tax purposes.\nThe Company follows FASB ASC Topic 740, Income Taxes, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each period end based on enacted tax laws and statutory tax rates, applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. ASC 740-10-25 provides criteria for the recognition, measurement, presentation and disclosure of uncertain tax position. The Company must recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate resolution. The Company did not recognize additional liabilities for uncertain tax positions pursuant to ASC 740-10-25 for the three and six month periods ended June 30, 2022 and 2021.\nConcentration of Credit Risk\nFinancial instruments that potentially subject the Company to concentrations of credit risk are accounts receivable arising from its normal business activities. The Company performs ongoing credit evaluations to its customers and establishes allowances when appropriate.\nCompany purchases from various vendors for its operations. For the three and six month periods ended June 30, 2022 and 2021, no purchases from any vendors accounted for a significant amount of the Company’s bean coffee purchases.\nRelated Parties\nRelated parties are any entities or individuals that, through employment, ownership, or other means, possess the ability to direct or cause the direction of management and policies of the Company.\nSignificant Recent Developments Regarding COVID-19\nThe novel coronavirus, known as the global pandemic COVID-19, was first identified in December 2019. During March 2020, a global pandemic was declared by the World Health Organization related to the rapidly spreading outbreak of a novel strain of coronavirus designated COVID-19. The pandemic has significantly impacted economic conditions in the United States. The outbreak of the virus impacted our company-owned retail locations in Southern California.\nThe Company first began to experience impacts from COVID-19 around the middle of March 2020 as federal, state and local governments began to react to the public health crisis by encouraging or requiring social distancing, instituting stay-at-home orders, and requiring, in varying degrees, restaurant dine-in limitations, capacity limitations or other restrictions that largely limited restaurants to take-out, drive-thru and delivery sales. Although we have experienced some recovery from the initial impact of COVID-19, the long-term impact of COVID-19 on the economy and on our business remains uncertain, the duration and scope of which cannot currently be predicted.\n9\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\nRecent Accounting Pronouncement\nIn June 2016, the FASB issued Accounting Standards Update No. 2016-13, “Financial Instruments - Credit Losses (Topic 326)” (“ASU 2016-13”). ASU 2016-13 revises the methodology for measuring credit losses on financial instruments and the timing of when such losses are recorded. Originally, ASU 2016-13 was effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2019, with early adoption permitted. In November 2019, FASB issued ASU 2019-10, “Financial Instruments – Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842).” This ASU defers the effective date of ASU 2016-13 for public companies that are considered smaller reporting companies as defined by the SEC to fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. The Company is planning to adopt this standard in the first quarter of fiscal 2023.The Company is currently evaluating the potential effects of adopting the provisions of ASU No. 2016-13 on its consolidated financial statements, particularly its recognition of allowances for accounts receivable.\nOther recently issued accounting updates are not expected to have a material impact on the Company’s consolidated financial statements.\n3. PROPERTY AND EQUIPMENT\nProperty and equipment consisted of the following:\n\n| June 30, 2022 | December 31, 2021 |\n| Furniture and equipment | $ | 849,809 | $ | 779,649 |\n| Leasehold improvement | 639,602 | 639,602 |\n| Store construction | 150,399 | 52,161 |\n| Store | 300,000 | 300,000 |\n| Total property and equipment | 1,939,810 | 1,771,412 |\n| Less accumulated depreciation | ( 758,445 | ) | ( 660,522 | ) |\n| Total property and equipment, net | $ | 1,181,365 | $ | 1,110,890 |\n\nIn February 2021, the Company repurchased its retail location in Corona Del Mar. The purchase price was $ 300,000 , comprised of $ 150,000 in cash and 232,558 shares of the Company’s common stock. The Company recorded the assumption of the ongoing lease for the store, which included a right of use asset of $ 183,442 and a lease liability of $ 193,463 .\nDepreciation expense on property and equipment amounted to approximately $ 97,922 and $ 81,926 for the six-month periods ended and $ 48,479 and $ 45,797 for the three-month periods ended June 30, 2022 and 2021, respectively.\n10\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n4. LOANS PAYABLE TO FINANCIAL INSTITUTIONS\nLoans payable to financial institutions consist of the following:\n\n| June 30, 2022 | December 31, 2021 |\n| July 2021 - Loan agreement with principal amount of $ 90,000 and repayment rate of 19 % for a total of $ 101,700 . The loan payable matures on January 31, 2023 . | $ | - | $ | 52,819 |\n| August 2021 - Loan agreement with principal amount of $72,500 and repayment rate of 18.5 % for a total of $ 81,925 . The loan payable matures on February 10, 2023 . | - | 36,502 |\n| August 2021 - Loan agreement with principal amount of $ 67,500 and repayment rate of 18.5 % for a total of $ 76,275 . The loan payable matures on February 11, 2023 . | - | 32,382 |\n| Total loan payable | $ | - | $ | 121,703 |\n| Less: current portion | - | ( 98,475 | ) |\n| Total loan payable, net of current | $ | - | $ | 23,228 |\n\nJuly 2021 - $ 101,700 loan payable\nIn July 2021, the Company entered into a loan agreement with Square Capital in the principal amount of $ 90,000 with loan cost $ 11,700 . The loan payable has a maturity date on January 31, 2023 . As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $ 0 and $ 52,819 , respectively.\nAugust 2021 - $ 81,925 loan payable\nIn August 2021, the Company entered into a loan agreement with Square Capital in the principal amount of $ 72,500 with loan cost $ 9,425 . The loan payable has a maturity date on February 10, 2023 . As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $ 0 and $ 36,502 , respectively.\nAugust 2021 - $ 76,275 loan payable\nIn August 2021, the Company entered into a loan agreement with Square Capital in the principal amount of $ 67,500 with loan cost $ 8,775 . The loan payable has a maturity date on February 11, 2023 . As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $ 0 and $ 32,382 , respectively.\n11\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n5. LOAN PAYABLES, EMERGENCY INJURY DISASTER LOAN (EIDL)\n\n| June 30, 2022 | December 31, 2021 |\n| May 16, 2020 ($ 150,000 ) - Loan agreement with principal amount of $150,000 with an interest rate of 3.75 % and maturity date on May 16, 2050 | $ | 150,000 | $ | 150,000 |\n| June 28, 2021 ($ 350,000 ) – Loan agreement with principal amount of $350,000 with an interest rate of 3.75 % and maturity date on May 18, 2050 | 350,000 | 350,000 |\n| Total long-term loan payable, emergency injury disaster loan (EIDL) | 500,000 | 500,000 |\n| Less - current portion | ( 10,760 | ) | ( 7,957 | ) |\n| Total loan payable, emergency injury disaster loan (EIDL), less current portion | $ | 489,240 | $ | 492,043 |\n\nThe following table provides future minimum payments:\n\n| For the years ended December 31, | Amount |\n| 2022 (remaining six months) | 5,330 |\n| 2023 | 10,964 |\n| 2024 | 11,382 |\n| 2025 | 11,816 |\n| 2026 | 12,267 |\n| Thereafter | 448,241 |\n| Total | $ | 500,000 |\n\nMay 16, 2020 – $ 150,000\nOn May 16, 2020, the Company executed the standard loan documents required for securing a loan (the “EIDL Loan”) from the SBA under its Economic Injury Disaster Loan (“EIDL”) assistance program in light of the impact of the COVID-19 pandemic on the TNB’s business. As of June 30, 2022, the loan payable, Emergency Injury Disaster Loan noted above is not in default.\nPursuant to that certain Loan Authorization and Agreement (the “SBA Loan Agreement”), the Company borrowed an aggregate principal amount of the EIDL Loan of $ 150,000 , with proceeds to be used for working capital purposes. Interest accrues at the rate of 3.75 % per annum and will accrue only on funds actually advanced from the date of each advance. Installment payments, including principal and interest, are due monthly beginning May 16, 2021 (twelve months from the date of the SBA Loan) in the amount of $ 731 . The balance of principal and interest is payable thirty years from the date of the SBA Loan.\nIn connection therewith, the Company executed (i) a loan for the benefit of the SBA (the “SBA Loan”), which contains customary events of default and (ii) a Security Agreement, granting the SBA a security interest in all tangible and intangible personal property of the Company, which also contains customary events of default (the “SBA Security Agreement”).\n12\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n5. LOAN PAYABLES, EMERGENCY INJURY DISASTER LOAN (EIDL) (continued)\nJune 28, 2021 – $ 350,000\nOn June 28, 2021, the Company executed the standard loan documents required for securing a loan (the “EIDL Loan”) from the SBA under its Economic Injury Disaster Loan (“EIDL”) assistance program in light of the impact of the COVID-19 pandemic on the TNB’s business. As of June 30, 2022, the loan payable, Emergency Injury Disaster Loan noted above is not in default.\nPursuant to that certain Amended Loan Authorization and Agreement (the “SBA Loan Agreement”), the Company borrowed an aggregate principal amount of the EIDL Loan of $ 500,000 , with proceeds to be used for working capital purposes. Interest accrues at the rate of 3.75 % per annum and will accrue only on funds actually advanced from the date of each advance. Installment payments, including principal and interest, are due monthly beginning October 16, 2022 (thirty months from the original date of the SBA Loan) in the amount of $ 2,505 . The balance of principal and interest is payable thirty years from the original date of the SBA Loan.\n6. LOAN PAYABLE, PAYROLL PROTECTION LOAN PROGRAM (PPP)\n\n| June 30, 2022 | December 31, 2021 |\n| Loan payable, payroll protection program (PPP) – February 10, 2021 | $ | 167,138 | $ | 167,138 |\n| Total long-term loan payable, payroll protection program (PPP) | 167,138 | 167,138 |\n| Less - current portion | ( 39,169 | ) | ( 42,345 | ) |\n| Total loan payable, payroll protection program (PPP), less current portion | $ | 127,969 | $ | 124,793 |\n\nThe Paycheck Protection Program Loan (the “PPP Loan”) is administered by the U.S. Small Business Administration (the “SBA”). The interest rate of the loan is 1.00 % per annum and accrues on the unpaid principal balance computed on the basis of the actual number of days elapsed in a year of 360 days. Commencing seven months after the effective date of the PPP Loan, the Company is required to pay the Lender equal monthly payments of principal and interest as required to fully amortize any unforgiven principal balance of the loan by the two-year anniversary of the effective date of the PPP Loan (the “Maturity Date”). The PPP Loan contains customary events of default relating to, among other things, payment defaults, making materially false or misleading representations to the SBA or the Lender, or breaching the terms of the PPP Loan. The occurrence of an event of default may result in the repayment of all amounts outstanding under the PPP Loan, collection of all amounts owing from the Company, or filing suit and obtaining judgment against the Company. Under the terms of the CARES Act, PPP loan recipients can apply for and be granted forgiveness for all or a portion of the loan granted under the PPP. Such forgiveness will be determined, subject to limitations, based on the use of loan proceeds for payment of payroll costs and any payments of mortgage interest, rent, and utilities. Recent modifications to the PPP by the U.S. Treasury and Congress have extended the time period for loan forgiveness beyond the original eight-week period, making it possible for the Company to apply for forgiveness of its PPP loan.\n13\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n7. EQUIPMENT LOAN PAYABLE\nEquipment loan payable consist of the following:\n\n| June 30, 2022 | December 31, 2021 |\n| October 2017 - Loan agreement with principal amount of $ 82,011 with an interest rate of 6.40 % and maturity date on October 1, 2022 | $ | 6,312 | $ | 15,989 |\n| Total long-term equipment loan payable | 6,312 | 15,989 |\n| Less – current portion | ( 6,312 | ) | ( 15,989 | ) |\n| Total long-term debt, net of current portion | $ | - | $ | - |\n\n\n| For the year ended December 31, | Amount |\n| 2022 (remaining six months) | $ | 6,312 |\n| Total long-term equipment loan payable | $ | 6,312 |\n\nOctober 2017 - $ 82,011 equipment loan payable\nIn October 2017, the Company entered into equipment finance loan agreement with US Bank Equipment Finance in the amount of $ 82,011 with an interest rate of 6.40 % and maturity date on October 1, 2022 , payable in 60 payments. All principal, together with interest cost is due and payable on October 1, 2022. As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $ 6,312 and $ 15,989 , respectively.\n8. INCOME TAX\nTotal income tax (benefit) expense consists of the following:\n\n| For the Six-Month Periods Ended June 30, | 2022 | 2021 |\n| Current provision (benefit): |\n| Federal | $ | - | $ | - |\n| State | - | - |\n| Total current provision (benefit) | - | - |\n| Deferred provision (benefit): |\n| Federal | - | - |\n| State | - | - |\n| Total deferred provision (benefit) | - | - |\n| Total tax provision (benefit) | $ | - | $ | - |\n\nA reconciliation of the Company’s effective tax rate to the statutory federal rate is as follows:\n\n| Description | Rate |\n| Statutory federal rate | 21.00 | % |\n| State income taxes net of federal income tax benefit and others | 8.84 | % |\n| Permanent differences for tax purposes and others | 0.00 | % |\n| Change in valuation allowance | - 29.84 | % |\n| Effective tax rate | 0 | % |\n\n14\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n8. INCOME TAX (continued)\nThe income tax benefit differs from the amount computed by applying the U.S. federal statutory tax rate of 21 % and California state income taxes of 8.84 % due to the change in the valuation allowance.\nDeferred income taxes reflect the temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The components of deferred tax assets and liabilities are as follows:\n\n| Deferred tax assets | June 30, 2022 | December 31, 2021 |\n| Deferred tax assets: |\n| Net operating loss | $ | 2,961,949 | $ | 2,513,674 |\n| Other temporary differences | - | - |\n| Total deferred tax assets | 2,961,949 | 2,513,674 |\n| Less - valuation allowance | ( 2,961,949 | ) | ( 2,513,674 | ) |\n| Total deferred tax assets, net of valuation allowance | $ | - | $ | - |\n\nAs of December 31, 2021, the Company had available net operating loss carryovers of approximately $ 8,423,841 . Per the Tax Cuts and Jobs Act (TCJA) implemented in 2018, the two-year carryback provision was removed and now allows for an indefinite carryforward period. The carryforwards are limited to 80 % of each subsequent year’s net income. As a result, net operating loss may be applied against future taxable income and expires at various dates subject to certain limitations. The Company has a deferred tax asset arising substantially from the benefits of such net operating loss deduction and has recorded a valuation allowance for the full amount of this deferred tax asset since it is more likely than not that some or all of the deferred tax asset may not be realized.\nThe Company files income tax returns in the U.S. federal jurisdiction and California and is subject to income tax examinations by federal tax authorities for tax year ended 2017 and later and subject to California authorities for tax year ended 2016 and later. The Company currently is not under examination by any tax authority. The Company’s policy is to record interest and penalties on uncertain tax positions as income tax expense. As of June 30, 2022 and December 31, 2021, the Company has no accrued interest or penalties related to uncertain tax positions.\nAs of June 30, 2022, the Company had cumulative net operating loss carryforwards for federal tax purposes of approximately $ 9,926,101 . In addition, the Company had state tax net operating loss carryforwards of approximately $ 9,926,101 . The carryforwards may be applied against future taxable income and expires at various dates subject to certain limitations.\n15\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n9. COMMITMENTS AND CONTINGENCIES\nOperating Leases\nThe Company entered into the following operating facility leases\n\n| ● | La Floresta - On July 25, 2016, the Company entered into an operating facility lease for its store located at La Floresta Shopping Village in Brea, California with 60 months term with option to extend. The lease started on July 2016 and expires on November 2024. |\n\n\n| ● | La Crescenta - On May 2017, the Company entered into an operating facility lease for its store located in La Crescenta, California with 120 months term with option to extend. The lease started on May 2017 and expires in May 2027. The Company entered into non-cancellable lease agreement for a coffee shop approximately 1,607 square feet located in La Crescenta, California commencing in May 2017 and expiring in April 2027. The monthly lease payment under the lease agreement approximately $ 6,026 . |\n\n\n| ● | Brea - On September 1, 2018, the Company entered into an operating facility lease for its corporate office located in Brea, California with 72 months term with option to extend. The lease starts on September 2018 and expires on August 2024. |\n\n\n| ● | Glendale – On October 27, 2020, The Company entered a 7-year operating facility lease for its store located at the Glendale Galleria in Glendale, California. The lease starts on November 2020 and expires in October 2027. |\n| ● | San Francisco - On December 22, 2020, the Company entered into an operating facility lease for its store located at Stonestown Galleria in San Francisco, California with 84 months term with option to extend. The lease starts in June 2021 and expires in April 2028. |\n\n\n| ● | Santa Anita - On December 22, 2020, the Company entered into an operating facility lease for its store located at Arcadia, California with 36 months term with option to extend. The lease starts in February 2021 and expires in January 2024. |\n| ● | Riverside - On February 4, 2021, the Company entered into an operating facility lease for its store located at Galleria at Tyler in Riverside, California with 84 months term with option to extend. The lease starts in April 2021 and expires in March 2028. |\n\n\n| ● | Corona Del Mar - On February 5, 2021, the Company repurchased its retail store in Corona Del Mar, California. As part of that repurchase, the Company assumed the original operating lease on the facility, with 66 months term with an option to extend. The lease expires in December 2022. |\n\n\n| ● | Laguna Woods - On February 12, 2021, the Company entered into an operating facility lease for its store located at Home Depot Center in Laguna Woods, California with 60 months term with option to extend. The lease starts in June 2021 and expires in May 2026. |\n\n\n| ● | Huntington Beach - On November 1 2021, the Company entered into an operating facility lease for its store located at Huntington Beach, California with 124 months term with option to extend. The lease starts in November 2021 and expires in February 2032. |\n\n\n| ● | Manhattan Village - On March 1 2022, the Company entered into an operating facility lease for its store located at Manhattan Beach, California with 60 months term with option to extend. The lease starts in March 2022 and expires in February 2027. |\n\nThe Company adopted ASC 842 as of January 2018 (date of formation). The Company has operating leases for the Company’s corporate office and stores and accounts for these leases in accordance with ASC 842, which resulted in the recognition of ROU assets and operating lease liabilities of $ 2,937,437 and $ 3,082,771 , respectively, as of June 30, 2022. Certain of the leases for the Company’s retail store facilities provide for variable payments for property taxes, insurance and common area maintenance payments related to rental payments based on future sales volumes at the leased location, which are not measurable at the inception of the lease, or rental payments that are adjusted periodically for inflation.\nFor the new lease and adjustments, the Company recorded an additional non-cash increase of $470,564 to ROU assets and $492,650 to operational lease liabilities for the six-month period ended June 30, 2022.\n16\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n9. COMMITMENTS AND CONTINGENCIES (continued)\nIn accordance with ASC 842, the components of lease expense were as follows:\n\n| Six-month period ended June 30, | 2022 | 2021 |\n| Operating lease expense | $ | 452,155 | $ | 279,888 |\n| Total lease expense | $ | 452,155 | $ | 279,888 |\n\nIn accordance with ASC 842, other information related to leases was as follows:\n\n| Six-month period ended June 30, | 2022 | 2021 |\n| Operating cash flows from operating leases | $ | 435,635 | $ | 224,988 |\n| Cash paid for amounts included in the measurement of lease liabilities | $ | 435,635 | $ | 224,988 |\n| Weighted-average remaining lease term—operating leases | 4.1 Years |\n| Weighted-average discount rate—operating leases | 8.9 | % |\n\nIn accordance with ASC 842, maturities of operating lease liabilities as of June 30, 2022 were as follows:\n\n| Operating |\n| For the years ended December 31, | Lease |\n| 2022 (remaining six months) | $ | 467,758 |\n| 2023 | 864,887 |\n| 2024 | 785,267 |\n| 2025 | 642,387 |\n| 2026 | 574,150 |\n| Thereafter | 456,435 |\n| Total undiscounted cash flows | $ | 3,790,884 |\n| Reconciliation of lease liabilities: |\n| Weighted-average remaining lease terms | 4.1 Years |\n| Weighted-average discount rate | 8.9 | % |\n| Present values | $ | 3,082,771 |\n| Lease liabilities—current | 655,603 |\n| Lease liabilities—long-term | 2,427,168 |\n| Lease liabilities—total | $ | 3,082,771 |\n| Difference between undiscounted and discounted cash flows | $ | 708,113 |\n\nContingencies\nThe Company is subject to various legal proceedings from time to time as part of its business. As of June 30, 2022, the Company was not currently party to any legal proceedings or threatened legal proceedings, the adverse outcome of which, individually or in the aggregate, it believes would have a material adverse effect on its business, financial condition, and results of operations.\n17\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n10. SHAREHOLDERS’ EQUITY\nCommon Stock\nThe Company has authorization to issue and have outstanding at any one time 40,000,000 share of common stock with a par value of $ 0.0001 per share. The shareholders of common stock shall be entitled to one vote per share and dividends declared by the Company’s Board of Directors.\nIn June 2022, the Company approved (a) the conversion of all Class B Common Stock into Class A Common Stock, (b) a 1 for 100 reverse split, and (c) an amendment to Articles of Incorporation to eliminate Class B and to change “Class A” to simply “common stock”. All share and earnings per share information have been retroactively adjusted to reflect the stock split and the incremental par value of the newly issued shares was recorded with the offset to additional paid-in capital.\nPreferred Stock\nThe Company has authorization to issue and have outstanding at any one time 1,000,000 share of preferred stock with a par value of $ 0.0001 per share, in one or more classes or series within a class as may be determined by our board of directors, who establish, from time to time, the number of shares to be included in each class or series, fix the designation, powers, preferences and rights of the shares of each such class or series and any qualifications, limitations or restrictions thereof. Any preferred stock so issued is senior to other existing classes of common stock with respect to the payment of dividends or amounts upon liquidation or dissolution. As of June 30, 2022 and December 31, 2021, no shares of our preferred stock had been designated any rights and we had no shares of preferred stock issued and outstanding.\nSubscription of Common Stock Receivables\nThe Company issued 1,569,768 shares of common stock to several individuals in March 2020 and in December 2020 for total proceeds of $ 1,350,000 , of which $ 553,500 was received in January, February, and June 2021.\nIssuance of Common Stock in Settlement of Antidilution Provisions\nIn May 2018, the Company had entered into a share exchange agreement wherein Capax, Inc., the predecessor entity of Reborn Coffee, Inc. (“Capax”) effectively merged with Reborn Global Holdings, Inc. to form the Company. In this share exchange agreement, the preexisting shareholder of Capax were provided covenants that for a period of one year following the date upon which the Company is approved for quotation or trading on a public exchange (“IPO”), the percentage of ownership of the prior shareholders of Capax would not be less than the 5% of the total number of shares of voting common stock outstanding of the Company that they owned following the share exchange. In the event the ownership of the pre-merger shareholders of Capax fell below 5%, the Company was obligated to issue that number of shares of common stock to those shareholders which would increase the ownership of all of the Pre-Merger Shareholders to five percent (5%) of the total outstanding voting common shares of the Company. During the year ended December 31, 2021, the Company issued 325,495 shares of common stock under these provisions.\nOn January 25, 2022, the Company modified this agreement with the preexisting shareholders to effectively end the antidilution protection at the time of a successful IPO, eliminating the one-year period following an IPO as provided under the original agreement. The shareholders would be entitled to additional protection through the IPO date should the Company issue any additional shares between December 31, 2021 and the IPO date. The Company has not issued any additional shares subsequent to December 31, 2021.\nDividend policy\nDividends are paid at the discretion of the Board of Directors. There were no dividends declared for the six-month periods ended June 30, 2022 and 2021.\n18\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n11. EARNINGS PER SHARE\nThe Company calculates earnings per share in accordance with FASB ASC 260, Earnings Per Share, which requires a dual presentation of basic and diluted earnings per share. Basic earnings per share are computed using the weighted average number of shares outstanding during the fiscal year. Potentially dilutive common shares consist of stock options outstanding (using the treasury method).\nThe following table sets forth the computation of basic and diluted net income per common share:\n\n| Six-Month Period | Three-Month Period |\n| Ended June 30, | Ended June 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Net Loss | $ | ( 1,502,260 | ) | $ | ( 635,163 | ) | $ | ( 937,148 | ) | $ | ( 307,684 | ) |\n| Weighted Average Shares of Common Stock Outstanding |\n| Basic | 11,642,550 | 10,282,669 | 11,667,545 | 10,380,944 |\n| Diluted | 11,642,550 | 10,282,669 | 11,667,545 | 10,380,944 |\n| Earnings Per Share - Basic |\n| Net Loss Per Share | ( 0.13 | ) | ( 0.06 | ) | ( 0.08 | ) | ( 0.03 | ) |\n| Earnings Per Share - Diluted |\n| Net Loss Per Share | ( 0.13 | ) | ( 0.06 | ) | ( 0.08 | ) | ( 0.03 | ) |\n\n12. SUBSEQUENT EVENTS\nThe Company evaluated all events or transactions that occurred after June 30, 2022 up through the date the unaudited condensed consolidated financial statements were available to be issued. During this period, the Company did not have any material recognizable subsequent events required to be disclosed as of and for the six-month period ended June 30, 2022, except for the following:\nInitial Public Offering\nIn August 2022, the Company consummated its initial public offering (the “IPO”) of 1,440,000 shares of its common stock at a public offering price of $5.00 per share, generating gross proceeds of $ 7,200,000 . Net proceeds from the IPO was approximately $ 6.2 million after deducting underwriting discounts and commissions and other offering expenses of approximately $ 998,000 .\nThe Company had granted the underwriters a 45-day option to purchase up to 216,000 additional shares (equal to 15 % of the shares of common stock sold in the offering) to cover over-allotments. In addition, the Company had agreed to issue to the representative of the several underwriters warrants to purchase the number of shares of common stock in the aggregate equal to five percent ( 5 %) of the shares of common stock to be issued and sold in the IPO. The warrants are exercisable for a price per share equal to 125 % of the public offering price. No over-allotment option or representative’s warrants have been exercised.\n19\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.\nYou should read the following discussion and analysis of our financial condition and results of operations together with our condensed consolidated financial statements and the related notes and other financial information included elsewhere in this Quarterly Report on Form 10-Q and with our audited consolidated financial statements included in our Prospectus on Form S-1. As discussed in the section titled “Note Regarding Forward-Looking Statements,” the following discussion and analysis contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. Factors that could cause or contribute to these differences include, but are not limited to, those identified below and those discussed in the section titled “Risk Factors” in our Prospectus filed on Form S-1 (File No: 333-261937).\nBusiness\nReborn Coffee is focused on serving high quality, specialty-roasted coffee at retail locations, kiosks and cafes. We are an innovative company that strives for constant improvement in the coffee experience through exploration of new technology and premier service, guided by traditional brewing techniques. We believe Reborn differentiates itself from other coffee roasters through its innovative techniques, including sourcing, washing, roasting, and brewing our coffee beans with a balance of precision and craft.\nFounded in 2015 by Jay Kim, our Chief Executive Officer, Mr. Kim and his team launched Reborn Coffee with the vision of using the finest pure ingredients and pristine water. We currently serve customers through our retail store locations in California: Brea, La Crescenta, Glendale, Corona Del Mar, Arcadia, Laguna Woods, Riverside, San Francisco and Manhattan Beach, with four other locations in development. Additionally, we expect to begin franchising in 2022 and expect to continue to develop additional retail locations as we expand outside of California. We estimate that the average development cost of a company-owned retail location is approximately $150,000. Therefore, taking into account the proceeds from this offering and within a year from its completion, we expect to open up to 20 company-owned retail locations (using approximately $3,000,000 of the proceeds of this offering) and 20 franchise locations (all costs and expenses associated with a franchise store location development are borne by the franchisees). We acknowledge that we have not yet signed any franchise agreements and that such number of franchise locations is purely speculative. Reborn Coffee continues to elevate the high-end coffee experience and we received 1st place traditional still in “America’s Best Cold Brew” competition by Coffee Fest in 2017 in Portland and 2018 in Los Angeles.\nThe Experience, Reborn\nAs leading pioneers of the emerging “Fourth Wave” movement, Reborn Coffee is redefining specialty coffee as an experience that demands much more than premium quality. We consider ourselves leaders of the “fourth wave” coffee movement because we are constantly developing our bean processing methods, researching design concepts, and reinventing new ways of drinking coffee. For instance, the current transition from the K-Cup trend to the pour over drip concept allowed us to reinvent the way people consume coffee, by merging convenience and quality. We took the pour over drip concept and made it available and affordable to the public through our Reborn Coffee Pour Over packs. Our Pour Over Packs allow our consumers to consume our specialty coffee outdoors and on-the-go.\nOur success in innovating within the “fourth wave” coffee movement is measured by our success in B2B sales with our introduction of Reborn Coffee Pour Over Packs to hotels. With the introduction of our Pour Over Packs to major hotels (including one hotel company with 7 locations), our B2B sales increased as these companies recognized the convenience and functionality our Pour Over Packs serve to their customers.\nReborn Coffee’s continuous Research and Development is essential to developing new parameters in the production of new blends. Our 1st place position in “America’s Best Cold Brew” competition by Coffee Fest in 2017 in Portland and 2018 in Los Angeles is a testament to the way we believe we lead the “fourth wave” movement by example.\nCentered around its core values of service, trust, and well-being, Reborn Coffee delivers an appreciation of coffee as both a science and an art. Developing innovative processes such as washing green coffee beans with magnetized water, we challenge traditional preparation methods by focusing on the relationship between water chemistry, health, and flavor profile. Leading research studies, testing brewing equipment, and refining roasting/brewing methods to a specific, Reborn Coffee proactively distinguishes exceptional quality from good quality by starting at the foundation and paying attention to the details. Our mission places an equal emphasis on humanizing the coffee experience, delivering a fresh take on “farm-to-table” by sourcing internationally. In this way, Reborn Coffee creates opportunities to develop transparency by paying homage to origin stories and spark new conversations by building cross-cultural communities united by a passion for the finest coffee.\nThrough a broad product offering, Reborn Coffee provides customers with a wide variety of beverages and coffee options. As a result, we believe we can capture share of any experience where customers seek to consume great beverages whether in our inviting store atmospheres which are designed for comfort, or on the go through our pour over packs, or at home with our whole bean ground coffee bags. We believe that the retail coffee market in the US is large and growing. According to IBIS, in 2021, the retail market for coffee in the United States is expected to be $46.2 billion. This is expected to grow due to a shift in consumer preferences to premium coffee, including specialized blends, espresso-based beverages, and cold brew options. Reborn aims to capture a growing portion of the market as we expand and increase consumer awareness of our brand.\n20\nPlan of Operation\nWe have a production and distribution center at our headquarters that we use to process and roast coffee for wholesale and retail distribution.\nCurrently, we have the following nine retail coffee locations, and four locations in development (i.e., Cabazon, Huntington Beach, Irvine and Mission Viejo, California):\n\n| ● | La Floresta Shopping Village in Brea, California; |\n| ● | La Crescenta, California; |\n\n\n| ● | Glendale Galleria in Glendale, California; |\n| ● | Galleria at Tyler in Riverside, California; |\n| ● | Home Depot Center in Laguna Woods, California; |\n| ● | Stonestown Galleria in San Francisco, California (opened in first quarter of 2022); |\n| ● | Corona Del Mar, California; |\n| ● | Santa Anita Westfield Mall in Arcadia, California; and |\n| ● | Manhattan Village at Manhattan Beach, California. |\n\nImpact of COVID-19\nThe COVID-19 pandemic and resulting disruptions including, without limitation, governmental lockdown mandates and restrictions, made 2020 a challenging year for businesses, particularly in the foodservice and restaurant industries. Reborn Coffee took immediate action to protect the health and safety of our employees and customers including the implementation of all operating protocols dictated by state and local guidelines and instituting strict health and safety practices. Fortunately, we did not experience any significant disruptions in our supply chain operations.\nDespite efforts to ensure a safe consumer experience, we did experience repressed customer flow through periods when malls and shopping centers were restricted or closed entirely due to governmental lockdown mandates and restrictions. Our current retail locations are within popular shopping areas with anticipated regular customer traffic. Such closures or limitations and restrictions were at times mandated the government, and at other times due to natural customer uncertainties regarding the status of COVID-19. Such restrictions and uncertainties not only impacted anticipated revenues from current locations, but added additional risk to us related to the opening of new locations. Thus, the uncertainty regarding the scope and longevity of such restrictions modified our plans as to how quickly we could enact our expansion plans.\nMore specifically, COVID-19 has challenged our performance at our kiosk locations, though our cafe locations have improved in performance. Shopping mall restrictions and mandates during the pandemic made it difficult for our kiosks to operate at maximum performance, as indoor restrictions of shopping malls affected the way we had to operate business. For instance, we had to offer only to-go/pickup operations to operate while meeting regulations. We have learned how to move forward aggressively despite such regulations and mandates, doing what we can to serve the coffee we are so proud to serve, whether this means offering to-go orders only or working with delivery services.\nIn May 2020, the Company availed itself of a loan under the Paycheck Protection Program (PPP) administered by the U.S. Small Business Administration (SBA) in the amount of $115,000, and $500,000 under the SBA’s Economic Injury Disaster Loan assistance program, all of which is currently outstanding as of December 31, 2021, provided however that repayment was deferred to commence in May 2022. In February 2021, the Company secured a second PPP loan under this program in the amount of approximately $167,000. The Company was granted forgiveness for the initial PPP Loan prior to December 31, 2021 and expects to be granted forgiveness on the remainder subsequently.\n21\nIn January 2022 we announced a price increase of our whole roasted beans by 15% on our website which we attribute to increases due to inflation in the cost of raw green coffee beans, the cost of shipping and supplies, and nationwide increases in labor costs-- factors that may or may not be attributable to the pandemic and/or the governmental policies and mandates that were implemented during and in the wake of COVID-19. As of the date hereof and in January 2022 at the time of our price increase, inflation has not had a material effect on our results of operations since we have been able to offset such increased costs by increasing the price of our whole roasted beans by 15% in January 2022, through increased sales and growth in opening 2 new company-owned retail locations, better lease terms on such new company-owned retail locations, more efficient purchasing practices (e.g., volume purchase discounts), productivity improvements and greater economies of scale. Severe increases in inflation, however, could affect the global and U.S. economies and could have a materially adverse impact on our business, financial condition or results of operations.\nWe do not expect COVID-19 to affect our future operating results significantly, as we are confident that coffee is an essential product that people rely on and will always drink. We intend to meet all governmental business operation regulations and improve sales by whatever means necessary, utilizing resources such as food delivery services and to-go/pickup orders. However, the impact of COVID-19 continues to evolve, and we cannot easily predict the future potential impacts of the pandemic on our business or operations or on the United States or global economy in general. This may include any recurrence of the disease, actions taken in response to the evolving pandemic, any ongoing effects on consumer demand and spending patterns or other impacts of the pandemic. Whether these or other currently unanticipated consequences of the pandemic are reasonably likely to materially affect our results of operations, cash flows or financial condition is yet to be determined. For additional details regarding the impact of COVID-19 on our business, see “Risk Factors-Risks Related to Our Business-Pandemics or disease outbreaks such as the COVID-19 have had, and may continue to have, an effect on our business and results of operations.”\nComponents of Our Results of Operations\nRevenue\nThe Company recognizes revenue in accordance with Accounting Standards Codification (“ASC”) 606, Revenue from Contracts with Customers. The Company’s net revenue primarily consists of revenues from its retail locations and wholesale and online store. Accordingly, the Company recognizes revenue as follows:\n\n| ● | Retail Store Revenue |\n| Retail store revenues are recognized when payment is tendered at the point of sale. Retail store revenues are reported net of sales, use or other transaction taxes that are collected from customers and remitted to taxing authorities. Sales taxes that are payable are recorded as accrued as other current liabilities. Retail store revenue makes up approximately 97% of the Company’s total revenue. |\n| ● | Wholesale and Online Revenue |\n| Wholesale and online revenues are recognized when the products are delivered, and title passes to customers or to the wholesale distributors. When customers pick up products at the Company’s warehouse, or distributed to the wholesale distributors, the title passes, and revenue is recognized. Wholesale revenues make up approximately 3% of the Company’s total revenue. |\n\n\n| ● | Royalties and Other Fees |\n| Franchise revenues consist of royalty fee and other franchise fees. Royalty fee is based on a percentage of franchisee’s weekly gross sales revenue at 5%. The Company recognizes the fee as the underlying sales occur. The Company recorded revenue from royalty of $0 for the three and six month periods ended June 30, 2022 and 2021. Other fees are earned as incurred and the Company did not have any other fee revenue for the three and six month periods ended June 30, 2022 and 2021. |\n\nCost of Sales\nCost of sales includes costs associated with generating revenue within our company-owned retail locations, and franchising operations (of which, as of the date of this prospectus, we had none).\nShipping and Handling Costs\nThe Company incurred freight out cost and is included in the Company’s cost of sale.\nGeneral and Administrative Expense\nGeneral and administrative expense includes store-related expense as well as the Company’s corporate headquarters’ expenses.\nAdvertising Expense\nAdvertising expense are expensed as incurred. Advertising expenses amounted to $20,513 and $50,160 for the six month periods ended June 30, 2022 and 2021, respectively, and is recorded under general and administrative expenses in the accompanying unaudited condensed consolidated statements of operations.\n22\nPre-opening Costs\nPre-opening costs for new stores, which are not material, consist primarily of payroll and recruiting expense, training, marketing, rent, travel, and supplies, and are expensed as incurred depreciated over the shorter of the useful life of the improvement or the lease term, including renewal periods that are reasonably assured.\nResults of Operations\nThree and six months ended June 30, 2022 Compared to three and six months ended June 30, 2021\nThe following table presents selected comparative results of operations from our unaudited financial statements for the three and six months ended June 30, 2022 compared to three and six months ended June 30, 2021. Our financial results for these periods are not necessarily indicative of the financial results that we will achieve in future periods. Certain totals for the table below may not sum to 100% due to rounding.\n\n| Six Months Ended June 30, | Increase / (Decrease) |\n| 2022 | 2021 | Dollars | Percentage |\n| Net revenues: |\n| Stores | $ | 1,511,952 | $ | 851,785 | $ | 660,167 | 77.5 | % |\n| Wholesale and online | 29,674 | 28,336 | 1,338 | 4.7 | % |\n| Total net revenues | 1,541,626 | 880,121 | 661,505 | 75.2 | % |\n| Operating costs and expenses: |\n| Product, food and drink costs—stores | 563,906 | 270,148 | 293,758 | 108.7 | % |\n| Cost of sales—wholesale and online | 12,997 | 12,412 | 585 | 4.7 | % |\n| General and administrative | 2,468,447 | 1,226,951 | 1,241,496 | 101.2 | % |\n| Loss from operations | (1,503,724 | ) | (629,390 | ) | (874,334 | ) | 138.9 | % |\n| Other income | 16,440 | - | 16,440 | N/A | % |\n| Interest expense | (14,976 | ) | (5,773 | ) | (9,203 | ) | 159.4 | % |\n| Loss before income taxes | (1,502,260 | ) | (635,163 | ) | (867,097 | ) | 136.5 | % |\n| Provision for income taxes | - | - | - | 0.0 | % |\n| Net loss | $ | (1,502,260 | ) | $ | (635,163 | ) | $ | (867,097 | ) | 136.5 | % |\n\n\n| Three Months Ended June 30, | Increase / (Decrease) |\n| 2022 | 2021 | Dollars | Percentage |\n| Net revenues: |\n| Stores | $ | 775,956 | $ | 475,824 | $ | 300,132 | 63.1 | % |\n| Wholesale and online | 12,520 | 15,368 | (2,848 | ) | -18.5 | % |\n| Total net revenues | 788,476 | 491,192 | 297,284 | 60.5 | % |\n| Operating costs and expenses: |\n| Product, food and drink costs—stores | 278,952 | 135,452 | 143,500 | 105.9 | % |\n| Cost of sales—wholesale and online | 5,484 | 6,732 | (1,248 | ) | -18.5 | % |\n| General and administrative | 1,432,432 | 656,310 | 776,122 | 118.3 | % |\n| Loss from operations | (928,392 | ) | (307,302 | ) | (621,090 | ) | 202.1 | % |\n| Other income | 1,440 | - | 1,440 | N/A | % |\n| Interest expense | (10,196 | ) | (382 | ) | (9,814 | ) | 2569.1 | % |\n| Loss before income taxes | (937,148 | ) | (307,684 | ) | (629,464 | ) | 204.6 | % |\n| Provision for income taxes | - | - | - | 0.0 | % |\n| Net loss | $ | (937,148 | ) | $ | (307,684 | ) | $ | (629,464 | ) | 204.6 | % |\n\n23\n\n| Six months ended June 30, | Three months ended June 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Net revenues: |\n| Stores | 98.1 | % | 96.8 | % | 98.4 | % | 96.9 | % |\n| Wholesale and online | 1.9 | % | 3.2 | % | 1.6 | % | 3.1 | % |\n| Total net revenues | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % |\n| Operating costs and expenses: |\n| Product, food and drink costs—stores | 36.6 | % | 30.7 | % | 35.4 | % | 27.6 | % |\n| Cost of sales—wholesale and online | 0.8 | % | 1.4 | % | 0.7 | % | 1.4 | % |\n| General and administrative | 160.1 | % | 139.4 | % | 181.7 | % | 133.6 | % |\n| Loss from operations | -97.5 | % | -71.5 | % | -117.7 | % | -62.6 | % |\n| Other income | 1.1 | % | 0.0 | % | 0.2 | % | 0.0 | % |\n| Interest expense | -1.0 | % | -0.7 | % | -1.3 | % | -0.1 | % |\n| Loss before income taxes | -97.4 | % | -72.2 | % | -118.9 | % | -62.6 | % |\n| Provision for income taxes | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % |\n| Net loss | -97.4 | % | -72.2 | % | -118.9 | % | -62.6 | % |\n\nRevenues. Revenues were approximately $1.5 million for the six-month period ended June 30, 2022, compared to $880,000 for the comparable period in 2021, representing an increase of $661,000, or 75.2%. Revenues were approximately $788,000 million for the three-month period ended June 30, 2022, compared to $491,000 for the comparable period in 2021, representing an increase of $297,000, or 60.5%. The increase in sales for the periods was primarily driven by the opening of the Corona Del Mar, Laguna Woods and Santa Anita locations during 2021, and to the continued focus on marketing efforts to grow brand recognition.\nProduct, food and drink costs. Product, food and drink costs were approximately $564,000 for the six-month period ended June 30, 2022 compared to $270,000 for the comparable period in 2021, representing an increase of approximately $294,000, or 108.7%, and were approximately $279,000 for the three-month period ended June 30, 2022 compared to $135,000 for the comparable period in the prior year, representing an increase of $144,000 of 105.9%. The increase in costs for the periods was partially driven by the opening of new locations and the overall increase in sales for the period. As a percentage of revenues, product, food and drink costs increased to 36.6% in the six-month period ended June 30, 2022 compared to 30.7% in the comparable period in 2021 and increased to 35.4% in the three-month period ended June 30, 2022 compared to 27.6% in the comparable period in 2021. The increase in costs as a percentage of sales was primarily driven by general inflationary pressures and the seasonal fluctuations in cost of ingredients. We monitor these fluctuations in product costs to analyze whether they are considered to be representative of general economic conditions, such as inflation, or to be related to commodity specific changes. For example, green bean suppliers raised pricing by 15 to 20% throughout 2021, higher than the overall rate of inflation, however it has been more stable recently and even decreasing slightly in the second quarter of 2022.\nGeneral and administrative expenses. General and administrative expenses were approximately $2.5 million for the six-month period ended June 30, 2022 compared to $1.2 million for the comparable period in the prior year, representing an increase of approximately $1.2 million, or 101.2%, and were approximately $1.4 million for the three-month period ended June 30, 2022 compared to $656,000 for the comparable period in 2021, representing an increase of approximately $775,000, or 118.3%. This increase in general and administrative expenses was primarily due to the hiring of additional administrative employees, increases in professional services and corporate-level costs to support growth plans, the opening of new restaurants, as well as costs associated with outside administrative, legal and professional fees and other general corporate expenses associated with preparing to become a public company. As a percentage of sales, general and administrative expenses increased to 160.1% in the six-month period ended June 30, 2022 from 139.4% in the comparable period of 2021, and increased to 181.7% for the three-month period ended June 30, 2022 from 133.6% in the comparable period in 2021, primarily due to the increased administrative expenditures for the reasons mentioned above.\n24\nLiquidity and Capital Resources\n\n| Six Months Ended June 30, |\n| 2022 | 2021 |\n| Statement of Cash Flow Data: |\n| Net cash used in operating activities | (1,199,979 | ) | (538,352 | ) |\n| Net cash used in investing activities | (168,397 | ) | (317,152 | ) |\n| Net cash provided by financing activities | 613,149 | 866,579 |\n\nCash Flows Provided by Operating Activities\nNet cash used in operating activities during the six-month period ended June 30, 2022 was $1.2 million, which resulted from net loss of $1.5 million, non-cash charges of $225,000 for stock compensation and $98,000 for depreciation and net cash outflows of $43,000 from changes in operating assets and liabilities. The net cash outflows from changes in operating assets and liabilities were primarily the result of increases in inventory of $14,000 and prepaid and other assets of $28,000 and a decrease in accounts payable of $46,000, partially offset by increase of $47,000 in accrued liabilities. The increase in accrued liabilities was primarily due to the timing of cash payments for sales tax and payroll.\nNet cash used in operating activities during the six-month period ended June 30, 2021 was $538,000, which resulted from net loss of $635,000, non-cash charges of $82,000 for depreciation, and net cash outflows of $6,000 from changes in operating assets and liabilities. The net cash outflows from changes in operating assets and liabilities were primarily the result of increases in inventories of $7,000 and prepaids and other assets of $65,000, partially offset by increases of $50,000 in accounts payable and $17,000 in accrued liabilities.\nCash Flows Used in Investing Activities\nNet cash used in investing activities during the six-month periods ended June 30, 2022 and 2021 was $168,000 and $317,000, respectively, These expenditures in each period are primarily related to purchases of property and equipment in connection with current and future location openings and maintaining our existing locations.\nCash Flows Provided by (Used in) Financing Activities\nNet cash provided by financing activities during the six-month period ended June 30, 2022 was $613,000, primarily due to $595,000 of borrowings under a line of credit, and $150,000 of loans from shareholders. This was partially offset by $131,000 of repayments of borrowings.\nNet cash provided by financing activities during the six-month period ended June 30, 2021 was $867,000, primarily due to approximately $533,000 cash received through borrowings and $553,000 of proceeds from issuance of common stock, offset by approximately $220,000 of repayments of borrowings.\nAs of June 30, 2022, the Company had total assets of $4,593,013. Our cash balance as of June 30, 2022 was approximately $150,000. From inception (of Reborn Global in November 2014) to June 30, 2022, we have not had any positive operating cash flow.\nCredit Facilities\nLoan with Fora Financial\nIn October 2019, the Company entered into a loan agreement with Fora Financial in the principal amount of $138,600 and remaining principal amount of $48,510. The loan payable has a maturity date on October 11, 2019. The loan was due on demand. As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $0.\nLoans with Square Capital\nBetween April and August 2021, the Company entered into loan agreements with Square Capital in the aggregate principal amount of approximately $268,000 with loan costs of $34,840. The loans have maturity dates ranging from September 2022 to February 2023. As of June 20, 2022 and December 31, 2021, there was a balance outstanding of approximately $0 and $122,000, respectively.\n25\nEconomic Injury Disaster Loan\nOn May 16, 2020, the Company executed the standard loan documents required for securing a loan (the “EIDL Loan”) from the SBA under its Economic Injury Disaster Loan (“EIDL”) assistance program in light of the impact of the COVID-19 pandemic on the Company’s business. As of June 30, 2022, the loan payable, Emergency Injury Disaster Loan noted above is not in default.\nPursuant to that certain Loan Authorization and Agreement (the “SBA Loan Agreement”), the Company borrowed an aggregate principal amount of the EIDL Loan of $500,000, with proceeds to be used for working capital purposes. Interest accrues at the rate of 3.75% per annum and will accrue only on funds actually advanced from the date of each advance. Installment payments, including principal and interest, are due monthly beginning May 16, 2021 (twelve months from the date of the SBA Loan) in the amount of $731. The balance of principal and interest is payable thirty years from the date of the SBA Loan. In connection therewith, the Company also received a $10,000 grant, which does not have to be repaid. During the year ended December 31, 2020, $10,000 was recorded in Economy injury disaster loan (EIDL) grant income in the Statements of Operations. The schedule of payments on this loan was later deferred to commence 24 months from the date of loan, and therefore, the full amount of the loan is outstanding as of June 30, 2022 and payments shall commence starting in May 2022.\nIn connection therewith, the Company executed (i) a loan for the benefit of the SBA (the “SBA Loan”), which contains customary events of default and (ii) a Security Agreement, granting the SBA a security interest in all tangible and intangible personal property of the Company, which also contains customary events of default (the “SBA Security Agreement”).\nPaycheck Protection Program Loan\nIn May 2020, the Company secured a loan under the Paycheck Protection Program administered by the U.S. Small Business Administration (the “SBA”) in the amount of $115,000. In February 2021, the Company secured a second loan under this program in the amount of approximately $167,000. The interest rate of the loan is 1.00% per annum and accrues on the unpaid principal balance computed on the basis of the actual number of days elapsed in a year of 360 days. Commencing seven months after the effective date of each PPP Loan, the Company is required to pay the Lender equal monthly payments of principal and interest as required to fully amortize any unforgiven principal balance of the loan by the two-year anniversary of the effective date of the loan. The PPP Loan contains customary events of default relating to, among other things, payment defaults, making materially false or misleading representations to the SBA or the Lender, or breaching the terms of the PPP Loan. The occurrence of an event of default may result in the repayment of all amounts outstanding under the PPP Loan, collection of all amounts owing from the Company, or filing suit and obtaining judgment against the Company. Under the terms of the CARES Act, PPP loan recipients can apply for and be granted forgiveness for all or a portion of the loan granted under the PPP. Such forgiveness will be determined, subject to limitations, based on the use of loan proceeds for payment of payroll costs and any payments of mortgage interest, rent, and utilities. Recent modifications to the PPP by the U.S. Treasury and Congress have extended the time period for loan forgiveness beyond the original eight-week period, making it possible for the Company to apply for forgiveness of its PPP loan. The Company was granted forgiveness for the initial PPP Loan prior to December 31, 2021 and expects to be granted forgiveness on the remainder subsequently.\nLine of Credit Facility\nDuring the second quarter of 2022, the Company entered into a line of credit agreement with a financial institution that provides a maximum borrowing limit of $2,000,000 with interest at 5% per annum. This line of credit facility matures on December 31, 2022. Total balance as of June 30, 2022 was $594,529.\nLeases\nOperating Leases\nWe currently lease all company-owned retail locations. Operating leases typically contain escalating rentals over the lease term, as well as optional renewal periods. Rent expense for operating leases is recorded on a straight-line basis over the lease term and begins when Reborn has the right to use the property. The difference between rent expense and cash payment is recorded as deferred rent on the accompanying consolidated balance sheets. Pre-opening rent is included in selling, general and administrative expenses on the accompanying consolidated statements of income. Tenant incentives used to fund leasehold improvements are recorded in deferred rent and amortized as reductions to rent expense over the term of the lease.\n26\nIncome Taxes\nReborn files income tax returns in the U.S. federal and California state jurisdictions.\nUpon the closing of this offering, we will be taxed at the prevailing U.S. corporate tax rates. We will be treated as a U.S. corporation and a regarded entity for U.S. federal, state and local income taxes. Accordingly, a provision will be recorded for the anticipated tax consequences of our reported results of operations for U.S. federal, state and foreign income taxes.\nJOBS Act Accounting Election\nWe are an “emerging growth company,” as defined in the JOBS Act, and may take advantage of certain exemptions from various public company reporting requirements for up to five years or until we are no longer an emerging growth company, whichever is earlier. The JOBS Act provides that an “emerging growth company” can delay adopting new or revised accounting standards until those standards apply to private companies. We have elected to use this extended transition period under the JOBS Act. Accordingly, our financial statements may not be comparable to the financial statements of public companies that comply with such new or revised accounting standards.\nOff Balance Sheet Arrangements\nWe do not have any off-balance sheet arrangements that we are required to disclose pursuant to these regulations. In the ordinary course of business, we enter into operating lease commitments, purchase commitments and other contractual obligations. These transactions are recognized in our financial statements in accordance with GAAP.\nCritical Accounting Policies\nThe preparation of financial statements requires management to utilize estimates and make judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. These estimates are based on historical experience and on various other assumptions that management believes to be reasonable under the circumstances. The estimates are evaluated by management on an ongoing basis, and the results of these evaluations form a basis for making decisions about the carrying value of assets and liabilities that are not readily apparent from other sources. Although actual results may differ from these estimates under different assumptions or conditions, management believes that the estimates used in the preparation of our financial statements are reasonable. The critical accounting policies affecting our financial reporting are summarized in Note 2 to the financial statements included elsewhere in this prospectus.\nRecent Accounting Pronouncements\nWe have determined that all other issued, but not yet effective accounting pronouncements are inapplicable or insignificant to us and once adopted are not expected to have a material impact on our financial position.\n27\n\nItem 3. Quantitative and Qualitative Disclosures About Market Risk.\nWe are a smaller reporting company as defined by 17 C.F.R. 229 (10)(f)(i) and are not required to provide information under this item.\n\nItem 4. Controls and Procedures.\nEvaluation of Disclosure Controls and Procedures\nOur management has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)), as of June 30, 2022. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that as of June 30, 2022, our disclosure controls and procedures were ineffective to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act (a) is recorded, processed, summarized and reported within the time periods specified by Securities and Exchange Commission (“SEC”) rules and forms and (b) is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding any required disclosure.\nChanges in Internal Control Over Financial Reporting\nDuring the period ended June 30, 2022, our management has evaluated the internal control over financial reporting pursuant to Rules 13a-15(d) or 15d-15(d) under the Exchange Act. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our internal controls over financial reporting were ineffective as of June 30, 2022. Management of the Company believes that the ineffectiveness of internal controls was due to the lack of accounting and financial team.\n28\nPART II—OTHER INFORMATION\n\nItem 1. Legal Proceedings.\nIn the future, the Company may be subject to various legal proceedings from time to time as part of its business. We are currently not involved in litigation that we believe will have a materially adverse effect on our financial condition or results of operations. As of June 30, 2022, there is no action, suit, proceeding, inquiry or investigation before or by any court, public board, government agency, self- regulatory organization or body pending or, to the knowledge of the executive officers of our company or any of our subsidiaries threatened against or affecting our company, our common stock, any of our subsidiaries or of our company’s or our company’s subsidiaries’ officers or directors in their capacities as such, in which an adverse decision is expected to have a material adverse effect.\n\nItem 1A. Risk Factors.\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, we are not required to provide information required by this item.\n\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\nWe have not made any sales of unregistered equity securities during the quarterly period ended June 30, 2022.\nIn August 2022, the Company consummated its initial public offering (the “IPO”) of 1,440,000 shares of its common stock at a public offering price of $5.00 per share, generating gross proceeds of $7,200,000 pursuant to our Registration Statement on Form S-1 (as amended) (File No. 333-261937), which was declared effective by the SEC on August 11, 2022. . EF Hutton, division of Benchmark Investments, LLC, acted as the representative of the underwriters of the IPO. After deducting underwriting discounts and commissions and other offering expenses payable by us, we received approximately $6.2 million in net proceeds from our initial public offering.\nThere has been no material change in the planned use of proceeds from our initial public offering as described in our final prospectus, dated August 11, 2022, which was filed with the SEC on August 16, 2021 pursuant to Rule 424(b) under the Securities Act. The primary use of the net proceeds from our initial public offering continues to be, as follows: (i) approximately $8.0 million for the acquisition of property and the development of a manufacturing plant to build, design and manufacture our new line of electric boats; (ii) approximately $2.0 million for ramp up of production and inventory; (iii) approximately $2.6 million for working capital.\nNo payments were made by us to directors, officers or persons owning ten percent or more of our common stock or to their associates, or to our affiliates, other than payments in the ordinary course of business to officers for salaries. Pending the uses described, we have invested the net proceeds in our operating cash account.\n29\n\nItem 6. Exhibits.\nThe following exhibits are included herein or incorporated herein by reference:\n\n| 3.1 | Certificate of Incorporation (Delaware), dated July 27, 2022 (incorporated by reference to Exhibit 3.1 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\n| 3.2 | Bylaws of Registrant (Delaware) (incorporated by reference to Exhibit 3.2 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\n| 4.1 | Specimen Common Stock Certificate (Delaware) (incorporated by reference to Exhibit 4.1 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\n| 4.2 | Form of Representative’s Warrant (incorporated by reference to Exhibit 4.5 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.1 | Share Exchange Agreement, dated May 7, 2018 by and among Capax, Reborn and each of the RB shareholders (incorporated by reference to Exhibit 10.1 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.2 | Form of Letter Agreement (Lockup) by and among Registrant, officers and directors of the Company and EF Hutton (incorporated by reference to Exhibit 10.2 to Amendment No. 6 to our Registration Statement on Form S-1 filed on August 9, 2022) |\n| 10.3 | Form of Director and Officer Indemnity Agreement (incorporated by reference to Exhibit 10.3 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.4 | Shopping Center Lease by and between Reborn Global Holdings, Inc. and La Floresta Regency, LLC, effective July 25, 2016 (incorporated by reference to Exhibit 10.4 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.5 | Standard Industrial/Commercial Multi-Tenant Lease, as amended, by and between Reborn Global Holdings, Inc. and Foothill Crescenta, LLC, effective December 6, 2016 (incorporated by reference to Exhibit 10.5 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.6 | Shopping Center Lease by and between Reborn Global Holdings, Inc. and Sibling Associates, LLC, effective July 12, 2017 (incorporated by reference to Exhibit 10.6 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.7 | Standard Lease by and between Reborn Global Holdings, Inc. and El Toro, LP, effective February 12, 2021 (incorporated by reference to Exhibit 10.7 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.8 | Form of Subscription Agreement (Regulation A+ Offering) (incorporated by reference to Exhibit 10.11 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.9 | Consulting Agreement by and between the Company and Kevin Hartley, effective September 15, 2021 (incorporated by reference to Exhibit 10.12 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.10 | Amendment to Share Exchange Agreement, dated January 25, 2022, by and among Reborn Coffee Inc., Andrew Weeraratne and each of the former shareholders of Reborn Global Holdings, Inc., a California corporation (incorporated by reference to Exhibit 10.10 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\n| 10.11 | Offer of Employment by and between the Company and Stephan Kim, dated July 27, 2022 (incorporated by reference to Exhibit 10.11 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\n| 31.1* | Certification of Jay Kim pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2* | Certification of Stephan Kim pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1** | Certification of Jay Kim pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2** | Certification of Stephan Kim pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS | Inline XBRL Instance Document. |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document. |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document. |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document. |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document. |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document. |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101). |\n\n\n| * | Filed herewith. |\n\n\n| ** | Furnished herewith. |\n\n30\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| Signature | Title | Date |\n| /s/ Jay Kim | Chief Executive Officer (Principal Executive Officer) | September 30, 2022 |\n| Jay Kim |\n| /s/ Stephan Kim | Chief Financial Officer (Principal Financial and Accounting Officer) | September 30, 2022 |\n\n31\n\n</text>\n\nWhat was the percentage change in earnings per share (EPS) year over year?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial Statements\nSEMRUSH HOLDINGS, INC.\nUNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS\n(in thousands, except share and per share data)\n| As of |\n| March 31, 2021 | December 31, 2020 |\n| Assets |\n| Current assets |\n| Cash and cash equivalents | $ | 171,867 | $ | 35,531 |\n| Accounts receivable | 2,383 | 1,399 |\n| Deferred contract costs, current portion | 4,817 | 4,049 |\n| Prepaid expenses and other current assets | 3,626 | 2,649 |\n| Total current assets | 182,693 | 43,628 |\n| Property and equipment, net | 3,876 | 2,968 |\n| Intangible assets, net | 2,176 | 2,231 |\n| Goodwill | 1,991 | 1,991 |\n| Deferred contract costs, net of current portion | 2,000 | 1,670 |\n| Other long-term assets | 1,130 | 2,470 |\n| Total assets | $ | 193,866 | $ | 54,958 |\n| Liabilities, redeemable convertible preferred stock and stockholders’ equity (deficit) |\n| Current liabilities |\n| Accounts payable | $ | 10,233 | $ | 8,654 |\n| Accrued expenses | 10,286 | 7,719 |\n| Deferred revenue | 32,078 | 26,537 |\n| Total current liabilities | 52,597 | 42,910 |\n| Long-term liabilities |\n| Deferred revenue, net of current portion | 181 | 123 |\n| Deferred tax liability | 153 | 209 |\n| Other long-term liabilities | 1,024 | 497 |\n| Total liabilities | 53,955 | 43,739 |\n| Commitments and contingencies (Note 11) |\n| Series A redeemable convertible preferred stock, $ 0.00001 par value - no shares authorized, issued or outstanding as of March 31, 2021; 3,379,400 shares authorized, issued and outstanding as of December 31, 2020 (liquidation value of $ 8,000 at December 31, 2020) | — | 7,789 |\n| Series A-1 redeemable convertible preferred stock, $ 0.00001 par value - no shares authorized, issued or outstanding as of March 31, 2021; 1,837,600 shares authorized, issued and outstanding as of December 31, 2020 (liquidation value of $ 5,000 at December 31, 2020) | — | 10,270 |\n| Stockholders' equity (deficit) |\n| Series B convertible preferred stock, $ 0.00001 par value - no shares authorized, issued or outstanding as of March 31, 2021; 4,681,400 shares authorized, issued and outstanding as of December 31, 2020 (liquidation value of $ 24,000 at December 31, 2020) | — | 24,000 |\n| Undesignated preferred stock, $ 0.00001 par value - 100,000,000 shares authorized, and no shares issued or outstanding as of March 31, 2021; no shares authorized, issued, or outstanding as of December 31, 2020 | — | — |\n| Common stock, $ 0.00001 par value - no shares authorized, issued, or outstanding as of March 31, 2021; 300,000,000 shares authorized, and 95,206,893 shares issued and 95,050,041 shares outstanding at December 31, 2020 | — | — |\n| Class A common stock, $ 0.00001 par value - 1,000,000,000 shares authorized, and 10,000,000 shares issued and outstanding as of March 31, 2021; no shares authorized, issued or outstanding as of December 31, 2020 | — | — |\n| Class B common stock, $ 0.00001 par value - 160,000,000 shares authorized, and 124,905,954 shares issued and 124,749,102 outstanding as of March 31, 2021; no shares authorized, issued or outstanding as of December 31, 2020 | 1 | — |\n| Additional paid-in capital | 174,254 | 4,975 |\n| Accumulated deficit | ( 34,344 ) | ( 35,815 ) |\n| Total stockholders’ equity (deficit) | 139,911 | ( 6,840 ) |\n| Total liabilities, redeemable convertible preferred stock, and stockholders' deficit | $ | 193,866 | $ | 54,958 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.1\nSEMRUSH HOLDINGS, INC.\nUNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)\n(in thousands, except per share data)\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| Revenue | $ | 39,998 | $ | 27,787 |\n| Cost of revenue | 8,773 | 6,611 |\n| Gross profit | 31,225 | 21,176 |\n| Operating expenses |\n| Sales and marketing | 16,457 | 12,877 |\n| Research and development | 5,358 | 4,237 |\n| General and administrative | 7,904 | 5,933 |\n| Total operating expenses | 29,719 | 23,047 |\n| Income (loss) from operations | 1,506 | ( 1,871 ) |\n| Other income, net | 51 | 56 |\n| Income (loss) before income taxes | 1,557 | ( 1,815 ) |\n| Provision for income taxes | 86 | 116 |\n| Net income (loss) and comprehensive income (loss) | $ | 1,471 | $ | ( 1,931 ) |\n| Net income (loss) per share attributable to common stockholders: |\n| Basic | $ | 0.02 | $ | ( 0.02 ) |\n| Diluted | $ | 0.01 | $ | ( 0.02 ) |\n| Weighted-average number of shares of common stock used in computing net income (loss) per share attributable to common stockholders: |\n| Basic | 96,376 | 94,593 |\n| Diluted | 131,356 | 94,593 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.2\nSEMRUSH HOLDINGS, INC.\nUNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY (DEFICIT)\n(in thousands, except share data)\n| Series A | Series A-1 | Series B | Common Stock | Class A Common Stock | Class B Common Stock | AdditionalPaid-inCapital | AccumulatedDeficit | TotalStockholders’Equity(Deficit) |\n| Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount |\n| Balances at December 31, 2019 | 3,379,400 | $ | 7,789 | 1,837,600 | $ | 10,270 | 4,681,400 | $ | 24,000 | 94,592,700 | $ | — | — | $ | — | — | $ | — | $ | 3,644 | $ | ( 28,803 ) | $ | ( 1,159 ) |\n| Stock-based compensation expense | — | — | — | — | — | — | — | — | — | — | — | — | 205 | — | 205 |\n| Net loss | — | — | — | — | — | — | — | — | — | — | — | — | — | ( 1,931 ) | ( 1,931 ) |\n| Balances at March 31, 2020 | 3,379,400 | $ | 7,789 | 1,837,600 | $ | 10,270 | 4,681,400 | $ | 24,000 | 94,592,700 | $ | — | — | $ | — | — | $ | — | 3,849 | ( 30,734 ) | ( 2,885 ) |\n| Balances at December 31, 2020 | 3,379,400 | $ | 7,789 | 1,837,600 | $ | 10,270 | 4,681,400 | $ | 24,000 | 95,050,041 | $ | — | — | $ | — | — | $ | — | 4,975 | ( 35,815 ) | $ | ( 6,840 ) |\n| Conversion of Preferred Stock | ( 3,379,400 ) | ( 7,789 ) | ( 1,837,600 ) | ( 10,270 ) | ( 4,681,400 ) | ( 24,000 ) | 29,695,200 | — | — | — | — | — | 42,058 | — | 18,058 |\n| Issuance of Class A Common Stock in connection with the initial public offering, net of $ 13,378 in issuance costs | — | — | — | — | — | — | — | — | 10,000,000 | — | — | — | 126,622 | — | 126,622 |\n| Reclassification of Common Stock to Class B Common Stock in connection with the initial public offering | — | — | — | — | — | — | ( 124,745,241 ) | — | — | — | 124,745,241 | 1 | ( 1 ) | — | — |\n| Exercise of stock options | — | — | — | — | — | — | — | — | — | — | 3,861 | — | 7 | — | 7 |\n| Stock-based compensation expense | — | — | — | — | — | — | — | — | — | — | — | — | 593 | — | 593 |\n| Net Income | — | — | — | — | — | — | — | — | — | — | — | — | — | 1,471 | 1,471 |\n| Balances at March 31, 2021 | — | $ | — | — | $ | — | — | $ | — | — | $ | — | 10,000,000 | $ | — | 124,749,102 | $ | 1 | $ | 174,254 | $ | ( 34,344 ) | $ | 139,911 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.3\nSEMRUSH HOLDINGS, INC.\nUNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(in thousands)\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| Operating Activities |\n| Net income (loss) | $ | 1,471 | $ | ( 1,931 ) |\n| Adjustments to reconcile net income (loss) to net cash provided by operating activities |\n| Depreciation and amortization expense | 460 | 232 |\n| Amortization of deferred contract costs | 1,322 | 1,104 |\n| Stock-based compensation expense | 593 | 205 |\n| Deferred taxes | ( 56 ) | ( 57 ) |\n| Changes in operating assets and liabilities |\n| Accounts receivable | ( 985 ) | 745 |\n| Deferred contract costs | ( 2,420 ) | ( 1,704 ) |\n| Prepaid expenses and other current assets | ( 976 ) | ( 747 ) |\n| Accounts payable | 1,579 | 58 |\n| Accrued expenses | 2,420 | 1,002 |\n| Deferred revenue | 5,599 | 1,654 |\n| Net cash provided by operating activities | 9,007 | 561 |\n| Investing Activities |\n| Purchases of property and equipment | ( 166 ) | ( 1,084 ) |\n| Purchases of convertible debt securities | ( 500 ) | — |\n| Capitalization of internal-use software development costs | ( 123 ) | ( 297 ) |\n| Cash paid for acquisition of business, net of cash acquired | ( 350 ) | — |\n| Net cash used in investing activities | ( 1,139 ) | ( 1,381 ) |\n| Financing Activities |\n| Proceeds from exercise of stock options | 7 | — |\n| Net proceeds from completing initial public offering | 128,461 | — |\n| Payment of deferred offering costs | — | ( 16 ) |\n| Net cash provided by (used in) financing activities | 128,468 | ( 16 ) |\n| Increase in cash, cash equivalents and restricted cash | 136,336 | ( 836 ) |\n| Cash, cash equivalents and restricted cash, at beginning of period | 35,619 | 37,523 |\n| Cash, cash equivalents and restricted cash, at end of period | $ | 171,955 | $ | 36,687 |\n| Supplemental cash flow disclosures |\n| Cash paid for income taxes | $ | 158 | $ | 154 |\n| Deferred offering costs incurred and not paid | $ | 1,839 | $ | — |\n| Acquisition of fixed asset under capital lease | $ | 1,024 | $ | — |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.4\nSEMRUSH HOLDINGS, INC.\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\nThree months ended March 31, 2021 and 2020\n(in thousands, except share and per share data, unless otherwise noted)\n1. Overview and Basis of Presentation\nDescription of Business\nSemrush Holdings, Inc. (“Semrush Holdings”) and its subsidiaries (together the “Group”, the “Company”, or “Semrush”) provide an online visibility management software-as-a-service (“SaaS”) platform. The Company’s platform enables its subscribers to improve their online visibility and drive traffic, including on their websites and social media pages, and distribute highly relevant content to their customers on a targeted basis across various channels to drive high-quality traffic and measure the effectiveness of their digital marketing campaigns. The Company is headquartered in Boston, Massachusetts, and has wholly owned subsidiaries in Cyprus, Russia, the Czech Republic, Poland, and the United States.\nThe Company is subject to a number of risks and uncertainties common to companies in similar industries and stages of development that could affect future operations and financial performance. These risks include, but are not limited to, rapid technological change, competitive pressure from substitute products or larger companies, protection of proprietary technology, management of international activities, the need to obtain additional financing to support growth, and dependence on third parties and key individuals.\n2019 Reorganization\nOn December 19, 2019, Semrush Holdings was incorporated in the state of Delaware and entered into a Contribution and Exchange Agreement with SEMrush CY Ltd (“SEMrush CY”) (a private limited liability company organized under the Cyprus Companies Law, Cap 113), pursuant to which the holders of all outstanding shares of capital stock of SEMrush CY contributed those shares to Semrush Holdings in exchange for identical shares of capital stock of Semrush Holdings (the “2019 Share Exchange”). Upon the 2019 Share Exchange, Semrush Holdings became the holding company of SEMrush CY and its wholly owned subsidiaries and the historical consolidated financial statements of SEMrush CY became the historical consolidated financial statements of Semrush Holdings. The 2019 Share Exchange and related transactions were completed on December 27, 2019.\nInitial Public Offering\nOn March 29, 2021, the Company closed its initial public offering (“IPO”) in which it sold 10,000,000 shares of its Class A common stock at a price to the public of $ 14.00 per share. The Company received $ 126.6 million in net proceeds after deducting approximately $ 13.4 million for underwriting discounts, commissions and offering expenses. Immediately prior to the completion of the IPO, all shares of common stock then outstanding were reclassified as Class B common stock, and all shares of redeemable convertible preferred stock and convertible preferred stock then outstanding were converted into shares of common stock on a one -to-one basis and then reclassified into Class B common stock.\nEffects of COVID-19\nThe Company considered the potential effects of the novel strain of coronavirus (“COVID-19”) pandemic on the Company. In March 2020, the World Health Organization declared the outbreak of COVID–19 a pandemic, and numerous new strains of COVID-19 have subsequently spread throughout\n5\nthe world. COVID–19 has continued to impact market and economic conditions globally. In an attempt to limit the spread of the virus, various governmental restrictions have been implemented, including restrictions with respect to business activities and travel restrictions, and “shelter–at–home” orders, that have had and may continue to have an adverse impact on the Company’s business and operations. In light of the evolving nature of COVID–19 and the uncertainty it has produced around the world, it is not possible to predict the COVID–19 pandemic’s cumulative and ultimate impact on the Company’s future business operations, results of operations, financial position, liquidity, and cash flows. The extent of the impact of the pandemic on the Company’s business and financial results will depend largely on future developments, including the duration of the spread of the outbreak both globally and within the U.S., the impact on capital, foreign currencies exchange and financial markets, and governmental or regulatory orders that impact the Company’s business, all of which are highly uncertain and cannot be predicted.\nThe Company will continue to actively monitor the current international and domestic impacts of and responses to COVID-19 and its related risks.\nBasis of Presentation\nThe accompanying unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and applicable rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Any reference in these notes to applicable guidance is meant to refer to the authoritative United States generally accepted accounting principles as found in the Accounting Standards Codification (“ASC”) and Accounting Standards Update (“ASU”) of the Financial Accounting Standards Board (“FASB”).\nThe unaudited condensed consolidated interim financial statements have been prepared on the same basis as the audited annual consolidated financial statements as of and for the year ended December 31, 2020, and, in the opinion of management, reflect all adjustments, consisting of normal recurring adjustments, necessary for the fair presentation of the Company’s financial position as of March 31, 2021, and the results of its operations and its cash flows for the three months ended March 31, 2021 and 2020. The consolidated balance sheet as of December 31, 2020 included herein was derived from the audited financial statements as of that date.\nThe results for the three months ended March 31, 2021 are not necessarily indicative of the results to be expected for the year ending December 31, 2021, any other interim periods, or any future year or period.\nThe unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes included in the Company’s final prospectus dated March 24, 2021 (the “Prospectus”) as filed with the SEC on March 25, 2021 pursuant to Rule 424(b) under the Securities Act of 1933, as amended (the “Securities Act”).\nThe accompanying unaudited condensed consolidated financial statements reflect the application of certain significant accounting policies as described below and elsewhere in these notes to the unaudited condensed consolidated financial statements. As of March 31, 2021, there have been no material changes in the Company's significant accounting policies from those that were disclosed in the Prospectus except as discussed below.\n2. Summary of Significant Accounting Policies\nPrinciples of Consolidation\n6\nThe unaudited condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany transactions and balances have been eliminated in consolidation.\nUse of Estimates\nThe preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. Significant estimates relied upon in preparing these financial statements include, but are not limited to, revenue recognition, expected future cash flows used to evaluate the recoverability of long-lived assets, contingent liabilities, expensing and capitalization of research and development costs for internal-use software, the average period of benefit associated with costs capitalized to obtain revenue contracts, the determination of the fair value of stock-based awards issued, stock-based compensation expense, and the recoverability of the Company’s net deferred tax assets and related valuation allowance.\nAlthough the Company regularly assesses these estimates, actual results could differ materially from these estimates. Changes in estimates are recorded in the period in which they become known. The Company bases its estimates on historical experience and various other assumptions that it believes to be reasonable under the circumstances. Actual results may differ from management’s estimates if these results differ from historical experience, or other assumptions do not turn out to be substantially accurate, even if such assumptions are reasonable when made.\nSubsequent Events Considerations\nThe Company considers events or transactions that occur after the balance sheet date but prior to the issuance of the financial statements to provide additional evidence for certain estimates or to identify matters that require additional disclosure. Subsequent events have been evaluated as required. The Company has evaluated all subsequent events and determined that there are no material recognized or unrecognized subsequent events requiring disclosure, other than those disclosed in this Quarterly Report on Form 10-Q.\nEmerging Growth Company Status\nThe Company is an \"emerging growth company,\" as defined in the Jumpstart Our Business Startups Act, or JOBS Act, and may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not \"emerging growth companies.\" The Company may take advantage of these exemptions until the Company is no longer an \"emerging growth company.\" Section 107 of the JOBS Act provides that an \"emerging growth company\" can take advantage of the extended transition period afforded by the JOBS Act for the implementation of new or revised accounting standards. The Company has elected to use the extended transition period for complying with new or revised accounting standards and, as a result of this election, its financial statements may not be comparable to companies that comply with public company effective dates. The Company may take advantage of these exemptions up until the last day of the year following the fifth anniversary of an offering or such earlier time that it is no longer an emerging growth company. The Company would cease to be an emerging growth company if it has more than $1.07 billion in annual revenue, has more than $700.0 million in market value of its stock held by non-affiliates (and it has been a public company for at least 12 months, and has filed one annual report on Form 10-K), or it issues more than $1.0 billion of non-convertible debt securities over a three-year period.\n7\nRevenue Recognition\nThe Company derives revenue from two sources: (1) subscription revenues via the Semrush Online Visibility Management Platform and the Prowly Public Relations Platform, which are comprised of subscription fees from customers accessing the Company’s SaaS services and related customer support; and (2) the Semrush Marketplace, which allows customers to pay a set fee for services or products offered through the marketplace.\nThe Company recognizes revenue in accordance with ASC 606, Revenue from Contracts with Customers (“ASC 606”). Revenue is recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration it expects to receive in exchange for those products or services. There were no changes to the Company’s revenue recognition policies since the filing of the Prospectus.\nFor the three months ended March 31, 2021 and 2020, subscription revenue accounted for nearly all of the Company’s revenue. Revenue related to the Semrush Marketplace was not material for the three months ended March 31, 2021 and 2020.\nAmounts that have been invoiced are recorded in accounts receivable and in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met. The Company primarily invoices and collects payments from customers for its services in advance on a monthly or annual basis.\nDeferred revenue represents amounts billed for which revenue has not yet been recognized. Deferred revenue that will be recognized during the succeeding 12-month period is recorded as current deferred revenue, and the remaining portion is recorded as long-term deferred revenue. Deferred revenue increased by $ 5,599 as of March 31, 2021 compared December 31, 2020. During the three months ended March 31, 2021 and 2020, $ 13,303 and $ 9,583 of revenue was recognized that was included in deferred revenue at the beginning of each respective period.\nThe Company has elected to exclude amounts charged to customers for sales tax from the transaction price. Accordingly, revenue is presented net of any sales tax collected from customers.\nTransaction Price Allocated to Future Performance Obligations\nASC 606 requires that the Company disclose the aggregate amount of the transaction price that is allocated to performance obligations that have not yet been satisfied as of the balance sheet dates reported.\nFor contracts with an original expected duration greater than one year, the aggregate amount of the transaction price allocated to the performance obligations that were unsatisfied as of March 31, 2021 and December 31, 2020 was $ 866 and $ 1,280 , respectively, which the Company expects to recognize over the next 12 months.\nFor contracts with an original expected duration of one year or less, the Company has applied the practical expedient available under ASC 606 to not disclose the amount of transaction price allocated to unsatisfied performance obligations as of March 31, 2021 and December 31, 2020. For performance obligations not satisfied as of March 31, 2021 and December 31, 2020, and to which this expedient applies, the nature of the performance obligations is consistent with performance obligations satisfied as of December 31, 2019. The remaining durations are less than one year.\nCosts to Obtain a Contract\nThe incremental direct costs of obtaining a contract, which primarily consist of sales commissions paid for new subscription contracts, are deferred and recorded as deferred contract costs in the\n8\nconsolidated balance sheet and are amortized over a period of approximately 24 months on a systematic basis, consistent with the pattern of transfer of the goods or services to which the asset relates. The 24-month period represents the estimated benefit period of the customer relationship and has been determined by taking into consideration the type of product sold, the commitment term of the customer contract, the nature of the Company’s technology development life-cycle, and an estimated customer relationship period based on historical experience and future expectations. Sales commissions for renewals and upgrade contracts are deferred and amortized on a straight-line basis over the remaining estimated customer relationship period of the related customer. Deferred contract costs that will be recorded as expense during the succeeding 12-month period are recorded as current deferred contract costs, and the remaining portion is recorded as deferred contract costs, net of current portion. Amortization of deferred contract costs is included in sales and marketing expense in the accompanying consolidated statement of operations and comprehensive loss.\nCash, Cash Equivalents, and Restricted Cash\nThe Company considers all highly liquid instruments purchased with an original maturity date of 90 days or less from the date of purchase to be cash equivalents. Management determines the appropriate classification of investments at the time of purchase and re-evaluates such determination at each balance sheet date.\nCash and cash equivalents consist of cash on deposit with banks and amounts held in interest-bearing money market funds. Cash equivalents are carried at cost, which approximates their fair market value. At both March 31, 2021 and December 31, 2020, restricted cash was $ 88 , and related to cash held at a financial institution in an interest-bearing cash account as collateral for a letter of credit related to the contractual provisions for one of the Company’s building leases.\nThe following table is a reconciliation of cash, cash equivalents and restricted cash included in the accompanying condensed consolidated balance sheets that sum to the total cash, cash equivalents and restricted cash included in the accompanying condensed consolidated statements of cash flows for the three months ended March 31, 2021 and 2020.\n| March 31, 2021 | March 31, 2020 |\n| Cash and cash equivalents | $ | 171,867 | $ | 36,599 |\n| Restricted cash included in “prepaid expenses and other current assets” and “other long-term assets,” respectively | 88 | 88 |\n| $ | 171,955 | $ | 36,687 |\n\nConcentrations of Credit Risk and Significant Customers\nThe Company has no off-balance sheet risk, such as foreign exchange contracts, option contracts, or other hedging arrangements. Credit losses historically have not been significant and the Company generally has not experienced any material losses related to receivables from individual customers, or groups of customers. Due to these factors, no additional credit risk beyond amounts provided for collection losses is believed by management to be probable in the Company's accounts receivable.\nCredit risk with respect to accounts receivable is dispersed due to the large number of customers of the Company. The Company routinely assesses the creditworthiness of its customers and generally does not require its customers to provide collateral or other security to support accounts receivable. Credit losses historically have not been significant and the Company generally has not experienced any material losses related to receivables from individual customers, or groups of customers. Due to these factors, no additional credit risk beyond amounts provided for collection losses is believed by management to be probable in the Company's accounts receivable.\n9\nAs of March 31, 2021 and December 31, 2020, no individual customer represented more than 10% of the Company’s accounts receivable. During the three months ended March 31, 2021 and 2020, no individual customer represented more than 10% of the Company’s revenue.\nDisclosure of Fair Value of Financial Instruments\nThe carrying amounts of the Company’s financial instruments, which include cash and cash equivalents, accounts receivable, accounts payable, and accrued expenses, approximated their fair values at March 31, 2021 and December 31, 2020, due to the short-term nature of these instruments.\nThe Company has evaluated the estimated fair value of financial instruments using available market information. The use of different market assumptions and/or estimation methodologies could have a significant effect on the estimated fair value amounts. See below for further discussion.\nFair Value Measurements\nASC 820, Fair Value Measurements and Disclosures (“ASC 820”), establishes a three-level valuation hierarchy for instruments measured at fair value that distinguishes between assumptions based on market data (observable inputs) and the Company’s own assumptions (unobservable inputs). Observable inputs are those that market participants would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions about the inputs that market participants would use in pricing the asset or liability and are developed based on the best information available in the circumstances.\nThis guidance further identifies fair value as the exchange price, or exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants based on the highest and best use of the asset or liability. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. The Company uses valuation techniques to measure fair value that maximize the use of observable inputs and minimize the use of unobservable inputs. These inputs are prioritized as follows:\nLevel 1 inputs—Unadjusted observable quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.\nLevel 2 inputs—Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly.\nLevel 3 inputs—Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity.\nTo the extent that the valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Accordingly, the degree of judgment exercised by the Company in determining fair value is greatest for instruments categorized in Level 3. A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement.\nThe Company evaluates assets and liabilities subject to fair value measurements on a recurring and nonrecurring basis to determine the appropriate level to classify them for each reporting period.\nCash equivalents include money market funds with original maturities of 90 days or less from the date of purchase. The fair value measurement of these assets is based on quoted market prices in active markets for identical assets and, therefore, these assets are recorded at fair value on a recurring basis\n10\nand classified as Level 1 in the fair value hierarchy. As of March 31, 2021 and December 31, 2020, cash equivalents held in money market funds totaled $ 35,505 and $ 29,369 , respectively.\nAs of March 31, 2021, the Company measured its investments in convertible notes (see Note 4) and its contingent consideration associated with the acquisition of Prowly.com sp. z o.o (“Prowly”) on a recurring basis using significant unobservable inputs (Level 3) and did not have any assets or liabilities measured at fair value on a recurring basis using significant other observable inputs (Level 2). Changes in fair value of the convertible notes were not material for the three months ended March 31, 2021 due to the short time period between when the investment was made and the balance sheet date. Changes in fair value of the contingent consideration associated with the Prowly acquisition were not material for the three months ended March 31, 2021. As of December 31, 2020, the Company did not have any assets or liabilities measured at fair value on a recurring basis using significant other observable inputs (Level 2).\nForeign Currency Translation\nThe Group operates in a multi-currency environment having transactions in such currencies as the U.S. dollar, Russian rubles, Czech koruna, euros, and others. The reporting currency of the Company is the U.S. dollar. The functional currency of the Company’s foreign subsidiaries is the U.S. dollar, with the exception of Prowly, where the functional currency is the local currency, the Zloty. The foreign currency translation adjustment as it relates to Prowly was immaterial for the three months ended March 31, 2021 and 2020. For all other entities, foreign currency transactions are measured initially in the functional currency of the recording entity by use of the exchange rate in effect at that date. At each subsequent balance sheet date, foreign currency denominated assets and liabilities of these international subsidiaries are remeasured into U.S. dollars using the exchange rates in effect at the balance sheet date or historical rates, as appropriate. Any differences resulting from the remeasurement of foreign denominated assets and liabilities of the international subsidiaries to the U.S. dollar functional currency are recorded within other income (expense) in the unaudited condensed consolidated statement of operations and comprehensive loss. The foreign currency exchange gain (loss) included in other income for the three months ended March 31, 2021 and 2020 was $ 44 and $( 107 ), respectively.\nNet Income (Loss) Per Share\nNet income (loss) per share information is determined using the two-class method, which includes the weighted-average number of shares of common stock outstanding during the period and other securities that participate in dividends (a participating security). Prior to the completion of the IPO, the Company considered the shares of Preferred Stock to be participating securities because they include rights to participate in dividends with the common stock. As of March 31, 2021, the Company did not have any participating securities outstanding.\nUnder the two-class method, basic net income (loss) per share attributable to common stockholders is computed by dividing the net income (loss) attributable to common stockholders by the weighted-average number of shares of common stock outstanding during the period. Diluted net income (loss) per share attributable to common stockholders is computed using the more dilutive of (1) the two-class method or (2) the if-converted method. The Company allocates net income first to preferred stockholders based on dividend rights under the Company’s certificate of incorporation and then to preferred and common stockholders based on ownership interests. Net losses are not allocated to preferred stockholders as they do not have an obligation to share in the Company’s net losses.\nDuring the three months ended March 31, 2021, the Company amended its certificate of incorporation to create two classes of common stock outstanding: Class A common stock and Class B common stock. As more fully described in Note 9, the rights of the holders of Class A and Class B common stock are identical, except with respect to voting and conversion. Each share of Class A common stock is entitled to one (1) vote per share and each share of Class B common stock is entitled to ten (10) votes per share. Each share of Class B common stock is convertible into one share of Class A common stock at the option\n11\nof the holder at any time. Shares of Class B common stock are automatically converted into Class A common stock upon sale or transfer, subject to certain limited exceptions. Shares of Class A common stock are not convertible. See Note 9 to these unaudited condensed consolidated financial statements for additional information regarding the current conversion and transfer terms of the Company’s common stock. The Company allocates undistributed earnings attributable to common stock between the common stock classes on a one to one basis when computing net income (loss) per share. As a result, basic and diluted net income (loss) per share of Class A common stock and share of Class B common stock are equivalent.\nDiluted net income (loss) per share gives effect to all potentially dilutive securities. Potential dilutive securities consist of shares of common stock issuable upon the exercise of stock options, shares of common stock issuable upon the conversion of the outstanding shares of Preferred Stock, and shares of common stock issuable upon the vesting of restricted stock awards or restricted stock units.\nFor the three months ended March 31, 2021, dilutive net income per share was calculated by dividing net income by the weighted-average number of shares of common stock outstanding during the period, the dilutive impact of stock options, shares of common stock issuable upon the vesting of RSUs, and the dilutive impact of shares issuable upon the conversion of the outstanding shares of Preferred Stock.\nFor the three months ended March 31, 2020, the net loss attributable to common stockholders is divided by the weighted-average number of shares of common stock outstanding during the period to calculate diluted earnings per share. The dilutive effect of common stock equivalents has been excluded from the calculation for the three months ended March 31, 2020 as their effect would have been anti-dilutive due to the net losses incurred for the period.\nThe following table presents a reconciliation of the weighted-average shares outstanding used in the calculation of basic and diluted net income (loss) per share:\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| Weighted-average shares outstanding: |\n| Weighted-average number of shares of common stock used in computing net income (loss) per share attributable to common stockholders—basic | 96,375,531 | 94,592,700 |\n| Dilutive effect of share equivalents resulting from stock options | 6,151,361 | — |\n| Dilutive effect of share equivalents resulting from RSAs | 123,841 | — |\n| Dilutive effect of shares issuable upon conversion of preferred stock | 28,705,360 | — |\n| Weighted-average number of shares of common stock used in computing net income (loss) per share attributable to common stockholders—diluted | 131,356,093 | 94,592,700 |\n\nThe following potentially dilutive common stock equivalents have been excluded from the calculation of diluted weighted-average shares outstanding for the three months ended March 31, 2021 and 2020:\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| Stock options outstanding | — | 6,286,357 |\n| Shares of Preferred Stock | — | 29,695,200 |\n| Restricted stock units outstanding | 1,733 | — |\n\n12\nComprehensive income (loss)\nComprehensive income (loss) is comprised of two components: net income (loss) and other comprehensive income (loss), which includes other changes in stockholders’ deficit that result from transactions and economic events other than those with stockholders. The Company had no items qualifying as other comprehensive income (loss) with the exception of an immaterial cumulative translation adjustment related to the Prowly entity and an immaterial fair-value adjustment related to the convertible note investments; accordingly, comprehensive income (loss) equaled total net loss for the three months ended March 31, 2021 and 2020.\nRecent Accounting Pronouncements\nIn February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). ASU 2016-02 requires a lessee to recognize most leases on the balance sheet but recognize expenses on the income statement in a manner similar to current practice. The update states that a lessee will recognize a lease liability for the obligation to make lease payments and a right-to-use asset for the right to use the underlying assets for the lease term. Leases will continue to be classified as either financing or operating, with classification affecting the recognition, measurement, and presentation of expenses and cash flows arising from a lease. For public entities, ASU 2016-02 is effective for years beginning after December 15, 2019. For non-public companies, ASU 2016-02 is effective for fiscal years beginning after December 15, 2021 and interim periods in annual periods beginning after December 15, 2022. Early adoption is permitted. The Company plans to adopt this guidance in the year ended December 31, 2022. The Company is currently assessing the impact that adopting this guidance will have on its consolidated financial statements.\nIn June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. ASU 2016-13 requires that credit losses be reported as an allowance using an expected losses model, representing the entity's current estimate of credit losses expected to be incurred. The accounting guidance currently in effect is based on an incurred loss model. ASU 2016-13 affect loans, debt securities, trade receivables, net investments in leases, off balance sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash. ASU 2016-13 is effective for public entities for annual reporting periods beginning after December 15, 2019, including interim periods within those fiscal years. For non-public companies, ASU 2016-13 is effective for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021. The Company plans to adopt this guidance in the year ended December 31, 2021. The Company is currently evaluating ASU 2016-13 and the potential impact on its condensed consolidated financial statements and financial statement disclosures.\nIn August 2018, the FASB issued ASU No. 2018-15, Intangible-Goodwill and Other Internal-Use Software (Subtopic 350-40). ASU 2018-15 updates guidance regarding accounting for implementation costs associated with a cloud computing arrangement that is a service contract. The amendments under ASU 2018-15 are effective for public entities for years beginning after December 15, 2019, and interim periods within those years. For non-public companies, ASU 2081-15 is effective for annual reporting periods beginning after December 15, 2020, and interim periods within annual periods beginning after December 15, 2021, with early adoption permitted. The Company plans to adopt this guidance in the year ended December 31, 2021. The Company is currently assessing the impact that adopting this guidance will have on its condensed consolidated financial statements.\nIn December 2019, the FASB issued ASU 2019-12, Income Taxes – Simplifying the Accounting for Income Taxes. The new guidance simplifies the accounting for income taxes by removing several exceptions in the current standard and adding guidance to reduce complexity in certain areas, such as requiring that an entity reflect the effect of an enacted change in tax laws or rates in the annual effective tax rate computation in the interim period that includes the enactment date. For public companies, the ASU is effective for years beginning after December 15, 2020, and interim periods within those years,\n13\nwith early adoption permitted. For non-public companies, the new standard is effective for years beginning after December 15, 2021, with early adoption permitted. The Company plans to adopt this guidance in the year ended December 31, 2021. The Company is currently assessing the impact that adopting this guidance will have on its condensed consolidated financial statements.\n3. Property and Equipment, Net\nProperty and equipment consists of the following (in thousands):\n| As of |\n| March 31,2021 | December 31,2020 |\n| Computer equipment | $ | 3,383 | $ | 3,513 |\n| Furniture and office equipment | 877 | 1,041 |\n| Leasehold improvements | 1,142 | 667 |\n| Capital leases | 1,024 | — |\n| Total property and equipment | 6,426 | 5,221 |\n| Less: accumulated depreciation and amortization | ( 2,550 ) | ( 2,253 ) |\n| Property and equipment, net | $ | 3,876 | $ | 2,968 |\n\nDepreciation and amortization expense related to property and equipment was $ 344 and $ 203 for the three months ended March 31, 2021 and 2020, respectively.\n4. Other Long-Term Assets\nDeferred Offering Costs\nDeferred offering costs, which primarily consist of direct incremental legal and accounting fees relating to the IPO and to a credit facility, are deferred. The deferred issuance costs relating to the IPO were offset against IPO proceeds upon the consummation of the Company’s offering. The deferred costs relating to the credit facility are being amortized to interest expense up through the maturity date of the facility. As of March 31, 2021 and December 31, 2020, the Company had deferred offering costs relating to the IPO of $ 0 and $ 1,839 . As of March 31, 2021 and December 31, 2020, the Company had $ 578 and $ 630 , respectively, in issuance costs relating to the credit facility. The issuance costs for the IPO and credit facility are classified in other long-term assets in the accompanying unaudited condensed consolidated balance sheets.\nInvestments in Convertible Debt\nIn January 2021, the Company purchased two convertible debt securities for a total aggregate investment of $ 500 . Both investments mature on January 1, 2023 and receive interest at an annual rate of 6 %. Interest accrues and becomes payable upon conversion of the convertible notes, or will be paid in connection with the repayment in full of the principal amount of such convertible notes.\nThese convertible note investments are classified as available-for-sale securities with changes in fair value reported in other comprehensive income (loss). Changes in fair value were not material for the three months ended March 31, 2021 due to the short time period between when the investment was made and the balance sheet date. These investments are classified in other long-term assets in the accompanying unaudited condensed consolidated balance sheets based on the maturity date.\n14\n5. Acquisitions, Acquired Intangible Assets, and Goodwill\nAcquisitions\nOn August 27, 2020, the Company acquired 100 % of the outstanding capital of Prowly for cash consideration of $ 3,317 . In addition to the purchase consideration, the founders of Prowly are eligible to earn up to a maximum of $ 2,750 in aggregate additional consideration based on the satisfaction of certain earnings targets as defined in the purchase agreement. For the three months ended March 31, 2021, the Company recognized compensation expense of $ 56 as compensation expense related to the additional consideration.\nIntangible Assets\nIntangible assets consisted of intangible assets resulting from the acquisition of Prowly and capitalized internal-use software development costs. Intangible assets consists of the following:\n| As of March 31, 2021 |\n| Gross | Net |\n| Carrying | Accumulated | Carrying |\n| Amount | Amortization | Amount |\n| Developed technology | 1,194 | ( 109 ) | 1,085 |\n| Trade name | 68 | ( 9 ) | 59 |\n| Capitalized internal-use software | 1,684 | ( 652 ) | 1,032 |\n| Total as of March 31, 2021 | $ | 2,946 | $ | ( 770 ) | $ | 2,176 |\n\n| As of December 31, 2020 |\n| Gross | Net |\n| Carrying | Accumulated | Carrying |\n| Amount | Amortization | Amount |\n| Developed technology | 1,194 | ( 66 ) | 1,128 |\n| Trade name | 68 | ( 3 ) | 65 |\n| Capitalized internal-use software | 1,561 | ( 523 ) | 1,038 |\n| Total as of December 31, 2020 | $ | 2,823 | $ | ( 592 ) | $ | 2,231 |\n\nDuring the three months ended March 31, 2021 and 2020, the Company capitalized $ 123 and $ 200 , respectively, of software development costs, which are classified as intangible assets on the accompanying consolidated balance sheets. The Company recorded amortization expense associated with its capitalized development costs of $ 129 and $ 52 for the three months ended March 31, 2021 and 2020, respectively. As of March 31, 2021 and December 31, 2020, the capitalized internal-use software asset balances totaled $ 1,032 and $ 1,038 , respectively.\nAmortization expense for acquired intangible assets was $ 55 for the three months ended March 31, 2021.\n15\nAs of March 31, 2021, future amortization expense is expected to be as follows:\n| Amount |\n| Remainder of 2021 | $ | 519 |\n| 2022 | 559 |\n| 2023 | 428 |\n| 2024 | 199 |\n| 2025 and thereafter | 471 |\n| Total | $ | 2,176 |\n\nGoodwill\nThe was no change in the carrying value of goodwill of $ 1,991 from December 31, 2020 through March 31, 2021.\n6. Accrued expenses\nAccrued expenses consist of the following:\n| As of |\n| March 31,2021 | December 31,2020 |\n| Employee compensation | $ | 4,776 | $ | 4,478 |\n| Vacation reserves | 464 | 465 |\n| Other current liabilities | 5,046 | 2,776 |\n| Total accrued expenses | $ | 10,286 | $ | 7,719 |\n\n7. Revolving Credit Facility\nSenior Secured Revolving Credit Facility\nOn January 12, 2021, the Company executed a credit agreement with JPMorgan Chase Bank, N.A., in the form of a revolving credit facility, that consists of a $ 45.0 million revolving credit facility and a letter of credit sub-facility with an aggregate limit equal to the lesser of $ 5.0 million and the aggregate unused amount of the revolving commitments then in effect. The availability of the credit facility is subject to the borrowing base based on an advance rate of 400 % multiplied by annualized retention applied to monthly recurring revenue. The credit facility has a maturity of three years and will mature on January 12, 2024.\nBorrowings under the credit facility bear interest at the Company’s option at (i) LIBOR, subject to a 0.50 % floor, plus a margin, or (ii) the alternate base rate, subject to a 3.25 % floor (or 1.50 % prior to positive consolidated adjusted earnings before interest, taxes, depreciation, and amortization (“adjusted EBITDA”) for the twelve months most recently ended), plus a margin. For LIBOR borrowings, the applicable rate margin is 2.75 % (or 3.50 % prior to positive consolidated adjusted EBITDA as of the twelve months most recently ended). For base rate borrowings, the applicable margin is 0.00 % (or 2.50 % prior to positive consolidated adjusted EBITDA as of the twelve months most recently ended). The Company is also required to pay a 0.25 % per annum fee on undrawn amounts under the Company’s revolving credit facility, payable quarterly in arrears.\n16\nAs of March 31, 2021, the Company has not drawn on this revolving credit facility. For the three months ended March 31, 2021, the Company incurred $ 53 in interest expense relating to this credit facility.\n8. Income Taxes\nWe are subject to U.S. federal, state, and foreign income taxes. For the three months ended March 31, 2021 and 2020, we recorded provisions for income taxes of $ 86 and $ 116 , respectively. Our effective tax rate for the three months ended March 31, 2021 and 2020 was lower than the U.S. statutory rate primarily due to the valuation allowance.\nWe recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities. These differences are measured using the enacted statutory tax rates that are expected to be in effect for the years in which differences are expected to reverse. On a periodic basis, we reassess any valuation allowances that we maintain on our deferred tax assets, weighing positive and negative evidence to assess the recoverability of the deferred tax assets. We will maintain a valuation allowance on certain federal, state, and foreign tax attributes that we expect will expire prior to the utilization.\nIn March 2020, the Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”) was signed into law. The CARES Act includes provisions relating to several aspects of corporate income taxes. We do not currently expect the CARES Act to have a significant impact on our provision for income taxes.\n9. Redeemable Convertible Preferred Stock and Stockholders’ Equity\nPrior to the IPO, the authorized capital stock of the Company included 9,898,400 shares of preferred stock, of which 3,379,400 shares have been designated as Series A Redeemable Convertible Preferred Stock, 1,837,600 shares have been designated as Series A-1 Redeemable Convertible Preferred Stock and 4,681,400 shares have been designated as Series B Convertible Preferred Stock (collectively the “Preferred Stock”).\nImmediately prior to the closing of the IPO, the outstanding shares of Preferred Stock were converted on a three -for-one basis into 29,695,200 shares of common stock. The holders of the Company’s Preferred Stock had certain voting, dividend, and redemption rights, as well as liquidation preferences and conversion privileges. All rights, preferences, and privileges associated with the preferred stock were terminated at the time of the Company’s IPO in conjunction with the conversion of all outstanding shares of Preferred Stock into shares of common stock.\nAs of March 31, 2021, the total number of shares of all classes of stock which the Company shall have authority to issue was (i) 1,000,000,000 shares of Class A common stock, par value $ 0.00001 per share, and (ii) 160,000,000 shares of Class B common stock, par value $ 0.00001 per share, and (iii) 100,000,000 undesignated shares of Preferred Stock, par value $ 0.00001 per share.\nEach share of Class A common stock entitles the holder to one vote for each share on all matters submitted to a vote of the Company's stockholders at all meetings of stockholders and written actions in lieu of meetings. Each share of Class B common stock entitles the holder to ten votes for each share on all matters submitted to a vote of the Company's stockholders at all meetings of stockholders and written actions in lieu of meetings.\nHolders of Class A common stock and Class B common stock are entitled to receive dividends, when and if declared by the board of directors (the “Board”).\n17\nEach share of Class B common stock is convertible into one share of Class A common stock at the option of the holder at any time. Automatic conversion shall occur upon the occurrence of (i) a Transfer, as defined in the amended and restated certificate of incorporation, of such share of Class B common stock, (ii) the affirmative vote of at least two-thirds of the outstanding shares of Class B common stock, voting as a single class, or (iii) on or after the earlier to occur of (a) the seventh year anniversary of the effectiveness of the amended and restated certificate of incorporation or (b) the date on which the outstanding shares of Class B common stock represents less than 10 % of the aggregate number of the then outstanding shares of Class A common stock and Class B common stock. Further, upon either the death or incapacitation of a holder of Class B common stock, the shares held by such shareholder shall automatically be converted into one share of Class A common stock.\nStock Split\nOn March 15, 2021, the Board approved a 3 -for-1 stock-split of the Company’s common stock. The stock split was approved by the stockholders on March 15, 2021 and became effective on March 15, 2021. Upon the effectiveness of the stock split, (i) every one share of common stock outstanding was increased to 3 shares of common stock, (ii) the number of shares of common stock into which each outstanding option to purchase common stock is exercisable was proportionally increased on a 3 -for-1 basis, and (iii) the exercise price of each outstanding option to purchase common stock was proportionately decreased on a 3 -for-1 basis. Additionally, shares of common stock reserved for issuance upon the conversion of the Company’s Preferred Stock were proportionately increased on a 3 -for-1 basis and the respective conversion prices of the Preferred Stock were proportionately reduced. All share and per share data shown in the accompanying consolidated financial statements and related notes have been retroactively revised to reflect the stock split.\nCommon Stock Reserved for Future Issuance\nAs of March 31, 2021, the Company had reserved the following shares of common stock for future issuance:\n| Options outstanding | 7,591,554 |\n| Options reserved for future issuance | 13,483,501 |\n| Restricted stock outstanding | 156,852 |\n| Restricted stock units | 19,500 |\n| Total authorized shares of common stock reserved for future issuance | 21,251,407 |\n\nn\n10. Stock-Based Compensation\nIn 2019, the Board adopted the Semrush Holdings, Inc. 2019 Stock Option and Grant Plan (the “2019 Plan”), which provides for the grant of qualified incentive stock options and nonqualified stock options or other awards, including restricted stock unit awards, to the Company’s employees, officers, directors, advisors, and outside consultants for the purchase of up to 8,682,600 shares of the Company’s common stock. In July 2020, the Plan was amended to provide for the grant of qualified incentive stock options and nonqualified stock options or other awards to the Company’s employees, officers, directors, advisors, and outside consultants for the purchase of up to 10,163,772 shares of the Company’s common stock. Stock options generally vest over a 4 year period and expire 10 years from the date of grant. Certain options provide for accelerated vesting if there is a change in control (as defined in the Plan).\nThe Semrush Holdings, Inc. 2021 Stock Option and Incentive Plan (the “2021 Plan”) was adopted by the Board March 3, 2021 and approved by stockholders on March 15, 2021 and became effective immediately prior to the effectiveness of the Company’s registration statement in connection with its IPO. The 2021 Plan replaced the 2019 Plan as the Board determined not to make additional awards under the\n18\n2019 Plan following the pricing of the Company’s IPO. The 2021 Plan allows the compensation committee of the Board to make equity-based and cash-based incentive awards to the Company’s officers, employees, directors and other key persons (including consultants).\nThe Company initially reserved 13,503,001 shares of Class A common stock for the issuance of awards under the 2021 Plan. The 2021 Plan provides that the number of shares reserved and available for issuance under the plan will automatically increase each January 1, beginning on January 1, 2022, by the lesser of 5 % of the outstanding number of shares of Class A and Class B common stock on the immediately preceding December 31, or such lesser number of shares as determined by the compensation committee. This number is subject to adjustment in the event of a stock split, stock dividend or other change in our capitalization.\nThe Company accounts for stock-based compensation in accordance with the provisions of ASC 718, which requires the recognition of expense related to the fair value of stock-based compensation awards in the statements of operations. For stock-based awards issued under the Company’s stock-based compensation plans to employees and members of the Board for their services on the Board, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model as discussed further below. For service-based awards, the Company recognizes compensation expense on a straight-line basis over the requisite service period of the award with actual forfeitures recognized as they occur.\nGiven the absence of an active market for the Company’s common stock prior to the completion of the IPO, the Board, the members of which the Company believes have extensive business, finance, and venture capital experience, were required to estimate the fair value of the Company’s common stock at the time of each grant of a stock-based award. The Company and the Board utilized various valuation methodologies in accordance with the framework of the American Institute of Certified Public Accountants’ Technical Practice Aid, Valuation of Privately-Held Company Equity Securities Issued as Compensation, to estimate the fair value of its common stock. Each valuation methodology included estimates and assumptions that require the Company’s judgment. These estimates and assumptions include a number of objective and subjective factors, in determining the value of the Company’s common stock at each grant date, including the following factors: (1) prices paid for the Company’s Preferred Stock, which the Company had sold to outside investors in arm’s-length transactions, and the rights, preferences, and privileges of the Company’s Preferred Stock and common stock; (2) valuations performed by an independent valuation specialist; (3) the Company’s stage of development and revenue growth; (4) the fact that the grants of stock-based awards involved illiquid securities in a private company; and (5) the likelihood of achieving a liquidity event for the common stock underlying the stock-based awards, such as an IPO or sale of the Company, given prevailing market conditions.\nThe Company believes this methodology to be reasonable based upon the Company’s internal peer company analyses, and further supported by several arm’s-length transactions involving the Company’s Preferred Stock. As the Company’s common stock is not actively traded, the determination of fair value involves assumptions, judgments, and estimates. If different assumptions were made, stock-based compensation expense, consolidated net income (loss) and consolidated net income (loss) per share could have been significantly different.\nThe Company has recorded stock-based compensation expense for stock options of $ 593 and $ 205 during the three months ended March 31, 2021 and 2020, respectively. The following table shows stock-\n19\nbased compensation expense by where the stock-based compensation expense is recorded in the Company’s unaudited condensed consolidated statement of operations:\n| For the Three Months EndedMarch 31, |\n| 2021 | 2020 |\n| Cost of revenue | $ | 7 | $ | 5 |\n| Sales and marketing | 190 | 27 |\n| Research and development | 67 | 29 |\n| General and administrative | 329 | 144 |\n| Total stock-based compensation | $ | 593 | $ | 205 |\n\nAs of March 31, 2021, there was $ 5,024 of unrecognized compensation cost related to unvested common stock option arrangements granted under the 2021 Plan, which is expected to be recognized over a weighted-average period of 3.12 years.\nThe fair value of each option award was estimated on the date of grant using the Black-Scholes option-pricing model. As there was no public market for its common stock prior to March 25, 2021, which was the first day of trading, and as the trading history of the Company’s common stock was limited through March 31, 2021, the Company determined the expected volatility for options granted based on an analysis of reported data for a peer group of companies that issued options with substantially similar terms. The expected volatility of options granted has been determined using an average of the historical volatility measures of this peer group of companies. The expected life of options granted to employees was calculated using the simplified method, which represents the average of the contractual term of the option and the weighted-average vesting period of the option. The Company uses the simplified method because it does not have sufficient historical option exercise data to provide a reasonable basis upon which to estimate expected term. The risk-free interest rate is based on a treasury instrument whose term is consistent with the expected life of the share option. The Company has not paid, nor anticipates paying, cash dividends on its ordinary shares; therefore, the expected dividend yield is assumed to be zero .\n20\nThe weighted-average assumptions utilized to determine the fair value of options granted to employees are presented in the following table:\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| Expected volatility | 52.0 | % | 46.7 | % |\n| Weighted-average risk-free interest rate | 0.58 | % | 1.46 | % |\n| Expected dividend yield | — | — |\n| Expected life – in years | 6 | 6 |\n\nA summary of the Company’s option activity as of March 31, 2021, which all occurred under the Semrush Holdings, Inc. Amended and Restated 2019 Stock Option and Grant Plan (the “2019 Plan”), and changes during the three months then ended are as follows:\n| Number of Options | Weighted-Average Exercise Price (per share) | Weighted-Average Remaining Contractual Term (in years) |\n| Outstanding at December 31, 2020 | 7,611,258 | $ | 1.37 | 8.40 |\n| Granted | 34,500 | 6.21 |\n| Exercised | ( 3,861 ) | 1.35 |\n| Forfeited | ( 50,343 ) | 2.00 |\n| Outstanding at March 31, 2021 | 7,591,554 | 1.39 | 8.28 |\n| Options exercisable at March 31, 2021 | 3,309,264 | 0.94 | 7.60 |\n\nThe weighted-average grant-date fair value of options granted during the three months ended March 31, 2021 and 2020 was $ 9.09 and $ 1.70 per share, respectively. No tax benefits were realized from options during the three months ended March 31, 2021.\nThe aggregate intrinsic value of options outstanding as of March 31, 2021 and December 31, 2020 was $ 79,858 and $ 36,816 , respectively.\nThe aggregate intrinsic value for options exercised during the three months ended March 31, 2021 was $ 19 . No options were exercised for the three months ended March 31,2020.\nThe aggregate intrinsic value for options exercisable as of March 31, 2021 was $ 36,313 .\nThe aggregate intrinsic value was calculated based on the positive difference, if any, between the estimated fair value of the Company’s common stock on March 31, 2021 and December 31, 2020, respectively, or the date of exercise, as appropriate, and the exercise price of the underlying options.\nOn July 28, 2020, the Company issued 156,852 shares of its restricted common stock (“Restricted Stock Issuance”) to the founders of Prowly for a total fair value of $ 291 under the 2019 Plan. This Restricted Stock Issuance vests over a three-year service period, applicable to both founders. On March 3, 2021, the Company granted, to an employee, a restricted stock unit award for 19,500 shares of Class A common stock under the 2021 Plan.\n2021 Employee Stock Purchase Plan\nThe Semrush Holdings, Inc. 2021 Employee Stock Purchase Plan (the “ESPP”) was adopted by the Board on March 3, 2021 and approved by stockholders on March 15, 2021 and became effective\n21\nimmediately prior to the effectiveness of the Company’s registration statement in connection with its IPO. The ESPP initially reserves and authorizes the issuance of up to a total of 3,000,667 shares of Class A common stock to participating employees. The ESPP provides that the number of shares reserved and available for issuance will automatically increase each January 1, beginning on January 1, 2022 and each January 1 thereafter through January 1, 2031, by the least of (i) 1 % of the outstanding number of shares of Class A and Class B common stock on the immediately preceding December 31; (ii) 3,000,667 shares or (iii) such lesser number of shares of Class A common stock as determined by the ESPP administrator. The number of shares reserved under the ESPP is subject to adjustment in the event of a stock split, stock dividend or other change in our capitalization. The Company expects to offer, sell and issue shares of common stock under the ESPP from time to time based on various factors and conditions, although the Company is under no obligation to sell any shares under the ESPP. The Company has not issued any shares of Class A common stock under the ESPP.\n11. Commitments and Contingencies\nThe Company leases office facilities under noncancelable operating leases that expire at various dates through 2024. In addition, the Company has multi-year commitments with data centers. Some of these lease agreements contain escalating rent payments. Rent expense is recorded on a straight-line basis. Rent expense was $ 928 and $ 1,086 for the three months ended March 31, 2021 and 2020, respectively. The Company also has non-cancelable commitments related to its data centers.\nFuture minimum amounts payable as of March 31, 2021, under the office facilities operating leases and data center agreements are as follows:\n| Operating Leases |\n| Remainder of 2021 | $ | 3,070 |\n| 2022 | 3,109 |\n| 2023 | 1,515 |\n| 2024 | 459 |\n| 2025 and thereafter | — |\n| Total minimum lease payments | $ | 8,153 |\n\nDuring the year ended December 31, 2020, the Company entered into leasing arrangements for certain data center equipment under non-cancelable capital leases. The leasing arrangements have terms of 36 months beginning on the date the Company accepts the installation of the equipment subject to the lease. As of December 31, 2020, the equipment had not been installed and the Company had not accepted the equipment under these leases, and as such the lease commencement date had not begun. During the three months ended March 31, 2021, a portion of the equipment was installed and the related lease commenced. The Company is required to make total payments of $ 6,045 over the term of the leases which is excluded from the table above. The Company recorded $ 1,024 in capital leases to property and equipment, net, as of March 31, 2021 (see Note 3), which is being depreciated over the lease term of 36 months. The $ 1,024 of capital leases represents the total balance of other-long term liabilities on the unaudited condensed consolidated balance sheet as of March 31, 2021.\nIn addition to the lease commitments above, the Company also has multi-year commitments with certain data providers. The Company is committed to spend approximately $ 4,124 , $ 6,776 , and $ 1,933 for the remainder of the year ending December 31, 2021, and for the years ending December 31, 2022, and 2023, respectively, for data services.\n22\nLitigation\nThe Company, from time to time, may be party to litigation arising in the ordinary course of its business. The Company was not subject to any material legal proceedings during the three months ended March 31, 2021, and, to the best of its knowledge, no material legal proceedings are currently pending or threatened.\nIndemnification\nThe Company typically enters into indemnification agreements with customers in the ordinary course of business. Pursuant to these agreements, the Company indemnifies and agrees to reimburse the indemnified party for losses suffered or incurred as a result of claims of intellectual property infringement. These indemnification agreements are provisions of the applicable customer agreement. Based on when clients first sign an agreement for the Company’s service, the maximum potential amount of future payments the Company could be required to make under certain of these indemnification agreements is unlimited. Based on historical experience and information known as of March 31, 2021, the Company has not incurred any costs for the above guarantees and indemnities.\nIn certain circumstances, the Company warrants that its services will perform in all material respects in accordance with its standard published specification documentation in effect at the time of delivery of the services to the customer for the term of the agreement. To date, the Company has not incurred significant expense under its warranties and, as a result, the Company believes the estimated fair value of these agreements is immaterial.\n12. Components of Other Income, Net\nThe components of other income, net, are as follows:\n| For the Three Months EndedMarch 31, |\n| 2021 | 2020 |\n| Foreign currency exchange gain (loss) | 44 | ( 107 ) |\n| Other, net | 7 | 163 |\n| Other income, net | $ | 51 | $ | 56 |\n\n13. Employee Benefit Plan\nThe Company maintains a defined contribution savings plan under Section 401(k) of the Internal Revenue Code (the “401(k) Plan”) covering all U.S. employees who satisfy certain eligibility requirements. The 401(k) Plan allows each participant to defer a percentage of their eligible compensation subject to applicable annual limits pursuant to the limits established by the Internal Revenue Service. The Company may, at the discretion of the Board, make contributions in the form of matching contributions or profit-sharing contributions. For the three months ended March 31, 2021 and 2020, the Company made matching contributions of $ 90 and $ 34 , respectively, to the 401(k) Plan.\n14. Segment and Geographic Information\nDisclosure requirements about segments of an enterprise and related information establishes standards for reporting information regarding operating segments in annual financial statements and requires selected information of those segments to be presented in interim financial reports issued to shareholders. Operating segments are defined as components of an enterprise about which separate discrete financial information is available that is evaluated regularly by the chief operating decision maker,\n23\nor decision-making group, in deciding how to allocate resources and in assessing performance. The Company’s chief operating decision maker is the chief executive officer. The Company and the chief executive officer view the Company’s operations and manage its business as one operating segment.\nGeographic Data\nThe Company allocates, for the purpose of geographic data reporting, its revenue based upon the location of the customer. Total revenue by geographic area was as follows:\n| For the Three Months EndedMarch 31, |\n| 2021 | 2020 |\n| Revenue: |\n| United States | $ | 18,132 | $ | 12,886 |\n| United Kingdom | 4,195 | 2,994 |\n| Other | 17,671 | 11,907 |\n| Total revenue | $ | 39,998 | $ | 27,787 |\n\nProperty and equipment, net by geographic location consists of the following:\n| As of |\n| March 31,2021 | December 31,2020 |\n| Property and equipment, net: |\n| United States | $ | 2,020 | $ | 1,023 |\n| Russia | 1,360 | 1,450 |\n| Czech Republic | 440 | 439 |\n| Other | 56 | 56 |\n| Total assets | $ | 3,876 | $ | 2,968 |\n\n15. Subsequent Events\nThe Company has completed an evaluation of all subsequent events after the balance sheet date of March 31, 2021 through the date this Quarterly Report on Form 10-Q was filed with the SEC, to ensure that this filing includes appropriate disclosure of events both recognized in the financial statements as of March 31, 2021, and events which occurred subsequently but were not recognized in the financial statements. The Company has concluded that no subsequent events have occurred that require disclosure, except as disclosed within these financial statements and except as disclosed below.\nExercise of Overallotment Option\nOn April 20, 2021, the underwriters of the Company’s IPO partially exercised their option to purchase additional shares of Class A common stock. In connection with the closing of the partial exercise on April 23, 2021, the underwriters purchased 719,266 shares of the Company’s Class A common stock for net proceeds to the Company of $ 9.4 million.\n24\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nYou should read the following discussion and analysis of our financial condition and results of operations together with the unaudited condensed consolidated financial statements, and related notes that are included elsewhere in this Quarterly Report on Form 10-Q, along with the financial information included in our prospectus dated March 24, 2021 (the “Prospectus”) as filed with the Securities Exchange Commission (the “SEC”) on March 25, 2021 pursuant to Rule 424(b) under the Securities Act of 1933, as amended (the “Securities Act”). Some of the information contained in this discussion and analysis, including information with respect to our planned investments in our research and development, sales and marketing, and general and administrative functions, contains forward-looking statements based upon current plans, beliefs, and expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under the sections titled “Special Note Regarding Forward-Looking Statements” and “Risk Factors” included elsewhere in this Quarterly Report on Form 10-Q.\nSPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS\nThis Quarterly Report on Form 10-Q contains forward-looking statements about Semrush Holdings, Inc. (“Semrush Holdings”) and our subsidiaries (collectively, the “Group”, the “Company”, “Semrush”, “we”, “us”, or “our”) and our industry that involve substantial risks and uncertainties. All statements other than statements of historical facts contained in this Quarterly Report on Form 10-Q, including statements regarding our future results of operations, financial condition, business strategy and plans and objectives of management for future operations, are forward-looking statements. In some cases, you can identify forward-looking statements because they contain words such as “anticipate,” “believe,” “contemplate,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “predict,” “project,” “should,” “target,” “will,” or “would,” or the negative of these words or other similar terms or expressions. Forward-looking statements contained in this Quarterly Report on Form 10-Q include, but are not limited to, statements about:\n•our future financial performance, including our revenue, annual recurring revenue (“ARR”), costs of revenue, gross profit or gross margin and operating expenses;\n•the sufficiency of our cash and cash equivalents to meet our liquidity needs;\n•anticipated trends and growth rates in our business and in the markets in which we operate;\n•our ability to maintain the security and availability of our internal networks and platform;\n•our ability to attract new paying customers and convert free customers into paying customers;\n•our ability to retain and expand sales to our existing paying customers, including upgrades to premium subscriptions, purchases of add-on offerings, and increasing the number of authorized users per paying customer;\n•our ability to access, collect, and analyze data;\n•our ability to successfully expand in our existing markets and into new markets;\n•our ability to effectively manage our growth and future expenses;\n•our ability to continue to innovate and develop new products and features, improve our data assets, and enhance our technological capabilities;\n•our estimated total addressable market;\n25\n•our ability to maintain, protect, and enhance our intellectual property;\n•our ability to comply with modified or new laws and regulations applying to our business;\n•the attraction and retention of qualified employees and key personnel;\n•our anticipated investments in sales and marketing, and research and development;\n•our ability to successfully defend litigation brought against us;\n•our ability to successfully acquire and integrate companies and assets;\n•the increased expenses associated with being a public company;\n•our use of the net proceeds from our initial public offering (“IPO”); and\n•the impact of the novel strain of coronavirus (“COVID-19”) on our business and industry.\nYou should not rely upon forward-looking statements as predictions of future events. We have based the forward-looking statements contained in this Quarterly Report on Form 10-Q primarily on our current expectations and projections about future events and trends that we believe may affect our business, financial condition, results of operations and prospects. The outcome of the events described in these forward-looking statements is subject to risks, uncertainties, and other factors described in the section titled “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q. Moreover, we operate in a very competitive and rapidly changing environment. New risks and uncertainties emerge from time to time, and it is not possible for us to predict all risks and uncertainties that could have an impact on the forward-looking statements contained in this Quarterly Report on Form 10-Q. The results, events, and circumstances reflected in the forward-looking statements may not be achieved or occur, and actual results, events, or circumstances could differ materially from those described in the forward-looking statements.\nThe forward-looking statements made in this Quarterly Report on Form 10-Q relate only to events as of the date on which the statements are made. We undertake no obligation to update any forward-looking statements made in this Quarterly Report on Form 10-Q to reflect events or circumstances after the date of this Quarterly Report on Form 10-Q or to reflect new information or the occurrence of unanticipated events, except as required by law. We may not actually achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. Our forward-looking statements do not reflect the potential impact of any future acquisitions, mergers, dispositions, joint ventures or investments we may make.\nIn addition, statements that “we believe” and similar statements reflect our beliefs and opinions on the relevant subject. These statements are based upon information available to us as of the date of this Quarterly Report on Form 10-Q, and while we believe such information forms a reasonable basis for such statements, such information may be limited or incomplete, and our statements should not be read to indicate that we have conducted an exhaustive inquiry into, or review of, all potentially available relevant information. These statements are inherently uncertain and you are cautioned not to unduly rely upon these statements.\nCompany Overview\nWe are a leading online visibility management software-as-a-service (“SaaS”) platform, enabling companies globally to identify and reach the right audience in the right context and through the right channels. Online visibility represents how effectively companies connect with consumers across a variety of digital channels, including search, social and digital media, digital public relations, and review websites.\n26\nOur proprietary SaaS platform enables us to aggregate and enrich trillions of data points collected from hundreds of millions of unique domains, social media platforms, online ads, and web traffic. This allows our customers to understand trends, derive unique and actionable insights to improve their websites and social media pages, and distribute highly relevant content to their targeted customers across channels to drive high-quality traffic.\nOn March 29, 2021, we completed our IPO in which we issued and sold 10,000,000 shares of our Class A common stock at a public offering price of $14.00 per share for aggregate gross proceeds of $140.0 million. We received approximately $126.6 million in net proceeds after deducting $9.8 million of underwriting discounts and commissions and approximately $3.6 million in offering costs. In connection with the closing of the IPO, all of the outstanding shares of our Preferred Stock and Common Stock automatically converted into 124,905,954 shares of Class B common stock.\nWe generate substantially all of our revenue from monthly and annual subscriptions to our online visibility management platform under a SaaS model. Subscription revenue is recognized ratably over the contract term beginning on the date the product is made available to customers.\nWe have one reportable segment. See Note 14 of our Unaudited Condensed Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q for more information.\nKey Factors Affecting Our Performance\nWe regularly review a number of factors that have impacted, and we believe will continue to impact, our results of operations and growth. These factors include:\nAcquiring New Paying Customers\nWe expect increasing demand for third-party online visibility software to accelerate adoption of our platform. Our recurring subscription model provides significant visibility into our future results and we believe ARR is the best indicator of the scale of our platform, while mitigating fluctuations due to seasonality and contract term. We define ARR as the daily revenue of all paid subscription agreements that are actively generating revenue as of the last day of the reporting period multiplied by 365. We include both monthly recurring paid subscriptions, which renew automatically unless cancelled, as well as the annual recurring paid subscriptions so long as we do not have any indication that a customer has cancelled or intends to cancel its subscription and we continue to generate revenue from them. As of March 31, 2021 and 2020, we had more than 72,000 paying customers and 56,000 paying customers, respectively, accounting for $167.6 million and $109.5 million in ARR, respectively.\nRetaining and Expanding Sales to Our Existing Customers\nWe serve a diverse customer base across a variety of sizes and industries that is focused on maximizing their online visibility. We believe there is a significant opportunity to expand within our existing customer base as customers often initially purchase our entry-level subscription, which offers lower usage limits and limited user licenses, as well as fewer features. We have demonstrated the ability to expand contract values with our existing customers as they use our products and recognize the critical nature of our platform and often seek premium offerings through incremental usage, features, add-ons, and additional user licenses.\nWe have successfully increased ARR per paying customer over time and believe this metric is an indicator of our ability to grow the long-term value of our platform. We expect ARR per paying customer to continue to increase as customers adopt our premium offerings and we continue to introduce new products and functionality. Our ARR per paying customer as of March 31, 2021 and 2020 was $2,274 and $1,942, respectively. We define ARR per paying customer during a given period as ARR from our paying customers at the end of the period divided by the number of paying customers as of the end of the same\n27\nperiod. We define the number of paying customers as the number of unique business and individual customers at the end of a particular period. We define a business customer as all accounts that contain a common non-individual business email domain (e.g., all subscriptions with an email domain of @XYZ.com will be considered to be one customer), and an individual customer as an account that uses an individual non-business email domain.\nSustaining Product and Technology Innovation\nWe have a strong track record of developing new products that have high adoption rates among our paying customers. Our product development organization plays a critical role in continuing to enhance the effectiveness and differentiation of our technology in an evolving landscape and maximizing retention of our existing customers. We intend to continue investing in product development to improve our data assets, expand our products and enhance our technological capabilities.\nNon-GAAP Financial Measures\nIn addition to our financial results determined in accordance with U.S. generally accepted accounting principles (“GAAP”), we believe that free cash flow and free cash flow margin, each a non-GAAP financial measure, are useful in evaluating the performance of our business.\nFree cash flow and free cash flow margin\nWe define free cash flow, a non-GAAP financial measure, as net cash provided by operating activities less purchases of property and equipment and capitalized software development costs. We define free cash flow margin as free cash flow divided by total revenue. We monitor free cash flow and free cash flow margin as two measures of our overall business performance, which enables us to analyze our future performance without the effects of non-cash items and allow us to better understand the cash needs of our business. While we believe that free cash flow and free cash flow margin are useful in evaluating our business, free cash flow and free cash flow margin are each a non-GAAP financial measure that have limitations as an analytical tool, and free cash flow and free cash flow margin should not be considered as an alternative to, or substitute for, net cash used in operating activities in accordance with GAAP. The utility of each of free cash flow and free cash flow margin as a measure of our liquidity is further limited as each measure does not represent the total increase or decrease in our cash balance for any given period. In addition, other companies, including companies in our industry, may calculate free cash flow and free cash flow margin differently or not at all, which reduces the usefulness of free cash flow and free cash flow margin as tool for comparison. A summary of our cash flows from operating, investing and financing activities is provided below. We recommend that you review the reconciliation of free cash flow to net cash used in operating activities, the most directly comparable GAAP financial measure, and the reconciliation of free cash flow margin to net cash used in operating activities (as a percentage of revenue), the most directly comparable GAAP financial measure, provided below, and that you not rely on free cash flow, free cash flow margin or any single financial measure to evaluate our business.\n| Three Months Ended March 31,(in thousands) |\n| 2021 | 2020 |\n| Net cash provided by operating activities | $ | 9,007 | $ | 561 |\n| Net cash used in investing activities | (1,139) | (1,381) |\n| Net cash provided by (used in) financing activities | 128,468 | (16) |\n| Net increase (decrease) in cash, cash equivalents and restricted cash | $ | 136,336 | (836) |\n\n28\n| Three Months Ended March 31,(in thousands) |\n| 2021 | 2020 |\n| Net cash provided by operating activities | $ | 9,007 | $ | 561 |\n| Purchases of property and equipment | (166) | (1,084) |\n| Capitalization of internal-use software costs | (123) | (297) |\n| Free cash flow | $ | 8,718 | $ | (820) |\n\n| Three Months Ended March 31,(in thousands) |\n| 2021 | 2020 |\n| Net cash provided by operating activities (as a percentage of revenue) | 22.5 | % | 2.0 | % |\n| Purchases of property and equipment (as a percentage of revenue) | (0.4) | % | (3.9) | % |\n| Capitalization of internal-use software costs (as a percentage of revenue) | (0.3) | % | (1.1) | % |\n| Free cash flow margin | 21.8 | % | (3.0) | % |\n\nComponents of our Results of Operations\nRevenue\nWe generate nearly all of our revenue from subscriptions to our online visibility management platform under a SaaS model. Subscription revenue is recognized ratably over the contract term beginning on the date on which we provide the customer access to our platform. Our customers do not have the right to take possession of our software. Our subscriptions are generally non-cancellable during the contractual subscription term, however our subscription contracts contain a right to a refund if requested within seven days of purchase.\nWe offer our paid products to customers via monthly or annual subscription plans, as well as one-time and ongoing add-ons. As of March 31, 2021 and 2020, approximately 77% and 76%, respectively, of our paying customers purchased monthly subscription plans. Our subscription-based model enables customers to select a plan based on their needs and license our platform on a per user per month basis.\nAs of March 31, 2021, we served approximately 72,000 paying customers in various industries, and our revenue is not concentrated with any single customer or industry. For the three months ended March 31, 2021 and 2020, no single customer accounted for more than 1% of our revenue.\nCost of Revenue\nCost of revenue primarily consists of expenses related to hosting our platform, acquiring data, and providing support to our customers. These expenses are comprised of personnel and related costs, including salaries, benefits, incentive compensation, and stock-based compensation expense related to the management of our data centers, our customer support team and our customer success team, and data acquisition costs. In addition to these expenses, we incur third-party service provider costs, such as data center and networking expenses, allocated overhead costs, depreciation expense and amortization associated with the Company’s property and equipment, and amortization of capitalized software development costs and other intangible assets. We allocate overhead costs, such as rent and facility costs, information technology costs, and employee benefit costs to all departments based on headcount. As such, general overhead expenses are reflected in cost of revenue and each operating expense category.\n29\nWe expect our cost of revenue to increase in absolute dollars due to expenditures related to the purchase of hardware, data, expansion, and support of our data center operations and customer support teams. We also expect that cost of revenue as a percentage of revenue will decrease over time as we are able to achieve economies of scale in our business, although it may fluctuate from period to period depending on the timing of significant expenditures. To the extent that our customer base grows, we intend to continue to invest additional resources in expanding the delivery capability of our products and other services. The timing of these additional expenses could affect our cost of revenue, both in terms of absolute dollars and as a percentage of revenue in any particular quarterly or annual period.\nOperating Expenses\nResearch and Development\nResearch and development expenses primarily consist of personnel and related costs, including salaries, benefits, incentive compensation, stock-based compensation, and allocated overhead costs. Research and development expenses also include depreciation expense and other expenses associated with product development. Other than internal-use software costs that qualify for capitalization, research and development costs are expensed as incurred. We plan to increase the dollar amount of our investment in research and development for the foreseeable future as we focus on developing new products, features, and enhancements to our platform. We believe that investing in the development of new products, features, and enhancements improves customer experience, makes our platform more attractive to new paying customers and provides us with opportunities to expand sales to existing paying customers and convert free customers to paying customers. However, we expect our research and development expenses to decrease as a percentage of our revenue over time.\nSales and Marketing\nSales and marketing expenses primarily consist of personnel and related costs directly associated with our sales and marketing department, including salaries, benefits, incentive compensation, and stock-based compensation, online advertising expenses, and marketing and promotional expenses, as well as allocated overhead costs. We expense all costs as they are incurred, excluding sales commissions identified as incremental costs to obtain a contract, which are capitalized and amortized on a straight-line basis over the average period of benefit, which we estimate to be two years. We expect that our sales and marketing expenses will continue to increase in absolute dollars in the year ending December 31, 2021. New sales personnel require training and may take several months or more to achieve productivity; as such, the costs we incur in connection with the hiring of new sales personnel in a given period are not typically offset by increased revenue in that period and may not result in new revenue if these sales personnel fail to become productive. We expect to increase our investment in sales and marketing as we add new services, which will increase these expenses in absolute dollars. Over the long term, we believe that sales and marketing expenses as a percentage of revenue will vary depending upon the mix of revenue from new and existing customers, as well as changes in the productivity of our sales and marketing programs.\nGeneral and Administrative\nGeneral and administrative expenses primarily consist of personnel and related expenses, including salaries, benefits, incentive compensation, and stock-based compensation, associated with our finance, legal, human resources, and other administrative employees. Our general and administrative expenses also include professional fees for external legal, accounting, and other consulting services, insurance, depreciation and amortization expense, as well as allocated overhead. We expect to increase the size of our general and administrative functions to support the growth of our business. We expect to continue to incur additional expenses as a result of operating as a public company, including costs to comply with rules and regulations applicable to companies listed on a U.S. securities exchange, costs related to compliance and reporting obligations pursuant to the rules and regulations of the SEC, increases in\n30\ninsurance premiums, investor relations and professional services. We expect the dollar amount of our general and administrative expenses to increase for the foreseeable future. However, we expect our general and administrative expenses to decrease as a percentage of revenue over time.\nOther Income, Net\nIncluded in other income, net are foreign currency transaction gains and losses. The functional currency of our international operations is the U.S. dollar except for Prowly, which is Polish Zloty. Any differences resulting from the re-measurement of assets and liabilities denominated in a currency other than the functional currency are recorded within other income, net. We expect our foreign currency exchange gains and losses to continue to fluctuate in the future as foreign currency exchange rates change.\nOther income, net also includes amounts for other miscellaneous income and expense unrelated to our core operations.\nIncome Tax Provision\nWe operate in several tax jurisdictions and are subject to taxes in each country or jurisdiction in which we conduct business. We account for income taxes in accordance with the asset and liability method. Under this method, deferred tax assets and liabilities are recognized based on temporary differences between the financial reporting and income tax bases of assets and liabilities using statutory rates. In addition, this method requires a valuation allowance against net deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. To date, we have incurred cumulative net losses and maintain a full valuation allowance on our net deferred tax assets. We expect this trend to continue for the foreseeable future. Our tax expense for the three months ended March 31, 2021 and 2020 primarily relates to income earned in certain foreign jurisdictions.\nResults of Operations\nThe following tables set forth information comparing our results of operations in dollars and as a percentage of total revenue for the periods presented. The period-to-period comparison of results is not necessarily indicative of results for future periods.\n31\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (in thousands) |\n| Revenue | $ | 39,998 | $ | 27,787 |\n| Cost of revenue (1) | 8,773 | 6,611 |\n| Gross profit | 31,225 | 21,176 |\n| Operating expenses |\n| Sales and marketing (1) | 16,457 | 12,877 |\n| Research and development (1) | 5,358 | 4,237 |\n| General and administrative (1) | 7,904 | 5,933 |\n| Total operating expenses | 29,719 | 23,047 |\n| Income (loss) from operations | 1,506 | (1,871) |\n| Other income, net | 51 | 56 |\n| Income (loss) before income taxes | 1,557 | (1,815) |\n| Provision for income taxes | 86 | 116 |\n| Net income (loss) | $ | 1,471 | $ | (1,931) |\n\n__________________\n(1)Includes stock-based compensation expense as follows:\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (in thousands) |\n| Cost of revenue | $ | 7 | $ | 5 |\n| Sales and marketing | 190 | 27 |\n| Research and development | 67 | 29 |\n| General and administrative | 329 | 144 |\n| Total stock-based compensation | $ | 593 | $ | 205 |\n\n32\nThe following table sets forth our unaudited condensed consolidated statements of operations data expressed as a percentage of revenue for the periods indicated:\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (as a percentage of total revenue) |\n| Revenue | 100 | % | 100 | % |\n| Cost of revenue | 22 | % | 24 | % |\n| Gross profit | 78 | % | 76 | % |\n| Operating expenses |\n| Sales and marketing | 41 | % | 46 | % |\n| Research and development | 13 | % | 15 | % |\n| General and administrative | 20 | % | 22 | % |\n| Total operating expenses | 74 | % | 83 | % |\n| Income (loss) from operations | 4 | % | (6) | % |\n| Other income, net | — | % | — | % |\n| Income (loss) before income taxes | 4 | % | (6) | % |\n| Provision for income taxes | — | % | — | % |\n| Net income (loss) | 4 | % | (6) | % |\n\nComparison of the Three Months Ended March 31, 2021 and 2020\nRevenue\nOur revenue during the three months ended March 31, 2021 and 2020 was as follows:\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Revenue | $ | 39,998 | 27,787 | $ | 12,211 | 44 | % |\n\nRevenue increased in all regions and was most pronounced in the United States. The majority of this increase was driven by an increase in the number of paying customers from 56,000 as of March 31, 2020 to 72,000 as of March 31, 2021. The net income for the three months ended March 31, 2021 was partially driven by an increase in the subscription price of our core product.\n33\nThe locations of our paying customers during the three months ended March 31, 2021 and 2020 were as follows:\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (in thousands) |\n| Revenue: |\n| United States | $ | 18,132 | $ | 12,886 |\n| United Kingdom | 4,195 | 2,994 |\n| Other | 17,671 | 11,907 |\n| Total revenue | $ | 39,998 | $ | 27,787 |\n\nCost of Revenue, Gross Profit and Gross Margin\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Cost of revenue | $ | 8,773 | $ | 6,611 | $ | 2,162 | 33 | % |\n| Gross profit | $ | 31,225 | $ | 21,176 | $ | 10,049 | 47 | % |\n| Gross margin | 78.1 | % | 76.2 | % |\n\nThe increase in cost of revenue for the three months ended March 31, 2021 compared to the three months ended March 31, 2020 was primarily due to the following changes:\n| Change |\n| (in thousands) |\n| Hosting fees | $ | 446 |\n| Integration and data costs | 787 |\n| Merchant fees | 309 |\n| Other | 620 |\n| Cost of revenue | $ | 2,162 |\n\nHosting fees increased, driven by the additional costs associated with our growth in subscription revenue and the additional costs associated with expanding our relationships with our current paying subscribers. Integration and data costs increased primarily as a result of increasing costs incurred related to new products and customer growth. Merchant fees increased commensurate with sales growth. Other costs increased primarily as a result of a 95% increase in headcount as we continue to grow our customer support and customer success teams to support our customer growth.\n34\nOperating Expenses\nSales and Marketing\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Sales and marketing | $ | 16,457 | $ | 12,877 | $ | 3,580 | 28 | % |\n| Percentage of total revenue | 41 | % | 46 | % |\n\nThe increase in sales and marketing expense for the three months ended March 31, 2021 compared to the three months ended March 31, 2020 was primarily due to the following:\n| Change |\n| (in thousands) |\n| Personnel costs | $ | 2,156 |\n| Advertising expense | 1,503 |\n| Other | (79) |\n| Sales and marketing | $ | 3,580 |\n\nPersonnel costs increased primarily as a result of a 24% increase in headcount as we continue to expand our sales teams to grow our customer base. Personnel costs include the amortization of capitalized commission costs, which increased quarter over quarter partially due to the amortization of commissions paid in prior periods, as well as expense associated with the amortization of commissions paid and capitalized during the three months ended March 31, 2021, which increased compared to the three months ended March 31, 2020 due to the overall growth in sales. Advertising expense increased primarily as a result of increasing expenses to acquire new paying customers.\nResearch and Development\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Research and development | $ | 5,358 | $ | 4,237 | $ | 1,121 | 26 | % |\n| Percentage of total revenue | 13 | % | 15 | % |\n\nResearch and development costs increased primarily as a result of a 31% increase in headcount as we continue to expand our product development teams.\nGeneral and administrative\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| General and administrative | $ | 7,904 | $ | 5,933 | $ | 1,971 | 33 | % |\n| Percentage of total revenue | 20 | % | 21 | % |\n\n35\nThe increase in general and administrative expense was primarily driven by a 47% increase in headcount as we continue to expand our accounting and reporting, legal and compliance, and internal support teams. It was also driven by a 167% increase in stock-based compensation applicable to these teams.\nOther Income, Net\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Other income, net | $ | 51 | $ | 56 | $ | (5) | (9) | % |\n| Percentage of total revenue | — | % | — | % |\n\nThe relatively small decrease in other income was partially driven by changes in the foreign exchange gains or losses from foreign currency translation adjustments associated with our international activities.\nProvision for Income Taxes\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Provision for income taxes | $ | 86 | $ | 116 | $ | (30) | (26) | % |\n| Percentage of total revenue | — | % | — | % |\n\nThe provision for income taxes is primarily attributable to estimated taxes related to our foreign jurisdictions.\nLiquidity and Capital Resources\nTo date, our principal sources of liquidity have been the net proceeds of $126.6 million, after deducting underwriting discounts and offering expenses paid or payable by us, from our IPO in March 2021, the net proceeds we received through private sales of equity securities, as well as sales of premium subscriptions to our platform.\nAs of March 31, 2021, our principal sources of liquidity were cash and cash equivalents of $171.9 million and accounts receivable of $2.4 million. With the exception of this three month period ended March 31, 2021, we have generated losses from operations since inception. With the exception of this three month period ended March 31, 2021, we expect to continue to incur operating losses and negative cash flows for the foreseeable future due to the investments in our business we intend to make as described above.\nOur principal uses of cash in recent periods have been to fund operations and invest in capital expenditures, and are held in cash deposits and money market funds.\nWe believe our existing cash will be sufficient to meet our operating and capital needs for at least the next 12 months. Our future capital requirements will depend on many factors, including our subscription growth rate, subscription renewal activity, billing frequency, the timing and extent of spending to support our research and development efforts, the expansion of sales and marketing activities, the introduction of new and enhanced product offerings, and the continuing market acceptance of our platform and products. In the future, we may enter into arrangements to acquire or invest in complementary companies,\n36\nproducts, and technologies, including intellectual property rights. We may be required to seek additional equity or debt financing. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us, or at all. If we are unable to raise additional capital or generate cash flows necessary to expand our operations, our business, results of operations, and financial condition could be adversely affected.\nOur Credit Facility\nPursuant to the Credit Agreement among us and Semrush Inc., a Delaware corporation (“Semrush US Sub”), each as a borrower, the lenders party thereto from time to time and JPMorgan Chase Bank, N.A., as the administrative agent, as amended from time to time, we have a senior secured credit facility that consists of a $45.0 million revolving credit facility and a letter of credit sub-facility with an aggregate limit equal to the lesser of $5.0 million and the aggregate unused amount of the revolving commitments then in effect. The availability of the credit facility is subject to the borrowing base based on an advance rate of 400% multiplied by annualized retention applied to monthly recurring revenue. The credit facility has a maturity of three years and will mature on January 12, 2024.\nBorrowings under our credit facility bear interest at our option at (i) LIBOR, subject to a 0.50% floor, plus a margin, or (ii) the alternate base rate, subject to a 3.25% floor (or 1.50% prior to positive consolidated adjusted earnings before interest, taxes, depreciation, and amortization (“adjusted EBITDA”) for the twelve months most recently ended), plus a margin. For LIBOR borrowings, the applicable rate margin is 2.75% (or 3.50% prior to positive consolidated adjusted EBITDA as of the twelve months most recently ended). For base rate borrowings, the applicable margin is 0.00% (or 2.50% prior to positive consolidated adjusted EBITDA as of the twelve months most recently ended). We are also required to pay a 0.25% per annum fee on undrawn amounts under our revolving credit facility, payable quarterly in arrears.\nOperating Activities\nOur largest source of operating cash is cash collections from our customers for subscription services. Our primary uses of cash from operating activities are for online advertising, personnel costs across the sales and marketing and product and development departments, and hosting costs.\nNet cash provided by operating activities during the three months ended March 31, 2021 was $9.0 million, which resulted from a net income of $1.5 million adjusted for non-cash charges of $2.3 million and a net cash inflow of $5.2 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of $0.5 million of depreciation and amortization expense, $1.3 million for amortization of deferred contract acquisition costs related to capitalized commissions, and $0.6 million of stock-based compensation expense. The changes in operating assets and liabilities was primarily the result of a $5.6 million increase in deferred revenue due to the addition of new customers and expansion of the business, a $2.4 million increase in accrued expenses, and a $1.6 million increase in accounts payable. These inflows were partially offset by a $2.4 million increase in deferred contract costs, a $1.0 million increase in prepaid expenses and other current assets, and a $1.0 million increase in accounts receivable.\nNet cash provided by operating activities during the three months ended March 31, 2020 was $0.6 million, which resulted from a net loss of $1.9 million adjusted for non-cash charges of $1.5 million and net cash inflow of $1.0 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of $1.1 million for amortization of deferred contract acquisition costs related to capitalized commissions, $0.2 million of stock-based compensation expense, and $0.2 million of depreciation and amortization expense. The changes in operating assets and liabilities was primarily the result of a $1.7 million increase in deferred revenue due to the addition of new customers and expansion of the business, a $1.0 million increase in accrued expenses, a $0.7 million decrease in accounts receivable, and a $0.1 million increase in accounts payable. These inflows were partially offset by\n37\na $1.7 million increase in deferred contract costs and a $0.7 million increase in prepaid expenses and other current assets.\nInvesting Activities\nNet cash used in investing activities for the three months ended March 31, 2021 and 2020 was $1.1 million and $1.4 million, respectively. The decrease of $0.2 million of cash used in investing activities was primarily due to the reduced purchases of computer equipment and hardware, as well as a decrease in capitalized costs associated with internal use software. During the three months ended March 31, 2021, cash used in investing activities also included $500 paid for two convertible debt securities.\nFinancing Activities\nNet cash provided by financing activities for the three months ended March 31, 2021 was $128.5 million, primarily consisting of the net proceeds from the IPO. Net cash used in financing activities for the three months ended March 31, 2020 was insignificant and consisted entirely of payments of deferred offering costs.\nContractual Obligations\nAs of March 31, 2021, there were no material changes in our contractual obligations and commitments from those disclosed in the Prospectus, other than those appearing in the notes to the Unaudited Condensed Consolidated Financial Statements appearing elsewhere in this Quarterly Report on Form 10-Q.\nOff-Balance Sheet Arrangements\nAs of March 31, 2021, we did not have any relationships with any entities or financial partnerships, such as structured finance or special purpose entities, that would have been established for the purpose of facilitating off-balance sheet arrangements or other purposes. As a result, we are not exposed to related financing, liquidity, market or credit risks that could arise if we had engaged in those types of arrangements.\nRecent Accounting Pronouncements\nRefer to the section titled “Recent Accounting Pronouncements” in Note 2 of the notes to our Unaudited Condensed Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q for more information.\nCritical Accounting Policies and Estimates\nOur Unaudited Condensed Consolidated Financial Statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these Unaudited Condensed Consolidated Financial Statements in conformity with GAAP requires management to make estimates, judgments, and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may differ from these estimates.\nOur critical accounting policies are described under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations— Critical Accounting Policies and Estimates” in the Prospectus and in Note 2 of the notes to our Unaudited Condensed Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q.\n38\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\nWe are exposed to market risk in the ordinary course of our business. Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in foreign currency exchange rates, interest rates and inflation. We do not hold or issue financial instruments for trading purposes.\nInterest Rate Risk\nWe had cash and cash equivalents of $171.9 million and $35.5 million as of March 31, 2021 and December 31, 2020, respectively. Our cash and cash equivalents are held in cash deposits and money market funds. Due to the short-term nature of these instruments, we do not believe that we have any material exposure to changes in the fair value of our investment portfolio as a result of changes in interest rates.\nAs of March 31, 2021, we had $45.0 million available under the revolving credit facility, with $5.0 million of such revolving commitments available under the letter of credit sub-facility. Borrowings under our credit facility bear interest at our option at (i) LIBOR, subject to a 0.50% floor, plus a margin, or (ii) the base rate, subject to a 3.25% floor (or 1.50% prior to an IPO or positive consolidated adjusted EBITDA as of the twelve months most recently ended), plus a margin. For LIBOR borrowings, the applicable rate margin is 2.75% (or 3.50% prior to an IPO or positive consolidated adjusted EBITDA as of the twelve months most recently ended). For base rate borrowings, the applicable margin is 0.00% (or 2.50% prior to an IPO or positive consolidated adjusted EBITDA as of the twelve months most recently ended). We are also required to pay a 0.25% per annum fee on undrawn amounts under our revolving credit facility, payable quarterly in arrears.\nWe did not have any current investments in marketable securities as of March 31, 2021 and 2020.\nForeign Currency Exchange Risk\nWe are not currently subject to significant foreign currency exchange risk with respect to revenue as our U.S. and international sales are predominantly denominated in U.S. dollars. However, we have some foreign currency risk related to a small amount of sales denominated in euros, and expenses denominated in euros, rubles, korunas, and zloty. Sales denominated in euros reflect the prevailing U.S. dollar exchange rate on the date of invoice for such sales. Increases in the relative value of the U.S. dollar to the euro may negatively affect revenue and other operating results as expressed in U.S. dollars. We incur significant expenses outside the United States denominated in these foreign currencies, primarily the ruble. If the average exchange rates of any of these foreign currencies strengthen against the dollar, the dollar value of our expenses outside the United States will increase. For example, an immediate 10% decrease or increase in the relative value of the U.S. dollar to the ruble would result in a $3.4 million loss or gain on our unaudited condensed consolidated statements of operations and cash flows.\nWe have not engaged in the hedging of foreign currency transactions to date. However, as our international operations expand, our foreign currency exchange risk may increase. If our foreign currency exchange risk increases in the future, we may evaluate the costs and benefits of initiating a foreign currency hedge program in connection with non-U.S. dollar denominated transactions.\n39\nItem 4. Controls and Procedures\nEvaluation of Disclosure Controls and Procedures\nOur management, including our Chief Executive Officer and Chief Financial Officer, have evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on management’s review, with participation of our Chief Executive Officer and Chief Financial Officer, the Chief Executive Officer and Chief Financial Officer have concluded that, as of the quarter ended March 31, 2021, the Company’s disclosure controls and procedures were not effective.\nAs previously disclosed under the section titled “Risk Factors” of the Prospectus, in connection with the audit of our consolidated financial statements for the year ended December 31, 2019, we and our independent registered public accounting firm identified a material weakness in our internal control over financial reporting related to deficiencies in our controls over the financial statement close process. Specifically, there were deficiencies in the design and operation of internal controls over the identification and review of complex accounting issues involving significant judgment or estimates with respect to certain prior period transactions.\nNotwithstanding the identified material weakness, our management believes the Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q fairly present, in all material respects, our financial condition, results of operations and cash flows as of and for the periods presented in accordance with U.S. generally accepted accounting principles.\nRemediation Plan for Material Weakness\nRemediation generally requires making changes to how controls are designed and implemented and then adhering to those changes for a sufficient period of time such that the effectiveness of those changes is demonstrated with an appropriate amount of consistency. In response to the material weakness, we implemented, and are continuing to implement, measures designed to improve our internal control over financial reporting. These measures include formalizing our processes and internal control documentation, strengthening supervisory reviews by our financial management, hiring additional qualified accounting and finance personnel, and engaging financial consultants to enable the implementation of internal control over financial reporting. Further, changes and improvements in our internal control over financial reporting environment will be implemented based on ongoing management reviews and the continued implementation of the remediation plan.\nChanges in Internal Control Over Financial Reporting\nExcept for the remediation measures in connection with the material weakness described above, there were no other changes to our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended March 31, 2021, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\nInherent Limitations on Effectiveness of Controls\nOur management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitation in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of\n40\nfraud, if any, within our company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the controls. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with policies or procedures may deteriorate. Due to inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.\n41\nPART II — OTHER INFORMATION\nItem 1. Legal Proceedings\nFrom time to time we may become in involved in legal proceedings or be subject to claims arising in the ordinary course of our business. We are not presently a party to any legal proceedings that, if determined adversely to us, would individually or taken together have a material adverse effect on our business, operating results, financial condition or cash flows. Regardless of the outcome, litigation can have an adverse impact on us because of defense and settlement costs, diversion of management resources and other factors.\nItem 1A. Risk Factors\nInvesting in our Class A common stock involves a high degree of risk. You should carefully consider the risks and uncertainties described below, together with all of the other information in this Quarterly Report on Form 10-Q, before making a decision to invest in our Class A common stock. If any of the risks actually occur, our business, results of operations, financial condition, and prospects could be harmed. In that event, the trading price of our Class A common stock could decline, and you could lose part or all of your investment.\nSummary of the Material Risks Associated with Our Business\nOur business is subject to numerous risks and uncertainties that you should be aware of in evaluating our business. These risks and uncertainties include, but are not limited to, the following:\n• We derive, and expect to continue to derive, substantially all of our revenue and cash flows from our paying customers with premium subscriptions, and our business and operating results will be harmed if our paying customers do not renew their premium subscriptions.\n• Our business and operating results will be harmed if our paying customers do not upgrade their premium subscriptions or if they fail to purchase additional products.\n• If we fail to attract new potential customers through unpaid and paid marketing efforts, register them for trials, and convert them into paying customers, our operating results would be harmed.\n• The market in which we operate is intensely competitive, and if we do not compete effectively, our ability to attract and retain free and paying customers could be harmed, which would negatively impact our business and operating results.\n• Our products depend on publicly available and paid third-party data sources, and, if we lose access to data provided by such data sources or the terms and conditions on which we obtain such access become less favorable, our business could suffer.\n• Our ability to introduce new products and add-ons is dependent on adequate research and development resources. If we do not adequately fund our research and development efforts or use product and development teams effectively, our business and operating results may be harmed.\n• If we are unable to maintain and enhance our brand, or if events occur that damage our reputation and brand, our ability to maintain and expand our customer base may be impaired, and our business and financial results may be harmed.\n42\n• We depend on our executive officers and other key employees, and the loss of one or more of these employees could harm our business.\n• An inability to attract and retain other highly skilled employees could harm our business.\n• Changes by search engines, social networking sites, and other third-party services to their underlying technology configurations or policies regarding the use of their platforms and/or technologies for commercial purposes, including anti-spam policies, may limit the efficacy of certain of our products, tools, and add-ons and as a result, our business may suffer.\n• If the security of the confidential information or personal information of any customers of our platform is breached or otherwise subjected to unauthorized access or disclosure, our reputation may be harmed and we may be exposed to liability.\n• The effects of the COVID-19 pandemic are uncertain and may materially affect our customers or potential customers and how we operate our business, and the duration and extent to which the pandemic continues to threaten our future operating results remains uncertain.\n• If the use of cookies or other tracking technologies becomes subject to unfavorable legislation or regulation, is restricted by internet users or other third parties or is blocked or limited by users or by technical changes on end users’ devices, our ability to attract new customers and to develop and provide certain products could be diminished or eliminated.\n• We may not be able to adequately protect our proprietary and intellectual property rights in our data or technology.\nMost Material Risks to Us\nWe derive, and expect to continue to derive, substantially all of our revenue and cash flows from our paying customers with premium subscriptions, and our business and operating results will be harmed if our paying customers do not renew their premium subscriptions.\nWe derive, and expect to continue to derive, substantially all of our revenue and cash flows from our paying customers with premium subscriptions. Our business and financial results depend on our paying customers renewing their subscriptions for our products when existing contract terms expire. Although our customer agreements provide for auto-renewal of subscriptions, our paying customers have no obligation to renew their premium subscriptions if they provide proper notice of their desire not to renew, and we cannot guarantee that they will renew their premium subscriptions for the same or longer terms, the same or a greater number of user licenses or products and add-ons, or at all. We offer premium subscriptions on a monthly or annual basis with our annual subscriptions receiving a discount for the longer-term commitment. Our paying customers predominantly choose monthly subscription terms, which allow them to terminate or adjust their premium subscriptions with us on a monthly basis as external factors change and could cause our results of operations to fluctuate significantly from quarter to quarter. Our renewal rates, including our dollar-based net revenue retention rate, may decline or fluctuate as a result of a number of factors, including customer satisfaction with our platform and products, reliability of our products, our customer success and support experience, the price and functionality of our platform, products, and add-ons relative to those of our competitors, mergers and acquisitions affecting our customer base, the effects of global economic conditions and other external factors, or reductions in our customers’ spending levels. Our business and operating results will be adversely affected if our paying customers do not renew their premium subscriptions.\n43\nOur business and operating results will be harmed if our paying customers do not upgrade their premium subscriptions or if they fail to purchase additional products.\nOur future financial performance also depends in part on our ability to continue to upgrade paying customers to higher-price point subscriptions and sell additional user licenses, and products and add-ons such as Prowly, Sellerly, and Competitive Intelligence. Conversely, our paying customers may convert to lower-cost or free subscriptions if they do not perceive value in paying for our higher-price point subscriptions, thereby impacting our ability to increase revenue. For example, a paying customer subscribing to our core product through a “Business” subscription may downgrade to the “Guru” subscription if they do not deem the additional features and functionality worth the incremental costs. To expand our relationships with our customers, we must demonstrate to existing paying and free customers that the additional functionality associated with an upgraded subscription outweighs the incremental costs. Our customers’ decisions as to whether to upgrade their subscriptions or not is driven by a number of factors, including customer satisfaction with the security, performance, and reliability of our platform and products, general economic conditions, the price and functionality of our platform and products relative to those of our competitors, and customer reaction to the price for additional products. If our efforts to expand our relationships with our existing paying and free customers are not successful, our revenue growth rate may decline and our business and operating results will be adversely affected.\nIf we fail to attract new potential customers through unpaid and paid marketing efforts, register them for trials, and convert them into paying customers, our operating results would be harmed.\nThe number of new customers we attract, whether as free or paying customers, is a key factor in growing our customer and premium subscription base which drive our revenues and collections. We utilize various unpaid content marketing strategies, including blogs, webinars, thought leadership, and social media engagement, as well as paid advertising, to attract visitors to our websites. We cannot guarantee that these unpaid or paid marketing efforts will continue to attract the same volume and quality of traffic to our websites or will continue to result in the same level of registrations for premium subscriptions as they have in the past. In the future, we may be required to increase our marketing spend to maintain the same volume and quality of traffic. Moreover, we cannot be certain that increased sales and marketing spend will generate more paying customers without increasing our customer acquisition costs on a per paying customer basis. We offer potential customers several tiered subscription options for our online visibility management platform, including free subscriptions of a limited-functionality product and premium subscriptions of our “Pro”, “Guru” or “Business” offerings for our core product, depending on the level of functionality they seek. We have materially grown our number of paying customers through the provision of free subscriptions and through trials of a premium version of our online visibility and marketing insight products. Trial subscriptions automatically become premium subscriptions if the customer does not opt out of the trial subscription after the trial period is over, and such trial subscriptions can be upgraded to obtain additional features, functionality, and varying levels of access and report generating capabilities. In the future, we may be required to provide additional functionality to our free subscriptions to attract visitors to our websites and incent visitors to sign up for free subscriptions. In addition, we encourage our free customers to upgrade to premium subscriptions through in-product prompts and notifications, by recommending additional features and functionality, and by providing customer support to explain such additional features and functionality. Our failure to attract new free customers and convert them into paying customers could have a material adverse effect on our operating results as our business may be adversely affected by the costs of, and sales lost from, making certain of our products available on a free basis. While we do not receive any revenue from our customers who use our platform on a free basis, we bear incremental expenses as a result of their continuing free access to our platform and certain of our products.\n44\nThe market in which we operate is intensely competitive, and if we do not compete effectively, our ability to attract and retain free and paying customers could be harmed, which would negatively impact our business and operating results.\nThe market for our products is fragmented, rapidly evolving, and highly competitive, with relatively low barriers to entry. Our all-in-one SaaS platform competes with software products and solutions that are focused on a particular customer need, or point solutions. For example, we compete with point solutions for search advertising and search engine optimization, marketing analytics and social media management, market intelligence, and web analytics services. Our ability to attract and retain free and paying customers depends in part on the actual and perceived quality and design of our platform, products, and add-ons compared to competitive point solutions and continued market acceptance of our platform, products, and add-ons for existing and new use-cases. To remain competitive and to acquire new customers, we must deliver features and functionality that enhance the utility and perceived value of our platform, products, and add-ons to our prospective and existing customers. Our platform, products, and add-ons must (i) operate without the presence of material software defects, whether actual or perceived, (ii) maintain deep and rich data sources, (iii) adapt to the changing needs of our current and prospective customers including by developing new technology, (iv) adapt to changing functionality and provide interoperability with third-party application programming interfaces (“APIs”), (v) maintain and develop integrations with complementary third-party services that provide value to our customers, (vi) be easy to use and visually pleasing, (vii) deliver rapid return on investment to our customers across multiple functions within their organizations, and (viii) be delivered with a superior customer support experience. We may not be successful in delivering on some or all of the foregoing or in doing so while maintaining competitive pricing, which could result in customer dissatisfaction leading to termination or downgrades of premium subscriptions, fewer new free customers, fewer subscription upgrades or lower dollar-based net revenue retention rates, prospective customers’ selection of our competitors’ products over our own, and other adverse effects on our business.\nMany of our current and future competitors benefit from competitive advantages over us, such as greater name recognition, longer operating histories, more targeted products for specific use cases, larger sales and more established relationships or integrations with third-party data providers, search engines, online retail platforms, and social media networking sites, and more established relationships with customers in the market. Additionally, many of our competitors may expend a considerably greater amount of funds on their research and development efforts, and those that do not, may be acquired by larger companies that would allocate greater resources to our competitors’ research and development programs. Specifically, our competitors focusing on point solutions may have the ability to expend greater funds in a more targeted manner to develop superior solutions that address a specific need, as compared to our research and development expenditures which are allocated across our platform. In addition, some of our competitors may enter into strategic relationships or consummate strategic acquisitions to offer a broader range of functionality than we do, a more competitive multi-point solution, or to address needs that our platform does not. These types of business combinations may make it more difficult for us to acquire new free customers or maintain or upgrade our free and paying customers, any of which could ultimately impact our ability to compete effectively. We expect these competitive pressures to continue as competitors attempt to strengthen or preserve their market positions and as new competitors enter the market.\nDemand for our platform is also price sensitive. Many factors, including our marketing, sales and technology costs, and the pricing and marketing strategies of our competitors, can significantly affect our pricing strategies. Certain competitors offer, or may in the future offer, lower-priced or free products that compete with our platform, products, and/or add-ons, or may bundle their solutions with other companies’ offerings to provide a broader range of functionality at reduced volume pricing. Similarly, certain competitors may use marketing strategies that enable them to acquire customers at a lower cost than we do. Even if such competitive products do not include all the features and functionality that our platform provides, we could face pricing pressure to the extent that customers find such alternative products to be sufficient to meet their needs or do not perceive a material return on investment from the additional\n45\nfeatures and functionality they would obtain by purchasing our platform relative to the competitive point solutions. Additionally, our competitors may further drive down the price through strategic business combinations. We may be forced to engage in price-cutting initiatives, offer other discounts, or increase our sales and marketing and other expenses to attract and retain free and paying customers in response to competitive pressures, any of which would harm our business and operating results.\nWe have incurred losses in the past and may not consistently achieve profitability in the future.\nWe have a history of incurring net losses and although we have achieved profitability in certain periods we expect to continue to incur net losses in the future. We incurred net losses of $10.2 million and $7.0 million for the years ended December 31, 2019 and 2020, respectively. As of March 31, 2021, we had an accumulated deficit of $34.3 million. We do not know if we will be able to achieve or sustain profitability in the future. We plan to continue to invest in our research and development, and sales and marketing efforts, and we anticipate that our operating expenses will continue to increase as we scale our business and expand our operations. We also expect our general and administrative expenses to increase as a result of our growth and operating as a public company. Our ability to achieve and sustain profitability is based on numerous factors, many of which are beyond our control.\nOur products depend on publicly available and paid third-party data sources, and, if we lose access to data provided by such data sources or the terms and conditions on which we obtain such access become less favorable, our business could suffer.\nWe have developed our platform, products, and add-ons to rely in part on access to data from third-party sources. The primary sources of third-party data include data collected from third-party websites algorithmically through our proprietary data collection techniques, including web crawling of third-party websites, data purchased from independent third-party data providers, which includes clickstream data, search engine data, online advertising data, and data from social media sources, and reference data that our customers grant us access to, which includes our customers’ website and social media data. We obtain social media data through APIs that connect to social media platform operators, including Facebook, Twitter, Instagram, Pinterest, and LinkedIn. We also collect data from our customers in connection with their use of our platform.\nTo date, our relationships with most data providers (including social media platforms) are governed by such data providers’ respective standard terms and conditions, which govern the availability and access to, and permitted uses of such data (including via APIs), and which are subject to change by such providers from time to time, with little or no notice and with little or no right of redress. Similarly, our access to publicly available data may depend on restrictions that website owners may impose through technical measures or otherwise, including restrictions on automated data collection. We cannot accurately predict the impact of changes in the terms of data providers that may impede our access to the data. If these data providers or websites choose not to make their data available on the same terms, or at all, we would have to seek alternative sources, which could prove expensive and time-consuming, and may be less efficient or effective. Such changes could impact our ability to provide our services in a timely manner, if at all, and could negatively impact the perceived value of our platform and our business. There can be no assurance that following any such modification of terms or termination we would be able to maintain the current level of functionality of our platform in such circumstances, which could adversely affect our results of operations.\nWe also rely on negotiated agreements with other data providers from whom we purchase independently sourced data, including clickstream data, search engine data, online advertising data, data from social media, and other sources. These negotiated agreements provide access to additional data that allow us to provide a more comprehensive solution for our customers. These agreements are subject to termination in certain circumstances, and there can be no assurance that we will be able to renew those agreements or that the terms of any such renewal, including pricing and levels of service, will be favorable. In addition, there can be no assurance that we will not be required to enter into new negotiated\n46\nagreements with data providers in the future to maintain or enhance the level of functionality of our platform, or that the terms and conditions of such agreements, including pricing and levels of service, will not be less favorable, which could adversely affect our results of operations. Further, third-party data providers have previously, and may again, cease operations or a specific business line or cease providing products or data to their customers, including us. If we are not able to obtain third-party data on commercially reasonable terms, if these data providers stop making their data available to us, or if our competitors are able to purchase such data on better terms, the functionality of our platform and our ability to compete could be harmed.\nTo the extent that we license or obtain data from third parties, we may be subject to contractual obligations to satisfy certain requirements under applicable laws including, but not limited to, providing public notice of our data processing activities and obtaining appropriate consents where required. If one or more of those third-party data providers considers that we have failed to satisfy these requirements, such third-party data provider may bring claims against us seeking damages, and/or seeking to prevent our future use of any data already provided. Such claims could potentially adversely affect our ability to provide our services and the current level of functionality of our platform in such circumstances, which could adversely affect our results of operations.\nOur business may be harmed if any of our data sources:\n•changes, limits or discontinues our access to their data;\n•modifies its terms of service or other policies, including imposing prohibitive fees or restrictions on our use of their data or our ability to access it;\n•changes or limits how customer information is accessed by us or our customers and their users;\n•changes or limits how we can use such data;\n•establishes more favorable relationships with one or more of our competitors; or\n•experiences disruptions of its technology, services or business generally.\nRisks Related to our Business\nOur ability to introduce new products and add-ons is dependent on adequate research and development resources. If we do not adequately fund our research and development efforts or use product and development teams effectively, our business and operating results may be harmed.\nTo remain competitive, we must continue to develop new product offerings, as well as features and enhancements to our existing platform and products. Maintaining adequate research and development personnel and resources to meet the demands of the market is essential. If we experience high turnover of our product and development personnel, a lack of management ability to guide our research and development, or a lack of other research and development resources, we may miss or fail to execute on new product development and strategic opportunities and consequently lose potential and actual market share. The success of our business is dependent on our product and development teams developing and executing on a product roadmap that allows us to retain and increase the spending of our existing customers, attract new customers and upgrade our free customers to premium subscriptions. Our failure to maintain adequate research and development resources, to use our research and development resources efficiently, and to address the demands of our prospective and actual customers could materially adversely affect our business.\n47\nIf we are unable to maintain and enhance our brand, or if events occur that damage our reputation and brand, our ability to maintain and expand our customer base may be impaired, and our business and financial results may be harmed.\nMaintaining, promoting, and enhancing our brand is critical to maintaining and expanding our customer base. We seek to build our brand through a mix of free and paid initiatives. We market our platform and products through free information resources on our website, including our blog and online digital marketing courses (including through our Semrush Academy), pay-per-click advertisements on search engines and social networking sites, participation in social networking sites, and free and paid banner advertisements on other websites. The strength of our brand further drives free traffic sources, including customer referrals, word-of-mouth, and direct searches for our “Semrush” name, or web presence solutions, in search engines. In addition, we maintain relationships with agencies and affiliates to further increase brand awareness and generate customer demand. To the extent that new customers are increasingly derived from paid as opposed to free marketing initiatives, our customer acquisition cost will increase.\nBeyond direct sales and marketing efforts, maintaining and enhancing our brand will depend largely on our ability to continue to provide a well-designed, useful, reliable, and innovative platform, efficient sales process, and high-quality customer service, which we may not do successfully. For a discussion of other factors that will impact our brand recognition see the risk factors described elsewhere in this section, including without limitation, those risk factors entitled “The market in which we operate is intensely competitive, and if we do not compete effectively, our ability to attract and retain free customers and paying customers could be harmed, which would negatively impact our business and operating results.”; “If we fail to offer high-quality customer service and provide a positive customer experience, it may be more difficult to add and retain paying customers and increase the number of user licenses per paying customer, especially from large enterprises.”; “If third-party applications change such that we do not or cannot maintain the compatibility of our platform with these applications or if we fail to integrate with or provide third-party applications that our customers desire to use with our products, demand for our solutions and platform could decline.”; “We rely on search engines and social networking sites to attract a meaningful portion of our customers, and if those search engines or social networking sites change their listings or policies regarding advertising, or increase their pricing or suffer problems, it may limit our ability to attract new customers.”; and “If we fail to anticipate and adapt to new and increasingly prevalent social media platforms, other competing products and services that do so more effectively could surpass us and lead to decreased demand for our platform and products.”\nWe depend on our executive officers and other key employees, and the loss of one or more of these employees could harm our business.\nOur success depends largely upon the continued services of our executive officers and other key employees. We rely on our leadership team in the areas of research and development, operations, security, marketing, sales, customer service, and general and administrative functions, and on individual contributors and team leaders in our research and development and operations. From time to time, there may be changes in our executive management team resulting from the hiring or departure of executives, which could disrupt our business. The loss of one or more of our executive officers or key employees could harm our business. Changes in our executive management team may also cause disruptions in, and harm to, our business.\nWe are led by our CEO and co-founder, Oleg Shchegolev, our COO and co-founder, Dmitry Melnikov, and our Chief Product Officer, Vitalii Obishchenko, each of whom plays an important role in driving our culture, determining our strategy, and executing against that strategy companywide. If the services of Mr. Shchegolev, Mr. Melnikov, and/or Mr. Obishchenko become unavailable to us for any reason, it may be difficult or impossible for us to find an adequate and timely replacement, which could cause us to be less successful in maintaining our culture, and developing and effectively executing on our strategies and initiatives.\n48\nAn inability to attract and retain other highly skilled employees could harm our business.\nTo execute our growth plan, we must attract and retain highly qualified personnel. Competition for highly qualified personnel in Boston, Massachusetts, where our headquarters is located, and Trevose, Pennsylvania, Dallas, Texas, Prague, Czech Republic, Limassol, Cyprus, St. Petersburg, Russia, and Warsaw, Poland where we have offices. Competition in these locations is intense, especially for software engineers experienced in designing and developing software and SaaS applications, and experienced sales professionals who understand our products and the market in which we operate. We have from time to time experienced, and we expect to continue to experience, difficulty in hiring and retaining employees with appropriate qualifications. In addition, immigration laws in the locations in which we have offices and operations restrict or limit our ability to recruit internationally. Any changes to the immigration policies applicable to locations in which we have offices and operations that restrain the flow of technical and professional talent may inhibit our ability to recruit and retain highly qualified employees. Many of the companies with which we compete for experienced personnel may be able to offer more attractive terms of employment to potential candidates. If we hire employees from competitors or other companies, their former employers may attempt to assert that these employees have breached their legal obligations to such former employers, resulting in a diversion of our time and resources.\nIn addition, job candidates and existing employees often consider the value of the equity awards they receive in connection with their employment as part of their overall compensation package. If the perceived value of our equity awards declines or does not compare favorably to the value of equity offered by other companies competing for the same personnel resources, it may harm our ability to recruit and retain highly skilled employees. In addition, we invest significant time and expense in training our employees, which increases their value to competitors who may seek to recruit them. For example, our software developers gain deep and direct experience in data analytics, machine learning, and search optimization, making them increasingly attractive to our competitors and other similar businesses. If we fail to attract new personnel or fail to retain and motivate our current personnel, our business and future growth prospects could be harmed.\nChanges by search engines, social networking sites, and other third-party services to their underlying technology configurations or policies regarding the use of their platforms and/or technologies for commercial purposes, including anti-spam policies, may limit the efficacy of certain of our products, tools, and add-ons and as a result, our business may suffer.\nOur online visibility platform is designed to help our customers connect with consumers across a variety of digital channels, search engines, social networking sites, and other third-party services. These services may adapt and change their strategies and policies over time. Search engines typically provide two types of search results, organic (i.e., non-paid) and purchased listings. Organic search results are determined and organized solely by automated criteria set by the search engine, and a ranking level cannot be purchased. Search engines revise their algorithms from time to time in an attempt to optimize their search result listings. Changes to search engine algorithms may diminish the efficacy of certain of our products, tools, and add-ons, and potentially render them obsolete. For example, if a given search engine stopped using backlinks in its ranking algorithm, our customers’ perception of our backlink analytics tool, which enables customers to analyze and monitor the backlink profile of their own and other websites, may be adversely impacted. Similarly, if a search engine ceases to manually penalize or take action against web pages for unnatural backlinks, then our customers may determine that auditing their backlinks is unnecessary which could cause them to devalue our backlink audit tool, which enables companies to check whether malicious websites have links to their sites, or cease using it altogether. In response to these types of changes we may be required to recalibrate our product offerings by reducing prices, discontinuing the affected product, or otherwise. These responses may be costly, may not be effective, and our business may suffer.\nAdditionally, search engines, social networking sites, and other third-party services typically have terms of service, guidelines, and other policies to which its users are contractually obligated to adhere.\n49\nFor example, Google’s Gmail offering has a spam and abuse policy that prohibits sending spam, distributing viruses, or otherwise abusing the service. Prowly and our link building tool enable our customers to send emails to their desired recipients, such as marketing and affiliate partners, social media influencers, journalists, and bloggers. Our link building tool relies on a direct Gmail integration through which our customers are able to send emails using our platform as if they were sending emails directly from their Gmail account, and our Prowly product involves emails initiated by customers over Prowly servers. Our customers’ actions using either the link building tool or Prowly could be flagged under Google’s spam and abuse policy or in the future such actions may be prohibited by subsequent changes to Google’s policies. Any change to the policies of the third-party services with which our products, tools, and add-ons integrate or interact, or with which our products are intended to be used, including any anti-spam policies, or any actions taken by these third-party service providers under their policies could adversely impact the efficacy and perceived value of our products, tools, and add-ons, and as a result, our business may be harmed.\nIf third-party applications change such that we do not or cannot maintain the compatibility of our platform with these applications or if we fail to integrate with or provide third-party applications that our customers desire to use with our products, demand for our solutions and platform could decline.\nThe attractiveness of our platform depends, in part, on our ability to integrate via APIs with third-party applications that our customers desire to use with our products, such as Google, Facebook, Instagram, Twitter, YouTube, LinkedIn, Pinterest, Majestic, and others. Third-party application providers may change the features of their applications and platforms, including their APIs, or alter the terms governing use of their applications and platforms in an adverse manner. Further, third-party application providers may refuse to partner with us, or limit or restrict our access to their applications and platforms. Such changes could functionally limit or terminate our ability to use these third-party applications with our platform, which could negatively impact our offerings and the customer experience, and ultimately harm our business. If we fail to integrate our platform with new third-party applications that our customers desire, or to adapt to the data transfer requirements of such third-party applications and platforms, we may not be able to offer the functionality that our customers expect, which would negatively impact our offerings and, as a result, harm our business. Additionally, our business could be harmed if our customers have negative experiences in using the third-party integrations that we offer.\nIf we fail to maintain and improve our methods and technologies, or fail to anticipate new methods or technologies for data collection and analysis, hardware, software, and software related technologies, competing products and services could surpass ours in depth, breadth, or accuracy of our data, the insights that we offer or in other respects.\nWe expect continuous development in the market with respect to data matching, data filtering, data predicting, algorithms, machine learning, and other related technologies and methods for gathering, cataloging, updating, processing, analyzing, and communicating data and other information about how consumers find, interact with, and digest digital content. Similarly, we expect continuous changes in computer hardware, network operating systems, programming tools, programming languages, operating systems, the use of the internet, and the variety of network, hardware, browser, mobile, and browser-side platforms, and related technologies with which our platform and products must integrate. Further, changes in customer preferences or regulatory requirements may require changes in the technology used to gather and process the data necessary to deliver our customers the insights that they expect. Any of these developments and changes could create opportunities for a competitor to create products or a platform comparable or superior to ours, or that takes material market share from us in one or more product categories, and create challenges and risks for us if we are unable to successfully modify and enhance our products to adapt accordingly.\n50\nIf we fail to anticipate and adapt to new and increasingly prevalent social media platforms, other competing products and services that do so more effectively could surpass us and lead to decreased demand for our platform and products.\nThe use of social media throughout the world is pervasive and growing. According to a survey by GlobalWebIndex of individuals ages 16 to 64, 97% of digital consumers have used social media during the first quarter of 2020, with digital consumers spending an average of 2 hours and 22 minutes per day on social networks and messaging apps between January and March 2020. The social media industry has experienced, and is likely to continue to experience, rapid change due to the evolving trends, tastes and preferences of users. If consumers widely adopt new social media networks and platforms, we will need to develop integrations and functionality related to these new networks and platforms. This development effort may require significant research and development and sales and marketing resources, as well as licensing fees, all of which could adversely affect our business and operating results. In addition, new social media networks and platforms may not provide us with sufficient access to data from their platforms, preventing us from building effective integrations with our platform and products. Changing consumer tastes may also render our current integrations or functionality obsolete and the financial terms, if any, under which we would obtain integrations or functionality, unfavorable. Any failure of our products to operate effectively with the social media networks used most frequently by consumers could reduce the demand for our products. If we are unable to respond to these changes in a cost-effective manner, our products and aspects of our platform may become less marketable and less competitive or obsolete, and our operating results may be negatively affected.\nIf we fail to offer high-quality customer service and provide a positive customer experience, it may be more difficult to add and retain paying customers, secure upgrades, sell add-ons, and increase the number of user licenses per paying customer.\nOur ability to add and retain paying customers, secure subscription upgrades, and sell add-ons depends in part on our customer service. Our sales and customer success team engages with customers to onboard them onto our platform, responds to support requests and other general inquiries, and assists with other account management matters. The perceived quality of customer service is one of the key facets potential customers evaluate when deciding between competing products and if our customer service is not viewed favorably, potential customers may choose our competitors’ products over our own. Additionally, our large enterprise customers from time to time demand custom solutions, such as custom APIs and custom reporting, and customer support that do not fit within one of our pre-packaged premium subscriptions, and addressing such demands often requires additional one-on-one engagement with our sales and customer success team members in order to finalize and service the commercial relationship. As we add more large enterprise customers and increase the number of user licenses per paying customer, we may need to devote more resources to customer service, and we may find it difficult and costly to effectively scale. If we do not adequately scale our customer success teams to meet the demands of new and existing customers, or if we otherwise fail to provide high-quality customer service during onboarding or at any other stage of the customer relationship, or a positive customer experience, we may lose such customers to our competition and fewer customers could renew or upgrade their subscriptions and purchase add-ons, which would harm our business, results of operations, and financial condition.\nFailures or loss of, or material changes with respect to, the third-party hardware, software, and infrastructure on which we rely, including third-party data center hosting facilities and third-party distribution channels to support our operations, could adversely affect our business.\nWe rely on leased and third-party owned hardware, software and infrastructure, including third-party data center hosting facilities and third-party distribution channels to support our operations. We primarily use three data centers in the United States, two located in Virginia and one in Georgia, as well as two Google Cloud locations in Virginia and South Carolina. We host each of our products and the data processed through such products in a combination of two of the foregoing locations for redundancy. If any\n51\nof our data center suppliers experience disruptions or failures, it would take time for the applicable backup data center to become fully functioning, and we would likely experience delays in delivering the affected products and segments of our platform, which may involve incurring significant additional expenses.\nFurthermore, the owners and operators of our data center facilities do not guarantee that access to our platform will be uninterrupted or error-free. We do not control the operation of these third-party providers’ facilities, which could be subject to break-ins, computer viruses, sabotage, intentional acts of vandalism and other misconduct. Further, our leased servers and data centers are vulnerable to damage or interruption from natural disasters, terrorist attacks, power loss, telecommunications failures or similar catastrophic events. The COVID-19 pandemic could cause our third-party data center hosting facilities and cloud computing platform providers, which are critical to our infrastructure, to shut down their operations, experience technical or security incidents that delay or disrupt performance or delivery of services to us, or experience interference with the supply chain of hardware required by their systems and services, any of which could materially adversely affect our business. For example, we have experienced delays in migrating to our new data center in Virginia, due to the limited availability of certain required hardware components resulting from supply chain delays caused by the COVID-19 pandemic. If there were to be a significant outage or disaster that rendered one of our servers or data centers inoperable for any length of time, we would have to undertake recovery operations for the impacted products, which could interrupt the availability of our platform. If we were unable to restore the availability of our platform and products within a reasonable period of time, our customer satisfaction could suffer, damaging our reputation as a result, and we could lose customers to our competition, which would materially and adversely affect our business and results of operations.\nIn addition, third-party data hosting and transmission services comprise a significant portion of our operating costs. If the costs for such services increase due to vendor consolidation, regulation, contract renegotiation, or otherwise, we may not be able to increase the fees for our platform or products to cover the changes, which would have a negative impact on our results of operations.\nIf the security of the confidential information or personal information of any customers of our platform is breached or otherwise subjected to unauthorized access or disclosure, our reputation may be harmed and we may be exposed to liability.\nWith consent from our customers, we obtain confidential and other customer data from our customers’ websites, social media accounts, and Google Analytics’ accounts to operate certain functionality on our platform. We rely on credit card purchases as the primary means of collecting our premium subscription fees. In addition, with consent from our customers, we collect and store certain personally identifiable information (“personal data”), credit card information, and other data needed to create, support, and administer the customer account, conduct our business, and comply with legal obligations, including rules imposed by the Payment Card Industry networks.\nWe believe that we take reasonable steps to protect the security, integrity, availability, and confidentiality of the information we and our third-party service providers hold, but there is no guarantee that despite our efforts, inadvertent disclosure (such as may arise from software bugs or other technical malfunctions, employee error or malfeasance, or other factors) or unauthorized disclosure or loss of personal or other confidential information will not occur or that third parties will not gain unauthorized access to this information. We have experienced, and may experience in the future, breaches of our security due to human error, malfeasance, system errors or vulnerabilities, or other irregularities. For example, we have been the target of attempts to identify and exploit system vulnerabilities and/or penetrate or bypass our security measures to gain unauthorized access to our systems, including a brute force attack that resulted in access to our affiliate program partner contact information. Since techniques used to obtain unauthorized access change frequently, we and our third-party service providers may be unable to anticipate these techniques or to implement adequate preventative measures. If our security measures or the security measures of our third-party service providers are breached because of third-party action, employee error, malfeasance or otherwise, or if design flaws in our software are exposed\n52\nand exploited, and, as a result, a third-party obtains unauthorized access to any customers’ data, our relationships with our customers may be damaged, and we could incur liability. Further, our customers with annual subscription terms may have the right to terminate their subscriptions before the end of the subscription term due to our uncured material breach of agreement, including with respect to our data security obligations. It is also possible that unauthorized access to customer data may be obtained through inadequate use of security controls by customers, suppliers or other vendors. While we are not currently aware of any impact that the SolarWinds supply chain attack had on our business, this is a recent event, and the scope of the attack is yet unknown. Therefore, there is residual risk that we may experience a security breach arising from the SolarWinds supply chain attack. We may also be subject to additional liability risks for failing to disclose data breaches or other security incidents under state data breach notification laws or under the private right of action granted to individuals under certain data privacy laws for actions arising from certain data security incidents, such as the California Consumer Privacy Act (“CCPA”) (which is further discussed below in this “Risk Factors” section). In addition, some regions, such as the EU, the United Kingdom (“UK”), and the United States, have enacted mandatory data breach notification requirements for companies to notify data protection authorities, state and federal agencies, or individuals of data security incidents or personal data breaches. We may also be contractually required to notify certain customers in the event of a security incident pursuant to the applicable customer agreement. These mandatory disclosures regarding a security breach may lead to negative publicity and may cause our customers to lose confidence in the effectiveness of our data security measures. Any security breach, whether actual or perceived, may harm our reputation, and we could lose customers or fail to acquire new customers.\nFederal, state, and provincial regulators and industry groups may also consider and implement from time to time new privacy and security requirements that apply to our business, such as the long established Massachusetts data security law and the recently enacted New York Stop Hacks and Improve Electronic Data Act, both of which establish prescriptive administrative, technical, and physical data security requirements on companies, and permits civil penalties for each violation. Compliance with evolving privacy and security laws, requirements, and regulations may result in cost increases due to necessary systems changes, new limitations or constraints on our business models and the development of new administrative processes. They also may impose further restrictions on our collection, disclosure, and use of personally identifiable information kept in our databases or those of our vendors. If our security measures fail to protect credit card information adequately, we could be liable to both our customers and their users for their losses, as well as the vendors under our agreements with them such that we could be subject to fines and higher transaction fees, we could face regulatory action, and our customers and vendors could end their relationships with us, any of which could harm our business, results of operations or financial condition. Any willful or accidental security breaches or other unauthorized access to or disclosure of personal data could expose us to enforcement actions, regulatory or governmental audits, investigations, litigation, fines, penalties, adverse publicity, downtime of our systems, and other possible liabilities. There can be no assurance that the limitations of liability in our contracts would be enforceable or adequate or would otherwise protect us from any such liabilities or damages with respect to any particular claim. In addition, our cybersecurity insurance coverage may be inadequate to cover all costs and expenses associated with a security breach that may occur in the future.\nIn recent periods, we have experienced, and expect to continue to experience, rapid growth and organizational change. If we fail to manage our growth effectively, we may be unable to execute our business plan, maintain high levels of service and customer satisfaction or attract new employees and customers.\nWe have experienced, and expect to continue to experience, rapid growth in our number of customers, sales, revenues, locations, and headcount, which has placed, and may continue to place, significant demands on our management, and our operational and financial resources. We have paying customers in over 142 countries, and the number of our paying customers has grown from over 56,000 as of March 31, 2020 to over 72,000 as of March 31, 2021. We have seven offices across the globe with salespeople dispersed in various other locations, and the continued domestic and international growth\n53\nthat we anticipate will require us to continue to expand our global employee headcount. It may be difficult for us to identify, recruit, train, and manage enough personnel to efficiently scale our operations, manage our product development effectively and to match the growth of our customer base. As we continue to grow, we face challenges of integrating, developing, training, and motivating a rapidly growing and dispersed employee base. We are facing novel challenges with respect to integrating new employees and managing multi-geographic teams as COVID-19 prevents certain of our onboarding personnel from travelling between our offices to assist with such integration and training. Certain members of our executive management team have not previously worked together for an extended period of time, which may affect how they manage our growth. If we fail to manage our anticipated growth effectively, our brand and reputation could be negatively affected, which could harm our ability to attract employees and customers.\nTo manage growth in our operations and personnel, we will need to continue to scale and improve our operational, financial, and management controls, and our reporting systems and procedures, which will require significant capital expenditures increasing our cost of operations and the reallocation of valuable management resources. As we scale, it may become more difficult and will require additional capital expenditures to maintain and increase the productivity of our employees, to address the needs of our actual and prospective customers, and provide high-quality customer service, to further develop and enhance our products, and remain competitive against our competitors’ products. Additionally, our expansion has placed, and our expected future growth will continue to place, a significant strain on our management, customer service teams, product and development, sales and marketing, administrative, financial, and other resources.\nTechnical problems or disruptions that affect either our customers’ (and their users’) ability to access our platform and products, or the software, internal applications, database, and network systems underlying our platform and products, could damage our reputation and brands, lead to reduced demand for our platform and products, lower revenues, and increased costs.\nOur business, brands, reputation, and ability to attract and retain customers depend upon the satisfactory performance, reliability, and availability of our platform, which in turn depend upon the availability of the internet and our third-party service providers. Interruptions in these systems, whether due to system failures, computer viruses, software errors, physical or electronic break-ins, malicious hacks or attacks on our systems (such as denial of service attacks), or force majeure events, could affect the security and availability of our products and prevent or inhibit the ability of customers to access our platform. In addition, the software, internal applications, and systems underlying our products and platform are complex and may not be error-free. We may encounter technical problems when we attempt to perform routine maintenance or enhance our software, internal applications, and systems. In addition, our platform may be negatively impacted by technical issues experienced by our third-party service providers. Any inefficiencies, errors, or technical problems with our software, internal applications, and systems could reduce the quality of our platform and products or interfere with our customers’ (and their users’) use of our platform and products, which could negatively impact our brand, reduce demand, lower our revenues, and increase our costs.\nWe are exposed to risks associated with premium subscription and payment processing and any disruption to such processing systems could adversely affect our business and results of operations.\nWe primarily rely on our own billing systems to manage our subscriptions and billing frequencies, and we use third-party subscription management and payment processing platforms for some of our products. If we or any of our third-party vendors were to experience an interruption, delay, or outage in service and availability, we may be unable to process new and renewals of subscriptions and our ability to process such subscription and credit card payments would be delayed while we activate an alternative billing platform. Although alternative third-party providers may be available to us, we may incur significant expenses and research and development efforts to deploy any alternative providers. To the extent there\n54\nare disruptions in our billing systems or third-party subscription and payment processing systems, we could experience revenue loss, accounting issues, and harm to our reputation and customer relationships, which would adversely affect our business and results of operations.\nWe are subject to a number of risks related to credit and debit card payments, including:\n•we pay interchange and other fees, which may increase over time and could require us to either increase the prices we charge for our products or experience an increase in our operating expenses;\n•if our billing systems fail to work properly and the failure has an adverse effect on our customer satisfaction, causes credit and debit card issuers to disallow our continued use of their payment products, or, does not permit us to automatically charge our paying customers’ credit and debit cards on a timely basis or at all, we could lose or experience a delay in collection of customer payments;\n•if we are unable to maintain our chargeback rate at acceptable levels, we may face civil liability, diminished public perception of our security measures and our credit card fees for chargeback transactions, or our fees for other credit and debit card transactions or issuers, may increase, or issuers may terminate their relationship with us; and\n•we could be significantly impaired in our ability to operate our business if we lose our ability to process payments on any major credit or debit card.\nA significant portion of our operations is located outside of the United States, which subjects us to additional risks, including increased complexity, the costs of managing international operations, geopolitical instability, and fluctuations in currency exchange rates.\nThe design and development of our products is primarily conducted by our subsidiaries in Russia, the Czech Republic, Cyprus, and Poland. We also have marketing and administrative operations in the same jurisdictions. In addition, members of our sales force are located in Russia, Europe, the United Kingdom and Australia. Approximately 55% of our revenue for the three months ended March 31, 2021 was generated from sales to paying customers located outside the United States, including indirect sales through our resellers outside of the United States. As a result of our international operations and sales efforts, we face numerous challenges and risks that could harm our international operations, delay new product releases, increase our operating costs, and hinder our ability to grow and detect underlying trends in our operations and business, and consequently adversely impact our business, financial condition, and results of operations. Such risks include but are not limited to the following:\n•geopolitical and economic instability in and impacting the localities where we have foreign operations, such as Russia;\n•military conflicts impacting the localities where we have foreign operations;\n•limited protection for, and vulnerability to theft of, our intellectual property rights, including our trade secrets;\n•compliance with local laws and regulations, and unanticipated changes in local laws and regulations, including tax laws and regulations;\n•trade and foreign exchange restrictions and higher tariffs;\n•the complexity of managing international trade sanctions and export restrictions from the jurisdictions in which we have foreign operations;\n55\n•fluctuations in foreign currency exchange rates which may make our premium subscriptions more expensive for international paying customers and which may increase our expenses for employee compensation and other operating expenses that are paid in currencies other than U.S. dollars;\n•restrictions imposed by the United States government against other countries, or foreign governments restrictions imposed on the United States, impacting our ability to do business with certain companies or in certain countries and the complexity of complying with those restrictions;\n•power outages, natural disasters, and other local events that could affect the availability of the internet and the consequences of disruptions, such as large-scale outages or interruptions of service from utilities or telecommunications providers;\n•difficulties in staffing international operations;\n•changes in immigration policies which may impact our ability to hire personnel;\n•differing employment practices, laws, and labor relations;\n•regional health issues and the impact of public health epidemics and pandemics on employees and the global economy, such as the COVID-19 pandemic; and\n•travel, work-from-home or other restrictions or work stoppages, like those currently imposed by governments around the world as a result of the COVID-19 pandemic.\nFurther, it is possible that governments of one or more foreign countries may seek to limit access to the internet or our platform, products or certain features in their countries, or impose other restrictions that may affect the availability of our platform, products, or certain features in their countries for an extended period of time or indefinitely. For example, Russia and China are among a number of countries that have recently blocked certain online services, including Amazon Web Services, making it difficult for such services to access those markets. In addition, governments in certain countries may seek to restrict or prohibit access to our platform if they consider us to be in violation of their laws (including privacy laws) and may require us to disclose or provide access to information in our possession. If we fail to anticipate developments in the law or fail for any reason to comply with relevant laws, our platforms could be further blocked or restricted and we could be exposed to significant liability that could harm our business. In the event that access to our platform is restricted, in whole or in part, in one or more countries or our competitors are able to successfully penetrate geographic markets that we cannot access, our ability to acquire new customers or renew or grow the premium subscriptions of existing paying customers may be adversely affected, we may not be able to maintain or grow our revenue as anticipated and our business, results of operations, and financial condition could be adversely affected.\nThe effects of the COVID-19 pandemic are uncertain and may materially affect our customers or potential customers and how we operate our business, and the duration and extent to which the pandemic continues to threaten our future operating results remains uncertain.\nThe global COVID-19 pandemic has disrupted the economy and put unprecedented strains on governments, health care systems, educational institutions, companies, and individuals around the world. The impact and duration of the COVID-19 pandemic are difficult to assess or predict and will depend in part upon the actions taken by governments, companies, and other enterprises in response to the pandemic. The pandemic has already caused, and is likely to result in further, significant disruption of global financial markets and economic uncertainty. Adverse market conditions resulting from the COVID-19 pandemic could materially adversely affect our revenues, business and the value of our Class A common stock.\n56\nOur customers, particularly small-to-medium sized businesses (“SMBs”) and marketing agencies focused on SMBs, which have been particularly impacted by the COVID-19 pandemic, have reduced and may further reduce their technology or sales and marketing spending or delay purchasing decisions, which could result in slowed growth, reduced demand from new and existing SMB customers, and/or lower dollar-based net revenue retention rates, which could materially and adversely impact our business. In March 2020, our paying customer growth rate was relatively flat compared to our paying customer growth rate in February 2020. However, in April 2020 our paying customer growth rate declined, which we believe was primarily a result of the COVID-19 pandemic and the related socioeconomic impacts. In response, we offered free or discounted pricing to certain paying customers contemplating canceling their premium subscriptions as a remedial measure to retain them. Our paying customer growth rate started to increase again by May 2020. Depending on the duration of the COVID-19 pandemic, we may in the future be required to take further remedial measures, including changing our terms or offering further discounts, which may materially adversely impact our revenues and business in future periods.\nIn response to the COVID-19 pandemic, we temporarily closed all of our offices (including our headquarters in Boston, Massachusetts, and offices in Trevose, Pennsylvania, Dallas, Texas, Prague, Czech Republic, Limassol, Cyprus, and St. Petersburg, Russia), subsequently reopened certain offices at reduced capacity, enabled our employees to work remotely, implemented temporary travel restrictions for all non-essential business, and shifted company events to virtual-only experiences. We may deem it advisable to similarly alter, postpone, or cancel additional events in the future. If the COVID-19 pandemic worsens, especially in regions where we have offices, our business activities conducted from those offices could be adversely affected and we may have to invest additional capital into improving our technology and remote working capabilities and in relocating those activities to alternate locations from which we operate. We may take further actions that alter our business operations as may be required by local, state, or federal authorities or that we determine are in the best interests of our employees. Such measures could negatively affect our sales and marketing efforts, sales cycles, employee productivity, or customer retention, any of which could harm our financial condition and business operations.\nFurther, the COVID-19 pandemic has resulted in our employees and the employees of many of our customers and vendors working remotely. If the network and infrastructure of internet providers becomes overburdened by increased usage or is otherwise unreliable or unavailable, our employees’, and our customers’ and vendors’ employees’ access to the internet and ability to conduct business could be negatively impacted. We and our vendors may experience an increase in attempted cyber-attacks, targeted intrusion, ransomware, and phishing campaigns seeking to take advantage of shifts to employees working remotely using their household or personal internet networks. Any of these factors could interrupt our ability to provide our platform, decrease the productivity of our workforce, and significantly harm our business operations, financial condition, and results of operations.\nTo the extent the COVID-19 pandemic adversely affects our business and financial results, it may also have the effect of heightening many of the other risks described in this ‘‘Risk Factors’’ section.\nAdverse or weakened general economic and market conditions may reduce spending on sales and marketing technology and information, which could harm our revenue, results of operations, and cash flows.\nOur revenue, results of operations, and cash flows depend on the overall demand for and use of technology and information for sales and marketing, which depends in part on the amount of spending allocated by our paying customers or potential paying customers on sales and marketing technology and information. In addition to the internal strategy of our paying customers, which is not predictable and is subject to change, this spending depends on worldwide economic and geopolitical conditions. The United States, EU, and other key international economies have experienced cyclical downturns from time to time in which economic activity was impacted by falling demand for a variety of goods and services, restricted credit, poor liquidity, reduced corporate profitability, volatility in credit, equity, and foreign exchange markets, bankruptcies, public health crises, and pandemics such as COVID-19, and overall economic\n57\nuncertainty. These economic conditions can arise suddenly, may disproportionately impact SMBs that make up an important segment of our paying customer base, and the full impact of such conditions often remains uncertain for extended periods of time. Further actions or inactions of the United States or other major national governments, including the UK’s 2016 vote in favor of the UK’s exit from the EU, may also impact economic conditions, which could result in financial market disruptions or an economic downturn.\nConcerns about the systemic impact of an economic recession, energy costs, geopolitical issues, or the availability and cost of credit could lead to increased market volatility, decreased consumer confidence, and diminished growth expectations in the U.S. economy and abroad, which could affect the rate of information technology spending and adversely affect our paying customers’ ability or willingness to purchase our products, delay prospective paying customers’ purchasing decisions, reduce the value or duration of their premium subscription contracts, or affect retention rates. Any of these conditions or occurrences could adversely affect our future sales and operating results because most of our paying customers are on month-to-month premium subscriptions that can be cancelled at any time. Further, some of our paying customers may view a premium subscription to our platform as a discretionary purchase, and our paying customers may reduce their discretionary spending on our platform during an economic downturn and consequently reduce or terminate their premium subscription or decide not to upgrade another premium subscription. In particular, spending patterns of the SMBs that make up a large portion of our paying customer base are difficult to predict and are sensitive to the general economic climate, the economic outlook specific to small businesses, the then-current level of profitability experienced by SMBs and overall consumer confidence. In addition, weak economic conditions can result in paying customers seeking to utilize free or lower-cost solutions from alternative sources. Prolonged economic slowdowns may result in requests to renegotiate existing contracts on less advantageous terms to us than those currently in place, payment defaults on existing contracts, or non-renewal at the end of a contract term.\nFailure of our commercial liability insurance policy to cover claims and any changes to the availability or coverage amounts in our existing policy could have a material adverse effect on our business, financial condition, and results of operations.\nWe cannot assure you that our existing general liability insurance coverage and coverage for errors and omissions in our products will be fully covered by our existing policies and will continue to be available on acceptable terms, or will be available in sufficient amounts to cover one or more large claims, or that the insurer will not deny coverage as to any future claim. The successful assertion of one or more large claims against us that exceeds available insurance coverage, or the occurrence of changes in our insurance policies, including premium increases or the imposition of large deductible or co-insurance requirements, could have a material adverse effect on our business, financial condition, and results of operations.\nAs we acquire and invest in companies or technologies, we may not realize expected business or financial benefits and the acquisitions or investments could prove difficult to integrate, disrupt our business, dilute stockholder value and adversely affect our business, results of operations, and financial condition.\nAs part of our business strategy, we evaluate and may make investments in, or acquisitions of, complementary companies, services, databases, and technologies, and we expect that we will continue to evaluate and pursue such investments and acquisitions in the future to further grow and augment our business, our platform, and product offerings. For example, in August 2020, we acquired Prowly, an advertising and public relations technology company based in Poland. We have incurred and will continue to incur costs to integrate Prowly’s business and selling process into our business and to integrate Prowly’s products into our platform, such as software integration expenses and costs related to the renegotiation of redundant vendor agreements, and we expect to incur similar costs to integrate future acquisitions. We may have difficulty effectively integrating the personnel, businesses, and technologies of these acquisitions into our company and platform, and achieving the strategic goals of those acquisitions.\n58\nOur strategy to make selective acquisitions to complement our platform depends in part on the availability of, our ability to identify, and our ability to engage and pursue suitable acquisition candidates. We may not be able to find suitable acquisition candidates, and we may not be able to complete acquisitions on favorable terms, if at all. Acquired assets, data, or companies may not be successfully integrated into our operations, costs in connection with acquisitions and integrations may be higher than expected, and we may also incur unanticipated acquisition-related costs. These costs could adversely affect our financial condition, results of operations, or prospects. Any acquisition we complete could be viewed negatively by customers, users, developers, and other employees, partners, or investors, and could have adverse effects on our existing business relationships and company culture.\nAcquisitions and other transactions, arrangements, and investments involve numerous risks and could create unforeseen operating difficulties and expenditures, including:\n•difficulties in, and the cost of, integrating personnel and cultures, operations, technologies, products, services, and platforms which may lead to failure to achieve the expected benefits on a timely basis or at all;\n•diversion of financial and managerial resources from existing operations;\n•the potential entry into new markets in which we have little or no experience or where competitors may have stronger market positions;\n•potential write-offs of acquired assets or investments, and potential financial and credit risks associated with acquired customers;\n•additional stock-based compensation and difficulties in, and financial costs of, addressing acquired compensation structures inconsistent with our compensation structure;\n•inability to generate sufficient revenue to offset acquisition and/or investment costs;\n•inability to maintain, or changes in, relationships with customers and partners of the acquired business;\n•challenges converting the revenue recognition policies of companies we may acquire and forecasting the recognition of their revenue, including subscription-based revenue and revenue based on the transfer of control, as well as appropriate allocation of the customer consideration to the individual deliverables;\n•difficulty with, and costs related to, transitioning the acquired technology onto our existing platform, augmenting the acquired technologies and platforms to the levels that are consistent with our brand and reputation, augmenting or maintaining the security standards for acquired technology consistent with our platform and other products, and customer acceptance of multiple platforms on a temporary or permanent basis;\n•potential unknown liabilities associated with the acquired companies, including risks associated with acquired intellectual property and/or technologies;\n•challenges relating to the structure of an investment, such as governance, accountability, and decision-making conflicts;\n•negative impact to our results of operations because of the depreciation and amortization of amounts related to acquired intangible assets, fixed assets, and deferred compensation;\n•the loss of acquired unearned revenue and unbilled unearned revenue;\n59\n•delays in customer purchases due to uncertainty related to any acquisition;\n•ineffective or inadequate controls, procedures, and policies at the acquired company;\n•challenges caused by integrating operations over distance, and across different languages, cultures, and political environments;\n•currency and regulatory risks associated with conducting operations in foreign countries and potential additional cybersecurity and compliance risks resulting from entry into new markets;\n•tax effects and costs of any such acquisitions, including the related integration into our tax structure and assessment of the impact on the realizability of our future tax assets or liabilities; and\n•potential challenges by governmental authorities for anti-competitive or other reasons.\nAny of these risks could harm our business. In addition, to facilitate these acquisitions or investments, we may seek additional equity or debt financing, which may not be available on terms favorable to us or at all, may affect our ability to complete subsequent acquisitions or investments and may affect the risks of owning our Class A common stock. For example, if we finance acquisitions by issuing equity or convertible debt securities or loans, our existing stockholders may be diluted, or we could face constraints related to the terms of, and repayment obligations related to, the incurrence of indebtedness that could affect the market price of our Class A common stock.\nOur debt obligations contain restrictions that impact our business and expose us to risks that could adversely affect our liquidity and financial condition.\nOn January 12, 2021, we executed a credit agreement with JPMorgan Chase Bank, N.A., in the form of a revolving credit facility, that consists of a $45.0 million revolving credit facility and a letter of credit sub-facility with an aggregate limit equal to the lesser of $5.0 million and the aggregate unused amount of the revolving commitments then in effect. The amount of borrowings permitted at any one time under the revolving credit facility is subject to a borrowing base based on an advance rate of 400% multiplied by annualized retention applied to monthly recurring revenue. As a result, our access to the revolving credit facility is potentially subject to significant fluctuations depending on the value of the borrowing base as of any measurement date.\nThe credit agreement (as amended, restated, amended and restated, supplemented or otherwise modified from time to time, the “Credit Agreement”) governing our revolving credit facility (collectively, our “credit facility”) contains various covenants that are operative so long as our credit facility remains outstanding. The covenants, among other things, limit our and certain of our subsidiaries’ abilities to:\n•incur additional indebtedness or guarantee indebtedness of others;\n•create additional liens on our assets;\n•pay dividends and make other distributions on our capital stock, and redeem and repurchase our capital stock;\n•make investments, including acquisitions;\n•make capital expenditures;\n•enter into mergers or consolidations or sell assets;\n•sell our subsidiaries; or\n60\n•enter into transactions with affiliates.\nOur credit facility also contains numerous affirmative covenants and a financial covenant of either minimum liquidity or a maximum leverage ratio.\nIf we experience a decline in cash flow due to any of the factors described in this “Risk Factors” section or otherwise, we could have difficulty paying interest due on our indebtedness and meeting the financial covenants set forth in our credit facility. If we fail to comply with the various requirements of our indebtedness, we could default under our credit facility. Any such default that is not cured or waived could result in an acceleration of indebtedness then outstanding under our credit facility, an increase in the applicable interest rates under our credit facility, and a requirement that Semrush US Sub, which is a co-borrower under the facility, pay the obligations in full, and would permit the lenders to exercise remedies with respect to all of the collateral that is securing our credit facility, including substantially all of our and Semrush US Sub’s assets. Thus, any such default could have a material adverse effect on our liquidity and financial condition.\nIf we cannot maintain our company culture as we grow, we could lose the innovation, teamwork, passion, and focus on execution that we believe contribute to our success and our business may be harmed.\nWe believe that a critical component to our success has been our company culture, which is based on transparency, innovation, creativity, and personal autonomy to take on challenges and initiatives. We have invested substantial time and resources in building our team within this company culture across our offices. Any failure to preserve our culture could negatively affect our ability to retain and recruit personnel and to effectively focus on and pursue our corporate objectives. As we grow and develop the infrastructure of a public company, we may find it difficult to maintain these foundational aspects of our company culture. If we fail to maintain our company culture, we may fail to recruit qualified employees, our existing employees may terminate their employment, our ability to execute on marketing, sales, product and development, and other initiatives may suffer, and our business may be adversely impacted in other ways.\nChanges in the sizes or types of paying customers that purchase premium subscriptions to our platform or products could affect our business, and our financial results may fluctuate due to increasing variability in our sales cycles.\nOur strategy is to sell premium subscriptions of our platform to paying customers of all sizes, from sole proprietors, to SMBs, to large enterprise customers. Selling monthly premium subscriptions to SMBs generally involves lower or plateauing premium subscription upgrade potential, lower retention rates (especially in times of economic uncertainty where marketing and sales budgets are subject to increased scrutiny and reduction), and more limited interaction with our sales and other personnel than sales to large enterprises. Conversely, sales to large enterprises generally entail longer sales cycles, more significant and costly selling and support efforts, and greater uncertainty of completing the sale than sales to SMBs. We plan our expenses based on certain assumptions about the length and variability of our sales cycle based upon historical trends for sales and conversion rates associated with our existing paying customers. If and as our paying customer base expands to include more large enterprise customers, our sales expenses may increase, sales cycles may lengthen and become less predictable, and we may see a greater number of paying customers with longer terms and extended payment terms which, in turn, may increase our paying customer acquisition costs, increase our credit risk, and may in other ways adversely affect our financial results. Additional factors that may influence the length and variability of our sales cycle include:\n•the need to educate prospective customers about the different products available on our platform, and their uses and benefits;\n61\n•the discretionary nature of purchase and budget cycles and decisions;\n•the competitive nature of evaluation and purchasing processes;\n•economic and political stability and other external factors;\n•evolving functionality demands;\n•announcements of planned introductions of new products, features or functionality by us or our competitors; and\n•lengthy and multi-faceted purchasing approval processes required by our customers, especially large enterprise customers.\nIf there are changes in, or we fail to adequately predict, the mix of paying customers that purchase premium subscriptions to our platform, our gross margins and operating results could be adversely affected, and fluctuations increasing the variability in our sales cycles could negatively affect our financial results.\nForecasts of our market and market growth may prove to be inaccurate, and even if the markets in which we compete achieve the forecasted growth, there can be no assurance that our business will grow at similar rates, or at all.\nGrowth forecasts that we have provided and may provide, including those in the Prospectus and in this Quarterly Report on Form 10-Q, relating to our market opportunities and the expected growth thereof are subject to significant uncertainty and are based on assumptions and estimates which may prove to be inaccurate. Even if these markets grow at the forecasted rates, we may not grow our business at a similar rate, or at all. Our growth is subject to many factors, including our success in implementing our business strategy, which is subject to many risks and uncertainties. Accordingly, the forecasts of market growth that we have provided and may in the future provide should not be taken as indicative of our future growth.\nOur management has broad discretion over the use of the proceeds from the IPO, and might not use the net proceeds effectively.\nOur management has broad discretion to use the net proceeds from the IPO, including for any of the purposes described in the section titled “Use of Proceeds” included in the Prospectus, and you will be relying on the judgment of our management regarding the application of these proceeds. Our management might not apply the net proceeds in ways that increase the value of your investment. Until we use the net proceeds from the IPO, we plan to invest them, and these investments may not yield a favorable rate of return. If we do not invest or apply the net proceeds from the IPO in ways that enhance stockholder value, we may fail to achieve expected financial results, which could cause our stock price to decline.\nWe may be subject to litigation for any of a variety of claims, which could harm our reputation and adversely affect our business, results of operations, and financial condition.\nIn the ordinary course of business, we may be involved in and subject to litigation for a variety of claims or disputes and receive regulatory inquiries. These claims, lawsuits, and proceedings could include labor and employment, wage and hour, income tax, commercial, data privacy, antitrust, alleged securities law violations or other investor claims, and other matters. The number and significance of these potential claims and disputes may increase as our business expands. Any claim against us, regardless of its merit, could be costly, divert management’s attention and operational resources, and harm our reputation. As litigation is inherently unpredictable, we cannot assure you that any potential claims or disputes will not\n62\nhave a material adverse effect on our business, results of operations, and financial condition. Any claims or litigation, even if fully indemnified or insured, could make it more difficult to compete effectively or to obtain adequate insurance in the future.\nIn addition, we may be required to spend significant resources to monitor and protect our contractual, intellectual property, and other rights, including collection of payments and fees. Litigation has been and may be necessary in the future to enforce such rights. Such litigation could be costly, time consuming, and distracting to management and could result in the impairment or loss of our rights. Furthermore, our efforts to enforce our rights may be met with defenses, counterclaims, and countersuits attacking the validity and enforceability of such rights. Our inability to protect our rights, as well as any costly litigation or diversion of our management’s attention and resources, could have an adverse effect on our business, results of operations, and financial condition or harm our reputation.\nOur failure to raise additional capital or generate cash flows necessary to expand our operations and invest in new technologies in the future could reduce our ability to compete successfully and harm our results of operations.\nWe may require additional financing, and we may not be able to obtain debt or equity financing on favorable terms, if at all. Any debt financing obtained by us could involve restrictive covenants relating to financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities, including potential acquisitions. If we raise additional funds through further issuances of equity, convertible debt securities or other securities convertible into equity, our existing stockholders could experience significant dilution, and any new equity securities we issue could have rights, preferences, and privileges senior to those of holders of our Class A common stock. The terms of any debt financing may include liquidity requirements, restrict our ability to pay dividends, and require us to comply with other covenants restrictions. If we need additional capital and cannot raise it on acceptable terms, or at all, we may not be able to, among other things:\n•develop new features, integrations, capabilities, and enhancements;\n•continue to expand our product and development, and sales and marketing teams;\n•hire, train, and retain employees;\n•respond to competitive pressures or unanticipated working capital requirements; or\n•pursue acquisition opportunities.\nOur referral partners and resellers provide revenue to our business, and we benefit from our association with them. Our failure to maintain successful relationships with these partners could adversely affect our business.\nOur referral partners and resellers drive revenue to our business and our agreements with these partners and resellers are non-exclusive, with the exception of one exclusive reseller agreement in Japan. While most of these partners and resellers offer products or services that are complementary to our platform and products, some offer point solutions that compete with certain functionalities of our platform. These referral partners and resellers may decide in the future to terminate their agreements with us and/or to market and sell a competitor’s or their own products or services rather than ours, which could cause our revenue to decline. Our competitors may in some cases be effective in causing our referral partners and resellers, or potential referrals and resellers, to favor their products and services or to prevent or reduce sales of our platform and products. Also, we derive tangible and intangible benefits from our association with some of our referral partners and members of our affiliate networking programs, particularly high-profile partners that reach a large number of companies through the internet. If a\n63\nsubstantial number of these partners or networking affiliates reduce or cease their relationships with us, our business, financial condition, and results of operations could be adversely affected.\nWe expect that we will need to continue to expand and maintain a network of referral partners and resellers in order to expand into certain international markets. A loss of or reduction in sales through these third parties could reduce our revenue. Recruiting and retaining qualified resellers in our network and training them in our technology and product offerings requires significant time and resources. If we decide to further develop and expand our indirect sales channels, we must continue to scale and improve our processes and procedures to support these channels, including investment in systems and training. Many resellers may not be willing to invest the time and resources required to train their staff to effectively sell our platform. If we fail to maintain relationships with our referral partners and resellers, fail to develop relationships with new referral partners and resellers in new markets or expand the same in existing markets, or fail to manage, train, or provide appropriate incentives to our existing referral partners and resellers, our ability to increase the number of new paying customers and increase sales to existing paying customers could be adversely impacted, which would harm our business.\nOur ability to utilize our net operating loss carryforwards may be limited.\nAs of December 31, 2020, we had U.S. federal and state net operating loss carryforwards of approximately $28.0 million and $14.1 million, respectively. Our ability to utilize our federal net operating loss carryforwards may be limited under Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”). The limitations apply if we experience an “ownership change,” which is generally defined as a greater than 50 percentage point change (by value) in the ownership of our equity by certain stockholders over a rolling three-year period. Similar provisions of state tax law may also apply to limit the use of our state net operating loss carryforwards. Future changes in our stock ownership, which may be outside of our control, may trigger an ownership change and, consequently, the limitations under Section 382 of the Code. As a result, if or when we earn net taxable income, our ability to use our pre-change net operating loss carryforwards to offset such taxable income may be subject to limitations, which could adversely affect our future cash flows.\nWe could be required to collect additional sales and other similar taxes or be subject to other tax liabilities that may increase the costs our customers would have to pay for our subscriptions and adversely affect our operating results.\nSales and use, value-added, goods and services, and similar tax laws and rates are complicated and vary greatly by jurisdiction. There is significant uncertainty as to what constitutes sufficient nexus for a national, state or local jurisdiction to levy taxes, fees, and surcharges for sales made over the internet, as well as whether our subscriptions are subject to tax in various jurisdictions. Certain countries and the vast majority of states have considered or adopted laws that impose tax collection obligations on out-of-state companies. Additionally, in the United States, the Supreme Court of the United States recently ruled in South Dakota v. Wayfair, Inc. et. al. (“Wayfair”) that online sellers can be required to collect sales and use tax despite not having a physical presence in the buyer’s state. In response to the Wayfair case, or otherwise, national, states or local governments may enforce laws requiring us to calculate, collect, and remit taxes on sales in their jurisdictions. We have not always collected sales and other similar taxes in all jurisdictions in which we are required to. We may be obligated to collect and remit sales tax in jurisdictions in which we have not previously collected and remitted sales tax. We could also be subject to audits in states and non-U.S. jurisdictions for which we have not accrued tax liabilities. A successful assertion by one or more countries or states requiring us to collect taxes where we historically have not or presently do not do so could result in substantial tax liabilities, including taxes on past sales, as well as penalties and interest. The imposition by national, state or local governments of sales tax collection obligations on out-of-state sellers could also create additional administrative burdens for us and decrease our future sales, which could adversely affect our business and operating results.\nRisks Related to the Regulatory Framework that Governs Us\n64\nIf the use of cookies or other tracking technologies becomes subject to unfavorable legislation or regulation, is restricted by internet users or other third parties or is blocked or limited by users or by technical changes on end users’ devices, our ability to attract new customers and to develop and provide certain products could be diminished or eliminated.\nWe rely on small text files and other technologies, such as web beacons (collectively, “cookies”) which are placed on internet browsers to gather data regarding the content of a user’s web browsing activity. We use cookies to store users’ settings between sessions and to enable visitors to our website to use certain features, such as gaining access to secure areas of the website. We also use cookies, including cookies placed by third-party services with which we integrate, to enable us to gather statistics about our visitors’ use of our website and to allow our website visitors to connect our platform to their social networking sites, which enables us to advertise our products to them using retargeting methods. The availability of this data may be limited by numerous potential factors, including government legislation or regulation restricting the use of cookies for certain purposes, such as retargeting, browser limitations on the collection or use of cookies, or internet users deleting or blocking cookies on their web browsers or on our website.\nOur ability, like those of other technology companies, to collect, augment, analyze, use, and share information collected through the use of third-party cookies for online behavioral advertising is governed by U.S. and foreign laws and regulations which change from time to time, such as those regulating the level of consumer notice and consent required before a company can employ cookies to collect data about interactions with users online. In the United States, both state and federal legislation govern activities such as the collection and use of data, and privacy in the advertising technology industry has frequently been subject to review, and occasional enforcement, by the Federal Trade Commission, or the FTC, U.S. Congress, and individual states.\nAs our business is global, our activities are also subject to foreign legislation and regulation. In the EU, the EU Directive 2002/58/EC (as amended by Directive 2009/136/EC), commonly referred to as the e-Privacy Directive, and related implementing legislation in the EU and the UK requires that accessing or storing information on an internet user’s device, such as through a cookie, is allowed only if the internet user has been informed thereof, and provided prior unambiguous, specific, and informed consent for the placement of a cookie on a user’s device. A new e-Privacy Regulation is currently under discussion by EU member states to replace the e-Privacy Directive. Although it remains under debate, the proposed e-Privacy Regulation would amend rules on third-party cookies and significantly increase penalties for non-compliance. We cannot yet determine the impact such future laws, regulations, and standards may have on our use of third-party cookies. Additionally, the use of third-party cookies in the digital advertising ecosystem, particularly in the context of real-time bidding advertising auctions, is subject to increased regulatory scrutiny in the EU. Several European data protection authorities (including in Belgium, Ireland, UK, Poland, Spain, Luxembourg, and the Netherlands) have launched investigations or inquiries over Google’s and other AdTech companies’ practices concerning the collection and sharing of consumer data through cookies, the outcome of which is still uncertain. These investigations or inquiries could result in the imposition of more stringent standards around consent to place cookies or otherwise restrict the use of third-party cookies for online behavioral advertising. We have also received inquiries from, and engaged in correspondence with, European data protection authorities regarding our practices regarding cookies used on our websites, and the outcome of these inquiries is still uncertain.\nAdditionally, new and expanding “Do Not Track” regulations have recently been enacted or proposed that protect users’ right to choose whether or not to be tracked online. These regulations seek, among other things, to allow end users to have greater control over the use of private information collected online, to forbid the collection or use of online information, to demand a business to comply with their choice to opt out of such collection or use, and to place limits upon the disclosure of information to third-party websites.\n65\nContinued regulation of cookies, and changes in the interpretation and enforcement of existing laws, regulations, standards, and other obligations, as well as increased enforcement by industry groups or data protection authorities, could restrict our activities, such as efforts to understand users’ internet usage and engage in marketing activities, or require changes to our practices. Any inability to obtain information through cookies or to obtain it on the terms we anticipate, could cause a significant impact on the operation of our platform, impair our ability to target and attract new customers, and reduce our ability to predict our customers’ interests in or need for one or more of our products, any of which may cause a reduction in revenue or a reduction in revenue growth, negatively impact our ability to obtain new subscriptions and retain or grow the subscriptions of existing customers.\nAdditionally, cookies may easily be deleted or blocked by internet users. All of the most commonly used internet browsers (including Chrome, Firefox, Internet Explorer, and Safari) allow internet users to prevent cookies from being accepted by their browsers. Internet users can also delete cookies from their computers at any time. Some internet users also download “ad blocking” software that prevents cookies from being stored on a user’s device. If more internet users adopt these settings or delete their cookies more frequently than they currently do, our business could be harmed. In addition, the Safari and Firefox browsers block third-party cookies by default, and other browsers may do so in the future. Unless such default settings in browsers were altered by internet users to permit the placement of third-party cookies, fewer cookies would be available, which could adversely affect our business. In addition, companies such as Google LLC have publicly disclosed their intention to move away from cookies to another form of persistent unique identifier, or ID, to identify individual internet users or internet-connected devices in the bidding process on advertising exchanges. If companies do not use shared IDs across the entire ecosystem, this could have a negative impact on our ability obtain content consumption data.\nChanges in laws, regulations, and public perception concerning data protection and privacy, or changes in the interpretation or patterns of enforcement of existing laws and regulations, could impair our efforts to maintain and expand our customer base or the ability of our customers and users to use our platform and some or all of our products. Breaches of laws and regulations concerning data protection and privacy could expose us to significant fines and other penalties.\nWe hold personal data about a variety of individuals, such as our customers, users, employees, contractors, and business partners, and we use such personal data as needed to collect payment from our customers, communicate with and recommend products to our customers and prospective customers through our marketing and advertising efforts, and comply with legal obligations. Processing of personal data is increasingly subject to legislation and regulation in numerous jurisdictions around the world.\nFor example, relevant applicable laws and regulations governing the collection, use, disclosure or other processing of personal information include, in the United States, rules and regulations promulgated under the authority of the Federal Trade Commission, the California Consumer Privacy Act of 2018 (the “CCPA”), and state breach notification laws. In particular, in California, the CCPA was enacted in June 2018, became effective back on January 1, 2020 and became subject to enforcement by the California Attorney General’s office on July 1, 2020. The CCPA broadly defines personal information and provides an expansive meaning to activity considered to be a sale of personal information, and gives California residents expanded privacy rights and protections, including the right to opt out of the sale of personal information. The CCPA also provides for civil penalties for violations and a private right of action for data breaches. Moreover, a new privacy law that amends and expands the CCPA, the California Privacy Rights Act, or CPRA, was passed on November 3, 2020. The CPRA creates additional obligations relating to personal information that take effect on January 1, 2023 (with certain provisions having retroactive effect to January 1, 2022). The CPRA also establishes a new enforcement agency dedicated to consumer privacy. The CPRA’s implementing regulations are expected on or before July 1, 2022, and enforcement is scheduled to begin July 1, 2023. We will continue to monitor developments related to the CPRA and anticipate additional costs and expenses associated with CPRA compliance. In addition, since the enactment of CCPA, new privacy and data security laws have been proposed in more than half of the states in the United States and in the U.S. Congress, reflecting a trend toward more stringent privacy\n66\nlegislation in the United States, which trend may accelerate depending on the results of the 2020 U.S. presidential election. The effects of the CCPA, CPRA, and other similar state or federal laws, are potentially significant and may require us to modify our data processing practices and policies, and to incur substantial costs and potential liability in an effort to comply with such legislation.\nWe maintain offices in the EU (including Poland, the Czech Republic, and Cyprus) and we have customers in the EU and the UK. Accordingly, we are subject to the General Data Protection Regulation (EU) 2016/679 (the “GDPR”), and related member state implementing legislation, and to the UK’s Data Protection Act 2018 (collectively, “European Data Protection Law”). European Data Protection Law places obligations on controllers and processors of personal data, while establishing rights for individuals with respect to their personal data, including rights of access and deletion in certain circumstances. European Data Protection Law is also explicitly extraterritorial in its application, and could affect our business activities in jurisdictions outside the EU and the UK.\nWe have implemented measures designed to comply with the requirements of European Data Protection Law. In respect of these measures, we rely on positions and interpretations of the law (including European Data Protection Law) that have yet to be fully tested before the relevant courts and regulators. If a regulator or court of competent jurisdiction determined that one or more of our compliance efforts does not satisfy the applicable requirements of the law (including European Data Protection Law), or if any party brought a claim in this regard, we could be subject to governmental or regulatory investigations, enforcement actions, regulatory fines, compliance orders, litigation or public statements against us by consumer advocacy groups or others, any of which could cause customers to lose trust in us or otherwise damage our reputation. Likewise, a change in guidance could be costly and have an adverse effect on our business.\nThe requirements of European Data Protection Law pertaining to the licensing of data or obtaining such data from third parties are not entirely clear in all cases. It is possible that third parties may bring claims against us, alleging non-compliance with such requirements, and seeking damages, seeking to prevent us from using certain data, or seeking to prevent us from using data in particular ways. Such claims could potentially adversely affect our ability to provide our services and the current level of functionality of our platform in such circumstances, which could adversely affect our results of operations.\nEuropean Data Protection Law also imposes strict rules on the transfer of personal data out of the EU/UK to third countries deemed to lack adequate privacy protections (including the United States), unless an appropriate safeguard specified by the GDPR is implemented, such as the Standard Contractual Clauses (“SCCs”), approved by the European Commission, or a derogation applies. The Court of Justice of the EU (the “CJEU”), recently deemed that the SCCs are valid. However, the CJEU ruled that transfers made pursuant to the SCCs and other alternative transfer mechanisms need to be analyzed on a case-by-case basis to ensure EU standards of data protection are met in the jurisdiction where the data importer is based, and there continue to be concerns about whether the SCCs and other mechanisms will face additional challenges. EU regulators have announced that there will be further guidance issued on these topics, but such guidance has yet to be finalized. We rely on SCCs and certain derogations to transfer personal data from the EU and the UK to the United States and Russia. Until the remaining legal uncertainties regarding how to legally continue transfers pursuant to the SCCs and other mechanisms are settled, we will continue to face uncertainty as to whether our efforts to comply with our obligations under European Data Protection Law are sufficient. European or multi-national customers may refuse or be reluctant to use or continue to use our platform or products as a result of such developments until law makers and regulators in the EU and the United States have resolved the issues that instigated the decision of the CJEU noted above. This and other future developments regarding the flow of data across borders could increase the cost and complexity of delivering our platform and products in some markets and may lead to governmental enforcement actions, litigation, fines, and penalties or adverse publicity, which could have an adverse effect on our reputation and business.\n67\nThe relationship between the UK and the EU in relation to certain aspects of data protection law remains unclear. In addition, it is likely that documentation will need to be put in place between UK entities and entities in EU member states to ensure adequate safeguards are in place for data transfers, which may result in us incurring additional costs with respect to transfers of personal data between the EU and the UK. We may find it necessary or advantageous to join industry bodies, or self-regulatory organizations, that impose stricter compliance requirements than those set out in applicable laws, including European Data Protection Laws. We may also be bound by contractual restrictions that prevent us from participating in data processing activities that would otherwise be permissible under applicable laws, including European Data Protection Laws. Such strategic choices may impact our ability to exploit data and may have an adverse impact on our business.\nAs we maintain offices in Russia, we face particular privacy, data security, and data protection risks in connection with requirements of Russia’s data protection and security laws, including Federal Law of 21 July 2014 No. 242-FZ, which entered into effect September 1, 2015, Federal Law of 27 July 2006 No. 152-FZ (as amended) and Federal Law of 27 July 2006 No. 149-FZ (as amended). Among other stringent requirements, these laws require ensuring that certain operations on personal data of Russian citizens are conducted in database(s) located in Russia.\nWe expect that there will continue to be new proposed laws, regulations, and industry standards concerning privacy, data protection, and information security in the United States, the EU, and other jurisdictions, and we cannot yet determine the impact such future laws, regulations, and standards may have on our business.\nThese and other legal requirements could require us to make additional changes to our platform or products in order for us or our customers to comply with such legal requirements or reduce our ability to lawfully collect personal data used in our platform and products. These changes could reduce demand for our platform or products, require us to take on more onerous obligations in our contracts, restrict our ability to store, transfer, and process personal data or, in some cases, impact our ability or our customers’ ability to offer our products in certain locations, to deploy our solutions, to reach current and prospective customers, or to derive insights from data globally.\nThe costs of complying with existing or new data privacy or data protection laws and regulations, regulatory guidance, our privacy policies and contractual obligations to customers, users, or other third parties, may limit the use and adoption of our platform and products, reduce overall demand for our products, make it more difficult for us to meet expectations from or commitments to customers and users, lead to significant fines, penalties, or liabilities for noncompliance, impact our reputation, or slow the pace at which we close sales transactions, any of which could harm our business.\nFurthermore, the uncertain and shifting regulatory environment and trust climate may cause concerns regarding data privacy and may cause our vendors, customers and users to resist providing the data necessary to allow us to offer our platform and products to our customers and users effectively, or could prompt individuals to opt out of our collection of their personal data. Even the perception that the privacy of personal data is not satisfactorily protected or does not meet regulatory requirements could discourage prospective customers from subscribing to our products or discourage current customers from renewing their subscriptions.\nCompliance with any of the foregoing laws and regulations can be costly and can delay or impede the development of new products. We may incur substantial fines if we violate any laws or regulations relating to the collection or use of personal data. For example, the GDPR imposes sanctions for violations up to the greater of €20 million and 4% of worldwide gross annual revenue, enables individuals to claim damages resulting from infringement of the GDPR and introduces the right for non-profit organizations to bring claims on behalf of data subjects. CCPA allows for fines of up to $7,500 for each violation (affected individual) that a business does not cure within 30 days of receiving notice of the violation. Non-compliance with Russian data localization rules may result in imposition of an administrative fine of up to\n68\nRUB 18 million, or approximately $240,000, for each violation. Our actual or alleged failure to comply with applicable privacy or data security laws, regulations, and policies, or to protect personal data, could result in enforcement actions and significant penalties against us, which could result in negative publicity or costs, subject us to claims or other remedies, and have a material adverse effect on our business, financial condition, and results of operations.\nMany aspects of data protection and privacy laws are relatively new and their scope has not been tested in the courts. As a result, these laws and regulations are subject to differing interpretations and may be inconsistent among jurisdictions. It is possible that these laws and regulations may be interpreted and applied in a manner that is inconsistent with our interpretations and existing data management practices or the features of our products. Certain of our activities could be found by a court, government or regulatory authority to be noncompliant or become noncompliant in the future with one or more data protection or data privacy laws, even if we have implemented and maintained a strategy that we believe to be compliant. Further, we may be subject to additional risks associated with data security breaches or other incidents, in particular because certain data privacy laws, including the GDPR and CCPA, grant individuals a private right of action arising from certain data security incidents. If so, in addition to the possibility of fines, lawsuits, and other claims and penalties, we could be required to fundamentally change our business activities and practices or modify our products, which could harm our business.\nWe also receive personal data from third-party vendors (e.g., data brokers). We may not be able to verify with complete certainty the source of such data, how it was collected, and that such data was collected and is being shared with us in compliance with all applicable data protection and privacy laws. Our use of personal data obtained from third-party vendors could result in potential regulatory investigations, fines, penalties, compliance orders, liability, litigation, and remediation costs, as well as reputational harm, any of which could materially adversely affect our business and financial results. The requirements of European Data Protection Law pertaining to the licensing of data or obtaining such data from third parties are not entirely clear in all cases. It is possible that third parties may bring claims against us, alleging non-compliance with such requirements, and seeking damages, seeking to prevent us from using certain data, or seeking to prevent us from using data in particular ways. Such claims could potentially adversely affect our ability to provide our services and the current level of functionality of our platform in such circumstances, which could adversely affect our results of operations.\nChanges in legislation or requirements related to automatically renewing subscription plans, or our failure to comply with existing or future regulations, may adversely impact our business.\nOur business relies heavily on the fact that customers enter subscription contracts where they agree that the subscription will automatically renew for a new term, and their credit or debit cards will automatically be charged on an ongoing basis, unless the subscription is canceled by the customer. Some states have passed or considered legislation limiting the duration for which subscriptions can automatically renew, if at all.\nAlthough this enacted and proposed legislation generally would not affect companies that sell subscriptions to other companies, like ours does, there could be variances and inconsistencies in these rules or requirements among jurisdictions that expose us to compliance risks that would have a material adverse effect on our business operations and financial condition, and could result in fines, penalties, damages, civil liability, and higher transaction fees. In addition, any costs that result from future legislation and regulations, or from changes in the interpretation of existing legislation and regulations, could individually or in the aggregate cause us to change or limit our business practices, which may make our subscription business model less attractive.\nChanges in laws and regulations related to the internet or changes in the internet infrastructure itself may diminish the demand for our platform and could harm our business.\n69\nThe future success of our business depends upon the continued use of the internet as a primary medium for commerce, communication, and business applications. Federal, state, or foreign governmental bodies or agencies have in the past adopted, and may in the future adopt, laws or regulations affecting the use of the internet as a commercial medium. The adoption of any laws or regulations that could reduce the growth or use of the internet, including laws or practices limiting internet neutrality, could decrease the demand for, or the usage of, our platform and products, increase our cost of doing business, require us to modify our platform or financial systems, and may harm our results of operations. In addition, government agencies or private organizations have imposed and may impose additional taxes, fees, or other charges for accessing the internet or commerce conducted via the internet, which could limit the growth of internet-related commerce or communications generally, result in higher prices for our products and platform, or result in reduced demand for internet-based products such as ours.\nAs the internet continues to experience growth in the number of users, frequency of use, and amount of data transmitted, the internet infrastructure that we and our customers rely on may be unable to support the demands placed upon it. In addition, there could be adverse effects from delays in the development or adoption of new standards and protocols to handle increased demands of internet activity, security, reliability, cost, ease-of-use, accessibility, and quality of service. Further, our platform depends on the quality of our customers’ access to the internet. The failure of the internet infrastructure that we or our customers rely on, even for a short period of time, could undermine our operations and harm our results of operations.\nInternet access is frequently provided by companies that have significant market power that could take actions that degrade, disrupt, or increase the cost of customer access to our platform, any of which would negatively impact our business. On June 11, 2018, the repeal of the Federal Communications Commission’s, or the FCC, “net neutrality” rules took effect and returned to a “light-touch” regulatory framework. The prior rules were designed to ensure that all online content is treated the same by internet service providers and other companies that provide broadband services. Additionally, on September 30, 2018, California enacted the California internet Consumer Protection and Net Neutrality Act of 2018, making California the fourth state to enact a state-level net neutrality law since the FCC repealed its nationwide regulations, mandating that all broadband services in California must be provided in accordance with state net neutrality requirements. The U.S. Department of Justice has sued to block the law going into effect, and California has agreed to delay enforcement until the resolution of the FCC’s repeal of the federal rules. A number of other states are considering legislation or executive actions that would regulate the conduct of broadband providers. We cannot predict whether the FCC order or state initiatives will be modified, overturned, or vacated by legal action of the court, federal legislation or the FCC. With the repeal of net neutrality rules, network operators may choose to implement usage-based pricing, discount pricing charged to providers of competitive products, otherwise materially change their pricing rates or schemes, charge us to deliver our traffic or throttle its delivery, implement bandwidth caps or other usage restrictions or otherwise try to monetize or control access to their networks, any of which could increase our costs, or those of our customers in accessing our platform, and negatively impact our business and results of operations.\nFederal, state, and foreign laws regulate internet tracking software, the sending of commercial emails and text messages, and other activities, which could impact the use of our platform and products, and potentially subject us to regulatory enforcement or private litigation.\nWe are subject to laws and regulations that govern sending marketing and advertising by electronic means, such email and telephone. For example, in the United States, the Controlling the Assault of Non-Solicited Pornography and Marketing Act of 2003, or the CAN-SPAM Act, among other things, obligates the sender of commercial emails to provide recipients with the ability to opt out of receiving future commercial emails from the sender. In addition, the Telephone Consumer Protection Act imposes certain notice, consent, and opt-out obligations on companies that send telephone or text communications using auto dialers to consumers, and provides consumers with private rights of action for violations. Further,\n70\ncertain states and foreign jurisdictions, such as Australia, Canada, and the EU, have enacted laws that prohibit sending unsolicited marketing emails unless the recipient has provided its prior consent to receipt of such email, or in other words has “opted-in” to receiving it. A requirement that recipients opt into, or the ability of recipients to opt out of, receiving commercial emails may minimize the effectiveness of our marketing, which could adversely affect our ability to attract new customers or entice existing customers to upgrade their subscriptions.\nWe are subject to U.S. economic sanctions, export control and anti-corruption laws, and regulations that could impair our ability to compete in international markets or subject us to liability if we violate such laws and regulations.\nWe are subject to U.S. economic sanctions, export control and anti-corruption laws, and regulations that prohibit the provision of certain products and services to certain countries, governments, and persons targeted by U.S. sanctions. We are in the process of implementing certain precautions to prevent our platform and products from being exported or accessed in violation of U.S. export controls or U.S. sanctions laws and regulations. However, we cannot be certain that the precautions we take will prevent all violations of these laws.\nWe have previously identified, and may continue to identify, customer accounts for our platform and products that may originate from, or are intended to benefit, persons in countries that are subject to U.S. embargoes, including transactions or events in or relating to Cuba, Iran, North Korea, Syria, and the Crimea region of Ukraine. We have recently submitted a voluntary self-disclosure to the U.S. Department of the Treasury’s Office of Foreign Assets Control, or OFAC, regarding potential violations of OFAC regulations that may have involved the provision of services to customers in sanctioned countries. We have not yet obtained a determination from OFAC.\nIf we are found to be in violation of U.S. sanctions or export control laws, we may be fined or other penalties could be imposed. Furthermore, changes in export control or economic sanctions laws and enforcement could also result in increased compliance requirements and related costs, which could materially adversely affect our business, results of operations, financial condition and/or cash flows.\nWe are also subject to various U.S. and international anti-corruption laws, such as the U.S. Foreign Corrupt Practices Act and the UK Bribery Act, as well as other similar anti-bribery and anti-kickback laws and regulations. These laws and regulations generally prohibit companies and their employees and intermediaries from authorizing, offering, or providing improper payments or benefits to government officials and other recipients for improper purposes. Our exposure for violating these laws may increase as we continue to expand our international presence, and any failure to comply with such laws could harm our business.\nOur internal controls over financial reporting currently do not meet all of the standards contemplated by Section 404 of the Sarbanes-Oxley Act of 2002, as amended (“SOX”), and failure to achieve and maintain effective internal controls over financial reporting in accordance with Section 404 of SOX could impair our ability to produce timely and accurate financial statements or comply with applicable regulations and have a material adverse effect on our business. In the future, our disclosure controls and procedures may not prevent or detect all errors or acts of fraud.\nAs a public company, we are subject to certain reporting requirements of the Exchange Act and have significant requirements for enhanced financial reporting and internal controls. Our disclosure controls and procedures are designed to reasonably assure that information required to be disclosed by us in reports we file or submit under the Exchange Act is accumulated and communicated to management, recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the SEC. The process of designing and implementing effective internal controls is a continuous effort that requires us to anticipate and react to changes in our business and the economic and regulatory environments, and to expend significant resources to maintain a system of internal controls that is\n71\nadequate to satisfy our reporting obligations as a public company. If we are unable to establish or maintain appropriate internal financial reporting controls and procedures, it could cause us to fail to meet our reporting obligations on a timely basis, result in material misstatements in our consolidated financial statements, and harm our operating results. We believe that any disclosure controls and procedures or internal controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by an unauthorized override of the controls. Accordingly, because of the inherent limitations in our control system, misstatements or insufficient disclosures due to error or fraud may occur and not be detected.\nIn addition, we are required pursuant to Section 404 of SOX, to furnish a report by management on, among other things, the effectiveness of our internal control over financial reporting in the Annual Report on Form 10-K for the year ended December 31, 2022. This assessment will need to include disclosure of any material weaknesses identified by our management in our internal control over financial reporting. The rules governing the standards that must be met for our management to assess our internal control over financial reporting are complex and require significant documentation, testing, and possible remediation. Testing and maintaining internal controls may divert management’s attention from other matters that are important to our business. Beginning with our Annual Report on Form 10-K for the year ended December 31, 2022, our independent registered public accounting firm may be required to attest to the effectiveness of our internal control over financial reporting on an annual basis. However, while we remain an emerging growth company, our independent registered public accounting firm will not be required to attest to the effectiveness of our internal control over financial reporting. If we are not able to complete our initial assessment of our internal controls and otherwise implement the requirements of Section 404 of SOX in a timely manner or with adequate compliance, our independent registered public accounting firm may not be able to certify as to the adequacy of our internal controls over financial reporting. Additionally, when required, an independent assessment of the effectiveness of our internal controls over financial reporting could detect problems that our management’s assessment might not. Undetected material weaknesses in our internal controls over financial reporting could lead to financial statement restatements and require us to incur the expense of remediation.\nMatters impacting our internal controls may cause us to be unable to report our financial information on a timely basis and thereby subject us to adverse regulatory consequences, including sanctions by the SEC or violations of applicable stock exchange listing rules, which may result in a breach of the covenants under existing or future financing arrangements. There also could be a negative reaction in the financial markets due to a loss of investor confidence in us and the reliability of our financial statements. Confidence in the reliability of our financial statements also could suffer if we or our independent registered public accounting firm report a material weakness in our internal controls over financial reporting. This could materially adversely affect us and lead to a decline in the market price of our Class A common stock.\nIn connection with the audit of our consolidated financial statements for the year ended December 31, 2019, we and our independent registered public accounting firm identified a material weakness in our internal control over financial reporting related to deficiencies in our controls over the financial statement close process. Specifically, there were deficiencies in the design and operations of internal controls over the identification and review of complex accounting issues involving significant judgment or estimates with respect to certain prior period transactions.\nWe have implemented, and are continuing to implement, measures designed to improve our internal control over financial reporting to remediate this material weakness. These measures include formalizing our processes and internal control documentation, strengthening supervisory reviews by our financial management, hiring additional qualified accounting and finance personnel, and engaging financial consultants to enable the implementation of internal control over financial reporting.\n72\nWe expect to incur additional costs to remediate the control deficiencies identified, though there can be no assurance that our efforts will be successful or avoid potential future material weaknesses. If we are unable to successfully remediate our existing or any future material weaknesses in our internal control over financial reporting, or if we identify any additional material weaknesses, the accuracy and timing of our financial reporting may be adversely affected, we may be unable to maintain compliance with securities law requirements regarding timely filing of periodic reports in addition to applicable stock exchange listing requirements, investors may lose confidence in our financial reporting, and our stock price may decline as a result. We also could become subject to investigations by the New York Stock Exchange (“NYSE”), the SEC or other regulatory authorities.\nOur internal resources and personnel may in the future be insufficient to avoid accounting errors and there can be no assurance that we will not have additional material weaknesses in the future. Any failure to develop or maintain effective controls or any difficulties encountered implementing required new or improved controls could harm our operating results or cause us to fail to meet our reporting obligations and may result in a restatement of our financial statements for prior periods. Any failure to implement and maintain effective internal control over financial reporting also could adversely affect the results of periodic management evaluations and annual independent registered public accounting firm attestation reports regarding the effectiveness of our internal control over financial reporting that we will eventually be required to include in our periodic reports that will be filed with the SEC. Ineffective disclosure controls, procedures, and internal control over financial reporting could also cause investors to lose confidence in our reported financial and other information, which would likely have a negative effect on the trading price of our common stock. In addition, if we are unable to continue to meet these requirements, we may not be able to remain listed on the NYSE.\nUnanticipated changes in our effective tax rate and additional tax liabilities may impact our financial results.\nWe are subject to income taxes in the United States and various jurisdictions outside of the United States. Our income tax obligations are generally determined based on our business operations in these jurisdictions. Significant judgment is often required in the determination of our worldwide provision for income taxes. Our effective tax rate could be impacted by changes in the earnings and losses in countries with differing statutory tax rates, changes in non-deductible expenses, changes in excess tax benefits of stock-based compensation, changes in the valuation of deferred tax assets and liabilities and our ability to utilize them, the applicability of withholding taxes, effects from acquisitions, changes in accounting principles and tax laws in jurisdictions where we operate. Any changes, ambiguity, or uncertainty in taxing jurisdictions’ administrative interpretations, decisions, policies, and positions could also materially impact our income tax liabilities.\nAs our business continues to grow and if we become more profitable, we anticipate that our income tax obligations could significantly increase. If our existing tax credits and net operating loss carry-forwards become fully utilized, we may be unable to offset or otherwise mitigate our tax obligations to the same extent as in prior years. This could have a material impact to our future cash flows or operating results.\nIn addition, recent global tax developments applicable to multinational companies, including certain approaches of addressing taxation of digital economy recently proposed or enacted by the Organisation for Economic Co-operation and Development, the European Commission or certain major jurisdictions where we operate or might in the future operate, might have a material impact to our business and future cash flow from operating activities, or future financial results. We are also subject to tax examinations in multiple jurisdictions. While we regularly evaluate new information that may change our judgment resulting in recognition, derecognition, or changes in measurement of a tax position taken, there can be no assurance that the final determination of any examinations will not have an adverse effect on our operating results and financial position. In addition, our operations may change, which may impact our tax liabilities. As our brand becomes increasingly recognizable both domestically and internationally, our tax\n73\nplanning structure and corresponding profile may be subject to increased scrutiny, and if we are perceived negatively, we may experience brand or reputational harm.\nWe may also be subject to additional tax liabilities and penalties due to changes in non-income based taxes resulting from changes in federal, state, or international tax laws, changes in taxing jurisdictions’ administrative interpretations, decisions, policies and positions, results of tax examinations, settlements or judicial decisions, changes in accounting principles, and changes to the business operations, including acquisitions, as well as the evaluation of new information that results in a change to a tax position taken in a prior period. Any resulting increase in our tax obligation or cash taxes paid could adversely affect our cash flows and financial results.\nOur international operations may subject us to greater than anticipated tax liabilities.\nWe are expanding our international operations to better support our growth into international markets. Our corporate structure and associated transfer pricing policies contemplate future growth in international markets, and consider the functions, risks, and assets of the various entities involved in intercompany transactions. The amount of taxes we pay in different jurisdictions may depend on the application of the tax laws of various jurisdictions, including the United States, to our international business activities, changes in tax rates, new or revised tax laws or interpretations of existing tax laws and policies, and our ability to operate our business in a manner consistent with our corporate structure and intercompany arrangements. The taxing authorities of the jurisdictions in which we operate may challenge our methodologies for pricing intercompany transactions pursuant to our intercompany arrangements or disagree with our determinations as to the income and expenses attributable to specific jurisdictions. If such a challenge or disagreement were to occur, and our position was not sustained, we could be required to pay additional taxes, interest, and penalties, which could result in one-time tax charges, higher effective tax rates, reduced cash flows, and lower overall profitability of our operations and we may be required to revise our intercompany agreements. Our financial statements could fail to reflect adequate reserves to cover such a contingency.\nRisks Related to Our Intellectual Property\nWe may not be able to adequately protect our proprietary and intellectual property rights in our data or technology.\nOur success is dependent, in part, upon protecting our proprietary information and technology. Our intellectual property portfolio primarily consists of registered and unregistered trademarks, unregistered copyrights, domain names, know-how, and trade secrets. We may be unsuccessful in adequately protecting our intellectual property. No assurance can be given that confidentiality, non-disclosure, or invention or copyright assignment agreements with employees, consultants, partners or other parties have been entered into, will not be breached, or will otherwise be effective in establishing our rights in intellectual property and in controlling access to and distribution of our platform, or certain aspects of our platform, and proprietary information. Further, these agreements do not prevent our competitors from independently developing technologies that are substantially equivalent or superior to our platform. Additionally, certain unauthorized use of our intellectual property may go undetected, or we may face legal or practical barriers to enforcing our legal rights even where unauthorized use is detected.\nCurrent laws may not provide for adequate protection of our platform or data, especially in foreign jurisdictions which may have laws that provide insufficient protections to companies. In addition, legal standards relating to the validity, enforceability, and scope of protection of proprietary rights in internet-related businesses are uncertain and evolving, and changes in these standards may adversely impact the viability or value of our proprietary rights. Some license provisions protecting against unauthorized use, copying, transfer, and disclosure of our products, or certain aspects of our platform, or our data may be unenforceable under the laws of certain jurisdictions. Further, the laws of some countries do not protect\n74\nproprietary rights to the same extent as the laws of the United States, and the laws and mechanisms for protection and enforcement of intellectual property rights in some foreign countries may be inadequate. As we continue to operate in foreign countries and expand our international activities, we have encountered and may in the future encounter challenges in navigating the laws of foreign countries, which may adversely affect our ability to protect our proprietary rights and subject us to claims from current or former personnel and other third parties. Moreover, our exposure to unauthorized copying of certain aspects of our platform, or our data may increase. Further, competitors, foreign governments, foreign government-backed actors, criminals, or other third parties may gain unauthorized access to our proprietary information and technology. Accordingly, despite our efforts, we may be unable to prevent third parties from infringing upon or misappropriating our technology and intellectual property or claiming that we infringe upon or misappropriate their technology and intellectual property.\nTo protect our intellectual property rights, we may be required to spend significant resources to monitor, protect, and defend these rights, and we may or may not be able to detect infringement by our customers or third parties. Litigation has been and may be necessary in the future to enforce our intellectual property rights and to protect our trade secrets. Such litigation could be costly, time consuming, and distracting to management and could result in the impairment or loss of portions of our intellectual property. Furthermore, our efforts to enforce our intellectual property rights may be met with defenses, counterclaims, and countersuits attacking the validity and enforceability of our intellectual property rights. Our inability to protect our proprietary technology against unauthorized copying or use, as well as any costly litigation or diversion of our management’s attention and resources, could delay further sales or the implementation of our platform, impair the functionality of our platform, delay introductions of new features, integrations, and capabilities, result in our substituting inferior or more costly technologies into our platform, or injure our reputation. In addition, we may be required to license additional technology from third parties to develop and market new features, integrations, and capabilities, and we cannot be certain that we could license that technology on commercially reasonable terms or at all, and our inability to license this technology could harm our ability to compete.\nIf third parties claim that we infringe upon or otherwise violate their intellectual property rights, our business could be adversely affected.\nWe have in the past and may in the future be subject to claims that we have infringed or otherwise violated third parties’ intellectual property rights. There is patent, copyright, and other intellectual property development and enforcement activity in our industry and relating to the technology we use in our business. Our future success depends in part on not infringing upon or otherwise violating the intellectual property rights of others. From time to time, our competitors or other third parties (including non-practicing entities and patent holding companies) may claim that we are infringing upon or otherwise violating their intellectual property rights, and we may be found to be infringing upon or otherwise violating such rights. In addition, we do not own any issued, nor do we have any pending patents, which limits our ability to deter patent infringement claims by competitors and other third parties who hold patents. We may be unaware of the intellectual property rights of others that may cover some or all of our current or future technology or conflict with our rights, and the patent, copyright, and other intellectual property rights of others may limit our ability to improve our technology and compete effectively. Any claims of intellectual property infringement or other intellectual property violations, even those without merit, could:\n•be expensive and time consuming to defend;\n•cause us to cease making, licensing or using our platform or products that incorporate the challenged intellectual property;\n•require us to modify, redesign, reengineer or rebrand our platform or products, if feasible;\n•divert management’s attention and resources; or\n75\n•require us to enter into royalty or licensing agreements to obtain the right to use a third-party’s intellectual property.\nAny royalty or licensing agreements, if required, may not be available to us on acceptable terms or at all. A successful claim of infringement against us could result in our being required to pay significant damages, enter into costly settlement agreements, or prevent us from offering our platform or products, any of which could have a negative impact on our operating profits and harm our future prospects. We may also be obligated to indemnify our customers or business partners in connection with any such litigation and to obtain licenses, modify our platform or products, or refund premium subscription fees, which could further exhaust our resources. Such disputes could also disrupt our platform or products, adversely affecting our customer satisfaction and ability to attract customers.\nOur use of “open source” software could negatively affect our ability to offer and sell access to our platform and products, and subject us to possible litigation.\nWe use open source software in our platform and products, and expect to continue to use open source software in the future. There are uncertainties regarding the proper interpretation of and compliance with open source licenses, and there is a risk that such licenses could be construed in a manner that imposes unanticipated conditions or restrictions on our ability to use such open source software, and consequently to provide or distribute our platform and products. Although use of open source software has historically been free, recently several open source providers have begun to charge license fees for use of their software. If our current open source providers were to begin to charge for these licenses or increase their license fees significantly, we would have to choose between paying such license fees or incurring the expense to replace the open source software with other software or with our own software, which would increase our research and development costs, and have a negative impact on our results of operations and financial condition.\nAdditionally, we may from time to time face claims from third parties claiming ownership of, or seeking to enforce the terms of, an open source license, including by demanding release of source code for the open source software, derivative works or our proprietary source code that was developed using or that is distributed with such open source software. These claims could also result in litigation and could require us to make our proprietary software source code freely available, require us to devote additional research and development resources to change our platform or incur additional costs and expenses, any of which could result in reputational harm and would have a negative effect on our business and operating results. In addition, if the license terms for the open source software we utilize change, we may be forced to reengineer our platform or incur additional costs to comply with the changed license terms or to replace the affected open source software. Further, use of certain open source software can lead to greater risks than use of third-party commercial software, as open source licensors generally do not provide warranties or controls on the origin of software or indemnification for third-party infringement claims. Although we have implemented policies to regulate the use and incorporation of open source software into our platform and products, we cannot be certain that we have not incorporated open source software in our platform and products in a manner that is inconsistent with such policies.\nIndemnity provisions in various agreements potentially expose us to substantial liability for intellectual property infringement and other losses.\nOur agreements with resellers and other third parties may include indemnification or other provisions under which we agree to indemnify or otherwise be liable to them for losses suffered or incurred as a result of claims of intellectual property infringement, damages caused by us to property or persons, or other liabilities relating to or arising from our platform, products or other acts or omissions. For some of our larger customers, we sometimes negotiate similar indemnification provisions or indemnification for breaches of our obligations, representations or warranties in the subscription agreement, gross negligence or willful misconduct, breaches of confidentiality, losses related to security incidents, breach of the data processing addendum or violations of applicable law. In some instances, the term of these\n76\ncontractual provisions survives the termination or expiration of the applicable agreement. Large indemnity payments or damage claims from contractual breach could harm our business, operating results, and financial condition.\nFrom time to time, third parties may assert infringement claims against our customers or resellers. These claims may require us to initiate or defend protracted and costly litigation on behalf of customers and resellers, regardless of the merits of these claims. If any of these claims succeed, we may be forced to pay damages on behalf of our customers and resellers or may be required to obtain licenses for the platform or products they use or resell or modify our platform or products. We may not be able to obtain all necessary licenses on commercially reasonable terms, or at all, or to make such modifications to avoid a claim, in which case our customers and resellers may be required to stop using or reselling our platform or products. Further, customers may require us to indemnify or otherwise be liable to them for breach of confidentiality or failure to implement adequate security measures with respect to their data stored, transmitted or processed by our employees or platform. Although we normally contractually limit our liability with respect to such obligations, we may still incur substantial liability related to them. Any dispute with a customer with respect to such obligations could have adverse effects on our relationship with that customer and other current and prospective customers, reduce demand for our platform or products, and harm our revenue, business, and operating results.\nRisks Related to Ownership of Our Class A Common Stock\nWe are an emerging growth company and we cannot be certain that the reduced disclosure requirements applicable to emerging growth companies will not make our Class A common stock less attractive to investors.\nWe are an “emerging growth company” as defined in the Jumpstart Our Business Startups Act, or the JOBS Act. Under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards until such time as those standards apply to private companies. We have elected to use this extended transition period for complying with new or revised accounting standards that have different effective dates for public and private companies until the earlier of the date we (i) are no longer an emerging growth company or (ii) affirmatively and irrevocably opt out of the extended transition period provided in the JOBS Act. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates.\nFor as long as we continue to be an emerging growth company, we also intend to take advantage of certain other exemptions from various reporting requirements that are applicable to other public companies including, but not limited to, reduced disclosure obligations regarding executive compensation in our periodic reports, proxy statements, and registration statements, and exemptions from the requirements of holding a non-binding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. We cannot predict if investors will find our Class A common stock less attractive because we will rely on these exemptions. If some investors find our Class A common stock less attractive as a result, there may be a less active trading market for our Class A common stock and our stock price may be more volatile.\nWe will remain an emerging growth company until the earliest of (i) the last day of the year in which we have total annual gross revenue of $1.07 billion or more, (ii) December 31, 2026, (iii) the date on which we have issued more than $1.0 billion in nonconvertible debt during the previous three years, or (iv) the date on which we are deemed to be a large accelerated filer under the rules of the SEC.\n77\nWe are subject to costs, regulations and requirements as a result of being a public company, which could impair our profitability, make it more difficult to run our business, or divert management’s attention from our business.\nAs a public company, and particularly after we are no longer an emerging growth company, we are required to commit significant resources, management time, and attention to the requirements of being a public company, which causes us to incur significant legal, accounting, and other expenses, including costs associated with public company reporting requirements, and recruiting and retaining independent directors. We also have incurred and will continue to incur costs associated with SOX and the Dodd-Frank Wall Street Reform and Consumer Protection Act and related rules implemented by the SEC and the NYSE, and compliance with these requirements will place significant demands on our legal, accounting, and finance staff and on our accounting, financial, and information systems. The expenses incurred by public companies generally for reporting and corporate governance purposes have been increasing. These rules and regulations may increase our legal and financial compliance costs and to make some activities more time-consuming and costly, although we are currently unable to estimate these costs with any degree of certainty. In addition, we might not be successful in implementing these requirements. These laws and regulations also could make it more difficult or costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. These laws and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors (the “Board”) or Board committees or as our executive officers. Furthermore, if we are unable to continue to satisfy our obligations as a public company, we could be subject to delisting of our Class A common stock, fines, sanctions, and other regulatory action and potentially civil litigation.\nAn active public market for our Class A common stock may not be sustained and could be highly volatile, and you may not be able to resell your shares at or above your original purchase price, if at all.\nWe have a limited trading history. The market price of our Class A common stock could be highly volatile and may fluctuate substantially as a result of many factors, including:\n•actual or anticipated fluctuations in our results of operations;\n•variance in our results of operation from the expectations of market analysts;\n•announcements by us or our competitors of significant business developments, changes in service provider relationships, acquisitions or expansion plans;\n•changes in the prices of our products;\n•our involvement in litigation;\n•our sale of Class A common stock or other securities in the future;\n•market conditions in our industry;\n•changes in key personnel;\n•the trading volume of our Class A common stock;\n•changes in the estimation of the future size and growth rate of our markets; and\n•general economic and market conditions.\n78\nIn addition, the stock markets have experienced extreme price and volume fluctuations. Broad market and industry factors may materially harm the market price of our Class A common stock, regardless of our results of operation. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted against that company. If we were involved in any similar litigation we could incur substantial costs, and our management’s attention and resources could be diverted.\nIf you purchase shares of our Class A common stock, you may not be able to resell those shares at or above the price you originally paid. An active or liquid market in our Class A common stock may not be sustainable, which could adversely affect your ability to sell your shares and could depress the market price of our Class A common stock.\nThe issuance of additional stock in connection with financings, acquisitions, investments, our stock incentive plans or otherwise will dilute all other stockholders.\nOur amended and restated certificate of incorporation authorizes us to issue up to 1,000,000,000 shares of Class A common stock and up to 100,000,000 shares of preferred stock with such rights and preferences as may be determined by our Board. Subject to compliance with applicable rules and regulations, we may issue our shares of Class A common stock or securities convertible into our Class A common stock from time to time in connection with a financing, acquisition, investment, our stock incentive plans or otherwise. Any such issuance could result in substantial dilution to our existing stockholders and cause the trading price of our Class A common stock to decline.\nA total of 124,905,954, or approximately 93%, of the outstanding shares of our Class A and Class B common stock are restricted from immediate resale, but may be sold on a stock exchange in the near future. The large number of shares eligible for public sale or subject to rights requiring us to register them for public sale could depress the market price of our Class A common stock.\nThe market price of our Class A common stock could decline as a result of sales of a large number of shares of our Class A common stock in the market, and the perception that these sales could occur may also depress the market price of our Class A common stock. We, our executive officers, directors, and the holders of substantially all of our capital stock and securities convertible into or exchangeable for our capital stock outstanding prior to our IPO have entered into lock-up agreements with the underwriters under which they have agreed, subject to specific exceptions and early release triggers, not to sell any of our stock for 180 days following March 24, 2021. Following the expiration of this period and subject to applicable securities laws, such shares may be sold on the public market.\nStockholders owning an aggregate of up to 36,750,000 shares of our Class B common stock are entitled, under contracts providing for registration rights, to require us to register shares owned by them for public sale in the United States. In addition, we filed a registration statement on Form S-8 on March 25, 2021, to register 24,114,926 shares of our Class A common stock under our equity compensation plans.\nSales of our shares as restrictions end or pursuant to registration rights may make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate. These sales also could cause the trading price of our Class A common stock to fall and make it more difficult for you to sell shares of our Class A common stock.\nIf we do not meet the expectations of equity research analysts, if they do not publish research or reports about our business or if they issue unfavorable commentary or downgrade our Class A common stock, the price of our Class A common stock could decline.\nThe trading market for our Class A common stock will depend in part on the research and reports that equity research analysts publish about us and our business. The analysts’ estimates are based upon their\n79\nown opinions and are often different from our estimates or expectations. If our results of operations are below the estimates or expectations of public market analysts and investors, our stock price could decline. Moreover, the price of our Class A common stock could decline if one or more securities analysts downgrade our Class A common stock or if those analysts issue other unfavorable commentary or cease publishing reports about us or our business.\nWe cannot predict the impact our dual structure may have on the market price of our Class A common stock.\nWe cannot predict whether our dual class structure, combined with the concentrated control of our stockholders who held our capital stock prior to the completion of our IPO, including our executive officers, employees, and directors and their affiliates, will result in a lower or more volatile market price of our Class A common stock or in adverse publicity or other adverse consequences. For example, certain index providers have announced restrictions on including companies with multiple class share structures in certain of their indices. In July 2017, FTSE Russell and Standard & Poor’s announced that they would cease to allow most newly public companies utilizing dual or multi-class capital structures to be included in their indices. Under the announced policies, our dual class capital structure would make us ineligible for inclusion in any of these indices. Given the sustained flow of investment funds into passive strategies that seek to track certain indexes, exclusion from stock indexes would likely preclude investment by many of these funds and could make our Class A common stock less attractive to other investors. As a result, the market price of our Class A common stock could be adversely affected.\nThe dual class structure of our common stock has the effect of concentrating voting control with those stockholders who held our capital stock prior to the completion of our IPO, including our directors, executive officers, and their affiliates, who as of March 31, 2021 held in aggregate 93% of the voting power of our capital stock, which will limit or preclude your ability to influence corporate matters.\nOur Class B common stock has ten votes per share, and our Class A common stock has one vote per share. As of March 31, 2021, our directors, executive officers, and their affiliates, held in the aggregate 93% of the voting power of our capital stock. Because of the ten-to-one voting ratio between our Class B common stock and Class A common stock, the holders of our Class B common stock collectively will continue to control a majority of the combined voting power of our common stock and therefore will be able to control all matters submitted to our stockholders for approval until the earlier of (a) the seven year anniversary of the closing of our IPO (b) such time as the outstanding shares of Class B common stock represent less than ten percent of the aggregate number of shares of our outstanding common stock and (c) the date the holders of two-thirds of our Class B common stock elect to convert the Class B common stock to Class A common stock. This concentrated control may limit or preclude your ability to influence corporate matters for the foreseeable future, including the election of directors, amendments of our organizational documents, and any merger, consolidation, sale of all or substantially all of our assets, or other major corporate transaction requiring stockholder approval. In addition, this may prevent or discourage unsolicited acquisition proposals or offers for our capital stock that you may feel are in your best interest as one of our stockholders.\nFuture transfers by holders of Class B common stock will generally result in those shares converting to Class A common stock, subject to limited exceptions, such as certain transfers effected for estate planning purposes. The conversion of Class B common stock to Class A common stock will have the effect, over time, of increasing the relative voting power of those holders of Class B common stock who retain their shares in the long term.\nWe do not expect to declare any dividends in the foreseeable future.\nWe do not anticipate declaring any cash dividends to holders of our common stock in the foreseeable future. In addition, our credit facility places restrictions on our ability to pay cash dividends. Consequently,\n80\ninvestors may need to rely on sales of their Class A common stock after price appreciation, which may never occur, as the only way to realize any future gains on their investment. Investors seeking cash dividends should not purchase our Class A common stock.\nProvisions in our charter documents and under Delaware law could make an acquisition of our company more difficult, limit attempts by our stockholders to replace or remove our current Board, and limit the market price of our Class A common stock.\nProvisions in our amended and restated certificate of incorporation and amended and restated bylaws may have the effect of delaying or preventing a change of control or changes in our management. Our amended and restated certificate of incorporation and amended and restated bylaws, include provisions that:\n•provide that the authorized but unissued shares of our common stock and our preferred stock are available for future issuance without stockholder approval;\n•provide that our Board is classified into three classes of directors with staggered three-year terms;\n•permit the Board to establish the number of directors and fill any vacancies and newly created directorships;\n•require super-majority voting to amend some provisions in our amended and restated certificate of incorporation and amended and restated bylaws;\n•authorize the issuance of “blank check” preferred stock that our Board could use to implement a stockholder rights plan;\n•provide that only the Chairperson of our Board, our Chief Executive Officer, or a majority of our Board will be authorized to call a special meeting of stockholders;\n•provide for a dual class common stock structure in which holders of our Class B common stock have the ability to control the outcome of matters requiring stockholder approval, even if they own significantly less than a majority of the outstanding shares of our Class A and Class B common stock, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or its assets;\n•prohibit stockholder action by written consent, which requires all stockholder actions to be taken at a meeting of our stockholders;\n•provide that the Board is expressly authorized to make, alter or repeal our bylaws; and\n•advance notice requirements for nominations for election to our Board or for proposing matters that can be acted upon by stockholders at annual stockholder meetings.\nMoreover, Section 203 of the Delaware General Corporation Law may discourage, delay, or prevent a change in control of our company. Section 203 imposes certain restrictions on mergers, business combinations, and other transactions between us and holders of 15% or more of our common stock.\nOur bylaws designate certain courts as the sole and exclusive forum for certain types of actions and proceedings that may be initiated by our stockholders, which could limit our stockholders’\n81\nability to obtain a favorable judicial forum for disputes with us or our directors, officers, or employees.\nOur bylaws provide that, unless we consent in writing to an alternative forum, the Court of Chancery of the State of Delaware will be the sole and exclusive forum for any state law claim for (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of or based on a fiduciary duty owed by any of our current or former directors, officers, or employees to us or our stockholders, (iii) any action asserting a claim arising pursuant to any provision of the Delaware General Corporation Law, our amended and restated certificate of incorporation or our amended and restated bylaws (including the interpretation, validity or enforceability thereof) or (iv) any action asserting a claim that is governed by the internal affairs doctrine, in each case subject to the Court of Chancery having personal jurisdiction over the indispensable parties named as defendants therein, or the Delaware Forum Provision. The Delaware Forum Provision will not apply to any causes of action arising under the Securities Act or the Exchange Act. Our amended and restated bylaws further provide that, unless we consent in writing to the selection of an alternative forum, the federal district courts of the United States shall be the sole and exclusive forum for resolving any complaint asserting a cause of action arising under the Securities Act, or the Federal Forum Provision. In addition, our amended and restated bylaws provide that any person or entity purchasing or otherwise acquiring any interest in shares of our common stock is deemed to have notice of and consented to the foregoing provisions; provided, however, that stockholders cannot and will not be deemed to have waived our compliance with the federal securities laws and the rules and regulations thereunder.\nThe Delaware Forum Provision and the Federal Forum Provision in our amended and restated bylaws may impose additional litigation costs on stockholders in pursuing any such claims, particularly if the stockholders do not reside in or near the State of Delaware. Additionally, the forum selection clauses in our amended and restated bylaws may limit our stockholders’ ability to bring a claim in a forum that they find favorable for disputes with us or our directors, officers or employees, which may discourage such lawsuits against us and our directors, officers and employees even though an action, if successful, might benefit our stockholders. In addition, while the Delaware Supreme Court ruled in March 2020 that federal forum selection provisions purporting to require claims under the Securities Act be brought in federal court were “facially valid” under Delaware law, there is uncertainty as to whether other courts will enforce our Federal Forum Provision. If the Federal Forum Provision is found to be unenforceable, we may incur additional costs associated with resolving such matters. The Federal Forum Provision may also impose additional litigation costs on stockholders who assert that the provision is not enforceable or invalid. The Court of Chancery of the State of Delaware and the federal district courts of the United States may also reach different judgments or results than would other courts, including courts where a stockholder considering an action may be located or would otherwise choose to bring the action, and such judgments may be more or less favorable to us than our stockholders.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nUnregistered Sales of Equity Securities\nFrom January 1, 2021 through March 31, 2021, pursuant to our Amended and Restated 2019 Stock Option and Grant Plan (the “2019 Plan”) we issued and sold to our employees, consultants and other service providers an aggregate of 3,861 shares of common stock upon the exercise of options under our 2019 Plan at exercise prices ranging from $1.23 to $1.68 per share, for an aggregate exercise price of $5,207. These 3,861 shares of common stock were exchanged for an equal number of shares of our Class B common stock in connection with our IPO.\nFrom January 1, 2021 through March 31, 2021, pursuant to our 2021 Stock Option and Grant Plan we granted one employee an aggregate of 19,500 restricted stock units, with a grant date fair value $14 per restricted stock unit.\n82\nNone of the foregoing transactions involved any underwriters, underwriting discounts or commissions, or any public offering. The sales of the above securities were deemed to be exempt from registration under the Securities Act in reliance on Section 4(a)(2) of the Securities Act or Rule 701 promulgated under Section 3(b) of the Securities Act as transactions by an issuer not involving any public offering or pursuant to benefit plans and contracts relating to compensation as provided under Rule 701. The recipients of the securities in each of these transactions represented their intentions to acquire the securities for investment only and not with a view to or for sale in connection with any distribution thereof, and appropriate legends were affixed to the securities issued in these transactions. All recipients had adequate access, through their relationships with us, to information about us. The sales of these securities were made without any general solicitation or advertising.\nUse of Proceeds From the IPO\nOn March 29, 2021, we closed the IPO, in which we issued 10,000,000 shares of Class A common stock, and on April 23, 2021 we closed the partial exercise of the underwriter’s option to purchase additional shares of our Class A common stock, in which we issued an additional 719,266 shares of Class A common stock, at a price to the public of $14.00 for aggregate net proceeds of $135,987 after deducting underwriting discounts and commissions of $10,505 and expenses payable by us of $3,578. The offer and sale of all of the shares in the IPO were registered under the Securities Act pursuant to the Prospectus. No payments were made by us to directors, officers or persons owning ten percent or more of our common stock or to their associates, or to our affiliates, other than payments in the ordinary course of business to officers for salaries and to non-employee directors pursuant to our director compensation policy. There has been no material change in the planned use of proceeds from the IPO as described in the Prospectus. We invested the funds received in accordance with our Board approved investment policy, which provides for investments in obligations of the U.S. and foreign governments, money market instruments, registered money market funds, corporate and municipal bonds. Goldman, Sachs & Co. LLC, J.P. Morgan Securities LLC and Jefferies LLC acted as joint lead bookrunning managers of the IPO.\nItem 3. Defaults Upon Senior Securities\nNone.\nItem 4. Mine Safety Disclosures\nNot applicable.\nItem 5. Other Information\nNone.\nItem 6. Exhibits\nThe exhibits listed below are filed or incorporated by reference in this Quarterly Report on Form 10-Q.\n| Exhibit Number | Exhibit Title |\n| 3.1(1) | Amended and Restated Certificate of Incorporation of the Registrant |\n| 3.2(2) | Amended and Restated Bylaws of the Registrant |\n| 4.1(3) | Form of Common Stock certificate of the Registrant |\n\n83\n| 31.1* | Certification of Principal Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended |\n| 31.2* | Certification of Principal Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended |\n| 32.1+ | Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act |\n| 101.INS* | XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document |\n| 101.SCH* | XBRL Taxonomy Extension Schema Document |\n| 101.CAL* | XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF* | XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB* | XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE* | XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104 | Cover Page with Interactive Data File (formatted as Inline XBRL with applicable taxonomy extension information contained in Exhibits 101) |\n\n(1) File as Exhibit 3.2 to Registrant’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on March 16, 2021, and incorporated herein by reference.\n(2) Filed as Exhibit 3.4 to Registrant’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on March 16, 2021, and incorporated herein by reference.\n(3) Filed as Exhibit 4.1 to Registrant’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on March 16, 2021, and incorporated herein by reference.\n* Filed herewith.\n+ The certifications furnished in Exhibit 32.1 hereto are deemed to accompany this Quarterly Report on Form 10-Q and will not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, except to the extent that the Registrant specifically incorporates it by reference. Such certifications will not be deemed to be incorporated by reference into any filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, except to the extent that the Registrant specifically incorporates it by reference.\n84\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n| SEMRUSH HOLDINGS, INC. |\n| May 11, 2021 | By: | /s/ Oleg Shchegolev |\n| Oleg Shchegolev |\n| Chief Executive Officer |\n| (Principal Executive Officer) |\n| May 11, 2021 | By: | /s/ Evgeny Fetisov |\n| Evgeny Fetisov |\n| Chief Financial Officer |\n| (Principal Financial Officer and Principal Accounting Officer) |\n\n85\n</text>\n\nIf the company plans to maintain an equal distribution of total assets and total liabilities and stockholders' equity by the end of 2021, along with a 10% increase in \"Deferred contract costs, net of current portion\" and \"Other long-term assets\" from March 2021 levels, what should be the new total of current assets in dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nITEM 1 —\nBusiness\nIn this annual report on Form 10-K, “the Company,” “we” or “our” refer to A. M. Castle & Co., a Maryland corporation, and its subsidiaries included in the consolidated financial statements, except as otherwise indicated or as the context otherwise requires.\nBusiness and Markets\nCompany Overview\nThe Company is a specialty metals (90% of net sales) and plastics (10% of net sales) distribution company serving customers on a global basis. The Company provides a broad range of products and value-added processing and supply chain services to a wide array of customers, principally within the producer durable equipment, oil and gas, aerospace, heavy industrial equipment, industrial goods, construction equipment, retail, marine and automotive sectors of the global economy. Particular focus is placed on the aerospace and defense, oil and gas, power generation, mining, heavy industrial equipment manufacturing, marine, office furniture and fixtures, safety products, life sciences applications, transportation and general manufacturing industries.\nThe Company’s corporate headquarters are currently located in Oak Brook, Illinois. The Company operates out of 49 service centers located throughout North America (44), Europe (4) and Asia (1). The Company’s service centers hold inventory and process and distribute products to both local and export markets.\nIndustry and Markets\nService centers act as supply chain intermediaries between primary producers, which deal in bulk quantities in order to achieve economies of scale, and end-users in a variety of industries that require specialized products in significantly smaller quantities and forms. Service centers also manage the differences in lead times that exist in the supply chain. While original equipment manufacturers (“OEM”) and other customers often demand delivery within hours, the lead time required by primary producers can be as long as several months. Service centers also provide value to customers by aggregating purchasing, providing warehousing and distribution services to meet specific customer needs, including demanding delivery times and precise metal specifications.\nThe principal markets served by the Company are highly competitive. Competition is based on service, quality, processing capabilities, inventory availability, timely delivery, ability to provide supply chain solutions and price. The\n3\nCompany competes in a highly fragmented industry. Competition in the various markets in which the Company participates comes from a large number of value-added metals processors and service centers on a regional and local basis, some of which have greater financial resources and some of which have more established brand names in the local markets served by the Company.\nThe Company also competes to a lesser extent with primary metals producers who typically sell to larger customers requiring shipments of large volumes of metal.\nIn order to capture scale efficiencies and remain competitive, many primary metal producers are consolidating their operations and focusing on their core production activities. These producers have increasingly outsourced metals distribution and inventory management to metals service centers. This process of outsourcing allows them to work with a relatively small number of intermediaries rather than many end customers. As a result, metals service centers, including the Company, are now providing a range of services for their customers, including metal purchasing, processing and supply chain solutions.\nRecent Acquisitions\nDuring December 2011, the Company completed its acquisition (the “Acquisition”) of Tube Supply, Inc. (“Tube Supply”), which has expanded the Company’s product offerings in the oil and gas industry. Subsequent to the acquisition, Tube Supply operated as a Limited Liability Corporation until it was merged with A. M. Castle & Co. in September of 2012. The results of Tube Supply are included in the Company’s Metals segment.\nProcurement\nThe Company purchases metals and plastics from many producers. Material is purchased in large lots and stocked at its service centers until sold, usually in smaller quantities and typically with some value-added processing services performed. The Company’s ability to provide quick delivery of a wide variety of specialty metals and plastic products, along with its processing capabilities and supply chain management solutions, allows customers to lower their own inventory investment by reducing their need to order the large quantities required by producers and their need to perform additional material processing services. Some of the Company’s purchases are covered by long-term contracts and commitments, which generally have corresponding customer sales agreements.\nOrders are primarily filled with materials shipped from Company stock. The materials required to fill the balance of sales are obtained from other sources, such as direct mill shipments to customers or purchases from other distributors. Deliveries are made principally by the Company’s fleet contracted through third party logistics providers. Common carrier delivery is used in areas not serviced directly by the Company’s fleet.\nAt December 31, 2012, the Company had 1,701 full-time employees. Of these, approximately 250 are represented by collective bargaining units, principally the United Steelworkers of America and International Brotherhood of Teamsters.\nBusiness Segments\nThe Company distributes and performs processing on both metals and plastics. Although the distribution processes are similar, the customer markets, supplier bases and types of products are different. Additionally, the Company’s Chief Executive Officer, the chief operating decision-maker, reviews and manages these two businesses separately. As such, these businesses are considered reportable segments and are reported accordingly in the Company’s various public filings. Neither of the Company’s reportable segments has any unusual working capital requirements.\nIn the last three years, the percentages of total sales of the two segments were as follows:\n| 2012 | 2011 | 2010 |\n| Metals | 90 | % | 90 | % | 89 | % |\n| Plastics | 10 | % | 10 | % | 11 | % |\n| 100 | % | 100 | % | 100 | % |\n\nMetals Segment\nIn its Metals segment, the Company’s marketing strategy focuses on distributing highly engineered specialty grades and alloys of metals as well as providing specialized processing services designed to meet very precise specifications. Core products include alloy, aluminum, nickel, stainless steel, carbon and titanium. Inventories of\n4\nthese products assume many forms such as plate, sheet, extrusions, round bar, hexagon bar, square and flat bar, tubing and coil. Depending on the size of the facility and the nature of the markets it serves, a service center is equipped as needed with bar saws, plate saws, oxygen and plasma arc flame cutting machinery, trepanning machinery, boring machinery, honing equipment, water-jet cutting equipment, stress relieving and annealing furnaces, surface grinding equipment, and sheet shearing equipment.\nThe Company’s customer base is well diversified and therefore, the Company does not have dependence upon any single customer, or a few customers. Our customer base includes many Fortune 500 companies as well as thousands of medium and smaller sized firms.\nThe Company’s broad network of locations provides same or next-day delivery to most of the segment’s markets, and two-day delivery to substantially all of the remaining markets.\nPlastics Segment\nThe Company’s Plastics segment consists exclusively of a wholly-owned subsidiary that operates as Total Plastics, Inc. (“TPI”), headquartered in Kalamazoo, Michigan, and its wholly-owned subsidiaries. The Plastics segment stocks and distributes a wide variety of plastics in forms that include plate, rod, tube, clear sheet, tape, gaskets and fittings. Processing activities within this segment include cut-to-length, cut-to-shape, bending and forming according to customer specifications.\nThe Plastics segment’s diverse customer base consists of companies in the retail (point-of-purchase), automotive, marine, office furniture and fixtures, safety products, life sciences applications, and general manufacturing industries. TPI has locations throughout the upper northeast and midwest regions of the U.S. and one facility in Florida from which it services a wide variety of users of industrial plastics.\nJoint Venture\nThe Company holds a 50% joint venture interest in Kreher Steel Co. (“Kreher”), a metals distributor of bulk quantities of alloy, special bar quality and stainless steel bars, headquartered in Melrose Park, Illinois. The Company’s equity in the earnings of this joint venture is reported separately in the Company’s consolidated statements of operations. Kreher is considered a significant subsidiary under Rule 3-09 of Regulation S-X. Therefore, its stand-alone financial statements are included in this filing.\nAccess to SEC Filings\nThe Company makes available free of charge on or through its Web site at www.amcastle.com the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the U.S. Securities and Exchange Commission (the “SEC”). Information on our website does not constitute part of this annual report on Form 10-K.\nITEM 1A —\nRisk Factors\nOur business, financial condition, results of operations, and cash flows are subject to various risks, many of which are not exclusively within our control that may cause actual performance to differ materially from historical or projected future performance. The risks described below are not the only risks we face. Any of the following risks, as well as other risks and uncertainties not currently known to us or that we currently consider to be immaterial, could materially and adversely affect our business, financial condition, results of operations, or cash flows.\nWe may not achieve all of the expected benefits from our restructuring and performance enhancement initiatives.\nWe have recently begun implementing restructuring actions in our metals business, including organizational restructuring, warehouse realignments and performance improvement programs. We expect these measures will result in improvements to annualized operating profits of approximately $33.0 million once fully implemented in 2013. In addition, we continue to evaluate additional options to improve efficiency and performance of our operations. We have made certain assumptions in estimating the anticipated impact of our restructuring and performance enhancement initiatives. These assumptions may turn out to be incorrect due to a variety of factors. In addition, our ability to realize the expected benefits from these initiatives is subject to significant business, economic, and competitive uncertainties and contingencies, many of which are beyond our control. Some of our cost saving measures may not have the impact on our operating profitability that we currently project. If we are unsuccessful in implementing these initiatives or if we do not achieve our expected results, our results of operations and cash flows could be materially adversely affected.\n5\nOur substantial level of indebtedness could adversely affect our financial condition and prevent us from fulfilling our obligations under our debt instruments.\nWe have substantial debt service obligations. As of December 31, 2012, we had approximately $322.5 million of total debt outstanding, excluding capital lease obligations of $1.4 million, of which $264.5 million is secured. As of December 31, 2012, the Company had approximately $50.5 million of availability under our revolving credit facility. Subject to restrictions contained in the debt instruments, we may incur additional indebtedness.\nOur substantial level of indebtedness could have significant effects on our business, including the following:\n\n| • | it may be more difficult for us to satisfy our financial obligations; |\n\n| • | our ability to obtain additional financing for working capital, capital expenditures, strategic acquisitions or general corporate purposes may be impaired; |\n\n| • | we must use a substantial portion of our cash flow from operations to pay interest on our indebtedness, which will reduce the funds available to use for operations and other purposes; |\n\n| • | our ability to fund a change of control offer under our debt instruments may be limited; |\n\n| • | our substantial level of indebtedness could place us at a competitive disadvantage compared to our competitors that may have proportionately less debt; |\n\n| • | our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate may be limited; and |\n\n| • | our substantial level of indebtedness may make us more vulnerable to economic downturns and adverse developments in our business. |\n\nWe expect to obtain the funds to pay our expenses and to repay our indebtedness primarily from our operations and, in the case of our indebtedness, from the refinancing thereof. Our ability to meet our expenses and make these payments therefore depends on our future performance, which will be affected by financial, business, economic and other factors, many of which we cannot control. Our business may not generate sufficient cash flow from operations in the future, and our currently anticipated growth in revenue and cash flow may not be realized, either or both of which could result in our being unable to repay indebtedness or to fund other liquidity needs. If we do not have enough funds, we may be required to refinance all or part of our then existing debt, sell assets or borrow more funds, which we may not be able to accomplish on terms acceptable to us, or at all. In addition, the terms of existing or future debt agreements may restrict us from pursuing any of these alternatives.\nOur debt instruments impose significant operating and financial restrictions, which may prevent us from pursuing certain business opportunities and taking certain actions and our failure to comply with the covenants contained in our debt instruments could result in an event of default that could adversely affect our operating results.\nOur debt agreements impose, and future debt agreements may impose, operating and financial restrictions on us. These restrictions limit or prohibit, among other things, our ability to:\n\n| • | incur additional indebtedness unless certain financial tests are satisfied or issue disqualified capital stock; |\n\n| • | pay dividends, redeem subordinated debt or make other restricted payments; |\n\n| • | make certain investments or acquisitions; |\n\n| • | issue stock of subsidiaries; |\n\n| • | grant or permit certain liens on our assets; |\n\n| • | enter into certain transactions with affiliates; |\n\n| • | merge, consolidate or transfer substantially all of our assets; |\n\n| • | incur dividend or other payment restrictions affecting certain of our subsidiaries; |\n\n| • | transfer, sell or acquire assets, including capital stock of our subsidiaries; and |\n\n| • | change the business we conduct. |\n\nThese covenants could adversely affect our ability to finance our future operations or capital needs, withstand a future downturn in our business or the economy in general, engage in business activities, including future opportunities that may be in our interest, and plan for or react to market conditions or otherwise execute our business strategies. A breach of any of these covenants could result in a default in respect of the related indebtedness. If a default occurs, the relevant lenders or holders of such indebtedness could elect to declare the indebtedness, together with accrued interest and other fees, to be immediately due and payable and proceed against any collateral securing that indebtedness. If the maturity of our indebtedness is accelerated, we may not have sufficient cash resources to satisfy our debt obligations and may not be able to continue our operations as planned.\n6\nWe may not be able to generate sufficient cash to service all of our existing debt service obligations, and may be forced to take other actions to satisfy our obligations under our debt agreements, which may not be successful.\nOur annual debt service obligations until December 2015, when our revolving credit facility is scheduled to mature, will be primarily limited to interest payments on our outstanding debt securities, with an aggregate principal amount of $282.5 million, and on borrowings under our $100.0 million revolving credit facility of $39.5 million as of December 31, 2012. Our ability to make scheduled payments on or to refinance our debt obligations depends on our future financial condition and operating performance, which are subject to prevailing economic and competitive conditions and to certain financial, business and other factors beyond our control. Our business may not generate sufficient cash flow from operations in the future and our currently anticipated levels of revenue and cash flow may not be realized, either or both of which could result in our being unable to repay indebtedness or to fund other liquidity needs. Therefore, we may not be able to maintain or realize a level of cash flows from operating activities sufficient to permit us to pay the principal, premium, if any, and interest on our indebtedness.\nIf our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay investments and capital expenditures, sell assets, seek additional capital or restructure or refinance our indebtedness. Our ability to restructure or refinance our debt will depend on the condition of the capital markets and our financial condition at such time. Any refinancing of our debt could be at higher interest rates and may require us to comply with more onerous borrowing covenants, which could further restrict our business operations. The terms of existing or future debt instruments may restrict us from adopting some of these alternatives. In addition, any failure to make payments of principal and interest on our outstanding indebtedness on a timely basis would likely result in a reduction of our credit rating, which could harm our ability to incur additional indebtedness. These alternative measures may not be successful and may not permit us to meet our scheduled debt service obligations.\nOur future operating results depend on the volatility of the prices of metals and plastics, which could cause our results to be adversely affected.\nThe prices we pay for raw materials, both metals and plastics, and the prices we charge for products may fluctuate depending on many factors, including general economic conditions (both domestic and international), competition, production levels, import duties and other trade restrictions and currency fluctuations. To the extent metals and plastics prices decline, we would generally expect lower sales and possibly lower net income, depending on the timing of the price changes and the ability to pass price changes on to our customers. To the extent we are not able to pass on to our customers any increases in our raw materials prices, our operating results may be adversely affected. In addition, because we maintain substantial inventories of metals and plastics in order to meet short lead-times and the just-in-time delivery requirements of our customers, a reduction in our selling prices could result in lower profitability or, in some cases, losses, either of which could adversely impact our ability to remain in compliance with certain financial covenants contained in our debt instruments, as well as result in us incurring impairment charges.\nDisruptions or shortages in the supply of raw materials could adversely affect our operating results and our ability to meet our customers’ demands.\nOur business requires materials that are sourced from third party suppliers. If for any reason our primary suppliers of metals should curtail or discontinue their delivery of raw materials to us at competitive prices and in a timely manner, our operating results could suffer. Unforeseen disruptions in our supply bases could materially impact our ability to deliver products to customers. The number of available suppliers could be reduced by factors such as industry consolidation and bankruptcies affecting metals and plastics producers, or suppliers may be unwilling or unable to meet our demand due to industry supply conditions generally. If we are unable to obtain sufficient amounts of raw materials from our traditional suppliers, we may not be able to obtain such raw materials from alternative sources at competitive prices to meet our delivery schedules, which could have an adverse impact on our operating results. To the extent we have quoted prices to customers and accepted orders for products prior to purchasing necessary raw materials, or have existing contracts, we may be unable to raise the price of products to cover all or part of the increased cost of the raw materials to our customers.\nIn some cases the availability of raw materials requires long lead times. As a result, we may experience delays or shortages in the supply of raw materials. If unable to obtain adequate and timely deliveries of required raw materials, we may be unable to timely supply customers with sufficient quantities of products. This could cause us to lose sales, incur additional costs, or suffer harm to our reputation.\n7\nIncreases in freight and energy prices would increase our operating costs and we may be unable to pass these increases on to our customers in the form of higher prices, which may adversely affect our operating results.\nWe use energy to process and transport our products. The prices for and availability of energy resources are subject to volatile market conditions, which are affected by political, economic and regulatory factors beyond our control. Our operating costs increase if energy costs, including electricity, diesel fuel and natural gas, rise. During periods of higher freight and energy costs, we may not be able to recover our operating cost increases through price increases without reducing demand for our products. In addition, we typically do not hedge our exposure to higher freight or energy prices.\nWe service industries that are highly cyclical, and any downturn in our customers’ industries could reduce our revenue and profitability.\nMany of our products are sold to customers in industries that experience significant fluctuations in demand based on economic conditions, energy prices, consumer demand, availability of adequate credit and financing, customer inventory levels, changes in governmental policies and other factors beyond our control. As a result of this volatility in the industries we serve, when one or more of our customers' industries experiences a decline, we may have difficulty increasing or maintaining our level of sales or profitability if we are not able to divert sales of our products to customers in other industries. We have made a strategic decision to focus sales resources on certain industries, specifically the aerospace, oil and gas and heavy equipment, machine tools and general industrial equipment industries. A downturn in these industries has had, and may in the future continue to have, an adverse effect on our operating results. We are also particularly sensitive to market trends in the manufacturing sector of the North American economy.\nA portion of our sales, particularly in the aerospace industry, are related to contracts awarded to our customers under various U.S. Government defense-related programs. Significant changes in defense spending, or in government priorities and requirements could impact the funding, or the timing of funding, of those defense programs, which could negatively impact our results of operations and financial condition.\nOur industry is highly competitive, which may force us to lower our prices and may have an adverse effect on our operating results.\nThe principal markets that we serve are highly competitive. Competition is based principally on price, service, quality, processing capabilities, inventory availability and timely delivery. We compete in a highly fragmented industry. Competition in the various markets in which we participate comes from a large number of value-added metals processors and service centers on a regional and local basis, some of which have greater financial resources than we do and some of which have more established brand names in the local markets we serve. We also compete to a lesser extent with primary metals producers who typically sell to very large customers requiring shipments of large volumes of metal. Increased competition could force us to lower our prices or to offer increased services at a higher cost to us, which could have an adverse effect on our operating results.\nOur operating results are subject to the seasonal nature of our customers’ businesses.\nA portion of our customers experience seasonal slowdowns. Historically, our revenues in the months of July, November and December have been lower than in other months because of a reduced number of shipping days and holiday or vacation closures for some customers. Consequently, our sales in the first two quarters of the year are usually higher than in the third and fourth quarters. As a result, analysts and investors may inaccurately estimate the effects of seasonality on our operating results in one or more future quarters and, consequently, our operating results may fall below expectations.\nWe rely upon our suppliers as to the specifications of the metals we purchase from them.\nWe rely on mill certifications that attest to the physical and chemical specifications of the metal received from our suppliers for resale and generally, consistent with industry practice, do not undertake independent testing of such metals. We rely on our customers to notify us of any metal that does not conform to the specifications certified by the supplying mill. Although our primary sources of products have been domestic mills, we have and will continue to purchase product from foreign suppliers when we believe it is appropriate. In the event that metal purchased from domestic suppliers is deemed to not meet quality specifications as set forth in the mill certifications or customer specifications, we generally have recourse against these suppliers for both the cost of the products purchased and possible claims from our customers. However, such recourse will not compensate us for the damage to our reputation that may arise from sub-standard products and possible losses of customers. Moreover, there is a greater level of risk that similar recourse will not be available to us in the event of claims by our customers related to products from foreign\n8\nsuppliers that do not meet the specifications set forth in the mill certifications. In such circumstances, we may be at greater risk of loss for claims for which we do not carry, or do not carry sufficient, insurance.\nWe are vulnerable to interest rate fluctuations on our indebtedness, which could hurt our operating results.\nWe are exposed to various interest rate risks that arise in the normal course of business. We finance our operations with fixed and variable rate borrowings. Market risk arises from changes in variable interest rates. Under our revolving credit facility, our interest rate on borrowings is subject to changes based on fluctuations in the LIBOR and prime rates of interest. If interest rates significantly increase, we could be unable to service our debt which could have an adverse effect on our operating results.\nWe operate in international markets, which expose us to a number of risks.\nAlthough a substantial majority of our business activity takes place in the United States, we serve and operate in certain international markets, which expose us to political, economic and currency related risks, including the following:\n| • | potential for adverse change in the local political or social climate or in government policies, laws and regulations; |\n\n| • | difficulty staffing and managing geographically diverse operations and the application of foreign labor regulations; |\n\n| • | restrictions on imports and exports or sources of supply; |\n\n| • | currency exchange rate risk; and |\n\n| • | change in duties and taxes. |\n\nWe operate in Canada, Mexico, France, and the United Kingdom, with limited operations in Singapore and China. An act of war or terrorism or major pandemic event could disrupt international shipping schedules, cause additional delays in importing our products into the United States or increase the costs required to do so. In addition, acts of crime or violence in these international markets (for example, in Mexico) could adversely affect our operating results. Fluctuations in the value of the U.S. dollar versus foreign currencies could reduce the value of these assets as reported in our financial statements, which could reduce our stockholders' equity. If we do not adequately anticipate and respond to these risks and the other risks inherent in international operations, it could have a material adverse effect on our operating results.\nWe may not be able to realize the benefits we anticipate from our acquisitions, including the Tube Supply acquisition.\nIn December 2011 we acquired Tube Supply, Inc. We intend to continue to seek attractive opportunities to acquire other businesses in the future. Achieving the benefits of these acquisitions depends on the timely, efficient and successful execution of a number of post-acquisition events, including our integration of the acquired businesses. Factors that could affect our ability to achieve the benefits we anticipate from our acquisition include:\n| • | difficulties in integrating and managing personnel, financial reporting and other systems used by the acquired businesses; |\n\n| • | the failure of the acquired businesses to perform in accordance with our expectations; |\n\n| • | failure to achieve anticipated synergies between our business units and the acquired businesses; |\n\n| • | the loss of the acquired businesses' customers; and |\n\n| • | cyclicality of business. |\n\nThe presence of any of the above factors individually or in combination could result in future impairment charges against the assets of the acquired businesses. If the acquired businesses do not operate as we anticipate, it could adversely affect our operating results and financial condition. As a result, there can be no assurance that the acquisitions, including the Tube Supply acquisition, will be successful or will not, in fact, adversely affect our business.\nOur business could be adversely affected by a disruption to our primary distribution hub.\nOur largest facility, in Franklin Park, Illinois, serves as a primary distribution center that ships product to our other facilities as well as external customers. Our business could be adversely impacted by a major disruption at this facility due to unforeseen developments occurring in or around the facility, such as:\n| • | damage to or inoperability of our warehouse or related systems; |\n\n| • | a prolonged power or telecommunication failure; |\n\n| • | a natural disaster, environmental or public health issue; or |\n\n| • | an airplane crash or act of war or terrorism on-site or nearby as the facility is located within seven miles of O'Hare International Airport (a major U.S. airport) and lies below certain take-off and landing flight patterns. |\n\n9\nA prolonged disruption of the services and capabilities of our Franklin Park facility and operation could adversely impact our operating results.\nDamage to or a disruption in our information technology systems could impact our ability to conduct business and/or report our financial performance.\nOver the last several years we have been implementing a new enterprise-wide resources planning (''ERP'') system. While we have completed the conversions of substantially all of our North American and European locations onto the new ERP system, we can provide no assurance that the continued phased-implementation at our remaining facilities, including Tube Supply, will be successful or will occur as planned. Difficulties associated with the design and implementation of the new ERP system could adversely affect our business, our customer service and our operating results.\nWe rely on information technology systems to provide inventory availability to our sales and operating personnel, improve customer service through better order and product reference data and monitor operating results. Difficulties associated with upgrades or integration with new systems could lead to business interruption that could harm our reputation, increase our operating costs and decrease profitability. In addition, any significant disruption relating to our current or new information technology systems, whether due from such things as fire, flood, tornado and other natural disasters, power loss, network failures, loss of data, security breaches and computer viruses, or otherwise, may have an adverse effect on our business, our operating results and our ability to report our financial performance in a timely manner.\nA portion of our workforce is represented by collective bargaining units, which may lead to work stoppages.\nAs of December 31, 2012, approximately 15% of our U.S. employees were represented by unions under collective bargaining agreements, including hourly warehouse employees at our primary distribution center in Franklin Park, Illinois. As these agreements expire, there can be no assurance that we will succeed in concluding collective bargaining agreements with the union to replace those that expire. Although we believe that our labor relations have generally been satisfactory, we cannot predict how stable our relationships with these labor organizations will be or whether we will be able to meet union requirements without impacting our operating results and financial condition. The unions may also limit our flexibility in dealing with our workforce. Work stoppages and instability in our union relationships could negatively impact the timely processing and shipment of our products, which could strain relationships with customers and adversely affect our operating results.\nAn impairment or restructuring charge could have an adverse effect on our operating results.\nWe continue to evaluate opportunities to reduce costs and improve operating performance. These actions could result in restructuring and related charges, including but not limited to asset impairments, employee termination costs, charges for pension benefits, and pension curtailments that could be significant, which could adversely affect our financial condition and results of operations.\nWe have a significant amount of long-lived assets, including goodwill and intangible assets. We review the recoverability of goodwill annually or whenever significant events or changes occur which might impair the recovery of recorded costs, making certain assumptions regarding future operating performance. We review the recoverability of definite lived intangible assets and other long-lived assets whenever significant events or changes occur which might impair the recovery of recorded costs, making certain assumptions regarding future operating performance. The results of these calculations may be affected by the current or further declines in the market conditions for our products, as well as interest rates and general economic conditions. If impairment is determined to exist, we will incur impairment losses, which will have an adverse effect on our operating results and our ability to remain in compliance with certain financial covenants contained in our debt instruments.\nWe could incur substantial costs in order to comply with, or to address any violations under, environmental and employee health and safety laws, which could adversely affect our operating results.\nOur operations are subject to various environmental statutes and regulations, including laws and regulations governing materials we use. In addition, certain of our operations are subject to international, federal, state and local environmental laws and regulations that impose limitations on the discharge of pollutants into the air and water and establish standards for the treatment, storage and disposal of solid and hazardous wastes. Our operations are also subject to various employee safety and health laws and regulations, including those concerning occupational injury and illness, employee exposure to hazardous materials and employee complaints. Certain of our facilities are located in industrial areas, have a history of heavy industrial use and have been in operation for many years and, over time, we and other\n10\npredecessor operators of these facilities have generated, used, handled and disposed of hazardous and other regulated wastes. Currently unknown cleanup obligations at these facilities, or at off-site locations at which materials from our operations were disposed, could result in future expenditures that cannot be currently quantified but which could have an adverse effect on our operating results.\nWe may face risks associated with current or future litigation and claims.\nFrom time to time, we are involved in a variety of lawsuits, claims and other proceedings relating to the conduct of our business. These suits concern issues including contract disputes, employment actions, employee benefits, taxes, environmental, health and safety, personal injury and product liability matters. Due to the uncertainties of litigation, we can give no assurance that we will prevail on all claims made against us in the lawsuits that we currently face or that additional claims will not be made against us in the future. While it is not feasible to predict the outcome of all pending lawsuits and claims, we do not believe that the disposition of any such pending matters is likely to have an adverse effect on our financial condition or liquidity, although the resolution in any reporting period of one of more of these matters could have an adverse effect on our operating results for that period. Also, we can give no assurance that any other lawsuits or claims brought in the future will not have an adverse effect on our financial condition, liquidity or operating results.\nPotential environmental legislative and regulatory actions could impose significant costs on the operations of our customers and suppliers, which could have a material adverse impact on our results of operations, financial condition and cash flows.\nClimate change regulation or some form of legislation aimed at reducing greenhouse gas (''GHG'') emissions is currently being considered in the United States as well as globally. As a metals and plastics distributor, our operations do not emit significant amounts of GHG. However, the manufacturing processes of many of our suppliers and customers are energy intensive and generate carbon dioxide and other GHG emissions. Any adopted future climate change and GHG regulations may impose significant costs on the operations of our customers and suppliers and indirectly impact our operations.\nThe Tube Supply acquisition significantly extends our exposure in the oil and gas sector to customers who utilize non-traditional drilling techniques, including hydraulic fracturing. Hydraulic fracturing is an important and commonly used process for the completion of natural gas, and to a lesser extent, oil wells in shale formations. Certain environmental and other groups have asserted that chemicals used in the fracturing process could adversely affect drinking water supplies. The U.S. Congress and various state and local governments are considering increased regulatory oversight of the hydraulic fracturing process, including through additional permit requirements, operational restrictions, reporting obligations and temporary or permanent bans on hydraulic fracturing in certain environmentally sensitive areas such as watersheds. We cannot predict whether such laws or regulations will be enacted and, if so, what actions any such laws or regulations would require or prohibit. Additional levels of regulatory oversight on, or otherwise limiting, the hydraulic fracturing process could subject the business and operations of our oil and gas customers to delays, increased operating costs and process prohibitions, and indirectly impact our oil and gas business through reduced demand for our products.\nUntil the timing, scope and extent of any future regulation becomes known, we cannot predict the effect on our results of operations, financial condition and cash flows.\nCommodity hedging transactions may expose us to loss or limit our potential gains.\nWe have entered into certain fixed price sales contracts with customers which expose us to risks associated with fluctuations in commodity prices. As part of our risk management program, we may use financial instruments from time-to-time to mitigate all or portions of these risks, including commodity futures, forwards or other derivative instruments. While intended to reduce the effects of the commodity price fluctuations, these transactions may limit our potential gains or expose us to losses. Also, should our counterparties to such transactions fail to honor their obligations due to financial distress we would be exposed to potential losses or the inability to recover anticipated gains from these transactions.\nOwnership of our stock is concentrated, which may limit stockholders’ ability to influence corporate matters.\nAs of December 31, 2012, based on filings made with the SEC and other information made available to us as of that date, we believe Patrick J. Herbert, III, one of our directors, may be deemed to beneficially own approximately 22.8% of our common stock. Accordingly, Mr. Herbert and his affiliates may have the voting power to substantially control the outcome of matters requiring a stockholder vote including the election of directors and the approval of significant\n11\ncorporate matters. Such a concentration of control could adversely affect the market price of our common stock or prevent a change in control or other business combinations that might be beneficial to us.\nWe have various mechanisms in place that may prevent a change in control that stockholders may otherwise consider favorable.\nOn August 31, 2012, our Board of Directors adopted a shareholder rights plan pursuant to which one purchase right was distributed as a dividend on each share of our common stock held of record as of the close of business on September 11, 2012. Upon becoming exercisable, each right will entitle its holder to purchase from the Company one one-hundredth of a share of our Series B Junior Preferred Stock for the purchase price of $54.00. Generally, the rights will become exercisable ten days after the date on which any person or group becomes the beneficial owner of 10% or more of our common stock or has commenced a tender or exchange offer which, if consummated, would result in any person or group becoming the beneficial owner of 10% or more of our common stock, subject to the terms and conditions set forth in the shareholder rights plan. The rights are attached to the certificates representing outstanding shares of common stock until the rights become exercisable, at which point separate certificates will be distributed to the record holders of our common stock. If a person or group becomes the beneficial owner of 10% or more of our common stock, which we refer to as an “acquiring person,” each right will entitle its holder, other than the acquiring person, to receive upon exercise a number of shares of our common stock having a market value of two times the purchase price of the right.\nThe shareholder rights plan is designed to deter coercive takeover tactics and to prevent an acquirer from gaining control of the Company without offering a fair price to all of our stockholders. The existence of the shareholder rights plan, however, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding common stock, and thereby adversely affect the market price of our common stock.\nIn addition, our charter and by-laws and the Maryland General Corporation Law, or the MGCL, include provisions that may be deemed to have antitakeover effects and may delay, defer or prevent a takeover attempt that stockholders might consider to be in their best interests. For example, the MGCL, our charter and bylaws require the approval of the holders of two-thirds of the votes entitled to be cast on the matter to amend our charter (unless our Board of Directors has unanimously approved the amendment, in which case the approval of the holders of a majority of such votes is required), contain certain advance notice procedures for nominating candidates for election to our Board of Directors, and permit our Board of Directors to issue up to 9.988 million shares of preferred stock.\nFurthermore, we are subject to the anti-takeover provisions of the MGCL that prohibit us from engaging in a “business combination” with an “interested stockholder” for a period of five years after the date of the transaction in which the person first becomes an “interested stockholder,” unless the business combination or stockholder interest is approved in a prescribed manner. The application of these and certain other provisions of our charter could have the effect of delaying or preventing a change of control, which could adversely affect the market price of our common stock.\nThe provisions of our debt instruments also contain limitations on our ability to enter into change of control transactions. In addition, the repurchase rights in our 7.0% convertible senior notes due 2017 (“Convertible Notes”) triggered by the occurrence of a “fundamental change” (as defined in the indenture for the Convertible Notes), and the additional shares of our common stock by which the conversion rate is increased in connection with certain fundamental change transactions, as described in the indenture for the Convertible Notes, could discourage a potential acquirer.\nWe may not have the cash necessary to satisfy our cash obligations under our Convertible Notes.\nAs of December 31, 2012, we had approximately $57.5 million of aggregate principal amount outstanding under the Convertible Notes. The Convertible Notes bear cash interest semiannually at a rate of 7.0% per year, and mature on December 15, 2017. Upon the occurrence of a fundamental change (as defined in the indenture for the Convertible Notes), we may be required to repurchase some or all of the Convertible Notes for cash at a repurchase price equal to 100% of the principal amount of the Convertible Notes being repurchased, plus any accrued and unpaid interest up to but excluding the relevant fundamental change repurchase date. We may not have sufficient funds to satisfy such cash obligations and, in such circumstances, may not be able to arrange the necessary financing on favorable terms or at all. In addition, our ability to satisfy such cash obligations will be restricted pursuant to covenants contained in the indenture for the Convertible Notes and will be permitted to be paid only in limited circumstances. We may also be limited in our ability to satisfy such cash obligations by applicable law or the terms of other instruments governing our indebtedness. Our inability to make cash payments to satisfy our obligations described above would trigger an event of default under the Convertible Notes, which in turn could constitute an event of default under any of our outstanding indebtedness, thereby resulting in the acceleration of such indebtedness, the prepayment of which could further restrict our ability to satisfy such cash obligations.\n12\nThe conditional conversion features of our Convertible Notes, if triggered, may adversely affect our financial condition and operating results.\nIn the event the conditional conversion features of the Convertible Notes are triggered, holders of the Convertible Notes will be entitled to convert the Convertible Notes at any time during specified periods at their option. If one or more holders elect to convert their Convertible Notes, and we elect or are deemed to have elected cash settlement or combination settlement, we would be required to pay cash to satisfy all or a portion of our conversion obligation for such Convertible Notes, which could adversely affect our liquidity. In addition, even if holders do not elect to convert their Convertible Notes, we could be required under applicable accounting rules to reclassify all or a portion of the outstanding principal of the Convertible Notes as a current rather than long-term liability, which would result in a material reduction of our net working capital.\nITEM 1B —\nUnresolved Staff Comments\nNone.\nITEM 2 —\nProperties\nThe Company’s corporate headquarters are located in Oak Brook, Illinois. All properties and equipment are sufficient for the Company’s current level of activities. Distribution centers and sales offices are maintained at each of the following locations, most of which are leased, except as indicated:\n| Locations | ApproximateFloor Area inSquare Feet |\n| Metals Segment |\n| North America |\n| Bedford Heights, Ohio | 374,400 | (1) |\n| Birmingham, Alabama | 76,000 | (1) |\n| Blaine, Minnesota | 65,200 | (1) |\n| Charlotte, North Carolina | 116,500 | (1) |\n| Edmonton, Alberta | 87,103 |\n| Fairless Hills, Pennsylvania | 71,600 | (1) |\n| Franklin Park, Illinois | 522,600 | (1) |\n| Gardena, California | 117,000 |\n| Grand Prairie, Texas | 78,000 | (1) |\n| Hammond, Indiana (H-A Industries) | 243,000 |\n| Houston, Texas | 383,100 | (3) |\n| Kansas City, Missouri | 118,000 |\n| Kennesaw, Georgia | 87,500 |\n| Kent, Washington | 53,000 |\n| Lafayette, Louisiana | 5,000 |\n| Mississauga, Ontario | 57,000 |\n| Orange, Connecticut | 57,389 |\n| Paramount, California | 155,500 |\n| Point Claire, Quebec | 38,760 |\n| Santa Cantarina, Nuevo Leon, Mexico | 112,000 |\n| Saskatoon, Saskatchewan | 15,000 |\n| Selkirk, Manitoba | 50,000 | (1) |\n| Stockton, California | 60,000 |\n| Twinsburg, Ohio | 120,000 |\n| Wichita, Kansas | 95,000 |\n\n13\n| Locations | ApproximateFloor Area inSquare Feet |\n| Worcester, Massachusetts | 53,500 | (1) |\n| Europe |\n| Blackburn, England | 62,139 |\n| Letchworth, England | 40,000 |\n| Trafford Park, England | 30,000 |\n| Montoir de Bretagne, France | 38,944 |\n| Asia |\n| Shanghai, China | 45,700 |\n| Sales Offices |\n| Bilbao, Spain | (Intentionally left blank) |\n| Fairfield, Ohio |\n| Milwaukee, Wisconsin |\n| Phoenix, Arizona |\n| Singapore |\n| Tulsa, Oklahoma |\n| Total Metals Segment | 3,428,935 |\n| Plastics Segment |\n| Baltimore, Maryland | 24,000 |\n| Cleveland, Ohio | 8,600 |\n| Cranston, Rhode Island | 14,990 |\n| Detroit, Michigan | 22,000 |\n| Elk Grove Village, Illinois | 22,500 |\n| Fort Wayne, Indiana | 17,600 |\n| Grand Rapids, Michigan | 42,500 | (1) |\n| Harrisburg, Pennsylvania | 13,900 |\n| Indianapolis, Indiana | 13,500 |\n| Kalamazoo, Michigan | 81,000 |\n| Knoxville, Tennessee | 16,530 |\n| Maple Shade, New Jersey | 12,480 |\n| Mt. Vernon, New York | 30,000 |\n| New Philadelphia, Ohio | 15,700 |\n| Pittsburgh, Pennsylvania | 12,800 |\n| Rockford, Michigan | 53,600 |\n| Tampa, Florida | 17,700 |\n| Worcester, Massachusetts | 2,500 | (1) |\n| Total Plastics Segment | 421,900 |\n| Headquarters |\n| Oak Brook, Illinois | 39,360 | (2) |\n| GRAND TOTAL | 3,890,195 |\n\n| (1) | Represents owned facility. |\n\n| (2) | The Company’s principal executive offices do not include a distribution or sales office. |\n\n| (3) | Represents two leased facilities (274,000 square feet) and one owned facility (109,100 square feet). |\n\n14\nITEM 3 —\nLegal Proceedings\n(Amounts in thousands)\nThe Company is party to a variety of legal proceedings and other claims, including proceedings by government authorities, which arise from the operation of its business. These proceedings are incidental and occur in the normal course of the Company's business affairs. The majority of these claims and proceedings relate to commercial disputes with customers, suppliers, and others; employment, including benefit matters; product quality; and environmental, health and safety claims. It is the opinion of management that the currently expected outcome of these proceedings and claims, after taking into account recorded accruals and the availability and limits of our insurance coverage, will not have a material adverse effect on the consolidated results of operations, financial condition or cash flows of the Company.\nGovernment Proceeding\nIn 2011, the Company determined that it inadvertently exported certain aluminum alloy bar that are listed on the U.S. Bureau of Industry and Security's (BIS) Commerce Control List to countries where there is an export license requirement if an exception is not otherwise available. The exports, which occurred in 2011, had a total transaction value of approximately $13 and were made without export licenses. The exports involved five shipments to the Company's wholly-owned subsidiary in China and to a customer in the Philippines. In response thereto, the Company submitted a voluntary self-disclosure describing the nature of these shipments to the Office of Export Enforcement of the Department of Commerce (OEE) in accordance with applicable Export Administration Regulations. If it is determined that the Company failed to comply with the applicable U.S. export regulations, the OEE could assess civil penalties of up to $1,250, restrict export privileges or provide an administrative warning. While the ultimate disposition of this matter cannot be predicted with certainty, it is the opinion of management, based on the information available at this time, that the outcome of this matter will not have a material effect on the Company's financial position, results of operations or cash flows.\nITEM 4 —\nMine Safety Disclosures\nNot applicable.\nExecutive Officers of The Registrant\nThe following selected information for each of our current executive officers (as defined by regulations of the SEC) was prepared as of March 4, 2013.\n| Name and Title | Age | Business Experience |\n| Patrick R. AndersonVice President, CorporateController and Chief Accounting Officer | 41 | Mr. Anderson began his employment with the registrant in 2007 and was elected to the position of Vice President, Corporate Controller and Chief Accounting Officer. Prior to joining the registrant, he was employed as a Senior Manager with Deloitte & Touche LLP (a global accounting firm) where he was employed from 1994 to 2007. |\n| Scott J. DolanPresident and Chief Executive Officer | 42 | Mr. Dolan most recently served as Senior Vice President, Airport Operations and Cargo, of United Continental Holdings, Inc. (a $37 billion publicly traded provider of passenger and cargo air transportation services), and its principal wholly-owned subsidiaries, United Airlines and Continental Airlines, from 2010 to 2011. From 2004 until 2010, Mr. Dolan served as Senior Vice President, Airport Operations and President, United Cargo (2006-2010) and as Senior Vice President and President, United Cargo (2004-2006) for UAL Corporation and its principal subsidiary, United Airlines. Mr. Dolan worked at Atlas Air Worldwide Holdings, Inc. (a global airfreight company) from 2002 to 2004, where he served as Senior Vice President and Chief Operating Officer from 2003-2004 and as Vice President, Business Integration from 2002 to 2003. Prior to joining Atlas Air, Mr. Dolan spent five years at General Electric Company, where he served in a variety of positions including Vice President, Operational Performance, Polar Air Cargo, a subsidiary of GE Capital Aviation Services. |\n\n15\n| Name and Title | Age | Business Experience |\n| Thomas L. GarrettVice President andPresident, Total Plastics, Inc. | 50 | Mr. Garrett began his employment with Total Plastics, Inc., a wholly owned subsidiary of the registrant, in 1988 and was appointed to the position of Controller. In 1996, he was elected to the position of Vice President and in 2001 was appointed to the position of Vice President of the registrant and President of Total Plastics, Inc. |\n| Kevin H. GlynnVice Presidentand Chief Information Officer | 49 | Mr. Glynn began his employment with the registrant in October 2010 as the Interim Chief Information Officer. In January 2011 he was appointed Vice President and Chief Information Officer. Prior to joining the registrant, he was employed as a Managing Principal at Laminar Group LLC (a management consulting company) from 2009 to 2010, Chief Operating Officer at IRON Solutions, Inc. (an information technology company specializing in data, software and media services for the agriculture equipment market) from 2008 to 2009 and as Senior Vice President and Chief Information Officer at CNH America, LLC (a manufacturer of agricultural and construction equipment) from 2006 to 2007. |\n| Robert J. PernaVice President,General Counsel and Secretary | 49 | Mr. Perna began his employment with the registrant in 2008 and was elected to the position of Vice President-General Counsel and Secretary. Prior to joining the registrant he was General Counsel, North America, CNH America, LLC (a manufacturer of agricultural and construction equipment) since 2007, and he also served as Associate General Counsel and Corporate Secretary for Navistar International Corporation (a manufacturer of commercial trucks and diesel engines) since 2001. |\n| Anne D. ScharmVice President, Human Resources | 36 | Ms. Scharm began her employment with the registrant in 2011 as the Director of Organizational Development. In December 2011, she was appointed as the Interim Vice President, Human Resources. In March 2012, she was appointed Vice President, Human Resources. Prior to joining the registrant, she was employed as Director of Human Resources and Organizational Development with Delnor Health System, (now known as Cadence Health - a healthcare organization) from 2006 to 2011. |\n| Scott F. StephensVice President,Chief Financial Officer and Treasurer | 43 | Mr. Stephens began his employment with the registrant in 2008 and was elected to the position of Vice President, Chief Financial Officer, and Treasurer. From February 2010 to December 2010, he was also appointed to the position of Interim President, Castle Metals Oil & Gas. In May 2012, Mr. Stephens was elected to serve as Interim Chief Executive Officer until October 2012. Formerly, he served as the CFO of Lawson Products, Inc. (a distributor of services, systems and products to the MRO and OEM marketplace) from 2004 to 2008, and CFO of The Wormser Company from 2001 to 2004. |\n| Blain A. TiffanyChief Commercial Officer | 54 | Mr. Tiffany began his employment with the registrant in 2000 and was appointed to the position of District Manager. He was appointed Eastern Region Manager in 2003, Vice President – Regional Manager in 2005 and in 2006 was appointed to the position of Vice President – Sales. In 2007, Mr. Tiffany was appointed to the position of Vice President, President of Castle Metals Plate. In 2009, Mr. Tiffany served as Vice President, President of Castle Metals Aerospace through 2011. In 2012, Mr. Tiffany served as Vice President, Castle Metals and in January 2013 was appointed to the position of Chief Commercial Officer. |\n\n16\nPART II\n\nITEM 5 —\nMarket for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities\nThe Company’s common stock trades on the New York Stock Exchange under the ticker symbol “CAS”. As of March 1, 2013 there were approximately 880 shareholders of record. Payment of cash dividends and repurchase of common stock are currently limited due to restrictions contained in the Company’s debt agreements. No cash dividends were paid on the Company’s common stock in 2012 and 2011. We may consider paying cash dividends on the Company common stock at some point in the future, subject to the limitations described above. Any future payment of cash dividends, if any, is at the discretion of the Board of Directors and will depend on the Company’s earnings, capital requirements and financial condition, restrictions under the Company’s debt instruments, and such other factors as the Board of Directors may consider.\nSee Part III, Item 12, “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters”, for information regarding common stock authorized for issuance under equity compensation plans.\nThe table below presents shares of the Company’s common stock which were acquired by the Company during the quarter ended December 31, 2012:\n| Period | TotalNumber ofSharesPurchased(1) | AveragePricePaid perShare | Total numberof SharesPurchased asPart ofPubliclyAnnouncedPlans orPrograms | MaximumNumber (orApproximateDollar Value) of Shares that May Yet Be Purchased under the Plans or Programs |\n| October 1 through October 31 | — | — | — | — |\n| November 1 through November 30 | — | — | — | — |\n| December 1 through December 31 | 24,469 | $ | 14.77 | — | — |\n| Total | 24,469 | $ | 14.77 | — | — |\n\n| (1) | The total number of shares purchased represents shares surrendered to the Company by employees to satisfy tax withholding obligations upon vesting of restricted stock units awarded pursuant to the Company’s 2010 - 2012 Long-Term Compensation Plan. |\n\nOn October 15, 2012 the Company granted 78,492 restricted stock units to Scott J. Dolan, President and Chief Executive Officer, as an equity inducement award. The restricted stock units subject to the inducement award will vest in four equal annual installments, subject to Mr. Dolan's continued employment by the Company. At the time of vesting, the Company will issue to Mr. Dolan in cancellation of the restricted stock units, the number of shares of common stock of the Company equal to the number of restricted stock units. The inducement award was granted outside of the Company's 2008 Omnibus Incentive Plan, authorized by the independent members of the Human Resources Committee of the Company's Board of Directors and granted as an inducement material to Mr. Dolan's employment with the Company in accordance with Section 303A.08 of the New York Stock Exchange Listed Company Manual. The issuance of these shares of restricted stock units was made in reliance upon the exemptions form registration provided by Section 4(2) under the Securities Act of 1933, as amended.\nThe following table sets forth the range of the high and low sales prices of shares of the Company’s common stock for the periods indicated:\n| 2012 | 2011 |\n| Low | High | Low | High |\n| First Quarter | $ | 9.59 | $ | 12.90 | $ | 15.14 | $ | 19.29 |\n| Second Quarter | $ | 9.65 | $ | 14.20 | $ | 15.25 | $ | 19.24 |\n| Third Quarter | $ | 6.99 | $ | 13.54 | $ | 10.37 | $ | 18.46 |\n| Fourth Quarter | $ | 10.83 | $ | 14.97 | $ | 7.85 | $ | 14.91 |\n\n17\nThe following graph compares the cumulative total stockholder return on our common stock for the five-year period ended December 31, 2012, with the cumulative total return of the Standard and Poor’s 500 Index and to a peer group index. The comparison in the graph assumes the investment of $100 on December 31, 2007. Cumulative total stockholder return means share price increases or decreases plus dividends paid, with the dividends reinvested, and reflect market capitalization weighting. The graph does not forecast future performance of our common stock. The Company moved to a new peer group index during 2010 in conjunction with the establishment of a relative total shareholder return performance measure under the Company’s long term compensation plan. The Company believes this new peer group provides a more meaningful comparison of our stock performance. The new peer group index is made up of companies in the metals industry or in the industrial products distribution business, although not all of the companies included in the new peer group index participate in all of the lines of business in which the Company is engaged and some of the companies included in the peer group index also engage in lines of business in which the Company does not participate. Additionally, the market capitalizations of many of the companies in the peer group are quite different from that of the Company.\nCOMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*\nAmong A.M. Castle & Co., the S&P 500 Index, and a Peer Group\n*$100 invested on 12/31/07 in stock or index, including reinvestment of dividends.\nFiscal year ending December 31.\nCopyright© 2013 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved.\n| 12/07 | 12/08 | 12/09 | 12/10 | 12/11 | 12/12 |\n| A. M. Castle & Co. | $ | 100.00 | $ | 40.32 | $ | 51.30 | $ | 68.99 | $ | 35.45 | $ | 55.35 |\n| S&P 500 | 100.00 | 63.00 | 79.67 | 91.67 | 93.61 | 108.59 |\n| Peer Group (a) | 100.00 | 51.46 | 69.81 | 84.89 | 76.47 | 78.43 |\n\n\n| (a) | The Peer Group Index consists of the following companies: AEP Industries Inc.; AK Steel Holding Corp.; Allegheny Technologies Inc.; Amcol International Corp.; Applied Industrial Technologies Inc.; Carpenter Technology Corp.; Cliffs Natural Resources Inc.; Commercial Metals Company; Fastenal Company; Gibraltar Industries Inc.; Haynes International Inc.; Kaman Corp.; Lawson Products Inc.; MSC Industrial Direct Company Inc.; Nucor Corp.; Olin Corp.; Olympic Steel, Inc.; Quanex Building Products Corp.; Reliance Steel & Aluminum Co.; RTI International Metals Inc.; Schnitzer Steel Industries Inc.; Steel Dynamics Inc.; Stillwater Mining Company; Texas Industries Inc.; United States Steel Corp.; and Worthington Industries Inc. |\n\n18\nITEM 6 —\nSelected Financial Data\nThe Selected Financial Data in the table below includes the results of the December 2011 and January 2008 acquisitions of Tube Supply and Metals U.K., respectively, from the date of acquisition.\n| (dollars in millions, except per share data) | 2012 | 2011 | 2010 | 2009 | 2008 |\n| For the year ended December 31: |\n| Net sales | $ | 1,270.4 | $ | 1,132.4 | $ | 943.7 | $ | 812.6 | $ | 1,501.0 |\n| Equity in earnings of joint venture | 7.2 | 11.7 | 5.6 | 0.4 | 8.8 |\n| Net loss from continuing operations | (9.7 | ) | (1.8 | ) | (5.6 | ) | (26.9 | ) | (17.1 | ) |\n| Basic (loss) earnings per common share from continuing operations | (0.42 | ) | (0.08 | ) | (0.25 | ) | (1.18 | ) | (0.76 | ) |\n| Diluted (loss) earnings per common share from continuing operations | (0.42 | ) | (0.08 | ) | (0.25 | ) | (1.18 | ) | (0.76 | ) |\n| Cash dividends declared per common share | — | — | — | 0.06 | 0.24 |\n| As of December 31: |\n| Total assets | 788.8 | 822.3 | 529.4 | 558.0 | 679.0 |\n| Long-term debt, less current portion | 296.2 | 314.2 | 61.1 | 67.7 | 75.0 |\n| Total debt | 297.1 | 314.9 | 69.1 | 89.2 | 117.1 |\n| Total stockholders’ equity | 337.3 | 312.3 | 313.5 | 318.2 | 347.3 |\n\nITEM 7 —\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations\nAmounts in millions except per share data\nInformation regarding the business and markets of A.M. Castle & Co. and its subsidiaries (the “Company”), including its reportable segments, is included in Item 1 “Business” of this annual report on Form 10-K.\nThe following discussion should be read in conjunction with Item 6 “Selected Financial Data” and the Company’s consolidated financial statements and related notes thereto in Item 8 “Financial Statements and Supplementary Data”.\nEXECUTIVE OVERVIEW\nThe Company’s strategy is to become the foremost global provider of specialty metals products and services and specialized supply chain solutions to targeted global industries.\nDuring 2012, the following significant events occurred which impacted the Company’s operations and/or financial results:\n\n| • | Lower LIFO charges and the inclusion of Tube Supply's activity in 2012 resulted in decreased cost of materials as a percentage of sales to 73.0% in 2012 compared to 74.7% in 2011; |\n\n| • | Increased operating income as a percentage of sales to 3.2%, up from 0.5% in 2011; |\n\n| • | Expanded operations in the United Kingdom to support the continued increase in aerospace defense program business; and |\n\n| • | In the first four months of 2012, the Company recognized $15.6 million of interest expense related to the mark-to-market adjustment on the conversion option associated with the convertible debt. In April, the Company reclassified the cumulative value of the conversion option associated with the convertible debt to additional paid-in capital as a result of the authorization of additional shares of common stock and the conversion option is no longer required to be marked-to-market through earnings. |\n\nRecent Market and Pricing Trends\nThe Company experienced decreased demand from its customer base during the second half of 2012 in the Metals segment as customer buying patterns slowed to reflect a more cautious outlook. Industry data indicates that U.S. service center steel shipments were higher than 2011 levels by approximately 1%, while U.S. service center aluminum shipments were approximately 1% lower in 2012 compared to 2011 levels. Virtually all key end-use\n19\nmarkets experienced decreases in demand in the Company’s Metals segment during 2012. The Plastics segment experienced an increase in demand for its products in 2012 compared to 2011, reflecting continued strength in the automotive sector. Due to the late-cycle nature of the Company’s targeted customers, results typically lag the general economic cycle by twelve months.\nPricing across the majority of the Company’s markets started strong during 2012 and then softened for the majority of the year. The combination of factors above negatively impacted the Company’s operating results during the last three quarters of 2012.\nChanges in pricing can have a more direct impact on the Company’s operating results than changes in volume due to certain factors including but not limited to:\n\n| • | Changes in volume typically result in corresponding changes to the Company’s variable costs. However, as pricing changes occur, variable expenses are not directly impacted. |\n\n| • | If surcharges are not passed through to the customer or are passed through without a mark-up, the Company’s profitability will be adversely impacted. |\n\nCurrent Business Outlook\nManagement uses the Purchasing Managers Index (‘PMI’) provided by the Institute for Supply Management (website is www.ism.ws) as an external indicator for tracking the demand outlook and possible trends in its general manufacturing markets. The table below shows PMI trends from the first quarter of 2010 through the fourth quarter of 2012. Generally speaking, according to the ISM, an index above 50.0 indicates growth in the manufacturing sector of the U.S. economy, while readings under 50.0 indicate contraction.\n| YEAR | Qtr 1 | Qtr 2 | Qtr 3 | Qtr 4 |\n| 2010 | 58.2 | 58.8 | 55.4 | 56.8 |\n| 2011 | 61.1 | 56.4 | 51.0 | 52.4 |\n| 2012 | 53.3 | 52.7 | 50.3 | 50.6 |\n\nMaterial pricing and demand in both the Metals and Plastics segments of the Company’s business have historically proven to be difficult to predict with any degree of accuracy. A favorable PMI trend suggests that demand for some of the Company’s products and services, in particular those that are sold to the general manufacturing customer base in the U.S., could potentially be at a higher level in the near-term. The PMI trended upward from late 2012 levels in the first two months of 2013 to 53.1 in January and 54.2 in February. The Company believes that its revenue trends typically correlate to the changes in PMI on a six to twelve month lag basis.\nRESULTS OF OPERATIONS: YEAR-TO-YEAR COMPARISONS AND COMMENTARY\nOur discussion of comparative period results is based upon the following components of the Company’s consolidated statements of operations.\nNet Sales —The Company derives its sales from the processing and delivery of metals and plastics. Pricing is established with each customer order and includes charges for the material, processing activities and delivery. The pricing varies by product line and type of processing. From time to time the Company may enter into fixed price arrangements with customers while simultaneously obtaining similar agreements with its suppliers.\nCost of Materials — Cost of materials consists of the costs that the Company pays suppliers for metals, plastics and related inbound freight charges, excluding depreciation and amortization which are included in operating costs and expenses discussed below. The Company accounts for inventory primarily on a last-in-first-out (“LIFO”) basis. LIFO adjustments are calculated as of December 31 of each year. The Company may enter into hedges to mitigate the risk associated with commodity price fluctuations. Gains and losses which result from marking the hedge contracts to market are recorded in cost of materials.\nOperating Costs and Expenses — Operating costs and expenses primarily consist of:\n\n| • | Warehouse, processing and delivery expenses, including occupancy costs, compensation and employee benefits for warehouse personnel, processing, shipping and handling costs; |\n\n| • | Sales expenses, including compensation and employee benefits for sales personnel; |\n\n20\n| • | General and administrative expenses, including compensation for executive officers and general management, expenses for professional services primarily related to accounting and legal advisory services, bad debt expense, data communication, computer hardware and maintenance and foreign currency gain or loss; and |\n\n| • | Depreciation and amortization expenses, including depreciation for all owned property and equipment, and amortization of various intangible assets. |\n\n2012 Results Compared to 2011\nAs a result of the acquisition of Tube Supply in December 2011, the full year results were included in the Company's Metals segment during 2012.\nConsolidated results by business segment are summarized in the following table for years 2012 and 2011.\nOperating Results by Segment\n| Year Ended December 31, | Fav / (Unfav) |\n| 2012 | 2011 | $ Change | % Change |\n| Net Sales |\n| Metals | $ | 1,143.9 | $ | 1,014.2 | $ | 129.7 | 12.8 | % |\n| Plastics | 126.5 | 118.2 | 8.3 | 7.0 | % |\n| Total Net Sales | $ | 1,270.4 | $ | 1,132.4 | $ | 138.0 | 12.2 | % |\n| Cost of Materials |\n| Metals | $ | 836.3 | $ | 763.0 | $ | (73.3 | ) | (9.6 | )% |\n| % of Metals Sales | 73.1 | % | 75.2 | % |\n| Plastics | 91.0 | 82.6 | (8.4 | ) | (10.2 | )% |\n| % of Plastics Sales | 71.9 | % | 69.9 | % |\n| Total Cost of Materials | $ | 927.3 | $ | 845.6 | $ | (81.7 | ) | (9.7 | )% |\n| % of Total Sales | 73.0 | % | 74.7 | % |\n| Operating Costs and Expenses |\n| Metals | $ | 257.8 | $ | 237.7 | $ | (20.1 | ) | (8.5 | )% |\n| Plastics | 32.3 | 32.7 | 0.4 | 1.2 | % |\n| Other | 11.9 | 11.2 | (0.7 | ) | (6.3 | )% |\n| Total Operating Costs & Expenses | $ | 302.0 | $ | 281.6 | $ | (20.4 | ) | (7.2 | )% |\n| % of Total Sales | 23.8 | % | 24.9 | % |\n| Operating Income (Loss) |\n| Metals | $ | 49.8 | $ | 13.5 | $ | 36.3 | 268.9 | % |\n| % of Metals Sales | 4.4 | % | 1.3 | % |\n| Plastics | 3.2 | 2.9 | 0.3 | 10.3 | % |\n| % of Plastics Sales | 2.5 | % | 2.5 | % |\n| Other | (11.9 | ) | (11.2 | ) | (0.7 | ) | (6.3 | )% |\n| Total Operating Income | $ | 41.1 | $ | 5.2 | $ | 35.9 | 690.4 | % |\n| % of Total Sales | 3.2 | % | 0.5 | % |\n\n“Other” includes costs of executive, legal and finance departments which are shared by both segments of the Company.\nNet Sales:\nConsolidated net sales were $1,270.4 million in 2012, an increase of $138.0 million, or 12.2%, versus 2011. Metals segment net sales during 2012 of $1,143.9 million were $129.7 million, or 12.8%, higher than 2011. Tube Supply contributed net sales of $178.5 million in 2012 compared to $7.6 million for the two-week period ended December 31, 2011. Excluding Tube Supply results, net sales for the Metals segment were $41.2 million lower in\n21\n2012 compared to 2011. Lower net sales were primarily the result of lower shipping volumes. Average tons sold per day, excluding Tube Supply, decreased 3.9% compared to the prior year. The decrease in demand experienced in 2012 was driven primarily by SBQ bar, carbon bar and aluminum products. Excluding Tube Supply, gains in the oil and gas business were offset by weakness in the industrial business in 2012 compared to 2011.\nPlastics segment net sales during 2012 of $126.5 million were $8.3 million, or 7.0%, higher than 2011 primarily due to increased sales volume, reflecting continued strength in the automotive sector.\nCost of Materials:\nCost of materials (exclusive of depreciation and amortization) were $927.3 million, an increase of $81.7 million, or 9.7%, compared to 2011. Material costs for the Metals segment were $836.3 million or 73.1% as a percent of net sales compared to $763.0 million or 75.2% as a percent of net sales in 2011. Tube Supply cost of materials were $118.7 million in 2012 compared to $5.3 million for the two-week period ended December 31, 2011. During 2011, the Company implemented a commodity hedging program to mitigate the risks associated with certain commodity price fluctuations. The 2012 results include a $0.4 million charge associated with the realized and unrealized losses for forward contracts related to the commodity hedging program compared to a $2.4 million charge in 2011. Cost of materials for the Metals segment include a LIFO charge of $1.1 million in 2012 compared to $15.1 million in 2011. The remaining increase in cost of materials for the Metals segment is consistent with the sales volume increase year-over-year.\nMaterial costs for the Plastics segment were 71.9% as a percent of net sales in 2012 as compared to 69.9% for the same period last year due to higher costs experienced in the automotive sector of the business.\nOperating Expenses and Operating Income (Loss):\nOperating costs and expenses increased $20.4 million, or 7.2%, compared to last year. Operating costs and expenses for 2012 were $302.0 million, or 23.8% as a percent of net sales, compared to $281.6 million million, or 24.9% as a percent of net sales last year. Operating costs related to Tube Supply were $32.9 million in 2012 compared to $0.9 million in 2011.\nDuring the second quarter of 2012, the Company incurred costs associated with executive employment transition in the amount of $1.6 million. As a result of the transition, share-based awards were forfeited, which resulted in a significant increase in the Company’s forfeiture rate. The increase in the forfeiture rate estimate associated with the active Long-term Compensation Plans resulted in a decrease in sales, general and administrative cost of approximately $1.0 million. The net impact of the employment transition costs on sales, general and administrative expense was approximately $0.6 million.\nThe increase in operating expenses for 2012 compared to 2011 primarily relates to the following:\n\n| • | Warehouse, processing and delivery costs increased by $13.4 million of which a $15.6 million increase is associated with the increase for Tube Supply for the period. The Tube Supply impact was offset by a $2.2 million decrease primarily attributed to a decline in workers’ compensation, overtime wage, temporary employee and utilities costs, partially offset by an increase in compensation and benefits expense as a result of headcount, merit and healthcare cost increases and rent expense due to a full year of expense for the expanded facility in Mexico, which was substantially completed in 2011 and rent expense for the new facility in Trafford Park, United Kingdom during 2012; |\n\n| • | Sales, general and administrative costs increased by $1.6 million of which a $9.8 million increase is associated with the increase for Tube Supply for the period. The net impact of the CEO transition costs of $0.6 million and an increase to bad debt reserves for customer bankruptcies of $0.8 million were included in the 2012 results. The 2011 results include a $0.9 million charge for export penalties related to product shipments that occurred from 2005 to 2008 and $4.3 million for charges related to the acquisition of Tube Supply. The remaining decrease of $4.6 million is primarily attributed to a decline incentive compensation and other compensation and benefits costs, partially offset by an increase in workers' compensation and outside services costs; and |\n\n| • | Depreciation and amortization expense was $5.4 million higher than 2011 primarily due to the depreciation and amortization of Tube Supply’s fixed and intangible assets acquired in December 2011. |\n\nConsolidated operating income for 2012 was $41.1 million compared to $5.2 million in 2011.\n22\nOther Income and Expense, Income Taxes and Net Loss:\nInterest expense was $56.7 million in 2012, an increase of $36.9 million versus 2011 as a result of interest charges on the Company’s new senior secured and convertible notes, as well as the unrealized loss for the mark-to-market adjustment on the conversion option associated with the convertible notes.\nThe increase in interest expense for 2012 compared to the prior year is a result of the following:\n\n| • | Increase for the non-cash interest charge of $11.6 million associated with the mark-to-market adjustment on the conversion option associated with the convertible notes, which is not deductible for federal income tax purposes; |\n\n| • | Increase for interest on senior secured and convertible notes of $31.0 million; and |\n\n| • | Increase for amortization of deferred financing fees and debt discount of $1.1 million. |\n\nIn addition to items above, there was a loss on extinguishment of the Company’s existing long-term notes of $6.2 million and a charge for underwriting fees associated with the debt financing of $3.4 million recorded in 2011.\nThe Company recorded income tax expense of $1.4 million in 2012 compared to a tax benefit of $1.1 million in 2011. The Company’s effective tax rate is expressed as ‘Income tax benefit’ (which includes tax expense on the Company’s share of joint venture earnings) as a percentage of ‘Loss before income taxes and equity in earnings of joint venture.’ This calculation includes taxes on the joint venture income but excludes joint venture income. The effective tax rate for 2012 and 2011 was 9.2% and 7.7%, respectively. The change in the effective tax rate for 2012 compared to 2011 was primarily the result of the non-deductibility of the change in the mark-to-market adjustment on the conversion option associated with the convertible notes in the amount of $11.6 million.\nEquity in earnings of the Company’s joint venture was $7.2 million in 2012 compared to $11.7 million in 2011. The decrease is a result of lower demand in virtually all of the joint venture’s end-use markets compared to last year.\nConsolidated net loss for 2012 was $9.7 million, or $0.42 per diluted share, compared to net loss of $1.8 million, or $0.08 per diluted share, for 2011.\n23\n2011 Results Compared to 2010\nConsolidated results by business segment are summarized in the following table for years 2011 and 2010.\nOperating Results by Segment\n| Year Ended December 31, | Fav / (Unfav) |\n| 2011 | 2010 | $ Change | % Change |\n| Net Sales |\n| Metals | $ | 1,014.2 | $ | 841.1 | $ | 173.1 | 20.6 | % |\n| Plastics | 118.2 | 102.6 | 15.6 | 15.2 | % |\n| Total Net Sales | $ | 1,132.4 | $ | 943.7 | $ | 188.7 | 20.0 | % |\n| Cost of Materials |\n| Metals | $ | 763.0 | $ | 631.1 | $ | (131.9 | ) | (20.9 | )% |\n| % of Metals Sales | 75.2 | % | 75.0 | % |\n| Plastics | 82.6 | 69.8 | (12.8 | ) | (18.3 | )% |\n| % of Plastics Sales | 69.9 | % | 68.0 | % |\n| Total Cost of Materials | $ | 845.6 | $ | 700.9 | $ | (144.7 | ) | (20.6 | )% |\n| % of Total Sales | 74.7 | % | 74.3 | % |\n| Operating Costs and Expenses |\n| Metals | $ | 237.7 | $ | 215.5 | $ | (22.2 | ) | (10.3 | )% |\n| Plastics | 32.7 | 29.3 | (3.4 | ) | (11.6 | )% |\n| Other | 11.2 | 7.4 | (3.8 | ) | (51.4 | )% |\n| Total Operating Costs & Expenses | $ | 281.6 | $ | 252.2 | $ | (29.4 | ) | (11.7 | )% |\n| % of Total Sales | 24.9 | % | 26.7 | % |\n| Operating (Loss) Income |\n| Metals | $ | 13.5 | $ | (5.5 | ) | $ | 19.0 | 345.5 | % |\n| % of Metals Sales | 1.3 | % | (0.7 | )% |\n| Plastics | 2.9 | 3.6 | (0.7 | ) | (19.4 | )% |\n| % of Plastics Sales | 2.5 | % | 3.5 | % |\n| Other | (11.2 | ) | (7.4 | ) | (3.8 | ) | (51.4 | )% |\n| Total Operating (Loss) | $ | 5.2 | $ | (9.3 | ) | $ | 14.5 | 155.9 | % |\n| % of Total Sales | 0.5 | % | (1.0 | )% |\n\n“Other” includes costs of executive, legal and finance departments which are shared by both segments of the Company.\nNet Sales:\nConsolidated net sales were $1,132.4 million in 2011, an increase of $188.7 million, or 20.0%, versus 2010. Metals segment net sales during 2011 of $1,014.2 million were $173.1 million, or 20.6%, higher than 2010. Tube Supply contributed net sales of $7.6 million for the two-week period ended December 31, 2011. Higher net sales were primarily the result of higher shipping volumes. Average tons sold per day, excluding Tube Supply, increased 18.1% compared to the prior year. The increase in demand experienced in 2011 was driven primarily by SBQ bar, alloy bar, carbon and alloy plate, stainless and tubing products. Key end-use markets that experienced increased demand in 2011 compared to 2010 include oil and gas, mining and heavy equipment and general industrial markets.\nPlastics segment net sales during 2011 of $118.2 million were $15.6 million, or 15.2%, higher than 2010 primarily due to higher overall pricing and, to a lesser extent, increased sales volume. The Plastics business experienced increased sales volume during 2011 reflecting strength in the automotive and office furniture end-use markets compared to 2010.\n24\nCost of Materials:\nCost of materials (exclusive of depreciation and amortization) were $845.6 million, an increase of $144.7 million, or 20.6%, compared to 2010. Material costs for the Metals segment were $763.0 million or 75.2% as a percent of net sales compared to $631.1 million or 75.0% as a percent of net sales in 2010. Tube Supply cost of materials were $5.3 million for the two-week period ended December 31, 2011. During 2011, the Company implemented a commodity hedging program to mitigate the risks associated with certain commodity price fluctuations. The 2011 results include a $2.4 million charge associated with the mark-to-market adjustment for forward contracts related to the commodity hedging program compared to no charge in 2010. The Metals segment recorded LIFO expense of $15.1 million in 2011 compared to $7.7 million in 2010. The remaining increase in cost of materials for the Metals segment is consistent with the sales volume increase year-over-year.\nMaterial costs for the Plastics segment were 69.9% as a percent of net sales in 2011 as compared to 68.0% for the same period last year. The Plastics segment recorded LIFO expense of $0.9 million in 2011 compared to $0.3 million in 2010.\nDuring 2010, a reduction in inventories resulted in a liquidation of applicable LIFO inventory quantities carried at lower costs in prior years. On a consolidated basis, cost of materials for 2010 were lower by $12.5 million as a result of the liquidations.\nOperating Expenses and Operating Income (Loss):\nOperating costs and expenses increased $29.4 million, or 11.7%, compared to last year. Operating costs and expenses for 2011 were $281.6 million, or 24.9% as a percent of net sales, compared to $252.2 million, or 26.7% as a percent of net sales last year. Operating costs and expenses in 2011 include a $0.9 million charge for export penalties related to product shipments that occurred from 2005 to 2008 and in 2011 compared to no charge in 2010. Additionally, there were no facility consolidation charges during 2011 compared to $2.4 million in 2010.\nFull workweeks and 401(k) matching contributions were reinstated in January and April 2010, respectively, resulting in overall increases in payroll related costs in 2011 compared to 2010. Additionally, effective July 1, 2011, the Company’s 401(k) matching contribution was increased to 100% of each dollar on eligible employee contributions up to the first 6% of the employee’s pre-tax compensation. Effective July 1, 2011, the Company’s fixed contribution of 4% of eligible earnings for all employees was eliminated. Other factors that contributed to increased payroll related costs in 2011 compared to 2010 included merit increases and headcount increases.\nIn addition to payroll related costs, there were costs associated with the acquisition of Tube Supply in December 2011 of $4.3 million, as well as Tube Supply activity for the two-week period ended December 31, 2011 that contributed $0.9 million to the overall increase.\nThe $29.4 million increase in operating expenses in 2011 compared to 2010 primarily relates to the following:\n\n| • | Warehouse, processing and delivery costs increased by $11.6 million of which $4.1 million is due to increased compensation and benefits expenses as a result of headcount, merit and healthcare cost increases and $7.2 million is the result of increases in charges associated with higher sales volumes, such as warehouse, packing and shipping supplies, repairs and maintenance, utilities, outside services, overtime wages and temporary help. The warehouse, processing and delivery cost increase associated with Tube Supply for the two-week period ended December 31, 2011 amounted to $0.3 million; |\n\n| • | Sales, general and administrative costs increased by $17.9 million. The increase is primarily comprised of $4.3 million of direct acquisition-related costs, $7.1 million as a result of headcount, merit and healthcare cost increases and a $0.9 million charge for export penalties related to product shipments that occurred from 2005 to 2008 and in 2011. The sales, general and administrative cost increase associated with Tube Supply for the two-week period ended December 31, 2011 amounted to $0.3 million. The balance of the difference relates other administrative expenses including training, travel and insurance; and |\n\n| • | Depreciation and amortization expense decreased $0.1 million in 2011 compared to 2010. The depreciation and amortization expense for Tube Supply for the two-week period ended December 31, 2011 amounted to $0.3 million. |\n\nConsolidated operating income for 2011 was $5.2 million compared to operating loss of $9.3 million in 2010.\n25\nOther Income and Expense, Income Taxes and Net Loss:\nInterest expense was $13.7 million in 2011, an increase of $8.7 million versus 2010 as a result of charges associated with refinancing the Company’s debt in conjunction with the Tube Supply acquisition. The Company issued $225.0 million of senior secured notes and $57.5 million of convertible senior notes and entered into a $100.0 million senior secured asset based revolving credit facility.\nInterest expense for 2011 includes the following charges:\n\n| • | Non-cash interest charge of $4.0 million associated with the mark-to-market adjustment for the derivative liability component of the convertible notes, which is not deductible for federal income tax purposes; |\n\n| • | Non-cash interest charge of $0.2 million for the amortization of new debt origination fees; |\n\n| • | Interest on new debt of $1.6 million; and |\n\n| • | Underwriting fees of $3.4 million associated with the debt financing. |\n\nIn addition to increased interest expense, there was a loss on extinguishment of the Company’s existing long-term notes of $6.2 million, which is comprised of a non-cash charge of $0.9 million for the write-off of existing debt issuance costs and $5.2 million for the fees associated with the prepayment of the notes.\nThe Company recorded a tax benefit of $1.1 million in 2011 compared to a tax benefit of $3.1 million in 2010. The Company’s effective tax rate is expressed as ‘Income tax benefit’ (which includes tax expense on the Company’s share of joint venture earnings) as a percentage of ‘Loss before income taxes and equity in earnings of joint venture.’ This calculation includes taxes on the joint venture income but excludes joint venture income. The effective tax rate for 2011 and 2010 was 7.7% and 21.7%, respectively. The change in the tax rate was due primarily to the additional income tax on joint venture income compared to 2010 and the non-deductibility of the mark-to-market charge on the derivative liability component of the convertible notes.\nEquity in earnings of the Company’s joint venture was $11.7 million in 2011 compared to $5.6 million in 2010. The increase is a result of higher demand in virtually all of the joint venture’s end-use markets, most notably the oil and gas and automotive sectors, and higher pricing compared to last year.\nConsolidated net loss for 2011 was $1.8 million, or $0.08 per diluted share, compared to net loss of $5.6 million, or $0.25 per diluted share, for 2010.\nLiquidity and Capital Resources\nCash and cash equivalents decreased by $8.9 million and $6.2 million for the years ended December 31, 2012 and 2011, respectively, and increased by $8.4 million for the year ended December 31, 2010.\nThe Company’s principal sources of liquidity are cash provided by operations and available borrowing capacity to fund working capital needs and growth initiatives. Cash provided by operations for the year-ended December 31, 2012 was $5.4 million compared to cash used in operations of $46.3 million for the year-ended December 31, 2011 and cash provided by operations of $34.4 million for the year-ended December 31, 2010. Specific components of the change in working capital are highlighted below:\n\n| • | During 2012, cash receipts from customers exceeded net sales resulting in a $44.6 million cash flow source due to a decrease in accounts receivable compared to a $26.4 million cash flow use due to an increase in accounts receivable for 2011. Net sales increased 12.2% from 2011. Average receivable days outstanding was 49.0 days for 2012 and 50.3 for 2011. |\n\n| • | During 2012, inventory purchases exceeded sales of inventory resulting in a $29.3 million cash flow use due to an increase in inventory compared to a $39.4 million cash flow use due to an increase in inventory in 2011. Average days sales in inventory was 187.0 days for 2012 verses 128.5 days for 2011. |\n\n| • | During 2012, cash paid for inventories and other goods and services exceeded purchases resulting in a $38.0 million cash flow use due to a net decrease in accounts payable and accrued liabilities compared to a $9.7 million cash flow source due to a net increase in accounts payable and accrued liabilities for 2011. |\n\n| • | The Company received its 2010 federal income tax refund of approximately $2.0 million during February 2012 and its 2009 federal income tax refund of approximately $6.3 million during January 2011. |\n\n26\nIn December 2011, in conjunction with the acquisition of Tube Supply, the Company issued $225.0 million aggregate principal amount of 12.75% Senior Secured Notes due 2016, $57.5 million aggregate principal amount of 7.0% Convertible Senior Notes due 2017 and entered into a $100.0 million senior secured asset based revolving credit facility (the “New Revolving Credit Facility”). Net proceeds of $304.6 million were used to complete the Acquisition, pay-off amounts outstanding under our previous credit agreement and for general corporate purposes.\nHistorically, the Company’s primary uses of liquidity and capital resources have been capital expenditures, payments on debt (including interest payments), acquisitions and dividend payments. Management believes the Company will be able to generate sufficient cash from operations and planned working capital improvements to fund its ongoing capital expenditure programs and meet its debt obligations for at least the next twelve months. Furthermore, the Company does have available borrowing capacity under the New Revolving Credit Agreement. The new debt agreements impose significant operating and financial restrictions which may prevent the Company from certain business opportunities such as, making acquisitions or paying dividends among other things. The New Revolving Credit facility contains a springing financial maintenance covenant requiring the Company to maintain the ratio of EBITDA (as defined in the agreement) to fixed charges of 1.1 to 1.0 when excess availability is less than the greater of 10% of the calculated borrowing base (as defined in the agreement) or $10 million. In addition, if excess availability is less than the greater of 12.5% of the calculated borrowing base (as defined in the agreement) or $12.5 million, the lender has the right to take full dominion of the Company’s cash collections and apply these proceeds to outstanding loans under the New Revolving Credit Agreement (“cash dominion”). Based on the Company’s cash projections, it does not anticipate a scenario whereby cash dominion would occur during the next twelve months.\nThe Company is committed to maintaining a strong financial position through maintaining sufficient levels of available liquidity, managing working capital and monitoring the Company’s overall capitalization. Cash and cash equivalents at December 31, 2012 were $21.6 million and the Company had $50.5 million of available borrowing capacity under its New Revolving Credit Facility. Approximately 23% of the Company’s consolidated cash and cash equivalents balance resides in the United States. As foreign earnings are permanently reinvested, availability under the Company’s New Revolving Credit Facility would be used to fund operations in the United States should the need arise in the future.\nWorking capital at December 31, 2012 was $379.3 million compared to $349.0 million at December 31, 2011. The increase in working capital is primarily due to higher inventory of $31.7 million, prepaid expenses and other current assets of $4.7 million and lower accounts payable of $48.9 million, offset by lower accounts receivable of $42.7 million and lower cash of $8.9 million, from December 31, 2011 to 2012.\nThe Company monitors its overall capitalization by evaluating total debt to total capitalization. Total debt to total capitalization is defined as the sum of short- and long-term debt, divided by the sum of total debt and stockholders’ equity. Total debt to total capitalization was 46.8% at December 31, 2012 and 50.2% at December 31, 2011. As of April 26, 2012, the conversion option value of $42.0 million associated with the convertible debt, which was issued in December 2011, was reclassified from long-term debt to additional paid-in capital, resulting in a decrease to the debt to total capitalization at December 31, 2012. The deferred tax benefit of $8.3 million associated with the temporary difference between the financial reporting basis of the derivative liability and its tax basis at the date of issuance (December 15, 2011) was also reclassified to additional paid-in capital. Over the long-term, the Company plans to continue to improve its total debt to total capitalization by improving operating results, managing working capital and using cash generated from operations to repay outstanding debt. Going forward, as and when permitted by term of agreements noted above, depending on market conditions, the Company may decide in the future to refinance, redeem or repurchase its debt and take other steps to reduce its debt or lease obligations or otherwise improve its overall financial position and balance sheet.\nCapital Expenditures\nCash paid for capital expenditures for 2012 was $11.1 million compared to $11.7 million in 2011. The expenditures during 2012 were comprised of approximately $1.1 million of ERP and other information technology enhancements and $1.3 million related to existing and new facility expansions for additional automotive business in the Plastics segment and for additional aerospace defense business in the United Kingdom. The balance of the capital expenditures in 2012 are the result of normal equipment, building improvement and furniture and fixture upgrades throughout the year. Management believes that capital expenditures will approximate $14 million in 2013.\n27\nContractual Obligations and Other Commitments\nThe following table includes information about the Company’s contractual obligations that impact its short-term and long-term liquidity and capital needs. The table includes information about payments due under specified contractual obligations and is aggregated by type of contractual obligation. It includes the maturity profile of the Company’s consolidated long-term debt, operating leases and other long-term liabilities.\nAt December 31, 2012, the Company’s contractual obligations, including estimated payments by period, were as follows:\n| Payments Due In | Total | Less Than One Year | One toThree Years | Three toFive Years | More Than Five Years |\n| Long-term debt obligations (excluding capital lease obligations) | $ | 322.0 | $ | — | $ | 39.5 | $ | 282.5 | $ | — |\n| Interest payments on debt obligations (a) | 137.4 | 33.6 | 67.1 | 36.7 | — |\n| Capital lease obligations | 1.4 | 0.4 | 0.8 | 0.2 | — |\n| Operating lease obligations | 76.7 | 14.4 | 21.5 | 16.7 | 24.1 |\n| Purchase obligations (b) | 333.5 | 222.6 | 110.9 | — | — |\n| Other (c) | 8.1 | 8.1 | — | — | — |\n| Total | $ | 879.1 | $ | 279.1 | $ | 239.8 | $ | 336.1 | $ | 24.1 |\n\n| a) | Interest payments on debt obligations represent interest on all Company debt outstanding as of December 31, 2012. The interest payment amounts related to the variable rate component of the Company’s debt assume that interest will be paid at the rates prevailing at December 31, 2012. Future interest rates may change, and therefore, actual interest payments could differ from those disclosed in the table above. |\n\n| b) | Purchase obligations consist of raw material purchases made in the normal course of business. The Company has contracts to purchase minimum quantities of material with certain suppliers. For each contractual purchase obligation, the Company generally has a purchase agreement from its customer for the same amount of material over the same time period. |\n\n| c) | ‘Other’ is comprised of deferred revenues that represent commitments to deliver products and obligations related to recognizing and measuring tax positions taken or expected to be taken in a tax return that directly or indirectly affect amounts reported in financial statements. The uncertain tax positions included in the Company’s obligations are related to temporary differences and uncertain tax positions where the Company anticipates a high probability of settlement within a given timeframe. The years for which the temporary differences related to the uncertain tax positions will reverse have been estimated in scheduling the obligations within the table. |\n\nThe table and corresponding footnotes above do not include $10.7 million of other non-current liabilities recorded on the consolidated balance sheets. These non-current liabilities consist of liabilities related to the Company’s non-funded supplemental pension plan and postretirement benefit plans for which payment periods cannot be determined. Non-current liabilities also include $37.5 million of deferred income taxes, deferred gain on the sale of certain assets, derivative liability associated with commodity hedges and unfavorable lease liability for a lease entered into in conjunction with the Tube Supply acquisition, which was excluded from the table as the amounts due and timing of payments (or receipts) at future contract settlement dates cannot be determined.\nPension Funding\nThe Company’s funding policy on its defined benefit pension plans is to satisfy the minimum funding requirements of the Employee Retirement Income Security Act (“ERISA”). Future funding requirements are dependent upon various factors outside the Company’s control including, but not limited to, fund asset performance and changes in regulatory or accounting requirements. Based upon factors known and considered as of December 31, 2012, the Company does not anticipate making significant cash contributions to the pension plans in 2013.\nThe investment target portfolio allocation for the Company-sponsored pension plans and supplemental pension plan focuses primarily on corporate fixed income securities that match the overall duration and term of the Company’s pension liability structure. Refer to “Retirement Plans” within Critical Accounting Policies and Note 5 to the consolidated financial statements for additional details regarding other plan assumptions.\nOff-Balance Sheet Arrangements\n28\nWith the exception of letters of credit and operating lease financing on certain equipment used in the operation of the business, it is not the Company’s general practice to use off-balance sheet arrangements, such as third-party special-purpose entities or guarantees of third parties.\nAs of December 31, 2012, the Company had $6.8 million of irrevocable letters of credit outstanding which primarily consisted of $4.0 million for collateral associated with commodity hedges and $2.0 million for compliance with the insurance reserve requirements of its workers’ compensation insurance carriers.\nThe Company is party to certain multi-employer pension plans. The overall cost of such plans to the Company is insignificant. If the Company withdraws from a multi-employer pension plan in the future, it could potentially incur a withdrawal liability at that time.\nObligations of the Company associated with its leased equipment are disclosed under the “Contractual Obligations and Other Commitments” section above.\nCritical Accounting Policies\nThe consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America, and include amounts that are based on management’s estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. The following is a description of the Company’s accounting policies that management believes require the most significant judgments and estimates when preparing the Company’s consolidated financial statements:\nRevenue Recognition — Revenue from the sales of products is recognized when the earnings process is complete and when the title and risk and rewards of ownership have passed to the customer, which is primarily at the time of shipment. Revenue recognized other than at time of shipment represents less than 3% of the Company’s consolidated net sales. Revenue from shipping and handling charges is recorded in net sales. Provisions for allowances related to sales discounts and rebates are recorded based on terms of the sale in the period that the sale is recorded. Management utilizes historical information and the current sales trends of the business to estimate such provisions. Actual results could differ from these estimates. The provisions related to discounts and rebates due to customers are recorded as a reduction within net sales in the Company’s consolidated statements of operations and comprehensive loss.\nThe Company maintains an allowance for doubtful accounts resulting from the inability of our customers to make required payments. The allowance for doubtful accounts is maintained at a level considered appropriate based on historical experience and specific identification of customer receivable balances for which collection is unlikely. The provisions for doubtful accounts is recorded in sales, general and administrative expense in the Company’s consolidated statements of operations and comprehensive loss. Estimates of doubtful accounts are based upon historical write-off experience as a percentage of net sales and judgments about the probable effects of economic conditions on certain customers, which can fluctuate significantly from year to year. The Company cannot be certain that the rate of future credit losses will be similar to past experience.\nThe Company also maintains an allowance for credit memos for estimated credit memos to be issued against current sales. Estimates of allowance for credit memos are based upon the application of a historical issuance lag period to the average credit memos issued each month. If actual results differ significantly from historical experience, there could be a negative impact on the Company’s operating results.\nIncome Taxes — The Company’s income tax expense, deferred tax assets and liabilities and reserve for uncertain tax positions reflect management’s best estimate of taxes to be paid. The Company is subject to income taxes in the U.S. and several foreign jurisdictions. The determination of the consolidated income tax expense requires judgment and estimation by management. It is possible that actual results could differ from the estimates that management has used to determine its consolidated income tax expense.\nThe Company accounts for deferred income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statement and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.\n29\nValuation allowances are recorded against deferred tax assets when it is more likely than not that the amounts will not be realized, which will increase the provision for income taxes in the period in which that determination is made.\nThe Company has undistributed earnings of foreign subsidiaries of approximately $83.4 million at December 31, 2012, for which deferred taxes have not been provided. Such earnings are considered indefinitely invested in the foreign subsidiaries. If such earnings were repatriated, additional tax expense may result, although due to the potential availability of foreign tax credits and other items, the calculation of such additional taxes is not practicable.\nThe Company’s investment in the joint venture is through a 50% interest in a limited liability corporation (LLC) taxed as a partnership. The joint venture has two subsidiaries organized as individually taxed C-Corporations. The Company includes in its income tax provision the income tax liability on its share of the income of the joint venture and its subsidiaries. The income tax liability of the joint venture itself is generally treated as a current income tax expense and the income tax liability associated with the profits of the two subsidiaries of the joint venture is treated as deferred income tax expense. The Company can not independently cause a dividend to be declared by one of the subsidiaries of the joint venture, therefore no benefit of a dividend received deduction can be recognized in the Company's tax provision until a dividend is declared. If one of the C-Corporation subsidiaries of the joint venture declares a dividend payable to the joint venture, the Company recognizes a benefit for the 80% dividends received deduction on its 50% share of the dividend.\nThe Company’s income tax provisions are based on calculations and assumptions that are subject to examination by the IRS and other tax authorities. Although the Company believes that the positions taken on previously filed tax returns are reasonable, it has established tax and interest reserves in recognition that various taxing authorities may challenge the positions taken, which could result in additional liabilities for taxes and interest. The Company regularly reviews its deferred tax assets for recoverability considering historical profitability, projected future taxable income, the expected timing of the reversals of existing temporary differences and tax planning strategies.\nFor uncertain tax positions, the Company applies the provisions of relevant authoritative guidance, which requires application of a “more likely than not” threshold to the recognition and derecognition of tax positions. The Company’s ongoing assessments of the more likely than not outcomes of tax authority examinations and related tax positions require significant judgment and can increase or decrease the Company’s effective tax rate as well as impact operating results.\nRetirement Plans — The Company values retirement plan liabilities based on assumptions and valuations established by management. Future valuations are subject to market changes, which are not in the control of the Company and could differ materially from the amounts currently reported. The Company evaluates the discount rate and expected return on assets at least annually and evaluates other assumptions involving demographic factors, such as retirement age, mortality and turnover periodically, and updates them to reflect actual experience and expectations for the future. Actual results in any given year will often differ from actuarial assumptions because of economic and other factors.\nAccumulated and projected benefit obligations are expressed as the present value of future cash payments which are discounted using the weighted average of market-observed yields for high quality fixed income securities with maturities that correspond to the payment of benefits. Lower discount rates increase present values and subsequent-year pension expense; higher discount rates decrease present values and subsequent-year pension expense. Discount rates used for determining the Company’s projected benefit obligation for retirement plans were 3.50 - 3.75% and 4.25% at December 31, 2012 and 2011, respectively.\nThe Company’s pension plan asset portfolio as of December 31, 2012 is primarily invested in fixed income securities with a duration of approximately 12 years. The assets generally fall within Level 2 of the fair value hierarchy. Assets in the Company’s pension plans have earned approximately 12% since 2008 when the Company changed its target investment allocation to focus primarily on fixed income securities. The target investment asset allocation for the pension plans’ funds focuses primarily on corporate fixed income securities that match the overall duration and term of the Company’s pension liability structure. As of December 31, 2012 and 2011, the funding surplus was approximately 3% and 6%, respectively. To determine the expected long-term rate of return on the pension plans’ assets, current and expected asset allocations are considered, as well as historical and expected returns on various categories of plan assets.\n30\nThe Company used the following weighted-average discount rates and expected return on plan assets to determine the net periodic pension credit:\n| 2012 | 2011 |\n| Discount rate | 4.25 | % | 5.25 | % |\n| Expected long-term rate of return on plan assets | 5.75 | % | 6.50 | % |\n\nHolding all other assumptions constant, the following table illustrates the sensitivity of changes to the discount rate and long-term rate of return assumptions on the Company’s net periodic pension credit (amounts in millions):\n| Impact on 2012Expenses - increase (decrease) |\n| 50 basis point decrease in discount rate | $(1.1) |\n| 50 basis point increase in discount rate | $1.1 |\n| 50 basis point decrease in expected return on assets | $0.9 |\n\nGoodwill and Other Intangible Assets Impairment — The carrying value of the Company’s goodwill is evaluated annually on January 1st of each fiscal year or when certain triggering events occur which require a more current valuation. The Company assesses, at least quarterly, whether any triggering events have occurred.\nA two-step method is used for determining goodwill impairment. The first step is performed to identify whether a potential impairment exists by comparing each reporting unit’s fair value to its carrying value. If the carrying value of a reporting unit exceeds its fair value, the next step it to measure the amount of impairment loss, if any.\nThe determination of the fair value of the reporting units requires significant estimates and assumptions to be made by management. The fair value of each reporting unit is estimated using a combination of an income approach, which estimates fair value based on a discounted cash flow analysis using historical data, estimates of future cash flows and discount rates based on the view of a market participant, and a market approach, which estimates fair value using market multiples of various financial measures of comparable public companies. In selecting the appropriate assumptions the Company considers: the selection of appropriate peer group companies; control premiums appropriate for acquisitions in the industry in which the Company competes; discount rates; terminal growth rates; long-term projections of future financial performance; and relative weighting of income and market approaches. The long-term projections used in the valuation are developed as part of the Company’s annual budgeting and strategic planning process. The discount rates used to determine the fair values of the reporting units are those of a hypothetical market participant which are developed based upon an analysis of comparable companies and include adjustments made to account for any individual reporting unit specific attributes such as, size and industry.\nBased on the impairment test performed on January 1, 2012 (the Company's annual measurement date), the Company concluded that the fair values for each reporting unit exceeded the carrying values. Except for Aerospace and Oil & Gas, all other reporting units' fair values exceeded their carrying values by more than 10% as of January 1, 2012.\nThe Company has completed its January 1, 2013 annual goodwill impairment test. As of January 1, 2013, the Aerospace and Oil & Gas reporting units had goodwill balances of approximately $21 million and $20 million, respectively, and $0 of indefinite lived intangible assets. A combination of the income approach and the market approach was utilized to estimate the reporting units' fair values. The Aerospace and Oil & Gas reporting units both had estimated fair values that exceeded carry value by less than 10%. Under the income approach, the following key assumptions were used in the Company's discounted cash flow analysis:\n| Aerospace | Oil & Gas |\n| Discount rate | 15.0 | % | 14.0 | % |\n| 5-year CAGR | 4.2 | % | 1.5 | % |\n| Terminal growth rate | 3.0 | % | 3.0 | % |\n\n31\nUnder the market approach, the Company used a multiple of earnings before interest, taxes, depreciation and amortization (“EBITDA”) of 6.5 and 6.0 for Aerospace and Oil & Gas, respectively. The EBITDA multiple observed in the marketplace for recent transactions ranged from 6.0 to 8.7 with a median of 6.9 as of January 1, 2013. The Company considers several factors in estimating the EBITDA multiple including a reporting unit's market position, gross and operating margins and prospects for growth, among other factors.\nHolding all other assumptions in the model constant, the Company has summarized what the discount rate and EBITDA multiple would have to be (holding the other variable constant) in order for the fair value of Aerospace and Oil & Gas reporting units to fall below their respective carrying value:\n| Aerospace | Oil & Gas |\n| Discount rate | 16.5 | % | 14.8 | % |\n| EBITDA multiple | 5.8 | 5.6 |\n\nIf either reporting unit's carrying value exceeded its fair value, additional valuation procedures would have been required to determine whether the reporting unit's goodwill was impaired, and to the extent goodwill was impaired, the magnitude of the impairment charge.\nAlthough the Company believes its estimates of fair value are reasonable, actual financial results could differ from those estimates due to the inherent uncertainty involved in making such estimates. Changes in assumptions concerning future financial results or other underlying assumptions could have a significant impact on either the fair value of the reporting units, the amount of the goodwill impairment charge, or both. Future declines in the overall market value of the Company’s equity may also result in a conclusion that the fair value of one or more reporting units has declined below its carrying value.\nThe majority of the Company’s recorded intangible assets were acquired as part of the Transtar and Tube Supply acquisitions in September 2006 and December 2011, respectively, and consist of customer relationships, non-compete agreements, trade names and developed technology. The initial values of the intangible assets were based on a discounted cash flow valuation using assumptions made by management as to future revenues from select customers, the level and pace of attrition in such revenues over time and assumed operating income amounts generated from such revenues. The intangible assets are amortized over their useful lives, which are 4 to 12 years for customer relationships, 3 years for non-compete agreements, 1 to 10 years for trade names and 3 years for developed technology. Useful lives are estimated by management and determined based on the timeframe over which a significant portion of the estimated future cash flows are expected to be realized from the respective intangible assets. Furthermore, when certain conditions or certain triggering events occur, a separate test of impairment, similar to the impairment test for long-lived assets discussed below, is performed. If the intangible asset is deemed to be impaired, such asset will be written down to its fair value.\nSee Note 8 to the consolidated financial statements for detailed information on goodwill and intangible assets.\nLong-Lived Assets — The Company’s long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows (undiscounted and without interest charges) expected to be generated by the asset. If such assets are impaired, the impairment charge is calculated as the amount by which the carrying amount of the assets exceeds the fair value of the assets. Determining whether impairment has occurred typically requires various estimates and assumptions, including determining which undiscounted cash flows are directly related to the potentially impaired asset, the useful life over which cash flows will occur, their amount, and the asset’s residual value, if any. The Company derives the required undiscounted cash flow estimates from historical experience and internal business plans. Measurement of an impairment loss requires a determination of fair value. The Company uses an income approach, which estimates fair value based on estimates of future cash flows discounted at an appropriate interest rate.\nShare-Based Compensation — The Company offers share-based compensation to executive and other key employees, as well as its directors. Share-based compensation expense is recorded over the vesting period based on the grant date fair value of the stock award. Stock options have an exercise price equal to the market price of the Company’s stock on the grant date (options granted prior to 2010) or the average closing price of the Company’s stock for the ten trading days preceding the grant date (options granted in 2010) and have a contractual life of eight to ten years. Options and restricted stock generally vest in one to five years for executives and employees and three years for directors. The Company may either issue shares from treasury or new shares upon share option exercise.\n32\nStock options are valued based on the market price of the Company’s stock on the grant date, using a Black-Scholes option-pricing model. The expense associated with stock option awards is recorded on a straight-line basis over the vesting period, net of estimated forfeitures.\nThe grant date fair value for stock options granted during 2010 was estimated using the Black-Scholes option-pricing model with the following assumptions:\n| 2010 |\n| Expected volatility | 58.5 | % |\n| Risk-free interest rate | 2.3 | % |\n| Expected life (in years) | 5.5 |\n| Expected dividend yield | 1.2 | % |\n\nShare-based compensation expense for non-vested shares and restricted share units in the long-term compensation plans (“LTC Plans”) is established using the market price of the Company’s common stock on the date of grant.\nThe grant date fair value of performance shares containing a market-based performance condition awarded under the LTC Plans were estimated using a Monte Carlo simulation with the following assumptions:\n| 2012 | 2011 | 2010 |\n| Expected volatility | 85.0 | % | 62.0 | % | 61.6 | % |\n| Risk-free interest rate | 0.40 | % | 1.10 | % | 1.45 | % |\n| Expected life (in years) | 2.81 | 2.84 | 2.80 |\n| Expected dividend yield | — | — | — |\n\nPerformance awards under the active LTC Plans were granted to the Company's new CEO in October 2012. The grant date fair values of performance shares awarded to the CEO containing the RTSR market-based performance condition was estimated using a Monte Carlo simulation with the following assumptions:\n| 2012 | 2011 | 2010 |\n| Expected volatility | 60.7 | % | 60.7 | % | 60.7 | % |\n| Risk-free interest rate | 0.34 | % | 0.34 | % | 0.34 | % |\n| Expected life (in years) | 2.21 | 1.21 | 0.21 |\n| Expected dividend yield | — | — | — |\n\nManagement estimates the probable number of shares which will ultimately vest when calculating the share-based compensation expense for the LTC Plans. As of December 31, 2012, the Company’s weighted average forfeiture rate is approximately 33%. The actual number of shares that vest may differ from management’s estimate. Final award vesting and distribution of performance awards granted under the LTC Plans are determined based on the Company’s actual performance versus the target goals for a three-year consecutive period as defined in each plan. Partial awards can be earned for performance less than the target goal, but in excess of minimum goals; and award distributions above the target can be achieved if the maximum goals are met or exceeded.\nUnder the 2012, 2011 and 2010 LTC Plans, the potential award for the performance shares granted is partially dependent on the Company’s relative total shareholder return (“RTSR”), which represents a market condition. RTSR is measured against a group of peer companies either in the metals industry or in the industrial products distribution industry. Compensation expense for performance awards containing a market condition is recognized regardless of whether the market condition is achieved to the extent the requisite service period condition is met.\nUnder the 2012 and 2011 LTC Plans, the potential award for performance shares containing a non-market-based performance condition is determined based on the Company’s actual performance versus Company-specific target goals for Return on Invested Capital (“ROIC”) (as defined in the 2012 and 2011 LTC Plans). Under the 2012 LTC Plan, the non-market based performance condition is determined based on the Company's average actual performance versus Company-specific goals for ROIC for the three-year performance period beginning on January 1st of the year of grant. Under the 2011 LTC Plan, the non-market-based performance condition is determined for\n33\nany one or more fiscal years during the three-year performance period beginning on January 1st of the year of grant. Partial performance awards can be earned for performance less than the target goal, but in excess of minimum goals and award distributions twice the target can be achieved if the maximum goals are met or exceeded. The number of performance shares, if any, that vest based on the performance achieved during the three-year performance period, will vest at the end of the three-year performance period. Compensation expense recognized is based on management’s expectation of future performance compared to the pre-established performance goals. If the performance goals are not expected to be met, no compensation expense is recognized and any previously recognized compensation expense is reversed.\nUnless covered by a specific change-in-control or severance arrangement, participants to whom restricted stock units, performance shares and other non-vested shares have been granted must be employed by the Company on the vesting date or at the end of the performance period, or the award will be forfeited.\nFair Value of Financial Instruments — The three-tier value hierarchy the Company utilizes, which prioritizes the inputs used in the valuation methodologies, is:\nLevel 1—Valuations based on quoted prices for identical assets and liabilities in active markets.\nLevel 2—Valuations based on observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data.\nLevel 3—Valuations based on unobservable inputs reflecting our own assumptions, consistent with reasonably available assumptions made by other market participants.\nThe fair value of cash, accounts receivable and accounts payable approximate their carrying values. The fair value of cash equivalents are determined using the fair value hierarchy described above. Cash equivalents consisting of money market funds are valued based on quoted prices in active markets and as a result are classified as Level 1.\nThe Company’s pension plan asset portfolio as of December 31, 2012 and 2011 is primarily invested in fixed income securities, which generally fall within Level 2 of the fair value hierarchy. Fixed income securities are valued based on evaluated prices provided to the trustee by independent pricing services. Such prices may be determined by factors which include, but are not limited to, market quotations, yields, maturities, call features, ratings, institutional size trading in similar groups of securities and developments related to specific securities.\nFair value disclosures for the Senior Secured Notes are determined based on recent trades of the bonds and fall within level 2 of the fair value hierarchy. The fair value of the Convertible Notes, which fall within level 3 of the fair value hierarchy, is determined based on similar debt instruments that do not contain a conversion feature, as well as other factors related to the callable nature of the notes. The estimated fair value of the derivative liability for the conversion feature, which falls within level 3 of the fair value hierarchy, is computed using a binomial lattice model using the Company’s historical volatility over the term corresponding to the remaining contractual term of the Convertible Notes and observed spreads of similar debt instruments that do not include a conversion feature. The estimated fair value of the Company’s debt outstanding under its revolving credit facilities, which fall within level 3 of the fair value hierarchy, assumes the current amount of debt outstanding at the end of the year was outstanding until the maturity of the Company’s facility in December 2015.\nFair value of commodity hedges is based on information which is representative of readily observable market data. Derivative liabilities associated with commodity hedges are classified as Level 2 in the fair value hierarchy.\nRecent Accounting Pronouncements\nEffective January 1, 2012, the Company adopted new guidance that applies to the presentation of other comprehensive (loss) income, the testing of goodwill for impairment and the measurement and disclosure of fair value of assets, liabilities and instruments classified in a reporting entity’s shareholders’ equity in the financial statements.\nSee Note 1 to the consolidated financial statements for detailed information on recent accounting pronouncements.\n34\nITEM 7a —\nQuantitative and Qualitative Disclosures about Market Risk\nThe Company is exposed to interest rate, commodity price, and foreign exchange rate risks that arise in the normal course of business.\nInterest Rate Risk — The Company is exposed to market risk related to its fixed rate and variable rate long-term debt. We do not utilize derivative instruments to manage exposure to interest rate changes. The market value of the Company’s $282.5 million of fixed rate long-term debt may be impacted by changes in interest rates. The Company does not expect to repay its fixed rate debt prior to its scheduled maturities.\nThe Company’s interest rates on borrowings under its $100 million four-year revolving credit facility are subject to changes in the LIBOR and prime interest rates. Borrowings under the Company’s revolving credit agreement were approximately $39.5 million as of December 31, 2012. A hypothetical 100 basis point increase on the Company’s variable rate debt would result in $0.4 million of additional interest expense on an annual basis.\nCommodity Price Risk — The Company’s raw material costs are comprised primarily of engineered metals and plastics. Market risk arises from changes in the price of steel, other metals and plastics. Although average selling prices generally increase or decrease as material costs increase or decrease, the impact of a change in the purchase price of materials is more immediately reflected in the Company’s cost of materials than in its selling prices. The ability to pass surcharges on to customers immediately can be limited due to contractual provisions with those customers. Therefore, a lag may exist between when the surcharge impacts net sales and cost of materials, respectively, which could result in a higher or lower operating profit.\nThe Company has a commodity hedging program to mitigate risks associated with certain commodity price fluctuations. If the commodity prices hedged were to decrease hypothetically by 100 basis points, the 2012 unrealized loss recorded in cost of materials would have increased by approximately $0.1 million.\nForeign Currency Risk — The Company conducts the majority of its business in the United States but also has operations in Canada, Mexico, France, the United Kingdom, Spain, China and Singapore. The Company’s results of operations historically have not been materially affected by foreign currency transaction gains and losses and, therefore, the Company has no financial instruments in place for managing the exposure to foreign currency exchange rates.\nAs a result of the new debt financing arrangements entered into during December 2011, the Company has certain outstanding intercompany borrowings denominated in the U.S. dollar at its Canadian and United Kingdom subsidiaries. These intercompany borrowings are not hedged and may cause foreign currency exposure, which could be significant, in future periods if they remain unhedged.\n35\nITEM 8 — Financial Statements and Supplementary Data\nAmounts in thousands, except par value and per share data\n| Consolidated Statements of Operations and Comprehensive Loss |\n| Year Ended December 31, |\n| 2012 | 2011 | 2010 |\n| Net sales | $ | 1,270,368 | $ | 1,132,366 | $ | 943,706 |\n| Costs and expenses: |\n| Cost of materials (exclusive of depreciation and amortization) | 927,287 | 845,609 | 700,854 |\n| Warehouse, processing and delivery expense | 148,256 | 134,898 | 123,318 |\n| Sales, general and administrative expense | 127,813 | 126,193 | 108,223 |\n| Depreciation and amortization expense | 25,867 | 20,472 | 20,649 |\n| Operating income (loss) | 41,145 | 5,194 | (9,338 | ) |\n| Interest expense, net | (41,090 | ) | (9,663 | ) | (4,988 | ) |\n| Interest expense - unrealized loss on debt conversion option | (15,597 | ) | (3,991 | ) | — |\n| Loss on extinguishment of debt | — | (6,153 | ) | — |\n| Loss before income taxes and equity in earnings of joint venture | (15,542 | ) | (14,613 | ) | (14,326 | ) |\n| Income taxes | (1,430 | ) | 1,126 | 3,101 |\n| Loss before equity in earnings of joint venture | (16,972 | ) | (13,487 | ) | (11,225 | ) |\n| Equity in earnings of joint venture | 7,224 | 11,727 | 5,585 |\n| Net loss | (9,748 | ) | (1,760 | ) | (5,640 | ) |\n| Basic loss per share | $ | (0.42 | ) | $ | (0.08 | ) | $ | (0.25 | ) |\n| Diluted loss per share | $ | (0.42 | ) | $ | (0.08 | ) | $ | (0.25 | ) |\n| Dividends per common share | $ | — | $ | — | $ | — |\n| Comprehensive loss: |\n| Foreign currency translation gains (losses) | $ | 2,369 | $ | (941 | ) | $ | (536 | ) |\n| Unrecognized pension and postretirement benefit costs, net of tax benefit of $2,312, $1,965 and $1,116 | (3,616 | ) | (3,071 | ) | (1,748 | ) |\n| Other comprehensive loss | (1,247 | ) | (4,012 | ) | (2,284 | ) |\n| Net loss | (9,748 | ) | (1,760 | ) | (5,640 | ) |\n| Comprehensive loss | $ | (10,995 | ) | $ | (5,772 | ) | $ | (7,924 | ) |\n\nThe accompanying notes to consolidated financial statements are an integral part of these statements.\n36\n| Consolidated Balance Sheets |\n| December 31, |\n| 2012 | 2011 |\n| Assets |\n| Current assets |\n| Cash and cash equivalents | $ | 21,607 | $ | 30,524 |\n| Accounts receivable, less allowances of $3,529 and $3,584 | 138,311 | 181,036 |\n| Inventories, principally on last-in first-out basis (replacement cost higher by $139,940 and $138,882) | 303,772 | 272,039 |\n| Prepaid expenses and other current assets | 15,092 | 10,382 |\n| Income tax receivable | 7,596 | 8,287 |\n| Total current assets | 486,378 | 502,268 |\n| Investment in joint venture | 38,854 | 36,460 |\n| Goodwill | 70,300 | 69,901 |\n| Intangible assets | 82,477 | 93,813 |\n| Prepaid pension cost | 12,891 | 15,956 |\n| Other assets | 18,266 | 21,784 |\n| Property, plant and equipment, at cost |\n| Land | 5,195 | 5,194 |\n| Building | 52,884 | 52,434 |\n| Machinery and equipment | 178,664 | 172,833 |\n| Property, plant and equipment, at cost | 236,743 | 230,461 |\n| Less—accumulated depreciation | (157,103 | ) | (148,320 | ) |\n| Property, plant and equipment, net | 79,640 | 82,141 |\n| Total assets | $ | 788,806 | $ | 822,323 |\n| Liabilities and Stockholders’ Equity |\n| Current liabilities |\n| Accounts payable | $ | 67,990 | $ | 116,874 |\n| Accrued payroll and employee benefits | 11,749 | 14,792 |\n| Accrued liabilities | 24,815 | 19,036 |\n| Income taxes payable | 1,563 | 1,884 |\n| Current portion of long-term debt | 415 | 192 |\n| Short term debt | 500 | 500 |\n| Total current liabilities | 107,032 | 153,278 |\n| Long-term debt, less current portion | 296,154 | 314,240 |\n| Deferred income taxes | 32,350 | 25,650 |\n| Other non-current liabilities | 5,279 | 7,252 |\n| Pension and post retirement benefit obligations | 10,651 | 9,624 |\n| Commitments and contingencies |\n| Stockholders’ equity |\n| Preferred stock, $0.01 par value—9,988 shares authorized (including 400 Series B Junior Preferred $0.00 par value shares); no shares issued and outstanding at December 31, 2012 and December 31, 2011 | — | — |\n| Common stock, $0.01 par value—60,000 shares authorized and 23,211 shares issued and 23,152 outstanding at December 31, 2012; 30,000 shares authorized and 23,159 shares issued and 23,010 outstanding at December 31, 2011 | 232 | 232 |\n| Additional paid-in capital | 219,619 | 184,596 |\n| Retained earnings | 139,239 | 148,987 |\n| Accumulated other comprehensive loss | (21,071 | ) | (19,824 | ) |\n| Treasury stock, at cost—59 shares at December 31, 2012 and 149 shares at December 31, 2011 | (679 | ) | (1,712 | ) |\n| Total stockholders’ equity | 337,340 | 312,279 |\n| Total liabilities and stockholders’ equity | $ | 788,806 | $ | 822,323 |\n\nThe accompanying notes to consolidated financial statements are an integral part of these statements.\n37\n| Consolidated Statements of Cash Flows |\n| Years Ended December 31, |\n| 2012 | 2011 | 2010 |\n| Operating activities: |\n| Net loss | $ | (9,748 | ) | $ | (1,760 | ) | $ | (5,640 | ) |\n| Adjustments to reconcile net loss to net cash from (used in) operating activities: |\n| Depreciation and amortization | 25,867 | 20,472 | 20,649 |\n| Amortization of deferred gain | (1,619 | ) | (503 | ) | (890 | ) |\n| Amortization of deferred financing costs and debt discount | 6,232 | 1,662 | 685 |\n| Loss on sale of fixed assets | 354 | 120 | 391 |\n| Unrealized loss on debt conversion option | 15,597 | 3,991 | — |\n| Unrealized losses on commodity hedges | 163 | 2,331 | — |\n| Equity in earnings of joint venture | (7,224 | ) | (11,727 | ) | (5,585 | ) |\n| Dividends from joint venture | 4,729 | 3,117 | 1,260 |\n| Deferred tax (benefit) provision | (1,284 | ) | (3,333 | ) | (11,386 | ) |\n| Share-based compensation expense | 2,277 | 4,349 | 2,411 |\n| Excess tax benefits from share-based payment arrangements | (90 | ) | (301 | ) | (219 | ) |\n| Increase (decrease) from changes in, net of acquisition: |\n| Accounts receivable | 44,570 | (26,446 | ) | (22,521 | ) |\n| Inventories | (29,340 | ) | (39,435 | ) | 39,686 |\n| Prepaid expenses and other current assets | (2,397 | ) | (3,408 | ) | (1,718 | ) |\n| Other assets | (480 | ) | 188 | 399 |\n| Prepaid pension costs | (2,863 | ) | (2,412 | ) | (1,530 | ) |\n| Accounts payable | (42,560 | ) | 9,910 | (1,866 | ) |\n| Accrued payroll and employee benefits | (2,974 | ) | (2,470 | ) | 5,827 |\n| Income taxes payable and receivable | 454 | (820 | ) | 11,536 |\n| Accrued liabilities | 4,514 | (184 | ) | 1,586 |\n| Postretirement benefit obligations and other liabilities | 1,173 | 371 | 1,287 |\n| Net cash from (used in) operating activities | 5,351 | (46,288 | ) | 34,362 |\n| Investing activities: |\n| Acquisition/Investment of businesses, net of cash acquired | (6,472 | ) | (174,244 | ) | — |\n| Capital expenditures | (11,121 | ) | (11,744 | ) | (7,572 | ) |\n| Proceeds from sale of fixed assets | 153 | 226 | 4 |\n| Insurance proceeds | — | 573 | 125 |\n| Net cash used in investing activities | (17,440 | ) | (185,189 | ) | (7,443 | ) |\n| Financing activities: |\n| Short-term (repayments) borrowings, net | (27 | ) | 653 | (13,720 | ) |\n| Net (repayments) borrowings on previously existing revolving lines of credit | — | (26,403 | ) | 2,324 |\n| Proceeds from long-term debt, including new revolving credit facility | 767,090 | 320,476 | — |\n| Repayments of long-term debt, including new revolving credit facility | (762,887 | ) | (53,212 | ) | (7,754 | ) |\n| Payment of debt issue costs | (1,503 | ) | (16,633 | ) | — |\n| Exercise of stock options | 146 | 356 | 566 |\n| Excess tax benefits from share-based payment arrangements | 90 | 301 | 219 |\n| Net cash from (used in) financing activities | 2,909 | 225,538 | (18,365 | ) |\n| Effect of exchange rate changes on cash and cash equivalents | 263 | (253 | ) | (149 | ) |\n| Net (decrease) increase in cash and cash equivalents | (8,917 | ) | (6,192 | ) | 8,405 |\n| Cash and cash equivalents—beginning of year | 30,524 | 36,716 | 28,311 |\n| Cash and cash equivalents—end of year | $ | 21,607 | $ | 30,524 | $ | 36,716 |\n\nSee Note 1 to the consolidated financial statements for supplemental cash flow disclosures.\nThe accompanying notes to consolidated financial statements are an integral part of these statements.\n38\n| Consolidated Statements of Stockholders' Equity |\n| CommonShares | TreasuryShares | PreferredStock | CommonStock | TreasuryStock | AdditionalPaid-inCapital | RetainedEarnings | Accumulated OtherComprehensiveIncome | Total |\n| Balance at January 1, 2010 | 23,115 | (209 | ) | $ | — | $ | 230 | $ | (3,010 | ) | $ | 178,129 | $ | 156,387 | $ | (13,528 | ) | $ | 318,208 |\n| Net loss | (5,640 | ) | (5,640 | ) |\n| Foreign currency translation | (536 | ) | (536 | ) |\n| Defined benefit pension liability adjustments, net of tax benefit of $1,116 | (1,748 | ) | (1,748 | ) |\n| Long-term incentive plan | 1,278 | 1,278 |\n| Exercise of stock options and other | 34 | 46 | 1 | 784 | 1,112 | 1,897 |\n| Balance at December 31, 2010 | 23,149 | (163 | ) | $ | — | $ | 231 | $ | (2,226 | ) | $ | 180,519 | $ | 150,747 | $ | (15,812 | ) | $ | 313,459 |\n| Net loss | (1,760 | ) | (1,760 | ) |\n| Foreign currency translation | (941 | ) | (941 | ) |\n| Defined benefit pension liability adjustments, net of tax benefit of $1,965 | (3,071 | ) | (3,071 | ) |\n| Long-term incentive plan | 3,260 | 3,260 |\n| Exercise of stock options and other | 10 | 14 | 1 | 514 | 817 | 1,332 |\n| Balance at December 31, 2011 | 23,159 | (149 | ) | $ | — | $ | 232 | $ | (1,712 | ) | $ | 184,596 | $ | 148,987 | $ | (19,824 | ) | $ | 312,279 |\n| Net loss | (9,748 | ) | — | (9,748 | ) |\n| Foreign currency translation | 2,369 | 2,369 |\n| Defined benefit pension liability adjustments, net of tax benefit of $2,312 | (3,616 | ) | (3,616 | ) |\n| Embedded conversion option, net of tax benefit of $8,285 | 33,752 | 33,752 |\n| Long-term incentive plan | 1,592 | 1,592 |\n| Exercise of stock options and other | 52 | 90 | 1,033 | (321 | ) | 712 |\n| Balance at December 31, 2012 | 23,211 | (59 | ) | $ | — | $ | 232 | $ | (679 | ) | $ | 219,619 | $ | 139,239 | $ | (21,071 | ) | $ | 337,340 |\n\nThe accompanying notes to consolidated financial statements are an integral part of these statements.\n39\nA. M. Castle & Co.\nNotes to Consolidated Financial Statements\nAmounts in thousands except per share data and percentages\n(1) Basis of Presentation and Significant Accounting Policies\nNature of operations — A.M. Castle & Co. and its subsidiaries (the “Company”) is a specialty metals and plastics distribution company serving principally the North American market, but with a growing global presence. The Company has operations in the United States, Canada, Mexico, France, the United Kingdom, Spain, China and Singapore. The Company provides a broad range of product inventories as well as value-added processing and supply chain services to a wide array of customers, principally within the producer durable equipment, oil and gas, aerospace, heavy industrial equipment, industrial goods, construction equipment, retail, marine and automotive sectors of the global economy. Particular focus is placed on the aerospace and defense, oil and gas, power generation, mining, heavy industrial equipment, marine, office furniture and fixtures, safety products, life science applications, automotive and general manufacturing industries as well as general engineering applications.\nThe Company’s corporate headquarters are located in Oak Brook, Illinois. The Company has 49 operational service centers located throughout North America (44), Europe (4) and Asia (1).\nThe Company purchases metals and plastics from many producers. Purchases are made in large lots and held in distribution centers until sold, usually in smaller quantities and often with value-added processing services performed. Orders are primarily filled with materials shipped from Company stock. The materials required to fill the balance of sales are obtained from other sources, such as direct mill shipments to customers or purchases from other distributors. Thousands of customers from a wide array of industries are serviced primarily through the Company’s own sales organization.\nBasis of presentation — The consolidated financial statements include the accounts of A. M. Castle & Co. and its subsidiaries over which the Company exhibits a controlling interest. The equity method of accounting is used for the Company’s 50% owned joint venture, Kreher Steel Company, LLC (“Kreher”). All inter-company accounts and transactions have been eliminated.\nReclassification — For comparability, certain 2011 amounts have been reclassified to conform to presentation adopted in 2012.\nUse of estimates — The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. The principal areas of estimation reflected in the consolidated financial statements are accounts receivable allowances, inventory reserves, goodwill and intangible assets, income taxes, pension and other post-employment benefits and share-based compensation and convertible debt feature mark-to-mark adjustments.\nRevenue recognition — Revenue from the sales of products is recognized when the earnings process is complete and when the title and risk and rewards of ownership have passed to the customer, which is primarily at the time of shipment. Revenue recognized other than at the time of shipment represents less than 3% of the Company’s consolidated net sales for the years ended December 31, 2012, 2011 and 2010. Provisions for allowances related to sales discounts and rebates are recorded based on terms of the sale in the period that the sale is recorded. Management utilizes historical information and the current sales trends of the business to estimate such provisions. The provisions related to discounts and rebates due to customers are recorded as a reduction within net sales in the Company’s consolidated statements of operations and comprehensive loss.\nThe Company maintains an allowance for doubtful accounts resulting from the inability of customers to make required payments. The allowance for doubtful accounts is maintained at a level considered appropriate based on historical experience and specific identification of customer receivable balances for which collection is unlikely. The provisions for doubtful accounts is recorded in sales, general and administrative expense in the Company’s consolidated statements of operations and comprehensive loss. Estimates of doubtful accounts are based upon historical write-off experience as a percentage of net sales and judgments about the probable effects of economic conditions on certain customers.\n40\nThe Company also maintains an allowance for credit memos for estimated credit memos to be issued against current sales. Estimates of allowance for credit memos are based upon the application of a historical issuance lag period to the average credit memos issued each month.\nAccounts receivable allowance activity is presented in the table below:\n| 2012 | 2011 | 2010 |\n| Balance, beginning of year | $ | 3,584 | $ | 3,848 | $ | 4,195 |\n| Add Provision charged to expense | 1,420 | 523 | 777 |\n| Recoveries | 90 | 140 | 186 |\n| Other | — | 157 | — |\n| Less Charges against allowance | (1,565 | ) | (1,084 | ) | (1,310 | ) |\n| Balance, end of year | $ | 3,529 | $ | 3,584 | $ | 3,848 |\n\nRevenue from shipping and handling charges is recorded in net sales. Costs incurred in connection with shipping and handling the Company’s products, which are related to third-party carriers or performed by Company personnel are included in warehouse, processing and delivery expenses. For the years ended December 31, 2012, 2011 and 2010, shipping and handling costs included in warehouse, processing and delivery expenses were $36,585, $35,214, and $31,067, respectively.\nCost of materials — Cost of materials consists of the costs the Company pays for metals, plastics and related inbound freight charges. It excludes depreciation and amortization which are discussed below. The Company accounts for the majority of its inventory on a last-in, first-out (“LIFO”) basis and LIFO adjustments are recorded in cost of materials.\nOperating expenses — Operating costs and expenses primarily consist of:\n\n| • | Warehouse, processing and delivery expenses, including occupancy costs, compensation and employee benefits for warehouse personnel, processing, shipping and handling costs; |\n\n| • | Sales expenses, including compensation and employee benefits for sales personnel; |\n\n| • | General and administrative expenses, including compensation for executive officers and general management, expenses for professional services primarily attributable to accounting and legal advisory services, bad debt expenses, data communication, computer hardware and maintenance and foreign currency gain or loss; and |\n\n| • | Depreciation and amortization expenses, including depreciation for all owned property and equipment, and amortization of various intangible assets. |\n\nCash equivalents — Cash equivalents are highly liquid, short-term investments that have an original maturity of 90 days or less.\nStatement of cash flows — Non-cash investing and financing activities and supplemental disclosures of consolidated cash flow information are as follows:\n| Year Ended December 31, |\n| 2012 | 2011 | 2010 |\n| Non-cash investing and financing activities: |\n| Capital expenditures financed by accounts payable | $ | 479 | $ | 1,123 | $ | 100 |\n| Capital lease obligations | 1,009 | — | — |\n| Deferred debt origination fees | — | 886 | — |\n| Additional purchase price paid in 2012 for Tube Supply acquisition | — | 6,472 | — |\n| Cash paid during the year for: |\n| Interest | 34,051 | 7,234 | 4,392 |\n| Income taxes | 5,557 | 9,555 | 1,631 |\n| Cash received during the year for: |\n| Income tax refunds | 3,184 | 6,724 | 4,430 |\n\n41\nInventories — Inventories consist of finished goods. Approximately eighty percent of the Company’s inventories are valued at the lower of LIFO cost or market at December 31, 2012 and 2011. Final inventory determination under the LIFO costing method is made at the end of each fiscal year based on the actual inventory levels and costs at that time. The Company values its LIFO increments using the cost of its latest purchases during the years reported. Current replacement cost of inventories exceeded book value by $139,940 and $138,882 at December 31, 2012 and 2011, respectively. Income taxes would become payable on any realization of this excess from reductions in the level of inventories.\nDuring 2010, a reduction in inventories resulted in a liquidation of applicable LIFO inventory quantities carried at lower costs in prior years. Cost of materials for 2010 were lower by $12,500, as a result of the liquidations.\nThe Company maintains allowances for excess and obsolete inventory and physical inventory losses. The excess and obsolete inventory allowance is determined based on specific identification of material, adjusted for expected scrap value to be received. The allowance for physical inventory losses is determined based on historical physical inventory experience.\nInsurance plans — In August 2009, the Company became a member of a group captive insurance company (the “Captive”) domiciled in Grand Cayman Island. The Captive reinsures losses related to certain of the Company’s workers’ compensation, automobile and general liability risks that occur subsequent to August 2009. Premiums are based on the Company’s loss experience and are accrued as expenses for the period to which the premium relates. Premiums are credited to the Company’s “loss fund” and earn investment income until claims are actually paid. For workers’ compensation, automobile and general liability claims that were incurred prior to August 2009, the Company is self-insured. Self-insurance amounts are capped, for individual claims and in the aggregate, for each policy year by an insurance company. Self-insurance reserves are based on unpaid, known claims (including related administrative fees assessed by the insurance company for claims processing) and a reserve for incurred but not reported claims based on the Company’s historical claims experience and development.\nThe Company is self-insured for medical insurance for its domestic operations. Self-insurance reserves are maintained based on incurred but not paid claims based on a historical lag.\nProperty, plant and equipment — Property, plant and equipment are stated at cost and include assets held under capital leases. Expenditures for major additions and improvements are capitalized, while maintenance and repair costs that do not substantially improve or extend the useful lives of the respective assets are expensed in the period in which they are incurred. When items are disposed, the related costs and accumulated depreciation are removed from the accounts and any gain or loss is reflected in income.\nThe Company provides for depreciation of plant and equipment sufficient to amortize the cost over their estimated useful lives as follows:\n| Buildings and building improvements | 3 – 40 years |\n| Plant equipment | 3 – 25 years |\n| Furniture and fixtures | 2 – 10 years |\n| Vehicles and office equipment | 3 – 7 years |\n\nLeasehold improvements are depreciated over the shorter of their useful lives or the remaining term of the lease. Depreciation is calculated using the straight-line method and depreciation expense for 2012, 2011 and 2010 was $14,024, $13,605 and $13,578, respectively.\nLong-lived assets — The Company’s long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset or asset group to future net cash flows (undiscounted and without interest charges) expected to be generated by the asset or asset group. If future net cash flows are less than the carrying value, the asset or asset group may be impaired. If such assets are impaired, the impairment charge is calculated as the amount by which the carrying amount of the assets exceeds the fair value of the assets. Determining whether impairment has occurred typically requires various estimates and assumptions, including determining which undiscounted cash flows are directly related to the potentially impaired asset, the useful life over which cash flows will occur, their amount, and the asset’s residual value, if any. The Company derives the required undiscounted cash flow estimates from historical experience and internal business plans.\n42\nGoodwill and intangible assets — The carrying value of the Company’s goodwill is evaluated annually on January 1st of each fiscal year or when certain triggering events occur which require a more current valuation. The Company assesses, at least quarterly, whether any triggering events have occurred.\nA two-step method is used for determining goodwill impairment. The first step is performed to identify whether a potential impairment exists by comparing each reporting unit’s fair value to its carrying value. If the carrying value of a reporting unit exceeds its fair value, the next step is to measure the amount of impairment loss, if any.\nThe majority of the Company’s recorded intangible assets were acquired as part of the Transtar and Tube Supply, Inc. (“Tube Supply”) acquisitions in September 2006 and December 2011, respectively, and consist of customer relationships, non-compete agreements, trade names and developed technology. The initial values of the intangible assets were based on a discounted cash flow valuation using assumptions made by management as to future revenues from select customers, the level and pace of attrition in such revenues over time and assumed operating income amounts generated from such revenues. These intangible assets are amortized over their useful lives, which are 4 to 12 years for customer relationships, 3 years for non-compete agreements, 1 to 10 years for trade names, and 3 years for developed technology. Useful lives are estimated by management and determined based on the timeframe over which a significant portion of the estimated future cash flows are expected to be realized from the respective intangible assets. Furthermore, when certain conditions or certain triggering events occur, a separate test of impairment, similar to the impairment test for long-lived assets, is performed. If the intangible asset is deemed to be impaired, such asset will be written down to its fair value.\nIncome taxes — The Company accounts for income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statement and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.\nThe Company records valuation allowances against its deferred tax assets when it is more likely than not that the amounts will not be realized, which will increase the provision for income taxes in the period in which that determination is made.\nThe Company has undistributed earnings of foreign subsidiaries of approximately $83,352 at December 31, 2012, for which deferred taxes have not been provided. Such earnings are considered indefinitely invested in the foreign subsidiaries. If such earnings were repatriated, additional tax expense may result, although due to the potential availability of foreign tax credits and other items, the calculation of such additional taxes is not practicable.\nThe Company's 50% ownership interest in Kreher (see Note 6) is through a 50% interest in a limited liability corporation (LLC) taxed as a partnership. Kreher has two subsidiaries organized as individually taxed C-Corporations. The Company includes in its income tax provision the income tax liability on its share of Kreher income. The income tax liability of Kreher itself is generally treated as a current income tax expense and the income tax liability associated with the profits of the two subsidiaries of Kreher is treated as a deferred income tax expense. The Company can not independently cause a dividend to be declared by one of Kreher's subsidiaries, therefore no benefit of a dividend received deduction can be recognized in the Company's tax provision until a dividend is declared. If one of Kreher's C-Corporation subsidiaries declares a dividend payable to Kreher, the Company recognizes a benefit for the 80% dividends received deduction on its 50% share of the dividend.\nThe Company recognizes the tax benefits of uncertain tax positions only if those benefits will more likely than not be sustained upon examination by the relevant tax authorities. Unrecognized tax benefits are subsequently recognized at the time the recognition threshold is met, the tax matter is effectively settled or the statute of limitations expires for the return containing the tax position, whichever is earlier. Due to the complexity of some of these uncertainties, the ultimate resolution may result in a payment that differs from the current estimate.\nThe Company recognizes interest and penalties related to unrecognized tax benefits within income tax expense. Accrued interest and penalties are included within other long-term liabilities in the consolidated balance sheets.\nForeign currency — For the majority of the Company’s non-U.S. operations, the functional currency is the local currency. Assets and liabilities of those operations are translated into U.S. dollars using year-end exchange rates, and income and expenses are translated using the average exchange rates for the reporting period. The currency effects of translating financial statements of the Company’s non-U.S. operations which operate in local currency environments are recorded in accumulated other comprehensive income (loss), a separate component of\n43\nstockholders’ equity. Transaction gains or losses resulting from foreign currency transactions were not material for any of the years presented.\nEarnings per share — Diluted earnings per share is computed by dividing net income by the weighted average number of shares of common stock plus common stock equivalents. Common stock equivalents consist of employee and director stock options, restricted stock awards, other share-based payment awards, and contingently issuable shares related to the Company’s convertible debt which are included in the calculation of weighted average shares outstanding using the treasury stock method, if dilutive.\nThe following table is a reconciliation of the basic and diluted earnings per share calculations:\n| 2012 | 2011 | 2010 |\n| Numerator: |\n| Net loss | $ | (9,748 | ) | $ | (1,760 | ) | $ | (5,640 | ) |\n| Denominator: |\n| Denominator for basic loss per share: |\n| Weighted average common shares outstanding | 22,993 | 22,983 | 22,708 |\n| Effect of dilutive securities: |\n| Outstanding common stock equivalents | — | — | — |\n| Denominator for diluted loss per share | 22,993 | 22,983 | 22,708 |\n| Basic loss per share | $ | (0.42 | ) | $ | (0.08 | ) | $ | (0.25 | ) |\n| Diluted loss per share | $ | (0.42 | ) | $ | (0.08 | ) | $ | (0.25 | ) |\n| Excluded outstanding share-based awards having an anti-dilutive effect | 994 | 757 | 471 |\n\nThe Convertible Notes are dilutive to the extent the Company generates net income and the average stock price during the period is greater than $10.28, the conversion price of the Convertible Notes. The Convertible Notes are only dilutive for the “in the money” portion of the Convertible Notes that could be settled with the Company’s stock. In future periods, absent a fundamental change, (as defined in the Convertible Notes agreement), the outstanding Convertible Notes could increase diluted average shares outstanding by a maximum of approximately 5,600 shares. As of December 31, 2012 and 2011, 1,416 and 1,734 shares, respectively, were excluded from diluted average shares outstanding as there would have been an anti-dilutive effect.\nFor the years ended December 31, 2012, 2011 and 2010, the participating securities, which represent certain non-vested shares granted by the Company, were less than one percent of total securities. These securities do not participate in the Company’s net losses.\nConcentrations — The Company serves a wide range of customers within the producer durable equipment, oil and gas, aerospace, heavy industrial equipment, industrial goods, construction equipment, retail, marine and automotive sectors of the economy from locations throughout the United States, Canada, Mexico, France, the United Kingdom, Spain, China and Singapore. Its customer base includes many Fortune 500 companies as well as thousands of medium and smaller sized firms spread across the entire spectrum of metals and plastics using industries. The Company’s customer base is well diversified and, therefore, the Company does not have dependence upon any single customer or a few customers. No single customer represents more than 3% of the Company’s total net sales. Approximately 78% of the Company’s business is conducted from locations in the United States.\nShare-based compensation — The Company offers share-based compensation to executive and other key employees, as well as its directors. Share-based compensation expense is recorded over the vesting period based on the grant date fair value of the stock award. Stock options have an exercise price equal to the market price of the Company’s stock on the grant date (options granted prior to 2010) or the average closing price of the Company’s stock for the 10 trading days preceding the grant date (options granted in 2010) and have a contractual life of eight to ten years. Options and restricted stock generally vest in one to five years for executives and employees and three years for directors. The Company may either issue shares from treasury or new shares upon share option exercise. Management estimates the probable number of shares which will ultimately vest when calculating the share-based compensation expense for the long-term compensation plans (\"LTC Plans\"). As of December 31, 2012, the Company’s weighted average forfeiture rate is approximately 33%. The actual number of shares that vest may differ from management’s estimate.\n44\nStock options are valued based on the market price of the Company’s stock on the grant date, using a Black-Scholes option-pricing model. The expense associated with stock option awards is recorded on a straight-line basis over the vesting period, net of estimated forfeitures.\nShare-based compensation expense for restricted share units and non-vested shares in the LTC Plans is established using the market price of the Company’s common stock on the date of grant.\nFinal award vesting and distribution of performance awards granted under the LTC Plans are determined based on the Company’s actual performance versus the target goals for a three-year consecutive period as defined in each plan. Partial awards can be earned for performance less than the target goal, but in excess of minimum goals; and award distributions above the target can be achieved if the maximum goals are met or exceeded.\nUnder the 2012, 2011, and 2010 LTC Plans, the potential award for the performance shares granted is partially dependent on the Company’s relative total shareholder return (“RTSR”), which represents a market condition. RTSR is measured against a group of peer companies either in the metals industry or in the industrial products distribution industry. Compensation expense for performance awards containing a market condition is recognized regardless of whether the market condition is achieved to the extent the requisite service period condition is met. The grant date fair value of performance shares containing a market-based performance condition awarded under the LTC Plans was estimated using a Monte Carlo simulation.\nUnder the 2012 and 2011 LTC Plans, the potential award for performance share units containing a non-market-based performance condition is determined based on the Company's actual performance versus Company-specific target goals for Return on Invested Capital (“ROIC”), as defined in the 2012 and 2011 LTC Plans. Under the 2012 LTC Plan, the non-market-based performance condition is determined based on the Company's average actual performance versus Company-specific goals for ROIC for the three-year performance period beginning on January 1st of the year of grant. Under the 2011 LTC Plan, the non-market-based performance condition is determined for any one or more fiscal years during the three-year performance period beginning on January 1st of the year of grant. Partial performance awards can be earned for performance less than the target goal, but in excess of minimum goals and award distributions twice the target can be achieved if the maximum goals are met or exceeded. The number of performance shares, if any, that vest based on the performance achieved during the three-year performance period, will vest at the end of the three-year performance period. Compensation expense recognized is based on management's expectation of future performance compared to the pre-established performance goals. If the performance goals are not expected to be met, no compensation expense is recognized and any previously recognized compensation expense is reversed.\nUnless covered by a specific change-in-control or severance arrangement, participants to whom restricted stock units, performance shares and other non-vested shares have been granted must be employed by the Company on the vesting date or at the end of the performance period, respectively, or the award will be forfeited.\nNew Accounting Standards Updates\nStandards Updates Adopted\nEffective January 1, 2012, the Company adopted ASU No. 2011-08, “Intangibles – Goodwill and Other.” The objective of this ASU is to simplify how entities test goodwill for impairment. The amendments allow entities to assess qualitative factors to determine whether it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test per Topic 350, “Intangibles – Goodwill and Other.” The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent. The adoption of this ASU impacts the way the Company tests goodwill for impairment. As allowed by this ASU for its January 1, 2012 annual impairment test, the Company did not elect the option to perform a qualitative evaluation about the likelihood of goodwill impairment to determine whether it should calculate the fair value of a reporting unit. Instead the Company followed the two-step method. Refer to Note 8 for the results of the annual goodwill impairment test.\nEffective January 1, 2012, the Company adopted ASU No. 2011-05, “Presentation of Comprehensive Income.” The amendments in this ASU impact all entities that report items of other comprehensive (loss) income and are effective retrospectively for public entities. The amendments in this ASU eliminate the option to present the components of other comprehensive (loss) income as part of the statement of changes in stockholders’ equity. The amendments provide the entity with the option to present the total of comprehensive (loss) income, the components of net (loss) income and the components of other comprehensive (loss) income either in a single continuous statement of comprehensive (loss) income or in two separate but consecutive statements. Both options require an entity to present each component of net (loss) income along with total net (loss) income, each component of other\n45\ncomprehensive (loss) income along with total other comprehensive (loss) income and a total amount for comprehensive (loss) income. The subsequent issuance of ASU 2011-12, “Comprehensive Income” in December 2011 deferred the changes in ASU 2011-05 that relate to the presentation of reclassification adjustments out of accumulated other comprehensive (loss) income. All other provisions in ASU 2011-05 were effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The presentation requirements associated with the adoption of ASU 2011-05 are reflected in the consolidated statements of operations and comprehensive loss herein.\nEffective January 1, 2012, the Company adopted ASU No. 2011-04, “Fair Value Measurement.” The amendments in this ASU apply to all reporting entities that are required or permitted to measure or disclose the fair value of an asset, a liability, or an instrument classified in a reporting entity’s shareholders’ equity in the financial statements. The amendments in this ASU clarify the requirements of the existing standard and include some changes to principles or requirements for measuring or disclosing information about fair value measurements. The adoption of this ASU did not have an impact on the Company's financial condition, liquidity or operating results. The disclosure requirements associated with the adoption of ASU 2011-04 are reflected in Note 10.\nStandards Updates Issued Not Yet Effective\nDuring December 2011, the FASB issued ASU No. 2011-11, “Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities.” The amendments in this ASU require an entity to disclose information to enable users of its financial statements to evaluate the effect or potential effect of netting arrangements on its financial position, including the effect or potential effect of rights of set off associated with an entity’s recognized assets and recognized liabilities within the scope of Topic 210. The ASU is effective for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. The adoption of this ASU may impact the Company’s disclosures in future interim and annual financial statements issued.\n(2) Acquisition\nOn December 15, 2011, the Company acquired 100 percent of the outstanding common shares of Tube Supply (the “Acquisition”). The Acquisition was accounted for using the acquisition method. Accordingly, the purchase price has been allocated to the assets acquired and liabilities assumed based on estimated fair values at date of acquisition. The nonrecurring fair value measurements are classified as Level 3 in the fair value hierarchy (see Note 10 for the definition of Level 3 inputs).\nThe results and the assets of Tube Supply are included in the Company’s Metals segment.\nTube Supply, based in Houston, Texas, is a leading value-added distributor of specialty tubular and bar products for the oil and gas industry. Tube Supply provides high quality products and services primarily to the North American oilfield equipment manufacturing industry. Tube Supply operates two service centers, which are located in Houston, Texas and Edmonton, Alberta. The Acquisition will allow the Company to capitalize on the growing demand and opportunities in the oil and gas sector through new product offerings to an expanded customer base.\nThe aggregate purchase price was $184,385 and represents the aggregate cash purchase price, including a working capital adjustment. The premium paid in excess of the fair value of the net assets acquired was primarily for the ability to expand the Company’s oil and gas product offerings, as well as to obtain Tube Supply’s skilled, established workforce.\nDuring 2011, the Company incurred $4,260 of direct acquisition-related costs, which are recorded in Sales, general and administrative expense.\n46\nAn allocation of the purchase price to the fair value of the assets acquired and liabilities assumed, which was finalized as of December 2012, is as follows:\nPurchase Price Allocation\n| Current assets | $ | 134,817 |\n| Property, plant and equipment, net | 6,767 |\n| Other assets | 346 |\n| Trade name | 7,700 |\n| Customer relationships | 48,800 |\n| Non-compete agreements | 1,000 |\n| Developed technology | 1,400 |\n| Goodwill | 19,637 |\n| Total assets acquired | 220,467 |\n| Current liabilities | 33,211 |\n| Long-term liabilities | 2,871 |\n| Total liabilities assumed | 36,082 |\n| Total purchase price | $ | 184,385 |\n\nThe acquired intangible assets have a weighted average useful life of approximately 11.4 years. Useful lives by intangible asset category are as follows: trade name - 10 years, customer relationships - 12 years, non-compete agreements - 3 years and developed technology - 3 years.\nAt closing, the Company entered into a lease agreement with the former owners of Tube Supply. At December 31, 2012 and 2011, an unfavorable lease liability associated with the lease for a newly constructed distribution center used by Tube Supply of $2,168 and $2,871, respectively, is recorded in other non-current liabilities. The current portion of the unfavorable lease liability in the amount of $645 is included in accrued liabilities in the consolidated balance sheets at December 31, 2012 and 2011. The unfavorable lease liability resulted from the present value of the difference between the estimated fair market value and the executed contract price the Company will pay to lease the property. The unfavorable lease liability will be amortized over the remaining life of the lease.\nThe goodwill and intangible assets are deductible for tax purposes.\nThe results of operations of Tube Supply have been included in the Company's consolidated statements of operations and comprehensive loss since December 15, 2011. The net sales and net income for Tube Supply during the period from December 15, 2011 through December 31, 2011 were $7,648 and $901, respectively.\nThe following unaudited pro forma summary presents the effect of the Acquisition during the years ended December 31, 2011 and 2010 as though the business had been acquired as of January 1, 2010:\n| Year ended December 31,(Unaudited) |\n| 2011 | 2010 |\n| Pro forma net sales | $ | 1,332,176 | $ | 1,069,564 |\n| Pro forma net income (loss) | 7,033 | (24,268 | ) |\n| Pro forma basic net income (loss) per share | $ | 0.31 | $ | (1.06 | ) |\n| Pro forma diluted net income (loss) per share | 0.28 | (1.06 | ) |\n\nUnaudited pro forma supplemental information is based upon management estimates and judgments. The unaudited pro forma supplemental information also includes purchase accounting and interest expense adjustments and the related tax effects. The unaudited pro forma supplemental information for the year ended December 31, 2011 excludes direct acquisition-related costs of $4,260 and includes loss on extinguishment of debt of $6,153 and interest costs of $7,366 associated with the underwriting fee for debt financing and the mark-to-market adjustment for the conversion option on the convertible bonds. The unaudited pro forma supplemental information for the year ended December 31, 2010 includes direct acquisition-related costs of $4,260. These pro forma results are not necessarily indicative of what would have occurred if the acquisition had been in effect for the periods presented or of future results. Pro forma financial information is not provided for the year ended December 31, 2012 as a full\n47\nyear of post-acquisition results of operations for Tube Supply were included in the Company's consolidated statements of operations and comprehensive loss.\nSee Note 9 for detailed discussion on the Company’s debt financing structure used to finance the Acquisition.\n(3) Segment Reporting\nThe Company distributes and performs processing on both metals and plastics. Although the distribution processes are similar, the customer markets, supplier bases and types of products are different. Additionally, the Company’s Chief Executive Officer, the chief operating decision-maker, reviews and manages these two businesses separately. As such, these businesses are considered reportable segments and are reported accordingly. Neither of the Company’s reportable segments has any unusual working capital requirements.\nIn its Metals segment, the Company’s marketing strategy focuses on distributing highly engineered specialty grades and alloys of metals as well as providing specialized processing services designed to meet very precise specifications. Core products include alloy, aluminum, stainless, nickel, titanium and carbon. Inventories of these products assume many forms such as plate, sheet, extrusions, round bar, hexagon bar, square and flat bar, tubing and coil. Depending on the size of the facility and the nature of the markets it serves, service centers are equipped as needed with bar saws, plate saws, oxygen and plasma arc flame cutting machinery, trepanning machinery, boring machinery, honing equipment, water-jet cutting, stress relieving and annealing furnaces, surface grinding equipment and sheet shearing equipment. This segment also performs various specialized fabrications for its customers through pre-qualified subcontractors that thermally process, turn, polish and straighten alloy and carbon bar.\nThe Company’s Plastics segment consists exclusively of a wholly-owned subsidiary that operates as Total Plastics, Inc. (“TPI”), headquartered in Kalamazoo, Michigan, and its wholly-owned subsidiaries. The Plastics segment stocks and distributes a wide variety of plastics in forms that include plate, rod, tube, clear sheet, tape, gaskets and fittings. Processing activities within this segment include cut-to-length, cut-to-shape, bending and forming according to customer specifications. The Plastics segment’s diverse customer base consists of companies in the retail (point-of-purchase), automotive, marine, office furniture and fixtures, safety products, life sciences applications, and general manufacturing industries. TPI has locations throughout the upper northeast and midwest regions of the U.S. and one facility in Florida from which it services a wide variety of users of industrial plastics.\nThe accounting policies of all segments are the same as described in Note 1. Management evaluates the performance of its business segments based on operating income.\nThe Company operates locations in the United States, Canada, Mexico, France, the United Kingdom, China and Singapore. No activity from any individual country outside the United States is material, and therefore, foreign activity is reported on an aggregate basis. Net sales are attributed to countries based on the location of the Company’s subsidiary that is selling direct to the customer. Company-wide geographic data as of and for the years ended December 31, 2012, 2011 and 2010 are as follows:\n| 2012 | 2011 | 2010 |\n| Net sales |\n| United States | $ | 988,161 | $ | 895,165 | $ | 757,052 |\n| All other countries | 282,207 | 237,201 | 186,654 |\n| Total | $ | 1,270,368 | $ | 1,132,366 | $ | 943,706 |\n| Long-lived assets |\n| United States | $ | 68,253 | $ | 72,138 |\n| All other countries | 11,387 | 10,003 |\n| Total | $ | 79,640 | $ | 82,141 |\n\n48\nSegment information as of and for the years ended December 31, 2012, 2011 and 2010 is as follows:\n| NetSales | OperatingIncome(Loss) | TotalAssets | CapitalExpenditures | Depreciation &Amortization |\n| 2012 |\n| Metals segment (a) | $ | 1,143,884 | $ | 49,822 | $ | 693,803 | $ | 9,819 | $ | 24,480 |\n| Plastics segment | 126,484 | 3,188 | 56,149 | 1,831 | 1,387 |\n| Other (b) | — | (11,865 | ) | 38,854 | — | — |\n| Consolidated | $ | 1,270,368 | $ | 41,145 | $ | 788,806 | $ | 11,650 | $ | 25,867 |\n| 2011 |\n| Metals segment (a) | $ | 1,014,130 | $ | 13,524 | $ | 729,692 | $ | 10,639 | $ | 19,329 |\n| Plastics segment | 118,236 | 2,860 | 56,171 | 2,228 | 1,143 |\n| Other (b) | — | (11,190 | ) | 36,460 | — | — |\n| Consolidated | $ | 1,132,366 | $ | 5,194 | $ | 822,323 | $ | 12,867 | $ | 20,472 |\n| 2010 |\n| Metals segment | $ | 841,067 | $ | (5,478 | ) | $ | 454,345 | $ | 6,815 | $ | 19,392 |\n| Plastics segment | 102,639 | 3,559 | 47,128 | 757 | 1,257 |\n| Other (b) | — | (7,419 | ) | 27,879 | — | — |\n| Consolidated | $ | 943,706 | $ | (9,338 | ) | $ | 529,352 | $ | 7,572 | $ | 20,649 |\n\n(a) The results of Tube Supply, acquired on December 15, 2011, are included in the Company's Metals segment.\n(b) “Other” – Operating loss includes the costs of executive, legal and finance departments, which are shared by both the Metals and Plastics segments. The “Other” category’s total assets consist of the Company’s investment in joint venture.\nBelow are reconciliations of segment data to the consolidated loss before income taxes:\n| 2012 | 2011 | 2010 |\n| Operating income (loss) | $ | 41,145 | $ | 5,194 | $ | (9,338 | ) |\n| Interest expense, net | (41,090 | ) | (9,663 | ) | (4,988 | ) |\n| Interest expense - unrealized loss on debt conversion option | (15,597 | ) | (3,991 | ) | — |\n| Loss on extinguishment of debt | — | (6,153 | ) | — |\n| Loss before income taxes and equity in earnings of joint venture | (15,542 | ) | (14,613 | ) | (14,326 | ) |\n| Equity in earnings of joint venture | 7,224 | 11,727 | 5,585 |\n| Consolidated loss before income taxes | $ | (8,318 | ) | $ | (2,886 | ) | $ | (8,741 | ) |\n\n(4) Lease Agreements\nThe Company has operating and capital leases covering certain warehouse facilities, equipment, automobiles and trucks, with the lapse of time as the basis for all rental payments.\nFuture minimum rental payments under operating and capital leases that have initial or remaining non-cancelable lease terms in excess of one year as of December 31, 2012, are as follows:\n| Capital | Operating |\n| 2013 | $ | 415 | $ | 14,401 |\n| 2014 | 396 | 11,375 |\n| 2015 | 392 | 10,091 |\n| 2016 | 197 | 8,702 |\n| 2017 | — | 8,007 |\n| Later years | — | 24,130 |\n| Total future minimum rental payments | $ | 1,400 | $ | 76,706 |\n\n49\nTotal rental payments charged to expense were $15,579 in 2012, $12,362 in 2011, and $13,712 in 2010. Lease extrication charges of $1,215 associated with the consolidation of two of the Company’s facilities in the Metals segment were included in total rental payments charged to expense in 2010 within Warehouse, processing and delivery expense in the consolidated statements of operations and comprehensive loss. There were no lease extrication charges in 2012 and 2011. Total gross value of property, plant and equipment under capital leases was $1,895 and $2,698 in 2012 and 2011, respectively.\n(5) Employee Benefit Plans\nPension Plans\nSubstantially all employees who meet certain requirements of age, length of service and hours worked per year are covered by Company-sponsored pension plans and supplemental pension plan (collectively, the “pension plans”). These pension plans are defined benefit, noncontributory plans. Benefits paid to retirees are based upon age at retirement, years of credited service and average earnings. The Company also has a supplemental pension plan, which is a non-qualified, unfunded plan. The Company uses a December 31 measurement date for the pension plans.\nThe Company-sponsored pension plans are frozen for all employees except for employees of certain subsidiaries and employees represented by the United Steelworkers of America. The assets of the Company-sponsored pension plans are maintained in a single trust account.\nThe Company’s funding policy is to satisfy the minimum funding requirements of the Employee Retirement Income Security Act of 1974, commonly called ERISA.\nComponents of net periodic pension credit are as follows:\n| 2012 | 2011 | 2010 |\n| Service cost | $ | 608 | $ | 539 | $ | 623 |\n| Interest cost | 6,832 | 7,393 | 7,456 |\n| Expected return on assets | (9,855 | ) | (10,054 | ) | (9,342 | ) |\n| Amortization of prior service cost | 324 | 324 | 231 |\n| Amortization of actuarial loss | 594 | 229 | 237 |\n| Net periodic pension credit | $ | (1,497 | ) | $ | (1,569 | ) | $ | (795 | ) |\n\nThe expected 2013 amortization of pension prior service cost and actuarial loss is $323 and $1,942, respectively.\n50\nThe status of the plans at December 31, 2012 and 2011 are as follows:\n| 2012 | 2011 |\n| Change in projected benefit obligation: |\n| Projected benefit obligation at beginning of year | $ | 164,407 | $ | 144,235 |\n| Service cost | 608 | 539 |\n| Interest cost | 6,832 | 7,393 |\n| Benefit payments | (6,558 | ) | (6,151 | ) |\n| Actuarial loss | 15,848 | 18,391 |\n| Projected benefit obligation at end of year | $ | 181,137 | $ | 164,407 |\n| Change in plan assets: |\n| Fair value of plan assets at beginning of year | $ | 174,938 | $ | 157,996 |\n| Actual return on assets | 18,463 | 22,867 |\n| Employer contributions | 307 | 226 |\n| Benefit payments | (6,558 | ) | (6,151 | ) |\n| Fair value of plan assets at end of year | $ | 187,150 | $ | 174,938 |\n| Funded status – net prepaid | $ | 6,013 | $ | 10,531 |\n| Amounts recognized in the consolidated balance sheets consist of: |\n| Prepaid pension cost | $ | 12,891 | $ | 15,956 |\n| Accrued liabilities | (309 | ) | (219 | ) |\n| Pension benefit obligations | (6,569 | ) | (5,206 | ) |\n| Net amount recognized | $ | 6,013 | $ | 10,531 |\n| Pre-tax components of accumulated other comprehensive income (loss): |\n| Unrecognized actuarial loss | $ | (29,778 | ) | $ | (23,131 | ) |\n| Unrecognized prior service cost | (1,617 | ) | (1,942 | ) |\n| Total | $ | (31,395 | ) | $ | (25,073 | ) |\n| Accumulated benefit obligation | $ | 180,551 | $ | 163,874 |\n\nFor the plan with an accumulated benefit obligation in excess of plan assets, the projected benefit obligation, accumulated benefit obligation and fair value of plan assets were $5,893, $5,893 and $0, respectively, at December 31, 2012; and $5,425, $5,425 and $0, respectively, at December 31, 2011.\nThe assumptions used to measure the projected benefit obligations for the Company’s defined benefit pension plans are as follows:\n| 2012 | 2011 |\n| Discount rate | 3.50 - 3.75% | 4.25 | % |\n| Projected annual salary increases | 0 - 3.00% | 0 - 3.00% |\n\nThe assumptions used to determine net periodic pension credit are as follows:\n| 2012 | 2011 | 2010 |\n| Discount rate | 4.25 | % | 5.25 | % | 5.75 | % |\n| Expected long-term rate of return on plan assets | 5.75 | % | 6.50 | % | 6.50 | % |\n| Projected annual salary increases | 0 - 3.00% | 0 - 3.00% | 0 - 3.00% |\n\nThe Company’s expected return on plan assets is derived from reviews of asset allocation strategies and historical and anticipated future long-term performance of individual asset classes. The Company’s analysis gives consideration to historical returns and long-term, prospective rates of return.\n51\nThe Company’s pension plan assets are allocated entirely to fixed income securities at December 31, 2012 and 2011.\nThe Company’s pension plans’ funds are managed in accordance with investment policies recommended by its investment advisor and approved by the Human Resources Committee of the Board of Directors. The overall target portfolio allocation is 100% fixed income securities. These funds’ conformance with style profiles and performance is monitored regularly by management, with the assistance of the Company’s investment advisor. Adjustments are typically made in the subsequent quarters when investment allocations deviate from the target range. The investment advisor provides quarterly reports to management and the Human Resources Committee of the Board of Directors.\nThe fair values of the Company’s pension plan assets fall within the following levels of the fair value hierarchy as of December 31, 2012:\n| Level 1 | Level 2 | Level 3 | Total |\n| Fixed income securities (1) | $ | 10,562 | $ | 176,610 | $ | — | $ | 187,172 |\n| Accounts payable – pending trades | (22 | ) |\n| Total | $ | 187,150 |\n\n\n| (1) | Fixed income securities are comprised of corporate bonds (75%), government bonds (16%), government agencies securities (6%) and other fixed income securities (3%). |\n\nThe fair values of the Company’s pension plan assets fall within the following levels of the fair value hierarchy as of December 31, 2011:\n| Level 1 | Level 2 | Level 3 | Total |\n| Fixed income securities (2) | $ | 9,949 | $ | 172,694 | $ | — | $ | 182,643 |\n| Accounts payable – pending trades | (7,705 | ) |\n| Total | $ | 174,938 |\n\n\n| (2) | Fixed income securities are comprised of corporate bonds (74%), government bonds (16%), government agencies securities (7%) and other fixed income securities (3%). |\n\nThe estimated future pension benefit payments are:\n| 2013 | $ | 7,974 |\n| 2014 | 8,213 |\n| 2015 | 8,828 |\n| 2016 | 9,115 |\n| 2017 | 9,607 |\n| 2018 — 2022 | 51,839 |\n\nThe Company is also party to certain multi-employer pension plans. The overall cost of such plans to the Company is insignificant. If the Company withdraws from a multi-employer pension plan in the future, it could potentially incur a withdrawal liability at that time.\nPostretirement Plan\nThe Company also provides declining value life insurance to its retirees and a maximum of three years of medical coverage to qualified individuals who retire between the ages of 62 and 65. The Company does not fund these benefits in advance, and uses a December 31 measurement date.\n52\nComponents of net periodic postretirement benefit cost for 2012, 2011 and 2010 were as follows:\n| 2012 | 2011 | 2010 |\n| Service cost | $ | 161 | $ | 164 | $ | 177 |\n| Interest cost | 170 | 222 | 219 |\n| Amortization of prior service cost | — | — | 29 |\n| Amortization of actuarial gain | — | — | (16 | ) |\n| Net periodic postretirement benefit cost | $ | 331 | $ | 386 | $ | 409 |\n\nThe expected 2012, amortization of postretirement prior service cost and actuarial gain are insignificant.\nThe status of the postretirement benefit plans at December 31, 2012 and 2011 were as follows:\n| 2012 | 2011 |\n| Change in accumulated postretirement benefit obligations: |\n| Accumulated postretirement benefit obligation at beginning of year | $ | 4,635 | $ | 4,339 |\n| Service cost | 161 | 164 |\n| Interest cost | 170 | 222 |\n| Benefit payments | (193 | ) | (100 | ) |\n| Actuarial (gain) loss | (394 | ) | 10 |\n| Accumulated postretirement benefit obligation at end of year | $ | 4,379 | $ | 4,635 |\n| Funded status – net liability | $ | 4,379 | $ | 4,635 |\n| Amounts recognized in the consolidated balance sheets consist of: |\n| Accrued liabilities | $ | (296 | ) | $ | (218 | ) |\n| Postretirement benefit obligations | (4,083 | ) | (4,417 | ) |\n| Net amount recognized | $ | (4,379 | ) | $ | (4,635 | ) |\n| Pre-tax components of accumulated other comprehensive income (loss): |\n| Unrecognized actuarial gain | $ | 661 | $ | 266 |\n| Total | $ | 661 | $ | 266 |\n\nThe assumed health care cost trend rates for medical plans at December 31 were as follows:\n| 2012 | 2011 | 2010 |\n| Medical cost trend rate | 8.00 | % | 8.50 | % | 8.00 | % |\n| Ultimate medical cost trend rate | 5.00 | % | 5.00 | % | 5.00 | % |\n| Year ultimate medical cost trend rate will be reached | 2019 | 2018 | 2013 |\n\nA 1% increase in the health care cost trend rate assumptions would have increased the accumulated postretirement benefit obligation at December 31, 2012 by $259 with no significant impact on the annual periodic postretirement benefit cost. A 1% decrease in the health care cost trend rate assumptions would have decreased the accumulated postretirement benefit obligation at December 31, 2012 by $235 with no significant impact on the annual periodic postretirement benefit cost.\n53\nThe weighted average discount rate used to determine the net periodic postretirement benefit costs and the accumulated postretirement benefit obligations were as follows:\n| 2012 | 2011 | 2010 |\n| Net periodic postretirement benefit costs | 3.75 | % | 5.25 | % | 5.75 | % |\n| Accumulated postretirement benefit obligations | 3.50 | % | 3.75 | % | 5.25 | % |\n\nRetirement Savings Plan\nThe Company’s retirement savings plan includes features under Section 401(k) of the Internal Revenue Code. Effective July 1, 2011, the Company’s 401(k) matching contribution was increased to 100% of each dollar on eligible employee contributions up to the first 6% of the employee’s pre-tax compensation and the Company’s fixed contribution of 4% of eligible earnings for all employees was eliminated. Company contributions cliff vest after two years of employment.\nEffective July 1, 2012, the Company's 401(k) plan was amended to include the U.S. employees of Tube Supply. Employees were eligible to participate in the Company's 401(k) plan immediately. Tube Supply's existing plan assets were rolled over into the Company's 401(k) plan during 2012 as a result of this amendment.\nThe amounts expensed are summarized below:\n| 2012 | 2011 | 2010 |\n| Supplemental contributions and 401(k) match | $ | 5,260 | $ | 4,414 | $ | 1,634 |\n\n(6) Joint Venture\nKreher Steel Co., LLC is a 50% owned joint venture of the Company. It is a metals distributor of bulk quantities of alloy, special bar quality and stainless steel bars, headquartered in Melrose Park, Illinois.\nThe following information summarizes the Company’s participation in the joint venture as of and for the year ended December 31:\n| 2012 | 2011 | 2010 |\n| Equity in earnings of joint venture | $ | 7,224 | $ | 11,727 | $ | 5,585 |\n| Investment in joint venture | 38,854 | 36,460 | 27,879 |\n| Sales to joint venture | 455 | 362 | 973 |\n| Purchases from joint venture | 695 | 884 | 223 |\n\nThe following information summarizes financial data for this joint venture as of and for the year ended December 31:\n| 2012 | 2011 | 2010 |\n| Revenues | $ | 257,776 | $ | 269,657 | $ | 188,107 |\n| Net income | 14,603 | 23,643 | 11,035 |\n| Current assets | 92,421 | 111,263 | 71,611 |\n| Non-current assets | 26,099 | 22,979 | 17,880 |\n| Current liabilities | 14,315 | 59,952 | 32,828 |\n| Non-current liabilities | 27,845 | 3,089 | 2,872 |\n| Members’ equity | 76,360 | 71,199 | 53,791 |\n| Capital expenditures | 5,259 | 6,736 | 2,271 |\n| Depreciation and amortization | 2,034 | 1,603 | 1,720 |\n\n54\n(7) Income Taxes\n(Loss) Income before income taxes and equity in earnings of joint venture generated by the Company’s U.S. and non-U.S. operations were as follows:\n| 2012 | 2011 | 2010 |\n| U.S | $ | (28,398 | ) | $ | (26,321 | ) | $ | (19,420 | ) |\n| Non-U.S. | 12,856 | 11,708 | 5,094 |\n\nThe Company’s income tax expense (benefit) is comprised of the following:\n| 2012 | 2011 | 2010 |\n| Federal |\n| current | $ | (842 | ) | $ | (1,204 | ) | $ | 6,823 |\n| deferred | (1,542 | ) | (2,041 | ) | (11,270 | ) |\n| State |\n| current | 629 | 461 | 17 |\n| deferred | 401 | (1,218 | ) | (186 | ) |\n| Foreign |\n| current | 2,927 | 2,970 | 1,464 |\n| deferred | (143 | ) | (94 | ) | 51 |\n| $ | 1,430 | $ | (1,126 | ) | $ | (3,101 | ) |\n\nThe reconciliation between the Company’s effective tax rate on income or loss and the U.S. federal income tax rate of 35% is as follows:\n| 2012 | 2011 | 2010 |\n| Federal income tax at statutory rates | $ | (5,439 | ) | $ | (5,115 | ) | $ | (5,014 | ) |\n| State income taxes, net of federal income tax benefits | 22 | (1,007 | ) | (313 | ) |\n| Permanent items: |\n| Dividends received deductions | (766 | ) | — | — |\n| Convertible debt mark-to-market - non-deductible | 6,206 | 1,551 |\n| Other permanent differences | 480 | 662 | 326 |\n| Federal and state income tax on joint venture | 2,766 | 4,478 | 2,158 |\n| Rate differential on foreign income | (1,680 | ) | (726 | ) | (755 | ) |\n| Unrecognized tax benefits | (557 | ) | (576 | ) | 424 |\n| Audit settlements | 218 | — | — |\n| State rate changes | (68 | ) | (478 | ) | — |\n| Other | 248 | 85 | 73 |\n| Income tax expense (benefit) | $ | 1,430 | $ | (1,126 | ) | $ | (3,101 | ) |\n| Effective income tax expense rate | 9.2 | % | 7.7 | % | 21.7 | % |\n\n55\nSignificant components of the Company’s deferred tax assets and liabilities are as follows:\n| 2012 | 2011 |\n| Deferred tax assets: |\n| Postretirement benefits | $ | 3,830 | $ | 3,675 |\n| Deferred compensation | 1,940 | 1,916 |\n| Deferred gain | — | 271 |\n| Impairments | 1,452 | 1,311 |\n| Alternative minimum tax and net operating loss carryforward | 3,487 | 2,635 |\n| Total deferred tax assets | $ | 10,709 | $ | 9,808 |\n| Deferred tax liabilities: |\n| Depreciation | $ | 8,032 | $ | 8,307 |\n| Inventory | 1,146 | 1,695 |\n| Pension | 4,240 | 5,742 |\n| Intangible assets and goodwill | 24,224 | 16,486 |\n| Other, net | 1,665 | 1,475 |\n| Total deferred tax liabilities | 39,307 | 33,705 |\n| Net deferred tax liabilities | $ | 28,598 | $ | 23,897 |\n\nAs of December 31, 2012, the Company has federal, state and foreign net operating losses (\"NOLs\") as follows:\n| Amount | Expiration Period |\n| Federal | $ | — |\n| State | 19,499 | 2015 to 2032 |\n| Foreign | 2,473 | (a) |\n\n(a) Foreign NOLs of $369 expire in 2014 and $2,104 do not expire.\nBased on all available evidence, including historical and forecasted financial results, the Company determined that it is more likely than not that the federal, state and foreign NOLs that have expiration dates will be realized due to the fact that the Company anticipates it will be able to have sufficient earnings in future years to use the NOL carryforwards prior to expiration. To the extent that the Company does not generate sufficient state or foreign taxable income within the statutory carryforward periods to utilize the NOL carryforwards in the respective jurisdictions, they will expire unused. However, based upon all available evidence, the Company has concluded that it will utilize these NOL carryforwards prior to the expiration period.\nThe following table shows the net change in the Company’s unrecognized tax benefits:\n| 2012 | 2011 | 2010 |\n| Balance as of January 1 | $ | 861 | $ | 1,465 | $ | 726 |\n| Increases (decreases) in unrecognized tax benefits: |\n| Due to tax positions taken in prior years | — | 91 | 729 |\n| Due to tax positions taken during the current year | 45 | 60 | 44 |\n| Due to settlement with tax authorities | (757 | ) | — | (34 | ) |\n| Due to expiration of statute | (44 | ) | (755 | ) | — |\n| Balance as of December 31 | $ | 105 | $ | 861 | $ | 1,465 |\n\nUnrecognized tax benefits of $105, $861 and $950 would impact the effective tax rate if recognized as of December 31, 2012, 2011 and 2010, respectively. The accrued interest and penalties related to unrecognized tax benefits were insignificant at December 31, 2012 and 2011. The interest and penalties recorded by the Company were insignificant for the years ended December 31, 2012, 2011 and 2010.\n56\nDuring 2012 and 2011, statutes expired on certain unrecognized tax benefits of the Company. The reversal of the reserve of these unrecognized tax benefits was recorded as a component of overall income tax benefit for the years ended December 31, 2012 and 2011, respectively.\nThe Company or its subsidiaries files income tax returns in the United States federal jurisdiction, 29 states, and 7 foreign jurisdictions.\nThe following tax years remain open to examination by the major taxing jurisdictions to which the Company is subject:\n| U.S. Federal | 2010 to 2011 |\n| U.S. States | 2008 to 2011 |\n| Foreign | 2007 to 2011 |\n\nDuring the second quarter of 2012, audits of the Company’s 2008 and 2009 U.S. federal income tax returns were concluded with no significant assessment. During 2011, the Company recognized $423 of tax benefits, excluding interest, due to the expiration of the statute of limitations for uncertain tax positions taken in prior years. Due to the potential for resolution of the examination or expiration of statutes of limitations, it is reasonably possible that the Company’s gross unrecognized tax benefits may change within the next 12 months by a range of zero to $60.\nThe Company received its 2010 federal tax refund of $2,025 during February 2012 and its 2009 federal income tax refund of $6,344 during January 2011.\n(8) Goodwill and Intangible Assets\nThe changes in carrying amounts of goodwill during the years ended December 31, 2012 and 2011 were as follows:\n| 2012 | 2011 |\n| MetalsSegment | PlasticsSegment | Total | MetalsSegment | PlasticsSegment | Total |\n| Balance as of January 1 |\n| Goodwill | $ | 117,145 | $ | 12,973 | $ | 130,118 | $ | 97,354 | $ | 12,973 | $ | 110,327 |\n| Accumulated impairment losses | (60,217 | ) | — | (60,217 | ) | (60,217 | ) | — | (60,217 | ) |\n| 56,928 | 12,973 | 69,901 | 37,137 | 12,973 | 50,110 |\n| Acquisition of Tube Supply | — | — | — | 19,637 | — | 19,637 |\n| Currency valuation | 399 | — | 399 | 154 | — | 154 |\n| Balance as of December 31 |\n| Goodwill | 117,544 | 12,973 | 130,517 | 117,145 | 12,973 | 130,118 |\n| Accumulated impairment losses | (60,217 | ) | — | (60,217 | ) | (60,217 | ) | — | (60,217 | ) |\n| $ | 57,327 | $ | 12,973 | $ | 70,300 | $ | 56,928 | $ | 12,973 | $ | 69,901 |\n\nThe Company’s annual test for goodwill impairment is completed as of January 1st each year. Based on its January 1, 2012 test, the Company determined that there was no impairment of goodwill. The Company's year-to-date operating results, among other factors, are considered in determining whether it is more likely than not that the fair value for any reporting unit has declined below its carrying value, which would require the Company to perform an interim goodwill impairment test. Another recession or economic declines in specific industries could change management's expectations of future financial results and/or key valuation assumptions used in determining the fair-value of its reporting units, which could result in a goodwill impairment.\n57\nThe following summarizes the components of intangible assets at December 31, 2012 and 2011 :\n| 2012 | 2011 |\n| Gross CarryingAmount | AccumulatedAmortization | Gross CarryingAmount | AccumulatedAmortization |\n| Customer relationships | $ | 119,118 | $ | 45,317 | $ | 118,567 | $ | 34,960 |\n| Non-compete agreements | 3,888 | 3,235 | 3,888 | 2,902 |\n| Trade names | 8,297 | 1,188 | 8,249 | 410 |\n| Developed technology | 1,400 | 486 | 1,400 | 19 |\n| Total | $ | 132,703 | $ | 50,226 | $ | 132,104 | $ | 38,291 |\n\nThe weighted-average amortization period for the intangible assets is 10.8 years, 11.3 years for customer relationships, 9.4 years for trade names, 3 years for non-compete agreements and 3 years for developed technology. Substantially all of the Company’s intangible assets were acquired as part of the acquisitions of Transtar on September 5, 2006 and Tube Supply on December 15, 2011.\nFor the years ended December 31, 2012, 2011, and 2010, the aggregate amortization expense was $11,843, $6,867 and $7,071, respectively.\nThe following is a summary of the estimated annual amortization expense for each of the next 5 years:\n| 2013 | $ | 11,775 |\n| 2014 | 11,742 |\n| 2015 | 10,975 |\n| 2016 | 10,975 |\n| 2017 | 8,951 |\n\n(9) Debt\nShort-term and long-term debt consisted of the following at December 31, 2012 and 2011:\n| 2012 | 2011 |\n| SHORT-TERM DEBT |\n| Foreign | $ | 500 | $ | 500 |\n| Total short-term debt | 500 | 500 |\n| LONG-TERM DEBT |\n| 12.75% Senior Secured Notes due December 15, 2016 | 225,000 | 225,000 |\n| 7.0% Convertible Notes due December 15, 2017 | 57,500 | 57,500 |\n| New Revolving Credit Facility due December 15, 2015 | 39,500 | 35,500 |\n| Other, primarily capital leases | 1,400 | 244 |\n| Total long-term debt | 323,400 | 318,244 |\n| Plus: derivative liability for conversion feature associated with convertible debt | — | 26,440 |\n| Less: unamortized discount | (26,831 | ) | (30,252 | ) |\n| Less: current portion | (415 | ) | (192 | ) |\n| Total long-term portion | 296,154 | 314,240 |\n| TOTAL SHORT-TERM AND LONG-TERM DEBT | $ | 297,069 | $ | 314,932 |\n\nDuring December of 2011, in conjunction with the completion of the Acquisition (see Note 2), the Company issued $225,000 aggregate principal amount of 12.75% Senior Secured Notes due 2016 (the “Secured Notes”), $57,500 aggregate principal amount of 7.0% Convertible Senior Notes due 2017 (the “Convertible Notes”) and entered into a $100,000 senior secured asset based revolving credit facility (the “New Revolving Credit Facility”). Net proceeds from these transactions (collectively referred to as the “Debt Transactions”) were used to complete the Acquisition, repay existing debt and for general corporate purposes. The Company incurred debt origination fees of $18,136\n58\nassociated with the Debt Transactions which are primarily being amortized using the effective interest method and recognized interest expense of $3,375 for underwriting fees associated with the debt financing. The Company recognized a loss of $6,153 on the extinguishment of its previously existing debt which included prepayment fees and the write-off of previously existing deferred financing costs.\nSecured Notes\nThe Company filed a registration statement with the Securities and Exchange Commission on Form S-4 on April 11, 2012. The registration statement was declared effective on June 12, 2012.\nOn June 12, 2012, the Company commenced an offer to exchange $225,000 principal amount of 12.75% Secured Notes due 2016, which are registered under the Securities Act of 1933 (the “New Secured Notes”), for $225,000 principal amount of outstanding 12.75% Senior Secured Notes due 2016, which had not been registered under the Securities Act of 1933 (the “Old Secured Notes”). The terms of the New Secured Notes issued are identical in all material respects to the Old Secured Notes, except that the New Secured Notes are registered under the Securities Act of 1933, do not have any of the transfer restrictions, registration rights and additional interest provisions relating to the Old Secured Notes and bear a different CUSIP number from the Old Secured Notes. The Company did not receive any proceeds from the exchange offer.\nThe New Secured Notes will mature on December 15, 2016. The Company will pay interest on the New Secured Notes at a rate of 12.75% per annum in cash semi-annually. During 2012, interest payments totaling $28,688 were made on June 15, 2012 and December 14, 2012. The New Secured Notes are fully and unconditionally guaranteed, jointly and severally, by certain 100% owned domestic subsidiaries of the Company (the “Note Guarantors”). The New Secured Notes and the related guarantees are secured by a lien on substantially all of the Company's and the Note Guarantors' assets, subject to certain exceptions and permitted liens pursuant to a pledge and security agreement. The terms of the New Secured Notes contain numerous covenants imposing financial and operating restrictions on the Company's business. These covenants place restrictions on the Company's ability and the ability of its subsidiaries to, among other things, pay dividends, redeem stock or make other distributions or restricted payments; incur indebtedness or issue common stock; make certain investments; create liens; agree to payment restrictions affecting certain subsidiaries; consolidate or merge; sell or otherwise transfer or dispose of assets, including equity interests of certain subsidiaries; enter into transactions with affiliates, enter into sale and leaseback transactions; and use the proceeds of permitted sales of the Company's assets. Refer to Note 14 for Guarantor Financial Information disclosure.\nOn or after December 15, 2014, the Company may redeem some or all of the New Secured Notes at a redemption premium of 106.375% of the principal amount for the 12-month period beginning December 15, 2014 and 100% thereafter, plus accrued and unpaid interest. Prior to December 15, 2014, the Company may redeem up to 35% of the aggregate principal amount of the New Secured Notes at a redemption price of 112.75% of the principal amount, plus accrued and unpaid interest, with the net cash proceeds of certain equity offerings. In addition, the Company may, at its option, redeem some or all of the New Secured Notes at any time prior to December 15, 2014, by paying a “make-whole” premium, plus accrued and unpaid interest.\nThe New Secured Notes also contain a provision that allows holders of the New Secured Notes to require the Company to repurchase all or any part of the Secured Notes if a change of control triggering event occurs. Under this provision, the repurchase of the New Secured Notes will occur at a purchase price of 101% of the outstanding principal amount, plus accrued and unpaid interest, if any, on such New Secured Notes to the date of repurchase. In addition, upon certain asset sales, the Company may be required to offer to use the net proceeds thereof to purchase some of the New Secured Notes at 100% of the principal amount thereof, plus accrued and unpaid interest.\nSubject to certain conditions, within 95 days after the end of each fiscal year, the Company must make an offer to purchase New Secured Notes with certain of its excess cash flow for such fiscal year (as defined in the indenture) for such fiscal year, commencing with the fiscal year ending December 31, 2012, at 103% of the principal amount thereof, plus accrued and unpaid interest. For the fiscal year ended December 31, 2012, the Company estimated excess cash flow (as defined in the indenture) to be approximately $17,000 and therefore, an offer to purchase New Secured Notes is required to be made within 95 days of year end.\nAlthough redemption of the New Secured Notes is outside of the control of the Company, the New Secured Notes in the amount of $17,000 are reported as long-term debt as availability under the Company's revolving credit facility, which is long-term in nature, would be used if redemption occurred.\n59\nConvertible Notes\nThe $50,000 Convertible Notes were issued pursuant to an indenture, dated as of December 15, 2011, among the Company, the Note Guarantors and U.S. Bank National Association, as trustee. The Convertible Notes were issued by the Company at an initial offering price equal to 100% of the principal amount. The Company granted the initial purchaser in the Convertible Notes offering an option, exercisable within 30 days, to purchase up to an additional $7,500 aggregate principal amount of Convertible Notes. The initial purchaser exercised their option in full and, on December 20, 2011, the Company issued an additional $7,500 aggregate principal amount of Convertible Notes.\nThe Convertible Notes will mature on December 15, 2017. The Company will pay interest on the Convertible Notes at a rate of 7.0% in cash semi-annually. During 2012, interest payments totaling $4,025 were made on June 15, 2012 and December 14, 2012. The Convertible Notes will be fully and unconditionally guaranteed, jointly and severally, on a senior unsecured basis by the Note Guarantors. The initial conversion rate for the Convertible Notes will be 97.2384 shares of the Company’s common stock per $1 principal amount of Convertible Notes, equivalent to an initial conversion price of approximately $10.28 per share of common stock. The conversion rate will be subject to adjustment, but will not be adjusted for accrued and unpaid interest, if any. In addition, if an event constituting a fundamental change occurs, the Company will in some cases increase the conversion rate for a holder that elects to convert its Convertible Notes in connection with such fundamental change. Upon conversion, the Company will pay and/or deliver, as the case may be, cash, shares of common stock or a combination of cash and shares of common stock, at the Company’s election, together with cash in lieu of fractional shares.\nHolders may convert their Convertible Notes at their option on any day prior to the close of business on the scheduled trading day immediately preceding June 15, 2017 only under the following circumstances: (1) during the five business-day period after any five consecutive trading-day period (the “measurement period”) in which the trading price per note for each day of that measurement period was less than 98% of the product of the last reported sale price of the Company’s common stock and the applicable conversion rate on each such day; (2) during any calendar quarter (and only during such calendar quarter) after the calendar quarter ended December 31, 2011, if the last reported sale price of the Company’s common stock for 20 or more trading days (whether or not consecutive) during the period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is equal to or greater than 130% of the applicable conversion price in effect for each applicable trading day; (3) upon the occurrence of specified corporate events, including certain dividends and distributions; or (4) if the Company calls the Convertible Notes for redemption on or after December 20, 2015. The Convertible Notes will be convertible, regardless of the foregoing circumstances, at any time from, and including, June 15, 2017 through the second scheduled trading day immediately preceding the maturity date.\nPrior to April 26, 2012, the Company had the option to elect not to issue shares of common stock upon conversion of the Convertible Notes to the extent such election would result in the issuance of more than 19.99% of the common stock outstanding immediately before the issuance of the Convertible Notes until the Company receives shareholder approval for such issuance and shareholder approval of the increase in the number of shares of common stock authorized and available for issuance upon conversion of the Convertible Notes. Since the Company did not have sufficient authorized shares available to share-settle the conversion option in full, the embedded conversion option did not qualify for equity classification and instead was separately valued and accounted for as a derivative liability as of December 31, 2011. The initial value allocated to the derivative liability was $22,330 of the $57,500 principal amount of the Convertible Notes, which represents a discount to the debt to be amortized through interest expense using the effective interest method through the maturity of the Convertible Notes. Accordingly, the effective interest rate used to amortize the debt discount on the Convertible Notes was determined to be 17.78%. During each reporting period prior to April 26, 2012, the derivative liability was marked to fair value through earnings. As of December 31, 2011, the derivative liability, which is classified in long-term debt, had a fair value of $26,440. There was no derivative liability as of December 31, 2012.\nOn April 26, 2012, at the Company's Annual Meeting of Stockholders, shareholder approval was obtained for the issuance of shares in excess of 20% of the Company's outstanding common stock to satisfy any conversions of the Convertible Notes. Additionally, shareholder approval was obtained to amend the Company's charter to authorize additional shares of common stock from 30,000 to 60,000. With these approvals, the Company now has the ability to share-settle the conversion option in full and therefore, the embedded conversion option is no longer required to be separately valued and accounted for as a derivative liability. As of April 26, 2012, the conversion option's cumulative value of $42,037 was reclassified to additional paid-in capital and will no longer be marked-to-market through earnings. The deferred tax benefit of $8,285 associated with the temporary difference between the financial reporting basis of the derivative liability and its tax basis at the date of issuance (December 15, 2011) was also reclassified to additional paid-in capital.\n60\nUpon a fundamental change, subject to certain exceptions, holders may require the Company to repurchase some or all of their Convertible Notes for cash at a repurchase price equal to 100% of the principal amount of the Convertible Notes being repurchased, plus any accrued and unpaid interest.\nThe Company may not redeem the Convertible Notes prior to December 20, 2015. On or after December 20, 2015, the Company may redeem all or part of the Convertible Notes (except for the Convertible Notes that we are required to repurchase as described above) if the last reported sale price of the Company’s common stock exceeds 135% of the applicable conversion price for 20 or more trading days in a period of 30 consecutive trading days ending on the trading day immediately prior to the date of the redemption notice. The redemption price will equal the sum of 100% of the principal amount of the Convertible Notes to be redeemed, plus accrued and unpaid interest, plus a “make-whole premium” payment. The Company must make the \"make-whole\" premium payments on all Convertible Notes called for redemption including Convertible Notes converted after the date we delivered the notice of redemption. The Company will pay the redemption price in cash except for any non-cash portion of the \"make-whole\" premium.\nNew Revolving Credit Facility\nThe New Revolving Credit Facility consists of a $100,000 senior secured asset-based revolving credit facility (subject to adjustment pursuant to a borrowing base described below), of which (a) up to an aggregate principal amount of $20,000 will be available for a Canadian subfacility, (b) up to an aggregate principal amount of $20,000 will be available for letters of credit and (c) up to an aggregate principal amount of $10,000 will be available for swingline loans. Loans under the New Revolving Credit Facility will be made available to the Company and certain domestic subsidiaries (the “U.S. Borrowers”) in U.S. dollars and the Canadian Borrowers in U.S. dollars and Canadian dollars. The New Revolving Credit Facility will mature on December 15, 2015.\nAll obligations of the U.S. Borrowers under the New Revolving Credit Facility are guaranteed on a senior secured basis by each direct and indirect, existing and future, domestic subsidiary of the U.S. Borrowers (the “U.S. Subsidiary Guarantors” and together with the U.S. Borrowers, the “U.S. Credit Parties”), subject to certain exceptions for immaterial subsidiaries. All obligations of the Canadian Borrowers under the New Revolving Credit Facility are guaranteed on a senior secured basis by (a) each U.S. Credit Party and (b) each direct and indirect, existing and future, Canadian subsidiary of the Company (the “Canadian Subsidiary Guarantors” and together with the Canadian Borrowers, the “Canadian Credit Parties”; and the U.S. Credit Parties together with the Canadian Credit Parties, the “Credit Parties”), subject to certain exceptions.\nAll obligations under the New Revolving Credit Facility are secured on a first-priority basis by a perfected security interest in substantially all assets of the Credit Parties (subject to certain exceptions for permitted liens). The New Revolving Credit Facility will rank pari passu in right of payment with the Secured Notes, but, pursuant to the intercreditor agreement, the Secured Notes will be effectively subordinated to the indebtedness under the New Revolving Credit Facility with respect to the collateral.\nAt the Company’s election, borrowings under the New Revolving Credit Facility will bear interest at variable rates based on (a) a customary base rate plus an applicable margin of between 0.50% and 1.00% (depending on quarterly average undrawn availability under the New Revolving Credit Facility) or (b) an adjusted LIBOR rate plus an applicable margin of between 1.50% and 2.00% (depending on quarterly average undrawn availability under the New Revolving Credit Facility). The weighted average interest rate on borrowings under the revolving credit facilities were 2.71% and 1.63% for the year ended December 31, 2012 and 2011, respectively. The Company will pay certain customary recurring fees with respect to the New Revolving Credit Facility.\nThe New Revolving Credit Facility permits the Company to increase the aggregate amount of the commitments under the New Revolving Credit Facility from time to time in an aggregate amount for all such increases not to exceed $50,000, subject to certain conditions. The existing lenders under the New Revolving Credit Facility are not obligated to provide the incremental commitments.\nThe New Revolving Credit facility contains a springing financial maintenance covenant requiring the Company to maintain the ratio of EBITDA (as defined in the agreement) to fixed charges of 1.1 to 1.0 when excess availability is less than the greater of 10% of the calculated borrowing base (as defined in the agreement) or $10,000. In addition, if excess availability is less than the greater of 12.5% of the calculated borrowing base (as defined in the agreement) or $12,500, the lender has the right to take full dominion of the Company’s cash collections and apply these proceeds to outstanding loans under the New Revolving Credit Agreement. As of December 31, 2012, the Company’s excess availability of $50,543 was above such thresholds.\n61\nNet interest expense reported on the consolidated statements of operations was reduced by interest income from investment of excess cash balances of $222 in 2012, $254 in 2011 and $201 in 2010.\n(10) Fair Value Measurements\nThe three-tier value hierarchy the Company utilizes, which prioritizes the inputs used in the valuation methodologies, is:\nLevel 1—Valuations based on quoted prices for identical assets and liabilities in active markets.\nLevel 2—Valuations based on observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data.\nLevel 3—Valuations based on unobservable inputs reflecting our own assumptions, consistent with reasonably available assumptions made by other market participants.\nThe fair value of cash, accounts receivable and accounts payable approximate their carrying values. The fair value of cash equivalents are determined using the fair value hierarchy described above. Cash equivalents consisting of money market funds are valued based on quoted prices in active markets and as a result are classified as Level 1.\nThe Company’s pension plan asset portfolio as of December 31, 2012 and 2011 is primarily invested in fixed income securities, which generally fall within Level 2 of the fair value hierarchy. Fixed income securities in the are valued based on evaluated prices provided to the trustee by independent pricing services. Such prices may be determined by factors which include, but are not limited to, market quotations, yields, maturities, call features, ratings, institutional size trading in similar groups of securities and developments related to specific securities. Refer to Note 5 for pension fair value disclosures.\nFair Value Measurements of Debt\nThe fair value of the Company’s Senior Secured Notes as of December 31, 2012 was estimated to be $263,813 compared to a carrying value of $218,335, net of unamortized discount. The fair value for the Senior Secured Notes is determined based on recent trades of the bonds and fall within level 2 of the fair value hierarchy.\nThe fair value of the Convertible Notes, as of December 31, 2012 was estimated to be approximately $95,000 compared to a carrying value of $37,334, net of unamortized discount. The fair value for the Convertible Notes, which fall within level 3 of the fair value hierarchy, is determined based on similar debt instruments that do not contain a conversion feature, as well as other factors related to the callable nature of the notes.\nThe main inputs and assumptions into the fair value model for the Convertible Notes at December 31, 2012 were as follows:\n| Company's stock price at the end of the period | $ | 14.77 |\n| Expected volatility | 22.3 | % |\n| Credit spreads | 8.22 | % |\n| Risk-free interest rate | 0.36 | % |\n\nThe estimated fair value of the derivative liability for the conversion feature (refer to table below), which falls within level 3 of the fair value hierarchy, as of December 31, 2011 was computed using a binomial lattice model using the Company’s historical volatility over the term corresponding to the remaining contractual term of the Convertible Notes and observed spreads of similar debt instruments that do not include a conversion feature.\nAs of December 31, 2012, the estimated fair value of the Company’s debt outstanding under its revolving credit facilities, which falls within level 3 of the fair value hierarchy, is $37,775 compared to its carrying value of $40,000, assuming the current amount of debt outstanding at the end of the year was outstanding until the maturity of the Company’s facility in December 2015. Although borrowings could be materially greater or less than the current amount of borrowings outstanding at the end of the year, it is not practical to estimate the amounts that may be outstanding during the future periods since there is no predetermined borrowing or repayment schedule.\n62\nFair Value Measurements of Commodity Hedges\nThe Company has a commodity hedging program to mitigate risks associated with certain commodity price fluctuations. At December 31, 2012, the Company had executed forward contracts that extend through 2016. The counterparty to these contracts is not considered a credit risk by the Company. At December 31, 2012 and 2011, the notional value associated with forward contracts was $17,191 and $15,486, respectively. The Company recorded, through cost of materials, realized and unrealized losses of $430 and $2,377 during the years ended December 31, 2012 and 2011, respectively, as a result of the decline in the fair value of the contracts. There were no gains or losses recorded for commodity hedges during 2010. Refer to Note 13 for letters of credit outstanding for collateral associated with commodity hedges.\nThe Company uses information which is representative of readily observable market data when valuing derivative liabilities associated with commodity hedges. The derivative liabilities are classified as Level 2 in the table below.\nThe liabilities measured at fair value on a recurring basis were as follows:\n| Level 1 | Level 2 | Level 3 | Total |\n| As of December 31, 2012: |\n| Derivative liability for commodity hedges | $ | — | $ | 2,494 | $ | — | $ | 2,494 |\n| As of December 31, 2011: |\n| Derivative liability for commodity hedges | $ | — | $ | 2,331 | $ | — | $ | 2,331 |\n| Derivative liability for conversion feature associated with convertible debt | — | — | 26,440 | 26,440 |\n\nThe following reconciliation represents the change in fair value of Level 3 liabilities between January 1, 2012 and December 31, 2012:\n| Derivative liability forconversion featureassociated withconvertible debt |\n| Fair value as of January 1 | $ | 26,440 |\n| Mark-to-market adjustment on conversion feature | 15,597 |\n| Reclassification from long-term debt to additional paid-in capital | (42,037 | ) |\n| Fair value as of December 31 | $ | — |\n\n(11) Share-based Compensation\nThe Company accounts for its share-based compensation arrangements by recognizing compensation expense for the fair value of the share awards ratably over their vesting period or a shorter period, as applicable. The consolidated compensation cost recorded for the Company’s share-based compensation arrangements was $2,277, $4,349 and $2,411 for 2012, 2011 and 2010, respectively. The total income tax benefit recognized in the consolidated statements of operations for share-based compensation arrangements was $872, $1,534 and $831 in 2012, 2011 and 2010, respectively. All compensation expense related to share-based compensation arrangements is recorded in sales, general and administrative expense. The unrecognized compensation cost as of December 31, 2012 associated with all share-based payment arrangements is $4,973 and the weighted average period over which it is to be expensed is 1.4 years.\n| Plan Description | Authorized Shares |\n| 1995 Directors Stock Option Plan | 188 |\n| 1996 Restricted Stock and Stock Option Plan | 938 |\n| 2000 Restricted Stock and Stock Option Plan | 1,200 |\n| 2004 Restricted Stock, Stock Option and Equity Compensation Plan | 1,350 |\n| 2008 A. M. Castle & Co. Omnibus Incentive Plan (amended and restated as of April 28, 2011) | 2,750 |\n\n63\nLong-Term Compensation and Incentive Plans\nOn March 7, 2012, the Human Resources Committee (the “Committee”) of the Board of Directors of the Company approved equity awards under the Company’s 2012 Long-Term Compensation Plan (\"2012 LTC Plan\") for executive officers and other select personnel. The 2012 LTC Plan awards included restricted stock units (\"RSUs\") and performance share units (\"PSUs\"). All 2012 LTC Plan awards are subject to the terms of the Company's 2008 A.M. Castle & Co. Omnibus Incentive Plan.\nOn March 2, 2011, the Committee approved equity awards under the Company's 2011 Long-Term Compensation Plan (\"2011 LTC Plan\") for executive officers and other select personnel. The 2011 LTC Plan awards included RSUs and PSUs. All 2011 LTC Plan awards are subject to the terms of the Company's 2008 A.M. Castle Omnibus Incentive Plan.\nOn March 18, 2010, the Committee approved equity awards under the Company’s 2010 Long-Term Compensation Plan (“2010 LTC Plan”) for executive officers and other select personnel. The 2010 LTC Plan awards included RSUs, PSUs, and stock options. All 2010 LTC Plan awards are subject to the terms of the Company’s 2008 Restricted Stock, Stock Option and Equity Compensation Plan, amended and restated as of December 9, 2010.\nUnless covered by a specific change-in-control or severance agreement, participants to whom RSUs, performance shares and other non-vested shares have been granted must be employed by the Company on the vesting date or at the end of the performance period, respectively, or the award will be forfeited. However, for stock option awards, unless a participant is covered by a specific change-in-control or severance agreement, options are forfeited in the event of the termination of employment other than by reason of disability or a retirement.\nCompensation expense is recognized based on management’s estimate of the total number of share-based awards expected to vest at the end of the service period.\nRestricted Share Units and Non-Vested Shares\nThe RSUs granted under the 2012 and 2011 LTC Plans will cliff vest on December 31, 2014 and December 31, 2013, respectively. Approximately 78 RSUs granted under the 2010 LTC Plan cliff vested on December 31, 2012. Each RSU that becomes vested entitles the participant to receive one share of the Company’s common stock. The number of shares delivered may be reduced by the number of shares required to be withheld for federal and state withholding tax requirements (determined at the market price of Company shares at the time of payout).\nThe outstanding non-vested share balance consists of shares issued to the Board of Directors during the second quarter of 2012 and shares issued for retention incentive purposes. The Director shares vest during the second quarter of 2015 and the balance of the shares vest on December 31, 2014. The RSU share balance consists of units granted to employees for incentive purposes.\nThe fair value of the RSUs and non-vested shares is established using the market price of the Company’s stock on the date of grant.\nA summary of the non-vested share and RSU activity is as follows:\n| Shares | Units |\n| Shares | Weighted-Average GrantDate Fair Value | Units | Weighted-Average GrantDate Fair Value |\n| Outstanding at January 1, 2012 | 38 | $ | 18.74 | 232 | $ | 14.39 |\n| Granted | 73 | $ | 12.22 | 309 | $ | 10.60 |\n| Forfeited | (5 | ) | $ | 17.02 | (158 | ) | $ | 12.44 |\n| Vested | (33 | ) | $ | 18.95 | (85 | ) | $ | 12.45 |\n| Outstanding at December 31, 2012 | 73 | $ | 12.22 | 298 | $ | 12.05 |\n| Expected to vest at December 31, 2012 | 73 | $ | 12.22 | 256 | $ | 12.36 |\n\nThe unrecognized compensation cost as of December 31, 2012 associated with RSU and non-vested share awards is $2,758. The total fair value of shares vested during the years ended December 31, 2012, 2011 and 2010 was $1,685, $2,166 and $600, respectively.\n64\nPerformance Shares\nUnder the 2012, 2011 and 2010 LTC Plans, the potential award for the performance shares granted is dependent on the Company’s relative total shareholder return (“RTSR”), which represents a market condition, over a three-year performance period, beginning January 1, 2012, January 1, 2011 and January 1, 2010 and ending December 31, 2014, December 31, 2013 and December 31, 2012, respectively. RTSR is measured against a group of peer companies either in the metals industry or in the industrial products distribution industry (the “RTSR Peer Group”). The 2012, 2011 and 2010 LTC Plans provide with respect to performance shares for (1) a threshold level up to which the threshold level of performance shares will vest, a target performance level at which the target number of performance shares will vest, a maximum performance level at or above which the maximum number of performance shares will vest, and pro rata vesting between the threshold and maximum performance levels and (2) minimum and maximum vesting opportunities ranging from one-half up to two times the target number. The threshold, target and maximum performance levels for RTSR are the 25th, 50th and 75th percentile, respectively, relative to RTSR Peer Group performance. The number of performance shares, if any, that vest based on the performance achieved during the three-year performance period, will vest at the end of the three-year performance period. Compensation expense for performance awards containing a market condition is recognized regardless of whether the market condition is achieved to the extent the requisite service period condition is met. Each performance share that becomes vested entitles the participant to receive one share of the Company’s common stock. The number of shares delivered may be reduced by the number of shares required to be withheld for federal and state withholding tax requirements (determined at the market price of Company shares at the time of payout).\nUnder the 2012 and 2011 LTC Plans, the potential award for performance shares containing a non-market-based performance condition is determined based on the Company's actual performance versus Company-specific target goals for Return on Invested Capital (“ROIC”), as defined in the 2012 and 2011 LTC Plans. Under the 2012 LTC Plan, the non-market-based performance condition is determined based on the Company's average actual performance versus Company-specific goals for ROIC for the three-year performance period beginning on January 1st of the year of grant. Under the 2011 LTC Plan, the non-market-based performance condition is determined for any one or more fiscal years during the three-year performance period beginning on January 1st of the year of grant. Partial performance awards can be earned for performance less than the target goal, but in excess of minimum goals and award distributions twice the target can be achieved if the maximum goals are met or exceeded. The number of performance shares, if any, that vest based on the performance achieved during the three-year performance period, will vest at the end of the three-year performance period. Compensation expense recognized is based on management’s expectation of future performance compared to the pre-established performance goals. If the performance goals are not expected to be met, no compensation expense is recognized and any previously recognized compensation expense is reversed.\nThe grant date fair values of performance shares awarded containing the RTSR market-based performance condition was estimated using a Monte Carlo simulation with the following assumptions:\n| 2012 | 2011 | 2010 |\n| Grant Date Fair Value per Share | $ | 13.78 | $ | 23.89 | $ | 12.26 |\n| Expected volatility | 85.0 | % | 62.0 | % | 61.6 | % |\n| Risk-free interest rate | 0.40 | % | 1.10 | % | 1.45 | % |\n| Expected life (in years) | 2.81 | 2.84 | 2.80 |\n| Expected dividend yield | — | — | — |\n\nPerformance awards under the active LTC Plans were granted to the Company's new CEO in October 2012. The grant date fair values of performance shares awarded to the CEO containing the RTSR market-based performance condition was estimated using a Monte Carlo simulation with the following assumptions:\n| 2012 | 2011 | 2010 |\n| Grant Date Fair Value per Share | $ | 16.65 | $ | 10.61 | $ | 5.57 |\n| Expected volatility | 60.7 | % | 60.7 | % | 60.7 | % |\n| Risk-free interest rate | 0.34 | % | 0.34 | % | 0.34 | % |\n| Expected life (in years) | 2.21 | 1.21 | 0.21 |\n| Expected dividend yield | — | — | — |\n\n65\nFinal award vesting and distribution of performance awards granted under the 2010 LTC Plan was determined based on the Company’s actual performance versus the target goals for a three-year consecutive period (as defined in the 2010 Plan). Refer to the table below for the number of shares expected to be issued under 2010 LTC Plan.\n| Plan Year | Grant Date Fair Value | Estimated Number ofPerformance Shares to be Issued | Maximum Number ofPerformance Shares thatcould Potentially be Issued |\n| 2012 LTC Plan |\n| Market-based performance condition | $ | 13.78 | 172 | 244 |\n| Market-based performance condition (1) | $ | 16.65 | 41 | 58 |\n| Non-market-based performance condition | $ | 10.02 | — | 244 |\n| Non-market-based performance condition (1) | $ | 12.74 | — | 58 |\n| 2011 LTC Plan |\n| Market-based performance condition | $ | 23.89 | 39 | 131 |\n| Market-based performance condition (1) | $ | 10.61 | 9 | 32 |\n| Non-market-based performance condition | $ | 17.13 | — | 131 |\n| Non-market-based performance condition (1) | $ | 12.74 | — | 32 |\n| 2010 LTC Plan |\n| Market-based performance condition | $ | 12.26 | 83 | 237 |\n| Market-based performance condition (1) | $ | 5.57 | 2 | 5 |\n\n(1) Represents the status of performance awards granted under the active LTC Plans in October 2012.\nThe unrecognized compensation cost as of December 31, 2012 associated with the 2012 and 2011 LTC Plans performance shares is $2,145.\nStock Options\nThere were no stock options issued under the 2012 or 2011 LTC Plans. The stock options issued under the 2010 LTC Plan vest and become exercisable three years from the date of the grant. The term of the options is eight years. The exercise price of the options is $12.79 per share. The grant date fair value of $5.71 per share was estimated using the Black-Scholes option-pricing model with the following assumptions:\n| 2010 |\n| Expected volatility | 58.5 | % |\n| Risk-free interest rate | 2.3 | % |\n| Expected life (in years) | 5.5 |\n| Expected dividend yield | 1.2 | % |\n\n| Shares | WeightedAverageExercise Price | IntrinsicValue | Weighted AverageRemainingContractual Life |\n| Stock options outstanding at January 1, 2012 | 418 | $ | 12.44 |\n| Exercised | (16 | ) | $ | 9.11 |\n| Forfeited | (113 | ) | $ | 15.56 |\n| Expired | (19 | ) | $ | 12.60 |\n| Stock options outstanding at December 31, 2012 | 270 | $ | 11.34 | $ | 937 | 3.8 |\n| Stock options exercisable at December 31, 2012 | 111 | $ | 9.25 | $ | 621 | 1.5 |\n| Stock options vested or expected to vest as of December 31, 2012 | 259 | $ | 11.28 | $ | 915 | 3.7 |\n\n66\nThe total intrinsic value of options exercised during the years ended December 31, 2012, 2011 and 2010, was $36, $194 and $219, respectively. The unrecognized compensation cost as of December 31, 2012 associated with stock options is $70.\n(12) Stockholders' Equity\nShareholder Rights Plan\nIn August 2012, the Company's Board of Directors adopted a Shareholder Rights Plan (the “Rights Plan”) and declared a dividend of one right for each outstanding share of the Company's common stock outstanding at the close of business on September 11, 2012. Pursuant to the Rights Plan, the Company is issuing one preferred stock purchase right (a “Right”) for each share of common stock outstanding on September 11, 2012. Each Right, once exercisable, represents the right to purchase one one-hundredth of a share (a “Unit”) of Series B Junior Preferred Stock of the Company, without par value, for $54.00, subject to adjustment. The Rights become exercisable in the event any individual person or entity, without Board approval, acquires 10% or more of the Company's common stock, subject to certain exceptions. In these circumstances, each holder of a Right (other than rights held by the acquirer) will be entitled to purchase, at the then-current exercise price of the Right, additional shares of the Company's common stock having a value of twice the exercise price of the Right. Additionally, if the Company is involved in a merger or other business combination transaction with another person after which its common stock does not remain outstanding, each Right will entitle its holder to purchase, at the then-current exercise price of the Right, shares of common stock of the ultimate parent of such other person having a market value of twice the exercise price of the Right. The Rights may be redeemed by the Company for $0.001 per Right at any time until the tenth business day following the first public announcement of an acquisition of beneficial ownership of 10% of the Company's common stock. The Rights Plan will expire on August 30, 2013.\nAccumulated Other Comprehensive Loss\nAccumulated other comprehensive loss as reported in the consolidated balance sheets as of December 31, 2012 and 2011 was comprised of the following:\n| 2012 | 2011 |\n| Foreign currency translation losses | $ | (2,322 | ) | $ | (4,691 | ) |\n| Unrecognized pension and postretirement benefit costs, net of tax | (18,749 | ) | (15,133 | ) |\n| Total accumulated other comprehensive loss | $ | (21,071 | ) | $ | (19,824 | ) |\n\n(13) Commitments and Contingent Liabilities\nAs of December 31, 2012, the Company had $6,794 of irrevocable letters of credit outstanding which primarily consisted of $4,000 for collateral associated with commodity hedges and $1,994 for compliance with the insurance reserve requirements of its workers’ compensation insurance carriers.\nThe Company is party to a variety of legal proceedings and other claims, including proceedings by government authorities, which arise from the operation of its business. These proceedings are incidental and occur in the normal course of the Company's business affairs. The majority of these claims and proceedings relate to commercial disputes with customers, suppliers, and others; employment, including benefit matters; product quality; and environmental, health and safety claims. It is the opinion of management that the currently expected outcome of these proceedings and claims, after taking into account recorded accruals and the availability and limits of our insurance coverage, will not have a material adverse effect on the consolidated results of operations, financial condition or cash flows of the Company.\nIn 2011, the Company determined that it inadvertently exported certain aluminum alloy bar that are listed on the U.S. Bureau of Industry and Security's (BIS) Commerce Control List to countries where there is an export license requirement if an exception is not otherwise available. The exports, which occurred in 2011, had a total transaction value of approximately $13 and were made without export licenses. The exports involved five shipments to the Company's wholly-owned subsidiary in China and to a customer in the Philippines. In response thereto, the Company submitted a voluntary self-disclosure describing the nature of these shipments to the Office of Export Enforcement of the Department of Commerce (OEE) in accordance with applicable Export Administration Regulations. The Company previously disclosed similar incidents to BIS in 2008, which were resolved in September 2011 through the payment of a $775 civil penalty and a commitment to satisfy certain compliance and reporting obligations. If it is determined that the Company failed to comply with the applicable U.S. export regulations, the OEE could assess civil penalties of up to $1,250, restrict export privileges or provide an administrative warning.\n67\nWhile the ultimate disposition of this matter cannot be predicted with certainty, it is the opinion of management, based on the information available at this time, that the outcome of this matter will not have a material effect on the Company's financial position, results of operations or cash flows.\n(14) Guarantor Financial Information\nThe accompanying consolidating financial information has been prepared and presented pursuant to Rule 3-10 of SEC Regulation S-X “Financial Statements of Guarantors and Issuers of Guaranteed Securities Registered or Being Registered.” The consolidating financial information presents A. M. Castle & Co. (Parent) and subsidiaries. The consolidating financial information has been prepared on the same basis as the consolidated statements of the Parent. The equity method of accounting is followed within this financial information.\nIn September 2012, the Company merged Tube Supply, LLC, a guarantor, with the Parent. The Company has reflected this change in its accompanying consolidating financial statements of guarantors and non-guarantors.\n68\n| Condensed Consolidating Balance SheetAs of December 31, 2012 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Assets |\n| Current assets |\n| Cash and cash equivalents | $ | 3,332 | $ | 1,677 | $ | 16,598 | $ | — | $ | 21,607 |\n| Accounts receivable, less allowance for doubtful accounts | 60,293 | 34,037 | 43,981 | — | 138,311 |\n| Receivables from affiliates | 95 | 1,118 | 668 | (1,881 | ) | — |\n| Inventories | 183,189 | 44,874 | 75,777 | (68 | ) | 303,772 |\n| Prepaid expenses and other current assets | 16,141 | (1,490 | ) | 8,239 | (202 | ) | 22,688 |\n| Total current assets | 263,050 | 80,216 | 145,263 | (2,151 | ) | 486,378 |\n| Investment in joint venture | 38,854 | — | — | — | 38,854 |\n| Goodwill | 12,921 | 41,556 | 15,823 | — | 70,300 |\n| Intangible assets | 34,343 | 28,325 | 19,809 | — | 82,477 |\n| Other assets | 28,142 | (98 | ) | 3,113 | — | 31,157 |\n| Investment in subsidiaries | 245,798 | 11,526 | — | (257,324 | ) | — |\n| Receivables from affiliates | 62,696 | 83,891 | 3,280 | (149,867 | ) | — |\n| Property, plant and equipment, net | 52,424 | 15,403 | 11,813 | — | 79,640 |\n| Total assets | $ | 738,228 | $ | 260,819 | $ | 199,101 | $ | (409,342 | ) | $ | 788,806 |\n| Liabilities and Stockholders’ Equity |\n| Current liabilities |\n| Accounts payable | $ | 40,510 | $ | 13,434 | $ | 14,046 | $ | — | $ | 67,990 |\n| Payables due to affiliates | 742 | 95 | 1,044 | (1,881 | ) | — |\n| Other current liabilities | 26,566 | 3,478 | 8,083 | — | 38,127 |\n| Current portion of long-term debt and short-term debt | 386 | 1 | 528 | — | 915 |\n| Total current liabilities | 68,204 | 17,008 | 23,701 | (1,881 | ) | 107,032 |\n| Long-term debt, less current portion | 292,086 | — | 4,068 | — | 296,154 |\n| Payables due to affiliates | 12,114 | 11,994 | 125,759 | (149,867 | ) | — |\n| Deferred income taxes | 14,209 | 18,614 | (473 | ) | — | 32,350 |\n| Other non-current liabilities | 14,275 | 1,339 | 316 | — | 15,930 |\n| Stockholders’ equity | 337,340 | 211,864 | 45,730 | (257,594 | ) | 337,340 |\n| Total liabilities and stockholders’ equity | $ | 738,228 | $ | 260,819 | $ | 199,101 | $ | (409,342 | ) | $ | 788,806 |\n\n69\n| Condensed Consolidating Balance SheetAs of December 31, 2011 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Assets |\n| Current assets |\n| Cash and cash equivalents | $ | 11,534 | $ | 582 | $ | 18,408 | $ | — | $ | 30,524 |\n| Accounts receivable, less allowance for doubtful accounts | 88,434 | 37,487 | 55,115 | — | 181,036 |\n| Receivables from affiliates | 273 | 3,495 | 146 | (3,914 | ) | — |\n| Inventories | 163,776 | 48,980 | 59,547 | (264 | ) | 272,039 |\n| Prepaid expenses and other current assets | 18,517 | (3,331 | ) | 3,483 | — | 18,669 |\n| Total current assets | 282,534 | 87,213 | 136,699 | (4,178 | ) | 502,268 |\n| Investment in joint venture | 36,460 | — | — | — | 36,460 |\n| Goodwill | 12,921 | 41,556 | 15,424 | — | 69,901 |\n| Intangible assets | 38,238 | 34,395 | 21,180 | — | 93,813 |\n| Other assets | 34,691 | 237 | 2,812 | — | 37,740 |\n| Investment in subsidiaries | 243,823 | 12,151 | — | (255,974 | ) | — |\n| Receivables from affiliates | 66,878 | 71,041 | 7,292 | (145,211 | ) | — |\n| Property, plant and equipment, net | 56,266 | 15,416 | 10,459 | — | 82,141 |\n| Total assets | $ | 771,811 | $ | 262,009 | $ | 193,866 | $ | (405,363 | ) | $ | 822,323 |\n| Liabilities and Stockholders’ Equity |\n| Current liabilities |\n| Accounts payable | $ | 84,437 | $ | 14,826 | $ | 17,611 | $ | — | $ | 116,874 |\n| Payables due to affiliates | 1,387 | 76 | 2,451 | (3,914 | ) | — |\n| Other current liabilities | 25,895 | 4,459 | 5,358 | — | 35,712 |\n| Current portion of long-term debt and short-term debt | 82 | 50 | 560 | — | 692 |\n| Total current liabilities | 111,801 | 19,411 | 25,980 | (3,914 | ) | 153,278 |\n| Long-term debt, less current portion | 303,739 | 1 | 10,500 | — | 314,240 |\n| Payables due to affiliates | 23,727 | 8,572 | 112,912 | (145,211 | ) | — |\n| Deferred income taxes | 6,280 | 19,647 | (277 | ) | — | 25,650 |\n| Other non-current liabilities | 13,985 | 2,324 | 567 | — | 16,876 |\n| Stockholders’ equity | 312,279 | 212,054 | 44,184 | (256,238 | ) | 312,279 |\n| Total liabilities and stockholders’ equity | $ | 771,811 | $ | 262,009 | $ | 193,866 | $ | (405,363 | ) | $ | 822,323 |\n\n70\n| Condensed Consolidating Statement of Operations and Comprehensive (Loss) IncomeFor the year ended December 31, 2012 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Net Sales | $ | 755,642 | $ | 270,644 | $ | 282,274 | $ | (38,192 | ) | $ | 1,270,368 |\n| Costs and expenses: |\n| Cost of materials (exclusive of depreciation and amortization) | 548,659 | 199,004 | 217,749 | (38,125 | ) | 927,287 |\n| Warehouse, processing and delivery expense | 91,628 | 32,459 | 24,169 | — | 148,256 |\n| Sales, general and administrative expense | 75,497 | 30,351 | 21,965 | — | 127,813 |\n| Depreciation and amortization expense | 12,955 | 8,888 | 4,024 | — | 25,867 |\n| Operating income (loss) | 26,903 | (58 | ) | 14,367 | (67 | ) | 41,145 |\n| Interest expense, net | (25,820 | ) | — | (15,270 | ) | — | (41,090 | ) |\n| Interest expense - unrealized loss on debt conversion option | (15,597 | ) | — | — | — | (15,597 | ) |\n| Loss before income taxes and equity in earnings of subsidiaries and joint venture | (14,514 | ) | (58 | ) | (903 | ) | (67 | ) | (15,542 | ) |\n| Income taxes | (1,805 | ) | 475 | 102 | (202 | ) | (1,430 | ) |\n| Equity in (losses) earnings of subsidiaries | (653 | ) | (1,203 | ) | — | 1,856 | — |\n| Equity in earnings of joint venture | 7,224 | — | — | — | 7,224 |\n| Net (loss) income | (9,748 | ) | (786 | ) | (801 | ) | 1,587 | (9,748 | ) |\n| Comprehensive (loss) income: |\n| Foreign currency translation gains (losses) | 2,369 | 578 | 2,369 | (2,947 | ) | 2,369 |\n| Unrecognized pension and postretirement benefit costs, net of tax | (3,616 | ) | — | — | — | (3,616 | ) |\n| Other comprehensive (loss) income | (1,247 | ) | 578 | 2,369 | (2,947 | ) | (1,247 | ) |\n| Net loss | (9,748 | ) | (786 | ) | (801 | ) | 1,587 | (9,748 | ) |\n| Comprehensive (loss) income | $ | (10,995 | ) | $ | (208 | ) | $ | 1,568 | $ | (1,360 | ) | $ | (10,995 | ) |\n\n71\n| Condensed Consolidating Statement of Operations Comprehensive (Loss) IncomeFor the year ended December 31, 2011 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Net Sales | $ | 621,036 | $ | 283,290 | $ | 237,201 | $ | (9,161 | ) | $ | 1,132,366 |\n| Costs and expenses: |\n| Cost of materials (exclusive of depreciation and amortization) | 466,133 | 207,269 | 181,104 | (8,897 | ) | 845,609 |\n| Warehouse, processing and delivery expense | 80,543 | 33,828 | 20,527 | — | 134,898 |\n| Sales, general and administrative expense | 74,154 | 31,807 | 20,232 | — | 126,193 |\n| Depreciation and amortization expense | 8,874 | 8,910 | 2,688 | — | 20,472 |\n| Operating (loss) income | (8,668 | ) | 1,476 | 12,650 | (264 | ) | 5,194 |\n| Interest expense, net | (4,982 | ) | — | (4,681 | ) | — | (9,663 | ) |\n| Interest expense - unrealized loss on debt conversion option | (3,991 | ) | (3,991 | ) |\n| Loss on extinguishment of debt | (6,153 | ) | — | — | — | (6,153 | ) |\n| (Loss) income before income taxes and equity in earnings of subsidiaries and joint venture | (23,794 | ) | 1,476 | 7,969 | (264 | ) | (14,613 | ) |\n| Income taxes | 3,267 | (433 | ) | (1,708 | ) | — | 1,126 |\n| Equity in earnings of subsidiaries | 7,040 | (209 | ) | — | (6,831 | ) | — |\n| Equity in earnings of joint venture | 11,727 | — | — | — | 11,727 |\n| Net (loss) income | (1,760 | ) | 834 | 6,261 | (7,095 | ) | (1,760 | ) |\n| Comprehensive (loss) income: |\n| Foreign currency translation (losses) gains | (941 | ) | 1,180 | (941 | ) | (239 | ) | (941 | ) |\n| Unrecognized pension and postretirement benefit costs, net of tax | (3,071 | ) | — | — | — | (3,071 | ) |\n| Other comprehensive (loss) income | (4,012 | ) | 1,180 | (941 | ) | (239 | ) | (4,012 | ) |\n| Net (loss) income | (1,760 | ) | 834 | 6,261 | (7,095 | ) | (1,760 | ) |\n| Comprehensive (loss) income | $ | (5,772 | ) | $ | 2,014 | $ | 5,320 | $ | (7,334 | ) | $ | (5,772 | ) |\n\n72\n| Condensed Consolidating Statement of Operations Comprehensive (Loss) IncomeFor the year ended December 31, 2010 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Net Sales | $ | 498,848 | $ | 266,491 | $ | 186,654 | $ | (8,287 | ) | $ | 943,706 |\n| Costs and expenses: |\n| Cost of materials (exclusive of depreciation and amortization) | 369,865 | 195,184 | 144,092 | (8,287 | ) | 700,854 |\n| Warehouse, processing and delivery expense | 72,234 | 33,250 | 17,834 | — | 123,318 |\n| Sales, general and administrative expense | 61,751 | 29,684 | 16,788 | — | 108,223 |\n| Depreciation and amortization expense | 8,665 | 9,114 | 2,870 | — | 20,649 |\n| Operating (loss) income | (13,667 | ) | (741 | ) | 5,070 | — | (9,338 | ) |\n| Interest expense, net | (1,008 | ) | — | (3,980 | ) | — | (4,988 | ) |\n| (Loss) income before income taxes and equity in earnings of subsidiaries and joint venture | (14,675 | ) | (741 | ) | 1,090 | — | (14,326 | ) |\n| Income taxes | 3,106 | 420 | (425 | ) | — | 3,101 |\n| Equity in earnings of subsidiaries | 344 | 110 | — | (454 | ) | — |\n| Equity in earnings of joint venture | 5,585 | — | — | — | 5,585 |\n| Net (loss) income | (5,640 | ) | (211 | ) | 665 | (454 | ) | (5,640 | ) |\n| Comprehensive (loss) income: |\n| Foreign currency translation (losses) gains | (536 | ) | (2,337 | ) | (536 | ) | 2,873 | (536 | ) |\n| Unrecognized pension and postretirement benefit costs, net of tax | (1,748 | ) | — | — | — | (1,748 | ) |\n| Other comprehensive (loss) income | (2,284 | ) | (2,337 | ) | (536 | ) | 2,873 | (2,284 | ) |\n| Net (loss) income | (5,640 | ) | (211 | ) | 665 | (454 | ) | (5,640 | ) |\n| Comprehensive (loss) income | $ | (7,924 | ) | $ | (2,548 | ) | $ | 129 | $ | 2,419 | $ | (7,924 | ) |\n\n73\n| Condensed Consolidating Statement of Cash FlowsFor the year ended December 31, 2012 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Operating activities: |\n| Net (loss) income | $ | (9,748 | ) | $ | (786 | ) | $ | (801 | ) | $ | 1,587 | $ | (9,748 | ) |\n| Equity in losses of subsidiaries | 653 | 1,203 | — | (1,856 | ) | — |\n| Adjustments to reconcile net (loss) income to cash provided by operating activities | 10,688 | 12,951 | (8,809 | ) | 269 | 15,099 |\n| Net cash from (used in) operating activities | 1,593 | 13,368 | (9,610 | ) | — | 5,351 |\n| Investing activities: |\n| Acquisition/Investment of businesses, net of cash acquired | (6,472 | ) | — | — | — | (6,472 | ) |\n| Capital expenditures | (5,336 | ) | (2,802 | ) | (2,983 | ) | — | (11,121 | ) |\n| Other investing activities, net | — | 6 | 147 | — | 153 |\n| Net cash used in investing activities | (11,808 | ) | (2,796 | ) | (2,836 | ) | — | (17,440 | ) |\n| Financing activities: |\n| Proceeds from long-term debt, including new revolving credit facility | 756,550 | — | 10,540 | — | 767,090 |\n| Repayments of long-term debt, including new revolving credit facility | (745,839 | ) | (49 | ) | (16,999 | ) | — | (762,887 | ) |\n| Payment of debt issue costs | (1,503 | ) | — | — | — | (1,503 | ) |\n| Net intercompany (repayments) borrowings | (7,431 | ) | (9,428 | ) | 16,859 | — | — |\n| Other financing | 236 | — | (27 | ) | — | 209 |\n| Net cash from (used in) financing activities | 2,013 | (9,477 | ) | 10,373 | — | 2,909 |\n| Effect of exchange rate changes on cash and cash equivalents | — | — | 263 | — | 263 |\n| (Decrease) increase in cash and cash equivalents | (8,202 | ) | 1,095 | (1,810 | ) | — | (8,917 | ) |\n| Cash and cash equivalents - beginning of year | 11,534 | 582 | 18,408 | — | 30,524 |\n| Cash and cash equivalents - end of period | $ | 3,332 | $ | 1,677 | $ | 16,598 | $ | — | $ | 21,607 |\n\n74\n| Condensed Consolidating Statement of Cash FlowsFor the year ended December 31, 2011 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Operating activities: |\n| Net (loss) income | $ | (1,760 | ) | $ | 834 | $ | 6,261 | $ | (7,095 | ) | $ | (1,760 | ) |\n| Equity in earnings of subsidiaries | (7,040 | ) | 209 | — | 6,831 | — |\n| Adjustments to reconcile net (loss) income to cash provided by operating activities | 10,232 | 15,095 | (70,119 | ) | 264 | (44,528 | ) |\n| Net cash from (used in) operating activities | 1,432 | 16,138 | (63,858 | ) | — | (46,288 | ) |\n| Investing activities: |\n| Acquisition/Investment of businesses, net of cash acquired | (175,836 | ) | — | 1,592 | (174,244 | ) |\n| Capital expenditures | (6,077 | ) | (2,783 | ) | (2,884 | ) | — | (11,744 | ) |\n| Other investing activities, net | 605 | 136 | 58 | — | 799 |\n| Net cash used in investing activities | (181,308 | ) | (2,647 | ) | (1,234 | ) | — | (185,189 | ) |\n| Financing activities: |\n| Net borrowings (repayments) of debt | 82 | 8 | (25,840 | ) | — | (25,750 | ) |\n| Proceeds from long-term debt, including new revolving credit facility | 309,625 | — | 10,851 | — | 320,476 |\n| Repayments of long-term debt, including new revolving credit facility | (52,896 | ) | (55 | ) | (261 | ) | — | (53,212 | ) |\n| Payment of debt issue costs | (16,380 | ) | — | (253 | ) | — | (16,633 | ) |\n| Net intercompany (repayments) borrowings | (57,307 | ) | (13,930 | ) | 71,237 | — | — |\n| Other financing activities, net | 657 | — | — | — | 657 |\n| Net cash from (used in) financing activities | 183,781 | (13,977 | ) | 55,734 | — | 225,538 |\n| Effect of exchange rate changes on cash and cash equivalents | — | — | (253 | ) | — | (253 | ) |\n| Increase (decrease) in cash and cash equivalents | 3,905 | (486 | ) | (9,611 | ) | — | (6,192 | ) |\n| Cash and cash equivalents - beginning of year | 7,629 | 1,068 | 28,019 | — | 36,716 |\n| Cash and cash equivalents - end of period | $ | 11,534 | $ | 582 | $ | 18,408 | $ | — | $ | 30,524 |\n\n75\n| Condensed Consolidating Statement of Cash FlowsFor the year ended December 31, 2010 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Operating activities: |\n| Net (loss) income | $ | (5,640 | ) | $ | (211 | ) | $ | 665 | $ | (454 | ) | $ | (5,640 | ) |\n| Equity in earnings of subsidiaries | (344 | ) | (110 | ) | — | 454 | — |\n| Adjustments to reconcile net (loss) income to cash provided by operating activities | 12,721 | 29,562 | 500 | (2,781 | ) | 40,002 |\n| Net cash from (used in) operating activities | 6,737 | 29,241 | 1,165 | (2,781 | ) | 34,362 |\n| Investing activities: |\n| Capital expenditures | (4,244 | ) | (1,267 | ) | (2,061 | ) | — | (7,572 | ) |\n| Other investing activities, net | 125 | 4 | — | — | 129 |\n| Net cash used in investing activities | (4,119 | ) | (1,263 | ) | (2,061 | ) | — | (7,443 | ) |\n| Financing activities: |\n| Net (repayments) borrowings of debt | (13,720 | ) | — | 2,324 | — | (11,396 | ) |\n| Repayments of long-term debt | (7,007 | ) | (343 | ) | (404 | ) | — | (7,754 | ) |\n| Net intercompany borrowings (repayments) | 15,794 | (27,350 | ) | 8,775 | 2,781 | — |\n| Other financing activities, net | 785 | — | — | — | 785 |\n| Net cash (used in) from financing activities | (4,148 | ) | (27,693 | ) | 10,695 | 2,781 | (18,365 | ) |\n| Effect of exchange rate changes on cash and cash equivalents | — | — | (149 | ) | — | (149 | ) |\n| (Decrease) increase in cash and cash equivalents | (1,530 | ) | 285 | 9,650 | — | 8,405 |\n| Cash and cash equivalents - beginning of year | 9,159 | 783 | 18,369 | — | 28,311 |\n| Cash and cash equivalents - end of period | $ | 7,629 | $ | 1,068 | $ | 28,019 | $ | — | $ | 36,716 |\n\n76\n(15) Selected Quarterly Data (Unaudited)\nThe results of Tube Supply, acquired during December 2011, were included in the 2012 selected quarterly data in the table below.\n| FirstQuarter | SecondQuarter | ThirdQuarter | FourthQuarter |\n| 2012 |\n| Net sales | $ | 362,916 | $ | 329,392 | $ | 304,039 | $ | 274,021 |\n| Gross profit (a) | 53,810 | 43,763 | 42,867 | 28,518 |\n| Net (loss) income (c) | (4,300 | ) | (2,978 | ) | 3,173 | (5,643 | ) |\n| Basic (loss) earnings per share | $ | (0.19 | ) | $ | (0.13 | ) | $ | 0.14 | $ | (0.24 | ) |\n| Diluted (loss) earnings per share | $ | (0.19 | ) | $ | (0.13 | ) | $ | 0.13 | $ | (0.24 | ) |\n| Common stock dividends declared | $ | — | $ | — | $ | — | $ | — |\n| 2011 |\n| Net sales | $ | 272,788 | $ | 282,568 | $ | 294,860 | $ | 282,150 |\n| Gross profit (a) | 33,219 | 35,165 | 33,233 | 29,770 |\n| Net income (loss) (b) | 2,703 | 3,697 | 3,803 | (11,963 | ) |\n| Basic earnings (loss) per share | $ | 0.12 | $ | 0.16 | $ | 0.17 | $ | (0.52 | ) |\n| Diluted earnings (loss) per share | $ | 0.12 | $ | 0.16 | $ | 0.16 | $ | (0.52 | ) |\n| Common stock dividends declared | $ | — | $ | — | $ | — | $ | — |\n\n| (a) | Gross profit equals net sales minus cost of materials, warehouse, processing, and delivery costs and less depreciation and amortization expense. |\n\n| (b) | Fourth quarter results include fees incurred as a result of the acquisition of Tube Supply and the related debt refinancing in December 2011. The results of Tube Supply are included in the fourth quarter results for the two-week period ended December 31, 2011 and for the entire fiscal year ended December 31, 2012. In addition, a mark-to-market adjustment related to the conversion option associated with the convertible debt in the amount of $3,991 was included in interest expense during the fourth quarter. |\n\n| (c) | First and second quarter results include a mark-to-market adjustment related to the conversion option associated with the convertible debt in the amount of $11,340 and $4,257, respectively. Amounts were included in interest expense during the respective quarters. |\n\n(16) Subsequent Events\nOn January 16, 2013, the Company announced restructuring actions, including an organizational restructuring, warehouse realignments and performance improvement programs. The total pre-tax charge associated with these actions is estimated to be approximately $10,000, which is expected to be incurred in the first half of 2013. Of this amount, approximately $3,500 is attributable to employee severance and other employment related benefits, $2,500 is attributable to lease termination costs, $1,600 is attributable to moving costs in conjunction with the warehouse realignments and $2,400 relates to other costs. The Company may identify additional opportunities as it implements the restructuring actions that could impact its overall estimate. In addition, the Company expects to incur capital expenditures of approximately $1,400 in 2013 that are directly associated with the restructuring actions.\n77\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\nTo the Board of Directors and Stockholders of A.M. Castle & Co.\nOak Brook, Illinois\nWe have audited the accompanying consolidated balance sheets of A.M. Castle & Co. and subsidiaries (the \"Company\") as of December 31, 2012 and 2011, and the related consolidated statements of operations and comprehensive income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2012. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the consolidated financial statements based on our audits. We did not audit the financial statements of Kreher Steel Company, LLC, a 50% owned joint venture, the Company's investment in which is accounted for by use of the equity method. The Company's equity of $38,854 and $36,460 in Kreher Steel Company, LLC's net assets at December 31, 2012 and 2011, respectively, and of $7,224 and $11,727 in that company's net income for the years then ended are included in the accompanying financial statements. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Kreher Steel Company, LLC, is based solely on the report of the other auditors.\nWe conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.\nIn our opinion, based on our audits and the report of other auditors, such consolidated financial statements present fairly, in all material respects, the financial position of A.M. Castle & Co. and subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America.\nWe have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of December 31, 2012, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 11, 2013 expressed an unqualified opinion on the Company's internal control over financial reporting.\n/s/ DELOITTE & TOUCHE LLP\nDELOITTE & TOUCHE LLP\nChicago, Illinois\nMarch 11, 2013\n78\n| Kreher Steel Company, LLC and SubsidiariesCONSOLIDATED BALANCE SHEETSDecember 31, |\n| 2012 | 2011 |\n| ASSETS |\n| Current assets |\n| Cash and cash equivalents | $ | 3,373,355 | $ | 8,743,820 |\n| Accounts receivable (net of allowance for doubtful accounts of approximately $1,435,000 in 2012 and $1,335,000 in 2011) | 19,736,301 | 32,461,983 |\n| Inventory, net | 66,958,361 | 69,297,422 |\n| Deferred taxes | 271,553 | 29,699 |\n| Prepaid income taxes | 1,424,064 | 186,889 |\n| Prepaid expenses and other current assets | 657,039 | 542,689 |\n| Total current assets | 92,420,673 | 111,262,502 |\n| Property and equipment |\n| Land and building | 14,485,343 | 14,334,997 |\n| Machinery and equipment | 16,533,990 | 11,923,342 |\n| Furniture, fixtures and office equipment | 2,155,447 | 1,952,447 |\n| Automobiles and trucks | 990,508 | 871,929 |\n| Leasehold improvements | 2,334,855 | 1,872,955 |\n| Construction in progress | 266,129 | 753,234 |\n| 36,766,272 | 31,708,904 |\n| Less accumulated depreciation and amortization | 14,719,685 | 12,856,503 |\n| Property and equipment, net | 22,046,587 | 18,852,401 |\n| Deferred financing costs, net of amortization | 104,616 | 121,263 |\n| Goodwill | 3,525,247 | 3,525,247 |\n| Intangible assets, net of amortization | 275,616 | 398,112 |\n| Other assets | 146,785 | 81,543 |\n| $ | 118,519,524 | $ | 134,241,068 |\n| LIABILITIES AND MEMBER'S CAPITAL |\n| Current liabilities |\n| Revolving line of credit | $ | — | $ | 35,000,000 |\n| Current portion of long-term debt | 211,894 | 215,918 |\n| Accounts payable | 11,536,613 | 21,094,460 |\n| Accrued expenses | 2,565,966 | 3,641,502 |\n| Total current liabilities | 14,314,473 | 59,951,880 |\n| Revolving line of credit | 24,000,000 | — |\n| Deferred taxes, non-current | 1,977,273 | 1,008,748 |\n| Long-term debt, less current portion | 1,867,707 | 2,080,993 |\n| Commitments and contingencies |\n| Member's capital | 76,360,071 | 71,199,447 |\n| $ | 118,519,524 | $ | 134,241,068 |\n\n79\n| Kreher Steel Company, LLC and SubsidiariesCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOMEYears ended December 31, |\n| 2012 | 2011 | 2010 |\n| Net revenues | $ | 257,776,157 | $ | 269,657,054 | $ | 188,107,237 |\n| Cost of sales | 213,490,152 | 219,478,535 | 156,801,397 |\n| Gross profit | 44,286,005 | 50,178,519 | 31,305,840 |\n| Operating expenses |\n| Selling | 12,970,475 | 12,761,204 | 9,729,856 |\n| General and administrative | 12,657,611 | 9,970,335 | 8,283,347 |\n| Total operating expenses | 25,628,086 | 22,731,539 | 18,013,203 |\n| Earnings from operations | 18,657,919 | 27,446,980 | 13,292,637 |\n| Other expense (income) |\n| Interest expense | 519,416 | 432,990 | 259,558 |\n| Interest income | (3,263 | ) | (1,994 | ) | (5,035 | ) |\n| Other income, net | (169,015 | ) | (180,807 | ) | (152,887 | ) |\n| Net earnings before taxes | 18,310,781 | 27,196,791 | 13,191,001 |\n| Income tax provision (benefit) | 3,708,101 | 3,553,382 | 2,155,950 |\n| NET EARNINGS | 14,602,680 | 23,643,409 | 11,035,051 |\n| Other comprehensive income |\n| Foreign currency translation adjustment | 15,554 | — | — |\n| COMPREHENSIVE INCOME | $ | 14,618,234 | $ | 23,643,409 | $ | 11,035,051 |\n\n80\n| Kreher Steel Company, LLC and SubsidiariesCONSOLIDATED STATEMENTS OF MEMBERS’ CAPITALThree years ended December 31, 2012 |\n| Accumulated |\n| other | Total |\n| Member's | Retained | Accumulated | Treasury | comprehensive | member's |\n| contribution | earnings | distributions | stock | income | capital |\n| Balance at January 1, 2010, 400 units | 7,042,411 | 67,379,821 | (23,906,770 | ) | (5,240,092 | ) | — | 45,275,370 |\n| Net earnings | — | 11,035,051 | — | — | — | 11,035,051 |\n| Distributions | — | — | (2,519,593 | ) | — | — | (2,519,593 | ) |\n| Balance at December 31, 2010, 400 units | 7,042,411 | 78,414,872 | (26,426,363 | ) | (5,240,092 | ) | — | 53,790,828 |\n| Net earnings | — | 23,643,409 | — | — | — | 23,643,409 |\n| Distributions | — | — | (6,234,790 | ) | — | — | (6,234,790 | ) |\n| Balance at December 31, 2011, 400 units | 7,042,411 | 102,058,281 | (32,661,153 | ) | (5,240,092 | ) | — | 71,199,447 |\n| Net earnings | — | 14,602,680 | — | — | — | 14,602,680 |\n| Distributions | — | — | (9,457,600 | ) | — | — | (9,457,600 | ) |\n| Foreign currency translation adjustment | — | — | — | — | 15,544 | 15,544 |\n| Balance at December 31, 2012, 400 units | $ | 7,042,411 | $ | 116,660,961 | $ | (42,118,753 | ) | $ | (5,240,092 | ) | $ | 15,544 | $ | 76,360,071 |\n\n81\n| Kreher Steel Company, LLC and SubsidiariesCONSOLIDATED STATEMENTS OF CASH FLOWSYears ended December 31, |\n| 2012 | 2011 | 2010 |\n| Cash flows from operating activities |\n| Net earnings | $ | 14,602,680 | $ | 23,643,409 | $ | 11,035,051 |\n| Adjustments to reconcile net earnings to net cash provided by (used in) operating activities |\n| Depreciation and amortization | 2,033,956 | 1,602,925 | 1,720,133 |\n| Deferred taxes | 726,671 | 390,341 | 84,362 |\n| Bad debt expense | 2,595,710 | 34,779 | 178,911 |\n| (Gain) loss on sale of property and equipment | (4,851 | ) | 9,790 | 59,676 |\n| Changes in assets and liabilities |\n| Accounts receivable | 10,129,971 | (8,508,956 | ) | (8,488,036 | ) |\n| Inventory | 2,339,061 | (27,383,374 | ) | (11,823,574 | ) |\n| Prepaid expenses and other assets | (1,400,121 | ) | (58,839 | ) | 182,962 |\n| Accounts payable | (9,557,992 | ) | 3,900,243 | 1,739,501 |\n| Accrued expenses | (1,075,536 | ) | 1,215,113 | 388,680 |\n| Net cash provided by (used in) operating activities | 20,389,549 | (5,154,569 | ) | (4,922,334 | ) |\n| Cash flows from investing activities |\n| Purchases of property and equipment | (5,258,846 | ) | (6,735,595 | ) | (2,271,435 | ) |\n| Proceeds from sale of property and equipment | 145,605 | 19,843 | 256,132 |\n| Net cash used in investing activities | (5,113,241 | ) | (6,715,752 | ) | (2,015,303 | ) |\n| Cash flows from financing activities |\n| Net (decrease) increase in line of credit | (11,000,000 | ) | 22,163,000 | 10,837,000 |\n| Repayment of long-term debt | (217,310 | ) | (268,089 | ) | (360,000 | ) |\n| Distributions to member | (9,457,600 | ) | (6,234,790 | ) | (2,519,593 | ) |\n| Net cash (used in) provided by financing activities | (20,674,910 | ) | 15,660,121 | 7,957,407 |\n| Effect of exchange rate changes on cash and cash equivalents | 28,137 | — | — |\n| Net (decrease) increase in cash and cash equivalents | (5,370,465 | ) | 3,789,800 | 1,019,770 |\n| Cash and cash equivalents at beginning of year | 8,743,820 | 4,954,020 | 3,934,250 |\n| Cash and cash equivalents at end of year | $ | 3,373,355 | $ | 8,743,820 | $ | 4,954,020 |\n| Supplemental disclosures of cash flow information |\n| Cash paid during the year for |\n| Interest | $ | 422,074 | $ | 350,341 | $ | 171,525 |\n| Income taxes, net of refunds | 4,855,764 | 2,910,000 | 1,097,409 |\n| Supplemental disclosures of non-cash investing and financing activities |\n| Acquisition of machinery and equipment through capital leases | $ | — | $ | — | $ | 150,019 |\n\n82\nNOTE A - NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nDescription of Company\nKreher Steel Company, LLC and Subsidiaries (the Company) was formed as a limited liability company (LLC) on January 11, 1996, and commenced business on May 1, 1996. The LLC member's initial contribution consisted of the net assets of Kreher Steel Co., Inc.\nThe Company is a national distributor and processor of carbon and alloy steel bar products. The Company has locations throughout the United States and in Edmonton, Canada, and primarily sells in the vicinity of these locations.\nPrinciples of Consolidation\nThe Company's financial statements are presented on a consolidated basis and include its wholly owned subsidiaries, Kreher Wire Processing, Inc. and Special Metals, Inc., as well as a branch of Kreher Steel Company, LLC located in Edmonton, Canada. All intercompany transactions and balances have been eliminated.\nUse of Estimates\nThe preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from these estimates.\nCash and Cash Equivalents\nThe Company considers all highly liquid investments with maturities of three months or less to be cash equivalents. The Company maintains cash balances at financial institutions in the United States of America that are insured by the Federal Deposit Insurance Corporation (FDIC). At December 31, 2012 and 2011, the Company had approximately $2,113,000 and $7,975,000, respectively, in excess of FDIC insured limits. The Company has not experienced any losses related to these balances, and management believes its credit risk to be minimal.\nShipping and Handling Fees\nFor the years ended December 31, 2012, 2011 and 2010, shipping and handling costs billed to customers amounted to approximately $1,548,000, $1,431,230 and $899,000, respectively, and were included in selling expenses.\nFinancial Instruments and Risk Management\nConcentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company's customer base and their dispersion across different businesses and geographic areas. At December 31, 2012, 2011 and 2010, there were no individual customers that made up more than 10% of consolidated sales.\nThe Company's financial instruments include cash equivalents, accounts receivable, accounts payable and notes payable. The carrying amounts of cash equivalents, accounts receivable, accounts payable and notes payable approximate fair value due to their short-term nature and variable interest rates paid.\nPrices for steel fluctuate based on worldwide production and, as a result, the Company is subject to the risk of future changing market prices. Furthermore, the Company purchased approximately 6%, 9% and 7% of its inventory from foreign suppliers for the years ended December 31, 2012, 2011 and 2010, respectively.\nInventory\nInventory is valued at the lower of cost or market. Cost is determined by the specific identification method. The Company provides a reserve for obsolete and slow-moving inventory. As of December 31, 2012 and 2011, the reserve for obsolete and slow-moving inventory was approximately $810,000 and $583,000, respectively.\n83\nChanges in the Company's inventory reserve are as follows at December 31:\n| 2012 | 2011 |\n| Beginning balance | $ | 583,346 | $ | 1,778,365 |\n| Provision (release of provision) | 307,440 | (1,140,966 | ) |\n| Write-offs | (81,119 | ) | (54,053 | ) |\n| Total inventory reserve | $ | 809,667 | $ | 583,346 |\n\nProperty and Equipment\nProperty and equipment are stated at cost less accumulated depreciation. Depreciation is based on the straight-line method and the estimated useful lives of the property and equipment. Depreciation of leasehold improvements is based on the estimated useful life or the term of the lease, whichever is shorter. The Company uses an accelerated method of depreciation for tax purposes. Depreciation expense for December 31, 2012, 2011 and 2010, was approximately $1,911,000, $1,467,000 and $1,543,000, respectively.\nDepreciable lives by asset classification are as follows:\n| Asset description | Life |\n| Furniture and fixtures | 5 - 7 years |\n| Office equipment | 5 - 7 years |\n| Machinery and equipment | 7 - 10 years |\n| Automobiles and trucks | 3 - 5 years |\n| Building and leasehold improvements | 7 - 40 years |\n\nRepairs and maintenance are charged to expense when incurred. Expenditures for improvements are capitalized. Upon sale or retirement, the related cost and accumulated depreciation or amortization are removed from the respective accounts, and any resulting gain or loss is included in operations.\nLong-Lived Assets\nThe Company reviews the carrying values of its long-lived assets for possible impairment whenever events or changes in circumstances indicate that the carrying amounts of the assets may not be recoverable. Any long-lived assets held for disposal are reported at the lower of their carrying amounts or fair value less cost to sell. No triggering events were identified during each year presented that would require an impairment analysis. Additionally, no assets were held for disposal as of December 31, 2012 or 2011.\nGoodwill and Intangible Assets\nGoodwill represents the excess of purchase price paid over the fair values of net assets acquired and liabilities assumed in the Company's acquisitions.\nIntangible assets include non-competition agreements and non-contractual customer relationships. The fair value of identifiable intangible assets was estimated based on discounted future cash flow projections. Intangible assets are amortized on a straight-line basis over their estimated economic lives. The weighted-average useful life of intangible assets was five years as of December 31, 2012.\nThe Company evaluates the recoverability of identifiable intangible assets whenever events or changes in circumstances indicate that an intangible asset's carrying amount may not be recoverable. Such circumstances could include, but are not limited to, a significant decrease in the market value of the asset, a significant adverse change in the extent or manner in which an asset is used, or an accumulation of costs significantly in excess of the amount originally expected for the acquisition of an asset. No events or changes in circumstances were identified during the year that required an impairment analysis.\n84\nManagement is required to evaluate goodwill for impairment on an annual basis. The Company tests for impairment using a two-step process that involves (1) comparing the estimated fair value of the reporting unit to its net book value and (2) comparing the estimated implied fair value of goodwill and intangible assets to its carrying value. Goodwill and intangible assets were valued on the date of the acquisition. As of December 31, 2012 and 2011, there was no impairment of the goodwill or intangible assets acquired based on the analysis performed as of December 31, 2012.\nRevenue Recognition\nRevenue from the sale of goods is recognized at the time of shipment, except for revenue from sales of products to certain customers whose contractual terms specify FOB destination. Revenue from sales of products to these customers is recognized at the time of receipt by the customer when title and risk of loss pass to the customer.\nAccounts Receivable\nCredit is extended based on an evaluation of a customer's financial condition and, generally, collateral is not required. Accounts receivable are generally due within 30 days of the negotiated terms and are stated at amounts due from customers net of an allowance for doubtful accounts. Accounts outstanding longer than the contractual payment terms are considered past due. The Company maintains reserves for potential losses on receivables and credits from its customers, and these losses have not exceeded management's expectations. The Company determines its allowance for doubtful accounts by considering a number of factors, including the length of time trade accounts receivable are past due, the Company's previous loss history, the customer's current ability to pay its obligation to the Company, and the condition of the general economy and the industry as a whole. The Company writes off accounts receivable when they become uncollectible, and payments subsequently received on such receivables are credited to the allowance for doubtful accounts.\nEconomic Dependency - Major Suppliers\nDuring the years ended December 31, 2012, 2011 and 2010, the Company purchased approximately 44%, 45% and 49%, respectively, of its materials from five suppliers.\nDeferred Financing Costs\nDeferred financing costs are amortized over the life of the underlying credit agreement or the expected remaining life of the underlying credit agreement.\nIncome Taxes\nAs an LLC, the Company is not subject to federal and state income taxes, and its income or loss is allocated to and reported in the tax returns of its member. Accordingly, no liability or provision for federal and state income taxes attributable to the LLC's operations is included in the accompanying financial statements. The Company provides for income taxes for its wholly owned subsidiaries, Kreher Wire Processing, Inc. and Special Metals, Inc., which are subject to federal and state income taxes as they are structured as C Corporations. Special Metals Canada, which is structured as a foreign branch of a domestic company, will pay federal and provincial taxes in Canada. The taxes paid will be reported to the member in order to claim foreign tax credits.\nThe Company applies a comprehensive model for the financial statement recognition, measurement, classification and disclosure of uncertain tax positions. In the first step of the two-step process, the Company evaluates the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. In the second step, the Company measures the tax benefit as the largest amount that is more than 50% likely of being realized upon settlement. As of December 31, 2012 and 2011, the Company determined that there are no uncertain tax positions with a more than 50% likelihood of being realized upon settlement.\nAdvertising Costs\nAdvertising costs are charged to expense when the advertisement is first run. The Company expensed advertising costs of approximately $102,000, $80,000 and $62,000 in 2012, 2011 and 2010, respectively.\n85\nReclassifications\nCertain reclassifications of prior-year presentations have been made to conform to the 2012 presentation.\nNOTE B - INTANGIBLE ASSETS\nIntangible assets are amortized using the straight-line method, using the remaining useful life, and are as follows at December 31, 2012:\n| Remaining |\n| Asset description | useful life |\n| Non-contractual customer relationships | 2.25 years |\n\nThe following is a summary of intangible assets at December 31:\n| 2012 | 2011 |\n| Intangible assets |\n| Finite life |\n| Non-compete agreements | $ | 220,000 | $ | 220,000 |\n| Non-contractual customer relationships | 980,000 | 980,000 |\n| 1,200,000 | 1,200,000 |\n| Less accumulated amortization | 924,384 | 801,888 |\n| Net intangible assets | $ | 275,616 | $ | 398,112 |\n\nAmortization expense related to identifiable intangible assets was $122,496, $136,245 and $177,492 for the years ended December 31, 2012, 2011 and 2010, respectively. The intangible assets related to the non-compete agreements became fully amortized during 2011. Estimated annual amortization expense as of December 31, 2012, is a follows:\n| Years ending December 31, |\n| 2013 | $ | 122,496 |\n| 2014 | 122,496 |\n| 2015 | 30,624 |\n\nNOTE C - TRANSACTIONS WITH AFFILIATES\nIncluded in accounts receivable at December 31, 2012, was approximately $3,000 due from companies related through common ownership. There was no amount included in accounts receivable at December 31, 2011, due from companies related through common ownership.\nIncluded in accounts payable at December 31, 2012 and 2011, was approximately $21,000 and $79,000, respectively, due to companies related through common ownership.\nSales to and purchases from companies related through common ownership for the year ended December 31, 2012, were approximately $695,000 and $809,000, respectively, for the year ended December 31, 2011, were approximately $851,000 and $2,294,000, respectively, and for the year ended December 31, 2010, were approximately $351,000 and $2,118,000, respectively.\nNOTE D - ALLOWANCE FOR DOUBTFUL ACCOUNTS\nChanges in the Company's allowance for doubtful accounts are as follows at December 31:\n86\n| 2012 | 2011 |\n| Beginning balance | $ | 1,335,000 | $ | 1,340,000 |\n| Bad debt expense | 2,595,710 | 34,779 |\n| Recoveries | 20,125 | 536 |\n| Accounts written off | (2,515,835 | ) | (40,315 | ) |\n| Total allowance for doubtful accounts | $ | 1,435,000 | $ | 1,335,000 |\n\nNOTE E - DEBT\nDebt as of December 31, 2012 and 2011, is as follows:\n| 2012 | 2011 |\n| Revolving lines of credit | $ | 24,000,000 | $ | 35,000,000 |\n| Notes payable |\n| Michigan Strategic Fund Limited Obligation Revenue Bonds (2000) | $ | 875,000 | $ | 950,000 |\n| Michigan Strategic Fund Limited Obligation Revenue Bonds (2006) | 1,150,000 | 1,245,000 |\n| Capitalized leases | 54,601 | 101,911 |\n| Total notes payable | 2,079,601 | 2,296,911 |\n| Current portion of long-term debt | 211,894 | 215,918 |\n| Long-term debt | $ | 1,867,707 | $ | 2,080,993 |\n\nIn April 2004, the Company entered into a loan agreement. The loan consists of advances on a revolving line of credit, with maximum availability of $25,000,000, with the option of extending the credit to $40,000,000, through April 2009. In May 2007, the Company took that option and refinanced its $25,000,000 secured revolving credit agreement from an asset-based loan to a commercial-based loan, which can be increased to $40,000,000 in $5,000,000 increments. In April 2008, the Company increased the revolving credit to $30,000,000. The Company decreased the revolving credit to $20,000,000 in September 2009. In August 2011, the Company increased the revolving credit to $25,000,000. The interest charged on the loan is divided into the LIBOR portion and the prime rate portion. The outstanding balance on the LIBOR portion at a rate of 1.22% was $21,000,000 at December 31, 2011. There was a balance of $2,000,000 outstanding on the prime rate portion at a rate of 2.625% (prime minus 0.625%) at December 31, 2011.\nIn May 2007, the Company's subsidiary, Special Metals, Inc., also entered into a commercial-based loan for $5,000,000, which can be increased to $10,000,000 in $1,000,000 increments. In October 2011, the Company amended the loan agreement and increased the revolving credit to $15,000,000 based on the consolidated availability of the Company. The interest charged on the loan is divided into the LIBOR portion and the prime rate portion. The outstanding balance on the LIBOR portion at a rate of 1.22% was $12,000,000 at December 31, 2011. There was no outstanding balance on the LIBOR portion of the loan at December 31, 2011.\nIn April 2012, the Company entered into a new loan agreement. The loan named both the Company and its subsidiary, Special Metals, Inc., as co-borrowers. The loan is for $50,000,000, which can be increased to $65,000,000 in $5,000,000 increments. The interest charged on the loan is divided into the LIBOR portion and the prime rate portion. The outstanding balance on the LIBOR portion at a rate of 1.21% was $22,000,000 at December 31, 2012. The outstanding balance on the prime rate portion at a rate of 2.75% was $2,000,000 at December 31, 2012. The loan is secured by the Company's receivables, inventory and fixed assets, and expires in April 2017.\nThe Company is in compliance with all covenants related to the revolving credit agreements and all other notes payable.\nIn 2000, the Company's subsidiary, Kreher Wire Processing, Inc., obtained a Michigan Strategic Fund Limited Obligation Revenue Bond for $4,900,000. Interest is charged at a variable rate as defined in the agreement. The interest rate as of December 31, 2012 and 2011, was 0.23% and 0.20%, respectively. The Company makes monthly interest payments and annual principal and debt service payments. The Company is also required to make annual payments for the letter of credit fee. The bonds mature on May 1, 2016.\n87\nIn 2006, Kreher Wire Processing, Inc. obtained a Michigan Strategic Fund Limited Obligation Revenue Bond for $2,695,000. Interest is charged at a variable rate as defined in the agreement. The interest rate as of December 31, 2012 and 2011, was 0.23% and 0.20%, respectively. The Company makes monthly interest payments and annual principal and debt service payments. The Company is also required to make quarterly payments for the letter of credit fee. The bonds mature on October 1, 2021.\nIn 2010, Special Metals, Inc. entered into several lease agreements that met the criteria for capitalization. At December 31, 2012 and 2011, the gross amount of cost related to capital leases included in machinery and equipment was approximately $150,000. Related accumulated amortization at December 31, 2012 and 2011, was approximately $110,000 and $65,000, respectively. The total rental payments incurred for the years ended December 31, 2012, 2011 and 2010, was approximately $73,000, $73,000 and $33,000, respectively.\nThe carrying value of debt approximates fair value given the variable nature of the interest rates. Maturities of debt at December 31, 2012, are as follows:\n| Years ending December 31, |\n| 2013 | $ | 211,894 |\n| 2014 | 205,778 |\n| 2015 | 226,929 |\n| 2016 | 725,000 |\n| 2017 | 24,125,000 |\n| Thereafter | 585,000 |\n| Total | $ | 26,079,601 |\n\nNOTE F - INCOME TAXES\nAs an LLC, the Company is not subject to federal and state income taxes, and its income or loss is allocated to and reported in the tax returns of its member. The Company provides for income taxes for its wholly owned subsidiaries, Kreher Wire Processing, Inc. and Special Metals, Inc., which are subject to federal and state income taxes. The Company also provides for federal and provincial taxes at Special Metals Canada, which is structured as a foreign branch of a domestic company. The taxes paid will be reported to the member in order to claim foreign tax credits.\nThe tax effect of temporary differences that give rise to deferred tax assets and liabilities as of December 31, 2012 and 2011, are as follows:\n| 2012 | 2011 |\n| Deferred tax assets |\n| Accounts receivable and inventory reserves | $ | 271,553 | $ | 29,699 |\n| Deferred tax liabilities |\n| Amortization of intangibles | (110,246 | ) | (159,245 | ) |\n| Depreciation and other | (1,867,027 | ) | (849,503 | ) |\n| Total deferred tax liabilities | (1,977,273 | ) | (1,008,748 | ) |\n| Net deferred tax liabilities | $ | (1,705,720 | ) | $ | (979,049 | ) |\n\n88\nThe net current and non-current components of the deferred income taxes recognized in the balance sheets at December 31, 2012 and 2011, are as follows:\n| 2012 | 2011 |\n| Net current assets | $ | 271,553 | $ | 29,699 |\n| Net long-term liabilities | (1,977,273 | ) | (1,008,748 | ) |\n| Total net deferred tax liabilities | $ | (1,705,720 | ) | $ | (979,049 | ) |\n\nIncome tax expense consists of the following components as of December 31:\n| 2012 | 2011 | 2010 |\n| Current |\n| Federal | $ | 2,673,070 | $ | 2,667,703 | $ | 1,845,850 |\n| State | 398,649 | 495,338 | 225,738 |\n| Foreign | (90,289 | ) | — | — |\n| Deferred | 726,671 | 390,341 | 84,362 |\n| Total income tax expense | $ | 3,708,101 | $ | 3,553,382 | $ | 2,155,950 |\n\nThe differences between the federal statutory rate of 34% and the effective rate are due to state income taxes, permanent deductions, settlement of prior returns related to the acquisition and the fact that no tax provisions are recorded for operations attributable to Kreher Steel Company, LLC in the accompanying financial statements. Tax years dated back to December 31, 2009, are open for federal and state tax audit purposes. The total effective rate of the subsidiaries at December 31, 2012, 2011 and 2010, was 20.2%, 13.1% and 16.3%, respectively.\nA reconciliation of the effective income tax rate to the U.S. statutory tax rate is as follows:\n| 2012 | 2011 | 2010 |\n| U.S. statutory tax rate | 34 | % | 34 | % | 34 | % |\n| Non-taxable LLC income | (16.2 | ) | (21.1 | ) | (20.4 | ) |\n| State and local taxes - net of federal tax expense | 2.2 | 0.5 | 2.1 |\n| Foreign taxes | (0.2 | ) | 0.0 | 0.0 |\n| Other, net | 0.4 | (0.3 | ) | 0.6 |\n| Effective tax rate | 20.2 | % | 13.1 | % | 16.3 | % |\n\n89\nNOTE G - COMMITMENTS\nOperating Lease Commitments\nThe Company leases certain equipment and warehouse space under operating lease obligations with rent escalation clauses for the warehouse space only. Accordingly, the Company has recorded these lease obligations on a straight-line basis and recorded a deferred rent liability of approximately $53,000 and $94,000 for the years ended December 31, 2012 and 2011, respectively. Rent expense, net of sublease income for the years ended December 31, 2012, 2011 and 2010, was approximately $1,339,000, $1,081,000 and $687,000, respectively. The following shows minimum future rental payments for the next five years under these obligations:\n| Years ending December 31, |\n| 2,013 | $ | 1,001,042 |\n| 2,014 | 629,844 |\n| 2,015 | 596,404 |\n| 2,016 | 538,668 |\n| 2017 and thereafter | 421,401 |\n\nHealth Insurance\nThe Company maintains a fully self-insured health insurance plan. Approximately $1,105,000, $1,021,000 and $904,000 were expensed in 2012, 2011 and 2010, respectively, under this plan. The Company also maintains a fully self-insured health insurance plan at one of its wholly owned subsidiaries. Approximately $850,000, $562,000 and $346,000 were expensed for this plan during 2012, 2011 and 2010, respectively.\nNOTE H - EMPLOYEE BENEFIT PLAN\nThe Company maintains a qualified plan under Section 401(k) of the Internal Revenue Code. This plan is available for all employees who have completed one year or more of continuous service. The plan allows employees to contribute an annual limit of the lesser of 60% of eligible compensation or $17,500 (the federal limit for 2012). The Company will match contributions at the discretion of management. The Company has a non-discretionary match of 100%, up to 4% of what employees elect. The Company also has a profit-sharing match of $500 per participant, which is discretionary. This discretionary match was paid in 2012, 2011 and 2010. Participants are fully vested at all times in their contributions and become fully vested in the Company's contributions over a defined period. The plan is responsible for costs associated with its administration. Approximately $280,000, $200,000 and $153,000 was charged to expense for the years ended December 31, 2012, 2011 and 2010, respectively.\nThe Company also maintains a qualified plan under Section 401(k) of the Internal Revenue Code at a wholly owned subsidiary. This plan is available for all employees who have completed one year or more of continuous service. The plan allows employees to contribute an annual limit of $17,500 (the federal limit for 2012). The Company will match contributions at the discretion of management. The Company also has a discretionary profit-sharing contribution. Participants are fully vested in all contributions. The plan is responsible for costs associated with its administration. During 2012, 2011 and 2010, approximately $320,000, $240,000 and $210,000, respectively, was charged to expense.\nNOTE I - CONTINGENCIES\nThe Company is subject to various legal proceedings that have arisen in the normal course of business. In the opinion of management, these actions, when concluded and determined, will not have a material adverse effect on the financial position or operations of the Company.\nNOTE J - MEMBER'S CAPITAL\nThe Company is a single-member LLC and shall continue until December 31, 2045.\n90\nNOTE K - SUBSEQUENT EVENTS\nThe Company evaluated its December 31, 2012, financial statements for subsequent events through February 18, 2013, the date the financial statements were available to be issued. The Company is not aware of any subsequent events that would require recognition or disclosure in the financial statements.\n91\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\nBoard of Directors\nKreher Steel Company, LLC\nWe have audited the accompanying consolidated balance sheets of Kreher Steel Company, LLC (a Delaware limited liability company) and Subsidiaries (the Company) as of December 31, 2012 and 2011, and the related consolidated statements of comprehensive income, member's capital and cash flows for each of the three years ended December 31, 2012. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.\nWe conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.\nIn our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kreher Steel Company, LLC and Subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America.\n/s/ Grant Thornton LLP\nGrant Thornton LLP\nChicago, Illinois\nFebruary 18, 2013\n92\nITEM 9 —\nChanges In and Disagreements With Accountants on Accounting and Financial Disclosure\nNone.\nITEM 9A —\nControls & Procedures\nDisclosure Controls and Procedures\nA review and evaluation was performed by the Company’s management, including the Chief Executive Officer (CEO) and Chief Financial Officer (CFO), of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) of the Security Exchange Act of 1934). Based upon that review and evaluation, the CEO and CFO have concluded that the Company’s disclosure controls and procedures were effective as of December 31, 2012.\n(a) Management’s Annual Report on Internal Control Over Financial Reporting\nThe Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in the Securities Exchange Act of 1934 rule 240.13a-15(f). The Company’s internal control over financial reporting is a process designed under the supervision of the Company’s Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles.\nInternal control over financial reporting, no matter how well designed, has inherent limitations and may not prevent or detect misstatements. Therefore, even effective internal control over financial reporting can only provide reasonable assurance with respect to the financial statement preparation and presentation. Also, projections of any evaluation of effectiveness to future periods are subject to risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.\nThe Company, under the direction of its Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of its internal control over financial reporting as of December 31, 2012 based upon the framework published by the Committee of Sponsoring Organizations of the Treadway Commission, referred to as the Internal Control—Integrated Framework.\nBased on our evaluation under the framework in Internal Control — Integrated Framework, the Company’s management has concluded that our internal control over financial reporting was effective as of December 31, 2012.\nThe effectiveness of the Company’s internal control over financial reporting as of December 31, 2012 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their attestation report included in Item 9A of this annual report.\n(b) Report of Independent Registered Public Accounting Firm\nTo the Board of Directors and Stockholders of\nA.M. Castle & Co.\nOak Brook, Illinois\nWe have audited the internal control over financial reporting of A.M. Castle & Co. and subsidiaries (the \"Company\") as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit.\nWe conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.\n93\nA company's internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.\nBecause of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.\nIn our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.\nWe have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2012 of the Company and our report dated March 11, 2013 expressed an unqualified opinion on those financial statements.\n/s/ DELOITTE & TOUCHE LLP\nDELOITTE & TOUCHE LLP\nChicago, Illinois\nMarch 11, 2013\n(c) Change in Internal Control Over Financial Reporting\nAn evaluation was performed by the Company’s management, including the CEO and CFO, of any changes in internal controls over financial reporting that occurred during the last fiscal quarter and that materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting. The evaluation did not identify any change in the Company’s internal control over financial reporting that occurred during the latest fiscal quarter and that has materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting.\nItem 9B —\nOther Information\nNone.\n94\nPART III\nITEM 10 —\nDirectors, Executive Officers and Corporate Governance\nInformation regarding our executive officers is included under the heading “Executive Officers of the Registrant” in Part I of this Annual Report on Form 10-K. All additional information required to be filed in Part III, Item 10, Form 10-K, has been included in the sections of the Company's Definitive Proxy Statement for its 2013 annual meeting of shareholders (fiscal 2012 Proxy Statement) dated and to be filed with the Securities and Exchange Commission on or about March 12, 2013 entitled “Proposal 1- Election of Directors,” “Certain Governance Matters,” and “Section 16(A) Beneficial Ownership Reporting Compliance,” and is hereby incorporated by this specific reference.\nITEM 11 —\nExecutive Compensation\nAll information required to be filed in Part III, Item 11, Form 10-K, has been included in the sections of the fiscal 2012 Proxy Statement entitled “Compensation Discussion and Analysis,” “Report of the Human Resources Committee,” “Compensation Committee Interlocks and Insider Participation”, “Compensation Risk”, “Non-Employee Director Compensation,” and “Executive Compensation and Other Information” and is hereby incorporated by this specific reference.\nITEM 12 —\nSecurity Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters\nThe information required to be filed in Part III, Item 12, Form 10-K, has been included in the sections of the fiscal 2012 Proxy Statement entitled “Stock Ownership of Directors, Management and Principal Stockholders” and “Equity Compensation Plan Information” and is hereby incorporated by this specific reference.\nITEM 13 —\nCertain Relationships and Related Transactions, and Director Independence\nAll information required to be filed in Part III, Item 13, Form 10-K, has been included in the sections of the fiscal 2012 Proxy Statement entitled “Related Party Transactions” and “Director Independence; Financial Experts” and is hereby incorporated by this specific reference.\nITEM 14 —\nPrincipal Accountant Fees and Services\nAll information required to be filed in Part III, Item 14, Form 10-K, has been included in the sections of the fiscal 2012 Proxy Statement entitled “Audit and Non-Audit Fees” and “Pre-Approval Policy for Audit and Non-Audit Services” and is hereby incorporated by this specific reference.\n95\nPART IV\nITEM 15 —\nExhibits\nA. M. Castle & Co.\nIndex To Financial Statements\n\n| Page |\n| Consolidated Statements of Operations and Comprehensive Loss—For the years ended December 31, 2012, 2011 and 2010 | 36 |\n| Consolidated Balance Sheets—December 31, 2012 and 2011 | 37 |\n| Consolidated Statements of Cash Flows—For the years ended December 31, 2012, 2011 and 2010 | 38 |\n| Consolidated Statements of Stockholders’ Equity – For the years ended December 31, 2012, 2011 and 2010 | 39 |\n| Notes to Consolidated Financial Statements | 40 |\n| Report of Independent Registered Public Accounting Firm | 77 |\n| Kreher Steel Co., LLC Financial Statements | 79 |\n| Exhibit Index |\n\n96\nThe following exhibits are filed herewith or incorporated by reference.\n| ExhibitNumber | Description of Exhibit |\n| 2.1 | Stock Purchase Agreement dated as of August 12, 2006 by and among A. M. Castle & Co. and Transtar Holdings #2, LLC. Filed as Exhibit 2.1 to Form 8-K filed August 17, 2006. Commission File No. 1-5415. |\n| 2.2 | Stock Purchase Agreement, dated November 9, 2011, by and among A.M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, Inc. Filed as Exhibit 2.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 2.3 | Agreement and Amendment, dated December 15, 2011, by and among A.M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, Tube Supply, Inc. and A.M. Castle & Co. (Canada) Inc. Filed as Exhibit 2.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 2.4 | Second Amendment to the Stock Purchase Agreement, dated January 13, 2012, by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). Incorporated by reference to Exhibit 2.3 to the Company's Form S-4/A filed with the SEC on May 25, 2012. Commission File No. 333-180662. |\n| 2.5 | Third Amendment to the Stock Purchase Agreement, dated May 11, 2012, by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). Incorporated by reference to Exhibit 2.4 to the Company's Form S-4/A filed with the SEC on May 25, 2012. Commission File No. 333-180662. |\n| 2.6 | Fourth Amendment to the Stock Purchase Agreement, dated September 13, 2012 by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). |\n| 2.7 | Fifth Amendment to the Stock Purchase Agreement, dated November 14, 2012 by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). |\n| 3.1 | Articles of Restatement of the Charter of the Company filed with the State Department of Assessments and Taxation of Maryland on April 27, 2012. Filed as Exhibit 3.1 to Quarterly Report on Form 10-Q for the period ended March 31, 2012, which was filed on May 3, 2012. Commission File No. 1-5415. |\n| 3.2 | By-Laws of the Company as amended on October 28, 2010. Filed as Exhibit 3.2 to Quarterly Report on Form 10-Q for the period ended September 30, 2010, which was filed on November 5, 2010. Commission File No. 1-5415. |\n| 3.3 | Articles Supplementary of the Company. Filed as Exhibit 3.1 to Form 8-A filed on September 6, 2012. Commission File No. 1-5415. |\n| 4.1 | Indenture, dated as of December 15, 2011, among A.M. Castle & Co., the Guarantors, U.S. Bank National Association, as trustee and U.S. Bank National Association, as collateral agent. Filed as Exhibit 4.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 4.2 | Indenture, dated as of December 15, 2011, between A.M. Castle & Co., the Guarantors and U.S. Bank National Association, as trustee. Filed as Exhibit 4.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 4.3 | Rights Agreement, dated as of August 31, 2012, by and between A.M. Castle & Co. and American Stock Transfer & Trust Company, LLC, as Rights Agent. Filed as Exhibit 4.1 to Form 8-K filed on August 31, 2012. Commission File No. 1-05415. |\n| 10.1* | A. M. Castle & Co. 1995 Director Stock Option Plan. Filed as Exhibit A to Proxy Statement filed March 7, 1995. Commission File No. 1-5415. |\n| 10.2* | A. M. Castle & Co. 1996 Restricted Stock and Stock Option Plan. Filed as Exhibit A to Proxy Statement filed March 8, 2006. Commission File No. 1-5415. |\n| 10.3* | A. M. Castle & Co. 2000 Restricted Stock and Stock Option Plan. Filed as Appendix B to Proxy Statement filed March 23, 2001. Commission File No. 1-5415. |\n\n97\n| ExhibitNumber | Description of Exhibit |\n| 10.4* | A. M. Castle & Co. 2004 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit D to Proxy Statement filed March 12, 2004. Commission File No. 1-5415. |\n| 10.5* | A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan, as amended and restated as of December 9, 2010. Filed as Exhibit 10.25 to Annual Report on Form 8-K filed on December 15, 2010. Commission File No. 1-5415. |\n| 10.6* | Form of Restricted Stock Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.11 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\n| 10.7* | Form of Performance Share Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.12 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\n| 10.8* | A. M. Castle & Co. Directors Deferred Compensation Plan, as amended and restated as of October 22, 2008. Filed as Exhibit 10.13 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\n| 10.9* | A. M. Castle & Co. Supplemental 401(k) Savings and Retirement Plan, as amended and restated, effective as of January 1, 2009. Filed as Exhibit 10.14 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\n| 10.10* | A. M. Castle & Co. Supplemental Pension Plan, as amended and restated, effective as of January 1, 2009. Filed as Exhibit 10.15 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\n| 10.11* | First Amendment to the A. M. Castle & Co. Supplemental 401(k) Savings and Retirement Plan, executed April 15, 2009 (as effective April 27, 2009). Filed as Exhibit 10.1 to Form 8-K filed on April 16, 2009. Commission File No. 1-5415. |\n| 10.12* | Form of A.M. Castle & Co. Indemnification Agreement to be executed with all directors and executive officers. Filed as Exhibit 10.16 to Form 8-K filed on July 29, 2009. Commission File No. 1-5415. |\n| 10.13* | Form of Restricted Stock Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.20 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. |\n| 10.14* | Form of Performance Share Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.21 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. |\n| 10.15* | Form of Incentive Stock Option Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.22 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. |\n| 10.16* | Form of Non-Qualified Stock Option Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.23 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. |\n| 10.17* | Form of Non-Employee Director Restricted Stock Award Agreement. Filed as Exhibit 10.1 to Form 8-K filed on April 27, 2010. Commission File No. 1-5415. |\n| 10.18* | Form of Amended and Restated Change of Control Agreement for all executive officers other than the CEO. Filed as Exhibit 10.24 to Form 8-K filed on September 21, 2010. Commission File No. 1-5415. |\n| 10.19* | Form of Amended and Restated Severance Agreement for executive officers other than the CEO. Filed as Exhibit 10.26 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. |\n| 10.20* | CEO Change in Control Agreement, as amended and restated December 22, 2010. Filed as Exhibit 10.27 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. |\n\n98\n| ExhibitNumber | Description of Exhibit |\n| 10.21* | CEO Employment/Non-Competition Agreement, as amended and restated December 22, 2010. Filed as Exhibit 10.28 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. |\n| 10.22* | Form of Performance Share Award Agreement, adopted March 2, 2011, under A.M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.29 to Form 8-K filed March 8, 2011. Commission File No. 1-5415. |\n| 10.23* | 2008 A. M. Castle & Co. Omnibus Incentive Plan, as amended and restated as of April 28, 2011. Filed as Exhibit 10.30 to Form 8-K filed May 3, 2011. Commission File No. 1-5415. |\n| 10.24* | Stephen V. Hooks Executive Retention and Severance Agreement, dated October 27, 2011. Filed as Exhibit 10.31 to Form 8-K filed November 1, 2011. Commission File No. 1-5415. |\n| 10.25 | Pledge and Security Agreement, dated as of December 15, 2011, by A.M. Castle & Co., and its subsidiaries that are party thereto, in favor of U.S. Bank National Association, as collateral agent, for the benefit of the Secured Parties. Filed as Exhibit 10.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 10.26 | Intercreditor Agreement, dated as of December 15, 2011, among Wells Fargo Bank, National Association, in its capacity as administrative and collateral agent for the First Lien Secured Parties and U.S. Bank National Association, a national banking association, in its capacity as trustee and collateral agend for the Second Lien Secured Parties. Filed as Exhibit 10.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 10.27 | Registration Rights Agreement, dated as of December 15, 2011, between A.M. Castle & Co., the Guarantors and Jefferies & Company, Inc., as initial purchaser, for the benefit of the Holders of the Notes. Filed as Exhibit 10.3 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 10.28 | Loan and Security Agreement, dated December 15, 2011, by and among A.M. Castle & Co., Transtar Metals Corp., Advanced Fabricating Technology, LLC, Oliver Steel Plate Co., Paramont Machine Company, LLC, Total Plastics, Inc., Tube Supply, LLC, A.M. Castle & Co. (Canada) Inc., Tube Supply Canada ULC, the other Loan Parties party thereto, the lenders which are now or which hereafter become a party thereto, and Wells Fargo Bank, National Association, a national banking association, in its capacity as administrative agent and collateral agent for Secured Parties. Filed as Exhibit 10.4 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 10.29* | Employment Agreement, dated November 9, 2011, by and between A. M. Castle & Co. and Mr. Paul Sorensen. Filed as Exhibit 10.29 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. |\n| 10.30* | Form of Retention Bonus Agreement for certain executive officers in connection with CEO leadership transition, dated May 14, 2012. Filed as Exhibit 10.30 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. |\n| 10.31* | Amendment to Employment Agreement, dated May 30, 2012, by and between A. M. Castle & Co. and Mr. Paul Sorensen. Filed as Exhibit 10.31 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. |\n| 10.32* | Employment Offer Letter dated October 10, 2012, between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.32 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. |\n| 10.33* | Form of Restricted Stock Unit Award Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.33 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. |\n| 10.34* | Form of Severance Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.34 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. |\n| 10.35* | Form of Change of Control Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.35 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. |\n\n99\n| ExhibitNumber | Description of Exhibit |\n| 10.36* | Offer of Chief Commercial Officer dated December 28, 2012, between A.M. Castle & Co. and Mr. Blain Tiffany. Filed as Exhibit 10.36 to Form 8-K filed January 22, 2013. Commission File No. 1-5415. |\n| 21.1 | Subsidiaries of Registrant |\n| 23.1 | Consent of Deloitte & Touche LLP |\n| 23.2 | Consent of Grant Thornton LLP |\n| 31.1 | CEO Certification Pursuant to Section 302 of the Sarbanes Oxley Act of 2002. |\n| 31.2 | CFO Certification Pursuant to Section 302 of the Sarbanes Oxley Act of 2002. |\n| 32.1 | CEO and CFO Certification Pursuant to Section 906 of the Sarbanes Oxley Act of 2002. |\n| 101.INS | XBRL Instance Document (1) |\n| 101.SCH | XBRL Taxonomy Extension Schema Document (1) |\n| 101.CAL | XBRL Taxonomy Calculation Linkbase Document (1) |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document(1) |\n| 101.LAB | XBRL Taxonomy Label Linkbase Document (1) |\n| 101.PRE | XBRL Taxonomy Presentation Linkbase Document (1) |\n\n| (1) | Furnished with this report. In accordance with Rule 406T of Regulation S-T, the information in these exhibits shall not be deemed to be “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to liability under that section, and shall not be incorporated by reference into any registration statement or other document filed under the Securities Act of 1933, as amended, except as expressly set forth by specific reference in such filing. |\n| * | These agreements are considered a compensatory plan or arrangement. |\n\n100\nSIGNATURES\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n| A. M. Castle & Co. |\n| (Registrant) |\n\n| By: | /s/ Patrick R. Anderson |\n| Patrick R. Anderson, Vice President—Controller and Chief Accounting Officer |\n| (Principal Accounting Officer) |\n| Date: | March 11, 2013 |\n\nPursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities as shown following their name on this 11th day of March, 2013.\n| /s/ Brian P. Anderson | /s/ Gary A. Masse | /s/ Ann M. Drake |\n| Brian P. Anderson, Chairman of the Board | Gary A. Masse, Director | Ann M. Drake, Director |\n| /s/ Scott J. Dolan | /s/ Scott F. Stephens | /s/ Reuben S. Donnelley |\n| Scott J. Dolan, President, | Scott F. Stephens, Vice President | Reuben S. Donnelley, Director |\n| Chief Executive Officer and | and Chief Financial Officer |\n| Director | (Principal Financial Officer) |\n| (Principal Executive Officer) |\n| /s/ Patrick J. Herbert, III | /s/ Terrence J. Keating | /s/ James D. Kelly |\n| Patrick J. Herbert, III, Director | Terrence J. Keating, Director | James D. Kelly, Director |\n| /s/ Pamela Forbes Lieberman |\n| Pamela Forbes Lieberman, Director | John McCartney, Director |\n\n101\nExhibit Index\nThe following exhibits are filed herewith or incorporated herein by reference:\n\n| Exhibit No. | Description | Page |\n| 2.1 | Stock Purchase Agreement dated as of August 12, 2006 by and among A. M. Castle & Co. and Transtar Holdings #2, LLC. Filed as Exhibit 2.1 to Form 8-K filed August 17, 2006. Commission File No. 1-5415. | — |\n| 2.2 | Stock Purchase Agreement, dated November 9, 2011, by and among A.M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, Inc. Filed as Exhibit 2.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 2.3 | Agreement and Amendment, dated December 15, 2011, by and among A.M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, Tube Supply, Inc. and A.M. Castle & Co. (Canada) Inc. Filed as Exhibit 2.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 2.4 | Second Amendment to the Stock Purchase Agreement, dated January 13, 2012, by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). Incorporated by reference to Exhibit 2.3 to the Company's Form S-4/A filed with the SEC on May 25, 2012. Commission File No. 333-180662. | — |\n| 2.5 | Third Amendment to the Stock Purchase Agreement, dated May 11, 2012, by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). Incorporated by reference to Exhibit 2.4 to the Company's Form S-4/A filed with the SEC on May 25, 2012. Commission File No. 333-180662. | — |\n| 2.6 | Fourth Amendment to the Stock Purchase Agreement, dated September 13, 2012 by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). | E-1 |\n| 2.7 | Fifth Amendment to the Stock Purchase Agreement, dated November 14, 2012 by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). | E-3 |\n| 3.1 | Articles of Restatement of the Charter of the Company filed with the State Department of Assessments and Taxation of Maryland on April 27, 2012. Filed as Exhibit 3.1 to Quarterly Report on Form 10-Q for the period ended March 31, 2012, which was filed on May 3, 2012. Commission File No. 1-5415. | — |\n| 3.2 | By-Laws of the Company as amended on October 28, 2010. Filed as Exhibit 3.2 to Quarterly Report on Form 10-Q for the period ended September 30, 2010, which was filed on November 5, 2010. Commission File No. 1-5415. | — |\n| 3.3 | Articles Supplementary of the Company. Filed as Exhibit 3.1 to Form 8-A filed on September 6, 2012. Commission File No. 1-5415. | — |\n| 4.1 | Indenture, dated as of December 15, 2011, among A.M. Castle & Co., the Guarantors, U.S. Bank National Association, as trustee and U.S. Bank National Association, as collateral agent. Filed as Exhibit 4.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 4.2 | Indenture, dated as of December 15, 2011, between A.M. Castle & Co., the Guarantors and U.S. Bank National Association, as trustee. Filed as Exhibit 4.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 4.3 | Rights Agreement, dated as of August 31, 2012, by and between A.M. Castle & Co. and American Stock Transfer & Trust Company, LLC, as Rights Agent. Filed as Exhibit 4.1 to Form 8-K filed on August 31, 2012. Commission File No. 1-05415. | — |\n| 10.1* | A. M. Castle & Co. 1995 Director Stock Option Plan. Filed as Exhibit A to Proxy Statement filed March 7, 1995. Commission File No. 1-5415. | — |\n| 10.2* | A. M. Castle & Co. 1996 Restricted Stock and Stock Option Plan. Filed as Exhibit A to Proxy Statement filed March 8, 2006. Commission File No. 1-5415. | — |\n\n102\n| Exhibit No. | Description | Page |\n| 10.3* | A. M. Castle & Co. 2000 Restricted Stock and Stock Option Plan. Filed as Appendix B to Proxy Statement filed March 23, 2001. Commission File No. 1-5415. | — |\n| 10.4* | A. M. Castle & Co. 2004 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit D to Proxy Statement filed March 12, 2004. Commission File No. 1-5415. | — |\n| 10.5* | A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan, as amended and restated as of December 9, 2010. Filed as Exhibit 10.25 to Annual Report on Form 8-K filed on December 15, 2010. Commission File No. 1-5415. | — |\n| 10.6* | Form of Restricted Stock Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.11 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\n| 10.7* | Form of Performance Share Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.12 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\n| 10.8* | A. M. Castle & Co. Directors Deferred Compensation Plan, as amended and restated as of October 22, 2008. Filed as Exhibit 10.13 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\n| 10.9* | A. M. Castle & Co. Supplemental 401(k) Savings and Retirement Plan, as amended and restated, effective as of January 1, 2009. Filed as Exhibit 10.14 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\n| 10.10* | A. M. Castle & Co. Supplemental Pension Plan, as amended and restated, effective as of January 1, 2009. Filed as Exhibit 10.15 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\n| 10.11* | First Amendment to the A. M. Castle & Co. Supplemental 401(k) Savings and Retirement Plan, executed April 15, 2009 (as effective April 27, 2009). Filed as Exhibit 10.1 to Form 8-K filed on April 16, 2009. Commission File No. 1-5415. | — |\n| 10.12* | Form of A.M. Castle & Co. Indemnification Agreement to be executed with all directors and executive officers. Filed as Exhibit 10.16 to Form 8-K filed on July 29, 2009. Commission File No. 1-5415. | — |\n| 10.13* | Form of Restricted Stock Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.20 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. | — |\n| 10.14* | Form of Performance Share Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.21 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. | — |\n| 10.15* | Form of Incentive Stock Option Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.22 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. | — |\n| 10.16* | Form of Non-Qualified Stock Option Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.23 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. | — |\n| 10.17* | Form of Non-Employee Director Restricted Stock Award Agreement. Filed as Exhibit 10.1 to Form 8-K filed on April 27, 2010. Commission File No. 1-5415. | — |\n| 10.18* | Form of Amended and Restated Change of Control Agreement for all executive officers other than the CEO. Filed as Exhibit 10.24 to Form 8-K filed on September 21, 2010. Commission File No. 1-5415. | — |\n\n103\n| Exhibit No. | Description | Page |\n| 10.19* | Form of Amended and Restated Severance Agreement for executive officers other than the CEO. Filed as Exhibit 10.26 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. | — |\n| 10.20* | CEO Change in Control Agreement, as amended and restated December 22, 2010. Filed as Exhibit 10.27 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. | — |\n| 10.21* | CEO Employment/Non-Competition Agreement, as amended and restated December 22, 2010. Filed as Exhibit 10.28 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. | — |\n| 10.22* | Form of Performance Share Award Agreement, adopted March 2, 2011, under A.M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.29 to Form 8-K filed March 8, 2011. Commission File No. 1-5415. | — |\n| 10.23* | 2008 A. M. Castle & Co. Omnibus Incentive Plan, as amended and restated as of April 28, 2011. Filed as Exhibit 10.30 to Form 8-K filed May 3, 2011. Commission File No. 1-5415. | — |\n| 10.24* | Stephen V. Hooks Executive Retention and Severance Agreement, dated October 27, 2011. Filed as Exhibit 10.31 to Form 8-K filed November 1, 2011. Commission File No. 1-5415. | — |\n| 10.25 | Pledge and Security Agreement, dated as of December 15, 2011, by A.M. Castle & Co., and its subsidiaries that are party thereto, in favor of U.S. Bank National Association, as collateral agent, for the benefit of the Secured Parties. Filed as Exhibit 10.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 10.26 | Intercreditor Agreement, dated as of December 15, 2011, among Wells Fargo Bank, National Association, in its capacity as administrative and collateral agent for the First Lien Secured Parties and U.S. Bank National Association, a national banking association, in its capacity as trustee and collateral agend for the Second Lien Secured Parties. Filed as Exhibit 10.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 10.27 | Registration Rights Agreement, dated as of December 15, 2011, between A.M. Castle & Co., the Guarantors and Jefferies & Company, Inc., as initial purchaser, for the benefit of the Holders of the Notes. Filed as Exhibit 10.3 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 10.28 | Loan and Security Agreement, dated December 15, 2011, by and among A.M. Castle & Co., Transtar Metals Corp., Advanced Fabricating Technology, LLC, Oliver Steel Plate Co., Paramont Machine Company, LLC, Total Plastics, Inc., Tube Supply, LLC, A.M. Castle & Co. (Canada) Inc., Tube Supply Canada ULC, the other Loan Parties party thereto, the lenders which are now or which hereafter become a party thereto, and Wells Fargo Bank, National Association, a national banking association, in its capacity as administrative agent and collateral agent for Secured Parties. Filed as Exhibit 10.4 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 10.29* | Employment Agreement, dated November 9, 2011, by and between A. M. Castle & Co. and Mr. Paul Sorensen. Filed as Exhibit 10.29 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. | — |\n| 10.30* | Form of Retention Bonus Agreement for certain executive officers in connection with CEO leadership transition, dated May 14, 2012. Filed as Exhibit 10.30 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. | — |\n| 10.31* | Amendment to Employment Agreement, dated May 30, 2012, by and between A. M. Castle & Co. and Mr. Paul Sorensen. Filed as Exhibit 10.31 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. | — |\n| 10.32* | Employment Offer Letter dated October 10, 2012, between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.32 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. | — |\n\n104\n| Exhibit No. | Description | Page |\n| 10.33* | Form of Restricted Stock Unit Award Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.33 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. | — |\n| 10.34* | Form of Severance Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.34 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. | — |\n| 10.35* | Form of Change of Control Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.35 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. | — |\n| 10.36* | Offer of Chief Commercial Officer dated December 28, 2012, between A.M. Castle & Co. and Mr. Blain Tiffany. Filed as Exhibit 10.36 to Form 8-K filed January 22, 2013. Commission File No. 1-5415. | — |\n| 21.1 | Subsidiaries of Registrant | E-5 |\n| 23.1 | Consent of Deloitte & Touche LLP | E-6 |\n| 23.2 | Consent of Grant Thornton LLP | E-7 |\n| 31.1 | CEO Certification Pursuant to Section 302 of the Sarbanes Oxley Act of 2002. | E-8 |\n| 31.2 | CFO Certification Pursuant to Section 302 of the Sarbanes Oxley Act of 2002. | E-9 |\n| 32.1 | CEO and CFO Certification Pursuant to Section 906 of the Sarbanes Oxley Act of 2002. | E-10 |\n| 101.INS | XBRL Instance Document (1) | — |\n| 101.SCH | XBRL Taxonomy Extension Schema Document (1) | — |\n| 101.CAL | XBRL Taxonomy Calculation Linkbase Document (1) | — |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document(1) | — |\n| 101.LAB | XBRL Taxonomy Label Linkbase Document (1) | — |\n| 101.PRE | XBRL Taxonomy Presentation Linkbase Document (1) | — |\n\n| (1) | Furnished with this report. In accordance with Rule 406T of Regulation S-T, the information in these exhibits shall not be deemed to be “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to liability under that section, and shall not be incorporated by reference into any registration statement or other document filed under the Securities Act of 1933, as amended, except as expressly set forth by specific reference in such filing. |\n| * | These agreements are considered a compensatory plan or arrangement. |\n\n105\n</text>\n\nWhat is the total cost incurred by the company for the acquisition of Tube Supply, inclusive of direct acquisition-related costs, CEO transition costs, bad debt reserves for customer bankruptcies, charges for export penalties related to product shipments and underwriting fees associated with debt financing in $ million?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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doc-math
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"style": "rule",
"ground_truth": "Therefore, the answer is 10.9."
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"index": 51,
"input_length": 92719
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docmath_40000_plus
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"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial statements\nSOCIETY PASS INCORPORATED\nCONDENSED CONSOLIDATED BALANCE SHEETS\nAS OF SEPTEMBER 30, 2021 AND DECEMBER 31, 2020\n(Currency expressed in United States Dollars (“US$”))\n\n| September 30, 2021 | December 31, 2020 |\n| (Unaudited) |\n| ASSETS |\n| Current assets: |\n| Cash and cash equivalents | $ | 5,722,450 | $ | 506,666 |\n| Due from related parties | 97,500 | — |\n| Accounts receivable, net | 87,803 | 1,897 |\n| Deposits, prepayments and other receivables | 69,623 | 60,532 |\n| Total current assets | 5,977,376 | 569,095 |\n| Non-current assets: |\n| Intangible assets, net | 4,800,000 | 7,200,000 |\n| Property, plant and equipment, net | 11,080 | 18,069 |\n| Right of use assets, net | 529,782 | 79,109 |\n| Total non-current assets | 5,340,862 | 7,297,178 |\n| TOTAL ASSETS | $ | 11,318,238 | $ | 7,866,273 |\n| LIABILITIES AND SHAREHOLDERS’ DEFICIT |\n| Current liabilities: |\n| Accounts payables | $ | 104,680 | $ | 54,256 |\n| Contract liabilities | 35,582 | 18,646 |\n| Accrued liabilities and other payables | 752,640 | 677,572 |\n| Contingent service payable | — | 633,000 |\n| Due to related parties | 24,763 | 1,571,737 |\n| Operating lease liabilities | 167,773 | 36,752 |\n| Total current liabilities | 1,085,438 | 2,991,963 |\n| Non-current liabilities |\n| Operating lease liabilities | 365,539 | 46,453 |\n| TOTAL LIABILITIES | 1,450,977 | 3,038,416 |\n| COMMITMENTS AND CONTINGENCIES |\n| Convertible preferred shares; $ 0.0001 par value, 5,000,000 shares authorized, 4,916,500 and 4,920,000 shares undesignated as of September 30, 2021 and December 31, 2020, respectively |\n| Series A shares: 10,000 shares designated; 8,000 and 8,000 Series A shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | 8,000,000 | 8,000,000 |\n| Series B shares: 10,000 shares designated; 2,548 and 2,548 Series B shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | 3,412,503 | 3,412,503 |\n| Series B-1 shares: 15,000 shares designated; 160 and 160 Series B-1 shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | 466,720 | 466,720 |\n| Series C shares: 15,000 shares designated; 1,552 and 362 Series C shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively, net of issuance cost | 8,353,373 | 2,151,706 |\n| Series C-1 shares: 30,000 shares designated; 13,984 and 2,885 Series C-1 shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively, net of issuance cost and stock subscription receivable | 5,057,192 | 1,211,700 |\n| SHAREHOLDERS’ DEFICIT |\n| Series X Super Voting Preferred Stock, $ 0.0001 par value, 3,500 shares designated; 3,500 and 0 Series X shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | — | — |\n| Common shares; $ 0.0001 par value, 95,000,000 shares authorized; 9,695,480 and 7,413,600 shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | 970 | 742 |\n| Additional paid-in capital | 12,712,290 | 2,227,033 |\n| Accumulated other comprehensive loss | ( 19,478 | ) | ( 55,236 | ) |\n| Accumulated deficit | ( 28,116,309 | ) | ( 12,587,311 | ) |\n| Total shareholders’ deficit | ( 15,422,527 | ) | ( 10,414,772 | ) |\n| TOTAL LIABILITIES AND SHAREHOLDERS’ DEFICIT | $ | 11,318,238 | $ | 7,866,273 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n\n| 3 |\n\nSOCIETY PASS INCORPORATED\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND\nOTHER COMPREHENSIVE LOSS\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2021 AND 2020\n(Currency expressed in United States Dollars (“US$”))\n(Unaudited)\n\n| Three months ended | Nine months ended |\n| September 30, | September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Revenue, net |\n| Hardware sales | $ | — | $ | 585 | $ | 335 | $ | 3,510 |\n| Software subscription | 10,016 | 11,044 | 26,970 | 37,752 |\n| Sales – online ordering | 73,518 | — | 73,518 | — |\n| Total revenue | 83,534 | 11,629 | 100,823 | 41,262 |\n| Cost of sales: |\n| Hardware sales | — | ( 585 | ) | ( 165 | ) | ( 2,982 | ) |\n| Software subscription | ( 101,695 | ) | ( 19,731 | ) | ( 206,387 | ) | ( 56,127 | ) |\n| Cost of online ordering | ( 57,741 | ) | — | ( 57,741 | ) | — |\n| Total cost of revenue | ( 159,436 | ) | ( 20,316 | ) | ( 264,293 | ) | ( 59,109 | ) |\n| Gross loss | ( 75,902 | ) | ( 8,687 | ) | ( 163,470 | ) | ( 17,847 | ) |\n| Operating expenses: |\n| Sales and marketing expenses | ( 42,843 | ) | — | ( 85,027 | ) | ( 3,125 | ) |\n| Software development costs | ( 9,709 | ) | ( 33,658 | ) | ( 76,698 | ) | ( 139,151 | ) |\n| Impairment loss | — | 4,164 | ( 200,000 | ) | ( 8,778 | ) |\n| General and administrative expenses | ( 8,292,463 | ) | ( 1,580,287 | ) | ( 14,414,362 | ) | ( 2,311,266 | ) |\n| Total operating expenses | ( 8,345,015 | ) | ( 1,609,781 | ) | ( 14,776,087 | ) | ( 2,462,320 | ) |\n| Loss from operations | ( 8,420,917 | ) | ( 1,618,468 | ) | ( 14,939,557 | ) | ( 2,480,167 | ) |\n| Other income (expense): |\n| Interest income | 55 | 3 | 71 | 11 |\n| Interest expense | ( 12,272 | ) | ( 12,261 | ) | ( 36,486 | ) | ( 36,381 | ) |\n| Loss on settlement of litigation | — | — | ( 550,000 | ) | — |\n| Other income | 5,170 | 3,737 | 6,917 | 9,495 |\n| Total other expense | ( 7,047 | ) | ( 8,521 | ) | ( 579,498 | ) | ( 26,875 | ) |\n| Loss before income taxes | ( 8,427,964 | ) | ( 1,626,989 | ) | ( 15,519,055 | ) | ( 2,507,042 | ) |\n| Income taxes | ( 1,303 | ) | ( 4 | ) | ( 9,943 | ) | ( 15,069 | ) |\n| NET LOSS | $ | ( 8,429,267 | ) | $ | ( 1,626,993 | ) | $ | ( 15,528,998 | ) | $ | ( 2,522,111 | ) |\n| Other comprehensive loss: |\n| Foreign currency translation income | 8,859 | 51,183 | 35,758 | 15,249 |\n| COMPREHENSIVE LOSS | $ | ( 8,420,408 | ) | $ | ( 1,575,810 | ) | $ | ( 15,493,240 | ) | $ | ( 2,506,862 | ) |\n| Net loss per share – Basic and Diluted | $ | ( 1 | ) | $ | ( 0 | ) | $ | ( 2 | ) | $ | ( 0 | ) |\n| Weighted average common shares outstanding – Basic and Diluted | 7,823,818 | 6,848,700 | 7,551,842 | 6,847,945 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n\n| 4 |\n\nSOCIETY PASS INCORPORATED\nCONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ DEFICIT\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2021 AND 2020\n(Currency expressed in United States Dollars (“US$”))\n(Unaudited)\n\n| Three months ended September 30, 2021 |\n| Common stock | Additional paid-in capital | Accumulated other comprehensive (loss) income | Accumulated deficit | Total shareholders’ deficit |\n| Shares | Amount |\n| Balance as of July 1, 2021 | 7,413,600 | $ | 742 | $ | 5,145,228 | $ | ( 28,337 | ) | $ | ( 19,687,042 | ) | $ | ( 14,569,409 | ) |\n| Imputed Interest | — | — | 12,260 | — | — | 12,260 |\n| Shares issued for services | 1,274,250 | 127 | 5,149,929 | — | — | 5,150,056 |\n| Shares issued for accrued salaries | 1,157,630 | 116 | 960,718 | — | — | 960,834 |\n| Share cancellation | ( 150,000 | ) | ( 15 | ) | 15 | — | — | — |\n| Waiver of related parties debts | — | — | 1,444,140 | — | — | 1,444,140 |\n| Net loss for the period | — | — | — | — | ( 8,429,267 | ) | ( 8,429,267 | ) |\n| Foreign currency translation adjustment | — | — | — | 8,859 | — | 8,859 |\n| Balance as of September 30, 2021 | 9,695,480 | $ | 970 | $ | 12,712,290 | $ | ( 19,478 | ) | $ | ( 28,116,309 | ) | $ | ( 15,422,527 | ) |\n\n\n| Three months ended September 30, 2020 |\n| Common stock | Additional paid-in capital | Accumulated other comprehensive (loss) income | Accumulated deficit | Total shareholder’ deficit |\n| Shares | Amount |\n| Balance as of July 1, 2020 | 6,847,200 | $ | 685 | $ | 1,729,064 | $ | ( 31,946 | ) | $ | ( 9,654,441 | ) | $ | ( 7,956,638 | ) |\n| Issuance of common stock for services | 1,016,400 | — | 848,505 | — | — | 848,505 |\n| Imputed interest | — | — | 12,261 | — | — | 12,261 |\n| Net loss for the period | — | — | — | — | ( 1,626,993 | ) | ( 1,626,993 | ) |\n| Foreign currency translation adjustment | — | — | — | 51,183 | — | 51,183 |\n| Balance as of September 30, 2020 | 7,863,600 | $ | 685 | $ | 2,589,830 | $ | 19,237 | $ | ( 11,281,434 | ) | $ | ( 8,671,682 | ) |\n\n\n| 5 |\n\n\n| Nine months ended September 30, 2021 |\n| Common stock | Additional paid-in capital | Accumulated other comprehensive (loss) income | Accumulated deficit | Total shareholder’ deficit |\n| Shares | Amount |\n| Balance as of January 1, 2021 | 7,413,600 | $ | 742 | $ | 2,227,033 | $ | ( 55,236 | ) | $ | ( 12,587,311 | ) | $ | ( 10,414,772 | ) |\n| Imputed Interest | — | — | 36,380 | — | — | 36,380 |\n| Shares issued for services | 1,274,250 | 127 | 5,149,929 | — | — | 5,150,056 |\n| Shares issued for accrued salaries | 1,157,630 | 116 | 960,718 | — | — | 960,834 |\n| Loss on fair value of shares issued for accrued salaries | — | — | 2,894,075 | — | — | 2,894,075 |\n| Share cancellation | ( 150,000 | ) | ( 15 | ) | 15 | — | — | — |\n| Waiver of related parties debts | — | — | 1,444,140 | — | — | 1,444,140 |\n| Net loss for the period | — | — | — | — | ( 15,528,998 | ) | ( 15,528,998 | ) |\n| Foreign currency translation adjustment | — | — | — | 35,758 | — | 35,758 |\n| Balance as of September 30, 2021 | 9,695,480 | $ | 970 | $ | 12,712,290 | $ | ( 19,478 | ) | $ | ( 28,116,309 | ) | $ | ( 15,422,527 | ) |\n\n\n| Nine months ended September 30, 2020 |\n| Common stock | Additional paid-in capital | Accumulated other comprehensive (loss) income | Accumulated deficit | Total shareholders’ deficit |\n| Shares | Amount |\n| Balance as of January 1, 2020 | 6,847,200 | $ | 685 | $ | 1,704,944 | $ | 3,988 | $ | ( 8,759,323 | ) | $ | ( 7,049,706 | ) |\n| Issuance of common stock for services | 1,016,400 | — | 848,505 | — | — | 848,505 |\n| Imputed interest | — | — | 36,381 | — | — | 36,381 |\n| Net loss for the period | — | — | — | — | ( 2,522,111 | ) | ( 2,522,111 | ) |\n| Foreign currency translation adjustment | — | — | — | 15,249 | — | 15,249 |\n| Balance as of September 30, 2020 | 7,863,600 | $ | 685 | $ | 2,589,830 | $ | 19,237 | $ | ( 11,281,434 | ) | $ | ( 8,671,682 | ) |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n\n| 6 |\n\nSOCIETY PASS INCORPORATED\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\nFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2021 AND 2020\n(Currency expressed in United States Dollars (“US$”))\n(Unaudited)\n\n| Nine months ended September 30, |\n| 2021 | 2020 |\n| Cash flows from operating activities: |\n| Net loss | $ | ( 15,528,998 | ) | $ | ( 2,522,111 | ) |\n| Adjustments to reconcile net loss to net cash used in operating activities |\n| Depreciation and amortization | 2,406,648 | 4,447 |\n| Impairment loss | 200,000 | 8,778 |\n| Imputed interest | 36,380 | 36,381 |\n| Loss on settlement of litigation | 550,000 | — |\n| Stock based compensation for services | 10,071,830 | 1,641,877 |\n| Change in operating assets and liabilities: |\n| Accounts receivable | ( 85,906 | ) | ( 19,900 | ) |\n| Inventories | — | ( 7,212 | ) |\n| Deposits, prepayments and other receivables | ( 9,091 | ) | ( 7,005 | ) |\n| Contract liabilities | 16,936 | 8,275 |\n| Accounts payables | 50,424 | 61 |\n| Accrued liabilities and other payables | ( 474,932 | ) | ( 37,960 | ) |\n| Advances to related parties | 127,500 | ( 76,278 | ) |\n| Right of use assets | 28,498 | — |\n| Operating lease liabilities | ( 29,064 | ) | — |\n| Net cash used in operating activities | ( 2,639,775 | ) | ( 970,647 | ) |\n| Cash flows from investing activities: |\n| Purchase of investment assets | ( 200,000 | ) | — |\n| Net cash used in investing activities | ( 200,000 | ) | — |\n| Cash flows from financing activities: |\n| Proceed from the issuance of Series C preferred stock and exercise of warrants | 8,019,461 | 708,960 |\n| Net cash provided by financing activities | 8,019,461 | 708,960 |\n| Effect on exchange rate change on cash and cash equivalents | 36,098 | 16,689 |\n| NET CHANGE IN CASH AND CASH EQUIVALENTS | 5,215,784 | ( 244,998 | ) |\n| CASH AND CASH EQUIVALENT AT BEGINNING OF PERIOD | 506,666 | 606,491 |\n| CASH AND CASH EQUIVALENT AT END OF PERIOD | $ | 5,722,450 | $ | 361,493 |\n| Supplemental disclosure of cash flow information: |\n| Cash paid for interest | $ | 106 | $ | — |\n| Cash paid for income tax | $ | — | $ | — |\n| NON-CASH INVESTING AND FINANCING ACTIVITIES |\n| Impact of adoption of ASC 842 - lease obligation and ROU asset | $ | 479,171 | $ | — |\n| Waiver of related party debt accounted as capital transaction | $ | 1,444,140 | $ | — |\n| Fair value of preferred stock issued for services | $ | 2,948,982 | $ | 793,372 |\n| Fair value of preferred stock accounted and included for issuance cost | $ | 441,642 | $ | — |\n| Common stock issued for accrued salaries | $ | 960,835 | $ | — |\n| Shares cancellation | $ | 15 | $ | — |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n\n| 7 |\n\nNOTE－1 DESCRIPTION OF BUSINESS AND ORGANIZATION\nSociety Pass Incorporated (the “Company”) is incorporated in State of Nevada on June 22, 2018 under the name of Food Society Inc. On October 3, 2018, the Company changed its corporate name to Society Pass Incorporated. The Company through its subsidiaries, mainly sells and distributes the hardware and software of Point of Sales (POS) application in Vietnam.\nDescription of subsidiaries incorporated by the Company\n\n| Schedule of Description of subsidiaries |\n| Name | Place and date of incorporation | Principal activities | Particulars of registered/ paid up share Capital | Effective interest held |\n| Society Technology LLC | State of Nevada , January 24, 2019 | IP Licensing | US$1 | 100 % |\n| SOPA Cognitive Analytics Private Limited | India , February 5, 2019 | Computer sciences consultancy and data analytics | INR1,238,470 | 100 % |\n| SOPA Technology Pte. Ltd . | Singapore , June 4, 2019 | Investment holding | SG$1,250,000 | 100 % |\n| SOPA Technology Company Limited | Vietnam , October 1, 2019 | Software production | Registered: VND 2,307,300,000; Paid up: VND 1,034,029,911 | 100 % |\n| Hottab Pte Ltd. (HPL) | Singapore , January 17, 2015 | Software development and marketing for the F&B industry | SG$620,287.75 | 100 % |\n| Hottab Vietnam Co. Ltd | Vietnam , April 17, 2015 | Sale of POS hardware and software | VND 1,000,000,000 | 100 % |\n| Hottab Asset Company Limited | Vietnam , July 25, 2019 | Sale of POS hardware and software | VND 5,000,000,000 | 100 % |\n\nThe Company and its subsidiaries are hereinafter referred to as (the “Company”).\nOn October 29, 2019 with the revised provision dated November 11, 2019, the Company acquired Hottab Pte Ltd and its subsidiaries, at the consideration of $ 1,050,000 consisted of Series C preference shares valued at $ 900,000 and the cash consideration of $ 150,000 . The value of the $900,000 Series C preference shares issued was determined based on the stated value per share of the Company’s shares at the acquisition date. Also, the Company shall pay to the Company additional Series C preference shares with an aggregate value of $ 558,000 (the “Equity Incentive”) in the event the Company able to fulfilled the other terms per their arrangement with in five months from the completion date.\nOn February 10, 2021, the Company effected a 750 for 1 stock split of the issued and outstanding shares of the Company’s common stock. The number of authorized shares and par value remain unchanged. All share and per share information in this financial statements and footnotes have been retroactively adjusted for the period and years presented, unless otherwise indicated, to give effect to the forward stock split.\nOn September 21, 2021, the Company effected a 1 for 2.5 stock split of the issued and outstanding shares of the Company’s common stock. The number of authorized shares and par value remain unchanged. All share and per share information in this financial statements and footnotes have been retroactively adjusted for the period and years presented, unless otherwise indicated, to give effect to the reverse stock split.\nAn additional result of the stock split was that the stated value of preferred stock, the number of designated shares and outstanding shares of each series of preferred stock was unchanged in accordance to the respective certificate of designations. The number of authorized shares of preferred stock remained unchanged.\n\n| 8 |\n\nSpun Out\nOn December 31, 2019, the Company recently spun out Food Society Group Limited (Food Business), which aims to develop and commercialize chain of restaurants in Vietnam.\nIn connection with the presentation of the Company’s consolidated financial statements, the Company considered the guidance described in the SEC’s codified Staff Accounting Bulletins, Topic 5, Section Z, paragraph 7, “Accounting for the Spin-off of a subsidiary”.\nThe Company’s initial registration of its securities under the 1933 Securities Act and the spin off transaction of the Food Society Group Limited occurred prior to the effectiveness of the Company’s registration statement.\nThe Company considered the following facts and circumstances in concluding omitting the Food Society Group Limited results of operations and financial position in the consolidated financial statements presented in the registration statement:\n• The Company’s operations as a developer of an e-commerce platform and the Food Society Group Limited operations as a two(2) retail restaurants are in dissimilar business that would ordinarily be distinguished as reportable segments as defined by FASB ASC 280-10-50-10.\n• The Company and the subsidiary have been managed and financed historically as if autonomous\n• The Company and the subsidiary have no common facilities or costs\n• The Company and the subsidiary are operated and financed autonomously after the spinoff, and\n• There are no material financial commitments , guarantees or contingent liabilities to each other after the spin off\nAccordingly, the Company has elected to characterize the spin-off of the Food Society Group Limited as a change in the Company’s reporting and present its historical financial statements as if the Company never had an investment in the subsidiary.\nThis spun off our subsidiary Food Society Group Limited which owns 100% of Vietnam Eats (Hong Kong) Limited which owns 100% of Loft Restaurant Service Trading Company Limited that operates 2 restaurants in Vietnam.\nThomas O’Connor, our former Chief Marketing Officer, serves as the legal representative of Loft Restaurant Service Trading Company Limited. Our Chief Executive Officer and Chairman of our board of directors, Dennis Nguyen., is the Chairman of Food Society Group Limited’s board of directors.\nThe two restaurants were making losses for the financial year of 2019. The Company wanted to focus on building our loyalty technology platform. On December 20, 2019’s Board of Directors meeting the CFO presented the case for the spun off. The board voted on the February 18, 2020 to spin out the Food Society Group Limited via a proportionate distribution of shareholding percentage to the existing shareholders as at December 31, 2019.\nNOTE－2 LIQUIDITY AND CAPITAL RESOURCES\nThe accompanying unaudited condensed consolidated financial statements have been prepared using the going concern basis of accounting, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.\nThe Company suffered from an accumulated deficit of 28,116,309 at September 30, 2021. The Company incurred continuous net loss of $ 15,528,998 during the nine months ended September 30, 2021. The continuation of the Company as a going concern is dependent upon the continued financial support from its shareholders. Management believes the Company is currently pursuing additional financing for its operations. However, there is no assurance that the Company will be successful in securing sufficient funds to sustain the operations.\n\n| 9 |\n\nThe registration statement for the Company’s Initial Public Offering became effective on November 8, 2021. On November 8, 2021, the Company entered into an underwriting agreement with Maxim Group LLC, related to the offering of 2,888,889 shares of the Company’s common stock (the “Firm Share”), at a public offering price of $ 9.00 per share. Under the terms of the Underwriting Agreement, the Company has granted the Underwriters an option, exercisable for 45 days, to purchase an additional 236,111 shares of common stock (the “Option Shares”) to cover over-allotments. The Company has raised funding from Initial Public Offering and Option shares of $ 26,000,001 and 2,124,999 . In addition, the Company has raised $ 8,019,461 , net of issuance cost in the form of equity subsequent to issuance of the audit report on the Company’s December 31, 2020 financial statements respectively in the form of equity subsequent to issuance of the audit report on the Company’s December 31, 2020 financial statements and based upon the capital raised, the Company believes it has sufficient liquidity to meet its working capital requirements for the next 12 months. As a result the Company has mitigated any doubts about its ability to continue as a going concern\nThe recent outbreak of COVID-19, which has been declared by the World Health Organization to be a pandemic, has spread across the globe and is impacting worldwide economic activity.. The COVID-19 pandemic has significantly impacted health and economic conditions throughout Vietnam, Singapore and Southeast Asia. National, regional and local governments took a variety of actions to contain the spread of COVID-19, including office and store closures, quarantining suspected COVID-19 patients, and capacity limitations. These developments have significantly impacted the results of operations, financial condition and cash flows of the Company included in this reporting. The impact included the difficulties of working remotely from home including slow Internet connection, the inability of our accounting and financial officers to collaborate as effectively as they would otherwise have in an office environment and issues arising from mandatory state quarantines.\nWhile it is not possible at this time to estimate with sufficient certainty the impact that COVID-19 could have on the Company’s business, the continued spread of COVID-19 and the measures taken by federal, state, local and foreign governments could disrupt the operation of the Company’s business. The COVID-19 outbreak and mitigation measures have also had and may continue to have an adverse impact on global and domestic economic conditions, which could have an adverse effect on the Company’s business and financial condition, including on its potential to conduct financings on terms acceptable to the Company, if at all. In addition, the Company has taken temporary precautionary measures intended to help minimize the risk of the virus to its employees, including temporarily requiring employees to work remotely, and discouraging employee attendance at in-person work-related meetings, which could negatively affect the Company’s business. These measures are continuing. The extent to which the COVID-19 outbreak impacts the Company’s results will depend on future developments that are highly uncertain and cannot be predicted, including new information that may emerge concerning the severity of the virus and the actions to contain its impact.\nNOTE－3 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nThe accompanying unaudited condensed consolidated financial statements reflect the application of certain significant accounting policies as described in this note and elsewhere in the accompanying condensed consolidated financial statements and notes.\n• Basis of presentation\nThe accompanying unaudited interim consolidated condensed financial statements of Society Pass Incorporated have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with Article 8-03 of Regulation S-X. Accordingly, they do not include all the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments, consisting only of normal recurring accruals necessary for a fair statement of financial position, results of operations and cash flows, have been included. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the financial statements and the accompanying notes included in the Company’s registration statement on Form S-1 for the year ended December 31, 2020. The year-end balance sheet data presented for comparative purposes was derived from audited financial statements, but does not include all disclosures required by GAAP. The results of operations for the three and nine months ended September 30, 2021 are not necessarily indicative of the operating results for the year ending December 31, 2021 or for any other subsequent interim period.\n\n| 10 |\n\n• Use of estimates and assumptions\nIn preparing these condensed consolidated financial statements, management makes estimates and assumptions that affect the reported amounts of assets and liabilities in the balance sheet and revenues and expenses during the years reported. Actual results may differ from these estimates. If actual results significantly differ from the Company’s estimates, the Company’s financial condition and results of operations could be materially impacted. Significant estimates in the period include the allowance for doubtful accounts on accounts and other receivables, assumptions used in assessing right of use assets, imputed interest on due to related parties, and impairment of long-term assets, business acquisition allocation of purchase consideration, and deferred tax valuation allowance.\n• Basis of consolidation\nThe condensed consolidated financial statements include the financial statements of the Company and its subsidiaries. All significant inter-company balances and transactions within the Company have been eliminated upon consolidation. In addition, certain amounts in the prior periods’ consolidated financial statements have been reclassified to conform to the current period presentation.\n• Cash and cash equivalents\nCash and cash equivalents are carried at cost and represent cash on hand, demand deposits placed with banks or other financial institutions and all highly liquid investments with an original maturity of three months or less as of the purchase date of such investments. As of September 30, 2021 and December 31, 2020, the cash and cash equivalent was amounted to $ 5,722,450 and $ 506,666 , respectively.\nThe Company currently has bank deposits with financial institutions in the U.S. which does not exceed FDIC insurance limits. FDIC insurance provides protection for bank deposits up to $ 250,000 , so there were uninsured balance of $ 4,895,306 and $ 208,635 in parent entity as of September 30, 2021 and December 31, 2020, respectively. In addition, the Company has uninsured bank deposits with a financial institution outside the U.S. All uninsured bank deposits are held at high quality credit institutions.\n• Accounts receivable\nAccounts receivable are recorded at the invoiced amount and do not bear interest, which are due within contractual payment terms, generally 30 to 90 days from completion of service. Credit is extended based on evaluation of a customer's financial condition, the customer credit-worthiness and their payment history. Accounts receivable outstanding longer than the contractual payment terms are considered past due. Past due balances over 90 days and over a specified amount are reviewed individually for collectibility. At the end of fiscal year, the Company specifically evaluates individual customer’s financial condition, credit history, and the current economic conditions to monitor the progress of the collection of accounts receivables. The Company considers the allowance for doubtful accounts for any estimated losses resulting from the inability of its customers to make required payments. For the receivables that are past due or not being paid according to payment terms, the appropriate actions are taken to exhaust all means of collection, including seeking legal resolution in a court of law. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. The Company does not have any off-balance-sheet credit exposure related to its customers. As of September 30, 2021 and December 31, 2020, the allowance for doubtful accounts amounted to $ 0 and $ 0 , respectively.\n• Inventories\nInventories are stated at the lower of cost or net realizable value, cost being determined on a first-in-first-out method. Costs include hardware equipment and peripheral costs which are purchased from the Company’s suppliers as merchandized goods. The Company provides inventory allowances based on excess and obsolete inventories determined principally by customer demand. During the nine months ended September 30, 2021 and 2020, the Company recorded an allowance for obsolete inventories of $ 0 and $ 0 , respectively. During the three months ended September 30, 2021 and 2020, the Company recorded an allowance for obsolete inventories of $ 0 and $ 0 , respectively. The inventories were amounted to $ 0 and $ 0 at September 30, 2021 and December 31, 2020, respectively.\n\n| 11 |\n\n• Property, plant and equipment\nPlant and equipment are stated at cost less accumulated depreciation and accumulated impairment losses, if any. Depreciation is calculated on the straight-line basis over the following expected useful lives from the date on which they become fully operational and after taking into account their estimated residual values:\n\n| Schedule of Expected useful life |\n| Expected useful lives |\n| Computer equipment | 3 years |\n| Office equipment | 5 years |\n\nExpenditures for repairs and maintenance are expensed as incurred. When assets have been retired or sold, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is recognized in the results of operations.\n• Impairment of long-lived assets\nIn accordance with the provisions of ASC Topic 360, “Impairment or Disposal of Long-Lived Assets”, all long-lived assets such as plant and equipment and intangible assets held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is evaluated by a comparison of the carrying amount of an asset to its estimated future undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amounts of the assets exceed the fair value of the assets. There has been no impairment charge for the periods presented.\n• Revenue recognition\nThe Company adopted Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”). Under ASU 2014-09, the Company applies the following five steps in order to determine the appropriate amount of revenue to be recognized as it fulfills its obligations under each of its agreements:\n\n| • | identify the contract with a customer; |\n| • | identify the performance obligations in the contract; |\n| • | determine the transaction price; |\n| • | allocate the transaction price to performance obligations in the contract; and |\n| • | recognize revenue as the performance obligation is satisfied. |\n\nThe revenues are generated from a diversified a mix of marketplace activities and the services of the Company provide merchants to help them grow their businesses. The revenue streams consist of Consumer Facing revenues and Merchant Facing revenues.\nConsumer Facing Business\nThe Company’s performance obligation includes providing connectivity between merchant and consumer, generally through an online ordering platform. The platform allows merchants to create account, place menu and track their sale reports on the merchant facing application. The platform also allows the consumers to create account and make orders from merchants on the consumer facing application. The platform allows delivering company to accept online delivery request and ship order from merchant to consumer.\nThe Company also has online lifestyle platform allow customers to purchase high-end brands of all catergories: Under the Company’s smart search engine, consumers search or review their favorite brands among hundreds of choices in Apparel, Bags & Shoes, Accessory, Health & Beauty, Home & Lifestyle, International, Women, Men and Kids & Babies categories. The platform also allow consumers order from hundreds of vendor choices with personalized promotions based on purchase history and location. The platform has also partnered up with a Vietnam-based delivery company, Tikinow, to offer seamless delivery of product from merchant to consumer’s home or office at the touch of a button. Consumers place orders for delivery or pickup at the Company’s logistics center.\n| 12 |\n\nRevenue streams for consumer facing business:\nF&B sector\n\n| 1) | Ordering fees comprise the fees that the different types of merchants pay for every completed transaction on the Platform, exclusive of delivery fees charged. Monthly/annual subscription fees or 10% commission on order value on each successful order will be charged. |\n\n\n| 2) | Delivery fees include an upfront fixed fee and additional variable fees based on the distance. Various percentage of commission will be charged as delivery fee on each successful order received and delivered. |\n\nThe Company recognizes revenues from consumer facing business upon the completion of delivery and services rendered.\nDuring the period ended September 30, 2021 and 2020, the Company have not generated any revenue from this stream.\nLifestyle sector\n\n| 1) | Customer placed orders on the website / app, sales orders report will be generated in the system. The Company will start to proceed to packaging and delivering customer. The sales recognised. |\n\nDuring the nine months ended September 30, 2021 and 2020, the Company have generated $ 73,518 and $ 0 , respectively revenue from this stream. During the three months ended September 30, 2021 and 2020, the Company have generated $ 73,518 and $ 0 , respectively revenue from this stream.\nMerchant Facing Business\nRevenue streams for merchant facing business include:\n\n| 1) | Subscription fees consist of the fees that the Company charge merchants to get on the Merchant Marketing Program; |\n| 2) | The Company provides optional add-on software services which includes Analytics and Chatbox capabilities at a fixed fee per month. |\n| 3) | The Company collects commissions when they sell third party hardware and equipment (cashier stations, waiter tablets and printers) to merchants. |\n| 4) | Vendor Financing. The Company collects brokerage fees whenever the Company facilitates financing transactions between merchants and one of the Company’s partner financial institutions. |\n\nDuring the nine months ended September 30, 2021 and 2020, the Company have generated $26,970 and $37,752, respectively revenue from this stream. During the three months ended September 30, 2021 and 2020, the Company have generated $10,016 and $11,044, respectively revenue from this stream.\nHardware Product Revenues — the Company generally is involved with the sale of on-premise appliances and end-point devices. The single performance obligation is to transfer the hardware product (which is to be installed with its licensed software integral to the functionality of the hardware product). The entire transaction price is allocated to the hardware product and is generally recognized as revenue at the time of delivery because the customer obtains control of the product at that point in time. It is concluded that control generally transfers at that point in time because the customer has title to the hardware, physical possession, and a present obligation to pay for the hardware. Payments for hardware contracts are generally due 30 to 90 days after shipment of the hardware product.\n\n| 13 |\n\nThe Company records revenues from the sales of third-party products on a “gross” basis pursuant to ASC 606-10 Revenue Recognition – Revenue from Contracts with Customers, when the Company controls the specified good before it is transferred to the end customer and have the risks and rewards as principal in the transaction, such as responsibility for fulfillment, retaining the risk for collection, and establishing the price of the products. If these indicators have not been met, or if indicators of net revenue reporting specified in ASC 606-10 are present in the arrangement, revenue is recognized net of related direct costs.\nSoftware License Revenues — The Company’s performance obligation includes providing connectivity to software, generally through a monthly subscription, where the Company typically satisfies its performance obligations prior to the submission of invoices to the customer for such services. The Company’s software sale arrangements grant customers the right to access and use the software products which are to be installed with the relevant hardware for connectivity at the outset of an arrangement, and to be entitled to both technical support and software upgrades and enhancements during the term of the agreement. The term of the subscription period is generally 12 months, with the automatic renewal of another one year, and the subscription license service is billed monthly, quarterly or annually. Sales are generally recorded in the month the service is provided. For clients who are billed on an annual basis, deferred revenue is recorded and amortized over the life of the contract. Payments are generally due 30 to 90 days after delivery of the software licenses.\nThe Company records its revenues on hardware product and software license, net of value added taxes (“VAT”) upon the services are rendered and the title and risk of loss of hardware products are fully transferred to the customers. The Company is subject to VAT which is levied on the majority of the hardware products at the rate of 10% on the invoiced value of sales.\nContract assets\nIn accordance with ASC 606-10-45-3, contract asset is when the Company’s right to payment for goods and services already transferred to a customer if that right to payment is conditional on something other than the passage of time. The Company will recognize a contract asset when it has fulfilled a contract obligation but must perform other obligations before being entitled to payment.\nThere were no contract assets at September 30, 2021 and December 31, 2020.\nContract liabilities\nIn accordance with ASC 606-10-45-2, a contract liability is Company’s obligation to transfer goods or services to a customer when the customer prepays consideration or when the customer’s consideration is due for goods and services that the Company will yet provide whichever happens earlier.\nContract liabilities represent amounts collected from, or invoiced to, customers in excess of revenues recognized, primarily from the billing of annual subscription agreements. The value of contract liabilities will increase or decrease based on the timing of invoices and recognition of revenue. The Company’s contract liability balance was $ 35,582 and $ 18,646 as of September 30, 2021 and December 31, 2020, respectively.\nContract costs\nUnder ASC-606, the Company applies the following three steps in order to evaluate the costs to be capitalized as it fulfills following three criteria:\n• Incremental costs directly related to a specific contract;\n• Costs that generate or enhance resources of the company that will be used to satisfy performance of the terms of the contract; and\n• Costs that are expected to be recovered from the customer.\nNo contract costs are capitalized for the nine months ended September 30, 2021 and 2020.\nNo contract costs are capitalized for the three months ended September 30, 2021 and 2020.\n\n| 14 |\n\n• Software development costs\nIn accordance with the relevant FASB accounting guidance regarding the development of software to be sold, leased, or marketed, the Company expenses such costs as they are incurred until technological feasibility has been established, at and after which time these costs are capitalized until the product is available for general release to customers. Once the technological feasibility is established per ASC 985-20, the Company capitalizes costs associated with the acquisition or development of major software for internal and external use in the balance sheet. Costs incurred to enhance the Company’s software products, after general market release of the services using the products, is expensed in the period they are incurred. The Company only capitalizes subsequent additions, modifications or upgrades to internally developed software to the extent that such changes allow the software to perform a task it previously did not perform. The Company also expenses website costs as incurred.\nResearch and development expenditures in the development of its own software are charged to operations as incurred. Based on the software development process, technological feasibility is established upon completion of a working model, which also requires certification and extensive testing. Costs incurred by the Company between completion of the working model and the point at which the product is ready for general release are immaterial. For the nine months ended September 30, 2021 and 2020, the software development costs were $ 76,698 and $ 139,151 , respectively. For three months ended September 30, 2021 and 2020, the software development costs were $ 9,709 and $ 33,658 , respectively.\n• Product warranties\nThe Company’s provision for estimated future warranty costs is based upon historical relationship of warranty claims to sales. Based upon historical sales trends and warranties provided by the Company’s suppliers, the Company has concluded that no warranty liability is required as of September 30, 2021 and December 31, 2020. To date, product allowance and returns have been minimal and, based on its experience, the Company believes that returns of its products will continue to be minimal.\n• Shipping and handling costs\nNo shipping and handling costs are associated with the distribution of the products to the customers which are borne by the Company’s suppliers or distributors.\n• Sales and marketing\nSales and marketing expenses include payroll, employee benefits and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $ 85,027 and $ 3,125 for the nine months ended September 30, 2021 and 2020, respectively. For three months ended September 30, 2021 and 2020, the Advertising expense were $ 42,843 and $ 0 , respectively.\n• Income tax\nThe Company adopted the ASC 740 Income Tax provisions of paragraph 740-10-25-13, which addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the condensed consolidated financial statements. Under paragraph 740-10-25-13, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the condensed consolidated financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent (50%) likelihood of being realized upon ultimate settlement. Paragraph 740-10-25-13 also provides guidance on de-recognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures. The Company had no material adjustments to its liabilities for unrecognized income tax benefits according to the provisions of paragraph 740-10-25-13.\n\n| 15 |\n\nThe estimated future tax effects of temporary differences between the tax basis of assets and liabilities are reported in the accompanying balance sheets, as well as tax credit carry-backs and carry-forwards. The Company periodically reviews the recoverability of deferred tax assets recorded on its balance sheets and provides valuation allowances as management deems necessary.\nThe Company and its wholly-owned foreign subsidiary, is subject to income taxes in the jurisdictions in which it operates. Significant judgment is required in determining the provision for income tax. There are many transactions and calculations undertaken during the ordinary course of business for which the ultimate tax determination is uncertain. The company recognizes liabilities for anticipated tax audit issues based on the Company’s current understanding of the tax law. Where the final tax outcome of these matters is different from the carrying amounts, such differences will impact the current and deferred tax provisions in the period in which such determination is made.\n• Uncertain tax positions\nThe Company did not take any uncertain tax positions and had no adjustments to its income tax liabilities or benefits pursuant to the ASC 740 provisions of Section 740-10-25 for the three and nine months ended September 30, 2021 and 2020.\n• Foreign currencies translation and transactions\nThe reporting currency of the Company is United States Dollar (\"US$\") and the accompanying condensed consolidated financial statements have been expressed in US$. In addition, the Company’s subsidiary is operating in the Republic of Vietnam and India and maintains its books and record in its local currency, Vietnam Dong (“VND”) and Indian Rupee (“INR), respectively, which are the functional currency as being the primary currency of the economic environment in which their operations are conducted. In general, for consolidation purposes, assets and liabilities of its subsidiaries whose functional currency is not US$ are translated into US$, in accordance with ASC Topic 830-30, “Translation of Financial Statement”, using the exchange rate on the balance sheet date. Shareholders’ equity is translated using the historical rates. Revenues and expenses are translated at average rates prevailing during the year. The gains and losses resulting from translation of financial statements of foreign subsidiary are recorded as a separate component of accumulated other comprehensive income within the statements of changes in shareholder’s equity.\nTranslation of amounts from SGD$ into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\n\n| Schedule of Foreign currencies translation and transactions |\n| September 30, 2021 | September 30, 2020 |\n| Period-end SGD$:US$ exchange rate | $ | 0.73534 | $ | 0.73118 |\n| Period average SGD$:US$ exchange rate | $ | 0.74658 | $ | 0.71922 |\n\nTranslation of amounts from VND into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\n\n| September 30, 2021 | September 30, 2020 |\n| Period-end VND$:US$ exchange rate | $ | 0.000044 | $ | 0.000043 |\n| Period average VND$:US$ exchange rate | $ | 0.000043 | $ | 0.000043 |\n\nTranslation of amounts from INR into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\n\n| September 30, 2021 | September 30, 2020 |\n| Period-end INR$:US$ exchange rate | $ | 0.013463 | $ | 0.013570 |\n| Period average INR$:US$ exchange rate | $ | 0.013576 | $ | 0.013490 |\n\nTranslation gains and losses that arise from exchange rate fluctuations from transactions denominated in a currency other than the functional currency are translated, as the case may be, at the rate on the date of the transaction and included in the results of operations as incurred.\n\n| 16 |\n\nForeign Exchange Loss (Gain). We recorded a foreign exchange gain of $ 8,859 for the three months ended September 30, 2021 as compared to a gain of $ 51,183 for the same period in 2020. Foreign exchange gains and losses are primarily unrealized (non-cash) in nature and results from the re-measuring of specific transactions and monetary accounts in a currency other than the functional currency. For example, a U.S. Dollar transaction which occurs in Singapore is re-measured at the period-end to Singapore dollar amount if it has not been settled previously. The foreign exchange gain for the three months ended September 30, 2021 was due to an increase in the value of the Singapore Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the Singapore dollar to the U.S. Dollar increased 0.56%. At September 30, 2021, the exchange rate was 0.73534 as compared to 0.73118 at September 30, 2020. In addition, a U.S. Dollar transaction which occurs in India is re-measured at the period-end to India dollar amount if it has not been settled previously. The foreign exchange loss for the three months ended September 30, 2021 was due to an increase in the value of the India Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the India dollar to the U.S. Dollar increased 0.79%. At September 30, 2021, the exchange rate was 0.013463 as compared to 0.013570 at September 30, 2020. A U.S. Dollar transaction which occurs in Vietnam is re-measured at the period-end to Vietnameses dollar amount if it has not been settled previously. The foreign exchange gain for the three months ended September 30, 2021 was due to an increase in the value of the Vietnamese Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the Vietnamese dollar to the U.S. Dollar increased 2.32%. At September 30, 2021, the exchange rate was 0.000044 as compared to 0.000043 at September 30, 2020.\n• Comprehensive income\nASC Topic 220, “Comprehensive Income”, establishes standards for reporting and display of comprehensive income, its components and accumulated balances. Comprehensive income as defined includes all changes in equity during a period from non-owner sources. Accumulated other comprehensive income, as presented in the accompanying condensed consolidated statements of changes in shareholders’ equity, consists of changes in unrealized gains and losses on foreign currency translation. This comprehensive income is not included in the computation of income tax expense or benefit.\n• Leases\nThe Company adopted Topic 842, Leases (“ASC 842”) to determine if an arrangement is a lease at inception. Operating leases are included in operating lease right-of-use (“ROU”) assets and operating lease liabilities in the condensed consolidated balance sheets. Finance leases are included in property and equipment, other current liabilities, and other long-term liabilities in the condensed consolidated balance sheets.\nROU assets represent the right to use an underlying asset for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As most of the Company’s leases do not provide an implicit rate, the Company generally use the incremental borrowing rate based on the estimated rate of interest for collateralized borrowing over a similar term of the lease payments at commencement date. The operating lease ROU asset also includes any lease payments made and excludes lease incentives. The lease terms may include options to extend or terminate the lease when it is reasonably certain that the Company will exercise that option. Lease expense for lease payments is recognized on a straight-line basis over the lease term.\n\n| 17 |\n\nIn accordance with the guidance in ASC 842, components of a lease should be split into three categories: lease components (e.g. land, building, etc.), non-lease components (e.g. common area maintenance, consumables, etc.), and non-components (e.g. property taxes, insurance, etc.). Subsequently, the fixed and in-substance fixed contract consideration (including any related to non-components) must be allocated based on the respective relative fair values to the lease components and non-lease components.\nAs of September 30, 2021 and December 31, 2020, the Company recorded the right of use asset of $ 529,782 and $ 79,109 respectively.\n• Related parties\nThe Company follows the ASC 850-10, Related Party for the identification of related parties and disclosure of related party transactions.\nPursuant to section 850-10-20 the related parties include a) affiliates of the Company; b) entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of section 825–10–15, to be accounted for by the equity method by the investing entity; c) trusts for the benefit of employees, such as pension and Income-sharing trusts that are managed by or under the trusteeship of management; d) principal owners of the Company; e) management of the Company; f) other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests; and g) other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.\nThe condensed consolidated financial statements shall include disclosures of material related party transactions, other than compensation arrangements, expense allowances, and other similar items in the ordinary course of business. However, disclosure of transactions that are eliminated in the preparation of consolidated or combined financial statements is not required in those statements. The disclosures shall include: a) the nature of the relationship(s) involved; b) a description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the financial statements; c) the dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period; and d) amount due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement.\n• Commitments and contingencies\nThe Company follows the ASC 450-20, Commitments to report accounting for contingencies. Certain conditions may exist as of the date the financial statements are issued, which may result in a loss to the Company but which will only be resolved when one or more future events occur or fail to occur. The Company assesses such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or un-asserted claims that may result in such proceedings, the Company evaluates the perceived merits of any legal proceedings or un-asserted claims as well as the perceived merits of the amount of relief sought or expected to be sought therein.\nIf the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s consolidated financial statements. If the assessment indicates that a potentially material loss contingency is not probable but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, and an estimate of the range of possible losses, if determinable and material, would be disclosed.\nLoss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the guarantees would be disclosed. Management does not believe, based upon information available at this time that these matters will have a material adverse effect on the Company’s financial position, results of operations or cash flows. However, there is no assurance that such matters will not materially and adversely affect the Company’s business, financial position, and results of operations or cash flows.\n\n| 18 |\n\n• Fair value of financial instruments\nThe Company follows paragraph 825-10-50-10 of the FASB Accounting Standards Codification for disclosures about fair value of its financial instruments and has adopted paragraph 820-10-35-37 of the FASB Accounting Standards Codification (“Paragraph 820-10-35-37”) to measure the fair value of its financial instruments. Paragraph 820-10-35-37 of the FASB Accounting Standards Codification establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. To increase consistency and comparability in fair value measurements and related disclosures, paragraph 820-10-35-37 of the FASB Accounting Standards Codification establishes a fair value hierarchy which prioritizes the inputs to valuation techniques used to measure fair value into three (3) broad levels. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The three (3) levels of fair value hierarchy defined by paragraph 820-10-35-37 of the FASB Accounting Standards Codification are described below:\n\n| Level 1 | Quoted market prices available in active markets for identical assets or liabilities as of the reporting date. |\n| Level 2 | Pricing inputs other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable as of the reporting date. |\n| Level 3 | Pricing inputs that are generally observable inputs and not corroborated by market data. |\n\nFinancial assets are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable.\nThe fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.\nThe carrying amounts of the Company’s financial assets and liabilities, such as cash and cash equivalents, accounts receivable, deposits, prepayments and other receivables, contract liabilities, accrued liabilities and other payables, amounts due to related parties and operating lease liabilities, approximate their fair values because of the short maturity of these instruments.\n• Cost of goods sold\nCost of goods sold consists of the cost of hardware, software and payroll, which are directly attributable to the sales of products. The cost also consists of costs of materials which has been sold attributable to the sales of high-end products. Additional costs may include freight paid to acquire the goods, custom duties, sales or use taxes not recoverable paid on materials used, and any fee for purchase.\n• Share-based compensation\nPursuant to ASU 2018-07, the Company follows ASC 718, Compensation—Stock Compensation (“ASC 718”), which requires the measurement and recognition of compensation expense for all share-based payment awards (employee or non employee), are measured at grant-date fair value of the equity instruments that an entity is obligated to issue. Restricted stock units are valued using the market price of the Company’s common shares on the date of grant. As of September 30, 2021, those shares issued for service compensations were immediately vested, and therefore this amount is thus recognized as expense with an offset to preferred or September 30, 2021 and 2020, the stock-based compensations are recorded in the General and administrative expenses within the Condensed Consolidated Statements of Operations and Other Comprehensive Loss.”\n\n| 19 |\n\n• Business combinations\nThe Company follows ASC 805, Business Combinations (“ASC 805”) and ASC 810-10-65, Consolidation. ASC 805 requires most identifiable assets, liabilities, non-controlling interests, and goodwill acquired in a business combination to be recorded at “fair value.” The statement applies to all business combinations, including combinations among mutual entities and combinations by contract alone. Under ASC 805, all business combinations are accounted for by applying the acquisition method. Accounting for goodwill requires significant management estimates and judgment. Management performs periodic reviews of the carrying value of goodwill to determine whether events and circumstances indicate that an impairment in value may have occurred. A variety of factors could cause the carrying value of goodwill to become impaired. A write-down of the carrying value of goodwill could result in a non-cash charge, which could have an adverse effect on the Company’s results of operations.\n• Earnings per share\nBasic per share amounts are calculated using the weighted average shares outstanding during the year, excluding unvested restricted stock units. The Company uses the treasury stock method to determine the dilutive effect of stock options and other dilutive instruments. Under the treasury stock method, only “in the money” dilutive instruments impact the diluted calculations in computing diluted earnings per share. Diluted calculations reflect the weighted average incremental common shares that would be issued upon exercise of dilutive options assuming the proceeds would be used to repurchase shares at average market prices for the period.\nAs of September 30, 2021 and December 31, 2020, the Company has the number of shares of common stock to be issued upon conversion of below:\n\n| Schedule of Common stock issued |\n| As of September 30, | As of December 31, |\n| 2021 | 2020 |\n| Series A Convertible Preferred Stock (a) | 8,000 | 8,000 |\n| Series B Convertible Preferred Stock | 764,400 | 764,400 |\n| Series B-1 Convertible Preferred Stock | 48,000 | 48,000 |\n| Series C Convertible Preferred Stock | 465,600 | 108,600 |\n| Series C-1 Convertible Preferred Stock | 4,195,200 | 865,500 |\n| Warrants granted | — | — |\n| Warrants granted with Series C-1 Convertible Preferred Stock | 1,178,700 | 614,100 |\n| Total: | 6,659,900 | 2,408,600 |\n\n\n| (a) | The Series A the conversion formula is aggregate Stated Value divided by IPO price (Stated Value for each Series A preferred share is $1,000). There are 8,000 shares of Series A Preferred Stock issued and outstanding (10,000 shares are designated Series A). The conversion formula would be $8 million (the aggregate stated value) divided by IPO price. |\n\n• Segment Reporting\nASC Topic 280, “Segment Reporting” establishes standards for reporting information about operating segments on a basis consistent with the Company’s internal organization structure as well as information about geographical areas, business segments and major customers in condensed consolidated financial statements. For the nine months ended September 30, 2021 and 2020, the Company operates in two reportable operating segment.\n• Emerging Growth Company\nWe are an “emerging growth company” under the JOBS Act. For as long as we are an “emerging growth company,” we are not required to: (i) comply with any new or revised financial accounting standards that have different effective dates for public and private companies until those standards would otherwise apply to private companies, (ii) provide an auditor’s attestation report on management’s assessment of the effectiveness of internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act, (iii) comply with any new requirements adopted by the Public Company Accounting Oversight Board (“PCAOB”) requiring mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor would be required to provide additional information about the audit and the financial statements of the issuer or (iv) comply with any new audit rules adopted by the PCAOB after April 5, 2012, unless the SEC determines otherwise. However, we have elected to “opt out” of the extended transition period discussed in (i) and will therefore comply with new or revised accounting standards on the applicable dates on which the adoption of such standards are required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to opt out of such extended transition period for compliance with new or revised accounting standards is irrevocable.\n\n| 20 |\n\n• Recent Accounting Pronouncements\nFrom time to time, new accounting pronouncements are issued by the Financial Accounting Standard Board (“FASB”) or other standard setting bodies and adopted by the Company as of the specified effective date. Unless otherwise discussed, the Company believes that the impact of recently issued standards that are not yet effective will not have a material impact on its financial position or results of operations upon adoption.\nAccounting Standards Adopted\nIn August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (“ASU 2018-13”), which eliminates, adds and modifies certain disclosure requirements for fair value measurements. The amendment is effective for interim and annual reporting periods beginning after December 15, 2019. The Company has evaluated and the adoption of this does not have any impact on the financial statements.\nIn November 2018, the FASB issued ASU No. 2018-18, Collaborative Arrangements (“ASU 2018-18”), which clarifies the interaction between ASC 808, Collaborative Arrangements and ASC 606, Revenue from Contracts with Customers. Certain transactions between participants in a collaborative arrangement should be accounted for under ASC 606 when the counterparty is a customer. In addition, ASU 2018-18 precludes an entity from presenting consideration from a transaction in a collaborative arrangement as revenue if the counterparty is not a customer for that transaction. ASU 2018-18 should be applied retrospectively to the date of initial application of ASC 606. This guidance is effective for interim and fiscal periods beginning after December 15, 2019. The Company has evaluated and the adoption of this does not have an any impact on the financial statements.\nAccounting Standards Issued, Not Adopted\nIn June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). This ASU requires measurement and recognition of expected credit losses for financial assets. ASU 2016-13 also requires new disclosures for financial assets measured at amortized cost, loans and available-for-sale debt securities. ASU 2016-13 is effective for the Company beginning January 1, 2023. Entities will apply the standard's provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. The Company is currently evaluating the potential effect of this standard on its financial statements. The Company does not expect this standard to have a material impact on its financial statements.\nIn December 2019, the FASB issued ASU No. 2019-12, Income Taxes: Simplifying the Accounting for Income Taxes (“ASU 2019-12”), which eliminates certain exceptions related to the approach for intraperiod tax allocation, the methodology for calculating income taxes in an interim period and the recognition of deferred tax liabilities for outside basis differences. The new guidance also simplifies aspects of the accounting for franchise taxes and enacted changes in tax laws or rates and clarifies the accounting for transactions that result in a step-up in the tax basis of goodwill. The standard is effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2020, with early adoption permitted. Adoption of the standard requires certain changes to be made prospectively, with some changes to be made retrospectively. The Company does not expect the adoption of this standard to have a material impact on its financial position, results of operations or cash flows.\n\n| 21 |\n\nIn March 2020, the FASB issued ASU 2020-03, “Codification Improvements to Financial Instruments”: The amendments in this update are to clarify, correct errors in, or make minor improvements to a variety of ASC topics. The changes in ASU 2020-03 are not expected to have a significant effect on current accounting practices. The ASU improves various financial instrument topics in the Codification to increase stakeholder awareness of the amendments and to expedite the improvement process by making the Codification easier to understand and easier to apply by eliminating inconsistencies and providing clarifications. The ASU is effective for smaller reporting companies for fiscal years beginning after December 15, 2022 with early application permitted. The Company is currently evaluating the impact the adoption of this guidance may have on its consolidated financial statements.\nIn August 2020, the FASB issued ASU 2020-06 Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40) related to the measurement and disclosure requirements for convertible instruments and contracts in an entity's own equity. The pronouncement simplifies and adds disclosure requirements for the accounting and measurement of convertible instruments and the settlement assessment for contracts in an entity's own equity. This pronouncement is effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2021 and early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. The Company is currently evaluating the impact that this standard will have on its consolidated financial statements.\nNo other new accounting pronouncements were issued or became effective in the period that had, or are expected to have, a material impact on our condensed consolidated Financial Statements.\nNOTE－4 BUSINESS COMBINATION\nOn November 11, 2019, the Company completed the acquisition of 100 % equity interest of Hottab Pte Limited (the “Acquisition”). The total consideration of the acquisition is 156 shares of series C convertible preferred stock, approximately $ 900,000 , cash consideration $ 150,000 and additional series C convertible preferred stock approximately $ 558,000 . The Company accounted for the transaction as an acquisition of a business pursuant to ASC 805, “Business Combinations” (“ASC 805”).\n\n| Schedule of Purchase price allocation |\n| Purchase price allocation: |\n| Fair value of stock at closing | $ | 900,000 |\n| Cash paid | 75,000 |\n| Deferred payments- Cash | 71,422 |\n| Deferred payment- shares | 531,380 |\n| Less cash received | ( 15,337 | ) |\n| Purchase price | $ | 1,562,465 |\n\nThe transaction was accounted for using the acquisition method. Accordingly, goodwill has been measured as the excess of the total consideration over the amounts assigned to the identifiable assets acquired and liabilities assumed based on their preliminary estimated fair values.\nThe deferred payments of $ 633,000 were discounted using the yield on a CCC rated corporate debt for 3-month, 6-month and 9-month maturities, respectively. The implied discount is approximately $ 30,198 , which will be amortized over the term on the payments.\nThe purchase price allocation resulted in $2,766,000 of goodwill, as below:\n\n| Schedule of Acquisition of assets and liability |\n| Acquired assets: |\n| Trade receivables | $ | 6,906 |\n| Other receivables | 1,857 |\n| Total acquired assets | 8,763 |\n| Less: Assumed liabilities |\n| Trade payables | 39,147 |\n| Accrued liabilities and other payable | 68,458 |\n| Amounts due to related parties | 1,080,904 |\n| Deferred revenue | 23,789 |\n| Total Assumed liabilities | 1,212,298 |\n| Fair value of net liabilities assumed | ( 1,203,535 | ) |\n| Goodwill recorded | 2,766,000 |\n| Cash consideration allocated | $ | 1,562,465 |\n\n\n| 22 |\n\nUnder the acquisition method of accounting, the total acquisition consideration price was allocated to the assets acquired and liabilities assumed based on their preliminary estimated fair values. The fair value measurements utilize estimates based on key assumptions of the Acquisition, and historical and current market data. The preliminary allocation of the purchase price is based on the best information available and is pending, amongst other things: (i) the finalization of the valuation of the fair values and useful lives of tangible assets acquired; (ii) the finalization of the valuations and useful lives for the intangible assets acquired; (iii) finalization of the valuation of accounts payable and accrued expenses; and (iv) finalization of the fair value of non-cash consideration.\nThe Acquisition was accounted for as a business combination in accordance with ASC 805 “Business Combinations”. The Company has allocated the purchase price consideration based upon the fair value of the identifiable assets acquired and liabilities assumed on the acquisition date. Management of the Company is responsible for determining the fair value of assets acquired, liabilities assumed and intangible assets identified as of the acquisition date and considered a number of factors including valuations from management estimation. Acquisition-related costs incurred for the acquisitions are not material and have been expensed as incurred in general and administrative expense.\nThe goodwill is not expected to be deductible for tax purposes. The goodwill is fully impaired during the year ended December 31, 2019, because there were continuous operating losses and negative cash flows incurred subsequently. Under ASC 350-20-50, the Company recognized the goodwill impairment loss by comparing the actual operating results of Hottab to the profit forecast and a negative performance is resulted.\nDuring the measurement period (which is the period required to obtain all necessary information that existed at the acquisition date, or to conclude that such information is unavailable, not to exceed one year), additional assets or liabilities may be recognized, or there could be changes to the amounts of assets or liabilities previously recognized on a preliminary basis, if new information is obtained about facts and circumstances that existed as of the acquisition date that, if known, would have resulted in the recognition of these assets or liabilities as of that date. No additional assets or liabilities were recognized during the measurement period, or the changes to the amounts of assets or liabilities previously recognized.\nOn September 30, 2021, the Company served the notification to a related party that certain terms under call option agreement and side letter were no longer effective, in case of non-fulfillment with the milestone conditions as set out in the agreements amounts of $75,000 cash consideration and $558,000 equity incentive. The said amount was written off and accounted as capital transaction and therefore credited the additional paid in capital account as of September 30, 2021.\nNOTE－5 REVENUE\nRevenue consisted of the following deliverables:\n\n| Schedule of Revenue |\n| Three months ended September 30, | Nine months ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Hardware sales | $ | — | $ | 585 | $ | 335 | $ | 3,510 |\n| Software subscription | 10,016 | 11,044 | 26,970 | 37,752 |\n| Sales – online ordering | 73,518 | — | 73,518 | — |\n| $ | 83,534 | $ | 11,629 | $ | 100,823 | $ | 41,262 |\n\n\n| 23 |\n\nIn accordance with ASC 280, Segment Reporting (“ASC 280”), we have two reportable geographic segments:\nSoftware License Revenues. Sales are based on the countries in which the customer is located. Summarized financial information concerning our geographic segments is shown in the following tables:\n\n| Schedule of geographic segments |\n| Three months ended September 30, | Nine months ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Indonesia | $ | 10,016 | $ | 9,788 | $ | 24,813 | $ | 31,604 |\n| Vietnam | — | 1,841 | 2,492 | 9,658 |\n| $ | 10,016 | $ | 11,629 | $ | 27,305 | $ | 41,262 |\n\nOnline Ordering Revenues. Sales are based on the countries in which the customer is located. Summarized financial information concerning our geographic segments is shown in the following tables:\n\n| Three months ended September 30, | Nine months ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Indonesia | $— | $— | $— | $— |\n| Vietnam | 73,518 | — | 73,518 | — |\n| $ | 73,518 | $ | — | $ | 73,518 | $ | — |\n\nContract liabilities recognized was related to software sales only and the following is reconciliation for the periods:\n\n| Schedule of Contract liabilities |\n| Period ended September 30, 2021 | Year ended December 31, 2020 |\n| (Unaudited) |\n| Contract liabilities, brought forward | $ | 18,646 | $ | 19,843 |\n| Add: recognized as deferred revenue | 35,582 | 47,090 |\n| Less: recognized as current period/year revenue | ( 18,646 | ) | ( 48,287 | ) |\n| Contract liabilities, carried forward | $ | 35,582 | $ | 18,646 |\n\nNOTE－6 INTANGIBLE ASSETS\nAs of September 30, 2021 and December 31, 2020, intangible assets consisted of the following:\n\n| Schedule of intangible assets |\n| Useful life | September 30, 2021 | December 31, 2020 |\n| (Unaudited) |\n| At cost: |\n| Software platform | 2.5 years | $ | 8,000,000 | $ | 8,000,000 |\n| Other intangible assets | 3 – 5 years | 1,725 | 1,725 |\n| 8,001,725 | 8,001,725 |\n| Less: accumulated amortization | ( 3,201,725 | ) | ( 801,725 | ) |\n| $ | 4,800,000 | $ | 7,200,000 |\n\n\n| 24 |\n\nOn November 1 2018, the Company entered software development agreement with CVO Advisors Pte Ltd (CVO) 2018 to design and build App and Web-based platform for the total consideration of $8,000,000. CVO who is a third party vendor in the business of designing, developing, operating computer software applications including mobile and web application for social media, big data, point of sales, loyalty rewards, food delivery and technology platforms in Asia. The CVO developer performed and accepted technical work, of software development phase, which was materially completed by December 23, 2018. The Company obtained a third party license (Wallet Factory International Ltd) for their technology build up by CVO.\nThe delivered platform was further developed by the Company’s in-house technology team (based in Noida that Sopa is currently using for the loyalty platform. The platform can be downloaded from Apple store or Googleplay store (i.e. SoPaApp) and the Company’s web version is on www.sopa.asia. The platform was completed developed on September 30, 2020 and has estimated life of 2.5 years. The platform started to be amortized from October 1, 2020.\nFurther, the Company entered subscription agreement with CVO to issued 8,000 shares of preferred stocks for the software development, equal to the aggregate of $ 8,000,000 or at the stated value of $ 1,000 per share.\nPursuant to the subscription agreement entered with CVO, the Company issued 8,000 shares of Series A convertible preferred stock for the purchase of software development at the stated value of $ 1,000 per share, totaling $8,000,000. CVO performed and accepted the technical work such as designing, developing, operating computer software applications including mobile and web application for social media, big data, point of sales, loyalty rewards, food delivery and technology platforms. The holder of this series A provided their consent to waive the warrant provision available with them and accordingly the preferred series A accounted in 2018.\nAlso, owner of CVO entered into call option agreement with the CEO of the Company to sale all the shares of CVO for the sum of $10 per share, as of date, these options were exercised by the CEO of the Company, but the equity holders of CVO Advisors Pte. Ltd. have not honored the exercise of the call. The parties are currently in litigation (refer Note 19). As a result of this option exercise, there was no accounting effect on the Company’s financial statement during the period ended September 30, 2021.\nAmortization of intangible assets attributable to future periods is as follows:\n\n| Schedule of Amortization of intangible assets |\n| Year ending December 31: | Amount |\n| 2021 (remaining period) | $ | 800,000 |\n| 2022 | 3,200,000 |\n| 2023 | 800,000 |\n| Total | $ | 4,800,000 |\n\nAmortization of intangible assets was $ 2,400,000 and $ 1,479 for the nine months ended September 30, 2021 and 2020, respectively.\nAmortization of intangible assets was $ 800,000 and $ 0 for the three months ended September 30, 2021 and 2020, respectively.\nNOTE－ 7 PROPERTY, PLANT AND EQUIPMENT\nProperty, plant and equipment consisted of the following:\n\n| Schedule of Property plant and equipment |\n| September 30, 2021 | December 31, 2020 |\n| (Unaudited) |\n| At cost: |\n| Computer | $ | 29,206 | $ | 29,206 |\n| Office equipment | 1,721 | 1,721 |\n| 30,927 | 30,927 |\n| Less: accumulated depreciation | ( 19,403 | ) | ( 12,755 | ) |\n| Less: exchange difference | ( 444 | ) | ( 103 | ) |\n| $ | 11,080 | $ | 18,069 |\n\nDepreciation expense for the nine months ended September 30, 2021 and 2020 were $ 6,648 and $ 2,968 , respectively.\nDepreciation expense for the three months ended September 30, 2021 and 2020 were $ 2,197 and $ 714 , respectively.\n\n| 25 |\n\nNOTE— 8 ASSET PURCHASE AGREEMENT\nOn February 16, 2021, the Company subsidiary SoPa Technology Pte Ltd (“SoPa Pte Ltd”) acquired certain e-commerce assets from Goodventures Sea Limited (“Goodventures”) pursuant to an Asset Purchase Agreement dated February 16, 2021 (the “Leflair Purchase Agreement”). The acquired assets consisted of intellectual property for it lifestyle e-commerce retail business.\nAs consideration for entering into the Asset Purchase Agreement, the Company agreed to pay Goodventure a total of $ 200,000 in cash payable in installments until April 16, 2021 and 1,500 ordinary shares of SoPa Pte Ltd by April 16, 2021, which represent 15% of the outstanding share capital of SoPa Technology Pte Ltd.\nThe assets acquired by SoPa Pte Ltd under the Leflair Purchase Agreement were substantially all of the assets of an online retail platform that carried the “Leflair” brand name and included a Leflair e-commrce website, Leflair iOs and Android Apps, and backend end infrastructure as well as marketing properties including a customer list and social media pages. In addition, SoPa Technology Ptd Ltd acquired intellectual property such as Leflair logos, trademarks and brands.\nThe Company accounted for this acquisition as an asset acquisition under ASC 805 and that the Company has early adopted the amendments of Regulation S-X dated May 21, 2020 and has concluded that this acquisition was not significant. Accordingly, the presentation of the assets acquired, historical financial statements under Rule 3-05 and related pro forma information under Article 11 of Regulation S-X, respectively, are not required to be presented.\n\n| Schedule of Asset acquisition |\n| Acquired assets: |\n| Intellectual property | $ | 200,000 |\n| Less: Assumed liabilities |\n| Accrued liabilities and other payable | — |\n| Fair value of net assets acquired | 200,000 |\n| Impairment loss recorded | ( 200,000 | ) |\n| Net asset value | $ | — |\n\nThe purchase price of $200,000 shall be allocated amongst the intangible assets acquired, further, these intangible have a short term life as well as the quantum of the value, the company decided to expense it and accounted $ 0 - and $ 200,000 as impairment loss during the three and nine months ended September 30, 2021.\nThe shares issued as part of this transaction do not give the holders the right to influence or control SoPa Pte Ltd. The holders do not have any special voting rights or the right to appoint any board members. SoPa Pte Ltd has not yet issued the shares to the future holders. Since the shares of SoPa Pte Ltd have not yet been issue, no minority interest needs to be recorded as of September 30, 2021.\n\n| 26 |\n\nSoPa Pte Ltd is a private company that was incorporated under the laws of Singapore on June 6, 2019. SoPa Pte Ltd manages Society Pass Incorporated’s operating activities in SEA countries and South Asia. As a pass-through holding company, the value of the 15% interest in the SoPa Pte Ltd to be issued to LeFlair owners has an indeterminate value and no real current value. Society Pass Incorporated plans to record the issuance of the shares at the nominal par value of the shares to be issued to the holders. The value of the assets acquired shall be the value of the cash paid and to be paid to the sellers.\nThe Company has paid $ 200,000 during the period ended September 30, 2021.\nNOTE－9 AMOUNTS DUE FROM (TO) RELATED PARTIES\nAmounts due to related parties consisted of the following:\n\n| Schedule of Amount due to related parties |\n| September 30, 2021 | December 31, 2020 |\n| (Unaudited) |\n| Amounts due to related parties (a) | $ | 24,763 | $ | 96,940 |\n| Amounts due to shareholders (b) | — | 738,964 |\n| Amount due to a director (c) | — | 735,833 |\n| $ | 24,763 | $ | 1,571,737 |\n\n(a) The amounts represented temporary advances to the Company including related parties (two officers), which were unsecured, interest-free and had no fixed terms of repayments. On September 30, 2021, the Company received the notifications that the outstanding amounts of $ 72,176 were forgiven by the related parties, the said amount was written off and accounted as capital transaction and therefore credited the additional paid in capital account as of September 30, 2021. The Company’s due to related parties balance was $ 24,763 and $ 96,940 as of September 30, 2021 and December 31, 2020, respectively.\n(b) In February 2018, the Company entered into MOU with Connect Investment Pte Ltd (Enter Asia) for capital alliance for approximately 27% of shareholdings in the Company. Further, in August 2018, the said MOU was modified and shareholding was revised from 27% to 10% in the Company. However, subsequently in October 2020, it was agreed between both the parties to cease the said MOU with the understanding that there is no current and future obligation with either of them i.e. neither EnterAsia to make investment in the Company nor the Company to issue shares to EnterAsia. Further, the EnterAsia is going to get the shares of the Hottab Holdings Ltd (HHL) for the amount so far invested in the Company and therefore the amount due to EnterAsia is reclassified into the amount due to shareholder “Hottab Holdings Ltd”.\nThis amounts represented temporary advances to the Company by shareholder, which were unsecured, interest-free and had no fixed terms of repayments. On September 30, 2021, the Company received the notifications that the outstanding amounts of $ 738,964 were forgiven by the related parties, the said amount was written off and accounted as capital transaction and therefore credited the additional paid in capital account as of September 30, 2021. The Company’s due to a shareholder balance was $ 0 and $ 738,964 as of September 30, 2021 and December 31, 2020, respectively. Imputed interest is charged at 4.5 % per annum, which was amounted to $ 36,380 and $ 36,381 for the nine months ended September 30, 2021 and 2020, respectively.\n(c) The amount represented paid salaries and bonus to the Director which was unsecured, interest-free and had no fixed terms of repayments. As of June 30, 2021, the Director had $ 960,833 in accrued, but unpaid compensation which could be converted to shares by dividing that amount by the employment agreement conversion price of $ 0.83 to produce 1,157,630 shares. During the period ended September 30, 2021, the Company issued those shares at the fair value of $ 3,854,908 , results into the additional compensation expenses of $ 2,894,075 accounted under stock based compensation account. The Company’s due to a director balance was $- 0 and $ 735,833 as of September 30, 2021 and December 31, 2020, respectively.\n\n| 27 |\n\nAmounts due from related parties\nThe director has advance $ 97,500 during the period ended September 30, 2021, subsequently as of date, the same was recovered by the Company.\nNOTE－10 ACCOUNTS PAYABLE AND ACCRUED LIABILITIES\nAccounts payable consisted of the following:\n\n| Schedule of Accounts payable |\n| September 30, 2021 | December 31, 2020 |\n| (Unaudited) |\n| Accounts payable | $ | 104,680 | $ | 54,256 |\n| Accrued liabilities and other payables- Related Party (a) | 224,669 | 197,548 |\n| Accrued liabilities and other payables (b) | 527,971 | 480,024 |\n| Total Accounts payable | $ | 857,320 | $ | 731,828 |\n\n(a) The amount represented due to three related parties in respect to unpaid salaries, unpaid legal fees and unpaid consulting fees amounted to $ 21,701 , $ 70,104 and $ 132,864 , respectively as of September 30, 2021.\nThe amount represented due to three related parties in respect to unpaid salaries, unpaid legal fees and unpaid consulting fees amounted to $ 5,000 , $ 112,692 and $ 79,856 , respectively as of December 31, 2020.\n(b) Accrued liabilities and other payables consisted of the following:\n\n| Schedule of Accrued liabilities |\n| September 30, 2021 | December 31, 2020 |\n| (Unaudited) |\n| Accrued payroll | $ | 54,528 | $ | 58,092 |\n| Other accrual | 154,325 | 146,826 |\n| Other payables (c) | 245,000 | 245,000 |\n| Accrued vat expenses | 19,932 | 1,788 |\n| Accrued taxes | 54,186 | 28,318 |\n| Total Accrued liabilities | $ | 527,971 | $ | 480,024 |\n\n(c) This included $75,000 related to SOSV. In January 2019, the HPL entered into stock purchase agreement and accelerator contract for equity (ACE) with SOSV IV LLC (SOSV) whereby the HPL will issue shares representing 5% of their capital stock for the amounts of $ 168,000 in three tranche (a) SOSV to pay to the HPL $ 75,000 for integration of Mobile Only Accelerator (MOX) software development kit, (b) SOSV to pay on behalf of the HPL $ 48,000 upon MOX successful application and setting up subsidiary, and (c) SOSV to pay on behalf of the HPL $ 45,000 for setting program for services. The Company received first tranche of $ 75,000 only and thereafter no other two tranche received by the HPL, however, the outcome of the deal did not results success and so later the HPL have not issued any shares to the SOSV, therefore the arrangement amount of $ 75,000 accounted as loan from SOSV. The Company sent the legal letter to the SOSV intimating that the Company acquired HPL by issuing 156 shares of preferred stock series C to Hottab Holding Limited for the 100% acquisition of HPL. As of September 30, 2021 and December 31, 2020, the Company had a total of $ 75,000 and $ 75,000 outstanding on this account, respectively. (refer footnote#19 for legal update).\n\n| 28 |\n\nNOTE－11 LEASES\nWe adopted ASU No. 2016-02, Leases, on January 1, 2019, the beginning of our fiscal 2019, using the modified retrospective approach. We determine whether an arrangement is a lease at inception. This determination generally depends on whether the arrangement conveys the right to control the use of an identified fixed asset explicitly or implicitly for a period of time in exchange for consideration. Control of an underlying asset is conveyed if we obtain the rights to direct the use of and to obtain substantially all of the economic benefit from the use of the underlying asset. Some of our leases include both lease and non-lease components which are accounted for as a single lease component as we have elected the practical expedient. Some of our operating lease agreements include variable lease costs, primarily taxes, insurance, common area maintenance or increases in rental costs related to inflation. Substantially all of our equipment leases and some of our real estate leases have terms of less than one year and, as such, are accounted for as short-term leases as we have elected the practical expedient.\nOperating leases are included in the right-of-use lease assets, other current liabilities and long-term lease liabilities on the Consolidated Balance Sheet. Right-of-use assets and lease liabilities are recognized at each lease’s commencement date based on the present values of its lease payments over its respective lease term. When a borrowing rate is not explicitly available for a lease, our incremental borrowing rate is used based on information available at the lease’s commencement date to determine the present value of its lease payments. Operating lease payments are recognized on a straight-line basis over the lease term. We had no financing leases as of September 30, 2021 and December 31, 2020.\nThe Company adopts a 5.26 % as weighted average incremental borrowing rate to determine the present value of the lease payments. The weighted average remaining life of the lease was 3.48 year.\nDuring the period ended September 30, 2021, the Company enter into new lease arrangements, and accounted as per ASC 842, the ROU asset and lease obligation of $ 479,171 .\nThe Company excludes short-term leases (those with lease terms of less than one year at inception) from the measurement of lease liabilities or right-of-use assets. The following tables summarize the lease expense for the period ended September 30:\n\n| Schedule of Lease expenses |\n| Three months ended September 30, | Nine months ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Operating lease expense (per ASC 842) | $ | 13,554 | $ | 6,076 | $ | 31,975 | $ | 21,802 |\n| Short-term lease expense (other than ASC 842) | 63,363 | 4,627 | 66,420 | 31,258 |\n| Total lease expense | $ | 76,917 | $ | 10,703 | $ | 98,395 | $ | 53,060 |\n\nAs of September 30, 2021, right-of-use assets were $ 529,782 and lease liabilities were $ 533,312 .\nAs of December 31, 2020, right-of-use assets were $ 79,109 and lease liabilities were $ 83,205 .\nComponents of Lease Expense\nWe recognize lease expense on a straight-line basis over the term of our operating leases, as reported within “general and administrative” expense on the accompanying consolidated statement of operations.\nFuture Contractual Lease Payments as of September 30, 2021\nThe below table summarizes our (i) minimum lease payments over the next five years, (ii) lease arrangement implied interest, and (iii) present value of future lease payments for the next three years ending September 30:\n\n| Schedule of Future Contractual Lease Payments |\n| Years ended September 30, | Operating lease amount |\n| 2022 | $ | 190,025 |\n| 2023 | 166,530 |\n| 2024 | 147,813 |\n| 2025 | 77,997 |\n| Total | 582,365 |\n| Less: interest | ( 49,053 | ) |\n| Present value of lease liabilities | $ | 533,312 |\n| Less: non-current portion | ( 365,539 | ) |\n| Present value of lease liabilities – current liability | $ | 167,773 |\n\n\n| 29 |\n\nNOTE－12 SHAREHOLDERS’ DEFICIT\nAuthorized stock\nThe Company is authorized to issue two classes of stock. The total number of shares of stock which the Company is authorized to issue is 100,000,000 shares of capital stock, consisting of 95,000,000 shares of common stock, $ 0.0001 par value per share, and 5,000,000 shares of preferred stock, $ 0.0001 par value per share.\nThe holders of the Company’s common stock are entitled to the following rights:\nVoting Rights: Each share of the Company’s common stock entitles its holder to one vote per share on all matters to be voted or consented upon by the stockholders. Holders of the Company’s common stock are not entitled to cumulative voting rights with respect to the election of directors.\nDividend Right: Subject to limitations under Nevada law and preferences that may apply to any shares of preferred stock that the Company may decide to issue in the future, holders of the Company’s common stock are entitled to receive ratably such dividends or other distributions, if any, as may be declared by the Board of the Company out of funds legally available therefor.\nLiquidation Right:. In the event of the liquidation, dissolution or winding up of our business, the holders of the Company’s common stock are entitled to share ratably in the assets available for distribution after the payment of all of the debts and other liabilities of the Company, subject to the prior rights of the holders of the Company’s preferred stock.\nOther Matters: The holders of the Company’s common stock have no subscription, redemption or conversion privileges. The Company’s common stock does not entitle its holders to preemptive rights. All of the outstanding shares of the Company’s common stock are fully paid and non-assessable. The rights, preferences and privileges of the holders of the Company’s common stock are subject to the rights of the holders of shares of any series of preferred stock which the Company may issue in the future.\nCommon stock outstanding\nAs of September 30, 2021 and December 31, 2020, the Company had a total of 9,695,480 and 7,413,600 shares of its common stock issued and outstanding, respectively.\nOn February 10, 2021, the Company effected a 750 for 1 stock split of the issued and outstanding shares of the Company’s common stock. The number of authorized shares and par value remain unchanged. All share and per share information in this financial statements and footnotes have been retroactively adjusted for the periods presented, unless otherwise indicated, to give effect to the forward stock split.\nOn September 21, 2021, the Company effected a 1 for 2.5 stock split of the issued and outstanding shares of the Company’s common stock. The number of authorized shares and par value remain unchanged. All share and per share information in this financial statements and footnotes have been retroactively adjusted for the periods presented, unless otherwise indicated, to give effect to the reverse stock split.\n\n| 30 |\n\nAn additional result of the stock split was that the stated value of preferred stock, the number of designated shares and outstanding shares of each series of preferred stock was unchanged in accordance to the respective certificate of designations. The number of authorized shares of preferred stock remained unchanged.\nDuring the period ended September 30, 2021 and 2020, the Company issued 824,250 and 1,014,900 shares of common stock for employee services for the value of $ 1,707,557 and $ 1,023,494 , respectively.\nDuring the period ended September 30, 2021 and 2020, the Company issued 1,157,630 and 0 shares of common stock for director’s accrued salaries for the value of $ 960,834 and $ 0 , respectively. The Company accounted $ 2,894,075 additional cost on these share issuance as loss on fair value of shares issued in 2021.\nDuring the period ended September 30, 2021 and 2020, the Company issued 450,000 and 0 shares of common stock for director’s bonus for the value of $ 3,442,499 and $ 0 , respectively.\nDuring the period ended September 30, 2021 and 2020, the Company cancelled 150,000 and 0 shares of common stock at par value.\nWarrants\nIn August 2019, the Company issued 21,000 shares of warrants to one employee for compensation of his service to purchase 21,000 shares of its common stock for the fair value of $17,500. Each share of warrant is converted to one share of common stock at an exercise price of $0.0001. The warrants will expire on the second (2nd) anniversary of the initial date of issuance. As at December 31, 2019, none of the warrants have been exercised. 21,000 shares fully exercised during the year ended December 31, 2020.\nIn December 2020, the Company issued certain numbers of warrants pursuant to the Series C-1 Subscription Agreement. Each redeemable warrant is entitled the holder to purchase one C-1 preferred share at a price of $ 420 per share. The warrants shall be exercisable on or before December 31, 2020 and September 30, 2021. During the nine months ended September 30, 2021, the Company issued 2,120 warrants. During the nine months ended September 30, 2020, the Company issued 1,824 warrants.\nIn December 2020, a total of 838 warrants are exercised in exchanged to 838 Series C-1 preferred shares. (refer note 13 for details).\nOn April 19, 2021, the Company extended the termination date of the Warrant issued to Preferred series C-1 holder by nine months from the expiration date of September 30, 2021 to December 31, 2021. The Company considers this warrant as permanent equity per ASC 815-40-35-2. As such, there is no value assigned to this extension.\nThe Company determined the fair value using the Black-Scholes option pricing model with the following assumptions for the period ended September 30, 2021 and year ended December 31, 2020:\n\n| Schedule of Stock option assumptions |\n| September 30, 2021 | December 31, 2020 |\n| Dividend rate | 0 | % | 0 | % |\n| Risk-free rate | 2 | % | 2 | % |\n| Weighted average expected life (years) | 9 months | 9 months |\n| Expected volatility | 0 | % | 0 | %(a) |\n| Share price | $ | 0.22 | $ | 0.22 |\n\n\n| (a) | The Company considered no volatility as from inception through the date there is very minimal transaction of the Company common stock. |\n\n\n| 31 |\n\nBelow is a summary of the Company’s issued and outstanding warrants as of September 30, 2021 and December 31, 2020:\n| Schedule of warrants issued and outstanding |\n| Warrants | Weighted average exercise price | Weighted average remaining contractual life (in years) |\n| Outstanding as of December 31, 2019 (a) | 21,000 | $ | 0.0001 | 1.3 |\n| Issued (b) | 4,094 | $ | 420 | 0.9 |\n| Exercised | ( 21,838 | ) | $ | ( 6.34 | ) | 1 |\n| Expired | ( 1,209 | ) | $ | ( 420 | ) | ( 0.6 | ) |\n| Outstanding as of December 31, 2020 | 2,047 | $ | 420 | 0.6 |\n| Issued (b) | 2,120 | $ | 420 | 0.5 |\n| Exercised | ( 238 | ) | $ | ( 420 | ) | — |\n| Expired | — | — | — |\n| Outstanding as of September 30, 2021 (b) | 3,929 | $ | 420 | 0.5 |\n\nThere is no intrinsic value for warrants as of September 30, 2021 and December 31, 2020.\n\n| (a) | Common stock will be issued if those warrants exercise. |\n\n\n| (b) | Preferred stock series C-1 will be issued if those warrants exercise. |\n\nNOTE－13 PREFERRED STOCKS AND WARRANTS\nAs of September 30, 2021 and December 31, 2020, the Company’s preferred stocks have been designated as follow:\n\n| Schedule of Preferred stocks |\n| No. of shares | Stated Value |\n| Series A Convertible Preferred Stock | 10,000 | $ | 1,000 |\n| Series B Convertible Preferred Stock | 10,000 | $ | 1,336 |\n| Series B-1 Convertible Preferred Stock | 15,000 | $ | 2,917 |\n| Series C Convertible Preferred Stock | 15,000 | $ | 5,763 |\n| Series C-1 Convertible Preferred Stock | 30,000 | $ | 420 |\n| Series X Super Voting Preferred Stock | 3,500 | $ | 0.0001 |\n\nAll of the Series A, B, B-1, C, and C-1 Preferred Shares were issued at a value of respective stated value per share. These all Series of Preferred Shares contain a conversion option, are convert into a fixed number of common shares or redeemable with the cash repayment at the liquidation, so as a result of this liquidation preference, under U.S GAAP, the Company has classified the all these Series of Preferred Shares within mezzanine equity in the condensed consolidated balance sheet.\nSeries X Super Voting Preferred Stock was issued a par value per share. This Series of Preferred Shares does not contain a conversion option, so as a result of this liquidation preference, under U.S GAAP, the Company has classified the this Series of Preferred Shares within permanent equity in the condensed consolidated balance sheet.\nVoting Rights: (1) The affirmative vote of at least a majority of the holders of each series of preferred stock shall be necessary to:\n\n| (a) | increase or decrease the par value of the shares of the Series A Preferred Stock, alter or change the powers, preferences or rights of the shares of Series A Preferred Stock or create, alter or change the powers, preferences or rights of any other capital stock of the Company if after such alteration or change such capital stock would be senior to or pari passu with Series A Preferred Stock; and |\n\n\n| (a) | adversely affect the shares of Series A Preferred Stock, including in connection with a merger, recapitalization, reorganization or otherwise. |\n\n\n| 32 |\n\n(2) The affirmative vote of at least a majority of the holders of the shares of the Series A Preferred Stock shall be necessary to:\n\n| (a) | enter into a transaction or series of related transactions deemed to be a liquidation, dissolution or winding up of the Corporation, or voluntarily liquidate or dissolve; |\n\n\n| (b) | authorize a merger, acquisition or sale of substantially all of the assets of the Company or any of its subsidiaries (other than a merger exclusively to effect a change of domicile of the Company to another state of the United States); |\n\n\n| (c) | increase or decrease (other than decreases resulting from conversion of the Series A Preferred Stock) the authorized number of shares of the Company’s preferred stock or any series thereof, the number of shares of the Company’s common stock or any series thereof or the number of shares of any other class or series of capital stock of the Company; and |\n\n\n| (d) | any repurchase or redemption of capital stock of the Company except any repurchase or redemption at cost upon the termination of services of a service provider to the Company or the exercise by the Company of contractual rights of first refusal as applied to such capital stock. |\n\nDividend Rights: The holders of the Company’s preferred stock are not entitled to any dividend rights.\nConversion Rights (Series A Preferred Stock): Upon the consummation of this offering, the issued and outstanding shares of Series A Preferred Stock automatically convert into a number of shares of the Company’s common stock equal to the quotient obtained by dividing (x) the aggregate Stated Value of the issued and outstanding Series A Preferred Stock plus any other amounts due to the holders thereof divided by (y) the offering price of the Company’s common stock. If 90 days after conversion, the closing market price of the Company’s common stock as quoted on Nasdaq (the “Market Value”) has decreased below the initial public offering price, each holder of the Series A Preferred Stock shall be issued a warrant to purchase a number of shares of the Company’s common stock equal to 40% of the quotient of the (a) aggregate Stated Value held by such holder before conversion at the initial public offering price and the Market Value of the shares of common stock that were issuable upon conversion divided by (b) the Market Value. The warrants shall have a term of five years and shall be exercisable at the Market Value.\nConversion Rights (Preferred Stock other than Series A and Series X Super Voting Preferred Stock): Upon the consummation of this offering, each issued and outstanding share of Series B Preferred Stock, Series B-1 Preferred Stock, Series C Preferred Stock and Series C-1 Preferred Stock will automatically convert into 750 shares of the Company’s common stock. Series X Super Voting Preferred stock shall not have any rights to convert into the Company’s common stock.\nLiquidation Rights: In the event of any liquidation, dissolution or winding up of the Company, either voluntary or involuntary (a \"Liquidation Event\"), the holders of each series of preferred stock shall be entitled to receive, prior and in preference to any distribution of any of the assets or surplus funds of the Company to the holders of the Company’s common stock by reason of their ownership thereof, an amount per share in cash equal to the greater of (x) the aggregate Stated Value for all shares of such series of Preferred Stock then held by then or (y) the amount payable per share of the Company’s common stock which such holder of preferred stock would have received if such holder had converted to common stock immediately prior to the Liquidation Event all of such series of preferred stock then held by such holder (the \"Series Stock Liquidation Preference\"). If, upon the occurrence of a Liquidation Event, the funds thus distributed among the holders of the preferred stock shall be insufficient to permit the payment to the holders of the preferred stock the full Series Stock Liquidation Preference for all series, then the entire assets and funds of the Company legally available for distribution shall be distributed ratably among the holders of the preferred stock in proportion to the aggregate Series Liquidation Preferences that would otherwise be payable to each of the holders of preferred stock. Such payment shall constitute payment in full to the holders of the preferred stock upon the Liquidation Event. After such payment shall have been made in full, or funds necessary for such payment shall have been set aside by the Company in trust for the account of the holders of preferred stock, so as to be immediately available for such payment, such holders of preferred stock shall be entitled to no further participation in the distribution of the assets of the Company. The sale of all or substantially all of the assets of the Company, or merger, tender offer or other business combination to which the Company is a party in which the voting stockholders of the Company prior to such transaction do not own a majority of the voting securities of the resulting entity or by which any person or group acquires beneficial ownership of 50% or more of the voting securities of the Company or resulting entity shall be deemed to be a Liquidation Event.\n\n| 33 |\n\nOther Matters: The holders of the Company’s preferred stock have no subscription or redemption privileges and are not subject to redemption. The Company’s Series Preferred Stock does not entitle its holders to preemptive rights. All of the outstanding shares of the Company’s preferred stock are fully paid and non-assessable.\nSeries A Preferred Shares\nDuring the year ended December 31, 2018, the Company issued 8,000 shares of Series A convertible preferred stock for the purchase of software at the stated value of $ 1,000 per share, totaling $ 8,000,000 . The holder of this series A provided their consent to waive the warrant provision available with them and accordingly the preferred series A accounted in 2018.\nThere was no Series A Preferred Shares issued during the nine months ended September 30, 2021 and 2020.\nAs of September 30, 2021 and December 31, 2020, there were 8,000 and 8,000 shares of Series A Preferred Shares issued and outstanding, respectively.\nSeries B Preferred Shares\nThere was no Series B Preferred Shares issued during the nine months ended September 30, 2021 and 2020.\nAs of September 30, 2021 and December 31, 2020, there were 2,548 and 2,548 shares of Series B Preferred Shares issued and outstanding, respectively.\nSeries B-1 Preferred Shares\nThere was no Series B-1 Preferred Shares issued during the nine months ended September 30, 2021 and 2020.\nAs of September 30, 2021 and December 31, 2020, there were 160 and 160 shares of Series B-1 Preferred Shares issued and outstanding, respectively.\nSeries C Preferred Shares\nDuring the nine months ended September 30, 2021, the Company issued 1,116 and 74 shares of Series C preferred stock for cash in private placement and consulting services for the value of $ 6,431,508 and $ 426,462 , respectively.\nDuring the nine months ended September 30, 2021, the Company incurred the issuance cost on above Series C private placement accounted $ 195,942 in shares and $ 460,361 in cash.\nThere was no Series C Preferred Shares issued during the nine months ended September 30, 2020.\nAs of September 30, 2021 and December 31, 2020, there were 1,552 and 362 shares of Series C Preferred Shares issued and outstanding, respectively.\nSeries C-1 Preferred Shares\nThe Company accounts for warrants issued in accordance with the guidance on “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity” in Topic 480. These warrants did not meet the criteria to be classified as a liability award and therefore were treated as an equity award and classified the Series C-1 Preferred Shares within mezzanine equity in the condensed consolidated balance sheet.\n\n| 34 |\n\nDuring the period ended September 30, 2021, the Company issued 6,235 and 4,864 shares of Series C-1 preferred stock for cash in private placement and consulting services for the value of $ 2,618,700 (out of which $479,640 is received subsequent to September 30, 2021) and $ 2,042,880 , respectively.\nDuring the nine months ended September 30, 2021, the Company incurred the issuance cost on above series C-1 private placement accounted $ 245,700 in shares and $ 90,748 in cash. There is no issuance cost incurred in 2020.\nDuring the period ended September 30, 2020, the Company issued 1,688 and 571 shares of Series C-1 preferred stock for cash in private placement and consulting services for the value of $ 708,960 and $ 239,820 , respectively.\nAs of September 30, 2021 and December 31, 2020, there were 13,984 and 2,885 shares of Series C-1 Preferred Shares issued and outstanding, respectively.\nSeries X Super Voting Preferred Shares\nIn August 2021, the Company created a new series of preferred stock to be titled “Series X Super Voting Preferred Stock,” consisting of 2,000 shares and to provide to such preferred stock certain rights and privileges including but not limited to the right to 10,000 votes per share (post reverse split: 4,000 votes per share) to vote on all matters that may come before the stockholders of the Corporation, voting together with the common stock as a single class on all matters to be voted or consented upon by the stockholders but is not entitled to any dividends, liquidation preference or conversion or redemption rights, so accordingly it is accounted as an equity classification. In September 2021, the Company increased the number of shares designated as Series X Super Voting Preferred to 3,500.\nDuring the period ended September 30, 2021 and 2020, the Company issued 3,500 and 0 shares of Series C-preferred stock at par value, respectively.\nAs of September 30, 2021 and December 31, 2020, there were 3,500 and 0 shares of Series C Preferred Shares issued and outstanding, respectively.\nNOTE－ 14 INCOME TAXES\nFor the nine months ended September 30, 2021 and 2020, the local (“Nevada”) and foreign components of loss before income taxes were comprised of the following:\n\n| Schedule of Loss before income tax |\n| Nine months ended September 30, |\n| 2021 | 2020 |\n| Tax jurisdiction from: |\n| - Local | $ | 14,272,684 | $ | — |\n| - Foreign | 1,246,371 | 2,507,042 |\n| Loss before income taxes | $ | 15,519,055 | $ | 2,507,042 |\n\nThe provision for income taxes consisted of the following:\n\n| Schedule of provision for income taxes |\n| Nine months ended September 30, |\n| 2021 | 2020 |\n| Current: |\n| - United States | $ | — | $ | — |\n| - Singapore | — | — |\n| - Vietnam | — | — |\n| - India | 9,943 | 15,069 |\n| Deferred: |\n| - United States | — | — |\n| - Singapore | — | — |\n| - Vietnam | — | — |\n| - India | — | — |\n| Income tax expense | $ | 9,943 | $ | 15,069 |\n\n\n| 35 |\n\nThe effective tax rate in the years presented is the result of the mix of income earned in various tax jurisdictions that apply a broad range of income tax rate. The Company operates in various countries: Singapore and Vietnam that are subject to taxes in the jurisdictions in which they operate, as follows:\nUnited States\nThe Company is registered in the Nevada and is subject to the tax laws of United States.\nAs of September 30, 2021, the operation in the United states incurred $ 25,094,900 of cumulative net operating losses which can be carried forward to offset future taxable income. The net operating loss carryforwards has no expiration. The Company has provided for a full valuation allowance against the deferred tax assets of $ 5,269,929 on the expected future tax benefits from the net operating loss carryforwards as the management believes it is more likely than not that these assets will not be realized in the future.\nSingapore\nThe Company’s subsidiary is registered in the Republic of Singapore and is subject to the tax laws of Singapore.\nAs of September 30, 2021, the operation in the Singapore incurred $ 1,437,668 of cumulative net operating losses which can be carried forward to offset future taxable income. The net operating loss carryforwards has no expiration. The Company has provided for a full valuation allowance against the deferred tax assets of $ 230,027 on the expected future tax benefits from the net operating loss carryforwards as the management believes it is more likely than not that these assets will not be realized in the future.\nVietnam\nThe Company’s subsidiary operating in Vietnam is subject to the Vietnam Income Tax at a standard income tax rate of 20 % during its tax year. The reconciliation of income tax rate to the effective income tax rate for the nine months ended September 30, 2021 and 2020 is as follows:\n\n| Schedule of Effective Income Tax Rate Reconciliation |\n| Nine months ended September 30, |\n| 2021 | 2020 |\n| Loss before income taxes | $ | ( 450,407 | ) | $ | ( 233,689 | ) |\n| Statutory income tax rate | 20 | % | 20 | % |\n| Income tax expense at statutory rate | ( 90,081 | ) | ( 46,738 | ) |\n| Tax effect of allowance | 90,081 | 46,738 |\n| Income tax expense | $ | — | $ | — |\n\nAs of September 30, 2021, the operation in the Vietnam incurred $ 859,275 of cumulative net operating losses which can be carried forward to offset future taxable income. The net operating loss carryforwards begin to expire in 2026, if unutilized. The Company has provided for a full valuation allowance against the deferred tax assets of $ 171,855 on the expected future tax benefits from the net operating loss carryforwards as the management believes it is more likely than not that these assets will not be realized in the future.\nIndia\nThe Company’s subsidiary operating in India is subject to the India Income Tax at a standard income tax rate of 25 % during its tax year. The reconciliation of income tax rate to the effective income tax rate for the nine months ended September 30, 2021 and 2020 is as follows:\n\n| Nine months ended September 30, |\n| 2021 | 2020 |\n| Income before income taxes | $ | 17,716 | $ | ( 182,363 | ) |\n| Statutory income tax rate | 25 | % | 15 | % |\n| Income tax expense at statutory rate | 4,429 | ( 27,354 | ) |\n| Tax effect of allowance | 5,514 | 42,423 |\n| Income tax expense | $ | 9,943 | $ | 15,069 |\n\n\n| 36 |\n\nAs of September 30, 2021, the operation in the India incurred $ 17,716 of net operating gain. The Company has provided for a full tax effect allowance against the current and deferred tax expenses of $ 9,943 .\nThe following table sets forth the significant components of the deferred tax assets and liabilities of the Company as of September 30, 2021 and December 31, 2020:\n\n| Schedule of Deferred Tax Assets and Liabilities |\n| September 30, 2021 | December 31, 2020 |\n| (Unaudited) |\n| Deferred tax assets: |\n| Net operating loss carryforwards |\n| - United States | $ | 5,269,929 | $ | 2,171,941 |\n| - Singapore | 230,027 | 131,985 |\n| - Vietnam | 171,855 | 81,774 |\n| - India | — | — |\n| 5,671,811 | 2,385,700 |\n| Less: valuation allowance | ( 5,671,811 | ) | ( 2,385,700 | ) |\n| Deferred tax assets, net | $ | — | $ | — |\n\nNOTE－ 15 PENSION COSTS\nThe Company is required to make contribution to their employees under a government-mandated defined contribution pension scheme for its eligible full-times employees in all countries operating in the Company. The Company is required to contribute a specified percentage of the participants’ relevant income based on their ages and wages level. During the nine months ended September 30, 2021 and 2020, $ 9,655 and $ 5,199 contributions were made accordingly. During the three months ended September 30, 2021 and 2020, $ 5,669 and $ 3,463 contributions were made accordingly.\nNOTE－ 16 RELATED PARTY TRANSACTIONS\nFrom time to time, the shareholder and director of the Company advanced funds to the Company for working capital purpose. Those advances are unsecured, non-interest bearing and due on demand.\nDuring the three month ended September 30, 2021 and 2020, the Company rendered the consultancy service with related parties for the issuance of 2,854 and 571 shares of Series C-1 preferred stock, at the price of $ 1,198,680 and $ 239,820 , respectively.\nDuring the nine month ended September 30, 2021 and 2020, the Company rendered the consultancy service with related parties for the issuance of 4,314 and 571 shares of Series C-1 preferred stock, at the price of $ 1,811,880 and $ 239,820 , respectively.\nThe Company paid and accrued to the directors, the total salaries of $ 196,108 and $ 22,529 and 201,588 and $ 0 during the three months ended September 30, 2021 and 2020, respectively.\nThe Company paid and accrued to the directors, the total salaries of $ 611,193 and $ 22,529 and $ 604,378 and $ 0 during the nine months ended September 30, 2021 and 2020, respectively.\n\n| 37 |\n\nDuring the three months ended September 30, 2021 and 2020, the Company issued 2,134,042 and 3000 shares of Common stock, at the price of $12,570,943 and $ 810,000 for the stock based compensation to director and employee, respectively.\nDuring the nine months ended September 30, 2021 and 2020, the Company issued 2,134,042 and 3000 shares of Common stock, at the price of $ 12,570,943 and 810,000 for the stock based compensation to director and employee, respectively.\nThe company subsidiaries paid and accrued their two officers, total professional fee of $ 5,785 and $ 1,259 and $ 8,310 and $ 1,300 during the three months ended September 30, 2021 and 2020, respectively.\nThe company subsidiaries paid and accrued their two officers, total professional fee of $ 10,307 and $ 1,259 and $ 35,898 and $ 1,300 during the nine months ended September 30, 2021 and 2020, respectively.\nThe Company paid and accrued its shareholders, total professional fee of $ 151,342 and $ 102,412 and $ 31,341 and $ 21,000 during the three months ended September 30, 2021 and 2020, respectively.\nThe Company paid and accrued its shareholders, total professional fee of $ 378,785 and $ 123,412 and $ 102,979 and $ 56,0000 during the nine months ended September 30, 2021 and 2020, respectively.\nDuring August and September 2021, the Company issued 3,300 shares of its Series X Super Voting Preferred Stock (the “Super Voting Preferred Stock”) to the founder and Chief Executive Officer, Mr. Dennis Nguyen and 200 shares of the Super Voting Preferred Stock to Chief Financial Officer, Mr. Raynauld Liang.\nIn August 2021, the Company approved the conversion of Inter-Company loan of $1,249,999 due and owing by Sopa Technology PTE. LTD. (“STPL”), by exchange of 8,500 shares of STPL which represents 85% of the total issued and paid-up capital of STPL on a fully diluted basis.\nOn September 30, 2021, the Company received the notifications that the outstanding amounts of $ 72,176 and $ 738,964 were forgiven by the related parties. Also, the Company served the notification to a related party that certain terms under call option agreement and side letter were no longer effective, in case of non-fulfillment with the milestone conditions as set out in the agreements amounts of $ 75,000 cash consideration and $ 558,000 equity incentive.\nAs of June 30, 2021, Mr. Nguyen had $ 960,833 in accrued, but unpaid compensation which could be converted to shares by dividing that amount by the employment agreement conversion price of $ 0.83 to produce 1,157,630 shares.\nHOTTAB Asset Vietnam Co Ltd, a company limited by shares incorporated under the laws of Vietnam on July 25, 2019, is currently wholly-owned by Ngo Cham, an employee of HOTTAB Vietnam Co Ltd. HOTTAB Asset Vietnam Co Ltd manages the Group’s website and apps in Vietnam via a contractual relationship. All profits accrued by HOTTAB Asset Vietnam Co Ltd are paid as management fees to HOTTAB Vietnam Co Ltd. HOTTAB Vietnam Co Ltd has an irrevocable call option to acquire 100% of the equity of HOTTAB Asset Vietnam Co Ltd.\nApart from the transactions and balances detailed elsewhere in these accompanying condensed consolidated financial statements, the Company has no other significant or material related party transactions during the periods presented.\nNOTE－17 CONCENTRATIONS OF RISK\nThe Company is exposed to the following concentrations of risk:\n(a) Major customers\nFor the nine months ended September 30, 2021 and 2020, the customers who accounted for 10% or more of the Company’s revenues and its outstanding receivable balances at year-end dates, are presented as follows:\n\n| Schedule of concentrations of risk |\n| Nine months ended September 30, 2021 | September 30, 2021 |\n| Customer | Revenues | Percentage of revenues | Accounts receivable |\n| Customer A | $ | 24,813 | 25 | % | $ | 19,308 |\n| Customer B | $ | 12,615 | 13 | % | $ | — |\n| Customer C | $ | 58,300 | 58 | % | $ | 68,285 | * |\n\n\n| * | - This included value added taxes (“VAT”) |\n\n\n| 38 |\n\n\n| Nine months ended September 30, 2020 | September 30, 2020 |\n| Customer | Revenues | Percentage of revenues | Accounts receivable |\n| Customer A | $ | 31,604 | 76 | % | $ | — |\n\nFor the three months ended September 30, 2021 and 2020, the customers who accounted for 10% or more of the Company’s revenues and its outstanding receivable balances at year-end dates, are presented as follows:\n\n| Three months ended September 30, 2021 |\n| Customer | Revenues | Percentage of revenues |\n| Customer A | $ | 10,016 | 12 | % |\n| Customer B | $ | 12,615 | 13 | % |\n| Customer C | $ | 58,300 | 58 | % |\n\n\n| Three months ended September 30, 2020 |\n| Customer | Revenues | Percentage of revenues |\n| Customer A | $ | 9,789 | 84 | % |\n\nAll customers are located in Vietnam except one located in Indonesia.\n(b) Major vendors\nFor the nine months ended September 30, 2021 and 2020, the vendors who accounts for 10% or more of the Company’s hardware purchases and software cost its outstanding payable balances as at year-end dates, are presented as follows:\n\n| Nine months ended September 30, 2021 | September 30, 2021 |\n| Vendors | Purchases | Percentage of purchases | Accounts payable |\n| Vendor A | $ | 30,577 | 27 % | $ | 44,867 |\n| Vendor B | $ | 17,827 | 16 % |\n\n\n| Nine months ended September 30, 2020 | September 30, 2020 |\n| Vendors | Purchases | Percentage of purchases | Accounts payable |\n| Vendor A | $ | 46,863 | 72 % | $ | — |\n| Vendor B | — | — | — |\n\n\n| 39 |\n\nFor the three months ended September 30, 2021 and 2020, the vendors who accounts for 10% or more of the Company’s hardware purchases and software cost its outstanding payable balances as at year-end dates, are presented as follows:\n\n| Three months ended September 30, 2021 |\n| Purchases | Percentage of purchases |\n| Vendors |\n| Vendor A | $ | — | — |\n\n\n| Three months ended September 30, 2020 |\n| Vendors | Purchases | Percentage of purchases |\n| Vendor A | $ | 24,401 | 90 % |\n| Vendor B | — | — |\n\nAll vendors are located in Vietnam.\n(c) Credit risk\nFinancial instruments that are potentially subject to credit risk consist principally of trade receivables. The Company believes the concentration of credit risk in its trade receivables is substantially mitigated by its ongoing credit evaluation process and relatively short collection terms. The Company does not generally require collateral from customers. The Company evaluates the need for an allowance for doubtful accounts based upon factors surrounding the credit risk of specific customers, historical trends and other information.\n(d) Exchange rate risk\nThe reporting currency of the Company is US$, to date the majority of the revenues and costs are denominated in VND, SGD and INR and a significant portion of the assets and liabilities are denominated in VND, SGD and INR. As a result, the Company is exposed to foreign exchange risk as its revenues and results of operations may be affected by fluctuations in the exchange rate between US$ and VND, SGD and INR. If VND, SGD and INR depreciates against US$, the value of VND, SGD and INR revenues and assets as expressed in US$ financial statements will decline. The Company does not hold any derivative or other financial instruments that expose to substantial market risk.\n(e) Economic and political risks\nThe Company's operations are conducted in the Republic of Vietnam. Accordingly, the Company's business, financial condition and results of operations may be influenced by the political, economic and legal environment in the Vietnam, and by the general state of the Vietnam economy.\nThe Company's operations in the Vietnam and India are subject to special considerations and significant risks not typically associated with companies in North America and Western Europe. These include risks associated with, among others, the political, economic and legal environment and foreign currency exchange. The Company's results may be adversely affected by changes in the political and social conditions in the Vietnam and India, and by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion, remittances abroad, and rates and methods of taxation.\nNOTE－18 COMMITMENTS AND CONTINGENCIES\nAs of September 30, 2021, the Company has no material commitments or contingencies.\nRight issues under Series C-1 preferred stock\nThe Company has issued warrant pursuant to the Series C-1 Subscription Agreement. Each redeemable warrant entitles the holder to purchase two (2) common shares at a price of $168 per share. The warrants shall be exercisable on or before December 31, 2020 and June 30, 2021, respectively. On April 19, 2021, the Company extended the termination date of the Warrant issued to Preferred series C-1 holder by six months from the expiration date of June 30, 2021 to December 31, 2021. The Company considers this warrant as permanent equity per ASC 815-40-35-2. As such, there is no value assigned to this extension.\n\n| 40 |\n\nFinancing arrangement (due to a shareholder)\nIn February 2018, the Company entered into MOU with Connect Investment Pte Ltd (Enter Asia) for capital alliance for approximately 27% of shareholdings in the Company. Further, in August 2018, the said MOU was modified and shareholding was revised from 27% to 10% in the Company. However, subsequently in October 2020, it was agreed between both the parties to cease the said MOU with the understanding that there is no current and future obligation with either of them i.e. neither EnterAsia to make investment in the Company nor the Company to issue shares to EnterAsia. Further, the EnterAsia is going to get the shares of the Hottab Holdings Ltd (HHL) for the amount so far invested in the Company and therefore the amount due to EnterAsia is reclassified into the amount due to shareholder “Hottab Holdings Ltd”.\nSOSV\nIn January 2019, the HPL entered into stock purchase agreement and accelerator contract for equity (ACE) with SOSV IV LLC (SOSV) whereby the HPL will issue shares representing 5% of their capital stock for the amounts of $ 168,000 in three tranche (a) SOSV to pay to the HPL $ 75,000 for integration of Mobile Only Accelerator (MOX) software development kit, (b) SOSV to pay on behalf of the HPL $ 48,000 upon MOX successful application and setting up subsidiary, and (c) SOSV to pay on behalf of the HPL $ 45,000 for setting program for services. The Company received first tranche of $ 75,000 only and thereafter no other two tranche received by the HPL, however, the outcome of the deal did not results success and so later the HPL have not issued any shares to the SOSV, therefore the arrangement amount of $ 75,000 accounted as loan from SOSV. On February 2, 2021, the Company sent the legal letter to the SOSV intimating that the Company acquired HPL by issuing 117,000 preferred stock series C to Hottab Holding Limited for the 100 % acquisition of HPL. As of September 30, 2021 and December 31, 2020, the Company had a total of $ 75,000 and $ 75,000 , outstanding on this account, respectively. (see below for legal update)\nService contracts\nThe Company carries various service contracts on its vendors for repairs, maintenance and inspections. All contracts are short term and can be cancelled.\nMaterial contracts\nOn 28 May 2021, the Company entered into a business cooperation agreement with Paytech Company Limited (“Strategic Partners”) to provide payment integration and loyalty services to the platform that allows merchants to process transactions with consumers. As of date, this program have not started and expected to commence in next year 2022.\nOn 15 August 2021, the Company entered into a business cooperation agreement with Rainbow Loyalty Company Limited (“Strategic Partners”) to provide loyalty services for merchants on the platform. As of date, this program have not started and expected to commence in next year 2022.\nExecutive service agreements\nOn April 1, 2017 the Company entered into an at-will Employment Agreement with Dennis Nguyen, its Chairman and Chief Executive Officer. The Employment Agreement provides for a monthly salary of $ 40,000 ; provided that until the Company has adequate reserves to pay Mr. Nguyen’s salary, he may convert any unpaid salary into common stock of the Company at a share price equal to $ 250 per share. Mr. Nguyen is also entitled to an annual cash bonus of $ 250,000 ; provided that until the Company has adequate reserves to pay Mr. Nguyen’s annual bonus, he may convert any unpaid bonus into common stock of the Company as described above. This provision was inserted into the employment agreement to compensate Mr. Nguyen in stock, at his option, and was to remain operable only until the Company has sufficient cash to pay him his salary in cash. From July 2021 until now, the Company’s cash balance has been at least $ 4 million and the Company has paid Mr. Nguyen his salary in full in every month from July 2021 until now. As a result of these facts, the conversion feature in Mr. Nguyen’s contract became inoperable as of July 1, 2021 and Mr. Nguyen no longer has the option to convert unpaid salary into the Company’s shares. On October 25, 2021, the Company has also amended Mr. Nguyen’s contract to delete the conversion feature to make clear the conversion feature will not be operable in the future. Therefore, the Company will not accrue any expense. Mr. Nguyen is also entitled to participate in all of the other benefits of the Company which are generally available to office employees and other employees of the Company. Mr. Nguyen is not entitled to any severance pay.\nOn September 1, 2021 the Company entered into a 5-year Employment Agreement with Raynauld Liang, its Chief Financial Officer and Singapore Country General Manager. The employment agreement provides Mr. Liang with compensation of (i) an annual base salary of $ 240,000 ; (ii) an annual discretionary incentive cash bonus with a minimum target of 25% of base salary; (iii) 814,950 shares of the Company’s common stock (taking into account the Company’s stock split 1:750 and reverse stock split 1:2.5), of which 651,960 shares are subject to vesting over a two-year period; and (iv) all other executive benefits sponsored by the Company. If a change of control of the Company occurs and if at the time of such change of control the Company’s common stock is trading at a price that is double the initial public offering price, then Mr. Liang will be entitled to a cash bonus equal to three (3) times his base salary. If Mr. Liang is terminated other than for cause or resigns for good reason, he will be entitled to receive continued base salary until the earlier of (x) the anniversary date of such termination and (y) the end of the 5-year term of the employment agreement; provided, however, if the termination is after September 1, 2022, then the period set forth in clause (x) shall be 18 months from the date of the employment agreement. Mr. Liang may terminate the employment agreement at any time other than for good reason with 30 days’ notice to the Company.\n\n| 41 |\n\nLitigation\nFrom time to time, the Company may become involved in various lawsuits and legal proceedings, which arise, in the ordinary course of business. However, litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm the Company’s business. The Company is not aware of any such legal proceedings that will have, individually or in the aggregate, a material adverse effect on its business, financial condition or operating results.\nTwo cases are employment actions filed by former employees who seek compensation alleged to be due pursuant to agreements with the Company. Both of the employees are represented by the same counsel and filed their cases in the Supreme Court of the State of New York, County of New York, in December 2019.\nIn one of those actions, a former employee claims entitlement to compensation and a bonus totaling $566,000 and 39,000-58,500 shares of Company common stock, together with costs. The Company responded to the complaint and also asserted counterclaims in the proceeding for $1,500,000 to $4,000,000 plus punitive damages, together with interest and costs, arising from, inter alia, the former employee’s breach of contract, unfair competition, misappropriation of trade secrets and breach of fiduciary duty. The former employee has responded to the Company’s counterclaims and this action is in the discovery phase of the litigation.\nIn the other employment action, another former employee claims entitlement to salary payments and expense reimbursement in the amount of $ 122,042 .60, plus liquidated damages, together with costs. This former employee also claims entitlement to 516,300 to 760,800 shares of the Company’s common stock. In addition, this action also includes claims by a plaintiff-entity alleging entitlement to $8 million in shares of the Company’s Series A Preferred stock. The Company responded to the complaint and also asserted counterclaims against the former employee in the proceeding for $1,500,000 to $2,000,000 plus punitive damages, together with costs, arising from, inter alia, the former employee’s breach of contract, breach of fiduciary duty, tortious interference and fraud. The former employee has responded to the Company’s counterclaims and this action is still in the discovery phase of litigation.\nThe third case also involves one of those former employees; therein, a Company affiliate filed suit in February 2020 seeking enforcement, by way of specific performance, of an agreement which entitles the affiliate to purchase all of the 99 percent of the shares of the plaintiff-entity which alleges entitlement to $8 million in shares of the Company’s Series A Preferred Stock in one of the employment actions described above. The former employee has responded to the Company’s complaint in this action with a motion to dismiss, which was later withdrawn by same, and then by way of an answer without counterclaims. The judge assigned to this action has announced his retirement and the case has not yet been reassigned.\nThe Company was in an AAA arbitration defending allegations of breach of an agreement. The Demand for Arbitration therein, dated August 25, 2020, asserted that the Petitioner, an LLC, had an agreement with the Company and its CEO granting the Petitioner the right to require the Company to redeem certain common stock in the Company for a cash payment.\nThe Demand alleged that the Petitioner submitted a Redemption Notice, as required under the alleged agreement, obligating the Company to redeem the shares. The Demand alleged that the failure of the Company to redeem the shares and pay Petitioner further obligated the Company to provide additional common stock to the Petitioner. The amount alleged to be due to the Petitioner as of July 31, 2020 was said to be $590,461.94 and growing daily while the number of additional common stock shares alleged to be due to Petitioner as of July 31, 2020 was said to be 708,542,582 and growing, daily.\nIn order to avoid an adverse award, the Company agreed to settle the matter for the sum of $550,000. No additional shares were included in the settlement agreement. The settlement sum was required to be paid in two tranches, with $250,000 to have been paid on or before May 28, 2021 and the remaining $300,000 to be paid on or before June 30, 2021. The Company made the required settlement payments and the matter is now considered closed.\n\n| 42 |\n\nOn or about March 5, 2021, SOSV IV LLC (“SOSV”) sent a demand letter to the Company in regard to its investment in Hottab Pte. Ltd. (“Hottab”).\nIn this letter, and the subsequently filed lawsuits, SOSV alleges that it entered into an investment arrangement with Hottab in which SOSV was to receive five percent (5%) of the common stock of Hottab and entered into an Accelerator Contract for Equity (the “ACE”) pursuant to which it alleges to have invested a sum of $168,000 with Hottab. These events are alleged to have taken place prior to the Company’s acquisition of Hottab. SOSV alleges that the Company subsequently acquired all of the outstanding shares of Hottab, which it alleges triggered a liquidity event clause under the ACE requiring the Company, by way of its ownership of Hottab, to pay SOSV twice its investment, or $336,000.\nSOSV further alleges that subsequent to a term sheet between the Company and Hottab being executed, the Company entered into an agreement to purchase one hundred percent (100%) of the issued and outstanding shares of Hottab from Hottab Holdings Limited (“Hottab Holdings”). As SOSV does not have any interest in Hottab Holdings, it did not receive any consideration as allegedly provided under the ACE.\nUpon these allegations, SOSV asserts causes of action sounding in fraudulent misrepresentation/concealment, breach of contract, breach of the covenant of good faith and fair dealing, quantum meruit and/or unjust enrichment, promissory estoppel, oppression of minority shareholder, and breach of fiduciary duties. SOSV seeks damages in the amount of $336,000.00 in addition damages equal to the value of SOSV’s alleged equity in Hottab or in the alternative shares of the Company in an amount equal to SOSV’s ownership interest in Hottab at the time of the purchase of Hottab’s shares from Hottab Holdings.\nInitially, SOSV filed suit in the District Court for New Jersey on June 10, 2021. SOSV voluntarily dismissed its New Jersey lawsuit and on October 29, 2021, re-filed the action in the Southern District of New York. The New York lawsuit was also voluntarily dismissed by SOSV. However, SOSV may choose to re-file its lawsuit.\nThe Company denies the accusations of SOSV and intends to vigorously defend this matter if the action is re-filed. As the lawsuit has been voluntarily dismissed, there have been no proceedings and we are unable to prognosticate a likelihood of success, or whether SOSV will re-file the action.\nAs of September 30, 2021 and December 31, 2020, the Company had a total of $75,000 and $75,000 outstanding on this account, respectively.\nAs of September 30, 2021, the Company expects no possible loss from these legal proceedings and no provision is accrued accordingly.\n\n| 43 |\n\nNOTE－19 SEGMENT REPORTING\nWe have two reportable segments: (i) e-commerce and (ii) Merchant POS. The e-commerce segment includes the operations of Sopa Technology Company Ltd. Additionally, the Merchant POS segment comprises the operations of Hottab group and SOPA entities except SOPA Technology Company Ltd. Lastly, reported under Merchant POS included acquired operating segment, Hottab group and all SOPA entities except SOPA Technology Company Ltd . Merchant POS includes Hardware sales, subscription sales and e-Commerce includes online ordering such as Fashion & Accessories, Beauty & Personal Care, and Home & Lifestyle.\nOur Chief Operating Decision Maker (CODM) evaluate operating segments using the following table presents revenues and gross profits by reportable segment and asset except liability information.\n| Schedule of Segment Reporting |\n| Nine Months Ended September 30, 2021 |\n| e-Commerce | Merchant POS | Total |\n| Revenue |\n| Hardware sales | $ | — | $ | 335 | $ | 335 |\n| Software subscription | — | 26,970 | 26,970 |\n| Sales – online ordering | 73,518 | — | 73,518 |\n| Total revenue | 73,518 | 27,305 | 100,823 |\n| Cost of sales: |\n| Hardware sales | — | ( 165 | ) | ( 165 | ) |\n| Software subscription | ( 166,761 | ) | ( 39,626 | ) | ( 206,387 | ) |\n| Cost of online ordering | ( 57,741 | ) | — | ( 57,741 | ) |\n| Total cost of revenue | ( 224,502 | ) | ( 39,791 | ) | ( 264,293 | ) |\n| Operating Expenses |\n| Sales and marketing expenses | ( 78,808 | ) | ( 6,219 | ) | ( 85,027 | ) |\n| Software development costs | — | ( 76,698 | ) | ( 76,698 | ) |\n| Impairment loss | ( 200,000 | ) | — | ( 200,000 | ) |\n| General and administrative expenses | ( 73,285 | ) | ( 14,341,077 | ) | ( 14,414,362 | ) |\n| Total operating expenses | ( 352,093 | ) | ( 14,423,994 | ) | ( 14,776,087 | ) |\n| Loss from operations | ( 503,077 | ) | ( 14,436,180 | ) | ( 14,939,557 | ) |\n\n\n| Three Months Ended September 30, 2021 |\n| e-Commerce | Merchant POS | Total |\n| Revenue |\n| Hardware sales | $ | — | $ | — | $ | — |\n| Software subscription | — | 10,016 | 10,016 |\n| Sales – online ordering | 73,518 | — | 73,518 |\n| Total revenue | 73,518 | 10,016 | 83,534 |\n| Cost of sales: |\n| Hardware sales | — | — | — |\n| Software subscription | ( 80,557 | ) | ( 21,138 | ) | ( 101,695 | ) |\n| Cost of online ordering | ( 57,741 | ) | — | ( 57,741 | ) |\n| Total cost of revenue | ( 138,298 | ) | ( 21,138 | ) | ( 159,436 | ) |\n| Operating Expenses |\n| Sales and marketing expenses | ( 40,744 | ) | ( 2,099 | ) | ( 42,843 | ) |\n| Software development costs | — | ( 9,709 | ) | ( 9,709 | ) |\n| Impairment loss | — | — | — |\n| General and administrative expenses | ( 48,658 | ) | ( 8,243,805 | ) | ( 8,292,463 | ) |\n| Total operating expenses | ( 89,402 | ) | ( 8,255,613 | ) | ( 8,345,015 | ) |\n| Loss from operations | ( 154,182 | ) | ( 8,266,735 | ) | ( 8,420,917 | ) |\n\n| 44 |\n\n\n| September 30, 2021 |\n| e-Commerce | Merchant POS | Total |\n| Identifiable assets | $ | 147,950 | $ | 11,170,288 | $ | 11,318,238 |\n\n\n| December 31, 2020 |\n| e-Commerce | Merchant POS | Total |\n| Identifiable assets | $ | — | $ | 7,866,273 | $ | 7,866,273 |\n\n\n| Nine Months Ended September 30, 2020 |\n| e-Commerce | Merchant POS | Total |\n| Revenue |\n| Hardware sales | $ | — | $ | 3,510 | $ | 3,510 |\n| Software subscription | — | 37,752 | 37,752 |\n| Sales – online ordering | — | — | — |\n| Total revenue | — | 41,262 | 41,262 |\n| Cost of sales: |\n| Hardware sales | — | ( 2,982 | ) | ( 2,982 | ) |\n| Software subscription | — | ( 56,127 | ) | ( 56,127 | ) |\n| Cost of online ordering | — | — | — |\n| Total cost of revenue | — | ( 59,109 | ) | ( 59,109 | ) |\n| Operating Expenses |\n| Sales and marketing expenses | — | ( 3,125 | ) | ( 3,125 | ) |\n| Software development costs | — | ( 139,151 | ) | ( 139,151 | ) |\n| Impairment loss | — | ( 8,778 | ) | ( 8,778 | ) |\n| General and administrative expenses | — | ( 2,311,266 | ) | ( 2,311,266 | ) |\n| Total operating expenses | — | ( 2,462,320 | ) | ( 2,462,320 | ) |\n| Loss from operations | — | ( 2,480,167 | ) | ( 2,480,167 | ) |\n\n\n| Three Months Ended September 30, 2020 |\n| e-Commerce | Merchant POS | Total |\n| Revenue |\n| Hardware sales | $ | — | $ | 585 | $ | 585 |\n| Software subscription | — | 11,044 | 11,044 |\n| Sales – online ordering | — | — | — |\n| Total revenue | — | 11,629 | 11,629 |\n| Cost of sales: |\n| Hardware sales | — | ( 585 | ) | ( 585 | ) |\n| Software subscription | — | ( 19,731 | ) | ( 19,731 | ) |\n| Cost of online ordering | — | — | — |\n| Total cost of revenue | — | ( 20,316 | ) | ( 20,316 | ) |\n| Operating Expenses |\n| Sales and marketing expenses | — | — | — |\n| Software development costs | — | ( 33,658 | ) | ( 33,658 | ) |\n| Impairment loss | — | 4,164 | 4,164 |\n| General and administrative expenses | — | ( 1,580,287 | ) | ( 1,580,287 | ) |\n| Total operating expenses | — | ( 1,609,781 | ) | ( 1,609,781 | ) |\n| Loss from operations | — | ( 1,618,468 | ) | ( 1,618,468 | ) |\n\n\n| 45 |\n\nNOTE－20 SUBSEQUENT EVENTS\nIn accordance with ASC Topic 855, “Subsequent Events”, which establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued, the Company has evaluated all events or transactions that occurred after September 30, 2021, up through the date the Company issued the unaudited condensed consolidated financial statements.\nOn November 8, 2021, the Company entered into an underwriting agreement (the “Underwriting Agreement”) with Maxim Group LLC, acting as representative to the underwriters (the “Representative”), related to the initial public offering of 2,888,889 shares of the Company’s common stock, par value $ 0.0001 per share (the “Firm Shares”), at a public offering price of $ 9.00 per share. Under the terms of the Underwriting Agreement, the Company has granted the Underwriters an option, exercisable for 45 days, to purchase up to an additional 433,334 shares of common stock (the “Option Shares”) at a public offering price of $ 9.00 , less discounts and commissions, to cover over-allotments, if any. The Company’s common stock was listed on the Nasdaq Capital Market on November 9, 2021 and began trading on such date. The closings (the “IPO Closings”) of the offering and sale of the Firm Shares and the sale of 236,111 Option Shares occurred on November 12, 2021. Aggregate gross proceeds from the closings related to the Firm Shares and the Option Shares was $ 26,000,001 and $ 2,124,999 , respectively.\nOn December 1, 2021, Leflair Incorporated under the laws of the State of Navada and subsequently share issued to the Company on December 7, 2021 as wholly-owned subsidiary.\nOn December 6, 2021, the Company entered into two consulting agreements with China-America Culture Media Inc. and New Continental Technology Inc., acting as Consultanct to assist the Company in completing certain Business Opportunities with potential partners until February 28, 2023. The consideration of the service are $ 3,250,000 and $ 3,190,000 .\nUpon the IPO Closings, all outstanding shares of preferred stock series A, B, B-1, C and C-1 automatically converted into 888,889 shares, 764,400 shares, 48,000 shares, 465,600 shares and 4,195,200 shares of the Company’s common stock, respectively.\n\n| 46 |\n\n\nItem 2. Management’s discussion and analysis of financial condition and results of operations.\nThe following discussion summarizes the significant factors affecting the operating results, financial condition, liquidity, and cash flows of our Company as of and for the periods presented below. The following discussion and analysis should be read in conjunction with “Selected Consolidated Financial Data,” the condensed consolidated financial statements and the related notes thereto, and the consolidated financial statements and the related notes thereto all included elsewhere in this report. The statements in this discussion regarding industry outlook, our expectations regarding our future performance, liquidity, and capital resources, and all other non-historical statements in this discussion are forward-looking statements and are based on the beliefs of our management, as well as assumptions made by, and information currently available to, our management. Actual results could differ materially from those discussed in or implied by forward-looking statements as a result of various factors, including those discussed in the Company’s final prospectus for its initial public offering on file with the Secuties and Exchange Commision (the “SEC”), particularly in the sections entitled “Special Note Regarding Forward-Looking Statements” and “Risk Factors.”\nOverview\nWe acquire and operate e-commerce platforms through our direct and indirect wholly-owned subsidiaries, including but not limited to Society Technology LLC, SoPa Technology Pte Ltd, SoPa Cognitive Analytics Pte Ltd, Sopa Technology Co Ltd, HOTTAB Pte Ltd and HOTTAB Vietnam Co Ltd. Along with HOTTAB Asset Vietnam Co Ltd (currently wholly-owned by one employee of HOTTAB Vietnam Co Ltd and contractually operated by HOTTAB Vietnam Co Ltd), these eight companies form the Society Pass Group (the “Group”). The Group currently markets to both consumers and merchants in Vietnam while maintaining an administrative headquarters in Singapore. In Feb 2021,we have acquired an online lifestyle platform of Leflair branded assets (the “Leflair Assets”) as more fully described in “Business – Leflair” and are in the process of integrating the Leflair assets with the SoPa and #HOTTAB platform. On 9 November 2021, the Group have been approved for listing on Nasdaq Capital Market (“Nasdaq”) and will trade under the ticker symbol “SOPA”. The Group is a leading Southeast Asian data-driven loyalty platform with its initial offering of 2,888,889 shares of common stock at a price of US$9.00 per share. After the completion of our initial public offering (“IPO”), we intend to expand our e-commerce ecosystem throughout the rest of SEA and South Asia with particular focuses on Philippines, India and Bangladesh.\nOur ecosystem currently comprises of seven e-commerce interfaces targeting consumers and merchants: SoPa food & beverage (“F&B”) App, SoPa.asia F&B Marketplace website, #HOTTAB Biz App, #HOTTAB POS App, Hottab.net admin website, Leflair App, and Leflair Lifetyle Marketplace website (the “Platform”). Our loyalty-focused and data-driven e-commerce marketing platform interfaces connect consumers with merchants in the F&B and lifestyle sectors, assisting local brick-and-mortar businesses to access new customers and markets to thrive in an increasingly convenience-driven economy. Our Platform integrates with both global and country-specific search engines and applications and accepts international address and phone number data, providing a consumer experience that respects local languages, address formats and customs. Our strategic partners work with us to penetrate local markets, while our Platform allows effortless integration with existing technological applications and websites.\nOur consumer facing business consists of our “SoPa” and “Leflair” brands. Through our SoPa F&B App, and SoPa.asia F&B Marketplace website, we provide frictionless online ordering and delivery experience for consumers in the F&B sector. Our Leflair lifestyle e-commerce platform markets and sells products in three verticals: Fashion & Accessories, Beauty & Personal Care, and Home & Lifestyle. Our consumer facing platforms feature an easy-to-navigate, multi-lingual user interface with multiple integrated payment and delivery options\nBranded as “#HOTTAB”, our merchant facing business helps merchants increase revenues and streamline costs with an online and multilingual store front, fully integrated POS software solution, joint marketing program, payment infrastructure, loyalty administration, customer profile analytics, and SME financing packages. Through #HOTTAB Biz App, #HOTTAB POS and Hottab.net merchant administration website interfaces, #HOTTAB functions both online and offline and facilitates transactions, orders, voucher redemption, and rewards. Merchants only need a smart device in order to quickly access our #HOTTAB product ecosystem. In addition, our Customer Care department provides attentive after-sales service.\n\n| 47 |\n\nUpon the expected launch of Society Points in the second half of 2021, consumers will be able to use our Society Points at merchant locations initially throughout Vietnam and then we expect to expand availability of Society Points throughout SEA and South Asia See “Business —Loyalty Points —Society Points.”\nAs of December 6, 2021 we have onboarded over 1.5 million registered consumers and over 5,500 registered merchants on our Platform.\nImpact of the COVID-19 Pandemic\nThe current outbreak of COVID-19 has globally resulted in loss of life, business shutdowns, restrictions on travel, and widespread cancellation of social gatherings. The extent to which the COVID-19 pandemic impacts our business will depend on future developments, which are highly uncertain and cannot be predicted at this time, including:\n\n| • | new information which may emerge concerning the severity of the disease in Vietnam and SEA; |\n\n| • | the duration and spread of the outbreak; |\n\n| • | the severity of travel restrictions imposed by geographic areas in which we operate, mandatory or voluntary business closures; |\n\n| • | regulatory actions taken in response to the pandemic, which may impact merchant operations, consumer and merchant pricing, and our product offerings; |\n\n| • | other business disruptions that affect our workforce; |\n\n| • | the impact on capital and financial markets; and |\n\n| • | action taken throughout the world, including in markets in which we operate, to contain the COVID-19 outbreak or treat its impact. |\n\nIn addition, the current outbreak of COVID-19 has resulted in a widespread global health crisis and adversely affected global economies and financial markets, and similar public health threats could do so in the future. Such events have impacted, and could in the future impact, demand for merchants and consumer purchase patterns, which in turn, could adversely affect our revenue and results of operations.\nSince the onset of the COVID-19 pandemic in March and April 2020, all our POS merchant clients are affected by COVID-19 measures for F&B to temporary stop restaurant dine ins.\n\n| • | Some of our restaurant clients ceased operations permanently and many were closed since June 2020 without any notice of reopening their business to date. |\n\n| • | Our largest POS client, a hotel chain for which we provide POS services to their F&B business in their hotels, ceased operations in two out of nine hotels since April 2020. |\n\n| • | The Company faces challenges to onboard new clients but at the same time losing many existing ones. |\n\nWith the ongoing pandemic, Company faces challenges in our operation as follows;\n\n| • | Disruption of operation in Vietnam, India, Singapore and US where staffs have to work from home. |\n\n| • | The coordination of rebooting of company’s recent asset acquisition of Leflair an ecommerce platform. |\n\n| • | Application of licenses are delayed as government agencies take longer time to review and process time. |\n\n| • | HR process to hire personnel are generally slow due to people not willing to leave their current job, company have to spend more time and resources. |\n\n\n| 48 |\n\nThe spread of COVID-19 has caused us to modify our business practices, including employee travel, employee work locations in certain cases, and cancellation of physical participation in certain meetings, events and conferences and further actions may be taken as required or recommended by government authorities or as we determine are in the best interests of our employees, customers, and other business partners. We are monitoring the global outbreak of the pandemic, in SEA, especially Vietnam and are taking steps in an effort to identify and mitigate the adverse impacts on, and risks to, our business posed by its spread and the governmental and community reactions thereto. See “Risk Factors--Our business may be materially adversely affected by the recent coronavirus (COVID-19) outbreak.\nFinancial Condition\nResults of Operations\nThe following table sets forth certain operational data for the three and nine months ended September 30, 2021 and 2020:\n\n| Three months ended September 30, | Nine months ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Revenue,net | 83,534 | 11,629 | 100,823 | 41,262 |\n| Cost of revenue | (159,436 | ) | (20,316 | ) | (264,293 | ) | (59,109 | ) |\n| Gross loss | (75,902 | ) | (8,687 | ) | (163,470 | ) | (17,847 | ) |\n| Less operating expenses: |\n| Sales and marketing expenses | (42,843 | ) | — | (85,027 | ) | (3,125 | ) |\n| Software development costs | (9,709 | ) | (33,658 | ) | (76,698 | ) | (139,151 | ) |\n| Impairment loss | — | 4,164 | (200,000 | ) | (8,778 | ) |\n| General and administrative expenses | (8,292,463 | ) | (1,580,287 | ) | (14,414,362 | ) | (2,311,266 | ) |\n| Total operating expenses | (8,345,015 | ) | (1,609,781 | ) | (14,776,087 | ) | (2,462,320 | ) |\n| Loss from operations | (8,420,917 | ) | (1,618,468 | ) | (14,939,557 | ) | (2,480,167 | ) |\n| Other income (expense): |\n| Interest income | 55 | 3 | 71 | 11 |\n| Interest expense | (12,272 | ) | (12,261 | ) | (36,486 | ) | (36,381 | ) |\n| Loss on settlement of litigation | — | — | (550,000 | ) | — |\n| Other income | 5,170 | 3,737 | 6,917 | 9,495 |\n| Total other expense | (7,047 | ) | (8,521 | ) | (579,498 | ) | (26,875 | ) |\n| Loss before income taxes | (8,427,964 | ) | (1,626,989 | ) | (15,519,055 | ) | (2,507,042 | ) |\n| Income taxes | (1,303 | ) | (4 | ) | (9,943 | ) | (15,069 | ) |\n| NET LOSS | $ | (8,429,267 | ) | $ | (1,626,993 | ) | $ | (15,528,998 | ) | $ | (2,522,111 | ) |\n\nRevenue. We generated revenues of $83,534 and $ 11,629 for the three months ended September 30, 2021 and 2020 respectively. During the nine month ended September 30, 2021 and 2020 we generated revenue of $100,823 and $41,262 respectively. The significant increase in revenue for three months and nine months was due to more merchants were joining our platform to operate their business.\n\n| 49 |\n\nDuring the nine months ended September 30, 2021 and 2020, the following customer exceeded 10% of the Company’s revenues:\n\n| Nine months ended September 30, 2021 | September 30, 2021 |\n| Customer | Revenues | Percentage of revenues | Accounts receivable |\n| Aryaduta Hospitality & Leisure Group | $ | 24,813 | 25 | % | $ | 19,308 |\n| PayDollars-Payment Gateway | $ | 12,615 | 13 | % | $ | — |\n| Tiki Smart Logistic | $ | 58,300 | 58 | % | $ | 68,285 | * |\n\n* - This included value added taxes (“VAT”)\n\n| Nine months ended September 30, 2020 | September 30, 2020 |\n| Customer | Revenues | Percentage of revenues | Accounts receivable |\n| Aryaduta Hospitality & Leisure Group | $ | 31,604 | 76 | % | $ | — |\n\nFor the three months ended September 30, 2021 and 2020, the customers who accounted for 10% or more of the Company’s revenues and its outstanding receivable balances at year-end dates, are presented as follows:\n\n| Three months ended September 30, 2021 |\n| Customer | Revenues | Percentage of revenues |\n| Aryaduta Hospitality & Leisure Group | $ | 10,016 | 12 | % |\n| PayDollars-Payment Gateway | $ | 12,615 | 13 | % |\n| Tiki Smart Logistic | $ | 58,300 | 58 | % |\n\n\n| Three months ended September 30, 2020 |\n| Customer | Revenues | Percentage of revenues |\n| Aryaduta Hospitality & Leisure Group | $ | 9,789 | 84 | % |\n\nAll of our customers are located in Vietnam except one above significant customer located in Indonesia.\nCost of Revenue. We incurred cost of revenue of $159,436 and $20,316 for three months ended September 30, 2021, and 2020 respectively. During the period of nine months ended September 30,2021 and 2020, we incurred cost of revenue of $264,293 and $59,109 respectively. Cost of revenue increased primarily as a result of the fixed subscription cost and the increased in number of headcounts arising from the acquisition of e-commerce assets from Goodventures Sea Limited.\nMajor vendors\nFor the nine months ended September 30, 2021 and 2020, the vendors who accounts for 10% or more of the Company’s hardware purchases and software cost its outstanding payable balances as at year-end dates, are presented as follows:\n\n| Nine months ended September 30, 2021 | September 30, 2021 |\n| Vendors | Purchases | Percentage of purchases | Accounts payable |\n| Vendor A | $ | 30,577 | 27% | $ | 44,867 |\n| Vendor B | 17,827 | 16% |\n\n\n| Nine months ended September 30, 2020 | September 30, 2020 |\n| Vendors | Purchases | Percentage of purchases | Accounts payable |\n| Vendor A | $ | 46,863 | 72% | $ | — |\n| Vendor B | — | — | — |\n\n\n| 50 |\n\nFor the three months ended September 30, 2021 and 2020, the vendors who accounts for 10% or more of the Company’s hardware purchases and software cost its outstanding payable balances as at year-end dates, are presented as follows:\n\n| Three months ended September 30, 2021 |\n| Vendors | Purchases | Percentage of purchases |\n| Vendor A | $ | — | — |\n\n\n| Three months ended September 30, 2020 |\n| Vendors | Purchases | Percentage of purchases |\n| Vendor A | $ | 24,201 | 90 | % |\n| Vendor B | — | — |\n\nAll vendors are located in Vietnam.\nGross Loss. We recorded a gross loss of $75,902 and $8,687 for three months ended September,30 2021 and 2020 respectively. During the nine months ended September 30,2021 and 2020, we recorded a gross loss of $163,470 and $17,847 respectively. The increase in gross loss is primarily attributable to fixed subscription cost and the number of headcounts arising from the acquisition of e-commerce assets from Goodventures Sea Limited.\nSales and Marketing Expenses (“S&M”). We incurred S&M expenses of $42,843 and $0 for three months ended September 30, 2021 and 2020 respectively. During nine months ended September 30,2021 and 2020, we have incurred S&M expenses of $85,027 and $3,125 respectively. The increase in S&M is primarily attributable to the increased in sales and promotion expenses related to get more merchants joining our e-commerce platform to operate their business. Also, increase marketing cost to attract attention of customer to our e-commerce platform.\nSoftware Development Cost (“SDC”). We incurred SDC expenses of $9,709 and 33,658 for three months ended September 30, 2021 and 2020 respectively. During the nine months ended September 30, 2021 and 2020, we incurred SDC exepenses of $76,698 and $139,151 respectively. The decrease in SDC is primarily attributable to the restructuring of our technology development team.\nImpairment Charge (“IC”). We incurred impairment charge of $200,000 and $8,778 for the nine months ended September 30, 2021, and 2020, respectively. No impairment charge imcurred for the three months ended September 30, 2021 and 2020. The increase is primarily attributable to the acquisition of Leflair ecommerce asset which was expensed in the same period due to the short life term of the asset and the quantum of consideration.\nGeneral and Administrative Expenses (“G&A”). We incurred G&A expenses of $8,292,463 and $1,580,287 for three months ended September 30, 2021 and 2020 respectively. During the nine months ended September 30, 2021 and 2020, we incurred G&A expenses of $14,414,362 and $2,311,266 respectively. The increase in G&A is primarily attributable to the professional cost associated with cost related to company filing for listing on Nasdaq, amortization of intangible assets and Stock based compensation for services.\nLoss on settlement of litigation. On May 21, 2021, the Company has agreed to settle the matter for the sum of $550,000. No additional shares were included in the settlement agreement. The settlement sum is required to be paid in two tranches, with $250,000 to have been paid on or before May 28, 2021 and the remaining $300,000 to be paid on or before June 30, 2021. The Company made the first payment of $250,000 on May 25, 2021 and complete the settlement sum as provided under the settlement agreement by paying the remaining $300,000 on June 29, 2021. In connection with the settlement, the Company recognized litigation settlement expense and a related accrued liability of $550,000 in the period ended September 30, 2021. There is no such expenses incurred in the comparative period ended September 30, 2020.\n\n| 51 |\n\nIncome Tax Expense. Our income tax expenses for the three months ended September 30,2021 and 2020 was $1,303 and $4 and for nine months ended September 30, 2021 and 2020 was $9,943 and $15,069, respectively.\nNet Loss. As a result for the three months ended September 30, 2021, we incurred a net loss of $8,429,267 as compare to the same period ended September 30,2020 of $1,626,993. During nine month ended September 30, 2021 the Group having loss of $15,528,998, as compared to $2,522,111 for the same period ended September 30, 2020. The increase in net loss is primarily attributable to the professional cost associated with cost related to company filing for listing on Nasdaq and amortization of intangible assets.\nLiquidity and Capital Resources\nAs of September 30, 2021, we had cash and cash equivalents of $5,722,450, accounts receivable of $87,803, deposits, prepayments and other receivables of $69,623 and due from related parties of $97,500.\nAs of December 31, 2020, we had cash and cash equivalents of $506,666, accounts receivable of $1,897, deposits, prepayments and other receivables of $60,532.\nThe accompanying consolidated financial statements have been prepared using the going concern basis of accounting, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.\nThe Company suffered from an accumulated deficit of $28,116,309 at September 30, 2021. The Company incurred net loss of $15,528,998 during the nine months ended September 30, 2021. These factors raise substantial doubt about the Company’s ability to continue as a going concern for a period of twelve months from the date of issuance of this financial statement, without additional debt or equity financing. The continuation of the Company as a going concern is dependent upon the continued financial support from its shareholders. Management believes the Company is currently pursuing additional financing for its operations. However, there is no assurance that the Company will be successful in securing sufficient funds to sustain the operations.\nThe registration statement for the Company’s Initial Public Offering became effective on November 8, 2021. On November 8, 2021, the Company entered into an underwriting agreement with Maxim Group LLC, related to the offering of 2,888,889 shares of the Company’s common stock (the “Firm Share”), at a public offering price of $9.00 per share. Under the terms of the Underwriting Agreement, the Company has granted the Underwriters an option, exercisable for 45 days, to purchase an additional 236,111 shares of common stock (the “Option Shares”) to cover over-allotments. The Company has raised funding from Initial Public Offering and Option shares of $26,000,001 and 2,124,999. In addition, the Company has raised $8,019,461, net of issuance cost in the form of equity subsequent to issuance of the audit report on the Company’s December 31, 2020 financial statements respectively in the form of equity subsequent to issuance of the audit report on the Company’s December 31, 2020 financial statements and based upon the capital raised, the Company believes it has sufficient liquidity to meet its working capital requirements for the next 12 months. As a result the Company has mitigated any doubts about its ability to continue as a going concern\nThese consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets and liabilities that may result in the Company not being able to continue as a going concern.\n\n| Nine Months Ended September 30, |\n| 2021 | 2020 |\n| Net cash (used in) operating activities | $ | (2,639,775 | ) | $ | (970,647 | ) |\n| Net cash (used in) investing activities | (200,000 | ) | — |\n| Net cash provided by financing activities | 8,019,461 | 708,960 |\n| Effect on exchange rate change | 36,098 | 16,689 |\n| Net change in cash and cash equivalents | 5,215,784 | (244,998 | ) |\n| Cash and cash equivalent at beginning of period | 506,666 | 606,491 |\n| Cash and cash equivalent at end of period | 5,722,450 | 361,493 |\n\n| 52 |\n\nNet Cash Used In Operating Activities.\nFor the nine months ended September 30, 2021, net cash used in operating activities was $2,639,775, which consisted primarily of a net loss of $15,528,998, offset by increase in stock based compensation for services of $10,071,830, increase in accounts receivables of $85,906, increase in deposits, prepayments and other receivables of $9,091, increase in contract liabilities $16,936, increase in accounts payables of $50,424, decrease in accrued liabilities and other payable of $474,932, increase in advance to related parties of $127,500, decrease in operating lease liabilities of $29,064, increase in depreciation and amortization of $2,406,648, increase in impairment loss of $200,000, increase in loss on settlement of litigation of 550,000.\nFor the nine months ended September 30, 2020, net cash used in operating activities was $970,647, which consisted primarily of net loss of $2,522,111, offset by increase in impairment loss of $8,778, increase in account receivable of $19,900, increase in inventories of $7,212, increase in deposits, prepayment and other receivables of $7005, increase in contract liabilities of $8,275, increase in accounts payable of $61, decrease in accrued liabilities and other payables of $37,960 and decrease in advance to related parties of $76,278.\nWe expect to continue to rely on cash generated through financing from our existing shareholders and private placements of our securities, however, to finance our operations and future acquisitions.\nNet Cash (Used In) Investing Activities.\nFor the nine months ended September 30, 2021, there is net cash of 200,000 being deposit paid for Leflair asset acquisition investing activities.\nFor the nine months ended September 30, 2020, there is no net cash impact on investing activities\nNet Cash Provided By Financing Activities.\nFor the nine months ended September 30, 2021, net cash provided by financing activities was $8,109,461, consisting primarily of funds raised from shareholders for Series C, Series C1 and warrant exercised.\nFor the nine months ended September 30, 2020, net cash provided by financing activities was $708,960, consisting primarily of funds raised from shareholders for Series C and warrant exercised.\nCritical Accounting Policies and Estimate\n• Basis of presentation\nThe accompanying unaudited interim consolidated condensed financial statements of Society Pass Incorporated have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with Article 8-03 of Regulation S-X. Accordingly, they do not include all the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments, consisting only of normal recurring accruals necessary for a fair statement of financial position, results of operations and cash flows, have been included. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the financial statements and the accompanying notes included in the Company’s registration statement on Form S-1 for the year ended December 31, 2020. The year-end balance sheet data presented for comparative purposes was derived from audited financial statements, but does not include all disclosures required by GAAP. The results of operations for the three and nine months ended September 30, 2021 are not necessarily indicative of the operating results for the year ending December 31, 2021 or for any other subsequent interim period.\n\n| 53 |\n\n• Use of estimates and assumptions\nIn preparing these consolidated financial statements, management makes estimates and assumptions that affect the reported amounts of assets and liabilities in the balance sheet and revenues and expenses during the years reported. Actual results may differ from these estimates. If actual results significantly differ from the Company’s estimates, the Company’s financial condition and results of operations could be materially impacted. Significant estimates in the period include the allowance for doubtful accounts on accounts and other receivables, assumptions used in assessing right of use assets, imputed interest on due to related parties, and impairment of long-term assets, business acquisition allocation of purchase consideration, and deferred tax valuation allowance.\n• Basis of consolidation\nThe condensed consolidated financial statements include the financial statements of the Company and its subsidiaries. All significant inter-company balances and transactions within the Company have been eliminated upon consolidation. In addition, certain amounts in the prior periods’ consolidated financial statements have been reclassified to conform to the current period presentation.\n• Cash and cash equivalents\nCash and cash equivalents are carried at cost and represent cash on hand, demand deposits placed with banks or other financial institutions and all highly liquid investments with an original maturity of three months or less as of the purchase date of such investments. As of September 30, 2021 and December 31, 2020, the cash and cash equivalent was amounted to $5,722,450 and $506,666, respectively.\nThe Company currently has bank deposits with financial institutions in the U.S. which does not exceed FDIC insurance limits. FDIC insurance provides protection for bank deposits up to $250,000, so there were uninsured balance of $4,895,306 and $208,635 in parent entity as of September 30, 2021 and December 31, 2020, respectively. In addition, the Company has uninsured bank deposits with a financial institution outside the U.S. All uninsured bank deposits are held at high quality credit institutions.\n• Accounts receivable\nAccounts receivable are recorded at the invoiced amount and do not bear interest, which are due within contractual payment terms, generally 30 to 90 days from completion of service. Credit is extended based on evaluation of a customer's financial condition, the customer credit-worthiness and their payment history. Accounts receivable outstanding longer than the contractual payment terms are considered past due. Past due balances over 90 days and over a specified amount are reviewed individually for collectibility. At the end of fiscal year, the Company specifically evaluates individual customer’s financial condition, credit history, and the current economic conditions to monitor the progress of the collection of accounts receivables. The Company considers the allowance for doubtful accounts for any estimated losses resulting from the inability of its customers to make required payments. For the receivables that are past due or not being paid according to payment terms, the appropriate actions are taken to exhaust all means of collection, including seeking legal resolution in a court of law. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. The Company does not have any off-balance-sheet credit exposure related to its customers. As of September 30, 2021 and December 31, 2020, the allowance for doubtful accounts amounted to $0 and $0, respectively.\n• Inventories\nInventories are stated at the lower of cost or net realizable value, cost being determined on a first-in-first-out method. Costs include hardware equipment and peripheral costs which are purchased from the Company’s suppliers as merchanized goods. The Company provides inventory allowances based on excess and obsolete inventories determined principally by customer demand. During the nine months ended September 30, 2021 and 2020, the Company recorded an allowance for obsolete inventories of $0 and $0, respectively. During the three months ended September 30, 2021 and 2020, the Company recorded an allowance for obsolete inventories of $0 and $0, respectively. The inventories were amounted to $0 and $0 at September 30, 2021 and December 31, 2020, respectively.\n\n| 54 |\n\n• Property, plant and equipment\nPlant and equipment are stated at cost less accumulated depreciation and accumulated impairment losses, if any. Depreciation is calculated on the straight-line basis over the following expected useful lives from the date on which they become fully operational and after taking into account their estimated residual values:\n\n| Expected useful lives |\n| Computer equipment | 3 years |\n| Office equipment | 5 years |\n\nExpenditures for repairs and maintenance are expensed as incurred. When assets have been retired or sold, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is recognized in the results of operations.\n• Impairment of long-lived assets\nIn accordance with the provisions of ASC Topic 360, “Impairment or Disposal of Long-Lived Assets”, all long-lived assets such as plant and equipment and intangible assets held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is evaluated by a comparison of the carrying amount of an asset to its estimated future undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amounts of the assets exceed the fair value of the assets. There has been no impairment charge for the periods presented.\n• Revenue recognition\nThe Company adopted Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”). Under ASU 2014-09, the Company applies the following five steps in order to determine the appropriate amount of revenue to be recognized as it fulfills its obligations under each of its agreements:\n\n| • | identify the contract with a customer; |\n| • | identify the performance obligations in the contract; |\n| • | determine the transaction price; |\n| • | allocate the transaction price to performance obligations in the contract; and |\n| • | recognize revenue as the performance obligation is satisfied. |\n\nThe revenues are generated from a diversified a mix of marketplace activities and the services of the Company provide merchants to help them grow their businesses. The revenue streams consist of Consumer Facing revenues and Merchant Facing revenues.\nConsumer Facing Business\nThe Company’s performance obligation includes providing connectivity between merchant and consumer, generally through an online ordering platform. The platform allows merchants to create account, place menu and track their sale reports on the merchant facing application. The platform also allows the consumers to create account and make orders from merchants on the consumer facing application. The platform allows delivering company to accept online delivery request and ship order from merchant to consumer.\nThe Company also has online lifestyle platform allow customers to purchase high-end brands of all catergories: Under the Company’s smart search engine, consumers search or review their favorite brands among hundreds of choices in Apparel, Bags & Shoes, Accessory, Health & Beauty, Home & Lifestyle, International, Women, Men and Kids & Babies categories. The platform also allow consumers order from hundreds of vendor choices with personalized promotions based on purchase history and location. The platform has also partnered up with a Vietnam-based delivery company, Tikinow, to offer seamless delivery of product from merchant to consumer’s home or office at the touch of a button. Consumers place orders for delivery or pickup at the Company’s logistics center\n| 55 |\n\nRevenue streams for consumer facing business:\nF&B sector\n\n| 1) | Ordering fees comprise the fees that the different types of merchants pay for every completed transaction on the Platform, exclusive of delivery fees charged. Monthly/annual subscription fees or 10% commission on order value on each successful order will be charged. |\n\n\n| 2) | Delivery fees include an upfront fixed fee and additional variable fees based on the distance. Various percentage of commission will be charged as delivery fee on each successful order received and delivered. |\n\nThe Company recognizes revenues from consumer facing business upon the completion of delivery and services rendered.\nDuring the period ended September 30, 2021 and 2020, the Company have not generated any revenue from this stream.\nLifestyle sector\n\n| 1) | Customer placed orders on the website / app, sales orders report will be generated in the system. The Company will start to proceed to packaging and delivering customer. The sales recognised. |\n\nDuring the nine months ended September 30, 2021 and 2020, the Company have generated $73,518 and $0, respectively revenue from this stream. During the three months ended September 30, 2021 and 2020, the Company have generated $73,518 and $0, respectively revenue from this stream.\nMerchant Facing Business\nRevenue streams for merchant facing business include:\n\n| 1) | Subscription fees consist of the fees that the Company charge merchants to get on the Merchant Marketing Program; |\n\n| 2) | The Company provides optional add-on software services which includes Analytics and Chatbox capabilities at a fixed fee per month. |\n\n| 3) | The Company collects commissions when they sell third party hardware and equipment (cashier stations, waiter tablets and printers) to merchants. |\n\n| 4) | Vendor Financing. The Company collects brokerage fees whenever the Company facilitates financing transactions between merchants and one of the Company’s partner financial institutions. |\n\nDuring the nine months ended September 30, 2021 and 2020, the Company have generated $26,970 and $37,752, respectively revenue from this stream. During the three months ended September 30, 2021 and 2020, the Company have generated $10,016 and $11,044, respectively revenue from this stream\nHardware Product Revenues — the Company generally is involved with the sale of on-premise appliances and end-point devices. The single performance obligation is to transfer the hardware product (which is to be installed with its licensed software integral to the functionality of the hardware product). The entire transaction price is allocated to the hardware product and is generally recognized as revenue at the time of delivery because the customer obtains control of the product at that point in time. It is concluded that control generally transfers at that point in time because the customer has title to the hardware, physical possession, and a present obligation to pay for the hardware. Payments for hardware contracts are generally due 30 to 90 days after shipment of the hardware product.\n\n| 56 |\n\nThe Company records revenues from the sales of third-party products on a “gross” basis pursuant to ASC 606-10 Revenue Recognition – Revenue from Contracts with Customers, when the Company controls the specified good before it is transferred to the end customer and have the risks and rewards as principal in the transaction, such as responsibility for fulfillment, retaining the risk for collection, and establishing the price of the products. If these indicators have not been met, or if indicators of net revenue reporting specified in ASC 606-10 are present in the arrangement, revenue is recognized net of related direct costs.\nSoftware License Revenues — The Company’s performance obligation includes providing connectivity to software, generally through a monthly subscription, where the Company typically satisfies its performance obligations prior to the submission of invoices to the customer for such services. The Company’s software sale arrangements grant customers the right to access and use the software products which are to be installed with the relevant hardware for connectivity at the outset of an arrangement, and to be entitled to both technical support and software upgrades and enhancements during the term of the agreement. The term of the subscription period is generally 12 months, with the automatic renewal of another one year, and the subscription license service is billed monthly, quarterly or annually. Sales are generally recorded in the month the service is provided. For clients who are billed on an annual basis, deferred revenue is recorded and amortized over the life of the contract. Payments are generally due 30 to 90 days after delivery of the software licenses.\nThe Company records its revenues on hardware product and software license, net of value added taxes (“VAT”) upon the services are rendered and the title and risk of loss of hardware products are fully transferred to the customers. The Company is subject to VAT which is levied on the majority of the hardware products at the rate of 10% on the invoiced value of sales.\nContract assets\nIn accordance with ASC 606-10-45-3, contract asset is when the Company’s right to payment for goods and services already transferred to a customer if that right to payment is conditional on something other than the passage of time. The Company will recognize a contract asset when it has fulfilled a contract obligation but must perform other obligations before being entitled to payment.\nThere were no contract assets at September 30, 2021 and December 31, 2020.\nContract liabilities\nIn accordance with ASC 606-10-45-2, A contract liability is Company’s obligation to transfer goods or services to a customer when the customer prepays consideration or when the customer’s consideration is due for goods and services that the Company will yet provide whichever happens earlier.\nContract liabilities represent amounts collected from, or invoiced to, customers in excess of revenues recognized, primarily from the billing of annual subscription agreements. The value of contract liabilities will increase or decrease based on the timing of invoices and recognition of revenue. The Company’s contract liability balance was $35,582 and $18,646 as of September 30, 2021 and December 31, 2020, respectively.\nContract costs\nUnder ASC-606, the Company applies the following three steps in order to evaluate the costs to be capitalized as it fulfills following three criteria:\n• Incremental costs directly related to a specific contract;\n• Costs that generate or enhance resources of the company that will be used to satisfy performance of the terms of the contract; and\n• Costs that are expected to be recovered from the customer.\nNo contract costs are capitalized for the three and nine months ended September 30, 2021 and 2020.\n\n| 57 |\n\n• Software development costs\nIn accordance with the relevant FASB accounting guidance regarding the development of software to be sold, leased, or marketed, the Company expenses such costs as they are incurred until technological feasibility has been established, at and after which time these costs are capitalized until the product is available for general release to customers. Once the technological feasibility is established per ASC 985-20, the Company capitalizes costs associated with the acquisition or development of major software for internal and external use in the balance sheet. Costs incurred to enhance the Company’s software products, after general market release of the services using the products, is expensed in the period they are incurred. The Company only capitalizes subsequent additions, modifications or upgrades to internally developed software to the extent that such changes allow the software to perform a task it previously did not perform. The Company also expenses website costs as incurred.\nResearch and development expenditures in the development of its own software are charged to operations as incurred. Based on the software development process, technological feasibility is established upon completion of a working model, which also requires certification and extensive testing. Costs incurred by the Company between completion of the working model and the point at which the product is ready for general release are immaterial. For the nine months ended September 30, 2021 and 2020, the software development costs were $76,698 and $139,151, respectively. For three months ended September 30, 2021 and 2020, the software development costs were $9,709 and $33,658, respectively.\n• Product warranties\nThe Company’s provision for estimated future warranty costs is based upon historical relationship of warranty claims to sales. Based upon historical sales trends and warranties provided by the Company’s suppliers, the Company has concluded that no warranty liability is required as of June 30, 2021 and 2020. To date, product allowance and returns have been minimal and, based on its experience, the Company believes that returns of its products will continue to be minimal.\n• Shipping and handling costs\nNo shipping and handling costs are associated with the distribution of the products to the customers which are borne by the Company’s suppliers or distributors.\n• Sales and marketing\nSales and marketing expenses include payroll, employee benefits and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $85,027 and $3,125 for the nine months ended September 30, 2021 and 2020, respectively. For three months ended September 30, 2021 and 2020, the Advertising expense were $42,843 and $0, respectively.\n• Income tax\nThe Company adopted the ASC 740 Income Tax provisions of paragraph 740-10-25-13, which addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the consolidated financial statements. Under paragraph 740-10-25-13, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent (50%) likelihood of being realized upon ultimate settlement. Paragraph 740-10-25-13 also provides guidance on de-recognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures. The Company had no material adjustments to its liabilities for unrecognized income tax benefits according to the provisions of paragraph 740-10-25-13.\n\n| 58 |\n\nThe estimated future tax effects of temporary differences between the tax basis of assets and liabilities are reported in the accompanying balance sheets, as well as tax credit carry-backs and carry-forwards. The Company periodically reviews the recoverability of deferred tax assets recorded on its balance sheets and provides valuation allowances as management deems necessary.\nThe Company and its wholly-owned foreign subsidiary, is subject to income taxes in the jurisdictions in which it operates. Significant judgment is required in determining the provision for income tax. There are many transactions and calculations undertaken during the ordinary course of business for which the ultimate tax determination is uncertain. The company recognizes liabilities for anticipated tax audit issues based on the Company’s current understanding of the tax law. Where the final tax outcome of these matters is different from the carrying amounts, such differences will impact the current and deferred tax provisions in the period in which such determination is made.\n• Uncertain tax positions\nThe Company did not take any uncertain tax positions and had no adjustments to its income tax liabilities or benefits pursuant to the ASC 740 provisions of Section 740-10-25 for the three and nine months ended September 30, 2021 and 2020.\n• Foreign currencies translation and transactions\nThe reporting currency of the Company is United States Dollar (\"US$\") and the accompanying consolidated financial statements have been expressed in US$. In addition, the Company’s subsidiary is operating in the Republic of Vietnam and India and maintains its books and record in its local currency, Vietnam Dong (“VND”) and Indian Rupee (“INR), respectively, which are the functional currency as being the primary currency of the economic environment in which their operations are conducted. In general, for consolidation purposes, assets and liabilities of its subsidiaries whose functional currency is not US$ are translated into US$, in accordance with ASC Topic 830-30, “Translation of Financial Statement”, using the exchange rate on the balance sheet date. Shareholders’ equity is translated using the historical rates. Revenues and expenses are translated at average rates prevailing during the year. The gains and losses resulting from translation of financial statements of foreign subsidiary are recorded as a separate component of accumulated other comprehensive income within the statements of changes in shareholder’s equity.\nTranslation of amounts from SGD$ into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\n\n| September 30, 2021 | September 30, 2020 |\n| Period-end SGD$:US$ exchange rate | $ | 0.73534 | $ | 0.73118 |\n| Period average SGD$:US$ exchange rate | $ | 0.74658 | $ | 0.71922 |\n\nTranslation of amounts from VND into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\n\n| September 30, 2021 | September 30, 2020 |\n| Period-end VND$:US$ exchange rate | $ | 0.000044 | $ | 0.000043 |\n| Period average VND$:US$ exchange rate | $ | 0.000043 | $ | 0.000043 |\n\nTranslation of amounts from INR into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\n\n| September 30, 2021 | September 30, 2020 |\n| Period-end INR$:US$ exchange rate | $ | 0.013463 | $ | 0.013570 |\n| Period average INR$:US$ exchange rate | $ | 0.013576 | $ | 0.013490 |\n\n\n| 59 |\n\nTranslation gains and losses that arise from exchange rate fluctuations from transactions denominated in a currency other than the functional currency are translated, as the case may be, at the rate on the date of the transaction and included in the results of operations as incurred.\nForeign Exchange Loss (Gain). We recorded a foreign exchange gain of $8,859 for the three months ended September 30, 2021 as compared to a gain of $51,183 for the same period in 2020. Foreign exchange gains and losses are primarily unrealized (non-cash) in nature and results from the re-measuring of specific transactions and monetary accounts in a currency other than the functional currency. For example, a U.S. Dollar transaction which occurs in Singapore is re-measured at the period-end to Singapore dollar amount if it has not been settled previously. The foreign exchange loss or gain for the three months ended September 30, 2021 was due to an increase in the value of the Singapore Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the Singapore dollar to the U.S. Dollar increased 0.56%. At September 30, 2021, the exchange rate was 0.73534 as compared to 0.73118 at September 30, 2020. In addition, a U.S. Dollar transaction which occurs in India is re-measured at the period-end to India dollar amount if it has not been settled previously. The foreign exchange loss for the three months ended September 30, 2021 was due to an increase in the value of the India Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the India dollar to the U.S. Dollar increased 0.79%. At September 30, 2021, the exchange rate was 0.013463 as compared to 0.013570 at September 30, 2020. A U.S. Dollar transaction which occurs in Vietnam is re-measured at the period-end to Vietnameses dollar amount if it has not been settled previously. The foreign exchange gain for the three months ended September 30, 2021 was due to an increase in the value of the Vietnamese Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the Vietnamese dollar to the U.S. Dollar increased 2.32%. At September 30, 2021, the exchange rate was 0.000044 as compared to 0.000043 at September 30, 2020.\n• Comprehensive income\nASC 220, “Comprehensive Income”, establishes standards for reporting and display of comprehensive income, its components and accumulated balances. Comprehensive income as defined includes all changes in equity during a period from non-owner sources. Accumulated other comprehensive income, as presented in the accompanying consolidated statements of changes in shareholders’ equity, consists of changes in unrealized gains and losses on foreign currency translation. This comprehensive income is not included in the computation of income tax expense or benefit.\n• Leases\nThe Company adopted ASC 842, Leases (“ASC 842”) to determines if an arrangement is a lease at inception. Operating leases are included in operating lease right-of-use (“ROU”) assets and operating lease liabilities in the consolidated balance sheets. Finance leases are included in property and equipment, other current liabilities, and other long-term liabilities in the condensed consolidated balance sheets.\nROU assets represent the right to use an underlying asset for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As most of the Company’s leases do not provide an implicit rate, the Company generally use the incremental borrowing rate based on the estimated rate of interest for collateralized borrowing over a similar term of the lease payments at commencement date. The operating lease ROU asset also includes any lease payments made and excludes lease incentives. The lease terms may include options to extend or terminate the lease when it is reasonably certain that the Company will exercise that option. Lease expense for lease payments is recognized on a straight-line basis over the lease term.\nIn accordance with the guidance in ASC 842, components of a lease should be split into three categories: lease components (e.g. land, building, etc.), non-lease components (e.g. common area maintenance, consumables, etc.), and non-components (e.g. property taxes, insurance, etc.). Subsequently, the fixed and in-substance fixed contract consideration (including any related to non-components) must be allocated based on the respective relative fair values to the lease components and non-lease components.\n• Related parties\nThe Company follows the ASC 850-10, Related Party for the identification of related parties and disclosure of related party transactions.\nPursuant to section 850-10-20 the related parties include a) affiliates of the Company; b) entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of section 825–10–15, to be accounted for by the equity method by the investing entity; c) trusts for the benefit of employees, such as pension and Income-sharing trusts that are managed by or under the trusteeship of management; d) principal owners of the Company; e) management of the Company; f) other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests; and g) other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting ;parties might be prevented from fully pursuing its own separate interests.\n\n| 60 |\n\nThe condnensed consolidated financial statements shall include disclosures of material related party transactions, other than compensation arrangements, expense allowances, and other similar items in the ordinary course of business. However, disclosure of transactions that are eliminated in the preparation of consolidated or combined financial statements is not required in those statements. The disclosures shall include: a) the nature of the relationship(s) involved; b) a description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the financial statements; c) the dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period; and d) amount due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement.\n• Commitments and contingencies\nThe Company follows the ASC 450-20, Commitments to report accounting for contingencies. Certain conditions may exist as of the date the financial statements are issued, which may result in a loss to the Company but which will only be resolved when one or more future events occur or fail to occur. The Company assesses such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or un-asserted claims that may result in such proceedings, the Company evaluates the perceived merits of any legal proceedings or un-asserted claims as well as the perceived merits of the amount of relief sought or expected to be sought therein.\nIf the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s consolidated financial statements. If the assessment indicates that a potentially material loss contingency is not probable but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, and an estimate of the range of possible losses, if determinable and material, would be disclosed.\nLoss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the guarantees would be disclosed. Management does not believe, based upon information available at this time that these matters will have a material adverse effect on the Company’s financial position, results of operations or cash flows. However, there is no assurance that such matters will not materially and adversely affect the Company’s business, financial position, and results of operations or cash flows.\n• Fair value of financial instruments\nThe Company follows paragraph 825-10-50-10 of the FASB Accounting Standards Codification for disclosures about fair value of its financial instruments and has adopted paragraph 820-10-35-37 of the FASB Accounting Standards Codification (“Paragraph 820-10-35-37”) to measure the fair value of its financial instruments. Paragraph 820-10-35-37 of the FASB Accounting Standards Codification establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. To increase consistency and comparability in fair value measurements and related disclosures, paragraph 820-10-35-37 of the FASB Accounting Standards Codification establishes a fair value hierarchy which prioritizes the inputs to valuation techniques used to measure fair value into three (3) broad levels. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The three (3) levels of fair value hierarchy defined by paragraph 820-10-35-37 of the FASB Accounting Standards Codification are described below:\n\n| Level 1 | Quoted market prices available in active markets for identical assets or liabilities as of the reporting date. |\n| Level 2 | Pricing inputs other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable as of the reporting date. |\n| Level 3 | Pricing inputs that are generally observable inputs and not corroborated by market data. |\n\n\n| 61 |\n\nFinancial assets are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable.\nThe fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.\nThe carrying amounts of the Company’s financial assets and liabilities, such as cash and cash equivalents, accounts receivable, deposits, prepayments and other receivables, contract liabilities, accrued liabilities and other payables, amounts due to related parties and operating lease liabilities, approximate their fair values because of the short maturity of these instruments.\n• Cost of goods sold\nCost of goods sold consists of the cost of hardware, software and payroll, which are directly attributable to the sales of products. The cost also consists of costs of materials which has been sold attributable to the sales of high-end products. Additional costs may include freight paid to acquire the goods, custom duties, sales or use taxes not recoverable paid on materials used, and any fee for purchase\n• Share-based compensation\nPursuant to ASU 2018-07, the Company follows ASC 718, Compensation—Stock Compensation (“ASC 718”), which requires the measurement and recognition of compensation expense for all share-based payment awards (employee or non employee), are measured at grant-date fair value of the equity instruments that an entity is obligated to issue. Restricted stock units are valued using the market price of the Company’s common shares on the date of grant. As of September 30, 2021, those shares issued for service compensations were immediately vested, and therefore this amount is thus recognized as expense with an offset to preferred or September 30, 2021 and 2020, the stock-based compensations are recorded in the General and administrative expenses within the Condensed Consolidated Statements of Operations and Other Comprehensive Loss.”\n• Business combinations\nThe Company follows ASC 805, Business Combinations (“ASC 805”) and ASC 810-10-65, Consolidation. ASC 805 requires most identifiable assets, liabilities, non-controlling interests, and goodwill acquired in a business combination to be recorded at “fair value.” The statement applies to all business combinations, including combinations among mutual entities and combinations by contract alone. Under ASC 805, all business combinations are accounted for by applying the acquisition method. Accounting for goodwill requires significant management estimates and judgment. Management performs periodic reviews of the carrying value of goodwill to determine whether events and circumstances indicate that an impairment in value may have occurred. A variety of factors could cause the carrying value of goodwill to become impaired. A write-down of the carrying value of goodwill could result in a non-cash charge, which could have an adverse effect on the Company’s results of operations.\n• Earnings per share\nBasic per share amounts are calculated using the weighted average shares outstanding during the year, excluding unvested restricted stock units. The Company uses the treasury stock method to determine the dilutive effect of stock options and other dilutive instruments. Under the treasury stock method, only “in the money” dilutive instruments impact the diluted calculations in computing diluted earnings per share. Diluted calculations reflect the weighted average incremental common shares that would be issued upon exercise of dilutive options assuming the proceeds would be used to repurchase shares at average market prices for the period.\n\n| 62 |\n\nAs of September 30, 2021 and December 31, 2020, the Company has the number of shares of common stock to be issued upon conversion of below:\n\n| As of September 30, | As of December 31, |\n| 2021 | 2020 |\n| Series A Convertible Preferred Stock (a) | 8,000 | 8,000 |\n| Series B Convertible Preferred Stock | 764,400 | 764,400 |\n| Series B-1 Convertible Preferred Stock | 48,000 | 48,000 |\n| Series C Convertible Preferred Stock | 465,600 | 108,600 |\n| Series C-1 Convertible Preferred Stock | 4,195,200 | 865,500 |\n| Warrants granted | — | — |\n| Warrants granted with Series C-1 Convertible Preferred Stock | 1,178,700 | 614,100 |\n| Total: | 6,659,900 | 2,408,600 |\n\n\n| (a) | The Series A the conversion formula is aggregate Stated Value divided by IPO price (Stated Value for each Series A preferred share is $1,000). There are 8,000 shares of Series A Preferred Stock issued and outstanding (10,000 shares are designated Series A). The conversion formula would be $8 million (the aggregate stated value) divided by IPO price. |\n\n• Segment Reporting\nASC Topic 280, “Segment Reporting” establishes standards for reporting information about operating segments on a basis consistent with the Company’s internal organization structure as well as information about geographical areas, business segments and major customers in condensed consolidated financial statements. For the nine months ended September 30, 2021 and 2020, the Company operates in two reportable operating segment.\nEmerging Growth Company\nWe are an “emerging growth company” under the JOBS Act. For as long as we are an “emerging growth company,” we are not required to: (i) comply with any new or revised financial accounting standards that have different effective dates for public and private companies until those standards would otherwise apply to private companies, (ii) provide an auditor’s attestation report on management’s assessment of the effectiveness of internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act, (iii) comply with any new requirements adopted by the Public Company Accounting Oversight Board (“PCAOB”) requiring mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor would be required to provide additional information about the audit and the financial statements of the issuer or (iv) comply with any new audit rules adopted by the PCAOB after April 5, 2012, unless the SEC determines otherwise. However, we have elected to “opt out” of the extended transition period discussed in (i) and will therefore comply with new or revised accounting standards on the applicable dates on which the adoption of such standards are required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to opt out of such extended transition period for compliance with new or revised accounting standards is irrevocable.\nCritical Accounting Policies and Estimate\n• Recent accounting pronouncements\nFrom time to time, new accounting pronouncements are issued by the Financial Accounting Standard Board (“FASB”) or other standard setting bodies and adopted by the Company as of the specified effective date. Unless otherwise discussed, the Company believes that the impact of recently issued standards that are not yet effective will not have a material impact on its financial position or results of operations upon adoption.\n\n| 63 |\n\nAccounting Standards Adopted\nIn August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (“ASU 2018-13”), which eliminates, adds and modifies certain disclosure requirements for fair value measurements. The amendment is effective for interim and annual reporting periods beginning after December 15, 2019. The Company has evaluated and the adoption of this does not have an any impact on the financial statements.\nIn November 2018, the FASB issued ASU No. 2018-18, Collaborative Arrangements (“ASU 2018-18”), which clarifies the interaction between ASC 808, Collaborative Arrangements and ASC 606, Revenue from Contracts with Customers. Certain transactions between participants in a collaborative arrangement should be accounted for under ASC 606 when the counterparty is a customer. In addition, ASU 2018-18 precludes an entity from presenting consideration from a transaction in a collaborative arrangement as revenue if the counterparty is not a customer for that transaction. ASU 2018-18 should be applied retrospectively to the date of initial application of ASC 606. This guidance is effective for interim and fiscal periods beginning after December 15, 2019. The Company has evaluated and the adoption of this does not have an any impact on the financial statements.\nAccounting Standards Issued, Not Adopted\nIn June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). This ASU requires measurement and recognition of expected credit losses for financial assets. ASU 2016-13 also requires new disclosures for financial assets measured at amortized cost, loans and available-for-sale debt securities. ASU 2016-13 is effective for the Company beginning January 1, 2023. Entities will apply the standard's provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. The Company is currently evaluating the potential effect of this standard on its financial statements. The Company does not expect this standard to have a material impact on its financial statements.\nIn December 2019, the FASB issued ASU No. 2019-12, Income Taxes: Simplifying the Accounting for Income Taxes (“ASU 2019-12”), which eliminates certain exceptions related to the approach for intraperiod tax allocation, the methodology for calculating income taxes in an interim period and the recognition of deferred tax liabilities for outside basis differences. The new guidance also simplifies aspects of the accounting for franchise taxes and enacted changes in tax laws or rates and clarifies the accounting for transactions that result in a step-up in the tax basis of goodwill. The standard is effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2020, with early adoption permitted. Adoption of the standard requires certain changes to be made prospectively, with some changes to be made retrospectively. The Company does not expect the adoption of this standard to have a material impact on its financial position, results of operations or cash flows.\nIn March 2020, the FASB issued ASU 2020-03, “Codification Improvements to Financial Instruments”: The amendments in this update are to clarify, correct errors in, or make minor improvements to a variety of ASC topics. The changes in ASU 2020-03 are not expected to have a significant effect on current accounting practices. The ASU improves various financial instrument topics in the Codification to increase stakeholder awareness of the amendments and to expedite the improvement process by making the Codification easier to understand and easier to apply by eliminating inconsistencies and providing clarifications. The ASU is effective for smaller reporting companies for fiscal years beginning after December 15, 2022 with early application permitted. The Company is currently evaluating the impact the adoption of this guidance may have on its consolidated financial statements.\nIn August 2020, the FASB issued ASU 2020-06 Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40) related to the measurement and disclosure requirements for convertible instruments and contracts in an entity's own equity. The pronouncement simplifies and adds disclosure requirements for the accounting and measurement of convertible instruments and the settlement assessment for contracts in an entity's own equity. This pronouncement is effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2021 and early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. The Company is currently evaluating the impact that this standard will have on its consolidated financial statements.\n\n| 64 |\n\n\nItem 3. Quantitative and Qualitative Disclosures about Market Risk.\nWe did not have investments and do not utilize derivative financial instruments to manage our interest rate risks.\nItem 4. Controls and Procedures.\nEvaluation of Disclosure Controls and Procedures\nWe maintain disclosure controls and procedures that are designed to provide reasonable assurance that the information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934, as amended (the \"Exchange Act\"), is recorded, processed, summarized and reported within the time periods specified in the rules and forms promulgated by the Securities and Exchange Commission, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Because of the inherent limitations to the effectiveness of any system of disclosure controls and procedures, no evaluation of disclosure controls and procedures can provide absolute assurance that all control issues and instances of fraud, if any, with a company have been prevented or detected on a timely basis. Even disclosure controls and procedures determined to be effective can only provide reasonable assurance that their objectives are achieved.\nAs of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) pursuant to Rule 13a-15 of the Exchange Act. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are not effective at the reasonable assurance level.\nOur size has prevented us from being able to employ sufficient resources to enable us to have an adequate level of supervision and segregation of duties. Therefore, it is difficult to effectively segregate accounting duties which comprises a material weakness in internal controls. This lack of segregation of duties leads management to conclude that the Company’s disclosure controls and procedures are not effective to give reasonable assurance that the information required to be disclosed in reports that the Company files under the Exchange Act is recorded, processed, summarized and reported as and when required.\nTo the extent reasonably possible given our limited resources, we intend to take measures to cure the aforementioned weaknesses, including, but not limited to, increasing the capacity of our qualified financial personnel to ensure that accounting policies and procedures are consistent across the organization and that we have adequate control over our Exchange Act reporting disclosures.\nChanges in Internal Control over Financial Reporting\nThere were no changes in the Company’s internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)) during the quarter ended September 30, 2021 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\n| 65 |\n\nPART II\nOTHER INFORMATION\n\nItem 1. Legal Proceedings.\nThe Company is currently litigating three cases pending in the Supreme Court of the State of New York and one case pending in the United States District Court for the District of New Jersey.\nTwo cases are employment actions filed by former employees who seek compensation alleged to be due pursuant to agreements with the Company. Both of the employees are represented by the same counsel and filed their cases in the Supreme Court of the State of New York, County of New York, in December 2019.\nIn one of those actions, a former employee claims entitlement to compensation and a bonus totaling $566,000 and 39,000-58,500 shares of Company common stock, together with costs. The Company responded to the complaint and also asserted counterclaims in the proceeding for $1,500,000 to $4,000,000 plus punitive damages, together with interest and costs, arising from, inter alia, the former employee’s breach of contract, unfair competition, misappropriation of trade secrets and breach of fiduciary duty. The former employee has responded to the Company’s counterclaims and this action is in the discovery phase of the litigation.\nIn the other employment action, another former employee claims entitlement to salary payments and expense reimbursement in the amount of $122,042.60, plus liquidated damages, together with costs. This former employee also claims entitlement to 516,300 to 760,800 shares of the Company’s common stock. In addition, this action also includes claims by a plaintiff-entity alleging entitlement to $8 million in shares of the Company’s Series A Preferred stock. The Company responded to the complaint and also asserted counterclaims against the former employee in the proceeding for $1,500,000 to $2,000,000 plus punitive damages, together with costs, arising from, inter alia, the former employee’s breach of contract, breach of fiduciary duty, tortious interference and fraud. The former employee has responded to the Company’s counterclaims. The judge assigned to this action retired at the end of 2020. A new judge has been assigned and this action is progressing through the discovery phase of litigation.\nThe third case also involves one of those former employees; therein, a Company affiliate filed suit in February 2020 seeking enforcement, by way of specific performance, of an agreement which entitles the affiliate to purchase all of the 99 percent of the shares of the plaintiff-entity which alleges entitlement to $8 million in shares of the Company’s Series A Preferred Stock in one of the employment actions described above. The former employee has responded to the Company’s complaint in this action with a motion to dismiss, which was later withdrawn by same, and then by way of an answer without counterclaims. The judge assigned to this action has announced his retirement and the case has not yet been reassigned.\nThe Company was in an AAA arbitration defending allegations of breach of an agreement. The Demand for Arbitration therein, dated August 25, 2020, asserted that the Petitioner, an LLC, had an agreement with the Company and its CEO granting the Petitioner the right to require the Company to redeem certain common stock in the Company for a cash payment.\nThe Demand alleged that the Petitioner submitted a Redemption Notice, as required under the alleged agreement, obligating the Company to redeem the shares. The Demand alleged that the failure of the Company to redeem the shares and pay Petitioner further obligated the Company to provide additional common stock to the Petitioner. The amount alleged to be due to the Petitioner as of July 31, 2020 was said to be $590,461.94 and growing daily while the number of additional common stock shares alleged to be due to Petitioner as of July 31, 2020 was said to be 708,542,582 and growing, daily.\nIn order to avoid an adverse award, the Company agreed to settle the matter for the sum of $550,000. No additional shares were included in the settlement agreement. The settlement sum was required to be paid in two tranches, with $250,000 to have been paid on or before May 28, 2021 and the remaining $300,000 to be paid on or before June 30, 2021. The Company made the required settlement payments and the matter is now considered closed.\n\n| 66 |\n\nOn or about March 5, 2021, SOSV IV LLC (“SOSV”) sent a demand letter to the Company in regard to its investment in Hottab Pte. Ltd. (“Hottab”).\nIn this letter, and the subsequently filed lawsuits, SOSV alleges that it entered into an investment arrangement with Hottab in which SOSV was to receive five percent (5%) of the common stock of Hottab and entered into an Accelerator Contract for Equity (the “ACE”) pursuant to which it alleges to have invested a sum of $168,000 with Hottab. These events are alleged to have taken place prior to the Company’s acquisition of Hottab. SOSV alleges that the Company subsequently acquired all of the outstanding shares of Hottab, which it alleges triggered a liquidity event clause under the ACE requiring the Company, by way of its ownership of Hottab, to pay SOSV twice its investment, or $336,000.\nSOSV further alleges that subsequent to a term sheet between the Company and Hottab being executed, the Company entered into an agreement to purchase one hundred percent (100%) of the issued and outstanding shares of Hottab from Hottab Holdings Limited (“Hottab Holdings”). As SOSV does not have any interest in Hottab Holdings, it did not receive any consideration as allegedly provided under the ACE.\nUpon these allegations, SOSV asserts causes of action sounding in fraudulent misrepresentation/concealment, breach of contract, breach of the covenant of good faith and fair dealing, quantum meruit and/or unjust enrichment, promissory estoppel, oppression of minority shareholder, and breach of fiduciary duties. SOSV seeks damages in the amount of $336,000.00 in addition damages equal to the value of SOSV’s alleged equity in Hottab or in the alternative shares of the Company in an amount equal to SOSV’s ownership interest in Hottab at the time of the purchase of Hottab’s shares from Hottab Holdings.\nInitially, SOSV filed suit in the District Court for New Jersey on June 10, 2021. SOSV voluntarily dismissed its New Jersey lawsuit and on October 29, 2021, re-filed the action in the Southern District of New York. The New York lawsuit was also voluntarily dismissed by SOSV. However, SOSV may choose to re-file its lawsuit.\nThe Company denies the accusations of SOSV and intends to vigorously defend this matter if the action is re-filed. As the lawsuit has been voluntarily dismissed, there have been no proceedings and we are unable to prognosticate a likelihood of success, or whether SOSV will re-file the action.\nAs of September 30, 2021 and December 31, 2020, the Company had a total of $75,000 and $75,000 outstanding on this account, respectively.\nAs of September 30, 2021, the Company does not expect any losses from these legal proceedings and accordingly has not accrued any provisions for them.\nItem 1A. Risk Factors.\nAs of the date of this Quarterly Report on Form 10-Q, there have been no material changes to the risk factors disclosed in our Prospectus, filed with the SEC on November 10, 2021, pursuant to Rule 424(b)(4) under the Securities Act of 1933, as amended. We may disclose changes to such factors or disclose additional factors from time to time in our future filings with the SEC.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\nNot Applicable\nItem 3. Defaults Upon Senior Securities.\nNot Applicable\nItem 4. Mine Safety Disclosures.\nNot Applicable\nItem 5. Other Information\nNone\n| 67 |\n\n\nItem 6. Exhibits\nEXHIBIT INDEX\n| Exhibit No. | Description |\n| 3.1 | Articles of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.2 | Amended Bylaws of The Registrant (incorporated by reference to Exhibit 3.2 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.3 | Certificate of Designation of Series A Convertible Preferred Stock incorporated by reference to Exhibit 3.3 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.4 | Certificate of Correction of Series A Certificate of Designation filed May 2019 incorporated by reference to Exhibit 3.4 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3. | Certificate of Correction to Series A Certificate of Designation filed December 2020 (incorporated by reference to Exhibit 3.5 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.6 | Certificate of Designation of Series B Convertible Preferred Stock (incorporated by reference to Exhibit 3.6 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.7 | Certificate of Correction of Series B Certificate of Designation (incorporated by reference to Exhibit 3.7 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.8 | Certificate of Designation of Series B-1 Convertible Preferred Stock (incorporated by reference to Exhibit 3.8 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.9 | Certificate of Correction of Series B-1 Certificate of Designation (incorporated by reference to Exhibit 3.9 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 20210. |\n| 3.10 | Certificate of Designation of Series C Convertible Preferred Stock (incorporated by reference to Exhibit 3.10 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.11 | Certificate of Correction of Series C Certificate of Designation (incorporated by reference to Exhibit 3.11 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.12 | Certificate of Designation of Series C-1 Convertible Preferred Stock (incorporated by reference to Exhibit 3.12 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.13 | Certificate of Designation for Series X Super Voting Preferred Stock ((incorporated by reference to Exhibit 3.13 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 20210. |\n| 3.14 | Certificate of Amendment to Articles of Incorporation to change the authorized capital of the Registrant, filed December 4, 2018 (incorporated by reference to Exhibit 3.14 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.15 | Certificate of Amendment to Articles of Incorporation to change the name of Registrant, filed October 2, 2018 (incorporated by reference to Exhibit 3.15 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.16 | Certificate of Amendment to Articles of Incorporation to effect reverse stock split (incorporated by reference to Exhibit 3.16 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.17 | Certificate of Amendment to Series X Super Voting Preferred Certificate of Designation (incorporated by reference to Exhibit 3.17 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 4.1 | Form of Series C-1 Warrant (incorporated by reference to Exhibit 4.1 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 4.2 | Form of Underwriter Warrant (incorporated by reference to Exhibit 4.2 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.1 | Software Set Up, Development and Use License Agreement dated November 15, 2018 between Society Pass Incorporated and Wallet Factory International Limited (incorporated by reference to Exhibit 10.1 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.2 | Stock Purchase Agreement dated January 10 2019 between HOTTAB PTE. LTD., SOSV IV LLC, General Mobile Corporation and Sanjeev Sapkota (incorporated by reference to Exhibit 10.2 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.3 | Accelerator Contract for Equity dated January 10, 2019 by and between HOTTAB PTE. LTD., SOV IV LLC and Sanjeev Sapkota (incorporated by reference to Exhibit 10.3 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.4 | Employment Agreement dated as of April 1, 2017 between Society Pass Incorporated and Dennis Luan Thuc Nguyen (incorporated by reference to Exhibit 10.4 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.5 | Employment Agreement dated as of September 1, 2020 between Society Pass Incorporated and Liang Wee Leong Raynauld (incorporated by reference to Exhibit 10.5 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.6 | Asset Purchase Agreement dated February 16, 2021 between Goodventures Sea Limited and Sopa Technology PTE. LTD. (incorporated by reference to Exhibit 10.6 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.7 | Shareholders Agreement dated February 16, 2021 between Goodventures Sea Limited and Sopa Technology PTE. LTD (incorporated by reference to Exhibit 10.7 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.8 | Food Delivery Partnership Agreement dated as of April 22, 2021 between Hottab Asset Vietnam Co. Ltd and Dream Space Trading Co. Ltd (incorporated by reference to Exhibit 10.8 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.9 | Food Delivery Partnership Agreement dated as of July 29, 2020 between Hottab Asset Vietnam Co. Ltd and Lala Move Vietnam Co. Ltd (incorporated by reference to Exhibit 10.9 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.10 | Payment Gateway Agreement dated February 25, 2020 between Hottab Asset Vietnam Co. Ltd and VTC Technology and Digital Content Company (incorporated by reference to Exhibit 10.10 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.11 | Payment Gateway Agreement dated April 20, 2020 between Hottab Asset Vietnam Co. Ltd and Media Corporation (Vietnam Post Telecommunication Media) (incorporated by reference to Exhibit 10.11 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.12 | Payment Gateway Agreement dated August 31, 2020 between Hottab Asset Vietnam Co. Ltd and Zion Joint Stock Company (incorporated by reference to Exhibit 10.12 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.13 | Payment Gateway Agreement dated August 31, 2020 between Hottab Asset Vietnam Co. Ltd and Online Mobile Service Joint Stock Co (incorporated by reference to Exhibit 10.13 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.14 | Vendor Finance Partnership Agreement, dated as of October 22, 2019 between Hottab Asset Vietnam Co. Ltd and SHBank Finance Co. Ltd (incorporated by reference to Exhibit 10.14 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.15 | Business Cooperation Agreement dated March 6, 2020 between Hottab Asset Vietnam Co. and Triip Pte. Ltd ((incorporated by reference to Exhibit 10.15 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.16 | The Registrant’s 2021 Equity Incentive Plan (incorporated by reference to Exhibit 10.16 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.17 | Business Cooperation Contract dated May 28, 2021 between Paytech, JSC and the Registrant (incorporated by reference to Exhibit 10.17 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.18 | Business Cooperation Agreement dated August 15, 2021 between Hottab Vietnam Company Limited and Rainbow Loyalty Company Limited (incorporated by reference to Exhibit 10.18 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.19 | Amendment to Employment Agreement dated October 25, 2021 between Dennis Nguyen and the Registrant (incorporated by reference to Exhibit 10.19 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 31.1 | Certification of principal executive officer pursuant to Rule 13a-14(A) promulgated under the Securities Exchange Act of 1934 |\n| 31.2 | Certification of principal financial officer pursuant to Rule 13a-14(A) promulgated under the Securities Exchange Act of 1934 |\n| 32.1* | Certification of principal executive officer and principal financial officer pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(B) promulgated under the Securities Exchange Act of 1934 |\n\n* The certifications furnished in Exhibit 32.1 hereto are deemed to accompany this Form 10-Q and are not deemed “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to the liability of that section, nor shall they be deemed incorporated by reference into any filing under the Securities Act or the Exchange Act.\n| 68 |\n\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n| SOCIETY PASS INCORPORATED |\n| (Registrant) |\n| Date: December 9, 2021 | By: | /s/ Dennis Nguyen |\n| Dennis Nuguyen |\n| Chief Executive Officer |\n| Date: December 9, 2021 | By: | /s/ Ranauld Liang |\n| Raynauld Liang |\n| Chief Financial Officer |\n\n\n| 69 |\n\n\n</text>\n\nWhat would be the total number of common stock to be issued in 2021 if the IPO price is $10 per share, if the conversion for Series A preferred stocks is its aggregate Stated Value divided by IPO price?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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doc-math
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"style": "rule",
"ground_truth": "Therefore, the answer is 7459900.0."
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"index": 52,
"input_length": 62394
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docmath_20000_40000
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nPART I—FINANCIAL INFORMATION\nITEM 1. FINANCIAL STATEMENTS\nBoise Cascade Company\nConsolidated Statements of Operations\n(unaudited)\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands, except per-share data) |\n| Sales | $ | 1,544,329 | $ | 2,326,282 |\n| Costs and expenses |\n| Materials, labor, and other operating expenses (excluding depreciation) | 1,230,635 | 1,729,896 |\n| Depreciation and amortization | 31,186 | 20,543 |\n| Selling and distribution expenses | 128,788 | 146,651 |\n| General and administrative expenses | 26,463 | 26,052 |\n| Other (income) expense, net | ( 345 ) | ( 2,488 ) |\n| 1,416,727 | 1,920,654 |\n| Income from operations | 127,602 | 405,628 |\n| Foreign currency exchange gain (loss) | ( 73 ) | 132 |\n| Pension expense (excluding service costs) | ( 41 ) | ( 171 ) |\n| Interest expense | ( 6,361 ) | ( 6,254 ) |\n| Interest income | 9,685 | 65 |\n| Change in fair value of interest rate swaps | ( 804 ) | 2,066 |\n| 2,406 | ( 4,162 ) |\n| Income before income taxes | 130,008 | 401,466 |\n| Income tax provision | ( 33,275 ) | ( 98,866 ) |\n| Net income | $ | 96,733 | $ | 302,600 |\n| Weighted average common shares outstanding: |\n| Basic | 39,593 | 39,474 |\n| Diluted | 39,838 | 39,768 |\n| Net income per common share: |\n| Basic | $ | 2.44 | $ | 7.67 |\n| Diluted | $ | 2.43 | $ | 7.61 |\n| Dividends declared per common share | $ | 0.15 | $ | 0.12 |\n\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\n1\nBoise Cascade Company\nConsolidated Statements of Comprehensive Income\n(unaudited)\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| Net income | $ | 96,733 | $ | 302,600 |\n| Other comprehensive income, net of tax |\n| Defined benefit pension plans |\n| Amortization of actuarial loss, net of tax of $ 2 and $ 5 , respectively | 6 | 16 |\n| Effect of settlements, net of tax of $ — and $ 32 , respectively | — | 98 |\n| Other comprehensive income, net of tax | 6 | 114 |\n| Comprehensive income | $ | 96,739 | $ | 302,714 |\n\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\n2\nBoise Cascade Company\nConsolidated Balance Sheets\n(unaudited)\n| March 31,2023 | December 31,2022 |\n| (thousands) |\n| ASSETS |\n| Current |\n| Cash and cash equivalents | $ | 1,000,721 | $ | 998,344 |\n| Receivables |\n| Trade, less allowances of $ 4,341 and $ 3,264 | 417,515 | 297,237 |\n| Related parties | 196 | 19 |\n| Other | 13,821 | 23,023 |\n| Inventories | 738,798 | 697,551 |\n| Prepaid expenses and other | 20,666 | 47,878 |\n| Total current assets | 2,191,717 | 2,064,052 |\n| Property and equipment, net | 772,734 | 770,023 |\n| Operating lease right-of-use assets | 52,441 | 55,582 |\n| Finance lease right-of-use assets | 25,883 | 26,501 |\n| Timber deposits | 8,299 | 7,519 |\n| Goodwill | 137,958 | 137,958 |\n| Intangible assets, net | 157,133 | 161,433 |\n| Deferred income taxes | 6,135 | 6,116 |\n| Other assets | 9,887 | 11,330 |\n| Total assets | $ | 3,362,187 | $ | 3,240,514 |\n\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\n3\nBoise Cascade Company\nConsolidated Balance Sheets (continued)\n(unaudited)\n| March 31,2023 | December 31,2022 |\n| (thousands, except per-share data) |\n| LIABILITIES AND STOCKHOLDERS' EQUITY |\n| Current |\n| Accounts payable |\n| Trade | $ | 400,455 | $ | 269,785 |\n| Related parties | 1,420 | 1,019 |\n| Accrued liabilities |\n| Compensation and benefits | 79,606 | 142,463 |\n| Interest payable | 5,088 | 9,955 |\n| Other | 93,579 | 122,606 |\n| Total current liabilities | 580,148 | 545,828 |\n| Debt |\n| Long-term debt | 444,614 | 444,392 |\n| Other |\n| Compensation and benefits | 33,280 | 33,226 |\n| Operating lease liabilities, net of current portion | 45,681 | 48,668 |\n| Finance lease liabilities, net of current portion | 29,549 | 30,022 |\n| Deferred income taxes | 66,855 | 63,454 |\n| Other long-term liabilities | 17,540 | 16,949 |\n| 192,905 | 192,319 |\n| Commitments and contingent liabilities |\n| Stockholders' equity |\n| Preferred stock, $ 0.01 par value per share; 50,000 shares authorized, no shares issued and outstanding | — | — |\n| Common stock, $ 0.01 par value per share; 300,000 shares authorized, 44,983 and 44,827 shares issued, respectively | 450 | 448 |\n| Treasury stock, 5,392 and 5,367 shares at cost, respectively | ( 140,391 ) | ( 138,909 ) |\n| Additional paid-in capital | 548,611 | 551,215 |\n| Accumulated other comprehensive loss | ( 514 ) | ( 520 ) |\n| Retained earnings | 1,736,364 | 1,645,741 |\n| Total stockholders' equity | 2,144,520 | 2,057,975 |\n| Total liabilities and stockholders' equity | $ | 3,362,187 | $ | 3,240,514 |\n\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\n4\nBoise Cascade Company\nConsolidated Statements of Cash Flows\n(unaudited)\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| Cash provided by (used for) operations |\n| Net income | $ | 96,733 | $ | 302,600 |\n| Items in net income not using (providing) cash |\n| Depreciation and amortization, including deferred financing costs and other | 31,853 | 20,993 |\n| Stock-based compensation | 3,324 | 2,392 |\n| Pension expense | 41 | 171 |\n| Deferred income taxes | 3,393 | ( 729 ) |\n| Change in fair value of interest rate swaps | 804 | ( 2,066 ) |\n| Other | ( 518 ) | ( 2,412 ) |\n| Decrease (increase) in working capital |\n| Receivables | ( 111,253 ) | ( 218,018 ) |\n| Inventories | ( 41,247 ) | ( 143,997 ) |\n| Prepaid expenses and other | ( 1,428 ) | ( 3,227 ) |\n| Accounts payable and accrued liabilities | 36,181 | 147,425 |\n| Pension contributions | ( 136 ) | ( 655 ) |\n| Income taxes payable | 28,631 | 95,352 |\n| Other | 1,614 | 1,116 |\n| Net cash provided by operations | 47,992 | 198,945 |\n| Cash provided by (used for) investment |\n| Expenditures for property and equipment | ( 30,063 ) | ( 17,448 ) |\n| Proceeds from sales of assets and other | 565 | 2,581 |\n| Net cash used for investment | ( 29,498 ) | ( 14,867 ) |\n| Cash provided by (used for) financing |\n| Dividends paid on common stock | ( 8,258 ) | ( 5,939 ) |\n| Tax withholding payments on stock-based awards | ( 5,926 ) | ( 3,930 ) |\n| Treasury stock purchased | ( 1,482 ) | — |\n| Other | ( 451 ) | ( 395 ) |\n| Net cash used for financing | ( 16,117 ) | ( 10,264 ) |\n| Net increase in cash and cash equivalents | 2,377 | 173,814 |\n| Balance at beginning of the period | 998,344 | 748,907 |\n| Balance at end of the period | $ | 1,000,721 | $ | 922,721 |\n\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\n5\nBoise Cascade Company\nConsolidated Statements of Stockholders' Equity\n(unaudited)\n| Common Stock | Treasury Stock | Additional Paid-In Capital | Accumulated Other Comprehensive Loss | Retained Earnings | Total |\n| Shares | Amount | Shares | Amount |\n| (thousands) |\n| Balance at December 31, 2022 | 44,827 | $ | 448 | 5,367 | $ | ( 138,909 ) | $ | 551,215 | $ | ( 520 ) | $ | 1,645,741 | $ | 2,057,975 |\n| Net income | 96,733 | 96,733 |\n| Other comprehensive income | 6 | 6 |\n| Common stock issued | 156 | 2 | 2 |\n| Treasury stock purchased | 25 | ( 1,482 ) | ( 1,482 ) |\n| Stock-based compensation | 3,324 | 3,324 |\n| Common stock dividends ($ 0.15 per share) | ( 6,110 ) | ( 6,110 ) |\n| Tax withholding payments on stock-based awards | ( 5,926 ) | ( 5,926 ) |\n| Other | ( 2 ) | ( 2 ) |\n| Balance at March 31, 2023 | 44,983 | $ | 450 | 5,392 | $ | ( 140,391 ) | $ | 548,611 | $ | ( 514 ) | $ | 1,736,364 | $ | 2,144,520 |\n\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\n6\nBoise Cascade Company\nConsolidated Statements of Stockholders' Equity (continued)\n(unaudited)\n| Common Stock | Treasury Stock | Additional Paid-In Capital | Accumulated Other Comprehensive Loss | Retained Earnings | Total |\n| Shares | Amount | Shares | Amount |\n| (thousands) |\n| Balance at December 31, 2021 | 44,698 | $ | 447 | 5,367 | $ | ( 138,909 ) | $ | 543,249 | $ | ( 1,047 ) | $ | 948,879 | $ | 1,352,619 |\n| Net income | 302,600 | 302,600 |\n| Other comprehensive income | 114 | 114 |\n| Common stock issued | 117 | 1 | 1 |\n| Stock-based compensation | 2,392 | 2,392 |\n| Common stock dividends ($ 0.12 per share) | ( 5,133 ) | ( 5,133 ) |\n| Tax withholding payments on stock-based awards | ( 3,930 ) | ( 3,930 ) |\n| Proceeds from exercise of stock options | 27 | 27 |\n| Other | ( 1 ) | ( 1 ) |\n| Balance at March 31, 2022 | 44,815 | $ | 448 | 5,367 | $ | ( 138,909 ) | $ | 541,737 | $ | ( 933 ) | $ | 1,246,346 | $ | 1,648,689 |\n\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\n7\nCondensed Notes to Unaudited Quarterly Consolidated Financial Statements\n1. Nature of Operations and Consolidation\nNature of Operations\nBoise Cascade Company is a building products company headquartered in Boise, Idaho. As used in this Form 10-Q, the terms \"Boise Cascade,\" \"we,\" and \"our\" refer to Boise Cascade Company and its consolidated subsidiaries. We are one of the largest producers of engineered wood products (EWP) and plywood in North America and a leading United States wholesale distributor of building products.\nWe operate our business using two reportable segments: (1) Wood Products, which primarily manufactures EWP and plywood, and (2) Building Materials Distribution (BMD), which is a wholesale distributor of building materials. For more information, see Note 12, Segment Information.\nConsolidation\nThe accompanying quarterly consolidated financial statements have not been audited by an independent registered public accounting firm but, in the opinion of management, include all adjustments necessary to present fairly the financial position, results of operations, cash flows, and stockholders' equity for the interim periods presented. Except as disclosed within these condensed notes to unaudited quarterly consolidated financial statements, the adjustments made were of a normal, recurring nature. Certain information and footnote disclosures normally included in our annual consolidated financial statements have been condensed or omitted. The quarterly consolidated financial statements include the accounts of Boise Cascade and its subsidiaries after elimination of intercompany balances and transactions. Quarterly results are not necessarily indicative of results that may be expected for the full year. These condensed notes to unaudited quarterly consolidated financial statements should be read in conjunction with our 2022 Form 10-K and the other reports we file with the Securities and Exchange Commission.\n2. Summary of Significant Accounting Policies\nAccounting Policies\nThe complete summary of significant accounting policies is included in Note 2, Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements in \"Item 8. Financial Statements and Supplementary Data\" in our 2022 Form 10-K.\nUse of Estimates\nThe preparation of financial statements in conformity with generally accepted accounting principles (GAAP) requires management to make estimates and assumptions about future events. These estimates and the underlying assumptions affect the amounts of assets and liabilities reported, disclosures about contingent assets and liabilities, and reported amounts of revenues and expenses. Such estimates include the valuation of accounts receivable, inventories, goodwill, intangible assets, and other long-lived assets; legal contingencies; guarantee obligations; indemnifications; assumptions used in retirement, medical, and workers' compensation benefits; assumptions used in the determination of right-of-use (ROU) assets and related lease liabilities; stock-based compensation; fair value measurements; income taxes; and vendor and customer rebates, among others. These estimates and assumptions are based on management's best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors, including the current economic environment, which management believes to be reasonable under the circumstances. We adjust such estimates and assumptions when facts and circumstances dictate. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in these estimates resulting from continuing changes in the economic environment will be reflected in the consolidated financial statements in future periods.\n8\nRevenue Recognition\nRevenues are recognized when control of the promised goods or services is transferred to our customers, in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services. For revenue disaggregated by major product line for each reportable segment, see Note 12, Segment Information.\nFees for shipping and handling charged to customers for sales transactions are included in \"Sales\" in our Consolidated Statements of Operations. When control over products has transferred to the customer, we have elected to recognize costs related to shipping and handling as fulfillment costs. For our Wood Products segment, costs related to shipping and handling are included in \"Materials, labor, and other operating expenses (excluding depreciation)\" in our Consolidated Statements of Operations. In our Wood Products segment, we view our shipping and handling costs as a cost of the manufacturing process and the movement of product to our end customers. For our BMD segment, costs related to shipping and handling of $ 53.5 million and $ 56.3 million for the three months ended March 31, 2023 and 2022, respectively, are included in \"Selling and distribution expenses\" in our Consolidated Statements of Operations. In our BMD segment, our activities relate to the purchase and resale of finished products, and excluding shipping and handling costs from \"Materials, labor, and other operating expenses (excluding depreciation)\" provides us a clearer view of our operating performance and the effectiveness of our sales and purchasing functions.\nCustomer Rebates and Allowances\nRebates are provided to our customers and our customers' customers based on the volume of their purchases, among other factors such as customer loyalty, conversion, and commitment, as well as temporary protection from price increases. We provide the rebates to increase the sell-through of our products. Rebates are generally estimated based on the expected amount to be paid and recorded as a decrease in \"Sales.\" At March 31, 2023 and December 31, 2022, we had $ 58.7 million and $ 92.9 million, respectively, of rebates payable to our customers recorded in \"Accrued liabilities, Other\" on our Consolidated Balance Sheets. We adjust our estimate of revenue at the earlier of when the probability of rebates paid changes or when the amounts become fixed. There have not been significant changes to our estimates of rebates, although it is reasonably possible that a change in the estimate may occur.\nVendor Rebates and Allowances\nWe receive rebates and allowances from our vendors under a number of different programs, including vendor marketing programs. At March 31, 2023 and December 31, 2022, we had $ 9.0 million and $ 17.8 million, respectively, of vendor rebates and allowances recorded in \"Receivables, Other\" on our Consolidated Balance Sheets. Rebates and allowances received from our vendors are recognized as a reduction of \"Materials, labor, and other operating expenses (excluding depreciation)\" when the product is sold, unless the rebates and allowances are linked to a specific incremental cost to sell a vendor's product. Amounts received from vendors that are linked to specific selling and distribution expenses are recognized as a reduction of \"Selling and distribution expenses\" in the period the expense is incurred.\nLeases\nWe primarily lease land, building, and equipment under operating and finance leases. We determine if an arrangement is a lease at inception and assess lease classification as either operating or finance at lease inception or upon modification. Substantially all of our leases with initial terms greater than one year are for real estate, including distribution centers, corporate headquarters, land, and other office space. Substantially all of these lease agreements have fixed payment terms based on the passage of time and are recorded in our BMD segment. Many of our leases include fixed escalation clauses, renewal options and/or termination options that are factored into our determination of lease term and lease payments when appropriate. Renewal options generally range from one to ten years with fixed payment terms similar to those in the original lease agreements. Some lease agreements provide us with the option to purchase the leased property at market value. Our lease agreements do not contain any residual value guarantees.\nROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. ROU assets and lease liabilities are recognized at the lease commencement date based on the estimated present value of fixed lease payments over the lease term. The current portion of our operating and finance lease liabilities are recorded in \"Accrued liabilities, Other\" on our Consolidated Balance Sheets.\nWe use our estimated incremental borrowing rate, which is derived from information available at the lease commencement date, in determining the present value of lease payments. In determining our incremental borrowing rates, we\n9\ngive consideration to publicly available interest rates for instruments with similar characteristics, including credit rating, term, and collateralization.\nFor purposes of determining straight-line rent expense, the lease term is calculated from the date we first take possession of the facility, including any periods of free rent and any renewal option periods we are reasonably certain of exercising. Variable lease expense generally includes reimbursement of actual costs for common area maintenance, property taxes, and insurance on leased real estate and are recorded as incurred. Most of our operating lease expense was recorded in \"Selling and distribution expenses\" in our Consolidated Statements of Operations. In addition, we do not separate lease and non-lease components for all of our leases.\nOur short-term leases primarily include equipment rentals with lease terms on a month-to-month basis, which provide for our seasonal needs and flexibility in the use of equipment. Our short-term leases also include certain real estate for which either party has the right to cancel upon providing notice of 30 to 90 days. We do not recognize ROU assets or lease liabilities for short-term leases.\nInventories\nInventories included the following (work in process is not material):\n\n| March 31,2023 | December 31,2022 |\n| (thousands) |\n| Finished goods and work in process | $ | 640,858 | $ | 596,328 |\n| Logs | 50,154 | 54,921 |\n| Other raw materials and supplies | 47,786 | 46,302 |\n| $ | 738,798 | $ | 697,551 |\n\nProperty and Equipment\nProperty and equipment consisted of the following asset classes:\n\n| March 31,2023 | December 31,2022 |\n| (thousands) |\n| Land | $ | 61,806 | $ | 60,211 |\n| Buildings | 242,484 | 231,087 |\n| Improvements | 70,419 | 69,832 |\n| Mobile equipment, information technology, and office furniture | 215,460 | 210,666 |\n| Machinery and equipment | 993,900 | 989,338 |\n| Construction in progress | 45,348 | 41,899 |\n| 1,629,417 | 1,603,033 |\n| Less: accumulated depreciation | ( 856,683 ) | ( 833,010 ) |\n| $ | 772,734 | $ | 770,023 |\n\n10\nFair Value\nFair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value hierarchy under GAAP gives the highest priority to quoted market prices (Level 1) and the lowest priority to unobservable inputs (Level 3). In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine fair value (Level 1). If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, we use quoted prices for similar assets and liabilities or inputs that are observable either directly or indirectly (Level 2). If quoted prices for identical or similar assets are not available or are unobservable, we may use internally developed valuation models, whose inputs include bid prices, and third-party valuations utilizing underlying asset assumptions (Level 3).\nFinancial Instruments\nOur financial instruments are cash and cash equivalents, accounts receivable, accounts payable, long-term debt, and an interest rate swap. Our cash is recorded at cost, which approximates fair value, and our cash equivalents are money market funds. As of March 31, 2023 and December 31, 2022, we held $ 981.1 million and $ 954.4 million, respectively, in money market funds that are measured at fair value on a recurring basis using Level 1 inputs. The recorded values of accounts receivable and accounts payable approximate fair values based on their short-term nature. At March 31, 2023 and December 31, 2022, the book value of our fixed-rate debt for each period was $ 400.0 million, and the fair value was estimated to be $ 348.0 million and $ 348.5 million, respectively. The difference between the book value and the fair value is derived from the difference between the period-end market interest rate and the stated rate of our fixed-rate, long-term debt. We estimated the fair value of our fixed-rate debt using quoted market prices of our debt in inactive markets (Level 2 inputs). The interest rate on our variable-rate debt is based on market conditions such as the Secured Overnight Financing Rate (SOFR) or a base rate. Because the interest rate on the variable-rate debt is based on current market conditions, we believe that the estimated fair value of the outstanding balance on our variable-rate debt approximates book value. As discussed below, we also have an interest rate swap to mitigate our variable interest rate exposure, the fair value of which is measured based on Level 2 inputs.\nInterest Rate Risk and Interest Rate Swap\nWe are exposed to interest rate risk arising from fluctuations in variable-rate SOFR on our term loan and when we have loan amounts outstanding on our Revolving Credit Facility. At March 31, 2023, we had $ 50.0 million of variable-rate debt outstanding based on one-month term SOFR . Our objective is to limit the variability of interest payments on our debt. To meet this objective, we enter into receive-variable, pay-fixed interest rate swaps to mitigate the variable-rate cash flow exposure with fixed-rate cash flows. In accordance with our risk management strategy, we actively monitor our interest rate exposure and use derivative instruments from time to time to manage the related risk. We do not speculate using derivative instruments.\nAt March 31, 2023, we had one interest rate swap agreement, which we entered into in 2020 and commenced in February 2022. Under the interest rate swap, we receive one-month SOFR plus a spread adjustment of 0.10 % variable interest rate payments and make fixed interest rate payments, thereby fixing the interest rate on $ 50.0 million of variable rate debt exposure. Payments on this interest rate swap, with a notional principal amount of $ 50.0 million, are due on a monthly basis at an annual fixed rate of 0.41 %, and this swap expires in June 2025.\nThe interest rate swap agreement was not designated as a cash flow hedge, and as a result, all changes in the fair value are recognized in \"Change in fair value of interest rate swaps\" in our Consolidated Statements of Operations rather than through other comprehensive income. At March 31, 2023 and December 31, 2022, we recorded long-term assets of $ 4.0 million and $ 4.8 million, respectively, in \"Other assets\" on our Consolidated Balance Sheets, representing the fair value of the interest rate swap agreement. The swap was valued based on observable inputs for similar assets and liabilities and other observable inputs for interest rates and yield curves (Level 2 inputs).\nConcentration of Credit Risk\nWe are exposed to credit risk related to customer accounts receivable. In order to manage credit risk, we consider customer concentrations and current economic trends and monitor the creditworthiness of significant customers based on ongoing credit evaluations. At March 31, 2023, receivables from two customers accounted for approximately 19 % and 12 % of total receivables. At December 31, 2022, receivables from these two customers accounted for approximately 17 % and 14 % of total receivables. No other customer accounted for 10% or more of total receivables.\n11\nNew and Recently Adopted Accounting Standards\nThere were no accounting standards recently issued that had or are expected to have a material impact on our consolidated financial statements and associated disclosures.\n3. Income Taxes\nFor the three months ended March 31, 2023 and 2022, we recorded $ 33.3 million and $ 98.9 million, respectively, of income tax expense and had an effective rate of 25.6 % and 24.6 %, respectively. For both periods, the primary reason for the difference between the federal statutory income tax rate of 21 % and the effective tax rate was the effect of state taxes.\nDuring the three months ended March 31, 2023 and 2022, cash paid for taxes, net of refunds received, were $ 1.2 million and $ 4.2 million, respectively.\n4. Net Income Per Common Share\nBasic net income per common share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Weighted average common shares outstanding for the basic net income per common share calculation includes certain vested restricted stock units (RSUs) and performance stock units (PSUs) as there are no conditions under which those shares will not be issued. Diluted net income per common share is computed by dividing net income by the combination of the weighted average number of common shares outstanding during the period and other potentially dilutive weighted average common shares. Other potentially dilutive weighted average common shares include the dilutive effect of stock options, RSUs, and PSUs for each period using the treasury stock method. Under the treasury stock method, the exercise price of a share and the amount of compensation expense, if any, for future service that has not yet been recognized are assumed to be used to repurchase shares in the current period.\nThe following table sets forth the computation of basic and diluted net income per common share:\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands, except per-share data) |\n| Net income | $ | 96,733 | $ | 302,600 |\n| Weighted average common shares outstanding during the period (for basic calculation) | 39,593 | 39,474 |\n| Dilutive effect of other potential common shares | 245 | 294 |\n| Weighted average common shares and potential common shares (for diluted calculation) | 39,838 | 39,768 |\n| Net income per common share - Basic | $ | 2.44 | $ | 7.67 |\n| Net income per common share - Diluted | $ | 2.43 | $ | 7.61 |\n\nThe computation of the dilutive effect of other potential common shares excludes stock awards representing an insignificant number of shares of common stock in both the three months ended March 31, 2023 and 2022. Under the treasury stock method, the inclusion of these stock awards would have been antidilutive.\n12\n5. Acquisition\nWe account for acquisition transactions in accordance with ASC 805, Business Combinations. Accordingly, the results of operations of the acquiree are included in our consolidated financial statements from the acquisition date. The consideration transferred is allocated to the identifiable assets acquired and liabilities assumed based on estimated fair values at the acquisition date, with any excess recorded as goodwill. Transaction-related costs are expensed in the period the costs are incurred. During the measurement period, which may be up to one year from the acquisition date, we may record adjustments to the assets acquired and liabilities assumed with the corresponding adjustment to goodwill.\nOn July 25, 2022, our wholly-owned subsidiary, Boise Cascade Wood Products, L.L.C., completed the acquisition of 100 % of the equity interest in Coastal Plywood, and its plywood manufacturing operations located in Havana, Florida, and Chapman, Alabama, for a purchase price of $ 515.2 million, including a post-closing adjustment of $ 1.6 million based upon a working capital target (the Acquisition).\nThe following table summarizes the final allocations of the purchase price to the assets acquired and liabilities assumed, based on our estimates of the fair value at the date of the Acquisition:\n| Acquisition Date Fair Value |\n| (thousands) |\n| Accounts receivable | $ | 16,123 |\n| Inventories | 22,977 |\n| Property and equipment | 251,329 |\n| Other assets | 1,809 |\n| Intangible assets: |\n| Trade name | 700 |\n| Customer relationships | 153,600 |\n| Goodwill | 77,576 |\n| Assets acquired | 524,114 |\n| Accounts payable and accrued liabilities | 6,299 |\n| Other long-term liabilities | 2,578 |\n| Liabilities assumed | 8,877 |\n| Net assets acquired | $ | 515,237 |\n\n13\n6. Goodwill and Intangible Assets\nGoodwill represents the excess of the purchase price and related costs over the fair value of the net tangible and intangible assets of businesses acquired.\nThe carrying amount of our goodwill by segment is as follows:\n| BuildingMaterialsDistribution | Wood Products | Total |\n| (thousands) |\n| Balance at December 31, 2022 and March 31, 2023 | $ | 11,792 | $ | 126,166 | $ | 137,958 |\n\nAt March 31, 2023 and December 31, 2022, intangible assets represented the values assigned to trade names and trademarks and customer relationships. We maintain trademarks for our manufactured wood products, particularly EWP. Our key registered trademarks are perpetual in duration as long as we continue to timely file all post registration maintenance documents related thereto. These trade names and trademarks have indefinite lives, are not amortized, and have a carrying amount of $ 8.9 million. In 2022, we acquired a trade name and customer relationships as discussed in Note 5, Acquisition. The acquired trade name has a useful life of one year . The weighted-average useful life for customer relationships from the date of purchase is approximately 10 years. For the three months ended March 31, 2023 and 2022 we recognized $ 4.3 million and $ 0.3 million, respectively, of amortization expense for intangible assets.\nIntangible assets consisted of the following:\n| March 31, 2023 |\n| Gross CarryingAmount | AccumulatedAmortization | Net CarryingAmount |\n| (thousands) |\n| Trade names and trademarks | $ | 9,600 | $ | ( 467 ) | $ | 9,133 |\n| Customer relationships | 166,050 | ( 18,050 ) | 148,000 |\n| $ | 175,650 | $ | ( 18,517 ) | $ | 157,133 |\n\n| December 31, 2022 |\n| Gross CarryingAmount | AccumulatedAmortization | Net CarryingAmount |\n| (thousands) |\n| Trade names and trademarks | $ | 9,600 | $ | ( 292 ) | $ | 9,308 |\n| Customer relationships | 166,050 | ( 13,925 ) | 152,125 |\n| $ | 175,650 | $ | ( 14,217 ) | $ | 161,433 |\n\n7. Debt\nLong-term debt consisted of the following:\n| March 31,2023 | December 31,2022 |\n| (thousands) |\n| Asset-based revolving credit facility due 2027 | $ | — | $ | — |\n| Asset-based credit facility term loan due 2027 | 50,000 | 50,000 |\n| 4.875% senior notes due 2030 | 400,000 | 400,000 |\n| Deferred financing costs | ( 5,386 ) | ( 5,608 ) |\n| Long-term debt | $ | 444,614 | $ | 444,392 |\n\n14\nAsset-Based Credit Facility\nOn May 15, 2015, Boise Cascade and its principal operating subsidiaries, Boise Cascade Wood Products, L.L.C., and Boise Cascade Building Materials Distribution, L.L.C., as borrowers, and Boise Cascade Wood Products Holdings Corp., as guarantor, entered into an Amended and Restated Credit Agreement, as amended, (the Amended Agreement) with Wells Fargo Capital Finance, LLC, as administrative agent, and the banks named therein as lenders. The Amended Agreement includes a $ 400 million senior secured asset-based revolving credit facility (Revolving Credit Facility) and a $ 50.0 million term loan (ABL Term Loan) maturing on the earlier of (a) September 9, 2027 and (b) 90 days prior to the maturity of our $ 400 million of 4.875 % senior notes due July 1, 2030 (or the maturity date of any permitted refinancing indebtedness or permitted upsized refinancing indebtedness in respect thereof). Interest on borrowings under our Revolving Credit Facility and ABL Term Loan are payable monthly. Borrowings under the Amended Agreement are constrained by a borrowing base formula dependent upon levels of eligible receivables and inventory reduced by outstanding borrowings and letters of credit (Availability).\nThe Amended Agreement is secured by a first-priority security interest in substantially all of our assets, except for property and equipment. The proceeds of borrowings under the agreement are available for working capital and other general corporate purposes.\nThe Amended Agreement contains customary nonfinancial covenants, including a negative pledge covenant and restrictions on new indebtedness, investments, distributions to equity holders, asset sales, and affiliate transactions, the scope of which are dependent on the Availability existing from time to time. The Amended Agreement also contains a requirement that we meet a 1 :1 fixed-charge coverage ratio (FCCR), applicable only if Availability falls below the greater of (a) 10 % of the Line Cap (as defined in the Amended Agreement) and (b) $ 35 million. Availability exceeded the minimum threshold amounts required for testing of the FCCR at all times since entering into the Amended Agreement, and Availability at March 31, 2023 was $ 395.9 million.\nThe Amended Agreement permits us to pay dividends only if at the time of payment (a) no default has occurred or is continuing (or would result from such payment) under the Amended Agreement, and (b) either (i) pro forma Excess Availability (as defined in the Amended Agreement) is equal to or exceeds the greater of (x) 20 % of the Line Cap and (y) $ 75 million or (ii) (x) pro forma Excess Availability is equal to or exceeds the greater of (1) 15 % of Line Cap and (2) $ 55 million and (y) our fixed-charge coverage ratio is greater than or equal to 1 :1 on a pro forma basis.\nRevolving Credit Facility\nInterest rates under the Revolving Credit Facility are based, at our election, on either Daily Simple SOFR, Term SOFR, or a base rate, as defined in the Amended Agreement, plus a spread over the index elected that ranges from 1.25 % to 1.50 % for loans based on SOFR and from 0.25 % to 0.50 % for loans based on the base rate. The spread is determined on the basis of a pricing grid that results in a higher spread as average quarterly Availability declines. Both SOFR options include an additional credit spread adjustment of 0.10 %. Letters of credit are subject to a fronting fee payable to the issuing bank and a fee payable to the lenders equal to the Term SOFR margin rate. In addition, we are required to pay an unused commitment fee at a rate of 0.20 % per annum of the average unused portion of the lending commitments.\nAt both March 31, 2023 and December 31, 2022, we had no borrowings outstanding under the Revolving Credit Facility and $ 4.1 million and $ 3.8 million, respectively, of letters of credit outstanding. These letters of credit and borrowings, if any, reduce availability under the Revolving Credit Facility by an equivalent amount.\nABL Term Loan\nThe ABL Term Loan was provided by institutions within the Farm Credit system. Borrowings under the ABL Term Loan may be repaid from time to time at the discretion of the borrowers without premium or penalty. However, any principal amount of ABL Term Loan repaid may not be subsequently re-borrowed.\nInterest rates under the ABL Term Loan are based, at our election, on either Daily Simple SOFR, Term SOFR, or a base rate, as defined in the Amended Agreement, plus a spread over the index elected that ranges from 1.75 % to 2.00 % for SOFR rate loans and from 0.75 % to 1.00 % for base rate loans, both dependent on the amount of Average Excess Availability (as defined in the Amended Agreement). Both SOFR options include an additional credit spread adjustment of 0.10 %. During the three months ended March 31, 2023, the average interest rate on the ABL Term Loan was approximately 6.36 %.\nWe have received and expect to continue receiving patronage credits under the ABL Term Loan. Patronage credits are distributions of profits from banks in the Farm Credit system, which are cooperatives that are required to distribute profits to\n15\ntheir members. Patronage distributions, which are generally made in cash, are received in the year after they are earned. Patronage credits are recorded as a reduction to interest expense in the year earned. After giving effect to expected patronage distributions, the effective average net interest rate on the ABL Term Loan was approximately 5.4 % during the three months ended March 31, 2023.\n2030 Notes\nOn July 27, 2020, we issued $ 400 million of 4.875 % senior notes due July 1, 2030 (2030 Notes) through a private placement that was exempt from the registration requirements of the Securities Act. Interest on our 2030 Notes is payable semiannually in arrears on January 1 and July 1. The 2030 Notes are guaranteed by each of our existing and future direct or indirect domestic subsidiaries that is a guarantor under our Amended Agreement.\nThe 2030 Notes are senior unsecured obligations and rank equally with all of the existing and future senior indebtedness of Boise Cascade Company and of the guarantors, senior to all of their existing and future subordinated indebtedness, effectively subordinated to all of their present and future senior secured indebtedness (including all borrowings with respect to our Amended Agreement to the extent of the value of the assets securing such indebtedness), and structurally subordinated to the indebtedness of any subsidiaries that do not guarantee the 2030 Notes.\nThe terms of the indenture governing the 2030 Notes, among other things, limit the ability of Boise Cascade and our restricted subsidiaries to: incur additional debt; declare or pay dividends; redeem stock or make other distributions to stockholders; make investments; create liens on assets; consolidate, merge or transfer substantially all of their assets; enter into transactions with affiliates; and sell or transfer certain assets. The indenture governing the 2030 Notes permits us to pay dividends only if at the time of payment (i) no default has occurred or is continuing (or would result from such payment) under the indenture, and (ii) our consolidated leverage ratio is no greater than 3.5 :1, or (iii) the dividend, together with other dividends since the issue date, would not exceed our \"builder\" basket under the indenture. In addition, the indenture includes certain specific baskets for the payment of dividends.\nThe indenture governing the 2030 Notes provides for customary events of default and remedies.\nInterest Rate Swap\nFor information on interest rate swap, see Interest Rate Risk and Interest Rate Swap of Note 2, Summary of Significant Accounting Policies.\nCash Paid for Interest\nFor the three months ended March 31, 2023 and 2022, cash payments for interest were $ 10.4 million and $ 10.6 million, respectively.\n16\n8. Leases\nLease Costs\nThe components of lease expense were as follows:\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| Operating lease cost | $ | 3,317 | $ | 3,561 |\n| Finance lease cost |\n| Amortization of right-of-use assets | 618 | 626 |\n| Interest on lease liabilities | 560 | 587 |\n| Variable lease cost | 1,385 | 1,034 |\n| Short-term lease cost | 1,551 | 1,312 |\n| Sublease income | ( 53 ) | ( 112 ) |\n| Total lease cost | $ | 7,378 | $ | 7,008 |\n\nOther Information\nSupplemental cash flow information related to leases was as follows:\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| Cash paid for amounts included in the measurement of lease liabilities |\n| Operating cash flows from operating leases | $ | 3,366 | $ | 3,440 |\n| Operating cash flows from finance leases | 560 | 587 |\n| Financing cash flows from finance leases | 451 | 422 |\n| Right-of-use assets obtained in exchange for lease obligations |\n| Operating leases | 92 | — |\n| Finance leases | — | — |\n\n17\nOther information related to leases was as follows:\n| March 31, 2023 | December 31, 2022 |\n| Weighted-average remaining lease term (years) |\n| Operating leases | 7 | 7 |\n| Finance leases | 14 | 14 |\n| Weighted-average discount rate |\n| Operating leases | 6.0 | % | 6.0 | % |\n| Finance leases | 7.6 | % | 7.6 | % |\n\nAs of March 31, 2023, our minimum lease payment requirements for noncancelable operating and finance leases are as follows:\n| Operating Leases | Finance Leases |\n| (thousands) |\n| Remainder of 2023 | $ | 10,162 | $ | 3,046 |\n| 2024 | 12,104 | 4,052 |\n| 2025 | 10,385 | 3,735 |\n| 2026 | 7,200 | 3,581 |\n| 2027 | 6,497 | 3,649 |\n| Thereafter | 23,633 | 33,086 |\n| Total future minimum lease payments | 69,981 | 51,149 |\n| Less: interest | ( 14,015 ) | ( 19,746 ) |\n| Total lease obligations | 55,966 | 31,403 |\n| Less: current obligations | ( 10,285 ) | ( 1,854 ) |\n| Long-term lease obligations | $ | 45,681 | $ | 29,549 |\n\n9. Stock-Based Compensation\nIn first quarter 2023 and 2022, we granted two types of stock-based awards under our incentive plan: performance stock units (PSUs) and restricted stock units (RSUs).\nPSU and RSU Awards\nDuring the three months ended March 31, 2023, we granted 93,282 PSUs to our officers and other employees, subject to performance and service conditions. For the officers, the number of shares actually awarded will range from 0 % to 200 % of the target amount, depending upon Boise Cascade's 2023 return on invested capital (ROIC), as approved by our compensation committee in accordance with the related grant agreement. We define ROIC as net operating profit after taxes (NOPAT) divided by average invested capital (based on a rolling thirteen-month average). We define NOPAT as net income plus after-tax financing expense. Invested capital is defined as total assets plus capitalized lease expense, less cash, cash equivalents, and current liabilities, excluding short-term debt. For the other employees, the number of shares actually awarded will range from 0 % to 200 % of the target amount, depending upon Boise Cascade’s 2023 EBITDA, defined as income before interest (interest expense and interest income), income taxes, and depreciation and amortization, as approved by executive management, determined in accordance with the related grant agreement. Because the PSUs contain a performance condition, we record compensation expense over the requisite service period based on the most probable number of shares expected to vest.\nDuring the three months ended March 31, 2022, we granted 66,180 PSUs to our officers and other employees, subject to performance and service conditions. During the 2022 performance period, officers and other employees earned 152 % and 200 %, respectively, of the target based on Boise Cascade's 2022 ROIC and EBITDA, as applicable, determined by our compensation committee and executive management, as applicable, in accordance with the related grant agreements.\nThe PSUs granted to officers generally vest in a single installment three years from the date of grant, while the PSUs granted to other employees vest in three equal tranches each year after the grant date.\n18\nDuring the three months ended March 31, 2023 and 2022, we granted an aggregate of 115,060 and 81,523 RSUs, respectively, to our officers, other employees, and nonemployee directors with only service conditions. The RSUs granted to officers and other employees vest in three equal tranches each year after the grant date. The RSUs granted to nonemployee directors vest in a single installment after a one year period.\nWe based the fair value of PSU and RSU awards on the closing market price of our common stock on the grant date. During the three months ended March 31, 2023 and 2022, the total fair value of PSUs and RSUs vested was $ 16.8 million and $ 12.0 million, respectively.\nThe following summarizes the activity of our PSUs and RSUs awarded under our incentive plan for the three months ended March 31, 2023:\n| PSUs | RSUs |\n| Number of shares | Weighted Average Grant-Date Fair Value | Number of shares | Weighted Average Grant-Date Fair Value |\n| Outstanding, December 31, 2022 | 317,854 | $ | 51.46 | 155,339 | $ | 65.17 |\n| Granted | 93,282 | 69.33 | 115,060 | 69.33 |\n| Performance condition adjustment (a) | 39,873 | 79.80 | — | — |\n| Vested | ( 154,794 ) | 40.61 | ( 87,632 ) | 60.64 |\n| Forfeited | ( 5,399 ) | 68.55 | ( 3,200 ) | 70.32 |\n| Outstanding, March 31, 2023 | 290,816 | $ | 66.54 | 179,567 | $ | 69.96 |\n\n_______________________________\n(a) Represents additional PSUs granted during the three months ended March 31, 2023, related to above-target achievement of the 2022 performance condition described above.\nCompensation Expense\nWe record compensation expense over the awards' vesting period and account for share-based award forfeitures as they occur, rather than making estimates of future forfeitures. Any shares not vested are forfeited. We recognize compensation expense for stock awards with only service conditions on a straight-line basis over the requisite service period. Most of our stock-based compensation expense was recorded in \"General and administrative expenses\" in our Consolidated Statements of Operations. Total stock-based compensation recognized from PSUs and RSUs, net of forfeitures, was as follows:\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| PSUs | $ | 1,814 | $ | 1,306 |\n| RSUs | 1,510 | 1,086 |\n| Total | $ | 3,324 | $ | 2,392 |\n\nThe related tax benefit for the three months ended March 31, 2023 and 2022, was $ 0.9 million and $ 0.6 million respectively. As of March 31, 2023, total unrecognized compensation expense related to nonvested share-based compensation arrangements was $ 23.7 million. This expense is expected to be recognized over a weighted-average period of 2.2 years.\n19\n10. Stockholders' Equity\nDividends\nOn November 14, 2017, we announced that our board of directors approved a dividend policy to pay quarterly cash dividends to holders of our common stock. For more information regarding our dividend declarations and payments made during each of the three months ended March 31, 2023 and 2022, see \"Common stock dividends\" on our Consolidated Statements of Stockholders' Equity.\nOn May 4, 2023 , our board of directors declared a quarterly dividend of $ 0.15 per share on our common stock, as well as a special dividend of $ 3.00 per share on our common stock, both payable on June 15, 2023 , to stockholders of record on June 1, 2023 . For a description of the restrictions in our asset-based credit facility and the indenture governing our senior notes on our ability to pay dividends, see Note 7, Debt.\nFuture dividend declarations, including amount per share, record date and payment date, will be made at the discretion of our board of directors and will depend upon, among other things, legal capital requirements and surplus, our future operations and earnings, general financial condition, material cash requirements, restrictions imposed by our asset-based credit facility and the indenture governing our senior notes, applicable laws, and other factors that our board of directors may deem relevant.\nStock Repurchase\nOn July 28, 2022, our board of directors authorized the repurchase of an additional 1.5 million shares of our common stock. This increase was in addition to the remaining authorized shares under our prior common stock repurchase program that was authorized on February 25, 2015 (the Program). Share repurchases may be made on an opportunistic basis, through open market transactions, privately negotiated transactions, or by other means in accordance with applicable federal securities laws. We are not obligated to purchase any shares and there is no set date that the Program will expire. Our board of directors may increase or decrease the number of shares under the Program or terminate the Program in its discretion at any time. During the three months ended March 31, 2023, we repurchased 24,727 shares under the Program at a cost of $ 1.5 million, or an average of $ 59.91 per share. The shares were purchased with cash on hand and are recorded as \"Treasury stock\" on our Consolidated Balance Sheet. As of March 31, 2023, there were 1,972,262 shares of common stock that may yet be purchased under the Program.\n11. Transactions With Related Party\nLouisiana Timber Procurement Company, L.L.C. (LTP) is an unconsolidated variable-interest entity that is 50 % owned by us and 50 % owned by Packaging Corporation of America (PCA). LTP procures sawtimber, pulpwood, residual chips, and other residual wood fiber to meet the wood and fiber requirements of us and PCA in Louisiana. We are not the primary beneficiary of LTP as we do not have power to direct the activities that most significantly affect the economic performance of LTP. Accordingly, we do not consolidate LTP's results in our financial statements.\nSales\nRelated-party sales to LTP from our Wood Products segment in our Consolidated Statements of Operations were $ 3.0 million and $ 3.7 million, respectively, during the three months ended March 31, 2023 and 2022. These sales are recorded in \"Sales\" in our Consolidated Statements of Operations.\nCosts and Expenses\nRelated-party wood fiber purchases from LTP were $ 20.1 million and $ 20.8 million, respectively, during the three months ended March 31, 2023 and 2022. These costs are recorded in \"Materials, labor, and other operating expenses (excluding depreciation)\" in our Consolidated Statements of Operations.\n20\n12. Segment Information\nWe operate our business using two reportable segments: Wood Products and BMD. We measure and evaluate our reportable segments based on net sales and segment operating income (loss). Accordingly, our chief operating decision maker reviews the performance of the company and allocates resources based primarily on net sales and segment operating income (loss) for our business segments. Unallocated corporate costs are presented as reconciling items to arrive at operating income. There are no differences in our basis of measurement of segment profit or loss from those disclosed in Note 16, Segment Information, of the Notes to Consolidated Financial Statements in \"Item 8. Financial Statements and Supplementary Data\" in our 2022 Form 10-K.\nWood Products and BMD segment sales to external customers, including related parties, by product line, are as follows:\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (millions) |\n| Wood Products (a) |\n| LVL (b) | $ | 7.4 | $ | 1.7 |\n| I-joists (b) | 4.7 | ( 2.2 ) |\n| Other engineered wood products (b) | 7.4 | 11.8 |\n| Plywood and veneer | 91.3 | 161.2 |\n| Lumber | 23.6 | 17.7 |\n| Byproducts | 24.3 | 19.1 |\n| Other | 6.5 | 5.2 |\n| 165.1 | 214.5 |\n| Building Materials Distribution |\n| Commodity | 547.5 | 1,102.0 |\n| General line | 533.6 | 615.1 |\n| Engineered wood products | 298.1 | 394.7 |\n| 1,379.2 | 2,111.8 |\n| $ | 1,544.3 | $ | 2,326.3 |\n\n___________________________________\n(a) Amounts represent sales to external customers. Sales are calculated after intersegment sales eliminations to our BMD segment.\n(b) Sales of EWP to external customers are net of the cost of all EWP rebates and sales allowances provided at various stages of the supply chain (including distributors, dealers, and homebuilders). For both the three months ended March 31, 2023 and 2022, approximately 79 % of Wood Products' EWP sales volumes were to our BMD segment.\n21\nAn analysis of our operations by segment is as follows:\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| Net sales by segment |\n| Wood Products | $ | 437,428 | $ | 558,944 |\n| Building Materials Distribution | 1,379,242 | 2,111,833 |\n| Intersegment eliminations (a) | ( 272,341 ) | ( 344,495 ) |\n| Total net sales | $ | 1,544,329 | $ | 2,326,282 |\n| Segment operating income |\n| Wood Products | $ | 69,395 | $ | 190,116 |\n| Building Materials Distribution | 69,685 | 225,892 |\n| Total segment operating income | 139,080 | 416,008 |\n| Unallocated corporate costs | ( 11,478 ) | ( 10,380 ) |\n| Income from operations | $ | 127,602 | $ | 405,628 |\n\n___________________________________\n(a) Primarily represents intersegment sales from our Wood Products segment to our BMD segment.\n13. Commitments, Legal Proceedings and Contingencies, and Guarantees\nCommitments\nWe are a party to a number of long-term log supply agreements that are discussed in Note 17, Commitments, Legal Proceedings and Contingencies, and Guarantees, of the Notes to Consolidated Financial Statements in \"Item 8. Financial Statements and Supplementary Data\" in our 2022 Form 10-K. In addition, we have purchase obligations for goods and services, capital expenditures, and raw materials entered into in the normal course of business. As of March 31, 2023, there have been no material changes to the above commitments disclosed in the 2022 Form 10-K.\nLegal Proceedings and Contingencies\nWe are a party to legal proceedings that arise in the ordinary course of our business, including commercial liability claims, premises claims, environmental claims, and employment-related claims, among others. As of the date of this filing, we do not believe that we are party to any legal action that could reasonably be expected to have, individually or in the aggregate, a material adverse effect on our financial position, results of operations, or cash flows.\nGuarantees\nWe provide guarantees, indemnifications, and assurances to others. Note 17, Commitments, Legal Proceedings and Contingencies, and Guarantees, of the Notes to Consolidated Financial Statements in \"Item 8. Financial Statements and Supplementary Data\" in our 2022 Form 10-K describes the nature of our guarantees, including the approximate terms of the guarantees, how the guarantees arose, the events or circumstances that would require us to perform under the guarantees, and the maximum potential undiscounted amounts of future payments we could be required to make. As of March 31, 2023, there have been no material changes to the guarantees disclosed in the 2022 Form 10-K.\n22\n\nITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nUnderstanding Our Financial Information\nThis Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and related notes in \"Item 1. Financial Statements\" of this Form 10-Q, as well as our 2022 Form 10-K. The following discussion includes statements regarding our expectations with respect to our future performance, liquidity, and capital resources. Such statements, along with any other nonhistorical statements in the discussion, are forward-looking. These forward-looking statements include, without limitation, any statement that may predict, indicate, or imply future results, performance, or achievements and may contain the words \"may,\" \"will,\" \"expect,\" \"believe,\" \"should,\" \"plan,\" \"anticipate,\" and other similar expressions. All of these forward-looking statements are based on estimates and assumptions made by our management that, although believed by us to be reasonable, are inherently uncertain. These forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in \"Item 1A. Risk Factors\" in our 2022 Form 10-K, as well as those factors listed in other documents we file with the Securities and Exchange Commission (the SEC). We do not assume an obligation to update any forward-looking statement. Our future actual results may differ materially from those contained in or implied by any of the forward-looking statements in this Form 10-Q.\nBackground\nBoise Cascade Company is a building products company headquartered in Boise, Idaho. As used in this Form 10-Q, the terms \"Boise Cascade,\" \"we,\" and \"our\" refer to Boise Cascade Company and its consolidated subsidiaries. Boise Cascade is a large, vertically-integrated wood products manufacturer and building materials distributor. We have two reportable segments: (i) Wood Products, which primarily manufactures engineered wood products (EWP) and plywood; and (ii) Building Materials Distribution (BMD), which is a wholesale distributor of building materials. Our products are used in the construction of new residential housing, including single-family, multi-family, and manufactured homes, the repair-and-remodeling of existing housing, the construction of light industrial and commercial buildings, and industrial applications. For more information, see Note 12, Segment Information, of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in \"Item 1. Financial Statements\" of this Form 10-Q.\nExecutive Overview\nWe recorded income from operations of $127.6 million during the three months ended March 31, 2023, compared with income from operations of $405.6 million during the three months ended March 31, 2022. In our Wood Products segment, income decreased $120.7 million to $69.4 million for the three months ended March 31, 2023, from $190.1 million for the three months ended March 31, 2022, due primarily to lower plywood sales prices, lower EWP sales volumes, higher per-unit conversion costs, and an increase in depreciation and amortization expense due to the acquisition of two plywood facilities located in Havana, Florida, and Chapman, Alabama, on July 25, 2022 (the Acquisition). These decreases were offset partially by higher EWP sales prices and higher plywood sales volumes, as well as lower OSB costs (used in the manufacture of I-joists). In our BMD segment, income decreased $156.2 million to $69.7 million for the three months ended March 31, 2023, from $225.9 million for the three months ended March 31, 2022, driven by a gross margin decrease of $177.3 million, resulting primarily from lower margins on commodity products and lower sales volumes, offset partially by decreased selling and distribution expenses of $20.3 million. These changes are discussed further in \"Our Operating Results\" below.\nWe ended first quarter 2023 with $1,000.7 million of cash and cash equivalents and $395.9 million of undrawn committed bank line availability, for total available liquidity of $1,396.7 million. We had $444.6 million of outstanding debt at March 31, 2023. We generated $2.4 million of cash during the three months ended March 31, 2023, as cash provided by operations was offset partially by capital spending, dividends paid on our common stock, and tax withholding payments on stock-based awards. A further description of our cash sources and uses for the three-month comparative periods are discussed in \"Liquidity and Capital Resources\" below.\nDemand for the products we manufacture, as well as the products we purchase and distribute, is correlated with new residential construction, residential repair-and-remodeling activity and light commercial construction. U.S. housing starts in March 2023 were approximately 1.42 million on a seasonally adjusted annual rate basis, as reported by the U.S. Census Bureau. In addition, mortgage rates have declined from peak levels in late 2022, and measures of builder sentiment have improved from fourth quarter 2022 levels. However, home affordability remains a challenge for consumers, and the Federal Reserve's ongoing actions in response to inflationary data and what impacts these actions have on future mortgage rates and the broader economy\n23\nwill influence the near-term demand environment. As such, the full year outlook for 2023 is uncertain and is reflected in various industry forecasts for 2023 U.S. housing starts that generally range from 1.2 million to 1.4 million units, compared with actual housing starts of 1.55 million in 2022, as reported by the U.S. Census Bureau. Regarding home improvement spending, the age of U.S. housing stock and elevated levels of homeowner equity have provided a favorable backdrop for repair-and-remodel spending. However, industry forecasts project continued moderation of year-over-year growth in renovation spending, and economic uncertainty may also negatively impact homeowners' further investment in their residences.\nAs a manufacturer of certain commodity products, we have sales and profitability exposure to declines in commodity product prices and rising input costs. Our distribution business purchases and resells a broad mix of commodity products with periods of increasing prices providing the opportunity for higher sales and increased margins, while declining price environments expose us to declines in sales and profitability. Future commodity product pricing and commodity input costs may be volatile in response to economic uncertainties, industry operating rates, transportation constraints or disruptions, net import and export activity, inventory levels in various distribution channels, and seasonal demand patterns. In addition, EWP volumes will continue to be influenced by demand for new residential construction, particularly single-family housing starts and we expect further EWP price erosion in the second quarter.\nFactors That Affect Our Operating Results and Trends\nOur results of operations and financial performance are influenced by a variety of factors, including the following:\n•the commodity nature of a portion of our products and their price movements, which are driven largely by industry capacity and operating rates, industry cycles that affect supply and demand, and net import and export activity;\n•general economic conditions, including but not limited to housing starts, repair-and-remodeling activity, light commercial construction, inventory levels of new and existing homes for sale, foreclosure rates, interest rates, inflation, unemployment rates, household formation rates, prospective home buyers' access to and cost of financing, and housing affordability, that ultimately affect demand for our products;\n•the highly competitive nature of our industry;\n•declines in demand for our products due to competing technologies or materials, as well as changes in building code provisions;\n•disruptions to information systems used to process and store customer, employee, and vendor information, as well as the technology that manages our operations and other business processes;\n•material disruptions and/or major equipment failure at our manufacturing facilities;\n•labor disruptions, shortages of skilled and technical labor, or increased labor costs;\n•the need to successfully formulate and implement succession plans for key members of our management team;\n•product shortages, loss of key suppliers, and our dependence on third-party suppliers and manufacturers;\n•the cost and availability of third-party transportation services used to deliver the goods we manufacture and distribute, as well as our raw materials;\n•cost and availability of raw materials, including wood fiber and glues and resins;\n•our ability to successfully and efficiently complete and integrate acquisitions;\n•the concentration of our sales among a relatively small group of customers, as well as the financial condition and creditworthiness of our customers;\n•impairment of our long-lived assets, goodwill, and/or intangible assets;\n•substantial ongoing capital investment costs, including those associated with acquisitions, and the difficulty in offsetting fixed costs related to those investments;\n24\n•our indebtedness, including the possibility that we may not generate sufficient cash flows from operations or that future borrowings may not be available in amounts sufficient to fulfill our debt obligations and fund other liquidity needs;\n•restrictive covenants contained in our debt agreements;\n•compliance with data privacy and security laws and regulations;\n•the impacts of climate change and related legislative and regulatory responses intended to reduce climate change;\n•cost of compliance with government regulations, in particular, environmental regulations;\n•the enactment of tax reform legislation;\n•exposure to product liability, product warranty, casualty, construction defect, and other claims;\n•fluctuations in the market for our equity; and\n•the other factors described in \"Item 1A. Risk Factors\" in our 2022 Form 10-K.\n25\nOur Operating Results\nThe following tables set forth our operating results in dollars and as a percentage of sales for the three months ended March 31, 2023 and 2022:\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (millions) |\n| Sales | $ | 1,544.3 | $ | 2,326.3 |\n| Costs and expenses |\n| Materials, labor, and other operating expenses (excluding depreciation) | 1,230.6 | 1,729.9 |\n| Depreciation and amortization | 31.2 | 20.5 |\n| Selling and distribution expenses | 128.8 | 146.7 |\n| General and administrative expenses | 26.5 | 26.1 |\n| Other (income) expense, net | (0.3) | (2.5) |\n| 1,416.7 | 1,920.7 |\n| Income from operations | $ | 127.6 | $ | 405.6 |\n| (percentage of sales) |\n| Sales | 100.0 | % | 100.0 | % |\n| Costs and expenses |\n| Materials, labor, and other operating expenses (excluding depreciation) | 79.7 | % | 74.4 | % |\n| Depreciation and amortization | 2.0 | 0.9 |\n| Selling and distribution expenses | 8.3 | 6.3 |\n| General and administrative expenses | 1.7 | 1.1 |\n| Other (income) expense, net | — | (0.1) |\n| 91.7 | % | 82.6 | % |\n| Income from operations | 8.3 | % | 17.4 | % |\n\n26\nSales Volumes and Prices\nSet forth below are historical U.S. housing starts data, segment sales volumes and average net selling prices for the principal products sold by our Wood Products segment, and sales mix and gross margin information for our BMD segment for the three months ended March 31, 2023 and 2022.\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| U.S. Housing Starts (a) |\n| Single-family | 190.5 | 266.8 |\n| Multi-family | 129.4 | 122.9 |\n| 319.9 | 389.7 |\n| (thousands) |\n| Segment Sales |\n| Wood Products | $ | 437,428 | $ | 558,944 |\n| Building Materials Distribution | 1,379,242 | 2,111,833 |\n| Intersegment eliminations | (272,341) | (344,495) |\n| Total sales | $ | 1,544,329 | $ | 2,326,282 |\n| Wood Products | (millions) |\n| Sales Volumes |\n| Laminated veneer lumber (LVL) (cubic feet) | 3.6 | 4.6 |\n| I-joists (equivalent lineal feet) | 39 | 65 |\n| Plywood (sq. ft.) (3/8\" basis) | 406 | 317 |\n| Wood Products | (dollars per unit) |\n| Average Net Selling Prices |\n| Laminated veneer lumber (LVL) (cubic foot) | $ | 31.17 | $ | 26.40 |\n| I-joists (1,000 equivalent lineal feet) | 2,168 | 1,877 |\n| Plywood (1,000 sq. ft.) (3/8\" basis) | 367 | 689 |\n| (percentage of Building Materials Distribution sales) |\n| Building Materials Distribution |\n| Product Line Sales |\n| Commodity | 39.7 | % | 52.2 | % |\n| General line | 38.7 | % | 29.1 | % |\n| Engineered wood products | 21.6 | % | 18.7 | % |\n| Gross margin percentage (b) | 14.8 | % | 18.0 | % |\n\n_______________________________________\n(a) Actual U.S. housing starts data reported by the U.S. Census Bureau.\n(b) We define gross margin as \"Sales\" less \"Materials, labor, and other operating expenses (excluding depreciation).\" Substantially all costs included in \"Materials, labor, and other operating expenses (excluding depreciation)\" for our BMD segment are for inventory purchased for resale. Gross margin percentage is gross margin as a percentage of segment sales.\n27\nSales\nFor the three months ended March 31, 2023, total sales decreased $782.0 million, or 34%, to $1,544.3 million from $2,326.3 million during the three months ended March 31, 2022. As described below, the decrease in sales was driven by the changes in sales prices and volumes for the products we manufacture and distribute with single-family residential construction activity being the key demand driver of our sales. In first quarter 2023, total U.S. housing starts decreased 18%, driven by a decrease in single-family housing starts of 29% compared with the same period in 2022. Average composite lumber and average composite panel prices for the three months ended March 31, 2023 were 67% and 59% lower, respectively, than in the same period in the prior year, as reflected by Random Lengths composite lumber and panel pricing.\nWood Products. Sales, including sales to our BMD segment, decreased $121.5 million, or 22%, to $437.4 million for the three months ended March 31, 2023, from $558.9 million for the three months ended March 31, 2022. The decrease in sales was driven by lower plywood sales prices of 47%, resulting in decreased sales of $130.6 million. In addition, lower sales volumes of I-joists and LVL (collectively referred to as EWP) of 41% and 22%, respectively, resulted in decreased sales of $50.0 million and $26.4 million, respectively. EWP sales volumes decreased due to a decline in housing starts. I-joist volumes were also impacted by the availability of product substitutes and construction methods in certain geographies that reduce the wood floor opportunity. These decreases were offset partially by higher sales volumes for plywood of 28%, resulting in increased sales of $61.3 million. In addition, higher sales prices for LVL and I-joists of 18% and 16%, respectively, resulted in increased sales of $17.4 million and $11.3 million, respectively. The increase in EWP pricing was due to realizations of previously announced price increases and the expiration of certain temporary price protection arrangements.\nBuilding Materials Distribution. Sales decreased $732.6 million, or 35%, to $1,379.2 million for the three months ended March 31, 2023, from $2,111.8 million for the three months ended March 31, 2022. Compared with the same quarter in the prior year, the overall decrease in sales was driven by sales price and sales volume decreases of 20% and 15%, respectively. By product line, commodity sales decreased 50%, or $554.5 million; general line product sales decreased 13%, or $81.6 million; and sales of EWP (substantially all of which are sourced through our Wood Products segment) decreased 24%, or $96.5 million.\nCosts and Expenses\nMaterials, labor, and other operating expenses (excluding depreciation) decreased $499.3 million, or 29%, to $1,230.6 million for the three months ended March 31, 2023, compared with $1,729.9 million during the same period in the prior year. In our Wood Products segment, materials, labor, and other operating expenses decreased due to lower EWP sales volumes, as well as lower per-unit costs of OSB (used in the manufacture of I-joists) of approximately 19%, compared with first quarter 2022, as well as decreased other manufacturing costs, offset partially by increased labor costs. However, materials, labor, and other operating expenses as a percentage of sales (MLO rate) in our Wood Products segment increased by 1,340 basis points. The increase in the MLO rate was primarily the result of lower plywood sales prices, resulting in decreased leveraging of labor, wood fiber, and other manufacturing costs. In BMD, the decrease in materials, labor, and other operating expenses was driven by lower purchased materials costs as a result of lower sales volumes and lower commodity prices, compared with first quarter 2022. However, the BMD segment MLO rate increased by 330 basis points compared with first quarter 2022, driven primarily by lower margin percentages on our commodity product sales. In our BMD Segment, periods of increasing prices provide the opportunity for higher sales and increased margins, while declining price environments generally result in declines in sales and profitability.\nDepreciation and amortization expenses increased $10.7 million, or 52%, to $31.2 million for the three months ended March 31, 2023, compared with $20.5 million during the same period in the prior year. The increase was due primarily to the Acquisition on July 25, 2022, and other capital expenditures.\nSelling and distribution expenses decreased $17.9 million, or 12%, to $128.8 million for the three months ended March 31, 2023, compared with $146.7 million during the same period in the prior year, primarily as a result of lower incentive compensation expenses of $20.0 million, offset partially by an increase in shipping and handling costs and discretionary expenses during the three months ended March 31, 2023 compared with the same period in the prior year.\nGeneral and administrative expenses increased $0.4 million, or 2%, to $26.5 million for the three months ended March 31, 2023, compared with $26.1 million for the same period in the prior year, primarily due to an increase in professional fees and employee-related expenses, offset partially by lower incentive compensation expenses during the three months ended March 31, 2023 compared with the same period in the prior year.\n28\nFor the three months ended March 31, 2023, other income (expense), net, was $0.3 million of income, compared with $2.5 million of income for the three months ended March 31, 2022. Other income for the three months ended March 31, 2022 primarily included earn-out income related to a previous asset sale in our Wood Products segment.\nIncome From Operations\nIncome from operations decreased $278.0 million to $127.6 million for the three months ended March 31, 2023, compared with $405.6 million for the three months ended March 31, 2022.\nWood Products. Segment income decreased $120.7 million to $69.4 million for the three months ended March 31, 2023, compared with $190.1 million for the three months ended March 31, 2022. The decrease in segment income was due primarily to lower plywood sales prices and lower EWP sales volumes. In addition, segment income was negatively impacted by higher per-unit conversion costs and an increase in depreciation and amortization expense of $10.7 million related to the Acquisition. These decreases in segment income were offset partially by higher EWP sales prices and higher plywood sales volumes, as well as lower OSB costs (used in the manufacture of I-joists).\nBuilding Materials Distribution. Segment income decreased $156.2 million to $69.7 million for the three months ended March 31, 2023, from $225.9 million for the three months ended March 31, 2022. The decline in segment income was driven by a gross margin decrease of $177.3 million, resulting primarily from lower margins on commodity products and lower sales volumes, offset partially by decreased selling and distribution expenses of $20.3 million.\nCorporate. Unallocated corporate expenses increased $1.1 million to $11.5 million for the three months ended March 31, 2023, from $10.4 million for the same period in the prior year. The increase was due primarily to an increase in professional fees.\nOther\nInterest Income. Interest income increased $9.6 million to $9.7 million for the three months ended March 31, 2023, from $0.1 million for the three months ended March 31, 2022. The increase was due primarily to higher interest rates on cash equivalents and increases in the average balances of cash equivalents.\nChange in fair value of interest rate swaps. For information related to our interest rate swap, see the discussion under \"Interest Rate Risk and Interest Rate Swap\" of Note 2, Summary of Significant Accounting Policies, of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in \"Item 1. Financial Statements\" of this Form 10-Q.\nIncome Tax Provision\nFor the three months ended March 31, 2023 and 2022, we recorded $33.3 million and $98.9 million, respectively, of income tax expense and had an effective rate of 25.6% and 24.6%, respectively. For both periods, the primary reason for the difference between the federal statutory income tax rate of 21% and the effective tax rate was the effect of state taxes.\nLiquidity and Capital Resources\nWe ended first quarter 2023 with $1,000.7 million of cash and cash equivalents and $444.6 million of debt. At March 31, 2023, we had $1,396.7 million of available liquidity (cash and cash equivalents and undrawn committed bank line availability). We generated $2.4 million of cash during the three months ended March 31, 2023, as cash provided by operations was offset partially by capital spending, dividends paid on our common stock, and tax withholding payments on stock-based awards. Further descriptions of our cash sources and uses for the three month comparative periods are noted below.\nWe believe that our cash flows from operations, combined with our current cash levels and available borrowing capacity, will be adequate to fund debt service requirements and provide cash, as required, to support our ongoing operations, capital expenditures, lease obligations, working capital, income tax payments, and to pay cash dividends to holders of our common stock over the next 12 months. We expect to fund our seasonal and intra-month working capital requirements in 2023 from cash on hand and, if necessary, borrowings under our revolving credit facility.\n29\nSources and Uses of Cash\nWe generate cash primarily from sales of our products, as well as short-term and long-term borrowings. Our primary uses of cash are for expenses related to the manufacture and distribution of building products, including inventory purchased for resale, wood fiber, labor, energy, and glues and resins. In addition to paying for ongoing operating costs, we use cash to invest in our business, service our debt and lease obligations, and return cash to our shareholders through dividends or common stock repurchases. Below is a discussion of our sources and uses of cash for operating activities, investing activities, and financing activities.\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| Net cash provided by operations | $ | 47,992 | $ | 198,945 |\n| Net cash used for investment | (29,498) | (14,867) |\n| Net cash used for financing | (16,117) | (10,264) |\n\nOperating Activities\nFor the three months ended March 31, 2023, our operating activities generated $48.0 million of cash, compared with $198.9 million of cash generated in the same period in 2022. The $150.9 million decrease in cash provided by operations was due primarily to a decrease in income from operations, offset partially by a lesser year-over-year increase in working capital and a decrease in cash paid for taxes, net of refunds, of $2.9 million. Working capital increased $117.7 million during the three months ended March 31, 2023, compared with a $217.8 million increase for the same period in the prior year. See \"Our Operating Results\" in this Management's Discussion and Analysis of Financial Condition and Results of Operations for more information related to factors affecting our operating results.\nThe increase in working capital during both periods was primarily attributable to higher receivables and inventories, offset by an increase in accounts payable and accrued liabilities. The increases in receivables in both periods primarily reflect increased sales of approximately 26% and 49%, comparing sales for the months of March 2023 and 2022 with sales for the months of December 2022 and 2021, respectively. Inventories increased during the three months ended March 31, 2023 in preparation for the spring building season. During the three months ended March 31, 2022 inventories increased primarily due to increased cost of inventory purchased for resale and higher production costs for our manufactured products. The increase in accounts payable and accrued liabilities as of March 31, 2023 was related to the increase in inventories, offset partially by employee incentive compensation payouts made during the quarter and lower accrued rebates. The increase in accounts payable and accrued liabilities as of March 31, 2022 was related to the increase in inventories and higher accrued rebates, offset partially by employee incentive compensation payouts made during first quarter 2022.\nInvestment Activities\nDuring the three months ended March 31, 2023 and 2022, we used $30.1 million and $17.4 million, respectively, of cash for purchases of property and equipment, including business improvement and quality/efficiency projects, replacement and expansion projects, and ongoing environmental compliance. During the three months ended March 31, 2022, we received $2.5 million of earn-out income related to a previous asset sale in our Wood Products segment.\nWe expect capital expenditures in 2023 to total approximately $120 million to $140 million. We expect our capital spending in 2023 will be for business improvement and quality/efficiency projects, replacement and expansion projects, and ongoing environmental compliance. Our 2023 capital expenditures range includes funding for greenfield distribution centers in South Carolina and Texas, projects at our mills in the southeast to expand our EWP capacity, and the purchase of property to house an additional door shop assembly operation in Kansas City, Missouri. This level of capital expenditures could increase or decrease as a result of several factors, including acquisitions, efforts to further accelerate organic growth, exercise of lease purchase options, our financial results, future economic conditions, availability of engineering and construction resources, and timing and availability of equipment purchases.\nFinancing Activities\nDuring the three months ended March 31, 2023, our financing activities used $16.1 million of cash, including $8.3 million for common stock dividend payments, $5.9 million of tax withholding payments on stock-based awards, and $1.5\n30\nmillion for the repurchase of 24,727 shares of our common stock. During the three months ended March 31, 2023, we did not borrow under our revolving credit facility, and therefore have no borrowings outstanding on the facility as of March 31, 2023.\nDuring the three months ended March 31, 2022, our financing activities used $10.3 million of cash, including $5.9 million for common stock dividend payments and $3.9 million of tax withholding payments on stock-based awards. During the three months ended March 31, 2022, we did not borrow under our revolving credit facility.\nFuture dividend declarations, including amount per share, record date and payment date, will be made at the discretion of our board of directors and will depend upon, among other things, legal capital requirements and surplus, our future operations and earnings, general financial condition, material cash requirements, restrictions imposed by our asset-based credit facility and the indenture governing our senior notes, applicable laws, and other factors that our board of directors may deem relevant.\nFor more information related to our debt transactions and structure, our dividend policy, and our stock repurchase program, see the discussion in Note 7, Debt, and Note 10, Stockholders' Equity, respectively, of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in \"Item 1. Financial Statements\" of this Form 10-Q.\nOther Material Cash Requirements\nFor information about other material cash requirements, see Liquidity and Capital Resources in \"Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations\" in our 2022 Form 10-K. As of March 31, 2023, there have been no material changes in other material cash requirements outside the ordinary course of business since December 31, 2022.\nGuarantees\nNote 9, Debt, and Note 17, Commitments, Legal Proceedings and Contingencies, and Guarantees, of the Notes to Consolidated Financial Statements in \"Item 8. Financial Statements and Supplementary Data\" in our 2022 Form 10-K describe the nature of our guarantees, including the approximate terms of the guarantees, how the guarantees arose, the events or circumstances that would require us to perform under the guarantees, and the maximum potential undiscounted amounts of future payments we could be required to make. As of March 31, 2023, there have been no material changes to the guarantees disclosed in our 2022 Form 10-K.\nSeasonal Influences\nWe are exposed to fluctuations in quarterly sales volumes and expenses due to seasonal factors. These seasonal factors are common in the building products industry. Seasonal changes in levels of building activity affect our building products businesses, which are dependent on housing starts, repair-and-remodeling activities, and light commercial construction activities. We typically report lower sales volumes in the first and fourth quarters due to the impact of poor weather on the construction market, and we generally have higher sales volumes in the second and third quarters, reflecting an increase in construction due to more favorable weather conditions. We typically have higher working capital in the first and second quarters in preparation and response to the building season. Seasonally cold weather increases costs, especially energy consumption costs, at most of our manufacturing facilities.\nEmployees\nAs of April 30, 2023, we had approximately 6,660 employees. Approximately 19% of these employees work pursuant to collective bargaining agreements. As of April 30, 2023, we had ten collective bargaining agreements. One agreement covering approximately 80 employees at our Canadian EWP facility expired on December 31, 2022, but the terms and conditions of this agreement remain in effect pending negotiation of a new agreement. We may not be able to renew this agreement or may renew it on terms that are less favorable to us than the current agreement. If any of these agreements are not renewed or extended upon their termination, we could experience a material labor disruption, strike, or significantly increased labor costs at one or more of our facilities, either in the course of negotiations of a labor agreement or otherwise. Labor disruptions or shortages could prevent us from meeting customer demands or result in increased costs, thereby reducing our sales and profitability.\n31\nDisclosures of Financial Market Risks\nIn the normal course of business, we are exposed to financial risks such as changes in commodity prices, interest rates, and foreign currency exchange rates. As of March 31, 2023, there have been no material changes to financial market risks disclosed in our 2022 Form 10-K.\nEnvironmental\nAs of March 31, 2023, there have been no material changes to environmental issues disclosed in our 2022 Form 10-K. For additional information, see Environmental in \"Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations\" in our 2022 Form 10-K.\nCritical Accounting Estimates\nCritical accounting estimates are those that are most important to the portrayal of our financial condition and results. These estimates require management's most difficult, subjective, or complex judgments, often as a result of the need to estimate matters that are inherently uncertain. We review the development, selection, and disclosure of our critical accounting estimates with the Audit Committee of our board of directors. For information about critical accounting estimates, see Critical Accounting Estimates in \"Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations\" in our 2022 Form 10-K. At March 31, 2023, there have been no material changes to our critical accounting estimates from those disclosed in our 2022 Form 10-K.\nNew and Recently Adopted Accounting Standards\nFor information related to new and recently adopted accounting standards, see \"New and Recently Adopted Accounting Standards\" in Note 2, Summary of Significant Accounting Policies, of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in \"Item 1. Financial Statements\" in this Form 10-Q.\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nFor information relating to quantitative and qualitative disclosures about market risk, see the discussion under \"Item 7A. Quantitative and Qualitative Disclosures About Market Risk\" and under the headings \"Disclosures of Financial Market Risks\" and \"Financial Instruments\" in \"Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations\" in our 2022 Form 10-K. As of March 31, 2023, there have been no material changes in our exposure to market risk from those disclosed in our 2022 Form 10-K.\n\nITEM 4. CONTROLS AND PROCEDURES\nEvaluation of Disclosure Controls and Procedures\nWe maintain \"disclosure controls and procedures,\" as defined in Rule 13a-15(e) under the Exchange Act. We have designed these controls and procedures to reasonably assure that information required to be disclosed in our reports filed or submitted under the Exchange Act, such as this Form 10-Q, is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. We have also designed our disclosure controls to provide reasonable assurance that such information is accumulated and communicated to our senior management, including our chief executive officer (CEO) and our chief financial officer (CFO), as appropriate, to allow them to make timely decisions regarding our required disclosures. Based on their evaluation, our CEO and CFO have concluded that as of March 31, 2023, our disclosure controls and procedures were effective.\nChanges in Internal Control Over Financial Reporting\nThere were no changes in our internal control over financial reporting that occurred during the three months ended March 31, 2023, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n32\nPART II—OTHER INFORMATION\nITEM 1. LEGAL PROCEEDINGS\nWe are a party to legal proceedings that arise in the ordinary course of our business, including commercial liability claims, premises claims, environmental claims, and employment-related claims, among others. As of the date of this filing, we do not believe that we are party to any legal action that could reasonably be expected to have, individually or in the aggregate, a material adverse effect on our financial position, results of operations, or cash flows.\nSEC regulations require us to disclose certain information about proceedings arising under federal, state or local environmental provisions if we reasonably believe that such proceedings may result in monetary sanctions above a stated threshold. Pursuant to the SEC regulations, we use a threshold of $1 million or more for purposes of determining whether disclosure of any such proceedings is required.\nITEM 1A. RISK FACTORS\nThis report on Form 10-Q contains forward-looking statements. Statements that are not historical or current facts, including statements about our expectations, anticipated financial results, projected capital expenditures, and future business prospects, are forward-looking statements. You can identify these statements by our use of words such as \"may,\" \"will,\" \"expect,\" \"believe,\" \"should,\" \"plan,\" \"anticipate,\" and other similar expressions. You can find examples of these statements throughout this report, including \"Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.\" We cannot guarantee that our actual results will be consistent with the forward-looking statements we make in this report. You should review carefully the risk factors listed in \"Item 1A. Risk Factors\" in our 2022 Form 10-K, as well as those factors listed in other documents we file with the Securities and Exchange Commission. We do not assume an obligation to update any forward-looking statement.\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nPurchase of Equity Securities by the Issuer and Affiliated Purchasers\nOn July 28, 2022, our board of directors authorized the repurchase of an additional 1.5 million shares of our common stock. This increase was in addition to the remaining authorized shares under our prior common stock repurchase program that was authorized on February 25, 2015 (the Program). Share repurchases may be made on an opportunistic basis, through open market transactions, privately negotiated transactions, or by other means in accordance with applicable federal securities laws. We are not obligated to purchase any shares and there is no set date that the Program will expire. Our board of directors may increase or decrease the number of shares under the Program or terminate the Program in its discretion at any time. During first quarter 2023, we repurchased 24,727 shares under the Program at a cost of $1.5 million, or an average of $59.91 per share. Set forth below is information regarding the Company's share repurchases during the first quarter ended March 31, 2023.\n| Total Number of Shares Purchased | Average Price Paid per Share | Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs | The Maximum Number of Shares That May Yet Be Purchased Under the Plans or Programs |\n| January 1, 2023 - January 31, 2023 | — | $ | — | — | 1,996,989 |\n| February 1, 2023 - February 28, 2023 | — | — | — | 1,996,989 |\n| March 1, 2023 - March 31, 2023 | 24,727 | 59.91 | 24,727 | 1,972,262 |\n| Total | 24,727 | $ | 59.91 | 24,727 | 1,972,262 |\n\nITEM 3. DEFAULTS UPON SENIOR SECURITIES\nNone.\nITEM 4. MINE SAFETY DISCLOSURES\nNot applicable.\n33\n\nITEM 5. OTHER INFORMATION\nNone.\nITEM 6. EXHIBITS\n| Number | Description |\n| 10.1 | Form of 2023 Restricted Stock Unit Agreement |\n| 10.2 | Form of 2023 Performance Stock Unit Agreement |\n| 10.3 | Form of 2023 Director Restricted Stock Unit Agreement |\n| 10.4 | Ninth Amendment to Amended and Restated Credit Agreement, dated March 31, 2023, by and among the Lenders identified on the signature pages thereof, Wells Fargo Capital Finance, LLC, as administrative agent, Boise Cascade Company, and the other Borrowers identified on the signature pages thereof |\n| 31.1 | CEO Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2 | CFO Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1 | CEO Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2 | CFO Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS | Inline XBRL Instance Document |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\n\n34\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| BOISE CASCADE COMPANY |\n| /s/ Kelly E. Hibbs |\n| Kelly E. HibbsSenior Vice President, Chief Financial Officer and Treasurer |\n\nDate: May 4, 2023\n35\n</text>\n\nWhat is the percentage increase in finance cost from the year 2022 to 2023 in relation to the net income for each year in percentage?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nITEM 1.\nFINANCIAL STATEMENTS\nARDELYX, INC.\nCondensed Balance Sheets\n(In thousands, except share and per share amounts)\n\n| June 30,2014 | December 31,2013 |\n| (Unaudited) |\n| Assets |\n| Current assets: |\n| Cash and cash equivalents | $ | 117,814 | $ | 34,435 |\n| Accounts receivable | 3,025 | 6,436 |\n| Prepaid expenses and other current assets | 1,308 | 965 |\n| Total current assets | 122,147 | 41,836 |\n| Property and equipment, net | 1,138 | 530 |\n| Other assets | 13 | 358 |\n| Restricted cash | 180 | 180 |\n| Total assets | $ | 123,478 | $ | 42,904 |\n| Liabilities, convertible preferred stock, and stockholders’ equity (deficit) |\n| Current liabilities: |\n| Accounts payable | $ | 2,308 | $ | 2,284 |\n| Accrued compensation and benefits | 802 | 927 |\n| Other accrued liabilities | 1,003 | 95 |\n| Deferred rent | — | 5 |\n| Deferred revenue, current portion | 23,221 | 13,828 |\n| Total current liabilities | 27,334 | 17,139 |\n| Deferred revenue, non-current | 33,170 | 26,470 |\n| Convertible preferred stock warrant liability | — | 6,456 |\n| Liabilities related to early exercise of options | 107 | 163 |\n| Total liabilities | 60,611 | 50,228 |\n| Commitments and contingencies |\n| Convertible preferred stock, $0.0001 par value per share — no shares and 108,829,748 shares authorized as of June 30, 2014 and December 31, 2013, respectively; no shares and 11,517,222 shares issued and outstanding as of June 30, 2014 and December 31, 2013, respectively | — | 56,155 |\n| Stockholders’ equity (deficit): |\n| Preferred stock, $0.0001 par value; 5,000,000 shares and no shares authorized as of June 30, 2014 and December 31, 2013, respectively; no shares issued and outstanding as of June 30, 2014 and December 31, 2013, respectively | — | — |\n| Common stock, $0.0001 par value — 300,000,000 and 130,360,121 shares authorized as of June 30, 2014 and December 31, 2013, respectively; 18,335,620 and 1,225,481 shares issued and outstanding as of June 30, 2014 and December 31, 2013, respectively | 2 | — |\n| Additional paid-in capital | 130,836 | 5,174 |\n| Accumulated deficit | (67,971 | ) | (68,653 | ) |\n| Total stockholders’ equity (deficit) | 62,867 | (63,479 | ) |\n| Total liabilities, convertible preferred stock, and stockholders’ equity (deficit) | $ | 123,478 | $ | 42,904 |\n\nSee accompanying notes.\n2\nARDELYX, INC.\nCondensed Statements of Operations and Comprehensive Income (Loss)\n(Unaudited)\n(In thousands, except share and per share amounts)\n\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Revenue: |\n| Licensing revenue | $ | 6,507 | $ | 1,989 | $ | 9,743 | $ | 3,978 |\n| Collaborative development revenue | 2,630 | 5,302 | 7,944 | 9,869 |\n| Total revenue | 9,137 | 7,291 | 17,687 | 13,847 |\n| Operating expenses: |\n| Research and development | 5,183 | 7,234 | 12,820 | 13,173 |\n| General and administrative | 1,203 | 908 | 2,580 | 1,935 |\n| Total operating expenses | 6,386 | 8,142 | 15,400 | 15,108 |\n| Income (loss) from operations | 2,751 | (851 | ) | 2,287 | (1,261 | ) |\n| Other expense, net | (8 | ) | (4 | ) | (12 | ) | (29 | ) |\n| Change in fair value of preferred stock warrant liability | 1,010 | — | (1,593 | ) | — |\n| Income (loss) before provision for income taxes | 3,753 | (855 | ) | 682 | (1,290 | ) |\n| Provision for income taxes | — | 36 | — | 71 |\n| Net income (loss) and comprehensive income (loss) | $ | 3,753 | $ | (891 | ) | $ | 682 | $ | (1,361 | ) |\n| Net income (loss) attributable to common stockholders: |\n| Basic | $ | 515 | $ | (891 | ) | $ | — | $ | (1,361 | ) |\n| Diluted | $ | 703 | $ | (891 | ) | $ | — | $ | (1,361 | ) |\n| Shares used to compute net income (loss) per share attributable to common stockholders: |\n| Basic | 2,611,259 | 1,102,093 | 1,937,509 | 1,072,583 |\n| Diluted | 3,904,136 | 1,102,093 | 1,937,509 | 1,072,583 |\n| Net income (loss) per share attributable to common stockholders: |\n| Basic | $ | 0.20 | $ | (0.81 | ) | $ | — | $ | (1.27 | ) |\n| Diluted | $ | 0.18 | $ | (0.81 | ) | $ | — | $ | (1.27 | ) |\n\nSee accompanying notes.\n3\nARDELYX, INC.\nCondensed Statements of Cash Flows\n(Unaudited)\n(In thousands)\n\n| Six Months Ended June 30, |\n| 2014 | 2013 |\n| Operating activities |\n| Net income (loss) | $ | 682 | $ | (1,361 | ) |\n| Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |\n| Depreciation and amortization expense | 128 | 356 |\n| Stock-based compensation | 163 | 190 |\n| Change in fair value of preferred stock warrant liability | 1,593 | — |\n| Changes in operating assets and liabilities: |\n| Accounts receivable | 3,411 | (3,912 | ) |\n| Prepaid and other current assets | (343 | ) | (496 | ) |\n| Other assets | 345 | (731 | ) |\n| Accounts payable | 24 | 1,131 |\n| Accrued compensation and benefits | (125 | ) | (377 | ) |\n| Other accrued liabilities | 908 | (572 | ) |\n| Deferred revenue | 16,093 | (2,863 | ) |\n| Deferred rent | (5 | ) | (262 | ) |\n| Net cash provided by (used in) operating activities | 22,874 | (8,897 | ) |\n| Investing activities |\n| Purchases of property and equipment | (736 | ) | (257 | ) |\n| Net cash used in investing activities | (736 | ) | (257 | ) |\n| Financing activities |\n| Proceeds from issuance of common stock | 61,241 | 2 |\n| Repurchase of unvested common stock | — | (2 | ) |\n| Net cash provided by financing activities | 61,241 | — |\n| Net increase (decrease) in cash and cash equivalents | 83,379 | (9,154 | ) |\n| Cash and cash equivalents at beginning of period | 34,435 | 32,903 |\n| Cash and cash equivalents at end of period | $ | 117,814 | $ | 23,749 |\n\nSee accompanying notes.\n4\nARDELYX, INC.\nNotes to the Unaudited Interim Condensed Financial Statements\n1. Organization and Basis of Presentation\nArdelyx, Inc. (the “Company”) is a clinical stage biopharmaceutical company focused on the discovery, development and commercialization of innovative, non-systemic, small molecule therapeutics that work exclusively in the gastrointestinal tract to treat cardio-renal, gastrointestinal and metabolic diseases. The Company has developed a drug discovery and design platform enabling it, in a rapid and cost-efficient manner, to discover and design novel drug candidates. The Company was incorporated in Delaware on October 17, 2007, under the name Nteryx and changed its name to Ardelyx, Inc. in June 2008.\nThe Company operates in only one business segment, which is the development of biopharmaceutical products.\nBasis of Presentation\nThe accompanying unaudited condensed financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) and following the requirements of the Securities and Exchange Commission (the “SEC”) for interim reporting. As permitted under those rules, certain footnotes or other financial information that are normally required by U.S. GAAP can be condensed or omitted. These financial statements have been prepared on the same basis as the Company’s annual financial statements and, in the opinion of management, reflect all adjustments, consisting only of normal recurring adjustments that are necessary for a fair statement of the Company’s financial information. The results of operations for the three and six months ended June 30, 2014 are not necessarily indicative of the results to be expected for the year ending December 31, 2014 or for any other interim period or for any other future year. The balance sheet as of December 31, 2013 has been derived from audited financial statements at that date but does not include all of the information required by U.S. GAAP for complete financial statements.\nThe accompanying condensed financial statements and related financial information should be read in conjunction with the audited financial statements and the related notes thereto for the year ended December 31, 2013 included in the Company’s Prospectus filed pursuant to Rule 424(b)(4) on June 19, 2014 with the SEC (the “Prospectus”).\nReverse Stock Split\nOn June 18, 2014, the Company’s Amended and Restated Certificate of Incorporation became effective resulting in a reverse split of the Company’s common stock and convertible preferred stock at a 1-for-9 ratio (the “Reverse Stock Split”). The par value and the authorized shares of the common stock and convertible preferred stock were not adjusted as a result of the Reverse Stock Split. All issued and outstanding common stock, convertible preferred stock, warrants for preferred stock, options for common stock and per share amounts contained in the financial statements have been retroactively adjusted to reflect this Reverse Stock Split for all periods presented.\nInitial Public Offering\nOn June 18, 2014, the Company’s registration statement on Form S-1 (File No. 333-196090) relating to the initial public offering (the “IPO”) of its common stock was declared effective by the SEC. The IPO closed on June 24, 2014 at which time the Company sold 4,928,900 shares of its common stock, which included the exercise in full by the underwriters of the IPO of their option to purchase 642,900 additional shares of the Company’s common stock. The Company received cash proceeds of $61.2 million from the IPO, net of underwriting discounts and commissions and expenses paid by the Company.\nOn June 24, 2014, prior to the closing of the IPO, all outstanding shares of convertible preferred stock converted into 11,517,222 shares of common stock with the related carrying value of $56.2 million reclassified to common stock and additional paid-in capital. In addition, all convertible preferred stock warrants were net exercised and converted into common stock and the related convertible preferred stock warrant liability was reclassified to additional paid-in capital.\nOn June 24, 2014, the Company’s Amended and Restated Certificate of Incorporation became effective and the number of shares of capital stock the Company is authorized to issue was increased to 305,000,000 shares, of which 300,000,000 shares may be common stock and 5,000,000 shares may be preferred stock. Both the common stock and preferred stock have a par value of $0.0001 per share. There are no shares of preferred stock outstanding at June 30, 2014.\n5\n2. Summary of Significant Accounting Policies\nUse of Estimates\nThe preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and judgments that affect the amounts reported in the financial statements and accompanying notes. On an ongoing basis, management evaluates its estimates, including those related to revenue recognition, clinical trial accruals, income taxes, and stock-based compensation. Management bases its estimates on historical experience and on various other market-specific and relevant assumptions that management believes to be reasonable under the circumstances. Actual results may differ from those estimates.\nCash and Cash Equivalents\nThe Company considers all highly liquid investments purchased with an original maturity date of 90 days or less on the date of purchase to be cash equivalents. The Company invests its cash in bank deposits and money market accounts.\nRestricted Cash\nThe Company is required to guarantee the credit limit on its corporate credit card with a certificate of deposit of $100,000. The collateral will be released upon the cancellation of the corporate credit card.\nThe Company is required under its facility lease agreement to maintain a line of credit with a bank in the amount of $80,000 for the benefit of the lessor. The line of credit is secured by a cash deposit with the bank. The cash deposit will be released upon expiration of the line of credit.\nComprehensive Income (Loss)\nComprehensive income (loss) is composed of two components: net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) refers to gains and losses that under GAAP are recorded as an element of stockholders’ equity (deficit), but are excluded from net income (loss). The Company did not record any transactions within other comprehensive income (loss) in the periods presented and, therefore, the net income (loss) and comprehensive income (loss) were the same for all periods presented.\nRevenue Recognition\nRevenue from research activities made under collaboration partnership agreements are recognized as the services are provided and when there is persuasive evidence that an arrangement exists, delivery has occurred, the price is fixed or determinable, and collectability is reasonably assured. Revenue generated from research and licensing agreements typically includes up-front signing or license fees, cost reimbursements, research services, minimum sublicense fees, milestone payments, and royalties on future licensees’ product sales.\nFor revenue agreements with multiple-element arrangements, such as license and development agreements, the Company allocates revenue to each non-contingent deliverable based on the relative selling price of each deliverable. When applying the relative selling price method, the Company determines the selling price for each deliverable using vendor-specific objective evidence or third-party evidence. If neither exists, the Company uses its best estimate of selling price for that deliverable. Revenue allocated is then recognized when the four basic revenue recognition criteria are met for each deliverable.\nThe Company recognizes revenue from upfront payments ratably over the term of its estimated period of performance under the agreement which is recorded as licensing revenue. Reimbursements for development costs incurred under the Company’s license agreement with AstraZeneca are classified as collaborative development revenue. The Company recognizes cost reimbursement revenue under collaboration partnership agreements as the related research and development costs for services are rendered. Deferred revenue represents the portion of research or license payments received which has not been earned.\nRevenues from milestones, if they are nonrefundable and deemed substantive, are recognized upon successful accomplishment of the milestones. To the extent that non-substantive milestones are achieved and the Company has remaining performance obligations, milestones are deferred and recognized as revenue over the estimated remaining period of performance. The Company will recognize revenue associated with the non-substantive milestones upon achievement of the milestone if there are no undelivered elements and it has no remaining performance obligations. The Company will account for sales-based milestones as royalties that will be recognized as revenue upon achievement of the milestone.\n6\nNet Income (Loss) per Share Attributable to Common Stockholders\nBasic net income (loss) per share attributable to common stockholders is calculated by dividing the net income (loss) attributable to common stockholders by the weighted-average number of shares of common stock outstanding for the period. Prior to the Company’s IPO of its common stock, the Company’s Series A and Series B convertible preferred stock was entitled to receive dividends of up to $0.8181 and $0.2781 per share, respectively, prior and in preference to any declaration or payment of any dividend on common stock and thereafter participate pro rata on an as converted basis with the common stock holders on any distributions to common stockholders. The convertible preferred shares were therefore considered to be participating securities. As a result, the Company calculated the net income (loss) per share using the two-class method. Accordingly, the net income (loss) attributable to common stockholders is derived from the net income (loss) for the period and, in periods in which the Company has net income attributable to common stockholders, an adjustment is made for the noncumulative dividends and allocations of earnings to participating securities based on their outstanding shareholder rights. Under the two-class method, the net loss attributable to common stockholders is not allocated to the convertible preferred stock as the convertible preferred stock did not have a contractual obligation to share in the Company’s losses. The diluted net income per share attributable to common stockholders is computed by giving effect to all potential dilutive common stock equivalents outstanding for the period. In periods when we have incurred a net loss, convertible preferred stock, options to purchase common stock and convertible preferred stock warrants are considered common stock equivalents but have been excluded from the calculation of diluted net loss per share attributable to common stockholders as their effect is antidilutive.\nRecent Accounting Pronouncement\nIn July 2013, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update (“ASU”) 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. The ASU concludes an unrecognized tax benefit should be presented as a reduction of a deferred tax asset when settlement in this manner is available under the law. The Company adopted this amendment as of January 1, 2014, which did not have a significant impact on the balance sheet.\nIn May 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”), which converges the FASB and the International Accounting Standards Board standards on revenue recognition. Areas of revenue recognition that will be affected include, but are not limited to, transfer of control, variable consideration, allocation of transfer pricing, licenses, time value of money, contract costs and disclosures. This guidance is effective for the fiscal years and interim reporting periods beginning after December 15, 2016, at which time the Company may adopt the new standard under the full retrospective method or the modified retrospective method. Early adoption is not permitted. The Company has not yet selected a transition method nor has the Company determined the impact of the new standard on its financial statements and related disclosures.\n3. Fair Value Measurements\nFinancial assets and liabilities are recorded at fair value. The carrying amounts of certain of the Company’s financial instruments, including cash equivalents, accounts receivable and accounts payable, are valued at cost, which approximates fair value due to their short maturities. The accounting guidance for fair value provides a framework for measuring fair value, and requires certain new disclosures about how fair value is determined. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the reporting date. The accounting guidance also establishes a three-level valuation hierarchy that prioritizes the inputs to valuation techniques used to measure fair value based upon whether such inputs are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect market assumptions made by the reporting entity.\nThe three-level hierarchy for the inputs to valuation techniques is briefly summarized as follows:\n\n| Level 1 | – | Observable inputs such as quoted prices (unadjusted) for identical instruments in active markets. |\n| Level 2 | – | Observable inputs such as quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, or model-derived valuations whose significant inputs are observable. |\n| Level 3 | – | Unobservable inputs that reflect the reporting entity’s own assumptions. |\n\n7\nThe following table sets forth the fair value of the Company’s financial assets and liabilities measured on a recurring basis by level within the fair value hierarchy:\n\n| June 30, 2014 |\n| Total | Level 1 | Level 2 | Level 3 |\n| (In thousands) |\n| Assets: |\n| Money market funds | $ | 116,653 | $ | 116,653 | $ | — | $ | — |\n| Certificates of deposit | 180 | — | 180 | — |\n| Total | $ | 116,833 | $ | 116,653 | $ | 180 | $ | — |\n\n\n| December 31, 2013 |\n| Total | Level 1 | Level 2 | Level 3 |\n| (In thousands) |\n| Assets: |\n| Money market funds | $ | 32,472 | $ | 32,472 | $ | — | $ | — |\n| Certificates of deposit | 180 | — | 180 | — |\n| Total | $ | 32,652 | $ | 32,472 | $ | 180 | $ | — |\n| Liabilities: |\n| Convertible preferred stock warrant liability | $ | 6,456 | $ | — | $ | — | $ | 6,456 |\n| Total | $ | 6,456 | $ | — | $ | — | $ | 6,456 |\n\nWhere quoted prices are available in an active market, securities are classified as Level 1. The Company classifies money market funds as Level 1. When quoted market prices are not available for the specific security, then the Company estimates fair value by using benchmark yields, reported trades, broker/dealer quotes, and issuer spreads. The Company classifies certificates of deposit as Level 2. In certain cases where there is limited activity or less transparency around inputs to valuation, securities are classified as Level 3. There were no transfers between Level 1 and Level 2 during the periods presented.\nLevel 3 liabilities that are measured at fair value on a recurring basis consist of the preferred stock warrant liability, which was measured using the probability weighted expected return method that calculated the probability of the Company going public or being acquired, and the option-pricing method for remaining private in the near to mid-term. The fair value of the preferred stock warrant liability as of December 31, 2013 was estimated using such scenarios that were weighted based on the Company’s estimate of the probability of each scenario: 20% for IPO; 10% for merger and 70% for stay private as of December 31, 2013. The preferred stock warrant liability was remeasured prior to the net exercise of the warrants using the IPO price. At the end of each reporting period, the change in estimated fair value during the period is recorded in change in fair value of convertible preferred stock warrant liability in the statements of operations and comprehensive income (loss). Generally, increases or decreases in the fair value of the underlying convertible preferred stock would result in a directionally similar impact in the fair value measurement of the warrant liability. The preferred stock warrants were net exercised and converted to common stock upon the completion of the IPO and are no longer subject to remeasurement.\nThe following table sets forth a summary of the changes in the estimated fair value of the Company’s preferred stock warrants which were measured at fair value on a recurring basis (in thousands):\n\n| ConvertiblePreferred StockWarrant Liability |\n| Balance at December 31, 2013 | $ | 6,456 |\n| Net increase in fair value of warrant liabilities upon revaluation | 1,593 |\n| Reclassification of warrant liability to additional paid-in capital | (8,049 | ) |\n| Balance at June 30, 2014 | $ | — |\n\n8\n4. Collaboration and Licensing agreements\nAstraZeneca AB (“AstraZeneca”)\nUnder the terms of the AstraZeneca collaboration partnership agreement, the Company received an up-front license fee of $35.0 million in October 2012 and a $15.0 million payment in December 2013, which are both being recognized as revenue on a straight-line basis over the estimated period of performance, which is currently estimated to be December 2016. AstraZeneca reimburses the Company for its internal and external development-related costs. These reimbursements are recognized as collaborative development revenue when the development-related costs are incurred.\nIn May 2014, the Company received from AstraZeneca a $25.0 million payment as a result of the dosing of the first patient in the Phase 2b clinical trial in hyperphosphatemia. As the $25.0 million did not meet the criteria to be considered the achievement of a substantive milestone for accounting purposes, the amount was recorded as deferred revenue when received and is being recognized as revenue on a straight-line basis over the remaining estimated period of performance under the AstraZeneca collaboration partnership agreement, which is currently estimated to be December 2016.\nAs of June 30, 2014, the Company was eligible to receive future contingent payments up to a total of $795.0 million, which is comprised of future development milestones up to an additional $197.5 million and launch, commercialization, and sales milestones up to an additional $597.5 million. The contingent payments are triggered upon the activities expected to be undertaken by AstraZeneca. Revenue from milestones, if they are nonrefundable and deemed substantive, are recognized upon successful accomplishment of the milestone. The Company will recognize revenue associated with non-substantive milestones upon achievement of the milestones if there are no undelivered elements and it has no remaining performance obligation. To the extent that non-substantive milestones are achieved and the Company has remaining performance obligations, milestones are deferred and recognized as revenue over the estimated remaining period of performance.\nFor the three months ended June 30, 2014 and 2013, the Company recognized revenue of $6.5 million and $2.0 million, respectively, related to amortization of the up-front and other license fees, and $2.6 million and $5.3 million for collaborative development services. For the six months ended June 30, 2014 and 2013, the Company recognized revenues of $9.7 million and $4.0 million, respectively, related to amortization of the up-front and other license fees, and $7.9 million and $9.9 million for collaborative development services. As of June 30, 2014 and December 31, 2013, the Company had total deferred revenue of $56.4 million and $40.3 million related to the AstraZeneca license agreement.\nSanofi SA (“Sanofi”)\nIn February 2014, the Company entered into a License Option and License Agreement with Sanofi (“Option and License Agreement”) for its NaP2b phosphate transport inhibitor program. NaP2b is an intestinal phosphate transporter whose activity accounts for a significant portion of dietary phosphate absorption in humans. The inhibition of NaP2b is believed to have utility for the treatment of hyperphosphatemia (elevated serum phosphate) in patients with end stage renal disease (ESRD) and other forms of chronic kidney disease (CKD). Under the Option and License Agreement, the Company granted Sanofi an exclusive worldwide license to conduct research utilizing the Company’s small molecule NaP2b inhibitors. In addition, Sanofi has the option to obtain an exclusive license to develop, manufacture and commercialize the Company’s NaP2b inhibitors. Sanofi is advancing this program towards first-in-human clinical trials. Under the Option and License Agreement, Sanofi is responsible for all of the costs and expenses for research and preclinical activities and, should it exercise its option, for the development and commercialization efforts under the program. Under the Option and License Agreement, the Company received a payment of $1.25 million, which was recognized as revenue after the Company provided to Sanofi the background know-how, listed patents, and materials (together, the “Technology Transfer Deliverables”) in May 2014 pursuant to the Option and License Agreement.\nThe Company has the potential to earn future development, regulatory and commercial milestone payments of up to $196.8 million if Sanofi continues to advance the program into development and through commercialization. If a NaP2b inhibitor is commercialized by Sanofi as a result of this program, the Company will receive tiered royalties ranging from mid-single digits into the low double digits. As part of the arrangement with Sanofi, the Company retains an option to participate in co-promotional activities in the United States. Future potential milestone payments do not meet the criteria to be considered substantive milestones, and therefore will be treated as other contingent consideration and recognized as revenue as they are achieved as the Company has no performance obligations under the Option and License Agreement. No milestones have been received since the inception of the agreement.\n9\n5. Stock Incentive Plan\nAs of June 30, 2014, a total of 2,149,021 shares of common stock had been reserved for issuance under the 2008 Plan, and no shares are available for future grant. The 2014 Equity Incentive Award Plan (“2014 Plan”) became effective on June 18, 2014, immediately prior to the time the Company’s Registration Statement on Form S-1 became effective. Under the 2014 Plan, 1,419,328 shares of common stock were initially reserved for issuance pursuant to a variety of stock-based compensation awards, including stock options, stock appreciation rights, or SARs, restricted stock awards, restricted stock unit awards, deferred stock awards, deferred stock unit awards, dividend equivalent awards, stock payment awards and performance awards. In addition, 35,221 shares that had been available for future awards under the 2008 Plan as of June 18, 2014, were added to the initial reserve available under the 2014 Plan, bringing the total reserve upon the effective date of the 2014 Plan to 1,454,549. The number of shares initially reserved for issuance or transfer pursuant to awards under the 2014 Plan will be increased by (i) the number of shares represented by awards outstanding under 2008 Plan on June 18, 2014, that are forfeited or lapse unexercised (ii) if approved by the Administrator of the 2014 Plan, an annual increase on the first day of each fiscal year beginning in 2015 and ending in 2024, equal to the lesser of (A) four percent (4.0%) of the shares of stock outstanding (on an as converted basis) on the last day of the immediately preceding fiscal year and (B) such smaller number of shares of stock as determined by our board of directors; provided, however, that no more than 10,683,053 shares of stock may be issued upon the exercise of incentive stock options. The Company also adopted the 2014 Employee Stock Purchase Plan (ESPP) and initially reserved 202,762 shares of common stock as of its effective date of June 18, 2014. If approved by the Administrator of the ESPP, on the first day of each calendar year, beginning in 2015 and ending in 2024, the number of shares in the reserve will increase by at least an amount equal to the lesser of (i) one percent (1.0%) of the shares of common stock outstanding on the last day of the immediately preceding fiscal year and (ii) such number of shares of common stock as determined by the board of directors; provided, however, no more than 2,230,374 shares of our common stock may be issued under the ESPP.\nThe following table summarizes activity under the 2008 Plan and the 2014 Plan, including grants to nonemployees and restricted stock issued:\n\n| Shares Availablefor Grant | OptionsOutstanding | WeightedAverageExercise Priceper Share | AggregateIntrinsicValue(in thousands) |\n| Balances at December 31, 2013 | 3,914 | 1,162,829 | $ | 1.03 |\n| Options authorized under the 2008 Plan | 33,333 | — |\n| Options authorized under the 2014 Plan | 1,419,328 | — |\n| Options granted | (63,888 | ) | 63,888 | 13.95 |\n| Options cancelled | 1,862 | (1,862 | ) | 0.77 |\n| Options exercised | — | (92,781 | ) | 0.60 |\n| Balances at June 30, 2014 | 1,394,549 | 1,132,074 | $ | 1.79 | $ | 16,050 |\n| Vested at June 30, 2014 | 576,049 | $ | 0.91 | $ | 8,678 |\n| Expected to vest at June 30, 2014 | 1,132,074 | $ | 1.79 | $ | 16,050 |\n\nThe weighted-average grant-date estimated fair value of options granted during the three and six months ended June 30, 2014 was $10.98 and $10.96, respectively, and during the three and six months ended June 30, 2013 was $0 and $2.65 per share, respectively. The aggregate intrinsic value was calculated as the difference between the exercise price of the options and the estimated fair value of the Company’s common stock of $15.97 per share as of June 30, 2014.\nLiability for Early Exercise of Stock Options\nAs of June 30, 2014 and December 31, 2013, there were 193,447 and 286,217 shares of common stock outstanding, respectively, subject to the Company’s right of repurchase at prices ranging from $0.27 to $1.08 per share. As of June 30, 2014 and December 31, 2013, the Company recorded $107,000 and $163,000, respectively, as liabilities associated with shares issued with repurchase rights.\n10\nStock-based Compensation\nTotal stock-based compensation recognized was as follows (in thousands):\n\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Research and development | $ | 38 | $ | 50 | $ | 75 | $ | 99 |\n| General and administrative | 61 | 32 | 88 | 91 |\n| Total | $ | 99 | $ | 82 | $ | 163 | $ | 190 |\n\nAs of June 30, 2014 and December 31, 2013, there was $1.1 million and $549,000, respectively, of unrecognized stock-based compensation expense, net of estimated forfeitures, related to unvested share options with a weighted-average remaining recognition period of 1.6 and 1.8 years.\nThe fair value of stock option awards to employees was estimated at the date of grant using a Black-Scholes option-pricing model with the following weighted-average assumptions:\n\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Expected term (years) | 5.77 | — | 5.79 | 6.08 |\n| Volatility | 101 | % | — | 101 | % | 97 | % |\n| Risk-free interest rate | 1.76 | % | — | 1.77 | % | 1.05 | % |\n| Dividend yield | — | % | — | — | % | — | % |\n\nFor the three months ended June 30, 2013, there were no stock options granted.\n6. Net Income (Loss) per Share Attributable to Common Stockholders\nThe following table sets forth the computation of the unaudited basic and diluted net income (loss) per share attributable to common stockholders (in thousands, except share and per share data):\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Net income (loss) | $ | 3,753 | $ | (891 | ) | $ | 682 | $ | (1,361 | ) |\n| Noncumulative dividends on convertible preferred stock | (1,099 | ) | — | (682 | ) | — |\n| Undistributed earnings allocated to participating securities | (2,139 | ) | — | — | — |\n| Net income (loss) attributable to common stockholders, basic | $ | 515 | $ | (891 | ) | $ | — | $ | (1,361 | ) |\n| Adjustment to undistributed earnings allocated to participating securities | 188 | — | — | — |\n| Net income (loss) attributable to common stockholders, diluted | $ | 703 | $ | (891 | ) | $ | — | $ | (1,361 | ) |\n| Basic shares: |\n| Weighted average common shares outstanding | 2,611,259 | 1,102,093 | 1,937,509 | 1,072,583 |\n| Diluted shares: |\n| Weighted average effect of dilutive stock options | 765,672 | — | — | — |\n| Weighted average convertible preferred stock warrants outstanding | 527,205 | — | — | — |\n| 3,904,136 | 1,102,093 | 1,937,509 | 1,072,583 |\n| Net income (loss) per share attributable to common stockholders: |\n| Basic | $ | 0.20 | $ | (0.81 | ) | $ | — | $ | (1.27 | ) |\n| Diluted | $ | 0.18 | $ | (0.81 | ) | $ | — | $ | (1.27 | ) |\n\n11\nThe following outstanding shares of common stock equivalents were excluded from the computation of diluted net income (loss) per share attributable to common stockholders for the periods presented because including them would have been antidilutive:\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Convertible preferred stock | — | 11,517,222 | — | 11,517,222 |\n| Options to purchase common stock | 12,459 | 1,215,262 | 1,132,074 | 1,215,262 |\n| Warrants to purchase convertible preferred stock | — | 574,953 | — | 574,953 |\n| Total | 12,459 | 13,307,437 | 1,132,074 | 13,307,437 |\n\n7. Related Party Transactions\nAs part of the consulting arrangement with the spouse of an executive of the Company to provide research and development services related to clinical operations, the Company incurred expenses of $60,000 and $64,000 for services rendered during the three months ended June 30, 2014 and 2013, respectively and $120,000 and $126,000 for services rendered during the six months ended June 30, 2014 and 2013, respectively. As of June 30, 2014 and December 31, 2013, the Company owed $20,000 and $18,000, respectively, to the individual, which is recorded in accounts payable.\n12\n\n\nITEM 2.\nMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.\nYou should read the following discussion in conjunction with our condensed financial statements (unaudited) and related notes included elsewhere in this report. This Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. All statements other than statements of historical facts contained in this report are forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “could,” “will,” “would,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “intend,” “predict,” “seek,” “contemplate,” “potential” or “continue” or the negative of these terms or other comparable terminology. These forward-looking statements, include, but are not limited to, the initiation, timing, progress and results of our preclinical studies and clinical trials, and our research and development programs; our ability to advance product candidates into, and successfully complete, clinical trials; our receipt of future milestone payments and/or royalties, and the expected timing of such payments; our collaborators’ exercise of their license options; the commercialization of our product candidates; the implementation of our business model, strategic plans for our business, product candidates and technology; the scope of protection we are able to establish and maintain for intellectual property rights covering our product candidates and technology; estimates of our expenses, future revenues, capital requirements and our needs for additional financing; the timing or likelihood of regulatory filings and approvals; our ability to maintain and establish collaborations or obtain additional government grant funding; our use of proceeds from our IPO; our financial performance; and developments relating to our competitors and our industry. These statements reflect our current views with respect to future events or our future financial performance, are based on assumptions, and involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Given these uncertainties, you should not place undue reliance on these forward-looking statements. Factors that may cause actual results to differ materially from current expectations include, among other things, those listed under “Risk Factors” in the Prospectus or described elsewhere in this Quarterly Report on Form 10-Q. These forward-looking statements speak only as of the date hereof. Except as required by law, we assume no obligation to update or revise these forward-looking statements for any reason, even if new information becomes available in the future. Unless the context requires otherwise, in this Quarterly Report on Form 10-Q, the terms “Ardelyx,” “Company,” “we,” “us” and “our” refer to Ardelyx, Inc., a Delaware corporation.\nOverview\nWe are a clinical-stage biopharmaceutical company focused on the discovery, development and commercialization of innovative, non-systemic, small molecule therapeutics that work exclusively in the gastrointestinal, or GI, tract to treat cardio-renal, GI and metabolic diseases. We have developed a proprietary drug discovery and design platform enabling us, in a rapid and cost-efficient manner, to discover and design novel drug candidates. Utilizing our platform, we discovered and designed our lead product candidate, tenapanor, which in preclinical and clinical studies has consistently demonstrated the ability to reduce the absorption of dietary sodium and phosphorus. To enhance our proprietary drug discovery and design platform, we have developed a cell-culture system to simulate gut tissues called the Ardelyx Primary Enterocyte and Colonocyte Culture System, or APECCS. We have also identified over 3,800 proteins on the inner surface of the gut, many of which we believe may be drug targets. In addition to tenapanor, we have discovered small molecule NaP2b inhibitors for the treatment of hyperphosphatemia in end stage renal disease, or ESRD, a program we have licensed to Sanofi S.A., or Sanofi. We are also independently advancing three other discovery and lead development programs focused in cardio-renal, GI and metabolic diseases.\nIn October 2012, we entered into a collaboration partnership with AstraZeneca AB, or AstraZeneca, for the worldwide development and commercialization of tenapanor. AstraZeneca is responsible for all of the development and commercialization costs for tenapanor, and we have retained an option to co-promote in the United States. Together with AstraZeneca, we are evaluating tenapanor in three Phase 2 clinical trials in patients with ESRD, late-stage CKD, and constipation-predominant irritable bowel syndrome, or IBS-C. If we exercise our right to co-fund the first Phase 3 clinical development program for tenapanor, we may invest $20.0 million, $30.0 million or $40.0 million to acquire an increase of 1%, 2% or 3%, respectively, in the royalties payable to us by AstraZeneca on net sales of tenapanor. In December 2013, we entered into an amendment to the license agreement to acknowledge the intention of AstraZeneca to commence development of tenapanor for the treatment of hyperphosphatemia in ESRD patients and to provide additional clarification for certain payments. There was no change in the total consideration that we could receive under the agreement.\nThrough our participation with AstraZeneca on a development collaboration committee, we are involved in the management and oversight of the development of tenapanor and participation will continue until all of Phase 2 clinical trials with tenapanor have been completed. In addition, we are directly responsible for the conduct of certain specified clinical trials being conducted with tenapanor. AstraZeneca reimburses us for our internal and external costs related to those development efforts, and any other development efforts that may be assigned to us by the development collaboration committee. We were initially responsible for supplying tenapanor for use in development. The agreement also obligates us to transfer the technology and other necessary information such that AstraZeneca will be able to assume the responsibility for the supply of the drug product for use in later-stage clinical trials.\n13\nUnder the terms of the agreement with AstraZeneca, we received a $35.0 million upfront payment and we are eligible to receive up to $237.5 million in development milestones, of which we have received $40.0 million as of June 30, 2014. The $40.0 million in development milestones consists of a payment of $15.0 million that we received in December 2013 and a payment of $25.0 million that we received in May 2014 as a result of the dosing of the first patient in the Phase 2b ESRD clinical trial in hyperphosphatemia in April 2014. In addition to the $237.5 million in total development milestones, we are also eligible to receive up to $597.5 million in sales and launch milestones. Through June 30, 2014, we also received $29.1 million in reimbursement for our development efforts provided under the agreement. We are also eligible to receive incremental tiered royalties based on aggregate annual net sales of each licensed product starting in the high single digits and increasing to high teen percentages as annual net sales increase, subject to an increase related to our co-fund election, if we decide to make such an election.\nWe have identified the deliverables within the arrangement as a license to the technology, the initial supply of the compound of the licensed product for use in development, and ongoing development activities through completion of all Phase 2 clinical trials to be conducted with tenapanor, which are accounted for as a single unit of accounting. We have concluded that the license is not a separate unit of accounting. It does not have stand-alone value to AstraZeneca, separable from the development services to be performed pursuant to the agreement, as AstraZeneca is unable to use the license for its intended purpose without our performance of the development services, which includes the initial supply of the compound of the licensed product. As a result, we recognize revenue from the $35.0 million up-front payment on a straight-line basis over the period from the effective date of the agreement through the completion of all Phase 2 clinical trials to be conducted with tenapanor, which we currently estimate to be December 2016, and we recognize revenue from the $15.0 million and the $25.0 million development milestone payments on a straight-line basis over the same estimated completion date.\nIn 2014, we entered into an option and license agreement with Sanofi under which we granted Sanofi an exclusive worldwide license to conduct research utilizing our small molecule NaP2b inhibitors. In addition, Sanofi has the option to obtain an exclusive license to develop, manufacture and commercialize our NaP2b inhibitors. Sanofi is advancing this program towards first-in-human clinical trials. Under our arrangement, Sanofi is responsible for all of the costs and expenses for research and preclinical activities and, should it exercise its option, for the development and commercialization efforts under the program. Under the license option and license agreement, we received an upfront payment of $1.25 million and are responsible for up to $0.2 million of patent costs, at which point any additional patent costs will be fully reimbursed to us by Sanofi. We have the potential to earn future development, regulatory and commercial milestone payments of up to $196.75 million if Sanofi continues to advance the program into development and through commercialization. If a NaP2b inhibitor is commercialized by Sanofi as a result of this program, we will receive tiered royalties ranging from the mid-single digits into the low double digits. As part of our agreement with Sanofi, we retain an option to co-promote licensed products in the United States. We recognized the $1.25 million to revenue after we completed the Technology Transfer Deliverables in May 2014 pursuant to the Option and License Agreement.\nOur revenue to date has been generated from collaboration and license revenue pursuant to our license agreements with AstraZeneca, and Sanofi. We have not generated any commercial product revenue. As of June 30, 2014, we had accumulated deficit of $68.0 million. We have incurred significant losses in the past and may continue to incur significant losses in the future as we advance our unpartnered preclinical programs. The significance of future losses will be dependent in part on whether AstraZeneca continues to develop and advance tenapanor, and whether Sanofi exercises its option to obtain an exclusive license to develop, manufacture and commercialize our NaP2b inhibitors, which in either case would result in milestone payments to us. There can be no assurance that we will receive additional collaboration revenue in the future.\nInitial Public Offering\nOn June 18, 2014, our registration statement on Form S-1 (File No. 333-196090) relating to the IPO of our common stock was declared effective by the SEC. The IPO closed on June 24, 2014 at which time we sold 4,928,900 shares of our common stock, which included 642,900 shares of common stock purchased by the underwriters upon the full exercise of their option to purchase additional shares of common stock. We received cash proceeds of $61.2 million from the IPO, net of underwriting discounts and commissions and expenses paid by us.\n14\nFinancial Operations Overview\nRevenue\nOur revenue to date has been generated from non-refundable license payments and reimbursements for research and development expenses under our license agreements. We recognize revenue from upfront payments ratably over the term of our estimated period of performance under the agreement which we consider to be licensing revenue. In addition to receiving upfront payments, we may also be entitled to milestone and other contingent payments upon achieving predefined objectives. Such payments are recorded as revenue when we achieve the underlying milestone if it is deemed to be a substantive milestone at the date the arrangement is entered into. To the extent that non-substantive milestones are achieved and we have remaining performance obligations, milestones are deferred and recognized as revenue over the estimated remaining period of performance. Reimbursements from AstraZeneca for development costs incurred under our license and collaboration agreement with them are classified as collaborative development revenue.\nResearch and Development Expenses\nResearch and development expenses represent costs incurred to conduct research, such as the discovery and development of our unpartnered product candidates, as well as the development of product candidates pursuant to our license agreement with AstraZeneca. We recognize all research and development costs as they are incurred.\nResearch and development expenses consist of the following:\n| | external research and development expenses incurred under agreements with consultants, third-party contract research organizations, or CROs, and investigative sites where a substantial portion of our clinical studies are conducted, and with contract manufacturing organizations, or CMOs, where our clinical supplies are produced; |\n\n| | employee-related expenses, which include salaries, benefits and stock-based compensation; and |\n\n| | facilities and other allocated expenses, which include direct and allocated expenses for rent and maintenance of facilities, depreciation and amortization expense and other supplies. |\n\nPrior to the execution of our license agreement with AstraZeneca in October 2012, we incurred $18.0 million in research and development expenses related to tenapanor. Following the execution of the license agreement and through June 30, 2014, we incurred $30.2 million in research and development expenses related to tenapanor, all of which are reimbursed by AstraZeneca under the license agreement. The reimbursements are recognized in collaborative development revenue in the Statement of Operations and Comprehensive Income (Loss).\nThe following table summarizes our research and development expenses during the three and six months ended June 30, 2014 and 2013 (in thousands):\n\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Discovery research expense | $ | 2,562 | $ | 2,052 | $ | 4,922 | $ | 3,761 |\n| AstraZeneca collaboration development expense | 2,621 | 5,182 | 7,898 | 9,412 |\n| Total research and development expenses | $ | 5,183 | $ | 7,234 | $ | 12,820 | $ | 13,173 |\n\nWe expect our unpartnered research and development expenses will increase in the future as we progress our internal product candidates, advance our discovery research projects into the preclinical stage and continue our early stage research including further development of our APECCS cell-culture system. The process of conducting preclinical studies and clinical trials necessary to obtain regulatory approval is costly and time consuming. We or our collaboration partners may never succeed in achieving marketing approval for any of our product candidates. The probability of success of each of the product candidates may be affected by numerous factors, including preclinical data, clinical data, competition, manufacturing capability and commercial viability.\nMost of our product development programs are at an early stage; therefore, the successful development of our product candidates is highly uncertain and may not result in approved products. Completion dates and completion costs can vary significantly for each product candidate and are difficult to predict. Given the uncertainty associated with clinical trial enrollment and the risks inherent in the development process, we are unable to determine the duration and completion costs of current or future clinical trials of our product candidates or if and to what extent we will generate revenues from the commercialization and sale of any of our product candidates. We anticipate that we and our collaboration partners will make determinations as to which programs to pursue and how much funding to direct to each program on an ongoing basis in response to the scientific and clinical success of each product candidate, as well as an ongoing assessment as to each product candidate’s commercial potential. We will need to raise additional\n15\ncapital or may seek additional collaboration partnerships in the future in order to complete the development and commercialization of our product candidates.\nGeneral and Administrative\nGeneral and administrative expenses includes personnel costs, travel expenses and other expenses for outside professional services, including legal, human resources, audit and accounting services. Personnel costs includes salaries, bonus, benefits and stock-based compensation. We expect to incur additional expenses as a result of being a public company following the completion of our IPO in June 2014, including expenses to comply with the rules and regulations applicable to companies listed on a national securities exchange and costs related to compliance and reporting obligations pursuant to the rules and regulations of the SEC, as well as increases in expenses for additional insurance, investor relations activities and other administration and professional services.\nChange in Fair Value of Convertible Preferred Stock Warrant Liability\nChange in fair value of convertible preferred stock warrant liability was the fair value remeasurement of our liability related to our convertible preferred stock warrants. We recorded adjustments to the estimated fair value of the convertible preferred stock warrants until they were net exercised prior to the completion of our IPO and then converted into common stock. At that time, the convertible preferred stock warrant liability was reclassified to additional paid-in capital and we no longer record any related periodic fair value adjustments.\nProvision for Income Taxes\nWe did not record a provision for income taxes for the three and six months ended June 30, 2014 because we expect to generate a net operating loss for the year ending December 31, 2014. Our deferred tax assets continue to be fully offset by a valuation allowance.\nProvision for income taxes for the 2013 periods consists of California state income taxes as we were required to pay the Alternative Minimum Tax for the $35.0 million upfront payment received from AstraZeneca in 2012.\nCritical Accounting Polices and Estimates\nThe discussion and analysis of our financial condition and results of operations are based upon our unaudited condensed financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our critical accounting policies and estimates. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. There have been no significant and material changes in our critical accounting policies during the three and six months ended June 30, 2014, as compared to those disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates” in the Prospectus filed with the SEC on June 19, 2014.\n16\nResults of Operations\nComparison of the Three Months Ended June 30, 2014 and 2013\n\n| Three Months Ended June 30, | Dollar Change |\n| 2014 | 2013 |\n| (In thousands) |\n| Revenue: |\n| Licensing revenue | $ | 6,507 | $ | 1,989 | $ | 4,518 |\n| Collaborative development revenue | 2,630 | 5,302 | (2,672 | ) |\n| Total revenue | 9,137 | 7,291 | 1,846 |\n| Operating expenses: |\n| Research and development | 5,183 | 7,234 | (2,051 | ) |\n| General and administrative | 1,203 | 908 | 295 |\n| Total operating expenses | 6,386 | 8,142 | (1,756 | ) |\n| Income (loss) from operations | 2,751 | (851 | ) | 3,602 |\n| Other expense, net | (8 | ) | (4 | ) | (4 | ) |\n| Change in fair value of preferred stock warrant liability | 1,010 | — | 1,010 |\n| Income (loss) before provision for income taxes | 3,753 | (855 | ) | 4,608 |\n| Provision for income taxes | — | 36 | (36 | ) |\n| Net income (loss) | $ | 3,753 | $ | (891 | ) | $ | 4,644 |\n\nRevenue\nLicensing revenue for the three months ended June 30, 2014 was $6.5 million, an increase of $4.5 million, or 227%, compared to licensing revenue of $2.0 million for the three months ended June 30, 2013. The increase was primarily due to the increased amounts recognized from the $15.0 million development milestone payment we received in December 2013 related to the amendment to the AstraZeneca agreement and the $25.0 million development milestone payment we received in May 2014 related to the dosing of the first patient in the Phase 2b ESRD clinical trial in hyperphosphatemia in April 2014, which are both being recognized ratably over our expected period of performance under the agreement. The estimated period of performance is based on the completion of all of the Phase 2 clinical trials for tenapanor. We estimate that the end of all Phase 2 clinical trials will be December 2016. The expected period of performance is reviewed quarterly and adjusted, as needed, to reflect the progress of clinical studies. The remaining increase was due to the $1.25 million we recognized pursuant to the Option and License Agreement with Sanofi.\nCollaborative development revenue consists of our development expenses that are reimbursable to us by AstraZeneca as part of our license agreement. Collaborative development revenue for the three months ended June 30, 2014 was $2.6 million, a decrease of $2.7 million, or 50%, compared to $5.3 million for the three months ended June 30, 2013. The decrease was primarily because of a decrease in our development activities related to the clinical trials that are a part of the AstraZeneca agreement.\nResearch and Development\nResearch and development expenses were $5.2 million for the three months ended June 30, 2014, a decrease of $2.1 million, or 28%, compared to $7.2 million for the three months ended June 30, 2013. The decrease was primarily driven by a $2.6 million decrease in development activities related to tenapanor conducted by Ardelyx in accordance with the AstraZeneca agreement. Discovery research expenses increased by $0.5 million due to an increase in our research activities for non-partnered programs.\nGeneral and Administrative\nGeneral and administrative expenses were $1.2 million for the three months ended June 30, 2014, an increase of $0.3 million, or 32%, compared to $0.9 million for the three months ended June 30, 2013. The increase was primarily due to an increase in professional services fees of $0.1 million and an increase of $0.1 million in personnel related expenses.\nChange in Fair Value of Preferred Stock Warrant Liability\nChange in fair value of preferred stock warrant liability was $1.0 million of income for the three months ended June 30, 2014 compared to zero for the three months ended June 30, 2013. The change was due to a decrease in the fair value of our convertible preferred stock over the three month period.\n17\nComparison of the Six Months Ended June 30, 2014 and 2013\n| Six Months Ended June 30, | Dollar Change |\n| 2014 | 2013 |\n| (In thousands) |\n| Revenue: |\n| Licensing revenue | $ | 9,743 | $ | 3,978 | $ | 5,765 |\n| Collaborative development revenue | 7,944 | 9,869 | (1,925 | ) |\n| Total revenue | 17,687 | 13,847 | 3,840 |\n| Operating expenses: |\n| Research and development | 12,820 | 13,173 | (353 | ) |\n| General and administrative | 2,580 | 1,935 | 645 |\n| Total operating expenses | 15,400 | 15,108 | 292 |\n| Income (loss) from operations | 2,287 | (1,261 | ) | 3,548 |\n| Other expense, net | (12 | ) | (29 | ) | 17 |\n| Change in fair value of preferred stock warrant liability | (1,593 | ) | — | (1,593 | ) |\n| Income (loss) before provision for income taxes | 682 | (1,290 | ) | 1,972 |\n| Provision for income taxes | — | 71 | (71 | ) |\n| Net income (loss) | $ | 682 | $ | (1,361 | ) | $ | 2,043 |\n\nRevenue\nLicensing revenue for the six months ended June 30, 2014 was $9.7 million, an increase of $5.8 million, or 145%, compared to total licensing revenue of $4.0 million for the six months ended June 30, 2013. The increase was primarily due to the increased amounts recognized from the $15.0 million development milestone payment we received in December 2013 related to the amendment to the AstraZeneca agreement and the $25.0 million development milestone payment we received in May 2014 related to the dosing of the first patient in the Phase 2b ESRD clinical trial in hyperphosphatemia in April 2014, which are both being recognized ratably over our expected period of performance under the agreement. The estimated period of performance is based on the completion of all of the Phase 2 clinical trials for tenapanor. We estimate that the end of all Phase 2 clinical trials will be December 2016. The expected period of performance is reviewed quarterly and adjusted, as needed, to reflect the progress of clinical studies. The remaining increase was due to the $1.25 million we recognized in May 2014 pursuant to the Option and License Agreement with Sanofi.\nCollaborative development revenue consists of our development expenses that are reimbursable to us by AstraZeneca as part of our license agreement. Collaborative development revenue for the six months ended June 30, 2014 was $7.9 million, a decrease of $1.9 million, or 20%, compared to $9.9 million for the six months ended June 30, 2013. The decrease was due to a decrease in our development activities primarily related to the clinical trials that are a part of the AstraZeneca agreement.\nResearch and Development\nResearch and development expenses were $12.8 million for the six months ended June 30, 2014, a decrease of $0.4 million, or 3%, compared to $13.2 million for the six months ended June 30, 2013. The decrease in AstraZeneca collaboration development expense of $1.5 million was primarily driven by the decrease in development activities related to tenapanor conducted by Ardelyx under the license agreement with AstraZeneca. Discovery research expenses increased by $1.2 million due to an increase in our research activities for non-partnered programs.\nGeneral and Administrative\nGeneral and administrative expenses were $2.6 million for the six months ended June 30, 2014, an increase of $0.6 million, or 33%, compared to $1.9 million for the six months ended June 30, 2013. The increase was primarily due to an increase in professional services fees of $0.4 million and an increase of $0.2 million personnel related expenses.\nChange in Fair Value of Preferred Stock Warrant Liability\nChange in fair value of preferred stock warrant liability was $1.6 million for the six months ended June 30, 2014, an increase of $1.6 million compared to zero for the six months ended June 30, 2013. The increase was due to an increase in the fair value of our convertible preferred stock over the six month period.\n18\nLiquidity and Capital Resources\nAs of June 30, 2014, we had cash and cash equivalents totaling $117.8 million. In connection with our IPO, we received cash proceeds of $61.2 million, net of underwriters’ discounts and commissions and expenses paid by the Company in June 2014. Prior to the IPO, we funded our operations primarily with cash flows from the sales of our convertible preferred stock in private placements and from the upfront payments and other collaboration related payments received from our collaboration partners AstraZeneca and Sanofi.\nOur primary uses of cash are to fund operating expenses, primarily research and development expenditures. Cash used to fund operating expenses is impacted by the timing of when we pay these expenses, as reflected in the change in our outstanding accounts payable and accrued expenses.\nWe believe that our existing capital resources as of June 30, 2014 will be sufficient to meet our projected operating requirements for at least the next 12 months. We have based this estimate on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we currently expect. Further, our operating plan may change, and we may need additional funds to meet operational needs and capital requirements for clinical trials and other research and development expenditures. We currently have no credit facility or committed sources of capital other than potential milestones receivable under our current collaboration partnerships. Because of the numerous risks and uncertainties associated with the development and commercialization of our product candidates and the extent to which we may enter into additional collaboration partnerships with third parties to participate in their development and commercialization, we are unable to estimate the amounts of increased capital outlays and operating expenditures associated with our current and anticipated clinical studies. Our future funding requirements will depend on many factors, including the following:\n| | our decision whether or not to exercise our right to co-fund the first Phase 3 clinical development program for tenapanor, in which we may invest $20.0 million, $30.0 million or $40.0 million to acquire an increase of 1%, 2% or 3%, respectively, in the royalties payable to us by AstraZeneca on net sales of tenapanor; |\n\n| | the achievement of development and regulatory milestones resulting in the payment to us from our collaboration partners of contractual milestone payments and the timing of the receipt of such payments, if any; |\n\n| | the progress, timing, scope, results and costs of our preclinical studies and clinical trials for our product candidates that have not been licensed, including the ability to enroll patients in a timely manner for clinical trials; |\n\n| | the time and cost necessary to obtain regulatory approvals for our product candidates that have not been licensed and the costs of post-marketing studies that could be required by regulatory authorities; |\n\n| | our ability and the ability of our collaboration partners to successfully commercialize and/or co-promote our product candidates; |\n\n| | the manufacturing, selling and marketing costs associated with product candidates, including the cost and timing of building our sales and marketing capabilities; |\n\n| | our ability to establish and maintain collaboration partnerships, in-license/out-license or other similar arrangements and the financial terms of such agreements; |\n\n| | the timing, receipt, and amount of sales of, or royalties on, our future products, if any; |\n\n| | the sales price and the availability of adequate third-party reimbursement for our product candidates; |\n\n| | the cash requirements of any future acquisitions or discovery of product candidates; |\n\n| | the number and scope of preclinical and discovery programs that we decide to pursue or initiate; |\n\n| | the time and cost necessary to respond to technological and market developments; and |\n\n| | the costs of filing, prosecuting, maintaining, defending and enforcing any patent claims and other intellectual property rights, including litigation costs and the outcome of such litigation, including costs of defending any claims of infringement brought by others in connection with the development, manufacture or commercialization of our product candidates. |\n\n19\nThe following table summarizes our cash flows for the periods indicated (in thousands):\n\n| Six MonthsEnded June 30, |\n| 2014 | 2013 |\n| Cash provided by (used in) operating activities | $ | 22,874 | $ | (8,897 | ) |\n| Cash used in investing activities | (736 | ) | (257 | ) |\n| Cash provided by financing activities | 61,241 | — |\n| Net increase (decrease) in cash and cash equivalents | $ | 83,379 | $ | (9,154 | ) |\n\nCash Flows from Operating Activities\nCash provided by operating activities for the six months ended June 30, 2014 was $22.9 million, consisting of net income of $0.7 million, non-cash charges of $0.1 million for depreciation and amortization expense, $0.2 million for stock-based compensation, $1.6 million for the change in the fair value remeasurement of our convertible preferred stock warrant liability and a net increase of $20.3 million in our net operating assets and liabilities. The changes in our net operating assets and liabilities was primarily due to a $16.1 million increase in deferred revenue which was mainly driven by the $25.0 million payment received in May 2014 in connection with our agreement with AstraZeneca, a $3.4 million decrease in our accounts receivable due to the timing of payments received from AstraZeneca for reimbursable costs incurred under our licensing agreement and a $0.9 million increase in our other accrued liabilities due to the timing of payments.\nCash used in operating activities for the six months ended June 30, 2013 was $8.9 million, consisting of a net loss of $1.4 million, which was partially offset by non-cash charges of $0.4 million for depreciation and amortization, $0.2 million for stock-based compensation and a net decrease of $8.1 million in our net operating assets and liabilities. The cash used as a result of the changes in our net operating assets and liabilities was due primarily to a $2.9 million decrease in deferred revenue which was mainly driven by the amortization of the $35.0 million up-front payment received in connection with our agreement with AstraZeneca and a $3.9 million increase in our accounts receivable due to the timing of payments received from AstraZeneca for reimbursable costs incurred under our licensing agreement and a $1.2 million increase in prepaid expenses and other assets related to advance payments made to vendors for clinical development activities. These changes were partially offset by a $1.1 million increase in our accounts payable due to the timing of payments.\nCash Flows from Investing Activities\nCash used in investing activities for the six months ended June 30, 2014 and 2013 of $0.7 million and $0.3 million was related to our acquisition of property and equipment related to the expansion of our laboratory and related equipment.\nCash Flows from Financing Activities\nCash provided by financing activities for the six months ended June 30, 2014 was due to the IPO proceeds of $61.2 million.\nOff-Balance Sheet Arrangements\nAs of June 30, 2014, we did not have any off-balance sheet arrangements or any holdings in variable interest entities.\nRecent Accounting Pronouncement\nIn July 2013, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update, or ASU 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. The ASU concludes an unrecognized tax benefit should be presented as a reduction of a deferred tax asset when settlement in this manner is available under the law. We adopted this amendment as of January 1, 2014, which did not have a significant impact on the balance sheet.\nIn May 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers, or ASU 2014-09, which converges the FASB and the International Accounting Standards Board standards on revenue recognition. Areas of revenue recognition that will be affected include, but are not limited to, transfer of control, variable consideration, allocation of transfer pricing, licenses, time value of money, contract costs and disclosures. This guidance is effective for the fiscal years and interim reporting periods beginning after December 15, 2016, at which time we may adopt the new standard under the full retrospective method or the modified retrospective method. Early adoption is not permitted. We have not yet selected a transition method nor have we determined the impact of the new standard on our financial statements and related disclosures\n20\n\n\nITEM 3.\nQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nWe are exposed to market risks in the ordinary course of our business. These risks primarily include risk related to interest rate sensitivities. We had cash and cash equivalents of $117.8 million as of June 30, 2014, which consist of bank deposits and money market funds. Such interest-earning instruments carry a degree of interest rate risk; however, historical fluctuations in interest income have not been significant. We had no outstanding debt as of June 30, 2014.\n\n\nITEM 4.\nCONTROLS AND PROCEDURES\nEvaluation of Disclosure Controls and Procedures\nAs required by Rule 13a-15(b) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), our management, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2014. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate, to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of June 30, 2014, our Chief Executive Officer and Chief Financial Officer have concluded that, as of June 30, 2014, our disclosure controls and procedures were effective at the reasonable assurance level.\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15(d) and 15d-15(d) of the Exchange Act that occurred during the quarter ended June 30, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\nPART II. OTHER INFORMATION\n\n\nITEM 1.\nLEGAL PROCEEDINGS\nWe are not currently a party to any material litigation or other material legal proceedings.\n\n\nITEM 1A.\nRISK FACTORS\nOur business involves significant risks, some of which are described below. You should carefully consider these risks, as well as other information in this Quarterly Report on Form 10-Q, including our financial statements and the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The occurrence of any of the events or developments described below could harm our business, financial condition, results of operations, cash flows, the trading price of our common stock and our growth prospects. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations.\nRisks Related to Our Limited Operating History, Financial Condition and Capital Requirements\nWe have a limited operating history, have incurred significant losses since our inception and we will incur losses in the future. We have only one product candidate in clinical trials and no product sales, which, together with our limited operating history, makes it difficult to assess our future viability.\nWe are a clinical-stage biopharmaceutical company with a limited operating history. Biopharmaceutical product development is a highly speculative undertaking and involves a substantial degree of risk. To date, we have focused substantially all of our efforts on our research and development activities, including developing our lead product candidate, tenapanor, and developing our proprietary drug discovery and design platform. To date, we have not commercialized any products or generated any revenue from the sale of products. We are not profitable and have incurred losses in each year since our inception in October 2007, and we do not know whether or when we will become profitable. We have only a limited operating history upon which to evaluate our business and prospects. We continue to incur significant research, development and other expenses related to our ongoing operations. Our net loss\n21\nfor the years ended December 31, 2012 and 2013 was $9.8 million and $6.6 million, respectively. While we had a net income of $3.8 million and $0.7 million, respectively, for the three and six months ended June 30, 2014, this performance may not be indicative of future performance. As of June 30, 2014, we had an accumulated deficit of $68.0 million.\nIf we do not receive anticipated milestone payments from our collaboration partners, AstraZeneca AB, or AstraZeneca and Sanofi S.A., or Sanofi, our operating losses will substantially increase for the foreseeable future as we continue our discovery, research, development, manufacturing and commercialization activities. There can be no assurance that we will receive any potential milestones under our agreements with AstraZeneca and/or Sanofi. For a discussion of the risks associated with our preclinical and clinical development programs with, and potential for milestone payments from, AstraZeneca and Sanofi, see below under “—Risks Related to Our Business.”\nEven if we receive the anticipated milestone payments or receive royalty payments from our collaboration partners, we may not be able to achieve or sustain profitability. For example, we may choose to exercise our right to co-fund a portion of the first Phase 3 clinical development program for tenapanor, incurring expenses of up to $40.0 million, and we would likely incur continued operating losses during the period we are co-funding the program. In addition, our receipt of milestone payments from our collaboration partners may not result in the recognition of revenue in the period received, as we may be required to amortize the milestone payment over a period of time. Depending upon such requirement and the period of amortization, we may continue to incur losses even after the receipt of such milestone payments. Therefore, there can be no assurance that our losses will not increase into the future. Our prior losses, combined with possible future losses, have had and will continue to have an adverse effect on our stockholders’ equity and working capital. Further, the net losses we incur may fluctuate significantly from quarter to quarter and year to year, such that a period-to-period comparison of our results of operations may not be a good indication of our future performance.\nWe have never generated any revenue from product sales and may never be profitable.\nWe have no products approved for sale and have never generated any revenue from product sales. Our ability to generate revenue from product sales and achieve profitability depends on our ability, and the ability of our collaboration partners, to successfully complete the development of and obtain the regulatory and marketing approvals necessary to commercialize one or more of our product candidates. We do not anticipate generating revenue from product sales for the foreseeable future. Our ability to generate future revenue from product sales or pursuant to milestone payments depends heavily on many factors, including but not limited to:\n| • | the completion of research and preclinical and clinical development of our product candidates; |\n\n| • | together with our collaboration partners, obtaining regulatory approvals for our product candidates; |\n\n| • | the ability of our collaboration partners to successfully commercialize and/or our ability to commercialize or co-promote, if we so choose, our product candidates; |\n\n| • | developing a sustainable and scalable manufacturing process for any approved product candidates and establishing and maintaining supply and manufacturing relationships with third parties that can provide adequate (in amount and quality) products to support clinical development and the market demand for our product candidates, if approved; |\n\n| • | obtaining market acceptance of our product candidates, if approved, as viable treatment options; |\n\n| • | addressing any competing technological and market developments; |\n\n| • | identifying, assessing, acquiring, in-licensing and/or developing new product candidates; |\n\n| • | negotiating favorable terms in any collaboration partnership, licensing or other arrangements into which we may enter; |\n\n| • | maintaining, protecting, and expanding our portfolio of intellectual property rights, including patents, trade secrets, and know-how, and our ability to develop, manufacture and commercialize our product candidates and products without infringing intellectual property rights of others; and |\n\n| • | attracting, hiring, and retaining qualified personnel. |\n\nIn cases where we, or our collaboration partners, are successful in obtaining regulatory approvals to market one or more of our product candidates, our revenue will be dependent, in part, upon the size of the markets in the territories for which regulatory approval is granted, the accepted price for the product, the ability to get reimbursement at any price and whether we have royalty and/or co-promotion rights for that territory. If the number of patients suitable for our product candidates is not as significant as we estimate, the indication approved by regulatory authorities is narrower than we expect, or the reasonably accepted population for treatment is narrowed by competition, physician choice or treatment guidelines, we may not generate significant revenue from the sale of such products, even if approved. Even if we achieve profitability in the future, we may not be able to sustain profitability in subsequent periods. Our failure to generate revenue from product sales would likely depress our market value and could impair our ability to raise capital, expand our business, discover or develop other product candidates or continue our operations. A decline in the value of our common stock could cause our stockholders to lose all or part of their investment.\n22\nWe may require substantial additional financing to achieve our goals, and a failure to obtain this necessary capital when needed on acceptable terms, or at all, could force us to delay, limit, reduce or terminate our product development or other operations.\nSince our inception, most of our resources have been dedicated to our research and development activities, including developing our lead product candidate, tenapanor, and developing our proprietary drug discovery and design platform. As of June 30, 2014, we had working capital of $94.8 million, including capital resources consisting of cash and cash equivalents of $117.8 million. We believe that we will continue to expend substantial resources for the foreseeable future, including costs associated with research and development, conducting preclinical studies and clinical trials, obtaining regulatory approvals and sales and marketing. Because the outcome of any clinical trial and/or regulatory approval process is highly uncertain, we cannot reasonably estimate the actual amounts necessary to successfully complete the development, regulatory approval process and commercialization or co-promotion of any of our product candidates.\nBased on our current operating plan, we believe that our existing capital resources will allow us to fund our operating plan through at least the next 12 months. However, our operating plan may change as a result of many factors currently unknown to us, and we may need to seek additional funds sooner than planned. Our future funding requirements will depend on many factors, including, but not limited to:\n| • | our decision whether or not to exercise our right to co-fund the first Phase 3 clinical development program for tenapanor, in which case we may invest $20.0 million, $30.0 million or $40.0 million to acquire an increase of 1%, 2% or 3%, respectively, in the royalties payable to us by AstraZeneca on net sales of tenapanor; |\n\n| • | the achievement of development and regulatory milestones resulting in the payment to us from our collaboration partners of contractual milestone payments and the timing of receipt of such payments, if any; |\n\n| • | the progress, timing, scope, results and costs of our preclinical studies and clinical trials for our product candidates that have not been licensed, including the ability to enroll patients in a timely manner for clinical trials; |\n\n| • | the time and cost necessary to obtain regulatory approvals for our product candidates that have not been licensed and the costs of post-marketing studies that could be required by regulatory authorities; |\n\n| • | our ability and the ability of our collaboration partners to successfully commercialize and/or co-promote our product candidates; |\n\n| • | the manufacturing, selling and marketing costs associated with product candidates, including the cost and timing of building our sales and marketing capabilities; |\n\n| • | our ability to establish and maintain collaboration partnerships, in-license/out-license or other similar arrangements and the financial terms of such agreements; |\n\n| • | the timing, receipt, and amount of sales of, or royalties on, our future products, if any; |\n\n| • | the sales price and the availability of adequate third-party reimbursement for our product candidates; |\n\n| • | the cash requirements of any future acquisitions or discovery of product candidates; |\n\n| • | the number and scope of preclinical and discovery programs that we decide to pursue or initiate; |\n\n| • | the time and cost necessary to respond to technological and market developments; and |\n\n| • | the costs of filing, prosecuting, maintaining, defending and enforcing any patent claims and other intellectual property rights, including litigation costs and the outcome of such litigation, including costs of defending any claims of infringement brought by others in connection with the development, manufacture or commercialization of our product candidates. |\n\nAdditional funds may not be available when we need them on terms that are acceptable to us, or at all. If adequate funds are not available to us on a timely basis, we may be required to delay, limit, reduce or terminate our research and development activities, preclinical and clinical trials for our product candidates for which we retain such responsibility and our establishment and maintenance of sales and marketing capabilities or other activities that may be necessary to commercialize or co-promote our product candidates.\n23\nRisks Related to Our Business\nWe are substantially dependent on the success of our lead product candidate, tenapanor, which may not be successful in nonclinical studies or clinical trials, receive regulatory approval or be successfully commercialized.\nTo date, we have invested a significant amount of our efforts and financial resources in the research and development of tenapanor, which is currently our lead product candidate and only product candidate in clinical trials. In particular, together with AstraZeneca, our collaboration partner for tenapanor, we have completed six Phase 1 and two Phase 2 trials and are currently conducting three Phase 2 trials and one Phase 1 study. Our near-term prospects, including our ability to finance our operations through the receipt of milestone payments and generate revenue from product sales, will depend heavily on the successful development and AstraZeneca’s commercialization of tenapanor, if approved. The clinical and commercial success of tenapanor will depend on a number of factors, including the following:\n| • | the timely completion of the ongoing clinical trials of tenapanor, which will depend substantially upon the satisfactory performance of third-party contractors; |\n\n| • | whether tenapanor’s safety and efficacy profile is satisfactory to the U.S. Food and Drug Administration, or FDA, and foreign regulatory authorities to warrant marketing approval; |\n\n| • | the timely completion of the ongoing chronic kidney disease, or CKD, Phase 2a clinical trial, which will depend substantially upon our ability to identify principal investigators with patient populations suitable for study, and the ability of those principal investigators to successfully enroll those patients into the trial; |\n\n| • | the results of a long-term rat carcinogenicity study required for approval of tenapanor, which will not be known for at least two and half years, and which may be delayed for a significant period of time for reasons outside of the control of AstraZeneca, particularly if AstraZeneca is required to restart or modify the study for any reason; |\n\n| • | whether FDA or foreign regulatory authorities require additional clinical trials prior to approval to market tenapanor; |\n\n| • | the prevalence and severity of adverse side effects of tenapanor; |\n\n| • | the timely receipt of necessary marketing approvals from the FDA and foreign regulatory authorities; |\n\n| • | the ability of AstraZeneca and us through our co-promotion rights, if we choose to exercise such rights and are not precluded from doing so under the terms of our agreement with AstraZeneca or any subsequent co-promotion agreements, to successfully commercialize tenapanor, if approved for marketing and sale by the FDA or foreign regulatory authorities, including educating physicians and patients about the benefits, administration and use of tenapanor; |\n\n| • | achieving and maintaining compliance with all regulatory requirements applicable to tenapanor; |\n\n| • | acceptance of tenapanor as safe and effective by patients and the medical community; |\n\n| • | the availability, perceived advantages, relative cost, relative safety and relative efficacy of alternative and competing treatments; |\n\n| • | obtaining and sustaining an adequate level of coverage and reimbursement for tenapanor by third-party payors; |\n\n| • | the effectiveness of AstraZeneca’s marketing, sales and distribution strategy and operations; |\n\n| • | the ability of AstraZeneca, or any third-party manufacturer it contracts with, to successfully scale up the manufacturing process for tenapanor, which has not yet been demonstrated, and to manufacture supplies of tenapanor and to develop, validate and maintain a commercially viable manufacturing process that is compliant with current good manufacturing practice, or cGMP, requirements; |\n\n| • | enforcing intellectual property rights in and to tenapanor; |\n\n| • | avoiding third-party interference, opposition, derivation or similar proceedings with respect to our patent rights, and avoiding other challenges to our patent rights and patent infringement claims; and |\n\n| • | a continued acceptable safety profile of tenapanor following approval. |\n\nMost of these factors are beyond our control, including clinical development, the regulatory submission process, manufacturing, marketing and sales efforts of AstraZeneca.\nAs a first-in-class drug, tenapanor, has not been extensively studied in humans and the nonclinical and clinical data on its effect in the human body is limited to the trials and studies that we and AstraZeneca have completed. As a first-in-class drug, there is a higher likelihood that approval may not be attained as compared to a class of drugs with approved products. We cannot be certain that tenapanor will be successful in preclinical studies, clinical trials or receive regulatory approval. For example, like phosphate binders, treatment with tenapanor in patients with end stage renal disease, or ESRD, may be significantly impacted by such patient’s adherence to a restrictive low phosphorus diet, and as such, adherence may be a factor in demonstrating the efficacy of tenapanor in clinical trials for this patient population. Further, it may not be possible or practicable to demonstrate, or if approved, to market on the basis of,\n24\ncertain of the benefits we believe tenapanor possesses, including the reduction of sodium absorption in patients with CKD, which is unlikely to be an endpoint to be considered for approval in CKD patients. Additionally, the reduction of serum phosphorus is currently an approvable endpoint in ESRD, but not in the broader CKD patient population in the United States. If the number of patients in the market for tenapanor or the price that the market can bear is not as significant as we estimate, we may not generate significant revenue from sales of tenapanor, if approved. Accordingly, there can be no assurance that tenapanor will ever be successfully commercialized or that we will ever generate revenue from sales of tenapanor. If we and AstraZeneca are not successful in completing the development of, obtaining approval for, and commercializing tenapanor, or are significantly delayed in doing so, our business will be materially harmed.\nWe are dependent on AstraZeneca for the development, regulatory approval, manufacture and commercialization of our small molecule NHE3 inhibitor program, which includes tenapanor, and if AstraZeneca fails to perform as expected, or is unable to obtain the required regulatory approvals for tenapanor, the potential for us to generate future revenue from milestone and royalty payments from tenapanor would be significantly reduced and our business would be materially and adversely harmed.\nIn October 2012, we entered into a license agreement with AstraZeneca granting it an exclusive worldwide license to our small molecule NHE3 inhibitor program, which includes our lead product candidate, tenapanor, for all indications. Under this agreement, AstraZeneca has responsibility for completing all nonclinical and clinical development and obtaining and maintaining regulatory approval for tenapanor from the FDA and regulatory agencies outside of the United States. Ultimately, if tenapanor is advanced through clinical trials and receives marketing approval from the FDA or comparable foreign regulatory agencies, AstraZeneca will be responsible for the commercialization of tenapanor, subject to our right to elect to participate in certain co-promotion activities in the United States. The potential for us to obtain future development milestone payments and, ultimately, generate revenue from royalties from tenapanor depends entirely on the successful development, regulatory approval, marketing and commercialization of tenapanor by AstraZeneca. In addition to the risks inherent in the development of a drug product candidate, our collaboration partnership with AstraZeneca may not be successful due to a number of important factors, including the following:\n| • | prior to the 175th day after the database lock for the ongoing Phase 2b clinical trial in hyperphosphatemic ESRD patients, AstraZeneca may terminate the license for any reason with 30 -days’ prior written notice and thereafter AstraZeneca may terminate the license with 120- days’ prior written notice; |\n\n| • | AstraZeneca has the unilateral ability to choose not to develop tenapanor for one or more indications for which it has been or is currently being evaluated, provided it pursues at least one indication, and AstraZeneca may choose to pursue an indication that is not in our strategic best interest or to delay the pursuit of, or forego an indication, even if clinical data is supportive of further development for such indication; |\n\n| • | AstraZeneca may choose not to develop and commercialize tenapanor in all relevant markets; |\n\n| • | AstraZeneca may take considerably more time advancing tenapanor through the clinical and regulatory process than we currently anticipate, which could materially delay the achievement of milestones and, consequently the receipt of milestone payments from AstraZeneca; |\n\n\n| • | AstraZeneca’s obligation to use “commercially reasonable efforts” with regard to the development, regulatory approval, manufacture and commercialization of tenapanor under our agreement leaves AstraZeneca with discretion in determining the efforts and resources that it will apply to the development, regulatory approval, manufacture and commercialization of tenapanor; |\n\n| • | subject to our right to elect to participate in co-promotion activities in the United States, AstraZeneca controls all aspects of the commercialization of tenapanor; |\n\n| • | AstraZeneca is obligated to reimburse a specified amount for the current constipation-predominant irritable bowel syndrome, or IBS-C, Phase 2b clinical trial, and despite our efforts to keep costs below that amount, we may be required to spend more than that to complete the trial, and if we do so, we will not be reimbursed for those excess amounts by AstraZeneca; |\n\n| • | AstraZeneca’s recent strategic withdrawal from selling gastrointestinal, or GI, products and the differing treatment of the IBS-C indication in our agreement implies that AstraZeneca may choose not to develop the IBS-C indication, even if our current Phase 2b clinical trial were successful; |\n\n| • | AstraZeneca may change the focus of its development and commercialization efforts or pursue higher-priority programs and, accordingly, reduce the efforts and resources allocated to tenapanor, which will have the direct effect of reducing our co-promotion activities as our level of co-promotion is limited to a percentage of the overall commercialization activities; |\n\n| • | AstraZeneca may fail to develop a commercially viable formulation or manufacturing process for tenapanor, and may fail to manufacture or supply sufficient drug substance of tenapanor for commercial use, if approved, which could result in lost revenue; |\n\n25\n\n| • | AstraZeneca may not comply with all applicable regulatory requirements or may fail to report safety data in accordance with all applicable regulatory requirements; |\n\n| • | AstraZeneca may sublicense its rights with respect to tenapanor to one or more third parties without our consent; |\n\n| • | AstraZeneca may not dedicate the resources that would be necessary to carry tenapanor through clinical development or may not obtain the necessary regulatory approvals; |\n\n| • | if AstraZeneca is acquired during the term of our collaboration partnership, the acquiror may have different strategic priorities that could cause it to terminate our agreement or reduce its commitment to our collaboration partnership; and |\n\n| • | if our agreement with AstraZeneca terminates, we will no longer have rights to receive potential revenue under the agreement with AstraZeneca for future milestones or royalties, in which case we would need to identify alternative means to continue the development, manufacture and commercialization of tenapanor, alone or with others. |\n\nThe timing and amount of any milestone and royalty payments we may receive under our agreement will depend on, among other things, the efforts, allocation of resources, and successful development and commercialization of tenapanor by AstraZeneca under our agreement. There can be no assurance that any of the development and regulatory milestones will be achieved or that we will receive any future milestone payments under the agreement. In addition, in certain circumstances we may believe that we have achieved a particular milestone and AstraZeneca may disagree with our belief. In that case, receipt of that milestone payment may be delayed or may never be received, which may require us to adjust our operating plans.\nIf AstraZeneca does not perform in the manner we expect or fulfill its responsibilities in a timely manner, or at all, the clinical development, regulatory approval and commercialization efforts related to tenapanor could be delayed or terminated and it could become necessary for us to assume the responsibility at our own expense for the clinical development of tenapanor. In that event, we would likely be required to substantially limit the size and scope of the development and commercialization of tenapanor or seek additional financing to fund further development, or to identify alternative collaboration partners for tenapanor, and our potential to generate future revenue from royalties and milestone payments from tenapanor would be significantly reduced or delayed and our business would be materially and adversely harmed.\nOur election to co-fund the first Phase 3 clinical development program for tenapanor must be made in a limited time period prior to the initiation of the first pivotal clinical trial for tenapanor and, as a result, we may make a substantial capital investment for a product candidate based on limited clinical data.\nUnder our agreement with AstraZeneca, we may elect to participate in the funding of the first Phase 3 clinical development program for the first indication of tenapanor by investing a co-funding amount of $20.0 million, $30.0 million or $40.0 million to acquire an increase of 1%, 2% or 3%, respectively, in the royalties payable to us by AstraZeneca on net sales of tenapanor. We may exercise this right only for a limited period of 60 days following AstraZeneca’s determination to proceed to the first Phase 3 clinical development program for tenapanor for a specific indication. An election to participate in the co-fund will be based, in part, on our analysis as to the likelihood of success of the Phase 3 clinical development program and the potential for regulatory approval to commercialize tenapanor. As a result, we will be required to make a substantial capital investment in tenapanor prior to the initiation of the first pivotal clinical trial and if tenapanor is unsuccessful in its pivotal trial or if it never receives regulatory approval, we will not receive any financial return on this capital investment.\nWe have not yet negotiated our agreement with AstraZeneca specifying all of the terms of our co-promotion right.\nPursuant to our license agreement with AstraZeneca, we have retained a co-promotion right with respect to tenapanor in the United States. While the license agreement includes the material terms of our co-promotion right, we and AstraZeneca mutually agreed to negotiate a separate agreement specifying the detailed activities and responsibilities in respect of the marketing and co-promotion of tenapanor following our election to exercise our co-promotion rights. If we elect to exercise our co-promotion rights, the separate agreement we negotiated with AstraZeneca may place restrictions or additional obligations on us, including financial obligations. Any restrictions or additional obligations may restrict our co-promotion activities or involve more significant financial obligations than we currently anticipate.\nExercising our co-promotion right under our license agreement with AstraZeneca may restrict our future commercialization and/or co-promotion activities.\nOur agreement with AstraZeneca prohibits us from using the same sales force to co-promote tenapanor as we do to promote other products that compete with tenapanor or with any other products that are then being actively promoted by AstraZeneca or its affiliates. If we elect to co-promote tenapanor, we may therefore be required to have a separate sales forces to promote other products we may elect to co-promote under our agreement with Sanofi, or other products we develop and commercialize on our own, should any of such products be competitive with tenapanor or with any other products promoted by AstraZeneca or its affiliates. The exercise of the co-promotion right under our agreement with AstraZeneca, could adversely affect the efficiency and cost of our promotion efforts for\n26\nour products and, effectively, may prohibit us from exercising our co-promotion rights under our agreement with Sanofi or with respect to other co-promotion rights with future collaboration partners.\nIf Sanofi does not exercise its option to obtain an exclusive license to develop, manufacture and commercialize our NaP2b inhibitors or if it exercises the option and subsequently terminates any development program under its collaboration partnership with us, any potential milestone payments or revenue from product sales under this collaboration partnership will be significantly reduced or non-existent, and our results of operations and financial condition will be materially and adversely affected.\nIn February 2014, we entered into a license option and license agreement with Sanofi under which we granted Sanofi an exclusive worldwide license to conduct research utilizing our small molecule NaP2b inhibitors, which we refer to as our RDX002 program, solely for the purpose of completing activities under a preclinical development plan. We believe the inhibition of NaP2b, an intestinal phosphate transporter, would provide utility for the treatment of hyperphosphatemia in ESRD patients, which is also the lead indication for which we and AstraZeneca are developing tenapanor.\nUnder the terms of this agreement, Sanofi has the option to obtain an exclusive license to develop, manufacture and commercialize our NaP2b inhibitors. Sanofi may exercise this option at any time following the effective date of the agreement and ending 45 days after the filing of an investigational new drug application, or IND, subject to certain exceptions, and if Sanofi does not file an IND on or before the 40th month anniversary of the completion of the technology transfer phase, the agreement will terminate.\nIf Sanofi does not exercise its option under its agreement with us, or terminates its rights and obligations with respect to the development program or the entire agreement, then depending on the timing of such event:\n| • | the development of our NaP2b inhibitor program may be terminated or significantly delayed; |\n\n| • | we would bear all of the risks and costs related to the further development and commercialization of product candidates that were previously the subject of the agreement if we decided to continue work under the NaP2b inhibitor program independently; |\n\n| • | we would not be eligible to receive any of the remaining development or regulatory milestone payments or royalties on product sales; |\n\n| • | in order to fund further development and commercialization of the NaP2b program, we may need to raise additional capital if we choose to internally pursue the development of the program, or we may need to seek out and establish alternative collaboration partnerships with third-party collaboration partners for the program, which may not be possible, or we may not be able to do so on terms which are acceptable to us, in which case it may be necessary for us to limit the size or scope of the programs or increase our expenditures and seek additional funding by other means; and |\n\n| • | our cash expenditures could increase significantly if it is necessary for us to hire additional employees and allocate scarce resources to the development and commercialization of the NaP2b program. |\n\nAny of these events would have a material adverse effect on our results of operations and financial condition.\nIn addition, we may be effectively prohibited from co-promoting any product candidates arising from the NaP2b program if we have previously exercised our co-promotion right under our agreement with AstraZeneca. For additional information regarding the effect of exercising our co-promotion right with AstraZeneca, see the risk factor above titled “Exercising our co-promotion right under our license agreement with AstraZeneca may restrict our future commercialization and/or co-promotion activities.”\nClinical drug development involves a lengthy and expensive process with an uncertain outcome, and we may encounter substantial delays in our clinical studies. Furthermore, results of earlier studies and trials may not be predictive of future trial results.\nBefore obtaining marketing approval from regulatory authorities for the sale of our product candidates, we, or our collaboration partners, must conduct extensive clinical studies to demonstrate the safety and efficacy of the product candidates in humans. Clinical testing is expensive and can take many years to complete, and its outcome is inherently uncertain. Failure can occur at any time during the clinical trial process. For example, in a Phase 2a study evaluating tenapanor in ESRD patients with fluid overload, while pharmacological activity of tenapanor was confirmed, the study failed to meet the primary endpoint of a statistically significant difference between tenapanor and placebo in change in interdialytic weight gain from baseline to week 4. The results of preclinical and clinical studies of our product candidates may not be predictive of the results of later-stage clinical trials. For example, the positive results generated to date in preclinical and clinical studies for tenapanor do not ensure that the ongoing Phase 2a and Phase 2b clinical trials, or future clinical trials, will demonstrate similar results. Product candidates in later stages of clinical trials may fail to show the desired safety and efficacy despite having progressed through preclinical studies and initial clinical trials. A number of companies in the pharmaceutical, biopharmaceutical and biotechnology industries have suffered significant setbacks in advanced clinical trials for similar indications that we are pursuing due to lack of efficacy or adverse safety profiles, notwithstanding promising\n27\nresults in earlier studies, and we cannot be certain that we will not face similar setbacks. Even if our clinical trials are completed, the results may not be sufficient to obtain regulatory approval for our product candidates.\nWe may experience delays in our ongoing or future trials, and we do not know whether future clinical trials will begin on time, need to be redesigned, enroll an adequate number of patients on time or be completed on schedule, if at all. Clinical trials can be delayed or terminated for a variety of reasons, including delay or failure to:\n| • | obtain regulatory approval to commence a trial, if applicable; |\n\n| • | reach agreement on acceptable terms with prospective contract research organizations, or CROs, and clinical trial sites, the terms of which can be subject to extensive negotiation and may vary significantly among different CROs and trial sites; |\n\n| • | obtain institutional review board, or IRB, approval at each site; |\n\n| • | recruit suitable patients in a timely manner to participate in our trials; |\n\n| • | have patients complete a trial or return for post-treatment follow-up; |\n\n| • | ensure that clinical sites observe trial protocol, comply with good clinical practices, or GCPs, or continue to participate in a trial; |\n\n| • | address any patient safety concerns that arise during the course of a trial; |\n\n| • | address any conflicts with new or existing laws or regulations; |\n\n| • | initiate or add a sufficient number of clinical trial sites; or |\n\n| • | manufacture sufficient quantities of product candidate for use in clinical trials. |\n\nPatient enrollment is a significant factor in the timing of clinical trials and is affected by many factors, including the size and nature of the patient population, the proximity of patients to clinical sites, the eligibility criteria for the trial, the design of the clinical trial, competing clinical trials and clinicians’ and patients’ perceptions as to the potential advantages of the drug being studied in relation to other available therapies, including any new drugs or treatments that may be approved for the indications we are investigating. We and AstraZeneca have experienced a delay in the enrollment of the ongoing Phase 2a clinical trial in CKD patients due to the restrictive eligibility criteria, and, although we have initiated efforts to increase enrollment by initiating new sites and amending the protocol, there can be no assurances that our efforts will be successful in increasing the rate of enrollment to complete this study on time, if at all.\nWe could also encounter delays if a clinical trial is suspended or terminated by us, our collaboration partner for the product candidate, by the IRBs of the institutions in which such trials are being conducted, by an independent data safety monitoring board, or DSMB, for such trial or by the FDA or other regulatory authorities. Such authorities may suspend or terminate a clinical trial due to a number of factors, including failure to conduct the clinical trial in accordance with regulatory requirements or our clinical protocols, inspection of the clinical trial operations or trial site by the FDA or other regulatory authorities resulting in the imposition of a clinical hold, unforeseen safety issues or adverse side effects, failure to demonstrate a benefit from using a drug, changes in governmental regulations or administrative actions or lack of adequate funding to continue the clinical trial.\nFurther, conducting clinical trials in foreign countries presents additional risks that may delay completion of clinical trials. These risks include the failure of physicians or enrolled patients in foreign countries to adhere to clinical protocol as a result of differences in healthcare services or cultural customs, managing additional administrative burdens associated with foreign regulatory schemes and political and economic risks relevant to such foreign countries. In addition, the FDA may determine that the clinical trial results obtained in foreign subjects do not represent the safety and efficacy of a product candidate when administered in U.S. patients and are thus not supportive of an NDA approval in the United States. As part of our effort to increase the rate of enrollment in the ongoing Phase 2a clinical trial in CKD patients, we and AstraZeneca have initiated sites in Germany. For the reasons stated above, these efforts may not improve the rate of enrollment in this study, or generate results that can be used to support the development of tenapanor.\nIf there are delays in the completion of, or termination of, any clinical trial of our product candidates, the commercial prospects of our product candidates may be harmed, and our ability to generate revenue from product sales from any of these product candidates will be delayed. In addition, any delays in completing the clinical trials will increase costs, slow down our product candidate development and approval process and jeopardize the ability to commence product sales and generate revenue from product sales. Any of these occurrences may significantly harm our business, financial condition and prospects. In addition, many of the factors that cause, or lead to, a delay in the commencement or completion of clinical trials may also ultimately lead to the denial of regulatory approval of our product candidates.\n28\nOur unlicensed product candidates are at an early stage of development and we may not be successful in our efforts to develop these products or expand our pipeline of product candidates.\nA key element of our strategy is to expand our pipeline of products candidates utilizing our proprietary drug discovery and design platform and to advance such product candidates through clinical development. Our current unlicensed product candidates are in the discovery and lead identification stages of preclinical development and will require substantial preclinical and clinical development, testing and regulatory approval prior to commercialization. In particular, tenapanor is our only product candidate in clinical trials and our other product candidates are in the preclinical stage with significant research and development required before we could file an IND with regulatory authorities to begin clinical studies. Of the large number of drugs in development, only a small percentage of such drugs successfully complete the FDA regulatory approval process and are commercialized. Accordingly, even if we are able to continue to fund our development programs, there can be no assurance that any product candidates will reach the clinic or be successfully developed or commercialized.\nResearch programs to identify product candidates require substantial technical, financial and human resources, whether or not any product candidates are ultimately identified. Although our research and development efforts to date have resulted in several development programs, we may not be able to develop product candidates that are safe and effective. Our research programs may initially show promise in identifying potential product candidates, yet fail to yield product candidates for clinical development or commercialization for many reasons, including the following:\n| • | the research methodology used and our drug discovery and design platform may not be successful in identifying potential product candidates; |\n\n| • | competitors may develop alternatives that render our product candidates obsolete or less attractive; |\n\n| • | product candidates we develop may nevertheless be covered by third parties’ patents or other exclusive rights; |\n\n| • | the market for a product candidate may change during our program so that the continued development of that product candidate is no longer reasonable; |\n\n| • | a product candidate may on further study be shown to have harmful side effects or other characteristics that indicate it is unlikely to be effective or otherwise does not meet applicable regulatory criteria; |\n\n| • | a product candidate may not be capable of being produced in commercial quantities at an acceptable cost, or at all; and |\n\n| • | a product candidate may not be accepted as safe and effective by patients, the medical community or third-party payors, if applicable. |\n\nEven if we are successful in continuing to expand our pipeline, through our own research and development efforts or by pursuing in-licensing or acquisition of product candidates, the potential product candidates for which we identify or acquire rights may not be suitable for clinical development, including as a result of being shown to have harmful side effects or other characteristics that indicate that they are unlikely to receive marketing approval and achieve market acceptance. If we do not successfully develop and commercialize a product pipeline, we may not be able to generate revenue from product sales in future periods or ever achieve profitability.\nOur proprietary drug discovery and design platform, and, in particular, APECCS, is a new approach to the discovery, design and development of new product candidates and may not result in any products of commercial value.\nWe have developed a proprietary drug discovery and design platform to enable the identification, screening, testing, design and development of new product candidates, and we recently we enhanced this platform with the addition of APECCS. We plan to utilize APECCS to identify new and potentially novel targets in the GI tract. We have also identified over 3,800 proteins on the inner surface of the gut, many of which we believe may be drug targets. However, there can be no assurance that APECCS will work or that any of these potential targets or other aspects of our proprietary drug discovery and design platform will yield product candidates that could enter clinical development and, ultimately, be commercially valuable.\nAlthough we expect to continue to enhance the capabilities of our APECCS system by advancing the cell culture and screening process and/or acquiring new technologies to broaden the scope of APECCS, we may not be successful in any of our enhancement and development efforts. For example, we may not be able to enter into agreements on suitable terms to obtain technologies required to develop certain capabilities of APECCS. In addition, we may not be successful in developing the conditions necessary to grow multiple segments of intestine or from multiple species, or otherwise develop assays or cell cultures necessary to expand these capabilities. If our enhancement or development efforts are unsuccessful, we may not be able to advance our drug discovery capabilities as quickly as we expect or identify as many potential drugable targets as we desire.\n29\nWe may expend our limited resources to pursue a particular product candidate or indication and fail to capitalize on product candidates or indications that may be more profitable or for which there is a greater likelihood of success.\nBecause we have limited financial and managerial resources, we have focused on research programs and product candidates that relate to discovery and development of non-systemic drugs that work in the GI tract. As a result, we may forego or delay pursuit of opportunities with other product candidates or for other indications that later prove to have greater commercial potential. Our resource allocation decisions may cause us to fail to capitalize on viable commercial products or profitable market opportunities. Our spending on current and future research and development programs and product candidates for specific indications may not yield any commercially viable products. If we do not accurately evaluate the commercial potential or target market for a particular product candidate, we may relinquish valuable rights to that product candidate through collaboration partnerships, licensing or other royalty arrangements in cases in which it would have been more advantageous for us to retain sole development and commercialization rights to such product candidate.\nWe rely on third parties to conduct some of our preclinical and nonclinical studies and all of our clinical trials. If these third parties do not successfully carry out their contractual duties or meet expected deadlines, we may be unable to obtain regulatory approval for or commercialize our product candidates.\nWe do not have the ability to independently conduct clinical trials and, in some cases, preclinical or nonclinical studies. We rely on medical institutions, clinical investigators, contract laboratories, collaboration partners and other third parties, such as CROs, to conduct clinical trials on our product candidates. The third parties with whom we contract for execution of the clinical trials we are conducting with AstraZeneca, as well as those third parties with whom we will contract for execution of clinical trials for our internal programs, play a significant role in the conduct of these trials and the subsequent collection and analysis of data. However, these third parties are not our employees, and except for contractual duties and obligations, we control only certain aspects of their activities and have limited ability to control the amount or timing of resources that they devote to our programs. Although we rely, and will continue to rely, on these third parties to conduct some of our preclinical and nonclinical studies and all of our clinical trials, we remain responsible for ensuring that each of our studies and clinical trials is conducted in accordance with the applicable protocol, legal, regulatory and scientific standards and our reliance on third parties does not relieve us of our regulatory responsibilities. We and these third parties are required to comply with current good laboratory practices, or GLPs, for preclinical and nonclinical studies, and good clinical practices, or GCPs, for clinical studies. GLPs and GCPs are regulations and guidelines enforced by the FDA, the Competent Authorities of the Member States of the European Economic Area, or EEA, and comparable foreign regulatory authorities for all of our products in preclinical and clinical development, respectively. Regulatory authorities enforce GCPs through periodic inspections of trial sponsors, principal investigators and trial sites. If we or any of our third party contractors fail to comply with applicable regulatory requirements, including GCPs, the clinical data generated in our clinical trials may be deemed unreliable and the FDA, the European Medicines Agency, or EMA, or comparable foreign regulatory authorities may require us to perform additional clinical trials before approving our marketing applications. There can be no assurance that upon inspection by a given regulatory authority, such regulatory authority will determine that any of our clinical trials comply with GCP regulations. In addition, our clinical trials must be conducted with product produced under cGMP regulations. Our failure to comply with these regulations may require us to repeat clinical trials, which would delay the regulatory approval process.\nEven if our product candidates obtain regulatory approval, they may never achieve market acceptance or commercial success, which will depend, in part, upon the degree of acceptance among physicians, patients, patient advocacy groups, health care payors and the medical community.\nEven if our product candidates obtain FDA or other regulatory approvals, and are ultimately commercialized, our product candidates may not achieve market acceptance among physicians, patients, third-party payors, patient advocacy groups, health care payors and the medical community. Market acceptance of our product candidates for which marketing approval is obtained depends on a number of factors, including:\n| • | the efficacy of the products as demonstrated in clinical trials; |\n\n| • | the prevalence and severity of any side effects and overall safety profile of the product; |\n\n| • | the clinical indications for which the product is approved; |\n\n| • | advantages over existing therapies; |\n\n| • | acceptance by physicians, major operators of clinics and patients of the product as a safe and effective treatment; |\n\n| • | relative convenience and ease of administration of our products; |\n\n| • | the potential and perceived advantages of our product candidates over current treatment options or alternative treatments, including future alternative treatments; |\n\n| • | the cost of treatment in relation to alternative treatments and willingness to pay for our products, if approved, on the part of physicians and patients; |\n\n30\n\n| • | the availability of alternative products and their ability to meet market demand; |\n\n| • | the strength of our or our collaboration partners’ marketing and distribution organizations; |\n\n| • | the quality of our relationships with patient advocacy groups; and |\n\n| • | sufficient third-party coverage or reimbursement. |\n\nAny failure by our product candidates that obtain regulatory approval to achieve market acceptance or commercial success would adversely affect our results of operations.\nOur product candidates may cause undesirable side effects or have other properties that could delay our clinical trials, or delay or prevent regulatory approval, limit the commercial profile of an approved label, or result in significant negative consequences following regulatory approval, if any. If any of our product candidates receives marketing approval and we or others later identify undesirable side effects caused by the product candidate, the ability to market the product candidates could be compromised.\nUndesirable side effects caused by our product candidates could cause us, our collaboration partners, or regulatory authorities to interrupt, delay or halt clinical trials, result in the delay or denial of regulatory approval by the FDA or other comparable foreign regulatory authorities or limit the commercial profile of an approved label. To date, patients treated with tenapanor have experienced drug-related side effects including diarrhea, nausea, flatulence, abdominal discomfort, abdominal pain, abdominal distention and changes in electrolytes. In the event that trials conducted by us or AstraZeneca with tenapanor, or trials we conduct with our other product candidates, reveal an unacceptable severity and prevalence of these or other side effects, such trials could be suspended or terminated and the FDA or comparable foreign regulatory authorities could order AstraZeneca or us to cease further development of or deny approval of tenapanor, or any such other product candidate, for any or all targeted indications. The drug-related side effects could affect patient recruitment or the ability of enrolled patients to complete the trial or result in potential product liability claims. Any of these occurrences may harm our business, financial condition and prospects significantly.\nIn addition, in the event that any of our product candidates receives regulatory approval and we or others later identify undesirable side effects caused by one of our products, a number of potentially significant negative consequences could occur, including:\n| • | regulatory authorities may withdraw their approval of the product or seize the product; |\n\n| • | we, or our collaboration partners, may be required to recall the product; |\n\n| • | additional restrictions may be imposed on the marketing of the particular product or the manufacturing processes for the product or any component thereof, including the imposition of a Risk Evaluation and Mitigation Strategies, or REMS, plan that may require creation of a Medication Guide outlining the risks of such side effects for distribution to patients, as well as elements to assure safe use of the product, such as a patient registry and training and certification of prescribers; |\n\n| • | we, or our collaboration partners, may be subject to fines, injunctions or the imposition of civil or criminal penalties; |\n\n| • | regulatory authorities may require the addition of labeling statements, such as a “black box” warning or a contraindication; |\n\n| • | we could be sued and held liable for harm caused to patients; |\n\n| • | the product may become less competitive; and |\n\n| • | our reputation may suffer |\n\nAny of the foregoing events could prevent us, or our collaboration partners, from achieving or maintaining market acceptance of a particular product candidate, if approved, and could result in the loss of significant revenue to us, which would materially and adversely affect our results of operations and business.\nWe face substantial competition and our competitors may discover, develop or commercialize products faster or more successfully than us.\nThe biotechnology and pharmaceutical industries are highly competitive, and we face significant competition from companies in the biotechnology, pharmaceutical and other related markets that are researching and marketing products designed to address diseases that we are currently developing products to treat. If approved for marketing by the FDA or other regulatory agencies, tenapanor, or our other product candidates, would compete against existing treatments. For example, tenapanor will, if approved, compete directly with phosphate binders for the treatment of hyperphosphatemia in patients with ESRD, including sevelamer hydrochloride (Renagel) and sevelamer carbonate (Renvela), which were launched by Genzyme. Impax Laboratories, Inc. launched an authorized generic version of sevelamer carbonate in April 2014 and is expected to launch a generic version of sevelamer hydrochloride in September 2014. In addition to the currently marketed phosphate binders, we are aware of several other binders in development such as ferric citrate (Zerenex), an iron-based binder in Phase 3 being developed in the United States by Keryx and approved in Japan, and fermagate (Alpharen), an iron-based binder in Phase 2 being developed by Opko Health.\n31\nWhile there are no treatments for CKD that have been proven to reverse the disease, we are aware of one agent, CLP-1001, being developed by Sorbent Therapeutics, which is an orally administered, non-systemic exchange resin that binds both sodium and potassium as well as protons that showed positive effects in CKD patients with heart failure in a Phase 2a clinical trial and which showed the ability to increase fecal sodium. We believe this agent, if approved, may be competitive with tenapanor to treat CKD and ESRD patients. We are aware of certain investigational drugs that were being developed for delaying kidney decline as measured by estimated glomerular filtration rate, or eGFR. Among other products, Concert Pharmaceuticals is developing CTP-499 which showed protective effects on kidney function at 48 weeks in a Phase 2 clinical trial in patients with CKD and type 2 diabetes.\nNumerous treatments exist for constipation and the constipation component of IBS-C, many of which are over-the-counter. These include psyllium husk (such as Metamucil), methylcellulose (such as Citrucel), calcium polycarbophil (such as FiberCon), lactulose (such as Cephulac), polyethylene glycol (such as MiraLax), sennosides (such as Exlax), bisacodyl (such as Ducolax), docusate sodium (such as Colace), magnesium hydroxide (such as Milk of Magnesia), saline enemas (such as Fleet) and sorbitol. These agents are generally inexpensive and work well to relieve temporary constipation. We are also aware of two prescription drugs currently on the U.S. market that are approved to treat IBS-C, Linzess (linaclotide), which was developed by Ironwood Pharmaceuticals and was approved in 2012 and 2013 for IBS-C and chronic constipation in both the United States and in Europe, and Amitiza (lubiprostone), which was first approved in the United States in 2006 and is currently marketed by Sucampo and Takeda for treatment of chronic idiopathic constipation, or CIC, IBS-C and opioid induced constipation, or OIC.\nIt is possible that our competitors will develop and market drugs or other treatments that are less expensive and more effective than our product candidates, or that will render our product candidates obsolete. It is also possible that our competitors will commercialize competing drugs or treatments before we, or our collaboration partners, can launch any products developed from our product candidates. We also anticipate that we will face increased competition in the future as new companies enter into our target markets.\nMany of our competitors have materially greater name recognition and financial, manufacturing, marketing, research and drug development resources than we do. Additional mergers and acquisitions in the biotechnology and pharmaceutical industries may result in even more resources being concentrated in our competitors. Large pharmaceutical companies in particular have extensive expertise in preclinical and clinical testing and in obtaining regulatory approvals for drugs. In addition, academic institutions, government agencies, and other public and private organizations conducting research may seek patent protection with respect to potentially competitive products or technologies. These organizations may also establish exclusive collaboration partnerships or licensing relationships with our competitors.\nWe currently have no sales organization. If we are unable to establish sales capabilities on our own or through third parties, we may not be able to co-promote tenapanor, if approved, or commercialize or co-promote any of our other product candidates.\nWe currently do not have a sales organization. In order to co-promote tenapanor or commercialize or co-promote any of our other product candidates, we must build our marketing, sales, distribution, managerial and other non-technical capabilities or make arrangements with third parties to perform these services, and we may not be successful in doing so. If one or more of our product candidates receives regulatory approval, we expect to establish a specialty sales organization with technical expertise and supporting distribution capabilities to co-promote and/or commercialize our product candidates, which will be expensive and time consuming. As a company, we have no prior experience in the marketing, sale and distribution of pharmaceutical products and there are significant risks involved in building and managing a sales organization, including our ability to hire, retain, and incentivize qualified individuals, generate sufficient sales leads, provide adequate training to sales and marketing personnel, comply with regulatory requirements applicable to the marketing and sale of drug products and effectively manage a geographically dispersed sales and marketing team. Any failure or delay in the development of our internal sales, marketing and distribution capabilities would adversely impact the commercialization of these products.\nWe may choose to collaborate with third parties that have direct sales forces and established distribution systems, either to augment our own sales force and distribution systems or in lieu of our own sales force and distribution systems. If we are unable to enter into such arrangements on acceptable terms or at all, we may not be able to successfully commercialize our product candidates.\n32\nWe rely completely on third parties to manufacture our preclinical and clinical drug supplies, and we intend to rely on third parties to produce commercial supplies of any approved product candidate. Our business would be harmed if those third parties fail to obtain approval of the FDA, Competent Authorities of the Member States of the EEA or comparable regulatory authorities, fail to provide us with sufficient quantities of drug product, or fail to do so at acceptable quality levels or prices.\nWe do not currently have, nor do we plan to acquire, the infrastructure or capability internally to manufacture our preclinical and clinical drug supplies for use in the conduct of our preclinical and clinical studies, and we lack the resources and the capability to manufacture any of our product candidates on a clinical or commercial scale. The facilities used by our contract manufacturers to manufacture any drug products must be approved by the FDA pursuant to inspections that will be conducted after an NDA is submitted to the FDA. We do not control the manufacturing process of our product candidates, and, other than with respect to tenapanor, we are completely dependent on our contract manufacturing partners for compliance with the regulatory requirements, known as cGMPs, for manufacture of both active drug substances and finished drug products. Under our agreement with AstraZeneca, the manufacturing of tenapanor is the responsibility of AstraZeneca. We are entirely dependent on AstraZeneca for all aspects of the manufacturing and validation process, as well as providing all commercial supply of tenapanor. For additional information regarding the risks of our dependence on AstraZeneca, see the risk factors above titled “We are substantially dependent on the success of our lead product candidate, tenapanor, which may not be successful in nonclinical studies or clinical trials, receive regulatory approval or be successfully commercialized” and “We are dependent on AstraZeneca for the development, regulatory approval, manufacture and commercialization of our small molecule NHE3 inhibitor program, which includes tenapanor, and if AstraZeneca fails to perform as expected, or is unable to obtain the required regulatory approvals for tenapanor, the potential for us to generate future revenue from milestone and royalty payments from tenapanor would be significantly reduced and our business would be materially and adversely harmed.”\nIf our contract manufacturers cannot successfully manufacture material that conforms to our specifications and the strict regulatory requirements of the FDA or others, they will not be able to secure and/or maintain regulatory approval for their manufacturing facilities. In addition, we have no control over the ability of our contract manufacturers to maintain adequate quality control, quality assurance and qualified personnel. If the FDA or a comparable foreign regulatory authority does not approve these facilities for the manufacture of our product candidates or if it withdraws any such approval in the future, we may need to find alternative manufacturing facilities, which would significantly impact our ability to develop, obtain regulatory approval for or market our product candidates, if approved.\nWe rely on our manufacturers to purchase from third-party suppliers the materials necessary to produce our product candidates for our clinical studies. There are a limited number of suppliers for raw materials that we use to manufacture our drugs, and there may be a need to identify alternate suppliers to prevent a possible disruption of the manufacture of the materials necessary to produce our product candidates for our clinical studies, and, if approved, ultimately for commercial sale. We do not have any control over the process or timing of the acquisition of these raw materials by our manufacturers. Although we generally do not begin a clinical study unless we believe we have on hand, or will be able to manufacture a sufficient supply of a product candidate to complete such study, any significant delay or discontinuity in the supply of a product candidate, or the raw material components thereof, for an ongoing clinical study due to the need to replace a third-party manufacturer could considerably delay completion of our clinical studies, product testing, and potential regulatory approval of our product candidates, which could harm our business and results of operations.\nThird-party payor coverage and reimbursement status of newly-approved products is uncertain. Failure to obtain or maintain adequate coverage and reimbursement for our products, if approved, could limit our ability to market those products and decrease our ability to generate revenue.\nThe pricing, coverage and reimbursement of our product candidates, if approved, must be adequate to support a commercial infrastructure. The availability and adequacy of coverage and reimbursement by governmental and private payors are essential for most patients to be able to afford treatments such as ours, assuming approval. Sales of our product candidates will depend substantially, both domestically and abroad, on the extent to which the costs of our product candidates will be paid for by health maintenance, managed care, pharmacy benefit, and similar healthcare management organizations, or reimbursed by government authorities, private health insurers, and other third-party payors. If coverage and reimbursement are not available, or are available only to limited levels, we may not be able to successfully commercialize our product candidates. Even if coverage is provided, the approved reimbursement amount may not be high enough to allow us to establish or maintain pricing sufficient to realize a return on our investment.\nThere is significant uncertainty related to the insurance coverage and reimbursement of newly approved products. In the United States, the principal decisions about coverage and reimbursement for new drugs are typically made by the Centers for Medicare & Medicaid Services, or CMS, an agency within the U.S. Department of Health and Human Services responsible for administering the Medicare program, as CMS decides whether and to what extent a new drug will be covered and reimbursed under Medicare. Private payors tend to follow the coverage reimbursement policies established by CMS to a substantial degree. It is difficult to predict what CMS will decide with respect to reimbursement for products such as ours.\n33\nIn July 2010, CMS released its final rule to implement a bundled prospective payment system for the treatment of ESRD patients as required by the Medicare Improvements for Patients and Providers Act, or MIPPA. The bundled payment covers a bundle of items and services routinely required for dialysis treatments furnished to Medicare beneficiaries in Medicare-certified ESRD facilities or at their home, including the cost of certain routine drugs. The final rule delayed the inclusion of oral medications without intravenous equivalents in the bundled payment until January 1, 2014 and in April 2014, President Obama signed the Protecting Access to Medicare Act of 2014, which further extends this implementation date to January 1, 2024. As a result of the recent legislation, beginning in 2024, ESRD-related drugs will be included in the bundle and separate Medicare reimbursement will no longer be available for such drugs, as it is today under Medicare Part D. While it is too early to project the full impact bundling may have on the industry, the impact could potentially cause dramatic price reductions for tenapanor, if approved. We and AstraZeneca may be unable to sell tenapanor, if approved, to dialysis providers on a profitable basis if third-party payors reduce their current levels of payment, or if our costs of production increase faster than increases in reimbursement levels.\nOutside the United States, international operations are generally subject to extensive governmental price controls and other market regulations, and we believe the increasing emphasis on cost-containment initiatives in Europe, Canada, China and other countries has and will continue to put pressure on the pricing and usage of our product candidates. In many countries, the prices of medical products are subject to varying price control mechanisms as part of national health systems. Other countries allow companies to fix their own prices for medicinal products, but monitor and control company profits. Additional foreign price controls or other changes in pricing regulation could restrict the amount that we are able to charge for our product candidates. Accordingly, in markets outside the United States, the reimbursement for our products may be reduced compared with the United States and may be insufficient to generate commercially reasonable revenue and profits.\nMoreover, increasing efforts by governmental and third-party payors in the United States and abroad to cap or reduce healthcare costs may cause such organizations to limit both coverage and the level of reimbursement for new products approved and, as a result, these caps may not cover or provide adequate payment for our product candidates. We expect to experience pricing pressures in connection with the sale of any of our product candidates due to the trend toward managed healthcare, the increasing influence of health maintenance organizations, and additional legislative changes. The downward pressure on healthcare costs in general, particularly prescription drugs and surgical procedures and other treatments, has become very intense. As a result, increasingly high barriers are being erected to the entry of new products.\nIf product liability lawsuits are brought against us, we may incur substantial liabilities and may be required to limit commercialization of our product candidates.\nWe face an inherent risk of product liability as a result of the clinical testing of our product candidates and will face an even greater risk if we commercialize any products. For example, we may be sued if any product we develop allegedly causes injury or is found to be otherwise unsuitable during product testing, manufacturing, marketing or sale. Any such product liability claims may include allegations of defects in manufacturing, defects in design, a failure to warn of dangers inherent in the product, negligence, strict liability, and a breach of warranties. Claims could also be asserted under state consumer protection acts. If we cannot successfully defend ourselves against product liability claims, we may incur substantial liabilities or be required to limit commercialization of our product candidates. Even successful defense would require significant financial and management resources. Regardless of the merits or eventual outcome, liability claims may result in:\n| • | decreased demand for our product candidates; |\n\n| • | injury to our reputation; |\n\n| • | withdrawal of clinical trial participants; |\n\n| • | costs to defend the related litigation; |\n\n| • | a diversion of management’s time and our resources; |\n\n| • | substantial monetary awards to trial participants or patients; |\n\n| • | regulatory investigations, product recalls or withdrawals, or labeling, marketing or promotional restrictions; |\n\n| • | loss of revenue; and |\n\n| • | the inability to commercialize or co-promote our product candidates. |\n\nOur inability to obtain and maintain sufficient product liability insurance at an acceptable cost and scope of coverage to protect against potential product liability claims could prevent or inhibit the commercialization of any products we develop. We currently carry product liability insurance covering use in our clinical trials in the amount of $10.0 million in the aggregate. Although we maintain such insurance, any claim that may be brought against us could result in a court judgment or settlement in an amount that is not covered, in whole or in part, by our insurance or that is in excess of the limits of our insurance coverage. Our insurance policies also have various exclusions and deductibles, and we may be subject to a product liability claim for which we have no coverage. We will\n34\nhave to pay any amounts awarded by a court or negotiated in a settlement that exceed our coverage limitations or that are not covered by our insurance, and we may not have, or be able to obtain, sufficient capital to pay such amounts. Moreover, in the future, we may not be able to maintain insurance coverage at a reasonable cost or in sufficient amounts to protect us against losses.\nWe are highly dependent on the services of our President and Chief Executive Officer, Michael Raab, our Chief Scientific Officer, Dominique Charmot, Ph.D., and our Vice President of Drug Development, David Rosenbaum, Ph.D., and if we are not able to retain these members of our management or recruit additional management, clinical and scientific personnel, our business will suffer.\nOur success depends in part on our continued ability to attract, retain and motivate highly qualified personnel. In particular, we are highly dependent upon Michael Raab, our President and Chief Executive Officer, Dominique Charmot, Ph.D., our Chief Scientific Officer, and David Rosenbaum, Ph.D., our Vice President of Drug Development. The loss of services of any of these individuals could delay or prevent the successful development of our product pipeline, completion of our planned clinical trials or the commercialization of our product candidates. Although we have entered into employment agreements with our senior management team, including Mr. Raab and Drs. Charmot and Rosenbaum, these agreements are terminable at will with or without notice and, therefore, we may not be able to retain their services as expected. Although we have not historically experienced unique difficulties attracting and retaining qualified employees, we could experience such problems in the future. For example, competition for qualified personnel in the biotechnology and pharmaceuticals field is intense due to the limited number of individuals who possess the skills and experience required by our industry. In addition to the competition for personnel, the San Francisco Bay area in particular is characterized by a high cost of living. As such, we could have difficulty attracting experienced personnel to our company and may be required to expend significant financial resources in our employee recruitment and retention efforts.\nWe will need to significantly increase the size of our organization, and we may experience difficulties in managing growth.\nAs of June 30, 2014, we had 36 full-time employees. We will need to continue to expand our managerial, operational, finance and other resources in order to manage our operations, preclinical and clinical trials, research and development activities, regulatory filings, manufacturing and supply activities, and any marketing and commercialization activities, including co-promotion activities. Our management, personnel, systems and facilities currently in place may not be adequate to support this future growth. Our need to effectively execute our growth strategy requires that we:\n| • | expand our general and administrative functions; |\n\n| • | establish and build a marketing and commercial organization; |\n\n| • | identify, recruit, retain, incentivize and integrate additional employees; |\n\n| • | manage our internal development efforts effectively while carrying out our contractual obligations to third parties; and |\n\n| • | continue to improve our operational, legal, financial and management controls, reporting systems and procedures. |\n\nIf we are not able to attract, retain and motivate necessary personnel to accomplish our business objectives, we may experience constraints that will significantly impede the achievement of our development objectives, our ability to raise additional capital and our ability to implement our business strategy.\nWe incur significant costs as a result of operating as a public company, and our management will devote substantial time to new compliance initiatives. We may fail to comply with the rules that apply to public companies, including Section 404 of the Sarbanes-Oxley Act of 2002, which could result in sanctions or other penalties that would harm our business.\nWe incur significant legal, accounting and other expenses as a public company, including costs resulting from public company reporting obligations under the Securities Exchange Act of 1934, as amended, or the Exchange Act, and regulations regarding corporate governance practices. The listing requirements of The NASDAQ Global Market require that we satisfy certain corporate governance requirements relating to director independence, distributing annual and interim reports, stockholder meetings, approvals and voting, soliciting proxies, conflicts of interest and a code of conduct. Our management and other personnel will need to devote a substantial amount of time to ensure that we comply with all of these requirements, and we will need to hire additional accounting and financial staff with appropriate public company reporting experience and technical accounting knowledge. Moreover, the reporting requirements, rules and regulations will increase our legal and financial compliance costs and will make some activities more time consuming and costly. Any changes we make to comply with these obligations may not be sufficient to allow us to satisfy our obligations as a public company on a timely basis, or at all. These reporting requirements, rules and regulations, coupled with the increase in potential litigation exposure associated with being a public company, could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors or board committees or to serve as executive officers, or to obtain certain types of insurance, including directors’ and officers’ insurance, on acceptable terms.\n35\nIn addition, we expect to implement an enterprise resource planning, or ERP, system for our company in connection with becoming a public reporting company. An ERP system is intended to combine and streamline the management of our financial, accounting, human resources, sales and marketing and other functions, enabling us to manage operations and track performance more effectively. However, an ERP system will require us to complete many processes and procedures for the effective use of the system or to run our business using the system, which may result in substantial costs. Additionally, during the conversion process, we may be limited in our ability to convert any business that we acquire to the ERP. Any disruptions or difficulties in implementing or using an ERP system could adversely affect our controls and harm our business, including our ability to forecast or make sales and collect our receivables. Moreover, such disruption or difficulties could result in unanticipated costs and diversion of management attention.\nWe are subject to Section 404 of The Sarbanes-Oxley Act of 2002, or Section 404, and the related rules of the Securities and Exchange Commission, or SEC, which generally require our management and independent registered public accounting firm to report on the effectiveness of our internal control over financial reporting. Beginning with the second annual report that we will be required to file with the SEC, Section 404 requires an annual management assessment of the effectiveness of our internal control over financial reporting. However, for so long as we remain an emerging growth company as defined in the Jumpstart Our Business Startups Act of 2012, or JOBS Act, we intend to take advantage of certain exemptions from various reporting requirements that are applicable to public companies that are not emerging growth companies, including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404. Once we are no longer an emerging growth company or, if prior to such date, we opt to no longer take advantage of the applicable exemption, we will be required to include an opinion from our independent registered public accounting firm on the effectiveness of our internal controls over financial reporting. We will remain an emerging growth company until the earlier of (1) the last day of the fiscal year following the fifth anniversary of the completion of our IPO (December 31, 2019), (2) the last day of the fiscal year in which we have total annual gross revenue of at least $1.0 billion, or (3) the last day of the fiscal year in which we are deemed to be a large accelerated filer, which means the market value of our common stock that is held by non-affiliates exceeds $700 million as of the prior June 30th, and (4) the date on which we have issued more than $1.0 billion in non-convertible debt during the prior three-year period.\nTo date, we have not conducted any other review of our internal control for the purpose of providing the reports required by Section 404 and the related SEC rules. During the course of our review and testing, we may identify deficiencies and be unable to remediate them before we must provide the required reports. Furthermore, if we have a material weakness in our internal controls over financial reporting, we may not detect errors on a timely basis and our financial statements may be materially misstated. We or our independent registered public accounting firm may not be able to conclude on an ongoing basis that we have effective internal control over financial reporting, which could harm our operating results, cause investors to lose confidence in our reported financial information and cause the trading price of our stock to fall. In addition, as a public company we are required to file accurate and timely quarterly and annual reports with the SEC under the Exchange Act. Any failure to report our financial results on an accurate and timely basis could result in sanctions, lawsuits, delisting of our shares from The NASDAQ Global Market or other adverse consequences that would materially harm our business.\nWe may form additional collaboration partnerships in the future with respect to our independent programs, and we may not realize the benefits of such collaborations.\nWe may form collaboration partnerships, create joint ventures or enter into licensing arrangements with third parties with respect to our independent programs that we believe will complement or augment our existing business. We have historically engaged, and intend to continue to engage, in partnering discussions with a range of pharmaceutical and biotechnology companies and could enter into new collaboration partnerships at any time. We face significant competition in seeking appropriate collaboration partners, and the negotiation process to secure appropriate terms is time-consuming and complex. Any delays in identifying suitable collaboration partners and entering into agreements to develop our product candidates could also delay the commercialization of our product candidates, which may reduce their competitiveness even if they reach the market. Moreover, we may not be successful in our efforts to establish such a collaboration partnership for any future product candidates and programs on terms that are acceptable to us, or at all. This may be because our product candidates and programs may be deemed to be at too early of a stage of development for collaborative effort, our research and development pipeline may be viewed as insufficient, and/or third parties may not view our product candidates and programs as having sufficient potential for commercialization, including the likelihood of an adequate safety and efficacy profile. Even if we are successful in entering into a collaboration partnership or license arrangement, there is no guarantee that the collaboration partnership will be successful, or that any future collaboration partner will commit sufficient resources to the development, regulatory approval, and commercialization effort for such products, or that such alliances will result in us achieving revenues that justify such transactions.\n36\nWe may engage in strategic transactions that could impact our liquidity, increase our expenses and present significant distractions to our management.\nWe intend to consider strategic transactions, such as acquisitions of companies, asset purchases, and or in-licensing of products, product candidates or technologies. Additional potential transactions that we may consider include a variety of different business arrangements, including spin-offs, collaboration partnerships, joint ventures, restructurings, divestitures, business combinations and investments. Any such transaction may require us to incur non-recurring or other charges, may increase our near- and long-term expenditures and may pose significant integration challenges or disrupt our management or business, which could adversely affect our operations and financial results. For example, these transactions may entail numerous operational and financial risks, including:\n| • | up-front, milestone and royalty payments, equity investments and financial support of new research and development candidates including increase of personnel, all of which may be substantial; |\n\n| • | exposure to unknown liabilities; |\n\n| • | disruption of our business and diversion of our management’s time and attention in order to develop acquired products, product candidates or technologies; |\n\n| • | incurrence of substantial debt or dilutive issuances of equity securities to pay for acquisitions; |\n\n\n| • | higher-than-expected acquisition and integration costs; |\n\n| • | write-downs of assets or goodwill or impairment charges; |\n\n| • | increased amortization expenses; |\n\n| • | difficulty and cost in combining the operations and personnel of any acquired businesses with our operations and personnel; |\n\n| • | impairment of relationships with key suppliers or customers of any acquired businesses due to changes in management and ownership; and |\n\n| • | inability to retain key employees of any acquired businesses. |\n\nAccordingly, although there can be no assurance that we will undertake or successfully complete any transactions of the nature described above, any transactions that we do complete may be subject to the foregoing or other risks and could have a material adverse effect on our business, results of operations, financial condition and prospects.\nIf we seek and obtain approval to commercialize our product candidates outside of the United States, or otherwise engage in business outside of the United States, a variety of risks associated with international operations could materially adversely affect our business.\nWe may decide to seek marketing approval for certain of our product candidates outside the United States or otherwise engage in business outside the United States, including entering into contractual agreements with third-parties. We expect that we will be subject to additional risks related to entering into these international business markets and relationships, including:\n| • | different regulatory requirements for drug approvals in foreign countries; |\n\n| • | differing United States and foreign drug import and export rules; |\n\n| • | reduced protection for intellectual property rights in foreign countries; |\n\n| • | unexpected changes in tariffs, trade barriers and regulatory requirements; |\n\n| • | different reimbursement systems, and different competitive drugs; |\n\n| • | economic weakness, including inflation, or political instability in particular foreign economies and markets; |\n\n| • | compliance with tax, employment, immigration and labor laws for employees living or traveling abroad; |\n\n| • | foreign taxes, including withholding of payroll taxes; |\n\n| • | foreign currency fluctuations, which could result in increased operating expenses and reduced revenues, and other obligations incident to doing business in another country; |\n\n| • | workforce uncertainty in countries where labor unrest is more common than in the United States; |\n\n| • | production shortages resulting from any events affecting raw material supply or manufacturing capabilities abroad; |\n\n| • | potential liability resulting from development work conducted by these distributors; and |\n\n| • | business interruptions resulting from geopolitical actions, including war and terrorism, or natural disasters. |\n\n37\nOur business involves the use of hazardous materials and we and third-parties with whom we contract must comply with environmental laws and regulations, which can be expensive and restrict how we do business.\nOur research and development activities involve the controlled storage, use and disposal of hazardous materials, including the components of our product candidates and other hazardous compounds. We and manufacturers and suppliers with whom we may contract are subject to laws and regulations governing the use, manufacture, storage, handling and disposal of these hazardous materials. In some cases, these hazardous materials and various wastes resulting from their use are stored at our and our manufacturers’ facilities pending their use and disposal. We cannot eliminate the risk of contamination, which could cause an interruption of our commercialization efforts, research and development efforts and business operations, environmental damage resulting in costly clean-up and liabilities under applicable laws and regulations governing the use, storage, handling and disposal of these materials and specified waste products. We cannot guarantee that that the safety procedures utilized by third-party manufacturers and suppliers with whom we may contract will comply with the standards prescribed by laws and regulations or will eliminate the risk of accidental contamination or injury from these materials. In such an event, we may be held liable for any resulting damages and such liability could exceed our resources and state or federal or other applicable authorities may curtail our use of certain materials and/or interrupt our business operations. Furthermore, environmental laws and regulations are complex, change frequently and have tended to become more stringent. We cannot predict the impact of such changes and cannot be certain of our future compliance. We do not currently carry biological or hazardous waste insurance coverage.\nOur internal computer systems, or those of our CROs or other contractors or consultants, may fail or suffer security breaches, which could result in a material disruption of our product development programs.\nDespite the implementation of security measures, our internal computer systems and those of our CROs and other contractors and consultants are vulnerable to damage from computer viruses, unauthorized access, natural disasters, terrorism, war and telecommunication and electrical failures. While we have not experienced any such system failure, accident or security breach to date, if such an event were to occur and cause interruptions in our operations, it could result in a material disruption of our programs. For example, the loss of clinical trial data from completed or ongoing clinical trials for any of our product candidates could result in delays in our regulatory approval efforts and significantly increase our costs to recover or reproduce the data. To the extent that any disruption or security breach results in a loss of or damage to our data or applications, or inappropriate disclosure of confidential or proprietary information, we could incur liability and the further development of our product candidates could be delayed.\nWe may be adversely affected by the current global economic environment.\nOur ability to attract and retain collaboration partners or customers, invest in and grow our business and meet our financial obligations depends on our operating and financial performance, which, in turn, is subject to numerous factors, including the prevailing economic conditions and financial, business and other factors beyond our control, such as the rate of unemployment, the number of uninsured persons in the United States and inflationary pressures. Our results of operations could be adversely affected by general conditions in the global economy and in the global financial markets. The recent global financial crisis caused extreme volatility and disruptions in the capital and credit markets. We cannot anticipate all the ways in which the current global economic climate and global financial market conditions could adversely impact our business.\nWe are exposed to risks associated with reduced profitability and the potential financial instability of our collaboration partners or customers, many of which may be adversely affected by volatile conditions in the financial markets. For example, unemployment and underemployment, and the resultant loss of insurance, may decrease the demand for healthcare services and pharmaceuticals. If fewer patients are seeking medical care because they do not have insurance coverage, our collaboration partners or customers may experience reductions in revenues, profitability and/or cash flow that could lead them to reduce their support of our programs or financing activities. If collaboration partners or customers are not successful in generating sufficient revenue or are precluded from securing financing, they may not be able to pay, or may delay payment of, accounts receivable that are owed to us. In addition, the volatility in the financial markets could cause significant fluctuations in the interest rate and currency markets. We currently do not hedge for these risks. The foregoing events, in turn, could adversely affect our financial condition and liquidity. In addition, if economic challenges in the United States result in widespread and prolonged unemployment, either regionally or on a national basis, prior to the effectiveness of certain provisions of the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act, collectively known as the Affordable Care Act, a substantial number of people may become uninsured or underinsured. To the extent economic challenges result in fewer individuals pursuing or being able to afford our product candidates once commercialized, our business, results of operations, financial condition and cash flows could be adversely affected.\nWe may be adversely affected by earthquakes or other natural disasters and our business continuity and disaster recovery plans may not adequately protect us from a serious disaster.\nOur corporate headquarters and other facilities are located in the San Francisco Bay Area, which in the past has experienced severe earthquakes. We do not carry earthquake insurance. Earthquakes or other natural disasters could severely disrupt our operations, and have a material adverse effect on our business, results of operations, financial condition and prospects.\n38\nIf a natural disaster, power outage or other event occurred that prevented us from using all or a significant portion of our headquarters, that damaged critical infrastructure, such as our enterprise financial systems or manufacturing resource planning and enterprise quality systems, or that otherwise disrupted operations, it may be difficult or, in certain cases, impossible for us to continue our business for a substantial period of time. The disaster recovery and business continuity plans we have in place currently are limited and are unlikely to prove adequate in the event of a serious disaster or similar event. We may incur substantial expenses as a result of the limited nature of our disaster recovery and business continuity plans, which, particularly when taken together with our lack of earthquake insurance, could have a material adverse effect on our business.\nRisks Related to Government Regulation\nThe regulatory approval processes of the FDA and comparable foreign authorities are lengthy, time consuming and inherently unpredictable. If we are ultimately unable to obtain regulatory approval for our product candidates, our business will be substantially harmed.\nThe research, testing, manufacturing, labeling, approval, selling, import, export, marketing and distribution of drug products are subject to extensive regulation by the FDA and other regulatory authorities in the United States and other countries, which regulations differ from country to country. Neither we nor any of our collaboration partners is permitted to market any drug product in the United States until we receive marketing approval from the FDA. We have not submitted an application or obtained marketing approval for any of our product candidates anywhere in the world. Obtaining regulatory approval of a new drug application, or NDA, can be a lengthy, expensive and uncertain process. In addition, failure to comply with FDA and other applicable United States and foreign regulatory requirements may subject us to administrative or judicially imposed sanctions or other actions, including:\n| • | warning letters; |\n\n| • | civil and criminal penalties; |\n\n| • | injunctions; |\n\n| • | withdrawal of regulatory approval of products; |\n\n| • | product seizure or detention; |\n\n| • | product recalls; |\n\n| • | total or partial suspension of production; and |\n\n| • | refusal to approve pending NDAs or supplements to approved NDAs. |\n\nPrior to obtaining approval to commercialize a drug candidate in the United States or abroad, we or our collaboration partners must demonstrate with substantial evidence from well-controlled clinical trials, and to the satisfaction of the FDA or other foreign regulatory agencies, that such drug candidates are safe and effective for their intended uses. The number of nonclinical studies and clinical trials that will be required for FDA approval varies depending on the drug candidate, the disease or condition that the drug candidate is designed to address, and the regulations applicable to any particular drug candidate. Results from nonclinical studies and clinical trials can be interpreted in different ways. Even if we believe the nonclinical or clinical data for our drug candidates are promising, such data may not be sufficient to support approval by the FDA and other regulatory authorities. Administering drug candidates to humans may produce undesirable side effects, which could interrupt, delay or halt clinical trials and result in the FDA or other regulatory authorities denying approval of a drug candidate for any or all targeted indications.\nThe time required to obtain approval by the FDA and comparable foreign authorities is unpredictable, typically takes many years following the commencement of clinical studies, and depends upon numerous factors. The FDA and comparable foreign authorities have substantial discretion in the approval process and we may encounter matters with the FDA or such comparable authorities that requires us to expend additional time and resources and delay or prevent the approval of our product candidates. For example, the FDA may require us to conduct additional studies or trials for drug product either prior to or post-approval, such as additional drug-drug interaction studies or safety or efficacy studies or trials, or it may object to elements of our clinical development program such as the number of subjects in our current clinical trials from the United States. In addition, approval policies, regulations or the type and amount of clinical data necessary to gain approval may change during the course of a product candidate’s clinical development and may vary among jurisdictions, which may cause delays in the approval or result in a decision not to approve an application for regulatory approval. Despite the time and expense exerted, failure can occur at any stage. Applications for our product candidates could fail to receive regulatory approval for many reasons, including but not limited to the following:\n| • | the FDA or comparable foreign regulatory authorities may disagree with the design or implementation of our, or our collaboration partners’, clinical studies; |\n\n| • | the population studied in the clinical program may not be sufficiently broad or representative to assure safety in the full population for which approval is sought; |\n\n39\n\n| • | the FDA or comparable foreign regulatory authorities may disagree with the interpretation of data from preclinical studies or clinical studies; |\n\n| • | the data collected from clinical studies of our product candidates may not be sufficient to support the submission of a NDA or other submission or to obtain regulatory approval in the United States or elsewhere; |\n\n| • | we or our collaboration partners may be unable to demonstrate to the FDA or comparable foreign regulatory authorities that a product candidate’s risk-benefit ratio for its proposed indication is acceptable; |\n\n| • | the FDA or comparable foreign regulatory authorities may fail to approve the manufacturing processes, test procedures and specifications, or facilities of third-party manufacturers responsible for clinical and commercial supplies; and |\n\n| • | the approval policies or regulations of the FDA or comparable foreign regulatory authorities may significantly change in a manner rendering our clinical data insufficient for approval. |\n\nThis lengthy approval process, as well as the unpredictability of the results of clinical studies, may result in our failure and/or that of our collaboration partners to obtain regulatory approval to market any of our product candidates, which would significantly harm our business, results of operations, and prospects. Additionally, if the FDA requires that we conduct additional clinical studies, places limitations in our label, delays approval to market our product candidates or limits the use of our products, our business and results of operations may be harmed.\nIn addition, even if we were to obtain approval, regulatory authorities may approve any of our product candidates for fewer or more limited indications than we request, may not approve the price we intend to charge for our products, may grant approval contingent on the performance of costly post-marketing clinical trials, or may approve a product candidate with a label that does not include the labeling claims necessary or desirable for the successful commercialization of that product candidate. Any of the foregoing scenarios could materially harm the commercial prospects for our product candidates.\nEven if we receive regulatory approval for a product candidate, we will be subject to ongoing regulatory obligations and continued regulatory review, which may result in significant additional expense. Additionally, any product candidates, if approved, could be subject to labeling and other restrictions and market withdrawal, and we may be subject to penalties if we fail to comply with regulatory requirements or experience unanticipated problems with our products.\nEven if a drug is approved by the FDA or foreign regulatory authorities, the manufacturing processes, labeling, packaging, distribution, adverse event reporting, storage, advertising, promotion and recordkeeping for the product will be subject to extensive and ongoing regulatory requirements. These requirements include submissions of safety and other post-marketing information and reports, registration, as well as continued compliance with cGMPs and GCPs for any clinical trials that we conduct post-approval. As such, we and our third party contract manufacturers will be subject to continual review and periodic inspections to assess compliance with regulatory requirements. Accordingly, we and others with whom we work must continue to expend time, money, and effort in all areas of regulatory compliance, including manufacturing, production, and quality control. Regulatory authorities may also impose significant restrictions on a product’s indicated uses or marketing or impose ongoing requirements for potentially costly post-marketing studies. Furthermore, any new legislation addressing drug safety issues could result in delays or increased costs to assure compliance.\nWe will also be required to report certain adverse reactions and production problems, if any, to the FDA, and to comply with requirements concerning advertising and promotion for our products. Promotional communications with respect to prescription drugs are subject to a variety of legal and regulatory restrictions and must be consistent with the information in the product’s approved label. As such, we may not promote our products for indications or uses for which they do not have FDA approval.\nLater discovery of previously unknown problems with a product, including adverse events of unanticipated severity or frequency, or with our third-party manufacturers or manufacturing processes, or failure to comply with regulatory requirements, may result in, among other things:\n| • | warning letters, fines or holds on clinical trials; |\n\n| • | restrictions on the marketing or manufacturing of the product, withdrawal of the product from the market or voluntary or mandatory product recalls; |\n\n| • | injunctions or the imposition of civil or criminal penalties; |\n\n| • | suspension or revocation of existing regulatory approvals; |\n\n| • | suspension of any of our ongoing clinical trials; |\n\n| • | refusal to approve pending applications or supplements to approved applications submitted by us; |\n\n| • | restrictions on our or our contract manufacturers’ operations; or |\n\n40\n\n| • | product seizure or detention, or refusal to permit the import or export of products. |\n\nAny government investigation of alleged violations of law could require us to expend significant time and resources in response, and could generate negative publicity. Any failure to comply with ongoing regulatory requirements may significantly and adversely affect our ability to commercialize our product candidates. If regulatory sanctions are applied or if regulatory approval is withdrawn, the value of our company and our operating results will be adversely affected.\nIn addition, the FDA’s policies may change and additional government regulations may be enacted that could prevent, limit or delay regulatory approval of our product candidates. If we are slow or unable to adapt to changes in existing requirements or the adoption of new requirements or policies, or if we are not able to maintain regulatory compliance, we may lose any marketing approval that we may have obtained, which would adversely affect our business, prospects and ability to achieve or sustain profitability.\nWe and our collaboration partners and contract manufacturers are subject to significant regulation with respect to manufacturing our product candidates. The manufacturing facilities on which we rely may not continue to meet regulatory requirements or may not be able to meet supply demands.\nAll entities involved in the preparation of product candidates for clinical studies or commercial sale, including our existing contract manufacturers for our product candidates and AstraZeneca, and those contract manufacturers it may rely upon with respect to the manufacture of tenapanor, are subject to extensive regulation. Components of a finished therapeutic product approved for commercial sale or used in late-stage clinical studies must be manufactured in accordance with cGMP. These regulations govern manufacturing processes and procedures (including record keeping) and the implementation and operation of quality systems to control and assure the quality of investigational products and products approved for sale. Poor control of production processes can lead to the introduction of contaminants or to inadvertent changes in the properties or stability of our product candidates that may not be detectable in final product testing. We, our collaboration partners, or our contract manufacturers must supply all necessary documentation in support of an NDA or comparable regulatory filing on a timely basis and must adhere to cGMP regulations enforced by the FDA and other regulatory agencies through their facilities inspection programs. Some of our contract manufacturers have never produced a commercially approved pharmaceutical product and therefore have not obtained the requisite regulatory authority approvals to do so. The facilities and quality systems of some or all of our collaboration partners and third-party contractors must pass a pre-approval inspection for compliance with the applicable regulations as a condition of regulatory approval of our product candidates. In addition, the regulatory authorities may, at any time, audit or inspect a manufacturing facility involved with the preparation of our product candidates or our other potential products or the associated quality systems for compliance with the regulations applicable to the activities being conducted. Although we oversee the contract manufacturers, we cannot control the manufacturing process of, and are completely dependent on, other than with respect to tenapanor, our contract manufacturing partners for compliance with the regulatory requirements. AstraZeneca is fully responsible for the manufacture of tenapanor, and we are entirely dependent upon AstraZeneca for compliance with the regulatory requirements. If these facilities do not pass a pre-approval plant inspection, regulatory approval of the products may not be granted or may be substantially delayed until any violations are corrected to the satisfaction of the regulatory authority, if ever. In addition, we have no control over the ability of our contract manufacturers to maintain adequate quality control, quality assurance and qualified personnel.\nThe regulatory authorities also may, at any time following approval of a product for sale, audit the manufacturing facilities of our collaboration partners and third-party contractors. If any such inspection or audit identifies a failure to comply with applicable regulations or if a violation of our product specifications or applicable regulations occurs independent of such an inspection or audit, we or the relevant regulatory authority may require remedial measures that may be costly and/or time consuming for us or a third party to implement, and that may include the temporary or permanent suspension of a clinical study or commercial sales or the temporary or permanent suspension of production or closure of a facility. Any such remedial measures imposed upon us or third parties with whom we contract could materially harm our business.\nIf we, our collaboration partners, or any of our third-party manufacturers fail to maintain regulatory compliance, the FDA or other applicable regulatory authority can impose regulatory sanctions including, among other things, refusal to approve a pending application for a new drug product, withdrawal of an approval, or suspension of production. As a result, our business, financial condition, and results of operations may be materially harmed.\nAdditionally, if supply from one approved manufacturer is interrupted, an alternative manufacturer would need to be qualified through an NDA, a supplemental NDA or equivalent foreign regulatory filing, which could result in further delay. The regulatory agencies may also require additional studies if a new manufacturer is relied upon for commercial production. Switching manufacturers may involve substantial costs and is likely to result in a delay in our desired clinical and commercial timelines.\n41\nThese factors could cause us to incur higher costs and could cause the delay or termination of clinical studies, regulatory submissions, required approvals, or commercialization of our product candidates. Furthermore, if our suppliers fail to meet contractual requirements and we are unable to secure one or more replacement suppliers capable of production at a substantially equivalent cost, our clinical studies may be delayed or we could lose potential revenue.\nIf we fail to comply or are found to have failed to comply with FDA and other regulations related to the promotion of our products for unapproved uses, we could be subject to criminal penalties, substantial fines or other sanctions and damage awards.\nThe regulations relating to the promotion of products for unapproved uses are complex and subject to substantial interpretation by the FDA and other government agencies. If tenapanor, or our other product candidates, receives marketing approval, we and our collaborating partners will be restricted from marketing the product outside of its approved labeling, also referred to as off-label promotion. However, physicians may nevertheless prescribe an approved product to their patients in a manner that is inconsistent with the approved label, which is an off-label use. We intend to implement compliance and training programs designed to ensure that our sales and marketing practices comply with applicable regulations regarding off-label promotion. Notwithstanding these programs, the FDA or other government agencies may allege or find that our practices constitute prohibited promotion of our product candidates for unapproved uses. We also cannot be sure that our employees will comply with company policies and applicable regulations regarding the promotion of products for unapproved uses.\nOver the past several years, a significant number of pharmaceutical and biotechnology companies have been the target of inquiries and investigations by various federal and state regulatory, investigative, prosecutorial and administrative entities in connection with the promotion of products for unapproved uses and other sales practices, including the Department of Justice and various U.S. Attorneys’ Offices, the Office of Inspector General of the Department of Health and Human Services, the FDA, the Federal Trade Commission and various state Attorneys General offices. These investigations have alleged violations of various federal and state laws and regulations, including claims asserting antitrust violations, violations of the Food, Drug and Cosmetic Act, the False Claims Act, the Prescription Drug Marketing Act, anti-kickback laws, and other alleged violations in connection with the promotion of products for unapproved uses, pricing and Medicare and/or Medicaid reimbursement. Many of these investigations originate as “qui tam” actions under the False Claims Act. Under the False Claims Act, any individual can bring a claim on behalf of the government alleging that a person or entity has presented a false claim, or caused a false claim to be submitted, to the government for payment. The person bringing a qui tam suit is entitled to a share of any recovery or settlement. Qui tam suits, also commonly referred to as “whistleblower suits,” are often brought by current or former employees. In a qui tam suit, the government must decide whether to intervene and prosecute the case. If it declines, the individual may pursue the case alone.\nIf the FDA or any other governmental agency initiates an enforcement action against us or if we are the subject of a qui tam suit and it is determined that we violated prohibitions relating to the promotion of products for unapproved uses, we could be subject to substantial civil or criminal fines or damage awards and other sanctions such as consent decrees and corporate integrity agreements pursuant to which our activities would be subject to ongoing scrutiny and monitoring to ensure compliance with applicable laws and regulations. Any such fines, awards or other sanctions would have an adverse effect on our revenue, business, financial prospects and reputation.\nIf approved, tenapanor and our other product candidates may cause or contribute to adverse medical events that we are required to report to regulatory agencies and if we fail to do so we could be subject to sanctions that would materially harm our business.\nSome participants in clinical studies of tenapanor have reported adverse effects after being treated with tenapanor, including diarrhea, nausea, flatulence, abdominal discomfort, abdominal pain, abdominal distention and changes in electrolytes. If we are successful in commercializing any products, FDA and foreign regulatory agency regulations require that we report certain information about adverse medical events if those products may have caused or contributed to those adverse events. The timing of our obligation to report would be triggered by the date we become aware of the adverse event as well as the nature of the event. We may fail to report adverse events we become aware of within the prescribed timeframe. We may also fail to appreciate that we have become aware of a reportable adverse event, especially if it is not reported to us as an adverse event or if it is an adverse event that is unexpected or removed in time from the use of our products. If we fail to comply with our reporting obligations, the FDA or a foreign regulatory agency could take action, including criminal prosecution, the imposition of civil monetary penalties, seizure of our products or delay in approval or clearance of future products.\n42\nOur employees, independent contractors, principal investigators, CROs, collaboration partners, consultants and vendors may engage in misconduct or other improper activities, including noncompliance with regulatory standards and requirements.\nWe are exposed to the risk that our employees, independent contractors, principal investigators, CROs, collaboration partners, consultants and vendors may engage in fraudulent conduct or other illegal activity. Misconduct by these parties could include intentional, reckless and/or negligent conduct or unauthorized activities that violate: (1) FDA regulations, including those laws that require the reporting of true, complete and accurate information to the FDA; (2) manufacturing standards; (3) federal and state healthcare fraud and abuse laws and regulations; or (4) laws that require the reporting of true and accurate financial information and data. Specifically, sales, marketing and business arrangements in the healthcare industry are subject to extensive laws and regulations intended to prevent fraud, kickbacks, self-dealing and other abusive practices. These laws and regulations may restrict or prohibit a wide range of pricing, discounting, marketing and promotion, sales commission, customer incentive programs and other business arrangements. These activities also include the improper use of information obtained in the course of clinical trials, which could result in regulatory sanctions and serious harm to our reputation. It is not always possible to identify and deter misconduct by employees and other third parties, and the precautions we take to detect and prevent this activity may not be effective in controlling unknown or unmanaged risks or losses or in protecting us from governmental investigations or other actions or lawsuits stemming from a failure to be in compliance with such laws or regulations. If any such actions are instituted against us, and we are not successful in defending ourselves or asserting our rights, those actions could have a significant impact on our business, including the imposition of significant civil, criminal and administrative penalties, damages, monetary fines, possible exclusion from participation in Medicare, Medicaid and other federal healthcare programs, contractual damages, reputational harm, diminished profits and future earnings, and curtailment of our operations, any of which could adversely affect our ability to operate our business and our results of operations.\nFailure to obtain regulatory approvals in foreign jurisdictions would prevent us from marketing our products internationally.\nIn order to market any product in the EEA (which is composed of the 28 Member States of the European Union plus Norway, Iceland and Liechtenstein), and many other foreign jurisdictions, separate regulatory approvals are required. In the EEA, medicinal products can only be commercialized after obtaining a Marketing Authorization, or MA. Before granting the MA, the EMA or the competent authorities of the Member States of the EEA make an assessment of the risk-benefit balance of the product on the basis of scientific criteria concerning its quality, safety and efficacy.\nThe approval procedures vary among countries and can involve additional clinical testing, and the time required to obtain approval may differ from that required to obtain FDA approval. Clinical trials conducted in one country may not be accepted by regulatory authorities in other countries. Approval by the FDA does not ensure approval by regulatory authorities in other countries, and approval by one or more foreign regulatory authorities does not ensure approval by regulatory authorities in other foreign countries or by the FDA. However, a failure or delay in obtaining regulatory approval in one country may have a negative effect on the regulatory process in others. The foreign regulatory approval process may include all of the risks associated with obtaining FDA approval. We may not be able to file for regulatory approvals or to do so on a timely basis, and even if we do file we may not receive necessary approvals to commercialize our products in any market.\nWe and our collaboration partners may be subject to healthcare laws, regulation and enforcement; our failure or the failure of our collaboration partners to comply with these laws could have a material adverse effect on our results of operations and financial conditions.\nAlthough we do not currently have any products on the market, once we begin commercializing our products, we and our collaboration partners may be subject to additional healthcare statutory and regulatory requirements and enforcement by the federal government and the states and foreign governments in which we conduct our business. The laws that may affect our ability to operate as a commercial organization include:\n| • | the federal Anti-Kickback Statute, which prohibits, among other things, persons from knowingly and willfully soliciting, receiving, offering or paying remuneration, directly or indirectly, in exchange for or to induce either the referral of an individual for, or the purchase, order or recommendation of, any good or service for which payment may be made under federal healthcare programs such as the Medicare and Medicaid programs; |\n\n| • | federal false claims laws which prohibit, among other things, individuals or entities from knowingly presenting, or causing to be presented, claims for payment from Medicare, Medicaid, or other third-party payors that are false or fraudulent; |\n\n| • | federal criminal laws that prohibit executing a scheme to defraud any healthcare benefit program or making false statements relating to healthcare matters; |\n\n| • | the federal Health Insurance Portability and Accountability Act of 1996, as amended by the Health Information Technology for Economic and Clinical Health Act, which governs the conduct of certain electronic healthcare transactions and protects the security and privacy of protected health information; |\n\n43\n\n| • | the federal physician sunshine requirements under the Affordable Care Act, which requires manufacturers of drugs, devices, biologics, and medical supplies to report annually to the CMS information related to payments and other transfers of value to physicians, other healthcare providers, and teaching hospitals, and ownership and investment interests held by physicians and other healthcare providers and their immediate family members; |\n\n| • | state law equivalents of each of the above federal laws, such as anti-kickback and false claims laws which may apply to items or services reimbursed by any third-party payor, including commercial insurers; |\n\n| • | state laws that require pharmaceutical companies to comply with the pharmaceutical industry’s voluntary compliance guidelines and the applicable compliance guidance promulgated by the federal government, or otherwise restrict payments that may be made to healthcare providers and other potential referral sources; |\n\n| • | state laws that require drug manufacturers to report information related to payments and other transfers of value to physicians and other healthcare providers or marketing expenditures; and state laws governing the privacy and security of health information in certain circumstances, many of which differ from each other in significant ways, thus complicating compliance efforts; and |\n\n| • | European and other foreign law equivalents of each of the laws, including reporting requirements detailing interactions with and payments to healthcare providers. |\n\nBecause of the breadth of these laws and the narrowness of the statutory exceptions and safe harbors available, it is possible that some of our business activities could be subject to challenge under one or more of such laws. The risk of our being found in violation of these laws is increased by the fact that many of them have not been fully interpreted by the regulatory authorities or the courts, and their provisions are open to a variety of interpretations. Further, the Affordable Care Act, among other things, amends the intent requirement of the federal anti-kickback and criminal health care fraud statutes. A person or entity no longer needs to have actual knowledge of this statute or specific intent to violate it. In addition, the Affordable Care Act provides that the government may assert that a claim including items or services resulting from a violation of the federal anti-kickback statute constitutes a false or fraudulent claim for purposes of the false claims statutes. Any action against us for violation of these laws, even if we successfully defend against it, could cause us to incur significant legal expenses and divert our management’s attention from the operation of our business. If our operations are found to be in violation of any of the laws described above or any other governmental laws and regulations that apply to us, we may be subject to penalties, including civil and criminal penalties, damages, fines, the curtailment or restructuring of our operations, the exclusion from participation in federal and state healthcare programs and imprisonment, any of which could adversely affect our ability to market our products and adversely impact our financial results.\nLegislative or regulatory healthcare reforms in the United States may make it more difficult and costly for us to obtain regulatory clearance or approval of our product candidates and to produce, market and distribute our products after clearance or approval is obtained.\nFrom time to time, legislation is drafted and introduced in Congress that could significantly change the statutory provisions governing the regulatory clearance or approval, manufacture, and marketing of regulated products or the reimbursement thereof. In addition, FDA regulations and guidance are often revised or reinterpreted by the FDA in ways that may significantly affect our business and our products. Any new regulations or revisions or reinterpretations of existing regulations may impose additional costs or lengthen review times of our product candidates. We cannot determine what effect changes in regulations, statutes, legal interpretation or policies, when and if promulgated, enacted or adopted may have on our business in the future. Such changes could, among other things, require:\n| • | additional clinical trials to be conducted prior to obtaining approval; |\n\n| • | changes to manufacturing methods; |\n\n| • | recall, replacement, or discontinuance of one or more of our products; and |\n\n| • | additional record keeping. |\n\nEach of these would likely entail substantial time and cost and could materially harm our business and our financial results. In addition, delays in receipt of or failure to receive regulatory clearances or approvals for any future products would harm our business, financial condition and results of operations.\nIn addition, the full impact of recent healthcare reform and other changes in the healthcare industry and in healthcare spending is currently unknown, and may adversely affect our business model. In the United States, the Affordable Care Act was enacted in 2010 with a goal of reducing the cost of healthcare and substantially changing the way healthcare is financed by both government and private insurers. The Affordable Care Act, among other things, increased the minimum Medicaid rebates owed by manufacturers under the Medicaid Drug Rebate Program and extended the rebate program to individuals enrolled in Medicaid managed care organizations, established annual fees and taxes on manufacturers of certain branded prescription drugs, and created a new Medicare\n44\nPart D coverage gap discount program, in which manufacturers must agree to offer 50% point-of-sale discounts off negotiated prices of applicable brand drugs to eligible beneficiaries during their coverage gap period as a condition for the manufacturer’s outpatient drugs to be covered under Medicare Part D.\nIn addition, other legislative changes have been proposed and adopted in the United States since the Affordable Care Act was enacted. On August 2, 2011, the Budget Control Act of 2011 created measures for spending reductions by Congress. A Joint Select Committee on Deficit Reduction, tasked with recommending a targeted deficit reduction of at least $1.2 trillion for the years 2013 through 2021, was unable to reach required goals, thereby triggering the legislation’s automatic reduction to several government programs. This included aggregate reductions of Medicare payments to providers of 2% per fiscal year, which went into effect on April 1, 2013. On January 2, 2013, the ATRA was signed into law, which, among other things, further reduced Medicare payments to several providers, including hospitals.\nIt is likely that federal and state legislatures within the United States and foreign governments will continue to consider changes to existing healthcare legislation. We cannot predict the reform initiatives that may be adopted in the future or whether initiatives that have been adopted will be repealed or modified. The continuing efforts of the government, insurance companies, managed care organizations and other payors of healthcare services to contain or reduce costs of healthcare may adversely affect the demand for any drug products for which we may obtain regulatory approval, our ability to set a price that we believe is fair for our products, our ability to obtain coverage and reimbursement approval for a product, our ability to generate revenues and achieve or maintain profitability, and the level of taxes that we are required to pay.\nRisks Related to Intellectual Property\nWe may become subject to claims alleging infringement of third parties’ patents or proprietary rights and/or claims seeking to invalidate our patents, which would be costly, time consuming and, if successfully asserted against us, delay or prevent the development and commercialization of tenapanor or any other product candidates.\nThere have been many lawsuits and other proceedings asserting infringement or misappropriation of patents and other intellectual property rights in the pharmaceutical and biotechnology industries. There can be no assurances that we will not be subject to claims alleging that the manufacture, use or sale of tenapanor or any other product candidates nor that any activities conducted by us, infringes existing or future third-party patents, or that such claims, if any, will not be successful. Because patent applications can take many years to issue and may be confidential for 18 months or more after filing, and because pending patent claims can be revised before issuance, there may be applications now pending which may later result in issued patents that may be infringed by the manufacture, use or sale of tenapanor or other product candidates or by the operation of our business. Moreover, we may face patent infringement claims from non-practicing entities that have no relevant product revenue and against whom our own patent portfolio may thus have no deterrent effect. We may be unaware of one or more issued patents that would be infringed by the manufacture, sale or use of tenapanor or our other product candidates.\nWe may be subject to third-party patent infringement claims in the future against us or our collaboration partners that would cause us to incur substantial expenses and, if successful against us, could cause us to pay substantial damages, including treble damages and attorney’s fees if we are found to be willfully infringing a third party’s patents. We may be required to indemnify future collaboration partners against such claims. We are not aware of any threatened or pending claims related to these matters, but in the future litigation may be necessary to defend against such claims. If a patent infringement suit were brought against us or our collaboration partners, we or they could be forced to stop or delay research, development, manufacturing or sales of the product or product candidate that is the subject of the suit. As a result of patent infringement claims, or in order to avoid potential claims, we or our collaboration partners may choose to seek, or be required to seek, a license from the third party and would most likely be required to pay license fees or royalties or both. These licenses may not be available on acceptable terms, or at all. Even if we or our collaboration partners were able to obtain a license, the rights may be nonexclusive, which would give our competitors access to the same intellectual property. Ultimately, we could be prevented from commercializing a product, or forced to redesign it, or to cease some aspect of our business operations if, as a result of actual or threatened patent infringement claims, we or our collaboration partners are unable to enter into licenses on acceptable terms. Even if we are successful in defending against such claims, such litigation can be expensive and time consuming to litigate and would divert management’s attention from our core business. Any of these events could harm our business significantly.\nIn addition to infringement claims against us, if third parties prepare and file patent applications in the United States that also claim technology similar or identical to ours, we may have to participate in interference or derivation proceedings in the United States Patent and Trademark Office, or the USPTO, to determine which party is entitled to a patent on the disputed invention. We may also become involved in similar opposition proceedings in the European Patent Office or similar offices in other jurisdictions regarding our intellectual property rights with respect to our products and technology. Since patent applications are confidential for a period of time after filing, we cannot be certain that we were the first to file any patent application related to our product candidates.\n45\nIf our intellectual property related to our product candidates is not adequate or if we are not able to protect our trade secrets or our confidential information, we may not be able to compete effectively in our market.\nWe rely upon a combination of patents, trade secret protection and confidentiality agreements to protect the intellectual property related to our product candidates, our drug discovery and development platform and our development programs. Any disclosure to or misappropriation by third parties of our confidential or proprietary information could enable competitors to quickly duplicate or surpass our technological achievements, thus eroding our competitive position in our market.\nThe strength of patents in the biotechnology and pharmaceutical field involves complex legal and scientific questions and can be uncertain. The patent applications that we own or license may fail to result in issued patents in the United States or in foreign countries. Additionally, our research and development efforts may result in product candidates for which patent protection is limited or not available. Even if patents do successfully issue, third parties may challenge the validity, enforceability or scope thereof, which may result in such patents being narrowed, invalidated or held unenforceable. For example, U.S. patents can be challenged by any person before the new USPTO Patent Trial and Appeals Board at any time before one year after that person is served an infringement complaint based on the patents. Patents granted by the European Patent Office may be similarly opposed by any person within nine months from the publication of the grant. Similar proceedings are available in other jurisdictions, and in the United States, Europe and other jurisdictions third parties can raise questions of validity with a patent office even before a patent has granted. Furthermore, even if they are unchallenged, our patents and patent applications may not adequately protect our intellectual property or prevent others from designing around our claims. For example, a third party may develop a competitive product that provides therapeutic benefits similar to one or more of our product candidates but has a sufficiently different composition to fall outside the scope of our patent protection. If the breadth or strength of protection provided by the patents and patent applications we hold or pursue with respect to our product candidates is successfully challenged, then our ability to commercialize such product candidates could be negatively affected, and we may face unexpected competition that could have a material adverse impact on our business. Further, if we encounter delays in our clinical trials, the period of time during which we or our collaboration partners could market tenapanor or other product candidates under patent protection would be reduced.\nEven where laws provide protection, costly and time-consuming litigation could be necessary to enforce and determine the scope of our proprietary rights, and the outcome of such litigation would be uncertain. If we or one of our collaboration partners were to initiate legal proceedings against a third party to enforce a patent covering the product candidate, the defendant could counterclaim that our patent is invalid and/or unenforceable. In patent litigation in the United States, defendant counterclaims alleging invalidity and/or unenforceability are commonplace. Grounds for a validity challenge could be an alleged failure to meet any of several statutory requirements, including lack of novelty, obviousness or non-enablement. Grounds for an unenforceability assertion could be an allegation that someone connected with prosecution of the patent withheld relevant information from the USPTO, or made a misleading statement, during prosecution. The outcome following legal assertions of invalidity and unenforceability is unpredictable. With respect to validity, for example, we cannot be certain that there is no invalidating prior art, of which we and the patent examiner were unaware during prosecution. If a defendant were to prevail on a legal assertion of invalidity and/or unenforceability against our intellectual property related to a product candidate, we would lose at least part, and perhaps all, of the patent protection on such product candidate. Such a loss of patent protection would have a material adverse impact on our business. Moreover, our competitors could counterclaim that we infringe their intellectual property, and some of our competitors have substantially greater intellectual property portfolios than we do.\nWe also rely on trade secret protection and confidentiality agreements to protect proprietary know-how that may not be patentable, processes for which patents may be difficult to obtain and/or enforce and any other elements of our drug discovery and development processes that involve proprietary know-how, information or technology that is not covered by patents. Although we require all of our employees, consultants, advisors and any third parties who have access to our proprietary know-how, information or technology, to assign their inventions to us, and endeavor to execute confidentiality agreements with all such parties, we cannot be certain that we have executed such agreements with all parties who may have helped to develop our intellectual property or who had access to our proprietary information, nor can we be certain that our agreements will not be breached by such consultants, advisors or third parties, or by our former employees. The breach of such agreements by individuals or entities who are actively involved in the discovery and design of our potential drug candidates, or in the development of our discovery and design platform, including APECCS, could require us to pursue legal action to protect our trade secrets and confidential information, which would be expensive, and the outcome of which would be unpredictable. If we are not successful in prohibiting the continued breach of such agreements, our business could be negatively impacted. We cannot guarantee that our trade secrets and other confidential proprietary information will not be disclosed or that competitors will not otherwise gain access to our trade secrets or independently develop substantially equivalent information and techniques.\n46\nFurther, the laws of some foreign countries do not protect proprietary rights to the same extent or in the same manner as the laws of the United States. As a result, we may encounter significant problems in protecting and defending our intellectual property both in the United States and abroad. If we are unable to prevent material disclosure of the intellectual property related to our technologies to third parties, we will not be able to establish or maintain a competitive advantage in our market, which could materially adversely affect our business, results of operations and financial condition.\nIf we or our collaboration partners do not obtain patent term extension in the United States under the Hatch-Waxman Act and in foreign countries under similar legislation, thereby potentially extending the term of marketing exclusivity for our product candidates, our business may be materially harmed.\nDepending upon the timing, duration and specifics of FDA marketing approval of our product candidates, if any, one of the U.S. patents covering each of such approved product(s) or the use thereof may be eligible for up to five years of patent term restoration under the Hatch-Waxman Act. The Hatch-Waxman Act allows a maximum of one patent to be extended per FDA approved product. Patent term extension also may be available in certain foreign countries upon regulatory approval of our product candidates. Nevertheless, we or our collaboration partners may not be granted patent term extension either in the United States or in any foreign country because of, for example, failing to apply within applicable deadlines, failing to apply prior to expiration of relevant patents or otherwise failing to satisfy applicable requirements. Moreover, the term of extension, as well as the scope of patent protection during any such extension, afforded by the governmental authority could be less than we request.\nIf we are unable to obtain patent term extension or restoration, or the term of any such extension is less than we or our collaboration partners request, the period during which we or our collaboration partners will have the right to exclusively market our product will be shortened and our competitors may obtain approval of competing products following our patent expiration, and our revenue could be reduced, possibly materially.\nChanges in U.S. patent law could diminish the value of patents in general, thereby impairing our ability to protect our products.\nAs is the case with other biopharmaceutical companies, our success is heavily dependent on intellectual property, particularly patents. Obtaining and enforcing patents in the biopharmaceutical industry involve both technological and legal complexity. Therefore, obtaining and enforcing biopharmaceutical patents is costly, time consuming and inherently uncertain. In addition, the United States has recently enacted and is currently implementing wide-ranging patent reform legislation, including the Leahy-Smith America Invents Act signed into law on September 16, 2011. That Act includes a number of significant changes to U.S. patent law. These include provisions that affect the way patent applications are prosecuted and new venues and opportunities for competitors to challenge patent portfolios. Because of that Act, the U.S. patent system is now a “first to file” system, which may make it more difficult to obtain patent protection for inventions and increase the uncertainties and costs surrounding the prosecution of our or our collaboration partners’ patent applications and the enforcement or defense of our or our collaboration partners’ issued patents, all of which could materially adversely affect our business, results of operations and financial condition.\nThe United States Supreme Court has ruled on several patent cases in recent years, either narrowing the scope of patent protection available in certain circumstances or weakening the rights of patent owners in certain situations. In addition to increasing uncertainty with regard to our ability to obtain patents in the future, this combination of events has created uncertainty with respect to the value of patents once obtained. Depending on future actions by the U.S. Congress, the federal courts, and the USPTO, the laws and regulations governing patents could change in unpredictable ways that would weaken our ability to obtain new patents or to enforce our existing patents and patents that we might obtain in the future.\nObtaining and maintaining our patent protection depends on compliance with various procedural, document submission, fee payment and other requirements imposed by governmental patent agencies, and our patent protection could be reduced or eliminated for non-compliance with these requirements.\nThe USPTO and various foreign patent agencies require compliance with a number of procedural, documentary, fee payment and other provisions to maintain patent applications and issued patents. Noncompliance with these requirements can result in abandonment or lapse of a patent or patent application, resulting in partial or complete loss of patent rights in the relevant jurisdiction. In such an event, competitors might be able to enter the market earlier than would otherwise have been the case.\nWe may not be able to enforce our intellectual property rights throughout the world.\nThe laws of some foreign countries do not protect intellectual property rights to the same extent as the laws of the United States. Many companies have encountered significant problems in protecting and defending intellectual property rights in certain foreign jurisdictions. The legal systems of some countries, particularly developing countries, do not favor the enforcement of patents and other intellectual property protection, especially those relating to life sciences. This could make it difficult for us to stop the infringement of our patents or the misappropriation of our other intellectual property rights. For example, many foreign countries have compulsory licensing laws under which a patent owner must grant licenses to third parties.\n47\nProceedings to enforce our patent rights in foreign jurisdictions, whether or not successful, could result in substantial costs and divert our efforts and attention from other aspects of our business. Furthermore, while we intend to protect our intellectual property rights in our expected significant markets, we cannot ensure that we will be able to initiate or maintain similar efforts in all jurisdictions in which we may wish to market our products. Accordingly, our efforts to protect our intellectual property rights in such countries may be inadequate. In addition, changes in the law and legal decisions by courts in the United States and foreign countries may affect our ability to obtain and enforce adequate intellectual property protection for our technology.\nWe may be subject to claims that we or our employees have misappropriated the intellectual property, including know-how or trade secrets, of a third party, or claiming ownership of what we regard as our own intellectual property.\nMany of our employees, consultants and contractors were previously employed at or engaged by other biotechnology or pharmaceutical companies, including our competitors or potential competitors. Some of these employees, consultants and contractors, executed proprietary rights, non-disclosure and non-competition agreements in connection with such previous employment. Although we try to ensure that our employees, consultants and contractors do not use the intellectual property and other proprietary information or know-how or trade secrets of others in their work for us, and do not perform work for us that is in conflict with their obligations to another employer or any other entity, we may be subject to claims that we or these employees, consultants and contractors have used or disclosed such intellectual property, including know-how, trade secrets or other proprietary information. In addition, an employee, advisor or consultant who performs work for us may have obligations to a third party that are in conflict with their obligations to us, and as a result such third party may claim an ownership interest in the intellectual property arising out of work performed for us. We are not aware of any threatened or pending claims related to these matters, but in the future litigation may be necessary to defend against such claims. If we fail in defending any such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights or personnel, or access to consultants and contractors. Even if we are successful in defending against such claims, litigation could result in substantial costs and be a distraction to management.\nIn addition, while we typically require our employees, consultants and contractors who may be involved in the development of intellectual property to execute agreements assigning such intellectual property to us, we may be unsuccessful in executing such an agreement with each party who in fact develops intellectual property that we regard as our own, which may result in claims by or against us related to the ownership of such intellectual property. If we fail in prosecuting or defending any such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights. Even if we are successful in prosecuting or defending against such claims, litigation could result in substantial costs and be a distraction to our management and scientific personnel.\nRisks Related to Our Common Stock\nOur stock price may be volatile and our stockholders may not be able to resell shares of our common stock at or above the price they paid.\nThe trading price of our common stock is highly volatile and could be subject to wide fluctuations in response to various factors, some of which are beyond our control. These factors include those discussed in this “Risk Factors” section of this Quarterly Report on Form 10Q and others such as:\n| • | results from, or any delays in, clinical trial programs relating to our product candidates, including the ongoing and planned clinical trials for tenapanor; |\n\n| • | ability to commercialize or obtain regulatory approval for our product candidates, or delays in commercializing or obtaining regulatory approval; |\n\n| • | announcements of regulatory approval or a complete response letter to tenapanor, or specific label indications or patient populations for its use, or changes or delays in the regulatory review process; |\n\n| • | announcements relating to future collaboration partnerships or our existing collaboration partnerships with AstraZeneca and/or Sanofi, including decisions regarding the exercise by AstraZeneca or Sanofi of their options or any termination by them of any development program under their collaboration partnerships with us; |\n\n| • | our election, and the related announcement, to exercise our co-fund right with respect to the first Phase 3 clinical development program for tenapanor; |\n\n| • | announcements of therapeutic innovations or new products by us or our competitors; |\n\n| • | adverse actions taken by regulatory agencies with respect to our clinical trials, manufacturing supply chain or sales and marketing activities; |\n\n| • | changes or developments in laws or regulations applicable to our product candidates; |\n\n| • | any adverse changes to our relationship with any manufacturers or suppliers; |\n\n\n| • | the success of our testing and clinical trials; |\n\n48\n\n| • | the success of our efforts to acquire or license or discover additional product candidates; |\n\n| • | any intellectual property infringement actions in which we may become involved; |\n\n| • | announcements concerning our competitors or the pharmaceutical industry in general; |\n\n| • | achievement of expected product sales and profitability; |\n\n| • | manufacture, supply or distribution shortages; |\n\n| • | actual or anticipated fluctuations in our operating results; |\n\n| • | FDA or other U.S. or foreign regulatory actions affecting us or our industry or other healthcare reform measures in the United States; |\n\n| • | changes in financial estimates or recommendations by securities analysts; |\n\n| • | trading volume of our common stock; |\n\n| • | sales of our common stock by us, our executive officers and directors or our stockholders in the future; |\n\n| • | general economic and market conditions and overall fluctuations in the United States equity markets; and |\n\n| • | the loss of any of our key scientific or management personnel. |\n\nIn addition, the stock markets in general, and the markets for pharmaceutical, biopharmaceutical and biotechnology stocks in particular, have experienced extreme volatility that may have been unrelated to the operating performance of the issuer. These broad market fluctuations may adversely affect the trading price or liquidity of our common stock. In the past, when the market price of a stock has been volatile, holders of that stock have sometimes instituted securities class action litigation against the issuer. If any of our stockholders were to bring such a lawsuit against us, we could incur substantial costs defending the lawsuit and the attention of our management would be diverted from the operation of our business, which could seriously harm our financial position. Any adverse determination in litigation could also subject us to significant liabilities.\nAn active, liquid and orderly market for our common stock may not develop or be sustained\nWe completed our IPO in June 2014. Prior to that, there had been no public market for shares of our common stock. Following our IPO, the trading volume of our common stock on The NASDAQ Global Market has been limited, and an active public market for our shares may not develop or, if it develops, be sustained.\nWe cannot predict the extent in which investor interest in our company will lead to the development of, or sustain an active trading market on The NASDAQ Global Market or otherwise or how liquid that market might become. The lack of an active market may impair our stockholders’ ability to sell their shares at the time they wish to sell them or at a price that they consider reasonable. An inactive market may also impair our ability to raise capital by selling shares and may impair our ability to acquire other businesses or technologies or in-license new product candidates using our shares as consideration.\nIf securities or industry analysts do not continue to publish research or reports about our business, or if they issue an adverse or misleading opinion regarding our stock, our stock price and trading volume could decline.\nThe trading market for our common stock is influenced by the research and reports that industry or securities analysts publish about us or our business. If any of the analysts who cover us issue an adverse or misleading opinion regarding us, our business model, our intellectual property or our stock performance, or if our clinical trials and operating results fail to meet the expectations of analysts, our stock price would likely decline. If one or more of these analysts cease coverage of us or fail to publish reports on us regularly, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline.\nWe are an “emerging growth company” and as a result of the reduced disclosure and governance requirements applicable to emerging growth companies, our common stock may be less attractive to investors.\nWe are an “emerging growth company,” as defined in the JOBS Act, and we intend to take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. If some investors find our common stock less attractive as a result of our reliance on the JOBS Act exemption, there may be a less active trading market for our common stock and our stock price may be more volatile. We may take advantage of these reporting exemptions until we are no longer an emerging growth company. We will remain an emerging growth company until the earlier of (1) the last day of the fiscal year following the fifth anniversary of the completion of our IPO (December 31, 2019), (2) the last day of the fiscal year in which we have total annual gross revenue of at least $1.0 billion, or (3) the last day of the fiscal year in\n49\nwhich we are deemed to be a large accelerated filer, which means the market value of our common stock that is held by non-affiliates exceeds $700 million as of the prior June 30th, and (4) the date on which we have issued more than $1.0 billion in non-convertible debt during the prior three-year period.\nIf we sell shares of our common stock in future financings, stockholders may experience immediate dilution and, as a result, our stock price may decline.\nWe may from time to time issue additional shares of common stock at a discount from the current trading price of our common stock. As a result, our stockholders would experience immediate dilution upon the purchase of any shares of our common stock sold at such discount. In addition, as opportunities present themselves, we may enter into financing or similar arrangements in the future, including the issuance of debt securities, preferred stock or common stock. If we issue common stock or securities convertible into common stock, our common stockholders would experience additional dilution and, as a result, our stock price may decline.\nSales of a substantial number of shares of our common stock in the public market could cause our stock price to fall.\nIf our existing stockholders sell, or indicate an intention to sell, substantial amounts of our common stock in the public market after the lock-up and other legal restrictions on resale in connection with our IPO lapse, the trading price of our common stock could decline. As of June 30, 2014, we had 18,529,067 shares of common stock outstanding. Of those shares, the 4,101,632 shares sold in our IPO are freely tradable, without restriction (except as otherwise applicable), in the public market. The remaining 827,268 shares sold in our IPO are subject to the lock-up agreements pertaining to our IPO.\nThe lock-up agreements pertaining to our IPO will expire on December 15, 2014. After the lock-up agreements expire, as of June 30, 2014, up to an additional 14,427,435 shares of common stock will be eligible for sale in the public market, 12,826,261 of which are held by current directors, executive officers and other affiliates and may be subject to Rule 144 under the Securities Act of 1933, or the Securities Act.\nIn addition, as of June 30, 2014, 1.1 million shares of common stock that are subject to outstanding options, will become eligible for sale in the public market to the extent permitted by the provisions of various vesting schedules, the lock-up agreements and Rule 144 and Rule 701 under the Securities Act. If these additional shares of common stock are sold, or if it is perceived that they will be sold, in the public market, the trading price of our common stock could decline.\nThe holders of approximately 12.4 million shares of our outstanding common stock as of June 30, 2014, are entitled to rights with respect to the registration of their shares under the Securities Act, subject to vesting schedules and to the lock-up agreements described above. Registration of these shares under the Securities Act would result in the shares becoming freely tradable without restriction under the Securities Act, except for shares purchased by affiliates. Any sales of securities by these stockholders could have a material adverse effect on the trading price of our common stock.\nOur principal stockholders and management own a significant percentage of our stock and will be able to exert significant control over matters subject to stockholder approval.\nAs of June 30, 2014, our executive officers, directors, holders of 5% or more of our capital stock and their respective affiliates beneficially owned approximately two-thirds of our outstanding voting stock. Therefore, these stockholders will have the ability to influence us through this ownership position. These stockholders may be able to determine all matters requiring stockholder approval. For example, these stockholders may be able to control elections of directors, amendments of our organizational documents, or approval of any merger, sale of assets, or other major corporate transaction. This may prevent or discourage unsolicited acquisition proposals or offers for our common stock that certain stockholders may feel are in their best interest as one of our stockholders.\nWe have broad discretion to determine how to use the funds raised in our IPO, and may use them in ways that may not enhance our operating results or the price of our common stock.\nOur management has broad discretion over the use of proceeds from our IPO, and we could spend the proceeds from this offering in ways our stockholders may not agree with or that do not yield a favorable return, if at all. We currently intend to use substantially all of the net proceeds of this offering to fund continued discovery and development efforts for our preclinical product candidates, the exercise of our right to co-fund the first Phase 3 clinical development program for tenapanor, if we decide to exercise such right, expenses related to the development of APECCS, and the balance for working capital and general corporate purposes, which will include facilities expansion and the pursuit of other research and discovery efforts and could also include the acquisition or in-license of other products, product candidates or technologies. However, our use of these proceeds may differ substantially from our current plans. If we do not invest or apply the proceeds of this offering in ways that improve our operating results, we may fail to achieve expected financial results, which could cause our stock price to decline.\n50\nProvisions in our charter documents and under Delaware law could discourage a takeover that stockholders may consider favorable and may lead to entrenchment of management.\nOur amended and restated certificate of incorporation and amended and restated bylaws contain provisions that could significantly reduce the value of our shares to a potential acquirer or delay or prevent changes in control or changes in our management without the consent of our board of directors. The provisions in our charter documents include the following:\n| • | a classified board of directors with three-year staggered terms, which may delay the ability of stockholders to change the membership of a majority of our board of directors; |\n\n| • | no cumulative voting in the election of directors, which limits the ability of minority stockholders to elect director candidates; |\n\n| • | the exclusive right of our board of directors to elect a director to fill a vacancy created by the expansion of the board of directors or the resignation, death or removal of a director, which prevents stockholders from being able to fill vacancies on our board of directors; |\n\n| • | the required approval of at least 66 2/3% of the shares entitled to vote to remove a director for cause, and the prohibition on removal of directors without cause; |\n\n| • | the ability of our board of directors to authorize the issuance of shares of preferred stock and to determine the price and other terms of those shares, including preferences and voting rights, without stockholder approval, which could be used to significantly dilute the ownership of a hostile acquiror; |\n\n| • | the ability of our board of directors to alter our bylaws without obtaining stockholder approval; |\n\n| • | the required approval of at least 66 2/3% of the shares entitled to vote at an election of directors to adopt, amend or repeal our bylaws or repeal the provisions of our amended and restated certificate of incorporation regarding the election and removal of directors; |\n\n| • | a prohibition on stockholder action by written consent, which forces stockholder action to be taken at an annual or special meeting of our stockholders; |\n\n| • | the requirement that a special meeting of stockholders may be called only by the chairman of the board of directors, the chief executive officer, the president or the board of directors, which may delay the ability of our stockholders to force consideration of a proposal or to take action, including the removal of directors; and |\n\n| • | advance notice procedures that stockholders must comply with in order to nominate candidates to our board of directors or to propose matters to be acted upon at a stockholders’ meeting, which may discourage or deter a potential acquiror from conducting a solicitation of proxies to elect the acquiror’s own slate of directors or otherwise attempting to obtain control of us. |\n\nIn addition, these provisions would apply even if we were to receive an offer that some stockholders may consider beneficial.\nWe are also subject to the anti-takeover provisions contained in Section 203 of the Delaware General Corporation Law. Under Section 203, a corporation may not, in general, engage in a business combination with any holder of 15% or more of its capital stock unless the holder has held the stock for three years or, among other exceptions, the board of directors has approved the transaction.\nClaims for indemnification by our directors and officers may reduce our available funds to satisfy successful third-party claims against us and may reduce the amount of money available to us.\nOur amended and restated certificate of incorporation and amended and restated bylaws provide that we will indemnify our directors and officers, in each case to the fullest extent permitted by Delaware law.\nIn addition, as permitted by Section 145 of the Delaware General Corporation Law, our amended and restated bylaws and our indemnification agreements that we have entered into with our directors and officers provide that:\n| • | We will indemnify our directors and officers for serving us in those capacities or for serving other business enterprises at our request, to the fullest extent permitted by Delaware law. Delaware law provides that a corporation may indemnify such person if such person acted in good faith and in a manner such person reasonably believed to be in or not opposed to the best interests of the registrant and, with respect to any criminal proceeding, had no reasonable cause to believe such person’s conduct was unlawful. |\n\n| • | We may, in our discretion, indemnify employees and agents in those circumstances where indemnification is permitted by applicable law. |\n\n51\n\n| • | We are required to advance expenses, as incurred, to our directors and officers in connection with defending a proceeding, except that such directors or officers shall undertake to repay such advances if it is ultimately determined that such person is not entitled to indemnification. |\n\n| • | We will not be obligated pursuant to our amended and restated bylaws to indemnify a person with respect to proceedings initiated by that person against us or our other indemnitees, except with respect to proceedings authorized by our board of directors or brought to enforce a right to indemnification. |\n\n| • | The rights conferred in our amended and restated bylaws are not exclusive, and we are authorized to enter into indemnification agreements with our directors, officers, employees and agents and to obtain insurance to indemnify such persons. |\n\n| • | We may not retroactively amend our amended and restated bylaw provisions to reduce our indemnification obligations to directors, officers, employees and agents. |\n\nWe do not currently intend to pay dividends on our common stock, and, consequently, our stockholders’ ability to achieve a return on their investment will depend on appreciation in the price of our common stock.\nWe do not currently intend to pay any cash dividends on our common stock for the foreseeable future. We currently intend to invest our future earnings, if any, to fund our growth. Additionally, the terms of our loan and security agreements could restrict our ability to pay dividends. Therefore, our stockholders are not likely to receive any dividends on our common stock for the foreseeable future. Since we do not intend to pay dividends, our stockholders’ ability to receive a return on their investment will depend on any future appreciation in the market value of our common stock. There is no guarantee that our common stock will appreciate or even maintain the price at which our holders have purchased it.\n\n\nITEM 2.\nUNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nUnregistered Sales of Equity Securities\nFrom April 1, 2014 through June 30, 2014, we sold and issued the following unregistered securities:\n1. In June 2014, upon the closing of our IPO, all of our then-outstanding shares of convertible preferred stock automatically converted into 11,517,222 shares of common stock, and all of our then-outstanding Series B warrants were net exercised into 571,244 shares of our common stock at an exercise price of $0.09 per share. The issuance of such shares of common stock was exempt from the registration requirements of the Securities Act pursuant to Section 3(a)(9) and Section 4(a)(2) of the Securities Act of 1933, as amended.\n2. We granted stock option to employees and directors under our 2008 Stock Incentive Plan and our 2014 Equity Incentive Plan covering an aggregate of 63,888 shares of common stock at a weighted average exercise price of $13.95 per share.\nUse of Proceeds\nOn June 18, 2014, the U.S. Securities and Exchange Commission declared effective our registration statement on Form S-1 (File No. 333-196090), as amended, filed in connection with our IPO. Pursuant to the registration statement, we registered the offer and sale of 4,286,000 shares of our common stock with an aggregate offering price of $60.0 million. With the full exercise of the underwriters’ over-allotment option, we sold and issued 4,928,900 shares of our common stock at a price to the public of $14.00 per share for an aggregate offering price of approximately $69.0 million. The managing underwriters of the offering were Citigroup Global Markets Inc., Leerink Partners LLC, JMP Securities LLC and Wedbush Securities Inc. After deducting underwriting discounts, commissions and offering expenses paid or payable by us of $7.8 million, the net proceeds from the offering were $61.2 million. No offering expenses were paid or are payable, directly or indirectly, to our directors or officers, to persons owning 10% or more of any class of our equity securities or to any of our affiliates.\nThe net proceeds from the IPO have been invested in money market funds.\nThere has been no material change in the expected use of the net proceeds from our IPO as described in our prospectus relating to our IPO.\n\n\nITEM 3.\nDefaults upon Senior Securities\nNot applicable.\n52\n\n\nITEM 4.\nMine Safety Disclosures\nNot applicable\n\n\nITEM 5.\nOther Information\nNone.\n\n\nITEM 6.\nExhibits\n\n| Incorporated by Reference |\n| ExhibitNumber | Exhibit Description | Form | Date | Number | FiledHerewith |\n| 3.1 | Amended and Restated Certificate of Incorporation. | 8-K | 6/24/2014 | 3.1 |\n| 3.2 | Amended and Restated Bylaws. | 8-K | 6/24/2014 | 3.2 |\n| 4.1 | Reference is made to exhibits 3.1 and 3.2. |\n| 4.2 | Form of Common Stock Certificate. | S-1/A | 6/18/2014 | 4.2 |\n| 10.1(a)# | Ardelyx, Inc. 2014 Equity Incentive Award Plan. | S-8 | 7/14/2014 | 99.3 |\n| 10.1(b)# | Form of Stock Option Grant Notice and Stock Option Agreement under the 2014 Equity Incentive Award Plan. | S-1/A | 6/18/2014 | 10.6(b) |\n| 10.1(c)# | Form of Restricted Stock Award Agreement and Restricted Stock Unit Award Grant Notice under the 2014 Equity Incentive Award Plan. | S-1/A | 6/18/2014 | 10.6.(c) |\n| 10.2# | Form of Indemnification Agreement for directors and officers. | S-1/A | 6/9/2014 | 10.7 |\n| 10.3# | Amended and Restated Executive Employment Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Michael Raab | S-1/A | 6/9/2014 | 10.8 |\n| 10.4# | Change in Control Severance Agreement, dated as of June 6, 2014, by and between Ardelyx, Inc. and Dominique Charmot, Ph.D | S-1/A | 6/9/2014 | 10.9 |\n| 10.5# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Mark Kaufmann | S-1/A | 6/9/2014 | 10.15 |\n| 10.6# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Elizabeth Grammer, Esq | S-1/A | 6/9/2014 | 10.16 |\n| 10.7# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Jeffrey Jacobs, Ph.D | S-1/A | 6/9/2014 | 10.16 |\n| 10.8# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and George Jue. | S-1/A | 6/9/2014 | 10.18 |\n| 10.9# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and David Rosenbaum, Ph.D | S-1/A | 6/9/2014 | 10.19 |\n\n53\n\n| Incorporated by Reference |\n| ExhibitNumber | Exhibit Description | Form | Date | Number | FiledHerewith |\n| 10.10# | Ardelyx, Inc. 2014 Employee Stock Purchase Plan. | S-8 | 7/14/2014 | 99.6 |\n| 10.11# | Non-Employee Director Compensation Program. | S-1/A | 6/9/2014 | 10.21 |\n| 31.1 | Certification of Principal Executive Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended. | X |\n| 31.2 | Certification of Principal Financial Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended. | X |\n| 32.1 | Certification of Principal Executive Officer and Principal Financial Officer Required Under Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C §1350. | X |\n| 101.INS* | XBRL Instance Document | X |\n| 101.SCH* | XBRL Taxonomy Extension Schema Document | X |\n| 101.CAL* | XBRL Taxonomy Extension Calculation Linkbase Document | X |\n| 101.DEF* | XBRL Taxonomy Extension Definition Linkbase Document | X |\n| 101.LAB* | XBRL Taxonomy Extension Label Linkbase Document | X |\n| 101.PRE* | XBRL Taxonomy Extension Presentation Linkbase Document | X |\n\n\n| # | Indicates management contract or compensatory plan. |\n\n\n| * | In accordance with Rule 406T of Regulation S-T, the Interactive Data Files in Exhibits 101.INS; 101.SCH; 101.CAL; 101.DEF; 101.LAB and 101.PRE are deemed not filed or a part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, and are deemed not filed for purposes of Section 18 of the Securities Act of 1934, as amended, and otherwise are not subject to liability under those sections. |\n\n54\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| Ardelyx, Inc. |\n| Date: August 8, 2014 | By: | /s/ Michael Raab |\n| Michael Raab President Chief Executive Officer and Director (Principal Executive Officer) |\n\n55\nEXHIBIT INDEX\nExhibit Index\n\n| Incorporated by Reference |\n| ExhibitNumber | Exhibit Description | Form | Date | Number | FiledHerewith |\n| 3.1 | Amended and Restated Certificate of Incorporation. | 8-K | 6/24/2014 | 3.1 |\n| 3.2 | Amended and Restated Bylaws. | 8-K | 6/24/2014 | 3.2 |\n| 4.1 | Reference is made to exhibits 3.1 and 3.2. |\n| 4.2 | Form of Common Stock Certificate. | S-1/A | 6/18/2014 | 4.2 |\n| 10.1(a)# | Ardelyx, Inc. 2014 Equity Incentive Award Plan. | S-8 | 7/14/2014 | 99.3 |\n| 10.1(b)# | Form of Stock Option Grant Notice and Stock Option Agreement under the 2014 Equity Incentive Award Plan. | S-1/A | 6/18/204 | 10.6(b) |\n| 10.1(c)# | Form of Restricted Stock Award Agreement and Restricted Stock Unit Award Grant Notice under the 2014 Equity Incentive Award Plan. | S-1/A | 6/18/2014 | 10.6(c) |\n| 10.2# | Form of Indemnification Agreement for directors and officers. | S-1/A | 6/9/2014 | 10.7 |\n| 10.3# | Amended and Restated Executive Employment Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Michael Raab | S-1/A | 6/9/2014 | 10.8 |\n| 10.4# | Change in Control Severance Agreement, dated as of June 6, 2014, by and between Ardelyx, Inc. and Dominique Charmot, Ph.D | S-1/A | 6/9/2014 | 10.9 |\n| 10.5# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Mark Kaufmann | S-1/A | 6/9/2014 | 10.15 |\n| 10.6# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Elizabeth Grammer, Esq | S-1/A | 6/9/2014 | 10.16 |\n| 10.7# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Jeffrey Jacobs, Ph.D | S-1/A | 6/9/2014 | 10.17 |\n| 10.8# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and George Jue. | S-1/A | 6/9/2014 | 10.18 |\n| 10.9# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and David Rosenbaum, Ph.D | S-1/A | 6/9/2014 | 10.19 |\n| 10.10# | Ardelyx, Inc. 2014 Employee Stock Purchase Plan. | S-8 | 7/14/2014 | 99.6 |\n| 10.11# | Non-Employee Director Compensation Program. | S-1/A | 6/9/2014 | 10.21 |\n| 31.1 | Certification of Principal Executive Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended. | X |\n| 31.2 | Certification of Principal Financial Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended. | X |\n\n56\n\n| Incorporated by Reference |\n| ExhibitNumber | Exhibit Description | Form | Date | Number | FiledHerewith |\n| 32.1 | Certification of Principal Executive Officer and Principal Financial Officer Required Under Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C §1350. | X |\n| 101.INS* | XBRL Instance Document | X |\n| 101.SCH* | XBRL Taxonomy Extension Schema Document | X |\n| 101.CAL* | XBRL Taxonomy Extension Calculation Linkbase Document | X |\n| 101.DEF* | XBRL Taxonomy Extension Definition Linkbase Document | X |\n| 101.LAB* | XBRL Taxonomy Extension Label Linkbase Document | X |\n| 101.PRE* | XBRL Taxonomy Extension Presentation Linkbase Document | X |\n\n\n| # | Indicates management contract or compensatory plan. |\n\n\n| * | In accordance with Rule 406T of Regulation S-T, the Interactive Data Files in Exhibits 101.INS; 101.SCH; 101.CAL; 101.DEF; 101.LAB and 101.PRE are deemed not filed or a part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, and are deemed not filed for purposes of Section 18 of the Securities Act of 1934, as amended, and otherwise are not subject to liability under those sections. |\n\n57\n\n</text>\n\nWhat is the increase in the overall exercise value of the options from December 31, 2013 to June 30, 2014, considering the balances at these dates and their respective weighted average exercise price per share (in thousands of dollars)?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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doc-math
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"ground_truth": "Therefore, the answer is 828.6985899999999."
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docmath_20000_40000
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nITEM 1. Business\nThe Company\n1. Organizational History\nWe are the result of a share exchange transaction completed in March 2004 between the shareholders of Tintic Gold Mining Company (“Tintic”), a corporation originally incorporated in the state of Utah on June 14, 1933 to perform mining operations in Utah, and the shareholders of Kiwa Bio-Tech Products Group Ltd. (“Kiwa BVI”), a company originally organized under the laws of the British Virgin Islands on June 5, 2002. The share exchange resulted in a change of control of Tintic, with former Kiwa BVI stockholders owning approximately 89% of Tintic on a fully diluted basis and Kiwa BVI surviving as a wholly-owned subsidiary of Tintic. Subsequent to the share exchange transaction, Tintic changed its name to Kiwa Bio-Tech Products Group Corporation. On July 21, 2004, we completed our reincorporation in the State of Delaware. On March 8, 2017, we completed our reincorporation in the State of Nevada.\nThe Company operates through a series of subsidiaries in the Peoples Republic of China as detailed in the following Organizational Chart. The Company had previously operated its business through its subsidiaries Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Kiwa Shandong”) and Tianjin Kiwa Feed Co., Ltd. (“Kiwa Tianjin”). Kiwa Tianjin has been dissolved since July 11, 2012. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\n\n| 3 |\n\n\n2. Overview of Business\nWe develop, manufacture, distribute and market innovative, cost-effective and environmentally safe bio-technological products for agriculture. Our products are designed to enhance the quality of human life by increasing the value, quality and productivity of crops and decreasing the negative environmental impact of chemicals and other wastes.\n\n| 4 |\n\n\nBio-fertilizers\nWe have developed six bio-fertilizer products with bacillus species (“bacillus spp”) and/or photosynthetic bacteria as core ingredients. Some of our products contain ingredients of both photosynthesis and bacillus bacteria. Bacillus spp is a species of bacteria that interacts with plants and promotes biological processes. It is highly effective for promoting plant growth, enhancing yield, improving quality and elevating resistances. Photosynthetic bacteria are a group of green and purple bacteria. Bacterial photosynthesis differs from green plant photosynthesis in that bacterial photosynthesis occurs in an anaerobic environment and does not produce oxygen. Photosynthetic bacteria can enhance the photosynthetic capacity of green plants by increasing the utilization of sunlight, which helps keep the photosynthetic process at a vigorous level, enhances the capacity of plants to transform inorganic materials to organic products, and boosts overall plant health and productivity.\nOur bacillus bacteria based fertilizers are protected by patents. In 2004, we acquired patent no. ZL 93101635.5 entitled “Highly Effective Composite Bacteria for Enhancing Yield and the Related Methodology for Manufacturing” from China Agricultural University (“CAU”) for the aggregate purchase of $480,411, consisting of $60,411 in cash and 5,000 shares of our common stock, valued at $84.00 per share (aggregate value of $420,000). Our photosynthetic bacteria based fertilizers are also protected by trade secret laws.\nThe patent acquired from CAU covers six different species of bacillus which have been tested as bio-fertilizers to enhance yield and plant health. The production methods of the six species are also patented. The patent has expired on February 19, 2013.There are no limitations under this agreement on our exclusive use of the patent. Pursuant to our agreement with CAU, the University agreed to provide research and technology support services at no additional cost to us in the event we decide to use the patent to produce commercial products. These research and technology support services include: (1) furnishing faculty or graduate-level researchers to help bacteria culturing, sampling, testing, trial production and production formula adjustment; (2) providing production technology and procedures to turn the products into powder form while keeping live required bacteria in the products; (3) establishing quality standards and quality control systems; (4) providing testing and research support for us to obtain necessary sale permits from the Chinese government; and (5) cooperation in developing derivative products.\nOn January 5, 2011, the State Intellectual Property Office of the PRC (“Intellectual Property Office”) granted Kiwa two Certificates of Patent of Invention for (1) “A cucumber dedicated composite anti-continuous cropping effect probiotics and their specific strains with related application” with patent number of “ZL 2008 1 0144492.6”; and (2) “Cotton dedicated composite anti-continuous cropping effect probiotics and their special strains with related application” with patent number of “ZL 2008 1 0144491.1” These two patents have been developed by Kiwa-CAU R&D Center. These two patents will expire on August 5, 2028. These two patents can be used to develop specific environment-friendly bio-fertilizer.\nWe have obtained five fertilizer registration certificates from the Chinese government - four covering our bacillus bacteria fertilizer and one covering our photosynthetic bacteria fertilizer. The five registration certificates are: (1) Microorganism Microbial Inoculum Fertilizer Registration Certificate issued by the PRC Ministry of Agriculture; (2) Photosynthetic Bacteria Fertilizer Registration Certificate issued by the PRC Ministry of Agriculture; (3) Amino Acid Foliar Fomular Fertilizer Registration Certificate issued by the PRC Ministry of Agriculture; (4) Organic Fertilizer Registration Certificate issued by Agriculture Department of Shandong Province; and (5) Organic Matter-Decomposing Inoculants Registration Certificate issued by the PRC Ministry of Agriculture on February 16, 2008. Protected by these five fertilizer registration certificates and five trademarks under the names of “KANGTAN” (Chinese translation name for Kiwa), “ZHIGUANGYOU,” “PUGUANGFU,” “JINWA” and “KANGGUAN,” we have developed six series of bio-fertilizer products with bacillus spp and/or photosynthetic bacteria as core ingredients. Valid period of fertilizer registration certificates is five years and may be extended for another five years upon application from the owner of fertilizer registration certificates. The Company has determined to re-apply the Fertilizer Registration Certificate issued by the PRC Ministry of Agriculture.\n\n| 5 |\n\n\nKiwa-CAU Research and Development Center\nIn July 2006, we established a new research center with CAU which is known as Kiwa-CAU Bio-Tech Research & Development Center (the “Kiwa-CAU R&D Center”). Pursuant to an agreement between CAU and Kiwa Shandong dated November 14, 2006, Kiwa agreed to contribute RMB 1 million (approximately $160,000) each year to fund research at Kiwa-CAU R&D Center. Under the above agreement, the Kiwa-CAU R&D Center is responsible for fulfilling the overall research-and-development functions of Kiwa Shandong, including: (1) development of new technologies and new products (which will be shared by Kiwa and CAU); (2) subsequent perfection of existing product-related technologies; and (3) training quality-control personnel and technicians and technical support for marketing activities. The Company has spent $224,704 and $178,388 for its research and development activities during the years ended December 31, 2016 and 2015, respectively. The costs incurred by Company’s research and development activities are not borne directly by customers.\nDuring fiscal 2014, Kiwa-CAU R&D Center had successfully isolated several strains of endophytic bacillus from plants. A number of strains had been observed to have the capability of boosting crop yield and dispelling chemical pesticide residual from soil. These strains could be used for developing not only new biological preparation but also environmental protection preparation.\nPursuant to the agreement on joint incorporation of the research and development center between CAU and Kiwa dated November 14, 2006, Kiwa agreed to invest RMB 1 million (approximately $160,000) each year to fund research at the R&D Center. The term of this agreement was ten years starting from July 1, 2006. Prof. Qi Wang, who became one of our directors in July 2007, has acted as the Director of Kiwa-CAU R&D Center since July 2006. The Company has negotiated a follow-up Cooperation Agreement for the technologies with China Agricultural University.\nOn November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). Pursuant to the Agreement, the Company will form a strategic partnership with the two institutes and establish an “International Cooperation Platform for Internet and Safe Agricultural Products”. To fund the cooperation platform’s R&D activities, the Company will provide RMB 1 million (approximately $160,000) per year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. The term of the Agreement is for three years beginning November 20, 2015. Prof. Yong Chang Wu, the authorized representative of IARRP, CAAS, is also one of the Company’s directors effective since November 20, 2015 until March 13, 2017.\nOn February 23, 2017, the Company agreed to a strategic relationship with ETS (Tianjin) Biological Science and Technology Development Co., Ltd. (“ETS”). The partnership will include the deployment and strategic use of ETS biotechnology to produce of bio-fertilizers for use in both China and internationally. Kiwa and ETS, together with the certain Chinese government departments, will work together to enhance China’s microbial fertilizer industry standards and China’s food safety industry chain standards. The parties will work together on the development of microbial technology and products in agriculture, environmental protection, soil management and other fields. Relying on the Chinese Academy of Sciences, ETS Environmental and Agricultural Microbial Technology Research Center and biotechnology project research results, Kiwa has introduced the ETS core technology to complete bio-fertilizer upgrading, transformation and to develop new product lines. In order to meet the growing global consumer demand to increase food supply and develop sustainable farming we are applying sustainable use of biotechnology and the use of biotechnology products to replace chemical products, which will strengthen environmental protection and promote international cooperation. As a result of strict management of many agricultural chemicals, such chemicals will continue to be abandoned, resulting is a growing demand for bio-fertilizers. It has been widely accepted that the application of ETS biotechnology facilitates agricultural sustainability and helps to protect the soil and improve grain output. The technology focuses on keeping soil healthy by restoring healthy microbes that are naturally present in healthy soils. As the technology gains worldwide recognition, it is imperative to popularize bio-fertilizer in developing countries to fulfill the needs of growing populations and promote environmentally friendly agriculture. Through the cooperation of Kiwa and ETS, the parties aim to enhance the usage of the bio-fertilizers in China. The cooperation will bring technological transformation and support for Kiwa to improve its existing manufacturing techniques. Kiwa and ETS will also collaborate to establish a comprehensive platform for producing, supplying, and marketing in China. Ultimately, Kiwa would look to introduce these products to the international market, including the United States.\n\n| 6 |\n\n\nOther\nOn November 30, 2015, we entered into an acquisition agreement (the “Agreement”) with the shareholders of Caber Holdings LTD, whose Chinese name is Hong Kong Baina Group Co., Ltd, located in Hong Kong (“Baina Hong Kong”), and Oriental Baina Co. Ltd. (hereinafter referred to as “Baina Beijing”), Baina Hong Kong’s wholly-owned subsidiary in Beijing, China. As a result of this Agreement, Kiwa renamed Baina Beijing to Kiwa Baiao Bio-Tech (Beijing) Co., Ltd., which replaced Kiwa Bio-Tech (Shandong) Co., Ltd (“Kiwa Shandong”) to operate Kiwa’s bio-fertilizer market expansion and become Kiwa’s platform for future acquisitions of new agricultural-related projects in China. In accordance with the terms of the Agreement, Kiwa agreed to pay US$30,000 to the Baina Hong Kong Shareholders for the acquisition of 100% of the equity of Baina Hong Kong. The Company paid RMB 220,000 (approximately $34,000) for the acquisition. The acquisition was completed on January 7, 2016. Both Baina Hong Kong and Baina Beijing had no activities before the acquisition date and had no assets and liabilities.\nThereafter, Baina Beijing formed two new subsidiaries—Kiwa Bio-Tech (Shenzhen) Co., Ltd (Registered in Shenzhen on November 2016); Kangdu Bio-Tech Hebei Co., Ltd. (Registered in Hebei on December 2106) to operate in specific markets in China.\nOn December 17, 2015, we entered into a distribution agreement (the “Agreement”) with Kangtan Gerui (Beijing) Bio-Tech Co., Ltd. (“Gerui”) and formally awarded Gerui a right to sell and distribute the Company’s fertilizer products in 3 major agricultural regions of China— Hainan Province, Hunan Province and Xinjiang Autonomous Region. The Company’s Research and Development department has been conducting application experiments in Hainan and Hunan Provinces since August 2015, in accordance with the market requirements. The experiment data indicates that the Company’s fertilizer products have fulfilled the requirements of reduction of content of heavy metals in soil and improved crop yield. Gerui was founded in Beijing in April 2015 and relies on the sales network of China’s Supply and Marketing Cooperatives system. Currently, the Company and Gerui do not hold any interest in each other; however, a collaboration and integration may take place in the future. The term of the Agreement is for a period of three years commencing December 17, 2015. In September 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd obtained a fertilizer sales permit from the Chinese government and began to sale the products directly to customers in those 3 major agricultural regions. In September 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd obtained a fertilizer sales permit from the Chinese government and began to sale the products directly to customers in those 3 major agricultural regions.\n\n| 7 |\n\n\nOn February 27, 2017, the Company signed a strategic cooperation agreement with the Beijing Zhongpin Agricultural Science and Technology Development Center (“Zhongpin Center”). Zhongpin Center is the Chinese Agricultural Science and Technology Innovation and Development Committee’s executive implementation agency (referred to as the Agricultural Science and Technology Commission). The Agricultural Science and Technology Commission is set up by the Chinese Central Government for the construction of the National Ecological Security Agriculture Industrial Chain standardization system. This includes the establishment of National Ecology Safe Agricultural Industrial Parks to build China’s Ecological Security and Agricultural Industrial in an orderly business environment, including completion of the National Soil Remediation Program and governance of the various government functions of the institutions. Through the guidance and support by the Zhongpin Center, Kiwa will participate and be involved in China’s National Soil Remediation Program and construction of the National Ecological Security Agriculture Industrial Chain Standardization System’s operation and process.\n\nITEM 1A. Risk Factors\nSmaller reporting companies are not required to provide the information required by this item.\n\n| 8 |\n\n\n\nITEM 1B. Unresolved Staff Comments\nNone.\n\nITEM 2. Properties\nIn June 2002, Kiwa Shandong entered into an agreement with Zoucheng Municipal Government granting us the use of at least 15.7 acres in Shandong Province, China at no cost for 10 years to construct a manufacturing facility. Under the agreement, we have the option to pay a fee of approximately RMB 480,000 (approximately $78,155) per acre for the land use right at the expiration of the 10-year period. We may not transfer or pledge the temporary land use right. In the same agreement, we have also committed to invest approximately $18 million to $24 million for developing the manufacturing and research facilities in Zoucheng, Shandong Province. On February 11, 2017 Kiwa Bio-Tech Products (Shandong) entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\n\nITEM 3. Legal Proceedings\nNone.\n\nITEM 4. Mine Safety Disclosures\nNot applicable.\nPart II\n\nITEM 5. Market for Registrants’ Common Equity, Related Stockholder Matters and Issuer Purchasers of Equity Securities\nMarket Information\nThe Company’s common stock has been quoted on the OTCQB under the symbol “KWBT” since March 30, 2004.\nThe following table sets forth the high and low bid quotations per share of our common stock as reported on the OTCQB for the periods indicated. The high and low bid quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. All prices are adjusted to reflect the Company’s one for 200 reverse split which went effective January 28, 2016.\n\n| Fiscal Year 2016 | High | Low |\n| First Quarter | $ | 2.24 | $ | 0.20 |\n| Second Quarter | $ | 1.98 | $ | 1.30 |\n| Third Quarter | $ | 1.65 | $ | 0.62 |\n| Fourth Quarter | $ | 1.43 | $ | 0.80 |\n\n\n| Fiscal Year 2015 | High | Low |\n| First Quarter | $ | 1.47 | $ | 0.12 |\n| Second Quarter | $ | 0.44 | $ | 0.02 |\n| Third Quarter | $ | 0.32 | $ | 0.12 |\n| Fourth Quarter | $ | 0.70 | $ | 0.12 |\n\nHolders\nAs of December 31, 2016, there were approximately 461 shareholders of record of our common shares.\nDividend Policy\nWe have not paid any dividends on our common shares since our inception and do not anticipate that dividends will be paid at any time in the immediate future.\nEquity Compensation Plan Information\nThe information required by Item 5 regarding securities authorized for issuance under equity compensation plans is included in Item 12 of this report.\n\n| 9 |\n\n\nRecent Sales of Unregistered Securities\nThe following is a list of securities issued for cash or converted with debentures or as stock compensation to consultants during the period from January 1, 2016 through April 14, 2017, which were not registered under the Securities Act:\n\n| Name of Purchaser | Issue Date | Security | Shares | Consideration |\n| YVONNE WANG | 3/24/16 | Common | 240,000 | Debenture Conversion |\n| WEI LI | 3/24/16 | Common | 2,900,000 | Debenture Conversion |\n| MARK E. CRONE | 3/25/16 | Common | 1,000 | Legal Fees |\n| ZENG MIN QING | 5/24/16 | Common | 125,000 | Stock Purchase |\n| CHENG TZU-YUN | 5/24/16 | Common | 50,000 | Stock Purchase |\n| ZHIMING ZHU | 5/24/16 | Common | 45,000 | Stock Purchase |\n| HANG ZHAO | 7/20/16 | Common | 20,000 | Stock Purchase |\n| SHIWEI XIE | 7/20/16 | Common | 10,000 | Stock Purchase |\n| XIAOQIANG YU | 7/20/16 | Common | 30,000 | Stock Purchase |\n| HANG ZHAO | 8/10/16 | Common | 20,000 | Stock Purchase |\n| XIAOQIANG YU | 8/10/16 | Common | 10,000 | Stock Purchase |\n| XIANGRON CHEN | 8/10/16 | Common | 40,000 | Stock Purchase |\n| JIMMY ZHOU | 8/24/16 | Common | 101,947 | Consultant Fees |\n| WEIHONG SHAN | 10/6/16 | Common | 150,000 | Stock Purchase |\n| LIFENG LIU | 10/6/16 | Common | 100,000 | Stock Purchase |\n| ZHENPING LI | 10/6/16 | Common | 100,000 | Stock Purchase |\n| QI JIANG | 10/6/16 | Common | 550,000 | Stock Purchase |\n| LEI HOU | 10/6/16 | Common | 100,000 | Stock Purchase |\n| BING ZHANG | 10/6/16 | Common | 150,000 | Stock Purchase |\n| DEMEI YANG | 10/6/16 | Common | 150,000 | Stock Purchase |\n| WSMG ADVISORS, INC. | 10/6/16 | Common | 100,000 | Consultant Fees |\n| EQUITIES.COM, INC | 10/6/16 | Common | 30,808 | Consultant Fees |\n| GENG LIU | 10/19/16 | Common | 500,000 | Consultant Fees |\n| LIXIN TIAN | 10/19/16 | Common | 500,000 | Consultant Fees |\n| XU LIU | 10/19/16 | Common | 500,000 | Consultant Fees |\n| QINGKE XING | 10/19/16 | Common | 60,000 | Consultant Fees |\n| GROWTH CIRCLE INC. | 10/19/16 | Common | 20,000 | Consultant Fees |\n| WILLIAM FARRANCE | 11/29/16 | Common | 125,000 | Stock Purchase |\n| JUNWEI ZHENG | 3/3/17 | Common | 920,000 | Stock Purchase |\n| YUAN WANG | 3/3/17 | Common | 80,000 | Stock Purchase |\n| YUAN WANG | 3/3/17 | Common | 70,000 | Consultant Fees |\n\n\nITEM 6. Selected Financial Data\nNot required.\n\nITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nThis Annual Report on Form 10-K for the fiscal year ended December 31, 2016 contains “forward-looking” statements within the meaning of Section 21E of the Securities and Exchange Act of 1934, as amended, including statements that include the words “believes,” “expects,” “anticipates,” or similar expressions. These forward-looking statements include, among others, statements concerning our expectations regarding our working capital requirements, financing requirements, business, growth prospects, competition and results of operations, and other statements of expectations, beliefs, future plans and strategies, anticipated events or trends, and similar expressions concerning matters that are not historical facts. The forward-looking statements in this Annual Report on Form 10-K for the fiscal year ended December 31, 2016 involve known and unknown risks, uncertainties and other factors (described in “Business-Risk Factors” under Item 1) that could cause our actual results, performance or achievements to differ materially from those expressed in or implied by the forward-looking statements contained herein.\nOverview\nThe Company took its present corporate form in March 2004 when the shareholders of Tintic Gold Mining Company, a Utah public corporation (“Tintic”), entered into a share exchange transaction with the shareholders of Kiwa BVI, a privately-held British Virgin Islands corporation that left the shareholders of Kiwa BVI owning a majority of Tintic and Kiwa BVI a wholly-owned subsidiary of Tintic, see “Business - The Company” under Item 1. For accounting purposes this transaction was treated as an acquisition of Tintic Gold Mining Company by Kiwa BVI in the form of a reverse triangular merger and a recapitalization of Kiwa BVI and its wholly owned subsidiary, Kiwa Shandong. On July 21, 2004, we completed our reincorporation in the State of Delaware. On March 8, 2017, we completed our reincorporation in the State of Nevada.\nThe Company operates through a series of subsidiaries in the Peoples Republic of China as detailed in the Organizational Chart on page 4, above. The Company had previously operated its business through its subsidiaries Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Kiwa Shandong”) and Tianjin Kiwa Feed Co., Ltd. (“Kiwa Tianjin”). Kiwa Tianjin has been dissolved since July 11, 2012. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\n\n| 10 |\n\n\nWe generated revenue in fiscal year 2016. We incurred a net income of $963,296 and a net loss $677,358 during fiscal 2016 and 2015, respectively.\nDue to our limited revenues, we have relied on the proceeds from loans from both unrelated and related parties to provide the resources necessary to fund the development of our business plan and operations. Our financing activities generated $1,053,358 and $148,009 during fiscal 2016 and 2015, respectively. These funds are insufficient to execute our business plan as currently contemplated, which may result in the risks described in “Risk Factors” under Item 1 - Business.\nGoing Concern\nThe consolidated financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.\nAs of December 31, 2016, the Company’s current liabilities substantially exceeded its current assets by $5,729,622. Although the company’s operations for the year ended December 31, 2016 resulted net income of $963,296, it had an accumulated deficit of $19,489,400 and stockholders’ deficiency of $5,601,213 at December 31, 2016. These circumstances, among others, raise substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. The financial statements also do not include any adjustments relating to the recoverability and classification of recorded asset amounts, or amounts and classifications of liabilities that might be necessary should the Company be unable to continue as a going concern.\nThe Company already raised additional fund through equity financing and plans to raise additional funds from domestic and foreign banks and/or financial institutions to increase working capital in order to meet capital demands. Please refer to Note 15 (Subsequent Evens) for additional information.\nTrends and Uncertainties in Regulation and Government Policy in China\nForeign Exchange Policy Changes\nChina is considering allowing its currency to be freely exchangeable for other major currencies. This change will result in greater liquidity for revenues generated in Renminbi (“RMB”). We would benefit by having easier access to and greater flexibility with capital generated in and held in the form of RMB. The majority of our assets are located in China and most of our earnings are currently generated in China, and are therefore denominated in RMB. Changes in the RMB-U.S. Dollar exchange rate will impact our reported results of operations and financial condition. In the event that RMB appreciates over the next year as compared to the U.S. Dollar, our earnings will benefit from the appreciation of the RMB. However, if we have to use U.S. Dollars to invest in our Chinese operations, we will suffer from the depreciation of U.S. Dollars against the RMB. On the other hand, if the value of the RMB were to depreciate compared to the U.S. Dollar, then our reported earnings and financial condition would be adversely affected when converted to U.S. Dollars.\nOn July 21, 2005, the People’s Bank of China announced it would appreciate the RMB, increasing the RMB-U.S. Dollar exchange rate from approximately US$1.00 = RMB 8.28 to approximately US$1.00 = RMB 8.11. So far the trend of such appreciation continues. The exchange rate of U.S. Dollar against RMB on December 31, 2016 was US$1.00 = RMB 6.945.\nCritical Accounting Policies and Estimates\nWe prepared our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Management periodically evaluates the estimates and judgments made. Management bases its estimates and judgments on historical experience and on various factors that are believed to be reasonable under current circumstances. Actual results may differ from these estimates as a result of different assumptions or conditions.\nThe following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements. In addition, you should refer to our accompanying audited balance sheets as of December 31, 2016 and 2015, and the audited statements of comprehensive loss, equity movement and cash flows for the fiscal years ended December 31, 2016 and 2015, and the related notes thereto, for further discussion of our accounting policies.\nFair value of warrants and options\nWe have adopted ASC Topic 815, “Accounting for Derivative Instruments and Hedging Activities” to recognize warrants relating to loans and warrants issued to consultants as compensation as derivative instruments in our consolidated financial statements.\n\n| 11 |\n\n\nWe also adopted ASC Topic 718, “Share Based Payment” to recognize options granted to employees as derivative instruments in our consolidated financial statements.\nWe calculate the fair value of the warrants and options using the Black-Scholes Model.\nIncome Taxes\nThe Company accounts for income taxes under the provisions of FASB ASC Topic 740, “Income Tax,” which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Deferred tax assets and liabilities are recognized for the future tax consequence attributable to the difference between the tax bases of assets and liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are measured using the enacted tax rate expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company establishes a valuation when it is more likely than not that the assets will not be recovered.\nASC Topic 740.10.30 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC Topic 740.10.40 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. We have no material uncertain tax positions for any of the reporting periods presented.\nMajor Customers and Suppliers.\nBio-fertilizer products\nDuring 2016, the following were Kiwa’s major customers:\n1. Qingzhou City Agricultural Production Materials Co., Ltd. second wholesale department (11.3% of sales)\n2. Huarong County Yinfeng fertilizer industry LTD. (81% of sales)\nDuring 2016, the following were Kiwa’s major suppliers:\n1. Weifang Druek Fertilizer Co., Ltd (92% of Subcontractor Production)\n2 Lianyungang Chuangyi Logistics Co., Ltd (Logistics provider)\n3. Linshu Shangrun Color Printing Co., Ltd (Packing provider)\nResults of Operations\nNet Sales\nNet sales were $9,617,845 and $0 for the years ended December 31, 2016 and 2015, respectively.\nCost of Sales\nCost of sales was $7,672,451 and $0 for the years ended December 31, 2016 and 2015, respectively.\nGross Profit/Loss\nGross profit for fiscal 2016 was $1,945,394 compared to $0 for fiscal 2015.\nLicensing Revenue\nLicensing revenue totaled $786,329 for the year ended December 31, 2016.\nGeneral and Administrative\nGeneral and administrative expenses were $874,097 and $313,589 for the years ended December 31, 2016 and 2015, respectively, an increase of $560,508 or 178%. General and administrative expenses include professional fees, officers’ compensation, depreciation and amortization, salaries, travel and entertainment, rent, office expense and telephone expense etc.\n\n| 12 |\n\n\nResearch and Development\nResearch and development expenses increased significantly by $45,445 or 25% to $224,433 for the year ended December 31, 2016, compared to $178,988 for the prior comparable period. Research and development expense mainly consists of the expenses of maintaining Kiwa-CAU R&D Center, which began operation in July 2006 (see “Business-Intellectual Property and Product Lines- Kiwa-CAU R&D Center” under Item 1 in Part I). On November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). Pursuant to the Agreement, the Company will form a strategic partnership with the two institutes and establish an “International Cooperation Platform for Internet and Safe Agricultural Products”. To fund the cooperation platform’s R&D activities, the Company will provide RMB 1 million (approximately $160,000) per year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. During the years ended December 31, 2016 and 2015, the Company accrued $224,433 and $178,988 for research and development respectively.\nPenalty Expense\nWe charged $77,575 and $72,512 of liquidated damages in connection with the 6% Notes to penalty expenses during the years ended December 31, 2016 and 2015, respectively. The increase of penalty expense was mainly due to accrued and unpaid interest on the 6% Notes.\nInterest Expenses\nNet interest expense was $112,977 and $112,629 in the fiscal years of 2016 and 2015, respectively, representing a increase of $348 or 0.3%.\nNet Income & (Loss)\nDuring the fiscal year 2016, net income was $963,296, comparing with net loss $677,358 for the same period of 2015, representing an increase of $1,640,654.\nComprehensive Gain & (Loss)\nComprehensive income increased by $1,446,652 from $(253,293) for fiscal 2015, as compared to $1,193,359 for the comparable year of 2016.\nLiquidity and Capital Resources\nSince inception of our ag-biotech business in 2002, we have relied on the proceeds from the sale of our equity securities and loans from both unrelated and related parties to provide the resources necessary to fund our operations and the execution of our business plan. During fiscal 2016 and 2015, we raised $1,053,358 and $148,009 in total from stock purchase agreements and related party loans. To some extent, these advances improved our short-term liquidity. However, as of December 31, 2016, our current liabilities substantially exceeded current assets by $5,729,622, reflecting a current ratio of 0.4451, whereas current liabilities exceeded current assets by $11,103.261, reflecting a current ratio of 0.0043 as of December 31, 2015. During the years ended December 31, 2016 and 2015, we did not issue any shares resulting from the conversion of principal of the 6% Notes into our common stock.\n\n| 13 |\n\n\nAs of December 31, 2016 and 2015, we had cash of $13,469 and $721, respectively. The change is outlined as follows:\nDuring the fiscal year of 2016, net cash used in our operating activities was $1,142,9741, compared to $150,208 for the comparable period of 2015. Such cash was mainly used for maintaining operations of a public company and working capital for our bio-fertilizer business.\nDuring the fiscal year of 2016, we incurred approximately $79,083 in investment activity, including $34,112 in acquiring a subsidiary.\nDuring the year ended December 31, 2016, we generated cash inflow for $1,053,358 from financing activities, compared to $148,009 of cash inflow during the year ended December 31, 2015, from financing activities.\nAs of December 31, 2016, we had an accumulated deficit of $19,489,400, down from $20,324,812 deficit at December 31, 2015, as a result of a net income of $967,296 including $127,884 for statutory reserve for the year ended December 31, 2016 and compared to a net loss of $677,358 for 2015.\nWe still require additional working capital to accomplish our business objectives and to sustain our operations. Continuously, we intend to raise additional capital through the issuance of debt or equity securities to fund the development of our planned business operations, although there can be no assurance that we will be successful in obtaining this financing. The following factors, among others, may significantly harm our ability to obtain required additional financing.\nGiven the facts that:\n\n| (1) | Outstanding 6% Notes. As of December 31, 2016, the amount of outstanding 6% Notes was $150,250. The 6% Notes have been in default since June 2009. |\n| (2) | Outstanding note payable of $360,000 as of December 31, 2016. This note has been in default since July 2007. |\n\nContractual Obligations\n(1) Operation of Kiwa-CAU R&D Center\nPursuant to the agreement on joint incorporation of the research and development center between CAU and Kiwa Shandong dated November 14, 2006, Kiwa Shandong agrees to invest RMB 1 million (approximately $160,000) each year to fund research at the R&D Center. The term of this agreement is ten years starting from July 1, 2006. Prof. Qi Wang, who became one of our directors in July 2007, has acted as the Director of Kiwa-CAU R&D Center since July 2006.\n(2) Investment in manufacturing and research facilities in Zoucheng, Shandong Province in China\nAccording to the Project Agreement with Zoucheng Municipal Government in 2002, we have committed to investing approximately $18 million to $24 million for developing the manufacturing and research facilities in Zoucheng, Shandong Province. As of December 31, 2016, we had invested approximately $1.91 million for the project. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\n\n| 14 |\n\n\n(3) Strategic cooperation with two institutes in China\nOn November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). Pursuant to the Agreement, the Company will form a strategic partnership with the two institutes and establish an “International Cooperation Platform for Internet and Safe Agricultural Products”. To fund the cooperation platform’s R&D activities, the Company will provide RMB 1 million (approximately $160,000) per year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. The term of the Agreement is for three years beginning November 20, 2015.\n(4) Acquisition of Caber Holdings LTD (Hong Kong Baina Group Co. LTD) in China\nOn November 30, 2015, we entered into an acquisition agreement (the “Agreement”) with the shareholders of Caber Holdings LTD, whose Chinese name is Hong Kong Baina Group Co., Ltd, located in Hong Kong (“Baina Hong Kong”), and Oriental Baina Co. Ltd. (hereinafter referred to as “Baina Beijing”), Baina Hong Kong’s wholly-owned subsidiary in Beijing, China. When this acquisition is completed, Kiwa will rename Baina Beijing to Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. Kiwa Baiao Co. Ltd will replace Kiwa’s current subsidiary in China - Kiwa Bio-Tech (Shandong) Co., Ltd (“Kiwa Shandong”) - to operate Kiwa’s bio-fertilizer market expansion and become Kiwa’s platform for future acquisitions of new agricultural-related projects in China. In accordance with the terms of the Agreement, Kiwa agreed to pay US$30,000 to the Baina Hong Kong Shareholders for the acquisition of 100% of the equity of Baina Hong Kong. As of December 31, 2015, the Company has paid RMB 220,000 (approximately $34,000) for the acquisition. The acquisition was completed on January 7, 2016. Both Baina Hong Kong and Baina Beijing had no activities before the acquisition date and had no assets and liabilities. Thereafter, Baina Beijing formed two new subsidiaries—Kiwa Bio-Tech (Shenzhen) Co., Ltd (Registered in Shenzhen on November 2016); Kangdu Bio-Tech Hebei Co., Ltd. (Registered in Hebei on December 2106) to operate in specific markets in China.\n(5) Distribution agreement with Kangtan Gerui Bio-Tech in China\nOn December 17, 2015, Kiwa Bio-Tech Products Group Corporation (the “Company”) entered into a distribution agreement (the “Agreement”) with Kangtan Gerui (Beijing) Bio-Tech Co., Ltd. (“Gerui”) and formally awarded Gerui a right to sell and distribute the Company’s fertilizer products in 3 major agricultural regions of China— Hainan Province, Hunan Province and Xinjiang Autonomous Region. The Company’s Research and Development department has been conducting application experiments in Hainan and Hunan Provinces since August 2015, in accordance with the market requirements. The experiment data indicates that the Company’s fertilizer products have fulfill the requirements of reduction of content of heavy metals in soil and improve crop yield. Gerui was founded in Beijing in April 2015 and relies on the sales network of China’s Supply and Marketing Cooperatives system. Currently, the Company and Gerui do not hold any interest in each other; however, a collaboration and integration may take place in the future. The term of the Agreement is for a period of three years commencing December 17, 2015. In September 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd obtained a fertilizer sales permit from the Chinese government and began to sale the products directly to customers in those 3 major agricultural regions.\n(6) Lease payments\n(1) On April 29, 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. entered an office lease agreement with two-year team. Monthly lease payment and building management fee totaled RMB 77,867 or approximately USD $11,622.\n(2) On November 11, 2017, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. entered an apartment lease agreement for its employees. The lease term is one year with monthly lease payment of RMB 6,000 or approximately USD $896.\n(3) In March 1, 2017, Kiwa Bio-Tech (Shenzhen) Co., Ltd, a newly established subsidiary entered an office lease agreement with one-year term. Monthly lease payment is RMB 29,000 or approximately of USD $4,320.\nOff-Balance Sheet Arrangements\nAt December 31, 2016, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise had we engaged in such relationships.\nRecent Accounting Pronouncements\nSee Note 2 to the Consolidated Financial Statements under Item 8, Part II.\n\n| 15 |\n\n\n\nITEM 7A. Quantitative and Qualitative Disclosures about Market Risk\nNot required.\n\nITEM 8. Financial Statements and Supplementary Data\nThe full text of our audited consolidated financial statements as of December 31, 2016 and 2015 begins on page F-1 of this annual report.\n\nITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure\nOn February 15, 2017, the Board of Directors of Kiwa Bio-Tech Products Group Corporation (“Kiwa” or “Company”) decided to engage DYH & Co. as independent principal accountant and auditor to report on the Company’s financial statements for the fiscal year ended December 31, 2016, including performing the required quarterly reviews.\nIn conjunction with the new engagement, the Company has dismissed its former accountant, Paritz & Co., P.A., Hackensack, NJ (“Paritz”), as the Company’s principal accountant effective February 22, 2016. Paritz has served the Company well since 2013. Under Item 304 of Regulation S-K, the reason for the auditor change is dismissal, not resignation nor declining to stand for re-election.\nDuring the two most recent fiscal years and the interim period through the date of the dismissal, there were no disagreements with Paritz on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which disagreements, if not resolved to Paritz’s satisfaction, would have caused Paritz to make reference to the subject matter of the disagreements in connection with its reports.\n\nITEM 9A. Controls and Procedures\nDisclosure Controls and Procedures\nOur management, under the supervision and with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), has evaluated the effectiveness of our disclosure controls and procedures as defined in SEC Rules 13a-15(e) and 15d-15(e) as of the end of the period covered by this Annual Report. Our disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports we file or submit under the Securities Exchange Act of 1934 (“Exchange Act”) is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management including our CEO and CFO, to allow timely decisions regarding required disclosures. Based on their evaluation, our CEO and CFO have concluded that, as of December 31, 2016, our disclosure controls and procedures were ineffective.\nManagement Report on Internal Control over Financial Reporting\nOur management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Our internal control over financial reporting was designed to provide reasonable assurance to the Company’s management and board of directors regarding the preparation and fair presentation of published consolidated financial statements. Internal control over financial reporting is promulgated under the Exchange Act as a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and effected by the Company’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting, no matter how well designed, has inherent limitations and may not prevent or detect misstatements. Therefore, even effective internal control over financial reporting can only provide reasonable assurance with respect to the financial statement preparation and presentation.\nOur management has conducted, with the participation of our CEO and CFO, an assessment, including testing of the effectiveness, of our internal control over financial reporting as of December 31, 2016. Management’s assessment of internal control over financial reporting was conducted using the criteria in Internal Control over Financial Reporting - Guidance for Smaller Public Companies issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on such evaluation, management identified deficiencies that were determined to be a material weakness.\nA material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. Because of the material weakness described below, management concluded that our internal control over financial reporting was ineffective as of December 31, 2016.\n\n| 16 |\n\n\nThe specific material weakness identified by the Company’s management as of December 31, 2016 is described as follows:\n\n| ● | The Company did not have sufficient and skilled accounting personnel with an appropriate level of technical accounting knowledge and experience in the application of accounting principles generally accepted in the United States of America commensurate with the Company’s financial reporting requirements, which resulted in a number of internal control deficiencies that were identified as being significant. The Company’s management determined that the number and nature of these significant deficiencies, when aggregated, constituted a material weakness. |\n| ● | The Company lacks qualified resources to perform the internal audit functions properly. In addition, the scope and effectiveness of the Company’s internal audit function are yet to be developed. |\n| ● | We currently do not have an audit committee. |\n\nRemediation Initiative\n\n| ● | We are committed to establishing the internal audit functions but due to limited qualified resources in the region, we were not able to hire sufficient internal audit resources before the end of 2016. However, internally we established a central management center to recruit more senior qualified people in order to improve our internal control procedures. Externally, we are looking forward to engaging an accounting firm to assist the Company in improving the Company’s internal control system based on COSO Framework. |\n| ● | We intend to establish an audit committee of the board of directors as soon as practicable. We envision that the audit committee will be primarily responsible for reviewing the services performed by our independent auditors, evaluating our accounting policies and our system of internal controls. |\n\nConclusion\nDespite the material weakness and deficiencies reported above, the Company’s management believes that its consolidated financial statements included in this report fairly present in all material respects the Company’s financial condition, results of operations and cash flows for the periods presented and that this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report.\nThis Annual Report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the SEC that permit the Company to provide only management’s report in this Annual Report.\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting during the fiscal year ended December 31, 2016 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n\nITEM 9B. Other Information\nNone.\n\n| 17 |\n\n\nPart III\n\nITEM 10. Directors, Executive Officers and Corporate Governance\nDirectors and Executive Officers\nSet forth below are the names of our directors and executive officers, their ages, their offices with us, if any, their principal occupations or employment for the past five years. The directors listed below will serve until the Company’s next annual meeting of the stockholders:\n\n| Name | Age | Position | Director Since |\n| Yvonne Wang | 39 | Acting President, CEO and CFO and Director | 2015 |\n| Feng Li | 28 | Secretary and Director | 2015 |\n| Qi Wang | 49 | Vice President of Technology, Director | 2007 |\n| Yong Lin Song Xiao Qiang Yu | 50 39 | CTO, Director of Technology and Director Sales and Marketing Director | 2017 2016 |\n\nYvonne Wang Ms. Wang became our Chairman in November 2015. She served as corporate Secretary from 2005 to 2015. Prior to 2005, she served as an executive assistant and a manager of the Company’s U.S. office between April 2003 and September 2005. She obtained her B.S. degree of Business Administration from University of Phoenix.\nOn August 11, 2106 became Company’s acting president, CEO and CFO.\nFeng Li became our Secretary and a Director in 2015. From 2011- 2012, Ms. Li has served as an assistant project manager for SCHSAsia, a boutique business consulting firm specializing in events and project management for overseas company wishing to expand into the Asia Pacific arena. From 2012 until 2014, Ms. Li served as a campaigner for WildAid China Office, a non-profit organization with focus on raising public awareness on wildlife and climate change related issues.\nQi Wang became our Vice President - Technical on July 19, 2005 and was elected as one of our directors of the Company on July 18, 2007. Prof. Wang has also acted as Director of Kiwa-CAU R&D Center since July 2006. Prof. Wang served as a Professor and Advisor for Ph.D. students in the Department of Plant Pathology, China Agricultural University (“CAU”) since January 2005. Prior to that, he served as an assistant professor and lecturer of CAU since June 1997. He obtained his master degree and Ph.D. in agricultural science from CAU in July 1994 and July 1997, respectively. Prof. Wang received his bachelor’s degree of science from Inner Mongolia Agricultural University in July 1989. He is a committee member of various scientific institutes in China, including the National Research and Application Center for Increasing-Yield Bacteria, Chinese Society of Plant Pathology, Chinese Association of Animal Science and Veterinary Medicine. Prof. Wang’s unique expertise in the field of agriculture offers significant knowledge and experience to the Board of Directors when making critical operational decisions.\nYong Lin Song became our CTO and Director of Technology responsible for the Company’s R&D operations on March 2016 and as one of our directors of the Company on March 2017. Mr. Song is a senior agronomist at the Institute of Agricultural Resources and Regional Planning, Chinese Academy of Agricultural Sciences. He has 29 years of experience in microbial R&D and technology promotion and has led many national agricultural projects. In 2001, he was responsible for technological achievement transformation and technology promotion of Agricultural Resources and Regional Planning, Chinese Academy of Agricultural Sciences. In 2009, he served as deputy secretary general of the Chinese Society of Plant Nutrition and Fertilizer Science.\nXiao Qiang Yu became our Sales and Marketing Director on June 2016 and is responsible for managing the overall marketing strategy of Kiwa, which includes brand expansion, sale targets, strategic planning and corporate communications. Mr. Yu participated in Chinese fertilizer market since 1999. Mr. Yu has over 15 years of marketing, management and strategy experience from two major fertilizer companies in China.\n\n| 18 |\n\n\nFamily Relationships\nThere are no family relationships among our directors or executive officers.\nInvolvement in Certain Legal Proceedings\nNone of our directors or executive officers has, during the past ten years:\n\n| (a) | Had any bankruptcy petition filed by or against any business of which such person was a general partner or executive officer either at the time of the bankruptcy or within two years prior to that time; |\n| (b) | Been convicted in a criminal proceeding or subject to a pending criminal proceeding; |\n| (c) | Been subject to any order, judgment, or decree, not subsequently reversed, suspended or vacated, of any court of competent jurisdiction or any federal or state authority, permanently or temporarily enjoining, barring, suspending or otherwise limiting his involvement in any type of business, securities, futures, commodities or banking activities; and |\n| (d) | Been found by a court of competent jurisdiction (in a civil action), the Securities and Exchange Commission or the Commodity Futures Trading Commission to have violated a federal or state securities or commodities law, and the judgment has not been reversed, suspended, or vacated. |\n\nSection 16(a) Beneficial Ownership Compliance\nSection 16(a) of the Securities Exchange Act of 1934 requires our officers, directors and certain persons holding more than 10 percent of a registered class of our common stock to file with the SEC initial reports of ownership and reports of changes in ownership of our common stock. Officers, directors and certain other shareholders are required by the SEC to furnish the Company with copies of all Section 16(a) forms they file. To the best of the Company’s knowledge, based solely upon a review of the copies of such reports, the Company believes that all Section 16(a) filing requirements applicable to its officers, directors and certain other shareholders were complied with during the fiscal year ended December 31, 2016.\nCode of Ethics\nWe have adopted a Code of Business Conduct and Ethics (the “Code”) that is applicable to all employees, consultants and members of the Board of Directors, including the Chief Executive Officer, Chief Financial Officer and Secretary. This Code embodies our commitment to conduct business in accordance with the highest ethical standards and applicable laws, rules and regulations. We will provide any person a copy of the Code, without charge, upon written request to the Company’s Secretary. Requests should be addressed in writing to Ms. Yvonne Wang; 310 N. Indian Hill Blvd., #702 Claremont, California 91711.\nBoard Composition; Audit Committee and Financial Expert\nOur Board of Directors is currently composed of four members: Yvonne Wang, Feng Li, Qi Wang and Yong Lin Song. All board actions require the approval of a majority of the directors in attendance at a meeting at which a quorum is present.\n\n| 19 |\n\n\nWe currently do not have an audit committee. We intend, however, to establish an audit committee of the board of directors as soon as practicable. We envision that the audit committee will be primarily responsible for reviewing the services performed by our independent auditors, evaluating our accounting policies and our system of internal controls. Currently such functions are performed by our Board of Directors.\nThe Board does not have a “financial expert” as defined by SEC rules implementing Section 407 of the Sarbanes-Oxley Act.\nBoard meetings and committees; annual meeting attendance.\nDuring fiscal year 2016, the Board of Directors did not have any meetings.\n\nITEM 11. Executive Compensation\nWe currently have no Compensation Committee. The Board of Directors is currently performing the duties and responsibilities of Compensation Committee. In addition, we have no formal compensation policy. We decide on our executives’ compensation based on average compensation levels of similar companies in the U.S. or China, depending on consideration of many factors such as where the executive works. Our Chief Executive Officer’s compensation is approved by the Board of Directors. Other named executive officers’ compensation are proposed by our Chief Executive Officer and approved by the Board of Directors.\nOur Stock Incentive Plan is administered by the Board of Directors. Any amendment to our Stock Incentive Plan requires majority approval of the stockholders of the Company.\nThe Company had no officers or directors whose total compensation during either 2016 or 2015 exceeded $100,000.\nCurrently, the main forms of compensation provided to each of our executive officers are: (1) annual salary; (2) non-equity Incentive Plan; and (3) the granting of incentive stock options subject to approval by our Board of Directors.\nSummary Compensation Table\nSummary Compensation Table\n\n| Name and principal position | Year | Salary ($) | Bonus ($) | Stock Awards ($) | Option Awards ($) | Non-Equity Incentive Plan Compensation ($) | Nonqualified Deferred Compensation Earnings ($) | All Other Compensation ($) | Total ($) |\n| (a) | (b) | (c) | (d) | (e) | (f) | (g) | (h) | (i) | (j) |\n| Yvonne Wang, | 2016 | 84,000 | Nil | Nil | Nil | Nil | Nil | Nil | 84,000 |\n| Acting President, CEO and CFO | 2015 | 51,000 | Nil | Nil | Nil | Nil | Nil | Nil | 51,000 |\n| Yong Lin Song, | 2016 | 29,828 | Nil | Nil | Nil | Nil | Nil | Nil | 29,828 |\n| CTO, Director of Technology | 2015 | Nil | Nil | Nil | Nil | Nil | Nil | Nil | Nil |\n| Xiao Qiang Yu, | 2016 | 30,259 | Nil | Nil | Nil | Nil | Nil | Nil | 30,259 |\n| Sales and Marketing Director | 2015 | Nil | Nil | Nil | Nil | Nil | Nil | Nil | Nil |\n\nEmployment Contracts and Termination of Employment and Change of Control Arrangements\nThere are no compensatory plans or arrangements with respect to a named executive officer that would result in payments or installments in excess of $100,000 upon the resignation, retirement or other termination of such executive officer’s employment with us or from a change-in-control.\n\n| 20 |\n\n\nStock Incentive Plan and Option Grants\n2016 Stock Incentive Plan\nOn March 8, 2017, pursuant to the consent of the holders of a majority of the votes entitled to be cast on the matter, were approved of the Kiwa Bio-Tech Products Group Corporation 2016 Employee, Director and Consultant Stock Plan. The Plan is a key aspect of our compensation program, designed to attract, retain, and motivate the highly qualified individuals required for our long-term success.\nNo options were granted under the Plan during 2016.\nOption Exercises and Stock Vested\nNo stock options were exercised by any officers or directors during 2016 and 2015. We did not adjust or amend the exercise price of any stock options previously awarded to any named executive officers during 2016 and 2015.\n\n| 21 |\n\n\nDirector Compensation for 2016\nWe currently have no policy in effect for providing compensation to our directors for their services on our Board of Directors, and did not compensate our directors in 2016 for services performed as directors.\n\nITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters\nThe following table sets forth as of April 7, 2017 certain information with respect to the beneficial ownership of our common stock by (i) each of our executive officers, (ii) each person who is known by us to beneficially own more than 5% of our outstanding common stock, and (iii) all of our directors and executive officers as a group. Percentage ownership is calculated based on 9,798,981 shares of our common stock and 500,000 shares of our Series A Preferred Stock outstanding as of April 7, 2017. None of the shares listed below are issuable pursuant to stock options or warrants of the Company.\n\n| Title of class | Name and Address of Beneficial Ownership(1) | Amount and Nature of Beneficial Owner (2) | Percentage of class |\n| Common Stock | Yvonne Wang | 240,000 | 2.45 | % |\n| Common Stock | Feng Li (3) | 1,965,326 | 20.06 | % |\n| Common Stock | Qi Wang | - | - |\n| Common Stock | Yong Lin Song | - | - |\n| Common Stock | All officers and directors as a group | 2,205,326 | 22.51 | % |\n| Ser. A Pref. Stock | Yvonne Wang | 250,000 | 50.00 | % |\n| Ser. A Pref. Stock | Feng Li | 250,000 | 50.00 | % |\n| Ser. A Pref. Stock | All officers and directors as a group | 500,000 | 100.00 | % |\n| 5% Holders: |\n| Common Stock | Troniya Industrial Incubator, Inc. | 1,000,000 | 10.21 | % |\n| Common Stock | Liu Geng | 500,000 | 5.10 | % |\n| Common Stock | Liu Xu | 500,000 | 5.10 | % |\n| Common Stock | Tian Lixin | 500,000 | 5.10 | % |\n| Common Stock | Zheng JunWei | 920,000 | 9.39 | % |\n| Common Stock | Wei Li (3) | 1,965,326 | 20.06 | % |\n\n\n| (1) | The address for all holders is 310 N. Indian Hill Blvd, #702, Claremont, CA 91711. |\n| (2) | In determining beneficial ownership of our Common Stock and Series A Preferred Stock, the number of shares shown includes shares which the beneficial owner may acquire upon exercise of debentures, warrants and options which may be acquired within 60 days. Unless otherwise stated, each beneficial owner has sole power to vote and dispose of its shares. |\n| (3) | Includes 61,784 shares of common stock held by All Star Technology, Inc., a British Virgin Islands international business company. Feng Li’s father, Wei Li, exercises voting and investment control over the shares held by All Star Technology, Inc. Wei Li is a principal stockholder of All Star Technology, Inc. and may be deemed to beneficially own such shares, but disclaims beneficial ownership in such shares held by All Star Technology, Inc. except to the extent of his pecuniary interest therein. Mr. Li has pledged all of his common stock of the Company as collateral security for the Company’s obligations under certain 6% Convertible Notes owed by the Company. |\n\n\n| 22 |\n\n\nChange in Control\nNone.\n\nITEM 13. Certain Relationships and Related Transactions, and Director Independence\nFor description of transactions with related parties, see Note 6 to Consolidated Financial Statements under Item 8 in Part II.\nUnder the independence standard set forth in Rule 4200(a) (15) of the Market Place Rules of the Nasdaq Stock Market, which is the independence standard that we have chosen to report under.\n\nITEM 14. Principal Accountant Fees and Services\nFees Paid to Independent Public Accountants for 2016 and 2015.\nAudit Fees\nAll of the services described below were approved by our board of directors prior to performance of such services. The board of directors has determined that the payments made to its independent accountants for these services are compatible with maintaining such auditor’s independence.\nThe aggregate audit fees for 2016 and 2015 paid and payable to DYH & Company and Paritz & Company, P.A. were approximately $38,000 and $30,500, respectively. The amounts include: (1) fees for professional services rendered by DYH & Company and Paritz & Company, P.A. in connection with the audit of our consolidated financial statements; (2) reviews of our quarterly reports on the Form 10-Q.\n\n| 23 |\n\n\nAudit-Related Fees\nAudit-related fees for 2016 and 2015 were $nil.\nTax Fees\nTax service fees billed by Paritz & Co., P.A. as tax consultant for 2016 and 2015 were $3,400 and $2,750, respectively.\nAll Other Fees\nNone.\nPolicy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditors\nSince we did not have a formal audit committee, our board of directors served as our audit committee. We have not adopted pre-approval policies and procedures with respect to our accountants in 2016. All of the services provided and fees charged by our independent registered accounting firms in 2016 were approved by the board of directors.\n\n| 24 |\n\n\nPart IV\n\nITEM 15. Exhibits and Financial Statement Schedules\n\n| Exhibit No. | Description |\n| 31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934 |\n| 31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934 |\n| 32.1 | Certification of Chief Executive Officer, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2 | Certification of Chief Financial Officer, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS | XBRL Instance Document |\n| 101.SCH | XBRL Taxonomy Extension Schema Document |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document |\n\n\n| 25 |\n\n\nKiwa Bio-Tech Products Group Corporation\nSignatures\nPursuant to the requirements of Section 13 or 15(d) of the Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\nDate: April 17, 2017\n\n| KIWA BIO-TECH PRODUCTS GROUP CORPORATION. |\n| By: | /s/ Yvonne Wang |\n| Yvonne Wang Chief Executive Officer (Principal Executive Officer) |\n| By: | /s/ Yvonne Wang |\n| Yvonne Wang Chief Financial Officer (Principal Financial and Accounting Officer) |\n\nPursuant to the requirements of Section 13 or 15(d) of the Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf of the registrant and in the capacities and on the dates indicated.\n\n| /s/ Yvonne Wang | Chief Executive Officer and Director | April 17, 2017 |\n| Yvonne Wang | (Principal Executive Officer) |\n| /s/ Yvonne Wang | Chief Financial Officer | April 17, 2017 |\n| Yvonne Wang | (Principal Financial and Accounting Officer) |\n| /s/ Feng Li | Secretary and Director | April 17, 2017 |\n| Feng Li |\n| /s/ Qi Wang | Vice President of Technology and Director | April 17, 2017 |\n| Qi Wang |\n| /s/ Yong Lin Song | CTO, Director of Technology and Director | April 17, 2017 |\n| Yong Lin Song |\n\n\n| 26 |\n\n\nKiwa Bio-Tech Products Group Corporation\nIndex to Consolidated Financial Statements\n\n| Page |\n| Reports of Independent Registered Public Accounting Firms | F-1 |\n| Consolidated Balance Sheets | F-3 |\n| Consolidated Statements of Comprehensive Income (Loss) | F-4 |\n| Consolidated Statements of Stockholders’ Deficiency | F-5 |\n| Consolidated Statements of Cash Flows | F-6 |\n| Notes to Consolidated Financial Statements | F-7 |\n\n\n| 27 |\n\n\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\nTo Board of Directors and the Stockholders of\nKiwa Bio-Tech Products Group Corporation\nWe have audited the accompanying consolidated balance sheet of Kiwa Bio-Tech Products Group Corporations as of December 31, 2015 and the related consolidated statement of comprehensive loss, changes in stockholders’ deficiency and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.\nWe conducted our audit in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.\nIn our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kiwa Bio-Tech Products Group Corporation as of December 31, 2015, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.\n/s/ Paritz & Company, P.A.\nHackensack, New Jersey\nApril 14, 2016\n\n| F-1 |\n\n\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\nTo the Board of Directors and Stockholders of Kiwa Bio-Tech Products Group Corporation\nWe have audited the accompanying consolidated balance sheet of Kiwa Bio-Tech Products Group Corporation as of December 31, 2016, and the related statements of income, comprehensive income, stockholders’ equity, and cash flows for the year ended December 31, 2016. Kiwa Bio-Tech Products Group Corporation’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits.\nWe conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.\nIn our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Kiwa Bio-Tech Products Group Corporation as of December 31, 2016, and the results of its operations and its cash flows for the year ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America.\nThe accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 3 to the consolidated financial statements, the Company’s current liabilities substantially exceeded its current assets by $5,729,622 at December 31, 2016. Although the Company reported net income approximately $963,296 for its fiscal year ended December 31, 2016, it had an accumulated deficit of $19,489,400 as of December 31, 2016. These circumstances, among others, raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regarding to these matters are described in Note 3, which include raising additional equity financing. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.\n/s/ DYH & Company\nIrvine, California\nApril 17, 2017\n\n| F-2 |\n\n\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\nCONSOLIDATED BALANCE SHEETS\n\n| December 31, 2016 | December 31, 2015 |\n| ASSETS |\n| Current assets |\n| Cash and cash equivalents | $ | 13,469 | $ | 721 |\n| Accounts receivable | 1,122,754 | - |\n| Prepaid expenses | 92,504 | - |\n| Other receivable | 1,561,331 | 47,453 |\n| Advance to suppliers | 1,805,044 | - |\n| Total current assets | 4,595,102 | 48,174 |\n| Property, plant and equipment - net | 59,778 | 2,807 |\n| Deposit | 34,519 | - |\n| Goodwill | 34,112 | - |\n| Total non-current assets | 128,409 | 2,807 |\n| Total assets | $ | 4,723,511 | $ | 50,981 |\n| LIABILITIES AND STOCKHOLDERS’ DEFICIENCY |\n| Current liabilities |\n| Accounts payable | $ | 1,318,802 | $ | 269,360 |\n| Accrued expenses | 35,715 | 30,887 |\n| Advances from customers | 12,883 | 13,800 |\n| Construction costs payable | 255,539 | 273,722 |\n| Due to related parties - trade | 1,283,215 | 1,143,978 |\n| Due to related parties - non-trade | 100,798 | 3,166,198 |\n| Convertible notes payable | 150,250 | 150,250 |\n| Notes payable | 360,000 | 360,000 |\n| Unsecured loans payable | 1,655,343 | 1,773,131 |\n| Salary payable | 1,688,353 | 1,632,881 |\n| Taxes payable | 919,255 | 478,209 |\n| Penalty payable | 482,327 | 404,752 |\n| Interest payable | 1,042,661 | 930,062 |\n| Other payables | 1,019,583 | 524,205 |\n| Total current liabilities | 10,324,724 | 11,151,435 |\n| SHAREHOLDER’S EQUITY |\n| Preferred stock - $0.001 par value, Authorized 20,000,000 shares. Issued and outstanding 500,000 and 500,000 shares at December 31, 2016 and 2015, respectively. | 500 | 500 |\n| Common stock - $0.001 per value. Authorized 100,000,000 shares. Issued and outstanding $8,728,981 and 2,000,000 shares at December 31, 2016 and 2015 | 8,729 | 2,000 |\n| Additional paid-in capital | 13,789,990 | 9,490,837 |\n| Statutory Reserve | 127,884 | - |\n| Accumulated deficit | (19,489,400 | ) | (20,324,812 | ) |\n| Accumulated other comprehensive loss | (38,916 | ) | (268,979 | ) |\n| Total stockholders’ deficiency | (5,601,213 | ) | (11,100,454 | ) |\n| Total liabilities and shareholder’s equity | $ | 4,723,511 | $ | 50,981 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n\n| F-3 |\n\n\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)\n\n| Years Ended December 31, |\n| 2016 | 2015 |\n| Revenue | $ | 9,617,845 | $ | - |\n| Cost of goods sold | 7,672,451 | - |\n| Gross profit | 1,945,394 | - |\n| Operating expenses |\n| Research and development | 224,433 | 178,988 |\n| Selling expenses | 49,295 | - |\n| General and administrative | 874,097 | 313,589 |\n| Total operating expenses | 1,147,825 | 492,577 |\n| Operating income (loss) | 797,569 | (492,577 | ) |\n| Other income |\n| License revenue | 786,329 | - |\n| Other expense |\n| Penalty expense | (77,575 | ) | (72,152 | ) |\n| Interest expense | (112,977 | ) | (112,629 | ) |\n| Other expense | (3,770 | ) | - |\n| Total other expense | (194,322 | ) | (184,781 | ) |\n| Net income (loss) before income tax | 1,389,576 | (677,358 | ) |\n| Income tax provision | (426,280 | ) | - |\n| Net income (loss) | 963,296 | (677,358 | ) |\n| Other comprehensive income |\n| Foreign currency translation adjustment | 230,063 | 424,065 |\n| Total comprehensive income (loss) | $ | 1,193,359 | $ | (253,293 | ) |\n| Net income (loss) per common share - basic | $ | 0.17 | $ | (0.34 | ) |\n| Net income (loss) per common share - diluted | $ | 0.11 | $ | (0.34 | ) |\n| Weighted average number of common shares outstanding - basic | 5,645,263 | 2,000,000 |\n| Weighted average number of common shares outstanding - diluted | 8,872,655 | 2,000,000 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n\n| F-4 |\n\n\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\nCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ DEFICIENCY\n\n| Common Stock | Preferred Stock | Additional Paid-in | Statutory | Accumulated | Accumulated Other Comprehensive | Total Stockholders’ |\n| Shares | Amount | Shares | Amount | Capital | Reserve | Deficit | Loss | Deficiency |\n| Balance, December 31, 2014 (Restated) | 2,000,000 | $ | 2,000 | - | $ | - | $ | 8,491,337 | $ | - | $ | (19,647,454 | ) | $ | (693,044 | ) | $ | (11,847,161 | ) |\n| Issuance of 500,000 shares of preferred stock as debt cancellation on December 14, 2015 | - | - | 500,000 | 500 | 999,500 | - | - | 1,000,000 |\n| Net loss | - | - | - | - | - | (677,358 | ) | - | (677,358 | ) |\n| Foreign currency translation adjustment | - | - | - | - | - | - | - | 424,065 | 424,065 |\n| Balance, December 31, 2015 | 2,000,000 | 2,000 | 500,000 | 500 | 9,490,837 | - | (20,324,812 | ) | (268,979 | ) | (11,100,454 | ) |\n| Issuance of common shares for cash | 1,775,000 | 1,775 | - | - | 857,884 | - | 859,659 |\n| Issuance of common shares for Liabilities settlement | 3,243,173 | 3,243 | - | - | 3,188,731 | - | 3,191,974 |\n| Issuance of common shares for consulting service | 1,710,808 | 1,711 | - | - | 252,539 | - | 254,250 |\n| Net income | - | - | - | - | - | 127,884 | 835,412 | 963,296 |\n| Foreign currency translation adjustments | 230,063 | 230,063 |\n| Balance, December 31, 2016 | 8,728,981 | $ | 8,729 | 500,000 | $ | 500 | $ | 13,789,991 | $ | 127,884 | $ | (19,489,400 | ) | $ | (38,916 | ) | $ | (5,601,212 | ) |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n\n| F-5 |\n\n\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\nCONSOLIDATED STATEMENTS OF CASH FLOWS\n\n| Years Ended December 31, |\n| 2016 | 2015 |\n| Cash flows from operating activities: |\n| Net income (loss) | $ | 963,296 | $ | (677,358 | ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: |\n| Depreciation | 23,980 | 4,352 |\n| Bad debt | 55,240 | - |\n| Provision for penalty payable | 77,575 | 72,152 |\n| Accrued interest on convertible notes and note payable | 112,599 | 112,538 |\n| Changes in operating assets and liabilities: | - | - |\n| Accounts receivable | (1,229,249 | ) | - |\n| Other receivable | (1,619,623 | ) | - |\n| Advance to supplier | (1,887,446 | ) | - |\n| Prepaid expense | (59,154 | ) | - |\n| Deposit | (36,095 | ) | (33,921 | ) |\n| Account payable | 1,116,061 | - |\n| Accrued expense | 7,117 | - |\n| Salary payable | 93,860 | 125,924 |\n| Taxes payable | 494,397 | 62,915 |\n| Due to related parties - trade | 217,293 | 178,988 |\n| Other payables | 527,175 | 4,202 |\n| Net cash used in operating activities | (1,142,974 | ) | (150,208 | ) |\n| Cash flows from investing activities: |\n| Purchase of property, plant and equipment | (79,083 | ) | - |\n| Net cash used in investing activities | (79,083 | ) | - |\n| Cash flows from financing activities: |\n| Proceeds from related parties, net of payments to related parties | 139,085 | 148,009 |\n| Proceeds from sale of common stock | 914,273 | - |\n| Net cash provided by financing activities | 1,053,358 | 148,009 |\n| Effect of exchange rate change | 181,447 | (43 | ) |\n| Cash and cash equivalents: |\n| Net increase (decrease) | 12,748 | (2,242 | ) |\n| Balance at beginning of year | 721 | 2,963 |\n| Balance at end of year | $ | 13,469 | $ | 721 |\n| Non-cash financing activities: |\n| Issuance of common stock for debts settlement | $ | 3,137,359 | $ | 1,000,000 |\n| Issuance of common stock for consulting service | 254,250 |\n| Supplemental Disclosures of Cash flow Information: |\n| Cash paid for interest | $ | $ | - |\n| Cash paid for income taxes | $ | $ | - |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n\n| F-6 |\n\n\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\nNOTES TO CONSOLIDATED FINANCIAL STATEMENTS\nDECEMBER 31, 2016\n1. Description of Business and Organization\nOrganization – Kiwa Bio-Tech Products Group Corporation (“the Company”) is the result of a share exchange transaction accomplished on March 12, 2004 between the shareholders of Kiwa Bio-Tech Products Group Ltd. (“Kiwa BVI”), a company originally organized under the laws of the British Virgin Islands on June 5, 2002 and Tintic Gold Mining Company (“Tintic”), a corporation originally incorporated in the state of Utah on June 14, 1933 to perform mining operations in Utah. The share exchange resulted in a change of control of Tintic, with former Kiwa BVI stockholders owning approximately 89% of Tintic on a fully diluted basis and Kiwa BVI surviving as a wholly-owned subsidiary of Tintic. Subsequent to the share exchange transaction, Tintic changed its name to Kiwa Bio-Tech Products Group Corporation. On July 21, 2004, the Company completed its reincorporation in the State of Delaware. On March 8, 2017, we completed our reincorporation in the State of Nevada.\nThe Company operates through a series of subsidiaries in the Peoples Republic of China as detailed in the following Organizational Chart. The Company had previously operated its business through its subsidiaries Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Kiwa Shandong”) and Tianjin Kiwa Feed Co., Ltd. (“Kiwa Tianjin ”). Kiwa Tianjin has been dissolved since July, 11, 2012. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\nBusiness – The Company’s business plan is to develop and market innovative, manufacture, distribute cost-effective and environmentally safe bio-technological products for agriculture markets primarily in China. The Company has acquired technologies to produce and market bio-fertilizer.\n2. Summary of Significant Accounting Policies\nPrinciple of Consolidation - These consolidated financial statements include the financial statements of the Company and its wholly-owned subsidiaries, Kiwa BVI, Hong Kong Baina Group Holding Company, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd, Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Kiwa Shandong”). All significant inter-company balances or transactions are eliminated on consolidation.\nReverse Split - On January 14, 2016, the Company filed a Certificate of Amendment of its Certificate of Incorporation with the State of Delaware with reference to a 1-for-200 reverse stock split with respect to its Common Stock with effective date of January 28, 2016. In connection with the reverse split, the Company’s authorized capital was amended to be 120,000,000 shares, comprising 100,000,000 shares of Common Stock par value $0.001 and 20,000,000 shares of Preferred Stock par value $0.001. All relevant information relating to numbers of shares, options and per share information have been retrospectively adjusted to reflect the reverse stock split for all periods presented.\nUse of Estimates - The preparation of financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant accounting estimates include the valuation of securities issued, deferred tax assets and related valuation allowance.\n\n| F-7 |\n\n\nCertain of our estimates, including evaluating the collectability of accounts receivable and the fair market value of long-lived assets, could be affected by external conditions, including those unique to our industry, and general economic conditions. It is possible that these external factors could have an effect on our estimates that could cause actual results to differ from our estimates. We re-evaluate all of our accounting estimates annually based on these conditions and record adjustments when necessary.\nCash and Cash Equivalents\nThe Company considers all highly liquid investments with a maturity of three months or less to be cash and cash equivalents. At times, such investments may be in excess of Federal Deposit Insurance Corporation (FDIC) insurance limit.\nAccounts Receivables - Accounts receivables represent customer accounts receivables. The allowance for doubtful accounts is based on a combination of current sales, historical charge offs and specific accounts identified as high risk. Uncollectible accounts receivable are charged against the allowance for doubtful accounts when all reasonable efforts to collect the amounts due have been exhausted. Such allowances, if any, would be recorded in the period the impairment is identified.\nAllowance for doubtful accounts\nThe Company provides an allowance for doubtful accounts equal to the estimated uncollectible amounts. The Company’s estimate is based on historical collection experience and a review of the current status of trade accounts receivable. It is reasonably possible that the Company’s estimate of the allowance for doubtful accounts will change. There was no allowance for doubtful accounts at December 31, 2016 and December 31, 2015.\nInventories - Inventories are stated at the lower of cost, determined on the weighted average method, and net realizable value. Work in progress and finished goods are composed of direct material, direct labor and a portion of manufacturing overhead. Net realizable value is the estimated selling price in the ordinary course of business, less estimated costs to complete and dispose.\nProperty, plant and equipment - Property, plant and equipment are stated at cost less accumulated depreciation and accumulated impairment losses, if any. Gains or losses on disposals are reflected as gain or loss in the year of disposal. The cost of improvements that extend the life of property, plant and equipment are capitalized. These capitalized costs may include structural improvements, equipment and fixtures. All ordinary repair and maintenance costs are expensed as incurred. Depreciation for financial reporting purposes is provided using the straight-line method over the estimated useful lives of the assets as follows:\n\n| Useful Life |\n| (In years) |\n| Buildings | 30 - 35 |\n| Machinery and equipment | 5 - 10 |\n| Automobiles | 8 |\n| Office equipment | 2 - 5 |\n| Computer software | 3 |\n\nImpairment of Long-Lived Assets - The Company’s long-lived assets consist of property, equipment and intangible assets. The Company evaluates its investment in long-lived assets, including property and equipment, for recoverability whenever events or changes in circumstances indicate the net carrying amount may not be recoverable. Judgments regarding potential impairment are based on legal factors, market conditions and operational performance indicators, among others. In assessing the impairment of property and equipment, the Company makes assumptions regarding the estimated future cash flows and other factors to determine the fair value of the respective assets.\nFair value of warrants and options - The Company adopted ASC Topic 815, “Accounting for Derivative Instruments and Hedging Activities” to recognize warrants relating to loans and warrants issued to consultants as compensation as derivative instruments in our consolidated financial statements. The Company also adopted ASC Topic 718, “Share Based Payment” to recognize options granted to employees as derivative instruments in our consolidated financial statements. The Company calculates the fair value of the warrants and options using the Black-Scholes Model.\n\n| F-8 |\n\n\nRevenue Recognition – The Company applies paragraph 605-10-S99-1 of the FASB Accounting Standards Codification for revenue recognition. The Company recognizes revenue when it is realized or realizable and earned. The Company considers revenue realized or realizable and earned when all of the following criteria are met: (i) persuasive evidence of an arrangement exists, (ii) the product has been shipped or the services have been rendered to the customer, (iii) the sales price is fixed or determinable, and (iv) collectability is reasonably assured.\nThe Company derives its revenues from sales contracts with its customer with revenues being generated upon delivery of products. Persuasive evidence of an arrangement is demonstrated via invoice; and the sales price to the customer is fixed upon acceptance of the purchase order and there is no separate sales rebate, discount, or volume incentive.\nShipping and Handling Costs - Substantially all costs of shipping and handling of products to customers are included in selling. Shipping and handling costs for the years ended December 31, 2016 and 2015 were $480,892 and $ nil, respectively.\nIncome Taxes - The Company accounts for income taxes under the provisions of FASB ASC Topic 740, “Income Tax,” which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Deferred tax assets and liabilities are recognized for the future tax consequence attributable to the difference between the tax bases of assets and liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are measured using the enacted tax rate expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company establishes a valuation when it is more likely than not that the assets will not be recovered.\nASC Topic 740.10.30 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC Topic 740.10.40 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. We have no material uncertain tax positions for any of the reporting periods presented.\nForeign Currency Translation and Other Comprehensive Income - The Company uses United States dollars (“US Dollar” or “US$” or “$”) for financial reporting purposes. However, the Company maintains the books and records in its functional currency, Chinese Renminbi (“RMB”), being the primary currency of the economic environment in which its operations are conducted. In general, the Company translates its assets and liabilities into U.S. dollars using the applicable exchange rates prevailing at the balance sheet date, and the statement of comprehensive loss and the statement of cash flow are translated at average exchange rates during the reporting period. Equity accounts are translated at historical rates. Adjustments resulting from the translation of the Company’s financial statements are recorded as accumulated other comprehensive income.\nOther comprehensive income for the years ended December 31, 2016 and 2015 represented foreign currency translation adjustments and were included in the consolidated statements of comprehensive loss.\nThe exchange rates used to translate amounts in RMB into U.S. Dollars for the purposes of preparing the consolidated financial statements were as follows:\n\n| As of December 31, |\n| 2016 | 2015 |\n| Balance sheet items, except for equity accounts | 6.94 | 6.4857 |\n\n\n| Years ended December 31, |\n| 2016 | 2015 |\n| Items in the statements of comprehensive loss | 6.62 | 6.2281 |\n\nAdvertising Costs - The Company charges all advertising costs to expense as incurred. The total amounts of advertising costs charged to selling, general and administrative expense were $nil for the years ended December 31, 2016 and 2015, respectively.\nResearch and Development Costs - Research and development costs are charged to expense as incurred. During the years ended December 31, 2016 and 2015, research and development costs were $224,433 and $178,988, respectively.\n\n| F-9 |\n\n\nNet Loss Per Common Share - Basic loss per common share is calculated by dividing net loss attributable to Kiwa stockholders by the weighted-average number of shares of common stock outstanding during the period. Diluted loss per common share includes dilutive effect of dilutive securities (stock options, warrants, convertible debt, stock subscription and other stock commitments issuable). These potentially dilutive securities were not included in the calculation of loss per share for the periods presented because the Company incurred a loss during such periods and thus the effect would have been anti-dilutive. Accordingly, basic and diluted loss per common share is the same for all periods presented. As of December 31, 2016 and 2015, potentially dilutive securities aggregated 8,872,655 (632,204 post-reverse split shares) and 126,440,833 (632,204 post-reverse split shares) shares of common stock, respectively.\nFair Value of Financial Instruments\nThe Company follows paragraph 825-10-50-10 of the FASB Accounting Standards Codification for disclosures about fair value of its financial instruments and paragraph 820- 10-35-37 of the FASB Accounting Standards Codification (“Paragraph 820-10-35-37”) to measure the fair value of its financial instruments. Paragraph 820-10-35-37 establishes a framework for measuring fair value with U.S. GAAP, and expands disclosures about fair value measurements.\nTo increase consistency and comparability in fair value measurements and related disclosures, Paragraph 820-10-35-37 establishes a fair value hierarchy which prioritizes the inputs to valuation techniques used to measure fair value into three (3) broad levels. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The three (3) levels of fair value hierarchy defined by Paragraph 820-10-35-37 are described below:\n\n| ● | Level 1: quoted market prices available in active markets for identical assets or liabilities as of the reporting date. |\n| ● | Level 2: pricing inputs other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable as of the reporting date. |\n| ● | Level 3: Pricing inputs that are generally observable inputs and not corroborated by market data. |\n\nFinancial assets are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable.\nThe fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.\nThe fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.\nThe carrying amount of the Company’s financial assets and liabilities, such as cash and cash equivalent, prepaid expenses, accounts payable and accrued expenses, approximate their fair value because of the short maturity of those instruments.\nTransactions involving related parties cannot be presumed to be carried out on an arm’s-length basis, as the requisite conditions of competitive, free-market dealings may not exist. Representations about transactions with related parties, if made, shall not imply that the related party transactions were consummated on terms equivalent to those that prevail in arm’s-length transactions unless such representations can be substantiated.\nIt is not however practical to determine the fair value of advances from stockholders, if any, due to their related party nature.\n\n| F-10 |\n\n\nRelated Parties\nThe Company follows subtopic 850-10 of the FASB Accounting Standards Codification for the identification of related parties and disclosure of related party transactions. Pursuant to Section 850-10-20 the related parties include: a) affiliates of the Company; b) entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of Section 825–10–15, to be accounted for by the equity method by the investing entity; c) trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of management; d) principal owners of the Company; e) management of the Company; f) other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests; and g) other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly Influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.\nThe consolidated financial statements shall include disclosures of material related party transactions, other than compensation arrangements, expense allowances, and other similar items in the ordinary course of business. However, disclosure of transactions that are eliminated in the preparation of consolidated financial statements is not required in those statements. The disclosures shall include: a. the nature of the relationship(s) involved; b. a description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the consolidated financial statements; c. the dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period; and d. amounts due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement.\nCommitments and Contingencies\nThe Company follows subtopic 450-20 of the FASB Accounting Standards Codification to report accounting for contingencies. Certain conditions may exist as of the date the consolidated financial statements are issued, which may result in a loss to the Company but which will only be resolved when one or more future events occur or fail to occur. The Company assesses such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or unasserted claims that may result in such proceedings, the Company evaluates the perceived merits of any legal proceedings or unasserted claims as well as the perceived merits of the amount of relief sought or expected to be sought therein.\n\n| F-11 |\n\n\nIf the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s consolidated financial statements. If the assessment indicates that a potential material loss contingency is not probable but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, and an estimate of the range of possible losses, if determinable and material, would be disclosed.\nLoss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the guarantees would be disclosed. Management does not believe, based upon information available at this time that these matters will have a material adverse effect on the Company’s financial position, results of operations or cash flows. However, there is no assurance that such matters will not materially and adversely\nStock Based Compensation\nThe Company accounts for employee and non-employee stock awards under ASC 718, whereby equity instruments issued to employees for services are recorded based on the fair value of the instrument issued and those issued to non-employees are recorded based on the fair value of the consideration received or the fair value of the equity instrument, whichever is more reliably measurable.\nNo stock based compensation was issued or outstanding as of December 31, 2016 and 2015.\nIncome Tax Provision\nIncome taxes are accounted for using the asset and liability method. Deferred income taxes are provided for temporary differences in recognizing certain income, expense and credit items for financial reporting purposes and tax reporting purposes. Such deferred income taxes primarily relate to the difference between the tax basis of assets and liabilities and their financial reporting amounts. Deferred tax assets and liabilities are measured by applying enacted statutory tax rates applicable to the future years in which deferred tax assets or liabilities are expected to be settled or realized. There were no material deferred tax assets or liabilities as of December 31, 2016 and December 31, 2015.\nAs of December 31, 2016, and 2015, the Company did not identify any material uncertain tax positions. As of December 31, 2016, the Company’s returns are subject to examination by federal and state taxing authorities, generally for three years and four years, respectively, after they are filed.\nNet Income (Loss) Per Common Share\nNet income (loss) per common share is computed pursuant to section 260-10-45 of the FASB Accounting Standards Codification. Basic net income (loss) per common share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period.\n\n| F-12 |\n\n\nDiluted net income (loss) per common share is computed by dividing net income (loss) by the weighted average number of shares of common stock and potentially outstanding shares of common stock during the period to reflect the potential dilution that could occur from common shares issuable through contingent shares issuance arrangement, stock options or warrants.\nThere were no potentially dilutive debt or equity instruments issued and outstanding at any time during the twelve-month periods ended December 31, 2016 and 2015.\nCash Flows Reporting\nThe Company adopted paragraph 230-10-45-24 of the FASB Accounting Standards Codification for cash flows reporting, classifies cash receipts and payments according to whether they stem from operating, investing, or financing activities and provides definitions of each category, and uses the indirect or reconciliation method (“Indirect method”) as defined by paragraph 230-10-45-25 of the FASB Accounting Standards Codification to report net cash flow from operating activities by adjusting net income to reconcile it to net cash flow from operating activities by removing the effects of (a) all deferrals of past operating cash receipts and payments and all accruals of expected future operating cash receipts and payments and (b) all items that are included in net income that do not affect operating cash receipts and payments. The Company reports the reporting currency equivalent of foreign currency cash flows, using the current exchange rate at the time of the cash flows and the effect of exchange rate changes on cash held in foreign currencies is reported as a separate item in the reconciliation of beginning and ending balances of cash and cash equivalents and separately provides information about investing and financing activities not resulting in cash receipts or payments in the period pursuant to paragraph 830-230-45-1 of the FASB Accounting Standards Codification.\nSubsequent Events\nThe Company follows the guidance in Section 855-10-50 of the FASB Accounting Standards Codification for the disclosure of subsequent events. The Company will evaluate subsequent events through the date when the financial statements were issued. Pursuant to ASU 2010-09 of the FASB Accounting Standards Codification, the Company as an SEC filer considers its financial statements issued when they are widely distributed to users, such as through filing them on EDGAR.\nRecent accounting pronouncements\nIn November 2015, FASB issued ASU 2015-17, “Balance Sheet Classification of Deferred Taxes.” ASU 2015-17 requires that deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial position. ASU 2015-17 is effective for financial statements issued for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. The Company does not expect these changes to have a material impact on the Company’s consolidated financial statements.\nIn January 2016, Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-01, “Recognition and Measurement of Financial Assets and Financial Liabilities.” ASU 2016-01 requires equity investments to be measured at fair value with changes in fair value recognized in net income; simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; Eliminates the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet; requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; requires an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments; requires separate presentation of financial assets and financial liabilities by measurement category and form of financial assets on the balance sheet or the accompanying notes to the financial statements and clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets. ASU 2016-01 is effective for financial statements issued for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. The Company does not expect these changes to have a material impact on the Company’s consolidated financial statements.\n\n| F-13 |\n\n\nIn March 2016, the FASB issued ASU 2016-09—Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. The amendments in this guidance are relating to employee share-based compensation. Under the new guidance, we are required to recognize the tax effects of stock compensation as income tax expense or benefit in the income statement and treat the tax effects of exercised or vested awards as discrete items in the reporting period in which they occur. Excess tax benefits are required to be classified as operating activities, and shares we withhold on behalf of employees for tax purposes are required to be classified as financing activities. We may make an accounting policy election to continue to estimate the number of awards that are expected to vest or account for forfeitures when they occur. The threshold to qualify for equity classification permits withholding up to the maximum statutory tax rates. This guidance is required to be adopted in the first quarter of 2017. We are currently evaluating the impact this guidance will have on our consolidated financial statements.\nIn August 2016, the FASB issued ASU 2016-15—Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (a consensus of the Emerging Issues Task Force). The amendments in this guidance on eight specific cash flow issues with regard to how cash receipts and cash payments are presented and classified in the statement of cash flows in order to clarify existing guidance and reduce diversity in practice. The guidance is required to be adopted in the first quarter of 2018 on a retrospective basis, unless it is impracticable to apply, in which case it should be applied prospectively as of the earliest date practicable. Early adoption is permitted. We are currently evaluating the impact this guidance will have on our consolidated statement of cash flows.\nIn January 2017, the FASB issued ASU 2017-01, “Business Combinations (Topic 805): Clarifying the Definition of a Business.” The amendments in this guidance are clarifying the definition of a business to assist entities when determining whether an integrated set of assets and activities meets the definition of a business. The update provides that when substantially all the fair value of the assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets, the set is not a business. The guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The adoption of this new guidance is not expected to have a material impact on our consolidated financial statements.\nIn January 2017, the FASB issued ASU 2017-04—Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. The amendments in this guidance to eliminate the requirement to calculate the implied fair value of goodwill to measure goodwill impairment charge (Step 2). As a result, an impairment charge will equal the amount by which a reporting unit’s carrying amount exceeds its fair value, not to exceed the amount of goodwill allocated to the reporting unit. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. The amendment should be applied on a prospective basis. The guidance is effective for goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for goodwill impairment tests performed after January 1, 2017. The impact of this guidance for the Company will depend on the outcomes of future goodwill impairment tests.\nThere were other updates recently issued. The Company does not believe that other than disclosed above, the recently issued, but not yet adopted, accounting pronouncements will have a material impact on its financial position, results of operations or cash flows.\nGoodwill and Other Intangibles\nIn accordance with Accounting Standards Update (ASU) No. 2014-02, management evaluates goodwill on an annual basis in the fourth quarter of more frequently if management believes indicators of impairment exist. Such indicators could, but are not limited to (1) a significant adverse change in legal factors or in business climate, (2) unanticipated competition, or (3) an adverse action or assessment by a regulator. The Company first assesses qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, including goodwill. If management concludes that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, management conducts a two-step quantitative goodwill impairment test. The first step of the impairment test involves comparing the fair value of the applicable reporting unit with its carrying value. The Company estimates the fair value of its reporting units using a combination of the income, or discounted cash flows, approach and the market approach, with utilizes comparable companies’ data. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, management performs the second step of the goodwill impairment test. The second step of the goodwill impairment test involves comparing the implied fair value of the affected reporting unit’s goodwill with the carrying value of that goodwill. The amount, by which the carrying value of the goodwill exceeds its implied fair value, if any, is recognized as an impairment loss. The Company’s evaluation of goodwill completed during the year resulted in no impairment losses.\n3. Going Concern\nThe consolidated financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.\nAs of December 31, 2016, the Company’s current liabilities substantially exceeded its current assets by $5,729,622, had an accumulated deficit of $19,489,400, and stockholders’ deficiency of $5,601,213. These circumstances, among others, raise substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. The financial statements also do not include any adjustments relating to the recoverability and classification of recorded asset amounts, or amounts and classifications of liabilities that might be necessary should the Company be unable to continue as a going concern.\nThe management of the Company already raised additional equity during the first quarter of 2017 for approximately $1,000,000. (Please refer to Note 14 for additional information) The Company is generating additional revenue while seeking additional equity financing. Management is very optimistic about the Company’s continue profitability for the coming years.\n4. Property, Plant and Equipment\nProperty, plant and equipment, net consisted of the following:\n\n| December 31, 2016 | December 31, 2015 |\n| Property, Plant and Equipment |\n| Buildings | $ | - | $ | 1,308,785 |\n| Machinery and equipment | - | 595,623 |\n| Automobiles | - | 85,769 |\n| Office equipment | 942 | 104,843 |\n| Furniture | 8,276 | - |\n| Leasehold improvement | 70,871 | - |\n| Computer software | - | 22,304 |\n| Property, plant and equipment - total | $ | 80,089 | $ | 2,117,324 |\n| Less: accumulated depreciation | (20,311 | ) | (762,791 | ) |\n| Less: impairment on long-lived assets | - | (1,351,726 | ) |\n| Property, plant and equipment - net | $ | 59,778 | $ | 2,807 |\n\nThe building is on a piece of land the use right of which was granted to Kiwa Bio-Tech Products (Shandong) Co., Ltd. by local government free for 10 years and then for another 20 years on a fee calculated according to Kiwa Shandong’s net profit. Since Kiwa Shandong did not generate any net profit, no fee is payable.\nDepreciation expense was $22,340 and $4,352 for the years ended December 31, 2016 and 2015, respectively.\nImpairment on long-lived assets was $nil for the years ended December 31, 2016 and 2015, respectively.\nAll of our property, plant and equipment have been held as collateral to secure the 6% Notes (see Note 8).\n5. Goodwill\nOn November 30, 2015, Kiwa Bio-tech Products Group Ltd in BVI (\"Kiwa BVI\") entered an acquisition agreement with shareholders of Caber Holdings Ltd. (“Acquiree”) in Hong Kong to acquire 100 percent entity interest of the acquiree, including a wholly owned subsidiary, Oriental Baina Co., Ltd. in Beijing for US$30,000. The acquisition was completed in January, 2016. On the acquisition date, there was no any asset or liability acquired, and thus no fair value was allocated to asset and liability. Including legal fee and government fees, the total payment of approximately $34,112 ($30,000 plus legal fee and government fees totaled $4,112) was recorded as goodwill. The fair value of the goodwill is tested prior to the year-end 2016, and management determined there is no impairment to the goodwill as of December 31, 2016.\n6. Construction Costs Payable\nConstruction costs payable represents remaining amounts to be paid for the first phase of construction of bio-fertilizer facility in Shandong. The balance of construction costs payable as of December 31, 2016 and 2015 was $255,539 and $273,722, respectively.\n\n| F-14 |\n\n\n7. Related Party Transactions\nAmounts due to related parties consisted of the following as of December 31, 2016 and 2015:\n\n| Item | Nature | Notes | December 31, 2016 | December 31, 2015 |\n| Mr. Wei Li (“Mr. Li”) | Non-trade | (1 | ) | $ | - | $ | 2,879,307 |\n| Kangtai Xinnong Agriculture Tech (Beijing) Co., Ltd. (“Kangtai”) | Non-trade | (2 | ) | - | (12,173 | ) |\n| Ms. Yvonne Wang (“Ms. Wang”) | Non-trade | (3 | ) | 100,798 | 299,064 |\n| Subtotal | 100,798 | 3,166,198 |\n| Kiwa-CAU R&D Center | Trade | (4 | ) | 1,122,754 | 1,125,553 |\n| CAAS IARRP and IAED Institutes | Trade | (5 | ) | 160,461 | 18,425 |\n| Subtotal | 1,283,215 | 1,143,978 |\n| Total | $ | 1,384,013 | $ | 4,310,176 |\n\n(1) Mr. Li\nMr. Li was the Chairman of the Board until November 20, 2015 and was the Chief Executive Officer of the Company until July 1, 2015.\nAdvances and Loans\nOn December 14, 2015, Mr. Li assigned $500,000 of obligation owed by the Company to his daughter, Feng Li. On the same day, Feng Li subscribed for the purchase of 250,000 shares of preferred stock for the aggregate amount of $500,000, and agreed to the concurrent cancellation of debt owed by the Company.\nOn March 24, 2016, the Company issued 2,900,000 shares of common stock to Mr. Li to settle down entire outstanding balance of $2,879,307. Subsequently in June 2016, Mr. Li transferred 1,000,000 shares to Troniya Industria Incubator Co., Ltd as a personal collateral for RMB 3.2 million received in Kiwa Baiao Bio-Tech (Beijing) Co., Ltd.’s account.\nGuarantees for the Company\nMr. Li has pledged without any compensation from the Company all of his common stock of the Company as collateral for the Company’s obligations under the 6% Notes (see Note 9).\n(2) Kangtai\nKangtai is a private company and is 64% owned by Mr. Li. Mr. Li is the Chairman of Kangtai.\n(3) Ms. Wang\nMs. Wang is the Secretary of the Company until November 20, 2015. Effective as of November 20, 2015, the Company appointed Ms. Wang as the Chairman of the Board. Effective August 11, 2016, the Company’s Board of Directors has assigned Ms. Wang the additional titles of Acting President, Acting Chief Executive Officer and Acting Chief Financial Officer.\nOn December 14, 2015, Ms. Wang subscribed for the purchase of 250,000 shares of preferred stock for the aggregate amount of $500,000, and agrees to the concurrent cancellation of debt owed by the Company.\nOn March 24, 2016, the Company issued 240,000 shares of common stock to Ms. Wang to pay off the loan balance of $240,000. During the year ended December 31, 2016, Ms. Wang paid various expenses on behalf of the Company. As of December 31, 2016, the amount due to Ms. Wang was $100,798.\n\n| F-15 |\n\n\n(4) Kiwa-CAU R&D Center\nIn November 2006, Kiwa and China Agricultural University (the “CAU”) agreed to jointly establish a new research and development center, named Kiwa-CAU R&D Center. The term of the agreement was ten years commencing July 1, 2006.\n\n| ● | Pursuant to the agreement, Kiwa agree to invest RMB 1 million (approximately $160,000) each year to fund research at Kiwa-CAU R&D Center. Prof. Qi Wang, a director of the Company, is also the director of Kiwa-CAU R&D Center. The Company recorded $75,528 and $160,563 research and development expenses related to this R&D Center for the years ended December 31, 2016 and 2015, respectively. |\n\n(5) CAAS IARRP and IAED Institutes\nOn November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). The term of the Agreement was three years commencing November 20, 2015.\n\n| ● | Pursuant to the agreement, Kiwa agree to invest RMB 1 million (approximately $160,000) each year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. Prof. Yong Chang Wu, the authorized representative of IARRP, CAAS, is also one of the Company's directors effective since November 20, 2015 until March 13, 2017. The Company recorded $149,176 and $18,425 research and development expenses related to the institutes, for the years ended December 31, 2016 and 2015, respectively, |\n\nResearch and Development expenses for the years ended December 31, 2016 and 2015, totaled $224,704 and $178,988, respectively.\n8. Unsecured Loans Payable\nUnsecured loans payable consisted of the following:\n\n| Item | December 31, 2016 | December 31, 2015 |\n| Unsecured loan payable to Zoucheng Municipal Government, non-interest bearing, becoming due within three years from Kiwa Shandong’s first profitable year on a formula basis, interest has not been imputed due to the undeterminable repayment date | $ | 1,269,880 | $ | 1,387,668 |\n| Unsecured loan payable to Zoucheng Science & Technology Bureau, non-interest bearing, it is due in Kiwa Shandong’s first profitable year, interest has not been imputed due to the undeterminable repayment date | 385,463 | 385,463 |\n| Total | $ | 1,655,343 | $ | 1,773,131 |\n\nThe Company qualifies for non-interest bearing loans under a Chinese government sponsored program to encourage economic development in certain industries and locations in China. To qualify for the favorable loan terms, a company must meet the following criteria: (1) be a technology company with innovative technology or product (as determined by the Science Bureau of the central Chinese government); (2) operate in specific industries that the Chinese government has determined are important to encourage development, such as agriculture, environmental, education, and others; and (3) be located in an undeveloped area such as Zoucheng, Shandong Province, where the manufacturing facility of the Company is located.\nAccording to the Company’s project agreement, Zoucheng Municipal Government granted the Company use of at least 15.7 acres in Shandong Province, China at no cost for 10 years to construct a manufacturing facility. Under the agreement, the Company has the option to pay a fee of RMB 480,000 ($77,100) per acre for the land use right after the 10-year period until May 2012. The Company may not transfer or pledge the temporary land use right. The Company also committed to invest approximately $18 million to $24 million for developing the manufacturing and research facilities in Zoucheng, Shandong Province. As of December 31, 2016, the Company invested approximately $2 million for the property, plant and equipment of the project and these assets were impaired as of December 31, 2016.\n\n| F-16 |\n\n\n9. Convertible Notes Payable\nConvertible notes payable consists of 6% secured convertible notes issued to FirsTrust Group Inc. on June 29, 2006. The notes beard interest at 6% and were due on June 29, 2009. Once the note is pass due, the interest rate increased to 15% per annum. The Company accrued $22,977 and $22,538 interest expense on convertible notes for the years ended December 31, 2016 and 2015, respectively. Interest payable to FirstTrust Group Inc. totaled $183,361 and $160,762 at December 31, 2016 and 2015, respectively.\nThe conversion price of the 6% Notes is based on a 40% discount to the average of the trading price of the Company’s common stock on the OTC Bulletin Board over a 20-day trading period. The conversion price is also adjusted for certain subsequent issuances of equity securities of the Company at prices below the conversion price then in effect. The 6% Notes contain a volume limitation that prohibits the holder from further converting the 6% Notes if doing so would cause the holder and its affiliates to hold more than 4.99% of the Company’s outstanding common stock. In addition, the holder of the 6% Notes agrees that they may not convert more than their pro-rata share (based on original principal amount) of the greater of $120,000 principal amount of the 6% Notes per calendar month or the average daily dollar volume calculated during the 10 business days prior to a conversion, per conversion. This conversion limit has since been eliminated pursuant to an agreement by the Company and the Purchasers.\nThe Company incurs a financial penalty in cash or shares at the option of the Company (equal to 2% of the outstanding amount of the Notes per month plus accrued and unpaid interest on the Notes, prorated for partial months) if it breaches this or other affirmative covenants in the Purchase Agreement, including a covenant to maintain a sufficient number of authorized shares under its Certificate of Incorporation to cover at least 110% of the stock issuable upon full conversion of the Notes. Pursuant to the relevant provisions for liquidated damages in the Purchase Agreement, the Company has accrued the penalty of $77,575 and $72,152 for the years ended December 31, 2016 and 2015, respectively.\nThe 6% Notes require the Company to procure the Purchaser’s consent prior to taking certain actions including the payment of dividends, repurchasing stock, incurring debt, guaranteeing obligations, merging or restructuring the Company, or selling significant assets.\nThe Company’s obligations under the 6% Notes are secured by a first priority security interest in the Company’s intellectual property pursuant to an Intellectual Property Security Agreement with the Purchasers, and by a first priority security interest in all of the Company’s other assets pursuant to a Security Agreement with the Purchasers. In addition, Mr. Li, the Company’s former Chief Executive Officer until July 1, 2015, has pledged all of his common stock of the Company as collateral for the Company’s obligations under the 6% Notes. The intellectual property pledged had a cost of $592,901 which carrying value of $179,897 was fully impaired during the year ended December 31, 2009.\n\n| F-17 |\n\n\n10. Note payable\nOn May 29, 2007, the Company issued a $360,000 promissory note to an unrelated individual. This note bears interest at 18% per annum and due on July 27, 2007. This note is currently in default and bears interest of 25% per annum (the “Default rate”) until paid in full. This note is secured by a pledge of 6,178,336 (post-reverse split 30,892) shares of the Company’s common stock owned by Investlink (China) Limited, a British Virgin Island corporation. The Company accrued $90,000 and $90,000 interest expense on note payable for the years ended December 31, 2016 and 2015, respectively.\n11.Stockholders’ Deficiency\nOn December 14, 2015, the Company issued 500,000 shares of preferred stock for the aggregate amount of $1,000,000 as debt cancellation owed to two related party individuals (see Note 7).\nIn March, 2016, the Company issued 3,140,000 shares of common stock to Mr. Li and Ms. Wang for debt and salary payable settlement for an aggregate amount of $3,141,000 (See Note 7). In addition, the Company issued 101,947 common shares to Jimmy Zhou, former CEO in August 2016, to settle payable to him for $50,974. All of issuances of common shares for settlement of debts were based the stock price on the transaction dates.\nDuring the year, the Company issued 1,775,000 common shares for cash at $0.8 per share for an aggregate subscribe price equivalent to $1,420,000, of which $859,659 has received while approximately $560,341 remaining subscribe receivable at December 31, 2016.\nDuring the year ended December 31, 2016, the Company issued 1,711,808 common shares to four consulting companies as compensation for their consulting service received, totaled $254,250 approximately for the year ended December 31, 2016.\n12. Stock-based Compensation\nOn December 12, 2006, the Company granted options for 2,000,000 shares (10,000 post-reverse split shares) of its common stock under its 2004 Stock Incentive Plan. Summary of options issued and outstanding at December 31, 2016 and 2015 and the movements during the years then ended are as follows:\n\n| F-18 |\n\n\n\n| Number of underlying shares | Weighted- Average Exercise Price Per Share | Aggregate Intrinsic Value | Weighted- Average Contractual Life Remaining in Years |\n| Outstanding at December 31, 2014 | 6,163 | $ | 35 | $ | - | 2 |\n| Exercised | - | - | - |\n| Expired | - | - | - |\n| Forfeited | - | - | - |\n| Outstanding at December 31, 2015 | 6,163 | $ | 35 | $ | - | 1 |\n| Exercised | - | - | - |\n| Expired | 6,163 | $ | 35 | - |\n| Forfeited | - | - | - |\n| Outstanding at December 31, 2016 | - | - | $ | - | - |\n| Exercisable at December 31, 2016 | - | - | $ | - | - |\n\nAs of December 31, 2016, no stock options or other stock-based compensation was outstanding and all prior grants of stock options had expired as of that date.\n13. Income Tax\nIn accordance with the current tax laws in China, Kiwa Shandong is subject to a corporate income tax rate of 25% on its taxable income. However, Kiwa Shandong has not provided for any corporate income taxes since it had no taxable income for the years ended December 31, 2016 and 2015.\nNo provision for taxes is made for U.S. income tax as the Company has no taxable income in the U.S. In accordance with the relevant tax laws in the British Virgin Islands, Kiwa BVI, as an International Business Company, is exempt from income taxes.\nA reconciliation of the provision for income taxes determined at the local income tax rate to the Company’s effective income tax rate is as follows:\n\n| Years ended December 31, |\n| 2016 | 2015 |\n| Pre-tax income (loss) | $ | 1,389,576 | $ | (677,358 | ) |\n| U.S. federal corporate income tax rate | 34 | % | 34 | % |\n| Income tax computed at U.S. federal corporate income tax rate | 472,456 | (230,302 | ) |\n| Reconciling items: |\n| Rate differential for PRC earnings | (139,923 | ) | 22,439 |\n| Change of valuation allowance | 301,813 | 171,993 |\n| Non-deductible expenses | (208,066 | ) | 35,870 |\n| Effective tax expense | $ | 426,280 | $ | - |\n\n\n| F-19 |\n\n\nThe Company had deferred tax assets as follows:\n\n| December 31, 2016 | December 31, 2015 |\n| Net operating losses carried forward | $ | 3,475,563 | $ | 3,398,402 |\n| Less: Valuation allowance | (3,475,563 | ) | (3,398,402 | ) |\n| Net deferred tax assets | $ | - | $ | - |\n\nAs of December 31, 2016 and 2015, the Company had approximately $3.5 million and $8 million net operating loss carryforwards available to reduce future taxable income. Net operating loss of the Company could be carried forward and taken against any taxable income for a period of not more than twenty years from the year of the initial loss pursuant to Section 172 of the Internal Revenue Code of 1986, as amended. The net operating loss of Kiwa Shandong could be carried forward for a period of not more than five years from the year of the initial loss pursuant to relevant PRC tax laws and regulations. It is more likely than not that the deferred tax assets cannot be utilized in the future because there will not be significant future earnings from the entity which generated the net operating loss. Therefore, the Company recorded a full valuation allowance on its deferred tax assets.\nAs of December 31, 2016 and 2015, the Company has no material unrecognized tax benefits which would favorably affect the effective income tax rate in future periods and does not believe that there will be any significant increases or decreases of unrecognized tax benefits within the next twelve months. No interest or penalties relating to income tax matters have been imposed on the Company during the two years ended December 31, 2016 and 2015, and no provision for interest and penalties is deemed necessary as of December 31, 2016 and 2015.\nAccording to the PRC Tax Administration and Collection Law, the statute of limitations is three years if the underpayment of taxes is due to computational errors made by the taxpayer or its withholding agent. The statute of limitations extends to five years under special circumstances, which are not clearly defined. In the case of a related party transaction, the statute of limitation is ten years. There is no statute of limitation in the case of tax evasion.\n14. Commitments and Contingencies\nThe Company has the following material contractual obligations:\n(1) Investment in manufacturing and research facilities in Zoucheng, Shandong Province in China\nAccording to the Project Agreement with Zoucheng Municipal Government in 2002, we have committed to investing approximately $18 million to $24 million for developing the manufacturing and research facilities in Zoucheng, Shandong Province. As of December 31, 2016, we had invested approximately $1.91 million for the project. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\n(2) Strategic cooperation with two institutes in China\nOn November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). Pursuant to the Agreement, the Company will form a strategic partnership with the two institutes and establish an “International Cooperation Platform for Internet and Safe Agricultural Products”. To fund the cooperation platform’s R&D activities, the Company will provide RMB 1 million (approximately $160,000) per year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. The term of the Agreement is for three years beginning November 20, 2015. Prof. Yong Chang Wu, the authorized representative of IARRP, CAAS, is also one of the Company’s directors effective since November 20, 2015 until March 13, 2017.\n\n| F-20 |\n\n\n(3) Distribution agreement with Kangtan Gerui Bio-Tech in China\nOn December 17, 2015, Kiwa Bio-Tech Products Group Corporation (the “Company”) entered into a distribution agreement (the “Agreement”) with Kangtan Gerui (Beijing) Bio-Tech Co., Ltd. (“Gerui”) and formally awarded Gerui a right to sell and distribute the Company’s fertilizer products in 3 major agricultural regions of China— Hainan Province, Hunan Province and Xinjiang Autonomous Region. The Company’s Research and Development department has been conducting application experiments in Hainan and Hunan Provinces since August 2015, in accordance with the market requirements. The experiment data indicates that the Company’s fertilizer products have fulfill the requirements of reduction of content of heavy metals in soil and improve crop yield. Gerui was founded in Beijing in April 2015 and relies on the sales network of China’s Supply and Marketing Cooperatives system. Currently, the Company and Gerui do not hold any interest in each other; however, a collaboration and integration may take place in the future. The term of the Agreement is for a period of three years commencing December 17, 2015. In September 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd obtained a fertilizer sales permit from the Chinese government and began to sale the products directly to customers in those 3 major agricultural regions.\n(4) Lease payments\n(1) On April 29, 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. entered an office lease agreement with two-year team. Monthly lease payment and building management fee totaled RMB 77,867 or approximately USD $11,622.\n(2) On November 11, 2017, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. entered an apartment lease agreement for its employees. The lease term is one year with monthly lease payment of RMB 6,000 or approximately USD $896.\n(3) In March 1, 2017, Kiwa Bio-Tech (Shenzhen) Co., Ltd, a newly established subsidiary entered an office lease agreement with one-year term. Monthly lease payment is RMB 29,000 or approximately of USD $4,320.\nThe future lease payments at December 31, 2016 are summarized below.\n\n| Beijing Office | Beijing Apartment | Shenzhen Office | Total |\n| 2017 | $ | 139,462 | $ | 3,632 | $ | 4,328 | $ | 147,422 |\n| 2018 | $ | 44,555 | - | - | $ | 44,555 |\n| Thereafter | - | - | - | - |\n\n15. Subsequent Events\nThe Company has evaluated the existence of significant events subsequent to the balance sheet date through the date these financial statements were issued and has determined that there were no subsequent events or transactions which would require recognition or disclosure in the financial statements, other than noted herein.\nOn February 11, 2017, the Company executed an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) whereby the Company transferred all of its right, title and interest in Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Shandong”) to the Transferee for the RMB equivalent of US$1.00. In connection with the transaction, the Transferee received all assets of Shandong which are estimated to be approximately RMB 14,057,713 at the effective date and assumed all liabilities of Shandong which are estimated to be approximately RMB 59,446,513 at the effective date. In connection with this transaction, Transferee agreed to indemnify the Company for any liability or claims of any third party(ies) against Shandong or the Company for five (5) years. The transaction is subject to obtaining Chinese government approval for the transaction, which the parties agrees to use their best efforts to obtain prior to December 31, 2017. The completion of transfer is under government processing.\n\n| F-21 |\n\n\nOn February 15, 2017, the Company completed the sale of 1,000,000 shares of Kiwa Common Stock (each a “Share”) at a price of $1.00 per share (total sale proceeds were $1,000,000) to Junwei Zheng in a private transaction which was exempt from registration under Section 4(a)(2) of the Securities Act of 1933, as amended (the “Act”) and Regulation S promulgated under the Act since, among other things, the transaction did not involve a public offering and the securities were acquired for investment purposes only and not with a view to or for sale in connection with any distribution thereof and were purchased by an investor who is not a resident of the United States. The net proceeds will be used for the further development of Kiwa products and distribution, as well as for general working capital.\nOn February 23, 2017, the Company has agreed to a strategic relationship with ETS (Tianjin) Biological Science and Technology Development Co., Ltd. (“ETS”). The partnership will include the deployment and strategic use of ETS biotechnology to produce of bio-fertilizers for use in both China and internationally. Kiwa and ETS, together with the certain Chinese government departments, will work together to enhance China’s microbial fertilizer industry standards and China’s food safety industry chain standards. The parties will work together on the development of microbial technology and products in agriculture, environmental protection, soil management and other fields. Relying on the Chinese Academy of Sciences, ETS Environmental and Agricultural Microbial Technology Research Center and biotechnology project research results, Kiwa has introduced the ETS core technology to complete bio-fertilizer upgrading, transformation and to develop new product lines. In order to meet the growing global consumer demand to increase food supply and develop sustainable farming we are applying sustainable use of biotechnology and the use of biotechnology products to replace chemical products, which will strengthen environmental protection and promote international cooperation. As a result of strict management of many agricultural chemicals, such chemicals will continue to be abandoned, resulting is a growing demand for bio-fertilizers. It has been widely accepted that the application of ETS biotechnology facilitates agricultural sustainability and helps to protect the soil and improve grain output. The technology focuses on keeping soil healthy by restoring healthy microbes that are naturally present in healthy soils. As the technology gains worldwide recognition, it is imperative to popularize bio-fertilizer in developing countries to fulfill the needs of growing populations and promote environmentally friendly agriculture. Through the cooperation of Kiwa and ETS, the parties aim to enhance the usage of the bio-fertilizers in China. The cooperation will bring technological transformation and support for Kiwa to improve its existing manufacturing techniques. Kiwa and ETS will also collaborate to establish a comprehensive platform for producing, supplying, and marketing in China. Ultimately, Kiwa would look to introduce these products to the international market, including the United States.\nOn February 27, 2017, the Company has signed a strategic cooperation agreement with the Beijing Zhongpin Agricultural Science and Technology Development Center (“Zhongpin Center”). Zhongpin Center is the Chinese Agricultural Science and Technology Innovation and Development Committee’s executive implementation agency (referred to as the Agricultural Science and Technology Commission). The Agricultural Science and Technology Commission is set up by the Chinese Central Government for the construction of the National Ecological Security Agriculture Industrial Chain standardization system. This includes the establishment of National Ecology Safe Agricultural Industrial Parks to build China’s Ecological Security and Agricultural Industrial in an orderly business environment, including completion of the National Soil Remediation Program and governance of the various government functions of the institutions. Through the guidance and support by the Zhongpin Center, Kiwa will participate and be involved in China’s National Soil Remediation Program and construction of the National Ecological Security Agriculture Industrial Chain Standardization System’s operation and process.\nOn March 8, 2017, pursuant to the consent of the holders of a majority of the votes entitled to be cast on the matter and the approval of the majority of the directors of the Company, the Company was converted from a Delaware corporation to a Nevada corporation by filing of Articles of Conversion and Articles of Incorporation in the State of Nevada and filing a Certificate of Dissolution in the State of Delaware.\nOn March 8, 2017, pursuant to the consent of the holders of a majority of the votes entitled to be cast on the matter and the approval of the Kiwa Bio-Tech Products Group Corporation 2016 Employee, Director and Consultant Stock Plan.\nOn March 13, 2017, Yong Change Wu was removed as a director of the Company by the consent of the holders of a majority of the votes entitled to be cast on the matter and the approval of the majority of the directors of the Company. Immediately thereafter, the Board appointed Yong Lin Song as a director of the Company to be effective immediately.\n\n| F-22 |\n\n\n\n</text>\n\nWhat is the total amount spent by the company on research and development, and acquisitions from 2004 to 2016 in US dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"ground_truth": "Therefore, the answer is 2517503.0."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nITEM 1. FINANCIAL STATEMENTS\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED BALANCE SHEETS\n(UNAUDITED)\n\n| September 30, | December 31, |\n| (in thousands, except share data) | 2022 | 2021 |\n| ASSETS |\n| Current assets |\n| Cash and cash equivalents | $ | 96,215 | $ | 164,622 |\n| Restricted cash | 18,079 | 16,015 |\n| Accounts receivable, net of allowance for expected credit losses of $ 13,648 and $ 15,916 , respectively | 833,432 | 797,677 |\n| Prepaid expenses and other current assets | 155,429 | 126,000 |\n| Total current assets | 1,103,155 | 1,104,314 |\n| Property and equipment, net | 69,084 | 63,696 |\n| Goodwill | 2,246,053 | 2,206,004 |\n| Other intangible assets, net | 2,150,075 | 2,287,514 |\n| Investments in unconsolidated affiliates | 124,815 | 125,158 |\n| Other assets | 120,644 | 67,582 |\n| Total assets | $ | 5,813,826 | $ | 5,854,268 |\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\n| Current liabilities |\n| Current portion of long-term debt | $ | 14,704 | $ | 14,397 |\n| Accounts payable | 267,684 | 277,366 |\n| Accrued compensation and benefits | 109,935 | 139,157 |\n| Other accrued expenses | 161,246 | 164,133 |\n| Deferred revenues | 47,441 | 50,467 |\n| Total current liabilities | 601,010 | 645,520 |\n| Long-term debt, net of current portion | 2,024,591 | 2,028,882 |\n| Deferred income tax liabilities | 456,755 | 483,165 |\n| Warrant liability | 733 | 22,189 |\n| Other long-term liabilities | 109,421 | 92,218 |\n| Total liabilities | 3,192,510 | 3,271,974 |\n| Commitments and contingencies (Note 10) |\n| Redeemable noncontrolling interest | 3,353 | 1,893 |\n| Equity attributable to stockholders of Advantage Solutions Inc. |\n| Common stock, $ 0.0001 par value, 3,290,000,000 shares authorized; 319,675,888 and 316,963,552 shares issued and outstanding as of September 30, 2022 and December 31, 2021, respectively | 32 | 32 |\n| Additional paid in capital | 3,398,477 | 3,373,278 |\n| Accumulated deficit | ( 823,212 | ) | ( 866,607 | ) |\n| Loans to Karman Topco L.P. | ( 6,357 | ) | ( 6,340 | ) |\n| Accumulated other comprehensive loss | ( 29,978 | ) | ( 4,479 | ) |\n| Treasury stock, at cost; 1,610,014 shares as of September 30, 2022 and December 31, 2021 | ( 12,567 | ) | ( 12,567 | ) |\n| Total equity attributable to stockholders of Advantage Solutions Inc. | 2,526,395 | 2,483,317 |\n| Nonredeemable noncontrolling interest | 91,568 | 97,084 |\n| Total stockholders’ equity | 2,617,963 | 2,580,401 |\n| Total liabilities, redeemable noncontrolling interest, and stockholders’ equity | $ | 5,813,826 | $ | 5,854,268 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n3\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME\n(UNAUDITED)\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (in thousands, except share and per share data) | 2022 | 2021 | 2022 | 2021 |\n| Revenues | $ | 1,051,095 | $ | 928,760 | $ | 2,946,979 | $ | 2,569,735 |\n| Cost of revenues (exclusive of depreciation and amortization shown separately below) | 908,523 | 766,253 | 2,536,256 | 2,117,818 |\n| Selling, general, and administrative expenses | 37,945 | 37,742 | 138,594 | 124,830 |\n| Depreciation and amortization | 57,785 | 59,163 | 173,997 | 181,450 |\n| Total operating expenses | 1,004,253 | 863,158 | 2,848,847 | 2,424,098 |\n| Operating income | 46,842 | 65,602 | 98,132 | 145,637 |\n| Other (income) expenses: |\n| Change in fair value of warrant liability | ( 1,100 | ) | ( 3,491 | ) | ( 21,456 | ) | ( 5,024 | ) |\n| Interest expense, net | 23,557 | 36,490 | 63,628 | 104,544 |\n| Total other expenses | 22,457 | 32,999 | 42,172 | 99,520 |\n| Income before income taxes | 24,385 | 32,603 | 55,960 | 46,117 |\n| Provision for income taxes | 1,158 | 8,276 | 11,523 | 16,582 |\n| Net income | 23,227 | 24,327 | 44,437 | 29,535 |\n| Less: net income attributable to noncontrolling interest | 2,168 | 1,016 | 1,042 | 219 |\n| Net income attributable to stockholders of Advantage Solutions Inc. | 21,059 | 23,311 | 43,395 | 29,316 |\n| Other comprehensive loss, net of tax: |\n| Foreign currency translation adjustments | ( 13,616 | ) | ( 2,443 | ) | ( 25,499 | ) | ( 4,239 | ) |\n| Total comprehensive income attributable to stockholders of Advantage Solutions Inc. | $ | 7,443 | $ | 20,868 | $ | 17,896 | $ | 25,077 |\n| Net income per common share: |\n| Basic | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n| Diluted | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n| Weighted-average number of common shares: |\n| Basic | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\n| Diluted | 319,725,065 | 320,120,634 | 319,190,804 | 319,654,817 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n4\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\n(UNAUDITED)\n\n| Accumulated | Advantage |\n| Common Stock | Treasury Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at July 1, 2022 | 318,465,449 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,390,899 | $ | ( 844,271 | ) | $ | ( 6,351 | ) | $ | ( 16,362 | ) | $ | 2,511,380 | $ | 90,109 | $ | 2,601,489 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | — | — | 21,059 | — | — | 21,059 | 2,092 | 23,151 |\n| Foreign currency translation adjustments | — | — | — | — | — | — | — | ( 13,616 | ) | ( 13,616 | ) | ( 6,824 | ) | ( 20,440 | ) |\n| Total comprehensive income (loss) | 7,443 | ( 4,732 | ) | 2,711 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | — | — | ( 6 | ) | — | ( 6 | ) | — | ( 6 | ) |\n| Increase in noncontrolling interest | — | — | — | — | — | — | — | — | — | 6,191 | 6,191 |\n| Equity-based compensation of Karman Topco L.P. | — | — | — | — | ( 828 | ) | — | — | — | ( 828 | ) | — | ( 828 | ) |\n| Shares issued under 2020 Employee Stock Purchase Plan | 470,786 | — | — | — | 1,667 | — | — | — | 1,667 | — | 1,667 |\n| Shares issued under 2020 Incentive Award Plan | 739,653 | — | — | — | — | — | — | — | — | — | — |\n| Stock-based compensation expense | — | — | — | — | 6,739 | — | — | — | 6,739 | — | 6,739 |\n| Balance at September 30, 2022 | 319,675,888 | $ | 32 | $ | 1,610,014 | $ | ( 12,567 | ) | $ | 3,398,477 | $ | ( 823,212 | ) | $ | ( 6,357 | ) | $ | ( 29,978 | ) | $ | 2,526,395 | $ | 91,568 | $ | 2,617,963 |\n\n\n| Accumulated | Advantage |\n| Common Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at July 1, 2021 | 318,496,390 | $ | 32 | $ | 3,361,262 | $ | ( 915,096 | ) | $ | ( 6,328 | ) | $ | ( 1,122 | ) | $ | 2,438,748 | $ | 95,916 | $ | 2,534,664 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | 23,311 | — | — | 23,311 | 973 | 24,284 |\n| Foreign currency translation adjustments | — | — | — | — | — | ( 2,443 | ) | ( 2,443 | ) | ( 2,305 | ) | ( 4,748 | ) |\n| Total comprehensive income (loss) | 20,868 | ( 1,332 | ) | 19,536 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | ( 6 | ) | — | ( 6 | ) | — | ( 6 | ) |\n| Redemption of noncontrolling interest | — | — | ( 16 | ) | — | — | — | ( 16 | ) | — | ( 16 | ) |\n| Equity-based compensation of Karman Topco L.P. | — | — | ( 6,030 | ) | — | — | — | ( 6,030 | ) | — | ( 6,030 | ) |\n| Shares issued upon exercise of warrants | 1 | — | — | — | — | — | — | — | — |\n| Shares issued under 2020 Employee Stock Purchase Plan | 77,172 | — | 736 | — | — | — | 736 | — | 736 |\n| Stock-based compensation expense | — | — | 8,413 | — | — | — | 8,413 | — | 8,413 |\n| Balance at September 30, 2021 | 318,573,563 | $ | 32 | $ | 3,364,365 | $ | ( 891,785 | ) | $ | ( 6,334 | ) | $ | ( 3,565 | ) | $ | 2,462,713 | $ | 94,584 | $ | 2,557,297 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n5\n\n| Accumulated | Advantage |\n| Common Stock | Treasury Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at January 1, 2022 | 316,963,552 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,373,278 | $ | ( 866,607 | ) | $ | ( 6,340 | ) | $ | ( 4,479 | ) | $ | 2,483,317 | $ | 97,084 | $ | 2,580,401 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | — | — | 43,395 | — | — | 43,395 | 918 | 44,313 |\n| Foreign currency translation adjustments | — | — | — | — | — | — | — | ( 25,499 | ) | ( 25,499 | ) | ( 12,625 | ) | ( 38,124 | ) |\n| Total comprehensive income (loss) | — | — | — | — | — | — | — | — | 17,896 | ( 11,707 | ) | 6,189 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | — | — | ( 17 | ) | — | ( 17 | ) | — | ( 17 | ) |\n| Increase in noncontrolling interest | — | — | — | — | — | — | — | — | — | 6,191 | 6,191 |\n| Equity-based compensation of Karman Topco L.P. | — | — | — | — | ( 7,142 | ) | — | — | — | ( 7,142 | ) | — | ( 7,142 | ) |\n| Shares issued under 2020 Employee Stock Purchase Plan | 713,213 | — | — | — | 3,320 | — | — | — | 3,320 | — | 3,320 |\n| Shares issued under 2020 Incentive Award Plan | 1,999,123 | — | — | — | — | — | — | — | — | — | — |\n| Stock-based compensation expense | — | — | — | — | 29,021 | — | — | — | 29,021 | — | 29,021 |\n| Balance at September 30, 2022 | 319,675,888 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,398,477 | $ | ( 823,212 | ) | $ | ( 6,357 | ) | $ | ( 29,978 | ) | $ | 2,526,395 | $ | 91,568 | $ | 2,617,963 |\n\n\n| Accumulated | Advantage |\n| Common Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at January 1, 2021 | 318,425,182 | $ | 32 | $ | 3,348,546 | $ | ( 921,101 | ) | $ | ( 6,316 | ) | $ | 674 | $ | 2,421,835 | $ | 96,954 | $ | 2,518,789 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | 29,316 | — | — | 29,316 | 190 | 29,506 |\n| Foreign currency translation adjustments | — | — | — | — | — | ( 4,239 | ) | ( 4,239 | ) | ( 2,796 | ) | ( 7,035 | ) |\n| Total comprehensive income (loss) | 25,077 | ( 2,606 | ) | 22,471 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | ( 18 | ) | — | ( 18 | ) | — | ( 18 | ) |\n| Redemption of noncontrolling interest | — | — | ( 452 | ) | — | — | — | ( 452 | ) | 236 | ( 216 | ) |\n| Equity-based compensation of Karman Topco L.P. | — | — | ( 13,140 | ) | — | — | — | ( 13,140 | ) | — | ( 13,140 | ) |\n| Shares issued under 2020 Incentive Award Plan | 24,784 | — | — | — | — | — | — | — | — |\n| Shares issued upon vesting of restricted stock units | 41,424 | — | — | — | — | — | — | — | — |\n| Shares issued under 2020 Employee Stock Purchase Plan | 77,172 | — | 736 | — | — | — | 736 | — | 736 |\n| Shares issued upon exercise of warrants | 5,001 | — | 58 | — | — | — | 58 | — | 58 |\n| Stock-based compensation expense | — | — | 28,617 | — | — | — | 28,617 | — | 28,617 |\n| Balance at September 30, 2021 | 318,573,563 | $ | 32 | $ | 3,364,365 | $ | ( 891,785 | ) | $ | ( 6,334 | ) | $ | ( 3,565 | ) | $ | 2,462,713 | $ | 94,584 | $ | 2,557,297 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n6\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(UNAUDITED)\n\n| Nine Months Ended September 30, |\n| (in thousands) | 2022 | 2021 |\n| CASH FLOWS FROM OPERATING ACTIVITIES |\n| Net income | $ | 44,437 | $ | 29,535 |\n| Adjustments to reconcile net income to net cash provided by operating activities |\n| Noncash interest (income) expense, net | ( 34,419 | ) | 2,893 |\n| Depreciation and amortization | 173,997 | 181,450 |\n| Change in fair value of warrant liability | ( 21,456 | ) | ( 5,024 | ) |\n| Fair value adjustments related to contingent consideration | 5,448 | 6,977 |\n| Deferred income taxes | ( 28,561 | ) | ( 17,468 | ) |\n| Equity-based compensation of Karman Topco L.P. | ( 7,142 | ) | ( 13,140 | ) |\n| Stock-based compensation | 29,906 | 28,617 |\n| Equity in earnings of unconsolidated affiliates | ( 6,480 | ) | ( 6,222 | ) |\n| Distribution received from unconsolidated affiliates | 1,339 | 1,154 |\n| Loss on disposal of property and equipment | 608 | 6,327 |\n| Loss on divestiture | 2,953 | — |\n| Changes in operating assets and liabilities, net of effects from purchases of businesses: |\n| Accounts receivable, net | ( 45,383 | ) | ( 121,036 | ) |\n| Prepaid expenses and other assets | ( 45,087 | ) | ( 64,716 | ) |\n| Accounts payable | ( 7,914 | ) | 37,294 |\n| Accrued compensation and benefits | ( 26,316 | ) | 16,684 |\n| Deferred revenues | ( 156 | ) | 2,869 |\n| Other accrued expenses and other liabilities | 46,176 | 14,874 |\n| Net cash provided by operating activities | 81,950 | 101,068 |\n| CASH FLOWS FROM INVESTING ACTIVITIES |\n| Purchase of businesses, net of cash acquired | ( 74,146 | ) | ( 40,046 | ) |\n| Purchase of investment in unconsolidated affiliates | ( 775 | ) | ( 2,000 | ) |\n| Purchase of property and equipment | ( 30,037 | ) | ( 24,106 | ) |\n| Proceeds from divestiture | 1,896 | — |\n| Net cash used in investing activities | ( 103,062 | ) | ( 66,152 | ) |\n| CASH FLOWS FROM FINANCING ACTIVITIES |\n| Borrowings under lines of credit | 140,333 | 51,685 |\n| Payments on lines of credit | ( 139,684 | ) | ( 102,493 | ) |\n| Proceeds from issuance of long-term debt | 266 | — |\n| Principal payments on long-term debt | ( 10,427 | ) | ( 10,133 | ) |\n| Proceeds from issuance of common stock | 3,320 | 794 |\n| Contingent consideration payments | ( 23,164 | ) | ( 6,247 | ) |\n| Holdback payments | ( 8,557 | ) | ( 2,389 | ) |\n| Contribution from noncontrolling interest | 5,217 | — |\n| Redemption of noncontrolling interest | ( 224 | ) | ( 216 | ) |\n| Net cash used in financing activities | ( 32,920 | ) | ( 68,999 | ) |\n| Net effect of foreign currency changes on cash | ( 12,311 | ) | ( 1,476 | ) |\n| Net change in cash, cash equivalents and restricted cash | ( 66,343 | ) | ( 35,559 | ) |\n| Cash, cash equivalents and restricted cash, beginning of period | 180,637 | 219,966 |\n| Cash, cash equivalents and restricted cash, end of period | $ | 114,294 | $ | 184,407 |\n| SUPPLEMENTAL CASH FLOW INFORMATION |\n| Purchase of property and equipment recorded in accounts payable and accrued expenses | $ | 1,409 | $ | 322 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n7\nADVANTAGE SOLUTIONS INC.\nNOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(UNAUDITED)\n1. Organization and Significant Accounting Policies Advantage Solutions Inc. (the “Company”) is a provider of outsourced solutions to consumer goods companies and retailers. The Company’s Class A common stock is listed on the Nasdaq Global Select Market under the symbol “ADV” and warrants to purchase the Class A common stock at an exercise price of $ 11.50 per share are listed on the Nasdaq Global Select Market under the symbol “ADVWW”. Basis of Presentation The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its subsidiaries. The unaudited condensed consolidated financial statements do not include all of the information required by accounting principles generally accepted in the United States (“GAAP”). The Condensed Consolidated Balance Sheet at December 31, 2021 was derived from the audited Consolidated Balance Sheet at that date and does not include all the disclosures required by GAAP. In the opinion of management, all adjustments which are of a normal recurring nature and necessary for a fair statement of the results as of September 30, 2022 and for the three and nine months ended September 30, 2022 and 2021 have been reflected in the condensed consolidated financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements as of and for the year ended December 31, 2021 and the related footnotes thereto. Operating results for the three and nine months ended September 30, 2022 are not necessarily indicative of the results to be expected during the remainder of the current year or for any future period. COVID-19 Pandemic Beginning in March 2020 and continuing through the first quarter of 2021, the Company’s services experienced the most severe effects from reductions in client spending due to the economic impact related to the COVID-19 pandemic. While mixed by services and geography, the spending reductions impacted all of the Company’s services and markets. Globally, the most impacted services were the Company's experiential services. Most services began to recover in April 2021, and the recovery has continued through the third quarter of 2022. Impact of the War in Ukraine The Company has a minority interest in a European company that has majority-ownership interests in local agencies in Russia. During the first quarter of 2022, the war in Ukraine resulted in the imposition of sanctions by the United States, the United Kingdom, and the European Union, that affected, and continues to affect, the cross-border operations of businesses operating in Russia. In addition, Russian regulators have imposed currency restrictions and regulations that created uncertainty regarding the Company's ability to recover its investment in operations in Russia, as well as the Company's ability to exercise control or influence over operations by the local agencies in Russia. As a result, the Company intends to use its influence to cause the European company to dispose of its ownership interests in the local agencies in Russia. Accordingly, the Company recorded pretax charges of $ 2.8 million in the first quarter of 2022, primarily consisting of its proportionate share of the net investment in its Russian interest in “Selling, general, and administrative expenses” in the Condensed Consolidated Statements of Operations and Comprehensive Income. Recent Accounting StandardsAccounting Standards Recently Adopted by the CompanyIn March 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on 8 Financial Reporting. This guidance provides optional expedients and exceptions for GAAP to contracts, hedging relationships, and other transactions that reference the London Interbank Offered Rate (“LIBOR”) or another reference rate if certain criteria are met. The amendments in this update are effective for reporting periods that include or are subsequent to March 12, 2020 and must be applied prospectively to contract modifications and hedging relationships through December 31, 2022. On April 1, 2022, the Company adopted the standard prospectively and determined that the adoption of this accounting guidance did not have a material impact on its condensed consolidated financial statements.On January 1, 2022, the Company adopted ASU No. 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity (“ASU 2020-06”), which simplifies accounting for convertible instruments by removing major separation models required under current GAAP, simplifies the contract settlement assessment for equity classification, requires the use of the if-converted method for all convertible instruments in the diluted earnings per share calculation and expands disclosure requirements. The adoption of this accounting standard, under the full retrospective method, did not have a material impact on the Company's condensed consolidated financial statements and use of the if-converted method did not have an impact on the Company's overall earnings per share calculation.On January 1, 2022, the Company adopted ASU 2021-04, Earnings Per Share (Topic 260), Debt—Modifications and Extinguishments (Subtopic 470-50), Compensation—Stock Compensation (Topic 718), and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Issuer’s Accounting for Certain Modifications or Exchanges of Freestanding Equity-Classified Written Call Options (a consensus of the FASB Emerging Issues Task Force). The guidance clarifies certain aspects of the current guidance to promote consistency among reporting of an issuer’s accounting for modifications or exchanges of freestanding equity-classified written call options (for example, warrants) that remain equity-classified after modification or exchange. The guidance is applied prospectively to all modifications or exchanges that occur on or after the date of adoption and the adoption of this accounting standard did not have a material impact on the Company’s condensed consolidated financial statements.On January 1, 2022, the Company adopted ASU 2021-10, Government Assistance (Topic 832): Disclosures by Business Entities about Government Assistance. This update requires annual disclosures about transactions with a government that are accounted for by applying a grant or contribution accounting model by analogy. The guidance is applied prospectively to all transactions within the scope of the amendments that are reflected in financial statements at the date of initial application and new transactions that are entered into after the date of initial application. The adoption of this accounting standard did not have a material impact on the Company’s condensed consolidated financial statements. Accounting Standards Recently Issued but Not Yet Adopted by the CompanyIn October 2021, the FASB issued ASU 2021-08, Business Combinations (Topic 606): Accounting for Contract Assets and Contract Liabilities from Contracts with Customers, which requires that an entity recognize and measure contract assets and contract liabilities acquired in a business combination in accordance with Topic 606 as if it had originated the contracts. Generally, this should result in an acquirer recognizing and measuring the acquired contract assets and contract liabilities consistent with how they were recognized and measured in the acquiree’s financial statements, if the acquiree prepared financial statements in accordance with GAAP. The amendment in this update is effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. The guidance should be applied prospectively to business combinations occurring on or after the effective date of the amendment in this update. The Company is evaluating the potential impact of this adoption on its consolidated financial statements. All other new accounting pronouncements issued, but not yet effective or adopted have been deemed to be not relevant to the Company and, accordingly, are not expected to have a material impact once adopted.\n9\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Sales brand-centric services | $ | 343,478 | $ | 330,740 | $ | 1,005,707 | $ | 946,147 |\n| Sales retail-centric services | 302,768 | 266,399 | 836,640 | 746,960 |\n| Total sales revenues | 646,246 | 597,139 | 1,842,347 | 1,693,107 |\n| Marketing brand-centric services | 143,241 | 142,554 | 393,155 | 381,358 |\n| Marketing retail-centric services | 261,608 | 189,067 | 711,477 | 495,270 |\n| Total marketing revenues | 404,849 | 331,621 | 1,104,632 | 876,628 |\n| Total revenues | $ | 1,051,095 | $ | 928,760 | $ | 2,946,979 | $ | 2,569,735 |\n\n| (in thousands) |\n| Consideration: |\n| Cash | $ | 74,146 |\n| Holdback | 810 |\n| Fair value of contingent consideration | 510 |\n| Total consideration | $ | 75,466 |\n| Recognized amounts of identifiable assets acquired and liabilities assumed: |\n| Assets |\n| Accounts receivable | $ | 9,409 |\n| Other assets | 3,446 |\n| Identifiable intangible assets | 25,546 |\n| Total assets | 38,401 |\n| Liabilities |\n| Accounts payable | 7,363 |\n| Deferred tax liabilities and other | 8,744 |\n| Total liabilities | 16,107 |\n| Redeemable noncontrolling interest | 1,987 |\n| Noncontrolling interest | 974 |\n| Total identifiable net assets | 19,333 |\n| Goodwill arising from acquisitions | $ | 56,133 |\n| (in thousands) | Amount | WeightedAverageUseful Life |\n| Client relationships | $ | 24,413 | 6 years |\n| Trade names | 1,133 | 10 years |\n| Total identifiable intangible assets | $ | 25,546 |\n| (in thousands) |\n| Consideration |\n| Cash | $ | 40,046 |\n| Holdbacks | 13,599 |\n| Fair value of contingent consideration | 19,883 |\n| Total consideration | $ | 73,528 |\n| Recognized amounts of identifiable assets acquired and liabilities assumed: |\n| Assets |\n| Accounts receivable | $ | 12,834 |\n| Other assets | 4,400 |\n| Property and equipment | 1,001 |\n| Identifiable intangible assets | 36,210 |\n| Total assets | 54,445 |\n| Liabilities |\n| Total liabilities | 21,758 |\n| Redeemable noncontrolling interest | 1,804 |\n| Total identifiable net assets | 30,883 |\n| Goodwill arising from acquisitions | $ | 42,645 |\n| (in thousands) | Amount | WeightedAverageUseful Life |\n| Client relationships | $ | 27,860 | 7 years |\n| Trade Names | 5,250 | 5 years |\n| Developed technology | 3,100 | 7 years |\n| Total identifiable intangible assets | $ | 36,210 |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Revenues | $ | 1,052,274 | $ | 963,576 | $ | 2,962,479 | $ | 2,719,111 |\n| Net income | $ | 21,467 | $ | 23,896 | $ | 46,461 | $ | 32,590 |\n\n\n| Sales | Marketing | Total |\n| (in thousands) |\n| Balance at January 1, 2021 | $ | 1,462,378 | $ | 700,961 | $ | 2,163,339 |\n| Acquisitions | 32,087 | 13,315 | 45,402 |\n| Measurement period adjustments | 179 | ( 1,043 | ) | ( 864 | ) |\n| Foreign exchange translation effects | ( 1,873 | ) | — | ( 1,873 | ) |\n| Balance at December 31, 2021 | $ | 1,492,771 | $ | 713,233 | $ | 2,206,004 |\n| Acquisitions | 5,672 | 50,461 | 56,133 |\n| Measurement period adjustments | ( 446 | ) | — | ( 446 | ) |\n| Foreign exchange translation effects | ( 15,638 | ) | — | ( 15,638 | ) |\n| Balance at September 30, 2022 | $ | 1,482,359 | $ | 763,694 | $ | 2,246,053 |\n| September 30, 2022 |\n| (amounts in thousands) | Weighted Average Useful Life | Gross CarryingValue | AccumulatedAmortization | Net Carrying Value |\n| Finite-lived intangible assets: |\n| Client relationships | 14 years | $ | 2,486,064 | $ | 1,290,842 | $ | 1,195,222 |\n| Trade names | 8 years | 135,271 | 84,067 | 51,204 |\n| Developed technology | 5 years | 13,260 | 9,870 | 3,390 |\n| Covenant not to compete | 5 years | 6,100 | 5,841 | 259 |\n| Total finite-lived intangible assets | 2,640,695 | 1,390,620 | 1,250,075 |\n| Indefinite-lived intangible assets: |\n| Trade names | 900,000 | — | 900,000 |\n| Total other intangible assets | $ | 3,540,695 | $ | 1,390,620 | $ | 2,150,075 |\n| December 31, 2021 |\n| (amounts in thousands) | Weighted Average Useful Life | Gross CarryingValue | AccumulatedAmortization | Net Carrying Value |\n| Finite-lived intangible assets: |\n| Client relationships | 14 years | $ | 2,480,167 | $ | 1,158,732 | $ | 1,321,435 |\n| Trade names | 8 years | 138,206 | 78,355 | 59,851 |\n| Developed technology | 5 years | 13,260 | 8,206 | 5,054 |\n| Covenant not to compete | 5 years | 6,100 | 4,926 | 1,174 |\n| Total finite-lived intangible assets | 2,637,733 | 1,250,219 | 1,387,514 |\n| Indefinite-lived intangible assets: |\n| Trade names | 900,000 | — | 900,000 |\n| Total other intangible assets | $ | 3,537,733 | $ | 1,250,219 | $ | 2,287,514 |\n| (in thousands) |\n| Remainder of 2022 | $ | 49,782 |\n| 2023 | 197,530 |\n| 2024 | 196,181 |\n| 2025 | 190,153 |\n| 2026 | 186,203 |\n| Thereafter | 430,226 |\n| Total amortization expense | $ | 1,250,075 |\n\n\n| September 30, | December 31, |\n| (in thousands) | 2022 | 2021 |\n| Term Loan Facility | $ | 1,301,813 | $ | 1,311,750 |\n| Notes | 775,000 | 775,000 |\n| Government loans for COVID-19 relief | 4,113 | 5,212 |\n| Other | 1,492 | 1,113 |\n| Total long-term debt | 2,082,418 | 2,093,075 |\n| Less: current portion | 14,704 | 14,397 |\n| Less: debt issuance costs | 43,123 | 49,796 |\n| Long-term debt, net of current portion | $ | 2,024,591 | $ | 2,028,882 |\n\n| September 30, 2022 |\n| (in thousands) | Fair Value | Level 1 | Level 2 | Level 3 |\n| Assets measured at fair value |\n| Derivative financial instruments | $ | 49,149 | $ | — | $ | 49,149 | $ | — |\n| Total assets measured at fair value | $ | 49,149 | $ | — | $ | 49,149 | $ | — |\n| Liabilities measured at fair value |\n| Warrant liability | $ | 733 | $ | — | $ | 733 | $ | — |\n| Contingent consideration liabilities | 40,431 | — | — | 40,431 |\n| Total liabilities measured at fair value | $ | 41,164 | $ | — | $ | 733 | $ | 40,431 |\n| December 31, 2021 |\n| (in thousands) | Fair Value | Level 1 | Level 2 | Level 3 |\n| Assets measured at fair value |\n| Derivative financial instruments | $ | 10,164 | $ | — | $ | 10,164 | $ | — |\n| Total assets measured at fair value | $ | 10,164 | $ | — | $ | 10,164 | $ | — |\n| Liabilities measured at fair value |\n| Derivative financial instruments | $ | 385 | $ | — | $ | 385 | $ | — |\n| Warrant liability | 22,189 | — | — | 22,189 |\n| Contingent consideration liabilities | 58,366 | — | — | 58,366 |\n| Total liabilities measured at fair value | $ | 80,940 | $ | — | $ | 385 | $ | 80,555 |\n| September 30, |\n| (in thousands) | 2022 | 2021 |\n| Beginning of the period | $ | 58,366 | $ | 45,901 |\n| Fair value of acquisitions | 510 | 19,883 |\n| Changes in fair value | 5,448 | 6,977 |\n| Payments | ( 23,164 | ) | ( 6,399 | ) |\n| Measurement period adjustments | — | ( 1,181 | ) |\n| Foreign exchange translation effects | ( 729 | ) | ( 69 | ) |\n| End of the period | $ | 40,431 | $ | 65,112 |\n| (in thousands) | Carrying Value | Fair Value(Level 2) |\n| Balance at September 30, 2022 |\n| Term Loan Facility | $ | 1,301,813 | $ | 1,329,741 |\n| Notes | 775,000 | 723,486 |\n| Government loans for COVID-19 relief | 4,113 | 4,306 |\n| Other | 1,492 | 1,492 |\n| Total long-term debt | $ | 2,082,418 | $ | 2,059,025 |\n| (in thousands) | Carrying Value | Fair Value(Level 2) |\n| Balance at December 31, 2021 |\n| Term Loan Facility | $ | 1,311,750 | $ | 1,406,552 |\n| Notes | 775,000 | 894,611 |\n| Government loans for COVID-19 relief | 5,212 | 5,615 |\n| Other | 1,113 | 1,113 |\n| Total long-term debt | $ | 2,093,075 | $ | 2,307,891 |\n\n\n| Revenues | Accounts Receivable |\n| Three Months Ended September 30, | Nine Months Ended September 30, | As of September 30, | As of December 31, |\n| (in thousands) | 2022 | 2021 | 2022 | 2021 | 2022 | 2021 |\n| Client 1 | $ | 450 | $ | — | $ | 1,275 | $ | — | $ | 301 | $ | 176 |\n| Client 2 | 136 | 42 | 668 | 75 | 289 | 160 |\n| Client 3 | 147 | 124 | 455 | 457 | 129 | 190 |\n| All other clients | 30 | 1,452 | 152 | 6,694 | 16 | 10 |\n| Total | $ | 763 | $ | 1,618 | $ | 2,550 | $ | 7,226 | $ | 735 | $ | 536 |\n\n8. Income TaxesThe Company’s effective tax rates were 4.7 % and 25.4 % for the three months ended September 30, 2022 and 2021, respectively. The effective tax rate is based upon the estimated income or loss before taxes for the year, by jurisdiction, and adjusted for estimated permanent tax adjustments. The fluctuation in the Company’s effective tax rate was primarily due to the three months pretax book income differences and the discrete impact of $ 5.0 million to remeasure the deferred tax liability as a result of a reduction in the Company's blended state tax rate driven primarily by a Pennsylvania statutory tax rate change for the three months ended September 30, 2022, no t included in the three months ended September 30, 2021.The Company’s effective tax rates were 20.6 % and 36.0 % for the nine months ended September 30, 2022 and 2021, respectively. The effective tax rate is based upon the estimated income or loss before taxes for the year, by jurisdiction, and adjusted for estimated permanent tax adjustments. The fluctuation in the Company’s effective tax rate was primarily due to the nine months pretax book income differences, the discrete impact of $ 5.0 million to remeasure the deferred tax liability as a result of a reduction in the Company's blended state tax rate driven primarily by a Pennsylvania statutory tax rate change for the nine months ended September 30, 2022, offset by a shortfall adjustment of $ 2.4 million of stock based compensation for the nine months ended September 30, 2022. On August 16, 2022, the U.S. government enacted the Inflation Reduction Act (“IRA”), which imposes a new corporate alternative minimum tax (“CAMT”), an excise tax on stock buybacks, and significant tax incentives for energy and climate initiatives, among other provisions. The Company does not expect the CAMT to have a material impact on its consolidated financial statements.\n| (in thousands) | Sales | Marketing | Total |\n| Three Months Ended September 30, 2022 |\n| Revenues | $ | 646,246 | $ | 404,849 | $ | 1,051,095 |\n| Depreciation and amortization | $ | 39,798 | $ | 17,987 | $ | 57,785 |\n| Operating income | $ | 31,765 | $ | 15,077 | $ | 46,842 |\n| Three Months Ended September 30, 2021 |\n| Revenues | $ | 597,139 | $ | 331,621 | $ | 928,760 |\n| Depreciation and amortization | $ | 41,515 | $ | 17,648 | $ | 59,163 |\n| Operating income | $ | 51,906 | $ | 13,696 | $ | 65,602 |\n| (in thousands) | Sales | Marketing | Total |\n| Nine Months Ended September 30, 2022 |\n| Revenues | $ | 1,842,347 | $ | 1,104,632 | $ | 2,946,979 |\n| Depreciation and amortization | $ | 121,310 | $ | 52,687 | $ | 173,997 |\n| Operating income | $ | 65,915 | $ | 32,217 | $ | 98,132 |\n| Nine Months Ended September 30, 2021 |\n| Revenues | $ | 1,693,107 | $ | 876,628 | $ | 2,569,735 |\n| Depreciation and amortization | $ | 128,789 | $ | 52,661 | $ | 181,450 |\n| Operating income | $ | 131,727 | $ | 13,910 | $ | 145,637 |\n\n10. Commitments and ContingenciesLitigationThe Company is involved in various legal matters that arise in the ordinary course of its business. Some of these legal matters purport or may be determined to be class and/or representative actions, or seek substantial damages, or penalties. The Company has accrued amounts in connection with certain legal matters, including with respect to certain of the matters described below. There can be no assurance, however, that these accruals will be sufficient to cover such matters or other legal matters or that such matters or other legal matters will not materially or adversely affect the Company’s financial position, liquidity, or results of operations.Employment MattersThe Company has also been involved in various litigation, including purported class or representative actions with respect to matters arising under the California Labor Code and Private Attorneys General Act. The Company has retained outside counsel to represent it in these matters and is vigorously defending its interests. Legal Matters Related to Take 5On April 1, 2018, the Company acquired certain assets and assumed liabilities of Take 5 Media Group (“Take 5”). In June 2019, as a result of a review of internal allegations related to inconsistency of data provided by Take 5 to its clients, the Company commenced an investigation into Take 5’s operations. In July 2019, as a result of the Company’s investigation, the Company determined that revenue during the fiscal year ended December 31, 2018 attributable to the Take 5 business had been recognized for services that were not performed on behalf of clients of Take 5 and that inaccurate reports were made to Take 5 clients about those services (referred to as the “Take 5 Matter”). As a result of these findings, in July 2019, the Company terminated all operations of Take 5, including the use of its associated trade names and the offering of its services to its clients and offered refunds to Take 5 clients of collected revenues attributable to Take 5 since the Company’s acquisition of Take 5. 20 USAO and FBI Voluntary Disclosure and Investigation Related to Take 5The Company voluntarily disclosed to the United States Attorney’s Office and the Federal Bureau of Investigation certain misconduct occurring at Take 5, a line of business that the Company closed in July 2019. The Company intends to cooperate in this and any other governmental investigations that may arise in connection with the Take 5 Matter. At this time, the Company cannot predict the ultimate outcome of any investigation related to the Take 5 Matter and is unable to estimate the potential impact such an investigation may have on the Company. Arbitration Proceedings Related to Take 5In August 2019, as a result of the Take 5 Matter, the Company provided a written indemnification claim notice to the sellers of Take 5 (the “Take 5 Sellers”) seeking monetary damages (including interest, fees and costs) based on allegations of breach of the asset purchase agreement (the “Take 5 APA”), as well as fraud. In September 2019, the Take 5 Sellers initiated arbitration proceedings against the Company, alleging breach of the Take 5 APA as a result of the Company’s decision to terminate the operations of the Take 5 business, and seeking monetary damages equal to all unpaid earn-out payments under the Take 5 APA (plus interest, fees and costs). In 2020, the Take 5 sellers amended their statement of claim to allege defamation, relating to statements the Company made to customers in connection with terminating the operations of the Take 5 business, and seeking monetary damages for the alleged injury to their reputation. The Company filed its response to the Take 5 Sellers’ claims, and asserted indemnification, fraud and other claims against the Take 5 Sellers as counterclaims and cross-claims in the arbitration proceedings. In October 2022, the arbitrator made a final award in favor of the Company. The Company is currently unable to estimate if or when it will be able to collect any amounts associated with this arbitration. Other Legal Matters Related to Take 5The Take 5 Matter may result in additional litigation against the Company, including lawsuits from clients, or governmental investigations, which may expose the Company to potential liability in excess of the amounts being offered by the Company as refunds to Take 5 clients. The Company is currently unable to determine the amount of any potential liability, costs or expenses (above the amounts already being offered as refunds) that may result from any lawsuits or investigations associated with the Take 5 Matter or determine whether any such issues will have any future material adverse effect on the Company’s financial position, liquidity, or results of operations. Although the Company has insurance covering certain liabilities, the insurance may not be sufficient to cover any potential liability or expenses associated with the Take 5 Matter.\n| (in thousands, except share and per share data) Performance Period | Number ofSharesThreshold | Number ofSharesTarget | Number ofSharesMaximum | WeightedAverage FairValue perShare | Maximum Remaining Unrecognized Compensation Expense | Weighted-average remaining requisite service periods |\n| January 1, 2022— December 31, 2022 | 2,479,997 | 4,959,993 | 7,439,990 | $ | 5.63 | $ | 80,689 | 1.5 years |\n| January 1, 2021— December 31, 2021 | 1,121,698 | 1,121,698 | 1,319,458 | $ | 13.17 | $ | 4,982 | 1.1 years |\n| Performance Share Units | Weighted Average GrantDate Fair Value |\n| Outstanding at January 1, 2022 | 2,609,079 | $ | 13.07 |\n| Granted | 5,393,085 | $ | 5.66 |\n| Distributed | 660,880 | $ | 13.09 |\n| Forfeited | 684,261 | $ | 8.19 |\n| PSU performance adjustment | ( 377,572 | ) | $ | 11.19 |\n| Outstanding at September 30, 2022 | 6,279,451 | $ | 7.22 |\n| Number of RSUs | Weighted Average GrantDate Fair Value |\n| Outstanding at January 1, 2022 | 3,660,553 | $ | 10.64 |\n| Granted | 6,302,801 | $ | 5.74 |\n| Distributed | 1,338,213 | $ | 10.61 |\n| Forfeited | 869,955 | $ | 8.02 |\n| Outstanding at September 30, 2022 | 7,755,186 | $ | 6.96 |\n| September 30, |\n| 2022 |\n| Share Price | $ | 5.99 |\n| Dividend yield | 0.0 | % |\n| Expected volatility | 30.0 | % |\n| Risk-free interest rate | 2.0 | % |\n| Expected term (years) | 6.5 |\n\n\n| (in thousands) |\n| Balance at January 1, 2022 | $ | 1,893 |\n| Fair value at acquisition | 1,987 |\n| Net income attributable to redeemable noncontrolling interests | 124 |\n| Dividend distribution | ( 223 | ) |\n| Foreign currency translation adjustment | ( 428 | ) |\n| Balance at September 30, 2022 | $ | 3,353 |\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (in thousands, except share and earnings per share data) | 2022 | 2021 | 2022 | 2021 |\n| Basic earnings per share computation: |\n| Numerator: |\n| Net income attributable to stockholders of Advantage Solutions Inc. | $ | 21,059 | $ | 23,311 | $ | 43,395 | $ | 29,316 |\n| Denominator: |\n| Weighted average common shares - basic | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\n| Basic earnings per common share | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n| Diluted earnings per share computation: |\n| Numerator: |\n| Net income attributable to stockholders of Advantage Solutions Inc. | $ | 21,059 | $ | 23,311 | $ | 43,395 | $ | 29,316 |\n| Denominator: |\n| Weighted average common shares outstanding | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\n| Performance and Restricted Stock Units | 602,566 | 1,450,668 | 496,968 | 1,335,011 |\n| Employee stock purchase plan and stock options | 300,604 | 106,469 | 348,271 | 106,469 |\n| Weighted average common shares - diluted | 319,725,065 | 320,120,634 | 319,190,804 | 319,654,817 |\n| Diluted earnings per common share | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n\n24\n14. Subsequent EventsIn October 2022, the Company granted 2,153,900 RSUs and 1,170,000 stock options, with an estimated aggregate grant date fair value of $ 4.8 million and $ 1.2 million, respectively.\n25\n\nITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nForward-Looking Statements\nThis Quarterly Report on Form 10-Q (this “Quarterly Report”), including the section titled “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements that are based on current expectations, estimates, forecasts and projections about us, our future performance, our business, our beliefs and our management’s assumptions. Such words as “expect,” “anticipate,” “outlook,” “could,” “target,” “project,” “intend,” “plan,” “believe,” “seek,” “estimate,” “should,” “may,” “assume” and “continue” as well as variations of such words and similar expressions are intended to identify such forward-looking statements, although not all forward-looking statements contain such terms. These statements are not guarantees of future performance and they involve certain risks, uncertainties and assumptions that are difficult to predict. We have based our forward-looking statements on our management’s beliefs and assumptions based on information available to our management at the time the statements are made. We caution you that actual outcomes and results may differ materially from what is expressed, implied or forecasted by our forward-looking statements. More information regarding these risks and uncertainties and other important factors that could cause actual results to differ materially from those in the forward-looking statements is set forth in Part II, Item 1A “Risk Factors” of this report. Investors are cautioned not to place undue reliance on any such forward-looking statements, which speak only as of the date they are made. Except as required under the federal securities laws and the rules and regulations of the Securities and Exchange Commission, we do not have any intention or obligation to update publicly any forward-looking statements after the distribution of this report, whether as a result of new information, future events, changes in assumptions or otherwise.\nExecutive Overview\nWe are a leading business solutions provider to consumer goods manufacturers and retailers. We have a strong platform of competitively advantaged sales and marketing services built over multiple decades – essential, business critical services like headquarter sales, retail merchandising, in-store sampling, digital commerce and shopper marketing. For brands and retailers of all sizes, we help get the right products on the shelf (whether physical or digital) and into the hands of consumers (however they shop). We use a scaled platform to innovate as a trusted partner with our clients, solving problems to increase their efficiency and effectiveness across a broad range of channels.\nWe have two reportable segments: sales and marketing.\nThrough our sales segment, which generated approximately 62.5% and 65.9% of our total revenues in the nine months ended September 30, 2022 and 2021, respectively, we offer headquarter sales representation services to consumer goods manufacturers, for whom we prepare and present to retailers a business case to increase distribution of manufacturers’ products and optimize how they are displayed, priced and promoted. We also make in-store merchandising visits for both manufacturer and retailer clients to ensure the products we represent are adequately stocked and properly displayed.\nThrough our marketing segment, which generated approximately 37.5% and 34.1% of our total revenues in the nine months ended September 30, 2022 and 2021, respectively, we help brands and retailers reach consumers through two main categories within the marketing segment. The first and largest category is our retail experiential business, also known as in-store sampling or demonstrations, where we manage highly customized large-scale sampling programs (both in-store and online) for leading retailers. The second category is our collection of specialized agency services, in which we provide private label services to retailers and develop granular marketing programs for brands and retailers through our shopper, consumer and digital marketing agencies.\n26\nBusiness Combination with Conyers Park\nOn October 28, 2020, Conyers Park II Acquisition Corp. (“Conyers Park”), a Delaware corporation, consummated a merger with ASI Intermediate Corp. (“ASI”), formerly known as Advantage Solutions Inc., with ASI surviving the merger as a wholly owned subsidiary of Conyers Park (the “Merger” and, together with the other transactions contemplated by the merger agreement, the “Transactions”). On October 28, 2020, and in connection with the closing of the Transactions, Conyers Park changed its name to Advantage Solutions Inc.\nImpacts of the COVID-19 Pandemic\nBeginning in March 2020 and continuing through the first quarter of 2021, our services experienced the effects from reductions in client spending due to the economic impact related to the COVID-19 pandemic. While mixed by services and geography, the spending reductions impacted all of our services and markets. Globally, the most impacted services were our experiential services. Most services began to improve in April 2021, and the improvement has continued through the third quarter of 2022.\nSummary\nOur financial performance for the three months ended September 30, 2022 as compared to the three months ended September 30, 2021 includes:\n•Revenues increased by $122.3 million, or 13.2%, to $1,051.1 million;\n•Operating income decreased by $18.8 million, or 28.6%, to $46.8 million;\n•Net income decreased by $1.1 million, or 4.5% to $23.2 million;\n•Adjusted Net Income increased by $3.6 million, or 6.1%, to $62.7 million; and\n•Adjusted EBITDA decreased by $15.5 million, or 11.6%, to $118.3 million.\nOur financial performance for the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021 includes:\n•Revenues increased by $377.2 million, or 14.7% to $2,947.0 million;\n•Operating income decreased by $47.5 million, or 32.6% to $98.1 million;\n•Net income increased by $14.9 million, or 50.5% to $44.4 million;\n•Adjusted Net Income increased by $5.8 million, or 3.9% to $152.5 million; and\n•Adjusted EBITDA decreased by $43.8 million, or 11.9% to $323.3 million.\nDuring the nine months ended September 30, 2022, we acquired four businesses. The aggregate purchase price was $75.5 million, of which $74.1 million was paid in cash, $0.5 million in contingent consideration and $0.8 million in holdback.\nFactors Affecting Our Business and Financial Reporting\nThere are a number of factors, in addition to the impact of the COVID-19 pandemic and inflation, that affect the performance of our business and the comparability of our results from period to period including:\n•Organic Growth. Part of our strategy is to generate organic growth by expanding our existing client relationships, continuing to win new clients, pursuing channel expansion and new industry opportunities, enhancing our digital technology solutions, developing our international platform, delivering operational efficiencies and expanding into logical adjacencies. We believe that by pursuing\n27\nthese organic growth opportunities we will be able to continue to enhance our value proposition to our clients and thereby grow our business.\n•Acquisitions. We have grown and expect to continue to grow our business in part by acquiring quality businesses, both domestic and international. Excluding the 2017 acquisition of Daymon Worldwide Inc., we have completed 73 acquisitions from January 2014 to November 9, 2022, ranging in purchase prices from approximately $0.3 million to $98.5 million. Many of our acquisition agreements include contingent consideration arrangements, which are described below. We have completed acquisitions at what we believe are attractive purchase prices and have regularly structured our agreements to result in the generation of long-lived tax assets, which have in turn reduced our effective purchase prices when incorporating the value of those tax assets. We continue to look for strategic acquisitions that can be completed at attractive purchase prices.\n•Contingent Consideration. Many of our acquisition agreements include contingent consideration arrangements, which are generally based on the achievement of financial performance thresholds by the operations attributable to the acquired businesses. The contingent consideration arrangements are based upon our valuations of the acquired businesses and are intended to share the investment risk with the sellers of such businesses if projected financial results are not achieved. The fair values of these contingent consideration arrangements are included as part of the purchase price of the acquired companies on their respective acquisition dates. For each transaction, we estimate the fair value of contingent consideration payments as part of the initial purchase price. We review and assess the estimated fair value of contingent consideration on a quarterly basis, and the updated fair value could differ materially from our initial estimates. Adjustments to the estimated fair value related to changes in all other unobservable inputs are reported in “Selling, general and administrative expenses” in our Condensed Consolidated Statements of Operations and Comprehensive Income.\n•Depreciation and Amortization. As a result of the acquisition of our business by Karman Topco L.P. (“Topco”) on July 25, 2014 (the “2014 Topco Acquisition”), we acquired significant intangible assets, the value of which is amortized, on a straight-line basis, over 15 years from the date of the 2014 Topco Acquisition, unless determined to be indefinite-lived. The amortization of such intangible assets recorded in our consolidated financial statements has a significant impact on our operating income (loss) and net income (loss). Our historical acquisitions have increased, and future acquisitions likely will increase, our intangible assets. We do not believe the amortization expense associated with the intangibles created from our purchase accounting adjustments reflect a material economic cost to our business. Unlike depreciation expense which has an economic cost reflected by the fact that we must re-invest in property and equipment to maintain the asset base delivering our results of operations, we do not have any capital re-investment requirements associated with the acquired intangibles, such as client relationships and trade names, that comprise the majority of the finite-lived intangibles that create our amortization expense.\n•Foreign Exchange Fluctuations. Our financial results are affected by fluctuations in the exchange rate between the U.S. dollar and other currencies, primarily Canadian dollars, British pounds and euros, due to our operations in such foreign jurisdictions. See also “ —Quantitative and Qualitative Disclosure of Market Risk—Foreign Currency Risk.”\n•Seasonality. Our quarterly results are seasonal in nature, with the fourth fiscal quarter typically generating a higher proportion of our revenues than other fiscal quarters, as a result of higher consumer spending. We generally record slightly lower revenues in the first fiscal quarter of each year, as our clients begin to roll out new programs for the year, and consumer spending generally is less in the first fiscal quarter than other quarters. Timing of our clients’ marketing expenses, associated with marketing campaigns and new product launches, can also result in fluctuations from one quarter to another.\n28\nHow We Assess the Performance of Our Business\nRevenues\nRevenues related to our sales segment are primarily comprised of commissions, fee-for-service and cost-plus fees for providing retail merchandising services, category and space management, headquarter relationship management, technology solutions and administrative services. A small portion of our arrangements include performance incentive provisions, which allow us to earn additional revenues on our performance relative to specified quantitative or qualitative goals. We recognize the incentive portion of revenues under these arrangements when the related services are transferred to the customer.\nMarketing segment revenues are primarily recognized in the form of a fee-for-service (including retainer fees, fees charged to clients based on hours incurred, project-based fees or fees for executing in-person consumer engagements or experiences, which engagements or experiences we refer to as events), commissions or on a cost-plus basis, in each case, related to services including experiential marketing, shopper and consumer marketing services, private label development or our digital, social and media services.\nGiven our acquisition strategy, we analyze our financial performance, in part, by measuring revenue growth in two ways—revenue growth attributable to organic activities and revenue growth attributable to acquisitions, which we refer to as organic revenues and acquired revenues, respectively.\nWe define organic revenues as any revenues that are not acquired revenues. Our organic revenues exclude the impacts of acquisitions and divestitures, when applicable, which improves comparability of our results from period to period.\nIn general, when we acquire a business, the acquisition includes a contingent consideration arrangement (e.g., an earn-out provision) and, accordingly, we separately track the relevant metrics associated with the earnout agreement of the acquired business. In such cases, we consider revenues generated by such a business during the 12 months following its acquisition to be acquired revenues. For example, if we completed an acquisition on July 1, 2021 for a business that included a contingent consideration arrangement, we would consider revenues from the acquired business from July 1, 2021 to June 30, 2022 to be acquired revenues. We generally consider growth attributable to the financial performance of an acquired business after the 12-month anniversary of the date of acquisition to be organic.\nIn limited cases, when the acquisition of an acquired business does not include a contingent consideration arrangement, or we otherwise do not separately track the financial performance of the acquired business due to operational integration, we consider the revenues that the business generated in the 12 months prior to its acquisition to be our acquired revenues for the 12 months following its acquisition, and any differences in revenues actually generated during the 12 months after its acquisition to be organic. For example, if we completed an acquisition on July 1, 2021 for a business that did not include a contingent consideration arrangement, we would consider the amount of revenues from the acquired business from July 1, 2020 to June 30, 2021 to be acquired revenues during the period from July 1, 2021 to June 30, 2022, with any differences from that amount actually generated during the latter period to be organic revenues.\nAll revenues generated by our acquired businesses are considered to be organic revenues after the 12-month anniversary of the date of acquisition.\nWhen we divest a business, we consider the revenues that the divested business generated in the 12 months prior to its divestiture to be subtracted from acquired revenues for the 12 months following its divestiture. For example, if we completed a divestiture on July 1, 2021 for a business, we would consider the amount of revenues from the divested business from July 1, 2020 to June 30, 2021 to be subtracted from acquired revenues during the period from July 1, 2021 to June 30, 2022.\nWe measure organic revenue growth and acquired revenue growth by comparing the organic revenues or acquired revenues, respectively, period over period, net of any divestitures.\n29\nCost of Revenues\nOur cost of revenues consists of both fixed and variable expenses primarily attributable to the hiring, training, compensation and benefits provided to both full-time and part-time associates, as well as other project-related expenses. A number of costs associated with our associates are subject to external factors, including inflation, increases in market specific wages and minimum wage rates at federal, state and municipal levels and minimum pay levels for exempt roles. Additionally, when we enter into certain new client relationships, we may experience an initial increase in expenses associated with hiring, training and other items needed to launch the new relationship.\nSelling, General and Administrative Expenses\nSelling, general and administrative expenses consist primarily of salaries, payroll taxes and benefits for corporate personnel. Other overhead costs include information technology, occupancy costs for corporate personnel, professional services fees, including accounting and legal services, and other general corporate expenses. Additionally, included in selling, general and administrative expenses are costs associated with the changes in fair value of the contingent consideration of acquisitions and other acquisition-related costs. Acquisition-related costs are comprised of fees related to change of equity ownership, transaction costs, professional fees, due diligence and integration activities.\nOther (Income) Expenses\nChange in Fair Value of Warrant Liability\nChange in fair value of warrant liability represents a non-cash (income) expense resulting from a fair value adjustment to warrant liability with respect to the private placement warrants. Based on the period of time the public warrants have now been trading, we determined the fair value of the liability classified private placement warrants by approximating the value with the share price of the public warrants at the respective period end, which is inherently less subjective and judgmental given it is based on observable inputs. Previously, the fair value of the warrant liability was based on the input assumptions used in the Black-Scholes option pricing model, including our stock price at the end of the reporting period, the implied volatility or other inputs to the model and the number of private placement warrants outstanding, which may vary from period to period. We believe these amounts are not correlated to future business operations.\nInterest Expense\nInterest expense relates primarily to borrowings under the Senior Secured Credit Facilities as described below. See “ —Liquidity and Capital Resources.”\nDepreciation and Amortization\nAmortization Expense\nIncluded in our depreciation and amortization expense is amortization of acquired intangible assets. We have ascribed value to identifiable intangible assets other than goodwill in our purchase price allocations for companies we have acquired. These assets include, but are not limited to, client relationships and trade names. To the extent we ascribe value to identifiable intangible assets that have finite lives, we amortize those values over the estimated useful lives of the assets. Such amortization expense, although non-cash in the period expensed, directly impacts our results of operations. It is difficult to predict with any precision the amount of expense we may record relating to future acquired intangible assets.\n30\nAs a result of the 2014 Topco Acquisition, we acquired significant intangible assets, the value of which is amortized, on a straight-line basis, over 15 years from the date of the 2014 Topco Acquisition, unless determined to be indefinite-lived.\nDepreciation Expense\nDepreciation expense relates to the property and equipment that we own, which represented less than 1% of our total assets at September 30, 2022 and 2021, respectively.\nIncome Taxes\nIncome tax expense and our effective tax rates can be affected by many factors, including state apportionment factors, our acquisition strategy, tax incentives and credits available to us, changes in judgment regarding our ability to realize our deferred tax assets, changes in our worldwide mix of pre-tax losses or earnings, changes in existing tax laws and our assessment of uncertain tax positions.\nCash Flows\nWe have positive cash flow characteristics, as described below, due to the limited required capital investment in the fixed assets and working capital needs to operate our business in the normal course. See “ —Liquidity and Capital Resources.”\nOur principal sources of liquidity are cash flows from operations, borrowings under the Revolving Credit Facility, and other debt. Our principal uses of cash are operating expenses, working capital requirements, acquisitions and repayment of debt.\nAdjusted Net Income\nAdjusted Net Income is a non-GAAP financial measure. Adjusted Net Income means Net income before (i) impairment of goodwill and indefinite-lived assets, (ii) amortization of intangible assets, (iii) equity-based compensation of Topco, (iv) changes in fair value of warrant liability, (v) fair value adjustments of contingent consideration related to acquisitions, (vi) acquisition-related expenses, (vii) costs associated with COVID-19, net of benefits received, (viii) EBITDA for economic interests in investments, (ix) restructuring expenses, (x) litigation expenses (recovery), (xi) costs associated with the Take 5 Matter, (xii) related tax adjustments and (xiii) other adjustments that management believes are helpful in evaluating our operating performance.\nWe present Adjusted Net Income because we use it as a supplemental measure to evaluate the performance of our business in a way that also considers our ability to generate profit without the impact of items that we do not believe are indicative of our operating performance or are unusual or infrequent in nature and aid in the comparability of our performance from period to period. Adjusted Net Income should not be considered as an alternative for Net income, our most directly comparable measure presented on a GAAP basis.\nAdjusted EBITDA and Adjusted EBITDA by Segment\nAdjusted EBITDA and Adjusted EBITDA by segment are supplemental non-GAAP financial measures of our operating performance. Adjusted EBITDA means Net income before (i) interest expense, net, (ii) provision for income taxes, (iii) depreciation, (iv) impairment of goodwill and indefinite-lived assets, (v) amortization of intangible assets, (vi) equity-based compensation of Topco, (vii) changes in fair value of warrant liability, (viii) stock-based compensation expense, (ix) fair value adjustments of contingent consideration related to acquisitions, (x) acquisition-related expenses, (xi) costs associated with COVID-19, net of benefits received, (xii) EBITDA for economic interests in investments, (xiii) restructuring expenses, (xiv) litigation expenses (recovery), (xv) costs associated with the Take 5 Matter and (xvi) other adjustments that management believes are helpful in evaluating our operating performance.\n31\nWe present Adjusted EBITDA and Adjusted EBITDA by segment because they are key operating measures used by us to assess our financial performance. These measures adjust for items that we believe do not reflect the ongoing operating performance of our business, such as certain noncash items, unusual or infrequent items or items that change from period to period without any material relevance to our operating performance. We evaluate these measures in conjunction with our results according to GAAP because we believe they provide a more complete understanding of factors and trends affecting our business than GAAP measures alone. Furthermore, the agreements governing our indebtedness contain covenants and other tests based on measures substantially similar to Adjusted EBITDA. Neither Adjusted EBITDA nor Adjusted EBITDA by segment should be considered as an alternative for Net income, our most directly comparable measure presented on a GAAP basis.\nResults of Operations for the Three and Nine Months Ended September 30, 2022 and 2021\nThe following table sets forth items derived from the Company’s consolidated statements of operations for the three and nine months ended September 30, 2022 and 2021 in dollars and as a percentage of total revenues.\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (amounts in thousands) | 2022 | 2021 | 2022 | 2021 |\n| Revenues | $ | 1,051,095 | 100.0 | % | $ | 928,760 | 100.0 | % | $ | 2,946,979 | 100.0 | % | $ | 2,569,735 | 100.0 | % |\n| Cost of revenues | 908,523 | 86.4 | % | 766,253 | 82.5 | % | 2,536,256 | 86.1 | % | 2,117,818 | 82.4 | % |\n| Selling, general, and administrative expenses | 37,945 | 3.6 | % | 37,742 | 4.1 | % | 138,594 | 4.7 | % | 124,830 | 4.9 | % |\n| Depreciation and amortization | 57,785 | 5.5 | % | 59,163 | 6.4 | % | 173,997 | 5.9 | % | 181,450 | 7.1 | % |\n| Total expenses | 1,004,253 | 95.5 | % | 863,158 | 92.9 | % | 2,848,847 | 96.7 | % | 2,424,098 | 94.3 | % |\n| Operating income | 46,842 | 4.5 | % | 65,602 | 7.1 | % | 98,132 | 3.3 | % | 145,637 | 5.7 | % |\n| Other (income) expenses: |\n| Change in fair value of warrant liability | (1,100 | ) | (0.1 | )% | (3,491 | ) | (0.4 | )% | (21,456 | ) | (0.7 | )% | (5,024 | ) | (0.2 | )% |\n| Interest expense, net | 23,557 | 2.2 | % | 36,490 | 3.9 | % | 63,628 | 2.2 | % | 104,544 | 4.1 | % |\n| Total other expenses | 22,457 | 2.1 | % | 32,999 | 3.6 | % | 42,172 | 1.4 | % | 99,520 | 3.9 | % |\n| Income before income taxes | 24,385 | 2.3 | % | 32,603 | 3.5 | % | 55,960 | 1.9 | % | 46,117 | 1.8 | % |\n| Provision for income taxes | 1,158 | 0.1 | % | 8,276 | 0.9 | % | 11,523 | 0.4 | % | 16,582 | 0.6 | % |\n| Net income | $ | 23,227 | 2.2 | % | $ | 24,327 | 2.6 | % | $ | 44,437 | 1.5 | % | $ | 29,535 | 1.1 | % |\n| Other Financial Data |\n| Adjusted Net Income(1) | $ | 62,682 | 6.0 | % | $ | 59,101 | 6.4 | % | $ | 152,541 | 5.2 | % | $ | 146,762 | 5.7 | % |\n| Adjusted EBITDA(1) | $ | 118,268 | 11.3 | % | $ | 133,756 | 14.4 | % | $ | 323,329 | 11.0 | % | $ | 367,155 | 14.3 | % |\n\n(1)Adjusted Net Income and Adjusted EBITDA are financial measures that are not calculated in accordance with GAAP. For a discussion of our presentation of Adjusted Net Income and Adjusted EBITDA and reconciliations of Net income to Adjusted Net Income and Adjusted EBITDA, see “—Non-GAAP Financial Measures.”\nComparison of the Three Months Ended September 30, 2022 and 2021\nRevenues\n\n| Three Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 646,246 | $ | 597,139 | $ | 49,107 | 8.2 | % |\n| Marketing | 404,849 | 331,621 | 73,228 | 22.1 | % |\n| Total revenues | $ | 1,051,095 | $ | 928,760 | $ | 122,335 | 13.2 | % |\n\nTotal revenues increased by $122.3 million, or 13.2%, during the three months ended September 30, 2022, as compared to the three months ended September 30, 2021.\nThe sales segment revenues increased $49.1 million during the three months ended September 30, 2022 as compared to the three months ended September 30, 2021, of which $23.6 million were revenues from acquired\n32\nbusinesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $17.0 million, the segment experienced an increase of $42.5 million in organic revenues primarily due to growth in our retail merchandising services and international businesses, partially offset by a decrease in our third party selling and retailing services.\nThe marketing segment revenues increased $73.2 million during the three months ended September 30, 2022 as compared to the three months ended September 30, 2021, of which $11.0 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $5.7 million, the segment experienced an increase of $67.9 million in organic revenues. The increase in revenues was primarily due to an increase in our in-store product demonstration and sampling services which continue to recover from the temporary suspensions as a result of the COVID-19 pandemic, partially offset by a decrease in certain of our client media spend.\nCost of Revenues\nCost of revenues as a percentage of revenues for the three months ended September 30, 2022 was 86.4%, as compared to 82.5% for the three months ended September 30, 2021. The increase as a percentage of revenues was largely attributable to the change in the revenue mix of our services as a result of recoveries from the COVID-19 pandemic and acquired businesses, and the ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\nSelling, General and Administrative Expenses\nSelling, general and administrative expenses as a percentage of revenues for the three months ended September 30, 2022 was 3.6%, compared to 4.1% for the three months ended September 30, 2021, primarily due to the change in fair value adjustments related to contingent consideration and a decrease in legal fees associated with the Take 5 Matter.\nDepreciation and Amortization Expense\nDepreciation and amortization expense decreased by $1.4 million, or 2.3%, to $57.8 million for the three months ended September 30, 2022 compared to $59.2 million for the three months ended September 30, 2021, which stayed relatively consistent year over year.\nOperating Income\n\n| Three Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 31,765 | $ | 51,906 | $ | (20,141 | ) | (38.8 | )% |\n| Marketing | 15,077 | 13,696 | 1,381 | 10.1 | % |\n| Total operating income | $ | 46,842 | $ | 65,602 | $ | (18,760 | ) | (28.6 | )% |\n\nIn the sales segment, the decrease in operating income during the three months ended September 30, 2022 was due to a shift in revenue mix and ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\nIn the marketing segment, the increase in operating income during the three months ended September 30, 2022 was due to the growth in revenues, partially offset by the increase in cost of revenues as described above.\nChange in Fair Value of Warrant Liability\nChange in fair value of warrant liability represents $1.1 million of non-cash gain resulting from a fair value adjustment to warrant liability with respect to the private placement warrants for the three months ended September 30, 2022, approximating the fair value with the warrant price of the public warrants.\n33\nInterest Expense, net\nInterest expense, net decreased $12.9 million, or 35.4%, to $23.6 million for the three months ended September 30, 2022, from $36.5 million for the three months ended September 30, 2021. The decrease in interest expense, net was primarily due to the increase in fair value changes in derivatives instruments.\nProvision for Income Taxes\nProvision for income taxes was $1.2 million for the three months ended September 30, 2022 as compared to $8.3 million of provision for income taxes for the three months ended September 30, 2021. The fluctuation was primarily attributable to the decrease in pre-tax income during the three months ended September 30, 2022 and decrease of $4.3 million of discrete items for the three months ended September 30, 2022.\nNet Income\nNet income was $23.2 million for the three months ended September 30, 2022, compared to net income of $24.3 million for the three months ended September 30, 2021. The decrease in net income was primarily driven by the decrease in operating income as described above, offset by the decrease in interest expense, net and provision for income taxes.\nAdjusted Net Income\nThe increase in Adjusted Net Income for the three months ended September 30, 2022 was attributable to the decrease in interest expense, net as described above. For a reconciliation of Adjusted Net Income to Net income, see “ —Non-GAAP Financial Measures.”\nAdjusted EBITDA and Adjusted EBITDA by Segment\n\n| Three Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 76,172 | $ | 95,199 | $ | (19,027 | ) | (20.0 | )% |\n| Marketing | 42,096 | 38,557 | 3,539 | 9.2 | % |\n| Total Adjusted EBITDA | $ | 118,268 | $ | 133,756 | $ | (15,488 | ) | (11.6 | )% |\n\nAdjusted EBITDA decreased by $15.5 million, or 11.6%, to $118.3 million for the three months ended September 30, 2022, from $133.8 million for the three months ended September 30, 2021. In the sales segment, the decrease in Adjusted EBITDA was primarily attributable to the increase in cost of revenues as described above. In the marketing segment, the increase in the Adjusted EBITDA was primarily attributable to the growth in revenues as described above. For a reconciliation of Adjusted EBITDA to Net income, see “—Non-GAAP Financial Measures.”\nComparison of the Nine Months Ended September 30, 2022 and 2021\nRevenues\n\n| Nine Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 1,842,347 | $ | 1,693,107 | $ | 149,240 | 8.8 | % |\n| Marketing | 1,104,632 | 876,628 | 228,004 | 26.0 | % |\n| Total revenues | $ | 2,946,979 | $ | 2,569,735 | $ | 377,244 | 14.7 | % |\n\n34\nTotal revenues increased by $377.2 million, or 14.7%, during the nine months ended September 30, 2022, as compared to the nine months ended September 30, 2021.\nThe sales segment revenues increased $149.2 million during the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021, of which $114.2 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $33.9 million, the segment experienced an increase of $68.9 million in organic revenues primarily due to our European joint venture which experienced continued recoveries from temporary reduction in services as a result of the COVID-19 pandemic and growth in our retail merchandising services partially offset by a decrease in our foodservice and third party selling and retailing services.\nThe marketing segment revenues increased $228.0 million during the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021, of which $23.1 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $11.6 million, the segment experienced an increase of $216.5 million in organic revenues. The increase in revenues was primarily due to an increase in our in-store product demonstration and sampling services which continue to recover from the temporary suspensions as a result of the COVID-19 pandemic, partially offset by a decrease in certain of our client media spend.\nCost of Revenues\nCost of revenues as a percentage of revenues for the nine months ended September 30, 2022 was 86.1%, as compared to 82.4% for the nine months ended September 30, 2021. The increase as a percentage of revenues was largely attributable to the change in the revenue mix of our services as a result of recoveries from the COVID-19 pandemic and acquired businesses, and the ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\nSelling, General and Administrative Expenses\nSelling, general and administrative expenses as a percentage of revenues for the nine months ended September 30, 2022 was 4.7%, compared to 4.9% for the nine months ended September 30, 2021.\nDepreciation and Amortization Expense\nDepreciation and amortization expense decreased by $7.5 million or 4.1% to $174.0 million for the nine months ended September 30, 2022 compared to $181.5 million for the nine months ended September 30, 2021. The decrease was primarily due to a decrease in depreciation expenses from our internally developed software.\nOperating Income\n\n| Nine Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 65,915 | $ | 131,727 | $ | (65,812 | ) | (50.0 | %) |\n| Marketing | 32,217 | 13,910 | 18,307 | 131.6 | % |\n| Total operating income | $ | 98,132 | $ | 145,637 | $ | (47,505 | ) | (32.6 | %) |\n\nIn the sales segment, the decrease in operating income during the nine months ended September 30, 2022 was primarily attributable to a shift in revenue mix, ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses, the change in fair value adjustments related to contingent consideration, and an increase in stock-based compensation expense, partially offset by a decrease in depreciation expense.\n35\nIn the marketing segment, the increase in operating income during the nine months ended September 30, 2022 was primarily attributable to the growth in revenues, partially offset by the increase in cost of revenues as described above and the change in fair value adjustments related to contingent consideration.\nChange in Fair Value of Warrant Liability\nChange in fair value of warrant liability represents $21.5 million of non-cash gain resulting from a fair value adjustment to warrant liability with respect to the private placement warrants for the nine months ended September 30, 2022, approximating the fair value with the warrant price of the public warrants.\nInterest Expense, net\nInterest expense, net decreased $40.9 million, or 39.1%, to $63.6 million for the nine months ended September 30, 2022, from $104.5 million for the nine months ended September 30, 2021. The decrease in interest expense, net was primarily due to the increase in fair value changes in derivatives instruments.\nProvision for Income Taxes\nProvision for income taxes was $11.5 million for the nine months ended September 30, 2022 as compared to $16.6 million for the nine months ended September 30, 2021. The fluctuation was primarily attributable to the increase in pre-tax income during the nine months ended September 30, 2022, partially offset by a decrease of $7.4 million of discrete items.\nNet Income\nNet income was $44.4 million for the nine months ended September 30, 2022, compared to net income of $29.5 million for the nine months ended September 30, 2021. The increase in net income was primarily driven by the decrease in change in fair value of warrant liability, interest expense, net, and provision for income taxes, partially offset by the decrease in operating income as described above.\nAdjusted Net Income\nThe increase in Adjusted Net Income for the nine months ended September 30, 2022 was attributable to the decrease in change in fair value of warrant liability, and interest expense, net as described above. For a reconciliation of Adjusted Net Income to Net income, see “ —Non-GAAP Financial Measures.”\nAdjusted EBITDA and Adjusted EBITDA by Segment\n\n| Nine Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 216,158 | $ | 268,798 | $ | (52,640 | ) | (19.6 | )% |\n| Marketing | 107,171 | 98,357 | 8,814 | 9.0 | % |\n| Total Adjusted EBITDA | $ | 323,329 | $ | 367,155 | $ | (43,826 | ) | (11.9 | )% |\n\nAdjusted EBITDA decreased by $43.8 million, or 11.9%, to $323.3 million for the nine months ended September 30, 2022, from $367.2 million for the nine months ended September 30, 2021. In the sales segment, the decrease in Adjusted EBITDA was primarily attributable to the increase in cost of revenues as described above. In the marketing segment, the increase in the Adjusted EBITDA was primarily attributable to the growth in revenues as described above. For a reconciliation of Adjusted EBITDA to Net income, see “—Non-GAAP Financial Measures.”\n36\nNon-GAAP Financial Measures\nAdjusted Net Income is a non-GAAP financial measure. Adjusted Net Income means Net income before (i) impairment of goodwill and indefinite-lived assets, (ii) amortization of intangible assets, (iii) equity-based compensation of Topco, (iv) change in fair value of warrant liability, (v) fair value adjustments of contingent consideration related to acquisitions, (vi) acquisition-related expenses, (vii) costs associated with COVID-19, net of benefits received, (viii) EBITDA for economic interests in investments, (ix) restructuring expenses, (x) litigation expenses (recovery), (xi) costs associated with the Take 5 Matter, (xii) related tax adjustments and (xiii)other adjustments that management believes are helpful in evaluating our operating performance.\nWe present Adjusted Net Income because we use it as a supplemental measure to evaluate the performance of our business in a way that also considers our ability to generate profit without the impact of items that we do not believe are indicative of our operating performance or are unusual or infrequent in nature and aid in the comparability of our performance from period to period. Adjusted Net Income should not be considered as an alternative for our Net income, our most directly comparable measure presented on a GAAP basis.\nA reconciliation of Adjusted Net Income to Net income is provided in the following table:\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Net income | $ | 23,227 | $ | 24,327 | $ | 44,437 | $ | 29,535 |\n| Less: Net income attributable to noncontrolling interest | 2,168 | 1,016 | 1,042 | 219 |\n| Add: |\n| Equity -based compensation of Karman Topco L.P.(a) | (828 | ) | (5,575 | ) | (7,142 | ) | (10,031 | ) |\n| Change in fair value of warrant liability | (1,100 | ) | (3,491 | ) | (21,456 | ) | (5,024 | ) |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (340 | ) | 3,221 | 5,448 | 5,776 |\n| Acquisition-related expenses(d) | 4,260 | 5,110 | 19,843 | 13,053 |\n| Restructuring expenses(e) | 3,562 | (394 | ) | 4,458 | 10,636 |\n| Litigation(f) | — | (92 | ) | (800 | ) | (910 | ) |\n| Amortization of intangible assets(g) | 49,997 | 49,786 | 150,930 | 148,396 |\n| Costs associated with COVID-19, net of benefits received(h) | 2,009 | 1,087 | 4,945 | (948 | ) |\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\n| Tax adjustments related to non-GAAP adjustments(j) | (16,215 | ) | (15,262 | ) | (49,168 | ) | (47,113 | ) |\n| Adjusted Net Income | $ | 62,682 | $ | 59,101 | $ | 152,541 | $ | 146,762 |\n\nAdjusted EBITDA and Adjusted EBITDA by segment are supplemental non-GAAP financial measures of our operating performance. Adjusted EBITDA means Net income before (i) interest expense, net, (ii) provision for income taxes, (iii) depreciation, (iv) impairment of goodwill and indefinite-lived assets, (v) amortization of intangible assets, (vi) equity-based compensation of Topco, (vii) change in fair value of warrant liability, (viii) stock-based compensation expense, (ix) fair value adjustments of contingent consideration related to acquisitions, (x) acquisition-related expenses, (xi) costs associated with COVID-19, net of benefits received, (xii) EBITDA for economic interests in investments, (xiii) restructuring expenses, (xiv) litigation expenses (recovery), (xv) costs associated with the Take 5 Matter and (xvi) other adjustments that management believes are helpful in evaluating our operating performance.\nWe present Adjusted EBITDA and Adjusted EBITDA by segment because they are key operating measures used by us to assess our financial performance. These measures adjust for items that we believe do not reflect the ongoing operating performance of our business, such as certain noncash items, unusual or infrequent items or items that change from period to period without any material relevance to our operating performance. We evaluate these measures in conjunction with our results according to GAAP because we believe they provide a more complete understanding of factors and trends affecting our business than GAAP measures alone. Furthermore, the agreements governing our indebtedness contain covenants and other tests based on measures substantially similar to\n37\nAdjusted EBITDA. Neither Adjusted EBITDA nor Adjusted EBITDA by segment should be considered as an alternative for our Net income, our most directly comparable measure presented on a GAAP basis.\nA reconciliation of Adjusted EBITDA to Net income is provided in the following table:\n\n| Consolidated | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Net income | $ | 23,227 | $ | 24,327 | $ | 44,437 | $ | 29,535 |\n| Add: |\n| Interest expense, net | 23,557 | 36,490 | 63,628 | 104,544 |\n| Provision for income taxes | 1,158 | 8,276 | 11,523 | 16,582 |\n| Depreciation and amortization | 57,785 | 59,163 | 173,997 | 181,450 |\n| Equity-based compensation of Karman Topco L.P.(a) | (828 | ) | (5,575 | ) | (7,142 | ) | (10,031 | ) |\n| Change in fair value of warrant liability | (1,100 | ) | (3,491 | ) | (21,456 | ) | (5,024 | ) |\n| Stock-based compensation expense(b) | 7,174 | 7,854 | 29,906 | 25,497 |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (340 | ) | 3,221 | 5,448 | 5,776 |\n| Acquisition-related expenses(d) | 4,260 | 5,110 | 19,843 | 13,053 |\n| EBITDA for economic interests in investments(k) | (2,474 | ) | (3,620 | ) | (7,546 | ) | (6,616 | ) |\n| Restructuring expenses(e) | 3,562 | (394 | ) | 4,458 | 10,636 |\n| Litigation(f) | — | (92 | ) | (800 | ) | (910 | ) |\n| Costs associated with COVID-19, net of benefits received(h) | 2,009 | 1,087 | 4,945 | (948 | ) |\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\n| Adjusted EBITDA | $ | 118,268 | $ | 133,756 | $ | 323,329 | $ | 367,155 |\n\nFinancial information by segment, including a reconciliation of Adjusted EBITDA by segment to operating income, the closest GAAP financial measure, is provided in the following table:\n\n| Sales Segment | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Operating income | $ | 31,765 | $ | 51,906 | $ | 65,915 | $ | 131,727 |\n| Add: |\n| Depreciation and amortization | 39,798 | 41,515 | 121,310 | 128,789 |\n| Equity-based compensation of Karman Topco L.P.(a) | (320 | ) | (4,844 | ) | (4,004 | ) | (7,360 | ) |\n| Stock-based compensation expense(b) | 4,080 | 4,371 | 18,009 | 13,795 |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (1,901 | ) | 192 | 4,992 | (4,057 | ) |\n| Acquisition-related expenses(d) | 2,880 | 3,899 | 13,734 | 9,499 |\n| EBITDA for economic interests in investments(k) | (2,656 | ) | (3,832 | ) | (8,018 | ) | (7,429 | ) |\n| Restructuring expenses(e) | 2,360 | 1,273 | 3,519 | 3,229 |\n| Litigation(f) | — | (68 | ) | (100 | ) | (584 | ) |\n| Costs associated with COVID-19, net of benefits received(h) | 166 | 787 | 801 | 1,189 |\n| Sales Segment Adjusted EBITDA | $ | 76,172 | $ | 95,199 | $ | 216,158 | $ | 268,798 |\n\n38\n\n| Marketing Segment | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Operating income | $ | 15,077 | $ | 13,696 | $ | 32,217 | $ | 13,910 |\n| Add: |\n| Depreciation and amortization | 17,987 | 17,648 | 52,687 | 52,661 |\n| Equity-based compensation of Karman Topco L.P.(a) | (508 | ) | (731 | ) | (3,138 | ) | (2,671 | ) |\n| Stock-based compensation expense(b) | 3,094 | 3,483 | 11,897 | 11,702 |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | 1,561 | 3,029 | 456 | 9,833 |\n| Acquisition-related expenses(d) | 1,380 | 1,211 | 6,109 | 3,554 |\n| EBITDA for economic interests in investments(k) | 182 | 212 | 472 | 813 |\n| Restructuring expenses(e) | 1,202 | (1,667 | ) | 939 | 7,407 |\n| Litigation(f) | — | (24 | ) | (700 | ) | (326 | ) |\n| Costs associated with COVID-19, net of benefits received(h) | 1,843 | 300 | 4,144 | (2,137 | ) |\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\n| Marketing Segment Adjusted EBITDA | $ | 42,096 | $ | 38,557 | $ | 107,171 | $ | 98,357 |\n\n\n\n\n| (a) | Represents expenses related to (i) equity-based compensation expense associated with grants of Common Series D Units of Topco made to one of the Advantage Sponsors (as defined below) and (ii) equity-based compensation expense associated with the Common Series C Units of Topco. |\n| (b) | Represents non-cash compensation expense related to the 2020 Incentive Award Plan and the 2020 Employee Stock Purchase Plan. |\n| (c) | Represents adjustments to the estimated fair value of our contingent consideration liabilities related to our acquisitions. See Note 6—Fair Value of Financial Instruments to our unaudited condensed financial statements for the three and nine months ended September 30, 2022 and 2021. |\n| (d) | Represents fees and costs associated with activities related to our acquisitions and restructuring activities, including professional fees, due diligence, and integration activities. |\n| (e) | Represents fees and costs associated with various internal reorganization activities among our consolidated entities. |\n| (f) | Represents legal settlements that are unusual or infrequent costs associated with our operating activities. |\n| (g) | Represents the amortization of intangible assets recorded in connection with the 2014 Topco Acquisition and our other acquisitions. |\n| (h) | Represents (i) costs related to implementation of strategies for workplace safety in response to COVID-19, including employee-relief fund, additional sick pay for front-line associates, medical benefit payments for furloughed associates, and personal protective equipment; and (ii) benefits received from government grants for COVID-19 relief. |\n| (i) | Represents costs associated with the Take 5 Matter, primarily, professional fees and other related costs, for the three and nine months ended September 30, 2022 and 2021, respectively. |\n| (j) | Represents the tax provision or benefit associated with the adjustments above, taking into account the Company’s applicable tax rates, after excluding adjustments related to items that do not have a related tax impact. |\n| (k) | Represents additions to reflect our proportional share of Adjusted EBITDA related to our equity method investments and reductions to remove the Adjusted EBITDA related to the minority ownership percentage of the entities that we fully consolidate in our financial statements. |\n\n39\nLiquidity and Capital Resources\nOur principal sources of liquidity were cash flows from operations, borrowings under the Revolving Credit Facility, and other debt. Our principal uses of cash are operating expenses, working capital requirements, acquisitions, interest on debt and repayment of debt.\nCash Flows\nA summary of our cash operating, investing and financing activities are shown in the following table:\n\n| Nine Months Ended September 30, |\n| (in thousands) | 2022 | 2021 |\n| Net cash provided by operating activities | $ | 81,950 | $ | 101,068 |\n| Net cash used in investing activities | (103,062 | ) | (66,152 | ) |\n| Net cash used in financing activities | (32,920 | ) | (68,999 | ) |\n| Net effect of foreign currency fluctuations on cash | (12,311 | ) | (1,476 | ) |\n| Net change in cash, cash equivalents and restricted cash | $ | (66,343 | ) | $ | (35,559 | ) |\n\nNet Cash Provided by Operating Activities\nNet cash used in operating activities during the nine months ended September 30, 2022 consisted of net income of $44.4 million adjusted for certain non-cash items, including depreciation and amortization of $174.0 million and effects of changes in working capital. Net cash provided by operating activities during the nine months ended September 30, 2021 consisted of net income of $29.5 million adjusted for certain non-cash items, including depreciation and amortization of $181.5 million and effects of changes in working capital. The decrease in cash provided by operating activities during the nine months ended September 30, 2022 relative to the same period in 2021 was primarily due to ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses during the nine months ended September 30, 2022.\nNet Cash Used in Investing Activities\nNet cash used in investing activities during the nine months ended September 30, 2022 primarily consisted of the purchase of businesses, net of cash acquired of $74.4 million and purchase of property and equipment of $30.0 million. Net cash used in investing activities during the nine months ended September 30, 2021 primarily consisted of the purchase of businesses, net of cash acquired of $40.0 million and purchase of property and equipment of $24.1 million.\nNet Cash Used in Financing Activities\nWe primarily finance our growth through cash flows from operations, however, we also incur long-term debt or borrow under lines of credit when necessary to execute acquisitions. Additionally, many of our acquisition agreements include contingent consideration arrangements, which are generally based on the achievement of future financial performance by the operations attributable to the acquired companies. The portion of the cash payment up to the acquisition date fair value of the contingent consideration liability are classified as financing outflows, and amounts paid in excess of the acquisition date fair value of that liability are classified as operating outflows.\nCash flows used in financing activities during the nine months ended September 30, 2022 were primarily related to payments of contingent consideration and holdback payments of $31.7 million, repayment of principal on our Term Loan Facility of $9.9 million, partially offset by $3.3 million related to proceeds from the issuance of Class A common stock and $5.2 million of contribution from noncontrolling interest. Cash flows related to financing activities during the nine months ended September 30, 2021 were primarily related to borrowings of $51.7 million and repayment of $102.7 million on the Revolving Credit Facility and our lines of credit and $8.6 million related to payments of contingent consideration and holdback payments.\n40\nDescription of Credit Facilities\nSenior Secured Credit Facilities\nIn connection with the consummation of the Transactions, Advantage Sales & Marketing Inc. (the “Borrower”), an indirect wholly-owned subsidiary of the Company, entered into (i) a senior secured asset-based revolving credit facility in an aggregate principal amount of up to $400.0 million, subject to borrowing base capacity (as may be amended from time to time, the “Revolving Credit Facility”) and (ii) a secured first lien term loan credit facility in an aggregate principal amount of $1.325 billion (as may be amended from time to time, the “Term Loan Facility” and together with the Revolving Credit Facility, the “Senior Secured Credit Facilities”).\nRevolving Credit Facility\nOur Revolving Credit Facility provides for revolving loans and letters of credit in an aggregate amount of up to $400.0 million, subject to borrowing base capacity. Letters of credit are limited to the lesser of (a) $150.0 million and (b) the aggregate unused amount of commitments under our Revolving Credit Facility then in effect. Loans under the Revolving Credit Facility may be denominated in either U.S. dollars or Canadian dollars. Bank of America, N.A., is administrative agent and ABL Collateral Agent. The Revolving Credit Facility is scheduled to mature in October 2025. We may use borrowings under the Revolving Credit Facility to fund working capital and for other general corporate purposes, including permitted acquisitions and other investments. As of September 30, 2022, we had unused capacity under our Revolving Credit Facility available to us of $400.0 million, subject to borrowing base limitations (without giving effect to approximately $54.5 million of outstanding letters of credit and the borrowing base limitations for additional borrowings).\nBorrowings under the Revolving Credit Facility are limited by borrowing base calculations based on the sum of specified percentages of eligible accounts receivable plus specified percentages of qualified cash, minus the amount of any applicable reserves. Borrowings will bear interest at a floating rate, which can be either an adjusted Eurodollar rate plus an applicable margin or, at the Borrower’s option, a base rate plus an applicable margin. The applicable margins for the Revolving Credit Facility are 2.00%, 2.25% or 2.50%, with respect to Eurodollar rate borrowings and 1.00%, 1.25% or 1.50%, with respect to base rate borrowings, in each case depending on average excess availability under the Revolving Credit Facility. The Borrower’s ability to draw under the Revolving Credit Facility or issue letters of credit thereunder will be conditioned upon, among other things, the Borrower’s delivery of prior written notice of a borrowing or issuance, as applicable, the Borrower’s ability to reaffirm the representations and warranties contained in the credit agreement governing the Revolving Credit Facility and the absence of any default or event of default thereunder.\nThe Borrower’s obligations under the Revolving Credit Facility are guaranteed by Karman Intermediate Corp. (“Holdings”) and all of the Borrower’s direct and indirect wholly owned material U.S. subsidiaries (subject to certain permitted exceptions) and Canadian subsidiaries (subject to certain permitted exceptions, including exceptions based on immateriality thresholders of aggregate assets and revenues of Canadian subsidiaries) (the “Guarantors”). The Revolving Credit Facility is secured by a lien on substantially all of Holdings’, the Borrower’s and the Guarantors’ assets (subject to certain permitted exceptions). The Borrower’s Revolving Credit Facility has a first-priority lien on the current asset collateral and a second-priority lien on security interests in the fixed asset collateral (second in priority to the liens securing the Notes and the Term Loan Facility discussed below), in each case, subject to other permitted liens.\nThe Revolving Credit Facility has the following fees: (i) an unused line fee of 0.375% or 0.250% per annum of the unused portion of the Revolving Credit Facility, depending on average excess availability under the Revolving Credit Facility; (ii) a letter of credit participation fee on the aggregate stated amount of each letter of credit equal to the applicable margin for adjusted Eurodollar rate loans, as applicable; and (iii) certain other customary fees and expenses of the lenders and agents thereunder.\nThe Revolving Credit Facility contains customary covenants, including, but not limited to, restrictions on the Borrower’s ability and that of our subsidiaries to merge and consolidate with other companies, incur indebtedness, grant liens or security interests on assets, make acquisitions, loans, advances or investments, pay dividends, sell or\n41\notherwise transfer assets, optionally prepay or modify terms of any junior indebtedness, enter into transactions with affiliates or change our line of business. The Revolving Credit Facility will require the maintenance of a fixed charge coverage ratio (as set forth in the credit agreement governing the Revolving Credit Facility) of 1.00 to 1.00 at the end of each fiscal quarter when excess availability is less than the greater of $25 million and 10% of the lesser of the borrowing base and maximum borrowing capacity. Such fixed charge coverage ratio will be tested at the end of each quarter until such time as excess availability exceeds the level set forth above.\nThe Revolving Credit Facility provides that, upon the occurrence of certain events of default, the Borrower’s obligations thereunder may be accelerated and the lending commitments terminated. Such events of default include payment defaults to the lenders thereunder, material inaccuracies of representations and warranties, covenant defaults, cross-defaults to other material indebtedness, voluntary and involuntary bankruptcy, insolvency, corporate arrangement, winding-up, liquidation or similar proceedings, material money judgments, material pension-plan events, certain change of control events and other customary events of default.\nOn October 28, 2021, the Borrower and Holdings entered into the First Amendment to ABL Revolving Credit Agreement (the “ABL Amendment”), which amended the ABL Revolving Credit Agreement, dated October 28, 2020, by and among the Borrower, Holdings, the lenders from time to time party thereto and Bank of America, as administrative agent. The ABL Amendment was entered into by the Borrower to amend certain terms and provisions, including (i) reducing the interest rate floor for Eurocurrency rate loans from 0.50% to 0.00% and base rate loans from 1.50% to 1.00%, and (ii) updating the provisions by which U.S. Dollar LIBOR will eventually be replaced with the Secured Oversight Financing Rate (“SOFR”) or another interest rate benchmark to reflect the most recent standards and practices used in the industry.\nTerm Loan Facility\nThe Term Loan Facility is a term loan facility denominated in U.S. dollars in an aggregate principal amount of $1.325 billion. Borrowings under the Term Loan Facility amortize in equal quarterly installments in an amount equal to 1.00% per annum of the principal amount. Borrowings will bear interest at a floating rate, which can be either an adjusted Eurodollar rate plus an applicable margin or, at the Borrower’s option, a base rate plus an applicable margin. The applicable margins for the Term Loan Facility are 4.50% with respect to Eurodollar rate borrowings and 3.50% with respect to base rate borrowings.\nThe Borrower may voluntarily prepay loans or reduce commitments under the Term Loan Facility, in whole or in part, subject to minimum amounts, with prior notice but without premium or penalty (other than a 1.00% premium on any prepayment in connection with a repricing transaction prior to the date that is six months after the effective date of the First Lien Amendment).\nThe Borrower will be required to prepay the Term Loan Facility with 100% of the net cash proceeds of certain asset sales (such percentage subject to reduction based on the achievement of specific first lien net leverage ratios) and subject to certain reinvestment rights, 100% of the net cash proceeds of certain debt issuances and 50% of excess cash flow (such percentage subject to reduction based on the achievement of specific first lien net leverage ratios).\nThe Borrower’s obligations under the Term Loan Facility are guaranteed by Holdings and the Guarantors. Our Term Loan Facility is secured by a lien on substantially all of Holdings’, the Borrower’s and the Guarantors’ assets (subject to certain permitted exceptions). The Term Loan Facility has a first-priority lien on the fixed asset collateral (equal in priority with the liens securing the Notes) and a second-priority lien on security interests in the current asset collateral (second in priority to the liens securing the Revolving Credit Facility), in each case, subject to other permitted liens.\nThe Term Loan Facility contains certain customary negative covenants, including, but not limited to, restrictions on the Borrower’s ability and that of our restricted subsidiaries to merge and consolidate with other companies, incur indebtedness, grant liens or security interests on assets, pay dividends or make other restricted payments, sell or otherwise transfer assets or enter into transactions with affiliates.\n42\nThe Term Loan Facility provides that, upon the occurrence of certain events of default, the Borrower’s obligations thereunder may be accelerated. Such events of default will include payment defaults to the lenders thereunder, material inaccuracies of representations and warranties, covenant defaults, cross-defaults to other material indebtedness, voluntary and involuntary bankruptcy, insolvency, corporate arrangement, winding-up, liquidation or similar proceedings, material money judgments, change of control and other customary events of default.\nOn October 28, 2021 (the “First Lien Amendment Effective Date”), the Borrower, Holdings, and certain of the Borrower’s subsidiaries, entered into Amendment No. 1 to the First Lien Credit Agreement (the “First Lien Amendment”), which amended the First Lien Credit Agreement, dated October 28, 2020, by and among the Borrower, Holdings, Bank of America, as administrative agent and collateral agent, each lender party from time to time thereto, and the other parties thereto. The First Lien Amendment was entered into by the Borrower to reduce the applicable interest rate on the term loan to 5.25% per annum, resulting in estimated interest savings of approximately $9.9 million or $7.3 million, net of tax, per annum. Additional terms and provisions amended include (i) resetting the period for six months following the First Lien Amendment Effective Date in which a 1.00% prepayment premium shall apply to any prepayment of the term loan in connection with certain repricing events, and (ii) updating the provisions by which U.S. Dollar LIBOR will eventually be replaced with SOFR or another interest rate benchmark to reflect the most recent standards and practices used in the industry and by Bank of America.\nSenior Secured Notes\nIn connection with the Transactions, Advantage Solutions FinCo LLC (“Finco”) issued $775.0 million aggregate principal amount of 6.50% Senior Secured Notes due 2028 (the “Notes”). Substantially concurrently with the Transactions, Finco merged with and into Advantage Sales & Marketing Inc. (in its capacity as the issuer of the Notes, the “Issuer”), with the Issuer continuing as the surviving entity and assuming the obligations of Finco. The Notes were sold to BofA Securities, Inc., Deutsche Bank Securities Inc., Morgan Stanley & Co. LLC and Apollo Global Securities, LLC. The Notes were resold to certain non-U.S. persons pursuant to Regulation S under the Securities Act of 1933, as amended (the “Securities Act”), and to persons reasonably believed to be qualified institutional buyers pursuant to Rule 144A under the Securities Act at a purchase price equal to 100% of their principal amount. The terms of the Notes are governed by an Indenture, dated as of October 28, 2020 (the “Indenture”), among Finco, the Issuer, the guarantors named therein (the “Notes Guarantors”) and Wilmington Trust, National Association, as trustee and collateral agent.\nInterest and maturity\nInterest on the Notes is payable semi-annually in arrears on May 15 and November 15 at a rate of 6.50% per annum, commencing on May 15, 2021. The Notes will mature on November 15, 2028.\nGuarantees\nThe Notes are guaranteed by Holdings and each of the Issuer’s direct and indirect wholly owned material U.S. subsidiaries (subject to certain permitted exceptions) and Canadian subsidiaries (subject to certain permitted exceptions, including exceptions based on immateriality thresholders of aggregate assets and revenues of Canadian subsidiaries) that is a borrower or guarantor under the Term Loan Facility.\nSecurity and Ranking\nThe Notes and the related guarantees are the general, senior secured obligations of the Issuer and the Notes Guarantors, are secured on a first-priority pari passu basis by security interests on the fixed asset collateral (equal in priority with liens securing the Term Loan Facility), and are secured on a second-priority basis by security interests on the current asset collateral (second in priority to the liens securing the Revolving Credit Facility and equal in priority with liens securing the Term Loan Facility), in each case, subject to certain limitations and exceptions and permitted liens.\n43\nThe Notes and related guarantees rank (i) equally in right of payment with all of the Issuer’s and the Guarantors’ senior indebtedness, without giving effect to collateral arrangements (including the Senior Secured Credit Facilities) and effectively equal to all of the Issuer’s and the Guarantors’ senior indebtedness secured on the same priority basis as the Notes, including the Term Loan Facility, (ii) effectively subordinated to any of the Issuer’s and the Guarantors’ indebtedness that is secured by assets that do not constitute collateral for the Notes to the extent of the value of the assets securing such indebtedness and to indebtedness that is secured by a senior-priority lien, including the Revolving Credit Facility to the extent of the value of the current asset collateral and (iii) structurally subordinated to the liabilities of the Issuer’s non-Guarantor subsidiaries.\nOptional redemption for the Notes\nThe Notes are redeemable on or after November 15, 2023 at the applicable redemption prices specified in the Indenture plus accrued and unpaid interest. The Notes may also be redeemed at any time prior to November 15, 2023 at a redemption price equal to 100% of the aggregate principal amount of such Notes to be redeemed plus a “make-whole” premium, plus accrued and unpaid interest. In addition, the Issuer may redeem up to 40% of the original aggregate principal amount of Notes before November 15, 2023 with the net cash proceeds of certain equity offerings at a redemption price equal to 106.5% of the aggregate principal amount of such Notes to be redeemed, plus accrued and unpaid interest. Furthermore, prior to November 15, 2023 the Issuer may redeem during each calendar year up to 10% of the original aggregate principal amount of the Notes at a redemption price equal to 103% of the aggregate principal amount of such Notes to be redeemed, plus accrued and unpaid interest. If the Issuer or its restricted subsidiaries sell certain of their respective assets or experience specific kinds of changes of control, subject to certain exceptions, the Issuer must offer to purchase the Notes at par. In connection with any offer to purchase all Notes, if holders of no less than 90% of the aggregate principal amount of Notes validly tender their Notes, the Issuer is entitled to redeem any remaining Notes at the price offered to each holder.\nRestrictive covenants\nThe Notes are subject to covenants that, among other things limit the Issuer’s ability and its restricted subsidiaries’ ability to: incur additional indebtedness or guarantee indebtedness; pay dividends or make other distributions in respect of, or repurchase or redeem, the Issuer’s or a parent entity’s capital stock; prepay, redeem or repurchase certain indebtedness; issue certain preferred stock or similar equity securities; make loans and investments; sell or otherwise dispose of assets; incur liens; enter into transactions with affiliates; enter into agreements restricting the Issuer’s subsidiaries’ ability to pay dividends; and consolidate, merge or sell all or substantially all of the Issuer’s assets. Most of these covenants will be suspended on the Notes so long as they have investment grade ratings from both Moody’s Investors Service, Inc. and S&P Global Ratings and so long as no default or event of default under the Indenture has occurred and is continuing.\nEvents of default\nThe following constitute events of default under the Notes, among others: default in the payment of interest; default in the payment of principal; failure to comply with covenants; failure to pay other indebtedness after final maturity or acceleration of other indebtedness exceeding a specified amount; certain events of bankruptcy; failure to pay a judgment for payment of money exceeding a specified aggregate amount; voidance of subsidiary guarantees; failure of any material provision of any security document or intercreditor agreement to be in full force and effect; and lack of perfection of liens on a material portion of the collateral, in each case subject to applicable grace periods.\nFuture Cash Requirement\nThere were no material changes to our contractual future cash requirements from those disclosed in our 2021 Annual Report.\n44\nCash and Cash Equivalents Held Outside the United States\nAs of September 30, 2022 and December 31, 2021, $71.6 million and $86.2 million, respectively, of our cash and cash equivalents were held by foreign subsidiaries. As of September 30, 2022, and December 31, 2021, $21.6 million and $40.0 million, respectively, of our cash and cash equivalents were held by foreign branches.\nWe assessed our determination as to our indefinite reinvestment intent for certain of our foreign subsidiaries and recorded a deferred tax liability of approximately $2.5 million of withholding tax as of December 31, 2021 for unremitted earnings in Canada with respect to which the Company does not have an indefinite reinvestment assertion. We will continue to evaluate our cash needs, however we currently do not intend, nor do we foresee a need, to repatriate funds from the foreign subsidiaries except for Canada. We have continued to assert indefinite reinvestment on all other earnings as it is necessary for continuing operations and to grow the business. If at a point in the future our assertion changes, we will evaluate tax-efficient means to repatriate the income. In addition, we expect existing domestic cash and cash flows from operations to continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, such as debt repayment and capital expenditures, for at least the next 12 months and thereafter for the foreseeable future.\nIf we should require more capital in the United States than is generated by our domestic operations, for example, to fund significant discretionary activities such as business acquisitions, we could elect to repatriate future earnings from foreign jurisdictions. These alternatives could result in higher tax expense or increased interest expense. We consider the majority of the undistributed earnings of our foreign subsidiaries, as of December 31, 2021, to be indefinitely reinvested and, accordingly, no provision has been made for taxes in excess of the $2.5 million noted above.\nOff-Balance Sheet Arrangements\nWe do not have any off-balance sheet financing arrangements or liabilities, guarantee contracts, retained or contingent interests in transferred assets or any obligation arising out of a material variable interest in an unconsolidated entity. We do not have any majority-owned subsidiaries that are not included in our consolidated financial statements. Additionally, we do not have an interest in, or relationships with, any special-purpose entities.\nCritical Accounting Policies and Estimates\nOur critical accounting policies and estimates are included in our 2021 Annual Report and did not materially change during the nine months ended September 30, 2022.\nRecently Issued Accounting Pronouncements\nSee the information set forth in Note 1, Organization and Significant Accounting Policies – Recent Accounting Standards, to our unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2022 and 2021 included in “Part I, Financial Information—Item 1. Financial Statements” in this Quarterly Report.\n45\n\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nForeign Currency Risk\nOur exposure to foreign currency exchange rate fluctuations is primarily the result of foreign subsidiaries and foreign branches primarily domiciled in Europe and Canada. We use financial derivative instruments to hedge foreign currency exchange rate risks associated with our Canadian subsidiary.\nThe assets and liabilities of our foreign subsidiaries and foreign branches, whose functional currencies are primarily Canadian dollars, British pounds and euros, respectively, are translated into U.S. dollars at exchange rates in effect at the balance sheet date. Income and expense items are translated at the average exchange rates prevailing during the period. The cumulative translation effects for subsidiaries using a functional currency other than the U.S. dollar are included in accumulated other comprehensive loss as a separate component of stockholders’ equity. We estimate that had the exchange rate in each country unfavorably changed by ten percent relative to the U.S. dollar, our consolidated income before taxes would have decreased by approximately $2.5 million for the nine months ended September 30, 2022.\nInterest Rate Risk\nInterest rate exposure relates primarily to the effect of interest rate changes on borrowings outstanding under the Term Loan Facility, Revolving Credit Facility and Notes.\nWe manage our interest rate risk through the use of derivative financial instruments. Specifically, we have entered into interest rate cap agreements to manage our exposure to potential interest rate increases that may result from fluctuations in LIBOR. We do not designate these derivatives as hedges for accounting purposes, and as a result, all changes in the fair value of derivatives, used to hedge interest rates, are recorded in “Interest expense, net” in our Condensed Consolidated Statements of Operations and Comprehensive Income.\nAs of September 30, 2022, we had interest rate cap contracts on an additional $650.0 million of notional value of principal from other financial institutions, with a maturity date of December 16, 2024 to manage our exposure to interest rate movements on variable rate credit facilities when one-month LIBOR on term loans exceeding a cap of 0.75%. The aggregate fair value of our interest rate caps represented an outstanding net asset of $49.1 million as of September 30, 2022.\nHolding other variables constant, a change of one-eighth percentage point in the weighted average interest rate above the floor of 0.75% on the Term Loan Facility and Revolving Credit Facility would have resulted in an increase of $0.7 million in interest expense, net of gains from interest rate caps, for the nine months ended September 30, 2022.\nIn the future, in order to manage our interest rate risk, we may refinance our existing debt, enter into additional interest rate cap agreements or modify our existing interest rate cap agreement. However, we do not intend or expect to enter into derivative or interest rate cap transactions for speculative purposes.\n46\n\nITEM 4. CONTROLS AND PROCEDURES\nOur management, with the participation of our chief executive officer and chief financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Quarterly Report. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of September 30, 2022, our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in reports we file or submit under the Exchange Act is (1) recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and (2) accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.\nThere were no changes in internal control over financial reporting that occurred during the quarter ended September 30, 2022, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\nIn designing and evaluating our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints, and that management is required to apply judgment in evaluating the benefits of possible controls and procedures relative to their costs.\n47\nPART II - OTHER INFORMATION\n\nITEM 1. LEGAL PROCEEDINGS\nWe are involved in various legal matters that arise in the ordinary course of our business. Some of these legal matters purport or may be determined to be class and/or representative actions, or seek substantial damages or penalties. Some of these legal matters relate to disputes regarding acquisitions. In connection with certain of the below matters and other legal matters, we have accrued amounts that we believe are appropriate. There can be no assurance, however, that the above matters and other legal matters will not result in us having to make payments in excess of such accruals or that the above matters or other legal matters will not materially or adversely affect our business, financial position or results of operations.\nEmployment-Related Matters\nWe have also been involved in various litigation, including purported class or representative actions with respect to matters arising under the U.S. Fair Labor Standards Act, California’s Labor Code (the “Labor Code”) and California’s Labor Code Private Attorneys General Act (“PAGA”). Many involve allegations for allegedly failing to pay wages and/or overtime, failing to provide meal and rest breaks and failing to pay reporting time pay, waiting time penalties and other penalties.\nA former employee filed a complaint in California Superior Court, Santa Clara County in July 2017, which seeks civil damages and penalties on behalf of the plaintiff and similarly situated persons for various alleged wage and hour violations under the Labor Code, including failure to pay wages and/or overtime, failure to provide meal and rest breaks, failure to pay reporting time pay, waiting time penalties and penalties pursuant to PAGA. We filed a motion for summary judgment. The court granted our motion for summary judgment in March 2020, and the plaintiff filed an appeal of the court’s ruling in May 2020. We have retained outside counsel to represent us and intend to vigorously defend our interests in this matter.\nProceedings Relating to Take 5\nThe following proceedings relate to the Take 5 Matter, which is discussed in greater detail in “PART I, Financial Information —Item 1. Financial Statements—Note 10. Commitments and Contingencies” and “Risk Factors — Risks Related to the Company’s Business and Industry” in this Quarterly Report.\nUSAO and FBI Voluntary Disclosure and Investigation Related to Take 5\nIn connection with the Take 5 Matter, we voluntarily disclosed to the United States Attorney’s Office and the Federal Bureau of Investigation certain misconduct occurring at Take 5. We intend to cooperate in this and any other governmental investigation that may arise in connection with the Take 5 Matter. At this time, we cannot predict the ultimate outcome of any investigation related to the Take 5 Matter and are unable to estimate the potential impact such an investigation may have on us.\nArbitration Proceedings Related to Take 5\nIn August 2019, as a result of the Take 5 Matter, we provided a written indemnification claim notice to the sellers of Take 5, or the Take 5 Sellers, seeking monetary damages (including interest, fees and costs) based on allegations of breach of the asset purchase agreement, or Take 5 APA, as well as fraud. In September 2019, the Take 5 Sellers initiated arbitration proceedings in the state of Delaware against us, alleging breach of the Take 5 APA as a result of our decision to terminate the operations of the Take 5 business and seeking monetary damages equal to all unpaid earn-out payments under the Take 5 APA (plus interest fees and costs). In 2020, the Take 5 Sellers amended their statement of claim to allege defamation, relating to statements we made to customers in connection with terminating the operations of the Take 5 business, and seeking monetary damages for the alleged injury to their reputation. We have filed our response to the Take 5 Sellers’ claims and asserted indemnification, fraud and other claims against the Take 5 Sellers as counterclaims and cross-claims in the arbitration proceedings.\n48\nIn October 2022, the arbitrator made a final award in our favor. We are currently unable to estimate if or when we will be able to collect any amounts associated with this arbitration.\nOther Legal Matters Related to Take 5\nThe Take 5 Matter may result in additional litigation against us, including lawsuits from clients, or governmental investigations, which may expose us to potential liability in excess of the amounts being offered by us as refunds to Take 5 clients. We are currently unable to determine the amount of any potential liability, costs or expenses (above the amounts already being offered as refunds) that may result from any lawsuits or investigations associated with the Take 5 Matter or determine whether any such issues will have any future material adverse effect on our financial position, liquidity or results of operations. Although we have insurance covering certain liabilities, we cannot assure that the insurance will be sufficient to cover any potential liability or expenses associated with the Take 5 Matter.\n\nITEM 1A. RISK FACTORS\nInvesting in our securities involves risks. Before you make a decision regarding our securities, in addition to the risks and uncertainties discussed above under “Forward-Looking Statements,” you should carefully consider the specific risks set forth herein. If any of these risks actually occur, it may materially harm our business, financial condition, liquidity and results of operations. As a result, the market price of our securities could decline, and you could lose all or part of your investment. Additionally, the risks and uncertainties described in this Quarterly Report are not the only risks and uncertainties that we face. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may become material and adversely affect our business. The following discussion should be read in conjunction with the financial statements and notes to the financial statements included herein.\nSummary of Principal Risks Associated with Our Business\nSet forth below is a summary of some of the principal risks we face:\n•the COVID-19 pandemic and the measures taken to mitigate its spread including its adverse effects on our business, results of operations, financial condition and liquidity;\n•market-driven wage changes or changes to labor laws or wage or job classification regulations, including minimum wage;\n•our ability to hire, timely train, and retain talented individuals for our workforce, and to maintain our corporate culture as we grow;\n•developments with respect to retailers that are out of our control;\n•our ability to continue to generate significant operating cash flow;\n•consolidation within the industry of our clients creating pressure on the nature and pricing of our services;\n•our reliance on continued access to retailers’ platforms;\n•consumer goods manufacturers and retailers reviewing and changing their sales, retail, marketing, and technology programs and relationships;\n•our ability to successfully develop and maintain relevant omni-channel services for our clients in an evolving industry and to otherwise adapt to significant technological change;\n•client procurement strategies putting additional operational and financial pressure on our services;\n•our ability to maintain proper and effective internal control over financial reporting in the future;\n•potential and actual harms to our business arising from the matter related to the 2018 acquisition of Take 5 Media Group (the “Take 5 Matter”);\n•our ability to identify attractive acquisition targets, acquire them at attractive prices, and successfully integrate the acquired businesses;\n•our ability to avoid or manage business conflicts among competing brands;\n49\n•difficulties in integrating acquired businesses;\n•our substantial indebtedness and our ability to refinance at favorable rates;\n•limitations, restrictions, and business decisions involving our joint ventures and minority investments;\n•our ability to respond to changes in digital practices and policies;\n•exposure to foreign currency exchange rate fluctuations and risks related to our international operations;\n•disruptions in global financial markets relating to terrorist attacks or geopolitical risk and the recent conflict between Russia and Ukraine;\n•the ability to maintain applicable listing standards;\n•changes in applicable laws or regulations; and\n•the possibility that we may be adversely affected by other political, economic, business, and/or competitive factors.\nRisks Related to the Company’s Business and Industry\nThe COVID-19 pandemic and the measures taken to mitigate its spread have had, and are likely to continue to have, an adverse effect on our business, results of operations, financial condition and liquidity.\nThe COVID-19 pandemic, including the measures taken to mitigate its spread, have had, and are likely to continue to have, adverse effects on our business and operations. There are many uncertainties regarding the current COVID-19 pandemic, including the scope of potential public health issues, the anticipated duration of the pandemic and the extent of local and worldwide social, political and economic disruption it has caused and may cause in the future. To date, the COVID-19 pandemic and measures taken to mitigate the spread of COVID-19, including restrictions on large gatherings, closures of face-to-face events and indoor dining facilities, “shelter in place” health orders and travel restrictions, have had far-reaching direct and indirect impacts on many aspects of our operations, including temporary termination of certain in-store demonstration services and other services, as well as on consumer behavior and purchasing patterns, in particular with respect to the foodservice industries, and declines in consumer demand for restaurant, school and hotel dining, where we promote our clients’ products. Since March 2020, our marketing segment has experienced a significant decline in revenues, primarily due to the temporary suspension or reduction of certain in-store demonstration services and decreased demand in our digital marketing services, both of which we believe were caused by the COVID-19 pandemic and the various governmental and private responses to the pandemic, and which may continue in the future. In our sales segment, we have experienced significant shifts in consumer spending preferences and habits. We can provide no assurances that the strength of that segment will continue or that we will be able to continue to evolve our business in the future as the COVID-19 pandemic continues to impact our clients’ businesses.\nWe have taken several actions in response to these business disruptions, including reducing certain of our discretionary expenditures, reducing our real estate foot print, through lease terminations and amendments (including abandoning several office leases prior to reaching termination agreements with its landlords), eliminating non-essential travel and terminating, furloughing or instituting pay reductions and deferrals for some of our associates. However, the pandemic has had, and may continue to have, an adverse effect on our results of operations, including our revenues, our financial condition and liquidity.\nThe COVID-19 pandemic also may have the effect of heightening many of the other risks described in these “Risk Factors”, including:\n•potential changes in the policies of retailers in response to the COVID-19 pandemic, including changes to or restrictions on their outsourcing of sales and marketing functions and restrictions on the performance of in-store demonstration services, if permitted at all;\n•potential changes in the demand for services by our clients in response to the COVID-19 pandemic;\n•our ability to hire, timely train and retain talented individuals for our workforce;\n•disruptions, delays and strains in certain domestic and internal supply changes that have had, and may continue to have, a negative effect on the flow or availability of certain products;\n50\n•the need for us to adapt to technological change and otherwise develop and maintain omni-channel solutions;\n•our ability to generate sufficient cash to service our substantial indebtedness;\n•our ability to maintain our credit rating;\n•our ability to offer high-quality customer support and maintain our reputation;\n•our ability to identify, perform adequate diligence on and consummate acquisitions of attractive business targets, and then subsequently integrate such acquired businesses;\n•our ability to maintain our corporate culture;\n•severe disruption and instability in the U.S. and global financial markets or deteriorations in credit and financing conditions, which could make it difficult for us to access debt and equity capital on attractive terms, or at all;\n•our ability to effectively manage our operations while a significant amount of our associates continue to work remotely due to the COVID-19 pandemic;\n•deteriorating economic conditions, declines in labor force participation rates, public transportation disruptions or other disruptions as a result of the COVID-19 pandemic;\n•potential cost-saving strategies implemented by clients that reduce fees paid to third-party service providers such as ourselves; and\n•our ability to implement additional internal control measures to improve our internal control over financial reporting.\nWe cannot predict the full extent to which the COVID-19 pandemic may affect our business, financial condition, results of operations and liquidity as such effects will depend on how the COVID-19 pandemic and the measures taken in response to the COVID-19 pandemic continue to develop. However, these effects may continue, evolve or increase in severity, each of which could further negatively impact our business, financial condition, results of operations and liquidity.\nMarket-driven wage increases and changes to wage or job classification regulations, including minimum wages could adversely affect our business, financial condition or results of operations.\nMarket competition has and may continue to cause us to increase the salaries or wages paid to our associates or the benefits packages that they receive. If we experience further market-driven increases in salaries, wage rates or benefits or if we fail to increase our offered salaries, wages or benefits packages competitively, the quality of our workforce could decline, causing our client service to suffer. Low unemployment rates or lower levels of labor force participation rates may increase the likelihood or impact of such market pressures. Any of these changes affecting wages or benefits for our associates could adversely affect our business, financial condition or results of operations.\nChanges in labor laws related to employee hours, wages, job classification and benefits, including health care benefits, could adversely affect our business, financial condition or results of operations. As of September 30, 2022, we employed approximately 75,000 associates, many of whom are paid above, but near, applicable minimum wages, and their wages may be affected by changes in minimum wage laws.\nAdditionally, many of our salaried associates are paid at rates that could be impacted by changes to minimum pay levels for exempt roles. Certain state or municipal jurisdictions in which we operate have recently increased their minimum wage by a significant amount, and other jurisdictions are considering or plan to implement similar actions, which may increase our labor costs. Any increases at the federal, state or municipal level to the minimum pay rate required to remain exempt from overtime pay may adversely affect our business, financial condition or results of operations.\nAn inability to hire, timely train and retain talented individuals for our workforce could slow our growth and adversely impact our ability to operate our business.\nOur ability to meet our workforce needs, while controlling associate-related costs, including salaries, wages and benefits, is subject to numerous external factors, including the availability of talented persons in the workforce in the local markets in which we operate, prevailing unemployment rates and competitive wage rates in such\n51\nmarkets. We may find that there is an insufficient number of qualified individuals to fill our associate positions with the qualifications we seek. Competition in these communities for qualified staff could require us to pay higher wages and provide greater benefits, especially if there is significant improvement in regional or national economic conditions. We must also train and, in some circumstances, certify these associates under our policies and practices and any applicable legal requirements. If we are unable to hire, timely train or retain talented individuals may result in higher turnover and increased labor costs, and could compromise the quality of our service, all of which could adversely affect our business.\nInflation may adversely affect our operating results.\nInflationary factors such as increases in the labor costs, material costs and overhead costs may adversely affect our operating results. A high rate of inflation, including a continuation of inflation at the current rate, has had and may continue to have an adverse effect on our ability to maintain attractive levels of gross margin and general and administrative expenses as a percentage of total revenue, if we are unable to pass on these costs through increased prices, revised budget estimates, or offset them in other ways.\nOur business and results of operations are affected by developments with and policies of retailers that are out of our control.\nA limited number of national retailers account for a large percentage of sales for our consumer goods manufacturer clients. We expect that a significant portion of these clients’ sales will continue to be made through a relatively small number of retailers and that this percentage may increase if the growth of mass retailers and the trend of retailer consolidation continues. As a result, changes in the strategies of large retailers, including a reduction in the number of brands that these retailers carry or an increase in shelf space that they dedicate to private label products, could materially reduce the value of our services to these clients or these clients’ use of our services and, in turn, our revenues and profitability. Many retailers have critically analyzed the number and variety of brands they sell, and have reduced or discontinued the sale of certain of our clients’ product lines at their stores, and more retailers may continue to do so. If this continues to occur and these clients are unable to improve distribution for their products at other retailers, our business or results of operations could be adversely affected. These trends may be accelerated as a result of the COVID-19 pandemic.\nAdditionally, many retailers, including several of the largest retailers in North America, which own and operate a significant number of the locations at which we provide our services, have implemented or may implement in the future, policies that designate certain service providers to be the exclusive provider or one of their preferred providers for specified services, including many of the services that we provide to such retailers or our clients.\nSome of these designations apply across all of such retailers’ stores, while other designations are limited to specific regions. If we are unable to respond effectively to the expectations and demands of such retailers or if retailers do not designate us as their exclusive provider or one of their preferred providers for any reason, they could reduce or restrict the services that we are permitted to perform for our clients at their facilities or require our clients to purchase services from other designated services providers, which include our competitors, either of which could adversely affect our business or results of operations.\nConsolidation in the industries we serve could put pressure on the pricing of our services, which could adversely affect our business, financial condition or results of operations.\nConsolidation in the consumer goods and retail industries we serve could reduce aggregate demand for our services in the future and could adversely affect our business or our results of operations. In October 2022, The Kroger Co. and Albertsons Companies, Inc., two large retailers, announced an agreement to merge their businesses together with an anticipated closing in 2024. When companies consolidate, the services they previously purchased separately are often purchased by the combined entity, leading to the termination of relationships with certain service providers or demands for reduced fees and commissions. The combined company may also choose to insource certain functions that were historically outsourced, resulting in the termination of existing relationships with third-party service providers. While we attempt to mitigate the revenue impact of any consolidation by maintaining existing or winning new service arrangements with the combined companies, there can be no assurance as to the degree to which we will be able to do so as consolidation continues in the industries we serve, and our business, financial condition or results of operations may be adversely affected.\n52\nConsumer goods manufacturers and retailers may periodically review and change their sales, retail, marketing and technology programs and relationships to our detriment.\nThe consumer goods manufacturers and retailers to whom we provide our business solutions operate in highly competitive and rapidly changing environments. From time to time these parties may put their sales, retail, marketing and technology programs and relationships up for competitive review, which may increase in frequency as a result of the COVID-19 pandemic and its impacts on the consumer goods manufacturers and retailer industries. We have occasionally lost accounts with significant clients as a result of these reviews in the past, and our clients are typically able to reduce or cancel current or future spending on our services on short notice for any reason. We believe that key competitive considerations for retaining existing and winning new accounts include our ability to develop solutions that meet the needs of these manufacturers and retailers in this environment, the quality and effectiveness of our services and our ability to operate efficiently. To the extent that we are not able to develop these solutions, maintain the quality and effectiveness of our services or operate efficiently, we may not be able to retain key clients, and our business, financial condition or results of operations may be adversely affected.\nOur largest clients generate a significant portion of our revenues.\nOur three largest clients generated approximately 11% of our revenues in the fiscal year ended December 31, 2021. These clients are generally able to reduce or cancel spending on our services on short notice for any reason. A significant reduction in spending on our services by our largest clients, or the loss of one or more of our largest clients, if not replaced by new clients or an increase in business from existing clients, would adversely affect our business and results of operations. In addition, when large retailers suspend or reduce in-store demonstration services, such as in response to the COVID-19 pandemic, our business and results of operations can be adversely affected.\nWe are reliant on continued access to retailer platforms on commercially reasonable terms for the provision of certain of our e-commerce services in which our clients’ products are resold by us, as the vendor of record, directly to the consumer.\nA portion of the e-commerce services we provide involve the purchase and resale by us, as the vendor of record, of our clients’ products through retailer platforms. The control that retailers such as Amazon have over the access and fee structures and/or pricing for products on their platforms could impact the volume of purchases of these products made on their platform and our revenues from the provision of such e-commerce services. If such retailers establish terms that restrict the offering of these products on their platform, significantly impact the financial terms on which such products are offered, or do not approve the inclusion of such products on their platform, our business could be negatively impacted. Additionally, we also generally rely on a retailer’s payment processing services for purchases made on its platform by consumers. To the extent such payment processing services are offered to us on less favorable terms, or become unavailable to us for any reason, our costs of revenue with respect to this aspect of our business could increase, and our margins could be materially adversely impacted. We cannot assure you that we will be successful in maintaining access to these retailer platforms on commercially reasonable terms, or at all.\nThe retail industry is evolving, and if we do not successfully develop and maintain relevant omni-channel services for our clients, our business, financial condition or results of operations could be adversely impacted.\nHistorically, substantially all of our sales segment revenues were generated by sales and services that ultimately occurred in traditional retail stores. The retail industry is evolving, as demonstrated by the number of retailers that offer both traditional retail stores and e-commerce platforms or exclusively e-commerce platforms. In addition, the COVID-19 pandemic has placed pressure on the traditional retail store model, including store closures, changes in consumer spending, and extensive health and safety risks and compliance requirements. Consumers are increasingly using computers, tablets, mobile phones and other devices to comparison shop, determine product availability and complete purchases online, a trend that has accelerated during the COVID-19 pandemic, and which may continue thereafter. If consumers continue to purchase more products online and e-commerce continues to displace brick-and-mortar retail sales, there may be a decrease in the demand for certain of our services. Omni-channel retailing is rapidly evolving and we believe we will need to keep pace with the changing consumer expectations and new developments by our competitors.\n53\nWhile we continue to seek to develop effective omni-channel solutions for our clients that support both their e-commerce and traditional retail needs, there can be no assurances that these efforts will result in revenue gains sufficient to offset potential decreases associated with a decline in traditional retail sales or that we will be able to maintain our position as a leader in our industry. If we are unable to provide, improve or develop innovative digital services and solutions in a timely manner or at all, our business, financial condition or results of operations could be adversely impacted.\nWe may be unable to adapt to significant technological change, which could adversely affect our business, financial condition or results of operations.\nWe operate businesses that require sophisticated data collection, processing and software for analysis and insights. Some of the technologies supporting the industries we serve are changing rapidly, particularly as a result of the COVID-19 pandemic. We will be required to continue to adapt to changing technologies, either by developing and marketing new services or by enhancing our existing services, to meet client demand.\nMoreover, the introduction of new services embodying new technologies, including automation of certain of our in-store services, and the emergence of new industry standards could render existing services obsolete. Our continued success will depend on our ability to adapt to changing technologies, manage and process increasing amounts of data and information and improve the performance, features and reliability of our existing services in response to changing client and industry demands. We may experience difficulties that could delay or prevent the successful design, development, testing, introduction or marketing of our services. New services or enhancements to existing services may not adequately meet the requirements of current and prospective clients or achieve market acceptance.\nOur ability to maintain our competitive position depends on our ability to attract and retain talented executives.\nWe believe that our continued success depends to a significant extent upon the efforts, abilities and relationships of our senior executives and the strength of our middle management team. Although we have entered into employment agreements with certain of our senior executives, each of them may terminate their employment with us at any time. The replacement of any of our senior executives likely would involve significant time and costs and may significantly delay or prevent the achievement of our business objectives and could therefore have an adverse impact on our business. In addition, we do not carry any “key person” insurance policies that could offset potential loss of service under applicable circumstances. Furthermore, if we are unable to attract and retain a talented team of middle management executives, it may be difficult to maintain the expertise and industry relationships that our clients value, and they may terminate or reduce their relationship with us.\nClient procurement and fee reduction strategies could put additional operational and financial pressure on our services or negatively impact our relationships, business, financial condition or results of operations.\nMany of our clients seek opportunities to reduce their costs through procurement strategies that reduce fees paid to third-party service providers. As a result, certain of our clients have sought, and may continue to seek, more aggressive terms from us, including with respect to pricing and payment terms. Such activities put operational and financial pressure on our business, which could limit the amounts we earn or delay the timing of our cash receipts. Such activities may also cause disputes with our clients or negatively impact our relationships or financial results. Our clients have experienced, and may continue to experience, increases in their expenses associated with materials and logistics, which may cause them to reduce expenses elsewhere. While we attempt to mitigate negative implications to client relationships and the revenue impact of any pricing pressure by aligning our revenues opportunity with satisfactory client outcomes, there can be no assurance as to the degree to which we will be able to do so successfully. Additionally, price concessions can lead to margin compression, which in turn could adversely affect our business, financial condition or results of operations.\nIf we fail to offer high-quality customer support, our business and reputation may suffer.\nHigh-quality education, training and customer support are important for successful marketing and sales and for the renewal of existing customers. Providing this education, training and support requires that our personnel who manage our online training resource or provide customer support have specific inbound experience domain knowledge and expertise, making it more difficult for us to hire qualified personnel and to scale up our support operations. The importance of high-quality customer support will increase as we expand our business and pursue\n54\nnew customers. If we do not help our customers use multiple applications and provide effective ongoing support, our ability to sell additional functionality and services to, or to retain, existing customers may suffer and our reputation with existing or potential customers may be harmed.\nWe may be adversely affected if clients reduce their outsourcing of sales and marketing functions.\nOur business and growth strategies depend in large part on companies continuing to elect to outsource sales and marketing functions. Our clients and potential clients will outsource if they perceive that outsourcing may provide quality services at a lower overall cost and permit them to focus on their core business activities and have done so in the past. We cannot be certain that the industry trend to outsource will continue or not be reversed or that clients that have historically outsourced functions will not decide to perform these functions themselves. Unfavorable developments with respect to outsourcing could adversely affect our business, financial conditions and results of operations.\nWe previously identified material weaknesses in our internal control over financial reporting. If we fail to maintain proper and effective internal control over financial reporting in the future, our ability to produce accurate and timely financial statements could be impaired, investors’ views of us could be harmed, and we could be subject to enforcement actions by the SEC.\nDuring 2021, we completed the remediation measures related to the material weaknesses previously identified and concluded that our internal control over financial reporting was effective as of December 31, 2021. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim consolidated financial statements will not be prevented or detected on a timely basis. If we are unable to maintain effective internal control over financial reporting or disclosure controls and procedures, our ability to record, process and report financial information accurately, and to prepare financial statements within required time periods could be adversely affected, which could subject us to litigation or investigations requiring management resources and payment of legal and other expenses, negatively affect investor confidence in our financial statements and adversely impact our stock price.\nIf we are unable to identify attractive acquisition targets, acquire them at attractive prices or successfully integrate the acquired businesses, we may be unsuccessful in growing our business.\nA significant portion of our growth has been as a result of our acquisition of complementary businesses that grow our service offerings, expand our geographic reach and strengthen valuable relationships with clients. However, there can be no assurance that we will find attractive acquisition targets, that we will acquire them at attractive prices, that we will succeed at effectively managing the integration of acquired businesses into our existing operations or that such acquired businesses or technologies will be well received by our clients, potential clients or our investors. We could also encounter higher-than-expected earn-out payments, unforeseen transaction- and integration-related costs or delays or other circumstances such as disputes with or the loss of key or other personnel from acquired businesses, challenges or delays in integrating systems or technology of acquired businesses, a deterioration in our associate and client relationships, harm to our reputation with clients, interruptions in our business activities or unforeseen or higher-than-expected inherited liabilities. Many of these potential circumstances are outside of our control and any of them could result in increased costs, decreased revenue, decreased synergies or the diversion of management time and attention.\nIn order for us to continue to grow our business through acquisitions we will need to identify appropriate acquisition opportunities and acquire them at attractive prices. We may choose to pay cash, incur debt or issue equity securities to pay for any such acquisition. The incurrence of indebtedness would result in increased fixed obligations and could also include covenants or other restrictions that would impede our ability to manage our operations. The sale of equity to finance any such acquisition could result in dilution to our stockholders.\nWe may encounter significant difficulties integrating acquired businesses.\nThe integration of any businesses is a complex, costly and time-consuming process. As a result, we have devoted, and will continue to devote, significant management attention and resources to integrating acquired businesses. The failure to meet the challenges involved in integrating businesses and to realize the anticipated benefits of any acquisition could cause an interruption of, or a loss of momentum in, the activities of our combined\n55\nbusiness and could adversely affect our results of operations. The difficulties of combining acquired businesses with our own include, among others:\n•the diversion of management attention to integration matters;\n•difficulties in integrating functional roles, processes and systems, including accounting systems;\n•challenges in conforming standards, controls, procedures and accounting and other policies, business cultures and compensation structures between the two companies;\n•difficulties in assimilating, attracting and retaining key personnel;\n•challenges in keeping existing clients and obtaining new clients;\n•difficulties in achieving anticipated cost savings, synergies, business opportunities and growth prospects from an acquisition;\n•difficulties in managing the expanded operations of a significantly larger and more complex business;\n•contingent liabilities, including contingent tax liabilities or litigation, that may be larger than expected; and\n•potential unknown liabilities, adverse consequences or unforeseen increased expenses associated with an acquisition, including possible adverse tax consequences to the combined business pursuant to changes in applicable tax laws or regulations.\nMany of these factors are outside of our control, and any one of them could result in increased costs, decreased expected revenues and diversion of management time and energy, all of which could adversely impact our business and results of operations. These difficulties have been enhanced further during the COVID-19 pandemic as a result of our office closures and work-from home policies, which may hinder assimilation of key personnel.\nIf we are not able to successfully integrate an acquisition, if we incur significantly greater costs to achieve the expected synergies than we anticipate or if activities related to the expected synergies have unintended consequences, our business, financial condition or results of operations could be adversely affected.\nOur corporate culture has contributed to our success and, if we are unable to maintain it as we evolve, our business, operating results and financial condition could be harmed.\nWe believe our corporate culture has been a significant factor in our success. However, as our company evolves, including through acquisitions and the impacts of the COVID-19 pandemic, such as working remotely and reductions in workforce, it may be difficult to maintain our culture, which could reduce our ability to innovate and operate effectively. The failure to maintain the key aspects of our culture as our organization evolves could result in decreased employee satisfaction, increased difficulty in attracting top talent, increased turnover and compromised the quality of our client service, all of which are important to our success and to the effective execution of our business strategy. If we are unable to maintain our corporate culture as we evolve and execute our growth strategies, our business, operating results and financial condition could be harmed.\nAcquiring new clients and retaining existing clients depends on our ability to avoid or manage business conflicts among competing brands.\nOur ability to acquire new clients and to retain existing clients, whether by expansion of our own operations or through an acquired business may in some cases be limited by the other parties’ perceptions of, or policies concerning, perceived competitive conflicts arising from our other relationships. Some of our contracts expressly restrict our ability to represent competitors of the counterparty. These perceived competitive conflicts may also become more challenging to avoid or manage as a result of continued consolidation in the consumer goods and retail industries and our own acquisitions. If we are unable to avoid or manage business conflicts among competing manufacturers and retailers, we may be unable to acquire new clients or be forced to terminate existing client relationships, and in either case, our business and results of operations may be adversely affected.\nLimitations, restrictions and business decisions involving our joint ventures and minority investments may adversely affect our growth and results of operations.\n56\nWe have made substantial investments in joint ventures and minority investments and may use these and other similar methods to expand our service offerings and geographical coverage in the future. These arrangements typically involve other business services companies as partners that may be competitors of ours in certain markets. Joint venture agreements may place limitations or restrictions on our services. As part of our joint venture with, and investments in Smollan, we are restricted under certain circumstances from making direct acquisitions and otherwise expanding our service offerings into markets outside of North America and Europe. As a result of our acquisition of Daymon Worldwide Inc. pursuant to the terms of our arrangements with Smollan and our joint venture, Smollan and our joint venture may elect to purchase from us, and have purchased, certain Daymon business units that operate outside of North America. If Smollan or our joint venture do not elect to purchase those business units, we may, under certain circumstances, elect to retain, sell or discontinue those business units. The limitations and restrictions tied to our joint venture and minority investments limit our potential business opportunities and reduce the economic opportunity for certain prospective international investments and operations. Additionally, though we control our joint ventures, we may rely upon our equity partners or local management for operational and compliance matters associated with our joint ventures or minority investments. Moreover, our other equity partners and minority investments may have business interests, strategies or goals that are inconsistent with ours. Business decisions, including actions or omissions, of a joint venture or other equity partner or management for a business unit may adversely affect the value of our investment, result in litigation or regulatory action against us or adversely affect our growth and results of operations.\nOur international operations expose us to risks that could impede growth in the future, and our attempts to grow our business internationally may not be successful.\nWe continue to explore opportunities in major international markets. International operations expose us to various additional risks that could adversely affect our business, including:\n•costs of customizing services for clients outside of the United States;\n•the burdens of complying with a wide variety of foreign laws;\n•potential difficulty in enforcing contracts;\n•being subject to U.S. laws and regulations governing international operations, including the U.S. Foreign Corrupt Practices Act and sanctions regimes;\n•being subject to foreign anti-bribery laws in the jurisdictions in which we operate, such as the UK Bribery Act;\n•reduced protection for intellectual property rights;\n•increased financial accounting and reporting complexity;\n•additional legal compliance requirements, including custom and import requirements with respect to products imported to and exported across international borders;\n•exposure to foreign currency exchange rate fluctuations;\n•exposure to local economic conditions;\n•limitations on the repatriation of funds or profits from foreign operations;\n•exposure to local or regional political conditions, including adverse tax policies and civil unrest;\n•the risks of a natural disaster, public health crisis (including the occurrence of a contagious disease or illness, such as the coronavirus), an outbreak of war (such as Russia's invasion of Ukraine), the escalation of hostilities and acts of terrorism in the jurisdictions in which we operate; and\n•the disparate impact of the COVID-19 pandemic, including the measures taken to mitigate its spread, across various jurisdictions.\nAdditionally, the withdrawal of the United Kingdom from the European Union, or “Brexit,” has created economic and political uncertainty, including volatility in global financial markets and the value of foreign currencies. The impact of Brexit may not be fully realized for several years. Additionally, in many countries outside of the United States, there has not been a historical practice of using third parties to provide sales and marketing services. Accordingly, while it is part of our strategy to expand into international markets, it may be difficult for us to grow our international business units on a timely basis, or at all.\nThe ongoing conflict between Russia and Ukraine may adversely affect our business and results of operations.\n57\nGiven the nature of our business and our international operations, political, economic, and other conditions in foreign countries and regions, including geopolitical risks such as those arising from the current conflict between Russia and Ukraine, may adversely affect our business and results of operations. The broader consequences of this conflict, which may include further sanctions, embargoes, regional instability, and geopolitical shifts; disruptions to transportation and distribution routes, or strategic decisions to alter certain routes; potential retaliatory action by the Russian government against companies, including us, including nationalization of foreign businesses and/or assets in Russia; increased tensions between the United States and countries in which we operate; and the extent of the conflict’s effect on our business and results of operations as well as the global economy, cannot be predicted.\nAdditionally, we have a minority interest in a European company that owns majority interests in local agencies in Russia. In addition to the imposition of sanctions by the United States, the United Kingdom, and the European Union that affect the cross-border operations of businesses operating in Russia, Russian regulators have imposed currency restrictions and regulations that created uncertainty regarding our ability to recover our investment in operations in Russia, as well as our ability to exercise control or influence involving operations by the local agencies in Russia. As a result, we intend to use our influence to cause the European company to dispose of our ownership interests in the local agencies in Russia. Accordingly, we recorded pretax charges of $2.8 million in the first quarter of 2022, primarily consisting of our proportionate share of the net investment in our Russian interest in “Selling, general, and administrative expenses” in the Condensed Consolidated Statements of Operations and Comprehensive Income.\nTo the extent the current conflict between Russia and Ukraine adversely affects our business, particularly in Russia, it may also have the effect of heightening many other risks disclosed in our 2021 Annual Report and this Quarterly Report, any of which could materially and adversely affect our business and results of operations. Such risks include, but are not limited to, adverse effects on macroeconomic conditions, including inflation and business spending; disruptions to our information technology infrastructure, including through cyberattack, ransom attack, or cyber-intrusion; adverse changes in international trade policies and relations; our ability to maintain or increase our prices, our ability to implement and execute our business strategy, disruptions in global supply chains, our exposure to foreign currency fluctuations, and constraints, volatility, or disruption in the capital markets, difficulty staffing and managing impacted operations, and the recoverability of assets in the region.\nWe may be subject to unionization, work stoppages, slowdowns or increased labor costs.\nCurrently, none of our associates in the United States are represented by a union. However, our associates have the right under the National Labor Relations Act to choose union representation. If all or a significant number of our associates become unionized and the terms of any collective bargaining agreement were significantly different from our current compensation arrangements, it could increase our costs and adversely impact our profitability. Moreover, if a significant number of our associates participate in labor unions, it could put us at increased risk of labor strikes and disruption of our operations or adversely affect our growth and results of operations. In December 2019, a union which commonly represents employees in the supermarket industry filed a petition with the National Labor Relations Board to represent approximately 120 of our associates who work in and around Boston. An election was held, and based on certified results of the election we prevailed in this election. Notwithstanding this successful election, we could face future union organization efforts or elections, which could lead to additional costs, distract management or otherwise harm our business.\nIf goodwill or other intangible assets in connection with our acquisitions become impaired, we could take significant non-cash charges against earnings.\nWe have made acquisitions to complement and expand the services we offer and intend to continue to do so when attractive acquisition opportunities exist in the market. As a result of prior acquisitions, including the acquisition of our business in 2014 by our current parent entity, Topco, we have goodwill and intangible assets recorded on our balance sheet of $2.2 billion and $2.2 billion, respectively, as of September 30, 2022, as further described in Note 4 to our condensed consolidated financial statements for the three and nine months ended September 30, 2022.\nUnder accounting guidelines, we must assess, at least annually, whether the value of goodwill and other intangible assets has been impaired. We have recognized non-cash goodwill and non-cash intangible asset impairment charges, and we can make no assurances that we will not record any additional impairment charges in\n58\nthe future. Any future reduction or impairment of the value of goodwill or other intangible assets will similarly result in charges against earnings, which could adversely affect our reported financial results in future periods.\nFailures in, or incidents involving, our technology infrastructure could damage our business, reputation and brand and substantially harm our business and results of operations.\nOur business is highly dependent on our ability to manage operations and process a large number of transactions on a daily basis. We rely heavily on our operating, payroll, financial, accounting and other data processing systems which require substantial support and maintenance, and may be subject to disabilities, errors, or other harms. If our data and network infrastructure were to fail, or if we were to suffer a data security breach, or an interruption or degradation of services in our data center, third-party cloud, and other infrastructure environments, we could lose important data, which could harm our business and reputation, and cause us to incur significant liabilities. Our facilities, as well as the facilities of third-parties that provide or maintain, or have access to our data or network infrastructure, are vulnerable to damage or interruption from earthquakes, hurricanes, floods, fires, cyber security attacks, terrorist attacks, power losses, telecommunications failures and similar events. In the event that our or any third-party provider’s systems or service abilities are hindered by any of the events discussed above, our ability to operate may be impaired. Our information technology systems, and the information technology systems of our current or future third-party vendors, collaborators, consultants and service providers, could be penetrated by internal or external parties intent on extracting information, corrupting information, stealing intellectual property or trade secrets, or disrupting business processes. A third party’s decision to close facilities or terminate services without adequate notice, or other unanticipated problems, could adversely impact our operations. Any of the aforementioned risks may be augmented if our or any third-party provider’s business continuity and disaster recovery plans prove to be inadequate in preventing the loss of data, service interruptions, disruptions to our operations or damages to important systems or facilities. Our data center, third-party cloud, and managed service provider infrastructure also could be subject to break-ins, cyber-attacks (including through the use of malware, software bugs, computer viruses, ransomware, social engineering, and denial of service), sabotage, intentional acts of vandalism and other misconduct, from a spectrum of actors ranging in sophistication from threats common to most industries to more advanced and persistent, highly organized adversaries. Any security breach or incident, including personal data breaches, that we experience could result in unauthorized access to, or misuse, modification, destruction or unauthorized acquisition of, our internal sensitive corporate data, such as personal data, financial data, trade secrets, intellectual property, or other competitively sensitive or confidential data. Such unauthorized access, misuse, acquisition, or modification of sensitive data may result in data loss, corruption or alteration, interruptions in our operations or damage to our computer hardware or systems or those of our employees or customers. Our systems have been the target of cyber-attacks. Although we have taken and continue to take steps to enhance our cybersecurity posture, we cannot assure that future cyber incidents will not occur or that our systems will not be targeted or breached in the future. Any such breach or unauthorized access could result in a disruption of the Company’s operations, the theft, unauthorized use or publication of the Company’s intellectual property, other proprietary information or the personal information of customers, employees, licensees or suppliers, a reduction of the revenues the Company is able to generate from its operations, damage to the Company’s brand and reputation, a loss of confidence in the security of the Company’s business and products, and significant legal and financial exposure. If any such incident results in litigation, we may be required to make significant expenditures in the course of such litigation and may be required to pay significant amounts in damages. We may not carry sufficient business interruption insurance to compensate us for losses that may occur as a result of any events that cause interruptions in our service. Significant unavailability of our services due to attacks could cause us to incur significant liability, could cause users to cease using our services and materially and adversely affect our business, prospects, financial condition and results of operations.\nWe use complex software in our technology infrastructure, which we seek to continually update and improve. Replacing such systems is often time-consuming and expensive and can also be intrusive to daily business operations. Further, we may not always be successful in executing these upgrades and improvements, which may result in a failure of our systems. We may experience periodic system interruptions from time to time. Any slowdown or failure of our underlying technology infrastructure could harm our business and reputation, which could materially adversely affect our results of operations. Our disaster recovery plan or those of our third-party providers may be inadequate, and our business interruption insurance may not be sufficient to compensate us for the losses that could occur.\n59\nFailure to comply with federal, state and foreign laws and regulations relating to privacy, data protection and consumer protection, or the expansion of current or the enactment of new laws or regulations relating to privacy, data protection and consumer protection, could adversely affect our business and our financial condition.\nA variety of federal, state and foreign laws and regulations govern the collection, use, retention, sharing and security of personal information. The information, security and privacy requirements imposed by such governmental laws and regulations relating to privacy, data protection and consumer protection are increasingly demanding, quickly evolving and may be subject to differing interpretations or legal theories among regulators, enforcers, and civil litigants. These requirements may not be harmonized, may be interpreted and applied in a manner that is inconsistent from one jurisdiction to another or may conflict with other rules or our practices. As a result, our practices may not have complied or may not comply in the future with all such laws, regulations, requirements and obligations. Our actual or perceived failure to comply with such laws and regulations could result in fines, investigations, enforcement actions, penalties, sanctions, claims for damages by affected individuals, and damage to our reputation, among other negative consequences, any of which could have a material adverse effect on its financial performance.\nCertain aspects of our business and/or the data it collects is subject to the California Consumer Protection Act of 2018 (“CCPA”), which became effective in 2020 and regulates the collection, use and processing of personal information relating to California residents, and which grants certain privacy rights to California residents, including rights to request access to and to request deletion of personal information relating to such individuals under certain circumstances. Compliance with the new obligations imposed by the CCPA depends in part on how its requirements are interpreted and applied by the California attorney general and courts. Alleged violations of the CCPA may result in substantial civil penalties or statutory damages when applied at scale, up to $2,500 per violation or $7,500 per intentional violation of any CCPA requirement, which may be applied on a per-person or per-record basis. The CCPA also establishes a private right of action if certain personal information of individuals is subject to an unauthorized access and exfiltration, theft, or disclosure as a result of a business’s violation of the duty to implement and maintain reasonable security procedures and practices, which authorizes statutory damages $100 to $750 per person per incident even if there is no actual harm or damage to plaintiffs. This private right of action may increase the likelihood of, and risks associated with, data breach litigation. Further, in November 2020, the State of California adopted the California Privacy Rights Act of 2020 (“CPRA”) which goes into effect January 1, 2023 and is enforceable starting on July 1, 2023. The CPRA expands and amends the CCPA, including additional and strengthened privacy rights for California residents, new requirements regarding sensitive data and data sharing for digital advertising, and tripled damages for violations involving children’s data. Also on January 1, 2023, the CCPA – as amended by the CPRA – will be newly applicable to personal information collected for employment-related purposes as well as from business-to-business contacts, creating new regulatory obligations as to datasets that until then had been largely exempt from the CCPA. The CPRA includes a 12-month “look-back” provision that requires businesses to map out all information retained since January 1, 2022. The CPRA also establishes a dedicated privacy regulator under California law, with rulemaking and enforcement responsibilities. Certain regulations implementing the CPRA are expected in draft and final form by the end of 2022, with potentially additional regulations to be proposed following the CPRA’s January 1, 2023 effective date.\nFour other states – Virginia, Colorado, Connecticut, and Utah – have passed their own comprehensive privacy laws to go into effect in 2023. Like the CCPA and CPRA, these laws regulate the collection, use, processing, and sharing of personal information relating to residents of each state respectively, and grants certain privacy rights to those residents. The new state laws also have key differences from the CCPA and CPRA, such as requiring affirmative consent before businesses may process sensitive personal information, requiring data protection assessments, and requiring contracts between data controllers and data processors that direct data processors to assist data controllers in performing their obligations, as well as other differences among them. Each law is enforceable by its own state’s attorney general – for example, violation of the Virginia or Utah laws will cost up to $7,500 per violation – and none include an explicit private right of action. Other states are expected to consider and potentially pass similar privacy laws in 2023.\nCertain aspects of our business and/or the data it collects is may also be subject to international privacy laws and regulations, many of which, such as the General Data Privacy Regulation (“GDPR”) and national laws implementing or supplementing the GDPR, such as the United Kingdom Data Protection Law 2018 (which retains\n60\nkey features of GDPR post-Brexit), as well as the EU’s Privacy and Electronic Communications Directive (“ePrivacy Directive”), are significantly more stringent than those currently enforced in the United States. The GDPR requires companies to meet requirements regarding the handling of personal data of individuals located in the European Economic Area (the “EEA”). The GDPR imposes mandatory data breach notification requirements subject to a 72-hour notification deadline. The GDPR also includes significant penalties for noncompliance, which may result in monetary penalties of up to the higher of €20.0 million or 4% of a group’s worldwide turnover for the preceding financial year for the most serious violations. The GDPR and other similar regulations such as the ePrivacy Directive and related member state regulations and directives require companies to give specific types of notice and informed consent is in many cases required for the placement of a cookie or similar technologies on a user’s device for online tracking for behavioral advertising and other purposes and for direct electronic marketing, and the GDPR also imposes additional conditions in order to satisfy such consent, such as a prohibition on pre-checked tick boxes and bundled consents. Enforcement of the GDPR and related regulations varies by each EU Member State and is ongoing. Further laws and regulations on these topics are forthcoming, including the ePrivacy Directive’s proposed successor, the Regulation on Privacy and Electronic Communications (“ePrivacy Regulation”), as well as the Digital Services Act (“DSA”) and Digital Markets Act (“DMA”). The GDPR may increase our responsibility and liability in relation to personal data that we process where that processing is subject to the GDPR. In addition, we may be required to put in place additional mechanisms to ensure compliance with the GDPR, including GDPR requirements as implemented by individual countries. Compliance with the GDPR will be a rigorous and time-intensive process that may increase our cost of doing business or require us to change our business practices.\nIn addition, under GDPR, transfers of personal data are prohibited to countries outside of the EEA that have not been determined by the European Commission to provide adequate protections for personal data, including the United States. There are mechanisms to permit the transfer of personal data from the EEA to the United States, but there is also uncertainty as to the future of such mechanisms, which have been under consistent scrutiny and challenge. In July 2020, decision of the Court of Justice of the European Union invalidated the EU-U.S. Privacy Shield Framework, a means that previously permitted transfers of personal data from the EEA to companies in the United States that certified adherence to the Privacy Shield Framework. While the Biden Administration issued an executive order in October 2022 mandating new legal safeguards over U.S. national security agencies’ access and use of EU and U.S. personal data, it is currently unclear what, if any, formal arrangement may replace the Privacy Shield Framework. Standard contractual clauses approved by the European Commission to permit transfers from the EU to third countries currently remain as a basis on which to transfer personal data from the EEA to other countries. Standard contractual clauses are also subject to legal challenge, and in November 2020, the European Commission published a draft of updated standard contractual clauses. In January 2022, for example, Austria’s data protection authority determined that the use of Google Analytics violated the GDPR and the Court of Justice of the European Union’s “Schrems II” decision on international data transfers. We presently rely on standard contractual clauses to transfer personal data from EEA member countries, and we may be impacted by changes in law as a result of future review or invalidation of, or changes to, this mechanism by European courts or regulators. While we will continue to undertake efforts to conform to current regulatory obligations and evolving best practices, we may be unsuccessful in conforming to permitted means of transferring personal data from the European Economic Area. We may also experience hesitancy, reluctance, or refusal by European or multi-national customers to continue to use some of our services due to the potential risk exposure of personal data transfers and the current data protection obligations imposed on them by certain data protection authorities. Such customers may also view any alternative approaches to the transfer of any personal data as being too costly, too burdensome, or otherwise objectionable, and therefore may decide not to do business with us if the transfer of personal data is a necessary requirement.\nAlthough we take reasonable efforts to comply with all applicable laws and regulations and have invested and continue to invest human and technology resources into data privacy compliance efforts, there can be no assurance that we will not be subject to regulatory action, including fines, in the event of an incident or other claim. Data protection laws and requirements may also be enacted, interpreted or applied in a manner that creates inconsistent or contradictory requirements on companies that operate across jurisdictions. We or our third-party service providers could be adversely affected if legislation or regulations are expanded to require changes in our or our third-party service providers’ business practices or if governing jurisdictions interpret or implement their legislation or regulations in ways that negatively affect our or our third-party service providers’ business, results of operations or financial condition. For example, we may find it necessary to establish alternative systems to maintain personal data in the EEA, which may involve substantial expense and may cause us to divert resources from other aspects of\n61\nour business, all of which may adversely affect our results from operations. Further, any inability to adequately address privacy concerns in connection with our solutions, or comply with applicable privacy or data protection laws, regulations and policies, could result in additional cost and liability to us, and adversely affect our ability to offer our solutions. GDPR, CCPA, CPRA and other similar laws and regulations, as well as any associated inquiries or investigations or any other government actions, may be costly to comply with, result in negative publicity, increase our operating costs, require significant management time and attention and subject us to remedies that may harm our business, including fines or demands or orders that we modify or cease existing business practices. Our systems may not be able to satisfy these changing requirements and manufacturer, retailer and associate expectations, or may require significant additional investments or time in order to do so.\nWe expect that new industry standards, laws and regulations will continue to be proposed regarding privacy, data protection and information security in many jurisdictions, including the European e-Privacy Regulation, which is currently in draft form, as well as at the U.S. federal and state levels. In addition, new data processes and datasets associated with emerging technologies are coming under increased regulatory scrutiny, such as biometrics and automated decision-making. We cannot yet determine the impact such future laws, regulations and standards may have on our business. Complying with these evolving obligations is challenging, time consuming and expensive, and federal regulators, state attorneys general and plaintiff’s attorneys have been, and will likely continue to be, active in this space. Expanding definitions and interpretations of what constitutes “personal data” (or the equivalent) within the United States, the EEA and elsewhere may increase our compliance costs and legal liability. For example, various state privacy proposals have included a private right of action for basic privacy violations which, if passed, would dramatically increase both the legal costs of defending frivolous lawsuits and the penalties and costs associated with alleged violations.\nA data breach or any failure, or perceived failure, by us to comply with any federal, state or foreign privacy or consumer protection-related laws, regulations or other principles or orders to which we may be subject or other legal obligations relating to privacy or consumer protection could adversely affect our reputation, brand and business, and may result in fines, enforcement actions, sanctions, claims (including claims for damages by affected individuals), investigations, proceedings or actions against us by governmental entities or others, or other penalties or liabilities or require us to change our operations and/or cease using certain data sets, among other negative consequences, any of which could have a material adverse effect on our business. Moreover, the proliferation of supply chain-based cyberattacks and vendor security incidents increases these potential risks and costs even in cases where the attack did not target us, occur on our systems, or result from any action or inaction by us. Depending on the nature of the information compromised, we may also have obligations to notify users, law enforcement, regulators, business partners or payment companies about the incident and provide some form of remedy, such as refunds or identity theft monitoring services, for the individuals affected by the incident.\nThe Take 5 Matter may lead to additional harms, risks and uncertainties for us, including litigation and governmental investigations, a reduction in revenue, a potential deterioration in our relationships or reputation and a loss in investor confidence.\nOn April 1, 2018, we acquired certain assets and assumed certain liabilities of Take 5 Media Group. In June 2019, as a result of a review of internal allegations related to inconsistency of data provided by Take 5 to its clients, we commenced an investigation into Take 5’s operations. In July 2019, as a result of our investigation, we terminated all operations of Take 5, including the use of its associated trade names and the offering of its services to its clients and offered refunds to Take 5 clients of collected revenues attributable to Take 5 since our acquisition of Take 5.\nAs a result of these matters, we may be subject to a number of additional harms, risks and uncertainties, including substantial costs for professional services fee, potential lawsuits by clients or other interested parties who claim to have been harmed by the misconduct at Take 5, other costs and fees related to the Take 5 Matter (in excess of the amounts already offered as refunds), potential governmental investigations arising from the Take 5 Matter, a reduction in our current and anticipated revenue and a potential deterioration in our associate and client relationships or our reputation. In addition, if we do not prevail in any litigation or governmental investigation related to these matters, we could be subject to costs related to such litigation or governmental investigation, including equitable relief, civil monetary damages, treble damages, repayment or criminal penalties, which may not be covered by insurance or may materially increase our insurance costs. We have incurred and will continue to incur additional substantial professional fees regardless of the outcome of any such litigation or governmental\n62\ninvestigation. In addition, there can be no assurance to what degree, if any, we will be able to recover any such costs or damages from the former owners of Take 5 or whether such former owners of Take 5 engaged in further unknown improper activities that may subject us to further costs or damages, including potential reputational harm. Likewise, such events have caused and may cause further diversion of our management’s time and attention. Any adverse outcome related to these matters cannot be predicted at this time, and may materially harm our business, reputation, financial condition and/or results of operations, or the trading price of our securities.\nOur business is seasonal in nature and quarterly operating results can fluctuate.\nOur services are seasonal in nature, with the fourth fiscal quarter typically generating a higher proportion of our revenues than other fiscal quarters. Adverse events, such as deteriorating economic conditions, higher unemployment, higher gas prices, public transportation disruptions, public health crises (including the COVID-19 pandemic) or unanticipated adverse weather, could result in lower-than-planned sales during key revenue-producing seasons. For example, frequent or unusually heavy snowfall, ice storms, rainstorms, windstorms or other extreme weather conditions over a prolonged period could make it difficult for consumers to travel to retail stores or foodservice locations. Such events could lead to lower revenues, negatively impacting our financial condition and results of operations.\nOur business is competitive, and increased competition could adversely affect our business and results of operations.\nThe sales, marketing and merchandising services industry is competitive. We face competition from a few other large, national or super-regional agencies as well as many niche and regional agencies. Remaining competitive in this industry requires that we closely monitor and respond to trends in all industry sectors. We cannot assure you that we will be able to anticipate and respond successfully to such trends in a timely manner. Moreover, some of our competitors may choose to sell services competitive to ours at lower prices by accepting lower margins and profitability or may be able to sell services competitive to ours at lower prices due to proprietary ownership of data or technical superiority, which could negatively impact the rates that we can charge. If we are unable to compete successfully, it could have a material adverse effect on our business, financial condition and our results of operations. If certain competitors were to combine into integrated sales, marketing and merchandising services companies, additional sales, marketing and merchandising service companies were to enter the market or existing participants in this industry were to become more competitive, including through technological innovation such as social media and crowdsourcing, it could have a material adverse effect on our business, financial condition or results of operations.\nDamage to our reputation could negatively impact our business, financial condition and results of operations.\nOur reputation and the quality of our brand are critical to our business and success in existing markets and will be critical to our success as we enter new markets. We believe that we have built our reputation on the high quality of our sales and marketing services, our commitment to our clients and our performance-based culture, and we must protect and grow the value of our brand in order for us to continue to be successful. Any incident that erodes client loyalty to our brand could significantly reduce its value and damage our business. Also, there has been a marked increase in the use of social media platforms and similar devices, including blogs, social media websites, Twitter and other forms of internet-based communications that provide individuals with access to a broad audience of consumers and other interested persons. Many social media platforms immediately publish the content their subscribers and participants post, often without filters or checks on accuracy of the content posted. Information concerning us may be posted on such platforms at any time. Information posted may be adverse to our interests or may be inaccurate, each of which may harm our performance, prospects or business. The harm may be immediate without affording us an opportunity for redress or correction.\nWe rely on third parties to provide certain data and services in connection with the provision of our services.\nWe rely on third parties to provide certain data and services for use in connection with the provision of our services. For example, we contract with third parties to obtain the raw data on retail product sales and inventories. These suppliers of data may impose restrictions on our use of such data, fail to adhere to our quality control standards, increase the price they charge us for this data or refuse altogether to license the data to us. If we are unable to use such third-party data and services or if we are unable to contract with third parties, when necessary,\n63\nour business, financial condition or our results of operations could be adversely affected. In the event that such data and services are unavailable for our use or the cost of acquiring such data and services increases, our business could be adversely affected.\nWe may be unable to timely and effectively respond to changes in digital practices and policies, which could adversely affect our business, financial condition or results of operations.\nChanges to practices and policies of operating systems, websites and other digital platforms, including, without limitation, Apple’s or Android’s transparency policies, may reduce the quantity and quality of the data and metrics that can be collected or used by us and our clients or reduce the value of our digital services. These limitations may adversely affect both our and our clients’ ability to effectively target and measure the performance of our digital services. In addition, our clients and third party vendors routinely evaluate their digital practices and policies, and if in the future they determine to modify such practices and policies for any reasons, including, without limitation, privacy, targeting, age or content concerns, this could decrease the desire for our digital services as compared to other alternatives. If we are unable to timely or effectively respond to changes in digital practices and policies, or if our clients do not believe that our digital services will generate a competitive return on investment relative to alternatives, then our business, financial condition or results of operations could be adversely affected.\nWe may not be able to adequately protect our intellectual property, which, in turn, could harm the value of our brands and adversely affect our business.\nOur ability to implement our business plan successfully depends in part on our ability to further build brand recognition using our trade names, service marks, trademarks, proprietary products and other intellectual property, including our name and logos. We rely on U.S. and foreign trademark, copyright and trade secret laws, as well as license agreements, nondisclosure agreements and confidentiality and other contractual provisions to protect our intellectual property. Nevertheless, these laws and procedures may not be adequate to prevent unauthorized parties from attempting to copy or otherwise obtain our processes and technology or deter our competitors from developing similar business solutions and concepts, and adequate remedies may not be available in the event of an unauthorized use or disclosure of our trade secrets and other intellectual property.\nThe success of our business depends on our continued ability to use our existing trademarks and service marks to increase brand awareness and further develop our brand in both domestic and international markets. We have registered and applied to register our trade names, service marks and trademarks in the United States and foreign jurisdictions. However, the steps we have taken to protect our intellectual property in the United States and in foreign countries may not be adequate, and third parties may misappropriate, dilute, infringe upon or otherwise harm the value of our intellectual property. If any of our registered or unregistered trademarks, trade names or service marks is challenged, infringed, circumvented or declared generic or determined to be infringing on other marks, it could have an adverse effect on our sales or market position. In addition, the laws of some foreign countries do not protect intellectual property to the same extent as the laws of the United States. Many companies have encountered significant problems in protecting and defending intellectual property rights in certain jurisdictions. This could make it difficult to stop the infringement or misappropriation of our intellectual property rights in foreign jurisdictions.\nWe rely upon trade secrets and other confidential and proprietary know‑how to develop and maintain our competitive position. While it is our policy to enter into agreements imposing nondisclosure and confidentiality obligations upon our employees and third parties to protect our intellectual property, these obligations may be breached, may not provide meaningful protection for our trade secrets or proprietary know‑how, or adequate remedies may not be available in the event of an unauthorized access, use or disclosure of our trade secrets and know‑how. Furthermore, despite the existence of such nondisclosure and confidentiality agreements, or other contractual restrictions, we may not be able to prevent the unauthorized disclosure or use of our confidential proprietary information or trade secrets by consultants, vendors and employees. In addition, others could obtain knowledge of our trade secrets through independent development or other legal means.\nAny claims or litigation initiated by us to protect our proprietary technology could be time consuming, costly and divert the attention of our technical and management resources. If we choose to go to court to stop a third party from infringing our intellectual property, that third party may ask the court to rule that our intellectual property rights are invalid and/or should not be enforced against that third party. Even if the action that we take to protect\n64\nour intellectual property rights is successful, any infringement may still have a material adverse effect on our business, financial condition and results of operations.\nWe may be subject to claims of infringement of third-party intellectual property rights that are costly to defend, result in the diversion of management’s time and efforts, require the payment of damages, limit our ability to use particular technologies in the future or prevent us from marketing our existing or future products and services.\nThird parties may assert that we infringe, misappropriate or otherwise violate their intellectual property, including with respect to our digital solutions and other technologies that are important to our business, and may sue us for intellectual property infringement. We may not be aware of whether our products or services do or will infringe existing or future patents or the intellectual property rights of others. In addition, there can be no assurance that one or more of our competitors who have developed competing technologies or our other competitors will not be granted patents for their technology and allege that we have infringed on such patents.\nAny claims that our business infringes the intellectual property rights of others, regardless of the merit or resolution of such claims, could incur substantial costs, and the time and attention of our management and other personnel may be diverted in pursuing these proceedings. An adverse determination in any intellectual property claim could require us to pay damages, be subject to an injunction, and/or stop using our technologies, trademarks, copyrighted works and other material found to be in violation of another party’s rights, and could prevent us from licensing our technologies to others unless we enter into royalty or licensing arrangements with the prevailing party or are able to redesign our products and services to avoid infringement. With respect to any third-party intellectual property that we use or wish to use in our business (whether or not asserted against us in litigation), we may not be able to enter into licensing or other arrangements with the owner of such intellectual property at a reasonable cost or on reasonable terms. Any of the foregoing could harm our commercial success.\nWe are dependent on proprietary technology licensed from others. If we lose our licenses, we may not be able to continue developing our products.\nWe have obtained licenses that give us rights to third party intellectual property that is necessary or useful to our business. These license agreements may impose various royalty and other obligations on us. One or more of our licensors may allege that we have breached our license agreement with them, and could seek to terminate our license, which could adversely affect our competitive business position and harm our business prospects. In addition, any claims brought against us by our licensors could be costly, time-consuming and divert the attention of our management and key personnel from our business operations.\nConsumer goods manufacturers and retailers, including some of our clients, are subject to extensive governmental regulation and we and they may be subject to enforcement in the event of noncompliance with applicable requirements.\nConsumer goods manufacturers and retailers, including some of our clients, are subject to a broad range of federal, state, local and international laws and regulations governing, among other things, the research, development, manufacture, distribution, marketing and post-market reporting of consumer products. These include laws administered by the U.S. Food and Drug Administration (the “FDA”), the U.S. Drug Enforcement Administration, the U.S. Federal Trade Commission, the U.S. Department of Agriculture and other federal, state, local and international regulatory authorities. For example, certain of our clients market and sell products containing cannabidiol (“CBD”). CBD products are subject to a number of federal, state, local and international laws and regulations restricting their use in certain categories of products and in certain jurisdictions. In particular, the FDA has publicly stated it is prohibited to sell into interstate commerce food, beverages or dietary supplements that contain CBD. These laws are broad in scope and subject to evolving interpretations, which could require us to incur costs associated with new or modified compliance requirements or require us or our clients to alter or limit our activities, including marketing and promotion, of such products, or to remove them from the market altogether.\nIf a regulatory authority determines that we or our current or future clients have not complied with the applicable regulatory requirements, our business may be materially impacted and we or our clients could be subject to enforcement actions or loss of business. We cannot predict the nature of any future laws, regulations, interpretations or applications of the laws, nor can we determine what effect additional laws, regulations or administrative policies and procedures, if and when enacted, promulgated and implemented, could have on our business.\n65\nWe may be subject to claims for products for which we are the vendor of record or may otherwise be in the chain of title.\nFor certain of our clients’ products, we become the vendor of record or otherwise may be in the chain of title. For these products, we could be subject to potential claims for misbranded, adulterated, contaminated, damaged or spoiled products, or could be subject to liability in connection with claims related to infringement of intellectual property, product liability, product recalls or other liabilities arising in connection with the sale or marketing of these products. As a result, we could be subject to claims or lawsuits (including potential class action lawsuits), and we could incur liabilities that are not insured or exceed our insurance coverage or for which the manufacturer of the product does not indemnify us. Even if product claims against us are not successful or fully pursued, these claims could be costly and time consuming and may require our management to spend time defending the claims rather than operating our business.\nA product that has been actually or allegedly misbranded, adulterated or damaged or is actually or allegedly defective could result in product withdrawals or recalls, destruction of product inventory, negative publicity and substantial costs of compliance or remediation. Any of these events, including a significant product liability judgment against us, could result in monetary damages and/or a loss of demand for our products, both of which could have an adverse effect on our business or results of operations.\nWe generate revenues and incur expenses throughout the world that are subject to exchange rate fluctuations, and our results of operations may suffer due to currency translations.\nOur U.S. operations earn revenues and incur expenses primarily in U.S. dollars, while our international operations earn revenues and incur expenses primarily in Canadian dollars, British pounds or euros. Because of currency exchange rate fluctuations, including possible devaluations, we are subject to currency translation exposure on the results of our operations, in addition to economic exposure. There has been, and may continue to be, volatility in currency exchange rates as a result of the United Kingdom’s withdrawal from the European Union, especially between the U.S. dollar and the British pound. These risks could adversely impact our business or results of operations.\nFluctuations in our tax obligations and effective tax rate and realization of our deferred tax assets may result in volatility of our operating results.\nWe are subject to taxes by the U.S. federal, state, local and foreign tax authorities, and our tax liabilities will be affected by the allocation of expenses to differing jurisdictions. We record tax expense based on our estimates of future payments, which may include reserves for uncertain tax positions in multiple tax jurisdictions, and valuation allowances related to certain net deferred tax assets. At any one time, many tax years may be subject to audit by various taxing jurisdictions. The results of these audits and negotiations with taxing authorities may affect the ultimate settlement of these matters. We expect that throughout the year there could be ongoing variability in our quarterly tax rates as events occur and exposures are evaluated. Our future effective tax rates could be subject to volatility or adversely affected by a number of factors, including:\n•changes in the valuation of our deferred tax assets and liabilities;\n•expected timing and amount of the release of any tax valuation allowance;\n•tax effects of equity-based compensation;\n•changes in tax laws, regulations or interpretations thereof; or\n•future earnings being lower than anticipated in jurisdictions where we have lower statutory tax rates and higher than anticipated earnings in jurisdictions where we have higher statutory tax rates.\nIn addition, our effective tax rate in a given financial statement period may be materially impacted by a variety of factors including but not limited to changes in the mix and level of earnings, varying tax rates in the different jurisdictions in which we operate, fluctuations in the valuation allowance, deductibility of certain items or changes to existing accounting rules or regulations. Further, tax legislation may be enacted in the future which could negatively impact our current or future tax structure and effective tax rates. We may be subject to audits of\n66\nour income, sales and other transaction taxes by U.S. federal, state, local and foreign taxing authorities. Outcomes from these audits could have an adverse effect on our operating results and financial condition.\nRisks Related to Ownership of Our Common Stock\nWe are controlled by Topco, the Advantage Sponsors, and the CP Sponsor, whose economic and other interests in our business may be different from yours.\nOur authorized capital stock consists of 3,290,000,000 shares of Class A common stock, and as of November 8, 2022, certain equityholders of Topco (the “Advantage Sponsors”), Topco and Conyers Park II Sponsor LLC, an affiliate of Centerview Capital Management, LLC, which was Conyers Park’s sponsor prior to the Merger (the “CP Sponsor”), collectively own 254,310,000 shares, or 79.55% (including 65.30% held by Topco), of our outstanding Class A common stock. Subject to applicable law, the Advantage Sponsors, through their direct ownership of our common stock and their ownership of equity interests of Topco, and the CP Sponsor are able to exert significant influence in the election of our directors and control actions to be taken by our stockholders, including amendments to our third amended and restated certificate of incorporation and approval of mergers, sales of substantially all of our assets, and other significant corporate transactions. It is possible that the interests of Topco, the Advantage Sponsors and the CP Sponsor may in some circumstances conflict with our interests and the interests of our other stockholders, including you.\nWe are a controlled company within the meaning of the Nasdaq Stock Market LLC listing requirements and as a result, may rely on exemptions from certain corporate governance requirements. To the extent we rely on such exemptions, you will not have the same protections afforded to stockholders of companies that are subject to such corporate governance requirements.\nBecause of the voting power over our company held by Topco, the Advantage Sponsors, and the CP Sponsor and the voting arrangement between such parties, we are considered a controlled company for the purposes of the Nasdaq Stock Market LLC (“Nasdaq”) listing requirements. As such, we are exempt from the corporate governance requirements that our board of directors, compensation committee, and nominating and corporate governance committee meet the standard of independence established by those corporate governance requirements. The independence standards are intended to ensure that directors who meet the independence standards are free of any conflicting interest that could influence their actions as directors.\nWe do not currently utilize the exemptions afforded to a controlled company, though we are entitled to do so. To the extent we utilize these exemptions, you will not have the same protections afforded to stockholders of companies that are subject to all of the corporate governance requirements of Nasdaq.\nThe anti-takeover provisions of our certificate of incorporation and bylaws could prevent or delay a change in control of us, even if such change in control would be beneficial to our stockholders.\nProvisions of our certificate of incorporation and bylaws, as well as provisions of Delaware law, could discourage, delay, or prevent a merger, acquisition, or other change in control of us, even if such change in control would be beneficial to our stockholders. These include:\n•authorizing the issuance of “blank check” preferred stock that could be issued by our board of directors to increase the number of outstanding shares and thwart a takeover attempt;\n•provision for a classified board of directors so that not all members of our board of directors are elected at one time;\n•not permitting the use of cumulative voting for the election of directors;\n•permitting the removal of directors only for cause;\n•limiting the ability of stockholders to call special meetings; •requiring all stockholder actions to be taken at a meeting of our stockholders;\n•requiring approval of the holders of at least two-thirds of the shares entitled to vote at an election of directors to adopt, amend, or repeal the proposed bylaws or repeal the provisions of the third amended and restated certificate of incorporation regarding the election and removal of directors; and\n67\n•establishing advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings.\nIn addition, although we have opted out of Section 203 of the Delaware General Corporation Law (“DGCL”), our certificate of incorporation contain similar provisions providing that we may not engage in certain “business combinations” with any “interested stockholder” for a three-year period following the time that the stockholder became an interested stockholder, subject to certain exceptions. Generally, a “business combination” includes a merger, asset, or stock sale or other transaction resulting in a financial benefit to the interested stockholder.\nSubject to certain exceptions, an “interested stockholder” is a person who, together with that person’s affiliates and associates, owns, or within the previous three years owned, 15% or more of our outstanding voting stock.\nUnder certain circumstances, this provision will make it more difficult for a person who would be an “interested stockholder” to effect various business combinations with us for a three-year period. These provisions also may have the effect of preventing changes in our board of directors and may make it more difficult to accomplish transactions which stockholders may otherwise deem to be in their best interests.\nMoreover, our certificate of incorporation provides that Topco and its affiliates do not constitute “interested stockholders” for purposes of this provision, and thus any business combination transaction between us and Topco and its affiliates would not be subject to the protections otherwise provided by this provision. Topco and its affiliates are not prohibited from selling a controlling interest in us to a third party and may do so without your approval and without providing for a purchase of your shares of common stock, subject to the lock-up restrictions applicable to Topco. Accordingly, your shares of common stock may be worth less than they would be if Topco and its affiliates did not maintain voting control over us.\nThe provisions of our certificate of incorporation and bylaws requiring exclusive venue in the Court of Chancery in the State of Delaware or the federal district courts of the United States of America for certain types of lawsuits may have the effect of discouraging lawsuits against our directors and officers.\nOur certificate of incorporation and bylaws require, to the fullest extent permitted by law, that (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of a fiduciary duty owed by any of our directors, officers, or other employees to us or our stockholders, (iii) any action asserting a claim against us arising pursuant to any provision of the DGCL or our certificate of incorporation or bylaws, or (iv) any action asserting a claim against us governed by the internal affairs doctrine will have to be brought only in the Court of Chancery in the State of Delaware (or the federal district court for the District of Delaware or other state courts of the State of Delaware if the Court of Chancery in the State of Delaware does not have jurisdiction).\nOur certificate of incorporation and bylaws also require that the federal district courts of the United States of America will be the exclusive forum for the resolution of any complaint asserting a cause of action arising under the Securities Act; however, there is uncertainty as to whether a court would enforce such provision, and investors cannot waive compliance with federal securities laws and the rules and regulations thereunder. Although we believe these provisions benefit us by providing increased consistency in the application of applicable law in the types of lawsuits to which they apply, the provisions may have the effect of discouraging lawsuits against our directors and officers. These provisions do not apply to any suits brought to enforce any liability or duty created by the Exchange Act or any other claim for which the federal courts of the United States have exclusive jurisdiction.\nBecause we have no current plans to pay cash dividends on our Class A common stock, you may not receive any return on investment unless you sell your Class A common stock for a price greater than that which you paid for it.\nWe have no current plans to pay cash dividends on our Class A common stock. The declaration, amount and payment of any future dividends on our Class A common stock will be at the discretion of our board of directors and will depend upon our results of operations, financial condition, capital requirements, and other factors that our board of directors deems relevant. The payment of cash dividends is also restricted under the terms of the agreements governing our debt and our ability to pay dividend may also be restricted by the terms of any future credit agreement or any securities we or our subsidiaries may issue.\n68\nAn active, liquid trading market for our Class A common stock may not be available.\nWe cannot predict the extent to which investor interest in our company will lead to availability of a trading market on Nasdaq or otherwise in the future or how active and liquid that market may be for our Class A common stock. If an active and liquid trading market is not available, you may have difficulty selling any of our Class A common stock. Among other things, in the absence of a liquid public trading market:\n•you may not be able to liquidate your investment in shares of Class A common stock;\n•you may not be able to resell your shares of Class A common stock at or above the price attributed to them in the Transactions;\n•the market price of shares of Class A common stock may experience significant price volatility; and\n•there may be less efficiency in carrying out your purchase and sale orders.\nThe trading price of our Class A common stock may be volatile or may decline regardless of our operating performance.\nThe market prices for our Class A common stock are likely to be volatile and may fluctuate significantly in response to a number of factors, most of which we cannot control, including:\n•quarterly variations in our operating results compared to market expectations;\n•changes in preferences of our clients;\n•announcements of new products or services or significant price reductions;\n•the size of our public float;\n•fluctuations in stock market prices and volumes;\n•defaults on our indebtedness;\n•changes in senior management or key personnel;\n•the granting, vesting, or exercise of employee stock options, restricted stock, or other equity rights;\n•the payment of any dividends thereon in shares of our common stock;\n•changes in financial estimates or recommendations by securities analysts;\n•negative earnings or other announcements by us;\n•downgrades in our credit ratings;\n•material litigation or governmental investigations;\n•issuances of capital stock;\n•global economic, legal, and regulatory factors unrelated to our performance, including the COVID-19 pandemic; or\n•the realization of any risks described in this Quarterly Report under “Risk Factors.”\nIn addition, in the past, stockholders have instituted securities class action litigation against companies following periods of market volatility. If we were involved in securities litigation, we could incur substantial costs and our resources and the attention of management could be diverted from our business.\nWe cannot provide any guaranty that we will continue to repurchase our common stock pursuant to our stock repurchase program.\nIn November 2021, our board of directors authorized a share repurchase program, under which we may repurchase up to $100 million of our outstanding Class A common stock (the “2021 Share Repurchase Program”). As of September 30, 2022, the remaining amount available for repurchase pursuant to the 2021 Share Repurchase Program is $87.4 million. However, we are not obligated to make any further purchases under the 2021 Share Repurchase Program and we may suspend or permanently discontinue this program at any time or significantly reduce the amount of repurchases under the program. Any announcement of a suspension, discontinuance or reduction of this program may negatively impact our reputation and investor confidence.\n69\nThe valuation of our private placement warrants could increase the volatility in our net income (loss) in our consolidated statements of earnings (loss).\nThe change in fair value of our private placement warrants is determined using the fair value of the liability classified private placement warrants by approximating the value with the share price of the public warrants. The change in fair value of warrant liability represents the mark-to-market fair value adjustments to the outstanding private placement warrants issued in connection with the initial public offering of Conyers Park. Significant changes in share price of the public warrants may adversely affect the volatility in our net income (loss) in our Condensed Consolidated Statements of Operations and Comprehensive Income.\nRisks Related to Indebtedness\nWe need to continue to generate significant operating cash flow in order to fund acquisitions and to service our debt.\nOur business currently generates operating cash flow, which we use to fund acquisitions to grow our business and to service our substantial indebtedness. If, because of loss of revenue, pressure on pricing from customers, increases in our costs (including increases in costs related to servicing our indebtedness or labor costs), general economic, financial, competitive, legislative, regulatory conditions or other factors, including any acceleration of the foregoing as a result of the COVID-19 pandemic, many of which are outside of our control our business generates less operating cash flow, we may not have sufficient funds to grow our business or to service our indebtedness.\nIf we are unable to generate sufficient cash flow or are otherwise unable to obtain funds necessary to meet required payments of principal, premium, if any, and interest on our indebtedness, or if we otherwise fail to comply with the various covenants in the agreements governing our indebtedness, we could be in default under the terms of the agreements governing such indebtedness. In the event of such default, the lenders under our credit facilities could elect to terminate their commitments thereunder, cease making further loans and institute foreclosure proceedings against our assets, and we could be forced into bankruptcy or liquidation. If our operating performance declines, we may in the future need to obtain waivers from the required lenders under our credit agreements to avoid being in default. If we or any of our subsidiaries breach the covenants under our credit agreements and seek a waiver, we may not be able to obtain a waiver from the required lenders. If this occurs, we would be in default under our credit agreements, the lenders could exercise their rights as described above, and we could be forced into bankruptcy or liquidation.\nOur substantial indebtedness could adversely affect our financial health, restrict our activities, and affect our ability to meet our obligations.\nWe have a significant amount of indebtedness. As of September 30, 2022, we had total indebtedness of $2.1 billion, excluding debt issuance costs, with an additional $54.5 million of letters of credit outstanding under our revolving credit facility. The agreements governing our indebtedness contain customary covenants that restrict us from taking certain actions, such as incurring additional debt, permitting liens on pledged assets, making investments, paying dividends or making distributions to equity holders, prepaying junior debt, engaging in mergers or restructurings, and selling assets, among other things, which may restrict our ability to successfully execute on our business plan. For a more detailed description of the covenants and material terms of our material indebtedness, please see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” in this Quarterly Report.\nDespite current indebtedness levels, we and our subsidiaries may still be able to incur additional indebtedness, which could increase the risks associated with our indebtedness.\nWe and our subsidiaries may be able to incur additional indebtedness in the future because the terms of our indebtedness do not fully prohibit us or our subsidiaries from doing so. Subject to covenant compliance and certain conditions, as of September 30, 2022, the agreements governing our indebtedness would have permitted us to borrow up to an additional $345.5 million under our revolving credit facility. In addition, we and our subsidiaries have, and will have, the ability to incur additional indebtedness as incremental facilities under our credit agreement\n70\nand we or our subsidiaries may issue additional notes in the future. If additional debt is added to our current debt levels and our subsidiaries’ current debt levels, the related risks that we and they now face could increase.\nFailure to maintain our credit ratings could adversely affect our liquidity, capital position, ability to hedge certain financial risks, borrowing costs, and access to capital markets.\nOur credit risk is evaluated by the major independent rating agencies, and such agencies have in the past downgraded, and could in the future downgrade, our ratings. Our credit rating may impact the interest rates on any future indebtedness as well as the applicability of certain covenants in the agreements governing our indebtedness. We cannot assure you that we will be able to maintain our current credit ratings, and any additional, actual or anticipated changes or downgrades in our credit ratings, including any announcement that our ratings are under further review for a downgrade, may have a negative impact on our liquidity, capital position, ability to hedge certain financial risks, and access to capital markets.\nOur variable rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase significantly.\nBorrowings under our credit facilities are at variable rates of interest and expose us to interest rate risk. If interest rates were to increase, our debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same, and our net income and cash flows, including cash available for servicing our indebtedness, will correspondingly decrease. On a pro forma basis, assuming no other prepayments of the credit facility and that our revolving credit facility is fully drawn (and to the extent that LIBOR is in excess of the 0.00% and 0.75% floors applicable to our revolving credit facility and our term loan credit facility, respectively), each one-eighth percentage point change in interest rates would result in an approximately $1.0 million change in interest expense, net of gains from interest rate caps, for the nine months ended September 30, 2022. In the future, we may enter into interest rate swaps that involve the exchange of floating- for fixed-rate interest payments in order to reduce interest rate volatility or risk. However, we may not maintain interest rate swaps with respect to any of our variable rate indebtedness, and any swaps we enter into may not fully or effectively mitigate our interest rate risk.\nThe elimination of LIBOR after June 2023 may affect our financial results\nCertain of our financial arrangements, including the Senior Secured Credit Facilities, were made at variable rates that use the London Interbank Offered Rate, or LIBOR (or metrics derived from or related to LIBOR), as a benchmark for establishing the interest rate. All LIBOR tenors relevant to us will cease to be published or will no longer be representative after June 30, 2023. This means that any of our LIBOR-based borrowings that extend beyond June 30, 2023 will need to be converted to a replacement rate. In the U.S., the Alternative Reference Rates Committee (the “ARRC”) convened by the Federal Reserve Board and the Federal Reserve Bank of New York has recommended the Secured Overnight Financing Rate (“SOFR”) plus a recommended spread adjustment as LIBOR’s replacement. There are significant differences between LIBOR and SOFR, such as LIBOR being an unsecured lending rate while SOFR is a secured lending rate, and SOFR being an overnight rate while LIBOR reflects term rates at different maturities. If our LIBOR-based financing arrangements are converted to SOFR, the differences between LIBOR and SOFR, plus the recommended spread adjustment, could result in interest costs that are higher than if LIBOR remained available, which could adversely impact our operating results. Although SOFR is the ARRC’s recommended replacement rate, it is also possible that lenders and other counterparties may instead choose alternative replacement rates that may differ from LIBOR in ways similar to SOFR or in other ways that would result in higher interest costs for us. There is no assurance that any alternative reference rate, including SOFR, will be similar to, or produce the same value or economic equivalence as, LIBOR, and there continues to be uncertainty regarding the nature of potential changes to and future utilization of specific LIBOR tenors, the development and acceptance of SOFR or alternative reference rates, and other reforms. These consequences cannot be entirely predicted and could have an adverse impact on the market value for or value of LIBOR-linked securities, loans and other financial obligations or extensions of credit held by or due to us. Changes in market interest rates may influence our financing costs, returns on financial investments and the valuation of derivative contracts and could reduce our earnings and cash flows.\n71\nGeneral Risk Factors\nOur business and financial results may be affected by various litigation and regulatory proceedings.\nWe are subject to litigation and regulatory proceedings in the normal course of business and could become subject to additional claims in the future. These proceedings have included, and in the future may include, matters involving personnel and employment issues, workers’ compensation, personal and property injury, disputes relating to acquisitions (including contingent consideration), governmental investigations and other proceedings. Some historical and current legal proceedings and future legal proceedings may purport to be brought as class actions or representative basis on behalf of similarly situated parties including with respect to employment-related matters. We cannot be certain of the ultimate outcomes of any such claims, and resolution of these types of matters against us may result in significant fines, judgments or settlements, which, if uninsured, or if the fines, judgments and settlements exceed insured levels, could adversely affect our business or financial results. See “Legal Proceedings.”\nWe are subject to many federal, state, local and international laws with which compliance is both costly and complex.\nOur business is subject to various, and sometimes complex, laws and regulations, including those that have been or may be implemented in response to the COVID-19 pandemic. In order to conduct our operations in compliance with these laws and regulations, we must obtain and maintain numerous permits, approvals and certificates from various federal, state, local and international governmental authorities. We may incur substantial costs in order to maintain compliance with these existing laws and regulations. In addition, our costs of compliance may increase if existing laws and regulations are revised or reinterpreted or if new laws and regulations become applicable to our operations. These costs could have an adverse impact on our business or results of operations. Moreover, our failure to comply with these laws and regulations, as interpreted and enforced, could lead to fines, penalties or management distraction or otherwise harm our business.\nOur insurance may not provide adequate levels of coverage against claims.\nWe believe that we maintain insurance customary for businesses of our size and type. However, there are types of losses we may incur that cannot be insured against or that we believe are not economically reasonable to insure. Further, insurance may not continue to be available to us on acceptable terms, if at all, and, if available, coverage may not be adequate. If we are unable to obtain insurance at an acceptable cost or on acceptable terms, we could be exposed to significant losses.\nWe have incurred and will continue to incur increased costs as a public company.\nAs a public company, we have incurred and will continue to incur significant legal, accounting, insurance, and other expenses that we did not incur as a private company, including costs associated with public company reporting requirements. We also have incurred and will incur costs associated with the Sarbanes-Oxley Act and related rules implemented by the SEC. The expenses incurred by public companies for reporting and corporate governance purposes generally have been increasing. We expect these rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly, although we are currently unable to estimate these costs with any degree of certainty. In estimating these costs, we took into account expenses related to insurance, legal, accounting, and compliance activities, as well as other expenses not currently incurred. These laws and regulations could also make it more difficult or costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. These laws and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, on our board committees, or as our executive officers. Furthermore, if we are unable to satisfy our obligations as a public company, we could be subject to delisting of our Class A common stock, fines, sanctions, and other regulatory action and potentially civil litigation.\nOur management has limited experience in operating a public company.\nOur executive officers have limited experience in the management of a publicly traded company. Our management team may not successfully or effectively manage our transition to a public company that will be\n72\nsubject to significant regulatory oversight and reporting obligations under federal securities laws. Their limited experience in dealing with the increasingly complex laws pertaining to public companies could be a significant disadvantage in that it is likely that an increasing amount of their time may be devoted to these activities which will result in less time being devoted to the management and growth of the Company. We may not have adequate personnel with the appropriate level of knowledge, experience, and training in the accounting policies, practices or internal control over financial reporting required of public companies in the United States. The development and implementation of the standards and controls necessary for the Company to achieve the level of accounting standards required of a public company in the United States may require costs greater than expected. It is possible that we will be required to expand our employee base and hire additional employees to support our operations as a public company which will increase our operating costs in future periods.\nIf securities analysts do not publish research or reports about our business or if they publish negative evaluations of our common stock, the price of our Class A common stock could decline.\nThe trading market for our Class A common stock will rely in part on the research and reports that industry or financial analysts publish about us or our business. If few analysts commence coverage of us, the trading price of our stock could be negatively affected. Even with analyst coverage, if one or more of the analysts covering our business downgrade their evaluations of our stock, the price of our Class A common stock could decline. If one or more of these analysts cease to cover our common stock, we could lose visibility in the market for our Class A common stock, which in turn could cause our Class A common stock price to decline.\nSubstantial future sales of our Class A common stock, or the perception in the public markets that these sales may occur, may depress our stock price.\nSales of substantial amounts of our common stock in the public market, or the perception that these sales could occur, could adversely affect the price of our common stock and could impair our ability to raise capital through the sale of additional shares. Certain shares of our common stock are freely tradable without restriction under the Securities Act, except for any shares of our common stock that may be held or acquired by our directors, executive officers, and other affiliates, as that term is defined in the Securities Act, which are to be restricted securities under the Securities Act. Restricted securities may not be sold in the public market unless the sale is registered under the Securities Act or an exemption from registration is available. Topco, the Advantage Sponsors, the CP Sponsor and members of our management have rights, subject to certain conditions, to require us to file registration statements covering Topco’s shares of our common stock or to include shares in registration statements that we may file for ourselves or other stockholders. In each of November 2020 and March 2021, we filed a registration statement on Form S-1 under which certain of our shareholders may sell, from time to time, 50,000,000 shares and 255,465,000 shares of our Class A common stock, respectively, that, if sold, will be freely tradable without restriction under the Securities Act. In the event a large number of shares of Class A common stock are sold in the public market, such sales could reduce the market price of our Class A common stock.\nWe may also issue shares of our common stock or securities convertible into our common stock from time to time in connection with financings, acquisitions, investments, or otherwise. Any such issuance could result in ownership dilution to you as a stockholder and cause the trading price of our common stock to decline.\n\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nNone\n\nItem 3. Defaults Upon Senior Securities\nNone\n\nItem 4. Mine Safety Disclosures\nNone\n73\n\nItem 5. Other Information\nNone\n\nItem 6. Exhibits\n74\nSignatures 75\n2\nPART I - FINANCIAL INFORMATION\nITEM 1. FINANCIAL STATEMENTS\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED BALANCE SHEETS\n(UNAUDITED)\n\n| September 30, | December 31, |\n| (in thousands, except share data) | 2022 | 2021 |\n| ASSETS |\n| Current assets |\n| Cash and cash equivalents | $ | 96,215 | $ | 164,622 |\n| Restricted cash | 18,079 | 16,015 |\n| Accounts receivable, net of allowance for expected credit losses of $ 13,648 and $ 15,916 , respectively | 833,432 | 797,677 |\n| Prepaid expenses and other current assets | 155,429 | 126,000 |\n| Total current assets | 1,103,155 | 1,104,314 |\n| Property and equipment, net | 69,084 | 63,696 |\n| Goodwill | 2,246,053 | 2,206,004 |\n| Other intangible assets, net | 2,150,075 | 2,287,514 |\n| Investments in unconsolidated affiliates | 124,815 | 125,158 |\n| Other assets | 120,644 | 67,582 |\n| Total assets | $ | 5,813,826 | $ | 5,854,268 |\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\n| Current liabilities |\n| Current portion of long-term debt | $ | 14,704 | $ | 14,397 |\n| Accounts payable | 267,684 | 277,366 |\n| Accrued compensation and benefits | 109,935 | 139,157 |\n| Other accrued expenses | 161,246 | 164,133 |\n| Deferred revenues | 47,441 | 50,467 |\n| Total current liabilities | 601,010 | 645,520 |\n| Long-term debt, net of current portion | 2,024,591 | 2,028,882 |\n| Deferred income tax liabilities | 456,755 | 483,165 |\n| Warrant liability | 733 | 22,189 |\n| Other long-term liabilities | 109,421 | 92,218 |\n| Total liabilities | 3,192,510 | 3,271,974 |\n| Commitments and contingencies (Note 10) |\n| Redeemable noncontrolling interest | 3,353 | 1,893 |\n| Equity attributable to stockholders of Advantage Solutions Inc. |\n| Common stock, $ 0.0001 par value, 3,290,000,000 shares authorized; 319,675,888 and 316,963,552 shares issued and outstanding as of September 30, 2022 and December 31, 2021, respectively | 32 | 32 |\n| Additional paid in capital | 3,398,477 | 3,373,278 |\n| Accumulated deficit | ( 823,212 | ) | ( 866,607 | ) |\n| Loans to Karman Topco L.P. | ( 6,357 | ) | ( 6,340 | ) |\n| Accumulated other comprehensive loss | ( 29,978 | ) | ( 4,479 | ) |\n| Treasury stock, at cost; 1,610,014 shares as of September 30, 2022 and December 31, 2021 | ( 12,567 | ) | ( 12,567 | ) |\n| Total equity attributable to stockholders of Advantage Solutions Inc. | 2,526,395 | 2,483,317 |\n| Nonredeemable noncontrolling interest | 91,568 | 97,084 |\n| Total stockholders’ equity | 2,617,963 | 2,580,401 |\n| Total liabilities, redeemable noncontrolling interest, and stockholders’ equity | $ | 5,813,826 | $ | 5,854,268 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n3\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME\n(UNAUDITED)\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (in thousands, except share and per share data) | 2022 | 2021 | 2022 | 2021 |\n| Revenues | $ | 1,051,095 | $ | 928,760 | $ | 2,946,979 | $ | 2,569,735 |\n| Cost of revenues (exclusive of depreciation and amortization shown separately below) | 908,523 | 766,253 | 2,536,256 | 2,117,818 |\n| Selling, general, and administrative expenses | 37,945 | 37,742 | 138,594 | 124,830 |\n| Depreciation and amortization | 57,785 | 59,163 | 173,997 | 181,450 |\n| Total operating expenses | 1,004,253 | 863,158 | 2,848,847 | 2,424,098 |\n| Operating income | 46,842 | 65,602 | 98,132 | 145,637 |\n| Other (income) expenses: |\n| Change in fair value of warrant liability | ( 1,100 | ) | ( 3,491 | ) | ( 21,456 | ) | ( 5,024 | ) |\n| Interest expense, net | 23,557 | 36,490 | 63,628 | 104,544 |\n| Total other expenses | 22,457 | 32,999 | 42,172 | 99,520 |\n| Income before income taxes | 24,385 | 32,603 | 55,960 | 46,117 |\n| Provision for income taxes | 1,158 | 8,276 | 11,523 | 16,582 |\n| Net income | 23,227 | 24,327 | 44,437 | 29,535 |\n| Less: net income attributable to noncontrolling interest | 2,168 | 1,016 | 1,042 | 219 |\n| Net income attributable to stockholders of Advantage Solutions Inc. | 21,059 | 23,311 | 43,395 | 29,316 |\n| Other comprehensive loss, net of tax: |\n| Foreign currency translation adjustments | ( 13,616 | ) | ( 2,443 | ) | ( 25,499 | ) | ( 4,239 | ) |\n| Total comprehensive income attributable to stockholders of Advantage Solutions Inc. | $ | 7,443 | $ | 20,868 | $ | 17,896 | $ | 25,077 |\n| Net income per common share: |\n| Basic | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n| Diluted | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n| Weighted-average number of common shares: |\n| Basic | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\n| Diluted | 319,725,065 | 320,120,634 | 319,190,804 | 319,654,817 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n4\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\n(UNAUDITED)\n\n| Accumulated | Advantage |\n| Common Stock | Treasury Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at July 1, 2022 | 318,465,449 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,390,899 | $ | ( 844,271 | ) | $ | ( 6,351 | ) | $ | ( 16,362 | ) | $ | 2,511,380 | $ | 90,109 | $ | 2,601,489 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | — | — | 21,059 | — | — | 21,059 | 2,092 | 23,151 |\n| Foreign currency translation adjustments | — | — | — | — | — | — | — | ( 13,616 | ) | ( 13,616 | ) | ( 6,824 | ) | ( 20,440 | ) |\n| Total comprehensive income (loss) | 7,443 | ( 4,732 | ) | 2,711 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | — | — | ( 6 | ) | — | ( 6 | ) | — | ( 6 | ) |\n| Increase in noncontrolling interest | — | — | — | — | — | — | — | — | — | 6,191 | 6,191 |\n| Equity-based compensation of Karman Topco L.P. | — | — | — | — | ( 828 | ) | — | — | — | ( 828 | ) | — | ( 828 | ) |\n| Shares issued under 2020 Employee Stock Purchase Plan | 470,786 | — | — | — | 1,667 | — | — | — | 1,667 | — | 1,667 |\n| Shares issued under 2020 Incentive Award Plan | 739,653 | — | — | — | — | — | — | — | — | — | — |\n| Stock-based compensation expense | — | — | — | — | 6,739 | — | — | — | 6,739 | — | 6,739 |\n| Balance at September 30, 2022 | 319,675,888 | $ | 32 | $ | 1,610,014 | $ | ( 12,567 | ) | $ | 3,398,477 | $ | ( 823,212 | ) | $ | ( 6,357 | ) | $ | ( 29,978 | ) | $ | 2,526,395 | $ | 91,568 | $ | 2,617,963 |\n\n\n| Accumulated | Advantage |\n| Common Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at July 1, 2021 | 318,496,390 | $ | 32 | $ | 3,361,262 | $ | ( 915,096 | ) | $ | ( 6,328 | ) | $ | ( 1,122 | ) | $ | 2,438,748 | $ | 95,916 | $ | 2,534,664 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | 23,311 | — | — | 23,311 | 973 | 24,284 |\n| Foreign currency translation adjustments | — | — | — | — | — | ( 2,443 | ) | ( 2,443 | ) | ( 2,305 | ) | ( 4,748 | ) |\n| Total comprehensive income (loss) | 20,868 | ( 1,332 | ) | 19,536 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | ( 6 | ) | — | ( 6 | ) | — | ( 6 | ) |\n| Redemption of noncontrolling interest | — | — | ( 16 | ) | — | — | — | ( 16 | ) | — | ( 16 | ) |\n| Equity-based compensation of Karman Topco L.P. | — | — | ( 6,030 | ) | — | — | — | ( 6,030 | ) | — | ( 6,030 | ) |\n| Shares issued upon exercise of warrants | 1 | — | — | — | — | — | — | — | — |\n| Shares issued under 2020 Employee Stock Purchase Plan | 77,172 | — | 736 | — | — | — | 736 | — | 736 |\n| Stock-based compensation expense | — | — | 8,413 | — | — | — | 8,413 | — | 8,413 |\n| Balance at September 30, 2021 | 318,573,563 | $ | 32 | $ | 3,364,365 | $ | ( 891,785 | ) | $ | ( 6,334 | ) | $ | ( 3,565 | ) | $ | 2,462,713 | $ | 94,584 | $ | 2,557,297 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n5\n\n| Accumulated | Advantage |\n| Common Stock | Treasury Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at January 1, 2022 | 316,963,552 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,373,278 | $ | ( 866,607 | ) | $ | ( 6,340 | ) | $ | ( 4,479 | ) | $ | 2,483,317 | $ | 97,084 | $ | 2,580,401 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | — | — | 43,395 | — | — | 43,395 | 918 | 44,313 |\n| Foreign currency translation adjustments | — | — | — | — | — | — | — | ( 25,499 | ) | ( 25,499 | ) | ( 12,625 | ) | ( 38,124 | ) |\n| Total comprehensive income (loss) | — | — | — | — | — | — | — | — | 17,896 | ( 11,707 | ) | 6,189 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | — | — | ( 17 | ) | — | ( 17 | ) | — | ( 17 | ) |\n| Increase in noncontrolling interest | — | — | — | — | — | — | — | — | — | 6,191 | 6,191 |\n| Equity-based compensation of Karman Topco L.P. | — | — | — | — | ( 7,142 | ) | — | — | — | ( 7,142 | ) | — | ( 7,142 | ) |\n| Shares issued under 2020 Employee Stock Purchase Plan | 713,213 | — | — | — | 3,320 | — | — | — | 3,320 | — | 3,320 |\n| Shares issued under 2020 Incentive Award Plan | 1,999,123 | — | — | — | — | — | — | — | — | — | — |\n| Stock-based compensation expense | — | — | — | — | 29,021 | — | — | — | 29,021 | — | 29,021 |\n| Balance at September 30, 2022 | 319,675,888 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,398,477 | $ | ( 823,212 | ) | $ | ( 6,357 | ) | $ | ( 29,978 | ) | $ | 2,526,395 | $ | 91,568 | $ | 2,617,963 |\n\n\n| Accumulated | Advantage |\n| Common Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at January 1, 2021 | 318,425,182 | $ | 32 | $ | 3,348,546 | $ | ( 921,101 | ) | $ | ( 6,316 | ) | $ | 674 | $ | 2,421,835 | $ | 96,954 | $ | 2,518,789 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | 29,316 | — | — | 29,316 | 190 | 29,506 |\n| Foreign currency translation adjustments | — | — | — | — | — | ( 4,239 | ) | ( 4,239 | ) | ( 2,796 | ) | ( 7,035 | ) |\n| Total comprehensive income (loss) | 25,077 | ( 2,606 | ) | 22,471 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | ( 18 | ) | — | ( 18 | ) | — | ( 18 | ) |\n| Redemption of noncontrolling interest | — | — | ( 452 | ) | — | — | — | ( 452 | ) | 236 | ( 216 | ) |\n| Equity-based compensation of Karman Topco L.P. | — | — | ( 13,140 | ) | — | — | — | ( 13,140 | ) | — | ( 13,140 | ) |\n| Shares issued under 2020 Incentive Award Plan | 24,784 | — | — | — | — | — | — | — | — |\n| Shares issued upon vesting of restricted stock units | 41,424 | — | — | — | — | — | — | — | — |\n| Shares issued under 2020 Employee Stock Purchase Plan | 77,172 | — | 736 | — | — | — | 736 | — | 736 |\n| Shares issued upon exercise of warrants | 5,001 | — | 58 | — | — | — | 58 | — | 58 |\n| Stock-based compensation expense | — | — | 28,617 | — | — | — | 28,617 | — | 28,617 |\n| Balance at September 30, 2021 | 318,573,563 | $ | 32 | $ | 3,364,365 | $ | ( 891,785 | ) | $ | ( 6,334 | ) | $ | ( 3,565 | ) | $ | 2,462,713 | $ | 94,584 | $ | 2,557,297 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n6\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(UNAUDITED)\n\n| Nine Months Ended September 30, |\n| (in thousands) | 2022 | 2021 |\n| CASH FLOWS FROM OPERATING ACTIVITIES |\n| Net income | $ | 44,437 | $ | 29,535 |\n| Adjustments to reconcile net income to net cash provided by operating activities |\n| Noncash interest (income) expense, net | ( 34,419 | ) | 2,893 |\n| Depreciation and amortization | 173,997 | 181,450 |\n| Change in fair value of warrant liability | ( 21,456 | ) | ( 5,024 | ) |\n| Fair value adjustments related to contingent consideration | 5,448 | 6,977 |\n| Deferred income taxes | ( 28,561 | ) | ( 17,468 | ) |\n| Equity-based compensation of Karman Topco L.P. | ( 7,142 | ) | ( 13,140 | ) |\n| Stock-based compensation | 29,906 | 28,617 |\n| Equity in earnings of unconsolidated affiliates | ( 6,480 | ) | ( 6,222 | ) |\n| Distribution received from unconsolidated affiliates | 1,339 | 1,154 |\n| Loss on disposal of property and equipment | 608 | 6,327 |\n| Loss on divestiture | 2,953 | — |\n| Changes in operating assets and liabilities, net of effects from purchases of businesses: |\n| Accounts receivable, net | ( 45,383 | ) | ( 121,036 | ) |\n| Prepaid expenses and other assets | ( 45,087 | ) | ( 64,716 | ) |\n| Accounts payable | ( 7,914 | ) | 37,294 |\n| Accrued compensation and benefits | ( 26,316 | ) | 16,684 |\n| Deferred revenues | ( 156 | ) | 2,869 |\n| Other accrued expenses and other liabilities | 46,176 | 14,874 |\n| Net cash provided by operating activities | 81,950 | 101,068 |\n| CASH FLOWS FROM INVESTING ACTIVITIES |\n| Purchase of businesses, net of cash acquired | ( 74,146 | ) | ( 40,046 | ) |\n| Purchase of investment in unconsolidated affiliates | ( 775 | ) | ( 2,000 | ) |\n| Purchase of property and equipment | ( 30,037 | ) | ( 24,106 | ) |\n| Proceeds from divestiture | 1,896 | — |\n| Net cash used in investing activities | ( 103,062 | ) | ( 66,152 | ) |\n| CASH FLOWS FROM FINANCING ACTIVITIES |\n| Borrowings under lines of credit | 140,333 | 51,685 |\n| Payments on lines of credit | ( 139,684 | ) | ( 102,493 | ) |\n| Proceeds from issuance of long-term debt | 266 | — |\n| Principal payments on long-term debt | ( 10,427 | ) | ( 10,133 | ) |\n| Proceeds from issuance of common stock | 3,320 | 794 |\n| Contingent consideration payments | ( 23,164 | ) | ( 6,247 | ) |\n| Holdback payments | ( 8,557 | ) | ( 2,389 | ) |\n| Contribution from noncontrolling interest | 5,217 | — |\n| Redemption of noncontrolling interest | ( 224 | ) | ( 216 | ) |\n| Net cash used in financing activities | ( 32,920 | ) | ( 68,999 | ) |\n| Net effect of foreign currency changes on cash | ( 12,311 | ) | ( 1,476 | ) |\n| Net change in cash, cash equivalents and restricted cash | ( 66,343 | ) | ( 35,559 | ) |\n| Cash, cash equivalents and restricted cash, beginning of period | 180,637 | 219,966 |\n| Cash, cash equivalents and restricted cash, end of period | $ | 114,294 | $ | 184,407 |\n| SUPPLEMENTAL CASH FLOW INFORMATION |\n| Purchase of property and equipment recorded in accounts payable and accrued expenses | $ | 1,409 | $ | 322 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n7\nADVANTAGE SOLUTIONS INC.\nNOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(UNAUDITED)\n1. Organization and Significant Accounting Policies Advantage Solutions Inc. (the “Company”) is a provider of outsourced solutions to consumer goods companies and retailers. The Company’s Class A common stock is listed on the Nasdaq Global Select Market under the symbol “ADV” and warrants to purchase the Class A common stock at an exercise price of $ 11.50 per share are listed on the Nasdaq Global Select Market under the symbol “ADVWW”. Basis of Presentation The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its subsidiaries. The unaudited condensed consolidated financial statements do not include all of the information required by accounting principles generally accepted in the United States (“GAAP”). The Condensed Consolidated Balance Sheet at December 31, 2021 was derived from the audited Consolidated Balance Sheet at that date and does not include all the disclosures required by GAAP. In the opinion of management, all adjustments which are of a normal recurring nature and necessary for a fair statement of the results as of September 30, 2022 and for the three and nine months ended September 30, 2022 and 2021 have been reflected in the condensed consolidated financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements as of and for the year ended December 31, 2021 and the related footnotes thereto. Operating results for the three and nine months ended September 30, 2022 are not necessarily indicative of the results to be expected during the remainder of the current year or for any future period. COVID-19 Pandemic Beginning in March 2020 and continuing through the first quarter of 2021, the Company’s services experienced the most severe effects from reductions in client spending due to the economic impact related to the COVID-19 pandemic. While mixed by services and geography, the spending reductions impacted all of the Company’s services and markets. Globally, the most impacted services were the Company's experiential services. Most services began to recover in April 2021, and the recovery has continued through the third quarter of 2022. Impact of the War in Ukraine The Company has a minority interest in a European company that has majority-ownership interests in local agencies in Russia. During the first quarter of 2022, the war in Ukraine resulted in the imposition of sanctions by the United States, the United Kingdom, and the European Union, that affected, and continues to affect, the cross-border operations of businesses operating in Russia. In addition, Russian regulators have imposed currency restrictions and regulations that created uncertainty regarding the Company's ability to recover its investment in operations in Russia, as well as the Company's ability to exercise control or influence over operations by the local agencies in Russia. As a result, the Company intends to use its influence to cause the European company to dispose of its ownership interests in the local agencies in Russia. Accordingly, the Company recorded pretax charges of $ 2.8 million in the first quarter of 2022, primarily consisting of its proportionate share of the net investment in its Russian interest in “Selling, general, and administrative expenses” in the Condensed Consolidated Statements of Operations and Comprehensive Income. Recent Accounting StandardsAccounting Standards Recently Adopted by the CompanyIn March 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on 8 Financial Reporting. This guidance provides optional expedients and exceptions for GAAP to contracts, hedging relationships, and other transactions that reference the London Interbank Offered Rate (“LIBOR”) or another reference rate if certain criteria are met. The amendments in this update are effective for reporting periods that include or are subsequent to March 12, 2020 and must be applied prospectively to contract modifications and hedging relationships through December 31, 2022. On April 1, 2022, the Company adopted the standard prospectively and determined that the adoption of this accounting guidance did not have a material impact on its condensed consolidated financial statements.On January 1, 2022, the Company adopted ASU No. 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity (“ASU 2020-06”), which simplifies accounting for convertible instruments by removing major separation models required under current GAAP, simplifies the contract settlement assessment for equity classification, requires the use of the if-converted method for all convertible instruments in the diluted earnings per share calculation and expands disclosure requirements. The adoption of this accounting standard, under the full retrospective method, did not have a material impact on the Company's condensed consolidated financial statements and use of the if-converted method did not have an impact on the Company's overall earnings per share calculation.On January 1, 2022, the Company adopted ASU 2021-04, Earnings Per Share (Topic 260), Debt—Modifications and Extinguishments (Subtopic 470-50), Compensation—Stock Compensation (Topic 718), and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Issuer’s Accounting for Certain Modifications or Exchanges of Freestanding Equity-Classified Written Call Options (a consensus of the FASB Emerging Issues Task Force). The guidance clarifies certain aspects of the current guidance to promote consistency among reporting of an issuer’s accounting for modifications or exchanges of freestanding equity-classified written call options (for example, warrants) that remain equity-classified after modification or exchange. The guidance is applied prospectively to all modifications or exchanges that occur on or after the date of adoption and the adoption of this accounting standard did not have a material impact on the Company’s condensed consolidated financial statements.On January 1, 2022, the Company adopted ASU 2021-10, Government Assistance (Topic 832): Disclosures by Business Entities about Government Assistance. This update requires annual disclosures about transactions with a government that are accounted for by applying a grant or contribution accounting model by analogy. The guidance is applied prospectively to all transactions within the scope of the amendments that are reflected in financial statements at the date of initial application and new transactions that are entered into after the date of initial application. The adoption of this accounting standard did not have a material impact on the Company’s condensed consolidated financial statements. Accounting Standards Recently Issued but Not Yet Adopted by the CompanyIn October 2021, the FASB issued ASU 2021-08, Business Combinations (Topic 606): Accounting for Contract Assets and Contract Liabilities from Contracts with Customers, which requires that an entity recognize and measure contract assets and contract liabilities acquired in a business combination in accordance with Topic 606 as if it had originated the contracts. Generally, this should result in an acquirer recognizing and measuring the acquired contract assets and contract liabilities consistent with how they were recognized and measured in the acquiree’s financial statements, if the acquiree prepared financial statements in accordance with GAAP. The amendment in this update is effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. The guidance should be applied prospectively to business combinations occurring on or after the effective date of the amendment in this update. The Company is evaluating the potential impact of this adoption on its consolidated financial statements. All other new accounting pronouncements issued, but not yet effective or adopted have been deemed to be not relevant to the Company and, accordingly, are not expected to have a material impact once adopted.\n9\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Sales brand-centric services | $ | 343,478 | $ | 330,740 | $ | 1,005,707 | $ | 946,147 |\n| Sales retail-centric services | 302,768 | 266,399 | 836,640 | 746,960 |\n| Total sales revenues | 646,246 | 597,139 | 1,842,347 | 1,693,107 |\n| Marketing brand-centric services | 143,241 | 142,554 | 393,155 | 381,358 |\n| Marketing retail-centric services | 261,608 | 189,067 | 711,477 | 495,270 |\n| Total marketing revenues | 404,849 | 331,621 | 1,104,632 | 876,628 |\n| Total revenues | $ | 1,051,095 | $ | 928,760 | $ | 2,946,979 | $ | 2,569,735 |\n\n| (in thousands) |\n| Consideration: |\n| Cash | $ | 74,146 |\n| Holdback | 810 |\n| Fair value of contingent consideration | 510 |\n| Total consideration | $ | 75,466 |\n| Recognized amounts of identifiable assets acquired and liabilities assumed: |\n| Assets |\n| Accounts receivable | $ | 9,409 |\n| Other assets | 3,446 |\n| Identifiable intangible assets | 25,546 |\n| Total assets | 38,401 |\n| Liabilities |\n| Accounts payable | 7,363 |\n| Deferred tax liabilities and other | 8,744 |\n| Total liabilities | 16,107 |\n| Redeemable noncontrolling interest | 1,987 |\n| Noncontrolling interest | 974 |\n| Total identifiable net assets | 19,333 |\n| Goodwill arising from acquisitions | $ | 56,133 |\n| (in thousands) | Amount | WeightedAverageUseful Life |\n| Client relationships | $ | 24,413 | 6 years |\n| Trade names | 1,133 | 10 years |\n| Total identifiable intangible assets | $ | 25,546 |\n| (in thousands) |\n| Consideration |\n| Cash | $ | 40,046 |\n| Holdbacks | 13,599 |\n| Fair value of contingent consideration | 19,883 |\n| Total consideration | $ | 73,528 |\n| Recognized amounts of identifiable assets acquired and liabilities assumed: |\n| Assets |\n| Accounts receivable | $ | 12,834 |\n| Other assets | 4,400 |\n| Property and equipment | 1,001 |\n| Identifiable intangible assets | 36,210 |\n| Total assets | 54,445 |\n| Liabilities |\n| Total liabilities | 21,758 |\n| Redeemable noncontrolling interest | 1,804 |\n| Total identifiable net assets | 30,883 |\n| Goodwill arising from acquisitions | $ | 42,645 |\n| (in thousands) | Amount | WeightedAverageUseful Life |\n| Client relationships | $ | 27,860 | 7 years |\n| Trade Names | 5,250 | 5 years |\n| Developed technology | 3,100 | 7 years |\n| Total identifiable intangible assets | $ | 36,210 |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Revenues | $ | 1,052,274 | $ | 963,576 | $ | 2,962,479 | $ | 2,719,111 |\n| Net income | $ | 21,467 | $ | 23,896 | $ | 46,461 | $ | 32,590 |\n\n\n| Sales | Marketing | Total |\n| (in thousands) |\n| Balance at January 1, 2021 | $ | 1,462,378 | $ | 700,961 | $ | 2,163,339 |\n| Acquisitions | 32,087 | 13,315 | 45,402 |\n| Measurement period adjustments | 179 | ( 1,043 | ) | ( 864 | ) |\n| Foreign exchange translation effects | ( 1,873 | ) | — | ( 1,873 | ) |\n| Balance at December 31, 2021 | $ | 1,492,771 | $ | 713,233 | $ | 2,206,004 |\n| Acquisitions | 5,672 | 50,461 | 56,133 |\n| Measurement period adjustments | ( 446 | ) | — | ( 446 | ) |\n| Foreign exchange translation effects | ( 15,638 | ) | — | ( 15,638 | ) |\n| Balance at September 30, 2022 | $ | 1,482,359 | $ | 763,694 | $ | 2,246,053 |\n| September 30, 2022 |\n| (amounts in thousands) | Weighted Average Useful Life | Gross CarryingValue | AccumulatedAmortization | Net Carrying Value |\n| Finite-lived intangible assets: |\n| Client relationships | 14 years | $ | 2,486,064 | $ | 1,290,842 | $ | 1,195,222 |\n| Trade names | 8 years | 135,271 | 84,067 | 51,204 |\n| Developed technology | 5 years | 13,260 | 9,870 | 3,390 |\n| Covenant not to compete | 5 years | 6,100 | 5,841 | 259 |\n| Total finite-lived intangible assets | 2,640,695 | 1,390,620 | 1,250,075 |\n| Indefinite-lived intangible assets: |\n| Trade names | 900,000 | — | 900,000 |\n| Total other intangible assets | $ | 3,540,695 | $ | 1,390,620 | $ | 2,150,075 |\n| December 31, 2021 |\n| (amounts in thousands) | Weighted Average Useful Life | Gross CarryingValue | AccumulatedAmortization | Net Carrying Value |\n| Finite-lived intangible assets: |\n| Client relationships | 14 years | $ | 2,480,167 | $ | 1,158,732 | $ | 1,321,435 |\n| Trade names | 8 years | 138,206 | 78,355 | 59,851 |\n| Developed technology | 5 years | 13,260 | 8,206 | 5,054 |\n| Covenant not to compete | 5 years | 6,100 | 4,926 | 1,174 |\n| Total finite-lived intangible assets | 2,637,733 | 1,250,219 | 1,387,514 |\n| Indefinite-lived intangible assets: |\n| Trade names | 900,000 | — | 900,000 |\n| Total other intangible assets | $ | 3,537,733 | $ | 1,250,219 | $ | 2,287,514 |\n| (in thousands) |\n| Remainder of 2022 | $ | 49,782 |\n| 2023 | 197,530 |\n| 2024 | 196,181 |\n| 2025 | 190,153 |\n| 2026 | 186,203 |\n| Thereafter | 430,226 |\n| Total amortization expense | $ | 1,250,075 |\n\n\n| September 30, | December 31, |\n| (in thousands) | 2022 | 2021 |\n| Term Loan Facility | $ | 1,301,813 | $ | 1,311,750 |\n| Notes | 775,000 | 775,000 |\n| Government loans for COVID-19 relief | 4,113 | 5,212 |\n| Other | 1,492 | 1,113 |\n| Total long-term debt | 2,082,418 | 2,093,075 |\n| Less: current portion | 14,704 | 14,397 |\n| Less: debt issuance costs | 43,123 | 49,796 |\n| Long-term debt, net of current portion | $ | 2,024,591 | $ | 2,028,882 |\n\n| September 30, 2022 |\n| (in thousands) | Fair Value | Level 1 | Level 2 | Level 3 |\n| Assets measured at fair value |\n| Derivative financial instruments | $ | 49,149 | $ | — | $ | 49,149 | $ | — |\n| Total assets measured at fair value | $ | 49,149 | $ | — | $ | 49,149 | $ | — |\n| Liabilities measured at fair value |\n| Warrant liability | $ | 733 | $ | — | $ | 733 | $ | — |\n| Contingent consideration liabilities | 40,431 | — | — | 40,431 |\n| Total liabilities measured at fair value | $ | 41,164 | $ | — | $ | 733 | $ | 40,431 |\n| December 31, 2021 |\n| (in thousands) | Fair Value | Level 1 | Level 2 | Level 3 |\n| Assets measured at fair value |\n| Derivative financial instruments | $ | 10,164 | $ | — | $ | 10,164 | $ | — |\n| Total assets measured at fair value | $ | 10,164 | $ | — | $ | 10,164 | $ | — |\n| Liabilities measured at fair value |\n| Derivative financial instruments | $ | 385 | $ | — | $ | 385 | $ | — |\n| Warrant liability | 22,189 | — | — | 22,189 |\n| Contingent consideration liabilities | 58,366 | — | — | 58,366 |\n| Total liabilities measured at fair value | $ | 80,940 | $ | — | $ | 385 | $ | 80,555 |\n| September 30, |\n| (in thousands) | 2022 | 2021 |\n| Beginning of the period | $ | 58,366 | $ | 45,901 |\n| Fair value of acquisitions | 510 | 19,883 |\n| Changes in fair value | 5,448 | 6,977 |\n| Payments | ( 23,164 | ) | ( 6,399 | ) |\n| Measurement period adjustments | — | ( 1,181 | ) |\n| Foreign exchange translation effects | ( 729 | ) | ( 69 | ) |\n| End of the period | $ | 40,431 | $ | 65,112 |\n| (in thousands) | Carrying Value | Fair Value(Level 2) |\n| Balance at September 30, 2022 |\n| Term Loan Facility | $ | 1,301,813 | $ | 1,329,741 |\n| Notes | 775,000 | 723,486 |\n| Government loans for COVID-19 relief | 4,113 | 4,306 |\n| Other | 1,492 | 1,492 |\n| Total long-term debt | $ | 2,082,418 | $ | 2,059,025 |\n| (in thousands) | Carrying Value | Fair Value(Level 2) |\n| Balance at December 31, 2021 |\n| Term Loan Facility | $ | 1,311,750 | $ | 1,406,552 |\n| Notes | 775,000 | 894,611 |\n| Government loans for COVID-19 relief | 5,212 | 5,615 |\n| Other | 1,113 | 1,113 |\n| Total long-term debt | $ | 2,093,075 | $ | 2,307,891 |\n\n\n| Revenues | Accounts Receivable |\n| Three Months Ended September 30, | Nine Months Ended September 30, | As of September 30, | As of December 31, |\n| (in thousands) | 2022 | 2021 | 2022 | 2021 | 2022 | 2021 |\n| Client 1 | $ | 450 | $ | — | $ | 1,275 | $ | — | $ | 301 | $ | 176 |\n| Client 2 | 136 | 42 | 668 | 75 | 289 | 160 |\n| Client 3 | 147 | 124 | 455 | 457 | 129 | 190 |\n| All other clients | 30 | 1,452 | 152 | 6,694 | 16 | 10 |\n| Total | $ | 763 | $ | 1,618 | $ | 2,550 | $ | 7,226 | $ | 735 | $ | 536 |\n\n8. Income TaxesThe Company’s effective tax rates were 4.7 % and 25.4 % for the three months ended September 30, 2022 and 2021, respectively. The effective tax rate is based upon the estimated income or loss before taxes for the year, by jurisdiction, and adjusted for estimated permanent tax adjustments. The fluctuation in the Company’s effective tax rate was primarily due to the three months pretax book income differences and the discrete impact of $ 5.0 million to remeasure the deferred tax liability as a result of a reduction in the Company's blended state tax rate driven primarily by a Pennsylvania statutory tax rate change for the three months ended September 30, 2022, no t included in the three months ended September 30, 2021.The Company’s effective tax rates were 20.6 % and 36.0 % for the nine months ended September 30, 2022 and 2021, respectively. The effective tax rate is based upon the estimated income or loss before taxes for the year, by jurisdiction, and adjusted for estimated permanent tax adjustments. The fluctuation in the Company’s effective tax rate was primarily due to the nine months pretax book income differences, the discrete impact of $ 5.0 million to remeasure the deferred tax liability as a result of a reduction in the Company's blended state tax rate driven primarily by a Pennsylvania statutory tax rate change for the nine months ended September 30, 2022, offset by a shortfall adjustment of $ 2.4 million of stock based compensation for the nine months ended September 30, 2022. On August 16, 2022, the U.S. government enacted the Inflation Reduction Act (“IRA”), which imposes a new corporate alternative minimum tax (“CAMT”), an excise tax on stock buybacks, and significant tax incentives for energy and climate initiatives, among other provisions. The Company does not expect the CAMT to have a material impact on its consolidated financial statements.\n| (in thousands) | Sales | Marketing | Total |\n| Three Months Ended September 30, 2022 |\n| Revenues | $ | 646,246 | $ | 404,849 | $ | 1,051,095 |\n| Depreciation and amortization | $ | 39,798 | $ | 17,987 | $ | 57,785 |\n| Operating income | $ | 31,765 | $ | 15,077 | $ | 46,842 |\n| Three Months Ended September 30, 2021 |\n| Revenues | $ | 597,139 | $ | 331,621 | $ | 928,760 |\n| Depreciation and amortization | $ | 41,515 | $ | 17,648 | $ | 59,163 |\n| Operating income | $ | 51,906 | $ | 13,696 | $ | 65,602 |\n| (in thousands) | Sales | Marketing | Total |\n| Nine Months Ended September 30, 2022 |\n| Revenues | $ | 1,842,347 | $ | 1,104,632 | $ | 2,946,979 |\n| Depreciation and amortization | $ | 121,310 | $ | 52,687 | $ | 173,997 |\n| Operating income | $ | 65,915 | $ | 32,217 | $ | 98,132 |\n| Nine Months Ended September 30, 2021 |\n| Revenues | $ | 1,693,107 | $ | 876,628 | $ | 2,569,735 |\n| Depreciation and amortization | $ | 128,789 | $ | 52,661 | $ | 181,450 |\n| Operating income | $ | 131,727 | $ | 13,910 | $ | 145,637 |\n\n10. Commitments and ContingenciesLitigationThe Company is involved in various legal matters that arise in the ordinary course of its business. Some of these legal matters purport or may be determined to be class and/or representative actions, or seek substantial damages, or penalties. The Company has accrued amounts in connection with certain legal matters, including with respect to certain of the matters described below. There can be no assurance, however, that these accruals will be sufficient to cover such matters or other legal matters or that such matters or other legal matters will not materially or adversely affect the Company’s financial position, liquidity, or results of operations.Employment MattersThe Company has also been involved in various litigation, including purported class or representative actions with respect to matters arising under the California Labor Code and Private Attorneys General Act. The Company has retained outside counsel to represent it in these matters and is vigorously defending its interests. Legal Matters Related to Take 5On April 1, 2018, the Company acquired certain assets and assumed liabilities of Take 5 Media Group (“Take 5”). In June 2019, as a result of a review of internal allegations related to inconsistency of data provided by Take 5 to its clients, the Company commenced an investigation into Take 5’s operations. In July 2019, as a result of the Company’s investigation, the Company determined that revenue during the fiscal year ended December 31, 2018 attributable to the Take 5 business had been recognized for services that were not performed on behalf of clients of Take 5 and that inaccurate reports were made to Take 5 clients about those services (referred to as the “Take 5 Matter”). As a result of these findings, in July 2019, the Company terminated all operations of Take 5, including the use of its associated trade names and the offering of its services to its clients and offered refunds to Take 5 clients of collected revenues attributable to Take 5 since the Company’s acquisition of Take 5. 20 USAO and FBI Voluntary Disclosure and Investigation Related to Take 5The Company voluntarily disclosed to the United States Attorney’s Office and the Federal Bureau of Investigation certain misconduct occurring at Take 5, a line of business that the Company closed in July 2019. The Company intends to cooperate in this and any other governmental investigations that may arise in connection with the Take 5 Matter. At this time, the Company cannot predict the ultimate outcome of any investigation related to the Take 5 Matter and is unable to estimate the potential impact such an investigation may have on the Company. Arbitration Proceedings Related to Take 5In August 2019, as a result of the Take 5 Matter, the Company provided a written indemnification claim notice to the sellers of Take 5 (the “Take 5 Sellers”) seeking monetary damages (including interest, fees and costs) based on allegations of breach of the asset purchase agreement (the “Take 5 APA”), as well as fraud. In September 2019, the Take 5 Sellers initiated arbitration proceedings against the Company, alleging breach of the Take 5 APA as a result of the Company’s decision to terminate the operations of the Take 5 business, and seeking monetary damages equal to all unpaid earn-out payments under the Take 5 APA (plus interest, fees and costs). In 2020, the Take 5 sellers amended their statement of claim to allege defamation, relating to statements the Company made to customers in connection with terminating the operations of the Take 5 business, and seeking monetary damages for the alleged injury to their reputation. The Company filed its response to the Take 5 Sellers’ claims, and asserted indemnification, fraud and other claims against the Take 5 Sellers as counterclaims and cross-claims in the arbitration proceedings. In October 2022, the arbitrator made a final award in favor of the Company. The Company is currently unable to estimate if or when it will be able to collect any amounts associated with this arbitration. Other Legal Matters Related to Take 5The Take 5 Matter may result in additional litigation against the Company, including lawsuits from clients, or governmental investigations, which may expose the Company to potential liability in excess of the amounts being offered by the Company as refunds to Take 5 clients. The Company is currently unable to determine the amount of any potential liability, costs or expenses (above the amounts already being offered as refunds) that may result from any lawsuits or investigations associated with the Take 5 Matter or determine whether any such issues will have any future material adverse effect on the Company’s financial position, liquidity, or results of operations. Although the Company has insurance covering certain liabilities, the insurance may not be sufficient to cover any potential liability or expenses associated with the Take 5 Matter.\n| (in thousands, except share and per share data) Performance Period | Number ofSharesThreshold | Number ofSharesTarget | Number ofSharesMaximum | WeightedAverage FairValue perShare | Maximum Remaining Unrecognized Compensation Expense | Weighted-average remaining requisite service periods |\n| January 1, 2022— December 31, 2022 | 2,479,997 | 4,959,993 | 7,439,990 | $ | 5.63 | $ | 80,689 | 1.5 years |\n| January 1, 2021— December 31, 2021 | 1,121,698 | 1,121,698 | 1,319,458 | $ | 13.17 | $ | 4,982 | 1.1 years |\n| Performance Share Units | Weighted Average GrantDate Fair Value |\n| Outstanding at January 1, 2022 | 2,609,079 | $ | 13.07 |\n| Granted | 5,393,085 | $ | 5.66 |\n| Distributed | 660,880 | $ | 13.09 |\n| Forfeited | 684,261 | $ | 8.19 |\n| PSU performance adjustment | ( 377,572 | ) | $ | 11.19 |\n| Outstanding at September 30, 2022 | 6,279,451 | $ | 7.22 |\n| Number of RSUs | Weighted Average GrantDate Fair Value |\n| Outstanding at January 1, 2022 | 3,660,553 | $ | 10.64 |\n| Granted | 6,302,801 | $ | 5.74 |\n| Distributed | 1,338,213 | $ | 10.61 |\n| Forfeited | 869,955 | $ | 8.02 |\n| Outstanding at September 30, 2022 | 7,755,186 | $ | 6.96 |\n| September 30, |\n| 2022 |\n| Share Price | $ | 5.99 |\n| Dividend yield | 0.0 | % |\n| Expected volatility | 30.0 | % |\n| Risk-free interest rate | 2.0 | % |\n| Expected term (years) | 6.5 |\n\n\n| (in thousands) |\n| Balance at January 1, 2022 | $ | 1,893 |\n| Fair value at acquisition | 1,987 |\n| Net income attributable to redeemable noncontrolling interests | 124 |\n| Dividend distribution | ( 223 | ) |\n| Foreign currency translation adjustment | ( 428 | ) |\n| Balance at September 30, 2022 | $ | 3,353 |\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (in thousands, except share and earnings per share data) | 2022 | 2021 | 2022 | 2021 |\n| Basic earnings per share computation: |\n| Numerator: |\n| Net income attributable to stockholders of Advantage Solutions Inc. | $ | 21,059 | $ | 23,311 | $ | 43,395 | $ | 29,316 |\n| Denominator: |\n| Weighted average common shares - basic | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\n| Basic earnings per common share | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n| Diluted earnings per share computation: |\n| Numerator: |\n| Net income attributable to stockholders of Advantage Solutions Inc. | $ | 21,059 | $ | 23,311 | $ | 43,395 | $ | 29,316 |\n| Denominator: |\n| Weighted average common shares outstanding | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\n| Performance and Restricted Stock Units | 602,566 | 1,450,668 | 496,968 | 1,335,011 |\n| Employee stock purchase plan and stock options | 300,604 | 106,469 | 348,271 | 106,469 |\n| Weighted average common shares - diluted | 319,725,065 | 320,120,634 | 319,190,804 | 319,654,817 |\n| Diluted earnings per common share | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n\n24\n14. Subsequent EventsIn October 2022, the Company granted 2,153,900 RSUs and 1,170,000 stock options, with an estimated aggregate grant date fair value of $ 4.8 million and $ 1.2 million, respectively.\n25\nITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nForward-Looking Statements\nThis Quarterly Report on Form 10-Q (this “Quarterly Report”), including the section titled “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements that are based on current expectations, estimates, forecasts and projections about us, our future performance, our business, our beliefs and our management’s assumptions. Such words as “expect,” “anticipate,” “outlook,” “could,” “target,” “project,” “intend,” “plan,” “believe,” “seek,” “estimate,” “should,” “may,” “assume” and “continue” as well as variations of such words and similar expressions are intended to identify such forward-looking statements, although not all forward-looking statements contain such terms. These statements are not guarantees of future performance and they involve certain risks, uncertainties and assumptions that are difficult to predict. We have based our forward-looking statements on our management’s beliefs and assumptions based on information available to our management at the time the statements are made. We caution you that actual outcomes and results may differ materially from what is expressed, implied or forecasted by our forward-looking statements. More information regarding these risks and uncertainties and other important factors that could cause actual results to differ materially from those in the forward-looking statements is set forth in Part II, Item 1A “Risk Factors” of this report. Investors are cautioned not to place undue reliance on any such forward-looking statements, which speak only as of the date they are made. Except as required under the federal securities laws and the rules and regulations of the Securities and Exchange Commission, we do not have any intention or obligation to update publicly any forward-looking statements after the distribution of this report, whether as a result of new information, future events, changes in assumptions or otherwise.\nExecutive Overview\nWe are a leading business solutions provider to consumer goods manufacturers and retailers. We have a strong platform of competitively advantaged sales and marketing services built over multiple decades – essential, business critical services like headquarter sales, retail merchandising, in-store sampling, digital commerce and shopper marketing. For brands and retailers of all sizes, we help get the right products on the shelf (whether physical or digital) and into the hands of consumers (however they shop). We use a scaled platform to innovate as a trusted partner with our clients, solving problems to increase their efficiency and effectiveness across a broad range of channels.\nWe have two reportable segments: sales and marketing.\nThrough our sales segment, which generated approximately 62.5% and 65.9% of our total revenues in the nine months ended September 30, 2022 and 2021, respectively, we offer headquarter sales representation services to consumer goods manufacturers, for whom we prepare and present to retailers a business case to increase distribution of manufacturers’ products and optimize how they are displayed, priced and promoted. We also make in-store merchandising visits for both manufacturer and retailer clients to ensure the products we represent are adequately stocked and properly displayed.\nThrough our marketing segment, which generated approximately 37.5% and 34.1% of our total revenues in the nine months ended September 30, 2022 and 2021, respectively, we help brands and retailers reach consumers through two main categories within the marketing segment. The first and largest category is our retail experiential business, also known as in-store sampling or demonstrations, where we manage highly customized large-scale sampling programs (both in-store and online) for leading retailers. The second category is our collection of specialized agency services, in which we provide private label services to retailers and develop granular marketing programs for brands and retailers through our shopper, consumer and digital marketing agencies.\n26\nBusiness Combination with Conyers Park\nOn October 28, 2020, Conyers Park II Acquisition Corp. (“Conyers Park”), a Delaware corporation, consummated a merger with ASI Intermediate Corp. (“ASI”), formerly known as Advantage Solutions Inc., with ASI surviving the merger as a wholly owned subsidiary of Conyers Park (the “Merger” and, together with the other transactions contemplated by the merger agreement, the “Transactions”). On October 28, 2020, and in connection with the closing of the Transactions, Conyers Park changed its name to Advantage Solutions Inc.\nImpacts of the COVID-19 Pandemic\nBeginning in March 2020 and continuing through the first quarter of 2021, our services experienced the effects from reductions in client spending due to the economic impact related to the COVID-19 pandemic. While mixed by services and geography, the spending reductions impacted all of our services and markets. Globally, the most impacted services were our experiential services. Most services began to improve in April 2021, and the improvement has continued through the third quarter of 2022.\nSummary\nOur financial performance for the three months ended September 30, 2022 as compared to the three months ended September 30, 2021 includes:\n•Revenues increased by $122.3 million, or 13.2%, to $1,051.1 million;\n•Operating income decreased by $18.8 million, or 28.6%, to $46.8 million;\n•Net income decreased by $1.1 million, or 4.5% to $23.2 million;\n•Adjusted Net Income increased by $3.6 million, or 6.1%, to $62.7 million; and\n•Adjusted EBITDA decreased by $15.5 million, or 11.6%, to $118.3 million.\nOur financial performance for the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021 includes:\n•Revenues increased by $377.2 million, or 14.7% to $2,947.0 million;\n•Operating income decreased by $47.5 million, or 32.6% to $98.1 million;\n•Net income increased by $14.9 million, or 50.5% to $44.4 million;\n•Adjusted Net Income increased by $5.8 million, or 3.9% to $152.5 million; and\n•Adjusted EBITDA decreased by $43.8 million, or 11.9% to $323.3 million.\nDuring the nine months ended September 30, 2022, we acquired four businesses. The aggregate purchase price was $75.5 million, of which $74.1 million was paid in cash, $0.5 million in contingent consideration and $0.8 million in holdback.\nFactors Affecting Our Business and Financial Reporting\nThere are a number of factors, in addition to the impact of the COVID-19 pandemic and inflation, that affect the performance of our business and the comparability of our results from period to period including:\n•Organic Growth. Part of our strategy is to generate organic growth by expanding our existing client relationships, continuing to win new clients, pursuing channel expansion and new industry opportunities, enhancing our digital technology solutions, developing our international platform, delivering operational efficiencies and expanding into logical adjacencies. We believe that by pursuing\n27\nthese organic growth opportunities we will be able to continue to enhance our value proposition to our clients and thereby grow our business.\n•Acquisitions. We have grown and expect to continue to grow our business in part by acquiring quality businesses, both domestic and international. Excluding the 2017 acquisition of Daymon Worldwide Inc., we have completed 73 acquisitions from January 2014 to November 9, 2022, ranging in purchase prices from approximately $0.3 million to $98.5 million. Many of our acquisition agreements include contingent consideration arrangements, which are described below. We have completed acquisitions at what we believe are attractive purchase prices and have regularly structured our agreements to result in the generation of long-lived tax assets, which have in turn reduced our effective purchase prices when incorporating the value of those tax assets. We continue to look for strategic acquisitions that can be completed at attractive purchase prices.\n•Contingent Consideration. Many of our acquisition agreements include contingent consideration arrangements, which are generally based on the achievement of financial performance thresholds by the operations attributable to the acquired businesses. The contingent consideration arrangements are based upon our valuations of the acquired businesses and are intended to share the investment risk with the sellers of such businesses if projected financial results are not achieved. The fair values of these contingent consideration arrangements are included as part of the purchase price of the acquired companies on their respective acquisition dates. For each transaction, we estimate the fair value of contingent consideration payments as part of the initial purchase price. We review and assess the estimated fair value of contingent consideration on a quarterly basis, and the updated fair value could differ materially from our initial estimates. Adjustments to the estimated fair value related to changes in all other unobservable inputs are reported in “Selling, general and administrative expenses” in our Condensed Consolidated Statements of Operations and Comprehensive Income.\n•Depreciation and Amortization. As a result of the acquisition of our business by Karman Topco L.P. (“Topco”) on July 25, 2014 (the “2014 Topco Acquisition”), we acquired significant intangible assets, the value of which is amortized, on a straight-line basis, over 15 years from the date of the 2014 Topco Acquisition, unless determined to be indefinite-lived. The amortization of such intangible assets recorded in our consolidated financial statements has a significant impact on our operating income (loss) and net income (loss). Our historical acquisitions have increased, and future acquisitions likely will increase, our intangible assets. We do not believe the amortization expense associated with the intangibles created from our purchase accounting adjustments reflect a material economic cost to our business. Unlike depreciation expense which has an economic cost reflected by the fact that we must re-invest in property and equipment to maintain the asset base delivering our results of operations, we do not have any capital re-investment requirements associated with the acquired intangibles, such as client relationships and trade names, that comprise the majority of the finite-lived intangibles that create our amortization expense.\n•Foreign Exchange Fluctuations. Our financial results are affected by fluctuations in the exchange rate between the U.S. dollar and other currencies, primarily Canadian dollars, British pounds and euros, due to our operations in such foreign jurisdictions. See also “ —Quantitative and Qualitative Disclosure of Market Risk—Foreign Currency Risk.”\n•Seasonality. Our quarterly results are seasonal in nature, with the fourth fiscal quarter typically generating a higher proportion of our revenues than other fiscal quarters, as a result of higher consumer spending. We generally record slightly lower revenues in the first fiscal quarter of each year, as our clients begin to roll out new programs for the year, and consumer spending generally is less in the first fiscal quarter than other quarters. Timing of our clients’ marketing expenses, associated with marketing campaigns and new product launches, can also result in fluctuations from one quarter to another.\n28\nHow We Assess the Performance of Our Business\nRevenues\nRevenues related to our sales segment are primarily comprised of commissions, fee-for-service and cost-plus fees for providing retail merchandising services, category and space management, headquarter relationship management, technology solutions and administrative services. A small portion of our arrangements include performance incentive provisions, which allow us to earn additional revenues on our performance relative to specified quantitative or qualitative goals. We recognize the incentive portion of revenues under these arrangements when the related services are transferred to the customer.\nMarketing segment revenues are primarily recognized in the form of a fee-for-service (including retainer fees, fees charged to clients based on hours incurred, project-based fees or fees for executing in-person consumer engagements or experiences, which engagements or experiences we refer to as events), commissions or on a cost-plus basis, in each case, related to services including experiential marketing, shopper and consumer marketing services, private label development or our digital, social and media services.\nGiven our acquisition strategy, we analyze our financial performance, in part, by measuring revenue growth in two ways—revenue growth attributable to organic activities and revenue growth attributable to acquisitions, which we refer to as organic revenues and acquired revenues, respectively.\nWe define organic revenues as any revenues that are not acquired revenues. Our organic revenues exclude the impacts of acquisitions and divestitures, when applicable, which improves comparability of our results from period to period.\nIn general, when we acquire a business, the acquisition includes a contingent consideration arrangement (e.g., an earn-out provision) and, accordingly, we separately track the relevant metrics associated with the earnout agreement of the acquired business. In such cases, we consider revenues generated by such a business during the 12 months following its acquisition to be acquired revenues. For example, if we completed an acquisition on July 1, 2021 for a business that included a contingent consideration arrangement, we would consider revenues from the acquired business from July 1, 2021 to June 30, 2022 to be acquired revenues. We generally consider growth attributable to the financial performance of an acquired business after the 12-month anniversary of the date of acquisition to be organic.\nIn limited cases, when the acquisition of an acquired business does not include a contingent consideration arrangement, or we otherwise do not separately track the financial performance of the acquired business due to operational integration, we consider the revenues that the business generated in the 12 months prior to its acquisition to be our acquired revenues for the 12 months following its acquisition, and any differences in revenues actually generated during the 12 months after its acquisition to be organic. For example, if we completed an acquisition on July 1, 2021 for a business that did not include a contingent consideration arrangement, we would consider the amount of revenues from the acquired business from July 1, 2020 to June 30, 2021 to be acquired revenues during the period from July 1, 2021 to June 30, 2022, with any differences from that amount actually generated during the latter period to be organic revenues.\nAll revenues generated by our acquired businesses are considered to be organic revenues after the 12-month anniversary of the date of acquisition.\nWhen we divest a business, we consider the revenues that the divested business generated in the 12 months prior to its divestiture to be subtracted from acquired revenues for the 12 months following its divestiture. For example, if we completed a divestiture on July 1, 2021 for a business, we would consider the amount of revenues from the divested business from July 1, 2020 to June 30, 2021 to be subtracted from acquired revenues during the period from July 1, 2021 to June 30, 2022.\nWe measure organic revenue growth and acquired revenue growth by comparing the organic revenues or acquired revenues, respectively, period over period, net of any divestitures.\n29\nCost of Revenues\nOur cost of revenues consists of both fixed and variable expenses primarily attributable to the hiring, training, compensation and benefits provided to both full-time and part-time associates, as well as other project-related expenses. A number of costs associated with our associates are subject to external factors, including inflation, increases in market specific wages and minimum wage rates at federal, state and municipal levels and minimum pay levels for exempt roles. Additionally, when we enter into certain new client relationships, we may experience an initial increase in expenses associated with hiring, training and other items needed to launch the new relationship.\nSelling, General and Administrative Expenses\nSelling, general and administrative expenses consist primarily of salaries, payroll taxes and benefits for corporate personnel. Other overhead costs include information technology, occupancy costs for corporate personnel, professional services fees, including accounting and legal services, and other general corporate expenses. Additionally, included in selling, general and administrative expenses are costs associated with the changes in fair value of the contingent consideration of acquisitions and other acquisition-related costs. Acquisition-related costs are comprised of fees related to change of equity ownership, transaction costs, professional fees, due diligence and integration activities.\nOther (Income) Expenses\nChange in Fair Value of Warrant Liability\nChange in fair value of warrant liability represents a non-cash (income) expense resulting from a fair value adjustment to warrant liability with respect to the private placement warrants. Based on the period of time the public warrants have now been trading, we determined the fair value of the liability classified private placement warrants by approximating the value with the share price of the public warrants at the respective period end, which is inherently less subjective and judgmental given it is based on observable inputs. Previously, the fair value of the warrant liability was based on the input assumptions used in the Black-Scholes option pricing model, including our stock price at the end of the reporting period, the implied volatility or other inputs to the model and the number of private placement warrants outstanding, which may vary from period to period. We believe these amounts are not correlated to future business operations.\nInterest Expense\nInterest expense relates primarily to borrowings under the Senior Secured Credit Facilities as described below. See “ —Liquidity and Capital Resources.”\nDepreciation and Amortization\nAmortization Expense\nIncluded in our depreciation and amortization expense is amortization of acquired intangible assets. We have ascribed value to identifiable intangible assets other than goodwill in our purchase price allocations for companies we have acquired. These assets include, but are not limited to, client relationships and trade names. To the extent we ascribe value to identifiable intangible assets that have finite lives, we amortize those values over the estimated useful lives of the assets. Such amortization expense, although non-cash in the period expensed, directly impacts our results of operations. It is difficult to predict with any precision the amount of expense we may record relating to future acquired intangible assets.\n30\nAs a result of the 2014 Topco Acquisition, we acquired significant intangible assets, the value of which is amortized, on a straight-line basis, over 15 years from the date of the 2014 Topco Acquisition, unless determined to be indefinite-lived.\nDepreciation Expense\nDepreciation expense relates to the property and equipment that we own, which represented less than 1% of our total assets at September 30, 2022 and 2021, respectively.\nIncome Taxes\nIncome tax expense and our effective tax rates can be affected by many factors, including state apportionment factors, our acquisition strategy, tax incentives and credits available to us, changes in judgment regarding our ability to realize our deferred tax assets, changes in our worldwide mix of pre-tax losses or earnings, changes in existing tax laws and our assessment of uncertain tax positions.\nCash Flows\nWe have positive cash flow characteristics, as described below, due to the limited required capital investment in the fixed assets and working capital needs to operate our business in the normal course. See “ —Liquidity and Capital Resources.”\nOur principal sources of liquidity are cash flows from operations, borrowings under the Revolving Credit Facility, and other debt. Our principal uses of cash are operating expenses, working capital requirements, acquisitions and repayment of debt.\nAdjusted Net Income\nAdjusted Net Income is a non-GAAP financial measure. Adjusted Net Income means Net income before (i) impairment of goodwill and indefinite-lived assets, (ii) amortization of intangible assets, (iii) equity-based compensation of Topco, (iv) changes in fair value of warrant liability, (v) fair value adjustments of contingent consideration related to acquisitions, (vi) acquisition-related expenses, (vii) costs associated with COVID-19, net of benefits received, (viii) EBITDA for economic interests in investments, (ix) restructuring expenses, (x) litigation expenses (recovery), (xi) costs associated with the Take 5 Matter, (xii) related tax adjustments and (xiii) other adjustments that management believes are helpful in evaluating our operating performance.\nWe present Adjusted Net Income because we use it as a supplemental measure to evaluate the performance of our business in a way that also considers our ability to generate profit without the impact of items that we do not believe are indicative of our operating performance or are unusual or infrequent in nature and aid in the comparability of our performance from period to period. Adjusted Net Income should not be considered as an alternative for Net income, our most directly comparable measure presented on a GAAP basis.\nAdjusted EBITDA and Adjusted EBITDA by Segment\nAdjusted EBITDA and Adjusted EBITDA by segment are supplemental non-GAAP financial measures of our operating performance. Adjusted EBITDA means Net income before (i) interest expense, net, (ii) provision for income taxes, (iii) depreciation, (iv) impairment of goodwill and indefinite-lived assets, (v) amortization of intangible assets, (vi) equity-based compensation of Topco, (vii) changes in fair value of warrant liability, (viii) stock-based compensation expense, (ix) fair value adjustments of contingent consideration related to acquisitions, (x) acquisition-related expenses, (xi) costs associated with COVID-19, net of benefits received, (xii) EBITDA for economic interests in investments, (xiii) restructuring expenses, (xiv) litigation expenses (recovery), (xv) costs associated with the Take 5 Matter and (xvi) other adjustments that management believes are helpful in evaluating our operating performance.\n31\nWe present Adjusted EBITDA and Adjusted EBITDA by segment because they are key operating measures used by us to assess our financial performance. These measures adjust for items that we believe do not reflect the ongoing operating performance of our business, such as certain noncash items, unusual or infrequent items or items that change from period to period without any material relevance to our operating performance. We evaluate these measures in conjunction with our results according to GAAP because we believe they provide a more complete understanding of factors and trends affecting our business than GAAP measures alone. Furthermore, the agreements governing our indebtedness contain covenants and other tests based on measures substantially similar to Adjusted EBITDA. Neither Adjusted EBITDA nor Adjusted EBITDA by segment should be considered as an alternative for Net income, our most directly comparable measure presented on a GAAP basis.\nResults of Operations for the Three and Nine Months Ended September 30, 2022 and 2021\nThe following table sets forth items derived from the Company’s consolidated statements of operations for the three and nine months ended September 30, 2022 and 2021 in dollars and as a percentage of total revenues.\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (amounts in thousands) | 2022 | 2021 | 2022 | 2021 |\n| Revenues | $ | 1,051,095 | 100.0 | % | $ | 928,760 | 100.0 | % | $ | 2,946,979 | 100.0 | % | $ | 2,569,735 | 100.0 | % |\n| Cost of revenues | 908,523 | 86.4 | % | 766,253 | 82.5 | % | 2,536,256 | 86.1 | % | 2,117,818 | 82.4 | % |\n| Selling, general, and administrative expenses | 37,945 | 3.6 | % | 37,742 | 4.1 | % | 138,594 | 4.7 | % | 124,830 | 4.9 | % |\n| Depreciation and amortization | 57,785 | 5.5 | % | 59,163 | 6.4 | % | 173,997 | 5.9 | % | 181,450 | 7.1 | % |\n| Total expenses | 1,004,253 | 95.5 | % | 863,158 | 92.9 | % | 2,848,847 | 96.7 | % | 2,424,098 | 94.3 | % |\n| Operating income | 46,842 | 4.5 | % | 65,602 | 7.1 | % | 98,132 | 3.3 | % | 145,637 | 5.7 | % |\n| Other (income) expenses: |\n| Change in fair value of warrant liability | (1,100 | ) | (0.1 | )% | (3,491 | ) | (0.4 | )% | (21,456 | ) | (0.7 | )% | (5,024 | ) | (0.2 | )% |\n| Interest expense, net | 23,557 | 2.2 | % | 36,490 | 3.9 | % | 63,628 | 2.2 | % | 104,544 | 4.1 | % |\n| Total other expenses | 22,457 | 2.1 | % | 32,999 | 3.6 | % | 42,172 | 1.4 | % | 99,520 | 3.9 | % |\n| Income before income taxes | 24,385 | 2.3 | % | 32,603 | 3.5 | % | 55,960 | 1.9 | % | 46,117 | 1.8 | % |\n| Provision for income taxes | 1,158 | 0.1 | % | 8,276 | 0.9 | % | 11,523 | 0.4 | % | 16,582 | 0.6 | % |\n| Net income | $ | 23,227 | 2.2 | % | $ | 24,327 | 2.6 | % | $ | 44,437 | 1.5 | % | $ | 29,535 | 1.1 | % |\n| Other Financial Data |\n| Adjusted Net Income(1) | $ | 62,682 | 6.0 | % | $ | 59,101 | 6.4 | % | $ | 152,541 | 5.2 | % | $ | 146,762 | 5.7 | % |\n| Adjusted EBITDA(1) | $ | 118,268 | 11.3 | % | $ | 133,756 | 14.4 | % | $ | 323,329 | 11.0 | % | $ | 367,155 | 14.3 | % |\n\n(1)Adjusted Net Income and Adjusted EBITDA are financial measures that are not calculated in accordance with GAAP. For a discussion of our presentation of Adjusted Net Income and Adjusted EBITDA and reconciliations of Net income to Adjusted Net Income and Adjusted EBITDA, see “—Non-GAAP Financial Measures.”\nComparison of the Three Months Ended September 30, 2022 and 2021\nRevenues\n\n| Three Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 646,246 | $ | 597,139 | $ | 49,107 | 8.2 | % |\n| Marketing | 404,849 | 331,621 | 73,228 | 22.1 | % |\n| Total revenues | $ | 1,051,095 | $ | 928,760 | $ | 122,335 | 13.2 | % |\n\nTotal revenues increased by $122.3 million, or 13.2%, during the three months ended September 30, 2022, as compared to the three months ended September 30, 2021.\nThe sales segment revenues increased $49.1 million during the three months ended September 30, 2022 as compared to the three months ended September 30, 2021, of which $23.6 million were revenues from acquired\n32\nbusinesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $17.0 million, the segment experienced an increase of $42.5 million in organic revenues primarily due to growth in our retail merchandising services and international businesses, partially offset by a decrease in our third party selling and retailing services.\nThe marketing segment revenues increased $73.2 million during the three months ended September 30, 2022 as compared to the three months ended September 30, 2021, of which $11.0 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $5.7 million, the segment experienced an increase of $67.9 million in organic revenues. The increase in revenues was primarily due to an increase in our in-store product demonstration and sampling services which continue to recover from the temporary suspensions as a result of the COVID-19 pandemic, partially offset by a decrease in certain of our client media spend.\nCost of Revenues\nCost of revenues as a percentage of revenues for the three months ended September 30, 2022 was 86.4%, as compared to 82.5% for the three months ended September 30, 2021. The increase as a percentage of revenues was largely attributable to the change in the revenue mix of our services as a result of recoveries from the COVID-19 pandemic and acquired businesses, and the ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\nSelling, General and Administrative Expenses\nSelling, general and administrative expenses as a percentage of revenues for the three months ended September 30, 2022 was 3.6%, compared to 4.1% for the three months ended September 30, 2021, primarily due to the change in fair value adjustments related to contingent consideration and a decrease in legal fees associated with the Take 5 Matter.\nDepreciation and Amortization Expense\nDepreciation and amortization expense decreased by $1.4 million, or 2.3%, to $57.8 million for the three months ended September 30, 2022 compared to $59.2 million for the three months ended September 30, 2021, which stayed relatively consistent year over year.\nOperating Income\n\n| Three Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 31,765 | $ | 51,906 | $ | (20,141 | ) | (38.8 | )% |\n| Marketing | 15,077 | 13,696 | 1,381 | 10.1 | % |\n| Total operating income | $ | 46,842 | $ | 65,602 | $ | (18,760 | ) | (28.6 | )% |\n\nIn the sales segment, the decrease in operating income during the three months ended September 30, 2022 was due to a shift in revenue mix and ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\nIn the marketing segment, the increase in operating income during the three months ended September 30, 2022 was due to the growth in revenues, partially offset by the increase in cost of revenues as described above.\nChange in Fair Value of Warrant Liability\nChange in fair value of warrant liability represents $1.1 million of non-cash gain resulting from a fair value adjustment to warrant liability with respect to the private placement warrants for the three months ended September 30, 2022, approximating the fair value with the warrant price of the public warrants.\n33\nInterest Expense, net\nInterest expense, net decreased $12.9 million, or 35.4%, to $23.6 million for the three months ended September 30, 2022, from $36.5 million for the three months ended September 30, 2021. The decrease in interest expense, net was primarily due to the increase in fair value changes in derivatives instruments.\nProvision for Income Taxes\nProvision for income taxes was $1.2 million for the three months ended September 30, 2022 as compared to $8.3 million of provision for income taxes for the three months ended September 30, 2021. The fluctuation was primarily attributable to the decrease in pre-tax income during the three months ended September 30, 2022 and decrease of $4.3 million of discrete items for the three months ended September 30, 2022.\nNet Income\nNet income was $23.2 million for the three months ended September 30, 2022, compared to net income of $24.3 million for the three months ended September 30, 2021. The decrease in net income was primarily driven by the decrease in operating income as described above, offset by the decrease in interest expense, net and provision for income taxes.\nAdjusted Net Income\nThe increase in Adjusted Net Income for the three months ended September 30, 2022 was attributable to the decrease in interest expense, net as described above. For a reconciliation of Adjusted Net Income to Net income, see “ —Non-GAAP Financial Measures.”\nAdjusted EBITDA and Adjusted EBITDA by Segment\n\n| Three Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 76,172 | $ | 95,199 | $ | (19,027 | ) | (20.0 | )% |\n| Marketing | 42,096 | 38,557 | 3,539 | 9.2 | % |\n| Total Adjusted EBITDA | $ | 118,268 | $ | 133,756 | $ | (15,488 | ) | (11.6 | )% |\n\nAdjusted EBITDA decreased by $15.5 million, or 11.6%, to $118.3 million for the three months ended September 30, 2022, from $133.8 million for the three months ended September 30, 2021. In the sales segment, the decrease in Adjusted EBITDA was primarily attributable to the increase in cost of revenues as described above. In the marketing segment, the increase in the Adjusted EBITDA was primarily attributable to the growth in revenues as described above. For a reconciliation of Adjusted EBITDA to Net income, see “—Non-GAAP Financial Measures.”\nComparison of the Nine Months Ended September 30, 2022 and 2021\nRevenues\n\n| Nine Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 1,842,347 | $ | 1,693,107 | $ | 149,240 | 8.8 | % |\n| Marketing | 1,104,632 | 876,628 | 228,004 | 26.0 | % |\n| Total revenues | $ | 2,946,979 | $ | 2,569,735 | $ | 377,244 | 14.7 | % |\n\n34\nTotal revenues increased by $377.2 million, or 14.7%, during the nine months ended September 30, 2022, as compared to the nine months ended September 30, 2021.\nThe sales segment revenues increased $149.2 million during the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021, of which $114.2 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $33.9 million, the segment experienced an increase of $68.9 million in organic revenues primarily due to our European joint venture which experienced continued recoveries from temporary reduction in services as a result of the COVID-19 pandemic and growth in our retail merchandising services partially offset by a decrease in our foodservice and third party selling and retailing services.\nThe marketing segment revenues increased $228.0 million during the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021, of which $23.1 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $11.6 million, the segment experienced an increase of $216.5 million in organic revenues. The increase in revenues was primarily due to an increase in our in-store product demonstration and sampling services which continue to recover from the temporary suspensions as a result of the COVID-19 pandemic, partially offset by a decrease in certain of our client media spend.\nCost of Revenues\nCost of revenues as a percentage of revenues for the nine months ended September 30, 2022 was 86.1%, as compared to 82.4% for the nine months ended September 30, 2021. The increase as a percentage of revenues was largely attributable to the change in the revenue mix of our services as a result of recoveries from the COVID-19 pandemic and acquired businesses, and the ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\nSelling, General and Administrative Expenses\nSelling, general and administrative expenses as a percentage of revenues for the nine months ended September 30, 2022 was 4.7%, compared to 4.9% for the nine months ended September 30, 2021.\nDepreciation and Amortization Expense\nDepreciation and amortization expense decreased by $7.5 million or 4.1% to $174.0 million for the nine months ended September 30, 2022 compared to $181.5 million for the nine months ended September 30, 2021. The decrease was primarily due to a decrease in depreciation expenses from our internally developed software.\nOperating Income\n\n| Nine Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 65,915 | $ | 131,727 | $ | (65,812 | ) | (50.0 | %) |\n| Marketing | 32,217 | 13,910 | 18,307 | 131.6 | % |\n| Total operating income | $ | 98,132 | $ | 145,637 | $ | (47,505 | ) | (32.6 | %) |\n\nIn the sales segment, the decrease in operating income during the nine months ended September 30, 2022 was primarily attributable to a shift in revenue mix, ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses, the change in fair value adjustments related to contingent consideration, and an increase in stock-based compensation expense, partially offset by a decrease in depreciation expense.\n35\nIn the marketing segment, the increase in operating income during the nine months ended September 30, 2022 was primarily attributable to the growth in revenues, partially offset by the increase in cost of revenues as described above and the change in fair value adjustments related to contingent consideration.\nChange in Fair Value of Warrant Liability\nChange in fair value of warrant liability represents $21.5 million of non-cash gain resulting from a fair value adjustment to warrant liability with respect to the private placement warrants for the nine months ended September 30, 2022, approximating the fair value with the warrant price of the public warrants.\nInterest Expense, net\nInterest expense, net decreased $40.9 million, or 39.1%, to $63.6 million for the nine months ended September 30, 2022, from $104.5 million for the nine months ended September 30, 2021. The decrease in interest expense, net was primarily due to the increase in fair value changes in derivatives instruments.\nProvision for Income Taxes\nProvision for income taxes was $11.5 million for the nine months ended September 30, 2022 as compared to $16.6 million for the nine months ended September 30, 2021. The fluctuation was primarily attributable to the increase in pre-tax income during the nine months ended September 30, 2022, partially offset by a decrease of $7.4 million of discrete items.\nNet Income\nNet income was $44.4 million for the nine months ended September 30, 2022, compared to net income of $29.5 million for the nine months ended September 30, 2021. The increase in net income was primarily driven by the decrease in change in fair value of warrant liability, interest expense, net, and provision for income taxes, partially offset by the decrease in operating income as described above.\nAdjusted Net Income\nThe increase in Adjusted Net Income for the nine months ended September 30, 2022 was attributable to the decrease in change in fair value of warrant liability, and interest expense, net as described above. For a reconciliation of Adjusted Net Income to Net income, see “ —Non-GAAP Financial Measures.”\nAdjusted EBITDA and Adjusted EBITDA by Segment\n\n| Nine Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 216,158 | $ | 268,798 | $ | (52,640 | ) | (19.6 | )% |\n| Marketing | 107,171 | 98,357 | 8,814 | 9.0 | % |\n| Total Adjusted EBITDA | $ | 323,329 | $ | 367,155 | $ | (43,826 | ) | (11.9 | )% |\n\nAdjusted EBITDA decreased by $43.8 million, or 11.9%, to $323.3 million for the nine months ended September 30, 2022, from $367.2 million for the nine months ended September 30, 2021. In the sales segment, the decrease in Adjusted EBITDA was primarily attributable to the increase in cost of revenues as described above. In the marketing segment, the increase in the Adjusted EBITDA was primarily attributable to the growth in revenues as described above. For a reconciliation of Adjusted EBITDA to Net income, see “—Non-GAAP Financial Measures.”\n36\nNon-GAAP Financial Measures\nAdjusted Net Income is a non-GAAP financial measure. Adjusted Net Income means Net income before (i) impairment of goodwill and indefinite-lived assets, (ii) amortization of intangible assets, (iii) equity-based compensation of Topco, (iv) change in fair value of warrant liability, (v) fair value adjustments of contingent consideration related to acquisitions, (vi) acquisition-related expenses, (vii) costs associated with COVID-19, net of benefits received, (viii) EBITDA for economic interests in investments, (ix) restructuring expenses, (x) litigation expenses (recovery), (xi) costs associated with the Take 5 Matter, (xii) related tax adjustments and (xiii)other adjustments that management believes are helpful in evaluating our operating performance.\nWe present Adjusted Net Income because we use it as a supplemental measure to evaluate the performance of our business in a way that also considers our ability to generate profit without the impact of items that we do not believe are indicative of our operating performance or are unusual or infrequent in nature and aid in the comparability of our performance from period to period. Adjusted Net Income should not be considered as an alternative for our Net income, our most directly comparable measure presented on a GAAP basis.\nA reconciliation of Adjusted Net Income to Net income is provided in the following table:\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Net income | $ | 23,227 | $ | 24,327 | $ | 44,437 | $ | 29,535 |\n| Less: Net income attributable to noncontrolling interest | 2,168 | 1,016 | 1,042 | 219 |\n| Add: |\n| Equity -based compensation of Karman Topco L.P.(a) | (828 | ) | (5,575 | ) | (7,142 | ) | (10,031 | ) |\n| Change in fair value of warrant liability | (1,100 | ) | (3,491 | ) | (21,456 | ) | (5,024 | ) |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (340 | ) | 3,221 | 5,448 | 5,776 |\n| Acquisition-related expenses(d) | 4,260 | 5,110 | 19,843 | 13,053 |\n| Restructuring expenses(e) | 3,562 | (394 | ) | 4,458 | 10,636 |\n| Litigation(f) | — | (92 | ) | (800 | ) | (910 | ) |\n| Amortization of intangible assets(g) | 49,997 | 49,786 | 150,930 | 148,396 |\n| Costs associated with COVID-19, net of benefits received(h) | 2,009 | 1,087 | 4,945 | (948 | ) |\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\n| Tax adjustments related to non-GAAP adjustments(j) | (16,215 | ) | (15,262 | ) | (49,168 | ) | (47,113 | ) |\n| Adjusted Net Income | $ | 62,682 | $ | 59,101 | $ | 152,541 | $ | 146,762 |\n\nAdjusted EBITDA and Adjusted EBITDA by segment are supplemental non-GAAP financial measures of our operating performance. Adjusted EBITDA means Net income before (i) interest expense, net, (ii) provision for income taxes, (iii) depreciation, (iv) impairment of goodwill and indefinite-lived assets, (v) amortization of intangible assets, (vi) equity-based compensation of Topco, (vii) change in fair value of warrant liability, (viii) stock-based compensation expense, (ix) fair value adjustments of contingent consideration related to acquisitions, (x) acquisition-related expenses, (xi) costs associated with COVID-19, net of benefits received, (xii) EBITDA for economic interests in investments, (xiii) restructuring expenses, (xiv) litigation expenses (recovery), (xv) costs associated with the Take 5 Matter and (xvi) other adjustments that management believes are helpful in evaluating our operating performance.\nWe present Adjusted EBITDA and Adjusted EBITDA by segment because they are key operating measures used by us to assess our financial performance. These measures adjust for items that we believe do not reflect the ongoing operating performance of our business, such as certain noncash items, unusual or infrequent items or items that change from period to period without any material relevance to our operating performance. We evaluate these measures in conjunction with our results according to GAAP because we believe they provide a more complete understanding of factors and trends affecting our business than GAAP measures alone. Furthermore, the agreements governing our indebtedness contain covenants and other tests based on measures substantially similar to\n37\nAdjusted EBITDA. Neither Adjusted EBITDA nor Adjusted EBITDA by segment should be considered as an alternative for our Net income, our most directly comparable measure presented on a GAAP basis.\nA reconciliation of Adjusted EBITDA to Net income is provided in the following table:\n\n| Consolidated | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Net income | $ | 23,227 | $ | 24,327 | $ | 44,437 | $ | 29,535 |\n| Add: |\n| Interest expense, net | 23,557 | 36,490 | 63,628 | 104,544 |\n| Provision for income taxes | 1,158 | 8,276 | 11,523 | 16,582 |\n| Depreciation and amortization | 57,785 | 59,163 | 173,997 | 181,450 |\n| Equity-based compensation of Karman Topco L.P.(a) | (828 | ) | (5,575 | ) | (7,142 | ) | (10,031 | ) |\n| Change in fair value of warrant liability | (1,100 | ) | (3,491 | ) | (21,456 | ) | (5,024 | ) |\n| Stock-based compensation expense(b) | 7,174 | 7,854 | 29,906 | 25,497 |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (340 | ) | 3,221 | 5,448 | 5,776 |\n| Acquisition-related expenses(d) | 4,260 | 5,110 | 19,843 | 13,053 |\n| EBITDA for economic interests in investments(k) | (2,474 | ) | (3,620 | ) | (7,546 | ) | (6,616 | ) |\n| Restructuring expenses(e) | 3,562 | (394 | ) | 4,458 | 10,636 |\n| Litigation(f) | — | (92 | ) | (800 | ) | (910 | ) |\n| Costs associated with COVID-19, net of benefits received(h) | 2,009 | 1,087 | 4,945 | (948 | ) |\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\n| Adjusted EBITDA | $ | 118,268 | $ | 133,756 | $ | 323,329 | $ | 367,155 |\n\nFinancial information by segment, including a reconciliation of Adjusted EBITDA by segment to operating income, the closest GAAP financial measure, is provided in the following table:\n\n| Sales Segment | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Operating income | $ | 31,765 | $ | 51,906 | $ | 65,915 | $ | 131,727 |\n| Add: |\n| Depreciation and amortization | 39,798 | 41,515 | 121,310 | 128,789 |\n| Equity-based compensation of Karman Topco L.P.(a) | (320 | ) | (4,844 | ) | (4,004 | ) | (7,360 | ) |\n| Stock-based compensation expense(b) | 4,080 | 4,371 | 18,009 | 13,795 |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (1,901 | ) | 192 | 4,992 | (4,057 | ) |\n| Acquisition-related expenses(d) | 2,880 | 3,899 | 13,734 | 9,499 |\n| EBITDA for economic interests in investments(k) | (2,656 | ) | (3,832 | ) | (8,018 | ) | (7,429 | ) |\n| Restructuring expenses(e) | 2,360 | 1,273 | 3,519 | 3,229 |\n| Litigation(f) | — | (68 | ) | (100 | ) | (584 | ) |\n| Costs associated with COVID-19, net of benefits received(h) | 166 | 787 | 801 | 1,189 |\n| Sales Segment Adjusted EBITDA | $ | 76,172 | $ | 95,199 | $ | 216,158 | $ | 268,798 |\n\n38\n\n| Marketing Segment | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Operating income | $ | 15,077 | $ | 13,696 | $ | 32,217 | $ | 13,910 |\n| Add: |\n| Depreciation and amortization | 17,987 | 17,648 | 52,687 | 52,661 |\n| Equity-based compensation of Karman Topco L.P.(a) | (508 | ) | (731 | ) | (3,138 | ) | (2,671 | ) |\n| Stock-based compensation expense(b) | 3,094 | 3,483 | 11,897 | 11,702 |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | 1,561 | 3,029 | 456 | 9,833 |\n| Acquisition-related expenses(d) | 1,380 | 1,211 | 6,109 | 3,554 |\n| EBITDA for economic interests in investments(k) | 182 | 212 | 472 | 813 |\n| Restructuring expenses(e) | 1,202 | (1,667 | ) | 939 | 7,407 |\n| Litigation(f) | — | (24 | ) | (700 | ) | (326 | ) |\n| Costs associated with COVID-19, net of benefits received(h) | 1,843 | 300 | 4,144 | (2,137 | ) |\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\n| Marketing Segment Adjusted EBITDA | $ | 42,096 | $ | 38,557 | $ | 107,171 | $ | 98,357 |\n\n\n\n\n| (a) | Represents expenses related to (i) equity-based compensation expense associated with grants of Common Series D Units of Topco made to one of the Advantage Sponsors (as defined below) and (ii) equity-based compensation expense associated with the Common Series C Units of Topco. |\n| (b) | Represents non-cash compensation expense related to the 2020 Incentive Award Plan and the 2020 Employee Stock Purchase Plan. |\n| (c) | Represents adjustments to the estimated fair value of our contingent consideration liabilities related to our acquisitions. See Note 6—Fair Value of Financial Instruments to our unaudited condensed financial statements for the three and nine months ended September 30, 2022 and 2021. |\n| (d) | Represents fees and costs associated with activities related to our acquisitions and restructuring activities, including professional fees, due diligence, and integration activities. |\n| (e) | Represents fees and costs associated with various internal reorganization activities among our consolidated entities. |\n| (f) | Represents legal settlements that are unusual or infrequent costs associated with our operating activities. |\n| (g) | Represents the amortization of intangible assets recorded in connection with the 2014 Topco Acquisition and our other acquisitions. |\n| (h) | Represents (i) costs related to implementation of strategies for workplace safety in response to COVID-19, including employee-relief fund, additional sick pay for front-line associates, medical benefit payments for furloughed associates, and personal protective equipment; and (ii) benefits received from government grants for COVID-19 relief. |\n| (i) | Represents costs associated with the Take 5 Matter, primarily, professional fees and other related costs, for the three and nine months ended September 30, 2022 and 2021, respectively. |\n| (j) | Represents the tax provision or benefit associated with the adjustments above, taking into account the Company’s applicable tax rates, after excluding adjustments related to items that do not have a related tax impact. |\n| (k) | Represents additions to reflect our proportional share of Adjusted EBITDA related to our equity method investments and reductions to remove the Adjusted EBITDA related to the minority ownership percentage of the entities that we fully consolidate in our financial statements. |\n\n39\nLiquidity and Capital Resources\nOur principal sources of liquidity were cash flows from operations, borrowings under the Revolving Credit Facility, and other debt. Our principal uses of cash are operating expenses, working capital requirements, acquisitions, interest on debt and repayment of debt.\nCash Flows\nA summary of our cash operating, investing and financing activities are shown in the following table:\n\n| Nine Months Ended September 30, |\n| (in thousands) | 2022 | 2021 |\n| Net cash provided by operating activities | $ | 81,950 | $ | 101,068 |\n| Net cash used in investing activities | (103,062 | ) | (66,152 | ) |\n| Net cash used in financing activities | (32,920 | ) | (68,999 | ) |\n| Net effect of foreign currency fluctuations on cash | (12,311 | ) | (1,476 | ) |\n| Net change in cash, cash equivalents and restricted cash | $ | (66,343 | ) | $ | (35,559 | ) |\n\nNet Cash Provided by Operating Activities\nNet cash used in operating activities during the nine months ended September 30, 2022 consisted of net income of $44.4 million adjusted for certain non-cash items, including depreciation and amortization of $174.0 million and effects of changes in working capital. Net cash provided by operating activities during the nine months ended September 30, 2021 consisted of net income of $29.5 million adjusted for certain non-cash items, including depreciation and amortization of $181.5 million and effects of changes in working capital. The decrease in cash provided by operating activities during the nine months ended September 30, 2022 relative to the same period in 2021 was primarily due to ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses during the nine months ended September 30, 2022.\nNet Cash Used in Investing Activities\nNet cash used in investing activities during the nine months ended September 30, 2022 primarily consisted of the purchase of businesses, net of cash acquired of $74.4 million and purchase of property and equipment of $30.0 million. Net cash used in investing activities during the nine months ended September 30, 2021 primarily consisted of the purchase of businesses, net of cash acquired of $40.0 million and purchase of property and equipment of $24.1 million.\nNet Cash Used in Financing Activities\nWe primarily finance our growth through cash flows from operations, however, we also incur long-term debt or borrow under lines of credit when necessary to execute acquisitions. Additionally, many of our acquisition agreements include contingent consideration arrangements, which are generally based on the achievement of future financial performance by the operations attributable to the acquired companies. The portion of the cash payment up to the acquisition date fair value of the contingent consideration liability are classified as financing outflows, and amounts paid in excess of the acquisition date fair value of that liability are classified as operating outflows.\nCash flows used in financing activities during the nine months ended September 30, 2022 were primarily related to payments of contingent consideration and holdback payments of $31.7 million, repayment of principal on our Term Loan Facility of $9.9 million, partially offset by $3.3 million related to proceeds from the issuance of Class A common stock and $5.2 million of contribution from noncontrolling interest. Cash flows related to financing activities during the nine months ended September 30, 2021 were primarily related to borrowings of $51.7 million and repayment of $102.7 million on the Revolving Credit Facility and our lines of credit and $8.6 million related to payments of contingent consideration and holdback payments.\n40\nDescription of Credit Facilities\nSenior Secured Credit Facilities\nIn connection with the consummation of the Transactions, Advantage Sales & Marketing Inc. (the “Borrower”), an indirect wholly-owned subsidiary of the Company, entered into (i) a senior secured asset-based revolving credit facility in an aggregate principal amount of up to $400.0 million, subject to borrowing base capacity (as may be amended from time to time, the “Revolving Credit Facility”) and (ii) a secured first lien term loan credit facility in an aggregate principal amount of $1.325 billion (as may be amended from time to time, the “Term Loan Facility” and together with the Revolving Credit Facility, the “Senior Secured Credit Facilities”).\nRevolving Credit Facility\nOur Revolving Credit Facility provides for revolving loans and letters of credit in an aggregate amount of up to $400.0 million, subject to borrowing base capacity. Letters of credit are limited to the lesser of (a) $150.0 million and (b) the aggregate unused amount of commitments under our Revolving Credit Facility then in effect. Loans under the Revolving Credit Facility may be denominated in either U.S. dollars or Canadian dollars. Bank of America, N.A., is administrative agent and ABL Collateral Agent. The Revolving Credit Facility is scheduled to mature in October 2025. We may use borrowings under the Revolving Credit Facility to fund working capital and for other general corporate purposes, including permitted acquisitions and other investments. As of September 30, 2022, we had unused capacity under our Revolving Credit Facility available to us of $400.0 million, subject to borrowing base limitations (without giving effect to approximately $54.5 million of outstanding letters of credit and the borrowing base limitations for additional borrowings).\nBorrowings under the Revolving Credit Facility are limited by borrowing base calculations based on the sum of specified percentages of eligible accounts receivable plus specified percentages of qualified cash, minus the amount of any applicable reserves. Borrowings will bear interest at a floating rate, which can be either an adjusted Eurodollar rate plus an applicable margin or, at the Borrower’s option, a base rate plus an applicable margin. The applicable margins for the Revolving Credit Facility are 2.00%, 2.25% or 2.50%, with respect to Eurodollar rate borrowings and 1.00%, 1.25% or 1.50%, with respect to base rate borrowings, in each case depending on average excess availability under the Revolving Credit Facility. The Borrower’s ability to draw under the Revolving Credit Facility or issue letters of credit thereunder will be conditioned upon, among other things, the Borrower’s delivery of prior written notice of a borrowing or issuance, as applicable, the Borrower’s ability to reaffirm the representations and warranties contained in the credit agreement governing the Revolving Credit Facility and the absence of any default or event of default thereunder.\nThe Borrower’s obligations under the Revolving Credit Facility are guaranteed by Karman Intermediate Corp. (“Holdings”) and all of the Borrower’s direct and indirect wholly owned material U.S. subsidiaries (subject to certain permitted exceptions) and Canadian subsidiaries (subject to certain permitted exceptions, including exceptions based on immateriality thresholders of aggregate assets and revenues of Canadian subsidiaries) (the “Guarantors”). The Revolving Credit Facility is secured by a lien on substantially all of Holdings’, the Borrower’s and the Guarantors’ assets (subject to certain permitted exceptions). The Borrower’s Revolving Credit Facility has a first-priority lien on the current asset collateral and a second-priority lien on security interests in the fixed asset collateral (second in priority to the liens securing the Notes and the Term Loan Facility discussed below), in each case, subject to other permitted liens.\nThe Revolving Credit Facility has the following fees: (i) an unused line fee of 0.375% or 0.250% per annum of the unused portion of the Revolving Credit Facility, depending on average excess availability under the Revolving Credit Facility; (ii) a letter of credit participation fee on the aggregate stated amount of each letter of credit equal to the applicable margin for adjusted Eurodollar rate loans, as applicable; and (iii) certain other customary fees and expenses of the lenders and agents thereunder.\nThe Revolving Credit Facility contains customary covenants, including, but not limited to, restrictions on the Borrower’s ability and that of our subsidiaries to merge and consolidate with other companies, incur indebtedness, grant liens or security interests on assets, make acquisitions, loans, advances or investments, pay dividends, sell or\n41\notherwise transfer assets, optionally prepay or modify terms of any junior indebtedness, enter into transactions with affiliates or change our line of business. The Revolving Credit Facility will require the maintenance of a fixed charge coverage ratio (as set forth in the credit agreement governing the Revolving Credit Facility) of 1.00 to 1.00 at the end of each fiscal quarter when excess availability is less than the greater of $25 million and 10% of the lesser of the borrowing base and maximum borrowing capacity. Such fixed charge coverage ratio will be tested at the end of each quarter until such time as excess availability exceeds the level set forth above.\nThe Revolving Credit Facility provides that, upon the occurrence of certain events of default, the Borrower’s obligations thereunder may be accelerated and the lending commitments terminated. Such events of default include payment defaults to the lenders thereunder, material inaccuracies of representations and warranties, covenant defaults, cross-defaults to other material indebtedness, voluntary and involuntary bankruptcy, insolvency, corporate arrangement, winding-up, liquidation or similar proceedings, material money judgments, material pension-plan events, certain change of control events and other customary events of default.\nOn October 28, 2021, the Borrower and Holdings entered into the First Amendment to ABL Revolving Credit Agreement (the “ABL Amendment”), which amended the ABL Revolving Credit Agreement, dated October 28, 2020, by and among the Borrower, Holdings, the lenders from time to time party thereto and Bank of America, as administrative agent. The ABL Amendment was entered into by the Borrower to amend certain terms and provisions, including (i) reducing the interest rate floor for Eurocurrency rate loans from 0.50% to 0.00% and base rate loans from 1.50% to 1.00%, and (ii) updating the provisions by which U.S. Dollar LIBOR will eventually be replaced with the Secured Oversight Financing Rate (“SOFR”) or another interest rate benchmark to reflect the most recent standards and practices used in the industry.\nTerm Loan Facility\nThe Term Loan Facility is a term loan facility denominated in U.S. dollars in an aggregate principal amount of $1.325 billion. Borrowings under the Term Loan Facility amortize in equal quarterly installments in an amount equal to 1.00% per annum of the principal amount. Borrowings will bear interest at a floating rate, which can be either an adjusted Eurodollar rate plus an applicable margin or, at the Borrower’s option, a base rate plus an applicable margin. The applicable margins for the Term Loan Facility are 4.50% with respect to Eurodollar rate borrowings and 3.50% with respect to base rate borrowings.\nThe Borrower may voluntarily prepay loans or reduce commitments under the Term Loan Facility, in whole or in part, subject to minimum amounts, with prior notice but without premium or penalty (other than a 1.00% premium on any prepayment in connection with a repricing transaction prior to the date that is six months after the effective date of the First Lien Amendment).\nThe Borrower will be required to prepay the Term Loan Facility with 100% of the net cash proceeds of certain asset sales (such percentage subject to reduction based on the achievement of specific first lien net leverage ratios) and subject to certain reinvestment rights, 100% of the net cash proceeds of certain debt issuances and 50% of excess cash flow (such percentage subject to reduction based on the achievement of specific first lien net leverage ratios).\nThe Borrower’s obligations under the Term Loan Facility are guaranteed by Holdings and the Guarantors. Our Term Loan Facility is secured by a lien on substantially all of Holdings’, the Borrower’s and the Guarantors’ assets (subject to certain permitted exceptions). The Term Loan Facility has a first-priority lien on the fixed asset collateral (equal in priority with the liens securing the Notes) and a second-priority lien on security interests in the current asset collateral (second in priority to the liens securing the Revolving Credit Facility), in each case, subject to other permitted liens.\nThe Term Loan Facility contains certain customary negative covenants, including, but not limited to, restrictions on the Borrower’s ability and that of our restricted subsidiaries to merge and consolidate with other companies, incur indebtedness, grant liens or security interests on assets, pay dividends or make other restricted payments, sell or otherwise transfer assets or enter into transactions with affiliates.\n42\nThe Term Loan Facility provides that, upon the occurrence of certain events of default, the Borrower’s obligations thereunder may be accelerated. Such events of default will include payment defaults to the lenders thereunder, material inaccuracies of representations and warranties, covenant defaults, cross-defaults to other material indebtedness, voluntary and involuntary bankruptcy, insolvency, corporate arrangement, winding-up, liquidation or similar proceedings, material money judgments, change of control and other customary events of default.\nOn October 28, 2021 (the “First Lien Amendment Effective Date”), the Borrower, Holdings, and certain of the Borrower’s subsidiaries, entered into Amendment No. 1 to the First Lien Credit Agreement (the “First Lien Amendment”), which amended the First Lien Credit Agreement, dated October 28, 2020, by and among the Borrower, Holdings, Bank of America, as administrative agent and collateral agent, each lender party from time to time thereto, and the other parties thereto. The First Lien Amendment was entered into by the Borrower to reduce the applicable interest rate on the term loan to 5.25% per annum, resulting in estimated interest savings of approximately $9.9 million or $7.3 million, net of tax, per annum. Additional terms and provisions amended include (i) resetting the period for six months following the First Lien Amendment Effective Date in which a 1.00% prepayment premium shall apply to any prepayment of the term loan in connection with certain repricing events, and (ii) updating the provisions by which U.S. Dollar LIBOR will eventually be replaced with SOFR or another interest rate benchmark to reflect the most recent standards and practices used in the industry and by Bank of America.\nSenior Secured Notes\nIn connection with the Transactions, Advantage Solutions FinCo LLC (“Finco”) issued $775.0 million aggregate principal amount of 6.50% Senior Secured Notes due 2028 (the “Notes”). Substantially concurrently with the Transactions, Finco merged with and into Advantage Sales & Marketing Inc. (in its capacity as the issuer of the Notes, the “Issuer”), with the Issuer continuing as the surviving entity and assuming the obligations of Finco. The Notes were sold to BofA Securities, Inc., Deutsche Bank Securities Inc., Morgan Stanley & Co. LLC and Apollo Global Securities, LLC. The Notes were resold to certain non-U.S. persons pursuant to Regulation S under the Securities Act of 1933, as amended (the “Securities Act”), and to persons reasonably believed to be qualified institutional buyers pursuant to Rule 144A under the Securities Act at a purchase price equal to 100% of their principal amount. The terms of the Notes are governed by an Indenture, dated as of October 28, 2020 (the “Indenture”), among Finco, the Issuer, the guarantors named therein (the “Notes Guarantors”) and Wilmington Trust, National Association, as trustee and collateral agent.\nInterest and maturity\nInterest on the Notes is payable semi-annually in arrears on May 15 and November 15 at a rate of 6.50% per annum, commencing on May 15, 2021. The Notes will mature on November 15, 2028.\nGuarantees\nThe Notes are guaranteed by Holdings and each of the Issuer’s direct and indirect wholly owned material U.S. subsidiaries (subject to certain permitted exceptions) and Canadian subsidiaries (subject to certain permitted exceptions, including exceptions based on immateriality thresholders of aggregate assets and revenues of Canadian subsidiaries) that is a borrower or guarantor under the Term Loan Facility.\nSecurity and Ranking\nThe Notes and the related guarantees are the general, senior secured obligations of the Issuer and the Notes Guarantors, are secured on a first-priority pari passu basis by security interests on the fixed asset collateral (equal in priority with liens securing the Term Loan Facility), and are secured on a second-priority basis by security interests on the current asset collateral (second in priority to the liens securing the Revolving Credit Facility and equal in priority with liens securing the Term Loan Facility), in each case, subject to certain limitations and exceptions and permitted liens.\n43\nThe Notes and related guarantees rank (i) equally in right of payment with all of the Issuer’s and the Guarantors’ senior indebtedness, without giving effect to collateral arrangements (including the Senior Secured Credit Facilities) and effectively equal to all of the Issuer’s and the Guarantors’ senior indebtedness secured on the same priority basis as the Notes, including the Term Loan Facility, (ii) effectively subordinated to any of the Issuer’s and the Guarantors’ indebtedness that is secured by assets that do not constitute collateral for the Notes to the extent of the value of the assets securing such indebtedness and to indebtedness that is secured by a senior-priority lien, including the Revolving Credit Facility to the extent of the value of the current asset collateral and (iii) structurally subordinated to the liabilities of the Issuer’s non-Guarantor subsidiaries.\nOptional redemption for the Notes\nThe Notes are redeemable on or after November 15, 2023 at the applicable redemption prices specified in the Indenture plus accrued and unpaid interest. The Notes may also be redeemed at any time prior to November 15, 2023 at a redemption price equal to 100% of the aggregate principal amount of such Notes to be redeemed plus a “make-whole” premium, plus accrued and unpaid interest. In addition, the Issuer may redeem up to 40% of the original aggregate principal amount of Notes before November 15, 2023 with the net cash proceeds of certain equity offerings at a redemption price equal to 106.5% of the aggregate principal amount of such Notes to be redeemed, plus accrued and unpaid interest. Furthermore, prior to November 15, 2023 the Issuer may redeem during each calendar year up to 10% of the original aggregate principal amount of the Notes at a redemption price equal to 103% of the aggregate principal amount of such Notes to be redeemed, plus accrued and unpaid interest. If the Issuer or its restricted subsidiaries sell certain of their respective assets or experience specific kinds of changes of control, subject to certain exceptions, the Issuer must offer to purchase the Notes at par. In connection with any offer to purchase all Notes, if holders of no less than 90% of the aggregate principal amount of Notes validly tender their Notes, the Issuer is entitled to redeem any remaining Notes at the price offered to each holder.\nRestrictive covenants\nThe Notes are subject to covenants that, among other things limit the Issuer’s ability and its restricted subsidiaries’ ability to: incur additional indebtedness or guarantee indebtedness; pay dividends or make other distributions in respect of, or repurchase or redeem, the Issuer’s or a parent entity’s capital stock; prepay, redeem or repurchase certain indebtedness; issue certain preferred stock or similar equity securities; make loans and investments; sell or otherwise dispose of assets; incur liens; enter into transactions with affiliates; enter into agreements restricting the Issuer’s subsidiaries’ ability to pay dividends; and consolidate, merge or sell all or substantially all of the Issuer’s assets. Most of these covenants will be suspended on the Notes so long as they have investment grade ratings from both Moody’s Investors Service, Inc. and S&P Global Ratings and so long as no default or event of default under the Indenture has occurred and is continuing.\nEvents of default\nThe following constitute events of default under the Notes, among others: default in the payment of interest; default in the payment of principal; failure to comply with covenants; failure to pay other indebtedness after final maturity or acceleration of other indebtedness exceeding a specified amount; certain events of bankruptcy; failure to pay a judgment for payment of money exceeding a specified aggregate amount; voidance of subsidiary guarantees; failure of any material provision of any security document or intercreditor agreement to be in full force and effect; and lack of perfection of liens on a material portion of the collateral, in each case subject to applicable grace periods.\nFuture Cash Requirement\nThere were no material changes to our contractual future cash requirements from those disclosed in our 2021 Annual Report.\n44\nCash and Cash Equivalents Held Outside the United States\nAs of September 30, 2022 and December 31, 2021, $71.6 million and $86.2 million, respectively, of our cash and cash equivalents were held by foreign subsidiaries. As of September 30, 2022, and December 31, 2021, $21.6 million and $40.0 million, respectively, of our cash and cash equivalents were held by foreign branches.\nWe assessed our determination as to our indefinite reinvestment intent for certain of our foreign subsidiaries and recorded a deferred tax liability of approximately $2.5 million of withholding tax as of December 31, 2021 for unremitted earnings in Canada with respect to which the Company does not have an indefinite reinvestment assertion. We will continue to evaluate our cash needs, however we currently do not intend, nor do we foresee a need, to repatriate funds from the foreign subsidiaries except for Canada. We have continued to assert indefinite reinvestment on all other earnings as it is necessary for continuing operations and to grow the business. If at a point in the future our assertion changes, we will evaluate tax-efficient means to repatriate the income. In addition, we expect existing domestic cash and cash flows from operations to continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, such as debt repayment and capital expenditures, for at least the next 12 months and thereafter for the foreseeable future.\nIf we should require more capital in the United States than is generated by our domestic operations, for example, to fund significant discretionary activities such as business acquisitions, we could elect to repatriate future earnings from foreign jurisdictions. These alternatives could result in higher tax expense or increased interest expense. We consider the majority of the undistributed earnings of our foreign subsidiaries, as of December 31, 2021, to be indefinitely reinvested and, accordingly, no provision has been made for taxes in excess of the $2.5 million noted above.\nOff-Balance Sheet Arrangements\nWe do not have any off-balance sheet financing arrangements or liabilities, guarantee contracts, retained or contingent interests in transferred assets or any obligation arising out of a material variable interest in an unconsolidated entity. We do not have any majority-owned subsidiaries that are not included in our consolidated financial statements. Additionally, we do not have an interest in, or relationships with, any special-purpose entities.\nCritical Accounting Policies and Estimates\nOur critical accounting policies and estimates are included in our 2021 Annual Report and did not materially change during the nine months ended September 30, 2022.\nRecently Issued Accounting Pronouncements\nSee the information set forth in Note 1, Organization and Significant Accounting Policies – Recent Accounting Standards, to our unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2022 and 2021 included in “Part I, Financial Information—Item 1. Financial Statements” in this Quarterly Report.\n45\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nForeign Currency Risk\nOur exposure to foreign currency exchange rate fluctuations is primarily the result of foreign subsidiaries and foreign branches primarily domiciled in Europe and Canada. We use financial derivative instruments to hedge foreign currency exchange rate risks associated with our Canadian subsidiary.\nThe assets and liabilities of our foreign subsidiaries and foreign branches, whose functional currencies are primarily Canadian dollars, British pounds and euros, respectively, are translated into U.S. dollars at exchange rates in effect at the balance sheet date. Income and expense items are translated at the average exchange rates prevailing during the period. The cumulative translation effects for subsidiaries using a functional currency other than the U.S. dollar are included in accumulated other comprehensive loss as a separate component of stockholders’ equity. We estimate that had the exchange rate in each country unfavorably changed by ten percent relative to the U.S. dollar, our consolidated income before taxes would have decreased by approximately $2.5 million for the nine months ended September 30, 2022.\nInterest Rate Risk\nInterest rate exposure relates primarily to the effect of interest rate changes on borrowings outstanding under the Term Loan Facility, Revolving Credit Facility and Notes.\nWe manage our interest rate risk through the use of derivative financial instruments. Specifically, we have entered into interest rate cap agreements to manage our exposure to potential interest rate increases that may result from fluctuations in LIBOR. We do not designate these derivatives as hedges for accounting purposes, and as a result, all changes in the fair value of derivatives, used to hedge interest rates, are recorded in “Interest expense, net” in our Condensed Consolidated Statements of Operations and Comprehensive Income.\nAs of September 30, 2022, we had interest rate cap contracts on an additional $650.0 million of notional value of principal from other financial institutions, with a maturity date of December 16, 2024 to manage our exposure to interest rate movements on variable rate credit facilities when one-month LIBOR on term loans exceeding a cap of 0.75%. The aggregate fair value of our interest rate caps represented an outstanding net asset of $49.1 million as of September 30, 2022.\nHolding other variables constant, a change of one-eighth percentage point in the weighted average interest rate above the floor of 0.75% on the Term Loan Facility and Revolving Credit Facility would have resulted in an increase of $0.7 million in interest expense, net of gains from interest rate caps, for the nine months ended September 30, 2022.\nIn the future, in order to manage our interest rate risk, we may refinance our existing debt, enter into additional interest rate cap agreements or modify our existing interest rate cap agreement. However, we do not intend or expect to enter into derivative or interest rate cap transactions for speculative purposes.\n46\nITEM 4. CONTROLS AND PROCEDURES\nOur management, with the participation of our chief executive officer and chief financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Quarterly Report. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of September 30, 2022, our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in reports we file or submit under the Exchange Act is (1) recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and (2) accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.\nThere were no changes in internal control over financial reporting that occurred during the quarter ended September 30, 2022, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\nIn designing and evaluating our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints, and that management is required to apply judgment in evaluating the benefits of possible controls and procedures relative to their costs.\n47\nPART II - OTHER INFORMATION\nITEM 1. LEGAL PROCEEDINGS\nWe are involved in various legal matters that arise in the ordinary course of our business. Some of these legal matters purport or may be determined to be class and/or representative actions, or seek substantial damages or penalties. Some of these legal matters relate to disputes regarding acquisitions. In connection with certain of the below matters and other legal matters, we have accrued amounts that we believe are appropriate. There can be no assurance, however, that the above matters and other legal matters will not result in us having to make payments in excess of such accruals or that the above matters or other legal matters will not materially or adversely affect our business, financial position or results of operations.\nEmployment-Related Matters\nWe have also been involved in various litigation, including purported class or representative actions with respect to matters arising under the U.S. Fair Labor Standards Act, California’s Labor Code (the “Labor Code”) and California’s Labor Code Private Attorneys General Act (“PAGA”). Many involve allegations for allegedly failing to pay wages and/or overtime, failing to provide meal and rest breaks and failing to pay reporting time pay, waiting time penalties and other penalties.\nA former employee filed a complaint in California Superior Court, Santa Clara County in July 2017, which seeks civil damages and penalties on behalf of the plaintiff and similarly situated persons for various alleged wage and hour violations under the Labor Code, including failure to pay wages and/or overtime, failure to provide meal and rest breaks, failure to pay reporting time pay, waiting time penalties and penalties pursuant to PAGA. We filed a motion for summary judgment. The court granted our motion for summary judgment in March 2020, and the plaintiff filed an appeal of the court’s ruling in May 2020. We have retained outside counsel to represent us and intend to vigorously defend our interests in this matter.\nProceedings Relating to Take 5\nThe following proceedings relate to the Take 5 Matter, which is discussed in greater detail in “PART I, Financial Information —Item 1. Financial Statements—Note 10. Commitments and Contingencies” and “Risk Factors — Risks Related to the Company’s Business and Industry” in this Quarterly Report.\nUSAO and FBI Voluntary Disclosure and Investigation Related to Take 5\nIn connection with the Take 5 Matter, we voluntarily disclosed to the United States Attorney’s Office and the Federal Bureau of Investigation certain misconduct occurring at Take 5. We intend to cooperate in this and any other governmental investigation that may arise in connection with the Take 5 Matter. At this time, we cannot predict the ultimate outcome of any investigation related to the Take 5 Matter and are unable to estimate the potential impact such an investigation may have on us.\nArbitration Proceedings Related to Take 5\nIn August 2019, as a result of the Take 5 Matter, we provided a written indemnification claim notice to the sellers of Take 5, or the Take 5 Sellers, seeking monetary damages (including interest, fees and costs) based on allegations of breach of the asset purchase agreement, or Take 5 APA, as well as fraud. In September 2019, the Take 5 Sellers initiated arbitration proceedings in the state of Delaware against us, alleging breach of the Take 5 APA as a result of our decision to terminate the operations of the Take 5 business and seeking monetary damages equal to all unpaid earn-out payments under the Take 5 APA (plus interest fees and costs). In 2020, the Take 5 Sellers amended their statement of claim to allege defamation, relating to statements we made to customers in connection with terminating the operations of the Take 5 business, and seeking monetary damages for the alleged injury to their reputation. We have filed our response to the Take 5 Sellers’ claims and asserted indemnification, fraud and other claims against the Take 5 Sellers as counterclaims and cross-claims in the arbitration proceedings.\n48\nIn October 2022, the arbitrator made a final award in our favor. We are currently unable to estimate if or when we will be able to collect any amounts associated with this arbitration.\nOther Legal Matters Related to Take 5\nThe Take 5 Matter may result in additional litigation against us, including lawsuits from clients, or governmental investigations, which may expose us to potential liability in excess of the amounts being offered by us as refunds to Take 5 clients. We are currently unable to determine the amount of any potential liability, costs or expenses (above the amounts already being offered as refunds) that may result from any lawsuits or investigations associated with the Take 5 Matter or determine whether any such issues will have any future material adverse effect on our financial position, liquidity or results of operations. Although we have insurance covering certain liabilities, we cannot assure that the insurance will be sufficient to cover any potential liability or expenses associated with the Take 5 Matter.\nITEM 1A. RISK FACTORS\nInvesting in our securities involves risks. Before you make a decision regarding our securities, in addition to the risks and uncertainties discussed above under “Forward-Looking Statements,” you should carefully consider the specific risks set forth herein. If any of these risks actually occur, it may materially harm our business, financial condition, liquidity and results of operations. As a result, the market price of our securities could decline, and you could lose all or part of your investment. Additionally, the risks and uncertainties described in this Quarterly Report are not the only risks and uncertainties that we face. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may become material and adversely affect our business. The following discussion should be read in conjunction with the financial statements and notes to the financial statements included herein.\nSummary of Principal Risks Associated with Our Business\nSet forth below is a summary of some of the principal risks we face:\n•the COVID-19 pandemic and the measures taken to mitigate its spread including its adverse effects on our business, results of operations, financial condition and liquidity;\n•market-driven wage changes or changes to labor laws or wage or job classification regulations, including minimum wage;\n•our ability to hire, timely train, and retain talented individuals for our workforce, and to maintain our corporate culture as we grow;\n•developments with respect to retailers that are out of our control;\n•our ability to continue to generate significant operating cash flow;\n•consolidation within the industry of our clients creating pressure on the nature and pricing of our services;\n•our reliance on continued access to retailers’ platforms;\n•consumer goods manufacturers and retailers reviewing and changing their sales, retail, marketing, and technology programs and relationships;\n•our ability to successfully develop and maintain relevant omni-channel services for our clients in an evolving industry and to otherwise adapt to significant technological change;\n•client procurement strategies putting additional operational and financial pressure on our services;\n•our ability to maintain proper and effective internal control over financial reporting in the future;\n•potential and actual harms to our business arising from the matter related to the 2018 acquisition of Take 5 Media Group (the “Take 5 Matter”);\n•our ability to identify attractive acquisition targets, acquire them at attractive prices, and successfully integrate the acquired businesses;\n•our ability to avoid or manage business conflicts among competing brands;\n49\n•difficulties in integrating acquired businesses;\n•our substantial indebtedness and our ability to refinance at favorable rates;\n•limitations, restrictions, and business decisions involving our joint ventures and minority investments;\n•our ability to respond to changes in digital practices and policies;\n•exposure to foreign currency exchange rate fluctuations and risks related to our international operations;\n•disruptions in global financial markets relating to terrorist attacks or geopolitical risk and the recent conflict between Russia and Ukraine;\n•the ability to maintain applicable listing standards;\n•changes in applicable laws or regulations; and\n•the possibility that we may be adversely affected by other political, economic, business, and/or competitive factors.\nRisks Related to the Company’s Business and Industry\nThe COVID-19 pandemic and the measures taken to mitigate its spread have had, and are likely to continue to have, an adverse effect on our business, results of operations, financial condition and liquidity.\nThe COVID-19 pandemic, including the measures taken to mitigate its spread, have had, and are likely to continue to have, adverse effects on our business and operations. There are many uncertainties regarding the current COVID-19 pandemic, including the scope of potential public health issues, the anticipated duration of the pandemic and the extent of local and worldwide social, political and economic disruption it has caused and may cause in the future. To date, the COVID-19 pandemic and measures taken to mitigate the spread of COVID-19, including restrictions on large gatherings, closures of face-to-face events and indoor dining facilities, “shelter in place” health orders and travel restrictions, have had far-reaching direct and indirect impacts on many aspects of our operations, including temporary termination of certain in-store demonstration services and other services, as well as on consumer behavior and purchasing patterns, in particular with respect to the foodservice industries, and declines in consumer demand for restaurant, school and hotel dining, where we promote our clients’ products. Since March 2020, our marketing segment has experienced a significant decline in revenues, primarily due to the temporary suspension or reduction of certain in-store demonstration services and decreased demand in our digital marketing services, both of which we believe were caused by the COVID-19 pandemic and the various governmental and private responses to the pandemic, and which may continue in the future. In our sales segment, we have experienced significant shifts in consumer spending preferences and habits. We can provide no assurances that the strength of that segment will continue or that we will be able to continue to evolve our business in the future as the COVID-19 pandemic continues to impact our clients’ businesses.\nWe have taken several actions in response to these business disruptions, including reducing certain of our discretionary expenditures, reducing our real estate foot print, through lease terminations and amendments (including abandoning several office leases prior to reaching termination agreements with its landlords), eliminating non-essential travel and terminating, furloughing or instituting pay reductions and deferrals for some of our associates. However, the pandemic has had, and may continue to have, an adverse effect on our results of operations, including our revenues, our financial condition and liquidity.\nThe COVID-19 pandemic also may have the effect of heightening many of the other risks described in these “Risk Factors”, including:\n•potential changes in the policies of retailers in response to the COVID-19 pandemic, including changes to or restrictions on their outsourcing of sales and marketing functions and restrictions on the performance of in-store demonstration services, if permitted at all;\n•potential changes in the demand for services by our clients in response to the COVID-19 pandemic;\n•our ability to hire, timely train and retain talented individuals for our workforce;\n•disruptions, delays and strains in certain domestic and internal supply changes that have had, and may continue to have, a negative effect on the flow or availability of certain products;\n50\n•the need for us to adapt to technological change and otherwise develop and maintain omni-channel solutions;\n•our ability to generate sufficient cash to service our substantial indebtedness;\n•our ability to maintain our credit rating;\n•our ability to offer high-quality customer support and maintain our reputation;\n•our ability to identify, perform adequate diligence on and consummate acquisitions of attractive business targets, and then subsequently integrate such acquired businesses;\n•our ability to maintain our corporate culture;\n•severe disruption and instability in the U.S. and global financial markets or deteriorations in credit and financing conditions, which could make it difficult for us to access debt and equity capital on attractive terms, or at all;\n•our ability to effectively manage our operations while a significant amount of our associates continue to work remotely due to the COVID-19 pandemic;\n•deteriorating economic conditions, declines in labor force participation rates, public transportation disruptions or other disruptions as a result of the COVID-19 pandemic;\n•potential cost-saving strategies implemented by clients that reduce fees paid to third-party service providers such as ourselves; and\n•our ability to implement additional internal control measures to improve our internal control over financial reporting.\nWe cannot predict the full extent to which the COVID-19 pandemic may affect our business, financial condition, results of operations and liquidity as such effects will depend on how the COVID-19 pandemic and the measures taken in response to the COVID-19 pandemic continue to develop. However, these effects may continue, evolve or increase in severity, each of which could further negatively impact our business, financial condition, results of operations and liquidity.\nMarket-driven wage increases and changes to wage or job classification regulations, including minimum wages could adversely affect our business, financial condition or results of operations.\nMarket competition has and may continue to cause us to increase the salaries or wages paid to our associates or the benefits packages that they receive. If we experience further market-driven increases in salaries, wage rates or benefits or if we fail to increase our offered salaries, wages or benefits packages competitively, the quality of our workforce could decline, causing our client service to suffer. Low unemployment rates or lower levels of labor force participation rates may increase the likelihood or impact of such market pressures. Any of these changes affecting wages or benefits for our associates could adversely affect our business, financial condition or results of operations.\nChanges in labor laws related to employee hours, wages, job classification and benefits, including health care benefits, could adversely affect our business, financial condition or results of operations. As of September 30, 2022, we employed approximately 75,000 associates, many of whom are paid above, but near, applicable minimum wages, and their wages may be affected by changes in minimum wage laws.\nAdditionally, many of our salaried associates are paid at rates that could be impacted by changes to minimum pay levels for exempt roles. Certain state or municipal jurisdictions in which we operate have recently increased their minimum wage by a significant amount, and other jurisdictions are considering or plan to implement similar actions, which may increase our labor costs. Any increases at the federal, state or municipal level to the minimum pay rate required to remain exempt from overtime pay may adversely affect our business, financial condition or results of operations.\nAn inability to hire, timely train and retain talented individuals for our workforce could slow our growth and adversely impact our ability to operate our business.\nOur ability to meet our workforce needs, while controlling associate-related costs, including salaries, wages and benefits, is subject to numerous external factors, including the availability of talented persons in the workforce in the local markets in which we operate, prevailing unemployment rates and competitive wage rates in such\n51\nmarkets. We may find that there is an insufficient number of qualified individuals to fill our associate positions with the qualifications we seek. Competition in these communities for qualified staff could require us to pay higher wages and provide greater benefits, especially if there is significant improvement in regional or national economic conditions. We must also train and, in some circumstances, certify these associates under our policies and practices and any applicable legal requirements. If we are unable to hire, timely train or retain talented individuals may result in higher turnover and increased labor costs, and could compromise the quality of our service, all of which could adversely affect our business.\nInflation may adversely affect our operating results.\nInflationary factors such as increases in the labor costs, material costs and overhead costs may adversely affect our operating results. A high rate of inflation, including a continuation of inflation at the current rate, has had and may continue to have an adverse effect on our ability to maintain attractive levels of gross margin and general and administrative expenses as a percentage of total revenue, if we are unable to pass on these costs through increased prices, revised budget estimates, or offset them in other ways.\nOur business and results of operations are affected by developments with and policies of retailers that are out of our control.\nA limited number of national retailers account for a large percentage of sales for our consumer goods manufacturer clients. We expect that a significant portion of these clients’ sales will continue to be made through a relatively small number of retailers and that this percentage may increase if the growth of mass retailers and the trend of retailer consolidation continues. As a result, changes in the strategies of large retailers, including a reduction in the number of brands that these retailers carry or an increase in shelf space that they dedicate to private label products, could materially reduce the value of our services to these clients or these clients’ use of our services and, in turn, our revenues and profitability. Many retailers have critically analyzed the number and variety of brands they sell, and have reduced or discontinued the sale of certain of our clients’ product lines at their stores, and more retailers may continue to do so. If this continues to occur and these clients are unable to improve distribution for their products at other retailers, our business or results of operations could be adversely affected. These trends may be accelerated as a result of the COVID-19 pandemic.\nAdditionally, many retailers, including several of the largest retailers in North America, which own and operate a significant number of the locations at which we provide our services, have implemented or may implement in the future, policies that designate certain service providers to be the exclusive provider or one of their preferred providers for specified services, including many of the services that we provide to such retailers or our clients.\nSome of these designations apply across all of such retailers’ stores, while other designations are limited to specific regions. If we are unable to respond effectively to the expectations and demands of such retailers or if retailers do not designate us as their exclusive provider or one of their preferred providers for any reason, they could reduce or restrict the services that we are permitted to perform for our clients at their facilities or require our clients to purchase services from other designated services providers, which include our competitors, either of which could adversely affect our business or results of operations.\nConsolidation in the industries we serve could put pressure on the pricing of our services, which could adversely affect our business, financial condition or results of operations.\nConsolidation in the consumer goods and retail industries we serve could reduce aggregate demand for our services in the future and could adversely affect our business or our results of operations. In October 2022, The Kroger Co. and Albertsons Companies, Inc., two large retailers, announced an agreement to merge their businesses together with an anticipated closing in 2024. When companies consolidate, the services they previously purchased separately are often purchased by the combined entity, leading to the termination of relationships with certain service providers or demands for reduced fees and commissions. The combined company may also choose to insource certain functions that were historically outsourced, resulting in the termination of existing relationships with third-party service providers. While we attempt to mitigate the revenue impact of any consolidation by maintaining existing or winning new service arrangements with the combined companies, there can be no assurance as to the degree to which we will be able to do so as consolidation continues in the industries we serve, and our business, financial condition or results of operations may be adversely affected.\n52\nConsumer goods manufacturers and retailers may periodically review and change their sales, retail, marketing and technology programs and relationships to our detriment.\nThe consumer goods manufacturers and retailers to whom we provide our business solutions operate in highly competitive and rapidly changing environments. From time to time these parties may put their sales, retail, marketing and technology programs and relationships up for competitive review, which may increase in frequency as a result of the COVID-19 pandemic and its impacts on the consumer goods manufacturers and retailer industries. We have occasionally lost accounts with significant clients as a result of these reviews in the past, and our clients are typically able to reduce or cancel current or future spending on our services on short notice for any reason. We believe that key competitive considerations for retaining existing and winning new accounts include our ability to develop solutions that meet the needs of these manufacturers and retailers in this environment, the quality and effectiveness of our services and our ability to operate efficiently. To the extent that we are not able to develop these solutions, maintain the quality and effectiveness of our services or operate efficiently, we may not be able to retain key clients, and our business, financial condition or results of operations may be adversely affected.\nOur largest clients generate a significant portion of our revenues.\nOur three largest clients generated approximately 11% of our revenues in the fiscal year ended December 31, 2021. These clients are generally able to reduce or cancel spending on our services on short notice for any reason. A significant reduction in spending on our services by our largest clients, or the loss of one or more of our largest clients, if not replaced by new clients or an increase in business from existing clients, would adversely affect our business and results of operations. In addition, when large retailers suspend or reduce in-store demonstration services, such as in response to the COVID-19 pandemic, our business and results of operations can be adversely affected.\nWe are reliant on continued access to retailer platforms on commercially reasonable terms for the provision of certain of our e-commerce services in which our clients’ products are resold by us, as the vendor of record, directly to the consumer.\nA portion of the e-commerce services we provide involve the purchase and resale by us, as the vendor of record, of our clients’ products through retailer platforms. The control that retailers such as Amazon have over the access and fee structures and/or pricing for products on their platforms could impact the volume of purchases of these products made on their platform and our revenues from the provision of such e-commerce services. If such retailers establish terms that restrict the offering of these products on their platform, significantly impact the financial terms on which such products are offered, or do not approve the inclusion of such products on their platform, our business could be negatively impacted. Additionally, we also generally rely on a retailer’s payment processing services for purchases made on its platform by consumers. To the extent such payment processing services are offered to us on less favorable terms, or become unavailable to us for any reason, our costs of revenue with respect to this aspect of our business could increase, and our margins could be materially adversely impacted. We cannot assure you that we will be successful in maintaining access to these retailer platforms on commercially reasonable terms, or at all.\nThe retail industry is evolving, and if we do not successfully develop and maintain relevant omni-channel services for our clients, our business, financial condition or results of operations could be adversely impacted.\nHistorically, substantially all of our sales segment revenues were generated by sales and services that ultimately occurred in traditional retail stores. The retail industry is evolving, as demonstrated by the number of retailers that offer both traditional retail stores and e-commerce platforms or exclusively e-commerce platforms. In addition, the COVID-19 pandemic has placed pressure on the traditional retail store model, including store closures, changes in consumer spending, and extensive health and safety risks and compliance requirements. Consumers are increasingly using computers, tablets, mobile phones and other devices to comparison shop, determine product availability and complete purchases online, a trend that has accelerated during the COVID-19 pandemic, and which may continue thereafter. If consumers continue to purchase more products online and e-commerce continues to displace brick-and-mortar retail sales, there may be a decrease in the demand for certain of our services. Omni-channel retailing is rapidly evolving and we believe we will need to keep pace with the changing consumer expectations and new developments by our competitors.\n53\nWhile we continue to seek to develop effective omni-channel solutions for our clients that support both their e-commerce and traditional retail needs, there can be no assurances that these efforts will result in revenue gains sufficient to offset potential decreases associated with a decline in traditional retail sales or that we will be able to maintain our position as a leader in our industry. If we are unable to provide, improve or develop innovative digital services and solutions in a timely manner or at all, our business, financial condition or results of operations could be adversely impacted.\nWe may be unable to adapt to significant technological change, which could adversely affect our business, financial condition or results of operations.\nWe operate businesses that require sophisticated data collection, processing and software for analysis and insights. Some of the technologies supporting the industries we serve are changing rapidly, particularly as a result of the COVID-19 pandemic. We will be required to continue to adapt to changing technologies, either by developing and marketing new services or by enhancing our existing services, to meet client demand.\nMoreover, the introduction of new services embodying new technologies, including automation of certain of our in-store services, and the emergence of new industry standards could render existing services obsolete. Our continued success will depend on our ability to adapt to changing technologies, manage and process increasing amounts of data and information and improve the performance, features and reliability of our existing services in response to changing client and industry demands. We may experience difficulties that could delay or prevent the successful design, development, testing, introduction or marketing of our services. New services or enhancements to existing services may not adequately meet the requirements of current and prospective clients or achieve market acceptance.\nOur ability to maintain our competitive position depends on our ability to attract and retain talented executives.\nWe believe that our continued success depends to a significant extent upon the efforts, abilities and relationships of our senior executives and the strength of our middle management team. Although we have entered into employment agreements with certain of our senior executives, each of them may terminate their employment with us at any time. The replacement of any of our senior executives likely would involve significant time and costs and may significantly delay or prevent the achievement of our business objectives and could therefore have an adverse impact on our business. In addition, we do not carry any “key person” insurance policies that could offset potential loss of service under applicable circumstances. Furthermore, if we are unable to attract and retain a talented team of middle management executives, it may be difficult to maintain the expertise and industry relationships that our clients value, and they may terminate or reduce their relationship with us.\nClient procurement and fee reduction strategies could put additional operational and financial pressure on our services or negatively impact our relationships, business, financial condition or results of operations.\nMany of our clients seek opportunities to reduce their costs through procurement strategies that reduce fees paid to third-party service providers. As a result, certain of our clients have sought, and may continue to seek, more aggressive terms from us, including with respect to pricing and payment terms. Such activities put operational and financial pressure on our business, which could limit the amounts we earn or delay the timing of our cash receipts. Such activities may also cause disputes with our clients or negatively impact our relationships or financial results. Our clients have experienced, and may continue to experience, increases in their expenses associated with materials and logistics, which may cause them to reduce expenses elsewhere. While we attempt to mitigate negative implications to client relationships and the revenue impact of any pricing pressure by aligning our revenues opportunity with satisfactory client outcomes, there can be no assurance as to the degree to which we will be able to do so successfully. Additionally, price concessions can lead to margin compression, which in turn could adversely affect our business, financial condition or results of operations.\nIf we fail to offer high-quality customer support, our business and reputation may suffer.\nHigh-quality education, training and customer support are important for successful marketing and sales and for the renewal of existing customers. Providing this education, training and support requires that our personnel who manage our online training resource or provide customer support have specific inbound experience domain knowledge and expertise, making it more difficult for us to hire qualified personnel and to scale up our support operations. The importance of high-quality customer support will increase as we expand our business and pursue\n54\nnew customers. If we do not help our customers use multiple applications and provide effective ongoing support, our ability to sell additional functionality and services to, or to retain, existing customers may suffer and our reputation with existing or potential customers may be harmed.\nWe may be adversely affected if clients reduce their outsourcing of sales and marketing functions.\nOur business and growth strategies depend in large part on companies continuing to elect to outsource sales and marketing functions. Our clients and potential clients will outsource if they perceive that outsourcing may provide quality services at a lower overall cost and permit them to focus on their core business activities and have done so in the past. We cannot be certain that the industry trend to outsource will continue or not be reversed or that clients that have historically outsourced functions will not decide to perform these functions themselves. Unfavorable developments with respect to outsourcing could adversely affect our business, financial conditions and results of operations.\nWe previously identified material weaknesses in our internal control over financial reporting. If we fail to maintain proper and effective internal control over financial reporting in the future, our ability to produce accurate and timely financial statements could be impaired, investors’ views of us could be harmed, and we could be subject to enforcement actions by the SEC.\nDuring 2021, we completed the remediation measures related to the material weaknesses previously identified and concluded that our internal control over financial reporting was effective as of December 31, 2021. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim consolidated financial statements will not be prevented or detected on a timely basis. If we are unable to maintain effective internal control over financial reporting or disclosure controls and procedures, our ability to record, process and report financial information accurately, and to prepare financial statements within required time periods could be adversely affected, which could subject us to litigation or investigations requiring management resources and payment of legal and other expenses, negatively affect investor confidence in our financial statements and adversely impact our stock price.\nIf we are unable to identify attractive acquisition targets, acquire them at attractive prices or successfully integrate the acquired businesses, we may be unsuccessful in growing our business.\nA significant portion of our growth has been as a result of our acquisition of complementary businesses that grow our service offerings, expand our geographic reach and strengthen valuable relationships with clients. However, there can be no assurance that we will find attractive acquisition targets, that we will acquire them at attractive prices, that we will succeed at effectively managing the integration of acquired businesses into our existing operations or that such acquired businesses or technologies will be well received by our clients, potential clients or our investors. We could also encounter higher-than-expected earn-out payments, unforeseen transaction- and integration-related costs or delays or other circumstances such as disputes with or the loss of key or other personnel from acquired businesses, challenges or delays in integrating systems or technology of acquired businesses, a deterioration in our associate and client relationships, harm to our reputation with clients, interruptions in our business activities or unforeseen or higher-than-expected inherited liabilities. Many of these potential circumstances are outside of our control and any of them could result in increased costs, decreased revenue, decreased synergies or the diversion of management time and attention.\nIn order for us to continue to grow our business through acquisitions we will need to identify appropriate acquisition opportunities and acquire them at attractive prices. We may choose to pay cash, incur debt or issue equity securities to pay for any such acquisition. The incurrence of indebtedness would result in increased fixed obligations and could also include covenants or other restrictions that would impede our ability to manage our operations. The sale of equity to finance any such acquisition could result in dilution to our stockholders.\nWe may encounter significant difficulties integrating acquired businesses.\nThe integration of any businesses is a complex, costly and time-consuming process. As a result, we have devoted, and will continue to devote, significant management attention and resources to integrating acquired businesses. The failure to meet the challenges involved in integrating businesses and to realize the anticipated benefits of any acquisition could cause an interruption of, or a loss of momentum in, the activities of our combined\n55\nbusiness and could adversely affect our results of operations. The difficulties of combining acquired businesses with our own include, among others:\n•the diversion of management attention to integration matters;\n•difficulties in integrating functional roles, processes and systems, including accounting systems;\n•challenges in conforming standards, controls, procedures and accounting and other policies, business cultures and compensation structures between the two companies;\n•difficulties in assimilating, attracting and retaining key personnel;\n•challenges in keeping existing clients and obtaining new clients;\n•difficulties in achieving anticipated cost savings, synergies, business opportunities and growth prospects from an acquisition;\n•difficulties in managing the expanded operations of a significantly larger and more complex business;\n•contingent liabilities, including contingent tax liabilities or litigation, that may be larger than expected; and\n•potential unknown liabilities, adverse consequences or unforeseen increased expenses associated with an acquisition, including possible adverse tax consequences to the combined business pursuant to changes in applicable tax laws or regulations.\nMany of these factors are outside of our control, and any one of them could result in increased costs, decreased expected revenues and diversion of management time and energy, all of which could adversely impact our business and results of operations. These difficulties have been enhanced further during the COVID-19 pandemic as a result of our office closures and work-from home policies, which may hinder assimilation of key personnel.\nIf we are not able to successfully integrate an acquisition, if we incur significantly greater costs to achieve the expected synergies than we anticipate or if activities related to the expected synergies have unintended consequences, our business, financial condition or results of operations could be adversely affected.\nOur corporate culture has contributed to our success and, if we are unable to maintain it as we evolve, our business, operating results and financial condition could be harmed.\nWe believe our corporate culture has been a significant factor in our success. However, as our company evolves, including through acquisitions and the impacts of the COVID-19 pandemic, such as working remotely and reductions in workforce, it may be difficult to maintain our culture, which could reduce our ability to innovate and operate effectively. The failure to maintain the key aspects of our culture as our organization evolves could result in decreased employee satisfaction, increased difficulty in attracting top talent, increased turnover and compromised the quality of our client service, all of which are important to our success and to the effective execution of our business strategy. If we are unable to maintain our corporate culture as we evolve and execute our growth strategies, our business, operating results and financial condition could be harmed.\nAcquiring new clients and retaining existing clients depends on our ability to avoid or manage business conflicts among competing brands.\nOur ability to acquire new clients and to retain existing clients, whether by expansion of our own operations or through an acquired business may in some cases be limited by the other parties’ perceptions of, or policies concerning, perceived competitive conflicts arising from our other relationships. Some of our contracts expressly restrict our ability to represent competitors of the counterparty. These perceived competitive conflicts may also become more challenging to avoid or manage as a result of continued consolidation in the consumer goods and retail industries and our own acquisitions. If we are unable to avoid or manage business conflicts among competing manufacturers and retailers, we may be unable to acquire new clients or be forced to terminate existing client relationships, and in either case, our business and results of operations may be adversely affected.\nLimitations, restrictions and business decisions involving our joint ventures and minority investments may adversely affect our growth and results of operations.\n56\nWe have made substantial investments in joint ventures and minority investments and may use these and other similar methods to expand our service offerings and geographical coverage in the future. These arrangements typically involve other business services companies as partners that may be competitors of ours in certain markets. Joint venture agreements may place limitations or restrictions on our services. As part of our joint venture with, and investments in Smollan, we are restricted under certain circumstances from making direct acquisitions and otherwise expanding our service offerings into markets outside of North America and Europe. As a result of our acquisition of Daymon Worldwide Inc. pursuant to the terms of our arrangements with Smollan and our joint venture, Smollan and our joint venture may elect to purchase from us, and have purchased, certain Daymon business units that operate outside of North America. If Smollan or our joint venture do not elect to purchase those business units, we may, under certain circumstances, elect to retain, sell or discontinue those business units. The limitations and restrictions tied to our joint venture and minority investments limit our potential business opportunities and reduce the economic opportunity for certain prospective international investments and operations. Additionally, though we control our joint ventures, we may rely upon our equity partners or local management for operational and compliance matters associated with our joint ventures or minority investments. Moreover, our other equity partners and minority investments may have business interests, strategies or goals that are inconsistent with ours. Business decisions, including actions or omissions, of a joint venture or other equity partner or management for a business unit may adversely affect the value of our investment, result in litigation or regulatory action against us or adversely affect our growth and results of operations.\nOur international operations expose us to risks that could impede growth in the future, and our attempts to grow our business internationally may not be successful.\nWe continue to explore opportunities in major international markets. International operations expose us to various additional risks that could adversely affect our business, including:\n•costs of customizing services for clients outside of the United States;\n•the burdens of complying with a wide variety of foreign laws;\n•potential difficulty in enforcing contracts;\n•being subject to U.S. laws and regulations governing international operations, including the U.S. Foreign Corrupt Practices Act and sanctions regimes;\n•being subject to foreign anti-bribery laws in the jurisdictions in which we operate, such as the UK Bribery Act;\n•reduced protection for intellectual property rights;\n•increased financial accounting and reporting complexity;\n•additional legal compliance requirements, including custom and import requirements with respect to products imported to and exported across international borders;\n•exposure to foreign currency exchange rate fluctuations;\n•exposure to local economic conditions;\n•limitations on the repatriation of funds or profits from foreign operations;\n•exposure to local or regional political conditions, including adverse tax policies and civil unrest;\n•the risks of a natural disaster, public health crisis (including the occurrence of a contagious disease or illness, such as the coronavirus), an outbreak of war (such as Russia's invasion of Ukraine), the escalation of hostilities and acts of terrorism in the jurisdictions in which we operate; and\n•the disparate impact of the COVID-19 pandemic, including the measures taken to mitigate its spread, across various jurisdictions.\nAdditionally, the withdrawal of the United Kingdom from the European Union, or “Brexit,” has created economic and political uncertainty, including volatility in global financial markets and the value of foreign currencies. The impact of Brexit may not be fully realized for several years. Additionally, in many countries outside of the United States, there has not been a historical practice of using third parties to provide sales and marketing services. Accordingly, while it is part of our strategy to expand into international markets, it may be difficult for us to grow our international business units on a timely basis, or at all.\nThe ongoing conflict between Russia and Ukraine may adversely affect our business and results of operations.\n57\nGiven the nature of our business and our international operations, political, economic, and other conditions in foreign countries and regions, including geopolitical risks such as those arising from the current conflict between Russia and Ukraine, may adversely affect our business and results of operations. The broader consequences of this conflict, which may include further sanctions, embargoes, regional instability, and geopolitical shifts; disruptions to transportation and distribution routes, or strategic decisions to alter certain routes; potential retaliatory action by the Russian government against companies, including us, including nationalization of foreign businesses and/or assets in Russia; increased tensions between the United States and countries in which we operate; and the extent of the conflict’s effect on our business and results of operations as well as the global economy, cannot be predicted.\nAdditionally, we have a minority interest in a European company that owns majority interests in local agencies in Russia. In addition to the imposition of sanctions by the United States, the United Kingdom, and the European Union that affect the cross-border operations of businesses operating in Russia, Russian regulators have imposed currency restrictions and regulations that created uncertainty regarding our ability to recover our investment in operations in Russia, as well as our ability to exercise control or influence involving operations by the local agencies in Russia. As a result, we intend to use our influence to cause the European company to dispose of our ownership interests in the local agencies in Russia. Accordingly, we recorded pretax charges of $2.8 million in the first quarter of 2022, primarily consisting of our proportionate share of the net investment in our Russian interest in “Selling, general, and administrative expenses” in the Condensed Consolidated Statements of Operations and Comprehensive Income.\nTo the extent the current conflict between Russia and Ukraine adversely affects our business, particularly in Russia, it may also have the effect of heightening many other risks disclosed in our 2021 Annual Report and this Quarterly Report, any of which could materially and adversely affect our business and results of operations. Such risks include, but are not limited to, adverse effects on macroeconomic conditions, including inflation and business spending; disruptions to our information technology infrastructure, including through cyberattack, ransom attack, or cyber-intrusion; adverse changes in international trade policies and relations; our ability to maintain or increase our prices, our ability to implement and execute our business strategy, disruptions in global supply chains, our exposure to foreign currency fluctuations, and constraints, volatility, or disruption in the capital markets, difficulty staffing and managing impacted operations, and the recoverability of assets in the region.\nWe may be subject to unionization, work stoppages, slowdowns or increased labor costs.\nCurrently, none of our associates in the United States are represented by a union. However, our associates have the right under the National Labor Relations Act to choose union representation. If all or a significant number of our associates become unionized and the terms of any collective bargaining agreement were significantly different from our current compensation arrangements, it could increase our costs and adversely impact our profitability. Moreover, if a significant number of our associates participate in labor unions, it could put us at increased risk of labor strikes and disruption of our operations or adversely affect our growth and results of operations. In December 2019, a union which commonly represents employees in the supermarket industry filed a petition with the National Labor Relations Board to represent approximately 120 of our associates who work in and around Boston. An election was held, and based on certified results of the election we prevailed in this election. Notwithstanding this successful election, we could face future union organization efforts or elections, which could lead to additional costs, distract management or otherwise harm our business.\nIf goodwill or other intangible assets in connection with our acquisitions become impaired, we could take significant non-cash charges against earnings.\nWe have made acquisitions to complement and expand the services we offer and intend to continue to do so when attractive acquisition opportunities exist in the market. As a result of prior acquisitions, including the acquisition of our business in 2014 by our current parent entity, Topco, we have goodwill and intangible assets recorded on our balance sheet of $2.2 billion and $2.2 billion, respectively, as of September 30, 2022, as further described in Note 4 to our condensed consolidated financial statements for the three and nine months ended September 30, 2022.\nUnder accounting guidelines, we must assess, at least annually, whether the value of goodwill and other intangible assets has been impaired. We have recognized non-cash goodwill and non-cash intangible asset impairment charges, and we can make no assurances that we will not record any additional impairment charges in\n58\nthe future. Any future reduction or impairment of the value of goodwill or other intangible assets will similarly result in charges against earnings, which could adversely affect our reported financial results in future periods.\nFailures in, or incidents involving, our technology infrastructure could damage our business, reputation and brand and substantially harm our business and results of operations.\nOur business is highly dependent on our ability to manage operations and process a large number of transactions on a daily basis. We rely heavily on our operating, payroll, financial, accounting and other data processing systems which require substantial support and maintenance, and may be subject to disabilities, errors, or other harms. If our data and network infrastructure were to fail, or if we were to suffer a data security breach, or an interruption or degradation of services in our data center, third-party cloud, and other infrastructure environments, we could lose important data, which could harm our business and reputation, and cause us to incur significant liabilities. Our facilities, as well as the facilities of third-parties that provide or maintain, or have access to our data or network infrastructure, are vulnerable to damage or interruption from earthquakes, hurricanes, floods, fires, cyber security attacks, terrorist attacks, power losses, telecommunications failures and similar events. In the event that our or any third-party provider’s systems or service abilities are hindered by any of the events discussed above, our ability to operate may be impaired. Our information technology systems, and the information technology systems of our current or future third-party vendors, collaborators, consultants and service providers, could be penetrated by internal or external parties intent on extracting information, corrupting information, stealing intellectual property or trade secrets, or disrupting business processes. A third party’s decision to close facilities or terminate services without adequate notice, or other unanticipated problems, could adversely impact our operations. Any of the aforementioned risks may be augmented if our or any third-party provider’s business continuity and disaster recovery plans prove to be inadequate in preventing the loss of data, service interruptions, disruptions to our operations or damages to important systems or facilities. Our data center, third-party cloud, and managed service provider infrastructure also could be subject to break-ins, cyber-attacks (including through the use of malware, software bugs, computer viruses, ransomware, social engineering, and denial of service), sabotage, intentional acts of vandalism and other misconduct, from a spectrum of actors ranging in sophistication from threats common to most industries to more advanced and persistent, highly organized adversaries. Any security breach or incident, including personal data breaches, that we experience could result in unauthorized access to, or misuse, modification, destruction or unauthorized acquisition of, our internal sensitive corporate data, such as personal data, financial data, trade secrets, intellectual property, or other competitively sensitive or confidential data. Such unauthorized access, misuse, acquisition, or modification of sensitive data may result in data loss, corruption or alteration, interruptions in our operations or damage to our computer hardware or systems or those of our employees or customers. Our systems have been the target of cyber-attacks. Although we have taken and continue to take steps to enhance our cybersecurity posture, we cannot assure that future cyber incidents will not occur or that our systems will not be targeted or breached in the future. Any such breach or unauthorized access could result in a disruption of the Company’s operations, the theft, unauthorized use or publication of the Company’s intellectual property, other proprietary information or the personal information of customers, employees, licensees or suppliers, a reduction of the revenues the Company is able to generate from its operations, damage to the Company’s brand and reputation, a loss of confidence in the security of the Company’s business and products, and significant legal and financial exposure. If any such incident results in litigation, we may be required to make significant expenditures in the course of such litigation and may be required to pay significant amounts in damages. We may not carry sufficient business interruption insurance to compensate us for losses that may occur as a result of any events that cause interruptions in our service. Significant unavailability of our services due to attacks could cause us to incur significant liability, could cause users to cease using our services and materially and adversely affect our business, prospects, financial condition and results of operations.\nWe use complex software in our technology infrastructure, which we seek to continually update and improve. Replacing such systems is often time-consuming and expensive and can also be intrusive to daily business operations. Further, we may not always be successful in executing these upgrades and improvements, which may result in a failure of our systems. We may experience periodic system interruptions from time to time. Any slowdown or failure of our underlying technology infrastructure could harm our business and reputation, which could materially adversely affect our results of operations. Our disaster recovery plan or those of our third-party providers may be inadequate, and our business interruption insurance may not be sufficient to compensate us for the losses that could occur.\n59\nFailure to comply with federal, state and foreign laws and regulations relating to privacy, data protection and consumer protection, or the expansion of current or the enactment of new laws or regulations relating to privacy, data protection and consumer protection, could adversely affect our business and our financial condition.\nA variety of federal, state and foreign laws and regulations govern the collection, use, retention, sharing and security of personal information. The information, security and privacy requirements imposed by such governmental laws and regulations relating to privacy, data protection and consumer protection are increasingly demanding, quickly evolving and may be subject to differing interpretations or legal theories among regulators, enforcers, and civil litigants. These requirements may not be harmonized, may be interpreted and applied in a manner that is inconsistent from one jurisdiction to another or may conflict with other rules or our practices. As a result, our practices may not have complied or may not comply in the future with all such laws, regulations, requirements and obligations. Our actual or perceived failure to comply with such laws and regulations could result in fines, investigations, enforcement actions, penalties, sanctions, claims for damages by affected individuals, and damage to our reputation, among other negative consequences, any of which could have a material adverse effect on its financial performance.\nCertain aspects of our business and/or the data it collects is subject to the California Consumer Protection Act of 2018 (“CCPA”), which became effective in 2020 and regulates the collection, use and processing of personal information relating to California residents, and which grants certain privacy rights to California residents, including rights to request access to and to request deletion of personal information relating to such individuals under certain circumstances. Compliance with the new obligations imposed by the CCPA depends in part on how its requirements are interpreted and applied by the California attorney general and courts. Alleged violations of the CCPA may result in substantial civil penalties or statutory damages when applied at scale, up to $2,500 per violation or $7,500 per intentional violation of any CCPA requirement, which may be applied on a per-person or per-record basis. The CCPA also establishes a private right of action if certain personal information of individuals is subject to an unauthorized access and exfiltration, theft, or disclosure as a result of a business’s violation of the duty to implement and maintain reasonable security procedures and practices, which authorizes statutory damages $100 to $750 per person per incident even if there is no actual harm or damage to plaintiffs. This private right of action may increase the likelihood of, and risks associated with, data breach litigation. Further, in November 2020, the State of California adopted the California Privacy Rights Act of 2020 (“CPRA”) which goes into effect January 1, 2023 and is enforceable starting on July 1, 2023. The CPRA expands and amends the CCPA, including additional and strengthened privacy rights for California residents, new requirements regarding sensitive data and data sharing for digital advertising, and tripled damages for violations involving children’s data. Also on January 1, 2023, the CCPA – as amended by the CPRA – will be newly applicable to personal information collected for employment-related purposes as well as from business-to-business contacts, creating new regulatory obligations as to datasets that until then had been largely exempt from the CCPA. The CPRA includes a 12-month “look-back” provision that requires businesses to map out all information retained since January 1, 2022. The CPRA also establishes a dedicated privacy regulator under California law, with rulemaking and enforcement responsibilities. Certain regulations implementing the CPRA are expected in draft and final form by the end of 2022, with potentially additional regulations to be proposed following the CPRA’s January 1, 2023 effective date.\nFour other states – Virginia, Colorado, Connecticut, and Utah – have passed their own comprehensive privacy laws to go into effect in 2023. Like the CCPA and CPRA, these laws regulate the collection, use, processing, and sharing of personal information relating to residents of each state respectively, and grants certain privacy rights to those residents. The new state laws also have key differences from the CCPA and CPRA, such as requiring affirmative consent before businesses may process sensitive personal information, requiring data protection assessments, and requiring contracts between data controllers and data processors that direct data processors to assist data controllers in performing their obligations, as well as other differences among them. Each law is enforceable by its own state’s attorney general – for example, violation of the Virginia or Utah laws will cost up to $7,500 per violation – and none include an explicit private right of action. Other states are expected to consider and potentially pass similar privacy laws in 2023.\nCertain aspects of our business and/or the data it collects is may also be subject to international privacy laws and regulations, many of which, such as the General Data Privacy Regulation (“GDPR”) and national laws implementing or supplementing the GDPR, such as the United Kingdom Data Protection Law 2018 (which retains\n60\nkey features of GDPR post-Brexit), as well as the EU’s Privacy and Electronic Communications Directive (“ePrivacy Directive”), are significantly more stringent than those currently enforced in the United States. The GDPR requires companies to meet requirements regarding the handling of personal data of individuals located in the European Economic Area (the “EEA”). The GDPR imposes mandatory data breach notification requirements subject to a 72-hour notification deadline. The GDPR also includes significant penalties for noncompliance, which may result in monetary penalties of up to the higher of €20.0 million or 4% of a group’s worldwide turnover for the preceding financial year for the most serious violations. The GDPR and other similar regulations such as the ePrivacy Directive and related member state regulations and directives require companies to give specific types of notice and informed consent is in many cases required for the placement of a cookie or similar technologies on a user’s device for online tracking for behavioral advertising and other purposes and for direct electronic marketing, and the GDPR also imposes additional conditions in order to satisfy such consent, such as a prohibition on pre-checked tick boxes and bundled consents. Enforcement of the GDPR and related regulations varies by each EU Member State and is ongoing. Further laws and regulations on these topics are forthcoming, including the ePrivacy Directive’s proposed successor, the Regulation on Privacy and Electronic Communications (“ePrivacy Regulation”), as well as the Digital Services Act (“DSA”) and Digital Markets Act (“DMA”). The GDPR may increase our responsibility and liability in relation to personal data that we process where that processing is subject to the GDPR. In addition, we may be required to put in place additional mechanisms to ensure compliance with the GDPR, including GDPR requirements as implemented by individual countries. Compliance with the GDPR will be a rigorous and time-intensive process that may increase our cost of doing business or require us to change our business practices.\nIn addition, under GDPR, transfers of personal data are prohibited to countries outside of the EEA that have not been determined by the European Commission to provide adequate protections for personal data, including the United States. There are mechanisms to permit the transfer of personal data from the EEA to the United States, but there is also uncertainty as to the future of such mechanisms, which have been under consistent scrutiny and challenge. In July 2020, decision of the Court of Justice of the European Union invalidated the EU-U.S. Privacy Shield Framework, a means that previously permitted transfers of personal data from the EEA to companies in the United States that certified adherence to the Privacy Shield Framework. While the Biden Administration issued an executive order in October 2022 mandating new legal safeguards over U.S. national security agencies’ access and use of EU and U.S. personal data, it is currently unclear what, if any, formal arrangement may replace the Privacy Shield Framework. Standard contractual clauses approved by the European Commission to permit transfers from the EU to third countries currently remain as a basis on which to transfer personal data from the EEA to other countries. Standard contractual clauses are also subject to legal challenge, and in November 2020, the European Commission published a draft of updated standard contractual clauses. In January 2022, for example, Austria’s data protection authority determined that the use of Google Analytics violated the GDPR and the Court of Justice of the European Union’s “Schrems II” decision on international data transfers. We presently rely on standard contractual clauses to transfer personal data from EEA member countries, and we may be impacted by changes in law as a result of future review or invalidation of, or changes to, this mechanism by European courts or regulators. While we will continue to undertake efforts to conform to current regulatory obligations and evolving best practices, we may be unsuccessful in conforming to permitted means of transferring personal data from the European Economic Area. We may also experience hesitancy, reluctance, or refusal by European or multi-national customers to continue to use some of our services due to the potential risk exposure of personal data transfers and the current data protection obligations imposed on them by certain data protection authorities. Such customers may also view any alternative approaches to the transfer of any personal data as being too costly, too burdensome, or otherwise objectionable, and therefore may decide not to do business with us if the transfer of personal data is a necessary requirement.\nAlthough we take reasonable efforts to comply with all applicable laws and regulations and have invested and continue to invest human and technology resources into data privacy compliance efforts, there can be no assurance that we will not be subject to regulatory action, including fines, in the event of an incident or other claim. Data protection laws and requirements may also be enacted, interpreted or applied in a manner that creates inconsistent or contradictory requirements on companies that operate across jurisdictions. We or our third-party service providers could be adversely affected if legislation or regulations are expanded to require changes in our or our third-party service providers’ business practices or if governing jurisdictions interpret or implement their legislation or regulations in ways that negatively affect our or our third-party service providers’ business, results of operations or financial condition. For example, we may find it necessary to establish alternative systems to maintain personal data in the EEA, which may involve substantial expense and may cause us to divert resources from other aspects of\n61\nour business, all of which may adversely affect our results from operations. Further, any inability to adequately address privacy concerns in connection with our solutions, or comply with applicable privacy or data protection laws, regulations and policies, could result in additional cost and liability to us, and adversely affect our ability to offer our solutions. GDPR, CCPA, CPRA and other similar laws and regulations, as well as any associated inquiries or investigations or any other government actions, may be costly to comply with, result in negative publicity, increase our operating costs, require significant management time and attention and subject us to remedies that may harm our business, including fines or demands or orders that we modify or cease existing business practices. Our systems may not be able to satisfy these changing requirements and manufacturer, retailer and associate expectations, or may require significant additional investments or time in order to do so.\nWe expect that new industry standards, laws and regulations will continue to be proposed regarding privacy, data protection and information security in many jurisdictions, including the European e-Privacy Regulation, which is currently in draft form, as well as at the U.S. federal and state levels. In addition, new data processes and datasets associated with emerging technologies are coming under increased regulatory scrutiny, such as biometrics and automated decision-making. We cannot yet determine the impact such future laws, regulations and standards may have on our business. Complying with these evolving obligations is challenging, time consuming and expensive, and federal regulators, state attorneys general and plaintiff’s attorneys have been, and will likely continue to be, active in this space. Expanding definitions and interpretations of what constitutes “personal data” (or the equivalent) within the United States, the EEA and elsewhere may increase our compliance costs and legal liability. For example, various state privacy proposals have included a private right of action for basic privacy violations which, if passed, would dramatically increase both the legal costs of defending frivolous lawsuits and the penalties and costs associated with alleged violations.\nA data breach or any failure, or perceived failure, by us to comply with any federal, state or foreign privacy or consumer protection-related laws, regulations or other principles or orders to which we may be subject or other legal obligations relating to privacy or consumer protection could adversely affect our reputation, brand and business, and may result in fines, enforcement actions, sanctions, claims (including claims for damages by affected individuals), investigations, proceedings or actions against us by governmental entities or others, or other penalties or liabilities or require us to change our operations and/or cease using certain data sets, among other negative consequences, any of which could have a material adverse effect on our business. Moreover, the proliferation of supply chain-based cyberattacks and vendor security incidents increases these potential risks and costs even in cases where the attack did not target us, occur on our systems, or result from any action or inaction by us. Depending on the nature of the information compromised, we may also have obligations to notify users, law enforcement, regulators, business partners or payment companies about the incident and provide some form of remedy, such as refunds or identity theft monitoring services, for the individuals affected by the incident.\nThe Take 5 Matter may lead to additional harms, risks and uncertainties for us, including litigation and governmental investigations, a reduction in revenue, a potential deterioration in our relationships or reputation and a loss in investor confidence.\nOn April 1, 2018, we acquired certain assets and assumed certain liabilities of Take 5 Media Group. In June 2019, as a result of a review of internal allegations related to inconsistency of data provided by Take 5 to its clients, we commenced an investigation into Take 5’s operations. In July 2019, as a result of our investigation, we terminated all operations of Take 5, including the use of its associated trade names and the offering of its services to its clients and offered refunds to Take 5 clients of collected revenues attributable to Take 5 since our acquisition of Take 5.\nAs a result of these matters, we may be subject to a number of additional harms, risks and uncertainties, including substantial costs for professional services fee, potential lawsuits by clients or other interested parties who claim to have been harmed by the misconduct at Take 5, other costs and fees related to the Take 5 Matter (in excess of the amounts already offered as refunds), potential governmental investigations arising from the Take 5 Matter, a reduction in our current and anticipated revenue and a potential deterioration in our associate and client relationships or our reputation. In addition, if we do not prevail in any litigation or governmental investigation related to these matters, we could be subject to costs related to such litigation or governmental investigation, including equitable relief, civil monetary damages, treble damages, repayment or criminal penalties, which may not be covered by insurance or may materially increase our insurance costs. We have incurred and will continue to incur additional substantial professional fees regardless of the outcome of any such litigation or governmental\n62\ninvestigation. In addition, there can be no assurance to what degree, if any, we will be able to recover any such costs or damages from the former owners of Take 5 or whether such former owners of Take 5 engaged in further unknown improper activities that may subject us to further costs or damages, including potential reputational harm. Likewise, such events have caused and may cause further diversion of our management’s time and attention. Any adverse outcome related to these matters cannot be predicted at this time, and may materially harm our business, reputation, financial condition and/or results of operations, or the trading price of our securities.\nOur business is seasonal in nature and quarterly operating results can fluctuate.\nOur services are seasonal in nature, with the fourth fiscal quarter typically generating a higher proportion of our revenues than other fiscal quarters. Adverse events, such as deteriorating economic conditions, higher unemployment, higher gas prices, public transportation disruptions, public health crises (including the COVID-19 pandemic) or unanticipated adverse weather, could result in lower-than-planned sales during key revenue-producing seasons. For example, frequent or unusually heavy snowfall, ice storms, rainstorms, windstorms or other extreme weather conditions over a prolonged period could make it difficult for consumers to travel to retail stores or foodservice locations. Such events could lead to lower revenues, negatively impacting our financial condition and results of operations.\nOur business is competitive, and increased competition could adversely affect our business and results of operations.\nThe sales, marketing and merchandising services industry is competitive. We face competition from a few other large, national or super-regional agencies as well as many niche and regional agencies. Remaining competitive in this industry requires that we closely monitor and respond to trends in all industry sectors. We cannot assure you that we will be able to anticipate and respond successfully to such trends in a timely manner. Moreover, some of our competitors may choose to sell services competitive to ours at lower prices by accepting lower margins and profitability or may be able to sell services competitive to ours at lower prices due to proprietary ownership of data or technical superiority, which could negatively impact the rates that we can charge. If we are unable to compete successfully, it could have a material adverse effect on our business, financial condition and our results of operations. If certain competitors were to combine into integrated sales, marketing and merchandising services companies, additional sales, marketing and merchandising service companies were to enter the market or existing participants in this industry were to become more competitive, including through technological innovation such as social media and crowdsourcing, it could have a material adverse effect on our business, financial condition or results of operations.\nDamage to our reputation could negatively impact our business, financial condition and results of operations.\nOur reputation and the quality of our brand are critical to our business and success in existing markets and will be critical to our success as we enter new markets. We believe that we have built our reputation on the high quality of our sales and marketing services, our commitment to our clients and our performance-based culture, and we must protect and grow the value of our brand in order for us to continue to be successful. Any incident that erodes client loyalty to our brand could significantly reduce its value and damage our business. Also, there has been a marked increase in the use of social media platforms and similar devices, including blogs, social media websites, Twitter and other forms of internet-based communications that provide individuals with access to a broad audience of consumers and other interested persons. Many social media platforms immediately publish the content their subscribers and participants post, often without filters or checks on accuracy of the content posted. Information concerning us may be posted on such platforms at any time. Information posted may be adverse to our interests or may be inaccurate, each of which may harm our performance, prospects or business. The harm may be immediate without affording us an opportunity for redress or correction.\nWe rely on third parties to provide certain data and services in connection with the provision of our services.\nWe rely on third parties to provide certain data and services for use in connection with the provision of our services. For example, we contract with third parties to obtain the raw data on retail product sales and inventories. These suppliers of data may impose restrictions on our use of such data, fail to adhere to our quality control standards, increase the price they charge us for this data or refuse altogether to license the data to us. If we are unable to use such third-party data and services or if we are unable to contract with third parties, when necessary,\n63\nour business, financial condition or our results of operations could be adversely affected. In the event that such data and services are unavailable for our use or the cost of acquiring such data and services increases, our business could be adversely affected.\nWe may be unable to timely and effectively respond to changes in digital practices and policies, which could adversely affect our business, financial condition or results of operations.\nChanges to practices and policies of operating systems, websites and other digital platforms, including, without limitation, Apple’s or Android’s transparency policies, may reduce the quantity and quality of the data and metrics that can be collected or used by us and our clients or reduce the value of our digital services. These limitations may adversely affect both our and our clients’ ability to effectively target and measure the performance of our digital services. In addition, our clients and third party vendors routinely evaluate their digital practices and policies, and if in the future they determine to modify such practices and policies for any reasons, including, without limitation, privacy, targeting, age or content concerns, this could decrease the desire for our digital services as compared to other alternatives. If we are unable to timely or effectively respond to changes in digital practices and policies, or if our clients do not believe that our digital services will generate a competitive return on investment relative to alternatives, then our business, financial condition or results of operations could be adversely affected.\nWe may not be able to adequately protect our intellectual property, which, in turn, could harm the value of our brands and adversely affect our business.\nOur ability to implement our business plan successfully depends in part on our ability to further build brand recognition using our trade names, service marks, trademarks, proprietary products and other intellectual property, including our name and logos. We rely on U.S. and foreign trademark, copyright and trade secret laws, as well as license agreements, nondisclosure agreements and confidentiality and other contractual provisions to protect our intellectual property. Nevertheless, these laws and procedures may not be adequate to prevent unauthorized parties from attempting to copy or otherwise obtain our processes and technology or deter our competitors from developing similar business solutions and concepts, and adequate remedies may not be available in the event of an unauthorized use or disclosure of our trade secrets and other intellectual property.\nThe success of our business depends on our continued ability to use our existing trademarks and service marks to increase brand awareness and further develop our brand in both domestic and international markets. We have registered and applied to register our trade names, service marks and trademarks in the United States and foreign jurisdictions. However, the steps we have taken to protect our intellectual property in the United States and in foreign countries may not be adequate, and third parties may misappropriate, dilute, infringe upon or otherwise harm the value of our intellectual property. If any of our registered or unregistered trademarks, trade names or service marks is challenged, infringed, circumvented or declared generic or determined to be infringing on other marks, it could have an adverse effect on our sales or market position. In addition, the laws of some foreign countries do not protect intellectual property to the same extent as the laws of the United States. Many companies have encountered significant problems in protecting and defending intellectual property rights in certain jurisdictions. This could make it difficult to stop the infringement or misappropriation of our intellectual property rights in foreign jurisdictions.\nWe rely upon trade secrets and other confidential and proprietary know‑how to develop and maintain our competitive position. While it is our policy to enter into agreements imposing nondisclosure and confidentiality obligations upon our employees and third parties to protect our intellectual property, these obligations may be breached, may not provide meaningful protection for our trade secrets or proprietary know‑how, or adequate remedies may not be available in the event of an unauthorized access, use or disclosure of our trade secrets and know‑how. Furthermore, despite the existence of such nondisclosure and confidentiality agreements, or other contractual restrictions, we may not be able to prevent the unauthorized disclosure or use of our confidential proprietary information or trade secrets by consultants, vendors and employees. In addition, others could obtain knowledge of our trade secrets through independent development or other legal means.\nAny claims or litigation initiated by us to protect our proprietary technology could be time consuming, costly and divert the attention of our technical and management resources. If we choose to go to court to stop a third party from infringing our intellectual property, that third party may ask the court to rule that our intellectual property rights are invalid and/or should not be enforced against that third party. Even if the action that we take to protect\n64\nour intellectual property rights is successful, any infringement may still have a material adverse effect on our business, financial condition and results of operations.\nWe may be subject to claims of infringement of third-party intellectual property rights that are costly to defend, result in the diversion of management’s time and efforts, require the payment of damages, limit our ability to use particular technologies in the future or prevent us from marketing our existing or future products and services.\nThird parties may assert that we infringe, misappropriate or otherwise violate their intellectual property, including with respect to our digital solutions and other technologies that are important to our business, and may sue us for intellectual property infringement. We may not be aware of whether our products or services do or will infringe existing or future patents or the intellectual property rights of others. In addition, there can be no assurance that one or more of our competitors who have developed competing technologies or our other competitors will not be granted patents for their technology and allege that we have infringed on such patents.\nAny claims that our business infringes the intellectual property rights of others, regardless of the merit or resolution of such claims, could incur substantial costs, and the time and attention of our management and other personnel may be diverted in pursuing these proceedings. An adverse determination in any intellectual property claim could require us to pay damages, be subject to an injunction, and/or stop using our technologies, trademarks, copyrighted works and other material found to be in violation of another party’s rights, and could prevent us from licensing our technologies to others unless we enter into royalty or licensing arrangements with the prevailing party or are able to redesign our products and services to avoid infringement. With respect to any third-party intellectual property that we use or wish to use in our business (whether or not asserted against us in litigation), we may not be able to enter into licensing or other arrangements with the owner of such intellectual property at a reasonable cost or on reasonable terms. Any of the foregoing could harm our commercial success.\nWe are dependent on proprietary technology licensed from others. If we lose our licenses, we may not be able to continue developing our products.\nWe have obtained licenses that give us rights to third party intellectual property that is necessary or useful to our business. These license agreements may impose various royalty and other obligations on us. One or more of our licensors may allege that we have breached our license agreement with them, and could seek to terminate our license, which could adversely affect our competitive business position and harm our business prospects. In addition, any claims brought against us by our licensors could be costly, time-consuming and divert the attention of our management and key personnel from our business operations.\nConsumer goods manufacturers and retailers, including some of our clients, are subject to extensive governmental regulation and we and they may be subject to enforcement in the event of noncompliance with applicable requirements.\nConsumer goods manufacturers and retailers, including some of our clients, are subject to a broad range of federal, state, local and international laws and regulations governing, among other things, the research, development, manufacture, distribution, marketing and post-market reporting of consumer products. These include laws administered by the U.S. Food and Drug Administration (the “FDA”), the U.S. Drug Enforcement Administration, the U.S. Federal Trade Commission, the U.S. Department of Agriculture and other federal, state, local and international regulatory authorities. For example, certain of our clients market and sell products containing cannabidiol (“CBD”). CBD products are subject to a number of federal, state, local and international laws and regulations restricting their use in certain categories of products and in certain jurisdictions. In particular, the FDA has publicly stated it is prohibited to sell into interstate commerce food, beverages or dietary supplements that contain CBD. These laws are broad in scope and subject to evolving interpretations, which could require us to incur costs associated with new or modified compliance requirements or require us or our clients to alter or limit our activities, including marketing and promotion, of such products, or to remove them from the market altogether.\nIf a regulatory authority determines that we or our current or future clients have not complied with the applicable regulatory requirements, our business may be materially impacted and we or our clients could be subject to enforcement actions or loss of business. We cannot predict the nature of any future laws, regulations, interpretations or applications of the laws, nor can we determine what effect additional laws, regulations or administrative policies and procedures, if and when enacted, promulgated and implemented, could have on our business.\n65\nWe may be subject to claims for products for which we are the vendor of record or may otherwise be in the chain of title.\nFor certain of our clients’ products, we become the vendor of record or otherwise may be in the chain of title. For these products, we could be subject to potential claims for misbranded, adulterated, contaminated, damaged or spoiled products, or could be subject to liability in connection with claims related to infringement of intellectual property, product liability, product recalls or other liabilities arising in connection with the sale or marketing of these products. As a result, we could be subject to claims or lawsuits (including potential class action lawsuits), and we could incur liabilities that are not insured or exceed our insurance coverage or for which the manufacturer of the product does not indemnify us. Even if product claims against us are not successful or fully pursued, these claims could be costly and time consuming and may require our management to spend time defending the claims rather than operating our business.\nA product that has been actually or allegedly misbranded, adulterated or damaged or is actually or allegedly defective could result in product withdrawals or recalls, destruction of product inventory, negative publicity and substantial costs of compliance or remediation. Any of these events, including a significant product liability judgment against us, could result in monetary damages and/or a loss of demand for our products, both of which could have an adverse effect on our business or results of operations.\nWe generate revenues and incur expenses throughout the world that are subject to exchange rate fluctuations, and our results of operations may suffer due to currency translations.\nOur U.S. operations earn revenues and incur expenses primarily in U.S. dollars, while our international operations earn revenues and incur expenses primarily in Canadian dollars, British pounds or euros. Because of currency exchange rate fluctuations, including possible devaluations, we are subject to currency translation exposure on the results of our operations, in addition to economic exposure. There has been, and may continue to be, volatility in currency exchange rates as a result of the United Kingdom’s withdrawal from the European Union, especially between the U.S. dollar and the British pound. These risks could adversely impact our business or results of operations.\nFluctuations in our tax obligations and effective tax rate and realization of our deferred tax assets may result in volatility of our operating results.\nWe are subject to taxes by the U.S. federal, state, local and foreign tax authorities, and our tax liabilities will be affected by the allocation of expenses to differing jurisdictions. We record tax expense based on our estimates of future payments, which may include reserves for uncertain tax positions in multiple tax jurisdictions, and valuation allowances related to certain net deferred tax assets. At any one time, many tax years may be subject to audit by various taxing jurisdictions. The results of these audits and negotiations with taxing authorities may affect the ultimate settlement of these matters. We expect that throughout the year there could be ongoing variability in our quarterly tax rates as events occur and exposures are evaluated. Our future effective tax rates could be subject to volatility or adversely affected by a number of factors, including:\n•changes in the valuation of our deferred tax assets and liabilities;\n•expected timing and amount of the release of any tax valuation allowance;\n•tax effects of equity-based compensation;\n•changes in tax laws, regulations or interpretations thereof; or\n•future earnings being lower than anticipated in jurisdictions where we have lower statutory tax rates and higher than anticipated earnings in jurisdictions where we have higher statutory tax rates.\nIn addition, our effective tax rate in a given financial statement period may be materially impacted by a variety of factors including but not limited to changes in the mix and level of earnings, varying tax rates in the different jurisdictions in which we operate, fluctuations in the valuation allowance, deductibility of certain items or changes to existing accounting rules or regulations. Further, tax legislation may be enacted in the future which could negatively impact our current or future tax structure and effective tax rates. We may be subject to audits of\n66\nour income, sales and other transaction taxes by U.S. federal, state, local and foreign taxing authorities. Outcomes from these audits could have an adverse effect on our operating results and financial condition.\nRisks Related to Ownership of Our Common Stock\nWe are controlled by Topco, the Advantage Sponsors, and the CP Sponsor, whose economic and other interests in our business may be different from yours.\nOur authorized capital stock consists of 3,290,000,000 shares of Class A common stock, and as of November 8, 2022, certain equityholders of Topco (the “Advantage Sponsors”), Topco and Conyers Park II Sponsor LLC, an affiliate of Centerview Capital Management, LLC, which was Conyers Park’s sponsor prior to the Merger (the “CP Sponsor”), collectively own 254,310,000 shares, or 79.55% (including 65.30% held by Topco), of our outstanding Class A common stock. Subject to applicable law, the Advantage Sponsors, through their direct ownership of our common stock and their ownership of equity interests of Topco, and the CP Sponsor are able to exert significant influence in the election of our directors and control actions to be taken by our stockholders, including amendments to our third amended and restated certificate of incorporation and approval of mergers, sales of substantially all of our assets, and other significant corporate transactions. It is possible that the interests of Topco, the Advantage Sponsors and the CP Sponsor may in some circumstances conflict with our interests and the interests of our other stockholders, including you.\nWe are a controlled company within the meaning of the Nasdaq Stock Market LLC listing requirements and as a result, may rely on exemptions from certain corporate governance requirements. To the extent we rely on such exemptions, you will not have the same protections afforded to stockholders of companies that are subject to such corporate governance requirements.\nBecause of the voting power over our company held by Topco, the Advantage Sponsors, and the CP Sponsor and the voting arrangement between such parties, we are considered a controlled company for the purposes of the Nasdaq Stock Market LLC (“Nasdaq”) listing requirements. As such, we are exempt from the corporate governance requirements that our board of directors, compensation committee, and nominating and corporate governance committee meet the standard of independence established by those corporate governance requirements. The independence standards are intended to ensure that directors who meet the independence standards are free of any conflicting interest that could influence their actions as directors.\nWe do not currently utilize the exemptions afforded to a controlled company, though we are entitled to do so. To the extent we utilize these exemptions, you will not have the same protections afforded to stockholders of companies that are subject to all of the corporate governance requirements of Nasdaq.\nThe anti-takeover provisions of our certificate of incorporation and bylaws could prevent or delay a change in control of us, even if such change in control would be beneficial to our stockholders.\nProvisions of our certificate of incorporation and bylaws, as well as provisions of Delaware law, could discourage, delay, or prevent a merger, acquisition, or other change in control of us, even if such change in control would be beneficial to our stockholders. These include:\n•authorizing the issuance of “blank check” preferred stock that could be issued by our board of directors to increase the number of outstanding shares and thwart a takeover attempt;\n•provision for a classified board of directors so that not all members of our board of directors are elected at one time;\n•not permitting the use of cumulative voting for the election of directors;\n•permitting the removal of directors only for cause;\n•limiting the ability of stockholders to call special meetings; •requiring all stockholder actions to be taken at a meeting of our stockholders;\n•requiring approval of the holders of at least two-thirds of the shares entitled to vote at an election of directors to adopt, amend, or repeal the proposed bylaws or repeal the provisions of the third amended and restated certificate of incorporation regarding the election and removal of directors; and\n67\n•establishing advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings.\nIn addition, although we have opted out of Section 203 of the Delaware General Corporation Law (“DGCL”), our certificate of incorporation contain similar provisions providing that we may not engage in certain “business combinations” with any “interested stockholder” for a three-year period following the time that the stockholder became an interested stockholder, subject to certain exceptions. Generally, a “business combination” includes a merger, asset, or stock sale or other transaction resulting in a financial benefit to the interested stockholder.\nSubject to certain exceptions, an “interested stockholder” is a person who, together with that person’s affiliates and associates, owns, or within the previous three years owned, 15% or more of our outstanding voting stock.\nUnder certain circumstances, this provision will make it more difficult for a person who would be an “interested stockholder” to effect various business combinations with us for a three-year period. These provisions also may have the effect of preventing changes in our board of directors and may make it more difficult to accomplish transactions which stockholders may otherwise deem to be in their best interests.\nMoreover, our certificate of incorporation provides that Topco and its affiliates do not constitute “interested stockholders” for purposes of this provision, and thus any business combination transaction between us and Topco and its affiliates would not be subject to the protections otherwise provided by this provision. Topco and its affiliates are not prohibited from selling a controlling interest in us to a third party and may do so without your approval and without providing for a purchase of your shares of common stock, subject to the lock-up restrictions applicable to Topco. Accordingly, your shares of common stock may be worth less than they would be if Topco and its affiliates did not maintain voting control over us.\nThe provisions of our certificate of incorporation and bylaws requiring exclusive venue in the Court of Chancery in the State of Delaware or the federal district courts of the United States of America for certain types of lawsuits may have the effect of discouraging lawsuits against our directors and officers.\nOur certificate of incorporation and bylaws require, to the fullest extent permitted by law, that (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of a fiduciary duty owed by any of our directors, officers, or other employees to us or our stockholders, (iii) any action asserting a claim against us arising pursuant to any provision of the DGCL or our certificate of incorporation or bylaws, or (iv) any action asserting a claim against us governed by the internal affairs doctrine will have to be brought only in the Court of Chancery in the State of Delaware (or the federal district court for the District of Delaware or other state courts of the State of Delaware if the Court of Chancery in the State of Delaware does not have jurisdiction).\nOur certificate of incorporation and bylaws also require that the federal district courts of the United States of America will be the exclusive forum for the resolution of any complaint asserting a cause of action arising under the Securities Act; however, there is uncertainty as to whether a court would enforce such provision, and investors cannot waive compliance with federal securities laws and the rules and regulations thereunder. Although we believe these provisions benefit us by providing increased consistency in the application of applicable law in the types of lawsuits to which they apply, the provisions may have the effect of discouraging lawsuits against our directors and officers. These provisions do not apply to any suits brought to enforce any liability or duty created by the Exchange Act or any other claim for which the federal courts of the United States have exclusive jurisdiction.\nBecause we have no current plans to pay cash dividends on our Class A common stock, you may not receive any return on investment unless you sell your Class A common stock for a price greater than that which you paid for it.\nWe have no current plans to pay cash dividends on our Class A common stock. The declaration, amount and payment of any future dividends on our Class A common stock will be at the discretion of our board of directors and will depend upon our results of operations, financial condition, capital requirements, and other factors that our board of directors deems relevant. The payment of cash dividends is also restricted under the terms of the agreements governing our debt and our ability to pay dividend may also be restricted by the terms of any future credit agreement or any securities we or our subsidiaries may issue.\n68\nAn active, liquid trading market for our Class A common stock may not be available.\nWe cannot predict the extent to which investor interest in our company will lead to availability of a trading market on Nasdaq or otherwise in the future or how active and liquid that market may be for our Class A common stock. If an active and liquid trading market is not available, you may have difficulty selling any of our Class A common stock. Among other things, in the absence of a liquid public trading market:\n•you may not be able to liquidate your investment in shares of Class A common stock;\n•you may not be able to resell your shares of Class A common stock at or above the price attributed to them in the Transactions;\n•the market price of shares of Class A common stock may experience significant price volatility; and\n•there may be less efficiency in carrying out your purchase and sale orders.\nThe trading price of our Class A common stock may be volatile or may decline regardless of our operating performance.\nThe market prices for our Class A common stock are likely to be volatile and may fluctuate significantly in response to a number of factors, most of which we cannot control, including:\n•quarterly variations in our operating results compared to market expectations;\n•changes in preferences of our clients;\n•announcements of new products or services or significant price reductions;\n•the size of our public float;\n•fluctuations in stock market prices and volumes;\n•defaults on our indebtedness;\n•changes in senior management or key personnel;\n•the granting, vesting, or exercise of employee stock options, restricted stock, or other equity rights;\n•the payment of any dividends thereon in shares of our common stock;\n•changes in financial estimates or recommendations by securities analysts;\n•negative earnings or other announcements by us;\n•downgrades in our credit ratings;\n•material litigation or governmental investigations;\n•issuances of capital stock;\n•global economic, legal, and regulatory factors unrelated to our performance, including the COVID-19 pandemic; or\n•the realization of any risks described in this Quarterly Report under “Risk Factors.”\nIn addition, in the past, stockholders have instituted securities class action litigation against companies following periods of market volatility. If we were involved in securities litigation, we could incur substantial costs and our resources and the attention of management could be diverted from our business.\nWe cannot provide any guaranty that we will continue to repurchase our common stock pursuant to our stock repurchase program.\nIn November 2021, our board of directors authorized a share repurchase program, under which we may repurchase up to $100 million of our outstanding Class A common stock (the “2021 Share Repurchase Program”). As of September 30, 2022, the remaining amount available for repurchase pursuant to the 2021 Share Repurchase Program is $87.4 million. However, we are not obligated to make any further purchases under the 2021 Share Repurchase Program and we may suspend or permanently discontinue this program at any time or significantly reduce the amount of repurchases under the program. Any announcement of a suspension, discontinuance or reduction of this program may negatively impact our reputation and investor confidence.\n69\nThe valuation of our private placement warrants could increase the volatility in our net income (loss) in our consolidated statements of earnings (loss).\nThe change in fair value of our private placement warrants is determined using the fair value of the liability classified private placement warrants by approximating the value with the share price of the public warrants. The change in fair value of warrant liability represents the mark-to-market fair value adjustments to the outstanding private placement warrants issued in connection with the initial public offering of Conyers Park. Significant changes in share price of the public warrants may adversely affect the volatility in our net income (loss) in our Condensed Consolidated Statements of Operations and Comprehensive Income.\nRisks Related to Indebtedness\nWe need to continue to generate significant operating cash flow in order to fund acquisitions and to service our debt.\nOur business currently generates operating cash flow, which we use to fund acquisitions to grow our business and to service our substantial indebtedness. If, because of loss of revenue, pressure on pricing from customers, increases in our costs (including increases in costs related to servicing our indebtedness or labor costs), general economic, financial, competitive, legislative, regulatory conditions or other factors, including any acceleration of the foregoing as a result of the COVID-19 pandemic, many of which are outside of our control our business generates less operating cash flow, we may not have sufficient funds to grow our business or to service our indebtedness.\nIf we are unable to generate sufficient cash flow or are otherwise unable to obtain funds necessary to meet required payments of principal, premium, if any, and interest on our indebtedness, or if we otherwise fail to comply with the various covenants in the agreements governing our indebtedness, we could be in default under the terms of the agreements governing such indebtedness. In the event of such default, the lenders under our credit facilities could elect to terminate their commitments thereunder, cease making further loans and institute foreclosure proceedings against our assets, and we could be forced into bankruptcy or liquidation. If our operating performance declines, we may in the future need to obtain waivers from the required lenders under our credit agreements to avoid being in default. If we or any of our subsidiaries breach the covenants under our credit agreements and seek a waiver, we may not be able to obtain a waiver from the required lenders. If this occurs, we would be in default under our credit agreements, the lenders could exercise their rights as described above, and we could be forced into bankruptcy or liquidation.\nOur substantial indebtedness could adversely affect our financial health, restrict our activities, and affect our ability to meet our obligations.\nWe have a significant amount of indebtedness. As of September 30, 2022, we had total indebtedness of $2.1 billion, excluding debt issuance costs, with an additional $54.5 million of letters of credit outstanding under our revolving credit facility. The agreements governing our indebtedness contain customary covenants that restrict us from taking certain actions, such as incurring additional debt, permitting liens on pledged assets, making investments, paying dividends or making distributions to equity holders, prepaying junior debt, engaging in mergers or restructurings, and selling assets, among other things, which may restrict our ability to successfully execute on our business plan. For a more detailed description of the covenants and material terms of our material indebtedness, please see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” in this Quarterly Report.\nDespite current indebtedness levels, we and our subsidiaries may still be able to incur additional indebtedness, which could increase the risks associated with our indebtedness.\nWe and our subsidiaries may be able to incur additional indebtedness in the future because the terms of our indebtedness do not fully prohibit us or our subsidiaries from doing so. Subject to covenant compliance and certain conditions, as of September 30, 2022, the agreements governing our indebtedness would have permitted us to borrow up to an additional $345.5 million under our revolving credit facility. In addition, we and our subsidiaries have, and will have, the ability to incur additional indebtedness as incremental facilities under our credit agreement\n70\nand we or our subsidiaries may issue additional notes in the future. If additional debt is added to our current debt levels and our subsidiaries’ current debt levels, the related risks that we and they now face could increase.\nFailure to maintain our credit ratings could adversely affect our liquidity, capital position, ability to hedge certain financial risks, borrowing costs, and access to capital markets.\nOur credit risk is evaluated by the major independent rating agencies, and such agencies have in the past downgraded, and could in the future downgrade, our ratings. Our credit rating may impact the interest rates on any future indebtedness as well as the applicability of certain covenants in the agreements governing our indebtedness. We cannot assure you that we will be able to maintain our current credit ratings, and any additional, actual or anticipated changes or downgrades in our credit ratings, including any announcement that our ratings are under further review for a downgrade, may have a negative impact on our liquidity, capital position, ability to hedge certain financial risks, and access to capital markets.\nOur variable rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase significantly.\nBorrowings under our credit facilities are at variable rates of interest and expose us to interest rate risk. If interest rates were to increase, our debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same, and our net income and cash flows, including cash available for servicing our indebtedness, will correspondingly decrease. On a pro forma basis, assuming no other prepayments of the credit facility and that our revolving credit facility is fully drawn (and to the extent that LIBOR is in excess of the 0.00% and 0.75% floors applicable to our revolving credit facility and our term loan credit facility, respectively), each one-eighth percentage point change in interest rates would result in an approximately $1.0 million change in interest expense, net of gains from interest rate caps, for the nine months ended September 30, 2022. In the future, we may enter into interest rate swaps that involve the exchange of floating- for fixed-rate interest payments in order to reduce interest rate volatility or risk. However, we may not maintain interest rate swaps with respect to any of our variable rate indebtedness, and any swaps we enter into may not fully or effectively mitigate our interest rate risk.\nThe elimination of LIBOR after June 2023 may affect our financial results\nCertain of our financial arrangements, including the Senior Secured Credit Facilities, were made at variable rates that use the London Interbank Offered Rate, or LIBOR (or metrics derived from or related to LIBOR), as a benchmark for establishing the interest rate. All LIBOR tenors relevant to us will cease to be published or will no longer be representative after June 30, 2023. This means that any of our LIBOR-based borrowings that extend beyond June 30, 2023 will need to be converted to a replacement rate. In the U.S., the Alternative Reference Rates Committee (the “ARRC”) convened by the Federal Reserve Board and the Federal Reserve Bank of New York has recommended the Secured Overnight Financing Rate (“SOFR”) plus a recommended spread adjustment as LIBOR’s replacement. There are significant differences between LIBOR and SOFR, such as LIBOR being an unsecured lending rate while SOFR is a secured lending rate, and SOFR being an overnight rate while LIBOR reflects term rates at different maturities. If our LIBOR-based financing arrangements are converted to SOFR, the differences between LIBOR and SOFR, plus the recommended spread adjustment, could result in interest costs that are higher than if LIBOR remained available, which could adversely impact our operating results. Although SOFR is the ARRC’s recommended replacement rate, it is also possible that lenders and other counterparties may instead choose alternative replacement rates that may differ from LIBOR in ways similar to SOFR or in other ways that would result in higher interest costs for us. There is no assurance that any alternative reference rate, including SOFR, will be similar to, or produce the same value or economic equivalence as, LIBOR, and there continues to be uncertainty regarding the nature of potential changes to and future utilization of specific LIBOR tenors, the development and acceptance of SOFR or alternative reference rates, and other reforms. These consequences cannot be entirely predicted and could have an adverse impact on the market value for or value of LIBOR-linked securities, loans and other financial obligations or extensions of credit held by or due to us. Changes in market interest rates may influence our financing costs, returns on financial investments and the valuation of derivative contracts and could reduce our earnings and cash flows.\n71\nGeneral Risk Factors\nOur business and financial results may be affected by various litigation and regulatory proceedings.\nWe are subject to litigation and regulatory proceedings in the normal course of business and could become subject to additional claims in the future. These proceedings have included, and in the future may include, matters involving personnel and employment issues, workers’ compensation, personal and property injury, disputes relating to acquisitions (including contingent consideration), governmental investigations and other proceedings. Some historical and current legal proceedings and future legal proceedings may purport to be brought as class actions or representative basis on behalf of similarly situated parties including with respect to employment-related matters. We cannot be certain of the ultimate outcomes of any such claims, and resolution of these types of matters against us may result in significant fines, judgments or settlements, which, if uninsured, or if the fines, judgments and settlements exceed insured levels, could adversely affect our business or financial results. See “Legal Proceedings.”\nWe are subject to many federal, state, local and international laws with which compliance is both costly and complex.\nOur business is subject to various, and sometimes complex, laws and regulations, including those that have been or may be implemented in response to the COVID-19 pandemic. In order to conduct our operations in compliance with these laws and regulations, we must obtain and maintain numerous permits, approvals and certificates from various federal, state, local and international governmental authorities. We may incur substantial costs in order to maintain compliance with these existing laws and regulations. In addition, our costs of compliance may increase if existing laws and regulations are revised or reinterpreted or if new laws and regulations become applicable to our operations. These costs could have an adverse impact on our business or results of operations. Moreover, our failure to comply with these laws and regulations, as interpreted and enforced, could lead to fines, penalties or management distraction or otherwise harm our business.\nOur insurance may not provide adequate levels of coverage against claims.\nWe believe that we maintain insurance customary for businesses of our size and type. However, there are types of losses we may incur that cannot be insured against or that we believe are not economically reasonable to insure. Further, insurance may not continue to be available to us on acceptable terms, if at all, and, if available, coverage may not be adequate. If we are unable to obtain insurance at an acceptable cost or on acceptable terms, we could be exposed to significant losses.\nWe have incurred and will continue to incur increased costs as a public company.\nAs a public company, we have incurred and will continue to incur significant legal, accounting, insurance, and other expenses that we did not incur as a private company, including costs associated with public company reporting requirements. We also have incurred and will incur costs associated with the Sarbanes-Oxley Act and related rules implemented by the SEC. The expenses incurred by public companies for reporting and corporate governance purposes generally have been increasing. We expect these rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly, although we are currently unable to estimate these costs with any degree of certainty. In estimating these costs, we took into account expenses related to insurance, legal, accounting, and compliance activities, as well as other expenses not currently incurred. These laws and regulations could also make it more difficult or costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. These laws and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, on our board committees, or as our executive officers. Furthermore, if we are unable to satisfy our obligations as a public company, we could be subject to delisting of our Class A common stock, fines, sanctions, and other regulatory action and potentially civil litigation.\nOur management has limited experience in operating a public company.\nOur executive officers have limited experience in the management of a publicly traded company. Our management team may not successfully or effectively manage our transition to a public company that will be\n72\nsubject to significant regulatory oversight and reporting obligations under federal securities laws. Their limited experience in dealing with the increasingly complex laws pertaining to public companies could be a significant disadvantage in that it is likely that an increasing amount of their time may be devoted to these activities which will result in less time being devoted to the management and growth of the Company. We may not have adequate personnel with the appropriate level of knowledge, experience, and training in the accounting policies, practices or internal control over financial reporting required of public companies in the United States. The development and implementation of the standards and controls necessary for the Company to achieve the level of accounting standards required of a public company in the United States may require costs greater than expected. It is possible that we will be required to expand our employee base and hire additional employees to support our operations as a public company which will increase our operating costs in future periods.\nIf securities analysts do not publish research or reports about our business or if they publish negative evaluations of our common stock, the price of our Class A common stock could decline.\nThe trading market for our Class A common stock will rely in part on the research and reports that industry or financial analysts publish about us or our business. If few analysts commence coverage of us, the trading price of our stock could be negatively affected. Even with analyst coverage, if one or more of the analysts covering our business downgrade their evaluations of our stock, the price of our Class A common stock could decline. If one or more of these analysts cease to cover our common stock, we could lose visibility in the market for our Class A common stock, which in turn could cause our Class A common stock price to decline.\nSubstantial future sales of our Class A common stock, or the perception in the public markets that these sales may occur, may depress our stock price.\nSales of substantial amounts of our common stock in the public market, or the perception that these sales could occur, could adversely affect the price of our common stock and could impair our ability to raise capital through the sale of additional shares. Certain shares of our common stock are freely tradable without restriction under the Securities Act, except for any shares of our common stock that may be held or acquired by our directors, executive officers, and other affiliates, as that term is defined in the Securities Act, which are to be restricted securities under the Securities Act. Restricted securities may not be sold in the public market unless the sale is registered under the Securities Act or an exemption from registration is available. Topco, the Advantage Sponsors, the CP Sponsor and members of our management have rights, subject to certain conditions, to require us to file registration statements covering Topco’s shares of our common stock or to include shares in registration statements that we may file for ourselves or other stockholders. In each of November 2020 and March 2021, we filed a registration statement on Form S-1 under which certain of our shareholders may sell, from time to time, 50,000,000 shares and 255,465,000 shares of our Class A common stock, respectively, that, if sold, will be freely tradable without restriction under the Securities Act. In the event a large number of shares of Class A common stock are sold in the public market, such sales could reduce the market price of our Class A common stock.\nWe may also issue shares of our common stock or securities convertible into our common stock from time to time in connection with financings, acquisitions, investments, or otherwise. Any such issuance could result in ownership dilution to you as a stockholder and cause the trading price of our common stock to decline.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nNone\nItem 3. Defaults Upon Senior Securities\nNone\nItem 4. Mine Safety Disclosures\nNone\n73\nItem 5. Other Information\nNone\nITEM 6. Exhibits\nThe following exhibits are filed with this Report:\n\n| ExhibitNumber | Description |\n| 31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934 |\n| 31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934 |\n| 32.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350 |\n| 32.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350 |\n| 101.INS | Inline XBRL Instance Document – the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\n\n***\n74\nSIGNATURES\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| ADVANTAGE SOLUTIONS INC. |\n| By: | /s/ Jill Griffin |\n| Jill Griffin |\n| Chief Executive Officer (Principal Executive Officer) |\n| Date: | November 9, 2022 |\n| By: | /s/ Brian Stevens |\n| Brian Stevens |\n| Chief Financial Officer and Chief Operating |\n| Officer (Principal Financial Officer) |\n| Date: | November 9, 2022 |\n\n75\n</text>\n\nWhat is the percentage change in the company's total net worth between July 1, 2021 and September 30, 2021?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1 – Financial Statements\n3\n Consolidated Balance Sheets (Unaudited) 3\n Consolidated Statements of Income (Unaudited) 4\n Consolidated Statements of Comprehensive Income (Unaudited) 5\n Consolidated Statements of Cash Flows (Unaudited) 6\n Notes to Consolidated Financial Statements (Unaudited) 7\n Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations 28\n Item 3 – Quantitative and Qualitative Disclosure about Market Risk 44\n Item 4 – Controls and Procedures 45\n PART II – Other Information 46\n Item 1 – Legal Proceedings 46\n Item 1A – Risk Factors 46\n Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds 46\n Item 3 – Defaults Upon Senior Securities 47\n Item 5 – Other Information 48\n Item 6 – Exhibits 48\n SIGNATURES 49\nCertifications\n2\nPART 1 – FINANCIAL INFORMATION\nItem 1 - Financial Statements\n\nREADING INTERNATIONAL, INC.\nCONSOLIDATED BALANCE SHEETS\n(Unaudited; U.S. dollars in thousands, except share information)\n\n\n| |\n| |\n| | March 31, | December 31, |\n| | 2019 | 2018 |\n| ASSETS | (unaudited) |\n| Current Assets: |\n| Cash and cash equivalents | $ | 12,648 | $ | 13,127 |\n| Receivables | 7,094 | 8,045 |\n| Inventory | 1,165 | 1,419 |\n| Prepaid and other current assets | 9,642 | 7,667 |\n| Total current assets | 30,549 | 30,258 |\n| Operating property, net | 257,402 | 257,667 |\n| Operating lease right-of-use assets | 229,266 | — |\n| Investment and development property, net | 95,156 | 86,804 |\n| Investment in unconsolidated joint ventures | 4,958 | 5,121 |\n| Goodwill | 20,836 | 19,445 |\n| Intangible assets, net | 3,694 | 7,369 |\n| Deferred tax asset, net | 26,483 | 26,235 |\n| Other assets | 6,199 | 6,129 |\n| Total assets | $ | 674,543 | $ | 439,028 |\n| LIABILITIES AND STOCKHOLDERS' EQUITY |\n| Current Liabilities: |\n| Accounts payable and accrued liabilities | $ | 23,492 | $ | 26,154 |\n| Film rent payable | 6,559 | 8,661 |\n| Debt - current portion | 40,077 | 30,393 |\n| Derivative financial instruments - current portion | 52 | 41 |\n| Taxes payable - current | 571 | 1,710 |\n| Deferred current revenue | 7,712 | 9,264 |\n| Operating lease liabilities - current portion | 19,797 | — |\n| Other current liabilities | 9,525 | 9,305 |\n| Total current liabilities | 107,785 | 85,528 |\n| Debt - long-term portion | 113,816 | 106,286 |\n| Derivative financial instruments - non-current portion | 203 | 145 |\n| Subordinated debt, net | 26,116 | 26,061 |\n| Noncurrent tax liabilities | 11,737 | 11,530 |\n| Operating lease liabilities - non-current portion | 222,594 | — |\n| Other liabilities | 12,346 | 28,931 |\n| Total liabilities | 494,597 | 258,481 |\n| Commitments and contingencies (Note 13) |\n| Stockholders’ equity: |\n| Class A non-voting common stock, par value $0.01, 100,000,000 shares authorized, |\n| 33,172,823 issued and 21,249,935 outstanding at March 31, 2019 and 33,112,337 issued and 21,194,748 outstanding at December 31, 2018 | 233 | 232 |\n| Class B voting common stock, par value $0.01, 20,000,000 shares authorized and |\n| 1,680,590 issued and outstanding at March 31, 2019 and December 31, 2018 | 17 | 17 |\n| Nonvoting preferred stock, par value $0.01, 12,000 shares authorized and no issued |\n| or outstanding shares at March 31, 2019 and December 31, 2018 | — | — |\n| Additional paid-in capital | 147,472 | 147,452 |\n| Retained earnings | 45,563 | 47,616 |\n| Treasury shares | (25,231) | (25,222) |\n| Accumulated other comprehensive income | 7,625 | 6,115 |\n| Total Reading International, Inc. stockholders’ equity | 175,679 | 176,210 |\n| Noncontrolling interests | 4,267 | 4,337 |\n| Total stockholders’ equity | 179,946 | 180,547 |\n| Total liabilities and stockholders’ equity | $ | 674,543 | $ | 439,028 |\n\n\nSee accompanying Notes to the Unaudited Consolidated Financial Statements.\n3\nREADING INTERNATIONAL, INC.\nCONSOLIDATED STATEMENTS OF INCOME\n(Unaudited; U.S. dollars in thousands, except per share data)\n\n\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| | 2019 | 2018 |\n| Revenue |\n| Cinema | $ | 57,986 | $ | 72,255 |\n| Real estate | 3,565 | 3,617 |\n| Total revenue | 61,551 | 75,872 |\n| Costs and expenses |\n| Cinema | (48,329) | (54,948) |\n| Real estate | (2,445) | (2,384) |\n| Depreciation and amortization | (5,594) | (5,250) |\n| General and administrative | (6,484) | (7,597) |\n| Total costs and expenses | (62,852) | (70,179) |\n| Operating income (loss) | (1,301) | 5,693 |\n| Interest expense, net | (1,852) | (1,594) |\n| Other income (expense) | (20) | (82) |\n| Income (loss) before income tax expense and equity earnings of unconsolidated joint ventures | (3,173) | 4,017 |\n| Equity earnings of unconsolidated joint ventures | 34 | 257 |\n| Income (loss) before income taxes | (3,139) | 4,274 |\n| Income tax benefit (expense) | 1,042 | (1,170) |\n| Net income (loss) | $ | (2,097) | $ | 3,104 |\n| Less: net income (loss) attributable to noncontrolling interests | (16) | 22 |\n| Net income (loss) attributable to Reading International, Inc. common shareholders | $ | (2,081) | $ | 3,082 |\n| Basic earnings (loss) per share attributable to Reading International, Inc. shareholders | $ | (0.09) | $ | 0.13 |\n| Diluted earnings (loss) per share attributable to Reading International, Inc. shareholders | $ | (0.09) | $ | 0.13 |\n| Weighted average number of shares outstanding–basic | 22,920,486 | 22,967,237 |\n| Weighted average number of shares outstanding–diluted | 23,124,106 | 23,132,989 |\n\n\nSee accompanying Notes to the Unaudited Consolidated Financial Statements.\n4\nREADING INTERNATIONAL, INC.\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME\n(Unaudited; U.S. dollars in thousands)\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| | 2019 | 2018 |\n| Net income (loss) | $ | (2,097) | $ | 3,104 |\n| Foreign currency translation gain (loss) | 1,526 | (803) |\n| Gain (loss) on cash flow hedges | (69) | — |\n| Other | 53 | 50 |\n| Comprehensive income (loss) | (587) | 2,351 |\n| Less: net income (loss) attributable to noncontrolling interests | (16) | 22 |\n| Less: comprehensive income (loss) attributable to noncontrolling interests | 1 | (3) |\n| Comprehensive income (loss) attributable to Reading International, Inc. | $ | (572) | $ | 2,332 |\n\n\nSee accompanying Notes to the Unaudited Consolidated Financial Statements.\n5\nREADING INTERNATIONAL, INC.\nCONSOLIDATED STATEMENTS OF CASH FLOWS\n(Unaudited; U.S. dollars in thousands)\n\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| | 2019 | 2018 |\n| Operating Activities |\n| Net income (loss) | $ | (2,097) | $ | 3,104 |\n| Adjustments to reconcile net income (loss) to net cash provided by operating activities: |\n| Equity earnings of unconsolidated joint ventures | (34) | (257) |\n| Distributions of earnings from unconsolidated joint ventures | 249 | 236 |\n| Amortization of operating leases | 5,895 | — |\n| Amortization of finance leases | 41 | — |\n| Change in operating lease liabilities | (5,754) | — |\n| Interest on hedged derivatives | (5) | — |\n| Change in net deferred tax assets | (150) | 172 |\n| Depreciation and amortization | 5,594 | 5,250 |\n| Other amortization | 341 | 224 |\n| Stock based compensation expense | 280 | 379 |\n| Net changes in operating assets and liabilities: |\n| Receivables | 993 | 3,205 |\n| Prepaid and other assets | (1,957) | (2,309) |\n| Payments for accrued pension | (171) | (2,404) |\n| Accounts payable and accrued expenses | (2,204) | 1,997 |\n| Film rent payable | (2,132) | (5,790) |\n| Taxes payable | (1,151) | 150 |\n| Deferred revenue and other liabilities | (1,579) | (1,505) |\n| Net cash provided by (used in) operating activities | (3,841) | 2,452 |\n| Investing Activities |\n| Purchases of and additions to operating and investment properties | (11,476) | (23,231) |\n| Acquisition of business combinations | (1,380) | — |\n| Change in restricted cash | 243 | (260) |\n| Net cash provided by (used in) investing activities | (12,613) | (23,491) |\n| Financing Activities |\n| Repayment of long-term borrowings | (6,113) | (9,707) |\n| Repayment of finance lease principle | (41) | — |\n| Proceeds from borrowings | 22,349 | 25,998 |\n| Repurchase of Class A Nonvoting Common Stock | (9) | (317) |\n| (Cash paid) proceeds from the exercise of stock options | (259) | 203 |\n| Noncontrolling interest contributions | 18 | 27 |\n| Noncontrolling interest distributions | (27) | (43) |\n| Net cash provided by (used in) financing activities | 15,918 | 16,161 |\n| Effect of exchange rate changes on cash and cash equivalents | 57 | (122) |\n| Net decrease in cash and cash equivalents | (479) | (5,000) |\n| Cash and cash equivalents at January 1 | 13,127 | 13,668 |\n| Cash and cash equivalents at March 31 | $ | 12,648 | $ | 8,668 |\n| Supplemental Disclosures |\n| Interest paid | $ | 2,304 | $ | 2,121 |\n| Income taxes paid | 1,883 | 808 |\n| Non-Cash Transactions |\n| Additions to operating and investing properties through accrued expenses | 3,423 | 4,530 |\n\n\nSee accompanying Notes to the Unaudited Consolidated Financial Statements.\n6\nREADING INTERNATIONAL, INC.\nNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)\nNote 1 – Description of Business and Segment Reporting\nThe Company\nReading International, Inc., a Nevada corporation (“RDI” and collectively with our consolidated subsidiaries and corporate predecessors, the “Company”, “Reading” and “we”, “us”, or “our”), was incorporated in 1999. Our businesses consist primarily of:\n| · | the operation, development and ownership of multiplex cinemas in the United States, Australia, and New Zealand; and, |\n\n| · | the development, ownership, operation and/or rental of retail, commercial and live venue real estate assets in Australia, New Zealand, and the United States. |\n\n\nBusiness Segments\nReported below are the operating segments of the Company for which separate financial information is available and evaluated regularly by the Chief Executive Officer, the chief operating decision-maker of the Company. As part of our real estate activities, we hold undeveloped land in urban and suburban centers in Australia, New Zealand, and the United States.\n\nThe table below summarizes the results of operations for each of our business segments for the quarter ended March 31, 2019 and 2018, respectively. Operating expense includes costs associated with the day-to-day operations of the cinemas and the management of rental properties, including our live theater assets.\n\n\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Revenue: |\n| Cinema exhibition | $ | 57,986 | $ | 72,255 |\n| Real estate | 5,431 | 6,008 |\n| Inter-segment elimination | (1,866) | (2,391) |\n| | $ | 61,551 | $ | 75,872 |\n| Segment operating income (loss): |\n| Cinema exhibition | $ | 2,642 | $ | 10,285 |\n| Real estate | 1,159 | 1,681 |\n| | $ | 3,801 | $ | 11,966 |\n\n\nA reconciliation of segment operating income to income before income taxes is as follows:\n\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Segment operating income (loss) | $ | 3,801 | $ | 11,966 |\n| Unallocated corporate expense |\n| Depreciation and amortization expense | (61) | (117) |\n| General and administrative expense | (5,041) | (6,156) |\n| Interest expense, net | (1,852) | (1,594) |\n| Equity earnings of unconsolidated joint ventures | 34 | 257 |\n| Other income (expense) | (20) | (82) |\n| Income (loss) before income tax expense | $ | (3,139) | $ | 4,274 |\n\nNote 2 – Summary of Significant Accounting Policies\n\nBasis of Consolidation\nThe accompanying consolidated financial statements include the accounts of the Company’s wholly-owned subsidiaries as well as majority-owned subsidiaries that the Company controls, and should be read in conjunction with the Company’s Annual Report on Form 10-K as of and for the year ended December 31, 2018 (“2018 Form 10-K”). All significant intercompany balances and transactions have been eliminated on consolidation. These consolidated financial statements were prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim reporting with the instructions for Form 10-Q and Rule 10-01 of Regulation S-X of the Securities and Exchange Commission (“SEC”). As such, they do not include\n7\nall information and footnotes required by U.S. GAAP for complete financial statements. We believe that we have included all normal and recurring adjustments necessary for a fair presentation of the results for the interim period.\n\nOperating results for the quarter ended March 31, 2019 are not necessarily indicative of the results that may be expected for the year ending December 31, 2019.\n\nUse of Estimates\nThe preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and footnotes thereto. Significant estimates include (i) projections we make regarding the recoverability and impairment of our assets (including goodwill and intangibles), (ii) valuations of our derivative instruments, (iii) recoverability of our deferred tax assets, (iv) estimation of breakage and redemption experience rates, which drive how we recognize breakage on our gift card and gift certificates, and revenue from our customer loyalty program, and (v) allocation of insurance proceeds to various recoverable components. Actual results may differ from those estimates.\n\nRecently Adopted and Issued Accounting Pronouncements\n\nAdopted:\n\nAccounting Standards Update (“ASU”) 2016-02 Leases: In February 2016, the Financial Accounting Standards Board (“FASB”) issued a new accounting standard, ASC 842 Leases, to increase transparency and comparability among organizations by requiring the recognition of right-of-use (\"ROU\") assets and lease liabilities on the balance sheet. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. A modified retrospective transition approach is required for lessees with capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available.\n\nOn January 1, 2019, we adopted the new accounting standard Accounting Standards Codification (“ASC”) 842 Leases using the modified retrospective method. We recognized the cumulative effect of initially applying the new leasing standard as an adjustment to the opening balance of retained earnings. The comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods. The standard had a material impact on our consolidated balance sheets, but not on our consolidated income statements or statements of cash flow.\n\n\n| |\n| (Dollars in thousands) | Balance atDecember 31,2018 | Adjustmentsdue to ASC842 | Balance atJanuary 1,2019 |\n| Assets |\n| Operating property, net | $ | 257,667 | $ | 370 | $ | 258,037 |\n| Operating lease right-of-use assets | — | 232,319 | 232,319 |\n| Intangible assets, net | 7,369 | (3,542) | 3,827 |\n| Deferred tax asset, net | 26,235 | 82 | 26,317 |\n| Liabilities |\n| Operating lease liabilities | $ | — | $ | 245,280 | $ | 245,280 |\n| Other non-current liabilities | 28,931 | (16,033) | 12,898 |\n| Stockholders' Equity |\n| Non-controlling interest | $ | 4,337 | $ | (46) | $ | 4,291 |\n| Retained earnings | 47,616 | 28 | 47,644 |\n\n\n\n\n| |\n| | Period Ended March 31, 2019 |\n| (Dollars in thousands) | As Reported,March 31, 2019 | BalancesWithoutAdoption ofASC 842 | Effect ofchangeHigher /(Lower) |\n| Cinema costs and expenses | $ | 48,329 | $ | 48,334 | $ | (5) |\n| Depreciation and amortization | 5,594 | 5,552 | 42 |\n| General and administrative | 6,484 | 6,528 | (44) |\n| Interest expense, net | 1,852 | 1,849 | 3 |\n| Income tax (benefit) expense | 1,042 | 1,041 | 1 |\n| Net income (loss) | $ | (2,097) | $ | (2,094) | $ | 3 |\n\n8\n\n\n\n| |\n| (Dollars in thousands) | As Reported,March 31, 2019 | BalancesWithoutAdoption ofASC 842 | Effect ofchangeHigher /(Lower) |\n| Assets |\n| Operating property, net | $ | 257,402 | $ | 257,072 | $ | 330 |\n| Intangible assets | 3,694 | 7,151 | (3,457) |\n| Operating lease right-of-use assets | 229,266 | — | 229,266 |\n| Deferred tax asset, net | 26,483 | 26,400 | 83 |\n| Liabilities |\n| Other current liabilities | $ | 9,525 | $ | 9,363 | $ | 162 |\n| Operating lease liabilities, current | 19,797 | — | 19,797 |\n| Other non-current liabilities | 12,346 | 28,643 | (16,297) |\n| Operating lease liabilities, non-current | 222,594 | — | 222,594 |\n| Stockholders' Equity |\n| Retained earnings | $ | 45,563 | $ | 45,585 | $ | (22) |\n\n\n\n| 1) | ASU 2014-09 Revenue from Contracts with Customers: On January 1, 2018, we adopted the new accounting standard ASC 606 Revenue from Contracts with Customers using the modified retrospective method. We recognized the cumulative effect of initially applying the new revenue standard as an adjustment to the opening balance of retained earnings. The comparative information was not restated. Adoption of this standard has no material effect on our consolidated financial statements. |\n\n\n| 2) | On January 1, 2018, the Company adopted ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash, a consensus of the FASB Emerging Issues Task Force. This standard requires that amounts generally described as restricted cash and cash equivalents should be combined with unrestricted cash and cash equivalents when reconciling the beginning and end of period balances on the statement of cash flows. Adoption of this standard has no material effect on our consolidated statement of cash flows. |\n\n\n| 3) | On January 1, 2018, the Company adopted ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments). The standard applies to eight (8) specific cash flow classification issues, reducing the current and potential future diversity in the presentation of certain cash flows. Adoption of this standard has no material effect on our consolidated statement of cash flows. |\n\n\n| 4) | On January 1, 2018, the Company adopted ASU 2017-07, Compensation—Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. This standard (i) requires that an employer disaggregate the service cost component from the other components of net benefit cost, and (ii) specifies how to present the service cost component and the other components of net benefit cost in the income statement and (iii) allows only the service cost component of net benefit cost to be eligible for capitalization. Adoption of this standard has no material impact on our consolidated financial statements. |\n\n\n| 5) | On January 1, 2018, the Company adopted ASU 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business. This ASU provides that when substantially all of the fair value of the gross assets acquired (or disposed of) is concentrated in a single identifiable asset or a group of similar identifiable assets, the asset is not a “business”, thus reducing the number of transactions that need further evaluation for business combination. The standard has no material impact on our current consolidated financial statements, and we do not expect it to be applicable to our consolidated financial statements in the near term unless we enter into a definitive business acquisition transaction. |\n\n\nIssued:\n\n| v | ASUs Effective 2019 and Beyond |\n\n| · | Goodwill Impairment Simplification (ASU 2017-04, Intangibles – Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment) |\n\n\nIssued by FASB in January 2017, this standard removes the second step of the two-step impairment test for measuring goodwill and is to be applied on a prospective basis only. The new standard is effective for the Company on January 1, 2020, including interim periods within the year of adoption. Early adoption is permitted for interim or annual goodwill impairment\n9\ntests performed on testing dates after January 1, 2017. It is not anticipated that adoption of this standard will have any material impact on our consolidated financial statements.\n\nPrior period financial statement correction of immaterial errors\n\nDuring the third quarter of 2018, we identified immaterial errors related to the accounting for straight line rent receivable from tenants in our real estate operations dating back to 2015. These errors resulted in an understatement of real estate revenue.\n\nWe assessed the materiality of these errors on our financial statements for prior periods in accordance with the SEC Staff Accounting Bulletin (“SAB”) No. 99, Materiality, codified in ASC 250, Presentation of Financial Statements, and concluded that they were not material to any prior annual or interim periods. However, the aggregate amount of $440k related to the prior period immaterial errors through June 30, 2018, would have been material to the quarterly accounts with our current Consolidated Statements of Income. Consequently, in accordance with ASC 250 (specifically SAB No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements), we have corrected these errors for all prior periods presented by revising the consolidated financial statements and other financial information included herein.\n\nThe following is a summary of the previously issued financial statement line items for all periods and statements included in this report.\n\nConsolidated Statements of Income:\n\n\n| |\n| | Three Months Ended March 31, 2018 |\n| (Dollars in thousands) | As Reported | Adjustment | As Revised |\n| Real estate revenue | $ | 3,567 | $ | 50 | $ | 3,617 |\n| Total revenue | 75,822 | 50 | 75,872 |\n| Operating income (loss) | 5,643 | 50 | 5,693 |\n| Income before income taxes | 4,224 | 50 | 4,274 |\n| Income tax benefit (expense) | (1,155) | (15) | (1,170) |\n| Net income (loss) | 3,069 | 35 | 3,104 |\n| Net income (loss) attributable to Reading International, Inc. common shareholders | 3,047 | 35 | 3,082 |\n| |\n| Basic earnings (loss) per share | $ | 0.13 | $ | — | $ | 0.13 |\n| Diluted earnings (loss) per share | 0.13 | — | 0.13 |\n\n\nConsolidated Balance Sheets:\n\n\n\n\n| |\n| | Summary of Equity |\n| (Dollars in thousands) | As Reported | Adjustment | As Revised |\n| Equity at January 1, 2018 | $ | 176,910 | $ | 377 | $ | 177,287 |\n| Net income (loss) | 3,047 | 35 | 3,082 |\n| Equity at March 31, 2018 | $ | 179,423 | $ | 412 | $ | 179,835 |\n\n\n\nConsolidated Statements of Cash Flows:\n\n\n| |\n| | Three Months Ended March 31, 2018 |\n| (Dollars in thousands) | As Reported | Adjustment | As Revised |\n| Net income (loss) | $ | 3,069 | $ | 35 | $ | 3,104 |\n| Change in net deferred tax assets | 157 | 15 | 172 |\n| Prepaid and other assets | (2,259) | (50) | (2,309) |\n| Net cash provided by operating activities | $ | 2,452 | $ | — | $ | 2,452 |\n\n10\nNote 3 – Operations in Foreign Currency\n\nWe have significant assets in Australia and New Zealand. Historically, we have conducted our Australian and New Zealand operations (collectively “foreign operations”) on a self-funding basis where we use cash flows generated by our foreign operations to pay for the expense of foreign operations. Our Australian and New Zealand assets and liabilities are translated from their functional currencies of Australian dollar (“AU$”) and New Zealand dollar (“NZ$”), respectively, to the U.S. dollar based on the exchange rate as of March 31, 2019. The carrying value of the assets and liabilities of our foreign operations fluctuates as a result of changes in the exchange rates between the functional currencies of the foreign operations and the U.S. dollar. The translation adjustments are accumulated in the Accumulated Other Comprehensive Income in the Consolidated Balance Sheets.\n\nDue to the natural-hedge nature of our funding policy, we have not historically used derivative financial instruments to hedge against the risk of foreign currency exposure. However, in certain circumstances, we move funds between jurisdictions where circumstances encouraged us to do so from an overall economic standpoint. Going forward, particularly in light of recent tax law changes, we intend to take a more global view of our financial resources, and to be more flexible in making use of resources from one jurisdiction in other jurisdictions.\n\nPresented in the table below are the currency exchange rates for Australia and New Zealand:\n\n\n| |\n| |\n| | Foreign Currency / USD |\n| | As of andfor thequarterended | As of andfor thetwelve monthsended | As of andfor thequarterended |\n| | March 31, 2019 | December 31, 2018 | March 31, 2018 |\n| Spot Rate |\n| Australian Dollar | 0.7104 | 0.7046 | 0.7690 |\n| New Zealand Dollar | 0.6820 | 0.6711 | 0.7239 |\n| Average Rate |\n| Australian Dollar | 0.7123 | 0.7479 | 0.7861 |\n| New Zealand Dollar | 0.6816 | 0.6930 | 0.7275 |\n\nNote 4 – Earnings Per Share\n\nBasic earnings per share (“EPS”) is calculated by dividing the net income attributable to the Company’s common stockholders by the weighted average number of common shares outstanding during the period. Diluted EPS is calculated by dividing the net income attributable to the Company’s common stockholders by the weighted average number of common and common equivalent shares outstanding during the period and is calculated using the treasury stock method for equity-based compensation awards.\n\nThe following table sets forth the computation of basic and diluted EPS and a reconciliation of the weighted average number of common and common equivalent shares outstanding:\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands, except share data) | 2019 | 2018 |\n| Numerator: |\n| Net income (loss) attributable to RDI common stockholders | $ | (2,081) | $ | 3,082 |\n| Denominator: |\n| Weighted average number of common stock – basic | 22,920,486 | 22,967,237 |\n| Weighted average dilutive impact of awards | 203,620 | 165,752 |\n| Weighted average number of common stock – diluted | 23,124,106 | 23,132,989 |\n| Basic earnings (loss) per share attributable to RDI common stockholders | $ | (0.09) | $ | 0.13 |\n| Diluted earnings (loss) per share attributable to RDI common stockholders | $ | (0.09) | $ | 0.13 |\n| Awards excluded from diluted earnings (loss) per share | 496,089 | — |\n\n\nOur weighted average number of common stock - basic decreased, primarily as a result of the repurchase of shares of Class A Non-Voting Common Stock pursuant to our current stock repurchase program offset by the issuance of shares due to the exercise of share options and vesting of restricted stock units.\n11\nNote 5 – Property and Equipment\n\nOperating Property, net\n\nAs of March 31, 2019 and December 31, 2018, property associated with our operating activities is summarized as follows:\n\n\n| |\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Land | $ | 76,110 | $ | 75,689 |\n| Building and improvements | 151,525 | 149,734 |\n| Leasehold improvements | 56,160 | 55,299 |\n| Fixtures and equipment | 171,674 | 167,943 |\n| Construction-in-progress | 3,185 | 3,478 |\n| Total cost | 458,654 | 452,143 |\n| Less: accumulated depreciation | (201,252) | (194,476) |\n| Operating property, net | $ | 257,402 | $ | 257,667 |\n\n\nDepreciation expense for operating property was $5.4 million for the quarter ended March 31, 2019 and $4.7 million for the quarter ended March 31, 2018.\n\nInvestment and Development Property, net\n\nAs of March 31, 2019 and December 31, 2018, our investment and development property is summarized below:\n\n| |\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Land | $ | 24,310 | $ | 24,371 |\n| Building | 1,900 | 1,900 |\n| Construction-in-progress (including capitalized interest) | 68,946 | 60,533 |\n| Investment and development property | $ | 95,156 | $ | 86,804 |\n\n\nConstruction-in-Progress – Operating and Investing Properties\n\nConstruction-in-Progress balances are included in both our operating and development properties. The balances of our major projects along with the movements for the three months ended March 31, 2019 are shown below:\n\n\n| |\n| |\n| (Dollars in thousands) | Balance,December 31,2018 | Additions during the period(1) | Completedduring theperiod | Foreigncurrencytranslation | Balance,March 31,2019 |\n| Union Square development | $ | 55,634 | $ | 7,724 | $ | — | $ | (1) | $ | 63,357 |\n| Newmarket Property development | 9 | 4 | — | — | 13 |\n| Courtenay Central development | 5,571 | 234 | — | 94 | 5,899 |\n| Cinema developments and improvements | 1,664 | 3,551 | (3,997) | 4 | 1,222 |\n| Other real estate projects | 1,133 | 528 | (27) | 6 | 1,640 |\n| Total | $ | 64,011 | $ | 12,041 | $ | (4,024) | $ | 103 | $ | 72,131 |\n\n\n| (1) | Includes capitalized interest of $1.3 million for the quarter ended March 31, 2019. |\n\n\nReal Estate Transactions\n\nPurchase of Income Producing Property at Auburn/Redyard, Australia – On June 29, 2018, we added 20,870 square feet of land, improved with a 16,830 square foot office building, to our Auburn/Redyard ETC. The property was acquired at auction for $3.5 million (AU$4.5 million) and is bordered by our existing ETC on three sides. The property is leased to Telstra through July 2022. This will allow us time to plan for the efficient integration of the property into our ETC. With this acquisition, Auburn/Redyard now represents approximately 519,992 square feet (48,309 square meters) of land, with approximately 1,620 feet (498 meters) of uninterrupted frontage to Parramatta Road, a major Sydney arterial motorway.\n\n12\nPurchase of Land at Cannon Park in Townsville, Australia – On June 13, 2018, we acquired a 163,000 square foot (15,150 square meter) parcel of land at our Cannon Park ETC, in connection with the restructuring of our relationship with the adjacent land owner. Prior to the restructuring, this parcel was commonly owned by us and the adjoining land owner. In the restructuring, the adjoining land owner conveyed to us its interest in the parcel for AU$1. We granted the adjoining land owner certain access rights with respect to that parcel.\n\nNote 6 – Investments in Unconsolidated Joint Ventures\n\nOur investments in unconsolidated joint ventures are accounted for under the equity method of accounting.\n\nThe table below summarizes our active investment holdings in two (2) unconsolidated joint ventures as of March 31, 2019 and December 31, 2018:\n\n| |\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | Interest | 2019 | 2018 |\n| Rialto Cinemas | 50.0% | $ | 1,224 | $ | 1,260 |\n| Mt. Gravatt | 33.3% | 3,734 | 3,861 |\n| Total investments | $ | 4,958 | $ | 5,121 |\n\n\nFor the quarter ended March 31, 2019 and 2018, the recognized share of equity earnings from our investments in unconsolidated joint ventures are as follows:\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Rialto Cinemas | $ | (56) | $ | 70 |\n| Mt. Gravatt | 90 | 187 |\n| Total equity earnings | $ | 34 | $ | 257 |\n\nNote 7 – Goodwill and Intangible Assets\n\nThe table below summarizes goodwill by business segment as of March 31, 2019 and December 31, 2018.\n\n\n| |\n| |\n| (Dollars in thousands) | Cinema | Real Estate | Total |\n| Balance at, December 31, 2018 | $ | 14,221 | $ | 5,224 | $ | 19,445 |\n| Change in goodwill due to a purchase of business combination | 1,248 | — | 1,248 |\n| Foreign currency translation adjustment | 143 | — | 143 |\n| Balance at, March 31, 2019 | $ | 15,612 | $ | 5,224 | $ | 20,836 |\n\n\nThe Company is required to test goodwill and other intangible assets for impairment on an annual basis and, if current events or circumstances require, on an interim basis. Our next annual evaluation of goodwill and other intangible assets is scheduled during the fourth quarter of 2019. To test the impairment of goodwill, the Company compares the fair value of each reporting unit to its carrying amount, including the goodwill, to determine if there is potential goodwill impairment. A reporting unit is generally one level below the operating segment. As of March 31, 2019, we were not aware that any events indicating potential impairment of goodwill had occurred.\n\nThe tables below summarize intangible assets other than goodwill as of March 31, 2019 and December 31, 2018, respectively.\n\n\n| |\n| |\n| | As of March 31, 2019 |\n| (Dollars in thousands) | BeneficialLeases | TradeName | OtherIntangibleAssets | Total |\n| Gross carrying amount | $ | 15,069 | $ | 7,255 | $ | 1,999 | $ | 24,323 |\n| Less: Accumulated amortization | (14,260) | (5,269) | (1,100) | (20,629) |\n| Net intangible assets other than goodwill | $ | 809 | $ | 1,986 | $ | 899 | $ | 3,694 |\n\n\n13\n\n| |\n| |\n| | As of December 31, 2018 |\n| (Dollars in thousands) | BeneficialLeases | TradeName | OtherIntangibleAssets | Total |\n| Gross carrying amount | $ | 28,592 | $ | 7,254 | $ | 1,951 | $ | 37,797 |\n| Less: Accumulated amortization | (24,145) | (5,207) | (1,076) | (30,428) |\n| Net intangible assets other than goodwill | $ | 4,447 | $ | 2,047 | $ | 875 | $ | 7,369 |\n\n\nBeneficial leases were amortized over the life of the lease up to 30 years up until January 1, 2019, when under ASC 842 they were incorporated into the relevant right-of-use asset. Trade names are amortized based on the accelerated amortization method over their estimated useful life of 30 years, and other intangible assets are amortized over their estimated useful lives of up to 30 years (except for transferrable liquor licenses, which are indefinite-lived assets). The table below summarizes the amortization expense of intangible assets for the quarter ended March 31, 2019.\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Beneficial lease amortization | $ | 79 | $ | 207 |\n| Other amortization | 22 | 93 |\n| Total intangible assets amortization | $ | 101 | $ | 300 |\n\nNote 8 – Prepaid and Other Assets\n\nPrepaid and other assets are summarized as follows:\n\n\n| |\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Prepaid and other current assets |\n| Prepaid expenses | $ | 2,105 | $ | 1,761 |\n| Prepaid rent | 1,020 | 930 |\n| Prepaid taxes | 1,026 | 646 |\n| Income taxes receivable | 4,106 | 2,704 |\n| Deposits | 242 | 242 |\n| Investment in marketable securities | 44 | 42 |\n| Restricted cash | 1,099 | 1,342 |\n| Total prepaid and other current assets | $ | 9,642 | $ | 7,667 |\n| Other non-current assets |\n| Straight-line rent | 4,219 | 4,150 |\n| Other non-cinema and non-rental real estate assets | 1,134 | 1,134 |\n| Investment in Reading International Trust I | 838 | 838 |\n| Long-term deposits | 8 | 7 |\n| Long-term restricted cash | — | — |\n| Total other non-current assets | $ | 6,199 | $ | 6,129 |\n\nNote 9 – Income Taxes\n\nThe interim provision for income taxes is different from the amount determined by applying the U.S. federal statutory rate to consolidated income before taxes. The differences are attributable to foreign tax rate differential, unrecognized tax benefits, and foreign tax credits. Our effective tax rate was 33.2% and 27.3% for the three months ended March 31, 2019 and 2018, respectively. The change between 2019 and 2018 is primarily related to decrease in benefits from foreign tax credits and increase in valuation allowance related to our foreign operation.\n\n14\nNote 10 – Debt\n\nThe Company’s borrowings at March 31, 2019 and December 31, 2018, net of deferred financing costs and including the impact of interest rate derivatives on effective interest rates, are summarized below:\n\n\n| |\n| |\n| | As of March 31, 2019 |\n| (Dollars in thousands) | Maturity Date | ContractualFacility | Balance,Gross | Balance, Net(1) | StatedInterest Rate | Effective Interest Rate(2) |\n| Denominated in USD |\n| Trust Preferred Securities (USA) | April 30, 2027 | $ | 27,913 | $ | 27,913 | $ | 26,116 | 6.75% | 6.75% |\n| Bank of America Credit Facility (USA) | May 1, 2020 | 55,000 | 30,000 | 30,000 | 5.02% | 5.02% |\n| Bank of America Line of Credit (USA) | October 31, 2019 | 5,000 | 3,500 | 3,500 | 5.52% | 5.52% |\n| Banc of America digital projector loan (USA) | December 28, 2019 | 1,979 | 1,979 | 1,979 | 5.00% | 5.00% |\n| Cinema 1, 2, 3 Term Loan (USA) | September 1, 2019 | 18,978 | 18,978 | 18,768 | 3.25% | 3.25% |\n| Minetta & Orpheum Theatres Loan (USA) | November 1, 2023 | 8,000 | 8,000 | 7,864 | 4.54% | 4.54% |\n| U.S. Corporate Office Term Loan (USA) | January 1, 2027 | 9,437 | 9,437 | 9,319 | 4.64% / 4.44% | 4.61% |\n| Union Square Construction Financing (USA) | December 29, 2019 | 57,500 | 33,934 | 32,463 | 6.76% / 12.51% | 8.02% |\n| Denominated in foreign currency (\"FC\") (3) |\n| NAB Corporate Term Loan (AU) | December 31, 2023 | 85,248 | 40,138 | 40,111 | 2.70% | 2.70% |\n| Westpac Bank Corporate (NZ) | December 31, 2023 | 21,824 | 9,889 | 9,889 | 3.80% | 3.80% |\n| | $ | 290,879 | $ | 183,768 | $ | 180,009 |\n\n\n| (1) | Net of deferred financing costs amounting to $3.8 million. |\n\n| (2) | Both interest rate derivatives associated with the Trust Preferred Securities and Bank of America Credit Facility expired in October 2017 so the effective interest rate no longer applies as of March 31, 2019. |\n\n| (3) | The contractual facilities and outstanding balances of the foreign currency denominated borrowings were translated into U.S. dollars based on the applicable exchange rates as of March 31, 2019. |\n\n\n| |\n| |\n| | As of December 31, 2018 |\n| (Dollars in thousands) | Maturity Date | ContractualFacility | Balance,Gross | Balance, Net(1) | StatedInterestRate | Effective Interest Rate (2) |\n| Denominated in USD |\n| Trust Preferred Securities (USA) | April 30, 2027 | $ | 27,913 | $ | 27,913 | $ | 26,061 | 6.52% | 6.52% |\n| Bank of America Credit Facility (USA) | May 1, 2020 | 55,000 | 25,000 | 25,000 | 5.02% | 5.02% |\n| Bank of America Line of Credit (USA) | October 31, 2019 | 5,000 | — | — | 5.48% | 5.48% |\n| Banc of America digital projector loan (USA) | December 28, 2019 | 2,604 | 2,604 | 2,604 | 5.00% | 5.00% |\n| Cinema 1, 2, 3 Term Loan (USA) | September 1, 2019 | 19,086 | 19,086 | 18,838 | 3.25% | 3.25% |\n| Minetta & Orpheum Theatres Loan (USA) | November 1, 2023 | 8,000 | 8,000 | 7,857 | 4.88% | 4.88% |\n| U.S. Corporate Office Term Loan (USA) | January 1, 2027 | 9,495 | 9,495 | 9,373 | 4.64% / 4.44% | 4.61% |\n| Union Square Construction Financing (USA) | December 29, 2019 | 57,500 | 27,182 | 25,280 | 6.76% / 12.51% | 8.35% |\n| Denominated in foreign currency (\"FC\")(3) |\n| NAB Corporate Loan Facility (AU) | December 31, 2023 | 46,856 | 37,696 | 37,660 | 3.05% | 3.05% |\n| Westpac Corporate Credit Facility (NZ) | December 31, 2023 | 21,475 | 10,067 | 10,067 | 3.80% | 3.80% |\n| | $ | 252,929 | $ | 167,043 | $ | 162,740 |\n\n\n| (1) | Net of deferred financing costs amounting to $4.3 million. |\n\n\n| (2) | Both interest rate derivatives associated with the Trust Preferred Securities and Bank of America Credit Facility expired in October 2017 so the effective interest rate no longer applies as of December 31, 2018. |\n\n| (3) | The contractual facilities and outstanding balances of the foreign currency denominated borrowings were translated into U.S. dollars based on the applicable exchange rates as of December 31, 2018. |\n\n\nOur loan arrangements are presented, net of the deferred financing costs, on the face of our consolidated balance sheet as follows:\n\n\n| |\n| |\n| | March 31, | December 31, |\n| Balance Sheet Caption | 2019 | 2018 |\n| Debt - current portion | $ | 40,077 | $ | 30,393 |\n| Debt - long-term portion | 113,816 | 106,286 |\n| Subordinated debt | 26,116 | 26,061 |\n| Total borrowings | $ | 180,009 | $ | 162,740 |\n\n\n15\nMinetta and Orpheum Theatres Loan\n\nOn October 12, 2018, we refinanced our $7.5 million loan with Santander Bank, which is secured by our Minetta and Orpheum Theatres, with a loan for a five year term of $8.0 million. Such modification was not considered to be substantial under US GAAP.\n\nBanc of America Digital Projector Loan\n\nOn February 5, 2018, we purchased our U.S. digital cinema projectors, which had previously been held on operating leases, using a $4.6 million loan from Banc of America. We made further U.S. digital projector purchases, of projectors similarly held on other operating leases, in March and April 2018, increasing this loan to $4.9 million. This loan carries an interest rate of 5% and is due and payable December 28, 2019.\n\nBank of America Credit Facility\n\nOn March 3, 2016, we amended our $55.0 million credit facility with Bank of America to permit real property acquisition loans. This amendment reduces the applicable consolidated leverage ratio covenant by 0.25% and modifies the term of the facility based on the earlier of the eighteen months from the date of such borrowing or the maturity date of the credit agreement. Such modification was not considered substantial in accordance with U.S. GAAP. On March 5, 2019, this Credit Facility was extended for six (6) months to May 1, 2020.\n\n44 Union Square Construction Financing\n\nOn December 29, 2016, we closed on our new construction finance facilities totaling $57.5 million to fund the non-equity portion of the anticipated construction costs of the redevelopment of our property at 44 Union Square in New York City. The combined facilities consist of $50.0 million in aggregate loans (comprised of three loan tranches) from Bank of the Ozarks (“BOTO”), and a $7.5 million mezzanine loan from Tammany Mezz Investor, LLC, an affiliate of Fisher Brothers. At December 31, 2016, Bank of the Ozarks advanced $8.0 million to repay the then existing $8.0 million loan with East West Bank. As of March 31, 2019, an additional $26.4 million had been advanced under the senior loan facility, along with the full $7.5 million available under the mezzanine loan facility.\n\nU.S. Corporate Office Term Loan\n\nOn December 13, 2016, we obtained a ten-year $8.4 million mortgage loan on our new Los Angeles Corporate Headquarters at a fixed annual interest rate of 4.64%. This loan provided for a second loan upon completion of certain improvements. On June 26, 2017, we obtained a further $1.5 million under this provision at a fixed annual interest rate of 4.44%.\n\nBank of America Line of Credit\n\nIn October 2016, the term of this $5.0 million line of credit was extended to October 31, 2019. Such modification was not considered to be substantial under US GAAP.\n\nCinema 1,2,3 Term Loan\n\nOn August 31, 2016, Sutton Hill Properties LLC (“SHP”), a 75% subsidiary of RDI, refinanced its $15.0 million Santander Bank term loan with a new lender, Valley National Bank. This new $20.0 million loan is collateralized by our Cinema 1,2,3 property and bears an interest rate of 3.25% per annum, with principal installments and accruing interest paid monthly. The new loan matures on September 1, 2019, with a one-time option to extend maturity date for another year. The Company presently intends to exercise that option and to extend the maturity date until September 1, 2020.\n\nWestpac Bank Corporate Credit Facility (NZ)\n\nOn December 20, 2018, we restructured our Westpac Corporate Credit Facilities. The maturity of the 1st tranche (general/non-construction credit line) was extended to December 31, 2023, with the available facility being reduced from NZ$35.0 million to NZ$32.0 million. The facility bears an interest rate of 1.75% above the Bank Bill Bid Rate on the drawn down balance and a 1.1% line of credit charge on the entire facility. The 2nd tranche (construction line) with a facility of NZ$18.0 million was not renewed.\n\nAustralian NAB Corporate Term Loan (AU)\n\nOn March 15, 2019, we amended our Revolving Corporate Markets Loan Facility with National Australia Bank (“NAB”) from a facility comprised of (i) a AU$66.5 million loan facility with an interest rate of 0.95% above the Bank Bill Swap Bid Rate (“BBSY”) and a maturity date of June 30, 2019 and (ii) a bank guarantee of AU$5.0 million at a rate of 1.90% per annum into a (i) AU$120.0\n16\nmillion Corporate Loan facility at rates of 0.85%-1.30% above BBSY depending on certain ratios with a due date of December 31, 2023, of which AU$80.0 million is revolving and AU$40.0 million is core and (ii) a Bank Guarantee Facility of AU$5.0 million at a rate of 1.85% per annum. Prior to this, on June 12, 2018, we had extended the maturity of these facilities from June 30, 2019, to December 31, 2019. Such modifications of this particular term loan were not considered to be substantial under US GAAP.\nNote 11 – Other Liabilities\n\nOther liabilities are summarized as follows:\n\n| |\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Current liabilities |\n| Lease liability | $ | 5,900 | $ | 5,900 |\n| Liability for demolition costs | 2,664 | 2,630 |\n| Accrued pension | 684 | 684 |\n| Security deposit payable | 88 | 84 |\n| Finance lease liabilities | 162 | — |\n| Other | 27 | 7 |\n| Other current liabilities | $ | 9,525 | $ | 9,305 |\n| Other liabilities |\n| Straight-line rent | $ | — | $ | 16,362 |\n| Lease make-good provision | 5,722 | 5,614 |\n| Accrued pension | 4,544 | 4,670 |\n| Environmental reserve | 1,656 | 1,656 |\n| Deferred revenue - real estate | 9 | 32 |\n| Acquired leases | 47 | 91 |\n| Finance lease liabilities | 169 | — |\n| Other | 199 | 506 |\n| Other liabilities | $ | 12,346 | $ | 28,931 |\n\n\nOn August 29, 2014, the Supplemental Executive Retirement Plan (“SERP”) that has been effective since March 1, 2007, was ended and replaced in accordance with the terms of a pension annuity. As a result of the termination of the SERP program, the accrued pension liability of $7.6 million was reversed and replaced with this pension annuity liability of $7.5 million. The valuation of the liability is based on the present value of $10.2 million discounted at a rate of 4.25% over a 15-year term, resulting in a monthly payment of $57,000. The discount rate of 4.25% has been applied since 2014 to determine the net periodic benefit cost and plan benefit obligation and is expected to be used in future years. The discounted value of $2.7 million (which is the difference between the estimated payout of $10.2 million and the present value of $7.5 million) as of August 29, 2014 will be amortized and expensed based on the 15-year term. In addition, the accumulated actuarial loss of $3.1 million recorded, as part of other comprehensive income will also be amortized based on the 15-year term.\n\nIn February 2018 we made a payment of $2.4 million relating to the annuity representing payments for the 42 months outstanding at the time. Monthly ongoing payments of $57,000 are now being made.\n\nAs a result of the above, included in our current and non-current liabilities are accrued pension costs of $5.2 million at March 31, 2019. The benefits of our pension plan are fully vested and therefore no service costs were recognized for the quarter ended March 31, 2019 and 2018. Our pension plan is unfunded.\n\nDuring the quarter ended March 31, 2019, the interest cost was $51,000 and actuarial loss was $51,000. During the quarter ended March 31, 2018, the interest cost was $45,000 and actuarial loss was $52,000.\n17\nNote 12 – Accumulated Other Comprehensive Income\n\nThe following table summarizes the changes in each component of accumulated other comprehensive income attributable to RDI:\n\n\n| |\n| |\n| (Dollars in thousands) | ForeignCurrencyItems | UnrealizedGain (Losses)on Available-for-SaleInvestments | AccruedPensionService Costs | Hedge Accounting Reserve | Total |\n| Balance at January 1, 2019 | $ | 8,687 | $ | 3 | $ | (2,438) | $ | (137) | $ | 6,115 |\n| |\n| Change related to derivatives |\n| Total change in hedge fair value recorded in Other Comprehensive Income | — | — | — | (81) | (81) |\n| Amounts reclassified from accumulated other comprehensive income | — | — | — | 12 | 12 |\n| Net change related to derivatives | — | — | — | (69) | (69) |\n| |\n| Net current-period other comprehensive income (loss) | 1,526 | 2 | 51 | (69) | 1,510 |\n| Balance at March 31, 2019 | $ | 10,213 | $ | 5 | $ | (2,387) | $ | (206) | $ | 7,625 |\n\nNote 13 – Commitments and Contingencies\n\nLitigation General\n\nWe are currently involved in certain legal proceedings and, as required, have accrued estimates of probable and estimable losses for the resolution of these claims, including legal costs.\n| · | Where we are a plaintiff, we accrue legal fees as incurred on an on-going basis and make no provision for any potential settlement amounts until received. In Australia, the prevailing party is usually entitled to recover its attorneys’ fees, which recoveries typically work out to be approximately 60% of the amounts actually spent where first-class legal counsel is engaged at customary rates. Where we are a plaintiff, we have likewise made no provision for the liability for the defendant’s attorneys' fees in the event we are determined not to be the prevailing party. |\n\n| · | Where we are a defendant, we accrue for probable damages that insurance may not cover as they become known and can be reasonably estimated. In our opinion, any claims and litigation in which we are currently involved are not reasonably likely to have a material adverse effect on our business, results of operations, financial position, or liquidity. It is possible, however, that future results of the operations for any particular quarterly or annual period could be materially affected by the ultimate outcome of the legal proceedings. From time-to-time, we are involved with claims and lawsuits arising in the ordinary course of our business that may include contractual obligations, insurance claims, tax claims, employment matters, and anti-trust issues, among other matters. |\n\n\nAll of these matters require significant judgments based on the facts known to us. These judgments are inherently uncertain and can change significantly when additional facts become known. We provide accruals for matters that have probable likelihood of occurrence and can be properly estimated as to their expected negative outcome. We do not record expected gains until the proceeds are received by us. However, we typically make no accruals for potential costs of defense, as such amounts are inherently uncertain and dependent upon the scope, extent and aggressiveness of the activities of the applicable plaintiff.\n\nEnvironmental and Asbestos Claims on Reading Legacy Operations\nCertain of our subsidiaries were historically involved in railroad operations, coal mining, and manufacturing. Also, certain of these subsidiaries appear in the chain-of-title of properties that may suffer from pollution. Accordingly, certain of these subsidiaries have, from time-to-time, been named in and may in the future be named in various actions brought under applicable environmental laws. Also, we are in the real estate development business and may encounter from time-to-time unanticipated environmental conditions at properties that we have acquired for development. These environmental conditions can increase the cost of such projects and adversely affect the value and potential for profit of such projects. We do not currently believe that our exposure under applicable environmental laws is material in amount.\n\nFrom time to time, there are claims brought against us relating to the exposure of former employees of our railroad operations to asbestos and coal dust. These are generally covered by an insurance settlement reached in September 1990 with our insurance providers. However, this insurance settlement does not cover litigation by people who were not our employees and who may claim second-hand exposure to asbestos, coal dust and/or other chemicals or elements now recognized as potentially causing cancer in humans. Our known exposure to these types of claims, asserted or probable of being asserted, is not material.\n\n18\nCotter Jr. Derivative Litigation\n\nThis action was originally brought by James J. Cotter, Jr. (“Cotter Jr.”) in June, 2015 in the Nevada District Court against all of the Directors of the Company and against the Company as a nominal defendant: James J. Cotter, Jr., individually and derivatively on behalf of Reading International, Inc. vs. Margaret Cotter, et al.” Case No,: A-15-719860-V. Summary judgment has been entered against Cotter, Jr., and in favor of all defendants and a $1.55 million cost judgment has been entered against Cotter, Jr., and in favor of our Company. Cotter, Jr. has appealed both judgements. Our application for $5.9 million in attorney’s fees was denied, and we have appealed that determination. The issues on appeal are currently being briefed. No date for oral argument has been set. It is unlikely that any hearing will be held this year. As the Directors and Officers Liability Insurance Policy covering Cotter, Jr.’s claims in the Derivative Case ($10.0 million) has been exhausted, the financial burden of defending our Directors against these claims, as required by applicable Nevada Law, has fallen upon our Company. During 2018, out-of-pocket third party costs in the amount of approximately $3.5 million were incurred by our Company in defending against these claims. In the quarter ended March 31, 2019, an additional $387,000 had been accrued, relating principally to the preparation of appellate briefs with respect to the Derivative Litigation.\nNote 14 – Non-controlling Interests\n\nThese are composed of the following enterprises:\n| · | Australia Country Cinemas Pty Ltd. - 25% noncontrolling interest owned by Panorama Cinemas for 21st Century Pty Ltd.; |\n\n| · | Shadow View Land and Farming, LLC - 50% noncontrolling membership interest owned by either the estate of Mr. James J. Cotter, Sr. (the “Cotter Estate”) and/or the James J. Cotter, Sr. Living Trust (the “Cotter Trust”); and, |\n\n| · | Sutton Hill Properties, LLC - 25% noncontrolling interest owned by Sutton Hill Capital, LLC (which in turn is 50% owned by the Cotter Estate and/or the Cotter Trust). |\n\n\nThe components of noncontrolling interests are as follows:\n\n| |\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Australian Country Cinemas, Pty Ltd | $ | 27 | $ | 89 |\n| Shadow View Land and Farming, LLC | 2,156 | 2,153 |\n| Sutton Hill Properties, LLC | 2,084 | 2,095 |\n| Noncontrolling interests in consolidated subsidiaries | $ | 4,267 | $ | 4,337 |\n\n\nThe components of income attributable to noncontrolling interests are as follows:\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Australian Country Cinemas, Pty Ltd | $ | 9 | $ | 41 |\n| Shadow View Land and Farming, LLC | (14) | (13) |\n| Sutton Hill Properties, LLC | (11) | (6) |\n| Net income (loss) attributable to noncontrolling interests | $ | (16) | $ | 22 |\n\n\n19\nSummary of Controlling and Noncontrolling Stockholders’ Equity\n\nA summary of the changes in controlling and noncontrolling stockholders’ equity is as follows:\n\n\n\n| |\n| |\n| (Dollars in thousands) | ControllingStockholders’Equity | NoncontrollingStockholders’Equity | TotalStockholders’Equity |\n| Equity at January 1, 2019 | $ | 176,210 | $ | 4,337 | $ | 180,547 |\n| Adjustments to opening retained earnings on adoption of ASC 842 | 28 | (46) | (18) |\n| Net income (loss) | (2,081) | (16) | (2,097) |\n| Increase in additional paid in capital | 21 | — | 21 |\n| Treasury stock purchased | (9) | — | (9) |\n| Contributions from noncontrolling stockholders | — | 18 | 18 |\n| Distributions to noncontrolling stockholders | — | (27) | (27) |\n| Accumulated other comprehensive income | 1,510 | 1 | 1,511 |\n| Equity at March 31, 2019 | $ | 175,679 | $ | 4,267 | $ | 179,946 |\n| |\n| (Dollars in thousands) | ControllingStockholders’Equity | NoncontrollingStockholders’Equity | TotalStockholders’Equity |\n| Equity at January 1, 2018 | $ | 177,287 | $ | 4,331 | $ | 181,618 |\n| Adjustments to opening retained earnings on adoption of ASC 606 | 194 | (2) | 192 |\n| Net income (loss) | 3,082 | 22 | 3,104 |\n| Increase in additional paid in capital | 339 | — | 339 |\n| Treasury stock purchased | (317) | — | (317) |\n| Contributions from noncontrolling stockholders | — | 27 | 27 |\n| Distributions to noncontrolling stockholders | — | (43) | (43) |\n| Accumulated other comprehensive loss | (750) | (3) | (753) |\n| Equity at March 31, 2018 | $ | 179,835 | $ | 4,332 | $ | 184,167 |\n\nNote 15 – Stock-Based Compensation and Stock Repurchases\n\nEmployee and Director Stock Option Plan\n\nThe Company may grant stock options and other share-based payment awards of our Common Stock to eligible employees, directors, and consultants under the 2010 Stock Incentive Plan (the “Plan”). The aggregate total number of shares of the Common Stock authorized for issuance under the Plan is 2,197,460.\n\nDuring the Company’s 2017 Annual Stockholders’ Meeting held on November 7, 2017, the Company's stockholders, upon recommendation of the Board of Directors, approved an amendment to the Plan to increase the number of shares of common stock issuable under the Plan by an additional 947,460 shares. The effect of the increase is to restore the amount of shares of Common Stock available under the Plan from the 302,540 shares available as of September 30, 2017, back up to its original reserve of 1,250,000 shares. As of March 31, 2019, we had 789,869 shares remaining for future issuances.\n\nSince the adoption of the Plan in 2010, the Company has granted awards primarily in the form of stock options. In the 1st quarter of 2016, the Company started to award restricted stock units (“RSUs”) to directors and certain members of management. Stock options are generally granted at exercise prices equal to the grant-date market prices and typically expire no later than five years from the grant date. In contrast to a stock option where the grantee buys the Company’s share at an exercise price determined on grant date, an RSU entitles the grantee to receive one share for every RSU based on a vesting plan. At the discretion of our Compensation and Stock Options Committee, the vesting period of stock options and RSUs granted to employees ranges from zero to four years. Grants to directors and certain executive officers are subject to Board approval. At the time the options are exercised or RSUs vest and are settled, at the discretion of management, we will issue treasury shares or make a new issuance of shares to the option or RSU holder.\n\nStock Options\nWe estimate the grant-date fair value of our stock options using the Black-Scholes option-valuation model, which takes into account assumptions such as the dividend yield, the risk-free interest rate, the expected stock price volatility, and the expected life of the options. We expense the estimated grant-date fair values of options over the vesting period on a straight-line basis. Based on our\n20\nhistorical experience, the “deemed exercise” of expiring in-the-money options and the relative market price to strike price of the options, we have not hereto estimated any forfeitures of vested or unvested options.\n\nThere were 219,408 stock options issued in the quarter ended March 31, 2019. The weighted average assumptions used in the option-valuation model were as follows:\n\n\n| |\n| |\n| | Three Months Ended March 31, |\n| | 2019 | 2018 |\n| Stock option exercise price | $ | 16.12 | $ | — |\n| Risk-free interest rate | 2.42% | 0.00% |\n| Expected dividend yield | — | — |\n| Expected option life in years | 3.75 | — |\n| Expected volatility | 23.32% | 0.00% |\n| Weighted average fair value | $ | 3.50 | $ | — |\n\n\nFor the quarters ended March 31, 2019 and 2018, we recorded compensation expense of $70,000 and $85,000, respectively. At March 31, 2019, the total unrecognized estimated compensation expense related to non-vested stock options was $1.5 million, which we expect to recognize over a weighted average vesting period of 2.11 years. The intrinsic, unrealized value of all options outstanding, vested and expected to vest, at March 31, 2019 was $2.0 million, of which 91% are currently exercisable.\n\nThe following table summarizes the number of options outstanding and exercisable as of March 31, 2019 and December 31, 2018:\n\n| |\n| |\n| | Outstanding Stock Options - Class A Shares |\n| | Numberof Options | WeightedAverageExercise Price | WeightedAverageRemainingYears ofContractualLife | AggregateIntrinsicValue |\n| | Class A | Class A | Class A | Class A |\n| Balance - December 31, 2017 | 524,589 | $ | 12.50 | 3.15 | $ | 3,054,325 |\n| Granted | 126,840 | 16.40 | — | — |\n| Exercised | (60,000) | 6.02 | — | 610,249 |\n| Forfeited | (4,960) | 12.08 | — | — |\n| Balance - December 31, 2018 | 586,469 | $ | 14.01 | 2.88 | $ | 1,530,528 |\n| Granted | 219,408 | 16.12 | — | — |\n| Exercised | (67,500) | 13.42 | — | 185,175 |\n| Forfeited | (25,000) | 13.42 | — | — |\n| Balance - March 31, 2019 | 713,377 | $ | 14.74 | 3.53 | $ | 1,993,628 |\n\n\n21\nRestricted Stock Units\nWe estimate the grant-date fair values of our RSUs using the Company’s stock price at grant-date and record such fair values as compensation expense over the vesting period on a straight-line basis. The following table summarizes the status of the RSUs granted to-date as of March 31, 2019:\n\n| |\n| |\n| | Outstanding Restricted Stock Units |\n| | RSU Grants (in units) | Vested, | Unvested, | Forfeited, |\n| Grant Date | Directors | Management | TotalGrants | March 31,2019 | March 31,2019 | March 31,2019 |\n| March 10, 2016 | 35,147 | 27,381 | 62,528 | 55,684 | 6,844 |\n| April 11, 2016 | — | 5,625 | 5,625 | 2,815 | 2,293 | 517 |\n| March 23, 2017 | 30,681 | 32,463 | 63,144 | 46,919 | 16,225 |\n| August 29, 2017 | — | 7,394 | 7,394 | 3,698 | 3,696 |\n| January 2, 2018 | 29,393 | — | 29,393 | 29,393 | — |\n| April 12, 2018 | — | 29,596 | 29,596 | — | 29,596 |\n| April 13, 2018 | — | 14,669 | 14,669 | — | 14,669 |\n| July 6, 2018 | — | 932 | 932 | — | — | 932 |\n| November 7, 2018 | 23,010 | — | 23,010 | — | 23,010 |\n| March 13, 2019 | — | 24,366 | 24,366 | — | 24,366 |\n| March 14, 2019 | — | 23,327 | 23,327 | — | 23,327 |\n| Total | 118,231 | 165,753 | 283,984 | 138,509 | 144,026 | 1,449 |\n\n\nRSU awards to management vest 25% at the end of each year for 4 years. Prior to November 7, 2018, RSU awards to directors vested 100% in January of the following year in which such RSUs were granted. At the November 7, 2018 Board meeting, it was determined that it would be more appropriate for the vesting of RSUs to align with the directors’ term of office. Accordingly, the RSUs granted on November 7, 2018, will vest upon the earlier of (i) the first anniversary of grant and (ii) the date of the next annual meeting of stockholders. This means that on the date of the annual meeting of stockholders on May 7, 2019, the RSUs granted to directors on November 7, 2018 vested. Due to the fact that the Company has moved up its annual meeting of stockholders from November to May this year, this created a shorter than normal vesting period for the RSUs issued on November 7, 2018. In order to adjust for this factor, the directors have determined that the award of RSUs to be made immediately following the 2019 Annual Meeting of Stockholders will be $35,000 or one half of last year's annual grant. For the quarter ended March 31, 2019 and 2018, we recorded compensation expense of $209,000 and $294,000, respectively. The total unrecognized compensation expense related to the non-vested RSUs was $1.9 million as of March 31, 2019, which we expect to recognize over a weighted average vesting period of 1.1 years.\n\nStock Repurchase Program\n\nOn March 2, 2017, the Company's Board of Directors authorized management, at its discretion, to spend up to an aggregate of $25.0 million to acquire shares of Reading’s Class A Common Stock. The previously approved stock repurchase program, which allowed management to spend up to an aggregate of $10.0 million to acquire shares of Reading’s Class A Common Stock, was completed as of December 31, 2016. On March 14, 2019, the Board of Directors extended this stock buy-back program for two years, through March 2, 2021. The Board of Directors did not increase the authorized amount which was $16.2 million at March 31, 2019.\n\nThe repurchase program allows Reading to repurchase its shares in accordance with the requirements of the SEC on the open market, in block trades and in privately negotiated transactions, depending on market conditions and other factors. All purchases are subject to the availability of shares at prices that are acceptable to Reading, and accordingly, no assurances can be given as to the timing or number of shares that may ultimately be acquired pursuant to this authorization.\n\nUnder the stock repurchase program, as of March 31, 2019, the Company has reacquired 559,627 shares of Class A Common Stock for $8.8 million at an average price of $15.81 per share (excluding transaction costs) to-date. 566 shares of Class A Common Stock were purchased during the quarter ended March 31, 2019 at an average price of $16.08 per share. This leaves $16.2 million available under the March 2, 2017 program, as extended, for repurchase as of March 31, 2019.\n\n22\nNote 16 - Leases\n\nIn all leases, whether we are the lessor or lessee, we define lease term as the non-cancellable term of the lease plus any renewals covered by renewal options that are reasonably certain of exercise based on our assessment of economic factors relevant to the lessee. The non-cancellable term of the lease commences on the date the lessor makes the underlying property in the lease available to the lessee, irrespective of when lease payments begin under the contract.\n\nAs Lessee\n\nWe have operating leases for certain cinemas and corporate offices, and finance leases for certain equipment assets. Our leases have remaining lease terms of 1 to 20 years, with certain leases having options to extend to up to a further 20 years.\n\nContracts are analyzed in accordance with the criteria set out in ASC 842 to determine if there is a lease present. For contracts that contain an operating lease, we account for the lease component and the non-lease component together as a single component. For contracts that contain a finance lease we account for the lease component and the non-lease component separately in accordance with ASC 842.\n\nIn leases where we are the lessee, we recognize a right of use asset and lease liability at lease commencement, which is measured by discounting lease payments using our incremental borrowing rate applicable to the lease term and currency of the lease as the discount rate. Subsequent amortization of the right of use asset and accretion of the lease liability for an operating lease is recognized as a single lease cost, on a straight line basis, over the term of the lease. A finance lease right-of-use asset is depreciated on a straight line basis over the lesser of the useful life of the leased asset or the lease term. Interest on each finance lease liability is determined as the amount that results in a constant periodic discount rate on the remaining balance of the liability. Property taxes and other non-lease costs are accounted for on an accrual basis.\n\nLease payments for our cinema operating leases consist of fixed base rent, and for certain leases, variable lease payments consisting of contracted percentages of revenue, changes in the relevant CPI, and/or other contracted financial metrics.\nThe components of lease expense were as follows:\n\n\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Lease cost |\n| Finance lease cost: | — |\n| Amortization of right-of-use assets | $ | 41 | $ | — |\n| Interest on lease liabilities | 3 | — |\n| Operating lease cost | 7,921 | — |\n| Variable lease cost | 105 | — |\n| Total lease cost | $ | 8,070 | $ | — |\n\n\n\nSupplemental cash flow information related to leases was as follows:\n\n\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Cash flows relating to lease cost |\n| Cash paid for amounts included in the measurement of lease liabilities: |\n| Operating cash flows from finance leases | $ | 44 | $ | — |\n| Operating cash flows from operating leases | 7,780 | — |\n| Right-of-use assets obtained in exchange for new finance lease liabilities | — | — |\n| Right-of-use assets obtained in exchange for new operating lease liabilities | 2,181 | — |\n\n23\n\n\n\nSupplemental balance sheet information related to leases was as follows:\n\n\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Operating leases |\n| Operating lease right-of-use assets | $ | 229,266 | $ | — |\n| Operating lease liabilities - current portion | 19,797 | — |\n| Operating lease liabilities - non-current portion | 222,594 | — |\n| Total operating lease liabilities | $ | 242,391 | $ | — |\n| Finance leases |\n| Property plant and equipment, gross | 372 | — |\n| Accumulated depreciation | (41) | — |\n| Property plant and equipment, net | $ | 331 | $ | — |\n| Other current liabilities | 162 | — |\n| Other long-term liabilities | 169 | — |\n| Total finance lease liabilities | $ | 331 | $ | — |\n| |\n| Other information |\n| Weighted-average remaining lease term - finance leases | 3 | — |\n| Weighted-average remaining lease term - operating leases | 11 | — |\n| Weighted-average discount rate - finance leases | 5.05% | — |\n| Weighted-average discount rate - operating leases | 4.97% | — |\n\n\n\nMaturity of leases were as follows:\n\n\n| |\n| (Dollars in thousands) | Operating leases | Finance leases |\n| 2019 | $ | 23,566 | $ | 133 |\n| 2020 | 31,434 | 101 |\n| 2021 | 31,717 | 53 |\n| 2022 | 31,901 | 43 |\n| 2023 | 31,018 | 28 |\n| Thereafter | 169,221 | — |\n| Total lease payments | $ | 318,857 | $ | 358 |\n| Less imputed interest | (76,466) | (27) |\n| Total | $ | 242,391 | $ | 331 |\n\n\n\nAs of March 31, 2019, we have additional operating leases, primarily for cinemas, that have not yet commenced of approximately $26.0 million. These operating leases will commence between fiscal year 2019 and fiscal year 2021 with lease terms of 15 to 20 years.\n\nAs Lessor\n\nThe Company has entered into various leases as a lessor for our owned real estate properties. These leases vary in length between 1 and 20 years, with certain leases containing options to extend at the behest of the applicable tenants. Lease components consist of fixed base rent, and for certain leases, variable lease payments consisting of contracted percentages of revenue, changes in the relevant CPI, and/or other contracted financial metrics. No terms exist by which a lessee is able to purchase the underlying asset.\n\nWe recognize lease payments for operating leases as property revenue on a straight-line basis over the lease term. Lease incentive payments we make to lessees are amortized as a reduction in property revenue over the lease term.\n24\nLease income relating to operating lease payments was as follows:\n\n\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Components of lease income |\n| Lease payments | $ | 2,229 | $ | 2,423 |\n| Variable lease payments | 265 | 80 |\n| Total lease income | $ | 2,494 | $ | 2,503 |\n\n\n\nThe book value of underlying assets under operating leases from owned assets was as follows:\n\n\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Building and improvements |\n| Gross balance | $ | 68,483 | $ | 67,887 |\n| Accumulated depreciation | (18,375) | (17,709) |\n| Net Book Value | $ | 50,108 | $ | 50,178 |\n\n\n\n\nMaturity of leases were as follows:\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n| |\n| (Dollars in thousands) | Operating leases |\n| 2019 | $ | 6,470 |\n| 2020 | 7,439 |\n| 2021 | 6,830 |\n| 2022 | 5,961 |\n| 2023 | 5,187 |\n| Thereafter | 10,295 |\n| Total | $ | 42,182 |\n\n\n\n\n\n\n\n\n\n\n\n\nNote 17 – Hedge Accounting\n\nAs of March 31, 2019 and March 31, 2018, the Company held interest rate derivatives in the total notional amount of $8.0 million and $nil, respectively.\n\nThe derivatives are recorded on the balance sheet at fair value and are included in the following line items:\n\n\n| |\n| | Liability Derivatives |\n| | March 31, | December 31, |\n| | 2019 | 2018 |\n| (Dollars in thousands) | Balance sheet location | Fair value | Balance sheet location | Fair value |\n| Interest rate contracts | Derivative financial instruments - current portion | $ | 52 | Derivative financial instruments - current portion | $ | 41 |\n| | Derivative financial instruments - non-current portion | 203 | Derivative financial instruments - non-current portion | 145 |\n| Total derivatives designated as hedging instruments | $ | 255 | $ | 186 |\n| Total derivatives | $ | 255 | $ | 186 |\n\n\n\n\n\n25\n\n\nWe have no derivatives designated as hedging instruments which are in asset positions.\n\nThe changes in fair value are recorded in Other Comprehensive Income and released into interest expense in the same period(s) in which the hedged transactions affect earnings. In the quarter to March 31, 2019 and March 31, 2018, respectively, the derivative instruments affected Comprehensive Income as follows:\n\n\n\n| |\n| (Dollars in thousands) | Location of Loss Recognized in Income on Derivatives | Amount of Loss Recognized in Income on Derivatives |\n| | 2019 | 2018 |\n| Interest rate contracts | Interest expense, net | $ | 12 | $ | — |\n| Total | $ | 12 | $ | — |\n\n\n\n| |\n| | Loss Recognized in OCI on Derivatives (Effective Portion) | Loss Reclassified from OCI into Income (Effective Portion) | Loss Recognized in Income on Derivatives (Ineffective Portion and Amount Excluded from Effectiveness Testing) |\n| (Dollars in thousands) | Amount | Line Item | Amount | Line Item | Amount |\n| | 2019 | 2018 | 2019 | 2018 | 2019 | 2018 |\n| Interest rate contracts | $ | 81 | $ | — | Interest expense, net | $ | 12 | $ | — | Interest expense, net | $ | — | $ | — |\n| Total | $ | 81 | $ | — | $ | 12 | $ | — | $ | — | $ | — |\n\n\n\nNote 18 – Fair Value Measurements\n\nASC 820, Fair Value Measurement establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The statement requires that assets and liabilities carried at fair value be classified and disclosed in one of the following three categories:\n| · | Level 1: Quoted market prices in active markets for identical assets or liabilities; |\n\n| · | Level 2: Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets; and, |\n\n| · | Level 3: Valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable. |\n\nAs of March 31, 2019 and December 31, 2018 material financial assets and financial liabilities were carried and measured at fair value on a recurring basis.\n\nThe following tables summarize our financial liabilities that are carried at cost and measured at fair value on a non-recurring basis as of March 31, 2019 and December 31, 2018, by level within the fair value hierarchy.\n\n\n| |\n| |\n| | Fair Value Measurement at March 31, 2019 |\n| (Dollars in thousands) | CarryingValue(1) | Level 1 | Level 2 | Level 3 | Total |\n| Notes payable | $ | 155,855 | $ | — | $ | — | $ | 159,871 | $ | 159,871 |\n| Subordinated debt | 27,913 | — | — | 19,162 | 19,162 |\n| | $ | 183,768 | $ | — | $ | — | $ | 179,033 | $ | 179,033 |\n\n\n\n| |\n| |\n| | Fair Value Measurement at December 31, 2018 |\n| (Dollars in thousands) | CarryingValue(1) | Level 1 | Level 2 | Level 3 | Total |\n| Notes payable | $ | 139,130 | $ | — | $ | — | $ | 143,564 | $ | 143,564 |\n| Subordinated debt | 27,913 | — | — | 18,895 | 18,895 |\n| | $ | 167,043 | $ | — | $ | — | $ | 162,459 | $ | 162,459 |\n\n\n| (1) | These balances are presented before any deduction for deferred financing costs. |\n\n26\n\nFollowing is a description of the valuation methodologies used to estimate the fair value of our financial assets and liabilities. There have been no changes in the methodologies used at March 31, 2019 and December 31, 2018.\n| · | Level 1 investments in marketable securities primarily consist of investments associated with the ownership of marketable securities in U.S. and New Zealand. These investments are valued based on observable market quotes on the last trading date of the reporting period. |\n\n| · | Level 2 derivative financial instruments are valued based on discounted cash flow models that incorporate observable inputs such as interest rates and yield curves from the derivative counterparties. The credit valuation adjustments associated with our non-performance risk and counterparty credit risk are incorporated in the fair value estimates of our derivatives. As of March 31, 2019 and December 31, 2018, we concluded that the credit valuation adjustments were not significant to the overall valuation of our derivatives. |\n\n| · | Level 3 borrowings include our secured and unsecured notes payable, trust preferred securities and other debt instruments. The borrowings are valued based on discounted cash flow models that incorporate appropriate market discount rates. We calculated the market discount rate by obtaining period-end treasury rates for fixed-rate debt, or LIBOR for variable-rate debt, for maturities that correspond to the maturities of our debt, adding appropriate credit spreads derived from information obtained from third-party financial institutions. These credit spreads take into account factors such as our credit rate, debt maturity, types of borrowings, and the loan-to-value ratios of the debt. |\n\n\nThe Company’s financial instruments also include cash, cash equivalents, receivables and accounts payable. The carrying values of these financial instruments approximate the fair values due to their short maturities. Additionally, there were no transfers of assets and liabilities between levels 1, 2, or 3 during the quarter ended March 31, 2019 and March 31, 2018.\nNote 19 – Business Combination\n\nOn January 30, 2019, we purchased the tenant’s interest and other operating assets of an established four-screen cinema in Devonport, Tasmania, Australia, for $1.4 million (AU$1.95 million). We commenced trading from this new cinema site on January 30, 2019.\n\nThe total purchase price was allocated to the identifiable assets acquired based on our preliminary estimates of their fair values on the acquisition date. There were no liabilities assumed. As of March 31, 2019, the Company is still finalizing its allocation and this may result in potential adjustments within the one-year measurement period from acquisition date. The determination of the fair values of the acquired assets (and the related determination of their estimated lives) requires significant judgment.\n\nOur preliminary purchase price allocation is as follows:\n\n\n| |\n| | Preliminary Purchase Price |\n| | Allocation |\n| (Dollars in thousands) | US Dollars(1) | AU dollars |\n| Tangible Assets |\n| Operating property: |\n| Fixtures and equipment | $ | 153 | $ | 213 |\n| Intangible Assets |\n| Goodwill | 1,248 | 1,734 |\n| Total assets acquired | 1,401 | 1,947 |\n| |\n| Net assets acquired | $ | 1,401 | $ | 1,947 |\n\n\n| (1) | The balances were translated into U.S. Dollars based on the applicable exchange rate as of the date of acquisition, January 30, 2019. |\n\n\n\n\n\n27\nThis MD&A should be read in conjunction with the accompanying unaudited consolidated financial statements included in Part I, Item 1 (Financial Statements). The foregoing discussions and analyses contain certain forward-looking statements. Please refer to the “Forward Looking Statements” included at the conclusion of this section and our “Risk Factors” set forth in our 2018 Form 10-K, Part 1, Item 1A and the Risk Factors set out below.\n\n\nItem 2 – Management’s Discussions and Analysis (“MD&A”) of Financial Condition and Results of Operations\n\nBUSINESS OVERVIEW\n\nWe are an internationally diversified company principally focused on the development, lease or ownership, and operation of entertainment and real estate assets in the United States, Australia, and New Zealand. As of March 31, 2019, we operate in two business segments:\n| · | Cinema exhibition, through our 60 multiplex cinemas; and, |\n\n| · | Real estate, including real estate development and the rental of retail, commercial and live theatre assets. |\n\n\nWe believe that these two business segments complement one another, as we can use the comparatively consistent cash flows generated by our cinema operations to fund the front-end cash demands of our real estate development business.\n\nCinema Exhibition\nWe manage our worldwide cinema exhibition businesses under various brands:\n| · | in the U.S., under the following brands: Reading Cinemas, Angelika Film Centers, Consolidated Theatres, and City Cinemas; |\n\n| · | in Australia, under the Reading Cinemas brand; and, |\n\n| · | in New Zealand, under the Reading Cinemas and Rialto Cinemas brands. |\n\n\nShown in the following table are the number of locations and theater screens in our theater circuit in each country, by state/territory/ region and indicating our cinema brands and our interest in the underlying assets as of March 31, 2019:\n\n\n| |\n| |\n| | State / Territory / | Location | Screen | Interest in AssetUnderlying the Cinema |\n| Country | Region | Count | Count | Leased | Owned | Operating Brands |\n| United States | Hawaii | 9 | 98 | 9 | Consolidated Theatres |\n| | California | 7 | 88 | 7 | Reading Cinemas, Angelika Film Center |\n| | New York(3) | 6 | 23 | 5 | 1 | Angelika Film Center, City Cinemas |\n| | Texas | 2 | 13 | 2 | Angelika Film Center |\n| | New Jersey | 1 | 12 | 1 | Reading Cinemas |\n| | Virginia | 1 | 8 | 1 | Angelika Film Center |\n| | Washington DC | 1 | 3 | 1 | Angelika Film Center |\n| | U.S. Total | 27 | 245 | 26 | 1 |\n| Australia | New South Wales | 6 | 44 | 4 | 2 | Reading Cinemas |\n| | Victoria | 6 | 43 | 6 | Reading Cinemas |\n| | Queensland | 5 | 50 | 2 | 3 | Reading Cinemas, Event Cinemas(1) |\n| | Western Australia | 2 | 16 | 1 | 1 | Reading Cinemas |\n| | South Australia | 2 | 15 | 2 | Reading Cinemas |\n| | Tasmania | 1 | 4 | 1 | Reading Cinemas |\n| | Australia Total | 22 | 172 | 16 | 6 |\n| New Zealand | Wellington | 2 | 15 | 1 | 1 | Reading Cinemas |\n| | Otago | 3 | 15 | 2 | 1 | Reading Cinemas, Rialto Cinemas(2) |\n| | Auckland | 2 | 15 | 2 | Reading Cinemas, Rialto Cinemas(2) |\n| | Canterbury | 1 | 8 | 1 | Reading Cinemas |\n| | Southland | 1 | 5 | 1 | Reading Cinemas |\n| | Bay of Plenty | 1 | 5 | 1 | Reading Cinemas |\n| | Hawke's Bay | 1 | 4 | 1 | Reading Cinemas |\n| | New Zealand Total | 11 | 67 | 6 | 5 |\n| GRAND TOTAL | 60 | 484 | 48 | 12 |\n\n\n| (1) | The Company has a 33.3% unincorporated joint venture interest in a 16-screen cinema located in Mt. Gravatt, Queensland managed by Event Cinemas. |\n\n| (2) | The Company is a 50% joint venture partner in two (2) New Zealand Rialto cinemas. We are responsible for the booking of these cinemas and our joint venture partner, Event Cinemas, manages their day-to-day operations. |\n\n| (3) | Our New York statistics include one (1) managed cinema, with a four-screen total. |\n\n\n28\nReal Estate\nWe engage in real estate development and the ownership, and rental or licensing to third parties of retail, commercial and live theater assets. We own the fee interests in all three of our live theaters, and in 12 of our cinemas (as presented in the preceding table). Our real estate business creates long-term value for our stockholders through the continuous improvement and development of our investment and operating properties, including our entertainment-themed centers (“ETCs”).\n\nOur real estate activities have historically consisted principally of:\n| · | the ownership of fee or long-term leasehold interests in properties used in our cinema exhibition activities or which were acquired for the development of cinemas or cinema-based real estate development projects; |\n\n| · | the acquisition and development of fee interests in land; |\n\n| · | the licensing to production companies of the use of our live theatres; and, |\n\n| · | the redevelopment of our existing fee-owned cinema or live theatre sites to their highest and best use. |\n\n\nCinema Exhibition\nOur cinema revenue consists primarily of admissions, Food & Beverage (“F&B”), advertising and theater rentals. Cinema operating expense consists of the costs directly attributable to the operation of the cinemas, including film rent expense, operating costs, and occupancy costs. Cinema revenue and expense fluctuate with the availability of quality first run films and the numbers of weeks such first run films stay in the market. For a breakdown of our current cinema assets that we own and/or manage, please see Part I, Item 1 – Our Business of our 2018 Form 10-K.\n\nWhile our capital projects in recent years have been focused in growing our real estate segment, we have over the past two years placed special emphasis on the expansion and upgrading of our cinema exhibition portfolio, as discussed below:\n\nCinema Additions (including re-openings)\nThe latest additions and enhancements to our cinema portfolio are as follows:\n| · | Opening our first dine-in concept, “Spotlight” in the United States: On March 30, 2018 we finished the conversion of one wing (six auditoriums) at our Reading Cinema in Murrieta, California (Cal Oaks) to our dine-in concept brand, “Spotlight”. |\n\n| · | AU and NZ Additions/Refurbishments On January 30, 2019, we purchased the tenant’s interest and other operating assets of an established four-screen cinema in Devonport, Tasmania, Australia, for $1.4 million (AU$1.95 million). We commenced trading from this new cinema site on January 30, 2019. For the first quarter of 2019, we invested in two additional Gold Lounge auditoriums at our Harbour Town cinema. In 2017 and 2018, we improved eight theaters: Belmont, Rouse Hill, Courtenay Central, Napier, Charlestown, Elizabeth, Auburn and Rotorua. |\n\n| · | U.S. Refurbishments For the first quarter of 2019, we continued investing in refurbishments primarily at our Mililani cinema. During 2017 and 2018, we continued to invest in the refurbishment and enhancements of our existing cinemas, as contemplated by our strategic plan. During this period, seven locations had significant refurbishment work performed: our Cal Oaks, Valley Plaza and Grossmont locations in California; our Ward, Pearlridge and Mililani locations in Hawaii; and our Manville location in New Jersey. Continuing with our strategic plan, since 2017, we converted (or are in the process of conversion), 74 of our 245 U.S. auditoriums to luxury recliner seating. |\n\nCinema Pipeline\nDuring 2019, we currently plan to upgrade or begin the upgrade of 11 cinemas in the U.S., Australia, and New Zealand.\n\nWe have entered into lease agreements for four new cinemas in Australia (25 screens), which we anticipate will come on line in 2019 - 2021.\n\nOur focus with respect to new cinemas is on featuring state-of-the-art projection and sound, luxury recliner seating, enhanced F&B (typically including alcohol service) and typically at least one major TITAN type presentation screen. Our focus is on providing best in class services and amenities that will differentiate us from in-home and mobile viewing options. We believe that a night at the movies should be a special and premium experience and, indeed, that it must be in order to compete with the variety of options being offered to consumers through other platforms.\n\nThroughout 2019, we will also be focusing on the rollout and enhancement of our proprietary on-line ticketing capabilities and social media interfaces. These are intended to enhance the convenience of our offering and to promote customer affinity with the experience and product that we are offering.\n\n29\nCinema Closures\nWe evaluate the performance of each of our cinemas and, in some instances, we may decide to close an operation when it is not economically viable to continue to operate from the location. We did not close any theaters leased from third parties in 2018 or to date in 2019. While some of our theaters have encountered new competition, and while we believe that others will benefit from planned refurbishment and upgrading, none of our leased theaters are currently slated for closure.\n\nDuring January 2019, we closed our Courtenay Central cinema in Wellington, New Zealand due to seismic concerns. We are currently assessing the redevelopment of that property. It is currently anticipated that the cinema component will be upgraded and restored in connection with any such redevelopment.\n\nUpgrades to our Film Exhibition Technology and Theatre Amenities\nWe continue to focus in areas of the matured cinema business where we believe we have growth potential and ultimately, provide long-term value to our stockholders. These are (i) upgrading of our existing cinemas and (ii) developing new cinemas to provide our customers with premium offerings, including state-of-the-art presentation (including sound, lounges and bar service) and luxury seating. As of March 31, 2019, the upgrades to our theater circuits’ film exhibition technology and amenities are summarized in the following table:\n\n| |\n| |\n| | LocationCount | ScreenCount |\n| Screen Format |\n| Digital (all cinemas in our theatre circuit) | 60 | 484 |\n| IMAX | 1 | 1 |\n| TITAN XC and LUXE | 18 | 20 |\n| Dine-in Service |\n| Gold Lounge (AU/NZ)(1) | 10 | 27 |\n| Premium (AU/NZ)(2) | 11 | 21 |\n| Spotlight (U.S.)(3) | 1 | 6 |\n| Upgraded Food & Beverage menu (U.S.)(4) | 14 | n/a |\n| Premium Seating (recliner seating features) | 22 | 142 |\n| Liquor Licenses Obtained(5) | 28 | n/a |\n\n| (1) | Gold Lounge: This is our \"First Class Full Dine-in Service\" in our Australian and New Zealand cinemas, which includes upgraded F&B menu (with alcoholic beverages), luxury recliner seating features (intimate 25-50 seat cinemas) and waiter service. |\n\n| (2) | Premium Service: This is our \"Business Class Dine-in Service\" in our Australian and New Zealand cinemas, which typically includes upgraded F&B menu (some with alcoholic beverages) and may include luxury recliner seating features (less intimate 80-seat cinemas), but no waiter service. |\n\n| (3) | Spotlight Service: On March 30, 2018 we opened “Spotlight” our first dine-in cinema concept in the United States at Cal Oaks. Six of our 17 auditoriums at this theater feature this dine-in concept. |\n\n| (4) | Upgraded Food & Beverage Menu: Fourteen of our US theaters feature an elevated food and beverage menu served from a common counter, which includes, without limitation, beer, wine and/or spirits and a food menu beyond traditional concessions. We have worked with former Food Network executives to create a menu of locally inspired and freshly prepared items. |\n\n| (5) | Liquor Licenses: Licenses are applicable at each cinema location, rather than each theatre auditorium. For accounting purposes, we capitalize the cost of successfully purchasing or applying for liquor licenses meeting certain thresholds as an intangible asset due to long-term economic benefits derived on future sales of alcoholic beverages. |\n\n\nReal Estate\nOur operating properties currently consists of the following assets:\n| · | our Newmarket, Queensland ETC, our Belmont, Western Australia ETC, our Auburn, New South Wales ETC, our Townsville, Queensland ETC and our Wellington, New Zealand ETC; and, |\n\n| · | two (2) single-auditorium live theatres in Manhattan (Minetta Lane and Orpheum) and a four-auditorium live theater complex (including the accompanying ancillary retail and commercial tenants) in Chicago (The Royal George); and, |\n\n| · | our US Headquarters building in Culver City, California and our Australia corporate office building in Melbourne, Australia; and, |\n\n| · | the ancillary retail and commercial space at some of our non-ETC cinema properties. |\n\n\nIn February 2018, we entered into a one-year license agreement with Audible, Inc. a subsidiary of Amazon, at the Minetta Lane Theatre. This agreement was extended through March 2020, with an option to extend for one additional year through March 2021. Audible intends to continue to produce one to two character plays and special engagements for live performance, to record those productions making them available through Audible streaming service.\n\nIn addition, we have various parcels of unimproved real estate held for development in Australia and New Zealand and certain unimproved land in the United States, including some that was used in our legacy activities.\n30\n\nOur key real estate transactions in recent years are as follows:\n\nStrategic Acquisitions\n| · | Purchase of Land at Cannon Park, Australia. On June 13, 2018, we acquired a 163,000 square foot (15,150 square meter) parcel at our Cannon Park ETC, in connection with the restructuring of our relationship with the adjacent land owner. Prior to the restructuring, this parcel was commonly owned by us and the adjoining land owner. In the restructuring, the adjoining land owner conveyed to us its interest in the parcel for AU$1. We granted the adjoining land owner certain access rights. |\n\n| · | Purchase of Property in Auburn, Australia – On June 29, 2018, we added 20,870 square feet of land, improved with a 16,830 office building, to our Auburn/Redyard ETC. The property was acquired at auction for $3.5 million (AU$4.5 million) and is bordered by our existing ETC on three sides. The property is leased to Telstra through July 2022. This will allow us time to plan for the efficient integration of the property into our ETC. The final settlement payment was made in early October 2018. |\n\n\nValue-creating Opportunities\nWe are engaged in several real estate development projects to take our properties to their highest and best use. The most notable of these value-creating projects are as follows:\n| · | Redevelopment of 44 Union Square Property in New York, USA. We secured construction financing for our 44 Union Square property in December 2016 and have entered into a guaranteed maximum price construction management agreement with an affiliate of CNY. We anticipate that the project will be ready for the commencement of tenant fit-out in the second quarter of 2019. Retail and office leasing interest to date has been strong and, while no assurances can be given, we are currently in exclusive negotiations with respect to long-term leases covering approximately 90% of the net rentable area of the building. This redevelopment will add approximately 23,000 square footage of rentable space to the current square footage of the building for an approximate total of 73,322 square feet of rentable space, inclusive of anticipated BOMA (Building Owners and Managers Association) adjustments and subject to lease negotiations and the final tenant mix. |\n\n| · | Expansion Project for our Newmarket Shopping Center at an affluent suburb of Brisbane, Australia. In December 2017 we opened our eight-screen Reading Cinema with TITAN LUXE, including 10,355 square feet of additional retail space and 124 parking spaces. As of March 31, 2019, approximately 80% of this new retail space has been leased. |\n\n| · | Courtenay Central Re-Development in Wellington, New Zealand. – Located in the heart of Wellington - New Zealand’s capital city – this center is comprised of 161,071 square feet of land situated proximate to the Te Papa Tongarewa Museum (attracting over 1.5 million visitors annually), across the street from the site of Wellington’s newly announced convention center (estimated to open its doors in 2022) and at a major public transit hub. Damage from the 2016 earthquake necessitated demolition of our nine-story parking garage at the site. Further, unrelated seismic issues have caused us to close the existing cinema and significant portions of the retail structure while we reevaluate the property for redevelopment as an entertainment themed urban center with a major food and grocery component. Wellington continues to be rated as one of the top cities in the world in which to live, and we continue to believe that the Courtenay Central site is located in one of the most vibrant and growing commercial and entertainment precincts of Wellington. |\n\n\n31\n\n| § | Cinema 1,2,3 Redevelopment – In June 2017, we entered into an exclusive dealing and pre-development agreement with our adjoining neighbors, 260-264 LLC, to jointly develop the properties, currently home to Cinemas 1,2,3 and Anassa Taverna. Under the terms of the agreement, Reading and 260-264 LLC worked together on a comprehensive mixed-use plan to co-develop the properties located on 3rd Avenue, between 59th Street and 60th Streets, in New York City. The parties completed an initial feasibility study, analyzing various retail, entertainment and residential uses for the site and during 2018 continued to work on the terms of a final agreement for the development of the combined property. We do not presently believe that we will be able to come to an agreement with our neighbors for a joint development of our properties and, have, accordingly, begun developing plans for an approximately 96,000 square foot mixed use stand-alone development. Our Cinemas 1,2,3, property is located on Third Avenue in New York City, between 59th and 60th Streets across from Bloomingdales. |\n\n| · | Manukau Land Rezoning – In August 2016, the Auckland City Council up-zoned 64.0 acres of our property in Manukau from agricultural to light industrial use. The remaining 6.4 acres were already zoned for heavy industrial use. Our zoning enhancement goal having been achieved, in 2018, we worked with adjoining landholders to jointly advance necessary infrastructure improvement issues. We estimate that our property will support approximately 1.6 million square feet of improvements. We see this property as a future value realization opportunity for us. This tract is adjacent to the Auckland Airport, which is currently undergoing a major improvement and expansion project. |\n\n\nCorporate Matters\n\n| § | Stock Repurchase Program – Our Board approved a $25-million repurchase program approved on March 2, 2017, and extended on March 14, 2019, and extended it on March 14, 2019. Under this authorization Reading may repurchase its Class A Common Stock from time to time in accordance with the requirements of the Securities and Exchange Commission on the open market, in block trades and in privately negotiated transactions, depending on market conditions and other factors. The new authorization continues through March 2, 2021. To date we have repurchased 559,627 shares of Class A Common Stock for $8.8 million at an average price of $15.81 per share (excluding transaction costs). 566 shares were purchased during the quarter ended March 31, 2019 at an average price of $16.08 per share. This leaves $16.2 million available under the March 2, 2017 program, as extended, for repurchase as of March 31, 2019. |\n\n\nOur Financing Strategy\n\nOur treasury management is focused on cash management using cash balances to reduce debt. We have used cash generated from operations and other excess cash, to the extent not needed for capital expenditures, to pay down our loans and credit facilities providing us flexibility on our available loan facilities for future use and, thereby, reducing interest charges. On a periodic basis, we review the maturities of our borrowing arrangements and negotiate for renewals and extensions where necessary in the current circumstances.\n\nOn March 15, 2019, we amended our Revolving Corporate Markets Loan Facility with National Australia Bank (“NAB”) from a facility comprised of (i) a AU$66.5 million loan facility with an interest rate of 0.95% above the Bank Bill Swap Bid Rate (“BBSY”) and a maturity date of June 30, 2019 and (ii) a bank guarantee of AU$5.0 million at a rate of 1.90% per annum into a (i) AU$120.0 million corporate loan facility at rates of 0.85%-1.30% above BBSY depending on certain ratios with a due date of December 31, 2023, of which AU$80.0 million is revolving and AU$40.0 million is core and (ii) a bank guarantee facility of AU$5.0 million at a rate of 1.85% per annum. Prior to this, on June 12, 2018, we had extended the maturity of these facilities from June 30, 2019, to December 31, 2019. Such modifications of this particular term loan were not considered to be substantial under US GAAP.\n\nOn December 20, 2018, we restructured our Westpac Corporate Credit Facilities. The maturity of the 1st tranche (general/non-construction credit line) was extended to December 31, 2023, with the available facility being reduced from NZ$35.0 million to NZ$32.0 million. The facility bears an interest rate of 1.75% above the Bank Bill Bid Rate on the drawn down balance and a 1.1% line of credit charge on the entire facility. The 2nd tranche (construction line) with a facility of NZ$18.0 million was removed.\n\nOn March 5, 2019, we extended our current Bank of America credit facilities until May 1, 2020 (the $55.0 million credit line). We anticipate refinancing this credit line during the second quarter of 2019.\n\nRefer to our 2018 Form 10-K for more details on our cinema and real estate segments.\n32\nRESULTS OF OPERATIONS\n\nThe table below summarizes the results of operations for each of our principal business segments along with the non-segment information for the three months ended March 31, 2019 and March 31, 2018:\n\n\n| |\n| | Three Months Ended | % Change |\n| (Dollars in thousands) | March 31,2019 | March 31,2018 | Fav/(Unfav) |\n| SEGMENT RESULTS |\n| | Revenue |\n| | Cinema exhibition | $ | 57,986 | $ | 72,255 | (20) | % |\n| | Real estate | 5,431 | 6,008 | (10) | % |\n| | Inter-segment elimination | (1,866) | (2,391) | 22 | % |\n| | Total revenue | 61,551 | 75,872 | (19) | % |\n| | Operating expense |\n| | Cinema exhibition | (50,195) | (57,339) | 12 | % |\n| | Real estate | (2,445) | (2,384) | (3) | % |\n| | Inter-segment elimination | 1,866 | 2,391 | (22) | % |\n| | Total operating expense | (50,774) | (57,332) | 11 | % |\n| | Depreciation and amortization |\n| | Cinema exhibition | (4,157) | (3,765) | (10) | % |\n| | Real estate | (1,376) | (1,369) | (1) | % |\n| | Total depreciation and amortization | (5,533) | (5,134) | (8) | % |\n| | General and administrative expense |\n| | Cinema exhibition | (992) | (866) | (15) | % |\n| | Real estate | (451) | (574) | 21 | % |\n| | Total general and administrative expense | (1,443) | (1,440) | - | % |\n| | Segment operating income |\n| | Cinema exhibition | 2,642 | 10,285 | (74) | % |\n| | Real estate | 1,159 | 1,681 | (31) | % |\n| | Total segment operating income | $ | 3,801 | $ | 11,966 | (68) | % |\n| NON-SEGMENT RESULTS |\n| | Depreciation and amortization expense | (61) | (117) | 48 | % |\n| | General and administrative expense | (5,041) | (6,156) | 18 | % |\n| | Interest expense, net | (1,852) | (1,594) | (16) | % |\n| | Equity earnings of unconsolidated joint ventures | 34 | 257 | (87) | % |\n| | Other income (expense) | (20) | (82) | 76 | % |\n| | Income before income taxes | (3,139) | 4,274 | (> 100) | % |\n| | Income tax benefit (expense) | 1,042 | (1,170) | > 100 | % |\n| Net income (loss) | (2,097) | 3,104 | (> 100) | % |\n| | Less: net (income) loss attributable to noncontrolling interests | (16) | 22 | (> 100) | % |\n| Net income (loss) attributable to RDI common stockholders | $ | (2,081) | $ | 3,082 | (> 100) | % |\n| Basic EPS | $ | (0.09) | $ | 0.13 | (> 100) | % |\n\n“nm – not meaningful”\nConsolidated and Non-Segment Results:\n\n1st Quarter Net Results\n\nNet income attributable to RDI common stockholders decreased by $5.2 million to a $(2.1) million loss. Basic EPS for the quarter ended March 31, 2019 decreased by $0.22 to $(0.09) from the prior-year quarter, mainly attributable to decreases in revenue in both the Cinema and Real Estate business segments.\n\nRevenue for the three months ended March 31, 2019 decreased by 19%or $14.3 million, to $61.6 million compared to the same period prior year. The revenue decrease was due to a decrease in revenues from our cinema business primarily due to the weak film slate experienced by the Cinema business segment worldwide, the closure of our cinema in Courtenay Central due to seismic concerns, and a decrease in revenues from the Real Estate business segment primarily due to the closure of most of the net rentable area of Courtenay Central due to seismic concerns. Overseas revenues were also adversely impacted by the continued weakness of the Australian and New Zealand Dollar compared to the U.S. dollar.\n\nU.S. admissions for the first quarter 2019 were down 19% falling from $24.7 million to $19.9 million for the same period in the prior year. According to industry sources, U.S. box office for the period was down 16%, falling from $2.5 billion to $2.1 billion. Australia and New Zealand Box Office saw similar declines. Again, in the case of New Zealand, the situation was exacerbated by the closure of our cinema at Courtenay Central. Due to the fact that our occupancy costs with respect to our cinema operations are fixed, the decrease in revenues disproportionally impacts the earnings from these operations, even though our film rent, cinema level labor and costs of goods sold are largely variable.\n\n33\nLooking forward, The Avengers: Endgame has been setting box office records, having grossed more than $620 million in North America and more than $2.2 billion worldwide since its opening weekend of April 25, 2019.\n\nNon-Segment General & Administrative Expenses\nNon-segment general and administrative expense for the quarter ended March 31, 2019 decreased by 18%, or $1.1 million, to $5.0 million compared to the same period of the prior year, respectively. This decrease mainly relates to lower legal expenses, offset by an increase in administrative occupancy cost in New Zealand attributable to the temporary closure of our administrative offices at Courtenay Central and need to lease replacement office space in Wellington.\n\nIncome Tax Expense\nIncome tax expense for the quarter ended March 31, 2019, decreased 189%, or $2.2 million compared to the same quarter prior year. The change between 2019 and 2018 is primarily related to the pretax loss in the first quarter of 2019.\nBusiness Segment Results\n\nAt March 31, 2019, we leased or owned and operated 60 cinemas with 484 screens, which includes (i) one managed cinema with 4 (four) screens and (ii) our interests in certain unconsolidated joint ventures that total 3 (three) cinemas with 29 screens. In the first quarter of 2019, we acquired a proven 4-screen cinema in Devonport, Tasmania, Australia, increasing our cinema count to 60 and our screen count to 484. We also (i) owned and operated 5 (five) ETCs located in Newmarket Village (a suburb of Brisbane), Belmont (a suburb of Perth), Auburn (a suburb of Sydney) and Townsville (a suburb of Cannon Park) in Australia and Wellington in New Zealand, (ii) owned and operated our headquarters office buildings in Culver City (an emerging high-tech and communications hub in Los Angeles County) and Melbourne, Australia, (iii) owned and operated the fee interests in three developed commercial properties in Manhattan and Chicago improved with live theaters comprising 6 (six) stages and ancillary retail and commercial space (our fourth live theatre was closed at the end of 2015 as part of the redevelopment of 44 Union Square in New York City), (iv) owned a 75% managing member interest in a limited liability company, which in turn owns the fee interest in Cinemas 1,2,3, (v) held for development approximately 70.4 acres of developable industrial land located next to the Auckland Airport in New Zealand, (vi) owned a 50% managing member interest in a limited liability company, which in turn owns a 202-acre property in Coachella, California that is zoned approximately 150 acres for single-family residential use (maximum 550 homes) and approximately 50 acres for high density mixed use in the U.S., that is held for development, and, (vii) owned 197 acres principally in Pennsylvania from our legacy railroad business, including the Reading Viaduct in downtown Philadelphia.\n\nThe Company transacts business in Australia and New Zealand and is subject to risks associated with changing foreign currency exchange rates. The Australian and New Zealand dollars based on the spot rate weakened versus prior three month period against the U.S. dollar slightly negatively impacting the value of our assets and liabilities. The average rate for the three months ended March 31, 2019 and 2018 has also weakened by 9.4% and 6.3% respectively. This has decreased the value of our Australian and New Zealand revenues and expenses. Refer to Note 3 – Operations in Foreign Currency for further information.\n\n34\nCinema Exhibition\n\nThe following table details our cinema exhibition segment operating results for the three months ended March 31, 2019 and March 31, 2018, respectively:\n\n\n| |\n| | % Change |\n| | Three Months Ended | Fav/(Unfav) |\n| (Dollars in thousands) | March 31,2019 | % of Revenue | March 31,2018 | % of Revenue | Three Months Ended |\n| REVENUE |\n| | United States | Admissions revenue | $ | 19,913 | 34% | $ | 24,706 | 34% | (19) | % |\n| | Food & beverage revenue | 9,575 | 17% | 10,765 | 15% | (11) | % |\n| | Advertising and other revenue | 2,545 | 4% | 2,516 | 3% | 1 | % |\n| | $ | 32,033 | 55% | $ | 37,987 | 53% | (16) | % |\n| | Australia | Admissions revenue | $ | 14,037 | 24% | $ | 17,051 | 24% | (18) | % |\n| | Food & beverage revenue | 6,061 | 10% | 7,837 | 11% | (23) | % |\n| | Advertising and other revenue | 1,343 | 2% | 1,829 | 3% | (27) | % |\n| | $ | 21,441 | 37% | $ | 26,717 | 37% | (20) | % |\n| | New Zealand | Admissions revenue | $ | 2,991 | 5% | $ | 4,934 | 7% | (39) | % |\n| | Food & beverage revenue | 1,309 | 3% | 2,266 | 3% | (42) | % |\n| | Advertising and other revenue | 212 | 0% | 351 | 0% | (40) | % |\n| | $ | 4,512 | 8% | $ | 7,551 | 10% | (40) | % |\n| |\n| | Total revenue | $ | 57,986 | 100% | $ | 72,255 | 100% | (20) | % |\n| OPERATING EXPENSE |\n| | United States | Film rent and advertising cost | $ | (10,127) | 17% | $ | (12,875) | 18% | 21 | % |\n| | Food & beverage cost | (2,322) | 4% | (2,302) | 3% | (1) | % |\n| | Occupancy expense | (6,945) | 12% | (7,202) | 10% | 4 | % |\n| | Other operating expense | (10,174) | 18% | (9,942) | 14% | (2) | % |\n| | $ | (29,568) | 51% | $ | (32,321) | 45% | 9 | % |\n| | Australia | Film rent and advertising cost | $ | (6,279) | 11% | $ | (7,699) | 11% | 18 | % |\n| | Food & beverage cost | (1,115) | 2% | (1,594) | 2% | 30 | % |\n| | Occupancy expense | (3,962) | 7% | (4,251) | 6% | 7 | % |\n| | Other operating expense | (5,415) | 9% | (5,754) | 8% | 6 | % |\n| | $ | (16,771) | 29% | $ | (19,298) | 27% | 13 | % |\n| | New Zealand | Film rent and advertising cost | $ | (1,336) | 3% | $ | (2,232) | 3% | 40 | % |\n| | Food & beverage cost | (292) | 1% | (491) | 1% | 41 | % |\n| | Occupancy expense | (803) | 1% | (1,344) | 2% | 40 | % |\n| | Other operating expense | (1,425) | 2% | (1,653) | 2% | 14 | % |\n| | $ | (3,856) | 7% | $ | (5,720) | 8% | 33 | % |\n| |\n| | Total operating expense | $ | (50,195) | 87% | $ | (57,339) | 79% | 12 | % |\n| DEPRECIATION, AMORTIZATION, GENERAL AND ADMINISTRATIVE EXPENSE |\n| | United States | Depreciation and amortization | $ | (2,626) | 5% | $ | (2,121) | 3% | (24) | % |\n| | General and administrative expense | (604) | 1% | (545) | 1% | (11) | % |\n| | $ | (3,230) | 6% | $ | (2,666) | 4% | (21) | % |\n| | Australia | Depreciation and amortization | $ | (1,181) | 2% | $ | (1,204) | 2% | 2 | % |\n| | General and administrative expense | (387) | 1% | (299) | 0% | (29) | % |\n| | $ | (1,568) | 3% | $ | (1,503) | 2% | (4) | % |\n| | New Zealand | Depreciation and amortization | $ | (350) | 1% | $ | (440) | 1% | 20 | % |\n| | General and administrative expense | (1) | 0% | (22) | 0% | 95 | % |\n| | $ | (351) | 1% | $ | (462) | 1% | 24 | % |\n| |\n| | Total depreciation, amortization, general and administrative expense | $ | (5,149) | 10% | $ | (4,631) | 6% | (11) | % |\n| OPERATING INCOME – CINEMA |\n| | United States | $ | (765) | (1)% | $ | 3,000 | 4% | (126) | % |\n| | Australia | 3,102 | 5% | 5,916 | 8% | (48) | % |\n| | New Zealand | 305 | 1% | 1,369 | 2% | (78) | % |\n| | Total Cinema operating income | $ | 2,642 | 5% | $ | 10,285 | 14% | (74) | % |\n\n\n“nm – not meaningful”\n\n35\n1st Quarter Results\n\nCinema Segment operating income\nCinema segment operating income decreased by 74%, or $7.6 million, to $2.6 million for the quarter ended March 31, 2019 compared to March 31, 2018, primarily driven by decreased operating income in the U.S., Australia, and New Zealand, which was due to a decrease in attendance worldwide, and fluctuations in average ticket price (“ATP”), and spend per patron (“SPP”) as outlined below.\n\nRevenue\nCinema revenue decreased by 20%, or $14.3 million, to $58.0 million for the quarter ended March 31, 2019 compared to March 31, 2018, primarily attributable to a weak foreign currency exchange rate, and a weak film slate worldwide.\n\nThe top box office performers for the first quarter of 2019 included “Captain Marvel”, ($5.1 million), “Aquaman,” ($2.9 million) and “How to Train Your Dragon: The Hidden World,” ($2.7 million), did not stack up well against the top films for the same period 2018, which included major films such as “Black Panther,” “Jumanji: Welcome to the Jungle,” and “The Greatest Showman,” (which combined totaled $15.0 million). We believe that the first quarter of 2019 results are principally the product of the film available for cinema exhibition, and not a reflection of declining consumer interest in cinema as a beyond-the-home source of entertainment.\n\nBelow are the changes in our cinema revenue by market:\n| · | U.S. cinema revenue decreased by 16%, or $6.0 million, to $32.0 million, due to a 22% decrease in attendance, offset by a 12% increase SPP, and a 4% increase in ATP. |\n\n| · | Australia cinema revenue decreased by 20%, or $5.3 million, to $21.4 million, primarily due to a 15% decrease in attendance, a 9% decrease in SPP, and a 4% decrease in ATP. |\n\n| · | New Zealand cinema revenue decreased by 40%, or $3.0 million, to $4.5 million versus the same period in 2018, due to a decrease of 40% in attendance, while ATP and SPP remained relatively flat. The decrease in New Zealand was materially greater than that in the U.S. and Australia due to the closure of our Courtenay Central cinema in January. |\n\n\nMore recently “Avengers:Endgame” had the biggest box office opening of any film since the opening weekend of April 25, 2019 with $620 million in North America box office and $2.2 billion in worldwide box office. Slated for release this spring and summer are a number of potentially strong box office performers, including “John Wick Chapter 3,” “Aladdin”, “Godzilla: King of the Monsters”, “Men in Black: International,” “Toy Story 4,” and “Spider-Man: Far From Home.”\n\nOperating expense\nOperating expense for the quarter ended March 31, 2019 decreased by 12%, to $50.2 million primarily attributable to (i) lower film rent expense driven by lower admissions revenue, and (ii) lower F&B costs due to lower F&B revenue primarily in Australia and New Zealand.\n\nOperating expense as a percentage of gross revenue has increased to 87% for the first quarter of 2019, compared to 79% for the same period in 2018, due to the lower than anticipated revenue in our box office and the fact that our occupancy costs are generally fixed, and cannot be adjusted to reflect such lower admission levels.\n\nDepreciation, amortization, general and administrative expense\nDepreciation, amortization, general and administrative expense for the quarter ended March 31, 2019 increased by 11%, or $0.5 million, to $5.1 million mainly due to the depreciation related to the completion of our capital improvements placed into service in the U.S.\n36\nReal Estate\nThe following table details our real estate segment operating results for the three months ended March 31, 2019 and 2018, respectively:\n\n\n\n| |\n| | % Change |\n| | Three Months Ended | Fav/(Unfav) |\n| (Dollars in thousands) | March 31,2019 | % ofRevenue | March 31,2018 | % ofRevenue | Three Months Ended |\n| REVENUE |\n| | United States | Live theater rental and ancillary income | $ | 936 | 17% | $ | 599 | 10% | 56 | % |\n| | Property rental income | 52 | 1% | 56 | 1% | (7) | % |\n| | 988 | 18% | 655 | 11% | 51 | % |\n| | Australia | Property rental income | 3,916 | 72% | 4,154 | 69% | (6) | % |\n| | New Zealand | Property rental income | 527 | 10% | 1,199 | 20% | (56) | % |\n| |\n| | Total revenue | $ | 5,431 | 100% | $ | 6,008 | 100% | (10) | % |\n| OPERATING EXPENSE |\n| | United States | Live theater cost | $ | (298) | 5% | $ | (296) | 5% | (1) | % |\n| | Property cost | (158) | 3% | (134) | 2% | (18) | % |\n| | Occupancy expense | (151) | 3% | (163) | 3% | 7 | % |\n| | (607) | 11% | (593) | 10% | (2) | % |\n| | Australia | Property cost | (701) | 13% | (752) | 13% | 7 | % |\n| | Occupancy expense | (692) | 13% | (567) | 9% | (22) | % |\n| | (1,393) | 26% | (1,319) | 22% | (6) | % |\n| | New Zealand | Property cost | (298) | 5% | (321) | 5% | 7 | % |\n| | Occupancy expense | (147) | 3% | (150) | 2% | 2 | % |\n| | (445) | 8% | (471) | 8% | 6 | % |\n| |\n| | Total operating expense | $ | (2,445) | 45% | $ | (2,383) | 40% | (3) | % |\n| DEPRECIATION, AMORTIZATION, GENERAL AND ADMINISTRATIVE EXPENSE |\n| | United States | Depreciation and amortization | $ | (195) | 4% | $ | (192) | 3% | (2) | % |\n| | General and administrative expense | (159) | 3% | (163) | 3% | 2 | % |\n| | (354) | 7% | (355) | 6% | - | % |\n| | Australia | Depreciation and amortization | $ | (926) | 17% | $ | (909) | 15% | (2) | % |\n| | General and administrative expense | (292) | 5% | (411) | 7% | 29 | % |\n| | (1,218) | 22% | (1,320) | 22% | 8 | % |\n| | New Zealand | Depreciation and amortization | (256) | 5% | (269) | 4% | 5 | % |\n| | General and administrative expense | — | 0% | — | 0% | - | % |\n| | (256) | 5% | (269) | 4% | 5 | % |\n| |\n| | Total depreciation, amortization, general and administrative expense | $ | (1,828) | 34% | $ | (1,944) | 32% | 6 | % |\n| OPERATING INCOME - REAL ESTATE |\n| | United States | $ | 27 | 0% | $ | (293) | (5)% | 109 | % |\n| | Australia | 1,305 | 24% | 1,515 | 25% | (14) | % |\n| | New Zealand | (174) | (3)% | 459 | 8% | (138) | % |\n| | Total real estate operating income | $ | 1,158 | 21% | $ | 1,681 | 28% | (31) | % |\n\n\n1st Quarter Results\n\nReal Estate Segment income\nReal estate segment operating income decreased by 31%, or $0.5 million, to $1.2 million for the quarter ended March 31, 2019 compared to March 31, 2018, primarily due to the closure of most of the net rentable area of Courtenay Central; offset by an increase in Live Theatre segment revenue of 56%, or $0.3 million, to $0.9 million.\n\nRevenue\nReal estate revenue for the quarter decreased by 10%, or $0.6 million, to $5.4 million primarily due to a weak foreign currency exchange rate and a decrease in revenues from our New Zealand segment, principally related to the closure of portions of Courtenay Central.\n\nOperating expense\nOperating expense for the quarter ended March 31, 2019 remained flat at $2.4 million.\n\nDepreciation, amortization, general and administrative expense\nDepreciation, amortization, general and administrative expense for the quarter ended March 31, 2019 decreased by 6%, or $0.1 million, to $1.8 million primarily driven by a weak foreign currency exchange rate and a decrease in general and administrative expenses in Australia.\n\nLIQUIDITY AND CAPITAL RESOURCES\n\nOur cinema exhibition business plan is to enhance our current cinemas where it is financially reasonable to do so; develop our specialty cinemas in select markets; expand our food and beverage offering, and continue on an opportunistic basis, to identify, develop, and acquire cinema properties that allow us to leverage our cinema expertise over a larger operating base.\n37\n\nOur real estate business is to complete the redevelopment of 44 Union Square in New York City; to reassess and master-plan the Cinemas 1,2,3 property for redevelopment as a stand-alone 96,000 square foot mixed use property and in the interim to continue to use it as a cinema; to continue the build-out of our Newmarket Village and Auburn ETCs and the master planning of the expansion of our Townsville ETC in Australia; to master plan and consider the redevelopment of our Courtenay Central site in New Zealand into an urban entertainment center with a focus on cinema exhibition, food and beverage, and grocery store uses; and in Manukau, New Zealand, to develop in concert with other major land owners, of plans for the development of the infrastructure needed to support the construction of income-producing improvements; and to continue to be sensitive to opportunities to convert our entertainment assets to higher and better uses, or, where appropriate, to dispose of such assets. We will also continue to explore potential synergistic acquisitions that may not readily fall into either our cinema or real estate segment.\nThe success of our Company is dependent on our ability to execute these business plans effectively through our available resources (both cash and available borrowing facilities) while still timely addressing our liquidity risk. Liquidity risk is the risk relating to our ability to meet our financial obligations when they come due. At the present, our financial obligations arise mainly from capital expenditure needs, working capital requirements, and debt servicing requirements. We manage the liquidity risk by ensuring our ability to generate sufficient cash flows from operating activities and to obtain adequate, reasonable financing or extension of maturity dates under reasonable arrangements, and/or to convert non-performing or non-strategic assets into cash.\n\nAt March 31, 2019, our consolidated cash and cash equivalents totaled $12.6 million. Of this amount, $3.2 million and $0.7 million were held by our Australian and New Zealand subsidiaries, respectively. Our intention is to indefinitely reinvest Australian earnings locally, but not indefinitely reinvest New Zealand earnings. If the Australian earnings were used to fund U.S. operations, they would be subject to additional state income taxes upon repatriation.\n\nThe changes in cash and cash equivalents for the three months ended March 31, 2019 and 2018 are discussed as follows:\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 | % Change |\n| Net cash provided by (used in) operating activities | $ | (3,841) | $ | 2,452 | (257) | % |\n| Net cash provided by (used in) investing activities | (12,613) | (23,491) | (46) | % |\n| Net cash provided by (used in) financing activities | 15,918 | 16,161 | 2 | % |\n| Effect of exchange rate changes on cash and cash equivalents | 57 | (122) | 147 | % |\n| Increase (decrease) in cash and cash equivalents | $ | (479) | $ | (5,000) | 90 | % |\n\n\nOperating activities\nCash provided by (used in) operating activities for the first three months of 2019 decreased by $6.3 million, to ($3.8) million primarily driven by $4.7 million lower cash inflows from operating activities as well as a $1.5 million decrease in net operating assets.\n\nInvesting activities\nCash used in investing activities during the three months ended March 31, 2019 decreased by $10.9 million compared to the same period in 2018, to net cash used of $12.6 million, primarily due to a decrease in our cinema refurbishment activities compared to the 2018 quarter and the substantial completion of the upgrading and expansion of our Newmarket and Auburn/Redyard ETCs in 2018. It is anticipated that spending on our cinema activities will pick up over the remainder of the year.\n\nFinancing Activities\nThe $15.9 million net cash provided by financing activities during the three months ended March 31, 2019 was primarily related to $22.3 million of new borrowings, offset by $6.1 million of loan repayments. Proceeds from these new borrowings related principally to the ongoing construction of our 44 Union Square project in Manhattan of $6.7 million and to fund the capital improvements in our cinemas and real estate segments.\n\nOn March 2, 2017, the Board of Directors authorized a stock repurchase program to repurchase up to $25.0 million of Reading’s Class A Common Stock. The Board on March 14, 2019, extended that program to March 2, 2021. At March 31, 2019, there was $16.2 million of capacity remaining in that authorization.\n38\n\nWe manage our cash, investments and capital structure so we are able to meet the short-term and long-term obligations of our business, while maintaining financial flexibility and liquidity. We forecast, analyze and monitor our cash flows to enable investment and financing within the overall constraints of our financial strategy. In recent years, our treasury management has been focused on more aggressive cash management using cash balances to reduce debt. In earlier years, we maintained significant cash balances in our bank accounts. We have used cash generated from operations and other excess cash, to the extent not needed for any capital expenditures, to pay down our loans and credit facilities providing us some flexibility on our available loan facilities for future use and thereby, reducing interest charges.\n\n\nThe table below presents the changes in our total available resources (cash and borrowings), debt-to-equity ratio, working capital and other relevant information addressing our liquidity for the three months ended March 31, 2019 and preceding four years:\n\n\n| |\n| |\n| | As of andfor the3-MonthsEnded | Year Ended December 31 |\n| ($ in thousands) | 3/31/2019 | 2018 | 2017 | 2016 | 2015 (2) |\n| Total Resources (cash and borrowings) |\n| Cash and cash equivalents (unrestricted) | $ | 12,648 | $ | 13,127 | $ | 13,668 | $ | 19,017 | $ | 19,702 |\n| Unused borrowing facility | 107,111 | 85,886 | 137,231 | 117,599 | 70,134 |\n| Restricted for capital projects (1) | 23,566 | 30,318 | 62,280 | 62,024 | 10,263 |\n| Unrestricted capacity | 83,545 | 55,568 | 74,951 | 55,575 | 59,871 |\n| Total resources at period end | 119,759 | 99,013 | 150,899 | 136,616 | 89,836 |\n| Total unrestricted resources at period end | 96,193 | 68,695 | 88,619 | 74,592 | 79,573 |\n| Debt-to-Equity Ratio |\n| Total contractual facility | $ | 290,879 | $ | 252,929 | $ | 271,732 | $ | 266,134 | $ | 207,075 |\n| Total debt (gross of deferred financing costs) | 184,099 | 167,043 | 134,501 | 148,535 | 130,941 |\n| Current | 40,077 | 30,393 | 8,109 | 567 | 15,000 |\n| Non-current | 143,691 | 136,650 | 126,392 | 147,968 | 115,941 |\n| Finance lease liabilities | 331 | — | — | — | — |\n| Total book equity(2) | 179,946 | 180,547 | 181,618 | 146,890 | 138,951 |\n| Debt-to-equity ratio | 1.02 | 0.93 | 0.74 | 1.01 | 0.94 |\n| Changes in Working Capital |\n| Working capital (deficit) (3) | $ | (77,236) | $ | (55,270) | $ | (46,971) | $ | 6,655 | $ | (35,581) |\n| Current ratio | 0.28 | 0.35 | 0.42 | 1.10 | 0.51 |\n| Capital Expenditures (including acquisitions) | $ | 11,476 | $ | 56,827 | $ | 76,708 | $ | 49,166 | $ | 53,119 |\n\n\n| (1) | This relates to the construction facilities specifically negotiated for: (i) Union Square redevelopment project, obtained in December 2016, and (ii) New Zealand construction projects, obtained in May 2015. The New Zealand construction loan expired December 31, 2018. |\n\n| (2) | Certain 2015 balances included the restatement impact as a result of a change in accounting principle (see Note 2 – Summary of Significant Accounting Policies – Accounting Changes). Certain 2017 and 2016 balances included the restatement impact as a result of a prior period financial statement correction of immaterial errors (see Note 2 – Summary of Significant Accounting Policies – Prior Period Financial Statement Correction of Immaterial Errors). |\n\n| (3) | Typically our working capital (deficit) is negative as we receive revenue from our cinema business ahead of the time that we have to pay our associated liabilities. We use the money we receive to pay down our borrowings in the first instance |\n\n\nCONTRACTUAL OBLIGATIONS, COMMITMENTS AND CONTINGENCIES\n\nThe following table provides information with respect to the maturities and scheduled principal repayments of our recorded contractual obligations and certain of our commitments and contingencies, either recorded or off-balance sheet, as of March 31, 2019:\n\n\n| |\n| |\n| (Dollars in thousands) | 2019 | 2020 | 2021 | 2022 | 2023 | Thereafter | Total |\n| Debt(1) | $ | 40,016 | $ | 48,799 | $ | 258 | $ | 270 | $ | 58,309 | $ | 8,204 | $ | 155,856 |\n| Operating leases, including imputed interest | 23,566 | 31,434 | 31,717 | 31,901 | 31,018 | 169,221 | 318,857 |\n| Finance leases, including imputed interest | 131 | 101 | 53 | 43 | 30 | — | 358 |\n| Subordinated debt(1) | — | — | — | — | — | 27,913 | 27,913 |\n| Pension liability | 513 | 684 | 684 | 684 | 684 | 1,979 | 5,228 |\n| Village East purchase option(3) | 5,900 | — | — | — | — | — | 5,900 |\n| Estimated interest on debt (2) | 7,717 | 6,098 | 5,156 | 5,157 | 5,134 | 7,498 | 36,761 |\n| Total | $ | 77,844 | $ | 87,116 | $ | 37,868 | $ | 38,055 | $ | 95,175 | $ | 214,815 | $ | 550,873 |\n\n\n| (1) | Information is presented gross of deferred financing costs. |\n\n| (2) | Estimated interest on debt is based on the anticipated loan balances for future periods and current applicable interest rates. |\n\n| (3) | Represents the lease liability of the option associated with the ground lease purchase of the Village East Cinema. |\n\n\nRefer to Note 13 – Commitments and Contingencies for additional information.\n\n\n\n39\nLitigation\nWe are currently involved in certain legal proceedings and, as required, have accrued estimates of probable and estimable losses for the resolution of these claims.\n\nWhere we are the plaintiffs, we expense all legal fees on an on-going basis and make no provision for any potential settlement amounts until received. In Australia, the prevailing party is usually entitled to recover its attorneys’ fees, which typically work out to be approximately 60% of the amounts actually spent where first class legal counsel is engaged at customary rates. Where we are a plaintiff, we have likewise made no provision for the liability for the defendant’s attorneys' fees in the event we are determined not to be the prevailing party.\n\nWhere we are the defendants, we accrue for probable damages that insurance may not cover as they become known and can be reasonably estimated. In our opinion, any claims and litigation in which we are currently involved are not reasonably likely to have a material adverse effect on our business, results of operations, financial position, or liquidity. It is possible, however, that future results of the operations for any particular quarterly or annual period could be materially affected by the ultimate outcome of the legal proceedings. Please refer to Item 3 – Legal Proceedings in our 2018 Form 10-K for more information. There have been no material changes to our litigation since our 2018 Form 10-K, except as set forth in Note 13 – Commitments and Contingencies in the accompanying consolidated financial statements included in this Form 10-Q.\n\nOff-Balance Sheet Arrangements\n\nSee Note 13 – Commitments and Contingencies to the Consolidated Financial Statements included herein on this report, there are no off-balance sheet arrangements or obligations (including contingent obligations) that have, or are reasonably likely to have, a current or future material effect on our financial condition, changes in the financial condition, revenue or expense, results of operations, liquidity, capital expenditures or capital resources.\n\nCRITICAL ACCOUNTING POLICIES\n\nWe believe that the application of the following accounting policies requires significant judgments and estimates in the preparation of our Consolidated Financial Statements and hence, are critical to our business operations and the understanding of our financial results:\n\n(i) Impairment of Long-lived Assets (other than Goodwill and Intangible Assets with indefinite lives) – we evaluate our long-lived assets and finite-lived intangible assets using historical and projected data of cash flows as our primary indicator of potential impairment and we take into consideration the seasonality of our business. If the sum of the estimated, undiscounted future cash flows is less than the carrying amount of the asset, then an impairment is recognized for the amount by which the carrying value of the asset exceeds its estimated fair value based on an appraisal or a discounted cash flow calculation. For certain non-income producing properties or for those assets with no consistent historical or projected cash flows, we obtain appraisals or other evidence to evaluate whether there are impairment indicators for these assets.\n\nBesides the write-down of the carrying amount of our parking structure adjacent to our Courtenay Central ETC in Wellington, New Zealand due to earthquake damage during the 4th quarter of 2016, no other impairment losses were recorded for long-lived and finite-lived intangible assets for the three years ended December 31, 2018. Refer to Note 20 – Insurance Recoveries on Impairment and Related Losses due to Earthquake in the 2018 Form 10-K for further details.\n\n(ii) Impairment of Goodwill and Intangible Assets with indefinite lives – goodwill and intangible assets with indefinite useful lives are not amortized, but instead, tested for impairment at least annually on a reporting unit basis. The impairment evaluation is based on the present value of estimated future cash flows of each reporting unit plus the expected terminal value. There are significant assumptions and estimates used in determining the future cash flows and terminal value. The most significant assumptions include our cost of debt and cost of equity assumptions that comprise the weighted average cost of capital for each reporting unit. Accordingly, actual results could vary materially from such estimates.\n\nNo impairment losses were recorded for goodwill and indefinite-lived intangible assets for the three months ended March 31, 2019.\n\nFINANCIAL RISK MANAGEMENT\n\nInternational Business Risks\nOur international operations are subject to a variety of risks, including the following:\n\n| · | Currency Risk: while we report our earnings and net assets in U.S. dollars, substantial portions of our revenue and of our obligations are denominated in either Australian or New Zealand dollars. The value of these currencies can vary significantly compared to the U.S. dollar and compared to each other. We do not hedge the currency risk, but rather have relied upon the 40 |\n| natural hedges that exist as a result of the fact that our film costs are typically fixed as a percentage of the box office, and our local operating costs and obligations are likewise typically denominated in local currencies. However, we do have intercompany debt and our ability to service this debt could be adversely impacted by declines in the relative value of the Australian and New Zealand dollar compared to the U.S. dollar. Also, our use of local borrowings to mitigate the business risk of currency fluctuations has reduced our flexibility to move cash between jurisdictions. Set forth below is a chart of the exchange ratios between these three currencies since 1996: |\n\n\n\n\nIn recent periods, we have repaid intercompany debt and used the proceeds to fund capital investment in the United States. Accordingly, our debt levels in Australia are higher than they would have been if funds had not been returned for such purposes. On a company wide basis, this means that a reduction in the relative strength of the U.S. dollar versus the Australian dollar and/or the New Zealand dollar will effectively raise the overall cost of our borrowing and capital and make it more expensive to return funds from the United States to Australia and New Zealand.\n\nOur exposure to interest rate risk arises out of our intermediate term floating-rate borrowings. To manage the risk, we utilize interest rate derivative contracts to convert certain floating-rate borrowings into fixed-rate borrowings. It is the Company’s policy to enter into interest rate derivative transactions only to the extent considered necessary to meet its objectives as stated above. The Company does not enter into these transactions or any other hedging transactions for speculative purposes.\n\nInflation\n\nWe continually monitor inflation and the effects of changing prices. Inflation increases the cost of goods and services used. Competitive conditions in many of our markets restrict our ability to recover fully the higher costs of acquired goods and services through price increases. We attempt to mitigate the impact of inflation by implementing continuous process improvement solutions to enhance productivity and efficiency and, as a result, lower costs and operating expenses. The effects of inflation have not had a material impact on our operations and the resulting financial position or liquidity.\n\n\n\n41\n\nFORWARD LOOKING STATEMENTS\n\nOur statements in this interim quarterly report contain a variety of forward-looking statements as defined by the Securities Litigation Reform Act of 1995. Forward-looking statements reflect only our expectations regarding future events and operating performance and necessarily speak only as of the date the information was prepared. No guarantees can be given that our expectation will in fact be realized, in whole or in part. You can recognize these statements by our use of words such as, by way of example, “may”, “will”, “expect”, “believe”, and “anticipate” or other similar terminology.\n\nThese forward-looking statements reflect our expectation after having considered a variety of risks and uncertainties. However, they are necessarily the product of internal discussion and do not necessarily completely reflect the views of individual members of our Board of Directors or of our management team. Individual Board members and individual members of our management team may have a different view as to the risks and uncertainties involved, and may have different views as to future events or our operating performance.\n\nAmong the factors that could cause actual results to differ materially from those expressed in or underlying our forward-looking statements are the following:\n| · | with respect to our cinema operations: |\n\n| o | the number and attractiveness to moviegoers of the films released in future periods; |\n\n| o | the amount of money spent by film distributors to promote their motion pictures; |\n\n| o | the licensing fees and terms required by film distributors from motion picture exhibitors in order to exhibit their films; |\n\n| o | the comparative attractiveness of motion pictures as a source of entertainment and willingness and/or ability of consumers (i) to spend their dollars on entertainment and (ii) to spend their entertainment dollars on movies in and outside the home environment; |\n\n| o | the extent to which we encounter competition from other cinema exhibitors, from other sources of outside-the-home entertainment, and from inside-the-home entertainment options, such as “home theaters” and competitive film product distribution technology, such as, by way of example, cable, satellite broadcast and Blu-ray/DVD rentals and sales, and so called “movies on demand;” |\n\n| o | the cost and impact of improvements to our cinemas, such as improved seating, enhanced food and beverage offerings and other improvements; |\n\n| o | disruptions from theater improvements; and |\n\n| o | the extent to and the efficiency with which we are able to integrate acquisitions of cinema circuits with our existing operations. |\n\n| · | with respect to our real estate development and operation activities: |\n\n| o | the rental rates and capitalization rates applicable to the markets in which we operate and the quality of properties that we own; |\n\n| o | the extent to which we can obtain on a timely basis the various land use approvals and entitlements needed to develop our properties; |\n\n| o | the risks and uncertainties associated with real estate development; |\n\n| o | the availability and cost of labor and materials; |\n\n| o | the ability to obtain all permits to construct improvements; |\n\n| o | the ability to finance improvements; |\n\n| o | the disruptions from construction; |\n\n| o | the possibility of construction delays, work stoppage and material shortage; |\n\n| o | competition for development sites and tenants; |\n\n| o | environmental remediation issues; |\n\n| o | the extent to which our cinemas can continue to serve as an anchor tenant that will, in turn, be influenced by the same factors as will influence generally the results of our cinema operations; |\n\n| o | the increased depreciation and amortization expenses as construction projects transition to leased real property; |\n\n| o | the ability to negotiate and execute joint venture opportunities and relationships; and |\n\n| o | certain of our activities are in geologically active areas, creating a risk of damage and/or disruption of real estate and/or cinema businesses from earthquakes. |\n\n42\n\n| · | with respect to our operations generally as an international company involved in both the development and operation of cinemas and the development and operation of real estate and previously engaged for many years in the railroad business in the United States: |\n\n| o | our ability to renew, extend or renegotiate our loans that mature in 2019; |\n\n| o | our ability to grow our Company and provide value to our stockholders; |\n\n| o | our ongoing access to borrowed funds and capital and the interest that must be paid on that debt and the returns that must be paid on such capital; |\n\n| o | expenses, management and Board distraction and other effects of the litigation efforts mounted by James Cotter, Jr. against the Company, including his efforts to cause a sale of voting control of the Company; |\n\n| o | the relative values of the currency used in the countries in which we operate; |\n\n| o | changes in government regulation, including by way of example, the costs resulting from the implementation of the requirements of Sarbanes-Oxley; |\n\n| o | our labor relations and costs of labor (including future government requirements with respect to pension liabilities, disability insurance and health coverage, and vacations and leave); |\n\n| o | our exposure from time to time to legal claims and to uninsurable risks such as those related to our historic railroad operations, including potential environmental claims and health-related claims relating to alleged exposure to asbestos or other substances now or in the future recognized as being possible causes of cancer or other health related problems; |\n\n| o | our exposure to cyber-security risks, including misappropriation of customer information or other breaches of information security; |\n\n| o | changes in future effective tax rates and the results of currently ongoing and future potential audits by taxing authorities having jurisdiction over our various companies; and |\n\n| o | changes in applicable accounting policies and practices. |\n\n\nThe above list is not necessarily exhaustive, as business is by definition unpredictable and risky, and subject to influence by numerous factors outside of our control, such as changes in government regulation or policy, competition, interest rates, supply, technological innovation, changes in consumer taste, the weather, and the extent to which consumers in our markets have the economic wherewithal to spend money on beyond-the-home entertainment. Refer to Item 1A Risk factors in the 2018 Form 10-K annual report for more information.\n\nGiven the variety and unpredictability of the factors that will ultimately influence our businesses and our results of operation, it naturally follows that no guarantees can be given that any of our forward-looking statements will ultimately prove to be correct. Actual results will undoubtedly vary and there is no guarantee as to how our securities will perform either when considered in isolation or when compared to other securities or investment opportunities.\n\nFinally, we undertake no obligation to update publicly or to revise any of our forward-looking statements, whether as a result of new information, future events or otherwise, except as may be required under applicable law. Accordingly, you should always note the date to which our forward-looking statements speak.\n\nAdditionally, certain of the presentations included in this interim quarterly report may contain “non-GAAP financial measures.” In such case, a reconciliation of this information to our GAAP financial statements will be made available in connection with such statements.\n43\n\nItem 3 –\nQuantitative and Qualitative Disclosure about Market Risk\n\nThe SEC requires that registrants include information about potential effects of changes in currency exchange and interest rates in their filings. Several alternatives, all with some limitations, have been offered. We base the following discussion on a sensitivity analysis that models the effects of fluctuations in currency exchange rates and interest rates. This analysis is constrained by several factors, including the following:\n| · | It is based on a single point in time; and |\n\n| · | It does not include the effects of other complex market reactions that would arise from the changes modeled. |\n\nAlthough the results of such an analysis may be useful as a benchmark, they should not be viewed as forecasts.\nAt March 31, 2019, approximately 33% and 11% of our assets were invested in assets denominated in Australian dollars (Reading Australia) and New Zealand dollars (Reading New Zealand), respectively, including approximately $3.9 million in cash and cash equivalents. At December 31, 2018, approximately 36% and 14% of our assets were invested in assets denominated in Australian dollars (Reading Australia) and New Zealand dollars (Reading New Zealand), including approximately $5.5 million in cash and cash equivalents.\n\nOur policy in Australia and New Zealand is to match revenues and expenses, whenever possible, in local currencies. As a result, we have procured a majority of our expenses in Australia and New Zealand in local currencies. Despite this natural hedge, recent movements in foreign currencies have had an effect on our current earnings. Although foreign currency has had an effect on our current earnings, the effect of the translation adjustment on our assets and liabilities noted in our other comprehensive income was an increase of $1.5 million for the three months ended March 31, 2019. As we continue to progress our acquisition and development activities in Australia and New Zealand, we cannot assure you that the foreign currency effect on our earnings will not be material in the future.\n\nHistorically, our policy has been to borrow in local currencies to finance the development and construction of our long-term assets in Australia and New Zealand whenever possible. As a result, the borrowings in local currencies have provided somewhat of a natural hedge against the foreign currency exchange exposure. Even so, and as a result of our issuance of subordinated Trust Preferred Securities in 2007, and their subsequent partial repayment, approximately 44% and 64% of our Australian and New Zealand assets, respectively, remain subject to such exposure, unless we elect to hedge our foreign currency exchange between the US and Australian and New Zealand dollars. If the foreign currency rates were to fluctuate by 10%, the resulting change in Australian and New Zealand assets would be $9.9 million and $4.6 million, respectively, and the change in our quarterly net income (loss) would be $0.2 million and ($0.1) million, respectively. Presently, we have no plan to hedge such exposure.\n\nWe record unrealized foreign currency translation gains or losses that could materially affect our financial position. As of March 31, 2019 and December 31, 2018, the balance of cumulative foreign currency translation adjustments was approximately $10.2 million gain and $8.7 million gain, respectively.\n\nHistorically, we maintain most of our cash and cash equivalent balances in short-term money market instruments with original maturities of three months or less. Due to the short-term nature of such investments, a change of 1% in short-term interest rates would not have a material effect on our financial condition.\n\nWe have a combination of fixed and variable interest rate loans. In connection with our variable interest rate loans, a change of approximately 1% in short-term interest rates would have resulted in approximately $239,000 increase or decrease in our quarterly interest expense.\n\nFor further discussion on market risks, please refer to International Business Risks included in Item 2, Part 1 of this Form 10-Q.\n44\n\nItem 4 –\nControls and Procedures\n\nWe maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s reports filed under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.\n\nUnder the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such, term is defined under Rule 13a-15(e) promulgated under the Exchange Act. Based upon that evaluation, we concluded that, as of March 31, 2019, our disclosure controls and procedures were effective.\n\nChanges in Internal Control over Financial Reporting\n\nThere were no other changes in our internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the quarter ended March 31, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n45\nPART II – Other Information\n\n\nItem 1 – Legal Proceedings\n\nThe information required under Part II, Item 1 (Legal Proceedings) is incorporated by reference to the information contained in Note 13 – Commitments and Contingencies to the Consolidated Financial Statements included herein in Part I, Item 1 (Financial Statements) on this Quarterly Report on Form 10-Q.\n\nIn the quarter ended March 31, 2019, the arbitration relating to the termination of Cotter, Jr.’s employment with our Company (Reading International, Inc. v. James J. Cotter, AAA Case No. 01-15-0004-2384, filed July 2015) was resolved. While our Company was the named claimant, this matter relates essentially to Cotter, Jr.’s claims for compensation and damages related to his termination as our Company’s president and chief executive officer which were originally included in the Derivative Action described in Note 13, above. The Arbitrator has determined that, while Cotter, Jr. did breach his obligations under his Employment Agreement with our Company, Cotter, Jr’s breaches were not sufficiently material to allow our Company relief from its obligations under the Employment Agreement to pay certain specified separation amounts, totaling $313,000 (the “Separation Payment Amount”). The arbitrator awarded this amount, plus interest at the rate of 10% from June 12, 2016, until the award was paid in full on March 6, 2019. The reserve set up by the Company in 2015 with respect to this claim has been reversed. The Arbitrator denied on substantive grounds Cotter, Jr’s claims for consequential damages and for damages based on various tort theories (including defamation) and/or upon wrongful termination claims and denied, on jurisdictional grounds, Cotter Jr’s claims that the unvested stock options granted to him under his Employment Agreement did not expire upon his termination and continued to be exercisable by him so long as he continued as a director of our Company. In total, Cotter, Jr., claimed specified damages in excess of $1,000,000 plus unspecified tort damages. While the award was less than half of the amount claimed by Cotter, Jr., and while finding that Cotter, Jr., was in breach of his agreement with our Company, the Arbitrator nevertheless determined that Cotter, Jr. was the prevailing party and awarded Cotter, Jr. $443,000 of his requested $787,769 in attorney’s fees and costs. The Arbitrator also assessed the costs of the arbitration against our Company and ordered a reimbursement of such costs paid to date by Cotter Jr. in the amount of $14,250. This amount is reflected in our Company’s financial statements. The determinations of the Arbitrator are final and binding on the parties, and not subject to appeal.\n\nFor further details on our legal proceedings, please refer to Item 3, Legal Proceedings, contained in our 2018 Form 10-K.\n\n\nItem 1A – Risk Factors\n\nThere have been no material changes in risk factors as previously disclosed in our 2018 Form 10-K.\n\n\nItem 2 – Unregistered Sales of Equity Securities and Use of Proceeds\n\nThere were no unregistered sales of equity securities during the periods covered by this report.\n\nThe following table summarizes our repurchases under the March 2, 2017, stock repurchase program up until March 31, 2019:\n\n| |\n| |\n| Period | Total Number of Shares Purchased | Average Price Paid per Share | Total Number of Shares Purchased as part of our Stock Buy-Back Program | Approximate Dollar Value of Shares that may yet be Purchased under the Stock Buy-Back Program |\n| March 2017 | 41,899 | $ | 15.99 | 41,899 | $ | 24,330,149 |\n| May 2017 | 98,816 | $ | 15.78 | 98,816 | $ | 22,771,316 |\n| June 2017 | 70,234 | $ | 16.39 | 70,234 | $ | 21,620,212 |\n| August 2017 | 160,489 | $ | 15.82 | 160,489 | $ | 19,081,288 |\n| September 2017 | 31,718 | $ | 15.77 | 31,718 | $ | 18,581,038 |\n| December 2017 | 6,567 | $ | 16.01 | 6,567 | $ | 18,475,900 |\n| February 2018 | 8,500 | $ | 16.98 | 8,500 | $ | 18,331,570 |\n| March 2018 | 10,138 | $ | 16.99 | 10,138 | $ | 18,159,364 |\n| April 2018 | 5,000 | $ | 16.12 | 5,000 | $ | 18,078,764 |\n| December 2018 | 125,700 | $ | 15.24 | 125,700 | $ | 16,162,529 |\n| March 2019 | 566 | $ | 16.08 | 566 | $ | 16,153,428 |\n| Total | 559,627 | $ | 15.81 | 559,627 | $ | 16,153,428 |\n\n\nFor a description of grants of stock to certain executives, see the Stock Based Compensation section under see Note 15 – Equity and Stock-Based Compensation to our Consolidated Financial Statements.\n46\n\n\nItem 3 – Defaults upon Senior Securities\n\nNone.\n\n\nItem 4 – Mine Safety Disclosure\n\nNot applicable.\n\n\n47\n\nItem 5 –\nOther Information\nNone\n\n\nItem 6 –\nExhibits\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n| |\n| 31.1 | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith. |\n| 31.2 | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith. |\n| 32 | Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, furnished herewith. |\n| 101.INS | XBRL Instance Document |\n| 101.SCH | XBRL Taxonomy Extension Schema |\n| 101.CAL | XBRL Taxonomy Extension Calculation |\n| 101.DEF | XBRL Taxonomy Extension Definition |\n| 101.LAB | XBRL Taxonomy Extension Labels |\n| 101.PRE | XBRL Taxonomy Extension Presentation |\n\n\n48\nSIGNATURES\n\nPursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\nREADING INTERNATIONAL, INC.\n\nDate: May 10, 2019\n\nBy: /s/ Ellen M. Cotter\nEllen M. Cotter\nChief Executive Officer\n\nDate: May 10, 2019\n\nBy: /s/ Gilbert Avanes\nGilbert Avanes\nInterim Chief Financial Officer\n\n\n\n\n\n\n49\n</text>\n\nWhat is the increase or decrease in the percentage of net income to net cash provided by operating activities from 2018 to 2019?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial Statements\niShares®Gold Trust Micro\nStatements of Assets and Liabilities (Unaudited)\nAt September 30, 2021 and June 15, 2021 (Date of Inception)\n\n| September 30, 2021 | June 15, 2021 |\n| Assets |\n| Investment in gold bullion, at fair value(a) | $ | 607,260,237 | $ | 9,325,500 |\n| Total Assets | 607,260,237 | 9,325,500 |\n| Liabilities |\n| Sponsor’s fees payable | 34,807 | — |\n| Total Liabilities | 34,807 | — |\n| Commitments and contingent liabilities (Note 6) | — | — |\n| Net Assets | $ | 607,225,430 | $ | 9,325,500 |\n| Shares issued and outstanding(b) | 34,850,000 | 500,000 |\n| Net asset value per Share (Note 2C) | $ | 17.42 | $ | 18.65 |\n\n\n| (a) | Cost of investment in gold bullion: $626,373,040 and $9,325,500, respectively. |\n| (b) | No par value, unlimited amount authorized. |\n\nSee notes to financial statements.\n1\niShares®Gold Trust Micro\nStatements of Operations (Unaudited)\nFor the three months ended September 30, 2021 and the period from June 15, 2021 (Date of Inception) to September 30, 2021\n\n| Three Months Ended September 30, 2021 | Period from June 15, 2021 (Date of Inception) to September 30, 2021 |\n| Expenses |\n| Sponsor’s fees | $ | 200,617 | $ | 201,169 |\n| Sponsor’s fees waived | ( 107,095 | ) | ( 107,134 | ) |\n| Total expenses | 93,522 | 94,035 |\n| Net investment loss | ( 93,522 | ) | ( 94,035 | ) |\n| Net Realized and Unrealized Gain (Loss) |\n| Net realized gain (loss) from: |\n| Gold bullion sold to pay expenses | 422 | 422 |\n| Net change in unrealized appreciation/depreciation | ( 18,603,053 | ) | ( 19,112,803 | ) |\n| Net realized and unrealized loss | ( 18,602,631 | ) | ( 19,112,381 | ) |\n| Net decrease in net assets resulting from operations | $ | ( 18,696,153 | ) | $ | ( 19,206,416 | ) |\n| Net decrease in net assets per Share | $ | ( 0.61 | ) | $ | ( 0.74 | ) |\n\nSee notes to financial statements.\n2\niShares®Gold Trust Micro\nStatements of Changes in Net Assets (Unaudited)\nFor the three months ended September 30, 2021 and the period from June 15, 2021 (Date of Inception) to September 30, 2021\n\n| Period from June 15, 2021 (Date of Inception) to September 30, 2021 |\n| Net Assets at June 15, 2021 | $ | 9,325,500 |\n| Operations: |\n| Net investment loss | ( 513 | ) |\n| Net change in unrealized appreciation/depreciation | ( 509,750 | ) |\n| Net decrease in net assets resulting from operations | ( 510,263 | ) |\n| Decrease in net assets | ( 510,263 | ) |\n| Net Assets at June 30, 2021 | $ | 8,815,237 |\n| Operations: |\n| Net investment loss | ( 93,522 | ) |\n| Net realized gain | 422 |\n| Net change in unrealized appreciation/depreciation | ( 18,603,053 | ) |\n| Net decrease in net assets resulting from operations | ( 18,696,153 | ) |\n| Capital Share Transactions: |\n| Contributions for Shares issued | 617,106,346 |\n| Net increase in net assets from capital share transactions | 617,106,346 |\n| Increase in net assets | 598,410,193 |\n| Net Assets at September 30, 2021 | $ | 607,225,430 |\n| Shares issued and redeemed |\n| Shares issued | 34,350,000 |\n| Net increase in Shares issued and outstanding | 34,350,000 |\n\nSee notes to financial statements.\n3\niShares®Gold Trust Micro\nStatement of Cash Flows (Unaudited)\nFor the period from June 15, 2021 (Date of Inception) to September 30, 2021\n\n| June 15, 2021 (Date of Inception) to September 30, 2021 |\n| Cash Flows from Operating Activities |\n| Proceeds from gold bullion sold to pay expenses | $ | 59,228 |\n| Expenses – Sponsor’s fees paid | ( 59,228 | ) |\n| Net cash provided by operating activities | — |\n| Increase (decrease) in cash | — |\n| Cash, beginning of period | — |\n| Cash, end of period | $ | — |\n| Reconciliation of Net Increase (Decrease) in Net Assets Resulting from Operations to Net Cash Provided by (Used in) Operating Activities |\n| Net decrease in net assets resulting from operations | $ | ( 19,206,416 | ) |\n| Adjustments to reconcile net increase (decrease) in net assets resulting from operations to net cash provided by (used in) operating activities: |\n| Proceeds from gold bullion sold to pay expenses | 59,228 |\n| Net realized (gain) loss | ( 422 | ) |\n| Net change in unrealized appreciation/depreciation | 19,112,803 |\n| Change in operating assets and liabilities: |\n| Sponsor’s fees payable | 34,807 |\n| Net cash provided by (used in) operating activities | $ | — |\n| Supplemental disclosure of non-cash information: |\n| Gold bullion contributed for Shares issued | $ | 617,106,346 |\n\nSee notes to financial statements.\n4\niShares®Gold Trust Micro\nSchedules of Investments (Unaudited)\nAt September 30, 2021 and June 15, 2021 (Date of Inception)\n\n| September 30, 2021 |\n\n\n| Description | Ounces | Cost | Fair Value |\n| Gold bullion | 348,439 | $ | 626,373,040 | $ | 607,260,237 |\n| Total Investments – 100.01% | 607,260,237 |\n| Less Liabilities – (0.01)% | ( 34,807 | ) |\n| Net Assets – 100.00% | $ | 607,225,430 |\n\n\n| June 15, 2021 (Date of Inception) |\n\n\n| Description | Ounces | Cost | Fair Value |\n| Gold bullion | 5,000 | $ | 9,325,500 | $ | 9,325,500 |\n| Total Investments – 100.00% | 9,325,500 |\n| Less Liabilities – (0.00)% | — |\n| Net Assets – 100.00% | $ | 9,325,500 |\n\nSee notes to financial statements.\n5\niShares®Gold Trust Micro\nNotes to Financial Statements (Unaudited)\nSeptember 30, 2021\n\n| 1 - | Organization |\n\nThe iShares Gold Trust Micro (the “Trust”) was organized on June 15, 2021 as a New York trust. The trustee is The Bank of New York Mellon (the “Trustee”), which is responsible for the day-to-day administration of the Trust. The Trust’s sponsor is iShares Delaware Trust Sponsor LLC, a Delaware limited liability company (the “Sponsor”). The Trust is governed by the provisions of the Depositary Trust Agreement (the “Trust Agreement”) executed by the Trustee and the Sponsor as of June 15, 2021. The Trust issues units of beneficial interest (“Shares”) representing fractional undivided beneficial interests in its net assets.\nBlackRock Financial Management, Inc. (the “Seed Capital Investor”), contributed 5,000 ounces of Gold in exchange for 500,000 shares (the “Seed Creation Baskets”) on June 15, 2021 for the benefit of BlackRock Financial Management, Inc. At contribution, the value of the gold deposited with the Trust was based on the price of an ounce of gold of $ 1,865.10 . The Seed Capital Investor is an affiliate of the Sponsor. The Seed Capital Investor did not and will not receive from the Trust, the Sponsor or any of their affiliates any fee or other compensation in connection with the sale of the Seed Creation Baskets.\nThe Trust seeks to reflect generally the performance of the price of gold. The Trust seeks to reflect such performance before payment of the Trust’s expenses and liabilities. The Trust is designed to provide a vehicle for investors to make an investment similar to an investment in gold.\nThe accompanying unaudited financial statements were prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”) for interim financial information and with the instructions for Form 10-Q and the rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”). In the opinion of management, all material adjustments, consisting only of normal recurring adjustments considered necessary for a fair statement of the interim period financial statements, have been made. Interim period results are not necessarily indicative of results for a full-year period. These financial statements and the notes thereto should be read in conjunction with the Trust’s financial statements included in the registration statement on Form S-1 as filed with the SEC on June 23, 2021.\nThe Trust qualifies as an investment company solely for accounting purposes and not for any other purpose and follows the accounting and reporting guidance under the Financial Accounting Standards Board Accounting Standards Codification Topic 946, Financial Services - Investment Companies, but is not registered, and is not required to be registered, as an investment company under the Investment Company Act of 1940, as amended.\n\n| 2 - | Significant Accounting Policies |\n\n\n\n| A. | Basis of Accounting |\n\nThe following significant accounting policies are consistently followed by the Trust in the preparation of its financial statements in conformity with U.S. GAAP. The preparation of financial statements in conformity with U.S. GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.\n\n\n| B. | Gold Bullion |\n\nJPMorgan Chase Bank N.A., London branch (the “Custodian”), is responsible for the safekeeping of gold bullion owned by the Trust.\nFair value of the gold bullion held by the Trust is based on that day’s London Bullion Market Association (“LBMA”) Gold Price PM. “LBMA Gold Price PM” is the price per fine troy ounce of gold, stated in U.S. dollars, determined by ICE Benchmark Administration (“IBA”) following an electronic auction consisting of one or more 30-second rounds starting at 3:00 p.m. (London time), on each day that the London gold market is open for business and published shortly thereafter. If there is no LBMA Gold Price PM on any day, the Trustee is authorized to use the most recently announced price of gold determined in an electronic auction hosted by IBA that begins at 10:30 a.m. (London time) (“LBMA Gold Price AM”) unless the Trustee, in consultation with the Sponsor, determines that such price is inappropriate as a basis for evaluation.\nGain or loss on sales of gold bullion is calculated on a trade date basis using the average cost method.\n6\nThe following tables summarize activity in gold bullion for the three months ended September 30, 2021 and the period from June 15, 2021 (Date of Inception) to September 30, 2021:\n\n| Three Months Ended September 30, 2021 | Ounces | Cost | Fair Value | Realized Gain (Loss) |\n| Beginning balance | 5,000 | $ | 9,325,500 | $ | 8,815,750 | $ | — |\n| Gold bullion contributed | 343,472 | 617,106,346 | 617,106,346 | — |\n| Gold bullion distributed | — | — | — | — |\n| Gold bullion sold to pay expenses | ( 33 | ) | ( 58,806 | ) | ( 59,228 | ) | 422 |\n| Net realized gain | — | — | 422 | — |\n| Net change in unrealized appreciation/depreciation | — | — | ( 18,603,053 | ) | — |\n| Ending balance | 348,439 | $ | 626,373,040 | $ | 607,260,237 | $ | 422 |\n\n\n| Period from June 15, 2021 (Date of Inception) to September 30, 2021 | Ounces | Cost | Fair Value | Realized Gain (Loss) |\n| Beginning balance | 5,000 | $ | 9,325,500 | $ | 9,325,500 | $ | — |\n| Gold bullion contributed | 343,472 | 617,106,346 | 617,106,346 | — |\n| Gold bullion distributed | — | — | — | — |\n| Gold bullion sold to pay expenses | ( 33 | ) | ( 58,806 | ) | ( 59,228 | ) | 422 |\n| Net realized gain | — | — | 422 | — |\n| Net change in unrealized appreciation/depreciation | — | — | ( 19,112,803 | ) | — |\n| Ending balance | 348,439 | $ | 626,373,040 | $ | 607,260,237 | $ | 422 |\n\n\n\n| C. | Calculation of Net Asset Value |\n\nOn each business day, as soon as practicable after 4:00 p.m. (New York time), the net asset value of the Trust is obtained by subtracting all accrued fees, expenses and other liabilities of the Trust from the fair value of the gold and other assets held by the Trust. The Trustee computes the net asset value per Share by dividing the net asset value of the Trust by the number of Shares outstanding on the date the computation is made.\n\n\n| D. | Offering of the Shares |\n\nTrust Shares are issued and redeemed continuously in aggregations of 50,000 Shares in exchange for gold bullion rather than cash. Individual investors cannot purchase or redeem Shares in direct transactions with the Trust. The Trust only transacts with registered broker-dealers that are eligible to settle securities transactions through the book-entry facilities of the Depository Trust Company and that have entered into a contractual arrangement with the Trustee and the Sponsor governing, among other matters, the creation and redemption of Shares (such broker-dealers, the “Authorized Participants”). Holders of Shares of the Trust may redeem their Shares at any time acting through an Authorized Participant and in the prescribed aggregations of 50,000 Shares; provided, that redemptions of Shares may be suspended during any period while regular trading on NYSE Arca, Inc. (“NYSE Arca”) is suspended or restricted, or in which an emergency exists as a result of which delivery, disposal or evaluation of gold is not reasonably practicable.\nThe per Share amount of gold exchanged for a purchase or redemption represents the per Share amount of gold held by the Trust, after giving effect to its liabilities.\nWhen gold bullion is exchanged in settlement of a redemption, it is considered a sale of gold bullion for accounting purposes.\n\n\n| E. | Federal Income Taxes |\n\nThe Trust is treated as a grantor trust for federal income tax purposes and, therefore, no provision for federal income taxes is required. Any interest, expenses, gains and losses are passed through to the holders of Shares of the Trust.\nThe Sponsor has analyzed applicable tax laws and regulations and their application to the Trust as of September 30, 2021 and does not believe that there are any uncertain tax positions that require recognition of a tax liability.\n\n| 3 - | Trust Expenses |\n\nThe Trust pays to the Sponsor a Sponsor’s fee that accrues daily at an annualized rate equal to 0.15 % of the net asset value of the Trust, paid monthly in arrears. Effective June 29, 2021, the Sponsor has voluntarily agreed to waive a portion of the Sponsor’s Fee so that the Sponsor’s Fee after the fee waiver will not exceed 0.07 % through June 30, 2024. Although the Sponsor has no current intention of doing so, because the fee waiver is voluntary, the Sponsor may revert to the 0.15 % fee prior to June 30, 2024. Should the Sponsor choose to revert to the 0.15 % fee (or an amount higher than 0.07 % but no greater than 0.15 % annualized), prior to June 30, 2024, it will provide shareholders with at least 30 days’ prior written notice of such change through either a prospectus supplement to its registration statement or through a report furnished on Form 8-K. The Sponsor has agreed to assume the following administrative and marketing expenses incurred by the Trust: the Trustee’s fee and reimbursement for its reasonable out-of-pocket expenses, the Custodian’s fee, NYSE Arca listing fees, SEC registration fees, printing and mailing costs, audit fees and expenses, and up to $ 100,000 per annum in legal fees and expenses. The amount waived is included in Sponsor’s fees waived in the Statement of Operations. For the quarter ended September 30, 2021, the amount waived was $ 107,095 .\n7\n\n| 4 - | Related Parties |\n\nThe Sponsor and the Trustee are considered to be related parties to the Trust. The Trustee’s fee is paid by the Sponsor and is not a separate expense of the Trust.\nAs of September 30, 2021 BlackRock Financial Management, Inc., an affiliate of the Sponsor, owned 500,000 Shares of the Trust.\n\n| 5 - | Indemnification |\n\nThe Trust Agreement provides that the Trustee shall indemnify the Sponsor, its directors, officers, employees and agents against, and hold each of them harmless from, any loss, liability, cost, expense or judgment (including reasonable fees and expenses of counsel) (i) caused by the negligence or bad faith of the Trustee or (ii) arising out of any information furnished in writing to the Sponsor by the Trustee expressly for use in the registration statement, or any amendment thereto or periodic or other report filed with the SEC relating to the Shares that is not materially altered by the Sponsor.\nThe Trust Agreement provides that the Sponsor and its shareholders, directors, officers, employees, affiliates (as such term is defined under the Securities Act of 1933, as amended) and subsidiaries shall be indemnified from the Trust and held harmless against any loss, liability or expense incurred without their (1) negligence, bad faith, willful misconduct or willful malfeasance arising out of or in connection with the performance of their obligations under the Trust Agreement or any actions taken in accordance with the provisions of the Trust Agreement or (2) reckless disregard of their obligations and duties under the Trust Agreement.\nThe Trust has agreed that the Custodian will only be responsible for any loss or damage suffered by the Trust as a direct result of the Custodian’s negligence, fraud or willful default in the performance of its duties.\n\n| 6 - | Commitments and Contingent Liabilities |\n\nIn the normal course of business, the Trust may enter into contracts with service providers that contain general indemnification clauses. The Trust’s maximum exposure under these arrangements is unknown as this would involve future claims that may be made against the Trust that have not yet occurred.\n\n| 7 - | Concentration Risk |\n\nSubstantially all of the Trust’s assets are holdings of gold bullion, which creates a concentration risk associated with fluctuations in the price of gold. Accordingly, a decline in the price of gold will have an adverse effect on the value of the Shares of the Trust. Factors that may have the effect of causing a decline in the price of gold include large sales by the official sector (governments, central banks, and related institutions); a significant increase in the hedging activities of gold producers; significant changes in the attitude of speculators, investors and other market participants towards gold; global gold supply and demand; global or regional political, economic or financial events and situations; investors’ expectations with respect to the rate of inflation; interest rates; investment and trading activities of hedge funds and commodity funds; other economic variables such as income growth, economic output, and monetary policies; and investor confidence.\n8\n\n| 8 - | Financial Highlights |\n\nThe following financial highlights relate to investment performance and operations for a Share outstanding for the three months ended September 30, 2021 and the period from June 15, 2021 (Date of Inception) to September 30, 2021.\n\n| Three Months Ended September 30, 2021 | Period from June 15, 2021 (Date of Inception) to September 30, 2021 |\n| Net asset value per Share, beginning of period | $ | 17.63 | $ | 18.65 |\n| Net investment loss(a) | ( 0.00 | )(b) | ( 0.00 | )(b) |\n| Net realized and unrealized gain (loss)(c) | ( 0.21 | ) | ( 1.23 | ) |\n| Net decrease in net assets from operations | ( 0.21 | ) | ( 1.23 | ) |\n| Net asset value per Share, end of period | $ | 17.42 | $ | 17.42 |\n| Total return, at net asset value(d)(e) | ( 1.19 | )% | ( 6.60 | )% |\n| Ratio to average net assets: |\n| Net investment loss(f) | ( 0.07 | )% | ( 0.07 | )% |\n| Total Expenses(f) | 0.15 | % | 0.15 | % |\n| Total expenses after fees waived(f) | 0.07 | % | 0.07 | % |\n\n\n| (a) | Based on average Shares outstanding during the period. |\n| (b) | Amount is greater than $( 0.005 ) per share |\n| (c) | The amounts reported for a Share outstanding may not accord with the change in aggregate gains and losses on investment for the period due to the timing of Trust Share transactions in relation to the fluctuating fair values of the Trust’s underlying investment. |\n| (d) | Based on the change in net asset value of a Share during the period. |\n| (e) | Percentage is not annualized. |\n| (f) | Percentage is annualized. |\n\n\n| 9 - | Investment Valuation |\n\nU.S. GAAP defines fair value as the price the Trust would receive to sell an asset or pay to transfer a liability in an orderly transaction between market participants at the measurement date. The Trust’s policy is to value its investment at fair value.\nVarious inputs are used in determining the fair value of assets and liabilities. Inputs may be based on independent market data (“observable inputs”) or they may be internally developed (“unobservable inputs”). These inputs are categorized into a disclosure hierarchy consisting of three broad levels for financial reporting purposes. The level of a value determined for an asset or liability within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement in its entirety. The three levels of the fair value hierarchy are as follows:\n\n| Level 1 − | Unadjusted quoted prices in active markets for identical assets or liabilities; |\n\n\n| Level 2 − | Inputs other than quoted prices included within Level 1 that are observable for the asset or liability either directly or indirectly, including quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not considered to be active, inputs other than quoted prices that are observable for the asset or liability, and inputs that are derived principally from or corroborated by observable market data by correlation or other means; and |\n\n\n| Level 3 − | Unobservable inputs that are unobservable for the asset or liability, including the Trust’s assumptions used in determining the fair value of investments. |\n\nAt September 30, 2021, the value of the gold bullion held by the Trust is categorized as Level 1.\n9\n\ns Discussion and Analysis of Financial Condition and Results of Operations.\nThis information should be read in conjunction with the financial statements and notes to financial statements included in Item 1 of Part I of this Form 10‑Q. The discussion and analysis that follows may contain statements that relate to future events or future performance. In some cases, such forward-looking statements can be identified by terminology such as “may,” “should,” “could,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential” or the negative of these terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially. These statements are based upon certain assumptions and analyses made by the Sponsor on the basis of its perception of historical trends, current conditions and expected future developments, as well as other factors it believes are appropriate in the circumstances. Whether or not actual results and developments will conform to the Sponsor’s expectations and predictions, however, is subject to a number of risks and uncertainties, including the special considerations discussed below, general economic, market and business conditions, changes in laws or regulations, including those concerning taxes, made by governmental authorities or regulatory bodies, and other world economic and political developments. Although the Sponsor does not make forward-looking statements unless it believes it has a reasonable basis for doing so, the Sponsor cannot guarantee their accuracy. Except as required by applicable disclosure laws, neither the Trust nor the Sponsor is under a duty to update any of the forward-looking statements to conform such statements to actual results or to a change in the Sponsor’s expectations or predictions.\nIntroduction\nThe iShares Gold Trust Micro (the “Trust”) is a grantor trust formed under the laws of the State of New York. The Trust does not have any officers, directors, or employees, and is administered by The Bank of New York Mellon (the “Trustee”) acting as trustee pursuant to the Depositary Trust Agreement (the “Trust Agreement”) between the Trustee and iShares Delaware Trust Sponsor LLC, the sponsor of the Trust (the “Sponsor”). The Trust issues units of beneficial interest (“Shares”) representing fractional undivided beneficial interests in its net assets. The assets of the Trust consist primarily of gold bullion held by a custodian as an agent of the Trust responsible only to the Trustee.\nThe Trust is a passive investment vehicle and seeks to reflect generally the performance of the price of gold. The Trust seeks to reflect such performance before payment of the Trust’s expenses and liabilities. The Trust does not engage in any activities designed to obtain a profit from, or ameliorate losses caused by, changes in the price of gold.\nThe Trust issues and redeems Shares only in exchange for gold, only in aggregations of 50,000 Shares (a “Basket”) or integral multiples thereof, and only in transactions with registered broker-dealers that have previously entered into an agreement with the Sponsor and the Trustee governing the terms and conditions of such issuance (such broker-dealers, the “Authorized Participants”). A list of the current Authorized Participants is available from the Sponsor or the Trustee.\nShares of the Trust trade on NYSE Arca, Inc. under the ticker symbol IAUM.\nValuation of Gold Bullion; Computation of Net Asset Value\nOn each business day, as soon as practicable after 4:00 p.m. (New York time), the Trustee evaluates the gold held by the Trust and determines the net asset value of the Trust and the net asset value per Share (“NAV”). The Trustee values the gold held by the Trust using the price per fine troy ounce of gold determined in an electronic auction hosted by ICE Benchmark Administration (“IBA”) that begins at 3:00 p.m. (London time) and published shortly thereafter, on the day the valuation takes place (such price, the “LBMA Gold Price PM”). If there is no announced LBMA Gold Price PM on any day, the Trustee is authorized to use the most recently announced price of gold determined in an electronic auction hosted by IBA that begins at 10:30 a.m. (London time) (such price, the “LBMA Gold Price AM”), unless the Trustee, in consultation with the Sponsor, determines that such price is inappropriate as a basis for evaluation. The LBMA Gold Price AM and LBMA Gold Price PM are used by the Trust because they are commonly used by the U.S. gold market as indicators of the value of gold and are permitted to be used under the Trust Agreement. The use of indicators of the value of gold bullion other than the LBMA Gold Price AM and LBMA Gold Price PM could result in materially different fair value pricing of the gold held by the Trust, and as such, could result in different cost or market adjustments or in different redemption value adjustments of the outstanding redeemable capital Shares. Having valued the gold held by the Trust, the Trustee then subtracts all accrued fees, expenses and other liabilities of the Trust from the total value of the gold held by the Trust and other assets held by the Trust. The result is the net asset value of the Trust. The Trustee computes NAV by dividing the net asset value of the Trust by the number of Shares outstanding on the date the computation is made.\nLiquidity\nThe Trust is not aware of any trends, demands, conditions or events that are reasonably likely to result in material changes to its liquidity needs. In exchange for a fee, the Sponsor has agreed to assume most of the expenses incurred by the Trust. As a result, the only ordinary expense of the Trust during the period covered by this report was the Sponsor’s fee. The Trust’s only source of liquidity is its sales of gold.\nCritical Accounting Policies\nThe financial statements and accompanying notes are prepared in accordance with generally accepted accounting principles in the United States of America. The preparation of these financial statements relies on estimates and assumptions that impact the Trust’s financial position and results of operations. These estimates and assumptions affect the Trust’s application of accounting policies. Below is a description of the valuation of gold bullion, a critical accounting policy that the Trust believes is important to understanding its results of operations and financial position, is provided in the section entitled “Valuation of Gold Bullion; Computation of Net Asset Value” above. In addition, please refer to Note 2 to the financial statements included in this report for further discussion of the Trust’s accounting policies.\n10\nResults of Operations\nThe Quarter Ended September 30, 2021\nThe Trust’s net asset value increased from $8,815,237 at June 30, 2021 to $607,225,430 at September 30, 2021, a 6,788.36% increase. The increase in the Trust’s net asset value resulted primarily from an increase in the number of outstanding shares, which rose from 500,000 Shares at June 30, 2021 to 34,850,000 Shares at September 30, 2021, a consequence of 34,350,000 Shares (687 Baskets) being created during the quarter. The increase in the Trust’s net asset value was partially offset by a decrease in the LMBA Gold Price, which fell 1.15% from $1,763.15 at June 30, 2021 to $1,742.80 at September 30, 2021.\nThe 1.19% decrease in the NAV from $17.63 at June 30, 2021 to $17.42 at September 30, 2021 is directly related to the 1.15% decrease in the price of gold.\nThe NAV decreased slightly more than the price of gold on a percentage basis due to the Sponsor’s fees, which were $93,522 for the quarter, or 0.02% of the Trust’s average weighted assets of $537,613,742 during the quarter. The NAV of $18.29 on July 29, 2021 was the highest during the quarter, compared with a low during the quarter of $17.23 on August 10, 2021.\nNet decrease in net assets resulting from operations for the quarter ended September 30, 2021 was $18,696,153, resulting from an unrealized loss on investment in gold bullion of $18,603,053, a net realized gain of $422 from gold bullion sold to pay expenses during the quarter, and a net investment loss of $93,522. Other than the Sponsor’s fees of $93,522, the Trust had no expenses during the quarter.\nThe Period from June 15, 2021 (Date of Inception) to September 30, 2021\nThe Trust’s net asset value increased from $9,325,500 at June 15, 2021 (Date of Inception) to $607,225,430 at September 30, 2021, a 6,411.45% increase. The increase in the Trust’s net asset value resulted primarily from an increase in the number of outstanding shares, which rose from 500,000 Shares at June 15, 2021 (Date of Inception) to 34,850,000 Shares at September 30, 2021, a consequence of 34,350,000 Shares (687 Baskets) being created during the period. The increase in the Trust’s net asset value was partially offset by a decrease in the LMBA Gold Price, which fell 6.56% from $1,865.10 at June 15, 2021 (Date of Inception) to $1,742.80 at September 30, 2021.\nThe 6.60% decrease in the NAV from $18.65 at June 15, 2021 (Date of Inception) to $17.42 at September 30, 2021 is directly related to the 6.56% decrease in the price of gold.\nThe NAV decreased slightly more than the price of gold on a percentage basis due to the Sponsor’s fees, which were $94,035 for the period, or 0.02% of the Trust’s average weighted assets of $459,291,726 during the period. The NAV of $18.65 on June 15, 2021 was the highest during the period, compared with a low during the period of $17.23 on August 10, 2021.\nNet decrease in net assets resulting from operations for the period ended September 30, 2021 was $19,206,416, resulting from an unrealized loss on investment in gold bullion of $19,112,803, a net realized gain of $422 from gold bullion sold to pay expenses during the quarter, and a net investment loss of $94,035. Other than the Sponsor’s fees of $94,035, the Trust had no expenses during the period.\n\nNot applicable.\n\nThe duly authorized officers of the Sponsor performing functions equivalent to those a principal executive officer and principal financial officer of the Trust would perform if the Trust had any officers, with the participation of the Trustee, have evaluated the effectiveness of the Trust’s disclosure controls and procedures, and have concluded that the disclosure controls and procedures of the Trust were effective as of the end of the period covered by this report to provide reasonable assurance that information required to be disclosed in the reports that the Trust files or submits under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported, within the time periods specified in the applicable rules and forms, and that it is accumulated and communicated to the duly authorized officers of the Sponsor performing functions equivalent to those a principal executive officer and principal financial officer of the Trust would perform if the Trust had any officers, as appropriate to allow timely decisions regarding required disclosure.\nThere are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures.\n11\nPART II – OTHER INFORMATION\n\nNone.\n\nThere have been no material changes to the Risk Factors in the registration statement on Form S-1, initially filed with the Securities and Exchange Commission on February 26, 2021 and declared effective on June 28, 2021.\n\na) None.\nb) Not applicable.\nc) There were no Shares redeemed during the period from June 15, 2021 (Date of Inception) to September 30, 2021.\n\nNone.\n\nNot applicable.\n\nNot applicable.\n12\n\n\n| Exhibit No. | Description |\n| 4.1 | Depositary Trust Agreement is incorporated by reference to Exhibit 4.1 of the Registration Statement on Form S‑1 (File No. 333‑253614) filed by the Registrant on June 21, 2021 |\n| 4.2 | Standard Terms for Authorized Participant Agreements is incorporated by reference to Exhibit 4.2 of the Registration Statement on Form S-1 (File No. 333-253614) filed by the Registrant on June 21, 2021 |\n| 10.1 | Custodian Agreement between The Bank of New York Mellon and JP Morgan Chase Bank N.A., London branch is incorporated by reference to Exhibit 10.1 of the Registration Statement on Form S-1 (File No. 333-253614) filed by the Registrant on June 21, 2021 |\n| 10.2 | Sub-license Agreement is incorporated by reference to Exhibit 10.2 of the Registration Statement on Form S-1 (File No. 333-253614) filed by the Registrant on June 21, 2021 |\n| 31.1 | Certification by Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2 | Certification by Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1 | Certification by Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes‑Oxley Act of 2002 |\n| 32.2 | Certification by Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes‑Oxley Act of 2002 |\n| 101.INS | Inline XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104 | Cover Page Interactive Data File included as Exhibit 101 (embedded within the Inline XBRL document) |\n\n13\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned in the capacities* indicated thereunto duly authorized.\niShares Delaware Trust Sponsor LLC, Sponsor of the iShares Gold Trust Micro (registrant)\n\n| /s/ Paul Lohrey |\n| Paul Lohrey |\n| Director, President and Chief Executive Officer |\n| (Principal executive officer) |\n\n\n| Date: | November 3, 2021 |\n\n\n| /s/ Trent Walker |\n| Trent Walker |\n| Chief Financial Officer |\n| (Principal financial and accounting officer) |\n\n\n| Date: | November 3, 2021 |\n\n\n| * | The registrant is a trust and the persons are signing in their respective capacities as officers of iShares Delaware Trust Sponsor LLC, the Sponsor of the registrant. |\n\n14\n</text>\n\nWhat is the percentage increase in the value of gold bullion from the date of inception until September 30, 2021?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial Statements.\nBETTER WORLD ACQUISITION CORP.\nCONDENSED BALANCE SHEETS\n\n| September 30, 2022 | December 31, 2021 |\n| (Unaudited) |\n| ASSETS |\n| Current assets |\n| Cash | $ | 83,760 | $ | 278,197 |\n| Prepaid expenses and other current assets | 48,251 | 30,805 |\n| Total Current Assets | 132,011 | 309,002 |\n| Cash and marketable securities held in Trust Account | 44,203,481 | 128,790,008 |\n| TOTAL ASSETS | $ | 44,335,492 | $ | 129,099,010 |\n| LIABILITIES AND STOCKHOLDERS’ DEFICIT |\n| Current liabilities - Accounts payable and accrued expenses | $ | 560,689 | $ | 430,800 |\n| Deferred legal fees | 1,371,549 | 1,009,868 |\n| Convertible promissory note – related party, at fair value | 913,900 | 958,400 |\n| Warrant Liabilities | 422,846 | 2,641,204 |\n| Income taxes payable | 27,528 | — |\n| Total Liabilities | 3,296,512 | 5,040,272 |\n| Commitments and Contingencies (Note 6) |\n| Common stock subject to possible redemption; $ 0.0001 par value; 4,213,453 shares at $ 10.49 per share redemption value as of September 30, 2022 and 12,618,600 shares at $ 10.20 per share redemption value as of December 31, 2021 | 44,203,481 | 128,709,720 |\n| Stockholders’ Deficit |\n| Preferred stock, $ 0.0001 par value; 1,000,000 shares authorized; none issued or outstanding | — | — |\n| Common stock, $ 0.0001 par value; 50,000,000 shares authorized; 3,487,070 shares issued and outstanding (excluding 4,213,453 and 12,618,600 shares subject to possible redemption) at September 30, 2022 and December 31, 2021, respectively | 348 | 348 |\n| Accumulated deficit | ( 3,164,849 | ) | ( 4,651,330 | ) |\n| Total Stockholders’ Deficit | ( 3,164,501 | ) | ( 4,650,982 | ) |\n| TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT | $ | 44,335,492 | $ | 129,099,010 |\n\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\n1\nBETTER WORLD ACQUISITION CORP.\nCONDENSED STATEMENTS OF OPERATIONS\n(UNAUDITED)\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Operational costs | $ | 396,066 | $ | 735,695 | $ | 1,327,272 | $ | 1,148,802 |\n| Loss from operations | ( 396,066 | ) | ( 735,695 | ) | ( 1,327,272 | ) | ( 1,148,802 | ) |\n| Other income (expense): |\n| Interest earned on marketable securities held in Trust Account | 254,709 | 23,138 | 423,734 | 58,976 |\n| Unrealized gain (loss) on marketable securities held in Trust Account | 1,078 | ( 4,654 | ) | — | ( 5,829 | ) |\n| Change in fair value of Private Warrants liabilities | ( 106,018 | ) | 2,192,941 | 2,218,358 | 3,302,913 |\n| Change in fair value of convertible promissory note – related party | 1,113,700 | — | 2,119,960 | — |\n| Other income, net | 1,263,469 | 2,211,425 | 4,762,052 | 3,356,060 |\n| Income before provision for income taxes | 867,403 | 1,475,730 | 3,434,780 | 2,207,258 |\n| Provision for income taxes | ( 23,249 | ) | — | ( 27,528 | ) | — |\n| Net income | $ | 844,154 | $ | 1,475,730 | $ | 3,407,252 | $ | 2,207,258 |\n| Basic and diluted weighted average shares outstanding, redeemable common stock | 5,591,938 | 12,618,600 | 9,268,327 | 12,618,600 |\n| Basic and diluted net income per share, redeemable common stock | $ | 0.09 | $ | 0.09 | $ | 0.27 | $ | 0.14 |\n| Basic and diluted weighted average shares outstanding, non-redeemable common stock | 3,487,070 | 3,487,070 | 3,487,070 | 3,487,070 |\n| Basic and diluted net income per share, non-redeemable common stock | $ | 0.09 | $ | 0.09 | $ | 0.27 | $ | 0.14 |\n\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\n2\nBETTER WORLD ACQUISITION CORP.\nCONDENSED STATEMENTS OF CHANGES IN STOCKHOLDERS’ DEFICIT\n(UNAUDITED)\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2022\n\n| Common Stock | Additional Paid | Accumulated | Total Stockholders’ |\n| Shares | Amount | in Capital | Deficit | Deficit |\n| Balance – January 1, 2022 | 3,487,070 | $ | 348 | $ | — | $ | ( 4,651,330 | ) | $ | ( 4,650,982 | ) |\n| Accretion for common stock to redemption amount | — | — | — | ( 1,261,860 | ) | ( 1,261,860 | ) |\n| Net income | — | — | — | 1,647,395 | 1,647,395 |\n| Balance – March 31, 2022 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 4,265,795 | ) | $ | ( 4,265,447 | ) |\n| Accretion for common stock to redemption amount | — | — | — | ( 500,000 | ) | ( 500,000 | ) |\n| Net income | — | — | — | 915,703 | 915,703 |\n| Balance – June 30, 2022 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 3,850,092 | ) | $ | ( 3,849,744 | ) |\n| Accretion for common stock to redemption amount | — | — | ( 346,400 | ) | ( 158,911 | ) | ( 505,311 | ) |\n| Promissory note proceeds in excess of initial fair value | — | — | 346,400 | — | 346,400 |\n| Net income | — | — | — | 844,154 | 844,154 |\n| Balance – September 30, 2022 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 3,164,849 | ) | $ | ( 3,164,501 | ) |\n\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2021\n\n| Common Stock | Additional Paid | Accumulated | Total Stockholders’ |\n| Shares | Amount | in Capital | Deficit | Deficit |\n| Balance – January 1, 2021 | 3,487,070 | $ | 348 | $ | — | $ | ( 5,489,693 | ) | $ | ( 5,489,345 | ) |\n| Net income | — | — | — | 832,646 | 832,646 |\n| Balance – March 31, 2021 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 4,657,047 | ) | $ | ( 4,656,699 | ) |\n| Net loss | — | — | — | ( 101,118 | ) | ( 101,118 | ) |\n| Balance – June 30, 2021 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 4,758,165 | ) | $ | ( 4,757,817 | ) |\n| Net income | — | — | — | 1,475,730 | 1,475,730 |\n| Balance – September 30, 2021 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 3,282,435 | ) | $ | ( 3,282,087 | ) |\n\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\n3\nBETTER WORLD ACQUISITION CORP.\nCONDENSED STATEMENTS OF CASH FLOWS\n(UNAUDITED)\n\n| Nine Months Ended September 30, |\n| 2022 | 2021 |\n| Cash Flows from Operating Activities: |\n| Net income | $ | 3,407,252 | $ | 2,207,258 |\n| Adjustments to reconcile net income to net cash used in operating activities: |\n| Interest earned on marketable securities held in Trust Account | ( 423,734 | ) | ( 58,976 | ) |\n| Unrealized gain on marketable securities held in Trust Account | — | 5,829 |\n| Change in fair value of convertible promissory note – related party | ( 2,119,960 | ) | — |\n| Change in fair value of Private Warrant liabilities | ( 2,218,358 | ) | ( 3,302,913 | ) |\n| Changes in operating assets and liabilities: |\n| Prepaid expenses and other current assets | ( 17,446 | ) | 45,890 |\n| Accounts payable and accrued expenses | 129,889 | 574,639 |\n| Income taxes payable | 27,528 | — |\n| Deferred legal fees payable | 361,681 | — |\n| Net cash used in operating activities | ( 853,148 | ) | ( 528,273 | ) |\n| Cash Flows from Investing Activities: |\n| Investment of cash into Trust Account | ( 2,121,860 | ) | — |\n| Cash withdrawn from Trust Account to pay franchise taxes | 358,711 | — |\n| Cash withdrawn from Trust Account in connection with redemption | 86,773,410 | — |\n| Net cash provided by investing activities | 85,010,261 | — |\n| Cash Flows from Financing Activities: |\n| Advances from related party | 100,000 | — |\n| Proceeds from promissory note – related party | — | 107,639 |\n| Repayment of promissory note – related party | — | ( 107,639 | ) |\n| Proceeds from convertible promissory note – related party | 2,321,860 | — |\n| Redemption of common stock | ( 86,773,410 | ) | — |\n| Net cash used in financing activities | ( 84,351,550 | ) | — |\n| Net Change in Cash | ( 194,437 | ) | ( 528,273 | ) |\n| Cash – Beginning of period | 278,197 | 1,023,178 |\n| Cash – End of period | $ | 83,760 | $ | 494,905 |\n| Non-Cash investing and financing activities: |\n| Conversion of advance to convertible promissory note – related party | $ | 100,000 | $ | — |\n| Accretion for common stock to redemption amount | $ | 1,928,271 | $ | — |\n| Promissory note proceeds in excess of initial fair value | $ | ( 338,900 | ) | $ | — |\n\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\n4\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nNOTE 1. DESCRIPTION OF ORGANIZATION, BUSINESS OPERATIONS, LIQUIDITY AND GOING CONCERN\nBetter World Acquisition Corp. (the “Company”) was incorporated in Delaware on August 5, 2020. The Company is a blank check company formed for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities (the “Business Combination”).\nAlthough the Company is not limited to a particular industry or sector for purposes of consummating a Business Combination, the Company is focused on target businesses in the healthy living industries that benefit from strong Environmental, Social and Governance (“ESG”) profiles. The Company is an early stage and emerging growth company and, as such, the Company is subject to all the risks associated with early stage and emerging growth companies.\nAs of September 30, 2022, the Company had not commenced any operations. All activity for the period from August 5, 2020 (inception) through September 30, 2022 relates to the Company’s formation, the initial public offering (“Initial Public Offering”), which is described below, and identifying a target company for a Business Combination. The Company will not generate any operating revenues until after the completion of a Business Combination, at the earliest. The Company generates non-operating income in the form of interest income from the marketable securities held in the Trust Account (as defined below).\nThe registration statement for the Company’s Initial Public Offering was declared effective on November 12, 2020. On November 17, 2020, the Company consummated the Initial Public Offering of 11,000,000 units (the “Units” and, with respect to the shares of common stock included in the Units sold, the “Public Shares”), at $ 10.00 per Unit, generating gross proceeds of $ 110,000,000 , which is described in Note 3.\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the sale of 4,800,000 warrants (the “Private Warrants”) at a price of $ 1.00 per Private Warrant in a private placement to BWA Holdings LLC (the “Sponsor”) and EarlyBirdCapital, Inc. (“EarlyBirdCapital”), generating gross proceeds of $ 4,800,000 , which is described in Note 4.\nFollowing the closing of the Initial Public Offering on November 17, 2020, an amount of $ 111,100,000 ($ 10.10 per Unit) from the net proceeds of the sale of the Units in the Initial Public Offering and the sale of the Private Warrants was placed in a trust account (the “Trust Account”) located in the United States and invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), with a maturity of 185 days or less or in any open-ended investment company that holds itself out as a money market fund selected by the Company meeting the conditions of Rule 2a-7 of the Investment Company Act, as determined by the Company, until the earlier of: (i) the completion of a Business Combination and (ii) the distribution of the funds in the Trust Account, as described below.\nOn November 17, 2020, the underwriters notified the Company of their intention to partially exercise their over-allotment option on November 19, 2020. As such, on November 19, 2020, the Company consummated the sale of an additional 1,618,600 Units, at $ 10.00 per Unit, generating gross proceeds of $ 16,186,000 , and the sale of an additional 485,580 Private Warrants, at $ 1.00 per Private Warrant, generating gross proceeds of $ 485,580 . A total of $ 16,347,860 of the net proceeds was deposited into the Trust Account on November 20, 2020, bringing the aggregate proceeds held in the Trust Account to $ 127,447,860 . On November 9, 2021, in connection with the first extension of the date by which the Company has to consummate a Business Combination, a total of $ 1,261,860 was deposited into the Trust Account. On February 17, 2022, a total of $ 1,261,860 was deposited in the Trust Account in connection with the second extension of the date by which the Company has to consummate a Business Combination to May 17, 2022. On May 18, 2022, a total of $ 500,000 was deposited into the Trust Account in connection with a further extension of the date by which the Company has to consummate a Business Combination to August 17, 2022. On August 17, 2022, a total of $ 360,000 was deposited into the Trust Account in connection with a further extension of the date by which the Company has to consummate a Business Combination to February 17, 2023.\nTransaction costs amounted to $ 2,880,354 consisting of $ 2,523,720 of underwriting fees and $ 356,634 of other offering costs.\nThe Company’s management has broad discretion with respect to the specific application of the net proceeds of the Initial Public Offering and the sale of the Private Warrants, although substantially all of the net proceeds are intended to be applied generally toward completing a Business Combination. The Company must complete a Business Combination having an aggregate fair market value of at least 80 % of the assets held in the Trust Account (excluding taxes payable on income earned on the Trust Account) at the time of the agreement to enter into an initial Business Combination. The Company will only complete a Business Combination if the post Business Combination company owns or acquires 50 % or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act. There is no assurance that the Company will be able to complete a Business Combination successfully.\n5\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nThe Company will provide its holders of the outstanding Public Shares (the “public stockholders”) with the opportunity to redeem all or a portion of their Public Shares upon the completion of a Business Combination either (i) in connection with a stockholder meeting called to approve the Business Combination or (ii) by means of a tender offer. The decision as to whether the Company will seek stockholder approval of a Business Combination or conduct a tender offer will be made by the Company, solely in its discretion. The public stockholders will be entitled to redeem their Public Shares for a pro rata portion of the amount then in the Trust Account ($ 10.46 per Public Share as of September 30, 2022 and $ 10.20 per Public Share as of December 31, 2021, plus any pro rata interest earned on the funds held in the Trust Account and not previously released to the Company to pay its tax obligations). There will be no redemption rights upon the completion of a Business Combination with respect to the Company’s warrants.\nThe Company will proceed with a Business Combination if the Company has net tangible assets of at least $ 5,000,001 immediately prior to or upon such consummation of a Business Combination and, if the Company seeks stockholder approval, a majority of the shares voted are voted in favor of the Business Combination. If a stockholder vote is not required by law and the Company does not decide to hold a stockholder vote for business or other legal reasons, the Company will, pursuant to its Amended and Restated Certificate of Incorporation (the “Amended and Restated Certificate of Incorporation”), conduct the redemptions pursuant to the tender offer rules of the U.S. Securities and Exchange Commission (“SEC”) and file tender offer documents with the SEC containing substantially the same information as would be included in a proxy statement prior to completing a Business Combination. If, however, stockholder approval of the transaction is required by law, or the Company decides to obtain stockholder approval for business or legal reasons, the Company will offer to redeem shares in conjunction with a proxy solicitation pursuant to the proxy rules and not pursuant to the tender offer rules. If the Company seeks stockholder approval in connection with a Business Combination, the Sponsor has agreed to vote its Founder Shares (as defined in Note 5), Representative Shares (as defined in Note 8) and any Public Shares purchased during or after the Initial Public Offering (a) in favor of approving a Business Combination and (b) not to redeem any shares in connection with a stockholder vote to approve a Business Combination or sell any shares to the Company in a tender offer in connection with a Business Combination. Additionally, each public stockholder may elect to redeem their Public Shares, irrespective of whether they vote for or against the proposed Business Combination.\nThe Sponsor has agreed (a) to waive its redemption rights with respect to the Founder Shares and Public Shares held by it in connection with the completion of a Business Combination and (b) not to propose an amendment to the Amended and Restated Certificate of Incorporation that would affect a public stockholders’ ability to convert or sell their shares to the Company in connection with a Business Combination or affect the substance or timing of the Company’s obligation to redeem 100 % of its Public Shares if the Company does not complete a Business Combination, unless the Company provides the public stockholders with the opportunity to redeem their Public Shares in conjunction with any such amendment.\nOn November 9, 2021, the Company’s board of directors approved the first extension of the date by which the Company has to consummate a Business Combination from November 17, 2021 to February 17, 2022. In connection with the extension, the Sponsor deposited into the Trust Account $ 0.10 for each of the 12,618,600 shares issued in the Initial Public Offering, for a total of $ 1,261,860 . The Company issued the Sponsor a non-interest bearing unsecured promissory note in the principal amount of $ 1,261,860 which is payable by the Company upon the earlier of the consummation of the Business Combination or the liquidation of the Company. The Note may be repaid in cash or convertible into Private Warrants at a price of $ 1.00 per Private Warrant. On February 16, 2022, the Company’s board of directors approved the second extension of the date by which the Company has to consummate a Business Combination from February 17, 2022 to May 17, 2022. In connection with the second extension, the Sponsor deposited into the Trust Account an additional $ 1,261,860 ($ 0.10 per Public Share) on February 17, 2022, and the Company amended and restated the promissory note in its entirety solely to increase the principal amount thereunder from $ 1,261,860 to $ 2,523,720 . On May 12, 2022, the Company held a special meeting of stockholders in which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from May 17, 2022 to August 17, 2022 (the “Combination Period”) was approved by the stockholders. In connection with this extension, the Company deposited $ 500,000 into the Trust Account on May 18, 2022. The Company amended and restated the promissory note to increase the principal amount thereunder from $ 2,523,720 to $ 3,223,720 , which included a drawdown of $ 500,000 for the extension and a drawdown of $ 200,000 for working capital needs. On August 17, 2022, the Company held a special meeting of stockholders in which the Company’s stockholders approved a second amendment to extend the date by which the Company must consummate a Business Combination from August 17, 2022 to February 17, 2023. On August 17, 2022, the Company amended and restated the promissory note to increase the principal amount thereunder from $ 3,223,720 to $ 3,683,720 , which included a drawdown of $ 360,000 for the extension and $ 100,000 for working capital purposes.\n6\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nIf the Company is unable to complete a Business Combination within the Combination Period, the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account including interest earned on the funds held in the Trust Account and not previously released to the Company to pay taxes, divided by the number of then outstanding Public Shares, which redemption will completely extinguish public stockholders’ rights as stockholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the Company’s remaining stockholders and the Company’s board of directors, dissolve and liquidate, subject in each case to the Company’s obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law.\nThe Sponsor has agreed to waive its liquidation rights with respect to the Founder Shares if the Company fails to complete a Business Combination within the Combination Period. However, if the Sponsor acquires Public Shares in or after the Initial Public Offering, such Public Shares will be entitled to liquidating distributions from the Trust Account if the Company fails to complete a Business Combination within the Combination Period. In the event of such distribution, it is possible that the per share value of the assets remaining available for distribution will be less than the amount of funds initially deposited into the Trust Account (initially $ 10.10 per share, subsequently increased to $ 10.46 per share as of September 30, 2022 following extensions).\nIn order to protect the amounts held in the Trust Account, the Sponsor has agreed to be liable to the Company if and to the extent any claims by a vendor for services rendered or products sold to the Company, or a prospective target business with which the Company has discussed entering into a transaction agreement, reduce the amount of funds in the Trust Account to below $ 10.10 per Public Share, except as to any claims by a third party who executed a valid and enforceable agreement with the Company waiving any right, title, interest or claim of any kind they may have in or to any monies held in the Trust Account and except as to any claims under the Company’s indemnity of the underwriters of Initial Public Offering against certain liabilities, including liabilities under the Securities Act of 1933, as amended (the “Securities Act”). Moreover, in the event that an executed waiver is deemed to be unenforceable against a third party, the insiders will not be responsible to the extent of any liability for such third-party claims. The Company will seek to reduce the possibility that the insiders will have to indemnify the Trust Account due to claims of creditors by endeavoring to have all vendors, service providers (except the Company’s independent registered public accounting firm), prospective target businesses or other entities with which the Company does business, execute agreements with the Company waiving any right, title, interest or claim of any kind in or to monies held in the Trust Account.\nRisks and Uncertainties\nManagement continues to evaluate the impact of the COVID-19 pandemic and the military conflict in the Ukraine and has concluded that while it is reasonably possible that the virus and the military conflict could have a negative effect on the Company’s financial position, results of its operations and/or search for a target company, the specific impacts are not readily determinable as of the date of these financial statements. The financial statements do not include any adjustments that might result from the outcome of these uncertainties.\nInflation Reduction Act of 2022\nOn August 16, 2022, the Inflation Reduction Act of 2022 (the “IR Act”) was signed into federal law. The IR Act provides for, among other things, a new U.S. federal 1 % excise tax on certain repurchases of stock by publicly traded U.S. domestic corporations and certain U.S. domestic subsidiaries of publicly traded foreign corporations occurring on or after January 1, 2023. The excise tax is imposed on the repurchasing corporation itself, not its shareholders from which shares are repurchased. The amount of the excise tax is generally 1 % of the fair market value of the shares repurchased at the time of the repurchase. However, for purposes of calculating the excise tax, repurchasing corporations are permitted to net the fair market value of certain new stock issuances against the fair market value of stock repurchases during the same taxable year. In addition, certain exceptions apply to the excise tax. The U.S. Department of the Treasury has been given authority to provide regulations and other guidance to carry out and prevent the abuse or avoidance of the excise tax.\nAny redemption or other repurchase that occurs after December 31, 2022, in connection with a Business Combination, extension vote or otherwise, may be subject to the excise tax. Whether and to what extent the Company would be subject to the excise tax in connection with a Business Combination, extension vote or otherwise would depend on a number of factors, including (i) the fair market value of the redemptions and repurchases in connection with the Business Combination, extension or otherwise, (ii) the structure of a Business Combination, (iii) the nature and amount of any “PIPE” or other equity issuances in connection with a Business Combination (or otherwise issued not in connection with a Business Combination but issued within the same taxable year of a Business Combination) and (iv) the content of regulations and other guidance from the U.S. Department of the Treasury. In addition, because the excise tax would be payable by the Company and not by the redeeming holder, the mechanics of any required payment of the excise tax have not been determined. The foregoing could cause a reduction in the cash available on hand to complete a Business Combination and in the Company’s ability to complete a Business Combination.\n7\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nLiquidity and Going Concern\nAs of September 30, 2022, the Company had $ 83,760 in its operating bank accounts and $ 44,203,481 in securities held in the Trust Account to be used for a Business Combination or to repurchase or redeem its common stock in connection therewith. As of September 30, 2022, $ 145,311 of the amount on deposit in the Trust Account represented accrued interest income, which can be withdrawn to pay the Company’s tax obligations.\nOn May 13, 2022, July 1, 2022 and August 16, 2022, the Company withdrew $ 178,564 , $ 66,751 and $ 113,396 , respectively, of accrued interest from the Trust Account to pay certain tax obligations.\nUntil the consummation of a Business Combination, the Company will use the funds not held in the Trust Account for identifying and evaluating prospective acquisition candidates, performing due diligence on prospective target businesses, paying for travel expenditures, selecting the target business to acquire, and structuring, negotiating and consummating the Business Combination.\nThe Company expects it will need to raise additional capital through loans or additional investments from its Sponsor, stockholders, officers, directors, or third parties. The Company’s officers, directors and the Sponsor may, but are not obligated to, loan the Company funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet the Company’s working capital needs. Accordingly, the Company may not be able to obtain additional financing. If the Company is unable to raise additional capital, it may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, and reducing overhead expenses. The Company cannot provide any assurance that new financing will be available to it on commercially acceptable terms, if at all.\nIn connection with the Company’s assessment of going concern considerations in accordance with Financial Accounting Standard Board’s Accounting Standards Update (“ASU”) 2014-15, “Disclosures of Uncertainties about an Entity’s Ability to Continue as a Going Concern,” the Company has until February 17, 2023 to consummate a Business Combination. It is uncertain that the Company will be able to consummate a Business Combination by this time. If a Business Combination is not consummated by this date and an extension has not been requested by the Sponsor and approved by the Company’s stockholders, there will be a mandatory liquidation and subsequent dissolution of the Company. Management has determined that the liquidity condition and the mandatory liquidation and potential subsequent dissolution raises substantial doubt about the Company’s ability to continue as a going concern. No adjustments have been made to the carrying amounts of assets or liabilities should the Company be required to liquidate after February 17, 2023. The Company intends to continue to search for and seek to complete a Business Combination before the mandatory liquidation date. The Company is within 12 months of its mandatory liquidation date as of the time of filing of this Quarterly Report on Form 10-Q.\nNOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nBasis of Presentation\nThe accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 8 of Regulation S-X of the SEC. Certain information or footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted, pursuant to the rules and regulations of the SEC for interim financial reporting. Accordingly, they do not include all the information and footnotes necessary for a complete presentation of financial position, results of operations, or cash flows. In the opinion of management, the accompanying unaudited condensed financial statements include all adjustments, consisting of a normal recurring nature, which are necessary for a fair presentation of the financial position, operating results and cash flows for the periods presented.\nThe accompanying unaudited condensed financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the period ended December 31, 2021, as filed with the SEC on March 31, 2022. The interim results for the three and nine months ended September 30, 2022 are not necessarily indicative of the results to be expected for the year ending December 31, 2022 or for any future periods.\n8\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nReclassification of Prior Year Presentation\nCertain prior year amounts have been reclassified to conform to the current period presentation. These reclassifications had no effect on the reported results of operations. An adjustment has been made to the balance sheet for December 31, 2021 to reclassify the deferred legal fees balance from accrued expenses to a separate deferred legal fees line.\nEmerging Growth Company\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the independent registered public accounting firm attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\nUse of Estimates\nThe preparation of the condensed financial statements in conformity with GAAP requires the Company’s management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements.\nMaking estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. Two of the more significant accounting estimates included in these financial statements is the determination of the fair value of the warrant liabilities as well as the fair value of the convertible promissory note. Such estimates may be subject to change as more current information becomes available and accordingly the actual results could differ significantly from those estimates.\nCash and Cash Equivalents\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did not have any cash equivalents as of September 30, 2022 and December 31, 2021.\n9\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nCash and Marketable Securities Held in Trust Account\nAt September 30, 2022, substantially all of the assets held in the Trust Account were held in money market funds which are invested primarily in U.S Treasury securities. At December 31, 2021, substantially all of the assets held in the Trust Account were held in U.S. Treasury Securities. All of the Company’s investments held in the Trust Account are classified as trading securities. Trading securities are presented on the balance sheets at fair value at the end of each reporting period. Gains and losses resulting from the change in fair value of investments held in the Trust Account are included in interest earned on marketable securities held in the Trust Account in the accompanying condensed statements of operations. The estimated fair values of investments held in the Trust Account are determined using available market information. As of September 30, 2022, the Company has withdrawn $ 358,711 of interest income from the Trust Account to pay certain tax obligations.\nCommon Stock Subject to Possible Redemption\nThe Company accounts for its common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that features redemption rights that is either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. The Company’s common stock features certain redemption rights that are considered to be outside of the Company’s control and subject to occurrence of uncertain future events. Accordingly, as of September 30, 2022 and December 31, 2021, respectively, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders’ deficit section of the Company’s condensed balance sheets.\nThe Company recognizes changes in redemption value immediately as they occur and adjusts the carrying value of redeemable common stock to equal the redemption value at the end of each reporting period. Increases or decreases in the carrying amount of redeemable common stock are affected by charges against additional paid in capital and accumulated deficit.\nAt September 30, 2022 and December 31, 2021, the common stock reflected in the condensed balance sheets are reconciled in the following table:\n\n| Gross proceeds | $ | 126,186,000 |\n| Less: |\n| Common stock issuance costs | ( 2,868,790 | ) |\n| Plus: |\n| Accretion of carrying value to redemption value | 5,392,510 |\n| Common stock subject to possible redemption – December 31, 2021 | $ | 128,709,720 |\n| Less: |\n| Redemption of shares | ( 86,773,410 | ) |\n| Plus: |\n| Accretion of carrying value to redemption value | 2,267,171 |\n| Common stock subject to possible redemption – September 30, 2022 | $ | 44,203,481 |\n\nWarrant Liabilities\nThe Company accounts for the Private Warrants in accordance with the guidance contained in ASC 815-40-15-7D and 7F under which the Private Warrants do not meet the criteria for equity treatment and must be recorded as liabilities. Accordingly, the Company classifies the Private Warrants as liabilities at their fair value and adjusts the Private Warrants to fair value at each reporting period. This liability is subject to re-measurement at each balance sheet date until exercised, and any change in fair value is recognized in our statements of operations. The Private Warrants for periods where no observable traded price was available are valued using a binomial lattice simulation model.\n10\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nConvertible Promissory Note – Related Party\nThe Company accounts for its convertible promissory note under ASC 815, Derivatives and Hedging (“ASC 815”). Under 815-15-25, the election can be at the inception of a financial instrument to account for the instrument under the fair value option under ASC 825. The Company has made such election for its convertible promissory note. Using fair value option, the convertible promissory note is required to be recorded at its initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of the note are recognized as non-cash change in the fair value of the convertible promissory note in the statements of operations. The fair value of the option to convert the convertible promissory note into Private Warrants was valued by utilizing a binomial lattice model incorporating the Cox-Ross-Rubenstein methodology.\nIncome Taxes\nThe Company accounts for income taxes under ASC 740, “Income Taxes.” ASC 740, Income Taxes, requires the recognition of deferred tax assets and liabilities for both the expected impact of differences between the unaudited condensed financial statements and tax basis of assets and liabilities and for the expected future tax benefit to be derived from tax loss and tax credit carry forwards. ASC 740 additionally requires a valuation allowance to be established when it is more likely than not that all or a portion of deferred tax assets will not be realized. As of September 30, 2022 and December 31, 2021, the Company’s deferred tax asset had a full valuation allowance recorded against it.\nThe Company’s effective tax rate was 2.68 % and 0.00 % for the three months ended September 30, 2022 and 2021, respectively, and 0.80 % and 0.00 % for the nine months ended September 30, 2022 and 2021, respectively. The effective tax rate differs from the statutory tax rate of 21 % for the three months and nine months ended September 30, 2022 and 2021, due to changes in fair value in warrant liability, changes in the fair value of the convertible promissory note and the valuation allowance on the deferred tax assets.\nASC 740 also clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. ASC 740 also provides guidance on derecognition, classification, interest and penalties, accounting in interim period, disclosure and transition.\nWhile ASC 740 identifies usage of an effective annual tax rate for purposes of an interim provision, it does allow for estimating individual elements in the current period if they are significant, unusual, or infrequent. Computing the effective tax rate for the Company is complicated due to the potential impact of the timing of any Business Combination expenses and the actual interest income that will be recognized during the year. The Company has taken a position as to the calculation of income tax expense in a current period based on ASC 740-270-25-3 which states, “If an entity is unable to estimate part of its ordinary income (or loss) or the related tax (benefit) but is otherwise able to make a reasonable estimate, the tax (or benefit) applicable to the item that cannot be estimated shall be reported in the interim period in which the item is reported.” The Company believes its calculation to be a reliable estimate and allows it to properly take into account the usual elements that can impact its annualized book income and its impact on the effective tax rate. As such, the Company is computing its taxable income (loss) and associated income tax provision based on actual results through September 30, 2022.\nThe Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of September 30, 2022 and December 31, 2021. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position.\nThe Company has identified the United States as its only “major” tax jurisdiction. The Company is subject to income taxation by major taxing authorities since inception. These examinations may include questioning the timing and amount of deductions, the nexus of income among various tax jurisdictions and compliance with federal and state tax laws. The Company’s management does not expect that the total amount of unrecognized tax benefits will materially change over the next twelve months.\nNet Income Per Common Share\nThe Company complies with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share”. Net income per common share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Accretion associated with the redeemable shares of common stock is excluded from income per common share as the redemption value approximates fair value.\nThe calculation of diluted income per share does not consider the effect of the warrants issued in connection with the (i) Initial Public Offering, and (ii) the private placement since the exercise of the warrants is contingent upon the occurrence of future events. The warrants are exercisable to purchase 17,904,180 shares of common stock in the aggregate. As of September 30, 2022 and 2021, the Company did not have any dilutive securities or other contracts that could, potentially, be exercised or converted into common stock and then participate in the earnings of the Company. As a result, diluted net income per common share is the same as basic net income per common share for the periods presented.\n11\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nReconciliation of Net Income per Common Share\nThe Company’s net income is adjusted for the portion of income that is attributable to common stock subject to possible redemption, as these shares only participate in the earnings of the Trust Account and not the income or losses of the Company. Accordingly, basic and diluted net income per common share is calculated as follows:\n\n| Three Months Ended September 30, 2022 | Three Months Ended September 30, 2021 | Nine Months Ended September 30, 2022 | Nine Months Ended September 30, 2021 |\n| Redeemable Common Stock | Non-Redeemable Common Stock | Redeemable Common Stock | Non-Redeemable Common Stock | Redeemable Common Stock | Non-Redeemable Common Stock | Redeemable Common Stock | Non-Redeemable Common Stock |\n| Basic and diluted net income per common share |\n| Numerator: |\n| Allocation of net income, as adjusted | $ | 519,931 | $ | 324,223 | $ | 1,156,217 | 319,513 | $ | 2,475,778 | $ | 931,474 | $ | 1,729,360 | $ | 477,898 |\n| Denominator: |\n| Basic and diluted weighted average shares outstanding | 5,591,938 | 3,487,070 | 12,618,600 | 3,487,070 | 9,268,327 | 3,487,070 | 12,618,600 | 3,487,070 |\n| Basic and diluted net income per common share | $ | 0.09 | $ | 0.09 | $ | 0.09 | $ | 0.09 | $ | 0.27 | $ | 0.27 | $ | 0.14 | $ | 0.14 |\n\nConcentration of Credit Risk\nFinancial instruments that potentially subject the Company to concentrations of credit risk consist of cash accounts in a financial institution, which, at times may exceed the Federal Deposit Insurance Corporation maximum coverage of $ 250,000 . The Company has not experienced losses on these accounts.\nFair Value of Financial Instruments\nThe fair value of the Company’s assets and liabilities, which qualify as financial instruments under ASC Topic 820, “Fair Value Measurement,” approximates the carrying amounts represented in the accompanying condensed balance sheets, primarily due to their short-term nature, except for warrant liabilities (see Note 9).\nFair Value Measurements\nFair value is defined as the price that would be received for sale of an asset or paid for transfer of a liability, in an orderly transaction between market participants at the measurement date. GAAP establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).\nIn some circumstances, the inputs used to measure fair value might be categorized within different levels of the fair value hierarchy. In those instances, the fair value measurement is categorized in its entirety in the fair value hierarchy based on the lowest level input that is significant to the fair value measurement.\n12\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nRecent Accounting Standards\nIn August 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2020-06, “Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity” (“ASU 2020-06”), which simplifies accounting for convertible instruments by removing major separation models required under current GAAP. ASU 2020-06 removes certain settlement conditions that are required for equity contracts to qualify for the derivative scope exception, and it also simplifies the diluted earnings per share calculation in certain areas. ASU 2020-06 is effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years, with early adoption permitted. The Company assessed the potential impact of ASU 2020-06 and determined it would not have a material impact on the condensed financial statements as presented.\nManagement does not believe that any other recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on the Company’s condensed financial statements.\nNOTE 3. PUBLIC OFFERING\nPursuant to the Initial Public Offering, the Company sold 11,000,000 Units at a price of $ 10.00 per Unit. Each Unit consists of one share of common stock and one redeemable warrant (“Public Warrant”). In connection with the underwriters’ partial exercise of the over-allotment option on November 19, 2020, the Company sold an additional 1,618,600 Units, at a purchase price of $ 10.00 per Unit. Each Public Warrant entitles the holder to purchase one share of common stock at an exercise price of $11.50 per share (see Note 8).\nNOTE 4. PRIVATE PLACEMENT\nSimultaneously with the closing of the Initial Public Offering, the Sponsor and EarlyBirdCapital purchased an aggregate of 4,800,000 Private Warrants at a price of $ 1.00 per Private Warrant for an aggregate purchase price of $ 4,800,000 . The Sponsor purchased 3,975,000 Private Warrants and EarlyBirdCapital purchased 825,000 Private Warrants. In connection with the underwriters’ partial exercise of the over-allotment option on November 19, 2020, the Sponsor and EarlyBirdCapital purchased an additional 485,580 Private Warrants, at a purchase price of $ 1.00 per Private Warrant, for an aggregate purchase price of $ 485,580 . Each Private Warrant entitles the holder to purchase one share of common stock at a price of $11.50 per full share, subject to adjustment (see Note 8). The proceeds from the Private Warrants were added to the proceeds from the Initial Public Offering held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the proceeds from the sale of the Private Warrants will be used to fund the redemption of the Public Shares (subject to the requirements of applicable law).\nNOTE 5. RELATED PARTY TRANSACTIONS\nFounder Shares\nOn August 5, 2020, the Sponsor paid $ 25,000 to cover certain offering costs of the Company in consideration for 3,593,750 shares of common stock (the “Founder Shares”). On November 9, 2020, the Sponsor returned to the Company for cancellation, at no cost, an aggregate of 718,750 Founder Shares, resulting in an aggregate of 2,875,000 Founder Shares outstanding and held by the Sponsor. On November 12, 2020, the Company effected a stock dividend of 0.1 shares for each share of common stock outstanding, resulting in an aggregate of 3,162,500 Founder Shares outstanding and held by the Sponsor. The Founder Shares included, after giving retroactive effect to the share surrender and stock dividend, an aggregate of up to 412,500 shares subject to forfeiture to the extent that the underwriters’ over-allotment was not exercised in full or in part, so that the Sponsor would collectively own 20 % of the Company’s issued and outstanding shares after the Initial Public Offering (assuming the Sponsor did not purchase any Public Shares in the Initial Public Offering). In connection with the underwriters’ partial exercise of the over-allotment option and the forfeiture of the remaining over-allotment option, 7,850 Founder Shares were forfeited, and 404,650 Founder Shares are no longer subject to forfeiture resulting in an aggregate of 3,154,650 Founder Shares outstanding at September 30, 2022.\nThe Sponsor has agreed, subject to certain limited exceptions, not to transfer, assign or sell any of the Founder Shares until (1) with respect to 50% of the Founder Shares, the earlier of one year after the completion of a Business Combination and the date on which the closing price of the common stock equals or exceeds $12.50 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing after a Business Combination and (2) with respect to the remaining 50% of the Founder Shares, one year after the completion of a Business Combination, or earlier, in either case, if, subsequent to a Business Combination, the Company completes a liquidation, merger, stock exchange or other similar transaction which results in all of the Company’s stockholders having the right to exchange their shares of common stock for cash, securities or other property.\n13\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nDue from Sponsor\nAt the closing of the Initial Public Offering on November 17, 2020, an aggregate amount of $ 25,038 was due to the Company. Such amount was paid by the Company to the Sponsor and was included in the prepaid expenses and other current assets on the balance sheet at December 31, 2020. No balance remains outstanding as of September 30, 2022.\nAdministrative Support Agreement\nThe Company has agreed, commencing on November 12, 2020 through the earlier of the Company’s consummation of a Business Combination and its liquidation, to pay an affiliate of the Company’s management a total of $ 10,000 per month for office space, utilities and secretarial support. For the three and nine months ended September 30, 2022, the Company incurred $ 30,000 and $ 90,000 , respectively, in fees for these services, of which such amounts are included in accrued expenses in the accompanying condensed balance sheets. For the three and nine months ended September 30, 2021, the Company incurred and paid $ 30,000 and $ 90,000 , respectively, in fees for these services.\nPromissory Note — Related Party\nOn August 5, 2020, the Company issued an unsecured promissory note to the Sponsor (the “Promissory Note”), pursuant to which the Company could borrow up to an aggregate principal amount of $ 300,000 . The Promissory Note was non-interest bearing and payable on the earlier of (i) March 31, 2021, (ii) the consummation of the Initial Public Offering or (iii) the date on which the Company determined not to proceed with the Initial Public Offering. The outstanding balance under the Promissory Note was repaid subsequent to the Initial Public Offering. As of September 30, 2022 and December 31, 2021, respectively, no balance is outstanding under the Promissory Note. Borrowings under the Promissory Note are no longer available.\nRelated Party Loans\nIn addition, in order to finance transaction costs in connection with a Business Combination, the Sponsor or certain of the Company’s officers and directors or their affiliates may, but are not obligated to, loan the Company funds as may be required (“Working Capital Loans”). Each loan would be evidenced by promissory note. The notes may be repaid upon completion of a Business Combination, without interest, or, at the lender’s discretion, up to $ 1,500,000 of notes may be converted upon completion of a Business Combination into warrants at a price of $ 1.00 per warrant. Such warrants would be identical to the Private Warrants. In the event that a Business Combination does not close, the Company may use a portion of proceeds held outside the Trust Account to repay the Working Capital Loans, but no proceeds held in the Trust Account would be used to repay the Working Capital Loans.\nOn April 14, 2022 the Sponsor advanced to the Company $ 100,000 to be used for working capital purposes. On August 17, 2022, the Company transferred the advance from the Sponsor to the second amended and restated promissory note (see Convertible Promissory Note – Related Party below). On October 13, 2022, the Sponsor advanced to the Company $ 200,000 to be used for working capital purposes.\nRelated Party Extension Loans\nAs discussed in Note 1, the Company previously extended the period of time to consummate a Business Combination two times, each by an additional three months (to May 17, 2022 to complete a Business Combination). In order to extend the time available for the Company to consummate a Business Combination, the Sponsor or its affiliates or designees deposited into the Trust Account $1,261,860 ($0.10 per Public Share), on or prior to the date of the applicable deadline, for each three-month extension. Payments were made in the form of a non-interest bearing, unsecured promissory note to be paid upon consummation of a Business Combination, or, at the relevant insider’s discretion, converted upon consummation of a Business Combination into additional Private Warrants at a price of $ 1.00 per Private Warrant. The Sponsor and its affiliates or designees are not obligated to fund the Trust Account to extend the time for the Company to complete a Business Combination. On May 12, 2022, the Company held a special meeting of stockholders at which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from May 17, 2022 to August 17, 2022 was approved by stockholders. In order to extend the time available for the Company to consummate a Business Combination, the Sponsor or its affiliates or designees deposited into the Trust Account $ 500,000 . On August 15, 2022, the Company held a special meeting of stockholders at which a proposal to amend the Company’s amended and restated certificate of incorporation, as amended to extend the date by which the Company must consummate a Business Combination from August 17, 2022 to February 17, 2023 was approved by stockholders. In order to extend the time available for the Company to consummate a Business Combination, the Sponsor or its affiliates or designees deposited into the Trust Account $ 360,000 .\n14\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nConvertible Promissory Note – Related Party\nOn November 9, 2021, the Company issued a promissory note in the principal amount of $ 1,261,860 to the Sponsor in connection with the Extension (“Convertible Promissory Note”) (as defined below). On February 17, 2022, April 14, 2022 and May 18, 2022, the Company amended and restated the Convertible Promissory Note to increase the principal amount thereunder from $1,261,860 to $3,223,720. On August 17, 2022 the Company amended and restated the Convertible Promissory Note to increase the principal amount thereunder from $3,223,720 to $3,683,720, which included $100,000 advanced by the Sponsor to the Company on April 14, 2022 and the payment of $360,000 for the extension from August 17, 2022 to November 17, 2022. The Note bears no interest and is due and payable upon the earlier to occur of (i) the date on which the Company’s Business Combination is consummated and (ii) the liquidation of the Company on or before February 17, 2023 or such later liquidation date as may be approved by the Company’s stockholders. On August 15, 2022, the Company held a special meeting of stockholders in which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from August 17, 2022 to February 17, 2023 was approved by stockholders. At the election of the Sponsor, up to $ 1,500,000 of the unpaid principal amount of the Note may be converted into warrants of the Company, each warrant exercisable for one share of common stock of the Company upon the consummation of its Business Combination, equal to: (x) the portion of the principal amount of the Note being converted, divided by (y) $ 1.00 , rounded up to the nearest whole number of warrants. As of September 30, 2022, there was a $ 3,683,720 balance outstanding under the Convertible Promissory Note. The Convertible Promissory Note was valued using the fair value method. The fair value of the note as of September 30, 2022, was $ 913,900 , which resulted in a change in fair value of the convertible promissory note of $ 1,113,700 and $ 2,119,960 which was recorded in the statements of operations for the three and nine months ended September 30, 2022, respectively (see Note 9).\nNOTE 6. COMMITMENTS AND CONTINGENCIES\nRegistration Rights\nPursuant to a registration rights agreement entered into on November 12, 2020, the holders of the Founder Shares and Representative Shares (as defined in Notes 5 and 8, respectively), as well as the holders of the Private Warrants (and underlying securities) and any warrants issued in payment of Working Capital Loans made to Company (and underlying securities) will be entitled to registration rights. The holders of a majority of these securities are entitled to make up to two demands that the Company register such securities. The holders of the majority of the Founder Shares can elect to exercise these registration rights at any time commencing three months prior to the date on which these shares of common stock are to be released from escrow. The holders of a majority of the Representative Shares, Private Warrants and warrants issued in payment of working capital loans made to the Company (or underlying securities) can elect to exercise these registration rights at any time after the Company consummates a Business Combination. Notwithstanding anything to the contrary, EarlyBirdCapital may only make a demand on one occasion and only during the five-year period beginning on the effective date of the registration statement of which this prospectus forms a part. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to consummation of a Business Combination; provided, however, that EarlyBirdCapital may participate in a “piggy-back” registration only during the seven-year period beginning on the effective date of the registration statement of which this prospectus forms a part. The registration rights agreement does not contain liquidating damages or other cash settlement provisions resulting from delays in registering the Company’s securities. The Company will bear the expenses incurred in connection with the filing of any such registration statements.\nUnderwriting Agreement\nThe Company granted the underwriters a 45-day option from the date of the Initial Public Offering to purchase up to 1,650,000 additional Units to cover over-allotments, if any, at the Initial Public Offering price less the underwriting discounts and commissions. On November 19, 2020, the underwriters partially exercised their over-allotment option to purchase an additional 1,618,600 Units at $ 10.00 per Unit and forfeited the remaining over-allotment option.\n15\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nBusiness Combination Marketing Agreement\nThe Company has engaged EarlyBirdCapital as an advisor in connection with a Business Combination to assist the Company in holding meetings with its stockholders to discuss the potential Business Combination and the target business’ attributes, introduce the Company to potential investors that are interested in purchasing the Company’s securities in connection with a Business Combination, assist the Company in obtaining stockholder approval for the Business Combination and assist the Company with its press releases and public filings in connection with the Business Combination. The Company will pay EarlyBirdCapital a cash fee for such services upon the consummation of a Business Combination in an amount equal to 3.5% of the gross proceeds of the Initial Public Offering, or $4,416,510, (exclusive of any applicable finders’ fees which might become payable); provided that up to 30% of the fee may be allocated at the Company’s sole discretion to other FINRA members that assist the Company in identifying and consummating a Business Combination.\nAdditionally, the Company will pay EarlyBirdCapital a cash fee equal to 1.0 % of the total consideration payable in a Business Combination if EarlyBirdCapital introduces the Company to the target business with which the Company completes a Business Combination.\nLegal Fee Agreements\nThe Company has engaged various law firms to provide legal due diligence services and business combination services related to potential target companies. All fees and expenses related to the various engagements will be deferred and are to be paid fully upon the closing of any Business Combination. The law firms will not be entitled to any contingent fees or expense reimbursement if the Company does not consummate a Business Combination within its deadline. Deferred fees of $ 1,371,549 and $ 1,009,868 related to these legal services have been accrued as of September 30, 2022 and December 31, 2021, respectively.\nTrust Extension\nOn February 16, 2022, the Company issued a press release announcing that its Sponsor has requested that the Company extend the date by which the Company has to consummate a Business Combination from February 17, 2022 to May 17, 2022 (the “Extension”). The Extension is the second of two three-month extensions permitted under the Company’s governing documents and provides the Company with additional time to complete its Business Combination. On February 18, 2022, the Company issued a press release announcing that the Sponsor had deposited an additional $ 1,261,860 (representing $ 0.10 per public share) into the Trust Account for its public stockholders. On May 12, 2022, the Company held a special meeting of stockholders in which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from May 17, 2022 to August 17, 2022 was approved by the stockholders. In connection with this extension, the Company deposited $ 500,000 into the Trust Account on May 18, 2022. In connection with the extension amendment, stockholders holding approximately 5,586,910 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $ 10.30 per share. On August 15, 2022, the Company held a special meeting of stockholders in which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from August 17, 2022 to February 17, 2023 was approved by the stockholders. In connection with this extension, the Company deposited $ 360,000 into the Trust Account on August 17, 2022. In connection with the extension amendment, stockholders holding approximately 2,818,237 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $ 10.37 per share.\nOn November 16, 2021, the Company had previously issued a promissory note (the “Note”) in the principal amount of $ 1,261,860 to the Company’s Sponsor. On February 17, 2022, April 14, 2022, May 18, 2022, and August 17, 2022, the Company amended and restated the Note in its entirety to increase the principal amount thereunder from $1,262,860 to $3,683,720.\nNOTE 7. STOCKHOLDERS’ DEFICIT\nPreferred Stock — The Company is authorized to issue 1,000,000 shares of preferred stock with a par value of $ 0.0001 per share with such designations, voting and other rights and preferences as may be determined from time to time by the Company’s board of directors. At September 30, 2022 and December 31, 2021, respectively, there were no shares of preferred stock issued or outstanding.\nCommon Stock — The Company is authorized to issue 50,000,000 shares of common stock with a par value of $ 0.0001 per share. At September 30, 2022 and December 31, 2021, there were 3,487,070 shares of common stock issued and outstanding, excluding 4,213,453 and 12,618,600 shares of common stock subject to possible redemption, respectively, which are presented as temporary equity. In connection with the extension on May 12, 2022, stockholders holding 5,586,910 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $ 10.30 per share. In connection with the extension on August 17, 2022, stockholders holding 2,818,237 shares of the Company’s redeemable stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $ 10.37 per share.\n16\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nNOTE 8. WARRANTS\nThe Public Warrants will become exercisable on the later of (a) 30 days after the completion of a Business Combination or (b) 12 months from the closing of the Initial Public Offering. No warrants will be exercisable for cash unless the Company has an effective and current registration statement covering the shares of common stock issuable upon exercise of the warrants and a current prospectus relating to such shares of common stock. Notwithstanding the foregoing, if a registration statement covering the shares of common stock issuable upon exercise of the Public Warrants is not effective within a specified period following the consummation of a Business Combination, warrant holders may, until such time as there is an effective registration statement and during any period when the Company shall have failed to maintain an effective registration statement, exercise warrants on a cashless basis pursuant to the exemption provided by Section 3(a)(9) of the Securities Act, provided that such exemption is available. If that exemption, or another exemption, is not available, holders will not be able to exercise their warrants on a cashless basis. The Public Warrants will expire five years after the completion of a Business Combination or earlier upon redemption or liquidation.\nThe Company may redeem the Public Warrants (excluding the Private Warrants and any warrants underlying units issued upon conversion of the Working Capital Loans):\n\n| ● | in whole and not in part; |\n| ● | at a price of $0.01 per warrant; |\n| ● | upon not less than 30 days’ prior written notice of redemption to each warrant holder; and |\n| ● | if, and only if, the last reported sale price of the common stock equals or exceeds $18.00 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations and the like), for any 20 trading days within a 30 trading day period ending on the third trading day prior to the date on which the Company sends the notice of redemption to the warrant holders. |\n\nIf the Company calls the Public Warrants for redemption, management will have the option to require all holders that wish to exercise the Public Warrants to do so on a “cashless basis,” as described in the warrant agreement. The exercise price and number of shares of common stock issuable upon exercise of the warrants may be adjusted in certain circumstances including in the event of a stock dividend, or recapitalization, reorganization, merger or consolidation. However, except as described below, the warrants will not be adjusted for issuance of common stock at a price below its exercise price. Additionally, in no event will the Company be required to net cash settle the warrants. If the Company is unable to complete a Business Combination within the Combination Period and the Company liquidates the funds held in the Trust Account, holders of warrants will not receive any of such funds with respect to their warrants, nor will they receive any distribution from the Company’s assets held outside of the Trust Account with the respect to such warrants. Accordingly, the warrants may expire worthless.\nIn addition, if (x) the Company issues additional common stock or equity-linked securities for capital raising purposes in connection with the closing of a Business Combination at an issue price or effective issue price of less than $9.20 per common stock (with such issue price or effective issue price to be determined in good faith by the Company’s board of directors and, in the case of any such issuance to the Sponsor or its affiliates, without taking into account any Founder Shares held by the Sponsor or such affiliates, as applicable, prior to such issuance), (y) the aggregate gross proceeds from such issuances represent more than 60% of the total equity proceeds, and interest thereon, available for the funding of a Business Combination on the date of the consummation of a Business Combination (net of redemptions), and (z) the volume weighted average trading price of its common stock during the 20 trading day period starting on the trading day prior to the day on which the Company consummates its Business Combination (such price, the “Market Value”) is below $9.20 per share, the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115% of the greater of (i) Market Value or (ii) the price at which the Company issue the additional shares of common stock or equity-linked securities.\nThe Private Warrants are identical to the Public Warrants underlying the Units sold in the Initial Public Offering, except that the Private Warrants and the shares of common stock issuable upon the exercise of the Private Warrants will not be transferable, assignable or saleable until after the completion of a Business Combination, subject to certain limited exceptions. Additionally, the Private Warrants will be exercisable for cash or on a cashless basis, at the holder’s option, and be non-redeemable so long as they are held by the initial purchasers or their permitted transferees. If the Private Warrants are held by someone other than the initial purchasers or their permitted transferees, the Private Warrants will be redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants.\n17\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nRepresentative Shares\nOn August 5, 2020, the Company issued to EarlyBirdCapital 377,750 shares of common stock (the “Representative Shares”). On November 9, 2020, EarlyBirdCapital returned to the Company for cancellation, at no cost, an aggregate of 75,550 Representative Shares, resulting in an aggregate of 302,200 Representative Shares outstanding and held by EarlyBirdCapital. On November 12, 2020, the Company effected a stock dividend of 0.1 shares for each share of common stock outstanding, resulting in EarlyBirdCapital holding an aggregate of 332,420 Representative Shares. The Company accounted for the Representative Shares as an offering cost of the Initial Public Offering, with a corresponding credit to stockholders’ equity. The Company estimated the fair value of Representative Shares to be $ 2,666 based upon the price of the Founder Shares issued to the Sponsor. The holders of the Representative Shares have agreed not to transfer, assign or sell any such shares until the completion of a Business Combination. In addition, the holders have agreed (i) to waive their redemption rights with respect to such shares in connection with the completion of a Business Combination and (ii) to waive their rights to liquidating distributions from the Trust Account with respect to such shares if the Company fails to complete a Business Combination within the Combination Period.\nThe Representative Shares have been deemed compensation by FINRA and are therefore subject to a lock-up for a period of 180 days immediately following the effective date of the registration statement related to the Initial Public Offering pursuant to Rule 5110(g)(1) of FINRA’s NASD Conduct Rules. Pursuant to FINRA Rule 5110(g)(1), these securities will not be sold during the Initial Public Offering, or sold, transferred, assigned, pledged, or hypothecated, or be the subject of any hedging, short sale, derivative, put or call transaction that would result in the economic disposition of the securities by any person for a period of 180 days immediately following the effective date of the Initial Public Offering, except to any underwriter and selected dealer participating in the Initial Public Offering and their bona fide officers or partners, provided that all securities so transferred remain subject to the lockup restriction above for the remainder of the time period.\nNOTE 9. FAIR VALUE MEASUREMENTS\nThe Company follows the guidance in ASC 820 for its financial assets and liabilities that are re-measured and reported at fair value at each reporting period, and non-financial assets and liabilities that are re-measured and reported at fair value at least annually.\nThe fair value of the Company’s financial assets and liabilities reflects management’s estimate of amounts that the Company would have received in connection with the sale of the assets or paid in connection with the transfer of the liabilities in an orderly transaction between market participants at the measurement date. In connection with measuring the fair value of its assets and liabilities, the Company seeks to maximize the use of observable inputs (market data obtained from independent sources) and to minimize the use of unobservable inputs (internal assumptions about how market participants would price assets and liabilities). The following fair value hierarchy is used to classify assets and liabilities based on the observable inputs and unobservable inputs used in order to value the assets and liabilities:\n\n| Level 1: | Quoted prices in active markets for identical assets or liabilities. An active market for an asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. |\n| Level 2: | Observable inputs other than Level 1 inputs. Examples of Level 2 inputs include quoted prices in active markets for similar assets or liabilities and quoted prices for identical assets or liabilities in markets that are not active. |\n| Level 3: | Unobservable inputs based on our assessment of the assumptions that market participants would use in pricing the asset or liability. |\n\nThe following table presents information about the Company’s assets that are measured at fair value on a recurring basis at September 30, 2022 and December 31, 2021, respectively, and indicates the fair value hierarchy of the valuation inputs the Company utilized to determine such fair value:\n\n| Description | Level | September, 2022 | December 31, 2021 |\n| Assets: |\n| Marketable securities held in Trust Account | 1 | $ | 44,203,481 | $ | 128,790,008 |\n| Liabilities: |\n| Warrant liabilities – Private Warrants | 3 | $ | 422,846 | $ | 2,641,204 |\n| Convertible promissory note – related party | 3 | $ | 913,900 | $ | 958,400 |\n\n18\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nWarrant Liabilities\nThe Private Warrants were accounted for as liabilities in accordance with ASC 815-40 and are presented within warrant liabilities on the condensed balance sheets. The warrant liabilities are measured at fair value at inception and on a recurring basis, with changes in fair value presented within change in fair value of warrant liabilities in the condensed statements of operations.\nThe Private Warrants were valued using a binomial lattice model. The Company allocated the proceeds received from (i) the sale of Units (which is inclusive of one share of common stock and one Public Warrant) and (ii) the sale of Private Warrants, first to the warrants based on their fair values as determined at initial measurement, with the remaining proceeds allocated to common stock subject to possible redemption. The Private Warrants were classified as Level 3 at the initial measurement date due to the use of unobservable inputs.\nThe following are the inputs used by the Company in establishing the fair value of its Private Warrants at September 30, 2022 and December 31, 2021.\n\n| Input | September 30, 2022 | December 31, 2021 |\n| Risk-free interest rate | 4.07 | % | 1.15 | % |\n| Trading days per year | 252 | 252 |\n| Expected volatility | 5.3 | % | 9.6 | % |\n| Exercise price | $ | 11.50 | $ | 11.50 |\n| Stock Price | $ | 10.35 | $ | 10.17 |\n\nOn December 31, 2021 and September 30, 2022, the Private Warrants were determined to be $ 0.50 per warrant and $ 0.08 per warrant, respectively, for an aggregate value of $ 2.64 million and $ 0.4 million, respectively.\nThe following table presents the changes in the fair value of the warrant liabilities:\n\n| Private Placement |\n| Fair value as of December 31, 2021 | $ | 2,641,204 |\n| Change in valuation inputs or other assumptions | ( 1,744,591 | ) |\n| Fair value as of March 31, 2022 | $ | 896,613 |\n| Change in valuation inputs or other assumptions | ( 579,785 | ) |\n| Fair value as of June 30, 2022 | $ | 316,828 |\n| Change in valuation inputs or other assumptions | 106,018 |\n| Fair value as of September 30, 2022 | $ | 422,846 |\n\n19\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nConvertible Promissory Note – Related Party\nThe fair value of the option to convert the convertible promissory note into Private Warrants was valued by utilizing a binomial lattice model incorporating the Cox-Ross-Rubenstein methodology.\nThe estimated fair value of the convertible promissory note was based on the following significant inputs:\n\n| September 30, 2022 |\n| Risk-free interest rate | 0.00 | % |\n| Time to Expiration (in years) | 1.38 |\n| Expected volatility | 5.3 | % |\n| Exercise price | $ | 11.50 |\n| Dividend yield | 0.00 | % |\n| Stock Price | $ | 10.35 |\n| Probability of transaction | 25.00 | % |\n\nThe following table presents the changes in the fair value of the Level 3 convertible promissory note:\n\n| Fair value as of January 1, 2021 | $ | 958,400 |\n| Proceeds received through Convertible Promissory Note | 1,261,860 |\n| Change in fair value | ( 337,260 | ) |\n| Fair value as of March 31, 2022 | $ | 1,883,000 |\n| Proceeds received through Convertible Promissory Note | 700,000 |\n| Change in fair value | ( 669,000 | ) |\n| Fair value as of June 30, 2022 | $ | 1,914,000 |\n| Conversion of Sponsor advance to Convertible Promissory Note | 100,000 |\n| Proceeds received through Convertible Promissory Note | 360,000 |\n| Change in fair value | ( 1,460,100 | ) |\n| Fair value as of September 30, 2022 | 913,900 |\n\nThere were no transfers in or out of Level 3 from other levels in the fair value hierarchy during the three and nine months ended September 30, 2022 for the convertible promissory note.\nNOTE 10. SUBSEQUENT EVENTS\nThe Company evaluated subsequent events and transactions that occurred after the balance sheet date up to the date that the financial statements were issued. Based upon this review the Company did not identify any subsequent events that would have required adjustment or disclosure in the condensed financial statements.\n20\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nReferences in this report (the “Quarterly Report”) to “we,” “us,” “our” or the “Company” refer to Better World Acquisition Corp. References to our “management” or our “management team” refer to our officers and directors, and references to the “Sponsor” refer to BWA Holdings LLC. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Quarterly Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\nSpecial Note Regarding Forward-Looking Statements\nThis Quarterly Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Exchange Act that are not historical facts and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. All statements, other than statements of historical fact included in this Form 10-Q including, without limitation, statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. Words such as “expect,” “believe,” “anticipate,” “intend,” “estimate,” “seek” and variations and similar words and expressions are intended to identify such forward-looking statements. Such forward-looking statements relate to future events or future performance, but reflect management’s current beliefs, based on information currently available. A number of factors could cause actual events, performance or results to differ materially from the events, performance and results discussed in the forward-looking statements. For information identifying important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements, please refer to the Risk Factors section of the Company’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission (the “SEC”) on March 31, 2022 and in our Quarterly Reports on Form 10-Q for the period ended March 31, 2022 and June 30, 2022, filed with the SEC on May 13, 2022 and August 3, 2022, respectively.\nOverview\nWe are a blank check company formed under the laws of the State of Delaware on August 5, 2020 for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities (an “initial business combination”). We intend to effectuate our initial business combination using cash from the proceeds of the Initial Public Offering and the sale of the Private Warrants, our capital stock, debt or a combination of cash, stock and debt.\nWe expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete a business combination will be successful.\n21\nResults of Operations\nWe have neither engaged in any operations nor generated any revenues to date. Our only activities from August 5, 2020 (inception) through September 30, 2022 were organizational activities, those necessary to prepare for the Initial Public Offering, described below, and identifying a target company for a business combination. We do not expect to generate any operating revenues until after the completion of our business combination. We generate non-operating income in the form of interest income on marketable securities held in the Trust Account. We incur expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence and transaction expenses.\nFor the three months ended September 30, 2022, we had net income of $844,154 which consists of the change in fair value of convertible promissory note – related party of $1,113,700, interest earned on marketable securities held in the Trust Account of $254,709 and unrealized gain on marketable securities held in the Trust Account of $1,078, offset by change in fair value of warrant liability of $106,018, a provision for income taxes of $23,249 and operational costs of $396,066.\nFor the nine months ended September 30, 2022, we had net income of $3,407,252 which consists of the change in fair value of warrant liability of $2,218,358, change in fair value of convertible promissory note – related party of $2,119,960, and interest earned on marketable securities held in the Trust Account of $423,734, offset by provision for income taxes of $27,528 and operational costs of $1,327,272.\nFor the three months ended September 30, 2021, we had net income of $1,475,730 which consists of the change in fair value of warrant liability of $2,192,941 and interest earned on marketable securities held in the Trust Account of $23,138, and unrealized loss on marketable securities held in the Trust Account of $4,654, offset by formation and operational costs of $735,695.\nFor the nine months ended September 30, 2021, we had net income of $2,207,258, which consists of the change in fair value of warrant liability of $3,302,913 and interest earned on marketable securities held in the Trust Account of $58,976, and unrealized loss on marketable securities held in the Trust Account of $5,829, offset by formation and operational costs of $1,148,802.\nLiquidity and Capital Resources\nOn November 17, 2020, we consummated the Initial Public Offering of 11,000,000 units, at $10.00 per Unit, generating gross proceeds of $110,000,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of 4,800,000 Private Warrants at a price of $1.00 per Private Warrant in a private placement to our Sponsor and EarlyBirdCapital, Inc. generating gross proceeds of $4,800,000.\nOn November 19, 2020, in connection with the underwriters’ partial exercise of their over-allotment option, we consummated the sale of an additional 1,618,600 units at a price of $10.00 per unit, generating total gross proceeds of $16,186,000. In addition, we also consummated the sale of an additional 485,580 private placement warrants at $1.00 per private placement warrant, generating total gross proceeds of $485,580.\nFollowing the initial public offering, the partial exercise of the over-allotment option, and the sale of the private placement warrants, $111,100,000 was placed in the trust account on November 18, 2020 and $16,347,860 was placed in the Trust Account on November 20, 2020, respectively, for a total of $127,447,860. We incurred $2,880,354 in the initial public offering related costs, including $2,523,720 of underwriting fees and $356,634 of other costs.\nFor the nine months ended September 30, 2022, cash used in operating activities was $853,148. Net income of $3,407,252 was affected by the change in fair value of warrant liability of $2,218,358, change in fair value of convertible promissory note – related party of $2,119,960 and interest earned on marketable securities held in the Trust Account of $423,734. Changes in operating assets and liabilities provided $501,652 of cash for operating activities.\nFor the nine months ended September 30, 2021, cash used in operating activities was $528,273. Net income of $2,207,258 was affected by the change in fair value of warrant liability of $3,302,913, interest earned on marketable securities held in the Trust Account of $58,976, and an unrealized loss on marketable securities held in our Trust Account of $5,829. Changes in operating assets and liabilities provided $620,529 of cash for operating activities.\nAs of September 30, 2022, in the U.S.-based trust account maintained by Continental Stock Transfer & Trust Company, acting as trustee, we had cash held of $947 and marketable securities held in the Trust Account of $44,202,534 (including approximately $145,311 of interest income) consisting of securities held in a money market fund that invests in U.S. Treasury securities with a maturity of 180 days or less. Interest income on the balance in the trust account may be used by us to pay taxes. In connection with the extension on May 12, 2022, stockholders holding 5,586,910 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $10.30 per share. In connection with the extension on August 15, 2022, stockholders holding 2,818,237 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds on the Trust Account at a redemption price of approximately $10.37 per share. Through September 30, 2022, we have withdrawn $358,711 of interest earned on the trust account to pay our taxes.\n22\nWe intend to use substantially all of the funds held in the trust account, to acquire a target business and to pay our expenses relating thereto upon consummation of our initial business combination for assisting us in connection with our initial business combination. To the extent that our capital stock is used in whole or in part as consideration to effect an initial business combination, the remaining funds held in the trust account will be used as working capital to finance the operations of the target business. Such working capital funds could be used in a variety of ways including continuing or expanding the target business’ operations, for strategic acquisitions and for marketing, research and development of existing or new products. Such funds could also be used to repay any operating expenses or finders’ fees which we had incurred prior to the completion of our initial business combination if the funds available to us outside of the trust account were insufficient to cover such expenses.\nAs of September 30, 2022, we had cash of $83,760 held outside the trust account. We intend to use the funds held outside the trust account for identifying and evaluating prospective acquisition candidates, performing business due diligence on prospective target businesses, traveling to and from the offices, plants or similar locations of prospective target businesses, reviewing corporate documents and material agreements of prospective target businesses, selecting the target business to acquire and structuring, negotiating and consummating the initial business combination.\nIn order to fund working capital deficiencies or finance transaction costs in connection with an initial business combination, the insiders, or certain of our officers and directors or their affiliates may, but are not obligated to, loan us funds as may be required. If we complete our initial business combination, we would repay such loaned amounts. In the event that our initial business combination does not close, we may use a portion of the working capital held outside the trust account to repay such loaned amounts but no proceeds from our trust account would be used for such repayment. Up to $1,500,000 of such loans may be convertible into warrants, at a price of $1.00 per warrant, at the option of the lender. The units would be identical to the private placement warrants. On November 9, 2021, we issued a promissory note in the principal amount of $1,261,860 to the Sponsor in connection with the Extension (“Convertible Promissory Note”) (as defined below). On February 17, 2022, April 14, 2022, May 18, 2022, and August 17, 2022, we amended and restated the Convertible Promissory Note to increase the principal amount thereunder from $1,261,860 to $3,683,720. The Note bears no interest and is due and payable upon the earlier to occur of (i) the date on which the Company’s Business Combination is consummated and (ii) the liquidation of the Company on or before February 17, 2023 or such later liquidation date as may be approved by the Company’s stockholders. At the election of the Sponsor, up to $1,500,000 of the unpaid principal amount of the Convertible Promissory Note may be converted into warrants of the Company, each warrant exercisable for one share of common stock of the Company upon the consummation of its Business Combination, equal to: (x) the portion of the principal amount of the Note being converted, divided by (y) $1.00, rounded up to the nearest whole number of warrants.\nWe expect that we will need to raise additional capital through loans or additional investments from our sponsor, stockholders, officers, directors, or third parties. Our officers, directors and sponsor may, but are not obligated to, loan us funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet our working capital needs. Accordingly, we may not be able to obtain additional financing. If we are unable to raise additional capital, we may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, and reducing overhead expenses. We cannot provide any assurance that new financing will be available to us on commercially acceptable terms, if at all.\nIn connection with the Company’s assessment of going concern considerations in accordance with Financial Accounting Standard Board’s Accounting Standards Update (“ASU”) 2014-15, “Disclosures of Uncertainties about an Entity’s Ability to Continue as a Going Concern,” the Company has until February 17, 2023 to consummate a Business Combination. It is uncertain that the Company will be able to consummate a Business Combination by this time. If a Business Combination is not consummated by this date and an extension has not been requested by the Sponsor and approved by the Company’s stockholders, there will be a mandatory liquidation and subsequent dissolution of the Company. Management has determined that the liquidity condition and the mandatory liquidation and potential subsequent dissolution raises substantial doubt about the Company’s ability to continue as a going concern. No adjustments have been made to the carrying amounts of assets or liabilities should the Company be required to liquidate after February 17, 2023. The Company intends to continue to search for and seek to complete a Business Combination before the mandatory liquidation date. The Company is within 12 months of its mandatory liquidation date as of the time of filing of this Quarterly Report on Form 10-Q.\nOff-Balance Sheet Financing Arrangements\nWe have no obligations, assets or liabilities, which would be considered off-balance sheet arrangements as of September 30, 2022. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets.\n23\nContractual Obligations\nWe have agreed, commencing on November 12, 2020 through the earlier of our consummation of an initial business combination and our liquidation, to pay an affiliate of our management a total of $10,000 per month for office space, utilities and secretarial support. For the three and nine months ended September 30, 2022, the Company incurred and accrued $30,000 and $90,000 in fees for these services, respectively, and those fees are included in accounts payable and accrued expenses in the accompanying condensed balance sheets. For the three and nine months ended September 30, 2021, the Company incurred and paid $30,000 and $90,000 in fees for these services.\nWe granted the underwriters a 45-day option from the date of the initial public offering to purchase up to 1,650,000 additional units to cover over-allotments, if any, at the initial public offering price less the underwriting discounts and commissions. On November 19, 2020, the underwriters partially exercised their over-allotment option to purchase an additional 1,618,600 units at $10.00 per unit and forfeited the remaining over-allotment option.\nWe have engaged EarlyBirdCapital as an advisor in connection with an initial business combination to assist us in holding meetings with its stockholders to discuss the potential initial business combination and the target business’ attributes, introduce us to potential investors that are interested in purchasing our securities in connection with an initial business combination, assist us in obtaining stockholder approval for the initial business combination and assist us with our press releases and public filings in connection with the initial business combination. We will pay EarlyBirdCapital a cash fee for such services upon the consummation of an initial business combination in an amount equal to 3.5% of the gross proceeds of the initial public offering, or $4,416,510 (exclusive of any applicable finders’ fees which might become payable); provided that up to 30% of the fee may be allocated at our sole discretion to other FINRA members that assist us in identifying and consummating an initial business combination.\nAdditionally, we will pay EarlyBirdCapital a cash fee equal to 1.0% of the total consideration payable in an initial business combination if EarlyBirdCapital introduces us to the target business with which we complete an initial business combination.\nWe have engaged various law firms to provide legal due diligence services and business combination services related to potential target companies. All fees and expenses related to the various engagements will be deferred and are to be paid fully upon the closing of any business combination. The law firms will not be entitled to any contingent fees or expense reimbursement if we do not consummate an initial business combination within our deadline. Deferred fees of $1,371,549 and $1,009,868 related to these legal services have been accrued as of September 30, 2022 and December 31, 2021, respectively.\nCritical Accounting Policies\nThe preparation of condensed financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have identified the following critical accounting policies:\nWarrant Liability\nThe Company accounts for the Private Warrants in accordance with the guidance contained in ASC 815-40-15-7D and 7F under which the Private Warrants do not meet the criteria for equity treatment and must be recorded as liabilities. Accordingly, the Company classifies the Private Warrants as liabilities at their fair value and adjusts the Private Warrants to fair value at each reporting period. This liability is subject to re-measurement at each balance sheet date until exercised, and any change in fair value is recognized in our statements of operations. The Private Warrants for periods where no observable traded price was available are valued using a binomial lattice simulation model.\n24\nConvertible Promissory Note\nWe account for our convertible promissory note under ASC 815, Derivatives and Hedging (“ASC 815”). Under 815-15-25, the election can be at the inception of a financial instrument to account for the instrument under the fair value option under ASC 825. We have made such election for our convertible promissory note. Using fair value option, the convertible promissory note is required to be recorded at its initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of the note are recognized as non-cash change in the fair value of the convertible promissory note in the statements of operations. The fair value of the option to convert the convertible promissory note into private placement warrants was valued by utilizing a binomial lattice model incorporating the Cox-Ross-Rubenstein methodology.\nCommon Stock Subject to Possible Redemption\nWe account for our common stock subject to possible conversion in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption is classified as a liability instrument and measured at fair value. Conditionally redeemable common stock (including common stock that features redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. Our common stock features certain redemption rights that are considered to be outside of our control and subject to occurrence of uncertain future events. Accordingly, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders’ deficit section of our condensed balance sheets.\nNet Income per Common Share\nNet income per common share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Accretion associated with the redeemable shares of common stock is excluded from net income per common share as the redemption value approximates fair value.\nRecent Accounting Standards\nIn August 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2020-06, “Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity” (“ASU 2020-06”), which simplifies accounting for convertible instruments by removing major separation models required under current GAAP. ASU 2020-06 removes certain settlement conditions that are required for equity contracts to qualify for the derivative scope exception, and it also simplifies the diluted earnings per share calculation in certain areas. ASU 2020-06 is effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years, with early adoption permitted. The Company assessed the potential impact of ASU 2020-06 and determined that it would not have a material impact on the condensed financial statements as presented.\nManagement does not believe that any other recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on our condensed financial statements.\nFactors That May Adversely Affect Our Results of Operations\nOur results of operation and our ability to complete an initial business combination may be adversely affected by various factors that could cause economic uncertainty and volatility in the financial markets, many of which are beyond our control. Our business could be impacted by, among other things, volatility in the financial markets or economic conditions, increase of oil price and interest rate, inflation, supply chain disruption, decline in consumer confidence and spending, the on-going effects of the COVID-19 pandemic, including resurgences and the emergence of new variants, and geopolitical instability, such as the military conflict in Ukraine. We cannot at this time fully predict one or more of the above events, their duration or magnitude of, or the extent to, which they may negatively impact our business and our ability to complete an initial business combination.\n25\n\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\nNot required for smaller reporting companies.\n\nItem 4. Controls and Procedures\nEvaluation of Disclosure Controls and Procedures\nDisclosure controls and procedures are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Exchange Act is recorded, processed, summarized, and reported within the time period specified in the SEC’s rules and forms. Disclosure controls and procedures are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.\nAs required by Rule 13a-15 under the Exchange Act, our Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of our disclosure controls and procedures as of September 30, 2022. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were not effective, due solely to the material weakness in our internal control over financial reporting related to our accounting for complex financial instruments. As a result, we performed additional analysis as deemed necessary to ensure that our financial statements were prepared in accordance with GAAP. Accordingly, management believes that the financial statements included in this Report present fairly in all material respects our financial position, results of operations and cash flows for the period presented.\nManagement has identified a material weakness in our internal controls related to the accounting for complex financial instruments. While we have processes to identify and appropriately apply applicable accounting requirements, we plan to continue to enhance our system of evaluating and implementing the accounting standards that apply to our financial statements, including through enhanced analyses by our personnel and third-party professionals with whom we consult regarding complex accounting applications. The elements of our remediation plan can only be accomplished over time, and we can offer no assurance that these initiatives will ultimately have the intended effects.\nManagement has implemented remediation steps to improve our internal control over financial reporting. Specifically, we expanded and improved our review process for complex securities and related accounting standards. We plan to further improve this process by enhancing access to accounting literature, identification of third-party professionals with whom to consult regarding complex accounting applications and consideration of additional staff with the requisite experience and training to supplement existing accounting professionals.\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n26\nPART II - OTHER INFORMATION\n\nItem 1. Legal Proceedings.\nTo the knowledge of our management team, there is no litigation currently pending or contemplated against us, any of our officers or directors in their capacity as such or against any of our property.\n\nItem 1A. Risk Factors\nAs of the date of this Quarterly Report on Form 10-Q, except as disclosed below, there have been no material changes to the risk factors previously disclosed in our final prospectus filed with the SEC on November 17, 2020 , in our Annual Report on Form 10-K for the year ended December 31, 2021 filed with the SEC on March 31, 2022 and in our Quarterly Reports on Form 10-Q for the period ended March 31, 2022 and June 30, 2022, filed with the SEC on May 13, 2022 and August 3, 2022, respectively. Any of these factors could result in a significant or material adverse effect on our results of operations or financial condition. Additional risk factors not presently known to us or that we currently deem immaterial may also impair our business or results of operations. We may disclose changes to such risk factors or disclose additional risk factors from time to time in our future filings with the SEC.\nA new 1% U.S. federal excise tax could be imposed on us in connection with redemptions of our shares in connection with a business combination or other stockholder vote pursuant to which stockholders would have a right to submit their shares for redemption (a “Redemption Event”).\nOn August 16, 2022, the Inflation Reduction Act of 2022 (the “IR Act”) was signed into federal law. The IR Act provides for, among other things, a new U.S. federal 1% excise tax on certain repurchases (including redemptions) of stock by publicly traded domestic corporations and certain domestic subsidiaries of publicly traded foreign corporations. The excise tax is imposed on the repurchasing corporation itself, not its stockholders from whom shares are repurchased. The amount of the excise tax is generally 1% of the fair market value of the shares repurchased at the time of the repurchase. However, for purposes of calculating the excise tax, repurchasing corporations are permitted to net the fair market value of certain new stock issuances against the fair market value of stock repurchases during the same taxable year. In addition, certain exceptions apply to the excise tax. The U.S. Department of the Treasury has been given authority to provide regulations and other guidance to carry out and prevent the abuse or avoidance of the excise tax. The IR Act applies only to repurchases that occur after December 31, 2022.\nAny redemption or other repurchase that occurs after December 31, 2022, in connection with a Redemption Event may be subject to the excise tax. Whether and to what extent we would be subject to the excise tax in connection with a Redemption Event would depend on a number of factors, including (i) the fair market value of the redemptions and repurchases in connection with the Redemption Event, (ii) the structure of the business combination, (iii) the nature and amount of any “PIPE” or other equity issuances in connection with the business combination (or otherwise issued not in connection with the Redemption Event but issued within the same taxable year of the business combination) and (iv) the content of regulations and other guidance from the U.S. Department of the Treasury. In addition, because the excise tax would be payable by us, and not by the redeeming holder, the mechanics of any required payment of the excise tax have not been determined. The foregoing could cause a reduction in the cash available on hand to complete a business combination and in our ability to complete a business combination.\nTo mitigate the risk that we might be deemed to be an investment company for purposes of the Investment Company Act, we expect to instruct the trustee to liquidate the securities held in our trust account and instead to hold the funds in our trust account in cash items until the earlier of the consummation of our initial business combination or our liquidation. As a result, we will likely receive minimal interest, if any, on the funds held in the trust account, which will likely reduce the dollar amount our public stockholders would receive upon any redemption or liquidation of the Company.\nThe funds in our trust account have, since our initial public offering, been held only in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds investing solely in U.S. government treasury obligations and meeting certain conditions under Rule 2a-7 under the Investment Company Act. However, to mitigate the risk of us being deemed to be an unregistered investment company (including under the subjective test of Section 3(a)(1)(A) of the Investment Company Act) and thus subject to regulation under the Investment Company Act, we expect to instruct Continental Stock Transfer & Trust Company, the trustee with respect to our trust account, to liquidate the U.S. government treasury obligations and money market funds held in the trust account and to hold all funds in the trust account as cash items until the earlier of the consummation of our initial business combination or the liquidation of the Company. Following such liquidation, we will likely receive minimal interest, if any, on the funds held in the trust account. However, interest previously earned on the funds held in the trust account still may be released to us to pay our taxes, if any. This will likely reduce the dollar amount our public stockholders would receive upon any redemption or liquidation of the Company. In the event that we may be deemed to be an investment company, we may be required to liquidate the Company.\n27\n\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\nNone.\n\nItem 3. Defaults Upon Senior Securities\nNone.\n\nItem 4. Mine Safety Disclosures\nNone.\n\nItem 5. Other Information\nNone.\n28\n\nItem 6. Exhibits\nThe following exhibits are filed as part of, or incorporated by reference into, this Quarterly Report on Form 10-Q.\n\n| No. | Description of Exhibit |\n| 3.1 | Second Amendment to the Amended and Restated Certificate of Incorporation, as amended (Incorporated by reference to the Company’s Form 8-K filed on August 17, 2022) |\n| 10.1 | Third Amended and Restated Promissory Note, dated August 17, 2022 (Incorporated by reference to the Company’s Form 8-K filed on August 17, 2022) |\n| 31.1* | Certification of Principal Executive Officer Pursuant to Securities Exchange Act Rules 13a-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2* | Certification of Principal Financial Officer Pursuant to Securities Exchange Act Rules 13a-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1** | Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2** | Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS* | Inline XBRL Instance Document |\n| 101.SCH* | Inline XBRL Taxonomy Extension Schema Document |\n| 101.CAL* | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF* | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB* | Inline XBRL Taxonomy Extension Labels Linkbase Document |\n| 101.PRE* | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104* | Cover Page Interactive Data File |\n\n\n| * | Filed herewith. |\n| ** | Furnished herewith. |\n\n29\nSIGNATURES\nIn accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| BETTER WORLD ACQUISITION CORP. |\n| Date: November 14, 2022 | By: | /s/ Rosemary L. Ripley |\n| Name: | Rosemary L. Ripley |\n| Title: | Chief Executive Officer |\n| (Principal Executive Officer) |\n| Date: November 14, 2022 | By: | /s/ Peter S.H. Grubstein |\n| Name: | Peter S.H. Grubstein |\n| Title: | Chief Financial Officer |\n| (Principal Financial Officer) |\n\n30\n\n</text>\n\nWhat's the estimated worth of the company Better World Acquisition Corp. at the end of Q4 in 2022 if the company continues to follow the same trend as it did in the first three quarters of 2022, in millions of dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nBusiness\nOrganization\nSotherly Hotels Inc. (the “Company”) is a self-managed and self-administered lodging real estate investment trust, or REIT, that was formed in August 2004 to own, acquire, renovate and reposition full-service, primarily upscale and upper-upscale hotel properties located in primary markets in the mid-Atlantic and southern United States. On December 21, 2004, the Company successfully completed its initial public offering and elected to be treated as a self-advised REIT for federal income tax purposes. The Company conducts its business through Sotherly Hotels LP, its operating partnership (the “Operating Partnership”), of which the Company is the general partner. The Company owns approximately 89.1% of the partnership units in the Operating Partnership. Limited partners (including certain of the Company’s officers and directors) own the remaining Operating Partnership units.\nAs of December 31, 2016, our portfolio consisted of twelve full-service, primarily upscale and upper-upscale hotels located in eight states with an aggregate total of 3,011 rooms and approximately 160,928 square feet of meeting space. All of our hotels are wholly-owned by subsidiaries of the Operating Partnership, and all are managed on a day to day basis by MHI Hotels Services, LLC, which does business as Chesapeake Hospitality (“Chesapeake Hospitality”).\nIn order for the Company to qualify as a REIT, it cannot directly manage or operate our wholly-owned hotels. Therefore, we lease our wholly-owned hotel properties to entities that we refer to as our TRS Lessees, which in turn have engaged Chesapeake Hospitality, an eligible independent management company, to manage our hotels. Our TRS Lessees are wholly-owned subsidiaries of MHI Hospitality TRS Holding, Inc. (“MHI Holding”, and collectively, “MHI TRS”). MHI TRS is a taxable REIT subsidiary for federal income tax purposes.\nOur corporate office is located at 410 West Francis Street, Williamsburg, Virginia 23185. Our telephone number is (757) 229-5648.\nOur Properties\nAs of December 31, 2016, our hotels were located in Florida, Georgia, Indiana, Maryland, North Carolina, Pennsylvania, Texas, and Virginia. Ten of these hotels operate under franchise agreements with major hotel brands, and two are independent hotels. Developments at our properties for the five years ended December 31, 2016 included the following:\n| • | In 2013 we acquired the Crowne Plaza Houston Downtown located in Houston, Texas at an aggregate value of approximately $30.9 million, including certain closing costs. |\n\n| • | In 2014, we acquired the Georgian Terrace located in Atlanta, Georgia at an aggregate value of approximately $61.1 million, including certain closing costs. We also, after extensive renovations, re-branded and renamed the Hilton Philadelphia Airport to the DoubleTree by Hilton Philadelphia Airport. |\n\n| • | In 2015, we acquired the remaining 75.0% interest in (i) the entity that owns the Crowne Plaza Hollywood Beach Resort, and (ii) the entity that leases the Crowne Plaza Hollywood Beach Resort. As a result, the Operating Partnership now has a 100% indirect ownership interest in the entities that own the Crowne Plaza Hollywood Beach Resort. We also, after extensive renovations, re-branded and renamed the Crowne Plaza Jacksonville Riverfront to the DoubleTree by Hilton Jacksonville Riverfront, and re-branded and renamed the Holiday Inn Laurel West to the DoubleTree by Hilton Laurel. |\n\n| • | In 2016, after extensive renovations, we re-branded and renamed the Crowne Plaza Houston Downtown to The Whitehall. |\n\nSee Items 2 and 7 of this Form 10-K for additional detail on our properties.\nOur Strategy and Investment Criteria\nOur strategy is to grow through acquisitions of full-service, upscale and upper-upscale hotel properties located in the primary markets of the southern United States. We intend to grow our portfolio through disciplined acquisitions of hotel properties and believe that we will be able to source significant external growth opportunities through our management team’s extensive network of industry, corporate and institutional relationships.\n5\nOur investment criteria are further detailed below:\n| • | Geographic Growth Markets: We are focusing our growth strategy on the major markets in the Southern region of the United States. Our management team remains confident in the long-term growth potential associated with this part of the United States. We believe these markets have, during the Company’s and our predecessors’ existence, been characterized by population growth, economic expansion, growth in new businesses and growth in the resort, recreation and leisure segments. We will continue to focus on these markets, including coastal locations, and will investigate other markets for acquisitions only if we believe these new markets will provide similar long-term growth prospects. |\n\n| • | Full-Service Hotels: We focus our acquisition strategy on the full-service hotel segment. Our full-service hotels fall primarily under the upscale to upper-upscale categories and include such brands as Hilton, Doubletree by Hilton, Sheraton and Crowne Plaza, as well as independent hotels affiliated with Preferred Hotels & Resorts. We may also acquire commercial unit(s) within upscale to upper-upscale condominium hotel projects, allowing us to establish and operate unit rental programs. We do not own economy hotels. We believe that full-service hotels, in the upscale to upper-upscale categories, will outperform the broader U.S. hotel industry, and thus offer the highest returns on invested capital. |\n\n| • | Significant Barriers to Entry: We intend to execute a strategy that entails the acquisition of hotels in prime locations with significant barriers to entry. |\n\n| • | Proximity to Demand Generators: We seek to acquire hotel properties located in central business districts for both leisure and business travelers within the respective markets, including large state universities, airports, convention centers, corporate headquarters, sports venues and office buildings. We seek to be in walking locations that are proximate to the markets’ major demand generators. |\n\nWe typically define underperforming hotels as those that are poorly managed, suffer from significant deferred maintenance and capital investment and that are not properly positioned in their respective markets. In pursuing these opportunities, we hope to improve revenue and cash flow and increase the long-term value of the underperforming hotels we acquire. Our ultimate goal is to achieve a total investment that is substantially less than replacement cost of a hotel or the acquisition cost of a market performing hotel. In analyzing a potential investment in an underperforming hotel property, we typically characterize the investment opportunity as one of the following:\n| • | Branding Opportunity: The acquisition of properties that includes a repositioning of the property through a change in brand affiliation, which may include positioning the property as an independent hotel. Branding opportunities typically include physical upgrades and enhanced efficiencies brought about by changes in operations. |\n\n| • | Shallow-Turn Opportunity: The acquisition of an underperforming but structurally sound hotel that requires moderate renovation to re-establish the hotel in its market. |\n\n| • | Deep-Turn Opportunity: The acquisition of a hotel that is closed or functionally obsolete and requires a restructuring of both the business components of the operations as well as the physical plant of the hotel, including extensive renovation of the building, furniture, fixtures and equipment. |\n\nTypically, in our experience, a deep turn opportunity takes a total of approximately four years from the initial acquisition of a property to achieving full post-renovation stabilization. Therefore, when evaluating future opportunities in underperforming hotels, we intend to focus on up-branding and shallow-turn opportunities, and to pursue deep-turn opportunities on a more limited basis and in joint venture partnerships, if possible.\nInvestment Vehicles. In pursuit of our investment strategy, we may employ various traditional and non-traditional investment vehicles:\n| • | Direct Purchase Opportunity: Our traditional investment strategy is to acquire direct ownership interests via our Operating Partnership in properties that meet our investment criteria, including opportunities that involve full-service, upscale and upper-upscale properties in identified geographic growth markets that have significant barriers to entry for new product delivery. Such properties, or portfolio of properties, may or may not be acquired subject to a mortgage, or other financing or lending instruments, by the seller or third-party. |\n\n| • | Joint Venture/Mezzanine Lending Opportunities: We may, from time to time, undertake a significant renovation and rehabilitation project that we characterize as a deep-turn opportunity. In such cases, we may acquire a functionally obsolete hotel whose renovation may be very lengthy and require significant capital. In these projects, we may choose to structure such acquisitions as a joint venture, or mezzanine lending program, in order to avoid severe short-term dilution and loss of current income commonly referred to as the “negative carry” associated with such extensive renovation programs. We will not pursue joint venture or mezzanine programs in which we would become a “de facto” lender to the real estate community. |\n\n6\nPortfolio and Asset Management Strategy\nWe intend to ensure that the management of our hotel properties maximizes market share, as evidenced by revenue per available room (“RevPAR”) penetration indices, and that our market share yields the optimum level of revenues for our hotels in their respective markets. Our strategy is designed to actively manage our hotels’ operating expenses in an effort to maximize hotel earnings before interest, taxes, depreciation and amortization (“Hotel EBITDA”).\nOver our long history in the lodging industry we have refined many portfolio and asset management techniques that we believe provide for exceptional cash returns at our hotels. We undertake extensive budgeting due diligence wherein we examine market trends, one-time or exceptional revenue opportunities, and/or changes in the regulatory climate that may impact costs. We review daily revenue results and revenue management strategies at the hotels, and we focus on our manager’s ability to produce high quality revenues that translate to higher profit margins. We look for ancillary forms of revenues, such as leasing roof-top space for cellular towers and other communication devices and also look to lease space to third parties in our hotels, which may include, but are not limited to, gift shops or restaurants. We have and will continue to engage parking management companies to maximize parking revenue. Our efforts further include periodic review of property insurance costs and coverage, and the cost of real and personal property taxes. We generally appeal tax increases in an effort to secure lower tax payments and routinely pursue strategies that allow for lower overall insurance costs, such as purchasing re-insurance and participating in state-sponsored insurance pools.\nWe also require detailed and refined reporting data from Chesapeake Hospitality, which includes detailed accounts of revenues, revenue segments, expenses and forecasts based on current and historic booking patterns. We also believe we optimize and successfully manage capital costs at our hotels while ensuring that adequate product standards are maintained to provide a positive guest experience.\nNone of our hotels are managed by a major national or global hotel franchise company. Through our long history in the lodging industry, we have found that management of our hotels by management companies other than franchisors is preferable to and more profitable than management services provided by the major franchise companies, specifically with respect to optimization of operating expenses and the delivery of guest service.\nOur portfolio management strategy includes our effort to optimize labor costs. The labor force in our hotels is predominately non-unionized, with only one property, the DoubleTree by Hilton Jacksonville Riverfront, having a total of approximately 26 employees electing to participate under a collective bargaining arrangement. Further, the labor force at our hotels is eligible to receive health and other insurance coverage through Chesapeake Hospitality, which self-insures. Self-insuring has, in our opinion and experience, provided significant savings over traditional insurance company sponsored plans.\nAsset Disposition Strategy. When a property no longer fits with our investment objectives, we will pursue a direct sale of the property for cash so that our investment capital can be redeployed according to the investment strategies outlined above. Where possible, we will seek to subsequently purchase a hotel in connection with the requirements of a tax-free exchange. Such a strategy may be deployed in order to mitigate the tax consequence that a direct sale may cause.\nOur Principal Agreements\nManagement Agreements\nChesapeake Hospitality is currently the management company for each of our hotels. Andrew M. Sims, our chairman and chief executive officer owns an equity interest in Chesapeake Hospitality. Immediately prior to March 1, 2017, our chairman and chief executive officer, and another of our directors were also directors of Chesapeake Hospitality.\nOn December 15, 2014, we entered into a master agreement (the “Master Agreement”) and a series of individual hotel management agreements (each a “Hotel Management Agreement” and, together, the “Hotel Management Agreements”) between the Company, the Operating Partnership, and MHI Hospitality TRS, LLC (and other TRS Lessees) on the one hand and Chesapeake Hospitality on the other hand, to address the scheduled expiration of the then existing master management agreement (the “MMA”) and the strategic alliance agreement (the “SA Agreement”) and to provide for ongoing management of the Company’s hotels. The Master Agreement and Hotel Management Agreements terminated and replaced the then existing MMA and individual management agreements.\nThe Master Agreement:\n| • | expires on December 31, 2019, or earlier if all of the Hotel Management Agreements expire or are terminated prior to that date. The Master Agreement will be extended beyond 2019 for such additional periods as a Hotel Management Agreement remains in effect; |\n\n7\n\n| • | terminated the then existing SA Agreement as of December 15, 2014; |\n\n| • | extended the term of the then existing MMA until December 31, 2014 and terminated the MMA and other individual management agreements for Tampa, Houston, and Atlanta as of such date; |\n\n| • | caused the Hotel Management Agreements to come into effect coincident with the termination of the MMA and other individual management agreements on December 31, 2014; |\n\n| • | requires Chesapeake Hospitality to provide dedicated executive level support for our managed hotels pursuant to certain criteria; |\n\n| • | provides a mechanism and established conditions on which the Company will offer Chesapeake Hospitality the opportunity to manage hotels acquired by the Company in the future, pursuant to a negotiated form of single facility management agreement, with the caveat that the Company is not required to offer the management of future hotels to Chesapeake Hospitality; and |\n\n| • | sets an incentive management fee for each of the hotels to be managed by Chesapeake Hospitality equal to 10% of the amount by which gross operating profit, as defined in the Hotel Management Agreement, for a given year exceeds the budgeted gross operating profit for such year; provided, however, that the incentive management fee payable in respect of any such year shall not exceed 0.25% of the gross revenues of the hotel included in such calculation. |\n\nEach of the Hotel Management Agreements has a term of five years commencing January 1, 2015, with the exception of the Hotel Management Agreement for the management of the Crowne Plaza Hollywood Beach Resort, which has a term of five years commencing July 31, 2015. Each of the Hotel Management Agreements may be extended for up to two additional periods of five years subject to the approval of both parties with respect to any such extension. The agreements provide that Chesapeake Hospitality will be the sole and exclusive manager of the hotels as the agent of the respective TRS Lessee and at the sole cost and expense of the TRS Lessee and subject to certain operating standards. Each agreement may be terminated in connection with a sale of the related hotel. In connection with a termination upon the sale of the hotel, Chesapeake Hospitality will be entitled to receive a termination fee equal to the lesser of the management fee paid with respect to the prior twelve months or the management fees paid for that number of months prior to the closing date of the hotel sale equal to the number of months remaining on the current term of the Hotel Management Agreement. No sale termination fee will be payable in the event the Company elects to provide Chesapeake Hospitality with the opportunity to manage another comparable hotel and Chesapeake Hospitality is not precluded from accepting such opportunity. Chesapeake Hospitality is required to qualify as an eligible independent contractor in order to permit the Company to continue to operate as a real estate investment trust.\nAmounts Payable under the Management Agreements. Chesapeake Hospitality receives a base management fee, and, if the hotels exceed certain financial thresholds, an additional incentive management fee for the management of our hotels.\nThe base management fee for our hotels will be a percentage of the gross revenues of the hotel and will be due monthly. The applicable percentage of gross revenue for the base management fee for each of our wholly-owned hotels is as follows (1):\n\n| 2019 | 2018 | 2017 | 2016 | 2015 | 2014 |\n| Crowne Plaza Hampton Marina (2) | N/A | N/A | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| Crowne Plaza Hollywood Beach Resort | 2.50 | % | 2.50 | % | (3) | (3) | 2.00 | % | N/A |\n| Crowne Plaza Tampa Westshore (4) | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| DoubleTree by Hilton Jacksonville Riverfront | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| DoubleTree by Hilton Laurel | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| DoubleTree by Hilton Philadelphia Airport | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| DoubleTree by Hilton Raleigh Brownstone – University | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| Georgian Terrace (5) | 2.50 | % | 2.50 | % | 2.50 | % | 2.25 | % | 2.00 | % | 2.00 | % |\n| Hilton Savannah DeSoto | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| Hilton Wilmington Riverside | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| Sheraton Louisville Riverside (6) | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| The Whitehall (7) | 2.50 | % | 2.50 | % | 2.50 | % | 2.25 | % | 2.00 | % | 2.00 | % |\n\n\n| (1) | The fees for 2014 were set by the MMA, and the individual management agreements for Tampa, Houston, and Atlanta. The fees for 2015-2019 are set by the Master Agreement and the Hotel Management Agreements. |\n\n| (2) | The Crowne Plaza Hampton Marina was sold on February 7, 2017; therefore, the base management fee no longer applies after February 7, 2017. |\n\n8\n\n| (3) | Upon acquiring the Crowne Plaza Hollywood Beach Resort in July 2015, we entered into a single facility management agreement with Chesapeake Hospitality for the management of the hotel. The terms of the agreement provide for a base management fee of 2.00% through July 2016, 2.25% through July 2017, and 2.50% thereafter. |\n\n| (4) | In January 2009, we entered a separate management agreement with Chesapeake Hospitality for the management of the Crowne Plaza Tampa Westshore. The provisions of the new agreement related to base management fee were the same as those contained in the MMA. The provisions of the agreement related to the incentive management fee were the same as those contained in the MMA except that it was calculated separately and not aggregated with the other properties covered by the MMA. |\n\n| (5) | In March 2014, we entered into the Atlanta Agreement with Chesapeake Hospitality for the management of the Georgian Terrace. The terms of the agreement provided for a base management fee of 2.0% and no incentive management fee. The Atlanta Agreement was terminated in connection with the entry into the Master Agreement and Hotel Management Agreements. |\n\n| (6) | Pursuant to the MMA, the term for each of the initial properties, which included the Holiday Inn Downtown Williamsburg, was 10 years. The management company agreed to substitute the Sheraton Louisville Riverside for the Holiday Inn Downtown Williamsburg for remainder of the term of the agreement. |\n\n| (7) | In November 2013, we assumed the existing management agreement with Chesapeake Hospitality for the management of the Crowne Plaza Houston Downtown. The terms of the agreement provided for a base management fee of 2.0% and no incentive management fee. |\n\nThe base management fee for a hotel acquired in the future which is first leased by our TRS Lessees, other than on the first day of a fiscal year, will be 2.0% for the partial year such hotel is first leased and for the first full year such hotel is managed. There is no fee cap on the base management fee.\nSubsequently Acquired Hotel Properties\n\n| First year | 2.00 | % |\n| Second year | 2.25 | % |\n| Third year and thereafter | 2.50 | % |\n\nTerminated Strategic Alliance Agreement and Management Agreements\nOn December 21, 2004, we entered into the now terminated ten-year SA Agreement with Chesapeake Hospitality pursuant to which (i) Chesapeake Hospitality agreed to refer to us (on an exclusive basis) hotel acquisition opportunities in the United States presented to Chesapeake Hospitality, and (ii) unless a majority of the Company’s independent directors in good faith concluded for valid business reasons that another management company should manage a hotel owned by us, we agreed to offer Chesapeake Hospitality or its subsidiaries the right to manage hotel properties that we acquired in the United States. The SA Agreement was terminated effective as of December 15, 2014, pursuant to the terms of the Master Agreement.\nPursuant to the terms of the now terminated MMA and other individual management agreements for Tampa, Houston and Atlanta, we engaged Chesapeake Hospitality as the property manager for each of our wholly-owned hotels through December 2015. The MMA had a term of ten (10) years for each initial hotel and a term of ten (10) years for each subsequently acquired hotel that became subject to the MMA. Chesapeake Hospitality benefited from the payment of management fees by us pursuant to the MMA. Chesapeake Hospitality received a base management fee equal to a percentage of each hotel’s revenues (2.0% for the first year, 2.5% for the second year and 3.0% thereafter). Additionally, pursuant to the MMA, Chesapeake Hospitality was entitled to receive certain incentive fees and project management fees. For Tampa, the base management and incentive management fees were the same as those contained in the MMA. For Houston and Atlanta, the base management fee was equal to 2% of the respective hotels’ revenues, and there was no incentive management fee. The MMA and the individual management agreements for Tampa, Houston, and Atlanta were terminated on December 31, 2014, pursuant to the terms of the Master Agreement.\nFranchise Agreements\nAs of December 31, 2016, all but two of our wholly-owned hotels operate under franchise licenses from national hotel companies. On March 27, 2014, we purchased an independent full-service hotel in Atlanta, Georgia, which does not operate under a franchise license. On April 12, 2016, we allowed the Crowne Plaza Houston Downtown’s franchise agreement to expire and rebranded it as The Whitehall, an independent full-service hotel.\nOur TRS Lessees hold the franchise licenses for our wholly-owned hotels. Chesapeake Hospitality must operate each of our hotels it manages in accordance with and pursuant to the terms of the franchise agreement for the hotel.\n9\nThe franchise licenses generally specify certain management, operational, record keeping, accounting, reporting and marketing standards and procedures with which the franchisee must comply. Under the franchise licenses, the franchisee must comply with the franchisors’ standards and requirements with respect to:\n| • | training of operational personnel; |\n\n| • | safety; |\n\n| • | maintaining specified insurance; |\n\n| • | the types of services and products ancillary to guest room services that may be provided; |\n\n| • | display of signage; |\n\n| • | marketing techniques including print media, billboards, and promotions standards; and |\n\n| • | the type, quality and age of furniture, fixtures and equipment included in guest rooms, lobbies and other common areas. |\n\nAdditionally, as the franchisee, our TRS Lessees are required to pay the franchise fees described below.\nThe following table sets forth certain information for the franchise licenses of our wholly-owned hotel properties as of December 31, 2016:\n\n| Marketing/ |\n| Franchise | Reservation | Expiration |\n| Fee (1) | Fee (1) | Date |\n| Crowne Plaza Hampton Marina (2) | 5.0 | % | 3.5 | % | 2/7/2017 |\n| Crowne Plaza Hollywood Beach Resort (3) | 5.0 | % | 3.5 | % | 10/31/2017 |\n| Crowne Plaza Tampa Westshore | 5.0 | % | 3.5 | % | 3/6/2019 |\n| DoubleTree by Hilton Jacksonville Riverfront (4) | 5.0 | % | 4.0 | % | 9/30/2025 |\n| DoubleTree by Hilton Laurel | 5.0 | % | 4.0 | % | 10/31/2030 |\n| DoubleTree by Hilton Philadelphia – Airport (5) | 5.0 | % | 4.0 | % | 10/31/2024 |\n| DoubleTree by Hilton Raleigh Brownstone – University (4) | 5.0 | % | 4.0 | % | 11/30/2021 |\n| Hilton Savannah DeSoto (6) | 5.0 | % | 4.0 | % | 7/31/2017 |\n| Hilton Wilmington Riverside | 5.0 | % | 4.0 | % | 3/31/2018 |\n| Sheraton Louisville Riverside | 5.0 | % | 3.5 | % | 4/25/2023 |\n\n\n| (1) | Percentage of room revenues payable to the franchisor. |\n\n| (2) | The Crowne Plaza Hampton Marina was sold on February 7, 2017, and the franchise license was transferred to the new owners. |\n\n| (3) | We have entered into a franchise agreement with Hilton to rebrand the Hollywood hotel as a DoubleTree by Hilton. |\n\n| (4) | The Franchise Fee is 3.0% for operating year 1, 4.0% for operating year 2, and 5.0% thereafter. |\n\n| (5) | The Franchise Fee is 4.0% for operating years 1 and 2, and 5.0% thereafter. |\n\n| (6) | We intend to convert the Savannah hotel to an independent hotel. |\n\nLease Agreements\nIn order for the Company to maintain qualification as a REIT, neither the Company nor the Operating Partnership or its subsidiaries can operate our hotels directly. Our wholly-owned hotels are leased to our TRS Lessees, which have engaged Chesapeake Hospitality to manage the hotels. Each lease has a non-cancelable term of three to thirty years, subject to earlier termination upon the occurrence of certain contingencies described in the lease.\nDuring the term of each lease, our TRS Lessees are obligated to pay a fixed annual base rent plus a percentage rent and certain other additional charges. Base rent accrues and is paid monthly. Percentage rent is calculated by multiplying fixed percentages by gross room revenues, in excess of certain threshold amounts and is paid monthly or quarterly, according to the terms of the agreement.\nTax Status\nThe Company elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the “Code”), commencing with its taxable year ended December 31, 2004. In order to maintain its qualification as a REIT, the Company must meet a number of organizational and operational requirements, including a requirement that it currently distribute, as “qualifying distributions,” at least 90.0% of its taxable income (determined without regard to the deduction for dividends paid and by\n10\nexcluding its net capital gains and reduced by certain non-cash items) to its stockholders. The Company has adhered to these requirements each taxable year since its formation in 2004 and intends to continue to adhere to these requirements and maintain its qualification for taxation as a REIT. As a REIT, the Company generally will not be subject to federal corporate income tax on that portion of its taxable income (including its net capital gain) that is distributed to its stockholders. If the Company fails to qualify for taxation as a REIT in any taxable year, and no relief provision applies, it will be subject to federal income taxes at regular corporate rates (as well as any applicable alternative minimum tax) and it would be disqualified from re-electing treatment as a REIT until the fifth taxable year after the year in which it failed to qualify as a REIT. Even if the Company qualifies for taxation as a REIT, it may be subject to certain state and local taxes on its income and property, and to federal income and excise taxes on its undistributed taxable income. In addition, taxable income from non-REIT activities managed through taxable REIT subsidiaries is subject to federal, state and local income taxes.\nWhile the Operating Partnership is generally not subject to federal and state income taxes, the unit holders of the Operating Partnership, including the Company, are subject to tax on their respective allocable shares of the Operating Partnership’s taxable income.\nThe Company has one taxable REIT subsidiary, MHI Holding, in which it owns an interest through the Operating Partnership. MHI Holding is subject to federal, state and local income taxes. MHI Holding has operated at a cumulative taxable loss, through December 31, 2016, of approximately $15.9 million and in addition had deferred timing differences of approximately $0.2 million attributable to start-up expenses related to the opening of several of its hotels, which was not deductible when incurred and is being amortized over 15 years and deferred timing differences of approximately $0.5 million attributable to accrued, but not deductible, vacation and sick pay amounts. The Company has not incurred federal income taxes since its formation. The cumulative taxable loss and combined timing differences result in a net deferred tax asset of approximately $6.9 million for these cumulative deferred tax loss carryforwards.\nEnvironmental Matters\nIn connection with the ownership and operation of the hotels, we are subject to various federal, state and local laws, ordinances and regulations relating to environmental protection. Under these laws, a current or previous owner or operator of real estate may be liable for the costs of removal or remediation of certain hazardous or toxic substances on, under, or in such property. Such laws often impose liability without regard to whether the owner or operator knew of, or was responsible for, the presence of hazardous or toxic substances. In addition, the presence of contamination from hazardous or toxic substances, or the failure to remediate such contaminated property properly, may adversely affect the owner’s ability to borrow using such property as collateral. Furthermore, a person who arranges for the disposal or treatment of a hazardous or toxic substance at a property owned by another, or who transports such substance to or from such property, may be liable for the costs of removal or remediation of such substance released into the environment at the disposal or treatment facility. The costs of remediation or removal of such substances may be substantial, and the presence of such substances may adversely affect the owner’s ability to sell such real estate or to borrow using such real estate as collateral. In connection with the ownership and operation of the hotels, we may be potentially liable for such costs.\nWe believe that our hotels are in compliance, in all material respects, with all federal, state and local environmental ordinances and regulations regarding hazardous or toxic substances and other environmental matters, the violation of which would have a material adverse effect on us. We have not received written notice from any governmental authority of any material noncompliance, liability or claim relating to hazardous or toxic substances or other environmental matters in connection with any of our present hotel properties.\nEmployees\nAs of December 31, 2016, we employed twelve full-time persons, all of whom work at our corporate office in Williamsburg, Virginia. All persons employed in the day-to-day operations of the hotels are employees of Chesapeake Hospitality, the management company engaged by our TRS Lessees to operate such hotels.\nSubsequent Events\nHyde Resort & Residences\nOn January 30, 2017, we purchased the commercial unit of the Hyde Resort & ResidencesTM, a condominium hotel located in the Hollywood, Florida market, for an aggregate price of approximately $4.8 million, including inventory and closing fees. The trademarked Hyde Resort & Residences is operated under license from SBE Hotel Licensing, LLC.\n11\nWe have entered into several agreements related to the Hyde Resort & Residences, which is zoned and operated as a condominium hotel with individual condominium units owned by third parties. In addition to our ownership of the commercial condominium unit, consisting of the designated lobby and front desk areas, we entered into a 20-year Lease Agreement with the condominium association responsible for the operation of the condominium, whereby we lease other common areas, including meeting rooms, office spaces, and 400 parking spaces, and also manage the parking garage. We have also entered into a 20-year Association Management Agreement with the condominium association, whereby we are engaged to manage the condominium association and to operate the Hyde Resort & Residences as a condominium hotel. Individual condominium unit owners may elect for their condominium units to be rented to condominium hotel guests pursuant to a rental management program managed for us by Chesapeake Hospitality pursuant to the Hyde Management Agreement, described below. As part of the rental management program, we have entered into individual rental agreements with condominium unit owners who have chosen to participate in our rental program, and may enter into rental agreements with unit owners in the future. We expect the number of individual condominium unit owners who elect to participate in our rental program to vary, and the number of units available for rental to condominium hotel guests at any given time will fluctuate pursuant to that participation and due to owner occupation of the condominium hotel units.\nOn February 3, 2017, we entered into a Condominium Hotel Management Agreement (the “Hyde Management Agreement”) with Chesapeake Hospitality for the management of the Hyde Resort & Residences condominium hotel. In accordance with the Master Agreement, the Hyde Management Agreement has an initial term of five years commencing January 30, 2017 and mirrors the material terms of the other Hotel Management Agreements. The terms of the Hyde Management Agreement provide for a base management fee equal to a percentage of gross revenues of the rental of condominium units participating in our rental program in the amount of 2.00% through January 2018, 2.25% through January 2019, and 2.50% thereafter. Pursuant to the Hyde Management Agreement, Chesapeake Hospitality will manage for us the rental of individually owned condominium units pursuant to rental agreements entered into with individual condominium unit owners. We also entered into an Association Sub Management and Assignment Agreement with Chesapeake Hospitality for the management and operation of the condominium association responsible for the operation of the Hyde Resort & Residences, and a Rental Management Agreement pursuant to which Chesapeake Hospitality agreed to manage the marketing and negotiation of rental agreements with individual condominium unit owners.\nCrowne Plaza Hampton Marina Disposition\nOn February 7, 2017, we sold the Crowne Plaza Hampton Marina for a price of approximately $5.6 million. Following the sale, our portfolio consisted of eleven wholly-owned hotels located in seven states with an aggregate total of 2,838 rooms and approximately 149,435 square feet of meeting space, as well as our interests in the Hyde Resort & Residences.\nEmployee Stock Ownership Plan\nBetween January 3, 2017 and February 23, 2017, the Company’s Employee Stock Ownership Plan (“ESOP”) purchased 682,500 shares of the Company’s common stock. The Company sponsors and maintains the ESOP and related trust for the benefit of its eligible employees. The ESOP, which was established January 1, 2016, is funded by a loan from the Company, pursuant to which the ESOP may borrow up to $5,000,000 to purchase shares of the Company’s common stock, which serve as collateral for the loan.\nDirector and Officer Changes\nOn March 1, 2017, Kim E. Sims resigned as a member of the board of directors of the Company.\nAvailable Information\nWe maintain an Internet site, http://www.sotherlyhotels.com, which contains additional information concerning Sotherly Hotels Inc. We make available free of charge through our Internet site all our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, definitive proxy statements and other reports filed with the Securities and Exchange Commission as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. We have also posted on this website the Company’s Code of Business Conduct and the charters of the Company’s Nominating, Corporate Governance and Compensation (“NCGC”) and Audit Committees of the Company’s board of directors. We intend to disclose on our website any changes to, or waivers from, the Company’s Code of Business Conduct. Information on the Company’s Internet site is neither part of nor incorporated into this Form 10-K.\n12\n\nItem 1A.\nRi\nsk Factors\nThe following are the material risks that may affect us. Any of the risks discussed herein can materially adversely affect our business, liquidity, operations, industry or financial position or our future financial performance.\nRisks Related to Our Debt\nWe have substantial financial leverage.\nAs of December 31, 2016, the principal balance of our debt was approximately $309.8 million, which is comprised of approximately $284.5 million secured debt and approximately $25.3 million unsecured debt related to the 7.0% senior unsecured notes due November 20, 2019 (the “7% Notes”) (not accounting for reductions of unamortized premiums or deferred financing costs as shown on our balance sheet). Historically, we have incurred debt for acquisitions and to fund our renovation, redevelopment and rebranding programs. Limitations upon our access to additional debt could adversely affect our ability to fund these programs or acquire hotels in the future.\nOur financial leverage could negatively affect our business and financial results, including the following:\n| • | require us to dedicate a substantial portion of our cash flow from operations to payments on our debt, thereby reducing funds available for operations, working capital, capital expenditures, future business opportunities, paying dividends or other purposes; |\n\n| • | limit our ability to obtain additional financing for working capital, renovation, redevelopment and rebranding plans, acquisitions, debt service requirements and other purposes; |\n\n| • | adversely affect our ability to satisfy our financial obligations, including those related to the 7% Notes; |\n\n| • | limit our ability to refinance existing debt; |\n\n| • | require us to agree to additional restrictions and limitations on our business operations and capital structure to obtain financing; |\n\n| • | force us to dispose of one or more of our properties, possibly on unfavorable terms; |\n\n| • | increase our vulnerability to adverse economic and industry conditions, and to interest rate fluctuations; |\n\n| • | force us to issue additional equity, possibly on terms unfavorable to existing shareholders; |\n\n| • | limit our flexibility to make, or react to, changes in our business and our industry; and |\n\n| • | place us at a competitive disadvantage, compared to our competitors that have less debt. |\n\nWe must comply with financial covenants in our mortgage loan agreements and in the indenture.\nOur mortgage loan agreements and indenture contain various financial covenants. Failure to comply with these financial covenants could result from, among other things, changes in the local competitive environment, general economic conditions and disruption caused by renovation activity or major weather disturbances.\nIf we violate the financial covenants contained in our mortgage loan agreements, we may attempt to negotiate waivers of the violations or amend the terms of the applicable mortgage loan agreement with the lender; however, we can make no assurance that we would be successful in any such negotiation or that, if successful in obtaining waivers or amendments, such waivers or amendments would be on attractive terms. Some mortgage loan agreements provide alternate cure provisions which may allow us to otherwise comply with the financial covenants by obtaining an appraisal of the hotel, prepaying a portion of the outstanding indebtedness or by providing cash collateral until such time as the financial covenants are met by the collateralized property without consideration of the cash collateral. Alternate cure provisions which include prepaying a portion of the outstanding indebtedness or providing cash collateral may have a material impact on our liquidity.\nIf we violate the financial covenants in the indenture, we may attempt to cure that violation by engaging in one or more transactions pursuant to the cure provision in the indenture.\nIf we are unable to negotiate a waiver or amendment or satisfy alternate cure provisions, if any, or unable to meet any alternate cure requirements and a default were to occur, we would possibly have to refinance the debt through debt financing, private or public offerings of debt securities, additional equity financing, or by disposing of an asset. We are uncertain whether we will be able to refinance these obligations or if refinancing terms will be favorable.\n13\nWe have one mortgage debt obligation maturing in 2018, and if we are not successful in extending the term of this indebtedness or in refinancing this debt on acceptable economic terms or at all, our overall financial condition could be materially and adversely affected.\nWe will be required to seek additional capital in the near future to refinance or replace existing long-term mortgage debt that is maturing. Based on current market conditions, the availability of financing is, and may continue to be, limited. There can be no assurance that we will be able to obtain future financings on acceptable terms, if at all.\nIn August 2018, the mortgage on our DoubleTree by Hilton Raleigh Brownstone University matures, and we have additional significant obligations maturing in subsequent years.\nWe have no material debt obligations maturing in 2017. The total aggregate amount of our debt obligations scheduled to mature in 2018, inclusive of monthly amortization of all our indebtedness, is approximately $24.6 million, which represents approximately 7.9% of our total debt obligation outstanding as of December 31, 2016.\nWe will need to, and plan to, renew, replace or extend our long-term indebtedness prior to the respective maturity date. If we are unable to extend this loan, we may be required to repay the outstanding principal amount at maturity or a portion of such indebtedness upon refinance. If we do not have sufficient funds to repay any portion of the indebtedness, it may be necessary to raise capital through debt financing, private or public offerings of debt securities or equity financings. We are uncertain whether we will be able to refinance this obligation or if refinancing terms will be favorable. If, at the time of any refinancing, prevailing interest rates or other factors result in higher interest rates on refinancing, increases in interest expense would lower our cash flow, and, consequently, cash available to meet our financial obligations. If we are unable to obtain alternative or additional financing arrangements in the future, or if we cannot obtain financing on acceptable terms, we may not be able to execute our business strategies or we may be forced to dispose of hotel properties on disadvantageous terms, potentially resulting in losses and potentially reducing cash flow from operating activities if the sale proceeds in excess of the amount required to satisfy the indebtedness could not be reinvested in equally profitable real property investments. Moreover, the terms of any additional financing may restrict our financial flexibility, including the debt we may incur in the future, or may restrict our ability to manage our business as we had intended. To the extent we cannot repay our outstanding debt, we risk losing some or all of our hotel properties to foreclosure and we could be required to invoke insolvency proceedings including, but not limited to, commencing a voluntary case under the U.S. Bankruptcy Code.\nFor tax purposes, a foreclosure of any of our hotels would be treated as a sale of the hotel for a purchase price equal to the outstanding balance of the debt secured by the mortgage. If the outstanding balance of the debt secured by the mortgage exceeds our tax basis in the hotel, we would recognize taxable income on foreclosure, but we would not receive any cash proceeds, which could hinder the Company’s ability to meet the REIT distribution requirements imposed by the Code. In addition, we may give full or partial guarantees to lenders of mortgage debt on behalf of the entities that own our hotels. When we give a guarantee on behalf of an entity that owns one of our hotels, we will be responsible to the lender for satisfaction of the debt if it is not paid by such entity.\nOur borrowing costs are sensitive to fluctuations in interest rates.\nHigher interest rates could increase our debt service requirements and interest expense. Currently, our floating rate debt is limited to the mortgages on the DoubleTree by Hilton Philadelphia Airport, the DoubleTree by Hilton Jacksonville Riverfront, the Crowne Plaza Tampa Westshore and The Whitehall. Each of these mortgages bears interest at rates tied to the 1-month London Interbank Offered Rate (“LIBOR”) and provide for minimum rates of interest. To the extent that increases in the LIBOR rate of interest cause the interest on the mortgages to exceed the minimum rates of interest, we are exposed to rising interest rates.\nShould we obtain new debt financing or refinance existing indebtedness, we may increase the amount of floating rate debt that currently exists. In addition, adverse economic conditions could also cause the terms on which we borrow to be unfavorable.\nRisks Related to Our Business and Properties\nIf the economy falls back into a recessionary period or fails to maintain positive growth, our operating performance and financial results may be harmed by declines in occupancy, average daily room rates and/or other operating revenues.\nThe performance of the lodging industry and the general economy historically have been closely linked. In an economic downturn, business and leisure travelers may seek to reduce costs by limiting travel and/or reducing costs on their trips. Our hotels, which are all full-service hotels, may be more susceptible to a decrease in revenue, as compared to hotels in other categories that have lower room rates. A decrease in demand for hotel stays and hotel services will negatively affect our operating revenues, which will lower our cash flow and may affect our ability to make distributions to stockholders and to maintain compliance with our loan obligations. We had net loss attributable to the common shareholders of approximately $0.2 million for the 2016 fiscal year. A renewed economic downturn may increase our losses or reduce our income in the future. A weakening of the economy may adversely and materially affect our industry, business and results of operations and we cannot predict the likelihood, severity or duration of any such downturn. Moreover, reduced revenues as a result of a weakening economy may also reduce our working capital and impact our long-term business strategy.\n14\nWe own a limited number of hotels and significant adverse changes at one hotel could have a material adverse effect on our financial performance and may limit our ability to make distributions to stockholders.\nAs of December 31, 2016, our portfolio consisted of twelve wholly-owned hotels with a total of 3,011 rooms. Significant adverse changes in the operations of any one hotel could have a material adverse effect on our financial performance and, accordingly, on our ability to make distributions to stockholders. Following the sale of the Crowne Plaza Hampton Marina on February 7, 2017, our portfolio consisted of eleven wholly-owned hotels with a total of 2,838 rooms, as well as our interests in the Hyde Resort & Residences.\nWe are subject to risks of increased hotel operating expenses and decreased hotel revenues.\nOur leases with our TRS Lessees provide for the payment of rent based in part on gross revenues from our hotels. Our TRS Lessees are subject to hotel operating risks including decreased hotel revenues and increased hotel operating expenses, including but not limited to the following:\n| • | wage and benefit costs; |\n\n| • | repair and maintenance expenses; |\n\n| • | energy costs; |\n\n| • | property taxes; |\n\n| • | insurance costs; and |\n\n| • | other operating expenses. |\n\nAny increases in these operating expenses can have a significant adverse impact on our TRS Lessees’ ability to pay rent and other operating expenses and, consequently, our earnings and cash flow.\nIn keeping with our investment strategy, we may acquire, renovate and/or re-brand hotels in new or existing geographic markets as part of our repositioning strategy. Unanticipated expenses and insufficient demand for newly repositioned hotels could adversely affect our financial performance and our ability to comply with covenants in the indenture and to make distributions to the Company’s stockholders.\nWe have in the past, and may in the future, develop or acquire hotels in geographic areas in which our management may have little or no operating experience. Additionally, those properties may also be renovated and re-branded as part of a repositioning strategy. Potential customers may not be familiar with our newly renovated hotel or be aware of the brand change. As a result, we may have to incur costs relating to the opening, operation and promotion of those new hotel properties that are substantially greater than those incurred in other geographic areas. These hotels may attract fewer customers than expected and we may choose to increase spending on advertising and marketing to promote the hotel and increase customer demand. Unanticipated expenses and insufficient demand at new hotel properties, therefore, could adversely affect our financial performance and our ability to comply with covenants in the indenture and to make distributions to the Company’s stockholders.\nWe do not have the authority to require any hotel to be operated in a particular manner or to govern any particular aspect of the daily operations of any hotel and as a result, our returns are dependent on the management of our hotels by Chesapeake Hospitality.\nSince federal income tax laws restrict REITs and their subsidiaries from operating or managing hotels, we do not operate or manage our hotels. Instead, we lease all of our hotels to our TRS Lessees, and our TRS Lessees retain third-party managers to operate our hotels pursuant to management agreements.\nUnder the terms of our management agreements with Chesapeake Hospitality and the REIT qualification rules, our ability to participate in operating decisions regarding the hotels is limited. We will depend on Chesapeake Hospitality to operate our hotels as provided in the management agreements. We do not have the authority to require any hotel to be operated in a particular manner or to govern any particular aspect of the daily operations of any hotel. Thus, even if we believe our hotels are being operated inefficiently or in a manner that does not result in satisfactory occupancy rates, RevPAR, and average daily rates (“ADR”), we may not be able to force Chesapeake Hospitality to change its method of operating our hotels. Additionally, in the event that we need to replace Chesapeake Hospitality or any other management companies in the future, we may be required by the terms of the applicable management agreement to pay substantial termination fees and may experience significant disruptions at the affected hotels.\n15\nOur ability to make distributions to the Company’s stockholders is subject to fluctuations in our financial performance, operating results and capital improvement requirements.\nAs a REIT, the Company is required to distribute, as “qualifying distributions,” at least 90.0% of its REIT taxable income (determined without regard to the dividends-paid deduction and by excluding its net capital gains, and reduced by certain non-cash items), each year to the Company’s stockholders. However, several factors may make us unable to declare or pay distributions to the Company’s stockholders, including poor operating results and financial performance or unanticipated capital improvements to our hotels, including capital improvements that may be required by our franchisors.\nWe lease all of our hotels to our TRS Lessees. Our TRS Lessees are subject to hotel operating risks, including risks of sustaining operating losses after payment of hotel operating expenses, including management fees. Among the factors which could cause our TRS Lessees to fail to make required rent payments are reduced net operating profits or operating losses, increased debt service requirements and capital expenditures at our hotels, including capital expenditures required by the franchisors of our hotels. Among the factors that could reduce the net operating profits of our TRS Lessees are decreases in hotel revenues and increases in hotel operating expenses. Hotel revenue can decrease for a number of reasons, including increased competition from a new supply of hotel rooms and decreased demand for hotel rooms. These factors can reduce both occupancy and room rates at our hotels.\nThe amount of any dividend distributions to holders of the Company’s common stock is in the sole discretion of the Company’s board of directors, which will consider, among other factors, our financial performance, debt service obligations, debt covenants and capital expenditure requirements. We cannot assure you that we will continue to generate sufficient cash to fund distributions.\nGeographic concentration of our hotels makes our business vulnerable to economic downturns in the mid-Atlantic and southern United States.\nOur hotels are located in the mid-Atlantic and southern United States. As a result, economic conditions in the mid-Atlantic and southern United States significantly affect our revenues and the value of our hotels to a greater extent than if we had a more geographically diversified portfolio. Business layoffs or downsizing, industry slowdowns, changing demographics and other similar factors that may adversely affect the economic climate in these areas could have a significant adverse impact on our business. Any resulting oversupply or reduced demand for hotels in the mid-Atlantic and southern United States and in our markets in particular would therefore have a disproportionate negative impact on our revenues and limit our ability to make distributions to stockholders.\nA substantial number of our hotels operate under a brand owned by Hilton Worldwide (Hilton), InterContinental Hotels Group (IHG) and Marriott International, Inc. (Marriott) brands; therefore, we are subject to risks associated with concentrating our portfolio in three brands.\nIn our portfolio, the majority of the hotels that we owned as of December 31, 2016 utilize brands owned by IHG, Marriott or Hilton. As a result, our success is dependent in part on the continued success of IHG, Marriott or Hilton and their respective brands. If market recognition or the positive perception of IHG, Marriott and/or Hilton is reduced or compromised, the goodwill associated with the IHG, Marriott and Hilton branded hotels in our portfolio may be adversely affected, which may have a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders.\nHedging against interest rate exposure may adversely affect us and our hedges may fail to protect us from the losses that the hedges were designed to offset.\nSubject to maintaining the Company’s qualification as a REIT, we may elect to manage our exposure to interest rate volatility by using interest rate hedging arrangements, such as cap agreements and swap agreements. These agreements involve the risks that these arrangements may fail to protect or adversely affect us because, among other things:\n| • | interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates; |\n\n| • | available interest rate hedges may not correspond directly with the interest rate risk for which protection is sought; |\n\n| • | the financial instruments we select may not have the effect of reducing our interest rate risk; |\n\n| • | the duration of the hedge may not match the duration of the related liability; |\n\n| • | the credit quality of the hedging counterparty owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; and |\n\n| • | the hedging counterparty owing money in the hedging transaction may default on its obligation to pay. |\n\n16\nAs a result of any of the foregoing, our hedging transactions, which are intended to limit losses, may fail to protect us from the losses that the hedges were designed to offset and could have a material adverse effect on us.\nOur investment opportunities and growth prospects may be affected by competition for acquisitions.\nWe compete for investment opportunities with other entities, some of which have substantially greater financial resources than we do. This competition may generally limit the number of suitable investment opportunities offered to us, which may limit our ability to grow. This competition may also increase the bargaining power of property owners seeking to sell to us, making it more difficult for us to acquire new properties on attractive terms, or at all.\nIf we fail to maintain an effective system of internal controls, we may not be able to accurately determine our financial results or prevent fraud. As a result, the Company’s stockholders could lose confidence in our financial results, which could harm our business and the value of the Company’s shares.\nEffective internal controls are necessary for us to provide reliable financial reports and effectively prevent fraud. Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate and report on our internal controls over financial reporting. Our internal controls and financial reporting are not subject to attestation by our independent registered public accounting firm pursuant to the exemption provided to issuers that are not “large accelerated filers” or “accelerated filers” under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. While we have undertaken substantial work to comply with Section 404, we cannot be certain that we will be successful in maintaining adequate internal controls over our financial reporting and financial processes in the future. We may in the future discover areas of our internal controls that need improvement. Furthermore, as we grow our business, our internal controls will become more complex, and we will require significantly more resources to ensure our internal controls remain effective. If we or our independent auditors discover a material weakness, the disclosure of that fact, even if quickly remedied, could reduce the market value of the Company’s shares. Additionally, the existence of any material weakness or significant deficiency would require management to devote significant time and incur significant expense to remediate any such material weaknesses or significant deficiencies and management may not be able to remediate any such material weaknesses or significant deficiencies in a timely manner. In 2014, we identified a material weakness in our internal control over financial reporting which has been remediated.\nWe are subject to cyber-security risks related to breaches of security pertaining to sensitive company, customer, employee and vendor information as well as breaches in the technology that manages operations and other business processes.\nOur business operations rely upon secure information technology systems for data capture, processing, storage and reporting. Despite careful security and controls design, implementation, updating and independent third party verification, our information technology systems, and those of our third party providers, could become subject to cyber-attacks. Network, system, application and data breaches could result in operational disruptions or information misappropriation including, but not limited to interruption to systems availability, denial of access to and misuse of applications required by our customers. Access to internal applications required to plan our operations could be denied or misused. Inappropriate disclosure of confidential company, employee, customer or vendor information, could stem from such incidents. Any of these operational disruptions and/or misappropriation of information could result in lost sales, business delays, and negative publicity and could have a material effect on our business.\nRisks Related to Conflicts of Interest of Our Officers and Directors\nConflicts of interest could result in our executive officers and certain of our directors acting in a manner other than in the Company’s stockholders’ best interest.\nConflicts of interest relating to Chesapeake Hospitality, the entity that manages the properties, and the terms of its management agreements may lead to management decisions that are not in the stockholders’ best interest.\nConflicts of interest relating to Chesapeake Hospitality may lead to management decisions that are not in the stockholders’ best interest. Andrew M. Sims, our chairman and chief executive officer, and Kim E. Sims, a former member of our board of directors, together own a substantial interest in Chesapeake Hospitality which manages our hotel properties.\nOur management agreements establish the terms of Chesapeake Hospitality’s management of our hotels. The new Master Agreement provides that in the event the agreement is terminated in connection with the sale of a hotel, and Chesapeake Hospitality accepts an offer to manage another hotel which is reasonable comparable to the hotel that was sold, we will not be liable for any termination fee. If we do not offer Chesapeake Hospitality such opportunity or Chesapeake Hospitality declines such opportunity, then a termination fee equivalent to the lesser of the management fees paid for the prior twelve-month period or the management fees for the period prior to the sale that is equal to the number of months remaining under the term of the agreement will be due. If we terminate the agreement at the end of any renewable five-year term, Chesapeake Hospitality is due a termination fee equivalent to one month’s management fees, as determined under the agreement.\n17\nAs a significant owner of Chesapeake Hospitality, which would receive any management and management termination fees payable by us under the management agreement, Andrew M. Sims may influence our decisions to sell a hotel or acquire or develop a hotel when it is not in the best interests of the Company’s stockholders to do so. In addition, Andrew M. Sims will have conflicts of interest with respect to decisions to enforce provisions of the management agreement, including any termination thereof.\nThere can be no assurance that provisions in our bylaws will always be successful in mitigating conflicts of interest.\nUnder our bylaws, a committee consisting of only independent directors must approve any transaction between us and Chesapeake Hospitality or its affiliates or any interested director. However, there can be no assurance that these policies always will be successful in mitigating such conflicts, and decisions could be made that might not fully reflect the interests of all of the Company’s stockholders.\nCertain of our officers and directors control trusts that hold units in our Operating Partnership and may seek to avoid adverse tax consequences, which could result from transactions that would otherwise benefit the Company’s stockholders.\nHolders of units in our Operating Partnership, including trusts controlled in whole or part by members of our management team, may suffer adverse tax consequences upon our sale or refinancing of certain properties. Therefore, holders of units, including a trust controlled by Andrew M. Sims and two former members of our board of directors, and a charitable trust controlled by Edward S. Stein, may have different objectives than holders of the Company’s stock regarding the appropriate pricing and timing of a property’s sale, or the timing and amount of a property’s refinancing. As of December 31, 2016, these trusts owned approximately 1.0% of the outstanding units in our Operating Partnership. Although the individuals controlling the trusts do not have any beneficial interest in the trusts, they may influence us not to sell or refinance certain properties, even if such sale or refinancing might be financially advantageous to the Company’s stockholders, or may influence us to enter into tax-deferred exchanges with the proceeds of such sales when such a reinvestment might not otherwise be in our best interest.\nOur agreements with Chesapeake Hospitality and its affiliates, including the contribution agreements and the partnership agreement of our Operating Partnership, were not negotiated on an arms’ length basis and may be less favorable to us than we could have obtained from third parties.\nIn connection with the Company’s initial public offering, we entered into various agreements with Chesapeake Hospitality and its affiliates, including contribution agreements, a master management agreement, a strategic alliance agreement, subleases, the partnership agreement of our Operating Partnership and employment agreements – of which only the contribution agreements and the partnership agreement of our Operating Partnership have not expired. In addition, we entered into various separate management agreements with Chesapeake Hospitality which have all been superseded by the new master management agreement and new individual hotel agreements executed in December 2014. The terms of all of these agreements were determined by our management team, who had conflicts of interest as described above and ownership interests in Chesapeake Hospitality and its affiliates. The terms of all of these agreements may be less favorable to us than we could have obtained from third parties.\nRisks Related to the Lodging Industry\nOur ability to comply with the terms of the indenture, our ability to make distributions to the Company’s stockholders and the value of our hotels in general, may be adversely affected by factors in the lodging industry.\nOperating Risks\nOur hotel properties are subject to various operating risks common to the lodging industry, many of which are beyond our control, including the following:\n| • | competition from other hotel properties in our markets; |\n\n| • | over-building of hotels in our markets, which adversely affects occupancy and revenues at our hotels; |\n\n| • | dependence on business and commercial travelers and tourism; |\n\n| • | increases in energy costs and other expenses affecting travel, which may affect travel patterns and reduce the number of business and commercial travelers and tourists; |\n\n| • | increases in operating costs due to inflation and other factors, including increases in labor costs, that may not be offset by increased room rates; |\n\n| • | changes in interest rates and in the availability, cost and terms of debt financing; |\n\n| • | changes in governmental laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance with laws and regulations, fiscal policies and ordinances; |\n\n18\n\n| • | adverse effects of international, national, regional and local economic and market conditions; |\n\n| • | adverse effects of a downturn in the lodging industry; and |\n\n| • | risks generally associated with the ownership of hotel properties and real estate, as we discuss in detail below. |\n\nThese factors could reduce the net income of our TRS Lessees, which in turn could adversely affect the value of our hotels and our ability to comply with the terms of the indenture and to make distributions to the Company’s stockholders.\nCompetition for Acquisitions\nWe may compete for investment opportunities with entities that may have substantially greater financial resources than we do. These entities generally may be able to accept more risk than we choose to prudently manage. This competition may generally limit the number of suitable investment opportunities offered to us. This competition may also increase the bargaining power of property owners seeking to sell to us, making it more difficult for us to acquire new properties on attractive terms.\nSeasonality of the Hotel Business\nThe lodging industry is seasonal in nature, which can be expected to cause quarterly fluctuations in our revenues. Our quarterly earnings may be adversely affected by factors outside our control, including weather conditions and poor economic factors. As a result, we may have to enter into short-term borrowings in certain quarters in order to offset these fluctuations in revenues and to make distributions to the Company’s stockholders.\nInvestment Concentration in Particular Segments of a Single Industry\nOur entire business is lodging-related. Therefore, a downturn in the lodging industry, in general, and the full-service, upscale and upper-upscale segments in which we operate, in particular, will have a material adverse effect on the value of our hotels, our financial condition and the extent to which cash may be available for distribution to the Company’s stockholders.\nCapital Expenditures\nOur hotel properties have an ongoing need for renovations and other capital improvements, including replacements, from time to time, of furniture, fixtures and equipment. The franchisors of our hotels also require us to make periodic capital improvements as a condition of keeping the franchise licenses. In addition, several of our mortgage lenders require that we set aside amounts for capital improvements to the secured properties on a monthly basis. For the years ended December 31, 2016 and 2015, we spent approximately $14.8 million and approximately $20.1 million, respectively, on capital improvements to our hotels. Capital improvements and renovation projects may give rise to the following risks:\n| • | possible environmental problems; |\n\n| • | construction cost overruns and delays; |\n\n| • | a possible shortage of available cash to fund capital improvements and the related possibility that financing for these capital improvements may not be available to us on affordable terms; and |\n\n| • | uncertainties as to market demand or a loss of market demand after capital improvements have begun. |\n\nThe costs of all these capital improvements as well as future capital improvements could adversely affect our financial condition and amounts available for distribution to the Company’s stockholders.\nOperating our hotels under franchise agreements could increase our operating costs and lower our net income.\nMost of our hotels operate under franchise agreements which subject us to risks in the event of negative publicity related to one of our franchisors.\nThe maintenance of the franchise licenses for our hotels is subject to our franchisors’ operating standards and other terms and conditions. Our franchisors periodically inspect our hotels to ensure that we, our TRS Lessees, and the management company follow their standards. Failure by us, our TRS Lessees or the management company to maintain these standards or other terms and conditions could result in a franchise license being canceled. If a franchise license terminates due to our failure to make required improvements or to otherwise comply with its terms, we may also be liable to the franchisor for a termination payment, which varies by franchisor and by hotel. As a condition of continuing a franchise license, a franchisor may require us to make capital expenditures, even if we do not believe the capital improvements are necessary or desirable or will result in an acceptable return on our investment. Nonetheless, we may risk losing a franchise license if we do not make franchisor-required capital expenditures.\n19\nIf a franchisor terminates the franchise license, we may try either to obtain a suitable replacement franchise license or to operate the hotel without a franchise license. The loss of a franchise license could significantly decrease the revenues at the hotel and reduce the underlying value of the hotel because of the loss of associated name recognition, marketing support and centralized reservation systems provided by the franchisor. A loss of a franchise license for one or more hotels could materially and adversely affect our revenues. This loss of revenues could, therefore, also adversely affect our financial condition and results of operations, our ability to comply with the terms of the indenture and reduce our cash available for distribution to stockholders.\nRestrictive covenants in certain of our franchise agreements contain provisions that may operate to limit our ability to sell or refinance our hotels, which could have a material adverse effect on us.\nFranchise agreements typically contain covenants that may affect our ability to sell or refinance a hotel, including requirements to obtain the consent of the franchisor in the event of such a sale or refinancing transaction. In the event that a franchisor’s consent is not forthcoming, the terms of a sale or refinancing may be less favorable to us than would otherwise be the case. Some of our franchise agreements provide the franchisor with a right of first offer in the event of certain sales or transfers of a hotel and provide that the franchisor has the right to approve any change in the hotel management company engaged to manage the hotel. Generally, we may be limited in our ability to sell, lease or otherwise transfer hotels unless the transferee is not a competitor of the franchisor and the transferee agrees to assume the related franchise agreements. If the franchisor does not consent to the sale or financing of our hotels, we may be unable to consummate transactions that are in our best interests or the terms of those transactions may be less favorable to us, which could have a material adverse effect on our financial condition and the execution of our strategies.\nHotel re-development is subject to timing, budgeting and other risks that would increase our operating costs and limit our ability to make distributions to stockholders.\nWe intend to acquire hotel properties from time to time as suitable opportunities arise, taking into consideration general economic conditions, and seek to re-develop or reposition these hotels. Redevelopment of hotel properties involves a number of risks, including risks associated with:\n| • | construction delays or cost overruns that may increase project costs; |\n\n| • | receipt of zoning, occupancy and other required governmental permits and authorizations; |\n\n| • | development costs incurred for projects that are not pursued to completion; |\n\n| • | acts of God such as earthquakes, hurricanes, floods or fires that could adversely impact a project; |\n\n| • | financing; and |\n\n| • | governmental restrictions on the nature or size of a project. |\n\nWe cannot assure you that any re-development project will be completed on time or within budget. Our inability to complete a project on time or within budget would increase our operating costs and reduce our net income.\nThe hotel business is capital intensive and our inability to obtain financing could limit our growth.\nOur hotel properties will require periodic capital expenditures and renovation to remain competitive. Acquisitions or development of additional hotel properties will require significant capital expenditures. In addition, several of our mortgage lenders require that we set aside annual amounts for capital improvements to the secured property. We may not be able to fund capital improvements or acquisitions solely from cash provided from our operating activities because we must distribute at least 90.0% of our REIT taxable income, excluding net capital gains, each year to maintain our REIT tax status. As a result, our ability to fund significant capital expenditures, acquisitions or hotel development through retained earnings is very limited. Consequently, we rely upon the availability of debt or equity capital to fund any significant investments or capital improvements. Our ability to grow through acquisitions or development of hotels will be limited if we cannot obtain satisfactory debt or equity financing which will depend on market conditions. Neither our charter nor our bylaws limit the amount of debt that we can incur. However, we cannot assure you that we will be able to obtain additional equity or debt financing or that we will be able to obtain such financing on favorable terms.\n20\nUninsured and underinsured losses could adversely affect our operating results and our ability to make distributions to the Company’s stockholders.\nWe maintain comprehensive insurance on each of our hotel properties, including liability, fire and extended coverage, of the type and amount we believe are customarily obtained for or by hotel owners. There are no assurances that current coverage will continue to be available at reasonable rates. Various types of catastrophic losses, like hurricanes, earthquakes and floods, such as Hurricane Matthew in October 2016 and Hurricane Sandy in October 2012, losses from foreign terrorist activities, such as those on September 11, 2001, or losses from domestic terrorist activities, such as the Oklahoma City bombing on April 19, 1995, may not be insurable or may not be economically insurable. Currently, our insurers provide terrorism coverage in conjunction with the Terrorism Risk Insurance Program sponsored by the federal government through which insurers are able to receive compensation for insured losses resulting from acts of terrorism.\nIn the event of a substantial loss, our insurance coverage may not be sufficient to cover the full current market value or replacement cost of our lost investment. Should an uninsured loss or a loss in excess of insured limits occur, we could lose all or a portion of the capital we have invested in a hotel, as well as the anticipated future revenue from the hotel. In that event, we might nevertheless remain obligated for any mortgage debt or other financial obligations related to the property. Inflation, changes in building codes and ordinances, environmental considerations and other factors might also keep us from using insurance proceeds to replace or renovate a hotel after it has been damaged or destroyed. Under those circumstances, the insurance proceeds we receive might be inadequate to restore our economic position on the damaged or destroyed property.\nNoncompliance with governmental regulations could adversely affect our operating results.\nEnvironmental Matters\nOur hotels may be subject to environmental liabilities. An owner of real property can face liability for environmental contamination created by the presence or discharge of hazardous substances on the property. We may face liability regardless of:\n| • | our knowledge of the contamination; |\n\n| • | the timing of the contamination; |\n\n| • | the cause of the contamination; or |\n\n| • | the party responsible for the contamination of the property. |\n\nThere may be unknown environmental problems associated with our properties. If environmental contamination exists on our properties, we could become subject to strict, joint and several liability for the contamination by virtue of our ownership interest.\nThe presence of hazardous substances on a property may adversely affect our ability to sell the property and we may incur substantial remediation costs. The discovery of environmental liabilities attached to our properties could have a material adverse effect on our results of operations and financial condition and our ability to comply with our covenants and to pay distributions to stockholders.\nAmericans with Disabilities Act and Other Changes in Governmental Rules and Regulations\nUnder the Americans with Disabilities Act of 1990, or the ADA, all public accommodations must meet various federal requirements related to access and use by disabled persons. Compliance with the ADA’s requirements could require removal of access barriers, and non-compliance could result in the U.S. government imposing fines or in private litigants winning damages. If we are required to make substantial modifications to our hotels, whether to comply with the ADA or other changes in governmental rules and regulations, our financial condition, results of operations and ability to comply with the terms of the indenture and to make distributions to the Company’s stockholders could be adversely affected.\nOur hotels may be subject to unknown or contingent liabilities which could cause us to incur substantial costs.\nThe hotel properties that we acquire may be subject to unknown or contingent liabilities for which we may have no recourse, or only limited recourse, against the sellers. Contingent or unknown liabilities with respect to entities or properties acquired might include:\n| • | liabilities for environmental conditions; |\n\n| • | losses in excess of our insured coverage; |\n\n| • | accrued but unpaid liabilities incurred in the ordinary course of business; |\n\n21\n\n| • | tax, legal and regulatory liabilities; |\n\n| • | claims of customers, vendors or other persons dealing with the Company’s predecessors prior to our formation or acquisition transactions that had not been asserted or were unknown prior to the Company’s formation or acquisition transactions; and |\n\n| • | claims for indemnification by the general partners, officers and directors and others indemnified by the former owners of our properties. |\n\nIn general, the representations and warranties provided under the transaction agreements related to the sales of the hotel properties may not survive the closing of the transactions. While we will likely seek to require the sellers to indemnify us with respect to breaches of representations and warranties that survive, such indemnification may be limited and subject to various materiality thresholds, a significant deductible or an aggregate cap on losses. As a result, there is no guarantee that we will recover any amounts with respect to losses due to breaches by the sellers of their representations and warranties. In addition, the total amount of costs and expenses that may be incurred with respect to liabilities associated with these hotels may exceed our expectations, and we may experience other unanticipated adverse effects, all of which may adversely affect our financial condition, results of operations and our ability to make distributions to the Company’s stockholders.\nFuture terrorist activities may adversely affect, and create uncertainty in, our business.\nTerrorism in the United States or elsewhere could have an adverse effect on our business, although the degree of impact will depend on a number of factors, including the U.S. and global economies and global financial markets. Previous terrorist attacks in the United States and subsequent terrorism alerts have adversely affected the travel and hospitality industries over the past several years. Such attacks, or the threat of such attacks, could have a material adverse effect on our business, our ability to finance our business, our ability to insure our properties and/or our results of operations and financial condition, as a whole.\nWe face risks related to pandemic diseases, which could materially and adversely affect travel and result in reduced demand for our hotels.\nOur business could be materially and adversely affected by the effect of a pandemic disease on the travel industry. For example, the outbreaks of SARS and avian flu in 2003 had a severe impact on the travel industry, the outbreaks of H1N1 flu in 2009 threatened to have a similar impact, and the perceived threat of a Zika virus outbreak in 2016 had an impact on the south Florida market. A prolonged recurrence of SARS, avian flu, H1N1 flu, Ebola virus, Zika virus or another pandemic disease also may result in health or other government authorities imposing restrictions on travel. Any of these events could result in a significant drop in demand for our hotels and adversely affect our financial conditions and results of operations.\nGeneral Risks Related to the Real Estate Industry\nIlliquidity of real estate investments could significantly impede our ability to respond to adverse changes in the performance of our properties and harm our financial condition.\nBecause real estate investments are relatively illiquid, our ability to promptly sell one or more hotel properties in our portfolio in response to changing economic, financial and investment conditions is limited.\nThe real estate market is affected by many factors that are beyond our control, including:\n| • | adverse changes in international, national, regional and local economic and market conditions; |\n\n| • | changes in interest rates and in the cost and terms of debt financing; |\n\n| • | absence of liquidity in credit markets which limits the availability and amount of debt financing; |\n\n| • | changes in governmental laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance with laws and regulations, fiscal policies and ordinances; |\n\n| • | the ongoing need for capital improvements, particularly in older structures; |\n\n| • | changes in operating expenses; and |\n\n| • | civil unrest, acts of God, including earthquakes, floods and other natural disasters such as Hurricane Matthew in October 2016 and Hurricane Sandy in October 2012, which may result in uninsured losses, and acts of war or terrorism, including the consequences of terrorist acts, such as those that occurred on September 11, 2001. |\n\n22\nWe may decide to sell our hotels in the future. We cannot predict whether we will be able to sell any hotel property for the price or on the terms set by us, or whether any price or other terms offered by a prospective purchaser would be acceptable to us. We also cannot predict the length of time needed to find a willing purchaser and to close the sale of a hotel property.\nWe may be required to expend funds to correct defects or to make improvements before a hotel property can be sold. We cannot assure you that we will have funds available to correct those defects or to make those improvements. In acquiring a hotel property, we may agree to lock-out provisions that materially restrict us from selling that property for a period of time or impose other restrictions, such as a limitation on the amount of debt that can be placed or repaid on that property. These factors and any others that would impede our ability to respond to adverse changes in the performance of our properties could have a material adverse effect on our operating results and financial condition, as well as our ability to comply with the terms of the indenture and to pay distributions to stockholders.\nFuture acquisitions may not yield the returns expected, may result in disruptions to our business, may strain management resources and may result in stockholder dilution.\nOur business strategy may not ultimately be successful and may not provide positive returns on our investments. Acquisitions may cause disruptions in our operations and divert management’s attention away from day-to-day operations. The issuance of equity securities in connection with any acquisition could be substantially dilutive to the Company’s stockholders.\nOur hotels may contain or develop harmful mold, which could lead to liability for adverse health effects and costs of remediating the problem.\nWhen excessive moisture accumulates in buildings or on building materials, mold growth may occur, particularly if the moisture problem remains undiscovered or is not addressed over a period of time. Some molds may produce airborne toxins or irritants. Concern about indoor exposure to mold has been increasing, as exposure to mold may cause a variety of adverse health effects and symptoms, including allergic or other reactions. As a result, the presence of significant mold at any of our properties could require us to undertake a costly remediation program to contain or remove the mold from the affected property, which would reduce our cash available for distribution. In addition, the presence of significant mold could expose us to liability from our guests, employees or the management company and others if property damage or health concerns arise and could harm our reputation.\nIncreases in property taxes would increase our operating costs, reduce our income and adversely affect our ability to make distributions to the Company’s stockholders.\nEach of our hotel properties is subject to real and personal property taxes. These taxes may increase as tax rates change and as the properties are assessed or reassessed by taxing authorities. If property taxes increase, our financial condition, results of operations and our ability to make distributions to the Company’s stockholders could be materially and adversely affected and the market price of the Company’s shares could decline.\nRisks Related to Our Organization and Structure\nOur ability to effect a merger or other business combination transaction may be restricted by our Operating Partnership agreement.\nIn the event of a change of control of the Company, the limited partners of our Operating Partnership will have the right, for a period of 30 days following the change of control event, to cause the Operating Partnership to redeem all of the units held by the limited partners for a cash amount equal to the cash redemption amount otherwise payable upon redemption pursuant to the partnership agreement. This cash redemption right may make it more unlikely or difficult for a third party to propose or consummate a change of control transaction, even if such transaction were in the best interests of the Company’s stockholders.\nProvisions of the Company’s charter may limit the ability of a third party to acquire control of the Company.\nAggregate Share and Common Share Ownership Limits\nThe Company’s charter provides that no person may directly or indirectly own more than 9.9% of the value of the Company’s outstanding shares of capital stock or more than 9.9% of the number of the Company’s outstanding shares of common stock. These ownership limitations may prevent an acquisition of control of the Company by a third party without the Company’s board of directors’ approval, even if the Company’s stockholders believe the change of control is in their interest. The Company’s board of directors has discretion to waive that ownership limit if, including other considerations, the board receives evidence that ownership in excess of the limit will not jeopardize the Company’s REIT status.\n23\nAuthority to Issue Stock\nThe Company’s amended and restated charter authorizes our board of directors to issue up to 49,000,000 shares of common stock and up to 11,000,000 shares of preferred stock, to classify or reclassify any unissued shares of common stock or preferred stock and to set the preferences, rights and other terms of the classified or reclassified shares. Issuances of additional shares of stock may have the effect of delaying or preventing a change in control of the Company, including transactions at a premium over the market price of the Company’s stock, even if stockholders believe that a change of control is in their interest. The Company will be able to issue additional shares of common or preferred stock without stockholder approval, unless stockholder approval is required by applicable law or the rules of any stock exchange or automated quotation system on which the Company’s securities may be listed or traded.\nProvisions of Maryland law may limit the ability of a third party to acquire control of the Company.\nCertain provisions of the Maryland General Corporation Law, or the MGCL, may have the effect of inhibiting a third party from making a proposal to acquire us or of impeding a change of control under circumstances that otherwise could provide the holders of shares of the Company’s common stock with the opportunity to realize a premium over the then-prevailing market price of such shares, including:\n| • | “business combination” provisions that, subject to limitations, prohibit certain business combinations between us and an “interested stockholder” (defined generally as any person who beneficially owns 10.0% or more of the voting power of our shares or an affiliate thereof) for five years after the most recent date on which the stockholder becomes an interested stockholder, and thereafter imposes special appraisal rights and special stockholder voting requirements on these combinations; and |\n\n| • | “control share” provisions that provide that “control shares” of the Company (defined as shares which, when aggregated with other shares controlled by the stockholder, entitle the stockholder to exercise one of three increasing ranges of voting power in electing directors) acquired in a “control share acquisition” (defined as the direct or indirect acquisition of ownership or control of “control shares”) have no voting rights except to the extent approved by the Company’s stockholders by the affirmative vote of at least two-thirds of all the votes entitled to be cast on the matter, excluding all interested shares. |\n\nThe Company has opted out of these provisions of the MGCL, in the case of the business combination provisions of the MGCL by resolution of the Company’s board of directors, and in the case of the control share provisions of the MGCL pursuant to a provision in the Company’s bylaws. However, the Company’s board of directors may by resolution elect to opt in to the business combination provisions of the MGCL and the Company may, by amendment to its bylaws, opt in to the control share provisions of the MGCL in the future. The Company’s board of directors has the exclusive power to amend the Company’s bylaws.\nAdditionally, Title 8, Subtitle 3 of the MGCL permits the Company’s board of directors, without stockholder approval and regardless of what is currently provided in the Company’s charter or bylaws, to implement takeover defenses, some of which (for example, a classified board) the Company does not currently have. These provisions may have the effect of inhibiting a third party from making an acquisition proposal for the Company or of delaying, deferring or preventing a change in control of the Company under the circumstances that otherwise could provide the holders of the Company’s common stock with the opportunity to realize a premium over the then current market price.\nProvisions in the Company’s executive officers’ employment agreements may make a change of control of the Company more costly or difficult.\nThe Company’s employment agreements with Andrew M. Sims, its chief executive officer, David R. Folsom, its president and chief operating officer, and Anthony E. Domalski, its chief financial officer, contain provisions providing for substantial payments to these officers in the event of a change of control of the Company. Specifically, if the Company terminates these executive’s employment without cause or the executive resigns with good reason, which includes a failure to nominate Andrew M. Sims to the Company’s board of directors or his involuntary removal from the Company’s board of directors, unless for cause or by vote of the stockholders, or if there is a change of control, each of these executives is entitled to the following:\n| • | any accrued but unpaid salary and bonuses; |\n\n| • | vesting of any previously issued stock options and restricted stock; |\n\n| • | payment of the executive’s life, health and disability insurance coverage for a period of five years following termination; |\n\n| • | any unreimbursed expenses; and |\n\n| • | a severance payment equal to three times for Andrew M. Sims’, David R. Folsom’s and Anthony E. Domalski’s respective combined salary and actual bonus compensation for the preceding fiscal year. |\n\n24\nIn addition, these executives will receive additional payments to compensate them for the additional taxes, if any, imposed on them under Section 4999 of the Code by reason of receipt of excess parachute payments. We will not be able to deduct any of the above amounts paid to the executives for tax purposes.\nThese provisions may make a change of control of the Company, even if it is in the best interests of the Company’s stockholders, more costly and difficult and may reduce the amounts the Company’s stockholders would receive in a change of control transaction.\nOur ownership limitations may restrict or prevent you from engaging in certain transfers of the Company’s common stock or preferred stock.\nIn order to maintain the Company’s REIT qualification, it cannot be closely held (i.e., more than 50.0% in value of our outstanding stock cannot be owned, directly or indirectly, by five or fewer individuals during the last half of any taxable year). To preserve the Company’s REIT qualification, the Company’s charter contains a 9.9% aggregate share ownership limit and a 9.9% common share ownership limit. Generally, any shares of the Company’s stock owned by affiliated persons will be added together for purposes of the aggregate share ownership limit, and any shares of common stock owned by affiliated owners will be added together for purposes of the common share ownership limit.\nIf anyone transfers shares in a way that would violate the aggregate share ownership limit or the common share ownership limit, or prevent the Company from continuing to qualify as a REIT under the federal income tax laws, those shares instead will be transferred to a trust for the benefit of a charitable beneficiary and will be either redeemed by us or sold to a person whose ownership of the shares will not violate the aggregate share ownership limit or the common share ownership limit. If this transfer to a trust fails to prevent such a violation or fails to preserve the Company’s continued qualification as a REIT, then the Company will consider the initial intended transfer to be null and void from the outset. The intended transferee of those shares will be deemed never to have owned the shares. Anyone who acquires shares in violation of the aggregate share ownership limit, the common share ownership limit or the other restrictions on transfer in the Company’s charter bears the risk of suffering a financial loss when the shares are redeemed or sold if the market price of the Company’s stock falls between the date of purchase and the date of redemption or sale.\nThe Company’s articles supplementary establishing and fixing the rights and preferences of Series B preferred stock provide that no person may directly or indirectly own more than 9.9% of the aggregate number of outstanding shares of Series B preferred stock, excluding any outstanding shares of Series B preferred stock not treated as outstanding for federal income tax purposes. The Company’s board of directors has discretion to waive that ownership limit if, including other considerations, the board receives evidence that ownership in excess of the limit will not jeopardize the Company’s REIT status.\nHolders of our outstanding preferred shares have dividend, liquidation and other rights that are senior to the rights of the holders of our common shares.\nOur board of directors has the authority to designate and issue preferred shares with liquidation, dividend and other rights that are senior to those of our common shares. As of December 31, 2016, 1,610,000 shares of our 8.0% Series B Cumulative Redeemable Preferred Stock were issued and outstanding. The aggregate liquidation preference with respect to the outstanding preferred shares is approximately $40.3 million, and annual dividends on our outstanding preferred shares are approximately $3.2 million. Holders of our Series B Preferred Stock are entitled to cumulative dividends before any dividends may be declared or set aside on our common shares. Upon our voluntary or involuntary liquidation, dissolution or winding up, before any payment is made to holders of our common shares, holders of these preferred shares are entitled to receive a liquidation preference of $25.00 per share plus any accrued and unpaid distributions. This will reduce the remaining amount of our assets, if any, available to distribute to holders of our common shares. In addition, holders of these preferred shares have the right to elect two additional directors to our board of directors whenever dividends on the preferred shares are in arrears in an aggregate amount equivalent to six or more quarterly dividends (whether or not consecutive). Because our decision to issue securities will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of any future preferred offerings. Thus, our stockholders bear the risk of our future securities issuances reducing the market price of our common shares and diluting their interest.\nThe change of control conversion and redemption features of the Series B Preferred Stock may make it more difficult for a party to take over our Company or discourage a party from taking over our Company.\nUpon a change of control (as defined in our charter), holders of our Series B Preferred Stock will have the right (unless, as provided in our charter, we have provided or provide notice of our election to exercise our special optional redemption right before the relevant date) to convert some or all of their shares of our Series B Preferred Stock into shares of our common stock (or equivalent value of alternative consideration). Upon such a conversion, holders will be limited to a maximum number of shares equal to the share cap, subject to adjustments. If the common stock price is less than $3.015, subject to adjustment, holders will receive a maximum of\n25\n8.29187 shares of our common stock per share of Series B Preferred Stock, which may result in a holder receiving value that is less than the liquidation preference of the Series B Preferred Stock. In addition, those features of our Series B Preferred Stock may have the effect of inhibiting or discouraging a third party from making an acquisition proposal for our Company or of delaying, deferring or preventing a change in control of our Company under circumstances that otherwise could provide the holders of shares of our common stock and shares of our Series B Preferred Stock with the opportunity to realize a premium over the then current market price or that stockholders may otherwise believe is in their best interests.\nThe board of directors’ revocation of the Company’s REIT status without stockholder approval may decrease the Company’s stockholders’ total return.\nThe Company’s charter provides that the Company’s board of directors may revoke or otherwise terminate the Company’s REIT election, without the approval of the Company’s stockholders, if the Company’s board of directors determines that it is no longer in the Company’s best interest to continue to qualify as a REIT. If the Company ceases to be a REIT, it would become subject to federal income tax on its taxable income and would no longer be required to distribute most of its taxable income to the Company’s stockholders, which may have adverse consequences on our total return to the Company’s stockholders.\nThe ability of the Company’s board of directors to change the Company’s major corporate policies may not be in your best interest.\nThe Company’s board of directors determines the Company’s major corporate policies, including its acquisition, financing, growth, operations and distribution policies. The Company’s board of directors may amend or revise these and other policies from time to time without the vote or consent of the Company’s stockholders.\nOur success depends on key personnel whose continued service is not guaranteed.\nWe depend on the efforts and expertise of our chairman and chief executive officer, Andrew M. Sims; our president and chief operating officer, David R. Folsom; and our chief financial officer, Anthony E. Domalski, to manage our day-to-day operations and strategic business direction. The loss of any of their services could have an adverse effect on our operations.\nFederal Income Tax Risks Related to the Company’s Status as a REIT\nThe federal income tax laws governing REITs are complex.\nThe Company intends to operate in a manner that will maintain its qualification as a REIT under the federal income tax laws. The REIT qualification requirements are extremely complex, however, and interpretations of the federal income tax laws governing qualification as a REIT are limited. The Company has not requested or obtained a ruling from the Internal Revenue Service, or the IRS, that it qualifies as a REIT. Accordingly, we cannot be certain that the Company will be successful in operating in a manner that will permit it to qualify as a REIT. At any time, new laws, interpretations or court decisions may change the federal tax laws or the federal income tax consequences of the Company’s qualification as a REIT. We cannot predict when or if any new federal income tax law, regulation or administrative interpretation, or any amendment to any existing federal income tax law, regulation or administrative interpretation, will be adopted, promulgated or become effective and any such law, regulation or interpretation may take effect retroactively. The Company and its stockholders could be adversely affected by any such change in, or any new, federal income tax law, regulation or administrative interpretation. We are not aware, however, of any pending tax legislation that would adversely affect the Company’s ability to qualify as a REIT.\nFailure to make distributions could subject the Company to tax.\nIn order to maintain its qualification as a REIT, each year the Company must pay out to its stockholders in distributions, as “qualifying distributions,” at least 90.0% of its REIT taxable income, computed without regard to the deductions for dividends paid and excluding net capital gains and reduced by certain non-cash items. To the extent that the Company satisfies this distribution requirement, but distributes less than 100.0% of its taxable income (including its net capital gain), it will be subject to federal corporate income tax on its undistributed taxable income. In addition, the Company will be subject to a 4.0% nondeductible excise tax if the actual amount that it pays out to its stockholders as a “qualifying distribution” for a calendar year is less than the sum of: (A) 85.0% of our ordinary income for such calendar year, plus (B) 95.0% of our capital gain net income for such calendar year. The Company’s only recurring source of funds to make these distributions comes from rent received from its TRS Lessees whose only recurring source of funds with which to make these payments and distributions is the net cash flow (after payment of operating and other costs and expenses and management fees) from hotel operations, and any dividend and other distributions that we may receive from MHI Holding. Accordingly, the Company may be required to borrow money or sell assets to make distributions sufficient to enable it to pay out enough of its taxable income to satisfy the distribution requirement and to avoid corporate income tax and the 4.0% nondeductible excise tax in a particular year.\n26\nFailure to qualify as a REIT would subject the Company to federal income tax.\nIf the Company fails to qualify as a REIT in any taxable year, it will be required to pay federal income tax (including any applicable alternative minimum tax) on its taxable income at regular corporate rates. The resulting tax liability might cause the Company to borrow funds, liquidate some of its investments or take other steps that could negatively affect its operating results in order to pay any such tax. Unless it is entitled to relief under certain statutory provisions, the Company would be disqualified from treatment as a REIT for the four taxable years following the year in which it lost its qualification. If the Company lost its REIT status, its net earnings available for investment or distribution to stockholders would be significantly reduced for each of the years involved. In addition, the Company would no longer be required to make distributions to its stockholders, and it would not be able to deduct any stockholder distributions in computing its taxable income. This would substantially reduce the Company’s earnings, cash available to pay distributions, and the value of common stock.\nFailure to qualify as a REIT may cause the Company to reduce or eliminate distributions to its stockholders, and the Company may face increased difficulty in raising capital or obtaining financing.\nIf the Company fails to remain qualified as a REIT, it may have to reduce or eliminate any distributions to its stockholders in order to satisfy its income tax liabilities. Any distributions that the Company does make to its stockholders would be treated as taxable dividends to the extent of its current and accumulated earnings and profits. This may result in negative investor and market perception regarding the market value of the Company’s stock, and the value of its stock may be reduced. In addition, the Company and the Operating Partnership may face increased difficulty in raising capital or obtaining financing if the Company fails to qualify or remain qualified as a REIT because of the resulting tax liability and potential reduction of its market valuation.\nIf MHI Holding exceeds certain value thresholds, this could cause the Company to fail to qualify as a REIT.\nFor taxable years of the Company ending on or before December 31, 2017, at the end of each quarter of each taxable year of the Company, no more than 25.0% of the value of the Company’s total assets may consist of securities of one or more taxable REIT subsidiaries (“TRSs”). For taxable years of the Company ending after December 31, 2017, at the end of each quarter of each taxable year of the Company, no more than 20.0% of the value of the Company’s total assets may consist of securities of one or more TRSs. MHI Holding is a TRS and the Company may form other TRSs in the future. The Company plans to monitor the value of its shares of MHI Holding and of any other TRS the Company may form. However, there can be no assurance that the Internal Revenue Service will not attempt to attribute additional value to the shares of MHI Holding or to the shares of any other TRS that the Company may form. If the Company is treated as owning securities of one or more TRSs with an aggregate value that is in excess of the thresholds outlined above, the Company could lose its status as a REIT or become subject to penalties.\nEven if the Company remains qualified as a REIT, it may face other tax liabilities that reduce its cash flow.\nEven if the Company remains qualified for taxation as a REIT, it may be subject to certain federal, state and local taxes on its income and assets. For example:\n| • | it will be required to pay tax on undistributed REIT taxable income (including net capital gain); |\n\n| • | it may be required to pay “alternative minimum tax” on its items of tax preference; |\n\n| • | if it has net income from the disposition of foreclosure property held primarily for sale to customers in the ordinary course of business or other non-qualifying income from foreclosure property, it must pay tax on that income at the highest corporate rate; |\n\n| • | if it (or the Operating Partnership or any subsidiary of the Operating Partnership other than MHI Holding) sells a property in a “prohibited transaction,” its gain, or its share of such gain, from the sale would be subject to a 100.0% penalty tax. A “prohibited transaction” would be a sale of property, other than a foreclosure property, held primarily for sale to customers in the ordinary course of business; |\n\n| • | MHI Holding is a fully taxable corporation and is required to pay federal and state taxes on its taxable income; and |\n\n| • | it may experience increases in its state and/or local income tax burdens as states and localities continue to look to modify their tax laws in order to raise revenues, including by (among other things) changing from a net taxable income-based regime to a gross receipts-based regime, suspending and/or limiting the use of net operating losses, increasing tax rates and fees, imposing surcharges and subjecting partnerships to an entity-level tax, and limiting or disallowing certain U.S. federal deductions such as the dividends-paid deduction. |\n\n27\nComplying with REIT requirements may cause the Company to forgo attractive opportunities that could otherwise generate strong risk-adjusted returns and instead pursue less attractive opportunities, or none at all.\nTo qualify as a REIT for federal income tax purposes, the Company must continually satisfy tests concerning, among other things, the sources of its income, the nature and diversification of its assets, the amounts it distributes to its stockholders and the ownership of its stock.\nIn general, when applying these tests, the Company is treated as owning its proportionate share of the Operating Partnership’s assets (which share is determined in accordance with the Company’s capital interest in the Operating Partnership) and as being entitled to the Operating Partnership’s income attributable to such share. Thus, compliance with the REIT requirements may hinder our ability to operate solely on the basis of generating strong risk-adjusted returns on invested capital for our stockholders.\nComplying with REIT requirements may force the Company to liquidate otherwise attractive investments, which could result in an overall loss on its investments.\nTo maintain qualification as a REIT, the Company must ensure that at the end of each calendar quarter at least 75.0% of the value of its assets consists of cash, cash items, government securities and qualified REIT real estate assets. The remainder of the Company’s assets (other than securities of one or more taxable REIT subsidiaries) generally cannot include more than 10.0% of the outstanding voting securities of any one issuer or more than 10.0% of the total value of the outstanding securities of any one issuer. In addition, in general, no more than 5.0% of the value of the Company’s assets (other than government securities, qualified real estate assets and securities of one or more taxable REIT subsidiaries) can consist of the securities of any one issuer, and no more than 25.0% (20.0% for taxable years beginning after December 31, 2017) of the value of the Company’s total assets can be represented by securities of one or more taxable REIT subsidiaries.\nWhen applying these asset tests, the Company is treated as owning its proportionate share of the Operating Partnership’s assets (which is determined in accordance with the Company’s capital interest in the Operating Partnership). If the Company fails to comply with these requirements at the end of any calendar quarter, it must correct such failure within 30 days after the end of the calendar quarter to avoid losing its REIT status and suffering adverse tax consequences. If the Company fails to comply with these requirements at the end of any calendar quarter, and the failure exceeds a de-minimis threshold, the Company may be able to preserve its REIT status if the failure was due to reasonable cause and not to willful neglect. In this case, we will be required to dispose of the assets causing the failure within six months after the last day of the quarter in which the failure occurred, and we will be required to pay an additional tax of the greater of $50,000 or the product of the highest applicable tax rate multiplied by the net income generated on those assets.\nAs a result, we may be required to liquidate otherwise attractive investments.\nIf the Operating Partnership fails to qualify as a partnership for federal income tax purposes, the Company could cease to qualify as a REIT and suffer other adverse consequences.\nWe believe that the Operating Partnership will continue to qualify to be treated as a partnership for U.S. federal income tax purposes. As a partnership, the Operating Partnership is not subject to federal income tax on its income. Instead, each of its partners, including the Company, will be required to pay tax on its allocable share of the Operating Partnership’s income. We cannot assure you, however, that the IRS will not challenge the Operating Partnership’s status as a partnership for U.S. federal income tax purposes, or that a court would not sustain such a challenge. If the IRS were successful in treating the Operating Partnership as a corporation for federal income tax purposes, the Company could fail to meet the gross income tests and certain of the asset tests applicable to REITs and, accordingly, cease to qualify as a REIT. Also, the failure of the Operating Partnership to qualify as a partnership would cause the Operating Partnership to become subject to federal and state corporate income tax, which would reduce significantly the amount of cash available for debt service and for distribution to its partners, including the Company.\nThe Company’s failure to qualify as a REIT would have serious adverse consequences to its stockholders.\nThe Company elected to be taxed as a REIT under Sections 856 through 860 of the Code, commencing with its taxable year ended December 31, 2004. The Company believes it has operated so as to qualify as a REIT under the Code and believes that its current organization and method of operation comply with the rules and regulations promulgated under the Code to enable the Company to continue to qualify as a REIT. However, it is possible that the Company has been organized or has operated in a manner that would not allow it to qualify as a REIT, or that its future operations could cause it to fail to qualify. Qualification as a REIT requires the Company to satisfy numerous requirements (some on an annual and others on a quarterly basis) established under highly technical and complex sections of the Code for which there are only limited judicial and administrative interpretations, and involves the determination of various factual matters and circumstances not entirely within its control. For example, in order to qualify as a\n28\nREIT, the Company must satisfy a 75.0% gross income test pursuant to Code Section 856(c)(3) and a 95.0% gross income test pursuant to Code Section 856(c)(2) each taxable year. In addition, the Company must pay dividends, as “qualifying distributions,” to its stockholders aggregating annually at least 90.0% of its REIT taxable income (determined without regard to the dividends-paid deduction and by excluding capital gains, and reduced by certain non-cash items) and must satisfy specified asset tests on a quarterly basis. While historically the Company has satisfied the distribution requirement discussed above by making cash distributions to its stockholders, the Company may choose to satisfy this requirement by making distributions of cash or other property, including, in limited circumstances, its stock. The provisions of the Code and applicable Treasury regulations regarding qualification as a REIT are more complicated in the Company’s case because its holds its assets through the Operating Partnership.\nIf MHI Holding does not qualify as a taxable REIT subsidiary, or if the Company’s hotel manager does not qualify as an “eligible independent contractor,” the Company would fail to qualify as a REIT and would be subject to higher taxes and have less cash available for distribution to its shareholders.\nRent paid by a lessee that is a “related party tenant” of ours will not be qualifying income for purposes of the two gross income tests applicable to REITs. The Company currently leases substantially all of its hotels to the TRS Lessees, which are disregarded entities for U.S. federal income tax purposes and are wholly-owned by MHI Holding, a taxable REIT subsidiary, and expects to continue to do so. So long as MHI Holding qualifies as a taxable REIT subsidiary, it will not be treated as a “related party tenant” with respect to the Company’s properties that are managed by an independent hotel management company that qualifies as an “eligible independent contractor.” The Company believes that MHI Holding will continue to qualify to be treated as a taxable REIT subsidiary for federal income tax purposes, but there can be no assurance that the IRS will not challenge this status or that a court would not sustain such a challenge. If the IRS were successful in such challenge, it is possible that the Company would fail to meet the asset tests applicable to REITs and substantially all of its income would fail to be qualifying income for purposes of the two gross income tests. If the Company failed to meet any of the asset or gross income tests, it would likely lose its REIT qualification for federal income tax purposes.\nAdditionally, if the Company’s hotel manager does not qualify as an “eligible independent contractor,” the Company would fail to qualify as a REIT. Each hotel manager that enters into a management contract with the TRS Lessees must qualify as an “eligible independent contractor” under the REIT rules in order for the rent paid by the TRS Lessees to be qualifying income for purposes of the REIT gross income tests. Among other requirements, in order to qualify as an eligible independent contractor, a hotel manager must not own, directly or through its shareholders, more than 35.0% of the Company’s outstanding shares, taking into account certain ownership attribution rules. The ownership attribution rules that apply for purposes of these 35.0% thresholds are complex. Although the Company intends to monitor ownership of its shares by its hotel manager and its owners, there can be no assurance that these ownership levels will not be exceeded.\nForeign investors may be subject to U.S. tax on the disposition of the Company’s stock if the Company does not qualify as a “domestically controlled” REIT.\nA foreign person disposing of a “U.S. real property interest,” which includes stock of a U.S. corporation whose assets consist principally of U.S. real property interests, is generally subject to U.S. federal income tax under the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) on the gain recognized on the disposition, unless such foreign person is a “qualified foreign pension fund” or one of the certain publicly traded non-U.S. “qualified collective investment vehicles”. Additionally, the transferee will be required to withhold 15.0% on the amount realized on the disposition if the foreign transferor is subject to U.S. federal income tax under FIRPTA. This 15.0% is creditable against the U.S. federal income tax liability of the foreign transferor in connection with such transferor’s disposition of the Company’s stock. FIRPTA does not apply, however, to the disposition of stock in a REIT if the REIT is “domestically controlled” (i.e., less than 50.0% of the REIT’s capital stock, by value, has been owned directly or indirectly by persons who are not qualifying U.S. persons during a continuous five-year period ending on the date of disposition or, if shorter, during the entire period of the REIT’s existence). We cannot be sure that the Company will qualify as a “domestically controlled” REIT. If the Company does not so qualify, gain realized by foreign investors on a sale of the Company’s stock would be subject to U.S. income and withholding tax under FIRPTA, unless the Company’s stock were traded on an established securities market and a foreign investor did not at any time during a specified testing period directly or indirectly own more than 10.0% of the value of the Company’s outstanding stock.\nMHI Holding increases our overall tax liability.\nOur TRS Lessees are single-member limited liability companies that are wholly-owned, directly or indirectly, by MHI Holding, a taxable REIT subsidiary that is wholly-owned by the Operating Partnership. Each of our TRS Lessees is disregarded as an entity separate from MHI Holding for U.S. federal income tax purposes, such that the assets, liabilities, income, gains, losses, credits and deductions of our TRS Lessees are treated as the assets, liabilities, income, gains, losses, credits and deductions of MHI Holding for U.S. federal income tax purposes. MHI Holding is subject to federal and state income tax on its taxable income, which will consist of\n29\nthe revenues from the hotels leased by the Company’s TRS Lessees, net of the operating expenses for such hotels and rent payments. Accordingly, although the Company’s ownership of MHI Holding and the TRS Lessees will allow it to participate in the operating income from its hotels in addition to receiving rent, that operating income will be fully subject to income tax. The after-tax net income of MHI Holding, if any, will be available for distribution to the Company.\nThe Company will incur a 100.0% excise tax on its transactions with MHI Holding and the TRS Lessees that are not conducted on an arm’s-length basis. For example, to the extent that the rent paid by the TRS Lessees exceeds an arm’s-length rental amount, such amount potentially will be subject to this excise tax. The Company intends that all transactions among itself, MHI Holding and the TRS Lessees will be conducted on an arm’s-length basis and, therefore, that the rent paid by the TRS Lessees will not be subject to this excise tax.\nOur ability to use net operating loss carryforwards to reduce future tax payments may be limited or restricted or may not exist at all, and if we do not sustain our profitability, we may be required to put up a valuation allowance against our deferred tax assets.\nAt December 31, 2016, our financial statements reflected deferred tax assets totaling approximately $6.9 million, of which approximately $6.0 million relates to significant federal and state net operating losses (“NOLs”) generated by our TRS Lessee over the past three years. We are generally able to carry NOLs forward to reduce taxable income in future years. Our ability to use our NOLs to reduce future tax payments is dependent upon our ability to sustain profitability during the time period over which these NOLs may be used under applicable tax law. A valuation allowance is required for deferred tax assets if, based on all available evidence, it is “more-likely-than-not” (defined as a likelihood of more than 50%) that all or a portion of the deferred tax assets will not be realized due to the inability to generate sufficient taxable income in certain financial statement periods. The net amount of deferred tax assets that are recorded on the financial statements must reflect the tax benefits that are expected to be realized using these criteria. We perform this analysis by evaluating a number of factors, including a demonstrated track record of past profitability, reasonable forecasts of future taxable income, and anticipated changes in the lease rental payments from the TRS Lessee to subsidiaries of the Operating Partnership. At December 31, 2016, we determined based on all available positive and negative evidence that it is more-likely-than-not that future taxable income will be available during the carryforward periods to absorb all of the consolidated federal and state net operating loss carryforward. We made this determination considering reasonable tax strategies available to us capable of ensuring the realization of our deferred tax assets, anticipated changes in the lease rental payments and one time losses that generated some of our net operating losses. However, there is no assurance that the TRS Lessee will be able to achieve profitability. The TRS Lessee’s ability to generate sustained profitability in the amounts necessary to realize our deferred tax assets against future taxable income depends upon general economic and market conditions, interest rates, and the TRS Lessee’s ability to meet our strategic plans. If the TRS Lessee is unable to generate adequate sustained profitability, we may be required to record a valuation allowance against some or all of our deferred tax assets, which would negatively impact our financial results.\nTaxation of dividend income could make the Company’s stock less attractive to investors and reduce the market price of its stock.\nThe federal income tax laws governing REITs, or the administrative interpretations of those laws, may be amended at any time. Any new laws or interpretations may take effect retroactively and could adversely affect the Company or could adversely affect its stockholders. Currently, “qualified dividends,” which include dividends from domestic C corporations that are paid to non-corporate stockholders, are subject to a reduced maximum U.S. federal income tax rate of 20.0%. Because REITs generally do not pay corporate-level taxes as a result of the dividends-paid deduction to which they are entitled, dividends from REITs generally are not treated as qualified dividends and thus do not qualify for a reduced tax rate. Non-corporate investors could view an investment in non-REIT corporations as more attractive than an investment in REITs because the dividends they would receive from non-REIT corporations would be subject to lower tax rates.\nInvestors may be subject to a 3.8% Medicare tax in connection with an investment in the Company’s stock or the 7% Notes.\nThe U.S. tax laws impose a 3.8% “Medicare tax” on the “net investment income” (i.e., interest, dividends, capital gains, annuities, and rents that are not derived in the ordinary course of a trade or business) of individuals with income exceeding $200,000 ($250,000 if married filing jointly or $125,000 if married filing separately), and of estates and trusts. Dividends on the Company’s stock and interest on the 7% Notes as well as gains from the disposition of the Company’s stock or the 7% Notes may be subject to the Medicare tax. Prospective investors should consult with their independent advisors as to the applicability of the Medicare tax to an investment in the Company’s stock or the 7% Notes in light of such investors’ particular circumstances.\n30\nInvestors may be subject to U.S. withholding tax under the “Foreign Account Tax Compliance Act.”\nOn March 18, 2010, the Hiring Incentives to Restore Employment Act, or the HIRE Act, was enacted in the United States. The HIRE Act includes provisions known as the Foreign Account Tax Compliance Act, or FATCA, that generally impose a 30.0% U.S. withholding tax on “withholdable payments,” which consist of (i) U.S.-source dividends, interest, rents and other “fixed or determinable annual or periodical income” paid after June 30, 2014 and (ii) certain U.S.-source gross proceeds paid after December 31, 2018 to (a) “foreign financial institutions” unless (x) they enter into an agreement with the IRS to collect and disclose to the IRS information regarding their direct and indirect U.S. owners or (y) they comply with the terms of any FATCA intergovernmental agreement executed between the authorities in their jurisdiction and the U.S., and (b) “non-financial foreign entities” (i.e., foreign entities that are not foreign financial institutions) unless they certify certain information regarding their direct and indirect U.S. owners. Final regulations under FATCA were issued by the IRS on January 17, 2013, and have been subsequently supplemented by additional regulations and guidance. FATCA does not replace the existing U.S. withholding tax regime. However, the FATCA regulations contain coordination provisions to avoid double withholding on U.S.-source income.\nA foreign investor that receives dividends on the Company’s stock or gross proceeds from a disposition of shares of the Company’s stock may be subject to FATCA withholding tax with respect to such dividends or gross proceeds.\nForeign investors will be subject to U.S. withholding tax on the receipt of ordinary dividends on the Company’s stock.\nThe portion of dividends received by a foreign investor payable out of the Company’s current and accumulated earnings and profits which are not attributable to capital gains and which are not effectively connected with a U.S. trade or business of the foreign investor will generally be subject to U.S. withholding tax at a statutory rate of 30.0%. This 30.0% withholding tax may be reduced by an applicable income tax treaty. The FATCA and nonresident withholding regulations are complex. Even if the 30.0% withholding is reduced or eliminated by treaty for payments made to a foreign investor, FATCA withholding of 30.0% could apply depending upon the foreign investor’s FATCA status. Foreign investors should consult with their independent advisors as to the U.S. withholding tax consequences to such investors with respect to their investment in the Company’s stock in light of their particular circumstances, as well as determining the appropriate documentation required to reduce or eliminate U.S. withholding tax.\nForeign investors will be subject to U.S. income tax on the receipt of capital gain dividends on the Company’s stock.\nUnder FIRPTA, distributions that we make to a foreign investor that are attributable to gains from our dispositions of U.S. real property interests (“capital gain dividends”) will be treated as income that is effectively connected with a U.S. trade or business, and therefore subject to U.S. federal income tax, in the hands of the foreign investor, unless such foreign person is a “qualified foreign pension fund” or one of certain publicly traded non-U.S. “qualified collective investment vehicles”. A foreign investor who is subject to tax under FIRPTA will be subject to U.S. federal income tax (at the rates applicable to U.S. investors) on any capital gain dividends, and will also be required to file U.S. federal income tax returns to report such capital gain dividends. Furthermore, capital gain dividends are subject to an additional 30.0% “branch profits tax” (which may be reduced by an applicable income tax treaty) in the hands of a foreign investor who is subject to tax under FIRPTA if such foreign investor is treated as a corporation for U.S. federal income tax purposes.\nLegislative or regulatory action could adversely affect you.\nBecause our operations are governed to a significant extent by the federal tax laws, new legislative or regulatory action could adversely affect our investors. You are strongly encouraged to consult with your own tax advisor with respect to the status of any legislative, regulatory or administrative developments, announcements and proposals and their potential impact on your investment in the Company’s stock.\n\nUnresolved Staff Comments\nNot applicable.\n31\n\nItem 2.\nP\nroperties\nAs of December 31, 2016, our portfolio consisted of the following properties (see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Key Operating Metrics, for definitions of Occupancy, ADR, and RevPAR):\n\n| Number of | Occupancy | ADR | RevPAR | Occupancy | ADR | RevPAR | Occupancy | ADR | RevPAR |\n| Wholly-Owned Properties | Rooms | 2016 | 2016 | 2016 | 2015 | 2015 | 2015 | 2014 | 2014 | 2014 |\n| Crowne Plaza Hampton Marina, Hampton, Virginia (1) | 173 | 55.2 | % | $ | 96.81 | $ | 53.40 | 55.2 | % | $ | 93.59 | $ | 51.64 | 50.8 | % | $ | 93.17 | $ | 48.27 |\n| Crowne Plaza Hollywood Beach Resort, Hollywood, Florida (2) | 311 | 79.6 | % | $ | 170.57 | $ | 135.74 | 83.1 | % | $ | 174.35 | $ | 144.86 | 83.1 | % | $ | 163.13 | $ | 135.55 |\n| Crowne Plaza Tampa Westshore, Tampa, Florida | 222 | 74.6 | % | $ | 116.15 | $ | 86.69 | 72.5 | % | $ | 111.08 | $ | 80.53 | 72.5 | % | $ | 104.90 | $ | 76.09 |\n| DoubleTree by Hilton Jacksonville Riverfront, Jacksonville, Florida | 293 | 77.4 | % | $ | 126.67 | $ | 98.06 | 67.4 | % | $ | 109.20 | $ | 73.60 | 65.8 | % | $ | 99.20 | $ | 65.24 |\n| DoubleTree by Hilton Laurel, Laurel, Maryland | 208 | 60.5 | % | $ | 104.35 | $ | 63.16 | 48.2 | % | $ | 95.19 | $ | 45.86 | 60.8 | % | $ | 89.08 | $ | 54.19 |\n| DoubleTree by Hilton Philadelphia Airport, Philadelphia, Pennsylvania | 331 | 77.0 | % | $ | 144.92 | $ | 111.66 | 79.3 | % | $ | 136.32 | $ | 108.13 | 75.9 | % | $ | 133.78 | $ | 101.58 |\n| DoubleTree by Hilton Raleigh Brownstone – University, Raleigh, North Carolina | 190 | 70.0 | % | $ | 134.74 | $ | 94.33 | 71.5 | % | $ | 131.61 | $ | 94.16 | 73.4 | % | $ | 122.60 | $ | 90.04 |\n| Georgian Terrace, Atlanta, Georgia (3) | 326 | 70.8 | % | $ | 160.89 | $ | 113.88 | 69.9 | % | $ | 155.56 | $ | 108.70 | 76.2 | % | $ | 137.65 | $ | 104.88 |\n| Hilton Savannah DeSoto, Savannah, Georgia | 246 | 71.5 | % | $ | 155.87 | $ | 111.48 | 76.9 | % | $ | 154.52 | $ | 118.89 | 75.7 | % | $ | 146.75 | $ | 111.14 |\n| Hilton Wilmington Riverside, Wilmington, North Carolina | 272 | 70.5 | % | $ | 147.14 | $ | 103.72 | 71.6 | % | $ | 138.36 | $ | 99.07 | 69.7 | % | $ | 139.09 | $ | 96.90 |\n| Sheraton Louisville Riverside, Jeffersonville, Indiana | 180 | 63.1 | % | $ | 137.34 | $ | 86.60 | 69.5 | % | $ | 131.74 | $ | 111.87 | 66.8 | % | $ | 150.20 | $ | 100.31 |\n| The Whitehall, Houston, Texas | 259 | 54.4 | % | $ | 140.70 | $ | 76.56 | 70.9 | % | $ | 142.05 | $ | 100.66 | 76.1 | % | $ | 138.93 | $ | 105.66 |\n| Total | 3,011 |\n\n\n| (1) | On February 7, 2017, the Company sold the Crowne Plaza Hampton Marina. |\n\n| (2) | The operating statistics for the Crowne Plaza Hollywood Beach Resort rely on information from both the period prior to, and the period subsequent to, the Company’s acquisition of the hotel. |\n\n| (3) | The operating statistics for the Georgian Terrace rely on information from both the period prior to, and the period subsequent to, the Company’s acquisition of the hotel. |\n\n\nLegal Proceedings\nWe are not involved in any material litigation, nor to our knowledge, is any material litigation threatened against us. We have settled, during the period covered by this report, all significant claims made during the same period. We are involved in routine litigation arising out of the ordinary course of business, all of which is expected to be covered by insurance, and none of which is expected to have a material impact on our financial condition or results of operations.\nMine Safety Disclosure\nNot applicable.\n32\nPART II\nMarket for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities\nSotherly Hotels Inc.\nMarket Information\nThe Company’s common stock trades on the NASDAQ ® Global Market under the symbol “SOHO”. The following table sets forth, for the indicated period, the intraday high and low prices for the common stock, as reported on NASDAQ ®:\n\n| Price Range |\n| High | Low |\n| Year Ended December 31, 2016 |\n| First Quarter | $ | 6.59 | $ | 4.59 |\n| Second Quarter | $ | 5.99 | $ | 5.00 |\n| Third Quarter | $ | 6.35 | $ | 5.22 |\n| Fourth Quarter | $ | 7.11 | $ | 4.65 |\n| Year Ended December 31, 2015 |\n| First Quarter | $ | 7.87 | $ | 6.26 |\n| Second Quarter | $ | 8.71 | $ | 6.94 |\n| Third Quarter | $ | 7.63 | $ | 5.83 |\n| Fourth Quarter | $ | 6.94 | $ | 4.50 |\n\nThe closing price of the Company’s common stock on the NASDAQ ® Global Market on March 1, 2017 was $6.97 per share.\nStockholder Information\nAs of March 1, 2017, there were 80 holders of record of the Company’s common stock and as of March 1, 2017, there were approximately 3,772 beneficial owners of the Company’s common stock.\nIn order to comply with certain requirements related to the Company’s qualification as a REIT, the Company’s charter, subject to certain exceptions, limits the number of common shares that may be owned by any single person or affiliated group to 9.9% of the outstanding common shares.\nRecent Sales of Unregistered Securities\nOn February 1, 2016, two holders of units in the Operating Partnership redeemed a total of 422,687 units for an equivalent number of shares of the Company’s common stock. The shares of common stock were issued to the unitholder pursuant to an exemption from registration under Section 4(2) of the Securities Act of 1933, as amended.\nOn December 2, 2016, the Company’s Board of Directors authorized a stock repurchase program under which the Company may purchase up to $10.0 million of its outstanding common stock, par value $0.01 per share, at prevailing prices on the open market or in privately negotiated transactions, at the discretion of management. The Company has used and expects to continue to use available working capital to fund purchases under the stock repurchase program and intends to complete the repurchase program prior to December 31, 2017, unless extended by the Board of Directors. Through December 31, 2016 the Company repurchased the following amounts of common stock and the repurchased shares have been returned to the status of authorized but unissued shares of common stock:\n\n| Period | Total Number of Shares Repurchased | Average Price Paid Per Share | Total Number of Shares Purchased As Part of PubliclyAnnounced Program | Maximum Number (or Approximate Dollar Value) of Shares ThatMay Yet Be Purchased Under the Program |\n| December 1- December 31, 2016 | 481,100 | $ | 6.53 | 481,100 | $ | 6,835,464 |\n\n33\nUse of Proceeds from Registered Securities\nOn August 23, 2016, the Company sold 1,610,000 shares, $0.01 par value per share, of its 8% Series B Cumulative Redeemable Perpetual Preferred Stock pursuant to a registration statement on Form S-3 (file no. 333-199256) for net proceeds after all expenses of approximately $37.8 million, which it contributed to the Operating Partnership for an equivalent number of preferred partnership units. The Operating Partnership used the net proceeds to redeem the entire $27.6 million aggregate principal amount of its outstanding 8.0% senior unsecured notes (the “8% Notes”), to acquire the commercial condominium unit and related inventories of the Hyde Resort & Residences for approximately $4.8 million, and will use the remainder of the proceeds for general corporate purposes.\nSotherly Hotels LP\nMarket Information\nThere is no established trading market for partnership units of the Operating Partnership. The Operating Partnership does not currently propose to offer partnership units to the public, and does not currently expect that a public market for those units will develop.\nPartnership Unitholder Information\nAs of March 1, 2017, there were 12 holders of the Operating Partnership’s partnership units, including Sotherly Hotels Inc.\nRecent Sales of Unregistered Securities\nFrom time to time, the Operating Partnership issues limited partnership units (common and/or preferred) to the Company, as required by the Amended and Restated Agreement of Limited Partnership of the Operating Partnership, to mirror the capital structure of the Company to reflect additional issuances by the Company and to preserve equitable ownership ratios.\nThere were no sales of unregistered securities in the Operating Partnership during 2016.\nUse of Proceeds from Registered Securities\nThere were no sales of registered securities in the Operating Partnership during 2016.\nSotherly Hotels Inc. and Sotherly Hotels LP\nDividend and Distribution Information\nThe Company elected to be taxed as a REIT commencing with our taxable year ending December 31, 2004. To maintain qualification as a REIT, we are required to make annual distributions to the Company’s stockholders of at least 90.0% of our REIT taxable income, excluding net capital gain, which does not necessarily equal net income as calculated in accordance with generally accepted accounting principles. Our ability to pay distributions to the Company’s stockholders will depend, in part, upon our receipt of distributions from our Operating Partnership which may depend upon receipt of lease payments with respect to our properties from our TRS Lessees, and in turn, upon the management of our properties by our hotel manager. Distributions to the Company’s stockholders will generally be taxable to the Company’s stockholders as ordinary income; however, because a portion of our investments will be equity ownership interests in hotels, which will result in depreciation and non-cash charges against our income, a portion of our distributions may constitute a tax-free return of capital. To the extent not inconsistent with maintaining our REIT status, our TRS Lessees may retain any after-tax earnings.\nIn order to maintain our qualification as a REIT, we must make distributions to our stockholders each year in an amount equal to at least:\n| • | 90% of our REIT taxable income determined without regard to the dividends paid deduction and excluding net capital gains; plus |\n\n| • | 90% of the excess of our net income from foreclosure property over the tax imposed on such income by the Code; minus |\n\n| • | Any excess noncash income (as defined in the Code). |\n\n34\nThe following tables set forth information regarding the declaration, payment and income tax characterization of distributions by the Company on its common and preferred shares to Company’s stockholders for fiscal year 2015 to 2016. The same table sets forth the Operating Partnership’s distributions per common and preferred partnership units for fiscal year 2015 to 2016:\n\n| Dividend (Distribution) Payments - Common |\n| Date Declared | For the Quarter Ended | Date Paid | Amount per Share and Unit | Ordinary Income | Return of Capital |\n| January 2015 | March 31, 2015 | April 10, 2015 | $ | 0.070 | 82.6% | 17.4% |\n| April 2015 | June 30, 2015 | July 10, 2015 | $ | 0.075 | 82.6% | 17.4% |\n| July 2015 | September 30, 2015 | October 9, 2015 | $ | 0.080 | 82.6% | 17.4% |\n| October 2015 | December 31, 2015 | January 11, 2016 | $ | 0.080 | 82.6% | 17.4% |\n| January 2016 | March 31, 2016 | April 11, 2016 | $ | 0.085 | 73.5% | 26.5% |\n| April 2016 | June 30, 2016 | July 11, 2016 | $ | 0.090 | 73.5% | 26.5% |\n| July 2016 | September 30, 2016 | October 11, 2016 | $ | 0.095 | 73.5% | 26.5% |\n| October 2016 | December 31, 2016 | January 11, 2017 | $ | 0.095 | 73.5% | 26.5% |\n\n\n| Dividend (Distribution) Payments - Preferred |\n| Date Declared | For the Quarter Ended | Date Paid | Amount per Share and Unit | Ordinary Income | Return of Capital |\n| August 2016 | September 30, 2016 | October 17, 2016 | $ | 0.2111 | 73.5% | 26.5% |\n| October 2016 | December 31, 2016 | January 17, 2017 | $ | 0.500 | 73.5% | 26.5% |\n\nThe amount of future common stock distributions will be based upon quarterly operating results, general economic conditions, requirements for capital improvements, the availability of debt and equity capital, the Code’s annual distribution requirements, and other factors, which the Company’s board of directors deems relevant. The amount, timing and frequency of distributions will be authorized by the Company’s board of directors and declared by us based upon a variety of factors deemed relevant by our directors, and no assurance can be given that our distribution policy will not change in the future.\n\nSelected Financial Data\nThe following table sets forth selected historical financial data for Sotherly Hotels Inc. and Sotherly Hotels LP for the years ended December 31, 2016, 2015, 2014, 2013, and 2012. The financial results for the Crowne Plaza Hollywood Beach Resort, in which we had a 25.0% indirect interest, are not consolidated through July 31, 2015, as we accounted for our investment under the equity method of accounting. However, from August 1, 2015 through December 31, 2015 we did consolidate the financial results for the Crowne Plaza Hollywood Beach Resort, as a result of our acquisition of the remaining 75.0% interest in the hotel. The following selected historical financial data was derived from audited consolidated financial statements contained elsewhere in this Annual Report on Form 10-K and in prior filings. The Company’s financial statements: for the year ended December 31, 2016, have been audited by Dixon Hughes Goodman LLP; for the years ended December 31, 2015 and 2014, have been audited by Grant Thornton LLP; and for the years ended December 31, 2013 and 2012, have been audited by PBMares, LLP (formerly Witt Mares, PLC), our independent registered public accounting firms, for such periods. The audited historical financial statements include reclassifications and all adjustments, consisting of normal recurring adjustments, which we consider necessary for a fair presentation of our financial condition and the results of operations as of those dates and for those periods under accounting principles generally accepted in the United States of America.\nThe information presented below is only a summary and does not provide all of the information contained in our consolidated financial statements, including notes thereto, and should be read together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K.\n35\nSOTHERLY HOTELS INC.\nSOTHERLY HOTELS LP\nSELECTED HISTORICAL FINANCIAL DATA\n\n| Year Ended | Year Ended | Year Ended | Year Ended | Year Ended |\n| December 31, | December 31, | December 31, | December 31, | December 31, |\n| 2016 | 2015 | 2014 | 2013 | 2012 |\n| Statement of Operations |\n| Total Revenues | $ | 152,845,752 | $ | 138,533,476 | $ | 122,939,919 | $ | 89,374,527 | $ | 87,343,220 |\n| Total Operating Expenses excluding Depreciation, Amortization, Disposal Gain and Impairment of Investments in Hotel Properties, net | (118,854,236 | ) | (109,153,366 | ) | (95,290,304 | ) | (69,888,820 | ) | (68,519,401 | ) |\n| Depreciation, Amortization, Disposal Gain and Impairment of Investments in Hotel Properties, net | (15,384,390 | ) | (14,050,060 | ) | (15,144,284 | ) | (9,078,228 | ) | (8,661,769 | ) |\n| Net Operating Income | 18,607,126 | 15,330,050 | 12,505,331 | 10,407,479 | 10,162,050 |\n| Interest Income | 115,785 | 50,461 | 19,865 | 17,914 | 16,158 |\n| Interest Expense | (17,735,107 | ) | (16,515,827 | ) | (14,636,870 | ) | (9,606,479 | ) | (10,399,962 | ) |\n| Other Income (Expense) – net | (1,455,289 | ) | 6,196,936 | (354,558 | ) | (3,796,410 | ) | (3,941,594 | ) |\n| Income Tax Benefit (Provision) | 1,367,634 | 1,336,033 | 1,727,723 | (1,496,096 | ) | (1,246,397 | ) |\n| Net Income (Loss) | 900,149 | 6,397,653 | (738,509 | ) | (4,473,592 | ) | (5,409,745 | ) |\n| Net (Income) Loss Attributable to Noncontrolling Interest | 26,567 | (1,040,987 | ) | 153,838 | 989,623 | 1,241,868 |\n| Net Income (Loss) Attributable to the Company | 926,716 | 5,356,666 | (584,671 | ) | (3,483,969 | ) | (4,167,877 | ) |\n| Distributions to Preferred Stockholders | (1,144,889 | ) | — | — | — | — |\n| Net Income/(Loss) Attributable to Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) | $ | (3,483,969 | ) | $ | (4,167,877 | ) |\n| Statement of Cash Flows |\n| Cash provided by Operations – net | $ | 17,139,409 | $ | 11,377,374 | $ | 14,851,255 | $ | 9,594,751 | $ | 9,011,957 |\n| Cash used in Investing – net | (12,940,766 | ) | (41,132,602 | ) | (71,096,578 | ) | (29,527,589 | ) | (3,156,121 | ) |\n| Cash provided by (used in) Financing – net | 16,074,218 | 24,614,643 | 63,503,194 | 22,133,750 | (3,090,079 | ) |\n| Net Increase (Decrease) in Cash and Cash Equivalents | $ | 20,272,861 | $ | (5,140,585 | ) | $ | 7,257,871 | $ | 2,200,912 | $ | 2,765,757 |\n| Balance Sheet |\n| Investments in Hotel Properties, Net | $ | 348,593,912 | $ | 354,963,242 | $ | 260,192,153 | $ | 202,645,633 | $ | 176,427,904 |\n| Investment in Hotel Properties Held for Sale, Net | 5,333,000 | — | — | — | — |\n| Total Assets (1) | 406,019,564 | 393,058,353 | 299,820,043 | 228,169,081 | 204,223,074 |\n| Mortgage Loans | 282,708,289 | 271,977,944 | 205,291,657 | 160,363,549 | 135,674,432 |\n| Unsecured Notes | 24,308,713 | 52,900,000 | 52,900,000 | 27,600,000 | — |\n| Redeemable Preferred Stock | — | — | — | — | 14,227,650 |\n| Total Liabilities | 324,680,276 | 340,199,985 | 272,310,186 | 197,314,286 | 167,179,121 |\n| Noncontrolling Interest (1) | 2,329,175 | 3,855,237 | 4,132,662 | 5,669,386 | 7,322,314 |\n| Total Sotherly Hotels Inc. Stockholders’ Equity (1) | $ | 79,010,113 | $ | 49,003,131 | $ | 23,377,195 | $ | 25,185,409 | $ | 29,721,639 |\n| Operating Data |\n| Average Number of Available Rooms | 3,011 | 2,828 | 2,622 | 2,148 | 2,113 |\n| Total Number of Available Room Nights | 1,102,026 | 1,032,353 | 957,060 | 783,936 | 773,358 |\n| Occupancy Percentage (2) | 69.8 | % | 69.9 | % | 70.3 | % | 67.4 | % | 68.9 | % |\n| Average Daily Rate (ADR) (2) | $ | 140.63 | $ | 134.21 | $ | 125.77 | $ | 118.91 | $ | 114.22 |\n| RevPAR (2) | $ | 98.18 | $ | 93.80 | $ | 88.42 | $ | 80.16 | $ | 78.65 |\n| Additional Financial Data |\n| FFO (3) | $ | 15,139,650 | $ | 14,103,844 | $ | 14,765,677 | $ | 5,150,303 | $ | 3,842,699 |\n| Adjusted FFO (3) | 15,100,188 | 14,904,608 | 14,142,080 | 10,766,147 | 9,218,032 |\n| Hotel EBITDA (4) | 40,012,581 | 36,447,390 | 32,084,957 | 23,220,515 | 22,296,938 |\n| Income (Loss) Per Basic Share | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) | $ | (0.34 | ) | $ | (0.42 | ) |\n\n\n| (1) | As of the period end. |\n\n| (2) | Occupancy Percent is calculated by dividing the total daily number of rooms sold by the total daily number of rooms available. ADR is calculated by dividing the total daily room revenue by the total daily number of rooms sold. RevPAR is calculated by dividing the total daily room revenue by the total daily number of rooms available. |\n\n36\n\n| (3) | Industry analysts and investors use Funds from Operations (“FFO”) as a supplemental operating performance measure of an equity REIT. FFO is calculated in accordance with the definition adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). FFO, as defined by NAREIT, represents net income or loss determined in accordance with generally accepted accounting principles (“GAAP”), excluding extraordinary items as defined under GAAP and gains or losses from sales of previously depreciated operating real estate assets, plus certain non-cash items such as real estate asset depreciation and amortization, and after adjustment for any noncontrolling interest from unconsolidated partnerships and joint ventures. |\n\nAdjusted FFO accounts for certain additional items that are not in NAREIT’s definition of FFO, including changes in deferred income taxes, any unrealized gain (loss) on its hedging instruments or warrant derivative, loan impairment losses, losses on early extinguishment of debt, aborted offering costs, franchise termination costs, loan modification fees, costs associated with the departure of executive officers, litigation settlement, over-assessed real estate taxes on appeal, change in control gains or losses and acquisition transaction costs.\n| (4) | Hotel EBITDA represents the portion of net income or loss excluding: (1) interest expense, (2) interest income, (3) income tax provision or benefit, (4) equity in the income or loss of equity investees, (5) unrealized gains and losses on derivative instruments not included in other comprehensive income, (6) gains and losses on disposal of assets, (7) realized gains and losses on investments, (8) impairment of long-lived assets or investments, (9) loss on early debt extinguishment, (10) gains or losses on change in control, (11) corporate general and administrative expense, (12) depreciation and amortization, (13) gains and losses on involuntary conversions of assets and (14) other operating revenue not related to our wholly-owned portfolio. |\n\nThe following is a reconciliation of net loss to FFO and Adjusted FFO for the years ended December 31, 2016, 2015, 2014, 2013, and 2012.\n\n| Year Ended | Year Ended | Year Ended | Year Ended | Year Ended |\n| December 31, | December 31, | December 31, | December 31, | December 31, |\n| 2016 | 2015 | 2014 | 2013 | 2012 |\n| Net Income/(Loss) Attributable to the Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) | $ | (3,483,969 | ) | $ | (4,186,709 | ) |\n| Add: Net Income (Loss) Attributable to the Noncontrolling Interest | (26,567 | ) | 1,040,987 | (153,838 | ) | (989,623 | ) | (1,223,036 | ) |\n| Depreciation and Amortization | 15,019,071 | 13,591,495 | 11,969,284 | 8,467,228 | 8,661,769 |\n| Equity in Depreciation and Amortization of Joint Venture | — | 259,279 | 529,053 | 545,667 | 590,675 |\n| Impairment of Investment in Hotel Properties, Net | — | 500,000 | 3,175,000 | 611,000 | — |\n| Gain on Change in Control | — | (6,603,148 | ) | — | — | — |\n| Gain on Involuntary Conversion of Asset | — | — | (169,151 | ) | — | — |\n| Loss (Gain) on Asset Disposal | 365,319 | (41,435 | ) | — | — | — |\n| Funds From Operations | $ | 15,139,650 | $ | 14,103,844 | $ | 14,765,677 | $ | 5,150,303 | $ | 3,842,699 |\n| (Increase) Decrease in Deferred Income Taxes | (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) | 1,370,189 | 1,241,848 |\n| Acquisition Costs | — | 634,376 | 155,187 | 89,743 | — |\n| Loss on Starwood Settlement | — | 324,271 | — | — | — |\n| Over-Assessed Real Estate Taxes Under Appeal | — | 497,733 | — | — | — |\n| Loan Modification Fees | 64,215 | 243,229 | — | — | — |\n| Franchise Termination Fee | — | — | 351,800 | — | — |\n| Realized and Unrealized (Gain) Loss on Hedging Activities (A) | 37,384 | 108,819 | — | (89,998 | ) | 13,752 |\n| Realized and Unrealized Loss on Warrant Derivative | — | — | — | 2,205,248 | 2,026,677 |\n| Impairment of Note Receivable | — | — | — | — | 110,871 |\n| Loss on Early Debt Extinguishment (A) | 1,417,905 | 772,907 | 831,079 | 2,040,662 | 1,982,184 |\n| Adjusted FFO | $ | 15,100,188 | $ | 14,904,608 | $ | 14,142,080 | $ | 10,766,147 | $ | 9,218,031 |\n\n\n| (A) | Includes equity in unrealized (gain)/loss on hedging activities and loss on early extinguishment of debt of joint venture. |\n\n37\nThe following is a reconciliation of net income/(loss) to Hotel EBITDA for the years ended December 31, 2016, 2015, 2014, 2013, and 2012.\n\n| Year Ended | Year Ended | Year Ended | Year Ended | Year Ended |\n| December 31, | December 31, | December 31, | December 31, | December 31, |\n| 2016 | 2015 | 2014 | 2013 | 2012 |\n| Net Income/(Loss) Attributable to the Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) | $ | (3,483,969 | ) | $ | (4,186,709 | ) |\n| Add: Net Income (Loss) Attributable to the Noncontrolling Interest | (26,567 | ) | 1,040,987 | (153,838 | ) | (989,623 | ) | (1,223,036 | ) |\n| Interest Expense | 17,735,107 | 16,515,827 | 14,636,870 | 9,606,479 | 10,399,962 |\n| Interest Income | (115,785 | ) | (50,461 | ) | (19,865 | ) | (17,914 | ) | (16,158 | ) |\n| Distributions to Preferred Stockholders | 1,144,889 | — | — | — | — |\n| Income Tax Provision (Benefit) | (1,367,634 | ) | (1,336,033 | ) | (1,727,723 | ) | 1,496,096 | 1,246,397 |\n| Depreciation and Amortization | 15,019,071 | 13,591,495 | 11,969,284 | 8,467,228 | 8,661,769 |\n| Equity in (Earnings) Loss of Joint Venture | — | (475,514 | ) | (307,370 | ) | (449,500 | ) | (178,138 | ) |\n| Loss (Gain) on Asset Disposal | 365,319 | (41,435 | ) | — | — | — |\n| Gain on Involuntary Conversion of Asset | — | — | (169,151 | ) | — | — |\n| Realized and Unrealized Loss (Gain) on Hedging Activities | 37,384 | 108,819 | — | — | — |\n| Realized and Unrealized Loss on Warrant Derivative | — | — | — | 2,205,248 | 2,026,677 |\n| Loss on Early Debt Extinguishment | 1,417,905 | 772,907 | 831,079 | 2,040,662 | 1,982,184 |\n| Impairment of Investment in Hotel Properties, Net | — | 500,000 | 3,175,000 | 611,000 | — |\n| Impairment of Note Receivable | — | — | — | — | 110,871 |\n| Corporate General and Administrative Expenses | 6,021,065 | 7,268,256 | 5,085,949 | 4,360,582 | 4,078,826 |\n| Gain on Change in Control | — | (6,603,148 | ) | — | — | — |\n| Net Lease Rental Income | — | — | (350,000 | ) | (350,000 | ) | (350,000 | ) |\n| Other Fee Income | — | (200,976 | ) | (300,607 | ) | (275,774 | ) | (255,707 | ) |\n| Hotel EBITDA | $ | 40,012,581 | $ | 36,447,390 | $ | 32,084,957 | $ | 23,220,515 | $ | 22,296,938 |\n\n38\n\nItem 7.\nManagement’s Discussion and Analysis of\nFinancial Condition and Results of Operations\nOverview\nThe Company is a self-managed and self-administered lodging REIT incorporated in Maryland in August 2004 to pursue opportunities in the full-service, primarily upscale and upper-upscale segments of the hotel industry located in primary and secondary markets in the mid-Atlantic and southern United States. We commenced operations in December 2004 when the Company completed its initial public offering and thereafter consummated the acquisition of six initial hotel properties. Since the Company’s initial public offering, we have engaged in the following acquisitions and dispositions:\n| • | On July 22, 2005, we acquired the Crowne Plaza Jacksonville Riverfront (formerly, the Hilton Jacksonville Riverfront). During September 2015, after extensive renovations, we re-branded and renamed the hotel the DoubleTree by Hilton Jacksonville Riverfront. |\n\n| • | On August 10, 2006, we sold the Holiday Inn Downtown Williamsburg. |\n\n| • | On September 20, 2006, we acquired the Louisville Ramada Riverfront Inn, which went through an extensive renovation and re-opened in May 2008 as the Sheraton Riverside Louisville. |\n\n| • | On August 8, 2007, through our joint venture with Carlyle, we acquired a 25.0% indirect noncontrolling interest in the Crowne Plaza Hollywood Beach Resort, a newly renovated 311-room hotel in Hollywood, Florida. |\n\n| • | On October 29, 2007, we acquired a hotel in Tampa, Florida, formerly known as the Tampa Clarion Hotel, which went through an extensive renovation and re-opened in March 2009 as the Crowne Plaza Tampa Westshore. |\n\n| • | On April 24, 2008, we acquired the Hampton Marina Hotel in Hampton, Virginia, which has been renovated and was converted to the Crowne Plaza Hampton Marina in October 2008. |\n\n| • | On November 13, 2013, we acquired the Crowne Plaza Houston Downtown in Houston, Texas. |\n\n| • | On March 27, 2014, we acquired the Georgian Terrace in Atlanta, Georgia. |\n\n| • | On July 31, 2015, we acquired the remaining 75.0% interest in (i) the entity that owns the Crowne Plaza Hollywood Beach Resort, and (ii) the entity that leases the Crowne Plaza Hollywood Beach Resort. As a result, the Operating Partnership now has a 100% indirect ownership interest in the entities that own the Crowne Plaza Hollywood Beach Resort. |\n\n| • | On January 30, 2017, we closed on the purchase of the hotel commercial unit of the Hyde Resort & Residences, a 400-unit condominium-hotel located in the Hollywood, Florida market. |\n\n| • | On February 7, 2017, we closed on the sale of the Crowne Plaza Hampton Marina. |\n\n39\nAs of December 31, 2016, our hotel portfolio consisted of twelve full-service, primarily upscale and upper-upscale hotels with 3,011 rooms, ten of which operate under well-known brands such as Hilton, Crowne Plaza, DoubleTree and Sheraton, and two of which are independent hotels. Following the sale of the Crowne Plaza Hampton Marina on February 7, 2017, our portfolio consisted of eleven wholly-owned hotels with a total of 2,838 rooms, as well as our interests in the Hyde Resort & Residences. As of December 31, 2016, we owned the following hotel properties:\n\n| Number |\n| Property | of Rooms | Location | Date of Acquisition | Chain Designation |\n| Wholly-owned |\n| Crowne Plaza Hampton Marina (1) | 173 | Hampton, VA | April 24, 2008 | Upscale |\n| Crowne Plaza Hollywood Beach Resort | 311 | Hollywood, FL | August 9, 2007 | Upscale |\n| Crowne Plaza Tampa Westshore | 222 | Tampa, FL | October 29, 2007 | Upscale |\n| DoubleTree by Hilton Jacksonville Riverfront | 293 | Jacksonville, FL | July 22, 2005 | Upscale |\n| DoubleTree by Hilton Laurel | 208 | Laurel, MD | December 21, 2004 | Upscale |\n| DoubleTree by Hilton Philadelphia Airport | 331 | Philadelphia, PA | December 21, 2004 | Upscale |\n| DoubleTree by Hilton Raleigh Brownstone-University | 190 | Raleigh, NC | December 21, 2004 | Upscale |\n| The Georgian Terrace | 326 | Atlanta, GA | March 27, 2014 | Independent(2) |\n| Hilton Savannah DeSoto | 246 | Savannah, GA | December 21, 2004 | Upper Upscale |\n| Hilton Wilmington Riverside | 272 | Wilmington, NC | December 21, 2004 | Upper Upscale |\n| Sheraton Louisville Riverside | 180 | Jeffersonville, IN | September 20, 2006 | Upper Upscale |\n| The Whitehall | 259 | Houston, TX | November 13, 2013 | Independent(2) |\n| Total | 3,011 |\n\n\n| (1) | On February 7, 2017, we closed on the sale of this hotel. |\n\n| (2) | We believe that the Georgian Terrace and The Whitehall would carry a chain scale designation of upper upscale if they were branded hotels. |\n\nWe conduct substantially all our business through the Operating Partnership, Sotherly Hotels LP. The Company is the sole general partner of the Operating Partnership and owns an approximate 89.1% interest in the Operating Partnership, with the remaining interest being held by limited partners who were contributors of our initial hotel properties and related assets.\nTo qualify as a REIT, neither the Company nor the Operating Partnership can operate our hotels. Therefore, our wholly-owned hotel properties are leased to our TRS Lessees that are wholly-owned subsidiaries of the Operating Partnership, which then engage a hotel management company to operate the hotels under a management agreement. Our TRS Lessees have engaged Chesapeake Hospitality to manage our hotels. Our TRS Lessees, and their parent, MHI Hospitality TRS Holding, Inc., are consolidated into each of our financial statements for accounting purposes. The earnings of MHI Hospitality TRS Holding, Inc. are subject to taxation similar to other C corporations.\nKey Operating Metrics\nIn the hotel industry, room revenue is considered the most important category of revenue and drives other revenue categories such as food, beverage, catering, parking and telephone. There are three key performance indicators used in the hotel industry to measure room revenues:\n| • | Occupancy, or the number of rooms sold, usually expressed as a percentage of total rooms available; |\n\n| • | Average daily rate, or ADR, which is total room revenue divided by the number of rooms sold; and |\n\n| • | Revenue per available room, or RevPAR, which is total room revenue divided by the total number of available rooms. |\n\nRevPAR changes that are primarily driven by changes in occupancy have different implications for overall revenues and profitability than changes that are driven primarily by changes in ADR. For example, an increase in occupancy at a hotel would lead to additional variable operating costs (such as housekeeping services, laundry, utilities, room supplies, franchise fees, management fees, credit card commissions and reservations expense), but could also result in increased non-room revenue from the hotel’s restaurant, banquet or parking facilities. Changes in RevPAR that are primarily driven by changes in ADR typically have a greater impact on operating margins and profitability as they do not generate all the additional variable operating costs associated with higher occupancy.\n40\nWe also use FFO, Adjusted FFO and Hotel EBITDA as measures of our operating performance. See “Non-GAAP Financial Measures”.\nResults of Operations\nComparison of Year Ended December 31, 2016 to Year Ended December 31, 2015\nThe following table illustrates the key operating metrics for the years ended December 31, 2016 and 2015 for our wholly-owned properties during each respective reporting period (“actual” properties) as well as the key operating metrics for the eleven wholly-owned properties that were under our control during all of 2015 (“same-store” properties). Accordingly, the same-store data does not reflect the performance of the Crowne Plaza Hollywood Beach Resort, which was acquired through a joint venture and in which we had a 25.0% indirect interest through July 31, 2015 and a 100.0% interest thereafter.\n\n| Year Ended December 31, 2016 | Year Ended December 31, 2015 |\n| Actual | Same-Store | Actual | Same-Store |\n| Occupancy % | 69.8 | % | 68.7 | % | 69.9 | % | 65.7 | % |\n| ADR | $ | 140.63 | $ | 136.63 | $ | 134.21 | $ | 130.09 |\n| RevPAR | $ | 98.18 | $ | 93.86 | $ | 93.80 | $ | 85.47 |\n\nRevenue. Total revenue for the year ended December 31, 2016 was approximately $152.8 million, an increase of approximately $14.3 million, or 10.3%, from total revenue for the year ended December 31, 2015 of approximately $138.5 million. Approximately $11.9 million of the increase relates to the acquisition of the remaining 75.0% interest in our property in Hollywood Beach, Florida in July 2015. Increases in revenues at our properties in Wilmington, North Carolina; Raleigh, North Carolina; Philadelphia, Pennsylvania; Laurel, Maryland; Jacksonville, Florida; Tampa, Florida; and Atlanta, Georgia of approximately $7.1 million, were offset by decreases in revenue at our properties impacted by renovation activities in Savannah, Georgia and Houston, Texas of approximately $3.3 million, as well as the remaining properties revenue decreases of $1.6 million.\nRoom revenues at our properties for the year ended December 31, 2016 increased approximately $11.4 million, or 11.7%, to approximately $108.2 million compared to room revenues for the year ended December 31, 2015 of approximately $96.8 million. The increase in room revenues for the year ended December 31, 2016 resulted mainly from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $9.6 million for the period. Our properties in Wilmington, North Carolina; Raleigh, North Carolina; Philadelphia, Pennsylvania; Jacksonville, Florida; Tampa, Florida; Hampton, Virginia and Atlanta, Georgia, experienced a significant increase in room revenues, offset by decreases at our properties impacted by renovation activities in Savannah, Georgia and Houston, Texas. We continue to expect occupancy and ADR to increase in 2017 as a result of continuing strong demand and the completion in 2016 of renovations at our properties in Houston, Texas and Atlanta, Georgia.\nFood and beverage revenues at our properties for the year ended December 31, 2016 increased approximately $2.1 million, or 6.3%, to approximately $35.4 million compared to food and beverage revenues of approximately $33.3 million for the year ended December 31, 2015. The increase in food and beverage revenues for the year ended December 31, 2016 resulted principally from our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $1.6 million for the period. Additional increases in food and beverage revenues at our properties in Savannah, Georgia; Raleigh, North Carolina; Laurel, Maryland: Jacksonville, Florida; and Tampa, Florida of approximately $1.5 million, were offset by decreases of approximately $1.0 million in food and beverage revenues at our other properties.\nOther operating revenues for the year ended December 31, 2016 increased approximately $0.8 million, or 10.0%, to approximately $9.3 million compared to other operating revenues for the year ended December 31, 2015 of approximately $8.4 million. The increase in other operating department revenues for the year ended December 31, 2016 resulted principally from our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $0.6 million for the period. Additional increases in other operating revenues at our properties in Philadelphia, Pennsylvania; Laurel, Maryland; Jacksonville, Florida; Jeffersonville, Indiana and Hampton, Virginia of approximately $0.5 million, were offset by decreases of approximately $0.5 million in other operating revenues at our other properties.\nHotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses, indirect expenses, and management fees, increased approximately $10.9 million, or 10.7%, for the year ended December 31, 2016 to approximately $112.8 million compared to hotel operating expenses for the year ended December 31, 2015 of approximately $101.9 million. The increase in hotel operating expenses for the year ended December 31, 2016 was substantially related to our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $9.0 million for the period, coupled with an increase in hotel operating expenses at our same-store properties of approximately $1.1 million, mainly from increased occupancy by 4.6%, offset with decreases in expenses at our properties in Wilmington, North Carolina; Philadelphia, Pennsylvania; Jeffersonville, Indiana; Hampton, Virginia and Houston, Texas.\n41\nRooms expense at our properties for the year ended December 31, 2016 increased approximately $3.1 million, or 12.1%, to approximately $28.9 million compared to rooms expense of approximately $25.8 million for the year ended December 31, 2015. The increase in rooms expense for the year ended December 31, 2016 was substantially related to our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $2.3 million for the period.\nFood and beverage expenses at our properties for the year ended December 31, 2016 increased approximately $1.4 million, or 5.9%, to approximately $24.4 million compared to food and beverage expense of approximately $23.0 million for the year ended December 31, 2015. The increase in food and beverage expenses for the year ended December 31, 2016 was substantially related to our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $1.2 million for the period.\nIndirect expenses at our properties for the year ended December 31, 2016 increased approximately $5.8 million, or 11.4%, to approximately $57.1 million compared to indirect expenses of approximately $51.3 million for the year ended December 31, 2015. Sales and marketing costs, franchise fees, utilities, repairs and maintenance, insurance, management fees, real and personal property taxes as well as general and administrative costs at the property level are included in indirect expenses. Most of the increase in indirect expenses related to expenses that increase proportionally with increases in occupancy and/or revenue, including management fees and franchise fees. Specifically, increases in indirect expenses were substantially related to our recently acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $5.1 million for the period, compared to the year ended December 31, 2015.\nDepreciation and Amortization. Depreciation and amortization for the year ended December 31, 2016 increased approximately $1.4 million, or 10.5%, to approximately $15.0 million compared to depreciation and amortization expense of approximately $13.6 million for the year ended December 31, 2015. The increase was mostly attributable to depreciation and amortization related to our recently acquired property in Hollywood Beach, Florida and depreciation and amortization related to our capital assets acquired in the fourth quarter of 2015 and for the year 2016, offset by reductions of intangible asset amortization during the year ended December 31, 2016 compared to the year ended December 31, 2015.\nImpairment of Investment in Hotel Properties, Net. The impairment of investment in hotel properties, net for the years ended December 31, 2016 and 2015 was $0 and $0.5 million, respectively. Our review of possible impairment of our hotel properties revealed no excess of current carrying cost over the estimated undiscounted future cash flows, as of December 31, 2016.\nGain / Loss on Disposal of Assets. During the year ended December 31, 2016, we recorded a net loss on disposal of assets of $365,319, comprised of disposals of furniture, fixtures, and equipment of $565,319, offset by a gain on sale of $200,000, compared to a $41,435 net gain on disposal of assets for the year ended December 31, 2015, comprised of a net gain on the sale of development parcel rights and the development parcel for approximately $710,250, offset by losses on disposals of furniture, fixtures and equipment of $668,815.\nCorporate General and Administrative. Corporate general and administrative expenses for the year ended December 31, 2016 decreased approximately $1.2 million, or 17.2%, to approximately $6.0 million compared to corporate general and administrative expenses of approximately $7.3 million for the year ended December 31, 2015. The decrease in corporate general and administrative expenses was mainly due to decreases in acquisition costs of approximately $0.6 million, the absence of a one-time tax penalty of $0.4 million in 2016, reduced professional fees of approximately $0.2 million, reduced loan modification costs of $0.2 million and reduced audit fees of approximately $0.2 million partially offset by additional staffing and related salary increase of approximately $0.3 million, an increase in legal fees of approximately $0.4 million and increased marketing support costs of $0.2 million.\nInterest Expense. Interest expense for the year ended December 31, 2016 increased approximately $1.2 million, or 7.4%, to approximately $17.7 million compared to approximately $16.5 million of interest expense for the year ended December 31, 2015. The increase in interest expense for the year ended December 31, 2016, was substantially related to the assumed mortgage loan for the acquired property in Hollywood Beach, Florida, accounting for an increase in interest expense of approximately $1.8 million. This increase was mainly offset by a decrease in interest from the redemption of the 8% Notes with an approximate decrease of $0.5 million.\nEquity Income (Loss) in Joint Venture. Equity in the income of the joint venture decreased approximately $0.5 million, or 100.0%, to $0 for the year ended December 31, 2016 compared to equity in the income of the joint venture of approximately $0.5 million for the year ended December 31, 2015, due the acquisition of the Crowne Plaza Hollywood Beach Resort in July 2015.\n42\nLoss on Early Debt Extinguishment. The loss on early debt extinguishment for the year ended December 31, 2016 increased approximately $0.6 million, or 83.5%, to approximately $1.4 million compared to a loss on debt extinguishment of approximately $0.8 million for the year ended December 31, 2015. During the year ended December 31, 2016, we refinanced mortgage loans at our properties in Wilmington, North Carolina; Savannah, Georgia; Jeffersonville, Indiana; Tampa, Florida and Houston, Texas with an increase in loss on early debt extinguishments of approximately $0.3 million. We also redeemed our 8% unsecured notes with the majority of the loss on early debt extinguishment of approximately $1.1 million.\nUnrealized Loss on Hedging Activities. During the year ended December 31, 2015, we refinanced a variable rate mortgage loan we had with Fifth Third Bank on the DoubleTree by Hilton Jacksonville Riverfront, with a new variable rate loan from Bank of the Ozarks. During August 2015, we purchased an interest rate cap for $179,800. As of December 31, 2016, the fair market value of the interest rate cap is $33,597 compared to the fair market value of $70,981, as of December 31, 2015. The unrealized loss on hedging activities during the year ended December 31, 2016 and 2015, was $37,384 and $108,818, respectively.\nGain on Change in Control. On July 31, 2015, we acquired from Carlyle the remaining 75.0% interest in the entities that own and lease the Crowne Plaza Hollywood Beach Resort. Due to the increased fair market value of the property for our original 25.0% interest we recognized a discounted gain on change in control. The gain on change in control during the year ended December 31, 2015, was approximately $6.6 million while no such gain was recorded in 2016.\nIncome Tax Benefit. The income tax benefit for the year ended December 31, 2016 increased approximately $32,000, or 2.4%, to approximately $1.4 million compared to an income tax provision of approximately $1.3 million for the year ended December 31, 2015. The income tax benefit was primarily derived from the operations of our TRS Lessees. Our TRS Lessees realized higher operating loss for the year ended December 31, 2016 compared to the year ended December 31, 2015. At December 31, 2016, deferred tax assets total approximately $6.9 million, of which approximately $6.0 million relate to net operating losses of our TRS Lessee. At December 31, 2016, we determined, based on all available positive and negative evidence, that it is more-likely-than-not that future taxable income will be available during the carryforward periods to absorb all of the consolidated federal and state net operating loss carryforward. We will continue to regularly evaluate the likelihood that we will be able to realize our deferred tax assets and the need for a valuation allowance for the deferred tax assets.\nNet Income. Net income for the year ended December 31, 2016 decreased approximately $5.5 million, or 85.9%, to approximately $0.9 million compared to net income of approximately $6.4 million for the year ended December 31, 2015, as a result of the operating results discussed above.\nDistributions to Preferred Stockholders. During the year ended December 31, 2016, we recorded distributions to preferred stockholders of approximately $1.1 million, compared to no distributions to preferred stockholders for the year ended December 31, 2015. As of December 31, 2016 and 2015, we accrued $805,000 and $0, as dividends on the preferred stock, respectively.\nComparison of Year Ended December 31, 2015 to Year Ended December 31, 2014\nThe following table illustrates the key operating metrics for the years ended December 31, 2015 and 2014, for our wholly-owned properties during each respective reporting period (“actual” properties) as well as the key operating metrics for the ten wholly-owned properties that were under our control during all of 2014 (“same-store” properties). Accordingly, the same-store data does not reflect the performance of the Georgian Terrace, which was acquired in March 2014. Each table excludes performance data for the Crowne Plaza Hollywood Beach Resort, which was acquired through a joint venture and in which we had a 25.0% indirect interest through July 31, 2015 and a 100.0% interest thereafter through December 31, 2015.\n\n| Year Ended December 31, 2015 | Year Ended December 31, 2014 |\n| Actual | Same-Store | Actual | Same-Store |\n| Occupancy % | 69.9 | % | 65.7 | % | 70.3 | % | 69.7 | % |\n| ADR | $ | 134.21 | $ | 130.09 | $ | 15.77 | $ | 124.27 |\n| RevPAR | $ | 93.80 | $ | 85.47 | $ | 88.42 | $ | 86.57 |\n\nRevenue. Total revenue for the year ended December 31, 2015 was approximately $138.5 million, an increase of approximately $15.6 million, or 12.7%, from total revenue for the year ended December 31, 2014 of approximately $122.9 million. Approximately $6.2 million of the increase relates to the acquisition of our property in Atlanta, Georgia in March 2014. Approximately $7.5 million of the increase relates to the acquisition of the remaining 75.0% interest in our property in Hollywood Beach, Florida in July 2015. Increases in revenues at our properties in Wilmington, North Carolina; Savannah, Georgia; Raleigh, North Carolina; Philadelphia, Pennsylvania; Jacksonville, Florida; Jeffersonville, Indiana; Tampa, Florida; Hampton, Virginia and Atlanta, Georgia were offset by decreases in revenue at our properties impacted by renovation activities in Laurel, Maryland and Houston, Texas, as well as by the loss of rental income associated with Shell Island which expired in December 2014.\n43\nRoom revenues at our properties for the year ended December 31, 2015 increased approximately $12.2 million, or 14.4%, to approximately $96.8 million compared to room revenues for the year ended December 31, 2014 of approximately $84.6 million. The increase in room revenue for the year ended December 31, 2015 resulted mainly from the acquired property in Atlanta, Georgia, accounting for an increase of approximately $3.3 million for the period and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $2.4 million for the period. Our properties in Wilmington, North Carolina; Savannah, Georgia; Raleigh, North Carolina; Philadelphia, Pennsylvania; Jacksonville, Florida; Tampa, Florida; and Hampton, Virginia and Atlanta, Georgia, experienced a significant increase in room revenue, offset by decreases at our properties impacted by renovation activities in Laurel, Maryland and Houston, Texas.\nFood and beverage revenues at our properties for the year ended December 31, 2015 increased approximately $1.8 million, or 5.8%, to approximately $33.3 million compared to food and beverage revenue of approximately $31.4 million for the year ended December 31, 2014. The increase in food and beverage revenues for the year ended December 31, 2015 resulted principally from our acquired property in Atlanta, Georgia, accounting for an increase of approximately $2.1 million for the period, and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $1.2 million for the period. Additional increases in food and beverage revenue at our properties in Wilmington, North Carolina; Raleigh, North Carolina and Jeffersonville, Indiana of approximately $0.3 million, were offset by decreases of approximately $1.6 million in banqueting revenue at our other properties.\nOther operating revenues for the year ended December 31, 2015 increased approximately $1.5 million, or 22.5%, to approximately $8.4 million compared to other operating revenues for the year ended December 31, 2014 of approximately $6.9 million. The increase in other operating departments revenues for the year ended December 31, 2015 resulted principally from our acquired property in Atlanta, Georgia, accounting for an increase of approximately $0.8 million for the period and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $0.5 million for the period.\nHotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses, indirect expenses, and management fees, increased approximately $11.7 million, or 12.9%, for the year ended December 31, 2015, to approximately $101.9 million compared to hotel operating expenses for the year ended December 31, 2014 of approximately $90.2 million. The increase in hotel operating expenses for the year ended December 31, 2015 was substantially related to our acquired property in Atlanta, Georgia, accounting for approximately $6.7 million of the increase in expenses for the year ended December 31, 2015 and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $9.2 million for the period, coupled by a decrease in hotel operating expenses at our same-store properties of approximately $1.0 million, mainly from reduced occupancy by 5.7% and RevPAR by 1.3% combined with decreases in expenses at our properties impacted by renovation activities in Laurel, Maryland and Houston, Texas.\nRooms expense at our properties for the year ended December 31, 2015 increased approximately $2.9 million, or 12.5%, to approximately $25.8 million compared to rooms expense of approximately $22.9 million for the year ended December 31, 2014. The increase in rooms expense for the year ended December 31, 2015 was substantially related to our acquired property in Atlanta, Georgia, accounting for approximately $1.0 million of the increase and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $1.3 million for the period.\nFood and beverage expenses at our properties for the year ended December 31, 2015 increased approximately $2.0 million, or 9.4%, to approximately $23.0 million compared to food and beverage expense of approximately $21.0 million for the year ended December 31, 2014. The increase in food and beverage expenses for the year ended December 31, 2015 was substantially related to our acquired property in Atlanta, Georgia, accounting for approximately $1.5 million of the increase and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $0.9 million for the period, offset by decreases in food and beverage expenses mainly from reduced occupancy and decreases in expenses at our property impacted by renovation activities in Houston, Texas.\nIndirect expenses at our properties for the year ended December 31, 2015 increased approximately $6.2 million, or 13.8%, to approximately $51.3 million compared to indirect expenses of approximately $45.1 million for the year ended December 31, 2014. Sales and marketing costs, franchise fees, utilities, repairs and maintenance, insurance, management fees, real and personal property taxes as well as general and administrative costs at the property level are included in indirect expenses. Most of the increase in indirect expenses related to expenses that increase proportionally with increases in occupancy and/or revenue, including management fees and franchise fees. Specifically, increases in indirect expenses were substantially related to our acquired property in Atlanta, Georgia, accounting for approximately $2.1 million of the increase and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $2.8 million for the period, compared to the year ended December 31, 2014.\n44\nDepreciation and Amortization. Depreciation and amortization for the year ended December 31, 2015 increased approximately $1.6 million, or 13.6%, to approximately $13.6 million compared to depreciation and amortization expense of approximately $12.0 million for the year ended December 31, 2014. The increase was mostly attributable to depreciation and amortization related to our acquired property in Atlanta, Georgia and depreciation and amortization related to our capital assets acquired in the fourth quarter of 2014 and the year of 2015, offset by reductions of intangible asset amortization during the year ended December 31, 2015 compared to the year ended December 31, 2014.\nImpairment of Investment in Hotel Properties, Net. The impairment of investment in hotel properties, net for the years ended December 31, 2015 and 2014, was approximately $0.5 million and $3.2 million, respectively. Our review of possible impairment at one of our hotel properties revealed an excess of current carrying cost over the estimated undiscounted future cash flows, which was triggered by a combination of a change in anticipated use and future branding of the property; and a re-evaluation of future revenues based on anticipated market conditions, market penetration and costs necessary to achieve such market penetration, resulting in an impairment to fair market value of $0.5 million, as of December 31, 2015.\nGain on Disposal of Assets. During the year ended December 31, 2015, we recorded a gain on disposal of assets of $41,435, compared to no gain or loss on disposal of assets for the year ended December 31, 2014.\nCorporate General and Administrative. Corporate general and administrative expenses for the year ended December 31, 2015 increased approximately $2.2 million, or 42.9%, to approximately $7.3 million compared to corporate general and administrative expenses of approximately $5.1 million for the year ended December 31, 2014. The increase in corporate general and administrative expenses was mainly due to an increase in acquisition costs of approximately $0.5 million, a one-time tax penalty of $0.4 million, additional staffing and related salary increase of approximately $0.3 million, increased professional fees of approximately $0.5 million, loan costs of $0.2 million on the loan modifications of the Crowne Plaza Hollywood Beach Resort mortgage and the DoubleTree by Hilton Laurel mortgage, and increased audit fees of approximately $0.1 million partially offset by a reduction in legal fees of approximately $0.1 million.\nInterest Expense. Interest expense for the year ended December 31, 2015 increased approximately $1.9 million, or 12.8%, to approximately $16.5 million compared to approximately $14.6 million of interest expense for the year ended December 31, 2014. The increase in interest expense for the year ended December 31, 2015 was substantially related to the additional mortgage on our acquired property in Atlanta, Georgia of $0.7 million, the assumed mortgage loan for the acquired property in Hollywood Beach, Florida, accounting for an increase in interest expense of approximately $1.4 million, the issuance of the 7% Notes due in 2019, accounting for an increase of approximately $1.6 million. These increases were offset by a decrease in interest from the reduction of the bridge loan with Richmond Hill Capital Partners, LP during the year ending December 31, 2015 of $1.3 million.\nEquity Income (Loss) in Joint Venture. Equity in the income of the joint venture increased approximately $0.2 million, or 54.7%, to approximately $0.5 million for the year ended December 31, 2015 compared to equity in the income of the joint venture of approximately $0.3 million for the year ended December 31, 2014 and represents our 25.0% share of the net income of the Crowne Plaza Hollywood Beach Resort through July 31, 2015. For the year ended December 31, 2015, the Crowne Plaza Hollywood Beach Resort reported occupancy of 83.1%, ADR of $174.35 and RevPAR of $144.86. This compares with results reported by the hotel for the year ended December 31, 2014 of occupancy of 83.1%, ADR of $163.13 and RevPAR of $135.55.\nLoss on Early Debt Extinguishment. The loss on early debt extinguishment for the year ended December 31, 2015 decreased approximately $0.1 million, or 7.0%, to approximately $0.7 million compared to a loss on debt extinguishment of approximately $0.8 million for the year ended December 31, 2014. During the year ended December 31, 2015, we refinanced a variable rate mortgage loan we had with the Bank of the Ozarks on the Georgian Terrace, with a new fixed rate loan from Bank of America. The amount of accumulated un-amortized loan costs of $697,582 was written off during 2015. In addition, we refinanced a variable rate mortgage loan we had with Fifth Third Bank on the DoubleTree by Hilton Jacksonville Riverfront, with a new variable rate loan from Bank of the Ozarks. The amount of accumulated un-amortized loan costs of $75,324 was written off during 2015.\nGain on Involuntary Conversion of Asset. Gain on involuntary conversion of asset for the year ended December 31, 2015 decreased approximately $0.2 million, or 100.0%, to $0 compared to approximately $0.2 million of gain on involuntary conversion of asset for the year ended December 31, 2014. During 2014, we had a one-time involuntary conversion of equipment at our Hilton Wilmington Riverside property for replacement of a water chiller in the amount of approximately $0.2 million.\nUnrealized Loss on Hedging Activities. During the year ended December 31, 2015, we refinanced a variable rate mortgage loan we had with Fifth Third Bank on the DoubleTree by Hilton Jacksonville Riverfront, with a new variable rate loan from Bank of the Ozarks. During August 2015, we purchased an interest rate cap for $179,800. As of December 31, 2015, the fair market value of the interest rate cap was $70,981. The unrealized loss on hedging activities during the years ended December 31, 2015 and 2014, was approximately $0.1 million and $0, respectively.\n45\nGain on Change in Control. On July 31, 2015, we acquired from Carlyle the remaining 75.0% interest in the entities that own and lease the Crowne Plaza Hollywood Beach Resort. Due to the increased fair market value of the property for our original 25.0% interest we recognized a discounted gain on change in control. The gain on change in control during the year ended December 31, 2015 was approximately $6.6 million while no such gain was recorded in 2014.\nIncome Tax Benefit. The income tax benefit for the year ended December 31, 2015 decreased approximately $0.4 million, or 22.7%, to approximately $1.3 million compared to an income tax benefit of approximately $1.7 million for the year ended December 31, 2014. The income tax benefit was primarily derived from the operations of our TRS Lessees. Our TRS Lessees realized lower operating loss for the year ended December 31, 2015 compared to the year ended December 31, 2014.\nNet Income (Loss). Net income for the year ended December 31, 2015 increased approximately $7.1 million, or 966.3%, to approximately $6.4 million compared to net loss of approximately $0.7 million for the year ended December 31, 2014 as a result of the operating results discussed above.\nSources and Uses of Cash\nThe following narrative discusses our sources and uses of cash for the year ended December 31, 2016.\nOperating Activities. Our principal source of cash to meet our operating requirements, including distributions to unit holders of the Operating Partnership and stockholders of the Company as well as debt service (excluding debt maturities), is the operations of our hotels. Cash flow provided by operating activities for the year ended December 31, 2016 was approximately $17.1 million. We expect that cash on hand and the net cash provided by operations will be adequate to fund our operating requirements, monthly and quarterly scheduled payments of principal and interest (excluding any balloon payments due upon maturity of a debt) and the payment of dividends (distributions) to the stockholders of the Company (the unitholders of the Operating Partnership) in accordance with federal income tax laws which require us to make annual distributions, as “qualifying distributions,” to the Company’s stockholders of at least 90.0% of its REIT taxable income (determined without regard to the dividends-paid deduction and by excluding its net capital gains, and reduced by certain non-cash items).\nInvesting Activities. During the year ended December 31, 2016, we spent approximately $14.9 million on capital expenditures, of which, approximately $5.3 million related to the routine replacement of furniture, fixtures and equipment; approximately $1.8 million related to the renovation of our property in Houston, Texas in anticipation of our newly independent hotel The Whitehall which opened in May 2016; approximately $4.9 million related to the renovation of our property in Savannah, Georgia; approximately $1.5 million related to the renovation of our property in Atlanta, Georgia; approximately $0.6 million related to the renovation of our property in Wilmington, North Carolina; approximately $0.4 million related to the renovation of our property in Laurel, Maryland and approximately $0.4 million related to the renovation of our property in Hollywood Beach, Florida.\nWe also contributed approximately $5.3 million during 2016 into reserves required by the lenders for ten of our hotels according to the provisions of their respective loan agreements. During 2016, we received reimbursements from those reserves of approximately $7.0 million for capital expenditures related to those properties for periods ending on or before December 31, 2016.\nFinancing Activities. Cash flow provided by financing activities for the year ended December 31, 2016 was approximately $16.1 million. This inflow was principally from proceeds from the sale of preferred stock of approximately $37.8 million and net mortgage proceeds of approximately $14.2 million, offset by redemption of the 8% Notes for $27.6 million, repurchase of common stock for approximately $2.1 million, dividend and distribution payments of approximately $6.2 million and payments of deferred financing costs of approximately $1.5 million.\nOn June 27, 2016, we entered into a promissory note and other loan documents to secure a $35.0 million mortgage on the Hilton Savannah DeSoto with MONY Life Insurance Company.\nOn June 30, 2016, we entered into a loan agreement and other loan documents, including a guaranty of payment by the Operating Partnership, to secure a $19.0 million mortgage on the Crowne Plaza Tampa Westshore with Fifth Third Bank.\nOn August 23, 2016, the Company issued 1,610,000 shares, $0.01 par value per share, of its 8% Series B Cumulative Redeemable Perpetual Preferred Stock for net proceeds after all expenses of approximately $37.8 million, which it contributed to the Operating Partnership for an equivalent number of preferred partnership units.\nOn September 30, 2016, the Operating Partnership redeemed the entire $27.6 million aggregate principal amount of its outstanding 8% Notes.\n46\nOn October 12, 2016, we entered into a loan agreement to secure a $20.5 million mortgage on The Whitehall with International Bank of Commerce. Pursuant to the loan documents, the loan provides initial proceeds of $15.0 million, with an additional $5.5 million available upon the satisfaction of certain conditions.\nOn November 3, 2016, we entered into a loan agreement to refinance the mortgage on the Sheraton Louisville Riverside with Symetra Life Insurance Company. Pursuant to the loan documents, the loan provides proceeds of $12.0 million.\nOn November 3, 2016, we entered into a loan agreement to modify and extend the $2.6 million mortgage on the Crowne Plaza Hampton Marina with TowneBank.\nOn December 1, 2016, we entered into a promissory note and other loan documents to secure a $35.0 million mortgage on the Hilton Wilmington Riverside with MONY Life Insurance Company. Pursuant to the loan documents, the loan provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions, namely, the completion of a renovation project.\nOn December 2, 2016, the Company’s Board of Directors authorized a stock repurchase program under which the Company may purchase up to $10.0 million of its outstanding common stock, par value $0.01 per share, at prevailing prices on the open market or in privately negotiated transactions, at the discretion of management. The Company expects to use available working capital to fund purchases under the stock repurchase program and intends to complete the repurchase program prior to December 31, 2017, unless extended by the Board of Directors. Through December 31, 2016, the Company repurchased 481,100 shares of common stock for $3.2 million and the repurchased shares have been returned to the status of authorized but unissued shares of common stock.\nThe following narrative discusses our sources and uses of cash for the year ended December 31, 2015.\nOperating Activities. Our principal source of cash to meet our operating requirements, including distributions to unit holders of the Operating Partnership and stockholders of the Company as well as debt service (excluding debt maturities), is the operations of our hotels. Cash flow provided by operating activities for the year ended December 31, 2015 was approximately $11.4 million. We expect that cash on hand and the net cash provided by operations will be adequate to fund our operating requirements, monthly and quarterly scheduled payments of principal and interest (excluding any balloon payments due upon maturity of a debt) and the payment of dividends (distributions) to the stockholders of the Company (the unitholders of the Operating Partnership) in accordance with federal income tax laws which require us to make annual distributions, as “qualifying distributions,” to the Company’s stockholders of at least 90.0% of its REIT taxable income (determined without regard to the dividends-paid deduction and by excluding its net capital gains, and reduced by certain non-cash items).\nInvesting Activities. During the year ended December 31, 2015, we used approximately $25.5 million to acquire the remaining 75.0% ownership interest in the Crowne Plaza Hollywood Beach Resort. We also spent approximately $20.1 million on capital expenditures, of which, approximately $5.1 million related to the routine replacement of furniture, fixtures and equipment; approximately $4.6 million related to the renovation of our property in Laurel, Maryland in anticipation of a new franchise agreement which commenced in October 2015; approximately $3.4 million related to the renovation of our property in Jacksonville, Florida in anticipation of a new franchise license which commenced in September 2015; approximately $3.1 million related to guestroom renovations at the Georgian Terrace; approximately $3.0 million in renovations at our property in Houston, Texas; and approximately $0.9 related to the renovation of our property in Philadelphia, Pennsylvania.\nWe also contributed approximately $5.0 million during 2015 into reserves required by the lenders for ten of our hotels according to the provisions of their respective loan agreements. During 2015, we received reimbursements from those reserves of approximately $6.4 million for capital expenditures related to those properties for periods ending on or before December 31, 2015 and we received net proceeds of approximately $2.4 million from the sale of a 0.3-acre parcel of excess land located adjacent to our property in Atlanta, Georgia and related development rights.\nFinancing Activities. Cash flow provided by financing activities for the year ended December 31, 2015 was approximately $24.6 million. This inflow was principally from proceeds from the sale of common stock of approximately $23.3 million and net mortgage proceeds of approximately $6.8 million, offset by dividend and distribution payments of approximately $4.1 million and payments of deferred financing costs of approximately $1.4 million.\nOn October 20, 2015, we secured $2.0 million of additional proceeds on the mortgage loan on the DoubleTree by Hilton Jacksonville Riverfront as part of an earn-out pursuant to the terms of the loan agreement.\nOn September 28, 2015, we entered into a loan agreement to secure a $60.0 million mortgage on the Crowne Plaza Hollywood Beach Resort with Bank of America, N.A.\n47\nOn July 17, 2015, the Company sold 435,000 shares of common stock for net proceeds of approximately $2.8 million, which it contributed to the Operating Partnership for an equivalent number of units.\nOn July 7, 2015, we entered into a loan agreement and other loan documents to secure an $18.5 million mortgage with Bank of the Ozarks collateralized by a first mortgage on the DoubleTree by Hilton Jacksonville Riverfront. The $18.5 million mortgage was received in two parts. We received $18.0 million on July 7, 2015 and the remainder of $0.5 million on October 20, 2015. The $0.5 million was included with the additional earn-out provision of $1.5 million, for a total of $2.0 million additional proceeds.\nOn July 1, 2015, the Company sold 3,000,000 shares of common stock, for net proceeds of approximately $19.8 million, which it contributed to the Operating Partnership for an equivalent number of units.\nDuring June 2015, the Company sold 98,682 shares of common stock for net proceeds of approximately $0.7 million, which it contributed to the Operating Partnership for an equivalent number of units.\nOn May 5, 2015, the Company obtained a $47.0 million mortgage with Bank of America, N.A. on the Georgian Terrace in Atlanta, Georgia.\nCapital Expenditures\nWe anticipate that our need for recurring capital expenditures for the replacement and refurbishment of furniture, fixtures and equipment over the next 12 to 24 months will be at historical norms for our properties and the industry. Historically, we have aimed to maintain overall capital expenditures, except for those required by our franchisors as a condition to a franchise license or license renewal, at 4.0% of gross revenue. In addition, during fiscal years 2017 and 2018 we expect total renovation capital expenditures of approximately $23.5 million related to our properties in Wilmington, North Carolina; Savannah, Georgia and Hollywood Beach, Florida.\nGiven our desire to proceed with the renovation activities at our properties in Wilmington, North Carolina; Savannah, Georgia and Hollywood Beach, Florida, we aim to restrict all other capital expenditures to the replacement of broken or damaged furniture and equipment and the acquisition of items mandated by our licensors that are necessary to maintain our brand affiliations. We anticipate that capital expenditures for the replacement and refurbishment of furniture, fixtures and equipment that are not related to these renovation activities to total 3.50% of gross revenues in 2017.\nWe expect capital expenditures for the recurring replacement or refurbishment of furniture, fixtures and equipment at our properties will be funded by our replacement reserve accounts, other than costs that we incur to make capital improvements required by our franchisors. Reserve accounts are escrowed accounts with funds deposited monthly and reserved for capital improvements or expenditures with respect to all of our hotels. We currently deposit an amount equal to 4.0% of gross revenue for the Hilton Savannah DeSoto, the Hilton Wilmington Riverside, the Crowne Plaza Hollywood Beach Resort, The DoubleTree by Hilton Jacksonville Riverside, the DoubleTree by Hilton Raleigh Brownstone-University, the Whitehall and the Georgian Terrace as well as 4.0% of room revenues for the DoubleTree by Hilton Philadelphia Airport on a monthly basis.\nLiquidity and Capital Resources\nAs of December 31, 2016, we had cash and cash equivalents of approximately $36.4 million, of which approximately $4.6 million was in restricted reserve accounts for capital improvements, real estate tax and insurance escrows. We expect that our cash on hand combined with our cash flow from our hotels should be adequate to fund continuing operations, recurring capital expenditures for the refurbishment and replacement of furniture, fixtures and equipment, and monthly and quarterly scheduled payments of principal and interest (excluding any balloon payments due upon maturity of the indentures or mortgage debt).\nWe intend to continue to invest in hotel properties as suitable opportunities arise. The success of our acquisition strategy depends, in part, on our ability to access additional capital through other sources. There can be no assurance that we will continue to make investments in properties that meet our investment criteria. Additionally, we may choose to dispose of certain hotels as a means to provide liquidity.\nWe expect to meet our liquidity requirements for hotel property acquisitions, property redevelopment, investments in new joint ventures and debt maturities, which include the repayment of the 7% Notes (which are callable after November 15, 2017) and the retirement of maturing mortgage debt, through net proceeds from additional issuances of common shares, additional issuances of preferred shares, issuances of units of limited partnership interest in our Operating Partnership, secured and unsecured borrowings, the selective disposition of non-core assets, and cash on hand. We remain committed to a flexible capital structure and strive to maintain prudent debt leverage.\n48\nWe do not have any debt obligations maturing until August 2018. In August 2018, the approximate $14.5 mortgage on our DoubleTree by Hilton Raleigh Brownstone University matures. We have approximately $87.6 million in debt obligations maturing in 2019, including $25.3 million of the Operating Partnership’s 7% Notes and approximately $62.3 million in mortgage debt, including reductions for future monthly principal payments on the mortgages.\nOn June 27, 2016, we entered into a promissory note and other loan documents to secure a $35.0 million mortgage on the Hilton Savannah DeSoto with MONY Life Insurance Company. The loan has a maturity date of July 1, 2026.\nOn June 30, 2016, we entered into a loan agreement and other loan documents, including a guaranty of payment by the Operating Partnership, to secure a $19.0 million mortgage on the Crowne Plaza Tampa Westshore with Fifth Third Bank. The loan has an initial term of three years with a maturity on July 1, 2019, and may be extended for two additional periods of one year each, subject to certain conditions.\nOn August 23, 2016, the Company issued 1,610,000 shares, $0.01 par value per share, of its 8% Series B Cumulative Redeemable Perpetual Preferred Stock for net proceeds after all expenses of approximately $37.8 million, which it contributed to the Operating Partnership for an equivalent number of preferred partnership units.\nOn September 30, 2016, the Operating Partnership redeemed the entire $27.6 million aggregate principal amount of its outstanding 8% Notes.\nOn October 12, 2016, we entered into a loan agreement to secure a $20.5 million mortgage on The Whitehall with International Bank of Commerce. Pursuant to the loan documents, the loan: provides initial proceeds of $15.0 million, with an additional $5.5 million available upon the satisfaction of certain conditions, has a term of five years, bears a floating interest rate of the one month LIBOR plus 3.5%, subject to a floor rate of 4.0%, amortizes on an 18-year schedule after a 2-year interest only period, is subject to prepayment fees, and is guaranteed by Sotherly Hotels LP.\nOn November 3, 2016, we entered into a loan agreement to refinance the mortgage on the Sheraton Louisville Riverside with Symetra Life Insurance Company. Pursuant to the loan documents, the loan: provides proceeds of $12.0 million, has a maturity date of December 1, 2026, bears a fixed interest rate of 4.27% for the first 5 years of the loan with an option for the lender to reset that rate after 5 years, amortizes on a 25-year schedule, is subject to prepayment fees, and is guaranteed by Sotherly Hotels LP at 50% of the unpaid principal balance, interest, and other amounts owed.\nOn December 1, 2016, we entered into a promissory note and other loan documents to secure a $35.0 million mortgage on the Hilton Wilmington Riverside with MONY Life Insurance Company. Pursuant to the loan documents, the loan: provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions, namely, the completion of a renovation project; has a term of 10 years; bears a fixed interest rate of 4.25%; amortizes on a 25-year schedule after a 1-year interest-only period and is subject to a prepayment premium.\nOn December 2, 2016, the Company’s Board of Directors authorized a stock repurchase program under which the Company may purchase up to $10.0 million of its outstanding common stock, par value $0.01 per share, at prevailing prices on the open market or in privately negotiated transactions, at the discretion of management. The Company expects to use available working capital to fund purchases under the stock repurchase program and intends to complete the repurchase program prior to December 31, 2017, unless extended by the Board of Directors. Through December 31, 2016, the Company repurchased 481,100 shares of common stock for approximately $3.2 million and the repurchased shares have been returned to the status of authorized but unissued shares of common stock.\nFinancial Covenants\nMortgage Loans\nOur mortgage loan agreements contain various financial covenants. Failure to comply with these financial covenants could result from, among other things, changes in the local competitive environment, general economic conditions and disruption caused by renovation activity or major weather disturbances.\n49\nIf we violate the financial covenants contained in these agreements, we may attempt to negotiate waivers of the violations or amend the terms of the applicable mortgage loan agreement with the lender; however, we can make no assurance that we would be successful in any such negotiation or that, if successful in obtaining waivers or amendments, such waivers or amendments would be on attractive terms. Some mortgage loan agreements provide alternate cure provisions which may allow us to otherwise comply with the financial covenants by obtaining an appraisal of the hotel, prepaying a portion of the outstanding indebtedness or by providing cash collateral until such time as the financial covenants are met by the collateralized property without consideration of the cash collateral. Alternate cure provisions which include prepaying a portion of the outstanding indebtedness or providing cash collateral may have a material impact on our liquidity.\nIf we are unable to negotiate a waiver or amendment or satisfy alternate cure provisions, if any, or unable to meet any alternate cure requirements and a default were to occur, we would possibly have to refinance the debt through additional debt financing, private or public offerings of debt securities, or additional equity financing.\nUnder the terms of our non-recourse secured mortgage loan agreements, failure to comply with the financial covenants in the loan agreement triggers cash flows from the property to be directed to the lender, which may limit our overall liquidity as that cash flow would not be available to us.\nAt December 31, 2016, we were in compliance with all debt covenants, current on all loan payments and not otherwise in default under any of our mortgage loans.\nUnsecured Notes\nThe indenture for the 7% Notes contains certain covenants and restrictions that require us to meet certain financial ratios. We are not permitted to incur any Debt (other than intercompany Debt), as defined in the indenture, if, immediately after giving effect to the incurrence of such Debt and to the application of the proceeds thereof, the ratio of the aggregate principal amount of all outstanding Debt to Adjusted Total Asset Value, as defined in the indenture, would be greater than 0.65 to 1.0. In addition, we are not permitted to incur any Debt if the ratio of Stabilized Consolidated Income Available for Debt Service to Stabilized Consolidated Interest Expense, both as defined in the indenture, on the date on which such additional Debt is to be incurred, on a pro-forma basis, after giving effect to the incurrence of such Debt and to the application of the proceeds thereof, would be less than 1.50 to 1.0.\n50\nThese financial measures are not calculated in accordance with GAAP and are presented below for the sole purpose of evaluating our compliance with the key financial covenants as they were or would have been applicable at December 31, 2016 and December 31, 2015, respectively.\n\n| December 31, | December 31, |\n| 2016 | 2015 |\n| Ratio of Stabilized Consolidated Income Available for Debt Service to Stabilized Consolidated Interest Expense |\n| Net income(1) | $ | 900,149 | $ | 6,397,653 |\n| Interest expense(1) | 17,735,107 | 16,515,827 |\n| Loss on early debt extinguishment | 1,417,905 | 772,907 |\n| Unrealized loss on hedging activities | 37,384 | 108,819 |\n| Gain on change in control | — | (6,603,148 | ) |\n| Loss (Gain) on disposal of assets | 365,319 | (41,435 | ) |\n| Income tax benefit(1) | (1,367,634 | ) | (1,336,033 | ) |\n| Equity in income of joint venture(1) | — | (475,514 | ) |\n| Impairment of investment in hotel properties, net(1) | — | 500,000 |\n| Depreciation and amortization(1) | 15,019,071 | 13,591,495 |\n| Corporate general and administrative expenses(1) | 6,021,065 | 7,268,256 |\n| Consolidated income available for debt service(1) | 40,128,366 | 36,698,827 |\n| Less: income of non-stabilized assets(1) | (10,203,893 | ) | (16,284,975 | ) |\n| Stabilized Consolidated Income Available for Debt Service(1) | $ | 29,924,473 | $ | 20,413,852 |\n| Interest expense(1) (2) | $ | 18,011,107 | $ | 16,515,827 |\n| Amortization of issuance costs(1) | (1,147,864 | ) | (1,300,032 | ) |\n| Consolidated interest expense(1) | 16,863,243 | 15,215,795 |\n| Less: interest expense of non-stabilized assets(1) | (3,417,412 | ) | (5,295,224 | ) |\n| Stabilized Consolidated Interest Expense(1) | $ | 13,445,831 | $ | 9,920,571 |\n| Ratio of Stabilized Consolidated Income Available for Debt Service to Stabilized Consolidated Interest Expense | 2.23 | 2.06 |\n| Threshold Ratio Minimum | 1.50 | 1.50 |\n| Ratio of Debt to Adjusted Total Asset Value: |\n| Mortgage loans | $ | 284,757,698 | $ | 271,977,944 |\n| Unsecured notes | 25,300,000 | 52,900,000 |\n| Total debt | $ | 310,057,698 | $ | 324,877,944 |\n| Stabilized Consolidated Income Available for Debt Service(1) | $ | 29,924,473 | $ | 20,413,852 |\n| Capitalization rate | 7.5 | % | 7.5 | % |\n| 398,992,973 | 272,184,693 |\n| Non-stabilized assets | 145,400,000 | 305,255,698 |\n| Total cash | 36,362,920 | 17,287,754 |\n| Adjusted Total Asset Value | $ | 580,755,893 | $ | 594,728,145 |\n| Ratio of Debt to Adjusted Total Asset Value | 0.53 | 0.55 |\n| Threshold Ratio Maximum | 0.65 | 0.65 |\n\n\n| (1) | As permitted by the indenture, the Hilton Savannah DeSoto, DoubleTree by Hilton Laurel, DoubleTree by Hilton Jacksonville Riverfront and The Whitehall, for the period ended December 31, 2016, and the DoubleTree by Hilton Laurel, DoubleTree by Hilton Jacksonville Riverfront and Crowne Plaza Hollywood Beach Resort, for the period ended December 31, 2015, are considered non-stabilized assets for purposes of the financial covenants. |\n\n| (2) | Includes losses on debt extinguishment paid for in cash of $276,000 in fiscal year 2016. |\n\n51\nMortgage Debt\nAs of December 31, 2016, we had a principal mortgage debt balance of approximately $284.5 million. The following table sets forth our mortgage debt obligations on our hotels.\n\n| December 31, | Prepayment | Maturity | Amortization |\n| Property | 2016 | Penalties | Date | Provisions | Interest Rate |\n| Crowne Plaza Hampton Marina (1) | $ | 2,584,633 | None | 11/1/2019 | $ | 3 years | 5.00% |\n| Crowne Plaza Hollywood Beach Resort (2) | 58,935,818 | N/A | 10/1/2025 | 30 years | 4.913% |\n| Crowne Plaza Tampa Westshore (3) | 15,561,400 | None | 6/30/2019 | 25 years | LIBOR plus 3.75 % |\n| DoubleTree by Hilton Jacksonville Riverfront (4) | 19,291,716 | Yes | 7/7/2019 | 25 years | LIBOR plus 3.50 % |\n| DoubleTree by Hilton Laurel (5) | 9,329,005 | Yes | 8/5/2021 | 25 years | 5.25% |\n| DoubleTree by Hilton Philadelphia Airport (6) | 31,261,991 | None | 4/1/2019 | 25 years | LIBOR plus 3.00 % |\n| DoubleTree by Hilton Raleigh Brownstone University (7) | 14,773,885 | N/A | 8/1/2018 | 30 years | 4.78% |\n| The Georgian Terrace (8) | 45,826,038 | N/A | 6/1/2025 | 30 years | 4.42% |\n| Hilton Savannah DeSoto (9) | 30,000,000 | Yes | 7/1/2026 | 25 years | 4.25% |\n| Hilton Wilmington Riverside (10) | 30,000,000 | Yes | 1/1/2027 | 25 years | 4.25% |\n| Sheraton Louisville Riverside (11) | 11,977,557 | Yes | 12/1/2026 | 25 years | 4.27% |\n| The Whitehall (12) | 15,000,000 | Yes | 10/12/2021 | 18 years | LIBOR plus 3.50 % |\n| Total Mortgage Principal Balance | 284,542,043 |\n| Deferred financing costs, net | (2,049,409) |\n| Unamortized premium on loan | 215,655 |\n| Total Mortgage Loans | $ | 282,708,289 |\n\n\n| (1) | The note was extended and modified in November 2016 for 3 years until November 1, 2019 and the Operating Partnership was required to make monthly principal payments of $15,367. The note rate was changed to a fixed rate of 5.00%, effective June 27, 2014. As of February 7, 2017, the note is no longer outstanding. |\n\n| (2) | With limited exception, the note may not be prepaid until June 2025. |\n\n| (3) | The note provides initial proceeds of $15.7 million, with an additional $3.3 million available upon the satisfaction of certain conditions; bears a floating interest rate of the 1-month LIBOR plus 3.75%, subject to a floor rate of 3.75%; the note provides that the mortgage can be extended for two additional periods of one year each, subject to certain conditions. |\n\n| (4) | The note is subject to a pre-payment penalty until July 2017. Prepayment can be made without penalty thereafter. The note provides that the mortgage can be extended until July 2020 if certain conditions have been satisfied. |\n\n| (5) | The note is subject to a pre-payment penalty except for any pre-payments made either between April 2017 and August 2017, or from April 2021 through maturity of the note. The note provides that on January 5, 2018, the rate of interest will adjust to a rate of 3.00% per annum plus the then-current five-year U.S. Treasury rate of interest, with a floor of 5.25%. |\n\n| (6) | The note bears a minimum interest rate of 3.50%. |\n\n| (7) | With limited exception, the note may not be prepaid until two months before maturity. |\n\n| (8) | With limited exception, the note may not be prepaid until February 2025. |\n\n| (9) | The note provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions, namely, the completion of a renovation project; amortizes on a 25-year schedule after a 1-year interest-only period; and is subject to a pre-payment penalty except for any pre-payments made within 120 days of the maturity date. |\n\n| (10) | The note provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions namely, the completion of a renovation project. The note amortizes on a 25-year schedule after a 1-year interest-only period; and is subject to a pre-payment penalty except for any pre-payments made within 120 days of the maturity date. |\n\n| (11) | The note bears a fixed interest rate of 4.27% for the first 5 years of the loan, with an option for the lender to reset the interest rate after 5 years. |\n\n| (12) | The note was refinanced in October 2016, provides initial proceeds of $15.0 million, with an additional $5.5 million available upon the satisfaction of certain conditions; bears a floating interest rate of the 1-month LIBOR plus 3.5%, subject to a floor rate of 4.0%; and is subject to prepayment penalties subject to a declining scale from 3.0% penalty on or before the first anniversary date, a 2.0% penalty during the second anniversary year and a 1.0% penalty after the third anniversary date. |\n\n52\nContractual Obligations\nThe following table outlines our contractual obligations as of December 31, 2016, and the effect such obligations are expected to have on our liquidity and cash flow in future periods (in thousands).\n\n| Payments due by period (in thousands) |\n| Less than | More than |\n| Contractual Obligations | Total | 1 year | 1-3 years | 3-5 years | 5 years |\n| Mortgage loans, including interest | $ | 355,927 | $ | 18,895 | $ | 119,609 | $ | 55,911 | $ | 161,512 |\n| Unsecured notes, including interest | 30,416 | 1,771 | 28,645 | — | — |\n| Ground, building, office and equipment leases | 1,137 | 224 | 276 | 191 | 446 |\n| Purchase commitment | 4,250 | 4,250 | — | — | — |\n| Totals | $ | 391,730 | $ | 25,140 | $ | 148,530 | $ | 56,102 | $ | 161,958 |\n\nIn connection with the acquisition of our six initial hotel properties, we entered into tax indemnity agreements that required us to indemnify the contributors of our initial properties against tax liabilities in the event we sold any of those properties in a taxable transaction during a 10-year period. The tax indemnity agreements expired on or about December 22, 2014. Our obligations under the contribution agreements may effectively preclude us from reducing our consolidated indebtedness below approximately $11.0 million.\nOff Balance Sheet Arrangements. Through a joint venture with a Carlyle subsidiary, we owned a 25.0% indirect, noncontrolling interest in an entity (the “JV Owner”) that acquired the 311-room Crowne Plaza Hollywood Beach Resort in Hollywood, Florida. We had the right to receive a pro rata share of operating surpluses and we had an obligation to fund our pro rata share of operating shortfalls. We also had the opportunity to earn an incentive participation in the net proceeds realized from the sale of the hotel based upon the achievement of certain overall investment returns, in addition to our pro rata share of net sale proceeds. The Crowne Plaza Hollywood Beach Resort was leased to another entity (the “Joint Venture Lessee”) in which we also owned a 25.0% indirect, noncontrolling interest.\nCarlyle owned a 75.0% controlling interest in the entities that own and lease the Crowne Plaza Hollywood Beach Resort. Carlyle had the right to dispose of the Crowne Plaza Hollywood Beach Resort without our consent. We accounted for our noncontrolling 25.0% interest in all of these entities under the equity method of accounting.\nOn July 31, 2015, indirect subsidiaries of the Operating Partnership acquired from Carlyle the remaining 75.0% interest in the entities that own and lease the Crowne Plaza Hollywood Beach Resort. As a result, the Operating Partnership now has a 100% indirect ownership interest in the entities that own the Crowne Plaza Hollywood Beach Resort. The property was refinanced on September 28, 2015 and is encumbered by a $60.0 million mortgage which matures in September 2025 and requires monthly payments of interest at a rate of 4.913%. The Crowne Plaza Hollywood Beach Resort secures the mortgage.\nDistributions to Stockholders and Holders of Units in the Operating Partnership. The Company has elected to be taxed as a REIT commencing with our taxable year ending December 31, 2004. To maintain qualification as a REIT, the Company is required to make annual distributions to its stockholders of at least 90.0% of our REIT taxable income, (excluding net capital gain, which does not necessarily equal net income as calculated in accordance with generally accepted accounting principles). The Company’s ability to pay distributions to its stockholders will depend, in part, upon its receipt of distributions from the Operating Partnership which may depend upon receipt of lease payments with respect to our properties from our TRS Lessees, and in turn, upon the management of our properties by our hotel manager. Distributions to the Company’s stockholders will generally be taxable to the Company’s stockholders as ordinary income; however, because a portion of our investments will be equity ownership interests in hotels, which will result in depreciation and non-cash charges against our income, a portion of our distributions may constitute a non-taxable return of capital. To the extent not inconsistent with maintaining the Company’s REIT status, our TRS Lessees may retain any after-tax earnings.\nDistributions to Preferred Stockholders and Holder of Preferred partnership units in the Operating Partnership. The Company is obligated to pay distributions to its preferred stockholders of the Company’s preferred stock and the Operating Partnership is obligated to pay its preferred unit holder, the Company. Holders of the Company’s 8% Series B Cumulative Redeemable Preferred Stock are entitled to receive distributions when authorized by the Company’s board of directors out of assets legally available for the payment of distributions. The amount of annual dividends on our outstanding preferred shares is approximately $3.2 million and the aggregate liquidation preference with respect to our outstanding preferred shares is approximately $40.3 million. The preferred stock is not redeemable by the holders, has no maturity date and is not convertible into any other security of the Company or its affiliates, except in the event of a change of control.\n53\nThe Company’s ability to pay distributions to its stockholders will depend, in part, upon its receipt of distributions from the Operating Partnership which may depend upon receipt of lease payments with respect to our properties from our TRS Lessees, and in turn, upon the management of our properties by our hotel manager. Distributions to the Company’s stockholders will generally be taxable to the Company’s stockholders as ordinary income; however, because a portion of our investments will be equity ownership interests in hotels, which will result in depreciation and non-cash charges against our income, a portion of our distributions may constitute a non-taxable return of capital. To the extent not inconsistent with maintaining the Company’s REIT status, our TRS Lessees may retain any after-tax earnings.\nThe amount, timing and frequency of distributions will be authorized by the Company’s board of directors and declared by the Company based upon a variety of factors deemed relevant by its directors, and no assurance can be given that the distribution policy will not change in the future.\nInflation\nWe generate revenues primarily from lease payments from our TRS Lessees and net income from the operations of our TRS Lessees. Therefore, we rely primarily on the performance of the individual properties and the ability of the management company to increase revenues and to keep pace with inflation. Operators of hotels, in general, possess the ability to adjust room rates daily to keep pace with inflation. However, competitive pressures at some or all of our hotels may limit the ability of the management company to raise room rates.\nOur expenses, including hotel operating expenses, administrative expenses, real estate taxes and property and casualty insurance are subject to inflation. These expenses are expected to grow with the general rate of inflation, except for energy, liability insurance, property and casualty insurance, property tax rates, employee benefits, and some wages, which are expected to increase at rates higher than inflation.\nGeographic Concentration and Seasonality\nOur hotels are located in Florida, Georgia, Indiana, Maryland, North Carolina, Pennsylvania, and Texas. As a result, we are particularly susceptible to adverse market conditions in these geographic areas, including industry downturns, relocation of businesses and any oversupply of hotel rooms or a reduction in lodging demand. Adverse economic developments in the markets in which we have a concentration of hotels, or in any of the other markets in which we operate, or any increase in hotel supply or decrease in lodging demand resulting from the local, regional or national business climate, could materially and adversely affect us.\nThe operations of our hotel properties have historically been seasonal. The months of April and May are traditionally strong, as is October. The periods from mid-November through mid-February are traditionally slow with the exception of hotels located in certain markets, namely Florida and Texas, which experience significant room demand during this period.\nCompetition\nThe hotel industry is highly competitive with various participants competing on the basis of price, level of service and geographic location. Each of our hotels is located in a developed area that includes other hotel properties. The number of competitive hotel properties in a particular area could have a material adverse effect on occupancy, ADR and RevPAR of our hotels or at hotel properties acquired in the future. We believe that brand recognition, location, the quality of the hotel, consistency of services provided, and price, are the principal competitive factors affecting our hotels.\nCritical Accounting Policies\nThe critical accounting policies are described below. We consider these policies critical because they involve difficult management judgments and assumptions, are subject to material change from external factors or are pervasive, and are significant to fully understand and evaluate our reported financial results.\nInvestment in Hotel Properties. Hotel properties are stated at cost, net of any impairment charges, and are depreciated using the straight-line method over an estimated useful life of 7-39 years for buildings and improvements and 3-10 years for furniture and equipment. In accordance with generally accepted accounting principles, the controlling interests in hotels comprising our accounting predecessor, MHI Hotels Services Group, and noncontrolling interests held by the controlling holders of our accounting predecessor in hotels, which were acquired from third parties contributed to us in connection with the Company’s initial public offering, are recorded at historical cost basis. Noncontrolling interests in those entities that comprise our accounting predecessor and the interests in hotels, other than those held by the controlling members of our accounting predecessor, acquired from third parties are recorded at fair value at the time of acquisition.\n54\nWe review our hotel properties for impairment whenever events or changes in circumstances indicate the carrying value of the hotel properties may not be recoverable. Events or circumstances that may cause us to perform our review include, but are not limited to, adverse permanent changes in the demand for lodging at our properties due to declining national or local economic conditions and/or new hotel construction in markets where our hotels are located. When such conditions exist, management performs a recoverability analysis to determine if the estimated undiscounted future cash flows from operating activities and the estimated proceeds from the ultimate disposition of a hotel property exceed its carrying value. If the estimated undiscounted future cash flows are found to be less than the carrying amount of the hotel property, an adjustment to reduce the carrying value to the related hotel property’s estimated fair market value would be recorded and an impairment loss recognized.\nOur review of possible impairment at one of our hotel properties revealed an excess of current carrying cost over the estimated undiscounted future cash flows, which resulted in an impairment to fair market value by an approximate amounts of $0.5 million and $3.2 million, as of December 31, 2015 and 2014, respectively.\nIn performing the recoverability analysis, we project future operating cash flows based upon significant assumptions regarding growth rates, occupancy, room rates, economic trends, property-specific operating costs and future capital expenditures required to maintain the hotel in its current operating condition. We also project cash flows from the eventual disposition of the hotel based upon various factors including property-specific capitalization rates, ratio of selling price to gross hotel revenues and the selling price per room.\nRevenue Recognition. Hotel revenues, including room, food, beverage and other hotel revenues, are recognized as the related services are delivered. We generally consider accounts receivable to be fully collectible; accordingly, no allowance for doubtful accounts is required. If we determine that amounts are uncollectible, which would generally be the result of a customer’s bankruptcy or other economic downturn, such amounts will be charged against operations when that determination is made.\nIncome Taxes. We record a valuation allowance to reduce deferred tax assets to an amount that we believe is more likely than not to be realized. Because of expected future taxable income of our TRS Lessee, we have not recorded a valuation allowance to reduce our net deferred tax asset as of December 31, 2016. We regularly evaluate the likelihood that our TRS Lessee will be able to realize its deferred tax assets and the continuing need for a valuation allowance. At December 31, 2016, we determined, based on all available positive and negative evidence, that it is more-likely-than-not that future taxable income will be available during the carryforward periods to absorb all of the consolidated federal and state net operating loss carryforward. A number of factors played a critical role in this determination, including:\n| • | a demonstrated track record of past profitability and utilization of past NOL carryforwards, |\n\n| • | reasonable forecasts of future taxable income, and |\n\n| • | anticipated changes in the lease rental payments from the TRS Lessee to subsidiaries of the Operating Partnership. |\n\nShould unanticipated adverse financial trends occur, or other negative evidence develop, a valuation allowance may be necessary in the future against some or all of our deferred tax assets.\nRecent Accounting Pronouncements\nFor a summary of recently adopted and newly issued accounting pronouncements, please refer to the Recent Accounting Pronouncements section of Note 2, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements.\nNon-GAAP Financial Measures\nWe consider FFO, Adjusted FFO and Hotel EBITDA, all of which are non-GAAP financial measures, to be key supplemental measures of our performance and could be considered along with, not alternatives to, net income (loss) as a measure of our performance. These measures do not represent cash generated from operating activities determined by generally accepted accounting principles (“GAAP”) or amounts available for our discretionary use and should not be considered alternative measures of net income, cash flows from operations or any other operating performance measure prescribed by GAAP.\nFFO and Adjusted FFO. Industry analysts and investors use Funds from Operations (“FFO”), as a supplemental operating performance measure of an equity REIT. FFO is calculated in accordance with the definition adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). FFO, as defined by NAREIT, represents net income or loss determined in accordance with GAAP, excluding extraordinary items as defined under GAAP and gains or losses from sales of previously depreciated operating real estate assets, plus certain non-cash items such as real estate asset depreciation and amortization,\n55\nand after adjustment for any noncontrolling interest from unconsolidated partnerships and joint ventures. Historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen or fallen with market conditions, many investors and analysts have considered the presentation of operating results for real estate companies that use historical cost accounting to be insufficient by itself.\nWe consider FFO to be a useful measure of adjusted net income (loss) for reviewing comparative operating and financial performance because we believe FFO is most directly comparable to net income (loss), which remains the primary measure of performance, because by excluding gains or losses related to sales of previously depreciated operating real estate assets and excluding real estate asset depreciation and amortization, FFO assists in comparing the operating performance of a company’s real estate between periods or as compared to different companies. Although FFO is intended to be a REIT industry standard, other companies may not calculate FFO in the same manner as we do, and investors should not assume that FFO as reported by us is comparable to FFO as reported by other REITs.\nWe further adjust FFO for certain additional items that are not in NAREIT’s definition of FFO, including changes in deferred income taxes, any unrealized gain (loss) on hedging instruments or warrant derivative, loan impairment losses, losses on early extinguishment of debt, aborted offering costs, loan modification fees, franchise termination costs, costs associated with the departure of executive officers, litigation settlement, over-assessed real estate taxes on appeal, change in control gains or losses and acquisition transaction costs. We exclude these items as we believe it allows for meaningful comparisons between periods and among other REITs and is more indicative than FFO of the on-going performance of our business and assets. Our calculation of Adjusted FFO may be different from similar measures calculated by other REITs.\nThe following is a reconciliation of net income (loss) to FFO and Adjusted FFO for the years ended December 31, 2016, 2015, and 2014.\n\n| Year Ended | Year Ended | Year Ended |\n| December 31, | December 31, | December 31, |\n| 2016 | 2015 | 2014 |\n| Net Income/(Loss) Attributable to the Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) |\n| Add: Net Income/(Loss) Attributable to the Noncontrolling Interest | (26,567 | ) | 1,040,987 | (153,838 | ) |\n| Depreciation and Amortization | 15,019,071 | 13,591,495 | 11,969,284 |\n| Impairment of Investment in Hotel Properties, Net | — | 500,000 | 3,175,000 |\n| Equity in Depreciation on Joint Venture | — | 259,279 | 529,053 |\n| Gain on Change in Control | — | (6,603,148 | ) | — |\n| Loss (Gain) on Disposal of Assets | 365,319 | (41,435 | ) | — |\n| Gain on Involuntary Conversion of Asset | — | — | (169,151 | ) |\n| Funds From Operations | $ | 15,139,650 | $ | 14,103,844 | $ | 14,765,677 |\n| Increase in Deferred Income Taxes | (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) |\n| Acquisition Costs | — | 634,376 | 155,187 |\n| Loss on Starwood Settlement | — | 324,271 | — |\n| Over-Assessed Real Estate Taxes Under Appeal | — | 497,733 | — |\n| Loan Modification Fees | 64,215 | 243,229 | — |\n| Franchise Termination Fee | — | — | 351,800 |\n| Realized and Unrealized Loss on Hedging Activities (A) | 37,384 | 108,819 | — |\n| Loss on Early Debt Extinguishment (A) | 1,417,905 | 772,907 | 831,079 |\n| Adjusted FFO | $ | 15,100,188 | $ | 14,904,608 | $ | 14,142,080 |\n\n\n| (A) | Includes equity in unrealized (gain)/loss on hedging activities and loss on early extinguishment of debt of joint venture. |\n\nHotel EBITDA. We define Hotel EBITDA as net income or loss excluding: (1) interest expense, (2) interest income, (3) income tax provision or benefit, (4) equity in the income or loss of equity investees, (5) unrealized gains and losses on derivative instruments not included in other comprehensive income, (6) gains and losses on disposal of assets, (7) realized gains and losses on investments, (8) impairment of long-lived assets or investments, (9) loss on early debt extinguishment, (10) gains or losses on change in control, (11) corporate general and administrative expense, (12) depreciation and amortization, (13) gains and losses on involuntary conversions of assets and (14) other operating revenue not related to our wholly-owned portfolio. We believe this provides a more\n56\ncomplete understanding of the operating results over which our wholly-owned hotels and its operators have direct control. We believe Hotel EBITDA provides investors with supplemental information on the on-going operational performance of our hotels and the effectiveness of third-party management companies operating our business on a property-level basis.\nOur calculation of Hotel EBITDA may be different from similar measures calculated by other REITs.\nThe following is a reconciliation of net loss to Hotel EBITDA for the years ended December 31, 2016, 2015, and 2014.\n\n| Year Ended | Year Ended | Year Ended |\n| December 31, | December 31, | December 31, |\n| 2016 | 2015 | 2014 |\n| Net Income/(Loss) Attributable to the Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) |\n| Add: Net Income/(Loss) Attributable to the Noncontrolling Interest | (26,567 | ) | 1,040,987 | (153,838 | ) |\n| Interest Expense | 17,735,107 | 16,515,827 | 14,636,870 |\n| Interest Income | (115,785 | ) | (50,461 | ) | (19,865 | ) |\n| Distributions to Preferred Stockholders | 1,144,889 | — | — |\n| Income Tax Benefit | (1,367,634 | ) | (1,336,033 | ) | (1,727,723 | ) |\n| Depreciation and Amortization | 15,019,071 | 13,591,495 | 11,969,284 |\n| Equity in Earnings of Joint Venture | — | (475,514 | ) | (307,370 | ) |\n| Unrealized Loss on Hedging Activities | 37,384 | 108,819 | — |\n| Gain on Change in Control | — | (6,603,148 | ) | — |\n| Loss on Debt Extinguishment | 1,417,905 | 772,907 | 831,079 |\n| Loss (Gain) on Disposal of Assets | 365,319 | (41,435 | ) | — |\n| Gain on Involuntary Conversion of Asset | — | — | (169,151 | ) |\n| Impairment of Investment in Hotel Properties, Net | — | 500,000 | 3,175,000 |\n| Corporate General and Administrative Expenses | 6,021,065 | 7,268,256 | 5,085,949 |\n| Net Lease Rental Income | — | — | (350,000 | ) |\n| Other Fee Income | — | (200,976 | ) | (300,607 | ) |\n| Hotel EBITDA | $ | 40,012,581 | $ | 36,447,390 | $ | 32,084,957 |\n\n\nQuantitative and Qualitative Disclosures about Market Risk\nThe effects of potential changes in interest rates are discussed below. Our market risk discussion includes “forward-looking statements” and represents an estimate of possible changes in fair value or future earnings that could occur assuming hypothetical future movements in interest rates. These disclosures are not precise indicators of expected future losses, but only indicators of reasonably possible losses. As a result, actual future results may differ materially from those presented. The analysis below presents the sensitivity of the market value of our financial instruments to selected changes in market interest rates.\nTo meet in part our long-term liquidity requirements, we will borrow funds at a combination of fixed and variable rates. Our interest rate risk management objective is to limit the impact of interest rate changes on earnings and cash flows and to lower our overall borrowing costs. From time to time we may enter into interest rate hedge contracts such as collars and treasury lock agreements in order to mitigate our interest rate risk with respect to various debt instruments. We do not intend to hold or issue derivative contracts for trading or speculative purposes.\nAs of December 31, 2016, we had approximately $228.7 million of fixed-rate debt and approximately $81.1 million of variable-rate debt. The weighted-average interest rate on the fixed-rate debt was 4.84%. A change in market interest rates on the fixed portion of our debt would impact the fair value of the debt, but have no impact on interest incurred or cash flows. Our variable-rate debt is exposed to changes in interest rates, specifically the changes in 1-month LIBOR. However, to the extent that 1-month LIBOR does not exceed the 1-month LIBOR floor on the mortgage on the DoubleTree by Hilton Philadelphia Airport of 0.50%, a portion of our variable-rate debt would not be exposed to changes in interest rates. Assuming that the aggregate amount outstanding on the mortgages on the Crowne Plaza Tampa Westshore, DoubleTree by Hilton Philadelphia Airport, DoubleTree by Hilton Jacksonville Riverfront and the mortgage on The Whitehall remains at approximately $81.1 million, the balance at December 31, 2016, the impact on our annual interest incurred and cash flows of a one percent increase in 1-month LIBOR would be approximately $0.8 million.\nAs of December 31, 2015, we had approximately $272.6 million of fixed-rate debt and approximately $52.3 million of variable-rate debt. The weighted-average interest rate on the fixed-rate debt was 5.58%. A change in market interest rates on the fixed portion\n57\nof our debt would impact the fair value of the debt, but have no impact on interest incurred or cash flows. Our variable-rate debt is exposed to changes in interest rates, specifically the changes in 1-month and 3-month LIBOR. However, to the extent that 1-month LIBOR does not exceed the 1-month LIBOR floor on the mortgage on the DoubleTree by Hilton Philadelphia Airport of 0.50%, a portion of our variable-rate debt would not be exposed to changes in interest rates. Assuming that the aggregate amount outstanding on the mortgage on the DoubleTree by Hilton Philadelphia Airport and the mortgage on the DoubleTree by Hilton Jacksonville Riverfront remains at approximately $52.2 million, the balance at December 31, 2015, the impact on our annual interest incurred and cash flows of a one percent increase in 1-month LIBOR and 3-month LIBOR would be approximately $0.5 million.\nFinancial Statements and Supplementary Data\nSee Index to Financial Statements and Financial Statement Schedules on page F-1.\nChanges in and Disagreements with Accountants on Accounting and Financial Disclosure\nNone.\nControls and Procedures\nSotherly Hotels Inc.\nDisclosure Controls and Procedures\nThe Company’s management, under the supervision and participation of its Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of its disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as required by paragraph (b) of Rules 13a-15 and 15d-15 under the Exchange Act), as of December 31, 2016. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of December 31, 2016, its disclosure controls and procedures were effective and designed to ensure that (i) information required to be disclosed in its reports filed under the Exchange Act is recorded, processed, summarized and reported with the time periods specified in the SEC’s rules and instructions, and (ii) information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.\nThe Company’s management, including its Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s disclosure controls and procedures or its internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of the controls can provide absolute assurance that all control issues and instances of fraud, if any, within Sotherly Hotels Inc. have been detected.\nManagement’s Report on Internal Control over Financial Reporting\nThe Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(e) under the Exchange Act). The Company’s management assessed the effectiveness over internal control over financial reporting as of December 31, 2016. In making this assessment, the Company’s management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) 2013 Internal Control-Integrated Framework. The Company’s management has concluded that, as of December 31, 2016, its internal control over financial reporting is effective based on these criteria.\nThis annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s independent registered public accounting firm pursuant to the exemption provided to issuers that are not “large accelerated filers” or “accelerated filers” under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.\n58\nChanges in Internal Control over Financial Reporting\nThere was no change in Sotherly Hotels Inc.’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Exchange Act during Sotherly Hotels Inc.’s last fiscal quarter that materially affected, or is reasonably likely to materially affect, Sotherly Hotels Inc.’s internal control over financial reporting.\nSotherly Hotels LP\nDisclosure Controls and Procedures\nThe Operating Partnership’s management, under the supervision and participation of the Chief Executive Officer and Chief Financial Officer of Sotherly Hotels Inc., as general partner, has evaluated the effectiveness of the disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, as required by paragraph (b) of Rules 13a-15 and 15d-15 under the Exchange Act), as of December 31, 2016. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of December 31, 2016, the disclosure controls and procedures were effective and designed to ensure that (i) information required to be disclosed in the reports filed under the Exchange Act is recorded, processed, summarized and reported with the time periods specified in the SEC’s rules and instructions, and (ii) information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.\nThe Operating Partnership’s management, including the Chief Executive Officer and Chief Financial Officer of Sotherly Hotels Inc., as general partner, does not expect that the disclosure controls and procedures or the internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of the controls can provide absolute assurance that all control issues and instances of fraud, if any, within Sotherly Hotels LP have been detected.\nManagement’s Report on Internal Control over Financial Reporting\nThe Operating Partnership’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(e) under the Exchange Act). Management assessed the effectiveness over internal control over financial reporting as of December 31, 2016. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in 2013 Internal Control-Integrated Framework. Management has concluded that, as of December 31, 2016, the Operating Partnership’s internal control over financial reporting is effective based on these criteria.\nThis annual report does not include an attestation report of the Operating Partnership’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Operating Partnership’s independent registered public accounting firm pursuant to the exemption provided to issuers that are not “large accelerated filers” or “accelerated filers” under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.\nChanges in Internal Control over Financial Reporting\nThere was no change in Sotherly Hotels LP’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Exchange Act during Sotherly Hotels LP’s last fiscal quarter that materially affected, or is reasonably likely to materially affect, Sotherly Hotels LP’s internal control over financial reporting.\nOther Information\nNone.\n59\nPART III\nThe information required by Items 10-14 is incorporated by reference to the Company’s proxy statement for the 2017 annual meeting of stockholders (to be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year covered by this report).\nDirectors, Executive Officers and Corporate Governance\nThe Company has adopted a code of business conduct and ethics, including a conflicts of interest policy that applies to its principal executive officer, principal financial officer, principal accounting officer or controller performing similar functions. We intend to maintain the highest standards of ethical business practices and compliance with all laws and regulations applicable to our business. A copy of the Company’s Code of Business Conduct is posted on the Company’s external website at www.sotherlyhotels.com. The Company and the Operating Partnership intend to post to its website any amendments to or waivers of its code. The Operating Partnership is managed by the Company, its sole general partner and parent company. Consequently, the Operating Partnership does not have its own separate directors or executive officers.\nInformation on the Company’s directors is incorporated by reference to the sections captioned “Proposal I – Election of Directors” and “Section 16(a) Beneficial Ownership Reporting Compliance” contained in the Company’s 2017 Proxy Statement.\n. Executive Compensation\nThe information required by this item is incorporated by reference to the section captioned “Director and Executive Compensation” contained in the Company’s 2017 Proxy Statement.\nSecurity Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters\n(a) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS\nInformation required by this item is incorporated herein by reference to the section captioned “Principal Holders” of the Company’s 2017 Proxy Statement.\n(b) SECURITY OWNERSHIP OF MANAGEMENT\nInformation required by this item is incorporated herein by reference to the section captioned “Principal Holders” of the Company’s 2017 Proxy Statement.\n(c) CHANGES IN CONTROL\nManagement of the Company knows of no arrangements, including any pledge by any person of securities of the Company, the operation of which may at a subsequent date result in a change in control of the Company.\n(d) SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS\nSet forth below is information as of December 31, 2016 with respect to compensation plans under which equity securities of the Company are authorized for issuance.\n60\nEQUITY COMPENSATION PLAN INFORMATION\n\n| NUMBER OF SECURITIES TO BE ISSUED UPON EXERCISE OF OUTSTANDING OPTIONS, WARRANTS AND RIGHTS | WEIGHTED-AVERAGE EXERCISE PRICE OF OUTSTANDING OPTIONS, WARRANTS AND RIGHTS | NUMBER OF SECURITIES REMAINING AVAILABLE FOR FUTURE ISSUANCE |\n| Equity compensation plans approved by security holders: |\n| 2013 Plan (1) | N/A | N/A | 640,900 |\n| Equity compensation plans not approved by security holders: |\n| None | N/A | N/A | N/A |\n| Total | N/A | N/A | 640,900 |\n\n\n| (1) | On February 2, 2016, we granted 8,000 shares of stock to Andrew M. Sims, 6,000 shares of stock to Anthony E. Domalski, 7,000 shares of stock to David R. Folsom, and 1,000 shares of stock to other employees of the Company. |\n\nOn February 2, 2016, we granted 12,000 shares (3,000 each) of restricted stock to certain of our independent directors that vested on December 31, 2016. Also on February 2, 2016, we granted an additional 2,250 shares of unrestricted stock to director Herschel J. Walker in consideration for his service during 2015.\nOn February 15, 2017, we granted 12,000 shares (3,000 each) of restricted stock to certain of our independent directors that will vest on December 31, 2017. These shares are included in the number of securities remaining available for future issuance at December 31, 2016.\nCertain Relationships and Related Transactions, and Director Independence\nThe information required by this item is incorporated by reference to the sections captioned “Certain Relationships and Related Transactions” and “Proposal I – Election of Directors” in the Company’s 2017 Proxy Statement.\nPrincipal Accountant Fees and Services\nThe information required by this item is incorporated by reference to the section captioned “Proposal II –Ratification of Appointment of Accountants” in the Company’s 2017 Proxy Statement.\n61\nPART IV\nExhibits and Financial Statement Schedules\n\n| 1. Financial Statements |\n| Index to Financial Statements and Financial Statement Schedules | F-1 |\n| Sotherly Hotels Inc. |\n| Report of Independent Registered Public Accounting Firm, Dixon Hughes Goodman LLP | F-2 |\n| Report of Independent Registered Public Accounting Firm, Grant Thornton LLP | F-3 |\n| Consolidated Balance Sheets for Sotherly Hotels Inc. as of December 31, 2016 and 2015 | F-4 |\n| Consolidated Statements of Operations for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-5 |\n| Consolidated Statements of Changes in Equity for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-6 |\n| Consolidated Statements of Cash Flows for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-7 |\n| Sotherly Hotels LP |\n| Report of Independent Registered Public Accounting Firm, Dixon Hughes Goodman LLP | F-8 |\n| Report of Independent Registered Public Accounting Firm, Grant Thornton LLP | F-9 |\n| Consolidated Balance Sheets for Sotherly Hotels LP as of December 31, 2016 and 2015 | F-10 |\n| Consolidated Statements of Operations for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-11 |\n| Consolidated Statements of Changes in Partners’ Capital for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-12 |\n| Consolidated Statements of Cash Flows for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-13 |\n| Notes to Consolidated Financial Statements | F-14 |\n| 2. Financial Statement Schedules |\n| Schedule III – Real Estate and Accumulated Depreciation as of December 31, 2016 | F-35 |\n\nAll other schedules for which provision is made in Regulation S-X are either not required to be included herein under the related instructions or are inapplicable or the related information is included in the footnotes to the applicable financial statement and, therefore, have been omitted.\nThe following exhibits are filed as part of this Form 10-K:\n\n| Exhibits |\n| 3.1 | Articles of Amendment and Restatement of the Company (incorporated by reference to the document previously filed as Exhibit 3.1 to the Company’s Pre-Effective Amendment No. 1 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on October 20, 2004 (File No. 333-118873)). |\n| 3.1A | Articles of Amendment to the Articles of Amendment and Restatement of the Company, effective as of April 16, 2013 (incorporated by reference to the document previously filed as Exhibit 3.7 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 16, 2013). |\n| 3.1B | Articles of Amendment to the Articles of Amendment and Restatement of the Company, effective as of August 12, 2016 (incorporated by reference to the document previously filed as Exhibit 3.1 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on August 15, 2016). |\n| 3.2 | Amended and Restated Agreement of Limited Partnership of Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 3.3 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). |\n| 3.2A | Amendment No. 1 to the Amended and Restated Agreement of Limited Partnership of Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 3.6 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 18, 2011). |\n\n62\n\n| Exhibits |\n| 3.2B | Amendment No. 2 to the Amended and Restated Agreement of Limited Partnership of Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 3.3 to the Operating Partnership’s Pre-Effective Amendment No. 1 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on August 9, 2013 (File No. 333-189821)). |\n| 3.2C | Amendment No. 3 to the Amended and Restated Agreement of Limited Partnership of Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 3.1 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on August 23, 2016). |\n| 3.3 | Articles Supplementary of Sotherly Hotels Inc. (incorporated by reference to the document previously filed as Exhibit 3.4 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 18, 2011). |\n| 3.4 | Second Amended and Restated Bylaws of the Company, effective as of April 16, 2013 (incorporated by reference to the document previously filed as Exhibit 3.8 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 16, 2013). |\n| 3.5 | Articles Supplementary designating the Series B Preferred Stock of the Company, effective as of August 19, 2016 (incorporated by reference to the document previously filed as Exhibit 3.5 to the Company’s Registration Statement on Form 8-A filed with the Securities and Exchange Commission on August 22, 2016). |\n| 4.0 | Form of Common Stock Certificate. |\n| 4.1 | Senior Unsecured Note issued by Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 4.6 to our Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2013, filed with the Securities and Exchange Commission on November 7, 2013). |\n| 4.2 | Indenture by and among Sotherly Hotels LP and Wilmington Trust, National Association, as trustee (incorporated by reference to the document previously filed as Exhibit 4.7 to our Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2013, filed with the Securities and Exchange Commission on November 7, 2013). |\n| 4.3 | Indenture by and among Sotherly Hotels Inc., Sotherly Hotels LP and Wilmington Trust, National Association, as trustee, dated November 21, 2014 (incorporated by reference to the document previously filed as Exhibit 4.8 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on November 21, 2014). |\n| 4.4 | First Supplemental Indenture, by and among Sotherly Hotels Inc., Sotherly Hotels LP and Wilmington Trust, National Association, as trustee, dated November 21, 2014 (incorporated by reference to the document previously filed as Exhibit 4.9 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on November 21, 2014). |\n| 4.5 | 7.00% Senior Unsecured Note due 2019, issued by Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 4.10 to our Annual Report on Form 10-K for the fiscal year ended December 31, 2014, filed with the Securities and Exchange Commission on April 14, 2015). |\n| 4.6 | Form of Specimen Certificate of Series B Preferred Stock of the Company (incorporated by reference to the document previously filed as Exhibit 4.1 to the Company’s Registration Statement on Form 8-A filed with the Securities and Exchange Commission on August 22, 2016). |\n| 10.1 | Sotherly Hotels Inc. 2004 Long-Term Incentive Plan (incorporated by reference to the document previously filed as Exhibit 10.1 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). * |\n| 10.1A | Form of Restricted Stock Award Agreement between Sotherly Hotels Inc. and Participant (incorporated by reference to the document previously filed as Exhibit 10.1A to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2008, filed with the Securities and Exchange Commission on March 25, 2009). * |\n| 10.2 | Executive Employment Agreement between Sotherly Hotels Inc. and Andrew M. Sims, dated January 12, 2015 (incorporated by reference to the document previously filed as Exhibit 10.2A to our Current Report on Form 8-K filed with the Securities and Exchange Commission on January 13, 2015). * |\n| 10.3 | Executive Employment Agreement between Sotherly Hotels Inc. and Anthony E. Domalski (incorporated by reference to the document previously filed as Exhibit 10.2A to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on January 3, 2013). * |\n\n63\n\n| Exhibits |\n| 10.4 | Contribution Agreement dated August 23, 2004 by and between the owners of Capitol Hotel Associates L.P., L.L.P. and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.6 to the Company’s Pre-Effective Amendment No. 6 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 15, 2004 (File No. 333-118873)). |\n| 10.5 | Contribution Agreement dated August 23, 2004 by and between the owners of Savannah Hotel Associates LLC and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.7 to the Company’s Pre-Effective Amendment No. 6 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 15, 2004 (File No. 333-118873)). |\n| 10.6 | Contribution Agreement dated August 23, 2004 by and between KDCA Partnership, MAVAS LLC, and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.8 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). |\n| 10.7 | Contribution Agreement dated September 8, 2004 by and between Elpizo Limited Partnership, Phileo Land Corporation and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.9 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). |\n| 10.8 | Asset Purchase Agreement dated August 19, 2004 by and between Accord LLC, West Laurel Corporation and MHI Hotels Services, LLC (incorporated by reference to the document previously filed as Exhibit 10.10 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). |\n| 10.9 | Agreement to Assign and Sublease Common Space Lease and Form of Sublease by and between MHI Hospitality L.P. and MHI Hotels, LLC (incorporated by reference to the document previously filed as Exhibit 10.11 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2011, filed with the Securities and Exchange Commission on November 9, 2011). |\n| 10.10 | Agreement to Assign and Sublease Commercial Space Lease and Form of Sublease by and between MHI Hospitality L.P. and MHI Hotels Two, Inc. (incorporated by reference to the document previously filed as Exhibit 10.12 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2011, filed with the Securities and Exchange Commission on November 9, 2011). |\n| 10.11 | Lease Agreement by and between Philadelphia Hotel Associates, LP and MHI Hospitality TRS, LLC (with a schedule of eight additional agreements that are substantially identical in all material respects to the Lease agreement, except as identified in such schedule, and are not being filed herewith per Instruction 2 to Item 601 of Regulation S-K (incorporated by reference to the document previously filed as Exhibit 10.13 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2011, filed with the Securities and Exchange Commission on November 9, 2011). |\n| 10.12 | Management Restructuring Agreement by and between MHI Hospitality TRS, LLC, MHI Hotels Services, LLC and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.14 to the Company’s Pre-Effective Amendment No. 3 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on November 15, 2004 (File No. 333-118873)). |\n| 10.13 | Contribution Agreement by and between MHI Hotels Services, LLC, MHI Hotels, LLC and MHI Hotels Two, Inc. (incorporated by reference to the document previously filed as Exhibit 10.15 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2011, filed with the Securities and Exchange Commission on November 9, 2011). |\n| 10.14 | Executive Employment Agreement, dated as of January 1, 2016, between Sotherly Hotels Inc. and David R. Folsom (incorporated by reference to the document previously filed as Exhibit 10.20A to our Current Report on Form 8-K filed with the Securities and Exchange Commission on January 4, 2016). * |\n| 10.15 | Promissory Note dated March 29, 2007, made by Capitol Hotel Associates, L.P., L.L.P. and MONY Life Insurance Company (incorporated by reference to the document previously filed as Exhibit 10.25 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 2, 2007). |\n| Exhibits |\n| 10.16 | Limited Liability Company Agreement of MHI/Carlyle Hotel Investment Program I, L.L.C. dated April 26, 2007 (incorporated by reference to the document previously filed as Exhibit 10.26A to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on May 2, 2007). |\n| 10.17 | Limited Liability Company Agreement of MHI/Carlyle Hotel Lessee Program I, L.L.C. dated April 26, 2007 (incorporated by reference to the document previously filed as Exhibit 10.26B to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on May 2, 2007). |\n| 10.18 | Promissory Note dated August 2, 2007 made by Savannah Hotel Associates L.L.C., to the order of MONY Life Insurance Company (incorporated by reference to the document previously filed as Exhibit 10.29 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on August 3, 2007). |\n| 10.19 | Sotherly Hotels Inc. 2013 Long-Term Incentive Plan (incorporated by reference to Appendix A to the Company’s Definitive Proxy Statement on Schedule 14A filed with the Securities and Exchange Commission on March 20, 2013). * |\n| 10.20 | Sales Agency Agreement, dated July 9, 2014, among Sotherly Hotels Inc., Sotherly Hotels LP and Sandler O’Neill & Partners, L.P. (incorporated by reference to the document previously filed as Exhibit 10.51 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on July 9, 2014). |\n| 10.21 | Master Agreement by and among Sotherly Hotels Inc., Sotherly Hotels LP, MHI Hospitality TRS, LLC and MHI Hotels Services LLC (incorporated by reference to the document previously filed as Exhibit 10.52 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on December 19, 2014). |\n| 10.22 | Purchase and Sale Agreement by and between MHI Hospitality TRS II, LLC, MHI Hotel Investments Holdings LLC and CRP/MHI Holdings, L.L.C., dated as of June 19, 2015 (incorporated by reference to the document previously filed as Exhibit 10.53 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on June 22, 2015). |\n| 10.23 | Agreement for Sale and Purchase of Property by and between Hampton Hotel Associates LLC, Three Capital Hotels, Inc., and Ajitkumar B. Patel, dated as of April 29, 2016 (incorporated by reference to the document previously filed as Exhibit 10.54 to our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2016, filed with the Securities and Exchange Commission on August 12, 2016). |\n| 10.24 | Amendment to the Agreement for Sale and Purchase of Property by and between Hampton Hotel Associates LLC, Three Capital Hotels, Inc., and Ajitkumar B. Patel, dated as of June 10, 2016 (incorporated by reference to the document previously filed as Exhibit 10.55 to our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2016, filed with the Securities and Exchange Commission on August 12, 2016). |\n| 10.25 | Commercial Unit Purchase Agreement between Sotherly Hotels Inc. and 4111 South Ocean Drive, LLC, dated as of September 14, 2016 (incorporated by reference to the document previously filed as Exhibit 10.56 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on September 20, 2016). |\n| 10.26 | Addendum to Commercial Unit Agreement between Sotherly Hotels Inc. and 4111 South Ocean Drive, LLC, dated as of September 14, 2016 (incorporated by reference to the document previously filed as Exhibit 10.57 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on September 20, 2016). |\n| 10.27 | Agreement for Sale and Purchase of Property by and between Hampton Hotel Associates LLC, Marina Hotel, LLC, Neil Amin and Shamin Hotels, Inc., dated as of October 6, 2016 (incorporated by reference to the document previously filed as Exhibit 10.58 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on February 9, 2017). |\n| 10.28 | Amendment to Agreement for Sale and Purchase of Property by and between Hampton Hotel Associates LLC, Marina Hotel, LLC, Neil Amin and Shamin Hotels, Inc., dated as of February 7, 2017 (incorporated by reference to the document previously filed as Exhibit 10.59 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on February 9, 2017). |\n| 16.1 | Letter from Grant Thornton LLP, dated April 6, 2016 (incorporated by reference to the document previously filed as Exhibit 16.1 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on April 6, 2016). |\n| 21.1 | List of Subsidiaries of Sotherly Hotels Inc. |\n| 21.2 | List of Subsidiaries of Sotherly Hotels LP. |\n| Exhibits |\n| 23.1 | Consent of Dixon Hughes Goodman LLP. |\n| 23.2 | Consent of Grant Thornton LLP. |\n| 23.3 | Consent of Dixon Hughes Goodman LLP. |\n| 23.4 | Consent of Grant Thornton LLP. |\n| 31.1 | Certification of Chief Executive Officer pursuant to Exchange Act Rule 13(a)-14 and 15(d)-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2 | Certification of Chief Financial Officer pursuant to Exchange Act Rule 13(a)-14 and 15(d)-14, as adopted, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.3 | Certification of Chief Executive Officer pursuant to Exchange Act Rule 13(a)-14 and 15(d)-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.4 | Certification of Chief Financial Officer pursuant to Exchange Act Rule 13(a)-14 and 15(d)-14, as adopted, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes-Oxley Act of 2002. |\n| 32.2 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes-Oxley Act of 2002. |\n| 32.3 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes-Oxley Act of 2002. |\n| 32.4 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes-Oxley Act of 2002. |\n| 101.INS | XBRL Instance Document |\n| 101.SCH | XBRL Taxonomy Extension Schema Document |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document |\n| * | Denotes management contract and/or compensatory plan/arrangement. |\n| SOTHERLY HOTELS INC. |\n| By: | /s/ ANDREW M. SIMS |\n| Andrew M. Sims Chief Executive Officer |\n| Signature | Title | Date |\n| /s/ ANDREW M. SIMS Andrew M. Sims | Chief Executive Officer and Chairman of the Board of Directors | March 22, 2017 |\n| /s/ DAVID R. FOLSOM David R. Folsom | President, Chief Operating Officer and Director | March 22, 2017 |\n| /s/ ANTHONY E. DOMALSKI Anthony E. Domalski | Chief Financial Officer | March 22, 2017 |\n| /s/ HERSCHEL J. WALKER Herschel J. Walker | Director | March 22, 2017 |\n| /s/ DAVID J. BEATTY David J. Beatty | Director | March 22, 2017 |\n| /s/ EDWARD S. STEIN Edward S. Stein | Director | March 22, 2017 |\n| /s/ ANTHONY C. ZINNI Anthony C. Zinni | Director | March 22, 2017 |\n| SOTHERLY HOTELS LP, |\n| by its General Partner, |\n| SOTHERLY HOTELS INC. |\n| By: | /s/ ANDREW M. SIMS |\n| Andrew M. Sims Chief Executive Officer |\n| Signature | Title | Date |\n| /s/ ANDREW M. SIMS Andrew M. Sims | Chief Executive Officer and Chairman of the Board of Directors of the General Partner | March 22, 2017 |\n| /s/ DAVID R. FOLSOM David R. Folsom | President, Chief Operating Officer and Director of the General Partner | March 22, 2017 |\n| /s/ ANTHONY E. DOMALSKI Anthony E. Domalski | Chief Financial Officer of the General Partner | March 22, 2017 |\n| /s/ HERSCHEL J. WALKER Herschel J. Walker | Director of the General Partner | March 22, 2017 |\n| /s/ DAVID J. BEATTY David J. Beatty | Director of the General Partner | March 22, 2017 |\n| /s/ EDWARD S. STEIN Edward S. Stein | Director of the General Partner | March 22, 2017 |\n| /s/ ANTHONY C. ZINNI Anthony C. Zinni | Director of the General Partner | March 22, 2017 |\n| Sotherly Hotels Inc. |\n| Report of Independent Registered Public Accounting Firm, Dixon Hughes Goodman LLP | F-2 |\n| Report of Independent Registered Public Accounting Firm, Grant Thornton LLP | F-3 |\n| Consolidated Balance Sheets for Sotherly Hotels Inc. as of December 31, 2016 and 2015 | F-4 |\n| Consolidated Statements of Operations for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-5 |\n| Consolidated Statements of Changes in Equity for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-6 |\n| Consolidated Statements of Cash Flows for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-7 |\n| Sotherly Hotels LP |\n| Report of Independent Registered Public Accounting Firm, Dixon Hughes Goodman LLP | F-8 |\n| Report of Independent Registered Public Accounting Firm, Grant Thornton LLP | F-9 |\n| Consolidated Balance Sheets for Sotherly Hotels LP as of December 31, 2016 and 2015 | F-10 |\n| Consolidated Statements of Operations for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-11 |\n| Consolidated Statements of Changes in Partners’ Capital for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-12 |\n| Consolidated Statements of Cash Flows for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-13 |\n| Notes to Consolidated Financial Statements | F-14 |\n| Schedule III – Real Estate and Accumulated Depreciation as of December 31, 2016 | F-35 |\n| December 31, 2016 | December 31, 2015 |\n| ASSETS |\n| Investment in hotel properties, net | $ | 348,593,912 | $ | 354,963,242 |\n| Investment in hotel properties held for sale, net | 5,333,000 | — |\n| Cash and cash equivalents | 31,766,775 | 11,493,914 |\n| Restricted cash | 4,596,145 | 5,793,840 |\n| Accounts receivable, net | 4,127,748 | 4,071,175 |\n| Accounts receivable-affiliate | 4,175 | 226,552 |\n| Loan proceeds receivable | — | 2,600,711 |\n| Prepaid expenses, inventory and other assets | 4,648,469 | 4,432,431 |\n| Deferred income taxes | 6,949,340 | 5,390,374 |\n| TOTAL ASSETS | $ | 406,019,564 | $ | 388,972,239 |\n| LIABILITIES |\n| Mortgage loans, net | $ | 282,708,289 | $ | 270,331,724 |\n| Unsecured notes, net | 24,308,713 | 50,460,106 |\n| Accounts payable and accrued expenses | 12,970,960 | 12,334,878 |\n| Advance deposits | 2,315,787 | 1,651,840 |\n| Dividends and distributions payable | 2,376,527 | 1,335,323 |\n| TOTAL LIABILITIES | $ | 324,680,276 | $ | 336,113,871 |\n| Commitments and contingencies (See Note 6) | — | — |\n| EQUITY |\n| Sotherly Hotels Inc. stockholders’ equity |\n| 8% Series B Cumulative Redeemable Perpetual Preferred stock, par value $0.01, 11,000,000 shares authorized, liquidation preference $25 per share, 1,610,000 shares and 0 shares issued and outstanding at December 31, 2016 and 2015, respectively | 16,100 | — |\n| Common stock, par value $0.01, 49,000,000 shares authorized, 14,468,551 shares and 14,490,714 shares issued and outstanding at December 31, 2016 and 2015, respectively | 144,685 | 144,907 |\n| Additional paid in capital | 118,395,082 | 82,749,058 |\n| Distributions in excess of retained earnings | (39,545,754 | ) | (33,890,834 | ) |\n| Total Sotherly Hotels Inc. stockholders’ equity | 79,010,113 | 49,003,131 |\n| Noncontrolling interest | 2,329,175 | 3,855,237 |\n| TOTAL EQUITY | 81,339,288 | 52,858,368 |\n| TOTAL LIABILITIES AND EQUITY | $ | 406,019,564 | $ | 388,972,239 |\n| 2016 | 2015 | 2014 |\n| REVENUE |\n| Rooms department | $ | 108,199,151 | $ | 96,837,386 | $ | 84,618,889 |\n| Food and beverage department | 35,384,530 | 33,273,599 | 31,444,984 |\n| Other operating departments | 9,262,071 | 8,422,491 | 6,876,046 |\n| Total revenue | 152,845,752 | 138,533,476 | 122,939,919 |\n| EXPENSES |\n| Hotel operating expenses |\n| Rooms department | 28,895,371 | 25,782,992 | 22,913,479 |\n| Food and beverage department | 24,357,248 | 23,005,629 | 21,026,202 |\n| Other operating departments | 2,438,860 | 1,786,197 | 1,192,183 |\n| Indirect | 57,141,692 | 51,310,292 | 45,072,491 |\n| Total hotel operating expenses | 112,833,171 | 101,885,110 | 90,204,355 |\n| Depreciation and amortization | 15,019,071 | 13,591,495 | 11,969,284 |\n| Impairment of investment in hotel properties, net | — | 500,000 | 3,175,000 |\n| Loss (gain) on disposal of assets | 365,319 | (41,435 | ) | — |\n| Corporate general and administrative | 6,021,065 | 7,268,256 | 5,085,949 |\n| Total operating expenses | 134,238,626 | 123,203,426 | 110,434,588 |\n| NET OPERATING INCOME | 18,607,126 | 15,330,050 | 12,505,331 |\n| Other income (expense) |\n| Interest expense | (17,735,107 | ) | (16,515,827 | ) | (14,636,870 | ) |\n| Interest income | 115,785 | 50,461 | 19,865 |\n| Equity income in joint venture | — | 475,514 | 307,370 |\n| Loss on early debt extinguishment | (1,417,905 | ) | (772,907 | ) | (831,079 | ) |\n| Unrealized loss on hedging activities | (37,384 | ) | (108,819 | ) | — |\n| Gain on change in control | — | 6,603,148 | — |\n| Gain on involuntary conversion of asset | — | — | 169,151 |\n| Net income/(loss) before income taxes | (467,485 | ) | 5,061,620 | (2,466,232 | ) |\n| Income tax benefit | 1,367,634 | 1,336,033 | 1,727,723 |\n| Net income/(loss) | 900,149 | 6,397,653 | (738,509 | ) |\n| Less: Net (income)/loss attributable to the noncontrolling interest | 26,567 | (1,040,987 | ) | 153,838 |\n| Net income/(loss) attributable to the Company | 926,716 | 5,356,666 | (584,671 | ) |\n| Distributions to preferred stockholders | (1,144,889 | ) | — | — |\n| Net income/(loss) attributable to common stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) |\n| Net income/(loss) per share attributable to the common stockholders |\n| Basic and diluted | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) |\n| Weighted average number of common shares outstanding |\n| Basic and diluted | 14,896,994 | 12,541,117 | 10,377,125 |\n| Additional | Distributions |\n| Preferred Stock | Common Stock | Paid- | in Excess of | Noncontrolling |\n| Shares | Par Value | Shares | Par Value | In Capital | Retained Earnings | Interest | Total |\n| Balances at December 31, 2013 | — | $ | — | 10,206,927 | $ | 102,069 | $ | 57,534,113 | $ | (32,450,773 | ) | $ | 5,669,386 | $ | 30,854,795 |\n| Net loss | — | — | — | — | — | (584,671 | ) | (153,838 | ) | (738,509 | ) |\n| Conversion of units in Operating Partnership to shares of common stock | — | — | 310,000 | 3,100 | 755,750 | — | (758,850 | ) | — |\n| Redemption of units in Operating Partnership | — | — | — | — | — | — | (25,621 | ) | (25,621 | ) |\n| Issuance of unrestricted common stock awards | — | — | 24,750 | 248 | 147,112 | — | — | 147,360 |\n| Issuance of restricted common stock awards | — | — | 12,000 | 120 | 78,165 | — | — | 78,285 |\n| Issuance of common stock through ATM offering, net | — | — | 17,255 | 172 | 124,739 | — | — | 124,911 |\n| Amortization of restricted stock award | — | — | — | — | 19,920 | — | — | 19,920 |\n| Dividends and distributions declared | — | — | — | — | (2,352,869 | ) | (598,415 | ) | (2,951,284 | ) |\n| Balances at December 31, 2014 | — | $ | — | 10,570,932 | $ | 105,709 | $ | 58,659,799 | $ | (35,388,313 | ) | $ | 4,132,662 | $ | 27,509,857 |\n| Net income | — | — | — | — | — | 5,356,666 | 1,040,987 | 6,397,653 |\n| Issuance of unrestricted common stock awards | — | — | 26,350 | 264 | 193,936 | — | — | 194,200 |\n| Issuance of restricted common stock awards | — | — | 9,750 | 98 | 71,760 | — | — | 71,858 |\n| Issuance of common stock from ATM sales | — | — | 98,682 | 986 | 681,222 | — | — | 682,208 |\n| Issuance of common stock from equity offering | — | — | 3,435,000 | 34,350 | 22,534,259 | — | — | 22,568,609 |\n| Conversion of Operating Partnership units into shares of common stock | — | — | 350,000 | 3,500 | 588,162 | — | (591,662 | ) | — |\n| Amortization of restricted stock award | — | — | — | — | 19,920 | — | — | 19,920 |\n| Dividends and distributions declared | — | — | — | — | — | (3,859,187 | ) | (726,750 | ) | (4,585,937 | ) |\n| Balances at December 31, 2015 | — | $ | — | 14,490,714 | $ | 144,907 | $ | 82,749,058 | $ | (33,890,834 | ) | $ | 3,855,237 | $ | 52,858,368 |\n| Net income (loss) | — | — | — | — | — | 926,716 | (26,567 | ) | 900,149 |\n| Issuance of Series B Preferred Stock | 1,610,000 | 16,100 | — | — | 37,750,431 | — | — | 37,766,531 |\n| Issuance of unrestricted common stock awards | — | — | 24,250 | 242 | 128,040 | — | — | 128,282 |\n| Issuance of restricted common stock awards | — | — | 12,000 | 120 | 63,360 | — | — | 63,480 |\n| Repurchase of common stock | — | — | (481,100 | ) | (4,811 | ) | (3,159,725 | ) | — | — | (3,164,536 | ) |\n| Conversion of Operating Partnership units into shares of common stock | — | — | 422,687 | 4,227 | 843,998 | — | (848,225 | ) | — |\n| Amortization of restricted stock award | — | — | — | — | 19,920 | — | — | 19,920 |\n| Preferred stock dividends declared | — | — | — | — | — | (1,144,889 | ) | — | (1,144,889 | ) |\n| Common stockholders' dividends and distributions declared | — | — | — | — | — | (5,436,747 | ) | (651,270 | ) | (6,088,017 | ) |\n| Balances at December 31, 2016 | 1,610,000 | $ | 16,100 | 14,468,551 | $ | 144,685 | $ | 118,395,082 | $ | (39,545,754 | ) | $ | 2,329,175 | $ | 81,339,288 |\n| 2016 | 2015 | 2014 |\n| Cash flows from operating activities: |\n| Net income (loss) | $ | 900,149 | $ | 6,397,653 | $ | (738,509 | ) |\n| Adjustments to reconcile net income (loss) to net cash provided by operating activities: |\n| Depreciation and amortization | 15,019,071 | 13,591,495 | 11,969,284 |\n| Gain on change in control | — | (6,603,148 | ) | — |\n| Equity income in joint venture | — | (475,514 | ) | (307,370 | ) |\n| Impairment of investment in hotel properties | — | 500,000 | 3,175,000 |\n| Amortization of deferred financing costs | 1,147,864 | 1,300,032 | 1,428,674 |\n| Amortization of mortgage premium | (24,682 | ) | (18,820 | ) | — |\n| Unrealized loss on derivative instrument | 37,384 | 108,819 | — |\n| Loss (gain) on disposal of assets | 365,319 | (41,435 | ) | — |\n| Loss on early debt extinguishment | 1,141,905 | 772,907 | — |\n| Charges related to equity-based compensation | 211,682 | 285,978 | 245,565 |\n| Changes in assets and liabilities: |\n| Restricted cash | (560,817 | ) | 584,926 | (92,439 | ) |\n| Accounts receivable | (56,573 | ) | (2,021,825 | ) | 369,685 |\n| Prepaid expenses, inventory and other assets | (334,063 | ) | (623,980 | ) | (1,677,032 | ) |\n| Deferred income taxes | (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) |\n| Accounts payable and other accrued liabilities | (35,188 | ) | (1,001,376 | ) | 2,338,688 |\n| Advance deposits | 663,947 | 431,111 | 89,099 |\n| Accounts receivable - affiliate | 222,377 | (28,878 | ) | 12,273 |\n| Net cash provided by operating activities | 17,139,409 | 11,377,374 | 14,851,255 |\n| Cash flows from investing activities: |\n| Acquisitions of hotel properties | — | (25,525,754 | ) | (61,106,085 | ) |\n| Improvements and additions to hotel properties | (14,912,677 | ) | (20,136,427 | ) | (9,801,018 | ) |\n| Payments on involuntary insurance conversions | — | — | — |\n| Distributions from joint venture | — | 600,000 | 750,000 |\n| Funding of restricted cash reserves | (5,276,518 | ) | (4,973,602 | ) | (3,692,045 | ) |\n| Proceeds of restricted cash reserves | 7,035,029 | 6,376,459 | 2,583,419 |\n| Proceeds from involuntary conversion of assets | — | 124,609 | 169,151 |\n| Proceeds from the sale of assets | 213,400 | 2,402,113 | — |\n| Net cash used in investing activities | (12,940,766 | ) | (41,132,602 | ) | (71,096,578 | ) |\n| Cash flows from financing activities: |\n| Proceeds of unsecured debt | — | — | 25,300,000 |\n| Proceeds of mortgage debt | 102,700,000 | 127,000,000 | 48,600,000 |\n| Proceeds from mortgage loan receivable | 2,600,711 | — | — |\n| Proceeds from loans | — | — | 19,000,000 |\n| Proceeds from sale of common stock, net | — | 23,250,818 | 124,911 |\n| Proceeds from sale of preferred stock, net | 37,766,531 | — | — |\n| Payments on mortgage loans | (89,619,564 | ) | (120,154,764 | ) | (24,171,892 | ) |\n| Redemption of unsecured notes | (27,600,000 | ) | — | — |\n| Repurchase of common stock | (2,061,407 | ) | — | — |\n| Payment of deferred financing costs | (1,520,351 | ) | (1,377,882 | ) | (2,637,637 | ) |\n| Dividends and distributions paid | (5,851,813 | ) | (4,103,529 | ) | (2,686,567 | ) |\n| Preferred dividends paid | (339,889 | ) | — | — |\n| Redemption of units in Operating Partnership | — | — | (25,621 | ) |\n| Net cash provided by financing activities | 16,074,218 | 24,614,643 | 63,503,194 |\n| Net increase (decrease) in cash and cash equivalents | 20,272,861 | (5,140,585 | ) | 7,257,871 |\n| Cash and cash equivalents at the beginning of the period | 11,493,914 | 16,634,499 | 9,376,628 |\n| Cash and cash equivalents at the end of the period | $ | 31,766,775 | $ | 11,493,914 | $ | 16,634,499 |\n| Supplemental disclosures: |\n| Cash paid during the period for interest | $ | 16,881,223 | $ | 15,415,695 | $ | 13,766,824 |\n| Cash paid during the period for income taxes | $ | 192,965 | $ | 570,762 | $ | 263,621 |\n| Non-cash investing and financing activities: |\n| Mortgage debt proceeds receivable and related loan costs | $ | — | $ | 2,704,415 | $ | — |\n| Assumption of mortgage loan on Crowne Plaza Hollywood Beach Resort acquisition | $ | — | $ | 57,000,000 | $ | — |\n| Assumption of loan premium on the Crowne Plaza Hollywood Beach Resort assumed loan | $ | — | $ | 246,815 | $ | — |\n| Change in amount of deferred financing and deferred offering cost in accounts payable and accrued liabilities | $ | — | $ | 624,117 | $ | 375,487 |\n| Change in amount of hotel property improvements in accounts payable and accrued liabilities | $ | 431,858 | $ | 601,895 | $ | 1,108,182 |\n| December 31, 2016 | December 31, 2015 |\n| ASSETS |\n| Investment in hotel properties, net | $ | 348,593,912 | $ | 354,963,242 |\n| Investment in hotel property held for sale, net | 5,333,000 | — |\n| Cash and cash equivalents | 31,766,775 | 11,493,914 |\n| Restricted cash | 4,596,145 | 5,793,840 |\n| Accounts receivable, net | 4,127,748 | 4,071,175 |\n| Accounts receivable-affiliate | 4,175 | 226,552 |\n| Loan proceeds receivable | — | 2,600,711 |\n| Prepaid expenses, inventory and other assets | 4,648,469 | 4,432,431 |\n| Deferred income taxes | 6,949,340 | 5,390,374 |\n| TOTAL ASSETS | $ | 406,019,564 | $ | 388,972,239 |\n| LIABILITIES |\n| Mortgage loans, net | $ | 282,708,289 | $ | 270,331,724 |\n| Unsecured notes, net | 24,308,713 | 50,460,106 |\n| Accounts payable and other accrued liabilities | 12,970,960 | 12,334,878 |\n| Advance deposits | 2,315,787 | 1,651,840 |\n| Dividends and distributions payable | 2,376,527 | 1,335,323 |\n| TOTAL LIABILITIES | $ | 324,680,276 | $ | 336,113,871 |\n| Commitments and contingencies (see Note 6) | — | — |\n| PARTNERS’ CAPITAL |\n| 8% Series B Cumulative Redeemable Perpetual Preferred partnership units, liquidation preference $25 per unit, 1,610,000 units and 0 units issued and outstanding at December 31, 2016 and 2015, respectively | 37,766,531 | — |\n| General Partner: 162,467 units and 166,915 units issued and outstanding as of December 31, 2016 and 2015, respectively | 681,389 | 774,295 |\n| Limited Partners: 16,084,224 units and 16,524,626 units issued and outstanding as of December 31, 2016 and 2015, respectively | 42,891,368 | 52,084,073 |\n| TOTAL PARTNERS’ CAPITAL | 81,339,288 | 52,858,368 |\n| TOTAL LIABILITIES AND PARTNERS’ CAPITAL | $ | 406,019,564 | $ | 388,972,239 |\n| 2016 | 2015 | 2014 |\n| REVENUE |\n| Rooms department | $ | 108,199,151 | $ | 96,837,386 | $ | 84,618,889 |\n| Food and beverage department | 35,384,530 | 33,273,599 | 31,444,984 |\n| Other operating departments | 9,262,071 | 8,422,491 | 6,876,046 |\n| Total revenue | 152,845,752 | 138,533,476 | 122,939,919 |\n| EXPENSES |\n| Hotel operating expenses |\n| Rooms department | 28,895,371 | 25,782,992 | 22,913,479 |\n| Food and beverage department | 24,357,248 | 23,005,629 | 21,026,202 |\n| Other operating departments | 2,438,860 | 1,786,197 | 1,192,183 |\n| Indirect | 57,141,692 | 51,310,292 | 45,072,491 |\n| Total hotel operating expenses | 112,833,171 | 101,885,110 | 90,204,355 |\n| Depreciation and amortization | 15,019,071 | 13,591,495 | 11,969,284 |\n| Impairment of investment in hotel properties, net | — | 500,000 | 3,175,000 |\n| Loss on disposal of assets | 365,319 | (41,435 | ) | — |\n| Corporate general and administrative | 6,021,065 | 7,268,256 | 5,085,949 |\n| Total operating expenses | 134,238,626 | 123,203,426 | 110,434,588 |\n| NET OPERATING INCOME | 18,607,126 | 15,330,050 | 12,505,331 |\n| Other income (expense) |\n| Interest expense | (17,735,107 | ) | (16,515,827 | ) | (14,636,870 | ) |\n| Interest income | 115,785 | 50,461 | 19,865 |\n| Equity income in joint venture | — | 475,514 | 307,370 |\n| Loss on early debt extinguishment | (1,417,905 | ) | (772,907 | ) | (831,079 | ) |\n| Unrealized loss on hedging activities | (37,384 | ) | (108,819 | ) | — |\n| Gain on change in control | — | 6,603,148 | — |\n| Gain on involuntary conversion of asset | — | — | 169,151 |\n| Net income/(loss) before income taxes | (467,485 | ) | 5,061,620 | (2,466,232 | ) |\n| Income tax benefit | 1,367,634 | 1,336,033 | 1,727,723 |\n| Net income/(loss) | 900,149 | 6,397,653 | (738,509 | ) |\n| Distributions to preferred unit holders | (1,144,889 | ) | — | — |\n| Net income/(loss) attributable to operating partnership unit holders | $ | (244,740 | ) | $ | 6,397,653 | $ | (738,509 | ) |\n| Net income/(loss) attributable per operating partner unit |\n| Basic and diluted | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) |\n| Weighted average number of operating partner units outstanding |\n| Basic and diluted | 16,710,935 | 14,924,410 | 13,107,413 |\n| Preferred Units | General Partner | Limited Partner |\n| Units | Amount | Units | Amount | Units | Amounts | Total |\n| Balances at December 31, 2013 | — | $ | — | 130,711 | $ | 554,316 | 12,940,343 | $ | 30,300,479 | $ | 30,854,795 |\n| Issuance of partnership units | — | — | 540 | 3,534 | 53,465 | 347,022 | 350,556 |\n| Amortization of restricted units award | — | — | — | 199 | — | 19,721 | 19,920 |\n| Distributions declared | — | — | — | (29,644 | ) | — | (2,921,640 | ) | (2,951,284 | ) |\n| Redemption of limited partnership units | — | — | (33 | ) | (228 | ) | (3,267 | ) | (25,393 | ) | (25,621 | ) |\n| Net loss | — | — | — | (7,386 | ) | — | (731,123 | ) | (738,509 | ) |\n| Balances at December 31, 2014 | — | $ | — | 131,218 | $ | 520,791 | 12,990,541 | $ | 26,989,066 | $ | 27,509,857 |\n| Issuance of partnership units | — | — | 35,697 | 235,237 | 3,534,085 | 23,281,638 | 23,516,875 |\n| Amortization of restricted units award | — | — | — | 149 | — | 19,771 | 19,920 |\n| Distributions declared | — | — | — | (45,859 | ) | — | (4,540,078 | ) | (4,585,937 | ) |\n| Net income | — | — | — | 63,977 | — | 6,333,676 | 6,397,653 |\n| Balances at December 31, 2015 | — | $ | — | 166,915 | $ | 774,295 | 16,524,626 | $ | 52,084,073 | $ | 52,858,368 |\n| Issuance of common partnership units | — | — | 363 | 1,918 | 35,887 | 189,844 | 191,762 |\n| Issuance of preferred partnership units | 1,610,000 | 37,766,531 | — | — | — | — | 37,766,531 |\n| Repurchased common units | — | — | (4,811 | ) | (31,645 | ) | (476,289 | ) | (3,132,891 | ) | (3,164,536 | ) |\n| Amortization of restricted units award | — | — | — | 149 | — | 19,771 | 19,920 |\n| Preferred partnership units distributions declared | — | (1,144,889 | ) | — | — | — | — | (1,144,889 | ) |\n| Partnership units distributions declared | — | — | — | (60,880 | ) | — | (6,027,137 | ) | (6,088,017 | ) |\n| Net income | — | 1,144,889 | — | (2,447 | ) | — | (242,293 | ) | 900,149 |\n| Balances at December 31, 2016 | 1,610,000 | $ | 37,766,531 | 162,467 | $ | 681,389 | 16,084,224 | $ | 42,891,368 | $ | 81,339,288 |\n| 2016 | 2015 | 2014 |\n| Cash flows from operating activities: |\n| Net income (loss) | $ | 900,149 | $ | 6,397,653 | $ | (738,509 | ) |\n| Adjustments to reconcile net income (loss) to net cash provided by operating activities: |\n| Depreciation and amortization | 15,019,071 | 13,591,495 | 11,969,284 |\n| Gain on change in control | — | (6,603,148 | ) | — |\n| Equity income in joint venture | — | (475,514 | ) | (307,370 | ) |\n| Impairment of investment in hotel properties | — | 500,000 | 3,175,000 |\n| Amortization of deferred financing costs | 1,147,864 | 1,300,032 | 1,428,674 |\n| Amortization of mortgage premium | (24,682 | ) | (18,820 | ) | — |\n| Unrealized loss on derivative instrument | 37,384 | 108,819 | — |\n| Loss (gain) on disposal of assets | 365,319 | (41,435 | ) | — |\n| Loss on early debt extinguishment | 1,141,905 | 772,907 | — |\n| Charges related to equity-based compensation | 211,682 | 285,978 | 245,565 |\n| Changes in assets and liabilities: |\n| Restricted cash | (560,817 | ) | 584,926 | (92,439 | ) |\n| Accounts receivable | (56,573 | ) | (2,021,825 | ) | 369,685 |\n| Prepaid expenses, inventory and other assets | (334,063 | ) | (623,980 | ) | (1,677,032 | ) |\n| Deferred income taxes | (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) |\n| Accounts payable and other accrued liabilities | (35,188 | ) | (1,001,376 | ) | 2,338,688 |\n| Advance deposits | 663,947 | 431,111 | 89,099 |\n| Accounts receivable - affiliate | 222,377 | (28,878 | ) | 12,273 |\n| Net cash provided by operating activities | 17,139,409 | 11,377,374 | 14,851,255 |\n| Cash flows from investing activities: |\n| Acquisitions of hotel properties | — | (25,525,754 | ) | (61,106,085 | ) |\n| Improvements and additions to hotel properties | (14,912,677 | ) | (20,136,427 | ) | (9,801,018 | ) |\n| Payments on involuntary insurance conversions | — | — | — |\n| Distributions from joint venture | — | 600,000 | 750,000 |\n| Funding of restricted cash reserves | (5,276,518 | ) | (4,973,602 | ) | (3,692,045 | ) |\n| Proceeds from involuntary conversion of assets | — | 124,609 | 169,151 |\n| Proceeds of restricted cash reserves | 7,035,029 | 6,376,459 | 2,583,419 |\n| Proceeds from the sale of assets | 213,400 | 2,402,113 |\n| Net cash used in investing activities | (12,940,766 | ) | (41,132,602 | ) | (71,096,578 | ) |\n| Cash flows from financing activities: |\n| Proceeds of unsecured debt | — | — | 25,300,000 |\n| Proceeds of mortgage debt | 102,700,000 | 127,000,000 | 48,600,000 |\n| Proceeds from mortgage loan receivable | 2,600,711 | — | — |\n| Proceeds from loans | — | — | 19,000,000 |\n| Proceeds from sale of operating units | — | 23,250,818 | 124,911 |\n| Proceeds from sale of preferred operating units | 37,766,531 | — | — |\n| Payments on mortgage loans | (89,619,564 | ) | (120,154,764 | ) | (24,171,892 | ) |\n| Redemption of unsecured notes | (27,600,000 | ) |\n| Repurchase of common units | (2,061,407 | ) | — | — |\n| Payment of deferred financing costs | (1,520,351 | ) | (1,377,882 | ) | (2,637,637 | ) |\n| Distributions paid | (5,851,813 | ) | (4,103,529 | ) | (2,686,567 | ) |\n| Preferred dividends paid | (339,889 | ) | — | — |\n| Redemption of units in Operating Partnership | — | — | (25,621 | ) |\n| Net cash provided by financing activities | 16,074,218 | 24,614,643 | 63,503,194 |\n| Net increase (decrease) in cash and cash equivalents | 20,272,861 | (5,140,585 | ) | 7,257,871 |\n| Cash and cash equivalents at the beginning of the period | 11,493,914 | 16,634,499 | 9,376,628 |\n| Cash and cash equivalents at the end of the period | $ | 31,766,775 | $ | 11,493,914 | $ | 16,634,499 |\n| Supplemental disclosures: |\n| Cash paid during the period for interest | $ | 16,881,223 | $ | 15,415,695 | $ | 13,766,824 |\n| Cash paid during the period for income taxes | $ | 192,965 | $ | 570,762 | $ | 263,621 |\n| Non-cash investing and financing activities: |\n| Mortgage debt proceeds receivable and related loan costs | $ | — | $ | 2,704,415 | $ | — |\n| Assumption of mortgage loan on Crowne Plaza Hollywood Beach Resort acquisition | $ | — | $ | 57,000,000 | $ | — |\n| Assumption of loan premium on the Crowne Plaza Hollywood Beach Resort assumed loan | $ | — | $ | 246,815 | $ | — |\n| Change in amount of deferred financing and deferred offering cost in accounts payable and accrued liabilities | $ | — | $ | 624,117 | $ | 375,487 |\n| Change in amount of hotel property improvements in accounts payable and accrued liabilities | $ | 431,858 | $ | 601,895 | $ | 1,108,182 |\n| Level 1 | Unadjusted quoted prices in active markets for identical assets or liabilities. |\n| Level 2 | Unadjusted quoted prices in active markets for similar assets or liabilities, or Unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or Inputs other than quoted prices that are observable for the asset or liability. |\n| Level 3 | Unobservable inputs for the asset or liability. |\n| Level 1 | Level 2 | Level 3 |\n| December 31, 2015 |\n| Investment in hotel property, net (1) | $ | — | $ | — | $ | 5,700,762 |\n| Interest Rate Cap (4) | $ | — | $ | 70,981 | $ | — |\n| Mortgage loans (2) | $ | — | $ | (272,933,327 | ) | $ | — |\n| Unsecured notes (3) | $ | (54,238,600 | ) | $ | — | $ | — |\n| December 31, 2016 |\n| Interest Rate Cap (4) | $ | — | $ | 33,597 | $ | — |\n| Mortgage loans (2) | $ | — | $ | (281,840,780 | ) | $ | — |\n| Unsecured notes (3) | $ | (26,241,160 | ) | $ | — | $ | — |\n| (1) | A non-recurring fair value measurement was conducted in 2015 for our investment in hotel property, which resulted in a recorded impairment charge for the year ended December 31, 2015, which represent the amounts by which the carrying value of the asset group exceeded its fair value. |\n| (2) | Mortgage loans are reflected at carrying value on our Consolidated Balance Sheet as of December 31, 2016 and December 31, 2015. |\n| (3) | Unsecured notes are recorded at historical cost on our Consolidated Balance Sheet as of December 31, 2016 and December 31, 2015. |\n| (4) | An interest rate cap on the DoubleTree by Hilton Jacksonville Riverfront mortgage with the Bank of the Ozarks is recorded at fair value on our Consolidated Balance Sheet as of December 31, 2016 and December 31, 2015. |\n| December 31, 2017 | $ | 1,105,165 |\n| December 31, 2018 | 632,365 |\n| December 31, 2019 | 544,920 |\n| December 31, 2020 | 499,294 |\n| December 31, 2021 | 246,388 |\n| December 31, 2022 and thereafter | 1,661,913 |\n| Total | $ | 4,690,045 |\n| Georgian Terrace | Crowne Plaza Hollywood Beach Resort |\n| Land and land improvements | $ | 10,127,687 | $ | 24,008,289 |\n| Buildings and improvements | 45,385,939 | 64,854,787 |\n| Furniture, fixtures and equipment | 5,163,135 | 2,802,135 |\n| Investment in hotel properties | 60,676,761 | 91,665,211 |\n| Restricted cash | 124,658 | 1,159,759 |\n| Accounts receivable | 465,287 | 140,588 |\n| Prepaid expenses, inventory and other assets | 430,997 | 797,505 |\n| Assumed mortgage | — | (57,259,159 | ) |\n| Accounts payable and accrued liabilities | (591,618 | ) | (2,485,442 | ) |\n| Equity investment | — | (1,889,560 | ) |\n| Gain on change in control | — | (6,603,148 | ) |\n| Net cash | $ | 61,106,085 | $ | 25,525,754 |\n| December 31, 2015 | December 31, 2014 |\n| (unaudited) | (unaudited) |\n| Pro forma revenues | $ | 151,931,931 | $ | 147,451,042 |\n| Pro forma operating expenses | $ | 133,346,497 | $ | 129,961,867 |\n| Pro forma operating income | $ | 18,585,434 | $ | 17,489,175 |\n| Pro forma net income (loss) | $ | 1,017,180 | $ | (1,671,774 | ) |\n| Pro forma earnings (loss) per basic and diluted share | $ | 0.07 | $ | (0.10 | ) |\n| Pro forma earnings (loss) per basic and diluted units | $ | 0.07 | $ | (0.10 | ) |\n| Pro forma basic and diluted common shares | 12,541,117 | 13,812,125 |\n| Pro forma basic and diluted units | 14,924,410 | 16,542,413 |\n| December 31, 2016 | December 31, 2015 |\n| Land and land improvements | $ | 57,851,380 | $ | 59,910,212 |\n| Buildings and improvements | 336,996,876 | 333,720,421 |\n| Furniture, fixtures and equipment | 43,458,781 | 42,245,334 |\n| 438,307,037 | 435,875,967 |\n| Less: accumulated depreciation and impairment | (89,713,125 | ) | (80,912,725 | ) |\n| Investment in Hotel Properties, Net | $ | 348,593,912 | $ | 354,963,242 |\n| December 31, 2016 | December 31, 2015 |\n| Land and land improvements | $ | 1,097,096 | $ | — |\n| Buildings and improvements | 6,242,504 | — |\n| Furniture, fixtures and equipment | 2,289,008 | — |\n| 9,628,608 | — |\n| Less: accumulated depreciation and impairment | (4,295,608 | ) | — |\n| Investment in Hotel Properties Held for Sale, Net | $ | 5,333,000 | $ | — |\n| Balance Outstanding as of |\n| December 31, | December 31, | Prepayment | Maturity | Amortization | Interest |\n| Property | 2016 | 2015 | Penalties | Date | Provisions | Rate |\n| Crowne Plaza Hampton Marina (1) | $ | 2,584,633 | $ | 3,512,586 | None | 11/1/2019 | 3 years | 5.00% |\n| Crowne Plaza Hollywood Beach Resort (2) | 58,935,818 | 59,795,743 | n/a | 10/1/2025 | 30 years | 4.913% |\n| Crowne Plaza Tampa Westshore (3) | 15,561,400 | 13,016,045 | None | 6/30/2019 | 25 years | LIBOR plus 3.75 % |\n| DoubleTree by Hilton Jacksonville Riverfront (4) | 19,291,716 | 19,774,577 | Yes | 7/7/2019 | 25 years | LIBOR plus 3.50 % |\n| DoubleTree by Hilton Laurel (5) | 9,329,005 | 9,500,000 | Yes | 8/5/2021 | 25 years | 5.25% |\n| DoubleTree by Hilton Philadelphia Airport (6) | 31,261,991 | 32,376,795 | None | 4/1/2019 | 25 years | LIBOR plus 3.00 % |\n| DoubleTree by Hilton Raleigh Brownstone University (7) | 14,773,885 | 15,029,121 | n/a | 8/1/2018 | 30 years | 4.78% |\n| The Georgian Terrace (8) | 45,826,038 | 46,579,011 | n/a | 6/1/2025 | 30 years | 4.42% |\n| Hilton Savannah DeSoto (9) | 30,000,000 | 20,522,836 | Yes | 7/1/2026 | 25 years | 4.25% |\n| Hilton Wilmington Riverside (10) | 30,000,000 | 19,825,772 | Yes | 1/1/2027 | 25 years | 4.25% |\n| Sheraton Louisville Riverside (11) | 11,977,557 | 11,345,866 | Yes | 12/1/2026 | 25 years | 4.27% |\n| The Whitehall (12) | 15,000,000 | 20,459,256 | Yes | 10/12/2021 | 18 years | LIBOR plus 3.50 % |\n| Total Mortgage Principal Balance | $ | 284,542,043 | $ | 271,737,608 |\n| Deferred financing costs, net | (2,049,409 | ) | (1,646,220 | ) |\n| Unamortized premium on loan | 215,655 | 240,336 |\n| Total Mortgage Loans, Net | $ | 282,708,289 | $ | 270,331,724 |\n| (1) | The note was extended and modified in November 2016 for 3 years until November 1, 2019 and the Operating Partnership was required to make monthly principal payments of $15,367. The note rate was changed to a fixed rate of 5.00%, effective June 27, 2014. As of February 7, 2017, the note is no longer outstanding. |\n| (2) | With limited exception, the note may not be prepaid until June 2025. |\n| (3) | The note provides initial proceeds of $15.7 million, with an additional $3.3 million available upon the satisfaction of certain conditions; bears a floating interest rate of the 30-day LIBOR plus 3.75%, subject to a floor rate of 3.75%; the note provides that the mortgage can be extended for two additional periods of one year each, subject to certain conditions. |\n| (4) | The note is subject to a pre-payment penalty until July 2017. Prepayment can be made without penalty thereafter. The note provides that the mortgage can be extended until July 2020 if certain conditions have been satisfied. |\n| (5) | The note is subject to a pre-payment penalty except for any pre-payments made either between April 2017 and August 2017, or from April 2021 through maturity of the note. The note provides that on January 5, 2018, the rate of interest will adjust to a rate of 3.00% per annum plus the then-current five-year U.S. Treasury rate of interest, with a floor of 5.25%. |\n| (6) | The note bears a minimum interest rate of 3.50%. |\n| (7) | With limited exception, the note may not be prepaid until two months before maturity. |\n| (8) | With limited exception, the note may not be prepaid until February 2025. |\n| (9) | The note provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions, namely, the completion of a renovation project; amortizes on a 25-year schedule after a 1-year interest-only period; and is subject to a pre-payment penalty except for any pre-payments made within 120 days of the maturity date. |\n| (10) | The note provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions namely, the completion of a renovation project; amortizes on a 25-year schedule after a 1-year interest-only period; and is subject to a pre-payment penalty except for any pre-payments made within 120 days of the maturity date. |\n| (11) | The note bears a fixed interest rate of 4.27% for the first 5 years of the loan, with an option for the lender to reset the interest rate after 5 years. |\n| (12) | The note was refinanced in October 2016, provides initial proceeds of $15.0 million, with an additional $5.5 million available upon the satisfaction of certain conditions; bears a floating interest rate of the 1-month LIBOR plus 3.5%, subject to a floor rate of 4.0% and is subject to prepayment penalties subject to a declining scale from 3.0% penalty on or before the first anniversary date, a 2.0% penalty during the second anniversary year and a 1.0% penalty after the third anniversary date. |\n| For the year ending: December 31, 2017 | $ | 6,363,323 |\n| December 31, 2018 | 24,626,923 |\n| December 31, 2019 | 73,423,203 |\n| December 31, 2020 | 9,248,750 |\n| December 31, 2021 | 31,008,186 |\n| December 31, 2022 and thereafter | 139,871,658 |\n| Total future maturities | $ | 284,542,043 |\n| For the year ending: December 31, 2017 | $ | 223,682 |\n| December 31, 2018 | 176,740 |\n| December 31, 2019 | 100,480 |\n| December 31, 2020 | 95,482 |\n| December 31, 2021 | 95,482 |\n| December 31, 2022 and thereafter | 445,583 |\n| Total | $ | 1,137,449 |\n| Quarter Ended | 2014 | 2015 | 2016 |\n| March 31, | $ | 0.045 | $ | 0.070 | $ | 0.085 |\n| June 30, | $ | 0.050 | $ | 0.075 | $ | 0.090 |\n| September 30, | $ | 0.065 | $ | 0.080 | $ | 0.095 |\n| December 31, | $ | 0.065 | $ | 0.080 | $ | 0.095 |\n| Seven Months Ended | Year Ended |\n| July 31, 2015 | December 31, 2014 |\n| Revenue |\n| Rooms department | $ | 10,605,941 | $ | 15,386,595 |\n| Food and beverage department | 1,911,950 | 2,968,395 |\n| Other operating departments | 880,564 | 1,385,469 |\n| Total revenue | 13,398,455 | 19,740,459 |\n| Expenses |\n| Hotel operating expenses |\n| Rooms department | 2,062,515 | 3,270,930 |\n| Food and beverage department | 1,442,139 | 2,270,918 |\n| Other operating departments | 388,087 | 655,818 |\n| Indirect | 4,774,322 | 7,436,198 |\n| Total hotel operating expenses | 8,667,063 | 13,633,864 |\n| Depreciation and amortization | 1,060,339 | 2,116,211 |\n| General and administrative | 252,565 | 148,873 |\n| Total operating expenses | 9,979,967 | 15,898,948 |\n| Operating income | 3,418,488 | 3,841,511 |\n| Interest expense | (1,516,433 | ) | (2,612,032 | ) |\n| Net income | $ | 1,902,055 | $ | 1,229,479 |\n| 2016 | 2015 | 2014 |\n| General and administrative | $ | 12,419,221 | $ | 11,595,819 | $ | 9,823,853 |\n| Sales and marketing | 13,754,600 | 11,426,637 | 9,788,079 |\n| Repairs and maintenance | 7,401,755 | 6,948,699 | 6,278,411 |\n| Utilities | 6,429,686 | 6,124,459 | 5,763,990 |\n| Franchise fees | 4,091,729 | 4,016,083 | 4,122,726 |\n| Management fees, including incentive | 3,865,362 | 3,490,586 | 3,439,807 |\n| Property taxes | 5,983,280 | 5,110,659 | 3,664,022 |\n| Insurance | 2,594,783 | 2,305,966 | 1,927,935 |\n| Other | 601,276 | 291,383 | 263,668 |\n| Total indirect hotel operating expenses | $ | 57,141,692 | $ | 51,310,292 | $ | 45,072,491 |\n| Year Ended | Year Ended | Year Ended |\n| December 31, 2016 | December 31, 2015 | December 31, 2014 |\n| Current: |\n| Federal | $ | — | $ | — | $ | — |\n| State | 191,332 | 444,538 | 233,940 |\n| 191,332 | 444,538 | 233,940 |\n| Deferred: |\n| Federal | (1,294,408 | ) | (1,510,726 | ) | (1,718,351 | ) |\n| State | (264,558 | ) | (269,845 | ) | (243,312 | ) |\n| (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) |\n| $ | (1,367,634 | ) | $ | (1,336,033 | ) | $ | (1,727,723 | ) |\n| Year Ended | Year Ended | Year Ended |\n| December 31, 2016 | December 31, 2015 | December 31, 2014 |\n| Statutory federal income tax expense | $ | (158,859 | ) | $ | 1,705,610 | $ | (838,519 | ) |\n| Effect of non-taxable REIT income | (1,135,549 | ) | (2,866,950 | ) | (898,576 | ) |\n| State income tax benefit | (73,226 | ) | (174,693 | ) | 9,372 |\n| $ | (1,367,634 | ) | $ | (1,336,033 | ) | $ | (1,727,723 | ) |\n| • | a demonstrated track record of past profitability and utilization of past NOL carryforwards, |\n| • | reasonable forecasts of future taxable income, and |\n| • | anticipated changes in the lease rental payments from the TRS Lessee to subsidiaries of the Operating Partnership. |\n| Year Ended | Year Ended | Year Ended |\n| December 31, 2016 | December 31, 2015 | December 31, 2014 |\n| Numerator |\n| Net income/(loss) attributable to the common shareholders for basic computation | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) |\n| Denominator |\n| Weighted average number of common shares outstanding for basic computation | 14,896,994 | 12,541,117 | 10,377,125 |\n| Basic and diluted net income (loss) per share | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) |\n| Year Ended | Year Ended | Year Ended |\n| December 31, 2016 | December 31, 2015 | December 31, 2014 |\n| Numerator |\n| Net income/(loss) attributable to the common unitholders for basic computation | $ | (244,740 | ) | $ | 6,397,653 | $ | (738,509 | ) |\n| Denominator |\n| Weighted average number of units outstanding | 16,710,935 | 14,924,410 | 13,107,413 |\n| Basic and diluted net income (loss) per unit | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) |\n| Quarters Ended 2016 |\n| March 31 | June 30 | September 30 | December 31 |\n| Total revenue | $ | 37,810,144 | $ | 41,824,954 | $ | 37,275,312 | $ | 35,935,342 |\n| Total operating expenses | 33,025,990 | 34,645,809 | 33,539,913 | 33,026,914 |\n| Net operating income | 4,784,154 | 7,179,145 | 3,735,399 | 2,908,428 |\n| Net income(loss) | 545,874 | 1,977,550 | (1,549,191 | ) | (74,084 | ) |\n| Net income (loss) attributable to common shareholders | 483,095 | 1,761,106 | (1,716,234 | ) | (746,140 | ) |\n| Earnings (loss) per share attributable to common shareholders– basic and diluted | $ | 0.03 | $ | 0.12 | $ | (0.11 | ) | $ | (0.05 | ) |\n| Quarters Ended 2015 |\n| March 31 | June 30 | September 30 | December 31 |\n| Total revenue | $ | 30,975,630 | $ | 36,865,108 | $ | 33,941,875 | $ | 36,750,863 |\n| Total operating expenses | 27,410,462 | 29,689,455 | 31,976,036 | 34,127,473 |\n| Net operating income | 3,565,168 | 7,175,653 | 1,965,839 | 2,623,390 |\n| Net income(loss) | 713,859 | 1,759,109 | 4,636,644 | (711,959 | ) |\n| Net income (loss) attributable to common shareholders | 575,336 | 1,431,110 | 3,872,394 | (522,174 | ) |\n| Earnings (loss) per share attributable to common shareholders– basic and diluted | $ | 0.05 | $ | 0.13 | $ | 0.27 | $ | (0.04 | ) |\n| Costs Capitalized | Life on |\n| Initial Costs | Subsequent to Acquisition | Gross Amount At End of Year | Accumulated | Which |\n| Building & | Building & | Building & | Depreciation | Date of | Date | Depreciation |\n| Description | Encumbrances | Land | Improvements | Land | Improvements | Land | Improvements | Total | & Impairment | Construction | Acquired | is Computed |\n| Crowne Plaza Hampton Marina – Hampton, Virginia | $ | 2,585 | $ | 1,061 | $ | 6,733 | $ | 36 | 3,796 | $ | 1,097 | $ | 10,529 | $ | 11,626 | $ | (4,296 | ) | 1988 | 2008 | 3-39 years |\n| Crowne Plaza Hollywood Beach Resort - Hollywood Beach, Florida | 58,936 | 22,865 | 67,660 | — | (124 | ) | 22,865 | 67,536 | 90,401 | (2,646 | ) | 1972 | 2015 | 3-39 years |\n| Crowne Plaza Tampa Westshore – Tampa, Florida | 15,561 | 4,153 | 9,670 | 297 | 22,259 | 4,450 | 31,929 | 36,379 | (7,707 | ) | 1973 | 2007 | 3-39 years |\n| DoubleTree by Hilton Jacksonville Riverfront – Jacksonville, Florida | 19,292 | 7,090 | 14,604 | 89 | 7,113 | 7,179 | 21,717 | 28,896 | (5,881 | ) | 1970 | 2005 | 3-39 years |\n| DoubleTree by Hilton Laurel – Laurel, Maryland | 9,329 | 900 | 9,443 | 175 | 5,679 | 1,075 | 15,122 | 16,197 | (3,913 | ) | 1985 | 2004 | 3-39 years |\n| DoubleTree by Hilton Philadelphia Airport – Philadelphia, Pennsylvania | 31,262 | 2,100 | 22,031 | 260 | 5,478 | 2,360 | 27,509 | 29,869 | (8,281 | ) | 1972 | 2004 | 3-39 years |\n| DoubleTree by Hilton Raleigh Brownstone – University – Raleigh, North Carolina | 14,774 | 815 | 7,416 | 213 | 5,761 | 1,028 | 13,177 | 14,205 | (4,831 | ) | 1971 | 2004 | 3-39 years |\n| Georgian Terrace – Atlanta, Georgia | 45,826 | 10,128 | 45,386 | (1,332 | ) | 4,811 | 8,796 | 50,197 | 58,993 | (3,715 | ) | 1911 | 2014 | 3-39 years |\n| Hilton Savannah DeSoto – Savannah, Georgia | 30,000 | 600 | 13,562 | 31 | 14,545 | 631 | 28,107 | 28,738 | (8,640 | ) | 1968 | 2004 | 3-39 years |\n| Hilton Wilmington Riverside – Wilmington, North Carolina | 30,000 | 785 | 16,829 | 228 | 12,514 | 1,013 | 29,343 | 30,356 | (11,283 | ) | 1970 | 2004 | 3-39 years |\n| Sheraton Louisville Riverside – Jeffersonville, Indiana | 11,977 | 782 | 6,891 | 222 | 14,566 | 1,004 | 21,457 | 22,461 | (5,074 | ) | 1972 | 2006 | 3-39 years |\n| The Whitehall – Houston, Texas | 15,000 | 7,374 | 22,185 | 78 | 4,431 | 7,452 | 26,616 | 34,068 | (2,239 | ) | 1963 | 2013 | 3-39 years |\n| $ | 284,542 | $ | 58,653 | $ | 242,410 | $ | 297 | $ | 100,829 | $ | 58,950 | $ | 343,239 | $ | 402,189 | $ | (68,506 | ) |\n| (1) | For the year ending December 31, 2016, the aggregate cost of our real estate assets for federal income tax purposes was approximately $398.6 million. |\n| Balance at December 31, 2014 | $ | 294,827 |\n| Acquisitions | 91,669 |\n| Improvements | 11,105 |\n| Disposal of Assets | (3,971 | ) |\n| Balance at December 31, 2015 | $ | 393,630 |\n| Acquisitions | — |\n| Improvements | 9,473 |\n| Disposal of Assets | (914 | ) |\n| Balance at December 31, 2016 | $ | 402,189 |\n| Balance at December 31, 2014 | $ | 53,233 |\n| Current Expense | 8,790 |\n| Impairment | 500 |\n| Disposal of Assets | (482 | ) |\n| Balance at December 31, 2015 | $ | 62,041 |\n| Current Expense | 7,018 |\n| Impairment | — |\n| Disposal of Assets | (553 | ) |\n| Balance at December 31, 2016 | $ | 68,506 |\n\n</text>\n\nWhat is the average annual franchise fee, in percentage, if the company operates the franchise for a period of 5 years based on the franchise fee for operating year 1, 2 and thereafter?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 4.4."
}
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{
"split": "test",
"index": 60,
"input_length": 87912
}
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docmath_40000_plus
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\nPART I—FINANCIAL INFORMATION\nITEM 1. FINANCIAL STATEMENTS\nQWEST CORPORATION\nCONSOLIDATED STATEMENTS OF OPERATIONS\n(UNAUDITED)\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| (Dollars in millions) |\n| OPERATING REVENUES |\n| Operating revenues | $ | 1,573 | 1,618 | 3,172 | 3,254 |\n| Operating revenues - affiliates | 650 | 604 | 1,304 | 1,185 |\n| Total operating revenues | 2,223 | 2,222 | 4,476 | 4,439 |\n| OPERATING EXPENSES |\n| Cost of services and products (exclusive of depreciation and amortization) | 731 | 743 | 1,439 | 1,435 |\n| Selling, general and administrative | 235 | 256 | 485 | 526 |\n| Operating expenses - affiliates | 231 | 238 | 482 | 486 |\n| Depreciation and amortization | 424 | 464 | 843 | 926 |\n| Total operating expenses | 1,621 | 1,701 | 3,249 | 3,373 |\n| OPERATING INCOME | 602 | 521 | 1,227 | 1,066 |\n| OTHER (EXPENSE) INCOME |\n| Interest expense | (120 | ) | (119 | ) | (241 | ) | (237 | ) |\n| Interest expense - affiliates, net | (15 | ) | (13 | ) | (29 | ) | (26 | ) |\n| Other income, net | — | 1 | 2 | 1 |\n| Total other expense, net | (135 | ) | (131 | ) | (268 | ) | (262 | ) |\n| INCOME BEFORE INCOME TAX EXPENSE | 467 | 390 | 959 | 804 |\n| Income tax expense | 179 | 152 | 367 | 319 |\n| NET INCOME | $ | 288 | 238 | 592 | 485 |\n\nSee accompanying notes to consolidated financial statements.\n3\nQWEST CORPORATION\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME\n(UNAUDITED)\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| (Dollars in millions) |\n| NET INCOME | $ | 288 | 238 | 592 | 485 |\n| OTHER COMPREHENSIVE INCOME: |\n| Foreign currency translation adjustment, net of $—, $—, $— and $— tax | 3 | — | — | — |\n| Other comprehensive income | 3 | — | — | — |\n| COMPREHENSIVE INCOME | $ | 291 | 238 | 592 | 485 |\n\nSee accompanying notes to consolidated financial statements.\n4\nQWEST CORPORATION\nCONSOLIDATED BALANCE SHEETS\n(UNAUDITED)\n| As of June 30, 2016 | As of December 31, 2015 |\n| (Dollars in millions) |\n| ASSETS |\n| CURRENT ASSETS |\n| Cash and cash equivalents | $ | 4 | 3 |\n| Accounts receivable, less allowance of $48 and $47 | 688 | 688 |\n| Advances to affiliates | 811 | 788 |\n| Other | 148 | 123 |\n| Total current assets | 1,651 | 1,602 |\n| NET PROPERTY, PLANT AND EQUIPMENT |\n| Property, plant and equipment | 12,619 | 12,182 |\n| Accumulated depreciation | (5,182 | ) | (4,808 | ) |\n| Net property, plant and equipment | 7,437 | 7,374 |\n| GOODWILL AND OTHER ASSETS |\n| Goodwill | 9,354 | 9,354 |\n| Customer relationships, less accumulated amortization of $3,549 and $3,264 | 2,150 | 2,435 |\n| Other intangible assets, less accumulated amortization of $1,435 and $1,383 | 539 | 613 |\n| Other, net | 98 | 92 |\n| Total goodwill and other assets | 12,141 | 12,494 |\n| TOTAL ASSETS | $ | 21,229 | 21,470 |\n| LIABILITIES AND STOCKHOLDER'S EQUITY |\n| CURRENT LIABILITIES |\n| Current maturities of long-term debt | $ | 509 | 242 |\n| Accounts payable | 350 | 369 |\n| Note payable - affiliate | 884 | 855 |\n| Accrued expenses and other liabilities |\n| Salaries and benefits | 186 | 211 |\n| Income and other taxes | 165 | 189 |\n| Other | 146 | 135 |\n| Current affiliate obligations, net | 94 | 97 |\n| Advance billings and customer deposits | 322 | 324 |\n| Total current liabilities | 2,656 | 2,422 |\n| LONG-TERM DEBT | 6,726 | 6,997 |\n| DEFERRED CREDITS AND OTHER LIABILITIES |\n| Deferred revenues | 123 | 137 |\n| Deferred income taxes, net | 1,861 | 1,896 |\n| Affiliate obligations, net | 1,003 | 1,051 |\n| Other | 61 | 60 |\n| Total deferred credits and other liabilities | 3,048 | 3,144 |\n| COMMITMENTS AND CONTINGENCIES (Note 5) |\n| STOCKHOLDER'S EQUITY |\n| Common stock - one share without par value, owned by Qwest Services Corporation | 10,050 | 10,050 |\n| Accumulated deficit | (1,251 | ) | (1,143 | ) |\n| Total stockholder's equity | 8,799 | 8,907 |\n| TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY | $ | 21,229 | 21,470 |\n\nSee accompanying notes to consolidated financial statements.\n5\nQWEST CORPORATION\nCONSOLIDATED STATEMENTS OF CASH FLOWS\n(UNAUDITED)\n| Six Months Ended June 30, |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| OPERATING ACTIVITIES |\n| Net income | $ | 592 | 485 |\n| Adjustments to reconcile net income to net cash provided by operating activities: |\n| Depreciation and amortization | 843 | 926 |\n| Deferred income taxes | (35 | ) | (180 | ) |\n| Provision for uncollectible accounts | 40 | 39 |\n| Net long-term debt issuance costs and premium amortization | (7 | ) | (11 | ) |\n| Accrued interest on affiliate note | 29 | 31 |\n| Changes in current assets and liabilities: |\n| Accounts receivable | (40 | ) | 8 |\n| Accounts payable | (20 | ) | 30 |\n| Accrued income and other taxes | (24 | ) | (14 | ) |\n| Other current assets and liabilities, net | (40 | ) | (34 | ) |\n| Other current assets and liabilities - affiliates, net | — | (4 | ) |\n| Changes in other noncurrent assets and liabilities, net | (11 | ) | (23 | ) |\n| Changes in affiliate obligations, net | (51 | ) | (4 | ) |\n| Other, net | 8 | 5 |\n| Net cash provided by operating activities | 1,284 | 1,254 |\n| INVESTING ACTIVITIES |\n| Payments for property, plant and equipment and capitalized software | (546 | ) | (564 | ) |\n| Changes in advances to affiliates | (23 | ) | (383 | ) |\n| Net cash used in investing activities | (569 | ) | (947 | ) |\n| FINANCING ACTIVITIES |\n| Net proceeds from issuance of long-term debt | 227 | 99 |\n| Payments of long-term debt | (241 | ) | (106 | ) |\n| Dividends paid to Qwest Services Corporation | (700 | ) | (300 | ) |\n| Net cash used in financing activities | (714 | ) | (307 | ) |\n| Net increase in cash and cash equivalents | 1 | — |\n| Cash and cash equivalents at beginning of period | 3 | 6 |\n| Cash and cash equivalents at end of period | $ | 4 | 6 |\n| Supplemental cash flow information: |\n| Income taxes paid, net | $ | (401 | ) | (379 | ) |\n| Interest paid (net of capitalized interest of $8 and $9) | $ | (249 | ) | (247 | ) |\n\nSee accompanying notes to consolidated financial statements.\n6\nQWEST CORPORATION\nCONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY\n(UNAUDITED)\n| Six Months Ended June 30, |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| COMMON STOCK |\n| Balance at beginning of period | $ | 10,050 | 10,050 |\n| Balance at end of period | 10,050 | 10,050 |\n| ACCUMULATED DEFICIT |\n| Balance at beginning of period | (1,143 | ) | (867 | ) |\n| Net income | 592 | 485 |\n| Dividends declared to Qwest Services Corporation | (700 | ) | (300 | ) |\n| Balance at end of period | (1,251 | ) | (682 | ) |\n| TOTAL STOCKHOLDER'S EQUITY | $ | 8,799 | 9,368 |\n\nSee accompanying notes to consolidated financial statements.\n7\nQWEST CORPORATION\nNOTES TO CONSOLIDATED FINANCIAL STATEMENTS\n(UNAUDITED)\nUnless the context requires otherwise, references in this report to \"QC\" refer to Qwest Corporation, references to \"Qwest,\" \"we,\" \"us,\" and \"our\" refer to Qwest Corporation and its consolidated subsidiaries, references to \"QSC\" refer to our direct parent company, Qwest Services Corporation, and its consolidated subsidiaries, references to \"QCII\" refer to QSC's direct parent company and our indirect parent company, Qwest Communications International Inc., and its consolidated subsidiaries, and references to \"CenturyLink\" refer to QCII's direct parent company and our ultimate parent company, CenturyLink, Inc., and its consolidated subsidiaries.\n(1) Basis of Presentation\nGeneral\nWe are an integrated communications company engaged primarily in providing an array of services to our residential and business customers. Our communications services include local voice, broadband, private line (including special access), network access, Ethernet, information technology, video and other ancillary services. In certain local and regional markets, we also provide local access and fiber transport services to competitive local exchange carriers.\nWe generate the majority of our total consolidated operating revenues from services provided in the 14-state region of Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and Wyoming. We refer to this region as our local service area.\nOur consolidated balance sheet as of December 31, 2015, which was derived from our audited consolidated financial statements, and our unaudited interim consolidated financial statements provided herein have been prepared in accordance with the instructions for Form 10-Q. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to rules and regulations of the Securities and Exchange Commission (\"SEC\"); however, in our opinion, the disclosures made are adequate to make the information presented not misleading. We believe that these consolidated financial statements include all normal recurring adjustments necessary to fairly present the results for the interim periods. The consolidated results of operations for the first six months of the year are not necessarily indicative of the consolidated results of operations that might be expected for the entire year. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2015.\nThe accompanying consolidated financial statements include our accounts and the accounts of our subsidiaries. Intercompany amounts and transactions with our consolidated subsidiaries have been eliminated. Transactions with our non-consolidated affiliates (referred to herein as affiliates) have not been eliminated.\nWe reclassified certain prior period amounts to conform to the current period presentation, including the categorization of our revenues. See Note 4—Products and Services Revenues for additional information. These changes had no impact on total operating revenues, total operating expenses or net income for any period.\nConnect America Fund\nIn 2015, CenturyLink accepted funding from the Federal Communications Commission's (\"FCC\") Connect America Fund (\"CAF\") of approximately $500 million per year for six years to fund the deployment of voice and broadband capable infrastructure for approximately 1.2 million rural households and businesses in 33 states under the CAF Phase 2 high-cost support program. The funding from the CAF Phase 2 support program in these 33 states will substantially supplant funding from the interstate Universal Service Fund (\"USF\") high-cost program that we previously utilized to support voice services in high-cost rural markets. Of these amounts, approximately $150 million per year is attributable to our service area, to provide service to approximately 0.3 million rural households and businesses in 13 states. In late 2015, we began receiving these support payments from the FCC under the new CAF Phase 2 support program, which included monthly support payments at a higher rate than under the interstate USF support program. We recorded $24 million and $48 million more in revenue for the three and six months ended June 30, 2016, respectively, than in the comparable periods for 2015 with respect to our 13 states. We received a substantial one-time cumulative catch-up payment related to the first half of 2015 from the FCC in the third quarter of 2015, and, as a result, we do not expect funding from the CAF Phase 2 support program to materially change our \"affiliate and other services\" revenues for the full year 2016 when compared to the full year 2015.\n8\nRecent Accounting Pronouncements\nFinancial Instruments\nOn June 16, 2016, the Financial Accounting Standards Board (\"FASB\") issued Accounting Standards Update (\"ASU\") 2016-13, “Measurement of Credit Losses on Financial Instruments” (“ASU 2016-13”). The primary impact of ASU 2016-13 for us is a change in the model for the recognition of credit losses related to our financial instruments from an incurred loss model, which recognized credit losses only if it was probable that a loss had been incurred to an expected loss model, which requires our management team to estimate the total credit losses expected on the portfolio of financial instruments. We are currently reviewing the requirements of the standard and evaluating the impact on our consolidated financial statements.\nWe are required to adopt the provisions of ASU 2016-13 effective January 1, 2020, but could elect to early adopt the provisions as of January 1, 2019. We expect to recognize the impacts of adopting ASU 2016-13 through a cumulative adjustment to retained earnings as of the date of adoption.\nShare-based Compensation\nOn March 30, 2016, the FASB issued ASU 2016-09, “Improvement to Employee Share-Based Payment Accounting\" (“ASU 2016-09”). ASU 2016-09 modifies the accounting and associated income tax accounting for share-based compensation in order to reduce the cost and complexity associated with current generally accepted accounting principles. ASU 2016-09 is effective for us as of January 1, 2017, but early adoption may be elected. ASU 2016-09 includes different transition requirements for the different changes implemented, including some provisions which allow retrospective application. We have not determined when we will implement this standard or if we will retrospectively apply the requirements when allowed.\nThe primary provisions of ASU 2016-09 that we expect will affect our financial statements are: 1) a reclassification of the tax effect associated with the difference between the expense recognized for share-based payments and the associated tax deduction from additional paid-in capital to income tax expense; 2) a reclassification of the tax effect associated with the difference between compensation expense and associated deduction from financing cash flow to operating cash flow; and 3) an optional accounting policy election to account for forfeitures of share-based payment grants as they occur as opposed to our current policy of estimating the forfeitures on the grant date. These provisions would not have had a material impact on our previously issued financial statements; however, this is not necessarily representative of future impacts. Adoption of ASU 2016-09 may increase the volatility of income tax expense and cash flow from operating activities.\nLeases\nOn February 25, 2016, the FASB issued ASU 2016-02, “Leases” (“ASU 2016-02”). The core principle of ASU 2016-02 will require lessees to present right-of-use assets and lease liabilities on their balance sheets for operating leases, which are currently not reflected on their balance sheets.\nASU 2016-02 is effective for annual and interim periods beginning January 1, 2019. Early adoption of ASU 2016-02 is permitted. Upon adoption of ASU 2016-02, we are required to recognize and measure leases at the beginning of the earliest period presented in our consolidated financial statements using a modified retrospective approach. The modified retrospective approach includes a number of optional practical expedients that we may elect to apply. We have not yet decided when we will adopt ASU 2016-02 or which practical expedient options we will elect. We are currently evaluating and assessing the impact ASU 2016-02 will have on us and our consolidated financial statements. As of the date of this report, we cannot provide any estimate of the impact of adopting ASU 2016-02.\nRevenue Recognition\nOn May 28, 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers” (“ASU 2014-09”). ASU 2014-09 replaces virtually all existing generally accepted accounting principles (“GAAP”) on revenue recognition and replaces them with a principles-based approach for determining revenue recognition using a new five step model. The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 also includes new accounting principles related to the deferral and amortization of contract acquisition and fulfillment costs. We currently do not defer any contract acquisition costs and we defer contract fulfillment costs only up to the extent of any revenue deferred.\n9\nOn July 9, 2015, the FASB approved the deferral of the effective date of ASU 2014-09 by one year until January 1, 2018, which is the date we plan to adopt this standard. ASU 2014-09 may be adopted by applying the provisions of this standard on a retrospective basis to the periods included in the financial statements or on a modified retrospective basis which would result in the recognition of a cumulative effect of adopting ASU 2014-09 in the first quarter of 2018. We have not yet decided which implementation method we will adopt. We are studying ASU 2014-09 and are assessing the impact this standard will have on us and our consolidated financial statements. We cannot at this time, however, provide any estimate of the impact of adopting ASU 2014-09.\n(2) Long-Term Debt and Revolving Promissory Note\nLong-term debt, including unamortized discounts and premiums, unamortized debt issuance costs and note payable - affiliate, were as follows:\n| Interest Rates | Maturities | As of June 30, 2016 | As of December 31, 2015 |\n| (Dollars in millions) |\n| Senior notes | 6.125% - 7.750% | 2017 - 2056 | $ | 7,229 | 7,229 |\n| Term loan | 2.220% | 2025 | 100 | 100 |\n| Capital lease and other obligations | Various | Various | 28 | 17 |\n| Unamortized premiums, net | 8 | 16 |\n| Unamortized debt issuance costs | (130 | ) | (123 | ) |\n| Total long-term debt | 7,235 | 7,239 |\n| Less current maturities | (509 | ) | (242 | ) |\n| Long-term debt, excluding current maturities | $ | 6,726 | 6,997 |\n| Note payable - affiliate | 6.795% | 2022 | $ | 884 | 855 |\n\nNew Issuance\nIn January 2016, QC issued $235 million aggregate principal amount of 7% Notes due 2056, in exchange for net proceeds, after deducting underwriting discounts and other expenses, of approximately $227 million. All of the 7% Notes are unsecured obligations and may be redeemed by QC, in whole or in part, on or after February 1, 2021, at a redemption price equal to 100% of the principal amount redeemed plus accrued and unpaid interest to the redemption date.\nRepayment\nOn May 2, 2016, QC paid at maturity the $235 million principal amount and accrued and unpaid interest due under its 8.375% Notes.\nRevolving Promissory Note\nWe are currently indebted to an affiliate of our ultimate parent company, CenturyLink, under a revolving promissory note that provides us with a funding commitment of up to $1.0 billion aggregate principal amount through June 30, 2022, of which $884 million was outstanding as of June 30, 2016. As of June 30, 2016, the weighted average interest rate was 6.795%. As of June 30, 2016 and December 31, 2015, this revolving promissory note is reflected on our consolidated balance sheets as a current liability under note payable - affiliate. As of June 30, 2016, $5 million of accrued interest is reflected in other current liabilities on our consolidated balance sheet. In accordance with the note agreement, all accrued interest and unpaid interest is capitalized to the unpaid principal balance on June 1 and December 1 of each year.\nCovenants\nThe indentures governing our notes contain certain covenants including, but not limited to: (i) a prohibition on certain liens on our assets; and (ii) a limitation on mergers or sales of all, or substantially all, of our assets, which limitation requires that a successor assume the obligation with regard to these notes. These indentures do not contain any cross-default provisions.\nOur senior notes were issued under indentures dated April 15, 1990 and October 15, 1999. These indentures do not contain any financial covenants, but do include restrictions that limit our ability to (i) incur, issue or create liens upon our property and (ii) consolidate with or merge into, transfer or lease all or substantially all of our assets to any other party.\nAs of June 30, 2016, we believe we were in compliance with the provisions and covenants of our debt agreements.\n10\n(3) Fair Value Disclosure\nOur financial instruments consist of cash and cash equivalents, accounts receivable, advances to affiliates, accounts payable, note payable - affiliate and long-term debt, excluding capital lease and other obligations. Due to their short-term nature, the carrying amounts of our cash and cash equivalents, accounts receivable, advances to affiliates, accounts payable, and note payable - affiliate approximate their fair values.\nFair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between independent and knowledgeable parties who are willing and able to transact for an asset or liability at the measurement date. We use valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs when determining fair value and then we rank the estimated values based on the reliability of the inputs used following the fair value hierarchy set forth by the FASB. We determined the fair values of our long-term debt, including the current portion, based on quoted market prices where available or, if not available, based on discounted future cash flows using current market interest rates.\n| Input Level | Description of Input |\n| Level 1 | Observable inputs such as quoted market prices in active markets. |\n| Level 2 | Inputs other than quoted prices in active markets that are either directly or indirectly observable. |\n| Level 3 | Unobservable inputs in which little or no market data exists. |\n\n| As of June 30, 2016 | As of December 31, 2015 |\n| InputLevel | CarryingAmount | FairValue | CarryingAmount | FairValue |\n| (Dollars in millions) |\n| Liabilities—Long-term debt, excluding capital lease and other obligations | 2 | $ | 7,207 | 7,579 | 7,222 | 7,456 |\n\n(4) Products and Services Revenues\nWe are an integrated communications company engaged primarily in providing an array of services, including local voice, broadband, private line (including special access), network access, Ethernet, information technology, video and other ancillary services. We strive to maintain our customer relationships by, among other things, bundling our service offerings to provide our customers with a complete offering of integrated communications services.\nFrom time to time, we may change the categorization of our products and services. During the second quarter of 2016, we determined that because of declines due to customer migration to other strategic products and services, certain of our services, specifically our private line (including special access) services, are now more closely aligned with our legacy services than with our strategic services. As a result, we now reflect these operating revenues as legacy services, and we have reclassified certain prior period amounts to conform to this change. The revision resulted in a reduction of revenue from strategic services and a corresponding increase in revenue from legacy services of $209 million and $426 million (net of $1 million and $2 million of deferred revenue included in affiliate and other services) for the three and six months ended June 30, 2015, respectively.\n11\nWe now categorize our products, services and revenues among the following three categories:\n| • | Strategic services, which include primarily broadband, Ethernet, video and other ancillary services; |\n\n| • | Legacy services, which include primarily local voice, private line (including special access), Integrated Services Digital Network (\"ISDN\") (which use regular telephone lines to support voice, video and data applications), switched access, traditional wide area network (\"WAN\") (which allow a local communications network to link to networks in remote locations) and other ancillary services; and |\n\n| • | Affiliates and other services, which consist primarily of CAF support payments, USF support payments, USF surcharges and services we provide to our affiliates. We receive federal support payments from both CAF Phase 1 and CAF Phase 2 programs, and support payments from both federal and state USF programs. These support payments are government subsidies designed to reimburse us for various costs related to certain telecommunications services, including the costs of deploying, maintaining and operating voice and broadband infrastructure in high-cost rural areas where we are not able to fully recover our costs from our customers. USF surcharges are the amounts we collect based on specific items we list on our customers' invoices to fund the FCC's universal service programs. We provide to our affiliates, telecommunication services that we also provide to external customers. In addition, we provide to our affiliates, computer system development and support services, network support and technical services. |\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| (Dollars in millions) |\n| Strategic services | $ | 674 | 650 | 1,345 | 1,291 |\n| Legacy services | 814 | 904 | 1,658 | 1,833 |\n| Affiliates and other services | 735 | 668 | 1,473 | 1,315 |\n| Total operating revenues | $ | 2,223 | 2,222 | 4,476 | 4,439 |\n\nWe do not have any single external customer that provides more than 10% of our total consolidated operating revenues. Substantially all of our consolidated revenues come from customers located in the United States.\nWe recognize revenues in our consolidated statements of operations for certain USF surcharges and transaction taxes that we bill to our customers. Our consolidated statements of operations also reflect the related expense for the amounts we remit to the government agencies. The total amount of such surcharges and transaction taxes that we included in revenues aggregated approximately $38 million for each of the three months ended June 30, 2016 and 2015, respectively, and approximately $76 million and $75 million for the six months ended June 30, 2016 and 2015, respectively. These USF surcharges, where we record revenue, are included in \"affiliate and other services\" revenues and these transaction taxes are included in \"legacy services\" revenues. We also act as a collection agent for certain other USF and transaction taxes that we are required by government agencies to bill our customers, for which we do not record any revenue or expense because we only act as a pass-through agent.\nOur operations are integrated into and reported as part of the consolidated segment data of CenturyLink. CenturyLink's chief operating decision maker (\"CODM\") is our CODM, but reviews our financial information on an aggregate basis only in connection with our quarterly and annual reports that we file with the Securities and Exchange Commission. Consequently, we do not provide our discrete financial information to the CODM on a regular basis. As such, we believe we have one reportable segment.\n(5) Commitments and Contingencies\nPending Matters\nSubsidiaries of CenturyLink, Inc., including us, are among hundreds of companies in an industry-wide dispute, raised in nearly 100 federal lawsuits (filed between 2014 and 2016) that have been consolidated in the United States District Court for the District of Northern Texas for pretrial procedures. The disputes relate to switched access charges that local exchange carriers (\"LECs\") collect from interexchange carriers (\"IXCs\") for IXCs' use of LEC's access services. In the lawsuits, three IXCs, Sprint Communications Company L.P. (\"Sprint\"), affiliates of Verizon Communications Inc. (\"Verizon\") and affiliates of Level 3 Communications LLC (\"Level 3\"), assert that federal and state laws bar LECs from collecting access charges when IXCs exchange certain types of calls between mobile and wireline devices that are routed through an IXC. Some of these IXCs have asserted claims seeking refunds of payments for access charges previously paid and relief from future access charges. In addition, Level 3 has ceased paying switched access charges on these calls.\n12\nIn November 2015, the federal court agreed with the LECs and rejected the IXCs' contention that federal law prohibits these particular access charges, and also allowed the IXCs to refile state-law claims. Since then, many of the LECs and IXCs have filed revised pleadings and additional motions, which remain pending. Separately, some of the defendants, including us, have petitioned the Federal Communications Commission to address these issues on an industry-wide basis.\nThe outcome of these disputes and lawsuits, as well as any related regulatory proceedings that could ensue, are currently not predictable. If we are required to stop assessing these charges or to pay refunds of any such charges, our financial results could be negatively affected.\nOther Proceedings and Disputes\nFrom time to time, we are involved in other proceedings incidental to our business, including patent infringement allegations, administrative hearings of state public utility commissions relating primarily to our rates or services, actions relating to employee claims, various tax issues, environmental law issues, grievance hearings before labor regulatory agencies and miscellaneous third party tort actions.\nWe are currently defending several patent infringement lawsuits asserted against us by non-practicing entities, many of whom are seeking substantial recoveries. These cases have progressed to various stages and one or more may go to trial in the coming 24 months if they are not otherwise resolved. Where applicable, we are seeking full or partial indemnification from our vendors and suppliers. As with all litigation, we are vigorously defending these actions and, as a matter of course, are prepared to litigate these matters to judgment, as well as to evaluate and consider all reasonable settlement opportunities.\nWe are subject to various federal, state and local environmental protection and health and safety laws. From time to time, we are subject to judicial and administrative proceedings brought by various governmental authorities under these laws. Several such proceedings are currently pending, but none is reasonably expected to exceed $100,000 in fines and penalties.\nThe outcome of these other proceedings is not predictable. However, based on current circumstances, we do not believe that the ultimate resolution of these other proceedings, after considering available defenses and any insurance coverage or indemnification rights, will have a material adverse effect on our financial position, results of operations or cash flows.\nCenturyLink, Inc. and its affiliates are involved in several legal proceedings to which we are not a party that, if resolved against them, could have a material adverse effect on their business and financial condition. As an indirect wholly-owned subsidiary of CenturyLink, Inc., our business and financial condition could be similarly affected. You can find descriptions of these legal proceedings in CenturyLink, Inc.'s quarterly and annual reports filed with the Securities and Exchange Commission. Because we are not a party to any of the matters, we have not accrued any liabilities for the matters.\n(6) Dividends\nDuring the six months ended June 30, 2016, we declared and paid dividends of $700 million to our direct parent company, Qwest Services Corporation. Dividends paid are reflected on our consolidated statements of cash flows as financing activities.\n(7) Other Financial Information\nOther Current Assets\n| As of June 30, 2016 | As of December 31, 2015 |\n| (Dollars in millions) |\n| Prepaid expenses | $ | 70 | 46 |\n| Other | 78 | 77 |\n| Total other current assets | $ | 148 | 123 |\n\n13\nSelected Current Liabilities\n| As of June 30, 2016 | As of December 31, 2015 |\n| (Dollars in millions) |\n| Accounts payable | $ | 350 | 369 |\n\nIncluded in accounts payable at both June 30, 2016 and December 31, 2015, was $29 million associated with capital expenditures.\n14\nITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nUnless the context requires otherwise, references in this report to \"QC\" refer to Qwest Corporation, and references to \"Qwest,\" \"we,\" \"us\" and \"our\" refer to Qwest Corporation and its consolidated subsidiaries.\nAll references to \"Notes\" in this Item 2 of Part I refer to the Notes to Consolidated Financial Statements included in Item 1 of Part I of this report.\nCertain statements in this report constitute forward-looking statements. See the last paragraph of this Item 2 of Part I and \"Risk Factors\" in Item 1A of Part II of this report for a discussion of certain factors that could cause our actual results to differ from our anticipated results or otherwise impact our business, financial condition, results of operations, liquidity or prospects.\nOverview\nManagement's Discussion and Analysis of Financial Condition and Results of Operations (\"MD&A\") included herein should be read in conjunction with MD&A and the other information included in our Annual Report on Form 10-K for the year ended December 31, 2015, and with the consolidated financial statements and related notes in Item 1 of Part I of this report. The results of operations for the first six months of the year are not necessarily indicative of the results of operations that might be expected for the entire year.\nWe are an integrated communications company engaged primarily in providing an array of services to our residential and business customers. Our communications services include local voice, broadband, private line (including special access), network access, Ethernet, information technology, video and other ancillary services. In certain local and regional markets, we also provide local access and fiber transport services to competitive local exchange carriers. We strive to maintain our customer relationships by, among other things, bundling our service offerings to provide our customers with a complete offering of integrated communications services.\nWe generate the majority of our total consolidated operating revenues from services provided in the 14-state region of Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and Wyoming. We refer to this region as our local service area.\nOur ultimate parent company, CenturyLink, Inc. (\"CenturyLink\"), has cash management arrangements between certain of its subsidiaries that include lines of credit, affiliate obligations, capital contributions and dividends. As part of these cash management arrangements, affiliates provide lines of credit to certain other affiliates. Amounts outstanding under these lines of credit and intercompany obligations vary from time to time. Under these arrangements, the majority of our cash balance is advanced on a daily basis to CenturyLink. From time to time we may declare and pay dividends to Qwest Services Corporation (\"QSC\"), our direct parent, using cash owed to us under these advances, which has the net effect of reducing the amount of these advances. We report the balance of these transfers on our consolidated balance sheet as advances to affiliates.\nFor the reasons noted in Note 4—Products and Services Revenues to our consolidated financial statements in Item 1 of Part I of this report, we believe we have one reportable segment.\nFrom time to time, we may change the categorization of our products and services. During the second quarter of 2016, we determined that because of declines due to customer migration to other strategic products and services, certain of our services, specifically our private line (including special access) services, are now more closely aligned with our legacy services than with our strategic services. As described in greater detail in Note 4—Products and Services Revenues, these operating revenues are now reflected as legacy services.\nWe now categorize our products, services and revenues among the following three categories:\n| • | Strategic services, which include primarily broadband, Ethernet, video and other ancillary services; |\n\n| • | Legacy services, which include primarily local voice, private line (including special access), Integrated Services Digital Network (\"ISDN\") (which use regular telephone lines to support voice, video and data applications), switched access, traditional wide area network (\"WAN\") (which allow a local communications network to link to networks in remote locations) and other ancillary services; and |\n\n15\n| • | Affiliates and other services, which consist primarily of Connect America Fund (\"CAF\") support payments, Universal Service Fund (\"USF\") support payments, USF surcharges and services we provide to our affiliates. We receive federal support payments from both CAF Phase 1 and CAF Phase 2 programs, and support payments from both federal and state USF programs. These support payments are government subsidies designed to reimburse us for various costs related to certain telecommunications services, including the costs of deploying, maintaining and operating voice and broadband infrastructure in high-cost rural areas where we are not able to fully recover our costs from our customers. USF surcharges are the amounts we collect based on specific items we list on our customers' invoices to fund the Federal Communications Commission's (\"FCC\") universal service programs. We provide to our affiliates, telecommunication services that we also provide to external customers. In addition, we provide to our affiliates, computer system development and support services, network support and technical services. |\n\nAt June 30, 2016, we operated approximately 6.8 million access lines and served approximately 3.5 million broadband subscribers. Our methodology for counting access lines and broadband subscribers, which is described further in the operational metrics table below under \"Results of Operations\", may not be comparable to those of other companies.\nThe following analysis is organized to provide the information we believe will be useful for understanding material trends affecting our business.\nBusiness Trends\nOur financial results were impacted by several significant trends, which are described below. We expect that these trends will continue to affect our results of operations, cash flows or financial position.\n| • | Strategic services. We continue to see shifts in the makeup of our total revenues as customers move to lower margin strategic services, such as broadband and video services, from higher margin legacy services. Revenues from our strategic services represented 30% and 29% of our total revenues for both the three and six months ended June 30, 2016 and 2015, respectively. We continue to experienced price compression due to competition, which negatively impacted the growth of our strategic revenues. We continue to focus on increasing subscribers of our broadband services, particularly among consumer and small business customers. We believe that continually increasing the scope and connection speeds of our broadband services is important to remaining competitive in our industry. As a result, we continue to invest in our broadband network, which allows for the delivery of higher speed broadband services to a greater number of customers. We compete in a maturing broadband market in which most customers already have broadband services and growth rates in new subscribers have slowed. Moreover, as described further in \"Risk Factors\" in Item 1A of Part II of this report, demand for our broadband services could be adversely affected by competitors continuing to provide services at higher broadband speeds than ours or expanding their advanced wireless data service offerings. Our Ethernet-based services in the wholesale market face competition from cable companies and competitive fiber-based telecommunications providers; |\n\n| • | Legacy services. Revenues from our legacy services represented 37% and 41% of our total revenues for the three and six months ended June 30, 2016 and 2015, respectively. We expect these percentages to continue to decline. Our legacy services revenues have been, and we expect they will continue to be adversely affected by access line losses and price compression. Intense competition and product substitution continue to drive our access line losses. For example, many consumers are replacing traditional voice telecommunications service with substitute services, including (i) cable and wireless voice services and (ii) electronic mail, texting and social networking services. We expect that these factors will continue to negatively impact our business. As a result of the expected loss of revenue associated with access lines, we continue to offer our customers service bundling and other product promotions to help mitigate this trend, as described below. Demand for our private line services (including special access) continues to decline due to customers' optimization of their networks, industry consolidation and technological migration to higher-speed services; |\n\n| • | Service bundling and product promotions. We offer our customers the ability to bundle multiple products and services. These customers can bundle local services with other services such as broadband and video. While we believe our bundled service offerings can help retain customers, they also tend to lower our profit margins due to the related discounts; and |\n\n| • | Operating efficiencies. We continue to evaluate our operating structure and focus. This involves balancing our workforce in response to our workload requirements, productivity improvements and changes in industry, competitive, technological and regulatory conditions. |\n\nWhile these trends are important to understanding and evaluating our financial results, the other transactions, events, uncertainties and trends discussed in \"Risk Factors\" in Item 1A of Part II of this report may also materially impact our business operations and financial results.\n16\nResults of Operations\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| (Dollars in millions) |\n| Operating revenues | $ | 2,223 | 2,222 | 4,476 | 4,439 |\n| Operating expenses | 1,621 | 1,701 | 3,249 | 3,373 |\n| Operating income | 602 | 521 | 1,227 | 1,066 |\n| Other expense, net | (135 | ) | (131 | ) | (268 | ) | (262 | ) |\n| Income tax expense | 179 | 152 | 367 | 319 |\n| Net income | $ | 288 | 238 | 592 | 485 |\n\n| As of June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (in thousands) |\n| Operational metrics: |\n| Total access lines (1) | 6,808 | 7,184 | (376 | ) | (5 | )% |\n| Total broadband subscribers (1) | 3,516 | 3,556 | (40 | ) | (1 | )% |\n| Total employees | 22.9 | 22.5 | 0.4 | 2 | % |\n\n(1) Access lines are lines reaching from the customers' premises to a connection with the public network and broadband subscribers are customers that purchase broadband connection service through their existing telephone lines, stand-alone telephone lines, or fiber-optic cables. Our methodology for counting our access lines and broadband subscribers includes only those lines that we use to provide services to external customers and excludes lines used solely by us and our affiliates. It also excludes unbundled loops and includes stand-alone broadband subscribers. We count lines when we install the service.\nOperating Revenues\n| Three Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Strategic services | $ | 674 | 650 | 24 | 4 | % |\n| Legacy services | 814 | 904 | (90 | ) | (10 | )% |\n| Affiliates and other services | 735 | 668 | 67 | 10 | % |\n| Total operating revenues | $ | 2,223 | 2,222 | 1 | — | % |\n\n| Six Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Strategic services | $ | 1,345 | 1,291 | 54 | 4 | % |\n| Legacy services | 1,658 | 1,833 | (175 | ) | (10 | )% |\n| Affiliates and other services | 1,473 | 1,315 | 158 | 12 | % |\n| Total operating revenues | $ | 4,476 | 4,439 | 37 | 1 | % |\n\n17\nStrategic Services\nStrategic services revenues increased by $24 million, or 4%, and increased by $54 million, or 4%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The increase in our strategic services revenues for both periods was primarily due to price increases for broadband services, volume increases in Ethernet services and price increases for other services.\nLegacy Services\nLegacy services revenues decreased by $90 million, or 10%, and decreased by $175 million, or 10%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The decline in our legacy services revenues for both periods was primarily due to lower local voice services revenues due to access line loss and reduced access services usage related to customer migration, competitive pressures and product substitution and to reductions in the volumes of our private line (including special access) services.\nAffiliates and Other Services\nAffiliates and other services revenues increased by $67 million, or 10%, and increased by $158 million, or 12%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The increase in our affiliates and other services revenues for both periods was primarily due to increases in the volume and in the rates we charge for the support services we provided to affiliates and to the additional revenue recorded under the FCC's CAF Phase 2 support program. We recorded $24 million and $48 million more in revenue for the three and six months ended June 30, 2016, respectively, than for the three and six months ended June 30, 2015, with respect to our 13 CAF Phase 2 states. We received a substantial one-time cumulative catch-up payment related to the first half of 2015 from the FCC in the third quarter of 2015, and, as a result, we do not expect funding from the CAF Phase 2 support program to materially change our other operating revenues for the full year 2016 when compared to the full year 2015.\nOperating Expenses\nThe following tables summarize our consolidated operating expenses:\n| Three Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Cost of services and products (exclusive of depreciation and amortization) | $ | 731 | 743 | (12 | ) | (2 | )% |\n| Selling, general and administrative | 235 | 256 | (21 | ) | (8 | )% |\n| Operating expenses - affiliates | 231 | 238 | (7 | ) | (3 | )% |\n| Depreciation and amortization | 424 | 464 | (40 | ) | (9 | )% |\n| Total operating expenses | $ | 1,621 | 1,701 | (80 | ) | (5 | )% |\n\n| Six Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Cost of services and products (exclusive of depreciation and amortization) | $ | 1,439 | 1,435 | 4 | — | % |\n| Selling, general and administrative | 485 | 526 | (41 | ) | (8 | )% |\n| Operating expenses - affiliates | 482 | 486 | (4 | ) | (1 | )% |\n| Depreciation and amortization | 843 | 926 | (83 | ) | (9 | )% |\n| Total operating expenses | $ | 3,249 | 3,373 | (124 | ) | (4 | )% |\n\n18\nCost of Services and Products (exclusive of depreciation and amortization)\nCost of services and products (exclusive of depreciation and amortization) are expenses incurred in providing products and services to our customers. These expenses include: employee-related expenses directly attributable to operating and maintaining our network (such as salaries, wages, benefits and professional fees); facilities expenses (which include third-party telecommunications expenses we incur for using other carriers' networks to provide services to our customers); rents and utilities expenses; equipment sales expenses (such as modem expenses); payments of universal service funds (which are federal and state funds that are established to promote the availability of telecommunications services to all consumers at reasonable and affordable rates, among other things, and to which we are often required to contribute); litigation expenses associated with our operations; and other expenses directly related to our operations.\nCost of services and products (exclusive of depreciation and amortization) decreased by $12 million, or 2%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015. The decrease in our cost of services and products was primarily due to decreases in employee benefits expense, professional fees and contract labor costs, which were partially offset by increases in facility costs and network expense. Cost of services and products (exclusive of depreciation and amortization) increased by $4 million, or less than 1%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The increase in our cost of services and products was primarily due to increases in facility costs and allocated corporate costs from affiliates, which were substantially offset by decreases in salaries and wages and related employee benefits expense (driven by increases in the amount of labor capitalized and allocated to our affiliates), professional fees and contract labor costs.\nSelling, General and Administrative\nSelling, general and administrative expenses are expenses incurred in selling products and services to our customers, corporate overhead and other operating expenses. These expenses include: employee-related expenses (such as salaries, wages, internal commissions, benefits and professional fees) directly attributable to selling products or services and employee-related expenses for administrative functions; marketing and advertising; property and other operating taxes and fees; external commissions; litigation expenses associated with general matters; bad debt expense; and other selling, general and administrative expenses.\nSelling, general and administrative expenses decreased by $21 million, or 8%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015. The decrease in our selling, general and administrative expenses was primarily due to decreases in salaries and wages and related employee benefits expense (driven by increases in the amount of labor capitalized and allocated to our affiliates), contract labor costs and property and other taxes, which were partially offset by an increase in external commissions. Selling, general and administrative expenses decreased by $41 million, or 8%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The decrease in our selling, general and administrative expenses was primarily due to decreases in salaries and wages and related employee benefits expense (driven by increases in the amount of labor capitalized and allocated to our affiliates), contract labor costs, property and other taxes and regulatory fines of $15 million associated with a 911 system outage in 2015, which were partially offset by an increase in external commissions.\nOperating Expenses - Affiliates\nSince CenturyLink's acquisition of us, we have incurred affiliates expenses related to our use of telecommunication services, marketing and employee related support services provided by CenturyLink and its subsidiaries.\nOperating expenses - affiliates decreased by $7 million, or 3%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015 and decreased by $4 million, or 1%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The decrease in operating expenses - affiliates for both periods was primarily due to decreases in level of services provided to us by our affiliates.\n19\nDepreciation and Amortization\nThe following tables provide detail of our depreciation and amortization expense:\n| Three Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Depreciation | $ | 230 | 244 | (14 | ) | (6 | )% |\n| Amortization | 194 | 220 | (26 | ) | (12 | )% |\n| Total depreciation and amortization | $ | 424 | 464 | (40 | ) | (9 | )% |\n\n| Six Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Depreciation | $ | 452 | 484 | (32 | ) | (7 | )% |\n| Amortization | 391 | 442 | (51 | ) | (12 | )% |\n| Total depreciation and amortization | $ | 843 | 926 | (83 | ) | (9 | )% |\n\nDepreciation expense is impacted by several factors, including changes in our depreciable cost basis, changes in our estimates of the remaining economic life of certain network assets and the addition of new plant. Depreciation expense decreased by $14 million, or 6%, and decreased by $32 million, or 7%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The depreciation expense related to our plant for the six months ended June 30, 2016 was lower than the depreciation expense for the six months ended June 30, 2015 due to full depreciation and retirement of certain plant placed in service prior to 2016. This decrease was partially offset by an increase in depreciation expense attributable to new plant placed in service since June 30, 2015.\nAmortization expense decreased by $26 million, or 12%, and decreased by $51 million, or 12%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The decrease in amortization expense for both periods was primarily due to software becoming fully amortized faster than new software was acquired or developed.\nOther Consolidated Results\nThe following tables summarize our total other expense, net and income tax expense:\n| Three Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Interest expense | $ | (120 | ) | (119 | ) | 1 | 1 | % |\n| Interest expense - affiliate | (15 | ) | (13 | ) | 2 | 15 | % |\n| Other income, net | — | 1 | (1 | ) | 100 | % |\n| Total other expense, net | $ | (135 | ) | (131 | ) | 4 | 3 | % |\n| Income tax expense | $ | 179 | 152 | 27 | 18 | % |\n\n20\n| Six Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Interest expense | $ | (241 | ) | (237 | ) | 4 | 2 | % |\n| Interest expense - affiliate | (29 | ) | (26 | ) | 3 | 12 | % |\n| Other income, net | 2 | 1 | 1 | 100 | % |\n| Total other expense, net | $ | (268 | ) | (262 | ) | 6 | 2 | % |\n| Income tax expense | $ | 367 | 319 | 48 | 15 | % |\n\nInterest Expense\nInterest expense increased by $1 million, or 1%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015 and increased by $4 million, or 2%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The increase in interest expense for both periods was primarily due to a reduction in the amount of net premium amortization recorded at acquisition primarily due to the retirement of several issuances of debt during the period. See Note 2—Long-Term Debt and Revolving Promissory Note to our consolidated financial statements in Item 1 of Part I of this report and Liquidity and Capital Resources below for additional information about our debt.\nInterest Expense - Affiliates, Net\nAffiliate interest expense increased by $2 million, or 15%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015 and increased by $3 million, or 12%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The increase in affiliate interest expense for both periods was primarily due to the increase in the average amount outstanding on our intercompany revolving indebtedness.\nIncome Tax Expense\nIncome tax expense for the three months ended June 30, 2016 was $179 million, or an effective tax rate of 38.3%, compared to $152 million, or an effective tax rate of 39.0%, for the three months ended June 30, 2015. Income tax expense for the six months ended June 30, 2016 was $367 million, or an effective tax rate of 38.3%, compared to $319 million, or an effective tax rate of 39.7%, for the six months ended June 30, 2015. The 2016 rates include the effect of changes in state apportionment factors and research and development credits. The 2015 rates include the effect of regulatory fines associated with a 911 system outage and state tax rate changes.\nLiquidity and Capital Resources\nOverview\nWe are an indirectly wholly-owned subsidiary of CenturyLink. As such, factors relating to, or affecting, CenturyLink's liquidity and capital resources could have material impacts on us, including impacts on our credit ratings, our access to capital markets and changes in the financial market's perception of us.\nCenturyLink has cash management arrangements between certain of its subsidiaries that include lines of credit, affiliate advances and obligations, capital contributions and dividends. As part of these cash management arrangements, affiliates provide lines of credit to certain other affiliates. Amounts outstanding under these lines of credit and intercompany obligations vary from time to time. Under these arrangements, the majority of our cash balance is advanced on a daily basis to CenturyLink. From time to time we may declare and pay dividends to our stockholder, QSC, in excess of our earnings to the extent permitted by applicable law, using cash owed to us under these advances, which has the net effect of reducing the amount of these advances. Our debt covenants do not currently limit the amount of dividends we can pay to QSC. Given our cash management arrangement with our ultimate parent, CenturyLink, and the resulting amounts due to us from CenturyLink, a significant component of our liquidity is dependent upon CenturyLink's ability to repay its obligation to us.\n21\nAt June 30, 2016, we had a working capital deficit of $1.005 billion, reflecting current liabilities of $2.656 billion and current assets of $1.651 billion, compared to a working capital deficit of approximately $820 million as of December 31, 2015. We have historically operated with a working capital deficit due to our practice of declaring and paying regular cash dividends to QSC. As long as we continue declaring and paying cash dividends to QSC, it is likely that we will continue to operate with a working capital deficit in the future. We anticipate that our future liquidity needs will be met through (i) our cash provided by our operating activities, (ii) amounts due to us from CenturyLink and (iii) capital contributions, advances or loans from CenturyLink or its affiliates if and to the extent they have available funds or access to available funds that they are willing and able to contribute, advance or loan.\nCapital Expenditures\nWe incur capital expenditures on an ongoing basis in order to enhance and modernize our networks, compete effectively in our markets and expand our service offerings. CenturyLink evaluates capital expenditure projects based on a variety of factors, including expected strategic impacts (such as forecasted impact on revenue growth, productivity, expenses, service levels and customer retention) and the expected return on investment. The amount of CenturyLink’s consolidated capital investment is influenced by, among other things, demand for CenturyLink’s services and products, cash flow generated by operating activities, cash required for other purposes and regulatory considerations (such as our CAF Phase 2 infrastructure buildout requirements discussed below). Based on the type and volume of services we provide, approximately 38% to 43% of CenturyLink’s annual consolidated capital expenditures have been attributed over the last couple of years to us for use in our operations. For more information on CenturyLink’s total capital expenditures, please see its annual and quarterly reports filed with the SEC.\nOur capital expenditures continue to be focused on our strategic services. For more information on our capital spending, see Item 1of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\nDebt and Other Financing Arrangements\nSubject to market conditions, and to the extent feasible, we expect to continue to issue debt securities from time to time in the future to refinance a substantial portion of our maturing debt. The availability, interest rate and other terms of any new borrowings will depend on the ratings assigned to us by credit rating agencies, among other factors. We have no debt maturities due during the remainder of 2016.\n| Agency | Credit Ratings |\n| Standard & Poor's | BBB- |\n| Moody's Investors Service, Inc. (1) | Ba1 |\n| Fitch Ratings | BBB- |\n\n| (1) | On March 15, 2016, Moody's Investors Service, Inc. downgraded CenturyLink's rating from Ba2 to Ba3 and downgraded Qwest Corporation's rating from Baa3 to Ba1. |\n\nOur credit ratings are reviewed and adjusted from time to time by the rating agencies, and downgrades could impact CenturyLink's and our access to debt capital or further raise CenturyLink's and our borrowing costs. Additional downgrades of CenturyLink's senior unsecured debt ratings could, under certain circumstances, incrementally increase the cost of CenturyLink's borrowing under its revolving credit facility, which could indirectly impact us. See \"Risk Factors—Risks Affecting our Liquidity and Capital Resources\" in Item 1A of Part II of this report.\nTerm Loan\nIn 2015, we entered into a term loan in the amount of $100 million with CoBank, ACB. The outstanding unpaid principal amount of this term loan plus any accrued and unpaid interest is due on February 20, 2025. Interest is paid monthly based upon either the London Interbank Offered Rate (“LIBOR”) or the base rate (as defined in the credit agreement) plus an applicable margin between 1.50% to 2.50% per annum for LIBOR loans and 0.50% to 1.50% per annum for base rate loans depending on our then current senior unsecured long-term debt rating. As of June 30, 2016, the outstanding principal balance on this term loan was $100 million.\n22\nRevolving Promissory Note\nWe are currently indebted to an affiliate of CenturyLink under a revolving promissory note that provides us with a funding commitment of up to $1.0 billion aggregate principal amount through June 30, 2022, of which $884 million was outstanding as of June 30, 2016. The revolving promissory note is due on demand and ranks equally to our outstanding Senior Notes. Interest is accrued on the outstanding balance using a weighted average per annum interest rate of CenturyLink's outstanding borrowings for the interest period. As of June 30, 2016, the weighted average interest rate was 6.795%. As of June 30, 2016 and December 31, 2015, this revolving promissory note is reflected on our consolidated balance sheets as a current liability under note payable - affiliate. As of June 30, 2016, $5 million of accrued interest is reflected in other current liabilities on our consolidated balance sheet.\nDividends\nWe periodically pay dividends to our direct parent company. See Note 6—Dividends and the discussion above under the heading \"Overview\".\nPension and Post-retirement Benefit Obligations\nCenturyLink is subject to material obligations under its existing defined benefit pension plans and post-retirement benefit plans. At December 31, 2015, the accounting unfunded status of CenturyLink's qualified and non-qualified defined benefit pension plans and post-retirement benefit plans was $2.277 billion and $3.374 billion, respectively. For additional information about CenturyLink's pension and post-retirement benefit arrangements, see \"Critical Accounting Policies and Estimates—Pensions and Post-Retirement Benefits\" in Item 7 of CenturyLink's Annual Report on Form 10-K for the year ended December 31, 2015, and see Note 7—Employee Benefits to the consolidated financial statements in Item 8 of Part II of the same report.\nA substantial portion of our active and retired employees participate in CenturyLink's qualified Combined Pension Plan and post-retirement benefit plans. On December 31, 2014, the Qwest Communications International Inc. (\"QCII\") pension plan and a pension plan of an affiliate were merged into the CenturyLink Retirement Plan, which was renamed the CenturyLink Combined Pension Plan. Our contributions to the trust are not segregated or restricted to pay amounts due to our employees and may be used to provide benefits to other employees of our affiliates. Prior to the pension plan merger, the above-noted employees participated in the QCII pension plan.\nThe affiliate obligations, net in current and noncurrent liabilities on our consolidated balance sheets represents the cumulative allocation of expense, net of payments, associated with QCII's pension plans and post-retirement benefits plans prior to the plan mergers. In 2015, we agreed to a plan to settle the outstanding pension and post-retirement affiliate obligations, net balance with QCII over a 30 year term. Payments will be made on a monthly basis. For the six months ended June 30, 2016, we made a settlement payment of $49 million to QCII on our affiliate obligations, net balance. Changes in the affiliate obligations, net are reflected in operating activities on our consolidated statements of cash flows. For the year ending December 31, 2016, we expect to make a settlement payment of $97 million to QCII on our affiliate obligations, net balance.\nFor 2016, CenturyLink's estimated annual long-term rate of return is 7.0% for both the pension plan trust assets and post-retirement plans trust assets, based on the assets currently held. However, actual returns could be substantially different.\nFor additional information, see “Risk Factors—Risks Affecting Our Liquidity and Capital Resources—Adverse changes in the value of assets or obligations associated with CenturyLink’s qualified pension plan could negatively impact CenturyLink’s liquidity, which may in turn affect our business and liquidity” in Item 1A of Part II of this report.\nConnect America Fund\nIn 2015, CenturyLink accepted CAF funding from the FCC of approximately $500 million per year for six years to fund the deployment of voice and broadband capable infrastructure for approximately 1.2 million rural households and businesses in 33 states under the CAF Phase 2 support program. Of these amounts, approximately $150 million per year is attributable to our service area, to provide service to approximately 0.3 million rural households and businesses in 13 states. The funding from the CAF Phase 2 support program is expected to substantially supplant the funding we previously received from the interstate USF program that we previously utilized to support voice services in high-cost rural markets in these 13 states. In late 2015, we began receiving these payments from the FCC under the new CAF Phase 2 support program, which included monthly support payments at a higher rate than under the interstate USF support program. We received a substantial one-time cumulative catch-up payment from the FCC in the third quarter of 2015, and, as a result, we do not expect our funding from the CAF Phase 2 support program to materially change our operating revenues for the full year 2016 when compared to the full year 2015.\n23\nAs a result of accepting CAF Phase 2 support payments for 13 states, we will be obligated to make substantial capital expenditures to build infrastructure over the next several years. See \"Capital Expenditures\" above.\nFor additional information on the FCC's CAF order and the USF program, see \"Business—Regulation\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015 and see \"Risk Factors—Risks Affecting our Liquidity and Capital Resources\" in Item 1A of Part II of this report.\nIn 2013, under the second round of the first phase of the CAF program, CenturyLink received $40 million in funding, $15 million attributed to our service areas, for deployment of broadband services in rural areas. For various reasons, we failed to meet certain broadband deployment requirements by specified deadlines, but we are currently developing alternate solutions, which may satisfy some or all of the requirements. If the FCC does not recognize our alternate deployment plans or grant us an extension of time to fulfill the deployment requirements, we anticipate that we will be requested to refund a substantial portion of the $15 million in funding we received. As of June 30, 2016, we have included approximately $8 million of CAF 1 Round 2 funding in other current liabilities and the remaining approximately $7 million of funding in other noncurrent liabilities on our consolidated balance sheet.\nFuture Contractual Obligations\nFor information regarding our estimated future contractual obligations, see the MD&A discussion included in our Annual Report on Form 10-K for the year ended December 31, 2015.\nHistorical Information\n| Six Months Ended June 30, | Increase / (Decrease) |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Cash Flows Provided By (Used In) |\n| Net cash provided by operating activities | $ | 1,284 | 1,254 | 30 |\n| Net cash used in investing activities | (569 | ) | (947 | ) | (378 | ) |\n| Net cash used in financing activities | (714 | ) | (307 | ) | 407 |\n\nNet cash provided by operating activities increased by $30 million for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015 primarily due to an increase in net income (which was directly impacted by the cash received from the CAF Phase 2 support program, which was $50 million greater than the cash we received in the first six months of 2015) adjusted for non-cash items, which was partially offset by negative variances in the changes in accounts receivable, accounts payable and affiliate obligations, net. For additional information about our operating results, see \"Results of Operations\" above.\nNet cash used in investing activities decreased by $378 million for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015 primarily due to a positive variance in the change in the amount of funds advanced to our affiliates.\nNet cash used in financing activities increased by $407 million for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015 primarily due to an increase in the amount of dividends paid to our direct parent company. For additional information regarding our financing activities, see Note 2—Long-Term Debt and Revolving Promissory Note to our consolidated financial statements in Item 1 of this report.\nOn May 2, 2016, QC paid at maturity the $235 million principal amount and accrued and unpaid interest due under its 8.375% Notes.\nIn January 2016, QC issued $235 million aggregate principal amount of 7% Notes due 2056, in exchange for net proceeds, after deducting underwriting discounts and other expenses, of approximately $227 million. For additional information on the terms of QC's 7% Notes due in 2056, see Note 2—Long-Term Debt and Revolving Promissory Note to our consolidated financial statements in Item 1 of this report.\n24\nOther Matters\nIn February 2015, the FCC adopted new regulations that regulate broadband services as a public utility under Title II of the Communications Act. In light of pending litigation, we believe it is premature for us to determine the ultimate impact of the new regulations on our operations; however, we currently expect that they will negatively impact our operations. For additional information, see “Risk Factors—Risks Relating to Legal and Regulatory Matters” in Item 1A of Part II of this report.\nCenturyLink and its affiliates are involved in several legal proceedings to which we are not a party that, if resolved against them, could have a material adverse effect on their business and financial condition. As a wholly-owned subsidiary of CenturyLink, our business and financial condition could be similarly affected. You can find descriptions of these legal proceedings in CenturyLink's quarterly and annual reports filed with the Securities and Exchange Commission (\"SEC\"). Because we are not a party to any of the matters, we have not accrued any liabilities for these matters as of June 30, 2016.\nMarket Risk\nWe are exposed to market risk from changes in interest rates on our variable rate long-term debt obligations and revolving promissory note. We seek to maintain a favorable mix of fixed and variable rate debt in an effort to limit interest costs and cash flow volatility resulting from changes in rates.\nManagement periodically reviews our exposure to interest rate fluctuations and periodically implements strategies to manage the exposure. From time to time, we have used derivative instruments to (i) lock-in or swap our exposure to changing or variable interest rates for fixed interest rates or (ii) to swap obligations to pay fixed interest rates for variable interest rates. As of June 30, 2016, we had no such instruments outstanding. We have established policies and procedures for risk assessment and the approval, reporting and monitoring of derivative instrument activities. We do not hold or issue derivative financial instruments for trading or speculative purposes.\nWe do not believe that there were any material changes to market risks arising from changes in interest rates for the six months ended June 30, 2016, when compared to the disclosures provided in our Annual Report on Form 10-K for the year ended December 31, 2015.\nCertain shortcomings are inherent in the method of analysis presented in the computation of exposures to market risks. Actual values may differ materially from those disclosed by us from time to time if market conditions vary from the assumptions used in the analyses performed. These analyses only incorporate the risk exposures that existed at June 30, 2016.\nOff-Balance Sheet Arrangements\nWe have no special purpose or limited purpose entities that provide off-balance sheet financing, liquidity, or market or credit risk support and we do not engage in leasing, hedging or other similar activities that expose us to any significant liabilities that are not (i) reflected on the face of the consolidated financial statements, (ii) disclosed in Note 15—Commitments and Contingencies to our consolidated financial statements in Item 8 of Part II of our Annual Report on Form 10-K for the year ended December 31, 2015 or (iii) discussed under the heading \"Market Risk\" above.\n25\nOther Information\nCenturyLink's and our website is www.centurylink.com. We routinely post important investor information in the \"Investor Relations\" section of our website at ir.centurylink.com. The information contained on, or that may be accessed through, our website is not part of this quarterly report. You may obtain free electronic copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports in the \"Investor Relations\" section of our website (ir.centurylink.com) under the heading \"SEC Filings.\" These reports are available on our website as soon as reasonably practicable after we electronically file them with the SEC.\nIn addition to historical information, this quarterly report includes certain forward-looking statements that are based upon our judgment and assumptions as of the date of this report concerning future developments and events, many of which are beyond our control. These forward-looking statements, and the assumptions upon which they are based, are not guarantees of future results, are inherently speculative and are subject to a number of risks and uncertainties. Actual events and results may differ materially from those anticipated, estimated, projected or implied by us in those statements if one or more of these risks or uncertainties materialize, or if underlying assumptions prove incorrect. Factors that could affect actual results include but are not limited to: the effects of competition from a wide variety of competitive providers, including lower demand for our legacy offerings; the effects of new, emerging or competing technologies, including those that could make our products less desirable or obsolete; the effects of ongoing changes in the regulation of the communications industry, including the outcome of regulatory or judicial proceedings relating to intercarrier compensation, interconnection obligations, access charges, universal service, broadband deployment, data protection and net neutrality; our ability to effectively adjust to changes in the communications industry, and changes in the composition of our markets and product mix; possible changes in the demand for, or pricing of, our products and services, including our ability to effectively respond to increased demand for high-speed broadband service; our ability to successfully maintain the quality and profitability of our existing product and service offerings and to introduce new offerings on a timely and cost-effective basis; the adverse impact on our business and network from possible equipment failures, service outages, security breaches or similar events impacting our network; our ability to generate cash flows sufficient to fund our financial commitments and objectives, including our capital expenditures, operating costs, dividends, pension contributions and debt payments; changes in our operating plans, corporate strategies, dividend payment plans or other capital allocation plans, whether based upon changes in our cash flows, cash requirements, financial performance, financial position, or otherwise; our ability to effectively retain and hire key personnel and to successfully negotiate collective bargaining agreements on reasonable terms without work stoppages; increases in the costs of CenturyLink's pension, health, post-employment or other benefits, including those caused by changes in markets, interest rates, mortality rates, demographics or regulations, which may in turn affect our business and liquidity; adverse changes in our access to credit markets on favorable terms, whether caused by changes in our financial position, lower debt credit ratings, unstable markets or otherwise; our ability to maintain favorable relations with our key business partners, suppliers, vendors, landlords and financial institutions; our ability to effectively manage our network buildout project and other expansion opportunities; our ability to collect our receivables from financially troubled customers; any adverse developments in legal or regulatory proceedings involving us or our affiliates (including CenturyLink); changes in tax, communications, pension, healthcare or other laws or regulations, in governmental support programs, or in general government funding levels; the effects of changes in accounting policies or practices, including potential future impairment charges; the effects of terrorism, adverse weather or other natural or man-made disasters; the effects of more general factors such as changes in interest rates, in operating costs, in general market, labor, economic or geo-political conditions, or in public policy; and other risks referenced in Item 1A or elsewhere in this Quarterly Report or other of our filings with the SEC. You should be aware that new factors may emerge from time to time and it is not possible for us to identify all such factors nor can we predict the impact of each such factor on the business or the extent to which any one or more factors may cause actual results to differ from those reflected in any forward-looking statements. Given these uncertainties, we caution investors not to unduly rely upon our forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements for any reason, whether as a result of new information, future events or developments, changed circumstances, or otherwise. Furthermore, any information about our intentions contained in any of our forward-looking statements reflects our intentions as of the date of this report, and is based upon, among other things, existing regulatory, technological, industry, competitive, economic and market conditions, and our assumptions as of such date. We may change our intentions, strategies or plans at any time and without notice, based upon any changes in such factors, in our assumptions or otherwise.\n26\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nWe have omitted this information pursuant to General Instruction H(2).\nITEM 4. CONTROLS AND PROCEDURES\nDisclosure Controls and Procedures\nThe Company maintains disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”)) designed to provide reasonable assurance that the information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. These include controls and procedures designed to ensure that this information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Management, with the participation of our Chief Executive Officer, Glen F. Post, III, and our Chief Financial Officer, R. Stewart Ewing, Jr., evaluated the effectiveness of the Company’s disclosure controls and procedures as of June 30, 2016. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2016, in providing reasonable assurance that the information required to be disclosed by us in this report was accumulated and communicated in the manner provided above.\nThe effectiveness of our or any system of disclosure controls and procedures is subject to certain limitations, including the exercise of judgment in designing, implementing and evaluating the controls and procedures, the assumptions used in identifying the likelihood of future events and the inability to eliminate misconduct completely. As a result, there can be no assurance that our disclosure controls and procedures will detect all errors or fraud. By their nature, our or any system of disclosure controls and procedures can provide only reasonable assurance regarding management's control objectives.\nChanges in Internal Control Over Financial Reporting\nThere were no changes in our internal control over financial reporting during the second quarter of 2016 that materially affected, or that we believe are reasonably likely to materially affect, our internal control over financial reporting.\n27\nPART II—OTHER INFORMATION\nITEM 1. LEGAL PROCEEDINGS\nThe information contained in Note 5—Commitments and Contingencies included in Item 1 of Part I of this report is incorporated herein by reference.\nITEM 1A. RISK FACTORS\nThe following discussion of “risk factors” identifies the most significant risks or uncertainties that could (i) materially and adversely affect our business, financial condition, results of operations, liquidity or prospects or (ii) cause our actual results to differ materially from our anticipated results or other expectations. You should carefully consider these factors, in addition to the other information set forth in this report and our subsequent filings with the SEC, when evaluating our business and whether to purchase, sell or hold our securities. Please note that the following discussion is not intended to comprehensively list all risks or uncertainties faced by us. Our operations or actual results could also be similarly impacted by additional risks and uncertainties that are not currently known to us, that we currently deem to be immaterial, that arise in the future or that are not specific to us, such as general economic conditions.\nRisks Affecting Our Business\nWe may not be able to compete successfully against current or future competitors.\nEach of our offerings to our residential and business customers face increasingly intense competition from a variety of sources under evolving market conditions. We expect these trends will continue. In addition to competition from larger national telecommunications providers, we are facing increasing competition from several other sources, including cable and satellite companies, wireless providers, technology companies, broadband providers, device providers, resellers, sales agents and facilities-based providers using their own networks as well as those leasing parts of our network. In particular, (i) intense competition from wireless and other communications providers has led to a long-term systemic decline in the number of our customers for wireline voice services, (ii) strong competition from cable companies and others has impacted the growth of our broadband operations and (iii) aggressive competition from a wide range of technology companies and other market entrants has limited the prospects for our cloud computing operations. For more detailed information, see \"Competition\" under Item 1 of our Annual Report on Form 10-K for the year ended December 31, 2015.\nSome of our current and potential competitors (i) offer products or services that are substitutes for our wireline voice services, including wireless voice and non-voice communication services, (ii) offer a more comprehensive range of communications products and services, (iii) offer products or services with features that we cannot readily match in some or all of our markets, including faster average broadband transmission speeds and greater content, (iv) offer shorter installation intervals, allowing customers to begin receiving services sooner after ordering, (v) have market presence, engineering and technical capabilities, and financial and other resources greater than ours, (vi) have larger or more diverse networks with greater transmission capacity or other advantages, (vii) conduct operations or raise capital at a lower cost than us, (viii) are subject to less regulation, which we believe enables such competitors to operate more flexibly than us with respect to certain offerings, (ix) offer services nationally or internationally to a larger geographic area or larger base of customers, (x) have substantially stronger brand names, which may provide them with greater pricing power than ours, or (xi) have larger operations than ours, which may enable them to offer higher compensation packages in connection with recruiting and retaining top technological, managerial and operational talent. Consequently, these competitors may be better equipped to provide more attractive offerings, to charge lower prices for their products and services, to develop and expand their communications and network infrastructure more quickly, to adapt more swiftly to new or emerging technologies and changes in customer requirements, to devote greater resources to the marketing and sale of their products and services, to provide more comprehensive customer service, to provide greater resources to research and development initiatives and to take advantage of acquisition or other opportunities more readily. In the past, several of our competitors and their operations have grown through acquisitions and aggressive product development. The continued growth of our competitors could further enhance their competitive positions.\nCompetition could adversely impact us in several ways, including (i) the loss of customers and market share, (ii) the possibility of customers reducing their usage of our services or shifting to less profitable services, (iii) reduced traffic on our networks, (iv) our need to expend substantial time or money on new capital improvement projects, (v) our need to lower prices or increase marketing expenses to remain competitive and (vi) our inability to diversify by successfully offering new products or services.\n28\nWe are continually taking steps to respond to these competitive pressures, but these efforts may not be successful. Our operating results and financial condition would be adversely affected if these initiatives are unsuccessful or insufficient and if we otherwise are unable to sufficiently stem our continuing access line losses and our legacy revenue declines. If this occurred, our ability to pay our debt and other obligations and to re-invest in the business would also be adversely affected.\nRapid technological changes could significantly impact our competitive and financial position.\nThe communications industry has been and continues to be impacted by significant technological changes, which in general are enhancing non-voice communications and enabling a broader array of companies to offer services competitive with ours. Many of those technological changes are (i) displacing or reducing demand for our wireline voice services, (ii) enabling the development of competitive products or services, or (iii) enabling our current customers to reduce or bypass use of our networks. Rapid changes in technology are increasing the competitiveness of the information technology services industry. In addition, demand for our broadband services has been constrained by certain technologies permitting cable companies and other competitors to deliver faster average broadband transmission speeds than ours. Demand for our broadband services could be further reduced by advanced wireless data transmission technologies being deployed by wireless providers, including \"long-term evolution\" or \"LTE\" technologies, especially if these wireless providers continue to increase their broadband transmission speed and decrease their service rates. To enhance the competitiveness of our broadband services, we may be required to expend additional capital to augment the capabilities of our copper-based services or to install more fiber optic cable.\nWe may not be able to accurately predict or respond to changes in technology or industry standards, or to the introduction of newly-offered services. Any of these developments could make some or all of our offerings less desirable or even obsolete. These developments could also require us to (i) expend capital or other resources in excess of currently contemplated levels, (ii) forego the development or provision of products or services that others can provide more efficiently, or (iii) make other changes to our operating plans, corporate strategies or capital allocation plans, any of which could be contrary to the expectations of our security holders or could adversely impact our operations. If we are not able to develop new products and services to keep pace with technological advances, or if those products and services are not widely accepted by customers, our ability to compete could be adversely affected and our market share could decline. Any inability to effectively respond to technological changes could also adversely affect our operating results and financial condition, as well as our ability to service debt and fund other commitments or initiatives.\nEven if we succeed in adapting to changes in technology or industry standards by developing new products or services, there is no assurance that the new products or services would have a positive impact on our profit margins or financial performance.\nIn addition to introducing new technologies and offerings, we may need, from time to time, to phase out outdated and unprofitable technologies and services. If we are unable to do so, on a cost-effective basis, we could experience reduced profits.\nFor additional information on the risks of increased expenditures, see \"Risk Factors—Risks Affecting our Liquidity and Capital Resources—Our business requires us to incur substantial capital and operating expenses, which reduces our available free cash flow.\"\nOur legacy services continue to experience declining revenues, and our efforts to offset these declines may not be successful.\nPrimarily as a result of the competitive and technological changes discussed above, we have experienced a prolonged systemic decline in our access lines and network access revenues. We have also experienced a decline in our private line revenues due to our customers' optimization of their networks, industry consolidation, price compression and technological migration to higher-speed services.\nWe have taken a variety of steps to counter these declines in our legacy services revenues, including:\n| • | an increased focus on selling a broader range of higher-growth strategic services, which are described in detail elsewhere in this report; |\n\n| • | an increased focus on serving a broader range of business, governmental and wholesale customers; and |\n\n| • | greater use of service bundles. |\n\nHowever, for the reasons described elsewhere in this report, most of our strategic services generate lower profit margins than our legacy services, and some can be expected to experience slowing growth as increasing numbers of our existing or potential customers subscribe to our newer strategic product and service offerings. Moreover, we cannot assure you that the revenues generated from our new offerings will offset revenue losses associated with our legacy services. In addition, our reliance on third parties to provide certain of these strategic services could constrain our flexibility, as described further below.\n29\nOur ability to successfully introduce new product or service offerings on a timely and cost-effective basis could be constrained by a range of factors, including network limitations, limited capital, an inability to attract key personnel with the necessary skills, intellectual property constraints, testing delays, or an inability to act as quickly as smaller, more nimble start-up competitors. Similarly, our ability to grow through acquisitions could be limited by several factors, including our leverage and inability to identify attractively-priced target companies. For these reasons, we cannot assure you that our new product or service offerings will be as successful as anticipated, or that we will be able to continue to grow through acquisitions.\nWe may not be able to successfully adjust to changes in our industry, our markets and our product mix.\nOngoing changes in the communications industry have fundamentally changed consumers’ communications expectations and requirements. In response to these changes, we have substantially altered our product and service offerings through acquisitions and internal product development. Many of these changes have placed a higher premium on sales, marketing and product development functions, and necessitated ongoing changes in our processes and operating protocols, as well as periodic reorganizations of our sales and leadership teams. In addition, we now offer a more complex range of products and services, operate larger and more complex networks and serve a much larger and more diverse set of customers. Consequently, we now face greater challenges in effectively managing and administering our operations and allocating capital and other resources to our various offerings. For all these reasons, we cannot assure you that our efforts to adjust to these changes will be timely or successful.\nWe could be harmed by security breaches, damages or other significant disruptions or failures of our networks, information technology infrastructure or related systems, or of those we operate for certain of our customers.\nWe are materially reliant upon our networks, information technology infrastructure and related technology systems (including our billing and provisioning systems) to provide products and services to our customers and to manage our operations and affairs. We face the risk, as does any company, of a security breach or significant disruption of our information technology infrastructure and related systems. As a communications company that transmits large amounts of sensitive and proprietary information over communications networks, we face an added risk that a security breach or other significant disruption of our public networks or information technology infrastructure and related systems that we develop, install, operate and maintain for certain of our business customers (which includes our wholesale and governmental customers) could lead to material interruptions or curtailments of service. Moreover, in connection with processing and storing confidential customer data, we face a heightened risk that a security breach or disruption could result in unauthorized access to our customers' proprietary information on our public networks or internal systems or the systems that we operate and maintain for certain of our customers.\nWe make significant efforts to maintain the security and integrity of information and systems under our control, and maintain contingency plans in the event of security breaches or other system disruptions. Nonetheless, we cannot assure you that our security efforts and measures will prevent unauthorized access to our systems, loss or destruction of data (including confidential customer information), account takeovers, unavailability of service, computer viruses, malware, distributed denial-of-service attacks, or other forms of cyber-attacks or similar events. These threats may derive from human error, hardware or software vulnerabilities, fraud, malice or sabotage on the part of employees, third parties or other nations, or could result from aging equipment or other accidental technological failure. These threats may also arise from failure or breaches of systems owned, operated or controlled by other unaffiliated operators to the extent we rely on such other operations to deliver services to our customers.\nSimilar to other large telecommunications companies, we are a constant target of cyber-attacks of varying degrees. Although some of these attacks have resulted in security breaches, to date, none of these breaches have resulted in a material adverse effect on our operating results or financial condition. You should be aware, however, that defenses against cyber-attacks currently available to U.S. companies are unlikely to prevent intrusions by a highly-determined, highly-sophisticated hacker. Consequently, you should assume that we will be unable to implement security barriers or other preventative measures that repel all future cyber-attacks. Any such future security breaches or disruptions could materially adversely affect our business, results of operations or financial condition, especially in light of the growing frequency, scope and well-documented sophistication of cyber-attacks and intrusions.\nAlthough CenturyLink maintains insurance coverage that may, subject to policy terms and conditions (including self-insured deductibles, coverage restrictions and monetary coverage caps), cover certain aspects of our cyber risks, such insurance coverage may be unavailable or insufficient to cover our losses.\nAdditional risks to our network, infrastructure and related systems include:\n| • | power losses or physical damage, whether caused by fire, adverse weather conditions, terrorism, sabotage, vandalism or otherwise; |\n\n30\n| • | capacity or system configuration limitations, including those resulting from changes in our customer's usage patterns, the introduction of new technologies or products, or incompatibilities between our newer and older systems; |\n\n| • | theft or failure of our equipment; |\n\n| • | software or hardware obsolescence, defects or malfunctions; |\n\n| • | deficiencies in our processes or controls; |\n\n| • | programming, processing and other human error; and |\n\n| • | service failures of our third-party vendors and other disruptions that are beyond our control. |\n\nDue to these factors, from time to time in the ordinary course of our business we experience short disruptions in our service, and could experience more significant disruptions in the future.\nDisruptions, security breaches and other significant failures of the above-described networks and systems could:\n| • | disrupt the proper functioning of these networks and systems, which could in turn disrupt (i) our operations or (ii) the operations of certain of our customers who rely upon us to provide services critical to their operations; |\n\n| • | require significant management attention or financial resources to remedy the damages that result or to change our systems, including expenses to repair systems, add new personnel or develop additional protective systems; |\n\n| • | result in the unauthorized access to, and destruction, loss, theft, misappropriation or release of proprietary, confidential, sensitive, classified or otherwise valuable information of ours, our customers or our customers' end users, including trade secrets, which others could use for competitive, disruptive, destructive or otherwise harmful purposes and outcomes; |\n\n| • | require us to notify customers, regulatory agencies or the public of data breaches; |\n\n| • | require us to provide credits for future service under certain service level commitments we have provided contractually to our customers or to offer expensive incentives to retain customers; |\n\n| • | subject us to claims for damages, fines, penalties, termination or other remedies under our customer contracts or service standards set by state regulatory commissions, which in certain cases could exceed our insurance coverage; or |\n\n| • | result in a loss of business, damage our reputation among our customers and the public generally, subject us to additional regulatory scrutiny or expose us to prolonged litigation. |\n\nWe could experience difficulties in expanding and updating our technical infrastructure.\nOur ability to expand and update our systems and information technology infrastructure in response to our growth and changing business needs is important to our ability to maintain and develop attractive product and service offerings. As discussed further under “Business—Network Architecture” in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015, we are currently undertaking several complex, costly and time-consuming projects to simplify and modernize our network, which combines our legacy network and CenturyLink's networks. Unanticipated delays in the completion of these projects may lead to increased project costs or operational inefficiencies. In addition, there may be issues related to our expanded or updated infrastructure that are not identified by our testing processes, and which may only become evident after we have started to fully utilize the redesigned systems. Our failure to modernize and upgrade our technology infrastructure could have adverse consequences, including the delayed implementation of new service offerings, decreased competitiveness of existing service offerings, network instabilities, increased operating or acquisition integration costs, service or billing interruptions, and the diversion of development resources.\nAny or all of the foregoing developments could have a negative impact on our business, results of operations, financial condition and cash flows.\n31\nIf we fail to hire and retain qualified executives, managers and employees, our operating results could be harmed.\nOur future success depends on our ability to identify, hire, train and retain executives, managers and employees with technological, engineering, product development, operational, provisioning, marketing, sales, administrative and managerial skills. There is a shortage of qualified personnel in several of these fields nationally and in our headquarters city of Monroe, Louisiana, in particular. We compete with several other companies for this limited pool of potential employees. As our industry increasingly becomes more competitive, it could become especially difficult to attract and retain top personnel with skills in high demand. In addition, subject to limited exceptions, none of our executives or domestic employees have long-term employment agreements. For all these reasons, there is no assurance that our efforts to recruit and retain qualified personnel will be successful.\nIncreases in broadband usage may cause network capacity limitations, resulting in service disruptions, reduced capacity or slower transmission speeds for our customers.\nVideo streaming services, gaming and peer-to-peer file sharing applications use significantly more bandwidth than other Internet activity such as web browsing and email. As use of these newer services continues to grow, our broadband customers will likely use much more bandwidth than in the past. If this occurs, we could be required to make significant capital expenditures to increase network capacity in order to avoid service disruptions, service degradation or slower transmission speeds for our customers. Alternatively, we could choose to implement network management practices to reduce the network capacity available to bandwidth-intensive activities during certain times in market areas experiencing congestion, which could negatively affect our ability to retain and attract customers in affected markets. While we believe demand for these services may drive broadband customers to pay for faster broadband speeds, competitive or regulatory constraints may preclude us from recovering the costs of the necessary network investments. This could result in an adverse impact to our operating margins, results of operations, financial condition and cash flows.\nWe have been accused of infringing the intellectual property rights of others and will likely face similar accusations in the future, which could subject us to costly and time-consuming litigation or require us to seek third-party licenses.\nFrom time to time, we receive notices from third parties or are named in lawsuits filed by third parties claiming we have infringed or are infringing upon their intellectual property rights. We are currently responding to several of these notices and claims. Like other communications companies, we have received an increasing number of these notices and claims in the past several years, and expect this industry-wide trend will continue. Responding to these claims may require us to expend significant time and money defending our use of the applicable technology, and divert management’s time and resources away from other business. In certain instances, we may be required to enter into licensing agreements requiring royalty payments or, in the case of litigation, to pay damages. If we are required to take one or more of these actions, our profit margins may decline. In addition, in responding to these claims, we may be required to stop selling or redesign one or more of our products or services, which could significantly and adversely affect our business, results of operations, financial condition and cash flows.\nSimilarly, from time to time, we may need to obtain the right to use certain patents or other intellectual property from third parties to be able to offer new products and services. If we cannot license or otherwise obtain rights to use any required technology from a third party on reasonable terms, our ability to offer new products and services may be prohibited, restricted, made more costly or delayed.\nOur operations, financial performance and liquidity are materially reliant on various third parties.\nReliance on other communications providers. To offer voice or data services in certain of our markets, we must either lease network capacity from, or interconnect our network with the infrastructure of, other communications companies who typically compete against us in those markets. Our reliance on these lease or interconnection arrangements limits our control over the quality of our services and exposes us to the risk that our ability to market our services could be adversely impacted by changes in the plans or properties of the carriers upon which we are reliant. In addition, we are exposed to the risk that the other carriers may be unwilling to continue or renew these arrangements in the future on terms favorable to us, or at all. This risk is heightened when the other carrier is a competitor of ours and may benefit from terminating the agreement. If we lose these arrangements and cannot timely replace them, our ability to provide services to our customers and conduct our business could be materially adversely affected.\nConversely, certain of our operations carry a significant amount of voice or data traffic for other communications providers. Their reliance on our services exposes us to the risk that they may transfer all or a portion of this traffic from our network to networks built, owned or leased by them, thereby reducing our revenues. For additional information, see \"Management's Discussion and Analysis of Financial Condition and Results of Operations—Business Trends\" included in Item 2 of Part I of this report.\n32\nWe also rely on reseller and sales agency arrangements with our affiliates and other communications companies to provide some of the services that we offer to our customers, including video services. As a reseller or sales agent, we do not control the availability, retail price, design, function, quality, reliability, customer service or branding of these products and services, nor do we directly control all of the marketing and promotion of these products and services. Similar to the risks described above regarding our reliance upon other carriers, we could be adversely affected if these communication companies fail to maintain competitive products or services, or fail to continue to make them available to us on attractive terms, or at all.\nOur operations and financial performance could be adversely affected if our relationships with any of these other communications companies are disrupted or terminated for any other reason, including if such other companies:\n| • | become bankrupt or experience substantial financial difficulties; |\n\n| • | suffer work stoppages or other labor strife; |\n\n| • | challenge our right to receive payments or services under applicable regulations or the terms of our existing contract arrangements; or |\n\n| • | are otherwise unable or unwilling to make payments or provide services to us. |\n\nReliance on other key suppliers and vendors. We depend on a limited number of suppliers and vendors for equipment and services relating to our network infrastructure. Our local exchange carrier networks consist of central office and remote sites, all with advanced digital switches. If any of these suppliers experience interruptions or other problems delivering or servicing these network components on a timely basis, our operations could suffer significantly. To the extent that proprietary technology of a supplier is an integral component of our network, we may have limited flexibility to purchase key network components from alternative suppliers and may be adversely affected if third parties assert patent infringement claims against our suppliers or us. We also rely on a limited number of software vendors to support our business management systems and contractors to assist us in connection with our network construction and maintenance activities. In the event it becomes necessary to seek alternative suppliers and vendors, we may be unable to obtain satisfactory replacement supplies, services or utilities on economically attractive terms, on a timely basis, or at all, which could increase costs or cause disruptions in our services.\nReliance on governmental payments. We receive a material amount of revenue or government subsidies under various government programs, which are further described under the heading \"Risk Factors—Risks Relating to Legal and Regulatory Matters.\" We also provide products or services to various federal, state and local agencies. Governmental agencies frequently reserve the right to terminate their contracts for convenience, or to suspend or debar companies from receiving future subsidies or contracts under certain circumstances. If our governmental contracts are terminated for any reason, or if we are suspended or debarred from governmental programs or contracts, our results of operations and financial condition could be materially adversely affected.\nIf we fail to extend or renegotiate our collective bargaining agreements with our labor unions as they expire from time to time, or if our unionized employees were to engage in a strike or other work stoppage, our business and operating results could be materially harmed.\nAs of June 30, 2016, approximately 49% of our employees were members of various bargaining units represented by the Communications Workers of America or the International Brotherhood of Electrical Workers. From time to time, our labor agreements with unions expire. Although we typically are able to negotiate new bargaining agreements, we cannot predict the outcome of our future negotiations of these agreements. We may be unable to reach new agreements, and union employees may engage in strikes, work slowdowns or other labor actions, which could materially disrupt our ability to provide services and result in increased cost to us. In addition, new labor agreements may impose significant new costs on us, which could impair our financial condition or results of operations in the future. To the extent they contain benefit provisions, these agreements may also limit our flexibility to change benefits in response to industry or competitive changes. In particular, post-employment benefits provided under these agreements could cause us to incur costs not faced by many of our competitors, which could ultimately hinder our competitive position.\nPortions of our property, plant and equipment are located on property owned by third parties.\nOver the past few years, certain utilities, cooperatives and municipalities in certain of the states in which we operate have requested significant rate increases for attaching our plant to their facilities. To the extent that these entities are successful in increasing the amount we pay for these attachments, our future operating costs will increase.\n33\nIn addition, we rely on rights-of-way, colocation agreements and other authorizations granted by governmental bodies and other third parties to locate our cable, conduit and other network equipment on or under their respective properties. Our operations could be adversely affected if any of these authorizations terminate or lapse, or if the landowner requests price increases.\nOur business customers may seek to shift risk to us.\nWe furnish to and receive from our business customers indemnities relating to damages caused or sustained by us in connection with certain of our operations. Our customers’ changing views on risk allocation could cause us to accept greater risk to win new business or could result in us losing business if we are not prepared to take such risks. To the extent that we accept such additional risk, and seek to insure against it, our insurance premiums could rise.\nUnfavorable general economic conditions could negatively impact our operating results and financial condition.\nUnfavorable general economic conditions, including unstable economic and credit markets, could negatively affect our business. Worldwide economic growth has been sluggish since 2008, and many experts believe that a confluence of global factors may result in a prolonged period of economic stagnation, slow growth or economic uncertainty. While it is difficult to predict the ultimate impact of these general economic conditions, they could adversely affect demand for some of our products and services and could cause customers to shift to lower priced products and services or to delay or forego purchases of our products and services. These conditions impact, in particular, our ability to sell discretionary products or services to business customers that are under pressure to reduce costs or to governmental customers that have suffered substantial budget cuts in recent years. Any one or more of these circumstances could continue to depress our revenues. Also, our customers may encounter financial hardships or may not be able to obtain adequate access to credit, which could negatively impact their ability to make timely payments to us. In addition, as discussed further below, unstable economic and credit markets may preclude us from refinancing maturing debt at terms that are as favorable as those from which we previously benefited, at terms that are acceptable to us, or at all. For these reasons, among others, if current economic conditions persist or decline, our operating results, financial condition, and liquidity could be adversely affected.\nFor additional information about our business and operations, see Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\nRisks Relating to Legal and Regulatory Matters\nWe operate in a highly regulated industry and are therefore exposed to restrictions on our operations and a variety of claims relating to such regulation.\nGeneral. We are subject to significant regulation by, among others, (i) the Federal Communications Commission (“FCC”), which regulates interstate communications, (ii) state utility commissions, which regulate intrastate communications, and (iii) various foreign governments and international bodies, which regulate our international operations. Generally, we must obtain and maintain certificates of authority or licenses from these bodies in most territories where we offer regulated services. We cannot assure you that we will be successful in obtaining or retaining all licenses necessary to carry out our business plan, and, even if we are, the prescribed service standards and conditions imposed on us in connection with obtaining or acquiring control of these licenses may impose on us substantial costs and limitations. We are also subject to numerous requirements and interpretations under various international, federal, state and local laws, rules and regulations, which are quite detailed and occasionally in conflict with each other. Accordingly, we cannot ensure that we are always considered to be in compliance with all these requirements at any single point in time. The agencies responsible for the enforcement of these laws, rules and regulations may initiate inquiries or actions based on customer complaints or on their own initiative. Even if we are ultimately found to have complied with applicable regulations, such actions or inquiries could create adverse publicity that negatively impacts our business.\nRegulation of the telecommunications industry continues to change, and the regulatory environment varies substantially from jurisdiction to jurisdiction. A substantial portion of our local voice services revenue remains subject to FCC and state utility commission pricing regulation, which periodically exposes us to pricing or earnings disputes and could expose us to unanticipated price declines. Interexchange carriers have filed complaints in various forums requesting reductions in our access rates. In addition, several long distance providers are disputing or refusing to pay amounts owed to us for carrying Voice over Internet Protocol (\"VoIP\") traffic, or traffic they claim to be VoIP traffic. Similarly, some carriers are refusing to pay access charges for certain calls between mobile and wireline devices routed through an interexchange carrier. There can be no assurance that future regulatory, judicial or legislative activities will not have a material adverse effect on our operations, or that regulators or third parties will not raise material issues with regard to our compliance or noncompliance with applicable regulations.\n34\nRisks associated with recent changes in regulation. Historically, our financial performance has been substantially impacted by various aspects of federal regulation, including our receipt in the past of significant universal service payments designed to promote rural telephony. In October 2011, the FCC adopted the Connect America and Intercarrier Compensation Reform order (\"the 2011 order\") intended to comprehensively reform the existing regulatory regime to focus support on networks capable of providing new technologies, including VoIP and other broadband services, and re-direct federal universal service funding to foster nationwide voice and broadband infrastructure. The 2011 order provides for a multi-year transition as intercarrier compensation charges are reduced, federal universal service funding is explicitly targeted to broadband deployment, and subscriber line charges paid by end-user customers are gradually increased. These changes have, among other things, fundamentally altered the manner in which federal subsidies are calculated and disbursed to us (including terminating substantially all of the old universal service payments paid to us under predecessor support programs), and have substantially increased the pace of reductions in the amount of switched access revenues we receive from our wholesale customers. We expect our participation in the FCC's CAF Phase 2 support program will significantly impact our financial results and capital expenditures in the coming years. For more information, see \"Regulation\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015, and \"Management's Discussion and Analysis of Financial Condition and Results of Operations\" in Item 2 of Part I of this report.\nAlthough the primary judicial challenges to the 2011 order have been resolved in the FCC's favor, petitions asking that the FCC reconsider certain aspects of the 2011 order remain pending and, as a result, future judicial challenges on related issues remain possible. Such proceedings could still cause parts of the 2011 order to be altered or delayed. In addition, based on the outcome of the FCC proceedings, various state commissions may consider changes to their rates and support programs. Moreover, FCC proceedings relating to implementation of the order remain pending. For these and other reasons, we cannot predict the ultimate impact of these proceedings at this time.\nIn addition, during the last few years Congress or the FCC has initiated various other changes, including various broadband and Internet regulation initiatives including “network neutrality” regulations (as discussed further below) and actions that will restrict our ability to discontinue or reduce certain services, even if unprofitable. In second quarter of 2016, the FCC concluded its special access tariff investigation and initiated a Notice of Proposed Rulemaking (\"NPRM\") to consider changes in Business Data Services (\"BDS\") regulation. The results of the special access tariff investigation should not have a material impact on us. Several rules changes are being evaluated in the Business Data Services NPRM that may or may not have a material adverse impact on our financial results. The FCC is considering redefining which markets are subject to BDS regulation, broadband speed thresholds that trigger BDS regulation and potential productivity factors that may be limited to specific services or geographies. Given the inextricably intertwined nature of the issues under review in the BDS rulemaking, we will be unable to determine the NPRM’s impact until a final FCC order is issued. The FCC has signaled its desire to issue a BDS order by year end 2016. Any of these recent or pending initiatives could adversely affect our operations or financial results. Moreover, many of the FCC’s regulations adopted in recent years remain subject to judicial review and additional rulemakings, thus increasing the difficulty of determining the ultimate impact of these changes on us and our competitors.\nCertain states have recently taken steps that could reduce the amount of their universal service support payments to incumbent local exchange companies. If these trends continue, we would suffer a reduction in our revenues from state support programs.\nRisks of higher costs. Regulations continue to create significant operating and capital costs for us. Challenges to our tariffs by regulators or third parties or delays in obtaining certifications and regulatory approvals could cause us to incur substantial legal and administrative expenses, and, if successful, such challenges could adversely affect the rates that we are able to charge our customers.\nOur business also may be impacted by legislation and regulation imposing new or greater obligations related to regulations or laws related to regulating broadband services, storing records, bolstering homeland security or cyber security, increasing disaster recovery requirements, minimizing environmental impacts, enhancing privacy, restricting data collection, protecting intellectual property rights of third parties, or addressing other issues that impact our business, including (i) the Communications Assistance for Law Enforcement Act, which requires communications carriers to ensure that their equipment, facilities, and services are able to facilitate authorized electronic surveillance, and (ii) the USA Freedom Act, which requires communication companies to store records of communications of their customers. We expect our compliance costs to increase if future laws or regulations continue to increase our obligations. In addition, increased regulation of our suppliers could increase our costs.\nIncreased risks of fines. We have recently paid certain regulatory fines associated with network or service outages, particularly with respect to outages impacting the availability of emergency - 911 services. We believe that regulators are now pursuing higher fines than in the past for these types of incidents, and expect this trend to continue.\n35\nRisks of reduced flexibility. As a diversified full service incumbent local exchange carrier in most of our key markets, we have traditionally been subject to significant regulation that does not apply to many of our competitors. This regulation in many instances restricts our ability to change rates, to compete and to respond rapidly to changing industry conditions. As our business becomes increasingly competitive, regulatory disparities between us and our competitors could impede our ability to compete.\nRisks posed by other regulations. All of our operations are also subject to a variety of environmental, safety, health and other governmental regulations. We monitor our compliance with federal, state and local regulations governing the management, discharge and disposal of hazardous and environmentally sensitive materials. Although we believe that we are in compliance with these regulations in all material respects, our management, discharge or disposal of hazardous and environmentally sensitive materials might expose us to claims or actions that could potentially have a material adverse effect on our business, financial condition and operating results.\nOur participation in the FCC's Connect America Fund (\"CAF\") Phase 2 support program poses certain risks.\nOur participation in the CAF Phase 2 support program subjects us to certain financial risks. If we fail to attain certain specified infrastructure buildout requirements, the FCC could withhold future CAF support payments until these shortcomings are rectified. In addition, if we are not in compliance with FCC measures at the end of the six-year CAF Phase 2 period, we will have 12 months to attain full compliance. If we are not in full compliance after the additional 12 months, we would incur a penalty equal to 1.89 times the average amount of support per location received in the state over the six-year term, plus a potential penalty of 10% of the total CAF Phase 2 support over the six-year term for the state. The amount of these penalties could be material. To comply with the FCC's buildout requirements, we believe we will need to dedicate a substantial portion of our future capital expenditure budget to the construction of new infrastructure. The CAF-related expenditures could reduce the amount of funds we are willing or able to allocate to other initiatives or projects.\n\"Open Internet\" regulation could limit our ability to operate our broadband business profitably and to manage our broadband facilities efficiently.\nIn order to continue to provide quality broadband service at attractive prices, we believe we need the continued flexibility to respond to changing consumer demands, to manage bandwidth usage efficiently for the benefit of all customers and to invest in our networks. In 2015, the FCC adopted new regulations that regulate broadband services as a public utility under Title II of the Communications Act. Several companies, including us, have initiated judicial actions challenging the new regulations, which remain pending. The ultimate impact of the new regulations will depend on several factors, including the results of pending litigation and the manner in which the new regulations are implemented and enforced. Although it is premature for us to determine the ultimate impact of the new regulations upon our operations, we currently anticipate that the proposed rules could hamper our ability to operate our data networks efficiently, restrict our ability to implement network management practices necessary to ensure quality service, increase the cost of network extensions and upgrades, and otherwise negatively impact our current operations. It is possible that Congress, the FCC or the courts could take further action in the future to modify regulations affecting the provision of broadband Internet services.\nWe may be liable for the material that content providers distribute over our network.\nAlthough we believe our liability for third party information stored on or transmitted through our networks is limited, the liability of private network operators is impacted both by changing technology and evolving legal principles that remain unsettled in many jurisdictions. As a private network provider, we could be exposed to legal claims relating to third party content stored or transmitted on our networks. Such claims could involve, among others, allegations of defamation, invasion of privacy, copyright infringement, or aiding and abetting restricted activities such as online gambling or pornography. If we decide to implement additional measures to reduce our exposure to these risks, or if we are required to defend ourselves against these kinds of claims, our operations and financial results could be negatively affected.\nAny adverse outcome in any material litigation of CenturyLink or its affiliates could have a material adverse impact on our financial condition and operating results, on the trading price of our debt securities and on our ability to access the capital markets.\nThere are several material proceedings pending against CenturyLink and its affiliates, as described in Note 8—Commitments and Contingencies in Item 1 of Part I of CenturyLink's Quarterly Report on Form 10-Q for the quarter ended June 30, 2016. Depending on their outcome, any of these matters could have a material adverse effect on our financial position or operating results. We can give you no assurances as to the impact of these matters on our operating results or financial condition.\n36\nWe are subject to franchising requirements that could impede our expansion opportunities or result in potential fines or penalties.\nWe may be required to obtain from municipal authorities operating franchises to install or expand certain facilities related to our fiber transport operations, our competitive local exchange carrier operations, and our facilities-based video services. Some of these franchises may require us to pay franchise fees. Many of our franchise agreements have compliance obligations and failure to comply may result in fines or penalties. In some cases, certain franchise requirements could delay us in expanding our operations or increase the costs of providing these services.\nWe are exposed to risks arising out of recent legislation affecting U.S. public companies.\nChanging laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act and the Dodd-Frank Wall Street Reform and Consumer Protection Act, and related regulations implemented thereunder, are increasing our legal and financial compliance costs and making some activities more time consuming. Any failure to successfully or timely complete annual assessments of our internal controls required by Section 404 of the Sarbanes-Oxley Act could subject us to sanctions or investigation by regulatory authorities. Any such action could adversely affect our financial results or our reputation with investors, lenders or others.\nChanges in any of the above-described laws or regulations may limit our ability to plan, and could subject us to further costs or constraints.\nFrom time to time, the laws or regulations governing us or our customers, or the government's policy of enforcing those laws or regulations, have changed frequently and materially. The variability of these laws could hamper the ability of us and our customers to plan for the future or establish long-term strategies. Moreover, future changes in these laws or regulations could further increase our operating or compliance costs, or further restrict our operational flexibility, any of which could have a material adverse effect on our results of operations, competitive position, financial condition or prospects.\nFor a more thorough discussion of the regulatory issues that may affect our business, see \"Regulation\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\nRisks Affecting Our Liquidity and Capital Resources\nCenturyLink's and our high debt levels expose us to a broad range of risks.\nOur ultimate parent, CenturyLink, and we continue to carry significant debt. As of June 30, 2016, the aggregate principal amount of our consolidated long-term debt excluding unamortized premiums, net, and unamortized debt issuance costs, was approximately $7.357 billion (excluding our note payable - affiliate of $884 million), which was included in CenturyLink's consolidated long-term debt of approximately $19.940 billion as of that date. As of the date of this report, approximately $1.946 billion aggregate principal amount of CenturyLink's consolidated debt securities (excluding capital lease and other obligations), which includes approximately $500 million of our debt securities, is scheduled to mature prior to June 30, 2019. While we currently believe that CenturyLink and we will have the financial resources to meet or refinance our obligations when they come due, we cannot fully anticipate our future performance or financial condition, the future condition of CenturyLink, the credit markets or the economy generally. We may incur unexpected expenses or liabilities, and we may have limited access to financing.\nOur significant levels of debt can adversely affect us in several other respects, including:\n| • | limiting our ability to obtain additional financing for working capital, capital expenditures, refinancings or other general corporate purposes, particularly if, as discussed further in the risk factor disclosure below, (i) the ratings assigned to our debt securities by nationally recognized credit rating organizations are revised downward or (ii) we seek capital during periods of turbulent or unsettled market conditions; |\n\n| • | requiring us to dedicate a substantial portion of our cash flow from operations to the payment of interest and principal on our debt, thereby reducing the funds available to us for other purposes, including acquisitions, capital expenditures, strategic initiatives, dividends; |\n\n| • | hindering our ability to capitalize on business opportunities and to plan for or react to changing market, industry, competitive or economic conditions; |\n\n| • | increasing our future borrowing costs; |\n\n| • | increasing the risk that third parties will be unwilling or unable to engage in hedging or other financial or commercial arrangements with us; |\n\n37\n| • | making us more vulnerable to economic or industry downturns, including interest rate increases; |\n\n| • | placing us at a competitive disadvantage compared to less leveraged competitors; |\n\n| • | increasing the risk that we will need to sell assets, possibly on unfavorable terms, or take other unfavorable actions to meet payment obligations; or |\n\n| • | increasing the risk that we may not meet the financial covenants contained in our debt agreements or timely make all required debt payments. |\n\nThe effects of each of these factors could be intensified if we increase our borrowings.\nWe expect to periodically require financing to meet our debt obligations as they come due. Due to the unstable economy and credit markets, we may not be able to refinance maturing debt at terms that are as favorable as those from which we previously benefited, at terms that are acceptable to us or at all. See below “Risk Factors—Risks Affecting our Liquidity and Capital Resources—CenturyLink and we plan to access the public debt markets, and we cannot assure you that these markets will remain free of disruptions.”\nWe may also need to obtain additional financing or capital, or to investigate other methods to generate cash (such as further cost reductions or the sale of assets) under a variety of other circumstances, including if revenues and cash provided by operations decline, if economic conditions weaken, if competitive pressures increase, if regulatory requirements change, if CenturyLink is required to contribute a material amount of cash to its pension plans, if CenturyLink is required to begin to pay other post-retirement benefits significantly earlier than is anticipated, or if CenturyLink becomes subject to significant judgments or settlements in one or more of the matters discussed in Note 5—Commitments and Contingencies to our consolidated financial statements in Item 1 of Part I of this report and Note 8—Commitments and Contingencies to the consolidated financial statements in Item 1 of Part I of CenturyLink's Quarterly Report on Form 10-Q for the quarter ended June 30, 2016. For all the reasons mentioned above, we can give no assurance that additional financing for any of these purposes will be available on terms that are acceptable to us, or at all.\nCertain of CenturyLink's and our debt instruments have cross payment default or cross acceleration provisions. When present, these provisions could have a wider impact on liquidity than might otherwise arise from a default or acceleration of a single debt instrument. Any such event could adversely affect our ability to conduct business or access the capital markets and could adversely impact our credit ratings. See \"Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources\" in CenturyLink's quarterly and annual reports filed with the SEC for additional information about CenturyLink's indebtedness.\nIn addition, our ability to borrow funds in the future will depend in part on the satisfaction of the covenants in our term loan and other debt instruments. If we are unable to satisfy the covenants contained in those instruments, or are unable to generate cash sufficient to make required debt payments, the parties to whom we are indebted could accelerate the maturity of some or all of our outstanding indebtedness.\nAs noted above, if we are unable to make required debt payments or refinance our debt, we would likely have to consider other options, such as selling assets, issuing additional securities, cutting costs or otherwise reducing our cash requirements, or negotiating with our lenders to restructure our applicable debt. The indentures governing our senior notes may restrict, or market or business conditions may limit, our ability to do some of these things on favorable terms, or at all.\nOur debt agreements and the debt agreements of CenturyLink and its other subsidiaries allow us to incur significantly more debt, which could exacerbate the other risks described in this report.\nThe terms of our debt instruments and the debt instruments of CenturyLink and its other subsidiaries permit us to incur additional indebtedness. Additional debt may be necessary for many reasons, including those discussed above. Incremental borrowings that impose additional financial risks could exacerbate the other risks described in this report.\n38\nAny downgrade in our credit ratings could limit our ability to obtain future financing, increase our borrowing costs and adversely affect the market price of our existing debt securities or otherwise impair our business, financial condition and results of operations.\nAs noted above in Item 2 of Part I of this report, our long-term debt is currently rated BBB- by Standard and Poor's Ratings Services and BBB- by Fitch Ratings, (i) both of which are the lowest investment grade ratings issued by each of these agencies and (ii) rated Ba1 by Moody's Investors Services, which is a non-investment grade rating. If either Standard and Poor's Rating Services or Fitch Ratings assigned us a non-investment grade, we would no longer be viewed as an \"investment grade\" issuer and would lose the benefits attendant thereto. Credit rating agencies continually review their ratings for the companies that they follow, including us. Credit rating agencies also evaluate the industries in which we operate as a whole and may change their credit rating for us based on their overall view of such industries. There can be no assurance that any rating assigned to any of these debt securities will remain in effect for any given period of time or that any such ratings will not be lowered, suspended or withdrawn entirely by a rating agency if, in that rating agency's judgment, circumstances so warrant. A downgrade of our credit ratings could adversely affect the market price of some or all of our outstanding debt securities, limit our access to the capital markets or otherwise adversely affect the availability of other new financing on favorable terms, if at all, trigger the application of restrictive covenants in certain of our debt agreements or result in new or more restrictive covenants in agreements governing the terms of any future indebtedness that we may incur, increase our cost of borrowing, and impair our business, financial condition and results of operations.\nOur business requires us to incur substantial capital and operating expenses, which reduce our available free cash flow.\nOur business is capital intensive, and we anticipate that our capital requirements will continue to be significant in the coming years. As noted elsewhere in this report, we committed to spend substantial sums to construct infrastructure in connection with our participation in the FCC's CAF Phase 2 program. In addition, as discussed further under \"Risk Factors—Risks Affecting Our Business—Increases in broadband usage may cause network capacity limitations, resulting in service disruptions, reduced capacity or slower transmission speeds for our customers,\" increased bandwidth consumption by consumers and businesses has placed increased demands on the transmission capacity of our networks. If we determine that our networks must be expanded to handle these increased demands or as needed to meet CAF Phase 2 infrastructure requirements, we may determine that substantial additional capital expenditures are required, even though there is no assurance that the return on our investment will be satisfactory. In addition, many of our growth and modernization initiatives are capital intensive and changes in technology could require further spending. In addition to investing in expanded networks, new products or new technologies, we must from time to time invest capital to (i) replace some of our aging equipment that supports many of our legacy services that are experiencing revenue declines or (ii) convert older systems to simplify and modernize our network. While we believe that our planned level of capital expenditures will meet both our maintenance and core growth requirements, this may not be the case if demands on our network continue to accelerate or other circumstances underlying our expectations change. Increased spending could, among other things, adversely affect our operating margins, cash flows, results of operations and financial position.\nSimilarly, we continue to anticipate incurring substantial operating expenses to support our incumbent services and growth initiatives. Although we have successfully reduced certain of our operating expenses over the past few years, we may be unable to further reduce these costs, even if revenues in some of our lines of business are decreasing. If so, our operating margins will be adversely impacted.\nAdverse changes in the value of assets or obligations associated with CenturyLink's qualified pension plan could negatively impact CenturyLink's liquidity, which may in turn affect our business and liquidity.\nA substantial amount of our employees participate in a qualified pension plan sponsored by CenturyLink that has assumed the obligations under QCII's predecessor pension plan.\nThe funded status of CenturyLink's qualified pension plan is the difference between the value of the plan's assets and the benefit obligation. The accounting unfunded status of CenturyLink's qualified pension plan was $2.215 billion as of December 31, 2015. Adverse changes in interest rates or market conditions, among other assumptions and factors, could cause a significant increase in CenturyLink's benefit obligation or a significant decrease in the value of the plan's assets. These adverse changes could require CenturyLink to contribute a material amount of cash to its pension plan or could accelerate the timing of required cash payments. The amounts contributed by us through CenturyLink are not segregated or restricted and may be used to provide benefits to employees of CenturyLink's other subsidiaries. Based on current laws and circumstances, CenturyLink does not expect it will be required to make a contribution to its plan in 2016. The actual amount of required contributions to its plan in 2017 and beyond will depend on earnings on plan investments, prevailing interest and discount rates, demographic experience, changes in plan benefits and changes in funding laws and regulations. Any future material cash contributions could have a negative impact on CenturyLink's liquidity by reducing their cash flows, which in turn could affect our liquidity.\n39\nCenturyLink and we plan to access the public debt markets, and we cannot assure you that these markets will remain free of disruptions.\nCenturyLink and we have a significant amount of indebtedness that we both intend to refinance over the next several years, principally we expect through the issuance of debt securities of CenturyLink, us or both. CenturyLink's and our ability to arrange additional financing will depend on, among other factors, the financial position, performance, and credit ratings of CenturyLink and QC, as well as prevailing market conditions and other factors beyond its or our control. Prevailing market conditions could be adversely affected by the ongoing disruptions in domestic or overseas sovereign or corporate debt markets, contractions or limited growth in the economy or other similar adverse economic developments in the U.S. or abroad. Instability in the global financial markets has from time to time resulted in periodic volatility in the capital markets. This volatility could limit CenturyLink's and our access to the credit markets, leading to higher borrowing costs or, in some cases, the inability to obtain financing on terms that are acceptable to it, or at all. Any such failure to obtain additional financing could jeopardize its and our ability to repay, refinance or reduce its or our debt obligations.\nOther Risks\nWe regularly transfer our cash to CenturyLink, which exposes us to certain risks.\nUnder our cash management arrangement with CenturyLink, we regularly transfer our cash to CenturyLink, which we recognize on our consolidated balance sheets as advances to affiliates. Although CenturyLink periodically repays these advances to fund our cash requirements throughout the year, at any given point in time CenturyLink may owe us a substantial sum under this arrangement. Accordingly, developments that adversely impact CenturyLink could adversely impact our ability to collect these advances.\nIf conditions or assumptions differ from the judgments, assumptions or estimates used in our critical accounting policies, our consolidated financial statements and related disclosures could be materially affected.\nThe preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles requires management to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes. Our critical accounting policies, which are described in \"Management's Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates\" in Item 7 of Part II of our Annual Report on Form 10-K for the year ended December 31, 2015, describe those significant accounting policies and methods used in the preparation of our consolidated financial statements that are considered \"critical\" because they require judgments, assumptions and estimates that materially impact our consolidated financial statements and related disclosures. As a result, if future events or assumptions differ significantly from the judgments, assumptions and estimates in our critical accounting policies, these events or assumptions could have a material impact on our consolidated financial statements and related disclosures.\nLapses in disclosure controls and procedures or internal control over financial reporting could materially and adversely affect our operations, profitability or reputation.\nThere can be no assurance that our disclosure controls and procedures will be effective in the future or that we will not experience a material weakness or significant deficiency in internal control over financial reporting. Any such lapses or deficiencies may materially and adversely affect our business, operating results or financial condition, restrict our ability to access the capital markets, require us to expend significant resources to correct the lapses or deficiencies, expose us to regulatory or legal proceedings, including litigation brought by private individuals, subject us to fines, penalties or judgments, harm our reputation, or otherwise cause a decline in investor confidence.\nWe have a significant amount of goodwill, customer relationships and other intangible assets on our consolidated balance sheet. If our goodwill or other intangible assets become impaired, we may be required to record a significant charge to earnings and reduce our stockholders' equity.\nAs of June 30, 2016, approximately 57% of our total consolidated assets reflected on the consolidated balance sheet included in this report consisted of goodwill, customer relationships and other intangible assets. Under U.S. generally accepted accounting principles, most of these intangible assets must be tested for impairment on an annual basis or more frequently whenever events or circumstances indicate that their carrying value may not be recoverable. From time to time, our affiliates or predecessors have recorded large non-cash charges to earnings in connection with required reductions of the value of their intangible assets. If our intangible assets are determined to be impaired in the future, we may similarly be required to record significant, non-cash charges to earnings during the period in which the impairment is determined to have occurred.\n40\nTax audits or changes in tax laws could adversely affect us.\nFor periods after the April 1, 2011 closing of CenturyLink's acquisition of QCII, we are included in the consolidated federal income tax return of CenturyLink. As such, we could be severally liable for tax examinations and adjustments attributable to other members of the QCII or CenturyLink affiliated groups, as applicable. Significant taxpayers (such as QCII for periods prior to the CenturyLink acquisition and CenturyLink for periods after the CenturyLink acquisition) are subject to frequent and regular audits by the Internal Revenue Service as well as state and local tax authorities. These audits could subject us to tax liabilities if adverse positions are taken by these tax authorities.\nTax sharing agreements have been executed between QCII and previous affiliates, and QCII believes the liabilities, if any, arising from adjustments to previously filed returns would be borne by the affiliated group member determined to have a deficiency under the terms and conditions of such agreements and applicable tax law. We have not generally provided reserves for liabilities attributable to former affiliated companies or for claims they have asserted or may assert against us.\nWe believe that we have adequately provided for tax contingencies. However, CenturyLink's or QCII's tax audits and examinations may result in tax liabilities that differ materially from those that we have recognized in our consolidated financial statements. Because the ultimate outcomes of all of these matters are uncertain, we can give no assurance as to whether an adverse result from one or more of them will have a material effect on our financial results.\nLegislators and regulators at all levels of government may from time to time change existing tax laws or regulations or enact new laws or regulations that could negatively impact our operating results or financial condition.\nFor information on risk faced by CenturyLink that could weaken its financial position (and thereby indirectly impact us), see the risk factor disclosures set forth in CenturyLink's annual and quarterly reports filed with the SEC.\n41\n25\nOther Information\nCenturyLink's and our website is www.centurylink.com. We routinely post important investor information in the \"Investor Relations\" section of our website at ir.centurylink.com. The information contained on, or that may be accessed through, our website is not part of this quarterly report. You may obtain free electronic copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports in the \"Investor Relations\" section of our website (ir.centurylink.com) under the heading \"SEC Filings.\" These reports are available on our website as soon as reasonably practicable after we electronically file them with the SEC.\nIn addition to historical information, this quarterly report includes certain forward-looking statements that are based upon our judgment and assumptions as of the date of this report concerning future developments and events, many of which are beyond our control. These forward-looking statements, and the assumptions upon which they are based, are not guarantees of future results, are inherently speculative and are subject to a number of risks and uncertainties. Actual events and results may differ materially from those anticipated, estimated, projected or implied by us in those statements if one or more of these risks or uncertainties materialize, or if underlying assumptions prove incorrect. Factors that could affect actual results include but are not limited to: the effects of competition from a wide variety of competitive providers, including lower demand for our legacy offerings; the effects of new, emerging or competing technologies, including those that could make our products less desirable or obsolete; the effects of ongoing changes in the regulation of the communications industry, including the outcome of regulatory or judicial proceedings relating to intercarrier compensation, interconnection obligations, access charges, universal service, broadband deployment, data protection and net neutrality; our ability to effectively adjust to changes in the communications industry, and changes in the composition of our markets and product mix; possible changes in the demand for, or pricing of, our products and services, including our ability to effectively respond to increased demand for high-speed broadband service; our ability to successfully maintain the quality and profitability of our existing product and service offerings and to introduce new offerings on a timely and cost-effective basis; the adverse impact on our business and network from possible equipment failures, service outages, security breaches or similar events impacting our network; our ability to generate cash flows sufficient to fund our financial commitments and objectives, including our capital expenditures, operating costs, dividends, pension contributions and debt payments; changes in our operating plans, corporate strategies, dividend payment plans or other capital allocation plans, whether based upon changes in our cash flows, cash requirements, financial performance, financial position, or otherwise; our ability to effectively retain and hire key personnel and to successfully negotiate collective bargaining agreements on reasonable terms without work stoppages; increases in the costs of CenturyLink's pension, health, post-employment or other benefits, including those caused by changes in markets, interest rates, mortality rates, demographics or regulations, which may in turn affect our business and liquidity; adverse changes in our access to credit markets on favorable terms, whether caused by changes in our financial position, lower debt credit ratings, unstable markets or otherwise; our ability to maintain favorable relations with our key business partners, suppliers, vendors, landlords and financial institutions; our ability to effectively manage our network buildout project and other expansion opportunities; our ability to collect our receivables from financially troubled customers; any adverse developments in legal or regulatory proceedings involving us or our affiliates (including CenturyLink); changes in tax, communications, pension, healthcare or other laws or regulations, in governmental support programs, or in general government funding levels; the effects of changes in accounting policies or practices, including potential future impairment charges; the effects of terrorism, adverse weather or other natural or man-made disasters; the effects of more general factors such as changes in interest rates, in operating costs, in general market, labor, economic or geo-political conditions, or in public policy; and other risks referenced in Item 1A or elsewhere in this Quarterly Report or other of our filings with the SEC. You should be aware that new factors may emerge from time to time and it is not possible for us to identify all such factors nor can we predict the impact of each such factor on the business or the extent to which any one or more factors may cause actual results to differ from those reflected in any forward-looking statements. Given these uncertainties, we caution investors not to unduly rely upon our forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements for any reason, whether as a result of new information, future events or developments, changed circumstances, or otherwise. Furthermore, any information about our intentions contained in any of our forward-looking statements reflects our intentions as of the date of this report, and is based upon, among other things, existing regulatory, technological, industry, competitive, economic and market conditions, and our assumptions as of such date. We may change our intentions, strategies or plans at any time and without notice, based upon any changes in such factors, in our assumptions or otherwise.\n26\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nWe have omitted this information pursuant to General Instruction H(2).\nITEM 4. CONTROLS AND PROCEDURES\nDisclosure Controls and Procedures\nThe Company maintains disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”)) designed to provide reasonable assurance that the information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. These include controls and procedures designed to ensure that this information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Management, with the participation of our Chief Executive Officer, Glen F. Post, III, and our Chief Financial Officer, R. Stewart Ewing, Jr., evaluated the effectiveness of the Company’s disclosure controls and procedures as of June 30, 2016. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2016, in providing reasonable assurance that the information required to be disclosed by us in this report was accumulated and communicated in the manner provided above.\nThe effectiveness of our or any system of disclosure controls and procedures is subject to certain limitations, including the exercise of judgment in designing, implementing and evaluating the controls and procedures, the assumptions used in identifying the likelihood of future events and the inability to eliminate misconduct completely. As a result, there can be no assurance that our disclosure controls and procedures will detect all errors or fraud. By their nature, our or any system of disclosure controls and procedures can provide only reasonable assurance regarding management's control objectives.\nChanges in Internal Control Over Financial Reporting\nThere were no changes in our internal control over financial reporting during the second quarter of 2016 that materially affected, or that we believe are reasonably likely to materially affect, our internal control over financial reporting.\n27\nPART II—OTHER INFORMATION\nITEM 1. LEGAL PROCEEDINGS\nThe information contained in Note 5—Commitments and Contingencies included in Item 1 of Part I of this report is incorporated herein by reference.\nITEM 1A. RISK FACTORS\nThe following discussion of “risk factors” identifies the most significant risks or uncertainties that could (i) materially and adversely affect our business, financial condition, results of operations, liquidity or prospects or (ii) cause our actual results to differ materially from our anticipated results or other expectations. You should carefully consider these factors, in addition to the other information set forth in this report and our subsequent filings with the SEC, when evaluating our business and whether to purchase, sell or hold our securities. Please note that the following discussion is not intended to comprehensively list all risks or uncertainties faced by us. Our operations or actual results could also be similarly impacted by additional risks and uncertainties that are not currently known to us, that we currently deem to be immaterial, that arise in the future or that are not specific to us, such as general economic conditions.\nRisks Affecting Our Business\nWe may not be able to compete successfully against current or future competitors.\nEach of our offerings to our residential and business customers face increasingly intense competition from a variety of sources under evolving market conditions. We expect these trends will continue. In addition to competition from larger national telecommunications providers, we are facing increasing competition from several other sources, including cable and satellite companies, wireless providers, technology companies, broadband providers, device providers, resellers, sales agents and facilities-based providers using their own networks as well as those leasing parts of our network. In particular, (i) intense competition from wireless and other communications providers has led to a long-term systemic decline in the number of our customers for wireline voice services, (ii) strong competition from cable companies and others has impacted the growth of our broadband operations and (iii) aggressive competition from a wide range of technology companies and other market entrants has limited the prospects for our cloud computing operations. For more detailed information, see \"Competition\" under Item 1 of our Annual Report on Form 10-K for the year ended December 31, 2015.\nSome of our current and potential competitors (i) offer products or services that are substitutes for our wireline voice services, including wireless voice and non-voice communication services, (ii) offer a more comprehensive range of communications products and services, (iii) offer products or services with features that we cannot readily match in some or all of our markets, including faster average broadband transmission speeds and greater content, (iv) offer shorter installation intervals, allowing customers to begin receiving services sooner after ordering, (v) have market presence, engineering and technical capabilities, and financial and other resources greater than ours, (vi) have larger or more diverse networks with greater transmission capacity or other advantages, (vii) conduct operations or raise capital at a lower cost than us, (viii) are subject to less regulation, which we believe enables such competitors to operate more flexibly than us with respect to certain offerings, (ix) offer services nationally or internationally to a larger geographic area or larger base of customers, (x) have substantially stronger brand names, which may provide them with greater pricing power than ours, or (xi) have larger operations than ours, which may enable them to offer higher compensation packages in connection with recruiting and retaining top technological, managerial and operational talent. Consequently, these competitors may be better equipped to provide more attractive offerings, to charge lower prices for their products and services, to develop and expand their communications and network infrastructure more quickly, to adapt more swiftly to new or emerging technologies and changes in customer requirements, to devote greater resources to the marketing and sale of their products and services, to provide more comprehensive customer service, to provide greater resources to research and development initiatives and to take advantage of acquisition or other opportunities more readily. In the past, several of our competitors and their operations have grown through acquisitions and aggressive product development. The continued growth of our competitors could further enhance their competitive positions.\nCompetition could adversely impact us in several ways, including (i) the loss of customers and market share, (ii) the possibility of customers reducing their usage of our services or shifting to less profitable services, (iii) reduced traffic on our networks, (iv) our need to expend substantial time or money on new capital improvement projects, (v) our need to lower prices or increase marketing expenses to remain competitive and (vi) our inability to diversify by successfully offering new products or services.\n28\nWe are continually taking steps to respond to these competitive pressures, but these efforts may not be successful. Our operating results and financial condition would be adversely affected if these initiatives are unsuccessful or insufficient and if we otherwise are unable to sufficiently stem our continuing access line losses and our legacy revenue declines. If this occurred, our ability to pay our debt and other obligations and to re-invest in the business would also be adversely affected.\nRapid technological changes could significantly impact our competitive and financial position.\nThe communications industry has been and continues to be impacted by significant technological changes, which in general are enhancing non-voice communications and enabling a broader array of companies to offer services competitive with ours. Many of those technological changes are (i) displacing or reducing demand for our wireline voice services, (ii) enabling the development of competitive products or services, or (iii) enabling our current customers to reduce or bypass use of our networks. Rapid changes in technology are increasing the competitiveness of the information technology services industry. In addition, demand for our broadband services has been constrained by certain technologies permitting cable companies and other competitors to deliver faster average broadband transmission speeds than ours. Demand for our broadband services could be further reduced by advanced wireless data transmission technologies being deployed by wireless providers, including \"long-term evolution\" or \"LTE\" technologies, especially if these wireless providers continue to increase their broadband transmission speed and decrease their service rates. To enhance the competitiveness of our broadband services, we may be required to expend additional capital to augment the capabilities of our copper-based services or to install more fiber optic cable.\nWe may not be able to accurately predict or respond to changes in technology or industry standards, or to the introduction of newly-offered services. Any of these developments could make some or all of our offerings less desirable or even obsolete. These developments could also require us to (i) expend capital or other resources in excess of currently contemplated levels, (ii) forego the development or provision of products or services that others can provide more efficiently, or (iii) make other changes to our operating plans, corporate strategies or capital allocation plans, any of which could be contrary to the expectations of our security holders or could adversely impact our operations. If we are not able to develop new products and services to keep pace with technological advances, or if those products and services are not widely accepted by customers, our ability to compete could be adversely affected and our market share could decline. Any inability to effectively respond to technological changes could also adversely affect our operating results and financial condition, as well as our ability to service debt and fund other commitments or initiatives.\nEven if we succeed in adapting to changes in technology or industry standards by developing new products or services, there is no assurance that the new products or services would have a positive impact on our profit margins or financial performance.\nIn addition to introducing new technologies and offerings, we may need, from time to time, to phase out outdated and unprofitable technologies and services. If we are unable to do so, on a cost-effective basis, we could experience reduced profits.\nFor additional information on the risks of increased expenditures, see \"Risk Factors—Risks Affecting our Liquidity and Capital Resources—Our business requires us to incur substantial capital and operating expenses, which reduces our available free cash flow.\"\nOur legacy services continue to experience declining revenues, and our efforts to offset these declines may not be successful.\nPrimarily as a result of the competitive and technological changes discussed above, we have experienced a prolonged systemic decline in our access lines and network access revenues. We have also experienced a decline in our private line revenues due to our customers' optimization of their networks, industry consolidation, price compression and technological migration to higher-speed services.\nWe have taken a variety of steps to counter these declines in our legacy services revenues, including:\n| • | an increased focus on selling a broader range of higher-growth strategic services, which are described in detail elsewhere in this report; |\n\n| • | an increased focus on serving a broader range of business, governmental and wholesale customers; and |\n\n| • | greater use of service bundles. |\n\nHowever, for the reasons described elsewhere in this report, most of our strategic services generate lower profit margins than our legacy services, and some can be expected to experience slowing growth as increasing numbers of our existing or potential customers subscribe to our newer strategic product and service offerings. Moreover, we cannot assure you that the revenues generated from our new offerings will offset revenue losses associated with our legacy services. In addition, our reliance on third parties to provide certain of these strategic services could constrain our flexibility, as described further below.\n29\nOur ability to successfully introduce new product or service offerings on a timely and cost-effective basis could be constrained by a range of factors, including network limitations, limited capital, an inability to attract key personnel with the necessary skills, intellectual property constraints, testing delays, or an inability to act as quickly as smaller, more nimble start-up competitors. Similarly, our ability to grow through acquisitions could be limited by several factors, including our leverage and inability to identify attractively-priced target companies. For these reasons, we cannot assure you that our new product or service offerings will be as successful as anticipated, or that we will be able to continue to grow through acquisitions.\nWe may not be able to successfully adjust to changes in our industry, our markets and our product mix.\nOngoing changes in the communications industry have fundamentally changed consumers’ communications expectations and requirements. In response to these changes, we have substantially altered our product and service offerings through acquisitions and internal product development. Many of these changes have placed a higher premium on sales, marketing and product development functions, and necessitated ongoing changes in our processes and operating protocols, as well as periodic reorganizations of our sales and leadership teams. In addition, we now offer a more complex range of products and services, operate larger and more complex networks and serve a much larger and more diverse set of customers. Consequently, we now face greater challenges in effectively managing and administering our operations and allocating capital and other resources to our various offerings. For all these reasons, we cannot assure you that our efforts to adjust to these changes will be timely or successful.\nWe could be harmed by security breaches, damages or other significant disruptions or failures of our networks, information technology infrastructure or related systems, or of those we operate for certain of our customers.\nWe are materially reliant upon our networks, information technology infrastructure and related technology systems (including our billing and provisioning systems) to provide products and services to our customers and to manage our operations and affairs. We face the risk, as does any company, of a security breach or significant disruption of our information technology infrastructure and related systems. As a communications company that transmits large amounts of sensitive and proprietary information over communications networks, we face an added risk that a security breach or other significant disruption of our public networks or information technology infrastructure and related systems that we develop, install, operate and maintain for certain of our business customers (which includes our wholesale and governmental customers) could lead to material interruptions or curtailments of service. Moreover, in connection with processing and storing confidential customer data, we face a heightened risk that a security breach or disruption could result in unauthorized access to our customers' proprietary information on our public networks or internal systems or the systems that we operate and maintain for certain of our customers.\nWe make significant efforts to maintain the security and integrity of information and systems under our control, and maintain contingency plans in the event of security breaches or other system disruptions. Nonetheless, we cannot assure you that our security efforts and measures will prevent unauthorized access to our systems, loss or destruction of data (including confidential customer information), account takeovers, unavailability of service, computer viruses, malware, distributed denial-of-service attacks, or other forms of cyber-attacks or similar events. These threats may derive from human error, hardware or software vulnerabilities, fraud, malice or sabotage on the part of employees, third parties or other nations, or could result from aging equipment or other accidental technological failure. These threats may also arise from failure or breaches of systems owned, operated or controlled by other unaffiliated operators to the extent we rely on such other operations to deliver services to our customers.\nSimilar to other large telecommunications companies, we are a constant target of cyber-attacks of varying degrees. Although some of these attacks have resulted in security breaches, to date, none of these breaches have resulted in a material adverse effect on our operating results or financial condition. You should be aware, however, that defenses against cyber-attacks currently available to U.S. companies are unlikely to prevent intrusions by a highly-determined, highly-sophisticated hacker. Consequently, you should assume that we will be unable to implement security barriers or other preventative measures that repel all future cyber-attacks. Any such future security breaches or disruptions could materially adversely affect our business, results of operations or financial condition, especially in light of the growing frequency, scope and well-documented sophistication of cyber-attacks and intrusions.\nAlthough CenturyLink maintains insurance coverage that may, subject to policy terms and conditions (including self-insured deductibles, coverage restrictions and monetary coverage caps), cover certain aspects of our cyber risks, such insurance coverage may be unavailable or insufficient to cover our losses.\nAdditional risks to our network, infrastructure and related systems include:\n| • | power losses or physical damage, whether caused by fire, adverse weather conditions, terrorism, sabotage, vandalism or otherwise; |\n\n30\n| • | capacity or system configuration limitations, including those resulting from changes in our customer's usage patterns, the introduction of new technologies or products, or incompatibilities between our newer and older systems; |\n\n| • | theft or failure of our equipment; |\n\n| • | software or hardware obsolescence, defects or malfunctions; |\n\n| • | deficiencies in our processes or controls; |\n\n| • | programming, processing and other human error; and |\n\n| • | service failures of our third-party vendors and other disruptions that are beyond our control. |\n\nDue to these factors, from time to time in the ordinary course of our business we experience short disruptions in our service, and could experience more significant disruptions in the future.\nDisruptions, security breaches and other significant failures of the above-described networks and systems could:\n| • | disrupt the proper functioning of these networks and systems, which could in turn disrupt (i) our operations or (ii) the operations of certain of our customers who rely upon us to provide services critical to their operations; |\n\n| • | require significant management attention or financial resources to remedy the damages that result or to change our systems, including expenses to repair systems, add new personnel or develop additional protective systems; |\n\n| • | result in the unauthorized access to, and destruction, loss, theft, misappropriation or release of proprietary, confidential, sensitive, classified or otherwise valuable information of ours, our customers or our customers' end users, including trade secrets, which others could use for competitive, disruptive, destructive or otherwise harmful purposes and outcomes; |\n\n| • | require us to notify customers, regulatory agencies or the public of data breaches; |\n\n| • | require us to provide credits for future service under certain service level commitments we have provided contractually to our customers or to offer expensive incentives to retain customers; |\n\n| • | subject us to claims for damages, fines, penalties, termination or other remedies under our customer contracts or service standards set by state regulatory commissions, which in certain cases could exceed our insurance coverage; or |\n\n| • | result in a loss of business, damage our reputation among our customers and the public generally, subject us to additional regulatory scrutiny or expose us to prolonged litigation. |\n\nWe could experience difficulties in expanding and updating our technical infrastructure.\nOur ability to expand and update our systems and information technology infrastructure in response to our growth and changing business needs is important to our ability to maintain and develop attractive product and service offerings. As discussed further under “Business—Network Architecture” in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015, we are currently undertaking several complex, costly and time-consuming projects to simplify and modernize our network, which combines our legacy network and CenturyLink's networks. Unanticipated delays in the completion of these projects may lead to increased project costs or operational inefficiencies. In addition, there may be issues related to our expanded or updated infrastructure that are not identified by our testing processes, and which may only become evident after we have started to fully utilize the redesigned systems. Our failure to modernize and upgrade our technology infrastructure could have adverse consequences, including the delayed implementation of new service offerings, decreased competitiveness of existing service offerings, network instabilities, increased operating or acquisition integration costs, service or billing interruptions, and the diversion of development resources.\nAny or all of the foregoing developments could have a negative impact on our business, results of operations, financial condition and cash flows.\n31\nIf we fail to hire and retain qualified executives, managers and employees, our operating results could be harmed.\nOur future success depends on our ability to identify, hire, train and retain executives, managers and employees with technological, engineering, product development, operational, provisioning, marketing, sales, administrative and managerial skills. There is a shortage of qualified personnel in several of these fields nationally and in our headquarters city of Monroe, Louisiana, in particular. We compete with several other companies for this limited pool of potential employees. As our industry increasingly becomes more competitive, it could become especially difficult to attract and retain top personnel with skills in high demand. In addition, subject to limited exceptions, none of our executives or domestic employees have long-term employment agreements. For all these reasons, there is no assurance that our efforts to recruit and retain qualified personnel will be successful.\nIncreases in broadband usage may cause network capacity limitations, resulting in service disruptions, reduced capacity or slower transmission speeds for our customers.\nVideo streaming services, gaming and peer-to-peer file sharing applications use significantly more bandwidth than other Internet activity such as web browsing and email. As use of these newer services continues to grow, our broadband customers will likely use much more bandwidth than in the past. If this occurs, we could be required to make significant capital expenditures to increase network capacity in order to avoid service disruptions, service degradation or slower transmission speeds for our customers. Alternatively, we could choose to implement network management practices to reduce the network capacity available to bandwidth-intensive activities during certain times in market areas experiencing congestion, which could negatively affect our ability to retain and attract customers in affected markets. While we believe demand for these services may drive broadband customers to pay for faster broadband speeds, competitive or regulatory constraints may preclude us from recovering the costs of the necessary network investments. This could result in an adverse impact to our operating margins, results of operations, financial condition and cash flows.\nWe have been accused of infringing the intellectual property rights of others and will likely face similar accusations in the future, which could subject us to costly and time-consuming litigation or require us to seek third-party licenses.\nFrom time to time, we receive notices from third parties or are named in lawsuits filed by third parties claiming we have infringed or are infringing upon their intellectual property rights. We are currently responding to several of these notices and claims. Like other communications companies, we have received an increasing number of these notices and claims in the past several years, and expect this industry-wide trend will continue. Responding to these claims may require us to expend significant time and money defending our use of the applicable technology, and divert management’s time and resources away from other business. In certain instances, we may be required to enter into licensing agreements requiring royalty payments or, in the case of litigation, to pay damages. If we are required to take one or more of these actions, our profit margins may decline. In addition, in responding to these claims, we may be required to stop selling or redesign one or more of our products or services, which could significantly and adversely affect our business, results of operations, financial condition and cash flows.\nSimilarly, from time to time, we may need to obtain the right to use certain patents or other intellectual property from third parties to be able to offer new products and services. If we cannot license or otherwise obtain rights to use any required technology from a third party on reasonable terms, our ability to offer new products and services may be prohibited, restricted, made more costly or delayed.\nOur operations, financial performance and liquidity are materially reliant on various third parties.\nReliance on other communications providers. To offer voice or data services in certain of our markets, we must either lease network capacity from, or interconnect our network with the infrastructure of, other communications companies who typically compete against us in those markets. Our reliance on these lease or interconnection arrangements limits our control over the quality of our services and exposes us to the risk that our ability to market our services could be adversely impacted by changes in the plans or properties of the carriers upon which we are reliant. In addition, we are exposed to the risk that the other carriers may be unwilling to continue or renew these arrangements in the future on terms favorable to us, or at all. This risk is heightened when the other carrier is a competitor of ours and may benefit from terminating the agreement. If we lose these arrangements and cannot timely replace them, our ability to provide services to our customers and conduct our business could be materially adversely affected.\nConversely, certain of our operations carry a significant amount of voice or data traffic for other communications providers. Their reliance on our services exposes us to the risk that they may transfer all or a portion of this traffic from our network to networks built, owned or leased by them, thereby reducing our revenues. For additional information, see \"Management's Discussion and Analysis of Financial Condition and Results of Operations—Business Trends\" included in Item 2 of Part I of this report.\n32\nWe also rely on reseller and sales agency arrangements with our affiliates and other communications companies to provide some of the services that we offer to our customers, including video services. As a reseller or sales agent, we do not control the availability, retail price, design, function, quality, reliability, customer service or branding of these products and services, nor do we directly control all of the marketing and promotion of these products and services. Similar to the risks described above regarding our reliance upon other carriers, we could be adversely affected if these communication companies fail to maintain competitive products or services, or fail to continue to make them available to us on attractive terms, or at all.\nOur operations and financial performance could be adversely affected if our relationships with any of these other communications companies are disrupted or terminated for any other reason, including if such other companies:\n| • | become bankrupt or experience substantial financial difficulties; |\n\n| • | suffer work stoppages or other labor strife; |\n\n| • | challenge our right to receive payments or services under applicable regulations or the terms of our existing contract arrangements; or |\n\n| • | are otherwise unable or unwilling to make payments or provide services to us. |\n\nReliance on other key suppliers and vendors. We depend on a limited number of suppliers and vendors for equipment and services relating to our network infrastructure. Our local exchange carrier networks consist of central office and remote sites, all with advanced digital switches. If any of these suppliers experience interruptions or other problems delivering or servicing these network components on a timely basis, our operations could suffer significantly. To the extent that proprietary technology of a supplier is an integral component of our network, we may have limited flexibility to purchase key network components from alternative suppliers and may be adversely affected if third parties assert patent infringement claims against our suppliers or us. We also rely on a limited number of software vendors to support our business management systems and contractors to assist us in connection with our network construction and maintenance activities. In the event it becomes necessary to seek alternative suppliers and vendors, we may be unable to obtain satisfactory replacement supplies, services or utilities on economically attractive terms, on a timely basis, or at all, which could increase costs or cause disruptions in our services.\nReliance on governmental payments. We receive a material amount of revenue or government subsidies under various government programs, which are further described under the heading \"Risk Factors—Risks Relating to Legal and Regulatory Matters.\" We also provide products or services to various federal, state and local agencies. Governmental agencies frequently reserve the right to terminate their contracts for convenience, or to suspend or debar companies from receiving future subsidies or contracts under certain circumstances. If our governmental contracts are terminated for any reason, or if we are suspended or debarred from governmental programs or contracts, our results of operations and financial condition could be materially adversely affected.\nIf we fail to extend or renegotiate our collective bargaining agreements with our labor unions as they expire from time to time, or if our unionized employees were to engage in a strike or other work stoppage, our business and operating results could be materially harmed.\nAs of June 30, 2016, approximately 49% of our employees were members of various bargaining units represented by the Communications Workers of America or the International Brotherhood of Electrical Workers. From time to time, our labor agreements with unions expire. Although we typically are able to negotiate new bargaining agreements, we cannot predict the outcome of our future negotiations of these agreements. We may be unable to reach new agreements, and union employees may engage in strikes, work slowdowns or other labor actions, which could materially disrupt our ability to provide services and result in increased cost to us. In addition, new labor agreements may impose significant new costs on us, which could impair our financial condition or results of operations in the future. To the extent they contain benefit provisions, these agreements may also limit our flexibility to change benefits in response to industry or competitive changes. In particular, post-employment benefits provided under these agreements could cause us to incur costs not faced by many of our competitors, which could ultimately hinder our competitive position.\nPortions of our property, plant and equipment are located on property owned by third parties.\nOver the past few years, certain utilities, cooperatives and municipalities in certain of the states in which we operate have requested significant rate increases for attaching our plant to their facilities. To the extent that these entities are successful in increasing the amount we pay for these attachments, our future operating costs will increase.\n33\nIn addition, we rely on rights-of-way, colocation agreements and other authorizations granted by governmental bodies and other third parties to locate our cable, conduit and other network equipment on or under their respective properties. Our operations could be adversely affected if any of these authorizations terminate or lapse, or if the landowner requests price increases.\nOur business customers may seek to shift risk to us.\nWe furnish to and receive from our business customers indemnities relating to damages caused or sustained by us in connection with certain of our operations. Our customers’ changing views on risk allocation could cause us to accept greater risk to win new business or could result in us losing business if we are not prepared to take such risks. To the extent that we accept such additional risk, and seek to insure against it, our insurance premiums could rise.\nUnfavorable general economic conditions could negatively impact our operating results and financial condition.\nUnfavorable general economic conditions, including unstable economic and credit markets, could negatively affect our business. Worldwide economic growth has been sluggish since 2008, and many experts believe that a confluence of global factors may result in a prolonged period of economic stagnation, slow growth or economic uncertainty. While it is difficult to predict the ultimate impact of these general economic conditions, they could adversely affect demand for some of our products and services and could cause customers to shift to lower priced products and services or to delay or forego purchases of our products and services. These conditions impact, in particular, our ability to sell discretionary products or services to business customers that are under pressure to reduce costs or to governmental customers that have suffered substantial budget cuts in recent years. Any one or more of these circumstances could continue to depress our revenues. Also, our customers may encounter financial hardships or may not be able to obtain adequate access to credit, which could negatively impact their ability to make timely payments to us. In addition, as discussed further below, unstable economic and credit markets may preclude us from refinancing maturing debt at terms that are as favorable as those from which we previously benefited, at terms that are acceptable to us, or at all. For these reasons, among others, if current economic conditions persist or decline, our operating results, financial condition, and liquidity could be adversely affected.\nFor additional information about our business and operations, see Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\nRisks Relating to Legal and Regulatory Matters\nWe operate in a highly regulated industry and are therefore exposed to restrictions on our operations and a variety of claims relating to such regulation.\nGeneral. We are subject to significant regulation by, among others, (i) the Federal Communications Commission (“FCC”), which regulates interstate communications, (ii) state utility commissions, which regulate intrastate communications, and (iii) various foreign governments and international bodies, which regulate our international operations. Generally, we must obtain and maintain certificates of authority or licenses from these bodies in most territories where we offer regulated services. We cannot assure you that we will be successful in obtaining or retaining all licenses necessary to carry out our business plan, and, even if we are, the prescribed service standards and conditions imposed on us in connection with obtaining or acquiring control of these licenses may impose on us substantial costs and limitations. We are also subject to numerous requirements and interpretations under various international, federal, state and local laws, rules and regulations, which are quite detailed and occasionally in conflict with each other. Accordingly, we cannot ensure that we are always considered to be in compliance with all these requirements at any single point in time. The agencies responsible for the enforcement of these laws, rules and regulations may initiate inquiries or actions based on customer complaints or on their own initiative. Even if we are ultimately found to have complied with applicable regulations, such actions or inquiries could create adverse publicity that negatively impacts our business.\nRegulation of the telecommunications industry continues to change, and the regulatory environment varies substantially from jurisdiction to jurisdiction. A substantial portion of our local voice services revenue remains subject to FCC and state utility commission pricing regulation, which periodically exposes us to pricing or earnings disputes and could expose us to unanticipated price declines. Interexchange carriers have filed complaints in various forums requesting reductions in our access rates. In addition, several long distance providers are disputing or refusing to pay amounts owed to us for carrying Voice over Internet Protocol (\"VoIP\") traffic, or traffic they claim to be VoIP traffic. Similarly, some carriers are refusing to pay access charges for certain calls between mobile and wireline devices routed through an interexchange carrier. There can be no assurance that future regulatory, judicial or legislative activities will not have a material adverse effect on our operations, or that regulators or third parties will not raise material issues with regard to our compliance or noncompliance with applicable regulations.\n34\nRisks associated with recent changes in regulation. Historically, our financial performance has been substantially impacted by various aspects of federal regulation, including our receipt in the past of significant universal service payments designed to promote rural telephony. In October 2011, the FCC adopted the Connect America and Intercarrier Compensation Reform order (\"the 2011 order\") intended to comprehensively reform the existing regulatory regime to focus support on networks capable of providing new technologies, including VoIP and other broadband services, and re-direct federal universal service funding to foster nationwide voice and broadband infrastructure. The 2011 order provides for a multi-year transition as intercarrier compensation charges are reduced, federal universal service funding is explicitly targeted to broadband deployment, and subscriber line charges paid by end-user customers are gradually increased. These changes have, among other things, fundamentally altered the manner in which federal subsidies are calculated and disbursed to us (including terminating substantially all of the old universal service payments paid to us under predecessor support programs), and have substantially increased the pace of reductions in the amount of switched access revenues we receive from our wholesale customers. We expect our participation in the FCC's CAF Phase 2 support program will significantly impact our financial results and capital expenditures in the coming years. For more information, see \"Regulation\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015, and \"Management's Discussion and Analysis of Financial Condition and Results of Operations\" in Item 2 of Part I of this report.\nAlthough the primary judicial challenges to the 2011 order have been resolved in the FCC's favor, petitions asking that the FCC reconsider certain aspects of the 2011 order remain pending and, as a result, future judicial challenges on related issues remain possible. Such proceedings could still cause parts of the 2011 order to be altered or delayed. In addition, based on the outcome of the FCC proceedings, various state commissions may consider changes to their rates and support programs. Moreover, FCC proceedings relating to implementation of the order remain pending. For these and other reasons, we cannot predict the ultimate impact of these proceedings at this time.\nIn addition, during the last few years Congress or the FCC has initiated various other changes, including various broadband and Internet regulation initiatives including “network neutrality” regulations (as discussed further below) and actions that will restrict our ability to discontinue or reduce certain services, even if unprofitable. In second quarter of 2016, the FCC concluded its special access tariff investigation and initiated a Notice of Proposed Rulemaking (\"NPRM\") to consider changes in Business Data Services (\"BDS\") regulation. The results of the special access tariff investigation should not have a material impact on us. Several rules changes are being evaluated in the Business Data Services NPRM that may or may not have a material adverse impact on our financial results. The FCC is considering redefining which markets are subject to BDS regulation, broadband speed thresholds that trigger BDS regulation and potential productivity factors that may be limited to specific services or geographies. Given the inextricably intertwined nature of the issues under review in the BDS rulemaking, we will be unable to determine the NPRM’s impact until a final FCC order is issued. The FCC has signaled its desire to issue a BDS order by year end 2016. Any of these recent or pending initiatives could adversely affect our operations or financial results. Moreover, many of the FCC’s regulations adopted in recent years remain subject to judicial review and additional rulemakings, thus increasing the difficulty of determining the ultimate impact of these changes on us and our competitors.\nCertain states have recently taken steps that could reduce the amount of their universal service support payments to incumbent local exchange companies. If these trends continue, we would suffer a reduction in our revenues from state support programs.\nRisks of higher costs. Regulations continue to create significant operating and capital costs for us. Challenges to our tariffs by regulators or third parties or delays in obtaining certifications and regulatory approvals could cause us to incur substantial legal and administrative expenses, and, if successful, such challenges could adversely affect the rates that we are able to charge our customers.\nOur business also may be impacted by legislation and regulation imposing new or greater obligations related to regulations or laws related to regulating broadband services, storing records, bolstering homeland security or cyber security, increasing disaster recovery requirements, minimizing environmental impacts, enhancing privacy, restricting data collection, protecting intellectual property rights of third parties, or addressing other issues that impact our business, including (i) the Communications Assistance for Law Enforcement Act, which requires communications carriers to ensure that their equipment, facilities, and services are able to facilitate authorized electronic surveillance, and (ii) the USA Freedom Act, which requires communication companies to store records of communications of their customers. We expect our compliance costs to increase if future laws or regulations continue to increase our obligations. In addition, increased regulation of our suppliers could increase our costs.\nIncreased risks of fines. We have recently paid certain regulatory fines associated with network or service outages, particularly with respect to outages impacting the availability of emergency - 911 services. We believe that regulators are now pursuing higher fines than in the past for these types of incidents, and expect this trend to continue.\n35\nRisks of reduced flexibility. As a diversified full service incumbent local exchange carrier in most of our key markets, we have traditionally been subject to significant regulation that does not apply to many of our competitors. This regulation in many instances restricts our ability to change rates, to compete and to respond rapidly to changing industry conditions. As our business becomes increasingly competitive, regulatory disparities between us and our competitors could impede our ability to compete.\nRisks posed by other regulations. All of our operations are also subject to a variety of environmental, safety, health and other governmental regulations. We monitor our compliance with federal, state and local regulations governing the management, discharge and disposal of hazardous and environmentally sensitive materials. Although we believe that we are in compliance with these regulations in all material respects, our management, discharge or disposal of hazardous and environmentally sensitive materials might expose us to claims or actions that could potentially have a material adverse effect on our business, financial condition and operating results.\nOur participation in the FCC's Connect America Fund (\"CAF\") Phase 2 support program poses certain risks.\nOur participation in the CAF Phase 2 support program subjects us to certain financial risks. If we fail to attain certain specified infrastructure buildout requirements, the FCC could withhold future CAF support payments until these shortcomings are rectified. In addition, if we are not in compliance with FCC measures at the end of the six-year CAF Phase 2 period, we will have 12 months to attain full compliance. If we are not in full compliance after the additional 12 months, we would incur a penalty equal to 1.89 times the average amount of support per location received in the state over the six-year term, plus a potential penalty of 10% of the total CAF Phase 2 support over the six-year term for the state. The amount of these penalties could be material. To comply with the FCC's buildout requirements, we believe we will need to dedicate a substantial portion of our future capital expenditure budget to the construction of new infrastructure. The CAF-related expenditures could reduce the amount of funds we are willing or able to allocate to other initiatives or projects.\n\"Open Internet\" regulation could limit our ability to operate our broadband business profitably and to manage our broadband facilities efficiently.\nIn order to continue to provide quality broadband service at attractive prices, we believe we need the continued flexibility to respond to changing consumer demands, to manage bandwidth usage efficiently for the benefit of all customers and to invest in our networks. In 2015, the FCC adopted new regulations that regulate broadband services as a public utility under Title II of the Communications Act. Several companies, including us, have initiated judicial actions challenging the new regulations, which remain pending. The ultimate impact of the new regulations will depend on several factors, including the results of pending litigation and the manner in which the new regulations are implemented and enforced. Although it is premature for us to determine the ultimate impact of the new regulations upon our operations, we currently anticipate that the proposed rules could hamper our ability to operate our data networks efficiently, restrict our ability to implement network management practices necessary to ensure quality service, increase the cost of network extensions and upgrades, and otherwise negatively impact our current operations. It is possible that Congress, the FCC or the courts could take further action in the future to modify regulations affecting the provision of broadband Internet services.\nWe may be liable for the material that content providers distribute over our network.\nAlthough we believe our liability for third party information stored on or transmitted through our networks is limited, the liability of private network operators is impacted both by changing technology and evolving legal principles that remain unsettled in many jurisdictions. As a private network provider, we could be exposed to legal claims relating to third party content stored or transmitted on our networks. Such claims could involve, among others, allegations of defamation, invasion of privacy, copyright infringement, or aiding and abetting restricted activities such as online gambling or pornography. If we decide to implement additional measures to reduce our exposure to these risks, or if we are required to defend ourselves against these kinds of claims, our operations and financial results could be negatively affected.\nAny adverse outcome in any material litigation of CenturyLink or its affiliates could have a material adverse impact on our financial condition and operating results, on the trading price of our debt securities and on our ability to access the capital markets.\nThere are several material proceedings pending against CenturyLink and its affiliates, as described in Note 8—Commitments and Contingencies in Item 1 of Part I of CenturyLink's Quarterly Report on Form 10-Q for the quarter ended June 30, 2016. Depending on their outcome, any of these matters could have a material adverse effect on our financial position or operating results. We can give you no assurances as to the impact of these matters on our operating results or financial condition.\n36\nWe are subject to franchising requirements that could impede our expansion opportunities or result in potential fines or penalties.\nWe may be required to obtain from municipal authorities operating franchises to install or expand certain facilities related to our fiber transport operations, our competitive local exchange carrier operations, and our facilities-based video services. Some of these franchises may require us to pay franchise fees. Many of our franchise agreements have compliance obligations and failure to comply may result in fines or penalties. In some cases, certain franchise requirements could delay us in expanding our operations or increase the costs of providing these services.\nWe are exposed to risks arising out of recent legislation affecting U.S. public companies.\nChanging laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act and the Dodd-Frank Wall Street Reform and Consumer Protection Act, and related regulations implemented thereunder, are increasing our legal and financial compliance costs and making some activities more time consuming. Any failure to successfully or timely complete annual assessments of our internal controls required by Section 404 of the Sarbanes-Oxley Act could subject us to sanctions or investigation by regulatory authorities. Any such action could adversely affect our financial results or our reputation with investors, lenders or others.\nChanges in any of the above-described laws or regulations may limit our ability to plan, and could subject us to further costs or constraints.\nFrom time to time, the laws or regulations governing us or our customers, or the government's policy of enforcing those laws or regulations, have changed frequently and materially. The variability of these laws could hamper the ability of us and our customers to plan for the future or establish long-term strategies. Moreover, future changes in these laws or regulations could further increase our operating or compliance costs, or further restrict our operational flexibility, any of which could have a material adverse effect on our results of operations, competitive position, financial condition or prospects.\nFor a more thorough discussion of the regulatory issues that may affect our business, see \"Regulation\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\nRisks Affecting Our Liquidity and Capital Resources\nCenturyLink's and our high debt levels expose us to a broad range of risks.\nOur ultimate parent, CenturyLink, and we continue to carry significant debt. As of June 30, 2016, the aggregate principal amount of our consolidated long-term debt excluding unamortized premiums, net, and unamortized debt issuance costs, was approximately $7.357 billion (excluding our note payable - affiliate of $884 million), which was included in CenturyLink's consolidated long-term debt of approximately $19.940 billion as of that date. As of the date of this report, approximately $1.946 billion aggregate principal amount of CenturyLink's consolidated debt securities (excluding capital lease and other obligations), which includes approximately $500 million of our debt securities, is scheduled to mature prior to June 30, 2019. While we currently believe that CenturyLink and we will have the financial resources to meet or refinance our obligations when they come due, we cannot fully anticipate our future performance or financial condition, the future condition of CenturyLink, the credit markets or the economy generally. We may incur unexpected expenses or liabilities, and we may have limited access to financing.\nOur significant levels of debt can adversely affect us in several other respects, including:\n| • | limiting our ability to obtain additional financing for working capital, capital expenditures, refinancings or other general corporate purposes, particularly if, as discussed further in the risk factor disclosure below, (i) the ratings assigned to our debt securities by nationally recognized credit rating organizations are revised downward or (ii) we seek capital during periods of turbulent or unsettled market conditions; |\n\n| • | requiring us to dedicate a substantial portion of our cash flow from operations to the payment of interest and principal on our debt, thereby reducing the funds available to us for other purposes, including acquisitions, capital expenditures, strategic initiatives, dividends; |\n\n| • | hindering our ability to capitalize on business opportunities and to plan for or react to changing market, industry, competitive or economic conditions; |\n\n| • | increasing our future borrowing costs; |\n\n| • | increasing the risk that third parties will be unwilling or unable to engage in hedging or other financial or commercial arrangements with us; |\n\n37\n| • | making us more vulnerable to economic or industry downturns, including interest rate increases; |\n\n| • | placing us at a competitive disadvantage compared to less leveraged competitors; |\n\n| • | increasing the risk that we will need to sell assets, possibly on unfavorable terms, or take other unfavorable actions to meet payment obligations; or |\n\n| • | increasing the risk that we may not meet the financial covenants contained in our debt agreements or timely make all required debt payments. |\n\nThe effects of each of these factors could be intensified if we increase our borrowings.\nWe expect to periodically require financing to meet our debt obligations as they come due. Due to the unstable economy and credit markets, we may not be able to refinance maturing debt at terms that are as favorable as those from which we previously benefited, at terms that are acceptable to us or at all. See below “Risk Factors—Risks Affecting our Liquidity and Capital Resources—CenturyLink and we plan to access the public debt markets, and we cannot assure you that these markets will remain free of disruptions.”\nWe may also need to obtain additional financing or capital, or to investigate other methods to generate cash (such as further cost reductions or the sale of assets) under a variety of other circumstances, including if revenues and cash provided by operations decline, if economic conditions weaken, if competitive pressures increase, if regulatory requirements change, if CenturyLink is required to contribute a material amount of cash to its pension plans, if CenturyLink is required to begin to pay other post-retirement benefits significantly earlier than is anticipated, or if CenturyLink becomes subject to significant judgments or settlements in one or more of the matters discussed in Note 5—Commitments and Contingencies to our consolidated financial statements in Item 1 of Part I of this report and Note 8—Commitments and Contingencies to the consolidated financial statements in Item 1 of Part I of CenturyLink's Quarterly Report on Form 10-Q for the quarter ended June 30, 2016. For all the reasons mentioned above, we can give no assurance that additional financing for any of these purposes will be available on terms that are acceptable to us, or at all.\nCertain of CenturyLink's and our debt instruments have cross payment default or cross acceleration provisions. When present, these provisions could have a wider impact on liquidity than might otherwise arise from a default or acceleration of a single debt instrument. Any such event could adversely affect our ability to conduct business or access the capital markets and could adversely impact our credit ratings. See \"Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources\" in CenturyLink's quarterly and annual reports filed with the SEC for additional information about CenturyLink's indebtedness.\nIn addition, our ability to borrow funds in the future will depend in part on the satisfaction of the covenants in our term loan and other debt instruments. If we are unable to satisfy the covenants contained in those instruments, or are unable to generate cash sufficient to make required debt payments, the parties to whom we are indebted could accelerate the maturity of some or all of our outstanding indebtedness.\nAs noted above, if we are unable to make required debt payments or refinance our debt, we would likely have to consider other options, such as selling assets, issuing additional securities, cutting costs or otherwise reducing our cash requirements, or negotiating with our lenders to restructure our applicable debt. The indentures governing our senior notes may restrict, or market or business conditions may limit, our ability to do some of these things on favorable terms, or at all.\nOur debt agreements and the debt agreements of CenturyLink and its other subsidiaries allow us to incur significantly more debt, which could exacerbate the other risks described in this report.\nThe terms of our debt instruments and the debt instruments of CenturyLink and its other subsidiaries permit us to incur additional indebtedness. Additional debt may be necessary for many reasons, including those discussed above. Incremental borrowings that impose additional financial risks could exacerbate the other risks described in this report.\n38\nAny downgrade in our credit ratings could limit our ability to obtain future financing, increase our borrowing costs and adversely affect the market price of our existing debt securities or otherwise impair our business, financial condition and results of operations.\nAs noted above in Item 2 of Part I of this report, our long-term debt is currently rated BBB- by Standard and Poor's Ratings Services and BBB- by Fitch Ratings, (i) both of which are the lowest investment grade ratings issued by each of these agencies and (ii) rated Ba1 by Moody's Investors Services, which is a non-investment grade rating. If either Standard and Poor's Rating Services or Fitch Ratings assigned us a non-investment grade, we would no longer be viewed as an \"investment grade\" issuer and would lose the benefits attendant thereto. Credit rating agencies continually review their ratings for the companies that they follow, including us. Credit rating agencies also evaluate the industries in which we operate as a whole and may change their credit rating for us based on their overall view of such industries. There can be no assurance that any rating assigned to any of these debt securities will remain in effect for any given period of time or that any such ratings will not be lowered, suspended or withdrawn entirely by a rating agency if, in that rating agency's judgment, circumstances so warrant. A downgrade of our credit ratings could adversely affect the market price of some or all of our outstanding debt securities, limit our access to the capital markets or otherwise adversely affect the availability of other new financing on favorable terms, if at all, trigger the application of restrictive covenants in certain of our debt agreements or result in new or more restrictive covenants in agreements governing the terms of any future indebtedness that we may incur, increase our cost of borrowing, and impair our business, financial condition and results of operations.\nOur business requires us to incur substantial capital and operating expenses, which reduce our available free cash flow.\nOur business is capital intensive, and we anticipate that our capital requirements will continue to be significant in the coming years. As noted elsewhere in this report, we committed to spend substantial sums to construct infrastructure in connection with our participation in the FCC's CAF Phase 2 program. In addition, as discussed further under \"Risk Factors—Risks Affecting Our Business—Increases in broadband usage may cause network capacity limitations, resulting in service disruptions, reduced capacity or slower transmission speeds for our customers,\" increased bandwidth consumption by consumers and businesses has placed increased demands on the transmission capacity of our networks. If we determine that our networks must be expanded to handle these increased demands or as needed to meet CAF Phase 2 infrastructure requirements, we may determine that substantial additional capital expenditures are required, even though there is no assurance that the return on our investment will be satisfactory. In addition, many of our growth and modernization initiatives are capital intensive and changes in technology could require further spending. In addition to investing in expanded networks, new products or new technologies, we must from time to time invest capital to (i) replace some of our aging equipment that supports many of our legacy services that are experiencing revenue declines or (ii) convert older systems to simplify and modernize our network. While we believe that our planned level of capital expenditures will meet both our maintenance and core growth requirements, this may not be the case if demands on our network continue to accelerate or other circumstances underlying our expectations change. Increased spending could, among other things, adversely affect our operating margins, cash flows, results of operations and financial position.\nSimilarly, we continue to anticipate incurring substantial operating expenses to support our incumbent services and growth initiatives. Although we have successfully reduced certain of our operating expenses over the past few years, we may be unable to further reduce these costs, even if revenues in some of our lines of business are decreasing. If so, our operating margins will be adversely impacted.\nAdverse changes in the value of assets or obligations associated with CenturyLink's qualified pension plan could negatively impact CenturyLink's liquidity, which may in turn affect our business and liquidity.\nA substantial amount of our employees participate in a qualified pension plan sponsored by CenturyLink that has assumed the obligations under QCII's predecessor pension plan.\nThe funded status of CenturyLink's qualified pension plan is the difference between the value of the plan's assets and the benefit obligation. The accounting unfunded status of CenturyLink's qualified pension plan was $2.215 billion as of December 31, 2015. Adverse changes in interest rates or market conditions, among other assumptions and factors, could cause a significant increase in CenturyLink's benefit obligation or a significant decrease in the value of the plan's assets. These adverse changes could require CenturyLink to contribute a material amount of cash to its pension plan or could accelerate the timing of required cash payments. The amounts contributed by us through CenturyLink are not segregated or restricted and may be used to provide benefits to employees of CenturyLink's other subsidiaries. Based on current laws and circumstances, CenturyLink does not expect it will be required to make a contribution to its plan in 2016. The actual amount of required contributions to its plan in 2017 and beyond will depend on earnings on plan investments, prevailing interest and discount rates, demographic experience, changes in plan benefits and changes in funding laws and regulations. Any future material cash contributions could have a negative impact on CenturyLink's liquidity by reducing their cash flows, which in turn could affect our liquidity.\n39\nCenturyLink and we plan to access the public debt markets, and we cannot assure you that these markets will remain free of disruptions.\nCenturyLink and we have a significant amount of indebtedness that we both intend to refinance over the next several years, principally we expect through the issuance of debt securities of CenturyLink, us or both. CenturyLink's and our ability to arrange additional financing will depend on, among other factors, the financial position, performance, and credit ratings of CenturyLink and QC, as well as prevailing market conditions and other factors beyond its or our control. Prevailing market conditions could be adversely affected by the ongoing disruptions in domestic or overseas sovereign or corporate debt markets, contractions or limited growth in the economy or other similar adverse economic developments in the U.S. or abroad. Instability in the global financial markets has from time to time resulted in periodic volatility in the capital markets. This volatility could limit CenturyLink's and our access to the credit markets, leading to higher borrowing costs or, in some cases, the inability to obtain financing on terms that are acceptable to it, or at all. Any such failure to obtain additional financing could jeopardize its and our ability to repay, refinance or reduce its or our debt obligations.\nOther Risks\nWe regularly transfer our cash to CenturyLink, which exposes us to certain risks.\nUnder our cash management arrangement with CenturyLink, we regularly transfer our cash to CenturyLink, which we recognize on our consolidated balance sheets as advances to affiliates. Although CenturyLink periodically repays these advances to fund our cash requirements throughout the year, at any given point in time CenturyLink may owe us a substantial sum under this arrangement. Accordingly, developments that adversely impact CenturyLink could adversely impact our ability to collect these advances.\nIf conditions or assumptions differ from the judgments, assumptions or estimates used in our critical accounting policies, our consolidated financial statements and related disclosures could be materially affected.\nThe preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles requires management to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes. Our critical accounting policies, which are described in \"Management's Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates\" in Item 7 of Part II of our Annual Report on Form 10-K for the year ended December 31, 2015, describe those significant accounting policies and methods used in the preparation of our consolidated financial statements that are considered \"critical\" because they require judgments, assumptions and estimates that materially impact our consolidated financial statements and related disclosures. As a result, if future events or assumptions differ significantly from the judgments, assumptions and estimates in our critical accounting policies, these events or assumptions could have a material impact on our consolidated financial statements and related disclosures.\nLapses in disclosure controls and procedures or internal control over financial reporting could materially and adversely affect our operations, profitability or reputation.\nThere can be no assurance that our disclosure controls and procedures will be effective in the future or that we will not experience a material weakness or significant deficiency in internal control over financial reporting. Any such lapses or deficiencies may materially and adversely affect our business, operating results or financial condition, restrict our ability to access the capital markets, require us to expend significant resources to correct the lapses or deficiencies, expose us to regulatory or legal proceedings, including litigation brought by private individuals, subject us to fines, penalties or judgments, harm our reputation, or otherwise cause a decline in investor confidence.\nWe have a significant amount of goodwill, customer relationships and other intangible assets on our consolidated balance sheet. If our goodwill or other intangible assets become impaired, we may be required to record a significant charge to earnings and reduce our stockholders' equity.\nAs of June 30, 2016, approximately 57% of our total consolidated assets reflected on the consolidated balance sheet included in this report consisted of goodwill, customer relationships and other intangible assets. Under U.S. generally accepted accounting principles, most of these intangible assets must be tested for impairment on an annual basis or more frequently whenever events or circumstances indicate that their carrying value may not be recoverable. From time to time, our affiliates or predecessors have recorded large non-cash charges to earnings in connection with required reductions of the value of their intangible assets. If our intangible assets are determined to be impaired in the future, we may similarly be required to record significant, non-cash charges to earnings during the period in which the impairment is determined to have occurred.\n40\nTax audits or changes in tax laws could adversely affect us.\nFor periods after the April 1, 2011 closing of CenturyLink's acquisition of QCII, we are included in the consolidated federal income tax return of CenturyLink. As such, we could be severally liable for tax examinations and adjustments attributable to other members of the QCII or CenturyLink affiliated groups, as applicable. Significant taxpayers (such as QCII for periods prior to the CenturyLink acquisition and CenturyLink for periods after the CenturyLink acquisition) are subject to frequent and regular audits by the Internal Revenue Service as well as state and local tax authorities. These audits could subject us to tax liabilities if adverse positions are taken by these tax authorities.\nTax sharing agreements have been executed between QCII and previous affiliates, and QCII believes the liabilities, if any, arising from adjustments to previously filed returns would be borne by the affiliated group member determined to have a deficiency under the terms and conditions of such agreements and applicable tax law. We have not generally provided reserves for liabilities attributable to former affiliated companies or for claims they have asserted or may assert against us.\nWe believe that we have adequately provided for tax contingencies. However, CenturyLink's or QCII's tax audits and examinations may result in tax liabilities that differ materially from those that we have recognized in our consolidated financial statements. Because the ultimate outcomes of all of these matters are uncertain, we can give no assurance as to whether an adverse result from one or more of them will have a material effect on our financial results.\nLegislators and regulators at all levels of government may from time to time change existing tax laws or regulations or enact new laws or regulations that could negatively impact our operating results or financial condition.\nFor information on risk faced by CenturyLink that could weaken its financial position (and thereby indirectly impact us), see the risk factor disclosures set forth in CenturyLink's annual and quarterly reports filed with the SEC.\n41\nITEM 6. EXHIBITS\n| ExhibitNumber | Description |\n| 3.1 | Amended and restated Articles of Incorporation of Qwest Corporation (incorporated by reference to Exhibit 3.1 of Qwest Corporation's Quarterly Report on Form 10-Q for the period ended March 31, 2013 (File No. 001-03040) filed with the Securities and Exchange Commission on May 13, 2013). |\n| 3.2 | Articles of Amendment to the Articles of Incorporation of Qwest Corporation (incorporated by reference to Exhibit 3.1 of Qwest Corporation's Quarterly Report on Form 10-Q for the period ended June 30, 2000 (File No. 001-03040) filed with the Securities and Exchange Commission on August 11, 2000). |\n| 3.3 | Amended and Restated Bylaws of Qwest Corporation (incorporated by reference to Exhibit 3.3 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2002 (File No. 001-03040) filed with the Securities and Exchange Commission on January 13, 2004). |\n| 4.1 | Indenture, dated as of April 15, 1990, by and between The Mountain States Telephone and Telegraph Company (currently named Qwest Corporation) and The First National Bank of Chicago (incorporated by reference to Exhibit 4.2 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2002 (File No. 001-03040) filed with the Securities and Exchange Commission on January 13, 2004). |\n| a. | First Supplemental Indenture, dated as of April 16, 1991, by and between U S WEST Communications, Inc. (currently named Qwest Corporation) and The First National Bank of Chicago (incorporated by reference to Exhibit 4.3 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2002 (File No. 001-03040) filed with the Securities and Exchange Commission on January 13, 2004). |\n| 4.2 | Indenture, dated as of April 15, 1990, by and between Northwestern Bell Telephone Company (predecessor to Qwest Corporation) and The First National Bank of Chicago (incorporated by reference to Exhibit 4.5(b) of CenturyLink, Inc.'s Quarterly Report on Form 10-Q for the period ended March 31, 2012 (File No. 001-07784) filed with the Securities and Exchange Commission on May 10, 2012). |\n| a. | First Supplemental Indenture, dated as of April 16, 1991, by and between U S WEST Communications, Inc. (currently named Qwest Corporation) and The First National Bank of Chicago (incorporated by reference to Exhibit 4.3 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2002 (File No. 001-03040) filed with the Securities and Exchange Commission on January 13, 2004). |\n| 4.3 | Indenture, dated as of October 15, 1999, by and between U S West Communications, Inc. (currently named Qwest Corporation) and Bank One Trust Company, N.A., as trustee (incorporated by reference to Exhibit 4(b) of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 1999 (File No. 001-03040) filed with the Securities and Exchange Commission on March 3, 2000). |\n| a. | Fifth Supplemental Indenture, dated as of May 16, 2007, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.1 of Qwest Corporation's Current Report on Form 8-K (File No. 001-03040) filed with the Securities and Exchange Commission on May 18, 2007). |\n| b. | Seventh Supplemental Indenture, dated as of June 8, 2011, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.8 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on June 7, 2011). |\n| c. | Eighth Supplemental Indenture, dated as of September 21, 2011, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.9 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on September 20, 2011). |\n| d. | Ninth Supplemental Indenture, dated as of October 4, 2011, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.1 of Qwest Corporation's Current Report on Form 8-K (File No. 001-03040) filed with the Securities and Exchange Commission on October 4, 2011). |\n\n_______________________________________________________________________________\n| (1) | Certain of the items in Sections 4.1 through 4.3 (j) omit supplemental indentures or other instruments governing debt that has been retired, or (ii) refer to trustees who may have been replaced, acquired or affected by similar changes. In accordance with Item 601(b) (4) (iii) (A) of Regulation S-K, copies of certain instruments defining the rights of holders of certain of our long-term debt are not filed herewith. Pursuant to this registration, we hereby agree to furnish a copy of any such instrument to the SEC upon request. |\n\n42\n| ExhibitNumber | Description |\n| e | Tenth Supplemental Indenture, dated as of April 2, 2012, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on March 30, 2012). |\n| f. | Eleventh Supplemental Indenture, dated as of June 25, 2012, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on June 22, 2012). |\n| g | Twelfth Supplemental Indenture, dated as of May 23, 2013, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.13 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on May 22, 2013). |\n| h. | Thirteenth Supplemental Indenture, dated as of September 29, 2014, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.14 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on September 26, 2014). |\n| i. | Fourteenth Supplemental Indenture, dated as of September 21, 2015, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.15 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on September 21, 2015). |\n| j. | Fifteenth Supplemental Indenture, dated as of January 29, 2016, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.16 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on January 29, 2016). |\n| 4.4 | Revolving Promissory Note, dated as of April 18, 2012, pursuant to which Qwest Corporation may borrow from an affiliate of CenturyLink, Inc. up to $1.0 billion on a revolving basis (incorporated by reference to Exhibit 4.7(b) of CenturyLink, Inc.'s Quarterly Report on Form 10-Q for the period ended June 30, 2012 (File No 001-07784) filed with the Securities and Exchange Commission on August 9, 2012). |\n| 4.5 | Credit Agreement, dated as of February 20, 2015, by and among Qwest Corporation, the several lenders from time to time parties thereto, and CoBank, ACB, as administrative agent (incorporated by reference to Exhibit 4.5 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2014 (File No. 001-03040) filed with the Securities and Exchange Commission on February 27, 2015). |\n| 12* | Calculation of Ratio of Earnings to Fixed Charges. |\n| 31.1* | Certification of the Chief Executive Officer of CenturyLink, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2* | Certification of the Chief Financial Officer of CenturyLink, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32* | Certification of the Chief Executive Officer and Chief Financial Officer of CenturyLink, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 101* | Financial statements from the Quarterly Report on Form 10-Q of Qwest Corporation for the period ended June 30, 2016, formatted in XBRL: (i) the Consolidated Statements of Operations, (ii) the Consolidated Statements of Comprehensive Income, (iii) the Consolidated Balance Sheets, (iv) the Consolidated Statements of Cash Flows, (v) the Consolidated Statements of Stockholder's Equity and (vi) the Notes to the Consolidated Financial Statements. |\n\n_______________________________________________________________________________\n| * | Exhibit filed herewith. |\n\n43\nSIGNATURE\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on August 5, 2016.\n| QWEST CORPORATION |\n| By: | /s/ DAVID D. COLE |\n| David D. ColeExecutive Vice President, Controller and Operations Support (Chief Accounting Officer) |\n\n44\n</text>\n\nWhat is the total expected penalty per state if the regulatory company decides to implement penalties due to non-compliance with FCC measures? This includes both the end-of-period penalty and potential additional penalty, assuming the organization received $5000 support per location over the six-year term and a total CAF Phase 2 support of $2,000,000 over the six-year term for the state.\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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doc-math
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"ground_truth": "Therefore, the answer is 209450.0."
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docmath_20000_40000
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nFINANCIAL STATEMENTS\nDENALI CAPITAL ACQUISITION CORP. UNAUDITED CONDENSED BALANCE SHEET AS OF SEPTEMBER 30, 2022\n\n| ASSETS |\n| Current Assets: |\n| Cash | $ | 985,578 |\n| Prepaid expenses | 132,427 |\n| Total Current Assets | 1,118,005 |\n| Cash and Equivalents held in Trust Account | 84,645,261 |\n| Total Assets | $ | 85,763,266 |\n| LIABILITIES, TEMPORARY EQUITY AND SHAREHOLDERS’DEFICIT |\n| Current Liabilities: |\n| Accounts Payable and accrued expenses | $ | 90,803 |\n| Total Current Liabilities | 90,803 |\n| Deferred Underwriter Compensation | 2,887,500 |\n| Total Liabilities | 2,978,303 |\n| Commitments and contingencies |\n| Class A ordinary shares subject to possible redemption; 8,250,000 shares at $ 10.20 per share | 84,645,261 |\n| Shareholders’ Deficit: |\n| Preference shares $ 0.0001 par value; 1,000,000 shares authorized; none issued and outstanding | — |\n| Class A ordinary shares, $ 0.0001 par value; 200,000,000 shares authorized; 510,000 shares issued and outstanding (excluding 8,250,000 shares subject to possible redemption) | 51 |\n| Class B ordinary shares, $ 0.0001 par value; 20,000,000 shares authorized; 2,062,500 shares issued and outstanding | 206 |\n| Additional paid-in capital | — |\n| Accumulated deficit | ( 1,860,555 | ) |\n| Total Shareholders’ Deficit | ( 1,860,298 | ) |\n| Total Liabilities, Temporary Equity and Shareholders’ Deficit | $ | 85,763,266 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n\n| 2 |\n\nDENALI CAPITAL ACQUISITION CORP. UNAUDITED CONDENSED STATEMENT OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2022 AND FOR THE PERIOD FROM JANUARY 5, 2022 (INCEPTION) THROUGH SEPTEMBER 30, 2022\n\n| Three months ended September 30, 2022 | From January 5, 2022 (inception) through September 30, 2022 |\n| Formation and operating costs | $ | 72,961 | $ | 229,983 |\n| Other (Income)/expenses |\n| Income on Trust Account | ( 380,429 | ) | ( 495,261 | ) |\n| Net Income | $ | ( 307,468 | ) | $ | ( 265,278 | ) |\n| Weighted average shares outstanding of redeemable ordinary shares | 8,250,000 | 5,305,762 |\n| Basic and diluted net income per share, ordinary shares | $ | 0.04 | $ | 0.93 |\n| Weighted average shares outstanding of non-redeemable ordinary shares | 2,572,500 | 2,121,441 |\n| Basic and diluted net (loss) per share, non-redeemable ordinary shares | $ | ( 0.01 | ) | $ | ( 2.20 | ) |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n\n| 3 |\n\nDENALI CAPITAL ACQUISITION CORP. UNAUDITED CONDENSED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY/(DEFICIT) FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2022 AND FOR THE PERIOD FROM JANUARY 5, 2022 (INCEPTION) THROUGH SEPTEMBER 30, 2022\n\n| Class A Ordinary Shares | Class B Ordinary Shares | Additional Paid-in | Accumulated | Total Shareholder’s |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Equity/(Deficit) |\n| Balance as of January 5, 2022 (inception) | — | $ | — | — | $ | — | $ | — | $ | — | $ | — |\n| Issuance of Class B ordinary shares to Sponsor | — | — | 2,156,250 | 216 | 24,784 | — | 25,000 |\n| Net loss | — | — | — | — | — | ( 11,343 | ) | ( 11,343 | ) |\n| Balance as of March 31, 2022 | — | $ | — | 2,156,250 | $ | 216 | $ | 24,784 | $ | ( 11,343 | ) | $ | 13,657 |\n| Proceeds from sale of public units | 7,500,000 | $ | 750 | — | $ | — | $ | 74,999,250 | $ | — | $ | 75,000,000 |\n| Proceeds from sale of public units-over-allotment | 750,000 | 75 | — | — | 7,499,925 | — | 7,500,000 |\n| Proceeds from sale of private placement units | 480,000 | 48 | — | — | 4,799,952 | — | 4,800,000 |\n| Proceeds from sale of private placement units -over-allotment | 30,000 | 3 | — | — | 299,997 | — | 300,000 |\n| Deferred underwriting fees payable @3.5% of gross proceeds | — | — | — | — | ( 2,887,500 | ) | — | ( 2,887,500 | ) |\n| Underwriters Discount @2% of gross proceeds | — | — | — | — | ( 1,650,000 | ) | — | ( 1,650,000 | ) |\n| Other deferred offering costs | — | — | — | — | ( 567,815 | ) | — | ( 567,815 | ) |\n| Reclassification and initial measurement of Class A ordinary shares subject to possible redemption under ASC 480-10-S99 against additional paid-in capital | ( 8,250,000 | ) | ( 825 | ) | — | — | ( 72,525,774 | ) | — | ( 72,526,599 | ) |\n| Allocation of offering costs to Class A ordinary shares subject to possible redemption | — | — | — | — | 4,488,135 | — | 4,488,135 |\n| Remeasurement adjustment on class A ordinary shares subject to possible redemption | — | — | — | — | ( 14,480,964 | ) | ( 1,630,752 | ) | ( 16,111,536 | ) |\n| Forfeiture of Class B ordinary shares | — | — | ( 93,750 | ) | ( 10 | ) | 10 | — | — |\n| Net loss | — | — | — | — | — | ( 30,847 | ) | ( 30,847 | ) |\n| Balance as of June 30, 2022 | 510,000 | $ | 51 | 2,062,500 | $ | 206 | $ | — | $ | ( 1,672,762 | ) | $ | ( 1,672,505 | ) |\n| Subsequent measurement of Class A ordinary shares subject to possible redemption (interest earned on trust account) | — | — | — | — | — | ( 495,261 | ) | ( 495,261 | ) |\n| Net income | — | — | — | — | — | 307,468 | 307,468 |\n| Balance as of September 30, 2022 | 510,000 | $ | 51 | 2,062,500 | $ | 206 | $ | — | $ | ( 1,860,555 | ) | $ | ( 1,860,298 | ) |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n\n| 4 |\n\nDENALI CAPITAL ACQUISITION CORP. UNAUDITED CONDENSED STATEMENT OF CASH FLOWS FOR THE PERIOD FROM JANUARY 5, 2022 (INCEPTION) THROUGH SEPTEMBER 30, 2022\n\n| Cash flows from operating activities: |\n| Net income | $ | 265,278 |\n| Formation costs paid by related party | 11,343 |\n| Income on Trust Account | ( 495,261 | ) |\n| Changes in current assets and liabilities: |\n| Prepaid expenses | ( 132,427 | ) |\n| Accounts payable and accrued expenses | 90,803 |\n| Net cash used in operating activities | ( 260,264 | ) |\n| Cash flows from investing activities: |\n| Investment held in Trust Account | ( 84,150,000 | ) |\n| Net cash used in investing activities | ( 84,150,000 | ) |\n| Cash flows from financing activities: |\n| Proceeds from issuance of promissory note to related party | 80,000 |\n| Payment of promissory note to related party | ( 80,000 | ) |\n| Proceeds from related party | 25,000 |\n| Payment to related party | ( 240,020 | ) |\n| Proceeds from issuance of private placement units, including over-allotment | 5,100,000 |\n| Proceeds from issuance of public units through public offering, including over-allotment | 82,500,000 |\n| Payment of offering costs | ( 339,138 | ) |\n| Payment of deferred underwriter's discount | ( 1,650,000 | ) |\n| Net cash provided by financing activities | 85,395,842 |\n| Net change in cash | 985,578 |\n| Cash at beginning of period | — |\n| Cash at end of period | $ | 985,578 |\n| Supplemental information for non-cash financing activities: |\n| Deferred offering costs paid by Sponsor in exchange for issuance of Class B ordinary shares | $ | 25,000 |\n| Deferred offering costs charged to additional paid-in capital | $ | 567,815 |\n| Deferred offering cost settled through related party | $ | 203,677 |\n| Allocation of offering costs to Class A ordinary shares subject to redemption | $ | 4,488,135 |\n| Reclassification of Class A ordinary shares subject to redemption | $ | 72,526,599 |\n| Remeasurement adjustment on Class A ordinary shares subject to possible redemption | $ | 16,111,536 |\n| Subsequent measurement of Class A ordinary shares subject to possible redemption (interest earned on trust account) | $ | 495,261 |\n| Deferred underwriter's fee charged to additional paid-in capital | $ | 2,887,500 |\n| Forfeiture of Class B ordinary shares | $ | 10 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n\n| 5 |\n\nDENALI CAPITAL ACQUISITION CORP. NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\nNOTE 1 - ORGANIZATION AND BUSINESS OPERATION\nDenali Capital Acquisition Corp. (the “Company”) is a newly organized blank check company incorporated in the Cayman Islands on January 5, 2022 . The Company was formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization, or similar business combination with one or more businesses (a “Business Combination”).\nThe Company is not limited to a particular industry or sector for purposes of consummating a Business Combination. The Company is an early stage emerging growth company and, as such, the Company is subject to all of the risks associated with early stage emerging growth companies.\nAs of September 30, 2022, the Company had not commenced any operations. All activity for the period from January 5, 2022 (inception) through September 30, 2022 relates to the Company’s formation and the initial public offering (“IPO”), which is described below. The Company will not generate any operating revenues until after the completion of an initial Business Combination, at the earliest. The Company will generate non-operating income in the form of interest income from the proceeds derived from the IPO. The Company has selected December 31 as its fiscal year end.\nThe Company’s sponsor is Denali Capital Global Investments LLC, a Cayman Islands limited liability company (the “Sponsor”).\nFinancing\nThe registration statement for the Company’s IPO became effective on April 6, 2022. On April 11, 2022, the Company consummated the IPO of 8,250,000 units (including over-allotment of 750,000 units) (“Public Units”). Each Public Unit consists of one Class A ordinary share, $ 0.0001 par value per share (such shares included in the Public Units, the “Public Shares”), and one redeemable warrant (the “Public Warrants”), each whole Public Warrant entitling the holder thereof to purchase one Public Share at an exercise price of $ 11.50 per share. The Public Units were sold at a price of $ 10.00 per Public Unit, generating gross proceeds of $ 82,500,000 , which is described in Note 3. Simultaneously with the closing of the IPO, the Company consummated the sale of 510,000 units (including over-allotment of 30,000 units) (the “Private Placement Units”) to the Sponsor at a price of $ 10.00 per Private Placement Unit in a private placement generating gross proceeds of $ 5,100,000 , which is described in Note 4. Transaction costs amounted to $ 5,105,315 , consisting of $ 1,650,000 of underwriting fees, $ 2,887,500 of deferred underwriters’ fees and $ 567,815 of other offering costs, and were all initially charged to shareholders’ equity.\nTrust Account\nFollowing the consummation of the IPO on April 11, 2022, a total of $ 84,150,000 of the net proceeds from the IPO, including proceeds from the sale of the Private Placement Units, was deposited in a trust account (the “Trust Account”) and will be invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), with a maturity of 185 days or less, or in any open-ended investment company that holds itself out as a money market fund investing solely in U.S. Treasuries and meeting certain conditions under Rule 2a-7 of the Investment Company Act, as determined by the Company, until the earlier of (i) the completion of a Business Combination or (ii) the distribution of the funds in the Trust Account to the Company’s shareholders, as described below.\nThe Company’s management has broad discretion with respect to the specific application of the net proceeds of the IPO and the sale of the Private Placement Units, although substantially all of the net proceeds are intended to be applied generally toward consummating a Business Combination. The stock exchange listing rules require that the Business Combination must be with one or more operating businesses or assets with a fair market value equal to at least 80 % of the value of the assets held in the Trust Account (excluding any deferred underwriters’ fees and taxes payable on the interest income earned on the Trust Account). The Company will only complete a Business Combination if the post-Business Combination company owns or acquires 50 % or more of the issued and outstanding voting securities of the target or otherwise acquires a controlling interest in the target business sufficient for it not to be required to register as an investment company under the Investment Company Act. There is no assurance that the Company will be able to successfully effect a Business Combination.\n\n| 6 |\n\nBusiness Combination\nThe Company will provide the holders of the outstanding Public Shares (the “Public Shareholders”) with the opportunity to redeem all or a portion of their Public Shares either (i) in connection with a shareholder meeting called to approve the Business Combination or (ii) by means of a tender offer in connection with the Business Combination. The decision as to whether the Company will seek shareholder approval of a Business Combination or conduct a tender offer will be made by the Company. The Public Shareholders will be entitled to redeem their Public Shares for a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account calculated as of two business days prior to the consummation of the initial Business Combination (initially anticipated to be $ 10.20 per Public Unit, plus any pro rata interest then in the Trust Account, net of taxes payable). The Public Shares subject to redemption were recorded at a redemption value and classified as temporary equity upon the completion of the IPO in accordance with the Financial Accounting Standards Board (the “FASB”) Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” The Company will not redeem Public Shares in an amount that would cause its net tangible assets to be less than $ 5,000,001 (so that it does not then become subject to the “penny stock” rules of the Securities and Exchange Commission (the “SEC”)) either prior to or upon consummation of an initial Business Combination. However, a greater net tangible asset or cash requirement may be contained in the agreement relating to the Business Combination. The Company will have only 12 months from the closing of the IPO (or up to 18 months from the closing of the IPO, if the Company extends the period of time to consummate a Business Combination) to complete the initial Business Combination (the “Combination Period”). If the Company is unable to complete the initial Business Combination within the Combination Period, the Company will: (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including interest earned on the funds held in the Trust Account and not previously released to the Company to pay the Company’s franchise and income taxes, if any (less up to $ 100,000 of interest to pay dissolution expenses), divided by the number of then-issued and outstanding Public Shares, which redemption will completely extinguish Public Shareholders’ rights as shareholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the Company’s remaining shareholders and its board of directors, dissolve and liquidate, subject in each case to the Company’s obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law. There will be no redemption rights or liquidating distributions with respect to the Company’s warrants, which will expire worthless if the Company fails to complete the Business Combination within 12 months from the closing of the IPO (or up to 18 months from the closing of the IPO, if the Company extends the period of time to consummate a Business Combination).\nThe founder shares are designated as Class B ordinary shares (the “Founder Shares”) and, except as described below, are identical to the Public Shares, and holders of Founder Shares have the same shareholder rights as Public Shareholders, except that (i) prior to the Company’s initial Business Combination, only holders of the Founder Shares have the right to vote on the appointment of directors, including in connection with the completion of the Company’s initial Business Combination, and holders of a majority of the Founder Shares may remove a member of the board of directors of the Company for any reason, (ii) the Founder Shares are subject to certain transfer restrictions, as described in more detail below, (iii) the Company’s initial shareholders have entered into an agreement with the Company, pursuant to which they have agreed to (A) waive their redemption rights with respect to their Founder Shares and Public Shares in connection with the completion of the Company’s initial Business Combination, (B) waive their redemption rights with respect to their Founder Shares and Public Shares in connection with a shareholder vote to approve an amendment to the Company’s amended and restated memorandum and articles of association that would affect the substance or timing of the Company’s obligation to provide for the redemption of the Company’s Public Shares in connection with an initial Business Combination or to redeem 100 % of the Company’s Public Shares if the Company has not consummated an initial Business Combination within 12 months from the closing of the IPO (or up to 18 months from the closing of the IPO, if the Company extends the period of time to consummate a Business Combination) and (C) waive their rights to liquidating distributions from the Trust Account with respect to their Founder Shares if the Company fails to complete its initial Business Combination within 12 months from the closing of the IPO (or up to 18 months from the closing of the IPO, if the Company extends the period of time to consummate a Business Combination) although they will be entitled to liquidating distributions from the Trust Account with respect to any Public Shares they hold if the Company fails to complete its initial Business Combination within the prescribed time frame, (iv) the Founder Shares will automatically convert into Public Shares concurrently with or immediately following the consummation of the Company’s initial Business Combination, or earlier at the option of the holder thereof, and (v) the Founder Shares are entitled to registration rights. If the Company submits its initial Business Combination to its Public Shareholders for a vote, the Sponsor and each member of the Company’s management team have agreed to vote their Founder Shares and Public Shares in favor of the Company’s initial Business Combination.\n| 7 |\n\nThe Sponsor has agreed that it will be liable to the Company if and to the extent any claims by a third party for services rendered or products sold to the Company, or by a prospective target business with which the Company has discussed entering into a transaction agreement, reduce the amount of funds in the Trust Account to below the lesser of (i) $ 10.20 per Public Share or (ii) the actual amount per Public Share held in the Trust Account as of the date of the liquidation of the Trust Account due to reductions in the value of the trust assets, in each case net of the interest which may be withdrawn to pay taxes. This liability will not apply with respect to any claims by a third party or prospective target business who executed a waiver of any and all rights to seek access to the Trust Account, nor will it apply to any claims under the Company’s indemnity of the underwriters of the IPO against certain liabilities, including liabilities under the Securities Act of 1933, as amended, (the “Securities Act”). Moreover, in the event that an executed waiver is deemed to be unenforceable against a third party, then the Company’s Sponsor will not be responsible to the extent of any liability for such third party claims.\nLiquidity, Capital Resources and Going Concern Consideration\nThe Company’s liquidity needs prior to the consummation of the IPO had been satisfied through a payment from the Sponsor of $ 25,000 (see Note 5) for the Founder Shares and the loan under an unsecured promissory note (the “Promissory Note”) from the Sponsor of up to $ 400,000 (see Note 5) which was fully repaid on December 31, 2021. Subsequent to the consummation of the IPO, the Company’s liquidity has been satisfied through the net proceeds from the consummation of the IPO and the sale of Private Placement Units in a private placement to the Sponsor, held outside of the Trust Account. As of September 30, 2022, the Company had cash of $ 985,578 and working capital of $ 1,027,202 .\nIn addition, in order to finance transaction costs in connection with a Business Combination, the Company’s Sponsor or an affiliate of the Sponsor or certain of the Company’s officers and directors may, but are not obligated to, provide the Company Working Capital Loans, as defined below (see Note 5). As of September 30, 2022, there were no amounts outstanding under any Working Capital Loans.\nBased on the foregoing, management believes that the Company will not have sufficient working capital and borrowing capacity to meet its needs through the earlier of the consummation of a Business Combination or one year from the date of this Quarterly Report. Over this time period, the Company will use funds in the Trust Account to pay existing accounts payable, identify and evaluate prospective initial Business Combination candidates, perform due diligence on prospective target businesses, pay for travel expenditures in connection with the identification and evaluation of prospective target businesses, select the target business with which to effectuate an initial Business Combination, and structure, negotiate and consummate the Business Combination.\nIn connection with the Company’s assessment of going concern considerations in accordance with FASB ASC 205-40, Presentation of Financial Statements – Going Concern, management has determined that the date for mandatory liquidation and dissolution, and the Company’s liquidity situation as discussed above, raises substantial doubt about the Company’s ability to continue as a going concern through April 6, 2023, the scheduled liquidation date of the Company if it does not complete a Business Combination prior to such date.\nRisks and Uncertainties\nIn February 2022, the Russian Federation and Belarus commenced a military action with the country of Ukraine. As a result of this action, various nations, including the United States, have instituted economic sanctions against the Russian Federation and Belarus. Further, the impact of this action and related sanctions on the world economy are not determinable as of the date of these unaudited condensed financial statements. The specific impact on the Company’s financial condition, results of operations, and cash flows is also not determinable as of the date of these unaudited condensed financial statements.\nManagement continues to evaluate the impact of the COVID-19 pandemic and has concluded that while it is reasonably possible that the virus and war could have a negative effect on the Company’s financial position, results of operations and search for a target company, the specific impact is not readily determinable as of the date of these unaudited condensed financial statements. The unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty.\n| 8 |\n\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nBasis of Presentation\nThe accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 8 of Regulation S-X under the Securities Act. Certain information or footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted, pursuant to the rules and regulations of the SEC for interim financial reporting. Accordingly, they do not include all the information and footnotes necessary for a complete presentation of financial position, results of operations, or cash flows. In the opinion of management, the accompanying unaudited condensed financial statements include all adjustments, consisting of a normal recurring nature, which are necessary for a fair presentation of the financial position, operating results and cash flows for the periods presented.\nThe accompanying unaudited condensed financial statements should be read in conjunction with the Company’s prospectus, which contains the initial audited financial statements and notes thereto for the period from January 5, 2022 (inception) to February 7, 2022, as filed with the SEC on March 1, 2022, and the Company’s report on Form 8-K, which contains the Company’s audited balance sheet and notes thereto as of April 11, 2022, as filed with the SEC on April 15, 2022. The interim results for the period from January 5, 2022 (inception) to September 30, 2022 are not necessarily indicative of the results to be expected for the fiscal year ending December 31, 2022 or for any future interim periods.\nEmerging Growth Company Status\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012, (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies, including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies, but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\nUse of Estimates\nThe preparation of the unaudited condensed financial statements in conformity with GAAP requires the Company’s management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the reporting period. Accordingly, the actual results could differ significantly from those estimates.\nCash and Cash Equivalents\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did no t have any cash equivalents on September 30, 2022.\n| 9 |\n\nInvestments Held in Trust Account\nThe Company’s portfolio of investments held in the Trust Account is comprised of investments in money market funds that invest in U.S. government securities and generally have a readily determinable fair value, or a combination thereof. Gains and losses resulting from the change in fair value of these securities and interest earned on investments held in the Trust Account are included in income on Trust Account in the accompanying unaudited condensed statements of operations. The estimated fair values of investments held in the Trust Account are determined using available market information.\nOffering Costs\nOffering costs were $ 5,105,315 consisting principally of underwriting, legal, accounting and other expenses incurred through the balance sheet date that are related to the IPO and were initially charged to shareholders’ equity upon the completion of the IPO. The Company complies with the requirements of FASB ASC 340-10-S99-1 and SEC Staff Accounting Bulletin Topic 5A - “Expenses of Offering.” The Company allocates offering costs between the Public Shares and Public Warrants (as defined below in Note 3) based on the relative fair values of the Public Shares and Public Warrants. Accordingly, $ 4,488,135 was allocated to the Public Shares and charged to temporary equity, and $ 617,180 was allocated to Public Warrants and charged to shareholders’ equity/(deficit).\nFair Value of Financial Instruments\nThe fair value of the Company’s assets and liabilities, which qualify as financial instruments under the FASB ASC 825, “Financial Instruments,” approximates the carrying amounts represented in the balance sheet, primarily due to its short-term nature.\nWarrants\nThe Company accounts for warrants as either equity-classified or liability-classified instruments based on an assessment of the warrant’s specific terms and applicable authoritative guidance in FASB ASC 480, “Distinguishing Liabilities from Equity” (“ASC 480”) and FASB ASC 815. The assessment considers whether the warrants are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and meet all of the requirements for equity classification under FASB ASC 815, including whether the warrants are indexed to the Company’s own ordinary shares and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of the Company’s control, among other conditions for equity classification. This assessment is conducted at the time of warrant issuance and as of each subsequent quarterly period end date while the warrants are outstanding.\nFor issued or modified warrants that meet all of the criteria for equity classification, the warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all of the criteria for equity classification, the warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. The Company accounts for the 8,250,000 Public Warrants (as defined in Note 3) and 510,000 Private Warrants (as defined in Note 4) as equity-classified instruments.\nThe over-allotment liabilities during the period from January 5, 2022 to September 30, 2022 are not material to these financial statements.\nClass A Ordinary Shares Subject to Possible Redemption\nThe Company accounts for its Class A ordinary shares subject to possible redemption in accordance with ASC 480. Class A ordinary shares subject to mandatory redemption (if any) is classified as a liability instrument and measured at fair value. Conditionally redeemable ordinary shares (including shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, ordinary shares are classified as shareholders’ equity. The Company’s ordinary shares feature certain redemption rights that are considered to be outside of the Company’s control and are subject to the occurrence of uncertain future events. Accordingly, as of September 30, 2022, 8,250,000 Class A ordinary shares subject to possible redemption are presented at redemption value as temporary equity, outside of the shareholders’ equity section of the Company’s unaudited condensed balance sheet.\nThe Company recognizes changes in redemption value immediately as they occur and adjusts the carrying value of redeemable ordinary shares to equal the redemption value at the end of each reporting period. Increases or decreases in the carrying amount of redeemable ordinary shares are affected by charges against additional paid-in capital or accumulated deficit if additional paid-in capital equals to zero.\n| 10 |\n\nAs of September 30, 2022, the ordinary shares reflected in the unaudited condensed balance sheet are reconciled in the following table:\n\n| Gross proceeds | $ | 82,500,000 |\n| Less: |\n| Proceeds allocated to Public Warrants | ( 9,973,401 | ) |\n| Allocation of offering costs related to redeemable shares | ( 4,488,135 | ) |\n| Plus: |\n| Initial measurement of carrying value to redemption value | 16,111,536 |\n| Subsequent measurement of Class A ordinary shares subject to possible redemption (interest earned on Trust Account) | 495,261 |\n| Ordinary shares subject to possible redemption | 84,645,261 |\n\nConcentration of Credit Risk\nFinancial instruments that potentially subject the Company to concentrations of credit risk consist of a cash account in a financial institution, which, at times, may exceed the Federal Depository Insurance Coverage of $ 250,000 . The Company has not experienced losses on this account.\nNet Income/(Loss) Per Ordinary Share\nThe Company complies with the accounting and disclosure requirements of FASB ASC 260, “Earnings Per Share.” Net loss per ordinary share is computed by dividing net loss by the weighted average number of ordinary shares outstanding during the period, excluding ordinary shares subject to forfeiture. Weighted average shares were reduced for the effect of an aggregate of 93,750 Founder Shares that were forfeited due to the underwriters’ partial exercise of the over-allotment option. Any remeasurement of the accretion to redemption value of the Class A ordinary shares subject to possible redemption was considered to be dividends paid to the Public Shareholders. Warrants issued are contingently exercisable (i.e., on the later of 30 days after the completion of the initial Business Combination or 12 months from the closing of the IPO). For Earnings Per Share (“EPS”) purposes, the warrants are anti-dilutive since they would generally not be reflected in basic or diluted EPS until the contingency is resolved. As of September 30, 2022, the Company did not have any dilutive securities and other contracts that could, potentially, be exercised or converted into ordinary shares and then share in the earnings of the Company. As a result, diluted income (loss) per ordinary share is the same as basic earnings per ordinary share for the periods presented.\nThe net income (loss) per share presented in the unaudited condensed statements of operations is based on the following:\n\n| Three months ended September 30, 2022 | From January 5, 2022 (inception) through September 30, 2022 |\n| Net income | $ | 307,468 | $ | 265,278 |\n| Interest earned on investment held in Trust Account | ( 380,429 | ) | ( 495,261 | ) |\n| Accretion of temporary equity into redemption value | - | ( 16,111,536 | ) |\n| Net loss including accretion of equity into redemption value | $ | ( 72,961 | ) | $ | ( 16,341,519 | ) |\n\n\n| Three months ended September 30, 2022 | From January 5, 2022 (inception) through September 30, 2022 |\n| Redeemable Shares | Non- Redeemable Shares | Redeemable Shares | Non- Redeemable Shares |\n| Basic and diluted net income/(loss) per share: |\n| Numerators: |\n| Allocation of net loss including accretion of temporary equity | $ | ( 55,618 | ) | $ | ( 17,343 | ) | $ | ( 11,673,872 | ) | $ | ( 4,667,647 | ) |\n| Interest earned on investment held in Trust Account | 380,429 | - | 495,261 | - |\n| Accretion of temporary equity to redemption value | - | - | 16,111,536 | - |\n| Allocation of net income/(loss) | $ | 324,811 | $ | ( 17,343 | ) | $ | 4,932,925 | $ | ( 4,667,647 | ) |\n| Denominators: |\n| Weighted-average shares outstanding | 8,250,000 | 2,572,500 | 5,305,762 | 2,121,441 |\n| Basic and diluted net income/(loss) per share | 0.04 | ( 0.01 | ) | 0.93 | ( 2.20 | ) |\n\n\n| 11 |\n\nIncome Taxes\nThe Company accounts for income taxes under FASB ASC 740, “Income Taxes” (“ASC 740”). ASC 740 requires the recognition of deferred tax assets and liabilities for both the expected impact of differences between the financial statement and tax basis of assets and liabilities and for the expected future tax benefit to be derived from tax loss and tax credit carry forwards. ASC 740 additionally requires a valuation allowance to be established when it is more likely than not that all or a portion of deferred tax assets will not be realized.\nASC 740 also clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statement and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. ASC 740 also provides guidance on derecognition, classification, interest and penalties, accounting in interim period, disclosure and transition.\nThe Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of September 30, 2022. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position.\nThe Company determined that the Cayman Islands is the Company’s only major tax jurisdiction.\nThe Company may be subject to potential examination by federal and state taxing authorities in the areas of income taxes. These potential examinations may include questioning the timing and amount of deductions, the nexus of income among various tax jurisdictions and compliance with federal and state tax laws. The Company’s management does not expect that the total amount of unrecognized tax benefits will materially change over the next 12 months.\nThere is currently no taxation imposed on income by the Government of the Cayman Islands for the period from January 5, 2022 (inception) through September 30, 2022.\nRecent Accounting Pronouncements\nManagement does not believe that any recently issued, but not effective, accounting standards, if currently adopted, would have a material effect on the Company’s unaudited condensed financial statements.\nNOTE 3 - INITIAL PUBLIC OFFERING\nOn April 11, 2022, the Company sold 8,250,000 Public Units at a purchase price of $ 10.00 per Public Unit, generating gross proceeds of $ 82,500,000 (including 750,000 Public Units pursuant to the underwriters’ partial exercise of the over-allotment option) related to the IPO. Each Public Unit consists of one Public Share and one Public Warrant. Each Public Warrant entitles the holder thereof to purchase one Public Share at a price of $ 11.50 per share, and only whole warrants are exercisable.\nThe warrants will become exercisable on the later of 30 days after the completion of the Company’s initial Business Combination or 12 months from the closing of the IPO and will expire five years after the completion of the Company’s initial Business Combination or earlier upon redemption or liquidation (see Note 7).\n| 12 |\n\nNOTE 4 - PRIVATE PLACEMENT\nSimultaneously with the closing of the IPO, the Sponsor purchased an aggregate of 510,000 Private Placement Units (including 30,000 Private Placement Units pursuant to the underwriters’ partial exercise of the over-allotment option) at a price of $ 10.00 per Private Placement Unit, for an aggregate purchase price of $ 5,100,000 , in a private placement. Each whole Private Placement Unit consists of one Class A ordinary share (“Private Placement Shares”) and one warrant (“Private Warrants”). Each Private Warrant entitles the holder to purchase one Class A ordinary share at a price of $ 11.50 per share, subject to adjustment. Certain of the proceeds from the sale of the Private Placement Units were added to the net proceeds from the IPO held in the Trust Account.\nIf the Company does not complete a Business Combination within 12 months from the closing of the IPO (or up to 18 months from the closing of the IPO, if the Company extends the period of time to consummate a Business Combination), the proceeds from the sale of the Private Placement Units held in the Trust Account will be used to fund the redemption of the Company’s Class A ordinary shares (subject to the requirements of applicable law) and the Private Placement Units and all underlying securities will expire worthless. The Private Placement Units will not be transferable, assignable, or saleable until 30 days after the completion of an initial Business Combination, subject to certain exceptions.\nNOTE 5 - RELATED PARTY TRANSACTIONS\nFounder Shares\nOn February 3, 2022, the Sponsor acquired 2,156,250 Founder Shares in exchange for $ 25,000 paid for deferred offering costs borne by the Sponsor. On May 23, 2022, 93,750 Founder Shares were forfeited as the underwriters did not exercise the over-allotment option on the remaining 375,000 Public Units (see Note 6).\nThe Founder Shares are identical to the Class A ordinary shares included in the units sold in the IPO, except that the Founder Shares will automatically convert into Class A ordinary shares at the time of the Company’s initial Business Combination. Also, the Sponsor and each member of the management team have entered into an agreement with the Company, pursuant to which they have agreed to waive their redemption rights with respect to any Founder Shares and Public Shares held by them.\nThe Sponsor and the Company’s directors and executive officers have agreed not to transfer, assign or sell any of their Founder Shares until the earlier of (A) one year after the completion of an initial Business Combination and (B) subsequent to the Company’s initial Business Combination, (x) if the closing price of Class A ordinary shares equals or exceeds $ 12.00 per share (as adjusted for share subdivisions, share capitalizations, reorganizations, recapitalizations and the like) for any 20 trading days within any 30 -trading day period commencing at least 150 days after an initial Business Combination, or (y) the date on which the Company completes a liquidation, merger, share exchange or other similar transaction that results in all Public Shareholders having the right to exchange their Public Shares for cash, securities or other property. Any permitted transferees would be subject to the same restrictions and other agreements of the Sponsor and the Company’s directors and executive officers with respect to any Founder Shares.\nPromissory Note - Related Party\nOn February 3, 2022, the Sponsor agreed to loan the Company up to $ 400,000 to be used for a portion of the expenses of the IPO. As of April 11, 2022, there was $ 80,000 outstanding under the Promissory Note. This loan was non-interest bearing, unsecured and due at the earlier of (i) September 30, 2022 or (ii) the closing of the IPO. On April 12, 2022, the loan was repaid upon the closing of the IPO out of the offering proceeds not held in the Trust Account.\nDue to Related Party\nThe Sponsor paid certain formation, operating or offering costs on behalf of the Company. These amounts are due on demand and are non-interest bearing. During the period from January 5, 2022 (inception) through March 31, 2022, the Sponsor paid $ 215,020 of formation, operating costs and offering costs on behalf of the Company. On April 12, 2022, the Company paid the Sponsor $ 160,020 and on April 14, 2022, the Company received $ 25,000 from the Sponsor. Subsequently on July 19, 2022, the Company fully paid $ 80,000 to the related party. As of September 30, 2022, there were no amounts outstanding due to related party.\n| 13 |\n\nWorking Capital Loan\nIn order to finance transaction costs in connection with a Business Combination, the Sponsor or an affiliate of the Sponsor, or certain of the Company’s officers and directors, may, but are not obligated to, loan the Company funds as may be required (the “Working Capital Loans”). If the Company completes a Business Combination, the Company would repay the Working Capital Loans out of the proceeds of the Trust Account released to the Company. Otherwise, the Working Capital Loans would be repaid only out of funds held outside of the Trust Account. In the event that a Business Combination does not complete, the Company may use a portion of proceeds held outside of the Trust Account to repay the Working Capital Loans, but no proceeds held in the Trust Account would be used to repay the Working Capital Loans.\nExcept for the foregoing, the terms of such Working Capital Loans, if any, have not been determined and no written agreements exist with respect to such loans. The Working Capital Loans would either be repaid upon consummation of a Business Combination, without interest, or, at the lender’s discretion, up to $ 1.5 million of such Working Capital Loans may be convertible into units of the post-business combination entity at a price of $ 10.00 per unit. The units would be identical to the Private Placement Units. As of September 30, 2022, no Working Capital Loans were outstanding.\nNOTE 6 - COMMITMENTS AND CONTINGENCIES\nRegistration Rights\nThe holders of the Founder Shares, Private Placement Shares and Private Warrants, including any of those issued upon conversion of Working Capital Loans (and any Private Placement Shares issuable upon the exercise of the Private Warrants that may be issued upon conversion of Working Capital Loans) will be entitled to registration rights pursuant to a registration and shareholder rights agreement signed on April 6, 2022. The holders of these securities are entitled to make up to three demands, excluding short-form demands, that the Company register such securities. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed after the completion of the initial Business Combination and rights to require the Company to register for resale such securities pursuant to Rule 415 under the Securities Act. The Company will bear the costs and expenses of filing any such registration statements.\nUnderwriting Agreement\nThe Company granted the underwriters a 45 -day option from the date of IPO to purchase up to 1,125,000 additional Public Units to cover over-allotments, if any, at the IPO price less the underwriting discounts and commissions. The underwriters exercised the over-allotment option in part for 750,000 Public Units on April 11, 2022. On May 23, 2022, the underwriters decided not to exercise the over-allotment option on the remaining 375,000 Public Units within the 45 -day period.\nThe underwriters received a cash underwriting discount of $ 0.20 per Public Unit, or $ 1,650,000 in the aggregate, paid upon the closing of the IPO. In addition, the underwriters will be entitled to a deferred fee of $ 0.35 per Public Unit, or $ 2,887,500 in the aggregate, which is included in the accompanying condensed balance sheet. The deferred fee will become payable to the underwriters from the amounts held in the Trust Account solely in the event that the Company completes a Business Combination, subject to the terms of the underwriting agreement.\nNOTE 7 - SHAREHOLDERS’ DEFICIT\nPreference shares - The Company is authorized to issue 1,000,000 preference shares with a par value of $ 0.0001 per share with such designations, voting and other rights and preferences as may be determined from time to time by the Company’s board of directors. As of September 30, 2022, there were no preference shares issued or outstanding.\n\n| 14 |\n\nClass A Ordinary Shares - The Company is authorized to issue 200,000,000 Class A ordinary shares with a par value of $ 0.0001 per share. As of September 30, 2022, there were 510,000 Class A ordinary shares issued and outstanding, excluding 8,250,000 Class A ordinary shares subject to possible redemption.\nClass B Ordinary Shares - The Company is authorized to issue 20,000,000 Class B ordinary shares with a par value of $ 0.0001 per share. As of September 30, 2022, there were 2,062,500 Class B ordinary shares issued and outstanding. On May 23, 2022, 93,750 Class B ordinary shares were forfeited as the underwriters did not exercise the over-allotment option on the remaining 375,000 Public Units.\nPrior to the Company’s initial Business Combination, only holders of Class B ordinary shares will have the right to vote on the appointment of directors and holders of a majority of the Company’s Class B ordinary shares may remove a member of the board of directors of the Company for any reason. In addition, in a vote to continue the Company in a jurisdiction outside the Cayman Islands (which requires the approval of at least two thirds of the votes of all ordinary shares voted at a general meeting), holders of Founder Shares will have ten votes for every Founder Share and holders of Class A ordinary shares will have one vote for every Class A ordinary share and, as a result, the Company’s initial shareholders will be able to approve any such proposal without the vote of any other shareholder.\nThe Class B ordinary shares will automatically convert into Class A ordinary shares on the consummation of the initial Business Combination at a ratio such that the number of Class A ordinary shares issuable upon conversion of all Founder Shares will equal, in the aggregate, on an as- converted basis, approximately 20 % of the sum of (i) the total number of ordinary shares issued and outstanding upon completion of the IPO, plus (ii) the total number of Class A ordinary shares issued or deemed issued or issuable upon conversion or exercise of any equity-linked securities or rights issued or deemed issued, by the Company in connection with or in relation to the consummation of the initial Business Combination (after giving effect to any redemptions of Class A ordinary shares by Public Shareholders), excluding any Class A ordinary shares or equity-linked securities exercisable for or convertible into Class A ordinary shares issued, deemed issued, or to be issued, to any seller in the initial Business Combination and any Private Placement Units issued to the Sponsor, its affiliates or any member of the Company’s management team upon conversion of Working Capital Loans. Any conversion of Class B ordinary shares described herein will take effect as a compulsory redemption of Class B ordinary shares and an issuance of Class A ordinary shares as a matter of Cayman Islands law. In no event will the Class B ordinary shares convert into Class A ordinary shares at a rate of less than one-to-one.\nWarrants\nAll warrants (Public Warrants and Private Warrants) will become exercisable at $ 11.50 per share, subject to adjustment, on the later of 30 days after the completion of the initial Business Combination or 12 months from the closing of the IPO; provided in each case that the Company has an effective registration statement under the Securities Act covering the issuance of the Class A ordinary shares issuable upon exercise of the warrants and a current prospectus relating to them is available (or the Company permits holders to exercise their warrants on a cashless basis under the circumstances specified in the warrant agreement). The warrants will expire at 5:00 p.m., New York City time, five years after the completion of the initial Business Combination or earlier upon redemption or liquidation. On the exercise of any warrant, the warrant exercise price will be paid directly to the Company and not placed in the Trust Account.\nIn addition, if (x) the Company issues additional Class A ordinary shares or equity-linked securities for capital raising purposes in connection with the closing of an initial Business Combination at an issue price or effective issue price of less than $ 9.20 per ordinary share (with such issue price or effective issue price to be determined in good faith by the board of directors of the Company and, in the case of any such issuance to the Sponsor or its affiliates, without taking into account any Founder Shares held by the Sponsor or such affiliates, as applicable, prior to such issuance) (the “Newly Issued Price”), (y) the aggregate gross proceeds from such issuances represent more than 60 % of the total equity proceeds, and interest thereon, available for the funding of an initial Business Combination on the date of the consummation of an initial Business Combination (net of redemptions), and (z) the volume weighted average trading price of Class A ordinary shares during the 20 -trading day period starting on the trading day prior to the day on which the Company consummates an initial Business Combination (such price, the “Market Value”) is below $9.20 per share, the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115 % of the higher of the Market Value or the Newly Issued Price and the $ 16.50 per share redemption trigger price will be adjusted (to the nearest cent) to be equal to 165 % of the higher of the Market Value or the Newly Issued Price.\n| 15 |\n\nThe Company is not registering the ordinary shares issuable upon exercise of the warrants at this time. However, the Company has agreed that as soon as practicable, but in no event later than 20 business days after the closing of the initial Business Combination, it will use commercially reasonable efforts to file with the SEC a registration statement covering the Class A ordinary shares issuable upon exercise of the warrants, and it will use commercially reasonable efforts to cause the same to become effective within 60 business days following the initial Business Combination and to maintain a current prospectus relating to those ordinary shares until the warrants expire or are redeemed; provided, that if the ordinary shares are at the time of any exercise of a warrant not listed on a national securities exchange such that they satisfy the definition of a “covered security” under Section 18(b)(1) of the Securities Act, the Company may, at its option, require holders of Public Warrants who exercise their warrants to do so on a “cashless basis” in accordance with Section 3(a)(9) of the Securities Act and, in the event the Company so elects, it will not be required to file or maintain in effect a registration statement, but the Company will be required to use commercially reasonable efforts to register or qualify the shares under applicable blue sky laws to the extent an exemption is not available.\nRedemption of Warrants\nOnce the warrants become exercisable, the Company may redeem the outstanding warrants:\n\n| | in whole and not in part; |\n\n| | at a price of $ 0.01 per warrant; |\n\n| | upon a minimum of 30 days’ prior written notice of redemption, which is referred to as the 30 -day redemption period; and |\n\n| | if, and only if, the last reported sale price of ordinary shares equals or exceeds $ 16.50 per share (as adjusted for share splits, share dividends, reorganizations, recapitalizations, and the like) for any 20 trading days within a 30 -trading day period ending on the third trading day prior to the date on which the Company sends the notice of redemption to the warrant holders. |\n\nThe Company will not redeem the warrants unless a registration statement under the Securities Act covering the ordinary shares issuable upon exercise of the warrants is effective and a current prospectus relating to those ordinary shares is available throughout the 30-day redemption period, except if the warrants may be exercised on a cashless basis and such cashless exercise is exempt from registration under the Securities Act. If and when the warrants become redeemable by the Company, the Company may exercise its redemption right even if it is unable to register or qualify the underlying securities for sale under all applicable state securities laws.\nIf the Company calls the warrants for redemption as described above, its management will have the option to require all holders that wish to exercise warrants to do so on a “cashless basis.” In determining whether to require all holders to exercise their warrants on a “cashless basis,” the Company’s management will consider, among other factors, the cash position, the number of warrants that are outstanding and the dilutive effect on the Company’s shareholders of issuing the maximum number of ordinary shares issuable upon the exercise of the Company’s warrants. In such event, each holder would pay the exercise price by surrendering the warrants for that number of ordinary shares equal to the quotient obtained by dividing (x) the product of the number of ordinary shares underlying the warrants, multiplied by the excess of the “fair market value” over the exercise price of the warrants by (y) the fair market value. The “fair market value” shall mean the average volume weighted average last reported sale price of the Class A ordinary shares for the 10 trading days ending on the third trading day prior to the date on which the notice of redemption is sent to the holders of warrants.\nNOTE 8 - FAIR VALUE MEASUREMENTS\nThe fair value of the Company’s financial assets and liabilities reflects management’s estimate of amounts that the Company would have received in connection with the sale of the assets or paid in connection with the transfer of the liabilities in an orderly transaction between market participants at the measurement date. In connection with measuring the fair value of its assets and liabilities, the Company seeks to maximize the use of observable inputs (market data obtained from independent sources) and to minimize the use of unobservable inputs (internal assumptions about how market participants would price assets and liabilities). The following fair value hierarchy is used to classify assets and liabilities based on the observable inputs and unobservable inputs used in order to value the assets and liabilities:\nLevel 1: Quoted prices in active markets for identical assets or liabilities. An active market for an asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis.\n| 16 |\n\nLevel 2: Observable inputs other than Level 1 inputs. Examples of Level 2 inputs include quoted prices in active markets for similar assets or liabilities and quoted prices for identical assets or liabilities in markets that are not active.\nLevel 3: Unobservable inputs based on our assessment of the assumptions that market participants would use in pricing the asset or liability.\nThe following table presents information about the Company’s assets that are measured at fair value on a recurring basis as of September 30, 2022 and indicates the fair value hierarchy of the valuation inputs the Company utilized to determine such fair value.\n\n| As of September 30, 2022 | QuotedPrices inActiveMarkets(Level 1) | SignificantOtherObservableInputs(Level 2) | SignificantOtherUnobservableInputs(Level 3) |\n| Assets: |\n| Investment held in Trust Account | $ | 84,645,261 | 84,645,261 | - | - |\n\nNOTE 9 - SUBSEQUENT EVENTS\nThe Company has evaluated subsequent events through November 15, 2022 , which was the date these unaudited condensed financial statements were available for issuance and determined that there were no significant unrecognized events through that date.\n| 17 |\n\nI\nMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nReferences in this Quarterly Report to “we,” “us” or the “Company” refer to Denali Capital Acquisition Corp. References to our “management” or our “management team” refer to our officers and directors, and references to the “Sponsor” refer to Denali Capital Global Investment LLC. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Quarterly Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\nSpecial Note Regarding Forward-Looking Statements\nThis Quarterly Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, that are not historical facts, and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. All statements, other than statements of historical fact included in this Form 10‑Q including, without limitation, statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward- looking statements. Words such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intends,” “may,” “might,” “plan,” “possible,” “potential,” “predict,” “project,” “should,” “would” and variations thereof and similar words and expressions are intended to identify such forward-looking statements. Such forward-looking statements relate to future events or future performance, but reflect management’s current beliefs, based on information currently available. A number of factors could cause actual events, performance or results to differ materially from the events, performance and results discussed in the forward-looking statements. For information identifying important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements, please refer to the Risk Factors section of the Company’s final prospectus for its initial public offering (“IPO”) filed with the SEC on April 7, 2022, and in its Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2022, filed with the SEC on August 12, 2022. The Company’s securities filings can be accessed on the EDGAR section of the SEC’s website at www.sec.gov. Except as expressly required by applicable securities law, the Company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.\nOverview\nWe are a blank check company incorporated in the Cayman Islands on January 5, 2022 (inception) formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses (a “Business Combination”). We intend to effectuate our Business Combination using cash derived from the proceeds of our initial public offering (“IPO”) and the sale of units (the “Private Placement Units”) in a private placement (the “Private Placement”) to the Company’s founder and sponsor, Denali Capital Global Investments LLC (the “Sponsor”), additional shares, debt or a combination of cash, shares and debt.\nWe expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete a Business Combination will be successful.\nResults of Operations\nWe have neither engaged in any operations nor generated any operating revenues to date. Our only activities from January 5, 2022 (inception) through September 30, 2022 were organizational activities and those necessary to prepare for and complete the IPO, described below. We do not expect to generate any operating revenues until after the completion of our initial Business Combination. We expect to generate non-operating income in the form of interest income on marketable securities held after the IPO. We expect that we will incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses in connection with searching for, and completing, a Business Combination.\n| 18 |\n\nFor the three months ended September 30, 2022, we had net income of $307,468, which consists of interest earned on investment held in the Trust Account, as defined below, of $380,429 partially offset by $72,961 of formation and operating costs.\nFor the period from January 5, 2022 (inception) through September 30, 2022, we had net income of $265,278, which consists of interest earned on investment held in the Trust Account of $495,261 partially offset by $229,983 of formation and operating costs.\nFor the period from January 5, 2022 (inception) through September 30, 2022, we had an increase in cash flows of $985,578 resulting from net cash used in operating activities of $260,264, net cash used in investing activities of $84,150,000 and net cash provided by financing activities of $85,395,842.\nCash Flows from Operating Activities- For the period from January 5, 2022 (inception) through September 30, 2022, net cash used in operations was $260,264 primarily due to net income of $265,278 for the period and the changes in current assets and liabilities of $(41,624), prepaid expenses of $(132,427) and accounts payable and accrued expenses of $90,803. In addition, net cash used in operating activities includes adjustments to reconcile net income from formation costs paid by related party of $11,343 and income on Trust Account of $495,261.\nCash Flows from Investing Activities- For the period from January 5, 2022 (inception) through September 30, 2022, net cash used in investing activities was $84,150,000 due to investment held in Trust Account.\nCash Flows from Financing Activities- For the period from January 5, 2022 (inception) through September 30, 2022, net cash provided by financing activities was $85,395,842 primarily due to proceeds from issuance of promissory note to related party of $80,000, proceeds from related party of $25,000, proceeds from issuance of private placement units of $5,100,000, proceeds from issuance of public units through public offering of $82,500,000, payment of promissory note to related party of $80,000, payment to related party of $240,020, payment of offering costs of $339,138 and payment of underwriter’s discount of $1,650,000.\nLiquidity and Capital Resources\nOur liquidity needs prior to the consummation of the IPO were satisfied through a payment from the Sponsor and the loan under an unsecured promissory note from the Sponsor of up to $400,000.\nOn April 11, 2022, we consummated the IPO of 8,250,000 units (“Public Units”), inclusive of 750,000 Public Units sold to the underwriters upon the underwriters’ election to partially exercise their over-allotment option. Each Public Unit consists of one Class A ordinary share, $0.0001 par value per share (such shares included in the Public Units, the “Public Shares”), and one redeemable warrant (the “Public Warrants”), each whole Public Warrant entitling the holder thereof to purchase one Public Share at an exercise price of $11.50 per share. The Public Units were sold at a price of $10.00 per Public Unit, generating gross proceeds of $82,500,000. Simultaneously with the closing of the IPO, we consummated the sale of 510,000 Private Placement Units, inclusive of 30,000 Private Placement Units sold to the Sponsor pursuant to the underwriters’ election to partially exercise their over-allotment option. Each whole Private Placement Unit consists of one Class A ordinary share (“Private Placement Shares”) and one warrant (“Private Warrants”), each whole Private Warrant entitling the holder thereof to purchase one Class A ordinary share at an exercise price of $11.50 per share. The Private Placement Units were sold at a price of $10.00 per Private Placement Unit, generating gross proceeds of $5,100,000.\nFollowing the closing of the IPO and sale of the Private Placement Units on April 11, 2022, a total of $84,150,000 was placed in a U.S.-based trust account maintained by Wilmington Trust, National Association, acting as trustee (the “Trust Account”), and we had $1,515,795 of cash held outside of the Trust Account, after payment of costs related to the IPO, and available for working capital purposes. In connection with the IPO, we incurred $5,105,315 in transaction costs, consisting of $1,650,000 of underwriting fees, $2,887,500 of deferred underwriting fees and $567,815 of other offering costs. Deferred offering costs consist of legal, accounting, and underwriting fees and other costs incurred through the balance sheet date that are directly related to the IPO.\nAs of September 30, 2022, we had marketable securities held in the Trust Account of $84,645,261. We intend to use substantially all of the funds held in the Trust Account, including any amounts representing interest earned on the Trust Account, excluding deferred underwriting commissions, to complete our Business Combination. We may withdraw interest from the Trust Account to pay taxes, if any. To the extent that our share capital or debt is used, in whole or in part, as consideration to complete a Business Combination, the remaining proceeds held in the Trust Account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies. We intend to use the funds held outside of the Trust Account to primarily identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, structure, negotiate and complete a Business Combination.\n| 19 |\n\nIn order to fund working capital deficiencies or finance transaction costs in connection with a Business Combination, our Sponsor or an affiliate of our Sponsor or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If the Company completes the initial Business Combination, it would repay such loaned amounts. In the event that the initial Business Combination does not close, the Company may use a portion of the working capital held outside of the Trust Account to repay such loaned amounts, but no proceeds from the Trust Account would be used for such repayment. Up to $1,500,000 of such loans may be convertible into units of the post-business combination entity, at a price of $10.00 per unit at the option of the lender. The units would be identical to the Private Placement Units. In the event that the initial Business Combination does not close, the Company may use a portion of the working capital held outside of the Trust Account to repay such loaned amounts, but no proceeds from the Trust Account would be used for such repayment.\nAs of September 30, 2022, we had cash of $985,578 and working capital of $1,027,202. In addition, in order to finance transaction costs in connection with a Business Combination, our Sponsor or an affiliate of our Sponsor or certain of our officers and directors may, but are not obligated to, provide us funds as may be required (the “Working Capital Loans”). As of September 30, 2022, there were no amounts outstanding under any Working Capital Loans.\nAccordingly, the accompanying unaudited condensed financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) which contemplates continuation of the Company as a going concern and the realization of assets and the satisfaction of liabilities in the normal course of business. The unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty. Further, we have incurred and expect to continue to incur significant costs in pursuit of our financing and acquisition plans. Management plans to address this uncertainty during the period leading up to the initial Business Combination. Based on the foregoing, management believes that the Company will not have sufficient working capital and borrowing capacity to meet its needs through the earlier of the consummation of a Business Combination or one year from the date of this filing. These factors, among others, raise substantial doubt about our ability to continue as a going concern. Over this time period, the Company will use these funds to pay existing accounts payable, identify and evaluate prospective initial Business Combination candidates, perform due diligence on prospective target businesses, pay for travel expenditures in connection with the identification and evaluation of prospective target businesses, select the target business with which to effectuate an initial Business Combination, and structure, negotiate and consummate the Business Combination. In case the Company is unable to consummate the initial Business Combination by April 6, 2023, it will seek to extend the combination period up to 18 months from the date of the IPO by resolution of the board of directors of the Company. In order to extend the time available for the Company to consummate an initial Business Combination for an additional three months, the Sponsor or its affiliates or designees must deposit into the Trust Account $825,000, (or $0.1 per share) or up to an aggregate of $1,500,000, or ($0.20) per share, on or prior to the date of the deadline. The Company will issue a press release announcing each extension at least three days prior to the deadline. In addition, it will issue a press release the day after the deadline, announcing whether the funds have been timely deposited. The Sponsor and its affiliates or designees are obligated to fund the Trust Account in order to extend the time for us to complete our initial Business Combination, but the Sponsor will not be obligated to extend such time. In addition to the foregoing arrangements, the Company may extend the period of time to consummate an initial Business Combination by a shareholder vote to amend our amended and restated memorandum and articles of association (“Shareholder Extension Period”).\nIf our estimate of the costs of identifying a target business, undertaking in-depth due diligence and negotiating a Business Combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our initial Business Combination. Moreover, we may need to obtain additional financing either to complete our Business Combination or because we become obligated to redeem a significant number of our Public Shares upon completion of our Business Combination, in which case we may issue additional securities or incur debt in connection with such Business Combination.\nOff-Balance Sheet Financing Arrangements\nWe have no obligations, assets or liabilities that would be considered off-balance sheet arrangements as of September 30, 2022. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets.\n| 20 |\n\nOther Contractual Obligations\nRegistration Rights\nThe holders of our Class B ordinary shares initially issued to our Sponsor in a private placement prior to the IPO (the “Founder Shares”), Private Placement Shares and Private Warrants, including any of those issued upon conversion of Working Capital Loans (and any Private Placement Shares issuable upon the exercise of the Private Warrants that may be issued upon conversion of Working Capital Loans) will be entitled to registration rights pursuant to a registration and shareholder rights agreement signed on April 6, 2022. The holders of these securities are entitled to make up to three demands, excluding short form demands, that the Company register such securities. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed after the completion of our initial Business Combination and rights to require us to register for resale such securities pursuant to Rule 415 under the Securities Act. The Company will bear the costs and expenses of filing any such registration statements.\nUnderwriting Agreement\nWe granted the underwriters a 45-day option from the date of IPO to purchase up to 1,125,000 additional Public Units to cover over-allotments, if any, at the IPO price less the underwriting discounts and commissions. The underwriters exercised the over-allotment option in part for 750,000 Public Units on April 11, 2022. On May 23, 2022, the underwriters decided not to exercise the over-allotment option on the remaining 375,000 Public Units.\nThe underwriters received a cash underwriting discount of $0.20 per Public Unit, or $1,650,000 in the aggregate, paid upon the closing of the IPO. In addition, the underwriters will be entitled to a deferred fee of $0.35 per Public Unit, or $2,887,500 in the aggregate. The deferred fee will become payable to the underwriters from the amounts held in the Trust Account solely in the event that the Company completes a Business Combination, subject to the terms of the underwriting agreement.\nCritical Accounting Policies\nBasis of Presentation\nThe accompanying unaudited condensed financial statements are presented in conformity with GAAP and pursuant to the rules and regulations of the SEC.\nEmerging Growth Company Status\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012, (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies, including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies, but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\n| 21 |\n\nClass A Ordinary Shares Subject to Possible Redemption\nThe Company will account for its Class A ordinary shares subject to possible redemption in accordance with the guidance in the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 480 “Distinguishing Liabilities from Equity.” Class A ordinary shares subject to mandatory redemption (if any) is classified as a liability instrument and measured at fair value. Conditionally redeemable ordinary shares (including shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, ordinary shares are classified as shareholders’ equity. The Company’s ordinary shares will feature certain redemption rights that are considered to be outside of the Company’s control and will be subject to the occurrence of uncertain future events. Accordingly, as of September 30, 2022, 8,250,000 Class A ordinary shares subject to possible redemption are presented at redemption value as temporary equity, outside of the shareholders’ equity section of the Company’s unaudited condensed balance sheet.\nThe Company recognizes changes in redemption value immediately as they occur and adjusts the carrying value of redeemable ordinary shares to equal the redemption value at the end of each reporting period. Increases or decreases in the carrying amount of redeemable ordinary shares are affected by charges against additional paid in capital or accumulated deficit if additional paid in capital equals to zero.\nWarrants\nThe Company accounts for warrants as either equity-classified or liability-classified instruments based on an assessment of the warrant’s specific terms and applicable authoritative guidance in FASB ASC 480, “Distinguishing Liabilities from Equity” (“ASC 480”) and FASB ASC 815. The assessment considers whether the warrants are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and meet all of the requirements for equity classification under FASB ASC 815, including whether the warrants are indexed to the Company’s own ordinary shares and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of the Company’s control, among other conditions for equity classification. This assessment is conducted at the time of warrant issuance and as of each subsequent quarterly period end date while the warrants are outstanding.\nFor issued or modified warrants that meet all of the criteria for equity classification, the warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all of the criteria for equity classification, the warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. The Company accounts for the 8,250,000 Public Warrants (as defined in Note 3) and 510,000 Private Warrants (as defined in Note 4) as equity-classified instruments.\nNet Income/(Loss) Per Ordinary Share\nThe Company complies with the accounting and disclosure requirements of FASB ASC 260, “Earnings Per Share.” Net loss per ordinary share is computed by dividing net loss by the weighted average number of ordinary shares outstanding during the period, excluding ordinary shares subject to forfeiture. Weighted average shares were reduced for the effect of an aggregate of 93,750 Founder Shares that were forfeited due to the underwriters’ partial exercise of the over-allotment option. Any remeasurement of the accretion to redemption value of the Class A ordinary shares subject to possible redemption was considered to be dividends paid to the Public Shareholders. Warrants issued are contingently exercisable (i.e., on the later of 30 days after the completion of the initial Business Combination or 12 months from the closing of the IPO). For Earnings Per Share (“EPS”) purposes, the warrants are anti-dilutive since they would generally not be reflected in basic or diluted EPS until the contingency is resolved. As of September 30, 2022, the Company did not have any dilutive securities and other contracts that could, potentially, be exercised or converted into ordinary shares and then share in the earnings of the Company. As a result, diluted profit (loss) per ordinary share is the same as basic earnings per ordinary share for the periods presented.\n| 22 |\n\nRecent Accounting Pronouncements\nManagement does not believe that any recently issued, but not effective, accounting standards, if currently adopted, would have a material effect on the Company’s financial statements.\nI\nQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nAs of September 30, 2022, we were not subject to any market or interest rate risk. Following the consummation of our IPO, the net proceeds of our IPO, including amounts in the Trust Account, have been invested in certain U.S. government securities with a maturity of 185 days or less or in certain money market funds that invest solely in U.S. treasuries. Due to the short-term nature of these investments, we believe there will be no associated material exposure to interest rate risk.\nI\nCONTROLS AND PROCEDURES\nDisclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.\n| 23 |\n\nEvaluation of Disclosure Controls and Procedures\nAs required by Rules 13a‑15 and 15d‑15 under the Exchange Act, our Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2022. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rules 13a‑15(e) and 15d‑15(e) under the Exchange Act) were effective.\nChanges in Internal Control Over Financial Reporting\nDuring the most recently completed fiscal quarter, there has been no change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\nPart II. OTHER INFORMATION\nI\nLEGAL PROCEEDINGS.\nNone.\nI\nRISK FACTORS.\nFactors that could cause our actual results to differ materially from those in this Quarterly Report are any of the risks described in our final prospectus for our IPO filed with the SEC on April 7, 2022, and in other filings with the SEC as described below. Any of these factors could result in a significant or material adverse effect on our results of operations or financial condition. We may disclose changes to such factors or disclose additional factors from time to time in our future filings with the SEC. Additional risk factors not currently known to us or that we currently deem immaterial may also impair our business or results of operations. As of the date of this Quarterly Report, there have been no material changes to the risk factors disclosed in (i) our final prospectus for our IPO filed with the SEC on April 7, 2022, and (ii) our Quarterly Report on Form 10-Q for the quarter ended June 30, 2022, as filed with the SEC on August 12, 2022. except for the following:\nChanges in laws or regulations or in how such laws or regulations are interpreted or applied, or a failure to comply with any laws, regulations, interpretations or applications, may adversely affect our business, investments and results of operations, and our ability to negotiate and complete our initial Business Combination.\nWe are subject to laws and regulations, and interpretations and applications of such laws and regulations enacted by national, regional, state and local governments and, potentially, non-U.S. jurisdictions. In particular, we will be required to comply with certain SEC and other legal and regulatory requirements, and our consummation of an initial Business Combination may be contingent upon our ability to comply with certain laws, regulations, interpretations and applications and any post-business combination company may be subject to additional laws, regulations, interpretations and applications. Compliance with, and monitoring of, the foregoing may be difficult, time consuming and costly. Those laws and regulations and their interpretation and application may also change from time to time, and those changes could have a material adverse effect on our business, investments and results of operations, and our ability to negotiate and complete an initial business combination. In addition, a failure to comply with applicable laws or regulations, as interpreted and applied, could have a material adverse effect on our business and results of operations, and our ability to negotiate and complete an initial business combination.\nOn March 30, 2022, the SEC issued proposed rules (the “SPAC Rule Proposals”) relating to, among other items, enhancing disclosures in business combination transactions involving special purpose acquisition companies (“SPACs”) and private operating companies; amending the financial statement requirements applicable to transactions involving shell companies; changing the treatment of financial projections in SEC filings in connection with proposed business combination transactions; increasing the potential liability of certain participants in proposed business combination transactions; and a proposed safe harbor for SPACs under the Investment Company Act of 1940, as amended (including certain time limits to announce and consummate a business combination) (the “Investment Company Act”). These proposed rules, if adopted, whether in the form proposed or in revised form, or pursuant to the SEC’s views expressed in the SPAC Rule Proposals, may materially adversely affect our ability to negotiate and complete our initial business combination and may increase the costs and time related thereto.\n| 24 |\n\nThe current economic downturn may lead to increased difficulty in completing our initial business combination.\nOur ability to consummate our initial Business Combination may depend, in part, on worldwide economic conditions. In recent months, we have observed increased economic uncertainty in the United States and abroad. Impacts of such economic weakness include:\n\n| ● | falling overall demand for goods and services, leading to reduced profitability; |\n\n\n| ● | reduced credit availability; |\n\n\n| ● | higher borrowing costs; |\n\n\n| ● | reduced liquidity; |\n\n\n| ● | volatility in credit, equity and foreign exchange markets; and |\n\n\n| ● | bankruptcies. |\n\nThese developments could lead to inflation, higher interest rates, and uncertainty about business continuity, which may adversely affect the business of our potential target businesses and create difficulties in obtaining debt or equity financing for our initial Business Combination, as well as leading to an increase in the number of Public Shareholders exercising redemption rights in connection therewith.\nRecent volatility in capital markets may affect our ability to obtain financing for our initial Business Combination through sales of ordinary shares or issuance of indebtedness.\nWith uncertainty in the capital markets and other factors, financing for our initial Business Combination may not be available on terms favorable to us or at all. If we raise additional funds through further issuances of equity or convertible debt securities, our existing shareholders could suffer significant dilution, and any new equity securities we issue could have rights, preferences, and privileges superior to those of holders of our ordinary shares. Any debt financing secured by us could involve additional restrictive covenants relating to our capital-raising activities and other financial and operational matters, which may limit the operations and growth of the surviving company of our initial Business Combination. If we are unable to obtain adequate financing or financing on terms satisfactory to us, we could face significant limitations on our ability to complete our initial Business Combination.\nMilitary conflict in Ukraine or elsewhere may lead to increased and price volatility for publicly traded securities, which could make it more difficult for us to consummate an initial Business Combination.\nMilitary conflict in Ukraine or elsewhere may lead to increased and price volatility for publicly traded securities, including ours, and to other national, regional and international economic disruptions and economic uncertainty, any of which could make it more difficult for us to identify a business combination target and consummate an initial Business Combination on acceptable commercial terms or at all.\nThere may be significant competition for us to find an attractive target for an initial Business Combination. This could increase the costs associated with completing our initial Business Combination and may result in our inability to find a suitable target for our initial Business Combination.\nIn recent years, the number of SPACs that have been formed has increased substantially. Many companies have entered into business combinations with SPACs, and there are still many SPACs seeking targets for their initial business combination, as well as additional SPACs currently in registration. As a result, at times, fewer attractive targets may be available, and it may require more time, effort and resources to identify a suitable target for an initial Business Combination.\n| 25 |\n\nIn addition, because there are a large number of SPACs seeking to enter into an initial Business Combination with available targets, the competition for available targets with attractive fundamentals or business models may increase, which could cause target companies to demand improved financial terms. Attractive deals could also become scarcer for other reasons, such as economic or industry sector downturns, geopolitical tensions or increases in the cost of additional capital needed to close business combinations or operate targets post-business combination. This could increase the cost of, delay or otherwise complicate or frustrate our ability to find a suitable target for and/or complete our initial Business Combination and may result in our inability to consummate an initial Business Combination on terms favorable to our investors altogether.\nIf we are deemed to be an investment company for purposes of the Investment Company Act, we would be required to institute burdensome compliance requirements and our activities would be severely restricted. As a result, in such circumstances, unless we are able to modify our activities so that we would not be deemed an investment company, we would expect to abandon our efforts to complete an initial Business Combination and instead to liquidate the Company.\nAs described further above, the SPAC Rule Proposals relate, among other matters, to the circumstances in which SPACs such as the Company could potentially be subject to the Investment Company Act and the regulations thereunder. The SPAC Rule Proposals would provide a safe harbor for such companies from the definition of “investment company” under Section 3(a)(1)(A) of the Investment Company Act, provided that a SPAC satisfies certain criteria, including a limited time period to announce and complete a de-SPAC transaction. Specifically, to comply with the safe harbor, the SPAC Rule Proposals would require a company to file a report on Form 8-K announcing that it has entered into an agreement with a target company for a business combination no later than 18 months after the effective date of its IPO registration statement. A company would then be required to complete its initial business combination no later than 24 months after the effective date of the IPO registration statement.\nBecause the SPAC Rule Proposals have not yet been adopted, there is currently uncertainty concerning the applicability of the Investment Company Act to a SPAC, including a company like ours that does not complete its business combination within 24 months after the effective date of the IPO registration statement.\nIf we are deemed to be an investment company under the Investment Company Act, our activities would be severely restricted. In addition, we would be subject to burdensome compliance requirements. We do not believe that our principal activities will subject us to regulation as an investment company under the Investment Company Act. However, if we are deemed to be an investment company and subject to compliance with and regulation under the Investment Company Act, we would be subject to additional regulatory burdens and expenses for which we have not allotted funds. As a result, unless we are able to modify our activities so that we would not be deemed an investment company, we would expect to abandon our efforts to complete an initial business combination and instead to liquidate the Company.\nTo mitigate the risk that we might be deemed to be an investment company for purposes of the Investment Company Act, we may, at any time, instruct the trustee to liquidate the securities held in the Trust Account and instead to hold the funds in the Trust Account in cash until the earlier of the consummation of our initial Business Combination or our liquidation. As a result, following the liquidation of securities in the Trust Account, we would likely receive minimal interest, if any, on the funds held in the Trust Account, which would reduce the dollar amount our Public Shareholders would receive upon any redemption or liquidation of the Company.\nThe funds in the Trust Account have, since our IPO, been held only in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds investing solely in U.S. government treasury obligations and meeting certain conditions under Rule 2a-7 under the Investment Company Act. However, to mitigate the risk of us being deemed to be an unregistered investment company (including under the subjective test of Section 3(a)(1)(A) of the Investment Company Act) and thus subject to regulation under the Investment Company Act, we may, at any time, and we expect that we will, on or prior to the 12-month anniversary of the effective date of the Registration Statement, instruct Wilmington Trust, National Association, the trustee with respect to the Trust Account, to liquidate the U.S. government treasury obligations or money market funds held in the Trust Account and thereafter to hold all funds in the Trust Account in cash until the earlier of consummation of our initial Business Combination or liquidation of the Company. Following such movement of funds, we would likely receive minimal interest, if any, on the funds held in the Trust Account. However, interest previously earned on the funds held in the Trust Account still may be released to us to pay our taxes, if any. As a result, any decision to liquidate the securities held in the Trust Account and thereafter to hold all funds in the Trust Account in cash would reduce the dollar amount our Public Shareholders would receive upon any redemption or liquidation of the Company.\n| 26 |\n\nIn addition, even prior to the 12-month anniversary of the effective date of the IPO Registration Statement, we may be deemed to be an investment company. The longer that the funds in the Trust Account are held in short-term U.S. government treasury obligations or in money market funds invested exclusively in such securities, the greater the risk that we may be considered an unregistered investment company, in which case we may be required to liquidate the Company. Accordingly, we may determine, in our discretion, to liquidate the securities held in the Trust Account at any time, even prior to the 12-month anniversary, and instead hold all funds in the Trust Account in cash, which would further reduce the dollar amount our Public Shareholders would receive upon any redemption or liquidation of the Company.\nThere is substantial doubt about our ability to continue as a “going concern.”\nIn connection with the Company’s assessment of going concern considerations under applicable accounting standards, management has determined that our possible need for additional financing to enable us to negotiate and complete our initial Business Combination, as well as the deadline by which we may be required to liquidate our Trust Account, raise substantial doubt about the Company’s ability to continue as a going concern through one year from the date the financial statements included elsewhere in this Quarterly Report were issued. In case the Company is unable to consummate the initial Business Combination by April 6, 2023, it will seek to extend the combination period up to 18 months from the date of the IPO.\nI\nUNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.\nOn February 3, 2022, the Sponsor acquired 2,156,250 Founder Shares for an aggregate purchase price of $25,000. The issuance of such Founder Shares to the Sponsor was made pursuant to the exemption from registration contained in Section 4(a)(2) of the Securities Act.\nSubstantially concurrently with the closing of the IPO, the Company completed the private sale of 510,000 Private Placement Units to the Sponsor at a purchase price of $10.00 per Private Placement Unit, generating gross proceeds to the Company of $5,100,000.\nThe Private Placement Shares sold as part of the Private Placement Units are identical to the Public Shares sold as part of the Public Units in the IPO, except that the Sponsor has agreed not to transfer, assign or sell any of the Private Placement Shares (except to certain permitted transferees) until 30 days after the completion of the Company’s initial business combination. The issuance of the Private Placement Shares was made pursuant to the exemption from registration contained in Section 4(a)(2) of the Securities Act.\nA total of $84,150,000, comprised of $80,850,000 of the proceeds from the IPO, and $3,300,000 of the proceeds from the Private Placement, were placed in a U.S.-based trust account maintained by Wilmington Trust, acting as trustee.\nFor a description of the use of the proceeds generated in the Private Placement, see Part I, Item 2 of this Form 10‑Q.\nI\nDEFAULTS UPON SENIOR SECURITIES.\nNone.\nI\nMINE SAFETY DISCLOSURES.\nNot applicable.\nI\nOTHER INFORMATION.\nNone.\n| 27 |\n\nI\nEXHIBITS.\nThe following exhibits are filed as part of, or incorporated by reference into, this Quarterly Report on Form 10‑Q.\n\n| No. | Description of Exhibit |\n| 31.1** | Certification of Chief Executive Officer (Principal Executive Officer) Pursuant to Rules 13a‑14(a) and 15d‑14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2** | Certification of Chief Financial Officer (Principal Financial and Accounting Officer) Pursuant to Rules 13a‑14(a) and 15d‑14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32.1*** | Certification of Chief Executive Officer (Principal Executive Officer) Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 32.2*** | Certification of Chief Financial Officer (Principal Financial and Accounting Officer) Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 101.INS** | XBRL Instance Document. |\n| 101.CAL** | XBRL Taxonomy Extension Calculation Linkbase Document. |\n| 101.SCH** | XBRL Taxonomy Extension Schema Document. |\n| 101.DEF** | XBRL Taxonomy Extension Definition Linkbase Document. |\n| 101.LAB** | XBRL Taxonomy Extension Labels Linkbase Document. |\n| 101.PRE** | XBRL Taxonomy Extension Presentation Linkbase Document. |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101). |\n\n\n| * | Incorporated herein by reference as indicated. |\n\n| ** | Filed herein. |\n\n| *** | Furnished herein. |\n\nPart III. SIGNATURES\nPursuant to the requirements of Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| Date: November 15, 2022 | DENALI CAPITAL ACQUISITION CORP. |\n| By: | /s/ Lei Huang |\n| Chief Executive Officer |\n| (Principal Executive Officer) |\n| By: | /s/ You “Patrick” Sun |\n| Chief Financial Officer |\n| (Principal Financial and Accounting Officer) |\n\n\n| 28 |\n\n\n</text>\n\nIf the company completes a business combination and all of the public warrants and private warrants are exercised at the price of $11.50 per share, what will be the total inflow of cash into the company from the exercise of these warrants in million dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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doc-math
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"ground_truth": "Therefore, the answer is 100.74."
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docmath_40000_plus
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial Statements.\nAKEBIA THERAPEUTICS, INC.\nCondensed Consolidated Balance Sheets\n(Unaudited)\n(in thousands, except share and per share data)\n| September 30,2022 | December 31,2021 |\n| Assets |\n| Current assets: |\n| Cash and cash equivalents | $ | 144,761 | $ | 149,800 |\n| Inventory | 40,039 | 38,195 |\n| Accounts receivable, net | 23,094 | 50,875 |\n| Prepaid expenses and other current assets | 29,618 | 33,140 |\n| Total current assets | 237,512 | 272,010 |\n| Property and equipment, net | 5,622 | 6,754 |\n| Operating lease assets | 30,337 | 33,852 |\n| Goodwill | 55,053 | 55,053 |\n| Other intangible assets, net | 81,095 | 108,127 |\n| Other assets | 26,275 | 49,754 |\n| Total assets | $ | 435,894 | $ | 525,550 |\n| Liabilities and stockholders' equity |\n| Current liabilities: |\n| Accounts payable | $ | 19,708 | $ | 33,588 |\n| Accrued expenses and other current liabilities | 87,364 | 104,456 |\n| Short-term deferred revenue | 1,265 | 20,906 |\n| Current portion of refund liability to customer | 13,681 | — |\n| Current portion of long-term debt | 65,947 | 97,543 |\n| Total current liabilities | 187,965 | 256,493 |\n| Deferred revenue, net of current portion | 43,296 | 21,474 |\n| Operating lease liabilities, net of current portion | 30,683 | 33,703 |\n| Derivative liability | 760 | 1,820 |\n| Liability related to sale of future royalties, net | 58,236 | 53,079 |\n| Refund liability to customer, net of current portion | 26,788 | — |\n| Other non-current liabilities | 74,313 | 82,525 |\n| Total liabilities | 422,041 | 449,094 |\n| Commitments and contingencies (Note 13) |\n| Stockholders' equity: |\n| Preferred stock $ 0.00001 par value, 25,000,000 shares authorized; 0 shares issued and outstanding at September 30, 2022 and December 31, 2021 | — | — |\n| Common stock $ 0.00001 par value; 350,000,000 shares authorized at September 30, 2022 and December 31, 2021; 183,951,583 and 177,000,963 shares issued and outstanding at September 30, 2022 and December 31, 2021, respectively | 2 | 1 |\n| Additional paid-in capital | 1,559,206 | 1,536,800 |\n| Accumulated other comprehensive loss | 6 | 6 |\n| Accumulated deficit | ( 1,545,361 ) | ( 1,460,351 ) |\n| Total stockholders' equity | 13,853 | 76,456 |\n| Total liabilities and stockholders' equity | $ | 435,894 | $ | 525,550 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n7\nAKEBIA THERAPEUTICS, INC.\nCondensed Consolidated Statements of Operations and Comprehensive Loss\n(Unaudited)\n(in thousands, except share and per share data)\n\n| Three Months EndedSeptember 30, | Nine Months EndedSeptember 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Revenues: |\n| Product revenue, net | $ | 42,239 | $ | 36,753 | $ | 127,390 | $ | 100,120 |\n| License, collaboration and other revenue | 6,725 | 12,003 | 110,032 | 53,853 |\n| Total revenues | 48,964 | 48,756 | 237,422 | 153,973 |\n| Cost of goods sold: |\n| Product | 28,936 | 6,933 | 60,859 | 76,012 |\n| Amortization of intangibles | 9,011 | 9,011 | 27,032 | 27,032 |\n| Total cost of goods sold | 37,947 | 15,944 | 87,891 | 103,044 |\n| Operating expenses: |\n| Research and development | 27,350 | 40,471 | 97,210 | 118,296 |\n| Selling, general and administrative | 30,918 | 46,357 | 108,052 | 129,336 |\n| License expense | 743 | 870 | 2,323 | 2,460 |\n| Restructuring | 180 | — | 14,711 | — |\n| Total operating expenses | 59,191 | 87,698 | 222,296 | 250,092 |\n| Operating loss | ( 48,174 ) | ( 54,886 ) | ( 72,765 ) | ( 199,163 ) |\n| Other income (expense): |\n| Interest expense | ( 3,952 ) | ( 5,085 ) | ( 14,051 ) | ( 14,853 ) |\n| Other income | 1,167 | 427 | 2,712 | 1,854 |\n| Loss on extinguishment of debt | ( 906 ) | — | ( 906 ) | — |\n| Net loss | $ | ( 51,865 ) | $ | ( 59,544 ) | $ | ( 85,010 ) | $ | ( 212,162 ) |\n| Net loss per share - basic and diluted | $ | ( 0.28 ) | $ | ( 0.34 ) | $ | ( 0.47 ) | $ | ( 1.30 ) |\n| Weighted-average number of common shares - basic and diluted | 183,882,446 | 173,782,151 | 182,375,443 | 163,050,769 |\n| Comprehensive loss: |\n| Net loss | $ | ( 51,865 ) | $ | ( 59,544 ) | $ | ( 85,010 ) | $ | ( 212,162 ) |\n| Other comprehensive loss - unrealized loss on debt securities | — | — | — | ( 7 ) |\n| Total comprehensive loss | $ | ( 51,865 ) | $ | ( 59,544 ) | $ | ( 85,010 ) | $ | ( 212,169 ) |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n8\nAKEBIA THERAPEUTICS, INC.\nCondensed Consolidated Statements of Stockholders’ Equity\n(Unaudited)\n(in thousands, except share data)\n| Common Stock |\n| Number ofShares | $ 0.00001 Par Value | Additional Paid-InCapital | UnrealizedGain/(Loss) | AccumulatedDeficit | Total Stockholders'Equity |\n| Balance at December 31, 2020 | 148,074,085 | $ | 1 | $ | 1,425,115 | $ | 13 | $ | ( 1,177,511 ) | $ | 247,618 |\n| Issuance of common stock, net of issuance costs | 9,228,017 | 1 | 29,497 | — | — | 29,498 |\n| Proceeds from sale of stock under employee stock purchase plan | 154,276 | — | 367 | — | — | 367 |\n| Stock-based compensation expense | — | — | 5,992 | — | — | 5,992 |\n| Restricted stock unit vesting | 1,063,711 | — | — | — | — | — |\n| Unrealized loss | — | — | — | ( 4 ) | — | ( 4 ) |\n| Net loss | — | — | — | — | ( 69,580 ) | ( 69,580 ) |\n| Balance at March 31, 2021 | 158,520,089 | $ | 2 | $ | 1,460,971 | $ | 9 | $ | ( 1,247,091 ) | $ | 213,891 |\n| Issuance of common stock, net of issuance costs | 10,446,160 | — | 37,266 | — | — | 37,266 |\n| Stock-based compensation expense | — | — | 6,515 | — | — | 6,515 |\n| Restricted stock unit vesting | 685,174 | — | — | — | — | — |\n| Unrealized loss | — | — | — | ( 3 ) | — | ( 3 ) |\n| Net loss | — | — | — | — | ( 83,038 ) | ( 83,038 ) |\n| Balance at June 30, 2021 | 169,651,423 | $ | 2 | $ | 1,504,752 | $ | 6 | $ | ( 1,330,129 ) | $ | 174,631 |\n| Issuance of common stock, net of issuance costs | 4,730,466 | — | 16,092 | — | — | 16,092 |\n| Proceeds from sale of stock under employee stock purchase plan | 152,917 | — | 379 | — | — | 379 |\n| Share-based compensation expense | — | — | 5,592 | — | — | 5,592 |\n| Restricted stock unit vesting | 17,183 | — | — | — | — | — |\n| Net loss | — | — | — | — | ( 59,544 ) | ( 59,544 ) |\n| Balance at September 30, 2021 | 174,551,989 | $ | 2 | $ | 1,526,815 | $ | 6 | $ | ( 1,389,673 ) | $ | 137,150 |\n| Balance at December 31, 2021 | 177,000,963 | $ | 1 | $ | 1,536,800 | $ | 6 | $ | ( 1,460,351 ) | $ | 76,456 |\n| Issuance of common stock, net of issuance costs | 4,404,600 | 1 | 7,177 | — | — | 7,178 |\n| Proceeds from sale of stock under employee stock purchase plan | 191,146 | — | 367 | — | — | 367 |\n| Stock-based compensation expense | — | — | 4,536 | — | — | 4,536 |\n| Restricted stock unit vesting | 1,789,326 | — | — | — | — | — |\n| Net loss | — | — | — | — | ( 62,421 ) | ( 62,421 ) |\n| Balance at March 31, 2022 | 183,386,035 | $ | 2 | $ | 1,548,880 | $ | 6 | $ | ( 1,522,772 ) | $ | 26,116 |\n| Stock-based compensation expense | — | — | 6,841 | — | — | 6,841 |\n| Exercise of options | 142,440 | — | 67 | — | — | 67 |\n| Restricted stock unit vesting | 176,179 | — | — | — | — | — |\n| Net income | — | — | — | — | 29,276 | 29,276 |\n| Balance at June 30, 2022 | 183,704,654 | $ | 2 | $ | 1,555,788 | $ | 6 | $ | ( 1,493,496 ) | $ | 62,300 |\n| Share-based compensation expense | — | — | 3,375 | — | — | 3,375 |\n| Proceeds from sale of stock under employee stock purchase plan | 144,000 | — | 43 | — | — | 43 |\n| Restricted stock unit vesting | 102,929 | — | — | — | — | — |\n| Net loss | — | — | — | — | ( 51,865 ) | ( 51,865 ) |\n| Balance at September 30, 2022 | 183,951,583 | $ | 2 | $ | 1,559,206 | $ | 6 | $ | ( 1,545,361 ) | $ | 13,853 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements\n9\nAKEBIA THERAPEUTICS, INC.\nCondensed Consolidated Statements of Cash Flows\n(Unaudited)\n(in thousands)\n10\n| Nine Months Ended |\n| September 30, 2022 | September 30, 2021 |\n| Operating activities: |\n| Net loss | $ | ( 85,010 ) | $ | ( 212,162 ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: |\n| Depreciation and amortization | 1,246 | 1,485 |\n| Amortization of intangibles | 27,032 | 27,032 |\n| Amortization of premium/discount on investments | — | ( 15 ) |\n| Non-cash interest expense related to sale of future royalties | 6,352 | 6,779 |\n| Non-cash royalty revenue related to sale of future royalties | ( 1,195 ) | ( 425 ) |\n| Non-cash collaboration revenue | ( 9,550 ) | — |\n| Non-cash R&D expense | 3,941 | — |\n| Non-cash interest expense | 1,467 | 852 |\n| Non-cash operating lease expense | ( 1,818 ) | ( 1,415 ) |\n| Non-cash loss on extinguishment of debt | 406 | — |\n| Fair value step-up of inventory sold or written off | — | 21,575 |\n| Write-down of inventory | 10,002 | 7,126 |\n| Change in excess inventory purchase commitments | 12,422 | 15,376 |\n| Stock-based compensation | 14,808 | 18,099 |\n| Change in fair value of derivative liability | ( 1,060 ) | ( 490 ) |\n| Changes in operating assets and liabilities: |\n| Accounts receivable | 27,781 | ( 22,837 ) |\n| Inventory | 1,405 | ( 35,282 ) |\n| Prepaid expenses and other current assets | 9,131 | ( 25,020 ) |\n| Other long-term assets | 14,817 | 4,728 |\n| Accounts payable | ( 17,420 ) | ( 14,933 ) |\n| Accrued expense | ( 22,364 ) | 15,099 |\n| Operating lease liabilities | 1,771 | 1,173 |\n| Deferred revenue | 2,181 | 3,098 |\n| Other non-current liabilities | ( 14,820 ) | — |\n| Net cash used in operating activities | ( 18,475 ) | ( 190,157 ) |\n| Investing activities: |\n| Purchase of equipment | ( 114 ) | ( 59 ) |\n| Proceeds from the maturities of available for sale securities | — | 40,000 |\n| Net cash (used in) provided by investing activities | ( 114 ) | 39,941 |\n| Financing activities: |\n| Proceeds from sale of future royalties, net | — | 44,783 |\n| Proceeds from refund liabilities to customers | 40,000 | — |\n| Proceeds from the issuance of common stock, net of issuance costs | 7,122 | 82,799 |\n| Proceeds from the sale of stock under employee stock purchase plan | 410 | 746 |\n| Proceeds from the exercise of stock options | 67 | — |\n| Payments on debt | ( 33,000 ) | — |\n| Net cash provided by financing activities | 14,599 | 128,328 |\n| (Decrease) in cash, cash equivalents, and restricted cash | ( 3,990 ) | ( 21,888 ) |\n| Cash, cash equivalents, and restricted cash at beginning of the period | 151,839 | 231,132 |\n| Cash, cash equivalents, and restricted cash at end of the period | $ | 147,849 | $ | 209,244 |\n| Non-cash financing activities |\n| Unpaid offering costs | $ | — | $ | 57 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements\n11\nAkebia Therapeutics, Inc.\nNotes to Condensed Consolidated Financial Statements\n(Unaudited)\n1. Nature of Organization and Operations\nAkebia Therapeutics, Inc., referred to as Akebia or the Company, was incorporated in the State of Delaware in 2007. Akebia is a biopharmaceutical company with the purpose of bettering the lives of people impacted by kidney disease. The Company has one commercial product, Auryxia® (ferric citrate), which is approved by the U.S. Food and Drug Administration, or FDA, and marketed for two indications in the United States: the control of serum phosphorus levels in adult patients with chronic kidney disease, or CKD, on dialysis, or DD-CKD, and the treatment of iron deficiency anemia, or IDA, in adult patients with CKD not on dialysis, or NDD-CKD. Ferric citrate is also approved and marketed in Japan as an oral treatment for IDA in adult patients for the improvement of hyperphosphatemia in such patients with DD-CKD and NDD-CKD under the trade name Riona (ferric citrate hydrate).\nVadadustat, the Company’s lead investigational product candidate, is an investigational oral hypoxia-inducible factor prolyl hydroxylase, or HIF-PH, inhibitor designed to mimic the physiologic effect of altitude on oxygen availability. On March 29, 2022, the Company received a complete response letter, or CRL, from the FDA. The CRL provided that the FDA had completed its review of the Company's new drug application, or NDA, for vadadustat for the treatment of anemia due to CKD in adult patients and had determined that it could not approve the NDA in its present form. In July 2022, the Company held an end of review meeting with the FDA to inform the Company's next steps with respect to the potential U.S. approval of vadadustat, if any, and in October 2022, the Company submitted a Formal Dispute Resolution Request, or FDRR, with the FDA. The FDRR focuses on the favorable balance between the benefits and risks of vadadustat for the treatment of anemia due to CKD in adult patients on dialysis in light of safety concerns expressed by the FDA in the CRL related to the rate of adjudicated thromboembolic events driven by vascular access thrombosis for vadadustat compared to the active comparator and the risk of drug-induced liver injury. On May 12, 2022, the Company received notice from its former collaboration partner, Otsuka Pharmaceutical Co. Ltd., or Otsuka, that Otsuka had elected to terminate the Collaboration and License Agreement dated December 18, 2016, or the Otsuka U.S. Agreement, and the Collaboration and License Agreement dated April 25, 2017, or the Otsuka International Agreement. On June 30, 2022, the Company and Otsuka entered into a Termination and Settlement Agreement, or the Termination Agreement, pursuant to which, among other things, the Company and Otsuka agreed to terminate the Otsuka U.S. Agreement and the Otsuka International Agreement as of June 30, 2022 (see Note 4 for further details). In October 2021, Otsuka submitted a Marketing Authorization Application, or MAA, for vadadustat for the treatment of anemia due to CKD in adult patients with DD-CKD and NDD-CKD to the European Medicines Agency, or EMA. In connection with the Termination Agreement, Otsuka transferred the MAA for vadadustat with the EMA to the Company. Vadadustat is approved in Japan as a treatment for anemia due to CKD in both DD-CKD and NDD-CKD patients under the trade name VafseoTM, and marketed and sold in Japan by Mitsubishi Tanabe Pharma Corporation, or MTPC.\nIn addition, the Company continues to explore additional development opportunities to expand its pipeline and portfolio of novel therapeutics.\nSince inception, the Company has devoted most of its resources to research and development, including its preclinical and clinical development activities, commercializing Auryxia, and providing general and administrative support for these operations. The Company began recording revenue from the U.S. sales of Auryxia and revenue from sublicensing rights to Auryxia in Japan from the Company’s Japanese partners, Japan Tobacco, Inc. and its subsidiary Torii Pharmaceutical Co., Ltd., collectively JT and Torii, in December 2018. Additionally, following regulatory approval of vadadustat in Japan, the Company began recognizing royalty revenues from MTPC from the sale of Vafseo in August 2020. In February 2021, the Company entered into a royalty interest acquisition agreement with HealthCare Royalty Partners IV, L.P., or HCR, or the Royalty Agreement, whereby the Company sold its right to receive royalties and sales milestones under its Collaboration Agreement with MTPC, or the MTPC Agreement, subject to certain caps and other terms and conditions (see Note 6 for additional information). The Company has not generated a profit to date, and may never generate profits, from product sales. Vadadustat and the Company’s other potential product candidates are subject to long development cycles, and the Company may be unsuccessful in its efforts to develop, obtain marketing approval for or market vadadustat and its other potential product candidates. If the Company does not successfully commercialize Auryxia, vadadustat, if approved, or any other potential product candidate, it may be unable to achieve profitability.\nGoing Concern\nThe Company’s management completed its going concern assessment in accordance with Accounting Standards Codification, or ASC, 205-40, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern, or ASC 205-40. Pursuant to the requirements of ASC 205-40, the Company’s management must evaluate whether there are conditions or events,\n12\nconsidered in the aggregate, that raise substantial doubt about the Company’s ability to continue as a going concern within one year after the date the financial statements are issued. This evaluation initially does not take into consideration the potential mitigating effect of management’s plans that have not been fully implemented as of the date the financial statements are issued.\nWhen substantial doubt exists under this methodology, the Company’s management evaluates whether the mitigating effect of its plans sufficiently alleviates substantial doubt about the Company’s ability to continue as a going concern. The mitigating effect of the Company’s plans, however, is only considered if both (1) it is probable that the plans will be effectively implemented within one year after the date that the financial statements are issued and (2) it is probable that the plans, when implemented, will mitigate the relevant conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued.\nAs of September 30, 2022, the Company had cash and cash equivalents of approximately $ 144.8 million. The Company believes that its cash resources will be sufficient to allow the Company to fund its current operating plan through at least the next twelve months from the filing of this Quarterly Report on Form 10-Q. However, the Company's operating plan includes assumptions pertaining to cost avoidance measures and the reduction of overhead costs that would result from the planned amendment of contractual arrangements with certain supply and collaboration partners, and the reduction of operating expenses. Therefore, because these cost avoidance measures and certain other elements of the Company's operating plan are outside of its control, including the planned amendment of contractual arrangements with certain supply and collaboration partners, and the reduction of operating expenses, there is uncertainty as to whether the Company's cash resources will be adequate to support its operations for a period through at least the next twelve months from the date of issuance of these financial statements.\nIn addition, on July 15, 2022, or the Effective Date, the Company entered into the Second Amendment and Waiver with BioPharma Credit PLC, or the Collateral Agent, BPCR Limited Partnership, as a Lender, and BioPharma Credit Investments V (Master) LP, as a Lender, or the Second Amendment and Waiver, which amends and waives certain provisions of the loan agreement entered on November 11, 2019, between the Company, with Keryx Biopharmaceuticals, Inc., or Keryx, as guarantor, and the Collateral Agent, as collateral agent and a lender, and BioPharma Credit Investments V (Master) LP as a lender, or the Loan Agreement, as amended by the First Amendment and Waiver among the Collateral Agent, the Lenders and the Company, dated February 18, 2022, or the First Amendment and Waiver. The Collateral Agent and the Lenders are collectively referred to as Pharmakon (see Note 11). Pursuant to the Second Amendment and Waiver, on the Effective Date, the Company made prepayments totaling $ 25.0 million together with a prepayment premium of $ 0.5 million plus all accrued and unpaid interest on such prepayments of principal to the Effective Date, and Pharmakon agreed to waive or modify certain covenants in the Loan Agreement (see Note 11). If an event of default occurs and is continuing under the Loan Agreement, the Collateral Agent is entitled to take enforcement action, including acceleration of amounts due under the Loan Agreement, which the Company may not have the available cash resources to repay at such time. For example, pursuant to covenants in the Loan Agreement, the Company's Annual Reports on Form 10-K must not be subject to any qualification as a going concern. If any of the Company's future Annual Reports on Form 10-K is subject to any qualification related to going concern, it will result in an event of default under the Loan Agreement.\nThese conditions raise substantial doubt regarding the Company’s ability to continue as a going concern for a period of one year after the date the financial statements are issued. Management’s plans to alleviate the conditions that raise substantial doubt through cost avoidance measures, including amending contractual arrangements with certain supply and collaboration partners, and reducing operating expenses, for the Company to continue as a going concern for a period of twelve months from the date the financial statements are issued. However, the Company has concluded that the likelihood that its plan to extend its cash runway from one or more of these approaches will be successful, while reasonably possible, is less than probable. Accordingly, the Company has concluded that substantial doubt exists about its ability to continue as a going concern for a period of at least twelve months from the date of issuance of these financial statements.\nThe accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the ordinary course of business. The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities, other than obligations under the Loan Agreement classified as current, that might result from the outcome of the uncertainties described above.\n2. Summary of Significant Accounting Policies\nBasis of Presentation\nThe accompanying unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the U.S., or GAAP, for interim financial reporting and as required by Regulation S-X, Rule 10-01. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. Any reference in these notes to applicable guidance is meant to refer to the authoritative GAAP as found in the ASC and Accounting Standards Update, or ASU, of the Financial Accounting Standards Board, or FASB.\n13\nIn the opinion of management, all adjustments, consisting of normal recurring accruals and revisions of estimates, considered necessary for a fair presentation of the unaudited condensed consolidated financial statements have been included. Interim results for the three and nine months ended September 30, 2022 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2022 or any other future period.\nThe accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. Management has determined that the Company operates in one segment, which is the business of developing and commercializing novel therapeutics for people with kidney disease. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the Company’s consolidated financial statements and the accompanying notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2021 filed with the U.S. Securities and Exchange Commission on March 1, 2022, or the 2021 Annual Report on Form 10-K.\nThe significant accounting policies used in preparation of these unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2022 are consistent with those discussed in Note 2 to the consolidated financial statements in the Company’s 2021 Annual Report on Form 10-K and are updated below as necessary.\nNew Accounting Pronouncements – Not Yet Adopted\nIn March 2020, the FASB issued ASU 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting. The amendments provide optional guidance for a limited time to ease the potential burden in accounting for reference rate reform. The new guidance provides optional expedients and exceptions for applying GAAP to contracts, hedging relationships and other transactions affected by reference rate reform if certain criteria are met. The amendments apply only to contracts and hedging relationships that reference LIBOR or another reference rate expected to be discontinued due to reference rate reform. These amendments are effective immediately and may be applied prospectively to contract modifications made and hedging relationships entered into or evaluated on or before December 31, 2022. The Company is currently evaluating its contracts and the optional expedients provided by the new standard.\nUse of Estimates\nThe preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ from those estimates. Management considers many factors in selecting appropriate financial accounting policies and controls, and in developing the estimates and assumptions that are used in the preparation of these financial statements. Management must apply significant judgment in this process. In addition, other factors may affect estimates, including expected business and operational changes, sensitivity and volatility associated with the assumptions used in developing estimates, and whether historical trends are expected to be representative of future trends. The estimation process often may yield a range of potentially reasonable estimates of the ultimate future outcomes, and management must select an amount that falls within that range of reasonable estimates. Estimates are used in the following areas, among others: prepaid and accrued research and development expense, operating lease assets and liabilities, derivative liabilities, refund liabilities to customers, other non-current liabilities, including the excess purchase commitment liability, stock-based compensation expense, product and collaboration revenues including various rebates and reserves related to product sales, non-cash interest expense on the liability related to sale of future royalties, inventories, income taxes, intangible assets and goodwill.\nAlthough the Company regularly assesses these estimates, actual results could differ materially from these estimates. Changes in estimates are recorded in the period they become known. The Company bases its estimates on historical experience and various other assumptions that it believes to be reasonable under the circumstances.\n3. Product Revenue and Reserves for Variable Consideration\nTo date, the Company’s only source of product revenue has been from the U.S. sales of Auryxia. Total net product revenue was $ 42.2 million and $ 36.8 million for the three months ended September 30, 2022 and 2021, respectively, and $ 127.4 million and $ 100.1 million for the nine months ended September 30, 2022 and 2021, respectively. The following table summarizes activity in each of the product revenue allowance and reserve categories for the nine months ended September 30, 2022 and 2021 (in thousands):\n14\n| Chargebacksand Discounts | Rebates, Feesand otherDeductions | Returns | Total |\n| Balance at December 31, 2021 | $ | 1,278 | $ | 26,625 | $ | 475 | $ | 28,378 |\n| Current provisions related to sales in current year | 8,592 | 64,322 | 3,692 | 76,606 |\n| Adjustments related to prior year sales | ( 248 ) | 33 | — | ( 215 ) |\n| Credits/payments made | ( 8,194 ) | ( 65,611 ) | ( 3,669 ) | ( 77,474 ) |\n| Balance at September 30, 2022 | $ | 1,428 | $ | 25,369 | $ | 498 | $ | 27,295 |\n| Balance at December 31, 2020 | $ | 802 | $ | 39,912 | $ | 649 | $ | 41,363 |\n| Current provisions related to sales in current year | 8,911 | 105,432 | 4,866 | 119,209 |\n| Adjustments related to prior year sales | ( 1 ) | ( 1,590 ) | — | ( 1,591 ) |\n| Credits/payments made | ( 8,593 ) | ( 99,518 ) | ( 4,979 ) | ( 113,090 ) |\n| Balance at September 30, 2021 | $ | 1,119 | $ | 44,236 | $ | 536 | $ | 45,891 |\n\nChargebacks, discounts and returns are recorded as a direct reduction of revenue on the unaudited condensed consolidated statement of operations with a corresponding reduction to accounts receivable on the unaudited condensed consolidated balance sheets. Rebates, distribution-related fees, and other sales-related deductions are recorded as a reduction in revenue on the unaudited condensed consolidated statement of operations with a corresponding increase to accrued liabilities or accounts payable on the unaudited condensed consolidated balance sheets.\nAccounts receivable, net related to product sales was approximately $ 24.0 million and $ 24.6 million as of September 30, 2022 and December 31, 2021, respectively.\n4. License, Collaboration and Other Significant Agreements\nDuring the three and nine months ended September 30, 2022 and 2021, the Company recognized the following revenues from its license, collaboration and other significant agreements and had the following deferred revenue balances as of September 30, 2022:\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| License, Collaboration and Other Revenue: | (in thousands) | (in thousands) |\n| MTPC Agreement | $ | 5,487 | $ | 2,555 | $ | 13,885 | $ | 7,167 |\n| Otsuka U.S. Agreement | — | 6,144 | 86,773 | 28,988 |\n| Otsuka International Agreement | — | 1,860 | 5,503 | 13,532 |\n| Total Proportional Performance Revenue | $ | 5,487 | $ | 10,559 | $ | 106,161 | $ | 49,687 |\n| JT and Torii | 1,238 | 1,444 | 3,871 | 4,093 |\n| MTPC Other Revenue | — | — | — | 73 |\n| Total License, Collaboration and Other Revenue | $ | 6,725 | $ | 12,003 | $ | 110,032 | $ | 53,853 |\n\n\n| September 30, 2022 |\n| Short-Term | Long-Term | Total |\n| Deferred Revenue: | (in thousands) |\n| MTPC Agreement | $ | 1,265 | $ | — | $ | 1,265 |\n| Vifor Pharma Agreement | — | 43,296 | 43,296 |\n| Total | $ | 1,265 | $ | 43,296 | $ | 44,561 |\n\nThe following table presents changes in the Company’s contract assets and liabilities during the nine months ended September 30, 2022 and 2021 (in thousands):\n15\n| Nine Months Ended September 30, 2022 | Balance atBeginning ofPeriod | Additions | Deductions | Balance at Endof Period |\n| Contract assets: |\n| Accounts receivable(1) | $ | 19,094 | $ | 92,612 | $ | ( 109,836 ) | $ | 1,870 |\n| Prepaid expenses and other current assets | $ | 4,309 | $ | 9,550 | $ | ( 8,250 ) | $ | 5,609 |\n| Contract liabilities: |\n| Deferred revenue | $ | 42,380 | $ | 66,307 | $ | ( 64,126 ) | $ | 44,561 |\n| Accounts payable | $ | 3,171 | $ | — | $ | ( 3,171 ) | $ | — |\n| Accrued expenses and other current liabilities | $ | — | $ | — | $ | — | $ | — |\n| Nine Months Ended September 30, 2021 |\n| Contract assets: |\n| Accounts receivable(1) | $ | 3,045 | $ | 38,795 | $ | ( 20,427 ) | $ | 21,413 |\n| Prepaid expenses and other current assets | $ | 1,722 | $ | 1,725 | $ | ( 5 ) | $ | 3,442 |\n| Contract liabilities: |\n| Deferred revenue | $ | 40,559 | $ | 65,890 | $ | ( 62,792 ) | $ | 43,657 |\n| Accounts payable | $ | 7,227 | $ | — | $ | ( 7,227 ) | $ | — |\n| Accrued expenses and other current liabilities | $ | 10,000 | $ | — | $ | — | $ | 10,000 |\n\n(1)Excludes accounts receivable from other services related to clinical and regulatory activities performed by the Company on behalf of MTPC that are not included in the performance obligations identified under the MTPC Agreement as of September 30, 2022 and 2021 and December 31, 2021 and 2020. Also excludes accounts receivable related to amounts due to the Company from product sales which are included in the accompanying unaudited condensed consolidated balance sheet as of September 30, 2022 and December 31, 2021.\nDuring the three and nine months ended September 30, 2022 and 2021, the Company recognized the following revenues as a result of changes in the contract asset and contract liability balances in the respective periods (in thousands):\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| Revenue Recognized in the Period: | 2022 | 2021 | 2022 | 2021 |\n| Amounts included in deferred revenue at the beginning of the period | $ | 5,047 | $ | 9,159 | $ | 29,574 | $ | 20,363 |\n| Performance obligations satisfied in previous periods | $ | — | $ | — | $ | — | $ | — |\n\nMitsubishi Tanabe Pharma Corporation Collaboration Agreement\nSummary of Agreement\nOn December 11, 2015, the Company and MTPC entered into the MTPC Agreement, providing MTPC with exclusive development and commercialization rights to vadadustat in Japan and certain other Asian countries, collectively, the MTPC Territory. In addition, the Company will supply vadadustat for both clinical and commercial use in the MTPC Territory, subject to MTPC’s option to manufacture commercial drug product in the MTPC Territory. In February 2021, the Company entered into the Royalty Agreement with HCR, whereby the Company sold its right to receive royalties and sales milestones under the MTPC Agreement, subject to certain caps and other terms and conditions (see Note 6 for additional information). A more detailed description of the MTPC Agreement and the Company's evaluation of this agreement under ASC 606 can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\nThe Company identified two performance obligations in connection with its material promises under the MTPC Agreement as follows: (i) License, Research and Clinical Supply Performance Obligation and (ii) Rights to Future Know-How Performance Obligation. The Company allocates the transaction price to each performance obligation based on the Company’s best estimate of the relative standalone selling price. The Company developed a best estimate of the standalone selling price for the Rights to Future Know-How Performance Obligation primarily based on the likelihood that additional intellectual property covered by the license conveyed will be developed during the term of the arrangement and determined it is immaterial. As such, the\n16\nCompany did not develop a best estimate of standalone selling price for the License, Research and Clinical Supply Performance Obligation and allocated the entire transaction price to this performance obligation. The deliverables associated with the License, Research and Clinical Supply Performance Obligation were satisfied as of June 30, 2018.\nAs of September 30, 2022, the transaction price was comprised of: (i) the up-front payment of $ 20.0 million, (ii) the cost for the Phase 2 studies of $ 20.5 million, (iii) the cost of all clinical supply provided to MTPC for the Phase 3 studies, (iv) $ 10.0 million in development milestones received, (v) $ 25.0 million in regulatory milestones received, comprised of $ 10.0 million relating to the NDA filing in Japan and $ 15.0 million relating to regulatory approval of vadadustat in Japan, and (vi) $ 2.4 million in royalties from net sales of Vafseo. As of September 30, 2022, all development milestones and $ 25.0 million in regulatory milestones have been achieved. No other regulatory milestones have been assessed as probable of being achieved and as a result have been fully constrained. The Company re-evaluates the transaction price in each reporting period and as uncertain events are resolved or other changes in circumstances occur. Revenue for the License, Research and Clinical Supply Performance Obligation for the MTPC Agreement is being recognized using a proportional performance method, for which all deliverables have been completed. During the three and nine months ended September 30, 2022, the Company recognized revenue from MTPC royalties totaling approximately $ 0.4 million and $ 1.2 million, respectively, and approximately $ 0.3 million and $ 0.4 million during the three and nine months ended September 30, 2021, respectively. As noted above, in February 2021, the Company entered into the Royalty Agreement, whereby the Company sold its right to receive these royalties and sales milestones under the MTPC Agreement, subject to certain caps and other terms and conditions (see Note 6 for additional information). The revenue is classified as license, collaboration and other revenue in the accompanying unaudited condensed consolidated statements of operations and comprehensive loss. As of September 30, 2022, the Company recorded $ 0.2 million in accounts receivable, no deferred revenue, and no contract assets. There were no asset or liability balances classified as long-term in the unaudited condensed consolidated balance sheet as of September 30, 2022.\nSupply of Drug Product to MTPC\nOn July 15, 2020, the Company and its collaboration partner MTPC entered into a supply agreement, or the MTPC Supply Agreement. The MTPC Supply Agreement includes the terms and conditions under which the Company will supply vadadustat drug product to MTPC for commercial use in Japan and certain other Asian countries, as contemplated by the MTPC Agreement. A more detailed description of this supply agreement can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\nThe Company recognized $ 5.1 million in revenue and $ 12.7 million in revenue under the MTPC Supply Agreement during the three and nine months ended September 30, 2022, respectively, and $ 2.2 million and $ 6.7 million during the three and nine months ended September 30, 2021, respectively. As of September 30, 2022, the Company recorded $ 0.2 million in accounts receivable, $ 1.3 million in deferred revenue and $ 18.6 million in other current liabilities.\nU.S. Collaboration and License Agreement with Otsuka Pharmaceutical Co. Ltd.\nOn December 18, 2016, the Company entered into the Otsuka U.S. Agreement. The collaboration was focused on the development and commercialization of vadadustat in the United States. The Company was responsible for leading the development of vadadustat, for which it submitted an NDA to the FDA in March 2021, and for which it received the CRL in March 2022.\nUnder the terms of the Otsuka U.S. Agreement, the Company granted to Otsuka a co-exclusive, non-sublicensable license under certain intellectual property controlled by the Company solely to perform medical affairs activities and to conduct non-promotional and commercialization activities related to vadadustat in the United States in accordance with the associated plans. The co-exclusive license related to activities that would be jointly conducted by the Company and Otsuka pursuant to the terms of the Otsuka U.S. Agreement. A more detailed description of this collaboration agreement and the Company's evaluation of this agreement under ASC 606 can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\nThe Company identified three performance obligations in connection with its obligations under the Otsuka U.S. Agreement as follows: (i) License and Development Services Combined (License Performance Obligation); (ii) Rights to Future Intellectual Property (Future IP Performance Obligation) and (iii) Joint Committee Services (Committee Performance Obligation). The Company allocated the transaction price to each performance obligation based on the Company’s best estimate of the relative standalone selling price. The Company developed a best estimate of standalone selling price for the Committee Performance Obligation after considering the nature of the services to be performed and estimates of the associated effort and rates applicable to such services that would be expected to be realized under similar contracts. The Company developed a best estimate of standalone selling price for the Future IP Performance Obligation primarily based on the likelihood that additional\n17\nintellectual property covered by the license conveyed would be developed during the term of the arrangement. The Company did not develop a best estimate of standalone selling price for the License Performance Obligation due to the following: (i) the best estimates of standalone selling price associated with the Future IP Performance Obligation was determined to be immaterial and (ii) the period of performance and pattern of recognition for the License Performance Obligation and the Committee Performance Obligation was determined to be similar.\nThe Company re-evaluated the transaction price in each reporting period and as uncertain events were resolved or other changes in circumstances occurred. The Company determined that under ASC 606, the contract was modified in the second quarter of 2019, when the Company elected to require Otsuka to increase the aggregate percentage of current global development costs it funds under the Otsuka U.S. Agreement and the Otsuka International Agreement from 52.5 % to 80 %, or the Otsuka Funding Option, and the Company became eligible to receive the amount from the Otsuka Funding Option. In connection with the modification, the Company adjusted the transaction price to include the amount from the Otsuka Funding Option as additional variable consideration. The Company constrained the variable consideration to an amount for which a significant revenue reversal is not probable.\nPursuant to the Otsuka U.S. Agreement, the Company received: (i) an up-front payment of $ 125.0 million, (ii) a cost share payment with respect to amounts incurred by the Company through December 31, 2016 of $ 33.8 million, and (iii) net cost share consideration with respect to amounts incurred by the Company under the global development plan of approximately $ 319.2 million with respect to amounts incurred by the Company subsequent to December 31, 2016.\nOn May 12, 2022, the Company received notice from Otsuka that it had elected to terminate the Otsuka U.S. Agreement and the Otsuka International Agreement. On June 30, 2022, the Company and Otsuka entered into the Termination Agreement, pursuant to which, among other things, the Company and Otsuka agreed to terminate, as of June 30, 2022, the Otsuka U.S. Agreement and the Otsuka International Agreement. In July 2022, the Company received a nonrefundable and non-creditable payment of $ 55.0 million in consideration for the covenants and agreements set forth in the Termination Agreement, including the settlement and release of all disputes and claims as provided therein. The Company determined that the Termination Agreement met the definition of a contract modification and was accounted for as a cumulative catch-up adjustment at the time of modification under ASC 606.\nDuring the three and nine months ended September 30, 2022, the Company recognized $ 0 and $ 92.3 million of collaboration revenue from the Otsuka U.S. Agreement and the Otsuka International Agreement combined in its condensed consolidated statement of operations and comprehensive loss. The collaboration revenue for the nine months ended September 30, 2022 is primarily comprised of the $ 55.0 million payment received pursuant to the Termination Agreement, $ 15.5 million related to previously deferred revenue as of the date of termination and $ 9.6 million of non-cash consideration related to Otsuka's obligations to complete certain agreed upon clinical activities related to the Phase 3b clinical trial of vadadustat Otsuka is conducting.\nDuring the three and nine months ended September 30, 2021, the Company recognized collaboration revenue totaling $ 6.1 million and $ 29.0 million, respectively, with respect to the Otsuka U.S. Agreement. Additionally, as of September 30, 2022, there was $ 5.6 million in prepaid expenses and other current assets in the accompanying unaudited condensed consolidated balance sheet. As of December 31, 2021, there was approximately $ 2.0 million in contract liabilities (included in accounts payable) and $ 3.0 million in prepaid expenses and other current assets in the consolidated balance sheet.\nInternational Collaboration and License Agreement with Otsuka Pharmaceutical Co. Ltd.\nOn April 25, 2017, the Company entered into the Otsuka International Agreement. The collaboration was focused on the development and commercialization of vadadustat in Europe, Russia, China, Canada, Australia, the Middle East and certain other territories, collectively, the Otsuka International Territory.\nUnder the terms of the Otsuka International Agreement, the Company granted to Otsuka an exclusive, sublicensable license under certain intellectual property controlled by the Company to develop and commercialize vadadustat and products containing or comprising vadadustat in the Otsuka International Territory. Additionally, under the terms of this agreement, the Company was responsible for leading the development of vadadustat. Otsuka had the sole responsibility, at its own cost, for the commercialization of vadadustat in the Otsuka International Territory, subject to the approval by the relevant regulatory authorities. A more detailed description of this collaboration agreement and the Company's evaluation of this agreement under ASC 606 can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\nThe Company identified three performance obligations in connection with its obligations under the Otsuka International Agreement as follows: (i) License and Development Services Combined (License Performance Obligation); (ii) Rights to\n18\nFuture Intellectual Property (Future IP Performance Obligation) and (iii) Joint Committee Services (Committee Performance Obligation). The Company allocated the transaction price to each performance obligation based on the Company’s best estimate of the relative standalone selling price. The Company developed a best estimate of standalone selling price for the Committee Performance Obligation after considering the nature of the services to be performed and estimates of the associated effort and rates applicable to such services that would be expected to be realized under similar contracts. The Company developed a best estimate of standalone selling price for the Future IP Performance Obligation primarily based on the likelihood that additional intellectual property covered by the license conveyed will be developed during the term of the arrangement. The Company did not develop a best estimate of standalone selling price for the License Performance Obligation due to the following: (i) the best estimates of standalone selling price associated with the Future IP Performance Obligation was determined to be immaterial and (ii) the period of performance and pattern of recognition for the License Performance Obligation and the Committee Performance Obligation was determined to be similar.\nThe Company re-evaluated the transaction price in each reporting period and as uncertain events were resolved or other changes in circumstances occurred. Pursuant to the Otsuka International Agreement, the Company received: (i) an up-front payment of $ 73.0 million, (ii) the cost share payment with respect to amounts incurred by the Company during the quarter ended March 31, 2017 of $ 0.2 million, and (iii) the net cost share consideration with respect to amounts incurred by the Company under the global development plan subsequent to March 31, 2017 of $ 216.7 million.\nAs discussed above, the Otsuka International Agreement was terminated on June 30, 2022 pursuant to the Termination Agreement. Refer to earlier in this Note 4 for further details of the recognition of this Termination Agreement in the Company's condensed consolidated statement of operations and comprehensive loss.\nDuring the three and nine months ended September 30, 2021, the Company recognized collaboration revenue totaling approximately $ 1.9 million and $ 13.5 million, respectively, with respect to the Otsuka International Agreement. As of December 31, 2021, there was approximately $ 0.9 million in contract liabilities (included in accounts payable) and $ 1.3 million in prepaid expenses and other current assets in the consolidated balance sheet.\nJanssen Pharmaceutica NV Research and License Agreement\nOn February 9, 2017, the Company entered into a Research and License Agreement, or the Janssen Agreement, with Janssen Pharmaceutica NV, or Janssen, a subsidiary of Johnson & Johnson, pursuant to which Janssen granted the Company an exclusive license under certain intellectual property rights to develop and commercialize worldwide certain HIF prolyl hydroxylase targeted compounds. Under the terms of the Janssen Agreement, Janssen granted to the Company a license for a three-year research term to conduct research on the HIF compound portfolio, which research term is now expired. A more detailed description of this collaboration agreement can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\nUnder the terms of the Janssen Agreement, the Company made an upfront payment of $ 1.0 million in cash to Janssen and issued a warrant, or the Warrant, to purchase 509,611 shares of the Company’s common stock, which expired on February 9, 2022. In addition, Janssen could be eligible to receive up to an aggregate of $ 16.5 million from the Company in specified development milestone payments on a product-by-product basis. Janssen could also be eligible to receive up to $ 215.0 million from the Company in specified commercial milestones as well as tiered, escalating royalties ranging from a low- to mid-single digit percentage of net sales, on a product-by-product basis, and subject to reduction upon expiration of patent rights or the launch of a generic product in the territory. A more detailed description of this collaboration agreement can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K. On August 1, 2022, the Company notified Janssen that it was exercising its right to terminate the Janssen Agreement, and Janssen agreed to the termination which became effective on August 2, 2022.\nCyclerion Therapeutics License Agreement\nOn June 4, 2021, the Company entered into a License Agreement, the Cyclerion Agreement, with Cyclerion Therapeutics Inc., or Cyclerion, pursuant to which Cyclerion granted the Company an exclusive global license under certain intellectual property rights to research, develop and commercialize praliciguat, an investigational oral soluble guanylate stimulator.\nUnder the terms of the Cyclerion Agreement, the Company made an upfront payment of $ 3.0 million in cash to Cyclerion, which was paid and recorded to research and development expense in June 2021. Substantially all of the fair value of the assets acquired in conjunction with the Cyclerion Agreement was concentrated in the acquired license. As a result, the Company accounted for this transaction as an asset acquisition under ASU No. 2017-01, Business Combinations (Topic 805): Clarifying\n19\nthe Definition of a Business. The upfront payment was charged to expense at acquisition, as it relates to a development stage compound with no alternative future use. In addition, Cyclerion is eligible to receive up to an aggregate of $ 222.0 million from the Company in specified development and regulatory milestone payments on a product-by-product basis. Cyclerion will also be eligible to receive specified commercial milestones as well as tiered royalties ranging from a low-single-digit- to mid-double-digit percentage of net sales, on a product-by-product basis, and subject to reduction upon expiration of patent rights or the launch of a generic product in the territory. A more detailed description of this agreement can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\nVifor Pharma License Agreement\nSummary of License Agreement\nOn May 12, 2017, the Company entered into a License Agreement, or the Vifor Agreement, with Vifor (International) Ltd., or Vifor Pharma, pursuant to which the Company granted Vifor Pharma an exclusive license to sell vadadustat solely to Fresenius Kidney Care Group LLC, an affiliate of Fresenius Medical Care North America, or FMCNA, in the United States. On April 8, 2019, the Company and Vifor Pharma entered into an Amended and Restated License Agreement, or the Vifor First Amended Agreement, which amended and restated in full the Vifor Agreement. On February 18, 2022, the Company and Vifor Pharma entered into a Second Amended and Restated License Agreement, or the Vifor Second Amended Agreement, which amends and restates the Vifor First Amended Agreement.\nPursuant to the Vifor Second Amended Agreement, the Company granted Vifor Pharma an exclusive license to sell vadadustat to FMCNA and its affiliates, including Fresenius Kidney Care Group LLC, to certain third party dialysis organizations approved by the Company, to independent dialysis organizations that are members of certain group purchasing organizations, and to certain non-retail specialty pharmacies, or collectively, the Supply Group, in the United States, or the Territory. Pursuant to the Vifor Second Amended Agreement, Vifor Pharma agreed that it would not sell or otherwise supply vadadustat until the FDA has granted regulatory approval for vadadustat in the DD-CKD Indication in the Territory and until Vifor Pharma has entered a supply agreement with the applicable member of the Supply Group.\nSimilar to the Vifor First Amended Agreement, the Vifor Second Amended Agreement is structured as a profit share arrangement between the Company and Vifor Pharma in which the Company will receive approximately 66 % of the profit, net of certain pre-specified costs. Under the Vifor Second Amended Agreement, Vifor Pharma made an upfront payment to the Company of $ 25.0 million in lieu of the previously disclosed milestone payment of $ 25.0 million that Vifor Pharma was to pay the Company following approval of vadadustat by the FDA, as established under the Vifor First Amended Agreement.\nUnless earlier terminated, the Vifor Second Amended Agreement will expire upon the later of the expiration of all patents that claim or cover vadadustat or expiration of marketing or regulatory exclusivity for vadadustat in the Territory. Vifor Pharma may terminate the Vifor Second Amended Agreement in its entirety upon 30 months' prior written notice after the first anniversary of the receipt of regulatory approval, if approved from the FDA for vadadustat for dialysis-dependent CKD patients. The Company may terminate the Vifor Second Amended Agreement in its entirety for convenience, following the earlier of a certain period of time elapsing or following certain specified regulatory events, and upon six months ’ prior written notice. If the Company so terminates for convenience, subject to specified exceptions, the Company will pay a termination fee to Vifor Pharma. In addition, either party may, subject to a cure period, terminate the Vifor Second Amended Agreement in the event of the other party’s uncured material breach or bankruptcy.\nInvestment Agreement\nIn connection with the Vifor Agreement, in May 2017, the Company and Vifor Pharma entered into an investment agreement, or the First Investment Agreement, pursuant to which the Company sold an aggregate of 3,571,429 shares of the Company’s common stock, or the 2017 Shares, to Vifor Pharma at a price per share of $ 14.00 for a total of $ 50.0 million. The amount representing the premium over the closing stock price of $ 12.69 on the date of the transaction, totaling $ 4.7 million, was determined by the Company to represent consideration related to the Vifor Agreement.\nVifor Pharma agreed to a lock-up restriction such that it agreed not to sell the 2017 Shares for a period of time following the effective date of the First Investment Agreement as well as a customary standstill agreement. In addition, the First Investment Agreement contains voting agreements made by Vifor Pharma with respect to the 2017 Shares. The 2017 Shares have not been registered pursuant to the Securities Act of 1933, as amended, or the Securities Act, and were issued and sold in reliance upon the exemption from registration contained in Section 4(a)(2) of the Securities Act and Rule 506 promulgated thereunder.\nIn connection with entering into the Vifor Second Amended Agreement, on February 18, 2022, the Company and Vifor Pharma entered into an investment agreement, or the Second Investment Agreement, pursuant to which the Company sold an aggregate\n20\nof 4,000,000 shares of its common stock, or the 2022 Shares, to Vifor Pharma for a total of $ 20 million on February 22, 2022. The amount representing the premium over the grant date fair value on the date of the transaction, $ 13.6 million, was determined by the Company to represent the consideration related to the Vifor Second Amended Agreement. Vifor Pharma has agreed to a lock-up restriction to not sell or otherwise dispose of the 2022 Shares for a period of time following the effective date of the Second Investment Agreement as well as a customary standstill agreement. In addition, the Second Investment Agreement contains voting agreements made by Vifor Pharma with respect to the 2022 Shares. The 2022 Shares have not been registered pursuant to the Securities Act and were issued and sold in reliance upon the exemption from registration contained in Section 4(a)(2) of the Securities Act and/or Rule 506 promulgated thereunder, as the transaction did not involve any public offering within the meaning of Section 4(a)(2) of the Securities Act.\nRevenue Recognition\nThe Company evaluated the elements of the Vifor Second Amended Agreement in accordance with the provisions of ASC 606 and concluded that the contract counterparty, Vifor Pharma, is a customer. The Company’s arrangement with Vifor Pharma contains one material promise under the contract at inception, which is the non-sublicensable, non-transferrable license under certain of the Company’s intellectual property to (i) sell vadadustat solely to the Supply Group, (ii) sell vadadustat to Designated Wholesalers solely for resale to members of the Supply Group, (iii) conduct medical affairs with respect to vadadustat in the Territory in the field during the term of the Vifor Second Amended Agreement and (iv) use the Akebia Trademark solely in connection with the sale of vadadustat (the License Deliverable).\nThe Company has identified one performance obligation in connection with its obligations under the Vifor Second Amended Agreement, which is the License Deliverable, or License Performance Obligation. The transaction price at inception was comprised of: (i) the up-front payment of $ 25.0 million, (ii) the premium paid by Vifor Pharma on the First Investment Agreement of $ 4.7 million, and (iii) the premium paid by Vifor Pharma on the Second Investment Agreement of $ 13.6 million. Pursuant to the terms of the Vifor Second Amended Agreement, these payments from Vifor Pharma are non-refundable and non-creditable against any other amount due to the Company. Also pursuant to the Vifor Second Amended Agreement, if the Centers for Medicare & Medicaid Services, or CMS, determines that vadadustat is excluded from the Transitional Drug Add-on Payment Adjustment, or TDAPA, the Company can terminate the Vifor Second Amended Agreement and will be required to repay the up-front payment and the premiums paid by Vifor Pharma in the First Investment Agreement and Second Investment Agreement, respectively. The Company considered whether the transaction price was constrained as required per the guidance in ASC 606-10-32-11. As part of its evaluation of the constraint, the Company considered numerous factors, including the CRL received from the FDA for vadadustat, the uncertainty associated with a potential future approval of vadadustat by the FDA, and if approval of vadadustat is received in the future, whether vadadustat would be included in certain reimbursement bundles by CMS, which are all outside of the Company’s control. Vifor Pharma also agreed that it will not sell or otherwise supply vadadustat until the FDA has granted regulatory approval for vadadustat in the DD-CKD Indication. The Company constrains the variable consideration to an amount for which a significant revenue reversal is not probable. Therefore, the Company determined that the entire transaction price at inception was constrained under ASC 606, and the Company has recorded the transaction price to deferred revenue as of September 30, 2022.\nRefund Liability to Customer\nPursuant to the Vifor Second Amended Agreement, Vifor Pharma contributed $ 40.0 million to a working capital fund established to partially fund the Company’s costs of purchasing vadadustat from its contract manufacturers, or the Working Capital Fund, which amount of funding will fluctuate, and which funding the Company will repay to Vifor over time. The $ 40 million initial contribution to the Working Capital Fund represents 50 % of the amount of purchase orders that the Company has placed with its contract manufacturers for the supply of vadadustat for the Territory already delivered as of the effective date of the Vifor Second Amended Agreement, and to be delivered through the end of 2022. The amount of the Working Capital Fund will be reviewed at specified intervals and is adjusted based on a number of factors including outstanding supply commitments for vadadustat for the Territory and agreed upon vadadustat inventory levels held by the Company for the Territory. Upon termination or expiration of the Vifor Second Amended Agreement for any reason other than convenience by Vifor Pharma (including following receipt of the CRL for vadadustat), the Company will be required to refund the outstanding balance of the Working Capital Fund on the date of termination or expiration.\nThe Company has recorded the Working Capital Fund as a refund liability under ASC 606. The Company has determined that the refund liability itself does not represent an obligation to transfer goods or services to Vifor Pharma in the future. The Company has therefore determined that this refund liability is not a contract liability under ASC 606. The Company accounted for the refund liability as a debt arrangement with zero coupon interest. The Company imputed interest on the refund liability to the customer at a rate of 15.0 % per annum, which was determined based on certain factors, including the Company's credit rating, comparable securities yield, and the expected repayment period of the Working Capital Fund. The Company recorded an\n21\ninitial discount on the refund liability to the customer and a corresponding deferred gain to the refund liability to customer on the condensed consolidated balance sheet as of the date the funds were received from Vifor Pharma, which was March 18, 2022. The discount on the note payable is being amortized to interest expense using the effective interest method over the expected term of the refund liability. The deferred gain is being amortized to interest income on a straight-line basis over the expected term of the refund liability. The amortization of the discount was $ 1.1 million and $ 2.3 million for the three and nine months ended September 30, 2022, respectively. The amortization of the deferred gain was $ 0.9 million and $ 1.8 million for the three and nine months ended September 30, 2022, respectively. Of the $ 40.5 million total refund liability, net of deferred gain and discount, the Company classified $ 13.7 million as a short-term refund liability based on management's estimate of potential amounts that could be refundable within a one-year period as a result of anticipated changes to the Company's operating plan following the CRL.\nPriority Review Voucher Letter Agreement\nOn February 14, 2020, the Company entered into a letter agreement, or the Letter Agreement, with Vifor Pharma relating to Vifor Pharma’s agreement with a third party to purchase a Priority Review Voucher, or the PRV, issued by the FDA, subject to satisfaction of customary closing conditions, or the PRV Purchase. A PRV entitles the holder to priority review of an NDA, or a Biologics License Application for a new drug, which reduces the target FDA review time to six months after official acceptance of the submission, and could lead to expedited approval. Pursuant to the Letter Agreement, Akebia paid Vifor Pharma $ 10.0 million in connection with the closing of the PRV Purchase.\nOn August 21, 2021, the Company and Vifor Pharma executed an amendment to the Letter Agreement whereby the parties agreed that Vifor Pharma would sell the PRV to a third party, and the Company and Vifor Pharma would share the proceeds from the sale based on certain terms. In the fourth quarter of 2021, Vifor Pharma sold the PRV to a third party, and Vifor Pharma paid the Company $ 8.6 million in proceeds from the sale, which was recorded as contra research and development expense. These proceeds were subsequently paid to Otsuka as reimbursement for their contribution to the purchase of the PRV, as required under a separate letter agreement executed with Otsuka. A more detailed description of this transaction can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\nLicense Agreement with Panion & BF Biotech, Inc.\nAs a result of the merger with Keryx, or the Merger, the Company had a license agreement, which was amended from time to time, with Panion & BF Biotech, Inc., or Panion, under which Keryx, the Company's wholly owned subsidiary, was the contracting party, or the Panion License Agreement, pursuant to which Keryx in-licensed the exclusive worldwide rights, excluding certain Asian-Pacific countries, or the Licensor Territory, for the development and commercialization of ferric citrate.\nOn April 17, 2019, the Company and Panion entered into a second amended and restated license agreement, or the Panion Amended License Agreement, which amends and restates in full the Panion License Agreement, effective as of April 17, 2019. The Panion Amended License Agreement provides Keryx with an exclusive license under Panion-owned know-how and patents with the right to sublicense, develop, make, use, sell, offer for sale, import and export ferric citrate worldwide, excluding the Licensor Territory. The Panion Amended License Agreement also provides Panion with an exclusive license under the Keryx-owned patents, with the right to sublicense (with the Company’s written consent), develop, make, use, sell, offer for sale, import and export ferric citrate in certain countries in the Licensor Territory. Under the Panion Amended License Agreement, Panion is eligible to receive from the Company or any sublicensee royalty payments based on a mid-single digit percentage of sales of ferric citrate in the Company’s licensed territories. The Company is eligible to receive from Panion or any sublicensee royalty payments based on a mid-single digit percentage of net sales of ferric citrate in Panion’s licensed territories. A more detailed description of this license agreement can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\nThe Company recognized royalty payments due to Panion of approximately $ 2.9 million and $ 3.0 million during the three months ended September 30, 2022 and 2021, respectively, and $ 9.5 million and $ 8.3 million during the nine months ended September 30, 2022 and 2021, respectively, relating to the Company’s sales of Auryxia in the United States and JT and Torii’s net sales of Riona in Japan, as the Company is required to pay a mid-single digit percentage of net sales of ferric citrate in the Company’s licensed territories to Panion under the terms of the Panion Amended License Agreement.\n22\nSublicense Agreement with Japan Tobacco, Inc. and its subsidiary, Torii Pharmaceutical Co., Ltd.\nAs a result of the Merger, the Company has an Amended and Restated Sublicense Agreement, which was amended in June 2013, with JT and Torii, or the JT and Torii Sublicense Agreement, under which Keryx, the Company’s wholly owned subsidiary, remains the contracting party. Under the JT and Torii Sublicense Agreement, JT and Torii obtained the exclusive sublicense rights for the development and commercialization of ferric citrate hydrate in Japan. JT and Torii are responsible for the future development and commercialization costs in Japan. A more detailed description of this sublicense agreement can be found in Note 4 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\nThe Company identified two performance obligations in connection with its obligations under the JT and Torii Sublicense Agreement: (i) License and Supply Performance Obligation and (ii) Rights to Future Know-How Performance Obligation. The Company allocated the transaction price to each performance obligation based on the Company’s best estimate of the relative standalone selling price. The Company developed a best estimate of the standalone selling price for the Rights to Future Know-How Performance Obligation primarily based on the likelihood that additional intellectual property covered by the license conveyed will be developed during the term of the arrangement and determined it immaterial. As such, the Company did not develop a best estimate of standalone selling price for the License and Supply Performance Obligation and allocated the entire transaction price to this performance obligation.\nThe Company recognized license revenue of $ 1.2 million and $ 1.4 million during the three months ended September 30, 2022 and 2021, respectively, and $ 3.9 million and $ 4.1 million during the nine months ended September 30, 2022 and 2021, respectively, related to royalties earned on net sales of Riona in Japan. The Company records the associated mid-single digit percentage of net sales royalty expense due to Panion, the licensor of Riona, in the same period as the royalty revenue from JT and Torii is recorded.\n5. Restructuring\nOn April 4, 2022, the Board of Directors of the Company approved a reduction of the Company’s workforce by approximately 42 % across all areas of the Company ( 47 % inclusive of the closing of the majority of open positions) following the receipt of the CRL from the FDA to the Company’s NDA for vadadustat for the treatment of anemia due to CKD in adult patients. The workforce reduction was substantially completed as of June 30, 2022. On May 5, 2022, the Company implemented a further reduction in workforce consisting of several members of management. The workforce reduction is expected to be substantially complete by the end of May 2023. These actions reflect the Company’s determination to refocus its strategic priorities around its commercial product, Auryxia®, and its development portfolio, and are steps in a cost savings plan to significantly reduce the Company’s expense profile in line with being a single commercial product company.\nThe workforce reduction is expected to include total restructuring charges of approximately $ 14.7 million. During the three and nine months ended September 30, 2022, the Company recognized $ 0.2 million and $ 14.7 million, respectively, of restructuring charges in the condensed consolidated statement of operations. These charges included $ 11.4 million of one-time termination benefits and contractual termination benefits for severance, healthcare, and related benefits and $ 3.3 million of non-cash share-based compensation expense. The charges were recorded pursuant to ASC 712, Compensation-Nonretirement Postemployment Benefits or ASC 420, Exit or Disposal Cost Obligations, depending on the employee.\nDetails of the restructuring liability activity for the Company's workforce reduction for the period ended September 30, 2022 are as follows:\n| September 30, 2022 |\n| (in thousands) |\n| Balance at December 31, 2021 | $ | — |\n| Restructuring charges | 14,711 |\n| Stock-based compensation expense | ( 3,253 ) |\n| Severance payments and adjustments | ( 7,220 ) |\n| Balance at September 30, 2022 | $ | 4,238 |\n\n23\n6. Liability Related to Sale of Future Royalties\nOn February 25, 2021, the Company entered into the Royalty Agreement with HCR, pursuant to which the Company sold to HCR its right to receive royalties and sales milestones for vadadustat in Japan and certain other Asian countries, such countries, collectively, the MTPC Territory, and such payments collectively the Royalty Interest Payments, in each case, payable to the Company under the MTPC Agreement, subject to an annual maximum “cap” of $ 13.0 million, or the Annual Cap, and an aggregate maximum “cap” of $ 150.0 million, or the Aggregate Cap. The Company received $ 44.8 million from HCR (net of certain transaction expenses) under the Royalty Agreement. The Company retains the right to receive all potential future regulatory milestones for vadadustat under the MTPC Agreement. Although the Company sold its right to receive royalties and sales milestones for vadadustat in the MTPC Territory as described above, as a result of its ongoing involvement in the cash flows related to these royalties, the Company will continue to account for these royalties as revenue. The Company recognized the proceeds received from HCR as a liability that is being amortized using the effective interest method over the life of the arrangement. At the transaction date, the Company recorded the net proceeds of $ 44.8 million as a liability. In order to determine the amortization of the liability, the Company is required to estimate the total amount of future net royalty payments to be made to HCR over the term of the Royalty Agreement. The total threshold of net royalties to be paid, less the net proceeds received, will be recorded as interest expense over the life of the liability. The Company imputes interest on the unamortized portion of the liability using the effective interest method. The annual effective interest rate as of September 30, 2022 was 13.6 % which is reflected as interest expense in the unaudited condensed consolidated statements of operations and comprehensive loss. On a quarterly basis, the Company reassesses the effective interest rate and adjusts the rate prospectively as needed. A more detailed description of Royalty Agreement can be found in Note 5 of the Notes to the Consolidated Financial Statements in the 2021 Annual Report on Form 10-K.\nThe following table shows the activity within the liability account for the nine months ended September 30, 2022:\n| September 30, 2022 |\n| (in thousands) |\n| Liability related to sale of future royalties, net beginning balance at December 31, 2021 | $ | 53,079 |\n| MTPC royalties payable | ( 1,195 ) |\n| Non-cash interest expense recognized | 6,352 |\n| Liability related to sale of future royalties, net — ending balance | $ | 58,236 |\n\n7. Fair Value of Financial Instruments\nThe Company utilizes a portfolio management company for the valuation of the majority of its investments. This portfolio management company is an independent, third-party vendor recognized to be an industry leader with access to market information that obtains or computes fair market values from quoted market prices, pricing for similar securities, recently executed transactions, cash flow models with yield curves and other pricing models. For valuations obtained from the pricing service, the Company performs due diligence to understand how the valuation was calculated or derived, focusing on the valuation technique used and the nature of the inputs.\nBased on the fair value hierarchy, the Company classifies its cash equivalents within Level 1 or Level 2. This is because the Company values its cash equivalents using quoted market prices or alternative pricing sources and models utilizing market observable inputs.\n24\nAssets measured or disclosed at fair value on a recurring basis as of September 30, 2022 and December 31, 2021 are summarized below:\n| Fair Value Measurements Using |\n| Level 1 | Level 2 | Level 3 | Total |\n| (in thousands) |\n| September 30, 2022 |\n| Assets: |\n| Cash and cash equivalents | $ | 144,761 | $ | — | $ | — | $ | 144,761 |\n| $ | 144,761 | $ | — | $ | — | $ | 144,761 |\n| Liabilities: |\n| Derivative liability | $ | — | $ | — | $ | 760 | $ | 760 |\n| $ | — | $ | — | $ | 760 | $ | 760 |\n\n\n| Fair Value Measurements Using |\n| Level 1 | Level 2 | Level 3 | Total |\n| (in thousands) |\n| December 31, 2021 |\n| Assets: |\n| Cash and cash equivalents | $ | 149,800 | $ | — | $ | — | $ | 149,800 |\n| $ | 149,800 | $ | — | $ | — | $ | 149,800 |\n| Liabilities: |\n| Derivative liability | $ | — | $ | — | $ | 1,820 | $ | 1,820 |\n| $ | — | $ | — | $ | 1,820 | $ | 1,820 |\n\nThe Company’s Loan Agreement with Pharmakon (see Note 11) contains certain provisions that change the underlying cash flows of the debt instrument, including a potential extension to the interest-only period dependent on both (i) no event of default having occurred and continuing and (ii) the Company achieving certain regulatory and revenue conditions. One of the regulatory conditions was approval of vadadustat by August 2022, however, in March 2022, the Company received the CRL from the FDA stating that the FDA had determined that it could not approve the NDA for vadadustat in its present form. Therefore, the Company is no longer eligible for the interest-only extension period and this no longer changes the underlying cash flows of the debt instrument. The Company also assessed the acceleration of the obligations under the Loan Agreement under certain events of default. In addition, under certain circumstances, a default interest rate will apply on all outstanding obligations during the occurrence and continuance of an event of default. In accordance with ASC 815, the Company concluded that these features are not clearly and closely related to the host instrument, and represent a single compound derivative that is required to be re-measured at fair value on a quarterly basis.\nThe potential events of default assessed include failure to maintain, on an annual basis, a minimum liquidity threshold which started in 2021, and on a quarterly basis, a minimum net sales threshold for Auryxia which started in the fourth quarter of 2020. The Company recorded a derivative liability related to the Company’s Loan Agreement with Pharmakon of $ 0.8 million and $ 1.8 million as of September 30, 2022 and December 31, 2021, respectively. The Company classified the derivative liability as a non-current liability on the unaudited condensed consolidated balance sheet as of September 30, 2022 and December 31, 2021. The estimated fair value of the derivative liability on both September 30, 2022 and December 31, 2021 was determined using a scenario-based approach and discounted cash flow model that includes principal and interest payments under various scenarios involving clinical development success for vadadustat and various cash flow assumptions. The Company used a 0 % probability of clinical development success due to receipt of the CRL from the FDA for vadadustat. Should the Company’s assessment of the probabilities around these scenarios change, including for changes in market conditions, there could be a change to the fair value of the derivative liability.\n25\nThe following table provides a roll-forward of the fair value of the derivative liability (in thousands):\n\n| Balance at December 31, 2021 | $ | 1,820 |\n| Change in fair value of derivative liability, recorded as other income | ( 710 ) |\n| Balance at March 31, 2022 | $ | 1,110 |\n| Change in fair value of derivative liability, recorded as other income | — |\n| Balance at June 30, 2022 | $ | 1,110 |\n| Change in fair value of derivative liability, recorded as other income | ( 350 ) |\n| Balance at September 30, 2022 | $ | 760 |\n\nThe Company had no other assets or liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) at September 30, 2022 and December 31, 2021.\n8. Inventory\nThe components of inventory are summarized as follows:\n\n| September 30, 2022 | December 31, 2021 |\n| (in thousands) |\n| Raw materials | $ | 397 | $ | 1,763 |\n| Work in process | 32,855 | 62,635 |\n| Finished goods | 18,970 | 14,661 |\n| Total inventory | $ | 52,222 | $ | 79,059 |\n\nLong-term inventory, which primarily consists of raw materials and work in process, is included in other assets in the Company’s unaudited condensed consolidated balance sheets.\n\n| September 30, 2022 | December 31, 2021 |\n| (in thousands) |\n| Balance Sheet Classification: |\n| Inventory | $ | 40,039 | $ | 38,195 |\n| Other assets | 12,183 | 40,864 |\n| Total inventory | $ | 52,222 | $ | 79,059 |\n\nInventory amounts written down as a result of excess, obsolescence, scrap or other reasons and charged to cost of goods sold totaled $ 2.6 million and $ 1.7 million during the three months ended September 30, 2022 and 2021, respectively, and $ 10.0 million and $ 7.1 million during the nine months ended September 30, 2022 and 2021, respectively. The increase in inventory amounts written down for the three and nine months ended September 30, 2022 as compared to the three and nine months ended September 30, 2021 was primarily due to higher write-downs to inventory reserves related to expired inventory. In addition, there were no related step-up charges during the nine months ended September 30, 2022 and $ 8.7 million related step-up charges during the nine months ended September 30, 2021. During the nine months ended September 30, 2022, the Company recorded $ 14.8 million of long-term inventory reserves and related reduction to the excess purchases commitment liability related to Auryxia inventory previously identified as excess, reflecting Auryxia inventory that was received during the period.\nIf future sales of Auryxia are lower than expected, the Company may be required to write-down the value of such inventories. Inventory write-downs and losses on purchase commitments are recorded as a component of cost of goods sold in the unaudited condensed consolidated statement of operations.\n26\n9. Intangible Assets and Goodwill\nIntangible Assets\nThe following table presents the Company’s intangible assets at September 30, 2022 and December 31, 2021 (in thousands):\n\n| September 30, 2022 |\n| Gross CarryingValue | Accumulated Amortization | Total |\n| Intangible assets: |\n| Developed product rights for Auryxia | $ | 213,603 | $ | ( 132,508 ) | $ | 81,095 |\n| Total | $ | 213,603 | $ | ( 132,508 ) | $ | 81,095 |\n\n| December 31, 2021 |\n| Gross CarryingValue | AccumulatedAmortization | Total |\n| Intangible assets: |\n| Developed product rights for Auryxia | $ | 213,603 | $ | ( 105,476 ) | $ | 108,127 |\n| Total | $ | 213,603 | $ | ( 105,476 ) | $ | 108,127 |\n\nThe Company amortizes its definite-lived intangible assets using the straight-line method, which is considered the best estimate of economic benefit, over its estimated useful life of six years . The Company recorded $ 9.0 million in amortization expense related to the developed product rights for Auryxia during each of the three months ended September 30, 2022 and 2021, and $ 27.0 million during each of the nine months ended September 30, 2022 and 2021.\nGoodwill\nThe Company's goodwill results from the acquisition of Keryx in December 2018. Goodwill was $ 55.1 million as of September 30, 2022 and December 31, 2021. The Company operates in one operating segment which the Company considers to be the only reporting unit. Goodwill is evaluated for impairment at the reporting unit level on an annual basis as of October 1, and more frequently if indicators are present or changes in circumstances suggest that it is more likely than not that the fair value of the reporting unit is less than its carrying amount. Events that could indicate impairment and trigger an interim impairment assessment include, but are not limited to, an adverse change in current economic or market conditions, including a significant prolonged decline in market capitalization, a significant adverse change in legal factors, unexpected adverse business conditions, and an adverse action by a regulator. During the nine months ended September 30, 2022, the Company evaluated business factors, including the receipt of the CRL from the FDA for vadadustat, the Company's market capitalization as impacted by a recent decline in the Company's stock price, the impact of the Otsuka Termination Agreement on the Company's future cash flows, and the increase to the Company's excess purchase commitment liability to determine if there were events or changes in circumstance to indicate that the fair value of the reporting unit was less than its carrying value. The Company performed qualitative interim impairment assessments of the Company's goodwill balance as of each of the three months ended March 31, 2022, June 30, 2022, and September 30, 2022. The Company determined that it was not more likely than not that the fair value of the reporting unit was less than its carrying value and, therefore, did not perform a further quantitative interim impairment test for any period.\nThe Company's qualitative assessments were based on the Company's estimates and assumptions, a number of which are dependent on external factors and actual results may differ materially from these estimates. In addition, the future occurrence of events including, but not limited to, an adverse change in current economic and market conditions, including a significant prolonged decline in market capitalization, a significant adverse change in legal factors, unexpected adverse business conditions and an adverse action or assessment by a regulator could indicate potential impairment and trigger an interim impairment assessment of goodwill, which could result in an impairment of goodwill. As a result of the significance of goodwill, the Company's results of operations and financial position in a future period could be negatively impacted should an impairment test be triggered that results in an impairment of goodwill.\n10. Accrued Expenses\nAccrued expenses as of September 30, 2022 and December 31, 2021 are as follows:\n27\n| September 30, 2022 | December 31, 2021 |\n| (in thousands) |\n| Product revenue allowances | $ | 25,222 | $ | 26,624 |\n| Accrued clinical | 8,652 | 14,036 |\n| Amounts due to collaboration partners | 19,550 | 22,654 |\n| Accrued payroll and related | 9,140 | 15,863 |\n| Lease liability | 4,260 | 4,802 |\n| Royalties | 2,916 | 3,472 |\n| Professional fees | 1,725 | 1,899 |\n| Accrued commercial manufacturing | 3,167 | 3,843 |\n| Accrued restructuring | 4,238 | — |\n| Accrued other | 8,494 | 11,263 |\n| Total accrued expenses | $ | 87,364 | $ | 104,456 |\n\n11. Debt\nTerm Loans\nOn November 11, 2019, the Company, with Keryx as guarantor, entered into a loan agreement, or the Loan Agreement, with BioPharma Credit PLC as collateral agent and a lender, or the Collateral Agent, and BioPharma Credit Investments V (Master) LP as a lender, pursuant to which term loans in an aggregate principal amount of $ 100.0 million were made available to the Company in two tranches, subject to certain terms and conditions, or the Term Loans. BioPharma Credit PLC subsequently transferred its interest in the Term Loans, solely in its capacity as a lender, to its affiliate, BPCR Limited Partnership. The Collateral Agent and the lenders are collectively referred to as Pharmakon (see Note 1 to our condensed consolidated financial statements). The first tranche of $ 80.0 million, or Tranche A, was drawn on November 25, 2019, or the Tranche A Funding Date, and the second tranche of $ 20.0 million, or Tranche B, was drawn on December 10, 2020, or the Tranche B Funding Date. Each of the Tranche A Funding Date and the Tranche B Funding Date, a Funding Date.\nProceeds from the Term Loans may be used for general corporate purposes. The Company and Keryx entered into a Guaranty and Security Agreement with the Collateral Agent, or the Guaranty and Security Agreement, on the Tranche A Funding Date. Pursuant to the Guaranty and Security Agreement, the Company’s obligations under the Term Loans are unconditionally guaranteed by Keryx, or the Guarantee. Additionally, the obligations of the Company and Keryx under the Term Loans and the Guarantee are secured by a first priority lien on certain assets of the Company and Keryx, including Auryxia and certain related assets, cash, and certain equity interests held by the Company and Keryx, collectively the Collateral.\nThe Term Loans bear interest at a floating rate per annum equal to the three-month LIBOR rate plus 7.50 %, subject to a 2.00 % LIBOR floor and a 3.35 % LIBOR cap, payable quarterly in arrears. The Term Loans will mature on the fifth anniversary of the Tranche A Funding Date, or the Maturity Date. The Company will repay the principal under the Term Loans in equal quarterly payments starting on the 33 rd-month anniversary of the applicable Funding Date, or the Amortization Schedule. If certain conditions were met, it would have had the option to repay the principal in equal quarterly payments starting on the 48 th-month anniversary of the applicable Funding Date. One of these conditions was approval of vadadustat; however, the Company received the CRL from the FDA in March 2022 stating that the FDA had determined that it could not approve the NDA in its present form. Therefore, the Company is no longer eligible for this option to delay repayment of the principal under the Loan Agreement. As of September 30, 2022, the Company made its first quarterly principal payment under the Term Loans of $ 8.0 million. Under certain circumstances, unless certain liquidity conditions are met, the Maturity Date may decrease by up to one year , and the Amortization Schedule may correspondingly commence up to one year earlier.\nOn the Tranche A Funding Date, the Company paid to Pharmakon a facility fee equal to 2.00 % of the aggregate principal amount of the Term Loans, or $ 2.0 million, in addition to other expenses incurred by Pharmakon and reimbursed by the Company, or Lender Expenses. The Tranche A draw was $ 77.3 million, net of facility fee, Lender Expenses and issuance costs. The Tranche B draw was $ 20.0 million, net of immaterial Lender Expenses and issuance costs. The Loan Agreement permits voluntary prepayment at any time in whole or in part, subject to a prepayment premium. The prepayment premium would be 2.00 % of the principal amount being prepaid prior to the third anniversary of the applicable Funding Date, 1.00 % on or after the third anniversary, but prior to the fourth anniversary, of the applicable Funding Date, and 0.50 % on or after the fourth anniversary of the applicable Funding Date but prior to the Maturity Date, and a make-whole premium on or prior to the second\n28\nanniversary of the applicable Funding Date in an amount equal to foregone interest through the second anniversary of the applicable Funding Date. A change of control triggers a mandatory prepayment of the Term Loans.\nThe Loan Agreement contains customary representations, warranties, events of default and covenants of the Company and its subsidiaries, including maintaining, on an annual basis, a minimum liquidity threshold which started in 2021, and on a quarterly basis, a minimum net sales threshold for Auryxia which started in the fourth quarter of 2020. On February 18, 2022, the Loan Agreement was amended by the First Amendment and Waiver, which waived the provision under the Loan Agreement that required the Company to not be subject to any qualification as a going concern within the Company's 2021 Annual Report on Form 10-K. Pursuant to the First Amendment and Waiver, the Company's filings of Form 10-Q for fiscal quarters ending June 30, 2022 and September 30, 2022, and its future Annual Reports on Form 10-K, must not be subject to any qualification as to going concern, which requirement as to the Company's filings on Form 10-Q was waived in the Second Amendment and Waiver. If the Company does not satisfy the covenant as to going concern in any of these filings, the Company will be in default under the Loan Agreement. There is uncertainty as to whether or not the Company will meet its future annual debt covenants related to qualification as to going concern. If an event of default occurs and is continuing under the Loan Agreement, the Collateral Agent is entitled to take enforcement action, including acceleration of amounts due under the Loan Agreement. Therefore, as of September 30, 2022, the Company continued to classify the borrowings under the Loan Agreement as current. Under certain circumstances, a default interest rate will apply on all outstanding obligations during the occurrence and continuance of an event of default. As of September 30, 2022 and December 31, 2021, the Company determined that no events of default had occurred.\nOn July 15, 2022, or the Effective Date, the Company and Pharmakon entered into the Second Amendment and Waiver, or the Second Amendment and Waiver, which amended and waived certain provisions of the Loan Agreement, as amended by the First Amendment and Waiver.\nPursuant to the Second Amendment and Waiver, on the Effective Date, the Company made a $ 5.0 million prepayment of the principal of the tranche A loan, or the Second Amendment Effective Date Tranche A Prepayment, and a $ 20.0 million prepayment of principal of the tranche B loan, or the Second Amendment Effective Date Tranche B Prepayment, in each case, together with any and all accrued and unpaid interest on such prepayments of principal to the Effective Date. In connection therewith, the Company also paid $ 0.5 million in prepayment premiums under the Loan Agreement. During each of the three and nine months ended September 30, 2022, the Company recorded a debt extinguishment loss of $ 0.9 million. Subject to the payment in full of the Second Amendment Effective Date Tranche A Prepayment and the Second Amendment Effective Date Tranche B Prepayment, Pharmakon agreed to, among other things, (1) increase the amount of the working capital facility established in connection with the Company’s Second Amended and Restated License Agreement with Vifor Pharma, which facility is part of the definition of Permitted Indebtedness (as such term is defined in the Loan Agreement) under the Loan Agreement, that the Company is permitted to repay to Vifor Pharma without causing an acceleration of the liabilities under the Loan Agreement, (2) waive the requirement that the Company’s Quarterly Reports on Form 10-Q for the fiscal quarters ending June 30, 2022 and September 30, 2022 not be subject to any qualification as to going concern, and (3) waive certain amounts payable under the Loan Agreement in connection with the Second Amendment Effective Date Tranche B Prepayment. Future principal payments pursuant to the contractual terms of the Loan Agreement, as amended by the Second Amendment and Waiver, are as follows (in thousands):\n| Principal |\n| Payments |\n| (in thousands) |\n| 2022 | $ | — |\n| 2023 | 32,000 |\n| 2024 | 35,000 |\n| Total before unamortized discount and issuance costs | 67,000 |\n| Less: unamortized discount and issuance costs | ( 1,053 ) |\n| Total term loans | $ | 65,947 |\n\nThe Company assessed the terms and features of the Loan Agreement in order to identify any potential embedded features that would require bifurcation or any beneficial conversion feature. As part of this analysis, the Company assessed the economic characteristics and risks of the Loan Agreement, including put and call features. The terms and features assessed include a potential extension to the interest-only period dependent on both no event of default having occurred and continuing and the Company achieving certain regulatory and revenue conditions. The Company also assessed the acceleration of the obligations under the Loan Agreement under an event of default. In addition, under certain circumstances, a default interest rate will apply\n29\non all outstanding obligations during the occurrence and continuance of an event of default. In accordance with ASC 815, the Company concluded that these features are not clearly and closely related to the host instrument, and represent a single compound derivative that is required to be re-measured at fair value on a quarterly basis.\nThe fair value of the derivative liability related to the Company’s Loan Agreement with Pharmakon was $ 0.8 million and $ 1.8 million as of September 30, 2022 and December 31, 2021, respectively. The Company classified the derivative liability as a non-current liability on the unaudited condensed consolidated balance sheet as of September 30, 2022.\nThe Company recognized interest expense related to the Loan Agreement of $ 2.1 million and $ 2.7 million during the three months ended September 30, 2022 and 2021, respectively, and $ 7.5 million and $ 8.1 million for the nine months ended September 30, 2022 and 2021, respectively.\n12. Stockholders’ Equity\nAuthorized and Outstanding Capital Stock\nOn June 5, 2020, the Company filed a Certificate of Amendment to its Ninth Amended and Restated Certificate of Incorporation, or its Charter, to increase the number of authorized shares of common stock from 175,000,000 to 350,000,000 . As of September 30, 2022, the authorized capital stock of the Company included 350,000,000 shares of common stock, par value $ 0.00001 per share, of which 183,951,583 and 177,000,963 shares were issued and outstanding as of September 30, 2022 and December 31, 2021, respectively; and 25,000,000 shares of undesignated preferred stock, par value $ 0.00001 per share, of which no shares were issued and outstanding as of September 30, 2022 and December 31, 2021.\nAt-the-Market Facility\nOn March 12, 2020, the Company filed a prospectus supplement relating to the Company's sales agreement with Cantor Fitzgerald & Co., or the Prior Sales Agreement, pursuant to which it was able to offer and sell up to $ 65.0 million of its common stock at current market prices from time to time. Through December 31, 2020, the Company sold 3,509,381 shares of common stock under this program with net proceeds (after deducting commissions and other offering expenses) of $ 10.6 million. During the three months ended March 31, 2021, the Company sold 5,224,278 shares of common stock under this program with net proceeds (after deducting commissions and other offering expenses) of $ 15.9 million.\nOn February 25, 2021, the Company filed a prospectus relating to the Prior Sales Agreement with its new shelf registration statement (which replaced the prior shelf registration statement and the sales agreement prospectus supplement), pursuant to which it was able to offer and sell up to $ 100.0 million of its common stock at current market prices from time to time. Through December 31, 2021, the Company sold 21,128,065 shares of common stock under this program with net proceeds (after deducting commissions and other offering expenses) of $ 72.4 million. On March 1, 2022, the Company filed a prospectus relating to the Prior Sales Agreement, pursuant to which it was authorized to offer and sell up to $ 25.3 million of its common stock at current market prices from time to time. On March 16, 2022, the Company terminated the Prior Sales Agreement. During the three months ended March 31, 2022, the Company sold 404,600 shares of common stock under this program with net proceeds (after deducting commissions and other offering expenses) of $ 0.8 million.\nOn April 7, 2022, the Company entered into an Open Market Sale AgreementSM, or the Sales Agreement, with Jefferies LLC, or Jefferies, as agent, for the offer and sale of common stock at current market prices in amounts to be determined from time to time. Also, on April 7, 2022, the Company filed a prospectus supplement relating to the Sales Agreement, pursuant to which it is able to offer and sell under the Sales Agreement up to $ 26.0 million of its common stock at current market prices from time to time. From the date of filing of the prospectus supplement through the date of the filing of this Quarterly Report on Form 10-Q, the Company has not sold any shares of its common stock under this program.\nEquity Plans\nThe Company maintains one stock incentive plan, the 2014 Incentive Plan, or the 2014 Plan, as well as the 2014 Employee Stock Purchase Plan, or the 2014 ESPP. The 2014 Plan replaced the Company’s Amended and Restated 2008 Equity Incentive Plan, or the 2008 Plan, however, options or other awards granted under the 2008 Plan prior to the adoption of the 2014 Plan that have not been settled or forfeited remain outstanding and effective. On June 6, 2019, the Company’s stockholders approved the Amended and Restated 2014 Employee Stock Purchase Plan, or the ESPP. The Company also maintains an inducement award program that is separate from the Company's equity plans under which inducement awards may be granted consistent with Nasdaq Listing Rule 5635(c)(4). During the nine months ended September 30, 2022, the Company granted 400,000 options to purchase shares of the Company’s common stock to new hires as inducements material to such employees' entering into employment with the Company, of which 266,000 options remained outstanding as of September 30, 2022.\n30\nThe 2014 Plan allows for the granting of stock options, stock appreciation rights, or SARs, restricted stock, unrestricted stock, RSUs, performance awards and other awards convertible into or otherwise based on shares of the Company’s common stock. Dividend equivalents may also be provided in connection with an award under the 2014 Plan. The Company’s employees, officers, directors and consultants and advisors are eligible to receive awards under the 2014 Plan. The Company initially reserved 1,785,000 shares of its common stock for the issuance of awards under the 2014 Plan. The 2014 Plan provides that the number of shares reserved and available for issuance under the 2014 Plan will automatically increase annually on January 1 of each calendar year, by an amount equal to three percent ( 3 %) of the number of the Company's outstanding shares on a fully diluted basis as of the close of business on the immediately preceding December 31, or the 2014 Plan Evergreen Provision. The Company’s Board of Directors may act prior to January 1 of any year to provide that there will be no automatic increase in the number of Akebia Shares available for grant under the 2014 Plan for that year (or that the increase will be less than the amount that would otherwise have automatically been made). On December 12, 2018, in connection with the consummation of the Merger, the Company assumed outstanding and unexercised options to purchase Keryx's stock, as adjusted by the Exchange Multiplier pursuant to the terms of the Merger Agreement, under the following Keryx equity plans, or the Keryx Equity Plans: the Keryx 1999 Share Option Plan, the Keryx 2004 Long-Term Incentive Plan, the Keryx 2007 Incentive Plan, the Keryx Amended and Restated 2013 Incentive Plan, and the Keryx 2018 Equity Incentive Plan, or the Keryx 2018 Plan. In addition, the number of Keryx Shares available for issuance under the Keryx 2018 Plan, as adjusted by the Exchange Multiplier pursuant to the terms of the Merger Agreement, may be used for awards granted by the Company under its 2014 Plan, or the Assumed Shares, provided that the Company uses the Assumed Shares for individuals who were not employees or directors of the Company prior to the consummation of the Merger.\nThe Company grants annual service-based stock options to employees under the 2014 Plan. During the nine months ended September 30, 2022, the Company issued 3,233,500 options to employees under the 2014 Plan. In addition, the Company issues stock options to directors, new hires and occasionally to other employees not in connection with the annual grant process. During the nine months ended September 30, 2022, the Company issued 140,700 options to directors under the 2014 Plan. Options granted by the Company generally vest over periods of between 12 and 48 months, subject, in each case, to the individual’s continued service through the applicable vesting date. Options generally vest either 100 % on the first anniversary of the grant date or in installments of (i) 25 % at the one year anniversary and (ii) 12 equal quarterly installments beginning after the one year anniversary of the grant date, subject to the individual’s continuous service with the Company. Options generally expire 10 years after the date of grant.\nThe Company also grants performance-based stock options to employees under the 2014 Plan. The Company issued 400,000 performance-based stock options under the 2014 Plan during the nine months ended September 30, 2022. The performance-based stock options granted by the Company generally vest in connection with the achievement of specified commercial and regulatory milestones. The performance-based stock options also generally feature a time-based vesting component. The expense recognized for these awards is based on the grant date fair value of the Company’s common stock multiplied by the number of options granted and recognized over time based on the probability of meeting such commercial and regulatory milestones.\nThe Company also grants annual service-based restricted stock units, or RSUs, to employees and directors under the 2014 Plan. The Company also occasionally issues RSUs not in connection with the annual grant process to employees and directors. During the nine months ended September 30, 2022, the Company issued 5,216,908 RSUs to employees and 95,900 RSUs to directors under the 2014 Plan. Generally, RSUs granted by the Company vest in one of the following ways: (i) 100 % of each RSU grant vests on the first anniversary of the grant date, (ii) one third of each RSU grant vests on the first, second and third anniversaries of the grant date, (iii) 50 % of each RSU grant vests on the first anniversary and 25 % of each RSU grant vests every six months after the one year anniversary of the grant date, or (iv) one third of each RSU grant vests on the first anniversary and the remaining two thirds vests in eight substantially equal quarterly installments beginning after the one year anniversary, subject, in each case, to the individual’s continued service through the applicable vesting date. The expense recognized for these awards is based on the grant date fair value of the Company’s common stock multiplied by the number of units granted and recognized on a straight-line basis over the vesting period.\nThe Company also grants performance-based restricted stock units, or PSUs, to employees under the 2014 Plan. The Company issued 400,000 PSUs during the nine months ended September 30, 2022. The PSUs granted by the Company generally vest in connection with the achievement of specified commercial, regulatory and corporate milestones. The PSUs also generally feature a time-based vesting component. The expense recognized for these awards is based on the grant date fair value of the Company’s common stock multiplied by the number of units granted and recognized over time based on the probability of meeting such commercial, regulatory and corporate milestones.\nThe ESPP provides for the issuance of options to purchase shares of the Company’s common stock to participating employees at a discount to their fair market value. As noted above, the Company’s stockholders approved the ESPP, which amended and restated the Company’s 2014 ESPP, on June 6, 2019. As of September 30, 2022, the maximum aggregate number of shares of\n31\nthe Company’s common stock available for future issuance under the ESPP is 4,837,995 . Under the ESPP, each offering period is six months , at the end of which employees who elect to purchase shares of the Company’s common stock through payroll deductions made over the term of the offering. The per-share purchase price at the end of each offering period is equal to the lesser of eighty-five percent ( 85 %) of the closing price of the Company’s common stock at the beginning or end of the offering period. The Company issued 335,146 shares under the ESPP during the nine months ended September 30, 2022.\n13. Commitments and Contingencies\nLeases\nThe Company leases approximately 65,167 square feet of office and lab space in Cambridge, Massachusetts under a lease which was most recently amended in November 2020, collectively the Cambridge Lease. Under the Third Amendment to the Cambridge Lease, or the Third Amendment, executed in July 2016, total monthly lease payments under the initial base rent were approximately $ 242,000 and are subject to annual rent escalations. In addition to such annual rent escalations, base rent payments for a portion of said premises commenced on January 1, 2017 in the monthly amount of approximately $ 22,000 . The Fourth Amendment to the Cambridge Lease, executed in May 2017, provided additional storage space to the Company and did not impact rent payments. In April 2018, the Company entered into a Fifth Amendment to the Cambridge Lease, or the Fifth Amendment, for an additional 19,805 square feet of office space on the 12th floor. Monthly lease payments for the existing 45,362 square feet of office and lab space, under the Third Amendment, remain unchanged. The new space leased by the Company was delivered in September 2018 and additional monthly lease payments of approximately $ 135,000 commenced in February 2019 and are subject to annual rent escalations, which commenced in September 2019. In November 2020, the Company entered into a Sixth Amendment to the Cambridge Lease, or the Sixth Amendment, to extend the term of the Cambridge Lease with respect to the lab space from November 30, 2021 to January 31, 2025. The Sixth Amendment includes two months of free rent starting in December 2020 and additional monthly lease payments of approximately $ 48,000 , which commenced in December 2021, and is subject to annual rent escalations, which commence in December 2022.\nAdditionally, as a result of the Merger, the Company has a lease for 27,300 square feet of office space in Boston, Massachusetts, or the Boston Lease. The total monthly lease payments under the initial base rent were approximately $ 136,000 and are subject to annual rent escalations. In February 2022, the Company entered into the First Amendment to the Boston Lease, or the First Lease Amendment, to extend the term of the Boston Lease from February 2023 to July 2031. The First Lease Amendment includes five months of free rent starting in March 2023 and monthly lease payments of $ 200,122 commencing on August 1, 2023, with an annual rent escalation of approximately 2 % commencing on August 1, 2024. The First Lease Amendment also includes a landlord's allowance for certain leasehold improvements to the premises in an amount of up to $ 1,954,680 , provided that such allowance must be used prior to August 1, 2024.\nThe term of the Cambridge Lease with respect to the office space expires on September 11, 2026, with one five-year extension option available. The term of the Boston Lease office space expires on July 31, 2031, with an extension option for one additional five-year term available. The renewal options in these real estate leases were not included in the calculation of the operating lease assets and operating lease liabilities as the renewal is not reasonably certain. The term of the Cambridge Lease with respect to the lab space expires on January 31, 2025, with an extension option for one additional period through September 11, 2026. The renewal option in this real estate lease was included in the calculation of the operating lease assets and operating lease liabilities as the renewal is reasonably certain. The lease agreements do not contain residual value guarantees. Operating lease costs were $ 1.8 million and $ 1.7 million for the three months ended September 30, 2022 and 2021, respectively, and $ 5.4 million and $ 5.0 million for the nine months ended September 30, 2022 and 2021, respectively. Cash paid for amounts included in the measurement of operating lease liabilities was $ 1.8 million for each of the three months ended September 30, 2022 and 2021 and $ 5.5 million and $ 5.3 million for the nine months ended September 30, 2022 and 2021, respectively.\nIn September 2019, Keryx entered into an agreement to sublease the Boston office space to Foundation Medicine, Inc., or Foundation. The sublease is subject and subordinate to the Boston Lease between Keryx and the landlord. The term of the sublease commenced on October 16, 2019, upon receipt of the required consent from the landlord for the sublease agreement, and expires on February 27, 2023. Foundation is obligated to pay Keryx rent that approximates the rent due from Keryx to its landlord with respect to the Boston Lease. Sublease rental income is recorded to other income. Keryx continues to be obligated for all payment terms pursuant to the Boston Lease, and the Company will guaranty Keryx’s obligations under the sublease. Keryx recorded $ 0.5 million and $ 0.4 million in sublease rental income from Foundation during the three months ended September 30, 2022 and 2021, respectively, and $ 1.4 million and $ 1.3 million during the nine months ended September 30, 2022 and 2021, respectively.\nThe Company has not entered into any material short-term leases or financing leases as of September 30, 2022.\n32\nThe total security deposit in connection with the Cambridge Lease is $ 1.6 million as of September 30, 2022. Additionally, the Company recorded $ 1.4 million for the security deposit under the Boston Lease. Both the Cambridge Lease and the Boston Lease have their security deposits in the form of a letter of credit, all of which are included as restricted cash in other assets in the Company’s unaudited condensed consolidated balance sheets as of September 30, 2022.\nAs of September 30, 2022, undiscounted minimum rental commitments under non-cancelable leases, for each of the next five years and total thereafter are as follows:\n| OperatingLeases | Lease Paymentsto be Receivedfrom Sublease | Net OperatingLease Payments |\n| (in thousands) |\n| Remaining 2022 | $ | 1,837 | $ | 461 | $ | 1,376 |\n| 2023 | 6,954 | 307 | 6,647 |\n| 2024 | 8,167 | — | 8,167 |\n| 2025 | 8,293 | — | 8,293 |\n| 2026 | 6,571 | — | 6,571 |\n| Thereafter | 12,200 | — | 12,200 |\n| Total | $ | 44,022 | $ | 768 | $ | 43,254 |\n\nIn arriving at the operating lease liabilities, the Company applied incremental borrowing rates ranging from 6.65 % to 7.25 %, which were based on the remaining lease term at either the date of adoption of ASC 842 or the effective date of any subsequent lease term extensions. As of September 30, 2022, the remaining lease terms ranged from 3.95 years to 8.84 years. As of September 30, 2022, the following represents the difference between the remaining undiscounted minimum rental commitments under non-cancelable leases and the operating lease liabilities:\n\n| Operating Leases |\n| (in thousands) |\n| Undiscounted minimum rental commitments | $ | 44,022 |\n| Present value adjustment using incremental borrowing rate | ( 8,733 ) |\n| Operating lease liabilities | $ | 35,289 |\n\nManufacturing Agreements\nAs a result of the Merger, the Company's contractual obligations include Keryx’s commercial supply agreements with BioVectra Inc., or BioVectra, and Siegfried Evionnaz SA, or Siegfried, to supply commercial drug substance for Auryxia.\nPursuant to the Manufacture and Supply Agreement with BioVectra and the Product Manufacture and Supply and Facility Construction Agreement with BioVectra, the Company agreed to purchase minimum quantities of Auryxia drug substance annually at predetermined prices. On September 4, 2020, the Company and BioVectra entered into an Amended and Restated Product Manufacture and Supply and Facility Construction Agreement, which provided for reduced minimum quantity commitments and revised the predetermined prices. The price per kilogram decreases with an increase in quantity above the predetermined purchase quantity tiers. In addition, the Manufacture and Supply Agreement with BioVectra and the Amended and Restated Product Manufacture and Supply and Facility Construction Agreement with BioVectra, require the Company to reimburse BioVectra for certain costs in connection with construction of a new facility for the manufacture and supply of Auryxia drug substance. These construction costs are recorded in other assets and amortized into drug substance as inventory is released to the Company from BioVectra. The term of the Manufacture and Supply Agreement with BioVectra expires on December 31, 2022. The term of the Amended and Restated Product Manufacture and Supply and Facility Construction Agreement expires on December 31, 2026, after which it automatically renews for successive one-year terms unless either party gives notice of its intention to terminate within a specified time prior to the end of the then-current term. In addition, the Company and BioVectra each have the ability to terminate these agreements upon the occurrence of certain conditions. As of September 30, 2022, the Company is required to reimburse BioVectra for certain costs in connection with the construction of the new facility and to purchase minimum quantities of Auryxia drug substance annually for a total cost of approximately $ 74.8 million through the end of the contract term.\nPursuant to the Siegfried Master Manufacturing Services and Supply Agreement, as amended (the most recent amendment having been executed on February 11, 2021), or the Siegfried Agreement, the Company has agreed to purchase a minimum\n33\nquantity of drug substance of Auryxia at predetermined prices. The price per kilogram will decrease with an increase in quantity above the minimum purchase quantity. The term of the Siegfried Agreement expires on December 31, 2022, subject to the Company's option to extend the term through December 31, 2023 by providing 12 months’ prior written notice to Siegfried. The Siegfried Agreement provides the Company and Siegfried with certain early termination rights. In the first quarter of 2022, the Company notified Siegfried that the Company had elected not to exercise the option to extend the term of the Siegfried Agreement through December 31, 2023. As of September 30, 2022, the Company is required to purchase a minimum quantity of drug substance for Auryxia annually at a total cost of approximately $ 9.9 million through the year ending December 31, 2022.\nCertain of the Company's commercial supply agreements are executory contracts between Keryx and its contract manufacturers for Auryxia, which include future firm purchase commitments. These executory contracts were deemed to have an off-market element related to the amount of purchase commitments that exceed the current forecast. The Company regularly reviews its estimate of the excess purchase commitment liability including a review of assumptions of expected future demand, estimates of anticipated expiry of inventory under firm purchase commitments that are estimated to expire before they could be sold as well as any modifications to supply agreements during each reporting period. The excess purchase commitment liability relating to these executory contracts was $ 74.3 million and $ 76.7 million as of September 30, 2022 and December 31, 2021, respectively. During the quarter ended September 30, 2022, the Company increased the excess purchase commitment liability and recorded a $ 13.2 million charge to cost of goods sold as a result of a routine long-term forecast update and continued declines in the binder market and a reduction in its contractual purchase commitment with a supplier. During the quarter ended September 30, 2022, the Company also reduced the excess purchase commitment liability by $ 5.8 million for inventory received that had previously been identified as excess. The Company considered whether the increase in the excess purchase commitment liability was a potential indicator of impairment of the Auryxia asset group as of September 30, 2022. As part of its assessment, the Company reviewed the Auryxia net sales and estimated future cash flows included in its forecast and concluded that the increase in excess purchase commitment liability was not an indicator of impairment of the Auryxia asset group as of September 30, 2022. During the quarter ended June 30, 2022, the Company reduced the excess purchase commitment liability by $ 5.8 million for inventory received that had been previously identified as excess. During the quarter ended March 31, 2022, the Company recorded a $ 0.8 million reduction to the excess purchase commitments liability within cost of goods sold and reduced the excess purchase commitment liability by $ 3.2 million for inventory received that had previously been identified as excess.\nOn April 9, 2019, the Company entered into a Supply Agreement with Esteve Química, S.A., or Esteve, or the Esteve Agreement. The Esteve Agreement includes the terms and conditions under which Esteve will manufacture vadadustat drug substance for commercial use. Pursuant to the Esteve Agreement, the Company provides rolling forecasts to Esteve on a quarterly basis, or the Esteve Forecast. The Esteve Forecast reflects the Company’s needs for vadadustat drug substance produced by Esteve over a certain number of months, represented as a quantity of vadadustat drug substance per calendar quarter. The parties have agreed to a volume-based pricing structure under the Esteve Agreement. The Esteve Agreement has an initial term of four years , beginning April 9, 2019 and ending April 9, 2023. Pursuant to the Esteve Agreement, the Company has agreed to purchase a certain percentage of the global demand for vadadustat drug substance from Esteve. As of September 30, 2022, the Company has committed to purchase $ 26.9 million of vadadustat drug substance from Esteve through the second quarter of 2023.\nOn March 11, 2020, the Company entered into a Supply Agreement with Patheon Inc., or Patheon, or the Patheon Agreement. The Patheon Agreement includes the terms and conditions under which Patheon will manufacture vadadustat drug product for commercial use. Pursuant to the Patheon Agreement, the Company provides Patheon a long-term forecast on an annual basis, as well as short-term forecasts on a quarterly basis, or the Patheon Forecast. The Patheon Forecast reflects the Company’s needs for commercial supply of vadadustat drug product produced by Patheon, represented as a quantity of drug product per calendar quarter. The parties have agreed to a volume-based pricing structure under the Patheon Agreement. The Patheon Agreement has an initial term, which began on March 11, 2020 and ends on June 30, 2023. Pursuant to the Patheon Agreement, the Company has agreed to purchase a certain percentage of the global demand for vadadustat drug product from Patheon. As of September 30, 2022, the Company had a minimum commitment with Patheon for $ 3.2 million through the fourth quarter of 2022.\nOn April 2, 2020, the Company entered into a Supply Agreement with STA Pharmaceutical Hong Kong Limited, a subsidiary of WuXi AppTec, or WuXi STA, as amended on April 15, 2021, or the WuXi STA DS Agreement. The WuXi STA DS Agreement includes the terms and conditions under which WuXi STA will manufacture vadadustat drug substance for commercial use. Pursuant to the WuXi STA DS Agreement, the Company provides rolling forecasts to WuXi STA on a quarterly basis, or the WuXi STA DS Forecast. The WuXi STA DS Forecast reflects the Company’s needs for vadadustat drug substance produced by WuXi STA over a certain number of quarters. The parties have agreed to a volume-based pricing structure under the WuXi STA DS Agreement. The WuXi STA DS Agreement has an initial term of four years , beginning April 2, 2020 and ending April 2, 2024. Pursuant to the WuXi STA DS Agreement, the Company has agreed to purchase a certain percentage of the global demand for vadadustat drug substance from WuXi STA. As of September 30, 2022, the Company has committed to purchase $ 19.2 million of vadadustat drug substance from WuXi STA through the end of 2023.\n34\nOn February 10, 2021, the Company entered into a Supply Agreement with WuXi STA, or the WuXi STA DP Agreement. The WuXi STA DP Agreement includes the terms and conditions under which WuXi STA will manufacture and supply vadadustat drug product for commercial purposes. Pursuant to the WuXi STA DP Agreement, the Company will provide rolling forecasts to WuXi STA on a quarterly basis, or the WuXi STA DP Forecast. Each WuXi STA DP Forecast will reflect the quantities of vadadustat drug product that the Company expects to order from WuXi STA over a certain number of months, represented as a quantity of vadadustat drug product per calendar quarter. Pursuant to the WuXi STA DP Agreement, the Company has agreed to purchase a certain percentage of global demand for vadadustat drug product from WuXi STA. The parties have agreed to a volume-based pricing structure under the WuXi STA DP Agreement. The vadadustat drug product price will remain fixed for the first 12 months and thereafter shall be annually reviewed by the Company and WuXi STA. The Company will also reimburse WuXi STA for certain reasonable expenses. The WuXi STA DP Agreement has an initial term of four years , beginning February 10, 2021 and ending February 10, 2025.\nOther Third-Party Contracts\nUnder the Company’s agreement with IQVIA to provide contract research organization services for the PRO2TECT and INNO2VATE programs, the total remaining contract costs as of September 30, 2022 were approximately $ 4.6 million. Substantive performance for the committed work with IQVIA was completed in 2020 and close out activities will be performed throughout 2022. The Company also contracts with various other organizations to conduct research and development activities with remaining contract costs to the Company of approximately $ 176.3 million at September 30, 2022. The scope of the services under these research and development contracts can be modified and the contracts cancelled by the Company upon written notice. In some instances, the contracts may be cancelled by the third party upon written notice.\nLitigation and Related Matters\nFrom time to time, the Company may become subject to legal proceedings and claims which arise in the ordinary course of its business. Consistent with ASC 450, Contingencies, the Company’s policy is to record a liability if a loss in a significant legal dispute is considered probable and an amount can be reasonably estimated. The Company provides disclosure when a loss in excess of any reserve is reasonably possible, and if estimable, the Company discloses the potential loss or range of possible loss. Significant judgment is required to assess the likelihood of various potential outcomes and the quantification of loss in those scenarios. The Company’s estimates change as litigation progresses and new information comes to light. Changes in Company estimates could have a material impact on the Company’s results and financial position. As of September 30, 2022, the Company does not have any significant legal disputes that require a loss liability to be recorded. The Company continually monitors the need for a loss liability for litigation and related matters.\n14. Net Loss per Share\nFor purposes of the diluted net loss per share calculation, preferred stock, stock options, warrants, restricted stock and RSUs are considered to be common stock equivalents and have been excluded from the calculation of diluted net loss per share, as their effect would be anti-dilutive for periods presented. Therefore, basic and diluted net loss per share were the same for all periods presented in the unaudited condensed consolidated statement of operations and comprehensive loss. The shares in the table below were excluded from the calculation of diluted net loss per share, prior to the use of the treasury stock method, due to their anti-dilutive effect:\n| As of September 30, |\n| 2022 | 2021 |\n| Warrant | — | 509,611 |\n| Outstanding stock options | 11,844,609 | 11,593,539 |\n| Unvested restricted stock units | 6,971,930 | 5,378,916 |\n| Total | 18,816,539 | 17,482,066 |\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nThe following information should be read in conjunction with our unaudited condensed consolidated financial statements and related notes included in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2021 filed with the U.S. Securities and Exchange Commission, or the SEC, on March 1, 2022, or the 2021 Annual Report on Form 10-K, including the audited consolidated financial statements and related notes therein. This discussion and analysis contains forward-looking statements that involve significant risks and uncertainties. As a result of many factors, such as those set forth under “Risk Factors” in Part II, Item 1A. of this Quarterly Report on Form 10-Q, our actual results may differ materially from those anticipated in these forward-looking statements.\n35\nBusiness Overview\nWe are a biopharmaceutical company with the purpose of bettering the life of each person impacted by kidney disease. Since our initial public offering in 2014, we have built a business focused on developing and commercializing innovative renal therapeutics that we believe serves as a foundation for future growth. We established ourselves as a leader in the kidney community, and we remain committed to our purpose as we believe our current and future products have the ability to deliver value. Our current portfolio includes a commercial product and a late-stage investigational product candidate:\n•Auryxia® (ferric citrate) is approved and marketed in the United States for two indications: (1) the control of serum phosphorus levels in adult patients with chronic kidney disease, or CKD, on dialysis, or DD-CKD, or the Hyperphosphatemia Indication, and (2) the treatment of iron deficiency anemia, or IDA, in adult patients with CKD not on dialysis, or NDD-CKD, or the IDA Indication. Ferric citrate is also approved and marketed in Japan as an oral treatment the improvement of hyperphosphatemia in adult patients with CKD, including DD-CKD and NDD-CKD, and for the treatment of patients with IDA under the trade name Riona (ferric citrate hydrate). Auryxia is our only product approved for sale in the United States and it generated approximately $42.2 million and $36.8 million in revenue from U.S. product sales during the three months ended September 30, 2022 and 2021, respectively.\n•Vadadustat is an investigational oral hypoxia-inducible factor prolyl hydroxylase, or HIF-PH, inhibitor designed to mimic the physiologic effect of altitude on oxygen availability. At higher altitudes, the body responds to lower oxygen availability with stabilization of hypoxia-inducible factor, or HIF, which stimulates erythropoietin, or EPO, production and can lead to red blood cell, or RBC, production and improved oxygen delivery to tissues. The significance of the HIF pathway was recognized by the 2019 Nobel Prize and the 2016 Albert Lasker Basic Medical Research Award, which honored the three physician-scientists who discovered the HIF pathway and elucidated this primary oxygen sensing mechanism that is essential for survival.\nOn March 29, 2022, we received a complete response letter, or CRL, from the U.S. Food and Drug Administration, or FDA. The CRL provided that the FDA had completed its review of our new drug application, or NDA, for vadadustat for the treatment of anemia due to CKD in adult patients, and determined that it could not approve the NDA in its present form. In July 2022, we held an end of review meeting with the FDA to inform the Company's next steps with respect to the potential U.S. approval of vadadustat, if any, and in October 2022, we submitted a Formal Dispute Resolution Request, or FDRR, to the FDA. The FDRR focuses on the favorable balance between the benefits and risks of vadadustat for the treatment of anemia due to CKD in adult patients on dialysis in light of safety concerns expressed by the FDA in the CRL related to the rate of adjudicated thromboembolic events driven by vascular access thrombosis for vadadustat compared to the active comparator and the risk of drug-induced liver injury. Based on the typical FDRR process, we expect to receive a response to the FDRR from the FDA by the end of 2022. Also, on April 1, 2022, we were notified by the FDA that the FDA had placed a partial clinical hold on our clinical trials of vadadustat in pediatric patients with anemia due to CKD in the United States. In addition, in May 2022, the Paediatric Committee of the European Medicines Agency, or the EMA, recommended that we not initiate such clinical trials in the European Union until the safety issues identified by the FDA in the CRL were addressed. As a result of the partial clinical hold and the EMA’s recommendations, all activities in the United States and Europe for and related to our clinical trials of vadadustat in pediatric patients were suspended.\nOur former collaboration partner, Otsuka Pharmaceutical Co. Ltd., or Otsuka, submitted a Marketing Authorization Application, or MAA, for vadadustat for the treatment of anemia due to CKD in both DD-CKD and NDD-CKD adult patients to the EMA, in October 2021, and in each of the United Kingdom, Switzerland, and Australia in the first quarter of 2022. On June 30, 2022, we and Otsuka entered into a Termination and Settlement Agreement, or the Termination Agreement, and pursuant to the Termination Agreement, Otsuka has transferred the MAAs for vadadustat with the EMA, and in the United Kingdom, Switzerland and Australia to us. Based on the current review timeline, we expect a decision on the MAA from EMA in the first quarter of 2023. As vadadustat did not meet the PRO2TECT program's primary safety endpoint, we are remaining cautious in our outlook for potential approval of vadadustat in NDD-CKD adult patients in Europe, the United Kingdom, Switzerland and Australia.\nIn June of 2020, we announced the first regulatory approval of vadadustat for the treatment of anemia due to CKD in DD-CKD and NDD-CKD adult patients in Japan. Our collaboration partner in Japan, Mitsubishi Tanabe Pharma Corporation, or MTPC, commenced commercial sales of vadadustat in Japan under the trade name, VafseoTM, in August 2020. In addition, MTPC filed new drug applications for vadadustat for the treatment of anemia due to CKD in adult patients in Taiwan in January of 2022 and in Korea in March 2022.\n36\nIn August of 2022, we announced initial findings from an investigator-sponsored clinical study by The University of Texas Health Science Center at Houston, or UTHealth, in Houston, Texas, evaluating the use of vadadustat as a potential therapy to prevent and treat acute respiratory distress syndrome, or ARDS, in patients with COVID-19 and hypoxemia, or the VSTAT Study. The VSTAT Study was a phase 2, randomized, double-blind, placebo-controlled study conducted by UTHealth and partially funded by Akebia. UTHealth was awarded $5.1 million in funding from the U.S. Department of Defense for the study. The VSTAT Study enrolled 449 adult patients at 5 hospitals who were randomized 1:1 to vadadustat 900mg or placebo once per day orally for up to 14 days while hospitalized. The VSTAT Study measured the proportion of patients with either 6 (non-invasive ventilation or high flow oxygen devices), 7 (invasive mechanical ventilation or extracorporeal membrane oxygenation), or 8 (death) on the National Institute of Allergy and Infectious Disease Ordinal Scale, or NIAID-OS, at Day 14 (primary) and Day 7. While a smaller proportion of patients in the vadadustat group had a score of 6, 7, or 8 on the NIAID-OS than in the placebo group at Day 14, the trial failed to meet its primary superiority threshold of >95% probability. Those receiving vadadustat, however, did demonstrate 94% probability of conferring benefit on the NIAID-OS at Day 14. While the VSTAT Study missed the primary endpoint, we are encouraged by the data and believe the data supports further development of vadadustat as a potential treatment for ARDS due to COVID-19 or other causes.\nIf we are successful in addressing the deficiencies noted in the CRL and in the event we receive FDA approval of vadadustat in the United States, we plan to commercialize vadadustat in the United States with our well-established, nephrology-focused commercial organization, which we may expand if vadadustat is approved. In addition, in February 2022, we entered into a Second Amended and Restated License Agreement, or the Vifor Second Amended Agreement, with Vifor (International) Ltd., or Vifor Pharma, which amended and restated the Amended and Restated License Agreement, dated April 8, 2019, or the Vifor First Amended Agreement. Pursuant to the Vifor Second Amended Agreement, we granted Vifor Pharma an exclusive license to sell vadadustat to Fresenius Medical Care North America and its affiliates, including Fresenius Kidney Care Group LLC, to certain third-party dialysis organizations approved by us, to independent dialysis organizations that are members of group purchase organizations, and to certain non-retail specialty pharmacies in the United States, or the Territory. We refer to Fresenius Medical Care North America and its affiliates, these organizations and specialty pharmacies collectively as the \"Supply Group\". We currently retain rights to commercialize vadadustat for use in the non-dialysis dependent CKD market and to sell to dialysis organizations outside of the Supply Group. During the term of the Vifor Second Amended Agreement, Vifor Pharma is not permitted to sell any HIF product that competes with vadadustat in the Territory to the Supply Group. We granted MTPC exclusive rights to commercialize vadadustat in Japan, where MTPC commenced commercial sales of vadadustat under the trade name, VafseoTM, in August 2020, and in certain other countries in Asia, subject to marketing approvals.\nIn addition, we continue to explore additional development opportunities to expand our pipeline and portfolio of novel therapeutics through both internal research and external innovation. Our development pipeline includes several earlier stage opportunities, including praliciguat, an investigational oral soluble guanylate cyclase, or sGC, stimulator, that we licensed from Cyclerion Therapeutics, Inc., or Cyclerion, in June 2021. One indication of interest is the treatment of focal segmental glomerulosclerosis, which is highly complementary of our strategy to identify and develop novel therapeutics for people impacted by kidney diseases.\nOperating Overview\nWe have incurred net losses in each year since inception. Our net losses were $51.9 million and $59.5 million for the three months ended September 30, 2022 and 2021, respectively. Our net losses were $85.0 million and $212.2 million for the nine months ended September 30, 2022 and 2021, respectively. Substantially all of our net losses resulted from costs incurred in connection with the continued commercialization of Auryxia and development efforts relating to vadadustat, including conducting clinical trials of, and seeking regulatory approval for, vadadustat, providing general and administrative support for these operations and protecting our intellectual property.\nOur ability to achieve profitability depends in part on our ability to manage our expenses. Following receipt of the CRL, in April 2022 and May 2022, we implemented a reduction of our workforce by approximately 42% across all areas of our company including several members of management (47% inclusive of the closing of the majority of open positions). These actions reflect our determination to refocus our strategic priorities around our commercial product, Auryxia®, and our development portfolio, and are steps in a cost savings plan to significantly reduce our expense profile in line with being a single commercial product company. The workforce reduction included net charges totaling approximately $14.7 million, including costs for one-time termination benefits and contractual termination benefits for severance, healthcare, and related benefits of $11.4 million and non-cash stock-based compensation expense of $3.3 million. During the three and nine months ended September 30, 2022, we recognized $0.2 million and 14.7 million, respectively, of restructuring charges in the condensed consolidated statement of operations and comprehensive loss. Refer to Note 5 to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for further details.\n37\nEven in light of the reduction in workforce, we expect to continue to incur significant expenses and operating losses for the foreseeable future. In addition to any additional costs not currently contemplated due to the events associated with or resulting from the workforce reduction noted above, our ability to achieve profitability and our financial position will depend, in part, on the rate of our future expenditures, on our product revenue from Auryxia, collaboration revenue, our ability to successfully implement cost avoidance measures and reduce overhead costs and our ability to obtain additional funding. We expect to continue to incur significant expenses if and as we:\n•continue our commercialization activities for Auryxia and vadadustat, if we are able to obtain marketing approval for vadadustat following receipt of the CRL from the FDA in March 2022, and any other product or product candidate, including those that may be in-licensed or acquired;\n•address the issues identified in the CRL for vadadustat that we received from the FDA and, in the event our FDRR is accepted by the FDA, pursue our appeal of the CRL for vadadustat with the FDA;\n•conduct and enroll patients in any clinical trials, including post-marketing studies or any other clinical trials for Auryxia, vadadustat or any other product or product candidate, including those that may be in-licensed or acquired;\n•seek marketing approvals for vadadustat and any other product candidate, including those that may be in-licensed or acquired;\n•maintain marketing approvals for Auryxia and vadadustat, if we are able to obtain marketing approval for vadadustat following receipt of the CRL from the FDA in March 2022, and any other product, including those that may be in-licensed or acquired;\n•manufacture Auryxia, vadadustat and any other product or product candidate, including those that may be in-licensed or acquired, for commercial sale and clinical trials;\n•conduct discovery and development activities for additional product candidates or platforms that may lead to the discovery of additional product candidates;\n•engage in transactions, including strategic, merger, collaboration, acquisition and licensing transactions, pursuant to which we would market and develop commercial products, or develop and commercialize other product candidates and technologies;\n•continue to repay, and pay any associated pre-payment penalties, if applicable, the senior secured term loans in an aggregate principal amount of $67.0 million, or the Term Loans, that were made available to us pursuant to the loan agreement that we entered into with funds managed by Pharmakon Advisors LP, in November 2019, which was amended in February 2022, and further amended in July 2022, or as amended, the Loan Agreement;\n•make royalty, milestone or other payments under our license agreements and any future license agreements;\n•maintain, protect and expand our intellectual property portfolio;\n•make decisions with respect to our personnel, including the retention of key employees;\n•make decisions with respect to our infrastructure, including to support our operations as a fully integrated publicly traded biopharmaceutical company; and\n•experience any additional delays or encounter issues with any of the above.\nWe have not generated, and may not generate, enough product revenue to realize net profits from product sales. We have no manufacturing facilities, and all of our manufacturing activities are contracted out to third parties. Additionally, we currently utilize contract research organizations, or CROs, to carry out our clinical development activities. If we obtain marketing approval for vadadustat, and as we continue to commercialize Auryxia, we expect to incur significant commercialization expenses related to product sales, marketing, manufacturing and distribution. We expect to finance future cash needs through product revenue, public or private equity or debt transactions, royalty transactions, strategic transactions, or a combination of these approaches. If we are unable to raise additional capital in sufficient amounts when needed or on attractive terms, we may not be able to pursue development and commercial activities related to Auryxia and vadadustat, if approved, or any additional products and product candidates, including those that may be in-licensed or acquired. Any of these events could significantly harm our business, financial condition and prospects.\n38\nFrom inception through September 30, 2022, we raised approximately $793.5 million of net proceeds from the sale of equity, including $519.8 million from various underwritten public offerings, $223.7 million from at-the-market offerings, or ATM offerings, pursuant to prior sales agreements with Cantor Fitzgerald & Co., and $70.0 million from the sale of 7,571,429 shares of common stock to Vifor Pharma. As of September 30, 2022, through our collaboration agreement with MTPC and our prior collaboration agreements with Otsuka we received approximately $837.1 million in cost-share funding, and are not entitled to receive any additional cost-share funding. On June 30, 2022, we entered into the Termination Agreement with Otsuka, pursuant to which we received a nonrefundable and non-creditable payment of $55.0 million in consideration for the covenants and agreements set forth in the Termination Agreement.\nOn November 11, 2019, we entered into the Loan Agreement with funds managed by Pharmakon, pursuant to which term loans in an aggregate principal amount of $100.0 million were made available to us in two tranches, subject to certain terms and conditions, or the Term Loans. As of September 30, 2022, we had drawn down the full $100.0 million made available to us under the Loan Agreement. On July 15, 2022, or the Effective Date, we entered into the Second Amendment and Waiver with BioPharma Credit PLC, or the Collateral Agent, BPCR Limited Partnership, as a Lender, and BioPharma Credit Investments V (Master) LP, as a Lender, or the Second Amendment and Waiver, which amends and waives certain provisions of the Loan Agreement as amended by the First Amendment and Waiver between the Collateral Agent, the Lenders and us, dated February 18, 2022, or the First Amendment and Waiver. The Collateral Agent and the Lenders are collectively referred to as Pharmakon (see Note 11 to our condensed consolidated financial statements). Pursuant to the Second Amendment and Waiver, we made prepayments totaling $25.0 million together with a prepayment premium of $0.5 million plus all accrued and unpaid interest on such prepayments of principal to the Effective Date, and Pharmakon agreed to waive or modify certain covenants in the Loan Agreement (see Note 11 to our condensed consolidated financial statements). In addition, on February 25, 2021, we received an upfront payment of $44.8 million (net of certain transaction expenses) in connection with our sale to HealthCare Royalty Partners IV, L.P., or HCR, of the right to receive all royalties and sales milestones payable to us under our collaboration agreement with MTPC, or the MTPC Agreement, subject to certain caps and other terms and conditions described elsewhere in this Quarterly Report on Form 10-Q. Finally, on February 18, 2022, we entered into a Second Amended and Restated License Agreement, or the Vifor Second Amended Agreement, with Vifor Pharma. Pursuant to the Vifor Second Amended Agreement, Vifor Pharma made an upfront payment to us of $25.0 million in lieu of the previously disclosed milestone payment of $25.0 million that Vifor Pharma was to pay to us following approval of vadadustat by the FDA. Also pursuant to the Vifor Second Amended Agreement, Vifor contributed $40 million to a working capital fund established to partially fund our costs of purchasing vadadustat from our contract manufacturers, or the Working Capital Fund, which amount of funding will fluctuate, and which funding we will repay to Vifor Pharma over time.\nImpacts of COVID-19 Pandemic\nThe COVID-19 pandemic has presented a substantial public health and economic challenge around the world and continues to affect our employees, patients, healthcare providers with whom we interact, customers, collaboration partners, CROs, contract manufacturing organizations, or CMOs, vendors, communities and business operations. The full extent to which the COVID-19 pandemic will directly or indirectly impact our business, results of operations and financial condition continues to depend on future developments that are highly uncertain and cannot be accurately predicted, including new information that may emerge concerning the COVID-19 pandemic, any resurgences or variants of COVID-19, the actions taken to contain it or treat its impact and the economic and other impacts on local, regional, national and international markets where the healthcare providers with whom we interact, our partners, our CROs, our CMOs, and our other vendors operate.\nWe believe our revenue growth was negatively impacted by the COVID-19 pandemic in 2021 and the first three quarters of 2022 primarily as the CKD patient populations that we serve experienced both high hospitalization and mortality rates due to COVID-19, and the pandemic had an adverse impact on the phosphate binder market in which Auryxia competes. Labor shortages and costs have adversely impacted dialysis providers. These impacts have refocused clinical efforts in addressing bone and mineral disorders like hyperphosphatemia to more acute operational issues to ensure patients receive dialysis treatments and still some patients have been rescheduled or missed treatments due to labor shortages. We believe, this and potentially other factors, has led to the reduction in the phosphate binder market, which has not experienced growth since early 2020. While we are unable to quantify the impact of the COVID-19 pandemic on future revenues and revenue growth, the COVID-19 pandemic and the ongoing impacts from the COVID-19 pandemic continue to adversely and disproportionately impact CKD patients and the phosphate binder market; therefore, we expect the COVID-19 pandemic and the ongoing impacts from the pandemic to continue to have a negative impact on our revenue growth for the foreseeable future.\nAs a result of the COVID-19 pandemic we adopted a flexible workplace policy allowing employees to work from home on a full or part-time basis, which may make it difficult for us to maintain our corporate culture or retain employees. Moreover, our future success substantially depends on the management skills of our executives and certain other key employees. The unanticipated loss or unavailability of key employees due to the pandemic could harm our ability to operate our business or execute our business strategy and we may not be successful in finding and integrating suitable successors in the event any of our key employees leave or are unavailable.\n39\nIn addition, several healthcare facilities have previously restricted access for non-patients, including the members of our sales force. For example, DaVita, Inc., or DaVita, and Fresenius Medical Care, or Fresenius, which account for a vast majority of the dialysis population in the United States, have previously restricted access to their clinics. As a result, we continue to engage with some healthcare providers and other customers virtually, where possible. The restrictions on our customer-facing employees' in-person interactions with healthcare providers have, and could continue to, negatively impact our access to healthcare providers and, ultimately, our sales, including with respect to vadadustat, if approved. Recently, such precautionary measures have been relaxed at certain healthcare facilities and, as a result, members of our sales force have resumed in person interactions with certain customers. Nevertheless, some restrictions remain, and more restrictions may be put in place again due to a resurgence in COVID-19 cases, including those involving new variants of COVID-19 which may be more contagious and more severe than prior strains of the virus. Given this uncertain environment and the disproportionate impact of the COVID-19 pandemic on CKD patients, we are actively monitoring the demand in the United States for Auryxia and will be for vadadustat, if approved, including the potential for further declines or changes in prescription trends and customer orders, which could have a material adverse effect on our business, results of operations and financial condition.\nIn addition, the direct and indirect impacts of the pandemic or the response efforts to the pandemic, including among others, competition for labor and resources and increases in labor, sourcing, manufacturing and shipping costs, may cause disruptions to, closures of, or other impacts on our CMOs and other vendors in our supply chain on which we rely for the supply of our products and product candidates. For example, areas of China have recently continued to implement lockdowns for COVID-19, which could impact the global supply chain. At this time, our third party contract manufacturers continue to operate at or near normal levels. However, it is possible that the COVID-19 pandemic and response efforts may have an impact in the future on our contract manufacturers' ability to manufacture and deliver Auryxia and vadadustat (if approved in the United States and EMA and which is currently marketed under the trade name VafseoTM by MTPC in Japan), which may result in increased costs and delays, or disruptions to the manufacturing and supply of our products.\nCOVID-19 pandemic precautions have caused moderate delays in enrolling new clinical trials and may cause delays in enrolling other new clinical trials. We are using remote monitoring and central monitoring, where possible.\nThis uncertain pandemic environment has presented new risks to our business. While we are working aggressively to mitigate the impacts on our business, we are mindful that many of these risks and the impact to the larger healthcare market are outside of our control.\nFor additional information on the various risks posed by the COVID-19 pandemic, please refer to Part II, Item 1A. Risk Factors below.\nFinancial Overview\nRevenue\nTo date, our revenues have been derived from product revenue from commercial sales of Auryxia, collaboration revenues, which include license and milestone payments, royalty and cost-sharing revenue generated through collaboration and license agreements with partners for the development and commercialization of vadadustat, a nonrefundable, non-creditable termination fee pursuant to the terms of the Termination Agreement with Otsuka, and royalty revenue from sales of Riona in Japan. Cost-sharing revenue represents amounts reimbursed by our collaboration partners for expenses incurred by us for research and development activities and, potentially, co-promotion activities, under our collaboration agreements.\nWe expect our revenue to continue to be generated primarily from our commercial sales of Auryxia, our collaboration with MTPC and any other collaborations into which we may enter, and royalty revenue from Japan Tobacco, Inc., and its subsidiary, Torii Pharmaceutical Co., Ltd., collectively JT and Torii, based on net sales of Riona in Japan. We will not recognize any future revenue pursuant to our collaboration with Otsuka.\nCost of Goods Sold\nCost of goods sold includes direct costs to manufacture commercial drug substance and drug product for Auryxia, as well as indirect costs including costs for packaging, shipping, insurance and quality assurance, idle capacity charges, write-offs for inventory that fails to meet specifications or is otherwise no longer suitable for commercial sale, changes in our excess purchase commitment liability, and royalties due to the licensor of Auryxia related to the U.S. product sales recognized during the period. Cost of goods sold also includes costs to manufacture drug product provided to MTPC for commercial sale of Vafseo in Japan.\nAs a result of the merger with Keryx Biopharmaceuticals, Inc., or Keryx, or the Merger, and the application of purchase accounting, costs of goods sold also includes both amortization expense and, if applicable, impairment charges associated with the fair value of the developed product rights for Auryxia as well as expense associated with the fair value inventory step-up. The fair value of the developed product rights for Auryxia is being amortized over its estimated useful life, which as of\n40\nSeptember 30, 2022 is estimated to be six years. The fair value inventory step-up as a result of the Merger was fully amortized as of the first quarter of 2021.\nResearch and Development Expenses\nResearch and development expenses consist primarily of costs incurred for the development of vadadustat, which include:\n•personnel-related expenses, including salaries, benefits, recruiting fees, travel and stock-based compensation expense of our research and development personnel;\n•expenses incurred under agreements with CROs and investigative sites that conduct our clinical studies;\n•the cost of acquiring, developing and manufacturing clinical study materials through CMOs;\n•facilities, depreciation and other expenses, which include direct and allocated expenses for rent and maintenance of facilities, insurance and other supplies;\n•costs associated with preclinical, clinical and regulatory activities; and\n•costs associated with pre-launch inventory build for vadadustat in the United States and Europe, for which we received the CRL from the FDA in the United States in March 2022.\nResearch and development costs are expensed as incurred. Costs for certain development activities are recognized based on an evaluation of the progress to completion of specific tasks using information and data provided to us by our vendors and our clinical sites.\nWe cannot determine with certainty the duration and completion costs of current or future clinical studies of Auryxia and vadadustat or if, when, or to what extent we will receive marketing approval for vadadustat or generate revenue from the commercialization and sale of vadadustat, if approved. We may never succeed in achieving marketing approval for vadadustat.\nThe duration, costs and timing of clinical studies and development of Auryxia and vadadustat will depend on a variety of factors including, but not limited to, those described in Part II, Item 1A. Risk Factors. A change in the outcome of any of these variables with respect to the development of Auryxia and vadadustat could mean a significant change in the costs and timing associated with that development. For example, if the FDA, the EMA, or other regulatory authorities were to require us to conduct clinical studies in addition to or different from those that we currently anticipate, or if we experience delays in any of our clinical studies, we could be required to expend significant additional financial resources and time on the completion of clinical development.\nFrom inception through September 30, 2022, we have incurred $1.5 billion in research and development expenses. We expect to incur significant research and development expenditures for the foreseeable future as we continue the development of Auryxia, vadadustat and any other product or product candidate, including those that may be in-licensed or acquired.\nOur direct research and development expenses consist principally of external costs, such as fees paid to clinical trial sites, consultants, central laboratories and CROs in connection with our clinical studies, and drug substance and drug product manufacturing for clinical studies.\nIn 2020, we completed our global Phase 3 clinical program for vadadustat to which the majority of our research and development costs have been attributable. A significant portion of our research and development costs have been external costs, which we track on a program-by-program basis. These external costs include fees paid to investigators, consultants, central laboratories and CROs in connection with our clinical trials, and costs related to acquiring and manufacturing clinical trial materials. Our internal research and development costs are primarily personnel-related costs, depreciation and other indirect costs. We do not track our internal research and development expenses on a program-by-program basis as they are deployed across multiple projects under development.\nThe following table summarizes our external research and development expenses by program, as well as expenses not allocated to programs, for the three and nine months ended September 30, 2022 and 2021:\n41\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) | (in thousands) |\n| Vadadustat external costs | $ | 13,840 | $ | 14,339 | $ | 42,752 | $ | 44,059 |\n| External costs for other programs | 3,823 | 7,425 | 15,279 | 18,989 |\n| Total external research and development expenses | 17,663 | 21,764 | 58,031 | 63,048 |\n| Headcount, consulting, facilities and other | 9,687 | 18,707 | 39,179 | 55,248 |\n| Total research and development expenses | $ | 27,350 | $ | 40,471 | $ | 97,210 | $ | 118,296 |\n\nSelling, General and Administrative Expenses\nSelling, general and administrative expenses consist primarily of salaries and related costs for personnel, including stock-based compensation and travel expenses for our commercial personnel, including our field sales force and other commercial support personnel, as well as personnel in executive and other administrative or non-research and development functions. Other selling, general and administrative expenses include facility-related costs, fees for directors, accounting and legal services fees, recruiting fees and expenses associated with obtaining and maintaining patents.\nResults of Operations\nComparison of the Three Months Ended September 30, 2022 and 2021\n\n| Three Months Ended | Increase |\n| September 30, 2022 | September 30, 2021 | (Decrease) |\n| (in thousands) |\n| Revenues: |\n| Product revenue, net | $ | 42,239 | $ | 36,753 | $ | 5,486 |\n| License, collaboration and other revenue | 6,725 | 12,003 | (5,278) |\n| Total revenues | 48,964 | 48,756 | 208 |\n| Cost of goods sold: |\n| Product | 28,936 | 6,933 | 22,003 |\n| Amortization of intangibles | 9,011 | 9,011 | — |\n| Total cost of goods sold | 37,947 | 15,944 | 22,003 |\n| Operating expenses: |\n| Research and development | 27,350 | 40,471 | (13,121) |\n| Selling, general and administrative | 30,918 | 46,357 | (15,439) |\n| License expense | 743 | 870 | (127) |\n| Restructuring | 180 | — | 180 |\n| Total operating expenses | 59,191 | 87,698 | (28,507) |\n| Operating loss | (48,174) | (54,886) | 6,712 |\n| Other expense, net | (2,785) | (4,658) | 1,873 |\n| Loss on extinguishment of debt | (906) | — | (906) |\n| Net loss | $ | (51,865) | $ | (59,544) | $ | 7,679 |\n\nProduct Revenue, Net. Net product revenue is derived from sales of our only commercial product in the United States, Auryxia. We distribute our product principally through a limited number of wholesale distributors as well as certain specialty pharmacy providers. Net product revenue was $42.2 million for the three months ended September 30, 2022, compared to $36.8 million for the three months ended September 30, 2021. The increase was primarily due to pricing and improved payer mix.\nLicense, Collaboration and Other Revenue. License, collaboration and other revenue was $6.7 million for the three months ended September 30, 2022 compared to $12.0 million for the three months ended September 30, 2021. The decrease is primarily due to a reduction in revenue from the Otsuka collaboration agreement because on June 30, 2022, we and Otsuka\n42\nentered into the Termination Agreement, which, among other things, terminated the cost sharing arrangement under the Otsuka collaboration agreement for the United States, or the Otsuka U.S. Agreement, and the Otsuka collaboration agreement for certain territories outside the United States, or the Otsuka International Agreement. Refer to Note 4 to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for further details. We will not recognize any future revenue under the Otsuka U.S. Agreement or the Otsuka International Agreement.\nCost of Goods Sold - Product. Cost of goods sold of $28.9 million for the three months ended September 30, 2022 consisted of costs associated with the manufacturing of Auryxia and supply of Vafseo to MTPC for commercial sale in Japan, $2.6 million related to excess and obsolescence reserves associated with inventory, and a $13.2 million non-cash charge related to an increase to the liability for excess purchase commitments. Refer to Note 13 to our condensed consolidated financial statements for further details on the excess purchase commitments liability.\nCost of goods sold of $6.9 million for the three months ended September 30, 2021 consisted of costs associated with the manufacturing of Auryxia partially offset by a $6.0 million reduction to the liability for excess purchase commitments, primarily due to the settlement of all patent litigation proceedings related to Abbreviated New Drug Applications filed with respect to Auryxia, which allows for generic versions of Auryxia beginning in March 2025. Refer to Note 13 to our condensed consolidated financial statements for further details on the excess purchase commitments liability.\nCost of Goods Sold - Amortization of Intangibles. Amortization of intangibles relates to the acquired developed product rights for Auryxia, which is being amortized using a straight-line method over its estimated useful life of approximately six years. Amortization of intangibles during each of the three months ended September 30, 2022 and 2021 was $9.0 million.\nResearch and Development Expenses. Research and development expenses were $27.4 million for the three months ended September 30, 2022, compared to $40.5 million for the three months ended September 30, 2021, a decrease of $13.1 million. The decrease was primarily due to the following:\n| (in millions) |\n| Vadadustat development expenses | $ | (0.5) |\n| Headcount, consulting, facilities and other | (12.6) |\n| Total net decrease | $ | (13.1) |\n\nThe decrease in research and development expense was primarily due to decreased headcount related costs as a result of the reduction in force and decreased consulting costs. Although we expect our research and development expenses to continue to decrease for the remainder of 2022, compared to 2021, we will continue to incur significant research and development expenses in future periods in support of ongoing or planned studies with respect to Auryxia and vadadustat and development of other potential product candidates.\nSelling, General and Administrative Expenses. Selling, general and administrative expenses were $30.9 million for the three months ended September 30, 2022, compared to $46.4 million for the three months ended September 30, 2021. The decrease of $15.4 million was primarily due to decreased headcount related costs as a result of the reduction in force, lower one-time legal costs, and lower marketing expenses. For the remainder of 2022, we expect our selling, general and administrative expenses to continue to decrease from 2021 as we continue to reduce our expense profile in line with being a single commercial product company.\nLicense Expenses. License expense related to royalties due to Panion relating to sales of Riona in Japan were $0.7 million for the three months ended September 30, 2022 compared to $0.9 million for the three months ended September 30, 2021.\nRestructuring. Restructuring expenses were $0.2 million for the three months ended September 30, 2022 due to one-time termination benefits for severance, healthcare, and related benefits related to the reduction in force. There were no restructuring expenses for the three months ended September 30, 2021.\nOther Expense, Net. Other expense, net, was $2.8 million for the three months ended September 30, 2022 compared to $4.7 million for the three months ended September 30, 2021. The decrease of $1.9 million was primarily due to a decrease in interest expense as a result of principal prepayments totaling $25.0 million made on the Term Loans pursuant to the Second Amendment and Waiver in the three months ended September 30, 2022, reducing our outstanding balance on the Term Loans. The decrease was also related to a decrease in the fair value of our derivative liability related to the Loan Agreement with Pharmakon during the three months ended September 30, 2022.\n43\nLoss on Extinguishment of Debt. During the three months ended September 30, 2022, the Company recorded a debt extinguishment loss of $0.9 million related to the principal prepayments made on the Term Loans pursuant to the Second Amendment and Waiver.\nComparison of the Nine Months Ended September 30, 2022 and 2021\n| Nine Months Ended | Increase |\n| September 30, 2022 | September 30, 2021 | (Decrease) |\n| (in thousands) |\n| Revenues: |\n| Product revenue, net | $ | 127,390 | $ | 100,120 | $ | 27,270 |\n| License, collaboration and other revenue | 110,032 | $ | 53,853 | 56,179 |\n| Total revenues | 237,422 | 153,973 | 83,449 |\n| Cost of goods sold: |\n| Product | 60,859 | $ | 76,012 | (15,153) |\n| Amortization of intangibles | 27,032 | 27,032 | — |\n| Total cost of goods sold | 87,891 | 103,044 | (15,153) |\n| Operating expenses: |\n| Research and development | 97,210 | 118,296 | (21,086) |\n| Selling, general and administrative | 108,052 | 129,336 | (21,284) |\n| License expense | 2,323 | 2,460 | (137) |\n| Restructuring | 14,711 | — | 14,711 |\n| Total operating expenses | 222,296 | 250,092 | (27,796) |\n| Operating loss | (72,765) | (199,163) | 126,398 |\n| Other expense, net | (11,339) | (12,999) | 1,660 |\n| Loss on extinguishment of debt | (906) | — | (906) |\n| Net loss | (85,010) | (212,162) | 127,152 |\n\nProduct Revenue, Net. Net product revenue is derived from sales of our only commercial product in the United States, Auryxia. We distribute our product principally through a limited number of wholesale distributors as well as certain specialty pharmacy providers. Net product revenue was $127.4 million for the nine months ended September 30, 2022, compared to net product revenue of $100.1 million for the nine months ended September 30, 2021. The increase was primarily due to pricing and improved payor mix.\nLicense, Collaboration and Other Revenue. License, collaboration and other revenue was $110.0 million for the nine months ended September 30, 2022, compared to $53.9 million for the nine months ended September 30, 2021. On June 30, 2022, we and Otsuka entered into the Termination Agreement, which, among other things, terminated the cost sharing arrangement under the Otsuka U.S. Agreement, and the Otsuka International Agreement. During the nine months ended September 30, 2022, we recognized $55.0 million in collaboration revenue related to a payment received pursuant to the terms of the Termination Agreement with Otsuka, $15.5 million related to previously deferred revenue as of the date of termination and $9.6 million of non-cash consideration related to Otsuka's obligations to complete certain agreed upon clinical activities related to the MODIFY Study, in accordance with the current study protocol, at its own cost and expense. We also recognized $19.1 million in collaboration revenue for the nine months ended September 30, 2022 from the Otsuka U.S. Agreement and the Otsuka International Agreement prior to the termination, as well as royalty revenue under the MTPC Agreement, and revenue under the MTPC Supply Agreement. We recognized $49.7 million in collaboration revenue for the nine months ended September 30, 2021 from the Otsuka U.S. Agreement, the Otsuka International Agreement, royalty revenue under our collaboration agreement with MTPC, and revenue under the MTPC Supply Agreement.\nCost of Goods Sold - Product. Cost of goods sold of $60.9 million for the nine months ended September 30, 2022 consisted of costs associated with the manufacturing of Auryxia and supply of Vafseo to MTPC for commercial sale in Japan, $10.0 million related to excess and obsolescence reserves associated with inventory, and a $12.4 million increase to the liability for excess\n44\npurchase commitments. Refer to Note 13 to our condensed consolidated financial statements for further details on the excess purchase commitments liability.\nCost of goods sold of $76.0 million for the nine months ended September 30, 2021 consisted primarily of costs associated with the manufacturing of Auryxia, $15.4 million in non-cash charges related to an increase to the liability for excess purchase commitments, $21.6 million in non-cash charges related to the fair-value inventory step-up from the application of purchase accounting, and $7.1 million related to inventory reserves associated with a previously disclosed manufacturing quality issue related to Auryxia.\nCost of Goods Sold - Amortization of Intangibles. Amortization of intangibles relates to the acquired developed product rights for Auryxia, which is being amortized using a straight-line method over its estimated useful life of approximately six years. Amortization of intangibles during each of the nine months ended September 30, 2022 and 2021 was $27.0 million.\nResearch and Development Expenses. Research and development expenses were $97.2 million for the nine months ended September 30, 2022, compared to $118.3 million for the nine months ended September 30, 2021, a decrease of $21.1 million. The decrease was primarily due to the following:\n| (in millions) |\n| Vadadustat development expenses | $ | (1.3) |\n| Headcount, consulting, facilities and other | (19.8) |\n| Total net decrease | (21.1) |\n\nThe decrease in research and development expense was primarily due to decreased headcount related costs as a result of the reduction in force, decreased consulting costs, and decreased regulatory fees. Also during the nine months ended September 30, 2021, we made an upfront payment of $3.0 million to Cyclerion for an exclusive global license to develop and commercialize praliciguat, an investigational oral sGC, stimulator, which was recorded to research and development expense which did not reoccur during the nine months ended September 30, 2022. Although we expect our research and development expenses for the remainder of 2022 to continue to decrease compared to 2021, we will continue to incur significant research and development expenses in future periods in support of ongoing or planned studies with respect to Auryxia and vadadustat and development of other potential product candidates.\nSelling, General and Administrative Expenses. Selling, general and administrative expenses were $108.1 million for the nine months ended September 30, 2022, compared to $129.3 million for the nine months ended September 30, 2021. The decrease of $21.3 million was primarily due to decreased headcount related costs as a result of the reduction in force, decreased one-time legal costs, and lower marketing expense following receipt of the CRL for vadadustat. For the remainder of 2022, we expect our selling, general and administrative expenses to continue to decrease from 2021 as we significantly reduce our expense profile in line with being a single commercial product company.\nLicense Expenses. License expense related to royalties due to Panion relating to sales of Riona in Japan was $2.3 million and $2.5 million for the nine months ended September 30, 2022 and 2021, respectively.\nRestructuring. Restructuring expenses were $14.7 million for the nine months ended September 30, 2022 due to one-time termination benefits and contractual termination benefits for severance, healthcare, and non-cash stock-based compensation related to the reduction in force. There were no restructuring expenses for the nine months ended September 30, 2021.\nOther Expense, Net. Other expense, net, was $11.3 million for the nine months ended September 30, 2022 compared to $13.0 million for the nine months ended September 30, 2021. The decrease in other expense compared to September 30, 2021 was primarily due to a decrease in interest expense as a result of principal prepayments totaling $25.0 million made on the Term Loans pursuant to the Second Amendment and Waiver in the nine months ended September 30, 2022, reducing our outstanding balance on the Term Loans. The decrease was also related to a decrease in the fair value of our derivative liability related to the Loan Agreement with Pharmakon during the nine months ended September 30, 2022.\nLoss on Extinguishment of Debt. During the three months ended September 30, 2022, the Company recorded a debt extinguishment loss of $0.9 million related to the principal prepayments made on the Term Loans pursuant to the Second Amendment and Waiver.\n45\nLiquidity and Capital Resources\nWe have funded our operations principally through sales of our common stock, payments received from our collaboration partners, product sales, debt, a royalty transaction, and a refund liability to a customer. As of September 30, 2022, we had cash and cash equivalents of approximately $144.8 million. Cash in excess of immediate requirements is invested in accordance with our investment policy, primarily with a view to liquidity and capital preservation. On April 7, 2022, we entered into an Open Market Sale AgreementSM, or the Sales Agreement, with Jefferies LLC, or Jefferies, as agent, for the offer and sale of common stock at current market prices in amounts to be determined from time to time. Also, on April 7, 2022, we filed a prospectus supplement relating to the Sales Agreement, pursuant to which we are able to offer and sell under the Sales Agreement up to $26.0 million of our common stock at current market prices from time to time. From the date of filing of the prospectus supplement through the date of the filing of this Quarterly Report on Form 10-Q, we have not sold any shares of our common stock under this program. As of September 30, 2022, through our collaboration agreements with Otsuka and MTPC we received approximately $837.1 million in cost-share funding, and are not entitled to receive any additional cost-share funding.\nCash Flows\nThe following table sets forth the primary sources and uses of cash for each of the periods set forth below:\n| Nine Months Ended |\n| September 30, 2022 | September 30, 2021 |\n| (in thousands) |\n| Net cash provided by (used in): |\n| Operating activities | $ | (18,475) | $ | (190,157) |\n| Investing activities | (114) | 39,941 |\n| Financing activities | 14,599 | 128,328 |\n| Net (decrease) in cash, cash equivalents, and restricted cash | $ | (3,990) | $ | (21,888) |\n\nOperating Activities. Net cash used in operating activities of $18.5 million for the nine months ended September 30, 2022 was driven by the net operating loss for the period and changes in working capital at period end.\nNet cash used in operating activities of $190.2 million for the nine months ended September 30, 2021 was largely driven by the net operating loss for the period and changes in working capital at period end.\nInvesting Activities. Net cash used in investing activities for the nine months ended September 30, 2022 was $0.1 million and was comprised of purchases of equipment.\nNet cash provided by investing activities for the nine months ended September 30, 2021 was $39.9 million and was primarily comprised of proceeds from the sale of available for sale securities of $40.0 million.\nFinancing Activities. Net cash provided by financing activities for the nine months ended September 30, 2022 was $14.6 million and consisted of net proceeds from refund liabilities to customers of $40.0 million, net proceeds from the issuance of common stock of $7.1 million, and proceeds from the sale of stock under our employee stock purchase plan, partially offset by principal payments of debt of $33.0 million.\nNet cash provided by financing activities for the nine months ended September 30, 2021 was $128.3 million and consisted of net proceeds from the sale of future royalties of $44.8 million, net proceeds from the public issuance of common stock in connection with our prior at-the-market sales agreement with Cantor Fitzgerald & Co. of $82.8 million, and proceeds from the sale of stock under our employee stock purchase plan.\nOperating Capital Requirements\nWe have one product, Auryxia, approved for commercial sale in the United States, but have not generated, and may not generate, enough product revenue from the sale of Auryxia to realize net profits from product sales. We have incurred losses and cumulative negative cash flows from operations in each year since our inception in February 2007, and as of September 30, 2022, we had an accumulated deficit of $1.5 billion. We anticipate that we will continue to incur losses for the foreseeable future, and we expect to continue to incur additional research and development expenses related to vadadustat and our\n46\ndevelopment pipeline, and research and development and selling, general and administrative expenses for our ongoing development and commercialization of Auryxia.\nWe expect our cash resources will be sufficient to fund our current operating plan through at least the next twelve months from the date of this filing. However, our operating plan includes assumptions pertaining to cost avoidance measures and the reduction of overhead costs that would result from the planned amendment of contractual arrangements with certain supply and collaboration partners and reduction of operating expenses. The outcome of certain of these cost avoidance measures are outside of our control, such as the planned amendment of contractual arrangements with certain supply partners. During 2022, we implemented some of the cost avoidance measures, and we have additional cost avoidance measures we plan to implement. For example, during the third quarter of 2022, we reduced future contractual commitments with certain supply partners, and we continue to work with our supply partners to further reduce costs. In addition, during the second quarter of 2022, we reduced our workforce by approximately 42% across all areas of our company following receipt of the CRL. These actions reflect our determination to refocus our strategic priorities around our commercial product, Auryxia® and our development portfolio, and is a step in a cost savings plan to significantly reduce our expense profile in line with being a single commercial product company (see Note 5 to our condensed consolidated financial statements). However, because certain of the other cost avoidance measures and certain other elements of our operating plan are outside of our control, there is uncertainty as to whether our cash resources will be adequate to support our operations for a period through at least the next twelve months from the date of issuance of these financial statements.\nIn addition, pursuant to the Second Amendment and Waiver, on the Effective Date, we made prepayments totaling $25.0 million together with a prepayment premium of $0.5 million plus all accrued and unpaid interest on such prepayments of principal to the Effective Date, and Pharmakon agreed to waive or modify certain covenants in the Loan Agreement (see Note 11 to our condensed consolidated financial statements). If an event of default occurs and is continuing under the Loan Agreement, the Collateral Agent is entitled to take enforcement action, including acceleration of amounts due under the Loan Agreement, which we may not have the available cash resources to repay at such time. For example, pursuant to covenants in the Loan Agreement, our Annual Reports on Form 10-K must not be subject to any qualification as a going concern. If any of our future Annual Reports on Form 10-K is subject to any qualification related to going concern, it will result in an event of default under the Loan Agreement. Should we not be able to meet the annual covenants in the future, we would seek a waiver of this provision. However, there can be no assurances that we would be successful in obtaining such waiver.\nWe believe that the execution of the cost avoidance measures detailed previously, future decisions by the FDA or foreign regulatory agencies related to the potential regulatory approval of vadadustat, and our ability to generate additional value from vadadustat, if approved through partnerships or other transactions could potentially further extend our cash runway for a period greater than twelve months. However, these future decisions or transactions are not contemplated in our operating plan. In addition, because the cost avoidance measures and certain other elements of our operating plan are outside of our control, they cannot be considered probable in the context of our going concern assessment. Therefore, there can be no assurance that our cash resources will fund our operating plan for the period anticipated by us.\nWe expect to finance future cash needs through product revenue, strategic transactions, or a combination of these approaches. We plan to reduce our need for future financing through the planned amendment of contractual arrangements with certain supply and collaboration partners, expense management, and cost avoidance measures in line with being a single commercial product company. Assuming we are successful in those endeavors, we will require additional funding to fund our strategic growth beyond Auryxia or to pursue later stage development and commercial activities for any additional product or product candidates, including those that may be in-licensed or acquired. There can be no assurance that the current operating plan will be achieved in the time frame anticipated by us, or that our cash resources will fund our operating plan for the period anticipated by us or that additional funding will be available on terms acceptable to us, or at all.\nGoing Concern\nOur operating plan includes assumptions pertaining to cost avoidance measures and the reduction of overhead costs that would result from the planned amendment of contractual arrangements with certain supply and collaboration partners, and reduction of operating expenses. However, because these cost avoidance measures and certain other elements of our operating plan are outside of our control, including the planned amendment of certain contractual arrangements and the reduction of operating expenses, there is uncertainty as to whether our cash resources will be adequate to support our operations for a period through at least the next twelve months from the date of issuance of these financial statements. The conditions above and the annual going concern covenant in our Loan Agreement raise substantial doubt regarding our ability to continue as a going concern for a period of twelve months after the date the financial statements are issued.\nManagement’s plans to alleviate the conditions that raise substantial doubt include cost avoidance measures, including amending contractual arrangements with certain supply and collaboration partners, and reducing operating expenses, for us to continue as a going concern for a period of twelve months from the date the financial statements are issued. However, we have concluded that the likelihood that our plan to extend our cash runway from one or more of these approaches will be successful, while reasonably possible, is less than probable. Accordingly, we have concluded that substantial doubt exists about our ability to continue as a going concern for a period of at least twelve months from the date of issuance of these financial statements.\n47\nOur forecast of the period of time through which our financial resources will be adequate to support our operations is a forward-looking statement and involves numerous risks and uncertainties, and actual results could vary as a result of a number of factors, many of which are outside our control. We have based this estimate on assumptions that may be substantially different than actual results, and we could utilize our available capital resources sooner than we currently expect. Our future funding requirements, both near- and long-term, will depend on many factors including, but not limited to, those described under Part I, Item 1A. Risk Factors under the heading \"Risks Related to our Financial Position, Need for Additional Capital and Growth Strategy.\"\nContractual Obligations\nAs of September 30, 2022, other than as disclosed in Note 13 to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q, there have been no material changes to our contractual obligations and commitments from those described under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our 2021 Annual Report on Form 10-K.\nTerm Loans\nOn November 11, 2019, Akebia, with Keryx as guarantor, entered into a loan agreement, or the Loan Agreement, with BioPharma Credit PLC as collateral agent and a lender, or the Collateral Agent, and BioPharma Credit Investments V (Master) LP as a lender, pursuant to which term loans in an aggregate principal amount of $100.0 million were made available to us in two tranches, subject to certain terms and conditions, or the Term Loans. BioPharma Credit PLC subsequently transferred its interest in the Term Loans, solely in its capacity as a lender, to its affiliate, BPCR Limited Partnership. The Collateral Agent and the lenders are collectively referred to as Pharmakon. The first tranche of $80.0 million, or Tranche A, was drawn on November 25, 2019, or the Tranche A Funding Date, and the second tranche of $20.0 million, or Tranche B, was drawn on December 10, 2020, or the Tranche B Funding Date. As of September 30, 2022, we made our first quarterly principal payment under the Term Loans of $8.0 million. In addition, on July 15, 2022, pursuant to the Loan Agreement, as amended, we made prepayments totaling $25.0 million together with a prepayment premium of $0.5 million plus all accrued and unpaid interest on such prepayments of principal to the Effective Date, and Pharmakon agreed to waive or modify certain covenants in the Loan Agreement. A more detailed description of the Term Loans can be found in Note 11 to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q.\nLiability Related to Sale of Future Royalties\nOn February 25, 2021, we entered into a royalty interest acquisition agreement, or the Royalty Agreement, with HCR, pursuant to which we sold to HCR our right to receive royalties and sales milestones for vadadustat in the MTPC Territory, such payments collectively the Royalty Interest Payments, in each case, payable to us under the MTPC Agreement, subject to an annual maximum “cap” of $13.0 million, or the Annual Cap, and an aggregate maximum “cap” of $150.0 million, or the Aggregate Cap. After HCR receives Royalty Interest Payments equal to the Annual Cap in a given calendar year, we will receive 85% of the Royalty Interest Payments for the remainder of that year. After HCR receives Royalty Interest Payments equal to the Aggregate Cap, or we pay the Aggregate Cap to HCR (net of the Royalty Interest Payments already received by HCR), the Royalty Interest Payments will revert back to us, and HCR would have no further right to any Royalty Interest Payments. We received $44.8 million from HCR (net of certain transaction expenses) under the Royalty Agreement, and we are eligible to receive an additional $5.0 million in each year from 2021 through 2023 under the Royalty Agreement if specified annual sales milestones are achieved for vadadustat in the MTPC Territory, subject to the satisfaction of certain customary conditions. We retain the right to receive all potential future regulatory milestones for vadadustat under the MTPC Agreement. A more detailed description of the liability related to the sale of future royalties can be found in Note 6 to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q.\nRefund Liability to Customer\nOn February 18, 2022, pursuant to the Vifor Second Amended Agreement, Vifor Pharma contributed $40.0 million to the Working Capital Fund, established to partially fund our costs of purchasing vadadustat from its contract manufacturers, which amount of funding will fluctuate, and which funding we will repay to Vifor over time. The $40.0 million initial contribution to the Working Capital Fund represents 50% of the amount of purchase orders that the Company has placed with its contract manufacturers for the supply of vadadustat for the United States, or the Territory, already delivered as of the effective date of the Vifor Second Amended Agreement, and to be delivered through the end of 2022.\nWe have recorded the Working Capital Fund as a refund liability under ASC 606. We accounted for the refund liability as a debt arrangement with zero coupon interest. We imputed interest on the refund liability to the customer at a rate of 15.0% per annum and recorded an initial discount on the refund liability to the customer and a related deferred gain as of the date the funds were received from Vifor Pharma, which was March 18, 2022. The discount on the note payable is being amortized to interest expense using the effective interest method over the expected term of the refund liability. The deferred gain is being amortized to interest income on a straight-line basis over the expected term of the refund liability. A more detailed description of the refund liability can be found in Note 4 to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q.\n48\nCritical Accounting Estimates and Significant Judgments\nOur management’s discussion and analysis of our financial condition and results of operations are based on our unaudited condensed consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these unaudited condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, and expenses and the disclosure of contingent assets and liabilities in our unaudited condensed consolidated financial statements. On an ongoing basis, we evaluate our estimates and judgments, including those related to revenue, inventory, our excess purchase commitment liability, liabilities related to sale of future royalties, refund liabilities to customers, impairment of intangible assets and income taxes. We base our estimates on historical experience, known trends and events, and various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. In making estimates and judgments, management employs critical accounting policies.\nDuring the nine months ended September 30, 2022, we had the following material change to our critical accounting estimates as reported in our 2021 Annual Report on Form 10-K:\nRefund Liability to Customer\nWe treat the refund liability to customer as a zero-coupon debt financing, which is recorded at net present value. We recorded an initial discount on the refund liability to the customer and a corresponding deferred gain to the refund liability to customer on the condensed consolidated balance sheet as of the date the funds were received from Vifor Pharma, which was March 18, 2022. The discount on the note payable is being amortized to interest expense using the effective interest method over the expected term of the refund liability. The deferred gain is being amortized to interest income on a straight-line basis over the expected term of the refund liability.\nRecent Accounting Pronouncements\nFor additional discussion of recent accounting pronouncements, please refer to New Accounting Pronouncements – Not Yet Adopted included within Note 2 to our condensed consolidated financial statements in Part I, Item 1. Financial Statements (unaudited) included in this Quarterly Report on Form 10-Q.\nItem 3. Quantitative and Qualitative Disclosures about Market Risk.\nWe are exposed to market risk related to changes in interest rates. As of September 30, 2022 and December 31, 2021, we had cash and cash equivalents of $144.8 million and $149.8 million, respectively, consisting primarily of money market mutual funds consisting of certificates of deposit and corporate debt securities. Interest rate sensitivity is affected by changes in the general level of U.S. interest rates, particularly because our investments are in short-term securities. Our investments are subject to interest rate risk and will fall in value if market interest rates increase. Due to the short-term duration of our investment portfolio and the low risk profile of our investments, an immediate 100 basis point change in interest rates would not have a material effect on the fair market value of our portfolio.\nIn addition, we are exposed to market risk related to exchange rates. A portion of our revenues for the nine months ended September 30, 2022 was received in royalty payments converted to U.S. dollars based on the net sales of Riona and VafseoTM in Japanese yen. Our exchange rate risk arises from such foreign currency net sales. As a result, we are exposed to movements in the exchange rates of the Japanese yen against the U.S. dollar.\nFor the royalty payments we received based on net sales of Riona and Vafseo in Japan for the nine months ended September 30, 2022 a 5.0% appreciation or depreciation of the Japanese yen against the U.S. dollar would have increased or decreased, respectively, our revenues in the nine months ended September 30, 2022 by approximately $0.2 million.\nWe have generally accepted the exposure to exchange rate movements without using derivative financial instruments to manage this foreign currency risk.\nItem 4. Controls and Procedures.\nManagement’s Evaluation of our Disclosure Controls and Procedures\nWe maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports that we file or submit under the Securities Exchange Act of 1934, as amended, or the Exchange Act, is (1) recorded, processed, summarized, and reported within the time periods specified in the SEC's rules and forms and (2) accumulated and\n49\ncommunicated to our management, including our principal executive officer and principal financial officer, to allow timely decisions regarding required disclosure.\nAs of September 30, 2022, our management, with the participation of our principal executive officer and principal financial officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives, and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on our evaluation, our management concluded that, as of September 30, 2022, our disclosure controls and procedures were not effective because our internal control over financial reporting was not adequate due to the material weakness described below.\nAs reported in our 2021 Annual Report on Form 10-K, our internal control over financial reporting as of December 31, 2021 was not effective due to the following material weakness: the Company did not design and maintain effective controls over the completeness, accuracy, existence and presentation and disclosure of inventory. A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of a company’s annual or interim consolidated financial statements will not be prevented or detected on a timely basis. Specifically, we did not maintain effective controls related to (i) the review of inventory reconciliations, (ii) the validation of the inventory costing, (iii) the periodic assessment of excess and obsolete inventory related reserves and (iv) verification that the existence of all inventories subject to physical inventory counts were correctly counted as of December 31, 2021. Management has taken and will continue to take actions to remediate the deficiencies in its internal control over financial reporting and implemented additional processes and controls designed to address the underlying causes associated with the material weakness. Management is committed to finalizing the remediation of the material weakness during 2022.\nAs management continues to evaluate and work to improve its internal control over financial reporting, management may determine it is necessary to take additional measures to address the material weakness. Until the controls have been operating for a sufficient period of time and management has concluded, through testing, that these controls are operating effectively, the material weakness described above will continue to exist. As such, management has concluded that the material weakness cannot be considered remediated as of September 30, 2022.\nChanges in Internal Control over Financial Reporting\nDuring the nine months ended September 30, 2022, we implemented certain internal controls in connection with our remediation efforts described above. There have been no other changes in our internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) promulgated under the Exchange Act, during our most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n50\nPART II—OTHER INFORMATION\nItem 1. Legal Proceedings.\nLegal Proceedings Relating to Vadadustat\nOpposition Proceedings Against Akebia\nIn September 2018, Dr. Reddy’s Laboratories Limited filed an opposition to our issued Indian Patent No. 287720 in the Indian Patent Office.\nOn July 26, 2022, Sandoz AG filed an opposition against our issued European Patent No. 3277270 in the European Patent Office.\nProceedings Filed by Akebia Against FibroGen, Inc.\nEurope\nWe filed an opposition in the European Patent Office, or the EPO, against FibroGen, Inc.’s, or FibroGen’s, European Patent No. 1463823, or the ’823 EP Patent on December 5, 2013, and an oral proceeding took place March 8 and 9, 2016. Following the oral proceeding, the Opposition Division of EPO ruled that the patent as granted did not meet the requirements for patentability under the European Patent Convention and, therefore, revoked the patent in its entirety. FibroGen has appealed that decision. Oral hearing for the appeal is scheduled for February 28 – March 1, 2023.\nOn May 13, 2015, May 20, 2015 and July 6, 2015, we filed oppositions to FibroGen’s European Patent Nos. 2322155, or the ’155 EP Patent, 1633333, or the ’333 EP Patent, and 2322153, or the ’153 EP Patent in the EPO, respectively, requesting the patents be revoked in their entirety. These method of use patents do not prevent persons from using the compound for other uses, including any previously known use of the compound. In particular, these patents do not claim methods of using any of our product candidates for purposes of inhibiting HIF-PH for the treatment of anemia due to chronic kidney disease, or CKD. While we do not believe these patents will prevent us from commercializing vadadustat for the treatment of anemia due to CKD, we filed these oppositions to provide us with maximum flexibility for developing vadadustat and our pipeline of investigational oral hypoxia-inducible factor prolyl hydroxylase, or HIF-PH, inhibitor compounds.\nWith regard to the opposition that we filed in Europe against the ’333 EP Patent, an oral proceeding took place on December 8 and 9, 2016. Following the oral proceeding, the Opposition Division of the EPO ruled that the patent as granted did not meet the requirements for patentability under the European Patent Convention and, therefore, revoked the patent in its entirety. On December 9, 2016, FibroGen filed a notice to appeal the decision to revoke the ’333 EP Patent. The Board of Appeal held an oral proceeding on this appeal on February 24 and 25, 2022, during which proceeding the '333 EP Patent was maintained in restricted form. The ‘333 EP patent was originally granted with four independent claims, one of which was found obvious on appeal. The remaining claims are directed to: treatment of anemia of chronic disease in subjects having a percent transferrin saturation of less than 20% (claim 1), treatment of anemia that is refractory to treatment with exogenously administered erythropoietin (claim 6), and treatment of iron deficiency (claim 15).\nIn oral proceedings held on May 29, 2017, regarding the ’155 EP Patent, the European Opposition Division ruled that the ’155 EP Patent as granted did not meet the requirements for patentability under the European Patent Convention and, therefore, revoked the patent in its entirety. FibroGen filed a notice to appeal the decision to revoke the ’155 EP Patent on May 29, 2017. An oral proceeding for the appeal was held on February 22, 2022, during which proceeding the Board of Appeal maintained the revocation of the ‘155 EP Patent in its entirety.\nIn related oral proceedings held on May 31, 2017 and June 1, 2017 for the ’153 EP Patent, the Opposition Division of the EPO maintained the patent after FibroGen significantly narrowed the claims to an indication for which vadadustat is not intended to be developed. We and Glaxo separately filed notices to appeal the decision to maintain the ’153 EP Patent on November 9, 2017. Bayer filed a notice to appeal the decision on November 14, 2017. Glaxo withdrew its appeal on March 2, 2020 and Bayer withdrew its appeal on June 30, 2021. An oral proceeding for the appeal was held on February 21, 2022, during which proceeding the Board of Appeal revoked the ‘153 patent in its entirety.\nOn April 3, 2019, we filed oppositions to FibroGen’s European Patent Nos. 2289531, or the ’531 EP Patent, and 2298301, or the ’301 EP Patent in the EPO, respectively, requesting the patents be revoked in their entirety. Oral proceedings for oppositions to the two patents were held on September 7-8 and 10, 2021. Following oral proceedings, the Opposition Division of the EPO maintained certain claims in amended form in the two patents. On January 26, 2022, we filed notice to appeal the Opposition Division’s decision for ’531 EP Patent. On July 8, 2022, FibroGen filed notice to appeal the Opposition Division’s\n51\ndecision for the ’301 EP Patent. These two patents will expire in December 2022, and we do not expect the Opposition Division’s decision on the two patents to have any effect on our commercialization of vadadustat in Europe.\nJapan\nOn June 2, 2014, we filed an invalidity proceeding before the Japan Patent Office, or JPO, against certain claims of FibroGen’s Japanese Patent No. 4804131, or the ’131 JP Patent, which is the Japanese counterpart to the ’823 EP Patent, and the JPO issued a preliminary decision finding all of the challenged claims to be invalid. FibroGen subsequently amended the claims and the JPO accepted the amendments. The resulting ’131 JP Patent does not cover vadadustat or any pyridine carboxamide compounds.\nIn 2018, we and our collaboration partner in Japan, Mitsubishi Tanabe Pharma Corporation, or MTPC, jointly filed a Request for Trial before the JPO to challenge the validity of certain of FibroGen’s HIF-related patents in Japan: JP4845728, JP5474872 and JP5474741. On September 26, 2019, the JPO conducted an invalidation trial for JP5474872 and JP4845728. On November 11, 2019, the JPO conducted an invalidation trial for JP5474741. On April 1, 2022, the JPO issued a final decision for JP4845728, which invalidated all claims except claims directed to the medical use to treat anemia that does not respond to erythropoiesis. On May 18, 2022, the JPO issued a final decision for JP5474741 and JP5474872, which maintained the claims in amended form. In May 2022, MTPC filed revocation lawsuits for the three patents in the Intellectual Property High Court requesting cancellation of the JPO’s decisions. In July 2022, we filed a revocation lawsuit for JP4845728 in the Intellectual Property High Court requesting cancellation of the JPO’s decision. In August 2022, we filed revocation lawsuits for JP5474741 and JP5474872 in the Intellectual Property High Court requesting cancellation of the JPO’s decisions. In September 2022, FibroGen filed a revocation lawsuit for JP4845728 in the Intellectual Property High Court requesting cancellation of the JPO’s decision on the claims that were invalidated. We do not believe the JPO’s decisions will prevent our collaboration partner MTPC from continuing to commercialize vadadustat for the treatment of anemia due to CKD in Japan.\nUnited Kingdom\nOn December 13, 2018, we filed Particulars of Claim in the Patents Court of the United Kingdom to challenge the validity of FibroGen’s six HIF-related patents in the UK: the ’823 EP Patent (UK), the ’333 EP Patent (UK), the ’153 EP Patent (UK), the ’155 EP Patent (UK), European Patent (UK) No. 2,289,531, or the ’531 EP Patent (UK), and European Patent (UK) No. 2,298,301, or the ’301 EP Patent (UK). In May 2019, Astellas Pharma Inc., or Astellas, the exclusive licensee of FibroGen’s HIF-related patents, sued Akebia for patent infringement in the Patents Court of the UK. In September 2019, we filed an Amended Particulars of Claim to include FibroGen’s European Patent No. 1487472, or the ’472 EP Patent (UK). On February 28, 2020, the parties agreed to dismiss the ’472 EP Patent (UK) from the trial.\nA trial was conducted in March 2020. On April 20, 2020, the Patents Court of the UK issued a judgment in favor of Akebia, which invalidated all the claims at issue in each of the ’823 EP Patent (UK), the ’333 EP Patent (UK), the ’153 EP Patent (UK), the ’155 EP Patent (UK) and the ’301 EP Patent (UK). The ’531 EP Patent (UK) was amended to a single claim to recite one specific compound; this claim was held to be valid but not infringed by vadadustat. On June 11, 2020, FibroGen and Astellas appealed the Patents Court’s judgment on the invalidity of the ’823 EP Patent (UK), the ’301 EP Patent (UK), the ’333 EP Patent (UK), the ’153 EP Patent (UK), and the ’155 EP Patent (UK) in the Court of Appeal (Civil Division). On June 8, 2021 - June 10, 2021, the United Kingdom Court of Appeal held a three-day hearing for the appeal. On August 24, 2021, the Court of Appeal issued a judgment, which reversed the Patents Court’s judgment on the invalidity of the ’823 EP Patent (UK) and maintained certain claims of the ’823 EP Patent (UK) and the ’301 EP Patent (UK) in amended form, and which affirmed the Patents Court’s judgment on the invalidity of the ’333 EP Patent (UK), the ’155 EP Patent (UK), and the ’153 EP Patent (UK). Akebia sought permission to appeal to the UK Supreme Court, which was granted on October 3, 2022. We do not expect the UK Court of Appeal’s judgment to have any effect on our commercialization of vadadustat in the UK.\nUnited States\nOn March 29, 2021, we filed a lawsuit against FibroGen and AstraZeneca AB in the United States District Court for the District of Delaware to seek a declaratory judgment of non-infringement and invalidity of FibroGen’s twelve HIF-related patents in the United States: U.S. Patent Nos. 8,318,703, 8,466,172, 8,614,204, 9,920,011, 8,629,131, 8,604,012, 8,609,646, 8,604,013, 10,626,090, 10,894,774, 10,882,827, and 10,927,081. On April 5, 2022, we voluntarily dismissed, without prejudice, our declaratory judgment complaint against FibroGen and AstraZeneca under Rule 41(a)(1)(A)(i) of the Federal Rules of Civil Procedure.\nLegal Proceedings Relating to Auryxia\nANDA Litigation\n52\nIn 2018 and 2019, Keryx Biopharmaceuticals, Inc., or Keryx, received Paragraph IV certification notice letters regarding Abbreviated New Drug Applications, or ANDAs, submitted to the U.S. Food and Drug Administration, or FDA, by third parties requesting approval for generic versions of Auryxia tablets (210 mg ferric iron per tablet). In response to such ANDA filings, Keryx and its licensors, Panion & BF Biotech, Inc., or Panion, and, as applicable, Chen Hsing Hsu, M.D., filed complaints for patent infringement against such third parties. Keryx, Panion and, as applicable, Dr. Hsu have now entered into settlement and license agreements resolving all patent litigation proceedings brought by Keryx, Panion and, as applicable, Dr. Hsu, in response to ANDAs filed by third parties seeking approval to market generic versions of Auryxia® (ferric citrate) tablets prior to the expiration of the applicable patents. Each settlement agreement granted the defendants a license to market a generic version of Auryxia in the United States beginning on March 20, 2025 (subject to FDA approval), or earlier under certain circumstances customary for settlement agreements of this nature.\nStockholder Litigation Relating to the Merger\nOn June 28, 2018, we entered into an Agreement and Plan of Merger with Keryx and Alpha Therapeutics Merger Sub, Inc., or the Merger Sub, pursuant to which the Merger Sub would merge with and into Keryx, with Keryx becoming a wholly owned subsidiary of ours, or the Merger. On December 12, 2018, we completed the Merger. In October and November 2018, four purported shareholders of Keryx filed four separate putative class actions, or the Merger Securities Actions, against Keryx, a former officer and director of Keryx (Jodie P. Morrison), former directors of Keryx (Kevin J. Cameron, Mark J. Enyedy, Steven C. Gilman, Michael T. Heffernan, Daniel P. Regan and Michael Rogers, some of whom are current members of our Board of Directors), and, with respect to the Rosenblatt action discussed below, the Merger Sub and Akebia, challenging the disclosures made in connection with the Merger.\nThree of the Merger Securities Actions were filed in the Delaware District Court: Corwin v. Keryx Biopharmaceuticals, Inc., et al. (filed October 16, 2018); Van Hulst v. Keryx Biopharmaceuticals, Inc., et al. (filed October 24, 2018); and Andreula v. Keryx Biopharmaceuticals, Inc., et al. (filed November 1, 2018). The fourth Merger Securities Action was filed in the Massachusetts District Court: Rosenblatt v. Keryx Biopharmaceuticals, Inc., et al. (filed October 23, 2018). On February 19, 2019, the plaintiff in the Rosenblatt action filed a notice of voluntary dismissal of the action without prejudice. On March 27, 2019, the plaintiff in the Van Hulst action filed a notice of voluntary dismissal of the action without prejudice.\nOn April 2, 2019, the Delaware District Court granted Abraham Kiswani, a member of the putative class in both the Andreula and Corwin actions, and plaintiff John Andreula’s motion to consolidate the remaining two Merger Securities Actions pending in the Delaware District Court and consolidated the Corwin and Andreula cases under the caption In re Keryx Biopharmaceuticals, Inc., or the Consolidated Federal Action. The Delaware District Court also appointed Kiswani and plaintiff Andreula as lead plaintiffs for the Consolidated Federal Action. On June 3, 2019, the lead plaintiffs filed a consolidated amended complaint in the Consolidated Federal Action, or the Consolidated Complaint. The Consolidated Complaint generally alleged that the registration statement filed in connection with the Merger contained allegedly false and misleading statements or failed to disclose certain allegedly material information in violation of Section 14(a) and 20(a) of the Exchange Act and Rule 14a-9 promulgated thereunder. The alleged misstatements or omissions related to (i) certain financial projections for Keryx and Akebia and certain financial analyses performed by our advisors and (ii) any alleged negotiations that may have taken place regarding the conversion of certain convertible notes of Keryx in connection with the Merger. The Consolidated Complaint sought compensatory and/or rescissory damages, a declaration that the defendants violated Sections 14(a) and 20(a) of the Exchange Act and Rule 14a-9 thereunder, and an award of lead plaintiffs’ costs, including reasonable allowance for attorneys’ fees and experts’ fees. The defendants in the Consolidated Federal Action moved to dismiss the Consolidated Complaint in its entirety and with prejudice on August 2, 2019. On April 15, 2020, the Delaware District Court granted the defendants’ motion and dismissed the Consolidated Complaint in its entirety. On July 2, 2020, lead plaintiffs filed a second consolidated amended complaint, or the Second Consolidated Complaint. The Second Consolidated Complaint (i) asserted the same claims under the Exchange Act as the Consolidated Complaint, (ii) named the same defendants as the Consolidated Complaint, (iii) sought the same relief as the Consolidated Complaint and (iv) as with the Consolidated Complaint, challenged as false or misleading alleged misstatements or omissions related to certain financial projections for Keryx and Akebia and certain financial analyses performed by our advisors. The defendants in the Consolidated Federal Action moved to dismiss the Second Consolidated Complaint in its entirety with prejudice on August 10, 2020. Briefing on defendants’ motion to dismiss was completed on September 28, 2020, and on April 1, 2021, the District Court granted Defendants’ motion in its entirety and dismissed the Second Consolidated Complaint with prejudice. The lead plaintiffs appealed, and briefing on the appeal was completed on October 7, 2021. The Third Circuit submitted the case on the briefs without oral argument on February 10, 2022. On July 21, 2022, the Third Circuit affirmed the District Court’s order of dismissal.\nOn July 15, 2021, a purported former Keryx stockholder filed a putative class action in the Supreme Court of the State of New York against Akebia, a current officer of Akebia (John P. Butler), a former officer of Akebia (Jason A. Amello), former directors of Akebia (Muneer A. Satter, Scott A. Canute, Michael D. Clayman, Maxine Gowen, Duane Nash, Ronald C. Renaud, Jr., and Michael S. Wyzga), a current director of Akebia (Cynthia Smith), a former director and officer of Keryx (Jodie P.\n53\nMorrison), a former officer of Keryx (Scott A. Holmes) and former directors of Keryx (Michael Rogers, Kevin J. Cameron, Steven C. Gilman, Daniel P. Regan, Mark J. Enyedy, and Michael T. Heffernan, some of whom are current members of our Board of Directors). The action is captioned Loper v. Akebia Therapeutics, Inc., et al., or the Loper Action. The complaint in the Loper Action alleges that the registration statement filed in connection with the Merger contained allegedly false and misleading statements or failed to disclose certain allegedly material information in violation of Section 11, 12(a)(2), and 15 of the Securities Act of 1933, as amended. It alleges, among other things, that Akebia failed to disclose heightened safety risks that allegedly threatened the prospects of the Phase 3 PRO2TECT clinical trial and the commercial viability of vadadustat. The complaint in the Loper Action seeks damages including interest thereon, an award of plaintiffs’ and the class’s costs and expenses, including counsel fees and expert fees, and rescission, disgorgement, or such other equitable or injunctive relief that the Court deems appropriate.\nOn August 16, 2021, another purported former Keryx stockholder filed a putative class action making substantially similar allegations and asserting the same claims as the Loper Action, also in the Supreme Court of the State of New York against Akebia and many of the same individual defendants named in the Loper Action. The action is captioned Panicho v. Akebia Therapeutics, Inc., et al., or the Panicho Action.\nOn September 13, 2021, the parties in the Loper Action and Panicho Action entered into a joint stipulation and proposed order, which provided for the consolidation of the two actions under the caption In re Akebia Therapeutics, Inc. Securities Litigation, or the Consolidated State Action. On October 27, 2021, plaintiffs filed a consolidated complaint in the Consolidated State Action. On January 10, 2022, defendants moved to dismiss the consolidated complaint in its entirety. Briefing on defendants’ motion to dismiss was completed on April 22, 2022. Oral argument was held on October 7, 2022, and the Court dismissed the complaint without prejudice on October 17, 2022, giving plaintiffs thirty days to amend their complaint. The Court further ordered that, in the event plaintiffs do not file an amended complaint within thirty days of the dismissal, the dismissal shall be deemed to be with prejudice.\nOn March 14, 2022, a purported stockholder of Akebia filed a putative federal securities class action against Akebia as well as three present and former officers of Akebia in the U.S. District Court for the Eastern District of New York. The action was captioned Deputy v. Akebia Therapeutics, Inc., et al., No. 1:22-cv-01411, or the EDNY Action. The complaint in the EDNY Action alleged that defendants made materially false and misleading statements in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. The alleged misstatements or omissions related to heightened safety risks that allegedly threatened the prospects of the Phase 3 PRO2TECT clinical trial and the commercial viability of vadadustat. The complaint in the EDNY Action sought damages including interest thereon, an award of plaintiffs’ and the class’s costs and expenses, including counsel fees and expert fees, or such other and further relief that the Court deems appropriate. Plaintiffs Abraham Kiswani and Joseph Gorski were appointed co-lead plaintiffs on June 28, 2022, and on July 22, 2022, a stipulated scheduling order was entered allowing co-lead plaintiffs to file an amended complaint on or before August 29, 2022. On August 29, 2022, co-lead plaintiffs filed a stipulation of voluntary dismissal, and the Court entered an order dismissing the co-lead plaintiffs from the action on August 30, 2022. The original named plaintiff filed a stipulation of voluntary dismissal on September 7, 2022, and the court formally terminated the case on September 8, 2022.\nWe deny any allegations of wrongdoing and intend to continue vigorously defending against the one active stockholder lawsuit described in this Legal Proceedings section, the Consolidated State Action. There is no assurance, however, that we will be successful in the defense of this action, or any associated appeals, or that insurance will be available or adequate to fund any settlement or judgment or the litigation costs of this action. Moreover, we are unable to predict the outcome or reasonably estimate a range of possible losses at this time. A resolution of the Consolidated State Action in a manner adverse to us, however, could have a material effect on our financial position and results of operations in the period in which the action is resolved.\nItem 1A. Risk Factors.\nWe face a variety of risks and uncertainties in our business. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may also become important factors that affect our business. If any of the following risks occurs, our business, financial condition, financial statements, results of operations and future growth prospects could be materially and adversely affected.\nRisks Related to our Financial Position, Need for Additional Capital and Growth Strategy\nWe have incurred significant losses since our inception, and anticipate that we will continue to incur significant losses and cannot guarantee when, if ever, we will become profitable or attain positive cash flows.\nInvestment in pharmaceutical product development and commercialization is highly speculative because it requires upfront capital expenditures and there is significant risk that a product candidate will fail to gain marketing approval or that an\n54\napproved product will not be commercially viable. Since our inception, we have devoted most of our resources to research and development, including our preclinical and clinical development activities and, following the merger, or the Merger, whereby Keryx Biopharmaceuticals, Inc., or Keryx, became a wholly owned subsidiary of ours, commercialization. We have financed our operations primarily through sales of equity securities, our strategic collaborations and, following the Merger, product revenues, a royalty monetization transaction and debt. Prior to the Merger, we had no products approved for commercial sale and had not generated any revenue from the sale of products. We are not currently profitable, and we have incurred net losses each year since our inception, including a net loss of $51.9 million for the three months ended September 30, 2022, and a net loss of $85.0 million for the nine months ended September 30, 2022. As of September 30, 2022, we had an accumulated deficit of $1.5 billion. We cannot guarantee when, if ever, we will become profitable.\nIn March 2022, we received a complete response letter, or CRL, from the FDA regarding our NDA for vadadustat, our lead investigational product candidate, for the treatment of anemia associated with CKD. The FDA concluded that the data in the NDA do not support a favorable benefit-risk assessment of vadadustat for dialysis and non-dialysis patients. In July 2022, we held an end of review meeting with the FDA to inform the Company's next steps with respect to the potential U.S. approval of vadadustat, if any, and in October 2022, we submitted a Formal Dispute Resolution Request, or FDRR, to the FDA. The FDRR focuses on the favorable balance between the benefits and risks of vadadustat for the treatment of anemia due to CKD in adult patients on dialysis in light of safety concerns expressed by the FDA in the CRL related to the rate of adjudicated thromboembolic events driven by vascular access thrombosis for vadadustat compared to the active comparator and the risk of drug-induced liver injury. There can be no assurances that our FDRR will be accepted by the FDA, or that, if accepted, we will be successful in our appeal and obtain approval for vadadustat in a timely manner, on favorable terms, or at all. As a result, the regulatory approval process for vadadustat in the U.S. is highly uncertain. We may not obtain approval at all, and if we are able to obtain approval, the expense and time to do so could adversely impact our ability to successfully commercialize vadadustat or conduct our other business operations, and our financial condition could be materially harmed.\nOur ability to generate product revenue and achieve profitability depends on the overall success of Auryxia(R), vadadustat, if approved, and any current or future product candidates, including those that may be in-licensed or acquired, which depends on several factors, including:\n•obtaining adequate or favorable pricing and reimbursement from private and governmental payors for Auryxia, vadadustat, if approved, and any other product or product candidate, including those that may be in-licensed or acquired;\n•obtaining and maintaining market acceptance of Auryxia, vadadustat, if approved, and any other product candidate, including those that may be in-licensed or acquired;\n•the size of any market in which Auryxia, vadadustat and any other product or product candidate, including those that may be in-licensed or acquired, receives approval and obtaining adequate market share in those markets;\n•addressing the issues identified in the CRL for vadadustat that we received from the FDA, including the results of the end of review meeting and, in the event our FDRR is accepted by the FDA, the outcome of our appeal;\n•the timing and scope of marketing approvals for vadadustat, if approved, and any other product candidate, if approved, including those that may be in-licensed or acquired; maintaining marketing approvals for Auryxia, vadadustat, if approved, and any other product, including those that may be in-licensed or acquired;\n•actual or perceived advantages or disadvantages of our products or product candidates as compared to alternative treatments, including their respective safety, tolerability and efficacy profiles, the potential convenience and ease of administration and cost;\n•maintaining an acceptable safety and tolerability profile of our approved products, including the frequency and severity of any side effects;\n•the willingness of the target patient population to try new therapies and of physicians to prescribe these therapies, based, in part, on their perception of our clinical trial data and/or the actual or perceived safety, tolerability and efficacy profile;\n•establishing and maintaining supply and manufacturing relationships with third parties that can provide adequate supplies of products that are compliant with good manufacturing practices, or GMPs, to support the clinical development and the market demand for Auryxia, vadadustat, if approved, and any other product and product candidate, including those that may be in-licensed or acquired;\n•current and future restrictions or limitations on our approved or future indications and patient populations or other adverse regulatory actions or in the event that the FDA requires Risk Evaluation and Mitigation Strategies, or REMS, or risk management plans that use restrictive risk minimization strategies;\n•the effectiveness of our sales, marketing, manufacturing and distribution strategies and operations;\n•competing effectively with any products for the same or similar indications as our products;\n•maintaining, protecting and expanding our portfolio of intellectual property rights, including patents and trade secrets; and\n55\n•the impact of the COVID-19 pandemic on the above factors, including the disproportionate impact of the COVID-19 pandemic on CKD patients, the adverse impact on the phosphate binder market in which we compete, and the limitation of our sales professionals to meet in person with healthcare professionals as the result of travel restrictions or limitations on access for non-patients.\nOur ability to achieve profitability also depends on our ability to manage our expenses. Following receipt of the CRL, in April and May 2022, we implemented a reduction of our workforce, by approximately 42% across all areas of the Company (47% inclusive of the closing of the majority of open positions), including several members of management. We recorded a restructuring charge of $14.7 million in the aggregate primarily related to contractual termination benefits including severance, non-cash stock-based compensation expense, healthcare and related benefits in the nine months ended September 30, 2022. However, we may incur additional costs not currently contemplated due to events associated with or resulting from the workforce reduction. Additionally, the reduction in workforce could impact our operations, including our commercialization of Auryxia, which could affect our ability to generate revenue.\nEven in light of the reduction in workforce, we expect to continue to incur significant expenses and operating losses for the foreseeable future. In addition to any additional costs not currently contemplated due to events associated with or resulting from the workforce reduction noted above, our ability to achieve profitability and our financial position will depend, in part, on the rate of our future expenditures, on product revenue, collaboration revenue, and our ability to obtain additional funding. On June 30, 2022, we entered into a Termination and Settlement Agreement, or the Termination Agreement, with Otsuka Pharmaceutical Co. Ltd., or Otsuka, pursuant to which we agreed to the immediate termination of the December 18, 2016 collaboration and license agreement with Otsuka, or the Otsuka U.S. Agreement, and the April 25, 2017 collaboration and license agreement with Otsuka, or the Otsuka International Agreement, in exchange for the payment of $55.0 million to us and the agreement between the parties with respect to the conduct of certain activities. Unless and until we are able to find a new partner for vadadustat in Europe and other countries previously licensed to Otsuka, we will incur additional expenses in connection with the development of vadadustat and will receive less collaboration revenue and, if approved, product revenue than originally anticipated. In addition, we expect to continue to incur significant expenses if and as we:\n•continue our commercialization activities for Auryxia and vadadustat, if we are able to obtain marketing approval for vadadustat following receipt of the CRL from the FDA in March 2022, and any other product or product candidate, including those that may be in-licensed or acquired;\n•address the issues identified in the CRL for vadadustat that we received from the FDA and pursue our appeal of the CRL for vadadustat with the FDA, in the event our FDRR is accepted;\n•conduct and enroll patients in any clinical trials, including post-marketing studies or any other clinical trials for Auryxia, vadadustat or any other product or product candidate, including those that may be in-licensed or acquired;\n•seek marketing approvals for vadadustat and any other product candidate, including those that may be in-licensed or acquired;\n•maintain marketing approvals for Auryxia and vadadustat, if we are able to obtain marketing approval for vadadustat following receipt of the CRL from the FDA in March 2022, and any other product, including those that may be in-licensed or acquired;\n•manufacture Auryxia, vadadustat and any other product or product candidate, including those that may be in-licensed or acquired, for commercial sale and clinical trials;\n•conduct discovery and development activities for additional product candidates or platforms that may lead to the discovery of additional product candidates;\n•engage in transactions, including strategic, merger, collaboration, acquisition and licensing transactions, pursuant to which we would market and develop commercial products, or develop and commercialize other product candidates and technologies;\n•continue to repay, and pay any associated pre-payment penalties, if applicable, the senior secured term loans in an aggregate principal amount of $67.0 million, or the Term Loans, that were made available to us pursuant to the Loan Agreement;\n•make royalty, milestone or other payments under our license agreements and any future license agreements;\n•maintain, protect and expand our intellectual property portfolio;\n•make decisions with respect to our personnel, including the retention of key employees;\n•make decisions with respect to our infrastructure, including to support our operations as a fully integrated, publicly traded biopharmaceutical company; and\n•experience any additional delays or encounter issues with any of the above.\nWe have and will continue to expend significant resources in our legal proceedings, as described above under Part II, Item I. Legal Proceedings, or any other legal proceedings brought by or against us in the future.\n56\nBecause of the numerous risks and uncertainties associated with pharmaceutical product development and commercialization, we are unable to accurately predict the timing or amount of increased expenses. The net losses we incur may fluctuate significantly from quarter to quarter and year to year, such that a period-to-period comparison of our results of operations may not be a good indication of our future performance. In any particular quarter, the progress of our clinical development and our operating results could be below the expectations of securities analysts or investors, which could cause our stock price to decline.\nWe will continue to incur substantial expenditures relating to continued commercialization and post-marketing requirements for Auryxia and vadadustat, if we are able to obtain marketing approval for vadadustat following receipt of the CRL from the FDA in March 2022, and any other products, including those that may be in-licensed or acquired, as well as costs relating to the research and development of any other product candidate, including those that may be in-licensed or acquired. Our prior losses and expected future losses have had and will continue to have an adverse effect on our stockholders’ equity and working capital.\nOur expenses could increase beyond expectations if we are required by the FDA, the European Medicines Agency, or the EMA, or other regulatory authorities, or if we otherwise believe it is necessary, to change our manufacturing processes or assays, to amend or replace our study protocols, to conduct any additional clinical trials, whether in order to obtain approval or as a post-approval study, including any additional clinical trial that we decide to conduct for vadadustat, to perform studies in addition to, different from or larger than those currently planned, if there are any delays in completing our clinical trials or if there are further delays in or issues with obtaining marketing approval for vadadustat in the United States, the European Union, or EU, or other jurisdictions. In addition, our ability to generate revenue would be negatively affected if the size of our addressable patient population is not as significant as we estimate, the indication approved by regulatory authorities is narrower than we sought or the patient population for treatment is narrowed by competition, physician choice, coverage or reimbursement, or payor or treatment guidelines. Even though we generate product revenue from Auryxia and royalties from RionaTM and VafseoTM in Japan and may generate revenue and royalties from the sale of any products that may be approved in the future, including those that may be in-licensed or acquired, we may never generate revenue and royalties that are significant enough for us to become and remain profitable, and we will need to obtain additional funding to continue to fund our operating plan and achieve strategic growth.\nWe will require substantial additional financing to achieve our goals. A failure to obtain this necessary capital when needed, or on acceptable terms, could force us to delay, limit, reduce or terminate our product development or commercialization efforts.\nAs of September 30, 2022, our cash and cash equivalents were $144.8 million. We expect to continue to expend substantial amounts of cash for the foreseeable future as we continue to commercialize Auryxia; in the event our FDRR is accepted by the FDA, pursue our appeal for vadadustat in the U.S. with the FDA; support the regulatory process with respect to vadadustat with the EMA and ACCESS Consortium; and develop and commercialize any other product or product candidate, including those that may be in-licensed or acquired. These expenditures will include costs associated with research and development, manufacturing, potentially obtaining marketing approvals and marketing products approved for sale. In addition, other unanticipated costs may arise. Because the outcomes of our current and anticipated clinical trials are highly uncertain, we cannot reasonably estimate the actual amount of funding necessary to successfully complete clinical development for any current or future product candidates, including vadadustat depending on what is required to address the issues identified in the CRL for vadadustat, including the outcome of our appeal and if additional clinical trials are required in order to obtain marketing approval, or to complete post-marketing studies for Auryxia and vadadustat, if approved. Our future capital requirements depend on many factors, including:\n•the scope, progress, results and costs of conducting clinical trials or any post-marketing requirements or any other clinical trials for Auryxia, vadadustat and any other product or product candidate, including those that may be in-licensed or acquired;\n•the cost and timing of commercialization activities, including product manufacturing, marketing, sales and distribution costs, for Auryxia, vadadustat, if approved, and any other product or product candidate, including those that may be in-licensed or acquired;\n•the results of our meetings with the FDA, the EMA and other regulatory authorities and any consequential effects, including on timing of and ability to obtain and maintain marketing approval, study design, study size and resulting operating costs;\n•any difficulties or delays in conducting our clinical trials, or enrolling patients in our clinical trials, for Auryxia, vadadustat or any other product candidates;\n•the outcome of our efforts to obtain marketing approval for vadadustat in the United States, Europe and in other jurisdictions and any other product candidates, including those that may be in-licensed or acquired, including any additional clinical trials or post-approval commitments imposed by regulatory authorities;\n57\n•the timing of, and the costs involved in obtaining, marketing approvals for vadadustat, including in the United States, Europe, China and certain other markets, and any other product candidate, including those that may be in-licensed or acquired, including to fund the preparation, filing and prosecution of regulatory submissions;\n•the costs of maintaining marketing approvals for Auryxia or any other product, including those that may be in-licensed or acquired;\n•the cost of securing and validating commercial manufacturing for any of our product candidates, including those that may be in-licensed or acquired, and maintaining our manufacturing arrangements for Auryxia and vadadustat or any other product, including those that may be in-licensed or acquired, or securing and validating additional arrangements;\n•the costs involved in preparing, filing and prosecuting patent applications and maintaining, defending and enforcing our intellectual property rights, including litigation costs, and the outcome of such litigation;\n•the costs involved in any legal proceedings to which we are a party;\n•our status as a publicly traded company on the Nasdaq Global Market;\n•our decisions with respect to personnel;\n•our decisions with respect to infrastructure; and\n•the extent to which we engage in transactions, including strategic, merger, collaboration, acquisition and licensing transactions, pursuant to which we could develop and market commercial products, or develop other product candidates and technologies.\nFurthermore, we expect to continue to incur costs associated with operating as a fully integrated, publicly traded biopharmaceutical company. Accordingly, we will need to obtain substantial additional funding to fund our operating plan beyond Auryxia and achieve strategic growth. If we are unable to raise capital when needed or on attractive terms, we could be forced to delay, reduce or eliminate our research and development programs or any future commercialization efforts.\nWe expect our cash resources to fund our current operating plan through at least the next twelve months from the filing of this Quarterly Report on Form 10-Q. However, our operating plan includes assumptions pertaining to cost avoidance measures and the reduction of overhead costs that would result from the planned amendment of contractual arrangements with certain supply and collaboration partners, and the reduction of operating expenses. If we are not able to execute any of the planned amendments of contractual arrangements with certain supply and collaboration partners, or to reduce our operating expenses, our cash resources may be inadequate to support our operations for a period through at least the next twelve months from the date of issuance of these financial statements. In addition, if we fail to satisfy any of the covenants under our Loan Agreement with Pharmakon, including the covenant that our Annual Report on Form 10-K for the fiscal year ending December 31, 2022 not be qualified as to going concern, and the loan is accelerated, we may not have sufficient resources to fund our operating plan through the next twelve months. There can be no assurance that the current operating plan will be achieved in the time frame anticipated by us, or that our cash resources will fund our operating plan for the period anticipated by us or that additional funding will be available on terms acceptable to us, or at all.\nAny additional fundraising efforts may divert our management’s attention away from their day-to-day activities, which may adversely affect our ability to develop and commercialize Auryxia and any other products or product candidates, including those that may be in-licensed or acquired, or to continue to seek regulatory approval for vadadustat. Also, additional funds may not be available to us in sufficient amounts or on acceptable terms or at all. If we are unable to raise additional capital in sufficient amounts when needed or on terms acceptable to us, we may have to significantly delay, scale back or discontinue the development and/or commercialization of Auryxia and any other products or product candidates, including those that may be in-licensed or acquired, or to take any actions with respect to vadadustat depending on future decisions with respect to vadadustat in the U.S. Any of these events could significantly harm our business, financial condition and prospects.\nOur independent registered public accounting firm included an explanatory paragraph relating to our ability to continue as a going concern in its report on our audited financial statements included in our Annual Report on Form 10-K and any future concerns relating to our ability to continue as a going concern would materially adversely affect us.\nWe believe that our cash resources will be sufficient to fund our current operating plan through at least the next twelve months from the filing of this Quarterly Report on Form 10-Q. However, there were conditions or events, considered in the aggregate, that raised substantial doubt about our ability to continue as a going concern within twelve months after the date the financial statements for December 31, 2021 were issued and certain elements of our operating plan were outside of our control at that time and continue to be outside of our control. In addition, as of the date of the financial statements included in this Quarterly Report on Form 10-Q, our operating plan includes assumptions pertaining to cost avoidance measures and the reduction of overhead costs that would result from the planned amendment of contractual arrangements with certain supply and collaboration partners, and the reduction of operating expenses. Because these cost avoidance measures and certain other elements of our operating plan are outside of our control, there is uncertainty as to whether our cash resources will be adequate to support our operations for a period through at least the next twelve months from the date of issuance of the financial statements included in this Quarterly Report on Form 10-Q. These conditions raise substantial doubt regarding our ability to continue as a going concern for a period of one year after the date these financial statements are issued. In the event we are not able to continue as a going concern, our business would be materially impacted. See Note 1 to our consolidated financial statements appearing elsewhere in our 2021 Annual Report on Form 10-K and Note 1 to this Quarterly Report on Form 10-Q,\n58\nas applicable, for additional information on our assessments. Future concerns relating to our ability to continue as a going concern, could have a material adverse affect on us.\nIf we are unable to manage our spending, generate sufficient product revenue from sales of Auryxia, or otherwise obtain sufficient funding, our business, prospects, financial condition and results of operations will be materially and adversely affected and we may be unable to continue as a going concern. If we are unable to continue as a going concern, we may have to liquidate our assets and may receive less than the value at which those assets are carried on our audited financial statements, and it is likely that investors will lose all or a part of their investment. If we seek additional financing to fund our business activities in the future and there remains substantial doubt about our ability to continue as a going concern, investors or other financing sources may be unwilling to provide additional funding to us on commercially reasonable terms or at all. There can be no assurance that the current operating plan will be achieved in the time frame anticipated by us, or that our cash resources will fund our operating plan for the period we anticipate or that additional funding will be available on terms acceptable to us, or at all.\nPursuant to covenants in the Loan Agreement, as amended by the First Amendment and Waiver and the Second Amendment and Waiver, our Annual Reports on Form 10-K, must not be subject to any qualification as to going concern. If we do not satisfy the covenant as to going concern in any of the required filings, we will be in default under the Loan Agreement. If an event of default occurs and is continuing under the Loan Agreement, the Collateral Agent is entitled to take enforcement action, including acceleration of amounts due under the Loan Agreement, and we may not have the available cash resources to repay at such time. If we are required to repay additional amounts due under the Loan Agreement earlier than anticipated, it would have a material adverse effect on our business, results of operations and financial condition.\nRaising additional capital may cause dilution to our existing stockholders, restrict our operations or require us to relinquish rights to our product and product candidates on unfavorable terms to us.\nWe expect to finance future cash needs through product revenue, royalty transactions, strategic transactions, public or private equity or debt transactions, or a combination of these approaches. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the ownership interests of our common stockholders will be diluted, our fixed payment obligations may increase, any such securities may have rights senior to those of our common stock, and the terms may include liquidation or other preferences and anti-dilution protections that adversely affect the rights of our common stockholders. Additional debt financing, if available, may involve agreements that would restrict our operations and potentially impair our competitiveness, such as limitations on our ability to incur additional debt, make capital expenditures, declare dividends, acquire, sell or license intellectual property rights, and other operating restrictions that could adversely impact our ability to conduct our business. If we raise additional funds through royalty transactions, we may have to relinquish valuable rights to our portfolio and future revenue streams, and enter into agreements that would restrict our operations and strategic flexibility. If we raise additional funds through strategic transactions with third parties, we may have to do so at an earlier stage than otherwise would be desirable. In connection with any such strategic transactions, we may be required to relinquish valuable rights to our product and product candidates, future revenue streams or research programs or grant licenses on terms that are not favorable to us. If we are unable to raise additional funds when needed, we may not be able to pursue planned development and commercialization activities and we may need to grant rights to develop and market product candidates that we would otherwise prefer to develop and market ourselves.\nIf we fail to regain compliance with the continued listing requirements of Nasdaq, our common stock may be delisted and the price of our common stock and our ability to access the capital markets could be negatively impacted.\nOn May 12, 2022, we received a deficiency letter from the Listing Qualifications Department of the Nasdaq Stock Market, or Nasdaq, notifying us that, for the last 30 consecutive business days, the bid price for our common stock had closed below the minimum $1.00 per share requirement for continued inclusion on the Nasdaq Global Market, referred to as the minimum bid price rule. In accordance with Nasdaq Listing Rules, we have an initial period of 180 calendar days, or until November 8, 2022, to regain compliance with the minimum bid price rule.\nTo date, we have not regained compliance with the minimum bid price rule. However, we have applied to transfer the listing of our common stock to the Nasdaq Capital Market. If the application is approved, then we may be eligible for an additional 180 day compliance period. However, there can be no assurance that we will satisfy the continued listing requirement for the market value of publicly held shares and all other initial listing standards for the Nasdaq Capital Market, with the exception of the minimum bid price requirement, and as such, we may not be eligible for the additional 180 day compliance period. If we are successful in transferring the listing of our common stock to the Nasdaq Capital Market and at any time during any additional compliance period the bid price for our common stock closes at $1.00 or more per share for a minimum of 10 consecutive business days, the Nasdaq Listing Qualifications Department staff will provide written notification to us that we are in compliance with the minimum bid price rule, unless the staff exercises its discretion to extend this 10-day period pursuant to the Nasdaq Listing Rules.\n59\nIf we do not regain compliance with the minimum bid price rule by the required date and we are not eligible for any additional compliance period at that time, the Nasdaq Listing Qualifications Department staff will provide us written notification that our common stock may be delisted. At that time, we may appeal the staff’s delisting determination to a Nasdaq Listing Qualifications Panel. We expect that our common stock would remain listed pending the panel’s decision. However, there can be no assurance that, even if we appeal the staff’s delisting determination to the Nasdaq Listing Qualifications Panel, such appeal would be successful.\nWe intend to monitor the closing bid price of our common stock and may, if appropriate, consider available options to regain compliance with the minimum bid price rule, which could include seeking to effect a reverse stock split. However, there can be no assurance that we will be able to regain compliance with the minimum bid price rule.\nThere are many factors that may adversely affect our minimum bid price, including those described throughout this section titled “Risk Factors.” Many of these factors are outside of our control. As a result, we may not be able to sustain compliance with the minimum bid price rule in the long term. Any potential delisting of our common stock from the Nasdaq Global Market would likely result in decreased liquidity and increased volatility for our common stock and would adversely affect our ability to raise additional capital or to enter into strategic transactions. Any potential delisting of our common stock from the Nasdaq Global Market would also make it more difficult for our stockholders to sell our common stock in the public market.\nWe may not be successful in our efforts to identify, acquire, in-license, discover, develop and commercialize additional products or product candidates or our decisions to prioritize the development of certain product candidates over others may not be successful, which could impair our ability to grow.\nAlthough we continue to focus a substantial amount of our efforts on the commercialization of Auryxia and in the event our FDRR is accepted by the FDA, to pursue our appeal for vadadustat in the U.S. with the FDA, including through the appeal process, a key element of our long-term growth strategy is to develop additional product candidates and acquire, in-license, develop and/or market additional products and product candidates.\nResearch programs to identify product candidates require substantial technical, financial and human resources, regardless of whether product candidates are ultimately identified. Our research and development programs may initially show promise, yet fail to yield product candidates for clinical development or commercialization for many reasons, including the following:\n•the research methodology used may not be successful in identifying potential indications and/or product candidates;\n•we may not be able or willing to assemble sufficient resources to acquire or discover additional product candidates;\n•a product candidate may be shown to have harmful side effects, a lack of efficacy or other characteristics that indicate that they are unlikely to be drugs that will receive marketing approval and/or achieve market acceptance;\n•a product candidate we develop and seek regulatory approval for, including vadadustat, may not be approved by the FDA on a timely basis, or at all;\n•product candidates we develop may nevertheless be covered by third party patents or other exclusive rights;\n•the market for a product candidate may change during our program so that the continued development of that product candidate is no longer commercially reasonable;\n•a product candidate may not be capable of being produced in commercial quantities at an acceptable cost, or at all; or\n•a product candidate may not be accepted as safe and effective by patients, the medical community, or third party payors, if applicable.\nIf any of these events occur, we may be forced to abandon our research and development efforts for one or more of our programs, or we may not be able to identify, discover, develop or commercialize additional product candidates, which may have a material adverse effect on our business.\nBecause we have limited financial and managerial resources, especially as a result of the CRL for vadadustat that we received in March 2022 and the reduction in workforce that we implemented in April and May 2022, we focus on products, research programs and product candidates for specific indications. As a result, we may forgo or delay pursuit of opportunities with other product candidates or for other indications, or out license rights to product candidates, that later prove to have greater commercial potential. For example, as a result of receipt of the CRL and implementation of the reduction in workforce, we delayed certain research activities. Our resource allocation decisions may cause us to fail to capitalize on viable commercial products or profitable market opportunities. Our spending on current and future research and development programs and product candidates for specific indications may not yield any commercially viable products.\nBecause our internal research capabilities are limited, we may be dependent upon other pharmaceutical and biotechnology companies, academic scientists, and other researchers to sell or license product candidates, products or technology to us. The success of this strategy depends partly upon our ability to identify, select, and acquire promising product candidates and products. The process of identifying, selecting, negotiating and implementing a license or acquisition of a product candidate or an approved product is lengthy and complex. Other companies, including some with substantially greater financial, marketing\n60\nand sales resources, may compete with us for the license or acquisition of a product candidate or an approved product. We have limited resources to identify and execute the acquisition or in-licensing of third party products, businesses, and technologies and integrate them into our current infrastructure.\nMoreover, we may devote resources to potential acquisitions or in-licensing opportunities that are never completed, or we may fail to realize the anticipated benefits of such efforts. Any product candidate that we acquire may require additional development efforts prior to commercial sale, including extensive clinical testing and approval by the FDA, the EMA, the Japanese Pharmaceuticals and Medical Devices Agency, or PMDA, or other regulatory authorities, or post-approval testing or other requirements if approved. All product candidates are prone to risks of failure typical of pharmaceutical product development, including the possibility that a product candidate will not be shown to be sufficiently safe and effective for approval by regulatory authorities. In addition, we cannot provide assurance that any of our products will be manufactured profitably, achieve market acceptance or not require substantial post-marketing clinical trials.\nAccordingly, there can be no assurance that we will ever be able to identify, acquire, in-license or develop suitable additional products or product candidates, which could materially adversely affect our future growth and prospects. We may focus our efforts and resources on potential products, product candidates or other programs that ultimately prove to be unsuccessful.\nWe may engage in strategic transactions to acquire assets, businesses, or rights to products, product candidates or technologies or form collaborations or make investments in other companies or technologies that could harm our operating results, dilute our stockholders’ ownership, increase our debt, or cause us to incur significant expense.\nAs part of our business strategy, we may engage in additional strategic transactions to expand and diversify our portfolio, including through the merger, acquisition or in-license of assets, businesses, or rights to products, product candidates or technologies or through strategic alliances or collaborations, similar to the Merger and our existing and prior collaboration and license arrangements. We may not identify suitable strategic transactions, or complete such transactions in a timely manner, on favorable terms, on a cost-effective basis, or at all. Moreover, we may devote resources to potential opportunities that are never completed or we may incorrectly judge the value or worth of such opportunities. Even if we successfully execute a strategic transaction, we may not be able to realize the anticipated benefits of such transaction and may experience losses related to our investments in such transactions. Integration of an acquired company or assets into our existing business may not be successful and may disrupt ongoing operations, require the hiring of additional personnel and the implementation and integration of additional internal systems and infrastructure, and require management resources that would otherwise focus on developing our existing business. Even if we are able to achieve the long-term benefits of a strategic transaction, our expenses and short-term costs may increase materially and adversely affect our liquidity. Any of the foregoing could have a detrimental effect on our business, results of operations and financial condition. For example, on June 4, 2021, we entered into a license agreement, the Cyclerion Agreement, with Cyclerion Therapeutics Inc., or Cyclerion, pursuant to which Cyclerion granted us an exclusive global license under certain intellectual property rights to research, develop and commercialize praliciguat, an investigational oral soluble guanylate cyclase, or sGC, stimulator. Although we have progressed pre-clinical studies for praliciguat, we may be unsuccessful in developing praliciguat. If any of the assumptions that we made in valuing the transaction, including the costs or timing of development of, or the potential benefits of, praliciguat, were incorrect, we may not recognize the anticipated benefits of the transaction and our business could be harmed.\nIn addition, future transactions may entail numerous operational, financial and legal risks, including:\n•incurring substantial debt, dilutive issuances of securities or depletion of cash to pay for acquisitions;\n•exposure to known and unknown liabilities, including contingent liabilities, possible intellectual property infringement claims, violations of laws, tax liabilities and commercial disputes;\n•higher than expected acquisition and integration costs;\n•difficulty in integrating operations, processes, systems and personnel of any acquired business;\n•increased amortization expenses or, in the case of a write-down of the value of acquired assets, impairment losses, such as the Auryxia intangible asset impairment in the second quarter of 2020 and corresponding adjustments to the estimated useful life of the developed product rights for Auryxia;\n•impairment of relationships with key suppliers or customers of any acquired business due to changes in management and ownership;\n•inability to retain personnel, customers, distributors, vendors and other business partners integral to an in-licensed or acquired product, product candidate or technology;\n•potential failure of the due diligence processes to identify significant problems, liabilities or other shortcomings or challenges;\n•entry into indications or markets in which we have no or limited development or commercial experience and where competitors in such markets have stronger market positions; and\n61\n•other challenges associated with managing an increasingly diversified business.\nIf we are unable to successfully manage any transaction in which we may engage, our ability to develop new products and continue to expand and diversify our portfolio may be limited.\nOur business has been and may continue to be, directly or indirectly, adversely affected by the COVID-19 pandemic.\nThe COVID-19 pandemic has presented a substantial public health and economic challenge around the world and continues to affect our employees, patients, healthcare providers with whom we interact, customers, collaboration partners, contract research organizations, or CROs, our contract manufacturing organizations, or CMOs, vendors, communities and business operations. The full extent to which the COVID-19 pandemic will directly or indirectly impact our business, results of operations and financial condition continues to depend on future developments that are highly uncertain and cannot be accurately predicted, including new information that may emerge concerning the COVID-19 pandemic, any resurgences or variants of COVID-19, the actions taken to contain it or treat its impact and the economic and other impacts on local, regional, national and international markets where the healthcare providers with whom we interact, our partners, our CROs, our CMOs, and our other vendors operate.\nWe believe our revenue growth was negatively impacted by the COVID-19 pandemic in 2021 and the first three quarters of 2022 primarily as the CKD patient populations that we serve experienced both high hospitalization and mortality rates due to COVID-19, and the pandemic had an adverse impact on the phosphate binder market in which Auryxia competes. Labor shortages and costs have adversely impacted dialysis providers. These impacts have refocused clinical efforts in addressing bone and mineral disorders like hyperphosphatemia to more acute operational issues to ensure patients receive dialysis treatments and still some patients have been rescheduled or missed treatments due to labor shortages. We believe, this and potentially other factors, has led to the reduction in the phosphate binder market, which has not experienced growth since early 2020. While we are unable to quantify the impact of the COVID-19 pandemic on future revenues and revenue growth, the COVID-19 pandemic and the ongoing impacts from the COVID-19 pandemic continue to adversely and disproportionately impact CKD patients and the phosphate binder market; therefore, we expect the COVID-19 pandemic and the ongoing impacts from the pandemic to continue to have a negative impact on our revenue growth for the foreseeable future.\nAs a result of the COVID-19 pandemic, we adopted a flexible workplace policy allowing employees to work from home on a full or part-time basis, which may make it difficult for us to maintain our corporate culture or retain employees. Moreover, our future success substantially depends on the management skills of our executives and certain other key employees. The unanticipated loss or unavailability of key employees due to the pandemic could harm our ability to operate our business or execute our business strategy, and we may not be successful in finding and integrating suitable successors in the event any of our key employees leave or are unavailable. This could have an adverse effect on our business, results of operations and cash flows.\nIn addition, several healthcare facilities have previously restricted access for non-patients, including the members of our sales force. For example, DaVita, Inc., or DaVita, and Fresenius Medical Care, or Fresenius, which account for a vast majority of the dialysis population in the United States, have previously restricted access to their clinics. As a result, we continue to engage with some healthcare providers and other customers virtually, where possible. The restrictions on our customer-facing employees’ in-person interactions with healthcare providers have, and could continue to, negatively impact our access to healthcare providers and, ultimately, our sales, including with respect to vadadustat, if approved. Recently, such precautionary measures have been relaxed at certain healthcare facilities and, as a result, members of our sales force have resumed in person interactions with certain customers. Nevertheless, some restrictions remain, and more restrictions may be put in place again due to a resurgence in COVID-19 cases, including those involving new variants of COVID-19, which may be more contagious and more severe than prior strains of the virus. Given this uncertain environment and the disproportionate impact of the COVID-19 pandemic on CKD patients, we are actively monitoring the demand in the United States for Auryxia and will be for vadadustat, if approved, including the potential for further declines or changes in prescription trends and customer orders, which could have a material adverse effect on our business, results of operations, and financial condition.\nIn addition, the direct and indirect impacts of the pandemic or the response efforts to the pandemic, including, among others, competition for labor and resources and increases in labor, sourcing, manufacturing and shipping costs, may cause disruptions to, closures of or other impacts on our CMOs and other vendors in our supply chain on which we rely for the supply of our products and product candidates. For example, areas of China have recently continued to implement lockdowns for COVID-19, which could impact the global supply chain. At this time, our CMOs continue to operate at or near normal levels. However, it is possible that the COVID-19 pandemic and response efforts may have an impact in the future on our contract manufacturers’ ability to manufacture and deliver Auryxia and vadadustat (if approved in the United States or EMA and which is currently marketed under the trade name VafseoTM by MTPC in Japan), which may result in increased costs and delays, or disruptions to the manufacturing and supply of our products. These impacts could have a negative effect on our inventory reserves, which could result in an increase in inventory write-offs due to expiry.\n62\nOutside of the impacts to our clinical trials as a result of the CRL, the pandemic has resulted in closures of and may continue to impact clinical trial sites on which we rely and will rely on in the future for the completion of certain clinical trials. COVID-19 pandemic precautions have caused moderate delays in enrolling new clinical trials and may cause delays in enrolling future clinical trials. Further, the pandemic has impacted and is likely to continue to impact the business of the FDA, the EMA and other government authorities, which potentially could result in delays in meetings, reviews, inspections and approvals relating to our product and product candidates. Any decision by the FDA, EMA or other governmental authorities to delay meeting with us or our collaboration partners or delay scheduling inspections in light of the COVID-19 pandemic could have a material adverse effect on clinical trials of our product candidates or on our efforts to obtain marketing approvals for vadadustat, which could increase our operating expenses and have a material adverse effect on our financial results, including the timing and amount of future regulatory milestones we could receive from our collaboration partners.\nIf we or any of the third parties with whom we engage, including our collaboration partners, or any of our customers were to experience further shutdowns, delays or other business disruptions, our ability to conduct our business in the manner and on the timelines presently planned, and our revenue expectations, could be materially and negatively impacted, which could have a material adverse effect on our business and our financial results.\nThe COVID-19 pandemic may continue to significantly impact economies and financial markets worldwide, which could result in adverse effects on our business and operations, impact our ability to raise additional funds and impact the volatility of our stock price and trading in our stock. Even after the COVID-19 pandemic has been contained or mitigated, we may continue to experience adverse impacts to our business as a result of any economic recession or depression that has occurred or may occur in the future.\nThe global impact of the COVID-19 pandemic continues to rapidly evolve, and we will continue to monitor the situation closely. In particular, areas we are monitoring include possible COVID-related changes in our commercial revenue payor mix, overall product sales, and reserves and allowances, as well as negative trends that could potentially have a further significant impact on product demand and, ultimately, product revenue, or could cause goodwill, intangible assets, and other assets to be impaired. This uncertain pandemic environment has presented new risks to our business. While we are working to mitigate the impacts on our business, we are mindful that many of these risks and the impact to the larger healthcare market are outside of our control. The extent to which the COVID-19 pandemic impacts our business will depend on future developments, which are highly uncertain and the magnitude of which cannot be predicted, including new information that may emerge concerning the severity of COVID-19 and the actions to contain COVID-19, and the effectiveness of vaccines against virus variants.\nRisks Related to our Financial Arrangements\nOur obligations in connection with the loan agreement with Pharmakon and requirements and restrictions in the loan agreement could adversely affect our financial condition and restrict our operations.\nWe entered into the Loan Agreement with Pharmakon, pursuant to which the Term Loans were made available to us in two tranches. The first tranche of $80.0 million closed on November 25, 2019, and the second tranche of $20.0 million closed on December 10, 2020. See Note 11 to our condensed consolidated financial statements in Part I, Item 1. Financial Statements of this Quarterly Report on Form 10-Q for additional information regarding our obligations under the Loan Agreement.\nThe Loan Agreement contains affirmative and negative covenants applicable to us and our subsidiaries, including maintaining, on an annual basis, a minimum liquidity threshold, which started in 2021, and on a quarterly basis, a minimum net sales threshold for Auryxia, which started in the fourth quarter of 2020. In addition, the Loan Agreement contains covenants that our Annual Reports on Form 10-K, must not be subject to any qualification as to going concern. Failure to maintain compliance with these or other covenants would result in an event of default under the Loan Agreement, which could result in enforcement action, including acceleration of amounts due under the Loan Agreement. Additionally, the liabilities under the Loan Agreement will be accelerated, subject to certain exceptions, if we are required to repay to Vifor Pharma all or a part of the working capital facility established in connection with the Second Amended and Restated License Agreement that we entered into with Vifor Pharma, in February 2022, or the Vifor Second Amended Agreement, as a result of certain terminations of the Vifor Second Amended Agreement or due to a reduction in the balance of the working capital facility by more than a prespecified amount.\nIn the event there is an acceleration of our and certain of our subsidiaries’ liabilities under the Loan Agreement as a result of an event of default or otherwise, we may not have sufficient funds or may be unable to arrange for additional financing to repay the liabilities or to make any accelerated payments, and Pharmakon could seek to enforce security interests in the collateral securing the Loan Agreement and our guarantee of the Term Loans, which would have a material adverse effect on our business, financial condition and results of operations.\n63\nThe Loan Agreement permits voluntary prepayment at any time in whole or in part, subject to prepayment premiums and make-whole premiums prior to certain dates. We made a voluntary prepayment of $25.0 million, including $0.5 million of prepayment penalties on July 15, 2022, pursuant to the Second Amendment and Waiver. This represented the repayment of $5.0 million of the first tranche and the full $20.0 million of the second tranche. Upon a change of control, mandatory prepayment provisions require us to prepay the principal amount outstanding, the applicable prepayment premium and make-whole premium and accrued and unpaid interest. In addition, our obligations in connection with the Loan Agreement could have additional significant adverse consequences, including, among other things:\n•restricting our activities, including limitations on transferring certain of our assets, engaging in certain transactions, terminating certain agreements, including the Vifor Second Amended Agreement, incurring certain additional indebtedness, creating certain liens, paying dividends or making certain other distributions and investments;\n•limiting our flexibility in planning for, or reacting to, changes in our business and our industry;\n•placing us at a possible competitive disadvantage compared to our competitors who have a smaller amount of debt or competitors with comparable debt at more favorable interest rates; and\n•limiting our ability to borrow additional amounts for working capital, capital expenditures, research and development efforts, acquisitions, debt service requirements, execution of our business strategy and other purposes.\nAny of these factors could materially and adversely affect our business, financial condition and results of operations.\nOur Royalty Interest Acquisition Agreement with HealthCare Royalty Partners IV, L.P. contains various covenants and other provisions, which, if violated, could materially adversely affect our financial condition.\nOn February 25, 2021, we entered into a royalty interest acquisition agreement, or the Royalty Agreement, with HealthCare Royalty Partners IV, L.P., or HCR, pursuant to which we sold to HCR our right to the to receive royalties and sales milestones for vadadustat, collectively the Royalty Interest Payments, in each case, payable to us under our Collaboration Agreement dated December 11, 2015, or the MTPC Agreement, with Mitsubishi Tanabe Pharma Corporation, or MTPC, subject to an annual maximum “cap” of $13.0 million, or the Annual Cap, and an aggregate maximum “cap” of $150.0 million, or the Aggregate Cap. Under the Royalty Agreement, we are required to comply with various covenants, including obligations to take certain actions, such as actions with respect to the Royalty Interest Payments, the MTPC Agreement, our agreement with MTPC for the commercial supply of vadadustat drug product, and our intellectual property. In addition, the Royalty Agreement includes customary events of default upon the occurrence of enumerated events, including failure to perform certain covenants and the occurrence of insolvency events. In the event we violate certain covenants and other provisions, we may not receive sales milestones from HCR even if the applicable sales thresholds are met. Upon the occurrence of an event of default, HCR would have the ability to exercise all available remedies in law and equity, which could have a material adverse effect on our financial condition.\nRisks Related to Commercialization\nOur business is substantially dependent on the commercial success of Auryxia. If we are unable to continue to successfully commercialize Auryxia, our results or operations and financial condition will be materially harmed.\nOur business and our ability to generate product revenue largely depend on our, and our collaborators’, ability to successfully commercialize Auryxia. Our ability to generate revenue depends on our ability to execute on our commercialization plans, and the size of the market for, and the level of market acceptance of, Auryxia and any other product or product candidate, including those that may be in-licensed or acquired. If the size of any market for which a product or product candidate is approved decreases or is smaller than we anticipate, our revenue and results of operations could be materially adversely affected. For example, the phosphate binder market declined since 2020, which we believe was partially a result of the COVID-19 pandemic. If the phosphate market does not recover or continues to decline, our revenue from Auyxia could be materially adversely affected.\nMarket acceptance is critical to our ability to generate significant product revenue. Any product may achieve only limited market acceptance or none at all. If Auryxia, or any of our product candidates that is approved, is not accepted by the market to the extent that we expect or market acceptance decreases, we may not be able to generate significant product revenue and our business would be materially harmed. Market acceptance of Auryxia or any other approved product depends on a number of factors, including:\n•the availability of adequate coverage and reimbursement by and the availability of discounts, rebates and price concessions from third party payors, pharmacy benefit managers, or PBMs, and governmental authorities;\n•the safety and efficacy of the product, as demonstrated in clinical trials and in the post-marketing setting;\n64\n•the prevalence and complications of the disease treated by the product;\n•the clinical indications for which the product is approved and the product label approved by regulatory authorities, including any warnings or limitations that may be required on the label as a consequence of potential safety risks associated with the product;\n•the countries in which marketing approvals are obtained;\n•the claims we and our collaborators are able to make regarding the safety and efficacy of the product;\n•the success of our physician and patient communications and education programs;\n•acceptance by physicians and patients of the product as a safe and effective treatment and the willingness of the target patient population to try new therapies and of physicians to prescribe new therapies;\n•the cost, safety and efficacy of the product in relation to alternative treatments;\n•the timing of receipt of marketing approvals and product launch relative to competing products and potential generic entrants;\n•relative convenience and ease of administration;\n•the frequency and severity of adverse side effects;\n•favorable or adverse publicity about our products or favorable or adverse publicity about competing products;\n•the effectiveness of our and our collaborators’ sales, marketing and distribution efforts; and\n•the restrictions on the use of the product together with other medications, if any.\nIf we are unable to maintain or expand, or, if vadadustat is approved, initiate, sales and marketing capabilities or enter into additional agreements with third parties, we may not be successful in commercializing Auryxia, vadadustat, if approved, or any other product candidates that may be approved.\nIn order to market Auryxia and any other approved product, we intend to continue to invest in sales and marketing, which will require substantial effort and significant management and financial resources. We have built a commercial infrastructure and sales force in the United States for Auryxia, our first commercial product. However, following receipt of the CRL, in April and May 2022, we implemented a reduction of our workforce by approximately 42% across all areas of the Company (47% inclusive of the closing of the majority of open positions), including several members of management. If the remaining sales and marketing team cannot successfully commercialize Auryxia, or if additional sales and marketing employees decide to leave as a result of the reduction in workforce or otherwise, it could have a material adverse effect on Auryxia revenue and our financial condition.\nIf we obtain regulatory approval to market vadadustat in the U.S., we believe that we can leverage the current commercial foundation for vadadustat in the U.S., but if we are unable to do so successfully this would materially harm our business. Additionally, training a sales force to successfully sell and market a new commercial product is expensive and time-consuming and could delay any commercial launch of such product candidate. We may underestimate the size of the sales force required for a successful product launch and we may need to expand our sales force earlier and at a higher cost than we anticipated. In 2021 and early 2022, we incurred commercialization expenses for vadadustat that were premature or unnecessary as a result of the receipt of the CRL for vadadustat, and may in the future incur additional commercialization expenses prematurely or unnecessarily if we do not receive marketing approval in the timeframe we expect, or at all, we may have prematurely or unnecessarily incurred commercialization expenses.\nWe devote significant effort, in particular, to recruiting individuals with experience in the sales and marketing of pharmaceutical products. Competition for personnel with these skills is significant and retaining qualified personnel with experience in our industry is difficult. Further, the continuing or recurring restrictions placed on recruiting, training and retention as a result of the COVID-19 pandemic and our recent reduction in workforce may further exacerbate these conditions and interfere with our ability to find and retain qualified personnel. As a result, we may not be able to retain our existing employees or hire new employees quickly enough to meet our needs. At the same time, we may face high turnover, requiring us to expend time and resources to source, train and integrate new employees.\nThere are risks involved with maintaining our own sales and marketing capabilities, including the following:\n•potential inability to recruit, train and retain adequate numbers of effective sales and marketing personnel;\n•potential inability of sales personnel to obtain access to physicians, including because of restrictions due to the COVID-19 pandemic;\n•potential lack of complementary products to be offered by sales personnel, which may put us at a competitive disadvantage relative to companies with more extensive product lines, especially as a result of the receipt of the CRL for vadadustat; and\n•costs and expenses associated with maintaining our own sales and marketing organization.\n65\nIf we are unable to maintain our own sales and marketing capabilities, we will not be successful in commercializing Auryxia, vadadustat, if approved, and any other product candidate that may be approved.\nFurthermore, if we are unable to maintain our arrangements with third parties with respect to sales and marketing, if we are unsuccessful in entering into additional arrangements with third parties to sell and market our products or we are unable to do so on terms that are favorable to us, or if such third parties are unable to carry out their obligations under such arrangements, it will be difficult to successfully commercialize our product and product candidates, including vadadustat, if approved. For example, if in connection with the Vifor Second Amended Agreement, we experience difficulties with Vifor Pharma, or if Vifor Pharma experiences difficulties with other parties to whom it expects to sell vadadustat, if approved, our ability to commercialize vadadustat, if approved, will be severely hindered and our business operations will be materially harmed.\nOur, or our partners', failure to obtain or maintain adequate coverage, pricing and reimbursement for Auryxia, vadadustat, if approved, or any other future approved products, could have a material adverse effect on our or our collaboration partners’ ability to sell such approved products profitably and otherwise have a material adverse impact on our business.\nMarket acceptance and sales of any approved products, including Auryxia and, if approved, vadadustat, depends significantly on the availability of adequate coverage and reimbursement from third party payors and may be affected by existing and future healthcare reform measures. Governmental authorities, third party payors, and PBMs decide which drugs they will cover, as well as establish formularies or implement other mechanisms to manage utilization of products and determine reimbursement levels. We cannot be sure that coverage or adequate reimbursement will be available for Auryxia, vadadustat, if approved, or any of our potential future products. Even if we obtain coverage for an approved product, third party payors may not establish adequate reimbursement amounts, which may reduce the demand for our product and prompt us to have to reduce pricing for the product. If reimbursement is not available or is limited, we may not be able to commercialize certain of our products. Coverage and reimbursement by a governmental authority, third-party payor or PBM may depend upon a number of factors, including the determination that use of a product is:\n•a covered benefit under the health plan;\n•safe, effective and medically necessary;\n•appropriate for the specific patient; and\n•cost effective.\nObtaining coverage and reimbursement approval for a product from a governmental authority, PBM or a third-party payor is a time consuming and costly process that could require us to provide supporting scientific, clinical and cost-effectiveness data for the use of our products to the payor. In the United States, there are multiple governmental authorities, PBMs and third-party payors with varying coverage and reimbursement levels for pharmaceutical products, and the timing of commencement of reimbursement by a governmental payor can be dependent on the assignment of codes via the Healthcare Common Procedural Coding System, which codes are assigned on a quarterly basis. Within Medicare, for oral drugs dispensed by pharmacies and also administered in facilities, coverage and reimbursement may vary depending on the setting. CMS, local Medicare administrative contractors, Medicare Part D plans and/or PBMs operating on behalf of Medicare Part D plans, may have some responsibility for determining the medical necessity of such drugs, and therefore coverage, for different patients. Different reimbursement methodologies may apply, and CMS may have some discretion in interpreting their application in certain settings.\nAs an oral drug, Auryxia is covered by Medicare under Part D. However, in September 2018, CMS decided that Auryxia would no longer be covered by Medicare for the treatment of iron deficiency anemia, or IDA, in adult patients with NDD-CKD, or the CMS Decision. While this decision does not impact CMS coverage for the control of serum phosphorus levels in adult patients with DD-CKD, or the Hyperphosphatemia Indication, it requires Part D plan sponsors to impose prior authorization or other steps to ensure that Auryxia is reimbursed only for the Hyperphosphatemia Indication. While we believe that the vast majority of the Medicare prescriptions written for Auryxia today are for the Hyperphosphatemia Indication and therefore will continue to be covered by Medicare with prior authorization, the CMS Decision has had and will continue to have an adverse impact on the sales and future growth of Auryxia for the Hyperphosphatemia Indication and the IDA Indication. For example, in the second quarter of 2020, we reduced our short-term and long-term Auryxia revenue forecast, primarily driven by the compounding impact of the CMS Decision. As a result, we recorded an impairment charge of $115.5 million to the Auryxia intangible asset associated with the developed product rights for Auryxia during the three months ended June 30, 2020.\nMedicaid reimbursement of drugs varies by state. Private third-party payor reimbursement policies also vary and may or may not be consistent with Medicare reimbursement methodologies. Manufacturers of outpatient prescription drugs may be required to provide discounts or rebates under government healthcare programs or to certain third-party payors in order to obtain coverage of such products.\n66\nAdditionally, we may be required to enter into contracts with third party payors and/or PBMs offering rebates or discounts on our products in order to obtain favorable formulary status and we may not be able to agree upon commercially reasonable terms with such third party payors or PBMs, or provide data sufficient to obtain favorable coverage and reimbursement for many reasons, including that we may be at a competitive disadvantage relative to companies with more extensive product lines. In addition, third party payors, PBMs and other entities that purchase our products may impose restrictions on our ability to raise prices for our products over time without incurring additional costs. Four distributors, Fresenius Medical Care Rx, McKesson Corporation, Cardinal Health, Inc. and Amerisource Bergen Drug Corporation, in the aggregate, accounted for a significant percentage of our gross accounts receivable as of September 30, 2022. If we are not able to maintain our arrangements with these key distributors on favorable terms, on a timely basis or at all, or if there is any adverse change in one or more of these distributors’ business practices or financial condition, it would adversely impact the market opportunity for Auryxia, our product revenues and operating results.\nFurthermore, vadadustat was approved in Japan for the treatment of adult patients with anemia due to CKD and is being marketed by MTPC in Japan under the trade name VafseoTM. Pricing and reimbursement strategy is a key component of MTPC’s commercialization plans for Vafseo in Japan. If coverage and reimbursement terms change, MTPC may not be able to, or may decide not to, continue commercialization of Vafseo in Japan.\nAlthough we currently believe it is likely that vadadustat, if approved, will be reimbursed using the Transitional Drug Add-on Payment Adjustment, or TDAPA, followed by reimbursement via the bundled reimbursement model, if vadadustat is neither reimbursed under the TDAPA nor the bundled reimbursement model, then patients would access vadadustat through contracts we negotiate with third party payors for reimbursement of vadadustat, which would be subject to the risks and uncertainties described above. Additionally, applying for and obtaining reimbursement under the TDAPA is expected to take several months following approval, which will affect adoption, uptake and product revenue for vadadustat during that time, and if there are updates to the TDAPA rule that decrease the basis for reimbursement or eligibility criteria during the transition period or if the TDAPA is eliminated, then our profitability may be adversely affected. For example, the Medicare Payment Advisory Commission, or MedPAC, an independent legislative branch advisory body to Congress on issues related to the Medicare program, has recommended that TDAPA not be provided to newly approved drug products considered to fall within “functional categories” for which costs are already accounted for in the bundled reimbursement model, such as for anemia management drugs.\nFurther, if vadadustat is approved in the United States and included in the fixed reimbursement model for a bundle of dialysis services, or the bundle, we would be required to enter into contracts to supply vadadustat to specific dialysis providers, instead of through distributors, which we believe could be challenging. The dialysis market is unique and is dominated by two providers: DaVita and Fresenius, which account for a vast majority of the dialysis population in the United States. Under the Vifor Second Amended Agreement, we granted Vifor Pharma an exclusive license to sell vadadustat to Fresenius Medical Care North America and its affiliates, including Fresenius Kidney Care Group LLC, to certain third-party dialysis organizations approved by us, to independent dialysis organizations that are members of group purchase organizations, and to certain non-retail specialty pharmacies in the United States. We refer to Fresenius Medical Care North America and its affiliates, these organizations and specialty pharmacies collectively as the “Supply Group\". See Note 4 to our consolidated financial statements in Part I, Item 1. Financial Statements of this Quarterly Report on Form 10-Q for additional information regarding the Vifor Second Amended Agreement. If vadadustat is approved and we are not able to maintain the Vifor Second Amended Agreement or enter into a supply agreement with DaVita or other dialysis clinics, our business may be materially harmed.\nSimilar to how payor coverage may affect the sales of a product, formulary status within dialysis organizations may affect what products are prescribed within that specific organization. Therefore, if a product is not on a formulary, the prescribers within that organization may be less likely to prescribe that product or may have a difficult time prescribing that product, resulting in less sales. Further, one dialysis organization’s determination to add a product to their formulary does not assure that other dialysis organizations will also add the product to theirs. There is always a risk a dialysis organization will not contract with a drug manufacturer for a specific product, resulting in that product not being on that organization’s formulary. If any dialysis organization does not add vadadustat, if approved, to the formulary, our business may be materially harmed.\nIn addition, we may be unable to sell Auryxia or vadadustat, if approved, to dialysis providers on a profitable basis if CMS significantly reduces the level of reimbursement for dialysis services and providers choose to use alternative therapies or look to re-negotiate their contracts with us. Our profitability may also be affected if our costs of production increase faster than increases in reimbursement levels. Adequate coverage and reimbursement of our products by government and private insurance plans are central to patient and provider acceptance of any products for which we receive marketing approval.\nFurther, in many countries outside the United States, a drug must be approved for reimbursement before it can be marketed or sold in that country. In some cases, the prices that we intend to charge for our products are also subject to approval. Approval by the FDA does not ensure approval by reimbursement authorities outside the United States, and approval by one\n67\nreimbursement authority outside the United States does not ensure approval by any other reimbursement authorities. However, the failure to obtain reimbursement in one jurisdiction may negatively impact our ability to obtain reimbursement in another jurisdiction. We may not be able to obtain such reimbursement approvals on a timely basis, if at all, and favorable pricing in certain countries depends on a number of factors, some of which are outside of our control.\nWe face substantial competition, which may result in others discovering, developing or commercializing products before, or more successfully than, we do.\nThe development and commercialization of new drugs is highly competitive and subject to rapid and significant technological change. Our future success depends on our ability to demonstrate and maintain a competitive advantage with respect to the development and commercialization of Auryxia, vadadustat, if approved, and any other product or product candidate, including those that may be in-licensed or acquired. Our objective is to continue to commercialize Auryxia and develop and commercialize new products with clinically proven efficacy, convenience, tolerability and/or safety. In many cases, any approved products that we commercialize will compete with existing, market-leading products.\nAuryxia is competing in the hyperphosphatemia market in the United States with other FDA-approved phosphate binders such as Renagel® (sevelamer hydrochloride) and Renvela® (sevelamer carbonate), both marketed by Sanofi, PhosLo® and Phoslyra® (calcium acetate), marketed by Fresenius Medical Care North America, Fosrenol® (lanthanum carbonate), marketed by Shire Pharmaceuticals Group plc, and Velphoro® (sucroferric oxyhydroxide), marketed by Fresenius Medical Care North America, as well as over-the-counter calcium carbonate products such as TUMS® and metal-based options such as aluminum, lanthanum and magnesium. Most of the phosphate binders listed above are now also available in generic forms. In addition, other agents are in development, including OPKO Health Inc.’s Alpharen™ Tablets (fermagate tablets) or could otherwise enter the market, including Ardelyx, Inc.’s tenapanor (which is approved in the United States for the treatment of adults with irritable bowel syndrome with constipation, but for which the FDA issued a complete response letter for with respect to the control of serum phosphorus in adult patients with CKD on dialysis), that may impact the market for Auryxia.\nAuryxia is competing in the IDA market in the United States with over-the-counter oral iron, ferrous sulfate, other prescription oral iron formulations, including ferrous gluconate, ferrous fumerate, and polysaccharide iron complex, and intravenous iron formulations, including Feraheme® (ferumoxytol injection), Venofer® (iron sucrose injection), Ferrlicit® (sodium ferric gluconate complex in sucrose injection), Injectafer® (ferric carboxymaltose injection), and Triferic® (ferric pyrophosphate citrate). In addition, other new therapies for the treatment of IDA may impact the market for Auryxia, such as Shield Therapeutics plc's Feraccru® (ferric maltol), which is available in Europe for the treatment of IDA and Accrufer® (ferric maltol), which was launched in the United States for the treatment of IDA in July 2021.\nFurthermore, Auryxia’s commercial opportunities may be reduced or eliminated if our competitors develop and market products that are less expensive, more effective, safer or offer greater patient convenience than Auryxia. Other companies have product candidates in various stages of preclinical or clinical development to treat diseases and complications of the diseases for which we are marketing Auryxia. In addition, we and Keryx’s licensors, Panion & BF Biotech, Inc., or Panion, and, as applicable, Dr. Hsu, entered into settlement agreements with each of the third parties who submitted Paragraph IV certification notice letters regarding Abbreviated New Drug Applications, or ANDAs, submitted to the FDA, pursuant to which we granted licenses to market a generic version of Auryxia in the United States beginning in March 2025 (subject to FDA approval), or earlier under certain circumstances customary for settlement agreements of this nature, which may impact our business and results of operation.\nDrugs that may compete with vadadustat include Epogen® (epoetin alfa) and Aranesp® (darbepoetin alfa), both commercialized by Amgen, Procrit® (epoetin alfa) and Eprex® (epoetin alfa), commercialized by Johnson & Johnson in the United States and Europe, respectively, and Mircera® (methoxy PEG-epoetin beta), commercialized by Vifor Pharma in the United States and Roche Holding Ltd. outside of the United States.\nWe and our partners may also face competition from potential new anemia therapies. There are several other HIF-PH inhibitor product candidates in various stages of development for anemia indications that may be in direct competition with vadadustat if and when they are approved and launched commercially. These candidates are being developed by companies such as FibroGen Inc., or FibroGen, together with its collaboration partners, Astellas Pharma Inc. and AstraZeneca PLC, Japan Tobacco International, or JT, GlaxoSmithKline plc, or GSK, and Bayer HealthCare AG, or Bayer.\nFurthermore, certain companies are developing potential new therapies for renal-related diseases that could potentially reduce injectable erythropoiesis stimulating agent, or ESA, utilization and thus limit the market potential for vadadustat if they are approved and launched commercially. Other new therapies are in development for the treatment of conditions inclusive of renal anemia that may impact the market for anemia-targeted treatment.\n68\nIn addition, in the United States, FibroGen filed an NDA for its product candidate, roxadustat, with the FDA, but the FDA issued a complete response letter indicating the FDA will not approve the NDA in its present form and requested that an additional clinical trial for roxadustat be conducted prior to resubmission of the NDA or additional response to the FDA's complete response letter. In Europe however, roxadustat is approved for the treatment of anemia in patients with CKD. Further, GSK filed an NDA for daprodustat, its product candidate for the treatment of anemia due to CKD, with the FDA in April 2022. If we obtain approval for vadadustat in the U.S., and roxadustat or daprodustat are also approved by the FDA, they will compete with vadadustat.\nIn Japan, Vafseo, which is approved for both the DD and NDD indications, competes with roxadustat, daprodustat and enarodustat. Roxadustat is approved for the treatment of anemia due to CKD in patients on dialysis, or DD-CKD, and patients not on dialysis, or NDD-CKD. In addition, daprodustat, GSK’s product candidate, and enarodustat, JT’s product candidate, are approved in Japan for the treatment of anemia due to CKD. In addition. Bayer HealthCare AG has submitted an NDA for its product candidate for the treatment of renal anemia in Japan. In China, roxadustat has launched for the treatment of anemia of DD-CKD and for the treatment of anemia due to CKD in NDD-CKD patients.\nA biosimilar is a biologic product that is approved based on demonstrating that it is highly similar to an existing, FDA-approved branded biologic product. The patents for the existing, branded biologic product must expire in a given market before biosimilars may enter that market without risk of being sued for patent infringement. In addition, an application for a biosimilar product cannot be approved by the FDA until 12 years after the existing, branded product was approved under a Biologics License Application, or BLA. The patents for epoetin alfa, an injectable ESA, expired in 2004 in the EU, and the remaining patents expired between 2012 and 2016 in the United States. Because injectable ESAs are biologic products, the introduction of biosimilars into the injectable ESA market in the United States will constitute additional competition for vadadustat if we are able to obtain approval for and commercially launch vadadustat. In the United States, Pfizer’s biosimilar version of injectable ESAs, Retacrit® (epoetin alfa-epbx), was approved by the FDA in May 2018 and launched in November 2018 and several biosimilar versions of injectable ESAs are available for sale in the EU.\nMany of our potential competitors have significantly greater financial, manufacturing, marketing, drug development, technical and human resources than we do. Large pharmaceutical companies, in particular, have extensive experience in clinical testing, obtaining marketing approvals, recruiting patients and manufacturing pharmaceutical products. Large and established companies such as Amgen and Roche, among others, compete in the market for drug products to treat kidney disease. In particular, these companies have greater experience and expertise in conducting preclinical testing and clinical trials, obtaining marketing approvals, manufacturing such products on a broad scale and marketing approved products. These companies also have significantly greater research and marketing capabilities than we do and may also have products that have been approved or are in late stages of development and have collaborative arrangements in our target markets with leading companies and research institutions. Established pharmaceutical companies may also invest heavily to accelerate discovery and development of novel compounds or to in-license novel compounds that could make the product candidates that we are developing obsolete. Smaller and other early-stage companies may also prove to be significant competitors. As a result of all of these factors, our competitors may succeed in obtaining patent protection and/or marketing approval, or discovering, developing and commercializing competitive products, before, or more effectively than, we do. If we are not able to compete effectively against potential competitors, our business will not grow and our financial condition and operations will suffer.\nThe commercialization of RionaTM and VafseoTM in Japan and our current and potential future efforts with respect to the development and commercialization of our products and product candidates outside of the United States subject us to a variety of risks associated with international operations, which could materially adversely affect our business.\nOur Japanese sublicensee, JT, and its subsidiary, Torii Pharmaceutical Co., Ltd., or Torii, commercialize Riona, the trade name for ferric citrate hydrate in Japan, as an oral treatment for the improvement of hyperphosphatemia in patients with CKD, including DD-CKD and NDD-CKD, and for the treatment of adult patients with IDA in Japan. In Japan and certain other countries in Asia, we granted MTPC exclusive rights to commercialize vadadustat, which has been approved and is being marketed by MTPC in Japan under the trade name VafseoTM.\nPursuant to the terms of the Termination Agreement with Otsuka, Otsuka has transferred to us the marketing authorization application, or MAA, for vadadustat with the EMA, and in the United Kingdom, Switzerland and Australia. In addition, we have conducted and in the future plan to conduct clinical trials outside of the United States for Auryxia, vadadustat and any other product or product candidate that may be in-licensed or acquired. As a result of these and other activities, we are or may become subject to additional risks in developing and commercializing Auryxia and vadadustat outside the United States, including, among others:\n•political, regulatory, compliance and economic developments, weakness or instability that could restrict our ability to manufacture, market and sell our products;\n•changes in international medical reimbursement policies and programs;\n69\n•changes in healthcare policies of foreign jurisdictions;\n•trade protection measures, including import or export licensing requirements and tariffs and our compliance therewith;\n•our ability to develop or manage relationships with qualified local distributors and trading companies;\n•diminished protection of intellectual property in some countries outside of the United States;\n•differing labor regulations and business practices;\n•compliance with laws, including the U.S. Foreign Corrupt Practices Act, or FCPA, the UK Bribery Act or similar local regulation, the EU General Data Protection Regulation, or GDPR, and similar data protection laws, and tax, employment, immigration and labor laws;\n•economic weakness, including inflation, or political instability in particular foreign economies and markets;\n•foreign currency fluctuations, which could result in increased operating expenses and reduced revenues, and other obligations incident to doing business in another country;\n•production shortages resulting from any events affecting raw material supply or manufacturing capabilities abroad, including as a result of the COVID-19 pandemic; and\n•business interruptions resulting from geopolitical actions, including war and terrorism, global pandemics, or natural disasters including earthquakes, typhoons, floods and fires.\nIn addition, we receive revenues from royalty payments converted to U.S. dollars based on net sales of Riona and VafseoTM in Japanese yen. The exchange rates between the Japanese yen on the one hand, and the U.S. dollar, on the other hand, have changed substantially in recent years and may fluctuate substantially in the future. Our results of operations could be adversely affected over time by certain movements in exchange rates, particularly if the Japanese yen depreciates against the U.S. dollar.\nAny of these factors may, individually or as a group, have a material adverse effect on our business and results of operations. As and if we continue to expand our commercialization efforts, we may encounter new risks.\nRisks Related to Product Development\nClinical drug development involves a lengthy and expensive process with an uncertain outcome, and we will incur additional costs in connection with, and may experience delays in completing, or ultimately be unable to complete, the development and, if approved, commercialization of vadadustat and any other product candidates.\nThe risk of failure in drug development is high. Before obtaining marketing approval from regulatory authorities for the sale of any product candidate, we must complete preclinical development and conduct extensive clinical trials to demonstrate the safety and efficacy of our product candidates in humans. Preclinical studies and clinical trials are expensive, difficult to design and implement, can take several years to complete, and their outcomes are inherently uncertain. Failure can occur at any time during the process. For example, we are currently conducting a clinical trial to evaluate three times per week oral dosing of vadadustat for dialysis dependent patients with anemia due to chronic kidney disease. If we experience delays in the conduct of this clinical trial or the results are not positive, it could affect the market potential of vadadustat, if approved.\nWe may be unable to successfully obtain approval of vadadustat or other product candidates, or to successfully complete clinical trials of Auryxia, vadadustat and other product candidates if the results of those trials and studies are not positive or are only modestly positive, or if there are concerns with the profile due to efficacy or safety. Further, the results of preclinical studies and early clinical trials of our product candidates may not be predictive of the results of later-stage clinical trials, interim results of a clinical trial do not necessarily predict final results, and results of Phase 3 clinical trials for one indication may not be predictive of results of Phase 3 clinical trials for another indication. For example, we announced positive top-line results from INNO2VATE and vadadustat achieved the primary and key secondary efficacy endpoint in each of the two PRO2TECT studies, but the PRO2TECT program did not meet the primary major adverse cardiovascular event, or MACE, safety endpoint. Many companies in the biopharmaceutical industry have suffered significant setbacks in late-stage clinical trials after achieving positive results in early-stage development, and we may face similar setbacks. Moreover, preclinical and clinical data are often susceptible to varying interpretations and analyses, and many companies that have believed their product candidates performed satisfactorily in preclinical studies and clinical trials have nonetheless failed to obtain marketing approval of their product candidates. In addition, in March 2022, we received the CRL for vadadustat indicating that the FDA had determined that it could not approve the NDA in its present form, thus delaying any potential approval of vadadustat. In July 2022, we held an end of review meeting with the FDA to inform the Company's next steps with respect to the potential U.S. approval of vadadustat, if any, and in October 2022, we submitted the FDRR to the FDA. However, it is impossible to predict when or if vadadustat or any of our other product candidates will prove effective or safe in humans or will receive marketing approval or on what terms.\nWe may experience numerous unforeseen events during, or as a result of, preclinical development or clinical trials that could delay, prevent or make more challenging our ability to receive or maintain marketing approval or commercialize our product\n70\ncandidates. We may be required to complete additional clinical trials for Auryxia, vadadustat and any other product or product candidate, including those that may be in-licensed or acquired, in order to obtain or maintain required regulatory approvals. Our preclinical studies and clinical trials may take longer to complete than currently anticipated, or may be delayed, suspended, required to be repeated, prematurely terminated or may not successfully demonstrate safety and/or efficacy needed to obtain or maintain regulatory approval for a variety of other reasons, such as:\n•the costs may be greater than we anticipate;\n•the number of patients required for clinical trials may be larger than we anticipate;\n•enrollment in our clinical trials may be slower than we anticipate, or participants may drop out of these clinical trials at a higher rate than we anticipate;\n•our third party contractors, such as our CROs, may fail to comply with regulatory requirements, perform effectively, or meet their contractual obligations to us in a timely manner, or at all, or we may fail to communicate effectively or provide the appropriate level of oversight of such third party contractors;\n•the supply or quality of our starting materials, drug substance and drug product necessary to conduct clinical trials of our product candidates may be insufficient or inadequate;\n•regulators, independent data monitoring committees, or IDMCs, institutional review boards, or IRBs, safety committees, or ethics committees, may require that we suspend or terminate our clinical trials for various reasons, including noncompliance with regulatory requirements, unforeseen safety issues or adverse side effects, failure to demonstrate a benefit from using our product candidate, or a finding that the participants are being exposed to unacceptable health risks;\n•clinical trials of our product candidates may produce negative or inconclusive results or results that may be interpreted in a manner different than we interpret them, and we may decide, or regulators may require us, to conduct additional clinical trials, repeat a clinical trial or abandon product development programs;\n•lack of adequate funding to continue a clinical trial, including unforeseen costs due to enrollment delays, requirements to conduct additional clinical trials or repeat a clinical trial and increased expenses associated with the services of our CROs and other third parties;\n•we may fail to initiate, delay of or failure to complete a clinical trial as a result of an Investigational New Drug application, or IND, being placed on clinical hold by the FDA, the EMA, the PMDA, or other regulatory authorities, or for other reasons, such as failure to recruit or enroll suitable patients or patients' failure to return for post-treatment follow up;\n•we may determine to change or expand a clinical trial, including after it has begun;\n•clinical trial sites and investigators deviating from the clinical protocol, failing to conduct the trial in accordance with regulatory requirements, or dropping out of a trial, or failure by us or our CROs to communicate effectively or provide the appropriate level of oversight of such clinical sites and investigators;\n•there may be an inability, delay, or failure in identifying and maintaining a sufficient number of clinical trial sites, many of which may already be engaged in other clinical programs;\n•there may be a delay or failure in reaching agreement with the FDA, the EMA, the PMDA or other regulatory authorities on a clinical trial design upon which we are able to execute;\n•there may be a delay or failure in obtaining authorization to commence a clinical trial or inability to comply with conditions imposed by a regulatory authority regarding the scope or design of a clinical trial;\n•there may be delays in reaching, or failure to reach, agreement on acceptable terms with prospective clinical trial sites and prospective CROs, the terms of which can be subject to extensive negotiation and may vary significantly among different CROs and clinical trial sites;\n•the FDA, the EMA, the PMDA or other regulatory authorities may require us to submit additional data or impose further requirements before permitting us to initiate a clinical trial or during an ongoing clinical trial;\n•the FDA, the EMA, the PMDA or other regulatory authorities may disagree with our clinical trial design and our interpretation of data from clinical trials, or may change the requirements for approval even after it has reviewed and commented on the design for our clinical trials;\n•third parties with which we work may fail to comply with good practice quality guidelines and regulations, or GXP, including good laboratory practice, good clinical practice, or GCP, and current good manufacturing practice, or cGMP; or\n•there may be changes in governmental regulations or administrative actions.\nIf any of the foregoing occurs, the following may occur:\n•regulators may require that we conduct additional clinical trials, repeat clinical trials or conduct other studies beyond those that we currently contemplate;\n•we may be delayed in obtaining marketing approval for vadadustat or other product candidates;\n•we may not obtain marketing approval for vadadustat or other product candidates at all;\n•we may obtain approval for indications or patient populations that are not as broad as intended or desired;\n71\n•we may obtain approval with labeling that includes significant use or distribution restrictions or safety warnings that would reduce the potential market for any approved product or inhibit our ability to successfully commercialize any approved product;\n•a REMS or FDA-imposed risk management plan that use risk minimization strategies to ensure that the benefits of certain prescription drugs outweigh their risks, may be required;\n•we may be subject to additional post-marketing restrictions and/or requirements; or\n•the product may be removed from the market after obtaining marketing approval.\nThe COVID-19 pandemic resulted in temporary closures of, and may continue to impact, clinical trial sites on which we rely and will rely for the completion of certain clinical trials and may delay enrollment of certain planned and ongoing clinical trials. In response to the COVID-19 pandemic, the FDA issued guidance on March 18, 2020, and has thereafter updated it, to address and facilitate the conduct of clinical trials during the pandemic. The guidance sets out a number of considerations for sponsors of clinical trials impacted by the pandemic, including the requirement to include in the clinical study report (or as a separate document) contingency measures implemented to manage the study, and any disruption of the study as a result of the pandemic.\nOur product development costs may also increase if we experience development delays or delays in receiving the requisite marketing approvals. Our preclinical studies or clinical trials may need to be restructured or may not be completed on schedule, or at all. Significant preclinical or clinical trial delays also could shorten any periods during which we may have the exclusive right to commercialize vadadustat, if approved, or any other product candidate, including those that may be in-licensed or acquired, or allow our competitors to bring products to market before we do. This could impair our ability to successfully commercialize our product candidates and may harm our business and results of operations.\nWe may find it difficult to enroll patients in our clinical trials, which could delay or prevent clinical trials of Auryxia, vadadustat or any other product or product candidate, including those that may be in-licensed or acquired.\nIdentifying and qualifying patients to participate in clinical trials is critical to our success. The timing of our clinical trials depends, in part, on the speed at which we can recruit patients to participate in our clinical trials. Patients may be unwilling to participate in our clinical trials because of concerns about adverse events observed with the product candidate under study, the current standard of care, competitor products and/or other investigational agents, in each case for the same indications and/or similar patient populations. In addition, in the case of clinical trials of any product candidate, patients currently receiving treatment with the current standard of care or a competitor product may be reluctant to participate in a clinical trial with an investigational drug. Furthermore, the COVID-19 pandemic resulted in temporary closures of, and may continue to impact, clinical trial sites on which we rely for the conduct of certain clinical trials and COVID-19 pandemic precautions have caused moderate delays in enrolling new clinical trials and may cause delays in enrolling other new clinical trials.\nIn addition, following receipt of the CRL, in April 2022, we were notified by the FDA that the FDA had placed a partial clinical hold on our clinical trials of vadadustat in pediatric patients with anemia due to chronic kidney disease in the United States. In addition, in May 2022, the Paediatric Committee of the EMA recommended that we not initiate such clinical trials in the European Union until the safety issues identified by the FDA were addressed. As a result of the partial clinical hold and EMA’s recommendations, all activities in the United States and Europe for and related to our clinical trials of vadadustat in pediatric patients were suspended. Furthermore, we are currently conducting clinical trials to evaluate three times per week oral dosing of vadadustat for dialysis dependent patients with anemia due to chronic kidney disease. If the FDA, investigators or patients are worried about the safety of vadadustat as a result of the CRL or partial clinical hold or otherwise decide not to participate or continue in those trials, we may not be able to complete those studies in a timely basis, or at all.\nFinally, competition for clinical study sites may limit our access to patients appropriate for our clinical trials. As a result, the timeline for recruiting patients and conducting studies may be delayed. These delays could result in increased costs, delays in advancing our development of any product or product candidate, or termination of the clinical trial altogether.\nWe may not be able to identify, recruit and enroll a sufficient number of patients, or those with required or desired characteristics, to complete our clinical trials in a timely manner. Patient enrollment is affected by many factors, including:\n•severity of the disease under investigation;\n•design of the study protocol;\n•size and nature of the patient population;\n•eligibility criteria for, and design of, the study in question;\n•perceived risks and benefits of the product or product candidate under study, including as a result of adverse effects observed in similar or competing therapies;\n•proximity and availability of clinical study sites for prospective patients;\n72\n•availability of competing therapies and clinical trials and clinicians’ and patients’ perceptions as to the potential advantages of the product or product candidate being studied in relation to available therapies or other product candidates in development;\n•efforts to facilitate timely enrollment in clinical trials;\n•clinical trial sites and investigators failing to perform effectively; and\n•patient referral practices of physicians.\nWe may not be able to initiate or complete clinical trials in a timely manner, or at all, if we cannot enroll a sufficient number of eligible patients to participate in the clinical trials required by regulatory agencies. If we have difficulty enrolling a sufficient number of patients to conduct our clinical trials as planned, we may need to delay, limit or terminate ongoing or planned clinical trials, any of which may delay approval, or result in failure to obtain approval, of our product candidates, which would have a material adverse effect on our business.\nConducting clinical trials outside of the United States, as we have done historically and as we may decide to do in the future, presents additional risks and complexities and, if we decide to conduct a clinical trial outside of the United States in the future, we may not complete such trials successfully, in a timely manner, or at all, which could affect our ability to obtain regulatory approvals.\nOur ability to successfully initiate, enroll and complete a clinical study in any country outside of the United States is subject to numerous additional risks unique to conducting business in jurisdictions outside the United States, including:\n•difficulty in establishing or managing relationships with qualified CROs, physicians and clinical trial sites;\n•difficulty in complying with different local standards for the conduct of clinical trials;\n•difficulty in complying with various and complex import laws and regulations when shipping drug to certain countries; and\n•the potential burden of complying with a variety of laws, medical standards and regulatory requirements, including the regulation of pharmaceutical and biotechnology products and treatments.\nData obtained from studies conducted in the United States may not be accepted by the EMA, the PMDA and other regulatory authorities outside of the United States. Also, certain jurisdictions require data from studies conducted in their country in order to obtain approval in that country.\nIf we or our collaboration partners have difficulty conducting future clinical trials in jurisdictions outside the United States as planned, we may need to delay, limit or terminate such clinical trials, any of which could have an adverse effect on our business.\nAuryxia, vadadustat or any other product or product candidate, including those that may be in-licensed or acquired, may cause undesirable side effects or have other properties that may delay or prevent marketing approval or limit their commercial potential.\nUndesirable effects caused by, or other undesirable properties of, Auryxia, vadadustat or any other product or product candidate, including those that may be in-licensed or acquired, or competing commercial products or product candidates in development that utilize a common mechanism of action could cause us or regulatory authorities to interrupt, delay or halt clinical trials, could result in a more restrictive label or the delay, denial or withdrawal of marketing approval by the FDA or other regulatory authorities, and could lead to potential product liability claims. In addition, results of our clinical trials could reveal a high frequency of undesirable effects or unexpected characteristics. For example, in March 2022, we received the CRL from the FDA for our NDA for vadadustat in which the FDA concluded that the data in the NDA do not support a favorable benefit-risk assessment of vadadustat for dialysis and non-dialysis patients. The FDA expressed safety concerns noting failure to meet non-inferiority in MACE in the non-dialysis patient population, the increased risk of thromboembolic events, driven by vascular access thrombosis in dialysis patients, and the risk of drug-induced liver injury. In July 2022, we held an end of review meeting with the FDA to inform the Company's next steps with respect to the potential U.S. approval of vadadustat, if any, and in October 2022, we submitted the FDRR to the FDA. The FDRR focuses on the favorable balance between the benefits and risks of vadadustat for the treatment of anemia due to CKD in adult patients on dialysis in light of safety concerns expressed by the FDA in the CRL related to the rate of adjudicated thromboembolic events driven by vascular access thrombosis for vadadustat compared to the active comparator and the risk of drug-induced liver injury. There can be no assurances that our FDRR will be accepted by the FDA, or that, if accepted, we will be successful in our appeal. If we are unable to overcome these concerns, vadadustat may not be approved by the FDA on favorable terms, or at all, and our financial condition could be materially harmed.\n73\nIf we or others identify undesirable effects caused by, or other undesirable properties of, Auryxia, vadadustat, or any other product or product candidate, including those that may be in-licensed or acquired, or if known undesirable effects are more frequent or severe than in the past, or if any of the foregoing are perceived to have occurred, either before or after receipt of marketing approval, a number of potentially significant negative consequences could result, including:\n•our product candidates may not be approved by regulatory authorities;\n•our clinical trials may be put on hold;\n•patient recruitment could be slowed, and enrolled patients may not want to complete the clinical trial;\n•regulatory authorities may require warnings on the label, such as the warning on Auryxia’s label regarding iron overload;\n•REMS or FDA-imposed risk management plans that use restrictive risk minimization strategies may be required;\n•we may decide to, or be required to, send drug warnings or safety alerts to physicians, pharmacists and hospitals (or the FDA or other regulatory authorities may choose to issue such alerts), or we may decide to conduct a product recall or be requested to do so by the FDA or other regulatory authority;\n•reformulation of the product, additional non-clinical or clinical trials, restrictive changes in labeling or changes to or re-approvals of manufacturing facilities may be required;\n•we may be precluded from pursuing additional development opportunities to enhance the clinical profile of a product within its indicated populations, or studying the product or product candidate in additional indications and populations or in new formulations; and\n•we could be investigated by the government or sued and held liable for harm caused to patients, including in class action lawsuits; and\n•our reputation may suffer.\nAny of these events could prevent us from achieving or maintaining, whether on a restricted basis or at all, marketing approval and, ultimately, market acceptance or penetration of Auryxia, vadadustat or any other product or product candidate, including those that may be in-licensed or acquired. In addition, any of these events could substantially increase our costs, and could significantly impact our ability to successfully commercialize Auryxia, vadadustat or any other product and product candidate, including those that may be in-licensed or acquired, and generate product revenue.\nThe patient populations treated with Auryxia and potential patient populations for vadadustat, if approved, have CKD, a serious disease that increases the risk of cardiovascular disease including heart attacks and stroke and, in its most severe form, results in, kidney failure and the need for dialysis or kidney transplant. Many patients with CKD are elderly with comorbidities making them susceptible to significant health risks. Therefore, the likelihood of these patients having adverse events, including serious adverse events is high.\nWith respect to the global INNO2VATE Phase 3 program, the incidence of treatment emergent adverse events during the Correction and Conversion study in vadadustat treated patients was 83.8% and 85.5% in darbepoetin alfa treated patients. During the study, the most common treatment emergent adverse events reported in vadadustat/darbepoetin alfa treated patients were hypertension (16.2%/ 12.9%) and diarrhea (10.1%/ 9.7%). Serious treatment emergent adverse events were lower in vadadustat treated patients at 49.7% compared to 56.5% for darbepoetin alfa treated patients. The incidence of treatment emergent adverse events during the prevalent dialysis patient study (Conversion) in the vadadustat treated patients was 88.3%, and 89.3% in darbepoetin alfa treated patients. During the study, the most common treatment emergent adverse events reported in vadadustat/darbepoetin alfa treated patients were diarrhea (13.0%/ 10.1%), pneumonia (11.0%/ 9.7%), hypertension (10.6%/ 13.8%), and hyperkalemia (9.0%/ 10.8%). Serious treatment emergent adverse events were slightly lower for vadadustat treated patients at 55.0% and 58.3% for darbepoetin alfa-treated patients. Patients with DD-CKD experienced an increased risk of thromboembolic events compared to darbepoetin alfa with a time to first event HR of 1.20 (95% CI 0.96 - 1.50) driven by thrombosis of vascular access.\nWith respect to the global PRO2TECT Phase 3 program, the incidence of treatment emergent adverse events during the ESA untreated patients study (Correction) in the vadadustat-treated patients was 90.9%, and 91.6% in darbepoetin alfa-treated patients. During the study, the most common treatment emergent adverse events reported in vadadustat/darbepoetin alfa-treated patients were end-stage renal disease (34.7%/ 35.2%), hypertension (17.7%/ 22.1.%), hyperkalemia (12.3.%/ 15.6%), urinary tract infection (12.9%/ 12.0%), diarrhea (13.9%/ 10.0%), peripheral oedema (12.5%/ 10.5%), fall (9.6%/ 10%) and nausea (10%/ 8.2%). Serious treatment emergent adverse events were 65.3% for vadadustat-treated patients and 64.5% for darbepoetin alfa-treated patients. The incidence of treatment emergent adverse events during the ESA-treated patients study (Conversion) in vadadustat treated patients was 89.1% and 87.7% in darbepoetin alfa-treated patients. During the study, the most common treatment emergent adverse events reported in vadadustat/darbepoetin alfa-treated patients were end-stage renal disease (27.5%/ 28.4%), hypertension (14.4%/ 14.8%), urinary tract infection (12.2%/ 14.5%), diarrhea (13.8.%/ 8.8.%), peripheral oedema\n74\n(9.9%/ 10.1%) and pneumonia (10.0%/ 9.7%). Serious treatment emergent adverse events were 58.5% for vadadustat-treated patients and 56.6% for darbepoetin alfa-treated patients.\nFor example, during the conduct of our Phase 3 program our team and hepatic experts analyzed hepatic cases (unblinded to treatment) and, following the completion of our global Phase 3 clinical program for vadadustat, there was a review of hepatic safety across the vadadustat clinical program, which included eight completed Phase 2 and 3 studies in NDD-CKD patients, 10 completed Phase 1, 2, and 3 studies, and two then-ongoing Phase 3b studies in DD-CKD patients, and 18 completed studies in healthy subjects (17 Phase 1 and one Phase 3). This review consisted of a blinded re-assessment of hepatic events conducted by a separate panel of hepatic experts. While hepatocellular injury attributed to vadadustat was reported in less than 1% of patients, there was one case of severe hepatocellular injury with jaundice, and we cannot guarantee that similar events will not happen in the future. Additionally, the FDA expressed safety concerns related to the risk of drug-induced liver injury in the CRL that it issued in March 2022.\nSerious adverse events considered related to vadadustat, including those noted in the CRL, and any other product candidates could have material adverse consequences on the development and potential approval of such product candidates and our business as a whole. Our understanding of adverse events in prior clinical trials of our product candidates may change as we gather more information, the FDA may not agree with our assessment of adverse events and additional unexpected adverse events may be observed in future clinical trials or in the market.\nAny of the above safety data or other occurrences could delay or prevent us from achieving or maintaining marketing approval, harm or prevent sales of Auryxia or, if approved, vadadustat or any other product or product candidate, including those that may be in-licensed or acquired, increase our expenses and impair or prevent our ability to successfully commercialize Auryxia, vadadustat or any other products or product candidates.\nIn addition, any post-marketing clinical trials conducted, if successful, may expand the patient populations treated with Auryxia, vadadustat or any other product we acquire or for which we receive marketing approval, within or outside of their current indications or patient populations, which could result in the identification of previously unknown undesirable effects, increased frequency or severity of known undesirable effects, or result in the identification of unexpected safety signals. In addition, as Auryxia, vadadustat, if approved, and any other products are commercialized, they will be used in significantly larger patient populations, in less rigorously controlled environments and, in some cases, by less experienced and less expert treating practitioners, than in clinical trials, which could result in increased or more serious adverse effects being reported. As a result, regulatory authorities, healthcare practitioners, third party payors or patients may perceive or conclude that the use of Auryxia, vadadustat, if approved, or any other products are associated with serious adverse effects, undermining our commercialization efforts.\nRisks Related to Regulatory Approval\nWe may not be able to obtain marketing approval for, or successfully commercialize, vadadustat or any other product candidate, or we may experience significant delays in doing so, any of which would materially harm our business.\nClinical trials, manufacturing and marketing of any product or product candidate are subject to extensive and rigorous review and regulation by numerous governmental authorities in the United States and other jurisdictions. Before obtaining marketing approval for the commercial sale of any product candidate, we must demonstrate through extensive preclinical testing and clinical trials that the product candidate is safe and effective for use in each target indication. This process can take many years and marketing approval may never be achieved. Of the large number of drugs in development in the United States and in other jurisdictions, only a small percentage successfully complete the FDA’s and other jurisdictions’ marketing approval processes and are commercialized. Accordingly, even if we are able to obtain the requisite capital to continue to fund our development and commercialization efforts, we may be unable to successfully obtain regulatory approval for or commercialize vadadustat or any other product or product candidate, including those that may be in-licensed or acquired.\nWe are not permitted to market vadadustat in the United States until we receive approval from the FDA, in the EU until we receive approval from the EMA, or in any other jurisdiction until the requisite approval from regulatory authorities in such jurisdiction is received. As a condition to receiving marketing approval for vadadustat, we may be required by the FDA, the EMA or other regulatory authorities to conduct additional preclinical studies or clinical trials.\nIn March 2022, we received the CRL from the FDA regarding our NDA for vadadustat for the treatment of anemia due to CKD. The FDA concluded that the data in the NDA do not support a favorable benefit-risk assessment of vadadustat for dialysis and non-dialysis patients. In July 2022, we held an end of review meeting with the FDA to inform the Company's next steps with respect to the potential U.S. approval of vadadustat, if any, and in October 2022, we submitted a Formal Dispute Resolution Request, or FDRR, to the FDA. The FDRR focuses on the favorable balance between the benefits and risks of vadadustat for the treatment of anemia due to CKD in adult patients on dialysis in light of safety concerns expressed by the FDA in the CRL\n75\nrelated to the rate of adjudicated thromboembolic events driven by vascular access thrombosis for vadadustat compared to the active comparator and the risk of drug-induced liver injury. There can be no assurances that our FDRR will be accepted by the FDA, or that, if accepted, we will be successful in our appeal and obtain approval for vadadustat in a timely manner, on favorable terms, or at all. As a result, the regulatory approval process for vadadustat in the U.S. is highly uncertain. We may not obtain approval at all, and if we are able to obtain approval, it may only be for patients with DD-CKD and, in any event, the expense and time to do so could adversely impact our ability to successfully commercialize vadadustat, and our financial condition could be materially harmed.\nFurther, vadadustat and any other product candidate may not receive marketing approval in the United States or the EU even if it is approved in other countries. For example, although vadadustat is approved in Japan for the treatment of anemia due to CKD in DD-CKD and NDD-CKD adult patients, such approval does not guarantee approval in the United States by the FDA or in the EU by the EMA for these indications or at all. In addition, while each regulatory authority makes their own assessment as to the safety and efficacy of a drug, FDA’s concern about the safety or efficacy of vadadustat or any other product candidate could impact the regulatory authority’s decision in another country.\nObtaining marketing approval in the United States and other jurisdictions for any product candidate depends upon numerous factors, many of which are subject to the substantial discretion of the regulatory authorities, including that regulatory agencies may not complete their review processes in a timely manner and, following completion of the review process, may not grant marketing approval or such marketing approval may be limited. Furthermore, approval of a drug does not ensure successful commercialization. For example, on September 23, 2015, the European Commission, or EC, approved Fexeric for the control of hyperphosphatemia in adult patients with CKD. Pursuant to the sunset clause under EU law, the EC’s approval of Fexeric in the EU was contingent on, among other things, our commencing marketing of Fexeric within three years; although we successfully negotiated an extension to December 23, 2019, we did not commence marketing Fexeric by such date and therefore the Fexeric approval in the EU has ceased to be valid.\nWe could face heightened risks with respect to seeking marketing approval in the United Kingdom, or UK, as a result of the recent withdrawal of the UK from the EU, commonly referred to as Brexit. Pursuant to the formal withdrawal arrangements agreed between the UK and the EU, the UK withdrew from the EU, effective December 31, 2020. On December 24, 2020, the UK and the EU entered into a Trade and Cooperation Agreement. The agreement sets out certain procedures for approval and recognition of medical products in each jurisdiction. Any delay in obtaining, or an inability to obtain, any marketing approvals, as a result of the Trade and Cooperation Agreement would prevent us from commercializing vadadustat or any other product candidate, including those that may be in-licensed or acquired, in the UK and/or the EU and restrict our ability to generate revenue and achieve and sustain profitability. If any of these outcomes occur, we may be forced to restrict or delay efforts to seek regulatory approval in the UK and/or the EU for vadadustat or any other product candidate, which could significantly and materially harm our business. As of January 1, 2021, the Medicines and Healthcare Products Regulatory Agency, or the MHRA, became responsible for supervising medicines and medical devices in Great Britain, comprising England, Scotland and Wales under domestic law, whereas Northern Ireland will continue to be subject to European Union rules under the Northern Ireland Protocol. The MHRA will rely on the Human Medicines Regulations 2012 (SI 2012/1916) (as amended) as the basis for regulating medicines.\nIn addition, the safety concerns associated with the current standard of care for the indications for which we are seeking marketing approval for vadadustat may affect the FDA’s, the EMA’s or other regulatory authorities’ review of the safety results of vadadustat. Additionally, these regulatory authorities may not agree with our assessment of adverse events. Further, the policies or regulations, or the type and amount of clinical data necessary to gain approval, may change during the course of a product candidate’s clinical development and may vary among jurisdictions. It is possible that vadadustat will never obtain marketing approval in the United States or certain other jurisdictions or for some or all of the indications for which we seek approval. The FDA, the EMA or other regulatory authorities may delay, limit or deny approval of vadadustat for many reasons including, among others:\n•we may not be able to demonstrate that vadadustat is safe and effective in treating adult patients with anemia due to CKD to the satisfaction of the relevant regulatory authority;\n•the results of our clinical trials may only be modestly positive, or there may be concerns with the profile due to efficacy or safety;\n•the results of our clinical trials may not meet the level of statistical or clinical significance required by the relevant regulatory authority for review and/or marketing approval;\n•the relevant regulatory authority may disagree with our interpretation of data from our preclinical studies and clinical trials;\n•the relevant regulatory authority may disagree with the number, design, size, conduct or implementation of our clinical trials;\n•the relevant regulatory authority may not approve the formulation, labeling or specifications we request for vadadustat;\n76\n•the relevant regulatory authority may approve vadadustat or any other product candidate for use only in a small patient population or for fewer or more limited indications than we request;\n•the relevant regulatory authority may require that we conduct additional clinical trials or repeat one or more clinical trials;\n•the FDA or other relevant regulatory authority may require development of a REMS as a condition of approval or post-approval;\n•the relevant regulatory authority may grant approval contingent on the performance of costly post-marketing clinical trials;\n•the relevant regulatory authority's onsite inspections may be delayed due to the COVID-19 pandemic;\n•we, or our CROs or other vendors, may fail to comply with GXP or fail to pass any regulatory inspections or audits;\n•we or our third party manufacturers may fail to perform in accordance with the FDA’s or other relevant regulatory authority's cGMP requirements and guidance;\n•the FDA may disagree with inclusion of data obtained from certain regions outside the United States to support the NDA for potential reasons such as differences in clinical practice from United States standards;\n•the relevant regulatory authority could deem that our financial relationships with certain principal investigators constitute a conflict of interest, such that the data from those principal investigators may not be used to support our applications;\n•as part of any future regulatory process, the FDA may ask an Advisory Committee to review portions of the NDA, the FDA may have difficulty scheduling an Advisory Committee meeting in a timely manner or, if convened, an FDA Advisory Committee could recommend non-approval, conditions of approval or restrictions on approval, and the FDA may ultimately agree with the recommendations;\n•the relevant regulatory authority’s review process and decision-making regarding vadadustat and any other product candidate may be impacted by the results of our and our competitors’ clinical trials and safety concerns of marketed products used to treat the same indications as the indications for which vadadustat and any other product candidate are being developed;\n•the relevant regulatory authority may not approve the manufacturing processes or facilities of third party manufacturers with whom we contract; or\n•the policies or regulations of the relevant regulatory authority may significantly change in a manner that renders our clinical data insufficient for approval or requires us to amend or submit new clinical protocols.\nIf we experience further delays in obtaining approval, or if we fail to obtain approval of vadadustat for some or all of the indications for which we have sought approval, the commercial prospects for vadadustat may be harmed and our ability to generate revenues will be materially impaired, which could have a material adverse effect on our business. For example, the FDRR we submitted to the FDA in October 2022 focuses on the favorable balance between the benefits and risks of vadadustat for the treatment of anemia due to CKD in adult patients on dialysis.\nProducts approved for marketing are subject to extensive post-marketing regulatory requirements and could be subject to post-marketing restrictions or withdrawal from the market, and we may be subject to penalties, including withdrawal of marketing approval, if we fail to comply with regulatory requirements or if we experience unanticipated problems with our products, or product candidates, when and if any of them is approved.\nMarketing approvals may be subject to limitations on the approved indicated uses for which the product may be marketed or other conditions of approval, or contain requirements or commitments for potentially costly post-marketing studies and surveillance to monitor the safety and efficacy of the product, including REMS, or registries or observational studies. For example, in connection with the FDA approvals of Auryxia, we initially committed to the FDA to conduct certain post-approval pediatric studies of Auryxia under the Pediatric Research Equity Act of 2003, or PREA. With regard to the Hyperphosphatemia Indication for Auryxia, we committed to completing the post-approval pediatric study and submitting a final report to the FDA by December 31, 2019. However, we did not complete the study and therefore did not submit the post-marketing requirement pediatric clinical study report by December 31, 2019. Consequently, we received a notification of noncompliance with PREA. Our request to extend this deadline was denied, and the study is considered delayed although we have initiated sites in the study and are recruiting for one patient cohort. Recruitment of the other patients is pending receipt of further data regarding the manufacturing of the smaller size tablets and the FDA’s concurrence before proceeding with the use of such formulation. With regard to our IDA Indication, we initially committed to completing the post-approval pediatric study and submitting a final report to the FDA by January 2023. We did not meet a milestone relating to this post-approval pediatric study of Auryxia in a timely manner and received a notification from the FDA. Subsequently, the FDA agreed to extend the pediatric clinical study timelines for the IDA Indication. We subsequently communicated to the FDA that we would be delaying the start of the clinical trial in the IDA Indication while we work to produce smaller size tablets. In response, the FDA issued a partial clinical hold until we manufacture the smaller tablets and provide the FDA with relevant information regarding the smaller sized tablets for\n77\nreview. The FDA lifted the partial clinical hold in June 2022, however, we have not commenced start up of this study pending resolution of the manufacturing of the smaller size tablets. If we are unable to complete these studies successfully, or have further delays in completing these studies, we will need to inform the FDA, have further discussions and, if the FDA finds that we failed to comply with pediatric study requirements, in violation of applicable law, it could institute enforcement proceedings to seize or enjoin the sale of Auryxia or seek civil penalties, which would have a material adverse impact on our ability to commercialize Auryxia and our ability to generate revenues from Auryxia.\nIn addition, the manufacturing processes, labeling, packaging, distribution, adverse event reporting, storage, advertising, promotion and recordkeeping for Auryxia, vadadustat, if approved, and any other product for which we receive regulatory approval will be subject to extensive and ongoing regulatory requirements and guidance. These requirements and guidance include manufacturing processes and procedures (including record keeping), the implementation and operation of quality systems to control and assure the quality of the product, submissions of safety and other post-marketing information and reports, as well as continued compliance with cGMPs and GCPs for any clinical trials that we conduct post-approval. If we, our CMOs or other third parties we engage fail to adhere to such regulatory requirements and guidance, we could suffer significant consequences, including product seizures or recalls, loss of product approval, fines and sanctions, reputational damage, loss of customer confidence, shipment delays, inventory shortages, inventory write-offs and other product-related charges and increased manufacturing costs, and our development or commercialization efforts may be materially harmed.\nMoreover, the FDA and other regulatory authorities closely regulate the post-approval marketing and promotion of drugs to ensure drugs are marketed only for the approved indications and in accordance with the provisions of the approved labeling. The FDA and other regulatory authorities impose stringent restrictions on companies’ communications regarding use of their products, and if we promote any approved product beyond its approved indications or inconsistent with the approved label, we may be subject to enforcement actions or prosecution arising from such activities. Violations of the U.S. Federal Food, Drug, and Cosmetic Act, or the FDCA, relating to the promotion of prescription drugs may lead to investigations alleging violations of federal and state healthcare fraud and abuse and other laws, as well as state consumer protection laws, insurance fraud laws, third party payor actions, stockholder actions and other lawsuits.\nPost-approval discovery of previously unknown problems with an approved product, including adverse events of unanticipated severity or frequency or relating to manufacturing operations or processes, or failure to comply with regulatory requirements, may result in, among other things:\n•restrictions on the marketing, distribution, use or manufacturing of the product;\n•withdrawal of the product from the market, or product recalls;\n•restrictions on the labeling or marketing of a product;\n•fines, restitution or disgorgement of profits or revenues;\n•warning or untitled letters or clinical holds;\n•refusal by the FDA or other regulatory authorities to approve pending applications or supplements to approved applications filed by us, or suspension or revocation of product approvals;\n•product seizure or detention, or refusal to permit the import or export of products;\n•REMS; and\n•injunctions or the imposition of civil or criminal penalties.\nFor example, we previously had three limited, voluntary recalls of Auryxia. These and any other recalls or any supply, quality or manufacturing issues in the future could result in significant negative consequences, including reputational harm, loss of customer confidence, and a negative impact on our financials, any of which could have a material adverse effect on our business and results of operations, and may impact our ability to supply Auryxia, VafseoTM, in Japan or vadadustat for commercial (if approved) and clinical use.\nNon-compliance with the FDA, the EMA, the PMDA and other regulatory authorities’ requirements regarding safety monitoring or pharmacovigilance can also result in significant financial penalties.\nThe FDA’s policies and those of other regulatory authorities may change, and additional government regulations may be enacted. We cannot predict the likelihood, nature or extent of government regulations that may arise from future legislation or administrative action, either in the United States or in other jurisdictions. If we are slow or unable to adapt to changes in existing requirements or the adoption of new requirements or policies, or are not able to maintain regulatory compliance, we may lose any marketing approval that we may have obtained and we may not achieve or sustain profitability, which would materially adversely affect our business.\nRisks Related to Governmental Regulation and Compliance\n78\nWe are subject to a complex regulatory scheme that requires significant resources to ensure compliance and our failure to comply with applicable laws could subject us to government scrutiny or enforcement, potentially resulting in costly investigations, fines, penalties or sanctions, contractual damages, reputational harm, administrative burdens and diminished profits and future earnings.\nIn general, a variety of laws apply to us or may otherwise restrict our activities, including the following:\n•laws and regulations governing the conduct of preclinical studies and clinical trials in the United States and other countries in which we are conducting such studies;\n•anti-corruption and anti-bribery laws, including the FCPA, the UK Bribery Act and various other anti-corruption laws in countries outside of the United States;\n•data privacy laws existing in the United States, the EU, the UK and other countries in which we operate, including the U.S. Health Insurance Portability and Accountability Act of 1996, or HIPAA, as amended by the Health Information Technology for Economic and Clinical Health Act, or HITECH, state privacy and data protection laws, such as the California Consumer Privacy Act, or CCPA, and the California Privacy Rights Act of 2020, or CPRA, as well as state consumer protection laws, GDPR, any additional applicable EU member state data protection laws in force from time to time, the retained EU law version of the General Data Protection Regulation as saved into United Kingdom law by virtue of section 3 of the United Kingdom's European Union (Withdrawal) Act 2018, or the EU GDPR;\n•federal and state laws requiring the submission of accurate product prices and notifications of price increases;\n•federal and state securities laws;\n•environmental, health and safety laws and regulations; and\n•international trade laws, which are laws that regulate the sale, purchase, import, export, re-export, transfer and shipment of goods, products, materials, services and technology.\nIn addition, our relationships with healthcare providers, physicians and third party payors expose us to broadly applicable fraud and abuse laws that may constrain the business or financial arrangements and relationships through which we market, sell and distribute Auryxia and vadadustat, if approved, and any other products for which we may obtain marketing approval. As such, these arrangements are subject to applicable anti-kickback, fraud and abuse, false claims, transparency, health information privacy and security, and other healthcare laws and regulations at federal, state and international levels. These restrictions include, but are not limited to, the following:\n•the FDCA which among other things, strictly regulates drug product marketing and promotion and prohibits manufacturers from marketing such products for off-label use;\n•federal laws that require pharmaceutical manufacturers to report certain calculated product prices to the government or provide certain discounts or rebates to government authorities or private entities, often as a condition of reimbursement under government healthcare programs, and laws requiring notification of price increases;\n•the federal Anti-Kickback Statute, which prohibits, among other things, persons from knowingly and willfully soliciting, offering, receiving or providing remuneration, directly or indirectly, in cash or in kind, to induce or reward, or in return for, either the referral of an individual for, or the purchase, order or recommendation or arranging of, any good or service, for which payment may be made under a federal healthcare program such as Medicare and Medicaid;\n•the federal False Claims Act, which imposes criminal and civil penalties, including through civil whistleblower or qui tam actions, against individuals or entities for, among other things, knowingly presenting, or causing to be presented, false or fraudulent claims for payment by a federal healthcare program or making a false statement or record material to payment of a false claim or avoiding, decreasing or concealing an obligation to pay money to the federal government, with potential liability including mandatory treble damages and significant per-claim penalties, and violations of the FDCA, the federal government pricing laws, and the federal Anti-Kickback Statute trigger liability under the federal False Claims Act;\n•HIPAA, which imposes criminal and civil liability for executing a scheme to defraud any healthcare benefit program or making false statements relating to healthcare matters;\n•HIPAA, as amended by the HITECH, and their respective implementing regulations, also imposes obligations, including mandatory contractual terms, with respect to safeguarding the privacy, security and transmission of individually identifiable health information;\n•the federal Physician Payments Sunshine Act (renamed the Open Payments Act) requires applicable manufacturers of covered drugs to report payments and other transfers of value to physicians, other healthcare providers and teaching hospitals, as well as ownership and investment interests held by physicians and their immediate family members;\n•analogous state and foreign laws and regulations, such as state anti-kickback and false claims laws and gift ban and transparency statutes, which may apply to sales or marketing arrangements and claims involving healthcare items or services reimbursed by state Medicaid or other programs, or non-governmental third party payors, including private\n79\ninsurers, and which are not preempted by federal laws and often differ from state to state, thus complicating compliance efforts; and\n•U.S. state laws restricting interactions with healthcare providers and other members of the healthcare community or requiring pharmaceutical manufacturers to implement certain compliance standards, which vary from state to state.\nBecause of the breadth of these U.S. laws, and their non-U.S. equivalents, and the narrowness of the statutory exceptions and safe harbors available, it is possible that some of our business activities could be subject to challenge under one or more of such laws. In addition, recent healthcare reforms have strengthened these laws. For example, the Health Care Reform Act, among other things, amended the intent requirement of the federal Anti-Kickback Statute. A person or entity no longer needs to have actual knowledge of the statute or specific intent to violate the law. The Health Care Reform Act also amended the False Claims Act, such that violations of the Anti-Kickback Statute are now deemed violations of the False Claims Act.\nSome state laws require pharmaceutical companies to comply with the pharmaceutical industry’s voluntary compliance guidelines, such as the Pharmaceutical Research and Manufacturers of America Code on Interactions with Health Care Professionals, known as the PhRMA Code. Additionally, some state and local laws require the registration of pharmaceutical sales representatives in the jurisdiction. State and foreign laws also govern the privacy and security of health information in some circumstances, many of which differ from each other in significant ways and often are not preempted by HIPAA.\nEfforts to ensure that our business complies with applicable healthcare laws and regulations involves substantial costs and requires us to expend significant resources. One of the potential areas for governmental scrutiny involves federal and state requirements for pharmaceutical manufacturers to submit accurate price reports to the government. Because our processes for calculating applicable government prices and the judgments involved in making these calculations involve subjective decisions and complex methodologies, these calculations are subject to risk of errors and differing interpretations. In addition, they are subject to review and challenge by the applicable governmental agencies, or potential qui tam complaints, and it is possible that such reviews could result in changes, recalculations, or defense costs that may have adverse legal or financial consequences. It is possible that governmental authorities will conclude that our business practices may not comply with current or future statutes, regulations or case law involving applicable fraud and abuse or other healthcare laws and regulations. If our operations are found to be in violation of any of these laws or any other governmental regulations that may apply to us, we may be subject to significant civil, criminal and administrative penalties, damages, fines, imprisonment, exclusion of products from government funded healthcare programs, such as Medicare and Medicaid, and the curtailment or restructuring of our operations, any of which could materially adversely affect our business and would result in increased costs and diversion of management attention and could negatively impact the development, regulatory approval and commercialization of Auryxia or vadadustat, any of which could have a material adverse effect on our business. Further, if any of the physicians or other healthcare providers or entities with whom we expect to do business is found to be not in compliance with applicable laws, they may be subject to criminal, civil or administrative sanctions, including exclusions from participation in government funded healthcare programs.\nWe will incur significant liability if it is determined that we are promoting any “off-label” use of Auryxia or any other product we may develop, in-license or acquire or if it is determined that any of our activities violates the federal Anti-Kickback Statute.\nPhysicians are permitted to prescribe drug products for uses that differ from those approved by the FDA or other applicable regulatory agencies. Although the FDA and other regulatory agencies do not regulate a physician’s choice of treatments, the FDA and other regulatory agencies do restrict manufacturer communications regarding unapproved uses of an approved drug. Companies are not permitted to promote drugs for unapproved uses or in a manner that is inconsistent with the FDA-approved labeling. There are also restrictions about making comparative or superiority claims based on safety or efficacy that are not supported by substantial evidence. Accordingly, we may not promote Auryxia in the United States for use in any indications other than the Hyperphosphatemia Indication and the IDA Indication, and all promotional claims must be consistent with the FDA-approved labeling for Auryxia.\nPromoting a drug off-label is a violation of the FDCA and can give rise to liability under the federal False Claims Act, as well as under additional federal and state laws and insurance statutes. The FDA, the Department of Justice and other regulatory and enforcement authorities enforce laws and regulations prohibiting promotion of off-label uses and the promotion of products for which marketing approval has not been obtained, as well as the false advertising or misleading promotion of drugs. In September 2021, the FDA published final regulations which describe the types of evidence that the agency will consider in determining the intended use of a drug product. In addition, laws and regulations govern the distribution and tracing of prescription drugs and prescription drug samples, including the Prescription Drug Marketing Act of 1976 and the Drug Supply Chain Security Act, which regulate the distribution and tracing of prescription drugs and prescription drug samples at the federal level and set minimum standards for the regulation of drug distributors by the states. A company that is found to have improperly promoted off-label uses or to have otherwise engaged in false or misleading promotion or improper distribution of\n80\ndrugs will be subject to significant liability, potentially including civil and administrative remedies as well as criminal sanctions. It may also be subject to exclusion and debarment from federal healthcare reimbursement programs.\nNotwithstanding the regulatory restrictions on off-label promotion, the FDA and other regulatory authorities allow companies to engage in truthful, non-misleading, and non-promotional scientific communications concerning their products in certain circumstances. In addition, under some relatively recent guidance from the FDA, companies may also promote information that is consistent with the prescribing information and proactively speak to formulary committee members of payors regarding data for an unapproved drug or unapproved uses of an approved drug. We intend to engage in these discussions and communicate with healthcare providers, payors and other constituencies in compliance with all applicable laws, regulatory guidance and industry best practices. Although we believe we have put in place a robust compliance program and processes designed to ensure that all such activities are performed in a legal and compliant manner, such program and processes may not be sufficient to deter or detect all violations.\nIn addition, if a company’s activities are determined to have violated the federal Anti-Kickback Statute, this can also give rise to liability under the federal False Claims Act and such violations can result in significant fines, criminal and civil remedies, and exclusion from Medicare and Medicaid. There is increased government focus on relationships between the pharmaceutical industry and physicians, pharmacies (especially specialty pharmacies), and other sources of referrals. Common industry activities, such as speaker programs, insurance assistance and support, relationships with foundations providing copayment assistance, and relationships with patient organizations and patients are receiving increased governmental attention. If any of our relationships or activities is determined to violate applicable federal and state anti-kickback laws, false claims laws, or other laws or regulations, the company and/or company executives, employees, and other representatives could be subject to significant fines and criminal sanctions, imprisonment, and potential exclusion from Medicare and Medicaid, and could harm our reputation or result in significant legal expenses and distraction of management.\nDisruptions in the FDA, regulatory authorities outside the U.S. and other government agencies caused by global health concerns or funding shortages could prevent new products and services from being developed or commercialized in a timely manner, which could negatively impact our business.\nThe ability of the FDA and regulatory authorities outside the U.S. to review and approve new products can be affected by a variety of factors, including global health concerns, government budget and funding levels, staffing shortages, statutory, regulatory, and policy changes and other events that may otherwise affect the FDA’s or other regulatory authorities' ability to perform routine functions. Average review times at the FDA have fluctuated in recent years as a result of certain of these factors. In addition, government funding of other government agencies that fund research and development activities is subject to the political process, which is inherently fluid and unpredictable. Disruptions at the FDA and other agencies may increase the time necessary for new drugs to be reviewed or approved by necessary government agencies, which would adversely affect our business. If a prolonged government shutdown occurs, it could significantly impact the ability of the FDA or other regulatory authorities to timely review and process our, or our collaboration partners', regulatory submissions, which could have a material adverse effect on our business.\nIn response to the COVID-19 pandemic, a number of companies in 2020 and 2021 announced receipt of complete response letters due to the FDA’s inability to complete required inspections for their applications. Following a period of false starts, and temporary suspensions due to the omicron variant, the FDA announced on February 2, 2022 that it would resume domestic inspections beginning on February 7, 2022, and indicated that it would conduct foreign inspections beginning in April 2022 on a prioritized basis. However, the FDA may not be able to continue its current pace and review timelines could be extended, including where a pre-approval inspection or an inspection of clinical sites is required and due to the ongoing COVID-19 pandemic and travel restrictions, the FDA is unable to complete such required inspections during the review period. Regulatory authorities outside the United States may also impose similar restrictions or other policy measures in response to the COVID-19 pandemic. If a prolonged government shutdown occurs, or if global health concerns continue to prevent the FDA or other regulatory authorities from conducting their regular inspections, reviews, or other regulatory activities, it could significantly impact the ability of the FDA or other regulatory authorities to timely review and process our regulatory submissions, which could have a material adverse effect on our business.\nCompliance with privacy and data security requirements could result in additional costs and liabilities to us or inhibit our ability to collect and process data globally, and the failure to comply with such requirements could subject us to significant fines and penalties, which may have a material adverse effect on our business, financial condition or results of operations.\nThe regulatory framework for the collection, use, safeguarding, sharing, transfer and other processing of information worldwide is rapidly evolving and is likely to remain uncertain for the foreseeable future. Globally, virtually every jurisdiction in which we operate has established its own data security and privacy frameworks with which we must comply. For example, the collection, use, disclosure, transfer, or other processing of personal data regarding individuals in the EU, including personal health data, is subject to the GDPR, which took effect across all member states of the European Economic Area, or EEA, in May 2018.\n81\nFollowing the withdrawal of the U.K. from the EU, the U.K. Data Protection Act 2018 applies to the processing of personal data that takes place in the U.K. and includes parallel obligations to those set forth by GDPR. The GDPR is wide-ranging in scope and imposes numerous requirements on companies that process personal data when required, including requirements relating to processing health and other sensitive data, obtaining consent of the individuals to whom the personal data relates, when required, providing information to individuals regarding data processing activities, implementing safeguards to protect the security and confidentiality of personal data, providing notification of data breaches, and taking certain measures when engaging third party processors. The GDPR increases our obligations as a sponsor in clinical trials in the EEA by expanding the definition of personal data to include coded data and requiring changes to informed consent practices and more detailed notices for clinical trial patients and investigators. In addition, the GDPR also imposes strict rules on the transfer of personal data to countries outside the EU, including the United States and, as a result, increases the scrutiny that we should apply to transfers of personal data from such sites to countries that are considered to lack an adequate level of data protection, such as the United States. The GDPR also permits data protection authorities to require destruction of improperly gathered or used personal information and/or impose substantial fines for violations of the GDPR, which can be up to four percent of global revenues or 20 million Euros, whichever is greater, and it also confers a private right of action on data subjects and consumer associations to lodge complaints with supervisory authorities, seek judicial remedies, and obtain compensation for damages resulting from violations of the GDPR. In addition, the GDPR provides that EU member states may make their own further laws and regulations limiting the processing of personal data, including genetic, biometric or health data and permits EU member states to adopt further penalties for violations that are not subject to the administrative fines outlined in the GDPR.\nGiven the breadth and depth of changes in data protection obligations, complying with the GDPR’s requirements is rigorous and time intensive and requires significant resources and a review of our technologies, systems and practices, as well as those of any third party collaborators, service providers, contractors or consultants that process or transfer personal data collected in the EU. The GDPR and other changes in laws or regulations associated with the enhanced protection of certain types of sensitive data, such as healthcare data or other personal information from our clinical trials, could require us to change our business practices and put in place additional compliance mechanisms, may interrupt or delay our development, regulatory and commercialization activities and increase our cost of doing business, and could lead to government enforcement actions, private litigation and significant fines and penalties against us and could have a material adverse effect on our business, financial condition or results of operations.\nSimilar privacy and data security requirements are either in place or underway in the United States. There are a broad variety of data protection laws that may be applicable to our activities, and a range of enforcement agencies at both the state and federal levels that can review companies for privacy and data security concerns. The Federal Trade Commission and state Attorneys General all are aggressive in reviewing privacy and data security protections for consumers. New laws also are being considered at both the state and federal levels. For example, the CCPA, which went into effect on January 1, 2020, and the CPRA, which amends CCPA by expanding the scope and applicability, while also introducing new privacy protections, is creating similar risks and obligations as those created by GDPR. Because of this, we may need to engage in additional activities (e.g., data mapping) to identify the personal information we are collecting and the purposes for which such information is collected. In addition, we will need to ensure that our policies recognize the rights granted to consumers (as that phrase is broadly defined in the CCPA and can include business contact information). Many other states are considering similar legislation. A broad range of legislative measures also have been introduced at the federal level. Accordingly, failure to comply with current and any future federal and state laws regarding privacy and security of personal information could expose us to fines and penalties. We also face a threat of potential consumer class actions related to these laws and the overall protection of personal data. Even if we are not determined to have violated these laws, investigations into these issues typically require the expenditure of significant resources and generate negative publicity, which could harm our reputation and our business.\nLegislative and regulatory healthcare reform may increase the difficulty and cost for us to obtain marketing approval of and commercialize our product candidates and affect the prices we may obtain for any products that are approved in the United States or foreign jurisdictions.\nIn the United States and some foreign jurisdictions, there have been a number of legislative and regulatory changes and proposed changes regarding the healthcare system that could prevent or delay marketing approval of vadadustat, or any other product candidate, restrict or regulate post-approval activities and affect our ability to profitably sell Auryxia and vadadustat, if approved. The pharmaceutical industry has been a particular focus of these efforts and has been significantly affected by legislative initiatives. Current laws, as well as other healthcare reform measures that may be adopted in the future, may result in more rigorous coverage criteria and in additional downward pressure on the price that we receive for any FDA approved product, such as Auryxia or vadadustat, if approved, or any reimbursement that physicians receive for administering any approved product.\nIn the United States, the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, or the MMA, changed the way Medicare covers and pays for pharmaceutical products. The legislation expanded Medicare coverage for drug purchases by the elderly and introduced a new reimbursement methodology based on average sales prices for physician-administered drugs. In addition, this legislation provided authority for limiting the number of drugs that will be covered in any therapeutic class. Cost reduction initiatives and other provisions of this legislation could decrease the coverage and price that we receive for Auryxia and any other approved products. While the MMA applies only to drug benefits for Medicare beneficiaries, private\n82\npayors often follow Medicare coverage policy and payment limitations in setting their own reimbursement rates. Therefore, any reduction in reimbursement that results from the MMA may result in a similar reduction in payments from private payors.\nIn March 2010, President Obama signed into law the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act of 2010, or, collectively, the ACA. Among the provisions of the ACA of potential importance to our business including, without limitation, our ability to commercialize and the prices we obtain for Auryxia and may obtain for any of our product candidates that are approved for sale, are the following:\n•an annual, non-deductible fee on any entity that manufactures or imports specified branded prescription drugs and biologic agents;\n•an increase in the statutory minimum rebates a manufacturer must pay under the Medicaid Drug Rebate Program;\n•expansion of healthcare fraud and abuse laws, including the civil False Claims Act and the federal anti-kickback statute, new government investigative powers and enhanced penalties for noncompliance;\n•a new Medicare Part D coverage gap discount program, in which manufacturers must agree to offer 70% point-of-sale discounts off negotiated prices;\n•extension of manufacturers’ Medicaid rebate liability;\n•expansion of eligibility criteria for Medicaid programs;\n•expansion of the entities eligible for discounts under the Public Health Service pharmaceutical pricing program;\n•new requirements to report certain financial arrangements with physicians and teaching hospitals;\n•a new requirement to annually report drug samples that manufacturers and distributors provide to physicians; and\n•a new Patient-Centered Outcomes Research Institute to oversee, identify priorities in, and conduct comparative clinical effectiveness research, along with funding for such research.\nIn addition, other legislative changes and regulatory have been proposed and adopted since the ACA was enacted. These changes include the Budget Control Act of 2011, which, among other things, led to aggregate reductions to Medicare payments to providers of up to 2% per fiscal year, which will remain in effect through 2031. However, pursuant to the Coronavirus Aid, Relief, and Economic Security Act, or the CARES Act, and subsequent legislation, these Medicare sequester reductions were suspended and reduced through the end of June 2022 but with the full 2% cut resuming as of July 1, 2022. The American Taxpayer Relief Act of 2012, which, among other things, reduced Medicare payments to several types of providers and increased the statute of limitations period for the government to recover overpayments to providers from three to five years. In addition, other legislative and regulatory changes have been proposed, but not yet adopted. For example, in July 2019, HHS proposed regulatory changes in kidney health policy and reimbursement. Any new legislative or regulatory changes may result in additional reductions in Medicare and other healthcare funding and otherwise affect the prices we may obtain for Auryxia or vadadustat, if approved, or the frequency with which Auryxia and vadadustat, if approved, is prescribed or used.\nThe costs and prices of prescription pharmaceuticals have also been the subject of considerable discussion in the United States. To date, there have been several recent U.S. congressional inquiries and proposed and enacted state and federal legislation designed to, among other things, bring more transparency to drug pricing, review the relationship between pricing and manufacturer patient programs, reduce the costs of drugs under Medicare and reform government program reimbursement methodologies for drug products. At the federal level, Congress and the current administration have each indicated that it will continue to seek new legislative and/or administrative measures to control drug costs.\nFor example, the former administration issued several executive orders intended to lower the costs of prescription products and certain provisions in these orders have been incorporated into regulations. These regulations include an interim final rule implementing a most favored nation model for prices that would tie Medicare Part B payments for certain physician-administered pharmaceuticals to the lowest price paid in other economically advanced countries, effective January 1, 2021. That rule, however, has been subject to a nationwide preliminary injunction and, on December 29, 2021, CMS issued a final rule to rescind it. With issuance of this rule, CMS stated that it will explore all options to incorporate value into payments for Medicare Part B pharmaceuticals and improve beneficiaries' access to evidence-based care.\nAt the same time, the administration may seek to limit Medicare Part D and public option drug prices through a tax penalty on manufacturers for increases in the cost of drugs and biologics above the general inflation rate. The American Rescue Plan Act of 2021, comprehensive COVID-19 pandemic relief legislation recently enacted under the current administration, includes a number of healthcare-related provisions, such as support to rural health care providers, increased tax subsidies for health insurance purchased through insurance exchange marketplaces, financial incentives to states to expand Medicaid programs and elimination of the Medicaid drug rebate cap effective in 2024.\nFurther, on July 9, 2021, the current administration signed Executive Order 14063, which focuses on, among other things, the price of pharmaceuticals. The Order directs HHS to create a plan within 45 days to combat “excessive pricing of prescription pharmaceuticals and enhance domestic pharmaceutical supply chains, to reduce the prices paid by the federal government for such pharmaceuticals, and to address the recurrent problem of price gouging.” On September 9, 2021, HHS released its plan to reduce pharmaceutical prices. The key features of that plan are to: (a) make pharmaceutical prices more affordable and\n83\nequitable for all consumers and throughout the health care system by supporting pharmaceutical price negotiations with manufacturers; (b) improve and promote competition throughout the prescription pharmaceutical industry by supporting market changes that strengthen supply chains, promote biosimilars and generic drugs, and increase transparency; and (c) foster scientific innovation to promote better healthcare and improve health by supporting public and private research and making sure that market incentives promote discovery of valuable and accessible new treatments.\nMore recently, with passage of the Inflation Reduction Act in August 2022, Congress authorized Medicare beginning in 2026 to negotiate lower prices for certain costly single-source drug and biologic products that do not have competing generics or biosimilars. This provision is limited in terms of the number of pharmaceuticals whose prices can be negotiated in any given year and it only applies to drug products that have been approved for at least nine years and biologics that have been licensed for 13 years. Drugs and biologics that have been approved for a single rare disease or condition are categorically excluded from price negotiation. Further, the new legislation provides that, effective October 1, 2022, if pharmaceutical companies raise commercial prices faster than the rate of inflation, they must pay rebates back to the government for the difference. The new law also caps Medicare out-of-pocket drug costs at an estimated $4,000 a year in 2024 and, thereafter beginning in 2025, at $2,000 a year.\nAt the state level, individual states are increasingly aggressive in passing legislation and implementing regulations designed to control pharmaceutical and biological product pricing, including price or patient reimbursement constraints, discounts, restrictions on certain product access, marketing cost disclosure and transparency measures, and, in some cases, designed to encourage importation from other countries and bulk purchasing. A number of states, for example, require drug manufacturers and other entities in the drug supply chain, including health carriers, pharmacy benefit managers, wholesale distributors, to disclose information about pricing of pharmaceuticals. In addition, regional healthcare authorities and individual hospitals are increasingly using bidding procedures to determine what pharmaceutical products and which suppliers will be included in their prescription drug and other healthcare programs. These measures could reduce the ultimate demand for our products or put pressure on our product pricing.\nIt is likely that federal and state legislatures within the United States and foreign governments will continue to consider changes to existing healthcare legislation. We expect that additional state and federal healthcare reform measures will be adopted in the future, any of which could limit the amounts that federal and state governments will pay for healthcare products and services, which could result in reduced demand for Auryxia and any product candidates for which we receive marketing approval or additional pricing pressures. We cannot predict the reform initiatives that may be adopted in the future or whether initiatives that have been adopted will be repealed or modified. The continuing efforts of the government, insurance companies, managed care organizations and other payors of healthcare services to contain or reduce costs of healthcare may adversely affect:\n•the demand for Auryxia and any products candidates for which we receive marketing approval;\n•our ability to set a price that we believe is fair for our products;\n•our ability to obtain and maintain coverage and reimbursement approval for Auryxia or any other approved product;\n•our ability to generate revenues and achieve or maintain profitability; and\n•the level of taxes that we are required to pay.\nIn addition, in some countries, including member states of the EU the pricing of prescription pharmaceuticals is subject to governmental control. In these countries, pricing negotiations with governmental authorities can take a significant amount of time after receipt of marketing approval for a product. In addition, there can be considerable pressure by governments and other stakeholders on prices and reimbursement levels, including as part of cost containment measures. Political, economic and regulatory developments may further complicate pricing negotiations, and pricing negotiations may continue after reimbursement has been obtained. Reference pricing used by various EU member states and parallel distribution, or arbitrage between low-priced and high-priced member states, can further reduce prices, and in certain instances render commercialization in certain markets infeasible or disadvantageous from a financial perspective. In some countries, we or our collaborators may be required to conduct a clinical trial or other studies that compare the cost-effectiveness of our product and/or our product candidates to other available products in order to obtain or maintain reimbursement or pricing approval. Publication of discounts by third party payors or government authorities may lead to further pressure on the prices or reimbursement levels. If reimbursement of our products is unavailable or limited in scope or amount, or if pricing is set at unsatisfactory levels, the commercial launch of our product and/or product candidates could be delayed, possibly for lengthy periods of time, we or our collaborators may not launch at all in a particular country, we may not be able to recoup our investment in one or more product candidates, and there could be a material adverse effect on our business.\nIf we fail to comply with environmental, health and safety laws and regulations, we could become subject to fines or penalties or incur costs that could harm our business.\nWe are subject to numerous environmental, health and safety laws and regulations, including those governing laboratory procedures and the handling, use, storage, treatment and disposal of hazardous materials and wastes. Our operations involve the use of hazardous and flammable materials, including chemicals and biological materials. Our operations also produce hazardous\n84\nwaste products. We generally contract with third parties for the use and disposal of these materials and wastes. We cannot eliminate the risk of contamination or injury from these materials. In the event of contamination or injury resulting from the use of hazardous materials by our employees, contractors or consultants, we could be held liable for any resulting damages, and any liability could exceed our resources. We also could incur significant costs associated with civil or criminal fines and penalties for failure to comply with such laws and regulations.\nAlthough we maintain workers’ compensation insurance to cover us for costs and expenses, we may incur due to injuries to our employees resulting from the use of hazardous materials, this insurance may not provide adequate coverage against potential liabilities. We do not maintain insurance for environmental liability or toxic tort claims that may be asserted against us in connection with our storage or disposal of biological, hazardous or radioactive materials.\nIn addition, we may incur substantial costs in order to comply with current or future environmental, health and safety laws and regulations. These current or future laws and regulations may impair our research, development or production efforts. Our failure to comply with these laws and regulations also may result in substantial fines, penalties or other sanctions.\nRisks Related to our Reliance on Third Parties\nWe depend on collaborations with third parties for the development and commercialization of Auryxia, Riona, Vafseo and vadadustat and if these collaborations are not successful or if our collaborators terminate their agreements with us, we may not be able to capitalize on the market potential of Auryxia, Riona, Vafseo and vadadustat, and our business could be materially harmed.\nWe sublicensed the rights to commercialize Riona to JT and Torii in Japan. We also entered into a collaboration agreement with MTPC to develop and commercialize vadadustat in Japan and certain other Asian countries. In addition, we entered into the Vifor Second Amended Agreement pursuant to which we granted Vifor Pharma an exclusive license to sell vadadustat to the Supply Group in the United States. We may form or seek other strategic alliances, joint ventures, or collaborations, or enter into additional licensing arrangements with third parties that we believe will complement or augment our and our partners' commercialization efforts with respect to Auryxia, Riona, Vafseo and our and our partners' development and, if approved, commercialization efforts with respect to vadadustat and any other product candidates. We may not be able to maintain our collaborations for development and commercialization. For example, on May 13, 2022, Otsuka elected to terminate our collaboration agreements with them, and we subsequently negotiated the Termination Agreement with Otsuka. This termination by Otsuka may make it difficult for us to attract a new collaborator or adversely affect how we are perceived in scientific and financial communities. We plan to pursue a new partner to develop and commercialize vadadustat in Europe and other territories previously licensed to Otsuka. If we are unsuccessful in entering into such agreements or arrangements in a timely manner, or at all, it may result in a need for additional capital and expansion of our internal capabilities to pursue further development or commercialization of the applicable products and product candidates, particularly the development and commercialization of vadadustat in the United States, Europe, China and certain other territories.\nIn addition, our current and any future collaborations may not be successful due to a number of important factors, including the following:\n•collaborators may have significant discretion in determining the efforts and resources that they will apply to these collaborations;\n•collaborations may be terminated in accordance with the terms of the collaboration agreements and, if terminated, may make it difficult for us to attract new collaborators or adversely affect how we are perceived in scientific and financial communities, and may result in a need for additional capital and expansion of our internal capabilities to pursue further development or commercialization of the applicable products and product candidates;\n•if permitted by the terms of the collaboration agreements, collaborators may elect not to continue or renew development or commercialization programs based on clinical trial results, changes in their strategic focus, availability of funding or other external factors such as a business combination that diverts resources or creates competing priorities;\n•if permitted by the terms of the collaboration agreements, collaborators may delay clinical trials, provide insufficient funding for a clinical trial program, stop a clinical trial, abandon a product candidate, repeat or conduct new clinical trials or require a new formulation of a product candidate for clinical testing;\n•a collaborator with marketing and distribution rights to our products may not commit sufficient resources to their marketing and distribution;\n•if permitted by the terms of the collaboration agreements, we and our collaborator may have a difference of opinion regarding the development or commercialization strategy for a particular product or product candidate, and our collaborator may have ultimate decision making authority;\n•disputes may arise between a collaborator and us that cause the delay or termination of activities related to research, development, supply or commercialization of Auryxia, Riona, Vafseo or vadadustat and any other product candidate, or that result in costly litigation or arbitration that diverts management attention and resources;\n85\n•collaborations may not lead to development or commercialization of products and product candidates, if approved, in the most efficient manner or at all;\n•a significant change in the senior management team, a change in the financial condition or a change in the business operations, including a change in control or internal corporate restructuring, of any of our collaborators, could result in delayed timelines, re-prioritization of our programs, decreasing resources or funding allocated to support our programs, or termination of the collaborations; and\n•collaborators may not comply with all applicable regulatory and legal requirements.\nIf any of these events occurs, the market potential of Auryxia, Riona, Vafseo and vadadustat, if and where approved, and any other products or product candidates, could be reduced, and our business could be materially harmed. Collaborations may also divert resources, including the attention of management and other employees, from other parts of our business, which could have an adverse effect on other parts of our business, and we cannot be certain that the benefits of the collaboration will outweigh the potential risks.\nWe may seek to establish additional collaborations and, if we are not able to establish them on commercially reasonable terms, or at all, we may have to alter our development and commercialization plans.\nWe will require substantial additional cash to fund the continued commercialization of Auryxia and the development and potential commercialization of any of our product candidates, including vadadustat, if approved, especially following the termination of our collaboration agreements with Otsuka. We may decide to enter into additional collaborations for the development and commercialization of vadadustat or Auryxia, both within and outside of the United States. For example, we plan to pursue a new partner to develop and commercialize vadadustat in Europe and other territories previously licensed to Otsuka. Any of these relationships may require us to incur non-recurring and other charges, increase our near and long-term expenditures, issue securities that dilute our existing stockholders, divert management’s attention, or disrupt our business.\nWe may not be successful in entering into additional collaborations as a result of many factors, including the following:\n•competition in seeking appropriate collaborators;\n•a reduced number of potential collaborators due to recent business combinations in the pharmaceutical industry;\n•an inability to negotiate collaborations on acceptable terms, on a timely basis or at all;\n•any international rules, regulations, guidance, laws, risks or uncertainties with respect to potential partners outside of the United States;\n•a potential collaborator’s evaluation of Auryxia, vadadustat or any other product or product candidate may differ substantially from ours;\n•a potential collaborator’s evaluation of our financial stability and resources;\n•a potential collaborator’s resources and expertise; and\n•restrictions due to an existing collaboration agreement.\nIf we are unable to enter into additional collaborations in a timely manner, or at all, we may have to delay or curtail the commercialization of Auryxia or vadadustat, if and where approved, reduce or delay its development program or other of our other development programs, or increase our expenditures and undertake additional development or commercialization activities at our own expense. If we elect to increase our expenditures to fund development or commercialization activities on our own, we may need to obtain additional capital, which may not be available to us on acceptable terms or at all. If we do not have sufficient funds, we may not be able to further develop or commercialize Auryxia or vadadustat, if approved.\nEven if we enter into additional collaboration agreements and strategic partnerships or license our intellectual property, we may not be able to maintain them or they may be unsuccessful, which could delay our timelines or otherwise adversely affect our business.\nRoyalties from commercial sales of vadadustat under our MTPC Agreement will likely fluctuate and will impact our rights to receive future payments under our Royalty Agreement with HCR.\nPursuant to the Royalty Agreement with HCR, we sold to HCR our right to receive the Royalty Interest Payments payable to us under the MTPC Agreement, subject to the Annual Cap and the Aggregate Cap. After HCR receives Royalty Interest Payments equal to the Annual Cap in a given calendar year, we will receive 85% of the Royalty Interest Payments for the remainder of that year. After HCR receives Royalty Interest Payments equal to the Aggregate Cap, or we pay the Aggregate Cap to HCR (net of the Royalty Interest Payments already received by HCR), the Royalty Interest Payments will revert back to us, and HCR would have no further right to any Royalty Interest Payments. We received $44.8 million from HCR (net of certain transaction expenses) under the Royalty Agreement, and we are eligible to receive up to an additional $15.0 million under the Royalty\n86\nAgreement if specified sales milestones are achieved for vadadustat in the territory covered by the MTPC Agreement, subject to the satisfaction of certain customary conditions.\nThe royalty revenues under the MTPC Agreement may fluctuate considerably because they depend upon, among other things, the rate of growth of sales of vadadustat in the territory covered by the MTPC Agreement. Negative fluctuations in these royalty revenues could delay, diminish or eliminate our right to receive up to the additional $15.0 million under the Royalty Agreement upon achievement of the specified sales milestones, our ability to receive 85% of the Royalty Interest Payments after the Annual Cap is achieved in a given calendar year, or our ability to receive 100% of the Royalty Interest Payments after the Aggregate Cap is achieved.\nWe rely upon third parties to conduct all aspects of our product manufacturing and the loss of these manufacturers, their failure to supply us on a timely basis, or at all, or their failure to successfully carry out their contractual duties or comply with regulatory requirements, cGMP requirements, or guidance could cause delays in or disruptions to our supply chain and substantially harm our business.\nWe do not have any manufacturing facilities and do not expect to independently manufacture any product or product candidates. We currently rely, and expect to continue to rely, on third party manufacturers to produce all of our commercial, clinical and preclinical supply, including the vadadustat drug product that we supply to our collaboration partner, MTPC, for the Japanese market. Our reliance on third party manufacturers, who have control over the manufacturing process, increases the risk that we will not have or be able to maintain sufficient quantities of Auryxia and vadadustat or the ability to obtain such quantities at an acceptable cost or quality, which could delay, prevent or impair our and our partners' development or commercialization efforts.\nWe currently have two suppliers of Auryxia drug substance, Siegfried Evionnaz SA (two approved sites) and BioVectra Inc. (one approved site), and one supplier of Auryxia drug product, Patheon Inc., or Patheon (three approved sites, two of which are active). However, our supply agreement with Siegfried Evionnaz SA expires on December 31, 2022, at which time we will only have one supplier for Auryxia drug substance. We have entered into supply agreements with Esteve Química, S.A. and STA Pharmaceutical Hong Kong Limited, a subsidiary of Wuxi AppTec, or STA, for the commercial manufacture of vadadustat drug substance and Patheon Inc. and STA for the commercial manufacture of vadadustat drug product. If any of the following occurs, we may not have sufficient quantities of Auryxia and/or vadadustat to support our clinical trials, development, commercialization, or obtaining and maintaining marketing approvals, which could materially and adversely impact our business and results of operations:\n•we are unsuccessful in maintaining our current supply arrangements for commercial quantities of Auryxia and vadadustat;\n•our commercial supply arrangements for Auryxia or vadadustat are terminated;\n•any of our third party manufacturers are unable to fulfill the terms of their agreements with us, including with respect to quality and quantity, or are unable or unwilling to continue to manufacture on the manufacturing lines included in our regulatory filings; or\n•any of our third party manufacturers breach our supply agreements, do not comply with quality or regulatory requirements and guidance, including cGMP or are subject to regulatory review or ceases their operations for any reason.\nIf any of our third party manufacturers cannot or do not perform as agreed or expected, including as a result of the COVID-19 pandemic, if they misappropriate our proprietary information, if they terminate their engagements with us, if we terminate our engagements with them, or if there is a significant disagreement, we may be forced to manufacture the materials ourselves, for which we currently do not have the capabilities or resources, or enter into agreements with other third party manufacturers, which we may not be able to do in a timely manner or on favorable or reasonable terms, if at all. For example, one of our manufacturers has notified us that it will be discontinuing operations at one site at a future date. In some cases, there may be a limited number of qualified replacement manufacturers, or the technical skills or equipment required to manufacture a product or product candidate may be unique or proprietary to the original manufacturer and we may have difficulty transferring such skills or technology to another third party, or a feasible alternative may not exist. These factors would increase our reliance on our current manufacturers or require us to obtain necessary regulatory approvals and licenses in order to have another third party manufacture Auryxia or vadadustat. If we are required to change manufacturers for any reason, we will be required to verify that the new manufacturer maintains facilities and procedures that comply with quality standards and with all applicable regulations and guidelines. The delays associated with the qualification of a new manufacturer and validation of manufacturing processes would negatively affect our ability to supply clinical trials, obtain and maintain marketing approval, or commercialize or satisfy patient demand for Auryxia and vadadustat, where approved, in a timely manner within budget or at all.\n87\nIn addition, the cost of obtaining Auryxia and vadadustat is subject to adjustment based on our third party manufacturers’ costs of obtaining raw materials and producing the product. We have limited control over the production of Auryxia and vadadustat, including the costs of raw materials, and any significant increase in the cost of obtaining our products could materially adversely affect our revenue for Auryxia and vadadustat, if approved.\nMoreover, issues that may arise in any scale-up and technology transfer and continued commercial scale manufacture of our products may lead to significant delays in our development, marketing approval and commercial timelines and negatively impact our financial performance. For example, a production-related issue resulted in an interruption in the supply of Auryxia in the third and fourth quarters of 2016. This supply interruption negatively impacted Keryx’s revenues in 2016. This supply interruption was resolved, and we have taken and continue to take actions designed to prevent future interruptions in the supply of Auryxia. However, we recently experienced issues in manufacturing Auryxia, and if we continue to experience manufacturing issues or our actions to prevent future interruptions are not successful, we may experience additional supply issues. Any future supply interruptions, whether quality or quantity based, for Auryxia or vadadustat, if and where approved, would negatively and materially impact our reputation and financial condition.\nThere are a limited number of manufacturers that are capable of manufacturing Auryxia and vadadustat for us and complying with cGMP regulations and guidance and other stringent regulatory requirements and guidance enforced by the FDA, EMA, PMDA and other regulatory authorities. These requirements include, among other things, quality control, quality assurance and the maintenance of records and documentation, which occur in addition to our own quality assurance releases. The facilities and processes used by our third party manufacturers to manufacture Auryxia may be inspected by the FDA and other regulatory authorities at any time, and the facilities and processes used by our third party manufacturers to manufacture vadadustat will be inspected by the FDA, the EMA and other regulatory authorities prior to or after we submit our marketing applications. Although we have general visibility into the manufacturing processes of our third party manufacturers, we do not ultimately control such manufacturing processes of, and have little control over, our third party manufacturers, including, without limitation, their compliance with cGMP requirements and guidance for the manufacture of certain starting materials, drug substance and finished drug product. Similarly, although we review final production, we have little control over the ability of our third party manufacturers to maintain adequate quality control, quality assurance and qualified personnel. Our third party manufacturers may experience problems with their manufacturing and distribution operations and processes, including, for example, quality issues, such as product specification and stability failures, procedural deviations, improper equipment installation or operation, utility failures, contamination, natural disasters and public health epidemics. We may also encounter difficulties relating to our own quality processes and procedures, including regulatory compliance, lot release, quality control and quality assurance, as well as shortages of qualified personnel. If our third party manufacturers cannot successfully manufacture material that conforms to our specifications and regulatory requirements and guidance, or if we or our third party manufacturers experience manufacturing, operations and/or quality issues, including an inability or unwillingness to continue manufacturing our products at all, in accordance with agreed-upon processes or on currently validated manufacturing lines, we may not be able to supply patient demand or maintain marketing approval for Auryxia, secure and maintain marketing approval for vadadustat, and we might be required to expend additional resources to obtain material from other manufacturers. If any of these events occur, our reputation and financial condition would be negatively and materially impacted.\nIf the FDA, the EMA or other regulatory authorities do not approve the facilities being used to manufacture vadadustat, or if they withdraw any approval of the facilities being used to manufacture Auryxia or vadadustat, we may need to find alternative manufacturing facilities, which would significantly impact our ability to continue commercializing Auryxia or Vafseo in Japan, or develop, obtain marketing approval for or market vadadustat or our other product candidates, if approved.\nMoreover, our failure or the failure of our third party manufacturers to comply with applicable regulations or guidance, or our failure to oversee or facilitate such compliance, could result in sanctions being imposed on us or our third party manufacturers, including, where applicable, clinical holds, fines, injunctions, civil penalties, delays in, suspension of or withdrawal of approvals, license revocation, seizures or recalls of Auryxia or Vafseo in Japan, operating restrictions, receipt of a Form 483 or warning letter, or criminal prosecutions, any of which could significantly and adversely affect the supply of Auryxia or vadadustat. For example, we previously conducted three limited, voluntary recalls of Auryxia. These and any other recalls or any supply, quality or manufacturing issues in the future and any related write-downs of inventory or other consequences could result in significant negative consequences, including reputational harm, loss of customer confidence, and a negative impact on our financials, any of which could have a material adverse effect on our business and results of operations, and may impact our ability to supply Auryxia, Vafseo in Japan or vadadustat for clinical and commercial use. Also, if our starting materials, drug substance or drug product are damaged or lost while in our or our third party manufacturers’ control, it may adversely impact our ability to supply Auryxia or vadadustat, and we may incur significant financial harm.\nIn addition, Auryxia and vadadustat may compete with other products and product candidates for access to third party manufacturing facilities. A third party manufacturer may also encounter delays or operational issues brought on by sudden internal resource constraints, labor disputes, shifting priorities or shifting regulatory protocols including, in each case, relating to the COVID-19 pandemic. Certain of these third party manufacturing facilities may be contractually prohibited from manufacturing Auryxia or vadadustat due to exclusivity provisions in agreements with our competitors. Any of the foregoing\n88\ncould negatively impact our third party manufacturers' ability to meet our demand, which could adversely impact our ability to supply Auryxia or vadadustat, and we may incur significant financial harm.\nOur current and anticipated future dependence on third parties for the manufacture of Auryxia and vadadustat may adversely affect our and our partners' ability to commercialize Auryxia and vadadustat, where approved, on a timely and competitive basis and may reduce any future profit margins.\nWe rely upon third parties to conduct our clinical trials and certain of our preclinical studies. If they do not successfully carry out their contractual duties, comply with regulatory requirements or meet expected deadlines, we may not be able to obtain or maintain marketing approval for Auryxia, vadadustat or any of our product candidates, and our business could be substantially harmed.\nWe do not have the ability to independently conduct certain preclinical studies and clinical trials. We are currently relying, and expect to continue to rely, upon third parties, such as CROs, clinical data management organizations, medical institutions and clinical investigators, to conduct our current and future preclinical studies and clinical trials. The third parties upon whom we rely may fail to perform effectively, or terminate their engagement with us, for a number of reasons, including the following:\n•if they experience staffing difficulties;\n•if we fail to communicate effectively or provide the appropriate level of oversight;\n•if they undergo changes in priorities or corporate structure including as a result of a merger or acquisition or other transaction, or become financially distressed; or\n•if they form relationships with other entities, some of which may be our competitors.\nIf the third parties upon whom we rely to conduct our trials fail to adhere to clinical trial protocols or to regulatory requirements, the quantity, quality or accuracy of the data obtained by the third parties may be compromised. We are exposed to risk of fraud or other misconduct by such third parties.\nAny of these events could cause our preclinical studies and clinical trials, including post-approval clinical trials, to be extended, delayed, suspended, required to be repeated or terminated, or we may receive untitled warning letters or be the subject of an enforcement action, which could result in our failing to obtain and maintain marketing approval of vadadustat or any other product candidates on a timely basis, or at all, or fail to maintain marketing approval of Auryxia, or any other products, any of which would adversely affect our business operations. In addition, if the third parties upon whom we rely fail to perform effectively or terminate their engagement with us, we may need to enter into alternative arrangements, which could delay, perhaps significantly, the development and commercialization of vadadustat, if approved, or any other product candidates.\nEven though we do not directly control the third parties upon whom we rely to conduct our preclinical studies and clinical trials and therefore cannot guarantee the satisfactory and timely performance of their obligations to us, we are nevertheless responsible for ensuring that each of our clinical trials and preclinical studies is conducted in accordance with the applicable protocol, legal and regulatory requirements, including GXP requirements, and scientific standards, and our reliance on these third parties, including CROs, will not relieve us of our regulatory responsibilities. If we or any of our CROs, their subcontractors, or clinical or preclinical trial sites fail to comply with applicable GXP requirements, the clinical data generated in our trials may be deemed unreliable or insufficient, our clinical trials could be put on hold, and/or the FDA, the EMA or other regulatory authorities may require us to perform additional clinical trials before approving our marketing applications. In addition, our clinical and preclinical trials must be conducted with drug product that meets certain specifications and is manufactured under applicable cGMP regulations. These requirements include, among other things, quality control, quality assurance, and the satisfactory maintenance of records and documentation.\nWe also rely upon third parties to store and distribute drug product for our clinical trials. For example, we use third parties to store product at various sites in the United States to distribute to our clinical trial sites. Any performance failure on the part of our storage or distributor partners could delay clinical development, marketing approval or commercialization, resulting in additional costs and depriving us of potential product revenue.\nIf the licensor of certain intellectual property relating to Auryxia terminates, modifies or threatens to terminate existing contracts or relationships with us, our business may be materially harmed.\nWe do not own all of the rights to our product, Auryxia. We have licensed and sublicensed certain rights, patent and otherwise, to Auryxia from a third party, Panion & BF Biotech, Inc., or Panion, who in turn licenses certain rights to Auryxia from one of the inventors of Auryxia. The license agreement with Panion, or the Panion License Agreement, requires us to meet development milestones and imposes development and commercialization due diligence requirements on us. In addition, under the Panion License Agreement, we must pay royalties based on a mid-single digit percentage of net sales of product resulting\n89\nfrom the licensed technologies, including Auryxia, and pay the patent filing, prosecution and maintenance costs related to the license. If we do not meet our obligations in a timely manner, or if we otherwise breach the terms of the Panion License Agreement, Panion could terminate the agreement, and we would lose the rights to Auryxia. For example, following announcement of the Merger, Panion notified Keryx in writing that Panion would terminate the Panion License Agreement on November 21, 2018 if Keryx did not cure the breach alleged by Panion, specifically, that Keryx failed to use commercially reasonable best efforts to commercialize Auryxia outside the United States. Keryx disagreed with Panion’s claims, and the parties entered discussions to resolve this dispute. On October 24, 2018, prior to the consummation of the Merger, we, Keryx and Panion entered into a letter agreement, or the Panion Letter Agreement, pursuant to which Panion agreed to rescind any and all prior termination threats or notices relating to the Panion License Agreement and waived its rights to terminate the license agreement based on any breach by us of our obligation to use commercially reasonable efforts to commercialize Auryxia outside the United States until the parties executed an amendment to the Panion License Agreement in accordance with the terms of the Panion Letter Agreement, following consummation of the Merger. On April 17, 2019, we and Panion entered into an amendment and restatement of the Panion License Agreement, or the Panion Amended License Agreement, which reflects certain revisions consistent with the terms of the Panion Letter Agreement. See Note 4 to our consolidated financial statements in Part I, Item 1. Financial Statements of this Quarterly Report on Form 10-Q for additional information regarding the Panion Amended License Agreement. Even though we entered into the Panion Amended License Agreement, there are no assurances that Panion will not allege other breaches of the Panion Amended License Agreement or otherwise attempt to terminate the Panion Amended License Agreement in the future. In addition, if Panion breaches its agreement with the inventor from whom it licenses rights to Auryxia, Panion could lose its license, which could impair or delay our ability to develop and commercialize Auryxia.\nFrom time to time, we may have disagreements with Panion, or Panion may have disagreements with the inventor from whom it licenses rights to Auryxia, regarding the terms of the agreements or ownership of proprietary rights, which could impact the commercialization of Auryxia, could require or result in litigation or arbitration, which would be time-consuming and expensive, could lead to the termination of the Panion Amended License Agreement, or force us to negotiate a revised or new license agreement on terms less favorable than the original. In addition, in the event that the owners and/or licensors of the rights we license were to enter into bankruptcy or similar proceedings, we could potentially lose our rights to Auryxia or our rights could otherwise be adversely affected, which could prevent us from continuing to commercialize Auryxia.\nRisks Related to our Intellectual Property\nIf we are unable to adequately protect our intellectual property, third parties may be able to use our intellectual property, which could adversely affect our ability to compete in the market.\nOur commercial success will depend in part on our ability, and the ability of our licensors, to obtain and maintain patent protection on our drug product and technologies, and to successfully defend these patents against third party challenges. We seek to protect our proprietary products and technology by filing patent applications in the United States and certain foreign jurisdictions. The process for obtaining patent protection is expensive and time consuming, and we may not be able to file and prosecute all necessary or desirable patent applications in a cost effective or timely manner. In addition, we may fail to identify patentable subject matter early enough to obtain patent protection. Further, license agreements with third parties may not allow us to control the preparation, filing and prosecution of patent applications, or the maintenance or enforcement of patents. Such third parties may decide not to enforce such patents or enforce such patents without our involvement. Thus, these patent applications and patents may not, under these circumstances, be prosecuted or enforced in a manner consistent with the best interests of the company.\nOur pending patent applications may not issue as patents and may not issue in all countries in which we develop, manufacture or potentially sell our product or in countries where others develop, manufacture and potentially sell products using our technologies. Moreover, our pending patent applications, if issued as patents, may not provide additional protection for our product.\nThe patent positions of pharmaceutical and biotechnology companies can be highly uncertain and involve complex legal and factual questions. No consistent policy regarding the breadth of claims allowed in pharmaceutical and biotechnology patents has emerged to date. Changes in the patent laws or the interpretation of the patent laws in the United States and other jurisdictions may diminish the value of our patents or narrow the scope of our patent protection. Accordingly, the patents we own or license may not be sufficiently broad to prevent others from practicing our technologies or from developing competing products. Furthermore, others may independently develop similar or alternative drug products or technologies or design around our patented drug product and technologies which may have an adverse effect on our business. If our competitors prepare and file patent applications in the United States that claim technology also claimed by us, we may have to participate in interference or derivation proceedings in front of the U.S. Patent and Trademark Office, or USPTO, to determine priority of invention, which could result in substantial cost, even if the eventual outcome is favorable to us. Because of the extensive time required for development, testing and regulatory review of a potential product, it is possible that any related patent may expire prior to, or\n90\nremain in existence for only a short period following, commercialization, which may significantly diminish our ability to exclude others from commercializing products that are similar or identical to ours. The patents we own or license may be challenged or invalidated or may fail to provide us with any competitive advantage. Since we have licensed or sublicensed many patents from third parties, we may not be able to enforce such licensed patents against third party infringers without the cooperation of the patent owner and the licensor, which may not be forthcoming. In addition, we may not be successful or timely in obtaining any patents for which we submit applications.\nGenerally, the first to file a patent application is entitled to the patent if all other requirements of patentability are met. However, prior to March 16, 2013, in the United States, the first to invent was entitled to the patent. Since publications of discoveries in the scientific literature often lag behind the actual discoveries, and patent applications in the United States and other jurisdictions are typically not published until 18 months after filing, or in some cases not at all, we cannot know with certainty whether we were the first to make the inventions claimed in our patents or pending patent applications, or that we were the first to file for patent protection of such inventions. Moreover, the laws enacted by the Leahy-Smith America Invents Act of 2011, which reformed certain patent laws in the United States, introduce procedures that permit competitors to challenge our patents in the USPTO after grant, including inter partes review and post grant review. Similar laws exist outside of the United States. The laws of the European Patent Convention, for example, provide for post-grant opposition procedures that permit competitors to challenge, or oppose, our European patents administratively at the European Patent Office.\nWe may become involved in addressing patentability objections based on third party submission of references, or we may become involved in defending our patent rights in oppositions, derivation proceedings, reexamination, inter partes review, post grant review, interference proceedings or other patent office proceedings or litigation, in the United States or elsewhere, challenging our patent rights or the patent rights of others. An adverse result in any such proceeding or litigation could reduce the scope of, or invalidate, our patent rights, allow third parties to commercialize our technology or products and compete directly with us, without payment to us.\nThe issuance of a patent is not conclusive as to its inventorship, scope, validity or enforceability, and our owned and licensed patents may be challenged on such a basis in the courts or patent offices in the United States and abroad. As a result of such challenges, we may lose exclusivity or freedom-to-operate or patent claims may be narrowed, invalidated or held unenforceable, in whole or in part, which could limit our ability to prevent third parties from using or commercializing similar or identical products, or limit the duration of the patent protection for our products.\nPeriodic maintenance fees on any issued patent are due to be paid to the USPTO and foreign patent agencies in several stages over the lifetime of the patent. The USPTO and governmental patent agencies in other jurisdictions also require compliance with a number of procedural, documentary, fee payment (such as annuities) and other similar provisions during the patent application process. While an inadvertent lapse in many cases can be cured by payment of a late fee or by other means in accordance with the applicable rules, there are situations in which non-compliance can result in abandonment or lapse of the patent or patent application, resulting in partial or complete loss of patent rights in the relevant jurisdiction. Non-compliance events that could result in abandonment or lapse of a patent or patent application include, but are not limited to, failure to respond to official actions within prescribed time limits, non-payment of fees, and failure to properly legalize and submit formal documents. In such an event, our competitors might be able to enter the market sooner than we expect, which would have a material adverse effect on our business.\nIn addition, patents protecting our product candidate might expire before or shortly after such candidate is commercialized. Thus, our patent portfolio may not provide sufficient rights to exclude others from commercializing products similar or identical to ours.\nWe also rely on trade secrets and know-how to protect our intellectual property where we believe patent protection is not appropriate or obtainable. Trade secrets are difficult to protect. While we require our employees, licensees, collaborators and consultants to enter into confidentiality agreements, this may not be sufficient to adequately protect our trade secrets or other proprietary information. In addition, in some cases, we share certain ownership and publication rights to data relating to some of our products and product candidates with research collaborators, licensees and other third parties. If we cannot maintain the confidentiality of this information, our ability to receive patent protection or protect our trade secrets or other proprietary information will be at risk.\nWe may not be able to protect our intellectual property rights throughout the world.\nFiling, prosecuting and defending patents on our products and product candidates in all countries throughout the world would be prohibitively expensive. Consequently, the breadth of our intellectual property rights in some countries outside the United States may be less extensive than those in the United States. In addition, the laws of some countries do not protect intellectual property rights to the same extent as laws in the United States. As a result, we may not be able to prevent third parties from practicing our inventions in all countries outside the United States, or from selling or importing products made using our\n91\ninventions in and into the United States or other countries. Competitors may use our technologies in countries where we have not obtained patent protection to develop their own products and, further, may infringe our patents in territories where we have patent protection, but where enforcement is not as strong as in the United States. These products may compete with our products and our patents or other intellectual property rights may not be effective or sufficient to prevent them from competing.\nMany companies have encountered significant problems in protecting and defending intellectual property rights in certain countries. The legal systems of certain countries, particularly certain developing countries, do not favor the enforcement of patents, trade secrets and other intellectual property, particularly those relating to pharmaceutical and biotechnology products, which could make it difficult for us to stop the infringement of our patents or the marketing of competing products in violation of our proprietary rights generally. Proceedings to enforce our patent rights in countries outside of the United States could result in substantial costs and divert our efforts and attention from other aspects of our business, could put our patents at risk of being invalidated or interpreted narrowly and our patent applications at risk of not issuing, and could provoke third parties to assert claims against us. We may not prevail in any lawsuits that we initiate, and the damages or other remedies awarded, if any, may not be commercially meaningful. Accordingly, our efforts to enforce our intellectual property rights around the world may be inadequate to obtain a significant commercial advantage for our products and product candidates from the intellectual property that we develop or license.\nThe intellectual property that we own or have licensed and related non-patent exclusivity relating to our current and future products is, and may be, limited, which could adversely affect our ability to compete in the market and adversely affect the value of Auryxia.\nThe patent rights and related non-patent exclusivity that we own or have licensed relating to Auryxia are limited in ways that may affect our ability to exclude third parties from competing against us. For example, a third party may design around our owned or licensed composition of matter patent claims or market a product for the methods of use not covered by our owned or licensed patents.\nObtaining proof of direct infringement by a competitor for a method of use patent requires us to demonstrate that the competitors make and market a product for the patented use(s). Alternatively, we can prove that our competitors induce or contribute to others in engaging in direct infringement. Proving that a competitor contributes to or induces infringement of a patented method by another has additional proof requirements. For example, proving inducement of infringement requires proof of intent by the competitor. If we are required to defend ourselves against claims or to protect our own proprietary rights against others, it could result in substantial costs to us and the distraction of our management. An adverse ruling in any litigation or administrative proceeding could prevent us from marketing and selling Auryxia, increase the risk that a generic or other similar version of Auryxia could enter the market to compete with Auryxia, limit our development and commercialization of Auryxia, or otherwise harm our competitive position and result in additional significant costs.\nMoreover, physicians may prescribe a competitive identical product for indications other than the one for which the product has been approved, or “off-label” indications, that are covered by the applicable patents. Although such off-label prescriptions may directly infringe or contribute to or induce infringement of method of use patents, such infringement is difficult to prevent.\nIn addition, any limitations of our patent protection described above may adversely affect the value of our drug product and may inhibit our ability to obtain a collaboration partner at terms acceptable to us, if at all.\nIn the United States, the FDA has the authority to grant additional regulatory exclusivity protection for approved drugs where the sponsor conducts specified testing in pediatric or adolescent populations. If granted, this pediatric exclusivity may provide an additional six months which are added to the term of any non-patent exclusivity that has been awarded as well as to the regulatory protection related to the term of a relevant patent, to the extent these protections have not already expired.\nIn addition to pediatric exclusivity protection, we may seek additional non-patent exclusivity for vadadustat and other product candidates under other provisions of the FDCA such as new chemical entity, or NCE, exclusivity, or exclusivity for a new use or new formulation, but there is no guarantee that vadadustat or any other product candidates will receive such exclusivity. The FDCA provides a five-year period of non-patent exclusivity within the United States to the first applicant to gain approval of an NDA for an NCE. A drug is an NCE if the FDA has not previously approved any other new drug containing the same active moiety, which consists of the molecule(s) or ion(s) responsible for the action of the drug substance (but not including those portions of the molecule that cause it to be a salt or ester or which are not bound to the molecule by covalent or similar bonds). During the exclusivity period, the FDA may not accept for review an ANDA or a 505(b)(2) NDA submitted by another company for another version of such drug where the applicant does not own or have a legal right of reference to all the data required for approval. However, an ANDA or 505(b)(2).\nAn ANDA that references an NDA product with NCE exclusivity may be submitted after four years if it contains a certification of patent invalidity or non-infringement. The FDCA also provides three years of exclusivity for an NDA, particularly a\n92\n505(b)(2) NDA or supplement to an existing NDA, if new clinical investigations, other than bioavailability studies, that were conducted or sponsored by the applicant are deemed by the FDA to be essential to the approval of the application (for example, for new indications, dosages, or strengths of an existing drug). This three-year exclusivity covers only the conditions associated with the new clinical investigations and does not prohibit the FDA from approving ANDAs for drugs containing the original active agent. The three-year exclusivity period, unlike five-year exclusivity, does not prevent the submission of a competing ANDA or 505(b)(2) NDA. Instead, it only prevents the FDA from granting final approval to such a product until expiration of the exclusivity period. Five-year and three-year exclusivity will not delay the submission (in the case of five-year exclusivity) or the approval (in the case of three-year exclusivity) of a full NDA submitted under section 505(b)(1) of the FDCA; however, an applicant submitting a full NDA would be required to conduct all of its own studies needed to independently support a finding of safety and effectiveness for the proposed product, or have a full right of reference to all studies not conducted by the applicant.\nWe received Paragraph IV certification notice letters regarding ANDAs submitted to the FDA requesting approval for generic versions of Auryxia tablets (210 mg iron per tablet), with the first received on October 31, 2018. We and Panion & BF Biotech, Inc., or Panion, and, Dr. Hsu, as applicable, filed certain complaints for patent infringement relating to such ANDAs, and have entered into settlement and license agreements with each of the ANDA filers.\nIn cases where NCE exclusivity has been granted to a new drug product, the 30-month stay triggered by such litigation is extended by the amount of time such that seven years and six months will elapse from the date of approval of the NDA for that product. Without NCE exclusivity, the 30-month stay on FDA final approval of an ANDA runs from the date on which the sponsor of the reference listed drug receives notice of a Paragraph IV certification from the ANDA applicant.\nWe cannot assure you that Auryxia, vadadustat, if approved, or any of our potential future products will obtain such pediatric exclusivity, NCE exclusivity or any other market exclusivity in the United States, EU or any other territory, or that we will be the first to receive the respective regulatory approval for such drugs so as to be eligible for any non-patent exclusivity protection. We also cannot assure you that Auryxia, vadadustat, if approved, or any of our potential future products will obtain patent term extension.\nThe market entry of one or more generic competitors or any third party’s attempt to challenge our intellectual property rights will likely limit Auryxia sales and have an adverse impact on our business and results of operation.\nAlthough the composition and use of Auryxia is currently claimed by 15 issued patents that are listed in the FDA’s Orange Book, we cannot assure you that we will be successful in defending against third parties attempting to invalidate or design around our patents or assert that our patents are invalid or otherwise unenforceable or not infringed, or in competing against third parties introducing generic equivalents of Auryxia or any of our potential future products. If our Orange Book-listed patents are successfully challenged by a third party and a generic version of Auryxia is approved and launched, revenue from Auryxia could decline significantly, which would have a material adverse effect on our sales, results of operations and financial condition.\nWe previously received Paragraph IV certification notice letters regarding ANDAs submitted to the FDA requesting approval for generic versions of Auryxia tablets (210 mg ferric iron per tablet). We filed complaints for patent infringement relating to such ANDAs, and subsequently entered into settlement and license agreements with all such ANDA filers that allow such ANDA filers to market a generic version of Auryxia in the United States beginning on March 20, 2025. It is possible that we may receive Paragraph IV certification notice letters from additional ANDA filers and may not ultimately be successful in an ANDA litigation. Generic competition for Auryxia or any of our potential future products could have a material adverse effect on our sales, results of operations and financial condition.\nLitigation, including third party claims of intellectual property infringement, may be costly and time consuming and may delay or harm our drug discovery, development and commercialization efforts.\nWe may be forced to initiate litigation to enforce our contractual and intellectual property rights, or we may be sued by third parties asserting claims based on contract, tort or intellectual property infringement. In addition, third parties may have or may obtain patents in the future and claim that our products or other technologies infringe their patents. If we are required to defend against suits brought by third parties, or if we sue third parties to protect our rights, we may be required to pay substantial litigation costs, and our management’s attention may be diverted from operating our business. In addition, any legal action against our licensor, licensees or us that seeks damages or an injunction of commercial activities relating to Auryxia, vadadustat or any other product candidates or other technologies, including those that may be in-licensed or acquired, could subject us to monetary liability, a temporary or permanent injunction preventing the development, marketing and sale of such products or such technologies, and/or require our licensor, licensees or us to obtain a license to continue to use such products or other technologies. We cannot predict whether our licensor, licensees or we would prevail in any of these types of actions or that any required license would be made available on commercially acceptable terms, if at all.\n93\nOur commercial success depends in part on our avoiding infringement of the patents and proprietary rights of third parties. The pharmaceutical and biotechnology industries are characterized by extensive litigation over patent and other intellectual property rights. We have in the past and may in the future become a party to, or be threatened with, future adversarial litigation or other proceedings regarding intellectual property rights with respect to our product and product candidates. As the pharmaceutical and biotechnology industries expand and more patents are issued, the risk increases that our drug candidates may give rise to claims of infringement of the patent rights of others.\nWhile our product candidates are in preclinical studies and clinical trials, we believe that the use of our product candidates in these preclinical studies and clinical trials in the United States falls within the scope of the exemptions provided by 35 U.S.C. Section 271(e), which provides that it shall not be an act of infringement to make, use, offer to sell, or sell within the United States or import into the United States a patented invention solely for uses reasonably related to the development and submission of information to the FDA. There is an increased possibility of a patent infringement claim against us with respect to commercial products. Our portfolio includes one commercial product, Auryxia. We received the CRL from the FDA regarding our NDA for vadadustat in March 2022, and, if in the future vadadustat is approved, vadadustat could be commercialized. We attempt to ensure that our products and product candidates and the methods we employ to manufacture them, as well as the methods for their use which we intend to promote, do not infringe other parties’ patents and other proprietary rights. There can be no assurance they do not, however, and competitors or other parties may assert that we infringe their proprietary rights in any event.\nFibroGen has filed patent applications in the United States and other countries directed to purportedly new methods of using previously known heterocyclic carboxamide compounds for purposes of treating or affecting specified conditions, and some of these applications have since issued as patents. To the extent any such patents issue or have been issued, we may initiate opposition or other legal proceedings with respect to such patents. We discuss the status of the opposition and/or invalidation proceedings against certain FibroGen patents in Part II, Item 1. Legal Proceedings of this Quarterly Report on Form 10-Q.\nThere may be patents of third parties of which we are currently unaware with claims to compounds, materials, formulations, methods of manufacture or methods for treatment related to the use or manufacture of our product candidates. Also, because patent applications can take many years to issue, there may be currently pending patent applications which may later result in issued patents that our product candidates may infringe.\nThird parties, including FibroGen, may in the future claim that our product and product candidates and other technologies infringe upon their patents and may challenge our ability to commercialize Auryxia and vadadustat, if approved. Parties making claims against us or our licensees may seek and obtain injunctive or other equitable relief, which could effectively block our or their ability to continue to commercialize Auryxia or further develop and commercialize vadadustat or any other product candidates, including those that may be in-licensed or acquired. If any third party patents were held by a court of competent jurisdiction to cover the manufacturing process of any of our products or product candidates, any molecules formed during the manufacturing process or any final product itself, the holders of any such patents may be able to block our ability to commercialize such product or product candidate unless we obtained a license under the applicable patents, or until such patents expire or they are finally determined to be held invalid or unenforceable. Similarly, if any third party patent were held by a court of competent jurisdiction to cover aspects of our formulations, processes for manufacture or our intended methods of use, the holders of any such patent may be able to block or impair our ability to develop and commercialize the applicable product candidate unless we obtained a license or until such patent expires or is finally determined to be held invalid or unenforceable. We may also elect to enter into a license in order to settle litigation or in order to resolve disputes prior to litigation. Furthermore, even in the absence of litigation, we may need to obtain licenses from third parties to advance our research or allow commercialization of our products or product candidates. Should a license to a third party patent become necessary, we cannot predict whether we would be able to obtain a license or, if a license were available, whether it would be available on commercially reasonable terms. If such a license is necessary and a license under the applicable patent is unavailable on commercially reasonable terms, or at all, our ability to commercialize our product or product candidate may be impaired or delayed, which could in turn significantly harm our business.\nFurther, defense of infringement claims, regardless of their merit, would involve substantial litigation expense and would be a substantial diversion of employee resources from our business. In the event of a successful claim of infringement against us, we may have to pay substantial damages, including treble damages and attorneys’ fees for willful infringement, pay royalties or redesign our products, which may be impossible or require substantial time and monetary expenditure.\nWe are currently involved in an opposition and invalidation proceedings and may in the future be involved in additional lawsuits or administrative proceedings to challenge the patents of our competitors or to protect or enforce our patents, which could be expensive, time consuming, and unsuccessful.\n94\nCompetitors may infringe our patents or misappropriate our trade secrets or confidential information. To counter infringement or unauthorized use, we may be required to file infringement or misappropriation claims, which can be expensive and time-consuming. We may not be able to prevent infringement of our patents or misappropriation of our trade secrets or confidential information, particularly in countries where the laws may not protect those rights as fully as in the United States. In addition, in an infringement proceeding, a court may decide that a patent of ours is not valid or is unenforceable, or may refuse to stop the other party from using the technology at issue on the grounds that our patents do not cover the technology in question. An adverse result in any litigation or defense proceedings could put one or more of our patents at risk of being invalidated, held unenforceable, or interpreted narrowly and held not infringed and could put our patent applications at risk of not issuing.\nIn addition, there may be a challenge or dispute regarding inventorship or ownership of patents or applications currently identified as being owned by or licensed to us. Defense of these claims, regardless of their merit, would involve substantial litigation expense and would be a substantial diversion of employee resources from our business. Interference proceedings provoked by third parties or brought by the USPTO may be necessary to determine the priority of inventions with respect to our patents or patent applications.\nVarious administrative proceedings are also available for challenging patents, including interference, reexamination, inter partes review, and post-grant review proceedings before the USPTO or oppositions and other comparable proceedings in foreign jurisdictions. An unfavorable outcome in any current or future proceeding in which we are challenging third party patents could require us to cease using the patented technology or to attempt to license rights to it from the prevailing party. Our business could be harmed if the prevailing party does not offer us a license on commercially reasonable terms or at all. Even if we are successful, participation in interference or other administrative proceedings before the USPTO or a foreign patent office may result in substantial costs and distract our management and other employees.\nWe are currently involved in opposition and invalidation proceedings in the European Patent Office, the Japan Patent Office, and the Patents Court of the UK. These proceedings may be ongoing for a number of years and may involve substantial expense and diversion of employee resources from our business. In addition, we may become involved in additional opposition proceedings or other legal or administrative proceedings in the future. For more information, see the other risk factors under “Risks Related to our Intellectual Property”.\nFurthermore, because of the substantial amount of discovery required in connection with intellectual property litigation and some administrative proceedings, there is a risk that some of our confidential information could be compromised by disclosure during discovery. In addition, there could be public announcements of the results of hearings, motions or other interim proceedings or developments. If securities analysts or investors perceive these results to be negative, it could have a substantial adverse effect on the price of our common stock.\nWe may be subject to claims that our employees, consultants or independent contractors have wrongfully used or disclosed confidential information of third parties.\nWe have received confidential and proprietary information from potential collaborators, prospective licensees and other third parties. In addition, we employ individuals who were previously employed at other biotechnology or pharmaceutical companies. We may be subject to claims that we or our employees, consultants or independent contractors have inadvertently or otherwise used or disclosed confidential information of these third parties or our employees’ former employers. We may also be subject to claims that former employees, collaborators or other third parties have an ownership interest in our patents or other intellectual property. We may be subject to ownership disputes in the future arising, for example, from conflicting obligations of consultants or others who are involved in developing our product candidates. Litigation may be necessary to defend against these claims. If we fail in defending any such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights, such as exclusive ownership of, or right to use, valuable intellectual property. Such an outcome could have a material adverse effect on our business. Even if we are successful in defending against these claims, litigation could result in substantial cost and be a distraction to our management and employees.\nRisks Related to our Business and Managing Growth\nIf we fail to attract, retain and motivate senior management and qualified personnel, we may be unable to successfully develop, obtain and/or maintain marketing approval of and commercialize vadadustat or commercialize Auryxia.\nRecruiting and retaining qualified personnel is critical to our success. We are also highly dependent on our executives, certain members of our senior management and certain members of our commercial organization. The loss of the services of our executives, senior managers or other employees could impede the achievement of our research, development, regulatory and commercialization objectives and seriously harm our ability to successfully implement our business strategy. Specifically, following receipt of the CRL, in April and May 2022, we implemented a reduction of our workforce by approximately 42% across all areas of our company (47% inclusive of the closing of the majority of open positions), including several members of\n95\nmanagement. Losing members of management and other key personnel subjects us to a number of risks, including the failure to coordinate responsibilities and tasks, the necessity to create new management systems and processes, the impact on corporate culture, and the retention of historical knowledge.\nFurthermore, replacing executives, senior managers and other key employees may be difficult and may take an extended period of time because of the limited number of individuals in our industry with the breadth of skills and experience required to successfully develop, obtain and/or maintain marketing approval of and commercialize Auryxia, vadadustat and other product candidates. Our future financial performance and our ability to develop, obtain and/or maintain marketing approval of and commercialize Auryxia and vadadustat and to compete effectively will depend, in part, on our ability to manage any future growth effectively. To that end, we must be able to hire, train, integrate, and retain additional qualified personnel with sufficient experience. We may be unable to hire, train, retain or motivate these personnel on acceptable terms given the intense competition among numerous biopharmaceutical companies for similar personnel, particularly in our geographic region.\nWe also experience competition for the hiring of personnel from universities and research institutions. In addition, we rely on contractors, consultants and advisors, including scientific and clinical advisors, to assist us in formulating and executing our research and development and commercialization strategy. Our contractors, consultants and advisors may become employed by companies other than ours and may have commitments with other entities that may limit their availability to us. If additional members of management or other personnel leave, or we are unable to continue to attract and retain high quality personnel, our ability to grow and pursue our business strategy will be limited.\nOur cost savings plan and the associated workforce reduction implemented in April and May 2022 may not result in anticipated savings, could result in total costs and expenses that are greater than expected and could disrupt our business.\nFollowing receipt of the CRL, in April and May 2022, we implemented a reduction in workforce by approximately 42% across all areas of our company (47% inclusive of the closing of the majority of open positions), including several members of management. The reduction in workforce reflects our determination to refocus our strategic priorities around our commercial product, Auryxia, and our development portfolio, and was the first step in a cost savings plan to significantly reduce our expense profile in line with being a single commercial product company. We may not realize, in full or in part, the anticipated benefits, savings and improvements in our cost structure from our restructuring efforts due to unforeseen difficulties, delays or unexpected costs. We recorded a restructuring charge of approximately $14.7 million in the aggregate primarily related to contractual termination benefits including severance, non-cash stock-based compensation expense, healthcare and related benefits in the nine months ended September 30, 2022. If we are unable to realize the expected operational efficiencies and cost savings from the restructuring, our operating results and financial condition would be adversely affected. We also cannot guarantee that we will not have to undertake additional workforce reductions or restructuring activities in the future. Furthermore, our cost savings plan may be disruptive to our operations, including our commercialization of Auryxia, which could affect our ability to generate product revenue. In addition, our workforce reductions could yield unanticipated consequences, such as attrition beyond planned staff reductions, or disruptions in our day-to-day operations. Our workforce reduction could also harm our ability to attract and retain qualified management, scientific, clinical, manufacturing and sales and marketing personnel who are critical to our business. Any failure to attract or retain qualified personnel could prevent us from successfully commercializing Auryxia and from successfully developing and commercializing our product candidates in the future, including vadadustat, if approved. If we are ultimately successful in obtaining approval of vadadustat in the United States, we will need to hire additional employees to support the commercialization of vadadustat in the United States, and if we are unsuccessful or delayed in doing so, the potential launch of vadadustat could be delayed.\nWe may encounter difficulties in managing our growth, including with respect to our employee base, and managing our operations successfully.\nIn our day-to-day operations, we may encounter difficulties in managing the size of our operations as well as challenges associated with managing our business. We have strategic collaborations for the commercialization of Riona and the development and commercialization of vadadustat, which is now being marketed under the trade name VafseoTM by our collaboration partner, MTPC, in Japan. Additionally, in the United States, we have a strategic relationship with Vifor Pharma related to the commercialization of vadadustat, if approved. As our operations continue, we expect that we will need to manage our current relationships and enter into new relationships, especially in light of the termination of our collaboration agreements with Otsuka, with various strategic collaborators, consultants, vendors, suppliers and other third parties. These relationships are complex and create numerous risks as we deal with issues that arise.\nOur future financial performance and our ability to commercialize Auryxia and vadadustat, if and where approved, and to compete effectively will depend, in part, on our ability to manage any future growth effectively. This future growth will impose significant added responsibilities on the business and members of management. To manage our recent and any future growth, we must continue to implement and improve our managerial, operational and financial systems, procedures and processes. We may not be able to implement these improvements in an efficient or timely manner and may discover deficiencies in existing\n96\nsystems, procedures and processes. Moreover, the systems, procedures and processes currently in place or to be implemented may not be adequate for any such growth. Any expansion of our operations may lead to significant costs and may divert our management and business development resources. Any inability to manage growth could delay the execution of our business plans or disrupt our operations. We may not be able to accomplish these tasks, and our failure to accomplish any of them could prevent us from successfully managing and, as applicable, growing our company.\nIn addition, we may need to further adjust the size of our workforce as a result of changes to our expectations for our business, which can result in management being required to divert a disproportionate amount of its attention away from our day-to-day activities and devote a substantial amount of time to managing these growth-related activities and related expenses.\nWe have identified a material weakness in our internal control over financial reporting relating to our inventory process. If we are not able to remediate this material weakness, or if we experience additional material weaknesses or other deficiencies in the future or otherwise fail to maintain an effective system of internal control over financial reporting, we may not be able to accurately report our financial results or prevent fraud.\nEffective internal control over financial reporting is necessary for us to provide reliable financial reports and, together with adequate disclosure controls and procedures, is designed to prevent fraud. Any failure to maintain or implement required new or improved controls, or difficulties encountered in implementation could cause us to fail to meet our reporting obligations. In addition, any testing by us, as and when required, conducted in connection with Section 404 of the Sarbanes-Oxley Act, or Section 404, or any testing by our independent registered public accounting firm, which became required for us as of December 31, 2019, may reveal deficiencies in our internal control over financial reporting that are deemed to be material weaknesses or that may require prospective or retroactive changes to our financial statements or identify other areas for further attention or improvement. As of December 31, 2019, management and our independent registered public accounting firm concluded that our internal control over financial reporting relating to our inventory process was not effective because of a material weakness due to our failure to design and maintain effective controls over the completeness, accuracy and presentation and disclosure of inventory. Despite remediation efforts we undertook during fiscal 2020 and 2021 and continue to make, our management and independent registered public accounting firm concluded that, as of September 30, 2022, our internal control over financial reporting relating to our inventory process was not effective because we did not maintain effective controls related to the review of inventory reconciliations, the validation of the inventory costing, the periodic assessment of excess and obsolete inventory related reserves and verification that the existence of all inventories subject to physical inventory counts were correctly counted. Additionally, as revised and enhanced controls need to be in operation for a sufficient period of time and be tested to ensure that the controls are operating as designed, management has concluded that the material weakness cannot be considered remediated as of September 30, 2022. Although we have initiated remediation measures to address the material weakness, we cannot provide assurance that we will be able to correct this material weakness in a timely manner or that our remediation efforts will be adequate to allow us to conclude that our internal controls will be effective in the future. Even if this material weakness is remediated in the future, our internal control over financial reporting could in the future have additional material weaknesses, deficiencies or conditions that could require correction or remediation.\nWe will need to continue to dedicate internal resources, engage outside consultants and maintain a detailed work plan to assess and document the adequacy of internal control over financial reporting, continue steps to remediate the material weakness relating to our inventory process described above and any future control deficiencies or material weaknesses, and improve control processes as appropriate, validate through testing that controls are functioning as documented and maintain a continuous reporting and improvement process for internal control over financial reporting. If we are not able to correct material weaknesses or deficiencies in internal controls in a timely manner or otherwise comply with the requirements of Section 404 in a timely manner, our ability to record, process, summarize and report financial information accurately and within applicable time periods may be adversely affected and we could be subject to sanctions or investigations by the SEC, the Nasdaq Stock Market or other regulatory authorities as well as stockholder litigation which would require additional financial and management resources and could adversely affect the market price of our common stock. Furthermore, if we cannot provide reliable financial reports or prevent fraud, our business and results of operations could be harmed. Inferior internal controls could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our common stock.\nSecurity breaches and unauthorized use of our information technology systems and information, or the information technology systems or information in the possession of our collaborators and other third parties, could damage the integrity of our clinical trials, impact our regulatory filings, compromise our ability to protect our intellectual property, and subject us to regulatory actions that could result in significant fines or other penalties.\nWe, our collaborators, contractors and other third parties rely significantly upon information technology, and any failure, inadequacy, interruption or security lapse of that technology, including any cybersecurity incidents, could harm our ability to operate our business effectively. In addition, we and our collaborators, contractors and other third parties rely on information technology networks and systems, including the Internet, to process, transmit and store clinical trial data, patient information, and other electronic information, and manage or support a variety of business processes, including operational and financial transactions and records, personal identifying information, payroll data and workforce scheduling information. We purchase\n97\nmost of our information technology from vendors, on whom our systems depend. We rely on commercially available systems, software, tools and monitoring to provide security for the processing, transmission and storage of company and customer information.\nIn the ordinary course of our business, we and our third party contractors maintain personal and other sensitive data on our and their respective networks, including our intellectual property and proprietary or confidential business information relating to our business and that of our clinical trial patients and business partners. In particular, we rely on CROs and other third parties to store and manage information from our clinical trials. We also rely on third parties to manage patient information for Auryxia. The secure maintenance of this sensitive information is critical to our business and reputation.\nCompanies and other entities and individuals have been increasingly subject to a wide variety of security incidents, cyber-attacks and other attempts to gain unauthorized access to systems and information. These threats can come from a variety of sources, ranging in sophistication from individual hackers to state-sponsored attacks. Cyber threats may be broadly targeted, or they may be custom-crafted against our information systems or those of our vendors or third party service providers. A security breach, cyberattack or unauthorized access of our clinical data or other data could damage the integrity of our clinical trials, impact our regulatory filings, cause significant risk to our business, compromise our ability to protect our intellectual property, and subject us to regulatory actions, including under the GDPR and CCPA discussed elsewhere in these risk factors and the privacy or security rules under federal, state, or other local laws outside of the United States protecting confidential or personal information, that could be expensive to defend and could result in significant fines or other penalties. Cyberattacks can include malware, computer viruses, hacking or other unauthorized access or other significant compromise of our computer, communications and related systems. Although we take steps to manage and avoid these risks and to be prepared to respond to attacks, our preventive and any remedial actions may not be successful and no such measures can eliminate the possibility of the systems’ improper functioning or the improper access or disclosure of confidential or personally identifiable information such as in the event of cyberattacks. Security breaches, whether through physical or electronic break-ins, computer viruses, ransomware, impersonation of authorized users, attacks by hackers or other means, can create system disruptions or shutdowns or the unauthorized disclosure of confidential information.\nAlthough we believe our collaborators, vendors and service providers, such as our CROs, take steps to manage and avoid information security risks and respond to attacks, we may be adversely affected by attacks against our collaborators, vendors or service providers, and we may not have adequate contractual remedies against such collaborators, vendors and service providers to remedy any harm to our business caused by such event. Additionally, outside parties may attempt to fraudulently induce employees, collaborators, or other contractors to disclose sensitive information or take other actions, including making fraudulent payments or downloading malware, by using “spoofing” and “phishing” emails or other types of attacks. Our employees may be targeted by such fraudulent activities. Outside parties may also subject us to distributed denial of services attacks or introduce viruses or other malware through “trojan horse” programs to our users’ computers in order to gain access to our systems and the data stored therein. In the recent past, cyber-attacks have become more prevalent and much harder to detect and defend against and, because the techniques used to obtain unauthorized access, disable or degrade service, or sabotage systems change frequently and continuously become more sophisticated, often are not recognized until launched against a target and may be difficult to detect for a long time, we may be unable to anticipate these techniques or to implement adequate preventive or detective measures, and we might not immediately detect such incidents and the damage caused by such incidents.\nSuch attacks, whether successful or unsuccessful, or other compromises with respect to our information security and the measures we implement to prevent, detect and respond to them, could:\n•result in our incurring significant costs related to, for example, rebuilding internal systems, defending against litigation, responding to regulatory inquiries or actions, paying damages or fines, or taking other remedial steps with respect to third parties;\n•lead to public exposure of personal information of participants in our clinical trials, Auryxia patients and others;\n•damage the integrity of our studies or delay their completion, disrupt our development programs, our business operations and commercialization efforts;\n•compromise our ability to protect our trade secrets and proprietary information;\n•damage our reputation and deter business partners from working with us; or\n•divert the attention of our management and key information technology resources.\nAny failure to maintain proper functionality and security of our internal computer and information systems could result in a loss of, or damage to, our data or marketing applications or inappropriate disclosure of confidential or proprietary information, interrupt our operations, damage our reputation, subject us to liability claims or regulatory penalties, under a variety of federal, state or other applicable privacy laws, such as HIPAA, the GDPR, or state data protection laws including the CCPA, harm our\n98\ncompetitive position and delay the further development and commercialization of our products and product candidates, or impact our relationships with customers and patients.\nOur employees, independent contractors, principal investigators, CROs, CMOs, consultants and vendors may engage in misconduct or other improper activities, including non-compliance with regulatory standards and requirements and insider trading.\nWe are exposed to the risk that our employees, independent contractors, principal investigators, CROs, CMOs, consultants and vendors may engage in fraudulent conduct or other illegal activity. Misconduct by these parties could include intentional, reckless and/or negligent conduct or unauthorized activities that violate applicable laws, including the following:\n•FDA and other healthcare authorities’ regulations, including those laws that require the reporting of true, complete and accurate information to regulatory authorities, and those prohibiting the promotion of unapproved drugs or approved drugs for an unapproved use;\n•quality standards, including GXP;\n•federal and state healthcare fraud and abuse laws and regulations and their non-U.S. equivalents;\n•anti-bribery and anti-corruption laws, such as the FCPA and the UK Bribery Act or country-specific anti-bribery or anti-corruption laws, as well as various import and export laws and regulations;\n•laws that require the reporting of true and accurate financial information and data; and\n•U.S. state and federal securities laws and regulations and their non-U.S. equivalents, including those related to insider trading.\nWe conducted our global clinical trials for vadadustat, and may in the future conduct additional trials, in countries where corruption is prevalent, and violations of any of these laws by our personnel or by any of our vendors or agents, such as our CROs or CMOs, could have a material adverse impact on our clinical trials and our business and could result in criminal or civil fines and sanctions. We are subject to complex laws that govern our international business practices. These laws include the FCPA, which prohibits U.S. companies and their intermediaries, such as CROs or CMOs, from making improper payments to foreign government officials for the purpose of obtaining or keeping business or obtaining any kind of advantage for the company. The FCPA also requires companies to keep accurate books and records and maintain adequate accounting controls. A number of past and recent FCPA investigations by the Department of Justice and the SEC have focused on the life sciences sector.\nCompliance with the FCPA is expensive and difficult, particularly in countries in which corruption is a recognized problem. Some of the countries in which we have conducted clinical trials and in which we have CMOs have a history of corruption, which increases our risks of FCPA violations. In addition, the FCPA presents unique challenges in the pharmaceutical industry because in many countries’ hospitals are operated by the government, and doctors and other hospital employees are considered foreign government officials. Certain payments made by pharmaceutical companies, or on their behalf by CROs, to hospitals in connection with clinical trials and other work have been deemed to be improper payments to government officials and have led to FCPA enforcement actions.\nAdditionally, the UK Bribery Act applies to our global activities and prohibits bribery of private individuals as well as public officials. The UK Bribery Act prohibits both the offering and accepting of a bribe and imposes strict liability on companies for failing to prevent bribery, unless the company can show that it had “adequate procedures” in place to prevent bribery. There are also local anti-bribery and anti-corruption laws in countries where we have conducted clinical trials, and many of these also carry the risk of significant financial or criminal penalties.\nWe are also subject to trade control regulations and trade sanctions laws that restrict the movement of certain goods, currency, products, materials, services and technology to, and certain operations in, various countries or with certain persons. Our ability to transfer commercial and clinical product and other clinical trial supplies, and for our employees, independent contractors, principal investigators, CROs, CMOs, consultants and vendors ability to travel, between certain countries is subject to maintaining required licenses and complying with these laws and regulations.\nEmployee misconduct could also involve the improper use of information obtained in the course of clinical trials, which could result in regulatory sanctions and serious harm to our reputation. This could include violations of HIPAA, other U.S. federal and state laws, and requirements of non-U.S. jurisdictions, including the GDPR. We are also exposed to risks in connection with any insider trading violations by employees or others affiliated with us.\nThe internal controls, policies and procedures, and training and compliance programs we have implemented to deter prohibited practices may not be effective in preventing our employees, contractors, consultants, agents or other representatives from\n99\nviolating or circumventing such internal policies or violating applicable laws and regulations. The failure to comply with laws governing international business practices may impact any future clinical trials, result in substantial civil or criminal penalties for us and any such individuals, including imprisonment, suspension or debarment from government contracting, withdrawal of our products, if approved, from the market, or being delisted from The Nasdaq Global Market. In addition, we may incur significant costs in implementing sufficient systems, controls and processes to ensure compliance with the aforementioned laws. The laws and regulations referenced above may restrict or prohibit a wide range of pricing, discounting, marketing and promotion, sales commission, customer incentive programs and other business arrangements that could adversely affect our business.\nAdditionally, it is not always possible to identify and deter misconduct by employees and third parties, and the precautions we take to detect and prevent this activity may not be effective in controlling known or unknown risks or preventing losses or in protecting us from governmental investigations or other actions or lawsuits stemming from a failure to be in compliance with such laws or regulations. If any such actions are instituted against us, and we are not successful in defending ourselves or asserting our rights, or if any such action is instituted against our employees, consultants, independent contractors, CROs, CMOs, vendors or principal investigators, those actions could have a significant impact on our business, including the imposition of civil, criminal and administrative penalties, damages, monetary fines, possible exclusion from participation in Medicare, Medicaid and other federal healthcare programs, contractual damages, reputational harm, diminished profits and future earnings, curtailment of our operations, disclosure of our confidential information and imprisonment, any of which could adversely affect our ability to operate our business and our results of operations.\nIf any of our service providers are later legally deemed to be employees, we could be subject to employment and tax withholding liabilities and other additional costs as well as other multiple damages and attorneys’ fees.\nWe rely on independent third parties to provide certain services to us. We structure our relationships with these outside service providers in a manner that we believe results in an independent contractor relationship, not an employee relationship. An independent contractor is generally distinguished from an employee by his or her degree of autonomy and independence in providing services. A high degree of autonomy and independence is generally indicative of an independent contractor relationship, while a high degree of control is generally indicative of an employment relationship. Tax or other regulatory authorities may challenge our characterization of services providers as independent contractors both under existing laws and regulations and under laws and regulations adopted in the future. If such regulatory authorities or state, federal or foreign courts were to determine that our service providers are employees and not independent contractors, we would, among other things, be required to withhold income taxes, to withhold and pay Social Security, Medicare and similar taxes, to pay unemployment and other related payroll taxes, and to provide certain employee benefits. We could also be liable for unpaid past taxes, interest and other costs and subject to penalties. Likewise, our service providers themselves may later challenge their classification as independent contractors, which may result in additional damages, including back wages, penalties, interest and attorneys’ fees. As a result, any legally binding determination that the service providers we characterize as independent contractors are actually our employees could have a material adverse effect on our business, financial condition and results of operations.\nOur financial statements include goodwill and an intangible asset as a result of the Merger. The intangible asset has become impaired and could become further impaired in the future under certain conditions. In addition, goodwill could become impaired in the future under certain conditions. Any potential future impairment of goodwill or intangible assets may significantly impact our results of operations and financial condition.\nAs of September 30, 2022, we had approximately $136.1 million in the aggregate of goodwill and a definite lived intangible asset from the Merger. In accordance with generally accepted accounting principles, or GAAP, we are required annually, or more frequently upon certain indicators of impairment, to review our estimates and assumptions underlying the fair value of our goodwill and our definite lived intangible assets when indicators of impairment are present. Events giving rise to impairment of goodwill or intangible assets are an inherent risk in the pharmaceutical industry and often cannot be predicted.\nConditions that could indicate impairment and necessitate such a review include, but are not limited to, Auryxia’s commercial performance, our inability to execute on our strategic initiatives, the deterioration of our market capitalization such that it is significantly below our net book value, a significant adverse change in legal factors, unexpected adverse business conditions, and an adverse action or assessment by a regulator. To the extent we conclude that goodwill and/or definite lived intangible assets have become impaired, we may be required to incur material write-offs relating to such impairment and any such write-offs could have a material impact on our future operating results and financial position. For example, in the second quarter of 2020, in connection with a routine business review, we reduced our short-term and long-term Auryxia revenue forecast. This reduction was primarily driven by the impact of the September 2018 CMS decision that Auryxia would no longer be covered by Medicare for the treatment of the IDA Indication. While this decision does not impact CMS coverage for the use of Auryxia for the control of serum phosphorus levels in adult patients with CKD on dialysis, or the Hyperphosphatemia Indication, it requires all Auryxia prescriptions for Medicare patients to undergo a prior authorization to ensure their use of Auryxia for the Hyperphosphatemia Indication. As a result, we recorded an impairment charge of $115.5 million during the three months ended\n100\nJune 30, 2020, which was entirely allocated to our only intangible asset, the developed product rights for Auryxia, and made a corresponding adjustment to the estimated useful life of the developed product rights for Auryxia, which we again adjusted during the three months ended December 31, 2020. The estimates, judgments and assumptions used in our impairment testing, and the results of our testing, are discussed in Note 9 to our consolidated financial statements in Part I, Item 1. Financial Statements of this Quarterly Report on Form 10-Q. If these estimates, judgments and assumptions change in the future, including if the Auryxia asset group does not meet its current forecasted projections, additional impairment charges related to goodwill or our intangible asset could be recorded in the future and additional corresponding adjustments may need to be made to the estimated useful life of the developed product rights for Auryxia, which could materially impact our financial position, certain of our material agreements, and our future operating results.\nIf product liability lawsuits are brought against us, we may incur substantial liabilities and may be required to limit commercialization of Auryxia or vadadustat, if approved.\nWe face an inherent risk of product liability as a result of the clinical and commercial use of Auryxia and vadadustat. For example, we may be sued if Auryxia or vadadustat allegedly causes injury or is found to be otherwise unsuitable during clinical trials, manufacturing, marketing or sale. Any such product liability claims may include allegations of defects in manufacturing, defects in design, a failure to warn of dangers inherent in the product or product candidate, negligence, strict liability and breach of warranties. Claims could also be asserted under state consumer protection acts. If we cannot successfully defend ourselves against product liability claims, we may incur substantial liabilities or be required to limit commercialization of Auryxia or vadadustat, if approved. Even a successful defense would require significant financial and management resources. Regardless of the merits or eventual outcome, product liability claims may result in:\n•decreased demand for Auryxia or vadadustat, if approved;\n•injury to our reputation and significant negative media attention;\n•withdrawal of clinical trial participants;\n•delay or termination of clinical trials;\n•our inability to continue to develop Auryxia or vadadustat;\n•significant costs to defend the related litigation;\n•a diversion of management’s time and our resources;\n•substantial monetary awards to study subjects or patients;\n•product recalls or withdrawals, or labeling, marketing or promotional restrictions;\n•decreased demand for Auryxia or vadadustat, if approved;\n•loss of revenue;\n•the inability to commercialize Auryxia or vadadustat, if approved; and\n•a decline in our stock price.\nFailure to obtain and retain sufficient product liability insurance at an acceptable cost to protect against potential product liability claims could prevent or inhibit the commercialization of products we develop. We currently carry product liability insurance that we believe is appropriate for our company. Although we maintain product liability insurance, any claim that may be brought against us could result in a court judgment or settlement in an amount that is not covered, in whole or in part, by our insurance or that is in excess of the limits of our insurance coverage. Our insurance policies also have various exclusions, and we may be subject to a product liability claim for which we have insufficient or no coverage. If we have to pay any amounts awarded by a court or negotiated in a settlement that exceed our coverage limitations or that are not covered by our insurance, we may not have, or be able to obtain, sufficient capital to pay such amounts. In addition, insurance coverage is becoming increasingly expensive, and we may not be able to maintain insurance coverage at a reasonable cost. We also may not be able to obtain additional insurance coverage that will be adequate to cover additional product liability risks that may arise. Consequently, a product liability claim may result in losses that could be material to our business.\nWe will continue to incur increased costs as a result of operating as a public company, and our management will be required to devote substantial time to compliance initiatives and corporate governance practices.\nAs a public company, we operate in a demanding regulatory environment, and we have and will continue to incur significant legal, accounting and other expenses. The Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act, the Dodd-Frank Wall Street Reform and Consumer Protection Act, the listing requirements of The Nasdaq Global Market and other applicable securities rules and regulations impose various requirements on public companies, including establishment and maintenance of effective disclosure and financial controls and certain corporate governance practices. In particular, our compliance with Section 404 of the Sarbanes-Oxley Act has required and will continue to require that we incur substantial accounting-related expenses and expend significant management efforts. Our testing, or the testing by our independent registered public accounting firm, may reveal deficiencies in our internal controls that we would be required to remediate in a timely manner. If we are not able to\n101\ncomply with the requirements of the Sarbanes-Oxley Act, we could be subject to sanctions or investigations by the SEC, the Nasdaq Global Market or other regulatory authorities, which would require additional financial and management resources and could adversely affect the market price of our securities. Furthermore, if we cannot provide reliable financial reports or prevent fraud, including as a result of remote working by our employees which has increased since the beginning of the COVID-19 pandemic, our business and results of operations would likely be materially and adversely affected.\nWe cannot predict or estimate the amount of additional costs we may incur to continue to operate as a public company, nor can we predict the timing of such costs. These rules and regulations are often subject to varying interpretations, in many cases due to their lack of specificity and, as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices.\nClaims for indemnification by our directors and officers may reduce our available funds to satisfy successful third-party claims against us and may reduce the amount of money available to us.\nOur Ninth Amended and Restated Certificate of Incorporation, as amended, or Charter, and our Amended and Restated By-Laws, or Bylaws, as amended to date, contain provisions that eliminate, to the maximum extent permitted by the General Corporation Law of the State of Delaware, or DGCL, the personal liability of our directors and executive officers for monetary damages for breach of their fiduciary duties as a director or officer. Our Charter and our Bylaws also provide that we will indemnify our directors and executive officers and may indemnify our employees and other agents to the fullest extent permitted by the DGCL.\nIn addition, as permitted by Section 145 of the DGCL our Bylaws and our indemnification agreements that we have entered into with our directors and executive officers provide that:\n•We will indemnify our directors and officers, as defined in our Bylaws, for serving us in those capacities or for serving other related business enterprises at our request, to the fullest extent permitted by Delaware law. Delaware law provides that a corporation may indemnify such person if such person acted in good faith and in a manner such person reasonably believed to be in or not opposed to the best interests of Akebia and, with respect to any criminal proceeding, had no reasonable cause to believe such person’s conduct was unlawful.\n•We may, in our discretion, indemnify employees and agents in those circumstances where indemnification is permitted by applicable law.\n•We are required to advance expenses, as incurred, to our directors and officers in connection with defending a proceeding, except that such directors or officers shall undertake to repay such advances if it is ultimately determined that such person is not entitled to indemnification.\n•The rights conferred in our Bylaws are not exclusive, and we are authorized to enter into indemnification agreements with our directors, officers, employees and agents and to obtain insurance to indemnify such persons.\nAny claims for indemnification made by our directors or officers could impact our cash resources and our ability to fund the business.\nOur ability to use net operating losses to offset future taxable income may be subject to certain limitations.\nUnder Section 382 of the Internal Revenue Code, or Section 382, a corporation that undergoes an “ownership change” is subject to limitations on its ability to utilize its pre-change net operating losses, or NOLs, to offset future taxable income. On December 12, 2018, we completed the Merger, which we believe has resulted in an ownership change under Section 382. In addition, the Tax Cuts and Jobs Act, including amendments made by the CARES Act, includes changes to U.S. federal tax rates and the rules governing net operating loss carryforwards that may significantly impact our ability to utilize our net operating losses to fully offset taxable income in the future. Future changes in our stock ownership, many of which are outside of our control, could result in an additional ownership change under Section 382. As a result, if we generate taxable income, our ability to use our pre-change NOL carryforwards to offset federal taxable income may be subject to limitations, which could potentially result in increased future tax liability to us. At the state level, state net operating losses generated in one state cannot be used to offset income generated in another state and there may be periods during which the use of NOL carryforwards is suspended or otherwise limited, which could accelerate or permanently increase state taxes owed.\nFurthermore, our ability to utilize our NOLs is conditioned upon our attaining profitability and generating U.S. taxable income. As described above under “—Risks Related to our Financial Position, Need for Additional Capital and Growth Strategy,” we have incurred significant net losses since our inception and anticipate that we will continue to incur significant losses for the\n102\nforeseeable future; thus, we do not know whether or when we will generate the U.S. taxable income necessary to utilize our NOLs.\nOur Charter designates the Court of Chancery of the State of Delaware as the sole and exclusive forum for certain types of actions and proceedings that may be initiated by our stockholders, which could limit our stockholders’ ability to obtain a favorable judicial forum for disputes with us or our directors, officers or employees.\nOur Charter provides that, subject to limited exceptions, the Court of Chancery of the State of Delaware will be the sole and exclusive forum for (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of a fiduciary duty owed by any of our directors, officers or other employees to us or our stockholders, (iii) any action asserting a claim against us arising pursuant to any provision of the DGCL our Charter or our Bylaws, or (iv) any other action asserting a claim against us, our directors, officers or other employees that is governed by the internal affairs doctrine. Under our Charter, this exclusive forum provision will not apply to claims that are vested in the exclusive jurisdiction of a court or forum other than the Court of Chancery of the State of Delaware, or for which the Court of Chancery of the State of Delaware does not have subject matter jurisdiction. For instance, the provision would not apply to actions arising under federal securities laws, including suits brought to enforce any liability or duty created by the Exchange Act, or the rules and regulations thereunder. Any person or entity purchasing or otherwise acquiring any interest in shares of our capital stock shall be deemed to have notice of and to have consented to the provisions of our Charter described above. This choice of forum provision may limit a stockholder’s ability to bring a claim in a judicial forum that it finds favorable for disputes with us or our directors, officers or other employees, which may discourage such lawsuits against us and our directors, officers and employees. Alternatively, if a court were to find these provisions of our Charter inapplicable to, or unenforceable with respect to, one or more of the specified types of actions or proceedings, we may incur additional costs associated with resolving such matters in other jurisdictions, which could adversely affect our business and financial condition.\nWe are currently subject to legal proceedings that could result in substantial costs and divert management's attention, and we could be subject to additional legal proceedings.\nWe are currently subject to legal proceedings, including those described in Part II, Item 1 in this Quarterly Report on Form 10-Q, and additional claims may arise in the future. In addition, securities class action and derivative lawsuits and other legal proceedings are often brought against companies for any of the risks described in this Quarterly Report on Form 10-Q following a decline in the market price of their securities. For example, we were party to a putative class action lawsuit in state court filed by purported Keryx stockholders challenging the disclosures made in connection with the Merger, including those that relate to vadadustat’s safety, approvability and commercial viability. Oral argument was held on October 7, 2022, and the Court dismissed the complaint without prejudice on October 17, 2022, giving plaintiffs thirty days to amend their complaint. The Court further ordered that, in the event plaintiffs do not file an amended complaint within thirty days of the dismissal, the dismissal shall be deemed to be with prejudice. In connection with any litigation or other legal proceedings, we could incur substantial costs, and such costs and any related settlements or judgments may not be covered by insurance. Monetary damages or any other adverse judgment would have a material adverse effect on our business and financial position. In addition, if other resolution or actions taken as a result of legal proceedings were to restrain our ability to operate or market our products and services, our consolidated financial position, results of operations or cash flows could be materially adversely affected. We could also suffer an adverse impact on our reputation, negative publicity and a diversion of management’s attention and resources, which could have a material adverse effect on our business.\nRisks Related to our Common Stock\nOur stock price has been and may continue to be volatile, which could result in substantial losses for holders or future purchasers of our common stock and lawsuits against us and our officers and directors.\nOur stock price has been and will likely continue to be volatile. The stock market in general and the market for similarly situated biopharmaceutical companies specifically have experienced extreme volatility that has often been unrelated to the operating performance of particular companies. Since our initial public offering in March 2014, the price of our common stock as reported on The Nasdaq Global Market has ranged from a low of $0.24 on October 24, 2022 to a high of $31.00 on June 20, 2014. The daily closing market price for our common stock varied between a high price of $0.46 on July 6, 2022 and a low price of $0.30 on September 29, 2022 in the three-month period ending on September 30, 2022. During that time, the price of our common stock ranged from an intra-day low of $0.30 per share to an intra-day high of $0.50 per share. From October 1, 2022 through the date of this Quarterly Report on Form 10-Q, the daily closing market price for our common stock has varied between a high price of $0.33 on October 6, 2022 and a low price of $0.25 on October 24, 2022. The market price of shares of our common stock could be subject to wide fluctuations in response to many risk factors listed in this section, including, among others, developments related to and results of our research or clinical trials, developments related to our regulatory submissions and meetings with regulatory authorities, in particular as it relates to vadadustat, commercialization of Auryxia, vadadustat, if and as approved in the U.S. and foreign markets including Europe, and any other product candidates, announcements by us or\n103\nour competitors of significant transactions or strategic collaborations, negative publicity around Auryxia or vadadustat, regulatory or legal developments in the United States and other countries, developments or disputes concerning our intellectual property, the recruitment or departure of key personnel including as a result of our recent reduction in workforce, actual or anticipated changes in estimates as to financial results, changes in the structure of healthcare payment systems, market conditions in the biopharmaceutical sector and other factors beyond our control. As a result of this volatility, our stockholders may not be able to sell their common stock at or above the price at which they purchased it.\nIn addition, companies that have experienced volatility in the market price of their stock have frequently been the subject of securities class action and shareholder derivative litigation. See Part II, Item 1. Legal Proceedings of this Quarterly Report on Form 10-Q for information concerning securities class action initiated against Keryx and certain current and former directors and officers of ours and Keryx’s. In addition, we could be the target of other such litigation in the future. Class action and shareholder derivative lawsuits, whether successful or not, could result in substantial costs, damage or settlement awards and a diversion of our management’s resources and attention from running our business, which could materially harm our reputation, financial condition and results of operations.\nThe issuance of additional shares of our common stock or the sale of shares of our common stock by any of our directors, officers or significant stockholders will dilute our stockholders’ ownership interest in Akebia and may cause the market price of our common stock to decline.\nMost of our outstanding common stock can be traded without restriction at any time. As such, sales of a substantial number of shares of our common stock in the public market could occur at any time. These sales, or the perception in the market that the holders of a large number of shares intend to sell such shares, could reduce the market price of our common stock.\nAs of September 30, 2022 and based on the amounts reported in the most recent filings made under Section 13(d) and 13(g) of the Securities Exchange Act of 1934, as amended, or the Exchange Act, the Vanguard Group, or Vanguard, beneficially owned just under 10.0% of our outstanding shares of common stock, State Street Corporation, or State Street, beneficially owned approximately 6.4% of our outstanding shares of common stock and Vifor Pharma beneficially owned approximately 4.1% of our outstanding shares of common stock. By selling a large number of shares of common stock, Vanguard or State Street could cause the price of our common stock to decline. The shares beneficially owned by Vifor Pharma have not been registered pursuant to the Securities Act and were issued and sold in reliance upon the exemption from registration contained in Section 4(a)(2) of the Securities Act and Rule 506 promulgated thereunder, but if they are registered in the future, those shares would become freely tradable and, if a large portion of such shares are sold, could cause the price of our common stock to decline.\nWe have a significant number of shares that are subject to outstanding options and restricted stock units, and in the future we may issue additional options, restricted stock units, or other derivative securities convertible into our common stock. The exercise or vesting of any such options, restricted stock units, or other derivative securities, and the subsequent sale of the underlying common stock, could cause a further decline in our stock price. These sales also might make it difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate. Such sales of our common stock could result in higher than average trading volume and may cause the market price for our common stock to decline.\nIn addition, we currently have on file with the SEC a shelf registration statement, which allows us to offer and sell up to $300 million in registered securities, such as common stock, preferred stock, debt securities, warrants and units, from time to time pursuant to one or more offerings at prices and terms to be determined at the time of sale, including a sales agreement prospectus that covers the offering, issuance and sale by us of up to a maximum aggregate offering price of up to $26 million of our common stock that may be issued and sold from time to time under a sales agreement with Jefferies LLC.\nSales of substantial amounts of shares of our common stock or other securities by our employees or our other stockholders or by us under our shelf registration statement, pursuant to at-the-market offerings or otherwise, could dilute our stockholders, lower the market price of our common stock and impair our ability to raise capital through the sale of equity securities.\nOur executive officers, directors and principal stockholders maintain the ability to significantly influence all matters submitted to stockholders for approval.\nAs of September 30, 2022, our executive officers, directors and principal stockholders, in the aggregate, beneficially owned shares representing a significant percentage of our capital stock. As a result, if these stockholders were to choose to act together, they would be able to significantly influence all matters submitted to our stockholders for approval, as well as our management and affairs. For example, these persons could significantly influence the election of directors and approval of any merger, consolidation or sale of all or substantially all of our assets. This concentration of voting power could delay or prevent an acquisition of our company on terms that other stockholders may desire.\n104\nProvisions in our organizational documents and Delaware law may have anti-takeover effects that could discourage an acquisition of us by others, even if an acquisition would be beneficial to our stockholders, and may prevent attempts by our stockholders to replace or remove our current management.\nProvisions in our Charter and our Bylaws contain provisions that may have the effect of discouraging, delaying or preventing a change in control of us or changes in our management. These provisions could also limit the price that investors might be willing to pay in the future for shares of our common stock, thereby depressing the market price of our common stock. In addition, because our Board of Directors is responsible for appointing certain members of our management team, these provisions may frustrate or prevent any attempts by our stockholders to replace or remove our current management by making it more difficult for stockholders to replace members of our Board of Directors. Among other things, these provisions:\n•authorize “blank check” preferred stock, which could be issued by our Board of Directors without stockholder approval and may contain voting, liquidation, dividend and other rights superior to our common stock;\n•create a classified Board of Directors whose members serve staggered three-year terms;\n•specify that special meetings of our stockholders can be called only by our Board of Directors pursuant to a resolution adopted by a majority of the total number of directors;\n•prohibit stockholder action by written consent;\n•establish an advance notice procedure for stockholder approvals to be brought before an annual meeting of our stockholders, including proposed nominations of persons for election to our Board of Directors;\n•provide that our directors may be removed only for cause;\n•provide that vacancies on our Board of Directors may be filled only by a majority of directors then in office, even though less than a quorum;\n•require a supermajority vote of 75% of the holders of our capital stock entitled to vote or the majority vote of our Board of Directors to amend our Bylaws; and\n•require a supermajority vote of 85% of the holders of our capital stock entitled to vote to amend the classification of our Board of Directors and to amend certain other provisions of our Charter.\nThese provisions, alone or together, could delay or prevent hostile takeovers, changes in control or changes in our management.\nIn addition, Section 203 of the DGCL prohibits a publicly-held Delaware corporation from engaging in a business combination with an interested stockholder, generally a person which together with its affiliates owns, or within the last three years has owned, 15% of our voting stock, for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner.\nBecause we do not anticipate paying any cash dividends on our capital in the foreseeable future, capital appreciation, if any, will be our stockholders’ sole source of gain.\nWe have never declared or paid cash dividends on our capital stock and we currently intend to retain all of our future earnings, if any, to finance the development and growth of our business. Any payment of cash dividends in the future would be at the discretion of our Board of Directors and would depend on, among other things, our earnings, financial condition, capital requirements, level of indebtedness, statutory and contractual restrictions applying to the payment of dividends and other considerations that the Board of Directors deems relevant. In addition, the terms of the Loan Agreement preclude us from paying cash dividends and future debt agreements may preclude us from paying cash dividends. As a result, capital appreciation, if any, of our common stock will be our stockholders’ sole source of gain for the foreseeable future.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\nSales of Unregistered Securities\nDuring the quarter ended September 30, 2022, we did not have any sales of unregistered securities.\nItem 3. Defaults Upon Senior Securities.\nNot applicable.\nItem 4. Mine Safety Disclosures.\nNot applicable.\n105\nItem 5. Other Information.\nAs previously disclosed, on May 9, 2022, in connection with our workforce reduction, we announced certain management transitions, including that we and Michel Dahan, our Chief Operating Officer, agreed that his employment with us would terminate effective January 23, 2023, except in the event of certain specified events when his employment with us would terminate later, but in no event later than July 1, 2023. On November 2, 2022, we and Mr. Dahan agreed to extend the effective date of his termination to May 5, 2023, and, in the event of certain specified events, the effective date of his termination may extend to October 20, 2023.\n106\nItem 6. Exhibits.\n| Exhibits |\n| 3.1 | Ninth Amended and Restated Certificate of Incorporation (incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K, filed on March 28, 2014). |\n| 3.2 | Certificate of Amendment of Ninth Amended and Restated Certificate of Incorporation of Akebia Therapeutics, Inc. (incorporated by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K, filed on June 9, 2020). |\n| 3.3 | Amended and Restated Bylaws (incorporated by reference to Exhibit 3.2 to the Company’s Current Report on Form 8-K, filed on March 28, 2014). |\n| 10.1# | Second Amendment and Waiver, dated July 15, 2022, by and among the Company, Biopharma Credit plc, BCPR Limited Partnership and Biopharma Credit Investments V (Master) LP (incorporated by reference to Exhibit 10.9 to the Company’s Quarterly Report on Form 10-Q (001-36352), filed on August 4, 2022). |\n| 10.2*# | Form of Amendment to Retention and Separation Agreement for Michel Dahan and Nicole R. Hadas. |\n| 31.1* | Certification of Principal Executive Officer Required Under Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended. |\n| 31.2* | Certification of Principal Financial Officer Required Under Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended. |\n| 32.1* | Certification of Principal Executive Officer and Principal Financial Officer Required Under Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C. 1350. |\n| 101.INS* | Inline XBRL Instance Document (the instance document does not appear in the Interactive Data File because XBRL tags are embedded within the Inline XBRL document) |\n| 101.SCH* | Inline XBRL Taxonomy Extension Schema Document |\n| 101.CAL* | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF* | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB* | Inline XBRL Taxonomy Extension Labels Linkbase Document |\n| 101.PRE* | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104* | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\n\n* Filed, or submitted electronically, herewith\n# Indicates portions of the exhibit (indicated by asterisks) have been omitted pursuant to Item 601(b)(10)(iv) of Regulation S-K\n107\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n| AKEBIA THERAPEUTICS, INC. |\n| Date: November 3, 2022 | By: | /s/ John P. Butler |\n| John P. Butler |\n| President and Chief Executive Officer (Principal Executive Officer) |\n| Date: November 3, 2022 | By: | /s/ David A. Spellman |\n| David A. Spellman |\n| Senior Vice President, Chief Financial Officer and Treasurer (Principal Financial Officer) |\n| Date: November 3, 2022 | By: | /s/ Violetta Cotreau |\n| Violetta Cotreau |\n| Senior Vice President, Chief Accounting Officer (Principal Accounting Officer) |\n\n108\n</text>\n\nIf the Company continues to earn revenue from the MTPC Supply Agreement at the same rate as in the nine months ended September 30, 2022, how many months of operation could the Company fund using solely this revenue, with its cash and cash equivalents as of September 30, 2022?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\n2\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations (Item 2) 3\nOverview 3\nNon-GAAP Financial Measures 8\nRecent Accounting Standards 10\nCritical Accounting Policies 10\nStatements of Income Analysis 11\nBalance Sheet Analysis 22\nBusiness Segment Review 29\nRisk Management—Overview 37\nCredit Risk Management 38\nInterest Rate and Price Risk Management 57\nLiquidity Risk Management 62\nOperational Risk Management 64\nLegal and Regulatory Compliance Risk Management 65\nCapital Management 66\nQuantitative and Qualitative Disclosures about Market Risk (Item 3) 69\nControls and Procedures (Item 4) 69\nCondensed Consolidated Financial Statements and Notes (Item 1) 70\nBalance Sheets (unaudited) 70\nStatements of Income (unaudited) 71\nStatements of Comprehensive Income (unaudited) 72\nStatements of Changes in Equity (unaudited) 73\nStatements of Cash Flows (unaudited) 75\nNotes to Condensed Consolidated Financial Statements (unaudited) 76\nPart II. Other Information\nLegal Proceedings (Item 1) 138\nRisk Factors (Item 1A) 138\nUnregistered Sales of Equity Securities and Use of Proceeds (Item 2) 139\nOther Information (Item 5) 139\nExhibits (Item 6) 140\nSignature 141\nFORWARD-LOOKING STATEMENTS\nThis report contains statements that we believe are “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Rule 175 promulgated thereunder, and Section 21E of the Securities Exchange Act of 1934, as amended, and Rule 3b-6 promulgated thereunder. These statements relate to our financial condition, results of operations, plans, objectives, future performance, capital actions or business. They usually can be identified by the use of forward-looking language such as “will likely result,” “may,” “are expected to,” “is anticipated,” “potential,” “estimate,” “forecast,” “projected,” “intends to,” or may include other similar words or phrases such as “believes,” “plans,” “trend,” “objective,” “continue,” “remain,” or similar expressions, or future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” “can,” or similar verbs. You should not place undue reliance on these statements, as they are subject to risks and uncertainties, including but not limited to the risk factors set forth in our most recent Annual Report on Form 10-K as updated by our Quarterly Reports on Form 10-Q. When considering these forward-looking statements, you should keep in mind these risks and uncertainties, as well as any cautionary statements we may make. Moreover, you should treat these statements as speaking only as of the date they are made and based only on information then actually known to us. We undertake no obligation to release revisions to these forward-looking statements or reflect events or circumstances after the date of this document. There are a number of important factors that could cause future results to differ materially from historical performance and these forward-looking statements. Factors that might cause such a difference include, but are not limited to: (1) effects of the global COVID-19 pandemic; (2) deteriorating credit quality; (3) loan concentration by location or industry of borrowers or collateral; (4) problems encountered by other financial institutions; (5) inadequate sources of funding or liquidity; (6) unfavorable actions of rating agencies; (7) inability to maintain or grow deposits; (8) limitations on the ability to receive dividends from subsidiaries; (9) cyber-security risks; (10) Fifth Third’s ability to secure confidential information and deliver products and services through the use of computer systems and telecommunications networks; (11) failures by third-party service providers; (12) inability to manage strategic initiatives and/or organizational changes; (13) inability to implement technology system enhancements; (14) failure of internal controls and other risk management systems; (15) losses related to fraud, theft, misappropriation or violence; (16) inability to attract and retain skilled personnel; (17) adverse impacts of government regulation; (18) governmental or regulatory changes or other actions; (19) failures to meet applicable capital requirements; (20) regulatory objections to Fifth Third’s capital plan; (21) regulation of Fifth Third’s derivatives activities; (22) deposit insurance premiums; (23) assessments for the orderly liquidation fund; (24) replacement of LIBOR; (25) weakness in the national or local economies; (26) global political and economic uncertainty or negative actions; (27) changes in interest rates; (28) changes and trends in capital markets; (29) fluctuation of Fifth Third’s stock price; (30) volatility in mortgage banking revenue; (31) litigation, investigations, and enforcement proceedings by governmental authorities; (32) breaches of contractual covenants, representations and warranties; (33) competition and changes in the financial services industry; (34) changing retail distribution strategies, customer preferences and behavior; (35) difficulties in identifying, acquiring or integrating suitable strategic partnerships, investments or acquisitions; (36) potential dilution from future acquisitions; (37) loss of income and/or difficulties encountered in the sale and separation of businesses, investments or other assets; (38) results of investments or acquired entities; (39) changes in accounting standards or interpretation or declines in the value of Fifth Third’s goodwill or other intangible assets; (40) inaccuracies or other failures from the use of models; (41) effects of critical accounting policies and judgments or the use of inaccurate estimates; (42) weather-related events, other natural disasters, or health emergencies (including pandemics); (43) the impact of reputational risk created by these or other developments on such matters as business generation and retention, funding and liquidity; and (44) changes in law or requirements imposed by Fifth Third’s regulators impacting our capital actions, including dividend payments and stock repurchases.\n1\n| PART I. FINANCIAL INFORMATION |\n| Glossary of Abbreviations and Acronyms |\n\nFifth Third Bancorp provides the following list of abbreviations and acronyms as a tool for the reader that are used in Management’s Discussion and Analysis of Financial Condition and Results of Operations, the Condensed Consolidated Financial Statements and the Notes to Condensed Consolidated Financial Statements.\n| ACL: Allowance for Credit Losses | GNMA: Government National Mortgage Association |\n| AFS: Available For Sale | GSE: United States Government Sponsored Enterprise |\n| ALCO: Asset Liability Management Committee | HTM: Held-To-Maturity |\n| ALLL: Allowance for Loan and Lease Losses | IPO: Initial Public Offering |\n| AOCI: Accumulated Other Comprehensive Income (Loss) | IRC: Internal Revenue Code |\n| APR: Annual Percentage Rate | IRLC: Interest Rate Lock Commitment |\n| ARM: Adjustable Rate Mortgage | ISDA: International Swaps and Derivatives Association, Inc. |\n| ASC: Accounting Standards Codification | LIBOR: London Interbank Offered Rate |\n| ASU: Accounting Standards Update | LIHTC: Low-Income Housing Tax Credit |\n| ATM: Automated Teller Machine | LLC: Limited Liability Company |\n| BHC: Bank Holding Company | LTV: Loan-to-Value Ratio |\n| BOLI: Bank Owned Life Insurance | MD&A: Management’s Discussion and Analysis of Financial |\n| bps: Basis Points | Condition and Results of Operations |\n| CARES: Coronavirus Aid, Relief and Economic Security | MSR: Mortgage Servicing Right |\n| CDC: Fifth Third Community Development Corporation | N/A: Not Applicable |\n| CECL: Current Expected Credit Loss | NII: Net Interest Income |\n| CET1: Common Equity Tier 1 | NM: Not Meaningful |\n| CFPB: United States Consumer Financial Protection Bureau | OAS: Option-Adjusted Spread |\n| C&I: Commercial and Industrial | OCC: Office of the Comptroller of the Currency |\n| DCF: Discounted Cash Flow | OCI: Other Comprehensive Income (Loss) |\n| DTCC: Depository Trust & Clearing Corporation | OREO: Other Real Estate Owned |\n| DTI: Debt-to-Income Ratio | PCD: Purchased Credit Deteriorated |\n| ERM: Enterprise Risk Management | PPP: Paycheck Protection Program |\n| ERMC: Enterprise Risk Management Committee | RCC: Risk Compliance Committee |\n| EVE: Economic Value of Equity | ROU: Right-of-Use |\n| FASB: Financial Accounting Standards Board | SBA: Small Business Administration |\n| FDIC: Federal Deposit Insurance Corporation | SEC: United States Securities and Exchange Commission |\n| FHA: Federal Housing Administration | SOFR: Secured Overnight Financing Rate |\n| FHLB: Federal Home Loan Bank | TBA: To Be Announced |\n| FHLMC: Federal Home Loan Mortgage Corporation | TDR: Troubled Debt Restructuring |\n| FICO: Fair Isaac Corporation (credit rating) | TILA: Truth in Lending Act |\n| FINRA: Financial Industry Regulatory Authority | U.S.: United States of America |\n| FNMA: Federal National Mortgage Association | USD: United States Dollar |\n| FOMC: Federal Open Market Committee | U.S. GAAP: United States Generally Accepted Accounting |\n| FRB: Federal Reserve Bank | Principles |\n| FTE: Fully Taxable Equivalent | VA: United States Department of Veterans Affairs |\n| FTP: Funds Transfer Pricing | VIE: Variable Interest Entity |\n| FTS: Fifth Third Securities | VRDN: Variable Rate Demand Note |\n| GDP: Gross Domestic Product |\n\n2\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (Item 2) |\n\nThe following is Management’s Discussion and Analysis of Financial Condition and Results of Operations of certain significant factors that have affected Fifth Third Bancorp’s (the “Bancorp” or “Fifth Third”) financial condition and results of operations during the periods included in the Condensed Consolidated Financial Statements, which are a part of this filing. Reference to the Bancorp incorporates the parent holding company and all consolidated subsidiaries. The Bancorp’s banking subsidiary is referred to as the Bank.\nOVERVIEW\nFifth Third Bancorp is a diversified financial services company headquartered in Cincinnati, Ohio. At June 30, 2021, the Bancorp had $205 billion in assets and operated 1,096 full-service banking centers and 2,369 Fifth Third branded ATMs in eleven states throughout the Midwestern and Southeastern regions of the U.S. The Bancorp reports on four business segments: Commercial Banking, Branch Banking, Consumer Lending and Wealth and Asset Management.\nThis overview of MD&A highlights selected information in the financial results of the Bancorp and may not contain all of the information that is important to you. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources and critical accounting policies and estimates, you should carefully read this entire document as well as the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020. Each of these items could have an impact on the Bancorp’s financial condition, results of operations and cash flows. In addition, refer to the Glossary of Abbreviations and Acronyms in this report for a list of terms included as a tool for the reader of this Quarterly Report on Form 10-Q. The abbreviations and acronyms identified therein are used throughout this MD&A, as well as the Condensed Consolidated Financial Statements and Notes to Condensed Consolidated Financial Statements.\nNet interest income, net interest margin, net interest rate spread and the efficiency ratio are presented in MD&A on an FTE basis. The FTE basis adjusts for the tax-favored status of income from certain loans and leases and securities held by the Bancorp that are not taxable for federal income tax purposes. The Bancorp believes this presentation to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and non-taxable amounts. The FTE basis for presenting net interest income is a non-GAAP measure. For further information, refer to the Non-GAAP Financial Measures section of MD&A.\nThe Bancorp’s revenues are dependent on both net interest income and noninterest income. For both the three and six months ended June 30, 2021, net interest income on an FTE basis and noninterest income provided 62% and 38% of total revenue, respectively. The Bancorp derives the majority of its revenues within the U.S. from customers domiciled in the U.S. Revenue from foreign countries and external customers domiciled in foreign countries was immaterial to the Condensed Consolidated Financial Statements for the three and six months ended June 30, 2021. Changes in interest rates, credit quality, economic trends and the capital markets are primary factors that drive the performance of the Bancorp. As discussed later in the Risk Management section of MD&A, risk identification, measurement, monitoring, control and reporting are important to the management of risk and to the financial performance and capital strength of the Bancorp.\nNet interest income is the difference between interest income earned on assets such as loans, leases and securities, and interest expense incurred on liabilities such as deposits, other short-term borrowings and long-term debt. Net interest income is affected by the general level of interest rates, the relative level of short-term and long-term interest rates, changes in interest rates and changes in the amount and composition of interest-earning assets and interest-bearing liabilities. Generally, the rates of interest the Bancorp earns on its assets and pays on its liabilities are established for a period of time. The change in market interest rates over time exposes the Bancorp to interest rate risk through potential adverse changes to net interest income and financial position. The Bancorp manages this risk by continually analyzing and adjusting the composition of its assets and liabilities based on their payment streams and interest rates, the timing of their maturities and their sensitivity to changes in market interest rates. Additionally, in the ordinary course of business, the Bancorp enters into certain derivative transactions as part of its overall strategy to manage its interest rate and prepayment risks. The Bancorp is also exposed to the risk of loss on its loan and lease portfolio, as a result of changing expected cash flows caused by borrower credit events, such as loan defaults and inadequate collateral.\nNoninterest income is derived from commercial banking revenue, service charges on deposits, wealth and asset management revenue, card and processing revenue, mortgage banking net revenue, leasing business revenue, other noninterest income and net securities gains or losses. Noninterest expense includes compensation and benefits, technology and communications, net occupancy expense, equipment expense, leasing business expense, card and processing expense, marketing expense and other noninterest expense.\nCOVID-19 Global Pandemic\nThe COVID-19 pandemic created significant economic uncertainty and financial disruptions during the year ended December 31, 2020, which has continued into 2021. Government and public responses to the COVID-19 pandemic, including temporary closures of businesses and the implementation of social distancing protocols, have caused and continue to cause, reductions and instability in economic activity that have resulted in increased unemployment levels in certain industries and volatility in the financial markets. During the year ended December 31, 2020 and the six months ended June 30, 2021, low interest rates, reduced economic activity and market volatility have had the most immediate negative impacts on the Bancorp’s performance. The Bancorp is unable to estimate the extent of the impact that these factors have had on its operating results since the pandemic began and it is likely that these factors will continue to adversely impact its future operating results.\n3\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe increased availability of COVID-19 vaccinations has begun to mitigate the public health effects of the pandemic, although there has been a rise of the Delta variant of COVID-19 and slower progress on vaccination rates, and recovery from the related economic crisis continues to disproportionately affect certain industries, geographies and demographics more than others. This uneven recovery, combined with the unprecedented nature of the government response to the pandemic, makes it difficult to predict the extent to which the pandemic will continue to adversely impact the Bancorp and its customers. Furthermore, resurgence risk remains present as new virus variants are identified. The Bancorp continues to closely monitor the pandemic and its effects on customers, employees, communities and markets.\nThe Bancorp has provided a variety of relief options for both commercial and consumer customers that were affected by the COVID-19 pandemic, including loan covenant relief, loan maturity extensions, payment deferrals, forbearances and fee waivers. For further information about these programs, refer to the Credit Risk Management subsection of the Risk Management section of MD&A included herein, and also Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\nGovernment Response to the COVID-19 Pandemic\nCongress, the FRB and the other U.S. state and federal financial regulatory agencies have taken actions to mitigate disruptions to economic activity and financial stability resulting from the COVID-19 pandemic. The descriptions below summarize certain significant government actions taken in response to the COVID-19 pandemic. The descriptions are qualified in their entirety by reference to the particular statutory or regulatory provisions or government programs summarized.\nThe CARES Act\nThe Coronavirus Aid, Relief and Economic Security (“CARES”) Act was signed into law on March 27, 2020 and has subsequently been amended several times, including by the Consolidated Appropriations Act, 2021. Among other provisions, the CARES Act included funding for the SBA to expand lending, relief from certain U.S. GAAP requirements to allow COVID-19-related loan modifications to not be categorized as TDRs, direct stimulus payments and a range of incentives to encourage deferment, forbearance or modification of consumer credit and mortgage contracts. One of the key CARES Act programs is the Paycheck Protection Program, discussed further below, which temporarily expanded the SBA’s business loan guarantee program.\nThe CARES Act contains additional protections for homeowners and renters of properties with federally-backed mortgages, including a 60-day moratorium on the initiation of foreclosure proceedings beginning on March 18, 2020 and a 120-day moratorium on initiating eviction proceedings effective March 27, 2020. Borrowers of federally-backed mortgages have the right under the CARES Act to request up to 360 days of forbearance on their mortgage payments if they experience financial hardship directly or indirectly due to the COVID-19 public health emergency. The FHA, FNMA and FHLMC independently extended their moratorium on foreclosures and evictions for single-family federally-backed mortgages through July 31, 2021.\nAlso pursuant to the CARES Act, the U.S. Treasury has the authority to provide loans, guarantees and other investments in support of eligible businesses, states and municipalities affected by the economic effects of COVID-19. Some of these funds have been used to support several FRB programs and facilities described below or additional programs or facilities that are established by its authority under Section 13(3) of the Federal Reserve Act which meet certain criteria.\nFRB Actions\nThe FRB has taken a range of actions to support the flow of credit to households and businesses, offset forced liquidations and restore liquidity in the financial markets. For example, on March 15, 2020, the FRB reduced the target range for the federal funds rate to 0 to 0.25% and announced that it would increase its holdings of U.S. Treasury securities and agency mortgage-backed securities and begin purchasing agency commercial mortgage-backed securities. The FRB has also encouraged depository institutions to borrow from the discount window and has lowered the primary credit rate for such borrowing by 150 basis points while extending the term of such loans up to 90 days. Reserve requirements have been reduced to zero as of March 26, 2020.\nIn addition, the FRB established a range of facilities and programs to support the U.S. economy and U.S. marketplace participants in response to economic disruptions associated with COVID-19. Through these facilities and programs, the FRB, relying on its authority under Section 13(3) of the Federal Reserve Act, has taken steps to directly or indirectly purchase assets from, or make loans to, U.S. companies, financial institutions, municipalities and other market participants.\nPaycheck Protection Program\nThe Bancorp is a participating lender in PPP, which is a program administered by the SBA to provide forgivable, guaranteed loans to eligible borrowers that have been affected by the COVID-19 pandemic. As of June 30, 2021, the Bancorp held PPP loans with a carrying amount of $3.7 billion under the program. PPP loans are available to a broader range of entities than ordinary SBA loans, require deferral of principal and interest repayment, and may be forgiven if the borrower demonstrates that the loan proceeds were used for qualified payroll costs and certain other expenses. The PPP has been expanded to permit second and third rounds of funding, including for certain borrowers who have already received a PPP loan, subject to certain conditions.\n4\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nAmerican Rescue Plan Act\nThe American Rescue Plan Act of 2021, which was signed into law on March 21, 2021, provides additional relief for businesses, states, municipalities and individuals by, among other things, allocating additional funds for the PPP, providing a third round of economic impact payments to individuals, extending supplemental federal unemployment benefits and providing advance payments of an expanded child tax credit. The impacts of the stimulus on the Bancorp’s business, results of operations and financial condition are highly uncertain and will depend on future developments, including the scope and duration of the pandemic and its impact on the economy in general.\nAccelerated Share Repurchase Transactions\nDuring the six months ended June 30, 2021, the Bancorp entered into and settled accelerated share repurchase transactions. As part of the transactions, the Bancorp entered into forward contracts in which the final number of shares delivered at settlement was based generally on a discount to the average daily volume weighted-average price of the Bancorp’s common stock during the term of the repurchase agreements. Refer to Note 15 and Note 23 of the Notes to Condensed Consolidated Financial Statements for additional information on share repurchase activity.\nThe following table presents a summary of the Bancorp’s accelerated share repurchase transactions that were entered into and settled during the six months ended June 30, 2021:\n| TABLE 1: Summary of Accelerated Share Repurchase Transactions |\n| Repurchase Date | Amount ($ in millions) | Shares Repurchased on Repurchase Date | Shares Received from Forward Contract Settlement | Total Shares Repurchased | Final Settlement Date |\n| January 26, 2021 | $ | 180 | 4,951,456 | 366,939 | 5,318,395 | March 31, 2021 |\n| April 23, 2021 | 347 | 7,894,807 | 675,295 | 8,570,102 | June 11, 2021 |\n\nLIBOR Transition\nIn July 2017, the Chief Executive of the United Kingdom Financial Conduct Authority (the “FCA”), which regulates LIBOR, announced that the FCA will stop persuading or compelling banks to submit rates for the calculation of LIBOR to the administrator of LIBOR after 2021. Since then, central banks around the world, including the Federal Reserve, have commissioned working groups of market participants and official sector representatives with the goal of finding suitable replacements for LIBOR. The Bancorp has substantial exposure to LIBOR-based products within its commercial lending, commercial deposits, business banking, consumer lending and capital markets lines of business as well as corporate treasury function. On November 30, 2020, the Federal Reserve, OCC, and FDIC issued a public statement that the administrator of LIBOR announced it will consult on an extension of publication of certain U.S. Dollar (“USD”) LIBOR tenors until June 30, 2023, which would allow additional legacy USD LIBOR contracts to mature before the succession of LIBOR. The administrator then announced on March 5, 2021, that it will cease publication of 1-week and 2-month USD LIBOR on December 31, 2021, and that overnight and 1-, 3-, 6-, and 12-month USD LIBOR will cease to be published on June 30, 2023. Although the full impact of LIBOR reforms and actions remains unclear, the Bancorp continues to prepare to transition from LIBOR to alternative reference rates, and it is expected that a broad transition away from the use of LIBOR to alternative reference rates for new financial contracts will occur by the end of 2021. In the United States, LIBOR-priced transactions and products will transfer to the Secured Overnight Financing Rate (“SOFR”), Prime Rate or other similar indices (collectively, “Alternative Rates”). There are risks inherent with the transition to any Alternative Rate as the rate may behave differently than LIBOR in reaction to monetary, market and economic events.\nThe Bancorp’s LIBOR transition plan is organized around key work streams, including continued engagement with central banks and industry working groups and regulators, active client engagement, comprehensive review of legacy documentation, internal operational and technological readiness, and risk management, among other things, to facilitate the transition to Alternative Rates. The Bancorp has implemented certain SOFR conventions and is in the process of developing other products and transaction agreements which are based on reference rates other than LIBOR. The Bancorp has also developed a transition plan for existing LIBOR-based financial contracts that are not expected to mature or settle prior to the cessation of LIBOR publication.\nFor a further discussion of the various risks the Bancorp faces in connection with the expected replacement of LIBOR on its operations, see “Risk Factors—Market Risks—The replacement of LIBOR could adversely affect Fifth Third’s revenue or expenses and the value of those assets or obligations.” in Item 1A. Risk Factors of the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\nKey Performance Indicators\nThe Bancorp, as a banking institution, utilizes various key indicators of financial condition and operating results in managing and monitoring the performance of the business. In addition to traditional financial metrics, such as revenue and expense trends, the Bancorp monitors other financial measures that assist in evaluating growth trends, capital strength and operational efficiencies. The Bancorp analyzes these key performance indicators against its past performance, its forecasted performance and with the performance of its peer banking institutions. These indicators may change from time to time as the operating environment and businesses change.\n5\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following are some of the key indicators used by management to assess the Bancorp’s business performance, including those which are considered in the Bancorp’s compensation programs:\n•CET1 Capital Ratio: CET1 capital divided by risk-weighted assets as defined by the Basel III standardized approach to risk-weighting of assets\n•Return on Average Tangible Common Equity (non-GAAP): Tangible net income available to common shareholders (annualized) divided by average tangible common equity\n•Net Interest Margin (non-GAAP): Net interest income on an FTE basis (annualized) divided by average interest-earning assets\n•Efficiency Ratio (non-GAAP): Noninterest expense divided by the sum of net interest income on an FTE basis and noninterest income\n•Earnings Per Share, Diluted: Net income allocated to common shareholders divided by average common shares outstanding after the effect of dilutive stock-based awards\n•Nonperforming Portfolio Assets Ratio: Nonperforming portfolio assets divided by portfolio loans and leases and OREO\n•Net Charge-off Ratio: Net losses charged-off (annualized) divided by average portfolio loans and leases\n•Return on Average Assets: Net income (annualized) divided by quarterly average assets\n•Loan-to-Deposit Ratio: Total loans divided by total deposits\nThe list of indicators above is intended to summarize some of the most important metrics utilized by management in evaluating the Bancorp’s performance and does not represent an all-inclusive list of all performance measures that may be considered relevant or important to management or investors.\n| TABLE 2: Earnings Summary |\n| For the three months endedJune 30, | % | For the six months endedJune 30, | % |\n| ($ in millions, except for per share data) | 2021 | 2020 | Change | 2021 | 2020 | Change |\n| Income Statement Data |\n| Net interest income (U.S. GAAP) | $ | 1,208 | 1,200 | 1 | $ | 2,385 | 2,429 | (2) |\n| Net interest income (FTE)(a)(b) | 1,211 | 1,203 | 1 | 2,391 | 2,436 | (2) |\n| Noninterest income | 741 | 650 | 14 | 1,490 | 1,321 | 13 |\n| Total revenue (FTE)(a)(b) | 1,952 | 1,853 | 5 | 3,881 | 3,757 | 3 |\n| (Benefit from) provision for credit losses(c) | (115) | 485 | NM | (288) | 1,125 | NM |\n| Noninterest expense | 1,153 | 1,121 | 3 | 2,369 | 2,321 | 2 |\n| Net income | 709 | 195 | 264 | 1,403 | 243 | 477 |\n| Net income available to common shareholders | 674 | 163 | 313 | 1,348 | 193 | 598 |\n| Common Share Data |\n| Earnings per share - basic | $ | 0.95 | 0.23 | 313 | $ | 1.89 | 0.27 | 600 |\n| Earnings per share - diluted | 0.94 | 0.23 | 309 | 1.87 | 0.27 | 593 |\n| Cash dividends declared per common share | 0.27 | 0.27 | — | 0.54 | 0.54 | — |\n| Book value per share | 29.57 | 28.88 | 2 | 29.57 | 28.88 | 2 |\n| Market value per share | 38.23 | 19.28 | 98 | 38.23 | 19.28 | 98 |\n| Financial Ratios |\n| Return on average assets | 1.38 | % | 0.40 | 245 | 1.38 | % | 0.26 | 431 |\n| Return on average common equity | 13.0 | 3.2 | 306 | 13.1 | 1.9 | 589 |\n| Return on average tangible common equity(b) | 16.6 | 4.3 | 286 | 16.7 | 2.7 | 519 |\n| Dividend payout | 28.4 | 117.4 | (76) | 28.6 | 200.0 | (86) |\n| Average total Bancorp shareholders’ equity as a percent of average assets | 11.11 | 11.30 | (2) | 11.18 | 11.92 | (74) |\n\n(a)Amounts presented on an FTE basis. The FTE adjustments were $3 for both the three months ended June 30, 2021 and 2020 and $6 and $7 for the six months ended June 30, 2021 and 2020, respectively.\n(b)These are non-GAAP measures. For further information, refer to the Non-GAAP Financial Measures section of MD&A.\n(c)The provision for credit losses is the sum of the provision for loan and lease losses and the provision for the reserve for unfunded commitments.\nEarnings Summary\nThe Bancorp’s net income available to common shareholders for the second quarter of 2021 was $674 million, or $0.94 per diluted share, which was net of $35 million in preferred stock dividends. The Bancorp’s net income available to common shareholders for the second quarter of 2020 was $163 million, or $0.23 per diluted share, which was net of $32 million in preferred stock dividends. The Bancorp’s net income available to common shareholders for the six months ended June 30, 2021 was $1.3 billion, or $1.87 per diluted share, which was net of $55 million in preferred stock dividends. The Bancorp’s net income available to common shareholders for the six months ended June 30, 2020 was $193 million, or $0.27 per diluted share, which was net of $50 million in preferred stock dividends.\n6\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nNet interest income on an FTE basis (non-GAAP) was $1.2 billion for the three months ended June 30, 2021, an increase of $8 million compared to the same period in the prior year. Net interest income benefited from increases in average residential mortgage loans and average indirect secured consumer loans from the three months ended June 30, 2020. Net interest income was also positively impacted by decreases in rates paid on average interest-bearing liabilities and a decrease in average long-term debt for the three months ended June 30, 2021 compared to the same period in the prior year. An increase in interest income recognized from PPP loans also positively impacted net interest income for the three months ended June 30, 2021. These benefits were partially offset by decreases in average balances in commercial and industrial loans and credit card from the three months ended June 30, 2020 and decreases in yields on average loans and leases due to the portfolio repricing to lower market interest rates.\nNet interest income on an FTE basis (non-GAAP) was $2.4 billion for the six months ended June 30, 2021, a decrease of $45 million compared to the same period in the prior year primarily due to the impact of lower market rates, which decreased the yield on total average loans and leases. In addition to market rate impacts on interest-earning assets, net interest income was also negatively impacted by decreases in average commercial and industrial loans, average credit card and average home equity balances from the six months ended June 30, 2020. These negative impacts were partially offset by decreases in rates paid on average interest-bearing liabilities. Net interest income also benefited from increases in average residential mortgage loan and average indirect secured consumer loan balances and a decrease in average long-term debt from the six months ended June 30, 2020. An increase in interest income recognized from PPP loans also positively impacted net interest income for the six months ended June 30, 2021. Net interest margin on an FTE basis (non-GAAP) was 2.63% and 2.62% for the three and six months ended June 30, 2021, respectively, compared to 2.75% and 2.99% for the comparable periods in the prior year.\nThe benefit from credit losses was $115 million and $288 million for the three and six months ended June 30, 2021, respectively, compared to a provision for credit losses of $485 million and $1.1 billion during the same periods in the prior year. Provision expense decreased for the three and six months ended June 30, 2021 compared to the same periods in the prior year primarily driven by factors which caused decreases in the ACL during those periods including improved economic forecasts, improved commercial and consumer credit quality and lower period-end loan and lease balances. Net losses charged off as a percent of average portfolio loans and leases were 0.16% and 0.44% for the three months ended June 30, 2021 and 2020, respectively, and 0.21% and 0.44% for the six months ended June 30, 2021 and 2020, respectively. At June 30, 2021, nonperforming portfolio assets as a percent of portfolio loans and leases and OREO decreased to 0.61% compared to 0.79% at December 31, 2020. For further discussion on credit quality refer to the Credit Risk Management subsection of the Risk Management section of MD&A as well as Note 6 of the Notes to Condensed Consolidated Financial Statements.\nNoninterest income increased $91 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to increases in other noninterest income, service charges on deposits, wealth and asset management revenue, commercial banking revenue and card and processing revenue of $37 million, $27 million, $25 million, $23 million, and $20 million, respectively. These increases were partially offset by a decrease in mortgage banking net revenue of $35 million.\nNoninterest income increased $169 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to increases in other noninterest income, commercial banking revenue, wealth and asset management revenue, card and processing revenue, service charges on deposits and leasing business revenue of $74 million, $52 million, $33 million, $29 million, $22 million and $17 million, respectively. These increases were partially offset by a decrease in mortgage banking net revenue of $70 million.\nNoninterest expense increased $32 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to increases in other noninterest expense and compensation and benefits expense of $29 million and $11 million, respectively. These increases were partially offset by decreases in card and processing expense and net occupancy expense of $9 million and $5 million, respectively.\nNoninterest expense increased $48 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to an increase in compensation and benefits expense of $69 million partially offset by decreases in card and processing expense, net occupancy expense and marketing expense of $10 million, $8 million and $8 million, respectively.\nFor more information on net interest income, noninterest income and noninterest expense refer to the Statements of Income Analysis section of MD&A.\nCapital Summary\nThe Bancorp calculated its regulatory capital ratios under the Basel III standardized approach to risk-weighting of assets and pursuant to the five-year transition provision option to phase in the effects of CECL on regulatory capital as of June 30, 2021. As of June 30, 2021, the Bancorp’s capital ratios, as defined by the U.S. banking agencies, were:\n•CET1 capital ratio: 10.37%;\n•Tier I risk-based capital ratio: 11.83%;\n•Total risk-based capital ratio: 14.60%; and\n•Tier I leverage ratio: 8.55%.\n7\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nNON-GAAP FINANCIAL MEASURES\nThe following are non-GAAP financial measures which provide useful insight to the reader of the Condensed Consolidated Financial Statements but should be supplemental to primary U.S. GAAP measures and should not be read in isolation or relied upon as a substitute for the primary U.S. GAAP measures.\nThe FTE basis adjusts for the tax-favored status of income from certain loans and leases and securities held by the Bancorp that are not taxable for federal income tax purposes. The Bancorp believes this presentation to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and non-taxable amounts.\nThe following table reconciles the non-GAAP financial measures of net interest income on an FTE basis, interest income on an FTE basis, net interest margin, net interest rate spread and the efficiency ratio to U.S. GAAP:\n| TABLE 3: Non-GAAP Financial Measures - Financial Measures and Ratios on an FTE basis |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Net interest income (U.S. GAAP) | $ | 1,208 | 1,200 | 2,385 | 2,429 |\n| Add: FTE adjustment | 3 | 3 | 6 | 7 |\n| Net interest income on an FTE basis (1) | $ | 1,211 | 1,203 | 2,391 | 2,436 |\n| Net interest income on an FTE basis (annualized) (2) | 4,857 | 4,838 | 4,822 | 4,899 |\n| Interest income (U.S. GAAP) | $ | 1,323 | 1,403 | 2,624 | 2,928 |\n| Add: FTE adjustment | 3 | 3 | 6 | 7 |\n| Interest income on an FTE basis | $ | 1,326 | 1,406 | 2,630 | 2,935 |\n| Interest income on an FTE basis (annualized) (3) | 5,319 | 5,655 | 5,304 | 5,902 |\n| Interest expense (annualized) (4) | $ | 461 | 816 | 482 | 1,003 |\n| Noninterest income (5) | 741 | 650 | 1,490 | 1,321 |\n| Noninterest expense (6) | 1,153 | 1,121 | 2,369 | 2,321 |\n| Average interest-earning assets (7) | 184,918 | 176,224 | 183,823 | 163,719 |\n| Average interest-bearing liabilities (8) | 115,951 | 124,478 | 116,315 | 116,861 |\n| Ratios: |\n| Net interest margin on an FTE basis (2) / (7) | 2.63 | % | 2.75 | 2.62 | 2.99 |\n| Net interest rate spread on an FTE basis ((3) / (7)) - ((4) / (8)) | 2.48 | 2.55 | 2.47 | 2.75 |\n| Efficiency ratio on an FTE basis (6) / ((1) + (5)) | 59.1 | 60.5 | 61.0 | 61.8 |\n\nThe Bancorp believes return on average tangible common equity is an important measure for comparative purposes with other financial institutions, but is not defined under U.S. GAAP, and therefore is considered a non-GAAP financial measure. This measure is useful for evaluating the performance of a business as it calculates the return available to common shareholders without the impact of intangible assets and their related amortization.\n8\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following table reconciles the non-GAAP financial measure of return on average tangible common equity to U.S. GAAP:\n| TABLE 4: Non-GAAP Financial Measures - Return on Average Tangible Common Equity |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Net income available to common shareholders (U.S. GAAP) | $ | 674 | 163 | 1,348 | 193 |\n| Add: Intangible amortization, net of tax | 8 | 9 | 17 | 20 |\n| Tangible net income available to common shareholders | $ | 682 | 172 | 1,365 | 213 |\n| Tangible net income available to common shareholders (annualized) (1) | 2,735 | 692 | 2,753 | 428 |\n| Average Bancorp shareholders’ equity (U.S. GAAP) | $ | 22,927 | 22,420 | 22,939 | 22,066 |\n| Less: Average preferred stock | 2,116 | 1,770 | 2,116 | 1,770 |\n| Average goodwill | 4,259 | 4,261 | 4,259 | 4,256 |\n| Average intangible assets | 122 | 178 | 128 | 186 |\n| Average tangible common equity (2) | $ | 16,430 | 16,211 | 16,436 | 15,854 |\n| Return on average tangible common equity (1) / (2) | 16.6 | % | 4.3 | 16.7 | 2.7 |\n\nThe Bancorp considers various measures when evaluating capital utilization and adequacy, including the tangible equity ratio and tangible common equity ratio, in addition to capital ratios defined by the U.S. banking agencies. These calculations are intended to complement the capital ratios defined by the U.S. banking agencies for both absolute and comparative purposes. Because U.S. GAAP does not include capital ratio measures, the Bancorp believes there are no comparable U.S. GAAP financial measures to these ratios. These ratios are not formally defined by U.S. GAAP or codified in the federal banking regulations and, therefore, are considered to be non-GAAP financial measures. The Bancorp encourages readers to consider its Condensed Consolidated Financial Statements in their entirety and not to rely on any single financial measure.\nThe following table reconciles non-GAAP capital ratios to U.S. GAAP:\n| TABLE 5: Non-GAAP Financial Measures - Capital Ratios |\n| As of ($ in millions) | June 30,2021 | December 31,2020 |\n| Total Bancorp Shareholders’ Equity (U.S. GAAP) | $ | 22,926 | 23,111 |\n| Less: Preferred stock | 2,116 | 2,116 |\n| Goodwill | 4,259 | 4,258 |\n| Intangible assets | 117 | 139 |\n| AOCI | 1,974 | 2,601 |\n| Tangible common equity, excluding AOCI (1) | $ | 14,460 | 13,997 |\n| Add: Preferred stock | 2,116 | 2,116 |\n| Tangible equity (2) | $ | 16,576 | 16,113 |\n| Total Assets (U.S. GAAP) | $ | 205,390 | 204,680 |\n| Less: Goodwill | 4,259 | 4,258 |\n| Intangible assets | 117 | 139 |\n| AOCI, before tax | 2,499 | 3,292 |\n| Tangible assets, excluding AOCI (3) | $ | 198,515 | 196,991 |\n| Ratios: |\n| Tangible equity as a percentage of tangible assets (2) / (3) | 8.35 | % | 8.18 |\n| Tangible common equity as a percentage of tangible assets (1) / (3) | 7.28 | 7.11 |\n\n9\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nRECENT ACCOUNTING STANDARDS\nNote 3 of the Notes to Condensed Consolidated Financial Statements provides a discussion of a significant new accounting standard applicable to the Bancorp.\nCRITICAL ACCOUNTING POLICIES\nThe Bancorp’s Condensed Consolidated Financial Statements are prepared in accordance with U.S. GAAP. Certain accounting policies require management to exercise judgment in determining methodologies, economic assumptions and estimates that may materially affect the Bancorp’s financial position, results of operations and cash flows. The Bancorp’s critical accounting policies include the accounting for the ALLL, reserve for unfunded commitments, valuation of servicing rights, fair value measurements, goodwill and legal contingencies. These accounting policies are discussed in detail in the Critical Accounting Policies section of the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020. There have been no material changes to the valuation techniques or models during the six months ended June 30, 2021.\n10\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nSTATEMENTS OF INCOME ANALYSIS\nNet Interest Income\nNet interest income is the interest earned on loans and leases (including yield-related fees), securities and other short-term investments less the interest incurred on core deposits (includes transaction deposits and other time deposits) and wholesale funding (includes certificates $100,000 and over, other deposits, federal funds purchased, other short-term borrowings and long-term debt). The net interest margin is calculated by dividing net interest income by average interest-earning assets. Net interest rate spread is the difference between the average yield earned on interest-earning assets and the average rate paid on interest-bearing liabilities. Net interest margin is typically greater than net interest rate spread due to the interest income earned on those assets that are funded by noninterest-bearing liabilities, or free funding, such as demand deposits or shareholders’ equity.\nTables 6 and 7 present the components of net interest income, net interest margin and net interest rate spread for the three and six months ended June 30, 2021 and 2020, as well as the relative impact of changes in the average balance sheet and changes in interest rates on net interest income. Nonaccrual loans and leases and loans and leases held for sale have been included in the average loan and lease balances. Average outstanding securities balances are based on amortized cost with any unrealized gains or losses included in average other assets.\nNet interest income on an FTE basis (non-GAAP) was $1.2 billion for the three months ended June 30, 2021, an increase of $8 million compared to the same period in the prior year. Net interest income benefited from increases in average residential mortgage loans and average indirect secured consumer loan balances of $4.3 billion and $2.6 billion, respectively, from the three months ended June 30, 2020. Net interest income was also positively impacted by decreases in rates paid on average interest-bearing liabilities primarily driven by decreases in rates paid on average money market deposits and average interest checking deposits of 27 bps and 18 bps, respectively, for the three months ended June 30, 2021 compared to the same period in the prior year. Net interest income also benefited from a decrease in average long-term debt of $3.1 billion for the three months ended June 30, 2021 compared to the same period in the prior year. Interest income recognized from PPP loans also positively impacted net interest income by $53 million for the three months ended June 30, 2021 compared to $23 million in the same period in the prior year. These benefits were partially offset by decreases in average commercial and industrial loan balances and average credit card balances of $10.3 billion and $478 million, respectively, from the three months ended June 30, 2020. Net interest income was also negatively impacted by loan portfolio repricing due to lower market interest rates, including a 63 bps decrease in yields on average indirect secured consumer loans for the three months ended June 30, 2021 compared to the same period in the prior year.\nNet interest income on an FTE basis (non-GAAP) was $2.4 billion for the six months ended June 30, 2021, a decrease of $45 million compared to the same period in the prior year primarily due to the impact of lower market rates. Monetary policy actions in response to the COVID-19 pandemic, including lowering the target range of the federal funds rate and the FRB’s bond purchase programs, have continued to adversely impact market rates since March of 2020. Yields on total average loans and leases decreased by 43 bps for the six months ended June 30, 2021 compared to the prior year driven by decreases in yields on average commercial loans and average consumer loans of 40 bps and 58 bps, respectively, for the six months ended June 30, 2021 compared to the same period in the prior year. The Bancorp has significant portfolios of floating interest rate loans (primarily LIBOR- or Prime-based) that were impacted by these decreases in yields. The Bancorp’s portfolios of fixed interest rate loans also decreased in yield as a result of increased refinance activity and lower reinvestment yields due to lower overall market rates. In addition to market rate impacts on interest-earning assets, net interest income was also negatively impacted by decreases in average commercial and industrial loans, average credit card and average home equity of $6.1 billion, $549 million and $1.1 billion, respectively, from the six months ended June 30, 2020. These negative impacts were partially offset by decreases in rates paid on average interest-bearing liabilities primarily driven by decreases in rates paid on average interest checking deposits and average money market deposits of 40 bps and 46 bps, respectively, for the six months ended June 30, 2021 compared to the same period in the prior year. Net interest income also benefited from increases in average residential mortgage loans and average indirect secured consumer loans of $3.4 billion and $2.4 billion, respectively, and a decrease in average long-term debt of $2.0 billion from the six months ended June 30, 2020. Interest income recognized from PPP loans also positively impacted net interest income by $106 million for the six months ended June 30, 2021 compared to $23 million in the same period in the prior year.\nNet interest rate spread on an FTE basis (non-GAAP) was 2.48% and 2.47% during the three and six months ended June 30, 2021, respectively, compared to 2.55% and 2.75% in the same periods in the prior year. Yields on average interest-earning assets decreased 33 bps and 72 bps for the three and six months ended June 30, 2021, respectively, partially offset by decreases in rates paid on average interest-bearing liabilities of 26 bps and 44 bps for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020.\nNet interest margin on an FTE basis (non-GAAP) was 2.63% and 2.62% for the three and six months ended June 30, 2021, respectively, compared to 2.75% and 2.99% for the comparable periods in the prior year. Net interest margin was negatively impacted by increases in low-yielding reserves held at the FRB reported in other short-term investments, which were primarily driven by elevated levels in average demand deposits and average interest-bearing deposits for the three and six months ended June 30, 2021 compared to the same periods in the prior year. Net interest margin results are expected to remain suppressed as a result of sustained excess cash balances, which are expected to remain elevated, driven by the amount of liquidity injected into the banking system as a result of monetary and fiscal stimulus programs implemented in response to the COVID-19 pandemic.\n11\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nInterest income on an FTE basis (non-GAAP) from loans and leases decreased $81 million and $288 million during the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020 driven by the previously mentioned decreases in yields and average balances of loans and leases. For more information on the Bancorp’s loan and lease portfolio, refer to the Loans and Leases subsection of the Balance Sheet Analysis section of MD&A. Interest income on an FTE basis (non-GAAP) from investment securities and other short-term investments increased $1 million during the three months ended June 30, 2021 compared to the three months ended June 30, 2020 primarily due to increases in the average balances of securities exempt from income taxes and other short-term investments, partially offset by a decrease in the average balance of taxable securities. Interest income on an FTE basis (non-GAAP) from investment securities and other short-term investments decreased $17 million during the six months ended June 30, 2021 compared to the six months ended June 30, 2020 primarily due to decreases in yields on average investment securities and average other short-term investments, partially offset by an increase in the average balance of other short-term investments.\nInterest expense on core deposits decreased $56 million and $188 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020 primarily due to decreases in the cost of average interest-bearing core deposits to 5 bps and 6 bps for the three and six months ended June 30, 2021, respectively, from 27 bps and 46 bps for the three and six months ended June 30, 2020. The decreases in the cost of average interest-bearing core deposits were primarily due to the previously mentioned decreases in rates paid on average interest checking deposits and average money market deposits. Refer to the Deposits subsection of the Balance Sheet Analysis section of MD&A for additional information on the Bancorp’s deposits.\nInterest expense on average wholesale funding decreased $32 million and $72 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020 primarily due to decreases in average balances of long-term debt and certificates $100,000 and over and decreases in rates paid on certificates $100,000 and over. Refer to the Borrowings subsection of the Balance Sheet Analysis section of MD&A for additional information on the Bancorp’s borrowings. During the three and six months ended June 30, 2021, average wholesale funding represented 14% and 15%, respectively, of average interest-bearing liabilities, compared to 19% for both the three and six months ended June 30, 2020. For more information on the Bancorp’s interest rate risk management, including estimated earnings sensitivity to changes in market interest rates, see the Interest Rate and Price Risk Management subsection of the Risk Management section of MD&A.\n12\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\n| TABLE 6: Condensed Average Balance Sheets and Analysis of Net Interest Income on an FTE Basis |\n| For the three months ended | June 30, 2021 | June 30, 2020 | Attribution of Change in Net Interest Income(a) |\n| ($ in millions) | Average Balance | Revenue/Cost | Average Yield/ Rate | Average Balance | Revenue/Cost | Average Yield/ Rate | Volume | Yield/ Rate | Total |\n| Assets: |\n| Interest-earning assets: |\n| Loans and leases:(b) |\n| Commercial and industrial loans | $ | 48,817 | 441 | 3.62 | % | $ | 59,106 | 510 | 3.47 | % | $ | (91) | 22 | (69) |\n| Commercial mortgage loans | 10,467 | 81 | 3.11 | 11,224 | 96 | 3.44 | (6) | (9) | (15) |\n| Commercial construction loans | 6,043 | 47 | 3.09 | 5,548 | 49 | 3.53 | 4 | (6) | (2) |\n| Commercial leases | 3,174 | 23 | 2.94 | 3,056 | 26 | 3.47 | 1 | (4) | (3) |\n| Total commercial loans and leases | $ | 68,501 | 592 | 3.47 | $ | 78,934 | 681 | 3.47 | $ | (92) | 3 | (89) |\n| Residential mortgage loans | 21,740 | 178 | 3.29 | 17,405 | 153 | 3.53 | 36 | (11) | 25 |\n| Home equity | 4,674 | 42 | 3.60 | 5,820 | 52 | 3.60 | (10) | — | (10) |\n| Indirect secured consumer loans | 14,702 | 125 | 3.41 | 12,124 | 122 | 4.04 | 24 | (21) | 3 |\n| Credit card | 1,770 | 54 | 12.13 | 2,248 | 63 | 11.28 | (14) | 5 | (9) |\n| Other consumer loans | 3,056 | 46 | 5.96 | 2,887 | 47 | 6.50 | 3 | (4) | (1) |\n| Total consumer loans | $ | 45,942 | 445 | 3.88 | $ | 40,484 | 437 | 4.34 | $ | 39 | (31) | 8 |\n| Total loans and leases | $ | 114,443 | 1,037 | 3.63 | % | $ | 119,418 | 1,118 | 3.76 | % | $ | (53) | (28) | (81) |\n| Securities: |\n| Taxable | 36,097 | 275 | 3.06 | 36,817 | 282 | 3.08 | (5) | (2) | (7) |\n| Exempt from income taxes(b) | 820 | 5 | 2.47 | 156 | 1 | 2.96 | 4 | — | 4 |\n| Other short-term investments | 33,558 | 9 | 0.11 | 19,833 | 5 | 0.11 | 4 | — | 4 |\n| Total interest-earning assets | $ | 184,918 | 1,326 | 2.88 | % | $ | 176,224 | 1,406 | 3.21 | % | $ | (50) | (30) | (80) |\n| Cash and due from banks | 3,033 | 3,121 |\n| Other assets | 20,608 | 21,394 |\n| Allowance for loan and lease losses | (2,206) | (2,352) |\n| Total assets | $ | 206,353 | $ | 198,387 |\n| Liabilities and Equity: |\n| Interest-bearing liabilities: |\n| Interest checking deposits | $ | 45,307 | 6 | 0.06 | % | $ | 49,760 | 29 | 0.24 | % | $ | (3) | (20) | (23) |\n| Savings deposits | 20,494 | 1 | 0.02 | 16,354 | 3 | 0.06 | — | (2) | (2) |\n| Money market deposits | 30,844 | 4 | 0.05 | 30,022 | 24 | 0.32 | 1 | (21) | (20) |\n| Foreign office deposits | 140 | — | 0.03 | 182 | — | 0.09 | — | — | — |\n| Other time deposits | 2,696 | 2 | 0.27 | 4,421 | 13 | 1.21 | (3) | (8) | (11) |\n| Total interest-bearing core deposits | $ | 99,481 | 13 | 0.05 | $ | 100,739 | 69 | 0.27 | $ | (5) | (51) | (56) |\n| Certificates $100,000 and over | 1,144 | 2 | 0.80 | 4,067 | 14 | 1.40 | (8) | (4) | (12) |\n| Other deposits | — | — | — | 31 | — | 0.04 | — | — | — |\n| Federal funds purchased | 346 | — | 0.10 | 309 | — | 0.16 | — | — | — |\n| Other short-term borrowings | 1,097 | — | 0.12 | 2,377 | 2 | 0.32 | (1) | (1) | (2) |\n| Long-term debt | 13,883 | 100 | 2.85 | 16,955 | 118 | 2.80 | (20) | 2 | (18) |\n| Total interest-bearing liabilities | $ | 115,951 | 115 | 0.40 | % | $ | 124,478 | 203 | 0.66 | % | $ | (34) | (54) | (88) |\n| Demand deposits | 61,994 | 45,761 |\n| Other liabilities | 5,481 | 5,727 |\n| Total liabilities | $ | 183,426 | $ | 175,966 |\n| Total equity | $ | 22,927 | $ | 22,421 |\n| Total liabilities and equity | $ | 206,353 | $ | 198,387 |\n| Net interest income (FTE)(c) | $ | 1,211 | $ | 1,203 | $ | (16) | 24 | 8 |\n| Net interest margin (FTE)(c) | 2.63 | % | 2.75 | % |\n| Net interest rate spread (FTE)(c) | 2.48 | 2.55 |\n| Interest-bearing liabilities to interest-earning assets | 62.70 | 70.64 |\n\n(a)Changes in interest not solely due to volume or yield/rate are allocated in proportion to the absolute dollar amount of change in volume and yield/rate.\n(b)The FTE adjustments included in the above table were $3 for both the three months ended June 30, 2021 and 2020.\n(c)Net interest income (FTE), net interest margin (FTE) and net interest rate spread (FTE) are non-GAAP measures. For further information, refer to the Non-GAAP Financial Measures section of MD&A.\n13\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\n| TABLE 7: Condensed Average Balance Sheets and Analysis of Net Interest Income on an FTE Basis |\n| For the six months ended | June 30, 2021 | June 30, 2020 | Attribution of Change in Net Interest Income(a) |\n| ($ in millions) | Average Balance | Revenue/Cost | Average Yield/ Rate | Average Balance | Revenue/Cost | Average Yield/ Rate | Volume | Yield/ Rate | Total |\n| Assets: |\n| Interest-earning assets: |\n| Loans and leases:(b) |\n| Commercial and industrial loans | $ | 49,263 | 882 | 3.61 | % | $ | 55,399 | 1,056 | 3.83 | % | $ | (115) | (59) | (174) |\n| Commercial mortgage loans | 10,500 | 161 | 3.09 | 11,122 | 218 | 3.94 | (12) | (45) | (57) |\n| Commercial construction loans | 6,041 | 94 | 3.15 | 5,340 | 110 | 4.15 | 13 | (29) | (16) |\n| Commercial leases | 3,152 | 48 | 3.05 | 3,128 | 54 | 3.47 | — | (6) | (6) |\n| Total commercial loans and leases | $ | 68,956 | 1,185 | 3.46 | $ | 74,989 | 1,438 | 3.86 | $ | (114) | (139) | (253) |\n| Residential mortgage loans | 21,095 | 347 | 3.32 | 17,715 | 315 | 3.58 | 56 | (24) | 32 |\n| Home equity | 4,841 | 86 | 3.59 | 5,913 | 123 | 4.16 | (22) | (15) | (37) |\n| Indirect secured consumer loans | 14,331 | 248 | 3.49 | 11,967 | 242 | 4.07 | 43 | (37) | 6 |\n| Credit card | 1,824 | 111 | 12.25 | 2,373 | 138 | 11.72 | (33) | 6 | (27) |\n| Other consumer loans | 3,027 | 91 | 6.04 | 2,842 | 100 | 7.09 | 6 | (15) | (9) |\n| Total consumer loans | $ | 45,118 | 883 | 3.95 | $ | 40,810 | 918 | 4.53 | $ | 50 | (85) | (35) |\n| Total loans and leases | $ | 114,074 | 2,068 | 3.66 | % | $ | 115,799 | 2,356 | 4.09 | % | $ | (64) | (224) | (288) |\n| Securities: |\n| Taxable | 35,932 | 537 | 3.01 | 36,395 | 564 | 3.12 | (8) | (19) | (27) |\n| Exempt from income taxes(b) | 677 | 8 | 2.39 | 159 | 3 | 3.00 | 6 | (1) | 5 |\n| Other short-term investments | 33,140 | 17 | 0.10 | 11,366 | 12 | 0.22 | 14 | (9) | 5 |\n| Total interest-earning assets | $ | 183,823 | 2,630 | 2.89 | % | $ | 163,719 | 2,935 | 3.61 | % | $ | (52) | (253) | (305) |\n| Cash and due from banks | 3,012 | 3,000 |\n| Other assets | 20,595 | 20,509 |\n| Allowance for loan and lease losses | (2,328) | (2,099) |\n| Total assets | $ | 205,102 | $ | 185,129 |\n| Liabilities and Equity: |\n| Interest-bearing liabilities: |\n| Interest checking deposits | $ | 45,437 | 14 | 0.06 | % | $ | 45,029 | 104 | 0.46 | % | $ | 1 | (91) | (90) |\n| Savings deposits | 19,727 | 2 | 0.02 | 15,534 | 7 | 0.09 | 1 | (6) | (5) |\n| Money market deposits | 30,723 | 7 | 0.05 | 28,565 | 72 | 0.51 | 5 | (70) | (65) |\n| Foreign office deposits | 134 | — | 0.04 | 196 | — | 0.35 | — | — | — |\n| Other time deposits | 2,870 | 5 | 0.36 | 4,751 | 33 | 1.40 | (10) | (18) | (28) |\n| Total interest-bearing core deposits | $ | 98,891 | 28 | 0.06 | $ | 94,075 | 216 | 0.46 | $ | (3) | (185) | (188) |\n| Certificates $100,000 and over | 1,574 | 8 | 0.98 | 3,711 | 31 | 1.71 | (13) | (10) | (23) |\n| Other deposits | — | — | — | 144 | 1 | 0.76 | (1) | — | (1) |\n| Federal funds purchased | 335 | — | 0.11 | 481 | 2 | 0.82 | (1) | (1) | (2) |\n| Other short-term borrowings | 1,153 | 1 | 0.18 | 2,063 | 8 | 0.74 | (3) | (4) | (7) |\n| Long-term debt | 14,362 | 202 | 2.84 | 16,387 | 241 | 2.95 | (30) | (9) | (39) |\n| Total interest-bearing liabilities | $ | 116,315 | 239 | 0.42 | % | $ | 116,861 | 499 | 0.86 | % | $ | (51) | (209) | (260) |\n| Demand deposits | 60,300 | 40,763 |\n| Other liabilities | 5,548 | 5,438 |\n| Total liabilities | $ | 182,163 | $ | 163,062 |\n| Total equity | $ | 22,939 | $ | 22,067 |\n| Total liabilities and equity | $ | 205,102 | $ | 185,129 |\n| Net interest income (FTE)(c) | $ | 2,391 | $ | 2,436 | $ | (1) | (44) | (45) |\n| Net interest margin (FTE)(c) | 2.62 | % | 2.99 | % |\n| Net interest rate spread (FTE)(c) | 2.47 | 2.75 |\n| Interest-bearing liabilities to interest-earning assets | 63.28 | 71.38 |\n\n(a)Changes in interest not solely due to volume or yield/rate are allocated in proportion to the absolute dollar amount of change in volume and yield/rate.\n(b)The FTE adjustments included in the above table were $6 and $7 for the six months ended June 30, 2021 and 2020, respectively.\n(c)Net interest income (FTE), net interest margin (FTE) and net interest rate spread (FTE) are non-GAAP measures. For further information, refer to the Non-GAAP Financial Measures section of MD&A.\n14\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nProvision for Credit Losses\nThe Bancorp provides, as an expense, an amount for expected credit losses within the loan and lease portfolio and the portfolio of unfunded loan commitments and letters of credit that is based on factors previously discussed in the Critical Accounting Policies section of the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020. The provision is recorded to bring the ALLL and reserve for unfunded commitments to a level deemed appropriate by the Bancorp to cover losses expected in the portfolios. Actual credit losses on loans and leases are charged against the ALLL. The amount of loans and leases actually removed from the Condensed Consolidated Balance Sheets are referred to as charge-offs. Net charge-offs include current period charge-offs less recoveries on previously charged-off loans and leases.\nThe benefit from credit losses was $115 million and $288 million for the three and six months ended June 30, 2021, respectively, compared to a provision for credit losses of $485 million and $1.1 billion during the same periods in the prior year. Provision expense decreased for the three and six months ended June 30, 2021 compared to the same periods in the prior year primarily driven by factors which caused decreases in the ACL during those periods including improved economic forecasts, improved commercial and consumer credit quality and lower period-end loan and lease balances. Provision expense was elevated in 2020 as the Bancorp increased its ACL in response to deterioration and uncertainty in the macroeconomic environment as a result of the impact of the COVID-19 pandemic, continued pressure on energy prices and the resulting impact of these factors on commercial borrowers as reflected in increased levels of commercial criticized assets. In the first and second quarters of 2021, the Bancorp decreased the ACL, reflecting credit quality and stabilization in the macroeconomic environment, aided by fiscal and monetary stimulus programs as well as the easing of government-imposed restrictions related to the COVID-19 pandemic.\nThe ALLL decreased $420 million from December 31, 2020 to $2.0 billion at June 30, 2021. At June 30, 2021, the ALLL as a percent of portfolio loans and leases decreased to 1.89%, compared to 2.25% at December 31, 2020. The reserve for unfunded commitments increased $17 million from December 31, 2020 to $189 million at June 30, 2021. The ACL as a percent of portfolio loans and leases decreased to 2.06% at June 30, 2021, compared to 2.41% at December 31, 2020.\nRefer to the Credit Risk Management subsection of the Risk Management section of MD&A as well as Note 6 of the Notes to Condensed Consolidated Financial Statements for more detailed information on the provision for credit losses, including an analysis of loan and lease portfolio composition, nonperforming assets, net charge-offs and other factors considered by the Bancorp in assessing the credit quality of the loan and lease portfolio and determining the level of the ACL.\nNoninterest Income\nNoninterest income increased $91 million and $169 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020.\nThe following table presents the components of noninterest income:\n| TABLE 8: Components of Noninterest Income |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | % Change | 2021 | 2020 | % Change |\n| Commercial banking revenue | $ | 160 | 137 | 17 | $ | 313 | 261 | 20 |\n| Service charges on deposits | 149 | 122 | 22 | 292 | 270 | 8 |\n| Wealth and asset management revenue | 145 | 120 | 21 | 288 | 255 | 13 |\n| Card and processing revenue | 102 | 82 | 24 | 196 | 167 | 17 |\n| Mortgage banking net revenue | 64 | 99 | (35) | 149 | 219 | (32) |\n| Leasing business revenue | 61 | 57 | 7 | 148 | 131 | 13 |\n| Other noninterest income | 49 | 12 | 308 | 92 | 18 | 411 |\n| Securities gains (losses), net | 10 | 21 | (52) | 13 | (3) | NM |\n| Securities (losses) gains, net – non-qualifying hedges on mortgage servicing rights | 1 | — | NM | (1) | 3 | NM |\n| Total noninterest income | $ | 741 | 650 | 14 | $ | 1,490 | 1,321 | 13 |\n\nCommercial banking revenue\nCommercial banking revenue increased $23 million and $52 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020. The increase for the three months ended June 30, 2021 compared to the same period in the prior year was primarily driven by increases in loan syndication fees and business lending fees of $20 million and $10 million, respectively, partially offset by a decrease in institutional sales of $10 million. The increase for the six months ended June 30, 2021 compared to the same period in the prior year was primarily due to increases in loan syndication fees, business lending fees and institutional sales of $29 million, $14 million and $12 million, respectively, partially offset by a decrease in contract revenue from commercial customer derivatives of $7 million.\n15\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nService charges on deposits\nService charges on deposits increased $27 million and $22 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020. The increase for the three months ended June 30, 2021 compared to the same period in the prior year was due to increases in commercial deposit fees and consumer deposit fees of $17 million and $10 million, respectively. The increase for the six months ended June 30, 2021 compared to the same period in the prior year was primarily due to an increase of $22 million in commercial deposit fees.\nWealth and asset management revenue\nWealth and asset management revenue increased $25 million and $33 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in private client service fees of $19 million and $28 million, respectively, and broker income of $10 million and $14 million, respectively. These increases were partially offset by decreases in institutional fees of $4 million and $7 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020. The Bancorp’s trust and registered investment advisory businesses had approximately $483 billion and $405 billion in total assets under care as of June 30, 2021 and 2020, respectively, and managed $61 billion and $49 billion in assets for individuals, corporations and not-for-profit organizations as of June 30, 2021 and 2020, respectively.\nCard and processing revenue\nCard and processing revenue increased $20 million and $29 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020 primarily due to an increase in debit and credit card interchange, partially offset by increased reward costs, all of which were driven by an increase in consumer and business card spend volume.\nMortgage banking net revenue\nMortgage banking net revenue decreased $35 million and $70 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020 primarily due to lower net mortgage servicing revenue.\nThe following table presents the components of mortgage banking net revenue:\n| TABLE 9: Components of Mortgage Banking Net Revenue |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Origination fees and gains on loan sales | $ | 81 | 95 | 170 | 176 |\n| Net mortgage servicing revenue: |\n| Gross mortgage servicing fees | 59 | 63 | 117 | 130 |\n| Net valuation adjustments on MSRs and free-standing derivatives purchased to economically hedge MSRs | (76) | (59) | (138) | (87) |\n| Net mortgage servicing revenue | (17) | 4 | (21) | 43 |\n| Total mortgage banking net revenue | $ | 64 | 99 | 149 | 219 |\n\nOrigination fees and gains on loan sales decreased $14 million and $6 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020 primarily driven by decreases in gain on sale margins partially offset by gains from sales of loans that were previously repurchased from GNMA. Residential mortgage loan originations increased to $5.0 billion and $9.7 billion for the three and six months ended June 30, 2021, respectively, from $3.4 billion and $7.4 billion for the three and six months ended June 30, 2020, respectively.\nNet mortgage servicing revenue decreased $21 million and $64 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020 primarily due to increases in net negative valuation adjustments of $17 million and $51 million, respectively, as well as decreases in gross mortgage servicing fees of $4 million and $13 million, respectively. Refer to Table 10 for the components of net valuation adjustments on the MSR portfolio and the impact of the non-qualifying hedging strategy.\n16\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\n| TABLE 10: Components of Net Valuation Adjustments on MSRs |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Changes in fair value and settlement of free-standing derivatives purchased to economically hedge the MSR portfolio | $ | 46 | 11 | (88) | 361 |\n| Changes in fair value: |\n| Due to changes in inputs or assumptions(a) | (49) | (12) | 103 | (343) |\n| Other changes in fair value(b) | (73) | (58) | (153) | (105) |\n| Net valuation adjustments on MSRs and free-standing derivatives purchased to economically hedge MSRs | $ | (76) | (59) | (138) | (87) |\n\n(a)Primarily reflects changes in prepayment speed and OAS assumptions which are updated based on market interest rates.\n(b)Primarily reflects changes due to realized cash flows and the passage of time.\nFor the three and six months ended June 30, 2021, the Bancorp recognized losses of $122 million and $50 million, respectively, in mortgage banking net revenue for valuation adjustments on the MSR portfolio. The valuation adjustments on the MSR portfolio included a decrease of $49 million for the three months ended June 30, 2021 and an increase of $103 million for the six months ended June 30, 2021 due to changes in market rates and other inputs in the valuation model, including future prepayment speeds and OAS assumptions. For the three months ended June 30, 2021, a decrease in mortgage rates caused modeled prepayment speeds to rise. For the six months ended June 30, 2021, an increase in mortgage rates resulted in a reduction to modeled prepayment speeds, and a tightening of the spread between mortgage rates and swap rates resulted in a decrease in the modeled OAS assumptions. The fair value of the MSR portfolio also decreased $73 million and $153 million as a result of contractual principal payments and actual prepayment activity for the three and six months ended June 30, 2021, respectively.\nMortgage rates decreased during both the three and six months ended June 30, 2020, which caused modeled prepayment speeds to rise. The fair value of the MSR portfolio decreased $12 million and $343 million for the three and six months ended June 30, 2020, respectively, due to changes to inputs to the valuation model including prepayment speeds and OAS assumptions and decreased $58 million and $105 million for the three and six months ended June 30, 2020, respectively, due to the impact of contractual principal payments and actual prepayment activity.\nFurther detail on the valuation of MSRs can be found in Note 12 of the Notes to Condensed Consolidated Financial Statements. The Bancorp maintains a non-qualifying hedging strategy to manage a portion of the risk associated with changes in the valuation of the MSR portfolio. Refer to Note 13 of the Notes to Condensed Consolidated Financial Statements for more information on the free-standing derivatives used to economically hedge the MSR portfolio.\nIn addition to the derivative positions used to economically hedge the MSR portfolio, the Bancorp acquires various securities as a component of its non-qualifying hedging strategy. The Bancorp recognized net gains of $1 million and net losses of $1 million during the three and six months ended June 30, 2021, respectively, compared to net gains of an immaterial amount and $3 million during the three and six months ended June 30, 2020, respectively, recorded in securities (losses) gains, net – non-qualifying hedges on mortgage servicing rights in the Bancorp’s Condensed Consolidated Statements of Income.\nThe Bancorp’s total residential mortgage loans serviced as of June 30, 2021 and 2020 were $93.0 billion and $95.4 billion, respectively, with $71.5 billion and $78.8 billion, respectively, of residential mortgage loans serviced for others.\nLeasing business revenue\nLeasing business revenue increased $4 million and $17 million for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020. The increase for the three months ended June 30, 2021 compared to the same period in the prior year was primarily due to increases in lease remarketing fees and leasing business solutions revenue of $3 million and $2 million respectively. The increase for the six months ended June 30, 2021 compared to the same period in the prior year was primarily due to an increase of $39 million in lease syndication fees, partially offset by a decrease of $22 million in lease remarketing fees.\n17\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nOther noninterest income\nThe following table presents the components of other noninterest income:\n| TABLE 11: Components of Other Noninterest Income |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| BOLI income | $ | 15 | 17 | 31 | 32 |\n| Cardholder fees | 13 | 10 | 25 | 21 |\n| Equity method investment income | 14 | — | 21 | 3 |\n| Private equity investment income (loss) | 20 | 6 | 19 | (8) |\n| Banking center income | 6 | 4 | 11 | 10 |\n| Consumer loan fees | 4 | 5 | 8 | 10 |\n| Insurance income | 2 | 4 | 3 | 10 |\n| Loss on swap associated with the sale of Visa, Inc. Class B Shares | (37) | (29) | (50) | (51) |\n| Net losses on disposition and impairment of bank premises and equipment | (1) | (12) | (1) | (15) |\n| Other, net | 13 | 7 | 25 | 6 |\n| Total other noninterest income | $ | 49 | 12 | 92 | 18 |\n\nOther noninterest income increased $37 million for the three months ended June 30, 2021 compared to the three months ended June 30, 2020 primarily due to increases in private equity investment income and equity method investment income as well as a decrease in net losses on disposition and impairment of bank premises and equipment, partially offset by an increase in the loss on the swap associated with the sale of Visa, Inc. Class B Shares.\nPrivate equity investment income increased $14 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily driven by the recognition of positive net valuation adjustments on certain private equity investments during the three months ended June 30, 2021. Equity method investment income increased $14 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to gains and proportional earnings recognized on certain equity method investments during the three months ended June 30, 2021. Net losses on disposition and impairment of bank premises and equipment decreased $11 million for the three months ended June 30, 2021 compared to the three months ended June 30, 2020 driven by the impact of impairment charges of $2 million during the three months ended June 30, 2021 compared to $12 million during the three months ended June 30, 2020. For additional information, refer to Note 7 of the Notes to Condensed Consolidated Financial Statements. The Bancorp recognized negative valuation adjustments of $37 million related to the Visa total return swap during the three months ended June 30, 2021 compared to negative valuation adjustments of $29 million during the three months ended June 30, 2020. For additional information on the valuation of the swap associated with the sale of Visa, Inc. Class B Shares, refer to Note 21 of the Notes to Condensed Consolidated Financial Statements.\nOther noninterest income increased $74 million for the six months ended June 30, 2021 compared to the six months ended June 30, 2020 primarily due to increases in private equity investment income and equity method investment income and a decrease in net losses on disposition and impairment of bank premises and equipment, partially offset by a decrease in insurance income.\nPrivate equity investment income increased $27 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily driven by the recognition of positive net valuation adjustments on certain private equity investments during the six months ended June 30, 2021 and the impact of impairment charges recognized on certain private equity investments during the six months ended June 30, 2020. For additional information on the valuation of private equity investments, refer to Note 21 of the Notes to Condensed Consolidated Financial Statements. Equity method investment income increased $18 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to gains and proportional earnings recognized on certain equity method investments during the six months ended June 30, 2021. Net losses on disposition and impairment of bank premises and equipment decreased $14 million for the six months ended June 30, 2021 compared to the six months ended June 30, 2020 driven by the impact of impairment charges of $4 million during the six months ended June 30, 2021 compared to $14 million during the six months ended June 30, 2020. For additional information, refer to Note 7 of the Notes to Condensed Consolidated Financial Statements. Insurance income decreased $7 million for the six months ended June 30, 2021 compared to the same period in the prior year driven by the sale of the Bancorp’s property and casualty insurance business in the fourth quarter of 2020.\n18\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nNoninterest Expense\nNoninterest expense increased $32 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to increases in other noninterest expense and compensation and benefits expense, partially offset by decreases in card and processing expense and net occupancy expense. Noninterest expense increased $48 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to an increase in compensation and benefits expense, partially offset by decreases in card and processing expense, net occupancy expense and marketing expense.\nThe following table presents the components of noninterest expense:\n| TABLE 12: Components of Noninterest Expense |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | % Change | 2021 | 2020 | % Change |\n| Compensation and benefits | $ | 638 | 627 | 2 | $ | 1,343 | 1,274 | 5 |\n| Technology and communications | 94 | 90 | 4 | 187 | 183 | 2 |\n| Net occupancy expense | 77 | 82 | (6) | 156 | 164 | (5) |\n| Equipment expense | 34 | 32 | 6 | 68 | 64 | 6 |\n| Leasing business expense | 33 | 33 | — | 68 | 68 | — |\n| Card and processing expense | 20 | 29 | (31) | 50 | 60 | (17) |\n| Marketing expense | 20 | 20 | — | 43 | 51 | (16) |\n| Other noninterest expense | 237 | 208 | 14 | 454 | 457 | (1) |\n| Total noninterest expense | $ | 1,153 | 1,121 | 3 | $ | 2,369 | 2,321 | 2 |\n| Efficiency ratio on an FTE basis(a) | 59.1 | % | 60.5 | 61.0 | % | 61.8 |\n\n(a)This is a non-GAAP measure. For further information, refer to the Non-GAAP Financial Measures section of MD&A.\nCompensation and benefits expense increased $11 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to an increase in performance-based compensation. Compensation and benefits expense increased $69 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to an increase in non-qualified deferred compensation expense and performance-based compensation. Full-time equivalent employees totaled 19,402 at June 30, 2021 compared to 20,340 at June 30, 2020.\nCard and processing expense decreased $9 million and $10 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to contract renegotiations with a third-party vendor. Net occupancy expense decreased $5 million and $8 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to a reduction of leased square footage. Marketing expense decreased $8 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to the impact of the COVID-19 pandemic, which resulted in a pause or slowdown in numerous marketing campaigns, including running less advertising, as well as the suspension of cash bonuses and other account acquisition programs.\n19\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following table presents the components of other noninterest expense:\n| TABLE 13: Components of Other Noninterest Expense |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Loan and lease | $ | 55 | 40 | 104 | 75 |\n| FDIC insurance and other taxes | 30 | 24 | 58 | 49 |\n| Data processing | 20 | 17 | 40 | 35 |\n| Professional service fees | 16 | 13 | 32 | 23 |\n| Losses and adjustments | 23 | 17 | 30 | 71 |\n| Intangible amortization | 10 | 12 | 21 | 25 |\n| Postal and courier | 9 | 8 | 18 | 18 |\n| Travel | 7 | 4 | 10 | 19 |\n| Recruitment and education | 5 | 5 | 10 | 11 |\n| Insurance | 4 | 3 | 8 | 7 |\n| Supplies | 3 | 3 | 5 | 7 |\n| Donations | 3 | 4 | 5 | 7 |\n| Other, net | 52 | 58 | 113 | 110 |\n| Total other noninterest expense | $ | 237 | 208 | 454 | 457 |\n\nOther noninterest expense increased $29 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to increases in loan and lease expense, losses and adjustments and FDIC insurance and other taxes. Other noninterest expense decreased $3 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to decreases in losses and adjustments and travel expense, partially offset by increases in loan and lease expense, FDIC insurance and other taxes and professional service fees.\nLoan and lease expense increased $15 million and $29 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to an increase in loan servicing expenses associated with the Bancorp’s purchases of certain government-guaranteed residential mortgage loans in forbearance programs. FDIC insurance and other taxes increased $6 million and $9 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily as a result of an increase in the assessment rate due to a change in asset mix as well as an increase in the assessment base.\nLosses and adjustments increased $6 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to an increase in legal settlements, partially offset by a decline in credit valuation adjustments on derivatives associated with customer accommodation contracts. Losses and adjustments decreased $41 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to a decline in credit valuation adjustments on derivatives associated with customer accommodation contracts, partially offset by an increase in legal settlements.\nTravel expense decreased $9 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily due to reduced business travel as a direct result of the COVID-19 pandemic.\nProfessional service fees increased $9 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily driven by increases in consulting fees and legal fees.\nApplicable Income Taxes\nThe Bancorp’s income before income taxes, applicable income tax expense and effective tax rate are as follows:\n| TABLE 14: Applicable Income Taxes |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Income before income taxes | $ | 911 | 244 | 1,794 | 304 |\n| Applicable income tax expense | 202 | 49 | 391 | 61 |\n| Effective tax rate | 22.1 | % | 19.9 | 21.8 | 20.4 |\n\nApplicable income tax expense for all periods presented includes the benefit from tax-exempt income, tax-advantaged investments, and tax credits (and other related tax benefits), partially offset by the effect of proportional amortization of qualifying LIHTC investments and certain nondeductible expenses. The tax credits are primarily associated with the Low-Income Housing Tax Credit program established under\n20\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nSection 42 of the IRC, the New Markets Tax Credit program established under Section 45D of the IRC, the Rehabilitation Investment Tax Credit program established under Section 47 of the IRC and the Qualified Zone Academy Bond program established under Section 1397E of the IRC.\nThe effective tax rate increased to 22.1% and 21.8% for the three and six months ended June 30, 2021, respectively, from 19.9% and 20.4% for the same periods in the prior year primarily related to an increase in forecasted income before income taxes.\n21\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nBALANCE SHEET ANALYSIS\nLoans and Leases\nThe Bancorp classifies its commercial loans and leases based upon primary purpose and consumer loans based upon product or collateral. Table 15 summarizes end of period loans and leases, including loans and leases held for sale and Table 16 summarizes average total loans and leases, including average loans and leases held for sale.\n| TABLE 15: Components of Total Loans and Leases (including loans and leases held for sale) |\n| June 30, 2021 | December 31, 2020 |\n| As of ($ in millions) | Carrying Value | % of Total | Carrying Value | % of Total |\n| Commercial loans and leases: |\n| Commercial and industrial loans(a) | $ | 47,575 | 42 | % | $ | 49,895 | 44 | % |\n| Commercial mortgage loans | 10,380 | 9 | 10,609 | 9 |\n| Commercial construction loans | 5,873 | 5 | 5,815 | 5 |\n| Commercial leases | 3,238 | 3 | 2,954 | 3 |\n| Total commercial loans and leases | $ | 67,066 | 59 | $ | 69,273 | 61 |\n| Consumer loans: |\n| Residential mortgage loans(b) | 21,815 | 19 | 20,393 | 18 |\n| Home equity | 4,545 | 4 | 5,183 | 4 |\n| Indirect secured consumer loans | 15,192 | 13 | 13,653 | 12 |\n| Credit card | 1,793 | 2 | 2,007 | 2 |\n| Other consumer loans | 3,052 | 3 | 3,014 | 3 |\n| Total consumer loans | $ | 46,397 | 41 | $ | 44,250 | 39 |\n| Total loans and leases | $ | 113,463 | 100 | % | $ | 113,523 | 100 | % |\n| Total portfolio loans and leases (excluding loans and leases held for sale) | $ | 107,733 | $ | 108,782 |\n\n(a)Includes $3.7 billion and $4.8 billion as of June 30, 2021 and December 31, 2020, respectively, related to the SBA’s Paycheck Protection Program.\n(b)Includes $39 as of December 31, 2020 of residential mortgage loans previously sold to GNMA for which the Bancorp was deemed to have regained effective control over under ASC Topic 860, but did not exercise its option to repurchase. Refer to Note 14 for further information.\nTotal loans and leases, including loans and leases held for sale, decreased $60 million from December 31, 2020. The decrease from December 31, 2020 was the result of a $2.2 billion, or 3%, decrease in commercial loans and leases, partially offset by a $2.1 billion, or 5%, increase in consumer loans.\nCommercial loans and leases decreased $2.2 billion from December 31, 2020 due to decreases in commercial and industrial loans and commercial mortgage loans, partially offset by increases in commercial leases and commercial construction loans. Commercial and industrial loans decreased $2.3 billion, or 5%, from December 31, 2020 primarily as a result of PPP loan forgiveness and paydowns in excess of loan originations. Commercial mortgage loans decreased $229 million, or 2%, from December 31, 2020 as payoffs exceeded loan originations. Commercial leases increased $284 million, or 10%, from December 31, 2020 primarily as a result of an increase in lease originations. Commercial construction loans increased $58 million, or 1%, from December 31, 2020 as draws on existing commitments exceeded payoffs.\nConsumer loans increased $2.1 billion from December 31, 2020 due to increases in indirect secured consumer loans, residential mortgage loans and other consumer loans, partially offset by decreases in home equity and credit card. Indirect secured consumer loans increased $1.5 billion, or 11%, from December 31, 2020 primarily as a result of loan production exceeding payoffs. Residential mortgage loans increased $1.4 billion, or 7%, from December 31, 2020 primarily due to increases in residential mortgage loans held for sale as the Bancorp purchased government-guaranteed loans in forbearance programs. Other consumer loans increased $38 million, or 1%, from December 31, 2020 primarily as a result of the purchase of a portfolio of point-of-sale loans. Home equity decreased $638 million, or 12%, from December 31, 2020 as payoffs exceeded loan originations. Credit card decreased $214 million, or 11%, from December 31, 2020 primarily due to seasonal paydowns on year-end balances as well as continuing impacts from the COVID-19 pandemic, including accelerated paydown activity driven by the amount of fiscal stimulus programs.\n22\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\n| TABLE 16: Components of Average Loans and Leases (including average loans and leases held for sale) |\n| June 30, 2021 | June 30, 2020 |\n| For the three months ended ($ in millions) | Carrying Value | % of Total | Carrying Value | % of Total |\n| Commercial loans and leases: |\n| Commercial and industrial loans | $ | 48,817 | 43 | % | $ | 59,106 | 49 | % |\n| Commercial mortgage loans | 10,467 | 9 | 11,224 | 9 |\n| Commercial construction loans | 6,043 | 5 | 5,548 | 5 |\n| Commercial leases | 3,174 | 3 | 3,056 | 3 |\n| Total commercial loans and leases | $ | 68,501 | 60 | $ | 78,934 | 66 |\n| Consumer loans: |\n| Residential mortgage loans | 21,740 | 19 | 17,405 | 15 |\n| Home equity | 4,674 | 4 | 5,820 | 5 |\n| Indirect secured consumer loans | 14,702 | 13 | 12,124 | 10 |\n| Credit card | 1,770 | 2 | 2,248 | 2 |\n| Other consumer loans | 3,056 | 2 | 2,887 | 2 |\n| Total consumer loans | $ | 45,942 | 40 | $ | 40,484 | 34 |\n| Total average loans and leases | $ | 114,443 | 100 | % | $ | 119,418 | 100 | % |\n| Total average portfolio loans and leases (excluding loans and leases held for sale) | $ | 108,534 | $ | 118,506 |\n\nAverage loans and leases, including average loans and leases held for sale, decreased $5.0 billion, or 4%, for the three months ended June 30, 2021 compared to the same period in the prior year as a result of a $10.4 billion, or 13%, decrease in average commercial loans and leases, partially offset by a $5.5 billion, or 13%, increase in average consumer loans.\nAverage commercial loans and leases decreased $10.4 billion for the three months ended June 30, 2021 compared to the same period in the prior year due to decreases in average commercial and industrial loans and average commercial mortgage loans, partially offset by increases in average commercial construction loans and average commercial leases. Average commercial and industrial loans decreased $10.3 billion, or 17%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily driven by continued paydowns on revolving lines of credit, partially offset by PPP loans originated since June of 2020. Average commercial mortgage loans decreased $757 million, or 7%, for the three months ended June 30, 2021 compared to the same period in the prior year as payoffs exceeded loan originations. Average commercial construction loans increased $495 million, or 9%, for the three months ended June 30, 2021 compared to the same period in the prior year as draws on existing commitments exceeded payoffs. Average commercial leases increased $118 million, or 4%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily as a result of an increase in lease originations.\nAverage consumer loans increased $5.5 billion for the three months ended June 30, 2021 compared to the same period in the prior year due to increases in average residential mortgage loans, average indirect secured consumer loans and average other consumer loans, partially offset by decreases in average home equity and average credit card. Average residential mortgage loans increased $4.3 billion, or 25%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to increases in residential mortgage loans held for sale as the Bancorp purchased government-guaranteed loans in forbearance programs, partially offset by higher runoff due to payoffs exceeding loan originations. Average indirect secured consumer loans increased $2.6 billion, or 21%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to loan production exceeding payoffs. Average other consumer loans increased $169 million, or 6%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily as a result of purchases of portfolios of point-of-sale loans. Average home equity decreased $1.1 billion, or 20%, for the three months ended June 30, 2021 compared to the same period in the prior year as payoffs exceeded loan originations. Average credit card decreased $478 million, or 21%, for the three months ended June 30, 2021 compared to the same period in the prior year driven by continuing impacts from the COVID-19 pandemic, including accelerated paydown activity driven by the amount of fiscal stimulus.\nInvestment Securities\nThe Bancorp uses investment securities as a means of managing interest rate risk, providing collateral for pledging purposes and for liquidity risk management. Total investment securities were $39.1 billion and $38.4 billion at June 30, 2021 and December 31, 2020, respectively. The taxable available-for-sale debt and other investment securities portfolio had an effective duration of 4.9 at June 30, 2021 compared to 4.4 at December 31, 2020.\nDebt securities are classified as available-for-sale when, in management’s judgment, they may be sold in response to, or in anticipation of, changes in market conditions. Securities that management has the intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized cost. Debt securities are classified as trading when bought and held principally for the purpose of selling them in the near term. At June 30, 2021, the Bancorp’s investment portfolio consisted primarily of AAA-rated available-for-sale debt and other securities. The Bancorp held an immaterial amount in below-investment grade available-for-sale debt and other securities at both June 30, 2021 and December 31, 2020. In the first quarter of 2021, the Bancorp recognized $7 million of impairment losses on its available-for-sale debt and\n23\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nother securities, included in securities gains (losses), net, in the Condensed Consolidated Statements of Income. These losses related to certain securities in unrealized loss positions that the Bancorp intended to sell prior to recovery of their amortized cost bases. The Bancorp did not consider these losses to be credit-related.\nAt both June 30, 2021 and December 31, 2020, the Bancorp completed its evaluation of the available-for-sale debt and other securities in an unrealized loss position and did not recognize an allowance for credit losses. The Bancorp did not recognize provision expense related to available-for-sale debt and other securities in an unrealized loss position during both the three and six months ended June 30, 2021 and June 30, 2020.\nThe following table summarizes the end of period components of investment securities:\n| TABLE 17: Components of Investment Securities |\n| As of ($ in millions) | June 30,2021 | December 31, 2020 |\n| Available-for-sale debt and other securities (amortized cost basis): |\n| U.S. Treasury and federal agencies securities | $ | 105 | 74 |\n| Obligations of states and political subdivisions securities | 18 | 17 |\n| Mortgage-backed securities: |\n| Agency residential mortgage-backed securities | 10,256 | 11,147 |\n| Agency commercial mortgage-backed securities | 18,142 | 16,745 |\n| Non-agency commercial mortgage-backed securities | 3,276 | 3,323 |\n| Asset-backed securities and other debt securities | 3,764 | 3,152 |\n| Other securities(a) | 520 | 524 |\n| Total available-for-sale debt and other securities | $ | 36,081 | 34,982 |\n| Held-to-maturity securities (amortized cost basis): |\n| Obligations of states and political subdivisions securities | $ | 9 | 9 |\n| Asset-backed securities and other debt securities | 1 | 2 |\n| Total held-to-maturity securities | $ | 10 | 11 |\n| Trading debt securities (fair value): |\n| U.S. Treasury and federal agencies securities | $ | 96 | 81 |\n| Obligations of states and political subdivisions securities | 63 | 10 |\n| Agency residential mortgage-backed securities | 69 | 30 |\n| Asset-backed securities and other debt securities | 483 | 439 |\n| Total trading debt securities | $ | 711 | 560 |\n| Total equity securities (fair value) | $ | 341 | 313 |\n\n(a)Other securities consist of FHLB, FRB and DTCC restricted stock holdings of $33, $485 and $2, respectively, at June 30, 2021 and $40, $482 and $2, respectively, at December 31, 2020, that are carried at cost.\nOn an amortized cost basis, available-for-sale debt and other securities increased $1.1 billion from December 31, 2020 primarily due to increases in agency commercial mortgage-backed securities and asset-backed securities and other debt securities, partially offset by a decrease in agency residential mortgage-backed securities.\nOn an amortized cost basis, available-for-sale debt and other securities were 20% and 19% of total interest-earning assets at June 30, 2021 and December 31, 2020, respectively. The estimated weighted-average life of the debt securities in the available-for-sale debt and other securities portfolio was 6.3 years at June 30, 2021 compared to 5.7 years at December 31, 2020. In addition, at June 30, 2021, the debt securities in the available-for-sale debt and other securities portfolio had a weighted-average yield of 2.88% compared to 3.05% at December 31, 2020.\nInformation presented in Table 18 is on a weighted-average life basis, anticipating future prepayments. Yield information is presented on an FTE basis and is computed using amortized cost balances and reflects the impact of prepayments. Maturity and yield calculations for the total available-for-sale debt and other securities portfolio exclude other securities that have no stated yield or maturity. Total net unrealized gains on the available-for-sale debt and other securities portfolio were $1.9 billion at June 30, 2021 compared to $2.5 billion at December 31, 2020. The fair value of investment securities is impacted by interest rates, credit spreads, market volatility and liquidity conditions. The fair value of investment securities generally increases when interest rates decrease or when credit spreads contract.\n24\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\n| TABLE 18: Characteristics of Available-for-Sale Debt and Other Securities |\n| As of June 30, 2021 ($ in millions) | Amortized Cost | Fair Value | Weighted-Average Life(in years) | Weighted-Average Yield |\n| U.S. Treasury and federal agencies securities: |\n| Average life of 1 year or less | $ | 30 | 30 | 0.1 | 0.02 | % |\n| Average life 1 – 5 years | 75 | 77 | 1.6 | 2.16 |\n| Total | $ | 105 | 107 | 1.2 | 2.05 | % |\n| Obligations of states and political subdivisions securities: |\n| Average life 1 – 5 years | 17 | 17 | 1.7 | 1.80 |\n| Average life greater than 10 years | 1 | 1 | 15.4 | 7.00 |\n| Total | $ | 18 | 18 | 2.5 | 2.12 | % |\n| Agency residential mortgage-backed securities: |\n| Average life of 1 year or less | 427 | 434 | 0.5 | 3.60 |\n| Average life 1 – 5 years | 4,471 | 4,665 | 3.4 | 3.08 |\n| Average life 5 – 10 years | 4,570 | 4,864 | 6.6 | 3.02 |\n| Average life greater than 10 years | 788 | 846 | 13.3 | 2.92 |\n| Total | $ | 10,256 | 10,809 | 5.5 | 3.06 | % |\n| Agency commercial mortgage-backed securities:(a) |\n| Average life of 1 year or less | 422 | 436 | 0.6 | 3.90 |\n| Average life 1 – 5 years | 6,293 | 6,661 | 2.9 | 3.31 |\n| Average life 5 – 10 years | 6,309 | 6,852 | 6.9 | 3.11 |\n| Average life greater than 10 years | 5,118 | 5,345 | 13.9 | 2.18 |\n| Total | $ | 18,142 | 19,294 | 7.4 | 2.94 | % |\n| Non-agency commercial mortgage-backed securities: |\n| Average life of 1 year or less | 7 | 7 | 0.4 | 2.58 |\n| Average life 1 – 5 years | 2,733 | 2,906 | 3.3 | 3.28 |\n| Average life 5 – 10 years | 526 | 556 | 7.0 | 2.59 |\n| Average life greater than 10 years | 10 | 10 | 10.0 | 2.40 |\n| Total | $ | 3,276 | 3,479 | 3.9 | 3.16 | % |\n| Asset-backed securities and other debt securities: |\n| Average life of 1 year or less | 342 | 342 | 0.5 | 3.19 |\n| Average life 1 – 5 years | 1,600 | 1,613 | 3.3 | 2.16 |\n| Average life 5 – 10 years | 1,256 | 1,254 | 6.9 | 1.47 |\n| Average life greater than 10 years | 566 | 576 | 14.8 | 1.43 |\n| Total | $ | 3,764 | 3,785 | 6.0 | 1.91 | % |\n| Other securities | 520 | 520 |\n| Total available-for-sale debt and other securities | $ | 36,081 | 38,012 | 6.3 | 2.88 | % |\n\n(a)Taxable-equivalent yield adjustments included in the above table are 0.05% and 0.01% for securities with an average life greater than 10 years and in total, respectively.\nOther Short-Term Investments\nOther short-term investments primarily include overnight interest-earning investments, including reserves held at the FRB. The Bancorp uses other short-term investments as part of its liquidity risk management tools. Other short-term investments were $32.4 billion and $33.4 billion at June 30, 2021 and December 31, 2020, respectively. The decrease of $990 million from December 31, 2020 was primarily due to wholesale funding maturities during the six months ended June 30, 2021.\nDeposits\nThe Bancorp’s deposit balances represent an important source of funding and revenue growth opportunity. The Bancorp continues to focus on core deposit growth in its retail and commercial franchises by improving customer satisfaction, building full relationships and offering competitive rates. Average core deposits represented 78% and 74% of the Bancorp’s average asset funding base for the three months ended June 30, 2021 and 2020, respectively.\n25\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following table presents the end of period components of deposits:\n| TABLE 19: Components of Deposits |\n| June 30, 2021 | December 31, 2020 |\n| As of ($ in millions) | Balance | % of Total | Balance | % of Total |\n| Demand | $ | 62,760 | 39 | % | $ | 57,711 | 36 | % |\n| Interest checking | 44,872 | 27 | 47,270 | 30 |\n| Savings | 20,667 | 13 | 18,258 | 12 |\n| Money market | 30,564 | 19 | 30,650 | 19 |\n| Foreign office | 152 | — | 143 | — |\n| Total transaction deposits | $ | 159,015 | 98 | $ | 154,032 | 97 |\n| Other time | 2,408 | 1 | 3,023 | 2 |\n| Total core deposits | $ | 161,423 | 99 | $ | 157,055 | 99 |\n| Certificates $100,000 and over(a) | 860 | 1 | 2,026 | 1 |\n| Total deposits | $ | 162,283 | 100 | % | $ | 159,081 | 100 | % |\n\n(a)Includes $310 million and $1.3 billion of institutional, retail and wholesale certificates $250,000 and over at June 30, 2021 and December 31, 2020, respectively.\nCore deposits increased $4.4 billion, or 3%, from December 31, 2020 as a result of an increase in transaction deposits, partially offset by a decrease in other time deposits. Transaction deposits increased $5.0 billion, or 3%, from December 31, 2020 primarily due to increases in demand deposits and savings deposits, partially offset by a decrease in interest checking deposits. Demand deposits increased $5.0 billion, or 9%, from December 31, 2020 primarily as a result of customers maintaining increased levels of liquidity driven by the amount of fiscal and monetary stimulus, as well as growth in the number of accounts and migration of balances from interest checking deposits during the six months ended June 30, 2021. Savings deposits increased $2.4 billion, or 13%, from December 31, 2020 primarily as a result of higher balances per customer account due to the amount of fiscal stimulus as well as decreased consumer spending. Interest checking deposits decreased $2.4 billion, or 5%, from December 31, 2020 primarily as a result of lower balances per commercial customer account as well as the aforementioned balance migration into demand deposits during the six months ended June 30, 2021. Other time deposits decreased $615 million, or 20%, from December 31, 2020 primarily due to lower offering rates on certificates less than $100,000.\nCertificates $100,000 and over decreased $1.2 billion, or 58%, from December 31, 2020 primarily due to maturities which were not replaced with new issuances given current market conditions and liquidity levels.\nThe following table presents the components of average deposits for the three months ended:\n| TABLE 20: Components of Average Deposits |\n| June 30, 2021 | June 30, 2020 |\n| ($ in millions) | Balance | % of Total | Balance | % of Total |\n| Demand | $ | 61,994 | 38 | % | $ | 45,761 | 30 | % |\n| Interest checking | 45,307 | 28 | 49,760 | 33 |\n| Savings | 20,494 | 12 | 16,354 | 11 |\n| Money market | 30,844 | 19 | 30,022 | 20 |\n| Foreign office | 140 | — | 182 | — |\n| Total transaction deposits | $ | 158,779 | 97 | $ | 142,079 | 94 |\n| Other time | 2,696 | 2 | 4,421 | 3 |\n| Total core deposits | $ | 161,475 | 99 | $ | 146,500 | 97 |\n| Certificates $100,000 and over(a) | 1,144 | 1 | 4,067 | 3 |\n| Other deposits | — | — | 31 | — |\n| Total average deposits | $ | 162,619 | 100 | % | $ | 150,598 | 100 | % |\n\n(a)Includes $326 million and $3.2 billion of average institutional, retail and wholesale certificates $250,000 and over for the three months ended June 30, 2021 and 2020, respectively.\nOn an average basis, core deposits increased $15.0 billion, or 10%, for the three months ended June 30, 2021 compared to the same period in the prior year due to an increase of $16.7 billion, or 12%, in average transaction deposits, partially offset by a decrease of $1.7 billion, or 39%, in average other time deposits. The increase in average transaction deposits was driven primarily by increases in average demand deposits, average savings deposits and average money market deposits, partially offset by a decrease in average interest checking deposits. Average demand deposits increased $16.2 billion, or 35%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily as a result of commercial customers maintaining increased levels of liquidity driven by the amount of fiscal and monetary stimulus, as well as growth in the number of accounts and migration of balances from interest checking deposits. Average savings deposits increased $4.1 billion, or 25%, and average money market deposits increased $822 million, or 3%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily as a result of higher average balances per customer account due to the amount of\n26\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nfiscal stimulus, uncertainty regarding the COVID-19 pandemic and decreased consumer spending. Average interest checking deposits decreased $4.5 billion, or 9%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily as a result of the aforementioned balance migration into demand deposits and lower average balances per commercial customer account, partially offset by higher average balances per consumer customer account due to the previously mentioned increased liquidity levels in the current economic environment in the form of excess cash balances driven by the amount of fiscal stimulus. Average other time deposits decreased primarily due to lower offering rates on certificates less than $100,000.\nAverage certificates $100,000 and over decreased $2.9 billion, or 72%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to maturities which were not replaced with new issuances given current market conditions and liquidity levels.\nContractual maturities\nThe contractual maturities of certificates $100,000 and over as of June 30, 2021 are summarized in the following table:\n| TABLE 21: Contractual Maturities of Certificates $100,000 and Over |\n| ($ in millions) |\n| Next 3 months | $ | 321 |\n| 3-6 months | 208 |\n| 6-12 months | 172 |\n| After 12 months | 159 |\n| Total certificates $100,000 and over | $ | 860 |\n\nThe contractual maturities of other time deposits and certificates $100,000 and over as of June 30, 2021 are summarized in the following table:\n| TABLE 22: Contractual Maturities of Other Time Deposits and Certificates $100,000 and Over |\n| ($ in millions) |\n| Next 12 months | $ | 2,717 |\n| 13-24 months | 269 |\n| 25-36 months | 126 |\n| 37-48 months | 88 |\n| 49-60 months | 62 |\n| After 60 months | 6 |\n| Total other time deposits and certificates $100,000 and over | $ | 3,268 |\n\nBorrowings\nThe Bancorp accesses a variety of short-term and long-term funding sources. Borrowings with original maturities of one year or less are classified as short-term and include federal funds purchased and other short-term borrowings. Total average borrowings as a percent of average interest-bearing liabilities were 13% and 16% for the three months ended June 30, 2021 and 2020, respectively.\nThe following table summarizes the end of period components of borrowings:\n| TABLE 23: Components of Borrowings |\n| As of ($ in millions) | June 30,2021 | December 31,2020 |\n| Federal funds purchased | $ | 338 | 300 |\n| Other short-term borrowings | 1,130 | 1,192 |\n| Long-term debt | 12,364 | 14,973 |\n| Total borrowings | $ | 13,832 | 16,465 |\n\nTotal borrowings decreased $2.6 billion, or 16%, from December 31, 2020 primarily due to decreases in long-term debt and other short-term borrowings. Long-term debt decreased $2.6 billion from December 31, 2020 driven by the early redemptions under the par call options of $2.3 billion of notes and $244 million of paydowns on long-term debt associated with automobile loan securitizations during the six months ended June 30, 2021. Other short-term borrowings decreased $62 million from December 31, 2020 primarily as a result of decreased short-term funding needs given continued core deposit growth. The level of other short-term borrowings can fluctuate significantly from period to period depending on funding needs and the sources that are used to satisfy those needs. For further information on the components of other short-term borrowings, refer to Note 14 of the Notes to Condensed Consolidated Financial Statements.\n27\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following table summarizes components of average borrowings for the three months ended:\n| TABLE 24: Components of Average Borrowings |\n| ($ in millions) | June 30,2021 | June 30,2020 |\n| Federal funds purchased | $ | 346 | 309 |\n| Other short-term borrowings | 1,097 | 2,377 |\n| Long-term debt | 13,883 | 16,955 |\n| Total average borrowings | $ | 15,326 | 19,641 |\n\nTotal average borrowings decreased $4.3 billion, or 22%, for the three months ended June 30, 2021 compared to the same period in the prior year primarily due to decreases in average long-term debt and average other short-term borrowings. Average long-term debt decreased $3.1 billion for the three months ended June 30, 2021 compared to the same period in the prior year primarily driven by maturities of $3.4 billion and $508 million of paydowns on long-term debt associated with automobile loan securitizations since June of 2020. Average other short-term borrowings decreased $1.3 billion for the three months ended June 30, 2021 compared to the same period in the prior year primarily as a result of decreased short-term funding needs given continued core deposit growth. Information on the average rates paid on borrowings is discussed in the Net Interest Income subsection of the Statements of Income Analysis section of MD&A. In addition, refer to the Liquidity Risk Management subsection of the Risk Management section of MD&A for a discussion on the role of borrowings in the Bancorp’s liquidity management.\n28\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nBUSINESS SEGMENT REVIEW\nThe Bancorp reports on four business segments: Commercial Banking, Branch Banking, Consumer Lending and Wealth and Asset Management. Additional information on each business segment is included in Note 22 of the Notes to Condensed Consolidated Financial Statements. Results of the Bancorp’s business segments are presented based on its management structure and management accounting practices. The structure and accounting practices are specific to the Bancorp; therefore, the financial results of the Bancorp’s business segments are not necessarily comparable with similar information for other financial institutions. The Bancorp refines its methodologies from time to time as management’s accounting practices and businesses change.\nThe Bancorp manages interest rate risk centrally at the corporate level. By employing an FTP methodology, the business segments are insulated from most benchmark interest rate volatility, enabling them to focus on serving customers through the origination of loans and acceptance of deposits. The FTP methodology assigns charge and credit rates to classes of assets and liabilities, respectively, based on the estimated amount and timing of cash flows for each transaction. Assigning the FTP rate based on matching the duration of cash flows allocates interest income and interest expense to each business segment so its resulting net interest income is insulated from future changes in benchmark interest rates. The Bancorp’s FTP methodology also allocates the contribution to net interest income of the asset-generating and deposit-providing businesses on a duration-adjusted basis to better attribute the driver of the performance. As the asset and liability durations are not perfectly matched, the residual impact of the FTP methodology is captured in General Corporate and Other. The charge and credit rates are determined using the FTP rate curve, which is based on an estimate of Fifth Third’s marginal borrowing cost in the wholesale funding markets. The FTP curve is constructed using the U.S. swap curve, brokered CD pricing and unsecured debt pricing.\nThe Bancorp adjusts the FTP charge and credit rates as dictated by changes in interest rates for various interest-earning assets and interest-bearing liabilities and by the review of behavioral assumptions, such as prepayment rates on interest-earning assets and the estimated durations for indeterminate-lived deposits. Key assumptions, including the credit rates provided for deposit accounts, are reviewed annually. Credit rates for deposit products and charge rates for loan products may be reset more frequently in response to changes in market conditions. In general, the charge rates on assets have declined since December 31, 2020 as they were affected by the prevailing level of interest rates and by the duration and repricing characteristics of the portfolio. The credit rates for deposit products also modestly declined due to lower interest rates and modified assumptions. Thus, net interest income for asset-generating business segments improved while deposit-providing business segments were negatively impacted during the six months ended June 30, 2021.\nThe Bancorp’s methodology for allocating provision for credit losses expense to the business segments includes charges or benefits associated with changes in criticized commercial loan levels in addition to actual net charge-offs experienced by the loans and leases owned by each business segment. Provision for credit losses expense attributable to loan and lease growth and changes in ALLL factors is captured in General Corporate and Other. The financial results of the business segments include allocations for shared services and headquarters expenses. Additionally, the business segments form synergies by taking advantage of relationship depth opportunities and funding operations by accessing the capital markets as a collective unit.\nThe following table summarizes net income (loss) by business segment:\n| TABLE 25: Net Income (Loss) by Business Segment |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Income Statement Data |\n| Commercial Banking | $ | 393 | 12 | 704 | 237 |\n| Branch Banking | 40 | 138 | 16 | 258 |\n| Consumer Lending | 33 | 48 | 65 | 107 |\n| Wealth and Asset Management | 26 | 40 | 45 | 64 |\n| General Corporate and Other | 217 | (43) | 573 | (423) |\n| Net income | $ | 709 | 195 | 1,403 | 243 |\n\n29\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nCommercial Banking\nCommercial Banking offers credit intermediation, cash management and financial services to large and middle-market businesses and government and professional customers. In addition to the traditional lending and depository offerings, Commercial Banking products and services include global cash management, foreign exchange and international trade finance, derivatives and capital markets services, asset-based lending, real estate finance, public finance, commercial leasing and syndicated finance.\nThe following table contains selected financial data for the Commercial Banking segment:\n| TABLE 26: Commercial Banking |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Income Statement Data |\n| Net interest income (FTE)(a) | $ | 378 | 573 | 745 | 1,085 |\n| (Benefit from) provision for credit losses | (151) | 457 | (227) | 502 |\n| Noninterest income: |\n| Commercial banking revenue | 156 | 136 | 307 | 260 |\n| Service charges on deposits | 92 | 79 | 181 | 162 |\n| Leasing business revenue | 61 | 57 | 148 | 131 |\n| Other noninterest income | 46 | 22 | 79 | 27 |\n| Noninterest expense: |\n| Compensation and benefits | 136 | 129 | 292 | 278 |\n| Leasing business expense | 33 | 33 | 68 | 68 |\n| Other noninterest expense | 230 | 243 | 459 | 538 |\n| Income before income taxes (FTE) | 485 | 5 | 868 | 279 |\n| Applicable income tax expense (benefit)(a)(b) | 92 | (7) | 164 | 42 |\n| Net income | $ | 393 | 12 | 704 | 237 |\n| Average Balance Sheet Data |\n| Commercial loans and leases, including held for sale | $ | 59,729 | 71,894 | 59,989 | 69,788 |\n| Demand deposits | 32,827 | 22,939 | 32,177 | 20,032 |\n| Interest checking deposits | 20,871 | 28,742 | 21,000 | 24,595 |\n| Savings and money market deposits | 6,315 | 6,955 | 6,341 | 5,958 |\n| Other time deposits and certificates $100,000 and over | 91 | 159 | 96 | 182 |\n| Foreign office deposits | 139 | 181 | 133 | 195 |\n\n(a)Includes FTE adjustments of $2 and $3 for the three months ended June 30, 2021 and 2020, respectively, and $4 and $7 for the six months ended June 30, 2021 and 2020, respectively.\n(b)Applicable income tax expense for all periods includes the tax benefit from tax-exempt income, tax-advantaged investments and tax credits partially offset by the effect of certain nondeductible expenses. Refer to the Applicable Income Taxes subsection of the Statements of Income Analysis section of MD&A for additional information.\nNet income was $393 million and $704 million for the three and six months ended June 30, 2021, respectively, compared to $12 million and $237 million, respectively, for the same periods in the prior year. The increases were primarily driven by decreases in the provision for credit losses as well as increases in noninterest income and decreases in noninterest expense, partially offset by decreases in net interest income on an FTE basis.\nNet interest income on an FTE basis decreased $195 million and $340 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in yields on and average balances of commercial loans and leases as well as decreases in FTP credit rates on interest checking deposits, demand deposits and savings and money market deposits. These negative impacts were partially offset by decreases in FTP charge rates on loans and leases as well as decreases in rates paid on average interest checking deposits and average savings and money market deposits.\nThe benefit from credit losses was $151 million and $227 million for the three and six months ended June 30, 2021, respectively, compared to a provision for credit losses of $457 million and $502 million for the three and six months ended June 30, 2020, respectively. The decreases for the three and six months ended June 30, 2021 compared to the same periods in the prior year were primarily driven by a decrease in commercial criticized asset levels as well as decreases in net charge-offs on commercial and industrial loans and commercial leases. Net charge-offs as a percent of average portfolio loans and leases decreased to 4 bps and 10 bps for the three and six months ended June 30, 2021, respectively, compared to 41 bps and 35 bps for the same periods in the prior year, respectively.\nNoninterest income increased $61 million and $135 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year driven by increases in other noninterest income, commercial banking revenue and service charges on deposits.\n30\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe increase for the six months ended June 30, 2021 was also driven by an increase in leasing business revenue. Other noninterest income increased $24 million and $52 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in private equity investment income and card and processing revenue. The increase for the six months ended June 30, 2021 was also driven by the recognition of securities gains, net of $6 million. Commercial banking revenue increased $20 million and $47 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year. The increase for the three months ended June 30, 2021 was primarily due to increases in loan syndication fees and business lending fees partially offset by a decrease in institutional sales. The increase for the six months ended June 30, 2021 was primarily due to increases in loan syndication fees, business lending fees and institutional sales partially offset by a decrease in contract revenue from commercial customer derivatives. Service charges on deposits increased $13 million and $19 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year driven by increases in commercial deposit fees primarily due to growth in volume-based service revenues, with continued benefit from lower earnings credit rates. Leasing business revenue increased $17 million for the six months ended June 30, 2021 compared to the same periods in the prior year primarily due to an increase in lease syndication fees partially offset by a decrease in lease remarketing fees.\nNoninterest expense decreased $6 million and $65 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year driven by decreases in other noninterest expense partially offset by increases in compensation and benefits. Other noninterest expense decreased $13 million and $79 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year. The decreases for both the three and six months ended June 30, 2021 reflect decreases in allocated expenses related to cash management services. The decrease for the six months ended June 30, 2021 was also due to a decline in credit valuation adjustments on derivatives associated with customer accommodation contracts. Compensation and benefits increased $7 million and $14 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily as a result of increases in incentive compensation and employee benefits expense driven by strong performance in fees related to business growth and expansion initiatives during the three and six months ended June 30, 2021.\nAverage commercial loans and leases decreased $12.2 billion and $9.8 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to decreases in average commercial and industrial loans and average commercial mortgage loans partially offset by increases in average commercial construction loans. Average commercial and industrial loans decreased for the three and six months ended June 30, 2021 compared to the same periods in the prior year primarily driven by continued paydowns on revolving lines of credit. Average commercial mortgage loans decreased for the three and six months ended June 30, 2021 compared to the same periods in the prior year as payoffs exceeded loan originations. Average commercial construction loans increased for the three and six months ended June 30, 2021 compared to the same periods in the prior year as draws on existing commitments exceeded payoffs.\nAverage core deposits increased $1.3 billion and $8.9 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to increases in average demand deposits partially offset by decreases in average interest checking deposits. The increase for the three months ended June 30, 2021 was also partially offset by a decrease in average savings and money market deposits. The increase for the six months ended June 30, 2021 also included an increase in average savings and money market deposits. Average demand deposits increased $9.9 billion and $12.1 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily as a result of commercial customers maintaining increased levels of liquidity driven by the amount of fiscal and monetary stimulus, as well as growth in the number of accounts and migration of balances from interest checking deposits. Average interest checking deposits decreased $7.9 billion and $3.6 billion, respectively, for the three and six months ended June 30, 2021 compared to the same periods in the prior year primarily as a result of the aforementioned balance migration into demand deposits and lower average balances per commercial customer account. Average savings and money market deposits decreased $640 million for the three months ended June 30, 2021 compared to the same period in the prior year primarily as a result of a decline in commercial customer accounts. Average savings and money market deposits increased $383 million for the six months ended June 30, 2021 compared to the same period in the prior year primarily as a result of new customers as well as higher average balances per commercial customer account due to the amount of fiscal stimulus and economic uncertainty regarding the COVID-19 pandemic.\n31\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nBranch Banking\nBranch Banking provides a full range of deposit and loan products to individuals and small businesses through 1,096 full-service banking centers. Branch Banking offers depository and loan products, such as checking and savings accounts, home equity loans and lines of credit, credit cards and loans for automobiles and other personal financing needs, as well as products designed to meet the specific needs of small businesses, including cash management services.\nThe following table contains selected financial data for the Branch Banking segment:\n| TABLE 27: Branch Banking |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Income Statement Data |\n| Net interest income | $ | 301 | 513 | 596 | 1,017 |\n| Provision for credit losses | 25 | 52 | 66 | 114 |\n| Noninterest income: |\n| Card and processing revenue | 84 | 68 | 161 | 133 |\n| Service charges on deposits | 57 | 42 | 111 | 107 |\n| Wealth and asset management revenue | 52 | 39 | 102 | 84 |\n| Other noninterest income | 31 | 18 | 55 | 40 |\n| Noninterest expense: |\n| Compensation and benefits | 158 | 161 | 328 | 330 |\n| Net occupancy and equipment expense | 58 | 54 | 115 | 108 |\n| Card and processing expense | 19 | 28 | 49 | 58 |\n| Other noninterest expense | 215 | 211 | 447 | 444 |\n| Income before income taxes | $ | 50 | 174 | 20 | 327 |\n| Applicable income tax expense | 10 | 36 | 4 | 69 |\n| Net income | $ | 40 | 138 | 16 | 258 |\n| Average Balance Sheet Data |\n| Consumer loans | $ | 11,867 | 12,964 | 11,974 | 13,124 |\n| Commercial loans, including held for sale | 2,983 | 2,288 | 2,982 | 2,292 |\n| Demand deposits | 26,227 | 19,840 | 25,105 | 18,108 |\n| Interest checking deposits | 15,830 | 12,323 | 15,604 | 11,914 |\n| Savings and money market deposits | 42,476 | 36,687 | 41,524 | 35,584 |\n| Other time deposits and certificates $100,000 and over | 3,453 | 5,759 | 3,672 | 6,276 |\n\nNet income was $40 million and $16 million for the three and six months ended June 30, 2021, respectively, compared to $138 million and $258 million, respectively for the same periods in the prior year. The decreases were primarily driven by decreases in net interest income partially offset by increases in noninterest income and decreases in provision for credit losses.\nNet interest income decreased $212 million and $421 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to decreases in FTP credit rates on core deposits and certificates $100,000 and over as well as decreases in average balances of credit card and home equity and decreases in yields on average other consumer loans. These negative impacts were partially offset by decreases in the rates paid on average interest-bearing deposits and a decrease in FTP charge rates on loans and leases.\nProvision for credit losses decreased $27 million and $48 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to decreases in net charge-offs on credit card, other consumer loans and home equity partially offset by increases in net charge-offs on commercial and industrial loans. The decrease in provision for credit losses for the three and six months ended June 30, 2021 compared to the same periods in the prior year also included the impact of a decrease in commercial criticized asset levels. Net charge-offs as a percent of average portfolio loans and leases decreased to 102 bps and 106 bps for the three and six months ended June 30, 2021, respectively, compared to 128 bps and 143 bps, respectively, for the same periods in the prior year.\nNoninterest income increased $57 million and $65 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in card and processing revenue, wealth and asset management revenue, other noninterest income and service charges on deposits. Card and processing revenue increased $16 million and $28 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily as a result of an increase in consumer customer spend volume, partially offset by increased reward costs. Wealth and asset management revenue increased $13 million and $18\n32\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nmillion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to increases in broker income and private client service fees. Other noninterest income increased $13 million and $15 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in cardholder fees, banking center income and decreases in net losses on disposition and impairment of bank premises and equipment. Service charges on deposits increased $15 million and $4 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year driven by increases in both commercial deposit fees and consumer deposit fees.\nNoninterest expense decreased $4 million and $1 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in card and processing expense partially offset by increases in net occupancy and equipment expense. Card and processing expense decreased $9 million for both the three and six months ended June 30, 2021 compared to the same periods in the prior year primarily driven by contract renegotiations with a third-party vendor. Net occupancy and equipment expense increased $4 million and $7 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to increases in allocated occupancy costs.\nAverage consumer loans decreased $1.1 billion and $1.2 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in average home equity as payoffs exceeded loan originations as well as decreases in average credit card driven by higher paydowns which were affected by the amount of fiscal stimulus. These decreases were partially offset by increases in average residential mortgage loans of $502 million and $447 million for the three and six months ended June 30, 2021, respectively, primarily as a result of increases in loan originations. Average commercial loans increased $695 million and $690 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in average commercial mortgage loans and average commercial and industrial loans.\nAverage deposits increased $13.4 billion and $14.0 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in average demand deposits, average savings and money market deposits and average interest checking deposits partially offset by decreases in average other time deposits and certificates $100,000 and over. Average demand deposits increased $6.4 billion and $7.0 billion, average savings and money market deposits increased $5.8 billion and $5.9 billion and average interest checking deposits increased $3.5 billion and $3.7 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily as a result of higher balances per customer account due to the amount of fiscal stimulus, uncertainty regarding the COVID-19 pandemic as well as decreased consumer spending. Average other time deposits and certificates $100,000 and over decreased $2.3 billion and $2.6 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to maturities on certificates greater than $100,000 as well as lower offering rates on certificates less than $100,000.\n33\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nConsumer Lending\nConsumer Lending includes the Bancorp’s residential mortgage, automobile and other indirect lending activities. Residential mortgage activities within Consumer Lending include the origination, retention and servicing of residential mortgage loans, sales and securitizations of those loans and all associated hedging activities. Residential mortgages are primarily originated through a dedicated sales force and through third-party correspondent lenders. Automobile and other indirect lending activities include extending loans to consumers through automobile dealers, motorcycle dealers, powersport dealers, recreational vehicle dealers and marine dealers.\nThe following table contains selected financial data for the Consumer Lending segment:\n| TABLE 28: Consumer Lending |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Income Statement Data |\n| Net interest income | $ | 142 | 92 | 269 | 181 |\n| Provision for credit losses | — | 10 | 8 | 23 |\n| Noninterest income: |\n| Mortgage banking net revenue | 60 | 96 | 142 | 213 |\n| Other noninterest income | 3 | 2 | 3 | 9 |\n| Noninterest expense: |\n| Compensation and benefits | 61 | 53 | 127 | 104 |\n| Other noninterest expense | 102 | 67 | 197 | 140 |\n| Income before income taxes | $ | 42 | 60 | 82 | 136 |\n| Applicable income tax expense | 9 | 12 | 17 | 29 |\n| Net income | $ | 33 | 48 | 65 | 107 |\n| Average Balance Sheet Data |\n| Residential mortgage loans, including held for sale | $ | 16,567 | 12,823 | 16,023 | 13,187 |\n| Home equity | 153 | 200 | 158 | 203 |\n| Indirect secured consumer loans | 14,577 | 11,935 | 14,198 | 11,770 |\n\nNet income was $33 million and $65 million for the three and six months ended June 30, 2021, respectively, compared to net income of $48 million and $107 million, respectively, for the same periods in the prior year. The decreases were primarily due to increases in noninterest expense and decreases in noninterest income partially offset by increases in net interest income and decreases in provision for credit losses.\nNet interest income increased $50 million and $88 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in FTP charge rates on loans and leases and increases in average residential mortgage loans and average indirect secured consumer loans. These increases were partially offset by decreases in yields on average residential mortgage loans and average indirect secured consumer loans as well as decreases in FTP credit rates on demand deposits.\nProvision for credit losses decreased $10 million and $15 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in net charge-offs on indirect secured consumer loans and residential mortgage loans. Net charge-offs as a percent of average portfolio loans and leases were an immaterial amount and 7 bps for the three and six months ended June 30, 2021, respectively, compared to 16 bps and 19 bps for the three and six months ended June 30, 2020, respectively.\nNoninterest income decreased $35 million and $77 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in mortgage banking net revenue. Refer to the Noninterest Income subsection of the Statements of Income Analysis section of MD&A for additional information on the fluctuations in mortgage banking net revenue.\nNoninterest expense increased $43 million and $80 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year due to increases in other noninterest expense and compensation and benefits. Other noninterest expense increased $35 million and $57 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in loan and lease expense, corporate overhead allocations and losses and adjustments. Compensation and benefits increased $8 million and $23 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to increases in base compensation and incentive compensation resulting from the increased mortgage origination activity for both the three and six months ended June 30, 2021.\nAverage consumer loans increased $6.3 billion and $5.2 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to increases in average residential mortgage loans and average indirect secured consumer loans. Average residential mortgage loans increased $3.7 billion and $2.8 billion for the three and six months ended June 30, 2021,\n34\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nrespectively, compared to the same periods in the prior year primarily due to increases in residential mortgage loans held for sale as the Bancorp purchased government-guaranteed loans in forbearance programs. Average indirect secured consumer loans increased $2.6 billion and $2.4 billion for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to loan production exceeding payoffs.\nWealth and Asset Management\nWealth and Asset Management provides a full range of wealth management services for individuals, companies and not-for-profit organizations. Wealth and Asset Management is made up of three main businesses: FTS, an indirect wholly-owned subsidiary of the Bancorp; Fifth Third Private Bank; and Fifth Third Institutional Services. FTS offers full-service retail brokerage services to individual clients and broker-dealer services to the institutional marketplace. Fifth Third Private Bank offers wealth management strategies to high net worth and ultra-high net worth clients through wealth planning, investment management, banking, insurance, trust and estate services. Fifth Third Institutional Services provides advisory services for institutional clients including middle market businesses, non-profits, states and municipalities.\nThe following table contains selected financial data for the Wealth and Asset Management segment:\n| TABLE 29: Wealth and Asset Management |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Income Statement Data |\n| Net interest income | $ | 21 | 51 | 42 | 88 |\n| Benefit from credit losses | — | (1) | (1) | — |\n| Noninterest income: |\n| Wealth and asset management revenue | 138 | 115 | 274 | 244 |\n| Other noninterest income | 5 | 6 | 7 | 14 |\n| Noninterest expense: |\n| Compensation and benefits | 49 | 50 | 103 | 112 |\n| Other noninterest expense | 82 | 72 | 164 | 154 |\n| Income before income taxes | $ | 33 | 51 | 57 | 80 |\n| Applicable income tax expense | 7 | 11 | 12 | 16 |\n| Net income | $ | 26 | 40 | 45 | 64 |\n| Average Balance Sheet Data |\n| Loans and leases, including held for sale | $ | 3,772 | 3,597 | 3,759 | 3,589 |\n| Core deposits | 11,163 | 11,091 | 11,426 | 10,807 |\n\nNet income was $26 million and $45 million for the three and six months ended June 30, 2021, respectively, compared to net income of $40 million and $64 million, respectively, for the same periods in the prior year. The decreases were primarily driven by decreases in net interest income partially offset by increases in noninterest income. The decrease for the three months ended June 30, 2021 also included an increase in noninterest expense.\nNet interest income decreased $30 million and $46 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in FTP credit rates on interest-bearing core deposits as well as decreases in yields on average loans and leases. These negative impacts were partially offset by decreases in rates paid on average interest-bearing core deposits as well as decreases in FTP charge rates on loans and leases.\nNoninterest income increased $22 million and $23 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year driven by increases in wealth and asset management revenue partially offset by decreases in other noninterest income. Wealth and asset management revenue increased $23 million and $30 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily as a result of increases in private client service fees and broker income partially offset by decreases in institutional fees. Other noninterest income decreased $1 million and $7 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily due to decreases in insurance income driven by the sale of the Bancorp’s property and casualty insurance business in the fourth quarter of 2020.\nNoninterest expense increased $9 million and $1 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year driven by increases in other noninterest expense partially offset by decreases in compensation and benefits. Other noninterest expense increased $10 million for both the three and six months ended June 30, 2021 compared to the same periods in the prior year primarily due to increases in expenses associated with intercompany revenue sharing agreements. Compensation and benefits decreased $1 million and $9 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior\n35\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nyear primarily as a result of decreases in base compensation which included a decline due to the sale of the Bancorp’s property and casualty insurance business in the fourth quarter of 2020.\nAverage loans and leases increased $175 million and $170 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by increases in average other consumer loans and average residential mortgage loans as a result of higher loan production partially offset by decreases in average commercial and industrial loans and average home equity as payoffs exceeded new loan production.\nAverage core deposits increased $72 million and $619 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year. The increase for the three months ended June 30, 2021 compared to the same period in the prior year was primarily driven by increases in average savings and money market deposits, partially offset by a decrease in average interest checking deposits as a result of fiscal stimulus and migration of balances from interest checking deposits. The increase for the six months ended June 30, 2021 compared to the same period in the prior year was primarily driven by increases in average savings and money market deposits, interest checking deposits and demand deposits as a result of higher average balances per customer account due to the amount of fiscal stimulus, uncertainty regarding the COVID-19 pandemic and decreased consumer spending.\nGeneral Corporate and Other\nGeneral Corporate and Other includes the unallocated portion of the investment securities portfolio, securities gains and losses, certain non-core deposit funding, unassigned equity, unallocated provision for credit losses expense or a benefit from the reduction of the ACL, the payment of preferred stock dividends and certain support activities and other items not attributed to the business segments.\nNet interest income on an FTE basis increased $394 million and $672 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year primarily driven by decreases in FTP credit rates on deposits allocated to the business segments, increases in interest income on loans and leases and decreases in interest expense on long-term debt and deposits. These positive impacts were partially offset by decreases in the benefit related to FTP charge rates on loans and leases allocated to the business segments and a decrease in interest income on investment securities.\nThe provision for credit losses was $11 million for the three months ended June 30, 2021 compared to a benefit from credit losses of $33 million for the three months ended June 30, 2020. The increase in provision expense for the three months ended June 30, 2021 compared to the same period in the prior year was primarily driven by the impact of the benefits provided to the business segments driven by lower commercial criticized assets owned by each business segment, partially offset by factors which caused a decrease in the ACL including improved economic forecasts, improved commercial and consumer credit quality and lower period-end loan and lease balances. The benefit from credit losses was $134 million for the six months ended June 30, 2021 compared to a provision for credit losses of $486 million for the six months ended June 30, 2020. The decrease in provision expense for the six months ended June 30, 2021 compared to the same period in the prior year was primarily driven by factors which caused a decrease in the ACL including improved economic forecasts, improved commercial and consumer credit quality and lower period-end loan balances. The decrease for the six months ended June 30, 2021 was partially offset by the impact of the benefits provided to the business segments driven by lower commercial criticized assets owned by each business segment.\nNoninterest income decreased $3 million and increased $37 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year. The decrease for the three months ended June 30, 2021 compared to the same period in the prior year was primarily driven by the recognition of securities gains of $10 million for the three months ended June 30, 2021 compared to securities gains of $21 million for the three months ended June 30, 2020 as well as an increase in the loss on the swap associated with the sale of Visa, Inc. Class B shares. These negative impacts were partially offset by a decrease in net losses on disposition and impairment of bank premises and equipment as well as an increase in equity method investment income during the three months ended June 30, 2021 compared to the same period in the prior year. The increase for the six months ended June 30, 2021 compared to the same period in the prior year was primarily driven by the recognition of securities gains of $7 million for the six months ended June 30, 2021 compared to securities losses of $3 million for the six months ended June 30, 2020 as well as a decrease in net losses on disposition and impairment of bank premises and equipment and an increase in equity method investment income during the six months ended June 30, 2021 compared to the same period in the prior year.\nNoninterest expense increased $1 million and $47 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year. The increase for the three months ended June 30, 2021 compared to the same period in the prior year was primarily driven by an increase in equipment expense, a decrease in corporate overhead allocations from General Corporate and Other to the other business segments as well as an increase in technology and communications expense partially offset by a decrease in net occupancy expense. The increase for the six months ended June 30, 2021 compared to the same period in the prior year was primarily due to an increase in compensation and benefits, a decrease in corporate overhead allocations from General Corporate and Other to the other business segments and an increase in equipment expense partially offset by a decrease in net occupancy expense.\n36\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nRISK MANAGEMENT – OVERVIEW\nEffective risk management is critical to the Bancorp’s ongoing success and ensures that the Bancorp operates in a safe and sound manner, complies with applicable laws and regulations and safeguards the Bancorp’s brand and reputation. Risks are inherent in the Bancorp’s business and are influenced by both internal and external factors. The Bancorp is responsible for managing these risks effectively to deliver through-the-cycle value and performance for the Bancorp’s shareholders, customers, employees and communities.\nFifth Third’s Risk Management Framework, which is approved annually by the Capital Committee, ERMC, RCC and the Board of Directors, includes the following key elements:\n•The Bancorp ensures transparency and escalation of risk through defined risk policies and a governance structure that includes the RCC, ERMC and other management-level risk committees and councils.\n•The Bancorp establishes a risk appetite in alignment with its strategic, financial and capital plans. The Bancorp’s risk appetite is defined using quantitative metrics and qualitative measures to ensure prudent risk taking and drive balanced decision making. The Bancorp’s goal is to ensure that aggregate residual risks do not exceed the Bancorp’s risk appetite, and that risks taken are supportive of the Bancorp’s portfolio diversification and profitability objectives. The Board and executive management approve the risk appetite, which is considered in the development of business strategies and forms the basis for enterprise risk management.\n•The core principles that define the Bancorp’s risk appetite are as follows:\n◦Act with integrity in all activities.\n◦Understand the risks taken and ensure that they are in alignment with the Bancorp’s business strategies and risk appetite.\n◦Avoid risks that cannot be understood, managed or monitored.\n◦Provide transparency of risk to the Bancorp’s management and Board by escalating risks and issues as necessary.\n◦Ensure Fifth Third’s products and services are aligned to the Bancorp’s core customer base and are designed, delivered and maintained to provide value and benefit to the Bancorp’s customers and to Fifth Third.\n◦Only offer products or services that are appropriate or suitable for the Bancorp’s customers.\n◦Focus on providing operational excellence by providing reliable, accurate and efficient services to meet the Bancorp’s customers’ needs.\n◦Maintain a strong financial position to ensure the Bancorp meets its strategic objectives through all economic cycles and is able to access the capital markets at all times, even under stressed conditions.\n◦Protect the Bancorp’s reputation by thoroughly understanding the consequences of business strategies, products and processes.\n◦Conduct the Bancorp’s business in compliance with all applicable laws, rules and regulations and in alignment with internal policies and procedures.\n•Fifth Third’s core values and culture provide the foundation for sound risk management practices by establishing expectations for appropriate conduct and accountability across the organization. All employees are expected to conduct themselves in alignment with Fifth Third’s Code of Business Conduct and Ethics, which may be found on www.53.com, while carrying out their responsibilities. Fifth Third’s Corporate Responsibility and Reputation Committee provides oversight of business conduct policies, programs and strategies, and monitors reporting of potential misconduct, trends or themes across the enterprise. Prudent risk management is a responsibility that is expected from all employees and is a foundational element of Fifth Third’s culture.\n•The Bancorp manages eight defined risk types to a prescribed appetite. The risk types are credit risk, liquidity risk, interest rate risk, price risk, legal and regulatory compliance risk, operational risk, reputational risk and strategic risk.\n•The Bancorp identifies and monitors existing and potential risks that may impact the company’s risk profile, including emerging risks that create uncertainties and/or would have broad implications if materialized (e.g. global pandemic, etc.). Enhanced monitoring and action plans are implemented as necessary to proactively mitigate risk.\n•Fifth Third’s Risk Management Process provides a consistent and integrated approach for managing risks. The five components of the Risk Management Process are: identify, assess, manage, monitor and report. The Bancorp has also established processes and programs to manage and report concentration risks, to ensure robust talent, compensation and performance management and to aggregate risks across the enterprise.\nFifth Third drives accountability for managing risk through its Three Lines of Defense structure:\n•The first line of defense is comprised of front-line units that create risk and are accountable for managing risk. These groups are the Bancorp’s primary risk takers and are responsible for implementing effective internal controls and maintaining processes for identifying, assessing and managing the risks associated with their activities consistent with established risk appetite and limits. The first line of defense also includes enterprise-wide functions that provide information technology, operations, servicing, processing or other support.\n•The second line of defense, or Independent Risk Management, consists of Risk Management, Compliance and Credit Review. The second line is responsible for developing frameworks and policies to govern risk-taking activities, overseeing risk-taking of the organization, advising on controlling that risk and providing input on key risk decisions. Risk Management complements the front line’s management of risk-taking activities through its monitoring and reporting responsibilities, including adherence to the risk appetite. Additionally, Risk Management is responsible for identifying, assessing, managing, monitoring and reporting on aggregate risks enterprise-wide.\n•The third line of defense is Internal Audit, which provides oversight of the first and second lines of defense, and independent assurance to the Board on the effectiveness of governance, risk management and internal controls.\n37\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nCREDIT RISK MANAGEMENT\nThe objective of the Bancorp’s credit risk management strategy is to quantify and manage credit risk on an aggregate portfolio basis, as well as to limit the risk of loss resulting from the failure of a borrower or counterparty to honor its financial or contractual obligations to the Bancorp. The Bancorp’s credit risk management strategy is based on three core principles: conservatism, diversification and monitoring. The Bancorp believes that effective credit risk management begins with conservative lending practices which are described below. These practices include the use of intentional risk-based limits for single name exposures and counterparty selection criteria designed to reduce or eliminate exposure to borrowers who have higher than average default risk and defined weaknesses in financial performance. The Bancorp carefully designed and monitors underwriting, documentation and collection standards. The Bancorp’s credit risk management strategy also emphasizes diversification on a geographic, industry and customer level as well as ongoing portfolio monitoring and timely management reviews of large credit exposures and credits experiencing deterioration of credit quality. Credit officers with the authority to extend credit are delegated specific authority amounts, the utilization of which is closely monitored. Underwriting activities are centrally managed, and ERM manages the policy and the authority delegation process directly. The Credit Risk Review function provides independent and objective assessments of the quality of underwriting and documentation, the accuracy of risk grades and the charge-off, nonaccrual and reserve analysis process. The Bancorp’s credit review process and overall assessment of the adequacy of the allowance for credit losses is based on quarterly assessments of the estimated losses expected in the loan and lease portfolio. The Bancorp uses these assessments to promptly identify potential problem loans or leases within the portfolio, maintain an adequate allowance for credit losses and record any necessary charge-offs. The Bancorp defines potential problem loans and leases as those rated substandard that do not meet the definition of a nonaccrual loan or a restructured loan. Refer to Note 6 of the Notes to Condensed Consolidated Financial Statements for further information on the Bancorp’s credit grade categories, which are derived from standard regulatory rating definitions. In addition, stress testing is performed on various commercial and consumer portfolios utilizing various models. For certain portfolios, such as real estate and leveraged lending, stress testing is performed by Credit department personnel at the individual loan level during credit underwriting.\nThe following tables provide a summary of potential problem portfolio loans and leases:\n| TABLE 30: Potential Problem Portfolio Loans and Leases |\n| As of June 30, 2021 ($ in millions) | CarryingValue | UnpaidPrincipalBalance | Exposure |\n| Commercial and industrial loans | $ | 2,071 | 2,077 | 3,436 |\n| Commercial mortgage loans | 983 | 991 | 996 |\n| Commercial construction loans | 462 | 463 | 500 |\n| Commercial leases | 72 | 72 | 87 |\n| Total potential problem portfolio loans and leases | $ | 3,588 | 3,603 | 5,019 |\n| TABLE 31: Potential Problem Portfolio Loans and Leases |\n| As of December 31, 2020 ($ in millions) | CarryingValue | UnpaidPrincipalBalance | Exposure |\n| Commercial and industrial loans | $ | 2,641 | 2,651 | 3,687 |\n| Commercial mortgage loans | 784 | 798 | 792 |\n| Commercial construction loans | 240 | 240 | 252 |\n| Commercial leases | 72 | 72 | 72 |\n| Total potential problem portfolio loans and leases | $ | 3,737 | 3,761 | 4,803 |\n\nIn addition to the individual review of larger commercial loans that exhibit probable or observed credit weaknesses, the commercial credit review process includes the use of two risk grading systems. The first of these risk grading systems encompasses ten categories, which are based on regulatory guidance for credit risk systems. These ratings are used by the Bancorp to monitor and manage its credit risk. The Bancorp also maintains a dual risk rating system for credit approval and pricing, portfolio monitoring and capital allocation that includes a “through-the-cycle” rating philosophy for assessing a borrower’s creditworthiness. A “through-the-cycle” rating philosophy uses a grading scale that assigns ratings based on average default rates through an entire business cycle for borrowers with similar financial performance. The dual risk rating system includes thirteen probabilities of default grade categories and an additional eleven grade categories for estimating losses given an event of default. The probability of default and loss given default evaluations are not separated in the ten-category regulatory risk rating system.\nThe Bancorp utilizes internally developed models to estimate expected credit losses for portfolio loans and leases. For loans and leases that are collectively evaluated, the Bancorp utilizes these models to forecast expected credit losses over a reasonable and supportable forecast period based on the probability of a loan or lease defaulting, the expected balance at the estimated date of default and the expected loss percentage given a default. Refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for additional information about the Bancorp’s processes for developing these models,\n38\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nestimating credit losses for periods beyond the reasonable and supportable forecast period and for estimating credit losses for individually evaluated loans.\nFor the commercial portfolio segment, the estimated probabilities of default are primarily based on the probability of default ratings assigned under the through-the-cycle dual risk rating system and historical observations of how those ratings migrate to a default over time in the context of macroeconomic conditions. For loans with available credit, the estimate of the expected balance at the time of default considers expected utilization rates, which are primarily based on macroeconomic conditions and the utilization history of similar borrowers under those economic conditions. The estimates for loss severity are primarily based on collateral type and coverage levels and the susceptibility of those characteristics to changes in macroeconomic conditions.\nFor collectively evaluated loans in the consumer and residential mortgage portfolio segments, the Bancorp’s expected credit loss models primarily utilize the borrower’s FICO score and delinquency history in combination with macroeconomic conditions when estimating the probability of default. The estimates for loss severity are primarily based on collateral type and coverage levels and the susceptibility of those characteristics to changes in macroeconomic conditions. The expected balance at the estimated date of default is also especially impactful in the expected credit loss models for portfolio classes which generally have longer terms (such as residential mortgage loans and home equity) and portfolio classes containing a high concentration of loans with revolving privileges (such as credit card and home equity). The estimate of the expected balance at the time of default considers expected prepayment and utilization rates where applicable, which are primarily based on macroeconomic conditions and the utilization history of similar borrowers under those economic conditions. The Bancorp also utilizes various scoring systems, analytical tools and portfolio performance monitoring processes to assess the credit risk of the consumer and residential mortgage portfolios.\nOverview\nThe consensus outlook for economic growth in 2021 continued to improve in the second quarter of 2021 as the reopening of the U.S. economy led to an upswing in demand for consumer goods and services. Although the rise of the Delta variant of COVID-19 and slower progress on vaccinations presents some downside risk to the economic outlook in the second half of 2021, the underlying fundamentals of the economy continue to strengthen as consumers and businesses return to more normal levels of activity. With the economy gaining momentum, nonfarm payrolls increased by 850,000 in June of 2021 while wages were up 3.6% year-over-year. The robust economic growth is leading to more persistent inflationary pressures throughout the economy as supply chain constraints limit production while labor supply remains constrained due to federal economic impact payments to individuals, COVID-19 health concerns and aging demographics.\nIn June 2021, the core Consumer Price Index rose 4.5% over the last 12-months, the largest 12-month increase since the period ending November 1991. At the June 2021 FOMC meeting, participants raised their 2021 core Personal Consumption Expenditures (“PCE”) inflation forecast to 3.0% from 2.2% and their risk assessment for core PCE inflation was weighted to the upside. Despite the upside risk around inflation, most meeting participants saw the increase as transitory and expected core PCE to drop back to 2% in 2022 and 2023. The FOMC also retired the language around “not talking about tapering bond purchases” and discussions have begun on when to begin tapering the monthly purchases of $80 billion of treasury securities and $40 billion of agency mortgage-backed securities.\nCOVID-19 Hardship Relief Programs\nIn response to the COVID-19 pandemic, the Bancorp began providing financial hardship relief in March 2020 to borrowers that were negatively impacted by the pandemic and its related economic impacts. For retail borrowers, these relief programs included three-month payment deferrals for non-real estate secured and unsecured portfolios, six-month payment deferrals for home equity loans and lines of credit and six-month forbearances for residential mortgages. The Bancorp also temporarily waived fees for certain products and services, suspended initiating any new repossession actions on vehicles and suspended all residential foreclosure activity. The fee waiver, repossession suspension and payment deferral programs for non-real estate secured and unsecured and home equity loans and lines of credit were discontinued early in the third quarter of 2020. However, new programs to assist consumer customers are now being offered to meet the uniqueness of the current economic environment. These primarily include a short-term hardship program which allows for a reduced payment amount for six months with full payments resuming thereafter or placement into a loan modification program that could include permanent rate reductions or maturity extensions. In most cases, these offers were not classified as TDRs if qualified for the TDR relief provisions provided by the CARES Act. As of June 30, 2021, substantially all of these borrowers have resumed making payments except for certain residential mortgage loans which continue to be in forbearance.\nThe Bancorp currently plans to continue to offer a forbearance program for its residential mortgage borrowers in alignment with the forbearances offered for federally-backed mortgage loans under the provisions of the CARES Act and GSE servicing guidance. Under the provisions of the CARES Act, borrowers with federally-backed residential mortgage loans were able to request a six-month forbearance with an option to extend the forbearance period for an additional period of up to six months. The GSEs have also permitted certain forbearances to be extended for an additional six months for a total of up to 18 months. Additionally, the Bancorp will continue to follow the specific GSE guidance for other non-forbearance COVID-19 pandemic relief programs when servicing its residential mortgage portfolio. These programs include traditional loan modifications and/or deferral of past due payments to the maturity of the loan. The Bancorp has continued to suspend residential foreclosure activity in alignment with GSE practices and will also be responsive to any legislative changes related to foreclosure activity. The foreclosure moratorium expired on July 31, 2021 but some foreclosure activity will remain suspended for a longer period in\n39\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\ncertain circumstances. Also, borrowers that have not taken advantage of a forbearance to date will have until September 30, 2021 to enter into a COVID-19-related forbearance.\nThe Bancorp offered a variety of relief options to its commercial borrowers that had been impacted by the COVID-19 pandemic. While these offers were individually negotiated and tailored to each borrower’s specific facts and circumstances, the most commonly offered relief measures included temporary covenant waivers and/or deferrals of principal and/or interest payments for up to 90 days. After the deferral program, a customer had the option to resume normal payments, enter into a formal loan modification program or restructure the loan arrangement. These relief options were discontinued in 2021.\nThe following table provides a summary of portfolio loans and leases as of June 30, 2021, by class, that have received payment deferrals or forbearances as part of the Bancorp’s COVID-19 pandemic hardship relief programs:\n| TABLE 32: Residential Mortgage and Consumer Portfolio Loans Enrolled In Hardship Relief Programs |\n| Amortized Cost Basis of Loans and Leases | Past Due(c) |\n| Completed Relief Period | In Active Relief Period(a) | Total that Have Received Payment Relief(b) |\n| June 30, 2021 ($ in millions) | Current(c) | 30-89 Days | 90 Days or More | Total Past Due |\n| Residential mortgage loans(b) | $ | 999 | 322 | 1,321 | 1,130 | 31 | 160 | 191 |\n| Consumer loans: |\n| Home equity | 177 | 2 | 179 | 165 | 5 | 9 | 14 |\n| Indirect secured consumer loans(d) | 806 | 85 | 891 | 855 | 32 | 4 | 36 |\n| Credit card | 85 | 14 | 99 | 85 | 7 | 7 | 14 |\n| Other consumer loans | 96 | 3 | 99 | 95 | 3 | 1 | 4 |\n| Total residential mortgage and consumer portfolio loans | $ | 2,163 | 426 | 2,589 | 2,330 | 78 | 181 | 259 |\n\n(a)Includes loans and leases that are still in the initial payment relief period (primarily residential mortgage and home equity loans) and loans that have requested additional relief.\n(b)Excludes $803 of loans previously sold to GNMA that the Bancorp had the option to repurchase as a result of forbearance, all of which were repurchased and are classified as held for sale.\n(c)For loans which are still in an active relief period, past due status is based on the borrower’s status as of March 1, 2020, as adjusted based on the borrower’s compliance with modified loan terms.\n(d)Indirect secured consumer loans which are still in an active relief period as of June 30, 2021 are required to make payments but at a reduced amount from original contractual terms.\nAs of June 30, 2021, $1.3 billion of the Bancorp’s residential mortgage loans had been enrolled in a COVID-19 forbearance program (either active or completed). These loans had a weighted-average FICO score of approximately 683 and a weighted-average origination LTV of approximately 81%. Approximately 72% of these borrowers made at least one payment since entering forbearance, and 85% of balances are reported as current as of June 30, 2021. The Bancorp had $322 million of these loans in an active relief period as of June 30, 2021 and these loans had a weighted-average FICO score of approximately 652 and a weighted-average origination LTV of approximately 83%. Approximately one third of borrowers in an active forbearance period have made at least one payment since entering forbearance and approximately 88% of the residential mortgage loans still in an active relief period have completed the initial six-month forbearance period and have requested an extended forbearance.\nCommercial Portfolio\nThe Bancorp’s credit risk management strategy seeks to minimize concentrations of risk through diversification. The Bancorp has commercial loan concentration limits based on industry, lines of business within the commercial segment, geography and credit product type. The risk within the commercial loan and lease portfolio is managed and monitored through an underwriting process utilizing detailed origination policies, continuous loan level reviews, monitoring of industry concentration and product type limits and continuous portfolio risk management reporting.\nThe Bancorp provides loans to a variety of customers ranging from large multinational firms to middle market businesses, sole proprietors and high net worth individuals. The origination policies for commercial and industrial loans outline the risks and underwriting requirements for loans to businesses in various industries. Included in the policies are maturity and amortization terms, collateral and leverage requirements, cash flow coverage measures and hold limits. The Bancorp aligns credit and sales teams with specific industry expertise to better monitor and manage different industry segments of the portfolio.\nCertain industries have experienced increased stress due to the COVID-19 pandemic. These include consumer-driven industries that require gathering or congregation such as leisure and recreation (including casinos, restaurants, sports, fitness, hotels and other industries), non-essential retail and leisure travel (primarily including airlines and cruise lines). Certain segments of the healthcare industry (including skilled\n40\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nnursing, physician offices and surgery/outpatient centers, among others) have also been impacted by the pandemic given delays and restrictions on in-person visits and elective procedures.\nThe following table presents industries impacted the most severely within the Bancorp’s commercial and industrial and commercial real estate loan portfolios as of June 30, 2021:\n| TABLE 33: Industries Impacted the Most Severely by the COVID-19 Pandemic |\n| ($ in millions) | Balance | Exposure | Industry Classification(b) |\n| Commercial and industrial loans:(a) |\n| Leisure and recreation(c) | $ | 3,260 | 7,084 | Accommodation and food / Entertainment and recreation |\n| Retail - non-essential | 645 | 2,941 | Retail trade |\n| Healthcare | 1,013 | 1,740 | Healthcare |\n| Leisure travel | 393 | 594 | Transportation and warehousing |\n| Total commercial and industrial loans | $ | 5,311 | 12,359 |\n| Commercial real estate owner-occupied loans: |\n| Leisure and recreation(c) | 366 | 414 | Accommodation and food / Entertainment and recreation |\n| Retail - non-essential | 70 | 70 | Real estate |\n| Healthcare | 1,535 | 1,786 | Healthcare |\n| Total commercial real estate owner-occupied loans | $ | 1,971 | 2,270 |\n| Commercial real estate nonowner-occupied loans: |\n| Leisure and recreation(c) | 1,929 | 2,178 | Accommodation and food / Entertainment and recreation |\n| Retail - non-essential | 983 | 1,011 | Real estate |\n| Healthcare | 111 | 132 | Healthcare |\n| Total commercial real estate nonowner-occupied loans | $ | 3,023 | 3,321 |\n| Total | $ | 10,305 | 17,950 |\n\n(a)Excludes PPP loans.\n(b)As defined by the North American Industry Classification System.\n(c)Balances include exposures to casinos, restaurants, sports, fitness, hotels and other.\n41\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following table provides detail on commercial loans and leases by industry classification (as defined by the North American Industry Classification System), by loan size and by state, illustrating the diversity and granularity of the Bancorp’s commercial loans and leases as of:\n| TABLE 34: Commercial Loan and Lease Portfolio (excluding loans and leases held for sale) |\n| June 30, 2021 | December 31, 2020 |\n| ($ in millions) | Outstanding | Exposure | Nonaccrual | Outstanding | Exposure | Nonaccrual |\n| By Industry: |\n| Real estate | $ | 10,790 | 16,227 | 62 | 11,416 | 16,865 | 143 |\n| Manufacturing | 10,517 | 21,588 | 59 | 10,699 | 21,986 | 68 |\n| Financial services and insurance | 7,056 | 16,141 | — | 6,868 | 15,113 | — |\n| Healthcare | 5,057 | 7,664 | 5 | 5,168 | 7,874 | 41 |\n| Business services | 5,003 | 9,129 | 24 | 5,344 | 9,114 | 66 |\n| Accommodation and food | 4,163 | 6,764 | 27 | 4,166 | 6,600 | 35 |\n| Wholesale trade | 4,162 | 8,307 | 7 | 4,204 | 7,990 | 25 |\n| Retail trade | 3,637 | 9,114 | 2 | 3,651 | 8,871 | 6 |\n| Communication and information | 3,052 | 6,956 | 25 | 3,128 | 5,802 | 39 |\n| Construction | 2,766 | 6,208 | 4 | 2,631 | 6,053 | 4 |\n| Transportation and warehousing | 2,660 | 4,503 | 16 | 2,846 | 4,596 | 13 |\n| Mining | 2,589 | 4,645 | 71 | 2,626 | 4,171 | 94 |\n| Entertainment and recreation | 1,804 | 3,299 | 80 | 2,248 | 3,537 | 84 |\n| Other services | 1,308 | 1,759 | 6 | 1,362 | 1,770 | 7 |\n| Utilities | 1,177 | 2,986 | — | 1,162 | 3,011 | — |\n| Public administration | 676 | 1,117 | 9 | 880 | 1,428 | — |\n| Agribusiness | 429 | 599 | 10 | 394 | 616 | 10 |\n| Other | 110 | 113 | 1 | 127 | 129 | 2 |\n| Individuals | 64 | 112 | 1 | 77 | 123 | 1 |\n| Total | $ | 67,020 | 127,231 | 409 | 68,997 | 125,649 | 638 |\n| By Loan Size: |\n| Less than $1 million | 6 | % | 4 | 10 | 7 | 5 | 10 |\n| $1 million to $5 million | 9 | 7 | 12 | 9 | 7 | 18 |\n| $5 million to $10 million | 7 | 6 | 10 | 7 | 6 | 14 |\n| $10 million to $25 million | 17 | 15 | 41 | 18 | 16 | 27 |\n| $25 million to $50 million | 24 | 23 | 27 | 24 | 23 | 31 |\n| Greater than $50 million | 37 | 45 | — | 35 | 43 | — |\n| Total | 100 | % | 100 | 100 | 100 | 100 | 100 |\n| By State: |\n| Illinois | 12 | % | 11 | 25 | 14 | 12 | 28 |\n| Ohio | 10 | 12 | 3 | 11 | 12 | 4 |\n| Florida | 8 | 7 | 1 | 8 | 7 | 1 |\n| California | 8 | 7 | 1 | 7 | 7 | 1 |\n| Texas | 7 | 7 | 13 | 7 | 7 | 10 |\n| Michigan | 6 | 6 | 11 | 6 | 6 | 7 |\n| Indiana | 4 | 4 | 2 | 4 | 4 | 1 |\n| Georgia | 3 | 4 | 8 | 3 | 4 | 7 |\n| North Carolina | 3 | 2 | 1 | 3 | 2 | 3 |\n| Tennessee | 3 | 3 | 1 | 2 | 3 | 1 |\n| Kentucky | 2 | 2 | — | 2 | 2 | 4 |\n| South Carolina | 2 | 1 | — | 2 | 1 | — |\n| Other | 32 | 34 | 34 | 31 | 33 | 33 |\n| Total | 100 | % | 100 | 100 | 100 | 100 | 100 |\n\n42\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe origination policies for commercial real estate outline the risks and underwriting requirements for owner and nonowner-occupied and construction lending. Included in the policies are maturity and amortization terms, maximum LTVs, minimum debt service coverage ratios, construction loan monitoring procedures, appraisal requirements, pre-leasing requirements (as applicable), pro forma analysis requirements and interest rate sensitivity. The Bancorp requires a valuation of real estate collateral, which may include third-party appraisals, be performed at the time of origination and renewal in accordance with regulatory requirements and on an as-needed basis when market conditions justify. Although the Bancorp does not back test these collateral value assumptions, the Bancorp maintains an appraisal review department to order and review third-party appraisals in accordance with regulatory requirements. Collateral values on criticized assets with relationships exceeding $1 million are reviewed quarterly to assess the appropriateness of the value ascribed in the assessment of charge-offs and specific reserves.\nThe Bancorp assesses all real estate and non-real estate collateral securing a loan and considers all cross-collateralized loans in the calculation of the LTV ratio. The following tables provide detail on the most recent LTV ratios for commercial mortgage loans greater than $1 million, excluding commercial mortgage loans that are individually evaluated. The Bancorp does not typically aggregate the LTV ratios for commercial mortgage loans less than $1 million.\n| TABLE 35: Commercial Mortgage Loans Outstanding by LTV, Loans Greater Than $1 Million |\n| As of June 30, 2021 ($ in millions) | LTV > 100% | LTV 80-100% | LTV < 80% |\n| Commercial mortgage owner-occupied loans | $ | 132 | 261 | 3,419 |\n| Commercial mortgage nonowner-occupied loans | 17 | 109 | 4,397 |\n| Total | $ | 149 | 370 | 7,816 |\n| TABLE 36: Commercial Mortgage Loans Outstanding by LTV, Loans Greater Than $1 Million |\n| As of December 31, 2020 ($ in millions) | LTV > 100% | LTV 80-100% | LTV < 80% |\n| Commercial mortgage owner-occupied loans | $ | 121 | 310 | 3,209 |\n| Commercial mortgage nonowner-occupied loans | 51 | 72 | 4,757 |\n| Total | $ | 172 | 382 | 7,966 |\n\nThe Bancorp views non-owner-occupied commercial real estate as a higher credit risk product compared to some other commercial loan portfolios due to the higher volatility of the industry.\nThe following tables provide an analysis of nonowner-occupied commercial real estate loans by state (excluding loans held for sale):\n| TABLE 37: Nonowner-Occupied Commercial Real Estate (excluding loans held for sale)(a) |\n| As of June 30, 2021 ($ in millions) | For the three months ended June 30, 2021 | For the six months ended June 30, 2021 |\n| Outstanding | Exposure | 90 DaysPast Due | Nonaccrual | Net (Recoveries) Charge-offs | Net (Recoveries) Charge-offs |\n| By State: |\n| Illinois | $ | 2,376 | 2,763 | — | 21 | — | — |\n| Ohio | 1,416 | 1,998 | — | — | — | — |\n| Florida | 1,094 | 1,678 | — | — | — | — |\n| North Carolina | 945 | 1,174 | — | 2 | — | — |\n| Michigan | 771 | 886 | — | — | — | — |\n| Indiana | 676 | 967 | — | — | — | — |\n| All other states | 3,433 | 5,369 | — | 1 | (1) | (1) |\n| Total | $ | 10,711 | 14,835 | — | 24 | (1) | (1) |\n\n(a)Included in commercial mortgage loans and commercial construction loans in the Loans and Leases subsection of the Balance Sheet Analysis section of MD&A.\n43\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\n| TABLE 38: Nonowner-Occupied Commercial Real Estate (excluding loans held for sale)(a) |\n| As of June 30, 2020 ($ in millions) | For the three months ended June 30, 2020 | For the six months ended June 30, 2020 |\n| Outstanding | Exposure | 90 DaysPast Due | Nonaccrual | Net Charge-offs | Net Charge-offs |\n| By State: |\n| Illinois | $ | 3,073 | 3,680 | 10 | 5 | 1 | 1 |\n| Ohio | 1,357 | 1,823 | — | 5 | — | — |\n| Florida | 1,026 | 1,620 | — | — | — | — |\n| North Carolina | 808 | 1,116 | — | 2 | — | — |\n| Michigan | 805 | 961 | — | 1 | — | — |\n| Indiana | 559 | 1,040 | — | — | — | — |\n| All other states | 3,580 | 5,722 | — | 59 | — | 1 |\n| Total | $ | 11,208 | 15,962 | 10 | 72 | 1 | 2 |\n\n(a)Included in commercial mortgage loans and commercial construction loans in the Loans and Leases subsection of the Balance Sheet Analysis section of MD&A.\nConsumer Portfolio\nConsumer credit risk management utilizes a framework that encompasses consistent processes for identifying, assessing, managing, monitoring and reporting credit risk. These processes are supported by a credit risk governance structure that includes Board oversight, policies, risk limits and risk committees.\nThe Bancorp’s consumer portfolio is materially comprised of five categories of loans: residential mortgage loans, home equity, indirect secured consumer loans, credit card and other consumer loans. The Bancorp has identified certain credit characteristics within these five categories of loans which it believes represent a higher level of risk compared to the rest of the consumer loan portfolio. The Bancorp does not update LTVs for the consumer portfolio subsequent to origination except as part of the charge-off process for real estate secured loans. Credit risk management continues to closely monitor the indirect secured consumer portfolio performance, which includes automobile loans. The automobile market has exhibited industry-wide gradual loosening of credit standards such as lower FICOs, longer terms and higher LTVs. The Bancorp has adjusted credit standards focused on improving risk-adjusted returns while maintaining credit risk tolerance. The Bancorp actively manages the automobile portfolio through concentration limits, which mitigate credit risk through limiting the exposure to lower FICO scores, higher advance rates and extended term originations.\nThe Bancorp enhanced its credit underwriting guidelines across the entire consumer portfolio in response to the economic stress created by the COVID-19 pandemic. As the economic environment stabilizes, the current set of credit guidelines have generally returned to pre-pandemic levels as the Bancorp continues to ensure that underwriting standards reflect forward-looking outlooks on both risks and market opportunities, support strategic objectives, provide value to consumers and ensure adherence to risk appetite.\nResidential mortgage portfolio\nThe Bancorp manages credit risk in the residential mortgage portfolio through underwriting guidelines that limit exposure to higher LTVs and lower FICO scores. Additionally, the portfolio is governed by concentration limits that ensure geographic, product and channel diversification. The Bancorp may also package and sell loans in the portfolio.\nThe Bancorp does not originate residential mortgage loans that permit customers to defer principal payments or make payments that are less than the accruing interest. The Bancorp originates both fixed-rate and ARM loans. Within the ARM portfolio, approximately $529 million of ARM loans will have rate resets during the next twelve months. Of these resets, 4% are expected to experience an increase in rate, with an average increase of approximately 0.23%. Underlying characteristics of these borrowers are relatively strong with a weighted average origination DTI of 32% and weighted average origination LTV of 71%.\nCertain residential mortgage products have contractual features that may increase credit exposure to the Bancorp in the event of a decline in housing values. These types of mortgage products offered by the Bancorp include loans with high LTVs, multiple loans secured by the same collateral that when combined result in an LTV greater than 80% and interest-only loans. The Bancorp has deemed residential mortgage loans with greater than 80% LTVs and no mortgage insurance as loans that represent a higher level of risk.\nIn response to the COVID-19 pandemic, the Bancorp is following GSE guidance regarding forbearance and foreclosure regulations which currently allow up to 18 months of forbearance. The foreclosure moratorium expired on July 31, 2021 but some foreclosure activity will remain suspended for a longer period in certain circumstances. Also, borrowers that have not taken advantage of a forbearance to date will have until September 30, 2021 to enter into a COVID-19-related forbearance.\n44\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following table provides an analysis of the residential mortgage portfolio loans outstanding by LTV at origination as of:\n| TABLE 39: Residential Mortgage Portfolio Loans by LTV at Origination |\n| June 30, 2021 | December 31, 2020 |\n| ($ in millions) | Outstanding | Weighted-Average LTV | Outstanding | Weighted-Average LTV |\n| LTV ≤ 80% | $ | 11,882 | 63.8 | % | $ | 11,336 | 65.2 | % |\n| LTV > 80%, with mortgage insurance(a) | 2,259 | 95.4 | 2,535 | 95.5 |\n| LTV > 80%, no mortgage insurance | 1,990 | 91.2 | 2,057 | 91.1 |\n| Total | $ | 16,131 | 72.5 | % | $ | 15,928 | 73.9 | % |\n\n(a)Includes loans with both borrower and lender paid mortgage insurance.\nThe following tables provide an analysis of the residential mortgage portfolio loans outstanding by state with a greater than 80% LTV at origination and no mortgage insurance:\n| TABLE 40: Residential Mortgage Portfolio Loans, LTV Greater Than 80% at Origination, No Mortgage Insurance |\n| As of June 30, 2021 ($ in millions) | For the three months ended June 30, 2021 | For the six months ended June 30, 2021 |\n| Outstanding | 90 DaysPast Due | Nonaccrual | Net Charge-offs | Net Charge-offs |\n| By State: |\n| Ohio | $ | 451 | 5 | 4 | — | — |\n| Illinois | 412 | 4 | 1 | — | — |\n| Florida | 301 | 1 | 2 | — | — |\n| Michigan | 156 | 1 | 1 | — | — |\n| Indiana | 140 | 1 | — | — | — |\n| North Carolina | 136 | 1 | — | — | — |\n| Kentucky | 93 | 1 | — | — | — |\n| All other states | 301 | 2 | 2 | — | — |\n| Total | $ | 1,990 | 16 | 10 | — | — |\n\n| TABLE 41: Residential Mortgage Portfolio Loans, LTV Greater Than 80% at Origination, No Mortgage Insurance |\n| As of June 30, 2020 ($ in millions) | For the three months endedJune 30, 2020 | For the six months endedJune 30, 2020 |\n| Outstanding | 90 DaysPast Due | Nonaccrual | Net Charge-offs | Net Charge-offs |\n| By State: |\n| Ohio | $ | 493 | 3 | 4 | — | — |\n| Illinois | 460 | 2 | 3 | — | — |\n| Florida | 325 | 1 | 2 | — | — |\n| Michigan | 210 | 2 | 1 | — | — |\n| Indiana | 177 | 1 | 1 | — | — |\n| North Carolina | 149 | 2 | — | — | — |\n| Kentucky | 100 | 1 | 1 | — | — |\n| All other states | 373 | 3 | 4 | — | — |\n| Total | $ | 2,287 | 15 | 16 | — | — |\n\nHome equity portfolio\nThe Bancorp’s home equity portfolio is primarily comprised of home equity lines of credit. Beginning in the first quarter of 2013, the Bancorp’s newly originated home equity lines of credit have a 10-year interest-only draw period followed by a 20-year amortization period. The home equity line of credit previously offered by the Bancorp was a revolving facility with a 20-year term, minimum payments of interest-only and a balloon payment of principal at maturity. Peak maturity years for the balloon home equity lines of credit are 2025 to 2028 and approximately 21% of the balances mature before 2025.\n45\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe ALLL provides coverage for expected losses in the home equity portfolio. The allowance attributable to the portion of the home equity portfolio that has not been restructured in a TDR is determined on a pooled basis using a probability of default, loss given default and exposure at default model framework to generate expected losses. The expected losses for the home equity portfolio are dependent upon loan delinquency, FICO scores, LTV, loan age and their historical correlation with macroeconomic variables including unemployment and the home price index. The expected losses generated from models are adjusted by certain qualitative adjustment factors to reflect risks associated with current conditions and trends. The qualitative factors include adjustments for changes in policies or procedures in underwriting, monitoring or collections, economic conditions, portfolio mix, lending and risk management personnel, results of internal audit and quality control reviews, collateral values and geographic concentrations.\nThe home equity portfolio is managed in two primary groups: loans outstanding with a combined LTV greater than 80% and those loans with an LTV of 80% or less based upon appraisals at origination. For additional information on these loans, refer to Table 43 and Table 44. Of the total $4.5 billion of outstanding home equity loans:\n● 81% reside within the Bancorp’s Midwest footprint of Ohio, Michigan, Kentucky, Indiana and Illinois as of June 30, 2021;\n● 40% are in senior lien positions and 60% are in junior lien positions at June 30, 2021;\n● 79% of non-delinquent borrowers made at least one payment greater than the minimum payment during the three months ended June 30, 2021; and\n● The portfolio had a weighted average refreshed FICO score of 748 at June 30, 2021.\nThe Bancorp actively manages lines of credit and makes adjustments in lending limits when it believes it is necessary based on FICO score deterioration and property devaluation. The Bancorp does not routinely obtain appraisals on performing loans to update LTVs after origination. However, the Bancorp monitors the local housing markets by reviewing various home price indices and incorporates the impact of the changing market conditions in its ongoing credit monitoring processes. For junior lien home equity loans which become 60 days or more past due, the Bancorp tracks the performance of the senior lien loans in which the Bancorp is the servicer and utilizes consumer credit bureau attributes to monitor the status of the senior lien loans that the Bancorp does not service. If the senior lien loan is found to be 120 days or more past due, the junior lien home equity loan is placed on nonaccrual status unless both loans are well-secured and in the process of collection. Additionally, if the junior lien home equity loan becomes 120 days or more past due and the senior lien loan is also 120 days or more past due, the junior lien home equity loan is assessed for charge-off. Refer to the Analysis of Nonperforming Assets subsection of the Risk Management section of MD&A for more information.\nThe following table provides an analysis of home equity portfolio loans outstanding disaggregated based upon refreshed FICO score as of:\n| TABLE 42: Home Equity Portfolio Loans Outstanding by Refreshed FICO Score |\n| June 30, 2021 | December 31, 2020 |\n| ($ in millions) | Outstanding | % of Total | Outstanding | % of Total |\n| Senior Liens: |\n| FICO ≤ 659 | $ | 151 | 3 | % | $ | 174 | 3 | % |\n| FICO 660-719 | 264 | 6 | 284 | 6 |\n| FICO ≥ 720 | 1,416 | 31 | 1,546 | 30 |\n| Total senior liens | $ | 1,831 | 40 | 2,004 | 39 |\n| Junior Liens: |\n| FICO ≤ 659 | 290 | 7 | 339 | 6 |\n| FICO 660-719 | 506 | 11 | 610 | 12 |\n| FICO ≥ 720 | 1,918 | 42 | 2,230 | 43 |\n| Total junior liens | $ | 2,714 | 60 | 3,179 | 61 |\n| Total | $ | 4,545 | 100 | % | $ | 5,183 | 100 | % |\n\n46\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe Bancorp believes that home equity portfolio loans with a greater than 80% combined LTV present a higher level of risk. The following table provides an analysis of the home equity portfolio loans outstanding in a senior and junior lien position by LTV at origination as of:\n| TABLE 43: Home Equity Portfolio Loans Outstanding by LTV at Origination |\n| June 30, 2021 | December 31, 2020 |\n| ($ in millions) | Outstanding | Weighted-Average LTV | Outstanding | Weighted-Average LTV |\n| Senior Liens: |\n| LTV ≤ 80% | $ | 1,588 | 53.7 | % | $ | 1,728 | 53.8 | % |\n| LTV > 80% | 243 | 89.1 | 276 | 89.1 |\n| Total senior liens | $ | 1,831 | 58.7 | 2,004 | 58.8 |\n| Junior Liens: |\n| LTV ≤ 80% | 1,623 | 66.5 | 1,864 | 66.5 |\n| LTV > 80% | 1,091 | 89.7 | 1,315 | 89.8 |\n| Total junior liens | $ | 2,714 | 76.7 | 3,179 | 77.1 |\n| Total | $ | 4,545 | 69.2 | % | $ | 5,183 | 69.8 | % |\n\nThe following tables provide an analysis of home equity portfolio loans outstanding by state with a combined LTV greater than 80% at origination:\n| TABLE 44: Home Equity Portfolio Loans Outstanding with an LTV Greater than 80% at Origination |\n| As of June 30, 2021 ($ in millions) | For the three months endedJune 30, 2021 | For the six months endedJune 30, 2021 |\n| Outstanding | Exposure | 90 DaysPast Due | Nonaccrual | Net (Recoveries) Charge-offs | Net (Recoveries) Charge-offs |\n| By State: |\n| Ohio | $ | 417 | 993 | — | 8 | — | — |\n| Michigan | 235 | 524 | — | 4 | — | — |\n| Illinois | 215 | 420 | 1 | 6 | (1) | (1) |\n| Indiana | 126 | 286 | — | 3 | — | — |\n| Kentucky | 105 | 250 | — | 2 | — | — |\n| Florida | 91 | 190 | — | 2 | — | — |\n| All other states | 145 | 306 | — | 4 | — | — |\n| Total | $ | 1,334 | 2,969 | 1 | 29 | (1) | (1) |\n\n| TABLE 45: Home Equity Portfolio Loans Outstanding with an LTV Greater than 80% at Origination |\n| As of June 30, 2020 ($ in millions) | For the three months endedJune 30, 2020 | For the six months endedJune 30, 2020 |\n| Outstanding | Exposure | 90 DaysPast Due | Nonaccrual | Net Charge-offs | Net Charge-offs |\n| By State: |\n| Ohio | $ | 564 | 1,231 | — | 9 | — | 1 |\n| Michigan | 328 | 656 | — | 6 | — | — |\n| Illinois | 249 | 483 | — | 6 | — | — |\n| Indiana | 166 | 355 | — | 3 | — | — |\n| Kentucky | 141 | 311 | — | 1 | — | — |\n| Florida | 128 | 245 | — | 3 | — | — |\n| All other states | 199 | 387 | — | 4 | — | — |\n| Total | $ | 1,775 | 3,668 | — | 32 | — | 1 |\n\nIndirect secured consumer portfolio\nThe indirect secured consumer portfolio is comprised of $14.1 billion of automobile loans and $1.1 billion of indirect motorcycle, powersport, recreational vehicle and marine loans as of June 30, 2021. The concentration of lower FICO (≤659) origination balances remained within targeted credit risk tolerance during the six months ended June 30, 2021. All concentration and guideline changes are monitored monthly to ensure alignment with original credit performance and return projections.\n47\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following table provides an analysis of indirect secured consumer portfolio loans outstanding disaggregated based upon FICO score at origination as of:\n| TABLE 46: Indirect Secured Consumer Portfolio Loans Outstanding by FICO Score at Origination |\n| June 30, 2021 | December 31, 2020 |\n| ($ in millions) | Outstanding | % of Total | Outstanding | % of Total |\n| FICO ≤ 659 | $ | 360 | 2 | % | $ | 417 | 3 | % |\n| FICO 660-719 | 3,653 | 24 | 3,568 | 26 |\n| FICO ≥ 720 | 11,179 | 74 | 9,668 | 71 |\n| Total | $ | 15,192 | 100 | % | $ | 13,653 | 100 | % |\n\nAs of June 30, 2021, 94% of the indirect secured consumer loan portfolio is comprised of automobile loans, powersport loans and motorcycle loans. It is a common industry practice to advance on these types of loans an amount in excess of the collateral value due to the inclusion of negative equity trade-in, maintenance/warranty products, taxes, title and other fees paid at closing. The Bancorp monitors its exposure to these higher risk loans. The remainder of the indirect secured consumer loan portfolio is comprised of marine and recreational vehicle loans. The Bancorp’s credit policies limit the maximum advance rate on these to 100% of collateral value.\nThe following table provides an analysis of indirect secured consumer portfolio loans outstanding by LTV at origination as of:\n| TABLE 47: Indirect Secured Consumer Portfolio Loans Outstanding by LTV at Origination |\n| June 30, 2021 | December 31, 2020 |\n| ($ in millions) | Outstanding | Weighted- Average LTV | Outstanding | Weighted- Average LTV |\n| LTV ≤ 100% | $ | 10,945 | 79.8 | % | $ | 9,371 | 80.3 | % |\n| LTV > 100% | 4,247 | 111.9 | 4,282 | 112.7 |\n| Total | $ | 15,192 | 89.0 | % | $ | 13,653 | 90.8 | % |\n\nThe following table provides an analysis of the Bancorp’s indirect secured consumer portfolio loans outstanding with an LTV greater than 100% at origination:\n| TABLE 48: Indirect Secured Consumer Portfolio Loans Outstanding with an LTV Greater than 100% at Origination |\n| As of ($ in millions) | Outstanding | 90 Days PastDue and Accruing | Nonaccrual | Net Charge-offs for the Three Months Ended | Net Charge-offs for the Six Months Ended |\n| June 30, 2021 | $ | 4,247 | 3 | 30 | 1 | 7 |\n| June 30, 2020 | 4,410 | 7 | 7 | 6 | 15 |\n\nCredit card portfolio\nThe credit card portfolio consists of predominantly prime accounts with 98% and 97% of balances existing within the Bancorp’s footprint at June 30, 2021 and December 31, 2020, respectively. At June 30, 2021 and December 31, 2020, 71% and 69%, respectively, of the outstanding balances were originated through branch-based relationships with the remainder coming from direct mail campaigns and online acquisitions.\nThe following table provides an analysis of credit card portfolio loans outstanding disaggregated based upon FICO score at origination as of:\n| TABLE 49: Credit Card Portfolio Loans Outstanding by FICO Score at Origination |\n| June 30, 2021 | December 31, 2020 |\n| ($ in millions) | Outstanding | % of Total | Outstanding | % of Total |\n| FICO ≤ 659 | $ | 82 | 5 | % | $ | 94 | 5 | % |\n| FICO 660-719 | 544 | 30 | 654 | 32 |\n| FICO ≥ 720 | 1,167 | 65 | 1,259 | 63 |\n| Total | $ | 1,793 | 100 | % | $ | 2,007 | 100 | % |\n\nOther consumer portfolio loans\nOther consumer portfolio loans are comprised of secured and unsecured loans originated through the Bancorp’s branch network as well as point-of-sale loans originated or purchased in connection with third-party financial technology companies. The Bancorp had $269 million in unfunded commitments associated with loans originated in connection with third-party financial technology companies as of June 30, 2021. The Bancorp closely monitors the credit performance of point-of-sale loans. Loans originated in connection with third-party financial technology companies are impacted by certain credit loss protection coverage provided by those companies.\n48\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following table provides an analysis of other consumer portfolio loans outstanding by product type as of:\n| TABLE 50: Other Consumer Portfolio Loans Outstanding by Product Type |\n| June 30, 2021 | December 31, 2020 |\n| ($ in millions) | Outstanding | % of Total | Outstanding | % of Total |\n| Unsecured | $ | 629 | 21 | % | $ | 683 | 23 | % |\n| Other secured | 817 | 27 | 774 | 26 |\n| Point-of-sale | 1,606 | 52 | 1,557 | 51 |\n| Total | $ | 3,052 | 100 | % | $ | 3,014 | 100 | % |\n\nAnalysis of Nonperforming Assets\nNonperforming assets include nonaccrual loans and leases for which ultimate collectability of the full amount of the principal and/or interest is uncertain; restructured commercial, credit card and certain consumer loans which have not yet met the requirements to be classified as a performing asset; restructured consumer loans which are 90 days past due based on the restructured terms unless the loan is both well-secured and in the process of collection; and certain other assets, including OREO and other repossessed property. A summary of nonperforming assets is included in Table 51. For further information on the Bancorp’s policies related to accounting for delinquent and nonperforming loans and leases, refer to the Nonaccrual Loans and Leases section of Note 1 of the Notes to the Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\nNonperforming assets were $697 million at June 30, 2021 compared to $870 million at December 31, 2020. At June 30, 2021, $40 million of nonaccrual loans were held for sale, compared to $6 million at December 31, 2020.\nNonperforming portfolio assets as a percent of portfolio loans and leases and OREO were 0.61% as of June 30, 2021 compared to 0.79% as of December 31, 2020. Nonaccrual loans and leases secured by real estate were 32% of nonaccrual loans and leases as of June 30, 2021 compared to 36% as of December 31, 2020.\nPortfolio commercial nonaccrual loans and leases were $409 million at June 30, 2021, a decrease of $229 million from December 31, 2020. Portfolio consumer nonaccrual loans were $212 million at June 30, 2021, an increase of $16 million from December 31, 2020. Refer to Table 52 for a rollforward of the portfolio nonaccrual loans and leases.\nOREO and other repossessed property was $36 million and $30 million at June 30, 2021 and December 31, 2020, respectively. The Bancorp recognized an immaterial amount and $1 million in losses on the transfer, sale or write-down of OREO properties for the three months ended June 30, 2021 and 2020, respectively, and $6 million in losses on the transfer, sale or write-down of OREO properties for both the six months ended June 30, 2021 and 2020.\nFor the three and six months ended June 30, 2021, approximately $8 million and $18 million, respectively, of interest income would have been recognized if the nonaccrual and renegotiated loans and leases on nonaccrual status had been current in accordance with their original terms compared to $9 million and $17 million in the same periods in the prior year. Although these values help demonstrate the costs of carrying nonaccrual credits, the Bancorp does not expect to recover the full amount of interest as nonaccrual loans and leases are generally carried below their principal balance.\n49\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\n| TABLE 51: Summary of Nonperforming Assets and Delinquent Loans and Leases |\n| As of ($ in millions) | June 30,2021 | December 31,2020 |\n| Nonaccrual portfolio loans and leases: |\n| Commercial and industrial loans | $ | 193 | 230 |\n| Commercial mortgage loans | 43 | 82 |\n| Commercial leases | 9 | 7 |\n| Residential mortgage loans(a) | 17 | 25 |\n| Home equity | 53 | 52 |\n| Indirect secured consumer loans | 6 | 9 |\n| Other consumer loans | 1 | 2 |\n| Nonaccrual portfolio restructured loans and leases: |\n| Commercial and industrial loans | 155 | 243 |\n| Commercial mortgage loans | 9 | 75 |\n| Commercial construction loans | — | 1 |\n| Residential mortgage loans(a) | 32 | 35 |\n| Home equity | 32 | 34 |\n| Indirect secured consumer loans | 43 | 7 |\n| Credit card | 27 | 32 |\n| Other consumer loans | 1 | — |\n| Total nonaccrual portfolio loans and leases(b) | $ | 621 | 834 |\n| OREO and other repossessed property | 36 | 30 |\n| Total nonperforming portfolio loans and leases and OREO | $ | 657 | 864 |\n| Nonaccrual loans held for sale | 13 | 5 |\n| Nonaccrual restructured loans held for sale | 27 | 1 |\n| Total nonperforming assets | $ | 697 | 870 |\n| Total portfolio loans and leases 90 days past due and still accruing: |\n| Commercial and industrial loans | $ | 2 | 39 |\n| Commercial mortgage loans | 4 | 8 |\n| Commercial leases | — | 1 |\n| Residential mortgage loans(a) | 57 | 70 |\n| Home equity | 1 | 2 |\n| Indirect secured consumer loans | 4 | 10 |\n| Credit card | 14 | 31 |\n| Other consumer loans | 1 | 2 |\n| Total portfolio loans and leases 90 days past due and still accruing | $ | 83 | 163 |\n| Nonperforming portfolio assets as a percent of portfolio loans and leases and OREO | 0.61 | % | 0.79 |\n| ALLL as a percent of nonperforming portfolio assets | 310 | 284 |\n| ACL as a percent of nonperforming portfolio assets | 338 | 304 |\n\n(a)Information for all periods presented excludes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. These advances were $316 as of June 30, 2021 and $317 as of December 31, 2020. The Bancorp recognized losses of an immaterial amount and $1 for the three months ended June 30, 2021 and 2020, respectively, and $1 and $2 for the six months ended June 30, 2021 and 2020, respectively, due to claim denials and curtailments associated with these insured or guaranteed loans.\n(b)Includes $26 and $29 of nonaccrual government insured commercial loans whose repayments are insured by the SBA as of June 30, 2021 and December 31, 2020, respectively, of which $13 and $17 are restructured nonaccrual government insured commercial loans as of June 30, 2021 and December 31, 2020, respectively.\n50\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following tables provide a rollforward of portfolio nonaccrual loans and leases, by portfolio segment:\n| TABLE 52: Rollforward of Portfolio Nonaccrual Loans and Leases |\n| For the six months ended June 30, 2021 ($ in millions) | Commercial | Residential Mortgage | Consumer | Total |\n| Balance, beginning of period | $ | 638 | 60 | 136 | 834 |\n| Transfers to nonaccrual status | 130 | 26 | 117 | 273 |\n| Transfers to accrual status | (1) | (36) | (45) | (82) |\n| Transfers to held for sale | (87) | — | — | (87) |\n| Loan paydowns/payoffs | (215) | — | (28) | (243) |\n| Transfers to OREO | (1) | (2) | — | (3) |\n| Charge-offs | (81) | — | (18) | (99) |\n| Draws/other extensions of credit | 26 | 1 | 1 | 28 |\n| Balance, end of period | $ | 409 | 49 | 163 | 621 |\n\n| TABLE 53: Rollforward of Portfolio Nonaccrual Loans and Leases |\n| For the six months ended June 30, 2020 ($ in millions) | Commercial | Residential Mortgage | Consumer | Total |\n| Balance, beginning of period | $ | 397 | 91 | 130 | 618 |\n| Transfers to nonaccrual status | 349 | 73 | 82 | 504 |\n| Transfers to accrual status | (31) | (72) | (45) | (148) |\n| Transfers to held for sale | (10) | — | — | (10) |\n| Loan paydowns/payoffs | (81) | (6) | (19) | (106) |\n| Transfers to OREO | — | (7) | — | (7) |\n| Charge-offs | (142) | — | (15) | (157) |\n| Draws/other extensions of credit | 5 | — | 1 | 6 |\n| Balance, end of period | $ | 487 | 79 | 134 | 700 |\n\nTroubled Debt Restructurings\nA loan is accounted for as a TDR if the Bancorp, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. TDRs include concessions granted under reorganization, arrangement or other provisions of the Federal Bankruptcy Act. A TDR typically involves a modification of terms such as a reduction of the stated interest rate or remaining principal amount of the loan, a reduction of accrued interest or an extension of the maturity date at a stated interest rate lower than the current market rate for a new loan with similar risk.\nAt the time of modification, the Bancorp maintains certain consumer loan TDRs (including certain residential mortgage loans, home equity loans and other consumer loans) on accrual status, provided there is reasonable assurance of repayment and performance according to the modified terms based upon a current, well-documented credit evaluation. Loans discharged in a Chapter 7 bankruptcy and not reaffirmed by the borrower are classified as collateral-dependent TDRs and placed on nonaccrual status regardless of the borrower’s payment history or capacity to repay in the future. These loans are returned to accrual status provided there is a sustained payment history of twelve months after bankruptcy and collectability is reasonably assured for all remaining contractual payments. Commercial loans modified as part of a TDR are maintained on accrual status provided there is a sustained payment history of six months or greater prior to the modification in accordance with the modified terms and all remaining contractual payments under the modified terms are reasonably assured of collection. TDRs of commercial loans and credit card loans that do not have a sustained payment history of six months or greater in accordance with the modified terms remain on nonaccrual status until a six-month payment history is sustained. Refer to the Regulatory Developments Related to the COVID-19 Pandemic section of Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for additional information on loans that were modified related to the COVID-19 pandemic but not classified as TDRs.\nConsumer restructured loans on accrual status totaled $699 million and $796 million at June 30, 2021 and December 31, 2020, respectively. As of June 30, 2021, the percentages of restructured residential mortgage loans, home equity loans and credit card loans that were past due 30 days or more from their modified terms were 28%, 19% and 24%, respectively.\n51\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following tables summarize portfolio TDRs by loan type and delinquency status:\n| TABLE 54: Accruing and Nonaccruing Portfolio TDRs |\n| Accruing |\n| 30-89 Days | 90 Days or |\n| As of June 30, 2021 ($ in millions) | Current | Past Due | More Past Due | Nonaccruing | Total |\n| Commercial loans(a) | $ | 80 | — | — | 164 | 244 |\n| Residential mortgage loans(b) | 387 | 26 | 94 | 32 | 539 |\n| Home equity | 157 | 5 | — | 32 | 194 |\n| Indirect secured consumer loans | 9 | — | — | 43 | 52 |\n| Credit card | 19 | 2 | — | 27 | 48 |\n| Other consumer | — | — | — | 1 | 1 |\n| Total | $ | 652 | 33 | 94 | 299 | 1,078 |\n\n(a)Excludes restructured nonaccrual loans held for sale.\n(b)Information includes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. As of June 30, 2021, these advances represented $188 of current loans, $21 of 30-89 days past due loans and $85 of 90 days or more past due loans.\n| TABLE 55: Accruing and Nonaccruing Portfolio TDRs |\n| Accruing |\n| 30-89 Days | 90 Days or |\n| As of December 31, 2020 ($ in millions) | Current | Past Due | More Past Due | Nonaccruing | Total |\n| Commercial loans(a) | $ | 92 | — | — | 319 | 411 |\n| Residential mortgage loans(b) | 462 | 32 | 102 | 35 | 631 |\n| Home equity | 171 | 7 | — | 34 | 212 |\n| Indirect secured consumer loans | 5 | — | — | 7 | 12 |\n| Credit card | 15 | 2 | — | 32 | 49 |\n| Total | $ | 745 | 41 | 102 | 427 | 1,315 |\n\n(a)Excludes restructured nonaccrual loans held for sale.\n(b)Information includes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. As of December 31, 2020, these advances represented $276 of current loans, $28 of 30-89 days past due loans and $78 of 90 days or more past due loans.\nAnalysis of Net Loan Charge-offs\nNet charge-offs were 16 bps and 44 bps of average portfolio loans and leases for the three months ended June 30, 2021 and 2020, respectively, and were 21 bps and 44 bps of average portfolio loans and leases for the six months ended June 30, 2021 and 2020, respectively. Table 56 provides a summary of credit loss experience and net charge-offs as a percent of average portfolio loans and leases outstanding by loan category.\nThe ratio of commercial loan and lease net charge-offs as a percent of average portfolio commercial loans and leases decreased to 10 bps and 14 bps during the three and six months ended June 30, 2021, respectively, compared to 40 bps and 36 bps during the three and six months ended June 30, 2020, respectively. The decrease was primarily due to decreases in net charge-offs on commercial and industrial loans of $52 million and $75 million for the three and six months ended June 30, 2021, respectively. Additionally, there were net recoveries on commercial leases of $2 million for both the three and six months ended June 30, 2021 compared to net charge-offs on commercial leases of $11 million and $16 million for the three and six months ended June 30, 2020, respectively.\nThe ratio of consumer loan net charge-offs as a percent of average portfolio consumer loans decreased to 26 bps and 34 bps during the three and six months ended June 30, 2021, respectively, compared to 52 bps and 59 bps during the three and six months ended June 30, 2020, respectively. The decrease was primarily due to decreases in net charge-offs on credit card loans of $14 million and $26 million for the three and six months ended June 30, 2021, respectively, and decreases in net charge-offs on indirect secured consumer loans of $7 million and $11 million for the three and six months ended June 30, 2021, respectively, compared to the same periods in the prior year. The decrease for both the three and six months ended June 30, 2021 included the impact of government stimulus programs and the Bancorp’s hardship programs. Additionally, the Bancorp continued to see increased used car values through the second quarter of 2021 which has directly impacted loss severity.\n52\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\n| TABLE 56: Summary of Credit Loss Experience |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Losses charged-off: |\n| Commercial and industrial loans | $ | (36) | (68) | (68) | (122) |\n| Commercial mortgage loans | (8) | (2) | (12) | (4) |\n| Commercial leases | (1) | (11) | (1) | (16) |\n| Residential mortgage loans | (1) | (2) | (2) | (4) |\n| Home equity | (2) | (3) | (4) | (8) |\n| Indirect secured consumer loans | (11) | (15) | (30) | (37) |\n| Credit card | (26) | (40) | (57) | (82) |\n| Other consumer loans(a) | (18) | (22) | (37) | (49) |\n| Total losses charged-off | $ | (103) | (163) | (211) | (322) |\n| Recoveries of losses previously charged-off: |\n| Commercial and industrial loans | $ | 23 | 3 | 28 | 7 |\n| Commercial mortgage loans | 2 | — | 4 | — |\n| Commercial leases | 3 | — | 3 | — |\n| Residential mortgage loans | 1 | 1 | 3 | 2 |\n| Home equity | 3 | 2 | 5 | 4 |\n| Indirect secured consumer loans | 11 | 8 | 21 | 17 |\n| Credit card | 6 | 6 | 12 | 11 |\n| Other consumer loans(a) | 10 | 13 | 20 | 29 |\n| Total recoveries of losses previously charged-off | $ | 59 | 33 | 96 | 70 |\n| Net losses charged-off: |\n| Commercial and industrial loans | $ | (13) | (65) | (40) | (115) |\n| Commercial mortgage loans | (6) | (2) | (8) | (4) |\n| Commercial leases | 2 | (11) | 2 | (16) |\n| Residential mortgage loans | — | (1) | 1 | (2) |\n| Home equity | 1 | (1) | 1 | (4) |\n| Indirect secured consumer loans | — | (7) | (9) | (20) |\n| Credit card | (20) | (34) | (45) | (71) |\n| Other consumer loans | (8) | (9) | (17) | (20) |\n| Total net losses charged-off | $ | (44) | (130) | (115) | (252) |\n| Net losses charged-off as a percent of average portfolio loans and leases: |\n| Commercial and industrial loans | 0.11 | % | 0.45 | 0.16 | 0.42 |\n| Commercial mortgage loans | 0.22 | 0.07 | 0.16 | 0.07 |\n| Commercial leases | (0.21) | 1.47 | (0.15) | 1.02 |\n| Total commercial loans and leases | 0.10 | % | 0.40 | 0.14 | 0.36 |\n| Residential mortgage loans | (0.01) | 0.02 | (0.01) | 0.02 |\n| Home equity | (0.09) | 0.07 | (0.04) | 0.12 |\n| Indirect secured consumer loans | 0.01 | 0.24 | 0.12 | 0.33 |\n| Credit card | 4.52 | 6.17 | 5.02 | 6.01 |\n| Other consumer loans | 0.91 | 1.17 | 1.03 | 1.51 |\n| Total consumer loans | 0.26 | % | 0.52 | 0.34 | 0.59 |\n| Total net losses charged-off as a percent of average portfolio loans and leases | 0.16 | % | 0.44 | 0.21 | 0.44 |\n\n(a)For the three and six months ended June 30, 2021, the Bancorp recorded $8 and $18, respectively, in both losses charged-off and recoveries of losses previously charged-off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements. For the three and six months ended June 30, 2020, the Bancorp recorded $9 and $22, respectively, in both losses charged-off and recoveries of losses previously charged-off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements.\nAllowance for Credit Losses\nThe allowance for credit losses is comprised of the ALLL and the reserve for unfunded commitments. As described in Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020, the Bancorp maintains the ALLL to absorb the amount of credit losses that are expected to be incurred over the remaining contractual terms of the related loans and leases (as adjusted for prepayments and reasonably expected TDRs). The Bancorp’s methodology for determining the ALLL includes an estimate of expected credit losses on a collective basis for groups of loans and leases with similar risk characteristics and\n53\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nspecific allowances for loans and leases which are individually evaluated. For collectively evaluated loans and leases, the Bancorp uses quantitative models to forecast expected credit losses based on the probability of a loan or lease defaulting, the expected balance at the estimated date of default and the expected loss percentage given a default. The Bancorp’s expected credit loss models consider historical credit loss experience, current market and economic conditions, and forecasted changes in market and economic conditions if such forecasts are considered reasonable and supportable.\nThe Bancorp also considers qualitative factors in determining the ALLL. Qualitative adjustments are used to capture characteristics in the portfolio that impact expected credit losses which are not fully captured within the Bancorp’s expected credit loss models. These factors include adjustments for changes in policies or procedures in underwriting, monitoring or collections, lending and risk management personnel and results of internal audit and quality control reviews. In addition, the qualitative adjustment framework can be utilized to address specific idiosyncratic risks such as geopolitical events, natural disasters or changes in current economic conditions that are not reflected in the quantitative credit loss models, and their effects on regional borrowers and changes in product structures. Qualitative factors may also be used to address the impacts of unforeseen events on key inputs and assumptions within the Bancorp’s expected credit loss models, such as the reasonable and supportable forecast period, changes to historical loss information or changes to the reversion period or methodology.\nIn addition to the ALLL, the Bancorp maintains a reserve for unfunded commitments recorded in other liabilities in the Condensed Consolidated Balance Sheets. The methodology used to determine the adequacy of this reserve is similar to the Bancorp’s methodology for determining the ALLL. The provision for unfunded commitments is included in the provision for credit losses in the Condensed Consolidated Statements of Income.\nFor the commercial portfolio segment, the estimates for probability of default are primarily based on internal ratings assigned to each commercial borrower on a 13-point scale and historical observations of how those ratings migrate to a default over time in the context of macroeconomic conditions. For loans with available credit, the estimate of the expected balance at the time of default considers expected utilization rates, which are primarily based on macroeconomic conditions and the utilization history of similar borrowers under those economic conditions. The estimates for loss severity are primarily based on collateral type and coverage levels and the susceptibility of those characteristics to changes in macroeconomic conditions.\nFor collectively evaluated loans in the consumer and residential mortgage portfolio segments, the Bancorp’s expected credit loss models primarily utilize the borrower’s FICO score and delinquency history in combination with macroeconomic conditions when estimating the probability of default. The estimates for loss severity are primarily based on collateral type and coverage levels and the susceptibility of those characteristics to changes in macroeconomic conditions. The expected balance at the estimated date of default is also especially impactful in the expected credit loss models for portfolio classes which generally have longer terms (such as residential mortgage loans and home equity) and portfolio classes containing a high concentration of loans with revolving privileges (such as credit card and home equity). The estimate of the expected balance at the time of default considers expected prepayment and utilization rates where applicable, which are primarily based on macroeconomic conditions and the utilization history of similar borrowers under those economic conditions.\nDay 1 Adoption Impact\nUpon adoption of ASU 2016-13 on January 1, 2020, the Bancorp used three forward-looking economic scenarios during the reasonable and supportable forecast period in its expected credit loss models to address the inherent imprecision in macroeconomic forecasting. Each of the three scenarios was developed by a third party that is subject to the Bancorp’s Third-Party Risk Management program including oversight by the Bancorp’s independent model risk management group. The scenarios included a most likely outcome (Baseline) and two less probable scenarios with one being more favorable than the Baseline and the other being less favorable. The more favorable alternative scenario (Upside) depicted a stronger near-term growth outlook while the less favorable outlook (Downside) depicted a moderate recession. The Baseline scenario was assigned a probability weighting of 80% with each of the Upside and Downside scenarios being assigned a 10% weighting.\nThe Baseline scenario was developed such that the expectation is that the economy will perform better than the projection 50% of the time and worse than the projection 50% of the time. The Upside scenario was developed such that there is a 10% probability that the economy will perform better than the projection and a 90% probability that it will perform worse. The Downside scenario was developed such that there is a 90% probability that the economy will perform better than the projection and a 10% probability that it will perform worse.\nJune 30, 2021 ACL\nThe ACL as of June 30, 2021 was impacted by several factors, including improvement in both the economic outlook and credit quality. As a result of these factors, the Bancorp incorporated a combination of quantitative model-based estimates and qualitative adjustments. For the quantitative estimates, the Bancorp incorporated three scenarios developed by the third party in May 2021 that included estimates of the expected impacts of the changes in economic conditions caused by the COVID-19 pandemic. The Baseline scenario was assigned a probability weighting of 60%, with a more favorable scenario (Upside) assigned a probability weighting of 20% and a less favorable scenario (Downside) assigned a probability of 20%. The Baseline scenario assumed that a “Build Back Better” program will be passed in late 2021, with implementation early next year. In 2021, real GDP is expected to rise 6.8%, while real consumer spending is forecast to increase 10.7% at an annualized rate. The Baseline scenario also assumes an average unemployment rate of 4.5% in the fourth quarter of 2021, decreasing to\n54\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\n3.7% in 2022. The Upside scenario assumes a faster than expected boost in consumer sentiment and spending as a result of the government stimulus programs. On an average annual basis, the change in real GDP is 7.3% in 2021 and 6.5% in 2022, and a full-employment rate is expected to be achieved by the third quarter of 2021. The Downside scenario excludes any additional stimulus package beyond the American Rescue Plan passed in March 2021. Real GDP declines through the first quarter of 2022, and the unemployment rate peaks at 9.2% in the third quarter of 2022 with full-employment not reached until the third quarter of 2026.\nThe Bancorp’s quantitative credit loss models are sensitive to changes in economic forecast assumptions over the reasonable and supportable forecast period. Applying a 100% probability weighting to the Downside scenario rather than using the probability-weighted three scenario approach would result in an increase in the quantitative ACL of approximately $763 million. This sensitivity calculation only reflects the impact of changing the probability weighting of the scenarios in the quantitative credit loss models and excludes any additional considerations associated with the qualitative component of the ACL that might be warranted if probability weights were adjusted.\nAt June 30, 2021, the qualitative component of the ACL included consideration of certain factors that represent emerging risks specifically associated with the current economic environment and the COVID-19 pandemic. These considerations resulted in qualitative adjustments to increase the ACL, primarily related to volatility in short-term unemployment rates, commercial borrowers experiencing prolonged distress, commercial borrowers in certain industries which have been severely impacted by the COVID-19 pandemic and consumer borrowers that deferred contractual payments under COVID-19 forbearance or hardship programs.\nThe following table provides a rollforward of the Bancorp’s ACL:\n| TABLE 57: Changes in Allowance for Credit Losses |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| ALLL: |\n| Balance, beginning of period | $ | 2,208 | 2,348 | 2,453 | 1,202 |\n| Losses charged-off(a) | (103) | (163) | (211) | (322) |\n| Recoveries of losses previously charged-off(a) | 59 | 33 | 96 | 70 |\n| (Benefit from) provision for loan and lease losses | (131) | 478 | (305) | 1,103 |\n| Impact of adoption of ASU 2016-13 | — | — | — | 643 |\n| Balance, end of period | $ | 2,033 | 2,696 | 2,033 | 2,696 |\n| Reserve for unfunded commitments: |\n| Balance, beginning of period | $ | 173 | 169 | 172 | 144 |\n| Provision for the reserve for unfunded commitments | 16 | 7 | 17 | 22 |\n| Impact of adoption of ASU 2016-13 | — | — | — | 10 |\n| Balance, end of period | $ | 189 | 176 | 189 | 176 |\n\n(a)For the three and six months ended June 30, 2021, the Bancorp recorded $8 and $18, respectively, in both losses charged-off and recoveries of losses previously charged-off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements. For the three and six months ended June 30, 2020, the Bancorp recorded $9 and $22, respectively, in both losses charged-off and recoveries of losses previously charged-off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements.\n55\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following table provides an attribution of the Bancorp’s ALLL to portfolio loans and leases:\n| TABLE 58: Attribution of Allowance for Loan and Lease Losses to Portfolio Loans and Leases |\n| As of ($ in millions) | June 30,2021 | December 31,2020 |\n| Attributed ALLL: |\n| Commercial and industrial loans | $ | 744 | 901 |\n| Commercial mortgage loans | 371 | 402 |\n| Commercial construction loans | 85 | 124 |\n| Commercial leases | 24 | 29 |\n| Residential mortgage loans | 235 | 294 |\n| Home equity | 152 | 201 |\n| Indirect secured consumer loans | 109 | 131 |\n| Credit card | 198 | 252 |\n| Other consumer loans | 115 | 119 |\n| Total ALLL | $ | 2,033 | 2,453 |\n| Portfolio loans and leases: |\n| Commercial and industrial loans | $ | 47,564 | 49,665 |\n| Commercial mortgage loans | 10,347 | 10,602 |\n| Commercial construction loans | 5,871 | 5,815 |\n| Commercial leases | 3,238 | 2,915 |\n| Residential mortgage loans | 16,131 | 15,928 |\n| Home equity | 4,545 | 5,183 |\n| Indirect secured consumer loans | 15,192 | 13,653 |\n| Credit card | 1,793 | 2,007 |\n| Other consumer loans | 3,052 | 3,014 |\n| Total portfolio loans and leases | $ | 107,733 | 108,782 |\n| Attributed ALLL as a percent of respective portfolio loans and leases: |\n| Commercial and industrial loans | 1.56 | % | 1.81 |\n| Commercial mortgage loans | 3.59 | 3.79 |\n| Commercial construction loans | 1.45 | 2.13 |\n| Commercial leases | 0.74 | 0.99 |\n| Residential mortgage loans | 1.46 | 1.85 |\n| Home equity | 3.34 | 3.88 |\n| Indirect secured consumer loans | 0.72 | 0.96 |\n| Credit card | 11.04 | 12.56 |\n| Other consumer loans | 3.77 | 3.95 |\n| Total ALLL as a percent of portfolio loans and leases | 1.89 | % | 2.25 |\n| Total ACL as a percent of portfolio loans and leases | 2.06 | 2.41 |\n\nThe Bancorp’s ALLL may vary significantly from period to period based on changes in economic conditions, economic forecasts and the composition and credit quality of the Bancorp’s loan and lease portfolio. For additional information on the Bancorp’s methodology for measuring the ACL, refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10‑K for the year ended December 31, 2020.\n56\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nINTEREST RATE AND PRICE RISK MANAGEMENT\nInterest rate risk is the risk to earnings or capital arising from movement of interest rates. This risk primarily impacts the Bancorp’s income categories through changes in interest income on earning assets and the cost of interest-bearing liabilities, and through fee items that are related to interest sensitive activities such as mortgage origination and servicing income and through earnings credits earned on commercial deposits that offset commercial deposit fees. Price risk is the risk to earnings or capital arising from changes in the value of financial instruments and portfolios due to movements in interest rates, volatilities, foreign exchange rates, equity prices and commodity prices. Management considers interest rate risk a prominent market risk in terms of its potential impact on earnings. Interest rate risk may occur for any one or more of the following reasons:\n•Assets and liabilities mature or reprice at different times;\n•Short-term and long-term market interest rates change by different amounts; or\n•The expected maturities of various assets or liabilities shorten or lengthen as interest rates change.\nIn addition to the direct impact of interest rate changes on NII and interest-sensitive fees, interest rates can impact earnings through their effect on loan and deposit demand, credit losses, mortgage origination volumes, the value of servicing rights and other sources of the Bancorp’s earnings. Changes in interest rates and other market factors can impact earnings through changes in the value of portfolios, if not appropriately hedged. Stability of the Bancorp’s net income is largely dependent upon the effective management of interest rate risk and to a lesser extent price risk. Management continually reviews the Bancorp’s on- and off-balance sheet composition, earnings flows, and hedging strategies and models interest rate risk and price risk exposures, and possible actions to manage these risks, given numerous possible future interest rate and market factor scenarios. A series of Policy Limits and Key Risk Indicators are employed to ensure that risks are managed within the Bancorp’s risk tolerance for interest rate risk and price risk.\nIn addition to the traditional forms of interest rate risk discussed in this section, the Bancorp is exposed to interest rate risk associated with the retirement and replacement of LIBOR. For more information on the LIBOR transition, refer to the Overview section of MD&A.\nThe Commercial and Wealth and Asset Management lines of business manage price risk for capital markets sales and trading activities related to their respective businesses. The Mortgage line of business manages price risk for the origination and sale of conforming residential mortgage loans to government agencies and government-sponsored enterprises. The Bancorp’s Treasury department manages interest rate risk and price risk for all other activities. Independent oversight is provided by ERM, and key risk indicators and Board-approved policy limits are used to ensure risks are managed within the Bancorp’s risk tolerance.\nThe Bancorp’s Market Risk Management Committee, which includes senior management representatives, is accountable to the ERMC, provides oversight and monitors price risk for the capital markets sales and trading activities. The Bancorp’s ALCO, which includes senior management representatives and is accountable to the ERMC, provides oversight and monitors interest rate and price risks for Mortgage and Treasury activities.\nNet Interest Income Sensitivity\nThe Bancorp employs a variety of measurement techniques to identify and manage its interest rate risk, including the use of an NII simulation model to analyze the sensitivity of NII to changes in interest rates. The model is based on contractual and estimated cash flows and repricing characteristics for all of the Bancorp’s assets, liabilities and off-balance sheet exposures and incorporates market-based assumptions regarding the effect of changing interest rates on the prepayment rates of certain assets and attrition rates of certain liabilities. The model also includes senior management’s projections of the future volume and pricing of each of the product lines offered by the Bancorp as well as other pertinent assumptions. Actual results may differ from simulated results due to timing, magnitude and frequency of interest rate changes, deviations from projected assumptions as well as from changes in market conditions and management strategies.\nAs of June 30, 2021, the Bancorp’s interest rate risk exposure is governed by a risk framework that utilizes the change in NII over 12-month and 24-month horizons assuming a 200 bps parallel ramped increase in interest rates. Given the unlikely probability associated with a potential negative rate environment, the Bancorp does not have a policy limit for scenarios that include negative rates. Therefore, the Bancorp has no policy limit for a scenario with a decrease in interest rates currently in effect as the Federal Funds target range is currently between zero and 25 basis points. However, the Bancorp routinely analyzes various potential and extreme scenarios, including parallel ramps and shocks as well as steepening and other non-parallel shifts in rates, including negative rate scenarios, to assess where risks to net interest income persist or develop as changes in the balance sheet and market rates evolve. Additionally, the Bancorp routinely evaluates its exposures to changes in the bases between interest rates. The ongoing COVID-19 pandemic has caused significant changes to interest rates, volatilities and the composition of the Bancorp’s balance sheet, including significant increases in deposit funding related to stimulus programs, which has resulted in an excess liquidity position. The excess liquidity is likely to continue negatively impacting net interest margin if short-term interest rates hold steady or move lower but may be partially offset by the amortization of fees related to PPP loans and investment opportunities should the yield curve steepen.\nIn order to recognize the risk of noninterest-bearing demand deposit balance run-off in a rising interest rate environment, the Bancorp’s NII sensitivity modeling assumes that approximately $5 billion of additional demand deposit balances run-off over 24 months above what is\n57\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nincluded in senior management’s baseline projections for each 100 bps increase in short-term market interest rates. Similarly, the Bancorp’s NII sensitivity modeling incorporates approximately $5 billion of incremental growth in noninterest-bearing deposit balances over 24 months above senior management’s baseline projections for each 100 bps decrease in short-term market interest rates. The incremental balance run-off and growth are modeled to flow into and out of funding products that reprice in conjunction with short-term market rate changes and reflect the Bank’s excess liquidity position.\nAnother important deposit modeling assumption is the amount by which interest-bearing deposit rates will increase or decrease when market interest rates increase or decrease. This deposit repricing sensitivity is known as the beta, and it represents the expected amount by which Bancorp deposit rates will change for a given change in short-term market rates. At June 30, 2021, the modeling assumed a weighted-average rising-rate interest-bearing deposit beta of 37%, which is aligned with the portfolio’s experience in the last rate hike cycle. In the event of further rate cuts by the FRB into negative territory, the Bancorp’s NII sensitivity modeling assumes a weighted-average falling-rate interest-bearing deposit beta of 32% at June 30, 2021, while maintaining that deposit rates themselves will not become negative. In addition, the modeling assumes there is no lag between the timing of changes in market rates and the timing of deposit repricing despite such timing lags having occurred in prior rate cycles.\nThe Bancorp continually evaluates the sensitivity of its interest rate risk measures to these important deposit modeling assumptions. The Bancorp also regularly monitors the sensitivity of other important modeling assumptions, such as loan and security prepayments and early withdrawals on fixed-rate customer liabilities.\nThe following table shows the Bancorp’s estimated NII sensitivity profile and ALCO policy limits as of:\n| TABLE 59: Estimated NII Sensitivity Profile and ALCO Policy Limits |\n| June 30, 2021 | June 30, 2020 |\n| % Change in NII (FTE) | ALCOPolicy Limit | % Change in NII (FTE) | ALCOPolicy Limit |\n| Change in Interest Rates (bps) | 12 Months | 13-24Months | 12Months | 13-24Months | 12 Months | 13-24Months | 12Months | 13-24Months |\n| +200 Ramp over 12 months | 10.79 | % | 22.38 | (4.00) | (6.00) | 1.98 | 7.26 | (4.00) | (6.00) |\n| +100 Ramp over 12 months | 5.64 | 12.37 | N/A | N/A | 1.02 | 3.88 | N/A | N/A |\n| -25 Ramp over 3 months | (2.06) | (3.15) | N/A | N/A | (1.64) | (2.53) | N/A | N/A |\n\nAt June 30, 2021, the Bancorp’s NII would benefit significantly in both year one and year two under the parallel rate ramp increases. The Bancorp maintains an asymmetric NII sensitivity profile, which is attributable to the level of floating-rate assets, including the predominantly floating-rate commercial loan portfolio, exceeding the level of floating-rate liabilities due to the increased amount of deposit rates near zero in this low interest rate environment and other fixed-rate borrowings. Reductions in the yield of the commercial loan portfolio would be expected to be only partially offset by a decline in the cost of interest-bearing deposits in a falling-rate scenario. However, proactive management of the securities and derivatives portfolios has reduced the ongoing near-term risk to declining market rates and provided significant protection from the decline in rates experienced as the COVID-19 pandemic unfolded. The changes in the estimated NII sensitivity profile compared to June 30, 2020 were primarily attributable to the revision of the deposit beta assumptions in the first quarter of 2021 and the significant increase in noninterest-bearing and low-cost interest-bearing deposits. The falling-rate scenario was also impacted by the higher composition of low-cost deposits hitting their floor rates more quickly in the current-year scenario due to the low-rate environment.\nTables 60 and 61 provide the sensitivity of the Bancorp’s estimated NII profile at June 30, 2021 to changes to certain deposit balance and deposit repricing sensitivity (betas) assumptions.\nThe following table includes the Bancorp’s estimated NII sensitivity profile at June 30, 2021 with an immediate $5 billion decrease and an immediate $5 billion increase in demand deposit balances:\n| TABLE 60: Estimated NII Sensitivity Profile at June 30, 2021 with a $5 Billion Change in Demand Deposit Assumption |\n| % Change in NII (FTE) |\n| Immediate $5 Billion BalanceDecrease | Immediate $5 Billion BalanceIncrease |\n| Change in Interest Rates (bps) | 12 Months | 13-24Months | 12Months | 13-24Months |\n| +200 Ramp over 12 months | 9.72 | % | 20.22 | 11.86 | 24.53 |\n| +100 Ramp over 12 months | 5.11 | 11.29 | 6.18 | 13.45 |\n| -25 Ramp over 3 months | (2.31) | (3.42) | (1.82) | (2.88) |\n\n58\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following table includes the Bancorp’s estimated NII sensitivity profile with a 25% increase and a 25% decrease to the corresponding deposit beta assumptions as of June 30, 2021:\n| TABLE 61: Estimated NII Sensitivity Profile at June 30, 2021 with Deposit Beta Assumptions Changes |\n| % Change in NII (FTE) |\n| Betas 25% Higher(a) | Betas 25% Lower(b) |\n| Change in Interest Rates (bps) | 12 Months | 13-24Months | 12Months | 13-24Months |\n| +200 Ramp over 12 months | 8.65 | % | 18.49 | 12.93 | 26.27 |\n| +100 Ramp over 12 months | 4.59 | 10.49 | 6.70 | 14.26 |\n| -25 Ramp over 3 months | (2.04) | (3.12) | (2.15) | (3.23) |\n\n(a)Includes weighted-average rising-rate and falling-rate interest-bearing deposit betas of 46% and 40%, respectively.\n(b)Includes weighted-average rising-rate and falling-rate interest-bearing deposit betas of 28% and 24%, respectively.\nEconomic Value of Equity Sensitivity\nThe Bancorp also uses EVE as a measurement tool in managing interest rate risk. Whereas the NII sensitivity analysis highlights the impact on forecasted NII on an FTE basis (non-GAAP) over one- and two-year time horizons, EVE is a point-in-time analysis of the economic sensitivity of current positions that incorporates all cash flows over their estimated remaining lives. The EVE of the balance sheet is defined as the discounted present value of all asset and net derivative cash flows less the discounted value of all liability cash flows. Due to this longer horizon, the sensitivity of EVE to changes in the level of interest rates is a measure of longer-term interest rate risk. EVE values only the current balance sheet and does not incorporate the balance growth assumptions used in the NII sensitivity analysis. As with the NII simulation model, assumptions about the timing and variability of existing balance sheet cash flows are critical in the EVE analysis. Particularly important are assumptions driving loan and security prepayments and the expected balance attrition and pricing of indeterminate-lived deposits.\nThe following table shows the Bancorp’s estimated EVE sensitivity profile as of:\n| TABLE 62: Estimated EVE Sensitivity Profile |\n| June 30, 2021 | June 30, 2020 |\n| Change in Interest Rates (bps) | % Change in EVE | ALCOPolicy Limit | % Change in EVE | ALCOPolicy Limit |\n| +200 Shock | 6.25 | % | (12.00) | (2.86) | (12.00) |\n| +100 Shock | 3.63 | N/A | (0.82) | N/A |\n| -25 Shock | (1.18) | N/A | N/A | N/A |\n\nThe EVE sensitivity is significantly positive in a +200 bps rising-rate scenario at June 30, 2021. The changes in the estimated EVE sensitivity profile from June 30, 2020 were primarily related to the revision of the deposit beta assumptions in the first quarter of 2021, growth in noninterest-bearing and low-cost interest-bearing deposits and the shorter expected lives of prepayable, fixed-rate assets due to the decrease in market interest rates. These items were partially offset by continued repositioning of the investment portfolio into securities with less principal cash flows in the near term.\nWhile an instantaneous shift in interest rates is used in this analysis to provide an estimate of exposure, the Bancorp believes that a gradual shift in interest rates would have a much more modest impact. Since EVE measures the discounted present value of cash flows over the estimated lives of instruments, the change in EVE does not directly correlate to the degree that earnings would be impacted over a shorter time horizon (e.g., the current fiscal year). Further, EVE does not account for factors such as future balance sheet growth, changes in product mix, changes in yield curve relationships and changing product spreads that could mitigate or exacerbate the impact of changes in interest rates. The NII simulations and EVE analyses do not necessarily include certain actions that management may undertake to manage risk in response to actual changes in interest rates.\nThe Bancorp regularly evaluates its exposures to a static balance sheet forecast, LIBOR, Prime Rate and other basis risks, yield curve twist risks and embedded options risks. In addition, the impacts on NII on an FTE basis and EVE of extreme changes in interest rates are modeled, wherein the Bancorp employs the use of yield curve shocks and environment-specific scenarios.\nUse of Derivatives to Manage Interest Rate Risk\nAn integral component of the Bancorp’s interest rate risk management strategy is its use of derivative instruments to minimize significant fluctuations in earnings caused by changes in market interest rates. Examples of derivative instruments that the Bancorp may use as part of its interest rate risk management strategy include interest rate swaps, interest rate floors, interest rate caps, forward contracts, forward starting interest rate swaps, options, swaptions and TBA securities.\n59\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nTables 63 and 64 show all swap and floor positions that are utilized for purposes of managing the Bancorp’s exposures to the variability of interest rates. These positions are used to convert the contractual interest rate index of agreed-upon amounts of assets and liabilities (i.e., notional amounts) to another interest rate index or to hedge forecasted transactions for the variability in cash flows attributable to the contractually specified interest rate. The volume, maturity and mix of portfolio swaps change frequently as the Bancorp adjusts its broader interest rate risk management objectives and the balance sheet positions to be hedged. For further information, including the notional amount and fair values of these derivatives, refer to Note 13 of the Notes to Condensed Consolidated Financial Statements.\nThe following tables present additional information about the interest rate swaps and floors used in Fifth Third’s asset and liability management activities:\n| TABLE 63: Weighted-Average Maturity, Receive Rate and Pay Rate on Qualifying Hedging Instruments |\n| As of June 30, 2021 ($ in millions) | NotionalAmount | FairValue | Remaining(years) | Receive/Strike Rate |\n| Interest rate swaps – cash flow – receive-fixed | $ | 8,000 | (1) | 2.5 | 3.02 | % | 1 ML |\n| Interest rate swaps – fair value – receive-fixed | 1,455 | 429 | 10.2 | 6.03 | 1 ML / 3 ML |\n| Total interest rate swaps | $ | 9,455 | 428 |\n| Interest rate floors – cash flow – receive-fixed | $ | 3,000 | 183 | 3.5 | 2.25 | 1 ML |\n| TABLE 64: Weighted-Average Maturity, Receive Rate and Pay Rate on Qualifying Hedging Instruments |\n| As of December 31, 2020 ($ in millions) | Notional Amount | Fair Value | Remaining (years) | Receive/Strike Rate |\n| Interest rate swaps – cash flow – receive-fixed | $ | 8,000 | 14 | 3.0 | 3.02 | % | 1 ML |\n| Interest rate swaps – fair value – receive-fixed | 1,955 | 528 | 8.1 | 5.35 | 1 ML / 3 ML |\n| Total interest rate swaps | $ | 9,955 | 542 |\n| Interest rate floors – cash flow – receive-fixed | $ | 3,000 | 244 | 4.0 | 2.25 | 1 ML |\n\nAdditionally, as part of its overall risk management strategy relative to its residential mortgage banking activities, the Bancorp enters into forward contracts accounted for as free-standing derivatives to economically hedge IRLCs that are also considered free-standing derivatives. The Bancorp economically hedges its exposure to residential mortgage loans held for sale through the use of forward contracts and mortgage options as well. See the Residential Mortgage Servicing Rights and Price Risk section for the discussion of the use of derivatives to economically hedge this exposure.\nThe Bancorp also enters into derivative contracts with major financial institutions to economically hedge market risks assumed in interest rate derivative contracts with commercial customers. Generally, these contracts have similar terms in order to protect the Bancorp from market volatility. Credit risk arises from the possible inability of the counterparties to meet the terms of their contracts, which the Bancorp minimizes through collateral arrangements, approvals, limits and monitoring procedures. The Bancorp has risk limits and internal controls in place to help ensure excessive risk is not being taken in providing this service to customers. These controls include an independent determination of interest rate volatility and credit equivalent exposure on these contracts and counterparty credit approvals performed by independent risk management. For further information, including the notional amount and fair values of these derivatives, refer to Note 13 of the Notes to Condensed Consolidated Financial Statements.\nResidential Mortgage Servicing Rights and Price Risk\nThe fair value of the residential MSR portfolio was $818 million and $656 million at June 30, 2021 and December 31, 2020, respectively. The value of servicing rights can fluctuate sharply depending on changes in interest rates and other factors. Generally, as interest rates decline and loans are prepaid to take advantage of refinancing, the total value of existing servicing rights declines because no further servicing fees are collected on repaid loans. The Bancorp maintains a non-qualifying hedging strategy relative to its mortgage banking activity in order to manage a portion of the risk associated with changes in the value of its MSR portfolio as a result of changing interest rates.\nFor the three and six months ended June 30, 2021, the Bancorp recognized losses of $122 million and $50 million, respectively, in mortgage banking net revenue for valuation adjustments on the MSR portfolio. The valuation adjustments on the MSR portfolio included a decrease of $49 million for the three months ended June 30, 2021 and an increase of $103 million for the six months ended June 30, 2021 due to changes to inputs in the valuation model, including future prepayment speeds and OAS assumptions. Assumptions were updated as a result of market rate changes during the three and six months ended June 30, 2021. For the three months ended June 30, 2021, a decrease in mortgage rates caused modeled prepayment speeds to rise. For the six months ended June 30, 2021, an increase in mortgage rates resulted in a reduction to modeled prepayment speeds, and a tightening of the spread between mortgage rates and swap rates resulted in a decrease in the modeled OAS assumptions. The fair value of the MSR portfolio also decreased $73 million and $153 million as a result of contractual principal payments and actual prepayment activity for the three and six months ended June 30, 2021, respectively.\n60\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nMortgage rates decreased during both the three and six months ended June 30, 2020, which caused modeled prepayment speeds to rise. The fair value of the MSR portfolio decreased $12 million and $343 million for the three and six months ended June 30, 2020, respectively, due to changes to inputs to the valuation model including prepayment speeds and OAS assumptions and decreased $58 million and $105 million for the three and six months ended June 30, 2020, respectively, due to the impact of contractual principal payments and actual prepayment activity.\nThe Bancorp recognized net gains of $47 million and net losses of $89 million on its non-qualifying hedging strategy for the three and six months ended June 30, 2021, respectively, compared to net gains of $11 million and $364 million during the three and six months ended June 30, 2020, respectively. These amounts included net gains of $1 million and net losses of $1 million for the three and six months ended June 30, 2021, respectively, compared to net gains of an immaterial amount and $3 million for the three and six months ended June 30, 2020, respectively, on securities related to the Bancorp’s non-qualifying hedging strategy. The Bancorp may adjust its hedging strategy to reflect its assessment of the composition of its MSR portfolio, the cost of hedging and the anticipated effectiveness of the hedges given the economic environment. Refer to Note 12 of the Notes to Condensed Consolidated Financial Statements for further discussion on servicing rights and the instruments used to hedge price risk on MSRs.\nForeign Currency Risk\nThe Bancorp may enter into foreign exchange derivative contracts to economically hedge certain foreign denominated loans. The derivatives are classified as free-standing instruments with the revaluation gain or loss being recorded in other noninterest income in the Condensed Consolidated Statements of Income. The balance of the Bancorp’s foreign denominated loans at June 30, 2021 and December 31, 2020 was $841 million and $655 million, respectively. The Bancorp also enters into foreign exchange contracts for the benefit of commercial customers to hedge their exposure to foreign currency fluctuations. Similar to the hedging of price risk from interest rate derivative contracts entered into with commercial customers, the Bancorp also enters into foreign exchange contracts with major financial institutions to economically hedge a substantial portion of the exposure from client-driven foreign exchange activity. The Bancorp has risk limits and internal controls in place to help ensure excessive risk is not being taken in providing this service to customers. These controls include an independent determination of currency volatility and credit equivalent exposure on these contracts, counterparty credit approvals and country limits performed by independent risk management.\nCommodity Risk\nThe Bancorp also enters into commodity contracts for the benefit of commercial customers to hedge their exposure to commodity price fluctuations. Similar to the hedging of foreign exchange and price risk from interest rate derivative contracts, the Bancorp also enters into commodity contracts with major financial institutions to economically hedge a substantial portion of the exposure from client-driven commodity activity. The Bancorp may also offset this risk with exchange-traded commodity contracts. The Bancorp has risk limits and internal controls in place to help ensure excessive risk is not taken in providing this service to customers. These controls include an independent determination of commodity volatility and credit equivalent exposure on these contracts and counterparty credit approvals performed by independent risk management.\n61\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nLIQUIDITY RISK MANAGEMENT\nThe goal of liquidity management is to provide adequate funds to meet changes in loan and lease demand, unexpected levels of deposit withdrawals and other contractual obligations. Mitigating liquidity risk is accomplished by maintaining liquid assets in the form of cash and investment securities, maintaining sufficient unused borrowing capacity in the debt markets and delivering consistent growth in core deposits. A summary of certain obligations and commitments to make future payments under contracts is included in Note 16 of the Notes to Condensed Consolidated Financial Statements.\nThe Bancorp’s Treasury department manages funding and liquidity based on point-in-time metrics as well as forward-looking projections, which incorporate different sources and uses of funds under base and stress scenarios. Liquidity risk is monitored and managed by the Treasury department with independent oversight provided by ERM, and a series of Policy Limits and Key Risk Indicators are established to ensure risks are managed within the Bancorp’s risk tolerance. The Bancorp maintains a contingency funding plan that provides for liquidity stress testing, which assesses the liquidity needs under varying market conditions, time horizons, asset growth rates and other events. The contingency plan provides for ongoing monitoring of unused borrowing capacity and available sources of contingent liquidity to prepare for unexpected liquidity needs and to cover unanticipated events that could affect liquidity. The contingency plan also outlines the Bancorp’s response to various levels of liquidity stress and actions that should be taken during various scenarios.\nLiquidity risk is monitored and managed for both Fifth Third Bancorp and its subsidiaries. The Bancorp receives substantially all of its liquidity from dividends from its subsidiaries, primarily Fifth Third Bank, National Association. Subsidiary dividends are supplemented with term debt to enable the Bancorp to maintain sufficient liquidity to meet its cash obligations, including debt service and scheduled maturities, common and preferred dividends, unfunded commitments to subsidiaries and other planned capital actions in the form of share repurchases. Liquidity resources are more limited at the Bancorp, making its liquidity position more susceptible to market disruptions. Bancorp liquidity is assessed using a cash coverage horizon, ensuring the entity maintains sufficient liquidity to withstand a period of sustained market disruption while meeting its anticipated obligations over an extended stressed horizon.\nThe Bancorp’s ALCO, which includes senior management representatives and is accountable to the ERMC, monitors and manages liquidity and funding risk within Board-approved policy limits. In addition to the risk management activities of ALCO, the Bancorp has a liquidity risk management function as part of ERM that provides independent oversight of liquidity risk management.\nSources of Funds\nThe Bancorp’s primary sources of funds relate to cash flows from loan and lease repayments, payments from securities related to sales and maturities, the sale or securitization of loans and leases and funds generated by core deposits, in addition to the use of public and private debt offerings.\nRefer to the Interest Rate and Price Risk Management subsection of the Risk Management section of MD&A included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for information about the expected cash flows from loan and lease repayments. Of the $38.0 billion of securities in the Bancorp’s available-for-sale debt and other securities portfolio at June 30, 2021, $4.7 billion in principal and interest is expected to be received in the next 12 months and an additional $4.2 billion is expected to be received in the next 13 to 24 months. For further information on the Bancorp’s securities portfolio, refer to the Investment Securities subsection of the Balance Sheet Analysis section of MD&A.\nAsset-driven liquidity is provided by the Bancorp’s ability to sell or securitize loans and leases. In order to reduce the exposure to interest rate fluctuations and to manage liquidity, the Bancorp has developed securitization and sale procedures for several types of interest-sensitive assets. A majority of the long-term, fixed-rate single-family residential mortgage loans underwritten according to FHLMC or FNMA guidelines are sold for cash upon origination. Additional assets such as certain other residential mortgage loans, certain commercial loans and leases, home equity loans, automobile loans and other consumer loans are also capable of being securitized or sold. For the three and six months ended June 30, 2021, the Bancorp sold or securitized loans and leases totaling $4.5 billion and $8.1 billion, respectively, compared to $3.1 billion and $6.2 billion during the three and six months ended June 30, 2020, respectively. For further information, refer to Note 12 of the Notes to Condensed Consolidated Financial Statements.\nCore deposits have historically provided the Bancorp with a sizeable source of relatively stable and low-cost funds. The Bancorp’s average core deposits and average shareholders’ equity funded 89% of its average total assets for both the three and six months ended June 30, 2021, compared to 85% for both the three and six months ended June 30, 2020. In addition to core deposit funding, the Bancorp also accesses a variety of other short-term and long-term funding sources, which include the use of the FHLB system. Certificates $100,000 and over and certain deposits in the Bancorp’s foreign branch located in the Cayman Islands are wholesale funding tools utilized to fund asset growth. Management does not rely on any one source of liquidity and manages availability in response to changing balance sheet needs.\nAs of June 30, 2021, $4.7 billion of debt or other securities were available for issuance under the current Bancorp’s Board of Directors’ authorizations and the Bancorp is authorized to file any necessary registration statements with the SEC to permit ready access to the public securities markets; however, access to these markets may depend on market conditions.\n62\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nAs of June 30, 2021, the Bank’s global bank note program had a borrowing capacity of $25.0 billion, of which $21.1 billion was available for issuance. Additionally, at June 30, 2021, the Bank had approximately $47.3 billion of borrowing capacity available through secured borrowing sources, including the FRB and FHLB.\nCurrent Liquidity Position\nThe COVID-19 pandemic has significantly impacted the economic environment, although financial markets, initially supported by Federal Reserve programs, have been stable and well-functioning following the onset of the crisis, aided by significant monetary and fiscal response. The Bancorp maintains a strong liquidity profile driven by strong core deposit funding and over $100 billion in current available liquidity. The Bancorp is managing liquidity prudently in the current environment and maintains a liquidity profile focused on core deposit and stable long-term funding sources which allows for the effective management of concentration and rollover risk.\nAs of June 30, 2021, the Bancorp has sufficient liquidity to meet contractual obligations and all preferred and common dividends without accessing the capital markets or receiving upstream dividends from the Bank subsidiary for 30 months.\nCredit Ratings\nThe cost and availability of financing to the Bancorp and Bank are impacted by its credit ratings. A downgrade to the Bancorp’s or Bank’s credit ratings could affect its ability to access the credit markets and increase its borrowing costs, thereby adversely impacting the Bancorp’s or Bank’s financial condition and liquidity. Key factors in maintaining high credit ratings include a stable and diverse earnings stream, strong credit quality, strong capital ratios and diverse funding sources, in addition to disciplined liquidity monitoring procedures.\nThe Bancorp’s and Bank’s credit ratings are summarized in Table 65. The ratings reflect the ratings agency’s view on the Bancorp’s and Bank’s capacity to meet financial commitments.*\n*As an investor, you should be aware that a security rating is not a recommendation to buy, sell or hold securities, that it may be subject to revision or withdrawal at any time by the assigning rating organization and that each rating should be evaluated independently of any other rating. Additional information on the credit rating ranking within the overall classification system is located on the website of each credit rating agency.\n| TABLE 65: Agency Ratings |\n| As of August 6, 2021 | Moody’s | Standard and Poor’s | Fitch | DBRS Morningstar |\n| Fifth Third Bancorp: |\n| Short-term borrowings | No rating | A-2 | F1 | R-1L |\n| Senior debt | Baa1 | BBB+ | A- | A |\n| Subordinated debt | Baa1 | BBB | BBB+ | AL |\n| Fifth Third Bank, National Association: |\n| Short-term borrowings | P-2 | A-2 | F1 | R-1M |\n| Short-term deposit | P-1 | No rating | F1 | No rating |\n| Long-term deposit | A1 | No rating | A | AH |\n| Senior debt | A3 | A- | A- | AH |\n| Subordinated debt | A3 | BBB+ | BBB+ | A |\n| Rating Agency Outlook for Fifth Third Bancorp and Fifth Third Bank, National Association | Stable | Stable | Stable | Negative |\n\n63\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nOPERATIONAL RISK MANAGEMENT\nOperational risk is the risk to current or projected financial condition and resilience arising from inadequate or failed internal processes or systems, human errors or misconduct or adverse external events that are neither market- nor credit-related. Operational risk is inherent in the Bancorp’s activities and can manifest itself in various ways, including fraudulent acts, business interruptions, inappropriate behavior of employees, unintentional failure to comply with applicable laws and regulations, poor design or delivery of products and services, cyber-security or physical security incidents and privacy breaches or failure of third parties to perform in accordance with their arrangements. These events could result in financial losses, litigation and regulatory fines, as well as other damage to the Bancorp. The Bancorp’s risk management goal is to keep operational risk at appropriate levels consistent with the Bancorp’s risk appetite, financial strength, the characteristics of its businesses, the markets in which it operates and the competitive and regulatory environment to which it is subject.\nTo control, monitor and govern operational risk, the Bancorp maintains an overall Risk Management Framework which comprises governance oversight, risk assessment, capital measurement, monitoring and reporting as well as a formal three lines of defense approach. ERM is responsible for prescribing the framework to the lines of business and corporate functions and providing independent oversight of its implementation (second line of defense). Business Controls groups are in place in each of the lines of business to ensure consistent implementation and execution of managing day-to-day operational risk (first line of defense).\nThe Bancorp’s risk management framework consists of five integrated components, including identifying, assessing, managing, monitoring and independent governance reporting of risk. The corporate Operational Risk Management function within Enterprise Risk is responsible for developing and overseeing the implementation of the Bancorp’s approach to managing operational risk. This includes providing governance, awareness and training, tools, guidance and oversight to support implementation of key risk programs and systems as they relate to operational risk management, such as risk and control self-assessments, product delivery risk assessment, scenario analysis, new product/initiative risk reviews, key risk indicators, Third-Party Risk Management, cyber-security risk management and review of operational losses. The function is also responsible for developing reports that support the proactive management of operational risk across the enterprise. The lines of business and corporate functions are responsible for managing the operational risks associated with their areas in accordance with the risk management framework. The framework is intended to enable the Bancorp to function with a sound and well-controlled operational environment. These processes support the Bancorp’s goals to minimize future operational losses and strengthen the Bancorp’s performance by maintaining sufficient capital to absorb operational losses that are incurred.\nThe Bancorp also maintains a robust information security program to support the management of cyber-security risk within the organization with a focus on prevention, detection and recovery processes. Fifth Third utilizes a wide array of techniques to secure its operations and proprietary information such as Board-approved policies and programs, network monitoring and testing, access controls and dedicated security personnel. Fifth Third has adopted the National Institute of Standards and Technology Cybersecurity Framework for the management and deployment of cyber-security controls and is an active participant in the financial sector information sharing organization structure, known as the Financial Services Information Sharing and Analysis Center. To ensure resiliency of key Bancorp functions, Fifth Third also employs redundancy protocols that include a robust business continuity function that works to mitigate any potential impacts to Fifth Third customers and its systems.\nFifth Third also focuses on the reporting and escalation of operational control issues to senior management and the Board of Directors. The Operational Risk Committee is the key committee that oversees and supports Fifth Third in the management of operational risk across the enterprise. The Information Security Governance Committee and Model Risk Committee report to the Operational Risk Committee and are responsible for governance of information security and model risks. The Operational Risk Committee reports to the ERMC, which reports to the Risk and Compliance Joint Committee of the Board of Directors of Fifth Third Bancorp and Fifth Third Bank, National Association.\nThe COVID-19 pandemic continues to put pressure on operational risk including cyber, fraud and third-party risks driven by factors such as remote work strategies, relief programs and outsourced service providers. Additionally, increased external threats have elevated fraud and cyber-security risks. These risks continue to be carefully managed and monitored to ensure effective controls are in place, with appropriate oversight and governance by the second line of defense. Fifth Third has a defined pandemic plan and a robust business continuity management process, which have been leveraged to support the continuity of processes across the Bank.\n64\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nLEGAL AND REGULATORY COMPLIANCE RISK MANAGEMENT\nLegal and regulatory compliance risk is the risk of legal or regulatory sanctions, financial loss or damage to reputation as a result of noncompliance with (i) applicable laws, regulations, rules and other regulatory requirements (including but not limited to the risk of consumers experiencing economic loss or other legal harm as a result of noncompliance with consumer protection laws, regulations and requirements); (ii) internal policies and procedures, standards of best practice or codes of conduct; and (iii) principles of integrity and fair dealing applicable to Fifth Third’s activities and functions. Legal risks include the risk of actions against the institution that result in unenforceable contracts, lawsuits, legal sanctions, or adverse judgments, which disrupt or otherwise negatively affect the operations or condition of the institution. Failure to effectively manage such risks can elevate the risk level or manifest itself as other types of key risks, including reputational or operational risk. Fifth Third focuses on managing legal and regulatory compliance risk in accordance with the Bancorp’s integrated risk management framework, which ensures consistent processes for identifying, assessing, managing, monitoring and reporting risks. The Bancorp’s risk management goal is to keep compliance risk at appropriate levels, consistent with the Bancorp’s risk appetite.\nTo mitigate such risks, Compliance Risk Management provides independent oversight to foster consistency and sufficiency in the execution of the program, and ensures that lines of business and support functions are adequately identifying, assessing and monitoring legal and regulatory compliance risks and adopting proper mitigation strategies. Moreover, such strategies are modified from time to time to respond to new or emerging risks in the environment. Compliance Risk Management and the Legal Division provide guidance to the lines of business and enterprise functions, which are ultimately responsible for managing such risks associated with their areas. The Chief Compliance Officer and Director of Financial Crimes is responsible for formulating and directing the strategy, development, implementation, communication and maintenance of the Compliance Risk Management program, which implements key compliance processes, including but not limited to, executive- and board-level governance and reporting routines, compliance-related policies, risk assessments, key risk indicators, issues tracking, regulatory change management and regulatory compliance testing and monitoring. As part of Compliance Risk Management, the Financial Crimes Division conducts and oversees anti-money laundering and economic sanctions processes. Compliance Risk Management partners with the Community and Economic Development team to oversee the Bancorp’s compliance with the Community Reinvestment Act.\nFifth Third also reports and escalates legal and regulatory compliance issues to senior management and the Board of Directors. The Management Compliance Committee, which is chaired by the Chief Compliance Officer and Director of Financial Crimes, is the key committee that oversees and supports Fifth Third in the management of compliance risk across the enterprise. The Management Compliance Committee oversees Bancorp-wide compliance issues, industry best practices, legislative developments, regulatory concerns and other leading indicators of legal and regulatory compliance risk. The Management Compliance Committee reports to the ERMC, which reports to the RCC of the Board of Directors of Fifth Third Bancorp and Fifth Third Bank, National Association.\n65\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nCAPITAL MANAGEMENT\nManagement regularly reviews the Bancorp’s capital levels to help ensure it is appropriately positioned under various operating environments. The Bancorp has established a Capital Committee which is responsible for making capital plan recommendations to management. These recommendations are reviewed by the ERMC and the annual capital plan is approved by the Board of Directors. The Capital Committee is responsible for execution and oversight of the capital actions of the capital plan.\nRegulatory Capital Ratios\nThe Basel III Final Rule sets minimum regulatory capital ratios as well as defines the measure of “well-capitalized” for insured depository institutions.\n| TABLE 66: Prescribed Capital Ratios |\n| Minimum | Well-Capitalized |\n| CET1 capital: |\n| Fifth Third Bancorp | 4.50 | % | N/A |\n| Fifth Third Bank, National Association | 4.50 | 6.50 |\n| Tier I risk-based capital: |\n| Fifth Third Bancorp | 6.00 | 6.00 |\n| Fifth Third Bank, National Association | 6.00 | 8.00 |\n| Total risk-based capital: |\n| Fifth Third Bancorp | 8.00 | 10.00 |\n| Fifth Third Bank, National Association | 8.00 | 10.00 |\n| Tier I leverage: |\n| Fifth Third Bancorp | 4.00 | N/A |\n| Fifth Third Bank, National Association | 4.00 | 5.00 |\n\nThe Bancorp is subject to the stress capital buffer requirement, which replaced the capital conservation buffer on October 1, 2020. Institutions subject to the stress capital buffer requirement must maintain capital ratios above their respective buffered minimum (regulatory minimum plus stress capital buffer) in order to avoid certain limitations on capital distributions and discretionary bonuses to executive officers. The FRB uses the supervisory stress test to determine the Bancorp’s stress capital buffer, subject to a floor of 2.5%. The Bancorp’s stress capital buffer requirement has been 2.5% since the introduction of this framework and was most recently affirmed on June 24, 2021. The Bancorp’s capital ratios have exceeded the stress capital buffer requirement for all periods presented.\nIn April 2018, the federal banking regulators proposed transitional arrangements to permit banking organizations to phase in the day-one impact of the adoption of ASU 2016-13, referred to as CECL, on regulatory capital over a period of three years. The proposed rule was adopted as final effective July 1, 2019. The phase-in provisions of the final rule are optional for a banking organization that experiences a reduction in retained earnings due to CECL adoption as of the beginning of the fiscal year in which the banking organization adopts CECL. A banking organization that elects the phase-in provisions of the final rule for regulatory capital purposes must phase in 25% of the transitional amounts impacting regulatory capital in the first year of adoption of CECL, 50% in the second year, 75% in the third year, with full impact beginning in the fourth year.\nIn March 2020, the banking agencies issued an interim final rule for additional transitional relief to regulatory capital related to the impact of the adoption of CECL given the disruption in economic activity caused by the COVID-19 pandemic. The interim final rule provides banking organizations that adopt CECL in the 2020 calendar year with the option to delay for two years the estimated impact of CECL on regulatory capital, followed by the aforementioned three-year transition period to phase out the aggregate amount of benefit during the initial two-year delay for a total five-year transition. The estimated impact of CECL on regulatory capital (modified CECL transitional amount) is calculated as the sum of the day-one impact on retained earnings upon adoption of CECL (CECL transitional amount) and the calculated change in the ACL relative to the day-one ACL upon adoption of CECL multiplied by a scaling factor of 25%. The scaling factor is used to approximate the difference in the ACL under CECL relative to the incurred loss methodology. The modified CECL transitional amount will be calculated each quarter for the first two years of the five-year transition. The amount of the modified CECL transition amount will be fixed as of December 31, 2021 and that amount will be subject to the three-year phase out.\nThe Bancorp adopted ASU 2016-13 on January 1, 2020 and elected the five-year transition phase-in option for the impact of CECL on regulatory capital with its regulatory filings as of March 31, 2020. The impact of the modified CECL transition amount on the Bancorp’s regulatory capital at June 30, 2021 was an increase in capital of approximately $535 million. On a fully phased-in basis, the Bancorp’s CET1 ratio would be reduced by 34 basis points as of June 30, 2021. The CECL transition amount will begin to phase in during the fiscal year starting January 1, 2022 and will be fully phased in by January 1, 2025.\n66\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nThe following table summarizes the Bancorp’s capital ratios as of:\n| TABLE 67: Capital Ratios |\n| ($ in millions) | June 30,2021 | December 31,2020 |\n| Quarterly average total Bancorp shareholders’ equity as a percent of average assets | 11.11 | % | 11.34 |\n| Tangible equity as a percent of tangible assets(a)(b) | 8.35 | 8.18 |\n| Tangible common equity as a percent of tangible assets(a)(b) | 7.28 | 7.11 |\n| Regulatory capital:(c) |\n| CET1 capital | $ | 15,050 | 14,682 |\n| Tier I capital | 17,166 | 16,797 |\n| Total regulatory capital | 21,184 | 21,412 |\n| Risk-weighted assets | 145,084 | 141,974 |\n| Regulatory capital ratios:(c) |\n| CET1 capital | 10.37 | % | 10.34 |\n| Tier I risk-based capital | 11.83 | 11.83 |\n| Total risk-based capital | 14.60 | 15.08 |\n| Tier I leverage | 8.55 | 8.49 |\n\n(a)These are non-GAAP measures. For further information, refer to the Non-GAAP Financial Measures section of MD&A.\n(b)Excludes AOCI.\n(c)Regulatory capital ratios as of June 30, 2021 are calculated pursuant to the five-year transition provision option to phase in the effects of CECL on regulatory capital.\nCapital Planning\nIn 2011, the FRB adopted the capital plan rule, which requires BHCs with consolidated assets of $50 billion or more to submit annual capital plans to the FRB for review. Under the rule, these capital plans must include detailed descriptions of the following: the BHC’s internal processes for assessing capital adequacy; the policies governing capital actions such as common stock issuances, dividends and share repurchases; and all planned capital actions over a nine-quarter planning horizon. Furthermore, each BHC must report to the FRB the results of stress tests conducted by the BHC under a number of scenarios that assess the sources and uses of capital under baseline and stressed economic conditions.\nOn October 10, 2019, the Federal Reserve Board adopted final rules to tailor certain prudential standards for large domestic and foreign banking organizations. As a result of the EPS Tailoring Rule, the Bancorp is subject to Category IV standards, under which the Bancorp is no longer required to file semi-annual, company-run stress tests with the FRB and publicly disclose the results. However, the Bancorp is required to develop and maintain a capital plan approved by the Board of Directors on an annual basis. As an institution subject to Category IV standards, the Bancorp is subject to the FRB’s supervisory stress tests every two years, the Board capital plan rule and certain FR Y-14 reporting requirements. The supervisory stress tests are forward-looking quantitative evaluations of the impact of stressful economic and financial market conditions on the Bancorp’s capital. The Bancorp became subject to Category IV standards on December 31, 2019, and the requirements outlined above apply to the stress test cycle that started on January 1, 2020. The Bancorp is not subject to the 2021 supervisory stress test conducted by the FRB but has submitted its Board-approved capital plan as required.\nIn June 2020, the FRB took several actions in connection with its announcement of stress test results in light of the uncertainty caused by the COVID-19 pandemic. Specifically, for the third quarter of 2020, the FRB required large banking organizations, including the Bancorp, to suspend share repurchases, cap dividend payments to the amount paid during the second quarter of 2020, and further limit dividends according to a formula based on recent income. These restrictions were extended, quarterly, with certain modifications, throughout the remainder of 2020.\nThe FRB extended these restrictions into the first and second quarters of 2021, with certain modifications to permit a limited amount of share repurchases. During the first and second quarters of 2021, the Bancorp was authorized to pay dividends and execute share repurchases according to a formula based on recent income provided the Bancorp did not increase the amount of its common dividend.\nIn June 2021, the FRB lifted the COVID-19 pandemic induced capital distribution limitations, which prohibited increases to the common dividend and placed limitations on share repurchases, and authorized the Bancorp, beginning July 1, 2021, to make capital distributions that are consistent with the requirements in the Board’s capital plan rule, inclusive of the Bancorp’s stress capital buffer requirement. The Bancorp maintains a comprehensive process for managing capital and expects the stress capital buffer framework to provide greater flexibility for the Bancorp to assess and deploy capital.\n67\n| Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) |\n\nDividend Policy and Stock Repurchase Program\nThe Bancorp’s common stock dividend policy and stock repurchase program reflect its earnings outlook, desired payout ratios, the need to maintain adequate capital levels, the ability of its subsidiaries to pay dividends and the need to comply with safe and sound banking practices as well as meet regulatory requirements and expectations. The Bancorp declared dividends per common share of $0.27 for both the three months ended June 30, 2021 and 2020, and $0.54 for both the six months ended June 30, 2021 and 2020. Pursuant to the Bancorp’s Board-approved capital plan, during the second quarter of 2021, the Bancorp entered into and settled an accelerated share repurchase transaction in the amount of $347 million. Refer to Note 15 and Note 23 of the Notes to Condensed Consolidated Financial Statements for additional information on share repurchase activity.\nThe following table summarizes the monthly share repurchase activity for the three months ended June 30, 2021:\n| TABLE 68: Share Repurchases |\n| Period | Total Numberof Shares Purchased(a) | Average PricePaid per Share | Total Number of SharesPurchased as a Part ofPublicly Announced Plans or Programs | Maximum Number ofShares that May Yet BePurchased under the Plans or Programs(b) |\n| April 1 - April 30, 2021 | 8,022,822 | $ | 40.46 | 7,894,807 | 63,224,146 |\n| May 1 - May 31, 2021 | 126,867 | 41.73 | — | 63,224,146 |\n| June 1 - June 30, 2021 | 713,157 | 40.53 | 675,295 | 62,548,851 |\n| Total | 8,862,846 | $ | 40.48 | 8,570,102 | 62,548,851 |\n\n(a) Includes 292,744 shares repurchased during the second quarter of 2021 in connection with various employee compensation plans. These purchases do not count against the maximum number of shares that may yet be purchased under the Board of Directors’ authorization.\n(b) In June 2019, the Bancorp announced that its Board of Directors had authorized management to purchase 100 million shares of the Bancorp’s common stock through the open market or in any private party transactions. This authorization did not include specific targets or an expiration date.\n68\n| Quantitative and Qualitative Disclosures about Market Risk (Item 3) |\n\nInformation presented in the Interest Rate and Price Risk Management section of Management’s Discussion and Analysis of Financial Condition and Results of Operations is incorporated herein by reference. This information contains certain statements that we believe are forward-looking statements. Refer to page 1 for cautionary information regarding forward-looking statements.\n| Controls and Procedures (Item 4) |\n\nThe Bancorp conducted an evaluation, under the supervision and with the participation of the Bancorp’s management, including the Bancorp’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Bancorp’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based on the foregoing, as of the end of the period covered by this report, the Bancorp’s Chief Executive Officer and Chief Financial Officer concluded that the Bancorp’s disclosure controls and procedures were effective, in all material respects, to ensure that information required to be disclosed in the reports the Bancorp files and submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported as and when required and information is accumulated and communicated to the Bancorp’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.\nThe Bancorp’s management also conducted an evaluation of internal control over financial reporting to determine whether any changes occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Bancorp’s internal control over financial reporting. Based on this evaluation there has been no such change during the period covered by this report.\n69\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (Item 1) |\n\n| CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited) |\n| As of |\n| June 30, | December 31, |\n| ($ in millions, except share data) | 2021 | 2020 |\n| Assets |\n| Cash and due from banks | $ | 3,285 | 3,147 |\n| Other short-term investments(a) | 32,409 | 33,399 |\n| Available-for-sale debt and other securities(b) | 38,012 | 37,513 |\n| Held-to-maturity securities(c) | 10 | 11 |\n| Trading debt securities | 711 | 560 |\n| Equity securities | 341 | 313 |\n| Loans and leases held for sale(d) | 5,730 | 4,741 |\n| Portfolio loans and leases(a)(e) | 107,733 | 108,782 |\n| Allowance for loan and lease losses(a) | ( 2,033 ) | ( 2,453 ) |\n| Portfolio loans and leases, net | 105,700 | 106,329 |\n| Bank premises and equipment(f) | 2,073 | 2,088 |\n| Operating lease equipment | 715 | 777 |\n| Goodwill | 4,259 | 4,258 |\n| Intangible assets | 117 | 139 |\n| Servicing rights | 818 | 656 |\n| Other assets(a) | 11,210 | 10,749 |\n| Total Assets | $ | 205,390 | 204,680 |\n| Liabilities |\n| Deposits: |\n| Noninterest-bearing deposits | $ | 62,760 | 57,711 |\n| Interest-bearing deposits(g) | 99,523 | 101,370 |\n| Total deposits | 162,283 | 159,081 |\n| Federal funds purchased | 338 | 300 |\n| Other short-term borrowings | 1,130 | 1,192 |\n| Accrued taxes, interest and expenses | 2,045 | 2,614 |\n| Other liabilities(a) | 4,304 | 3,409 |\n| Long-term debt(a) | 12,364 | 14,973 |\n| Total Liabilities | $ | 182,464 | 181,569 |\n| Equity |\n| Common stock(h) | $ | 2,051 | 2,051 |\n| Preferred stock(i) | 2,116 | 2,116 |\n| Capital surplus | 3,602 | 3,635 |\n| Retained earnings | 19,343 | 18,384 |\n| Accumulated other comprehensive income | 1,974 | 2,601 |\n| Treasury stock(h) | ( 6,160 ) | ( 5,676 ) |\n| Total Equity | $ | 22,926 | 23,111 |\n| Total Liabilities and Equity | $ | 205,390 | 204,680 |\n\n(a) Includes $ 33 and $ 55 of other short-term investments, $ 455 and $ 756 of portfolio loans and leases, $( 3 ) and $( 7 ) of ALLL, $ 3 and $ 5 of other assets, $ 1 and $ 2 of other liabilities, and $ 400 and $ 656 of long-term debt from consolidated VIEs that are included in their respective captions above at June 30, 2021 and December 31, 2020, respectively. For further information, refer to Note 11.\n(b) Amortized cost of $ 36,081 and $ 34,982 at June 30, 2021 and December 31, 2020, respectively.\n(c) Fair value of $ 10 and $ 11 at June 30, 2021 and December 31, 2020, respectively.\n(d) Includes $ 1,633 and $ 1,481 of residential mortgage loans held for sale measured at fair value at June 30, 2021 and December 31, 2020, respectively.\n(e) Includes $ 151 and $ 161 of residential mortgage loans measured at fair value at June 30, 2021 and December 31, 2020, respectively.\n(f) Includes $ 25 and $ 35 of bank premises and equipment held for sale at June 30, 2021 and December 31, 2020, respectively.\n(g) Includes $ 341 and $ 351 of interest checking deposits held for sale at June 30, 2021 and December 31, 2020, respectively.\n(h) Common shares: Stated value $ 2.22 per share; authorized 2,000,000,000 ; outstanding at June 30, 2021 – 703,739,634 (excludes 220,152,947 treasury shares), December 31, 2020 – 712,760,325 (excludes 211,132,256 treasury shares).\n(i) 500,000 shares of no par value preferred stock were authorized at both June 30, 2021 and December 31, 2020. There were 422,000 unissued shares of undesignated no par value preferred stock at both June 30, 2021 and December 31, 2020. Each issued share of no par value preferred stock has a liquidation preference of $ 25,000 . 500,000 shares of no par value Class B preferred stock were authorized at both June 30, 2021 and December 31, 2020. There were 300,000 unissued shares of undesignated no par value Class B preferred stock at both June 30, 2021 and December 31, 2020. Each issued share of no par value Class B preferred stock has a liquidation preference of $ 1,000 .\nRefer to the Notes to Condensed Consolidated Financial Statements.\n70\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\n| CONDENSED CONSOLIDATED STATEMENTS OF INCOME (unaudited) |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions, except share data) | 2021 | 2020 | 2021 | 2020 |\n| Interest Income |\n| Interest and fees on loans and leases | $ | 1,035 | 1,115 | 2,064 | 2,350 |\n| Interest on securities | 279 | 283 | 543 | 566 |\n| Interest on other short-term investments | 9 | 5 | 17 | 12 |\n| Total interest income | 1,323 | 1,403 | 2,624 | 2,928 |\n| Interest Expense |\n| Interest on deposits | 15 | 83 | 36 | 248 |\n| Interest on federal funds purchased | — | — | — | 2 |\n| Interest on other short-term borrowings | — | 2 | 1 | 8 |\n| Interest on long-term debt | 100 | 118 | 202 | 241 |\n| Total interest expense | 115 | 203 | 239 | 499 |\n| Net Interest Income | 1,208 | 1,200 | 2,385 | 2,429 |\n| (Benefit from) provision for credit losses | ( 115 ) | 485 | ( 288 ) | 1,125 |\n| Net Interest Income After (Benefit from) Provision for Credit Losses | 1,323 | 715 | 2,673 | 1,304 |\n| Noninterest Income |\n| Commercial banking revenue | 160 | 137 | 313 | 261 |\n| Service charges on deposits | 149 | 122 | 292 | 270 |\n| Wealth and asset management revenue | 145 | 120 | 288 | 255 |\n| Card and processing revenue | 102 | 82 | 196 | 167 |\n| Mortgage banking net revenue | 64 | 99 | 149 | 219 |\n| Leasing business revenue | 61 | 57 | 148 | 131 |\n| Other noninterest income | 49 | 12 | 92 | 18 |\n| Securities gains (losses), net | 10 | 21 | 13 | ( 3 ) |\n| Securities (losses) gains, net – non-qualifying hedges on mortgage servicing rights | 1 | — | ( 1 ) | 3 |\n| Total noninterest income | 741 | 650 | 1,490 | 1,321 |\n| Noninterest Expense |\n| Compensation and benefits | 638 | 627 | 1,343 | 1,274 |\n| Technology and communications | 94 | 90 | 187 | 183 |\n| Net occupancy expense | 77 | 82 | 156 | 164 |\n| Equipment expense | 34 | 32 | 68 | 64 |\n| Leasing business expense | 33 | 33 | 68 | 68 |\n| Card and processing expense | 20 | 29 | 50 | 60 |\n| Marketing expense | 20 | 20 | 43 | 51 |\n| Other noninterest expense | 237 | 208 | 454 | 457 |\n| Total noninterest expense | 1,153 | 1,121 | 2,369 | 2,321 |\n| Income Before Income Taxes | 911 | 244 | 1,794 | 304 |\n| Applicable income tax expense | 202 | 49 | 391 | 61 |\n| Net Income | 709 | 195 | 1,403 | 243 |\n| Dividends on preferred stock | 35 | 32 | 55 | 50 |\n| Net Income Available to Common Shareholders | $ | 674 | 163 | 1,348 | 193 |\n| Earnings per share - basic | $ | 0.95 | 0.23 | 1.89 | 0.27 |\n| Earnings per share - diluted | $ | 0.94 | 0.23 | 1.87 | 0.27 |\n| Average common shares outstanding - basic | 708,832,787 | 714,766,570 | 711,617,331 | 714,161,131 |\n| Average common shares outstanding - diluted | 718,084,745 | 717,571,890 | 720,740,176 | 718,967,293 |\n\nRefer to the Notes to Condensed Consolidated Financial Statements.\n71\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\n| CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (unaudited) |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Net Income | $ | 709 | 195 | 1,403 | 243 |\n| Other Comprehensive (Loss) Income, Net of Tax: |\n| Unrealized gains on available-for-sale debt securities: |\n| Unrealized holding (losses) gains arising during period | 235 | 456 | ( 466 ) | 1,338 |\n| Reclassification adjustment for net losses (gains) included in net income | ( 5 ) | — | 7 | — |\n| Unrealized gains on cash flow hedge derivatives: |\n| Unrealized holding (losses) gains arising during period | 9 | 66 | ( 55 ) | 493 |\n| Reclassification adjustment for net gains included in net income | ( 58 ) | ( 49 ) | ( 115 ) | ( 74 ) |\n| Defined benefit pension plans, net: |\n| Net actuarial loss arising during the year | ( 1 ) | — | ( 1 ) | — |\n| Reclassification of amounts to net periodic benefit costs | 2 | 1 | 3 | 2 |\n| Other comprehensive (loss) income, net of tax | 182 | 474 | ( 627 ) | 1,759 |\n| Comprehensive Income | $ | 891 | 669 | 776 | 2,002 |\n\nRefer to the Notes to Condensed Consolidated Financial Statements.\n72\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\n| CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY (unaudited) |\n| ($ in millions, except per share data) | CommonStock | PreferredStock | CapitalSurplus | RetainedEarnings | AccumulatedOtherComprehensiveIncome | TreasuryStock | TotalEquity |\n| Balance at March 31, 2020 | $ | 2,051 | 1,770 | 3,597 | 17,677 | 2,477 | ( 5,699 ) | 21,873 |\n| Net income | 195 | 195 |\n| Other comprehensive income, net of tax | 474 | 474 |\n| Cash dividends declared: |\n| Common stock ($ 0.27 per share) | ( 195 ) | ( 195 ) |\n| Preferred stock: |\n| Series H ($ 637.50 per share) | ( 15 ) | ( 15 ) |\n| Series I ($ 414.06 per share) | ( 7 ) | ( 7 ) |\n| Series J ($ 289.38 per share) | ( 4 ) | ( 4 ) |\n| Series K ($ 309.38 per share) | ( 3 ) | ( 3 ) |\n| Class B, Series A ($ 15.00 per share) | ( 3 ) | ( 3 ) |\n| Impact of stock transactions under stock compensation plans, net | 6 | 14 | 20 |\n| Other | ( 2 ) | 2 | — |\n| Balance at June 30, 2020 | $ | 2,051 | 1,770 | 3,603 | 17,643 | 2,951 | ( 5,683 ) | 22,335 |\n| Balance at March 31, 2021 | $ | 2,051 | 2,116 | 3,592 | 18,863 | 1,792 | ( 5,819 ) | 22,595 |\n| Net income | 709 | 709 |\n| Other comprehensive income, net of tax | 182 | 182 |\n| Cash dividends declared: |\n| Common stock ($ 0.27 per share) | ( 192 ) | ( 192 ) |\n| Preferred stock: |\n| Series H ($ 637.50 per share) | ( 15 ) | ( 15 ) |\n| Series I ($ 414.06 per share) | ( 7 ) | ( 7 ) |\n| Series J ($ 210.44 per share) | ( 3 ) | ( 3 ) |\n| Series K ($ 309.38 per share) | ( 3 ) | ( 3 ) |\n| Series L ($ 281.25 per share) | ( 4 ) | ( 4 ) |\n| Class B, Series A ($ 15.00 per share) | ( 3 ) | ( 3 ) |\n| Shares acquired for treasury | ( 347 ) | ( 347 ) |\n| Impact of stock transactions under stock compensation plans, net | 10 | 5 |\n\nQuantitative and Qualitative Disclosures about Market Risk (Item 3)\nInformation presented in the Interest Rate and Price Risk Management section of Management’s Discussion and Analysis of Financial Condition and Results of Operations is incorporated herein by reference. This information contains certain statements that we believe are forward-looking statements. Refer to page 1 for cautionary information regarding forward-looking statements.\nControls and Procedures (Item 4)\nThe Bancorp conducted an evaluation, under the supervision and with the participation of the Bancorp’s management, including the Bancorp’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Bancorp’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based on the foregoing, as of the end of the period covered by this report, the Bancorp’s Chief Executive Officer and Chief Financial Officer concluded that the Bancorp’s disclosure controls and procedures were effective, in all material respects, to ensure that information required to be disclosed in the reports the Bancorp files and submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported as and when required and information is accumulated and communicated to the Bancorp’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.\nThe Bancorp’s management also conducted an evaluation of internal control over financial reporting to determine whether any changes occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Bancorp’s internal control over financial reporting. Based on this evaluation there has been no such change during the period covered by this report.\n69\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (Item 1) |\n\n| CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited) |\n| As of |\n| June 30, | December 31, |\n| ($ in millions, except share data) | 2021 | 2020 |\n| Assets |\n| Cash and due from banks | $ | 3,285 | 3,147 |\n| Other short-term investments(a) | 32,409 | 33,399 |\n| Available-for-sale debt and other securities(b) | 38,012 | 37,513 |\n| Held-to-maturity securities(c) | 10 | 11 |\n| Trading debt securities | 711 | 560 |\n| Equity securities | 341 | 313 |\n| Loans and leases held for sale(d) | 5,730 | 4,741 |\n| Portfolio loans and leases(a)(e) | 107,733 | 108,782 |\n| Allowance for loan and lease losses(a) | ( 2,033 ) | ( 2,453 ) |\n| Portfolio loans and leases, net | 105,700 | 106,329 |\n| Bank premises and equipment(f) | 2,073 | 2,088 |\n| Operating lease equipment | 715 | 777 |\n| Goodwill | 4,259 | 4,258 |\n| Intangible assets | 117 | 139 |\n| Servicing rights | 818 | 656 |\n| Other assets(a) | 11,210 | 10,749 |\n| Total Assets | $ | 205,390 | 204,680 |\n| Liabilities |\n| Deposits: |\n| Noninterest-bearing deposits | $ | 62,760 | 57,711 |\n| Interest-bearing deposits(g) | 99,523 | 101,370 |\n| Total deposits | 162,283 | 159,081 |\n| Federal funds purchased | 338 | 300 |\n| Other short-term borrowings | 1,130 | 1,192 |\n| Accrued taxes, interest and expenses | 2,045 | 2,614 |\n| Other liabilities(a) | 4,304 | 3,409 |\n| Long-term debt(a) | 12,364 | 14,973 |\n| Total Liabilities | $ | 182,464 | 181,569 |\n| Equity |\n| Common stock(h) | $ | 2,051 | 2,051 |\n| Preferred stock(i) | 2,116 | 2,116 |\n| Capital surplus | 3,602 | 3,635 |\n| Retained earnings | 19,343 | 18,384 |\n| Accumulated other comprehensive income | 1,974 | 2,601 |\n| Treasury stock(h) | ( 6,160 ) | ( 5,676 ) |\n| Total Equity | $ | 22,926 | 23,111 |\n| Total Liabilities and Equity | $ | 205,390 | 204,680 |\n\n(a) Includes $ 33 and $ 55 of other short-term investments, $ 455 and $ 756 of portfolio loans and leases, $( 3 ) and $( 7 ) of ALLL, $ 3 and $ 5 of other assets, $ 1 and $ 2 of other liabilities, and $ 400 and $ 656 of long-term debt from consolidated VIEs that are included in their respective captions above at June 30, 2021 and December 31, 2020, respectively. For further information, refer to Note 11.\n(b) Amortized cost of $ 36,081 and $ 34,982 at June 30, 2021 and December 31, 2020, respectively.\n(c) Fair value of $ 10 and $ 11 at June 30, 2021 and December 31, 2020, respectively.\n(d) Includes $ 1,633 and $ 1,481 of residential mortgage loans held for sale measured at fair value at June 30, 2021 and December 31, 2020, respectively.\n(e) Includes $ 151 and $ 161 of residential mortgage loans measured at fair value at June 30, 2021 and December 31, 2020, respectively.\n(f) Includes $ 25 and $ 35 of bank premises and equipment held for sale at June 30, 2021 and December 31, 2020, respectively.\n(g) Includes $ 341 and $ 351 of interest checking deposits held for sale at June 30, 2021 and December 31, 2020, respectively.\n(h) Common shares: Stated value $ 2.22 per share; authorized 2,000,000,000 ; outstanding at June 30, 2021 – 703,739,634 (excludes 220,152,947 treasury shares), December 31, 2020 – 712,760,325 (excludes 211,132,256 treasury shares).\n(i) 500,000 shares of no par value preferred stock were authorized at both June 30, 2021 and December 31, 2020. There were 422,000 unissued shares of undesignated no par value preferred stock at both June 30, 2021 and December 31, 2020. Each issued share of no par value preferred stock has a liquidation preference of $ 25,000 . 500,000 shares of no par value Class B preferred stock were authorized at both June 30, 2021 and December 31, 2020. There were 300,000 unissued shares of undesignated no par value Class B preferred stock at both June 30, 2021 and December 31, 2020. Each issued share of no par value Class B preferred stock has a liquidation preference of $ 1,000 .\nRefer to the Notes to Condensed Consolidated Financial Statements.\n70\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\n| CONDENSED CONSOLIDATED STATEMENTS OF INCOME (unaudited) |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions, except share data) | 2021 | 2020 | 2021 | 2020 |\n| Interest Income |\n| Interest and fees on loans and leases | $ | 1,035 | 1,115 | 2,064 | 2,350 |\n| Interest on securities | 279 | 283 | 543 | 566 |\n| Interest on other short-term investments | 9 | 5 | 17 | 12 |\n| Total interest income | 1,323 | 1,403 | 2,624 | 2,928 |\n| Interest Expense |\n| Interest on deposits | 15 | 83 | 36 | 248 |\n| Interest on federal funds purchased | — | — | — | 2 |\n| Interest on other short-term borrowings | — | 2 | 1 | 8 |\n| Interest on long-term debt | 100 | 118 | 202 | 241 |\n| Total interest expense | 115 | 203 | 239 | 499 |\n| Net Interest Income | 1,208 | 1,200 | 2,385 | 2,429 |\n| (Benefit from) provision for credit losses | ( 115 ) | 485 | ( 288 ) | 1,125 |\n| Net Interest Income After (Benefit from) Provision for Credit Losses | 1,323 | 715 | 2,673 | 1,304 |\n| Noninterest Income |\n| Commercial banking revenue | 160 | 137 | 313 | 261 |\n| Service charges on deposits | 149 | 122 | 292 | 270 |\n| Wealth and asset management revenue | 145 | 120 | 288 | 255 |\n| Card and processing revenue | 102 | 82 | 196 | 167 |\n| Mortgage banking net revenue | 64 | 99 | 149 | 219 |\n| Leasing business revenue | 61 | 57 | 148 | 131 |\n| Other noninterest income | 49 | 12 | 92 | 18 |\n| Securities gains (losses), net | 10 | 21 | 13 | ( 3 ) |\n| Securities (losses) gains, net – non-qualifying hedges on mortgage servicing rights | 1 | — | ( 1 ) | 3 |\n| Total noninterest income | 741 | 650 | 1,490 | 1,321 |\n| Noninterest Expense |\n| Compensation and benefits | 638 | 627 | 1,343 | 1,274 |\n| Technology and communications | 94 | 90 | 187 | 183 |\n| Net occupancy expense | 77 | 82 | 156 | 164 |\n| Equipment expense | 34 | 32 | 68 | 64 |\n| Leasing business expense | 33 | 33 | 68 | 68 |\n| Card and processing expense | 20 | 29 | 50 | 60 |\n| Marketing expense | 20 | 20 | 43 | 51 |\n| Other noninterest expense | 237 | 208 | 454 | 457 |\n| Total noninterest expense | 1,153 | 1,121 | 2,369 | 2,321 |\n| Income Before Income Taxes | 911 | 244 | 1,794 | 304 |\n| Applicable income tax expense | 202 | 49 | 391 | 61 |\n| Net Income | 709 | 195 | 1,403 | 243 |\n| Dividends on preferred stock | 35 | 32 | 55 | 50 |\n| Net Income Available to Common Shareholders | $ | 674 | 163 | 1,348 | 193 |\n| Earnings per share - basic | $ | 0.95 | 0.23 | 1.89 | 0.27 |\n| Earnings per share - diluted | $ | 0.94 | 0.23 | 1.87 | 0.27 |\n| Average common shares outstanding - basic | 708,832,787 | 714,766,570 | 711,617,331 | 714,161,131 |\n| Average common shares outstanding - diluted | 718,084,745 | 717,571,890 | 720,740,176 | 718,967,293 |\n\nRefer to the Notes to Condensed Consolidated Financial Statements.\n71\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\n| CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (unaudited) |\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Net Income | $ | 709 | 195 | 1,403 | 243 |\n| Other Comprehensive (Loss) Income, Net of Tax: |\n| Unrealized gains on available-for-sale debt securities: |\n| Unrealized holding (losses) gains arising during period | 235 | 456 | ( 466 ) | 1,338 |\n| Reclassification adjustment for net losses (gains) included in net income | ( 5 ) | — | 7 | — |\n| Unrealized gains on cash flow hedge derivatives: |\n| Unrealized holding (losses) gains arising during period | 9 | 66 | ( 55 ) | 493 |\n| Reclassification adjustment for net gains included in net income | ( 58 ) | ( 49 ) | ( 115 ) | ( 74 ) |\n| Defined benefit pension plans, net: |\n| Net actuarial loss arising during the year | ( 1 ) | — | ( 1 ) | — |\n| Reclassification of amounts to net periodic benefit costs | 2 | 1 | 3 | 2 |\n| Other comprehensive (loss) income, net of tax | 182 | 474 | ( 627 ) | 1,759 |\n| Comprehensive Income | $ | 891 | 669 | 776 | 2,002 |\n\nRefer to the Notes to Condensed Consolidated Financial Statements.\n72\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\n| CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY (unaudited) |\n| ($ in millions, except per share data) | CommonStock | PreferredStock | CapitalSurplus | RetainedEarnings | AccumulatedOtherComprehensiveIncome | TreasuryStock | TotalEquity |\n| Balance at March 31, 2020 | $ | 2,051 | 1,770 | 3,597 | 17,677 | 2,477 | ( 5,699 ) | 21,873 |\n| Net income | 195 | 195 |\n| Other comprehensive income, net of tax | 474 | 474 |\n| Cash dividends declared: |\n| Common stock ($ 0.27 per share) | ( 195 ) | ( 195 ) |\n| Preferred stock: |\n| Series H ($ 637.50 per share) | ( 15 ) | ( 15 ) |\n| Series I ($ 414.06 per share) | ( 7 ) | ( 7 ) |\n| Series J ($ 289.38 per share) | ( 4 ) | ( 4 ) |\n| Series K ($ 309.38 per share) | ( 3 ) | ( 3 ) |\n| Class B, Series A ($ 15.00 per share) | ( 3 ) | ( 3 ) |\n| Impact of stock transactions under stock compensation plans, net | 6 | 14 | 20 |\n| Other | ( 2 ) | 2 | — |\n| Balance at June 30, 2020 | $ | 2,051 | 1,770 | 3,603 | 17,643 | 2,951 | ( 5,683 ) | 22,335 |\n| Balance at March 31, 2021 | $ | 2,051 | 2,116 | 3,592 | 18,863 | 1,792 | ( 5,819 ) | 22,595 |\n| Net income | 709 | 709 |\n| Other comprehensive income, net of tax | 182 | 182 |\n| Cash dividends declared: |\n| Common stock ($ 0.27 per share) | ( 192 ) | ( 192 ) |\n| Preferred stock: |\n| Series H ($ 637.50 per share) | ( 15 ) | ( 15 ) |\n| Series I ($ 414.06 per share) | ( 7 ) | ( 7 ) |\n| Series J ($ 210.44 per share) | ( 3 ) | ( 3 ) |\n| Series K ($ 309.38 per share) | ( 3 ) | ( 3 ) |\n| Series L ($ 281.25 per share) | ( 4 ) | ( 4 ) |\n| Class B, Series A ($ 15.00 per share) | ( 3 ) | ( 3 ) |\n| Shares acquired for treasury | ( 347 ) | ( 347 ) |\n| Impact of stock transactions under stock compensation plans, net | 10 | 5 | 15 |\n| Other | ( 2 ) | 1 | ( 1 ) |\n| Balance at June 30, 2021 | $ | 2,051 | 2,116 | 3,602 | 19,343 | 1,974 | ( 6,160 ) | 22,926 |\n\n73\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\n| CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY (unaudited) |\n| ($ in millions, except per share data) | CommonStock | PreferredStock | CapitalSurplus | RetainedEarnings | AccumulatedOtherComprehensiveIncome | TreasuryStock | TotalEquity |\n| Balance at December 31, 2019 | $ | 2,051 | 1,770 | 3,599 | 18,315 | 1,192 | ( 5,724 ) | 21,203 |\n| Impact of cumulative effect of change in accounting principle | ( 472 ) | ( 472 ) |\n| Balance at January 1, 2020 | $ | 2,051 | 1,770 | 3,599 | 17,843 | 1,192 | ( 5,724 ) | 20,731 |\n| Net income | 243 | 243 |\n| Other comprehensive income, net of tax | 1,759 | 1,759 |\n| Cash dividends declared: |\n| Common stock ($ 0.54 per share) | ( 390 ) | ( 390 ) |\n| Preferred stock: |\n| Series H ($ 637.50 per share) | ( 15 ) | ( 15 ) |\n| Series I ($ 828.12 per share) | ( 15 ) | ( 15 ) |\n| Series J ($ 609.93 per share) | ( 8 ) | ( 8 ) |\n| Series K ($ 618.76 per share) | ( 6 ) | ( 6 ) |\n| Class B, Series A ($ 30.00 per share) | ( 6 ) | ( 6 ) |\n| Impact of stock transactions under stock compensation plans, net | 4 | 39 | 43 |\n| Other | ( 3 ) | 2 | ( 1 ) |\n| Balance at June 30, 2020 | $ | 2,051 | 1,770 | 3,603 | 17,643 | 2,951 | ( 5,683 ) | 22,335 |\n| Balance at December 31, 2020 | $ | 2,051 | 2,116 | 3,635 | 18,384 | 2,601 | ( 5,676 ) | 23,111 |\n| Net income | 1,403 | 1,403 |\n| Other comprehensive loss, net of tax | ( 627 ) | ( 627 ) |\n| Cash dividends declared: |\n| Common stock ($ 0.54 per share) | ( 387 ) | ( 387 ) |\n| Preferred stock: |\n| Series H ($ 637.50 per share) | ( 15 ) | ( 15 ) |\n| Series I ($ 828.12 per share) | ( 15 ) | ( 15 ) |\n| Series J ($ 421.94 per share) | ( 5 ) | ( 5 ) |\n| Series K ($ 618.75 per share) | ( 6 ) | ( 6 ) |\n| Series L ($ 562.50 per share) | ( 8 ) | ( 8 ) |\n| Class B, Series A ($ 30.00 per share) | ( 6 ) | ( 6 ) |\n| Shares acquired for treasury | ( 527 ) | ( 527 ) |\n| Impact of stock transactions under stock compensation plans, net | ( 33 ) | 42 | 9 |\n| Other | ( 2 ) | 1 | ( 1 ) |\n| Balance at June 30, 2021 | $ | 2,051 | 2,116 | 3,602 | 19,343 | 1,974 | ( 6,160 ) | 22,926 |\n\nRefer to the Notes to Condensed Consolidated Financial Statements.\n74\n| Fifth Third Bancorp and SubsidiariesCondensed Consolidated Financial Statements and Notes (continued) |\n| CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) |\n| For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 |\n| Operating Activities |\n| Net income | $ | 1,403 | 243 |\n| Adjustments to reconcile net income to net cash provided by operating activities: |\n| (Benefit from) provision for credit losses | ( 288 ) | 1,125 |\n| Depreciation, amortization and accretion | 243 | 231 |\n| Stock-based compensation expense | 79 | 77 |\n| Benefit from deferred income taxes | ( 239 ) | ( 48 ) |\n| Securities gains, net | ( 9 ) | ( 6 ) |\n| MSR fair value adjustment | 50 | 448 |\n| Net gains on sales of loans and fair value adjustments on loans held for sale | ( 176 ) | ( 88 ) |\n| Net losses on disposition and impairment of bank premises and equipment | 1 | 15 |\n| Net losses (gains) on disposition and impairment of operating lease equipment | 20 | ( 5 ) |\n| Proceeds from sales of loans held for sale | 7,974 | 6,234 |\n| Loans originated or purchased for sale, net of repayments | ( 8,899 ) | ( 5,706 ) |\n| Dividends representing return on equity investments | 20 | 6 |\n| Net change in: |\n| Equity and trading debt securities | ( 163 ) | 68 |\n| Other assets | 232 | ( 529 ) |\n| Accrued taxes, interest and expenses and other liabilities | ( 125 ) | ( 113 ) |\n| Net Cash Provided by Operating Activities | 123 | 1,952 |\n| Investing Activities |\n| Proceeds from sales: |\n| AFS securities and other investments | 1,454 | 868 |\n| Loans and leases | 436 | 57 |\n| Bank premises and equipment | 17 | 12 |\n| Proceeds from repayments / maturities of AFS and HTM securities and other investments | 2,948 | 1,252 |\n| Purchases: |\n| AFS securities and other investments | ( 5,825 ) | ( 2,815 ) |\n| Bank premises and equipment | ( 126 ) | ( 133 ) |\n| MSRs | ( 109 ) | ( 30 ) |\n| Proceeds from settlement of BOLI | 15 | 8 |\n| Proceeds from sales and dividends representing return of equity investments | 29 | 8 |\n| Net change in: |\n| Other short-term investments | 990 | ( 26,293 ) |\n| Portfolio loans and leases | 582 | ( 5,605 ) |\n| Operating lease equipment | ( 23 ) | ( 20 ) |\n| Net Cash Provided by (Used in) Investing Activities | 388 | ( 32,691 ) |\n| Financing Activities |\n| Net change in deposits | 3,202 | 29,884 |\n| Net change in other short-term borrowings and federal funds purchased | 14 | 195 |\n| Dividends paid on common and preferred stock | ( 444 ) | ( 417 ) |\n| Proceeds from issuance of long-term debt | 44 | 2,511 |\n| Repayment of long-term debt | ( 2,585 ) | ( 1,450 ) |\n| Repurchases of treasury stock and related forward contract | ( 527 ) | — |\n| Other | ( 77 ) | ( 41 ) |\n| Net Cash (Used in) Provided by Financing Activities | ( 373 ) | 30,682 |\n| Increase (Decrease) in Cash and Due from Banks | 138 | ( 57 ) |\n| Cash and Due from Banks at Beginning of Period | 3,147 | 3,278 |\n| Cash and Due from Banks at End of Period | $ | 3,285 | 3,221 |\n\nRefer to the Notes to Condensed Consolidated Financial Statements. Note 2 contains cash payments related to interest and income taxes in addition to non-cash investing and financing activities.\n75\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n1. Basis of Presentation\nThe Condensed Consolidated Financial Statements include the accounts of the Bancorp and its majority-owned subsidiaries and VIEs in which the Bancorp has been determined to be the primary beneficiary. Other entities, including certain joint ventures in which the Bancorp has the ability to exercise significant influence over operating and financial policies of the investee, but upon which the Bancorp does not possess control, are accounted for by the equity method and not consolidated. The investments in those entities in which the Bancorp does not have the ability to exercise significant influence are generally carried at fair value unless the investment does not have a readily determinable fair value. The Bancorp accounts for equity investments without a readily determinable fair value using the measurement alternative to fair value, representing the cost of the investment minus impairment recorded, if any, plus or minus changes resulting from observable price changes in orderly transactions for an identical or a similar investment of the same issuer. Intercompany transactions and balances among consolidated entities have been eliminated.\nIn the opinion of management, the unaudited Condensed Consolidated Financial Statements include all adjustments, which consist of normal recurring accruals, necessary to present fairly the results for the periods presented. In accordance with U.S. GAAP and the rules and regulations of the SEC for interim financial information, these statements do not include certain information and footnote disclosures required for complete annual financial statements and it is suggested that these Condensed Consolidated Financial Statements be read in conjunction with the Bancorp’s Annual Report on Form 10-K. The results of operations, comprehensive income and changes in equity for the three and six months ended June 30, 2021 and 2020 and the cash flows for the six months ended June 30, 2021 and 2020 are not necessarily indicative of the results to be expected for the full year. Financial information as of December 31, 2020 has been derived from the Bancorp’s Annual Report on Form 10-K.\nThe preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.\n2. Supplemental Cash Flow Information\nCash payments related to interest and income taxes in addition to non-cash investing and financing activities are presented in the following table for the six months ended June 30:\n| ($ in millions) | 2021 | 2020 |\n| Cash Payments: |\n| Interest | $ | 256 | 528 |\n| Income taxes | 336 | 268 |\n| Transfers: |\n| Portfolio loans and leases to loans and leases held for sale(a) | $ | 337 | 31 |\n| Loans and leases held for sale to portfolio loans and leases | 20 | 29 |\n| Portfolio loans and leases to OREO | 9 | 6 |\n| Loans and leases held for sale to OREO | — | 2 |\n| Bank premises and equipment to OREO | 17 | — |\n| Supplemental Disclosures: |\n| Net additions to lease liabilities under operating leases | $ | 31 | 27 |\n| Net additions to lease liabilities under finance leases | 25 | 76 |\n\n(a) Includes $ 139 of residential mortgage loans previously sold to GNMA which the Bancorp was initially deemed to have regained effective control over under ASC Topic 860 and which were recorded as portfolio loans. The Bancorp subsequently repurchased these loans and classified them as held for sal e.\n76\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n3. Accounting and Reporting Developments\nStandards Adopted in 2021\nThe Bancorp adopted the following new accounting standard during the six months ended June 30, 2021:\nASU 2019-12 – Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes\nIn December 2019, the FASB issued ASU 2019-12, which simplifies the accounting for income taxes by removing certain exceptions to the general principles in Topic 740. The amendments also clarify and amend existing guidance for other areas of Topic 740. The Bancorp adopted the amended guidance on January 1, 2021 on a modified retrospective basis, except for certain provisions of the amended guidance which were required to be adopted prospectively. The adoption of the amended guidance did not have a material impact on the Condensed Consolidated Financial Statements.\nReference Rate Reform and LIBOR Transition\nIn March 2020, the FASB issued ASU 2020-04, which provides optional expedients and exceptions for applying U.S. GAAP to contracts, hedging relationships and other transactions affected by reference rate reform if certain criteria are met. The amendments in the ASU apply only to contracts, hedging relationships and other transactions that reference LIBOR or another reference rate expected to be discontinued because of reference rate reform. Subsequently, in January 2021, the FASB issued ASU 2021-01, which clarified that the optional expedients and exceptions in Topic 848 for contract modifications and hedge accounting also apply to derivatives that are affected by the discounting transition. The expedients and exceptions provided by the amendments do not apply to contract modifications made and hedging relationships entered into or evaluated after December 31, 2022, except for hedging relationships existing as of December 31, 2022 for which an entity has elected certain optional expedients and that are retained through the end of the hedging relationship. The amendments in this ASU are effective for the Bancorp as of March 12, 2020 through December 31, 2022. The Bancorp is in the process of evaluating and applying, as applicable, the optional expedients and exceptions in accounting for eligible contract modifications, eligible existing hedging relationships and new hedging relationships available through December 31, 2022.\n77\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n4. Investment Securities\nThe following tables provide the amortized cost, unrealized gains and losses and fair value for the major categories of the available-for-sale debt and other securities and held-to-maturity securities portfolios as of:\n| June 30, 2021 ($ in millions) | AmortizedCost | UnrealizedGains | UnrealizedLosses | FairValue |\n| Available-for-sale debt and other securities: |\n| U.S. Treasury and federal agencies securities | $ | 105 | 2 | — | 107 |\n| Obligations of states and political subdivisions securities | 18 | — | — | 18 |\n| Mortgage-backed securities: |\n| Agency residential mortgage-backed securities | 10,256 | 573 | ( 20 ) | 10,809 |\n| Agency commercial mortgage-backed securities | 18,142 | 1,188 | ( 36 ) | 19,294 |\n| Non-agency commercial mortgage-backed securities | 3,276 | 203 | — | 3,479 |\n| Asset-backed securities and other debt securities | 3,764 | 48 | ( 27 ) | 3,785 |\n| Other securities(a) | 520 | — | — | 520 |\n| Total available-for-sale debt and other securities | $ | 36,081 | 2,014 | ( 83 ) | 38,012 |\n| Held-to-maturity securities: |\n| Obligations of states and political subdivisions securities | $ | 9 | — | — | 9 |\n| Asset-backed securities and other debt securities | 1 | — | — | 1 |\n| Total held-to-maturity securities | $ | 10 | — | — | 10 |\n\n(a)Other securities consist of FHLB, FRB and DTCC restricted stock holdings of $ 33 , $ 485 and $ 2 , respectively, at June 30, 2021, that are carried at cost.\n| December 31, 2020 ($ in millions) | AmortizedCost | UnrealizedGains | UnrealizedLosses | FairValue |\n| Available-for-sale debt and other securities: |\n| U.S. Treasury and federal agencies securities | $ | 74 | 4 | — | 78 |\n| Obligations of states and political subdivisions securities | 17 | — | — | 17 |\n| Mortgage-backed securities: |\n| Agency residential mortgage-backed securities | 11,147 | 768 | ( 8 ) | 11,907 |\n| Agency commercial mortgage-backed securities | 16,745 | 1,481 | ( 5 ) | 18,221 |\n| Non-agency commercial mortgage-backed securities | 3,323 | 267 | — | 3,590 |\n| Asset-backed securities and other debt securities | 3,152 | 48 | ( 24 ) | 3,176 |\n| Other securities(a) | 524 | — | — | 524 |\n| Total available-for-sale debt and other securities | $ | 34,982 | 2,568 | ( 37 ) | 37,513 |\n| Held-to-maturity securities: |\n| Obligations of states and political subdivisions securities | $ | 9 | — | — | 9 |\n| Asset-backed securities and other debt securities | 2 | — | — | 2 |\n| Total held-to-maturity securities | $ | 11 | — | — | 11 |\n\n(a)Other securities consist of FHLB, FRB and DTCC restricted stock holdings of $ 40 , $ 482 and $ 2 , respectively, at December 31, 2020, that are carried at cost.\nThe following table provides the fair value of trading debt securities and equity securities as of:\n| ($ in millions) | June 30,2021 | December 31,2020 |\n| Trading debt securities | $ | 711 | 560 |\n| Equity securities | 341 | 313 |\n\nThe amounts reported in the preceding tables exclude accrued interest receivable on investment securities of $ 86 million and $ 87 million at June 30, 2021 and December 31, 2020, respectively, which are presented as a component of other assets in the Condensed Consolidated Balance Sheets.\nThe Bancorp uses investment securities as a means of managing interest rate risk, providing collateral for pledging purposes and for liquidity to satisfy regulatory requirements. As part of managing interest rate risk, the Bancorp acquires securities as a component of its MSR non-qualifying hedging strategy, with net gains or losses recorded in securities (losses) gains, net – non-qualifying hedges on mortgage servicing rights in the Condensed Consolidated Statements of Income.\n78\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following table presents securities gains (losses) recognized in the Condensed Consolidated Statements of Income:\n| For the three months ended June 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Available-for-sale debt and other securities: |\n| Realized gains | $ | 7 | — | 8 | 1 |\n| Realized losses | — | — | ( 10 ) | ( 1 ) |\n| Impairment losses | — | — | ( 7 ) | — |\n| Net (losses) gains on available-for sale debt and other securities | $ | 7 | — | ( 9 ) | — |\n| Total trading debt securities (losses) gains | $ | ( 7 ) | — | — | 3 |\n| Total equity securities gains (losses)(a) | $ | 11 | 21 | 21 | ( 3 ) |\n| Total gains recognized in income from available-for-sale debt and other securities, trading debt securities and equity securities(b) | $ | 11 | 21 | 12 | — |\n\n(a)Includes net unrealized gains of $ 10 and $ 17 for the three and six months ended June 30, 2021, respectively, and net unrealized gains of $ 21 and net unrealized losses of $ 2 for the three and six months ended June 30, 2020, respectively.\n(b)Excludes $ 1 and $ 3 of net securities losses for the three and six months ended June 30, 2021, respectively, and $ 8 and $ 6 of net securities gains for the three and six months ended June 30, 2020, respectively, related to securities held by FTS to facilitate the timely execution of customer transactions. These losses and gains are included in commercial banking revenue and wealth and asset management revenue in the Condensed Consolidated Statements of Income.\nIn the first quarter of 2021, the Bancorp recognized impairment losses on available-for-sale debt and other securities of $ 7 million. These losses related to certain securities in unrealized loss positions that the Bancorp intended to sell prior to recovery of their amortized cost bases. The Bancorp did not consider these losses to be credit-related.\nAt both June 30, 2021 and December 31, 2020, the Bancorp completed its evaluation of the available-for-sale debt and other securities in an unrealized loss position and did not recognize an allowance for credit losses. The Bancorp did not recognize provision expense related to available-for-sale debt and other securities in an unrealized loss position during both the three and six months ended June 30, 2021 and 2020.\nAt both June 30, 2021 and December 31, 2020, investment securities with a fair value of $ 11.0 billion were pledged to secure borrowings, public deposits, trust funds, derivative contracts and for other purposes as required or permitted by law.\nThe expected maturity distribution of the Bancorp’s mortgage-backed securities and the contractual maturity distribution of the remainder of the Bancorp’s available-for-sale debt and other securities and held-to-maturity securities as of June 30, 2021 are shown in the following table:\n| ($ in millions) | Available-for-Sale Debt and Other | Held-to-Maturity |\n| Amortized Cost | Fair Value | Amortized Cost | Fair Value |\n| Debt securities:(a) |\n| Less than 1 year | $ | 886 | 907 | 4 | 4 |\n| 1-5 years | 14,074 | 14,825 | 4 | 4 |\n| 5-10 years | 11,482 | 12,349 | — | — |\n| Over 10 years | 9,119 | 9,411 | 2 | 2 |\n| Other securities | 520 | 520 | — | — |\n| Total | $ | 36,081 | 38,012 | 10 | 10 |\n\n(a)Actual maturities may differ from contractual maturities when a right to call or prepay obligations exists with or without call or prepayment penalties.\n79\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following table provides the fair value and gross unrealized losses on available-for-sale debt and other securities in an unrealized loss position, aggregated by investment category and length of time the individual securities have been in a continuous unrealized loss position as of:\n| Less than 12 months | 12 months or more | Total |\n| ($ in millions) | Fair Value | UnrealizedLosses | Fair Value | UnrealizedLosses | Fair Value | UnrealizedLosses |\n| June 30, 2021 |\n| Agency residential mortgage-backed securities | $ | 701 | ( 20 ) | 1 | — | 702 | ( 20 ) |\n| Agency commercial mortgage-backed securities | 1,632 | ( 36 ) | — | — | 1,632 | ( 36 ) |\n| Non-agency commercial mortgage-backed securities | 1 | — | — | — | 1 | — |\n| Asset-backed securities and other debt securities | 435 | ( 7 ) | 843 | ( 20 ) | 1,278 | ( 27 ) |\n| Total | $ | 2,769 | ( 63 ) | 844 | ( 20 ) | 3,613 | ( 83 ) |\n| December 31, 2020 |\n| Agency residential mortgage-backed securities | $ | 426 | ( 8 ) | 1 | — | 427 | ( 8 ) |\n| Agency commercial mortgage-backed securities | 388 | ( 5 ) | — | — | 388 | ( 5 ) |\n| Non-agency commercial mortgage-backed securities | 2 | — | — | — | 2 | — |\n| Asset-backed securities and other debt securities | 520 | ( 7 ) | 603 | ( 17 ) | 1,123 | ( 24 ) |\n| Total | $ | 1,336 | ( 20 ) | 604 | ( 17 ) | 1,940 | ( 37 ) |\n\nAt both June 30, 2021 and December 31, 2020, $ 1 million of unrealized losses in the available-for-sale debt and other securities portfolio were represented by non-rated securities.\n80\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n5. Loans and Leases\nThe Bancorp diversifies its loan and lease portfolio by offering a variety of loan and lease products with various payment terms and rate structures. The Bancorp’s commercial loan and lease portfolio consists of lending to various industry types. Management periodically reviews the performance of its loan and lease products to evaluate whether they are performing within acceptable interest rate and credit risk levels and changes are made to underwriting policies and procedures as needed. The Bancorp maintains an allowance to absorb loan and lease losses that are expected to be incurred over the remaining contractual terms of the related loans and leases. For further information on credit quality and the ALLL, refer to Note 6.\nThe following table provides a summary of commercial loans and leases classified by primary purpose and consumer loans classified based upon product or collateral as of:\n| ($ in millions) | June 30,2021 | December 31,2020 |\n| Loans and leases held for sale: |\n| Commercial and industrial loans | $ | 11 | 230 |\n| Commercial mortgage loans | 33 | 7 |\n| Commercial construction loans | 2 | — |\n| Commercial leases | — | 39 |\n| Residential mortgage loans | 5,684 | 4,465 |\n| Total loans and leases held for sale | $ | 5,730 | 4,741 |\n| Portfolio loans and leases: |\n| Commercial and industrial loans(a) | $ | 47,564 | 49,665 |\n| Commercial mortgage loans | 10,347 | 10,602 |\n| Commercial construction loans | 5,871 | 5,815 |\n| Commercial leases | 3,238 | 2,915 |\n| Total commercial loans and leases | $ | 67,020 | 68,997 |\n| Residential mortgage loans(b) | $ | 16,131 | 15,928 |\n| Home equity | 4,545 | 5,183 |\n| Indirect secured consumer loans | 15,192 | 13,653 |\n| Credit card | 1,793 | 2,007 |\n| Other consumer loans | 3,052 | 3,014 |\n| Total consumer loans | $ | 40,713 | 39,785 |\n| Total portfolio loans and leases | $ | 107,733 | 108,782 |\n\n(a)Includes $ 3.7 billion and $ 4.8 billion as of June 30, 2021 and December 31, 2020, respectively, related to the SBA’s Paycheck Protection Program.\n(b)Includes $ 39 as of December 31, 2020 of residential mortgage loans previously sold to GNMA for which the Bancorp was deemed to have regained effective control over under ASC Topic 860, but did not exercise its option to repurchase. Refer to Note 14 for further information.\nPortfolio loans and leases are recorded net of unearned income, which totaled $ 274 million as of June 30, 2021 and $ 280 million as of December 31, 2020. Additionally, portfolio loans and leases are recorded net of unamortized premiums and discounts, deferred direct loan origination fees and costs and fair value adjustments (associated with acquired loans or loans designated as fair value upon origination), which totaled a net premium of $ 356 million and $ 251 million as of June 30, 2021 and December 31, 2020, respectively. The amortized cost basis of loans and leases excludes accrued interest receivable of $ 372 million and $ 350 million at June 30, 2021 and December 31, 2020, respectively, which is presented as a component of other assets in the Condensed Consolidated Balance Sheets.\nThe Bancorp’s FHLB and FRB borrowings are primarily secured by loans. The Bancorp had loans of $ 15.2 billion and $ 15.5 billion at June 30, 2021 and December 31, 2020, respectively, pledged at the FHLB, and loans of $ 42.0 billion and $ 37.8 billion at June 30, 2021 and December 31, 2020, respectively, pledged at the FRB.\n81\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following table presents a summary of the total loans and leases owned by the Bancorp as of:\n| Carrying Value | 90 Days Past Dueand Still Accruing |\n| ($ in millions) | June 30,2021 | December 31,2020 | June 30,2021 | December 31,2020 |\n| Commercial and industrial loans | $ | 47,575 | 49,895 | 2 | 39 |\n| Commercial mortgage loans | 10,380 | 10,609 | 4 | 8 |\n| Commercial construction loans | 5,873 | 5,815 | — | — |\n| Commercial leases | 3,238 | 2,954 | — | 1 |\n| Residential mortgage loans | 21,815 | 20,393 | 57 | 70 |\n| Home equity | 4,545 | 5,183 | 1 | 2 |\n| Indirect secured consumer loans | 15,192 | 13,653 | 4 | 10 |\n| Credit card | 1,793 | 2,007 | 14 | 31 |\n| Other consumer loans | 3,052 | 3,014 | 1 | 2 |\n| Total loans and leases | $ | 113,463 | 113,523 | 83 | 163 |\n| Less: Loans and leases held for sale | $ | 5,730 | 4,741 |\n| Total portfolio loans and leases | $ | 107,733 | 108,782 |\n\nThe following table presents a summary of net charge-offs (recoveries):\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Commercial and industrial loans | $ | 13 | 65 | 40 | 115 |\n| Commercial mortgage loans | 6 | 2 | 8 | 4 |\n| Commercial leases | ( 2 ) | 11 | ( 2 ) | 16 |\n| Residential mortgage loans | — | 1 | ( 1 ) | 2 |\n| Home equity | ( 1 ) | 1 | ( 1 ) | 4 |\n| Indirect secured consumer loans | — | 7 | 9 | 20 |\n| Credit card | 20 | 34 | 45 | 71 |\n| Other consumer loans | 8 | 9 | 17 | 20 |\n| Total net charge-offs | $ | 44 | 130 | 115 | 252 |\n\nThe Bancorp engages in commercial lease products primarily related to the financing of commercial equipment. Leases are classified as sales-type if the Bancorp transfers control of the underlying asset to the lessee. The Bancorp classifies leases that do not meet any of the criteria for a sales-type lease as a direct financing lease if the present value of the sum of the lease payments and any residual value guaranteed by the lessee and/or any other third party equals or exceeds substantially all of the fair value of the underlying asset and the collection of the lease payments and residual value guarantee is probable.\nThe following table presents the components of the net investment in leases as of:\n| ($ in millions)(a) | June 30,2021 | December 31, 2020 |\n| Net investment in direct financing leases: |\n| Lease payment receivable (present value) | $ | 1,161 | 1,400 |\n| Unguaranteed residual assets (present value) | 167 | 181 |\n| Net discount on acquired leases | — | ( 1 ) |\n| Net investment in sales-type leases: |\n| Lease payment receivable (present value) | 1,551 | 976 |\n| Unguaranteed residual assets (present value) | 48 | 36 |\n\n(a)Excludes $ 311 and $ 323 of leveraged leases at June 30, 2021 and December 31, 2020, respectively.\nInterest income recognized in the Condensed Consolidated Statements of Income for the three and six months ended June 30, 2021 was $ 11 million and $ 23 million, respectively, for direct financing leases and $ 10 million and $ 20 million, respectively, for sales-type leases. For the three and six months ended June 30, 2020, interest income recognized was $ 17 million and $ 35 million, respectively, for direct financing leases and $ 6 million and $ 13 million, respectively, for sales-type leases.\n82\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following table presents undiscounted cash flows for both direct financing and sales-type leases for the remainder of 2021 through 2026 and thereafter as well as a reconciliation of the undiscounted cash flows to the total lease receivables as follows:\n| As of June 30, 2021 ($ in millions) | Direct FinancingLeases | Sales-Type Leases |\n| Remainder of 2021 | $ | 216 | 278 |\n| 2022 | 350 | 479 |\n| 2023 | 224 | 288 |\n| 2024 | 160 | 216 |\n| 2025 | 114 | 150 |\n| 2026 | 69 | 82 |\n| Thereafter | 105 | 165 |\n| Total undiscounted cash flows | $ | 1,238 | 1,658 |\n| Less: Difference between undiscounted cash flows and discounted cash flows | 77 | 107 |\n| Present value of lease payments (recognized as lease receivables) | $ | 1,161 | 1,551 |\n\nThe lease residual value represents the present value of the estimated fair value of the leased equipment at the end of the lease. The Bancorp performs quarterly reviews of residual values associated with its leasing portfolio considering factors such as the subject equipment, structure of the transaction, industry, prior experience with the lessee and other factors that impact the residual value to assess for impairment. The Bancorp maintained an allowance of $ 24 million and $ 29 million at June 30, 2021 and December 31, 2020, respectively, to cover the losses that are expected to be incurred over the remaining contractual terms of the related leases, including the potential losses related to the residual value, in the net investment in leases. Refer to Note 6 for additional information on credit quality and the ALLL.\n83\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n6. Credit Quality and the Allowance for Loan and Lease Losses\nThe Bancorp disaggregates ALLL balances and transactions in the ALLL by portfolio segment. Credit quality related disclosures for loans and leases are further disaggregated by class.\nAllowance for Loan and Lease Losses\nThe following tables summarize transactions in the ALLL by portfolio segment:\n| For the three months ended June 30, 2021 ($ in millions) | Commercial | ResidentialMortgage | Consumer | Total |\n| Balance, beginning of period | $ | 1,329 | 247 | 632 | 2,208 |\n| Losses charged off(a) | ( 45 ) | ( 1 ) | ( 57 ) | ( 103 ) |\n| Recoveries of losses previously charged off(a) | 28 | 1 | 30 | 59 |\n| Benefit from loan and lease losses | ( 88 ) | ( 12 ) | ( 31 ) | ( 131 ) |\n| Balance, end of period | $ | 1,224 | 235 | 574 | 2,033 |\n\n(a)The Bancorp recorded $ 8 in both losses charged off and recoveries of losses previously charged off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements.\n| For the three months ended June 30, 2020 ($ in millions) | Commercial | ResidentialMortgage | Consumer | Total |\n| Balance, beginning of period | $ | 1,313 | 260 | 775 | 2,348 |\n| Losses charged off(a) | ( 81 ) | ( 2 ) | ( 80 ) | ( 163 ) |\n| Recoveries of losses previously charged off(a) | 3 | 1 | 29 | 33 |\n| Provision for loan and lease losses(b) | 267 | 68 | 143 | 478 |\n| Balance, end of period | $ | 1,502 | 327 | 867 | 2,696 |\n\n(a)The Bancorp recorded $ 9 in both losses charged off and recoveries of losses previously charged off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements.\n(b)Includes $ 1 in Residential Mortgage related to the initial recognition of an ALLL on PCD loans.\n| For the six months ended June 30, 2021 ($ in millions) | Commercial | ResidentialMortgage | Consumer | Total |\n| Balance, beginning of period | $ | 1,456 | 294 | 703 | 2,453 |\n| Losses charged off(a) | ( 81 ) | ( 2 ) | ( 128 ) | ( 211 ) |\n| Recoveries of losses previously charged off(a) | 35 | 3 | 58 | 96 |\n| Benefit from loan and lease losses | ( 186 ) | ( 60 ) | ( 59 ) | ( 305 ) |\n| Balance, end of period | $ | 1,224 | 235 | 574 | 2,033 |\n\n(a)The Bancorp recorded $ 18 in both losses charged off and recoveries of losses previously charged off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements.\n| For the six months ended June 30, 2020 ($ in millions) | Commercial | Residential Mortgage | Consumer | Unallocated | Total |\n| Balance, beginning of period | $ | 710 | 73 | 298 | 121 | 1,202 |\n| Impact of adoption of ASU 2016-13(a) | 160 | 196 | 408 | ( 121 ) | 643 |\n| Losses charged off(b) | ( 142 ) | ( 4 ) | ( 176 ) | — | ( 322 ) |\n| Recoveries of losses previously charged off(b) | 7 | 2 | 61 | — | 70 |\n| Provision for loan and lease losses | 767 | 60 | 276 | — | 1,103 |\n| Balance, end of period | $ | 1,502 | 327 | 867 | — | 2,696 |\n\n(a)Includes $ 31 , $ 2 and $ 1 in Commercial, Residential Mortgage and Consumer, respectively, related to the initial recognition of an ALLL on PCD loans.\n(b)The Bancorp recorded $ 22 in both losses charged off and recoveries of losses previously charged off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements.\n84\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following tables provide a summary of the ALLL and related loans and leases classified by portfolio segment:\n| As of June 30, 2021 ($ in millions) | Commercial | ResidentialMortgage | Consumer | Total |\n| ALLL:(a) |\n| Individually evaluated | $ | 101 | 55 | 38 | 194 |\n| Collectively evaluated | 1,123 | 180 | 536 | 1,839 |\n| Total ALLL | $ | 1,224 | 235 | 574 | 2,033 |\n| Portfolio loans and leases:(b) |\n| Individually evaluated | $ | 629 | 539 | 295 | 1,463 |\n| Collectively evaluated | 66,391 | 15,441 | 24,287 | 106,119 |\n| Total portfolio loans and leases | $ | 67,020 | 15,980 | 24,582 | 107,582 |\n\n(a)Includes $ 3 related to commercial leveraged leases at June 30, 2021.\n(b)Excludes $ 151 of residential mortgage loans measured at fair value and includes $ 311 of commercial leveraged leases, net of unearned income at June 30, 2021.\n| As of December 31, 2020 ($ in millions) | Commercial | ResidentialMortgage | Consumer | Total |\n| ALLL:(a) |\n| Individually evaluated | $ | 114 | 68 | 43 | 225 |\n| Collectively evaluated | 1,342 | 226 | 660 | 2,228 |\n| Total ALLL | $ | 1,456 | 294 | 703 | 2,453 |\n| Portfolio loans and leases:(b) |\n| Individually evaluated | $ | 962 | 628 | 273 | 1,863 |\n| Collectively evaluated | 67,701 | 15,073 | 23,569 | 106,343 |\n| Purchased credit deteriorated(c) | 334 | 66 | 15 | 415 |\n| Total portfolio loans and leases | $ | 68,997 | 15,767 | 23,857 | 108,621 |\n\n(a)Includes $ 3 related to commercial leveraged leases at December 31, 2020.\n(b)Excludes $ 161 of residential mortgage loans measured at fair value and includes $ 323 of commercial leveraged leases, net of unearned income at December 31, 2020.\n(c)Includes $ 39 , as of December 31, 2020, of residential mortgage loans previously sold to GNMA for which the Bancorp was deemed to have regained effective control over under ASC Topic 860, but did not exercise its option to repurchase. Refer to Note 14 for further information.\nCREDIT RISK PROFILE\nCommercial Portfolio Segment\nFor purposes of monitoring the credit quality and risk characteristics of its commercial portfolio segment, the Bancorp disaggregates the segment into the following classes: commercial and industrial, commercial mortgage owner-occupied, commercial mortgage nonowner-occupied, commercial construction and commercial leases.\nTo facilitate the monitoring of credit quality within the commercial portfolio segment, the Bancorp utilizes the following categories of credit grades: pass, special mention, substandard, doubtful and loss. The five categories, which are derived from standard regulatory rating definitions, are assigned upon initial approval of credit to borrowers and updated periodically thereafter.\nPass ratings, which are assigned to those borrowers that do not have identified potential or well-defined weaknesses and for which there is a high likelihood of orderly repayment, are updated at least annually based on the size and credit characteristics of the borrower. All other categories are updated on a quarterly basis during the month preceding the end of the calendar quarter.\nThe Bancorp assigns a special mention rating to loans and leases that have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may, at some future date, result in the deterioration of the repayment prospects for the loan or lease or the Bancorp’s credit position.\nThe Bancorp assigns a substandard rating to loans and leases that are inadequately protected by the current sound worth and paying capacity of the borrower or of the collateral pledged. Substandard loans and leases have well-defined weaknesses or weaknesses that could jeopardize the orderly repayment of the debt. Loans and leases in this grade also are characterized by the distinct possibility that the Bancorp will sustain some loss if the deficiencies noted are not addressed and corrected.\nThe Bancorp assigns a doubtful rating to loans and leases that have all the attributes of a substandard rating with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. The possibility of loss is extremely high, but because of certain important and reasonable specific pending factors that may work to the advantage of and strengthen the credit quality of the loan or lease, its classification as an estimated loss is deferred until its more exact\n85\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nstatus may be determined. Pending factors may include a proposed merger or acquisition, liquidation proceeding, capital injection, perfecting liens on additional collateral or refinancing plans.\nLoans and leases classified as loss are considered uncollectible and are charged off in the period in which they are determined to be uncollectible. Because loans and leases in this category are fully charged off, they are not included in the following tables.\nFor loans and leases that are collectively evaluated, the Bancorp utilizes models to forecast expected credit losses over a reasonable and supportable forecast period based on the probability of a loan or lease defaulting, the expected balance at the estimated date of default and the expected loss percentage given a default. For the commercial portfolio segment, the estimates for probability of default are primarily based on internal ratings assigned to each commercial borrower on a 13-point scale and historical observations of how those ratings migrate to a default over time in the context of macroeconomic conditions. For loans with available credit, the estimate of the expected balance at the time of default considers expected utilization rates, which are primarily based on macroeconomic conditions and the utilization history of similar borrowers under those economic conditions. The estimates for loss severity are primarily based on collateral type and coverage levels and the susceptibility of those characteristics to changes in macroeconomic conditions. For more information about the Bancorp’s processes for developing these models, estimating credit losses for periods beyond the reasonable and supportable forecast period and for estimating credit losses for individually evaluated loans, refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\n86\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following tables present the amortized cost basis of the Bancorp’s commercial portfolio segment, by class and vintage, disaggregated by credit risk grade:\n| As of June 30, 2021 ($ in millions) | Term Loans and Leases by Origination Year | Revolving Loans | Revolving Loans Converted to Term Loans |\n| 2021 | 2020 | 2019 | 2018 | 2017 | Prior | Total |\n| Commercial and industrial loans: |\n| Pass | $ | 3,164 | 4,183 | 1,733 | 743 | 466 | 928 | 32,500 | — | 43,717 |\n| Special mention | 17 | 33 | 35 | 26 | 30 | 21 | 1,210 | — | 1,372 |\n| Substandard | 26 | 92 | 59 | 119 | 70 | 109 | 2,000 | — | 2,475 |\n| Doubtful | — | — | — | — | — | — | — | — | — |\n| Total commercial and industrial loans | $ | 3,207 | 4,308 | 1,827 | 888 | 566 | 1,058 | 35,710 | — | 47,564 |\n| Commercial mortgage owner-occupied loans: |\n| Pass | $ | 517 | 927 | 596 | 358 | 246 | 513 | 1,140 | — | 4,297 |\n| Special mention | 4 | 30 | 40 | 2 | — | 22 | 85 | — | 183 |\n| Substandard | 38 | 67 | 11 | 25 | 2 | 27 | 107 | — | 277 |\n| Doubtful | — | — | — | — | — | — | — | — | — |\n| Total commercial mortgage owner- occupied loans | $ | 559 | 1,024 | 647 | 385 | 248 | 562 | 1,332 | — | 4,757 |\n| Commercial mortgage nonowner-occupied loans: |\n| Pass | $ | 205 | 736 | 627 | 381 | 207 | 459 | 1,598 | — | 4,213 |\n| Special mention | 31 | 120 | 57 | 61 | 8 | — | 338 | — | 615 |\n| Substandard | 31 | 195 | 26 | 64 | 3 | 11 | 432 | — | 762 |\n| Doubtful | — | — | — | — | — | — | — | — | — |\n| Total commercial mortgage nonowner-occupied loans | $ | 267 | 1,051 | 710 | 506 | 218 | 470 | 2,368 | — | 5,590 |\n| Commercial construction loans: |\n| Pass | $ | 28 | 73 | 47 | 27 | — | 11 | 4,715 | — | 4,901 |\n| Special mention | — | 66 | — | — | — | — | 442 | — | 508 |\n| Substandard | 15 | — | — | — | — | — | 447 | — | 462 |\n| Doubtful | — | — | — | — | — | — | — | — | — |\n| Total commercial construction loans | $ | 43 | 139 | 47 | 27 | — | 11 | 5,604 | — | 5,871 |\n| Commercial leases: |\n| Pass | $ | 732 | 511 | 350 | 276 | 297 | 989 | — | — | 3,155 |\n| Special mention | 1 | 7 | 7 | 5 | — | 4 | — | — | 24 |\n| Substandard | 10 | 3 | 7 | 12 | 16 | 11 | — | — | 59 |\n| Doubtful | — | — | — | — | — | — | — | — | — |\n| Total commercial leases | $ | 743 | 521 | 364 | 293 | 313 | 1,004 | — | — | 3,238 |\n| Total commercial loans and leases: |\n| Pass | $ | 4,646 | 6,430 | 3,353 | 1,785 | 1,216 | 2,900 | 39,953 | — | 60,283 |\n| Special mention | 53 | 256 | 139 | 94 | 38 | 47 | 2,075 | — | 2,702 |\n| Substandard | 120 | 357 | 103 | 220 | 91 | 158 | 2,986 | — | 4,035 |\n| Doubtful | — | — | — | — | — | — | — | — | — |\n| Total commercial loans and leases | $ | 4,819 | 7,043 | 3,595 | 2,099 | 1,345 | 3,105 | 45,014 | — | 67,020 |\n\n87\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n| As of December 31, 2020 ($ in millions) | Term Loans and Leases by Origination Year | Revolving Loans | Revolving Loans Converted to Term Loans |\n| 2020 | 2019 | 2018 | 2017 | 2016 | Prior | Total |\n| Commercial and industrial loans: |\n| Pass | $ | 7,042 | 2,144 | 1,114 | 700 | 471 | 703 | 31,657 | — | 43,831 |\n| Special mention | 66 | 46 | 167 | 46 | 5 | 21 | 2,317 | — | 2,668 |\n| Substandard | 119 | 80 | 107 | 60 | 39 | 104 | 2,639 | — | 3,148 |\n| Doubtful | — | 2 | 9 | — | — | — | 7 | — | 18 |\n| Total commercial and industrial loans | $ | 7,227 | 2,272 | 1,397 | 806 | 515 | 828 | 36,620 | — | 49,665 |\n| Commercial mortgage owner-occupied loans: |\n| Pass | $ | 1,047 | 655 | 416 | 288 | 249 | 420 | 1,025 | — | 4,100 |\n| Special mention | 58 | 12 | 16 | 7 | 2 | 17 | 64 | — | 176 |\n| Substandard | 211 | 17 | 33 | 7 | 13 | 30 | 88 | — | 399 |\n| Doubtful | — | — | — | — | — | — | — | — | — |\n| Total commercial mortgage owner-occupied loans | $ | 1,316 | 684 | 465 | 302 | 264 | 467 | 1,177 | — | 4,675 |\n| Commercial mortgage nonowner-occupied loans: |\n| Pass | $ | 902 | 679 | 548 | 247 | 223 | 341 | 1,626 | — | 4,566 |\n| Special mention | 252 | 68 | 17 | 8 | 36 | 9 | 416 | — | 806 |\n| Substandard | 149 | 3 | 49 | 14 | 2 | 25 | 301 | — | 543 |\n| Doubtful | 12 | — | — | — | — | — | — | — | 12 |\n| Total commercial mortgage nonowner-occupied loans | $ | 1,315 | 750 | 614 | 269 | 261 | 375 | 2,343 | — | 5,927 |\n| Commercial construction loans: |\n| Pass | $ | 98 | 49 | 27 | — | 9 | 12 | 4,721 | — | 4,916 |\n| Special mention | 67 | — | — | — | — | — | 591 | — | 658 |\n| Substandard | 8 | — | — | — | — | — | 233 | — | 241 |\n| Doubtful | — | — | — | — | — | — | — | — | — |\n| Total commercial construction loans | $ | 173 | 49 | 27 | — | 9 | 12 | 5,545 | — | 5,815 |\n| Commercial leases: |\n| Pass | $ | 622 | 374 | 315 | 369 | 314 | 824 | — | — | 2,818 |\n| Special mention | 5 | 16 | 5 | — | — | — | — | — | 26 |\n| Substandard | 7 | 4 | 16 | 21 | 6 | 17 | — | — | 71 |\n| Doubtful | — | — | — | — | — | — | — | — | — |\n| Total commercial leases | $ | 634 | 394 | 336 | 390 | 320 | 841 | — | — | 2,915 |\n| Total commercial loans and leases: |\n| Pass | $ | 9,711 | 3,901 | 2,420 | 1,604 | 1,266 | 2,300 | 39,029 | — | 60,231 |\n| Special mention | 448 | 142 | 205 | 61 | 43 | 47 | 3,388 | — | 4,334 |\n| Substandard | 494 | 104 | 205 | 102 | 60 | 176 | 3,261 | — | 4,402 |\n| Doubtful | 12 | 2 | 9 | — | — | — | 7 | — | 30 |\n| Total commercial loans and leases | $ | 10,665 | 4,149 | 2,839 | 1,767 | 1,369 | 2,523 | 45,685 | — | 68,997 |\n\n88\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nAge Analysis of Past Due Commercial Loans and Leases\nThe following tables summarize the Bancorp’s amortized cost basis in portfolio commercial loans and leases, by age and class:\n| CurrentLoans andLeases(a) | Past Due | Total Loans and Leases | 90 Days PastDue and StillAccruing |\n| As of June 30, 2021 ($ in millions) | 30-89Days(a) | 90 Daysor More(a) | TotalPast Due |\n| Commercial loans and leases: |\n| Commercial and industrial loans | $ | 47,398 | 111 | 55 | 166 | 47,564 | 2 |\n| Commercial mortgage owner-occupied loans | 4,706 | 35 | 16 | 51 | 4,757 | 4 |\n| Commercial mortgage nonowner-occupied loans | 5,587 | 1 | 2 | 3 | 5,590 | — |\n| Commercial construction loans | 5,871 | — | — | — | 5,871 | — |\n| Commercial leases | 3,224 | 13 | 1 | 14 | 3,238 | — |\n| Total portfolio commercial loans and leases | $ | 66,786 | 160 | 74 | 234 | 67,020 | 6 |\n\n(a)Includes accrual and nonaccrual loans and leases.\n| CurrentLoans andLeases(a) | Past Due | Total Loans and Leases | 90 Days PastDue and StillAccruing |\n| As of December 31, 2020 ($ in millions) | 30-89Days(a) | 90 Daysor More(a) | TotalPast Due |\n| Commercial loans and leases: |\n| Commercial and industrial loans | $ | 49,421 | 119 | 125 | 244 | 49,665 | 39 |\n| Commercial mortgage owner-occupied loans | 4,645 | 7 | 23 | 30 | 4,675 | 7 |\n| Commercial mortgage nonowner-occupied loans | 5,860 | 31 | 36 | 67 | 5,927 | 1 |\n| Commercial construction loans | 5,808 | 7 | — | 7 | 5,815 | — |\n| Commercial leases | 2,906 | 7 | 2 | 9 | 2,915 | 1 |\n| Total portfolio commercial loans and leases | $ | 68,640 | 171 | 186 | 357 | 68,997 | 48 |\n\n(a)Includes accrual and nonaccrual loans and leases.\nResidential Mortgage and Consumer Portfolio Segments\nFor purposes of monitoring the credit quality and risk characteristics of its consumer portfolio segment, the Bancorp disaggregates the segment into the following classes: home equity, indirect secured consumer loans, credit card and other consumer loans. The Bancorp’s residential mortgage portfolio segment is also a separate class.\nThe Bancorp considers repayment performance as the best indicator of credit quality for residential mortgage and consumer loans, which includes both the delinquency status and performing versus nonperforming status of the loans. The delinquency status of all residential mortgage and consumer loans and the performing versus nonperforming status is presented in the following table. Refer to the nonaccrual loans and leases section of Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for additional delinquency and nonperforming information. Loans and leases which received payment deferrals or forbearances as part of the Bancorp’s COVID-19 customer relief programs are generally not reported as delinquent during the forbearance or deferral period if the loan or lease was less than 30 days past due at March 1, 2020 (the effective date of the COVID-19 national emergency declaration) unless the loan or lease subsequently becomes delinquent according to its modified terms. Refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for additional information.\nFor collectively evaluated loans in the consumer and residential mortgage portfolio segments, the Bancorp’s expected credit loss models primarily utilize the borrower’s FICO score and delinquency history in combination with macroeconomic conditions when estimating the probability of default. The estimates for loss severity are primarily based on collateral type and coverage levels and the susceptibility of those characteristics to changes in macroeconomic conditions. The expected balance at the estimated date of default is also particularly significant for portfolio classes which generally have longer terms (such as residential mortgage loans and home equity) and portfolio classes containing a high concentration of loans with revolving privileges (such as credit card and home equity). The estimate of the expected balance at the time of default considers expected prepayment and utilization rates where applicable, which are primarily based on macroeconomic conditions and the utilization history of similar borrowers under those economic conditions. Refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for additional information about the Bancorp’s process for developing these models and its process for estimating credit losses for periods beyond the reasonable and supportable forecast period.\n89\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following tables present the amortized cost basis of the Bancorp’s residential mortgage and consumer portfolio segments, by class and vintage, disaggregated by both age and performing versus nonperforming status:\n| As of June 30, 2021 ($ in millions) | Term Loans by Origination Year | Revolving Loans | Revolving Loans Converted to Term Loans |\n| 2021 | 2020 | 2019 | 2018 | 2017 | Prior | Total |\n| Residential mortgage loans: |\n| Performing: |\n| Current(a) | $ | 3,080 | 3,840 | 1,696 | 574 | 1,226 | 5,439 | — | — | 15,855 |\n| 30-89 days past due | 1 | 2 | 1 | — | 2 | 13 | — | — | 19 |\n| 90 days or more past due | — | 3 | 4 | 2 | 5 | 43 | — | — | 57 |\n| Total performing | 3,081 | 3,845 | 1,701 | 576 | 1,233 | 5,495 | — | — | 15,931 |\n| Nonperforming | — | — | — | 1 | 3 | 45 | — | — | 49 |\n| Total residential mortgage loans(b) | $ | 3,081 | 3,845 | 1,701 | 577 | 1,236 | 5,540 | — | — | 15,980 |\n| Home equity: |\n| Performing: |\n| Current | $ | 1 | 9 | 18 | 23 | 3 | 134 | 4,243 | 8 | 4,439 |\n| 30-89 days past due | — | — | — | — | — | 3 | 17 | — | 20 |\n| 90 days or more past due | — | — | — | — | — | 1 | — | — | 1 |\n| Total performing | 1 | 9 | 18 | 23 | 3 | 138 | 4,260 | 8 | 4,460 |\n| Nonperforming | — | — | — | — | — | 10 | 74 | 1 | 85 |\n| Total home equity | $ | 1 | 9 | 18 | 23 | 3 | 148 | 4,334 | 9 | 4,545 |\n| Indirect secured consumer loans: |\n| Performing: |\n| Current | $ | 4,691 | 5,268 | 2,930 | 1,252 | 593 | 337 | — | — | 15,071 |\n| 30-89 days past due | 5 | 17 | 20 | 15 | 7 | 4 | — | — | 68 |\n| 90 days or more past due | — | 1 | 1 | 1 | 1 | — | — | — | 4 |\n| Total performing | 4,696 | 5,286 | 2,951 | 1,268 | 601 | 341 | — | — | 15,143 |\n| Nonperforming | — | 29 | 6 | 7 | 4 | 3 | — | — | 49 |\n| Total indirect secured consumer loans | $ | 4,696 | 5,315 | 2,957 | 1,275 | 605 | 344 | — | — | 15,192 |\n| Credit card: |\n| Performing: |\n| Current | $ | — | — | — | — | — | — | 1,737 | — | 1,737 |\n| 30-89 days past due | — | — | — | — | — | — | 15 | — | 15 |\n| 90 days or more past due | — | — | — | — | — | — | 14 | — | 14 |\n| Total performing | — | — | — | — | — | — | 1,766 | — | 1,766 |\n| Nonperforming | — | — | — | — | — | — | 27 | — | 27 |\n| Total credit card | $ | — | — | — | — | — | — | 1,793 | — | 1,793 |\n| Other consumer loans: |\n| Performing: |\n| Current | $ | 451 | 702 | 382 | 371 | 138 | 57 | 936 | 1 | 3,038 |\n| 30-89 days past due | 1 | 2 | 3 | 2 | 1 | — | 2 | — | 11 |\n| 90 days or more past due | — | — | 1 | — | — | — | — | — | 1 |\n| Total performing | 452 | 704 | 386 | 373 | 139 | 57 | 938 | 1 | 3,050 |\n| Nonperforming | — | 1 | — | — | — | — | 1 | — | 2 |\n| Total other consumer loans | $ | 452 | 705 | 386 | 373 | 139 | 57 | 939 | 1 | 3,052 |\n| Total residential mortgage and consumer loans: |\n| Performing: |\n| Current | $ | 8,223 | 9,819 | 5,026 | 2,220 | 1,960 | 5,967 | 6,916 | 9 | 40,140 |\n| 30-89 days past due | 7 | 21 | 24 | 17 | 10 | 20 | 34 | — | 133 |\n| 90 days or more past due | — | 4 | 6 | 3 | 6 | 44 | 14 | — | 77 |\n| Total performing | 8,230 | 9,844 | 5,056 | 2,240 | 1,976 | 6,031 | 6,964 | 9 | 40,350 |\n| Nonperforming | — | 30 | 6 | 8 | 7 | 58 | 102 | 1 | 212 |\n| Total residential mortgage and consumer loans(b) | $ | 8,230 | 9,874 | 5,062 | 2,248 | 1,983 | 6,089 | 7,066 | 10 | 40,562 |\n\n(a)Information includes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. As of June 30, 2021, $ 65 of these loans were 30-89 days past due and $ 163 were 90 days or more past due. The Bancorp recognized an immaterial amount and $ 1 of losses during the three and six months ended June 30, 2021, respectively, due to claim denials and curtailments associated with these insured or guaranteed loans.\n(b)Excludes $ 151 of residential mortgage loans measured at fair value at June 30, 2021.\n90\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n| As of December 31, 2020 ($ in millions) | Term Loans by Origination Year | Revolving Loans | Revolving Loans Converted to Term Loans |\n| 2020 | 2019 | 2018 | 2017 | 2016 | Prior | Total |\n| Residential mortgage loans: |\n| Performing: |\n| Current(a) | $ | 4,006 | 2,128 | 827 | 1,635 | 2,301 | 4,719 | — | — | 15,616 |\n| 30-89 days past due | 1 | 1 | 3 | 3 | 1 | 12 | — | — | 21 |\n| 90 days or more past due | — | 6 | 2 | 7 | 7 | 48 | — | — | 70 |\n| Total performing | 4,007 | 2,135 | 832 | 1,645 | 2,309 | 4,779 | — | — | 15,707 |\n| Nonperforming | 1 | — | 2 | 2 | 3 | 52 | — | — | 60 |\n| Total residential mortgage loans(b) | $ | 4,008 | 2,135 | 834 | 1,647 | 2,312 | 4,831 | — | — | 15,767 |\n| Home equity: |\n| Performing: |\n| Current | $ | 11 | 24 | 30 | 4 | 2 | 153 | 4,825 | 10 | 5,059 |\n| 30-89 days past due | — | — | — | — | — | 3 | 33 | — | 36 |\n| 90 days or more past due | — | — | — | — | — | 2 | — | — | 2 |\n| Total performing | 11 | 24 | 30 | 4 | 2 | 158 | 4,858 | 10 | 5,097 |\n| Nonperforming | — | — | — | — | — | 10 | 75 | 1 | 86 |\n| Total home equity | $ | 11 | 24 | 30 | 4 | 2 | 168 | 4,933 | 11 | 5,183 |\n| Indirect secured consumer loans: |\n| Performing: |\n| Current | $ | 6,626 | 3,752 | 1,678 | 860 | 372 | 214 | — | — | 13,502 |\n| 30-89 days past due | 25 | 41 | 31 | 17 | 7 | 4 | — | — | 125 |\n| 90 days or more past due | 1 | 2 | 3 | 2 | 1 | 1 | — | — | 10 |\n| Total performing | 6,652 | 3,795 | 1,712 | 879 | 380 | 219 | — | — | 13,637 |\n| Nonperforming | 1 | 5 | 4 | 3 | 2 | 1 | — | — | 16 |\n| Total indirect secured consumer loans | $ | 6,653 | 3,800 | 1,716 | 882 | 382 | 220 | — | — | 13,653 |\n| Credit card: |\n| Performing: |\n| Current | $ | — | — | — | — | — | — | 1,914 | — | 1,914 |\n| 30-89 days past due | — | — | — | — | — | — | 30 | — | 30 |\n| 90 days or more past due | — | — | — | — | — | — | 31 | — | 31 |\n| Total performing | — | — | — | — | — | — | 1,975 | — | 1,975 |\n| Nonperforming | — | — | — | — | — | — | 32 | — | 32 |\n| Total credit card | $ | — | — | — | — | — | — | 2,007 | — | 2,007 |\n| Other consumer loans: |\n| Performing: |\n| Current | $ | 883 | 546 | 437 | 178 | 32 | 40 | 878 | 1 | 2,995 |\n| 30-89 days past due | 2 | 5 | 4 | 2 | — | — | 2 | — | 15 |\n| 90 days or more past due | — | 2 | — | — | — | — | — | — | 2 |\n| Total performing | 885 | 553 | 441 | 180 | 32 | 40 | 880 | 1 | 3,012 |\n| Nonperforming | — | — | — | — | — | 1 | 1 | — | 2 |\n| Total other consumer loans | $ | 885 | 553 | 441 | 180 | 32 | 41 | 881 | 1 | 3,014 |\n| Total residential mortgage and consumer loans: |\n| Performing: |\n| Current | $ | 11,526 | 6,450 | 2,972 | 2,677 | 2,707 | 5,126 | 7,617 | 11 | 39,086 |\n| 30-89 days past due | 28 | 47 | 38 | 22 | 8 | 19 | 65 | — | 227 |\n| 90 days or more past due | 1 | 10 | 5 | 9 | 8 | 51 | 31 | — | 115 |\n| Total performing | 11,555 | 6,507 | 3,015 | 2,708 | 2,723 | 5,196 | 7,713 | 11 | 39,428 |\n| Nonperforming | 2 | 5 | 6 | 5 | 5 | 64 | 108 | 1 | 196 |\n| Total residential mortgage and consumer loans(b) | $ | 11,557 | 6,512 | 3,021 | 2,713 | 2,728 | 5,260 | 7,821 | 12 | 39,624 |\n\n(a)Information includes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. As of December 31, 2020, $ 103 of these loans were 30-89 days past due and $ 242 were 90 days or more past due. The Bancorp recognized $ 1 and $ 2 of losses during the three and six months ended June 30, 2020, respectively, due to claim denials and curtailments associated with these insured or guaranteed loans.\n(b)Excludes $ 161 of residential mortgage loans measured at fair value at December 31, 2020.\n91\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nCollateral-Dependent Loans and Leases\nThe Bancorp considers a loan or lease to be collateral-dependent when the borrower is experiencing financial difficulty and repayment is expected to be provided substantially through the operation or sale of the collateral. When a loan or lease is collateral-dependent, its fair value is generally based on the fair value less cost to sell of the underlying collateral.\nThe following table presents the amortized cost basis of the Bancorp’s collateral-dependent loans and leases, by portfolio class, as of:\n| ($ in millions) | June 30,2021 | December 31,2020 |\n| Commercial loans and leases: |\n| Commercial and industrial loans | $ | 539 | 810 |\n| Commercial mortgage owner-occupied loans | 35 | 101 |\n| Commercial mortgage nonowner-occupied loans | 29 | 82 |\n| Commercial construction loans | 18 | 19 |\n| Commercial leases | 8 | 6 |\n| Total commercial loans and leases | $ | 629 | 1,018 |\n| Residential mortgage loans | 67 | 80 |\n| Consumer loans: |\n| Home equity | 65 | 71 |\n| Indirect secured consumer loans | 9 | 9 |\n| Total consumer loans | $ | 74 | 80 |\n| Total portfolio loans and leases | $ | 770 | 1,178 |\n\nNonperforming Assets\nNonperforming assets include nonaccrual loans and leases for which ultimate collectability of the full amount of the principal and/or interest is uncertain; restructured loans which have not yet met the requirements to be returned to accrual status; certain restructured consumer and residential mortgage loans which are 90 days past due based on the restructured terms unless the loan is both well-secured and in the process of collection; and certain other assets, including OREO and other repossessed property.\nThe following table presents the amortized cost basis of the Bancorp’s nonaccrual loans and leases, by class, and OREO and other repossessed property as of:\n| June 30, 2021 | December 31, 2020 |\n| ($ in millions) | With an ALLL | No RelatedALLL | Total | With an ALLL | No RelatedALLL | Total |\n| Commercial loans and leases: |\n| Commercial and industrial loans | $ | 181 | 167 | 348 | 213 | 260 | 473 |\n| Commercial mortgage owner-occupied loans | 11 | 17 | 28 | 20 | 60 | 80 |\n| Commercial mortgage nonowner-occupied loans | 23 | 1 | 24 | 34 | 43 | 77 |\n| Commercial construction loans | — | — | — | 1 | — | 1 |\n| Commercial leases | 6 | 3 | 9 | 6 | 1 | 7 |\n| Total nonaccrual portfolio commercial loans and leases | $ | 221 | 188 | 409 | 274 | 364 | 638 |\n| Residential mortgage loans | 3 | 46 | 49 | 11 | 49 | 60 |\n| Consumer loans: |\n| Home equity | 56 | 29 | 85 | 55 | 31 | 86 |\n| Indirect secured consumer loans | 42 | 7 | 49 | 8 | 8 | 16 |\n| Credit card | 27 | — | 27 | 32 | — | 32 |\n| Other consumer loans | 2 | — | 2 | 2 | — | 2 |\n| Total nonaccrual portfolio consumer loans | $ | 127 | 36 | 163 | 97 | 39 | 136 |\n| Total nonaccrual portfolio loans and leases(a)(b) | $ | 351 | 270 | 621 | 382 | 452 | 834 |\n| OREO and other repossessed property | — | 36 | 36 | — | 30 | 30 |\n| Total nonperforming portfolio assets(a)(b) | $ | 351 | 306 | 657 | 382 | 482 | 864 |\n\n(a)Excludes $ 13 and $ 5 of nonaccrual loans held for sale as of June 30, 2021 and December 31, 2020, respectively, and $ 27 and $ 1 of nonaccrual restructured loans held for sale as of June 30, 2021 and December 31, 2020, respectively.\n(b)Includes $ 26 and $ 29 of nonaccrual government insured commercial loans whose repayments are insured by the SBA as of June 30, 2021 and December 31, 2020, respectively, of which $ 13 and $ 17 are restructured nonaccrual government insured commercial loans as of June 30, 2021 and December 31, 2020, respectively.\n92\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following table presents the interest income recognized on the Bancorp’s nonaccrual loans and leases, by class:\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Commercial loans and leases: |\n| Commercial and industrial loans | $ | 4 | 3 | 9 | 4 |\n| Commercial mortgage owner-occupied loans | 2 | — | 7 | — |\n| Commercial mortgage nonowner-occupied loans | 2 | — | 2 | — |\n| Commercial leases | — | — | — | 1 |\n| Total nonaccrual portfolio commercial loans and leases | $ | 8 | 3 | 18 | 5 |\n| Residential mortgage loans | 6 | 7 | 13 | 15 |\n| Consumer loans: |\n| Home equity | 2 | 2 | 4 | 5 |\n| Indirect secured consumer loans | — | — | 1 | — |\n| Credit card | 1 | 1 | 2 | 2 |\n| Total nonaccrual portfolio consumer loans | $ | 3 | 3 | 7 | 7 |\n| Total nonaccrual portfolio loans and leases | $ | 17 | 13 | 38 | 27 |\n\nThe Bancorp’s amortized cost basis of consumer mortgage loans secured by residential real estate properties for which formal foreclosure proceedings are in process according to local requirements of the applicable jurisdiction was $ 118 million and $ 136 million as of June 30, 2021 and December 31, 2020, respectively.\nTroubled Debt Restructurings\nA loan is accounted for as a TDR if the Bancorp, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. TDRs include concessions granted under reorganization, arrangement or other provisions of the Federal Bankruptcy Act. Within each of the Bancorp’s loan classes, TDRs typically involve either a reduction of the stated interest rate of the loan, an extension of the loan’s maturity date with a stated rate lower than the current market rate for a new loan with similar risk, or in limited circumstances, a reduction of the principal balance of the loan or the loan’s accrued interest. Modifying the terms of a loan may result in an increase or decrease to the ALLL depending upon the terms modified, the method used to measure the ALLL for a loan prior to modification, the extent of collateral, and whether any charge-offs were recorded on the loan before or at the time of modification. Refer to the ALLL section of Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for information on the Bancorp’s ALLL methodology. Upon modification of a loan, the Bancorp measures the expected credit loss as either the difference between the amortized cost of the loan and the fair value of collateral less cost to sell or the difference between the estimated future cash flows expected to be collected on the modified loan, discounted at the original effective yield of the loan, and the carrying value of the loan. The resulting measurement may result in the need for minimal or no allowance regardless of which is used because it is probable that all cash flows will be collected under the modified terms of the loan. In addition, if the stated interest rate was increased in a TDR that is not collateral-dependent, the cash flows on the modified loan, using the pre-modification interest rate as the discount rate, often exceed the amortized cost basis of the loan. Conversely, upon a modification that reduces the stated interest rate on a loan that is not collateral-dependent, the Bancorp recognizes an increase to the ALLL. If a TDR involves a reduction of the principal balance of the loan or the loan’s accrued interest, that amount is charged off to the ALLL. Loans discharged in a Chapter 7 bankruptcy and not reaffirmed by the borrower are treated as nonaccrual collateral-dependent loans with a charge-off recognized to reduce the carrying values of such loans to the fair value of the related collateral less costs to sell. Certain loan modifications which were made in response to the COVID-19 pandemic were not evaluated for classification as a TDR. Refer to the Regulatory Developments Related to the COVID-19 Pandemic section of Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for additional information.\nThe Bancorp had commitments to lend additional funds to borrowers whose terms have been modified in a TDR, consisting of line of credit and letter of credit commitments of $ 41 million and $ 67 million, respectively, as of June 30, 2021 compared to $ 67 million and $ 72 million, respectively, as of December 31, 2020.\n93\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following tables provide a summary of portfolio loans, by class, modified in a TDR by the Bancorp during the three months ended:\n| June 30, 2021 ($ in millions) | Number of LoansModified in a TDRDuring the Period(a) | Amortized Cost Basisof Loans Modifiedin a TDRDuring the Period | Increaseto ALLL UponModification | Charge-offsRecognized Upon Modification |\n| Commercial loans: |\n| Commercial and industrial loans | 7 | $ | 25 | — | — |\n| Residential mortgage loans | 124 | 23 | 1 | — |\n| Consumer loans: |\n| Home equity | 39 | 2 | — | — |\n| Indirect secured consumer loans | 450 | 8 | — | — |\n| Credit card | 1,373 | 8 | 1 | — |\n| Total portfolio loans | 1,993 | $ | 66 | 2 | — |\n\n(a)Represents number of loans post-modification and excludes loans previously modified in a TDR.\n| June 30, 2020 ($ in millions) | Number of LoansModified in a TDRDuring the Period(a) | Amortized Cost Basisin Loans Modifiedin a TDRDuring the Period | Increase to ALLL Upon Modification | Charge-offsRecognized Upon Modification |\n| Commercial loans: |\n| Commercial and industrial loans | 33 | $ | 107 | 14 | — |\n| Commercial mortgage owner-occupied loans | 17 | 12 | — | — |\n| Commercial mortgage nonowner-occupied loans | 9 | 14 | — | — |\n| Commercial construction | 2 | 21 | 1 | — |\n| Residential mortgage loans | 109 | 13 | 1 | — |\n| Consumer loans: |\n| Home equity | 21 | 2 | — | — |\n| Indirect secured consumer loans | 20 | — | — | — |\n| Credit card | 973 | 5 | 2 | — |\n| Total portfolio loans | 1,184 | $ | 174 | 18 | — |\n\n(a)Represents number of loans post-modification and excludes loans previously modified in a TDR.\nThe following tables provide a summary of portfolio loans, by class, modified in a TDR by the Bancorp during the six months ended:\n| June 30, 2021 ($ in millions) | Number of LoansModified in a TDRDuring the Period(a) | Amortized Cost Basisof Loans Modifiedin a TDRDuring the Period | Increase (Decrease)to ALLL UponModification | Charge-offsRecognized Upon Modification |\n| Commercial loans: |\n| Commercial and industrial loans | 26 | $ | 31 | 1 | — |\n| Commercial mortgage owner-occupied loans | 1 | 4 | — | — |\n| Commercial mortgage nonowner-occupied loans | 3 | 25 | — | — |\n| Residential mortgage loans | 302 | 59 | 2 | — |\n| Consumer loans: |\n| Home equity | 97 | 5 | ( 1 ) | — |\n| Indirect secured consumer loans | 2,193 | 51 | 1 | — |\n| Credit card | 3,168 | 18 | 4 | — |\n| Total portfolio loans | 5,790 | $ | 193 | 7 | — |\n\n(a)Represents number of loans post-modification and excludes loans previously modified in a TDR.\n94\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n| June 30, 2020 ($ in millions) | Number of LoansModified in a TDRDuring the Period(a) | Recorded Investmentin Loans Modifiedin a TDRDuring the Period | Increase(Decrease)to ALLL UponModification | Charge-offsRecognized Upon Modification |\n| Commercial loans: |\n| Commercial and industrial loans | 63 | $ | 176 | 24 | — |\n| Commercial mortgage owner-occupied loans | 28 | 19 | — | — |\n| Commercial mortgage nonowner-occupied loans | 12 | 22 | — | — |\n| Commercial construction | 3 | 21 | 1 | — |\n| Residential mortgage loans | 293 | 37 | 1 | — |\n| Consumer loans: |\n| Home equity | 42 | 4 | ( 1 ) | — |\n| Indirect secured consumer loans | 42 | — | — | — |\n| Credit card | 2,857 | 15 | 6 | — |\n| Total portfolio loans | 3,340 | $ | 294 | 31 | — |\n\n(a)Represents number of loans post-modification and excludes loans previously modified in a TDR.\nThe Bancorp considers TDRs that become 90 days or more past due under the modified terms as subsequently defaulted. For commercial loans not subject to individual evaluation for an ALLL, the applicable commercial models are applied for purposes of determining the ALLL as well as qualitatively assessing whether those loans are reasonably expected to be further restructured prior to their maturity date and, if so, the impact such a restructuring would have on the remaining contractual life of the loans. When a residential mortgage, home equity, indirect secured consumer or other consumer loan that has been modified in a TDR subsequently defaults, the present value of expected cash flows used in the measurement of the expected credit loss is generally limited to the expected net proceeds from the sale of the loan’s underlying collateral and any resulting collateral shortfall is reflected as a charge-off or an increase in ALLL. The Bancorp recognizes an ALLL for the entire balance of the credit card loans modified in a TDR that subsequently default.\nThe following tables provide a summary of TDRs that subsequently defaulted during the three months ended June 30, 2021 and 2020 and were within 12 months of the restructuring date:\n| June 30, 2021 ($ in millions)(a) | Number ofContracts | AmortizedCost |\n| Commercial loans: |\n| Commercial and industrial loans | 1 | $ | — |\n| Residential mortgage loans | 16 | 2 |\n| Consumer loans: |\n| Home equity | 5 | — |\n| Indirect secured consumer loans | 32 | — |\n| Credit card | 11 | — |\n| Total portfolio loans | 65 | $ | 2 |\n\n(a)Excludes all loans held for sale and loans acquired with deteriorated credit quality which were accounted for within a pool.\n| June 30, 2020 ($ in millions)(a) | Number ofContracts | AmortizedCost |\n| Commercial loans: |\n| Commercial and industrial loans | 6 | $ | 4 |\n| Commercial mortgage owner-occupied loans | 5 | 1 |\n| Commercial mortgage nonowner-occupied loans | 1 | 4 |\n| Residential mortgage loans | 25 | 4 |\n| Consumer loans: |\n| Home equity | 2 | — |\n| Indirect secured consumer loans | 3 | — |\n| Credit card | 16 | — |\n| Total portfolio loans | 58 | $ | 13 |\n\n(a)Excludes all loans held for sale and loans acquired with deteriorated credit quality which were accounted for within a pool.\n95\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following tables provide a summary of TDRs that subsequently defaulted during the six months ended June 30, 2021 and 2020 and were within 12 months of the restructuring date:\n| June 30, 2021 ($ in millions)(a) | Number ofContracts | AmortizedCost |\n| Commercial loans: |\n| Commercial and industrial loans | 1 | $ | — |\n| Commercial mortgage nonowner-occupied loans | 1 | 25 |\n| Residential mortgage loans | 51 | 7 |\n| Consumer loans: |\n| Home equity | 17 | 1 |\n| Indirect secured consumer loans | 58 | 1 |\n| Credit card | 34 | — |\n| Total portfolio loans | 162 | $ | 34 |\n\n(a)Excludes all loans and leases held for sale and loans acquired with deteriorated credit quality which were accounted for within a pool.\n| June 30, 2020 ($ in millions)(a) | Number ofContracts | AmortizedCost |\n| Commercial loans: |\n| Commercial and industrial loans | 6 | $ | 4 |\n| Commercial mortgage owner-occupied loans | 7 | 2 |\n| Commercial mortgage nonowner-occupied loans | 2 | 9 |\n| Residential mortgage loans | 72 | 10 |\n| Consumer loans: |\n| Home equity | 3 | — |\n| Indirect secured consumer loans | 6 | — |\n| Credit card | 217 | 1 |\n| Total portfolio loans | 313 | $ | 26 |\n\n(a)Excludes all loans and leases held for sale and loans acquired with deteriorated credit quality which were accounted for within a pool.\n96\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n7. Bank Premises and Equipment\nThe following table provides a summary of bank premises and equipment as of:\n| ($ in millions) | June 30,2021 | December 31,2020 |\n| Equipment | $ | 2,348 | 2,302 |\n| Buildings(a) | 1,625 | 1,612 |\n| Land and improvements(a) | 641 | 636 |\n| Leasehold improvements | 472 | 467 |\n| Construction in progress(a) | 103 | 108 |\n| Bank premises and equipment held for sale: |\n| Land and improvements | 18 | 27 |\n| Buildings | 7 | 8 |\n| Accumulated depreciation and amortization | ( 3,141 ) | ( 3,072 ) |\n| Total bank premises and equipment | $ | 2,073 | 2,088 |\n\n(a)Buildings, land and improvements and construction in progress included $ 50 and $ 46 associated with parcels of undeveloped land intended for future branch expansion at June 30, 2021 and December 31, 2020, respectively.\nThe Bancorp monitors changing customer preferences associated with the channels it uses for banking transactions to evaluate the efficiency, competitiveness and quality of the customer service experience in its consumer distribution network. As part of this ongoing assessment, the Bancorp may determine that it is no longer fully committed to maintaining full-service banking centers at certain locations. Similarly, the Bancorp may also determine that it is no longer fully committed to building banking centers on certain parcels of land which had previously been held for future branch expansion. The Bancorp closed a total of 43 banking centers throughout its footprint during the six months ended June 30, 2021.\nThe Bancorp performs assessments of the recoverability of long-lived assets when events or changes in circumstances indicate that their carrying values may not be recoverable. Impairment losses associated with such assessments and lower of cost or market adjustments were $ 2 million and $ 12 million for the three months ended June 30, 2021 and 2020, respectively, and $ 4 million and $ 14 million for the six months ended June 30, 2021 and 2020, respectively. The recognized impairment losses were recorded in other noninterest income in the Condensed Consolidated Statements of Income.\n8. Operating Lease Equipment\nOperating lease equipment was $ 715 million and $ 777 million at June 30, 2021 and December 31, 2020, respectively, net of accumulated depreciation of $ 298 million and $ 290 million at June 30, 2021 and December 31, 2020, respectively. The Bancorp recorded lease income of $ 39 million relating to lease payments for operating leases in leasing business revenue in the Condensed Consolidated Statements of Income during both the three months ended June 30, 2021 and 2020, and $ 78 million during both the six months ended June 30, 2021 and 2020. Depreciation expense related to operating lease equipment was $ 31 million during both the three months ended June 30, 2021 and 2020, and $ 64 million and $ 63 million during the six months ended June 30, 2021 and 2020, respectively. The Bancorp received payments of $ 80 million related to operating leases during both the six months ended June 30, 2021 and 2020.\nThe Bancorp performs assessments of the recoverability of long-lived assets when events or changes in circumstances indicate that their carrying values may not be recoverable. As a result of these recoverability assessments, the Bancorp recognized an immaterial amount of impairment losses associated with operating lease assets for both the three months ended June 30, 2021 and 2020 and recognized $ 25 million and $ 3 million of impairment losses for the six months ended June 30, 2021 and 2020, respectively. The recognized impairment losses were recorded in leasing business revenue in the Condensed Consolidated Statements of Income.\nThe following table presents future lease payments receivable from operating leases for the remainder of 2021 through 2026 and thereafter:\n| As of June 30, 2021 ($ in millions) | Undiscounted Cash Flows |\n| Remainder of 2021 | $ | 73 |\n| 2022 | 129 |\n| 2023 | 102 |\n| 2024 | 65 |\n| 2025 | 42 |\n| 2026 | 26 |\n| Thereafter | 39 |\n| Total operating lease payments | $ | 476 |\n\n97\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n9. Lease Obligations – Lessee\nThe Bancorp leases certain banking centers, ATM sites, land for owned buildings and equipment. The Bancorp’s lease agreements typically do not contain any residual value guarantees or any material restrictive covenants. For more information on the accounting for lease obligations, refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\nThe following table provides a summary of lease assets and lease liabilities as of:\n| ($ in millions) | Condensed Consolidated Balance Sheets Caption | June 30,2021 | December 31,2020 |\n| Assets |\n| Operating lease right-of-use assets | Other assets | $ | 425 | 423 |\n| Finance lease right-of-use assets | Bank premises and equipment | 144 | 129 |\n| Total right-of-use assets(a) | $ | 569 | 552 |\n| Liabilities |\n| Operating lease liabilities | Accrued taxes, interest and expenses | $ | 523 | 527 |\n| Finance lease liabilities | Long-term debt | 146 | 130 |\n| Total lease liabilities | $ | 669 | 657 |\n\n(a) Operating and finance lease right-of-use assets are recorded net of accumulated amortization of $ 169 and $ 38 , respectively, as of June 30, 2021, and $ 152 and $ 29 , respectively, as of December 31, 2020.\nThe following table presents the components of lease costs:\n| ($ in millions) | Condensed Consolidated Statements of Income Caption | For the three months endedJune 30, | For the six months endedJune 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Lease costs: |\n| Amortization of ROU assets | Net occupancy and equipment expense | $ | 4 | 2 | 9 | 3 |\n| Interest on lease liabilities | Interest on long-term debt | 1 | — | 2 | 1 |\n| Total finance lease costs | $ | 5 | 2 | 11 | 4 |\n| Operating lease cost | Net occupancy expense | $ | 19 | 22 | 39 | 46 |\n| Short-term lease cost | Net occupancy expense | — | — | 1 | 1 |\n| Variable lease cost | Net occupancy expense | 8 | 7 | 16 | 14 |\n| Sublease income | Net occupancy expense | — | — | ( 1 ) | ( 1 ) |\n| Total operating lease costs | $ | 27 | 29 | 55 | 60 |\n| Total lease costs | $ | 32 | 31 | 66 | 64 |\n\nThe Bancorp performs impairment assessments for ROU assets when events or changes in circumstances indicate that their carrying values may not be recoverable. In addition to the lease costs disclosed in the table above, the Bancorp recognized $ 2 million and $ 3 million of impairment losses and termination charges for the ROU assets related to certain operating leases during the three months ended June 30, 2021 and 2020, respectively, and $ 2 million and $ 5 million during the six months ended June 30, 2021 and 2020, respectively. The recognized losses were recorded in net occupancy expense in the Condensed Consolidated Statements of Income.\nThe following table presents undiscounted cash flows payable for both operating leases and finance leases for the remainder of 2021 through 2026 and thereafter as well as a reconciliation of the undiscounted cash flows to the total lease liabilities as follows:\n| As of June 30, 2021 ($ in millions) | OperatingLeases | FinanceLeases | Total |\n| Remainder of 2021 | $ | 44 | 9 | 53 |\n| 2022 | 83 | 20 | 103 |\n| 2023 | 76 | 18 | 94 |\n| 2024 | 68 | 18 | 86 |\n| 2025 | 60 | 12 | 72 |\n| 2026 | 51 | 6 | 57 |\n| Thereafter | 220 | 100 | 320 |\n| Total undiscounted cash flows | $ | 602 | 183 | 785 |\n| Less: Difference between undiscounted cash flows and discounted cash flows | 79 | 37 | 116 |\n| Present value of lease liabilities | $ | 523 | 146 | 669 |\n\n98\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following table presents the weighted-average remaining lease term and weighted-average discount rate as of:\n| June 30,2021 | December 31,2020 |\n| Weighted-average remaining lease term (years): |\n| Operating leases | 9.09 | 9.06 |\n| Finance leases | 14.42 | 12.93 |\n| Weighted-average discount rate: |\n| Operating leases | 2.95 | % | 3.05 |\n| Finance leases | 2.58 | 2.39 |\n\nThe following table presents information related to lease transactions for the six months ended June 30:\n| ($ in millions) | 2021 | 2020 |\n| Cash paid for amounts included in the measurement of lease liabilities:(a) |\n| Operating cash flows from operating leases | $ | 44 | 47 |\n| Operating cash flows from finance leases | 2 | 1 |\n| Financing cash flows from finance leases | 9 | 2 |\n| Gains on sale-leaseback transactions | 2 | — |\n\n(a) The cash flows related to the short-term and variable lease payments are not included in the amounts in the table as they were not included in the measurement of lease liabilities.\n10. Intangible Assets\nIntangible assets consist of core deposit intangibles, customer relationships, operating leases, non-compete agreements, trade names and books of business. Intangible assets are amortized on either a straight-line or an accelerated basis over their estimated useful lives and, based on the type of intangible asset, the amortization expense may be recorded in either leasing business revenue or other noninterest expense in the Condensed Consolidated Statements of Income.\nThe details of the Bancorp’s intangible assets are shown in the following table:\n| ($ in millions) | Gross CarryingAmount | AccumulatedAmortization | Net CarryingAmount |\n| As of June 30, 2021 |\n| Core deposit intangibles | $ | 229 | ( 135 ) | 94 |\n| Customer relationships | 24 | ( 6 ) | 18 |\n| Operating leases | 14 | ( 11 ) | 3 |\n| Other | 3 | ( 1 ) | 2 |\n| Total intangible assets | $ | 270 | ( 153 ) | 117 |\n| As of December 31, 2020 |\n| Core deposit intangibles | $ | 229 | ( 116 ) | 113 |\n| Customer relationships | 24 | ( 5 ) | 19 |\n| Operating leases | 17 | ( 12 ) | 5 |\n| Other | 3 | ( 1 ) | 2 |\n| Total intangible assets | $ | 273 | ( 134 ) | 139 |\n\nAs of June 30, 2021, all of the Bancorp’s intangible assets were being amortized. Amortization expense recognized on intangible assets was $ 10 million and $ 13 million for the three months ended June 30, 2021 and 2020, respectively, and $ 22 million and $ 29 million for the six months ended June 30, 2021 and 2020, respectively. The Bancorp’s projections of amortization expense shown in the following table are based on existing asset balances as of June 30, 2021. Future amortization expense may vary from these projections.\nEstimated amortization expense for the remainder of 2021 through 2025 is as follows:\n| ($ in millions) | Total |\n| Remainder of 2021 | $ | 20 |\n| 2022 | 33 |\n| 2023 | 24 |\n| 2024 | 16 |\n| 2025 | 9 |\n\n99\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n11. Variable Interest Entities\nThe Bancorp, in the normal course of business, engages in a variety of activities that involve VIEs, which are legal entities that lack sufficient equity at risk to finance their activities without additional subordinated financial support or the equity investors of the entities as a group lack any of the characteristics of a controlling interest. The Bancorp evaluates its interest in certain entities to determine if these entities meet the definition of a VIE and whether the Bancorp is the primary beneficiary and should consolidate the entity based on the variable interests it held both at inception and when there is a change in circumstances that requires a reconsideration. If the Bancorp is determined to be the primary beneficiary of a VIE, it must account for the VIE as a consolidated subsidiary. If the Bancorp is determined not to be the primary beneficiary of a VIE but holds a variable interest in the entity, such variable interests are accounted for under the equity method of accounting or other accounting standards as appropriate.\nConsolidated VIEs\nThe Bancorp has consolidated VIEs related to certain automobile loan securitizations where it has determined that it is the primary beneficiary. The following table provides a summary of assets and liabilities carried on the Condensed Consolidated Balance Sheets for consolidated VIEs as of:\n| ($ in millions) | June 30,2021 | December 31,2020 |\n| Assets: |\n| Other short-term investments | $ | 33 | 55 |\n| Indirect secured consumer loans | 455 | 756 |\n| ALLL | ( 3 ) | ( 7 ) |\n| Other assets | 3 | 5 |\n| Total assets | $ | 488 | 809 |\n| Liabilities: |\n| Other liabilities | $ | 1 | 2 |\n| Long-term debt | 400 | 656 |\n| Total liabilities | $ | 401 | 658 |\n\nThe Bancorp has previously completed securitization transactions in which the Bancorp transferred certain consumer automobile loans to bankruptcy remote trusts which were also deemed to be VIEs. In each of these securitization transactions, the primary purposes of the VIEs were to issue asset-backed securities with varying levels of credit subordination and payment priority, as well as residual interests, and to provide the Bancorp with access to liquidity for its originated loans. The Bancorp retained residual interests in the VIEs and, therefore, has an obligation to absorb losses and a right to receive benefits from the VIEs that could potentially be significant to the VIEs. In addition, the Bancorp retained servicing rights for the underlying loans and, therefore, holds the power to direct the activities of the VIEs that most significantly impact the economic performance of the VIEs. As a result, the Bancorp concluded that it is the primary beneficiary of the VIEs and has consolidated these VIEs. The assets of the VIEs are restricted to the settlement of the asset-backed securities and other obligations of the VIEs. The third-party holders of the asset-backed notes do not have recourse to the general assets of the Bancorp.\nThe economic performance of the VIEs is most significantly impacted by the performance of the underlying loans. The principal risks to which the VIEs are exposed include credit risk and prepayment risk. The credit and prepayment risks are managed through credit enhancements in the form of reserve accounts, overcollateralization, excess interest on the loans and the subordination of certain classes of asset-backed securities to other classes.\nNon-consolidated VIEs\nThe following tables provide a summary of assets and liabilities carried on the Condensed Consolidated Balance Sheets related to non-consolidated VIEs for which the Bancorp holds an interest, but is not the primary beneficiary of the VIE, as well as the Bancorp’s maximum exposure to losses associated with its interests in the entities as of:\n| June 30, 2021 ($ in millions) | TotalAssets | TotalLiabilities | MaximumExposure |\n| CDC investments | $ | 1,668 | 519 | 1,668 |\n| Private equity investments | 117 | — | 208 |\n| Loans provided to VIEs | 2,872 | — | 4,268 |\n| Lease pool entities | 75 | — | 75 |\n\n100\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n| December 31, 2020 ($ in millions) | TotalAssets | TotalLiabilities | MaximumExposure |\n| CDC investments | $ | 1,546 | 478 | 1,546 |\n| Private equity investments | 117 | — | 200 |\n| Loans provided to VIEs | 2,420 | — | 3,649 |\n| Lease pool entities | 73 | — | 73 |\n\nCDC investments\nCDC, a wholly-owned indirect subsidiary of the Bancorp, was created to invest in projects to create affordable housing, revitalize business and residential areas and preserve historic landmarks. CDC generally co-invests with other unrelated companies and/or individuals and typically makes investments in a separate legal entity that owns the property under development. The entities are usually formed as limited partnerships and LLCs and CDC typically invests as a limited partner/investor member in the form of equity contributions. The economic performance of the VIEs is driven by the performance of their underlying investment projects as well as the VIEs’ ability to operate in compliance with the rules and regulations necessary for the qualification of tax credits generated by equity investments. The Bancorp has determined that it is not the primary beneficiary of these VIEs because it lacks the power to direct the activities that most significantly impact the economic performance of the underlying project or the VIEs’ ability to operate in compliance with the rules and regulations necessary for the qualification of tax credits generated by equity investments. This power is held by the managing members who exercise full and exclusive control of the operations of the VIEs. For information regarding the Bancorp’s accounting for these investments, refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\nThe Bancorp’s funding requirements are limited to its invested capital and any additional unfunded commitments for future equity contributions. The Bancorp’s maximum exposure to loss as a result of its involvement with the VIEs is limited to the carrying amounts of the investments, including the unfunded commitments. The carrying amounts of these investments, which are included in other assets in the Condensed Consolidated Balance Sheets, and the liabilities related to the unfunded commitments, which are included in other liabilities in the Condensed Consolidated Balance Sheets, are included in the previous tables for all periods presented. The Bancorp has no other liquidity arrangements or obligations to purchase assets of the VIEs that would expose the Bancorp to a loss. In certain arrangements, the general partner/managing member of the VIE has guaranteed a level of projected tax credits to be received by the limited partners/investor members, thereby minimizing a portion of the Bancorp’s risk.\nThe Bancorp’s CDC investments included $ 1.4 billion and $ 1.3 billion of investments in affordable housing tax credits recognized in other assets in the Condensed Consolidated Balance Sheets at June 30, 2021 and December 31, 2020, respectively. The unfunded commitments related to these investments were $ 514 million and $ 478 million at June 30, 2021 and December 31, 2020, respectively. The unfunded commitments as of June 30, 2021 are expected to be funded from 2021 to 2039 .\nThe Bancorp has accounted for all of its qualifying LIHTC investments using the proportional amortization method of accounting. The following table summarizes the impact to the Condensed Consolidated Statements of Income related to these investments:\n| Condensed ConsolidatedStatements of Income Caption(a) | For the three months ended June 30, | For the six months ended June 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Proportional amortization | Applicable income tax expense | $ | 43 | 27 | 87 | 32 |\n| Tax credits and other benefits | Applicable income tax expense | ( 50 ) | ( 32 ) | ( 101 ) | ( 37 ) |\n\n(a)The Bancorp did no t recognize impairment losses resulting from the forfeiture or ineligibility of tax credits or other circumstances during both the three and six months ended June 30, 2021 and 2020.\nPrivate equity investments\nThe Bancorp invests as a limited partner in private equity investments which provide the Bancorp an opportunity to obtain higher rates of return on invested capital, while also creating cross-selling opportunities for the Bancorp’s commercial products. Each of the limited partnerships has an unrelated third-party general partner responsible for appointing the fund manager. The Bancorp has not been appointed fund manager for any of these private equity investments. The funds finance primarily all of their activities from the partners’ capital contributions and investment returns. The Bancorp has determined that it is not the primary beneficiary of the funds because it does not have the obligation to absorb the funds’ expected losses or the right to receive the funds’ expected residual returns that could potentially be significant to the funds and lacks the power to direct the activities that most significantly impact the economic performance of the funds. The Bancorp, as a limited partner, does not have substantive participating or substantive kick-out rights over the general partner. Therefore, the Bancorp accounts for its investments in these limited partnerships under the equity method of accounting.\nThe Bancorp is exposed to losses arising from the negative performance of the underlying investments in the private equity investments. As a limited partner, the Bancorp’s maximum exposure to loss is limited to the carrying amounts of the investments plus unfunded commitments. The carrying amounts of these investments, which are included in other assets in the Condensed Consolidated Balance Sheets, are presented\n101\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nin previous tables. Also, at June 30, 2021 and December 31, 2020, the Bancorp’s unfunded commitment amounts to the private equity funds were $ 91 million and $ 83 million, respectively. As part of previous commitments, the Bancorp made capital contributions to private equity investments of $ 6 million and $ 1 million during the three months ended June 30, 2021 and 2020, respectively, and $ 7 million and $ 5 million during the six months ended June 30, 2021 and 2020, respectively.\nLoans provided to VIEs\nThe Bancorp has provided funding to certain unconsolidated VIEs sponsored by third parties. These VIEs are generally established to finance certain consumer and small business loans originated by third parties. The entities are primarily funded through the issuance of a loan from the Bancorp or a syndication through which the Bancorp is involved. The sponsor/administrator of the entities is responsible for servicing the underlying assets in the VIEs. Because the sponsor/administrator, not the Bancorp, holds the servicing responsibilities, which include the establishment and employment of default mitigation policies and procedures, the Bancorp does not hold the power to direct the activities that most significantly impact the economic performance of the entity and, therefore, is not the primary beneficiary.\nThe principal risk to which these entities are exposed is credit risk related to the underlying assets. The Bancorp’s maximum exposure to loss is equal to the carrying amounts of the loans and unfunded commitments to the VIEs. The Bancorp’s outstanding loans to these VIEs are included in commercial loans in Note 5. As of June 30, 2021 and December 31, 2020, the Bancorp’s unfunded commitments to these entities were $ 1.4 billion and $ 1.2 billion, respectively. The loans and unfunded commitments to these VIEs are included in the Bancorp’s overall analysis of the ALLL and reserve for unfunded commitments, respectively. The Bancorp does not provide any implicit or explicit liquidity guarantees or principal value guarantees to these VIEs.\nLease pool entities\nThe Bancorp is a co-investor with other unrelated leasing companies in three LLCs designed for the purpose of purchasing pools of residual interests in leases which have been originated or purchased by the other investing member. For each LLC, the leasing company is the managing member and has full authority over the day-to-day operations of the entity. While the Bancorp holds more than 50 % of the equity interests in each LLC, the operating agreements require both members to consent to significant corporate actions, such as liquidating the entity or removing the manager. In addition, the Bancorp has a preference with regards to distributions such that all of the Bancorp’s equity contribution for each pool must be distributed, plus a pre-defined rate of return, before the other member may receive distributions. The leasing company is also entitled to the return of its investment plus a pre-defined rate of return before any residual profits are distributed to the members.\nThe lease pool entities are primarily subject to risk of losses on the lease residuals purchased. The Bancorp has determined that it is not the primary beneficiary of these VIEs because it does not have the power to direct the activities that most significantly impact the economic performance of the entities. This power is held by the leasing company, who as managing member controls the servicing of the leases and collection of the proceeds on the residual interests.\n102\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n12. Sales of Receivables and Servicing Rights\nResidential Mortgage Loan Sales\nThe Bancorp sold fixed and adjustable-rate residential mortgage loans during the three and six months ended June 30, 2021 and 2020. In those sales, the Bancorp obtained servicing responsibilities and provided certain standard representations and warranties; however, the investors have no recourse to the Bancorp’s other assets for failure of debtors to pay when due. The Bancorp receives servicing fees based on a percentage of the outstanding balance. The Bancorp identifies classes of servicing assets based on financial asset type and interest rates.\nInformation related to residential mortgage loan sales and the Bancorp’s mortgage banking activity, which is included in mortgage banking net revenue in the Condensed Consolidated Statements of Income, is as follows:\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Residential mortgage loan sales(a) | $ | 4,416 | 3,063 | 7,626 | 6,018 |\n| Origination fees and gains on loan sales | 81 | 95 | 170 | 176 |\n| Gross mortgage servicing fees | 59 | 63 | 117 | 130 |\n\n(a)Represents the unpaid principal balance at the time of the sale.\nServicing Rights\nThe Bancorp measures all of its servicing rights at fair value with changes in fair value reported in mortgage banking net revenue in the Condensed Consolidated Statements of Income.\nThe following table presents changes in the servicing rights related to residential mortgage loans for the six months ended June 30:\n| ($ in millions) | 2021 | 2020 |\n| Balance, beginning of period | $ | 656 | 993 |\n| Servicing rights originated | 103 | 101 |\n| Servicing rights purchased | 109 | 30 |\n| Changes in fair value: |\n| Due to changes in inputs or assumptions(a) | 103 | ( 343 ) |\n| Other changes in fair value(b) | ( 153 ) | ( 105 ) |\n| Balance, end of period | $ | 818 | 676 |\n\n(a)Primarily reflects changes in prepayment speed and OAS assumptions which are updated based on market interest rates.\n(b)Primarily reflects changes due to realized cash flows and the passage of time.\nThe Bancorp maintains a non-qualifying hedging strategy to manage a portion of the risk associated with changes in the value of the MSR portfolio. This strategy may include the purchase of free-standing derivatives and various available-for-sale debt and trading debt securities. The interest income, mark-to-market adjustments and gain or loss from sale activities associated with these portfolios are expected to economically hedge a portion of the change in value of the MSR portfolio caused by fluctuating OAS, earnings rates and prepayment speeds. The fair value of the servicing asset is based on the present value of expected future cash flows.\nThe following table presents activity related to valuations of the MSR portfolio and the impact of the non-qualifying hedging strategy:\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Securities (losses) gains, net – non-qualifying hedges on mortgage servicing rights | $ | 1 | — | ( 1 ) | 3 |\n| Changes in fair value and settlement of free-standing derivatives purchased to economically hedge the MSR portfolio(a) | 46 | 11 | ( 88 ) | 361 |\n| MSR fair value adjustment due to changes in inputs or assumptions(a) | ( 49 ) | ( 12 ) | 103 | ( 343 ) |\n\n(a)Included in mortgage banking net revenue in the Condensed Consolidated Statements of Income.\n103\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe key economic assumptions used in measuring the servicing rights related to residential mortgage loans that continued to be held by the Bancorp at the date of sale, securitization or purchase resulting from transactions completed during the three months ended June 30, 2021 and 2020 were as follows:\n| June 30, 2021 | June 30, 2020 |\n| Weighted-Average Life(in years) | PrepaymentSpeed(annual) | OAS(bps) | Weighted-Average Life(in years) | PrepaymentSpeed(annual) | OAS(bps) |\n| Fixed-rate | 5.9 | 12.3 | % | 610 | 5.8 | 12.4 | % | 777 |\n| Adjustable-rate | — | — | — | 3.0 | 27.1 | 725 |\n\nBased on historical credit experience, expected credit losses for residential mortgage loan servicing rights have been deemed immaterial, as the Bancorp sold the majority of the underlying loans without recourse. At June 30, 2021 and December 31, 2020, the Bancorp serviced $ 71.5 billion and $ 68.8 billion, respectively, of residential mortgage loans for other investors. The value of MSRs that continue to be held by the Bancorp is subject to credit, prepayment and interest rate risks on the sold financial assets.\nAt June 30, 2021, the sensitivity of the current fair value of residual cash flows to immediate 10%, 20% and 50% adverse changes in prepayment speed assumptions and immediate 10% and 20% adverse changes in OAS for servicing rights related to residential mortgage loans are as follows:\n| PrepaymentSpeed Assumption | OASAssumption |\n| Fair Value($ in millions)(a) | Weighted-Average Life(in years) | Impact of Adverse Changeon Fair Value | OAS(bps) | Impact of Adverse Change on Fair Value |\n| Rate | 10% | 20% | 50% | 10% | 20% |\n| Fixed-rate | $ | 812 | 5.0 | 14.5 | % | $ | ( 29 ) | ( 55 ) | ( 125 ) | 542 | $ | ( 16 ) | ( 32 ) |\n| Adjustable-rate | 6 | 3.7 | 21.6 | — | ( 1 ) | ( 2 ) | 978 | — | — |\n\n(a)The impact of the weighted-average default rate on the current fair value of residual cash flows for all scenarios is immaterial.\nThese sensitivities are hypothetical and should be used with caution. As the figures indicate, changes in fair value based on these variations in the assumptions typically cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. The Bancorp believes that variations of these levels are reasonably possible; however, there is the potential that adverse changes in key assumptions could be even greater. Also, in the previous table, the effect of a variation in a particular assumption on the fair value of the interests that continue to be held by the Bancorp is calculated without changing any other assumption; in reality, changes in one factor may result in changes in another (for example, increases in market interest rates may result in lower prepayments), which might magnify or counteract these sensitivities.\n104\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n13. Derivative Financial Instruments\nThe Bancorp maintains an overall risk management strategy that incorporates the use of derivative instruments to reduce certain risks related to interest rate, prepayment and foreign currency volatility. Additionally, the Bancorp holds derivative instruments for the benefit of its commercial customers and for other business purposes. The Bancorp does not enter into unhedged speculative derivative positions.\nThe Bancorp’s interest rate risk management strategy involves modifying the repricing characteristics of certain financial instruments so that changes in interest rates do not adversely affect the Bancorp’s net interest margin and cash flows. Derivative instruments that the Bancorp may use as part of its interest rate risk management strategy include interest rate swaps, interest rate floors, interest rate caps, forward contracts, forward starting interest rate swaps, options, swaptions and TBA securities. Interest rate swap contracts are exchanges of interest payments, such as fixed-rate payments for floating-rate payments, based on a stated notional amount and maturity date. Interest rate floors protect against declining rates, while interest rate caps protect against rising interest rates. Forward contracts are contracts in which the buyer agrees to purchase, and the seller agrees to make delivery of, a specific financial instrument at a predetermined price or yield. Options provide the purchaser with the right, but not the obligation, to purchase or sell a contracted item during a specified period at an agreed-upon price. Swaptions are financial instruments granting the owner the right, but not the obligation, to enter into or cancel a swap.\nPrepayment volatility arises mostly from changes in fair value of the largely fixed-rate MSR portfolio, mortgage loans and mortgage-backed securities. The Bancorp may enter into various free-standing derivatives (principal-only swaps, interest rate swaptions, interest rate floors, mortgage options, TBA securities and interest rate swaps) to economically hedge prepayment volatility. Principal-only swaps are total return swaps based on changes in the value of the underlying mortgage principal-only trust. TBA securities are a forward purchase agreement for a mortgage-backed securities trade whereby the terms of the security are undefined at the time the trade is made.\nForeign currency volatility occurs as the Bancorp enters into certain loans denominated in foreign currencies. Derivative instruments that the Bancorp may use to economically hedge these foreign denominated loans include foreign exchange swaps and forward contracts.\nThe Bancorp also enters into derivative contracts (including foreign exchange contracts, commodity contracts and interest rate contracts) for the benefit of commercial customers and other business purposes. The Bancorp economically hedges significant exposures related to these free-standing derivatives by entering into offsetting third-party contracts with approved, reputable and independent counterparties with substantially matching terms and currencies. Credit risk arises from the possible inability of counterparties to meet the terms of their contracts. The Bancorp’s exposure is limited to the replacement value of the contracts rather than the notional, principal or contract amounts. Credit risk is minimized through credit approvals, limits, counterparty collateral and monitoring procedures.\nThe fair value of derivative instruments is presented on a gross basis, even when the derivative instruments are subject to master netting arrangements. Derivative instruments with a positive fair value are reported in other assets in the Condensed Consolidated Balance Sheets while derivative instruments with a negative fair value are reported in other liabilities in the Condensed Consolidated Balance Sheets. Cash collateral payables and receivables associated with the derivative instruments are not added to or netted against the fair value amounts with the exception of certain variation margin payments that are considered legal settlements of the derivative contracts. For derivative contracts cleared through certain central clearing parties who have modified their rules to treat variation margin payments as settlements, the variation margin payments are applied to net the fair value of the respective derivative contracts.\nThe Bancorp’s derivative assets include certain contractual features in which the Bancorp requires the counterparties to provide collateral in the form of cash and securities to offset changes in the fair value of the derivatives, including changes in the fair value due to credit risk of the counterparty. As of June 30, 2021 and December 31, 2020, the balance of collateral held by the Bancorp for derivative assets was $ 1.1 billion and $ 1.0 billion, respectively. For derivative contracts cleared through certain central clearing parties whose rules treat variation margin payments as settlement of the derivative contract, the payments for variation margin of $ 898 million and $ 1.1 billion were applied to reduce the respective derivative contracts and were also not included in the total amount of collateral held as of June 30, 2021 and December 31, 2020, respectively. As of June 30, 2021 and December 31, 2020, the credit component negatively impacting the fair value of derivative assets associated with customer accommodation contracts was $ 26 million and $ 42 million, respectively.\nIn measuring the fair value of derivative liabilities, the Bancorp considers its own credit risk, taking into consideration collateral maintenance requirements of certain derivative counterparties and the duration of instruments with counterparties that do not require collateral maintenance. When necessary, the Bancorp posts collateral primarily in the form of cash and securities to offset changes in fair value of the derivatives, including changes in fair value due to the Bancorp’s credit risk. As of June 30, 2021 and December 31, 2020, the balance of collateral posted by the Bancorp for derivative liabilities was $ 1.1 billion and $ 463 million, respectively. Additionally, as of June 30, 2021 and December 31, 2020, $ 768 million and $ 1.1 billion, respectively, of variation margin payments were applied to the respective derivative contracts to reduce the Bancorp’s derivative liabilities and were also not included in the total amount of collateral posted. Certain of the Bancorp’s derivative liabilities contain credit-risk related contingent features that could result in the requirement to post additional collateral upon the occurrence of specified events. As of both June 30, 2021 and December 31, 2020, the fair value of the additional collateral that could be required to be posted as a result of the credit-risk-related contingent features being triggered was immaterial to the Bancorp’s Condensed Consolidated Financial Statements. The posting of collateral has been determined to remove the need for further consideration of\n105\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\ncredit risk. As a result, the Bancorp determined that the impact of the Bancorp’s credit risk to the valuation of its derivative liabilities was immaterial to the Bancorp’s Condensed Consolidated Financial Statements.\nThe Bancorp holds certain derivative instruments that qualify for hedge accounting treatment and are designated as either fair value hedges or cash flow hedges. Derivative instruments that do not qualify for hedge accounting treatment, or for which hedge accounting is not established, are held as free-standing derivatives. All customer accommodation derivatives are held as free-standing derivatives.\nThe following tables reflect the notional amounts and fair values for all derivative instruments included in the Condensed Consolidated Balance Sheets as of:\n| Fair Value |\n| June 30, 2021 ($ in millions) | NotionalAmount | DerivativeAssets | DerivativeLiabilities |\n| Derivatives Designated as Qualifying Hedging Instruments: |\n| Fair value hedges: |\n| Interest rate swaps related to long-term debt | $ | 1,455 | 429 | — |\n| Total fair value hedges | 429 | — |\n| Cash flow hedges: |\n| Interest rate floors related to C&I loans | 3,000 | 183 | — |\n| Interest rate swaps related to C&I loans | 8,000 | — | 1 |\n| Total cash flow hedges | 183 | 1 |\n| Total derivatives designated as qualifying hedging instruments | 612 | 1 |\n| Derivatives Not Designated as Qualifying Hedging Instruments: |\n| Free-standing derivatives - risk management and other business purposes: |\n| Interest rate contracts related to MSR portfolio | 6,310 | 146 | — |\n| Forward contracts related to residential mortgage loans held for sale(b) | 3,395 | 1 | 8 |\n| Swap associated with the sale of Visa, Inc. Class B Shares | 3,836 | — | 213 |\n| Foreign exchange contracts | 208 | 5 | — |\n| Interest rate contracts for collateral management | 12,000 | 5 | 5 |\n| Interest rate contracts for LIBOR transition | 2,372 | — | — |\n| Total free-standing derivatives – risk management and other business purposes | 157 | 226 |\n| Free-standing derivatives – customer accommodation: |\n| Interest rate contracts(a) | 80,338 | 879 | 225 |\n| Interest rate lock commitments | 1,865 | 39 | — |\n| Commodity contracts | 10,369 | 1,240 | 1,209 |\n| TBA securities | 92 | — | — |\n| Foreign exchange contracts | 19,778 | 281 | 246 |\n| Total free-standing derivatives – customer accommodation | 2,439 | 1,680 |\n| Total derivatives not designated as qualifying hedging instruments | 2,596 | 1,906 |\n| Total | $ | 3,208 | 1,907 |\n\n(a)Derivative assets and liabilities are presented net of variation margin of $ 52 and $ 734 , respectively.\n(b)Includes forward sale and forward purchase contracts which are utilized to manage market risk on residential mortgage loans held for sale and the related interest rate lock commitments.\n106\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n| Fair Value |\n| December 31, 2020 ($ in millions) | NotionalAmount | DerivativeAssets | DerivativeLiabilities |\n| Derivatives Designated as Qualifying Hedging Instruments: |\n| Fair value hedges: |\n| Interest rate swaps related to long-term debt | $ | 1,955 | 528 | — |\n| Total fair value hedges | 528 | — |\n| Cash flow hedges: |\n| Interest rate floors related to C&I loans | 3,000 | 244 | — |\n| Interest rate swaps related to C&I loans | 8,000 | 16 | 2 |\n| Total cash flow hedges | 260 | 2 |\n| Total derivatives designated as qualifying hedging instruments | 788 | 2 |\n| Derivatives Not Designated as Qualifying Hedging Instruments: |\n| Free-standing derivatives – risk management and other business purposes: |\n| Interest rate contracts related to MSR portfolio | 6,910 | 202 | 1 |\n| Forward contracts related to residential mortgage loans held for sale | 2,903 | 1 | 16 |\n| Swap associated with the sale of Visa, Inc. Class B Shares | 3,588 | — | 201 |\n| Foreign exchange contracts | 204 | — | 3 |\n| Interest rate contracts for collateral management | 12,000 | 3 | 1 |\n| Interest rate contracts for LIBOR transition | 2,372 | — | — |\n| Total free-standing derivatives – risk management and other business purposes | 206 | 222 |\n| Free-standing derivatives – customer accommodation: |\n| Interest rate contracts(a) | 77,806 | 1,238 | 265 |\n| Interest rate lock commitments | 1,830 | 57 | — |\n| Commodity contracts | 7,762 | 375 | 359 |\n| Foreign exchange contracts | 14,587 | 255 | 224 |\n| Total free-standing derivatives – customer accommodation | 1,925 | 848 |\n| Total derivatives not designated as qualifying hedging instruments | 2,131 | 1,070 |\n| Total | $ | 2,919 | 1,072 |\n\n(a)Derivative assets and liabilities are presented net of variation margin of $ 47 and $ 1,063 , respectively.\nFair Value Hedges\nThe Bancorp may enter into interest rate swaps to convert its fixed-rate funding to floating-rate. Decisions to convert fixed-rate funding to floating are made primarily through consideration of the asset/liability mix of the Bancorp, the desired asset/liability sensitivity and interest rate levels. As of June 30, 2021, certain interest rate swaps met the criteria required to qualify for the shortcut method of accounting that permits the assumption of perfect offset. For all designated fair value hedges of interest rate risk as of June 30, 2021 that were not accounted for under the shortcut method of accounting, the Bancorp performed an assessment of hedge effectiveness using regression analysis with changes in the fair value of the derivative instrument and changes in the fair value of the hedged asset or liability attributable to the hedged risk recorded in the same income statement line in current period net income.\nThe following table reflects the change in fair value of interest rate contracts, designated as fair value hedges, as well as the change in fair value of the related hedged items attributable to the risk being hedged, included in the Condensed Consolidated Statements of Income:\n| Condensed ConsolidatedStatements ofIncome Caption | For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Change in fair value of interest rate swaps hedging long- term debt | Interest on long-term debt | $ | 46 | ( 1 ) | ( 99 ) | 226 |\n| Change in fair value of hedged long-term debt attributable to the risk being hedged | Interest on long-term debt | ( 46 ) | 2 | 99 | ( 225 ) |\n\n107\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following amounts were recorded in the Condensed Consolidated Balance Sheets related to cumulative basis adjustments for fair value hedges as of:\n| ($ in millions) | Condensed ConsolidatedBalance Sheets Caption | June 30,2021 | December 31,2020 |\n| Carrying amount of the hedged items | Long-term debt | $ | 1,879 | 2,478 |\n| Cumulative amount of fair value hedging adjustments included in the carrying amount of the hedged items | Long-term debt | 435 | 534 |\n\nCash Flow Hedges\nThe Bancorp may enter into interest rate swaps to convert floating-rate assets and liabilities to fixed rates or to hedge certain forecasted transactions for the variability in cash flows attributable to the contractually specified interest rate. The assets or liabilities may be grouped in circumstances where they share the same risk exposure that the Bancorp desires to hedge. The Bancorp may also enter into interest rate caps and floors to limit cash flow variability of floating-rate assets and liabilities. As of June 30, 2021, all hedges designated as cash flow hedges were assessed for effectiveness using regression analysis. The entire change in the fair value of the interest rate swap included in the assessment of hedge effectiveness is recorded in AOCI and reclassified from AOCI to current period earnings when the hedged item affects earnings. As of June 30, 2021, the maximum length of time over which the Bancorp is hedging its exposure to the variability in future cash flows is 42 months.\nReclassified gains and losses on interest rate contracts related to commercial and industrial loans are recorded within interest income in the Condensed Consolidated Statements of Income. As of June 30, 2021 and December 31, 2020, $ 548 million and $ 718 million, respectively, of net deferred gains, net of tax, on cash flow hedges were recorded in AOCI in the Condensed Consolidated Balance Sheets. As of June 30, 2021, $ 213 million in net unrealized gains, net of tax, recorded in AOCI are expected to be reclassified into earnings during the next 12 months. This amount could differ from amounts actually recognized due to changes in interest rates, hedge de-designations or the addition of other hedges subsequent to June 30, 2021.\nDuring both the three and six months ended June 30, 2021 and 2020, there were no gains or losses reclassified from AOCI into earnings associated with the discontinuance of cash flow hedges because it was probable that the original forecasted transaction would no longer occur by the end of the originally specified time period or within the additional period of time as defined by U.S. GAAP.\nThe following table presents the pre-tax net (losses) gains recorded in the Condensed Consolidated Statements of Income and in the Condensed Consolidated Statements of Comprehensive Income relating to derivative instruments designated as cash flow hedges:\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Amount of pre-tax net (losses) gains recognized in OCI | $ | 11 | 83 | ( 70 ) | 624 |\n| Amount of pre-tax net gains reclassified from OCI into net income | 73 | 62 | 146 | 94 |\n\nFree-Standing Derivative Instruments – Risk Management and Other Business Purposes\nAs part of its overall risk management strategy relative to its mortgage banking activity, the Bancorp may enter into various free-standing derivatives (principal-only swaps, interest rate swaptions, interest rate floors, mortgage options, TBA securities and interest rate swaps) to economically hedge changes in fair value of its largely fixed-rate MSR portfolio. Principal-only swaps hedge the spread between mortgage rates and LIBOR because these swaps appreciate in value as a result of tightening spreads. Principal-only swaps also provide prepayment protection by increasing in value when prepayment speeds increase, as opposed to MSRs that lose value in a faster prepayment environment. Receive fixed/pay floating interest rate swaps and swaptions increase in value when interest rates do not increase as quickly as expected.\nThe Bancorp enters into forward contracts and mortgage options to economically hedge the change in fair value of certain residential mortgage loans held for sale due to changes in interest rates. IRLCs issued on residential mortgage loan commitments that will be held for sale are also considered free-standing derivative instruments and the interest rate exposure on these commitments is economically hedged primarily with forward contracts. Revaluation gains and losses from free-standing derivatives related to mortgage banking activity are recorded as a component of mortgage banking net revenue in the Condensed Consolidated Statements of Income.\nIn conjunction with the sale of Visa, Inc. Class B Shares in 2009, the Bancorp entered into a total return swap in which the Bancorp will make or receive payments based on subsequent changes in the conversion rate of the Class B Shares into Class A Shares. This total return swap is accounted for as a free-standing derivative. Refer to Note 21 for further discussion of significant inputs and assumptions used in the valuation of this instrument.\nThe Bancorp entered into certain interest rate swap contracts for the purpose of managing its collateral positions across two central clearing parties. These interest rate swaps were perfectly offsetting positions that allowed the Bancorp to lower the cash posted as required initial\n108\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nmargin at the clearing parties, which reduced its credit exposure to the clearing parties. Given that all relevant terms for these interest rate swaps are offsetting, these trades create no additional market risk for the Bancorp.\nAs part of the LIBOR to SOFR transition, the Bancorp received certain interest rate swap contracts from the two central clearing parties that are moving from an Effective Federal Funds Rate discounting curve to a SOFR discounting curve. The purpose of these interest rate swaps was to neutralize the impact on collateral requirements due to the change in discounting curves implemented by the central clearing parties.\nThe net gains (losses) recorded in the Condensed Consolidated Statements of Income relating to free-standing derivative instruments used for risk management and other business purposes are summarized in the following table:\n| Condensed ConsolidatedStatements ofIncome Caption | For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Interest rate contracts: |\n| Forward contracts related to residential mortgage loans held for sale | Mortgage banking net revenue | $ | ( 58 ) | 47 | 9 | ( 11 ) |\n| Interest rate contracts related to MSR portfolio | Mortgage banking net revenue | 46 | 11 | ( 88 ) | 361 |\n| Foreign exchange contracts: |\n| Foreign exchange contracts for risk management purposes | Other noninterest income | ( 3 ) | ( 6 ) | ( 5 ) | 8 |\n| Equity contracts: |\n| Swap associated with sale of Visa, Inc. Class B Shares | Other noninterest income | ( 37 ) | ( 29 ) | ( 50 ) | ( 51 ) |\n\nFree-Standing Derivative Instruments – Customer Accommodation\nThe majority of the free-standing derivative instruments the Bancorp enters into are for the benefit of its commercial customers. These derivative contracts are not designated against specific assets or liabilities on the Condensed Consolidated Balance Sheets or to forecasted transactions and, therefore, do not qualify for hedge accounting. These instruments include foreign exchange derivative contracts entered into for the benefit of commercial customers involved in international trade to hedge their exposure to foreign currency fluctuations and commodity contracts to hedge such items as natural gas and various other derivative contracts. The Bancorp may economically hedge significant exposures related to these derivative contracts entered into for the benefit of customers by entering into offsetting contracts with approved, reputable, independent counterparties with substantially matching terms. The Bancorp hedges its interest rate exposure on commercial customer transactions by executing offsetting swap agreements with primary dealers. Revaluation gains and losses on interest rate, foreign exchange, commodity and other commercial customer derivative contracts are recorded as a component of commercial banking revenue or other noninterest income in the Condensed Consolidated Statements of Income.\nThe Bancorp enters into risk participation agreements, under which the Bancorp assumes credit exposure relating to certain underlying interest rate derivative contracts. The Bancorp only enters into these risk participation agreements in instances in which the Bancorp has participated in the loan that the underlying interest rate derivative contract was designed to hedge. The Bancorp will make payments under these agreements if a customer defaults on its obligation to perform under the terms of the underlying interest rate derivative contract. The total notional amount of the risk participation agreements was $ 3.4 billion at both June 30, 2021 and December 31, 2020 and the fair value was a liability of $ 8 million at both June 30, 2021 and December 31, 2020, which is included in other liabilities in the Condensed Consolidated Balance Sheets. As of June 30, 2021, the risk participation agreements had a weighted-average remaining life of 3.2 years.\nThe Bancorp’s maximum exposure in the risk participation agreements is contingent on the fair value of the underlying interest rate derivative contracts in an asset position at the time of default. The Bancorp monitors the credit risk associated with the underlying customers in the risk participation agreements through the same risk grading system currently utilized for establishing loss reserves in its loan and lease portfolio.\nRisk ratings of the notional amount of risk participation agreements under this risk rating system are summarized in the following table as of:\n| ($ in millions) | June 30,2021 | December 31,2020 |\n| Pass | $ | 3,385 | 3,231 |\n| Special mention | 14 | 113 |\n| Substandard | 49 | 52 |\n| Total | $ | 3,448 | 3,396 |\n\n109\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe net gains (losses) recorded in the Condensed Consolidated Statements of Income relating to free-standing derivative instruments used for customer accommodation are summarized in the following table:\n| Condensed ConsolidatedStatements of Income Caption | For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Interest rate contracts: |\n| Interest rate contracts for customers (contract revenue) | Commercial banking revenue | $ | 12 | 12 | 19 | 26 |\n| Interest rate contracts for customers (credit portion of fair value adjustment) | Other noninterest expense | 1 | ( 1 ) | 16 | ( 34 ) |\n| Interest rate lock commitments | Mortgage banking net revenue | 57 | 82 | 89 | 182 |\n| Commodity contracts: |\n| Commodity contracts for customers (contract revenue) | Commercial banking revenue | 6 | 4 | 11 | 7 |\n| Commodity contracts for customers (credit portion of fair value adjustment) | Other noninterest expense | ( 1 ) | — | — | ( 1 ) |\n| Commodity contracts for customers (credit losses) | Other noninterest expense | — | ( 1 ) | — | ( 1 ) |\n| Foreign exchange contracts: |\n| Foreign exchange contracts for customers (contract revenue) | Commercial banking revenue | 16 | 14 | 30 | 26 |\n| Foreign exchange contracts for customers (contract revenue) | Other noninterest income | ( 2 ) | ( 3 ) | ( 1 ) | 3 |\n| Foreign exchange contracts for customers (credit portion of fair value adjustment) | Other noninterest expense | — | 1 | — | ( 1 ) |\n\nOffsetting Derivative Financial Instruments\nThe Bancorp’s derivative transactions are generally governed by ISDA Master Agreements and similar arrangements, which include provisions governing the setoff of assets and liabilities between the parties. When the Bancorp has more than one outstanding derivative transaction with a single counterparty, the setoff provisions contained within these agreements generally allow the non-defaulting party the right to reduce its liability to the defaulting party by amounts eligible for setoff, including the collateral received as well as eligible offsetting transactions with that counterparty, irrespective of the currency, place of payment or booking office. The Bancorp’s policy is to present its derivative assets and derivative liabilities on the Condensed Consolidated Balance Sheets on a gross basis, even when provisions allowing for setoff are in place. However, for derivative contracts cleared through certain central clearing parties who have modified their rules to treat variation margin payments as settlements, the fair value of the respective derivative contracts is reported net of the variation margin payments.\nCollateral amounts included in the tables below consist primarily of cash and highly rated government-backed securities and do not include variation margin payments for derivative contracts with legal rights of setoff for both periods shown.\nThe following tables provide a summary of offsetting derivative financial instruments:\n| Gross AmountRecognized in theCondensed ConsolidatedBalance Sheets(a) | Gross Amounts Not Offset in theCondensed Consolidated Balance Sheets |\n| Derivatives | Collateral(b) | Net Amount |\n| As of June 30, 2021 |\n| Derivative assets | $ | 3,169 | ( 742 ) | ( 632 ) | 1,795 |\n| Derivative liabilities | 1,907 | ( 742 ) | ( 811 ) | 354 |\n| As of December 31, 2020 |\n| Derivative assets | $ | 2,862 | ( 621 ) | ( 755 ) | 1,486 |\n| Derivative liabilities | 1,072 | ( 621 ) | ( 221 ) | 230 |\n\n(a)Amount does not include IRLCs because these instruments are not subject to master netting or similar arrangements.\n(b)Amount of collateral received as an offset to asset positions or pledged as an offset to liability positions. Collateral values in excess of related derivative amounts recognized in the Condensed Consolidated Balance Sheets were excluded from this table.\n110\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n14. Other Short-Term Borrowings\nBorrowings with original maturities of one year or less are classified as short-term. The following table presents a summary of the Bancorp’s other short-term borrowings as of:\n| ($ in millions) | June 30,2021 | December 31,2020 |\n| Securities sold under repurchase agreements | $ | 533 | 679 |\n| Derivative collateral | 596 | 474 |\n| Other secured borrowings | 1 | 39 |\n| Total other short-term borrowings | $ | 1,130 | 1,192 |\n\nThe Bancorp’s securities sold under repurchase agreements are accounted for as secured borrowings and are collateralized by securities included in available-for-sale debt and other securities in the Condensed Consolidated Balance Sheets. These securities are subject to changes in market value and, therefore, the Bancorp may increase or decrease the level of securities pledged as collateral based upon these movements in market value. As of both June 30, 2021 and December 31, 2020, all securities sold under repurchase agreements were secured by agency residential mortgage-backed securities and the repurchase agreements had an overnight remaining contractual maturity.\nThe Bancorp’s other secured borrowings at December 31, 2020 primarily included obligations recognized by the Bancorp under ASC Topic 860 related to certain loans sold to GNMA and serviced by the Bancorp. Under ASC Topic 860, once the Bancorp has the unilateral right to repurchase the GNMA loans due to the borrower missing three consecutive payments, the Bancorp is considered to have regained effective control over the loan. As such, the Bancorp is required to recognize both the loan and the repurchase liability, regardless of the intent to repurchase the loans. The Bancorp repurchased these loans during the second quarter of 2021.\n15. Capital Actions\nAccelerated Share Repurchase Transactions\nDuring the six months ended June 30, 2021, the Bancorp entered into and settled accelerated share repurchase transactions. As part of these transactions, the Bancorp entered into forward contracts in which the final number of shares delivered at settlement was based generally on a discount to the average daily volume weighted-average price of the Bancorp’s common stock during the term of these repurchase agreements. The accelerated share repurchases were treated as two separate transactions, (i) the repurchase of treasury shares on the repurchase date and (ii) a forward contract indexed to the Bancorp’s common stock.\nThe following table presents a summary of the Bancorp’s accelerated share repurchase transactions that were entered into and settled during the six months ended June 30, 2021:\n| Repurchase Date | Amount ($ in millions) | Shares Repurchased on Repurchase Date | Shares Received from Forward Contract Settlement | Total Shares Repurchased | Final Settlement Date |\n| January 26, 2021 | $ | 180 | 4,951,456 | 366,939 | 5,318,395 | March 31, 2021 |\n| April 23, 2021 | 347 | 7,894,807 | 675,295 | 8,570,102 | June 11, 2021 |\n\nFor further information on a subsequent event related to capital actions, refer to Note 23.\n111\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n16. Commitments, Contingent Liabilities and Guarantees\nThe Bancorp, in the normal course of business, enters into financial instruments and various agreements to meet the financing needs of its customers. The Bancorp also enters into certain transactions and agreements to manage its interest rate and prepayment risks, provide funding, equipment and locations for its operations and invest in its communities. These instruments and agreements involve, to varying degrees, elements of credit risk, counterparty risk and market risk in excess of the amounts recognized in the Condensed Consolidated Balance Sheets. The creditworthiness of counterparties for all instruments and agreements is evaluated on a case-by-case basis in accordance with the Bancorp’s credit policies. The Bancorp’s significant commitments, contingent liabilities and guarantees in excess of the amounts recognized in the Condensed Consolidated Balance Sheets are discussed in the following sections.\nCommitments\nThe Bancorp has certain commitments to make future payments under contracts. The following table reflects a summary of significant commitments as of:\n| ($ in millions) | June 30,2021 | December 31,2020 |\n| Commitments to extend credit | $ | 77,081 | 74,499 |\n| Forward contracts related to residential mortgage loans held for sale | 3,395 | 2,903 |\n| Letters of credit | 1,858 | 1,982 |\n| Purchase obligations | 161 | 195 |\n| Capital expenditures | 93 | 75 |\n| Capital commitments for private equity investments | 91 | 83 |\n\nCommitments to extend credit\nCommitments to extend credit are agreements to lend, typically having fixed expiration dates or other termination clauses that may require payment of a fee. Since many of the commitments to extend credit may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash flow requirements. The Bancorp is exposed to credit risk in the event of nonperformance by the counterparty for the amount of the contract. Fixed-rate commitments are also subject to market risk resulting from fluctuations in interest rates and the Bancorp’s exposure is limited to the replacement value of those commitments. As of June 30, 2021 and December 31, 2020, the Bancorp had a reserve for unfunded commitments, including letters of credit, totaling $ 189 million and $ 172 million, respectively, included in other liabilities in the Condensed Consolidated Balance Sheets. The Bancorp monitors the credit risk associated with commitments to extend credit using the same standard regulatory risk rating systems utilized for its loan and lease portfolio.\nRisk ratings of outstanding commitments to extend credit under this risk rating system are summarized in the following table as of:\n| ($ in millions) | June 30,2021 | December 31,2020 |\n| Pass | $ | 74,230 | 71,386 |\n| Special mention | 1,468 | 2,049 |\n| Substandard | 1,383 | 1,063 |\n| Doubtful | — | 1 |\n| Total commitments to extend credit | $ | 77,081 | 74,499 |\n\nLetters of credit\nStandby and commercial letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party and expire as summarized in the following table as of June 30, 2021:\n| ($ in millions) |\n| Less than 1 year(a) | $ | 999 |\n| 1 - 5 years(a) | 856 |\n| Over 5 years | 3 |\n| Total letters of credit | $ | 1,858 |\n\n(a)Includes $ 14 and $ 3 issued on behalf of commercial customers to facilitate trade payments in U.S. dollars and foreign currencies which expire less than 1 year and between 1 -5 years, respectively.\nStandby letters of credit accounted for approximately 99 % of total letters of credit at both June 30, 2021 and December 31, 2020, and are considered guarantees in accordance with U.S. GAAP. Approximately 72 % and 68 % of the total standby letters of credit were collateralized as of June 30, 2021 and December 31, 2020, respectively. In the event of nonperformance by the customers, the Bancorp has rights to the underlying collateral, which can include commercial real estate, physical plant and property, inventory, receivables, cash and marketable securities. The reserve related to these standby letters of credit, which was included in the total reserve for unfunded commitments, was $ 25\n112\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nmillion and $ 27 million at June 30, 2021 and December 31, 2020, respectively. The Bancorp monitors the credit risk associated with letters of credit using the same standard regulatory risk rating systems utilized for its loan and lease portfolio.\nRisk ratings of outstanding letters of credit under this risk rating system are summarized in the following table as of:\n| ($ in millions) | June 30,2021 | December 31,2020 |\n| Pass | $ | 1,632 | 1,739 |\n| Special mention | 66 | 111 |\n| Substandard | 160 | 132 |\n| Total letters of credit | $ | 1,858 | 1,982 |\n\nAt June 30, 2021 and December 31, 2020, the Bancorp had outstanding letters of credit that were supporting certain securities issued as VRDNs. The Bancorp facilitates financing for its commercial customers, which consist of companies and municipalities, by marketing the VRDNs to investors. The VRDNs pay interest to holders at a rate of interest that fluctuates based upon market demand. The VRDNs generally have long-term maturity dates, but can be tendered by the holder for purchase at par value upon proper advance notice. When the VRDNs are tendered, a remarketing agent generally finds another investor to purchase the VRDNs to keep the securities outstanding in the market. As of June 30, 2021 and December 31, 2020, total VRDNs in which the Bancorp was the remarketing agent or that were supported by a Bancorp letter of credit were $ 485 million and $ 385 million, respectively, of which FTS acted as the remarketing agent to issuers on $ 485 million and $ 385 million, respectively. As remarketing agent, FTS is responsible for actively remarketing VRDNs to other investors when they have been tendered. If another investor is not identified, FTS may choose to purchase the VRDNs into inventory at its discretion while it continues to remarket them. If FTS purchases the VRDNs into inventory, it can subsequently tender back the VRDNs to the issuer’s trustee with proper advance notice. The Bancorp issued letters of credit, as a credit enhancement, to $ 138 million and $ 142 million of the VRDNs remarketed by FTS at June 30, 2021 and December 31, 2020, respectively. These letters of credit are included in the total letters of credit balance provided in the previous table. The Bancorp did no t hold any of these VRDNs in its portfolio at June 30, 2021 or December 31, 2020 but classifies them as trading debt securities when held.\nForward contracts related to residential mortgage loans held for sale\nThe Bancorp enters into forward contracts to economically hedge the change in fair value of certain residential mortgage loans held for sale due to changes in interest rates. The outstanding notional amounts of these forward contracts are included in the summary of significant commitments table for all periods presented.\nOther commitments\nThe Bancorp has entered into a limited number of agreements for work related to banking center construction and to purchase goods or services.\nContingent Liabilities\nLegal claims\nThere are legal claims pending against the Bancorp and its subsidiaries that have arisen in the normal course of business. Refer to Note 17 for additional information regarding these proceedings.\nGuarantees\nThe Bancorp has performance obligations upon the occurrence of certain events under financial guarantees provided in certain contractual arrangements as discussed in the following sections.\nResidential mortgage loans sold with representation and warranty provisions\nConforming residential mortgage loans sold to unrelated third parties are generally sold with representation and warranty provisions. A contractual liability arises only in the event of a breach of these representations and warranties and, in general, only when a loss results from the breach. The Bancorp may be required to repurchase any previously sold loan, or indemnify or make whole the investor or insurer for which the representation or warranty of the Bancorp proves to be inaccurate, incomplete or misleading. For more information on how the Bancorp establishes the residential mortgage repurchase reserve, refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\nAs of June 30, 2021 and December 31, 2020, the Bancorp maintained reserves related to loans sold with representation and warranty provisions totaling $ 9 million and $ 8 million, respectively, included in other liabilities in the Condensed Consolidated Balance Sheets.\nThe Bancorp uses the best information available when estimating its mortgage representation and warranty reserve; however, the estimation process is inherently uncertain and imprecise and, accordingly, losses in excess of the amounts reserved as of June 30, 2021 are reasonably possible. The Bancorp currently estimates that it is reasonably possible that it could incur losses related to mortgage representation and warranty provisions in an amount up to approximately $ 11 million in excess of amounts reserved. This estimate was derived by modifying\n113\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nthe key assumptions to reflect management’s judgment regarding reasonably possible adverse changes to those assumptions. The actual repurchase losses could vary significantly from the recorded mortgage representation and warranty reserve or this estimate of reasonably possible losses, depending on the outcome of various factors, including those previously discussed.\nFor both the three months ended June 30, 2021 and 2020, the Bancorp paid an immaterial amount in the form of make-whole payments and repurchased $ 9 million and $ 7 million, respectively, in outstanding principal of loans to satisfy investor demands. For the six months ended June 30, 2021 and 2020, the Bancorp paid $ 1 million and an immaterial amount, respectively, in the form of make-whole payments and repurchased $ 19 million and $ 13 million, respectively, in outstanding principal of loans to satisfy investor demands. Total repurchase demand requests during the three months ended June 30, 2021 and 2020 were $ 18 million and $ 9 million, respectively. Total repurchase demand requests during the six months ended June 30, 2021 and 2020 were $ 28 million and $ 19 million, respectively. Total outstanding repurchase demand inventory was $ 11 million and $ 5 million at June 30, 2021 and December 31, 2020, respectively.\nMargin accounts\nFTS, an indirect wholly-owned subsidiary of the Bancorp, guarantees the collection of all margin account balances held by its brokerage clearing agent for the benefit of its customers. FTS is responsible for payment to its brokerage clearing agent for any loss, liability, damage, cost or expense incurred as a result of customers failing to comply with margin or margin maintenance calls on all margin accounts. The margin account balances held by the brokerage clearing agent were $ 27 million and $ 14 million at June 30, 2021 and December 31, 2020, respectively. In the event of any customer default, FTS has rights to the underlying collateral provided. Given the existence of the underlying collateral provided and negligible historical credit losses, the Bancorp does not maintain a loss reserve related to the margin accounts.\nLong-term borrowing obligations\nThe Bancorp had certain fully and unconditionally guaranteed long-term borrowing obligations issued by wholly-owned issuing trust entities of $ 62 million at both June 30, 2021 and December 31, 2020.\nVisa litigation\nThe Bancorp, as a member bank of Visa prior to Visa’s reorganization and IPO (the “IPO”) of its Class A common shares (the “Class A Shares”) in 2008, had certain indemnification obligations pursuant to Visa’s certificate of incorporation and bylaws and in accordance with its membership agreements. In accordance with Visa’s bylaws prior to the IPO, the Bancorp could have been required to indemnify Visa for the Bancorp’s proportional share of losses based on the pre-IPO membership interests. As part of its reorganization and IPO, the Bancorp’s indemnification obligation was modified to include only certain known or anticipated litigation (the “Covered Litigation”) as of the date of the restructuring. This modification triggered a requirement for the Bancorp to recognize a liability equal to the fair value of the indemnification liability.\nIn conjunction with the IPO, the Bancorp received 10.1 million of Visa’s Class B common shares (the “Class B Shares”) based on the Bancorp’s membership percentage in Visa prior to the IPO. The Class B Shares are not transferable (other than to another member bank) until the later of the third anniversary of the IPO closing or the date on which the Covered Litigation has been resolved; therefore, the Bancorp’s Class B Shares were classified in other assets and accounted for at their carryover basis of $ 0 . Visa deposited $ 3 billion of the proceeds from the IPO into a litigation escrow account, established for the purpose of funding judgments in, or settlements of, the Covered Litigation. Since then, when Visa’s litigation committee determined that the escrow account was insufficient, Visa issued additional Class A Shares and deposited the proceeds from the sale of the Class A Shares into the litigation escrow account. When Visa funded the litigation escrow account, the Class B Shares were subjected to dilution through an adjustment in the conversion rate of Class B Shares into Class A Shares.\nIn 2009, the Bancorp completed the sale of Visa, Inc. Class B Shares and entered into a total return swap in which the Bancorp will make or receive payments based on subsequent changes in the conversion rate of the Class B Shares into Class A Shares. The swap terminates on the later of the third anniversary of Visa’s IPO or the date on which the Covered Litigation is settled. Refer to Note 21 for additional information on the valuation of the swap. The counterparty to the swap as a result of its ownership of the Class B Shares will be impacted by dilutive adjustments to the conversion rate of the Class B Shares into Class A Shares caused by any Covered Litigation losses in excess of the litigation escrow account. If actual judgments in, or settlements of, the Covered Litigation significantly exceed current expectations, then additional funding by Visa of the litigation escrow account and the resulting dilution of the Class B Shares could result in a scenario where the Bancorp’s ultimate exposure associated with the Covered Litigation (the “Visa Litigation Exposure”) exceeds the value of the Class B Shares owned by the swap counterparty (the “Class B Value”). In the event the Bancorp concludes that it is probable that the Visa Litigation Exposure exceeds the Class B Value, the Bancorp would record a litigation reserve liability and a corresponding amount of other noninterest expense for the amount of the excess. Any such litigation reserve liability would be separate and distinct from the fair value derivative liability associated with the total return swap.\nAs of the date of the Bancorp’s sale of the Visa Class B Shares and through June 30, 2021, the Bancorp has concluded that it is not probable that the Visa Litigation Exposure will exceed the Class B value. Based on this determination, upon the sale of Class B Shares, the Bancorp reversed its net Visa litigation reserve liability and recognized a free-standing derivative liability associated with the total return swap. The fair value of the swap liability was $ 213 million at June 30, 2021 and $ 201 million at December 31, 2020. Refer to Note 13 and Note 21 for further information.\n114\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nAfter the Bancorp’s sale of the Class B Shares, Visa has funded additional amounts into the litigation escrow account which have resulted in further dilutive adjustments to the conversion of Class B Shares into Class A Shares, and along with other terms of the total return swap, required the Bancorp to make cash payments in varying amounts to the swap counterparty as follows:\n| Period ($ in millions) | VisaFunding Amount | Bancorp CashPayment Amount |\n| Q2 2010 | $ | 500 | 20 |\n| Q4 2010 | 800 | 35 |\n| Q2 2011 | 400 | 19 |\n| Q1 2012 | 1,565 | 75 |\n| Q3 2012 | 150 | 6 |\n| Q3 2014 | 450 | 18 |\n| Q2 2018 | 600 | 26 |\n| Q3 2019 | 300 | 12 |\n\n115\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n17. Legal and Regulatory Proceedings\nLitigation\nVisa/MasterCard Merchant Interchange Litigation\nIn April 2006, the Bancorp was added as a defendant in a consolidated antitrust class action lawsuit originally filed against Visa®, MasterCard® and several other major financial institutions in the United States District Court for the Eastern District of New York (In re: Payment Card Interchange Fee and Merchant Discount Antitrust Litigation, Case No. 5-MD-1720). The plaintiffs, merchants operating commercial businesses throughout the U.S. and trade associations, claimed that the interchange fees charged by card-issuing banks were unreasonable and sought injunctive relief and unspecified damages. In addition to being a named defendant, the Bancorp is currently also subject to a possible indemnification obligation of Visa as discussed in Note 16 and has also entered into judgment and loss sharing agreements with Visa, MasterCard and certain other named defendants. In October 2012, the parties to the litigation entered into a settlement agreement that was initially approved by the trial court but reversed by the U.S. Second Circuit Court of Appeals and remanded to the district court for further proceedings. Pursuant to the terms of the overturned settlement agreement, the Bancorp had previously paid $ 46 million into a class settlement escrow account. Approximately 8,000 merchants requested exclusion from the class settlement, and therefore, pursuant to the terms of the overturned settlement agreement, approximately 25 % of the funds paid into the class settlement escrow account had been already returned to the control of the defendants. The remaining settlement funds paid by the Bancorp have been maintained in the escrow account. More than 500 of the merchants who requested exclusion from the class filed separate federal lawsuits against Visa, MasterCard and certain other defendants alleging similar antitrust violations. These individual federal lawsuits were transferred to the United States District Court for the Eastern District of New York. While the Bancorp is only named as a defendant in one of the individual federal lawsuits, it may have obligations pursuant to indemnification arrangements and/or the judgment or loss sharing agreements noted above. On September 17, 2018, the defendants in the consolidated class action signed a second settlement agreement (the “Amended Settlement Agreement”) resolving the claims seeking monetary damages by the proposed plaintiffs’ class (the “Plaintiff Damages Class”) and superseding the original settlement agreement entered into in October 2012. The Amended Settlement Agreement included, among other terms, a release from participating class members for liability for claims that accrue no later than five years after the Amended Settlement Agreement becomes final. The Amended Settlement Agreement provided for a total payment by all defendants of approximately $ 6.24 billion, composed of approximately $ 5.34 billion held in escrow plus an additional $ 900 million in new funds. Pursuant to the terms of the Settlement Agreement, $ 700 million of the additional $ 900 million has been returned to the defendants due to the level of opt-outs from the class. The Bancorp’s allocated share of the settlement is within existing reserves, including funds maintained in escrow. On December 13, 2019, the Court entered an order granting final approval for the settlement. The settlement does not resolve the claims of the separate proposed plaintiffs’ class seeking injunctive relief or the claims of merchants who have opted out of the proposed class settlement and are pursuing, or may in the future decide to pursue, private lawsuits. The ultimate outcome in this matter, including the timing of resolution, therefore remains uncertain. Refer to Note 16 for further information.\nKlopfenstein v. Fifth Third Bank\nOn August 3, 2012, William Klopfenstein and Adam McKinney filed a lawsuit against Fifth Third Bank in the United States District Court for the Northern District of Ohio (Klopfenstein et al. v. Fifth Third Bank), alleging that the 120 % APR that Fifth Third disclosed on its Early Access program was misleading. Early Access is a deposit-advance program offered to eligible customers with checking accounts. The plaintiffs sought to represent a nationwide class of customers who used the Early Access program and repaid their cash advances within 30 days. On October 31, 2012, the case was transferred to the United States District Court for the Southern District of Ohio. In 2013, four similar putative class action lawsuits were filed against Fifth Third Bank in federal courts throughout the country (Lori and Danielle Laskaris v. Fifth Third Bank, Janet Fyock v. Fifth Third Bank, Jesse McQuillen v. Fifth Third Bank, and Brian Harrison v. Fifth Third Bank). Those four lawsuits were transferred to the Southern District of Ohio and consolidated with the original lawsuit as In re: Fifth Third Early Access Cash Advance Litigation (Case No. 1:12-CV-851). On behalf of a putative class, the plaintiffs sought unspecified monetary and statutory damages, injunctive relief, punitive damages, attorneys’ fees, and pre- and post-judgment interest. On March 30, 2015, the court dismissed all claims alleged in the consolidated lawsuit except a claim under the TILA. On May 28, 2019, the Sixth Circuit Court of Appeals reversed the dismissal of plaintiffs’ breach of contract claim and remanded for further proceedings. The plaintiffs’ claimed damages for the alleged breach of contract claim exceed $ 280 million. On March 26, 2021, the trial court granted plaintiffs’ motion for class certification. No trial date has been set.\nHelton v. Fifth Third Bank\nOn August 31, 2015, trust beneficiaries filed an action against Fifth Third Bank, as trustee, in the Probate Court for Hamilton County, Ohio (Helen Clarke Helton, et al. v. Fifth Third Bank, Case No. 2015003814). The plaintiffs alleged breach of the duty to diversify, breach of the duty of impartiality, breach of trust/fiduciary duty, and unjust enrichment, based on Fifth Third’s alleged failure to diversify assets held in two trusts for the plaintiffs’ benefit. The lawsuit sought over $ 800 million in alleged damages, attorneys’ fees, removal of Fifth Third as trustee, and injunctive relief. On April 20, 2018, the Court denied plaintiffs’ motion for summary judgment and granted summary judgment to Fifth Third, dismissing the case in its entirety. On December 18, 2019, the Ohio Court of Appeals affirmed the Probate Court’s dismissal of all of plaintiffs’ claims based upon allegations of Fifth Third’s alleged failure to diversify assets held in two trusts for plaintiffs’ benefit. The appeals court reversed summary judgment on one claim related to Fifth Third’s alleged unjust enrichment through its receipt of certain fees in managing the trusts. The Court of Appeals remanded the case to the Probate Court for further consideration of the lone surviving claim, which comprises a small fraction of the damages originally sought by plaintiffs in the lawsuit. Plaintiffs filed an appeal to the Ohio Supreme\n116\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nCourt, seeking review of the decision from the Ohio Court of Appeals. On April 14, 2020, the Ohio Supreme Court announced its denial of plaintiffs’ request for review, and subsequently denied plaintiffs’ request for reconsideration. Thereafter, the case returned to the trial court for further adjudication of the lone surviving claim. On July 28, 2021 the trial court issued an order granting summary judgment to Fifth Third on a portion of plaintiffs’ unjust enrichment claim, leaving the remainder of the claim to be resolved at trial, currently scheduled for February 22, 2022.\nBureau of Consumer Financial Protection v. Fifth Third Bank, National Association\nOn March 9, 2020, the CFPB filed a lawsuit against Fifth Third in the United States District Court for the Northern District of Illinois entitled CFPB v. Fifth Third Bank, National Association, Case No. 1:20-CV-1683 (N.D. Ill.) (ABW), alleging violations of the Consumer Financial Protection Act, TILA, and Truth in Savings Act related to Fifth Third’s alleged opening of unspecified numbers of allegedly unauthorized credit card, savings, checking, online banking and early access accounts from 2010 through 2016. The CFPB seeks unspecified amounts of civil monetary penalties as well as unspecified customer remediation. On February 12, 2021, the court granted Fifth Third’s motion to transfer venue to the United States District Court for the Southern District of Ohio. The Bancorp is also subject to a consumer class action lawsuit related to the alleged opening of unauthorized accounts which has also been transferred to the United States District Court for the Southern District of Ohio (Zanni v. Fifth Third Bank, et al., Case No. 2020CH04022).\nShareholder Litigation\nOn April 7, 2020, Plaintiff Lee Christakis filed a putative class action lawsuit against Fifth Third Bancorp, Fifth Third Chairman and Chief Executive Officer Greg D. Carmichael, and former Fifth Third Chief Financial Officer Tayfun Tuzun in the U.S. District Court for the Northern District of Illinois entitled Lee Christakis, individually and on behalf of all others similarly situated v. Fifth Third Bancorp, et al., Case No. 1:20-cv-2176 (N.D. Ill). The case brings two claims for violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, alleging that the Defendants made material misstatements and omissions in connection with the alleged unauthorized opening of credit card, savings, checking, online banking and early access accounts from 2010 through 2016. The plaintiff seeks certification of a class, unspecified damages, attorneys’ fees and costs. On June 29, 2020, the Court appointed Heavy & General Laborers’ Local 472 & 172 Pension and Annuity Funds as lead plaintiff, and Robins Geller Rudman & Dowd LLP as lead counsel for the plaintiff. On September 14, 2020, the lead plaintiff filed its amended consolidated complaint. On April 27, 2021, the Court granted the defendants’ motion to dismiss and provided plaintiff with leave to amend to attempt to cure the deficiencies.\nOn July 31, 2020, a second putative shareholder class action lawsuit captioned Dr. Steven Fox, individually and on behalf of all others similarly situated v. Fifth Third Bancorp, et al., Case No. 2020CH05219 was filed on behalf of former shareholders of MB Financial, Inc. in the Cook County, Illinois Circuit Court. The suit brings claims for violation of Sections 11 and 12(a)(2) of the Securities Act of 1933, alleging that the Bancorp and certain of its officers and directors made material misstatements and omissions regarding the alleged improper cross-selling strategy in filings made in connection with the Bancorp’s merger with MB Financial, Inc. On March 19, 2021, the trial court denied the defendants’ motion to dismiss.\nIn addition, shareholder derivative lawsuits have been filed seeking monetary damages on behalf of the Bancorp alleging certain claims against various officers and directors relating to an alleged improper cross-selling strategy. Four lawsuits filed in the U.S. District Court for the Northern District of Illinois have been consolidated into a single action captioned In re Fifth Third Bancorp Derivative Litigation, Case No. 1:20-cv-04115. Those cases consist of: (1) Pemberton v. Carmichael, et al., Case No. 20-cv-4115 (filed July 13, 2020); (2) Meyer v. Carmichael, et al., Case No. 20-cv-4244 (filed July 17, 2020); (3) Cox v. Carmichael, et al., Case No. 20-cv-4660 (filed August 7, 2020); and (4) Hansen v. Carmichael, et al., Case No. 20-cv-5339 (filed September 10, 2020). Also pending are shareholder derivative matters Reese v. Carmichael, et al., Case No. 20-cv-866 pending in the U.S. District Court of the Southern District of Ohio (filed November 4, 2020), which was subsequently transferred to the Northern District of Illinois (Case No. 1:21-cv-01631) and Sandys v. Carmichael, et al., Case No. A2004539 pending in the Hamilton County, Ohio Court of Common Pleas (filed December 28, 2020).\nThe Bancorp has also received several shareholder demands under Ohio Rev. Code § 1701.37(c) and lawsuits have been filed arising out of the same. Finally, the Bancorp has received shareholder demands that the Bancorp’s Board of Directors investigate and commence a civil action for failure to detect and/or prevent the alleged illegal cross-selling strategy. One of those shareholders subsequently filed the aforementioned Sandys v. Carmichael, et al. matter.\nOther litigation\nThe Bancorp and its subsidiaries are not parties to any other material litigation. However, there are other litigation matters that arise in the normal course of business. While it is impossible to ascertain the ultimate resolution or range of financial liability with respect to these contingent matters, management believes that the resulting liability, if any, from these other actions would not have a material effect upon the Bancorp’s consolidated financial position, results of operations or cash flows.\nGovernmental Investigations and Proceedings\nThe Bancorp and/or its affiliates are or may become involved in information-gathering requests, reviews, investigations and proceedings (both formal and informal) by various governmental regulatory agencies and law enforcement authorities, including but not limited to the FRB, OCC, CFPB, SEC, FINRA, U.S. Department of Justice, etc., as well as state and other governmental authorities and self-regulatory\n117\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nbodies regarding their respective businesses. Additional matters will likely arise from time to time. Any of these matters may result in material adverse consequences or reputational harm to the Bancorp, its affiliates and/or their respective directors, officers and other personnel, including adverse judgments, findings, settlements, fines, penalties, orders, injunctions or other actions, amendments and/or restatements of the Bancorp’s SEC filings and/or financial statements, as applicable, and/or determinations of material weaknesses in our disclosure controls and procedures. Investigations by regulatory authorities may from time to time result in civil or criminal referrals to law enforcement. Additionally, in some cases, regulatory authorities may take supervisory actions that are considered to be confidential supervisory information which may not be publicly disclosed.\nReasonably Possible Losses in Excess of Accruals\nThe Bancorp and its subsidiaries are parties to numerous claims and lawsuits as well as threatened or potential actions or claims concerning matters arising from the conduct of its business activities. The outcome of claims or litigation and the timing of ultimate resolution are inherently difficult to predict. The following factors, among others, contribute to this lack of predictability: claims often include significant legal uncertainties, damages alleged by plaintiffs are often unspecified or overstated, discovery may not have started or may not be complete and material facts may be disputed or unsubstantiated. As a result of these factors, the Bancorp is not always able to provide an estimate of the range of reasonably possible outcomes for each claim. An accrual for a potential litigation loss is established when information related to the loss contingency indicates both that a loss is probable and that the amount of loss can be reasonably estimated. Any such accrual is adjusted from time to time thereafter as appropriate to reflect changes in circumstances. The Bancorp also determines, when possible (due to the uncertainties described above), estimates of reasonably possible losses or ranges of reasonably possible losses, in excess of amounts accrued. Under U.S. GAAP, an event is “reasonably possible” if “the chance of the future event or events occurring is more than remote but less than likely” and an event is “remote” if “the chance of the future event or events occurring is slight.” Thus, references to the upper end of the range of reasonably possible loss for cases in which the Bancorp is able to estimate a range of reasonably possible loss mean the upper end of the range of loss for cases for which the Bancorp believes the risk of loss is more than slight. For matters where the Bancorp is able to estimate such possible losses or ranges of possible losses, the Bancorp currently estimates that it is reasonably possible that it could incur losses related to legal and regulatory proceedings, in an aggregate amount up to approximately $ 49 million in excess of amounts accrued, with it also being reasonably possible that no losses will be incurred in these matters. The estimates included in this amount are based on the Bancorp’s analysis of currently available information, and as new information is obtained the Bancorp may change its estimates.\nFor these matters and others where an unfavorable outcome is reasonably possible but not probable, there may be a range of possible losses in excess of the established accrual that cannot be estimated. Based on information currently available, advice of counsel, available insurance coverage and established accruals, the Bancorp believes that the eventual outcome of the actions against the Bancorp and/or its subsidiaries, including the matters described above, will not, individually or in the aggregate, have a material adverse effect on the Bancorp’s consolidated financial position. However, in the event of unexpected future developments, it is possible that the ultimate resolution of those matters, if unfavorable, may be material to the Bancorp’s results of operations for any particular period, depending, in part, upon the size of the loss or liability imposed and the operating results for the applicable period.\n18. Income Taxes\nThe applicable income tax expense was $ 202 million and $ 49 million for the three months ended June 30, 2021 and 2020, respectively, and $ 391 million and $ 61 million for the six months ended June 30, 2021 and 2020, respectively. The effective tax rates for the three months ended June 30, 2021 and 2020 were 22.1 % and 19.9 %, respectively, and 21.8 % and 20.4 % for the six months ended June 30, 2021 and 2020, respectively.\nWhile it is reasonably possible that the amount of the unrecognized tax benefits with respect to certain of the Bancorp’s uncertain tax positions could increase or decrease during the next 12 months, the Bancorp believes it is unlikely that its unrecognized tax benefits will change by a material amount during the next 12 months.\n118\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n19. Accumulated Other Comprehensive Income\nThe tables below present the activity of the components of OCI and AOCI for the three months ended:\n| Total OCI | Total AOCI |\n| June 30, 2021 ($ in millions) | Pre-tax Activity | TaxEffect | NetActivity | Beginning Balance | NetActivity | EndingBalance |\n| Unrealized holding gains on available-for-sale debt securities arising during period | $ | 306 | ( 71 ) | 235 |\n| Reclassification adjustment for net gains on available-for-sale debt securities included in net income | ( 7 ) | 2 | ( 5 ) |\n| Net unrealized gains on available-for-sale debt securities | 299 | ( 69 ) | 230 | 1,242 | 230 | 1,472 |\n| Unrealized holding gains on cash flow hedge derivatives arising during period | 11 | ( 2 ) | 9 |\n| Reclassification adjustment for net gains on cash flow hedge derivatives included in net income | ( 73 ) | 15 | ( 58 ) |\n| Net unrealized gains on cash flow hedge derivatives | ( 62 ) | 13 | ( 49 ) | 597 | ( 49 ) | 548 |\n| Net actuarial loss arising during the year | ( 1 ) | — | ( 1 ) |\n| Reclassification of amounts to net periodic benefit costs | 3 | ( 1 ) | 2 |\n| Defined benefit pension plans, net | 2 | ( 1 ) | 1 | ( 43 ) | 1 | ( 42 ) |\n| Other | — | — | — | ( 4 ) | — | ( 4 ) |\n| Total | $ | 239 | ( 57 ) | 182 | 1,792 | 182 | 1,974 |\n\n| Total OCI | Total AOCI |\n| June 30, 2020 ($ in millions) | Pre-tax Activity | TaxEffect | NetActivity | Beginning Balance | NetActivity | EndingBalance |\n| Unrealized holding gains on available-for-sale debt securities arising during period | $ | 602 | ( 146 ) | 456 |\n| Net unrealized gains on available-for-sale debt securities | 602 | ( 146 ) | 456 | 1,694 | 456 | 2,150 |\n| Unrealized holding gains on cash flow hedge derivatives arising during period | 83 | ( 17 ) | 66 |\n| Reclassification adjustment for net gains on cash flow hedge derivatives included in net income | ( 62 ) | 13 | ( 49 ) |\n| Net unrealized gains on cash flow hedge derivatives | 21 | ( 4 ) | 17 | 824 | 17 | 841 |\n| Reclassification of amounts to net periodic benefit costs | 1 | — | 1 |\n| Defined benefit pension plans, net | 1 | — | 1 | ( 41 ) | 1 | ( 40 ) |\n| Total | $ | 624 | ( 150 ) | 474 | 2,477 | 474 | 2,951 |\n\n119\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe tables below present the activity of the components of OCI and AOCI for the six months ended:\n| Total OCI | Total AOCI |\n| June 30, 2021 ($ in millions) | Pre-tax Activity | Tax Effect | Net Activity | Beginning Balance | Net Activity | Ending Balance |\n| Unrealized holding losses on available-for-sale debt securities arising during period | $ | ( 609 ) | 143 | ( 466 ) |\n| Reclassification adjustment for net losses on available-for-sale debt securities included in net income | 9 | ( 2 ) | 7 |\n| Net unrealized gains on available-for-sale debt securities | ( 600 ) | 141 | ( 459 ) | 1,931 | ( 459 ) | 1,472 |\n| Unrealized holding losses on cash flow hedge derivatives arising during period | ( 70 ) | 15 | ( 55 ) |\n| Reclassification adjustment for net gains on cash flow hedge derivatives included in net income | ( 146 ) | 31 | ( 115 ) |\n| Net unrealized gains on cash flow hedge derivatives | ( 216 ) | 46 | ( 170 ) | 718 | ( 170 ) | 548 |\n| Net actuarial loss arising during the year | ( 1 ) | — | ( 1 ) |\n| Reclassification of amounts to net periodic benefit costs | 4 | ( 1 ) | 3 |\n| Defined benefit pension plans, net | 3 | ( 1 ) | 2 | ( 44 ) | 2 | ( 42 ) |\n| Other | — | — | — | ( 4 ) | — | ( 4 ) |\n| Total | $ | ( 813 ) | 186 | ( 627 ) | 2,601 | ( 627 ) | 1,974 |\n\n| Total OCI | Total AOCI |\n| June 30, 2020 ($ in millions) | Pre-tax Activity | Tax Effect | Net Activity | Beginning Balance | Net Activity | Ending Balance |\n| Unrealized holding gains on available-for-sale debt securities arising during period | $ | 1,757 | ( 419 ) | 1,338 |\n| Net unrealized gains on available-for-sale debt securities | 1,757 | ( 419 ) | 1,338 | 812 | 1,338 | 2,150 |\n| Unrealized holding gains on cash flow hedge derivatives arising during period | 624 | ( 131 ) | 493 |\n| Reclassification adjustment for net gains on cash flow hedge derivatives included in net income | ( 94 ) | 20 | ( 74 ) |\n| Net unrealized gains on cash flow hedge derivatives | 530 | ( 111 ) | 419 | 422 | 419 | 841 |\n| Reclassification of amounts to net periodic benefit costs | 3 | ( 1 ) | 2 |\n| Defined benefit pension plans, net | 3 | ( 1 ) | 2 | ( 42 ) | 2 | ( 40 ) |\n| Total | $ | 2,290 | ( 531 ) | 1,759 | 1,192 | 1,759 | 2,951 |\n\n120\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe table below presents reclassifications out of AOCI:\n| Condensed Consolidated Statements ofIncome Caption | For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Net unrealized gains on available-for-sale debt securities:(b) |\n| Net losses included in net income | Securities gains (losses), net | $ | 7 | — | ( 9 ) | — |\n| Income before income taxes | 7 | — | ( 9 ) | — |\n| Applicable income tax expense | ( 2 ) | — | 2 | — |\n| Net income | 5 | — | ( 7 ) | — |\n| Net unrealized gains on cash flow hedge derivatives:(b) |\n| Interest rate contracts related to C&I loans | Interest and fees on loans and leases | 73 | 62 | 146 | 94 |\n| Income before income taxes | 73 | 62 | 146 | 94 |\n| Applicable income tax expense | ( 15 ) | ( 13 ) | ( 31 ) | ( 20 ) |\n| Net income | 58 | 49 | 115 | 74 |\n| Net periodic benefit costs:(b) |\n| Amortization of net actuarial loss | Compensation and benefits(a) | ( 2 ) | ( 1 ) | ( 3 ) | ( 3 ) |\n| Settlements | Compensation and benefits(a) | ( 1 ) | — | ( 1 ) | — |\n| Income before income taxes | ( 3 ) | ( 1 ) | ( 4 ) | ( 3 ) |\n| Applicable income tax expense | 1 | — | 1 | 1 |\n| Net income | ( 2 ) | ( 1 ) | ( 3 ) | ( 2 ) |\n| Total reclassifications for the period | Net income | $ | 61 | 48 | 105 | 72 |\n\n(a)This AOCI component is included in the computation of net periodic benefit cost. Refer to Note 23 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020 for further information.\n(b)Amounts in parentheses indicate reductions to net income.\n121\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n20. Earnings Per Share\nThe following tables provide the calculation of earnings per share and the reconciliation of earnings per share and earnings per diluted share:\n| 2021 | 2020 |\n| For the three months ended June 30,(in millions, except per share data) | Income | AverageShares | Per ShareAmount | Income | AverageShares | Per ShareAmount |\n| Earnings Per Share: |\n| Net income available to common shareholders | $ | 674 | $ | 163 |\n| Less: Income allocated to participating securities | 1 | 1 |\n| Net income allocated to common shareholders | $ | 673 | 709 | $ | 0.95 | $ | 162 | 715 | $ | 0.23 |\n| Earnings Per Diluted Share: |\n| Net income available to common shareholders | $ | 674 | $ | 163 |\n| Effect of dilutive securities: |\n| Stock-based awards | — | 9 | — | 3 |\n| Net income available to common shareholders plus assumed conversions | $ | 674 | $ | 163 |\n| Less: Income allocated to participating securities | 1 | 1 |\n| Net income allocated to common shareholders plus assumed conversions | $ | 673 | 718 | $ | 0.94 | $ | 162 | 718 | $ | 0.23 |\n\n| 2021 | 2020 |\n| For the six months ended June 30,(in millions, except per share data) | Income | Average Shares | Per Share Amount | Income | Average Shares | Per Share Amount |\n| Earnings Per Share: |\n| Net income available to common shareholders | $ | 1,348 | $ | 193 |\n| Less: Income allocated to participating securities | 4 | 2 |\n| Net income allocated to common shareholders | $ | 1,344 | 712 | $ | 1.89 | $ | 191 | 714 | $ | 0.27 |\n| Earnings Per Diluted Share: |\n| Net income available to common shareholders | $ | 1,348 | $ | 193 |\n| Effect of dilutive securities: |\n| Stock-based awards | — | 9 | — | 5 |\n| Net income available to common shareholders plus assumed conversions | $ | 1,348 | $ | 193 |\n| Less: Income allocated to participating securities | 4 | 2 |\n| Net income allocated to common shareholders plus assumed conversions | $ | 1,344 | 721 | $ | 1.87 | $ | 191 | 719 | $ | 0.27 |\n\nShares are excluded from the computation of earnings per diluted share when their inclusion has an anti-dilutive effect on earnings per share. The diluted earnings per share computation for both the three and six months ended June 30, 2021 excludes an immaterial amount of stock-based awards because their inclusion would have been anti-dilutive. The diluted earnings per share computation for the three and six months ended June 30, 2020 excludes 12 million and 9 million shares, respectively, of stock-based awards because their inclusion would have been anti-dilutive.\n122\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n21. Fair Value Measurements\nThe Bancorp measures certain financial assets and liabilities at fair value in accordance with U.S. GAAP, which defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. U.S. GAAP also establishes a fair value hierarchy, which prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the instrument’s fair value measurement. For more information regarding the fair value hierarchy, refer to Note 1 of the Notes to Consolidated Financial Statements included in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.\nAssets and Liabilities Measured at Fair Value on a Recurring Basis\nThe following tables summarize assets and liabilities measured at fair value on a recurring basis as of:\n| Fair Value Measurements Using |\n| June 30, 2021 ($ in millions) | Level 1 | Level 2 | Level 3 | Total Fair Value |\n| Assets: |\n| Available-for-sale debt and other securities: |\n| U.S. Treasury and federal agencies securities | $ | 107 | — | — | 107 |\n| Obligations of states and political subdivisions securities | — | 18 | — | 18 |\n| Mortgage-backed securities: |\n| Agency residential mortgage-backed securities | — | 10,809 | — | 10,809 |\n| Agency commercial mortgage-backed securities | — | 19,294 | — | 19,294 |\n| Non-agency commercial mortgage-backed securities | — | 3,479 | — | 3,479 |\n| Asset-backed securities and other debt securities | — | 3,785 | — | 3,785 |\n| Available-for-sale debt and other securities(a) | 107 | 37,385 | — | 37,492 |\n| Trading debt securities: |\n| U.S. Treasury and federal agencies securities | 96 | — | — | 96 |\n| Obligations of states and political subdivisions securities | — | 63 | — | 63 |\n| Agency residential mortgage-backed securities | — | 69 | — | 69 |\n| Asset-backed securities and other debt securities | — | 483 | — | 483 |\n| Trading debt securities | 96 | 615 | — | 711 |\n| Equity securities | 329 | 12 | — | 341 |\n| Residential mortgage loans held for sale | — | 1,633 | — | 1,633 |\n| Residential mortgage loans(b) | — | — | 151 | 151 |\n| Servicing rights | — | — | 818 | 818 |\n| Derivative assets: |\n| Interest rate contracts | 1 | 1,642 | 39 | 1,682 |\n| Foreign exchange contracts | — | 286 | — | 286 |\n| Commodity contracts | 27 | 1,213 | — | 1,240 |\n| Derivative assets(c) | 28 | 3,141 | 39 | 3,208 |\n| Total assets | $ | 560 | 42,786 | 1,008 | 44,354 |\n| Liabilities: |\n| Derivative liabilities: |\n| Interest rate contracts | $ | 8 | 223 | 8 | 239 |\n| Foreign exchange contracts | — | 246 | — | 246 |\n| Equity contracts | — | — | 213 | 213 |\n| Commodity contracts | 397 | 812 | — | 1,209 |\n| Derivative liabilities(d) | 405 | 1,281 | 221 | 1,907 |\n| Short positions: |\n| U.S. Treasury and federal agencies securities | 110 | — | — | 110 |\n| Asset-backed securities and other debt securities | — | 417 | — | 417 |\n| Short positions(d) | 110 | 417 | — | 527 |\n| Total liabilities | $ | 515 | 1,698 | 221 | 2,434 |\n\n(a)Excludes FHLB, FRB and DTCC restricted stock holdings totaling $ 33 , $ 485 and $ 2 , respectively, at June 30, 2021.\n(b)Includes residential mortgage loans originated as held for sale and subsequently transferred to held for investment.\n(c)Included in other assets in the Condensed Consolidated Balance Sheets.\n(d)Included in other liabilities in the Condensed Consolidated Balance Sheets.\n123\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n| Fair Value Measurements Using |\n| December 31, 2020 ($ in millions) | Level 1 | Level 2 | Level 3 | Total Fair Value |\n| Assets: |\n| Available-for-sale debt and other securities: |\n| U.S. Treasury and federal agencies securities | $ | 78 | — | — | 78 |\n| Obligations of states and political subdivisions securities | — | 17 | — | 17 |\n| Mortgage-backed securities: |\n| Agency residential mortgage-backed securities | — | 11,907 | — | 11,907 |\n| Agency commercial mortgage-backed securities | — | 18,221 | — | 18,221 |\n| Non-agency commercial mortgage-backed securities | — | 3,590 | — | 3,590 |\n| Asset-backed securities and other debt securities | — | 3,176 | — | 3,176 |\n| Available-for-sale debt and other securities(a) | 78 | 36,911 | — | 36,989 |\n| Trading debt securities: |\n| U.S. Treasury and federal agencies securities | 81 | — | — | 81 |\n| Obligations of states and political subdivisions securities | — | 10 | — | 10 |\n| Agency residential mortgage-backed securities | — | 30 | — | 30 |\n| Asset-backed securities and other debt securities | — | 439 | — | 439 |\n| Trading debt securities | 81 | 479 | — | 560 |\n| Equity securities | 293 | 20 | — | 313 |\n| Residential mortgage loans held for sale | — | 1,481 | — | 1,481 |\n| Residential mortgage loans(b) | — | — | 161 | 161 |\n| Servicing rights | — | — | 656 | 656 |\n| Derivative assets: |\n| Interest rate contracts | 1 | 2,227 | 61 | 2,289 |\n| Foreign exchange contracts | — | 255 | — | 255 |\n| Commodity contracts | 24 | 351 | — | 375 |\n| Derivative assets(c) | 25 | 2,833 | 61 | 2,919 |\n| Total assets | $ | 477 | 41,724 | 878 | 43,079 |\n| Liabilities: |\n| Derivative liabilities: |\n| Interest rate contracts | $ | 16 | 261 | 8 | 285 |\n| Foreign exchange contracts | — | 227 | — | 227 |\n| Equity contracts | — | — | 201 | 201 |\n| Commodity contracts | 55 | 304 | — | 359 |\n| Derivative liabilities(d) | 71 | 792 | 209 | 1,072 |\n| Short positions: |\n| U.S. Treasury and federal agencies securities | 63 | — | — | 63 |\n| Asset-backed securities and other debt securities | — | 392 | — | 392 |\n| Short positions(d) | 63 | 392 | — | 455 |\n| Total liabilities | $ | 134 | 1,184 | 209 | 1,527 |\n\n(a)Excludes FHLB, FRB and DTCC restricted stock holdings totaling $ 40 , $ 482 and $ 2 , respectively, at December 31, 2020.\n(b)Includes residential mortgage loans originated as held for sale and subsequently transferred to held for investment.\n(c)Included in other assets in the Condensed Consolidated Balance Sheets.\n(d)Included in other liabilities in the Condensed Consolidated Balance Sheets.\nThe following is a description of the valuation methodologies used for significant instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy.\nAvailable-for-sale debt and other securities, trading debt securities and equity securities\nWhere quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities include U.S. Treasury securities and equity securities. If quoted market prices are not available, then fair values are estimated using pricing models which primarily utilize quoted prices of securities with similar characteristics. Level 2 securities may include federal agencies securities, obligations of states and political subdivisions securities, agency residential mortgage-backed securities, agency and non-agency commercial mortgage-backed securities, asset-backed securities and other debt securities and equity securities. These securities are generally valued using a market approach based on observable prices of securities with similar characteristics.\n124\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nResidential mortgage loans held for sale\nFor residential mortgage loans held for sale for which the fair value election has been made, fair value is estimated based upon mortgage-backed securities prices and spreads to those prices or, for certain ARM loans, DCF models that may incorporate the anticipated portfolio composition, credit spreads of asset-backed securities with similar collateral and market conditions. The anticipated portfolio composition includes the effect of interest rate spreads and discount rates due to loan characteristics such as the state in which the loan was originated, the loan amount and the ARM margin. Residential mortgage loans held for sale that are valued based on mortgage-backed securities prices are classified within Level 2 of the valuation hierarchy as the valuation is based on external pricing for similar instruments. ARM loans classified as held for sale are also classified within Level 2 of the valuation hierarchy due to the use of observable inputs in the DCF model. These observable inputs include interest rate spreads from agency mortgage-backed securities market rates and observable discount rates.\nResidential mortgage loans\nResidential mortgage loans held for sale that are reclassified to held for investment are transferred from Level 2 to Level 3 of the fair value hierarchy. For residential mortgage loans for which the fair value election has been made, and that are reclassified from held for sale to held for investment, the fair value estimation is based on mortgage-backed securities prices, interest rate risk and an internally developed credit component. Therefore, these loans are classified within Level 3 of the valuation hierarchy. An adverse change in the loss rate or severity assumption would result in a decrease in fair value of the related loans.\nServicing rights\nMSRs do not trade in an active, open market with readily observable prices. While sales of MSRs do occur, the precise terms and conditions typically are not readily available. Accordingly, the Bancorp estimates the fair value of MSRs using internal OAS models with certain unobservable inputs, primarily prepayment speed assumptions, OAS and weighted-average lives, resulting in a classification within Level 3 of the valuation hierarchy. Refer to Note 12 for further information on the assumptions used in the valuation of the Bancorp’s MSRs.\nDerivatives\nExchange-traded derivatives valued using quoted prices and certain over-the-counter derivatives valued using active bids are classified within Level 1 of the valuation hierarchy. Most of the Bancorp’s derivative contracts are valued using DCF or other models that incorporate current market interest rates, credit spreads assigned to the derivative counterparties and other market parameters and, therefore, are classified within Level 2 of the valuation hierarchy. Such derivatives include basic and structured interest rate, foreign exchange and commodity swaps and options. Derivatives that are valued based upon models with significant unobservable market parameters are classified within Level 3 of the valuation hierarchy. At June 30, 2021 and December 31, 2020, derivatives classified as Level 3, which are valued using models containing unobservable inputs, consisted primarily of a total return swap associated with the Bancorp’s sale of Visa, Inc. Class B Shares as well as IRLCs, which utilize internally generated loan closing rate assumptions as a significant unobservable input in the valuation process.\nUnder the terms of the total return swap, the Bancorp will make or receive payments based on subsequent changes in the conversion rate of the Visa, Inc. Class B Shares into Class A Shares. Additionally, the Bancorp will make a quarterly payment based on Visa’s stock price and the conversion rate of the Visa, Inc. Class B Shares into Class A Shares until the date on which the Covered Litigation is settled. The fair value of the total return swap was calculated using a DCF model based on unobservable inputs consisting of management’s estimate of the probability of certain litigation scenarios, the timing of the resolution of the Covered Litigation and Visa litigation loss estimates in excess, or shortfall, of the Bancorp’s proportional share of escrow funds.\nAn increase in the loss estimate or a delay in the resolution of the Covered Litigation would result in an increase in the fair value of the derivative liability; conversely, a decrease in the loss estimate or an acceleration of the resolution of the Covered Litigation would result in a decrease in the fair value of the derivative liability. Refer to Note 16 for additional information on the Covered Litigation.\nThe net asset fair value of the Bancorp’s IRLCs at June 30, 2021 was $ 39 million. Immediate decreases in current interest rates of 25 bps and 50 bps would result in increases in the fair value of the IRLCs of approximately $ 16 million and $ 29 million, respectively. Immediate increases of current interest rates of 25 bps and 50 bps would result in decreases in the fair value of the IRLCs of approximately $ 18 million and $ 37 million, respectively. The decrease in fair value of IRLCs due to immediate 10% and 20% adverse changes in the assumed loan closing rates would be approximately $ 4 million and $ 8 million, respectively, and the increase in fair value due to immediate 10% and 20% favorable changes in the assumed loan closing rates would be approximately $ 4 million and $ 8 million, respectively. These sensitivities are hypothetical and should be used with caution, as changes in fair value based on a variation in assumptions typically cannot be extrapolated because the relationship of the change in assumptions to the change in fair value may not be linear.\nShort positions\nWhere quoted prices are available in an active market, short positions are classified within Level 1 of the valuation hierarchy. Level 1 securities include U.S. Treasury securities. If quoted market prices are not available, then fair values are estimated using pricing models which primarily utilize quoted prices of securities with similar characteristics and therefore are classified within Level 2 of the valuation hierarchy. Level 2 securities include asset-backed and other debt securities.\n125\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following tables are a reconciliation of assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3):\n| Fair Value Measurements Using Significant Unobservable Inputs (Level 3) |\n| For the three months ended June 30, 2021 ($ in millions) | ResidentialMortgageLoans | ServicingRights | Interest RateDerivatives,Net(a) | EquityDerivatives | TotalFair Value |\n| Balance, beginning of period | $ | 153 | 784 | 30 | ( 195 ) | 772 |\n| Total (losses) gains (realized/unrealized):(b) |\n| Included in earnings | — | ( 122 ) | 57 | ( 37 ) | ( 102 ) |\n| Purchases/originations | — | 156 | — | — | 156 |\n| Settlements | ( 12 ) | — | ( 56 ) | 19 | ( 49 ) |\n| Transfers into Level 3(c) | 10 | — | — | — | 10 |\n| Balance, end of period | $ | 151 | 818 | 31 | ( 213 ) | 787 |\n| The amount of total (losses) gains for the period included in earnings attributable to the change in unrealized gains or losses relating to instruments still held at June 30, 2021 | $ | — | ( 56 ) | 37 | ( 37 ) | ( 56 ) |\n\n(a)Net interest rate derivatives include derivative assets and liabilities of $ 39 and $ 8 , respectively, as of June 30, 2021.\n(b)There were no unrealized gains or losses for the period included in other comprehensive income for instruments still held at June 30, 2021.\n(c)Includes certain residential mortgage loans originated as held for sale that were transferred to held for investment.\n| Fair Value Measurements Using Significant Unobservable Inputs (Level 3) |\n| For the three months ended June 30, 2020 ($ in millions) | ResidentialMortgageLoans | ServicingRights | Interest RateDerivatives,Net(a) | EquityDerivatives | TotalFair Value |\n| Balance, beginning of period | $ | 185 | 685 | 61 | ( 171 ) | 760 |\n| Total (losses) gains (realized/unrealized):(b) |\n| Included in earnings | ( 2 ) | ( 70 ) | 83 | ( 29 ) | ( 18 ) |\n| Purchases/originations | — | 61 | 5 | — | 66 |\n| Settlements | ( 20 ) | — | ( 60 ) | 17 | ( 63 ) |\n| Transfers into Level 3(c) | 22 | — | — | — | 22 |\n| Balance, end of period | $ | 185 | 676 | 89 | ( 183 ) | 767 |\n| The amount of total gains (losses) for the period included in earnings attributable to the change in unrealized gains or losses relating to instruments still held at June 30, 2020 | $ | ( 2 ) | ( 23 ) | 85 | ( 29 ) | 31 |\n\n(a)Net interest rate derivatives include derivative assets and liabilities of $ 98 and $ 9 , respectively, as of June 30, 2020.\n(b)There were no unrealized gains or losses for the period included in other comprehensive income for instruments still held at June 30, 2020.\n(c)Includes certain residential mortgage loans originated as held for sale that were transferred to held for investment.\n| Fair Value Measurements Using Significant Unobservable Inputs (Level 3) |\n| For the six months ended June 30, 2021 ($ in millions) | ResidentialMortgageLoans | ServicingRights | Interest RateDerivatives,Net(a) | EquityDerivatives | TotalFair Value |\n| Balance, beginning of period | $ | 161 | 656 | 53 | ( 201 ) | 669 |\n| Total (losses) gains (realized/unrealized):(b) |\n| Included in earnings | ( 1 ) | ( 50 ) | 91 | ( 50 ) | ( 10 ) |\n| Purchases/originations | — | 212 | ( 1 ) | — | 211 |\n| Settlements | ( 29 ) | — | ( 112 ) | 38 | ( 103 ) |\n| Transfers into Level 3(c) | 20 | — | — | — | 20 |\n| Balance, end of period | $ | 151 | 818 | 31 | ( 213 ) | 787 |\n| The amount of total gains (losses) for the period included in earnings attributable to the change in unrealized gains or losses relating to instruments still held at June 30, 2021 | $ | ( 1 ) | 69 | 40 | ( 50 ) | 58 |\n\n(a)Net interest rate derivatives include derivative assets and liabilities of $ 39 and $ 8 , respectively, as of June 30, 2021.\n(b)There were no unrealized gains or losses for the period included in other comprehensive income for instruments still held at June 30, 2021.\n(c)Includes certain residential mortgage loans originated as held for sale that were transferred to held for investment.\n126\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n| Fair Value Measurements Using Significant Unobservable Inputs (Level 3) |\n| For the six months ended June 30, 2020 ($ in millions) | ResidentialMortgageLoans | ServicingRights | Interest RateDerivatives,Net(a) | EquityDerivatives | TotalFair Value |\n| Balance, beginning of period | $ | 183 | 993 | 10 | ( 163 ) | 1,023 |\n| Total (losses) gains (realized/unrealized):(b) |\n| Included in earnings | 2 | ( 448 ) | 186 | ( 51 ) | ( 311 ) |\n| Purchases/originations | — | 131 | 4 | — | 135 |\n| Settlements | ( 29 ) | — | ( 111 ) | 31 | ( 109 ) |\n| Transfers into Level 3(c) | 29 | — | — | — | 29 |\n| Balance, end of period | $ | 185 | 676 | 89 | ( 183 ) | 767 |\n| The amount of total (losses) gains for the period included in earnings attributable to the change in unrealized gains or losses relating to instruments still held at June 30, 2020 | $ | 2 | ( 331 ) | 93 | ( 51 ) | ( 287 ) |\n\n(a)Net interest rate derivatives include derivative assets and liabilities of $ 98 and $ 9 , respectively, as of June 30, 2020.\n(b)There were no unrealized gains or losses for the period included in other comprehensive income for instruments still held at June 30, 2020.\n(c)Includes certain residential mortgage loans originated as held for sale that were transferred to held for investment.\nThe total losses and gains included in earnings for assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) were recorded in the Condensed Consolidated Statements of Income as follows:\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Mortgage banking net revenue | $ | ( 66 ) | 10 | 39 | ( 261 ) |\n| Commercial banking revenue | 1 | 1 | 1 | 1 |\n| Other noninterest income | ( 37 ) | ( 29 ) | ( 50 ) | ( 51 ) |\n| Total losses | $ | ( 102 ) | ( 18 ) | ( 10 ) | ( 311 ) |\n\nThe total gains and losses included in earnings attributable to changes in unrealized gains and losses related to Level 3 assets and liabilities still held at June 30, 2021 and 2020 were recorded in the Condensed Consolidated Statements of Income as follows:\n| For the three months endedJune 30, | For the six months endedJune 30, |\n| ($ in millions) | 2021 | 2020 | 2021 | 2020 |\n| Mortgage banking net revenue | $ | ( 20 ) | 59 | 107 | ( 237 ) |\n| Commercial banking revenue | 1 | 1 | 1 | 1 |\n| Other noninterest income | ( 37 ) | ( 29 ) | ( 50 ) | ( 51 ) |\n| Total gains (losses) | $ | ( 56 ) | 31 | 58 | ( 287 ) |\n\n127\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following tables present information as of June 30, 2021 and 2020 about significant unobservable inputs related to the Bancorp’s material categories of Level 3 financial assets and liabilities measured at fair value on a recurring basis:\n| As of June 30, 2021 ($ in millions) |\n| Financial Instrument | Fair Value | ValuationTechnique | SignificantUnobservable Inputs | Range of Inputs | Weighted-Average |\n| Residential mortgage loans | $ | 151 | Loss rate model | Interest rate risk factor | ( 9.2 ) | - | 9.0 % | 1.1 | % | (a) |\n| Credit risk factor | — | - | 24.8 % | 0.5 | % | (a) |\n| (Fixed) | 14.5 | % | (b) |\n| Servicing rights | 818 | DCF | Prepayment speed | — | - | 100.0 % | (Adjustable) | 21.6 | % | (b) |\n| (Fixed) | 542 | (b) |\n| OAS (bps) | 406 | - | 1,587 | (Adjustable) | 978 | (b) |\n| IRLCs, net | 39 | DCF | Loan closing rates | 10.0 | - | 97.2 % | 76.5 | % | (c) |\n| Swap associated with the sale of Visa, Inc. Class B Shares | ( 213 ) | DCF | Timing of the resolution of the Covered Litigation | Q1 2023 | - | Q1 2025 | Q4 2023 | (d) |\n\n(a)Unobservable inputs were weighted by the relative carrying value of the instruments.\n(b)Unobservable inputs were weighted by the relative unpaid principal balance of the instruments.\n(c)Unobservable inputs were weighted by the relative notional amount of the instruments.\n(d)Unobservable inputs were weighted by the probability of the final funding date of the instruments.\n| As of June 30, 2020 ($ in millions) |\n| Financial Instrument | Fair Value | ValuationTechnique | SignificantUnobservable Inputs | Range of Inputs | Weighted-Average |\n| Residential mortgage loans | $ | 185 | Loss rate model | Interest rate risk factor | ( 7.4 ) | - | 11.6 % | 0.7 | % | (a) |\n| Credit risk factor | — | - | 26.4 % | 0.4 | % | (a) |\n| (Fixed) | 20.1 | % | (b) |\n| Servicing rights | 676 | DCF | Prepayment speed | 0.5 | - | 99.6 % | (Adjustable) | 23.4 | % | (b) |\n| (Fixed) | 784 | (b) |\n| OAS (bps) | 536 | - | 1,386 | (Adjustable) | 934 | (b) |\n| IRLCs, net | 91 | DCF | Loan closing rates | 7.2 | - | 97.2 % | 65.7 | % | (c) |\n| Swap associated with the sale of Visa, Inc. Class B Shares | ( 183 ) | DCF | Timing of the resolution of the Covered Litigation | Q3 2022 | - | Q2 2024 | Q1 2023 | (d) |\n\n(a)Unobservable inputs were weighted by the relative carrying value of the instruments.\n(b)Unobservable inputs were weighted by the relative unpaid principal balance of the instruments.\n(c)Unobservable inputs were weighted by the relative notional amount of the instruments.\n(d)Unobservable inputs were weighted by the probability of the final funding date of the instruments.\nAssets and Liabilities Measured at Fair Value on a Nonrecurring Basis\nCertain assets and liabilities are measured at fair value on a nonrecurring basis. These assets and liabilities are not measured at fair value on an ongoing basis; however, they are subject to fair value adjustments in certain circumstances, such as when there is evidence of impairment.\nThe following tables provide the fair value hierarchy and carrying amount of all assets that were held as of June 30, 2021 and 2020, and for which a nonrecurring fair value adjustment was recorded during the three and six months ended June 30, 2021 and 2020, and the related gains and losses from fair value adjustments on assets sold during the period as well as assets still held as of the end of the period.\n| Fair Value Measurements Using | Total (Losses) Gains |\n| As of June 30, 2021 ($ in millions) | Level 1 | Level 2 | Level 3 | Total | For the three months ended June 30, 2021 | For the six months ended June 30, 2021 |\n| Commercial loans held for sale | $ | — | — | 2 | 2 | — | 1 |\n| Commercial loans and leases | — | — | 313 | 313 | ( 39 ) | ( 44 ) |\n| Consumer and residential mortgage loans | — | — | 140 | 140 | 1 | ( 1 ) |\n| OREO | — | — | 6 | 6 | — | ( 6 ) |\n| Bank premises and equipment | — | — | 7 | 7 | ( 1 ) | ( 2 ) |\n| Operating lease equipment | — | — | 34 | 34 | — | ( 25 ) |\n| Private equity investments | — | 1 | — | 1 | — | — |\n| Total | $ | — | 1 | 502 | 503 | ( 39 ) | ( 77 ) |\n\n128\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n| Fair Value Measurements Using | Total (Losses) Gains |\n| As of June 30, 2020 ($ in millions) | Level 1 | Level 2 | Level 3 | Total | For the three months ended June 30, 2020 | For the six months ended June 30, 2020 |\n| Commercial loans held for sale | $ | — | 37 | 17 | 54 | ( 1 ) | ( 4 ) |\n| Commercial loans and leases | — | — | 569 | 569 | ( 118 ) | ( 192 ) |\n| Consumer and residential mortgage loans | — | — | 186 | 186 | 2 | 3 |\n| OREO | — | — | 18 | 18 | ( 1 ) | ( 6 ) |\n| Bank premises and equipment | — | — | 14 | 14 | ( 12 ) | ( 14 ) |\n| Operating lease equipment | — | — | 10 | 10 | — | ( 3 ) |\n| Private equity investments | — | — | 70 | 70 | — | ( 9 ) |\n| Total | $ | — | 37 | 884 | 921 | ( 130 ) | ( 225 ) |\n\nThe following tables present information as of June 30, 2021 and 2020 about significant unobservable inputs related to the Bancorp’s material categories of Level 3 financial assets and liabilities measured on a nonrecurring basis:\n| As of June 30, 2021 ($ in millions) |\n| Financial Instrument | Fair Value | Valuation Technique | Significant Unobservable Inputs | Ranges ofInputs | Weighted-Average |\n| Commercial loans held for sale | $ | 2 | Comparable company analysis | Market comparable transactions | NM | NM |\n| Commercial loans and leases | 313 | Appraised value | Collateral value | NM | NM |\n| Consumer and residential mortgage loans | 140 | Appraised value | Collateral value | NM | NM |\n| OREO | 6 | Appraised value | Appraised value | NM | NM |\n| Bank premises and equipment | 7 | Appraised value | Appraised value | NM | NM |\n| Operating lease equipment | 34 | Appraised value | Appraised value | NM | NM |\n\n| As of June 30, 2020 ($ in millions) |\n| Financial Instrument | Fair Value | Valuation Technique | Significant Unobservable Inputs | Ranges ofInputs | Weighted-Average |\n| Commercial loans held for sale | $ | 16 | Comparable company analysis | Market comparable transactions | NM | NM |\n| 1 | Appraised value | Appraised value | NM | NM |\n| Commercial loans and leases | 569 | Appraised value | Collateral value | NM | NM |\n| Consumer and residential mortgage loans | 186 | Appraised value | Collateral value | NM | NM |\n| OREO | 18 | Appraised value | Appraised value | NM | NM |\n| Bank premises and equipment | 14 | Appraised value | Appraised value | NM | NM |\n| Operating lease equipment | 10 | Appraised value | Appraised value | NM | NM |\n| Private equity investments | 70 | Comparable company analysis | Market comparable transactions | NM | NM |\n\nCommercial loans held for sale\nThe Bancorp estimated the fair value of certain commercial loans held for sale during the six months ended June 30, 2021 and 2020, resulting in positive fair value adjustments of an immaterial amount during both the three and six months ended June 30, 2021, and negative fair value adjustments of $ 1 million and $ 4 million during the three and six months ended June 30, 2020, respectively. These valuations were based on quoted prices for similar assets in active markets (Level 2 of the valuation hierarchy), appraisals of the underlying collateral or by applying unobservable inputs such as an estimated market discount to the unpaid principal balance of the loans or the appraised values of the assets (Level 3 of the valuation hierarchy). The Bancorp recognized losses of an immaterial amount and gains of $ 1 million on the sale of certain commercial loans held for sale during the three and six months ended June 30, 2021, respectively, and gains of an immaterial amount during both the three and six months ended June 30, 2020.\nPortfolio loans and leases\nDuring the three and six months ended June 30, 2021 and 2020, the Bancorp recorded nonrecurring impairment adjustments to certain collateral-dependent portfolio loans and leases. When a loan is collateral-dependent, the fair value of the loan is generally based on the fair value less cost to sell of the underlying collateral supporting the loan and therefore these loans were classified within Level 3 of the valuation hierarchy. In cases where the carrying value exceeds the fair value, an impairment loss is recognized. The fair values and recognized impairment losses are reflected in the previous tables.\nOREO\nDuring the three and six months ended June 30, 2021 and 2020, the Bancorp recorded nonrecurring adjustments to certain commercial and residential real estate properties and branch-related real estate no longer intended to be used for banking purposes classified as OREO and\n129\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nmeasured at the lower of carrying amount or fair value. These nonrecurring losses were primarily due to declines in real estate values of the properties recorded in OREO. These losses include an immaterial amount and $ 6 million in losses, respectively, recorded as charge-offs on new OREO properties transferred from loans, during the three and six months ended June 30, 2021 compared to an immaterial amount and $ 2 million in losses during the three and six months ended June 30, 2020, respectively. These losses also included an immaterial amount for both the three and six months ended June 30, 2021, and $ 1 million and $ 4 million for the three and six months ended June 30, 2020, respectively, recorded as negative fair value adjustments on OREO in other noninterest expense or other noninterest income in the Condensed Consolidated Statements of Income subsequent to their transfer into OREO. The fair value amounts are generally based on appraisals of the property values, resulting in a classification within Level 3 of the valuation hierarchy. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized. The previous tables reflect the fair value measurements of the properties before deducting the estimated costs to sell.\nBank premises and equipment\nThe Bancorp performs assessments of the recoverability of long-lived assets when events or changes in circumstances indicate that their carrying values may not be recoverable. These properties were written down to their lower of cost or market values. At least annually thereafter, the Bancorp will review these properties for market fluctuations. The fair value amounts were generally based on appraisals of the property values, resulting in a classification within Level 3 of the valuation hierarchy. For further information on bank premises and equipment, refer to Note 7.\nOperating lease equipment\nThe Bancorp performs assessments of the recoverability of long-lived assets when events or changes in circumstances indicate that their carrying values may not be recoverable. When evaluating whether an individual asset is impaired, the Bancorp considers the current fair value of the asset, the changes in overall market demand for the asset and the rate of change in advancements associated with technological improvements that impact the demand for the specific asset under review. As part of this ongoing assessment, the Bancorp determined that the carrying values of certain operating lease equipment were not recoverable and, as a result, the Bancorp recorded an impairment loss equal to the amount by which the carrying value of the assets exceeded the fair value. The fair value amounts were generally based on appraised values of the assets, resulting in a classification within Level 3 of the valuation hierarchy.\nPrivate equity investments\nThe Bancorp accounts for its private equity investments using the measurement alternative to fair value, except for those accounted for under the equity method of accounting. Under the measurement alternative, the Bancorp carries each investment at its cost basis minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for identical or similar investments of the same issuer. The Bancorp recognized an immaterial amount of gains resulting from observable price changes during both the three and six months ended June 30, 2021 and 2020. The carrying value of the Bancorp’s private equity investments still held as of June 30, 2021 includes a cumulative $ 70 million of positive adjustments as a result of observable price changes since January 1, 2018. Because these adjustments are based on observable transactions in inactive markets, they are classified in Level 2 of the fair value hierarchy.\nFor private equity investments which are accounted for using the measurement alternative to fair value, the Bancorp qualitatively evaluates each investment quarterly to determine if impairment may exist. If necessary, the Bancorp then measures impairment by estimating the value of its investment and comparing that to the investment’s carrying value, whether or not the Bancorp considers the impairment to be temporary. These valuations are typically developed using a DCF method, but other methods may be used if more appropriate for the circumstances. These valuations are based on unobservable inputs and therefore are classified in Level 3 of the fair value hierarchy. The Bancorp recognized impairments of an immaterial amount for both the three and six months ended June 30, 2021 compared to zero and $ 9 million for the three and six months ended June 30, 2020, respectively. The carrying value of the Bancorp’s private equity investments still held as of June 30, 2021 includes a cumulative $ 21 million of impairment charges recognized since adoption of the measurement alternative to fair value on January 1, 2018.\nFair Value Option\nThe Bancorp elected to measure certain residential mortgage loans held for sale under the fair value option as allowed under U.S. GAAP. Electing to measure residential mortgage loans held for sale at fair value reduces certain timing differences and better matches changes in the value of these assets with changes in the value of derivatives used as economic hedges for these assets. Management’s intent to sell residential mortgage loans classified as held for sale may change over time due to such factors as changes in the overall liquidity in markets or changes in characteristics specific to certain loans held for sale. Consequently, these loans may be reclassified to loans held for investment and maintained in the Bancorp’s loan portfolio. In such cases, the loans will continue to be measured at fair value.\nFair value changes recognized in earnings for residential mortgage loans held at June 30, 2021 and 2020 for which the fair value option was elected, as well as the changes in fair value of the underlying IRLCs, included gains of $ 59 million and $ 45 million, respectively. These gains are reported in mortgage banking net revenue in the Condensed Consolidated Statements of Income.\n130\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nValuation adjustments related to instrument-specific credit risk for residential mortgage loans measured at fair value negatively impacted the fair value of those loans by $ 1 million at both June 30, 2021 and December 31, 2020. Interest on loans measured at fair value is accrued as it is earned using the effective interest method and is reported as interest income in the Condensed Consolidated Statements of Income.\nThe following table summarizes the difference between the fair value and the unpaid principal balance for residential mortgage loans measured at fair value as of:\n| June 30, 2021 ($ in millions) | AggregateFair Value | Aggregate UnpaidPrincipal Balance | Difference |\n| Residential mortgage loans measured at fair value | $ | 1,784 | 1,725 | 59 |\n| Past due loans of 90 days or more | 2 | 3 | ( 1 ) |\n| Nonaccrual loans | — | — | — |\n| December 31, 2020 |\n| Residential mortgage loans measured at fair value | $ | 1,642 | 1,567 | 75 |\n| Past due loans of 90 days or more | 3 | 3 | — |\n| Nonaccrual loans | — | — | — |\n\nThe Bancorp invests in certain hybrid financial instruments with embedded derivatives that are not clearly and closely related to the host contracts. The Bancorp has elected to measure the entire instrument at fair value with changes in fair value recognized in earnings. The carrying value of these investments was $ 48 million as of June 30, 2021 and the investments are classified as trading debt securities on the Condensed Consolidated Balance Sheets. Fair value changes recognized in earnings included losses of $ 8 million and gains of $ 1 million for the three and six months ended June 30, 2021, respectively, reported in securities gains (losses), net in the Condensed Consolidated Statements of Income.\nFair Value of Certain Financial Instruments\nThe following tables summarize the carrying amounts and estimated fair values for certain financial instruments, excluding financial instruments measured at fair value on a recurring basis:\n| Net CarryingAmount | Fair Value Measurements Using | TotalFair Value |\n| As of June 30, 2021 ($ in millions) | Level 1 | Level 2 | Level 3 |\n| Financial assets: |\n| Cash and due from banks | $ | 3,285 | 3,285 | — | — | 3,285 |\n| Other short-term investments | 32,409 | 32,409 | — | — | 32,409 |\n| Other securities | 520 | — | 520 | — | 520 |\n| Held-to-maturity securities | 10 | — | — | 10 | 10 |\n| Loans and leases held for sale | 4,097 | — | — | 4,104 | 4,104 |\n| Portfolio loans and leases: |\n| Commercial loans and leases | 65,796 | — | — | 66,498 | 66,498 |\n| Consumer and residential mortgage loans | 39,753 | — | — | 40,941 | 40,941 |\n| Total portfolio loans and leases, net | $ | 105,549 | — | — | 107,439 | 107,439 |\n| Financial liabilities: |\n| Deposits | $ | 162,283 | — | 162,285 | — | 162,285 |\n| Federal funds purchased | 338 | 338 | — | — | 338 |\n| Other short-term borrowings | 1,130 | — | 1,130 | — | 1,130 |\n| Long-term debt | 12,364 | 12,821 | 850 | — | 13,671 |\n\n131\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n| Net CarryingAmount | Fair Value Measurements Using | TotalFair Value |\n| As of December 31, 2020 ($ in millions) | Level 1 | Level 2 | Level 3 |\n| Financial assets: |\n| Cash and due from banks | $ | 3,147 | 3,147 | — | — | 3,147 |\n| Other short-term investments | 33,399 | 33,399 | — | — | 33,399 |\n| Other securities | 524 | — | 524 | — | 524 |\n| Held-to-maturity securities | 11 | — | — | 11 | 11 |\n| Loans and leases held for sale | 3,260 | — | — | 3,269 | 3,269 |\n| Portfolio loans and leases: |\n| Commercial loans and leases | 67,541 | — | — | 67,810 | 67,810 |\n| Consumer loans | 38,627 | — | — | 40,522 | 40,522 |\n| Total portfolio loans and leases, net | $ | 106,168 | — | — | 108,332 | 108,332 |\n| Financial liabilities: |\n| Deposits | $ | 159,081 | — | 159,094 | — | 159,094 |\n| Federal funds purchased | 300 | 300 | — | — | 300 |\n| Other short-term borrowings | 1,192 | — | 1,192 | — | 1,192 |\n| Long-term debt | 14,973 | 15,606 | 923 | — | 16,529 |\n\n132\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n22. Business Segments\nThe Bancorp reports on four business segments: Commercial Banking, Branch Banking, Consumer Lending and Wealth and Asset Management. Results of the Bancorp’s business segments are presented based on its management structure and management accounting practices. The structure and accounting practices are specific to the Bancorp; therefore, the financial results of the Bancorp’s business segments are not necessarily comparable with similar information for other financial institutions. The Bancorp refines its methodologies from time to time as management’s accounting practices and businesses change.\nThe Bancorp manages interest rate risk centrally at the corporate level. By employing an FTP methodology, the business segments are insulated from most benchmark interest rate volatility, enabling them to focus on serving customers through the origination of loans and acceptance of deposits. The FTP methodology assigns charge and credit rates to classes of assets and liabilities, respectively, based on the estimated amount and timing of the cash flows for each transaction. Assigning the FTP rate based on matching the duration of cash flows allocates interest income and interest expense to each business segment so its resulting net interest income is insulated from future changes in benchmark interest rates. The Bancorp’s FTP methodology also allocates the contribution to net interest income of the asset-generating and deposit-providing businesses on a duration-adjusted basis to better attribute the driver of the performance. As the asset and liability durations are not perfectly matched, the residual impact of the FTP methodology is captured in General Corporate and Other. The charge and credit rates are determined using the FTP rate curve, which is based on an estimate of Fifth Third’s marginal borrowing cost in the wholesale funding markets. The FTP curve is constructed using the U.S. swap curve, brokered CD pricing and unsecured debt pricing.\nThe Bancorp adjusts the FTP charge and credit rates as dictated by changes in interest rates for various interest-earning assets and interest-bearing liabilities and by the review of behavioral assumptions, such as prepayment rates on interest-earning assets and the estimated durations for indeterminate-lived deposits. Key assumptions, including the credit rates provided for deposit accounts, are reviewed annually. Credit rates for deposit products and charge rates for loan products may be reset more frequently in response to changes in market conditions.\nThe Bancorp’s methodology for allocating provision for credit losses expense to the business segments includes charges or benefits associated with changes in criticized commercial loan levels in addition to actual net charge-offs experienced by the loans and leases owned by each business segment. Provision for credit losses expense attributable to loan and lease growth and changes in ALLL factors is captured in General Corporate and Other. The financial results of the business segments include allocations for shared services and headquarters expenses. Additionally, the business segments form synergies by taking advantage of relationship depth opportunities and funding operations by accessing the capital markets as a collective unit.\nThe following is a description of each of the Bancorp’s business segments and the products and services they provide to their respective client bases.\nCommercial Banking offers credit intermediation, cash management and financial services to large and middle-market businesses and government and professional customers. In addition to the traditional lending and depository offerings, Commercial Banking products and services include global cash management, foreign exchange and international trade finance, derivatives and capital markets services, asset-based lending, real estate finance, public finance, commercial leasing and syndicated finance.\nBranch Banking provides a full range of deposit and loan and lease products to individuals and small businesses through 1,096 full-service banking centers. Branch Banking offers depository and loan products, such as checking and savings accounts, home equity loans and lines of credit, credit cards and loans for automobiles and other personal financing needs, as well as products designed to meet the specific needs of small businesses, including cash management services.\nConsumer Lending includes the Bancorp’s residential mortgage, automobile and other indirect lending activities. Residential mortgage activities within Consumer Lending include the origination, retention and servicing of residential mortgage loans, sales and securitizations of those loans and all associated hedging activities. Residential mortgages are primarily originated through a dedicated sales force and through third-party correspondent lenders. Automobile and other indirect lending activities include extending loans to consumers through automobile dealers, motorcycle dealers, powersport dealers, recreational vehicle dealers and marine dealers.\nWealth and Asset Management provides a full range of wealth management services for individuals, companies and not-for-profit organizations. Wealth and Asset Management is made up of three main businesses: FTS, an indirect wholly-owned subsidiary of the Bancorp; Fifth Third Private Bank; and Fifth Third Institutional Services. FTS offers full service retail brokerage services to individual clients and broker-dealer services to the institutional marketplace. Fifth Third Private Bank offers wealth management strategies to high net worth and ultra-high net worth clients through wealth planning, investment management, banking, insurance, trust and estate services. Fifth Third Institutional Services provides advisory services for institutional clients, including middle market businesses, non-profits, states and municipalities.\n133\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following tables present the results of operations and assets by business segment for the three months ended:\n| June 30, 2021 ($ in millions) | CommercialBanking | BranchBanking | ConsumerLending | Wealthand AssetManagement | GeneralCorporate and Other | Eliminations | Total |\n| Net interest income | $ | 376 | 301 | 142 | 21 | 368 | — | 1,208 |\n| (Benefit from) provision for credit losses | ( 151 ) | 25 | — | — | 11 | — | ( 115 ) |\n| Net interest income after (benefit from) provision for credit losses | $ | 527 | 276 | 142 | 21 | 357 | — | 1,323 |\n| Noninterest income: |\n| Commercial banking revenue | $ | 156 | 3 | — | 1 | — | — | 160 |\n| Service charges on deposits | 92 | 57 | — | — | — | — | 149 |\n| Wealth and asset management revenue | 1 | 52 | — | 138 | — | ( 46 ) | (a) | 145 |\n| Card and processing revenue | 15 | 84 | — | 1 | 2 | — | 102 |\n| Mortgage banking net revenue | — | 3 | 60 | 1 | — | — | 64 |\n| Leasing business revenue | 61 | — | — | — | — | — | 61 |\n| Other noninterest income(b) | 30 | 25 | 2 | 2 | ( 10 ) | — | 49 |\n| Securities gains, net | — | — | — | — | 10 | — | 10 |\n| Securities gains, net – non-qualifying hedges on MSRs | — | — | 1 | — | — | — | 1 |\n| Total noninterest income | $ | 355 | 224 | 63 | 143 | 2 | ( 46 ) | 741 |\n| Noninterest expense: |\n| Compensation and benefits | $ | 136 | 158 | 61 | 49 | 234 | — | 638 |\n| Technology and communications | 4 | 1 | 3 | — | 86 | — | 94 |\n| Net occupancy expense(c) | 8 | 49 | 3 | 4 | 13 | — | 77 |\n| Equipment expense | 7 | 9 | — | — | 18 | — | 34 |\n| Leasing business expense | 33 | — | — | — | — | — | 33 |\n| Card and processing expense | 2 | 19 | — | — | ( 1 ) | — | 20 |\n| Marketing expense | 2 | 7 | 1 | — | 10 | — | 20 |\n| Other noninterest expense | 207 | 207 | 95 | 78 | ( 304 ) | ( 46 ) | 237 |\n| Total noninterest expense | $ | 399 | 450 | 163 | 131 | 56 | ( 46 ) | 1,153 |\n| Income before income taxes | $ | 483 | 50 | 42 | 33 | 303 | — | 911 |\n| Applicable income tax expense | 90 | 10 | 9 | 7 | 86 | — | 202 |\n| Net income | $ | 393 | 40 | 33 | 26 | 217 | — | 709 |\n| Total goodwill | $ | 1,981 | 2,047 | — | 231 | — | — | 4,259 |\n| Total assets | $ | 68,851 | 87,646 | 33,215 | 10,881 | 4,797 | (d) | — | 205,390 |\n\n(a)Revenue sharing agreements between wealth and asset management and branch banking are eliminated in the Condensed Consolidated Statements of Income.\n(b)Includes impairment charges of $ 2 for branches and land recorded in Branch Banking. For more information, refer to Note 7 and Note 21.\n(c)Includes impairment losses and termination charges of $ 2 for ROU assets related to certain operating leases. For more information refer to Note 9.\n(d)Includes bank premises and equipment of $ 25 classified as held for sale. For more information, refer to Note 7.\n134\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n| June 30, 2020 ($ in millions) | CommercialBanking | BranchBanking | ConsumerLending | Wealthand AssetManagement | GeneralCorporate and Other | Eliminations | Total |\n| Net interest income | $ | 570 | 513 | 92 | 51 | ( 26 ) | — | 1,200 |\n| Provision for (benefit from) credit losses | 457 | 52 | 10 | ( 1 ) | ( 33 ) | — | 485 |\n| Net interest income after provision for (benefit from) credit losses | $ | 113 | 461 | 82 | 52 | 7 | — | 715 |\n| Noninterest income: |\n| Commercial banking revenue | $ | 136 | 1 | — | 1 | ( 1 ) | — | 137 |\n| Service charges on deposits | 79 | 42 | — | — | 1 | — | 122 |\n| Wealth and asset management revenue | 1 | 39 | — | 115 | — | ( 35 ) | (a) | 120 |\n| Card and processing revenue | 11 | 68 | — | — | 3 | — | 82 |\n| Mortgage banking net revenue | — | 2 | 96 | 1 | — | — | 99 |\n| Leasing business revenue | 57 | — | — | — | — | — | 57 |\n| Other noninterest income(b) | 10 | 15 | 2 | 4 | ( 19 ) | — | 12 |\n| Securities gains, net | — | — | — | — | 21 | — | 21 |\n| Securities gains, net – non-qualifying hedges on MSRs | — | — | — | — | — | — | — |\n| Total noninterest income | $ | 294 | 167 | 98 | 121 | 5 | ( 35 ) | 650 |\n| Noninterest expense: |\n| Compensation and benefits | $ | 129 | 161 | 53 | 50 | 234 | — | 627 |\n| Technology and communications | 3 | 1 | 2 | — | 84 | — | 90 |\n| Net occupancy expense(c) | 8 | 44 | 2 | 3 | 25 | — | 82 |\n| Equipment expense | 7 | 10 | — | — | 15 | — | 32 |\n| Leasing business expense | 33 | — | — | — | — | — | 33 |\n| Card and processing expense | 2 | 28 | — | — | ( 1 ) | — | 29 |\n| Marketing expense | 2 | 5 | 1 | — | 12 | — | 20 |\n| Other noninterest expense | 221 | 205 | 62 | 69 | ( 314 ) | ( 35 ) | 208 |\n| Total noninterest expense | $ | 405 | 454 | 120 | 122 | 55 | ( 35 ) | 1,121 |\n| Income (loss) before income taxes | $ | 2 | 174 | 60 | 51 | ( 43 ) | — | 244 |\n| Applicable income tax expense (benefit) | ( 10 ) | 36 | 12 | 11 | — | — | 49 |\n| Net income (loss) | $ | 12 | 138 | 48 | 40 | ( 43 ) | — | 195 |\n| Total goodwill | $ | 1,961 | 2,047 | — | 253 | — | — | 4,261 |\n| Total assets | $ | 76,437 | 77,219 | 26,451 | 11,680 | 11,119 | (d) | — | 202,906 |\n\n(a)Revenue sharing agreements between wealth and asset management and branch banking are eliminated in the Condensed Consolidated Statements of Income.\n(b)Includes impairment charges of $ 4 and $ 8 for branches and land recorded in Branch Banking and General Corporate and Other, respectively. For more information, refer to Note 7 and Note 21.\n(c)Includes impairment losses and termination charges of $ 3 for ROU assets related to certain operating leases. For more information refer to Note 9.\n(d)Includes bank premises and equipment of $ 53 classified as held for sale. For more information, refer to Note 7.\n135\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\nThe following tables present the results of operations and assets by business segment for the six months ended:\n| June 30, 2021 ($ in millions) | CommercialBanking | BranchBanking | ConsumerLending | Wealthand AssetManagement | GeneralCorporate and Other | Eliminations | Total |\n| Net interest income | $ | 741 | 596 | 269 | 42 | 737 | — | 2,385 |\n| (Benefit from) provision for credit losses | ( 227 ) | 66 | 8 | ( 1 ) | ( 134 ) | — | ( 288 ) |\n| Net interest income after (benefit from) provision for credit losses | $ | 968 | 530 | 261 | 43 | 871 | — | 2,673 |\n| Noninterest income: |\n| Commercial banking revenue | $ | 307 | 5 | — | 1 | — | — | 313 |\n| Service charges on deposits | 181 | 111 | — | — | — | — | 292 |\n| Wealth and asset management revenue | 1 | 102 | — | 274 | — | ( 89 ) | (a) | 288 |\n| Card and processing revenue | 29 | 161 | — | 1 | 5 | — | 196 |\n| Mortgage banking net revenue | — | 5 | 142 | 2 | — | — | 149 |\n| Leasing business revenue | 148 | (c) | — | — | — | — | — | 148 |\n| Other noninterest income(b) | 42 | 45 | 4 | 3 | ( 2 ) | — | 92 |\n| Securities gains, net | 7 | — | — | — | 6 | — | 13 |\n| Securities losses, net – non-qualifying hedges on MSRs | — | — | ( 1 ) | — | — | — | ( 1 ) |\n| Total noninterest income | $ | 715 | 429 | 145 | 281 | 9 | ( 89 ) | 1,490 |\n| Noninterest expense: |\n| Compensation and benefits | $ | 292 | 328 | 127 | 103 | 493 | — | 1,343 |\n| Technology and communications | 7 | 2 | 5 | — | 173 | — | 187 |\n| Net occupancy expense(d) | 17 | 96 | 5 | 7 | 31 | — | 156 |\n| Equipment expense | 13 | 19 | — | — | 36 | — | 68 |\n| Leasing business expense | 68 | — | — | — | — | — | 68 |\n| Card and processing expense | 3 | 49 | — | — | ( 2 ) | — | 50 |\n| Marketing expense | 3 | 15 | 1 | 1 | 23 | — | 43 |\n| Other noninterest expense | 416 | 430 | 186 | 156 | ( 645 ) | ( 89 ) | 454 |\n| Total noninterest expense | $ | 819 | 939 | 324 | 267 | 109 | ( 89 ) | 2,369 |\n| Income before income taxes | $ | 864 | 20 | 82 | 57 | 771 | — | 1,794 |\n| Applicable income tax expense | 160 | 4 | 17 | 12 | 198 | — | 391 |\n| Net income | $ | 704 | 16 | 65 | 45 | 573 | — | 1,403 |\n| Total goodwill | $ | 1,981 | 2,047 | — | 231 | — | — | 4,259 |\n| Total assets | $ | 68,851 | 87,646 | 33,215 | 10,881 | 4,797 | (e) | — | 205,390 |\n\n(a)Revenue sharing agreements between wealth and asset management and branch banking are eliminated in the Condensed Consolidated Statements of Income.\n(b)Includes impairment charges of $ 3 and $ 1 for branches and land recorded in Branch Banking and General Corporate and Other, respectively. For more information, refer to Note 7 and Note 21.\n(c)Includes impairment charges of $ 25 for operating lease equipment. For more information, refer to Note 8 and Note 21.\n(d)Includes impairment losses and termination charges of $ 2 for ROU assets related to certain operating leases. For more information refer to Note 9.\n(e)Includes bank premises and equipment of $ 25 classified as held for sale. For more information, refer to Note 7.\n136\n| Fifth Third Bancorp and SubsidiariesNotes to Condensed Consolidated Financial Statements (unaudited) |\n\n| June 30, 2020 ($ in millions) | CommercialBanking | BranchBanking | ConsumerLending | Wealthand AssetManagement | GeneralCorporate and Other | Eliminations | Total |\n| Net interest income | $ | 1,078 | 1,017 | 181 | 88 | 65 | — | 2,429 |\n| Provision for credit losses | 502 | 114 | 23 | — | 486 | — | 1,125 |\n| Net interest income after provision for credit losses | $ | 576 | 903 | 158 | 88 | ( 421 ) | — | 1,304 |\n| Noninterest income: |\n| Commercial banking revenue | $ | 260 | 2 | — | 1 | ( 2 ) | — | 261 |\n| Service charges on deposits | 162 | 107 | — | 1 | — | — | 270 |\n| Wealth and asset management revenue | 2 | 84 | — | 244 | — | ( 75 ) | (a) | 255 |\n| Card and processing revenue | 26 | 133 | — | 1 | 7 | — | 167 |\n| Mortgage banking net revenue | — | 4 | 213 | 2 | — | — | 219 |\n| Leasing business revenue | 131 | (c) | — | — | — | — | — | 131 |\n| Other noninterest income(b) | ( 1 ) | 34 | 6 | 9 | ( 30 ) | — | 18 |\n| Securities losses, net | — | — | — | — | ( 3 ) | — | ( 3 ) |\n| Securities gains, net – non-qualifying hedges on MSRs | — | — | 3 | — | — | — | 3 |\n| Total noninterest income | $ | 580 | 364 | 222 | 258 | ( 28 ) | ( 75 ) | 1,321 |\n| Noninterest expense: |\n| Compensation and benefits | $ | 278 | 330 | 104 | 112 | 450 | — | 1,274 |\n| Technology and communications | 6 | 1 | 5 | — | 171 | — | 183 |\n| Net occupancy expense(e) | 15 | 87 | 5 | 6 | 51 | — | 164 |\n| Equipment expense | 14 | 21 | — | — | 29 | — | 64 |\n| Leasing business expense | 68 | — | — | — | — | — | 68 |\n| Card and processing expense | 4 | 58 | — | — | ( 2 ) | — | 60 |\n| Marketing expense | 4 | 17 | 2 | 1 | 27 | — | 51 |\n| Other noninterest expense | 495 | 426 | 128 | 147 | ( 664 ) | ( 75 ) | 457 |\n| Total noninterest expense | $ | 884 | 940 | 244 | 266 | 62 | ( 75 ) | 2,321 |\n| Income (loss) before income taxes | $ | 272 | 327 | 136 | 80 | ( 511 ) | — | 304 |\n| Applicable income tax expense (benefit) | 35 | 69 | 29 | 16 | ( 88 ) | — | 61 |\n| Net income (loss) | $ | 237 | 258 | 107 | 64 | ( 423 ) | — | 243 |\n| Total goodwill | $ | 1,961 | 2,047 | — | 253 | — | — | 4,261 |\n| Total assets | $ | 76,437 | 77,219 | 26,451 | 11,680 | 11,119 | (d) | — | 202,906 |\n\n(a)Revenue sharing agreements between wealth and asset management and branch banking are eliminated in the Condensed Consolidated Statements of Income.\n(b)Includes impairment charges of $ 4 and $ 10 for branches and land recorded in Branch Banking and General Corporate and Other, respectively. For more information, refer to Note 7 and Note 21.\n(c)Includes impairment charges of $ 3 for operating lease equipment. For more information, refer to Note 8 and Note 21.\n(d)Includes bank premises and equipment of $ 53 classified as held for sale. For more information, refer to Note 7.\n(e)Includes impairment losses of and termination charges of $ 5 for ROU assets related to certain operating leases. For more information, refer to Note 9.\n23. Subsequent Event\nOn July 23, 2021, the Bancorp entered into an accelerated share repurchase transaction with a counterparty pursuant to which the Bancorp paid $ 550 million on July 27, 2021 to repurchase shares of its outstanding common stock. The Bancorp is repurchasing the shares of its common stock as part of its Board-approved 100 million share repurchase program previously announced on June 18, 2019. The Bancorp expects the final settlement of the transaction to occur on or before September 29, 2021.\n137\nPART II. OTHER INFORMATION\nLegal Proceedings (Item 1)\nRefer to Note 17 of the Notes to Condensed Consolidated Financial Statements in Part I, Item 1 for information regarding legal proceedings.\nRisk Factors (Item 1A)\nThe following is a change to the risk factors as previously disclosed in Item 1A of the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2020. Other than as set forth below, there were no material changes to the risk factors disclosed in Item 1A of the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2020.\nThe COVID-19 pandemic creates significant risks and uncertainties for Fifth Third’s business.\nIn March 2020, the World Health Organization declared novel coronavirus disease 2019 (COVID-19) a global pandemic. The COVID-19 pandemic has negatively impacted the global economy, disrupted global supply chains, created significant volatility and disruption in financial markets and increased unemployment levels, all of which may become heightened concerns upon subsequent waves of infection or future developments. In addition, the pandemic resulted in temporary closures of many businesses and the institution of social distancing and sheltering in place requirements in many states and communities, including those in major markets in which the Bancorp is located or does business.\nAs a result, the demand for the Bancorp’s products and services has been, and is expected to continue to be, significantly impacted. Furthermore, the pandemic could influence the recognition of credit losses in the Bancorp’s loan and lease portfolios and increase its allowance for credit losses as both businesses and consumers are negatively impacted by the economic downturn. In addition, governmental actions are meaningfully influencing the interest-rate environment, which could continue to adversely affect the Bancorp’s results of operations and financial condition. The business operations of subsidiaries of the Bancorp, such as Fifth Third Bank, National Association, have been, and may also be disrupted in the future, if significant portions of their workforce are unable to work effectively, including because of illness, quarantines, government actions, travel restrictions, technology limitations and/or disruptions or other restrictions in connection with the pandemic. Furthermore, the business operations of subsidiaries of the Bancorp have been, and may again in the future be, disrupted due to vendors and third party service providers being unable to work or provide services effectively, including because of illness, quarantines, government actions, or other restrictions in connection with the pandemic. An increase in the remote work force due to the COVID-19 pandemic and the potential for a long-term change in Fifth Third’s remote work strategy may also increase risks related to cybersecurity and information security.\nIn response to the pandemic, the Bancorp provided financial hardship relief to borrowers that were negatively impacted by the pandemic and its related economic impacts. These programs included payment deferrals and forbearances for both commercial and retail borrowers. The Bancorp has also temporarily suspended all residential foreclosure activity. These actions are expected to negatively impact revenue and other results of operations of the Bancorp in the near term and, if not effective in mitigating the effects of the COVID-19 pandemic on the Bancorp’s customers, may adversely affect the Bancorp’s business and results of operations more substantially over a longer period of time.\nGovernmental authorities have taken significant measures to provide economic assistance to households and businesses, to stabilize the markets and to support economic growth. For example, in response to the COVID-19 pandemic, the FRB and other U.S. state and federal financial regulatory agencies took action to mitigate the resulting disruptions to economic activity and financial stability by implementing a number of facilities to provide emergency liquidity to various segments of the U.S. economy and financial markets. Many of these facilities expired on or before December 31, 2020 or were extended for brief periods into 2021. The expiration of these facilities could have an adverse effect on U.S. economy and ultimately on the Bancorp’s business.\nAmong other relief programs, the Bancorp is a participating lender in the SBA’s Paycheck Protection Program. Paycheck Protection Program loans are fixed, unsecured, low interest rate loans that are guaranteed by the SBA and subject to numerous other regulatory requirements, and a borrower may apply to have all or a portion of the loan forgiven. If Paycheck Protection Program borrowers fail to qualify for loan forgiveness, the Bancorp faces a heightened risk of holding these loans at unfavorable interest rates for an extended period of time. While the Paycheck Protection Program loans are guaranteed by the SBA, various regulatory requirements will apply to the Bancorp’s ability to seek recourse under the guarantees and the related procedures are currently subject to uncertainty. If a borrower defaults on a Paycheck Protection Program loan, these requirements and uncertainties may limit the Bancorp’s ability to fully recover against the loan guarantee or to seek full recourse against the borrower. These assistance efforts may adversely affect the Bancorp’s revenue and results of operations and may make the Bancorp’s results more difficult to forecast. Further, the timing and amount of forgiveness to which the Bancorp’s borrowers will be entitled cannot be predicted. The Paycheck Protection Program and other government programs in which the Bancorp may participate are complex and the Bancorp’s participation may lead to governmental and regulatory scrutiny, negative publicity and damage to the Bancorp’s reputation.\nThe extent to which the COVID-19 pandemic impacts the Bancorp’s business, results of operations, and financial condition, as well as its regulatory capital and liquidity ratios, will depend on highly uncertain future developments, including the scope and duration of the pandemic (including the possibility of further surges of COVID-19 and any virus variants, which may or may not respond to available vaccinations), the timing and efficacy of the vaccination program in the U.S. and further actions taken by governmental authorities and other third parties in response to the pandemic. Government actions to mitigate the economic suffering caused by the COVID-19 pandemic may not be successful\n138\nor may result in increased pressure on the banking sector, which could adversely affect the Bancorp’s business, results of operations and financial condition more substantially over a longer period of time. In addition, the unique historical nature of the pandemic and the unprecedented level of governmental response may also significantly impact the Bancorp’s ability to effectively manage its business or predict future performance.\nAs the COVID-19 pandemic subsides, the U.S. economy may require some time to fully recover from its effects, the length of which is unknown. The effects of the COVID-19 pandemic may heighten many of the other risks described in Item 1A. Risk Factors of the Bancorp’s Annual Report on Form 10-K and any subsequent Quarterly Report on Form 10-Q or Current Report on Form 8-K, including, but not limited to, risks of credit deterioration, interest rate changes, rating agency actions, governmental actions, market volatility, theft, fraud, security breaches and technology interruptions.\nUnregistered Sales of Equity Securities and Use of Proceeds (Item 2)\nRefer to the “Capital Management” section within Management’s Discussion and Analysis in Part I, Item 2 for information regarding purchases and sales of equity securities by the Bancorp during the second quarter of 2021.\nDefaults Upon Senior Securities (Item 3)\nNone.\nMine Safety Disclosures (Item 4)\nNot applicable.\nOther Information (Item 5)\nNone.\n139\nExhibits (Item 6)\n| 3.1 | Amended Articles of Incorporation of Fifth Third Bancorp. Incorporated by reference to Exhibit 3.1 of the Registrant’s Quarterly Report on Form 10-Q filed on May 7, 2021. |\n| 3.2 | Regulations of Fifth Third Bancorp as Amended as of March 23, 2020. Incorporated by reference to Exhibit 3.2 of the Registrant’s Current Report on Form 8-K filed on March 24, 2020. |\n| 10.1 | Fifth Third Bancorp 2021 Incentive Compensation Plan. Incorporated by reference to Annex A to the Registrant’s Proxy Statement filed on March 2, 2021. |\n| 10.2 | Supplemental Confirmation dated April 21, 2021, to Master Confirmation dated July 29, 2015, for accelerated share repurchase transaction between Fifth Third Bancorp and Morgan Stanley & Co. LLC* |\n| 10.3 | 2021 Restricted Stock Unit Grant Agreement (for Directors). |\n| 31(i) | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 by Chief Executive Officer. |\n| 31(ii) | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 by Chief Financial Officer. |\n| 32(i) | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Chief Executive Officer. |\n| 32(ii) | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Chief Financial Officer. |\n| 101.INS | Inline XBRL Instance Document. |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema. |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase. |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase. |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase. |\n| 101.DEF | Inline XBRL Taxonomy Definition Linkbase. |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101). |\n| * Selected portions of this exhibit have been omitted in accordance with Item 601(b)(10) of Regulation S-K. |\n\n140\nSignature\nPursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n| Fifth Third Bancorp |\n| Registrant |\n\nDate: August 6, 2021\n| /s/ James C. Leonard |\n| James C. Leonard |\n| Executive Vice President and |\n| Chief Financial Officer |\n| (Duly Authorized Officer & Principal Financial Officer) |\n\n141\n</text>\n\nWhat is the adjusted Return on Average Tangible Common Equity (ROATCE) for the first half of the year 2021 in percent, considering net income available to common shareholders (U.S. GAAP), average tangible common equity, and attributable changes in net interest income due to volume and yield/rate?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"ground_truth": "Therefore, the answer is 6.4492577269408615."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nITEM 1.\nFinancial Statements\nNewpark Resources, Inc.Condensed Consolidated Balance Sheets(Unaudited)\n\n| (In thousands, except share data) | March 31, 2014 | December 31, 2013 |\n| ASSETS |\n| Cash and cash equivalents | $ | 130,187 | $ | 65,840 |\n| Receivables, net | 276,082 | 268,529 |\n| Inventories | 199,565 | 189,680 |\n| Deferred tax asset | 11,750 | 11,272 |\n| Prepaid expenses and other current assets | 15,034 | 11,016 |\n| Assets of discontinued operations | - | 13,103 |\n| Total current assets | 632,618 | 559,440 |\n| Property, plant and equipment, net | 227,050 | 217,010 |\n| Goodwill | 93,781 | 94,064 |\n| Other intangible assets, net | 23,870 | 25,900 |\n| Other assets | 9,813 | 6,086 |\n| Assets of discontinued operations | - | 65,917 |\n| Total assets | $ | 987,132 | $ | 968,417 |\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\n| Short-term debt | $ | 15,759 | $ | 12,867 |\n| Accounts payable | 88,328 | 88,586 |\n| Accrued liabilities | 65,196 | 46,341 |\n| Liabilities of discontinued operations | - | 5,957 |\n| Total current liabilities | 169,283 | 153,751 |\n| Long-term debt, less current portion | 172,771 | 172,786 |\n| Deferred tax liability | 26,235 | 27,060 |\n| Other noncurrent liabilities | 11,288 | 11,026 |\n| Liabilities of discontinued operations | - | 22,740 |\n| Total liabilities | 379,577 | 387,363 |\n| Commitments and contingencies (Note 9) |\n| Common stock, $0.01 par value, 200,000,000 shares authorized and 98,032,555 and 98,030,839 shares issued, respectively | 980 | 980 |\n| Paid-in capital | 507,820 | 504,675 |\n| Accumulated other comprehensive loss | (8,279 | ) | (9,484 | ) |\n| Retained earnings | 195,349 | 160,338 |\n| Treasury stock, at cost; 11,904,275 and 10,832,845 shares, respectively | (88,315 | ) | (75,455 | ) |\n| Total stockholders’ equity | 607,555 | 581,054 |\n| Total liabilities and stockholders' equity | $ | 987,132 | $ | 968,417 |\n\nSee Accompanying Notes to Unaudited Condensed Consolidated Financial Statements\n2\nNewpark Resources, Inc.Condensed Consolidated Statements of Operations(Unaudited)\n\n| Three Months Ended March 31, |\n| (In thousands, except per share data) | 2014 | 2013 |\n| Revenues | $ | 242,824 | $ | 267,923 |\n| Cost of revenues | 196,560 | 220,735 |\n| Selling, general and administrative expenses | 25,523 | 22,451 |\n| Other operating income, net | (16 | ) | (124 | ) |\n| Operating income | 20,757 | 24,861 |\n| Foreign currency exchange loss (gain) | 54 | (368 | ) |\n| Interest expense, net | 2,920 | 2,520 |\n| Income from continuing operations before income taxes | 17,783 | 22,709 |\n| Provision for income taxes | 6,041 | 7,842 |\n| Income from continuing operations | 11,742 | 14,867 |\n| Income from discontinued operations, net of tax | 1,152 | 2,508 |\n| Gain from disposal of discontinued operations, net of tax | 22,117 | - |\n| Net income | $ | 35,011 | $ | 17,375 |\n| Income per common share -basic: |\n| Income from continuing operations | $ | 0.14 | $ | 0.18 |\n| Income from discontinued operations | 0.27 | 0.03 |\n| Net income | $ | 0.41 | $ | 0.21 |\n| Income per common share -diluted: |\n| Income from continuing operations | $ | 0.13 | $ | 0.16 |\n| Income from discontinued operations | 0.23 | 0.02 |\n| Net income | $ | 0.36 | $ | 0.18 |\n\nSee Accompanying Notes to Unaudited Condensed Consolidated Financial Statements\n3\nNewpark Resources, Inc.Condensed Consolidated Statements of Comprehensive Income(Unaudited)\n\n| Three Months Ended March 31, |\n| (In thousands) | 2014 | 2013 |\n| Net income | $ | 35,011 | $ | 17,375 |\n| Foreign currency translation adjustments | 1,205 | (2,764 | ) |\n| Comprehensive income | $ | 36,216 | $ | 14,611 |\n\nSee Accompanying Notes to Unaudited Condensed Consolidated Financial Statements\n4\nNewpark Resources, Inc.Condensed Consolidated Statements of Cash Flows(Unaudited)\n\n| Three Months Ended March 31, |\n| (In thousands) | 2014 | 2013 |\n| Cash flows from operating activities: |\n| Net income | $ | 35,011 | $ | 17,375 |\n| Adjustments to reconcile net income to net cash provided by operations: |\n| Depreciation and amortization | 10,287 | 10,954 |\n| Stock-based compensation expense | 2,840 | 1,973 |\n| Provision for deferred income taxes | (13,108 | ) | 534 |\n| Net provision for doubtful accounts | 173 | 208 |\n| Gain on sale of a business | (33,974 | ) | - |\n| Gain on sale of assets | (362 | ) | (99 | ) |\n| Change in assets and liabilities: |\n| Increase in receivables | (1,080 | ) | (20,969 | ) |\n| Increase in inventories | (9,229 | ) | (1,280 | ) |\n| Increase in other assets | (3,858 | ) | (2,382 | ) |\n| (Decrease) increase in accounts payable | (1,248 | ) | 4,179 |\n| Increase in accrued liabilities and other | 18,142 | 4,747 |\n| Net cash provided by operating activities | 3,594 | 15,240 |\n| Cash flows from investing activities: |\n| Capital expenditures | (18,509 | ) | (16,127 | ) |\n| Proceeds from sale of property, plant and equipment | 754 | 213 |\n| Proceeds from sale of a business | 89,167 | - |\n| Net cash provided by (used in) investing activities | 71,412 | (15,914 | ) |\n| Cash flows from financing activities: |\n| Borrowings on lines of credit | 47,562 | 71,102 |\n| Payments on lines of credit | (45,113 | ) | (78,748 | ) |\n| Other financing activities | (13 | ) | (38 | ) |\n| Proceeds from employee stock plans | 34 | 3,808 |\n| Purchase of treasury stock | (13,123 | ) | - |\n| Net cash used in financing activities | (10,653 | ) | (3,876 | ) |\n| Effect of exchange rate changes on cash | (6 | ) | (586 | ) |\n| Net increase (decrease) in cash and cash equivalents | 64,347 | (5,136 | ) |\n| Cash and cash equivalents at beginning of year | 65,840 | 46,846 |\n| Cash and cash equivalents at end of period | $ | 130,187 | $ | 41,710 |\n| Cash paid for: |\n| Income taxes (net of refunds) | $ | 9,500 | $ | 4,294 |\n| Interest | $ | 667 | $ | 331 |\n\nSee Accompanying Notes to Unaudited Condensed Consolidated Financial Statements\n5\nNEWPARK RESOURCES, INC.\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\nNote 1 – Basis of Presentation and Significant Accounting Policies\nThe accompanying unaudited condensed consolidated financial statements of Newpark Resources, Inc. and our wholly-owned subsidiaries, which we refer to as “we,” “our” or “us,” have been prepared in accordance with Rule 10-01 of Regulation S-X for interim financial statements required to be filed with the Securities and Exchange Commission (“SEC”), and do not include all information and footnotes required by the accounting principles generally accepted in the United States (“U.S. GAAP”) for complete financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2013. Our fiscal year end is December 31 and our first quarter represents the three month period ended March 31. The results of operations for the first quarter of 2014 are not necessarily indicative of the results to be expected for the entire year. Unless otherwise stated, all currency amounts are stated in U.S. dollars.\nIn the opinion of management, the accompanying unaudited condensed consolidated financial statements reflect all adjustments necessary to present fairly our financial position as of March 31, 2014, the results of our operations for the first quarter of 2014 and 2013, and our cash flows for the first quarter of 2014 and 2013. All adjustments are of a normal recurring nature. Our balance sheet at December 31, 2013 is derived from the audited consolidated financial statements at that date.\nThe preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. For further information, see Note 1 in our Annual Report on Form 10-K for the year ended December 31, 2013.\nNew Accounting Standards\nIn April 2014, the Financial Accounting Standards Board (“FASB”) issued updated guidance that changes the criteria for reporting discontinued operations including enhanced disclosure requirements. Under the new guidance, only disposals representing a strategic shift in operations should be presented as discontinued operations. Those strategic shifts should have a major effect on the organization´s operations and financial results. The new guidance is effective for us in the first quarter of 2015, however we do not expect the adoption to have a material effect on our consolidated financial statements.\n6\nNote 2 – Discontinued Operations\nOn March 17, 2014, we completed the previously announced sale of our Environmental Services business for $100 million in cash, subject to adjustment based on actual working capital conveyed at closing. Cash proceeds from the sale were $89.2 million in the first quarter of 2014, net of transaction related expenses. In addition, $8 million of the sale price was withheld in escrow associated with transaction representations, warranties and indemnities, and is expected to be released over the next two years. As a result of the sale transaction, we recorded a gain on the disposal of the business of $34.0 million ($22.1 million after-tax). All assets, liabilities and results of operations for this business have been reclassified to discontinued operations for all periods presented.\nSummarized results of operations from discontinued operations are as follows:\n\n| Three Months Ended March 31, |\n| (In thousands) | 2014 | 2013 |\n| Revenues | $ | 11,744 | $ | 14,595 |\n| Income from discontinued operations before income taxes | 1,770 | 3,508 |\n| Income from discontinued operations, net of tax | 1,152 | 2,508 |\n| Gain from disposal of discontinued operations before income taxes | 33,974 | - |\n| Gain from disposal of discontinued operations, net of tax | 22,117 | - |\n\nAs of March 31, 2014, our reported accrued liabilities of $65.2 million, includes approximately $31 million of accrued income taxes payable, the majority of which is related to the sale of this business. Assets and liabilities of discontinued operations as of December 31, 2013 were as follows:\n\n| December 31, |\n| (In thousands) | 2013 |\n| Receivables, net | $ | 11,915 |\n| Prepaid expenses and other current assets | 1,188 |\n| Property, plant and equipment | 62,333 |\n| Other assets | 3,584 |\n| Assets of discontinued operations | $ | 79,020 |\n| Accounts payable | $ | 4,415 |\n| Other Accrued liabilities | 1,542 |\n| Deferred tax liability | 12,449 |\n| Other noncurrent liabilities | 10,291 |\n| Liabilities of discontinued operations | $ | 28,697 |\n\n7\nNote 3 – Earnings per Share\nThe following table presents the reconciliation of the numerator and denominator for calculating earnings per share from continuing operations:\n\n| First Quarter |\n| (In thousands, except per share data) | 2014 | 2013 |\n| Basic EPS: |\n| Income from continuing operations | $ | 11,742 | $ | 14,867 |\n| Weighted average number of common shares outstanding | 84,743 | 84,100 |\n| Basic income from continuing operations per common share | $ | 0.14 | $ | 0.18 |\n| Diluted EPS: |\n| Income from continuing operations | $ | 11,742 | $ | 14,867 |\n| Assumed conversions of Senior Notes | 1,261 | 1,250 |\n| Adjusted income from continuing operations | $ | 13,003 | $ | 16,117 |\n| Weighted average number of common shares outstanding-basic | 84,743 | 84,100 |\n| Add: Dilutive effect of stock options and restricted stock awards | 1,674 | 1,572 |\n| Dilutive effect of Senior Notes | 15,682 | 15,682 |\n| Diluted weighted average number of common shares outstanding | 102,099 | 101,354 |\n| Diluted income from continuing operations per common share | $ | 0.13 | $ | 0.16 |\n| Stock options excluded from calculation of diluted earnings per share because anti-dilutive for the period | 627 | 592 |\n\nFor the first quarter of 2014 and 2013, we had weighted average dilutive stock options and restricted stock outstanding of approximately 5.0 million shares and 5.5 million shares, respectively. The resulting net effect of stock options and restricted stock were used in calculating diluted earnings per share for the period.\nNote 4 – Acquisition\nIn December 2013, we completed the acquisition of Terrafirma Roadways (“Terrafirma”), a provider of temporary roadways and worksites based in the United Kingdom, for total cash consideration of $6.8 million, net of cash acquired. Additional consideration up to £1.0 million ($1.6 million) may be payable based on earnings of the business over the 18-month period following the acquisition. Prior to the acquisition, Terrafirma had been operating as a partner to the Company since 2008, developing a rental business with DURA-BASE® composite mats, primarily focused in the utility industry in the U.K.\n8\nThe transaction has been recorded using the acquisition method of accounting and accordingly, assets acquired and liabilities assumed were recorded at their fair values as of the acquisition date. The excess of the total consideration, including projected additional consideration, was recorded as goodwill and includes the value of the assembled workforce. While the initial purchase price allocation has been completed, the allocation of the purchase price is subject to change for a period of one year following the acquisition. The following table summarizes the amounts recognized for assets acquired and liabilities assumed as of the December 2013 acquisition date:\n\n| (In thousands) |\n| Receivables, net | $ | 2,155 |\n| Property, plant and equipment, net | 2,160 |\n| Goodwill | 4,544 |\n| Other intangibles, net | 4,528 |\n| Total assets acquired | 13,387 |\n| Accounts payable | 3,350 |\n| Short-term debt | 284 |\n| Accrued liabilities | 285 |\n| Deferred tax liability | 1,092 |\n| Other noncurrent liabilities | 1,600 |\n| Total liabilities assumed | 6,611 |\n| Total cash conveyed at closing | $ | 6,776 |\n\nPro forma results of operation for the acquired business have not been presented as the effect of this acquisition is not material to our consolidated financial statements.\nNote 5 – Treasury Stock\nIn April 2013, our Board of Directors approved a share repurchase program that authorizes the Company to purchase up to $50.0 million of its outstanding shares of common stock. In February 2014, our Board of Directors increased the total authorization of the program to $100.0 million, subject to completion of the Environmental Services divesture. These purchases are funded with a combination of cash generated from operations, the sale of the Environmental Services business and borrowings under the Company’s revolving credit facility. The repurchase program has no specific term. The Company may repurchase shares in the open market or as otherwise determined by management, subject to market conditions, business opportunities and other factors. As part of the share repurchase program, the Company’s management has been authorized to establish trading plans under Rule 10b5-1 of the Securities Exchange Act of 1934.\nDuring the first quarter of 2014, 1,095,413 shares were repurchased for an average price of approximately $11.84 per share, including commissions, leaving $80.3 million remaining under the program. All of the shares repurchased are held as treasury stock. We record treasury stock purchases under the cost method whereby the entire cost of the acquired stock is recorded as treasury stock.\n9\nNote 6 – Receivables\nReceivables - Receivables consist of the following:\n\n| March 31, | December 31, |\n| (In thousands) | 2014 | 2013 |\n| Gross trade receivables | $ | 254,376 | $ | 252,168 |\n| Allowance for doubtful accounts | (4,204 | ) | (4,142 | ) |\n| Net trade receivables | 250,172 | 248,026 |\n| Other receivables | 25,910 | 20,503 |\n| Total receivables, net | $ | 276,082 | $ | 268,529 |\n\nNote 7 – Inventories\nInventories- Inventories consist of the following:\n\n| (In thousands) | March 31, 2014 | December 31, 2013 |\n| Raw materials: |\n| Drilling fluids | $ | 173,393 | $ | 153,901 |\n| Mats | 914 | 790 |\n| Total raw materials | 174,307 | 154,691 |\n| Blended drilling fluids components | 23,914 | 34,075 |\n| Finished goods- mats | 1,344 | 914 |\n| Total | $ | 199,565 | $ | 189,680 |\n\nRaw materials consist primarily of barite, chemicals, and other additives that are consumed in the production of our drilling fluid systems. Our blended drilling fluids components consist of base drilling fluid systems that have been either mixed internally at our mixing plants or purchased from third party vendors. These base systems require raw materials to be added, as required to meet specified customer requirements.\nNote 8 – Financing Arrangements and Fair Value of Financial Instruments\nOur financing arrangements include $172.5 million of unsecured convertible senior notes (“Senior Notes”) and a $125.0 million revolving credit facility which can be increased by $75.0 million for a maximum $200.0 million of capacity. At March 31, 2014, we had no outstanding borrowings under the revolving credit facility. The Senior Notes bear interest at a rate of 4.0% per year, payable semi-annually in arrears on April 1 and October 1 of each year, beginning April 1, 2011. Holders may convert the Senior Notes at their option at any time prior to the close of business on the business day immediately preceding the October 1, 2017 maturity date. The conversion rate is initially 90.8893 shares of our common stock per $1,000 principal amount of Senior Notes (equivalent to an initial conversion price of $11.00 per share of common stock), subject to adjustment in certain circumstances. Upon conversion, the Senior Notes will be settled in shares of our common stock. We may not redeem the Senior Notes prior to their maturity date.\n10\nOur financial instruments include cash and cash equivalents, receivables, payables and debt. We believe the carrying values of these instruments, with the exception of our Senior Notes, approximated their fair values at March 31, 2014 and December 31, 2013. The estimated fair value of our Senior Notes is $219.1 million at March 31, 2014 and $231.2 million at December 31, 2013, based on quoted market prices at these respective dates.\nNote 9 – Commitments and Contingencies\nIn the ordinary course of conducting our business, we become involved in litigation and other claims from private party actions, as well as judicial and administrative proceedings involving governmental authorities at the federal, state and local levels. In the opinion of management, any liability in these matters should not have a material effect on our consolidated financial statements.\nNote 10 – Segment Data\nSummarized operating results for our reportable segments is shown in the following table (net of inter-segment transfers):\n\n| First Quarter |\n| (In thousands) | 2014 | 2013 |\n| Revenues |\n| Fluids systems | $ | 211,400 | $ | 247,339 |\n| Mats & integrated services | 31,424 | 20,584 |\n| Total Revenues | $ | 242,824 | $ | 267,923 |\n| Operating Income (loss) |\n| Fluids systems | $ | 15,740 | $ | 22,622 |\n| Mats & integrated services | 13,373 | 8,480 |\n| Corporate office | (8,356 | ) | (6,241 | ) |\n| Operating Income | $ | 20,757 | $ | 24,861 |\n\n11\n\n\nITEM 2.\nManagement's Discussion and Analysis of Financial Condition and Results of Operations\nThe following discussion of our financial condition, results of operations, liquidity and capital resources should be read together with our unaudited condensed consolidated financial statements and notes to unaudited condensed consolidated financial statements contained in this report as well as our Annual Report on Form 10-K for the year ended December 31, 2013. Our first quarter represents the three month period ended March 31, 2014. Unless otherwise stated, all currency amounts are stated in U.S. dollars.\nOverview\nWe are a diversified oil and gas industry supplier providing products and services primarily to the oil and gas exploration and production (“E&P”) industry. We operate our business through two reportable segments: Fluids Systems and Mats and Integrated Services.\nIn March 2014, we completed the sale of our Environmental Services business, which was historically reported as a third operating segment for $100 million in cash. The proceeds will be used for general corporate purposes, including investments in our core drilling fluids and mats segments, potential acquisitions, along with the continued share purchases under the current repurchase program. See Note 2 Discontinued Operations in our Notes to Unaudited Condensed Consolidated Financial Statements in Item 1 for additional information.\nOur Fluids Systems segment, which generated 87% of consolidated revenues in the first quarter of 2014, provides customized drilling fluids solutions to E&P customers globally, operating through four geographic regions: North America, Europe, the Middle East and Africa (“EMEA”), Latin America, and Asia Pacific.\nIn 2013, we announced several international contract awards, including two in the deepwater market. In Brazil, we were awarded a two-year contract from a subsidiary of Total S.A., to provide drilling fluids and related services for a series of wells planned in the Campos Basin. In our EMEA region, we were awarded a contract by another customer to provide drilling fluids and related services for a series of wells to be drilled in the Black Sea. In addition, we were awarded two contracts to provide drilling fluids and related services for land operations, including a five year contract by the Kuwait Oil Company and a four year contract by another customer in India. Work under the Brazil contract began in the first quarter of 2014, while work under the other three contracts is expected to begin later in 2014.\nWe are continuing the roll-out of Evolution®, our high performance water-based drilling fluid system launched in 2010, which we believe provides superior performance and environmental benefits to our customers, as compared to traditional fluids systems used in the industry. After completing the roll-out of the system into most major North American drilling basins in 2011 and 2012, we are seeking to further penetrate markets in North America, while expanding into key international markets. The system has now been used in our EMEA and Asia Pacific regions. Revenues from wells using the Evolution system were approximately $48 million in the first quarter of 2014, compared to $29 million in the first quarter of 2013.\nOur Mats and Integrated Services segment, which generated 13% of consolidated revenues through the first quarter of 2014, provides composite mat rentals, well site construction and related site services to oil and gas customers and mat rentals to the petrochemicals industry in the U.S. and the utility industry in the U.K. We also sell composite mats to E&P customers outside of the U.S., and to domestic customers outside of the oil and gas industry.\nIn October 2013, we announced plans to expand our mat manufacturing facility, located in Carencro, Louisiana. The $40 million expansion project is expected to be completed in early 2015. Upon completion, the project will significantly increase our production capacity and support expansion into new markets, both domestically and internationally. The new facility will also include a research and development center, intended to drive continued new product development efforts. Until this manufacturing facility expansion project is completed, we expect revenues from mat sales to continue to be limited by our manufacturing capacity limitations, along with our efforts to meet growing demand for mat rentals. During both the first quarters of 2014 and 2013, we allocated the majority of our composite mat production toward the expansion of our rental fleet, leaving fewer mats available for sale to customers.\n12\nIn December 2013 we completed the acquisition of Terrafirma Roadways (“Terrafirma”), a provider of temporary roadways and worksites based in the United Kingdom, for total cash consideration of $6.8 million, net of cash acquired. Prior to the acquisition, Terrafirma had been operating as a partner to the Company since 2008, developing a rental business with DURA-BASE® composite mats, primarily focused in the utility industry in the U.K.\nRig count data is the most widely accepted indicator of drilling activity. Average North American rig count data for the first quarter of 2014, as compared to the first quarter of 2013 is as follows:\n\n| First Quarter | 2014 vs 2013 |\n| 2014 | 2013 | Count | % |\n| U.S. Rig Count | 1,779 | 1,758 | 21 | 1 | % |\n| Canadian Rig Count | 525 | 531 | (6 | ) | (1 | %) |\n| North America | 2,304 | 2,289 | 15 | 1 | % |\n\nSource: Baker Hughes Incorporated\nFirst Quarter of 2014 Compared to First Quarter of 2013\nConsolidated Results of Operations\nSummarized results of operations for the first quarter of 2014 compared to the first quarter of 2013 are as follows:\n\n| First Quarter | 2014 vs 2013 |\n| (In thousands) | 2014 | 2013 | % |\n| Revenues | $ | 242,824 | $ | 267,923 | $ | (25,099 | ) | (9 | %) |\n| Cost of revenues | 196,560 | 220,735 | (24,175 | ) | (11 | %) |\n| Selling, general and administrative expenses | 25,523 | 22,451 | 3,072 | 14 | % |\n| Other operating income, net | (16 | ) | (124 | ) | 108 | (87 | %) |\n| Operating income | 20,757 | 24,861 | (4,104 | ) | (17 | %) |\n| Foreign currency exchange loss (gain) | 54 | (368 | ) | 422 | (115 | %) |\n| Interest expense, net | 2,920 | 2,520 | 400 | 16 | % |\n| Income from continuing operations before income taxes | 17,783 | 22,709 | (4,926 | ) | (22 | %) |\n| Provision for income taxes | 6,041 | 7,842 | (1,801 | ) | (23 | %) |\n| Income from continuing operations | 11,742 | 14,867 | (3,125 | ) | (21 | %) |\n| Income from discontinued operations, net of tax | 1,152 | 2,508 | (1,356 | ) | (54 | %) |\n| Gain from disposal of discontinued operations, net of tax | 22,117 | - | 22,117 | NM |\n| Net income | $ | 35,011 | $ | 17,375 | $ | 17,636 | 102 | % |\n| NM-Not meaningful |\n\n13\nRevenues\nRevenues decreased 9% to $242.8 million in the first quarter of 2014, compared to $267.9 million in the first quarter of 2013. This $25.1 million decrease includes a $22.1 million (11%) decrease in revenues in North America, including a $31.3 million decline in our Fluids Systems segment. Revenues from our international operations decreased by $3.0 million (4%), including declines in Asia Pacific and Brazil. Additional information regarding the change in revenues is provided within the operating segment results below.\nCost of revenues\nCost of revenues decreased 11% to $196.6 million in the first quarter of 2014, compared to $220.7 million in the first quarter of 2013. The decrease is primarily driven by the decrease in revenues. Additional information regarding the change in cost of revenues is provided within the operating segment results below.\nSelling, general and administrative expenses\nSelling, general and administrative expenses increased $3.1 million to $25.5 million in the first quarter of 2014 from $22.5 million in the first quarter of 2013. The increase is primarily attributable to a $1.7 million increase in spending related to strategic planning projects, including the development of our deepwater market penetration strategy and international treasury and tax planning projects.\nForeign currency exchange\nForeign currency exchange was a $0.1 million loss in the first quarter of 2014, compared to a $0.4 million gain in the first quarter of 2013, and primarily reflects the impact of currency translations on assets and liabilities held in our international operations that are denominated in currencies other than functional currencies.\nInterest expense, net\nInterest expense totaled $2.9 million for the first quarter of 2014 compared to $2.5 million for the first quarter of 2013. The $0.4 million increase primarily reflects the impact of increased borrowings in our Brazilian subsidiary.\nProvision for income taxes\nThe provision for income taxes for the first quarter of 2014 was $6.0 million, reflecting an effective tax rate of 34.0%, compared to $7.8 million in the first quarter of 2013, reflecting an effective tax rate of 34.5%.\nDiscontinued operations\nIncome from our discontinued Environmental Services operations was $1.2 million in the first quarter of 2014 compared to $2.5 million the first quarter of 2013. In addition, the first quarter of 2014 included a $22.1 million gain from the March 2014 sale of the business, described above. See Note 2 Discontinued Operations in our Notes to the unaudited condensed consolidated financial statements in Item 1.\n14\nOperating Segment Results\nSummarized financial information for our reportable segments is shown in the following table (net of inter-segment transfers):\n\n| First Quarter | 2014 vs 2013 |\n| (In thousands) | 2014 | 2013 | $ | % |\n| Revenues |\n| Fluids systems | $ | 211,400 | $ | 247,339 | $ | (35,939 | ) | (15 | %) |\n| Mats and integrated services | 31,424 | 20,584 | 10,840 | 53 | % |\n| Total revenues | $ | 242,824 | $ | 267,923 | $ | (25,099 | ) | (9 | %) |\n| Operating income (loss) |\n| Fluids systems | $ | 15,740 | $ | 22,622 | $ | (6,882 | ) |\n| Mats and integrated services | 13,373 | 8,480 | 4,893 |\n| Corporate office | (8,356 | ) | (6,241 | ) | (2,115 | ) |\n| Operating income | $ | 20,757 | $ | 24,861 | $ | (4,104 | ) |\n| Segment operating margin |\n| Fluids systems | 7.4 | % | 9.1 | % |\n| Mats and integrated services | 42.6 | % | 41.2 | % |\n\nFluids Systems\nRevenues\nTotal revenues for this segment consisted of the following:\n\n| First Quarter | 2014 vs 2013 |\n| (In thousands) | 2014 | 2013 | $ | % |\n| United States | $ | 124,776 | $ | 159,144 | $ | (34,368 | ) | (22 | %) |\n| Canada | 21,711 | 18,651 | 3,060 | 16 | % |\n| Total North America | 146,487 | 177,795 | (31,308 | ) | (18 | %) |\n| EMEA | 34,720 | 34,518 | 202 | 1 | % |\n| Latin America | 22,003 | 24,961 | (2,958 | ) | (12 | %) |\n| Asia Pacific | 8,190 | 10,065 | (1,875 | ) | (19 | %) |\n| Total | $ | 211,400 | $ | 247,339 | $ | (35,939 | ) | (15 | %) |\n\nNorth American revenues decreased 18% to $146.5 million in the first quarter of 2014, compared to $177.8 million in the first quarter of 2013. While the North American rig count improved by 1% over this period, the decrease is largely attributable to market share losses in South Texas, along with reduced drilling activity of a key customer in the U.S.\nInternationally, revenues were down 7% to $64.9 million in the first quarter of 2014, as compared to $69.5 million in first quarter 2013. This decrease is primarily attributable to decreased activity with Petrobras in Brazil, along with lower revenues for land drilling customers in Australia.\n15\nOperating Income\nOperating income decreased $6.9 million in the first quarter of 2014, as compared to the first quarter of 2013, largely attributable to the $35.9 million decline in revenues described above. The decline in operating income includes a $6.4 million decrease from North American operations, along with a $0.5 million decrease from international operations.\nIn recent quarters, the business environment in Brazil has become increasingly challenging, particularly as Petrobras, our primary customer in the region, has focused more efforts on well completions and less on drilling activities. Also, the lack of timely payment of Petrobras-related invoicing has caused increases in invested working capital associated with participation in this market. In response to these changes in the business environment, we are continuing to evaluate opportunities to reduce the cost structure of this operation. While the Brazilian deepwater drilling market remains an important component of our long-term strategy, the profitability of our business remains highly dependent on increasing levels of drilling activity by Petrobras and other E&P customers. In the absence of a longer-term increase in drilling activity, we may incur additional charges, as we seek to reduce our cost structure in country, which may negatively impact our future operating results.\nMats and Integrated Services\nRevenues\nTotal revenues for this segment consisted of the following:\n\n| First Quarter | 2014 vs 2013 |\n| (In thousands) | 2014 | 2013 | $ | % |\n| Mat rental and services | $ | 24,537 | $ | 14,778 | $ | 9,759 | 66 | % |\n| Mat sales | 6,887 | 5,806 | 1,081 | 19 | % |\n| Total | $ | 31,424 | $ | 20,584 | $ | 10,840 | 53 | % |\n\nMat rental and services revenues increased $9.8 million compared to the first quarter of 2013, primarily due to increasing demand for our composite mat products, particularly in the Northeast U.S. and Gulf Coast regions. In addition, the first quarter of 2014 benefitted from a $1.6 million increase from the U.K. rental operation, following the December 2013 Terrafirma acquisition, as described above. Mat sales increased by $1.1 million from the first quarter of 2013. As described above, quarterly revenues from mat sales typically fluctuate based on management’s allocation of plant capacity, along with the timing of mat orders from customers.\nOperating Income\nSegment operating income increased by $4.9 million, as compared to the first quarter of 2013, largely attributable to the $10.8 million increase in revenues described above. The segment operating margin continues to remain elevated, driven by high utilization of mats in our rental fleet, and high utilization of our production facility, which continues to run at maximum production capacity levels.\nThe levels of mats sales in a given quarter are determined by several factors, including customer demand, as well as our allocation of mat production between sales and deployment into our rental fleet. The allocation of our production between additions to our rental fleet and sales in any given quarter is driven by a number of factors including commitments to meeting customer schedules, ability of our customers to take delivery of mats, timing of large mat rental projects/events, and plant capacity/efficiencies. As noted above, in the first quarter of 2014, we allocated the majority of our composite mat production toward the expansion of our rental fleet, leaving fewer mats available for sale to customers. Based on the continuing strong demand for our mats in the rental fleet, we expect the majority of our production to continue to be dedicated toward the expansion of our rental fleet until completion of the new mat manufacturing facility, resulting in lower mat sales revenues and income.\n16\nCorporate Office\nCorporate office expenses increased $2.1 million to $8.4 million in the first quarter of 2014, compared to $6.2 million in the first quarter of 2013. The increase is primarily attributable to a $1.7 million increase in spending related to strategic planning projects, including the development of our deepwater market penetration strategy and international treasury and tax planning projects.\nLiquidity and Capital Resources\nNet cash provided by operating activities during the first quarter of 2014 totaled $3.6 million. During the first quarter of 2014, net cash provided by operating activities was negatively impacted by a $6.5 million reduction in accrued payroll and related costs, largely attributable to the first quarter payment of annual performance-based incentives, along with a $9.2 million increase in inventories, largely associated with the timing of receipts of barite ore purchased from China.\nNet cash provided by investing activities during the first quarter of 2014 was $71.4 million, primarily consisting of net proceeds from the sale of the Environmental Services business of $89.2 million offset by capital expenditures of $18.5 million. The first quarter of 2014 capital expenditures included $9.8 million in the Mats & Integrated Services segment, related to the deployment of produced mats into the rental fleet and the manufacturing plant expansion project described above.\nWe anticipate that our working capital requirements for our operations will decline in the near term due to continued efforts to reduce accounts receivable and inventory from the levels at March 31, 2014. We expect total 2014 capital expenditures to range between $65 million to $85 million. As of March 31, 2014, we had cash on-hand of $130.2 million of which $53.4 million resides within our foreign subsidiaries which we intend to leave permanently reinvested abroad. We expect our subsidiary cash on-hand, along with cash generated by operations and availability under our existing credit agreement to be adequate to fund our anticipated capital needs during the next 12 months.\nOur capitalization is as follows:\n\n| March 31, | December 31, |\n| (In thousands) | 2014 | 2013 |\n| Senior Notes | $ | 172,500 | $ | 172,500 |\n| Revolving credit facility | - | - |\n| Other | 16,030 | 13,153 |\n| Total | 188,530 | 185,653 |\n| Stockholder's equity | 607,555 | 581,054 |\n| Total capitalization | $ | 796,085 | $ | 766,707 |\n| Total debt to capitalization | 23.7 | % | 24.2 | % |\n\nOur financing arrangements include $172.5 million of Senior Notes and a $125.0 million revolving credit facility. The Senior Notes bear interest at a rate of 4.0% per year, payable semi-annually in arrears on April 1 and October 1 of each year, beginning April 1, 2011. Holders may convert the Senior Notes at their option at any time prior to the close of business on the business day immediately preceding the October 1, 2017 maturity date. The conversion rate is initially 90.8893 shares of our common stock per $1,000 principal amount of Senior Notes (equivalent to an initial conversion price of $11.00 per share of common stock), subject to adjustment in certain circumstances. Upon conversion, the Senior Notes will be settled in shares of our common stock. We may not redeem the Senior Notes prior to their maturity date.\n17\nOur revolving credit facility (the \"Credit Agreement\") provides for a $125.0 million revolving loan facility available for borrowings and letters of credit which expires in November 2016. The Credit Agreement can be increased by $75.0 million for a maximum $200.0 million of capacity. Under the terms of the Credit Agreement, we can elect to borrow at an interest rate either based on LIBOR plus a margin based on our consolidated leverage ratio, ranging from 175 to 300 basis points, or at an interest rate based on the greatest of: (a) prime rate, (b) the federal funds rate in effect plus 50 basis points, or (c) the Eurodollar rate for a Eurodollar Loan with a one-month interest period plus 100 basis points, in each case plus a margin ranging from 75 to 200 basis points. The applicable margin on LIBOR borrowings on March 31, 2014 was 200 basis points. In addition, we are required to pay a commitment fee on the unused portion of the Credit Agreement of 37.5 basis points. The Credit Agreement contains customary financial and operating covenants, including a consolidated leverage ratio, a senior secured leverage ratio and an interest coverage ratio. We were in compliance with these covenants as of March 31, 2014.\nAt March 31, 2014, we had letters of credit issued and outstanding under the Credit Agreement which totaled $31.4 million leaving $93.6 million of availability at March 31, 2014. Additionally, our foreign operations had $16.0 million outstanding under lines of credit and other borrowings, as well as $1.6 million outstanding in letters of credit.\nThe Credit Agreement is a senior secured obligation, secured by first liens on all of our U.S. tangible and intangible assets, including our accounts receivable and inventory. Additionally, a portion of the capital stock of our non-U.S. subsidiaries has also been pledged as collateral.\nCritical Accounting Estimates\nOur consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, which requires us to make assumptions, estimates and judgments that affect the amounts reported. We periodically evaluate our estimates and judgments related to uncollectible accounts and notes receivable, customer returns, reserves for obsolete and slow moving inventory, impairments of long-lived assets, including goodwill and other intangibles and our valuation allowance for deferred tax assets. Our estimates are based on historical experience and on our future expectations that we believe to be reasonable. The combination of these factors forms the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from our current estimates and those differences may be material.\nFor additional discussion of our critical accounting estimates and policies, see “Management's Discussion and Analysis of Financial Condition and Results of Operations” included in our Annual Report on Form 10-K for the year ended December 31, 2013. Our critical accounting policies have not changed materially since December 31, 2013.\n\n\nITEM 3.\nQuantitative and Qualitative Disclosures about Market Risk\nWe are exposed to market risk from changes in interest rates and changes in foreign currency rates. A discussion of our primary market risk exposure in financial instruments is presented below.\nInterest Rate Risk\nAt March 31, 2014, we had total debt outstanding of $188.5 million, including $172.5 million of Senior Notes, bearing interest at a fixed rate of 4.0%. Variable rate debt totaled $16.0 million which relates to our foreign operations under lines of credit and other borrowings. At the March 31, 2014 balance, a 200 basis point increase in market interest rates during 2014 would cause our annual interest expense to increase approximately $0.2 million.\n18\nForeign Currency\nOur principal foreign operations are conducted in certain areas of EMEA, Latin America, Asia Pacific, and Canada. We have foreign currency exchange risks associated with these operations, which are conducted principally in the foreign currency of the jurisdictions in which we operate which include European euros, Australian dollars, Canadian dollars, British pound and Brazilian reais. Historically, we have not used off-balance sheet financial hedging instruments to manage foreign currency risks when we enter into a transaction denominated in a currency other than our local currencies because the dollar amount of these transactions has not warranted our using hedging instruments.\n\n\nITEM 4.\nControls and Procedures\nEvaluation of disclosure controls and procedures\nBased on their evaluation of our disclosure controls and procedures as of the end of the period covered by this report, our Chief Executive Officer and Chief Financial Officer have concluded that the disclosure controls and procedures were effective as of March 31, 2014, the end of the period covered by this quarterly report.\nChanges in internal control over financial reporting\nThere has been no change in internal control over financial reporting during the quarter ended March 31, 2014 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\n\n| PART II | OTHER INFORMATION |\n\nITEM 1.\nLegal Proceedings\nThe information set forth in the legal proceedings section of “Note 9, Commitments and Contingencies,” to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q is incorporated by reference into this Item 1.\n\n\nITEM 1A.\nRisk Factors\nThere have been no material changes during the period ended March 31, 2014 in our “Risk Factors” as discussed in Item 1A to our Annual Report on Form 10-K for the year ended December 31, 2013.\n19\n\n\nITEM 2.\nUnregistered Sales of Equity Securities and Use of Proceeds\n\n| (a) | Not applicable |\n\n\n| (b) | Not applicable |\n\n\n| (c) | The following table details our repurchases of shares of our common stock, for the three months ended March 31, 2014: |\n\n\n| Total Number of | Maximum Approximate Dollar |\n| Shares Purchased as Part | Value of Shares that May Yet |\n| Total Number of | Average Price | of Publicly Announced | be Purchased Under |\n| Period | Shares Purchased | (1) | per Share | Plans or Programs | Plans or Programs |\n| January 1 - 31, 2014 | 876,820 | $ | 12.07 | 872,313 | $32.8 |\n| February 1 - 28, 2014 | - | - | - | $32.8 |\n| March 1 - 31, 2014 | 232,311 | 10.94 | 223,100 | $80.3 |\n| Total | 1,109,131 | $ | 11.83 | 1,095,413 |\n\n(1) During the three months ended March 31, 2014, we purchased an aggregate of 13,718 shares surrendered in lieu of taxes under vesting of restricted stock awards. In February 2014, the Company’s Board of Directors authorized an amendment to the $50.0 million repurchase program to increase the amount authorized to $100.0 million, subject to completion of the Environmental Services divesture which was completed in March 2014. Subsequent to quarter-end, we repurchased an additional 1,541,468 shares at an average cost of approximately $11.42 per share.\nITEM 3.\nDefaults Upon Senior Securities\nNot applicable.\n\n\nITEM 4.\nMine Safety Disclosures\nThe information concerning mine safety violations and other regulatory matters required by section 1503(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act and Item 104 of Regulation S-K is included in Exhibit 95.1 of this Quarterly Report on Form 10-Q, which is incorporated by reference.\n\n\nITEM 5.\nOther Information\nNone.\n20\n\n\nITEM 6.\nExhibits\n\n| *10.1 | Membership Interests Purchase Agreement dated as of February 10, 2014 by and among Newpark Resources, Inc., Newpark Drilling Fluids LLC and ecoserv, LLC. |\n\n\n| *31.1 | Certification of Paul L. Howes pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n\n\n| *31.2 | Certification of Gregg S. Piontek pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n\n\n| *32.1 | Certification of Paul L. Howes pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n\n\n| *32.2 | Certification of Gregg S. Piontek pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n\n*95.1 Reporting requirements under the Mine Safety and Health Administration.\n*101.INS XBRL Instance Document *101.SCH XBRL Schema Document *101.CAL XBRL Calculation Linkbase Document *101.LAB XBRL Label Linkbase Document *101.PRE XBRL Presentation Linkbase Document *101.DEF XBRL Definition Linkbase Document\n* Filed herewith.\n21\nNEWPARK RESOURCES, INC.\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\nDate: April 25, 2014\n\n| *95.1 | Reporting requirements under the Mine Safety and Health Administration. |\n\n\n| *101.INS | XBRL Instance Document |\n| *101.SCH | XBRL Schema Document |\n| *101.CAL | XBRL Calculation Linkbase Document |\n| *101.LAB | XBRL Label Linkbase Document |\n| *101.PRE | XBRL Presentation Linkbase Document |\n| *101.DEF | XBRL Definition Linkbase Document |\n\n22\nEXHIBIT INDEX\n\n| NEWPARK RESOURCES, INC. |\n| By: | /s/ Paul L. Howes |\n| Paul L. Howes, President and |\n| Chief Executive Officer |\n| (Principal Executive Officer) |\n\n\n| By: | /s/ Gregg S. Piontek |\n| Gregg S. Piontek, Vice President and |\n| Chief Financial Officer |\n| (Principal Financial and Accounting Officer) |\n\n\n| *10.1 | Membership Interests Purchase Agreement dated as of February 10, 2014 by and among Newpark Resources, Inc., Newpark Drilling Fluids LLC and ecoserv, LLC. |\n\n\n| *31.1 | Certification of Paul L. Howes pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n\n\n| *31.2 | Certification of Gregg S. Piontek pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n\n\n| *32.1 | Certification of Paul L. Howes pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n\n*101.INS XBRL Instance Document *101.SCH XBRL Schema Document *101.CAL XBRL Calculation Linkbase Document *101.LAB XBRL Label Linkbase Document *101.PRE XBRL Presentation Linkbase Document *101.DEF XBRL Definition Linkbase Document\n* Filed herewith.\n23\n</text>\n\nWhat is the percentage change in net cash flow from December 2013 to March 2014 after factoring in the revenues from the sale of Environmental services, acquisition, and share repurchase program?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nITEM 1. BUSINESS\nGeneral\nFLEETCOR is a leading global provider of commercial payment solutions. We help businesses of all sizes control, simplify and secure payment of various domestic and cross-border payables using specialized payment products. We serve businesses, merchants and partners in North America, Latin America, Europe, and Australasia. FLEETCOR’s predecessor company was organized in the United States in 1986, and FLEETCOR had its initial public offering in 2010 (NYSE: FLT).\nFLEETCOR has two reportable segments, North America and International. We report these two segments as they align with our senior executive organizational structure, reflect how we organize and manage our employees around the world, manage operating performance, contemplate the differing regulatory environments in North America versus other geographies, and help us isolate the impact of foreign exchange fluctuations on our financial results.\nOur payment solutions provide our customers with a payment method designed to be superior to and more robust and effective than what they use currently, whether they use a competitor’s product or another alternative method such as cash or check. Our solutions are comprised of payment products, networks and associated services.\nFLEETCOR payment products function like a charge card or prepaid card, and tend to be specialized for specific spend categories, such as fuel or lodging, and/or specific customer groups, such as long haul transportation. FLEETCOR’s five primary product lines are Fuel, Lodging, Tolls, Corporate Payments and Gift. Additionally, we provide other payment products including fleet maintenance, employee benefits and long haul transportation-related services. Our products are used in 56 countries around the world, with our primary geographies being the U.S., Brazil and the United Kingdom, which combined accounted for approximately 90% of our revenue in 2017.\nFLEETCOR uses both proprietary and third-party networks to deliver our payment solutions. FLEETCOR owns and operates proprietary networks with well-established brands throughout the world, bringing incremental sales and loyalty to affiliated merchants. Third-party networks are used to broaden payment product acceptance and use. In 2017, we processed approximately 3 billion transactions within these networks, of which approximately 1.4 billion were related to our Gift product line.\nFLEETCOR capitalizes on its products’ specialization with sales and marketing efforts by deploying product-dedicated sales forces to target specific customer segments. We market our products directly through multiple sales channels, including field sales, telesales and digital marketing, and indirectly through our partners, which include major oil companies, leasing companies, petroleum marketers, value-added resellers (VARs) and referral partners.\nWe believe that our size and scale, product breadth and specialization, geographic reach, proprietary networks, robust distribution capabilities and advanced technology contribute to our industry leading position.\nProducts and services\nWe offer specialized payment solutions predominately for commercial businesses. Our payment solutions are intended to provide our customers with a payment method superior to that which they formerly used, whether they used a competitor’s product or another alternative method such as cash or check. Our solutions are comprised of payment products, networks and associated services.\nOur payment products typically function like a charge card or prepaid card. FLEETCOR provides a variety of payment mechanisms such as a plastic card, electronic tag, or other form to the customer. We issue credit to the customer (or accept prepaid funds from the customer) to allow for purchases using the payment product. FLEETCOR then reports the purchases to the customer and invoices (or debits prepaid amounts) for payment of purchases made on the customer’s account.\nPayment networks are integral to our solutions, as they allow us to electronically connect to merchants and capture transaction data from the point of sale. We use both proprietary and third-party networks to deliver our payment solutions. For our proprietary networks, FLEETCOR provides merchant acquiring services, which may include affiliation, contract management, point-of-sale terminals, reporting and settlement. FLEETCOR owns and operates proprietary networks with well-established brands across 56 countries, bringing incremental sales and loyalty to affiliated merchants. Third-party networks include MasterCard in the U.S. and Visa in the U.K. and continental Europe, the retail outlets of various partners, and proprietary\n4\nnetworks owned and operated by other partners. We use these third-party networks in order to broaden our payment product acceptance and use. Through our proprietary and third-party networks, we capture detailed transaction data and can often enable advanced purchase controls at the point-of-sale.\nWe support our payment products with specialized issuing, processing and information services that enable us to manage customer accounts, facilitate the routing, authorization, clearing and settlement of transactions, and provide value-added functionality and data, including customizable user-level controls and productivity analysis tools. Our customers can use these data, controls and tools to lower their operating costs, and combat fraud and employee misuse and streamline expense administration.\nDepending on our customers’ and partners’ needs, we provide our products and services in a variety of combinations ranging from a comprehensive “end-to-end” solution (encompassing issuing, processing and network services) to limited back office processing services.\nOur solutions tend to be specialized for specific spend categories, such as fuel or lodging, and/or specific customer segments, such as long haul transportation. This specialization is manifested in the purchase controls, merchant network, and reporting applicable to the spend category or customer segment. For example, a fuel card could provide controls on the type of fuel purchased, be accepted only at gas stations for fuel purchases, and provide fuel usage and efficiency reports for a customer’s fleet of vehicles. The combination of these specialized attributes allows our payment products to compete well against less specialized products such as cash or general purpose credit cards when it comes to controlling purchases within certain spend categories.\nFLEETCOR’s five primary product lines are Fuel, Lodging, Tolls, Corporate Payments and Gift. Additionally, we provide other payment products including fleet maintenance, employee benefits and long haul transportation-related services.\nFuel payment product line\nOur fuel payment product line is our largest product category, representing approximately 49% of our revenue in 2017.\nFLEETCOR offers fuel payment solutions to businesses and government entities who operate vehicle fleets, as well as to major oil companies, leasing companies and fuel marketers. Our fuel payment products are most often in the form of plastic cards, but also include other forms such as electronic RFID tags and paper vouchers. While predominately used to purchase fuel, many of our fuel payment products have additional purchasing capabilities to allow customers to purchase non-fuel items such as oil, vehicle maintenance supplies and services and building supplies.\nOur fuel payment products, excluding paper vouchers, provide customers with tools and information to control their fuel and other fleet-related operating costs. Our proprietary processing and card management systems provide customers with customizable user-level controls, detailed transaction reporting, programmable alerts, configurable networks, contracted fuel price validation and audit, and vehicle efficiency analyses. Our customers can use these data, controls and tools to combat fraud and employee misuse, streamline expense administration and lower their vehicle fleets’ operating costs. The combination of these specialized attributes allows our fuel payment products to compete well against less specialized products such as cash or general purpose credit cards when it comes to controlling fuel purchases.\nFor major oil companies, leasing companies and petroleum marketers, we provide program management services which allow these partners to outsource the sales, marketing, credit, service, and system operations of their branded fuel card portfolios. Depending on our partners’ needs and internal capabilities, we provide our products and services in a variety of combinations ranging from a comprehensive “end-to-end” solution (encompassing issuing, processing and network services) to limited back office processing services. Our fuel payment product partners include British Petroleum (BP), its subsidiary Arco, Shell and Speedway, and over 775 fuel marketers of all sizes.\nWhile we refer to companies with whom we have strategic relationships as “partners,” our legal relationships with these companies are contractual, and do not constitute legal partnerships. Our contracts with our major oil company partners typically have initial terms of five to ten years with current remaining terms ranging from two to seven years. No single partner represented more than 10% of our consolidated revenue in any year during the last four years.\nWe use both proprietary and third-party networks to deliver our fuel payment solutions, including the following examples:\n5\nNorth America proprietary networks for fuel payment products\n\n| • | Fuelman network—our primary proprietary fleet card network in the U.S. We have negotiated card acceptance and settlement terms with approximately 11,000 individual merchants, providing the Fuelman network with approximately 59,000 fueling sites and approximately 28,000 maintenance sites across the country. |\n\n| • | Comdata network—our network of truck stops and fuel merchants for the over-the-road trucking industry. We have negotiated card acceptance and settlement terms at over 8,100 truck stops and fuel merchants across the U.S. and Canada. |\n\n| • | Commercial Fueling Network (CFN)—our “members only” fueling network in the U.S. and Canada composed of over 2,500 fueling sites owned by CFN members themselves. The majority of these fueling sites are unattended cardlock facilities located in commercial and industrial areas. |\n\n| • | Pacific Pride Fueling network—our \"franchise\" fueling network in the U.S. composed of over 1,100 fueling sites owned by more than 240 franchisees. The majority of these fueling sites are unattended cardlock facilities located in commercial and industrial areas. |\n\nInternational proprietary networks for fuel payment products\n\n| • | Allstar network—our proprietary fleet card network in the U.K. We have negotiated card acceptance and settlement terms with approximately 2,200 individual merchants, providing this network with over 7,300 fueling sites. |\n\n| • | Keyfuels network—our proprietary fleet card network in the U.K. We have negotiated card acceptance and settlement terms with more than 500 individual merchants, providing the Keyfuels network with approximately 2,800 fueling sites. |\n\n| • | CCS network—our primary proprietary fleet card network in the Czech Republic and Slovakia. We have negotiated card acceptance and settlement terms with several major oil companies on a brand-wide basis, including MOL, Benzina, OMV, Slovnaft and Shell, and with approximately 1,100 other merchants, providing the CCS network at over 2,600 fueling sites and 800 other sites accepting our cards. |\n\n| • | Petrol Plus Region (PPR) network—our primary proprietary fleet card network in Russia, Poland, Ukraine, Belarus, Kazakhstan and Moldova. We have negotiated card acceptance and settlement terms with over 700 individual merchants, providing the PPR network with approximately 13,500 fueling sites across the region. |\n\n| • | Efectivale network—our proprietary fuel card and voucher network in Mexico. We have negotiated acceptance and settlement terms individual merchants, providing the network with over 6,300 fueling sites. |\n\n| • | CTF network—our proprietary fuel controls network in Brazil, composed of over 1,700 highway fueling sites through our partners, BR Distribuidora (Petrobas) and Ipiranga Distribuidora. |\n\nThird-Party networks for fuel payments products\nIn addition to our proprietary “closed-loop” networks, we also utilize various third-party networks to deliver our payment programs and services. Examples of these networks include:\n\n| • | MasterCard network—In the U.S. and Canada, we issue co-branded MasterCard products which are accepted at over 175,000 fuel sites and 469,000 maintenance locations. These MasterCard products have additional purchasing capabilities which, when enabled, allow the cards to be accepted at approximately 10.9 million locations throughout the U.S. and Canada. |\n\n| • | Visa network—In the U.K., we issue products that utilize the Visa payment network, which includes over 8,400 fuel sites and 1,100 maintenance locations. These Visa products have additional purchasing capabilities which, when enabled, allow the cards to be accepted throughout the Visa network. |\n\n| • | Major oil and fuel marketer networks—The proprietary networks of branded locations owned by our major oil and fuel marketer partners in both North America and internationally are generally utilized to support the proprietary, branded card programs of these partners. |\n\n6\n| • | UTA network—UNION TANK Eckstein GmbH & Co. KG (UTA) operates a network of over 55,000 points of acceptance in 40 European countries, including more than 44,000 fueling sites. The UTA network is generally utilized by European transport companies that travel between multiple countries. |\n\n| • | DKV network—DKV operates a network of over 65,000 fleet card-accepting locations across more than 40 countries throughout Europe. The DKV network is generally utilized by European transport companies that travel between multiple countries. |\n\n| • | Carnet networks—A national debit network in Mexico, which includes over 11,500 fueling sites across the country. |\n\nWe distribute our fuel payment solutions through direct and indirect channels to businesses of all sizes. This includes businesses with small- to medium-sized fleets, which we believe represent an attractive segment of the global commercial fleet market given their relatively high use of less efficient payment products, such as cash and general purpose credit cards. We serve customers across numerous industry verticals and particularly those verticals with significant vehicle fueling needs such as trucking, construction, manufacturing, energy, and consumer products distribution.\nOur indirect channel includes our partners, such as major oil companies, leasing companies and fuel marketers. We generally provide our fuel payments solutions to our partners who offer our services under their own brands on a “white-label” basis. In turn, we leverage our partners’ brands, retail outlets, websites, and sales forces to help distribute our fuel payment products.\nIn Brazil, we have designed proprietary equipment which, when installed at the fueling site and on the vehicle and combined with our processing system, significantly reduces the likelihood of unauthorized and fraudulent transactions. We offer this product to over-the-road trucking fleets, shipping fleets and other operators of heavily industrialized equipment, including sea-going vessels, mining equipment, agricultural equipment, and locomotives. We generally co-brand this product with BR Distribuidora (Petrobas) or Ipiranga Distribuidora, depending on which fuel distributor provides fuel to our fleet clients via its retail and wholesale distribution operations.\nWith regard to our fuel payment products, we compete with independent fuel card issuers, major oil companies and petroleum marketers. Excluding major oil companies, our most significant competitors in this product category include WEX, U.S. Bank Voyager Fleet Systems, World Fuel Services, Edenred, Sodexo, Alelo, DKV, and Radius Payment Solutions.\nLodging payment product line\nWe offer lodging payment solutions to businesses in North America that have employees who travel overnight for work purposes. We offer two lodging payment products, a card-based solution for individual travelers and non-card based solution for crews. Our solutions can be customized to meet the specific needs of our customers, including access to a deeply discount hotel network and customer-specific rate negotiation, the ability to customize the network to fit customers’ specific travel needs and policies, enhanced controls and reporting, and audit and tax management services.\nOur lodging payment products operate on our proprietary CLC Lodging network, which includes over 16,700 hotels across the U.S. and Canada. We also can secure hotel rooms outside our proprietary network if required by our customers. The size, scale and nature of our lodging customer base enable us to negotiate lodging nightly rates lower than the rates most companies could negotiate directly and far below the rates available to the general public.\nOur customers can secure room nights with our solutions through our website or mobile app, by phone or email, or by walking into participating lodging properties and presenting their FLEETCOR lodging payment product credentials.\nFLEETCOR has developed data management and payment processing systems to manage client billings and reports which, combined with our discounted hotel network, provide clients with savings and increased visibility into their lodging costs.\nWe distribute our lodging payment solutions mostly through direct channels to businesses of all sizes and serve customers across a wide range of industries, including trucking, railroads, construction, telecom, energy, food service, retail distribution, and emergency response services such as FEMA and the American Red Cross. We provide our custom lodging solutions to large customers under contracts.\nOur lodging payment solutions compete with similar offerings from Travelliance, Egencia (Expedia), hotelengine.com, and in-house travel departments of large corporations.\n7\nToll payment product line\nIn Brazil, we offer an electronic toll and parking payments product to businesses and consumers in the form of RFID tags affixed to vehicles’ windshields. Our electronic toll and parking payments product operates on our proprietary Sem Parar network, which processed toll transactions for more than 3.2 million customers on 99% of the toll roads across Brazil. Our electronic tags may also be used to purchase fuel at select gas stations.\nElectronic tolling provides convenience and faster travel for customers, while also reducing manual labor and cash handling at merchants’ toll booths. At gas stations, payment via electronic tags is faster, safer and more secure for customers, which in turn increases loyalty and station throughput for merchants. Beyond these benefits, our electronic toll payment product also provides commercial customers with driver routing controls and fare auditing, mostly in the form of vehicle type and axle count configuration.\nFor certain commercial customers, we also offer prepaid paper vouchers as a means of payment on toll roads. We provide these vouchers to companies who contract with third-party drivers who do not have an electronic tag in their vehicles and for whom the companies are legally obligated to prepay tolls. Our paper toll vouchers are accepted for payment within our proprietary RODOCRED toll network, on behalf of more than 96,000 customers on all toll roads across Brazil.\nWe distribute our toll payment products through direct and indirect channels to customers of all sizes and across a broad number of industry verticals. To reach commercial customers, we utilize the same set of direct channels as our other commercially-focused product lines including field sales, telesales and digital marketing. To reach consumers, we also place proprietary manned kiosks and unmanned vending machines in areas with high consumer foot traffic, such as shopping malls.\nOur indirect channel includes a range of resellers and referral partners, including retail establishments with high consumer foot traffic such as grocery stores, pharmacies and gas stations. We provide our toll payment product to these partners under our brand and, in select cases, under the partner’s brand.\nOur electronic toll payment product competes with similar offerings such as Move Mais, ConectCar (Banco Itaú and Ipiranga), Veloe (Alelo), Repom (Edenred), and Visa Vale (Banco Bradesco).\nCorporate payments product line\nWe offer a broad suite of corporate payments solutions with vertical-specific applications, which enable our customers to manage and control electronic payments across their enterprise, optimize corporate spending and offer innovative services that increase employee efficiency and customer loyalty. Our primary corporate payments products include virtual cards, purchasing cards, travel & entertainment (T&E) cards, payroll cards and cross-border payment facilitation. These products are predominately marketed in North America, with cross-border payments also offered in the United Kingdom and Australia. This collection of comprehensive solutions positions us to enable automation and savings across a customer’s entire accounts payables (A/P) process, including both domestic and international payables.\nA virtual card provides a single-use card number for a specific amount within a defined timeframe and serves as a highly-effective replacement for check payments. Virtual cards provide enhanced security relative to checks while reducing payment costs for our customers. Full remittance data accompanies each virtual card payment, providing significant reconciliation advantages to ACH payments. We have integrated our virtual card offering into most leading ERP systems, providing a seamless experience for accounts payable personnel to select our virtual card as the payment mechanism of choice.\nFLEETCOR’s virtual card product operates on the Mastercard payment network. We have built a network of approximately 700,000 merchants that accept our virtual card payments, which has been growing at an average rate of 12,500 merchants per month. This network is managed with proprietary technology that allows us to continuously expand virtual card acceptance and optimize the amount of virtual card spend we can capture. This network, coupled with a best-in-class, in-house vendor enrollment service, is a major competitive advantage.\nOur purchasing and T&E cards operate on the MasterCard payment network and are accepted at approximately 10.7 million locations throughout the United States and Canada. These card products are generally sold in conjunction with our virtual card offering to augment our customers’ purchasing capabilities. FLEETCOR also provides full A/P outsourcing services for customers who send us their entire A/P file and allow us to execute payments across all modalities, including the aforementioned products as well as ACH, wires and checks. We also provide expense management software, which combines and leverages transaction data captured from our virtual, purchasing and T&E card products to help our customers analyze and control their corporate spending.\n8\nOur virtual, purchasing and T&E card products compete with similar offerings from large financial institutions such as Bank of America, Citibank, J.P. Morgan Chase, PNC Bank, U.S. Bank, Wells Fargo and American Express.\nFLEETCOR offers a payroll card product in the form of a reloadable stored value card, which operates on the MasterCard payment network and the All Point ATM network. These cards are distributed to our customers’ employees and are funded by our customers with their employees’ earned wages. As cardholders, the employees may present the payroll card as a form of payment for personal purchases, transfer funds to their bank account or withdraw funds from participating ATMs.\nOur payroll card product competes with similar offerings from First Data Corporation, Fidelity National Information Services, Global Cash Card, Green Dot Financial, Total System Services, Automatic Data Processing, Paychex and Heartland Payment Systems.\nFLEETCOR’s cross-border payment services are offered predominantly to commercial customers, who range from small businesses to mid-cap corporate entities. Customers generally use our cross-border payment services to pay international suppliers, foreign office and personnel expenses, capital expenditures, and profit repatriation and dividends. We administer foreign exchange trades and payment settlement with recipients through a global network of banks, enabling us to send payments to recipients in over 200 countries and in over 140 currencies. We employ rigorous compliance standards in all geographies where we are licensed. By using transaction monitoring and watch list screening systems, we ensure payments are safe, secure, and meet all applicable regulatory requirements.\nOur cross-border payment services compete with similar offerings from Western Union Business Solutions, Associated Foreign Exchange (AFEX), WorldFirst, Moneycorp, HiFX, Currencies Direct, GPS Capital Markets and large financial institutions.\nFLEETCOR’s corporate payment solutions are enabled by our technology and operations. Our ERP integrations, API capabilities, strategic vendor enrollment, and transaction management tools enable us to optimize our customers’ electronic payables programs.\nWe distribute our corporate payment solutions through direct and indirect channels to businesses of all sizes and types across a broad number of industry verticals. We serve customers across numerous industry verticals, such as retail, healthcare, construction, manufacturing, hospitality, energy, entertainment, insurance and trade finance. As FLEETCOR both issues and processes its virtual cards and commercial cards, we have the control and flexibility to meet the unique needs of customers in different verticals.\nWe generally provide our domestic corporate payment solutions under contracts with our customers. Pricing terms vary based on usage volumes, incentives and contract duration. When our corporate payment solutions include short term credit, our contracts for those solutions contain credit and collection terms.\nOur indirect channel includes a broad range of VARs and other referral partners that expand our reach into new customer segments, new industry verticals and new geographies faster and at a significantly lower cost. We provide our corporate payments solutions to these partners who offer our services under our brands or their own brands on a “white-label” basis. For example, we provide healthcare payment solutions through healthcare networks, corporate payment solutions through software and services providers and payroll card solutions through payroll service providers.\nGift payment product line\nWe provide fully integrated gift card product management and processing services in over 55 different countries around the world. These products come in the form of plastic and digital gift cards, carry our customers’ brands and are generally accepted exclusively within the retail network, websites, and mobile applications of each respective customer.\nOur services include card design, production and packaging, delivery and fulfillment, card and account management, transaction processing, promotion development and management, website design and hosting, program analytics, and card distribution channel management. The combination of our products and services provides a turnkey solution to our customers, who benefit in the form of brand promotion, cardholder loyalty, increased sales, interest income on prepaid balances, and breakage on abandoned card balances.\nWe distribute our gift payment products and services directly through a specialized, dedicated field sales force. We serve our commercial customers in numerous industry verticals, with a focus in restaurants, supermarkets, drugstores, airlines, hotels, apparel and other retail categories. We help our commercial customers manage distribution with omni-channel strategies which include card sales through the customers’ retail outlets, websites and mobile applications, as well as through third party\n9\nlocations, such as supermarkets and drug stores. This third party distribution is generally provided by other companies, such as Blackhawk and InComm, who are reliant on access to our systems to meet their distribution obligations.\nWe compete with a number of national companies in providing gift cards, the largest of which include First Data Corporation and Vantiv. We also compete with businesses that rely on in-house solutions.\nAdditional products\nFLEETCOR provides several other payment products that, due to their nature or size, are not considered primary product lines.\nFleet maintenance\nWe provide a vehicle maintenance service offering that helps fleet customers to manage their vehicle maintenance, service, and repair needs in the U.K. This product is provided through our proprietary 1link maintenance and repair network which processes transactions for fleet customers through approximately 9,400 service centers across the U.K. With regard to our fleet maintenance product, we compete with several companies including Ebbon-Dacs and Fleet on Demand.\nEmployee benefit payments\nIn Mexico, we offer prepaid food vouchers and cards that may be used as a form of payment in restaurants and grocery stores. These payment products operate on one of the following networks:\n| • | Efectivale network—also our proprietary food card and voucher network in Mexico. We have negotiated acceptance and settlement terms with over 56,700 individual merchants, providing the network with over 44,600 food locations and 5,800 restaurants. |\n\n| • | Carnet network—a national debit network in Mexico, which also includes over 47,400 food locations across the country. |\n\nIn Brazil, we offer prepaid transportation cards and vouchers that may be used as a form of payment on public transportation such as buses, subways and trains. Our proprietary VB Servicos, Comercio e Administracao LTDA (“VB”) distribution network distributes cards and vouchers to employees on behalf of approximately 26,000 customers and negotiates with more than 1,400 public transportation agencies across Brazil.\nWe provide these various payment products to businesses of all sizes and industry verticals and the businesses in turn offer the products to their employees as a form of benefit. With regard to our employee benefit payment products, we compete with numerous companies, the largest of which includes Edenred, Sodexo, Chèque Déjeuner, and Alelo.\nLong haul transportation services\nIn addition to, and often in conjunction with our fuel payment product, we provide trucking companies in North America with various products and services specifically relevant to their industry, including road tax compliance analysis and reporting, permit procurement, and cash movement and disbursement. We compete with several companies in providing these products and services, including EFS (WEX), Keller, and RTS Financial.\nCompetition\nWe face considerable competition in our business. The most significant competitive factors in our business are the breadth of product and service features, credit extension, payment terms, customer service and account management, and price. For certain payment-related products, we also compete on the respective size or nature (i.e., open versus closed loop) of each product’s acceptance network. For certain payment processing services, systems and technology are also significant competitive factors. We believe that we generally compete favorably with respect to each of these factors. However, we may experience competitive disadvantages with respect to each of these factors from time to time as potential customers prioritize or value these competitive factors differently. As a result, a specific offering of our products and service features, networks and pricing may serve as a competitive advantage with respect to one customer and a disadvantage for another based on the customers’ preferences. The companies with whom we compete often vary by product line and/or geography, and are therefore identified by name in the respective product line discussions.\n10\nSales and marketing\nWe market our products and services to prospective customers in North America and internationally through multiple channels including field sales, telesales, direct marketing, point-of-sale marketing and the internet. We also leverage the sales and marketing capabilities of our strategic relationships. Worldwide, our sales and marketing employees are focused on acquiring new customers and retaining existing customers for our different products. We also utilize tradeshows, advertising and other awareness campaigns to further market our products and services.\nWe utilize proprietary and third-party databases to develop our prospect universe and segment those prospects by various characteristics, including industry, geography, size, and credit score, to identify potential customers. We develop customized offers for different types of potential customers and work to deliver those offers through the most effective marketing channel. We actively manage prospects across our various marketing channels to optimize our results and avoid marketing channel conflicts.\nOur primary means of acquiring new customers include:\n| • | Field sales—Our field sales organizations are comprised of remote or local office-based sales representatives who conduct face-to-face sales presentations and product demonstrations with prospects, assist with post-sale program implementation and training, and provide in-person account management. Field sales representatives also attend and manage our marketing at tradeshows. Our field sales force is generally dedicated to specific products or service categories and tend to target larger prospects. |\n\n| • | Telesales—We have telesales representatives handling inbound and outbound sales calls. |\n\n| • | Our inbound call volume is primarily generated as a result of marketing activities, including direct marketing, point-of-sale marketing and the internet. |\n\n| • | Our outbound phone calls typically target prospects that have expressed an initial interest in our services or have been identified through database analysis as prospective customers. Our telesales teams are generally dedicated to a specific product or service category and tend to target smaller prospects. We also leverage our telesales channel to cross-sell additional products to existing customers. |\n\n| • | Digital marketing—We manage numerous marketing websites around the world which tend to fall into two categories: product-specific websites and marketing portals. |\n\n| • | Product-specific websites—Our product-specific websites, including fuelman.com, checkinncard.com, allstarcard.co.uk and semparar.com.br, focus on one or more specific products, provide the most in-depth information available online regarding those particular products, allow prospects to apply online (where appropriate) and allow customers to access and manage their accounts online. We manage product-specific websites for our own proprietary programs, as well as white labeled sites for our strategic relationships. |\n\n| • | Marketing portals—Our marketing portals, including fleetcardsUSA.com and fuelcards.co.uk, serve as information sources for fleet operators interested in fleet card products. In addition to providing helpful information on fleet management, including maintenance, tax reporting and fuel efficiency, these websites allow fleet operators to research card products, compare the features and benefits of multiple products, and identify the card product which best meets the fleet manager’s needs. |\n\nAs part of our digital marketing strategy, we monitor and modify our marketing websites to improve our search engine rankings and test our advertising keywords to optimize our banner advertising placement and costs and our pay-per-click advertising spend among the major internet search firms such as Google and Yahoo.\n| • | Direct marketing—We market directly to potential customers via mail and email. We test various program offers and promotions, and adopt the most successful features into subsequent direct marketing initiatives. We seek to enhance the sales conversion rates of our direct marketing efforts by coordinating timely follow-up calls by our telesales teams. |\n\n| • | Point-of-sale marketing—We provide marketing literature at the point-of-sale within our proprietary networks and those of our partner relationships. Literature may include “take-one” applications, pump-top advertising and in-store advertising. Our point-of-sale marketing leverages the branding and distribution reach of the physical merchant locations. |\n\n11\nAccount management\n\n| • | Customer service, account activation, account retention—We provide account management and customer service to our customers. Based in dedicated call centers across our key markets, these professionals handle transaction authorizations, billing questions and account changes. Customers also have the opportunity to self-service their accounts through interactive voice response and online tools. We monitor the quality of the service we provide to our customers by adhering to industry standard service levels with respect to abandon rates and answer times and through regular agent call monitoring. We also conduct regular customer surveys to ensure customers are satisfied with our products and services. In addition to our base customer service support, we provide the following specialized services: |\n\n| • | Implementation and activation—We have dedicated implementation teams that are responsible for establishing the system set-up for each customer account. These teams focus on successful activation and utilization of our new customers and provide training and education on the use of our products and services. Technical support resources are provided to support the accurate and timely set-up of technical integrations between our proprietary processing systems and customer systems (e.g., payroll, enterprise resource planning and point-of-sale). Larger accounts are provided dedicated program managers who are responsible for managing and coordinating customer activities for the duration of the implementation. These program managers are responsible for the successful set-up of accounts to meet stated customer objectives. |\n\n| • | Strategic account management—We assign designated account managers who serve as the single point of contact for our large accounts. Our account managers have in-depth knowledge of our programs and our customers’ operations and objectives. Our account managers train customer administrators and support them on the operation and optimal use of our programs, oversee account setup and activation, review online billing and create customized reports. Our account managers also prepare periodic account reviews, provide specific information on trends in their accounts and work together to identify and discuss major issues and emerging needs. |\n\n| • | Account retention—We have proprietary, proactive strategies to contact customers who may be at risk of terminating their relationship with us. Through these strategies we seek to address service concerns, enhance product structures and provide customized solutions to address customer issues. |\n\n| • | Customer service—Day-to-day servicing representatives are designated for customer accounts. These designated representatives are responsible for the daily service items and issue resolution of customers. These servicing representatives are familiar with the nuanced requirements and specifics of a customer’s program. Service representatives are responsible for customer training, fraud disputes, card orders, card maintenance, billing, etc. |\n\n| • | Cardholder support—We provide cardholder support for individuals utilizing our payment products. This support allows cardholders to activate cards, check balances, and resolve issues in a timely and effective fashion. Cardholder support is conducted 24 hours a day, seven days per week in multiple languages utilizing telephony, web and call center technologies to deliver comprehensive and cost effective servicing. We have rigorous operational metrics in place to increase cardholder responsiveness to corporate and customer objectives. |\n\n| • | Merchant network services—Our representatives work with merchants such as fuel, toll operators and vehicle maintenance providers to enroll them in one of our proprietary networks, install and test all network and terminal software and hardware and train them on the sale and transaction authorization process. In addition, our representatives provide transaction analysis and site reporting and address settlement issues. |\n\n| • | Call center program administrator—Off-hour call center support is provided to customers to handle time-sensitive requests and issues outside of normal business hours. |\n\n| • | Management tools—We offer a variety of online servicing tools that enable customers to identify and provide authority to program administrators to self-service their accounts. |\n\n\n| • | Credit underwriting and collections—We follow detailed application credit review, account management, and collections procedures for all customers of our payment solutions. We use multiple levers including billing frequency, payment terms, spending limits and security to manage risk in our portfolio. For the years ended December 31, 2017 and 2016, our bad debt expense was $44.9 million and $35.9 million, or 7 bps and 8 bps, respectively. |\n\n| • | New account underwriting—We use a combination of quantitative, third-party credit scoring models and judgmental underwriting to screen potential customers and establish appropriate credit terms and spend |\n\n12\nlimits. Our underwriting process provides additional scrutiny for large credit amounts and we utilize tiered credit approval authority among our management.\n| • | Prepaid and secured accounts—We also offer products and services on a prepaid or fully-secured basis. Prepaid customer accounts are funded with an initial deposit and subsequently debited for each purchase transacted on the cards issued to the customer. Fully-secured customer accounts are secured with cash deposits, letters of credit and/or insurance bonds. The security is held until such time as the customer either fails to pay the account or closes its account after paying outstanding amounts. Under either approach, our prepaid and fully-secured offerings allow us to market to a broader universe of prospects, including customers who might otherwise not meet our credit standards. |\n\n| • | Monitoring and account management—We use fraud detection programs, including both proprietary and third-party solutions, to monitor transactions and prevent misuse of our products. We monitor the credit quality of our portfolio periodically utilizing external credit scores and internal behavior data to identify high risk or deteriorating credit quality accounts. We conduct targeted strategies to minimize exposure to high risk accounts, including reducing spending limits and payment terms or requiring additional security. |\n\n| • | Collections—As accounts become delinquent, we may suspend future transactions based on our risk assessment of the account. Our collections strategy includes a combination of internal and outsourced resources which use both manual and dialer-based calling strategies. We use a segmented collection strategy which prioritizes higher risk and higher balance accounts. For severely delinquent, high balance accounts we may pursue legal remedies. |\n\nTechnology\nOur technology provides continuous authorization of transactions, processing of critical account and client information and settlement between merchants, issuing companies and individual commercial entities. We recognize the importance of state-of-the-art, secure, efficient and reliable technology in our business and have made significant investments in our applications and infrastructure. In 2017, we spent more than $185 million in capital and operating expenses to operate, protect and enhance our technology and expect to continue the build out of our proprietary processing platform in Europe and Asia, as well as the integration of our recently acquired businesses.\nOur technology function is based in the United States, Europe and Brazil and has expertise in the management of applications, transaction networks and infrastructure. We operate application development centers in the United States, United Kingdom, Netherlands, Russia, Czech Republic, Brazil and New Zealand. Our distributed application architecture allows us to maintain, administer and upgrade our systems in a cost-effective and flexible manner. We integrate our systems with third-party vendor applications for certain products, sales and customer relationship management and back-office support. Our technology organization has undertaken and successfully executed large scale projects to develop or consolidate new systems, convert oil company and petroleum marketer systems and integrate acquisitions while continuing to operate and enhance existing systems.\nOur technology infrastructure is supported by highly-secure data centers, with redundant locations. We operate our primary data centers, which are located in Atlanta, Georgia; Brentwood, Tennessee; Prague; Czech Republic; Las Vegas, Nevada; Lexington and Louisville, Kentucky; Sao Paulo, Brazil; Toronto, Canada and Moscow, Russia. We use only proven technology and have no foreseeable capacity limitations. Our systems align with industry standards for security with multiple industry certifications. Our network is configured with multiple layers of security to isolate our databases from unauthorized access. We use security protocols for communication among applications, and our employees access critical components on a need-only basis. As of December 31, 2017, we are not aware of any material breach of our data security systems. See Item 1A, “Risk Factors-We may not be able to adequately protect our systems or the data we collect from continually evolving cybersecurity risks or other technological risks, which could subject us to liability and damage our reputation” for a discussion of the potential data breach and cybersecurity risks facing the Company.\nWe maintain disaster recovery and business continuity plans. Our telecommunications and internet systems have multiple levels of redundancy to ensure reliability of network service. In 2017, we experienced 99.9% up-time for authorizations.\nProprietary processing systems\nWe operate several proprietary processing systems that provide features and functionality to run our card programs and product offerings, including our card issuing, processing and information services. Our processing systems also integrate with our proprietary networks, which provide brand awareness and connectivity to our acceptance locations that enables the “end-to-\n13\nend” card acceptance, data capture and transaction authorization capabilities of our card programs. Our proprietary processing systems and aggregation software are tailored to meet the unique needs of the individual markets they serve and enable us to create and deliver commercial payment solutions and stored value programs that serve each of our industry verticals and geographies. Our technology platforms are primarily comprised of four key components, which were primarily developed and are maintained in-house: (1) a core processing platform; (2) specialized software; (3) integrated network capabilities; and (4) a cloud based architecture with proprietary APIs.\nIntellectual property\nOur intellectual property is an important element of our business. We rely on trademark, copyright, trade secret, patent and other intellectual property laws, confidentiality agreements, contractual provisions and similar measures to protect our intellectual property. Our employees involved in technology development in some of the countries in which we operate, including the United States, are required to sign agreements acknowledging that all intellectual property created by them on our behalf is owned by us. We also have internal policies regarding the protection, disclosure and use of our confidential information. Confidentiality, license or similar agreements or clauses are generally used with our business partners and vendors to control access, use and distribution of our intellectual property. Unauthorized persons may attempt to obtain our intellectual property despite our efforts and others may develop similar intellectual property independently. We own trade names, service marks, trademarks and registered trademarks supporting a number of our brands, such as FLEETCOR, Fuelman, Comdata, and Comchek (among others) in the United States. We also own trademarks and registered trademarks in various foreign jurisdictions for a number of our brands, such as Keyfuels, AllStar, CTF, and Sem Parar (among others). We hold a number of patents and pending applications relating to payment cards and fuel tax returns.\nAcquisitions\nSince 2002, we have completed over 75 acquisitions of companies and commercial account portfolios, including the acquisition of Cambridge Global Payments in August 2017. Acquisitions have been an important part of our growth strategy, and it is our intention to continue to seek opportunities to increase our customer base and diversify our service offering through further strategic acquisitions. For a discussion of recent acquisitions, see “Management’s Discussion and Analysis of Financial Conditions and Results of Operations—Acquisitions”.\nRegulatory\nA substantial number of laws and regulations, both in the United States and in other jurisdictions, apply to businesses offering payment cards to customers or processing or servicing for payment cards and related accounts. These laws and regulations are often evolving and sometimes ambiguous or inconsistent, and the extent to which they apply to us is at times unclear. Failure to comply with regulations may result in the suspension or revocation of licenses or registrations, the limitation, suspension, or termination of services, and/or the imposition of civil and criminal penalties, including fines. Certain of our services are also subject to rules set by various payment networks, such as MasterCard, as more fully described below.\nThe following, while not exhaustive, is a description of several federal and state laws and regulations in the United States that are applicable to our business. The laws and regulations of other jurisdictions also affect us, and they may be more or less restrictive than those in the United States and may also impact different parts of our operations. In addition, the legal and regulatory framework governing our business is subject to ongoing revision, and changes in that framework could have a significant effect on us.\nMoney Transmission and Payment Instrument Licensing Regulations\nWe are subject to various U.S. laws and regulations governing money transmission and the issuance and sale of payment instruments relating to certain aspects of our business. In the United States, most states license money transmitters and issuers of payment instruments. Through our subsidiaries, we are licensed in all states where required for business. Many states exercise authority over the operations of our services related to money transmission and payment instruments and, as part of this authority, subject us to periodic examinations, which may include a review of our compliance practices, policies and procedures, financial position and related records, privacy and data security policies and procedures, and other matters related to our business. Some state agencies conduct periodic examinations and issue findings and recommendations as a result of which we make changes to our operations, such as improving our reporting processes, detailing our intercompany arrangements, and implementing new or revising existing policies and procedures such as our anti-money laundering and the U.S. Department of Treasury's Office of Foreign Assets Control (\"OFAC\") compliance program and complaints management process, and improvements to our documentation processes.\n14\nAs a licensee, we are subject to certain restrictions and requirements, including net worth and surety bond requirements, record keeping and reporting requirements, requirements for regulatory approval of controlling stockholders, and requirements to maintain certain levels of permissible investments in an amount equal to our outstanding payment obligations. Many states also require money transmitters and issuers of payment instruments to comply with federal and/or state anti-money laundering laws and regulations. Many states require prior approval for both direct and indirect changes of control of the licensee and certain other corporate events.\nGovernment agencies may impose new or additional requirements on money transmission and sales of payment instruments, and we expect that compliance costs will increase in the future for our regulated subsidiaries.\nPrivacy and Information Security Regulations\nWe provide services that may be subject to various state, federal, and foreign privacy laws and regulations, including, among others, the Financial Services Modernization Act of 1999, which we refer to as the Gramm-Leach-Bliley Act, and Directive 95/46/EC, and the Personal Information Protection and Electronic Documents Act in Canada. These laws and their implementing regulations restrict certain collection, processing, storage, use, and disclosure of personal information, require notice to individuals of privacy practices, and provide individuals with certain rights to prevent use and disclosure of protected information. These laws also impose requirements for the safeguarding and proper destruction of personal information through the issuance of data security standards or guidelines. Certain federal, state and foreign laws and regulations impose similar privacy obligations and, in certain circumstances, obligations to notify affected individuals, state officers or other governmental authorities, the media, and consumer reporting agencies, as well as businesses and governmental agencies, of security breaches affecting personal information. In addition, there are state and foreign laws restricting the ability to collect and utilize certain types of information such as Social Security and driver’s license numbers. In February 2013, the European Commission proposed additional European Union-wide legislation regarding cyber security in the form of the proposed NIS Directive. The NIS Directive was adopted by the European Parliament in July 2016 and entered into force in August 2016. The NIS Directive provides legal measures intended to boost the overall level of cybersecurity in the EU by ensuring: (1) Member States’ preparedness by requiring them to be appropriately equipped, for example, via a Computer Security Incident Response Team and a competent national NIS authority; (2) cooperation among all the Member States, by setting up a cooperation group, in order to support and facilitate strategic cooperation and the exchange of information among Member States; and (3) a culture of security across sectors vital to the EU’s economy and society, including banking, financial market infrastructures and digital infrastructure.\nAs a processor of personal data of EU data subjects, we are also subject to regulation and oversight in the applicable EU Member States with regard to data protection legislation. The existing Data Protection Directive, contains various obligations on the processing of personal data in the EU including restrictions on transferring personal data outside of the EU to countries which have not been recognized as having adequate data protection standards, unless specific conditions are met. Our EU operations are currently operating in accordance with these standards. In May 2018, a new European wide Regulation on data privacy will come into force. The General Data Protection Regulation (the “GDPR”) contains additional obligations on data controllers and data processors operating in the EU or offering services to consumers within the EU. While the core rules contained in the Data Protection Directive are retained in GDPR, there are significant enhancements with regard to the rights of data subjects (which include the right to be forgotten and the right of data portability), stricter regulation on obtaining consent to processing of personal data and sensitive personal data, stricter obligations with regard to the information to be included in privacy notices and significant enhanced requirements with regard to compliance, including a regime of “accountability” for processors and controllers and a requirement to embed compliance with GDPR into the fabric of an organization by developing appropriate policies and practices, to achieve a standard of data protection by “design and default.” The GDPR includes enhanced data security obligations (to run in parallel to those contained in NIS regulations), requiring data processors and controllers to take appropriate technical and organizational measures to protect the data they process and their systems. Organizations that process significant amounts of data may be required to appoint a Data Protection Officer responsible for reporting to highest level of management within the business. There are greatly enhanced sanctions under GDPR for failing to comply with the core principles of the GDPR or failing to secure data. We are working to prepare for the GDPR in readiness for its implementation in May 2018.\nIn addition, there are state laws restricting the ability to collect and utilize certain types of information such as Social Security and driver’s license numbers. Certain state laws impose similar privacy obligations as well as obligations to provide notification of security breaches of computer databases that contain personal information to affected individuals, state officers and consumer reporting agencies and businesses and governmental agencies that own data.\nCertain of our products that access payment networks require compliance with Payment Card Industry (“PCI”) standards. Our subsidiary, Comdata Inc., is PCI 3.2 compliant and its Attestation of Compliance is listed on MasterCard’s compliant\n15\nservice provider listing. Failure to maintain compliance with updates to PCI data security standards including having effective technical and administrative safeguards and policies and procedures could result in fines and assessments from payment networks and regulatory authorities, as well as litigation.\nFederal Trade Commission Act\nAll persons engaged in commerce, including, but not limited to, us and our bank sponsors and customers are subject to Section 5 of the Federal Trade Commission Act prohibiting unfair or deceptive acts or practices, and certain products are subject to the jurisdiction of the Consumer Financial Protection Bureau (\"CFPB\") regarding the prohibition of unfair, deceptive, or abusive acts and practices (both, collectively, UDAAP). Various federal and state regulatory enforcement agencies including the Federal Trade Commission (“FTC”), CFPB and the state attorneys general have authority to take action against businesses, merchants and financial institutions that engage in UDAAP or violate other laws, rules and regulations. If we violate such laws, rules and regulations, we may be subject to enforcement actions and as a result, may incur losses and liabilities that may impact our business. A number of state laws and regulations also prohibit unfair and deceptive business practices.\nTruth in Lending Act\nThe Truth in Lending Act, or TILA, was enacted as a consumer protection measure to increase consumer awareness of the cost of credit and to protect consumers from unauthorized charges or billing errors, and is implemented by Regulation Z. Most provisions of TILA and Regulation Z apply only to the extension of consumer credit, but a limited number of provisions apply to commercial cards as well. One example where TILA and Regulation Z are generally applicable is a limitation on liability for unauthorized use, although a business that acquires 10 or more credit cards for its personnel can agree to more expansive liability. Our cardholder agreements generally provide that these business customers waive, to the fullest extent possible, all limitations on liability for unauthorized card use.\nCredit Card Accountability, Responsibility, and Disclosure Act of 2009\nThe Credit Card Accountability, Responsibility, and Disclosure Act of 2009 is an act that, among other things, amended provisions of TILA that affect consumer credit and also directed the Federal Reserve Board to study the use of credit cards by small businesses and to make legislative recommendations. The report concluded that it is not clear whether the potential benefits outweigh the increased cost and reduced credit availability if the disclosure and substantive restrictions applicable to consumer cards were to be applied to small business cards. Legislation has been introduced, from time to time, to increase the protections afforded to small businesses that use payment cards. If legislation of this kind were enacted, our products and services for small businesses could be adversely impacted.\nEqual Credit Opportunity Act\nThe Equal Credit Opportunity Act, or ECOA, together with Regulation B prohibit creditors from discriminating on certain prohibited bases, such as an applicant’s sex, race, nationality, age and marital status, and further requires that creditors disclose the reasons for taking any adverse action against an applicant or a customer seeking credit.\nThe Fair Credit Reporting Act\nThe Fair Credit Reporting Act, or FCRA, regulates consumer reporting agencies and the disclosure and use of consumer reports. We may obtain consumer reports with respect to an individual who guarantees or otherwise is obligated on a commercial card.\nFACT Act\nThe Fair and Accurate Credit Transactions Act of 2003 amended FCRA and requires creditors to adopt identity theft prevention programs to detect, prevent and mitigate identity theft in connection with covered accounts, which can include business accounts for which there is a reasonably foreseeable risk of identity theft.\nAnti-Money Laundering and Counter Terrorist Regulations\nThe Currency and Foreign Transactions Reporting Act, which is also known as the Bank Secrecy Act (the \"BSA\") and which has been amended by the USA PATRIOT Act of 2001, contains a variety of provisions aimed at fighting terrorism and money laundering. Our business in Canada is also subject to Proceeds of Crime (Money Laundering) and Terrorist Financing Act, or the PCTFA, which is a corollary to the BSA. Among other things, the BSA and implementing regulations issued by the U.S. Treasury Department require financial-services providers to establish anti-money laundering programs, to not engage in terrorist financing, to report suspicious activity, and to maintain a number of related records.\nNon-banks that provide certain financial services are required to register with the Financial Crimes Enforcement Network of the U.S. Department of the Treasury (FinCEN) as “money services businesses” (MSBs). Through certain subsidiaries, we are\n16\nregistered as MSBs. As a result, we have established anti-money laundering compliance programs that include: (i) internal policies and controls; (ii) designation of a compliance officer; (iii) ongoing employee training; and (iv) an independent review function. We have developed and implemented compliance programs comprised of policies, procedures, systems and internal controls to monitor and address various legal requirements and developments.\nIn addition, provisions of the BSA known as the Prepaid Access Rule issued by FinCEN impose certain obligations, such as registration and collection of consumer information, on “providers” of certain prepaid access programs, including the stored value products issued by our sponsor banks for which we serve as program manager. FinCEN has taken the position that, where the issuing bank has principal oversight and control of such prepaid access programs, no other participant in the distribution chain would be required to register as a provider under the Prepaid Access Rule. Despite this position, we have opted to register as a provider of prepaid access through our subsidiary, Comdata Inc. We are also subject to certain economic and trade sanctions programs that are administered by the OFAC that prohibit or restrict transactions to or from or dealings with specified countries, their governments and, in certain circumstances, their nationals, narcotics traffickers, and terrorists or terrorist organizations.\nDodd-Frank Wall Street Reform and Consumer Protection Act\nThe Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, or the Dodd-Frank Act, effected comprehensive revisions to a wide array of federal laws governing financial institutions, financial services, and financial markets. Among its most notable provisions is the creation of the CFPB, which is charged with regulating consumer financial products or services and which is assuming much of the rulemaking authority under TILA, ECOA, FCRA, and other federal laws affecting the extension of credit. In addition to rulemaking authority over several enumerated federal consumer financial protection laws, the CFPB is authorized to issue rules prohibiting unfair, deceptive, and abusive acts and practices (UDAAP) by persons offering consumer financial products or services and their service providers, and has authority to enforce these consumer financial protection laws and CFPB rules. The CFPB has not defined what is a consumer financial product or service but has indicated informally that, in some instances, small businesses may be covered under consumer protection.\nAs a service provider to certain of our bank sponsors, we may be subject to direct supervision and examination by the CFPB, in connection with certain of our products and services. CFPB rules, examinations and enforcement actions may require us to adjust our activities and may increase our compliance costs.\nIn addition, the Durbin Amendment to the Dodd-Frank Act provided that interchange fees that a card issuer or payment network receives or charges for debit transactions will now be regulated by the Federal Reserve and must be “reasonable and proportional” to the cost incurred by the card issuer in authorizing, clearing and settling the transaction. Payment network fees may not be used directly or indirectly to compensate card issuers in circumvention of the interchange transaction fee restrictions. In July 2011, the Federal Reserve published the final rules governing debit interchange fees. Effective in October 2011, with certain exceptions, debit interchange rates are capped at $0.21 per transaction with an additional component of five basis points of the transaction’s value to reflect a portion of the issuer’s fraud losses plus, for qualifying issuing financial institutions, an additional $0.01 per transaction in debit interchange for fraud prevention costs. The cap on interchange fees is not expected to have a material direct impact on our results of operations because we qualify for an exemption for the majority of our debit transactions.\nThe implementation of the Dodd-Frank Act is ongoing, and as a result, its overall impact remains unclear. Its provisions, however, are sufficiently far reaching that it is possible that we could be further directly or indirectly impacted.\nAnti-Bribery Regulations\nThe FCPA prohibits the payment of bribes to foreign government officials and political figures and includes anti-bribery provisions enforced by the Department of Justice and accounting provisions enforced by the SEC. The statute has a broad reach, covering all U.S. companies and citizens doing business abroad, among others, and defining a foreign official to include not only those holding public office but also local citizens affiliated with foreign government-run or -owned organizations. The statute also requires maintenance of appropriate books and records and maintenance of adequate internal controls to prevent and detect possible FCPA violations.\nPayment Card Industry Rules\nBanks issuing payment cards bearing the MasterCard brand, and FLEETCOR to the extent that we provide certain services in connection with those cards and fleet customers acting as merchants accepting those cards, must comply with the bylaws, regulations and requirements that are promulgated by MasterCard and other applicable payment-card organizations, including the Payment Card Industry Data Security Standard developed by MasterCard and VISA, the MasterCard Site Data Protection Program and other applicable data-security program requirements. A breach of such payment card network rules could subject\n17\nus to a variety of fines or penalties that may be levied by the payment networks for certain acts or omissions. The payment networks routinely update and modify their requirements. Our failure to comply with the networks’ requirements or to pay the fines they impose could cause the termination of our registration and require us to stop processing transactions on their networks.\nWe are also subject to network operating rules promulgated by the National Automated Clearing House Association relating to payment transactions processed by us using the Automated Clearing House Network.\nEscheat Regulations\nWe may be subject to unclaimed or abandoned property (escheat) laws in the United States that require us to turn over to certain government authorities the property of others that we hold that has been unclaimed for a specified period of time such as payment instruments that have not been presented for payment and account balances that are due to a customer following discontinuation of our relationship. We may be subject to audit by individual U.S. states with regard to our escheatment practices.\nPrepaid Card Regulations\nPrepaid card programs managed by us are subject to various federal and state laws and regulations, in addition to those identified above, including the Credit Card Accountability Responsibility and Disclosure Act of 2009 and the Federal Reserve’s Regulation E, which impose requirements on general-use prepaid cards, store gift cards and electronic gift certificates. These laws and regulations are evolving, unclear and sometimes inconsistent and subject to judicial and regulatory challenge and interpretation, and therefore the extent to which these laws and rules have application to, and their impact on us, is in flux. At this time we are unable to determine the impact that the clarification of these laws and their potential application and future interpretations, as well as new laws, may have on us in a number of jurisdictions. On October 5, 2016, the Consumer Financial Protection Bureau issued a final rule amending Regulations E and Z to create comprehensive consumer protections for prepaid financial products, and on January 25, 2018, the CFPB released final amendments to the final rule, clarifying certain disclosure provisions and reducing potential liability with respect to cardholders who are not registered and verified. These changes include a delay of the final rule’s effective date until April 1, 2019. The extensive nature of these regulations and the implementation dates for this additional rulemaking may result in additional compliance obligations and expense for our business.\nState Usury Laws\nExtensions of credit under many of our card products may be treated as commercial loans. In some states, usury laws limit the interest rates that can be charged not only on consumer loans but on commercial loans as well. To the extent that these usury laws apply, we are limited in the amount of interest that we can charge and collect from our customers. Because we have substantial operations in multiple jurisdictions, we utilize choice of law provisions in our cardholder agreements as to the laws of which jurisdiction to apply. In addition, the interest rates on certain of our card products are set based upon the usury limit of the cardholder’s state. With respect to card products where we work with a partner or issuing bank, the partner bank may utilize the law of the jurisdiction applicable to the bank and “exports” the usury limit of that state in connection with cards issued to residents of other states or we may use our choice of law provisions.\nOther\nWe are subject to examination by our sponsor banks’ regulators, and must comply with certain regulations to which our sponsor banks are subject, as applicable. We are subject to audit by certain sponsor banks.\nThe Housing Assistance Tax Act of 2008 requires information returns to be made for each calendar year by merchants acquiring entities and third-party settlement organizations with respect to payments made in settlement of electronic payment transactions and third-party payment network transactions occurring in that calendar year. Reportable transactions are also subject to backup withholding requirements. We are required to comply with these requirements for the merchants in our Comdata network. We could be liable for penalties if our information return is not in compliance with these regulations.\nEmployees and labor relations\nAs of December 31, 2017, we employed approximately 7,890 employees, approximately 2,620 of whom were located in the United States. We consider our employee relations to be good and have never experienced a work stoppage.\nAdditional Information\nOur website address is www.fleetcor.com. You may obtain free electronic copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements and all related amendments required to be filed or\n18\nfurnished pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, at our website under the headings “Investor Relations—SEC Filings.” Information from our website is not incorporated by reference into this annual report on Form 10-K.\n19\nITEM X. EXECUTIVE OFFICERS OF THE REGISTRANT\nThe following table sets forth certain information regarding our executive officers, with their respective ages as of December 31, 2017. Our officers serve at the discretion of our board of directors. There are no family relationships between any of our directors or executive officers.\n| Name | Age | Position(s) |\n| Ronald F. Clarke | 62 | Chief Executive Officer and Chairman of the Board of Directors |\n| Eric R. Dey | 58 | Chief Financial Officer |\n| Kurt P. Adams | 48 | President—Comdata Corporate Payments |\n| Andrew R. Blazye | 59 | President—International Corporate Development |\n| John S. Coughlin | 50 | Executive Vice President—Global Corporate Development |\n| Pedro L. Donda | 64 | President-—Serviços e Tecnologia de Pagamentos S.A. (\"STP\") |\n| Charles R. Freund | 45 | Executive Vice President—Corporate Strategy |\n| Alexey P. Gavrilenya | 41 | President—Continental Europe |\n| Alan King | 41 | President—UK, Australia and New Zealand |\n| David D. Maxsimic | 58 | President—North America Partners |\n| Armando L. Netto | 49 | President—Brazil |\n| John A. Reed | 63 | Technology Executive Officer |\n| Gregory L. Secord | 55 | President—Comdata North America Trucking and CLC Lodging |\n\nRonald F. Clarke has been our Chief Executive Officer since August 2000 and was appointed Chairman of our board of directors in March 2003. From 1999 to 2000, Mr. Clarke served as President and Chief Operating Officer of AHL Services, Inc., a staffing firm. From 1990 to 1998, Mr. Clarke served as Chief Marketing Officer and later as a division president with Automatic Data Processing, Inc. (ADP), a computer services company. From 1987 to 1990, Mr. Clarke was a principal with Booz Allen Hamilton, a global management consulting firm. Earlier in his career, Mr. Clarke was a marketing manager for General Electric Company, a diversified technology, media, and financial services corporation.\nEric R. Dey has been our Chief Financial Officer since November 2002. From October 2000 to October 2002, Mr. Dey served as Chief Financial Officer of NCI Corporation, a call center company. From July 1999 to October 2000, Mr. Dey served as Chief Financial Officer of Leisure Time Technology, a software development/manufacturing company. From 1994 to 1999, Mr. Dey served as Corporate Controller with Excel Communications, a telecommunications service provider. From 1984 to 1994, Mr. Dey held a variety of financial and accounting positions with PepsiCo, Inc., a global beverage, snack and food company.\nKurt P. Adams joined us in September 2015 as our President—Comdata Corporate Payments. Prior to joining us, Mr. Adams was most recently President, Corporate Payments Solutions for U.S. Bancorp. Prior to that, Mr. Adams led strategy and planning for NOVA Information Systems (now Elavon – a U.S. Bancorp subsidiary) in Europe. Prior to his career in payments, Mr. Adams enjoyed a successful investment banking career with Piper Jaffray.\nAndrew R. Blazye has served as our President—International Corporate Development since 2012. From July 2007 to May 2012, Mr. Blazye served as our Chief Executive Officer—FLEETCOR Europe. From April 2006 to June 2007, Mr. Blazye was a Group Director for Dunnhumby Ltd., a research firm. From September 1980, to March 2006, Mr. Blazye held various positions with Shell International Ltd., a subsidiary of Royal Dutch Shell plc, a global energy company, including Global Payments General Manager.\nJohn S. Coughlin has served as our Executive Vice President—Global Corporate Development since September 2010. From 2007 to 2010, Mr. Coughlin served as a Managing Director at PCG Capital Partners, a private equity firm. From 2005 to 2006, Mr. Coughlin served as Chief Executive Officer of NCDR LLC, a private equity owned national dental practice management company. From 1994 to 2005, Mr. Coughlin was with The Parthenon Group, a strategic advisory and principal investment firm, where he was a Senior Partner and the founder and head of the firm’s San Francisco office. From 1990 to 1992, Mr. Coughlin was an investment banker with Credit Suisse First Boston.\nPedro L. Donda has served as our President—STP since our acquisition of the business in August 2016. Mr. Donda served in this role at STP, since 2006. From 2001 to 2003, Mr. Donda served as a Chief Executive Officer at IBOPE, a market research company in Brazil. Mr. Donda founded and led Americanas.com, a B2W Digital business in e-commerce. From 1990 to 1998, Mr. Donda founded and led Interchange, an electronic data interchange provider for banks, as well as specializing in logistics\n20\nand consumer packaged goods supply-chain. From 1980 to 1989, Mr. Donda, was an executive within Citibank N.A. Prior to this, Mr. Donda served in various technology positions.\nCharles R. Freund was named our Executive Vice President-Corporate Strategy in January 2017 and has been with us since 2000. During his tenure with FLEETCOR, Mr. Freund has held numerous roles including Executive Vice President-Global Sales, President-Emerging Markets, Senior Vice President-Corporate Strategy, Managing Director-The Fuelcard Company UK Limited, and Vice President of Business Development.\nAlexey P. Gavrilenya was named President—Continental Europe in February 2016, adding to his responsibilities as President—Central/Eastern Europe. Mr. Gavrilenya has been President, Eastern Europe since May 2011, where he has been responsible for PPR and NKT. From March 2009 to April 2011, Mr. Gavrilenya served as our Executive Vice President Strategy and Finance, Eastern Europe. Prior to joining us, Mr. Gavrilenya was Chief Financial Officer of Matarex, Ltd.\nAlan King joined us in August 2016 as our President—UK, Australia and New Zealand. Prior to joining us, Mr. King held various positions at MasterCard from 2005 to 2016, including Managing Director of MasterCard Prepaid Management Services, Group Head of Global Prepaid Solutions, Group General Manager for Market and Business Development in the UK and Ireland and General Manager of Global Accounts. Prior to MasterCard, Mr. King held leadership positions at VISA in the CEMEA region from 2003 to 2005 and at Citibank from 1998 to 2003, largely across commercial payments in international markets. Mr. King spent the early part of his career in the telecom and automotive industries, in various sales and marketing roles covering Europe.\nDavid D. Maxsimic was named President—North America Partners in November 2015 and in July 2017 assumed leadership of the U.S. sales shared services. Mr. Maxsimic joined us in January 2015 as our Group CEO—UK and Australasia. Prior to joining us, Mr. Maxsimic held various positions at WEX (also known as Wright Express) from 1997 to 2014, including President International, executive vice president of sales and marketing, senior vice president of sales, and vice president and general manager for Wright Express Direct Card. Prior to WEX, Mr. Maxsimic served as senior sales executive for several major fleet service companies, including U.S. Fleet Leasing, GE Capital Fleet Services, and PHH Fleet America. Mr. Maxsimic has over 25 years of experience in sales, marketing and managing customer relationships, in addition to managing and executing sales of complex financial services.\nArmando L. Netto joined us in June 2014 as our President—Brazil. Prior to joining us, Mr. Netto led IT Services for TIVIT, an IT and BPO services company, from 2006 to 2014, where he led the integration of functional areas into the business unit, focused on onboarding new clients and ensured service quality. Prior to TIVIT, Mr. Netto held various leadership roles with Unisys and McKinsey, where he gained international experience in Europe supporting clients in the UK, France, Austria, Portugal and the Netherlands.\nJohn A. Reed was named Technology Executive Officer effective January 2018, over system development and emerging technologies. Prior to this role, Mr. Reed served as our Global Chief Information Officer over product development and IT operations since 2013. From 2000 to 2009, Mr. Reed served various technology leadership roles at MBNA/Bank of America, Zurich Insurance and Unisys. From 1997 to 2000, Mr. Reed was the President and Managing Director for Business Innovations Inc., a financial services technology consulting company.\nGregory L. Secord joined us in July 2015 as our President—Comdata North America Trucking and in July 2017 assumed leadership of the U.S. operations shared services. Prior to joining us, Mr. Secord worked with ADP, where he was President—ADP Canada operations. Prior to his 20 year career with ADP, Mr. Secord held sales and marketing management roles with Canon and Xerox.\n21\nITEM 1A. RISK FACTORS\nYou should carefully consider the following risks applicable to us. If any of the following risks actually occur, our business, operating results, financial condition and the trading price of our common stock could be materially adversely affected. The risks discussed below also include forward-looking statements, and our actual results may differ substantially from those discussed in these forward-looking statements. See \"Note Regarding Forward-Looking Statements\" in this report.\nRisks related to our business\nA decline in retail fuel prices could adversely affect our revenue and operating results.\nOur fleet customers use our products and services primarily in connection with the purchase of fuel. Accordingly, our revenue is affected by fuel prices, which are subject to significant volatility. A decline in retail fuel prices could cause a decrease in our revenue from fees paid to us by merchants based on a percentage of each transaction purchase amount. We believe that in 2017, approximately 13% our consolidated revenue was directly influenced by the absolute price of fuel. Changes in the absolute price of fuel may also impact unpaid account balances and the late fees and charges based on these amounts. A decline in retail fuel prices could adversely affect our revenue and operating results.\nFuel prices are dependent on several factors, all of which are beyond our control. These factors include, among others:\n\n| • | supply and demand for oil and gas, and market expectations regarding supply and demand; |\n\n| • | actions by members of OPEC and other major oil-producing nations; |\n\n| • | new oil production being developed in the U.S. and elsewhere; |\n\n| • | political conditions in oil-producing and gas-producing nations, including insurgency, terrorism or war; |\n\n| • | oil refinery capacity; |\n\n| • | weather; |\n\n| • | the prices of foreign exports; |\n\n| • | speculative trading; |\n\n| • | the implementation of fuel efficiency standards and the adoption by our fleet customers of vehicles with greater fuel efficiency or alternative fuel sources; |\n\n| • | general worldwide economic conditions; and |\n\n| • | governmental regulations, taxes and tariffs. |\n\nA portion of our revenue is derived from fuel-price spreads. As a result, a contraction in fuel-price spreads could adversely affect our operating results.\nApproximately 10% of our consolidated revenue in 2017 was derived from transactions where our revenue is tied to fuel-price spreads. Fuel-price spreads equal the difference between the fuel price we charge to the fleet customer and the fuel price paid to the fuel merchant. In transactions where we derive revenue from fuel-price spreads, the fuel price paid to the fuel merchant is calculated as the merchant’s wholesale cost of fuel plus a commission. The merchant’s wholesale cost of fuel is dependent on several factors including, among others, the factors described above affecting fuel prices. The fuel price that we charge to our fleet customer is dependent on several factors including, among others, the fuel price paid to the fuel merchant, posted retail fuel prices and competitive fuel prices. We experience fuel-price spread contraction when the merchant’s wholesale cost of fuel increases at a faster rate than the fuel price we charge to our fleet customers, or the fuel price we charge to our fleet customers decreases at a faster rate than the merchant’s wholesale cost of fuel. Accordingly, when fuel-price spreads contract, we generate less revenue, which could adversely affect our operating results.\nIf we fail to adequately assess and monitor credit risks of our customers, we could experience an increase in credit loss.\nWe are subject to the credit risk of our customers which range in size from small sole proprietorships to large publicly traded companies. We use various methods to screen potential customers and establish appropriate credit limits, but these methods cannot eliminate all potential credit risks and may not always prevent us from approving customer applications that are not credit-worthy or are fraudulently completed. Changes in our industry, customer demand, and, in relation to our fleet customers, movement in fuel prices may result in periodic increases to customer credit limits and spending and, as a result, could lead to increased credit losses. We may also fail to detect changes to the credit risk of customers over time. Further, during a declining economic environment, we experience increased customer defaults and preference claims by bankrupt customers. If we fail to adequately manage our credit risks, our bad debt expense could be significantly higher than historic levels and adversely affect our business, operating results and financial condition. Our bad debt expense was $44.9 million in 2017 and $35.9 million in 2016, or 7 bps in 2017 and 8 bps in 2016, respectively.\n22\nWe derive a significant portion of our revenue from program fees and charges paid by the users of our cards. Any decrease in our receipt of such fees and charges, or limitations on our fees and charges, could adversely affect our business, results of operations and financial condition.\nOur card programs include a variety of fees and charges associated with transactions, cards, reports, optional services and late payments. Revenues for late fees and finance charges represent 6% of our consolidated revenue for the year ended December 31, 2017. If the users of our cards decrease their transaction activity, or the extent to which they use optional services or pay invoices late, our revenue could be materially adversely affected. In addition, several market factors can affect the amount of our fees and charges, including the market for similar charges for competitive card products and the availability of alternative payment methods such as cash or house accounts. Furthermore, regulators and Congress have scrutinized the electronic payments industry’s pricing, charges and other practices related to its customers. Any legislative or regulatory restrictions on our ability to price our products and services could materially and adversely affect our revenue. Any decrease in our revenue derived from these fees and charges could materially and adversely affect our business, operating results and financial condition.\nWe operate in a competitive business environment, and if we are unable to compete effectively, our business, operating results and financial condition would be adversely affected.\nThe market for our products and services is highly competitive, and competition could intensify in the future. Our competitors vary in size and in the scope and breadth of the products and services they offer. In the fleet card business, our primary competitors in North America are small regional and large independent fleet card providers, major oil companies and petroleum marketers that issue their own fleet cards, and major financial services companies that provide card services to major oil companies and petroleum marketers. In the commercial payments business, we face a variety of competitors, some of which have greater financial resources, name recognition and scope and breadth of products and services. Competitors in the hotel card business include travel agencies, online lodging discounters, internal corporate procurement and travel resources, and independent services companies. We also compete for customers with providers of alternative payment mechanisms, such as merchants offering house cash accounts or other forms of credit. Our primary competitors in Europe, Australia and New Zealand are independent fleet card providers, major oil companies and petroleum marketers that issue branded fleet cards, and providers of card outsourcing services to major oil companies and petroleum marketers. Our primary competitors in Latin America are independent providers of fleet cards and vouchers for food, fuel, tolls, and transportation and major oil companies and providers of card outsourcing services to major oil companies and petroleum marketers who offer commercial fleet cards.\nThe most significant competitive factors in our business are the breadth of product and service features, network acceptance size, customer service, account management, and price. We may experience competitive disadvantages with respect to any of these factors from time to time as potential customers prioritize or value these competitive factors differently. As a result, a specific offering of our products and service features, networks and pricing may serve as a competitive advantage with respect to one customer and a disadvantage for another based on the customers’ preferences.\nSome of our existing and potential competitors have longer operating histories, greater brand name recognition, larger customer bases, more extensive customer relationships or greater financial and technical resources than we do. In addition, our larger competitors may also have greater resources than we do to devote to the promotion and sale of their products and services and to pursue acquisitions. Many of our competitors provide additional and unrelated products and services to customers, such as treasury management, commercial lending and credit card processing. By providing these services that we do not provide, these competitors have an advantage of being able to bundle their products and services together and present them to existing customers with whom they have established relationships, sometimes at a discount. For example, in the commercial payments business, we compete with full service banks that are able to offer treasury management and commercial lending in addition to commercial payment solutions. If price competition continues to intensify, we may have to increase the incentives that we offer to our customers, decrease the prices of our products and services or lose customers, each of which could adversely affect our operating results. In the fleet card business, major oil companies and petroleum marketers and large financial institutions may choose to integrate fuel-card services as a complement to their existing card products and services, as well as offer add-on complementary services. As a result, they may be able to adapt more quickly to new or emerging technologies and changing opportunities, standards or customer requirements. To the extent that our competitors are regarded as leaders in specific categories, they may have an advantage over us as we attempt to further penetrate these categories.\nFuture mergers or consolidations among competitors, or acquisitions of our competitors by large companies may present competitive challenges to our business. Resulting combined entities could be at a competitive advantage if their fuel-card products and services are effectively integrated and bundled into sales packages with their widely utilized non-fuel-card-related products and services. Further, competitors may reduce the fees for their services, which could increase pricing pressure within our markets.\n23\nOverall, increased competition in our markets could result in intensified pricing pressure, reduced profit margins, increased sales and marketing expenses and a failure to increase, or a loss of, market share. We may not be able to maintain or improve our competitive position against our current or future competitors, which could adversely affect our business, operating results and financial condition.\nOur fleet card business is dependent on several key strategic relationships, the loss of which could adversely affect our operating results.\nWe intend to seek to expand our strategic relationships with major oil companies and to establish additional relationships with other petroleum marketers. We refer to the major oil companies and petroleum marketers with whom we have strategic relationships as our “partners.” We use this term in the business sense to refer to strategic business relationships formed through contracts such as Card Program Agreements, and not in the legal sense of operating under legal partnership arrangements created pursuant to laws such as the Uniform Partnership Act. During 2017, our top three strategic relationships with major oil companies accounted for less than 6% of our consolidated revenue. Our agreements with our major oil company partners typically have initial terms of five to ten years with current remaining terms ranging from about one to six years.\nThe success of our business is in part dependent on our ability to maintain these strategic relationships and enter into additional strategic relationships with major oil companies. In our relationships with these major oil companies, our services are marketed under our partners’ brands. If these partners fail to maintain their brands or decrease the size of their branded networks, our ability to grow our business may be adversely affected. Also, our inability to maintain or further develop these relationships or add additional strategic relationships could materially and adversely affect our business and operating results.\nTo enter into a new strategic relationship or renew an existing strategic relationship with a major oil company, we often must participate in a competitive bidding process, which may focus on a limited number of factors, including pricing. The bidding and negotiating processes generally occur over a protracted time period. The use of these processes may affect our ability to effectively compete for these relationships. Our competitors may be willing to bid for these contracts on pricing or other terms that we consider uneconomical in order to win business. The loss of our existing major oil company partners or the failure to contract or delays in contracting with additional partners could materially and adversely affect our business, operating results and financial condition.\nIn 2016, we received notice from an oil partner that they did not intend to renew our current contract when it expired at the end of 2017. Additionally, in 2017, we signed an agreement to extend the management of the commercial fuel card program for a strategic partner. We do not expect these contracts to have a material impact on our business and operating results.\nWe depend, in part, on our merchant relationships to grow our business. To grow our customer base in the closed loop fleet card and lodging card businesses, we must retain and add relationships with merchants who are located in areas where our customers purchase fuel, maintenance services and lodging. If we are unable to maintain and expand these relationships, our closed loop fleet card and lodging card businesses may be adversely affected.\nWith respect to the closed loop networks we utilize, a portion of our growth is derived from acquiring new merchant relationships to serve our customers, new and enhanced product and service offerings, and cross-selling our products and services through existing merchant relationships. We rely on the continuing growth of our merchant relationships and our distribution channels in order to expand our customer base. There can be no guarantee that this growth will continue. Similarly, our growth also will depend on our ability to retain and maintain existing merchant relationships that accept our proprietary closed-loop networks in areas where our customers purchase fuel and lodging. Our contractual agreements with fuel merchants and service garages typically have initial terms of one or two years and automatically renew on the same basis unless either party gives notice of termination. Our agreements with lodging providers typically have initial terms of one year and automatically renew on a month-to-month basis unless either party gives notice of termination. Furthermore, merchants with which we have relationships may experience bankruptcy, financial distress, or otherwise be forced to contract their operations. The loss of existing merchant relationships, failure to continue such relationships on similarly attractive economic terms, the contraction of our existing merchants’ operations or the inability to acquire new merchant relationships could adversely affect our ability to serve our customers and our business and operating results.\nWe depend on our relationships with major truck stop merchants to serve our over-the-road fuel card customers. We must maintain these relationships to effectively serve our customers that use these merchants. If we are unable to maintain these relationships, our over-the-road fuel card businesses may be adversely affected.\nWe have long standing relationships with major truck stop merchants to accept our over-the-road fuel cards. Over-the-road customers purchase a significant proportion of their fuel at major truck stop merchants. The loss of existing major truck stop\n24\nmerchant relationships or failure to continue such relationships on similar terms could adversely affect our ability to serve our over-the-road fuel card customers and our business and operating results.\nA decline in general economic conditions, and in particular, a decline in demand for fuel and other business related products and services would adversely affect our business, operating results and financial condition.\nOur operating results are materially affected by conditions in the economy generally, both in the U.S and internationally. We generate revenue based in part on the volume of purchase transactions we process. Our transaction volume is correlated with general economic conditions, particularly in the U.S., Europe, Russia, Latin America, Australia and New Zealand, and the amount of business activity in economies in which we operate. Downturns in these economies are generally characterized by reduced commercial activity and, consequently, reduced purchasing of fuel and other business related products and services by our customers. The commercial payments industry in general, and our commercial payment solutions business specifically, depends heavily upon the overall level of spending. Unfavorable changes in economic conditions, including declining consumer confidence, inflation, recession, political climate or other changes, may lead our corporate customers to reduce their spending, resulting in reduced demand for, or use of, our products and services. In addition, unfavorable changes in economic conditions, may lead our fleet card customers to demand less fuel, or lead our partners to reduce their use of our products and services. As a result, a sustained deterioration in general economic conditions in the U.S. or abroad could have a material adverse effect on our revenue and profitability.\nFurther, economic conditions also may impact the ability of our customers or partners to pay for fuel or other services they have purchased and, as a result, our reserve for credit losses and write-offs of accounts receivable could increase. A weakening economy could also force some retailers and merchants to close, resulting in exposure to potential credit losses and transaction declines. In addition, demand for fuel and other business related products and services may be reduced by other factors that are beyond our control, such as the development and use of vehicles with greater fuel efficiency and alternative fuel sources.\nWe are unable to predict the likely duration of current economic conditions in the U.S., Europe, Russia, Latin America, Australia and New Zealand. As a result, weaknesses in general economic conditions or increases in interest rates in key countries in which we operate could adversely affect our business and operating results.\nWe have expanded into new lines of business in the past and may do so in the future. If we are unable to successfully integrate these new businesses, our results of operations and financial condition may be adversely affected.\nWe have expanded our business to encompass new lines of business in the past. For example, we have entered into the corporate payments, stored value card, vehicle maintenance management and telematics business in the U.S. and Europe, and transaction processing, fuel, food, toll and transportation card and voucher businesses in Brazil and Mexico. We may continue to enter into new lines of business and offer new products and services in the future. There is no guarantee that we will be successful in integrating these new lines of business into our operations. If we are unable to do so, our operating results and financial condition may be adversely affected.\nIf we fail to develop and implement new technology, products and services, adapt our products and services to changes in technology, the marketplace requirements, or if our ongoing efforts to upgrade our technology, products and services are not successful, we could lose customers and partners.\nThe markets for our products and services are highly competitive and characterized by technological change, frequent introduction of new products and services and evolving industry standards. We must respond to the technological advances offered by our competitors and the requirements of our customers and partners, in order to maintain and improve upon our competitive position and fulfill contractual obligations. We may be unsuccessful in expanding our technological capabilities and developing, marketing or selling new products and services that meet these changing demands, which could jeopardize our competitive position. In addition, we engage in significant efforts to upgrade our products and services and the technology that supports these activities on a regular basis.\nThe products we deliver are designed to process complex transactions and provide reports and other information on those transactions, all at high volumes and processing speeds. Any failure to deliver an effective and secure product or service or any performance issue that arises with a new product or service could result in significant processing or reporting errors or other losses. We may rely on third parties to develop or co-develop our solutions or to incorporate our solutions into broader platforms for the commercial payments industry. We may not be able to enter into such relationships on attractive terms, or at all, and these relationships may not be successful. In addition, partners, some of whom may be our competitors or potential competitors, may choose to develop competing solutions on their own or with third parties. Even if we are successful in developing new services and technologies, these new services and technologies may not achieve broad acceptance due to a\n25\nvariety of factors, including a lack of industry-wide standards, competing products and services, or resistance to these changes from our customers. In addition, we may not be able to derive revenue from these efforts.\nIf we are unsuccessful in completing the migration of material technology, otherwise upgrading our products and services and supporting technology or completing or gaining market acceptance of new technology, products and services, it would have a material adverse effect on our ability to retain existing customers and attract new ones in the impacted business line.\nOur debt obligations, or our incurrence of additional debt obligations, could limit our flexibility in managing our business and could materially and adversely affect our financial performance.\nAt December 31, 2017, we had approximately $4.47 billion of debt outstanding under our Credit Facility and Securitization Facility. In addition, we are permitted under our credit agreement to incur additional indebtedness, subject to specified limitations. Our substantial indebtedness currently outstanding, or as may be outstanding if we incur additional indebtedness, could have important consequences, including the following:\n\n| • | we may have difficulty satisfying our obligations under our debt facilities and, if we fail to satisfy these obligations, an event of default could result; |\n\n| • | we may be required to dedicate a substantial portion of our cash flow from operations to required payments on our indebtedness, thereby reducing the availability of cash flow for acquisitions, working capital, capital expenditures and other general corporate activities. See \"Management’s Discussion and Analysis of Financial Condition and Results of Operations—Contractual Obligations,\" which sets forth our payment obligations with respect to our existing long-term debt; |\n\n| • | covenants relating to our debt may limit our ability to enter into certain contracts or to obtain additional financing for acquisitions, working capital, capital expenditures and other general corporate activities; |\n\n| • | covenants relating to our debt may limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate, including by restricting our ability to make strategic acquisitions; |\n\n| • | we may be more vulnerable than our competitors to the impact of economic downturns and adverse developments in the industry in which we operate; |\n\n| • | we are exposed to the risk of increased interest rates because certain of our borrowings are subject to variable rates of interest; |\n\n| • | although we have no current intention to pay any dividends, we may be unable to pay dividends or make other distributions with respect to your investment; and |\n\n| • | we may be placed at a competitive disadvantage against any less leveraged competitors. |\n\nThe occurrence of one or more of these potential consequences could have a material adverse effect on our business, financial condition, operating results, and ability to satisfy our obligations under our indebtedness.\nIn addition, we and our subsidiaries may incur substantial additional indebtedness in the future. Although our credit agreements contain restrictions on the incurrence of additional indebtedness, these restrictions are subject to a number of significant qualifications and exceptions, and under certain circumstances, the amount of additional indebtedness that could be incurred in compliance with these restrictions could be substantial. If new debt is added to our existing debt levels, the related risks that we will face would increase.\nWe meet a significant portion of our working capital needs through a securitization facility, which we must renew every three years.\nWe meet a significant portion of our working capital needs through a securitization facility, pursuant to which we sell accounts receivable to a special-purpose entity that in turn sells undivided participation interests in the accounts receivable to certain purchasers, who finance their purchases through the issuance of short-term commercial paper. The securitization facility has a three year term. Although we have been able to renew our Securitization Facility annually in the past, there can be no assurance that we will continue to be able to renew this facility in the future on terms acceptable to us. For example, the market for commercial paper experienced significant volatility during the financial crisis that began in 2008. Also, a significant rise in fuel prices could cause our accounts receivable to increase beyond the capacity of the securitization facility. There can be no\n26\nassurance that the size of the facility can be expanded to meet these increased working capital needs. Further, we may not be able to fund such increases in accounts receivable with our available cash resources. Our inability to meet working capital needs could adversely affect our financial condition and business, including our relationships with merchants, customers and partners. Further, we are exposed to the risk of increased interest rates because our borrowings under the Securitization Facility are subject to variable rates of interest. We renewed our Securitization Facility as of November 14, 2017, with an expiration date of November 14, 2020.\nWe are subject to risks related to volatility in foreign currency exchange rates, and restrictions on our ability to utilize revenue generated in foreign currencies.\nAs a result of our foreign operations, we are subject to risks related to changes in currency rates for revenue generated in currencies other than the U.S. dollar. For the year ended December 31, 2017, approximately 37% of our revenue was denominated in currencies other than the U.S. dollar (primarily, British pound, Brazilian real, Canadian dollar, Russian ruble, Mexican peso, Czech koruna, Euro, Australian dollar and New Zealand dollar). Revenue and profit generated by international operations may increase or decrease compared to prior periods as a result of changes in foreign currency exchange rates. Resulting exchange gains and losses are included in our net income. Volatility in foreign currency exchange rates may materially adversely affect our operating results and financial condition.\nFurthermore, we are subject to exchange control regulations that restrict or prohibit the conversion of more than a specified amount of our foreign currencies into U.S. dollars, and, as we continue to expand, we may become subject to further exchange control regulations that limit our ability to freely utilize and transfer currency in and out of particular jurisdictions. These restrictions may make it more difficult to effectively utilize the cash generated by our operations and may adversely affect our financial condition.\nWe expect to continue our expansion through acquisitions, which may divert our management’s attention and result in unexpected operating difficulties, increased costs and dilution to our stockholders. We also may never realize the anticipated benefits of the acquisitions.\nWe have been an active business acquirer in the U.S. and internationally, and, as part of our growth strategy, we expect to seek to acquire businesses, commercial account portfolios, technologies, services and products in the future. We have substantially expanded our overall business, customer base, headcount and operations through acquisitions. The acquisition and integration of each business involves a number of risks and may result in unforeseen operating difficulties and expenditures in assimilating or integrating the businesses, technologies, products, personnel or operations of the acquired business. Furthermore, acquisitions may:\n\n| • | involve our entry into geographic or business markets in which we have little or no prior experience; |\n\n| • | involve difficulties in retaining the customers of the acquired business; |\n\n| • | involve difficulties and expense associated with regulatory requirements, competition controls or investigations; |\n\n| • | result in a delay or reduction of sales for both us and the business we acquire; and |\n\n| • | disrupt our ongoing business, divert our resources and require significant management attention that would otherwise be available for ongoing development of our current business. |\n\nIn addition, international acquisitions often involve additional or increased risks including, for example:\n\n| • | difficulty managing geographically separated organizations, systems and facilities; |\n\n| • | difficulty integrating personnel with diverse business backgrounds, languages and organizational cultures; |\n\n| • | difficulty and expense introducing our corporate policies or controls; |\n\n| • | increased expense to comply with foreign regulatory requirements applicable to acquisitions; |\n\n| • | difficulty entering new foreign markets due to, among other things, lack of customer acceptance and a lack of business knowledge of these new markets; and |\n\n| • | political, social and economic instability. |\n\n27\nIn addition, the integration process following an acquisition requires significant management attention and resources. Integration of acquisitions could result in the distraction of our management, the disruption of our ongoing business or inconsistencies on our services, standards, controls, procedures and policies, any of which could affect our ability to achieve the anticipated benefits of an acquisition or otherwise adversely affect our business and financial results.\nTo complete future acquisitions, we may determine that it is necessary to use a substantial amount of our cash or engage in equity or debt financing. If we raise additional funds through further issuances of equity or convertible debt securities, our existing stockholders could suffer significant dilution, and any new equity securities we issue could have rights, preferences and privileges senior to those of holders of our common stock. Any debt financing obtained by us in the future could involve restrictive covenants relating to our capital-raising activities and other financial and operational matters that make it more difficult for us to obtain additional capital in the future and to pursue other business opportunities, including potential acquisitions. In addition, we may not be able to obtain additional financing on terms favorable to us, if at all, which could limit our ability to engage in acquisitions. Moreover, we can make no assurances that the anticipated benefits of any acquisition, such as operating improvements or anticipated cost savings, would be realized or that we would not be exposed to unexpected liabilities in connection with any acquisition.\nFurther, an acquisition may negatively affect our operating results because it may require us to incur charges and substantial debt or other liabilities, may cause adverse tax consequences, substantial depreciation and amortization or deferred compensation charges, may require the amortization, write-down or impairment of amounts related to deferred compensation, goodwill and other intangible assets, may include substantial contingent consideration payments or other compensation that reduce our earnings during the quarter in which incurred, or may not generate sufficient financial return to offset acquisition costs.\nWe conduct a significant portion of our business in foreign countries and we expect to expand our operations into additional foreign countries where we may be adversely affected by operational and political risks that are greater than in the U.S.\nWe have foreign operations in, or provide services for commercial card accounts in Australia, Austria, Azerbaijan, Belarus, Belgium, Brazil, Bulgaria, Canada, Croatia, Czech Republic, Denmark, Estonia, Finland, France, Georgia, Germany, Gibraltar, Greece, Hong Kong, Hungary, Ireland, Italy, Kazakhstan, Latvia, Lithuania, Luxembourg, Macau, Malaysia, Mexico, Moldova, Mongolia, the Netherlands, New Zealand, Norway, Pakistan, Papua New Guinea, Peru, Philippines, Poland, Portugal, Romania, Russia, Singapore, Slovakia, Slovenia, South Africa, South Korea, Spain, Sweden, Switzerland, Taiwan, Thailand, Turkey, Ukraine, United Arab Emirates and the United Kingdom. We also expect to seek to expand our operations into various countries in Asia, Europe and Latin America as part of our growth strategy.\nSome of the countries where we operate, and other countries where we will seek to operate, such as Russia, Brazil and Mexico, have undergone significant political, economic and social change in recent years, and the risk of unforeseen changes in these countries may be greater than in the U.S. For example, Russia and Ukraine are experiencing significant unrest, which could escalate into broader armed conflict and additional economic sanctions by the U.S., United Nations or other countries against Russia. In addition, political discourse in the U.S. may impact business practices in Mexico and other jurisdictions. In addition, changes in laws or regulations, including with respect to payment service providers, taxation, information technology, data transmission and the Internet, revenues from non-U.S. operations or in the interpretation of existing laws or regulations, whether caused by a change in government or otherwise, could materially adversely affect our business, operating results and financial condition.\nIn addition, conducting and expanding our international operations subjects us to other risks that we do not generally face in the U.S. These include:\n\n| • | difficulties in managing the staffing of our international operations, including hiring and retaining qualified employees; |\n\n| • | difficulties and increased expense introducing corporate policies and controls in our international operations; |\n\n| • | increased expense related to localization of our products and services, including language translation and the creation of localized agreements; |\n\n| • | potentially adverse tax consequences, including the complexities of foreign value added tax systems, restrictions on the repatriation of earnings and changes in tax rates; |\n\n28\n| • | increased expense to comply with foreign laws and legal standards, including laws that regulate pricing and promotion activities and the import and export of information technology, which can be difficult to monitor and are often subject to change; |\n\n| • | increased expense to comply with U.S. laws that apply to foreign operations, including the Foreign Corrupt Practices Act (the \"FCPA\") and OFAC regulations; |\n\n| • | increased expense to comply with U.K. laws that apply to foreign operations, including the U.K. Bribery Act; |\n\n| • | longer accounts receivable payment cycles and difficulties in collecting accounts receivable; |\n\n| • | increased financial accounting and reporting burdens and complexities; |\n\n| • | political, social and economic instability; |\n\n| • | terrorist attacks and security concerns in general; and |\n\n| • | reduced or varied protection for intellectual property rights and cultural norms in some geographies that are simply not respectful of intellectual property rights. |\n\nIn addition, in June 2016, voters in the United Kingdom approved an advisory referendum to withdraw from the European Union, commonly referred to as \"Brexit.\" This referendum has created political and economic uncertainty, particularly in the United Kingdom and the European Union, and this uncertainty may persist for years. A withdrawal could significantly disrupt the free movement of goods, services, and people between the United Kingdom and the European Union, and result in increased legal and regulatory complexities, as well as potential higher costs of conducting business in Europe. The United Kingdom's vote to exit the European Union could also result in similar referendums or votes in other European countries in which we do business. The uncertainty surrounding the terms of the United Kingdom's withdrawal and its consequences could adversely impact consumer and investor confidence, and the level of consumer purchases of discretionary items and retail products, including our products. Any of these effects, among others, could materially adversely affect our business, results of operations, and financial condition.\nThe occurrence of one or more of these events could negatively affect our international operations and, consequently, our operating results. Further, operating in international markets requires significant management attention and financial resources. Due to the additional uncertainties and risks of doing business in foreign jurisdictions, international acquisitions tend to entail risks and require additional oversight and management attention that are typically not attendant to acquisitions made within the U.S. We cannot be certain that the investment and additional resources required to establish, acquire or integrate operations in other countries will produce desired levels of revenue or profitability.\nWe are dependent on the efficient and uninterrupted operation of interconnected computer systems, telecommunications, data centers and call centers, including technology and network systems managed by multiple third parties, which could result in our inability to prevent disruptions in our services.\nOur ability to provide reliable service to customers, cardholders and other network participants depends upon uninterrupted operation of our data centers and call centers as well as third-party labor and services providers. Our business involves processing large numbers of transactions, the movement of large sums of money and the management of large amounts of data. We rely on the ability of our employees, contractors, suppliers, systems and processes to complete these transactions in a secure, uninterrupted and error-free manner.\nOur subsidiaries operate in various countries and country specific factors, such as power availability, telecommunications carrier redundancy, embargoes and regulation can adversely impact our information processing by or for our local subsidiaries.\nWe engage backup facilities for each of our processing centers for key systems and data. However, there could be material delays in fully activating backup facilities depending on the nature of the breakdown, security breach or catastrophic event (such as fire, explosion, flood, pandemic, natural disaster, power loss, telecommunications failure or physical break-in). We have controls and documented measures to mitigate these risks but these mitigating controls might not reduce the duration, scope or severity of an outage in time to avoid adverse effects.\n29\nWe may experience software defects, system errors, computer viruses and development delays, which could damage customer relationships, decrease our profitability and expose us to liability.\nOur business depends heavily on the reliability of proprietary and third-party processing systems. A system outage could adversely affect our business, financial condition or results of operations, including by damaging our reputation or exposing us to third-party liability. To successfully operate our business, we must be able to protect our processing and other systems from interruption, including from events that may be beyond our control. Events that could cause system interruptions include fire, natural disaster, unauthorized entry, power loss, telecommunications failure, computer viruses, terrorist acts and war. Although we have taken steps to protect against data loss and system failures, there is still risk that we may lose critical data or experience system failures.\nOur products and services are based on sophisticated software and computing systems that are constantly evolving. We often encounter delays and cost overruns in developing changes implemented to our systems. In addition, the underlying software may contain undetected errors, viruses or defects. Defects in our software products and errors or delays in our processing of electronic transactions could result in additional development costs, diversion of technical and other resources from our other development efforts, loss of credibility with current or potential customers, harm to our reputation or exposure to liability claims. In addition, we rely on technologies supplied to us by third parties that may also contain undetected errors, viruses or defects that could adversely affect our business, financial condition or results of operations. Although we attempt to limit our potential liability for warranty claims through disclaimers in our software documentation and limitation of liability provisions in our licenses and other agreements with our customers, we cannot assure that these measures will be successful in limiting our liability.\nWe may incur substantial losses due to fraudulent use of our payment cards or vouchers.\nUnder certain circumstances, when we fund customer transactions, we may bear the risk of substantial losses due to fraudulent use of our payment cards or vouchers. We do not maintain insurance to protect us against such losses. We bear similar risk relating to fraudulent acts of employees or contractors, for which we maintain insurance. However, the conditions or limits of coverage may be insufficient to protect us against such losses.\nCriminals are using increasingly sophisticated methods to engage in illegal activities involving financial products, such as skimming and counterfeiting payment cards and identity theft. A single significant incident of fraud, or increases in the overall level of fraud, involving our cards and other products and services, could result in reputational damage to us, which could reduce the use and acceptance of our cards and other products and services or lead to greater regulation that would increase our compliance costs. Fraudulent activity could also result in the imposition of regulatory sanctions, including significant monetary fines, which could have a material adverse effect on our business, financial condition and results of operations.\nWe may not be able to adequately protect our systems or the data we collect from continually evolving cybersecurity risks or other technological risks, which could subject us to liability and damage our reputation.\nWe electronically receive, process, store and transmit data and sensitive information about our customers and merchants, including bank account information, social security numbers, expense data, and credit card, debit card and checking account numbers. We endeavor to keep this information confidential; however, our websites, networks, information systems, services and technologies may be targeted for sabotage, disruption or misappropriation. The uninterrupted operation of our information systems and our ability to maintain the confidentiality of the customer and consumer information that resides on our systems are critical to the successful operation of our business. Unauthorized access to our networks and computer systems could result in the theft or publication of confidential information or the deletion or modification of records or could otherwise cause interruptions in our service and operations. Although we are not aware of any material breach of our or our associated third parties’ computer systems or material losses relating to cyber-attacks or other information security breaches, we and others in our industry are regularly the subject of attempts by bad actors to gain unauthorized access to these computer systems and data or to obtain, change or destroy confidential data (including personal consumer information of individuals) through a variety of means, including computer viruses, malware and phishing.\nBecause techniques used to sabotage or obtain unauthorized access to our systems and the data we collect change frequently and may not be recognized until launched against a target, we may be unable to anticipate these techniques or to implement adequate preventative measures. Threats to our systems and our associated third parties’ systems can derive from human error, fraud or malice on the part of employees or third parties, or may result from accidental technological failure. Computer viruses can be distributed and could infiltrate our systems or those of our associated third parties. In addition, denial of service or other attacks could be launched against us for a variety of purposes, including to interfere with our services or create a diversion for other malicious activities. Although we believe we have sufficient controls in place to prevent disruption and misappropriation\n30\nand to respond to such attacks, any inability to prevent security breaches could have a negative impact on our reputation, expose us to liability, decrease market acceptance of electronic transactions and cause our present and potential clients to choose another service provider. Any of these developments could have a material adverse effect on our business, operating results and financial condition.\nWe could also be subject to liability for claims relating to misuse of personal information, such as unauthorized marketing purposes and violation of data privacy laws. We cannot provide assurance that the contractual requirements related to security and privacy that we impose on our service providers who have access to customer and consumer data will be followed or will be adequate to prevent the unauthorized use or disclosure of data. In addition, we have agreed in certain agreements to take certain protective measures to ensure the confidentiality of customer data. The costs of systems and procedures associated with such protective measures may increase and could adversely affect our ability to compete effectively. Any failure to adequately enforce or provide these protective measures could result in liability, protracted and costly litigation, governmental and card network intervention and fines and, with respect to misuse of personal information of our customers, lost revenue and reputational harm.\nIn addition, under payment network rules, regulatory requirements, and related obligations, we may be responsible for the acts or failures to act of certain third parties, such as third party service providers, vendors, partners and others, which we refer to collectively as associated participants. The failure of our associated participants to safeguard cardholder data and other information in accordance with such rules, requirements and obligations could result in significant fines and sanctions and could harm our reputation and deter existing and prospective customers from using our services. We cannot assure you that there are written agreements in place with every associated participant or that such written agreements will ensure the adequate safeguarding of such data or information or allow us to seek reimbursement from associated participants. Any such unauthorized use or disclosure of data or information also could result in litigation that could result in a material adverse effect on our business, financial condition and results of operations.\nThe market for our commercial payment, fleet and stored value card services is evolving and may not continue to develop or grow.\nA substantial portion of our revenue is based on the volume of payment card transactions by our customers. If businesses do not continue to use, or increase their use of, credit, debit or stored value cards as a payment mechanism for their transactions, it could have a material adverse effect on our business, financial condition and results of operations. We believe that future growth in the use of credit, debit and stored value cards and other electronic payments will be driven by the cost, ease-of-use, and quality of services offered. In order for us to consistently increase and maintain profitability, businesses must continue to use and increase the use of electronic payment methods, including credit, debit and stored value cards. Moreover, if there is an adverse development in the payments industry in general, such as new legislation or regulation that makes it more difficult for customers to do business, or a well-publicized data security breach that undermines the confidence of the public in electronic payment systems, it could have a material adverse effect on our business, financial condition and results of operations.\nOur fleet card businesses rely on the acceptance and use of payment cards by businesses to purchase fuel for their vehicle fleets. If the use of fleet cards by businesses does not continue to grow, it could have a material adverse effect on our business, operating results and financial condition. In order to consistently increase and maintain our profitability, businesses and partners must continue to adopt our services. Similarly, growth in the acceptance and use of fleet cards will be impacted by the acceptance and use of electronic payment transactions generally.\nFurthermore, new technologies may displace credit, debit and/or stored value cards as payment mechanisms for purchase transactions by businesses. A decline in the acceptance and use of credit, debit and/or stored value cards, and electronic payment transactions generally, by businesses and merchants could have a material adverse effect on our business, operating results and financial condition. The market for our lodging cards, food vouchers and cards, transportation and toll road payments, telematics solutions and fleet maintenance management services is also evolving and those portions of our business are subject to similar risks.\nIf we fail to retain any of our stored value gift card customers, it will be difficult to find a replacement customer on a timely basis or at all, which will reduce our revenue.\nMost of our stored value gift card customers in the U.S. are national retailers. During 2017, a majority of our gift card revenue was derived from the design and purchase of gift card inventory, with the remaining portion of our 2017 gift card revenue derived primarily from processing fees. If we fail to retain any of these customers, it will be difficult to find a replacement customer on a timely basis or at all because there is a limited number of national retailers in the U.S. and nearly all of those\n31\nother national retailers already have a gift card solution in place, either in-house or with one of our competitors. As such, any loss of a stored value gift card customer would reduce our revenue.\nAdverse weather conditions across a geographic region can cause a decline in the number and amount of payment transactions we process, which could have a material adverse effect on our business, financial condition and results of operations.\nWhen travel is severely curtailed across a geographic region during adverse weather conditions, the number and amount of transactions we process can be significantly diminished, particularly in our fleet business, and revenue can materially decline. For example, during parts of January 2014, severe winter weather shut down a large portion of the eastern United States. Prolonged adverse weather events, especially those that impact regions in which we process a large number and amount of payment transactions, could have a material adverse effect on our business, financial condition and results of operations.\nOur fuel card, workforce payment solutions and gift card businesses’ results are subject to seasonality, which could result in fluctuations in our quarterly net income.\nOur fuel card and workforce payment solutions businesses have experienced in the past, and expect to continue to experience, seasonal fluctuations in revenues and profit, which are impacted during the first and fourth quarter each year by the weather, holidays in the U.S., Christmas being celebrated in Russia in January, and lower business levels in Brazil due to summer break and the Carnival celebration. Our gift card business has experienced in the past, and expects to continue to experience, seasonal fluctuations in revenues as a result of consumer spending patterns. Historically gift card business revenues have been strongest in the third and fourth quarters and weakest in the first and second quarters, as the retail industry has its highest level of activity during and leading up to the Christmas holiday season.\nOur balance sheet includes significant amounts of goodwill and intangible assets. The impairment of a significant portion of these assets would negatively affect our financial results.\nOur balance sheet includes goodwill and intangible assets that represent approximately 66% of our total assets at December 31, 2017. These assets consist primarily of goodwill and identified intangible assets associated with our acquisitions. We also expect to engage in additional acquisitions, which may result in our recognition of additional goodwill and intangible assets. Under current accounting standards, we are required to amortize certain intangible assets over the useful life of the asset, while goodwill and indefinite lived intangible assets are not amortized. On at least an annual basis, we assess whether there have been impairments in the carrying value of goodwill and indefinite lived intangible assets. If the carrying value of the asset is determined to be impaired, it is written down to fair value by a charge to operating earnings. An impairment of a significant portion of goodwill or intangible assets could materially negatively affect our operating results and financial condition.\nIf we are unable to protect our intellectual property rights and confidential information, our competitive position could be harmed and we could be required to incur significant expenses in order to enforce our rights.\nTo protect our proprietary technology, we rely on copyright, trade secret, patent and other intellectual property laws and confidentiality agreements with employees and third parties, all of which offer only limited protection. Despite our precautions, it may be possible for third parties to obtain and use without our consent confidential information or infringe on our intellectual property rights, and our ability to police that misappropriation or infringement is uncertain, particularly in countries outside of the U.S. In addition, our confidentiality agreements with employees, vendors, customers and other third parties may not effectively prevent disclosure or use of proprietary technology or confidential information and may not provide an adequate remedy in the event of such unauthorized use or disclosure.\nProtecting against the unauthorized use of our intellectual property and confidential information is expensive, difficult and not always possible. Litigation may be necessary in the future to enforce or defend our intellectual property rights, to protect our confidential information, including trade secrets, or to determine the validity and scope of the proprietary rights of others. This litigation could be costly and divert management resources, either of which could harm our business, operating results and financial condition. Accordingly, despite our efforts, we may not be able to prevent third parties from infringing upon or misappropriating our intellectual property and proprietary information.\nWe cannot be certain that the steps we have taken will prevent the unauthorized use or the reverse engineering of our proprietary technology. Moreover, others may independently develop technologies that are competitive to ours or infringe our intellectual property. The enforcement of our intellectual property rights also depends on our legal actions against these infringers being successful, and we cannot be sure these actions will be successful, even when our rights have been infringed.\n32\nFurthermore, effective patent, trademark, service mark, copyright and trade secret protection may not be available in every country in which we may offer our products and services.\nClaims by others that we or our customers infringe their intellectual property rights could harm our business.\nThird parties have in the past, and could in the future claim that our technologies and processes underlying our products and services infringe their intellectual property. In addition, to the extent that we gain greater visibility, market exposure, and add new products and services, we may face a higher risk of being the target of intellectual property infringement claims asserted by third parties. We may, in the future, receive notices alleging that we have misappropriated or infringed a third party’s intellectual property rights. There may be third-party intellectual property rights, including patents and pending patent applications that cover significant aspects of our technologies, processes or business methods. Any claims of infringement or misappropriation by a third party, even those without merit, could cause us to incur substantial defense costs and could distract our management from our business, and there can be no assurance that we will be able to prevail against such claims. Some of our competitors may have the capability to dedicate substantially greater resources to enforcing their intellectual property rights and to defending claims that may be brought against them than we do. Furthermore, a party making such a claim, if successful, could secure a judgment that requires us to pay substantial damages, potentially including treble damages if we are found to have willfully infringed a patent. A judgment could also include an injunction or other court order that could prevent us from offering our products and services. In addition, we might be required to seek a license for the use of a third party’s intellectual property, which may not be available on commercially reasonable terms or at all. Alternatively, we might be required to develop non-infringing technology, which could require significant effort and expense and might ultimately not be successful.\nThird parties may also assert infringement claims against our customers relating to their use of our technologies or processes. Any of these claims might require us to defend potentially protracted and costly litigation on their behalf, regardless of the merits of these claims, because under certain conditions we may agree to indemnify our customers from third-party claims of intellectual property infringement. If any of these claims succeed, we might be forced to pay damages on behalf of our customers, which could adversely affect our business, operating results and financial condition.\nFinally, we use open source software in connection with our technology and services. Companies that incorporate open source software into their products, from time to time, face claims challenging the ownership of open source software. As a result, we could be subject to suits by parties claiming ownership of what we believe to be open source software. Open source software is also provided without warranty, and may therefore include bugs, security vulnerabilities or other defects. Some open source software licenses require users of such software to publicly disclose all or part of the source code to their software and/or make available any derivative works of the open source code on unfavorable terms or at no cost. While we monitor the use of open source software in our technology and services and try to ensure that none is used in a manner that would require us to disclose the source code to the related technology or service, such use could inadvertently occur and any requirement to disclose our proprietary source code could be harmful to our business, financial condition and results of operations.\nOur success is dependent, in part, upon our executive officers and other key personnel, and the loss of key personnel could materially adversely affect our business.\nOur success depends, in part, on our executive officers and other key personnel. Our senior management team has significant industry experience and would be difficult to replace. The market for qualified individuals is competitive, and we may not be able to attract and retain qualified personnel or candidates to replace or succeed members of our senior management team or other key personnel. The loss of key personnel could materially adversely affect our business.\nChanges in laws, regulations and enforcement activities may adversely affect our products and services and the markets in which we operate.\nThe electronic payments industry is subject to increasing regulation in the U.S. and internationally. Domestic and foreign government regulations impose compliance obligations on us and restrictions on our operating activities, which can be difficult to administer because of their scope, mandates and varied requirements. We are subject to a number of government regulations, including, among others: interest rate and fee restrictions; credit access and disclosure requirements; collection and pricing regulations; compliance obligations; security and data breach requirements; identity theft avoidance programs; and anti-money laundering compliance programs. Government regulations can also include licensing or registration requirements. While a large portion of these regulations focuses on individual consumer protection, legislatures continue to consider whether to include business customers within the scope of these regulations. As a result, new or expanded regulation focusing on business customers or changes in interpretation or enforcement of regulations may have an adverse effect on our business and operating results, due to increased compliance costs and new restrictions affecting the terms under which we offer our products and services.\n33\nFor example, certain of our subsidiaries are currently licensed as money transmitters on the state level by the banking departments or other state agencies. Continued licensing by these states is subject to periodic examinations and ongoing satisfaction of compliance requirements regarding safety and soundness, including maintenance of certain levels of net worth, surety bonding, permissible investments in amounts sufficient to cover our outstanding payment obligations with respect to certain of our products subject to licensure, and record keeping and reporting. If our subsidiaries are unable to obtain, maintain or renew necessary licenses or comply with other relevant state regulations, they will not be able to operate as a money transmitter in those states or provide certain other services and products, which could have a material adverse effect on our business, financial condition and results of operations.\nIn addition, certain of our subsidiaries are subject to regulation by the Financial Crimes Enforcement Network, or FinCEN, and must comply with applicable anti-money laundering requirements, including implementation of an effective anti-money laundering program. Changes in this regulatory environment, including changing interpretations and the implementation of new or varying regulatory requirements by the government, may significantly affect or change the manner in which we currently conduct some aspects of our business.\nRegulatory changes may also restrict or eliminate present and future business opportunities available to certain of our subsidiaries. For example, the Durbin Amendment to the Dodd-Frank Act, which serves to limit interchange fees may restrict or otherwise impact the way our subsidiaries do business or limit their ability to charge certain fees to customers. The Consumer Financial Protection Bureau (\"CFPB\") is also engaged in rule making and regulation of the payments industry, in particular with respect to prepaid cards, and in October 2016, the CFPB issued a final rule amending Regulations E and Z to create comprehensive consumer protections for prepaid financial products. The extensive nature of these regulations and the implementation dates for this additional rulemaking may result in additional compliance obligations and expense for our business. The CFPB’s focus on the protection of consumers might also extend to many of our small business customers. As a service provider to certain of our bank sponsors, we are subject to direct supervision and examination by the CFPB, in connection with certain of our products and services. CFPB rules, examinations and enforcement actions may require us to adjust our activities and may increase our compliance costs. Changing regulations or standards in the area of privacy and data protection could also adversely impact us. In addition, certain of our bank partners are subject to regulation by federal and state authority and, as a result, could pass through some of those compliance obligations to us.\nOur business is subject to U.S. federal anti-money laundering laws and regulations, including the BSA. Our business in Canada is also subject to Proceeds of Crime (Money Laundering) and Terrorist Financing Act, or the PCTFA, which is a corollary to the BSA. The BSA, among other things, requires money services businesses (such as money transmitters, issuers of money orders and official checks and providers of prepaid access) to develop and implement risk-based anti-money laundering programs, report large cash transactions and suspicious activity and maintain transaction records. The PCTFA imposes similar requirements.\nMany of these laws and regulations are evolving, unclear and inconsistent across various jurisdictions, and ensuring compliance with them is difficult and costly. With increasing frequency, federal and state regulators are holding businesses like ours to higher standards of training, monitoring and compliance, including monitoring for possible violations of laws by our customers and people who do business with our customers while using our products. If we fail or are unable to comply with existing or changed government regulations in a timely and appropriate manner, we may be subject to injunctions, other sanctions and the payment of fines and penalties, and our reputation may be harmed, which could have a material adverse effect on our business, financial condition and results of operations.\nOur partner banks also operate in a highly regulated industry, which recently has been the subject of extensive structural reforms that are expected to negatively affect the conduct and scope of their businesses, their ability to maintain or expand offerings of products and services, and the costs of their operations. These legislative and regulatory changes could prompt our partner banks to alter the extent or the terms of their dealings with us in ways that may have adverse consequences for our business.\nIn addition, recently implemented and pending changes in accounting standards (for example, changes relating to revenue recognition for customer contracts that will become effective for fiscal 2018) may adversely affect our results of operations.\nFinally, we have endeavored to structure our businesses in accordance with existing tax laws and interpretations, including those related to state occupancy taxes, value added taxes in foreign jurisdictions, payroll taxes and restrictions on repatriation of funds or transfers of revenue between jurisdictions. Changes in tax laws, their interpretations or their enforcement could increase our tax liability, further limit our utilization of funds located in foreign jurisdictions and have a material adverse effect on our business and financial condition.\n34\nFor more information about laws, regulations and enforcement activities that may adversely affect our products and services and the markets in which we operate, see “Business- Regulatory.”\nDerivatives Regulations\nRules adopted under the Dodd-Frank Act by the Commodity Futures Trading Commission (the \"CFTC\"), as well as the provisions of the European Market Infrastructure Regulation and its technical standards, which are directly applicable in the member states of the European Union, have subjected certain of the foreign exchange derivative contracts we offer to our customers as part of Cambridge's business, to reporting, recordkeeping, and other requirements. Additionally, certain foreign exchange derivatives transactions we may enter into in the future may be subject to centralized clearing requirements, or may be subject to margin requirements in the United States and European Union. Other jurisdictions outside the United States and the European Union are considering, have implemented, or are implementing regulations similar to those described above. Derivatives regulations have added costs to our business and any additional requirements, such as future registration requirements and increased regulation of derivative contracts, may result in additional costs or impact the way we conduct our hedging activities, as well as impact how we conduct our business within our international payments provider operations. In particular, the CFTC has recently issued a proposed rule that, if adopted as proposed, would increase the likelihood that we will have to register one or more of our subsidiaries with the CFTC as swap dealers. Swap dealers are subject to a comprehensive regulatory framework and compliance with this framework will lead to additional costs, including costs relating to regulatory capital and margin requirements, and may impact how we conduct our hedging activities and derivatives business with customers. We are currently evaluating the impact the proposed rule, if adopted, would have on our hedging activities and operations.\nOur compliance with these requirements has resulted, and may continue to result, in additional costs to our business and may impact our international payments provider business operations. Furthermore, our failure to comply with these requirements could result in fines and other sanctions, as well as necessitate a temporary or permanent cessation to some or all of our derivative related activities. Any such fines, sanctions or limitations on our business could adversely affect our operations and financial results. Additionally, the regulatory regimes for derivatives in the United States and European Union, such as under the Dodd-Frank Act and the European Markets in Financial Instruments Directive known as \"MiFID II,\" are continuing to evolve and changes to such regimes, our designation under such regimes, or the implementation of new rules under such regimes, such as future registration requirements and increased regulation of derivative contracts, may result in additional costs to our business. Other jurisdictions outside the United States and the European Union are considering, have implemented, or are implementing regulations similar to those described above and these may result in greater costs to us as well.\nGovernmental regulations designed to protect or limit access to personal information could adversely affect our ability to effectively provide our services.\nGovernmental bodies in the U.S. and abroad have adopted, or are considering the adoption of, laws and regulations restricting the transfer of, and requiring safeguarding of, non-public personal information. For example, in the U.S., all financial institutions must undertake certain steps to help protect the privacy and security of consumer financial information. In connection with providing services to our clients, we are required by regulations and arrangements with payment networks, our sponsor bank and certain clients to provide assurances regarding the confidentiality and security of non-public consumer information. These arrangements require periodic audits by independent companies regarding our compliance with industry standards such as PCI standards and also allow for similar audits regarding best practices established by regulatory guidelines. The compliance standards relate to our infrastructure, components, and operational procedures designed to safeguard the confidentiality and security of non-public consumer personal information received from our customers. Our ability to maintain compliance with these standards and satisfy these audits will affect our ability to attract and maintain business in the future. If we fail to comply with these regulations, we could be exposed to suits for breach of contract or to governmental proceedings. In addition, our client relationships and reputation could be harmed, and we could be inhibited in our ability to obtain new clients. If more restrictive privacy laws or rules are adopted by authorities in the future on the federal or state level, our compliance costs may increase, our opportunities for growth may be curtailed by our compliance capabilities or reputational harm and our potential liability for security breaches may increase, all of which could have a material adverse effect on our business, financial condition and results of operations.\n35\nWe are subject to governmental regulation and other legal obligations, particularly related to privacy, data protection and information security, and we are subject to disparate consumer protection laws across different countries. Our actual or perceived failure to comply with such obligations could harm our business.\nIn the U.S., the European Union and in other jurisdictions around the world, we are subject to numerous and disparate consumer laws (including laws on disputed transactions) as well as regulations on eCommerce or similar legislation. If we are found to have breached any consumer, eCommerce or similar legislation in any country, we may be subject to enforcement actions that require us to change our business practices in a manner which may negatively impact revenue, as well as litigation, fines, penalties and adverse publicity that could cause our customers to lose trust in us, which could have an adverse effect on our reputation and business in a manner that harms our financial position.\nWe collect personally identifiable information and other data from our customers. Laws and regulations in several countries restrict certain collection, processing, storage, use, disclosure and security of personal information, require notice to individuals of privacy practices, and provide individuals with certain rights to prevent use and disclosure of protected information. Several foreign countries and governmental bodies, including the countries of the European Union and Canada, have laws and regulations which are often more restrictive than those in the United States. The data privacy regime in the EU includes certain directives which, among other things, require European Union member states to regulate the processing and movement of personal data, marketing and the use of cookies. Each European Union member state has transposed the requirements of these directives into its own national data privacy regime, and therefore the laws differ from jurisdiction to jurisdiction. These laws and regulations are subject to frequent revisions and differing interpretations, and have generally become more stringent over time.\nFuture restrictions on the collection, use, sharing or disclosure of personally identifiable information or additional requirements and liability for security and data integrity could require us to modify our solutions and features, possibly in a material manner, and could limit our ability to develop new services and features. For example, the EU-wide General Data Protection Regulation, or GDPR, which was passed by the European Union Parliament in the spring of 2016 and will become fully effective in May 2018, following a two-year implementation period, will replace the data protection laws of each European Union member state. The GDPR will implement more stringent operational requirements for processors and controllers of personal data, including, for example, increased requirements to erase an individual’s information upon request, mandatory data breach notification requirements and onerous new obligations on service providers. It also significantly increases penalties for non-compliance, including where we act as a service provider (e.g., data processor). If our privacy or data security measures fail to comply with applicable current or future laws and regulations, we may be subject to litigation, regulatory investigations, enforcement notices requiring us to change the way we use personal data or our marketing practices, fines, for example, of up to 20,000,000 Euros or up to 4% of the total worldwide annual turnover of the preceding financial year (whichever is higher) under the GDPR, or other liabilities, as well as negative publicity and a potential loss of business.\nIn February 2013, the European Commission proposed EU-wide legislation regarding cybersecurity in the form of the proposed Network and Information Security Directive, or the NIS Directive. The NIS Directive requires EU member states to impose cybersecurity obligations-including data breach notification requirements-to operators of “essential services” and to “digital service providers.” The NIS Directive and its implementing legislation if held to apply to us may lead to compliance obligations that require us to change one or more aspects of the way we operate our business, which could increase our operating costs, and failure to comply may result in governmental enforcement actions, litigation, fines, penalties and adverse publicity.\nUnfavorable resolution of tax contingencies or changes to enacted tax rates could adversely affect our tax expense and results of operations.\nOur tax returns and positions are subject to review and audit by federal, state, local, and international taxing authorities. An unfavorable outcome to a tax audit could result in higher tax expense, thereby negatively impacting our results of operations. We have established contingent liabilities for material known tax exposures relating to deductions, transactions and other matters involving some uncertainty as to the proper tax treatment of the item. These liabilities reflect what we believe to be reasonable assumptions as to the likely final resolution of each issue if raised by a taxing authority. There can be no assurance that, in all instances, an issue raised by a tax authority will be finally resolved at a financial cost less than any related liability. An unfavorable resolution, therefore, could negatively impact our financial position, operating results and cash flows in the current and/or future periods.\nOur acquisition documents include warranties, covenants and conditions regarding various tax matters that occurred prior to the acquisition, supported by indemnification and, in some cases, holdbacks or escrows from the sellers. The obligations of the\n36\nsellers are also generally subject to various limitations. In the event of a tax claim related to a pre-acquisition tax year, we would seek to recover costs and losses from the sellers under the acquisition agreement. However, there is no assurance that any indemnification, holdback or escrow would be sufficient or that we would recover such costs or losses, which could negatively impact our financial position, operating results and cash flows in the current and/or future periods.\nWe record deferred income taxes to reflect the impact of temporary differences between the amounts of assets and liabilities for financial accounting and income tax purposes. Deferred income taxes are determined using enacted tax rates. Changes in enacted tax rates may negatively impact our operating results.\nThe recently passed Tax Cuts and Jobs Act (the \"Tax Act\") act could adversely affect our business and financial condition.\nOn December 22, 2017, President Trump signed into law new legislation that significantly revises the Internal Revenue Code of 1986, as amended, or the Code. The newly enacted Tax Act among other things, contains significant changes to corporate taxation, including by reducing the corporate tax rate from a top marginal rate of 35% to a flat rate of 21%, significantly limiting the tax deduction for net interest expense, limiting the deduction for post-2017 net operating losses to 80% of current year taxable income and eliminating carrybacks of such net operating losses, imposing a one-time transition tax on offshore earnings regardless of whether they are repatriated, migrating from a “worldwide” system of taxation in the direction of a territorial system (subject to certain important exceptions), allowing immediate expensing of certain new investments instead of depreciating such investments over time, modifying or repealing many business deductions and credits, and requiring the accrual of certain income for U.S. federal income tax purposes no later than when such income is taken into account as revenue on our financial statements (subject to an exception for certain income that is already subject to a special method of accounting under the Code). We continue to examine the impact the new legislation may have on our business. Notwithstanding the reduction in the corporate income tax rate, the overall impact of the new federal tax law is uncertain, and our business and financial condition could be adversely affected. In addition, it is uncertain if and to what extent various states will conform to the newly enacted federal tax law. The impact of this tax reform on holders of our common stock is also uncertain and could be adverse.\nWe generate a portion of our revenue from our lodging card business, which is affected by conditions in the hotel industry generally and has a concentration of customers in the railroad and trucking industries.\nOur lodging card business earns revenue from customers purchasing lodging from the hotel industry and derives a significant portion of this revenue from end users in the railroad and trucking industries. Therefore, we are exposed to risks affecting each of these industries. For example, unfavorable economic conditions adversely impacting the hotel, railroad and trucking industries generally could cause a decrease in demand for our products and services in our lodging card business, resulting in decreased revenue, or increased credit risk and related losses, resulting in increased expenses. In addition, mergers or consolidations in these industries could reduce our customer and partnership base, resulting in a smaller market for our products and services.\nWe contract with government entities and are subject to risks related to our governmental contracts.\nIn the course of our business we contract with domestic and foreign government entities, including state and local government customers, as well as federal government agencies. As a result, we are subject to various laws and regulations that apply to companies doing business with federal, state and local governments. The laws relating to government contracts differ from other commercial contracting laws and our government contracts may contain pricing terms and conditions that are not common among commercial contracts. In addition, we may be subject to investigation from time to time concerning our compliance with the laws and regulations relating to our government contracts. Our failure to comply with these laws and regulations may result in suspension of these contracts or administrative or other penalties.\nLitigation and regulatory actions could subject us to significant fines, penalties or requirements resulting in significantly increased expenses, damage to our reputation and/or material adverse effects on our business.\nWe are subject to claims and a number of judicial and administrative proceedings considered normal in the course of our current and past operations, including employment-related disputes, contract disputes, intellectual property disputes, government audits and regulatory proceedings, customer disputes and tort claims. Responding to proceedings may be difficult and expensive, and we may not prevail. In some proceedings, the claimant seeks damages as well as other relief, which, if granted, would require expenditures on our part or changes in how we conduct business. There can be no certainty that we will not ultimately incur charges in excess of presently established or future financial accruals or insurance coverage, or that we will prevail with respect to such proceedings. Regardless of whether we prevail or not, such proceedings could have a material adverse effect on our business, reputation, financial condition and results of operations. From time to time, we have had, and expect to continue to receive, inquiries from regulatory bodies and administrative agencies relating to the operation of our\n37\nbusiness. Such inquiries have resulted in, and may continue to result in, various audits, reviews and investigations, which can be time consuming and expensive. These types of inquiries, audits, reviews, and investigations could result in the institution of administrative or civil proceedings, sanctions and the payment of fines and penalties, changes in personnel, and increased review and scrutiny by customers, regulatory authorities, the media and others, which could have a material adverse effect on our business, reputation, financial condition and results of operations. For more information about our judicial and other proceedings, see “Business—Legal Proceedings.”\nWe are named in a federal securities class action lawsuit and derivative complaint; if we are unable to resolve these matters favorably, then our business, operating results and financial condition may be adversely affected.\nIn June 2017, a shareholder filed a class action complaint in the Unites States District Court for the Northern District of Georgia against the Company and certain of its officers and directors on behalf of all persons who purchased or otherwise acquired the Company’s stock between February 5, 2016 and May 2, 2017. In July 2017, a shareholder derivative complaint was filed against certain of the Company’s directors and officers in the United States District Court for the Northern District of Georgia seeking recovery on behalf of the Company. See “Part II-Item 3 - Legal Proceedings” below for additional information about the lawsuit and the derivative complaint. We cannot at this time predict the outcome of these matters or reasonably determine the probability of a material adverse result or reasonably estimate range of potential exposure, if any, that these matters might have on us, our business, our financial condition or our results of operations, although such effects could be materially adverse. In addition, in the future, we may need to record litigation reserves with respect to these matters. Further, regardless of how these matters proceed, it could divert our management’s attention and other resources away from our business.\nOur revenues from MasterCard cards are dependent upon our continued MasterCard registration and financial institution sponsorship. If we fail to comply with the applicable requirements of MasterCard, it could seek to fine us, suspend us or terminate our registrations through our financial institution sponsors.\nA significant source of our revenue comes from processing transactions through the MasterCard networks. In order to offer MasterCard programs to our customers, one of our subsidiaries is registered as a member service provider with MasterCard through sponsorship by MasterCard member banks in both the U.S. and Canada. Registration as a service provider is dependent upon our being sponsored by member banks. If our sponsor banks should stop providing sponsorship for us or determine to provide sponsorship on materially less favorable terms, we would need to find other financial institutions to provide those services or we would need to become a MasterCard member, either of which could prove to be difficult and expensive. Even if we pursue sponsorship by alternative member banks, similar requirements and dependencies would likely still exist. In addition, MasterCard routinely updates and modifies its requirements. Changes in the requirements may make it significantly more expensive for us to provide these services. If we do not comply with MasterCard requirements, it could seek to fine us, suspend us or terminate our registration, which allows us to process transactions on its networks. The termination of our registration, or any changes in the payment network rules that would impair our registration, could require us to stop providing MasterCard payment processing services. If we are unable to find a replacement financial institution to provide sponsorship or become a member, we may no longer be able to provide such services to the affected customers, which would have a material adverse effect our business, financial condition and results of operations.\nChanges in MasterCard interchange fees could decrease our revenue.\nA portion of our revenue is generated by network processing fees charged to merchants, known as interchange fees, associated with transactions processed using our MasterCard-branded cards. Interchange fee amounts associated with our MasterCard network cards are affected by a number of factors, including regulatory limits in the United States and Europe and fee changes imposed by MasterCard. In addition, interchange fees are the subject of intense legal and regulatory scrutiny and competitive pressures in the electronic payments industry, which could result in lower interchange fees generally in the future. Temporary or permanent decreases in the interchange fees associated with our MasterCard network card transactions, could adversely affect our business and operating results.\nIf we are not able to maintain and enhance our brands, it could adversely affect our business, operating results and financial condition.\nWe believe that maintaining and enhancing our brands is critical to our customer relationships, and our ability to obtain partners and retain employees. The successful promotion of our brands will depend upon our marketing and public relations efforts, our ability to continue to offer high-quality products and services and our ability to successfully differentiate our services from those of our competitors. In addition, future extension of our brands to add new products or services different from our current offerings may dilute our brands, particularly if we fail to maintain our quality standards in these new areas. The promotion of\n38\nour brands will require us to make substantial expenditures, and we anticipate that the expenditures will increase as our markets become more competitive and we expand into new markets. To the extent that these activities yield increased revenues, this revenue may not offset the expenses we incur. There can be no assurance that our brand promotion activities will be successful.\nFailure to comply with the FCPA, anti-money laundering regulations, economic and trade sanctions regulations and similar laws and regulations associated with our international activities, could subject us to penalties and other adverse consequences.\nAs we continue to expand our business internationally, we may continue to expand into certain foreign countries, particularly those with developing economies, where companies often engage in business practices that are prohibited by U.S., U.K. and other foreign regulations, including the FCPA, the U.K. Bribery Act, the 2013 Brazilian Clean Companies Act and the 2013 Russian Law on Preventing Corruption. These laws and regulations generally prohibit us, our employees, consultants and agents from bribing, being bribed or making other prohibited payments to government officials or other persons to obtain or retain business or gain some other business advantage. We have implemented policies to discourage such practices; however, there can be no assurances that all of our employees, consultants and agents, including those that may be based in or from countries where practices that violate U.S. laws may be customary, will not take actions in violation of our policies, for which we may be ultimately responsible. Violations of the FCPA or similar laws may result in severe criminal or civil sanctions and, in the U.S., suspension or debarment from U.S. government contracting, which could negatively affect our business, operating results and financial condition.\nIn addition, we are subject to anti-money laundering laws and regulations, including the BSA. Among other things, the BSA requires money services businesses (such as money transmitters and providers of prepaid access) to develop and implement risk-based anti-money laundering programs, report large cash transactions and suspicious activity, and maintain transaction records.\nWe are also subject to certain economic and trade sanctions programs that are administered by OFAC, which prohibit or restrict transactions to or from or dealings with specified countries, their governments, and in certain circumstances, their nationals, and with individuals and entities that are specially-designated nationals of those countries, narcotics traffickers, and terrorists or terrorist organizations. Other group entities may be subject to additional foreign or local sanctions requirements in other relevant jurisdictions.\nSimilar anti-money laundering and counter-terrorist financing and proceeds of crime laws apply to movements of currency and payments through electronic transactions and to dealings with persons specified in lists maintained by the country equivalent to OFAC lists in several other countries and require specific data retention obligations to be observed by intermediaries in the payment process. Our businesses in those jurisdictions are subject to those data retention obligations.\nViolations of these laws and regulations may result in severe criminal or civil sanctions and, in the U.S., suspension or debarment from U.S. government contracting, which could negatively affect our business, operating results and financial condition. Likewise, any investigation of any potential violations of these laws and regulations by U.S. or foreign authorities could also have an adverse impact on our reputation, business, financial condition and operating results. In addition, we cannot predict the nature, scope or effect of future regulatory requirements to which our international operations might be subject or the manner in which existing laws and regulations might be administered or interpreted.\nGlobal economic downturns or slower growth or declines in the money transfer, payment service, and other markets in which we operate, including downturns or declines related to interruptions in migration patterns, and difficult conditions in global financial markets and financial market disruptions could adversely affect our business, financial condition, results of operations, and cash flows.\nThe global economy has experienced in recent years, and may experience, downturns, volatility and disruption, and we face certain risks relating to such events, including:\n| • | Our international payments provider business provides currency conversion and foreign exchange hedging services to our customers, exposing us to foreign currency exchange risk. In order to help mitigate these risks, we enter into derivative contracts. However, these contracts do not eliminate all of the risks related to fluctuating foreign currency rates. |\n\n| • | Our international payments provider business is heavily dependent on global trade. A downturn in global trade or the failure of long-term import growth rates to return to historic levels could have an adverse effect on our business, financial condition, results of operations, cash flows, and our cash management strategies. Additionally, as customer |\n\n39\nhedging activity in our international payments provider business generally varies with currency volatility, we have experienced and may experience in the future lower foreign exchange revenues in periods of lower currency volatility.\n| • | The counterparties to the derivative financial instruments that we use in our international payments provider business to reduce our exposure to various market risks, including changes in foreign exchange rates, may fail to honor their obligations, which could expose us to risks we had sought to mitigate. This includes the exposure generated when we write derivative contracts to our customers as part of our cross-currency payments business, and we typically hedge the net exposure through offsetting contracts with established financial institution counterparties. That failure could have an adverse effect on our financial condition, results of operations, and cash flows. |\n\nRisks associated with operations outside the U.S. and foreign currencies could adversely affect our business, financial condition, results of operations, and cash flows.\nWe have additional foreign exchange risk and associated foreign exchange risk management requirements due to the nature of our international payments provider business. The majority of this business' revenue is from exchanges of currency at spot rates, which enable customers to make cross-currency payments. Additionally, this business also writes foreign currency forward and option contracts for our customers. The duration of these derivative contracts at inception is generally less than one year. The credit risk associated with our derivative contracts increases when foreign currency exchange rates move against our customers, possibly impacting their ability to honor their obligations to deliver currency to us or to maintain appropriate collateral with us.\nOur international payments provider business aggregates its foreign exchange exposures arising from customer contracts, including the derivative contracts described above, and hedges the resulting net currency risks by entering into offsetting contracts with established financial institution counterparties. If we are unable to obtain offsetting positions, our business, financial condition, results of operations, and cash flows could be adversely affected.\nWe face credit, liquidity and fraud risks from our agents, consumers, businesses, and third-party processors that could adversely affect our business, financial condition, results of operations, and cash flows.\nWe are exposed to credit risk in our international payments provider business relating to: (a) derivatives written by us to our customers and (b) the extension of trade credit when transactions are paid to recipients prior to our receiving cleared funds from the sending customers. The credit risk associated with our derivative contracts increases when foreign currency exchange rates move against our customers, possibly impacting their ability to honor their obligations to deliver currency to us or\nto maintain appropriate collateral with us. If a customer becomes insolvent, files for bankruptcy, commits fraud or otherwise fails to pay us, we may be exposed to the value of an offsetting position with a financial institution counterparty for the derivatives or may bear financial risk for those receivables where we have offered trade credit.\nIf we are unable to maintain our relationships with banks needed to conduct our services, or fail to comply with our contract requirements, our business, financial condition, results of operations, and cash flows would be adversely affected.\nIn our international payments provider business, we facilitate payment and foreign exchange solutions, primarily cross-border, cross-currency transactions, for small and medium size enterprises and other organizations. Increased regulation and compliance requirements are impacting these businesses by making it more costly for us to provide our services or by making it more cumbersome for businesses to do business with us. We may also have difficulty establishing or maintaining banking relationships needed to conduct our services due to banks’ policies. If we are unable to maintain our current business or banking relationships or establish new relationships under terms consistent with those currently in place, our ability to continue to offer our services may be adversely impacted, which could have an adverse effect on our business, financial condition, results of operations, and cash flows.\nRisks related to ownership of our common stock\nOur stock price could be volatile and our stock could decline in value.\nThe market price of our common stock may fluctuate substantially as a result of many factors, some of which are beyond our control. Factors that could cause fluctuations in the market price of our common stock include the following:\n\n| • | quarterly variations in our results of operations; |\n\n| • | results of operations that vary from the expectations of securities analysts and investors; |\n\n| • | results of operations that vary from those of our competitors; |\n\n40\n| • | changes in expectations as to our future financial performance, including financial estimates by securities analysts and investors; |\n\n| • | announcements by us or our competitors of significant contracts, acquisitions, or capital commitments; |\n\n| • | announcements by third parties of significant claims or proceedings against us; |\n\n| • | regulatory developments in the U.S. and abroad; |\n\n| • | future sales of our common stock, and additions or departures of key personnel; and |\n\n| • | general domestic and international economic, market and currency factors and conditions unrelated to our performance. |\n\nIn addition, the stock market in general has experienced significant price and volume fluctuations that have often been unrelated or disproportionate to operating performance of individual companies. These broad market factors may seriously harm the market price of our common stock, regardless of our operating performance. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted. A securities class action suit against us could result in significant liabilities and, regardless of the outcome, could result in substantial costs and the diversion of our management’s attention and resources.\nOur disclosure controls and procedures may not prevent or detect all errors or acts of fraud.\nWe are subject to the periodic reporting requirements of the Securities Exchange Act of 1934, as amended, or the Exchange Act. Our disclosure controls and procedures are designed to reasonably ensure that information required to be disclosed by us in reports we file or submit under the Exchange Act is accumulated and communicated to management and recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission (the \"SEC\"). We believe that any disclosure controls and procedures or internal controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are and will be met. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by an unauthorized override of the controls. Accordingly, because of the inherent limitations in our control system, misstatements due to error or fraud may occur and not be detected.\nAnti-takeover provisions in our charter documents could discourage, delay or prevent a change in control of our company and may affect the trading price of our common stock.\nOur corporate documents and the Delaware General Corporation Law contain provisions that may enable our board of directors to resist a change in control of FLEETCOR even if a change in control were to be considered favorable by you and other stockholders. These provisions:\n| • | stagger the terms of our board of directors and require supermajority stockholder voting to remove directors; |\n\n| • | authorize our board of directors to issue preferred stock and to determine the rights and preferences of those shares, which may be senior to our common stock, without prior stockholder approval; |\n\n| • | establish advance notice requirements for nominating directors and proposing matters to be voted on by stockholders at stockholder meetings; |\n\n| • | prohibit our stockholders from calling a special meeting and prohibit stockholders from acting by written consent; and |\n\n| • | require super-majority stockholder voting to effect certain amendments to our certificate of incorporation and bylaws. |\n\nIn addition, Delaware law imposes some restrictions on mergers and other business combinations between any holder of 15% or more of our outstanding voting stock and us. These provisions could discourage, delay or prevent a transaction involving a change in control of FLEETCOR. These provisions could also discourage proxy contests and make it more difficult for you and other stockholders to elect directors of your choosing and cause us to take other corporate actions you desire.\nWe do not expect to pay any dividends on our common stock for the foreseeable future.\nWe currently expect to retain all future earnings, if any, for future operation, expansion and debt repayment and have no current plans to pay any cash dividends to holders of our common stock for the foreseeable future. Any decision to declare and pay\n41\ndividends in the future will be made at the discretion of our board of directors and will depend on, among other things, our operating results, financial condition, cash requirements, contractual restrictions and other factors that our board of directors may deem relevant. In addition, we must comply with the covenants in our credit agreements in order to be able to pay cash dividends, and our ability to pay dividends generally may be further limited by covenants of any existing and future outstanding indebtedness we or our subsidiaries incur.\nITEM 1B. UNRESOLVED STAFF COMMENTS\nWe have no unresolved written comments regarding our periodic or current reports from the staff of the SEC.\n42\nITEM 2. PROPERTIES\nWe lease all of the real property used in our business, except as noted below. The following table lists each of our material facilities and its location, use and approximate square footage, at December 31, 2017.\n| Facility | Use | Approximate size |\n| United States | Square Feet |\n| Norcross, Georgia | Corporate headquarters and operations | 98,000 |\n| Covington, Louisiana | Corporate accounting and treasury | 24,000 |\n| Houston, Texas | Credit and collections | 6,300 |\n| Concord, California | Customer support | 7,100 |\n| Wichita, Kansas | CLC operations and customer support | 38,000 |\n| Salem, Oregon | Pacific Pride sales, operations and customer support | 10,000 |\n| Brentwood, Tennessee | Comdata sales, operations and customer support | 135,000 |\n| Nashville, Tennessee | Comdata operations | 38,300 |\n| Louisville, Kentucky | SVS sales, operations and customer support | 66,000 |\n| Lexington, Kentucky | CLS operations | 60,100 |\n| Austin, Texas | Comdata operations | 4,300 |\n| New York, New York | Cambridge U.S. headquarters | 5,900 |\n| Bala Cynwyd, Pennsylvania | Cambridge global exchange division | 4,800 |\n| International |\n| Prague, Czech Republic | CCS headquarters and Shell Europe (Germany, Austria, Poland, Hungary, Switzerland, Czech Republic and Slovakia, France, Belgium, Netherlands and Luxembourg) operations, credit and collections, customer service, sales and finance | 38,400 |\n| Mexico City, Mexico(1) | FLEETCOR Mexico headquarters and operations | 27,500 |\n| Moscow, Russia | PPR and NKT headquarters, sales, customer support, operations, credit and collections | 16,300 |\n| Bryansk, Russia | Sales and marketing | 19,900 |\n| Ipswich, United Kingdom(1) | Operations, sales and customer support | 17,900 |\n| Knaresborough, United Kingdom | Operations, sales and customer support | 5,100 |\n| London, United Kingdom | Europe headquarters (including Cambridge Europe) | 7,540 |\n| Swindon, United Kingdom | Allstar operations, sales and customer support | 18,300 |\n| Walsall, United Kingdom | Operations, sales and customer support | 9,500 |\n| Birmingham, United Kingdom | EPYX headquarters, sales, operations and customer support | 14,800 |\n| Sao Paulo, Brazil | CTF and VB Servicios headquarters, sales, customer support and operations | 32,300 |\n| Osasco, Brazil | CTF and VB Servicios operations, STP and SemParar Headquarters, sales, operations and customer support | 59,900 |\n| Rio de Janeiro, Brazil | DB Trans and AExpresso headquarters, sales, operations and customer support | 15,300 |\n| Auckland, New Zealand | CardLink headquarters, sales, operations and customer support | 7,200 |\n| Nuremberg, Germany | Shell Europe sales | 6,900 |\n| Almere, Netherlands | Travelcard headquarters, sales, customer support, operations, credit and collections | 5,600 |\n| Rostov-on-Don, Russia | Gazprom headquarters and operations | 10,600 |\n| Toronto, Canada | Cambridge global headquarters | 27,600 |\n\n| (1) | We own these facilities. |\n\nWe also own approximately 1.5 acres of land in Nashville, Tennessee, for employee parking. Additionally, we lease a number of minor additional facilities, including local sales and operations offices less than 3,250 square feet, small storage facilities and a small number of service stations in the United Kingdom; which are not included in the above list. We believe our facilities are adequate for our needs for at least the next 12 months. We anticipate that suitable additional or alternative facilities will be available to accommodate foreseeable expansion of our operations.\n43\nITEM 3. LEGAL PROCEEDINGS\nIn the ordinary course of business, we are subject to various pending and potential legal actions, arbitration proceedings, claims, subpoenas, and matters relating to compliance with laws and regulations (collectively, legal proceedings). Based on our current knowledge, management presently does not believe that the liabilities arising from these legal proceedings will have a material adverse effect on our consolidated financial condition, results of operations or cash flows. However, it is possible that the ultimate resolution of these legal proceedings could have a material adverse effect on our results of operations and financial condition for any particular period.\nShareholder Class Action and Derivative Lawsuits\nOn June 14, 2017, a shareholder filed a class action complaint in the United States District Court for the Northern District of Georgia against the Company and certain of its officers and directors on behalf of all persons who purchased or otherwise acquired the Company’s stock between February 5, 2016 and May 2, 2017. On October 13, 2017, the shareholder filed an amended complaint asserting claims on behalf of a putative class of all persons who purchased or otherwise acquired the Company's common stock between February 4, 2016 and May 3, 2017. The complaint alleges that the defendants made false or misleading statements regarding fee charges and the reasons for its earnings and growth in certain press releases and other public statements in violation of the federal securities laws. Plaintiff seeks class certification, unspecified monetary damages, costs, and attorneys’ fees. The Company disputes the allegations in the complaint and intends to vigorously defend against the claims.\nOn July 10, 2017, a shareholder derivative complaint was filed against the Company and certain of the Company’s directors and officers in the United States District Court for the Northern District of Georgia seeking recovery on behalf of the Company. The derivative complaint alleges that the defendants issued a false and misleading proxy statement in violation of the federal securities laws; that defendants breached their fiduciary duties by causing or permitting the Company to make allegedly false and misleading public statements concerning the Company’s fee charges, and financial and business prospects; and that certain defendants breached their fiduciary duties through allegedly improper sales of stock. The complaint seeks unspecified monetary damages on behalf of the Company, corporate governance reforms, disgorgement of profits, benefits and compensation by the defendants, restitution, costs, and attorneys’ and experts’ fees. On August 18, 2017, the court entered an order deferring the case pending a ruling on the defendants' motion to dismiss the putative shareholder class action, or until otherwise agreed to by the parties. The defendants dispute the allegations in the complaint and intend to vigorously defend against the claims.\nEstimating an amount or range of possible losses resulting from litigation proceedings is inherently difficult and requires an extensive degree of judgment, particularly where the matters involve indeterminate claims for monetary damages, and are in the stages of the proceedings where key factual and legal issues have not been resolved. For these reasons, we are currently unable to predict the ultimate timing or outcome of, or reasonably estimate the possible losses or a range of possible losses resulting from the matters described above.\nITEM 4. MINE SAFETY DISCLOSURES\nNot applicable.\n44\nPART II\nITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER\nMATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES\nOur common stock is traded on the New York Stock Exchange (NYSE) under the symbol “FLT.” As of December 31, 2017, there were 146 holders of record of our common stock. The table set forth below provides the intra-day high and low sales prices per share of our common stock for the four quarters during 2017 and 2016.\n\n| High | Low |\n| 2017: |\n| First Quarter | $ | 171.78 | $ | 142.62 |\n| Second Quarter | 157.36 | 121.52 |\n| Third Quarter | 157.40 | 138.43 |\n| Fourth Quarter | 194.51 | 153.45 |\n| 2016: |\n| First Quarter | $ | 150.25 | $ | 107.56 |\n| Second Quarter | 156.58 | 133.64 |\n| Third Quarter | 174.84 | 137.26 |\n| Fourth Quarter | 176.42 | 140.75 |\n\nDIVIDENDS AND SHARE REPURCHASES\nWe currently expect to retain all future earnings, if any, for use in the operation and expansion of our business. We have never declared or paid any dividends on our common stock and do not anticipate paying cash dividends to holders of our common stock in the foreseeable future. In addition, our credit agreements restrict our ability to pay dividends. Any determination to pay dividends in the future will be at the discretion of our board of directors and will depend upon, among other factors, our results of operations, financial condition, capital requirements and covenants in our existing financing arrangements and any future financing arrangements.\nOn February 4, 2016, our Board of Directors approved a stock repurchase program (the \"Program\") under which we may begin purchasing up to an aggregate of $500 million of the outstanding common stock over the following 18 month period. On July 27, 2017, the Company's Board of Directors authorized an increase in the size of the Program by an additional $250 million and an extension of the Program by an additional 18 months. On November 1, 2017, the Company announced that its Board of Directors had authorized an increase in the size of the Program by an additional $350 million, resulting in total aggregate repurchases authorized under the Program of $1.1 billion. Since the beginning of the Program, 4,114,104 shares for an aggregate purchase price of $590 million have been repurchased.\nWe did not make any purchases of common stock during the three months ended December 31, 2017 as defined in Rule 10b-18(a)(3) under the Exchange Act.\n45\nPERFORMANCE GRAPH\nThe following graph assumes $100 invested on December 31, 2012, at the closing price ($53.65) of our common stock on that day, and compares (a) the percentage change of our cumulative total stockholder return on the common stock (as measured by dividing (i) the difference between our share price at the end and the beginning of the period presented by (ii) the share price at the beginning of the periods presented) with (b) (i) the Russell 2000 Index and (ii) the S&P 500® Data Processing & Outsourced Services.\n\n| Period Ending | FLEETCORTechnologies, Inc. | Russell 2000 | S&P DataProcessing andOutsourcedServices |\n| 12/31/2012 | $ | 100.00 | $ | 100.00 | $ | 100.00 |\n| 3/31/2013 | $ | 142.91 | $ | 112.03 | $ | 112.20 |\n| 6/30/2013 | $ | 151.54 | $ | 115.09 | $ | 118.85 |\n| 9/30/2013 | $ | 205.33 | $ | 126.42 | $ | 130.25 |\n| 12/31/2013 | $ | 218.40 | $ | 137.00 | $ | 151.76 |\n| 3/31/2014 | $ | 214.54 | $ | 138.11 | $ | 144.46 |\n| 6/30/2014 | $ | 245.67 | $ | 140.46 | $ | 144.86 |\n| 9/30/2014 | $ | 264.90 | $ | 129.71 | $ | 146.72 |\n| 12/31/2014 | $ | 277.19 | $ | 141.84 | $ | 170.19 |\n| 3/31/2015 | $ | 281.30 | $ | 147.50 | $ | 173.97 |\n| 6/30/2015 | $ | 290.89 | $ | 147.64 | $ | 175.73 |\n| 9/30/2015 | $ | 256.51 | $ | 129.59 | $ | 172.99 |\n| 12/31/2015 | $ | 266.41 | $ | 133.74 | $ | 188.13 |\n| 3/30/2016 | $ | 277.26 | $ | 131.16 | $ | 188.59 |\n| 6/30/2016 | $ | 266.78 | $ | 135.62 | $ | 185.00 |\n| 9/30/2016 | $ | 323.82 | $ | 147.37 | $ | 199.67 |\n| 12/31/2016 | $ | 263.78 | $ | 159.78 | $ | 199.15 |\n| 3/31/2017 | $ | 282.26 | $ | 163.17 | $ | 216.67 |\n| 6/30/2017 | $ | 268.80 | $ | 166.64 | $ | 232.21 |\n| 9/30/2017 | $ | 288.48 | $ | 175.53 | $ | 259.13 |\n| 12/31/2017 | $ | 358.68 | $ | 180.79 | $ | 280.89 |\n\n46\nRECENT SALES OF UNREGISTERED SECURITIES AND USE OF PROCEEDS\nNot Applicable.\n47\nITEM 6. SELECTED FINANCIAL DATA\nWe derived the consolidated statement of income and other financial data for the years ended December 31, 2017, 2016 and 2015 and the selected consolidated balance sheet data as of December 31, 2017 and 2016 from the audited consolidated financial statements included elsewhere in this report. We derived the selected historical financial data for the years ended December 31, 2014 and 2013 and the selected consolidated balance sheets as of December 31, 2015, 2014 and 2013 from our audited consolidated financial statements that are not included in this report.\nThe selected consolidated financial data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited consolidated financial statements and notes thereto included elsewhere in this report. Our historical results are not necessarily indicative of the results to be expected in any future period.\n\n| (in thousands, except per share data) | 2017 | 2016 | 2015 | 2014 | 2013 |\n| Consolidated statement of income data: |\n| Revenues, net | $ | 2,249,538 | $ | 1,831,546 | $ | 1,702,865 | $ | 1,199,390 | $ | 895,171 |\n| Expenses: |\n| Merchant commissions | 113,133 | 104,345 | 108,257 | 96,254 | 68,143 |\n| Processing | 429,613 | 355,414 | 331,073 | 173,337 | 134,030 |\n| Selling | 170,717 | 131,443 | 109,075 | 75,527 | 57,346 |\n| General and administrative | 387,694 | 283,625 | 297,715 | 205,963 | 142,283 |\n| Depreciation and amortization | 264,560 | 203,256 | 193,453 | 112,361 | 72,737 |\n| Other operating, net | 61 | (690 | ) | (4,242 | ) | (29,501 | ) | — |\n| Operating income | 883,760 | 754,153 | 667,534 | 565,449 | 420,632 |\n| Investment loss | 53,164 | 36,356 | 57,668 | 8,586 | — |\n| Other (income) expense, net | (173,436 | ) | 2,982 | 2,523 | (700 | ) | 602 |\n| Interest expense, net | 107,146 | 71,896 | 71,339 | 28,856 | 16,461 |\n| Loss on extinguishment of debt | 3,296 | — | — | 15,764 | — |\n| Total other (income) expense | (9,830 | ) | 111,234 | 131,530 | 52,506 | 17,063 |\n| Income before income taxes | 893,590 | 642,919 | 536,004 | 512,943 | 403,569 |\n| Provision for income taxes | 153,390 | 190,534 | 173,573 | 144,236 | 119,068 |\n| Net income | $ | 740,200 | $ | 452,385 | $ | 362,431 | $ | 368,707 | $ | 284,501 |\n| Earnings per share: |\n| Basic earnings per share | $ | 8.12 | $ | 4.89 | $ | 3.94 | $ | 4.37 | $ | 3.48 |\n| Diluted earnings per share | $ | 7.91 | $ | 4.75 | $ | 3.85 | $ | 4.24 | $ | 3.36 |\n| Weighted average shares outstanding: |\n| Basic shares | 91,129 | 92,597 | 92,023 | 84,317 | 81,793 |\n| Diluted shares | 93,594 | 95,213 | 94,139 | 86,982 | 84,655 |\n| As of December 31, |\n| (in thousands) | 2017 | 2016 | 2015 | 2014 | 2013 |\n| Consolidated balance sheet data: |\n| Cash and cash equivalents | $ | 913,595 | $ | 475,018 | $ | 447,152 | $ | 477,069 | $ | 338,105 |\n| Restricted cash(1) | 217,275 | 168,752 | 167,492 | 135,144 | 48,244 |\n| Total assets | 11,318,359 | 9,626,732 | 7,889,806 | 8,524,701 | 3,908,717 |\n| Total debt | 4,518,616 | 3,858,233 | 2,935,000 | 3,593,717 | 1,486,378 |\n| Total stockholders’ equity | 3,676,522 | 3,084,038 | 2,830,047 | 2,618,562 | 1,223,502 |\n\n(1) Restricted cash represents customer deposits repayable on demand, as well as collateral received from customers for cross-currency transactions.\n48\nITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND\nRESULTS OF OPERATIONS\nThe following discussion and analysis of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes appearing elsewhere in this report. In addition to historical information, this discussion contains forward-looking statements that involve risks, uncertainties and assumptions that could cause actual results to differ materially from management’s expectations. Factors that could cause such differences include, but are not limited to, those identified below and those described in Item 1A “Risk Factors” appearing elsewhere in this report. All foreign currency amounts that have been converted into U.S. dollars in this discussion are based on the exchange rate as reported by Oanda for the applicable periods.\nGeneral Business\nFLEETCOR is a leading global provider of commercial payment solutions. We help businesses of all sizes control, simplify and secure payment of various domestic and cross-border payables using specialized payment products. We serve businesses, merchants and partners in North America, Latin America, Europe, and Australasia. FLEETCOR’s predecessor company was organized in the United States in 1986, and FLEETCOR had its initial public offering in 2010 (NYSE: FLT).\nFLEETCOR has two reportable segments, North America and International. We report these two segments as they align with our senior executive organizational structure, reflect how we organize and manage our employees around the world, manage operating performance, contemplate the differing regulatory environments in North America versus other geographies, and help us isolate the impact of foreign exchange fluctuations on our financial results.\nOur payment solutions provide our customers with a payment method designed to be superior to and more robust and effective than what they use currently, whether they use a competitor’s product or another alternative method such as cash or check. Our solutions are comprised of payment products, networks and associated services.\nOur payment products function like a charge card or prepaid card and tend to be specialized for specific spend categories, such as fuel or lodging, and/or specific customer groups, such as long haul transportation. FLEETCOR’s five primary product lines are Fuel, Lodging, Tolls, Corporate Payments and Gift. Additionally, we provide other payment products including fleet maintenance, employee benefits and long haul transportation-related services. Our products are used in 56 countries around the world, with our primary geographies being the U.S., Brazil and the United Kingdom, which combined accounted for approximately 90% of our revenue in 2017.\nFLEETCOR uses both proprietary and third-party networks to deliver our payment solutions. FLEETCOR owns and operates proprietary networks with well-established brands throughout the world, bringing incremental sales and loyalty to affiliated merchants. Third-party networks are used to broaden payment product acceptance and use. In 2017, we processed approximately 3 billion transactions within these networks, of which approximately 1.4 billion were related to our Gift product line.\nFLEETCOR capitalizes on its products’ specialization with sales and marketing efforts by deploying product-dedicated sales forces to target specific customer segments. We market our products directly through multiple sales channels, including field sales, telesales and digital marketing, and indirectly through our partners, which include major oil companies, leasing companies, petroleum marketers, value-added resellers (VARs) and referral partners.\nWe believe that our size and scale, product breadth and specialization, geographic reach, proprietary networks, robust distribution capabilities and advanced technology contribute to our industry leading position.\nExecutive Overview\nWe operate in two segments, which we refer to as our North America and International segments. Our revenue is reported net of the wholesale cost for underlying products and services. In this report, we refer to this net revenue as “revenue\". See “Results of Operations” for additional segment information.\nWe report our results from Cambridge (acquired in the third quarter of 2017) and CLS (acquired in the fourth quarter of 2017) in our North America segment. The results of operations from the fuel card business acquired in Russia are included within our International segment. As part of our plan to exit the telematics business, on July 27, 2017, we sold NexTraq, a U.S. fleet telematics business, which has historically been included in our North America segment.\n49\nRevenues, net, by Segment. For the years ended December 31, 2017, 2016 and 2015, our North America and International segments generated the following revenue:\n| Year ended December 31, |\n| 2017 | 2016 | 2015 |\n| (in millions) | Revenues,net | % oftotalrevenues, net | Revenues,net | % oftotalrevenues, net | Revenues,net | % oftotalrevenues, net |\n| North America | $ | 1,429 | 63.5 | % | $ | 1,279 | 69.8 | % | $ | 1,232 | 72.3 | % |\n| International | 821 | 36.5 | % | 552 | 30.2 | % | 471 | 27.7 | % |\n| $ | 2,250 | 100.0 | % | $ | 1,832 | 100.0 | % | $ | 1,703 | 100.0 | % |\n\nRevenues, net, Net Income and Net Income Per Diluted Share. Set forth below are revenues, net, net income and net income per diluted share for the years ended December 31, 2017, 2016 and 2015.\n| Year ended December 31, |\n| (in millions, except per share amounts) | 2017 | 2016 | 2015 |\n| Revenues, net | $ | 2,250 | $ | 1,832 | $ | 1,703 |\n| Net income | $ | 740 | $ | 452 | $ | 362 |\n| Net income per diluted share | $ | 7.91 | $ | 4.75 | $ | 3.85 |\n\nAdjusted Revenues, Adjusted Net Income and Adjusted Net Income Per Diluted Share. Set forth below are adjusted revenues, adjusted net income and adjusted net income per diluted share for the years ended December 31, 2017, 2016 and 2015.\n| Year Ended December 31, |\n| 2017 | 2016 | 2015 |\n| (in millions, except per share amounts) |\n| Adjusted revenues | $ | 2,136 | $ | 1,727 | $ | 1,595 |\n| Adjusted net income | $ | 799 | $ | 659 | $ | 593 |\n| Adjusted net income per diluted share | $ | 8.54 | $ | 6.92 | $ | 6.30 |\n\nAdjusted revenues, adjusted net income and adjusted net income per diluted share are supplemental non-GAAP financial measures of operating performance. See the heading entitled “Management’s Use of Non-GAAP Financial Measures.” We use adjusted revenues as a basis to evaluate our revenues, net of the commissions that are paid to merchants that participate in certain of our card programs. The commissions paid to merchants can vary when market spreads fluctuate in much the same way as revenues are impacted when market spreads fluctuate. Thus, we believe this is a more effective way to evaluate our revenue performance on a consistent basis. We use adjusted net income and adjusted net income per diluted share to eliminate the effect of items that we do not consider indicative of our core operating performance on a consistent basis.\nSources of Revenue\nTransactions. In both of our segments, we derive revenue from transactions. A transaction is defined as a purchase by a customer utilizing one of our payment products at a participating merchant. The following diagram illustrates a typical transaction flow, which is representative of many, but not all, of our businesses.\n50\nIllustrative Transaction Flow\nThe revenue we derive from transactions is generated from both customers and merchants. Customers may include directly- and indirectly-sold commercial businesses as well as partners for whom we manage payment programs. Merchants may include those merchants affiliated with our proprietary networks or those participating in the third-party networks we utilize.\nFrom our customers and partners, we generate revenue through a variety of program fees, including transaction fees, card fees, network fees and charges. These fees may be charged as fixed amounts, costs plus a mark-up, or based on a percentage of the transaction purchase amounts. Our programs include other fees and charges associated with late payments and based on customer credit risk.\nFrom our merchants and third-party networks, we generate revenue mostly from the difference between the amount charged to a customer and the amount paid to the merchant or network for a given transaction, as well as network fees and charges in certain businesses. The amount paid to a merchant or network may be calculated as (i) the merchant’s wholesale product cost plus a markup; (ii) the transaction purchase amount less a percentage discount; or (iii) the transaction purchase amount less a fixed fee per unit. The following table provides illustrations of these three merchant payment models, which are representative of many, but not all, of our businesses.\nIllustrative Merchant Payment Models\n| i) Cost Plus Mark-up: | ii) Percentage Discount: | iii) Fixed Fee: |\n| Wholesale Cost | $ | 2.86 | Retail Price | $ | 3.00 | Retail Price | $ | 3.00 |\n| Mark-up | 0.05 | Discount (3%) | (0.09 | ) | Fixed Fee | (0.09 | ) |\n| Price Paid to Merchant | $ | 2.91 | Price Paid to Merchant | $ | 2.91 | Price Paid to Merchant | $ | 2.91 |\n\nFor a transaction involving the purchase of fuel where the amount paid to the merchant is calculated under the cost plus markup model, we refer to the difference between the amount charged to the customer and the amount paid to the merchant as merchant revenue tied to fuel-price spreads. In all other cases, we refer to the difference between the amount charged to the customer and the amount paid to the merchant for a given transaction as interchange revenue.\nRevenue per transaction. Set forth below is revenue per transaction by segment information for the years ended December 31, 2017, 2016 and 2015. Revenue per transactions by segment is affected by the mix of products and acquisitions, which may result in revenue per transaction by product providing more meaningful data for analysis.\n51\n| Year ended December 31, |\n| (Unaudited) | 2017 | 2016 | 2015 |\n| Transactions (in millions) |\n| North America | 1,842.4 | 1,714.6 | 1,667.5 |\n| International | 1,114.5 | 507.8 | 183.9 |\n| Total transactions | 2,956.9 | 2,222.4 | 1,851.4 |\n| Revenue per transaction |\n| North America | $ | 0.78 | $ | 0.75 | $ | 0.74 |\n| International | $ | 0.74 | $ | 1.09 | $ | 2.56 |\n| Consolidated revenue per transaction | $ | 0.76 | $ | 0.82 | $ | 0.92 |\n| Consolidated adjusted revenue per transaction | $ | 0.72 | $ | 0.78 | $ | 0.86 |\n\nThe following table provides a breakdown of revenue per transaction by product for the years ended December 31, 2017 and 2016 (in millions, except per transaction data):\n| As Reported | Pro Forma and Macro Adjusted2 |\n| Year Ended December 31, | Year Ended December 31, |\n| (Unaudited) | 2017 | 2016 | Change | % Change | 20173 | 20164 | Change | % Change |\n| Fuel Cards6 |\n| Transactions5 | 466 | 434 | 32 | 7 | % | 466 | 444 | 23 | 5 | % |\n| Revenues, net per transaction | $ | 2.35 | $ | 2.30 | $ | 0.05 | 2 | % | $ | 2.29 | $ | 2.25 | $ | 0.04 | 2 | % |\n| Revenues, net5 | $ | 1,096 | $ | 997 | $ | 99 | 10 | % | $ | 1,066 | $ | 998 | $ | 68 | 7 | % |\n| Corporate Payments |\n| Transactions | 42 | 39 | 3 | 7 | % | 42 | 39 | 3 | 6 | % |\n| Revenues, net per transaction | $ | 6.30 | $ | 4.64 | $ | 1.66 | 36 | % | $ | 6.26 | $ | 5.80 | $ | 0.46 | 8 | % |\n| Revenues, net | $ | 262 | $ | 180 | $ | 82 | 46 | % | $ | 260 | $ | 226 | $ | 34 | 15 | % |\n| Tolls |\n| Transactions | 916 | 327 | 589 | 180 | % | 916 | 894 | 22 | 2 | % |\n| Revenues, net per transaction | $ | 0.36 | $ | 0.31 | $ | 0.04 | 13 | % | $ | 0.33 | $ | 0.29 | $ | 0.04 | 14 | % |\n| Revenues, net | $ | 327 | $ | 103 | $ | 224 | 218 | % | $ | 302 | $ | 257 | $ | 45 | 18 | % |\n| Lodging |\n| Transactions | 17 | 13 | 4 | 30 | % | 17 | 14 | 3 | 22 | % |\n| Revenues, net per transaction | $ | 7.45 | $ | 7.58 | $ | (0.13 | ) | (2 | )% | $ | 7.45 | $ | 7.68 | (0.23 | ) | (3 | )% |\n| Revenues, net | $ | 127 | $ | 101 | $ | 26 | 26 | % | $ | 127 | 105 | $ | 22 | 21 | % |\n| Gift |\n| Transactions | 1,439 | 1,327 | 111 | 8 | % | 1,439 | 1,327 | 111 | 8 | % |\n| Revenues, net per transaction | $ | 0.13 | $0.14 | $0.00 | (3 | )% | $ | 0.13 | $ | 0.14 | $ | (0.01 | ) | (7 | )% |\n| Revenues, net | $ | 194 | $185 | $9 | 5 | % | $ | 194 | $ | 185 | $ | 9 | 5 | % |\n| Other1 |\n| Transactions5 | 77 | 82 | (5 | ) | (6 | )% | 77 | 82 | (4 | ) | (5 | )% |\n| Revenues, net per transaction | $ | 3.15 | $ | 3.23 | $ | (0.08 | ) | (2 | )% | $ | 3.14 | $ | 2.99 | $ | 0.15 | 5 | % |\n| Revenues, net5 | $ | 244 | $ | 266 | $ | (23 | ) | (8 | )% | $ | 243 | $ | 244 | $ | (1 | ) | — | % |\n| FLEETCOR CONSOLIDATED REVENUES |\n| ‑Transactions5 | 2,957 | 2,222 | 735 | 33 | % | 2,957 | 2,799 | 158 | 6 | % |\n| ‑Revenues, net per transaction | $ | 0.76 | $ | 0.82 | $ | (0.06 | ) | (7 | )% | $ | 0.74 | $ | 0.73 | $ | 0.02 | 2 | % |\n| ‑ Revenues, net | $ | 2,250 | $ | 1,832 | $ | 418 | 23 | % | $ | 2,193 | $ | 2,015 | $ | 178 | 9 | % |\n\n52\n\n| *Columns may not calculate due to rounding. |\n| 1Other includes telematics, maintenance, food, and transportation related businesses. |\n| 2 Pro forma and macro adjusted revenue is a non-GAAP financial measure defined as revenues, net adjusted for the impact of the macroeconomic environment and acquisitions and dispositions and other one-time items. We use pro forma and macro adjusted revenue as a basis to evaluate our organic growth. See the heading entitled “Management’s Use of Non-GAAP Financial Measures” for a reconciliation of pro forma and macro adjusted revenue by product, non-GAAP measures, to the GAAP equivalent. |\n| 32017 is adjusted to remove the impact of changes in the macroeconomic environment to be consistent with the same period of prior year, using constant fuel prices, fuel price spreads and foreign exchange rates. |\n| 42016 is pro forma to include acquisitions and exclude dispositions consistent with 2017 ownership. |\n| 52016 revenue and transactions reflect immaterial corrections from previously disclosed amounts for the prior period. |\n| 6Fuel Cards product category further refined to Fuel, to reflect different ways that fuel is paid for by our customers. |\n\nRevenue per transaction is derived from the various revenue types as discussed above and can vary based on geography, the relevant merchant relationship, the payment product utilized and the types of products or services purchased, the mix of which would be influenced by our acquisitions, organic growth in our business, and the overall macroeconomic environment, including fluctuations in foreign currency exchange rates, fuel prices and spreads. Revenue per transaction per customer changes as the level of services we provide to a customer increases or decreases, as macroeconomic factors change and as adjustments are made to merchant and customer rates. See “Results of Operations” for further discussion of transaction volumes and revenue per transaction.\nSources of Expense\nWe incur expenses in the following categories:\n\n| • | Merchant commissions—In certain of our card programs, we incur merchant commissions expense when we reimburse merchants with whom we have direct, contractual relationships for specific transactions where a customer purchases products or services from the merchant. In the card programs where it is paid, merchant commissions equal the difference between the price paid by us to the merchant and the merchant’s wholesale cost of the underlying products or services. |\n\n| • | Processing—Our processing expense consists of expenses related to processing transactions, servicing our customers and merchants, bad debt expense and cost of goods sold related to our hardware sales in certain businesses. |\n\n| • | Selling—Our selling expenses consist primarily of wages, benefits, sales commissions (other than merchant commissions) and related expenses for our sales, marketing and account management personnel and activities. |\n\n| • | General and administrative—Our general and administrative expenses include compensation and related expenses (including stock-based compensation) for our executive, finance and accounting, information technology, human resources, legal and other administrative personnel. Also included are facilities expenses, third-party professional services fees, travel and entertainment expenses, and other corporate-level expenses. |\n\n| • | Depreciation and amortization—Our depreciation expenses include depreciation of property and equipment, consisting of computer hardware and software (including proprietary software development amortization expense), card-reading equipment, furniture, fixtures, vehicles and buildings and leasehold improvements related to office space. Our amortization expenses include amortization of intangible assets related to customer and vendor relationships, trade names and trademarks and non-compete agreements. We also amortize intangible assets related to business acquisitions and certain private label contracts associated with the purchase of accounts receivable. |\n\n| • | Other operating, net—Our other operating, net includes other operating expenses and income items unusual to the period and presented separately. |\n\n| • | Investment loss (income)—Our investment results relate to our minority interest in Masternaut, a provider of telematics solutions to commercial fleets in Europe, which we historically accounted for using the equity method. On September 30, 2017, we entered into an amended Masternaut investment agreement that resulted in the loss of significant influence, and we began accounting for the Masternaut investment by applying the cost method. |\n\n| • | Other (income) expense, net—Our other (income) expense, net includes proceeds/costs from the sale of assets, foreign currency transaction gains or losses, and other miscellaneous operating costs and revenue. |\n\n53\n| • | Interest expense, net—Our interest expense, net includes interest income on our cash balances and interest expense on our outstanding debt and on our Securitization Facility. We have historically invested our cash primarily in short-term money market funds. |\n\n| • | Loss on extinguishment of debt—Loss on extinguishment of debt relates to our write-off of debt issuance costs associated with the refinancing of our existing Credit Facility. |\n\n| • | Provision for income taxes—The provision for income taxes consists primarily of corporate income taxes related to profits resulting from the sale of our products and services. Our worldwide effective tax rate is lower than the U.S. statutory rate of 35%, due primarily to the Tax Cuts and Job Act (\"Tax Act\") and lower rates in foreign jurisdictions and foreign-sourced non-taxable income. |\n\nFactors and Trends Impacting our Business\nWe believe that the following factors and trends are important in understanding our financial performance:\n\n| • | Global economic conditions—Our results of operations are materially affected by conditions in the economy generally, both in North America and internationally. Factors affected by the economy include our transaction volumes and the credit risk of our customers. These factors affected our businesses in both our North America and International segments. |\n\n| • | Foreign currency changes—Our results of operations are significantly impacted by changes in foreign currency rates; namely, by movements of the Australian dollar, Brazilian real, British pound, Canadian dollar, Czech koruna, Euro, Mexican peso, New Zealand dollar and Russian ruble, relative to the U.S. dollar. Approximately 62%, 70% and 72% of our revenue in 2017, 2016 and 2015, respectively, was derived in U.S. dollars and was not affected by foreign currency exchange rates. See “Results of Operations” for information related to foreign currency impact on our total revenue, net. |\n\n| • | Fuel prices—Our fleet customers use our products and services primarily in connection with the purchase of fuel. Accordingly, our revenue is affected by fuel prices, which are subject to significant volatility. A change in retail fuel prices could cause a decrease or increase in our revenue from several sources, including fees paid to us based on a percentage of each customer’s total purchase. Changes in the absolute price of fuel may also impact unpaid account balances and the finance fees and charges based on these amounts. See “Sources of Revenue” above for further information related to the absolute price of fuel. |\n\n| • | Fuel-price spread volatility—A portion of our revenue involves transactions where we derive revenue from fuel-price spreads, which is the difference between the price charged to a fleet customer for a transaction and the price paid to the merchant for the same transaction. In these transactions, the price paid to the merchant is based on the wholesale cost of fuel. The merchant’s wholesale cost of fuel is dependent on several factors including, among others, the factors described above affecting fuel prices. The fuel price that we charge to our customer is dependent on several factors including, among others, the fuel price paid to the merchant, posted retail fuel prices and competitive fuel prices. We experience fuel-price spread contraction when the merchant’s wholesale cost of fuel increases at a faster rate than the fuel price we charge to our customers, or the fuel price we charge to our customers decreases at a faster rate than the merchant’s wholesale cost of fuel. See “Sources of Revenue” above for further information related to fuel-price spreads. |\n\n| • | Acquisitions—Since 2002, we have completed over 75 acquisitions of companies and commercial account portfolios. Acquisitions have been an important part of our growth strategy, and it is our intention to continue to seek opportunities to increase our customer base and diversify our service offering through further strategic acquisitions. The impact of acquisitions has, and may continue to have, a significant impact on our results of operations and may make it difficult to compare our results between periods. |\n\n| • | Interest rates—Our results of operations are affected by interest rates. We are exposed to market risk changes in interest rates on our cash investments and debt. |\n\n| • | Expenses— Over the long term, we expect that our general and administrative expense will decrease as a percentage of revenue as our revenue increases. To support our expected revenue growth, we plan to continue to incur additional sales and marketing expense by investing in our direct marketing, third-party agents, internet marketing, telemarketing and field sales force. |\n\n54\nAcquisitions and Investments\nDuring 2017, the Company completed acquisitions with an aggregate purchase price of $720.8 million, net of cash acquired of $96.2 million. During 2017, the Company made investments in other businesses of $39 million.\n| • | On August 9, 2017, we acquired Cambridge, a leading business to business (B2B) international payments provider, for approximately $616.1 million in cash, net of cash acquired of $94.5 million and inclusive of a note payable of $23.8 million. Cambridge processes B2B cross-border payments, assisting business clients in making international payments. The purpose of this acquisition is to further expand our corporate payments footprint. |\n\n| • | On September 26, 2017, we acquired a fuel card provider in Russia. |\n\n| • | On October 13, 2017, we completed the acquisition of CLS, a small lodging tuck-in business, in the United States. |\n\nDuring 2016, we completed acquisitions with an aggregate purchase price of $1.3 billion, net of cash acquired of $51.3 million, which includes deferred payments made during the period related to prior acquisitions of $6.1 million.\n| • | In August 2016, we acquired all of the outstanding stock of Serviços e Tecnologia de Pagamentos S.A. (“STP”) for $1.23 billion, net of cash acquired of $40.2 million. STP is an electronic toll payments company in Brazil and provides cardless fuel payments at a number of Shell sites throughout Brazil. The purpose of this acquisition was to expand our presence in the toll market in Brazil. |\n\n| • | During 2016, we acquired additional fuel card portfolios in the U.S. and the United Kingdom, additional Shell fuel card markets in Europe and Travelcard in the Netherlands totaling $76.7 million, net of cash acquired of $11.1 million. |\n\n| • | During 2016, we made additional investments of $7.9 million related to our investment at Masternaut. We also received a $9.2 million return of our investment in Masternaut in 2016. |\n\nDuring 2015, we completed acquisitions of Shell portfolios related to our fuel card businesses in Europe, as well as a small acquisition internationally, with an aggregate purchase price of $46.3 million, each included within our International segment from the date of acquisition, and made additional investments of $8.4 million related to our equity method investment at Masternaut and deferred payments of $3.4 million related to acquisitions occurring in prior years.\nWe report our results from Cambridge and CLS acquired in the third and fourth quarters of 2017, respectively, in our North America segment, from the date of acquisition. The results of operations from the fuel card business in Russia acquired in the third quarter of 2017, are included within our International segment from the date of acquisition. The results of operations from the fuel card portfolio acquired in the U.S. are included within our North America segment, from the date of acquisition. The results of operations of STP, the fuel card portfolio in the United Kingdom, the additional Shell markets, the Travelcard business in the Netherlands and the small business in Brazil are included within our International segment, from the date of acquisition.\nAsset Dispositions\nTelematics Businesses\nAs part of our plan to exit the telematics business, on July 27, 2017, we sold NexTraq, a U.S. fleet telematics business, to Michelin Group for $316.5 million. We recorded a pre-tax gain on the disposal of NexTraq of $175.0 million during the third quarter of 2017, which is net of transaction closing costs. We recorded tax on the gain of disposal of $65.8 million. The gain on the disposal is included in other (income) expense, net in the accompanying Consolidated Statements of Income. NexTraq had historically been included in our North America segment.\nOn September 30, 2017, we entered into an amended Masternaut investment agreement that resulted in the loss of significant influence, and we began accounting for the Masternaut investment by applying the cost method.\nWe regularly evaluate the carrying value of our Masternaut investment and during the third quarter of 2017, we determined that the fair value of our 44% investment in Masternaut had declined as a result of our loss of significant influence and the operating results of Masternaut. As a result, we determined that the carrying value of our investment exceeded its fair value, and concluded that this decline in value was other than temporary. We recorded a $44.6 million impairment loss in the Masternaut investment that includes adjustment for $31.4 million of currency translation losses previously recognized in accumulated other comprehensive income, in the accompanying Consolidated Statements of Income.\n55\nResults of Operations\nYear ended December 31, 2017 compared to the year ended December 31, 2016\nThe following table sets forth selected consolidated statement of income and selected operational data for the years ended December 31, 2017 and 2016 (in millions, except percentages)*.\n| Year endedDecember 31,2017 | % of totalrevenue | Year endedDecember 31,2016 | % of totalrevenue | Increase(decrease) | % Change |\n| Revenues, net: |\n| North America | $ | 1,428.7 | 63.5 | % | $ | 1,279.1 | 69.8 | % | $ | 149.6 | 11.7 | % |\n| International | 820.8 | 36.5 | % | 552.4 | 30.2 | % | 268.4 | 48.6 | % |\n| Total revenues, net | 2,249.5 | 100.0 | % | 1,831.5 | 100.0 | % | 418.0 | 22.8 | % |\n| Consolidated operating expenses: |\n| Merchant commissions | 113.1 | 5.0 | % | 104.3 | 5.7 | % | 8.8 | 8.4 | % |\n| Processing | 429.6 | 19.1 | % | 355.4 | 19.4 | % | 74.2 | 20.9 | % |\n| Selling | 170.7 | 7.6 | % | 131.4 | 7.2 | % | 39.3 | 29.9 | % |\n| General and administrative | 387.7 | 17.2 | % | 283.6 | 15.5 | % | 104.1 | 36.7 | % |\n| Depreciation and amortization | 264.6 | 11.8 | % | 203.3 | 11.1 | % | 61.3 | 30.2 | % |\n| Other operating, net | 0.1 | — | % | (0.7 | ) | — | % | (0.8 | ) | (108.8 | )% |\n| Operating income | 883.8 | 39.3 | % | 754.2 | 41.2 | % | 129.6 | 17.2 | % |\n| Investment loss | 53.2 | 2.4 | % | 36.4 | 2.0 | % | 16.8 | 46.2 | % |\n| Other (income) expense, net | (173.4 | ) | (7.7 | )% | 3.0 | 0.2 | % | (176.4 | ) | NM |\n| Interest expense, net | 107.1 | 4.8 | % | 71.9 | 3.9 | % | 35.3 | 49.0 | % |\n| Loss on extinguishment of debt | 3.3 | 0.1 | % | — | — | % | 3.3 | — | % |\n| Provision for income taxes | 153.4 | 6.8 | % | 190.5 | 10.4 | % | (37.1 | ) | (19.5 | )% |\n| Net income | $ | 740.2 | 32.9 | % | $ | 452.4 | 24.7 | % | $ | 287.8 | 63.6 | % |\n| Operating income for segments: |\n| North America | $ | 541.6 | $ | 506.4 | $ | 35.2 | 6.9 | % |\n| International | 342.2 | 247.7 | 94.4 | 38.1 | % |\n| Operating income | $ | 883.8 | $ | 754.2 | $ | 129.6 | 17.2 | % |\n| Operating margin for segments: |\n| North America | 37.9 | % | 39.6 | % | (1.7 | )% |\n| International | 41.7 | % | 44.8 | % | (3.2 | )% |\n| Total | 39.3 | % | 41.2 | % | (1.9 | )% |\n\nNM = Not Meaningful\n*Columns may not calculate due to rounding.\nRevenues\nOur consolidated revenue increased from $1,831.5 million in 2016 to $2,249.5 million in 2017, an increase of $418.0 million, or 22.8%. The increase in our consolidated revenue was primarily due to:\n\n| • | The impact of acquisitions completed in 2016 and 2017, which contributed approximately $212 million in additional revenue. |\n\n| • | Organic growth of approximately 9% on a constant fuel price, fuel spread margin, foreign currency and pro forma basis, driven by increases in both volume and revenue per transaction in certain of our payment programs. |\n\n| • | Although we cannot precisely measure the impact of the macroeconomic environment, in total we believe it had a favorable impact on our consolidated revenue for 2017 over 2016 of approximately $33 million. We believe the favorable impact of higher fuel prices and fuel spread margins, primarily in the U.S., had a favorable impact on consolidated revenues in 2017 over in 2016 of approximately $30 million. Additionally, changes in foreign exchange |\n\n56\nrates had a favorable impact on consolidated revenues in 2017 over in 2016 of approximately $3 million, primarily due to favorable changes in foreign exchange rates in Brazil.\nThese increases were partially offset by the impact of the disposition of the NexTraq telematics business in July 2017 of $23 million.\nNorth America segment revenues. North America revenues increased from $1,279.1 million in 2016 to $1,428.7 million in 2017, an increase of $149.6 million, or 11.7%. The increase in our North America segment revenue was primarily due to:\n| • | The impact of our Cambridge and CLS acquisitions during the third and fourth quarters of 2017, respectively, which contributed approximately $51 million in additional revenue. |\n\n| • | Organic growth of approximately 8%, on a constant fuel price, fuel spread margin and pro forma basis, driven by increases in both volume and revenue per transaction in certain of our payment programs. |\n\n| • | Although we cannot precisely measure the impact of the macroeconomic environment, in total we believe it had a positive impact on our North America segment revenue in 2017 over in 2016 of approximately $26 million, primarily due to the favorable impact of changes in fuel prices and slightly higher fuel spread margins. |\n\nThese increases were partially offset by the impact of the disposition of the NexTraq business in July 2017 of $23 million.\nInternational segment revenue. International segment revenues increased from $552.4 million in 2016 to $820.8 million in 2017, an increase of $268.4 million, or 48.6%. The increase in our International segment revenue was primarily due to:\n\n| • | The impact of acquisitions during 2016 and 2017, which contributed approximately $161 million in additional revenue. |\n\n| • | Organic growth of approximately 11% on a constant macroeconomic and pro forma basis, driven by increases in both volume and revenue per transaction in certain of our payment programs. |\n\n| • | Although we cannot precisely measure the impact of the macroeconomic environment, in total we believe it had a positive impact on our International segment revenue for 2017 over 2016 of approximately $7 million, primarily due to favorable changes in foreign exchange rates in Brazil, as well as favorable impact of changes in fuel prices. |\n\nRevenues by geography, product and source. Set forth below are further breakdowns of revenue by geography, product and source for the years ended December 31, 2017 and 2016 (in millions), which we believe is useful in understanding the results of our business.\n| Year Ended December 31, |\n| (Unaudited) | 2017 | 2016 |\n| Revenue by Geography* | Revenues,net | % oftotalrevenues, net | Revenues,net | % oftotalrevenues, net |\n| United States | $ | 1,401 | 62 | % | $ | 1,279 | 70 | % |\n| United Kingdom | 237 | 11 | 229 | 13 |\n| Brazil | 395 | 18 | 168 | 9 |\n| Other | 218 | 10 | 156 | 8 |\n| Consolidated revenues, net | $ | 2,250 | 100 | % | $ | 1,832 | 100 | % |\n\n*Columns may not calculate due to rounding.\n57\n| Year Ended December 31, |\n| (Unaudited) | 2017 | 2016 |\n| Revenue by Product Category* | Revenues,net | % of total revenues, net | Revenues,net | % of totalrevenues, net |\n| Fuel cards1 | $ | 1,096 | 49 | % | $ | 997 | 54 | % |\n| Corporate payments | 262 | 12 | 180 | 10 |\n| Tolls | 327 | 15 | 103 | 6 |\n| Lodging | 127 | 6 | 101 | 5 |\n| Gift | 194 | 9 | 185 | 10 |\n| Other1 | 244 | 11 | 266 | 15 |\n| Consolidated revenues, net | $ | 2,250 | 100.0 | % | $ | 1,832 | 100 | % |\n\n*Columns may not calculate due to rounding.\n1 Amounts shown for 2016 reflect corrections in estimated allocation of revenue by source from previously disclosed amounts.\n| Year Ended December 31,8 |\n| (Unaudited) | 2017 | 2016 |\n| Major Sources of Revenue* | Revenues,net | % of totalrevenues, net | Revenues,net | % of totalrevenues, net |\n| Customer |\n| Processing and program revenue1 | $ | 1,093 | 49 | % | $ | 809 | 44 | % |\n| Late fees and finance charges2 | 141 | 6 | 118 | 6 |\n| Miscellaneous fees3 | 129 | 6 | 129 | 7 |\n| 1,363 | 61 | 1,057 | 58 |\n| Merchant |\n| Discount revenue (Fuel)4 | 303 | 13 | 260 | 14 |\n| Discount revenue (Nonfuel)5 | 175 | 8 | 157 | 9 |\n| Tied to fuel-price spreads6 | 220 | 10 | 194 | 11 |\n| Program revenue7 | 189 | 8 | 164 | 9 |\n| Consolidated revenues, net | $ | 2,250 | 100 | % | $ | 1,832 | 100 | % |\n\n1Includes revenue from customers based on accounts, cards, devices, transactions, load amounts, and/or purchase mounts, etc. for participation in our various fleet and workforce related programs; as well as, revenue from partners (e.g., major retailers, leasing companies, oil companies, petroleum marketers, etc.) for processing and network management services. Primarily represents revenue from North American trucking, lodging, prepaid benefits, telematics, gift cards and toll related businesses.\n2Fees for late payment and interest charges for carrying a balanced charged to a customer.\n3Non-standard fees charged to customers based on customer behavior or optional participation, primarily including high credit risk surcharges, over credit limit charges, minimum processing fees, printing and mailing fees, environmental fees, etc.\n4Interchange revenue directly influenced by the absolute price of fuel and other interchange related to fuel products.\n5Interchange revenue related to nonfuel products.\n6Revenue derived from the difference between the price charged to a fleet customer for a transaction and the price paid to the merchant for the same transaction.\n7Revenue derived primarily from the sales of equipment, software and related maintenance to merchants.\n8 Amounts shown for the years ended December 31, 2017 and 2016 reflect corrections in estimated allocation of revenue by source from previously disclosed amounts.\n* We may not be able to precisely calculate revenue by source, as certain estimates were made in these allocations. Columns may not calculate due to rounding. This table reflects how management views the sources of revenue and may not be consistent with prior disclosure.\n58\nConsolidated operating expenses\nMerchant commission. Merchant commissions increased from $104.3 million in 2016 to $113.1 million in 2017, an increase of $8.8 million or 8.4%. This increase was primarily due to the fluctuation of the margin between the wholesale cost and retail price of fuel and the impact of higher volume in certain revenue streams where merchant commissions are paid.\nProcessing. Processing expenses increased from $355.4 million in 2016 to $429.6 million in 2017, an increase of $74.2 million or 20.9%. Increases in processing expenses were primarily due to expenses related to acquisitions completed in 2016 and 2017 of approximately $62 million, as well as the impact of changes in foreign exchange rates, partially offset by the impact of negotiated lower vendor processing costs. The increase in bad debt was primarily due to bad debt inherent in the acquired STP business. These increases were partially offset by the impact of disposition of the NexTraq business of approximately $6 million.\nSelling. Selling expenses increased from $131.4 million in 2016 to $170.7 million in 2017, an increase of $39.3 million or 29.9%. Increases in spending were primarily due to ongoing expenses related to acquisitions completed in 2016 and 2017 of approximately $26 million and additional spending in certain lines of business. These increases were partially offset by the impact of disposition of the NexTraq business of approximately $2 million.\nGeneral and administrative. General and administrative expense increased from $283.6 million in 2016 to $387.7 million in 2017, an increase of $104.1 million or 36.7%. The increase was primarily due to ongoing expenses related to acquisitions completed in 2016 and 2017 of approximately $42 million, increased stock based compensation expense of approximately $30 million and increases in other professional and legal fees totaling approximately $22 million. These increases were partially offset by the impact of disposition of the NexTraq business of approximately $2 million.\nDepreciation and amortization. Depreciation and amortization increased from $203.3 million in 2016 to $264.6 million in 2017, an increase of $61.3 million or 30.2%. The increase was primarily due to amortization of intangible assets related to acquisitions completed in 2016 and 2017 of approximately $47 million and increased capital spending. These increases were partially offset by the impact of disposition of the NexTraq business of approximately $4 million.\nInvestment loss. Investment losses increased from $36.4 million in 2016 to $53.2 million in 2017. We regularly evaluate the carrying value of our Masternaut investment and during the third quarter of 2017, we determined that the fair value of our 44% investment in Masternaut had declined as a result of our loss of significant influence due to the amendment of the Masternaut investment agreement, executed September 30, 2017, and the operating results of Masternaut. As a result, we determined that the carrying value of our investment exceeded its fair value, and concluded that this decline in value was other than temporary. We recorded a $44.6 million impairment loss in the Masternaut investment that includes adjustment for $31.4 million of currency translation losses previously recognized in accumulated other comprehensive income.\nOther (income) expense, net. Other income, net was $173.4 million in 2017, compared to other expense, net of $3.0 million in 2016. The increase was due primarily to the pre-tax gain on the sale of our NexTraq business of $175 million in 2017.\nInterest expense, net. Interest expense increased from $71.9 million in 2016 to $107.1 million in 2017, an increase of $35.3 million or 49.0%. The increase in interest expense is primarily due to the impact of additional borrowings to finance the acquisitions in 2016 and 2017, share buybacks and increases in LIBOR. The following table sets forth the average interest rates paid on borrowings under our Credit Facility, excluding the related unused credit facility fees.\n| (Unaudited) | 2017 | 2016 |\n| Term loan A | 2.79 | % | 2.05 | % |\n| Term loan B | 3.28 | % | 3.75 | % |\n| Domestic Revolver A | 2.88 | % | 2.07 | % |\n| Foreign Revolver B | 2.05 | % | 1.84 | % |\n| Foreign Revolver B swing line | 2.01 | % | 1.84 | % |\n\nThe average unused credit facility fee for Domestic Revolver A was 0.35% and 0.31% in 2017 and 2016, respectively.\n59\nLoss on extinguishment of debt. Loss on extinguishment of debt of $3.3 million relates to our write-off of debt issuance costs associated with the refinancing of our existing credit facility during the third quarter of 2017.\nProvision for income taxes. The provision for income taxes decreased from $190.5 million in 2016 to $153.4 million in 2017, a decrease of $37.1 million or 19.5%, primarily driven by the impact of the enactment of the Tax Act, partially offset by the increase in pretax book income for 2017 as compared to 2016. On December 22, 2017, the U.S. government enacted tax legislation referred to as the Tax Act. The Tax Act makes broad and complex changes to the U.S. tax code, including, but not limited to reducing the U.S. federal corporate tax rate from 35% to 21% and requiring companies to pay a one-time transition tax on certain unrepatriated earnings of foreign subsidiaries. The transition tax can be paid over eight years.\nAlso, the SEC staff issued Staff Accounting Bulletin (\"SAB\") 118, which provides guidance on accounting for the tax effects of the Tax Act. In accordance with SAB 118, we have a one-year measurement period in which to complete our accounting for the Tax Act.\nWe have made an estimate of the effects on our existing deferred tax balances and the one-time transition tax, which resulted in a provisional net tax benefit of $128.2 million, which is included as a component of income tax expense from continuing operations. We remeasured certain deferred tax assets and liabilities after considering the U.S. federal income tax rate reduction to 21%. The one-time transition tax is based on our total post-1986 earnings and profits that we previously deferred from U.S. income taxes. In 2017, we recorded a provisional amount for the one-time transition tax expense of $81.8 million, net of foreign tax credits.\nNet income. For the reasons discussed above, our net income increased from $452.4 million in 2016 to $740.2 million in 2017, an increase of $287.8 million or 63.6%, primarily due to the impact of the enactment of the Tax Act on earnings of approximately $127.5 million and the gain on the disposition of NexTraq of $109.2 million, partially offset by incremental amortization expense, stock based compensation expense, impairment of our investment in Masternaut and legal fees during 2017.\nOperating income and operating margin\nConsolidated operating income. Operating income increased from $754.2 million in 2016 to $883.8 million in 2017, an increase of $129.6 million or 17.2%. Consolidated operating margin was 41.2% in 2016 and 39.3% in 2017. The increase in operating income was primarily due to acquisitions completed in 2016 and 2017, organic growth, as well as the positive impact of the macroeconomic environment of approximately $25 million, as previously discussed. These increases were partially offset by higher operating expenses related to acquisitions completed in 2016 and 2017 of approximately $178 million, additional stock based compensation of approximately $30 million, higher professional and legal fees totaling approximately $22 million and the disposition of the NexTraq business in July 2017 of approximately $8 million. The decrease in operating margin is driven by the items discussed above.\nFor the purpose of segment operating results, we calculate segment operating income by subtracting segment operating expenses from segment revenue. Segment operating margin is calculated by dividing segment operating income by segment revenue.\nNorth America segment operating income. North America operating income increased from $506.4 million in 2016 to $541.6 million in 2017, an increase of $35.2 million, or 6.9%. North America operating margin was 39.6% in 2016 and 37.9% in 2017. The increase in operating income was due primarily to organic growth and the positive impact of the macroeconomic environment of approximately $24 million, driven primarily by higher fuel prices. These increases were partially offset by additional stock based compensation of approximately $21 million, higher operating expenses related to acquisitions completed in 2017 of approximately $50 million, higher professional and legal fees totaling approximately $22 million and the disposition of the NexTraq business in July 2017 of approximately $8 million. The decrease in operating margin is driven by the items discussed above.\nInternational segment operating income. International operating income increased from $247.7 million in 2016 to $342.2 million in 2017, an increase of $94.4 million, or 38.1%. International operating margin was 44.8% in 2016 and 41.7% in 2017. The increase in operating income was due primarily to the impact of acquisitions completed in 2016 and 2017 and organic growth and the slightly positive impact of the macroeconomic environment. These increases were partially offset by higher operating expenses related to acquisitions completed in 2016 and 2017 of approximately $128 million and additional stock based compensation of approximately $9 million. The decrease in operating margin is driven by the items discussed above.\n60\nYear ended December 31, 2016 compared to the year ended December 31, 2015\nThe following table sets forth selected consolidated statement of income and selected operational data for the years ended December 31, 2016 and 2015 (in millions, except percentages).\n\n| Year endedDecember 31,2016 | % of totalrevenue | Year endedDecember 31,2015 | % of totalrevenue | Increase(decrease) | % Change |\n| North America | $ | 1,279.1 | 69.8 | % | $ | 1,232.0 | 72.3 | % | $ | 47.1 | 3.8 | % |\n| International | 552.4 | 30.2 | % | 470.9 | 27.7 | % | 81.5 | 17.3 | % |\n| Total revenues, net | 1,831.5 | 100.0 | % | 1,702.9 | 100.0 | % | 128.7 | 7.6 | % |\n| Consolidated operating expenses: |\n| Merchant commissions | 104.3 | 5.7 | % | 108.3 | 6.4 | % | (3.9 | ) | (3.6 | )% |\n| Processing | 355.4 | 19.4 | % | 331.1 | 19.4 | % | 24.3 | 7.4 | % |\n| Selling | 131.4 | 7.2 | % | 109.1 | 6.4 | % | 22.4 | 20.5 | % |\n| General and administrative | 283.6 | 15.5 | % | 297.7 | 17.5 | % | (14.1 | ) | (4.7 | )% |\n| Depreciation and amortization | 203.3 | 11.1 | % | 193.5 | 11.4 | % | 9.8 | 5.1 | % |\n| Other operating, net | (0.7 | ) | — | % | (4.2 | ) | 0.2 | % | (3.6 | ) | (83.7 | )% |\n| Operating income | 754.2 | 41.2 | % | 667.5 | 39.2 | % | 86.6 | 13.0 | % |\n| Investment loss | 36.4 | 2.0 | % | 57.7 | 3.4 | % | (21.3 | ) | (37.0 | )% |\n| Other expense, net | 3.0 | 0.2 | % | 2.5 | 0.1 | % | 0.5 | 18.2 | % |\n| Interest expense, net | 71.9 | 3.9 | % | 71.3 | 4.2 | % | 0.6 | 0.8 | % |\n| Provision for income taxes | 190.5 | 10.4 | % | 173.6 | 10.2 | % | 17.0 | 9.8 | % |\n| Net income | $ | 452.4 | 24.7 | % | $ | 362.4 | 21.3 | % | $ | 90.0 | 24.8 | % |\n| Operating income for segments: |\n| North America | $ | 506.4 | $ | 442.0 | $ | 64.4 | 14.6 | % |\n| International | 247.7 | 225.5 | 22.3 | 9.9 | % |\n| Operating income | $ | 754.2 | $ | 667.5 | $ | 86.6 | 13.0 | % |\n| Operating margin for segments: |\n| North America | 39.6 | % | 35.9 | % | 3.7 | % |\n| International | 44.8 | % | 47.9 | % | (3.0 | )% |\n| Total | 41.2 | % | 39.2 | % | 2.0 | % |\n\nNM = Not Meaningful\nRevenues\nOur consolidated revenue increased from $1,702.9 million in 2015 to $1,831.5 million in 2016, an increase of $128.7 million, or 7.6%. The increase in our consolidated revenue was primarily due to the following:\n| • | The impact of acquisitions completed in 2016, which contributed approximately $87 million in additional revenue. |\n\n| • | Organic growth in certain of our payment programs driven primarily by increases in both volume and revenue per transaction. |\n\n| • | Partially offsetting this growth was the negative impact of the macroeconomic environment. Although we cannot precisely measure the impact of the macroeconomic environment, in total we believe it had a negative impact on our consolidated revenue for 2016 over the comparable period in 2015 of approximately $109 million. We believe the impact of lower fuel prices, primarily in the U.S., and lower fuel spread margins, had an unfavorable impact on consolidated revenues of approximately $66 million. Additionally, changes in foreign exchange rates had an unfavorable impact on consolidated revenues of approximately $43 million due to unfavorable fluctuations in rates in most geographies in 2016 compared to 2015. |\n\n61\nNorth America segment revenues. North America revenue increased from $1,232.0 million in 2015 to $1,279.1 million in 2016, an increase of $47.1 million, or 3.8%. The increase in our North America revenue was primarily due to:\n| • | Organic growth in certain of our payment programs driven by increases in both volume and revenue per transaction. |\n\n| • | Partially offsetting the organic growth was the negative impact of macroeconomic environment. Although we cannot precisely measure the impact of the macroeconomic environment, in total we believe it had a negative impact on our North America segment revenue in 2016 over the comparable period in 2015 of approximately $65 million, primarily due to the impact of lower fuel prices and lower fuel spread margins. |\n\nInternational segment revenue. International segment revenues increased from $470.9 million in 2015 to $552.4 million in 2016, an increase of $81.5 million, or 17.3%. The increase in our International segment revenue was primarily due to:\n\n| • | The impact of acquisitions during 2016, which contributed approximately $87 million in additional revenue. |\n\n| • | Organic growth in certain of our payment programs driven by increases in both volume and revenue per transaction. |\n\n| • | Partially offsetting this growth was the negative impact of the macroeconomic environment. Although we cannot precisely measure the impact of the macroeconomic environment, in total we believe it had a negative impact on our International segment revenue for 2016 over the comparable period in 2015 of approximately $44 million, primarily due to unfavorable fluctuations in foreign exchange rates in most geographies where we do business and slightly lower fuel prices. |\n\nRevenues by geography and product. Set forth below are further breakdowns of revenue by geography and product for the years ended December 31, 2016 and 2015 (in millions), which we believe is useful in understanding the results of our business.\n| Year Ended December 31, |\n| (Unaudited) | 2016 | 2015 |\n| Revenue by Geography* | Revenues,net | % of totalrevenues, net | Revenues,net | % of totalrevenues, net |\n| United States | $ | 1,279 | 70 | % | $ | 1,232 | 72 | % |\n| United Kingdom | 229 | 13 | 248 | 15 | % |\n| Brazil | 168 | 9 | 85 | 5 | % |\n| Other | 156 | 8 | 138 | 8 | % |\n| Consolidated revenues, net | $ | 1,832 | 100 | % | $ | 1,703 | 100 | % |\n\n*Columns may not calculate due to rounding.\n| Year Ended December 31, |\n| (Unaudited) | 2016 | 2015 |\n| Revenue by Product Category* | Revenues,net | % of totalrevenues, net | Revenues,net | % of total revenues, net |\n| Fuel cards1 | $ | 997 | 54 | % | $ | 992 | 58 | % |\n| Corporate payments | 180 | 10 | 162 | 10 | % |\n| Tolls | 103 | 6 | 9 | 1 | % |\n| Lodging | 101 | 5 | 92 | 5 | % |\n| Gift | 185 | 10 | 170 | 10 | % |\n| Other1 | 266 | 15 | 278 | 16 | % |\n| Consolidated revenues, net | $ | 1,832 | 100 | % | $ | 1,703 | 100 | % |\n\n*Columns may not calculate due to rounding.\n1 Amounts shown for the years ended December 31, 2016 and 2015 reflect corrections in estimated allocation of revenue by product from previously disclosed amounts.\nConsolidated operating expenses\nMerchant commission. Merchant commissions decreased from $108.3 million in 2015 to $104.3 million in 2016, a decrease of$3.9 million, or 3.6%. This decrease was primarily due to the fluctuation of the margin between the wholesale cost and retail price of fuel, which impacted merchant commissions in certain card programs, as well as the impact of fluctuations in foreign exchange rates.\n62\nProcessing. Processing expenses increased from $331.1 million in 2015 to $355.4 million in 2016, an increase of $24.3 million, or 7.4%. Increases in processing expenses were primarily due to ongoing expenses related to acquisitions completed in 2016 and incremental bad debt expense, partially offset by the impact of fluctuations in foreign exchange rates and lower negotiated vendor processing costs.\nSelling. Selling expenses increased from $109.1 million in 2015 to $131.4 million in 2016, an increase of $22.4 million, or 20.5%. Increases in spending were primarily due to ongoing expenses related to acquisitions completed in 2016 as well as additional sales and marketing spending in certain markets, partially offset by the impact of fluctuations in foreign exchange rates.\nGeneral and administrative. General and administrative expense decreased from $297.7 million in 2015 to $283.6 million in 2016, a decrease of $14.1 million, or 4.7%. The decrease was primarily due to decreased stock based compensation of approximately $26 million from the comparable period in 2015 and the impact of fluctuations in foreign exchange rates, partially offset by ongoing expenses related to acquisitions completed in 2016 and an incremental $2 million in acquisition related expenses over 2015.\nDepreciation and amortization. Depreciation and amortization increased from $193.5 million in 2015 to $203.3 million in 2016, an increase of $9.8 million, or 5.1%. The increase was primarily due to ongoing expenses related to acquisitions completed in 2016, partially offset by movements in and adjustments from changes in foreign exchange rates of approximately $2 million.\nOther operating, net. Other operating, net decreased from $4.2 million in 2015 to $0.7 million in 2016. The decrease is due to favorable reversals of various contingent liabilities for tax indemnifications related to our acquisitions of DB Trans S.A. (\"DB\") and VB in Brazil in 2015.\nInvestment loss. Losses at our equity method investment decreased from $57.7 million in 2015 to $36.4 million in 2016. The decrease was primarily due to a non-recurring gain of $13.8 million during 2016, as well as less costs incurred to restructure the operations of the business and a smaller impairment of our investment, compared to 2015.\nWe regularly evaluate our investments, which are not carried at fair value, for other than temporary impairment in accordance with U. S. GAAP. During the fourth quarter of 2016, we determined that the performance improvement initiatives planned at Masternaut were more challenging to implement than we originally projected. As a result, we recorded a $36.1 million non-cash impairment charge in our equity method investment in 2016, compared to a $40 million charge in 2015.\nInterest expense, net. Interest expense was $71.3 million in 2015 compared to $71.9 million in 2016. The following table sets forth the average interest rates paid on borrowings under our Credit Facility, excluding the relevant unused credit facility fees.\n| (Unaudited) | 2016 | 2015 |\n| Term loan A | 2.05 | % | 1.94 | % |\n| Term loan B | 3.75 | % | 3.75 | % |\n| Domestic Revolver A | 2.07 | % | 1.95 | % |\n| Foreign Revolver B | 1.84 | % | 2.36 | % |\n| Foreign Revolver B swing line | 1.84 | % | 2.29 | % |\n\nThe average unused credit facility fee for Domestic Revolver A was 0.31% and 0.35% in 2016 and 2015, respectively.\nProvision for income taxes. The provision for income taxes increased from $173.6 million in 2015 to $190.5 million in 2016, an increase of $17.0 million, or 9.8%. The increase in income taxes from 2015 to 2016 was primarily driven by the increase in book earnings for 2016 as compared to 2015. The increase in taxes was partially offset by a decrease in our effective tax rate from 32.4% in 2015 to 29.7% in 2016. The decrease in our effective tax rate was primarily due to the adoption of ASU 2016-09, \"Compensation-Stock Compensation: Improvements to Employee Share-Based Payment Accounting\", which resulted in excess tax benefits being recorded as a reduction of income tax expense during 2016, rather than additional paid in capital as discussed in the summary of significant accounting policies footnote. We also had a non-recurring net gain recorded by our equity method investment, which favorably impacted pre-tax earnings but was not subject to U.S. income taxes and the impact of certain tax planning initiatives that were implemented during 2016. We pay taxes in many different taxing jurisdictions, including the U.S., most U.S. states and many non-U.S. jurisdictions. The tax rates in certain non-U.S. taxing jurisdictions are\n63\nlower than the U.S. tax rate. Consequently, as our earnings fluctuate between taxing jurisdictions, our effective tax rate fluctuates.\nNet income. For the reasons discussed above, our net income increased from $362.4 million in 2015 to $452.4 million in 2016, an increase of $90.0 million, or 24.8%.\nOperating income and operating margin\nConsolidated operating income. Operating income increased from $667.5 million in 2015 to $754.2 million in 2016, an increase of $86.6 million, or 13.0%. Consolidated operating margin was 39.2% in 2015 and 41.2% in 2016. The increase in operating income was primarily due to acquisitions completed in 2016, $26 million less stock based compensation expense compared to 2015 and organic growth in the business, partially offset by the negative impact of the macroeconomic environment of approximately $82 million, driven by lower fuel prices and spreads, and unfavorable fluctuations in foreign exchange rates.\nFor the purpose of segment operating results, we calculate segment operating income by subtracting segment operating expenses from segment revenue. Segment operating margin is calculated by dividing segment operating income by segment revenue.\nNorth America segment operating income. North America operating income increased from $442.0 million in 2015 to $506.4 million in 2016, an increase of $64.4 million, or 14.6%. North America operating margin was 35.9% in 2015 and 39.6% in 2016. The increase in operating income was due primarily to less stock based compensation expense compared to 2015 and organic growth in the business, partially offset by the negative impact of the macroeconomic environment of approximately $56 million, driven by lower fuel prices and lower fuel spread margins.\nInternational segment operating income. International operating income increased from $225.5 million in 2015 to $247.7 million in 2016, an increase of $22.3 million, or 9.9%. International operating margin was 47.9% in 2015 and 44.8% in 2016. The increase in operating income was due primarily to acquisitions completed in 2016 and organic growth in the business, partially offset by the approximately $26 million unfavorable impact of the macroeconomic environment, specifically unfavorable changes in foreign exchange rates, as well as the negative impact of fuel prices internationally. The impact of changes in fuel price spreads was negligible.\nLiquidity and capital resources\nOur principal liquidity requirements are to service and repay our indebtedness, make acquisitions of businesses and commercial account portfolios, repurchase shares of our common stock and meet working capital, tax and capital expenditure needs.\nSources of liquidity. At December 31, 2017, our cash balances totaled $1,130.9 million, with approximately $217.3 million restricted. Restricted cash represents customer deposits in the Czech Republic and in our Comdata business in the U.S., as well as collateral received from customers for cross-currency transactions in our Cambridge business, which are restricted from use other than to repay customer deposits, as well as secure and settle cross-currency transactions.\nAt December 31, 2017, cash and cash equivalents held in foreign subsidiaries where we have determined we are permanently reinvested was $556.1 million. All of the cash and cash equivalents held by our foreign subsidiaries, excluding restricted cash, are available for general corporate purposes. Our current intent is to permanently reinvest these funds outside of the U.S. Our current expectation for funds held in our foreign subsidiaries is to use the funds to finance foreign organic growth, to pay for potential future foreign acquisitions and to repay any foreign borrowings that may arise from time to time. We currently believe that funds generated from our U.S. operations, along with available borrowing capacity in the U.S. will be sufficient to fund our U.S. operations for the foreseeable future, and therefore do not foresee a need to repatriate cash held by our foreign subsidiaries to fund our U.S. operations.\nIn the fourth quarter of 2017, the U.S. enacted the Tax Act, which includes provisions for a tax on all previously undistributed earnings in foreign jurisdictions. We have provisionally recorded an $81.8 million charge on these undistributed earnings in 2017. As permitted by the Tax Act, we intend to pay the one-time transition tax in eight annual interest-free installments beginning in 2018. We are currently evaluating the remaining undistributed foreign earnings for which we have not provided deferred taxes for foreign withholding tax, as these earnings are considered to be indefinitely reinvested. The amount of these unrecorded deferred taxes is not expected to be material.\n64\nWe utilize an accounts receivable Securitization Facility to finance a majority of our domestic fuel card receivables, to lower our cost of borrowing and more efficiently use capital. We generate and record accounts receivable when a customer makes a purchase from a merchant using one of our card products and generally pay merchants before collecting the receivable. As a result, we utilize the Securitization Facility as a source of liquidity to provide the cash flow required to fund merchant payments while we collect customer balances. These balances are primarily composed of charge balances, which are typically billed to the customer on a weekly, semimonthly or monthly basis, and are generally required to be paid within 14 days of billing. We also consider the undrawn amounts under our Securitization Facility and Credit Facility as funds available for working capital purposes and acquisitions. At December 31, 2017, we had no additional liquidity under our Securitization Facility. At December 31, 2017, we had approximately $615 million available under our Credit Facility.\nBased on our current forecasts and anticipated market conditions, we believe that our current cash balances, our available borrowing capacity and our ability to generate cash from operations, will be sufficient to fund our liquidity needs for at least the next twelve months. However, we regularly evaluate our cash requirements for current operations, commitments, capital requirements and acquisitions, and we may elect to raise additional funds for these purposes in the future, either through the issuance of debt or equity securities. We may not be able to obtain additional financing on terms favorable to us, if at all.\nCash flows\nThe following table summarizes our cash flows for the years ended December 31, 2017, 2016 and 2015.\n\n| Year ended December 31, |\n| (in millions) | 2017 | 2016 | 2015 |\n| Net cash provided by operating activities | $ | 675.7 | $ | 705.9 | $ | 754.6 |\n| Net cash used in investing activities | (497.8 | ) | (1,389.6 | ) | (99.4 | ) |\n| Net cash provided by (used in) financing activities | 251.9 | 754.0 | (648.1 | ) |\n\nOperating activities. Net cash provided by operating activities decreased from $705.9 million in 2016 to $675.7 million in 2017. Operating cash flows were primarily affected by higher net income, the gain on the sale of our NexTraq business in 2017 (treated as an investing activity) and deferred income taxes resulting from enactment of the Tax Act. Also included in cash flows from operating activities were unfavorable working capital adjustments primarily due to the timing of cash receipts and payments in 2017 over the comparable period in 2016.\nNet cash provided by operating activities decreased from $754.6 million in 2015 to $705.9 million in 2016. The decrease was primarily due to changes in working capital driven by fluctuations in receivables and payables, largely due to timing of month end transactions and volume. Cash flow was favorably impacted by additional net income of $90 million during 2016 over the comparable period in 2015.\nInvesting activities. Net cash used in investing activities decreased from $1.4 billion in 2016 to $497.8 million in 2017. This decrease was primarily due to reduction in cash outlay for acquisitions and the proceeds received from the sale of our NexTraq business during the third quarter of 2017.\nNet cash used in investing activities increased from $99.4 million in 2015 to $1,389.6 million in 2016. This increase was primarily due to the increase in cash paid for our STP and Travelcard acquisitions completed in 2016.\nFinancing activities. Net cash provided by financing activities decreased from $754.0 million in 2016 to $251.9 million in 2017. The decrease is primarily due to additional repayments on our Credit Facility of $599.8 million in 2017 over 2016, and increased spending to repurchase our common stock of $214.7 million, partially offset by an increase in borrowings of $243 million on our Securitization Facility and an increase in borrowings of $55.5 million on our Credit Facility.\nNet cash from financing activities increased from net cash used of $648.1 million in 2015 to net cash provided of $754.0 million in 2016. The increase was primarily due to an increase in net borrowings on our revolving Credit Facility and term loans of $952.2 million and $585.0 million, respectively, to fund acquisitions during 2016.\n65\nCapital spending summary\nOur capital expenditures increased from $59.0 million in 2016 to $70.1 million in 2017, an increase of $11 million or 18.8%. This increase is primarily due to increased spending on strategic projects, including continued investment in our operating systems, as well as incremental spending related to acquisitions in 2016 and 2017.\nOur capital expenditures increased from $41.9 million in 2015 to $59.0 million in 2016, an increase of $17 million or 40.9%. This increase was primarily due to increased spending on strategic projects, including continued investment in our GFN application.\nCredit Facility\nFLEETCOR Technologies Operating Company, LLC, and certain of our domestic and foreign owned subsidiaries, as designated co-borrowers (the “Borrowers”), are parties to a $4.33 billion Credit Agreement (the \"Credit Agreement\"), with Bank of America, N.A., as administrative agent, swing line lender and local currency issuer, and a syndicate of financial institutions (the “Lenders”), which has been amended multiple times. The Credit Agreement provides for senior secured credit facilities consisting of a revolving A credit facility in the amount of $1.285 billion, a term loan A facility in the amount of $2.69 billion and a term loan B facility in the amount of $350.0 million as of December 31, 2017. The revolving credit facility consists of (a) a revolving A credit facility in the amount of $800 million, with sublimits for letters of credit and swing line loans, (b) a revolving B facility in the amount of $450 million for swing line loans and multi-currency borrowings and, (c) a revolving C facility in the amount of $35 million for multi-currency borrowings in Australian Dollars or New Zealand Dollars.\nOn January 20, 2017, we entered into the second amendment to the Credit Agreement, which established a new term B loan. Interest on the term B loan facility accrues based on the Eurocurrency Rate or the Base Rate at 2.25% for Eurocurrency Loans and at 1.25% for Base Rate Loans. Interest on amounts outstanding under the Credit Agreement (other than the term B loan) accrues based on the British Bankers Association LIBOR Rate (the Eurocurrency Rate), plus a margin based on a leverage ratio, or our option, the Base Rate (defined as the rate equal to the highest of (a) the Federal Funds Rate plus 0.50%, (b) the prime rate announced by Bank of America, N.A., or (c) the Eurocurrency Rate plus 1.00%) plus a margin based on a leverage ratio. In addition, the Company pays a quarterly commitment fee at a rate per annum ranging from 0.20% to 0.40% of the daily unused portion of the credit facility.\nOn August 2, 2017, we entered into the third amendment to the Credit Agreement, which increased the total facility by $708.7 million and extended the terms of the credit facilities. The stated maturity dates for the term A loan, revolving loans and letters of credit under the Credit Agreement is August 2, 2022 and August 2, 2024 for the term B loan. The term A and revolver pricing remains the same and the term B pricing was reduced by 25 basis points to LIBOR plus 200 basis points.\nAt December 31, 2017, the interest rate on the term A loan and the domestic revolving A facility was 3.32%, the interest rate on the foreign revolving B facility was 2.25%, the interest rate on the revolving B facility foreign swing line of credit was 2.22% and the interest rate on the term B loan was 3.57%. The unused credit facility was 0.35% for all revolving facilities at December 31, 2017.\nThe Credit Agreement also contains an accordion feature for borrowing an additional $750 million in term A, term B or revolver A debt. Proceeds from the Credit Facility may be used for working capital purposes, acquisitions, and other general corporate purposes.\nThe term loans are payable in quarterly installments and are due on the last business day of each March, June, September, and December with the final principal payment due on the respective maturity date. Borrowings on the revolving line of credit are repayable at our option of one, two, three or nine months after borrowing, depending on the term of the borrowing on the facility. Borrowings on the foreign swing line of credit are due no later than ten business days after such loan is made.\nThe Credit Facility contains representations, warranties and events of default, as well as certain affirmative and negative covenants, customary for financings of this nature. These covenants include limitations on the ability to pay dividends and make other restricted payments under certain circumstances and compliance with certain financial ratios.As of December 31, 2017, we were in compliance with each of the covenants under the Credit Facility.\nOur Credit Agreement contains a number of negative covenants restricting, among other things, limitations on liens (with exceptions for our Securitization Facility) and investments, incurrence or guarantees of indebtedness, mergers, acquisitions, dissolutions, liquidations and consolidations, dispositions, dividends and other restricted payments and prepayments of other indebtedness. In particular, we are not permitted to make any restricted payments (which includes any dividend or other distribution) except that the we may declare and make dividend payments or other distributions to our stockholders so long as (i) on a pro forma basis both before and after the distribution the consolidated leverage ratio is not greater than 3.25:1.00 and we are in compliance with the financial covenants and (ii) no default or event of default shall exist or result therefrom. The\n66\nCredit Agreement also contains customary events of default. The Credit Agreement includes financial covenants where the Company is required to maintain a consolidated leverage ratio to consolidated EBITDA of less than (i) 4.00 to 1.00 as of the end of any fiscal quarter provided that in connection with any Material Acquisition the leverage ratio may be increased to 4.25 to 1.00 for the quarter in which the Material Acquisition is consummated and the next three fiscal quarters; and a consolidated interest coverage ratio of no more than 4.00 to 1.0.\nThe obligations of the Borrowers under the Credit Agreement are secured by substantially all of the assets of FLEETCOR and its domestic subsidiaries, pursuant to a security agreement and includes a pledge of (i) 100% of the issued and outstanding equity interests owned by us of each Domestic Subsidiary and (2) 66% of the voting shares of the first-tier foreign subsidiaries, but excluding real property, personal property located outside of the U.S., accounts receivables and related assets subject to the Securitization Facility and certain investments required under money transmitter laws to be held free and clear of liens.\nAt December 31, 2017, we had $2.7 billion in borrowings outstanding on term A loan, excluding the related debt discount, $349.1 million in borrowings outstanding on term B loan, excluding the related debt discount, $635 million in borrowings outstanding on the domestic revolving A facility, $28.3 million in borrowings outstanding on the foreign revolving B facility and $6.9 million in borrowings outstanding on the foreign swing line revolving B facility. The Company has unamortized debt discounts of $6.0 million related to the term A facility and $0.7 million related to the term B facility and deferred financing costs of $5.1 million at December 31, 2017. In August 2017, the Company expensed $3.3 million and capitalized $10.6 million of debt issuance costs associated with the refinancing of its Credit Facility. The effective interest rate incurred on term loans was 2.69% and 2.57% during 2017 and 2016, respectively, related to the discount on debt.\nDuring 2017, we made principal payments of $423.2 million on the term loans, $930.0 million on the domestic revolving A facility, $101.7 million on the foreign revolving A facility and $52.7 million on the foreign swing line revolving B facility.\nSecuritization Facility\nWe are a party to a receivables purchase agreement among FleetCor Funding LLC, as seller, PNC Bank, National Association as administrator, and various purchaser agents, conduit purchasers and related committed purchasers parties thereto, which was amended and restated for the Fifth time as of November 14, 2014. We refer to this arrangement as the Securitization Facility. There have been several amendments to the Securitization Facility. The current purchase limit under the Securitization Facility is $950 million and the Securitization Facility expires on November 14, 2020. The Securitization Facility contains certain customary financial covenants.\nThere is a program fee equal to one month LIBOR plus 0.90% or the Commercial Paper Rate plus 0.80% as of December 31, 2017 and one month LIBOR or the Commercial Paper Rate plus 0.90% as of December 31, 2016. The program fee was 1.55% plus 0.86% as of December 31, 2017 and 0.85% plus 0.90% as of December 31, 2016. The unused facility fee is payable at a rate of 0.40% as of December 31, 2017 and 2016.\nUnder a related purchase and sale agreement, dated as of December 20, 2004, and most recently amended on November 14, 2014 to include Comdata as an originator, between FLEETCOR Funding LLC, as purchaser, and certain of our subsidiaries, as originators, the receivables generated by the originators are deemed to be sold to FLEETCOR Funding LLC immediately and without further action upon creation of such receivables. At the request of FLEETCOR Funding LLC, as seller, undivided percentage ownership interests in the receivables are ratably purchased by the purchasers in amounts not to exceed their respective commitments under the facility. Collections on receivables are required to be made pursuant to a written credit and collection policy and may be reinvested in other receivables, may be held in trust for the purchasers, or may be distributed. Fees are paid to each purchaser agent for the benefit of the purchasers and liquidity providers in the related purchaser group in accordance with the Securitization Facility and certain fee letter agreements.\nThe Securitization Facility provides for certain termination events, which includes nonpayment, upon the occurrence of which the administrator may declare the facility termination date to have occurred, may exercise certain enforcement rights with respect to the receivables, and may appoint a successor servicer, among other things.\nWe were in compliance with all financial and non-financial covenant requirements related to our Securitization Facility as of December 31, 2017.\nOther Liabilities\nIn connection with our acquisition of certain businesses, we owe final payments of $29.3 million, of which $3.6 million is payable in the next twelve months and $25.7 million in periods beyond a year.\n67\nStock Repurchase Program\nOn February 4, 2016, our Board of Directors approved a stock repurchase program (the \"Program\") under which we may purchase up to an aggregate of $500 million of our common stock over the following 18 months period. On July 27, 2017, our Board of Directors authorized an increase in the size of the Program by an additional $250 million and an extension of the Program by an additional 18 months. On November 1, 2017, we announced that our Board of Directors had authorized an additional increase in the size of the Program by an another $350 million, resulting in total aggregate repurchases authorized under the Program of $1.1 billion. With the increase and giving effect to $590.1 million of previous repurchases, we may repurchase up to $510 million in shares of our common stock at any time prior to February 1, 2019.\nAny stock repurchases may be made at times and in such amounts as deemed appropriate. The timing and amount of stock repurchases, if any, will depend on a variety of factors including the stock price, market conditions, corporate and regulatory requirements, and any additional constraints related to material inside information we may possess. Any repurchases have been and are expected to be funded by a combination of available cash flow from the business, working capital and debt.\nOn August 3, 2017, as part of the Program, we entered an Accelerated Share Repurchase agreement (\"ASR Agreement\") with a third-party financial institution to repurchase $250 million of our common stock. Pursuant to the ASR Agreement, we delivered $250 million in cash and received 1,491,647 shares based on a stock price of $142.46 on August 7, 2017. The ASR Agreement was completed on September 7, 2017, at which time the we received 263,012 additional shares based on a final weighted average per share purchase price during the repurchase period of $142.48.\nWe accounted for the ASR Agreement as two separate transactions: (i) as shares of reacquired common stock for the shares delivered to us upon effectiveness of the ASR Agreement and (ii) as a forward contract indexed to our common stock for the undelivered shares. The initial delivery of shares was included in treasury stock at cost and results in an immediate reduction of the outstanding shares used to calculate the weighted average common shares outstanding for basic and diluted earnings per share. The forward contracts indexed to our own common stock met the criteria for equity classification, and these amounts were initially recorded in additional paid-in capital and then reclassified to treasury stock upon completion of the ASR agreement.\nSince the beginning of the Program, 4,114,104 shares for an aggregate purchase price of $590.1 million have been repurchased. There were 2,854,959 common shares totaling $402.4 million repurchased under the Program during 2017.\nCritical accounting policies and estimates\nIn applying the accounting policies that we use to prepare our consolidated financial statements, we necessarily make accounting estimates that affect our reported amounts of assets, liabilities, revenue and expenses. Some of these estimates require us to make assumptions about matters that are highly uncertain at the time we make the accounting estimates. We base these assumptions and the resulting estimates on historical information and other factors that we believe to be reasonable under the circumstances, and we evaluate these assumptions and estimates on an ongoing basis. In many instances, however, we reasonably could have used different accounting estimates and, in other instances, changes in our accounting estimates could occur from period to period, with the result in each case being a material change in the financial statement presentation of our financial condition or results of operations. We refer to estimates of this type as critical accounting estimates. Our significant accounting policies are summarized in the consolidated financial statements contained elsewhere in this report. The critical accounting estimates that we discuss below are those that we believe are most important to an understanding of our consolidated financial statements.\nSee Footnote 2 to the Consolidated Financial Statements, Summary of Significant Accounting Policies.\nRevenue recognition and presentation. Revenue is derived from our merchant and network relationships, as well as from customers and partners. We recognize revenue on fees generated through services primarily to commercial fleets, commercial businesses, major oil companies, petroleum marketers and leasing companies and record revenue net of the wholesale cost of the underlying products and services based on the following: (i) we are not the primary obligor in the arrangement and we are not responsible for fulfillment and the acceptability of the product; (ii) we have no inventory risk, do not bear the risk of product loss and do not make any changes to the product or have any involvement in the product specifications; (iii) we do not have significant latitude with respect to establishing the price for the product and (iv) the amount we earn for our services is fixed, within a limited range. We recognize revenue from merchant and network relationships, processing and other arrangements when persuasive evidence of an arrangement exists, the services have been provided to the customer, the sales price is fixed or determinable and collectability is reasonably assured, as more fully described below.\n68\nThrough our merchant and network relationships we provide fuel, prepaid cards, vehicle maintenance, lodging, food, toll, and transportation related services to our customers. We derive revenue from our merchant and network relationships based on the difference between the price charged to a customer for a transaction and the price paid to the merchant or network for the same transaction. Our revenue consists of margin on sales and fees for technical support, processing, communications and reporting. The price paid to a merchant or network may be calculated as (i) the merchant’s wholesale cost of the product plus a markup; (ii) the transaction purchase price less a percentage discount; or (iii) the transaction purchase price less a fixed fee per unit. The difference between the price we pay to a merchant and the merchant’s wholesale cost for the underlying products and services is considered a merchant commission and is recognized as expense when the fuel purchase transaction is executed. We have entered into agreements with major oil companies, petroleum marketers and leasing companies, among others, that specify that a transaction is deemed to be captured when we have validated that the transaction has no errors and have accepted and posted the data to our records.\nWe also derive revenue from customers and partners from a variety of program fees including transaction fees, card fees, network fees, service fees, report fees and other transaction-based fees, which typically are calculated based on measures such as percentage of dollar volume processed, number of transactions processed, or some combination thereof. Such services are provided through proprietary networks or through the use of third-party networks. Transaction fees and other transaction-based fees generated from our proprietary networks and third-party networks are recognized at the time the transaction is captured. Card fees, network fees and program fees are recognized as we fulfill our contractual service obligations. In addition, we recognize revenue from late fees and finance charges, in jurisdictions where permitted under local regulations, primarily in the U.S. and Canada. Such fees are recognized net of a provision for estimated uncollectible amounts, at the time the fees and finance charges are assessed. The Company ceases billing and accruing for late fees and finance charges approximately 30-40 days after the customer’s balance becomes delinquent.\nWe also charge our customers transaction fees to load value onto prepaid fuel, food, toll and transportation vouchers and cards. We recognize fee revenue upon providing the activated fuel, food, toll and transportation vouchers and prepaid cards to the customer. Revenue is recognized on lodging and transportation management services when the lodging stay or transportation service is provided. Revenue is also derived from the sale of equipment and cards in certain of our businesses, which is recognized at the time the device is sold and the risks and rewards of ownership have passed. This revenue is recognized gross of the cost of sales related to the equipment in revenues, net within the Consolidated Statements of Income. The related cost of sales for the equipment is recorded within processing expenses in the Consolidated Statements of Income. We have recorded $96.8 million of expenses related to sales of equipment within the processing expenses line of the Consolidated Statements of Income in 2017. Sales commissions paid to personnel are expensed as incurred.\nWe deliver both stored value cards and card-based services primarily in the form of gift cards. For multiple-deliverable customer contracts, stored value cards and card-based services are separated into two units of accounting. Stored valued cards are generally recognized upon shipment to the customer. Card-based services are recognized when the card services are rendered.\nWe present taxes assessed by the government imposed concurrent with a revenue producing transaction between us and our customers (e.g. VAT) on a net basis within revenues, net.\nOur fiscal year ends on December 31. In certain of our U.K. businesses, we record the operating results using a 4-4-5 week accounting cycle with the fiscal year ending on the Friday on or immediately preceding December 31.\nAccounts receivable. As described above under the heading “Securitization facility,” we maintain a revolving trade accounts receivable Securitization Facility. The current purchase limit under the Securitization Facility is $950 million. Accounts receivable collateralized within our Securitization Facility relate to trade receivables resulting from charge card activity in the U.S. Pursuant to the terms of the Securitization Facility, we transfer certain of our domestic receivables, on a revolving basis, to FLEETCOR Funding LLC (Funding), a wholly-owned bankruptcy remote subsidiary. In turn, Funding sells, without recourse, on a revolving basis, up to $950 million of undivided ownership interests in this pool of accounts receivable to a multi-seller, asset-backed commercial paper conduit (Conduit). Funding maintains a subordinated interest, in the form of over collateralization, in a portion of the receivables sold to the Conduit. Purchases by the Conduit are financed with the sale of highly-rated commercial paper.\nWe utilize proceeds from the sale of our accounts receivable as an alternative to other forms of financing, to reduce our overall borrowing costs. We have agreed to continue servicing the sold receivables for the financial institution at market rates, which approximates our cost of servicing. We retain a residual interest in the accounts receivable sold as a form of credit\n69\nenhancement. The residual interest’s fair value approximates carrying value due to its short-term nature. Funding determines the level of funding achieved by the sale of trade accounts receivable, subject to a maximum amount.\nThe Company’s Consolidated Balance Sheets and Statements of Income reflect the activity related to securitized accounts receivable and the corresponding securitized debt, including interest income, fees generated from late payments, provision for losses on accounts receivable and interest expense. The cash flows from borrowings and repayments, associated with the securitized debt, are presented as cash flows from financing activities.\nForeign receivables are not included in our receivable securitization program. At December 31, 2017 and 2016, there was $811 million and $591 million, respectively, of short-term debt outstanding under our accounts receivable Securitization Facility.\nCredit risk and reserve for losses on receivables. We control credit risk by performing periodic credit evaluations of our customers. Payments from customers are generally due within 14 days or less of billing. We routinely review our accounts receivable balances and make provisions for probable doubtful accounts based primarily on the aging of those balances. Accounts receivable are deemed uncollectible once they age past 90 days and are deemed uncollectible from the customer. We also provide an allowance for receivables aged less than 90 days that we expect will be uncollectible based on historical collections experience including accounts that have filed for bankruptcy. At December 31, 2017, approximately 96% of outstanding accounts receivable were current. Accounts receivable deemed uncollectible are removed from accounts receivable and the allowance for doubtful accounts when internal collection efforts have been exhausted and accounts have been turned over to a third-party collection agency. Recoveries from the third-party collection agency are not significant.\nImpairment of long-lived assets, intangibles and investments. We test our long-lived assets for impairment in accordance with relevant authoritative guidance. We evaluate if impairment indicators related to our property, plant and equipment and other long-lived assets are present. These impairment indicators may include a significant decrease in the market price of a long-lived asset or asset group, a significant adverse change in the extent or manner in which a long-lived asset or asset group is being used or in its physical condition, or a current-period operating or cash flow loss combined with a history of operating or cash flow losses or a forecast that demonstrates continuing losses associated with the use of a long-lived asset or asset group. If impairment indicators are present, we estimate the future cash flows for the asset or asset group. The sum of the undiscounted future cash flows attributable to the asset or group of assets is compared to their carrying amount. The cash flows are estimated utilizing various projections of revenues and expenses, working capital and proceeds from asset disposals on a basis consistent with management’s intended actions. If the carrying amount exceeds the sum of the undiscounted future cash flows, we determine the assets’ fair value by discounting the future cash flows using a discount rate required for a similar investment of like risk and records an impairment charge as the difference between the fair value and the carrying value of the asset group. Generally, we perform our testing of the asset group at the business-line level, as this is the lowest level for which identifiable cash flows are available.\nWe complete an impairment test of goodwill at least annually or more frequently if facts or circumstances indicate that goodwill might be impaired. Goodwill is tested for impairment at the reporting unit level, and the impairment test consists of two steps, as well as a qualitative assessment, as appropriate. We have performed a qualitative assessment of certain of our reporting units. In this qualitative assessment we individually considered the following items for each reporting unit where we determined a qualitative analysis to be appropriate: the macroeconomic conditions, including any deterioration of general conditions, limitations on accessing capital, fluctuations in foreign exchange rates and other developments in equity and credit markets; industry and market conditions, including any deterioration in the environment where the reporting unit operates, increased competition, changes in the products/services and regulator and political developments; cost of doing business; overall financial performance, including any declining cash flows and performance in relation to planned revenues and earnings in past periods; other relevant reporting unit specific facts, such as changes in management or key personnel or pending litigation; events affecting the reporting unit, including changes in the\ncarrying value of net assets, likelihood of disposal and whether there were any other impairment considerations within the business; the overall performance of our share price in relation to the market and our peers; and a quantitative stress test of the previously completed step 1 test from the prior year, updated with current year results, weighted-average cost of capital rates and future projections.\nIn step 1 of the goodwill impairment test for reporting units, the reporting unit’s carrying amount, including goodwill, is compared to its fair value which is measured based upon, among other factors, a discounted cash flow analysis as well as market multiples for comparable companies. If the carrying amount of the reporting unit is greater than its fair value, goodwill is considered impaired and step two must be performed. Step two measures the impairment loss by comparing the implied fair value of reporting unit goodwill with the carrying amount of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit to all the assets and liabilities of that unit (including unrecognized intangibles) as\n70\nif the reporting unit had been acquired in a business combination. The excess of fair value over the amounts allocated to the assets and liabilities of the reporting unit is the implied fair value of goodwill. The excess of the carrying amount over the implied fair value is the impairment loss.\nWe estimated the fair value of our reporting units using a combination of the income approach and the market approach. The income approach utilizes a discounted cash flow model incorporating management’s expectations for future revenue, operating expenses, earnings before interest, taxes, depreciation and amortization, capital expenditures and an anticipated tax rate. We discounted the related cash flow forecasts using an estimated weighted-average cost of capital for each reporting unit at the date of valuation. The market approach utilizes comparative market multiples in the valuation estimate. Multiples are derived by relating the value of guideline companies, based on either the market price of publicly traded shares or the prices of companies being acquired in the marketplace, to various measures of their earnings and cash flow. Such multiples are then applied to the historical and projected earnings and cash flow of the reporting unit in developing the valuation estimate.\nPreparation of forecasts and the selection of the discount rates involve significant judgments about expected future business performance and general market conditions. Significant changes in forecasts, the discount rates selected or the weighting of the income and market approach could affect the estimated fair value of one or more of our reporting units and could result in a goodwill impairment charge in a future period.\nBased on the goodwill asset impairment analysis performed quantitatively on October 1, 2017, we determined that the fair value of each of our reporting units is in excess of the carrying value. No events or changes in circumstances have occurred since the date of our most recent annual impairment test that would more likely than not reduce the fair value of a reporting unit below its carrying amount.\nWe also evaluate indefinite-lived intangible assets (primarily trademarks and trade names) for impairment annually. We also test for impairment if events and circumstances indicate that it is more likely than not that the fair value of an indefinite-lived intangible asset is below its carrying amount. Estimates critical to our evaluation of indefinite-lived intangible assets for impairment include the discount rate, royalty rates used in our evaluation of trade names, projected average revenue growth and projected long-term growth rates in the determination of terminal values. An impairment charge is recorded if the carrying amount of an indefinite-lived intangible asset exceeds the estimated fair value on the measurement date.\nWe also regularly evaluate the carrying value of our investments, which are not carried at fair value, for other-than-temporary impairment. We estimate the fair value of our investments using a combination of the income approach and the market approach. The income approach utilizes a discounted cash flow model incorporating management’s expectations for future revenue, operating expenses, earnings before interest, taxes, depreciation and amortization, capital expenditures and an anticipated tax rate. We discount the related cash flow forecasts using an estimated weighted-average cost of capital for each reporting unit at the date of valuation. The market approach utilizes comparative market multiples in the valuation estimate. Multiples are derived by relating the value of guideline companies, based on either the market price of publicly traded shares or the prices of companies being acquired in the marketplace, to various measures of their earnings and cash flow. Such multiples are then applied to the historical and projected earnings and cash flow of our investments in developing the valuation estimate.\nOn September 30, 2017, we entered into an amended Masternaut Group Holdings Limited (\"Masternaut\") investment agreement that resulted in the loss of significant influence, and we began accounting for the Masternaut investment by applying the cost method. We regularly evaluate the carrying value of our investment and during the third quarter of 2017, we determined that the fair value of our 44% investment in Masternaut had declined as a result of our loss of significant influence. As a result, we determined that the carrying value of our investment exceeded its fair value, and concluded that this decline in value was other than temporary. We recorded a $44.6 million impairment loss in the Masternaut investment that includes adjustment for $31.4 million of currency losses previously recognized in accumulated other comprehensive income, in the year ended December 31, 2017, in the accompanying Consolidated Statements of Income. During the fourth quarters of 2016 and 2015, we determined that the performance improvement initiatives in our investment in Masternaut were taking longer to and were more challenging to implement than originally projected, based on revised cash flow projections provided by the business. As a result, we recorded a $36.1 million and $40 million non-cash impairment charge in its Masternaut investment for 2016 and 2015, respectively.\nIncome taxes. We account for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or\n71\nsettled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date.\nThe ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which the associated temporary differences become deductible. We evaluate on a quarterly basis, whether it is more likely than not that our deferred tax assets will be realized in the future and conclude whether a valuation allowance must be established.\nCurrent accounting guidance clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements and prescribes threshold and measurement attributes for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Under the relevant authoritative literature, the impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more likely than not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50 percent likelihood of being sustained. We include any estimated interest and penalties on tax related matters in income tax expense.\nIn the fourth quarter of 2017, the U.S. government enacted tax legislation referred to as the Tax Act. As a result of Tax Act, the U.S. federal corporate tax rate was reduced from 35% to 21%. The Tax Act also includes provisions for a tax on all previously undistributed earnings in foreign jurisdictions. We have provisionally recorded a $210 million deferred tax benefit for the benefit for the corporate rate reduction on our deferred tax assets and liabilities. Additionally, in 2017, We have provisionally recorded an $81.8 million charge on all previously undistributed earnings in foreign jurisdictions. We are currently evaluating the remaining undistributed foreign earnings for which we have not provided deferred taxes for foreign withholding tax, as these earnings are considered to be indefinitely reinvested. The amount of these unrecorded deferred taxes is not expected to be material. If in the future these earnings are repatriated to the U.S., or if we determine that the earnings will be remitted in the foreseeable future, additional tax provisions may be required. See Note 11 for further information regarding income taxes.\nBusiness combinations. Business combinations completed by us have been accounted for under the acquisition method of accounting. The acquisition method requires that the acquired assets and liabilities, including contingencies, be recorded at fair value determined as of the acquisition date and changes thereafter reflected in income. For significant acquisitions, we obtain independent third-party valuation studies for certain of the assets acquired and liabilities assumed to assist us in determining fair value. Goodwill represents the excess of the purchase price over the fair values of the tangible and intangible assets acquired and liabilities assumed. The results of the acquired businesses are included in our results of operations beginning from the completion date of the applicable transaction.\nEstimates of fair value are revised during an allocation period as necessary when, and if, information becomes available to further define and quantify the fair value of the assets acquired and liabilities assumed. Provisional estimates of the fair values of the assets acquired and liabilities assumed involves a number of estimates and assumptions that could differ materially from the final amounts recorded. The allocation period does not exceed one year from the date of the acquisition. To the extent additional information to refine the original allocation becomes available during the allocation period, the allocation of the purchase price is adjusted. Should information become available after the allocation period, those items are adjusted through operating results. The direct costs of the acquisition are recorded as operating expenses. Certain acquisitions include contingent consideration related to the performance of the acquired operations following the acquisition. Contingent consideration is recorded at estimated fair value at the date of the acquisition, and is remeasured each reporting period, with any changes in fair value recorded in the Consolidated Statements of Income. We estimate the fair value of the acquisition-related contingent consideration using various valuation approaches, as well as significant unobservable inputs, reflecting our assessment of the assumptions market participants would use to value these liabilities.\nStock-based compensation. We account for employee stock options and restricted stock in accordance with relevant authoritative literature. Stock options are granted with an exercise price estimated to be equal to the fair market value on the date of grant as authorized by our board of directors. Options granted have vesting provisions ranging from one to five years and vesting of the options is generally based on the passage of time or performance. Stock option grants are subject to forfeiture if employment terminates prior to vesting. We have selected the Black-Scholes option pricing model for estimating the grant date fair value of stock option awards granted. We have considered the retirement and forfeiture provisions of the options and utilized our historical experience to estimate the expected life of the options. Option forfeitures are accounted for upon occurrence. We base the risk-free interest rate on the yield of a zero coupon U.S. Treasury security with a maturity equal to the expected life of the option from the date of the grant. Stock-based compensation cost is measured at the grant date based on the\n72\nvalue of the award and is recognized as expense over the requisite service period based on the number of years for which the requisite service is expected to be rendered.\nAwards of restricted stock and restricted stock units are independent of stock option grants and are subject to forfeiture if employment terminates prior to vesting. The vesting of shares granted is generally based on the passage of time, performance or market conditions, or a combination of these. Shares vesting based on the passage of time have vesting provisions of one to three years. The fair value of restricted stock where the shares vest based on the passage of time or performance is based on the grant date fair value of our stock.\nFor performance-based restricted stock awards and performance based stock option awards, we must also make assumptions regarding the likelihood of achieving performance goals. If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations could be materially affected.\nDerivatives. With our acquisition of Cambridge in August 2017, we use derivatives to facilitate cross-currency corporate payments by writing derivatives to customers, which are not designated as hedging instruments. The majority of Cambridge's revenue is from exchanges of currency at spot rates, which enable customers to make cross-currency payments. In addition, Cambridge also writes foreign currency forward and option contracts for its customers to facilitate future payments. The duration of these derivative contracts at inception is generally less than one year. We aggregate our foreign exchange exposures arising from customer contracts, including forwards, options and spot exchanges of currency, and hedges (economic hedge) the resulting net currency risks by entering into offsetting contracts with established financial institution counterparties. The changes in fair value related to these contracts are recorded in revenues, net in the Consolidated Statements of Income.\nWe recognize all derivatives in \"prepaid expenses and other current assets\" and \"other current liabilities\" in the accompanying Consolidated Balance Sheets at their fair value. All cash flows associated with derivatives are included in cash flows from operating activities in the Consolidated Statements of Cash Flows.\nPending Adoption of Recently Issued Accounting Standards\nFrom time to time, new accounting pronouncements are issued by the FASB or other standards setting bodies that are adopted by the Company as of the specified effective date. Unless otherwise discussed, the Company’s management believes that the impact of recently issued standards that are not yet effective will not have a material impact on the Company’s consolidated financial statements upon adoption.\nTax Act. The SEC staff issued Staff Accounting Bulletin No. 118, \"Income Tax Accounting Implications of the Tax Cuts and Jobs Act\" (\"SAB 118\"), which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC 740. In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Act for which the accounting under ASC 740 is complete. To the extent that a company’s accounting for certain income tax effects of the Tax Act is incomplete but it is able to determine a reasonable estimate, it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax laws that were in effect immediately before the enactment of the Tax Act.\nRevenue Recognition. In May 2014, the FASB issued ASU 2014-09, \"Revenue from Contracts with Customers (Topic 606)\". The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 will replace most existing revenue recognition guidance in GAAP and permits the use of either the retrospective or modified retrospective transition method. The update requires significant additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments. ASU 2014-09, as amended by ASU 2015-14, \"Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date\", is effective for years beginning after December 15, 2017, including interim periods, with early adoption permitted for years beginning after December 15, 2016. Since the issuance of ASU 2014-09, the FASB has issued additional interpretive guidance, including new accounting standards updates, that clarifies certain points of the standard and modifies certain requirements.\nWe have performed a review of the requirements of the new revenue standard and we are monitoring the activity of the FASB and the transition resource group as it relates to specific interpretive guidance. We have established an implementation team to assess the effects of the new revenue standard in a multi-phase approach. In the first phase, we analyzed customer contracts for our most significant contract categories, applied the five-step model of Topic 606 to each contract category and comparing the\n73\nresults to our current accounting practices. The second phase, which includes quantifying the potential effects identified during the first phase, assessing additional contract categories and principal versus agent considerations, revising accounting policies and considering the effects on related disclosures and/or internal control over financial reporting is ongoing and expected to be concluded during the first quarter of 2018.\nTopic 606 could change the amount and timing of revenue and expenses to be recognized under certain of our arrangement types. In addition, it could also increase the administrative burden on our operations to account for customer contracts and provide the more expansive required disclosures. More judgment and estimates may be required within the process of applying the requirements of the new standard than are required under existing GAAP, such as identifying performance obligations in contracts, estimating the amount of variable consideration to include in transaction price, allocating transaction price to each separate performance obligation and estimating expected customer lives. We are in the process of finalizing our assessment and completing the quantification of the effect the new guidance will have on our consolidated financial statements, related disclosures and/or internal control over financial reporting. This conclusion will be made over the remainder of the first quarter of 2018 and will include finalizing our evaluation of the application of the principal vs. agent guidance, specifically as it relates to products where we utilize a third-party payment network and in certain businesses where we pay merchant commissions. However, our preliminary view is that the expected amount and timing of revenue to be recognized under Topic 606 for our most significant contract categories, fuel card payments, lodging payments, toll payments, corporate payments, and gift cards, will be similar to the amount and timing of revenue recognized under our current accounting practices, except as it relates to the presentation of certain costs where we may be determined to be an agent in the processing relationship under the new guidance, resulting in recording such costs as a reduction of revenue. We will be required to capitalize additional costs to obtain contracts with customers, and, in some cases, may be required to amortize these costs over a contractual time period. Finally, we expect disclosures about our revenues and related customer acquisition costs to be more extensive.\nWe plan to adopt Topic 606, as well as other clarifications and technical guidance issued by the FASB related to this new revenue standard, effective January 1, 2018. We will apply the modified retrospective transition method, which would result in an adjustment to retained earnings for the cumulative effect, if any, of applying the standard to contracts that are not completed at the date of initial application. Under this method, we would not restate the prior financial statements presented, therefore the new standard requires us to provide additional disclosures of the amount by which each financial statement line item is affected in the current reporting period during 2018, as compared to the guidance that was in effect before the change, and an explanation of the reasons for significant changes, if any.\nAccounting for Leases. In February 2016, the FASB issued ASU 2016-02, “Leases”, which requires lessees to recognize a right-of-use asset and a lease liability on the balance sheet for all leases with the exception of short-term leases. This ASU also requires disclosures to provide additional information about the amounts recorded in the financial statements. This ASU is effective for us for annual periods beginning after December 15, 2018 and interim periods therein. Early adoption is permitted. The new standard must be adopted using a modified retrospective transition and requires application of the new guidance for leases that exist or are entered into after the beginning of the earliest comparative period presented. We are currently evaluating the impact of ASU 2016-02 on our consolidated financial statements; however, we expect to recognize right of use assets and liabilities for operating leases in the Consolidated Balance Sheet upon adoption.\nAccounting for Breakage. In March 2016, the FASB issued ASU 2016-04, “Liabilities-Extinguishments of Liabilities: Recognition of Breakage for Certain Prepaid Stored-Value Products”, which requires entities that sell prepaid stored value products redeemable for goods, services or cash at third-party merchants to derecognize liabilities related to those products for breakage. This ASU is effective for the Company for reporting periods beginning after December 15, 2017. Early adoption is permitted. The ASU must be adopted using either a modified retrospective approach with a cumulative effect adjustment to retained earnings as of the beginning of the period of adoption or a full retrospective approach. Our adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows.\nCash Flow Classification. In August 2016, the FASB issued ASU 2016-15, \"Classification of Certain Cash Receipts and Cash Payments\", which amends the guidance in ASC 230, Statement of Cash Flows. This amended guidance reduces the diversity in practice that has resulted from the lack of consistent principles related to the classification of certain cash receipts and payments in the statement of cash flows. This ASU is effective for reporting periods beginning after December 15, 2017. Early adoption is permitted. Entities must apply the guidance retrospectively to all periods presented but may apply it prospectively from the earliest date practicable if retrospective application would be impracticable.Our adoption of this ASU is not expected to have a material impact on the results of operations or financial condition.\nIn November 2016, the FASB issued ASU 2016-18, \"Statement of Cash Flows (Topic 230): Restricted Cash\", which amends the guidance in ASC 230, Statement of Cash Flows, on the classification and presentation of restricted cash in the statement of cash flows. This ASU is effective for reporting periods beginning after December 15, 2017. Early adoption is permitted. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. The amendments in this ASU should be applied using a retrospective transition method to\n74\neach period presented. We do not believe the adoption of this ASU will impact the results of operations, financial condition, or cash flows.\nIntangibles - Goodwill and Other Impairment. In January 2017, the FASB issued ASU 2017-04, \"Simplifying the Test for Goodwill Impairment\", which eliminates the requirement to calculate the implied fair value of goodwill (i.e., Step 2 of the goodwill impairment test) to measure a goodwill impairment charge. Instead, entities will record an impairment charge based on the excess of a reporting unit’s carrying amount over its fair value (i.e., measure the charge based on Step 1). The standard has tiered effective dates, starting in 2020 for calendar-year public business entities that meet the definition of an SEC filer. Early adoption is permitted for interim and annual goodwill impairment testing dates after January 1, 2017. Our adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows, unless a goodwill impairment is identified.\nDefinition of a Business. In January 2017, the FASB issued ASU 2017-01, \"Clarifying the Definition of a Business\", which amends the definition of a business to assist entities with evaluating when a set of transferred assets and activities is a business. The guidance requires an entity to evaluate if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets. If so, the set of transferred assets and activities is not a business. The guidance also requires a business to include at least one substantive process and narrows the definition of outputs. The guidance is effective for the reporting periods beginning after December 15, 2017, and interim periods within those years. Early adoption is permitted. Our adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows, however it could result in accounting for acquisitions as asset acquisitions versus business combinations upon adoption.\nAccounting for Modifications to Stock-Based Compensation. In May 2017, the FASB issued ASU 2017-09, \"Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting\", which amends the scope of modification accounting for share-based payment arrangements. The ASU provides guidance on the types of changes to the terms or conditions of share-based payment awards to which an entity would be required to apply modification accounting under ASC 718. Specifically, an entity would not apply modification accounting if the fair value, vesting conditions and classification of the awards are the same immediately before and after the modification. The guidance is effective for reporting periods beginning after December 15, 2017, and interim periods within those years. Early adoption is permitted. Our adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows.\nAccounting for Derivative Financial Instruments. In August 2017, the FASB issued ASU 2017-12, \"Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities\", which amends the hedge accounting recognition and presentation requirements in ASC 815. The FASB issued accounting guidance to better align hedge accounting with a company’s risk management activities, simplify the application of hedge accounting and improve the disclosures of hedging arrangements. The guidance is effective for reporting periods beginning after December 15, 2018, and interim periods within those years. Early adoption is permitted. Our adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows.\nContractual obligations\nThe table below summarizes the estimated dollar amounts of payments under contractual obligations identified below as of December 31, 2017 for the periods specified:\n\n| Payments due by period(a) |\n| (in millions) | Total | Less than1 year | 1-3years | 3-5years | More than5 years |\n| Credit Facility | $ | 3,663.9 | $ | 805.5 | $ | 271.0 | $ | 2,256.2 | $ | 331.2 |\n| Securitization Facility | 811.0 | 811.0 | — | — | — |\n| Estimated interest payments- Credit Facility(b) | 534.1 | 119.5 | 330.8 | 77.0 | 6.8 |\n| Estimated interest payments- Securitization Facility(b) | 57.0 | 19.5 | 37.5 | — | — |\n| Operating leases | 92.0 | 19.3 | 26.5 | 20.9 | 25.3 |\n| Deferred purchase price(c) | 29.3 | 3.6 | 25.7 | — | — |\n| Other(c) | 18.1 | — | 13.5 | 1.4 | 3.2 |\n| Total | $ | 5,205.4 | $ | 1,778.5 | $ | 704.9 | $ | 2,355.4 | $ | 366.6 |\n\n______________________\n75\n| (a) | Deferred income tax liabilities as of December 31, 2017 were approximately $517.1 million. Refer to Note 11 to our audited consolidated financial statements. This amount is not included in the total contractual obligations table because we believe this presentation would not be meaningful. Deferred income tax liabilities are calculated based on temporary differences between the tax bases of assets and liabilities and their respective book bases, which will result in taxable amounts in future years when the liabilities are settled at their reported financial statement amounts. The results of these calculations do not have a direct connection with the amount of cash taxes to be paid in any future periods. As a result, scheduling deferred income tax liabilities as payments due by period could be misleading, as this scheduling would not relate to liquidity needs. At December 31, 2017, we had approximately $31.6 million of unrecognized income tax benefits related to uncertain tax positions. We cannot reasonably estimate when all of these unrecognized income tax benefits may be settled. We do not expect reductions to unrecognized income tax benefits within the next 12 months as a result of projected resolutions of income tax uncertainties. |\n\n| (b) | We draw upon and pay down on the revolver within our Credit Agreement and our Securitization Facility borrowings outside of a normal schedule, as excess cash is available. For our variable rate debt, we have assumed the December 31, 2017 interest rates to calculate the estimated interest payments, for all years presented. This analysis also assumes that outstanding principal is held constant at the December 31, 2017 balances for our Credit Agreement and Securitization Facility, except for mandatory pay downs on the term loans in accordance with the loan documents. We typically expect to settle such interest payments with cash flows from operating activities and/or other short-term borrowings. |\n\n| (c) | The long-term portion of contingent consideration agreements and deferred purchase price payments are included with ‘other debt’ in the detail of our debt instruments disclosed in Note 10 to our audited consolidated financial statements. To reconcile the amount of ‘other debt’ as disclosed in the footnote to the contractual obligations table above, the long-term portion of deferred purchase price payments should be combined with ‘Other’. |\n\nManagement’s Use of Non-GAAP Financial Measures\nWe have included in the discussion above certain financial measures that were not prepared in accordance with GAAP. Any analysis of non-GAAP financial measures should be used only in conjunction with results presented in accordance with GAAP. Below, we define the non-GAAP financial measures, provide a reconciliation of the non-GAAP financial measure to the most directly comparable financial measure calculated in accordance with GAAP, and discuss the reasons that we believe this information is useful to management and may be useful to investors.\nAdjusted revenues. We have defined the non-GAAP measure adjusted revenues as revenues, net less merchant commissions as reflected in our income statement.\nWe use adjusted revenues as a basis to evaluate our revenues, net of the commissions that are paid to merchants to participate in our card programs. The commissions paid to merchants can vary when market spreads fluctuate in much the same way as revenues are impacted when market spreads fluctuate. We believe that adjusted revenue is an appropriate supplemental measure of financial performance and may be useful to investors to understanding our revenue performance on a consistent basis. Adjusted revenues are not intended to be a substitute for GAAP financial measures and should not be used as such.\nSet forth below is a reconciliation of adjusted revenues to the most directly comparable GAAP measure, revenues, net (in millions):\n| Year Ended December 31, |\n| 2017 | 2016 | 2015 |\n| Revenues, net | $ | 2,250 | $ | 1,832 | $ | 1,703 |\n| Merchant commissions | 113 | 104 | 108 |\n| Total adjusted revenues | $ | 2,136 | $ | 1,727 | $ | 1,595 |\n\nPro forma and macro adjusted revenues. We have defined the non-GAAP measure pro forma and macro adjusted revenue as revenues, net adjusted for the impact of the macroeconomic environment, acquisitions and dispositions and other one-time items. We use pro forma and macro adjusted revenue as a basis to evaluate our organic growth.\nSet forth below is a reconciliation of pro forma and macro adjusted revenues to the most directly comparable GAAP measure, revenues, net (in millions):\n76\n| Year Ended December 31,* |\n| 2017 | 2016 |\n| (Unaudited) | Macro Adjusted1 | Pro forma2,3 |\n| FUEL CARDS |\n| Pro forma and macro adjusted | $ | 1,068 | $ | 996 |\n| Impact of acquisitions/dispositions | — | (7 | ) |\n| Impact of fuel prices/spread | 30 | — |\n| Impact of foreign exchange rates | — | — |\n| One-time items4 | (2 | ) | 8 |\n| As reported | $ | 1,096 | $ | 997 |\n| CORPORATE PAYMENTS |\n| Pro forma and macro adjusted | $ | 260 | $ | 226 |\n| Impact of acquisitions/dispositions | — | (47 | ) |\n| Impact of fuel prices/spread | 1 | — |\n| Impact of foreign exchange rates | 1 | — |\n| One-time items4 | — | — |\n| As reported | $ | 262 | $ | 180 |\n| TOLLS |\n| Pro forma and macro adjusted | $ | 302 | $ | 257 |\n| Impact of acquisitions/dispositions | — | (154 | ) |\n| Impact of fuel prices/spread | — | — |\n| Impact of foreign exchange rates | 25 | — |\n| One-time items4 | — | — |\n| As reported | $ | 327 | $ | 103 |\n| LODGING |\n| Pro forma and macro adjusted | $ | 127 | $ | 105 |\n| Impact of acquisitions/dispositions | — | (4 | ) |\n| Impact of fuel prices/spread | — | — |\n| Impact of foreign exchange rates | — | — |\n| One-time items4 | — | — |\n| As reported | $ | 127 | $ | 101 |\n| GIFT |\n| Pro forma and macro adjusted | $ | 194 | $ | 185 |\n| Impact of acquisitions/dispositions | — | — |\n| Impact of fuel prices/spread | — | — |\n| Impact of foreign exchange rates | — | — |\n| One-time items4 | — | — |\n| As reported | $ | 194 | $ | 185 |\n| OTHER5 |\n| Pro forma and macro adjusted | $ | 243 | $ | 244 |\n| Impact of acquisitions/dispositions | — | 23 |\n| Impact of fuel prices/spread | — | — |\n| Impact of foreign exchange rates | 1 | — |\n| One-time items4 | — | — |\n| As reported | $ | 244 | $ | 266 |\n\n77\n| FLEETCOR CONSOLIDATED REVENUES |\n| Pro forma and macro adjusted | $ | 2,194 | $ | 2,013 |\n| Impact of acquisitions/dispositions | — | (189 | ) |\n| Impact of fuel prices/spread | 30 | — |\n| Impact of foreign exchange rates | 27 | — |\n| One-time items4 | (2 | ) | 8 |\n| As reported | $ | 2,250 | $ | 1,832 |\n\n* Columns may not calculate due to rounding.\n1 Adjusted to remove the impact of changes in the macroeconomic environment to be consistent with the same period of prior year, using constant fuel prices, fuel price spreads and foreign exchange rates, as well as one-time items.\n2 Pro forma to include acquisitions and exclude dispositions and one-time items, consistent with previous period ownership.\n3 2016 reflects immaterial corrections in estimated allocation of revenue by product from previously disclosed amounts.\n4 Adjustments related to one-time items not representative of normal business operations.\n5 Other includes telematics, maintenance, food and transportation related businesses.\nAdjusted net income and adjusted net income per diluted share. We have defined the non-GAAP measure adjusted net income as net income as reflected in our statement of income, adjusted to eliminate (a) non-cash stock-based compensation expense related to share-based compensation awards, (b) amortization of deferred financing costs, discounts and intangible assets, amortization of the premium recognized on the purchase of receivables, and our proportionate share of amortization of intangible assets at our equity method investment, (c) a non-recurring net gain at equity method investment, (d) impairment of our equity method investment, (e) net gain on disposition of business, (f) loss on extinguishment of debt and, (g) other non-recurring items, including the impact of the Tax Act.\nWe have defined the non-GAAP measure adjusted net income per diluted share as the calculation previously noted divided by the weighted average diluted shares outstanding as reflected in our statement of income.\nWe use adjusted net income to eliminate the effect of items that we do not consider indicative of our core operating performance. We believe it is useful to exclude non-cash stock based compensation expense from adjusted net income because non-cash equity grants made at a certain price and point in time do not necessarily reflect how our business is performing at any particular time and stock based compensation expense is not a key measure of our core operating performance. We also believe that amortization expense can vary substantially from company to company and from period to period depending upon their financing and accounting methods, the fair value and average expected life of their acquired intangible assets, their capital structures and the method by which their assets were acquired. Therefore, we have excluded amortization expense from adjusted net income. We believe that adjusted net income and adjusted net income per diluted share are appropriate supplemental measures of financial performance and may be useful to investors to understanding our operating performance on a consistent basis. Adjusted net income and adjusted net income per diluted share are not intended to be a substitute for GAAP financial measures and should not be used as such.\n78\nSet forth below is a reconciliation of adjusted net income and adjusted net income per diluted share to the most directly comparable GAAP measure, net income and net income per diluted share (in thousands, except per share amounts):\n| Year Ended December 31,* |\n| (Unaudited) | 2017 | 20162 | 2015 |\n| Net income | $ | 740,200 | $ | 452,385 | $ | 362,431 |\n| Net income per diluted share | $ | 7.91 | $ | 4.75 | $ | 3.85 |\n| Stock based compensation | 93,297 | 63,946 | 90,122 |\n| Amortization of intangible assets, premium on receivables, deferred financing costs and discounts | 233,280 | 184,475 | 180,704 |\n| Impairment of investment | 44,600 | 36,065 | 40,000 |\n| Net gain on disposition of business | (109,205 | ) | — | — |\n| Loss on extinguishment of debt | 3,296 | — | — |\n| Non-recurring loss due to merger of entities | 2,028 | — | — |\n| Non-recurring net gain at equity method investment | — | (10,845 | ) | — |\n| Legal settlement | 11,000 | — | — |\n| Restructuring costs | 1,043 | — | — |\n| Total pre-tax adjustments | 279,339 | 273,641 | 310,826 |\n| Impact of 2017 Tax Act | (127,466 | ) | — | — |\n| Income tax impact of pre-tax adjustments at the effective tax rate1 | (93,164 | ) | (66,850 | ) | (80,632 | ) |\n| Adjusted net income | $ | 798,909 | $ | 659,176 | $ | 592,625 |\n| Adjusted net income per diluted share | $ | 8.54 | $ | 6.92 | $ | 6.30 |\n| Diluted shares | 93,594 | 95,213 | 94,139 |\n\n| *Columns may not calculate due to rounding. |\n| 1Excludes the results of our equity method investment on our effective tax rate, as results from our investment are reported within the Consolidated Income Statements on a post-tax basis and no tax-over-book outside basis differences related to our equity method investment. Also excludes the net gain realized upon our disposition of NexTraq, representing a pretax gain of $175.0 and tax on gain of $65.8. The tax on the gain is included in \"Net gain on disposition of business\". |\n| 2 Reflects the impact of the Company's adoption of Accounting Standards Update 2016-09, \"Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting\", to simplify several aspects of the accounting for share-based compensation, including the income tax consequences. |\n\n79\nITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nForeign currency risk\nForeign Earnings\nOur International segment exposes us to foreign currency exchange rate changes that can impact translations of foreign-denominated assets and liabilities into U.S. dollars and future earnings and cash flows from transactions denominated in different currencies. Revenue from our International segment was 36.5%, 30.2% and 27.7% of total revenue for the years ended December 31, 2017, 2016, and 2015, respectively. We measure foreign currency exchange risk based on changes in foreign currency exchange rates using a sensitivity analysis. The sensitivity analysis measures the potential change in earnings based on a hypothetical 10% change in currency exchange rates. Exchange rates and currency positions as of December 31, 2017 were used to perform the sensitivity analysis. Such analysis indicated that a hypothetical 10% change in foreign currency exchange rates would have increased or decreased consolidated operating income during the year ended December 31, 2017 by approximately $34.2 million had the U.S. dollar exchange rate increased or decreased relative to the currencies to which we had exposure. When exchange rates and currency positions as of December 31, 2016 and 2015 were used to perform this sensitivity analysis, the analysis indicated that a hypothetical 10% change in currency exchange rates would have increased or decreased consolidated operating income for the years ended December 31, 2016 and 2015 by approximately $24.8 million and $22.5 million, respectively.\nUnhedged Cross-Currency Risk\nWith the acquisition of Cambridge in August 2017, we have additional foreign exchange risk and associated foreign exchange risk management requirements due to the nature of our international payments provider business. The majority of Cambridge's revenue is from exchanges of currency at spot rates, which enable customers to make cross-currency payments. In addition, Cambridge also writes foreign currency forward and option contracts for customers to facilitate future payments. The duration of these derivative contracts at inception is generally less than one year. Cambridge aggregates its foreign exchange exposures arising from customer contracts, including the derivative contracts described above, and hedges (economic hedge) the resulting net currency risks by entering into offsetting contracts with established financial institution counterparties.\nInterest rate risk\nWe are exposed to changes in interest rates on our cash investments and debt. We invest our excess cash either to pay down our Securitization Facility debt or in securities that we believe are highly liquid and marketable in the short term. These investments are not held for trading or other speculative purposes. Under our $4.325 billion Credit Agreement, the Credit Agreement provides for senior secured credit facilities consisting of a revolving A credit facility in the amount of $1.285 billion, a term loan A facility in the amount of $2.690 billion and a term loan B facility in the amount of $350.0 million as of December 31, 2017. The revolving credit facility consists of (a) a revolving A credit facility in the amount of $800.0 million, with sublimits for letters of credit and swing line loans, (b) a revolving B facility in the amount of $450.0 million for swing line loans and multi-currency borrowings and, (c) a revolving C facility in the amount of $35.0 million for multi-currency borrowings in Australian Dollars or New Zealand Dollars.\nOn January 20, 2017, we entered into the second amendment to the Credit Agreement, which established a new term B loan. Interest on the term B loan facility accrues based on the Eurocurrency Rate or the Base Rate at 2.25% for Eurocurrency Loans and at 1.25% for Base Rate Loans. Interest on amounts outstanding under the Credit Agreement (other than the Term B loan) accrues based on the British Bankers Association LIBOR Rate (the Eurocurrency Rate), plus a margin based on a leverage ratio, or our option, the Base Rate (defined as the rate equal to the highest of (a) the Federal Funds Rate plus 0.50%, (b) the prime rate announced by Bank of America, N.A., or (c) the Eurocurrency Rate plus 1.00%) plus a margin based on a leverage ratio. In addition, the Company pays a quarterly commitment fee at a rate per annum ranging from 0.20% to 0.40% of the daily unused portion of the credit facility.\nBased on the amounts and mix of our fixed and floating rate debt (exclusive of our Securitization Facility) at December 31, 2017, 2016 and 2015, if market interest rates had increased or decreased an average of 100 basis points, our interest expense would have changed by approximately $34.7 million, $27.9 million and $26.2 million, respectively. We determined these amounts by considering the impact of the hypothetical interest rates on our borrowing costs. These analyses do not consider the effects of changes in the level of overall economic activity that could exist in such an environment.\nFuel price risk\n80\nOur fleet customers use our products and services primarily in connection with the purchase of fuel. Accordingly, our revenue is affected by fuel prices, which are subject to significant volatility. A decline in retail fuel prices could cause a change in our revenue from several sources, including fees paid to us based on a percentage of each customer’s total purchase. Changes in the absolute price of fuel may also impact unpaid account balances and the late fees and charges based on these amounts. The impact of changes in fuel price is somewhat mitigated by our agreements with certain merchants, where the price paid to the merchant is equal to the lesser of the merchant’s cost plus a markup or a percentage of the transaction purchase price. We do not enter into any fuel price derivative instruments.\nFuel-price spread risk\nFrom our merchant and network relationships, we derive revenue from the difference between the price charged to a fleet customer for a transaction and the price paid to the merchant or network for the same transaction. The price paid to a merchant or network is calculated as the merchant’s wholesale cost of fuel plus a markup. The merchant’s wholesale cost of fuel is dependent on several factors including, among others, the factors described above affecting fuel prices. The fuel price that we charge to our customer is dependent on several factors including, among others, the fuel price paid to the fuel merchant, posted retail fuel prices and competitive fuel prices. We experience fuel-price spread contraction when the merchant’s wholesale cost of fuel increases at a faster rate than the fuel price we charge to our customers, or the fuel price we charge to our customers decreases at a faster rate than the merchant’s wholesale cost of fuel. Accordingly, if fuel-price spreads contract, we may generate less revenue, which could adversely affect our operating results. The impact of volatility in fuel spreads is somewhat mitigated by our agreements with certain merchants, where the price paid to the merchant is equal to the lesser of the merchant’s cost plus a markup or a percentage of the transaction purchase price.\n81\nITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA\nINDEX TO CONSOLIDATED FINANCIAL STATEMENTS\n\n| Page |\n| Reports of Independent Registered Public Accounting Firm | 83 |\n| Consolidated Balance Sheets at December 31, 2017 and 2016 | 85 |\n| Consolidated Statements of Income for the Years Ended December 31, 2017, 2016 and 2015 | 86 |\n| Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2017, 2016 and 2015 | 87 |\n| Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2017, 2016 and 2015 | 88 |\n| Consolidated Statements of Cash Flows for the Years Ended December 31, 2017, 2016 and 2015 | 89 |\n| Notes to Consolidated Financial Statements | 90 |\n\n82\nReport of Independent Registered Public Accounting Firm\nTo the Shareholders and the Board of Directors of FleetCor Technologies, Inc. and Subsidiaries\nOpinion on the Financial Statements\nWe have audited the accompanying consolidated balance sheets of FleetCor Technologies, Inc. and subsidiaries (the Company) as of December 31, 2017 and 2016, the related consolidated statements of income, comprehensive income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2017, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2017, in conformity with U.S. generally accepted accounting principles.\nWe also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated March 1, 2018 expressed an unqualified opinion thereon.\nBasis for Opinion\nThese consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.\nWe conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.\n/s/ Ernst & Young LLP\nWe have served as the Company‘s auditor since 2002.\nAtlanta, Georgia\nMarch 1, 2018\n83\nReport of Independent Registered Public Accounting Firm\nTo the Shareholders and the Board of Directors of FLEETCOR Technologies, Inc. and Subsidiaries\nOpinion on Internal Control over Financial Reporting\nWe have audited FleetCor Technologies, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission 2013 framework (the COSO criteria). In our opinion, FleetCor and subsidiaries (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2017, based on the COSO criteria.\nAs indicated in the accompanying Management Report on Internal Control over Financial Reporting, management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of Cambridge Global Payments, Creative Lodging Solutions, and a fuel card provider in Russia (the “Acquired Entities”), which is included in the 2017 consolidated financial statements of the Company and constituted 11% of total assets as of December 31, 2017 and 3% of revenues for the year then ended. Our audit of internal control over financial reporting of the Company also did not include an evaluation of the internal control over financial reporting of the Acquired Entities.\nWe also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the FleetCor Technologies, Inc. and subsidiaries as of December 31, 2017 and 2016, the related consolidated statements of comprehensive income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2017, and the related notes and our report dated March 1, 2018 expressed an unqualified opinion thereon\nBasis for Opinion\nThe Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management Report on Internal Controls over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.\nWe conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.\nOur audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.\nDefinition and Limitations of Internal Control Over Financial Reporting\nA company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.\nBecause of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.\n/s/ Ernst & Young LLP\nAtlanta, Georgia\nMarch 1, 2018\n84\nFLEETCOR Technologies, Inc. and Subsidiaries\nConsolidated Balance Sheets\n| December 31, |\n| 2017 | 2016 |\n| Assets |\n| Current assets: |\n| Cash and cash equivalents | $ | 913,595 | $ | 475,018 |\n| Restricted cash | 217,275 | 168,752 |\n| Accounts and other receivables (less allowance for doubtful accounts of $46,031 and $32,506, respectively) | 1,420,011 | 1,202,009 |\n| Securitized accounts receivable—restricted for securitization investors | 811,000 | 591,000 |\n| Prepaid expenses and other current assets | 187,820 | 90,914 |\n| Total current assets | 3,549,701 | 2,527,693 |\n| Property and equipment, net | 180,057 | 142,504 |\n| Goodwill | 4,715,823 | 4,195,150 |\n| Other intangibles, net | 2,724,957 | 2,653,233 |\n| Investments | 32,859 | 36,200 |\n| Other assets | 114,962 | 71,952 |\n| Total assets | $ | 11,318,359 | $ | 9,626,732 |\n| Liabilities and stockholders’ equity |\n| Current liabilities: |\n| Accounts payable | $ | 1,437,314 | $ | 1,151,432 |\n| Accrued expenses | 238,472 | 238,812 |\n| Customer deposits | 732,171 | 530,787 |\n| Securitization facility | 811,000 | 591,000 |\n| Current portion of notes payable and lines of credit | 805,512 | 745,506 |\n| Other current liabilities | 71,033 | 38,781 |\n| Total current liabilities | 4,095,502 | 3,296,318 |\n| Notes payable and other obligations, less current portion | 2,902,104 | 2,521,727 |\n| Deferred income taxes | 518,912 | 668,580 |\n| Other noncurrent liabilities | 125,319 | 56,069 |\n| Total noncurrent liabilities | 3,546,335 | 3,246,376 |\n| Commitments and contingencies (Note 13) |\n| Stockholders’ equity: |\n| Common stock, $0.001 par value; 475,000,000 shares authorized; 122,083,059 shares issued and 89,803,982 shares outstanding at December 31, 2017; and 121,259,960 shares issued and 91,836,938 shares outstanding at December 31, 2016 | 122 | 121 |\n| Additional paid-in capital | 2,214,224 | 2,074,094 |\n| Retained earnings | 2,958,921 | 2,218,721 |\n| Accumulated other comprehensive loss | (551,857 | ) | (666,403 | ) |\n| Less treasury stock (32,279,077 shares at December 31, 2017; and 29,423,022 shares at December 31, 2016) | (944,888 | ) | (542,495 | ) |\n| Total stockholders’ equity | 3,676,522 | 3,084,038 |\n| Total liabilities and stockholders’ equity | $ | 11,318,359 | $ | 9,626,732 |\n\nSee accompanying notes.\n85\nFLEETCOR Technologies, Inc. and Subsidiaries\nConsolidated Statements of Income\n(In Thousands, Except Per Share Amounts)\n\n| Year Ended December 31, |\n| 2017 | 2016 | 2015 |\n| Revenues, net | $ | 2,249,538 | $ | 1,831,546 | $ | 1,702,865 |\n| Expenses: |\n| Merchant commissions | 113,133 | 104,345 | 108,257 |\n| Processing | 429,613 | 355,414 | 331,073 |\n| Selling | 170,717 | 131,443 | 109,075 |\n| General and administrative | 387,694 | 283,625 | 297,715 |\n| Depreciation and amortization | 264,560 | 203,256 | 193,453 |\n| Other operating, net | 61 | (690 | ) | (4,242 | ) |\n| Operating income | 883,760 | 754,153 | 667,534 |\n| Investment loss | 53,164 | 36,356 | 57,668 |\n| Other (income) expense, net | (173,436 | ) | 2,982 | 2,523 |\n| Interest expense, net | 107,146 | 71,896 | 71,339 |\n| Loss on extinguishment of debt | 3,296 | — | — |\n| Total other (income) expense | (9,830 | ) | 111,234 | 131,530 |\n| Income before income taxes | 893,590 | 642,919 | 536,004 |\n| Provision for income taxes | 153,390 | 190,534 | 173,573 |\n| Net income | $ | 740,200 | $ | 452,385 | $ | 362,431 |\n| Basic earnings per share | $ | 8.12 | $ | 4.89 | $ | 3.94 |\n| Diluted earnings per share | $ | 7.91 | $ | 4.75 | $ | 3.85 |\n| Weighted average shares outstanding: |\n| Basic shares | 91,129 | 92,597 | 92,023 |\n| Diluted shares | 93,594 | 95,213 | 94,139 |\n\nSee accompanying notes.\n86\nFLEETCOR Technologies, Inc. and Subsidiaries\nConsolidated Statements of Comprehensive Income\n(In Thousands)\n\n| Year Ended December 31, |\n| 2017 | 2016 | 2015 |\n| Net income | $ | 740,200 | $ | 452,385 | $ | 362,431 |\n| Other comprehensive income (loss): |\n| Foreign currency translation gains (losses), net of tax | 83,165 | (95,592 | ) | (279,303 | ) |\n| Reclassification of foreign currency translation loss to investment, net of tax | 31,381 | — | — |\n| Total other comprehensive income (loss) | 114,546 | (95,592 | ) | (279,303 | ) |\n| Total comprehensive income | $ | 854,746 | $ | 356,793 | $ | 83,128 |\n\nSee accompanying notes.\n87\nFLEETCOR Technologies, Inc. and Subsidiaries\nConsolidated Statements of Stockholders’ Equity\n(In Thousands)\n\n| CommonStock | AdditionalPaid-InCapital | RetainedEarnings | AccumulatedOtherComprehensiveLoss | TreasuryStock | Total |\n| Balance at December 31, 2014 | $ | 120 | $ | 1,852,442 | $ | 1,403,905 | $ | (291,508 | ) | $ | (346,397 | ) | $ | 2,618,562 |\n| Net income | — | — | 362,431 | — | — | 362,431 |\n| Other comprehensive loss, net of tax of $0 | — | — | — | (279,303 | ) | — | (279,303 | ) |\n| Acquisition of common stock | — | — | — | — | (8,119 | ) | (8,119 | ) |\n| Issuance of common stock | 1 | 136,475 | — | — | — | 136,476 |\n| Balance at December 31, 2015 | 121 | 1,988,917 | 1,766,336 | (570,811 | ) | (354,516 | ) | 2,830,047 |\n| Net income | — | — | 452,385 | — | — | 452,385 |\n| Other comprehensive loss, net of tax of $0 | — | — | — | (95,592 | ) | — | (95,592 | ) |\n| Acquisition/return of common stock | — | — | — | — | (187,979 | ) | (187,979 | ) |\n| Issuance of common stock | — | 85,177 | — | — | — | 85,177 |\n| Balance at December 31, 2016 | 121 | 2,074,094 | 2,218,721 | (666,403 | ) | (542,495 | ) | 3,084,038 |\n| Net income | — | — | 740,200 | — | — | 740,200 |\n| Other comprehensive income, net of tax of $0 | — | — | — | 114,546 | — | 114,546 |\n| Acquisition of common stock | — | — | — | — | (402,393 | ) | (402,393 | ) |\n| Issuance of common stock | 1 | 140,130 | — | — | — | 140,131 |\n| Balance at December 31, 2017 | $ | 122 | $ | 2,214,224 | $ | 2,958,921 | $ | (551,857 | ) | $ | (944,888 | ) | $ | 3,676,522 |\n\nSee accompanying notes.\n88\nFLEETCOR Technologies, Inc. and Subsidiaries\nConsolidated Statements of Cash Flows\n(In Thousands)\n| Year Ended Year Ended December 31, |\n| 2017 | 2016 | 2015 |\n| Operating activities |\n| Net income | $ | 740,200 | $ | 452,385 | $ | 362,431 |\n| Adjustments to reconcile net income to net cash provided by operating activities: |\n| Depreciation | 46,599 | 36,456 | 30,462 |\n| Stock-based compensation | 93,297 | 63,946 | 90,122 |\n| Provision for losses on accounts receivable | 44,857 | 35,885 | 24,629 |\n| Amortization of deferred financing costs and discounts | 6,952 | 7,582 | 7,049 |\n| Amortization of intangible assets | 211,849 | 161,635 | 159,740 |\n| Amortization of premium on receivables | 6,112 | 5,165 | 3,250 |\n| Loss on extinguishment of debt | 3,296 | — | — |\n| Deferred income taxes | (247,712 | ) | (28,681 | ) | 30,626 |\n| Investment loss | 53,164 | 36,356 | 57,668 |\n| Gain on disposition of business | (174,983 | ) | — | — |\n| Other non-cash operating income | (61 | ) | (690 | ) | (4,242 | ) |\n| Changes in operating assets and liabilities (net of acquisitions and disposition): |\n| Restricted cash | (4,335 | ) | (2,306 | ) | (35,676 | ) |\n| Accounts receivable and other receivables | (431,003 | ) | (338,796 | ) | 40,017 |\n| Prepaid expenses and other current assets | 26,102 | 5,301 | (12,564 | ) |\n| Other assets | (20,957 | ) | (20,345 | ) | (2,524 | ) |\n| Excess tax benefits related to stock-based compensation | — | — | (26,427 | ) |\n| Accounts payable, accrued expenses and customer deposits | 322,346 | 292,019 | 30,023 |\n| Net cash provided by operating activities | 675,723 | 705,912 | 754,584 |\n| Investing activities |\n| Acquisitions, net of cash acquired1 | (705,257 | ) | (1,331,985 | ) | (49,069 | ) |\n| Purchases of property and equipment | (70,093 | ) | (59,011 | ) | (41,875 | ) |\n| Proceeds from disposal of a business | 316,501 | — | — |\n| Other | (38,953 | ) | 1,411 | (8,470 | ) |\n| Net cash used in investing activities | (497,802 | ) | (1,389,585 | ) | (99,414 | ) |\n| Financing activities |\n| Excess tax benefits related to stock-based compensation | — | — | 26,427 |\n| Proceeds from issuance of common stock | 44,690 | 21,231 | 19,926 |\n| Borrowings (payments) on securitization facility, net | 220,000 | (23,000 | ) | (61,000 | ) |\n| Repurchase of common stock | (402,393 | ) | (187,678 | ) | — |\n| Deferred financing costs paid and debt discount | (12,908 | ) | (2,272 | ) | — |\n| Proceeds from issuance of notes payable | 780,656 | 600,000 | — |\n| Principal payments on notes payable | (423,156 | ) | (118,500 | ) | (103,500 | ) |\n| Borrowings from revolver | 1,100,000 | 1,225,107 | — |\n| Payments on revolver | (1,031,722 | ) | (786,849 | ) | (486,818 | ) |\n| Borrowings (payments) on swing line of credit, net | (23,686 | ) | 26,606 | (546 | ) |\n| Payment of contingent consideration | — | — | (42,177 | ) |\n| Other | 457 | (676 | ) | (377 | ) |\n| Net cash provided by (used in) financing activities | 251,938 | 753,969 | (648,065 | ) |\n| Effect of foreign currency exchange rates on cash | 8,718 | (42,430 | ) | (37,022 | ) |\n| Net increase (decrease) in cash | 438,577 | 27,866 | (29,917 | ) |\n| Cash and cash equivalents, beginning of year | 475,018 | 447,152 | 477,069 |\n| Cash and cash equivalents, end of year | $ | 913,595 | $ | 475,018 | $ | 447,152 |\n| Supplemental cash flow information |\n| Cash paid for interest | $ | 113,416 | $ | 70,339 | $ | 72,537 |\n| Cash paid for income taxes | $ | 392,192 | $ | 101,951 | $ | 83,380 |\n| Non cash investing activity, notes assumed in acquisitions | $ | 29,341 | $ | — | $ | — |\n| 1Amounts reported in acquisitions and investment, net of cash acquired, includes debt assumed and immediately repaid in acquisitions. |\n| See accompanying notes. |\n\n89\nFLEETCOR Technologies, Inc. and Subsidiaries\nNotes to Consolidated Financial Statements\nDecember 31, 2017\n1. Description of Business\nFLEETCOR Technologies, Inc. and its subsidiaries (the Company) is a leading global provider of commercial payment solutions. The Company helps businesses of all sizes control, simplify and secure payment of various domestic and cross-border payables using specialized payment products. The Company serves businesses, merchants and partners in North America, Latin America, Europe, and Australasia.\nThe Company has two reportable segments, North America and International. The Company reports these two segments as they align with its senior executive organizational structure, reflect how the Company organizes and manages its employees around the world, manages operating performance, contemplates the differing regulatory environments in North America versus other geographies, and helps the Company isolate the impact of foreign exchange fluctuations on its financial results.\nThe Company's payment solutions provide its customers with a payment method designed to be superior and more robust and effective than what they use currently, whether they use a competitor’s product or another alternative method such as cash or check. The Company's solutions are comprised of payment products, networks and associated services.\nThe Company's payment products function like a charge card or prepaid card and tend to be specialized for specific spend categories, such as fuel or lodging, and/or specific customer groups, such as long haul transportation. The Company's five primary product lines are Fuel, Lodging, Tolls, Corporate Payments and Gift. Additionally, the Company provides other payment products including fleet maintenance, employee benefits and long haul transportation-related services. The Company's products are used in 56 countries around the world, with its primary geographies being the U.S., Brazil and the United Kingdom, which combined accounted for approximately 90% of the Company's revenue in 2017.\nThe Company uses both proprietary and third-party networks to deliver its payment solutions. FLEETCOR owns and operates proprietary networks with brands throughout the world, bringing incremental sales and loyalty to affiliated merchants. Third-party networks are used to broaden payment product acceptance and use.\nThe Company markets its products directly through multiple sales channels, including field sales, telesales and digital marketing, and indirectly through its partners, which include major oil companies, leasing companies, petroleum marketers, value-added resellers (VARs) and referral partners.\n2. Summary of Significant Accounting Policies\nRevenue Recognition and Presentation\nRevenue is derived from the Company’s merchant and network relationships as well as from customers and partners. The Company recognizes revenue on fees generated through services primarily to commercial fleets, commercial businesses, major oil companies, petroleum marketers and leasing companies and records revenue net of the wholesale cost of the underlying products and services based on the following: (i) the Company is not the primary obligor in the arrangement and is not responsible for fulfillment and the acceptability of the product; (ii) the Company has no inventory risk, does not bear the risk of product loss and does not make any changes to the product or have any involvement in the product specifications; (iii) the Company does not have significant latitude with respect to establishing the price for the product; and (iv) the amount the Company earns for services is fixed, within a limited range. The Company recognizes revenue from merchant and network relationships, processing and other arrangements when persuasive evidence of an arrangement exists, the services have been provided to the customer, the sales price is fixed or determinable and collectability is reasonably assured, as more fully described below.\nThrough the Company’s merchant and network relationships the Company provides fuel, prepaid cards, vehicle maintenance, lodging, food, toll, and transportation related services to our customers. The Company derives revenue from its merchant and network relationships based on the difference between the price charged to a customer for a transaction and the price paid to the merchant or network for the same transaction. The Company’s revenue consists of margin on sales and fees for technical support, processing, communications and reporting. The price paid to a merchant or network may be calculated as (i) the merchant’s wholesale cost of the product plus a markup; (ii) the transaction purchase price less a percentage discount; or (iii) the transaction purchase price less a fixed fee per unit. The difference between the price the Company pays to a merchant and the merchant’s wholesale cost for the underlying products and services is considered a merchant commission and is recognized as expense when the fuel purchase transaction is executed. The Company has entered into agreements with major oil companies, petroleum marketers and leasing companies, among others, that specify that a transaction is deemed to be\n90\ncaptured when we have validated that the transaction has no errors and have accepted and posted the data to the Company’s records.\nThe Company also derives revenue from customers and partners from a variety of program fees including transaction fees, card fees, network fees, service fees, report fees and other transaction-based fees, which typically are calculated based on measures such as percentage of dollar volume processed, number of transactions processed, or some combination thereof. Such services are provided through proprietary networks or through the use of third-party networks. Transaction fees and other transaction-based fees generated from the Company’s proprietary networks and third-party networks are recognized at the time the transaction is captured. Card fees, network fees and program fees are recognized as the Company fulfills its contractual service obligations. In addition, the Company recognizes revenue from late fees and finance charges, in jurisdictions where permitted under local regulations, primarily in the U.S. and Canada. Such fees are recognized net of a provision for estimated uncollectible amounts, at the time the fees and finance charges are assessed and services are provided. The Company ceases billing and accruing for late fees and finance charges approximately 30-40 days after the customer’s balance becomes delinquent.\nThe Company also charges its customers transaction fees to load value onto prepaid fuel, food, toll and transportation vouchers and cards. The Company recognizes fee revenue upon providing the activated fuel, food, toll and transportation vouchers and prepaid cards to the customer. Revenue is recognized on lodging and transportation management services when the lodging stay or transportation service is completed. Revenue is also derived from the sale of equipment and cards in certain of the Company’s businesses, which is recognized at the time the device is sold and the risks and rewards of ownership have passed. This revenue is recognized gross of the cost of sales related to the equipment in revenues, net within the Consolidated Statements of Income. The related cost of sales for the equipment is recorded within processing expenses in the Consolidated Statements of Income. The Company has recorded $96.8 million, $91.6 million and $84.1 million of expenses related to sales of equipment within the processing expenses line of the Consolidated Statements of Income for the years ended December 31, 2017, 2016 and 2015, respectively. Sales commissions paid to personnel are expensed as incurred.\nThe Company delivers both stored value cards and card-based services primarily in the form of gift cards. For multiple-deliverable customer contracts, stored value cards and card-based services are separated into two units of accounting. Stored valued cards are generally recognized upon shipment to the customer. Card-based services are recognized when the card services are rendered.\nThe Company presents taxes assessed by the government imposed concurrent with a revenue producing transaction between us and our customers (e.g. VAT) on a net basis within revenues, net.\nUse of Estimates\nThe preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.\nPrinciples of Consolidation\nThe accompanying consolidated financial statements include the accounts of FLEETCOR Technologies, Inc. and all of its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated.\nThe Company’s fiscal year ends on December 31. In certain of the Company’s U.K. businesses, the Company records the operating results using a 4-4-5 week accounting cycle with the fiscal year ending on the Friday on or immediately preceding December 31. Fiscal years 2017, 2016 and 2015 include 52 weeks for the businesses reporting using a 4-4-5 accounting cycle.\nCredit Risk and Reserve for Losses on Receivables\nThe Company controls credit risk by performing periodic credit evaluations of its customers. Payments from customers are generally due within 14 days or less of billing. The Company routinely reviews its accounts receivable balances and makes provisions for probable doubtful accounts based primarily on the aging of those balances. Accounts receivable are deemed uncollectible once they age past 90 days and are deemed uncollectible from the customer. The Company also provides an allowance for receivables aged less than 90 days that it expects will be uncollectible based on historical collections experience including accounts that have filed for bankruptcy. At December 31, 2017 and 2016, approximately 96% and 95%, respectively, of outstanding accounts receivable were current. Accounts receivable deemed uncollectible are removed from accounts\n91\nreceivable and the allowance for doubtful accounts when internal collection efforts have been exhausted and accounts have been turned over to a third-party collection agency. Recoveries from the third-party collection agency are not significant.\nBusiness Combinations\nBusiness combinations completed by the Company have been accounted for under the acquisition method of accounting. The acquisition method requires that the acquired assets and liabilities, including contingencies, be recorded at fair value determined as of the acquisition date and changes thereafter reflected in income. For significant acquisitions, the Company obtains independent third-party valuation studies for certain of the assets acquired and liabilities assumed to assist the Company in determining fair value. Goodwill represents the excess of the purchase price over the fair values of the tangible and intangible assets acquired and liabilities assumed. The results of the acquired businesses are included in the Company’s results of operations beginning from the completion date of the applicable transaction.\nEstimates of fair value are revised during an allocation period as necessary when, and if, information becomes available to further define and quantify the fair value of the assets acquired and liabilities assumed. Provisional estimates of the fair values of the assets acquired and liabilities assumed involves a number of estimates and assumptions that could differ materially from the final amounts recorded. The allocation period does not exceed one year from the date of the acquisition. To the extent additional information to refine the original allocation becomes available during the allocation period, the allocation of the purchase price is adjusted. Should information become available after the allocation period, those items are adjusted through operating results. The direct costs of the acquisition are recorded as operating expenses. Certain acquisitions include contingent consideration related to the performance of the acquired operations following the acquisition. Contingent consideration is recorded at estimated fair value at the date of the acquisition, and is remeasured each reporting period, with any changes in fair value recorded in the Consolidated Statements of Income. The Company estimates the fair value of the acquisition-related contingent consideration using various valuation approaches, as well as significant unobservable inputs, reflecting the Company’s assessment of the assumptions market participants would use to value these liabilities.\nImpairment of Long-Lived Assets, Goodwill, Intangibles and Investments\nThe Company tests its long-lived assets for impairment in accordance with relevant authoritative guidance. The Company evaluates if impairment indicators related to its property, plant and equipment and other long-lived assets are present. These impairment indicators may include a significant decrease in the market price of a long-lived asset or asset group, a significant adverse change in the extent or manner in which a long-lived asset or asset group is being used or in its physical condition, or a current-period operating or cash flow loss combined with a history of operating or cash flow losses or a forecast that demonstrates continuing losses associated with the use of a long-lived asset or asset group. If impairment indicators are present, the Company estimates the future cash flows for the asset or asset group. The sum of the undiscounted future cash flows attributable to the asset or asset group is compared to its carrying amount. The cash flows are estimated utilizing various projections of revenues and expenses, working capital and proceeds from asset disposals on a basis consistent with management’s intended actions. If the carrying amount exceeds the sum of the undiscounted future cash flows, the Company determines the assets’ fair value by discounting the future cash flows using a discount rate required for a similar investment of like risk and records an impairment charge as the difference between the fair value and the carrying value of the asset group. Generally, the Company performs its testing of the asset group at the business-line level, as this is the lowest level for which identifiable cash flows are available.\nThe Company completes an impairment test of goodwill at least annually or more frequently if facts or circumstances indicate that goodwill might be impaired. Goodwill is tested for impairment at the reporting unit level, and the impairment test consists of two steps, as well as a qualitative assessment, as appropriate. The Company has performed a qualitative assessment of certain of its reporting units. In this qualitative assessment, the Company individually considered the following items for each reporting unit where the Company determined a qualitative analysis to be appropriate: the macroeconomic conditions, including any deterioration of general conditions, limitations on accessing capital, fluctuations in foreign exchange rates and other developments in equity and credit markets; industry and market conditions, including any deterioration in the environment where the reporting unit operates, increased competition, changes in the products/services and regulator and political developments; cost of doing business; overall financial performance, including any declining cash flows and performance in relation to planned revenues and earnings in past periods; other relevant reporting unit specific facts, such as changes in management or key personnel or pending litigation; events affecting the reporting unit, including changes in the carrying value of net assets, likelihood of disposal and whether there were any other impairment considerations within the business; the overall performance of our share price in relation to the market and our peers; and a quantitative stress test of the previously completed step 1 test from the prior year, updated with current year results, weighted-average cost of capital rates and future projections.\n92\nIn step 1 of the goodwill impairment test for reporting units, the reporting unit’s carrying amount, including goodwill, is compared to its fair value which is measured based upon, among other factors, a discounted cash flow analysis, as well as market multiples for comparable companies. If the carrying amount of the reporting unit is greater than its fair value, goodwill is considered impaired and step two must be performed. Step two measures the impairment loss by comparing the implied fair value of reporting unit goodwill with the carrying amount of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit to all the assets and liabilities of that unit (including unrecognized intangibles) as if the reporting unit had been acquired in a business combination. The excess of fair value over the amounts allocated to the assets and liabilities of the reporting unit is the implied fair value of goodwill. The excess of the carrying amount over the implied fair value is the impairment loss.\nThe Company estimated the fair value of its reporting units using a combination of the income approach and the market approach. The income approach utilizes a discounted cash flow model incorporating management’s expectations for future revenue, operating expenses, earnings before interest, taxes, depreciation and amortization, capital expenditures and an anticipated tax rate. The Company discounted the related cash flow forecasts using an estimated weighted-average cost of capital for each reporting unit at the date of valuation. The market approach utilizes comparative market multiples in the valuation estimate. Multiples are derived by relating the value of guideline companies, based on either the market price of publicly traded shares or the prices of companies being acquired in the marketplace, to various measures of their earnings and cash flow. Such multiples are then applied to the historical and projected earnings and cash flow of the reporting unit in developing the valuation estimate.\nPreparation of forecasts and the selection of the discount rates involve significant judgments about expected future business performance and general market conditions. Significant changes in forecasts, the discount rates selected or the weighting of the income and market approach could affect the estimated fair value of one or more of our reporting units and could result in a goodwill impairment charge in a future period.\nBased on the goodwill asset impairment analysis performed quantitatively on October 1, 2017, the Company determined that the fair value of each of its reporting units was in excess of the carrying value. No events or changes in circumstances have occurred since the date of this most recent annual impairment test that would more likely than not reduce the fair value of a reporting unit below its carrying amount.\nThe Company also evaluates indefinite-lived intangible assets (primarily trademarks and trade names) for impairment annually. The Company also tests for impairment if events and circumstances indicate that it is more likely than not that the fair value of an indefinite-lived intangible asset is below its carrying amount. Estimates critical to the Company’s evaluation of indefinite-lived intangible assets for impairment include the discount rate, royalty rates used in its evaluation of trade names, projected average revenue growth and projected long-term growth rates in the determination of terminal values. An impairment charge is recorded if the carrying amount of an indefinite-lived intangible asset exceeds the estimated fair value on the measurement date.\nThe Company regularly evaluates the carrying value of its investments, which are not carried at fair value, for other-than-temporary impairment. The Company estimates the fair value of its investments using a combination of the income approach and the market approach. The income approach utilizes a discounted cash flow model incorporating management’s expectations for future revenue, operating expenses, earnings before interest, taxes, depreciation and amortization, capital expenditures and an anticipated tax rate. The Company discounts the related cash flow forecasts using an estimated weighted-average cost of capital for each reporting unit at the date of valuation. The market approach utilizes comparative market multiples in the valuation estimate. Multiples are derived by relating the value of guideline companies, based on either the market price of publicly traded shares or the prices of companies being acquired in the marketplace, to various measures of their earnings and cash flow. Such multiples are then applied to the historical and projected earnings and cash flow of the Company's investments in developing the valuation estimate.\nOn September 30, 2017, the Company entered into an amended Masternaut Group Holdings Limited (\"Masternaut\") investment agreement that resulted in the loss of significant influence, and the Company began accounting for the Masternaut investment by applying the cost method. The Company regularly evaluates the carrying value of its investment and during the third quarter of 2017, the Company determined that the fair value of its 44% investment in Masternaut had declined as a result of the Company's loss of significant influence and the operating results of Masternaut. As a result, the Company determined that the carrying value of its investment exceeded its fair value, and concluded that this decline in value was other than temporary during the third quarter of 2017. The Company recorded a $44.6 million impairment loss in the Masternaut investment that includes adjustment for $31.4 million of currency losses previously recognized in accumulated other comprehensive income, in the year ended December 31, 2017, in the accompanying Consolidated Statements of Income. During the fourth quarters of 2016 and 2015, the Company determined that the performance improvement initiatives in its investment in Masternaut were\n93\ntaking longer to and were more challenging to implement than originally projected, based on revised cash flow projections provided by the business. As a result, the Company recorded a $36.1 million and $40 million non-cash impairment charge in its Masternaut investment for 2016 and 2015, respectively.\nProperty, Plant and Equipment and Definite-Lived Intangible Assets\nProperty, plant and equipment are stated at cost and depreciated on the straight-line basis. Definite-lived intangible assets, consisting primarily of customer relationships, are stated at fair value upon acquisition and are amortized over their estimated useful lives. Customer and merchant relationship useful lives are estimated using historical attrition rates.\nThe Company develops software that is used in providing processing and information management services to customers. A significant portion of the Company’s capital expenditures are devoted to the development of such internal-use computer software. Software development costs are capitalized once technological feasibility of the software has been established. Costs incurred prior to establishing technological feasibility are expensed as incurred. Technological feasibility is established when the Company has completed all planning, designing, coding and testing activities that are necessary to determine that the software can be produced to meet its design specifications, including functions, features and technical performance requirements. Capitalization of costs ceases when the software is ready for its intended use. Software development costs are amortized using the straight-line method over the estimated useful life of the software. The Company capitalized software costs of $37.4 million, $33.1 million and $23.4 million in 2017, 2016 and 2015, respectively. Amortization expense for software totaled $21.8 million, $17.7 million and $11.6 million in 2017, 2016 and 2015, respectively.\nIncome Taxes\nThe Company accounts for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date.\nThe ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which the associated temporary differences become deductible. The Company evaluates on a quarterly basis whether it is more likely than not that its deferred tax assets will be realized in the future and concludes whether a valuation allowance must be established.\nCurrent accounting guidance clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements and prescribes threshold and measurement attributes for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Under the relevant authoritative literature, the impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more likely than not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50 percent likelihood of being sustained. The Company includes any estimated interest and penalties on tax related matters in income tax expense.\nIn the fourth quarter of 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (“Tax Act”). As a result of Tax Act, the U.S. federal corporate tax rate was reduced from 35% to 21%. The Tax Act also includes provisions for a tax on all previously undistributed earnings in foreign jurisdictions. The Company has provisionally recorded a $210 million deferred tax benefit for the benefit for the corporate rate reduction on our deferred tax assets and liabilities. Additionally, in 2017, the Company has provisionally recorded an $81.8 million charge on all previously undistributed earnings in foreign jurisdictions. The Company is currently evaluating the remaining undistributed foreign earnings for which it has not provided deferred taxes for foreign withholding tax, as these earnings are considered to be indefinitely reinvested. The amount of these unrecorded deferred taxes is not expected to be material. If in the future these earnings are repatriated to the United States, or if we determine that the earnings will be remitted in the foreseeable future, additional tax provisions may be required. See Note 11 for further information regarding income taxes.\nCash Equivalents\nCash equivalents consist of cash on hand and highly liquid investments with original maturities of three months or less. Restricted cash represents customer deposits repayable on demand.\n94\nForeign Currency Translation\nAssets and liabilities of foreign subsidiaries are translated into U.S. dollars at the rates of exchange in effect at period-end. The related translation adjustments are made directly to accumulated other comprehensive income. Income and expenses are translated at the average monthly rates of exchange in effect during the year. Gains and losses from foreign currency transactions of these subsidiaries are included in net income. The Company recognized a foreign exchange loss of $0.2 million, $2.8 million and $2.4 million for the years ended December 31, 2017, 2016 and 2015 respectively, which are recorded within other expense, net in the Consolidated Statements of Income.\nDerivatives\nWith its acquisition of Cambridge Global Payments (\"Cambridge\") in August 2017, the Company uses derivatives to facilitate cross-currency corporate payments by writing derivatives to customers, which are not designated as hedging instruments. The majority of Cambridge's revenue is from exchanges of currency at spot rates, which enable customers to make cross-currency payments. In addition, Cambridge also writes foreign currency forward and option contracts for its customers to facilitate future payments. The duration of these derivative contracts at inception is generally less than one year. The Company aggregates its foreign exchange exposures arising from customer contracts, including forwards, options and spot exchanges of currency, and hedges (economic hedge) the resulting net currency risks by entering into offsetting contracts with established financial institution counterparties. The changes in fair value related to these contracts are recorded in revenues, net in the Consolidated Statements of Income.\nThe Company recognizes all derivatives in \"prepaid expenses and other current assets\" and \"other current liabilities\" in the accompanying Consolidated Balance Sheets at their fair value. All cash flows associated with derivatives are included in cash flows from operating activities in the Consolidated Statements of Cash Flows.\nStock-Based Compensation\nThe Company accounts for employee stock options and restricted stock in accordance with relevant authoritative literature. Stock options are granted with an exercise price estimated to be equal to the fair market value on the date of grant as authorized by the Company’s board of directors. Options granted have vesting provisions ranging from one to five years and vesting of the options is generally based on the passage of time or performance. Stock option grants are subject to forfeiture if employment terminates prior to vesting. The Company has selected the Black-Scholes option pricing model for estimating the grant date fair value of stock option awards granted. The Company has considered the retirement and forfeiture provisions of the options and utilized its historical experience to estimate the expected life of the options. Option forfeitures are accounted for upon occurrence. The Company bases the risk-free interest rate on the yield of a zero coupon U.S. Treasury security with a maturity equal to the expected life of the option from the date of the grant. Stock-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense over the requisite service period based on the number of years for which the requisite service is expected to be rendered.\nAwards of restricted stock and restricted stock units are independent of stock option grants and are subject to forfeiture if employment terminates prior to vesting. The vesting of shares granted is generally based on the passage of time, performance or market conditions, or a combination of these. Shares vesting based on the passage of time have vesting provisions of one to three years. The fair value of restricted stock where the shares vest based on the passage of time or performance is based on the grant date fair value of the Company’s stock.\nFor performance-based restricted stock awards and performance based stock option awards, the Company must also make assumptions regarding the likelihood of achieving performance goals. If actual results differ significantly from these estimates, stock-based compensation expense and the Company’s results of operations could be materially affected.\nDeferred Financing Costs/Debt Discounts\nCosts incurred to obtain financing, net of accumulated amortization, are amortized over the term of the related debt, using the effective interest method and are included within interest expense. The Company capitalized additional debt issuance costs of $12.9 million associated with refinancing its Credit Facility and Securitization Facility in 2017 and $2.3 million with refinancing its Credit Facility in 2016. At December 31, 2017 and 2016, the Company had net deferred financing costs of $16.3 million and $13.1 million, respectively.\n95\nComprehensive Income (Loss)\nComprehensive income (loss) is defined as the total of net income and all other changes in equity that result from transactions and other economic events of a reporting period other than transactions with owners.\nAccounts Receivable\nThe Company maintains a $950 million revolving trade accounts receivable Securitization Facility. Accounts receivable collateralized within our Securitization Facility relate to trade receivables resulting from charge card activity in the U.S. Pursuant to the terms of the Securitization Facility, the Company transfers certain of its domestic receivables, on a revolving basis, to FLEETCOR Funding LLC (Funding), a wholly-owned bankruptcy remote subsidiary. In turn, Funding sells, without recourse, on a revolving basis, up to $950 million of undivided ownership interests in this pool of accounts receivable to a multi-seller, asset-backed commercial paper conduit (Conduit). Funding maintains a subordinated interest, in the form of over-collateralization, in a portion of the receivables sold to the Conduit. Purchases by the Conduit are financed with the sale of highly-rated commercial paper.\nThe Company utilizes proceeds from the sale of its accounts receivable as an alternative to other forms of financing to reduce its overall borrowing costs. The Company has agreed to continue servicing the sold receivables for the financial institution at market rates, which approximates the Company’s cost of servicing. The Company retains a residual interest in the accounts receivable sold as a form of credit enhancement. The residual interest’s fair value approximates carrying value due to its short-term nature. Funding determines the level of funding achieved by the sale of trade accounts receivable, subject to a maximum amount.\nThe Company’s Consolidated Balance Sheets and Statements of Income reflect the activity related to securitized accounts receivable and the corresponding securitized debt, including interest income, fees generated from late payments, provision for losses on accounts receivable and interest expense. The cash flows from borrowings and repayments, associated with the securitized debt, are presented as cash flows from financing activities.\nOn November 14, 2017, the Company extended the term of its asset Securitization Facility to November 14, 2020. The Company capitalized $1.7 million in fees in connection with this extension.\nThe Company’s accounts receivable and securitized accounts receivable include the following at December 31 (in thousands):\n\n| 2017 | 2016 |\n| Gross domestic accounts receivables | $ | 661,677 | $ | 529,885 |\n| Gross domestic securitized accounts receivable | 811,000 | 591,000 |\n| Gross foreign receivables | 804,365 | 704,630 |\n| Total gross receivables | 2,277,042 | 1,825,515 |\n| Less allowance for doubtful accounts | (46,031 | ) | (32,506 | ) |\n| Net accounts and securitized accounts receivable | $ | 2,231,011 | $ | 1,793,009 |\n\nA rollforward of the Company’s allowance for doubtful accounts related to accounts receivable for the years ended December 31 is as follows (in thousands):\n\n| 2017 | 2016 | 2015 |\n| Allowance for doubtful accounts beginning of year | $ | 32,506 | $ | 21,903 | $ | 23,842 |\n| Provision for bad debts | 44,857 | 35,885 | 24,629 |\n| Write-offs | (31,332 | ) | (25,282 | ) | (26,568 | ) |\n| Allowance for doubtful accounts end of year | $ | 46,031 | $ | 32,506 | $ | 21,903 |\n\nAdvertising\nThe Company expenses advertising costs as incurred. Advertising expense was $26.1 million, $22.2 million and $19.9 million for the years ended December 31, 2017, 2016 and 2015, respectively.\n96\nEarnings Per Share\nThe Company reports basic and diluted earnings per share. Basic earnings per share is calculated using the weighted average of common stock and non-vested, non-forfeitable restricted shares outstanding, unadjusted for dilution, and net income attributable to common shareholders.\nDiluted earnings per share is calculated using the weighted average shares outstanding and contingently issuable shares less weighted average shares recognized during the period. The net outstanding shares have been adjusted for the dilutive effect of common stock equivalents, which consist of outstanding stock options and unvested forfeitable restricted stock units.\nPending Adoption of Recently Issued Accounting Standards\nFrom time to time, new accounting pronouncements are issued by the FASB or other standards setting bodies that are adopted by the Company as of the specified effective date. Unless otherwise discussed, the Company’s management believes that the impact of recently issued standards that are not yet effective will not have a material impact on the Company’s consolidated financial statements upon adoption.\nTax Act\nThe SEC staff issued Staff Accounting Bulletin No. 118, \"Income Tax Accounting Implications of the Tax Cuts and Jobs Act\" (\"SAB 118\"), which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC 740. In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Act for which the accounting under ASC 740 is complete. To the extent that a company’s accounting for certain income tax effects of the Tax Act is incomplete but it is able to determine a reasonable estimate, it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax laws that were in effect immediately before the enactment of the Tax Act.\nRevenue Recognition\nIn May 2014, the FASB issued ASU 2014-09, \"Revenue from Contracts with Customers (Topic 606)\". The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 will replace most existing revenue recognition guidance in GAAP and permits the use of either the retrospective or modified retrospective transition method. The update requires significant additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments. ASU 2014-09, as amended by ASU 2015-14, \"Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date\", is effective for years beginning after December 15, 2017, including interim periods, with early adoption permitted for years beginning after December 15, 2016. Since the issuance of ASU 2014-09, the FASB has issued additional interpretive guidance, including new accounting standards updates, that clarifies certain points of the standard and modifies certain requirements.\nThe Company has performed a review of the requirements of the new revenue standard and is monitoring the activity of the FASB and the transition resource group as it relates to specific interpretive guidance. The Company established an implementation team to assess the effects of the new revenue standard in a multi-phase approach. In the first phase, the Company analyzed customer contracts for its most significant contract categories, applied the five-step model of the new standard to each contract category and comparing the results to our current accounting practices. The second phase, which includes quantifying the potential effects identified during the first phase, assessing additional contract categories and principal versus agent considerations, revising accounting policies and considering the effects on related disclosures and/or internal control over financial reporting is ongoing and expected to be concluded during the first quarter of 2018.\nThe new standard could change the amount and timing of revenue and expenses to be recognized under certain of our arrangement types. In addition, it could also increase the administrative burden on our operations to account for customer contracts and provide the more expansive required disclosures. More judgment and estimates may be required within the process of applying the requirements of the new standard than are required under existing GAAP, such as identifying performance obligations in contracts, estimating the amount of variable consideration to include in transaction price, allocating transaction price to each separate performance obligation and estimating expected customer lives. The Company is in the process of finalizing its assessment and completing the quantification of the effect the new guidance will have on its consolidated financial statements, related disclosures and/or internal control over financial reporting. This conclusion will be made over the remainder of the first quarter of 2018 and will include finalizing its evaluation of the application of the principal\n97\nvs. agent guidance, specifically as it relates to products where we utilize a third-party payment network and in certain businesses where we pay merchant commissions. However, the Company's preliminary view is that the expected amount and timing of revenue to be recognized under ASU 2014-09 for our most significant contract categories, fuel card payments, lodging payments, toll payments, corporate payments, and gift cards, will be similar to the amount and timing of revenue recognized under its current accounting practices, except as it relates to the presentation of certain costs where the Company may be determined to be an agent in the processing relationship under the new guidance, resulting in recording such costs as a reduction of revenue. The Company will be required to capitalize additional costs to obtain contracts with customers, and, in some cases, may be required to amortize these costs over a contractual time period. Finally, the Company expects disclosures about its revenues and related customer acquisition costs to be more extensive.\nThe Company plans to adopt ASU 2014-09, as well as other clarifications and technical guidance issued by the FASB related to this new revenue standard, on January 1, 2018. The Company will apply the modified retrospective transition method, which would result in an adjustment to retained earnings for the cumulative effect, if any, of applying the standard to contracts that are not completed at the date of initial application. Under this method, the Company would not restate the prior financial statements presented, therefore the new standard requires the Company to provide additional disclosures of the amount by which each financial statement line item is affected in the current reporting period during 2018, as compared to the guidance that was in effect before the change, and an explanation of the reasons for significant changes, if any.\nAccounting for Leases\nIn February 2016, the FASB issued ASU 2016-02, “Leases”, which requires lessees to recognize a right-of-use asset and a lease liability on the balance sheet for all leases with the exception of short-term leases. This ASU also requires disclosures to provide additional information about the amounts recorded in the financial statements. This ASU is effective for the Company for annual periods beginning after December 15, 2018 and interim periods therein. Early adoption is permitted. The new standard must be adopted using a modified retrospective transition and requires application of the new guidance for leases that exist or are entered into after the beginning of the earliest comparative period presented. The Company is currently evaluating the impact of ASU 2016-02 on its consolidated financial statements; however, the Company expect to recognize right of use assets and liabilities for operating leases in the Consolidated Balance Sheet upon adoption.\nAccounting for Breakage\nIn March 2016, the FASB issued ASU 2016-04, “Liabilities-Extinguishments of Liabilities: Recognition of Breakage for Certain Prepaid Stored-Value Products”, which requires entities that sell prepaid stored value products redeemable for goods, services or cash at third-party merchants to derecognize liabilities related to those products for breakage. This ASU is effective for the Company for reporting periods beginning after December 15, 2017. Early adoption is permitted. The ASU must be adopted using either a modified retrospective approach with a cumulative effect adjustment to retained earnings as of the beginning of the period of adoption or a full retrospective approach. The Company’s adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows.\nCash Flow Classification\nIn August 2016, the FASB issued ASU 2016-15, \"Classification of Certain Cash Receipts and Cash Payments\", which amends the guidance in ASC 230, Statement of Cash Flows. This amended guidance reduces the diversity in practice that has resulted from the lack of consistent principles related to the classification of certain cash receipts and payments in the statement of cash flows. This ASU is effective for the Company for reporting periods beginning after December 15, 2017. Early adoption is permitted. Entities must apply the guidance retrospectively to all periods presented but may apply it prospectively from the earliest date practicable if retrospective application would be impracticable. The Company’s adoption of this ASU is not expected to have a material impact on the results of operations or financial condition.\nIn November 2016, the FASB issued ASU 2016-18, \"Statement of Cash Flows (Topic 230): Restricted Cash\", which amends the guidance in ASC 230, Statement of Cash Flows, on the classification and presentation of restricted cash in the statement of cash flows. This ASU is effective for the Company for reporting periods beginning after December 15, 2017. Early adoption is permitted. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. The amendments in this ASU should be applied using a retrospective transition method to each period presented. The Company is evaluating what impact, if any, the adoption of this ASU will have on the results of operations, financial condition, or cash flows.\nIntangibles - Goodwill and Other Impairment\nIn January 2017, the FASB issued ASU 2017-04, \"Simplifying the Test for Goodwill Impairment\", which eliminates the requirement to calculate the implied fair value of goodwill (i.e., Step 2 of the goodwill impairment test) to measure a goodwill impairment charge. Instead, entities will record an impairment charge based on the excess of a reporting unit’s carrying amount over its fair value (i.e., measure the charge based on Step 1). The standard has tiered effective dates, starting in 2020 for\n98\ncalendar-year public business entities that meet the definition of an SEC filer. Early adoption is permitted for interim and annual goodwill impairment testing dates after January 1, 2017. The Company’s adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows, unless a goodwill impairment is identified.\nDefinition of a Business\nIn January 2017, the FASB issued ASU 2017-01, \"Clarifying the Definition of a Business\", which amends the definition of a business to assist entities with evaluating when a set of transferred assets and activities is a business. The guidance requires an entity to evaluate if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets. If so, the set of transferred assets and activities is not a business. The guidance also requires a business to include at least one substantive process and narrows the definition of outputs. The guidance is effective for the Company for reporting periods beginning after December 15, 2017, and interim periods within those years. Early adoption is permitted. The Company’s adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows, however it could result in accounting for acquisitions as asset acquisitions versus business combinations upon adoption.\nAccounting for Modifications to Stock-Based Compensation\nIn May 2017, the FASB issued ASU 2017-09, \"Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting\", which amends the scope of modification accounting for share-based payment arrangements. The ASU provides guidance on the types of changes to the terms or conditions of share-based payment awards to which an entity would be required to apply modification accounting under ASC 718. Specifically, an entity would not apply modification accounting if the fair value, vesting conditions and classification of the awards are the same immediately before and after the modification. The guidance is effective for the Company for reporting periods beginning after December 15, 2017, and interim periods within those years. Early adoption is permitted. The Company's adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows.\nAccounting for Derivative Financial Instruments\nIn August 2017, the FASB issued ASU 2017-12, \"Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities\", which amends the hedge accounting recognition and presentation requirements in ASC 815. The FASB issued accounting guidance to better align hedge accounting with a company’s risk management activities, simplify the application of hedge accounting and improve the disclosures of hedging arrangements. The guidance is effective for the Company for reporting periods beginning after December 15, 2018, and interim periods within those years. Early adoption is permitted. The Company's adoption of this ASU is not expected to have a material impact on the results of operations, financial condition, or cash flows.\n3. Fair Value Measurements\nFair value is a market-based measurement that reflects assumptions that market participants would use in pricing an asset or liability. GAAP discusses valuation techniques, such as the market approach (comparable market prices), the income approach (present value of future income or cash flow), and the cost approach (cost to replace the service capacity of an asset or replacement cost). These valuation techniques are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions.\nAs the basis for evaluating such inputs, a three-tier value hierarchy prioritizes the inputs used in measuring fair value as follows:\n\n| • | Level 1: Observable inputs such as quoted prices for identical assets or liabilities in active markets. |\n\n| • | Level 2: Observable inputs other than quoted prices that are directly or indirectly observable for the asset or liability, including quoted prices for similar assets or liabilities in active markets; quoted prices for similar or identical assets or liabilities in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable. |\n\n| • | Level 3: Unobservable inputs for which there is little or no market data, which require the reporting entity to develop its own assumptions. The fair value hierarchy also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. |\n\n99\nThe following table presents the Company’s financial assets and liabilities which are measured at fair values on a recurring basis as of December 31, 2017 and 2016, (in thousands):\n\n| Fair Value | Level 1 | Level 2 | Level 3 |\n| December 31, 2017 |\n| Assets: |\n| Repurchase agreements | $ | 420,838 | $ | — | $ | 420,838 | $ | — |\n| Money market | 50,423 | — | 50,423 | — |\n| Certificates of deposit | 7,417 | — | 7,417 | — |\n| Foreign exchange contracts | 39,045 | 10 | 39,035 | — |\n| Total cash equivalents | $ | 517,723 | $ | 10 | $ | 517,713 | $ | — |\n| Cash collateral for foreign exchange contracts | $ | 12,540 | $ | — | $ | — | $ | — |\n| Liabilities: |\n| Foreign exchange contracts | $ | 26,888 | $ | 67 | $ | 26,821 | $ | — |\n| Total liabilities | $ | 26,888 | $ | 67 | $ | 26,821 | $ | — |\n| Cash collateral obligation for foreign exchange contracts | $ | 10,882 | $ | — | $ | — | $ | — |\n| December 31, 2016 |\n| Assets: |\n| Repurchase agreements | $ | 232,131 | $ | — | $ | 232,131 | $ | — |\n| Money market | 50,179 | — | 50,179 | — |\n| Certificates of deposit | 48 | — | 48 | — |\n| Total cash equivalents | $ | 282,358 | $ | — | $ | 282,358 | $ | — |\n\nThe Company has highly-liquid investments classified as cash equivalents, with original maturities of 90 days or less, included in our Consolidated Balance Sheets. The Company utilizes Level 2 fair value determinations derived from directly or indirectly observable (market based) information to determine the fair value of these highly liquid investments. The Company has certain cash and cash equivalents that are invested on an overnight basis in repurchase agreements, money markets and certificates of deposit. The value of overnight repurchase agreements is determined based upon the quoted market prices for the treasury securities associated with the repurchase agreements. The value of money market instruments is the financial institutions' month-end statement, as these instruments are not tradeable and must be settled directly by us with the respective financial institution. Certificates of deposit are valued at cost, plus interest accrued. Given the short-term nature of these instruments, the carrying value approximates fair value. Foreign exchange derivative contracts are carried at fair value, with changes in fair value recognized in the Consolidated Statements of Income. The fair value of the Company's derivatives is derived with reference to a valuation from a derivatives dealer operating in an active market, which the Company accepts as the fair value of these instruments. The fair value represents what would be received and or paid by the Company if the contracts were terminated as of the reporting date. Cash collateral received for foreign exchange derivatives is recorded within customer deposits in our Consolidated Balance Sheet at December 31, 2017. Cash collateral paid for foreign exchange derivatives is recorded within restricted cash in our Consolidated Balance Sheet at December 31, 2017.\nThe level within the fair value hierarchy and the measurement technique are reviewed quarterly. Transfers between levels are deemed to have occurred at the end of the quarter. There were no transfers between fair value levels during the periods presented for 2017 and 2016.\nThe Company’s assets that are measured at fair value on a nonrecurring basis and are evaluated with periodic testing for impairment include property, plant and equipment, investments, goodwill and other intangible assets. Estimates of the fair value of assets acquired and liabilities assumed in business combinations are generally developed using key inputs such as management’s projections of cash flows on a held-and-used basis (if applicable), discounted as appropriate, management’s projections of cash flows upon disposition and discount rates. Accordingly, these fair value measurements are in Level 3 of the fair value hierarchy. See footnote 2 for discussion of Masternaut's other than temporary decline in fair value during the year.\nThe fair value of the Company’s cash, accounts receivable, securitized accounts receivable and related facility, prepaid expenses and other current assets, accounts payable, accrued expenses, customer deposits and short-term borrowings approximate their respective carrying values due to the short-term maturities of the instruments. The carrying value of the\n100\nCompany’s debt obligations approximates fair value as the interest rates on the debt are variable market based interest rates that reset on a quarterly basis. These are each Level 2 fair value measurements, except for cash, which is a Level 1 fair value measurement.\n4. Stockholders' Equity\nOn February 4, 2016, the Company's Board of Directors approved a stock repurchase program (the \"Program\") under which the Company may purchase up to an aggregate of $500 million of its common stock over the following 18 months period. On July 27, 2017, the Company's Board of Directors authorized an increase in the size of the Program by an additional $250 million and an extension of the Program by an additional 18 months. On November 1, 2017, the Company announced that its Board of Directors had authorized an increase in the size of the Program by an additional $350 million, resulting in total aggregate repurchases authorized under the Program of $1.1 billion. With the increase and giving effect to the Company's $590.1 million of previous repurchases, the Company may repurchase up to $510 million in shares of its common stock at any time prior to February 1, 2019.\nAny stock repurchases may be made at times and in such amounts as deemed appropriate. The timing and amount of stock repurchases, if any, will depend on a variety of factors including the stock price, market conditions, corporate and regulatory requirements, and any additional constraints related to material inside information the Company may possess. Any repurchases have been and are expected to be funded by a combination of available cash flow from the business, working capital and debt.\nOn August 3, 2017, as part of the Program, the Company entered an Accelerated Share Repurchase agreement (\"ASR Agreement\") with a third-party financial institution to repurchase $250 million of its common stock. Pursuant to the ASR Agreement, the Company delivered $250 million in cash and received 1,491,647 shares based on a stock price of $142.46 on August 7, 2017. The ASR Agreement was completed on September 7, 2017, at which time the Company received 263,012 additional shares based on a final weighted average per share purchase price during the repurchase period of $142.48.\nThe Company accounted for the ASR Agreement as two separate transactions: (i) as shares of reacquired common stock for the shares delivered to the Company upon effectiveness of the ASR Agreement and (ii) as a forward contract indexed to the Company's common stock for the undelivered shares. The initial delivery of shares was included in treasury stock at cost and results in an immediate reduction of the outstanding shares used to calculate the weighted average common shares outstanding for basic and diluted earnings per share. The forward contracts indexed to the Company's own common stock met the criteria for equity classification, and these amounts were initially recorded in additional paid-in capital and then reclassified to treasury stock upon completion of the ASR agreement.\nSince the beginning of the Program, 4,114,104 shares for an aggregate purchase price of $590.1 million have been repurchased. There were 2,854,959 common shares totaling $402.4 million repurchased under the Program during 2017.\n5. Stock Based Compensation\nThe Company accounts for stock-based compensation pursuant to relevant authoritative guidance, which requires measurement of compensation cost for all stock awards at fair value on the date of grant and recognition of compensation, net of estimated forfeitures, over the requisite service period for awards expected to vest. The Company has Stock Incentive Plans (the Plans) pursuant to which the Company’s board of directors may grant stock options or restricted stock to employees. The Company is authorized to issue grants of restricted stock and stock options to purchase up to 26,963,150 shares for the years ended December 31, 2017, 2016 and 2015, respectively. On May 13, 2013, the Company’s stockholders authorized an increase of 6,500,000 shares of common stock available for grant pursuant to the 2010 Equity Compensation Plan. Giving effect to this increase, there were 277,821 additional shares remaining available for grant under the Plans at December 31, 2017.\nOn February 7, 2018, the stockholders of the Company approved the FleetCor Technologies, Inc. Amended and Restated 2010 Equity Incentive Plan (the \"Amended Plan\"). The Amended Plan was authorized and approved by the Company's Board of Directors on December 20, 2017, and Company's stockholders at a special meeting held on February 7, 2018. The Amended Plan amends the Registrant’s existing 2010 Equity Incentive Plan (as amended, the \"Prior Plan\") to, among other things, increase the number of shares of common stock available for issuance from 13,250,000 to 16,750,000 and make certain other amendments to the Prior Plan.\n101\nThe table below summarizes the expense recognized within general and administrative expenses in the Consolidated Statements of Income related to share-based payments recognized for the years ended December 31 (in thousands):\n| 2017 | 2016 | 2015 |\n| Stock options | $ | 56,400 | $ | 35,234 | $ | 44,260 |\n| Restricted stock | 36,897 | 28,712 | 45,862 |\n| Stock-based compensation | $ | 93,297 | $ | 63,946 | $ | 90,122 |\n\nThe tax benefits recorded on stock based compensation were $48.6 million, $35.0 million and $35.7 million for the years ended December 31, 2017, 2016 and 2015, respectively.\nThe following table summarizes the Company’s total unrecognized compensation cost related to stock-based compensation as of December 31, 2017 (cost in thousands):\n| UnrecognizedCompensationCost | Weighted AveragePeriod of ExpenseRecognition(in Years) |\n| Stock options | $ | 84,452 | 1.33 |\n| Restricted stock | 18,819 | 1.06 |\n| Total | $ | 103,271 |\n\nStock Options\nThe following summarizes the changes in the number of shares of common stock under option for the following periods (shares and aggregate intrinsic value in thousands):\n| Shares | WeightedAverageExercisePrice | OptionsExercisableat End ofYear | WeightedAverageExercisePrice ofExercisableOptions | WeightedAverage FairValue ofOptionsGranted Duringthe Year | AggregateIntrinsicValue |\n| Outstanding at December 31, 2014 | 5,131 | $ | 58.71 | 2,370 | $ | 21.75 | $ | 461,770 |\n| Granted | 654 | 154.56 | $ | 35.32 |\n| Exercised | (586 | ) | 33.97 | 63,863 |\n| Forfeited | (196 | ) | 95.16 |\n| Outstanding at December 31, 2015 | 5,003 | 72.72 | 2,545 | 26.82 | 351,277 |\n| Granted | 1,780 | 133.33 | $ | 28.61 |\n| Exercised | (500 | ) | 42.36 | 49,592 |\n| Forfeited | (137 | ) | 140.67 |\n| Outstanding at December 31, 2016 | 6,146 | 91.20 | 3,429 | 55.00 | 309,238 |\n| Granted | 2,885 | 145.35 | $ | 32.57 |\n| Exercised | (633 | ) | 71.43 | 76,546 |\n| Forfeited | (367 | ) | 144.51 |\n| Outstanding at December 31, 2017 | 8,031 | $ | 109.78 | 4,029 | $ | 75.80 | $ | 663,815 |\n| Expected to vest at December 31, 2017 | 8,031 | $ | 109.78 |\n\n102\nThe following table summarizes information about stock options outstanding at December 31, 2017 (shares in thousands):\n| Exercise Price | OptionsOutstanding | Weighted AverageRemaining VestingLife in Years | OptionsExercisable |\n| $10.00 – 58.02 | 2,218 | 0.00 | 2,218 |\n| 74.99 – 111.09 | 104 | 0.03 | 90 |\n| 114.90 – 138.47 | 2,029 | 0.77 | 577 |\n| 140.23-150.74 | 2,593 | 1.60 | 906 |\n| 151.16-158.24 | 618 | 1.48 | 195 |\n| 165.96-174.35 | 469 | 3.08 | 43 |\n| 8,031 | 4,029 |\n\nThe aggregate intrinsic value of stock options exercisable at December 31, 2017 was $469.8 million. The weighted average remaining contractual term of options exercisable at December 31, 2017 was 5.0 years.\nThe fair value of stock option awards granted was estimated using the Black-Scholes option pricing model with the following weighted-average assumptions for grants or modifications during the years ended December 31 as follows:\n\n| 2017 | 2016 | 2015 |\n| Risk-free interest rate | 1.65 | % | 1.08 | % | 1.47 | % |\n| Dividend yield | — | — | — |\n| Expected volatility | 28.00 | % | 27.29 | % | 27.77 | % |\n| Expected life (in years) | 3.4 | 3.5 | 4.5 |\n\nThe weighted-average remaining contractual life for options outstanding was 6.9 years at December 31, 2017.\nRestricted Stock\nThere were no restricted stock shares granted with market based vesting conditions in 2017, 2016 and 2015. The following table summarizes the changes in the number of shares of restricted stock and restricted stock units for the following periods (shares in thousands):\n| Shares | WeightedAverageGrant DateFair Value |\n| Outstanding at December 31, 2014 | 716 | $ | 121.38 |\n| Granted | 126 | 151.33 |\n| Cancelled | (52 | ) | 135.92 |\n| Issued | (293 | ) | 85.40 |\n| Outstanding at December 31, 2015 | 497 | 149.40 |\n| Granted | 152 | 128.90 |\n| Cancelled | (41 | ) | 145.25 |\n| Issued | (229 | ) | 151.72 |\n| Outstanding at December 31, 2016 | 379 | 140.39 |\n| Granted | 238 | 141.99 |\n| Cancelled | (48 | ) | 152.95 |\n| Issued | (204 | ) | 136.85 |\n| Outstanding at December 31, 2017 | 365 | $ | 155.58 |\n\n103\n6. Acquisitions\n2017 Acquisitions\nDuring 2017, the Company completed acquisitions with an aggregate purchase price of $720.8 million, net of cash acquired of $96.2 million and inclusive of notes payable of $29.3 million. During 2017, the Company made investments in other businesses of $39 million.\nCambridge Global Payments\nOn August 9, 2017, the Company acquired Cambridge, a leading business to business (B2B) international payments provider, for approximately $616.1 million in cash, net of cash acquired of $94.5 million and inclusive of a note payable of $23.8 million. Cambridge processes B2B cross-border payments, assisting business clients in making international payments. The purpose of this acquisition is to further expand the Company's corporate payments footprint. The Company financed the acquisition using a combination of existing cash and borrowings under its existing credit facility. The results from Cambridge are reported in its North America segment. The following table summarizes the preliminary acquisition accounting for Cambridge (in thousands):\n| Restricted cash | $ | 37,666 |\n| Trade and other receivables | 61,801 |\n| Prepaid expenses and other current assets | 15,190 |\n| Property and equipment | 7,106 |\n| Other long term assets | 10,025 |\n| Goodwill | 500,391 |\n| Customer relationships and other identifiable intangible assets | 271,793 |\n| Liabilities assumed | (194,552 | ) |\n| Deferred tax liabilities | (93,364 | ) |\n| Aggregate purchase price | $ | 616,056 |\n\nThe estimated fair value of intangible assets acquired and the related estimated useful lives consisted of the following (in thousands):\n| Useful Lives (in Years) | Value |\n| Banking relationships | 20 | $ | 705 |\n| Trade name and trademarks | Indefinite | 35,110 |\n| Technology | 5 | 16,039 |\n| Customer relationships - excluding Accounts Payable Solutions | 7-18 | 178,190 |\n| Customer relationships - Accounts Payable Solutions | 20 | 41,749 |\n| $ | 271,793 |\n\nAlong with the Company's acquisition of Cambridge, the Company signed noncompete agreements with certain parties with an estimated fair value of $5.8 million. Acquisition accounting for Cambridge is preliminary as the Company is still completing the valuation for goodwill, intangible assets, income taxes, certain acquired contingencies, derivatives and the working capital adjustment period remains open. Goodwill recorded is comprised primarily of expected synergies from combining the operations of the Company and Cambridge, as well as assembled workforce.\nOther\nDuring 2017, the Company acquired Creative Lodging Solutions (\"CLS\"), a small lodging tuck-in business, and a fuel card provider in Russia for approximately $104.7 million, net of cash acquired of $1.8 million and inclusive of a note payable of $5.5 million. The Company financed the acquisitions using a combination of existing cash and borrowings under its existing credit facility. The accounting for these acquisitions is preliminary as the Company is still completing the valuation of goodwill, intangible assets, income taxes and evaluation of acquired contingencies.\n104\nThe following table summarizes the preliminary acquisition accounting for the acquisitions (in thousands):\n| Trade and other receivables | $ | 37,986 |\n| Prepaid expenses and other | 1,426 |\n| Property and equipment | 5,745 |\n| Goodwill | 55,711 |\n| Other intangible assets | 53,259 |\n| Liabilities assumed | (32,202 | ) |\n| Deferred tax liabilities | (17,217 | ) |\n| Aggregate purchase prices | $ | 104,708 |\n\nThe estimated fair value of intangible assets acquired and the related estimated useful lives consisted of the following (in thousands):\n| Useful Lives (in Years) | Value |\n| Trade name and trademarks | 1 | $ | 180 |\n| Technology | 4 | 1,750 |\n| Customer relationships | 8 | 51,329 |\n| $ | 53,259 |\n\nAlong with the Company's acquisition of CLS, the Company signed noncompete agreements with certain parties with an estimated fair value of $4.5 million.\n2016 Acquisitions\nDuring 2016, the Company completed acquisitions with an aggregate purchase price of $1.3 billion, net of cash acquired of $51.3 million, which includes deferred payments made during the period related to prior acquisitions of $6.1 million.\nDuring 2016, the Company made additional investments of $7.9 million related to its equity method investment at Masternaut. The Company also received a $9.2 million return of its investment in Masternaut in 2016.\nSTP\nOn August 31, 2016, the Company acquired all of the outstanding stock of Serviços e Tecnologia de Pagamentos S.A. (“STP”), for approximately $1.23 billion, net of cash acquired of $40.2 million. STP is an electronic toll payments company in Brazil and provides cardless fuel payments at a number of Shell sites throughout Brazil. The purpose of this acquisition was to expand the Company's presence in the toll market in Brazil. The Company financed the acquisition using a combination of existing cash and borrowings under its existing credit facility. Results from the acquired business have been reported in the Company's international segment since the date of acquisition. The following table summarizes the acquisition accounting for STP (in thousands):\n\n| Trade and other receivables | $ | 243,157 |\n| Prepaid expenses and other | 5,757 |\n| Deferred tax assets | 20,644 |\n| Property and equipment | 44,226 |\n| Other long term assets | 14,280 |\n| Goodwill | 663,040 |\n| Customer relationships and other identifiable intangible assets | 548,682 |\n| Liabilities assumed | (312,297 | ) |\n| Aggregate purchase price | $ | 1,227,489 |\n\n105\nThe estimated fair value of intangible assets acquired and the related estimated useful lives consisted of the following (in thousands):\n| Useful Lives(in Years) | Value |\n| Customer relationships | 8.5-20 | $ | 348,414 |\n| Trade names and trademarks | Indefinite | 154,851 |\n| Technology | 6 | 45,417 |\n| $ | 548,682 |\n\nIn connection with the STP acquisition, the Company recorded contingent liabilities aggregating $15.1 million, recorded within other noncurrent liabilities and accrued expenses in the Consolidated Balance Sheet at the date of acquisition. A portion of these acquired liabilities have been indemnified by the respective sellers. As a result, an indemnification asset of $15.1 million was recorded within prepaid and other long term assets in the Consolidated Balance Sheet. Along with the Company's acquisition of STP, the Company signed noncompete agreements with certain parties with an estimated fair value of $23.2 million.\nGoodwill recognized is comprised primarily of expected synergies from combining the operations of the Company and STP, as well as the assembled workforce. The goodwill and definite lived intangibles acquired with STP will be deductible for tax purposes.\nOther\nDuring 2016, the Company acquired additional fuel card portfolios in the U.S. and the United Kingdom, additional Shell fuel card markets in Europe and Travelcard in the Netherlands totaling approximately $76.7 million, net of cash acquired of $11.1 million. The following table summarizes the acquisition accounting for these acquisitions (in thousands):\n| Trade and other receivables | $ | 27,810 |\n| Prepaid expenses and other | 5,097 |\n| Property and equipment | 992 |\n| Goodwill | 28,540 |\n| Other intangible assets | 61,823 |\n| Deferred tax asset | 146 |\n| Deferred tax liabilities | (5,123 | ) |\n| Liabilities assumed | (42,550 | ) |\n| Aggregate purchase prices | $ | 76,735 |\n\nThe estimated fair value of intangible assets acquired and the related estimated useful lives consisted of the following (in thousands):\n| Useful Lives(in Years) | Value |\n| Customer relationships and other identifiable intangible assets | 10-18 | $ | 61,823 |\n| $ | 61,823 |\n\n2015 Acquisitions\nDuring 2015, the Company completed acquisitions of Shell portfolios related to our fuel card businesses in Europe, as well as a small acquisition internationally, with an aggregate purchase price of $46.3 million, made additional investments of $8.4 million related to its equity method investment at Masternaut and deferred payments of $3.4 million related to acquisitions occurring in prior years.\n106\nThe following table summarizes the acquisition accounting for the acquisitions completed during 2015 (in thousands):\n\n| Trade and other receivables | $ | 521 |\n| Prepaid expenses and other | 996 |\n| Property and equipment | 197 |\n| Goodwill | 9,561 |\n| Other intangible assets | 39,791 |\n| Deferred tax liabilities | (2,437 | ) |\n| Liabilities assumed | (2,331 | ) |\n| Aggregate purchase prices | $ | 46,298 |\n\nThe final estimated fair value of intangible assets acquired and the related estimated useful lives consisted of the following (in thousands):\n| Useful Lives(in Years) | Value |\n| Customer relationships | 14-20 | $ | 39,791 |\n| $ | 39,791 |\n\n7. Goodwill and Other Intangible Assets\n| December 31, 2016 | Acquisitions | Dispositions | Acquisition AccountingAdjustments | ForeignCurrency | December 31, 2017 |\n| Segment |\n| North America | $ | 2,640,409 | $ | 534,777 | $ | (92,046 | ) | $ | — | $ | 983 | $ | 3,084,123 |\n| International | 1,554,741 | 21,325 | — | 3,752 | 51,882 | 1,631,700 |\n| $ | 4,195,150 | $ | 556,102 | $ | (92,046 | ) | $ | 3,752 | $ | 52,865 | $ | 4,715,823 |\n\n\n| December 31, 2015 | Acquisitions | Acquisition AccountingAdjustments | ForeignCurrency | December 31, 2016 |\n| Segment |\n| North America | $ | 2,640,409 | $ | — | $ | — | $ | — | $ | 2,640,409 |\n| International | 905,625 | 687,828 | (521 | ) | (38,191 | ) | 1,554,741 |\n| $ | 3,546,034 | $ | 687,828 | $ | (521 | ) | $ | (38,191 | ) | $ | 4,195,150 |\n\nAt December 31, 2017 and 2016, approximately $988.0 million and $362.6 million of the Company’s goodwill is deductible for tax purposes, respectively. Acquisition accounting adjustments recorded in 2017 and 2016 are a result of the Company completing its acquisition accounting and working capital adjustments for certain prior year acquisitions.\n107\nOther intangible assets consisted of the following at December 31 (in thousands):\n\n| 2017 | 2016 |\n| Weighted-Avg UsefulLife(Years) | GrossCarryingAmounts | AccumulatedAmortization | NetCarryingAmount | GrossCarryingAmounts | AccumulatedAmortization | NetCarryingAmount |\n| Customer and vendor agreements | 17.0 | $ | 2,698,428 | $ | (605,347 | ) | $ | 2,093,081 | $ | 2,449,389 | $ | (458,118 | ) | $ | 1,991,271 |\n| Trade names and trademarks—indefinite lived | N/A | 499,587 | — | 499,587 | 510,952 | — | 510,952 |\n| Trade names and trademarks—other | 13.8 | 2,986 | (2,207 | ) | 779 | 2,746 | (2,021 | ) | 725 |\n| Software | 6.0 | 219,019 | (116,654 | ) | 102,365 | 211,331 | (85,167 | ) | 126,164 |\n| Non-compete agreements | 4.5 | 48,221 | (19,076 | ) | 29,145 | 35,191 | (11,070 | ) | 24,121 |\n| Total other intangibles | $ | 3,468,241 | $ | (743,284 | ) | $ | 2,724,957 | $ | 3,209,609 | $ | (556,376 | ) | $ | 2,653,233 |\n\nChanges in foreign exchange rates resulted in a $24.2 million increase to the carrying values of other intangible assets in the year ended December 31, 2017. Amortization expense related to intangible assets for the years ended December 31, 2017, 2016 and 2015 was $211.8 million, $161.6 million and $159.7 million, respectively. As part of the Company's plan to exit the telematics business, on July 27, 2017, the Company sold NexTraq, a U.S. fleet telematics business, to Michelin Group, resulting in a $41.8 million reduction in the net carrying values of other intangible assets.\nThe future estimated amortization of intangibles at December 31, 2017 is as follows (in thousands):\n\n| 2018 | $ | 220,506 |\n| 2019 | 206,174 |\n| 2020 | 186,259 |\n| 2021 | 182,156 |\n| 2022 | 171,177 |\n| Thereafter | 1,259,098 |\n\n8. Property, Plant and Equipment\nProperty, plant and equipment, net consisted of the following at December 31 (in thousands):\n| EstimatedUseful Lives(in Years) | 2017 | 2016 |\n| Computer hardware and software | 3 to 5 | $ | 244,655 | $ | 197,958 |\n| Card-reading equipment | 4 to 6 | 25,462 | 25,553 |\n| Furniture, fixtures, and vehicles | 2 to 10 | 18,846 | 15,418 |\n| Buildings and improvements | 5 to 50 | 21,603 | 14,432 |\n| Property, plant and equipment, gross | 310,566 | 253,361 |\n| Less: accumulated depreciation | (130,509 | ) | (110,857 | ) |\n| Property, plant and equipment, net | $ | 180,057 | $ | 142,504 |\n\nDepreciation expense related to property and equipment for the years ended December 31, 2017, 2016 and 2015 was $46.6 million, $36.5 million and $30.5 million, respectively. Depreciation expense includes $21.8 million, $17.7 million and $11.6 million, for capitalized computer software costs for the years ended December 31, 2017, 2016 and 2015, respectively. At December 31, 2017 and 2016, the Company had unamortized computer software costs of $75.8 million and $60.2 million, respectively.\n108\n9. Accrued Expenses\nAccrued expenses consisted of the following at December 31 (in thousands):\n\n| 2017 | 2016 |\n| Accrued bonuses | $ | 15,119 | $ | 15,866 |\n| Accrued payroll and severance | 18,500 | 10,704 |\n| Accrued taxes | 63,698 | 104,623 |\n| Accrued commissions/rebates | 47,198 | 43,467 |\n| Other | 93,957 | 64,152 |\n| $ | 238,472 | $ | 238,812 |\n\n10. Debt\nThe Company’s debt instruments at December 31 consist primarily of term notes, revolving lines of credit and a Securitization Facility as follows (in thousands):\n| 2017 | 2016 |\n| Term notes payable—domestic(a), net of discounts | $ | 2,993,667 | $ | 2,639,279 |\n| Revolving line of credit A Facility—domestic(a) | 635,000 | 465,000 |\n| Revolving line of credit B Facility—foreign(a) | 28,334 | 123,412 |\n| Revolving line of credit B Facility—swing line(a) | 6,879 | 26,608 |\n| Other(c) | 43,736 | 12,934 |\n| Total notes payable and other obligations | 3,707,616 | 3,267,233 |\n| Securitization Facility(b) | 811,000 | 591,000 |\n| Total notes payable, credit agreements and Securitization Facility | $ | 4,518,616 | $ | 3,858,233 |\n| Current portion | $ | 1,616,512 | $ | 1,336,506 |\n| Long-term portion | 2,902,104 | 2,521,727 |\n| Total notes payable, credit agreements and Securitization Facility | $ | 4,518,616 | $ | 3,858,233 |\n\n_____________________\n| (a) | The Company has a Credit Agreement, which has been amended multiple times and provides for senior secured credit facilities consisting of a revolving A credit facility in the amount of $1.285 billion, a term loan A facility in the amount of $2.69 billion and a term loan B facility in the amount of $350 million as of December 31, 2017. The revolving credit facility consists of (a) a revolving A credit facility in the amount of $800 million, with sublimits for letters of credit and swing line loans, (b) a revolving B facility in the amount of $450 million for swing line loans and multi-currency borrowings and, (c) a revolving C facility in the amount of $35 million for multi-currency borrowings in Australian Dollars or New Zealand Dollars. The Credit Agreement also includes an accordion feature for borrowing an additional $750 million in term A, term B or revolver A debt. Proceeds from the credit facilities may be used for working capital purposes, acquisitions, and other general corporate purposes. On January 20, 2017, the Company entered into the second amendment to the Credit Agreement, which established a new term B loan. On August 2, 2017, the Company entered into the third amendment to the Credit Agreement, which increased the total facility by $708.7 million and extended the terms of the credit facilities to August 2, 2022 for the term A loan, revolving loans, and letters of credit under the Credit Agreement and August 2, 2024 for the term B loan. |\n\nInterest on amounts outstanding under the Credit Agreement (other than the term B loan) accrues based on the British Bankers Association LIBOR Rate (the Eurocurrency Rate), plus a margin based on a leverage ratio, or our option, the Base Rate (defined as the rate equal to the highest of (a) the Federal Funds Rate plus 0.50%, (b) the prime rate announced by Bank of America, N.A., or (c) the Eurocurrency Rate plus 1.00%) plus a margin based on a leverage ratio. Interest on the term B loan facility accrues based on the Eurocurrency Rate plus 2.00% for Eurocurrency Loans and at 1.00% for Base Rate Loans. In addition, the Company pays a quarterly commitment fee at a rate per annum ranging from 0.20% to 0.40% of the daily unused portion of the credit facility.\nAt December 31, 2017, the interest rate on the term A loan and the domestic revolving A facility was 3.32%, the interest rate on the foreign revolving B facility was 2.25%, the interest rate on the revolving B facility foreign swing line of\n109\ncredit was 2.22% and the interest rate on the term B loan was 3.57%. The unused credit facility was 0.35% for all revolving facilities at December 31, 2017.\nThe term loans are payable in quarterly installments and are due on the last business day of each March, June, September, and December with the final principal payment due on the respective maturity date. Borrowings on the revolving line of credit are repayable at the option of one, two, three or nine months after borrowing, depending on the term of the borrowing on the facility. Borrowings on the foreign swing line of credit are due no later than ten business days after such loan is made.\nAt December 31, 2017, the Company had $2.7 billion in borrowings outstanding on term A loan, excluding the related debt discount, $349.1 million in borrowings outstanding on term B loan, excluding the related debt discount, $635 million in borrowings outstanding on the domestic revolving A facility, $28.3 million in borrowings outstanding on the foreign revolving B facility and $6.9 million in borrowings outstanding on the foreign swing line revolving B facility. The Company has unamortized debt discounts of $6.0 million related to the term A facility and $0.7 million related to the term B facility and deferred financing costs of $5.1 million at December 31, 2017. In August 2017, the Company expensed $3.3 million and capitalized $10.6 million of debt issuance costs associated with the refinancing of its Credit Facility. The effective interest rate incurred on term loans was 2.69% and 2.57% during 2017 and 2016, respectively, related to the discount on debt. Principal payments of $423.2 million were made on the term loans during 2017.\n\n| (b) | The Company is party to a $950 million receivables purchase agreement (Securitization Facility) that was amended and restated on November 14, 2017. There is a program fee equal to one month LIBOR plus 0.90% or the Commercial Paper Rate plus 0.80% as of December 31, 2017 and one month LIBOR or the Commercial Paper Rate plus 0.90% as of December 31, 2016. The program fee was 1.55% plus 0.86% as of December 31, 2017 and 0.85% plus 0.90% as of December 31, 2016. The unused facility fee is payable at a rate of 0.40% as of December 31, 2017 and 2016. The Securitization Facility provides for certain termination events, which includes nonpayment, upon the occurrence of which the administrator may declare the facility termination date to have occurred, may exercise certain enforcement rights with respect to the receivables, and may appoint a successor servicer, among other things. |\n\n| (c) | Other includes the long term portion of contingent consideration and deferred payments associated with certain of our businesses. |\n\nThe Company was in compliance with all financial and non-financial covenants at December 31, 2017.\nThe contractual maturities of the Company’s notes payable and other obligations at December 31, 2017 are as follows (in thousands):\n\n| 2018 | $ | 805,512 |\n| 2019 | 173,927 |\n| 2020 | 136,197 |\n| 2021 | 136,337 |\n| 2022 | 2,121,177 |\n| Thereafter | 334,466 |\n\n11. Income Taxes\nOn December 22, 2017, the U.S. government enacted tax legislation referred to as the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act makes broad and complex changes to the U.S. tax code, including, but not limited to, (1) reducing the U.S. federal corporate tax rate from 35 percent to 21 percent; (2) requiring companies to pay a one-time Deemed Repatriation Transition Tax (“Transition Tax”) on certain unrepatriated earnings of foreign subsidiaries that can be paid over eight years; (3) a new provision designed to tax global intangible low-taxed income (GILTI), which allows for the possibility of using foreign tax credits (FTCs) and a deduction of up to 50 percent to offset the income tax liability (subject to some limitations); (4) the repeal of the domestic production activity deduction beginning January 1, 2018; (5) limitations on the deductibility of certain executive compensation; and (6) a new limitation on deductible interest expense beginning January 1, 2018.\nAt December 31, 2017, the Company has not completed its accounting for the tax effects of enactment of the Tax Act. However, as described below, the Company has made a reasonable estimate of the effects on its existing deferred tax balances and the one-time Transition Tax. In other cases, the Company has not been able to make a reasonable estimate and continue to\n110\naccount for those items based on its existing accounting under ASC 740 (\"Income Taxes\"), and the provisions of the tax laws that were in effect immediately prior to enactment. The Company was not able to make a reasonable estimate of the impact of the new limitations on the deductibility of certain executive compensation.\nFor those items for which it was able to determine a reasonable estimate, the Company recognized a provisional net tax benefit of $128.2 million, which is included as a component of income tax expense from continuing operations. In all cases, the Company will continue to make and refine its calculations as additional analysis is completed. In addition, it is anticipated that the U.S. Treasury Department will publish new regulations providing some clarity to many of the provisions included in the new act. As a result, the Company's estimates may also be affected as it gains a more thorough understanding of the Tax Act via new regulations and other guidance.\nThe SEC staff issued Staff Accounting Bulletin No. 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act (\"SAB 118\"), which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC 740. In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Act for which the accounting under ASC 740 is complete. To the extent that a company’s accounting for certain income tax effects of the Tax Act is incomplete but it is able to determine a reasonable estimate, it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax laws that were in effect immediately before the enactment of the Tax Act.\nIn connection with its initial analysis of the impact of the Tax Act, the Company has recorded a net tax benefit of $128.2 million in the period ending December 31, 2017. This net benefit primarily consists of a net benefit for the corporate rate reduction on the deferred tax assets and liabilities of $210 million and a net expense for the Transition Tax of $81.8 million. For various reasons that are discussed more fully below, the Company has not completed its accounting for the income tax effects of certain elements of the Tax Act. However, the Company was able to make reasonable estimates of the effects of the elements for which its analysis is not yet complete and recorded provisional adjustments.\nThe Company's accounting for the following elements of the Tax Act are incomplete. However, the Company was able to make reasonable estimates of certain effects and, therefore, recorded provisional adjustments.\nDeferred tax effects\nThe Tax Act reduces the corporate tax rate to 21 percent, effective January 1, 2018. For its deferred tax assets and deferred tax liabilities, the Company has recorded a provisional decrease of $210 million with a corresponding net adjustment to deferred tax benefit of $210 million for the year ended December 31, 2017. While the Company was able to make a reasonable estimate of the impact of the reduction in corporate rate, the impact may be affected by other analysis related to the Tax Act, including, but not limited to, FLEETCOR's calculation of deemed repatriation of deferred foreign income and the state tax effect of adjustments made to federal temporary differences.\nOne time transition tax\nThe Transition Tax is a tax on previously untaxed accumulated and current earnings and profits (\"E&P\") of certain of the Company's foreign subsidiaries. To determine the amount of the Transition Tax, the Company must determine, in addition to other factors, the amount of post-1986 E&P of the relevant subsidiaries, as well as the amount of non-U.S. income taxes paid on such earnings. The Company was able to make a reasonable estimate of the Transition Tax and recorded a provisional Transition Tax obligation of $81.8 million. However, the Company is continuing to gather additional information to more precisely compute the amount of the Transition Tax. Further, the Transition Tax is based in part on the amount of accumulated and current E&P held in cash and other specified assets. This amount may change when the Company finalizes the calculation of post-1986 foreign E&P previously deferred from U.S. federal taxation and finalize the amounts held in cash or other specified assets. Double tax relief is available for the pool of foreign tax credits attributed to the accumulated and current E&P. The amount of foreign tax credits claimed when the Company finalizes the calculation of the pool of foreign tax credits.\nNo additional income taxes have been provided for any remaining undistributed foreign earnings not subject to the Transition Tax, or any additional outside basis differences inherent in these entities, as these amounts continue to be indefinitely reinvested in foreign operations. The Company has not been able to make a reasonable estimate of the impact of the unrecognized deferred tax liability related to any remaining undistributed foreign earnings not subject to the Transition Tax or additional outside basis differences in these entities.\n111\nThe Company has also not been able to make a reasonable estimate of the impact of the new limitations on the deductibility of certain executive compensation and continues to account for that item based on its existing accounting under ASC 740 and the provisions of the tax laws that were in effect immediately prior to enactment.\nGlobal Intangible Low-Taxed Income\nThe Tax Act subjects a U.S. shareholder to current tax on global intangible low-taxed income (GILTI) earned by certain foreign subsidiaries. The FASB Staff Q&A, Topic 740 No. 5, \"Accounting for Global Intangible Low-Taxed Income\", states that an entity can make an accounting policy election to either recognize deferred taxes for temporary differences expected to reverse as GILTI in future years or provide for the tax expense related to GILTI in the year the tax is incurred. Based on the Company's preliminary assessment of the GILTI tax, the Company believes it will recognize tax on GILTI as a period expense.\nIncome before the provision for income taxes is attributable to the following jurisdictions for years ended December 31 (in thousands) :\n| 2017 | 2016 | 2015 |\n| United States | $ | 524,669 | $ | 383,427 | $ | 304,743 |\n| Foreign | 368,921 | 259,492 | 231,261 |\n| Total | $ | 893,590 | $ | 642,919 | $ | 536,004 |\n\nThe provision for income taxes for the years ended December 31 consists of the following (in thousands):\n\n| 2017 | 2016 | 2015 |\n| Current: |\n| Federal | $ | 303,514 | $ | 147,406 | $ | 82,926 |\n| State | 19,234 | 10,725 | 8,051 |\n| Foreign | 78,354 | 61,084 | 51,970 |\n| Total current | 401,102 | 219,215 | 142,947 |\n| Deferred: |\n| Federal | (255,188 | ) | (18,723 | ) | 36,723 |\n| State | 276 | 1,608 | 1,525 |\n| Foreign | 7,200 | (11,566 | ) | (7,622 | ) |\n| Total deferred | (247,712 | ) | (28,681 | ) | 30,626 |\n| Total provision | $ | 153,390 | $ | 190,534 | $ | 173,573 |\n\n112\nThe provision for income taxes differs from amounts computed by applying the U.S. federal tax rate of 35% to income before income taxes for the years ended December 31 due to the following (in thousands):\n\n| 2017 | 2016 | 2015 |\n| Computed “expected” tax expense | $ | 312,756 | 35.0 | % | $ | 225,022 | 35.0 | % | $ | 187,601 | 35.0 | % |\n| Changes resulting from: |\n| Change in valuation allowance | 18,289 | 2.0 | 11,952 | 1.9 | 20,243 | 3.8 |\n| Foreign income tax differential | (38,695 | ) | (4.3 | ) | (25,533 | ) | (4.0 | ) | (23,718 | ) | (4.4 | ) |\n| State taxes net of federal benefits | 12,884 | 1.4 | 9,439 | 1.5 | 6,711 | 1.2 |\n| Foreign-sourced nontaxable income | (8,836 | ) | (1.0 | ) | (13,659 | ) | (1.2 | ) | (10,573 | ) | (2.0 | ) |\n| IRC Section 199 deduction | (8,844 | ) | (1.0 | ) | (7,731 | ) | (1.2 | ) | (10,221 | ) | (1.9 | ) |\n| Excess tax benefits related to stock-based compensation | (18,058 | ) | (2.0 | ) | (11,974 | ) | (1.9 | ) | — | — |\n| Subpart F income/transition tax - federal only | 195,779 | 21.9 | — | — | — | — |\n| Foreign tax credit/transition tax - federal only | (113,955 | ) | (12.8 | ) | — | — | — | — |\n| Tax reform - federal rate reduction | (209,966 | ) | (23.5 | ) | — | — | — | — |\n| Other | 12,036 | 1.3 | 3,018 | (0.4 | ) | 3,530 | 0.7 |\n| Provision for income taxes | $ | 153,390 | 17.2 | % | $ | 190,534 | 29.7 | % | $ | 173,573 | 32.4 | % |\n\nThe tax effects of temporary differences that give rise to significant portions of the deferred tax assets and liabilities at December 31 are as follows (in thousands):\n\n| 2017 | 2016 |\n| Deferred tax assets: |\n| Accounts receivable, principally due to the allowance for doubtful accounts | $ | 6,752 | $ | 7,148 |\n| Accrued expenses not currently deductible for tax | 442 | 2,647 |\n| Stock based compensation | 37,274 | 41,415 |\n| Income tax credits | 376 | 376 |\n| Net operating loss carry forwards | 41,168 | 45,969 |\n| Investments | 37,804 | 53,379 |\n| Accrued escheat | 4,768 | 7,290 |\n| Fixed assets, intangibles and other | 12,604 | 15,622 |\n| Deferred tax assets before valuation allowance | 141,188 | 173,846 |\n| Valuation allowance | (59,349 | ) | (76,395 | ) |\n| Deferred tax assets, net | 81,839 | 97,451 |\n| Deferred tax liabilities: |\n| Intangibles—including goodwill | (508,958 | ) | (687,443 | ) |\n| Basis difference in investment in foreign subsidiaries | (39,287 | ) | (48,354 | ) |\n| Prepaid expenses | (1,605 | ) | (3,644 | ) |\n| Property and equipment, principally due to differences between book and tax depreciation, and other | (49,100 | ) | (24,157 | ) |\n| Deferred tax liabilities | (598,950 | ) | (763,598 | ) |\n| Net deferred tax liabilities | $ | (517,111 | ) | $ | (666,147 | ) |\n\n113\nThe Company’s deferred tax balances are classified in its balance sheets as of December 31 as follows (in thousands):\n\n| 2017 | 2016 |\n| Long term deferred tax assets and liabilities: |\n| Long term deferred tax assets | 1,801 | 2,433 |\n| Long term deferred tax liabilities | (518,912 | ) | (668,580 | ) |\n| Net long term deferred taxes | (517,111 | ) | (666,147 | ) |\n| Net deferred tax liabilities | $ | (517,111 | ) | $ | (666,147 | ) |\n\nThe valuation allowance for deferred tax assets at December 31, 2017 and 2016 was $59.3 million and $76.4 million, respectively. These valuation allowances related to basis differences in equity method investments, capital loss carryforwards, income tax credits, foreign net operating loss carryforwards and state net operating loss carryforwards. The net change in the total valuation allowance for the years ended December 31, 2017 and 2016 was a decrease of $17.0 million and an increase of $13.8 million, respectively. The valuation decrease from the prior year was due to the U.S. tax rate reduction that resulted from the Tax Act, which was offset by an increase in basis differences related to equity method investments completed in 2014. The increase in 2016 was primarily due to changes in the Company's deferred tax asset related to basis differences in an equity method investment.\n| Balances at December 31, 2014 | $ | 27,082 |\n| Additions | 35,523 |\n| Balance at December 31, 2015 | 62,605 |\n| Additions | 13,790 |\n| Balance at December 31, 2016 | 76,395 |\n| Additions | 5,332 |\n| Reduction in valuation allowance due to rate change from Tax Act | (22,378 | ) |\n| Balance at December 31, 2017 | $ | 59,349 |\n\nThe valuation allowances relate to basis differences in cost method investments, capital loss carryforwards, income tax credits, foreign net operating loss carryforwards and state net operating loss carryforwards. The net change in the total valuation allowance for the year ended December 31, 2017 was a decrease of $17.0 million. The valuation decrease from the prior year was due to the U.S. tax rate reduction that resulted from the Tax Act, which was partially offset by an increase in the basis differences related to cost method investments. The increase in 2015 and 2016 were primarily due to changes in the Company's deferred tax asset related to basis differences in a cost method investment.\nAs of December 31, 2017, the Company had a net operating loss carryforward for state income tax purposes of approximately $590.0 million that is available to offset future state taxable income through 2029. Additionally, the Company had $44.0 million net operating loss carryforwards for foreign income tax purposes that are available to offset future foreign taxable income. The foreign net operating loss carryforwards will not expire in future years.\nThe Company recognizes interest and penalties on unrecognized tax benefits (including interest and penalties calculated on uncertain tax positions on which the Company believes it will ultimately prevail) within the provision for income taxes on continuing operations in the consolidated financial statements. This policy is a continuation of the Company's policy prior to the adoption of the guidance regarding uncertain tax positions. During 2017 and 2016, the Company had recorded accrued interest and penalties related to the unrecognized tax benefits of $1.3 million and $5.9 million, respectively.\n114\nA reconciliation of the beginning and ending balances of the total amounts of gross unrecognized tax benefits including interest for the years ended December 31, 2017, 2016 and 2015 is as follows (in thousands):\n| Unrecognized tax benefits at December 31, 2014 | $ | 18,641 |\n| Additions based on tax provisions related to the current year | 9,079 |\n| Additions based on tax provisions related to the prior year | 477 |\n| Deductions based on settlement/expiration of prior year tax positions | (6,363 | ) |\n| Unrecognized tax benefits at December 31, 2015 | 21,834 |\n| Additions based on tax provisions related to the current year | 3,332 |\n| Additions based on tax provisions related to the prior year | 2,496 |\n| Deductions based on settlement/expiration of prior year tax positions | (1,507 | ) |\n| Unrecognized tax benefits at December 31, 2016 | 26,155 |\n| Additions based on tax provisions related to the current year | 4,143 |\n| Additions for tax positions due to acquisitions | 9,208 |\n| Additions based on tax provisions related to the prior year | 1,171 |\n| Deductions based on settlement/expiration of prior year tax positions | (9,119 | ) |\n| Unrecognized tax benefits at December 31, 2017 | $ | 31,558 |\n\nAs of December 31, 2017, the Company had total unrecognized tax benefits of $31.6 million of which $31.6 million, if recognized, would affect its effective tax rate. It is not anticipated that there are any unrecognized tax benefits that will significantly increase or decrease within the next twelve months.\nThe Company files numerous consolidated and separate income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions. The statute of limitations for the Company’s U.S. federal income tax returns has expired for years prior to 2014. The statute of limitations for the Company’s U.K. income tax returns has expired for years prior to 2015. The statute of limitations has expired for years prior to 2014 for the Company’s Czech Republic income tax returns, 2014 for the Company’s Russian income tax returns, 2012 for the Company’s Mexican income tax returns, 2012 for the Company’s Brazilian income tax returns, 2012 for the Company’s Luxembourg income tax returns, 2013 for the Company’s New Zealand income tax returns, and 2015 for the Company’s Australian income tax returns.\n12. Leases\nThe Company enters into noncancelable operating lease agreements for equipment, buildings and vehicles. The minimum lease payments for the noncancelable operating lease agreements are as follows (in thousands):\n\n| 2018 | $ | 19,343 |\n| 2019 | 14,362 |\n| 2020 | 12,132 |\n| 2021 | 10,661 |\n| 2022 | 10,195 |\n| Thereafter | 25,335 |\n\nRent expense for noncancelable operating leases approximated $18.4 million, $15.1 million and $14.1 million for the years ended December 31, 2017, 2016 and 2015, respectively. The leases are generally renewable at the Company’s option for periods of one to five years.\n13. Commitments and Contingencies\nIn the ordinary course of business, the Company is involved in various pending or threatened legal actions, arbitration proceedings, claims, subpoenas, and matters relating to compliance with laws and regulations (collectively, legal proceedings). Based on our current knowledge, management presently does not believe that the liabilities arising from these legal\n115\nproceedings will have a material adverse effect on our consolidated financial condition, results of operations or cash flows. However, it is possible that the ultimate resolution of these legal proceedings could have a material adverse effect on our results of operations and financial condition for any particular period.\nShareholder Class Action and Derivative Lawsuits\nOn June 14, 2017, a shareholder filed a class action complaint in the United States District Court for the Northern District of Georgia against the Company and certain of its officers and directors on behalf of all persons who purchased or otherwise acquired the Company’s stock between February 5, 2016 and May 2, 2017. On October 13, 2017, the shareholder filed an amended complaint asserting claims on behalf of a putative class of all persons who purchased or otherwise acquired the Company's common stock between February 4, 2016 and May 3, 2017. The complaint alleges that the defendants made false or misleading statements regarding fee charges and the reasons for its earnings and growth in certain press releases and other public statements in violation of the federal securities laws. Plaintiff seeks class certification, unspecified monetary damages, costs, and attorneys’ fees. The Company disputes the allegations in the complaint and intends to vigorously defend against the claims.\nOn July 10, 2017, a shareholder derivative complaint was filed against the Company and certain of the Company’s directors and officers in the United States District Court for the Northern District of Georgia seeking recovery on behalf of the Company. The derivative complaint alleges that the defendants issued a false and misleading proxy statement in violation of the federal securities laws; that defendants breached their fiduciary duties by causing or permitting the Company to make allegedly false and misleading public statements concerning the Company’s fee charges, and financial and business prospects; and that certain defendants breached their fiduciary duties through allegedly improper sales of stock. The complaint seeks unspecified monetary damages on behalf of the Company, corporate governance reforms, disgorgement of profits, benefits and compensation by the defendants, restitution, costs, and attorneys’ and experts’ fees. On August 18, 2017, the court entered an order deferring the case pending a ruling on the defendants' motion to dismiss the putative shareholder class action, or until otherwise agreed to by the parties. The defendants dispute the allegations in the complaint and intend to vigorously defend against the claims.\nEstimating an amount or range of possible losses resulting from litigation proceedings is inherently difficult and requires an extensive degree of judgment, particularly where the matters involve indeterminate claims for monetary damages, and are in the stages of the proceedings where key factual and legal issues have not been resolved. For these reasons, the Company is currently unable to predict the ultimate timing or outcome of, or reasonably estimate the possible losses or a range of possible losses resulting from the matters described above.\n14. Asset Dispositions\nTelematics Businesses\nAs part of the Company's plan to exit the telematics business, on July 27, 2017, the Company sold NexTraq, a U.S. fleet telematics business, to Michelin Group for $316.5 million. The Company recorded a pre-tax gain on the disposal of NexTraq of $175.0 million during the third quarter of 2017, which is net of transaction closing costs. The Company recorded tax on the gain of disposal of $65.8 million. The gain on the disposal is included in other (income) expense, net in the accompanying Consolidated Statements of Income. NexTraq had historically been included in the Company's North America segment.\n15. Derivative Financial Instruments\nAs a result of the Cambridge acquisition during 2017, the Company writes derivatives, primarily foreign currency forward contracts, option contracts, and swaps, mostly with small and medium size enterprises that are customers and derives a currency spread from this activity. Derivative transactions include:\n| • | Forward contracts, which are commitments to buy or sell at a future date a currency at a contract price and will be settled in cash. |\n\n| • | Option contracts, which gives the purchaser, the right, but not the obligation to buy or sell within a specified time a currency at a contracted price that may be settled in cash. |\n\n| • | Swap contracts, which are commitments to settlement in cash at a future date or dates, usually on an overnight basis. |\n\nThe credit risk inherent in derivative agreements represents the possibility that a loss may occur from the nonperformance of a counterparty to the agreements. The Company performs a review of the credit risk of these counterparties at the inception of\n116\nthe contract and on an ongoing basis. The Company also monitors the concentration of its contracts with any individual counterparty against limits at the individual counterparty level. The Company anticipates that the counterparties will be able to fully satisfy their obligations under the agreements, but takes action when doubt arises about the counterparties' ability to perform. These actions may include requiring customers to post or increase collateral, and for all counterparties, the possible termination of the related contracts. The Company does not designate any of its foreign exchange derivatives as hedging instruments in accordance with ASC 815.\nThe aggregate equivalent U.S. dollar notional amount of foreign exchange derivative customer contracts held by the Company as of December 31, 2017 (in millions) is presented in the table below. Notional amounts do not reflect the netting of offsetting trades, although these offsetting positions may result in minimal overall market risk. Aggregate derivative notional amounts can fluctuate from period to period in the normal course of business based on market conditions, levels of customer activity and other factors.\n| Net Notional |\n| Foreign exchange contracts: |\n| Swaps | $ | 515.4 |\n| Futures, forwards and spot | 3,274.5 |\n| Written options | 2,934.2 |\n| Purchased options | 2,314.1 |\n| Total | $ | 9,038.1 |\n\nThe majority of customer foreign exchange contracts are written in major currencies such as the U.S. Dollar, Canadian Dollar, British Pound, Euro and Australian Dollar.\nThe following table summarizes the fair value of derivatives reported in the Consolidated Balance Sheet as of December 31, 2017 (in millions):\n| Fair Value, Gross | Fair Value, Net |\n| Derivative Assets | Derivative Liabilities | Derivative Assets | Derivative Liabilities |\n| Derivatives - undesignated: |\n| Over the counter | $ | 80.4 | $ | 68.2 | $ | 39.0 | $ | 26.8 |\n| Exchange traded | — | 0.1 | — | 0.1 |\n| Foreign exchange contracts | 80.4 | 68.3 | 39.0 | 26.9 |\n| Cash collateral | 12.5 | 10.9 | 12.5 | 10.9 |\n| Total net derivative assets and liabilities | $ | 67.9 | $ | 57.4 | $ | 26.5 | $ | 16.0 |\n\nThe fair values of derivative assets and liabilities associated with contracts that include netting language that the Company believes to be enforceable have been netted to present the Company's net exposure with these counterparties. The Company recognizes all derivative assets, net in prepaid expense and other current assets and all derivative liabilities, net in other current liabilities, both net at the customer level as right of offset exists, in its Consolidated Balance Sheets at their fair value. The gain or loss on the fair value is recognized immediately within revenues, net in the Consolidated Statements of Income. The Company does not offset fair value amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral. At December 31, 2017, $39.0 million derivative assets and $26.9 million derivative liabilities were recorded in other current assets and other current liabilities, respectively, in the Consolidated Balance Sheet. The Company receives cash from customers as collateral for trade exposures, which is recorded within cash and cash equivalents and customer deposits in the Consolidated Balance Sheet. The customer has the right to recall their collateral in the event exposures move in their favor, they unwind all outstanding trades or they cease to do business with the Company.\n16. Earnings Per Share\nThe Company reports basic and diluted earnings per share. Basic earnings per share is computed by dividing net income attributable to shareholders of the Company by the weighted average number of common shares outstanding during the reported period. Diluted earnings per share reflect the potential dilution related to equity-based incentives using the treasury stock method.\n117\nThe calculation and reconciliation of basic and diluted earnings per share for the years ended December 31 (in thousands, except per share data) follows:\n\n| 2017 | 2016 | 2015 |\n| Net income | $ | 740,200 | $ | 452,385 | $ | 362,431 |\n| Denominator for basic earnings per share | 91,129 | 92,597 | 92,023 |\n| Dilutive securities | 2,465 | 2,616 | 2,116 |\n| Denominator for diluted earnings per share | 93,594 | 95,213 | 94,139 |\n| Basic earnings per share | $ | 8.12 | $ | 4.89 | $ | 3.94 |\n| Diluted earnings per share | 7.91 | 4.75 | 3.85 |\n\nThere were 0.1 million antidilutive shares for the year ended December 31, 2017. Diluted earnings per share for the years ended December 31, 2017, 2016 and 2015 excludes the effect of 0.1 million , 0.4 million and 1.4 million shares, respectively, of common stock that may be issued upon the exercise of employee stock options because such effect would be antidilutive. There were 0.1 million antidilutive shares for 2016. Diluted earnings per share also excludes the effect of 0.3 million, 0.2 million and 0.2 million shares of performance based restricted stock for which the performance criteria have not yet been achieved for the years ended December 31, 2017, 2016 and 2015, respectively.\n17. Segments\nThe Company reports information about its operating segments in accordance with the authoritative guidance related to segments. The Company’s reportable segments represent components of the business for which separate financial information is evaluated regularly by the chief operating decision maker in determining how to allocate resources and in assessing performance. The Company operates in two reportable segments, North America and International. The results from the Cambridge business acquired in the third quarter of 2017 and CLS business acquired in the fourth quarter of 2017 are reported in the Company's North America segment. The results from the Company's Russian business acquired in the fourth quarter of 2017 are reported in its International segment. There were no inter-segment sales.\nThe Company’s segment results are as follows as of and for the years ended December 31 (in thousands):\n\n| 2017 | 2016 | 2015 |\n| Revenues, net: |\n| North America | $ | 1,428,711 | $ | 1,279,102 | $ | 1,231,957 |\n| International | 820,827 | 552,444 | 470,908 |\n| $ | 2,249,538 | $ | 1,831,546 | $ | 1,702,865 |\n| Operating income: |\n| North America | $ | 541,598 | $ | 506,414 | $ | 442,052 |\n| International | 342,162 | 247,739 | 225,482 |\n| $ | 883,760 | $ | 754,153 | $ | 667,534 |\n| Depreciation and amortization: |\n| North America | $ | 139,418 | $ | 129,653 | $ | 127,863 |\n| International | 125,142 | 73,603 | 65,590 |\n| $ | 264,560 | $ | 203,256 | $ | 193,453 |\n| Capital expenditures: |\n| North America | $ | 40,747 | $ | 39,000 | $ | 19,883 |\n| International | 29,346 | 20,011 | 21,992 |\n| $ | 70,093 | $ | 59,011 | $ | 41,875 |\n| Long-lived assets (excluding goodwill): |\n| North America | $ | 1,888,599 | $ | 1,664,224 | $ | 1,719,639 |\n| International | 1,131,610 | 1,203,465 | 602,941 |\n| $ | 3,020,209 | $ | 2,867,689 | $ | 2,322,580 |\n\n118\nThe Company attributes revenues, net from external customers to individual countries based upon the country in which the related services were rendered. The table below presents certain financial information related to the Company’s significant operations as of and for the years ended December 31 (in thousands):\n| 2017 | 2016 | 2015 |\n| Revenues, net by location: |\n| United States (country of domicile) | $ | 1,400,801 | $ | 1,278,828 | $ | 1,231,641 |\n| Brazil | 394,550 | 167,769 | 85,124 |\n| United Kingdom | 236,550 | 229,125 | 248,598 |\n\nThe table below presents the Company's revenues, net from its primary product categories as of and for the years ended December 31 (in thousands).\n| Year Ended December 31, |\n| 2017 | 2016 | 2015 |\n| Revenue by Product Category | Revenues, net | Revenues, net | Revenues, net |\n| Fuel1 | $ | 1,096,153 | $ | 997,398 | $ | 1,115,570 |\n| Corporate payments | 261,822 | 179,557 | 162,283 |\n| Tolls | 326,977 | 102,740 | 9,337 |\n| Lodging | 126,657 | 100,664 | 91,751 |\n| Gift | 194,099 | 184,743 | 170,095 |\n| Other | 243,830 | 266,444 | 153,829 |\n| Consolidated revenues, net | $ | 2,249,538 | $ | 1,831,546 | $ | 1,702,865 |\n\n| 1Amounts shown for 2016 and 2015 from previously disclosed amounts conform to the current year's presentation. |\n\nThe table below presents the Company's long-lived assets (excluding goodwill) at December 31 (in thousands).\n| 2017 | 2016 |\n| Long-lived assets (excluding goodwill): |\n| United States (country of domicile) | $ | 1,808,043 | $ | 1,664,224 |\n| Brazil | 688,809 | 784,816 |\n| United Kingdom | 294,039 | 286,928 |\n\nNo single customer represented more than 10% of the Company’s consolidated revenue in 2017, 2016 and 2015.\n119\n18. Selected Quarterly Financial Data (Unaudited)\n\n| Fiscal Quarters Year Ended December 31, 2017 | First | Second | Third | Fourth |\n| Revenues, net | $ | 520,433 | $ | 541,237 | $ | 577,877 | $ | 609,991 |\n| Operating income | 195,068 | 216,043 | 232,637 | 240,012 |\n| Net income | 123,693 | 130,987 | 202,823 | 282,697 |\n| Basic earnings per share | $ | 1.34 | $ | 1.42 | $ | 2.23 | $ | 3.15 |\n| Diluted earnings per share | 1.31 | 1.39 | 2.18 | 3.05 |\n| Weighted average shares outstanding: |\n| Basic shares | 92,108 | 92,013 | 90,751 | 89,676 |\n| Diluted shares | 94,560 | 94,223 | 93,001 | 92,623 |\n\n\n| Fiscal Quarters Year Ended December 31, 2016* | First | Second | Third | Fourth |\n| Revenues, net | $ | 414,262 | $ | 417,905 | $ | 484,426 | $ | 514,953 |\n| Operating income | 175,955 | 171,168 | 191,055 | 215,975 |\n| Net income | 111,090 | 116,253 | 129,618 | 95,424 |\n| Earnings per share: |\n| Basic earnings per share | $ | 1.20 | $ | 1.25 | $ | 1.40 | $ | 1.03 |\n| Diluted earnings per share | 1.17 | 1.22 | 1.36 | 1.00 |\n| Weighted average shares outstanding: |\n| Basic shares | 92,516 | 92,665 | 92,631 | 92,574 |\n| Diluted shares | 95,030 | 95,279 | 95,307 | 95,235 |\n\n*2016 quarterly amounts reflect the impact of the Company's adoption of Accounting Standards Update 2016-09, Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payments Accounting, to simplify several aspects of the accounting for share-based compensation, including the income tax consequences.\nThe sum of the quarterly earnings per common share amounts for 2017 and 2016 may not equal the earnings per common share for the 2017 and 2016 due to rounding.\nThe fourth quarter of 2017 includes the provisional net tax benefit of $128.2 million as a result of the Tax Act and $11 million of incremental legal fees.\nThe fourth quarter of 2016 includes a $36.1 million impairment charge related to the Company’s minority investment in Masternaut, partially offset by a $31.8 million decrease in non-cash stock based compensation expense.\n120\nITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE\nNot applicable.\nITEM 9A. CONTROLS AND PROCEDURES\nEvaluation of Disclosure Controls and Procedures\nAs of December 31, 2017, management carried out, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2017, our disclosure controls and procedures were effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in applicable rules and forms and are designed to ensure that information required to be disclosed in those reports is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.\nManagement Report on Internal Control over Financial Reporting\nOur management team is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2017. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. As of December 31, 2017, management believes that the Company’s internal control over financial reporting is effective based on those criteria. Our independent registered public accounting firm has issued an audit report on our internal control over financial reporting, which is included in this annual report.\nIn connection with management's evaluation, our management team excluded from its assessment of the effectiveness of our internal control over financial reporting as of December 31, 2017, the internal controls related to three subsidiaries that we acquired during the year ended December 31, 2017, and for which financial results are included in our consolidated financial statements.\nOn August 9, 2017, we acquired Cambridge Global Payments (“Cambridge”), a leading business to business (B2B) international payments provider in Canada. On September 26, 2017, we acquired a fuel card provider in Russia. On October 13, 2017, we completed the acquisition of Creative Lodging Solutions (\"CLS\"), a lodging business, in the United States. Collectively we refer to these transactions as the Acquisitions. These Acquisitions constituted 11% of total assets, at December 31, 2017, and 3% of revenues, for the year then ended. This exclusion was in accordance with Securities and Exchange Commission guidance that an assessment of a recently acquired business may be omitted in management's report on internal control over financial reporting the year of acquisition.\nBecause of its inherent limitations, internal control over financial reporting may not prevent or detect all misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate. Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Due to such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, such risk.\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting during the quarter ended December 31, 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n121\nITEM 9B. OTHER INFORMATION\nNot applicable.\n122\nPART III\nITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE\nA list of our executive officers and biographical information appears in Part I, Item X of this Form 10-K. Information about our directors may be found under the caption “Nominees” and “Continuing Directors” in our Proxy Statement for the Annual Meeting of Shareholders to be held June 6, 2018 (the “Proxy Statement”). Information about our Audit Committee may be found under the caption “Board Committees” in the Proxy Statement. The foregoing information is incorporated herein by reference.\nThe information in the Proxy Statement set forth under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by reference.\nWe have adopted the FLEETCOR Code of Business Conduct and Ethics (the “code of ethics”), which applies to our Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer and Corporate Controller, and other finance organization employees. The code of ethics is publicly available on our website at www.fleetcor.com under Investor Relations. If we make any substantive amendments to the code of ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer, or Chief Accounting Officer, we will disclose the nature of the amendment or waiver on that website or in a report on Form 8-K.\nITEM 11. EXECUTIVE COMPENSATION\nThe information in the Proxy Statement set forth under the captions “Director Compensation,” “Named Executive Officer Compensation,” “Compensation Committee Report,” and “Compensation Committee Interlocks and Insider Participation” is incorporated herein by reference.\nITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT\nAND RELATED STOCKHOLDER MATTERS\nThe information in the Proxy Statement set forth under the captions “Securities Authorized for Issuance Under Equity Compensation Plans,” “Information Regarding Beneficial Ownership of Principal Shareholders, Directors, and Management” and “Equity Compensation Plan Information” is incorporated herein by reference.\nITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR\nINDEPENDENCE\nThe information set forth in the Proxy Statement under the captions “Director Independence” and “Certain Relationships and Related Transactions” is incorporated herein by reference.\nITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES\nInformation concerning principal accountant fees and services appears in the Proxy Statement under the headings “Fees Billed by Ernst & Young LLP” and “Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditor” and is incorporated herein by reference.\n123\nPART IV\nITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES\n(a) Financial Statements and Schedules\nThe financial statements are set forth under Item 8 of this Form 10-K, as indexed below. Financial statement schedules have been omitted since they either are not required, not applicable, or the information is otherwise included.\nIndex to Financial Statements\n| Page |\n| Reports of Independent Registered Public Accounting Firm | 83 |\n| Consolidated Balance Sheets at December 31, 2017 and 2016 | 85 |\n| Consolidated Statements of Income for the Years Ended December 31, 2017, 2016 and 2015 | 86 |\n| Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2017, 2016 and 2015 | 87 |\n| Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2017, 2016 and 2015 | 88 |\n| Consolidated Statements of Cash Flows for the Years Ended December 31, 2017, 2016 and 2015 | 89 |\n| Notes to Consolidated Financial Statements | 90 |\n\n(b) Exhibit Listing\n| Exhibit no. |\n| 2.1 | Stock Purchase Agreement, dated as of April 1, 2009, among FLEETCOR Technologies Operating Company, LLC, CLC Group, Inc., and the entities and individuals identified on the signature pages thereto (incorporated by reference to Exhibit No. 2.1 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\n| 2.2 | Share Purchase Agreement among Arval UK Group Limited, FLEETCOR UK Acquisition Limited and FLEETCOR Technologies, Inc. (incorporated by reference to exhibit No. 2.1 to the registrant’s Form 8-K, filed with the SEC on December 13, 2011) |\n| 2.3 | Agreement and Plan of Merger, dated August 12, 2014, by and among Comdata Inc., Ceridian LLC, FLEETCOR Technologies, Inc. and FCHC Project, Inc. (incorporated by reference to Exhibit No. 2.1 to the registrant’s Form 10-Q, filed with the SEC with the SEC on November 10, 2014) |\n| 2.4 | Amendment to Agreement and Plan of Merger, dated November 10, 2014, by and among Comdata Inc., Ceridian LLC, FLEETCOR Technologies, Inc. and FCHC Project, Inc. (incorporated by reference to Exhibit No. 10.2 to the registrant’s Form 8-K, filed with the SEC on November 17, 2014) |\n| 2.5 | Acquisition agreement to acquire Serviços e Tecnologia de Pagamentos S.A. (incorporated by reference to Exhibit 2.1 to the registrant’s Form 8-K, File No. 001-35004, filed with the Securities and Exchange Commission on March 18, 2016) |\n| 3.1 | Amended and Restated Certificate of Incorporation of FLEETCOR Technologies, Inc. (incorporated by reference to Exhibit 3.1 to the registrant’s Annual Report on Form 10-K, File No. 001-35004, filed with SEC on March 25, 2011) |\n| 3.2 | Amended and Restated Bylaws of FLEETCOR Technologies, Inc. (incorporated by reference to Exhibit 3.1 to the registrant’s Current Report on Form 8-K, filed with the SEC on January 29, 2018) |\n| 4.1 | Form of Stock Certificate for Common Stock (incorporated by reference to Exhibit 4.1 to Amendment No. 3 to the registrant’s Registration Statement on Form S-1, File No. 333-166092, filed with the SEC on June 29, 2010) |\n| 10.1* | Form of Indemnity Agreement entered into between FLEETCOR and its directors and executive officers (incorporated by reference to Exhibit 10.1 to Amendment No. 3 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on June 29, 2010) |\n\n124\n| 10.2* | FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.2 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\n| 10.3* | First Amendment to FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.3 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\n| 10.4* | Second Amendment to FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.4 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\n| 10.5* | Third Amendment to FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.5 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\n| 10.6* | Fourth Amendment to FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.6 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\n| 10.7* | Form of Incentive Stock Option Award Agreement pursuant to the FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.7 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\n| 10.8* | Form of Non-Qualified Stock Option Award Agreement pursuant to the FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.8 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\n| 10.9* | Form of Performance Share Restricted Stock Agreement pursuant to the FLEETCOR Technologies, Inc. Amended and Restated Stock Incentive Plan (incorporated by reference to Exhibit 10.9 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on May 20, 2010) |\n| 10.10* | FLEETCOR Technologies, Inc. Annual Executive Bonus Program (incorporated by reference to Exhibit 10.11 to Amendment No. 2 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on June 8, 2010) |\n| 10.11* | Employee Noncompetition, Nondisclosure and Developments Agreement, dated September 25, 2000, between Fleetman, Inc. and Ronald F. Clarke (incorporated by reference to Exhibit 10.12 to Amendment No. 2 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on June 8, 2010) |\n| 10.12* | Offer Letter, dated September 20, 2002, between FLEETCOR Technologies, Inc. and Eric R. Dey (incorporated by reference to Exhibit 10.13 to Amendment No. 2 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on June 8, 2010) |\n| 10.13* | Service Agreement, dated July 9, 2007, between FLEETCOR Technologies, Inc. and Andrew R. Blazye (incorporated by reference to Exhibit 10.16 to Amendment No. 2 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on June 8, 2010) |\n| 10.14 | Sixth Amended and Restated Registration Rights Agreement, dated April 1, 2009, between FLEETCOR Technologies, Inc. and each of the stockholders party thereto (incorporated by reference to Exhibit 10.17 to Amendment No. 2 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on June 8, 2010) |\n| 10.15 | First Amendment to Sixth Amended and Restated Registration Rights Agreement (incorporated by reference to Exhibit No. 10.17 to the registrant’s form 10-K, filed with the SEC with the SEC on March 25, 2011) |\n| 10.16 | Form of Indemnity Agreement to be entered into between FLEETCOR and representatives of its major stockholders (incorporated by reference to Exhibit 10.37 to Amendment No. 3 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on June 29, 2010) |\n| 10.17 | Form of Director Restricted Stock Grant Agreement pursuant to the FLEETCOR Technologies, Inc. 2010 Equity Compensation Plan (incorporated by reference to Exhibit 10.38 to Amendment No. 6 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on November 30, 2010) |\n| 10.18* | Form of Employee Performance Share Restricted Stock Agreement pursuant to the FLEETCOR Technologies, Inc. 2010 Equity Compensation Plan (incorporated by reference to Exhibit 10.39 to Amendment No. 6 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on November 30, 2010) |\n\n125\n| 10.19* | Form of Employee Incentive Stock Option Award Agreement pursuant to the FLEETCOR Technologies, Inc. 2010 Equity Compensation Plan (incorporated by reference to Exhibit 10.40 to Amendment No. 6 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC on November 30, 2010) |\n| 10.20* | Form of Employee Non-Qualified Stock Option Award Agreement pursuant to the FLEETCOR Technologies, Inc. 2010 Equity Compensation Plan (incorporated by reference to Exhibit 10.41 to Amendment No. 6 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on November 30, 2010) |\n| 10.21 | Form of Director Non-Qualified Stock Option Award Agreement pursuant to the FLEETCOR Technologies, Inc. 2010 Equity Compensation Plan (incorporated by reference to Exhibit 10.42 to Amendment No. 6 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on November 30, 2010) |\n| 10.22* | Amended and Restated Employee Noncompetition, Nondisclosure and Developments Agreement, dated November 29, 2010, between FLEETCOR Technologies, Inc. and Ronald F. Clarke (incorporated by reference to Exhibit No. 10.43 to Amendment No. 6 to the registrant’s Registration Statement on Form S-1, file number 333-166092, filed with the SEC with the SEC on November 30, 2010) |\n| 10.23 | Arrangement Agreement Among FLEETCOR Luxembourg Holdings2 S.À.R.L, FLEETCOR Technologies, Inc. and CTF Technologies, Inc. (incorporated by reference to Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q, filed with the SEC on May 10, 2012) |\n| 10.24 | Repurchase Agreement, dated November 26, 2012, among the Company and the Repurchase Stockholders (incorporated by reference to Exhibit 10.1 to the registrant’s Form 8-K, filed with the SEC on November 27, 2012) |\n| 10.25* | FLEETCOR Technologies, Inc. 2010 Equity Compensation Plan, as amended and restated effective February 7, 2018 (incorporated by reference from Appendix A to Exhibit 10.1 to the registrant's Current Report on Form 8-K, filed with the SEC on February 12, 2018 ) |\n| 10.26 | FLEETCOR Technologies, Inc. Section 162(M) Performance—Based Program (incorporated by reference to Annex A to the registrant’s Proxy Statement, filed with the SEC on April 18, 2014) |\n| 10.27 | Credit Agreement, dated October 24, 2014, among FLEETCOR Technologies Operating Company, LLC, as Borrower, FLEETCOR Technologies, Inc., as Parent, FLEETCOR Technologies Operating Company, LLC, as a borrower and guarantor, certain of the our foreign subsidiaries as borrowers, Bank of America, N.A., as administrative agent, swing line lender and L/C issuer and a syndicate of financial institutions (incorporated by reference to Exhibit No. 10.4 to the registrant’s Form 10-Q filed with the SEC on November 10, 2014) |\n| 10.28 | Fifth Amended and Restated Receivables Purchase Agreement, dated November 14, 2014, by and among FLEETCOR Technologies, Inc. and PNC Bank, National Association, as administrator for a group of purchasers and purchaser agents, and certain other parties (incorporated by reference to Exhibit No. 10.1 to the registrant’s Form 8-K, filed with the SEC on November 17, 2014) |\n| 10.29 | Amended and Restated Performance Guaranty dated as of November 14, 2014 made by FLEETCOR Technologies, Inc. and FLEETCOR Technologies Operating Company, LLC, in favor of PNC Bank, National Association, as administrator under the Fifth Amended and Restated Receivables Purchase Agreement (incorporated by reference to Exhibit 10.32 to the registrant’s Form 10-K, file number 001-35004, filed with the SEC on March 2, 2015) |\n| 10.30 | Amended and Restated Purchase and Sale Agreement dated as of November 14, 2014, among various entities listed on Schedule I thereto, as originators, and FLEETCOR Funding LLC (incorporated by reference to Exhibit 10.33 to the registrant’s Form 10-K, file number 001-35004, filed with the SEC on March 2, 2015) |\n| 10.31 | Receivables Purchase and Sale Agreement dated as of November 14, 2014, among Comdata TN, Inc. and Comdata Network, Inc. of California, as the sellers, and Comdata Inc., as the buyer (incorporated by reference to Exhibit 10.34 to the registrant’s Form 10-K, file number 001-35004, filed with the SEC on March 2, 2015) |\n| 10.32 | Investor Rights Agreement, dated November 14, 2014, between FLEETCOR Technologies, Inc. and Ceridian LLC (incorporated by reference to Exhibit 10.35 to the registrant’s Form 10-K, file number 001-35004, filed with the SEC on March 2, 2015) |\n| 10.33* | Offer Letter, dated June 19, 2013, between FLEETCOR Technologies, Inc. and John A. Reed (incorporated by reference to Exhibit No. 10.3 to the registrant’s Form 10-Q, filed with the SEC on May 12, 2014) |\n| 10.34* | Offer Letter, dated July 29, 2014, between FLEETCOR Technologies, Inc. and Armando Lins Netto (incorporated by reference to Exhibit 10.1 to the registrant’s Form 10-Q, file number 001-35004, filed with the SEC on May 11, 2015) |\n\n126\n| 10.35 | First Amendment to the Fifth Amended and Restated Receivables Purchase Agreement, dated as of November 5, 2015, by and among FLEETCOR Funding LLC, FLEETCOR Technologies Operating Company, LLC and PNC Bank, National Association, as administrator for a group of purchasers and purchaser agents, and certain other parties (incorporated by reference to Exhibit 10.2 to the registrant’s Form 10-Q, file number 001-35004, filed with the SEC on November 9, 2015) |\n| 10.36* | Employee agreement on confidentiality, work product, non-competition, and non-solicitation (incorporated by reference to Exhibit 10.38 to the registrant's Form 10-K, file number 001-35004, filed with the SEC on February 29, 2016) |\n| 10.37 | Second Amendment to the Fifth Amended and Restated Receivables Purchase Agreement, dated as of December 1, 2015, by and among FLEETCOR Funding LLC, FLEETCOR Technologies Operating Company, LLC and PNC Bank, National Association, as administrator for a group of purchasers and purchaser agents, and certain other parties (incorporated by reference to Exhibit 10.39 to the registrant's Form 10-K, file number 001-35004, filed with the SEC on February 29, 2016) |\n| 10.40 | First Amendment to Credit Agreement and Lender Joiner Agreement, dated as of August 22, 2016, by and among FLEETCOR Funding LLC, FLEETCOR Technologies Operating Company, LLC and PNC Bank, National Association, as administrator for a group of purchasers and purchaser agents, and certain other parties (incorporated by reference to Exhibit 10.1 to the registrant’s Form 10-Q, filed with the SEC on November 9, 2016) |\n| 10.41 | Second Amendment to Credit Agreement, dated as of January 2017, among FLEETCOR Technologies Operating Company, LLC, as the Company, FLEETCOR Technologies, Inc., as the Parent, the designated borrowers party hereto, the other guarantors party hereto, Bank of America, N.A., as administrative agent, swing line lender and l/c issuer, and the other lenders party hereto and Merrill Lynch, Pierce, Fenner & Smith Incorporated, as sole lead arranger and sole bookrunner (incorporated by reference to Exhibit 10.41 to the registrant's Form 10-K, filed with the SEC on March 1, 2017) |\n| 10.42 | Third Amendment to Credit Agreement, dated as of August 2, 2017, among FLEETCOR Technologies Operating Company, LLC, as the Company, FLEETCOR Technologies, Inc., as the Parent, the designated borrowers party hereto, the other guarantors party hereto, Bank of America, N.A., as administrative agent, swing line lender and l/c issuer, and the other lenders party hereto, and Merrill Lynch, Pierce, Fenner & Smith Incorporated, as sole lead arranger and sole bookrunner (incorporated by reference to Exhibit 10.1 to the registrant’s Form 10-Q, filed with the SEC on August 8, 2017) |\n| 10.43 | Third Amendment to Fifth Amended and Restated Receivables Purchase Agreement, dated as of November 14, 2017, by and among FLEETCOR Funding LLC, FLEETCOR Technologies Operating Company, LLC, PNC Bank, National Association, as administrator for a group of purchasers and purchase agents, and certain other parties |\n| 11.1 | Statement of Computation of Share Earnings (See Note 16) |\n| 21.1 | List of subsidiaries of FLEETCOR Technologies, Inc. |\n| 23.1 | Consent of Independent Registered Public Accounting Firm |\n| 31.1 | Certification of Chief Executive Officer Pursuant to Section 302 |\n| 31.2 | Certification of Chief Financial Officer Pursuant to Section 302 |\n| 32.1 | Certification of Chief Executive Officer Pursuant to Section 906 |\n| 32.2 | Certification of Chief Financial Officer Pursuant to Section 906 |\n| 101 | The following financial information for the registrant formatted in XBRL (Extensible Business Reporting Language): (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income; (iv) the Consolidated Statements of Stockholders' Equity; (v) the Consolidated Statements of Cash Flows and (vi) the Notes to Consolidated Financial Statements |\n\n| * | Identifies management contract or compensatory plan or arrangement. |\n\n127\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned; thereunto duly authorized, in the City of Atlanta, State of Georgia, on March 1, 2018.\n\n| FLEETCOR Technologies, Inc. |\n| By: | /S/ RONALD F. CLARKE |\n| Ronald F. Clarke |\n| President and Chief Executive Officer |\n\nPursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of registrant and in the capacities indicated on March 1, 2018.\n\n| Signature | Title |\n| /S/ RONALD F. CLARKE | President, Chief Executive Officer and Chairman of the Board of Directors(Principal Executive Officer) |\n| Ronald F. Clarke |\n| /S/ ERIC R. DEY | Chief Financial Officer(Principal Financial Officer and Principal Accounting Officer) |\n| Eric R. Dey |\n| /s/ MICHAEL BUCKMAN | Director |\n| Michael Buckman |\n| /s/ JOSEPH W. FARRELLY | Director |\n| Joseph W. Farrelly |\n| /s/ THOMAS M. HAGERTY | Director |\n| Thomas M. Hagerty |\n| /s/ MARK A. JOHNSON | Director |\n| Mark A. Johnson |\n| /s/ RICHARD MACCHIA | Director |\n| Richard Macchia |\n| /s/ HALA G. MODDELMOG | Director |\n| Hala G. Moddelmog |\n| /s/ JEFFREY S. SLOAN | Director |\n| Jeffrey S. Sloan |\n| /s/ STEVEN T. STULL | Director |\n| Steven T. Stull |\n\n128\n</text>\n\nWhat is the ratio per million locations of hotels under FLEETCOR's proprietary CLC Lodging network to the number of locations accepting FLEETCOR's purchasing and T&E cards in the United States and Canada?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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doc-math
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"style": "rule",
"ground_truth": "Therefore, the answer is 1560.747663551402."
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"split": "test",
"index": 66,
"input_length": 117094
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docmath_40000_plus
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"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\nITEM 1. FINANCIAL STATEMENTS\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\n| CONDENSED CONSOLIDATED BALANCE SHEETS |\n| (dollars in thousands) |\n| September 30, 2019 | December 31, 2018 |\n| (Unaudited) |\n| Assets |\n| Investments in: |\n| Excess mortgage servicing rights, at fair value | $ | 398,064 | $ | 447,860 |\n| Excess mortgage servicing rights, equity method investees, at fair value | 132,259 | 147,964 |\n| Mortgage servicing rights, at fair value | 3,431,968 | 2,884,100 |\n| Mortgage servicing rights financing receivables, at fair value | 1,811,261 | 1,644,504 |\n| Servicer advance investments, at fair value(A) | 600,547 | 735,846 |\n| Real estate and other securities, available-for-sale | 16,853,910 | 11,636,581 |\n| Residential mortgage loans, held-for-investment (includes $113,133 and $121,088 at fair value at September 30, 2019 and December 31, 2018, respectively)(A) | 613,657 | 735,329 |\n| Residential mortgage loans, held-for-sale | 1,349,997 | 932,480 |\n| Residential mortgage loans, held-for-sale, at fair value | 5,206,251 | 2,808,529 |\n| Consumer loans, held-for-investment(A) | 881,183 | 1,072,202 |\n| Cash and cash equivalents(A) | 738,219 | 251,058 |\n| Restricted cash | 163,148 | 164,020 |\n| Servicer advances receivable | 2,911,798 | 3,277,796 |\n| Trades receivable | 4,487,772 | 3,925,198 |\n| Deferred tax asset, net | 43,372 | 65,832 |\n| Other assets (includes $168,532 and $121,602 in residential mortgage loan subject to repurchase at September 30, 2019 and December 31,2018, respectively) | 1,724,519 | 961,714 |\n| $ | 41,347,925 | $ | 31,691,013 |\n| Liabilities and Equity |\n| Liabilities |\n| Repurchase agreements | $ | 23,110,359 | $ | 15,553,969 |\n| Notes and bonds payable (includes $474,309 and $117,048 at fair value at September 30, 2019 and December 31, 2018, respectively)(A) | 7,405,872 | 7,102,266 |\n| Trades payable | 2,536,188 | 2,048,348 |\n| Dividends payable | 213,098 | 184,552 |\n| Accrued expenses and other liabilities(A) (includes $168,532 and $121,602 in residential mortgage loans repurchase liabilities at September 30, 2019 and December 31,2018, respectively) | 820,291 | 713,583 |\n| 34,085,808 | 25,602,718 |\n| Commitments and Contingencies |\n| Equity |\n| Preferred Stock, par value of $0.01 per share, 23,000,000 shares authorized: |\n| 7.50% Series A Preferred Stock, $0.01 par value, 11,500,000 shares authorized, 6,210,000 and 0 issued and outstanding at September 30, 2019 and December 31, 2018, respectively | 150,026 | — |\n| 7.125% Series B Preferred Stock, $0.01 par value, 11,500,000 shares authorized, 11,300,000 and 0 issued and outstanding at September 30, 2019 and December 31, 2018, respectively | 273,418 | — |\n| Common Stock, $0.01 par value, 2,000,000,000 shares authorized, 415,520,780 and 369,104,429 issued and outstanding at September 30, 2019 and December 31, 2018, respectively | 4,156 | 3,692 |\n| Additional paid-in capital | 5,498,226 | 4,746,242 |\n| Retained earnings | 545,713 | 830,713 |\n| Accumulated other comprehensive income (loss) | 706,926 | 417,023 |\n| Total New Residential stockholders’ equity | 7,178,465 | 5,997,670 |\n| Noncontrolling interests in equity of consolidated subsidiaries | 83,652 | 90,625 |\n| Total Equity | 7,262,117 | 6,088,295 |\n| $ | 41,347,925 | $ | 31,691,013 |\n\n1\n| (A) | New Residential’s Condensed Consolidated Balance Sheets include the assets and liabilities of certain consolidated VIEs, Advance Purchaser LLC (the “Buyer”) (Note 6), the RPL Borrowers (defined in Note 8), Shellpoint Asset Funding Trust 2013-1 (“SAFT 2013-1”) and the Shelter retail mortgage origination joint ventures (“Shelter JVs”) (Note 8) and the Consumer Loan SPVs (Note 9), which primarily hold investments in Servicer Advance Investments, residential mortgage loans and consumer loans, respectively, financed with notes and bonds payable. The balance sheets of the Buyer, the RPL Borrowers, SAFT 2013-1, Shelter JVs and the Consumer Loan SPVs are included in Notes 6, 8 and 9, respectively. The creditors of the Buyer, the RPL Borrowers, SAFT 2013-1, Shelter JVs and the Consumer Loan SPVs do not have recourse to the general credit of New Residential and the assets of the Buyer, the RPL Borrowers, SAFT 2013-1, Shelter JVs and the Consumer Loan SPVs are not directly available to satisfy New Residential’s obligations. |\n\nSee notes to condensed consolidated financial statements.\n2\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\n| CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) |\n| (dollars in thousands, except per share data) |\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Interest income | $ | 448,127 | $ | 425,524 | $ | 1,303,041 | $ | 1,212,902 |\n| Interest expense | 245,902 | 162,806 | 686,738 | 421,109 |\n| Net Interest Income | 202,225 | 262,718 | 616,303 | 791,793 |\n| Impairment |\n| Other-than-temporary impairment (OTTI) on securities | 5,567 | 3,889 | 21,942 | 23,190 |\n| Valuation and loss provision (reversal) on loans and real estate owned (REO) | ( 10,690 | ) | 5,471 | 8,042 | 28,136 |\n| ( 5,123 | ) | 9,360 | 29,984 | 51,326 |\n| Net interest income after impairment | 207,348 | 253,358 | 586,319 | 740,467 |\n| Servicing revenue, net of change in fair value of $(228,405), $(26,741), $(619,914), and $35,118, respectively | 53,050 | 175,355 | 133,366 | 538,784 |\n| Gain on sale of originated mortgage loans, net | 100,541 | 45,732 | 194,029 | 45,732 |\n| Other Income |\n| Change in fair value of investments in excess mortgage servicing rights | 2,407 | ( 4,744 | ) | ( 1,421 | ) | ( 55,711 | ) |\n| Change in fair value of investments in excess mortgage servicing rights, equity method investees | 4,751 | 3,396 | 4,087 | 5,624 |\n| Change in fair value of investments in mortgage servicing rights financing receivables | ( 41,410 | ) | ( 88,345 | ) | ( 133,200 | ) | 63,628 |\n| Change in fair value of servicer advance investments | 6,641 | ( 5,353 | ) | 15,932 | ( 86,581 | ) |\n| Change in fair value of investments in residential mortgage loans | ( 19,037 | ) | 647 | 90,551 | 647 |\n| Change in fair value of derivative instruments | 58,508 | 24,299 | ( 1,988 | ) | 27,985 |\n| Gain (loss) on settlement of investments, net | 154,752 | ( 11,893 | ) | 157,013 | 106,064 |\n| Earnings from investments in consumer loans, equity method investees | ( 2,547 | ) | 4,555 | ( 890 | ) | 12,343 |\n| Other income (loss), net | ( 35,219 | ) | ( 5,860 | ) | ( 16,451 | ) | 10,415 |\n| 128,846 | ( 83,298 | ) | 113,633 | 84,414 |\n| Operating Expenses |\n| General and administrative expenses | 133,513 | 98,587 | 351,359 | 139,169 |\n| Management fee to affiliate | 20,678 | 15,464 | 58,261 | 46,027 |\n| Incentive compensation to affiliate | 36,307 | 23,848 | 49,265 | 65,169 |\n| Loan servicing expense | 7,192 | 11,060 | 26,167 | 33,609 |\n| Subservicing expense | 52,875 | 43,148 | 147,763 | 135,703 |\n| 250,565 | 192,107 | 632,815 | 419,677 |\n| Income (Loss) Before Income Taxes | 239,220 | 199,040 | 394,532 | 989,720 |\n| Income tax expense (benefit) | ( 5,440 | ) | 3,563 | 18,980 | ( 5,957 | ) |\n| Net Income (Loss) | $ | 244,660 | $ | 195,477 | $ | 375,552 | $ | 995,677 |\n| Noncontrolling Interests in Income of Consolidated Subsidiaries | $ | 14,738 | $ | 10,869 | $ | 31,979 | $ | 32,058 |\n| Dividends on Preferred Stock | $ | 5,338 | $ | — | $ | 5,338 | $ | — |\n| Net Income (Loss) Attributable to Common Stockholders | $ | 224,584 | $ | 184,608 | $ | 338,235 | $ | 963,619 |\n| Net Income (Loss) Per Share of Common Stock |\n| Basic | $ | 0.54 | $ | 0.54 | $ | 0.83 | $ | 2.87 |\n| Diluted | $ | 0.54 | $ | 0.54 | $ | 0.83 | $ | 2.86 |\n| Weighted Average Number of Shares of Common Stock Outstanding |\n| Basic | 415,520,780 | 340,044,440 | 406,521,273 | 335,615,566 |\n| Diluted | 415,588,238 | 340,868,403 | 406,671,972 | 337,078,824 |\n| Dividends Declared per Share of Common Stock | $ | 0.50 | $ | 0.50 | $ | 1.50 | $ | 1.50 |\n\nSee notes to condensed consolidated financial statements.\n3\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\n| CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED) |\n| (dollars in thousands) |\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Comprehensive income (loss), net of tax |\n| Net (loss) income | $ | 244,660 | $ | 195,477 | $ | 375,552 | $ | 995,677 |\n| Other comprehensive income (loss) |\n| Net unrealized gain (loss) on securities | 109,668 | ( 22,445 | ) | 469,183 | 14,600 |\n| Reclassification of net realized (gain) loss on securities into earnings | ( 89,436 | ) | 32,626 | ( 179,280 | ) | 89,885 |\n| 20,232 | 10,181 | 289,903 | 104,485 |\n| Total comprehensive income | $ | 264,892 | $ | 205,658 | $ | 665,455 | $ | 1,100,162 |\n| Comprehensive income attributable to noncontrolling interests | $ | 14,738 | $ | 10,869 | $ | 31,979 | $ | 32,058 |\n| Dividends on preferred stock | $ | 5,338 | $ | — | $ | 5,338 | $ | — |\n| Comprehensive income attributable to common stockholders | $ | 244,816 | $ | 194,789 | $ | 628,138 | $ | 1,068,104 |\n\nSee notes to condensed consolidated financial statements.\n4\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (UNAUDITED)\nFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2019 AND 2018\n| (dollars in thousands) |\n\n| Common Stock |\n| Preferred Stock | Shares | Amount | Additional Paid-in Capital | Retained Earnings | Accumulated Other Comprehensive Income | Total New Residential Stockholders’ Equity | Noncontrolling Interests in Equity of Consolidated Subsidiaries | Total Equity |\n| Equity - December 31, 2018 | $ | — | 369,104,429 | $ | 3,692 | $ | 4,746,242 | $ | 830,713 | $ | 417,023 | $ | 5,997,670 | $ | 90,625 | $ | 6,088,295 |\n| Dividends declared on common stock | — | — | — | — | ( 623,235 | ) | — | ( 623,235 | ) | — | ( 623,235 | ) |\n| Dividends declared on preferred stock | — | — | — | — | ( 5,338 | ) | — | ( 5,338 | ) | — | ( 5,338 | ) |\n| Capital contributions | — | — | — | — | — | — | — | — | — |\n| Capital distributions | — | — | — | — | — | — | — | ( 38,952 | ) | ( 38,952 | ) |\n| Issuance of common stock | — | 46,000,000 | 460 | 750,933 | — | — | 751,393 | — | 751,393 |\n| Issuance of preferred stock | 423,444 | — | — | — | — | — | 423,444 | — | 423,444 |\n| Option exercise | — | 348,613 | 3 | ( 3 | ) | — | — | — | — | — |\n| Purchase of noncontrolling interests in the Buyer | — | — | — | — | — | — | — | — | — |\n| Other dilution | — | — | — | — | — | — | — | — | — |\n| Director share grants | — | 67,738 | 1 | 1,054 | — | — | 1,055 | — | 1,055 |\n| Comprehensive income (loss) |\n| Net income (loss) | — | — | — | — | 343,573 | — | 343,573 | 31,979 | 375,552 |\n| Net unrealized gain (loss) on securities | — | — | — | — | — | 469,183 | 469,183 | — | 469,183 |\n| Reclassification of net realized (gain) loss on securities into earnings | — | — | — | — | — | ( 179,280 | ) | ( 179,280 | ) | — | ( 179,280 | ) |\n| Total comprehensive income (loss) | 633,476 | 31,979 | 665,455 |\n| Equity - September 30, 2019 | $ | 423,444 | 415,520,780 | $ | 4,156 | $ | 5,498,226 | $ | 545,713 | $ | 706,926 | $ | 7,178,465 | $ | 83,652 | $ | 7,262,117 |\n\n5\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (UNAUDITED), CONTINUED\nFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2019 AND 2018\n| (dollars in thousands) |\n\n| Common Stock |\n| Shares | Amount | Additional Paid-in Capital | Retained Earnings | Accumulated Other Comprehensive Income | Total New Residential Stockholders’ Equity | Noncontrolling Interests in Equity of Consolidated Subsidiaries | Total Equity |\n| Equity - December 31, 2017 | 307,361,309 | $ | 3,074 | $ | 3,763,188 | $ | 559,476 | $ | 364,467 | $ | 4,690,205 | $ | 105,957 | $ | 4,796,162 |\n| Dividends declared on common stock | — | — | — | ( 508,176 | ) | — | ( 508,176 | ) | — | ( 508,176 | ) |\n| Capital contributions | — | — | — | — | — | — | — | — |\n| Capital distributions | — | — | — | — | — | — | ( 51,735 | ) | ( 51,735 | ) |\n| Issuance of common stock | 29,241,659 | 292 | 491,312 | — | — | 491,604 | — | 491,604 |\n| Option exercise | 3,694,228 | 37 | ( 37 | ) | — | — | — | — | — |\n| Other dilution | — | — | ( 63 | ) | — | — | ( 63 | ) | — | ( 63 | ) |\n| Purchase of Noncontrolling Interests | — | — | 627 | — | — | 627 | 7,448 | 8,075 |\n| Director share grants | 57,233 | 1 | 1,018 | — | — | 1,019 | — | 1,019 |\n| Comprehensive income (loss) |\n| Net income (loss) | — | — | — | 963,619 | — | 963,619 | 32,058 | 995,677 |\n| Net unrealized gain (loss) on securities | — | — | — | — | 14,600 | 14,600 | — | 14,600 |\n| Reclassification of net realized (gain) loss on securities into earnings | — | — | — | — | 89,885 | 89,885 | — | 89,885 |\n| Total comprehensive income (loss) | 1,068,104 | 32,058 | 1,100,162 |\n| Equity - September 30, 2018 | 340,354,429 | $ | 3,404 | $ | 4,256,045 | $ | 1,014,919 | $ | 468,952 | $ | 5,743,320 | $ | 93,728 | $ | 5,837,048 |\n\nSee notes to condensed consolidated financial statements.\n6\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\n| CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) |\n| (dollars in thousands) |\n\n| Nine Months Ended September 30, |\n| 2019 | 2018 |\n| Cash Flows From Operating Activities |\n| Net income | $ | 375,552 | $ | 995,677 |\n| Adjustments to reconcile net income to net cash provided by (used in) operating activities: |\n| Change in fair value of investments in excess mortgage servicing rights | 1,421 | 55,711 |\n| Change in fair value of investments in excess mortgage servicing rights, equity method investees | ( 4,087 | ) | ( 5,624 | ) |\n| Change in fair value of investments in mortgage servicing rights financing receivables | 133,200 | ( 63,628 | ) |\n| Change in fair value of servicer advance investments | ( 15,932 | ) | 86,581 |\n| Change in fair value of residential mortgage loans, at fair value, and notes and bonds payable, at fair value | ( 85,303 | ) | 1,462 |\n| (Gain) / loss on settlement of investments (net) | ( 157,013 | ) | ( 106,064 | ) |\n| (Gain) / loss on sale of originated mortgage loans (net) | ( 194,029 | ) | ( 45,732 | ) |\n| Earnings from investments in consumer loans, equity method investees | 890 | ( 12,343 | ) |\n| Change in fair value of derivative instruments | 1,988 | ( 27,985 | ) |\n| Changes in fair value of contingent consideration | 7,430 | — |\n| Unrealized (gain) / loss on other ABS | ( 9,010 | ) | ( 12,001 | ) |\n| (Gain) / loss on transfer of loans to REO | ( 7,814 | ) | ( 16,609 | ) |\n| (Gain) / loss on transfer of loans to other assets | 378 | 1,648 |\n| (Gain) / loss on Excess MSR recapture agreements | ( 1,771 | ) | ( 5,257 | ) |\n| (Gain) / loss on Ocwen common stock | ( 3,134 | ) | ( 4,655 | ) |\n| Accretion and other amortization | ( 298,933 | ) | ( 528,981 | ) |\n| Other-than-temporary impairment | 21,942 | 23,190 |\n| Valuation and loss provision on loans and real estate owned | 8,042 | 28,136 |\n| Non-cash portions of servicing revenue, net | 619,914 | ( 35,118 | ) |\n| Non-cash directors’ compensation | 1,055 | 1,019 |\n| Deferred tax provision | 18,080 | ( 12,680 | ) |\n| Changes in: |\n| Servicer advances receivable | 366,426 | 441,351 |\n| Other assets | ( 516,107 | ) | ( 168,862 | ) |\n| Due to affiliates | ( 41,920 | ) | ( 14,826 | ) |\n| Accrued expenses and other liabilities | 263,420 | 161,246 |\n| Other operating cash flows: |\n| Interest received from excess mortgage servicing rights | 19,180 | 33,521 |\n| Interest received from servicer advance investments | 22,212 | 25,901 |\n| Interest received from Non-Agency RMBS | 203,309 | 156,420 |\n| Interest received from PCD residential mortgage loans, held-for-investment | 6,697 | 6,656 |\n| Interest received from PCD consumer loans, held-for-investment | 23,789 | 27,681 |\n| Distributions of earnings from excess mortgage servicing rights, equity method investees | 7,762 | 7,976 |\n| Distributions of earnings from consumer loan equity method investees | 1,178 | 6,176 |\n| Purchases of residential mortgage loans, held-for-sale | ( 6,002,975 | ) | ( 3,295,378 | ) |\n| Origination of residential mortgage loans, held-for-sale | ( 10,424,325 | ) | ( 1,678,606 | ) |\n| Proceeds from sales of purchased and originated residential mortgage loans, held-for-sale | 13,046,546 | 3,752,066 |\n| Principal repayments from purchased residential mortgage loans, held-for-sale | 295,584 | 146,170 |\n| Net cash provided by (used in) operating activities | ( 2,316,358 | ) | ( 75,761 | ) |\n\nContinued on next page.\n7\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\n| CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED), CONTINUED |\n| (dollars in thousands) |\n\n| Nine Months Ended September 30, |\n| 2019 | 2018 |\n| Cash Flows From Investing Activities |\n| Acquisition of Shellpoint, net of cash required | — | ( 118,285 | ) |\n| Purchase of servicer advance investments | ( 1,255,306 | ) | ( 1,790,635 | ) |\n| Purchase of MSRs, MSR financing receivables and servicer advances receivable | ( 1,365,333 | ) | ( 971,079 | ) |\n| Purchase of Agency RMBS | ( 25,212,307 | ) | ( 6,574,783 | ) |\n| Purchase of Non-Agency RMBS | ( 689,308 | ) | ( 2,714,991 | ) |\n| Purchase of residential mortgage loans | — | ( 85,778 | ) |\n| Purchase of real estate owned and other assets | ( 44,539 | ) | ( 26,807 | ) |\n| Purchase of investment in consumer loans, equity method investees | ( 63,969 | ) | ( 292,616 | ) |\n| Draws on revolving consumer loans | ( 42,231 | ) | ( 45,017 | ) |\n| Payments for settlement of derivatives | ( 283,037 | ) | ( 59,113 | ) |\n| Return of investments in excess mortgage servicing rights | 43,938 | 43,690 |\n| Return of investments in excess mortgage servicing rights, equity method investees | 12,030 | 14,474 |\n| Return of investments in consumer loans, equity method investees | 55,848 | 279,669 |\n| Principal repayments from servicer advance investments | 1,402,187 | 1,845,411 |\n| Principal repayments from Agency RMBS | 987,523 | 76,515 |\n| Principal repayments from Non-Agency RMBS | 996,396 | 565,460 |\n| Principal repayments from residential mortgage loans | 83,483 | 110,770 |\n| Proceeds from sale of residential mortgage loans | 41,308 | 21,278 |\n| Principal repayments from consumer loans | 203,607 | 237,129 |\n| Principal repayments from MSRs and MSR financing receivables | 21,306 | — |\n| Proceeds from sale of mortgage servicing rights | 1,047 | — |\n| Proceeds from sale of mortgage servicing rights financing receivables | 15,575 | — |\n| Proceeds from sale of excess mortgage servicing rights | 114 | — |\n| Proceeds from sale of Agency RMBS | 17,998,736 | 4,121,325 |\n| Proceeds from sale of Non-Agency RMBS | 1,664,017 | 81,325 |\n| Proceeds from settlement of derivatives | 74,724 | 146,146 |\n| Proceeds from sale of real estate owned | 103,258 | 111,459 |\n| Net cash provided by (used in) investing activities | ( 5,250,933 | ) | ( 5,024,453 | ) |\n\nContinued on next page.\n8\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\n| CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED), CONTINUED |\n| (dollars in thousands) |\n\n| Nine Months Ended September 30, |\n| 2019 | 2018 |\n| Cash Flows From Financing Activities |\n| Repayments of repurchase agreements | ( 144,545,608 | ) | ( 58,414,966 | ) |\n| Margin deposits under repurchase agreements and derivatives | ( 2,913,627 | ) | ( 1,374,374 | ) |\n| Repayments of notes and bonds payable | ( 7,306,541 | ) | ( 7,512,484 | ) |\n| Payment of deferred financing fees | ( 7,821 | ) | ( 12,838 | ) |\n| Common stock dividends paid | ( 600,027 | ) | ( 491,680 | ) |\n| Borrowings under repurchase agreements | 152,101,817 | 63,696,426 |\n| Return of margin deposits under repurchase agreements and derivatives | 2,589,160 | 1,263,220 |\n| Borrowings under notes and bonds payable | 7,600,342 | 7,547,541 |\n| Issuance of preferred stock | 423,444 | — |\n| Issuance of common stock | 752,217 | 492,285 |\n| Costs related to issuance of common stock | ( 824 | ) | ( 681 | ) |\n| Noncontrolling interest in equity of consolidated subsidiaries - contributions | — | — |\n| Noncontrolling interest in equity of consolidated subsidiaries - distributions | ( 38,952 | ) | ( 51,735 | ) |\n| Purchase of noncontrolling interests | — | ( 653 | ) |\n| Net cash provided by (used in) financing activities | 8,053,580 | 5,140,061 |\n| Net Increase (Decrease) in Cash, Cash Equivalents, and Restricted Cash | 486,289 | 39,847 |\n| Cash, Cash Equivalents, and Restricted Cash, Beginning of Period | 415,078 | 446,050 |\n| Cash, Cash Equivalents, and Restricted Cash, End of Period | $ | 901,367 | $ | 485,897 |\n| Supplemental Disclosure of Cash Flow Information |\n| Cash paid during the period for interest | $ | 643,349 | $ | 405,672 |\n| Cash paid during the period for income taxes | 1,208 | 3,176 |\n| Supplemental Schedule of Non-Cash Investing and Financing Activities |\n| Dividends declared but not paid | $ | 213,098 | $ | 170,177 |\n| Purchase of Agency and Non-Agency RMBS, settled after quarter end | 2,536,188 | 1,791,191 |\n| Sale of investments, primarily Agency RMBS, settled after quarter end | 4,487,772 | 3,424,865 |\n| Transfer from residential mortgage loans to real estate owned and other assets | 70,080 | 88,376 |\n| Transfer from residential mortgage loans, held-for-investment to residential mortgage loans, held-for-sale | 38,842 | — |\n| Non-cash distributions from LoanCo | 21,314 | 25,739 |\n| MSR purchase price holdback | 1,963 | 8,692 |\n| Shellpoint Acquisition purchase price holdback | — | 10,173 |\n| Shellpoint Acquisition contingent consideration | — | 42,770 |\n| Real estate securities retained from loan securitizations | 454,310 | 762,056 |\n| Residential mortgage loans subject to repurchase | 168,532 | 110,181 |\n| Ocwen transaction (Note 5) - excess mortgage servicing rights | — | 638,567 |\n| Ocwen transaction (Note 5) - servicer advance investments | — | 3,175,891 |\n| Ocwen transaction (Note 5) - mortgage servicing rights financing receivables, at fair value | — | 1,017,993 |\n\nSee notes to condensed consolidated financial statements.\n9\nNEW RESIDENTIAL INVESTMENT CORP. AND SUBSIDIARIES\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| 1. | ORGANIZATION AND BASIS OF PRESENTATION |\n\nNew Residential Investment Corp. (together with its subsidiaries, “New Residential”) is a Delaware corporation that was formed as a limited liability company in September 2011 for the purpose of making real estate related investments and commenced operations on December 8, 2011. New Residential is an independent publicly traded real estate investment trust (“REIT”) primarily focused on investing in residential mortgage related assets. New Residential is listed on the New York Stock Exchange (“NYSE”) under the symbol “NRZ.”\nNew Residential has elected and intends to qualify to be taxed as a REIT for U.S. federal income tax purposes. As such, New Residential will generally not be subject to U.S. federal corporate income tax on that portion of its net income that is distributed to stockholders if it distributes at least 90% of its REIT taxable income to its stockholders by prescribed dates and complies with various other requirements. See Note 17 regarding New Residential’s taxable REIT subsidiaries.\nNew Residential, through its wholly-owned subsidiaries New Residential Mortgage LLC (“NRM”) and NewRez LLC (“NewRez”), is licensed or otherwise eligible to service residential mortgage loans in all states within the United States and the District of Columbia. NRM and NewRez perform servicing on behalf of investors, including the Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”) (collectively, Government Sponsored Enterprises or “GSEs”) and Government National Mortgage Association (“Ginnie Mae”), and on behalf of other servicers (subservicing).\nNewRez originates, sells and securitizes conventional (conforming to the underwriting standards of Fannie Mae or Freddie Mac; collectively referred to as “Agency” loans), government-insured (Federal Housing Administration (“FHA”) and Department of Veterans Affairs (“VA”)) and non-qualified (“Non-QM”) residential mortgage loans. The GSEs or Ginnie Mae guarantee securitizations completed under their applicable policies and guidelines. New Residential generally retains the right to service the underlying residential mortgage loans sold and securitized by NRM and NewRez. NRM and NewRez are required to conduct aspects of their operations in accordance with applicable policies and guidelines published by FHA, Fannie Mae and Freddie Mac in order to maintain those approvals.\nNew Residential has entered into a management agreement (the “Management Agreement”) with FIG LLC (the “Manager”), an affiliate of Fortress Investment Group LLC (“Fortress”), pursuant to which the Manager provides a management team and other professionals who are responsible for implementing New Residential’s business strategy, subject to the supervision of New Residential’s board of directors. For its services, the Manager is entitled to management fees and incentive compensation, both defined in, and in accordance with the terms of, the Management Agreement.\nAs of September 30, 2019, New Residential conducted its business through the following segments: (i) Servicing and Originations, (ii) Residential Securities and Loans, (iii) Consumer Loans and (iv) Corporate.\nApproximately 2.4 million shares of New Residential’s common stock were held by Fortress, through its affiliates, as of September 30, 2019. In addition, Fortress, through its affiliates, held options relating to approximately 10.5 million shares of New Residential’s common stock as of September 30, 2019.\nInterim Financial Statements\nThe accompanying condensed consolidated financial statements and related notes of New Residential have been prepared in accordance with accounting principles generally accepted in the United States for interim financial reporting and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, certain information and note disclosures normally included in financial statements prepared under U.S. generally accepted accounting principles have been condensed or omitted. In the opinion of management, all adjustments considered necessary for a fair presentation of New Residential’s financial position, results of operations and cash flows have been included and are of a normal and recurring nature. The operating results presented for interim periods are not necessarily indicative of the results that may be expected for any other interim period or for the entire year. These condensed consolidated financial statements should be read in conjunction with New Residential’s consolidated financial statements for the year ended December 31, 2018 and notes thereto included in New Residential’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (the “SEC”). Capitalized terms used herein, and not otherwise defined, are defined in\n10\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nNew Residential’s consolidated financial statements for the year ended December 31, 2018. Certain prior period amounts have been reclassified to conform to the current period’s presentation.\nRecent Accounting Pronouncements\nIn January 2016, the FASB issued ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10) - Recognition and Measurement of Financial Assets and Financial Liabilities. The standard: (i) requires that certain equity investments be measured at fair value, and modifies the assessment of impairment for certain other equity investments, (ii) changes certain disclosure requirements related to the fair value of financial instruments measured at amortized cost, (iii) changes certain disclosure requirements related to liabilities measured at fair value, (iv) requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset, and (v) clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets. ASU No. 2016-01 was effective for New Residential in the first quarter of 2018. The adoption of ASU No. 2016-01 did not have a material impact on the condensed consolidated financial statements.\nIn February 2016, the FASB issued ASU No. 2016-02, Leases. The standard requires that lessees recognize a right-of-use asset and corresponding lease liability on the balance sheet for most leases. The guidance applied by a lessor under ASU No. 2016-02 is substantially similar to existing GAAP. ASU No. 2016-02 was effective for New Residential in the first quarter of 2019. An entity should apply ASU No. 2016-02 by means of a modified retrospective transition method for all leases existing at, or entered into after, the date of initial application. The adoption of ASU No. 2016-02 did not have a material impact on the condensed consolidated financial statements (see Notes 2 and 14 for details).\nIn June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326) - Measurement of Credit Losses on Financial Instruments. The standard requires that a financial asset measured at amortized cost basis be presented at the net amount expected to be collected, net of an allowance for all expected (rather than incurred) credit losses. The measurement of expected credit losses is based on relevant information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectibility of the reported amount. The standard also changes the accounting for purchased credit deteriorated assets and available-for-sale securities, which will require the recognition of credit losses through a valuation allowance when fair value is less than amortized cost, regardless of whether the impairment is considered to be other-than-temporary. ASU No. 2016-13 is effective for New Residential in the first quarter of 2020. Early adoption is permitted beginning in 2019. An entity should apply ASU No. 2016-13 by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. New Residential is currently evaluating the new guidance to determine the impact it may have on its condensed consolidated financial statements. New Residential plans to elect the fair value option on Residential mortgage loans, held-for-investment and Consumer loans, held-for-investment.\nIn January 2017, the FASB issued ASU No. 2017-04, Simplifying the Test for Goodwill Impairment (Topic 805). The standard simplifies the accounting for goodwill impairment for all entities by requiring impairment charges to be based on the first step in the current two-step impairment test. Under the new guidance, an impairment charge, if triggered, is calculated as the difference between a reporting unit’s carrying value and fair value, but it is limited to the carrying value of goodwill. ASU No. 2017-04 is effective for New Residential in the first quarter of 2020 and early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The adoption of ASU No. 2017-04 is not expected to have a material impact on the condensed consolidated financial statements.\nIn August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (Topic 820). The standard: (i) adds incremental requirements for entities to disclose (a) the amount of total gains or losses for the period recognized in other comprehensive income that is attributable to fair value changes in assets and liabilities held as of the balance sheet date and categorized within Level 3 of the fair value hierarchy, (b) the range and weighted average used to develop significant unobservable inputs and (c) how the weighted average was calculated for fair value measurements categorized within Level 3 of the fair value hierarchy and (ii) eliminates disclosure requirements for (a) transfers between Level 1 and Level 2 and (b) valuation processes for Level 3 fair value measurements. ASU No. 2018-13 is effective for New Residential in the first quarter of 2020. The adoption of ASU No. 2018-13 is not expected to have a material impact on the condensed consolidated financial statements.\n11\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nAcquisition of Shellpoint Partners LLC\nOn November 29, 2017, NRM Acquisition LLC (the “Shellpoint Purchaser”), a Delaware limited liability company and a wholly owned subsidiary of New Residential, entered into a Securities Purchase Agreement (the “Shellpoint SPA”) to acquire Shellpoint Partners LLC, a Delaware limited liability company (“Shellpoint”).\nOn July 3, 2018, the Shellpoint Purchaser acquired 100 % of the outstanding equity interests of Shellpoint for a cash purchase price of $ 212.3 million (the “Shellpoint Acquisition”). As additional consideration for the Shellpoint Acquisition, the Shellpoint Purchaser may make up to three cash earnout payments, which will be calculated following each of the first three anniversaries of the Shellpoint closing as a percentage of the amount by which the pre-tax income of certain of Shellpoint’s businesses exceeds certain specified thresholds, up to an aggregate maximum amount of $ 60.0 million (the “Shellpoint Earnout Payments”). The Shellpoint Earnout Payments are classified as contingent consideration recorded at fair value at the acquisition date and included in the total consideration transferred for the Shellpoint Acquisition. The contingent consideration is subsequently measured at fair value on a quarterly basis with changes in fair value recorded in other income.\nShellpoint is a vertically integrated mortgage platform with established origination and servicing capabilities and provides New Residential with in-house servicing, asset origination and recapture capabilities. The results of Shellpoint’s operations have been included in the Company’s condensed consolidated statements of income for the nine months ended September 30, 2019 and represent $ 444.8 million and $ 97.2 million of revenue and net income, respectively.\nThe acquisition date fair value of the consideration transferred includes $ 212.3 million in cash consideration, $ 39.3 million in contingent consideration and $ 173.9 million in effective settlement of preexisting relationships. The total consideration is summarized as follows:\n| Total Consideration (in millions) | Amount |\n| Cash Consideration | $ | 212.3 |\n| Earnout Payment(A) | 39.3 |\n| Effective Settlement of Preexisting Relationships(B) | 173.9 |\n| Total Consideration | $ | 425.5 |\n\n| (A) | The range of outcomes for this contingent consideration is from $ 0 to $ 60.0 million, dependent on the performance of Shellpoint. New Residential derived a fair value of the remaining contingent consideration payment in three years of $ 39.3 million. This amount excludes contingent payments to the long-term employee incentive plans that require continuing employment and are recognized as compensation expense within General and Administrative expenses in the post-acquisition consolidated financial statements separate from New Residential’s acquisition of assets and assumption of liabilities in the business combination. On September 5, 2019, New Residential paid $ 10.0 million as the first of three potential earnout payments. As of September 30, 2019, the contingent consideration had a fair value of $ 38.3 million. |\n\n| (B) | Represents the effective settlement of preexisting relationships between New Residential and Shellpoint including 1) MSR acquisitions, 2) a note payable and 3) operating accounts receivable and payable existing prior to the acquisition date. The effective settlement of these preexisting relationships had no impact to New Residential’s condensed consolidated statements of income. |\n\n12\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nNew Residential has performed an allocation of the total consideration of $ 425.5 million to Shellpoint’s assets and liabilities, as set forth below. The final amount and allocation of total consideration reflects certain measurement period adjustments identified during the fourth quarter of 2018, including the effect on earnings that would have been recorded during the third quarter of 2018 had the accounting been completed at the acquisition date. Such measurement period adjustments included 1) a decrease of $ 3.5 million in the amount of contingent consideration based upon finalization of the internal valuation 2) a decrease of $ 6.4 million to consideration transferred for the effective settlement of existing relationships 3) an increase of $ 14.1 million to the fair value of identifiable intangible assets based upon receipt of the final valuation report from a third-party valuation firm and 4) an increase of $ 0.3 million to other assets due to a decrease in the fair value discount on certain servicing advance receivables. These measurement period adjustments resulted in a corresponding decrease to goodwill in the amount of $ 24.3 million.\n| Total Consideration ($ in millions) | $ | 425.5 |\n| Assets |\n| Cash and cash equivalents | $ | 79.2 |\n| Restricted cash | 9.9 |\n| Residential mortgage loans, held-for-sale, at fair value | 488.2 |\n| Mortgage servicing rights, at fair value(A) | 286.6 |\n| Residential mortgage loans, held-for-investment, at fair value | 125.3 |\n| Residential mortgage loans subject to repurchase | 121.4 |\n| Intangible assets(B) | 18.4 |\n| Other assets | 81.5 |\n| Total Assets Acquired | $ | 1,210.5 |\n| Liabilities |\n| Repurchase agreements | $ | 439.6 |\n| Notes and bonds payable | 20.7 |\n| Mortgage-backed securities issued, at fair value | 120.7 |\n| Residential mortgage loans repurchase liability | 121.4 |\n| Excess spread financing, at fair value | 48.3 |\n| Accrued expenses and other liabilities | 50.6 |\n| Total Liabilities Assumed | $ | 801.3 |\n| Noncontrolling Interest | $ | 8.3 |\n| Net Assets | $ | 400.9 |\n| Goodwill | $ | 24.6 |\n\n| (A) | Includes $ 135.3 million of Ginnie Mae MSRs where New Residential acquired the rights to the economic value of the servicing rights from Shellpoint prior to the acquisition date. |\n\n| (B) | Includes intangible assets in the form of mortgage origination and servicing licenses, internally developed software and a tradename. New Residential determined that mortgage origination and servicing licenses have an indefinite useful life and will be evaluated for impairment given no legal, regulatory, contractual, competitive or economic factors that would limit the useful life. Internally developed software will be amortized over a finite useful life of five years and tradenames were fully amortized over six months , respectively, based on the expected software development timeline and New Residential’s determination of the time to change a tradename with limited value. |\n\nThe goodwill of $ 24.6 million primarily includes the synergies and benefits expected to result from combining operations with Shellpoint and adding in-house servicing, asset origination and recapture capabilities. The full amount of goodwill for tax purposes of $ 24.6 million is expected to be deductible. New Residential will assess the goodwill annually on October 1 and in interim periods in case of events or circumstances make it more likely than not that an impairment may have occurred. Based on New Residential’s assessment performed, there were no indicators of impairment as of September 30, 2019.\n13\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nCertain transactions were recognized separately from New Residential’s acquisition of assets and assumption of liabilities in the business combination. These separately recognized transactions include 1) contingent payments to Shellpoint’s employees and 2) effective settlement of preexisting relationships discussed above.\nUnaudited Supplemental Pro Forma Financial Information — The following table presents unaudited pro forma combined Servicing and Originations Revenue, which is comprised of 1) servicing revenue, net and 2) gain on sale of originated mortgage loans, net, and Income Before Income Taxes for the three and nine months ended September 30, 2019 and 2018 prepared as if the Shellpoint Acquisition had been consummated on January 1, 2018.\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Pro Forma |\n| Servicing and Originations Revenue | $ | 153,591 | $ | 221,087 | $ | 327,395 | $ | 733,901 |\n| Income Before Income Taxes | 239,220 | 199,040 | 394,532 | 1,003,378 |\n\nThe unaudited supplemental pro forma financial information has not been adjusted for transactions other than the Shellpoint Acquisition, or for the conforming of accounting policies. The unaudited supplemental pro forma financial information does not include any anticipated synergies or other anticipated benefits of the Shellpoint Acquisition and, accordingly, the unaudited supplemental pro forma financial information is not necessarily indicative of either future results of operations or results that might have been achieved had the Shellpoint Acquisition occurred on January 1, 2018.\n| 2. | OTHER INCOME, GENERAL AND ADMINISTRATIVE, OTHER ASSETS AND LIABILITIES |\n\nGain (loss) on settlement of investments, net is comprised of the following:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Gain (loss) on sale of real estate securities, net | $ | 95,003 | $ | ( 28,737 | ) | $ | 201,222 | $ | ( 66,695 | ) |\n| Gain (loss) on sale of acquired residential mortgage loans, net | 43,648 | 4,065 | 53,405 | ( 1,358 | ) |\n| Gain (loss) on settlement of derivatives | ( 14,147 | ) | 19,459 | ( 152,424 | ) | 76,092 |\n| Gain (loss) on liquidated residential mortgage loans | ( 198 | ) | ( 1,113 | ) | ( 3,320 | ) | ( 2,267 | ) |\n| Gain (loss) on sale of REO | ( 3,169 | ) | ( 4,971 | ) | ( 9,445 | ) | ( 12,114 | ) |\n| Gains on settlement of investments in excess MSRs and servicer advance investments | — | — | — | 113,002 |\n| Gain (loss) on sale or securitization of originated mortgage loans(A) | 21,611 | — | 62,399 | — |\n| Other gains (losses) | 12,004 | ( 596 | ) | 5,176 | ( 596 | ) |\n| $ | 154,752 | $ | ( 11,893 | ) | $ | 157,013 | $ | 106,064 |\n\n| (A) | Represents gains on securitizations of Non-QM residential mortgage loans originated by NewRez. |\n\n14\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nOther income (loss), net, is comprised of the following:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Unrealized gain (loss) on other ABS | $ | ( 5,054 | ) | $ | 7,197 | $ | 9,010 | $ | 12,001 |\n| Unrealized gain (loss) on notes and bonds payable | ( 2,647 | ) | 900 | ( 5,248 | ) | 900 |\n| Unrealized gain (loss) on contingent consideration | ( 2,703 | ) | — | ( 7,430 | ) | — |\n| Gain (loss) on transfer of loans to REO | 1,230 | 6,119 | 7,814 | 16,609 |\n| Gain (loss) on transfer of loans to other assets | ( 101 | ) | ( 1,528 | ) | ( 378 | ) | ( 1,648 | ) |\n| Gain (loss) on Excess MSR recapture agreements | 529 | 987 | 1,771 | 5,257 |\n| Gain (loss) on Ocwen common stock | ( 1,103 | ) | ( 145 | ) | 3,134 | 4,655 |\n| Other income (loss) | ( 25,370 | ) | ( 19,390 | ) | ( 25,124 | ) | ( 27,359 | ) |\n| $ | ( 35,219 | ) | $ | ( 5,860 | ) | $ | ( 16,451 | ) | $ | 10,415 |\n\nGeneral and Administrative Expenses is comprised of the following:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Compensation and benefits expense, servicing | $ | 30,494 | $ | 22,498 | $ | 87,219 | $ | 22,498 |\n| Compensation and benefits expense, origination | 44,270 | 32,822 | 112,977 | 32,822 |\n| Legal and professional expense | 16,442 | 11,749 | 46,352 | 35,378 |\n| Loan origination expense | 17,882 | 7,801 | 42,349 | 7,801 |\n| Occupancy expense | 5,114 | 4,394 | 14,079 | 4,394 |\n| Other(A) | 19,311 | 19,323 | 48,383 | 36,276 |\n| $ | 133,513 | $ | 98,587 | $ | 351,359 | $ | 139,169 |\n\n| (A) | Represents miscellaneous general and administrative expenses. |\n\n15\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nOther assets and liabilities are comprised of the following:\n| Other Assets | Accrued Expenses and Other Liabilities |\n| September 30, 2019 | December 31, 2018 | September 30, 2019 | December 31, 2018 |\n| Margin receivable, net(A) | $ | 409,526 | $ | 145,857 | MSR purchase price holdback | $ | 102,556 | $ | 100,593 |\n| Servicing fee receivables | 144,550 | 105,563 | Accounts payable | 89,372 | 75,591 |\n| Due from servicers | 171,916 | 95,261 | Derivative liabilities (Note 10) | 1,842 | 29,389 |\n| Principal and interest receivable | 98,067 | 76,015 | Interest payable | 80,892 | 49,352 |\n| Equity investments(B) | 117,375 | 74,323 | Due to servicers | 144,156 | 95,419 |\n| Ditech deposit | 70,000 | — | Residential mortgage loan repurchase liability | 168,532 | 121,602 |\n| Other receivables | 103,933 | 23,723 | Due to affiliates | 59,551 | 101,471 |\n| Real Estate Owned | 105,968 | 113,410 | Contingent Consideration | 52,761 | 40,842 |\n| Residential mortgage loans subject to repurchase | 168,532 | 121,602 | Excess spread financing, at fair value | 30,377 | 39,304 |\n| Consumer loans, equity method investees (Note 9) | 23,033 | 38,294 | Operating lease liability | 24,532 | — |\n| Goodwill(C) | 41,986 | 24,645 | Reserve for sales recourse | 9,173 | 5,880 |\n| Receivable from government agency(D) | 20,505 | 20,795 | Other liabilities | 56,547 | 54,140 |\n| Intangible assets | 19,346 | 18,708 | $ | 820,291 | $ | 713,583 |\n| Prepaid expenses | 33,120 | 29,165 |\n| Operating lease right-of-use asset | 18,773 | — |\n| Derivative assets (Note 10) | 36,712 | 10,893 |\n| Ocwen common stock, at fair value | 10,912 | 7,778 |\n| Other assets | 130,265 | 55,682 |\n| $ | 1,724,519 | $ | 961,714 |\n\n| (A) | Represents collateral posted primarily as a result of changes in fair value of our 1) real estate securities securing our repurchase agreements and 2) derivative instruments. |\n\n| (B) | Represents equity investments in funds that invest in 1) a commercial redevelopment project and 2) operating companies in the single family housing industry. The indirect investments are accounted for at fair value based on the net asset value (“NAV”) of New Residential’s investment and as an equity method investment, respectively. |\n\n| (C) | Includes goodwill derived from the Shellpoint Acquisition (see Note 1 for details) and the Company’s acquisition of Guardian Asset Management, a leading national provider of field services and property management to government agencies, financial institutions and asset management firms. |\n\n| (D) | Represents claims receivable from the FHA on EBO and reverse mortgage loans for which foreclosure has been completed and for which New Residential has made or intends to make a claim on the FHA guarantee. |\n\n16\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nAs reflected on the Condensed Consolidated Statements of Cash Flows, accretion and other amortization is comprised of the following:\n| Nine Months Ended September 30, |\n| 2019 | 2018 |\n| Accretion of net discount on securities and loans(A) | $ | 266,467 | $ | 296,961 |\n| Accretion of servicer advances receivable discount and servicer advance investments | 18,290 | 207,428 |\n| Accretion of excess mortgage servicing rights income | 18,203 | 32,371 |\n| Amortization of deferred financing costs | ( 2,984 | ) | ( 6,180 | ) |\n| Amortization of discount on notes and bonds payable | ( 1,043 | ) | ( 1,599 | ) |\n| $ | 298,933 | $ | 528,981 |\n\n| (A) | Includes accretion of the accretable yield on PCD loans. |\n\n| 3. | SEGMENT REPORTING |\n\nNew Residential conducts its business through the following segments: (i) Servicing and Originations, (ii) Residential Securities and Loans, (iii) Consumer Loans and (iv) Corporate. The corporate segment consists primarily of (i) general and administrative expenses, (ii) the management fees and incentive compensation related to the Management Agreement and (iii) corporate cash and related interest income. Securities owned by New Residential (Note 7) that are collateralized by servicer advances and consumer loans are included in the Servicing and Originations and Consumer Loans segments, respectively. Secured corporate loans effectively collateralized by Excess MSRs are included in the Servicing and Originations segment.\nDuring the third quarter of 2018, New Residential changed the composition of its reportable segments primarily to reflect the (i) aggregation of the similar MSR, Excess MSR and Servicer Advance segments as the new Servicing and Originations segment and (ii) incorporation of the Shellpoint Acquisition. Segment information for prior periods has been restated to reflect this change.\nSummary financial data on New Residential’s segments is given below, together with a reconciliation to the same data for New Residential as a whole:\n| Residential Securities and Loans |\n| Servicing and Originations | Real Estate Securities | Residential Mortgage Loans | Consumer Loans | Corporate | Total |\n| Three Months Ended September 30, 2019 |\n| Interest income | $ | 135,892 | $ | 184,933 | $ | 86,971 | $ | 40,331 | $ | — | $ | 448,127 |\n| Interest expense | 69,679 | 123,023 | 45,707 | 7,493 | — | 245,902 |\n| Net interest income (expense) | 66,213 | 61,910 | 41,264 | 32,838 | — | 202,225 |\n| Impairment | — | 5,567 | ( 16,553 | ) | 5,863 | — | ( 5,123 | ) |\n| Servicing revenue, net | 53,050 | — | — | — | — | 53,050 |\n| Gain on sale of originated mortgage loans, net | 100,541 | — | — | — | — | 100,541 |\n| Other income (loss) | ( 38,547 | ) | 116,081 | 55,152 | ( 2,651 | ) | ( 1,189 | ) | 128,846 |\n| Operating expenses | 168,100 | 1,839 | 14,006 | 3,965 | 62,655 | 250,565 |\n| Income (Loss) Before Income Taxes | 13,157 | 170,585 | 98,963 | 20,359 | ( 63,844 | ) | 239,220 |\n| Income tax expense (benefit) | 10,749 | — | ( 15,546 | ) | ( 643 | ) | — | ( 5,440 | ) |\n| Net Income (Loss) | $ | 2,408 | $ | 170,585 | $ | 114,509 | $ | 21,002 | $ | ( 63,844 | ) | $ | 244,660 |\n| Noncontrolling interests in income (loss) of consolidated subsidiaries | $ | 4,141 | $ | — | $ | — | $ | 10,597 | $ | — | $ | 14,738 |\n| Dividends on Preferred Stock | $ | — | $ | — | $ | — | $ | — | $ | 5,338 | $ | 5,338 |\n| Net income (loss) attributable to common stockholders | $ | ( 1,733 | ) | $ | 170,585 | $ | 114,509 | $ | 10,405 | $ | ( 69,182 | ) | $ | 224,584 |\n\n17\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| Residential Securities and Loans |\n| Servicing and Originations | Real Estate Securities | Residential Mortgage Loans | Consumer Loans | Corporate | Total |\n| Nine Months Ended September 30, 2019 |\n| Interest income | $ | 396,662 | $ | 557,895 | $ | 219,909 | $ | 128,575 | $ | — | $ | 1,303,041 |\n| Interest expense | 203,940 | 330,992 | 126,288 | 25,518 | — | 686,738 |\n| Net interest income (expense) | 192,722 | 226,903 | 93,621 | 103,057 | — | 616,303 |\n| Impairment | — | 21,942 | ( 16,557 | ) | 24,599 | — | 29,984 |\n| Servicing revenue, net | 133,366 | — | — | — | — | 133,366 |\n| Gain on sale of originated mortgage loans, net | 194,029 | — | — | — | — | 194,029 |\n| Other income (loss) | ( 92,878 | ) | 31,677 | 180,643 | ( 10,324 | ) | 4,515 | 113,633 |\n| Operating expenses | 457,276 | 4,124 | 31,289 | 18,396 | 121,730 | 632,815 |\n| Income (Loss) Before Income Taxes | ( 30,037 | ) | 232,514 | 259,532 | 49,738 | ( 117,215 | ) | 394,532 |\n| Income tax expense (benefit) | 8,474 | — | 11,048 | ( 542 | ) | — | 18,980 |\n| Net Income (Loss) | $ | ( 38,511 | ) | $ | 232,514 | $ | 248,484 | $ | 50,280 | $ | ( 117,215 | ) | $ | 375,552 |\n| Noncontrolling interests in income (loss) of consolidated subsidiaries | $ | 8,873 | $ | — | $ | — | $ | 23,106 | $ | — | $ | 31,979 |\n| Dividends on Preferred Stock | $ | — | $ | — | $ | — | $ | — | $ | 5,338 | $ | 5,338 |\n| Net income (loss) attributable to common stockholders | $ | ( 47,384 | ) | $ | 232,514 | $ | 248,484 | $ | 27,174 | $ | ( 122,553 | ) | $ | 338,235 |\n\n| Residential Securities and Loans |\n| Servicing and Originations | Real Estate Securities | Residential Mortgage Loans | Consumer Loans | Corporate | Total |\n| September 30, 2019 |\n| Investments | $ | 6,374,099 | $ | 16,853,910 | $ | 7,444,405 | $ | 904,216 | $ | — | $ | 31,576,630 |\n| Cash and cash equivalents | 197,607 | 43,604 | 7,281 | 12,091 | 477,636 | 738,219 |\n| Restricted cash | 129,504 | — | — | 33,644 | — | 163,148 |\n| Other assets | 3,378,631 | 4,939,205 | 247,431 | 34,384 | 228,291 | 8,827,942 |\n| Goodwill | 41,986 | — | — | — | — | 41,986 |\n| Total assets | $ | 10,121,827 | $ | 21,836,719 | $ | 7,699,117 | $ | 984,335 | $ | 705,927 | $ | 41,347,925 |\n| Debt | $ | 6,192,811 | $ | 17,196,772 | $ | 6,248,142 | $ | 878,506 | $ | — | $ | 30,516,231 |\n| Other liabilities | 600,622 | 2,608,316 | 68,838 | 14,897 | 276,904 | 3,569,577 |\n| Total liabilities | 6,793,433 | 19,805,088 | 6,316,980 | 893,403 | 276,904 | 34,085,808 |\n| Total equity | 3,328,394 | 2,031,631 | 1,382,137 | 90,932 | 429,023 | 7,262,117 |\n| Noncontrolling interests in equity of consolidated subsidiaries | 61,132 | — | — | 22,520 | — | 83,652 |\n| Total New Residential stockholders’ equity | $ | 3,267,262 | $ | 2,031,631 | $ | 1,382,137 | $ | 68,412 | $ | 429,023 | $ | 7,178,465 |\n| Investments in equity method investees | $ | 249,134 | $ | — | $ | — | $ | 23,033 | $ | — | $ | 272,167 |\n\n18\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| Residential Securities and Loans |\n| Servicing and Originations | Real Estate Securities | Residential Mortgage Loans | Consumer Loans | Corporate | Total |\n| Three Months Ended September 30, 2018 |\n| Interest income | $ | 187,584 | $ | 138,197 | $ | 48,782 | $ | 50,961 | $ | — | $ | 425,524 |\n| Interest expense | 61,706 | 67,117 | 23,662 | 10,321 | — | 162,806 |\n| Net interest income (expense) | 125,878 | 71,080 | 25,120 | 40,640 | — | 262,718 |\n| Impairment | — | 3,889 | ( 4,436 | ) | 9,907 | — | 9,360 |\n| Servicing revenue, net | 175,355 | — | — | — | — | 175,355 |\n| Gain on sale of originated mortgage loans, net | 45,732 | — | — | — | — | 45,732 |\n| Other income (loss) | ( 92,243 | ) | 17,994 | ( 12,729 | ) | 3,795 | ( 115 | ) | ( 83,298 | ) |\n| Operating expenses | 132,542 | 63 | 6,436 | 8,467 | 44,599 | 192,107 |\n| Income (Loss) Before Income Taxes | 122,180 | 85,122 | 10,391 | 26,061 | ( 44,714 | ) | 199,040 |\n| Income tax expense (benefit) | 495 | — | 3,100 | ( 32 | ) | — | 3,563 |\n| Net Income (Loss) | $ | 121,685 | $ | 85,122 | $ | 7,291 | $ | 26,093 | $ | ( 44,714 | ) | $ | 195,477 |\n| Noncontrolling interests in income (loss) of consolidated subsidiaries | $ | 1,086 | $ | — | $ | — | $ | 9,783 | $ | — | $ | 10,869 |\n| Net income (loss) attributable to common stockholders | $ | 120,599 | $ | 85,122 | $ | 7,291 | $ | 16,310 | $ | ( 44,714 | ) | $ | 184,608 |\n\n| Residential Securities and Loans |\n| Servicing and Originations | Real Estate Securities | Residential Mortgage Loans | Consumer Loans | Corporate | Total |\n| Nine Months Ended September 30, 2018 |\n| Interest income | $ | 574,379 | $ | 354,922 | $ | 123,464 | $ | 158,631 | $ | 1,506 | $ | 1,212,902 |\n| Interest expense | 172,471 | 157,195 | 58,587 | 32,856 | — | 421,109 |\n| Net interest income (expense) | 401,908 | 197,727 | 64,877 | 125,775 | 1,506 | 791,793 |\n| Impairment | — | 23,190 | ( 8,683 | ) | 36,819 | — | 51,326 |\n| Servicing revenue, net | 538,784 | — | — | — | — | 538,784 |\n| Gain on sale of originated mortgage loans, net | 45,732 | — | — | — | — | 45,732 |\n| Other income (loss) | 48,128 | 45,346 | ( 27,219 | ) | 13,363 | 4,796 | 84,414 |\n| Operating expenses | 235,417 | 1,003 | 25,658 | 26,743 | 130,856 | 419,677 |\n| Income (Loss) Before Income Taxes | 799,135 | 218,880 | 20,683 | 75,576 | ( 124,554 | ) | 989,720 |\n| Income tax expense (benefit) | ( 6,458 | ) | — | 289 | 212 | — | ( 5,957 | ) |\n| Net Income (Loss) | $ | 805,593 | $ | 218,880 | $ | 20,394 | $ | 75,364 | $ | ( 124,554 | ) | $ | 995,677 |\n| Noncontrolling interests in income (loss) of consolidated subsidiaries | $ | 3,525 | $ | — | $ | — | $ | 28,533 | $ | — | $ | 32,058 |\n| Net income (loss) attributable to common stockholders | $ | 802,068 | $ | 218,880 | $ | 20,394 | $ | 46,831 | $ | ( 124,554 | ) | $ | 963,619 |\n\n19\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| 4. | INVESTMENTS IN EXCESS MORTGAGE SERVICING RIGHTS |\n\nThe following table presents activity related to the carrying value of New Residential’s direct investments in Excess MSRs:\n| Servicer |\n| Nationstar | SLS(A) | Total |\n| Balance as of December 31, 2018 | $ | 445,328 | $ | 2,532 | $ | 447,860 |\n| Purchases | — | — | — |\n| Interest income | 18,159 | 44 | 18,203 |\n| Other income | 2,092 | — | 2,092 |\n| Proceeds from repayments | ( 63,794 | ) | ( 295 | ) | ( 64,089 | ) |\n| Proceeds from sales | ( 4,581 | ) | — | ( 4,581 | ) |\n| Change in fair value | ( 1,258 | ) | ( 163 | ) | ( 1,421 | ) |\n| Balance as of September 30, 2019 | $ | 395,946 | $ | 2,118 | $ | 398,064 |\n\n| (A) | Specialized Loan Servicing LLC (“SLS”). |\n\nNationstar or SLS, as applicable, as servicer, performs all of the servicing and advancing functions, and retains the ancillary income, servicing obligations and liabilities as the servicer of the underlying loans in the portfolio.\nNew Residential has entered into a “recapture agreement” with respect to each of the Excess MSR investments serviced by Nationstar and SLS. Under such arrangements, New Residential is generally entitled to a pro rata interest in the Excess MSRs on any initial or subsequent refinancing by Nationstar of a loan in the original portfolio. These recapture agreements do not apply to New Residential’s Servicer Advance Investments (Note 6).\nNew Residential elected to record its investments in Excess MSRs at fair value pursuant to the fair value option for financial instruments in order to provide users of the financial statements with better information regarding the effects of prepayment risk and other market factors on the Excess MSRs.\nThe following is a summary of New Residential’s direct investments in Excess MSRs:\n| September 30, 2019 | December 31, 2018 |\n| UPB of Underlying Mortgages | Interest in Excess MSR | Weighted Average Life Years(A) | Amortized Cost Basis(B) | Carrying Value(C) | Carrying Value(C) |\n| New Residential(D) | Fortress-managed funds | Nationstar |\n| Agency | $ | 45,900,654 | 32.5% - 66.7% (53.3%) | 0.0% - 40.0% | 20.0% - 35.0% | 5.4 | $ | 183,064 | $ | 221,560 | $ | 257,387 |\n| Non-Agency(E) | $ | 47,124,536 | 33.3% - 100.0% (59.4%) | 0.0% - 50.0% | 0.0% - 33.3% | 6.5 | $ | 129,647 | $ | 176,504 | $ | 190,473 |\n| Total | $ | 93,025,190 | 5.9 | $ | 312,711 | $ | 398,064 | $ | 447,860 |\n\n\n| (A) | Weighted Average Life represents the weighted average expected timing of the receipt of expected cash flows for this investment. |\n\n| (B) | The amortized cost basis of the recapture agreements is determined based on the relative fair values of the recapture agreements and related Excess MSRs at the time they were acquired. |\n\n| (C) | Carrying Value represents the fair value of the pools or recapture agreements, as applicable. |\n\n| (D) | Amounts in parentheses represent weighted averages. |\n\n| (E) | Serviced by Nationstar and SLS, New Residential is also invested in related Servicer Advance Investments, including the basic fee component of the related MSR as of September 30, 2019 (Note 6) on $ 33.4 billion UPB underlying these Excess MSRs. |\n\n20\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nChanges in fair value recorded in other income is comprised of the following:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Original and Recaptured Pools | $ | 2,407 | $ | ( 4,744 | ) | $ | ( 1,421 | ) | $ | ( 55,711 | ) |\n\nAs of September 30, 2019, a weighted average discount rate of 7.8 % was used to value New Residential’s investments in Excess MSRs (directly and through equity method investees).\nNew Residential entered into investments in joint ventures (“Excess MSR joint ventures”) jointly controlled by New Residential and Fortress-managed funds investing in Excess MSRs. New Residential elected to record these investments at fair value pursuant to the fair value option for financial instruments to provide users of the financial statements with better information regarding the effects of prepayment risk and other market factors.\nThe following tables summarize the financial results of the Excess MSR joint ventures, accounted for as equity method investees, held by New Residential:\n| September 30, 2019 | December 31, 2018 |\n| Excess MSR assets | $ | 236,786 | $ | 269,203 |\n| Other assets | 28,418 | 27,411 |\n| Other liabilities | ( 687 | ) | ( 687 | ) |\n| Equity | $ | 264,517 | $ | 295,927 |\n| New Residential’s investment | $ | 132,259 | $ | 147,964 |\n| New Residential’s ownership | 50.0 | % | 50.0 | % |\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Interest income | $ | 7,990 | $ | 8,935 | $ | 12,251 | $ | 21,026 |\n| Other income (loss) | 1,528 | ( 2,143 | ) | ( 4,029 | ) | ( 9,778 | ) |\n| Expenses | ( 16 | ) | — | ( 48 | ) | — |\n| Net income (loss) | $ | 9,502 | $ | 6,792 | $ | 8,174 | $ | 11,248 |\n\nNew Residential’s investments in equity method investees changed during the nine months ended September 30, 2019 as follows:\n| Balance at December 31, 2018 | $ | 147,964 |\n| Contributions to equity method investees | — |\n| Distributions of earnings from equity method investees | ( 7,762 | ) |\n| Distributions of capital from equity method investees | ( 12,030 | ) |\n| Change in fair value of investments in equity method investees | 4,087 |\n| Balance at September 30, 2019 | $ | 132,259 |\n\n21\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nThe following is a summary of New Residential’s Excess MSR investments made through equity method investees:\n| September 30, 2019 |\n| Unpaid Principal Balance | Investee Interest in Excess MSR(A) | New Residential Interest in Investees | Amortized Cost Basis(B) | Carrying Value(C) | Weighted Average Life (Years)(D) |\n| Agency | $ | 35,632,429 | 66.7 | % | 50.0 | % | $ | 171,553 | $ | 236,786 | 5.3 |\n\n\n| (A) | The remaining interests are held by Nationstar. |\n\n| (B) | Represents the amortized cost basis of the equity method investees in which New Residential holds a 50 % interest. The amortized cost basis of the recapture agreements is determined based on the relative fair values of the recapture agreements and related Excess MSRs at the time they were acquired. |\n\n| (C) | Represents the carrying value of the Excess MSRs held in equity method investees, in which New Residential holds a 50 % interest. Carrying value represents the fair value of the pools or recapture agreements, as applicable. |\n\n| (D) | The weighted average life represents the weighted average expected timing of the receipt of cash flows of each investment. |\n\nSee Note 11 regarding the financing of Excess MSRs.\n5. INVESTMENTS IN MORTGAGE SERVICING RIGHTS AND MSR FINANCING RECEIVABLES\nA subsidiary of New Residential, New Residential Mortgage LLC (“NRM”), engages third party licensed mortgage servicers as subservicers to perform the operational servicing duties in connection with the MSRs it acquires, in exchange for a subservicing fee which is recorded as “Subservicing expense” on New Residential’s Condensed Consolidated Statements of Income. As of September 30, 2019, these subservicers include PHH Mortgage Corporation (“PHH”), Nationstar, LoanCare, LLC (“LoanCare”), AmeriHome Mortgage Company, LLC (“AmeriHome”), and Flagstar Bank, FSB (“Flagstar”), which subservice 26.9 %, 23.1 %, 19.2 %, 1.8 %, and 0.8 % of the underlying UPB of the related mortgages, respectively (includes both Mortgage Servicing Rights and MSR Financing Receivables). The remaining 28.2 % of the underlying UPB of the related mortgages is subserviced by a subsidiary of New Residential, Shellpoint Mortgage Servicing (Note 1).\nNew Residential has entered into recapture agreements with respect to each of its MSR investments subserviced by PHH, LoanCare, Flagstar, and Nationstar. Under the recapture agreements, New Residential is generally entitled to the MSRs on any initial or subsequent refinancing by PHH, Loancare, Flagstar or Nationstar of a loan in the original portfolios.\nIn certain cases, New Residential has legally purchased MSRs or the right to the economic interest in MSRs; however, New Residential has determined that the purchase agreement would not be treated as a sale under GAAP. Therefore, rather than recording an investment in MSRs, New Residential has recorded an investment in mortgage servicing rights financing receivables (“MSR Financing Receivables”). Income from these investments (net of subservicing fees) are recorded as interest income, and New Residential has elected to measure the investments at fair value, with changes in fair value flowing through change in fair value of investments in MSR financing receivables in the Condensed Consolidated Statements of Income.\nNew Residential records its investments in MSRs and MSR Financing Receivables at fair value at acquisition and has elected to subsequently measure at fair value pursuant to the fair value measurement method.\n22\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nThe following table presents activity related to the carrying value of New Residential’s investments in MSRs and MSR Financing Receivables:\n| MSRs | MSR Financing Receivables | Total |\n| Balance as of December 31, 2018 | $ | 2,884,100 | $ | 1,644,504 | $ | 4,528,604 |\n| Purchases, net(A) | 632,144 | 735,152 | 1,367,296 |\n| Transfers(B) | 367,121 | ( 367,121 | ) | — |\n| Other transfers(C) | ( 410 | ) | — | ( 410 | ) |\n| Originations(D) | 190,666 | — | 190,666 |\n| Prepayments(E) | ( 11,210 | ) | ( 52,499 | ) | ( 63,709 | ) |\n| Proceeds from sales | ( 1,047 | ) | ( 15,575 | ) | ( 16,622 | ) |\n| Amortization of servicing rights(F) | ( 351,867 | ) | ( 131,417 | ) | ( 483,284 | ) |\n| Change in valuation inputs and assumptions(G) | ( 279,758 | ) | 1,437 | ( 278,321 | ) |\n| (Gain)/loss on sales | 2,229 | ( 3,220 | ) | ( 991 | ) |\n| Balance as of September 30, 2019 | $ | 3,431,968 | $ | 1,811,261 | $ | 5,243,229 |\n\n| (A) | Net of purchase price adjustments. |\n\n| (B) | Represents MSRs previously accounted for as MSR Financing Receivables. As a result of the length of the initial term of the related subservicing agreement between NRM and PHH, although the MSRs were legally sold, solely for accounting purposes, the purchase agreement was not treated as a sale under GAAP through June 30, 2019. |\n\n| (C) | Represents Ginnie Mae MSRs repurchased. |\n\n| (D) | Represents MSRs retained on the sale of originated mortgage loans. |\n\n| (E) | Represents purchase price fully reimbursable from sellers as a result of prepayment protection. |\n\n| (F) | Based on the ratio of the current UPB of the underlying residential mortgage loans relative to the original UPB of the underlying residential mortgage loans. |\n\n| (G) | Change in valuation inputs and assumptions includes changes in inputs or assumptions used in the valuation model. |\n\nServicing revenue, net recognized by New Residential related to its investments in MSRs was comprised of the following:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Servicing fee revenue | $ | 222,966 | $ | 158,458 | $ | 602,241 | $ | 408,967 |\n| Ancillary and other fees | 58,489 | 43,638 | 151,039 | 94,699 |\n| Servicing fee revenue and fees | 281,455 | 202,096 | 753,280 | 503,666 |\n| Amortization of servicing rights | ( 168,776 | ) | ( 70,933 | ) | ( 346,772 | ) | ( 191,499 | ) |\n| Change in valuation inputs and assumptions(A) (B) | ( 61,858 | ) | 44,192 | ( 275,371 | ) | 226,617 |\n| (Gain)/loss on sales | 2,229 | — | 2,229 | — |\n| Servicing revenue, net | $ | 53,050 | $ | 175,355 | $ | 133,366 | $ | 538,784 |\n\n| (A) | Change in valuation inputs and assumptions includes changes in inputs or assumptions used in the valuation model. |\n\n| (B) | Includes $ 3.6 million and $ 4.4 million of fair value adjustment to Excess spread financing for the three and nine months ended September 30, 2019, respectively. |\n\n23\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nInterest income from investments in MSR Receivables was comprised of the following:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Servicing fee revenue | $ | 128,936 | $ | 181,495 | $ | 385,306 | $ | 575,909 |\n| Ancillary and other fees | 21,417 | 39,257 | 82,695 | 109,852 |\n| Less: subservicing expense | ( 40,410 | ) | ( 61,454 | ) | ( 145,649 | ) | ( 192,275 | ) |\n| Interest income, investments in mortgage servicing rights financing receivables | $ | 109,943 | $ | 159,298 | $ | 322,352 | $ | 493,486 |\n\nChange in fair value of investments in MSR Financing Receivables was comprised of the following:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Amortization of servicing rights | $ | ( 48,340 | ) | $ | ( 49,016 | ) | $ | ( 131,417 | ) | $ | ( 154,559 | ) |\n| Change in valuation inputs and assumptions(A) | 9,349 | ( 39,329 | ) | 1,437 | 218,187 |\n| (Gain)/loss on sales(B) | ( 2,419 | ) | — | ( 3,220 | ) | — |\n| Change in fair value of investments in mortgage servicing rights financing receivables | $ | ( 41,410 | ) | $ | ( 88,345 | ) | $ | ( 133,200 | ) | $ | 63,628 |\n\n| (A) | Change in valuation inputs and assumptions includes changes in inputs or assumptions used in the valuation model. |\n\n| (B) | Represents the realization of unrealized gain/(loss) as a result of sales. |\n\nThe following is a summary of New Residential’s investments in MSRs as of September 30, 2019:\n| UPB of Underlying Mortgages | Weighted Average Life (Years)(A) | Amortized Cost Basis | Carrying Value(B) |\n| MSRs: |\n| Agency | $ | 288,673,487 | 4.9 | $ | 2,968,392 | $ | 3,038,721 |\n| Non-Agency | 2,350,471 | 5.6 | 12,294 | 20,321 |\n| Ginnie Mae(C) | 28,903,327 | 4.0 | 383,454 | 372,926 |\n| MSR Financing Receivables: |\n| Agency | 61,162,569 | 4.3 | 659,950 | 597,990 |\n| Non-Agency | 79,360,666 | 7.7 | 840,279 | 1,213,271 |\n| Total | $ | 460,450,520 | 5.2 | $ | 4,864,369 | $ | 5,243,229 |\n\n| (A) | Weighted Average Life represents the weighted average expected timing of the receipt of expected cash flows for this investment. |\n\n| (B) | Carrying Value represents fair value. As of September 30, 2019, a weighted average discount rate of 7.5 % and 8.8 % was used to value New Residential’s investments in MSRs and MSR Financing Receivables, respectively. |\n\n| (C) | NewRez, as an approved issuer of Ginnie Mae MBS, originates, sells and securitizes government-insured residential mortgage loans into Ginnie Mae guaranteed securitizations and NewRez retains the right to service the underlying residential mortgage loans. As the servicer, NewRez holds an option to repurchase delinquent loans from the securitization at its discretion. As of September 30, 2019, New Residential holds approximately $ 168.5 million in residential mortgage loans subject to repurchase and residential mortgage loans repurchase liability on its condensed consolidated balance sheets. |\n\n24\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nOcwen MSR Financing Receivable Transactions\nOn July 23, 2017, Ocwen and New Residential entered into a Master Agreement (the “Ocwen Master Agreement”) and a Transfer Agreement (the “Ocwen Transfer Agreement”) pursuant to which Ocwen and New Residential agreed to undertake certain actions to facilitate the transfer from Ocwen to New Residential of Ocwen’s remaining interests in the mortgage servicing rights relating to loans with an aggregate unpaid principal balance of approximately $ 110.0 billion that are subject to the Original Ocwen Agreements (the “Ocwen Subject MSRs”) and with respect to which New Residential holds the Rights to MSRs (as defined in the Original Ocwen Agreements). New Residential and Ocwen concurrently entered into a subservicing agreement pursuant to which Ocwen will subservice the mortgage loans related to the Ocwen Subject MSRs that are transferred to New Residential pursuant to the Ocwen Master Agreement and Ocwen Transfer Agreement.\nOn January 18, 2018, New Residential entered into a new agreement regarding the rights to MSRs (the “New Ocwen RMSR Agreement”) including a servicing addendum thereto (the “Ocwen Servicing Addendum”), Amendment No. 1 to Transfer Agreement (the “New Ocwen Transfer Agreement”) and a Brokerage Services Agreement (the “Ocwen Brokerage Services Agreement” and, collectively, the “New Ocwen Agreements”) with Ocwen. The New Ocwen Agreements amend and supplement the arrangements among the parties set forth in the Original Ocwen Agreements, the Ocwen Master Agreement, the Ocwen Transfer Agreement, and the Ocwen Subservicing Agreement (together with the Original Ocwen Agreements, the Ocwen Master Agreement, and the Ocwen Transfer Agreement, the “Existing Ocwen Agreements”). NRM made a lump-sum “Fee Restructuring Payment” of $ 279.6 million to Ocwen on January 18, 2018, the date of the New Ocwen RMSR Agreement, with respect to such Existing Ocwen Subject MSRs.\nUnder the Existing Ocwen Agreements, Ocwen sold and transferred to New Residential certain “Rights to MSRs” and other assets related to mortgage servicing rights for loans with an unpaid principal balance of approximately $ 86.8 billion as of the opening balances in January 2018 (the “Existing Ocwen Subject MSRs”). The New Ocwen Agreements and NRM’s Fee Restructuring Payment resulted in a new investment structured as a transfer of the full interests and economics of the Ocwen subject MSRs.\nPursuant to the New Ocwen Agreements, Ocwen will continue to service the mortgage loans related to the Existing Ocwen Subject MSRs until the necessary third party consents are obtained in order to transfer the Existing Ocwen Subject MSRs in accordance with the New Ocwen Agreements.\nPursuant to the Ocwen Brokerage Services Agreement, Ocwen will engage NRZ Brokerage to perform brokerage and marketing services for all REO properties serviced by Ocwen pursuant to the Subject Servicing Agreements as defined in the New Ocwen RMSR Agreement. Such REO properties are subject to the Altisource Brokerage Agreement and Altisource Letter Agreement.\nAs of September 30, 2019, MSRs representing approximately $ 66.7 billion UPB of underlying loans have been transferred pursuant to the Ocwen Transaction. Economics related to the remaining MSRs subject to the Ocwen Transaction were transferred pursuant to the New Ocwen Agreements. As a result of the length of the initial term of the related subservicing agreement between NRM and Ocwen, although the MSRs transferred pursuant to the Ocwen Transaction were legally sold, solely for accounting purposes, New Residential determined that substantially all of the risks and rewards inherent in owning the MSRs had not been transferred to NRM, and that the purchase agreement would not be treated as a sale under GAAP.\nAs a part of the ongoing integration efforts related to the Ocwen and PHH merger completed on October 4, 2018, Ocwen now conducts its mortgage servicing business under the PHH tradename.\nNationstar MSR Financing Receivable Transaction\nOn February 28, 2019, NRM entered into an agreement with Nationstar to purchase the MSRs, and related servicer advance receivables, with respect to $ 9.5 billion in total UPB of seasoned Agency residential mortgage loans. The residential mortgage loans underlying the MSRs acquired by NRM are subserviced by Nationstar pursuant to an existing subservicing agreement with NRM. As a result of the length of the initial term of the related subservicing agreement between NRM and Nationstar, although the MSRs were legally sold, solely for accounting purposes, New Residential determined that substantially all of the risks and rewards inherent in owning the MSRs had not been transferred to NRM, and that the purchase agreement would not be treated as a sale under GAAP.\n25\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nUnited Shore MSR Financing Receivable Transactions\nOn April 2, 2019 and May 21, 2019, NRM entered into agreements with United Shore to purchase the MSRs, and related servicer advance receivables, with respect to $ 8.2 billion and $ 23.7 billion in total UPB of seasoned Agency residential mortgage loans, respectively. The residential mortgage loans underlying the MSRs acquired by NRM will be subserviced by NewRez, Nationstar and LoanCare pursuant to existing subservicing agreements with NRM. As a result of the length of term of prepayment protection provided to NRM, although the MSRs were legally sold, solely for accounting purposes, New Residential determined that the transferor retained more than minor protection provisions, and that the purchase agreement would not be treated as a sale under GAAP.\nQuicken MSR Financing Receivable Transaction\nOn August 6, 2019, NRM entered into an agreement with Quicken to purchase the MSRs, and related servicer advance receivables, with respect to $ 29.1 billion in total UPB of seasoned Agency residential mortgage loans. The residential mortgage loans underlying the MSRs acquired by NRM are subserviced by LoanCare pursuant to an existing subservicing agreement with NRM. As a result of the length of term of prepayment protection provided to NRM, although the MSRs were legally sold, solely for accounting purposes, New Residential determined that the transferor retained more than minor protection provisions, and that the purchase agreement would not be treated as a sale under GAAP.\nThe table below summarizes the geographic distribution of the underlying residential mortgage loans of the investments in MSRs and MSR Financing Receivables:\n| Percentage of Total Outstanding Unpaid Principal Amount |\n| State Concentration | September 30, 2019 | December 31, 2018 |\n| California | 23.0 | % | 21.7 | % |\n| Florida | 6.8 | % | 6.9 | % |\n| New York | 6.8 | % | 7.8 | % |\n| Texas | 5.2 | % | 5.3 | % |\n| New Jersey | 5.0 | % | 5.0 | % |\n| Illinois | 3.6 | % | 3.7 | % |\n| Washington | 3.5 | % | 2.3 | % |\n| Massachusetts | 3.3 | % | 3.5 | % |\n| Maryland | 3.1 | % | 3.4 | % |\n| Georgia | 3.0 | % | 3.0 | % |\n| Other U.S. | 36.7 | % | 37.4 | % |\n| 100.0 | % | 100.0 | % |\n\nGeographic concentrations of investments expose New Residential to the risk of economic downturns within the relevant states. Any such downturn in a state where New Residential holds significant investments could affect the underlying borrower’s ability to make mortgage payments and therefore could have a meaningful, negative impact on the MSRs.\nMortgage Subservicing\nNewRez performs servicing of residential mortgage loans for third parties under subservicing agreements. Mortgage subservicing does not meet the criteria to be recognized as a servicing right asset and, therefore, is not recognized on New Residential’s condensed consolidated balance sheets. The UPB of residential mortgage loans subserviced for others as of September 30, 2019 was $ 54.7 billion and subservicing revenue of $ 99.7 million for the nine months ended September 30, 2019 is included within servicing revenue, net in the Condensed Consolidated Statements of Income.\n26\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nServicer Advances Receivable\nIn connection with its investments in MSRs and MSR financing receivables, New Residential generally acquires any related outstanding servicer advances (not included in the purchase prices described above), which it records at fair value within servicer advances receivable upon acquisition.\nIn addition to receiving cash flows from the MSRs, NRM and NewRez, as servicers, have the obligation to fund future servicer advances on the underlying pool of mortgages (Note 14). These servicer advances are recorded when advanced and are included in servicer advances receivable.\nThe following types of advances are included in the Servicer Advances Receivable:\n| September 30, 2019 | December 31, 2018 |\n| Principal and interest advances | $ | 723,155 | $ | 793,790 |\n| Escrow advances (taxes and insurance advances) | 1,945,271 | 2,186,831 |\n| Foreclosure advances | 173,032 | 199,203 |\n| Total(A) (B) (C) | $ | 2,841,458 | $ | 3,179,824 |\n\n| (A) | Includes $ 243.0 million and $ 231.2 million of servicer advances receivable related to Agency MSRs, respectively, recoverable from the Agencies. |\n\n| (B) | Includes $ 62.7 million and $ 41.6 million of servicer advances receivable related to Ginnie Mae MSRs, respectively, recoverable from Ginnie Mae. Reserves for advances associated with Ginnie Mae loans in the MSR portfolio are considered in the MSR fair valuation through a nonreimbursable advance loss assumption. |\n\n| (C) | Net of $ 70.3 million and $ 98.0 million, respectively, in accrual for advance recoveries. |\n\nNew Residential’s Servicer Advances Receivable related to Non-Agency MSRs generally have the highest reimbursement priority (i.e., “top of the waterfall”) and New Residential is generally entitled to repayment from respective loan or REO liquidation proceeds before any interest or principal is paid on the bonds that were issued by the trust. In the majority of cases, advances in excess of respective loan or REO liquidation proceeds may be recovered from pool-level proceeds. Furthermore, to the extent that advances are not recoverable by New Residential as a result of the subservicer’s failure to comply with applicable requirements in the relevant servicing agreements, New Residential has a contractual right to be reimbursed by the subservicer. New Residential assesses the recoverability of Servicer Advance Receivables periodically and as of September 30, 2019 and December 31, 2018, expected full recovery of the Servicer Advance Receivables.\nSee Note 11 regarding the financing of MSRs.\n| 6. | SERVICER ADVANCE INVESTMENTS |\n\nAll of New Residential’s Servicer Advance Investments are comprised of outstanding servicer advances, the requirement to purchase all future servicer advances made with respect to a specified pool of residential mortgage loans, and the basic fee component of the related MSR. New Residential elected to record its Servicer Advance Investments, including the right to the basic fee component of the related MSRs, at fair value pursuant to the fair value option for financial instruments to provide users of the financial statements with better information regarding the effects of market factors.\nA taxable wholly-owned subsidiary of New Residential is the managing member of the Buyer and owned an approximately 73.2 % interest in the Buyer as of September 30, 2019. As of September 30, 2019, third-party co-investors, owning the remaining interest in the Buyer, have funded capital commitments to the Buyer of $ 389.6 million and New Residential has funded capital commitments to the Buyer of $ 312.7 million. The Buyer may call capital up to the commitment amount on unfunded commitments and recall capital to the extent the Buyer makes a distribution to the co-investors, including New Residential. As of September 30, 2019, the noncontrolling third-party co-investors and New Residential had previously funded their commitments, however the Buyer may recall $ 325.0 million and $ 297.6 million of capital distributed to the third-party co-investors and New Residential, respectively. Neither the third-party co-investors nor New Residential is obligated to fund amounts in excess of their respective capital commitments, regardless of the capital requirements of the Buyer.\n27\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nSee Note 5 regarding the New Ocwen Agreements. Subsequent to the New Ocwen Agreements, the Servicer Advance Investments serviced by Ocwen are accounted for as Servicer Advances Receivable, as described in Note 5.\nThe following is a summary of New Residential’s Servicer Advance Investments, including the right to the basic fee component of the related MSRs:\n| Amortized Cost Basis | Carrying Value(A) | Weighted Average Discount Rate | Weighted Average Yield | Weighted Average Life (Years)(B) |\n| September 30, 2019 |\n| Servicer Advance Investments | $ | 570,570 | $ | 600,547 | 5.1 | % | 5.7 | % | 6.3 |\n| As of December 31, 2018 |\n| Servicer Advance Investments | $ | 721,801 | $ | 735,846 | 5.9 | % | 5.8 | % | 5.7 |\n\n\n| (A) | Carrying value represents the fair value of the Servicer Advance Investments, including the basic fee component of the related MSRs. |\n\n| (B) | Weighted Average Life represents the weighted average expected timing of the receipt of expected net cash flows for this investment. |\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Change in Fair Value of Servicer Advance Investments | $ | 6,641 | $ | ( 5,353 | ) | $ | 15,932 | $ | ( 86,581 | ) |\n\nThe following is additional information regarding the Servicer Advance Investments and related financing:\n| Loan-to-Value (“LTV”)(A) | Cost of Funds(C) |\n| UPB of Underlying Residential Mortgage Loans | Outstanding Servicer Advances | Servicer Advances to UPB of Underlying Residential Mortgage Loans | Face Amount of Notes and Bonds Payable | Gross | Net(B) | Gross | Net |\n| September 30, 2019 |\n| Servicer Advance Investments(D) | $ | 33,406,320 | $ | 492,480 | 1.5 | % | $ | 449,731 | 87.3 | % | 86.1 | % | 3.8 | % | 3.1 | % |\n| December 31, 2018 |\n| Servicer Advance Investments(D) | $ | 40,096,998 | $ | 620,050 | 1.5 | % | $ | 574,117 | 88.3 | % | 87.2 | % | 3.7 | % | 3.1 | % |\n\n\n| (A) | Based on outstanding servicer advances, excluding purchased but unsettled servicer advances. |\n\n| (B) | Ratio of face amount of borrowings to par amount of servicer advance collateral, net of any general reserve. |\n\n| (C) | Annualized measure of the cost associated with borrowings. Gross Cost of Funds primarily includes interest expense and facility fees. Net Cost of Funds excludes facility fees. |\n\n| (D) | The following types of advances are included in the Servicer Advance Investments: |\n\n| September 30, 2019 | December 31, 2018 |\n| Principal and interest advances | $ | 82,999 | $ | 108,317 |\n| Escrow advances (taxes and insurance advances) | 185,774 | 238,349 |\n| Foreclosure advances | 223,707 | 273,384 |\n| Total | $ | 492,480 | $ | 620,050 |\n\n28\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nInterest income recognized by New Residential related to its Servicer Advance Investments was comprised of the following:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Interest income, gross of amounts attributable to servicer compensation | $ | 14,212 | $ | 21,183 | $ | 43,220 | $ | 63,731 |\n| Amounts attributable to base servicer compensation | ( 1,606 | ) | ( 2,347 | ) | ( 4,578 | ) | ( 6,354 | ) |\n| Amounts attributable to incentive servicer compensation | ( 7,273 | ) | ( 7,095 | ) | ( 20,780 | ) | ( 14,255 | ) |\n| Interest income from Servicer Advance Investments | $ | 5,333 | $ | 11,741 | $ | 17,862 | $ | 43,122 |\n\nNew Residential has determined that the Buyer is a VIE. The following table presents information on the assets and liabilities related to this consolidated VIE.\n| As of |\n| September 30, 2019 | December 31, 2018 |\n| Assets |\n| Servicer advance investments, at fair value | $ | 580,829 | $ | 713,239 |\n| Cash and cash equivalents | 36,457 | 29,833 |\n| All other assets | 8,662 | 10,223 |\n| Total assets(A) | $ | 625,948 | $ | 753,295 |\n| Liabilities |\n| Notes and bonds payable | $ | 435,935 | $ | 556,340 |\n| All other liabilities | 2,021 | 2,442 |\n| Total liabilities(A) | $ | 437,956 | $ | 558,782 |\n\n| (A) | The creditors of the Buyer do not have recourse to the general credit of New Residential and the assets of the Buyer are not directly available to satisfy New Residential’s obligations. |\n\nOthers’ interests in the equity of the Buyer is computed as follows:\n| September 30, 2019 | December 31, 2018 |\n| Total Advance Purchaser LLC equity | $ | 187,992 | $ | 194,513 |\n| Others’ ownership interest | 26.8 | % | 26.8 | % |\n| Others’ interest in equity of consolidated subsidiary | $ | 50,319 | $ | 52,066 |\n\nOthers’ interests in the Buyer’s net income is computed as follows:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Net Advance Purchaser LLC income | $ | 6,288 | $ | ( 299 | ) | $ | 16,678 | $ | 8,667 |\n| Others’ ownership interest as a percent of total | 26.8 | % | 27.1 | % | 26.8 | % | 27.2 | % |\n| Others’ interest in net income of consolidated subsidiaries | $ | 1,684 | $ | ( 81 | ) | $ | 4,466 | $ | 2,358 |\n\nSee Note 11 regarding the financing of Servicer Advance Investments.\n29\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| 7. | INVESTMENTS IN REAL ESTATE AND OTHER SECURITIES |\n\n“Agency” residential mortgage backed securities (“RMBS”) are RMBS issued by a government sponsored enterprise, such as the Federal National Mortgage Association (“Fannie Mae”) or the Federal Home Loan Mortgage Corporation (“Freddie Mac”). “Non-Agency” RMBS are issued by either public trusts or private label securitization entities.\nActivities related to New Residential’s investments in real estate and other securities were as follows:\n| Three Months Ended September 30, 2019 | Nine Months Ended September 30, 2019 |\n| (in millions) | (in millions) |\n| Agency | Non-Agency | Agency | Non-Agency |\n| Purchases |\n| Face | $ | 12,306.4 | $ | 3,324.9 | $ | 25,123.5 | $ | 7,899.1 |\n| Purchase Price | 12,610.9 | 247.0 | 25,700.0 | 1,164.9 |\n| Sales |\n| Face | $ | 6,073.4 | $ | 1,325.2 | $ | 17,898.5 | $ | 2,162.7 |\n| Amortized Cost | 6,233.5 | 832.4 | 18,339.1 | 1,571.0 |\n| Sale Price | 6,252.8 | 910.9 | 18,451.4 | 1,662.9 |\n| Gain (Loss) on Sale | 19.3 | 78.5 | 112.3 | 91.9 |\n\nAs of September 30, 2019, New Residential had sold and purchased $ 4.3 billion and $ 2.5 billion face amount of Agency RMBS for $ 4.4 billion and $ 2.5 billion, respectively, which had not yet been settled. These unsettled sales and purchases were recorded on the balance sheet on trade date as Trades Receivable and Trades Payable.\nNew Residential has exercised its call rights with respect to Non-Agency RMBS trusts and purchased performing and non-performing residential mortgage loans and REO contained in such trusts prior to their termination. In certain cases, New Residential sold portions of the purchased loans through securitizations, and retained bonds issued by such securitizations. In addition, New Residential received par on the securities issued by the called trusts which it owned prior to such trusts’ termination. Refer to Note 8 for further details on these transactions.\nThe following is a summary of New Residential’s real estate and other securities, all of which are classified as available-for-sale and are, therefore, reported at fair value with changes in fair value recorded in other comprehensive income, except for securities that are other-than-temporarily impaired and except for securities which New Residential elected to carry at fair value and record changes to valuation through the income statement.\n| September 30, 2019 | December 31, 2018 |\n| Gross Unrealized | Weighted Average |\n| Asset Type | Outstanding Face Amount | Amortized Cost Basis | Gains | Losses | Carrying Value(A) | Number of Securities | Rating(B) | Coupon(C) | Yield | Life (Years)(D) | Principal Subordination(E) | Carrying Value |\n| Agency RMBS(F) (G) | $ | 8,797,199 | $ | 8,950,763 | $ | 56,939 | $ | ( 9,636 | ) | $ | 8,998,066 | 39 | AAA | 3.66 | % | 3.06 | % | 4.6 | N/A | $ | 2,665,618 |\n| Non-Agency RMBS(H) (I) | 21,845,814 | 7,175,703 | 711,078 | ( 30,937 | ) | 7,855,844 | 950 | B+ | 3.03 | % | 4.84 | % | 6.3 | 10.6 | % | 8,970,963 |\n| Total/ Weighted Average | $ | 30,643,013 | $ | 16,126,466 | $ | 768,017 | $ | ( 40,573 | ) | $ | 16,853,910 | 989 | BBB+ | 3.35 | % | 3.85 | % | 5.3 | $ | 11,636,581 |\n\n\n| (A) | Fair value, which is equal to carrying value for all securities. See Note 12 regarding the estimation of fair value. |\n\n| (B) | Represents the weighted average of the ratings of all securities in each asset type, expressed as an S&P equivalent rating. This excludes the ratings of the collateral underlying 312 bonds with a carrying value of $ 1,064.1 million which either have never been rated or for which rating information is no longer provided. For each security rated by multiple rating agencies, the lowest rating is used. New Residential used an implied AAA rating for the Agency RMBS. Ratings provided were determined by third party rating agencies, and represent the most recent credit ratings available as of the reporting date and may not be current. |\n\n30\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| (C) | Excludes residual bonds, and certain other Non-Agency bonds, with a carrying value of $ 225.2 million and $ 3.5 million, respectively, for which no coupon payment is expected. |\n\n| (D) | The weighted average life is based on the timing of expected principal reduction on the assets. |\n\n| (E) | Percentage of the amortized cost basis of securities that is subordinate to New Residential’s investments, excluding fair value option securities. |\n\n| (F) | Includes securities issued or guaranteed by U.S. Government agencies such as Fannie Mae or Freddie Mac. |\n\n| (G) | The total outstanding face amount was $ 8.8 billion for fixed rate securities and $ 0.0 billion for floating rate securities as of September 30, 2019. |\n\n| (H) | The total outstanding face amount was $ 10.2 billion (including $ 7.9 billion of residual and fair value option notional amount) for fixed rate securities and $ 11.7 billion (including $ 4.9 billion of residual and fair value option notional amount) for floating rate securities as of September 30, 2019. |\n\n| (I) | Includes other asset backed securities (“ABS”) consisting primarily of (i) interest-only securities and servicing strips (fair value option securities) which New Residential elected to carry at fair value and record changes to valuation through the income statement, (ii) bonds backed by consumer loans, and (iii) corporate debt. |\n\n| Gross Unrealized | Weighted Average |\n| Asset Type | Outstanding Face Amount | Amortized Cost Basis | Gains | Losses | Carrying Value | Number of Securities | Rating | Coupon | Yield | Life (Years) | Principal Subordination |\n| Corporate debt | $ | 85,000 | $ | 85,000 | $ | — | $ | ( 7,013 | ) | $ | 77,987 | 1 | B- | 8.25 | % | 8.25 | % | 5.5 | N/A |\n| Consumer loan bonds | 30,945 | 29,990 | 566 | ( 5,073 | ) | 25,483 | 6 | N/A | N/A | 8.09 | % | 1.5 | N/A |\n| Fair Value Option Securities: |\n| Interest-only securities | 9,574,284 | 290,481 | 33,963 | ( 13,890 | ) | 310,554 | 111 | AA | 1.44 | % | 7.43 | % | 3.2 | N/A |\n| Servicing Strips | 2,568,427 | 32,216 | 4,306 | ( 3,178 | ) | 33,344 | 37 | N/A | 0.39 | % | 5.88 | % | 5.3 | N/A |\n\nUnrealized losses that are considered other-than-temporary and are attributable to credit losses are recognized currently in earnings. During the nine months ended September 30, 2019, New Residential recorded OTTI charges of $ 21.9 million with respect to real estate securities. Any remaining unrealized losses on New Residential’s securities were primarily the result of changes in market factors, rather than issue-specific credit impairment. New Residential performed analyses in relation to such securities, using its best estimate of their cash flows, which support its belief that the carrying values of such securities were fully recoverable over their expected holding period. New Residential has no intent to sell, and is not more likely than not to be required to sell, these securities.\nThe following table summarizes New Residential’s securities in an unrealized loss position as of September 30, 2019.\n| Amortized Cost Basis | Weighted Average |\n| Securities in an Unrealized Loss Position | Outstanding Face Amount | Before Impairment | Other-Than-Temporary Impairment(A) | After Impairment | Gross Unrealized Losses | Carrying Value | Number of Securities | Rating(B) | Coupon | Yield | Life(Years) |\n| Less than 12 Months | $ | 7,069,880 | $ | 2,162,118 | $ | ( 3,768 | ) | $ | 2,158,350 | $ | ( 20,406 | ) | $ | 2,137,944 | 77 | BBB | 4.27 | % | 4.24 | % | 6.4 |\n| 12 or More Months | 1,297,245 | 190,556 | ( 1,799 | ) | 188,757 | ( 20,167 | ) | 168,590 | 63 | BB | 4.58 | % | 5.74 | % | 5.1 |\n| Total/Weighted Average | $ | 8,367,125 | $ | 2,352,674 | $ | ( 5,567 | ) | $ | 2,347,107 | $ | ( 40,573 | ) | $ | 2,306,534 | 140 | BB+ | 4.29 | % | 4.36 | % | 6.3 |\n\n\n| (A) | This amount represents OTTI recorded on securities that are in an unrealized loss position as of September 30, 2019. |\n\n| (B) | The weighted average rating of securities in an unrealized loss position for less than 12 months excludes the rating of 43 bonds which either have never been rated or for which rating information is no longer provided. The weighted average rating of securities in an unrealized loss position for 12 or more months excludes the rating of 24 bonds which either have never been rated or for which rating information is no longer provided. |\n\n31\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nNew Residential performed an assessment of all of its debt securities that are in an unrealized loss position (an unrealized loss position exists when a security’s amortized cost basis, excluding the effect of OTTI, exceeds its fair value) and determined the following:\n| September 30, 2019 |\n| Gross Unrealized Losses |\n| Fair Value | Amortized Cost Basis After Impairment | Credit(A) | Non-Credit(B) |\n| Securities New Residential intends to sell(C) | $ | — | $ | — | $ | — | $ | — |\n| Securities New Residential is more likely than not to be required to sell(D) | — | — | — | N/A |\n| Securities New Residential has no intent to sell and is not more likely than not to be required to sell: |\n| Credit impaired securities | 159,172 | 165,780 | ( 5,567 | ) | ( 6,608 | ) |\n| Non-credit impaired securities | 2,147,362 | 2,181,327 | — | ( 33,965 | ) |\n| Total debt securities in an unrealized loss position | $ | 2,306,534 | $ | 2,347,107 | $ | ( 5,567 | ) | $ | ( 40,573 | ) |\n\n\n| (A) | This amount is required to be recorded as OTTI through earnings. In measuring the portion of credit losses, New Residential estimates the expected cash flow for each of the securities. This evaluation includes a review of the credit status and the performance of the collateral supporting those securities, including the credit of the issuer, key terms of the securities and the effect of local, industry and broader economic trends. Significant inputs in estimating the cash flows include New Residential’s expectations of prepayment rates, default rates and loss severities. Credit losses are measured as the decline in the present value of the expected future cash flows discounted at the investment’s effective interest rate. |\n\n| (B) | This amount represents unrealized losses on securities that are due to non-credit factors and recorded through other comprehensive income. |\n\n| (C) | A portion of securities New Residential intends to sell have a fair value equal to their amortized cost basis after impairment, and, therefore do no t have unrealized losses reflected in other comprehensive income as of September 30, 2019. |\n\n| (D) | New Residential may, at times, be more likely than not to be required to sell certain securities for liquidity purposes. While the amount of the securities to be sold may be an estimate, and the securities to be sold have not yet been identified, New Residential must make its best estimate, which is subject to significant judgment regarding future events, and may differ materially from actual future sales. |\n\nThe following table summarizes the activity related to credit losses on debt securities:\n| Nine Months Ended September 30, 2019 |\n| Beginning balance of credit losses on debt securities for which a portion of an OTTI was recognized in other comprehensive income | $ | 52,803 |\n| Increases to credit losses on securities for which an OTTI was previously recognized and a portion of an OTTI was recognized in other comprehensive income | 20,034 |\n| Additions for credit losses on securities for which an OTTI was not previously recognized | 1,908 |\n| Reductions for securities for which the amount previously recognized in other comprehensive income was recognized in earnings because the entity intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis | — |\n| Reduction for credit losses on securities for which no OTTI was recognized in other comprehensive income at the current measurement date | — |\n| Reduction for securities sold/paid off during the period | ( 18,431 | ) |\n| Ending balance of credit losses on debt securities for which a portion of an OTTI was recognized in other comprehensive income | $ | 56,314 |\n\n32\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nThe table below summarizes the geographic distribution of the collateral securing New Residential’s Non-Agency RMBS:\n| September 30, 2019 | December 31, 2018 |\n| Geographic Location(A) | Outstanding Face Amount | Percentage of Total Outstanding | Outstanding Face Amount | Percentage of Total Outstanding |\n| Western U.S. | $ | 8,348,465 | 38.4 | % | $ | 7,318,616 | 37.7 | % |\n| Southeastern U.S. | 5,232,919 | 24.1 | % | 4,613,314 | 23.8 | % |\n| Northeastern U.S. | 4,615,081 | 21.2 | % | 3,829,725 | 19.7 | % |\n| Midwestern U.S. | 2,134,577 | 9.8 | % | 2,063,263 | 10.6 | % |\n| Southwestern U.S. | 1,378,512 | 6.4 | % | 1,321,853 | 6.8 | % |\n| Other(B) | 20,315 | 0.1 | % | 250,833 | 1.4 | % |\n| $ | 21,729,869 | 100.0 | % | $ | 19,397,604 | 100.0 | % |\n\n\n| (A) | Excludes $ 30.9 million and $ 56.8 million face amount of bonds backed by consumer loans and $ 85.0 million and $ 85.0 million face amount of bonds backed by corporate debt as of September 30, 2019 and December 31, 2018, respectively. |\n\n| (B) | Represents collateral for which New Residential was unable to obtain geographic information. |\n\nNew Residential evaluates the credit quality of its real estate securities, as of the acquisition date, for evidence of credit quality deterioration. As a result, New Residential identified a population of real estate securities for which it was determined that it was probable that New Residential would be unable to collect all contractually required payments. For securities acquired during the nine months ended September 30, 2019, excluding residual and fair value option securities, the face amount of these real estate securities was $ 496.2 million, with total expected cash flows of $ 481.0 million and a fair value of $ 290.5 million on the dates that New Residential purchased the respective securities.\nThe following is the outstanding face amount and carrying value for securities, for which, as of the acquisition date, it was probable that New Residential would be unable to collect all contractually required payments, excluding residual and fair value option securities:\n| Outstanding Face Amount | Carrying Value |\n| September 30, 2019 | $ | 5,317,777 | $ | 3,641,142 |\n| December 31, 2018 | 6,385,306 | 4,217,242 |\n\nThe following is a summary of the changes in accretable yield for these securities:\n| Nine Months Ended September 30, 2019 |\n| Balance at December 31, 2018 | $ | 2,245,983 |\n| Additions | 190,482 |\n| Accretion | ( 191,559 | ) |\n| Reclassifications from (to) non-accretable difference | ( 430,080 | ) |\n| Disposals | ( 266,552 | ) |\n| Balance at September 30, 2019 | $ | 1,548,274 |\n\nSee Note 11 regarding the financing of real estate securities.\n| 8. | INVESTMENTS IN RESIDENTIAL MORTGAGE LOANS |\n\nNew Residential accumulated its residential mortgage loan portfolio through various bulk acquisitions and the execution of call rights. As a result of the Shellpoint Acquisition, New Residential, through its wholly owned subsidiary, NewRez, originates\n33\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nresidential mortgage loans for sale and securitization to third parties and generally retains the servicing rights on the underlying loans.\nLoans are accounted for based on New Residential’s strategy for the loan, and on whether the loan was credit-impaired at the date of acquisition. New Residential accounts for loans based on the following categories:\n| • | Loans Held-for-Investment (which may include PCD Loans) |\n\n| • | Loans Held-for-Investment, at fair value |\n\n| • | Loans Held-for-Sale, at lower of cost or fair value |\n\n| • | Loans Held-for-Sale, at fair value |\n\n| • | Real Estate Owned (“REO”) |\n\nThe following table presents certain information regarding New Residential’s residential mortgage loans outstanding by loan type, excluding REO:\n| September 30, 2019 | December 31, 2018 |\n| Outstanding Face Amount | Carrying Value | LoanCount | Weighted Average Yield | Weighted Average Life (Years)(A) | Floating Rate Loans as a % of Face Amount | Loan to Value Ratio (“LTV”)(B) | Weighted Avg. Delinquency(C) | Weighted Average FICO(D) | Carrying Value |\n| Loan Type |\n| Performing Loans(G) (J) | $ | 557,762 | $ | 524,387 | 7,695 | 7.8 | % | 4.6 | 20.2 | % | 72.3 | % | 10.2 | % | 647 | $ | 591,264 |\n| Purchased Credit Deteriorated Loans(H) | 124,238 | 89,270 | 1,106 | 7.9 | % | 3.2 | 19.3 | % | 88.1 | % | 60.7 | % | 590 | 144,065 |\n| Total Residential Mortgage Loans, held-for-investment | $ | 682,000 | $ | 613,657 | 8,801 | 7.8 | % | 4.4 | 20.1 | % | 75.2 | % | 19.4 | % | 636 | $ | 735,329 |\n| Reverse Mortgage Loans(E) (F) | $ | 13,032 | $ | 6,450 | 32 | 7.8 | % | 5.3 | 10.1 | % | 151.6 | % | 65.1 | % | N/A | $ | 6,557 |\n| Performing Loans(G) (I) | 709,867 | 726,935 | 10,798 | 4.3 | % | 4.0 | 62.4 | % | 54.3 | % | 5.9 | % | 688 | 413,883 |\n| Non-Performing Loans(H) (I) | 726,570 | 616,612 | 5,562 | 5.1 | % | 3.3 | 12.0 | % | 80.7 | % | 68.7 | % | 594 | 512,040 |\n| Total Residential Mortgage Loans, held-for-sale | $ | 1,449,469 | $ | 1,349,997 | 16,392 | 4.8 | % | 3.6 | 36.7 | % | 68.4 | % | 37.9 | % | 641 | $ | 932,480 |\n| Acquired Loans | $ | 4,024,252 | $ | 3,916,826 | 26,236 | 4.2 | % | 7.4 | 2.0 | % | 71.1 | % | 15.3 | % | 622 | $ | 2,153,269 |\n| Originated Loans | 1,248,711 | 1,289,425 | 4,465 | 4.0 | % | 28.6 | 4.0 | % | 77.6 | % | 29.2 | % | 672 | 655,260 |\n| Total Residential Mortgage Loans, held-for-sale, at fair value(K) | $ | 5,272,963 | $ | 5,206,251 | 30,701 | 4.1 | % | 12.5 | 2.5 | % | 72.7 | % | 18.6 | % | 634 | $ | 2,808,529 |\n\n| (A) | The weighted average life is based on the expected timing of the receipt of cash flows. |\n\n| (B) | LTV refers to the ratio comparing the loan’s unpaid principal balance to the value of the collateral property. |\n\n| (C) | Represents the percentage of the total principal balance that is 60+ days delinquent. |\n\n| (D) | The weighted average FICO score is based on the weighted average of information updated and provided by the loan servicer on a monthly basis. |\n\n| (E) | Represents a 70 % participation interest that New Residential holds in a portfolio of reverse mortgage loans. Nationstar holds the other 30 % interest and services the loans. The average loan balance outstanding based on total UPB was $ 0.6 million. Approximately 51 % of these loans have reached a termination event. As a result of the termination event, each such loan has matured and the borrower can no longer make draws on these loans. |\n\n| (F) | FICO scores are not used in determining how much a borrower can access via a reverse mortgage loan. |\n\n| (G) | Performing loans are generally placed on nonaccrual status when principal or interest is 120 days or more past due. |\n\n| (H) | Includes loans with evidence of credit deterioration since origination where it is probable that New Residential will not collect all contractually required principal and interest payments. As of September 30, 2019, New Residential has placed Non-Performing Loans, held-for-sale on nonaccrual status, except as described in (I) below. |\n\n| (I) | Includes $ 37.8 million and $ 27.7 million UPB of Ginnie Mae EBO performing and non-performing loans, respectively, on accrual status as contractual cash flows are guaranteed by the FHA. |\n\n| (J) | Includes $ 112.1 million UPB of non-agency mortgage loans underlying the SAFT 2013-1 securitization, which are carried at fair value based on New Residential’s election of the fair value option. Interest earned on loans measured at fair value are reported in other income. |\n\n| (K) | New Residential elected the fair value option to measure these loans at fair value on a recurring basis. Interest earned on loans measured at fair value are reported in other income. |\n\n34\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nNew Residential generally considers the delinquency status, loan-to-value ratios, and geographic area of residential mortgage loans as its credit quality indicators. Delinquency status is a primary credit quality indicator as loans that are more than 60 days past due provide an early warning of borrowers who may be experiencing financial difficulties. Current LTV ratio is an indicator of the potential loss severity in the event of default. Finally, the geographic distribution of the loan collateral also provides insight as to the credit quality of the portfolio, as factors such as the regional economy, home price changes and specific events will affect credit quality.\nThe table below summarizes the geographic distribution of the underlying residential mortgage loans:\n| Percentage of Total Outstanding Unpaid Principal Amount |\n| State Concentration | September 30, 2019 | December 31, 2018 |\n| California | 17.7 | % | 16.7 | % |\n| Florida | 9.0 | % | 8.8 | % |\n| New York | 9.9 | % | 11.7 | % |\n| New Jersey | 4.8 | % | 4.7 | % |\n| Texas | 4.6 | % | 5.3 | % |\n| Georgia | 4.3 | % | 2.7 | % |\n| Illinois | 3.9 | % | 4.0 | % |\n| Maryland | 3.7 | % | 3.1 | % |\n| Massachusetts | 3.3 | % | 3.1 | % |\n| Pennsylvania | 3.3 | % | 3.6 | % |\n| Other U.S. | 35.5 | % | 36.3 | % |\n| 100.0 | % | 100.0 | % |\n\nSee Note 11 regarding the financing of residential mortgage loans and related assets.\nCall Rights\nNew Residential has executed calls with respect to Non-Agency RMBS trusts and purchased performing and non-performing residential mortgage loans and REO assets contained in such trusts prior to their termination. In certain cases, New Residential sold portions of the purchased loans through securitizations, and retained bonds issued by such securitizations. In addition, New Residential received par on the securities issued by the called trusts which it owned prior to such trusts’ termination. For the nine months ended September 30, 2019, New Residential executed calls on a total of 97 trusts and recognized $ 45.3 million of interest income on securities held in the collapsed trusts and $ 54.2 million of gain on securitizations accounted for as sales.\nPerforming Loans\nThe following table provides past due information regarding New Residential’s Performing Loans, which is an important indicator of credit quality and the establishment of the allowance for loan losses:\n| September 30, 2019 |\n| Days Past Due | Delinquency Status(A) |\n| Current | 84.1 | % |\n| 30-59 | 8.2 | % |\n| 60-89 | 2.7 | % |\n| 90-119(B) | 0.7 | % |\n| 120+(C) | 4.3 | % |\n| 100.0 | % |\n\n| (A) | Represents the percentage of the total principal balance that corresponds to loans that are in each delinquency status. |\n\n35\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| (B) | Includes loans 90-119 days past due and still accruing interest because they are generally placed on nonaccrual status at 120 days or more past due. |\n\n| (C) | Represents nonaccrual loans. |\n\nActivities related to the carrying value of residential mortgage loans held-for-investment were as follows:\n| Performing Loans |\n| Balance at December 31, 2018 | $ | 591,253 |\n| Purchases/additional fundings | — |\n| Proceeds from repayments | ( 73,397 | ) |\n| Accretion of loan discount (premium) and other amortization(A) | 9,998 |\n| Provision for loan losses | ( 800 | ) |\n| Transfer of loans to other assets(B) | — |\n| Transfer of loans to real estate owned | ( 4,739 | ) |\n| Transfers of loans to held for sale | ( 168 | ) |\n| Fair value adjustment | 2,240 |\n| Balance at September 30, 2019 | $ | 524,387 |\n\n| (A) | Includes accelerated accretion of discount on loans paid in full and on loans transferred to other assets. |\n\n| (B) | Represents loans for which foreclosure has been completed and for which New Residential has made, or intends to make, a claim with the governmental agency that has guaranteed the loans that are now recognized as claims receivable in Other Assets (Note 2). |\n\nActivities related to the valuation and loss provision on reverse mortgage loans and allowance for loan losses on performing loans held-for-investment were as follows:\n| Performing Loans |\n| Balance at December 31, 2018 | $ | — |\n| Provision for loan losses(A) | 800 |\n| Charge-offs(B) | ( 800 | ) |\n| Balance at September 30, 2019 | $ | — |\n\n| (A) | Based on an analysis of collective borrower performance, credit ratings of borrowers, loan-to-value ratios, estimated value of the underlying collateral, key terms of the loans and historical and anticipated trends in defaults and loss severities at a pool level. |\n\n| (B) | Loans, other than PCD loans, are generally charged off or charged down to the net realizable value of the collateral (i.e., fair value less costs to sell), with an offset to the allowance for loan losses, when available information confirms that loans are uncollectible. |\n\nPurchased Credit Deteriorated Loans\nNew Residential determined at acquisition that the PCD loans acquired would be aggregated into pools based on common risk characteristics (FICO score, delinquency status, collateral type, loan-to-value ratio). Loans aggregated into pools are accounted for as if each pool were a single loan with a single composite interest rate and an aggregate expectation of cash flows, including consideration of involuntary prepayments.\n36\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nActivities related to the carrying value of PCD loans held-for-investment were as follows:\n| Balance at December 31, 2018 | $ | 144,065 |\n| Purchases/additional fundings | — |\n| Sales | — |\n| Proceeds from repayments | ( 13,935 | ) |\n| Accretion of loan discount and other amortization | 12,961 |\n| (Allowance) reversal for loan losses(A) | ( 2,332 | ) |\n| Transfer of loans to real estate owned | ( 12,815 | ) |\n| Transfer of loans to held-for-sale | ( 38,674 | ) |\n| Balance at September 30, 2019 | $ | 89,270 |\n\n| (A) | An allowance represents the present value of cash flows expected at acquisition that are no longer expected to be collected. A reversal results from an increase to expected cash flows that reverses a prior allowance. |\n\nThe following is a summary of the changes in accretable yield for these loans:\n| Balance at December 31, 2018 | $ | 68,632 |\n| Additions | — |\n| Accretion | ( 12,961 | ) |\n| Reclassifications from (to) non-accretable difference(A) | 8,188 |\n| Disposals(B) | ( 10,965 | ) |\n| Transfer of loans to held-for-sale(C) | ( 8,406 | ) |\n| Balance at September 30, 2019 | $ | 44,488 |\n\n| (A) | Represents a probable and significant increase (decrease) in cash flows previously expected to be uncollectible. |\n\n| (B) | Includes sales of loans or foreclosures, which result in removal of the loan from the PCD loan pool at its carrying amount. |\n\n| (C) | Represents loans not initially acquired with the intent to sell for which New Residential determined that it no longer has the intent to hold for the foreseeable future, or until maturity or payoff. |\n\nLoans Held-for-Sale, at Lower of Cost or Fair Value\nActivities related to the carrying value of loans held-for-sale, at lower of cost or fair value were as follows:\n| Balance at December 31, 2018 | $ | 932,480 |\n| Purchases(A) | 842,752 |\n| Transfer of loans from held-for-investment(B) | 38,842 |\n| Sales | ( 307,004 | ) |\n| Transfer of loans to other assets(C) | ( 8,564 | ) |\n| Transfer of loans to real estate owned | ( 35,326 | ) |\n| Proceeds from repayments | ( 133,279 | ) |\n| Valuation (provision) reversal on loans(D) | 20,096 |\n| Balance at September 30, 2019 | $ | 1,349,997 |\n\n| (A) | Represents loans acquired with the intent to sell. |\n\n| (B) | Represents loans not initially acquired with the intent to sell for which New Residential determined that it no longer has the intent to hold for the foreseeable future, or until maturity or payoff. |\n\n| (C) | Represents loans for which foreclosure has been completed and for which New Residential has made, or intends to make, a claim with the governmental agency that has guaranteed the loans that are now recognized as claims receivable in Other Assets (Note 2). |\n\n37\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| (D) | Represents the fair value adjustments to loans upon transfer to held-for-sale and provision recorded on certain purchased held-for-sale loans, including an aggregate of $ 4.8 million of provision related to the call transactions executed during the nine months ended September 30, 2019 . |\n\nLoans Held-for-Sale, at Fair Value\nActivities related to the carrying value of originated loans held-for-sale, at fair value were as follows:\n| Balance at December 31, 2018 | $ | 655,260 |\n| Originations | 10,427,690 |\n| Sales | ( 9,784,536 | ) |\n| Proceeds from repayments | ( 24,035 | ) |\n| Transfer of loans to other assets | ( 412 | ) |\n| Change in fair value | 15,458 |\n| Balance at September 30, 2019 | $ | 1,289,425 |\n\nActivities related to the carrying value of acquired loans held-for-sale, at fair value were as follows:\n| Balance at December 31, 2018 | $ | 2,153,269 |\n| Purchases(A) | 5,170,388 |\n| Sales | ( 3,338,140 | ) |\n| Proceeds from repayments | ( 141,109 | ) |\n| Transfer of loans to real estate owned | ( 435 | ) |\n| Accretion of loan discount and other amortization | — |\n| Change in fair value | 72,853 |\n| Balance at September 30, 2019 | $ | 3,916,826 |\n\n| (A) | Includes an acquisition date fair value adjustment increase of $ 10.2 million on loans acquired through call transactions executed during the nine months ended September 30, 2019. |\n\n38\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nNet Interest Income\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Interest Income: |\n| Acquired Residential Mortgage Loans, held-for-investment | $ | 14,532 | $ | 19,466 | $ | 47,167 | $ | 58,689 |\n| Acquired Residential Mortgage Loans, held-for-sale | 15,966 | 7,433 | 43,423 | 30,001 |\n| Acquired Residential Mortgage Loans, held-for-sale, at fair value | 43,288 | 15,453 | 96,393 | 28,344 |\n| Originated Residential Mortgage Loans, held-for-sale, at fair value | 13,185 | 6,430 | 32,926 | 6,430 |\n| Total Interest Income on Residential Mortgage Loans | 86,971 | 48,782 | 219,909 | 123,464 |\n| Interest Expense: |\n| Acquired Residential Mortgage Loans, held-for-investment | 3,953 | 6,537 | 15,717 | 17,447 |\n| Acquired Residential Mortgage Loans, held-for-sale | 9,357 | 8,306 | 26,873 | 26,264 |\n| Acquired Residential Mortgage Loans, held-for-sale, at fair value | 30,053 | 7,531 | 77,247 | 13,588 |\n| Originated Residential Mortgage Loans, held-for-sale,at fair value | 2,344 | 1,288 | 6,451 | 1,288 |\n| Total Interest Expense on Residential Mortgage Loans | 45,707 | 23,662 | 126,288 | 58,587 |\n| Total Net Interest Income on Residential Mortgage Loans | $ | 41,264 | $ | 25,120 | $ | 93,621 | $ | 64,877 |\n\nGain on Sale of Originated Mortgage Loans, Net\nNewRez, a wholly owned subsidiary of New Residential, originates conventional, government-insured and nonconforming residential mortgage loans for sale and securitization. The GSEs or Ginnie Mae guarantee conventional and government insured mortgage securitizations and mortgage investors issue nonconforming private label mortgage securitizations while NewRez generally retains the right to service the underlying residential mortgage loans. In connection with the transfer of loans to the GSEs or mortgage investors, New Residential reports gain on sale of originated mortgage loans, net in the condensed consolidated statements of income.\nGain on sale of originated mortgage loans, net is summarized below:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Gain on loans originated and sold(A) | $ | 24,312 | $ | 24,684 | $ | 36,413 | $ | 24,684 |\n| Gain (loss) on settlement of mortgage loan origination derivative instruments(B) | ( 32,138 | ) | ( 2,757 | ) | ( 61,879 | ) | ( 2,757 | ) |\n| MSRs retained on transfer of loans(C) | 96,317 | 17,282 | 190,666 | 17,282 |\n| Other(D) | 12,050 | 6,523 | 28,829 | 6,523 |\n| Gain on sale of originated mortgage loans, net | $ | 100,541 | $ | 45,732 | $ | 194,029 | $ | 45,732 |\n\n| (A) | Includes loan origination fees and direct loan origination costs. Other indirect costs related to loan origination are included within general and administrative expenses. |\n\n| (B) | Represents settlement of forward securities delivery commitments utilized as an economic hedge for mortgage loans not included within forward loan sale commitments. |\n\n| (C) | Represents the initial fair value of the capitalized mortgage servicing rights upon loan sales with servicing retained. |\n\n| (D) | Includes fees for services associated with the loan origination process. |\n\n39\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nReal estate owned (REO)\nNew Residential recognizes REO assets at the completion of the foreclosure process or upon execution of a deed in lieu of foreclosure with the borrower. REO assets are managed for prompt sale and disposition at the best possible economic value.\n| Real Estate Owned |\n| Balance at December 31, 2018 | $ | 113,410 |\n| Purchases | 44,539 |\n| Transfer of loans to real estate owned | 61,129 |\n| Sales | ( 112,703 | ) |\n| Valuation (provision) reversal on REO | ( 407 | ) |\n| Balance at September 30, 2019 | $ | 105,968 |\n\nAs of September 30, 2019, New Residential had residential mortgage loans that were in the process of foreclosure with an unpaid principal balance of $ 393.0 million.\nIn addition, New Residential has recognized $ 20.4 million in unpaid claims receivable from FHA on Ginnie Mae EBO loans and reverse mortgage loans for which foreclosure has been completed and for which New Residential has made, or intends to make, a claim.\nVariable Interest Entities\nDuring the first quarter of 2019, New Residential formed entities (the “RPL Borrowers”) that issued securitized debt collateralized by reperforming residential mortgage loans. New Residential determined that the RPL Borrowers should be evaluated for consolidation under the VIE model rather than the voting interest entity model as the equity holders as a group lack the characteristics of a controlling financial interest. Under the VIE model, New Residential’s consolidated subsidiaries had both 1) the power to direct the most significant activities of the RPL Borrowers and 2) significant variable interests in each of the RPL Borrowers, through their control of the related optional redemption feature and their ownership of certain notes issued by the RPL Borrowers and, therefore, met the primary beneficiary criterion and consolidated the RPL Borrowers. The following table presents information on the combined assets and liabilities related to these consolidated VIEs.\n| Three Months Ended September 30, |\n| 2019 |\n| Assets |\n| Residential mortgage loans | $ | 430,461 |\n| Other assets | — |\n| Total assets(A) | $ | 430,461 |\n| Liabilities |\n| Notes and bonds payable | $ | 364,380 |\n| Accounts payable and accrued expenses | 3,562 |\n| Total liabilities(A) | $ | 367,942 |\n\n| (A) | The creditors of the RPL Borrowers do not have recourse to the general credit of New Residential, and the assets of the RPL Borrowers are not directly available to satisfy New Residential’s obligations. |\n\nA wholly owned subsidiary of NewRez, Shelter Mortgage Company LLC (“Shelter”) is a mortgage originator specializing in retail origination. Shelter operates its business through a series of joint ventures and was deemed to be the primary beneficiary of the joint ventures as a result of its ability to direct activities that most significantly impact the economic performance of the entities and its ownership of a significant equity investment.\n40\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nThe following table presents information on the assets and liabilities of the Shelter JVs.\n| September 30, 2019 | December 31, 2018 |\n| Assets |\n| Cash and cash equivalents | $ | 21,604 | $ | 17,346 |\n| Property and equipment, net | 128 | 137 |\n| Intangible assets, net | 58 | 70 |\n| Prepaid expenses and other assets | 4,903 | 411 |\n| Total assets | $ | 26,693 | $ | 17,964 |\n| Liabilities |\n| Accounts payable and accrued expenses | $ | 3,065 | $ | 1,315 |\n| Reserve for sales recourse | 1,192 | 967 |\n| Total liabilities | $ | 4,257 | $ | 2,282 |\n\nNoncontrolling Interests\nNoncontrolling interests in the equity of the Shelter JVs is computed as follows:\n| September 30, 2019 | December 31, 2018 |\n| Total consolidated equity of JVs | $ | 22,436 | $ | 15,682 |\n| Noncontrolling ownership interest | 48.2 | % | 51.0 | % |\n| Noncontrolling equity interest in consolidated JVs | $ | 10,813 | $ | 7,998 |\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Total consolidated net income of JVs | $ | 5,098 | $ | 2,306 | $ | 9,144 | $ | 2,306 |\n| Noncontrolling ownership interest in net income | 48.2 | % | 50.6 | % | 48.2 | % | 50.6 | % |\n| Noncontrolling interest in net income of consolidated JVs | $ | 2,457 | $ | 1,167 | $ | 4,407 | $ | 1,167 |\n\nAs described in “Call Rights” above, New Residential has issued securitizations which were treated as sales under GAAP. New Residential has no obligation to repurchase any loans from these securitizations and its exposure to loss is limited to the carrying amount of its retained interests in the securitization entities. These securitizations are conducted through variable interest entities, of which New Residential is not the primary beneficiary.\n41\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nAdditionally, New Residential and NewRez, a wholly owned subsidiary of New Residential, were deemed to be the primary beneficiaries of the RPL Borrowers and SAFT 2013-1 securitization entity as a result of their ability to direct activities that most significantly impact the economic performance of the entities and their ownership of significant variable interests in the RPL Borrowers and SAFT 2013-1 securitization, respectively. The following table summarizes certain characteristics of the underlying residential mortgage loans, and related financing, in these securitizations as of September 30, 2019:\n| Residential mortgage loan UPB | $ | 11,183,024 |\n| Weighted average delinquency(A) | 1.97 | % |\n| Net credit losses for the nine months ended September 30, 2019 | $ | 5,738 |\n| Face amount of debt held by third parties(B) | $ | 10,074,690 |\n| Carrying value of bonds retained by New Residential(C) (D) | $ | 1,258,292 |\n| Cash flows received by New Residential on these bonds for the nine months ended September 30, 2019 | $ | 161,794 |\n\n| (A) | Represents the percentage of the UPB that is 60 + days delinquent. |\n\n| (B) | Excludes bonds retained by New Residential. |\n\n| (C) | Includes bonds retained pursuant to required risk retention regulations. |\n\n| (D) | Classified within Level 3 of the fair value hierarchy as the valuation is based on certain unobservable inputs including discount rate, prepayment rates and loss severity. See Note 12 for details on unobservable inputs. |\n\n| 9. | INVESTMENTS IN CONSUMER LOANS |\n\nNew Residential, through newly formed limited liability companies (together, the “Consumer Loan Companies”), has a co-investment in a portfolio of consumer loans. The portfolio includes personal unsecured loans and personal homeowner loans. OneMain is the servicer of the loans and provides all servicing and advancing functions for the portfolio. As of September 30, 2019, New Residential owns 53.5 % of the limited liability company interests in, and consolidates, the Consumer Loan Companies.\nOn June 4, 2019, the Consumer Loan Companies refinanced the outstanding asset-backed notes with an asset-backed securitization for approximately $ 938.7 million. The proceeds in excess of the refinanced debt of $ 13.4 million were distributed to the respective co-investors of which New Residential received approximately $ 7.8 million.\nNew Residential also purchased certain newly originated consumer loans from a third party (“Consumer Loan Seller”). These loans are not held in the Consumer Loan Companies and have been designated as performing consumer loans, held-for-investment. In addition, see “Equity Method Investees” below.\nThe following table summarizes the investment in consumer loans, held-for-investment held by New Residential:\n| Unpaid Principal Balance | Interest in Consumer Loans | Carrying Value | Weighted Average Coupon | Weighted Average Expected Life (Years)(A) | Weighted Average Delinquency(B) |\n| September 30, 2019 |\n| Consumer Loan Companies |\n| Performing Loans | $ | 684,064 | 53.5 | % | $ | 722,826 | 18.9 | % | 4.0 | 4.5 | % |\n| Purchased Credit Deteriorated Loans(C) | 182,171 | 53.5 | % | 147,059 | 15.6 | % | 3.5 | 10.0 | % |\n| Other - Performing Loans | 12,196 | 100.0 | % | 11,298 | 14.9 | % | 0.8 | 5.5 | % |\n| Total Consumer Loans, held-for-investment | $ | 878,431 | $ | 881,183 | 18.1 | % | 3.9 | 5.6 | % |\n| December 31, 2018 |\n| Consumer Loan Companies |\n| Performing Loans | $ | 815,341 | 53.5 | % | $ | 856,563 | 18.8 | % | 3.6 | 5.4 | % |\n| Purchased Credit Deteriorated Loans(C) | 221,910 | 53.5 | % | 182,917 | 16.0 | % | 3.4 | 11.6 | % |\n| Other - Performing Loans | 35,326 | 100.0 | % | 32,722 | 14.2 | % | 0.8 | 5.6 | % |\n| Total Consumer Loans, held-for-investment | $ | 1,072,577 | $ | 1,072,202 | 18.1 | % | 3.5 | 6.7 | % |\n\n42\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| (A) | Represents the weighted average expected timing of the receipt of expected cash flows for this investment. |\n\n| (B) | Represents the percentage of the total unpaid principal balance that is 30+ days delinquent. Delinquency status is the primary credit quality indicator as it provides early warning of borrowers who may be experiencing financial difficulties. |\n\n| (C) | Includes loans with evidence of credit deterioration since origination where it is probable that New Residential will not collect all contractually required principal and interest payments, which are accounted for as PCD loans. |\n\nSee Note 11 regarding the financing of consumer loans.\nPerforming Loans\nThe following table provides past due information regarding New Residential’s performing consumer loans, held-for-investment, which is an important indicator of credit quality and the establishment of the allowance for loan losses:\n| September 30, 2019 |\n| Days Past Due | Delinquency Status(A) |\n| Current | 95.5 | % |\n| 30-59 | 1.7 | % |\n| 60-89 | 1.0 | % |\n| 90-119(B) | 0.7 | % |\n| 120+(B) (C) | 1.1 | % |\n| 100.0 | % |\n\n| (A) | Represents the percentage of the total unpaid principal balance that corresponds to loans that are in each delinquency status. |\n\n| (B) | Includes loans more than 90 days past due and still accruing interest. |\n\n| (C) | Interest is accrued up to the date of charge-off at 180 days past due. |\n\nActivities related to the carrying value of performing consumer loans, held-for-investment were as follows:\n| Performing Loans |\n| Balance at December 31, 2018 | $ | 889,285 |\n| Purchases | — |\n| Additional fundings(A) | 42,231 |\n| Proceeds from repayments | ( 166,897 | ) |\n| Accretion of loan discount and premium amortization, net | 272 |\n| Gross charge-offs | ( 30,325 | ) |\n| Additions to the allowance for loan losses, net | ( 442 | ) |\n| Balance at September 30, 2019 | $ | 734,124 |\n\n| (A) | Represents draws on consumer loans with revolving privileges. |\n\nActivities related to the allowance for loan losses on performing consumer loans, held-for-investment were as follows:\n| Collectively Evaluated(A) | Individually Impaired(B) | Total |\n| Balance at December 31, 2018 | $ | 2,604 | $ | 2,064 | $ | 4,668 |\n| Provision (reversal) for loan losses | 23,966 | 442 | 24,408 |\n| Net charge-offs(C) | ( 25,672 | ) | — | ( 25,672 | ) |\n| Balance at September 30, 2019 | $ | 898 | $ | 2,506 | $ | 3,404 |\n\n43\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| (A) | Represents smaller-balance homogeneous loans that are not individually considered impaired and are evaluated based on an analysis of collective borrower performance, key terms of the loans and historical and anticipated trends in defaults and loss severities, and consideration of the unamortized acquisition discount. |\n\n| (B) | Represents consumer loan modifications considered to be troubled debt restructurings (“TDRs”) as they provide concessions to borrowers, primarily in the form of interest rate reductions, who are experiencing financial difficulty. As of September 30, 2019, there are $ 17.3 million in UPB and $ 15.5 million in carrying value of consumer loans classified as TDRs. |\n\n| (C) | Consumer loans, other than PCD loans, are charged off when available information confirms that loans are uncollectible, which is generally when they become 180 days past due. Charge-offs are presented net of $ 6.4 million in recoveries of previously charged-off UPB. |\n\nPurchased Credit Deteriorated Loans\nA portion of the consumer loans are considered PCD loans. Activities related to the carrying value of PCD consumer loans, held-for-investment were as follows:\n| Balance at December 31, 2018 | $ | 182,917 |\n| (Allowance) reversal for loan losses(A) | ( 40 | ) |\n| Proceeds from repayments | ( 60,499 | ) |\n| Accretion of loan discount and other amortization | 24,681 |\n| Balance at September 30, 2019 | $ | 147,059 |\n\n| (A) | An allowance represents the present value of cash flows expected at acquisition that are no longer expected to be collected. A reversal results from an increase to expected cash flows that reverses a prior allowance. |\n\nThe following is the unpaid principal balance and carrying value for consumer loans, for which, as of the acquisition date, it was probable that New Residential would be unable to collect all contractually required payments:\n| Unpaid Principal Balance | Carrying Value |\n| September 30, 2019 | $ | 182,171 | $ | 147,059 |\n| December 31, 2018 | 221,910 | 182,917 |\n\nThe following is a summary of the changes in accretable yield for these loans:\n| Balance at December 31, 2018 | $ | 126,518 |\n| Accretion | ( 24,681 | ) |\n| Reclassifications from (to) non-accretable difference(A) | 10,344 |\n| Balance at September 30, 2019 | $ | 112,181 |\n\n| (A) | Represents a probable and significant increase (decrease) in cash flows previously expected to be uncollectible. |\n\nNoncontrolling Interests\nOthers’ interests in the equity of the Consumer Loan Companies is computed as follows:\n| September 30, 2019 | December 31, 2018 |\n| Total Consumer Loan Companies equity | $ | 47,314 | $ | 66,105 |\n| Others’ ownership interest | 46.5 | % | 46.5 | % |\n| Others’ interests in equity of consolidated subsidiary | $ | 22,520 | $ | 30,561 |\n\n44\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nOthers’ interests in the Consumer Loan Companies’ net income (loss) is computed as follows:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Net Consumer Loan Companies income (loss) | $ | 22,790 | $ | 21,038 | $ | 49,690 | $ | 61,359 |\n| Others’ ownership interest as a percent of total | 46.5 | % | 46.5 | % | 46.5 | % | 46.5 | % |\n| Others’ interest in net income (loss) of consolidated subsidiaries | $ | 10,597 | $ | 9,783 | $ | 23,106 | $ | 28,533 |\n\nVariable Interest Entities\nThe Consumer Loan Companies consolidate certain entities that issued securitized debt collateralized by the consumer loans (the “Consumer Loan SPVs”). The Consumer Loan SPVs are VIEs of which the Consumer Loan Companies are the primary beneficiaries. The following table presents information on the combined assets and liabilities related to these consolidated VIEs.\n| As of |\n| September 30, 2019 | December 31, 2018 |\n| Assets |\n| Consumer loans, held-for-investment | $ | 869,885 | $ | 1,039,480 |\n| Restricted cash | 9,338 | 10,186 |\n| Accrued interest receivable | 13,148 | 15,627 |\n| Total assets(A) | $ | 892,371 | $ | 1,065,293 |\n| Liabilities |\n| Notes and bonds payable(B) | $ | 873,724 | $ | 1,030,096 |\n| Accounts payable and accrued expenses | 4,034 | 3,814 |\n| Total liabilities(A) | $ | 877,758 | $ | 1,033,910 |\n\n| (A) | The creditors of the Consumer Loan SPVs do not have recourse to the general credit of New Residential, and the assets of the Consumer Loan SPVs are not directly available to satisfy New Residential’s obligations. |\n\n| (B) | Includes $ 10.0 million face amount of bonds retained by New Residential issued by these VIEs. |\n\nEquity Method Investees\nIn February 2017, New Residential completed a co-investment, through a newly formed entity, PF LoanCo Funding LLC (“LoanCo”), to purchase up to $ 5.0 billion worth of newly originated consumer loans from Consumer Loan Seller over a two year term. New Residential, along with three co-investors, each acquired 25 % membership interests in LoanCo. New Residential accounts for its investment in LoanCo pursuant to the equity method of accounting because it can exercise significant influence over LoanCo but the requirements for consolidation are not met. New Residential’s investment in LoanCo is recorded as Investment in Consumer Loans, Equity Method Investees which is included within Other Assets (see Note 2 for details). LoanCo has elected to account for its investments in consumer loans at fair value. New Residential has elected to record LoanCo’s activity on a one month lag.\nIn addition, New Residential and the LoanCo co-investors agreed to purchase warrants to purchase up to 177.7 million shares of Series F convertible preferred stock in the Consumer Loan Seller’s parent company (“ParentCo”), which were valued at approximately $ 75.0 million in the aggregate as of February 2017, through a newly formed entity, PF WarrantCo Holdings, LP (“WarrantCo”). New Residential acquired a 23.57 % interest in WarrantCo, the remaining interest being acquired by three co-investors. WarrantCo has agreed to purchase a pro rata portion of the warrants each time LoanCo closes on a portion of its consumer loan purchase agreement from Consumer Loan Seller. The holder of the warrants has the option to purchase an equivalent number of shares of Series F convertible preferred stock in ParentCo at a price of $ 0.01 per share. WarrantCo is vested in the warrants to purchase an aggregate of 147.7 million Series F convertible preferred stock in ParentCo as of August 31, 2019, and New Residential and LoanCo co-investors are vested in the warrants to purchase an aggregate of 30.0 million Series F convertible preferred stock in ParentCo as of August 31, 2019. The Series F convertible preferred stock holders have the right to convert such preferred stock to common stock at any time, are entitled to the number of votes equal to the number of shares of common stock into which such\n45\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nshares of convertible preferred stock could be converted, and will have liquidation rights in the event of liquidation. New Residential accounts for its investment in WarrantCo pursuant to the equity method of accounting because it can exercise significant influence over WarrantCo but the requirements for consolidation are not met. New Residential’s investment in WarrantCo is recorded as Investment in Consumer Loans, Equity Method Investees which is included within Other Assets (see Note 2 for details). WarrantCo has elected to account for its investments in warrants at fair value. New Residential has elected to record WarrantCo’s activity on a one month lag.\nThe following tables summarize the investment in LoanCo and WarrantCo held by New Residential:\n| September 30, 2019(A) | December 31, 2018(A) |\n| Consumer loans, at fair value | $ | 1,632 | $ | 231,560 |\n| Warrants, at fair value | 106,378 | 103,067 |\n| Other assets | 1,685 | 25,971 |\n| Warehouse financing | — | ( 182,065 | ) |\n| Other liabilities | ( 118 | ) | ( 1,142 | ) |\n| Equity | $ | 109,577 | $ | 177,391 |\n| Undistributed retained earnings | $ | — | $ | — |\n| New Residential’s investment | $ | 25,875 | $ | 42,875 |\n| New Residential’s ownership | 23.6 | % | 24.2 | % |\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019(B) | 2018(B) | 2019(B) | 2018(B) |\n| Interest income | $ | 636 | $ | 16,513 | $ | 20,003 | $ | 38,032 |\n| Interest expense | — | ( 4,364 | ) | ( 6,487 | ) | ( 10,082 | ) |\n| Change in fair value of consumer loans and warrants | ( 2,933 | ) | 5,676 | ( 4,390 | ) | 24,750 |\n| Gain on sale of consumer loans(C) | ( 7,525 | ) | 2,379 | ( 9,193 | ) | 3,512 |\n| Other expenses | ( 576 | ) | ( 1,604 | ) | ( 3,494 | ) | ( 6,201 | ) |\n| Net income | $ | ( 10,398 | ) | $ | 18,600 | $ | ( 3,561 | ) | $ | 50,011 |\n| New Residential’s equity in net income | $ | ( 2,547 | ) | $ | 4,555 | $ | ( 890 | ) | $ | 12,343 |\n| New Residential’s ownership | 24.5 | % | 24.5 | % | 25.0 | % | 24.7 | % |\n\n| (A) | Data as of August 31, 2019 and November 30, 2018, respectively, as a result of the one month reporting lag. |\n\n| (B) | Data for the periods ended August 31, 2019 and 2018, respectively, as a result of the one month reporting lag. |\n\n| (C) | During the nine months ended September 30, 2019, LoanCo sold, through securitizations which were treated as sales for accounting purposes, $ 406.1 million in UPB of consumer loans. LoanCo retained $ 83.9 million of residual interest in the securitizations and distributed them to the LoanCo co-investors, including New Residential. |\n\nThe following is a summary of LoanCo’s consumer loan investments:\n| Unpaid Principal Balance | Interest in Consumer Loans | Carrying Value | Weighted Average Coupon | Weighted Average Expected Life (Years)(A) | Weighted Average Delinquency(B) |\n| September 30, 2019(C) | $ | 1,226 | 25.0 | % | $ | 1,632 | 18.7 | % | 1.0 | — | % |\n\n| (A) | Represents the weighted average expected timing of the receipt of expected cash flows for this investment. |\n\n| (B) | Represents the percentage of the total unpaid principal balance that is 30+ days delinquent. Delinquency status is the primary credit quality indicator as it provides early warning of borrowers who may be experiencing financial difficulties. |\n\n| (C) | Data as of August 31, 2019 as a result of the one month reporting lag. |\n\n46\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nNew Residential’s investment in LoanCo and WarrantCo changed as follows:\n| Balance at December 31, 2018 | $ | 38,294 |\n| Contributions to equity method investees | 63,969 |\n| Distributions of earnings from equity method investees | ( 1,178 | ) |\n| Distributions of capital from equity method investees | ( 77,162 | ) |\n| Earnings from investments in consumer loans, equity method investees | ( 890 | ) |\n| Balance at September 30, 2019 | $ | 23,033 |\n\n| 10. | DERIVATIVES |\n\nNew Residential uses interest rate swaps and interest rate caps as economic hedges to hedge a portion of its interest rate risk exposure. Interest rate risk is sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations, as well as other factors. New Residential’s credit risk with respect to economic hedges is the risk of default on New Residential’s investments that results from a borrower’s or counterparty’s inability or unwillingness to make contractually required payments.\nAs of September 30, 2019, New Residential held to-be-announced forward contract positions (“TBAs”) which were entered into as an economic hedge in order to mitigate New Residential’s interest rate risk on certain specified mortgage backed securities and any amounts or obligations owed by or to New Residential are subject to the right of set-off with the TBA counterparty. As part of executing these trades, New Residential has entered into agreements with its TBA counterparties that govern the transactions for the TBA purchases or sales made, including margin maintenance, payment and transfer, events of default, settlements, and various other provisions. New Residential has fulfilled all obligations and requirements entered into under these agreements.\nIn addition, as of September 30, 2019, New Residential held interest rate lock commitments (“IRLCs”), which represent a commitment to a particular interest rate provided the borrower is able to close the loan within a specified period, and forward loan sale and securities delivery commitments, which represent a commitment to sell specific mortgage loans at prices which are fixed as of the forward commitment date. New Residential enters into forward loan sale and securities delivery commitments in order to hedge the exposure related to IRLCs and mortgage loans that are not covered by mortgage loan sale commitments.\nNew Residential’s derivatives are recorded at fair value on the Condensed Consolidated Balance Sheets as follows:\n| Balance Sheet Location | September 30, 2019 | December 31, 2018 |\n| Derivative assets |\n| Interest Rate Caps | Other assets | $ | — | $ | 3 |\n| Interest Rate Lock Commitments | Other assets | 26,214 | 10,851 |\n| Forward Loan Sale Commitments | Other assets | — | 39 |\n| TBAs | Other assets | 10,498 | — |\n| $ | 36,712 | $ | 10,893 |\n| Derivative liabilities |\n| Interest Rate Swaps(A) | Accrued expenses and other liabilities | $ | 135 | $ | 5,245 |\n| Interest Rate Lock Commitments | Accrued expenses and other liabilities | 1,676 | 223 |\n| Forward Loan Sale Commitments | Accrued expenses and other liabilities | 31 |\n| TBAs | Accrued expenses and other liabilities | — | 23,921 |\n| $ | 1,842 | $ | 29,389 |\n\n| (A) | Net of $ 165.7 million of related variation margin accounts as of September 30, 2019. As of December 31, 2018, net of $ 106.1 million of related variation margin accounts existed. |\n\n47\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nThe following table summarizes notional amounts related to derivatives:\n| September 30, 2019 | December 31, 2018 |\n| Interest Rate Caps(A) | $ | 50,000 | $ | 50,000 |\n| Interest Rate Swaps(B) | 7,780,000 | 4,725,000 |\n| Interest Rate Lock Commitments | 2,735,387 | 823,187 |\n| Forward Loan Sale Commitments | 6,893 | 30,274 |\n| TBAs, short position(C) | 5,488,000 | 5,904,300 |\n| TBAs, long position(C) | 9,709,894 | 5,067,200 |\n\n| (A) | As of September 30, 2019, caps LIBOR at 4.00 % for $ 50.0 million of notional. The weighted average maturity of the interest rate caps as of September 30, 2019 was 14 months. |\n\n| (B) | Includes $ 4.5 billion notional of Receive LIBOR/Pay Fixed of 3.16 % and $ 3.3 billion notional of Receive Fixed of 1.51 %/Pay LIBOR with weighted average maturities of 43 months and 65 months, respectively, as of September 30, 2019. |\n\n| (C) | Represents the notional amount of Agency RMBS, classified as derivatives. |\n\nThe following table summarizes all income (losses) recorded in relation to derivatives:\n| For the Three Months Ended September 30, | For the Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Change in fair value of derivative instruments(A) |\n| Interest Rate Caps | $ | — | $ | ( 2 | ) | $ | ( 3 | ) | $ | 436 |\n| Interest Rate Swaps | 42,306 | 18,785 | ( 26,893 | ) | 19,668 |\n| Unrealized gains (losses) on Interest Rate Lock Commitments | 3,002 | ( 2,247 | ) | 13,911 | ( 2,247 | ) |\n| Forward Loan Sale Commitments | ( 272 | ) | ( 17 | ) | ( 70 | ) | ( 17 | ) |\n| TBAs | 13,472 | 7,780 | 11,067 | 10,145 |\n| 58,508 | 24,299 | ( 1,988 | ) | 27,985 |\n| Gain (loss) on settlement of investments, net |\n| Interest Rate Caps | — | — | — | ( 603 | ) |\n| Interest Rate Swaps | ( 10,338 | ) | ( 656 | ) | ( 32,529 | ) | 37,287 |\n| TBAs(B) | ( 3,809 | ) | 20,115 | ( 119,895 | ) | 39,408 |\n| ( 14,147 | ) | 19,459 | ( 152,424 | ) | 76,092 |\n| Total income (losses) | $ | 44,361 | $ | 43,758 | $ | ( 154,412 | ) | $ | 104,077 |\n\n| (A) | Represents unrealized gains (losses). |\n\n| (B) | Excludes $ 32.1 million and $ 61.9 million in loss on settlement included within gain on sale of originated mortgage loans, net (Note 8) for the three and nine months ended September 30, 2019, respectively. |\n\n48\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| 11. | DEBT OBLIGATIONS |\n\nThe following table presents certain information regarding New Residential’s debt obligations:\n| September 30, 2019 | December 31, 2018 |\n| Collateral |\n| Debt Obligations/Collateral | Outstanding Face Amount | Carrying Value(A) | Final Stated Maturity(B) | Weighted Average Funding Cost | Weighted Average Life (Years) | Outstanding Face | Amortized Cost Basis | Carrying Value | Weighted Average Life (Years) | Carrying Value(A) |\n| Repurchase Agreements(C) |\n| Agency RMBS(D) | $ | 10,733,236 | $ | 10,733,236 | Oct-19 to May-20 | 2.31 | % | 0.1 | $ | 10,611,553 | $ | 10,825,984 | $ | 10,886,787 | 2.4 | $ | 4,346,070 |\n| Non-Agency RMBS (E) | 7,144,329 | 7,144,329 | Oct-19 to Sep-20 | 3.08 | % | 0.1 | 21,021,981 | 7,113,471 | 7,786,425 | 6.3 | 7,434,785 |\n| Residential Mortgage Loans(F) | 5,165,150 | 5,164,159 | Oct-19 to May-21 | 3.74 | % | 0.6 | 5,960,958 | 6,025,596 | 5,805,242 | 13.9 | 3,678,246 |\n| Real Estate Owned(G)(H) | 68,651 | 68,635 | Oct-19 to May-21 | 3.85 | % | 0.4 | N/A | N/A | 95,410 | N/A | 94,868 |\n| Total Repurchase Agreements | 23,111,366 | 23,110,359 | 2.87 | % | 0.3 | 15,553,969 |\n| Notes and Bonds Payable |\n| Excess MSRs(I) | 269,759 | 269,759 | Feb-20 to Jul-22 | 4.95 | % | 1.9 | 103,514,484 | 315,847 | 416,899 | 5.8 | 297,563 |\n| MSRs(J) | 2,360,182 | 2,352,961 | Mar-20 to Jul-24 | 4.23 | % | 2.0 | 452,215,330 | 4,718,333 | 5,113,271 | 5.5 | 2,360,856 |\n| Servicer Advances(K) | 2,903,093 | 2,896,819 | Jan-20 to Aug-23 | 3.22 | % | 2.0 | 3,316,416 | 3,482,368 | 3,512,345 | 1.6 | 3,382,455 |\n| Residential Mortgage Loans(L) | 1,012,342 | 1,015,360 | Apr-20 to Jul-43 | 4.09 | % | 3.7 | 1,258,875 | 1,277,193 | 1,194,186 | 8.0 | 124,945 |\n| Consumer Loans(M) | 868,214 | 870,973 | Dec-21 to May-36 | 3.25 | % | 4.0 | 878,317 | 884,473 | 881,069 | 5.6 | 936,447 |\n| Total Notes and Bonds Payable | 7,413,590 | 7,405,872 | 3.73 | % | 2.5 | 7,102,266 |\n| Total/ Weighted Average | $ | 30,524,956 | $ | 30,516,231 | 3.08 | % | 0.8 | $ | 22,656,235 |\n\n| (A) | Net of deferred financing costs. |\n\n| (B) | All debt obligations with a stated maturity through October 31, 2019 were refinanced, extended or repaid. |\n\n| (C) | These repurchase agreements had approximately $ 77.8 million of associated accrued interest payable as of September 30, 2019. |\n\n| (D) | All of the Agency RMBS repurchase agreements have a fixed rate. Collateral amounts include approximately $ 4.4 billion of related trade and other receivables. |\n\n| (E) | $ 6,585.6 million face amount of the Non-Agency RMBS repurchase agreements have LIBOR-based floating interest rates while the remaining $ 558.8 million face amount of the Non-Agency RMBS repurchase agreements have a fixed rate. This also includes repurchase agreements of $ 7.5 million on retained servicer advance and consumer loan bonds and of $ 671.3 million on retained bonds collateralized by Agency MSRs. |\n\n| (F) | All of these repurchase agreements have LIBOR-based floating interest rates. |\n\n| (G) | All of these repurchase agreements have LIBOR-based floating interest rates. |\n\n| (H) | Includes financing collateralized by receivables including claims from FHA on Ginnie Mae EBO loans for which foreclosure has been completed and for which New Residential has made or intends to make a claim on the FHA guarantee. |\n\n| (I) | Includes $ 169.8 million of corporate loans which bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin of 3.00 %, and $ 100.0 million of corporate loans which bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin of 2.50 %. The outstanding face amount of the collateral represents the UPB of the residential mortgage loans underlying the interests in MSRs that secure these notes. |\n\n| (J) | Includes: $ 940.2 million of MSR notes which bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin ranging from 2.25 % to 2.75 %; and $ 1,419.9 million of public notes with fixed interest rates ranging from 3.55 % to 4.62 %. The outstanding face amount of the collateral represents the UPB of the residential mortgage loans underlying the MSRs and mortgage servicing rights financing receivables that secure these notes. |\n\n| (K) | $ 2.6 billion face amount of the notes have a fixed rate while the remaining notes bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR or a cost of funds rate, as applicable, and (ii) a margin ranging from 1.15 % to 1.99 %. Collateral includes Servicer Advance Investments, as well as servicer advances receivable related to the mortgage servicing rights and mortgage servicing rights financing receivables owned by NRM. |\n\n49\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| (L) | Represents: (i) a $ 6.0 million note payable to Nationstar which includes a $ 1.5 million receivable from government agency and bears interest equal to one-month LIBOR plus 2.88 %, (ii) $ 109.9 million fair value of SAFT 2013-1 mortgage-backed securities issued with fixed interest rates ranging from 3.50 % to 3.76 % (see Note 12 for details), (iii) $ 362.1 million of asset-backed notes held by third parties which bear interest equal to 4.59 % (see Note 12 for details), and (iv) $ 535.1 million of asset-backed notes held by third parties which include $ 1.3 million of REO and bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin of 1.25 %. |\n\n| (M) | Includes the SpringCastle debt, which is comprised of the following classes of asset-backed notes held by third parties: $ 787.9 million UPB of Class A notes with a coupon of 3.20 % and a stated maturity date in May 2036, $ 70.4 million UPB of Class B notes with a coupon of 3.58 % and a stated maturity date in May 2036, and $ 8.7 million UPB of Class C notes with a coupon of 5.06 % and a stated maturity date in May 2036. Also includes a $ 1.2 million face amount note which bears interest equal to 4.00 %. |\n\nAs of September 30, 2019, New Residential had no outstanding repurchase agreements where the amount at risk with any individual counterparty or group of related counterparties exceeded 10% of New Residential’s stockholders' equity. The amount at risk under repurchase agreements is defined as the excess of carrying amount (or market value, if higher than the carrying amount) of the securities or other assets sold under agreement to repurchase, including accrued interest plus any cash or other assets on deposit to secure the repurchase obligation, over the amount of the repurchase liability (adjusted for accrued interest).\nGeneral\nCertain of the debt obligations included above are obligations of New Residential’s consolidated subsidiaries, which own the related collateral. In some cases, such collateral is not available to other creditors of New Residential.\nNew Residential has margin exposure on $ 23.1 billion of repurchase agreements as of September 30, 2019. To the extent that the value of the collateral underlying these repurchase agreements declines, New Residential may be required to post margin, which could significantly impact its liquidity.\nActivities related to the carrying value of New Residential’s debt obligations were as follows:\n| Excess MSRs | MSRs | Servicer Advances(A) | Real Estate Securities | Residential Mortgage Loans and REO | Consumer Loans | Total |\n| Balance at December 31, 2018 | $ | 297,563 | $ | 2,360,856 | $ | 3,382,455 | $ | 11,780,855 | $ | 3,898,059 | $ | 936,447 | $ | 22,656,235 |\n| Repurchase Agreements: |\n| Borrowings | — | — | — | 131,684,478 | 20,417,339 | — | 152,101,817 |\n| Repayments | — | — | — | ( 125,587,933 | ) | ( 18,957,675 | ) | — | ( 144,545,608 | ) |\n| Capitalized deferred financing costs, net of amortization | — | — | — | 165 | 17 | — | 182 |\n| Notes and Bonds Payable: |\n| Borrowings | 300,000 | 2,039,949 | 3,419,265 | — | 912,445 | 928,683 | 7,600,342 |\n| Repayments | ( 328,000 | ) | ( 2,048,653 | ) | ( 3,902,406 | ) | — | ( 27,279 | ) | ( 1,000,203 | ) | ( 7,306,541 | ) |\n| Discount on borrowings, net of amortization | — | — | 29 | — | — | 6,046 | 6,075 |\n| Unrealized gain on notes, fair value | — | — | — | — | 5,248 | — | 5,248 |\n| Capitalized deferred financing costs, net of amortization | 196 | 809 | ( 2,524 | ) | — | — | — | ( 1,519 | ) |\n| Balance at September 30, 2019 | $ | 269,759 | $ | 2,352,961 | $ | 2,896,819 | $ | 17,877,565 | $ | 6,248,154 | $ | 870,973 | $ | 30,516,231 |\n\n| (A) | New Residential net settles daily borrowings and repayments of the Notes and Bonds Payable on its servicer advances. |\n\n50\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nMaturities\nNew Residential’s debt obligations as of September 30, 2019 had contractual maturities as follows:\n| Year | Nonrecourse | Recourse | Total |\n| October 1 through December 31, 2019 | $ | 1,978 | $ | 18,781,709 | $ | 18,783,687 |\n| 2020 | 615,733 | 5,480,786 | 6,096,519 |\n| 2021 | 1,088,623 | 1,034,034 | 2,122,657 |\n| 2022 | 1,162,067 | 169,759 | 1,331,826 |\n| 2023 | 400,000 | 403,433 | 803,433 |\n| 2024 and thereafter | 976,300 | 410,534 | 1,386,834 |\n| $ | 4,244,701 | $ | 26,280,255 | $ | 30,524,956 |\n\nBorrowing Capacity\nThe following table represents New Residential’s borrowing capacity as of September 30, 2019:\n| Debt Obligations / Collateral | Borrowing Capacity | Balance Outstanding | Available Financing |\n| Repurchase Agreements |\n| Residential mortgage loans and REO | $ | 9,112,297 | $ | 5,233,801 | $ | 3,878,496 |\n| Non-Agency RMBS | 650,000 | 558,756 | 91,244 |\n| Notes and Bonds Payable |\n| Excess MSRs | 150,000 | 100,000 | 50,000 |\n| MSRs | 1,375,000 | 940,188 | 434,812 |\n| Servicer advances(A) | 1,204,660 | 1,053,127 | 151,533 |\n| Residential Mortgage Loans | 650,000 | 535,063 | 114,937 |\n| Consumer loans | 150,000 | 1,228 | 148,772 |\n| $ | 13,291,957 | $ | 8,422,163 | $ | 4,869,794 |\n\n| (A) | New Residential’s unused borrowing capacity is available if New Residential has additional eligible collateral to pledge and meets other borrowing conditions as set forth in the applicable agreements, including any applicable advance rate. New Residential pays a 0.02 % fee on the unused borrowing capacity. |\n\nCertain of the debt obligations are subject to customary loan covenants and event of default provisions, including event of default provisions triggered by certain specified declines in New Residential’s equity or a failure to maintain a specified tangible net worth, liquidity, or indebtedness to tangible net worth ratio. New Residential was in compliance with all of its debt covenants as of September 30, 2019.\n51\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| 12. | FAIR VALUE MEASUREMENT |\n\nThe carrying values and fair values of New Residential’s assets and liabilities recorded at fair value on a recurring basis, as well as other financial instruments for which fair value is disclosed, as of September 30, 2019 were as follows:\n| Fair Value |\n| Principal Balance or Notional Amount | Carrying Value | Level 1 | Level 2 | Level 3 | Total |\n| Assets |\n| Investments in: |\n| Excess mortgage servicing rights, at fair value(A) | $ | 93,025,190 | $ | 398,064 | $ | — | $ | — | $ | 398,064 | $ | 398,064 |\n| Excess mortgage servicing rights, equity method investees, at fair value(A) | 35,632,429 | 132,259 | — | — | 132,259 | 132,259 |\n| Mortgage servicing rights, at fair value(A) | 319,927,285 | 3,431,968 | — | — | 3,431,968 | 3,431,968 |\n| Mortgage servicing rights financing receivables, at fair value | 140,523,235 | 1,811,261 | — | — | — | 1,811,261 | 1,811,261 |\n| Servicer advance investments, at fair value | 492,480 | 600,547 | — | — | 600,547 | 600,547 |\n| Real estate and other securities, available-for-sale | 30,643,013 | 16,853,910 | — | 8,998,066 | 7,855,844 | 16,853,910 |\n| Residential mortgage loans, held-for-investment | 569,888 | 500,524 | — | — | 495,424 | 495,424 |\n| Residential mortgage loans, held-for-sale | 1,449,469 | 1,349,997 | — | — | 1,365,262 | 1,365,262 |\n| Residential mortgage loans, held-for-sale, at fair value | 5,272,963 | 5,206,251 | — | 872,088 | 4,334,192 | 5,206,280 |\n| Residential mortgage loans, held-for-investment, at fair value | 112,112 | 113,133 | — | — | 113,133 | 113,133 |\n| Residential mortgage loans subject to repurchase | 168,532 | 168,532 | — | 168,532 | — | 168,532 |\n| Consumer loans, held-for-investment | 878,431 | 881,183 | — | — | 903,805 | 903,805 |\n| Derivative assets | 17,619,076 | 36,712 | — | 10,498 | 26,214 | 36,712 |\n| Cash and cash equivalents | 738,219 | 738,219 | 738,219 | — | — | 738,219 |\n| Restricted cash | 163,148 | 163,148 | 163,148 | — | — | 163,148 |\n| Other assets(B) | N/A | 25,187 | 10,912 | — | 14,275 | 25,187 |\n| $ | 32,410,895 | $ | 912,279 | $ | 10,049,184 | $ | 21,482,248 | $ | 32,443,711 |\n| Liabilities |\n| Repurchase agreements | $ | 23,111,366 | $ | 23,110,359 | $ | — | $ | 23,111,366 | $ | — | $ | 23,111,366 |\n| Notes and bonds payable(C) | 7,413,590 | 7,405,872 | — | — | 7,486,297 | 7,486,297 |\n| Residential mortgage loan repurchase liability | 168,532 | 168,532 | — | 168,532 | — | 168,532 |\n| Derivative liabilities | 8,151,098 | 1,842 | — | 166 | 1,676 | 1,842 |\n| Excess spread financing | 3,113,756 | 30,377 | — | — | 30,377 | 30,377 |\n| Contingent consideration | N/A | 52,761 | — | — | 52,761 | 52,761 |\n| $ | 30,769,743 | $ | — | $ | 23,280,064 | $ | 7,571,111 | $ | 30,851,175 |\n\n\n| (A) | The notional amount represents the total unpaid principal balance of the residential mortgage loans underlying the MSRs, MSR financing receivables and Excess MSRs. New Residential does not receive an excess mortgage servicing amount on non-performing loans in Agency portfolios. |\n\n| (B) | Excludes the indirect equity investment in a commercial redevelopment project that is accounted for at fair value on a recurring basis based on the NAV of New Residential’s investment. The investment had a fair value of $ 74.1 million as of September 30, 2019. |\n\n52\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| (C) | Includes the SAFT 2013-1 mortgage-backed securities and the 2019-RPL1 asset-backed notes issued for which the fair value option for financial instruments was elected and resulted in a fair value of $ 474.3 million as of September 30, 2019. |\n\nNew Residential’s assets measured at fair value on a recurring basis using Level 3 inputs changed as follows:\n| Level 3 |\n| Excess MSRs(A) | Excess MSRs in Equity Method Investees(A)(B) | MSRs(A) | Mortgage Servicing Rights Financing Receivable(A) | Servicer Advance Investments | Non-Agency RMBS | Derivatives(C) | Residential Mortgage Loans |\n| Agency | Non-Agency | Total |\n| Balance at December 31, 2018 | $ | 257,387 | $ | 190,473 | $ | 147,964 | $ | 2,884,100 | $ | 1,644,504 | $ | 735,846 | $ | 8,970,963 | $ | 10,628 | $ | 2,330,627 | $ | 17,172,492 |\n| Transfers(D) |\n| Transfers from Level 3 | — | — | — | — | — | — | — | — | ( 19,726 | ) | ( 19,726 | ) |\n| Transfers to Level 3 | — | — | — | — | — | — | — | — | 301,174 | 301,174 |\n| Shellpoint Acquisition (Note 1) | — | — | — | — | — | — | 805 | 805 |\n| Transfers from investments in mortgage servicing rights financing receivables to investments in mortgage servicing rights | — | — | — | 367,121 | ( 367,121 | ) | — | — | — | — | — |\n| Gains (losses) included in net income |\n| Included in other-than-temporary impairment on securities(E) | — | — | — | — | — | — | ( 21,942 | ) | — | — | ( 21,942 | ) |\n| Included in change in fair value of investments in excess mortgage servicing rights(E) | ( 946 | ) | ( 475 | ) | — | — | — | — | — | — | — | ( 1,421 | ) |\n| Included in change in fair value of investments in excess mortgage servicing rights, equity method investees(E) | — | — | 4,087 | — | — | — | — | — | — | 4,087 |\n| Included in servicing revenue, net(F) | — | — | — | ( 629,396 | ) | — | — | — | — | — | ( 629,396 | ) |\n| Included in change in fair value of investments in mortgage servicing rights financing receivables(E) | — | — | — | — | ( 133,200 | ) | — | — | — | — | ( 133,200 | ) |\n| Included in change in fair value of servicer advance investments | — | — | — | — | — | 15,932 | — | — | — | 15,932 |\n| Included in change in fair value of investments in residential mortgage loans | — | — | — | — | — | — | — | — | 82,559 | 82,559 |\n| Included in gain (loss) on settlement of investments, net | 231 | 90 | — | — | — | — | 91,895 | — | — | 92,216 |\n| Included in other income (loss), net(E) | 1,036 | 735 | — | — | — | — | 9,010 | 13,910 | — | 24,691 |\n| Gains (losses) included in other comprehensive income(G) | — | — | — | — | — | — | 254,044 | — | — | 254,044 |\n| Interest income | 4,452 | 13,751 | — | — | — | 17,862 | 243,538 | — | — | 279,603 |\n| Purchases, sales and repayments |\n| Purchases | — | — | — | 632,144 | 735,152 | 1,255,306 | 1,164,853 | — | 7,634,281 | 11,421,736 |\n| Proceeds from sales | ( 4,579 | ) | ( 2 | ) | — | ( 1,047 | ) | ( 15,575 | ) | ( 1,662,900 | ) | — | ( 6,559,120 | ) | ( 8,243,223 | ) |\n| Proceeds from repayments | ( 36,021 | ) | ( 28,068 | ) | ( 19,792 | ) | ( 11,210 | ) | ( 52,499 | ) | ( 1,424,399 | ) | ( 1,193,617 | ) | — | ( 170,668 | ) | ( 2,936,274 | ) |\n| Originations and other | — | — | — | 190,256 | — | — | — | — | 847,393 | 1,037,649 |\n| Balance at September 30, 2019 | $ | 221,560 | $ | 176,504 | $ | 132,259 | $ | 3,431,968 | $ | 1,811,261 | $ | 600,547 | $ | 7,855,844 | $ | 24,538 | $ | 4,447,325 | $ | 18,701,806 |\n\n\n| (A) | Includes the recapture agreement for each respective pool, as applicable. |\n\n| (B) | Amounts represent New Residential’s portion of the Excess MSRs held by the respective joint ventures in which New Residential has a 50 % interest. |\n\n| (C) | For the purpose of this table, the IRLC asset and liability positions are shown net. |\n\n| (D) | Transfers are assumed to occur at the beginning of the respective period. |\n\n| (E) | The gains (losses) recorded in earnings during the period are attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting dates and realized gains (losses) recorded during the period. |\n\n| (F) | The components of Servicing revenue, net are disclosed in Note 5. |\n\n| (G) | These gains (losses) were included in net unrealized gain (loss) on securities in the Condensed Consolidated Statements of Comprehensive Income. |\n\n53\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nNew Residential’s liabilities measured at fair value on a recurring basis using Level 3 inputs changed as follows:\n| Level 3 |\n| Excess Spread Financing | Mortgage-Backed Securities Issued | Contingent Consideration |\n| Total |\n| Balance at December 31, 2018 | $ | 39,304 | $ | 117,048 | $ | 40,842 | $ | 197,194 |\n| Transfers(A) |\n| Transfers from Level 3 | — | — | — | — |\n| Transfers to Level 3 | — | — | — | — |\n| Acquisition | — | — | 14,488 | 14,488 |\n| Gains (losses) included in net income |\n| Included in other-than-temporary impairment on securities(B) | — | — | — | — |\n| Included in change in fair value of investments in excess mortgage servicing rights | — | — | — | — |\n| Included in change in fair value of investments in excess mortgage servicing rights, equity method investees(B) | — | — | — | — |\n| Included in servicing revenue, net(C) | ( 9,482 | ) | — | — | ( 9,482 | ) |\n| Included in change in fair value of investments in notes receivable - rights to MSRs | — | — | — | — |\n| Included in change in fair value of servicer advance investments | — | — | — | — |\n| Included in change in fair value of investments in residential mortgage loans | — | — | — | — |\n| Included in gain (loss) on settlement of investments, net | — | — | — | — |\n| Included in other income(B) | — | 5,248 | 7,431 | 12,679 |\n| Gains (losses) included in other comprehensive income, net of tax(D) | — | — | — | — |\n| Interest income | — | — | — | — |\n| Purchases, sales and repayments |\n| Purchases | — | 378,569 | — | 378,569 |\n| Proceeds from sales | — | — | — | — |\n| Proceeds from repayments | — | ( 26,556 | ) | — | ( 26,556 | ) |\n| Other | 555 | — | ( 10,000 | ) | ( 9,445 | ) |\n| Balance at September 30, 2019 | $ | 30,377 | $ | 474,309 | $ | 52,761 | $ | 557,447 |\n\n| (A) | Transfers are assumed to occur at the beginning of the respective period. |\n\n| (B) | The gains (losses) recorded in earnings during the period are attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting dates and realized gains (losses) recorded during the period. |\n\n| (C) | The components of Servicing revenue, net are disclosed in Note 5. |\n\n| (D) | These gains (losses) were included in net unrealized gain (loss) on securities in the Condensed Consolidated Statements of Comprehensive Income. |\n\n54\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nInvestments in Excess MSRs, Excess MSRs Equity Method Investees, MSRs and MSR Financing Receivables Valuation\nThe following table summarizes certain information regarding the weighted average inputs used as of September 30, 2019:\n| Significant Inputs(A) |\n| Prepayment Rate(B) | Delinquency(C) | Recapture Rate(D) | Mortgage Servicing Amount or Excess Mortgage Servicing Amount (bps)(E) | Collateral Weighted Average Maturity (Years)(F) |\n| Excess MSRs Directly Held (Note 4) |\n| Agency |\n| Original Pools | 9.3 | % | 1.2 | % | 23.5 | % | 21 | 20 |\n| Recaptured Pools | 12.3 | % | 0.5 | % | 35.0 | % | 22 | 23 |\n| 10.0 | % | 1.0 | % | 26.3 | % | 21 | 21 |\n| Non-Agency(G) |\n| Nationstar and SLS Serviced: |\n| Original Pools | 9.9 | % | N/A | 17.5 | % | 15 | 24 |\n| Recaptured Pools | 8.6 | % | N/A | 20.9 | % | 24 | 24 |\n| 9.7 | % | N/A | 17.9 | % | 16 | 24 |\n| Total/Weighted Average--Excess MSRs Directly Held | 9.9 | % | 1.0 | % | 22.6 | % | 19 | 22 |\n| Excess MSRs Held through Equity Method Investees (Note 4) |\n| Agency |\n| Original Pools | 10.0 | % | 1.5 | % | 26.7 | % | 19 | 19 |\n| Recaptured Pools | 11.7 | % | 0.9 | % | 32.6 | % | 24 | 23 |\n| Total/Weighted Average--Excess MSRs Held through Investees | 10.7 | % | 1.2 | % | 29.3 | % | 21 | 21 |\n| Total/Weighted Average--Excess MSRs All Pools | 10.2 | % | 1.1 | % | 24.8 | % | 20 | 22 |\n| MSRs |\n| Agency |\n| Mortgage Servicing Rights(H) (I) | 13.7 | % | 0.7 | % | 27.1 | % | 27 | 22 |\n| MSR Financing Receivables | 17.6 | % | 0.3 | % | 14.9 | % | 27 | 25 |\n| Non-Agency |\n| Mortgage Servicing Rights | 12.4 | % | 0.2 | % | 24.6 | % | 26 | 26 |\n| MSR Financing Receivables | 8.3 | % | 14.1 | % | 10.2 | % | 47 | 26 |\n| Ginnie Mae |\n| Mortgage Servicing Rights(I) | 14.8 | % | 3.6 | % | 29.7 | % | 32 | 27 |\n\n| (A) | Weighted by fair value of the portfolio. |\n\n| (B) | Projected annualized weighted average lifetime voluntary and involuntary prepayment rate using a prepayment vector. |\n\n| (C) | Projected percentage of residential mortgage loans in the pool for which the borrower will miss its mortgage payments. |\n\n| (D) | Percentage of voluntarily prepaid loans that are expected to be refinanced by the related servicer or subservicer, as applicable. |\n\n| (E) | Weighted average total mortgage servicing amount, in excess of the basic fee as applicable, measured in basis points (bps). A weighted average cost of subservicing of $ 6.46 per loan per month was used to value the agency MSRs, including MSR Financing Receivables. A weighted average cost of subservicing of $ 11.23 per loan per month was used to value the non-agency MSRs, including MSR Financing Receivables. A weighted average cost of subservicing of $ 8.81 per loan per month was used to value the Ginnie Mae MSRs. |\n\n| (F) | Weighted average maturity of the underlying residential mortgage loans in the pool. |\n\n| (G) | For certain pools, the Excess MSR will be paid on the total UPB of the mortgage portfolio (including both performing and delinquent loans until REO). For these pools, no delinquency assumption is used. |\n\n55\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| (H) | For certain pools, recapture rate represents the expected recapture rate with the successor subservicer appointed by NRM. |\n\n| (I) | Includes valuation of the related Excess spread financing (Note 5). |\n\nWith respect to valuing the Ocwen-serviced mortgage servicing rights financing receivables, which include a significant servicer advances receivable component, the cost of financing servicer advances receivable is assumed to be LIBOR plus 0.9 %.\nAs of September 30, 2019, a weighted average discount rate of 7.8 % was used to value New Residential’s investments in Excess MSRs (directly and through equity method investees). As of September 30, 2019, a weighted average discount rate of 7.5 % was used to value New Residential’s investments in MSRs and a weighted average discount rate of 8.8 % was used to value New Residential’s investments in MSR financing receivables.\nServicer Advance Investments Valuation\nThe following table summarizes certain information regarding the inputs used in valuing the Servicer Advance Investments, including the basic fee component of the related MSRs:\n| Significant Inputs |\n| Weighted Average |\n| Outstanding Servicer Advances to UPB of Underlying Residential Mortgage Loans | Prepayment Rate(A) | Delinquency | Mortgage Servicing Amount(B) | Discount Rate | Collateral Weighted Average Maturity (Years)(C) |\n| September 30, 2019 | 1.4 | % | 10.6 | % | 16.1 | % | 19.6 | bps | 5.1 | % | 23.0 |\n\n| (A) | Projected annual weighted average lifetime voluntary and involuntary prepayment rate using a prepayment vector. |\n\n| (B) | Mortgage servicing amount is net of 10.2 bps which represents the amount New Residential paid its servicers as a monthly servicing fee. |\n\n| (C) | Weighted average maturity of the underlying residential mortgage loans in the pool. |\n\nReal Estate and Other Securities Valuation\nAs of September 30, 2019, New Residential’s securities valuation methodology and results are further detailed as follows:\n| Fair Value |\n| Asset Type | Outstanding Face Amount | Amortized Cost Basis | Multiple Quotes(A) | Single Quote(B) | Total | Level |\n| Agency RMBS | $ | 8,797,199 | $ | 8,950,763 | $ | 8,998,066 | $ | — | $ | 8,998,066 | 2 |\n| Non-Agency RMBS(C) | 21,845,814 | 7,175,703 | 7,853,955 | 1,889 | 7,855,844 | 3 |\n| Total | $ | 30,643,013 | $ | 16,126,466 | $ | 16,852,021 | $ | 1,889 | $ | 16,853,910 |\n\n\n| (A) | New Residential generally obtained pricing service quotations or broker quotations from two sources, one of which was generally the seller (the party that sold New Residential the security) for Non-Agency RMBS. New Residential evaluates quotes received and determines one as being most representative of fair value, and does not use an average of the quotes. Even if New Residential receives two or more quotes on a particular security that come from non-selling brokers or pricing services, it does not use an average because it believes using an actual quote more closely represents a transactable price for the security than an average level. Furthermore, in some cases, for non-agency RMBS, there is a wide disparity between the quotes New Residential receives. New Residential believes using an average of the quotes in these cases would not represent the fair value of the asset. Based on New Residential’s own fair value analysis, it selects one of the quotes which is believed to more accurately reflect fair value. New Residential has not adjusted any of the quotes received in the periods presented. These quotations are generally received via email and contain disclaimers which state that they are “indicative” and not “actionable” — meaning that the party giving the quotation is not bound to actually purchase |\n\n56\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nthe security at the quoted price. New Residential’s investments in Agency RMBS are classified within Level 2 of the fair value hierarchy because the market for these securities is very active and market prices are readily observable.\nThe third-party pricing services and brokers engaged by New Residential (collectively, “valuation providers”) use either the income approach or the market approach, or a combination of the two, in arriving at their estimated valuations of RMBS. Valuation providers using the market approach generally look at prices and other relevant information generated by market transactions involving identical or comparable assets. Valuation providers using the income approach create pricing models that generally incorporate such assumptions as discount rates, expected prepayment rates, expected default rates and expected loss severities. New Residential has reviewed the methodologies utilized by its valuation providers and has found them to be consistent with GAAP requirements. In addition to obtaining multiple quotations, when available, and reviewing the valuation methodologies of its valuation providers, New Residential creates its own internal pricing models for Level 3 securities and uses the outputs of these models as part of its process of evaluating the fair value estimates it receives from its valuation providers. These models incorporate the same types of assumptions as the models used by the valuation providers, but the assumptions are developed independently. These assumptions are regularly refined and updated at least quarterly by New Residential, and reviewed by its valuation group, which is separate from its investment acquisition and management group, to reflect market developments and actual performance.\nFor 67.0 % of New Residential’s Non-Agency RMBS, the ranges of assumptions used by New Residential’s valuation providers are summarized in the table below. The assumptions used by New Residential’s valuation providers with respect to the remainder of New Residential’s Non-Agency RMBS were not readily available.\n| Fair Value | Discount Rate | Prepayment Rate(a) | CDR(b) | Loss Severity(c) |\n| Non-Agency RMBS | $ | 5,262,801 | 1.03% to 27.44% | 0.5% to 23.00% | 0.25% to 7.00% | 5.0% to 100% |\n\n| (a) | Represents the annualized rate of the prepayments as a percentage of the total principal balance of the pool. |\n\n| (b) | Represents the annualized rate of the involuntary prepayments (defaults) as a percentage of the total principal balance of the pool. |\n\n| (c) | Represents the expected amount of future realized losses resulting from the ultimate liquidation of a particular loan, expressed as the net amount of loss relative to the outstanding balance. |\n\n| (B) | New Residential was unable to obtain quotations from more than one source on these securities. |\n\n| (C) | Includes New Residential’s investments in interest-only notes for which the fair value option for financial instruments was elected. |\n\nResidential Mortgage Loans Valuation\nNew Residential, through its wholly owned subsidiary, NewRez, originates mortgage loans that it intends to sell into Fannie Mae, Freddie Mac, and Ginnie Mae mortgage backed securitizations. Residential mortgage loans held-for-sale, at fair value are typically pooled together and sold into certain exit markets, depending upon underlying attributes of the loan, such as agency eligibility, product type, interest rate, and credit quality. Residential mortgage loans held-for-sale, at fair value are valued using a market approach by utilizing either: (i) the fair value of securities backed by similar mortgage loans, adjusted for certain factors to approximate the fair value of a whole mortgage loan, (ii) current commitments to purchase loans or (iii) recent observable market trades for similar loans, adjusted for credit risk and other individual loan characteristics. As these prices are derived from market observable inputs, New Residential classifies these valuations as Level 2 in the fair value hierarchy.\nResidential mortgage loans held-for-sale, at fair value also includes certain nonconforming mortgage loans originated for sale to private investors, which are valued using internal pricing models to forecast loan level cash flows based on a potential securitization exit using inputs such as default rates, prepayments speeds and discount rates. As the internal pricing model is based on certain unobservable inputs, New Residential classifies these valuations as Level 3 in the fair value hierarchy.\n57\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nThe following table summarizes certain information regarding the inputs used in valuing residential mortgage loans held-for-sale, at fair value classified as Level 3:\n| Fair Value | Discount Rate | Prepayment Rate | CDR | Loss Severity |\n| Acquired Loans | $ | 3,916,826 | 4.20 % | 7.4 % | 1.6 % | 28.5 % |\n| Originated Loans | 417,366 | 3.0-4.5% | 6.0-16.0% | 0.0-3.5% | 0.0% - 50.0% |\n| Residential Mortgage Loans Held-for-Sale, at Fair Value | $ | 4,334,192 |\n\nResidential mortgage loans held-for-investment, at fair value includes mortgage loans underlying the SAFT 2013-1 securitization, which are valued using internal pricing models using inputs such as default rates, prepayment speeds and discount rates. As the internal pricing model is based on certain unobservable inputs, New Residential classifies these valuations as Level 3 in the fair value hierarchy.\nThe following table summarizes certain information regarding the inputs used in valuing residential mortgage loans held-for-investment, at fair value classified as Level 3:\n| Fair Value | Discount Rate | Prepayment Rate | CDR | Loss Severity |\n| Residential Mortgage Loans Held-for-Investment, at Fair Value | $ | 113,133 | 3.75 % | 8.0 % | 0.5 % | 20.0 % |\n\nDerivative Valuation\nNew Residential enters into economic hedges including interest rate swaps, caps and TBAs, which are categorized as Level 2 in the valuation hierarchy. New Residential generally values such derivatives using quotations, similarly to the method of valuation used for New Residential’s other assets that are classified as Level 2 in the fair value hierarchy.\nAs a part of the mortgage loan origination business, New Residential enters into forward loan sale and securities delivery commitments, which are valued based on observed market pricing for similar instruments and therefore, are classified as Level 2. In addition, New Residential enters into IRLCs, which are valued using internal pricing models incorporating (i) market pricing for instruments with similar characteristics (ii) estimating the fair value of the servicing rights expected to be recorded at sale of the loan and (iii) adjusted for anticipated loan funding probability. Both the fair value of servicing rights expected to be recorded at the date of sale of the loan and anticipated loan funding probability are significant unobservable inputs and therefore, IRLCs are classified as Level 3 in the fair value hierarchy.\nThe following table summarizes certain information regarding the inputs used in valuing IRLCs:\n| Fair Value | Loan Funding Probability | Fair Value of initial servicing rights (bps) |\n| IRLCs | $ | 24,538 | 54% to 100% | 0 to 315 |\n\nMortgage-Backed Securities Issued\nNew Residential and NewRez, a wholly owned subsidiary of New Residential, were deemed to be the primary beneficiaries of the RPL Borrowers and SAFT 2013-1 securitization entity and therefore, New Residential’s condensed consolidated balance sheets include the mortgage-backed securities issued by the RPL Borrowers and SAFT 2013-1, respectively. New Residential elected the fair value option for these financial instruments and the mortgage-backed securities issued were valued consistently with New Residential’s Non-Agency RMBS described above.\n58\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nThe following table summarizes certain information regards the inputs used in valuing Mortgage-Backed Securities Issued:\n| Fair Value | Discount Rate | Prepayment Rate | CDR | Loss Severity |\n| Mortgage-Backed Securities Issued | $ | 474,309 | 3.05% - 6.75% | 7% - 15% | 0.1%-3.5% | 10%-25% |\n\nContingent Consideration Valuation\nNew Residential, as additional consideration for the Shellpoint Acquisition, may make up to three cash earnout payments, which will be calculated following each of the first three anniversaries of the Shellpoint Closing as a percentage of the amount by which the pre-tax income of certain of Shellpoint’s businesses exceeds certain specified thresholds, up to an aggregate maximum amount of $ 60.0 million (the “Shellpoint Earnout Payments”). On September 5, 2019, New Residential paid $ 10.0 million as the first of three potential earnout payments. In accordance with ASC 805, New Residential measures its contingent consideration at fair value on a recurring basis using a scenario-based method to weigh the probability of multiple outcomes to arrive at an expected payment cash flow and then discounts the expected cash flow. The inputs utilized in valuing the contingent consideration include a discount rate of 11 % and the application of probability weighting of income scenarios, which are significant unobservable inputs and therefore, contingent consideration is classified as Level 3 in the fair value hierarchy.\nAssets and Liabilities Measured at Fair Value on a Nonrecurring Basis\nCertain assets are measured at fair value on a nonrecurring basis; that is, they are not measured at fair value on an ongoing basis but are subject to fair value adjustments only in certain circumstances, such as when there is evidence of impairment. For residential mortgage loans held-for-sale and foreclosed real estate accounted for as REO, New Residential applies the lower of cost or fair value accounting and may be required, from time to time, to record a nonrecurring fair value adjustment.\nAt September 30, 2019, assets measured at fair value on a nonrecurring basis were $ 1.3 billion. The $ 1.3 billion of assets include approximately $ 1,236.5 million of residential mortgage loans held-for-sale and $ 51.8 million of REO. The fair value of New Residential’s residential mortgage loans, held-for-sale is estimated based on a discounted cash flow model analysis using internal pricing models and is categorized within Level 3 of the fair value hierarchy.\nThe following table summarizes the inputs used in valuing these residential mortgage loans as of September 30, 2019:\n| Fair Value and Carrying Value | Discount Rate | Weighted Average Life (Years)(A) | Prepayment Rate | CDR(B) | Loss Severity(C) |\n| Performing Loans | $ | 715,110 | 4.4 | % | 4.0 | 13.0 | % | 2.0 | % | 35.5 | % |\n| Non-Performing Loans | 521,435 | 5.5 | % | 3.1 | 3.0 | % | 2.9 | % | 30.0 | % |\n| Total/Weighted Average | $ | 1,236,545 | 4.9 | % | 3.6 | 8.8 | % | 2.4 | % | 33.2 | % |\n\n| (A) | The weighted average life is based on the expected timing of the receipt of cash flows. |\n\n| (B) | Represents the annualized rate of the involuntary prepayments (defaults) as a percentage of the total principal balance. |\n\n| (C) | Loss severity is the expected amount of future realized losses resulting from the ultimate liquidation of a particular loan, expressed as the net amount of loss relative to the outstanding loan balance. |\n\nThe fair value of REO is estimated using a broker’s price opinion discounted based upon New Residential’s experience with actual liquidation values and, therefore, is categorized within Level 3 of the fair value hierarchy. These discounts to the broker price opinion generally range from 10 % to 25 %, depending on the information available to the broker.\nThe total change in the recorded value of assets for which a fair value adjustment has been included in the Condensed Consolidated Statements of Income for the nine months ended September 30, 2019 consisted of a reversal of prior valuation allowance of $ 17.0 million for residential mortgage loans, offset by $ 0.4 million increased allowance for REO.\n59\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\n| 13. | EQUITY AND EARNINGS PER SHARE |\n\nEquity and Dividends\nIn February 2019, New Residential issued 46.0 million shares of its common stock in a public offering at a price to the public of $ 16.50 per share for net proceeds of approximately $ 751.7 million. To compensate the Manager for its successful efforts in raising capital for New Residential, in connection with this offering, New Residential granted options to the Manager relating to 4.6 million shares of New Residential’s common stock at the public offering price, which had a fair value of approximately $ 3.8 million as of the grant date. The assumptions used in valuing the options were: a 2.40 % risk-free rate, a 9.30 % dividend yield, 19.26 % volatility and a 10 -year term.\nOn July 2, 2019, in a public offering, New Residential issued 6.2 million shares of its 7.50 % Series A Fixed-to-Floating Rate Cumulative Redeemable Preferred Stock (“Preferred Series A”), par value $ 0.01 per share, with a liquidation preference of $ 25.00 per share for net proceeds of approximately $ 150.0 million. To compensate the Manager for its successful efforts in raising capital for New Residential, in connection with this offering, New Residential granted options to the Manager relating to 0.6 million shares of New Residential’s common stock at the closing price per share of common stock on the pricing date, which had a fair value of approximately $ 0.5 million as of the grant date. The assumptions used in valuing the options were: a 1.91 % risk-free rate, a 9.73 % dividend yield, 17.95 % volatility and 10 -year term.\nOn August 15, 2019, in a public offering, New Residential issued 11.3 million shares of its 7.125 % Series B Fixed-to-Floating Rate Cumulative Redeemable Preferred Stock (“Preferred Series B”), par value $ 0.01 per share, with a liquidation preference of $ 25.00 per share for net proceeds of approximately $ 273.4 million. To compensate the Manager for its successful efforts in raising capital for New Residential, in connection with this offering, New Residential granted options to the Manager relating to 1.1 million shares of New Residential’s common stock at the closing price per share of common stock on the pricing date, which had a fair value of approximately $ 0.7 million as of the grant date. The assumptions used in valuing the options were: a 1.56 % risk-free rate, a 11.2 % dividend yield, 18.23 % volatility and 10 -year term.\nOn September 23, 2019, New Residential’s board of directors declared a third quarter 2019 common dividend of $ 0.50 per common share or $ 207.8 million and preferred dividends of $ 0.69 per share of Preferred Series A and $ 0.45 per share of Preferred Series B, or $ 4.3 million and $ 5.0 million, respectively.\nApproximately 2.4 million shares of New Residential’s common stock were held by Fortress, through its affiliates, at September 30, 2019.\nOn August 20, 2019, New Residential announced that its board of directors had authorized the repurchase of up to $ 200.0 million of its common stock through December 31, 2020. Repurchases may be made from time to time through open market purchases or privately negotiated transactions, pursuant to one or more plans established pursuant to Rule 10b5-1 under the Securities Exchange Act of 1934 or by means of one or more tender offers, in each case, as permitted by securities laws and other legal requirements. The amount and timing of the purchases will depend on a number of factors including the price and availability of New Residential’s shares, trading volume, capital availability, New Residential’s performance and general economic and market conditions. No share repurchases have been made as of the date of issuance of these consolidated financial statements. The share repurchase program may be suspended or discontinued at any time.\nOption Plan\nAs of September 30, 2019, New Residential’s outstanding options were summarized as follows:\n| Held by the Manager | 10,511,167 |\n| Issued to the Manager and subsequently assigned to certain of the Manager’s employees | 2,290,749 |\n| Issued to the independent directors | 7,000 |\n| Total | 12,808,916 |\n\n60\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nThe following table summarizes New Residential’s outstanding options as of September 30, 2019. The last sales price on the New York Stock Exchange for New Residential’s common stock in the quarter ended September 30, 2019 was $ 15.68 per share.\n| Recipient | Date ofGrant/Exercise(A) | Number of UnexercisedOptions | OptionsExercisable as ofSeptember 30, 2019 | WeightedAverageExercisePrice(B) | Intrinsic Value of Exercisable Options as ofSeptember 30, 2019(millions) |\n| Directors | Various | 7,000 | 7,000 | $ | 13.61 | $ | — |\n| Manager(C) | 2017 | 1,130,916 | — | 14.09 | 1.8 |\n| Manager(C) | 2018 | 5,320,000 | 2,416,798 | 16.61 | — |\n| Manager(C) | 2019 | 6,351,000 | 1,152,400 | 16.43 | — |\n| Outstanding | 12,808,916 | 3,576,198 |\n\n\n| (A) | Options expire on the tenth anniversary from date of grant. |\n\n| (B) | The exercise prices are subject to adjustment in connection with return of capital dividends. A portion of New Residential’s 2018 dividends was deemed to be a return of capital and the exercise prices were adjusted accordingly. |\n\n| (C) | The Manager assigned certain of its options to its employees as follows: |\n\n| Date of Grant to Manager | Range of ExercisePrices | Total UnexercisedInception to Date |\n| 2017 | $ 14.09 | 1,130,916 |\n| 2018 | $16.48 to $17.73 | 1,159,833 |\n| Total | 2,290,749 |\n\nThe following table summarizes activity in New Residential’s outstanding options:\n| Amount | Weighted Average Exercise Price |\n| December 31, 2018 outstanding options | 8,498,138 |\n| Options granted | 6,352,000 | $ | 16.20 |\n| Options exercised | ( 2,041,222 | ) | $ | 13.88 |\n| Options expired unexercised | — |\n| September 30, 2019 outstanding options | 12,808,916 | See table above |\n\nIncome and Earnings Per Share\nNew Residential is required to present both basic and diluted earnings per share (“EPS”). Basic EPS is calculated by dividing net income by the weighted average number of shares of common stock outstanding. Diluted EPS is computed by dividing net income by the weighted average number of shares of common stock outstanding plus the additional dilutive effect, if any, of common stock equivalents during each period. New Residential’s common stock equivalents are its outstanding options. During the nine months ended September 30, 2019, based on the treasury stock method, New Residential had 150,699 dilutive common stock equivalents outstanding. During the nine months ended September 30, 2018, based on the treasury stock method, New Residential had 1,463,258 dilutive common stock equivalents outstanding.\nNoncontrolling Interests\nNoncontrolling interests is comprised of the interests held by third parties in consolidated entities that hold New Residential’s Servicer Advance Investments (Note 6), Shelter JVs (Note 8) and Consumer Loans (Note 9).\n| 14. | COMMITMENTS AND CONTINGENCIES |\n\nLitigation – New Residential is or may become, from time to time, involved in various disputes, litigation and regulatory inquiry and investigation matters that arise in the ordinary course of business. Given the inherent unpredictability of these types of proceedings, it is possible that future adverse outcomes could have a material adverse effect on its business, financial position or results of operations. New Residential is not aware of any unasserted claims that it believes are material and probable of assertion where the risk of loss is expected to be reasonably possible.\nNew Residential is, from time to time, subject to inquiries by government entities. New Residential currently does not believe any of these inquiries would result in a material adverse effect on New Residential’s business.\nIndemnifications – In the normal course of business, New Residential and its subsidiaries enter into contracts that contain a variety of representations and warranties and that provide general indemnifications. New Residential’s maximum exposure under these arrangements is unknown as this would involve future claims that may be made against New Residential that have not yet occurred. However, based on its experience, New Residential expects the risk of material loss to be remote.\nCapital Commitments — As of September 30, 2019, New Residential had outstanding capital commitments related to investments in the following investment types (also refer to Note 5 for MSR investment commitments and to Note 18 for additional capital commitments entered into subsequent to September 30, 2019, if any):\nMSRs and Servicer Advances — New Residential and, in some cases, third-party co-investors agreed to purchase future servicer advances related to certain Non-Agency mortgage loans. In addition, New Residential’s subsidiary, NRM, is generally obligated to fund future servicer advances related to the loans it is obligated to service. The actual amount of future advances purchased will be based on: (a) the credit and prepayment performance of the underlying loans, (b) the amount of advances recoverable prior to liquidation of the related collateral and (c) the percentage of the loans with respect to which no additional advance obligations are made. The actual amount of future advances is subject to significant uncertainty. See Notes 5 and 6 for information on New Residential’s investments in MSRs and Servicer Advance Investments, respectively.\nMortgage Origination Reserves — NewRez, a wholly owned subsidiary of New Residential, originates conventional, government-insured and nonconforming residential mortgage loans for sale and securitization. The GSEs or Ginnie Mae guarantee conventional and government insured mortgage securitizations and mortgage investors issue nonconforming private label mortgage securitizations while NewRez generally retains the right to service the underlying residential mortgage loans. In connection with the transfer of loans to the GSEs or mortgage investors, NewRez makes representations and warranties regarding certain attributes of the loans and, subsequent to the sale, if it is determined that a sold loan is in breach of these representations and warranties, NewRez generally has an obligation to cure the breach. If NewRez is unable to cure the breach, the purchaser may require NewRez to repurchase the loan.\nIn addition, for Ginnie Mae guaranteed securitizations, NewRez holds a Ginnie Mae Buy-Back Option to repurchase delinquent loans from the securitization at its discretion. While NewRez is not obligated to repurchase the delinquent loans, NewRez generally executes its option to repurchase that will result in an economic benefit. As of September 30, 2019, New Residential’s estimated liability associated with representations and warranties and Ginnie Mae repurchases was $ 9.2 million and $ 168.5 million, respectively. See Notes 5 and 8 for information on New Residential’s Ginnie Mae Buy-Back Option and mortgage origination, respectively.\nMortgage Origination Unfunded Commitments — As of September 30, 2019, NewRez was committed to fund approximately $ 2.7 billion of mortgage loans and had forward loan sale commitments of $ 7.0 million. The forward sales are expected to close during the fourth quarter of 2019.\nResidential Mortgage Loans — As part of its investment in residential mortgage loans, New Residential may be required to outlay capital. These capital outflows primarily consist of advance escrow and tax payments, residential maintenance and property disposition fees. The actual amount of these outflows is subject to significant uncertainty. See Note 8 for information on New Residential’s investments in residential mortgage loans.\nConsumer Loans — The Consumer Loan Companies have invested in loans with an aggregate of $ 279.4 million of unfunded and available revolving credit privileges as of September 30, 2019. However, under the terms of these loans, requests for draws may be denied and unfunded availability may be terminated at New Residential’s discretion.\n61\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nLeases — New Residential, through its wholly owned subsidiary, Shellpoint, has leases on office space expiring through 2025. Future commitments under non-cancelable leases are approximately $ 25.4 million.\nEnvironmental Costs — As a residential real estate owner, through its REO, New Residential is subject to potential environmental costs. At September 30, 2019, New Residential is not aware of any environmental concerns that would have a material adverse effect on its consolidated financial position or results of operations.\nDebt Covenants — New Residential’s debt obligations contain various customary loan covenants (Note 11).\nCertain Tax-Related Covenants — If New Residential is treated as a successor to Drive Shack Inc. (“Drive Shack”) under applicable U.S. federal income tax rules, and if Drive Shack failed to qualify as a REIT for a taxable year ending on or before December 31, 2014, New Residential could be prohibited from electing to be a REIT. Accordingly, in the separation and distribution agreement executed in connection with New Residential’s spin-off from Drive Shack, Drive Shack (i) represented that it had no knowledge of any fact or circumstance that would cause New Residential to fail to qualify as a REIT, (ii) covenanted to use commercially reasonable efforts to cooperate with New Residential as necessary to enable New Residential to qualify for taxation as a REIT and receive customary legal opinions concerning REIT status, including providing information and representations to New Residential and its tax counsel with respect to the composition of Drive Shack’s income and assets, the composition of its stockholders, and its operation as a REIT; and (iii) covenanted to use its reasonable best efforts to maintain its REIT status for each of Drive Shack’s taxable years ending on or before December 31, 2014 (unless Drive Shack obtains an opinion from a nationally recognized tax counsel or a private letter ruling from the U.S. Internal Revenue Service (“IRS”) to the effect that Drive Shack’s failure to maintain its REIT status will not cause New Residential to fail to qualify as a REIT under the successor REIT rule referred to above). Additionally, New Residential covenanted to use its reasonable best efforts to qualify for taxation as a REIT for its taxable year ended December 31, 2013.\n| 15. | TRANSACTIONS WITH AFFILIATES AND AFFILIATED ENTITIES |\n\nNew Residential is party to a Management Agreement with its Manager which provides for automatically renewing one-year terms subject to certain termination rights. The Manager’s performance is reviewed annually and the Management Agreement may be terminated by New Residential by payment of a termination fee, as defined in the Management Agreement, equal to the amount of management fees earned by the Manager during the 12 consecutive calendar months immediately preceding the termination, upon the affirmative vote of at least two-thirds of the independent directors, or by a majority vote of the holders of common stock. If the Management Agreement is terminated, the Manager may require New Residential to purchase from the Manager the right of the Manager to receive the Incentive Compensation. In exchange therefor, New Residential would be obligated to pay the Manager a cash purchase price equal to the amount of the Incentive Compensation that would be paid to the Manager if all of New Residential’s assets were sold for cash at their then current fair market value (taking into account, among other things, expected future performance of the underlying investments). Pursuant to the Management Agreement, the Manager, under the supervision of New Residential’s board of directors, formulates investment strategies, arranges for the acquisition of assets and associated financing, monitors the performance of New Residential’s assets and provides certain advisory, administrative and managerial services in connection with the operations of New Residential.\nThe Manager is entitled to receive a management fee in an amount equal to 1.5 % per annum of New Residential’s gross equity calculated and payable monthly in arrears in cash. Gross equity is generally (i) the equity transferred by Drive Shack, formerly Newcastle Investment Corp., which was the sole stockholder of New Residential until the spin-off of New Residential completed on May 15, 2013, on the date of the spin-off, (ii) plus total net proceeds from stock offerings, plus certain capital contributions to subsidiaries, less capital distributions and repurchases of common stock.\nIn addition, the Manager is entitled to receive annual incentive compensation in an amount equal to the product of (A) 25 % of the dollar amount by which (1) (a) New Residential’s funds from operations before the incentive compensation, excluding funds from operations from investments in the Consumer Loan Companies and any unrealized gains or losses from mark-to-market valuation changes on investments and debt (and any deferred tax impact thereof), per share of common stock, plus (b) earnings (or losses) from the Consumer Loan Companies computed on a level-yield basis (such that the loans are treated as if they qualified as loans acquired with a discount for credit quality as set forth in ASC No. 310-30, as such codification was in effect on June 30, 2013) as if the Consumer Loan Companies had been acquired at their GAAP basis on May 15, 2013, plus earnings (or losses) from equity method investees invested in Excess MSRs as if such equity method investees had not made a fair value election, plus gains (or losses) from debt restructuring and gains (or losses) from sales of property, and plus non-routine items, minus amortization of non-\n62\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nroutine items, in each case per share of common stock, exceed (2) an amount equal to (a) the weighted average of the book value per share of the equity transferred by Drive Shack on the date of the spin-off and the prices per share of New Residential’s common stock in any offerings (adjusted for prior capital dividends or capital distributions) multiplied by (b) a simple interest rate of 10 % per annum, multiplied by (B) the weighted average number of shares of common stock outstanding. “Funds from operations” means net income (computed in accordance with GAAP), excluding gains (or losses) from debt restructuring and gains (or losses) from sales of property, plus depreciation on real estate assets, and after adjustments for unconsolidated partnerships and joint ventures. Funds from operations will be computed on an unconsolidated basis. The computation of funds from operations may be adjusted at the direction of New Residential’s independent directors based on changes in, or certain applications of, GAAP. Funds from operations is determined from the date of the spin-off and without regard to Drive Shack’s prior performance.\nIn addition to the management fee and incentive compensation, New Residential is responsible for reimbursing the Manager for certain expenses paid by the Manager on behalf of New Residential.\nDue to affiliates is comprised of the following amounts:\n| September 30, 2019 | December 31, 2018 |\n| Management fees | $ | 7,076 | $ | 5,779 |\n| Incentive compensation | 49,265 | 94,900 |\n| Expense reimbursements and other | 3,210 | 792 |\n| Total | $ | 59,551 | $ | 101,471 |\n\nAffiliate expenses and fees were comprised of:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Management fees | $ | 20,678 | $ | 15,464 | $ | 58,261 | $ | 46,027 |\n| Incentive compensation | 36,307 | 23,848 | 49,265 | 65,169 |\n| Expense reimbursements(A) | 125 | 125 | 375 | 375 |\n| Total | $ | 57,110 | $ | 39,437 | $ | 107,901 | $ | 111,571 |\n\n\n| (A) | Included in General and Administrative Expenses in the Condensed Consolidated Statements of Income. |\n\nSee Note 4 regarding co-investments with Fortress-managed funds.\nSee Note 13 regarding options granted to the Manager.\n| 16. | RECLASSIFICATION FROM ACCUMULATED OTHER COMPREHENSIVE INCOME INTO NET INCOME |\n\nThe following table summarizes the amounts reclassified out of accumulated other comprehensive income into net income:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| Accumulated Other Comprehensive Income Components | Statement of Income Location | 2019 | 2018 | 2019 | 2018 |\n| Reclassification of net realized (gain) loss on securities into earnings | Gain (loss) on settlement of investments, net | $ | ( 95,003 | ) | $ | 28,737 | $ | ( 201,222 | ) | $ | 66,695 |\n| Reclassification of net realized (gain) loss on securities into earnings | Other-than-temporary impairment on securities | 5,567 | 3,889 | 21,942 | 23,190 |\n| Total reclassifications | $ | ( 89,436 | ) | $ | 32,626 | $ | ( 179,280 | ) | $ | 89,885 |\n\nNew Residential did not allocate any income tax expense or benefit to any component of other comprehensive income for any period presented, as no taxable subsidiary generated other comprehensive income.\n| 17. | INCOME TAXES |\n\nIncome tax expense (benefit) consists of the following:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Current: |\n| Federal | $ | 1,198 | $ | 5,691 | $ | 785 | $ | 6,299 |\n| State and Local | 14 | ( 263 | ) | 115 | 424 |\n| Total Current Income Tax Expense (Benefit) | 1,212 | 5,428 | 900 | 6,723 |\n| Deferred: |\n| Federal | ( 5,385 | ) | ( 1,201 | ) | 14,762 | ( 12,829 | ) |\n| State and Local | ( 1,267 | ) | ( 664 | ) | 3,318 | 149 |\n| Total Deferred Income Tax Expense (Benefit) | ( 6,652 | ) | ( 1,865 | ) | 18,080 | ( 12,680 | ) |\n| Total Income Tax Expense (Benefit) | $ | ( 5,440 | ) | $ | 3,563 | $ | 18,980 | $ | ( 5,957 | ) |\n\nNew Residential intends to qualify as a REIT for each of its tax years through December 31, 2019. A REIT is generally not subject to U.S. federal corporate income tax on that portion of its income that is distributed to stockholders if it distributes at least 90% of its REIT taxable income to its stockholders by prescribed dates and complies with various other requirements.\n63\n| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) |\n| September 30, 2019 |\n| (dollars in tables in thousands, except share data) |\n\nNew Residential operates various securitization vehicles and has made certain investments, particularly its investments in MSRs (Note 5), Servicer Advance Investments (Note 6) and REO (Note 8), through taxable REIT subsidiaries (“TRSs”) that are subject to regular corporate income taxes which have been provided for in the provision for income taxes, as applicable.\nNew Residential has recorded a net deferred tax asset of approximately $ 43.4 million as of September 30, 2019 , primarily related to unrealized gains and discount accruals offset by net operating loss carry forwards.\n| 18. | SUBSEQUENT EVENTS |\n\nThese financial statements include a discussion of material events that have occurred subsequent to September 30, 2019 (referred to as “subsequent events”) through the issuance of these condensed consolidated financial statements. Events subsequent to that date have not been considered in these financial statements.\nCorporate Activities\nOn October 1, 2019, New Residential completed its purchase of Ditech’s forward Fannie Mae, Ginnie Mae and non-agency MSRs with an aggregate UPB of approximately $ 62.0 billion as of August 31, 2019, the servicer advance receivables relating to such MSRs and other assets core to the forward origination and servicing operations. Additionally, New Residential assumed certain Ditech office spaces and added approximately 1,100 Ditech employees to support the increase in volume to its existing origination and servicing operations. The approximate purchase price at the closing was $ 1.2 billion and the acquisition was financed via financing facilities and cash on hand.\nOn October 4, 2019, New Residential issued a securitization of approximately $ 1.73 billion UPB of reperforming residential mortgage loans for net proceeds of $ 1.67 billion.\n64\nITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nManagement’s discussion and analysis of financial condition and results of operations is intended to help the reader understand the results of operations and financial condition of New Residential. The following should be read in conjunction with the unaudited Condensed Consolidated Financial Statements and notes thereto included herein, and with “Risk Factors.”\nGENERAL\nNew Residential is a publicly traded REIT primarily focused on opportunistically investing in, and actively managing, investments related to residential real estate. We primarily target investments in mortgage servicing related assets and related opportunistic investments. We are externally managed by an affiliate of Fortress pursuant to the Management Agreement. Our goal is to drive strong risk-adjusted returns primarily through our investments, and our investment guidelines are purposefully broad to enable us to make investments in a wide array of assets in diverse markets, including non-real estate related assets such as consumer loans. We generally target assets that generate significant current cash flows and/or have the potential for meaningful capital appreciation.\nOur portfolio is currently composed of mortgage servicing related assets, Non-Agency RMBS (and associated call rights), residential mortgage loans and other opportunistic investments. Our asset allocation and target assets may change over time, depending on our investment decisions in light of prevailing market conditions. The assets in our portfolio are described in more detail below under “—Our Portfolio.”\nNew Residential, through its wholly-owned subsidiaries New Residential Mortgage LLC (“NRM”) and NewRez LLC (“NewRez”), is licensed or otherwise eligible to service residential mortgage loans in all states within the United States and the District of Columbia. NRM and NewRez perform servicing on behalf of investors, including the Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”) (collectively, Government Sponsored Enterprises or “GSEs”) and Government National Mortgage Association (“Ginnie Mae”), and on behalf of other servicers (subservicing).\nNewRez originates, sells and securitizes conventional (conforming to the underwriting standards of Fannie Mae or Freddie Mac; collectively referred to as “Agency” loans), government-insured (Federal Housing Administration (“FHA”) and Department of Veterans Affairs (“VA”)) and non-qualified (“Non-QM”) residential mortgage loans. The GSEs or Ginnie Mae guarantee securitizations completed under their applicable policies and guidelines. New Residential generally retains the right to service the underlying residential mortgage loans sold and securitized by NRM and NewRez. NRM and NewRez are required to conduct aspects of their operations in accordance with applicable policies and guidelines published by FHA, Fannie Mae and Freddie Mac in order to maintain those approvals.\nMARKET CONSIDERATIONS\nDevelopments in the U.S. Housing Market\nAs of the third quarter of 2019, the top 100 mortgage servicers serviced over 99% of the $10.9 trillion one-to-four family mortgage debt outstanding, according to Inside Mortgage Finance. Furthermore, according to Inside Mortgage Finance, as of the third quarter of 2019, approximately 66% of such outstanding mortgage debt was serviced by the top 25 mortgage servicers, of which 15 are non-banks. Given current market dynamics and an overall competitive servicing environment, we may expect additional market consolidation among non-bank servicers. As a result, we believe additional MSR sales will be likely for some period of time. These factors have resulted in increased opportunities for us to acquire interests in MSRs and to provide capital to non-bank servicers. In addition, approximately $1.64 trillion of new loans were originated in 2018 and another $1.86 trillion are forecasted for 2019, according to the Mortgage Bankers Association. We believe this creates an opportunity to enter into “flow arrangements,” whereby loan originators or servicers agree to sell MSRs or Excess MSRs on newly originated loans on a recurring basis (often monthly or quarterly). Recently, strong demand for mortgage assets in general has led to tighter spreads and lower required rates of return. This, in turn, creates a reach for yield and increased difficulty in sourcing accretive investments in the current investment landscape. These market conditions have driven prices higher, thereby also increasing the value of certain of our existing investments.\nInterest Rates and Prepayment Rates\nAs further described in “Quantitative and Qualitative Disclosures About Market Risk,” decreasing interest rates are generally associated with increasing prepayment rates for residential mortgage loans since they decrease the cost of borrowing for homeowners. Increasing prepayment rates, in turn, would generally be expected to decrease the value of our interests in Excess MSRs, MSRs and Servicer Advance Investments, which include the right to a portion of the related MSRs, because the duration\n65\nof the cash flows we are entitled to receive decreases and results in a reduction in current cash flows. Changes in interest rates will also directly impact our costs of borrowing either immediately (floating rate debt) or upon refinancing (fixed rate debt) and may also be associated with changes in credit spreads and/or the discount rates used in valuing investments. Increasing prepayment rates have a positive impact on the value of investments purchased at a significant discount since the recovery of that discount is accelerated.\nIn the third quarter of 2019, given mixed economic data, the Federal Reserve lowered borrowing costs twice and signaled that future rate cuts in 2019 were a possibility resulting in current interest rates moving lower, with the 10-year Treasury declining 34 bps during the quarter, to 1.67% as of September 30, 2019 from 2.01% as of June 30, 2019, and LIBOR declining 38 bps during the quarter to 2.01% as of September 30, 2019 from 2.39% as of June 30, 2019. Meanwhile, the primary mortgage rate decreased 11 bps during the quarter to 3.718% as of September 30, 2019 from 3.824% as of June 30, 2019. With respect to our Non-Agency RMBS, which are generally purchased at a significant discount to par, market interest rates decreased and market credit spreads increased, with the net result being a decrease in value of these investments during the quarter.\nThe value of our MSRs and Excess MSRs is subject to a variety of factors, as described in “Quantitative and Qualitative Disclosures About Market Risk” and in “Risk Factors.” In the third quarter of 2019, the fair value of our direct investments in Excess MSRs and our share of the fair value of the Excess MSRs held through equity method investees increased by approximately $3.2 million in the aggregate, primarily as a result of a decrease in discount rates. In addition, faster prepayment speeds partially offset by lower discount rates caused the fair value of our MSRs, including MSR financing receivables, to decrease by approximately $48.9 million during the period.\nChanges in interest rates did not have a meaningful impact on the net interest spread of our Agency and Non-Agency RMBS portfolios. Our RMBS are primarily floating rate or hybrid (i.e., fixed to floating rate) securities, which we generally finance with floating rate debt, or are economically hedged with respect to interest rates. Therefore, while decreasing interest rates will generally result in a lower cost of financing, they will also result in a lower coupon payable on the securities. The net interest spread on our Agency RMBS portfolio as of September 30, 2019 was 0.75%, compared to 0.55% as of June 30, 2019. The spread changed primarily as a result of increased funding costs. The net interest spread on our Non-Agency RMBS portfolio as of September 30, 2019 was 1.76%, compared to 1.61% as of June 30, 2019. This spread changed primarily as a result of lower funding costs.\nWe employ a variety of hedging strategies to reduce book value volatility. Both our diverse portfolio composition (inclusive of long and short duration instruments and various operating businesses) as well as specific hedging instruments (including Agency MBS, interest rate swaps etc.) mitigate book value volatility.\nGeneral U.S. Economy and Unemployment\nDuring the third quarter of 2019, the U.S. unemployment rate continued to decline slightly to 3.5% as of September 30, 2019, signaling a general improvement in the U.S. economy. In our view, an improvement in the economy, as demonstrated through such measure, generally improves the value of housing and the ability of borrowers to make payments on their loans, thereby decreasing delinquencies and defaults on residential mortgage loans, consumer loans and RMBS. This relationship generally held true, however, the third quarter of 2019 continued to show certain indications that the rate of home price increases across the U.S. has slowed. The Case Shiller U.S. National Home Price Index reported a 2.0% annual gain in July 2019, down from 4.3% in January 2019. In addition, according to CoreLogic, the total number of mortgaged residential properties with negative equity stood at 2.0 million, or 3.8%, as of the second quarter of 2019, down from 3.8% in the first quarter of 2019 and on a year-over-year basis, the number of mortgaged properties in negative equity fell 9.0%. While potentially slowing, this trend continues to help support the values of our residential mortgage loans, consumer loans and RMBS.\nCredit Spreads\nCorporate credit spreads, which generally have an impact on the value of yield driven financial instruments (e.g., RMBS and loan portfolios), continued to tighten during the third quarter of 2019. In addition, collateral performance, market liquidity, mortgage credit spreads and other factors related specifically to certain investments within our mortgage securities and loan portfolio caused an increase to the value of the portion of this portfolio that was owned for the entire quarter.\nFor more information regarding these and other market factors which impact our portfolio, see Item 3. “Quantitative and Qualitative Disclosures About Market Risk.”\n66\nOur Manager\nOn December 27, 2017, SoftBank Group Corp. (“SoftBank”) announced that it completed its previously announced acquisition of Fortress (the “SoftBank Merger”). In connection with the SoftBank Merger, Fortress operates within SoftBank as an independent business headquartered in New York.\nOUR PORTFOLIO\nOur portfolio is currently composed of mortgage servicing related assets, residential securities and loans and other investments, as described in more detail below. The assets in our portfolio are described in more detail below (dollars in thousands), as of September 30, 2019.\n| OutstandingFace Amount | AmortizedCost Basis | Percentage of Total Amortized Cost Basis | CarryingValue | WeightedAverageLife (years)(A) |\n| Investments in: |\n| Excess MSRs(B) | $ | 128,657,619 | $ | 398,488 | 1.3 | % | $ | 530,323 | 5.7 |\n| MSRs(B) | 319,927,285 | 3,364,140 | 11.2 | % | 3,431,968 | 4.8 |\n| MSR Financing Receivables(B) (C) | 140,523,235 | 1,500,229 | 5.0 | % | 1,811,261 | 6.2 |\n| Servicer Advance Investments(B) (D) | 492,480 | 570,570 | 1.7 | % | 600,547 | 6.3 |\n| Agency RMBS(E) | 8,797,199 | 8,950,763 | 29.9 | % | 8,998,066 | 4.6 |\n| Non-Agency RMBS(E) | 21,845,814 | 7,175,703 | 24.1 | % | 7,855,844 | 6.3 |\n| Residential Mortgage Loans | 7,404,432 | 7,067,812 | 23.7 | % | 7,169,905 | 10.0 |\n| Consumer Loans | 878,431 | 884,587 | 3.1 | % | 881,183 | 3.9 |\n| Total/Weighted Average | $ | 29,912,292 | 100.0 | % | $ | 31,279,097 | 6.4 |\n| Reconciliation to GAAP total assets: |\n| Cash and restricted cash | 901,367 |\n| Servicer advances receivable | 2,911,798 |\n| Trades receivable | 4,487,772 |\n| Deferred tax asset, net | 43,372 |\n| Other assets | 1,724,519 |\n| GAAP total assets | $ | 41,347,925 |\n\n\n| (A) | Weighted average life is based on the timing of expected principal reduction on the asset. |\n\n| (B) | The outstanding face amount of Excess MSRs, MSRs, MSR Financing Receivables, and Servicer Advance Investments is based on 100% of the face amount of the underlying residential mortgage loans and currently outstanding advances, as applicable. |\n\n| (C) | Includes certain MSRs where our subsidiary, NRM, is the named servicer. |\n\n| (D) | The value of our Servicer Advance Investments also includes the rights to a portion of the related MSR. |\n\n| (E) | Amortized cost basis is net of impairment. |\n\nServicing Related Assets\nMSRs and MSR Financing Receivables\nAs of September 30, 2019, we had $5.2 billion carrying value of MSRs and mortgage servicing rights financing receivables within our servicer subsidiary, NRM.\nNRM has contracted with certain subservicers to perform the related servicing duties on the residential mortgage loans underlying its MSRs. As of September 30, 2019, these subservicers include PHH, Nationstar, LoanCare, AmeriHome, and Flagstar, which subservice 26.9%, 23.1%, 19.2%, 1.8%, and 0.8% of the underlying UPB of the related mortgages, respectively (includes both Mortgage Servicing Rights and MSR Financing Receivables). The remaining 28.2% of the underlying UPB of the related mortgages is subserviced by our subsidiary, Shellpoint Mortgage Servicing (Note 1 to our Condensed Consolidated Financial Statements).\n67\nNRM has entered into agreements with PHH, LoanCare, Flagstar, and Nationstar whereby NRM is entitled to the MSR on any refinancing by such subservicer of a loan in the related original portfolio.\nThe table below summarizes our investments in MSRs and mortgage servicing rights financing receivables as of September 30, 2019.\n| Current UPB (bn) | Weighted Average MSR (bps) | Carrying Value (mm) |\n| Mortgage Servicing Rights |\n| Agency | $ | 288.7 | 27 | bps | $ | 3,038.7 |\n| Non-Agency | 2.3 | 26 | 20.3 |\n| Ginnie Mae | 28.9 | 32 | 372.9 |\n| MSR Financing Receivables |\n| Agency | 61.2 | 27 | 598.0 |\n| Non-Agency | 79.4 | 47 | 1,213.3 |\n| Total | $ | 460.5 | 31 | bps | $ | 5,243.2 |\n\nThe following table summarizes the collateral characteristics of the loans underlying our investments in MSRs and mortgage servicing rights financing receivables as of September 30, 2019 (dollars in thousands):\n| Collateral Characteristics |\n| Current Carrying Amount | Current Principal Balance | Number of Loans | WA FICO Score(A) | WA Coupon | WA Maturity (months) | Average Loan Age (months) | Adjustable Rate Mortgage %(B) | Three Month Average CPR(C) | Three Month Average CRR(D) | Three Month Average CDR(E) | Three Month Average Recapture Rate |\n| Mortgage Servicing Rights |\n| Agency | $ | 3,038,721 | $ | 288,673,487 | 1,820,794 | 749 | 4.3 | % | 263 | 66 | 2.8 | % | 14.6 | % | 14.4 | % | 0.2 | % | 10.1 | % |\n| Non-Agency | 20,321 | 2,350,471 | 5,656 | 743 | 4.0 | % | 308 | 34 | 3.8 | % | 14.1 | % | 14.1 | % | — | % | 5.8 | % |\n| Ginnie Mae | 372,926 | 28,903,327 | 137,168 | 681 | 3.8 | % | 319 | 36 | 5.6 | % | 17.6 | % | 17.0 | % | 0.7 | % | 24.1 | % |\n| MSR Financing Receivables |\n| Agency | 597,990 | 61,162,569 | 249,339 | 749 | 4.4 | % | 305 | 26 | 1.1 | % | 30.8 | % | 30.8 | % | — | % | 1.8 | % |\n| Non-Agency | 1,213,271 | 79,360,666 | 577,024 | 645 | 4.5 | % | 306 | 164 | 16.1 | % | 9.9 | % | 8.0 | % | 1.9 | % | 0.5 | % |\n| Total | $ | 5,243,229 | $ | 460,450,520 | 2,789,981 | 727 | 4.3 | % | 280 | 76 | 5.1 | % | 16.1 | % | 15.6 | % | 0.5 | % | 8.2 | % |\n\n| Collateral Characteristics |\n| Delinquency 30 Days(F) | Delinquency 60 Days(F) | Delinquency 90+ Days(F) | Loans in Foreclosure | Real Estate Owned | Loans in Bankruptcy |\n| Mortgage Servicing Rights |\n| Agency | 1.5 | % | 0.3 | % | 0.4 | % | 0.3 | % | — | % | 0.3 | % |\n| Non-Agency | 0.4 | % | 0.1 | % | 0.1 | % | 0.3 | % | 0.1 | % | 0.1 | % |\n| Ginnie Mae | 4.1 | % | 1.2 | % | 1.1 | % | 1.4 | % | 0.1 | % | 1.2 | % |\n| MSR Financing Receivables |\n| Agency | 1.6 | % | 0.1 | % | 0.1 | % | — | % | — | % | 0.1 | % |\n| Non-Agency | 9.5 | % | 4.9 | % | 4.2 | % | 7.7 | % | 1.9 | % | 2.9 | % |\n| Total | 3.1 | % | 1.1 | % | 1.1 | % | 1.6 | % | 0.3 | % | 0.8 | % |\n\n| (A) | The WA FICO score is based on the weighted average of information provided by the loan servicer on a monthly basis. The loan servicer generally updates the FICO score when loans are refinanced or become delinquent. |\n\n| (B) | Adjustable Rate Mortgage % represents the percentage of the total principal balance of the pool that corresponds to adjustable rate mortgages. |\n\n| (C) | Three Month Average CPR, or the constant prepayment rate, represents the annualized rate of the prepayments during the quarter as a percentage of the total principal balance of the pool. |\n\n| (D) | Three Month Average CRR, or the voluntary prepayment rate, represents the annualized rate of the voluntary prepayments during the quarter as a percentage of the total principal balance of the pool. |\n\n| (E) | Three Month Average CDR, or the involuntary prepayment rate, represents the annualized rate of the involuntary prepayments (defaults) during the quarter as a percentage of the total principal balance of the pool. |\n\n68\n| (F) | Delinquency 30 Days, Delinquency 60 Days and Delinquency 90+ Days represent the percentage of the total principal balance of the pool that corresponds to loans that are delinquent by 30–59 days, 60–89 days or 90 or more days, respectively. |\n\nExcess MSRs\nThe tables below summarize the terms of our investments in Excess MSRs completed as of September 30, 2019.\nSummary of Direct Excess MSR Investments as of September 30, 2019\n| MSR Component(A) | Excess MSR |\n| Current UPB (bn) | Weighted Average MSR (bps) | Weighted Average Excess MSR (bps) | Interest in Excess MSR (%) | Carrying Value (mm) |\n| Agency | $ | 45.9 | 29 | bps | 21 | bps | 32.5% - 66.7% | $ | 221.6 |\n| Non-Agency(B) | 47.1 | 35 | 15 | 33.3% - 100.0% | $ | 176.5 |\n| Total/Weighted Average | $ | 93.0 | 32 | bps | 18 | bps | $ | 398.1 |\n\n\n| (A) | The MSR is a weighted average as of September 30, 2019, and the Excess MSR represents the difference between the weighted average MSR and the basic fee (which fee remains constant). |\n\n| (B) | Serviced by Nationstar and SLS, we also invested in related Servicer Advance Investments, including the basic fee component of the related MSR (Note 6 to our Condensed Consolidated Financial Statements) on $33.4 billion UPB underlying these Excess MSRs. |\n\nSummary of Excess MSR Investments Through Equity Method Investees as of September 30, 2019\n| MSR Component(A) |\n| Current UPB (bn) | Weighted Average MSR (bps) | Weighted Average Excess MSR (bps) | New Residential Interest in Investee (%) | Investee Interest in Excess MSR (%) | New Residential Effective Ownership (%) | Investee Carrying Value (mm) |\n| Agency | $ | 35.6 | 33 | bps | 21 | bps | 50.0 | % | 66.7 | % | 33.3 | % | $ | 236.8 |\n\n\n| (A) | The MSR is a weighted average as of September 30, 2019, and the Excess MSR represents the difference between the weighted average MSR and the basic fee (which fee remains constant). |\n\nThe following table summarizes the collateral characteristics of the loans underlying our direct Excess MSR investments as of September 30, 2019 (dollars in thousands):\n| Collateral Characteristics |\n| Current Carrying Amount | Current Principal Balance | Number of Loans | WA FICO Score(A) | WA Coupon | WA Maturity (months) | Average Loan Age (months) | Adjustable Rate Mortgage %(B) | Three Month Average CPR(C) | Three Month Average CRR(D) | Three Month Average CDR(E) | Three Month Average Recapture Rate |\n| Agency |\n| Original Pools | $ | 168,463 | $ | 33,627,899 | 242,096 | 723 | 4.7 | % | 247 | 115 | 1.9 | % | 13.2 | % | 12.7 | % | 0.6 | % | 11.6 | % |\n| Recaptured Loans | 53,097 | 12,272,755 | 73,762 | 725 | 4.4 | % | 278 | 42 | 0.1 | % | 13.0 | % | 12.6 | % | 0.5 | % | 29.1 | % |\n| $ | 221,560 | $ | 45,900,654 | 315,858 | 724 | 4.6 | % | 256 | 93 | 1.5 | % | 13.2 | % | 12.6 | % | 0.6 | % | 16.2 | % |\n| Non-Agency(F) |\n| Nationstar and SLS Serviced: |\n| Original Pools | $ | 153,927 | $ | 43,127,383 | 242,478 | 672 | 4.8 | % | 281 | 162 | 10.1 | % | 14.4 | % | 11.6 | % | 3.2 | % | 8.8 | % |\n| Recaptured Loans | 22,577 | 3,997,153 | 18,203 | 739 | 4.3 | % | 285 | 29 | 0.1 | % | 13.2 | % | 13.2 | % | — | % | 25.5 | % |\n| $ | 176,504 | $ | 47,124,536 | 260,681 | 678 | 4.7 | % | 281 | 151 | 8.8 | % | 14.3 | % | 11.7 | % | 2.9 | % | 10.2 | % |\n| Total/Weighted Average(H) | $ | 398,064 | $ | 93,025,190 | 576,539 | 700 | 4.7 | % | 269 | 124 | 4.7 | % | 13.8 | % | 12.2 | % | 1.8 | % | 13.2 | % |\n\n69\n| Collateral Characteristics |\n| Delinquency 30 Days(G) | Delinquency 60 Days(G) | Delinquency 90+ Days(G) | Loans inForeclosure | RealEstateOwned | Loans inBankruptcy |\n| Agency |\n| Original Pools | 2.9 | % | 0.9 | % | 0.6 | % | 0.6 | % | 0.2 | % | 0.2 | % |\n| Recaptured Loans | 1.8 | % | 0.4 | % | 0.4 | % | 0.2 | % | 0.1 | % | — | % |\n| 2.6 | % | 0.7 | % | 0.5 | % | 0.5 | % | 0.2 | % | 0.1 | % |\n| Non-Agency(F) |\n| Nationstar and SLS Serviced: |\n| Original Pools | 10.8 | % | 3.2 | % | 2.3 | % | 5.4 | % | 1.1 | % | 2.0 | % |\n| Recaptured Loans | 1.5 | % | 0.3 | % | 0.1 | % | — | % | — | % | — | % |\n| 10.0 | % | 3.0 | % | 2.1 | % | 4.9 | % | 1.0 | % | 1.8 | % |\n| Total/Weighted Average(H) | 6.5 | % | 1.9 | % | 1.4 | % | 2.8 | % | 0.6 | % | 1.0 | % |\n\n\n| (A) | The WA FICO score is based on the weighted average of information provided by the loan servicer on a monthly basis. The loan servicer generally updates the FICO score when loans are refinanced or become delinquent. |\n\n| (B) | Adjustable Rate Mortgage % represents the percentage of the total principal balance of the pool that corresponds to adjustable rate mortgages. |\n\n| (C) | Three Month Average CPR, or the constant prepayment rate, represents the annualized rate of the prepayments during the quarter as a percentage of the total principal balance of the pool. |\n\n| (D) | Three Month Average CRR, or the voluntary prepayment rate, represents the annualized rate of the voluntary prepayments during the quarter as a percentage of the total principal balance of the pool. |\n\n| (E) | Three Month Average CDR, or the involuntary prepayment rate, represents the annualized rate of the involuntary prepayments (defaults) during the quarter as a percentage of the total principal balance of the pool. |\n\n| (F) | We also invested in related Servicer Advance Investments, including the basic fee component of the related MSR (Note 6 to our Condensed Consolidated Financial Statements) on $33.4 billion UPB underlying these Excess MSRs. |\n\n| (G) | Delinquency 30 Days, Delinquency 60 Days and Delinquency 90+ Days represent the percentage of the total principal balance of the pool that corresponds to loans that are delinquent by 30–59 days, 60–89 days or 90 or more days, respectively. |\n\n| (H) | Weighted averages exclude collateral information for which collateral data was not available as of the report date. |\n\nThe following table summarizes the collateral characteristics as of September 30, 2019 of the loans underlying Excess MSR investments made through joint ventures accounted for as equity method investees (dollars in thousands). For each of these pools, we own a 50% interest in an entity that invested in a 66.7% interest in the Excess MSRs.\n| Collateral Characteristics |\n| Current Carrying Amount | CurrentPrincipal Balance | New Residential Effective Ownership(%) | Numberof Loans | WA FICO Score(A) | WA Coupon | WA Maturity (months) | Average LoanAge (months) | Adjustable Rate Mortgage %(B) | Three Month Average CPR(C) | Three Month Average CRR(D) | Three Month Average CDR(E) | Three Month Average Recapture Rate |\n| Agency |\n| Original Pools | $ | 148,573 | $ | 21,303,865 | 33.3 | % | 216,012 | 703 | 5.2 | % | 239 | 134 | 1.5 | % | 14.4 | % | 13.3 | % | 1.3 | % | 16.8 | % |\n| Recaptured Loans | 88,213 | 14,328,564 | 33.3 | % | 102,067 | 710 | 4.3 | % | 272 | 49 | 0.1 | % | 12.7 | % | 11.8 | % | 1.0 | % | 35.6 | % |\n| Total/Weighted Average(G) | $ | 236,786 | $ | 35,632,429 | 318,079 | 706 | 4.9 | % | 252 | 101 | 1.5 | % | 13.7 | % | 12.7 | % | 1.2 | % | 24.2 | % |\n\n| Collateral Characteristics |\n| Delinquency 30 Days(F) | Delinquency 60 Days(F) | Delinquency 90+ Days(F) | Loans inForeclosure | RealEstateOwned | Loans inBankruptcy |\n| Agency |\n| Original Pools | 4.2 | % | 1.3 | % | 0.7 | % | 0.9 | % | 0.3 | % | 0.3 | % |\n| Recaptured Loans | 2.9 | % | 0.9 | % | 0.4 | % | 0.3 | % | 0.1 | % | 0.1 | % |\n| Total/Weighted Average(G) | 3.7 | % | 1.1 | % | 0.6 | % | 0.7 | % | 0.2 | % | 0.2 | % |\n\n\n| (A) | The WA FICO score is based on the weighted average of information provided by the loan servicer on a monthly basis. The loan servicer generally updates the FICO score on a monthly basis. |\n\n70\n| (B) | Adjustable Rate Mortgage % represents the percentage of the total principal balance of the pool that corresponds to adjustable rate mortgages. |\n\n| (C) | Three Month Average CPR, or the constant prepayment rate, represents the annualized rate of the prepayments during the quarter as a percentage of the total principal balance of the pool. |\n\n| (D) | Three Month Average CRR, or the voluntary prepayment rate, represents the annualized rate of the voluntary prepayments during the quarter as a percentage of the total principal balance of the pool. |\n\n| (E) | Three Month Average CDR, or the involuntary prepayment rate, represents the annualized rate of the involuntary prepayments (defaults) during the quarter as a percentage of the total principal balance of the pool. |\n\n| (F) | Delinquency 30 Days, Delinquency 60 Days and Delinquency 90+ Days represent the percentage of the total principal balance of the pool that corresponds to loans that are delinquent by 30-59 days, 60-89 days or 90 or more days, respectively. |\n\n| (G) | Weighted averages exclude collateral information for which collateral data was not available as of the report date. |\n\nServicer Advance Investments\nThe following is a summary of our Servicer Advance Investments, including the right to the basic fee component of the related MSRs (dollars in thousands):\n| September 30, 2019 |\n| Amortized Cost Basis | Carrying Value(A) | UPB of Underlying Residential Mortgage Loans | Outstanding Servicer Advances | Servicer Advances to UPB of Underlying Residential Mortgage Loans |\n| Servicer Advance Investments |\n| Nationstar and SLS serviced pools | $ | 570,570 | $ | 600,547 | $ | 33,406,320 | $ | 492,480 | 1.5 | % |\n\n\n| (A) | Carrying value represents the fair value of the Servicer Advance Investments, including the basic fee component of the related MSRs. |\n\nThe following is additional information regarding our Servicer Advance Investments, and related financing, as of and for the nine months ended, September 30, 2019 (dollars in thousands):\n| Nine Months Ended September 30, 2019 | Loan-to-Value (“LTV”)(A) | Cost of Funds(B) |\n| Weighted Average Discount Rate | Weighted Average Life (Years)(C) | Change in Fair Value Recorded in Other Income | Face Amount of Notes and Bonds Payable | Gross | Net(D) | Gross | Net |\n| Servicer Advance Investments(E) | 5.1 | % | 6.3 | $ | 15,932 | $ | 449,731 | 87.3 | % | 86.1 | % | 3.8 | % | 3.1 | % |\n\n\n| (A) | Based on outstanding servicer advances, excluding purchased but unsettled servicer advances. |\n\n| (B) | Annualized measure of the cost associated with borrowings. Gross Cost of Funds primarily includes interest expense and facility fees. Net Cost of Funds excludes facility fees. |\n\n| (C) | Weighted Average Life represents the weighted average expected timing of the receipt of expected net cash flows for this investment. |\n\n| (D) | Ratio of face amount of borrowings to par amount of servicer advance collateral, net of any general reserve. |\n\n| (E) | The following types of advances are included in Servicer Advance Investments: |\n\n| September 30, 2019 |\n| Principal and interest advances | $ | 82,999 |\n| Escrow advances (taxes and insurance advances) | 185,774 |\n| Foreclosure advances | 223,707 |\n| Total | $ | 492,480 |\n\nA discussion of the sensitivity of these incentive fees to changes in LIBOR is included below under “Quantitative and Qualitative Disclosures About Market Risk.”\n71\nOriginations\nNewRez, our wholly owned subsidiary, originates conventional, government-insured and nonconforming residential mortgage loans for sale and securitization. The GSEs or Ginnie Mae guarantee conventional and government insured mortgage securitizations and mortgage investors issue Nonconforming private label mortgage securitizations while NewRez generally retains the right to service the underlying residential mortgage loans. In connection with the transfer of loans to the GSEs or mortgage investors, we report gain on sale of originated mortgage loans, net in our condensed consolidated statements of income.\nDuring the third quarter of 2019, NewRez increased loan origination volume to $5.7 billion, which is a 49% increase quarter over quarter and approximately 200% increase year over year. Gain on sale of originated mortgage loans, net is summarized below:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Gain on loans originated and sold(A) | $ | 24,312 | $ | 24,684 | $ | 36,413 | $ | 24,684 |\n| Gain (loss) on settlement of mortgage loan origination derivative instruments(B) | (32,138 | ) | (2,757 | ) | (61,879 | ) | (2,757 | ) |\n| MSRs retained on transfer of loans(C) | 96,317 | 17,282 | 190,666 | 17,282 |\n| Other(D) | 12,050 | 6,523 | 28,829 | 6,523 |\n| Gain on sale of originated mortgage loans, net | $ | 100,541 | $ | 45,732 | $ | 194,029 | $ | 45,732 |\n\n| (A) | Includes loan origination fees and direct loan origination costs. Other indirect costs related to loan origination are included within general and administrative expenses. |\n\n| (B) | Represents settlement of forward securities delivery commitments utilized as an economic hedge for mortgage loans not included within forward loan sale commitments. |\n\n| (C) | Represents the initial fair value of the capitalized mortgage servicing rights upon loan sales with servicing retained. |\n\n| (D) | Includes fees for services associated with the loan origination process. |\n\nResidential Securities and Loans\nReal Estate Securities\nAgency RMBS\nThe following table summarizes our Agency RMBS portfolio as of September 30, 2019 (dollars in thousands):\n| Gross Unrealized |\n| Asset Type | Outstanding Face Amount | Amortized Cost Basis | Percentage of Total Amortized Cost Basis | Gains | Losses | CarryingValue(A) | Count | Weighted Average Life (Years) | 3-Month CPR | Outstanding Repurchase Agreements |\n| Agency Specified Pools | $ | 8,797,199 | $ | 8,950,763 | 100.0 | % | $ | 56,939 | $ | (9,636 | ) | $ | 8,998,066 | 39 | 4.6 | 0.3 | % | $ | 7,300,198 |\n\n\n| (A) | Fair value, which is equal to carrying value for all securities. |\n\nThe following table summarizes the net interest spread of our Agency RMBS portfolio as of September 30, 2019:\n| Net Interest Spread(A) |\n| Weighted Average Asset Yield | 3.06 | % |\n| Weighted Average Funding Cost | 2.31 | % |\n| Net Interest Spread | 0.75 | % |\n\n\n| (A) | The Agency RMBS portfolio consists of 100.0% fixed rate securities (based on amortized cost basis). |\n\n72\nNon-Agency RMBS\nThe following table summarizes our Non-Agency RMBS portfolio as of September 30, 2019 (dollars in thousands):\n| Gross Unrealized |\n| Asset Type | Outstanding Face Amount | Amortized Cost Basis | Gains | Losses | CarryingValue(A) | Outstanding Repurchase Agreements |\n| Non-Agency RMBS | $ | 21,845,814 | $ | 7,175,703 | $ | 711,078 | $ | (30,937 | ) | $ | 7,855,844 | $ | 7,142,351 |\n\n\n| (A) | Fair value, which is equal to carrying value for all securities. |\n\nThe following tables summarize the characteristics of our Non-Agency RMBS portfolio and of the collateral underlying our Non-Agency RMBS as of September 30, 2019 (dollars in thousands):\n| Non-Agency RMBS Characteristics(A) |\n| Vintage(B) | Average Minimum Rating(C) | Number of Securities | Outstanding Face Amount | Amortized Cost Basis | Percentage of Total Amortized Cost Basis | Carrying Value | Principal Subordination(D) | Excess Spread(E) | Weighted Average Life (Years) | Weighted Average Coupon(F) |\n| Pre 2006 | CCC- | 365 | $ | 1,956,007 | $ | 1,487,306 | 21.1 | % | $ | 1,663,069 | 14.2 | % | 0.8 | % | 6.8 | 3.4 | % |\n| 2006 | CC | 133 | 2,774,332 | 1,746,860 | 24.7 | % | 1,979,226 | 7.1 | % | 1.2 | % | 7.6 | 2.3 | % |\n| 2007 | CCC- | 82 | 2,224,528 | 1,348,788 | 19.1 | % | 1,520,709 | 5.2 | % | 0.9 | % | 7.1 | 2.5 | % |\n| 2008 and later | BBB | 363 | 14,775,002 | 2,477,759 | 35.1 | % | 2,589,370 | 14.0 | % | 0.1 | % | 4.8 | 3.5 | % |\n| Total/Weighted Average | B- | 943 | $ | 21,729,869 | $ | 7,060,713 | 100.0 | % | $ | 7,752,374 | 10.5 | % | 0.7 | % | 6.3 | 3.0 | % |\n\n\n| Collateral Characteristics(A) (G) |\n| Vintage(B) | Average Loan Age (years) | Collateral Factor(H) | 3-Month CPR(I) | Delinquency(J) | Cumulative Losses to Date |\n| Pre 2006 | 14.8 | 0.07 | 9.7 | % | 10.8 | % | 13.0 | % |\n| 2006 | 13.4 | 0.12 | 10.0 | % | 10.6 | % | 32.2 | % |\n| 2007 | 12.6 | 0.22 | 11.2 | % | 10.6 | % | 36.7 | % |\n| 2008 and later | 8.5 | 0.79 | 18.9 | % | 1.7 | % | 0.5 | % |\n| Total/Weighted Average | 11.8 | 0.36 | 13.3 | % | 7.5 | % | 17.9 | % |\n\n\n| (A) | Excludes $30.9 million face amount of bonds backed by consumer loans and $85.0 million face amount of bonds backed by corporate debt. |\n\n| (B) | The year in which the securities were issued. |\n\n| (C) | Ratings provided above were determined by third party rating agencies, represent the most recent credit ratings available as of the reporting date and may not be current. This excludes the ratings of the collateral underlying 312 bonds with a carrying value of $1,064.1 million, which either have never been rated or for which rating information is no longer provided. We had no assets that were on negative watch for possible downgrade by at least one rating agency as of September 30, 2019. |\n\n| (D) | The percentage of amortized cost basis of securities and residual interests that is subordinate to our investments. This excludes interest-only bonds. |\n\n| (E) | The current amount of interest received on the underlying loans in excess of the interest paid on the securities, as a percentage of the outstanding collateral balance for the quarter ended September 30, 2019. |\n\n| (F) | Excludes residual bonds, and certain other Non-Agency bonds, with a carrying value of $225.2 million and $3.5 million, respectively, for which no coupon payment is expected. |\n\n| (G) | The weighted average loan size of the underlying collateral is $204.0 thousand. |\n\n| (H) | The ratio of original UPB of loans still outstanding. |\n\n| (I) | Three month average constant prepayment rate and default rates. |\n\n| (J) | The percentage of underlying loans that are 90+ days delinquent, or in foreclosure or considered REO. |\n\n73\nThe following table summarizes the net interest spread of our Non-Agency RMBS portfolio as of September 30, 2019:\n| Net Interest Spread(A) |\n| Weighted Average Asset Yield | 4.84 | % |\n| Weighted Average Funding Cost | 3.08 | % |\n| Net Interest Spread | 1.76 | % |\n\n\n| (A) | The Non-Agency RMBS portfolio consists of 68.6% floating rate securities and 31.4% fixed rate securities (based on amortized cost basis). |\n\nCall Rights\nWe hold a limited right to cleanup call options with respect to certain securitization trusts serviced or master serviced by Nationstar whereby, when the UPB of the underlying residential mortgage loans falls below a pre-determined threshold, we can effectively purchase the underlying residential mortgage loans at par, plus unreimbursed servicer advances, resulting in the repayment of all of the outstanding securitization financing at par, in exchange for a fee of 0.75% of UPB paid to Nationstar at the time of exercise. We similarly hold a limited right to cleanup call options with respect to certain securitization trusts master serviced by SLS for no fee, and also with respect to certain securitization trusts serviced or master serviced by Ocwen subject to a fee of 0.5% of UPB on loans that are current or thirty (30) days or less delinquent, paid to Ocwen at the time of exercise. The aggregate UPB of the underlying residential mortgage loans within these various securitization trusts is approximately $101.0 billion.\nWe continue to evaluate the call rights we acquired from each of our servicers, and our ability to exercise such rights and realize the benefits therefrom are subject to a number of risks. See “Risk Factors—Risks Related to Our Business—Our ability to exercise our cleanup call rights may be limited or delayed if a third party also possessing such cleanup call rights exercises such rights, if the related securitization trustee refuses to permit the exercise of such rights, or if a related party is subject to bankruptcy proceedings.” The actual UPB of the residential mortgage loans on which we can successfully exercise call rights and realize the benefits therefrom may differ materially from our initial assumptions.\nWe have exercised our call rights with respect to Non-Agency RMBS trusts and purchased performing and non-performing residential mortgage loans and REO contained in such trusts prior to their termination. In certain cases, we sold portions of the purchased loans through securitizations, and retained bonds issued by such securitizations. In addition, we received par on the securities issued by the called trusts which we owned prior to such trusts’ termination. Refer to Note 8 in our Condensed Consolidated Financial Statements for further details on these transactions.\nResidential Mortgage Loans\nAs of September 30, 2019, we had approximately $7.4 billion outstanding face amount of residential mortgage loans. These investments were financed with repurchase agreements with an aggregate face amount of approximately $5.2 billion and notes and bonds payable with an aggregate face amount of approximately $1.0 billion. We acquired these loans through open market purchases, as well as through the exercise of call rights.\nThe following table presents the total residential mortgage loans outstanding by loan type at September 30, 2019 (dollars in thousands).\n| Outstanding Face Amount | Carrying Value | LoanCount | Weighted Average Yield | Weighted Average Life (Years)(A) | Floating Rate Loans as a % of Face Amount | LTV Ratio(B) | Weighted Avg. Delinquency(C) | Weighted Average FICO(D) |\n| Performing Loans(G) (J) | $ | 557,762 | $ | 524,387 | 7,695 | 7.8 | % | 4.6 | 20.2 | % | 72.3 | % | 10.2 | % | 647 |\n| Purchased Credit Deteriorated Loans(H) | 124,238 | 89,270 | 1,106 | 7.9 | % | 3.2 | 19.3 | % | 88.1 | % | 60.7 | % | 590 |\n| Total Residential Mortgage Loans, held-for-investment | $ | 682,000 | $ | 613,657 | 8,801 | 7.8 | % | 4.4 | 20.1 | % | 75.2 | % | 19.4 | % | 636 |\n| Reverse Mortgage Loans(E) (F) | $ | 13,032 | $ | 6,450 | 32 | 7.8 | % | 5.3 | 10.1 | % | 151.6 | % | 65.1 | % | N/A |\n| Performing Loans(G) (I) | 709,867 | 726,935 | 10,798 | 4.3 | % | 4.0 | 62.4 | % | 54.3 | % | 5.9 | % | 688 |\n| Non-Performing Loans(H) (I) | 726,570 | 616,612 | 5,562 | 5.1 | % | 3.3 | 12.0 | % | 80.7 | % | 68.7 | % | 594 |\n| Total Residential Mortgage Loans, held-for-sale | $ | 1,449,469 | $ | 1,349,997 | 16,392 | 4.8 | % | 3.6 | 36.7 | % | 68.4 | % | 37.9 | % | 641 |\n| Acquired Loans | $ | 4,024,252 | $ | 3,916,826 | 26,236 | 4.2 | % | 7.4 | 2.0 | % | 71.1 | % | 15.3 | % | 622 |\n| Originated Loans | 1,248,711 | 1,289,425 | 4,465 | 4.0 | % | 28.6 | 4.0 | % | 77.6 | % | 29.2 | % | 672 |\n| Total Residential Mortgage Loans, held-for-sale, at fair value(K) | $ | 5,272,963 | $ | 5,206,251 | 30,701 | 4.1 | % | 12.5 | 2.5 | % | 72.7 | % | 18.6 | % | 634 |\n\n74\n| (A) | The weighted average life is based on the expected timing of the receipt of cash flows. |\n\n| (B) | LTV refers to the ratio comparing the loan’s unpaid principal balance to the value of the collateral property. |\n\n| (C) | Represents the percentage of the total principal balance that is 60+ days delinquent. |\n\n| (D) | The weighted average FICO score is based on the weighted average of information updated and provided by the loan servicer on a monthly basis. |\n\n| (E) | Represents a 70% participation interest we hold in a portfolio of reverse mortgage loans. The average loan balance outstanding based on total UPB was $0.6 million. Approximately 51% of these loans outstanding have reached a termination event. As a result of the termination event, each such loan has matured and the borrower can no longer make draws on these loans. |\n\n| (F) | FICO scores are not used in determining how much a borrower can access via a reverse mortgage loan. |\n\n| (G) | Performing loans are generally placed on nonaccrual status when principal or interest is 120 days or more past due. |\n\n| (H) | Includes loans with evidence of credit deterioration since origination where it is probable that we will not collect all contractually required principal and interest payments. As of September 30, 2019, we have placed all Non-Performing Loans, held-for-sale on nonaccrual status, except as described in (I) below. |\n\n| (I) | Includes $37.8 million and $27.7 million UPB of Ginnie Mae EBO performing and non-performing loans, respectively, on accrual status as contractual cash flows are guaranteed by the FHA. |\n\n| (J) | Includes $112.1 million UPB of non-agency mortgage loans underlying the SAFT 2013-1 securitization, which are carried at fair value based on New Residential’s election of the fair value option. |\n\n| (K) | New Residential elected the fair value option to measure these loans at fair value on a recurring basis. |\n\nWe consider the delinquency status, loan-to-value ratios, and geographic area of residential mortgage loans as our credit quality indicators.\nOther\nConsumer Loans\nThe table below summarizes the collateral characteristics of the consumer loans, including those held in the Consumer Loan Companies and those acquired from the Consumer Loan Seller, as of September 30, 2019 (dollars in thousands):\n| Collateral Characteristics |\n| UPB | Personal Unsecured Loans % | Personal Homeowner Loans % | Number of Loans | Weighted Average Original FICO Score(A) | Weighted Average Coupon | Adjustable Rate Loan % | Average Loan Age (months) | Average Expected Life (Years) | Delinquency 30 Days(B) | Delinquency 60 Days(B) | Delinquency 90+ Days(B) | 12-Month CRR(C) | 12-Month CDR(D) |\n| Consumer loans, held-for-investment | $ | 878,431 | 59.6 | % | 40.4 | % | 117,312 | 675 | 18.3 | % | 12.0 | % | 172 | 3.9 | 1.7 | % | 1.0 | % | 1.8 | % | 16.4 | % | 5.0 | % |\n\n\n| (A) | Weighted average original FICO score represents the FICO score at the time the loan was originated. |\n\n| (B) | Delinquency 30 Days, Delinquency 60 Days and Delinquency 90+ Days represent the percentage of the total principal balance of the pool that corresponds to loans that are delinquent by 30-59 days, 60-89 days or 90 or more days, respectively. |\n\n| (C) | 12-Month CRR, or the voluntary prepayment rate, represents the annualized rate of the voluntary prepayments during the three months as a percentage of the total principal balance of the pool. |\n\n| (D) | 12-Month CDR, or the involuntary prepayment rate, represents the annualized rate of the involuntary prepayments (defaults) during the three months as a percentage of the total principal balance of the pool. |\n\nIn addition, as of September 30, 2019, we had a net investment of $23.0 million in LoanCo and WarrantCo. For further information, see Note 9 to our Condensed Consolidated Financial Statements.\nThe following is a summary of LoanCo’s consumer loan investments:\n| Unpaid Principal Balance | Interest in Consumer Loans | Carrying Value | Weighted Average Coupon | Weighted Average Expected Life (Years)(A) | Weighted Average Delinquency(B) |\n| September 30, 2019(C) | $ | 1,226 | 25.0 | % | $ | 1,632 | 18.7 | % | 1.0 | — | % |\n\n| (A) | Represents the weighted average expected timing of the receipt of expected cash flows for this investment. |\n\n| (B) | Represents the percentage of the total unpaid principal balance that is 30+ days delinquent. Delinquency status is the primary credit quality indicator as it provides early warning of borrowers who may be experiencing financial difficulties. |\n\n| (C) | Data as of August 31, 2019 as a result of the one month reporting lag. |\n\n75\nAPPLICATION OF CRITICAL ACCOUNTING POLICIES\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our Condensed Consolidated Financial Statements, which have been prepared in accordance with GAAP. The preparation of financial statements in conformity with GAAP requires the use of estimates and assumptions that could affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities and the reported amounts of revenue and expenses. Actual results could differ from these estimates. We believe that the estimates and assumptions utilized in the preparation of the Condensed Consolidated Financial Statements are prudent and reasonable. Actual results historically have generally been in line with our estimates and judgments used in applying each of the accounting policies described below, as modified periodically to reflect current market conditions.\nOur critical accounting policies as of September 30, 2019, which represent our accounting policies that are most affected by judgments, estimates and assumptions, included all of the critical accounting policies referred to in our annual report on Form 10-K for the year ended December 31, 2018.\nRecent Accounting Pronouncements\nSee Note 1 to our Condensed Consolidated Financial Statements.\nRESULTS OF OPERATIONS\nThe following table summarizes the changes in our results of operations for the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018 (dollars in thousands). Our results of operations are not necessarily indicative of future performance.\n| Three Months Ended September 30, | Increase (Decrease) | Nine Months Ended September 30, | Increase (Decrease) |\n| 2019 | 2018 | Amount | 2019 | 2018 | Amount |\n| Interest income | $ | 448,127 | $ | 425,524 | $ | 22,603 | $ | 1,303,041 | $ | 1,212,902 | $ | 90,139 |\n| Interest expense | 245,902 | 162,806 | 83,096 | 686,738 | 421,109 | 265,629 |\n| Net Interest Income | 202,225 | 262,718 | (60,493 | ) | 616,303 | 791,793 | (175,490 | ) |\n| Impairment |\n| Other-than-temporary impairment (OTTI) on securities | 5,567 | 3,889 | 1,678 | 21,942 | 23,190 | (1,248 | ) |\n| Valuation and loss provision (reversal) on loans and real estate owned (REO) | (10,690 | ) | 5,471 | (16,161 | ) | 8,042 | 28,136 | (20,094 | ) |\n| (5,123 | ) | 9,360 | (14,483 | ) | 29,984 | 51,326 | (21,342 | ) |\n| Net interest income after impairment | 207,348 | 253,358 | (46,010 | ) | 586,319 | 740,467 | (154,148 | ) |\n| Servicing revenue, net of change in fair value of $(228,405), $(26,741), $(619,914), and $35,118, respectively | 53,050 | 175,355 | (122,305 | ) | 133,366 | 538,784 | (405,418 | ) |\n| Gain on sale of originated mortgage loans, net | 100,541 | 45,732 | 54,809 | 194,029 | 45,732 | 148,297 |\n| Other Income |\n| Change in fair value of investments in excess mortgage servicing rights | 2,407 | (4,744 | ) | 7,151 | (1,421 | ) | (55,711 | ) | 54,290 |\n| Change in fair value of investments in excess mortgage servicing rights, equity method investees | 4,751 | 3,396 | 1,355 | 4,087 | 5,624 | (1,537 | ) |\n| Change in fair value of investments in mortgage servicing rights financing receivables | (41,410 | ) | (88,345 | ) | 46,935 | (133,200 | ) | 63,628 | (196,828 | ) |\n| Change in fair value of servicer advance investments | 6,641 | (5,353 | ) | 11,994 | 15,932 | (86,581 | ) | 102,513 |\n| Change in fair value of investments in residential mortgage loans | (19,037 | ) | 647 | (19,684 | ) | 90,551 | 647 | 89,904 |\n| Change in fair value of derivative instruments | 58,508 | 24,299 | 34,209 | (1,988 | ) | 27,985 | (29,973 | ) |\n| Gain (loss) on settlement of investments, net | 154,752 | (11,893 | ) | 166,645 | 157,013 | 106,064 | 50,949 |\n| Earnings from investments in consumer loans, equity method investees | (2,547 | ) | 4,555 | (7,102 | ) | (890 | ) | 12,343 | (13,233 | ) |\n| Other income (loss), net | (35,219 | ) | (5,860 | ) | (29,359 | ) | (16,451 | ) | 10,415 | (26,866 | ) |\n| 128,846 | (83,298 | ) | 212,144 | 113,633 | 84,414 | 29,219 |\n| Operating Expenses |\n| General and administrative expenses | 133,513 | 98,587 | 34,926 | 351,359 | 139,169 | 212,190 |\n| Management fee to affiliate | 20,678 | 15,464 | 5,214 | 58,261 | 46,027 | 12,234 |\n| Incentive compensation to affiliate | 36,307 | 23,848 | 12,459 | 49,265 | 65,169 | (15,904 | ) |\n| Loan servicing expense | 7,192 | 11,060 | (3,868 | ) | 26,167 | 33,609 | (7,442 | ) |\n| Subservicing expense | 52,875 | 43,148 | 9,727 | 147,763 | 135,703 | 12,060 |\n| 250,565 | 192,107 | 58,458 | 632,815 | 419,677 | 213,138 |\n| Income (Loss) Before Income Taxes | 239,220 | 199,040 | 40,180 | 394,532 | 989,720 | (595,188 | ) |\n| Income tax expense (benefit) | (5,440 | ) | 3,563 | (9,003 | ) | 18,980 | (5,957 | ) | 24,937 |\n| Net Income (Loss) | $ | 244,660 | $ | 195,477 | $ | 49,183 | $ | 375,552 | $ | 995,677 | $ | (620,125 | ) |\n| Noncontrolling Interests in Income (Loss) of Consolidated Subsidiaries | $ | 14,738 | $ | 10,869 | $ | 3,869 | $ | 31,979 | $ | 32,058 | $ | (79 | ) |\n| Dividends on Preferred Stock | $ | 5,338 | $ | — | $ | 5,338 | $ | 5,338 | $ | — | $ | 5,338 |\n| Net Income (Loss) Attributable to Common Stockholders | $ | 224,584 | $ | 184,608 | $ | 39,976 | $ | 338,235 | $ | 963,619 | $ | (625,384 | ) |\n\n76\nInterest Income\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nInterest income increased by $22.6 million, primarily attributable to incremental interest income of (i) $46.7 million from an increase in the size of the Real Estate Securities portfolio and (ii) $38.2 million from the Residential Mortgage Loans portfolio due to the acquisition of loans through purchases, originations, and the execution of calls. The increase was partially offset by (iii) a $39.2 million decrease from MSR Financing Receivable attributable to the drop in discount accretion income recognized on servicer advances related to the Ocwen Transaction subsequent to September 30, 2018, (iv) a $12.5 million decrease from Servicer Advance Investments and Excess Mortgage Servicing Rights driven by retrospective adjustments resulting from changes in valuation assumptions on September 30, 2019, and (v) a $10.6 million decrease from Consumer Loans attributable to lower unpaid principal balance.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nInterest income increased by $90.1 million, primarily attributable to incremental interest income of (i) $203.0 million from an increase in the size of the Real Estate Securities portfolio and accelerated accretion on Real Estate Securities owned in Non-Agency RMBS trusts that were terminated upon the execution of calls and (ii) $96.4 million from the Residential Mortgage Loans portfolio due to the acquisition of loans through purchases, originations, and the execution of calls. The increase was partially offset by (iii) a $137.5 million decrease from MSR Financing Receivable attributable to the drop in discount accretion income recognized on servicer advances related to the Ocwen Transaction subsequent to September 30, 2018, (iv) a $40.2 million decrease from Servicer Advance Investments and Excess Mortgage Servicing Rights driven by retrospective adjustments resulting from changes in valuation assumptions on September 30, 2019, and (v) a $30.1 million decrease from Consumer Loans attributable to lower unpaid principal balance.\nInterest Expense\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nInterest expense increased by $83.1 million primarily attributable to increases of (i) $55.9 million of interest expense on repurchase agreements financings on Real Estate Securities in which we made additional levered investments subsequent to September 30, 2018, (ii) $22.0 million on Residential Mortgage Loans due to an increase in the underlying principal balance of the portfolio levered with repurchase agreements, (iii) $7.4 million of interest expense on MSRs and related servicer advances financing obtained subsequent to September 30, 2018, and (iv) a $0.6 million increase in interest on debt collateralized by Excess MSRs as a result of draws subsequent to September 30, 2018. The increases were partially offset by (v) a $2.8 million decrease in interest expense on the Consumer Loan securitization notes due to a decrease in the principal balance outstanding and refinancing.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nInterest expense increased by $265.6 million primarily attributable to increases of (i) $173.8 million of interest expense on repurchase agreements financings on Real Estate Securities in which we made additional levered investments subsequent to September 30, 2018, (ii) $67.7 million on Residential Mortgage Loans due to an increase in the underlying principal balance of the portfolio levered with repurchase agreements, (iii) $31.1 million of interest expense on MSRs and related servicer advances financing obtained subsequent to September 30, 2018, and (iv) a $0.4 million increase in interest on debt collateralized by Excess MSRs as a result of draws subsequent to September 30, 2018. The increases were partially offset by (v) a $7.4 million decrease in interest expense on the Consumer Loan securitization notes due to a decrease in the principal balance outstanding and refinancing.\nOther-Than-Temporary Impairment on Securities\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nThe other-than-temporary impairment on securities increased by $1.7 million during the three months ended September 30, 2019 compared to the three months ended September 30, 2018, primarily resulting from a decline in fair values on a larger portion of our Non-Agency RMBS, which we purchased with existing credit impairment, below their amortized cost basis as of September 30, 2019.\n77\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nThe other-than-temporary impairment on securities decreased by $1.2 million during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018, primarily resulting from a decline in fair values on a smaller portion of our Non-Agency RMBS, which we purchased with existing credit impairment, below their amortized cost basis as of September 30, 2019.\nValuation and Loss Provision (Reversal) on Loans and Real Estate Owned\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nThe $16.2 million decrease in the valuation and loss provision (reversal) on loans and real estate owned resulted from (i) a $12.1 million in reversal of impairment on certain loans related to changes in interest rates and improved performance and certain REOs with an increase in home prices, and (ii) $4.1 million less provision due to a reduction in net charge-offs on the Consumer Loan Companies attributable to lower unpaid principal balance.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nThe $20.1 million decrease in the valuation and loss provision (reversal) on loans and real estate owned resulted from (i) a $7.9 million in reversal of impairment on certain loans related to changes in interest rates and improved performance, partially offset by additional impairment on certain REOs with an decrease in home prices, and (ii) $12.2 million less provision due to a reduction in net charge-offs on the Consumer Loan Companies attributable to lower unpaid principal balance.\nServicing Revenue, Net\nThe component of servicing revenue, net related to changes in valuation inputs and assumptions related to the following:\n| Three Months Ended September 30, | Increase (Decrease) | Nine Months Ended September 30, | Increase (Decrease) |\n| 2019 | 2018 | Amount | 2019 | 2018 | Amount |\n| Changes in interest rates and prepayment rates | $ | (149,413 | ) | $ | 38,546 | $ | (187,959 | ) | $ | (555,765 | ) | $ | 209,182 | $ | (764,947 | ) |\n| Changes in discount rates | 57,896 | (6,695 | ) | 64,591 | 127,314 | 46,264 | 81,050 |\n| Changes in other factors | 29,659 | 12,341 | 17,318 | 153,080 | (28,829 | ) | 181,909 |\n| Total | $ | (61,858 | ) | $ | 44,192 | $ | (106,050 | ) | $ | (275,371 | ) | $ | 226,617 | $ | (501,988 | ) |\n\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nServicing revenue, net decreased $122.3 million during the three months ended September 30, 2019 compared to the three months ended September 30, 2018, primarily driven by (i) a $106.1 million change from positive mark-to-market adjustments during the three months ended September 30, 2018 to negative mark-to-market adjustments during the three months ended September 30, 2019, and (ii) a $97.8 million increase in amortization as a result of MSR acquisitions by our licensed servicer subsidiary, NRM (Note 5 to our Condensed Consolidated Financial Statements) that closed subsequent to September 30, 2018. The negative mark-to-market adjustments during the three months ended September 30, 2019 was primarily driven by an increase in prepayment rates, partially offset by a decrease in discount rates. The decrease was partially offset by (iii) a $79.4 million increase in servicing fee revenue and fees as a result of MSR acquisitions that closed subsequent to September 30, 2018.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nServicing revenue, net decreased $405.4 million during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018, primarily driven by (i) a $502.0 million change from positive mark-to-market adjustments during the nine months ended September 30, 2018 to negative mark-to-market adjustments during the nine months ended September 30, 2019, and (ii) a $155.3 million increase in amortization as a result of MSR acquisitions by our licensed servicer subsidiary, NRM (Note 5 to our Condensed Consolidated Financial Statements), as well as the Shellpoint Acquisition (Note 1 to our Condensed Consolidated Financial Statements), which closed in July 2018. The negative mark-to-market adjustments during the nine months ended September 30, 2019 were primarily driven by an increase in prepayment rates, partially offset by a decrease in discount rates and costs of subservicing, and an increase in ancillary income. The decrease was partially offset by (iii) a $249.6 million increase in servicing fee revenue and fees as a result of MSR acquisitions and the Shellpoint Acquisition that closed in July 2018.\n78\nGain on Sale of Originated Mortgage Loans, Net\nAs a result of the Shellpoint Acquisition in July 2018 (Note 1 to our Condensed Consolidated Financial Statements), our wholly owned subsidiary, NewRez, originates conventional, government-insured and nonconforming residential mortgage loans for sale and securitization. The GSEs or Ginnie Mae guarantee conventional and government insured mortgage securitizations and private investors issue nonconforming private label mortgage securitizations while NewRez generally retains the right to service the underlying residential mortgage loans.\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nGain on sale of originated mortgage loans, net increased $54.8 million during the three months ended September 30, 2019 compared to the three months ended September 30, 2018, primarily driven by (i) $79.0 million higher value of MSRs retained on transfer of loans, and (ii) a $5.5 million increase in appraisal and other revenues earned in conjunction with the loan origination process, partially offset by (iii) a $29.4 million increase in loss on settlement of mortgage loan origination derivative instruments.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nGain on sale of originated mortgage loans, net increased $148.3 million during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018, primarily driven by (i) $173.4 million higher value of MSRs retained on transfer of loans, (ii) a $22.3 million increase in appraisal and other revenues earned in conjunction with the loan origination process, and (iii) an $11.7 million increase in gain on loans originated and sold. The increase was partially offset by (iv) a $59.1 million increase in loss on settlement of mortgage loan origination derivative instruments.\nChange in Fair Value of Investments in Excess Mortgage Servicing Rights\nChanges in the fair value of investments in Excess MSRs related to the following:\n| Three Months Ended September 30, | Increase (Decrease) | Nine Months Ended September 30, | Increase (Decrease) |\n| 2019 | 2018 | Amount | 2019 | 2018 | Amount |\n| Changes in interest rates and prepayment rates | $ | (2,566 | ) | $ | (9,872 | ) | $ | 7,306 | $ | (20,268 | ) | $ | (15,742 | ) | $ | (4,526 | ) |\n| Changes in discount rates | 4,167 | — | 4,167 | 13,446 | — | 13,446 |\n| Changes in other factors | 806 | 5,128 | (4,322 | ) | 5,401 | (39,969 | ) | 45,370 |\n| Total | $ | 2,407 | $ | (4,744 | ) | $ | 7,151 | $ | (1,421 | ) | $ | (55,711 | ) | $ | 54,290 |\n\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nThe positive mark-to-market adjustments during the three months ended September 30, 2019 were mainly driven by a decrease in discount rates, partially offset by changes in interest rates and prepayment rates. The negative mark-to-market adjustments during the three months ended September 30, 2018 were mainly driven by changes in interest rates and prepayment rates, as well as lower delinquency assumptions.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nThe negative mark-to-market adjustments during the nine months ended September 30, 2019 were mainly driven by changes in interest rates and prepayment rates, partially offset by a decrease in discount rates. The change between the mark-to-market adjustments during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018 were due to the realization of unrealized gains related to the Ocwen Transaction in 2018, which were reflected in Gain (Loss) on Settlement of Investments, Net.\n79\nChange in Fair Value of Investments in Excess Mortgage Servicing Rights, Equity Method Investees\nChanges in the fair value of investments in Excess MSRs, equity method investees related to the following:\n| Three Months Ended September 30, | Increase (Decrease) | Nine Months Ended September 30, | Increase (Decrease) |\n| 2019 | 2018 | Amount | 2019 | 2018 | Amount |\n| Changes in interest rates and prepayment rates | $ | (432 | ) | $ | (2,203 | ) | $ | 1,771 | $ | (7,897 | ) | $ | (3,711 | ) | $ | (4,186 | ) |\n| Changes in discount rates | 768 | — | 768 | 3,939 | — | 3,939 |\n| Changes in other factors | 4,415 | 5,599 | (1,184 | ) | 8,045 | 9,335 | (1,290 | ) |\n| Total | $ | 4,751 | $ | 3,396 | $ | 1,355 | $ | 4,087 | $ | 5,624 | $ | (1,537 | ) |\n\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nThe positive mark-to-market adjustments during the three months ended September 30, 2019 were mainly driven by interest income net of expenses recorded at the investee level, and a decrease in discount rates. Compared to the three months ended September 30, 2018 where the positive mark-to-market adjustments were mainly driven by interest income net of expenses recorded at the investee level, partially offset by changes in interest rates and prepayment rates.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nThe positive mark-to-market adjustments during the nine months ended September 30, 2019 were mainly driven by interest income net of expenses recorded at the investee level, and a decrease in discount rates, partially offset by changes in interest rates and prepayment rates. Compared to the nine months ended September 30, 2018 where the positive mark-to-market adjustments were mainly driven by interest income net of expenses recorded at the investee level and other market factors, partially offset by changes in interest rates and prepayment rates.\nChange in Fair Value of Investments in MSR Financing Receivables\nThe component of changes in the fair value of investments in mortgage servicing rights financing receivables related to changes in valuation inputs and assumptions related to the following:\n| Three Months Ended September 30, | Increase (Decrease) | Nine Months Ended September 30, | Increase (Decrease) |\n| 2019 | 2018 | Amount | 2019 | 2018 | Amount |\n| Changes in interest rates and prepayment rates | $ | (44,152 | ) | $ | (4,326 | ) | $ | (39,826 | ) | $ | (138,727 | ) | $ | (18,939 | ) | $ | (119,788 | ) |\n| Changes in discount rates | 60,273 | — | 60,273 | 99,674 | 212,273 | (112,599 | ) |\n| Changes in other factors | (6,772 | ) | (35,003 | ) | 28,231 | 40,490 | 24,853 | 15,637 |\n| Total | $ | 9,349 | $ | (39,329 | ) | $ | 48,678 | $ | 1,437 | $ | 218,187 | $ | (216,750 | ) |\n\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nThe change in fair value of investments in mortgage servicing rights financing receivable increased $46.9 million during the three months ended September 30, 2019 compared to the three months ended September 30, 2018. $48.7 million of the increase was related to changes in valuation inputs and assumptions, primarily due to decrease in discount rates and costs of subservicing, and an increase in ancillary income, partially offset by an increase in prepayment rates. The remaining increase was primarily due to $0.7 million decrease in amortization expense, attributable to lower unpaid principal balance.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nThe change in fair value of investments in mortgage servicing rights financing receivable decreased $196.8 million during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018. $216.8 million of the decrease was related to changes in valuation inputs and assumptions, primarily due to less decrease in discount rates and an increase in prepayment rates, partially offset by a decrease in costs of subservicing and an increase in ancillary income. The decrease was partially offset by $23.1 million decrease in amortization expense, attributable to lower unpaid principal balance.\n80\nChange in Fair Value of Servicer Advance Investments\nChanges in the fair value of Servicer Advance Investments related to the following:\n| Three Months Ended September 30, | Increase (Decrease) | Nine Months Ended September 30, | Increase (Decrease) |\n| 2019 | 2018 | Amount | 2019 | 2018 | Amount |\n| Changes in interest rates and prepayment rates | $ | (675 | ) | $ | 820 | $ | (1,495 | ) | $ | (2,379 | ) | $ | 2,357 | $ | (4,736 | ) |\n| Changes in discount rates | 8,419 | (4,173 | ) | 12,592 | 22,045 | (12,829 | ) | 34,874 |\n| Changes in other factors | (1,103 | ) | (2,000 | ) | 897 | (3,734 | ) | (76,109 | ) | 72,375 |\n| Total | $ | 6,641 | $ | (5,353 | ) | $ | 11,994 | $ | 15,932 | $ | (86,581 | ) | $ | 102,513 |\n\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nThe positive mark-to-market adjustments during the three months ended September 30, 2019 were mainly driven by a decrease in discount rates, compared to the three months ended September 30, 2018 where the negative mark-to-market adjustments were mainly driven by an increase in discount rates.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nThe positive mark-to-market adjustments during the nine months ended September 30, 2019 were mainly driven by a decrease in discount rates, compared to an increase in discount rates during the nine months ended September 30, 2018 resulting in negative mark-to-market adjustments. The change between the mark-to-market adjustments during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018 were due to the realization of unrealized gains related to the Ocwen Transaction in 2018, which were reflected in Gain (Loss) on Settlement of Investments, Net.\nChange in Fair Value of Investments in Residential Mortgage Loans\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nThe change in fair value of investments in Residential Mortgage Loans decreased $19.7 million during the three months ended September 30, 2019 compared to the three months ended September 30, 2018 was primarily due to (i) $36.0 million gain realized through securitizations, net of (ii) $16.1 million unrealized gains from changes in valuation assumptions and inputs.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nThe change in fair value of investments in Residential Mortgage Loans of increased $89.9 million during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018, primarily due to the election of the fair value option on certain Residential Mortgage Loans acquired beginning July 2018, coupled with a decrease in discount rates on loans acquired. Residential Mortgage Loans were held at lower of cost or market value, rather than fair value, during the six months ended June 30, 2018.\nChange in Fair Value of Derivative Instruments\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nChange in fair value of derivative instruments increased $34.2 million. The increase was primarily related to (i) a $23.5 million increase in unrealized gain on Interest Rate Swaps, (ii) a $5.7 million increase in unrealized gain on TBAs, and (iii) a $5.2 million change from unrealized loss to unrealized gain on Interest Rate Lock Commitments due to increase in market interest rates.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nChange in fair value of derivative instruments decreased $30.0 million. The decrease was primarily related to (i) a $46.6 million change from unrealized gain to unrealized loss on Interest Rate Swaps. The decrease was partially offset by (ii) a $16.2 million change from unrealized loss to unrealized gain on Interest Rate Lock Commitments, and (iii) $0.9 million increase in unrealized gain on TBAs due to increase in market interest rates.\n81\nGain (Loss) on Settlement of Investments, Net\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nGain (loss) on settlement of investments increased by $166.6 million from a loss to a gain, primarily related to (i) a $123.7 million change in loss on sale of real estate securities to gain on sale of real estate securities, (ii) a $39.6 million increase in gain on sale of residential mortgage loans, (iii) a $21.6 million increase in gain on sale or securitization of originated mortgage loans, (iv) a $11.5 million increase in gain on collapses due primarily to market interest rates and decreased delinquencies, (v) a $1.8 million decrease in loss on sale of REO, and (vi) a $0.6 million decrease in loss on extinguishment of debt related to debt restructuring. The increase was partially offset by (vii) a $33.6 million change in gain on settlement of derivatives to loss on settlement of derivatives related to TBAs and interest rate swaps, during the three months ended September 30, 2019 compared to the three months ended September 30, 2018.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nGain (loss) on settlement of investments increased by $50.9 million, primarily related to (i) a $267.9 million change in loss on sale of real estate securities to gain on sale of real estate securities, (ii) a $62.4 million increase in gain on sale or securitization of originated mortgage loans, (iii) a $54.8 million change from loss on sale of residential mortgage loans to gain on sale of residential mortgage loans, (iv) a $10.2 million increase in gain on collapses due primarily to market interest rates and decreased delinquencies, and (v) a $2.7 million decrease in loss on sale of REO. The increase was partially offset by (vi) a $228.5 million change in gain on settlement of derivatives to loss on settlement of derivatives related to TBAs and interest rate swaps, (vii) a $113.0 million decrease in gains on settlement of investments in excess MSRs and Servicer Advance Investments as a result of the Ocwen Transaction, and (viii) a $7.9 million increase in loss on extinguishment of debt related to debt restructuring, during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nEarnings from Investments in Consumer Loans, Equity Method Investees\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nEarnings from investments in Consumer Loans, Equity Method Investees decreased by $7.1 million as a result of a decrease in net earnings generated by our approximately 25% member interest in LoanCo and WarrantCo (Note 9 to our Condensed Consolidated Financial Statements), primarily as a result of declining portfolio and securitization, during the three months ended September 30, 2019 compared to the three months ended September 30, 2018.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nEarnings from investments in Consumer Loans, Equity Method Investees decreased by $13.2 million as a result of a decrease in net earnings generated by our approximately 25% member interest in LoanCo and WarrantCo (Note 9 to our Condensed Consolidated Financial Statements), primarily as a result of declining portfolio and securitization, during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nOther Income (Loss), Net\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nOther income (loss), net decreased by $29.4 million, primarily attributable to (i) a $14.4 million loss from uncollectible receivables, (ii) a $12.3 million change in unrealized gain on other ABS to unrealized loss on other ABS, (iii) a $4.9 million decrease in gain on transfer of loans to REO, (iv) a $3.5 million change in unrealized gain to unrealized loss on notes and bonds payable related to the SAFT bonds acquired in the Shellpoint Acquisition (Note 1 to our Condensed Consolidated Financial Statements), (v) a $2.7 million increase in unrealized loss on contingent consideration related to the Shellpoint Acquisition (Note 1 to our Condensed Consolidated Financial Statements). The decrease was partially offset by (vi) a $6.2 million decrease in servicer advance expenses, and (vii) a $1.4 million decrease in loss on transfer of loans to other assets.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nOther income (loss), net decreased by $26.9 million, primarily attributable to (i) a $14.4 million loss from uncollectible receivables,(ii) a $8.8 million decrease in gain on transfer of loans to REO, (iii) a $7.4 million increase in unrealized loss on contingent consideration related to the Shellpoint Acquisition (Note 1 to our Condensed Consolidated Financial Statements), (iv) a $6.1 million change in unrealized gain to unrealized loss on notes and bonds payable related to the SAFT bonds acquired in the Shellpoint\n82\nAcquisition (Note 1 to our Condensed Consolidated Financial Statements), (v) a $3.5 million decrease in positive mark-to-market adjustments for retained MSRs, and (vi) a $3.0 million decrease in unrealized gain on other ABS. The decrease was partially offset by (vii) a $7.1 million decrease in servicer advance expenses, (viii) a $4.3 million decrease in REO expenses, and (ix) a $3.7 million decrease in other losses related to residential mortgage loans.\nGeneral and Administrative Expenses\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nGeneral and administrative expenses increased by $34.9 million primarily attributable to (i) a $30.2 million increase in compensation and benefits expenses, loan origination expense, as well as rent, office, and other miscellaneous G&A expenses resulting from the Shellpoint Acquisition (Note 1 to our Condensed Consolidated Financial Statements), and (ii) a $4.7 million increase in securitization fees, and deal and other consulting expenses due to increased securitization, deal, and refinancing activity during the three months ended September 30, 2019 compared to the three months ended September 30, 2018.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nGeneral and administrative expenses increased by $212.2 million primarily attributable to (i) a $200.1 million increase in compensation and benefits expenses, loan origination expense, as well as rent, office, and other miscellaneous G&A expenses resulting from the Shellpoint Acquisition (Note 1 to our Condensed Consolidated Financial Statements), and (ii) an $11.0 million increase in securitization fees, and deal and other consulting expenses due to increased securitization, deal, and refinancing activity during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nManagement Fee to Affiliate\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nManagement fee to affiliate increased by $5.2 million as a result of increases to our gross equity subsequent to September 30, 2018.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nManagement fee to affiliate increased by $12.2 million as a result of increases to our gross equity subsequent to September 30, 2018.\nIncentive Compensation to Affiliate\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nIncentive compensation to affiliate increased by $12.5 million due to an increase in our incentive compensation earnings measure resulting from the changes in the income and expense items described above, excluding any unrealized gains or losses from mark-to-market valuation changes on investments and debt, during the three months ended September 30, 2019 compared to the three months ended September 30, 2018.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nIncentive compensation to affiliate decreased by $15.9 million due to a decrease in our incentive compensation earnings measure resulting from the changes in the income and expense items described above, excluding any unrealized gains or losses from mark-to-market valuation changes on investments and debt, during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nLoan Servicing Expense\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nLoan servicing expense decreased by $3.9 million primarily due to (i) a $4.5 million decrease of loan servicing expense on Consumer Loans, held for investment, attributable to lower unpaid principal balance, partially offset by (ii) a $0.6 million increase of loan servicing expense on Residential Mortgage Loans portfolio due to the acquisition of loans through the execution of calls.\n83\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nLoan servicing expense decreased by $7.4 million primarily due to (i) a $8.2 million decrease of loan servicing expense on Consumer Loans, held for investment, attributable to lower unpaid principal balance, partially offset by (ii) a $0.8 million increase of loan servicing expense on Residential Mortgage Loans portfolio due to the acquisition of loans through the execution of calls.\nSubservicing Expense\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nSubservicing expense increased $9.7 million during the three months ended September 30, 2019 compared to the three months ended September 30, 2018 as a result of an increase in subserviced loans due to transactions that closed subsequent to September 30, 2018 within our licensed servicer subsidiary, NRM (Note 5 to our Condensed Consolidated Financial Statements).\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nSubservicing expense increased $12.1 million during the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018 as a result of an increase in subserviced loans due to transactions that closed subsequent to September 30, 2018 within our licensed servicer subsidiary, NRM (Note 5 to our Condensed Consolidated Financial Statements).\nIncome Tax Expense (Benefit)\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nIncome tax expense (benefit) changed by $9.0 million, as a result of an income tax benefit of $5.4 million during the three months ended September 30, 2019 compared to an income tax expense of $3.6 million during the three months ended September 30, 2018, primarily due to the deferred tax benefit generated by changes in the fair value of MSRs quarter over quarter.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nIncome tax expense (benefit) changed by $24.9 million, as a result of an income tax expense of $19.0 million during the nine months ended September 30, 2019 compared to an income tax benefit of $6.0 million during the nine months ended September 30, 2018, primarily due to the deferred tax expense generated by changes in the fair value of MSRs giving rise to an increase in taxable income in the TRS.\nNoncontrolling Interests in Income (Loss) of Consolidated Subsidiaries\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nNoncontrolling interests in income of consolidated subsidiaries increased by $3.9 million primarily due to (i) a $1.8 million increase in other’s interest in the net income of the Buyer as a result of a change from negative to positive mark-to-market adjustments in the fair value of the Buyer’s assets and lower interest expense, partially offset by a net decrease in interest income earned on the Buyer’s levered assets, (ii) a $1.3 million increase from the Shelter JVs, acquired as part of the Shellpoint Acquisition in the third quarter of 2018 (Note 1 to our Condensed Consolidated Financial Statements), and (iii) a $0.8 million increase from a net increase in income from the Consumer Loan Companies, which are 46.5% owned by third parties, during the three months ended September 30, 2019.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nNoncontrolling interests in income of consolidated subsidiaries decreased by $0.1 million primarily due to (i) a $5.4 million decrease from a net decrease in income from the Consumer Loan Companies, which are 46.5% owned by third parties, during the nine months ended September 30, 2019. The decrease was partially offset by (ii) a $3.2 million increase from the Shelter JVs, acquired as part of the Shellpoint Acquisition in the third quarter of 2018 (Note 1 to our Condensed Consolidated Financial Statements), and (iii) a $2.1 million increase in other’s interest in the net income of the Buyer as a result of a change from negative to positive mark-to-market adjustments in the fair value of the Buyer’s assets and lower interest expense, partially offset by a net decrease in interest income earned on the Buyer’s levered assets, during the nine months ended September 30, 2019.\n84\nDividends on Preferred Stock\nThree months ended September 30, 2019 compared to the three months ended September 30, 2018.\nDuring the three months ended September 30, 2019, in a public offering, we issued Preferred Series A and Preferred Series B (Note 13 to our Condensed Consolidated Financial Statements), and declared preferred dividends of $5.3 million.\nNine months ended September 30, 2019 compared to the nine months ended September 30, 2018.\nDuring the nine months ended September 30, 2019, in a public offering, we issued Preferred Series A and Preferred Series B (Note 13 to our Condensed Consolidated Financial Statements), and declared preferred dividends of $5.3 million.\nOther Comprehensive Income. See “—Accumulated Other Comprehensive Income (Loss)” below.\nLIQUIDITY AND CAPITAL RESOURCES\nLiquidity is a measurement of our ability to meet potential cash requirements, including ongoing commitments to repay borrowings, fund and maintain investments, and other general business needs. Additionally, to maintain our status as a REIT under the Internal Revenue Code, we must distribute annually at least 90% of our REIT taxable income. We note that a portion of this requirement may be able to be met in future years through stock dividends, rather than cash, subject to limitations based on the value of our stock.\nOur primary sources of funds for liquidity generally consist of cash provided by operating activities (primarily income from our investments in Excess MSRs, MSRs, Servicer Advance Investments, RMBS and loans), sales of and repayments from our investments, potential debt financing sources, including securitizations, and the issuance of equity securities, when feasible and appropriate. Our ability to utilize funds generated by the MSRs held in our servicer subsidiaries, NRM and NewRez, is subject to regulatory requirements regarding NRM’s and NewRez’s liquidity. As of September 30, 2019, approximately $454.3 million of our cash and cash equivalents was held at NRM and NewRez, of which $288.0 million was in excess of regulatory liquidity requirements and available for deployment. Our primary uses of funds are the payment of interest, management fees, incentive compensation, servicing and subservicing expenses, outstanding commitments (including margins and mortgage loan originations) and other operating expenses, and the repayment of borrowings and hedge obligations, as well as dividends. Although we have other sources of liquidity, such as sales of and repayments from our investments, potential debt financing sources and the issuance of equity securities, there can be no assurance that we will generate sufficient cash or achieve investment results that will allow us to make a specified level of cash distributions or year-to-year increases in cash distributions in the future. We have also committed to purchase certain future servicer advances. Currently, we expect that net recoveries of servicer advances will exceed net fundings for the foreseeable future. However, in the event of a significant economic downturn, net fundings could exceed net recoveries, which could have a materially adverse impact on our liquidity and could also result in additional expenses, primarily interest expense on any related financings of incremental advances.\nCurrently, our primary sources of financing are notes and bonds payable and repurchase agreements, although we have in the past and may in the future also pursue one or more other sources of financing such as securitizations and other secured and unsecured forms of borrowing. As of September 30, 2019, we had outstanding repurchase agreements with an aggregate face amount of approximately $23.1 billion to finance our investments. The financing of our entire RMBS portfolio, which generally has 30 to 90 day terms, is subject to margin calls. Under repurchase agreements, we sell a security to a counterparty and concurrently agree to repurchase the same security at a later date for a higher specified price. The sale price represents financing proceeds and the difference between the sale and repurchase prices represents interest on the financing. The price at which the security is sold generally represents the market value of the security less a discount or “haircut,” which can range broadly, for example from 2% - 5% for Agency RMBS, 4% - 60% for Non-Agency RMBS, and 6% - 55% for residential mortgage loans. During the term of the repurchase agreement, the counterparty holds the security as collateral. If the agreement is subject to margin calls, the counterparty monitors and calculates what it estimates to be the value of the collateral during the term of the agreement. If this value declines by more than a de minimis threshold, the counterparty could require us to post additional collateral (or “margin”) in order to maintain the initial haircut on the collateral. This margin is typically required to be posted in the form of cash and cash equivalents. Furthermore, we may, from time to time, be a party to derivative agreements or financing arrangements that may be subject to margin calls based on the value of such instruments. In addition, $2.6 billion face amount of our MSR and Excess MSR financing is subject to mandatory monthly repayment to the extent that the outstanding balance exceeds the market value (as defined in the related agreement) of the financed asset multiplied by the contractual maximum loan-to-value ratio. We seek to maintain adequate cash reserves and other sources of available liquidity to meet any margin calls or related requirements resulting from decreases in value related to a reasonably possible (in our opinion) change in interest rates.\n85\nOur ability to obtain borrowings and to raise future equity capital is dependent on our ability to access borrowings and the capital markets on attractive terms. We continually monitor market conditions for financing opportunities and at any given time may be entering or pursuing one or more of the transactions described above. Our Manager’s senior management team has extensive long-term relationships with investment banks, brokerage firms and commercial banks, which we believe will enhance our ability to source and finance asset acquisitions on attractive terms and access borrowings and the capital markets at attractive levels.\nWith respect to the next 12 months, we expect that our cash on hand combined with our cash flow provided by operations and our ability to roll our repurchase agreements and servicer advance financings will be sufficient to satisfy our anticipated liquidity needs with respect to our current investment portfolio, including related financings, potential margin calls, mortgage loan originations and operating expenses. Our ability to roll over short-term borrowings is critical to our liquidity outlook. While it is inherently more difficult to forecast beyond the next 12 months, we currently expect to meet our long-term liquidity requirements through our cash on hand and, if needed, additional borrowings, proceeds received from repurchase agreements and other financings, proceeds from equity offerings and the liquidation or refinancing of our assets.\nThese short-term and long-term expectations are forward-looking and subject to a number of uncertainties and assumptions, including those described under “—Market Considerations” as well as “Risk Factors.” If our assumptions about our liquidity prove to be incorrect, we could be subject to a shortfall in liquidity in the future, and such a shortfall may occur rapidly and with little or no notice, which could limit our ability to address the shortfall on a timely basis and could have a material adverse effect on our business.\nOur cash flow provided by operations differs from our net income due to these primary factors: (i) the difference between (a) accretion and amortization and unrealized gains and losses recorded with respect to our investments and (b) cash received therefrom, (ii) unrealized gains and losses on our derivatives, and recorded impairments, if any, (iii) deferred taxes, and (iv) principal cash flows related to held-for-sale loans, which are characterized as operating cash flows under GAAP.\nIn addition to the information referenced above, the following factors could affect our liquidity, access to capital resources and our capital obligations. As such, if their outcomes do not fall within our expectations, changes in these factors could negatively affect our liquidity.\n\n| • | Access to Financing from Counterparties – Decisions by investors, counterparties and lenders to enter into transactions with us will depend upon a number of factors, such as our historical and projected financial performance, compliance with the terms of our current credit arrangements, industry and market trends, the availability of capital and our investors’, counterparties’ and lenders’ policies and rates applicable thereto, and the relative attractiveness of alternative investment or lending opportunities. Our business strategy is dependent upon our ability to finance certain of our investments at rates that provide a positive net spread. |\n\n| • | Impact of Expected Repayment or Forecasted Sale on Cash Flows – The timing of and proceeds from the repayment or sale of certain investments may be different than expected or may not occur as expected. Proceeds from sales of assets are unpredictable and may vary materially from their estimated fair value and their carrying value. Further, the availability of investments that provide similar returns to those repaid or sold investments is unpredictable and returns on new investments may vary materially from those on existing investments. |\n\n86\nDebt Obligations\nThe following table presents certain information regarding our debt obligations (dollars in thousands):\n| September 30, 2019 |\n| Collateral |\n| Debt Obligations/Collateral | Outstanding Face Amount | Carrying Value(A) | Final Stated Maturity(B) | Weighted Average Funding Cost | Weighted Average Life (Years) | Outstanding Face | Amortized Cost Basis | Carrying Value | Weighted Average Life (Years) |\n| Repurchase Agreements(C) |\n| Agency RMBS(D) | $ | 10,733,236 | $ | 10,733,236 | Oct-19 to May-20 | 2.31 | % | 0.1 | $ | 10,611,553 | $ | 10,825,984 | $ | 10,886,787 | 2.4 |\n| Non-Agency RMBS (E) | 7,144,329 | 7,144,329 | Oct-19 to Sep-20 | 3.08 | % | 0.1 | 21,021,981 | 7,113,471 | 7,786,425 | 6.3 |\n| Residential Mortgage Loans(F) | 5,165,150 | 5,164,159 | Oct-19 to May-21 | 3.74 | % | 0.6 | 5,960,958 | 6,025,596 | 5,805,242 | 13.9 |\n| Real Estate Owned(G)(H) | 68,651 | 68,635 | Oct-19 to May-21 | 3.85 | % | 0.4 | N/A | N/A | 95,410 | N/A |\n| Total Repurchase Agreements | 23,111,366 | 23,110,359 | 2.87 | % | 0.3 |\n| Notes and Bonds Payable |\n| Excess MSRs(I) | 269,759 | 269,759 | Feb-20 to Jul-22 | 4.95 | % | 1.9 | 103,514,484 | 315,847 | 416,899 | 5.8 |\n| MSRs(J) | 2,360,182 | 2,352,961 | Mar-20 to Jul-24 | 4.23 | % | 2.0 | 452,215,330 | 4,718,333 | 5,113,271 | 5.5 |\n| Servicer Advances(K) | 2,903,093 | 2,896,819 | Jan-20 to Aug-23 | 3.22 | % | 2.0 | 3,316,416 | 3,482,368 | 3,512,345 | 1.6 |\n| Residential Mortgage Loans(L) | 1,012,342 | 1,015,360 | Apr-20 to Jul-43 | 4.09 | % | 3.7 | 1,258,875 | 1,277,193 | 1,194,186 | 8.0 |\n| Consumer Loans(M) | 868,214 | 870,973 | Dec-21 to May-36 | 3.25 | % | 4.0 | 878,317 | 884,473 | 881,069 | 5.6 |\n| Total Notes and Bonds Payable | 7,413,590 | 7,405,872 | 3.73 | % | 2.5 |\n| Total/ Weighted Average | $ | 30,524,956 | $ | 30,516,231 | 3.08 | % | 0.8 |\n\n\n| (A) | Net of deferred financing costs. |\n\n| (B) | All debt obligations with a stated maturity through October 31, 2019 were refinanced, extended or repaid. |\n\n| (C) | These repurchase agreements had approximately $77.8 million of associated accrued interest payable as of September 30, 2019. |\n\n| (D) | All of the Agency RMBS repurchase agreements have a fixed rate. Collateral amounts include approximately $4.4 billion of related trade and other receivables. |\n\n| (E) | $6,585.6 million face amount of the Non-Agency RMBS repurchase agreements have LIBOR-based floating interest rates while the remaining $558.8 million face amount of the Non-Agency RMBS repurchase agreements have a fixed rate. This also includes repurchase agreements of $7.5 million on retained servicer advance and consumer loan bonds and of $671.3 million on retained bonds collateralized by Agency MSRs. |\n\n| (F) | All of these repurchase agreements have LIBOR-based floating interest rates. |\n\n| (G) | All of these repurchase agreements have LIBOR-based floating interest rates. |\n\n| (H) | Includes financing collateralized by receivables including claims from FHA on Ginnie Mae EBO loans for which foreclosure has been completed and for which we have made or intend to make a claim on the FHA guarantee. |\n\n| (I) | Includes $169.8 million of corporate loans which bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin of 3.00%, and $100.0 million of corporate loans which bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin of 2.50%. The outstanding face amount of the collateral represents the UPB of our residential mortgage loans underlying our interests in MSRs that secure these notes. |\n\n| (J) | Includes: $940.2 million of MSR notes which bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin ranging from 2.25% to 2.75%; and $1,419.9 million of public notes with fixed interest rates ranging from 3.55% to 4.62%. The outstanding face amount of the collateral represents the UPB of the residential mortgage loans underlying the MSRs and mortgage servicing rights financing receivables that secure these notes. |\n\n| (K) | $2.6 billion face amount of the notes have a fixed rate while the remaining notes bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR or a cost of funds rate, as applicable, and (ii) a margin ranging from 1.15% to 1.99%. Collateral includes Servicer Advance Investments, as well as servicer advances receivable related to the mortgage servicing rights and mortgage servicing rights financing receivables owned by NRM. |\n\n| (L) | Represents: (i) a $6.0 million note payable to Nationstar which includes a $1.5 million receivable from government agency and bears interest equal to one-month LIBOR plus 2.88%, (ii) $109.9 million fair value of SAFT 2013-1 mortgage-backed securities issued with fixed interest rates ranging from 3.50% to 3.76% (see Note 12 for details), (iii) $362.1 million of asset-backed notes held by third parties which bear interest equal to 4.59% (see Note 12 for details), and (iv) |\n\n87\n$535.1 million of asset-backed notes held by third parties which include $1.3 million of REO and bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR and (ii) a margin of 1.25%.\n| (M) | Includes the SpringCastle debt, which is comprised of the following classes of asset-backed notes held by third parties: $787.9 million UPB of Class A notes with a coupon of 3.20% and a stated maturity date in May 2036, $70.4 million UPB of Class B notes with a coupon of 3.58% and a stated maturity date in May 2036, and $8.7 million UPB of Class C notes with a coupon of 5.06% and a stated maturity date in May 2036. Also includes a $1.2 million face amount note which bears interest equal to 4.00%. |\n\nCertain of the debt obligations included above are obligations of our consolidated subsidiaries, which own the related collateral. In some cases, such collateral is not available to other creditors of ours.\nWe have margin exposure on $23.1 billion of repurchase agreements. To the extent that the value of the collateral underlying these repurchase agreements declines, we may be required to post margin, which could significantly impact our liquidity.\nThe following table provides additional information regarding our short-term borrowings (dollars in thousands):\n| Nine Months Ended September 30, 2019 |\n| OutstandingBalance at September 30, 2019 | Average Daily Amount Outstanding(A) | Maximum Amount Outstanding | Weighted Average Daily Interest Rate |\n| Repurchase Agreements |\n| Agency RMBS | $ | 10,733,236 | $ | 7,604,281 | $ | 16,181,622 | 2.53 | % |\n| Non-Agency RMBS | 7,144,329 | 7,681,276 | 8,864,155 | 3.46 | % |\n| Residential mortgage loans | 4,742,824 | 2,403,677 | 5,155,161 | 4.24 | % |\n| Real estate owned | 63,831 | 65,768 | 101,153 | 4.40 | % |\n| Notes and Bonds Payable |\n| Excess MSRs | 100,000 | 71,062 | 100,000 | 4.87 | % |\n| MSRs | 940,188 | 728,119 | 1,256,040 | 4.71 | % |\n| Servicer advances | 615,733 | 357,863 | 773,968 | 3.15 | % |\n| Residential mortgage loans | 541,040 | 361,984 | 542,321 | 3.56 | % |\n| Total/Weighted Average | $ | 24,881,181 | $ | 19,274,030 | 3.26 | % |\n\n\n| (A) | Represents the average for the period the debt was outstanding. |\n\n| Average Daily Amount Outstanding(A) |\n| Three Months Ended |\n| December 31, 2018 | March 31, 2019 | June 30, 2019 | September 30, 2019 |\n| Repurchase Agreements |\n| Agency RMBS | $ | 3,428,226 | $ | 5,364,480 | $ | 6,846,716 | $ | 10,544,720 |\n| Non-Agency RMBS | 7,444,959 | 7,399,226 | 7,675,607 | 7,986,868 |\n| Residential mortgage loans | 1,675,353 | 2,155,752 | 2,681,220 | 3,432,062 |\n| Real estate owned | 68,416 | 91,025 | 48,247 | 58,390 |\n\n| (A) | Represents the average for the period the debt was outstanding. |\n\nFor additional information on our debt activities, see Note 11 to our Condensed Consolidated Financial Statements.\n88\nMaturities\nOur debt obligations as of September 30, 2019, as summarized in Note 11 to our Condensed Consolidated Financial Statements, had contractual maturities as follows (in thousands):\n| Year | Nonrecourse(A) | Recourse(B) | Total |\n| October 1 through December 31, 2019 | $ | 1,978 | $ | 18,781,709 | $ | 18,783,687 |\n| 2020 | 615,733 | 5,480,786 | 6,096,519 |\n| 2021 | 1,088,623 | 1,034,034 | 2,122,657 |\n| 2022 | 1,162,067 | 169,759 | 1,331,826 |\n| 2023 | 400,000 | 403,433 | 803,433 |\n| 2024 and thereafter | 976,300 | 410,534 | 1,386,834 |\n| $ | 4,244,701 | $ | 26,280,255 | $ | 30,524,956 |\n\n| (A) | Includes repurchase agreements and notes and bonds payable of $2.0 million and $4,242.7 million, respectively. |\n\n| (B) | Includes repurchase agreements and notes and bonds payable of $23,109.4 million and $3,170.9 million, respectively. |\n\nThe weighted average differences between the fair value of the assets and the face amount of available financing for the Agency RMBS repurchase agreements (including amounts related to Trades Receivable) and Non-Agency RMBS repurchase agreements were 1.4% and 8.2%, respectively, and for Residential Mortgage Loans and Real Estate Owned were 11.0% and 28.0%, respectively, during the nine months ended September 30, 2019.\nBorrowing Capacity\nThe following table represents our borrowing capacity as of September 30, 2019 (in thousands):\n| Debt Obligations/ Collateral | Borrowing Capacity | Balance Outstanding | Available Financing |\n| Repurchase Agreements |\n| Residential mortgage loans and REO | $ | 9,112,297 | $ | 5,233,801 | $ | 3,878,496 |\n| Non-Agency RMBS | 650,000 | 558,756 | 91,244 |\n| Notes and Bonds Payable |\n| Excess MSRs | 150,000 | 100,000 | 50,000 |\n| MSRs | 1,375,000 | 940,188 | 434,812 |\n| Servicer advances(A) | 1,204,660 | 1,053,127 | 151,533 |\n| Residential Mortgage Loans | 650,000 | 535,063 | 114,937 |\n| Consumer loans | 150,000 | 1,228 | 148,772 |\n| $ | 13,291,957 | $ | 8,422,163 | $ | 4,869,794 |\n\n\n| (A) | Our unused borrowing capacity is available to us if we have additional eligible collateral to pledge and meet other borrowing conditions as set forth in the applicable agreements, including any applicable advance rate. We pay a 0.02% fee on the unused borrowing capacity. |\n\nCovenants\nCertain of the debt obligations are subject to customary loan covenants and event of default provisions, including event of default provisions triggered by certain specified declines in our equity or failure to maintain a specified tangible net worth, liquidity, or indebtedness to tangible net worth ratio. We were in compliance with all of our debt covenants as of September 30, 2019.\n89\nStockholders’ Equity\nPreferred Stock\nPursuant to our certificate of incorporation, we are authorized to designate and issue up to 100.0 million shares of preferred stock, par value of $0.01 per share, in one or more classes or series.\nOn July 2, 2019, we issued 6.2 million shares of our Preferred Series A. To compensate the Manager for its successful efforts in raising capital for us, in connection with this offering, we granted options to the Manager relating to 0.6 million shares of our common stock at the closing price per share of common stock on the pricing date, which had a fair value of approximately $0.5 million as of the grant date.\nOn August 15, 2019, in a public offering, we issued 11.3 million shares of our Preferred Series B. To compensate the Manager for its successful efforts in raising capital for us, in connection with this offering, we granted options to the Manager relating to 1.1 million shares of our common stock at the closing price per share of common stock on the pricing date, which had a fair value of approximately $0.7 million as of the grant date.\nOur Preferred Series A and Preferred Series B rank senior to all classes or series of our common stock and to all other equity securities issued by us that expressly indicate are subordinated to the Preferred Series A and Preferred Series B with respect to rights to the payment of dividends and the distribution of assets upon our liquidation, dissolution or winding up. Our Preferred Series A and Preferred Series B have no stated maturity, are not subject to any sinking fund or mandatory redemption and rank on parity with each other. Under certain circumstances upon a change of control, our Preferred Series A and Preferred Series B are convertible to shares of our common stock.\nFrom and including, July 2, 2019 and August 15, 2019, but excluding, August 15, 2024, holders of shares of our Preferred Series A and Preferred Series B are entitled to receive cumulative cash dividends at a rate of 7.50% per annum and 7.125% of the $25.00 liquidation preference per share (equivalent to $1.875 and $1.781 per annum per share), respectively, and from and including August 15, 2024, at a floating rate per annum equal to the three-month LIBOR plus a spread of 5.802% and 5.640% per annum, respectively. Dividends are payable quarterly in arrears on or about the 15th day of each February, May, August and October.\nThe Preferred Series A and Preferred Series B will not be redeemable before August 15, 2024, except under certain limited circumstances intended to preserve the Company’s qualification as a REIT for U.S. federal income tax purposes and except upon the occurrence of a Change of Control (as defined in the Certificate of Designations). On or after August 15, 2024, we may, at our option, upon not less than 30 nor more than 60 days’ written notice, redeem the Series A and Series B Preferred Stock, in whole or in part, at any time or from time to time, for cash at a redemption price of $25.00 per share, plus any accumulated and unpaid dividends thereon (whether or not authorized or declared) to, but excluding, the redemption date, without interest.\nCommon Stock\nApproximately 2.4 million shares of our common stock were held by Fortress, through its affiliates, as of September 30, 2019.\nIn January 2018, New Residential issued 28.8 million shares of its common stock in a public offering at a price to the public of $17.10 per share for net proceeds of approximately $482.3 million. To compensate the Manager for its successful efforts in raising capital for New Residential, in connection with this offering, New Residential granted options to the Manager relating to 2.9 million shares of New Residential’s common stock at the public offering price, which had a fair value of approximately $3.8 million as of the grant date. The assumptions used in valuing the options were: a 2.58% risk-free rate, a 9.86% dividend yield, 23.16% volatility and a 10-year term.\nOn July 30, 2018, we entered into a Distribution Agreement to sell shares of its common stock, par value $0.01 per share (the “ATM Shares”), having an aggregate offering price of up to $500.0 million, from time to time, through an “at-the-market” equity offering program (the “ATM Program”). As of June 30, 2019, we had sold 0.5 million ATM Shares for aggregate proceeds of $9.1 million. In connection with the shares sold under the ATM program, we granted options to the Manager relating to 0.05 million shares of our common stock at the offering price, which had fair value of approximately $0.1 million as of the grant date.\nOn November 5, 2018, we issued 28.8 million shares of our common stock in a public offering at a price of $17.32 per share for net proceeds of approximately $489.2 million. To compensate the Manager for its successful efforts in raising capital for us, in connection with this offering, we granted options to the Manager relating to 2.9 million shares of our common stock at the public offering price, which had a fair value of approximately $3.8 million as of the grant date. The assumptions used in valuing the options were: a 3.25% risk-free rate, a 8.61% dividend yield, 17.50% volatility and a 10-year term.\n90\nIn February 2019, we issued 46.0 million shares of our common stock in a public offering at a price to the public of $16.50 per share for net proceeds of approximately $751.7 million. To compensate the Manager for its successful efforts in raising capital for us, in connection with this offering, we granted options to the Manager relating to 4.6 million shares of our common stock at the public offering price, which had a fair value of approximately $3.8 million as of the grant date. The assumptions used in valuing the options were: a 2.40% risk-free rate, a 9.30% dividend yield, 19.26% volatility and a 10-year term.\nOn August 20, 2019, we announced that our board of directors had authorized the repurchase of up to $200.0 million of our common stock through December 31, 2020. Repurchases may be made at any time and from time to time through open market purchases or privately negotiated transactions, pursuant to one or more plans established pursuant to Rule 10b5-1 under the Exchange Act, by means of one or more tender offers, or otherwise, in each case, as permitted by securities laws and other legal and contractual requirements. The amount and timing of the purchases will depend on a number of factors including the price and availability of our shares, trading volume, capital availability, our performance and general economic and market conditions. The share repurchase program may be suspended or discontinued at any time. No share repurchases have been made as of the filing of this report. Repurchases may impact our financial results, including fees paid to our Manager.\nAs of September 30, 2019, our outstanding options had a weighted average exercise price of $16.30. Our outstanding options as of September 30, 2019 were summarized as follows:\n| Held by the Manager | 10,511,167 |\n| Issued to the Manager and subsequently assigned to certain of the Manager’s employees | 2,290,749 |\n| Issued to the independent directors | 7,000 |\n| Total | 12,808,916 |\n\nAccumulated Other Comprehensive Income (Loss)\nDuring the nine months ended September 30, 2019, our accumulated other comprehensive income (loss) changed due to the following factors (in thousands):\n| Total Accumulated Other Comprehensive Income |\n| Accumulated other comprehensive income, December 31, 2018 | $ | 417,023 |\n| Net unrealized gain (loss) on securities | 469,183 |\n| Reclassification of net realized (gain) loss on securities into earnings | (179,280 | ) |\n| Accumulated other comprehensive income, September 30, 2019 | $ | 706,926 |\n\nOur GAAP equity changes as our real estate securities portfolio is marked to market each quarter, among other factors. The primary causes of mark to market changes are changes in interest rates and credit spreads. During the nine months ended September 30, 2019, we recorded unrealized gains on our real estate securities primarily caused by performance, liquidity and other factors related specifically to certain investments, coupled with a net tightening of mortgage credit spreads. We recorded OTTI charges of $21.9 million with respect to real estate securities and realized gains of $201.2 million on sales of real estate securities.\nSee “—Market Considerations” above for a further discussion of recent trends and events affecting our unrealized gains and losses, as well as our liquidity.\nCommon Dividends\nWe are organized and intend to conduct our operations to qualify as a REIT for U.S. federal income tax purposes. We intend to make regular quarterly distributions to holders of our common stock. U.S. federal income tax law generally requires that a REIT distribute annually at least 90% of its REIT taxable income, without regard to the deduction for dividends paid and excluding net capital gains, and that it pay tax at regular corporate rates to the extent that it annually distributes less than 100% of its taxable income. We intend to make regular quarterly distributions of our taxable income to holders of our common stock out of assets legally available for this purpose, if and to the extent authorized by our board of directors. Before we pay any dividend, whether for U.S. federal income tax purposes or otherwise, we must first meet both our operating requirements and debt service on our repurchase agreements and other debt payable. If our cash available for distribution is less than our taxable income, we could be\n91\nrequired to sell assets or raise capital to make cash distributions or we may make a portion of the required distribution in the form of a taxable stock distribution or distribution of debt securities.\nWe make distributions based on a number of factors, including an estimate of taxable earnings per common share. Dividends distributed and taxable and GAAP earnings will typically differ due to items such as fair value adjustments, differences in premium amortization and discount accretion, other differences in method of accounting, non-deductible general and administrative expenses, taxable income arising from certain modifications of debt instruments and investments held in TRSs. Our quarterly dividend per share may be substantially different than our quarterly taxable earnings and GAAP earnings per share.\n| Common Dividends Declared for the Period Ended | Paid/Payable | Amount Per Share |\n| September 30, 2018 | October 2018 | $ | 0.50 |\n| December 31, 2018 | January 2019 | $ | 0.50 |\n| March 31, 2019 | April 2019 | $ | 0.50 |\n| June 30, 2019 | July 2019 | $ | 0.50 |\n| September 30, 2019 | October 2019 | $ | 0.50 |\n\nCash Flow\nOperating Activities\nNet cash flows provided by operating activities increased approximately $2.2 billion for the nine months ended September 30, 2019 as compared to the nine months ended September 30, 2018. Operating cash flows for the nine months ended September 30, 2019 primarily consisted of proceeds from sales and principal repayments of purchased residential mortgage loans, held-for-sale of $13.3 billion, servicing fees received of $729.2 million, net recoveries of servicer advances receivable of $366.4 million, net interest income received of $702.3 million, and distributions of earnings from equity method investees of $8.9 million. Operating cash outflows primarily consisted of purchases of residential mortgage loans, held-for-sale of $6.0 billion, originations of $10.4 billion, incentive compensation and management fees paid to the Manager of $151.9 million, income taxes paid of $1.2 million, subservicing fees paid of $273.7 million and other outflows of approximately $611.3 million including general and administrative costs and loan servicing fees.\nInvesting Activities\nCash flows provided by (used in) investing activities were $(5.3) billion for the nine months ended September 30, 2019. Investing activities consisted primarily of the acquisition of MSRs, real estate securities, and the funding of servicer advances, net of principal repayments from Servicer Advance Investments, MSRs, real estate securities and loans as well as proceeds from the sale of real estate securities, loans and REO, and derivative cash flows.\nFinancing Activities\nCash flows provided by (used in) financing activities were approximately $8.1 billion during the nine months ended September 30, 2019. Financing activities consisted primarily of borrowings net of repayments under debt obligations, equity offerings, capital contributions net of distributions from noncontrolling interests in the equity of consolidated subsidiaries, and payment of dividends.\nINTEREST RATE, CREDIT AND SPREAD RISK\nWe are subject to interest rate, credit and spread risk with respect to our investments. These risks are further described in “Quantitative and Qualitative Disclosures About Market Risk.”\nOFF-BALANCE SHEET ARRANGEMENTS\nWe have material off-balance sheet arrangements related to our non-consolidated securitizations of residential mortgage loans treated as sales in which we retained certain interests. We believe that these off-balance sheet structures presented the most efficient and least expensive form of financing for these assets at the time they were entered and represented the most common market-accepted method for financing such assets. Our exposure to credit losses related to these non-recourse, off-balance sheet financings is limited to $1.3 billion. As of September 30, 2019, there was $11.2 billion in total outstanding unpaid principal balance of residential mortgage loans underlying such securitization trusts that represent off-balance sheet financings.\nWe have a co-investment in a portfolio of consumer loans held through an entity (“LoanCo”) which we account for under the equity method.\nWe did not have any other off-balance sheet arrangements as of September 30, 2019. We did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured investment vehicles, or special purpose or variable interest entities, established to facilitate off-balance sheet arrangements or other contractually narrow or limited purposes, other than the entities described above. Further, we have not guaranteed any obligations of unconsolidated entities or entered into any commitment and do not intend to provide additional funding to any such entities.\n92\nCONTRACTUAL OBLIGATIONS\nOur contractual obligations as of September 30, 2019 included all of the material contractual obligations referred to in our annual report on Form 10-K for the year ended December 31, 2018, excluding debt that was repaid as described in “—Liquidity and Capital Resources—Debt Obligations.”\nIn addition, we executed the following material contractual obligations during the nine months ended September 30, 2019:\n\n| • | Derivatives – as described in Note 10 to our Condensed Consolidated Financial Statements, we have altered the composition of our economic hedges during the period. |\n\n| • | Debt obligations – as described in Note 11 to our Condensed Consolidated Financial Statements, we borrowed additional amounts. |\n\nSee Notes 14 and 18 to our Condensed Consolidated Financial Statements included in this report for information regarding commitments and material contracts entered into subsequent to September 30, 2019, if any. As described in Note 14, we have committed to purchase certain future servicer advances. The actual amount of future advances is subject to significant uncertainty. However, we currently expect that net recoveries of servicer advances will exceed net fundings for the foreseeable future. This expectation is based on judgments, estimates and assumptions, all of which are subject to significant uncertainty, as further described in “—Application of Critical Accounting Policies—Servicer Advance Investments.” In addition, the Consumer Loan Companies have invested in loans with an aggregate of $279.4 million of unfunded and available revolving credit privileges as of September 30, 2019. However, under the terms of these loans, requests for draws may be denied and unfunded availability may be terminated at management’s discretion.\nINFLATION\nVirtually all of our assets and liabilities are financial in nature. As a result, interest rates and other factors affect our performance more so than inflation, although inflation rates can often have a meaningful influence over the direction of interest rates. Furthermore, our financial statements are prepared in accordance with GAAP and our distributions are determined by our board of directors primarily based on a number of factors, including taxable income, and, in each case, our activities and balance sheet are measured with reference to historical cost and/or fair market value without considering inflation. See “Quantitative and Qualitative Disclosures About Market Risk—Interest Rate Risk.”\nCORE EARNINGS\nWe have four primary variables that impact our operating performance: (i) the current yield earned on our investments, (ii) the interest expense under the debt incurred to finance our investments, (iii) our operating expenses and taxes and (iv) our realized and unrealized gains or losses, including any impairment, on our investments. “Core earnings” is a non-GAAP measure of our operating performance, excluding the fourth variable above and adjusts the earnings from the consumer loan investment to a level yield basis. Core earnings is used by management to evaluate our performance without taking into account: (i) realized and unrealized gains and losses, which although they represent a part of our recurring operations, are subject to significant variability and are generally limited to a potential indicator of future economic performance; (ii) incentive compensation paid to our Manager; (iii) non-capitalized transaction-related expenses; and (iv) deferred taxes, which are not representative of current operations.\nOur definition of core earnings includes accretion on held-for-sale loans as if they continued to be held-for-investment. Although we intend to sell such loans, there is no guarantee that such loans will be sold or that they will be sold within any expected timeframe. During the period prior to sale, we continue to receive cash flows from such loans and believe that it is appropriate to record a yield thereon. In addition, our definition of core earnings excludes all deferred taxes, rather than just deferred taxes related to unrealized gains or losses, because we believe deferred taxes are not representative of current operations. Our definition of core earnings also limits accreted interest income on RMBS where we receive par upon the exercise of associated call rights based on the estimated value of the underlying collateral, net of related costs including advances. We created this limit in order to be able\n93\nto accrete to the lower of par or the net value of the underlying collateral, in instances where the net value of the underlying collateral is lower than par. We believe this amount represents the amount of accretion we would have expected to earn on such bonds had the call rights not been exercised.\nOur investments in consumer loans are accounted for under ASC No. 310-20 and ASC No. 310-30, including certain non-performing consumer loans with revolving privileges that are explicitly excluded from being accounted for under ASC No. 310-30. Under ASC No. 310-20, the recognition of expected losses on these non-performing consumer loans is delayed in comparison to the level yield methodology under ASC No. 310-30, which recognizes income based on an expected cash flow model reflecting an investment’s lifetime expected losses. The purpose of the Core Earnings adjustment to adjust consumer loans to a level yield is to present income recognition across the consumer loan portfolio in the manner in which it is economically earned, avoid potential delays in loss recognition, and align it with our overall portfolio of mortgage-related assets which generally record income on a level yield basis. With respect to consumer loans classified as held-for-sale, the level yield is computed through the expected sale date. With respect to the gains recorded under GAAP in 2014 and 2016 as a result of a refinancing of, and the consolidation of, the Consumer Loan Companies, respectively, we continue to record a level yield on those assets based on their original purchase price.\nWhile incentive compensation paid to our Manager may be a material operating expense, we exclude it from core earnings because (i) from time to time, a component of the computation of this expense will relate to items (such as gains or losses) that are excluded from core earnings, and (ii) it is impractical to determine the portion of the expense related to core earnings and non-core earnings, and the type of earnings (loss) that created an excess (deficit) above or below, as applicable, the incentive compensation threshold. To illustrate why it is impractical to determine the portion of incentive compensation expense that should be allocated to core earnings, we note that, as an example, in a given period, we may have core earnings in excess of the incentive compensation threshold but incur losses (which are excluded from core earnings) that reduce total earnings below the incentive compensation threshold. In such case, we would either need to (a) allocate zero incentive compensation expense to core earnings, even though core earnings exceeded the incentive compensation threshold, or (b) assign a “pro forma” amount of incentive compensation expense to core earnings, even though no incentive compensation was actually incurred. We believe that neither of these allocation methodologies achieves a logical result. Accordingly, the exclusion of incentive compensation facilitates comparability between periods and avoids the distortion to our non-GAAP operating measure that would result from the inclusion of incentive compensation that relates to non-core earnings.\nWith regard to non-capitalized transaction-related expenses, management does not view these costs as part of our core operations, as they are considered by management to be similar to realized losses incurred at acquisition. Non-capitalized transaction-related expenses are generally legal and valuation service costs, as well as other professional service fees, incurred when we acquire certain investments, as well as costs associated with the acquisition and integration of acquired businesses.\nSince the third quarter of 2018, as a result of the Shellpoint Acquisition, the Company, through its wholly owned subsidiary, NewRez, originates conventional, government-insured and nonconforming residential mortgage loans for sale and securitization. In connection with the transfer of loans to the GSEs or mortgage investors, New Residential reports realized gains or losses on the sale of originated residential mortgage loans and retention of mortgage servicing rights, which we believe is an indicator of performance for the Servicing and Origination segment and therefore included in core earnings. Realized gains or losses on the sale of originated residential mortgage loans had no impact on core earnings in any prior period, but may impact core earnings in future periods.\nBeginning with the third quarter of 2019, as a result of the continued evaluation of how Shellpoint operates its business and its impact on our operating performance, core earnings includes Shellpoint’s GAAP net income with the exception of the unrealized gains or losses due to changes in valuation inputs and assumptions on MSRs owned by NewRez, and non-capitalized transaction-related expenses. This change was not material to core earnings for the quarter ended September 30, 2019.\nManagement believes that the adjustments to compute “core earnings” specified above allow investors and analysts to readily identify and track the operating performance of the assets that form the core of our activity, assist in comparing the core operating results between periods, and enable investors to evaluate our current core performance using the same measure that management uses to operate the business. Management also utilizes core earnings as a measure in its decision-making process relating to improvements to the underlying fundamental operations of our investments, as well as the allocation of resources between those investments, and management also relies on core earnings as an indicator of the results of such decisions. Core earnings excludes certain recurring items, such as gains and losses (including impairment as well as derivative activities) and non-capitalized transaction-related expenses, because they are not considered by management to be part of our core operations for the reasons described herein. As such, core earnings is not intended to reflect all of our activity and should be considered as only one of the factors used by management in assessing our performance, along with GAAP net income which is inclusive of all of our activities.\n94\nThe primary differences between core earnings and the measure we use to calculate incentive compensation relate to (i) realized gains and losses (including impairments), (ii) non-capitalized transaction-related expenses and (iii) deferred taxes (other than those related to unrealized gains and losses). Each are excluded from core earnings and included in our incentive compensation measure (either immediately or through amortization). In addition, our incentive compensation measure does not include accretion on held-for-sale loans and the timing of recognition of income from consumer loans is different. Unlike core earnings, our incentive compensation measure is intended to reflect all realized results of operations. The Gain on Remeasurement of Consumer Loans Investment was treated as an unrealized gain for the purposes of calculating incentive compensation and was therefore excluded from such calculation.\nCore earnings does not represent and should not be considered as a substitute for, or superior to, net income or as a substitute for, or superior to, cash flows from operating activities, each as determined in accordance with U.S. GAAP, and our calculation of this measure may not be comparable to similarly entitled measures reported by other companies. For a further description of the difference between cash flows provided by operations and net income, see “—Liquidity and Capital Resources” above. Set forth below is a reconciliation of core earnings to the most directly comparable GAAP financial measure (dollars in thousands):\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2019 | 2018 | 2019 | 2018 |\n| Net income (loss) attributable to common stockholders | $ | 224,584 | $ | 184,608 | $ | 338,235 | $ | 963,619 |\n| Adjustments for Non-Core Earnings: |\n| Impairment | (5,123 | ) | 9,360 | 29,984 | 51,326 |\n| Change in fair value of investments in mortgage servicing rights | 45,541 | (3,515 | ) | 272,259 | (394,717 | ) |\n| Change in fair value of servicer advance investments | (6,641 | ) | 5,353 | (15,932 | ) | 86,581 |\n| Change in fair value of investments in residential mortgage loans | 7,290 | (647 | ) | (102,298 | ) | (647 | ) |\n| Change in fair value of derivative instruments | (41,910 | ) | (24,299 | ) | 18,586 | (27,985 | ) |\n| (Gain) loss on settlement of investments, net (Note 2) | (135,935 | ) | 11,893 | (108,455 | ) | (106,064 | ) |\n| Other (income) loss (Note 2) | 35,271 | 5,860 | 16,503 | (10,415 | ) |\n| Other Income and Impairment attributable to non-controlling interests | (994 | ) | (4,633 | ) | (9,052 | ) | (17,088 | ) |\n| Gain (loss) on sale or securitization of originated mortgage loans (Note 2) | 21,611 | 2,757 | 62,399 | 2,757 |\n| Non-capitalized transaction-related expenses (Note 2) | 8,155 | 5,274 | 24,305 | 18,784 |\n| Incentive compensation to affiliate (Note 14) | 36,307 | 23,848 | 49,265 | 65,169 |\n| Preferred stock management fee to affiliate | 1,055 | — | 1,055 | — |\n| Deferred taxes (Note 17) | (6,652 | ) | (1,865 | ) | 18,080 | (12,680 | ) |\n| Interest income on residential mortgage loans, held-for-sale | 18,852 | 5,906 | 45,041 | 12,774 |\n| Limit on RMBS discount accretion related to called deals | (34 | ) | (2,914 | ) | (19,590 | ) | (13,108 | ) |\n| Adjust consumer loans to level yield | 1,922 | (6,760 | ) | 4,884 | (21,915 | ) |\n| Core earnings of equity method investees: |\n| Excess mortgage servicing rights (Note 4) | 3,987 | 4,468 | 6,102 | 10,514 |\n| Core Earnings | $ | 207,286 | $ | 214,694 | $ | 631,371 | $ | 606,905 |\n| Net Income Per Diluted Share | $ | 0.54 | $ | 0.54 | $ | 0.83 | $ | 2.86 |\n| Core Earnings Per Diluted Share | $ | 0.50 | $ | 0.63 | $ | 1.55 | $ | 1.80 |\n| Weighted Average Number of Shares of Common Stock Outstanding, Diluted | 415,588,238 | 340,868,403 | 406,671,972 | 337,078,824 |\n\n95\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nMarket risk is the exposure to loss resulting from changes in interest rates, credit spreads, foreign currency exchange rates, commodity prices, equity prices and other market based risks. The primary market risks that we are exposed to are interest rate risk, mortgage basis spread risk, prepayment rate risk and credit risk. These risks are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. All of our market risk sensitive assets, liabilities and derivative positions (other than TBAs) are for non-trading purposes only. For a further discussion of how market risk may affect our financial position or results of operations, please refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Application of Critical Accounting Policies.”\nBeginning with the third quarter of 2019, as a result of refinement of our risk management practices, including expansion of our hedging program, we have adjusted our sensitivity analysis. In prior periods, our sensitivity analysis reported the impact specific to changes in short term interest rates with no changes to discount rate spreads and yields. We have adjusted to report projected changes from a parallel shift in interest rates across all maturities along with corresponding changes in discount rates. In addition, based on management’s evaluation of the significance of each market risk exposure to our company, we have adjusted our sensitivity analysis to capture changes in mortgage basis spread risk and to remove credit spread risk. These changes resulted in a material impact to the results of our sensitivity analysis and therefore, we have provided summarized comparable information under the new sensitivity analysis for the prior period.\nInterest Rate Risk\nChanges in interest rates, including changes in expected interest rates or “yield curves,” affect our investments in various ways, the most significant of which are discussed below.\nFair Value Impact\nChanges in the level of interest rates also affect the yields required by the marketplace on interest rate instruments. Increasing interest rates would decrease the value of the fixed rate assets we hold at the time because higher required yields result in lower prices on existing fixed rate assets in order to adjust their yield upward to meet the market.\nChanges in unrealized gains or losses resulting from changes in market interest rates do not directly affect our cash flows, or our ability to pay a dividend, to the extent the related assets are expected to be held and continue to perform as expected, as their fair value is not relevant to their underlying cash flows. Changes in unrealized gains or losses would impact our ability to realize gains on existing investments if they were sold. Furthermore, with respect to changes in unrealized gains or losses on investments which are carried at fair value, changes in unrealized gains or losses would impact our net book value and, in certain cases, our net income.\nChanges in interest rates can also have ancillary impacts on our investments. Generally, in a declining interest rate environment, residential mortgage loan prepayment rates increase which in turn would cause the value of MSRs, mortgage servicing rights financing receivables, Excess MSRs and the rights to the basic fee components of MSRs to decrease, because the duration of the cash flows we are entitled to receive becomes shortened, and the value of loans and Non-Agency RMBS to increase, because we generally acquired these investments at a discount whose recovery would be accelerated. With respect to a significant portion of our investments in MSRs and Excess MSRs, we have recapture agreements, as described in Notes 4 and 5 to our Consolidated Financial Statements. These recapture agreements help to protect these investments from the impact of increasing prepayment rates. In addition, to the extent that the loans underlying our investments in MSRs, mortgage servicing rights financing receivables, Excess MSRs and the rights to the basic fee components of MSRs are well-seasoned with credit-impaired borrowers who may have limited refinancing options, we believe the impact of interest rates on prepayments would be reduced. Conversely, in an increasing interest rate environment, prepayment rates decrease which in turn would cause the value of MSRs, mortgage servicing rights financing receivables, Excess MSRs and the rights to the basic fee components of MSRs to increase and the value of loans and Non-Agency RMBS to decrease. To the extent we do not hedge against changes in interest rates, our balance sheet, results of operations and cash flows would be susceptible to significant volatility due to changes in the fair value of, or cash flows from, our investments as interest rates change. However, rising interest rates could result from more robust market conditions, which could reduce the credit risk associated with our investments. The effects of such a decrease in values on our financial position, results of operations and liquidity are discussed below under “—Prepayment Rate Exposure.”\nChanges in the value of our assets could affect our ability to borrow and access capital. Also, if the value of our assets subject to short-term financing were to decline, it could cause us to fund margin, or repay debt, and affect our ability to refinance such assets upon the maturity of the related financings, adversely impacting our rate of return on such investments.\n96\nWe are subject to margin calls on our repurchase agreements. Furthermore, we may, from time to time, be a party to derivative agreements or financing arrangements that are subject to margin calls, or mandatory repayment, based on the value of such instruments. We seek to maintain adequate cash reserves and other sources of available liquidity to meet any margin calls, or required repayments, resulting from decreases in value related to a reasonably possible (in our opinion) change in interest rates but there can be no assurance that our cash reserves will be sufficient.\nIn addition, changes in interest rates may impact our ability to exercise our call rights and to realize or maximize potential profits from them. A significant portion of the residential mortgage loans underlying our call rights bear fixed rates and may decline in value during a period of rising market interest rates. Furthermore, rising rates could cause prepayment rates on these loans to decline, which would delay our ability to exercise our call rights. These impacts could be at least partially offset by potential declines in the value of Non-Agency RMBS related to the call rights, which could then be acquired more cheaply, and in credit spreads, which could offset the impact of rising market interest rates on the value of fixed rate loans to some degree. Conversely, declining interest rates could increase the value of our call rights by increasing the value of the underlying loans.\nWe believe our consumer loan investments generally have limited interest rate sensitivity given that our portfolio is mostly composed of very seasoned loans with credit-impaired borrowers who are paying fixed rates, who we believe are relatively unlikely to change their prepayment patterns based on changes in interest rates.\nAs of September 30, 2019, an immediate 50 basis point increase in short term interest rates, based on a parallel shift in the yield curve (assuming an unchanged mortgage basis), would reduce our net book value by approximately $6.2 million, whereas a 50 basis point decrease in short term interest rates would increase our net book value by approximately $3.7 million, based on the present value of estimated cash flows on a static portfolio of investments. This includes changes in our book value resulting from potential related changes in discount rates.\nInterest rates are highly sensitive to many factors, including fiscal and monetary policies and domestic and international economic and political considerations, as well as other factors beyond our control.\nLIBOR and other indices which are deemed “benchmarks” are the subject of recent national, international, and other regulatory guidance and proposals for reform, and it appears likely that LIBOR will be phased out or the methodology for determining LIBOR will be modified by 2021. We currently have agreements that are indexed to LIBOR and are monitoring related reform proposals and evaluating the related risks; however, it is not possible to predict the effects of any of these developments, and any future initiatives to regulate, reform or change the manner of administration of LIBOR could result in adverse consequences to the rate of interest payable and receivable on, market value of and market liquidity for LIBOR-based financial instruments. The below table is comparative in order to show the prior period sensitivity analysis under our new methodology.\n| June 30, 2019 | September 30, 2019 |\n| Interest rate change (bps) | Estimated Change in Fair Value ($mm) | Estimated Change in Fair Value ($mm) |\n| +50bps | +$6.2mm | -$36.2mm |\n| +25bps | +$4.0mm | -$14.0mm |\n| -25bps | -$5.9mm | +$5.9mm |\n| -50bps | -$13.7mm | +$3.7mm |\n\nMortgage Basis Spread Risk\nMortgage basis measures the spread between the yield on current coupon mortgage backed securities and benchmark rates including treasuries and swaps. The level of mortgage basis is driven by demand and supply of mortgage backed instruments relative to other rate-sensitive assets. Changes in the mortgage basis have an impact on prepayment rates driven by the ability of borrowers underlying our portfolio to refinance. A lower mortgage basis would imply a lower mortgage rate which would increase prepayment speeds due to higher refinance activity and, therefore, lower fair value of our mortgage portfolio. As of September 30, 2019, an immediate 20 basis point increase in mortgage basis would increase our net book value by approximately $39.4 million, whereas a 20 basis point decrease in mortgage basis would decrease our net book value by approximately $40.6 million, based on the present value of estimated cash flows on a static portfolio of investments. The below table is comparative in order to show the prior period sensitivity analysis under our new methodology.\n97\n| June 30, 2019 | September 30, 2019 |\n| Mortgage Basis change (bps) | Estimated Change in Fair Value ($mm) | Estimated Change in Fair Value ($mm) |\n| +20bps | +$79.8mm | +$39.4mm |\n| +10bps | +$39.9mm | +$19.8mm |\n| -10bps | -$40.0mm | -$20.1mm |\n| -20bps | -$80.2mm | -$40.6mm |\n\nPrepayment Rate Exposure\nPrepayment rates significantly affect the value of MSRs, mortgage servicing rights financing receivables, Excess MSRs, the basic fee component of MSRs (which we own as part of our Servicer Advance Investments), Non-Agency RMBS and loans, including consumer loans. Prepayment rate is the measurement of how quickly borrowers pay down the UPB of their loans or how quickly loans are otherwise brought current, modified, liquidated or charged off. The price we pay to acquire certain investments will be based on, among other things, our projection of the cash flows from the related pool of loans. Our expectation of prepayment rates is a significant assumption underlying those cash flow projections. If the fair value of MSRs, mortgage servicing rights financing receivables, Excess MSRs or the basic fee component of MSRs decreases, we would be required to record a non-cash charge, which would have a negative impact on our financial results. Furthermore, a significant increase in prepayment rates could materially reduce the ultimate cash flows we receive from MSRs, mortgage servicing rights financing receivables, Excess MSRs or our right to the basic fee component of MSRs, and we could ultimately receive substantially less than what we paid for such assets. Conversely, a significant decrease in prepayment rates with respect to our loans or RMBS could delay our expected cash flows and reduce the yield on these investments.\nWe seek to reduce our exposure to prepayment through the structuring of our investments. For example, in our MSR and Excess MSR investments, we seek to enter into “recapture agreements” whereby our MSR or Excess MSR is retained if the applicable servicer or subservicer originates a new loan the proceeds of which are used to repay a loan underlying an MSR or Excess MSR in our portfolio. We seek to enter into such recapture agreements in order to protect our returns in the event of a rise in voluntary prepayment rates.\nPlease refer to the table in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Application of Critical Accounting Policies—Excess MSRs” for an analysis of the sensitivity of these investments to changes in certain market factors.\nCredit Risk\nWe are subject to varying degrees of credit risk in connection with our assets. Credit risk refers to the ability of each individual borrower underlying our investments in MSRs, mortgage servicing rights financing receivables, Excess MSRs, Servicer Advance Investments, securities and loans to make required interest and principal payments on the scheduled due dates. If delinquencies increase, then the amount of servicer advances we are required to make will also increase, as would our financing cost thereof. We may also invest in loans and Non-Agency RMBS which represent “first loss” pieces; in other words, they do not benefit from credit support although we believe they predominantly benefit from underlying collateral value in excess of their carrying amounts. Although we do not expect to encounter credit risk in our Agency RMBS, we do anticipate credit risk related to Non-Agency RMBS, residential mortgage loans and consumer loans.\nWe seek to reduce credit risk through prudent asset selection, actively monitoring our asset portfolio and the underlying credit quality of our holdings and, where appropriate and achievable, repositioning our investments to upgrade their credit quality. Our pre-acquisition due diligence and processes for monitoring performance include the evaluation of, among other things, credit and risk ratings, principal subordination, prepayment rates, delinquency and default rates, and vintage of collateral.\nFor our MSRs, mortgage servicing rights financing receivables, and Excess MSRs on Agency collateral and our Agency RMBS, delinquency and default rates have an effect similar to prepayment rates. Our Excess MSRs on Non-Agency portfolios are not directly affected by delinquency rates because the servicer continues to advance principal and interest until a default occurs on the applicable loan, so delinquencies decrease prepayments therefore having a positive impact on fair value, while increased defaults have an effect similar to increased prepayments. For our Non-Agency RMBS and loans, higher default rates can lead to greater loss of principal. For our call rights, higher delinquencies and defaults could reduce the value of the underlying loans, therefore reducing or eliminating the related potential profit.\n98\nMarket factors that could influence the degree of the impact of credit risk on our investments include (i) unemployment and the general economy, which impact borrowers’ ability to make payments on their loans, (ii) home prices, which impact the value of collateral underlying residential mortgage loans, (iii) the availability of credit, which impacts borrowers’ ability to refinance, and (iv) other factors, all of which are beyond our control.\nLiquidity Risk\nThe assets that comprise our asset portfolio are generally not publicly traded. A portion of these assets may be subject to legal and other restrictions on resale or otherwise be less liquid than publicly-traded securities. The illiquidity of our assets may make it difficult for us to sell such assets if the need or desire arises, including in response to changes in economic and other conditions.\nInvestment Specific Sensitivity Analyses\nExcess MSRs\nThe following table summarizes the estimated change in fair value of our interests in the Agency Excess MSRs owned directly as of September 30, 2019 given several parallel shifts in the discount rate, prepayment rate, delinquency rate and recapture rate (dollars in thousands):\n| Fair value at September 30, 2019 | $ | 221,560 |\n| Discount rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 233,576 | $ | 227,967 | $ | 215,552 | $ | 208,747 |\n| Change in estimated fair value: |\n| Amount | $ | 12,016 | $ | 6,407 | $ | (6,008 | ) | $ | (12,813 | ) |\n| % | 5.4 | % | 2.9 | % | (2.7 | )% | (5.8 | )% |\n| Prepayment rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 233,618 | $ | 228,908 | $ | 214,816 | $ | 211,680 |\n| Change in estimated fair value: |\n| Amount | $ | 12,058 | $ | 7,348 | $ | (6,744 | ) | $ | (9,880 | ) |\n| % | 5.4 | % | 3.3 | % | (3.0 | )% | (4.5 | )% |\n| Delinquency rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 221,913 | $ | 221,744 | $ | 221,404 | $ | 221,235 |\n| Change in estimated fair value: |\n| Amount | $ | 353 | $ | 184 | $ | (156 | ) | $ | (325 | ) |\n| % | 0.2 | % | 0.1 | % | (0.1 | )% | (0.1 | )% |\n| Recapture rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 214,864 | $ | 218,219 | $ | 224,929 | $ | 228,284 |\n| Change in estimated fair value: |\n| Amount | $ | (6,696 | ) | $ | (3,341 | ) | $ | 3,369 | $ | 6,724 |\n| % | (3.0 | )% | (1.5 | )% | 1.5 | % | 3.0 | % |\n\n99\nThe following table summarizes the estimated change in fair value of our interests in the Non-Agency Excess MSRs owned directly as of September 30, 2019 given several parallel shifts in the discount rate, prepayment rate, delinquency rate and recapture rate (dollars in thousands):\n| Fair value at September 30, 2019 | $ | 176,504 |\n| Discount rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 187,808 | $ | 182,601 | $ | 170,900 | $ | 164,407 |\n| Change in estimated fair value: |\n| Amount | $ | 11,304 | $ | 6,097 | $ | (5,604 | ) | $ | (12,097 | ) |\n| % | 6.4 | % | 3.5 | % | (3.2 | )% | (6.9 | )% |\n| Prepayment rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 190,121 | $ | 184,296 | $ | 169,440 | $ | 165,449 |\n| Change in estimated fair value: |\n| Amount | $ | 13,617 | $ | 7,792 | $ | (7,064 | ) | $ | (11,055 | ) |\n| % | 7.7 | % | 4.4 | % | (4.0 | )% | (6.3 | )% |\n| Delinquency rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 176,523 | $ | 176,521 | $ | 176,518 | $ | 176,516 |\n| Change in estimated fair value: |\n| Amount | $ | 19 | $ | 17 | $ | 14 | $ | 12 |\n| % | — | % | — | % | — | % | — | % |\n| Recapture rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 173,437 | $ | 174,978 | $ | 178,061 | $ | 179,602 |\n| Change in estimated fair value: |\n| Amount | $ | (3,067 | ) | $ | (1,526 | ) | $ | 1,557 | $ | 3,098 |\n| % | (1.7 | )% | (0.9 | )% | 0.9 | % | 1.8 | % |\n\nThe following table summarizes the estimated change in fair value of our interests in the Agency Excess MSRs owned through equity method investees as of September 30, 2019 given several parallel shifts in the discount rate, prepayment rate, delinquency rate and recapture rate (dollars in thousands):\n| Fair value at September 30, 2019 | $ | 132,259 |\n| Discount rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 138,805 | $ | 135,647 | $ | 128,986 | $ | 125,484 |\n| Change in estimated fair value: |\n| Amount | $ | 6,546 | $ | 3,388 | $ | (3,273 | ) | $ | (6,775 | ) |\n| % | 4.9 | % | 2.6 | % | (2.5 | )% | (5.1 | )% |\n| Prepayment rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 138,370 | $ | 135,993 | $ | 128,756 | $ | 127,242 |\n| Change in estimated fair value: |\n| Amount | $ | 6,111 | $ | 3,734 | $ | (3,503 | ) | $ | (5,017 | ) |\n| % | 4.6 | % | 2.8 | % | (2.6 | )% | (3.8 | )% |\n| Delinquency rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 132,487 | $ | 132,352 | $ | 132,083 | $ | 131,949 |\n| Change in estimated fair value: |\n| Amount | $ | 228 | $ | 93 | $ | (176 | ) | $ | (310 | ) |\n| % | 0.2 | % | 0.1 | % | (0.1 | )% | (0.2 | )% |\n| Recapture rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 128,488 | $ | 130,353 | $ | 134,082 | $ | 135,947 |\n| Change in estimated fair value: |\n| Amount | $ | (3,771 | ) | $ | (1,906 | ) | $ | 1,823 | $ | 3,688 |\n| % | (2.9 | )% | (1.4 | )% | 1.4 | % | 2.8 | % |\n\n100\nMSRs\nThe following table summarizes the estimated change in fair value of our interests in the Agency MSRs, including mortgage servicing rights financing receivables, owned as of September 30, 2019 given several parallel shifts in the discount rate, prepayment rate, delinquency rate and recapture rate (dollars in thousands):\n| Fair value at September 30, 2019 | $ | 3,636,711 |\n| Discount rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 3,819,885 | $ | 3,733,227 | $ | 3,545,124 | $ | 3,443,678 |\n| Change in estimated fair value: |\n| Amount | $ | 183,174 | $ | 96,516 | $ | (91,587 | ) | $ | (193,033 | ) |\n| % | 5.0 | % | 2.7 | % | (2.5 | )% | (5.3 | )% |\n| Prepayment rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 3,864,772 | $ | 3,743,884 | $ | 3,539,852 | $ | 3,452,425 |\n| Change in estimated fair value: |\n| Amount | $ | 228,061 | $ | 107,173 | $ | (96,859 | ) | $ | (184,286 | ) |\n| % | 6.3 | % | 2.9 | % | (2.7 | )% | (5.1 | )% |\n| Delinquency rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 3,650,369 | $ | 3,643,454 | $ | 3,629,626 | $ | 3,622,717 |\n| Change in estimated fair value: |\n| Amount | $ | 13,658 | $ | 6,743 | $ | (7,085 | ) | $ | (13,994 | ) |\n| % | 0.4 | % | 0.2 | % | (0.2 | )% | (0.4 | )% |\n| Recapture rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 3,511,603 | $ | 3,574,071 | $ | 3,699,008 | $ | 3,761,477 |\n| Change in estimated fair value: |\n| Amount | $ | (125,108 | ) | $ | (62,640 | ) | $ | 62,297 | $ | 124,766 |\n| % | (3.4 | )% | (1.7 | )% | 1.7 | % | 3.4 | % |\n\n101\nThe following table summarizes the estimated change in fair value of our interests in the Non-Agency MSRs, including mortgage servicing rights financing receivables, owned as of September 30, 2019 given several parallel shifts in the discount rate, prepayment rate, delinquency rate and recapture rate (dollars in thousands):\n| Fair value at September 30, 2019 | $ | 1,233,592 |\n| Discount rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 1,328,865 | $ | 1,287,146 | $ | 1,185,955 | $ | 1,126,483 |\n| Change in estimated fair value: |\n| Amount | $ | 95,273 | $ | 53,554 | $ | (47,637 | ) | $ | (107,109 | ) |\n| % | 7.7 | % | 4.3 | % | (3.9 | )% | (8.7 | )% |\n| Prepayment rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 1,286,886 | $ | 1,259,011 | $ | 1,213,398 | $ | 1,195,616 |\n| Change in estimated fair value: |\n| Amount | $ | 53,294 | $ | 25,419 | $ | (20,194 | ) | $ | (37,976 | ) |\n| % | 4.3 | % | 2.1 | % | (1.6 | )% | (3.1 | )% |\n| Delinquency rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 1,267,992 | $ | 1,245,516 | $ | 1,200,545 | $ | 1,178,053 |\n| Change in estimated fair value: |\n| Amount | $ | 34,400 | $ | 11,924 | $ | (33,047 | ) | $ | (55,539 | ) |\n| % | 2.8 | % | 1.0 | % | (2.7 | )% | (4.5 | )% |\n| Recapture rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 1,215,987 | $ | 1,225,223 | $ | 1,243,692 | $ | 1,252,927 |\n| Change in estimated fair value: |\n| Amount | $ | (17,605 | ) | $ | (8,369 | ) | $ | 10,100 | $ | 19,335 |\n| % | (1.4 | )% | (0.7 | )% | 0.8 | % | 1.6 | % |\n\nThe following table summarizes the estimated change in fair value of our interests in the Ginnie Mae MSRs, owned as of September 30, 2019 given several parallel shifts in the discount rate, prepayment rate, delinquency rate and recapture rate (dollars in thousands):\n| Fair value at September 30, 2019 | $ | 372,926 |\n| Discount rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 392,886 | $ | 382,305 | $ | 362,946 | $ | 354,169 |\n| Change in estimated fair value: |\n| Amount | $ | 19,960 | $ | 9,379 | $ | (9,980 | ) | $ | (18,757 | ) |\n| % | 5.4 | % | 2.5 | % | (2.7 | )% | (5.0 | )% |\n| Prepayment rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 398,886 | $ | 384,635 | $ | 361,543 | $ | 351,942 |\n| Change in estimated fair value: |\n| Amount | $ | 25,960 | $ | 11,709 | $ | (11,383 | ) | $ | (20,984 | ) |\n| % | 7.0 | % | 3.1 | % | (3.1 | )% | (5.6 | )% |\n| Delinquency rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 377,595 | $ | 374,961 | $ | 369,692 | $ | 367,058 |\n| Change in estimated fair value: |\n| Amount | $ | 4,669 | $ | 2,035 | $ | (3,234 | ) | $ | (5,868 | ) |\n| % | 1.3 | % | 0.5 | % | (0.9 | )% | (1.6 | )% |\n| Recapture rate shift in % | -20% | -10% | 10% | 20% |\n| Estimated fair value | $ | 354,049 | $ | 363,187 | $ | 381,465 | $ | 390,603 |\n| Change in estimated fair value: |\n| Amount | $ | (18,877 | ) | $ | (9,739 | ) | $ | 8,539 | $ | 17,677 |\n| % | (5.1 | )% | (2.6 | )% | 2.3 | % | 4.7 | % |\n\n102\nEach of the preceding sensitivity analyses is hypothetical and should be used with caution. In particular, the results are calculated by stressing a particular economic assumption independent of changes in any other assumption; in practice, changes in one factor may result in changes in another, which might counteract or amplify the sensitivities. Also, changes in the fair value based on a 10% variation in an assumption generally may not be extrapolated because the relationship of the change in the assumption to the change in fair value may not be linear.\nITEM 4. CONTROLS AND PROCEDURES\nDisclosure Controls and Procedures\nThe Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. The Company’s disclosure controls and procedures are designed to provide reasonable assurance that information is recorded, processed, summarized and reported accurately and on a timely basis. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures were effective.\nChanges in Internal Control Over Financial Reporting\nThere have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\n103\nPART II. OTHER INFORMATION\n\nITEM 1. LEGAL PROCEEDINGS\nWe are or may become, from time to time, involved in various disputes, litigation and regulatory inquiry and investigation matters that arise in the ordinary course of business. Given the inherent unpredictability of these types of proceedings, it is possible that future adverse outcomes could have a material adverse effect on our business, financial position or results of operations.\nNew Residential is, from time to time, subject to inquiries by government entities. New Residential currently does not believe any of these inquiries would result in a material adverse effect on New Residential’s business.\nITEM 1A. RISK FACTORS\nInvesting in our stock involves a high degree of risk. You should carefully read and consider the following risk factors and all other information contained in this report. If any of the following risks, as well as additional risks and uncertainties not currently known to us or that we currently deem immaterial, occur, our business, financial condition or results of operations could be materially and adversely affected. The risk factors summarized below are categorized as follows: (i) Risks Related to Our Business, (ii) Risks Related to Our Manager, (iii) Risks Related to the Financial Markets, (iv) Risks Related to Our Taxation as a REIT and (v) Risks Related to Our Stock. However, these categories do overlap and should not be considered exclusive.\nRisks Related to Our Business\nWe may not be able to successfully operate our business strategy or generate sufficient revenue to make or sustain distributions to our stockholders.\nWe cannot assure you that we will be able to successfully operate our business or implement our operating policies and strategies. There can be no assurance that we will be able to generate sufficient returns to pay our operating expenses and make satisfactory distributions to our stockholders, or any distributions at all. Our results of operations and our ability to make or sustain distributions to our stockholders depend on several factors, including the availability of opportunities to acquire attractive assets, the level and volatility of interest rates, the availability of adequate short- and long-term financing, and conditions in the real estate market, the financial markets and economic conditions.\nThe value of our investments is based on various assumptions that could prove to be incorrect and could have a negative impact on our financial results.\nWhen we make investments, we base the price we pay and, in some cases, the rate of amortization of those investments on, among other things, our projection of the cash flows from the related pool of loans. We generally record such investments on our balance sheet at fair value, and we measure their fair value on a recurring basis. Our projections of the cash flow from our investments, and the determination of the fair value thereof, are based on assumptions about various factors, including, but not limited to:\n\n| • | rates of prepayment and repayment of the underlying loans; |\n\n| • | potential fluctuations in prevailing interest rates and credit spreads; |\n\n| • | rates of delinquencies and defaults, and related loss severities; |\n\n| • | costs of engaging a subservicer to service MSRs; |\n\n| • | market discount rates; |\n\n| • | in the case of MSRs and Excess MSRs, recapture rates; and |\n\n| • | in the case of Servicer Advance Investments and servicer advances receivable, the amount and timing of servicer advances and recoveries. |\n\nOur assumptions could differ materially from actual results. The use of different estimates or assumptions in connection with the valuation of these investments could produce materially different fair values for such investments, which could have a material adverse effect on our consolidated financial position and results of operations. The ultimate realization of the value of our investments may be materially different than the fair values of such investments as reflected in our Condensed Consolidated Financial Statements as of any particular date.\nWe refer to our MSRs, mortgage servicing rights financing receivables, Excess MSRs, and the base fee portion of the related MSRs included in our Servicer Advance Investments, collectively, as our interests in MSRs.\n104\nWith respect to our investments in interests in MSRs, residential mortgage loans and consumer loans, and a portion of our RMBS, when the related loans are prepaid as a result of a refinancing or otherwise, the related cash flows payable to us will either, in the case of interest-only RMBS, and/or interests in MSRs, cease (unless, in the case of our interests in MSRs, the loans are recaptured upon a refinancing), or we will cease to receive interest income on such investments, as applicable. Borrowers under residential mortgage loans and consumer loans are generally permitted to prepay their loans at any time without penalty. Our expectation of prepayment rates is a significant assumption underlying our cash flow projections. Prepayment rate is the measurement of how quickly borrowers pay down the UPB of their loans or how quickly loans are otherwise brought current, modified, liquidated or charged off. A significant increase in prepayment rates could materially reduce the ultimate cash flows and/or interest income, as applicable, we receive from our investments, and we could ultimately receive substantially less than what we paid for such assets, decreasing the fair value of our investments. If the fair value of our investment portfolio decreases, we would generally be required to record a non-cash charge, which would have a negative impact on our financial results. Consequently, the price we pay to acquire our investments may prove to be too high if there is a significant increase in prepayment rates.\nThe values of our investments are highly sensitive to changes in interest rates. Historically, the value of MSRs, which underpin the value of our investments, including interests in MSRs, has increased when interest rates rise and decreased when interest rates decline due to the effect of changes in interest rates on prepayment rates. Prepayment rates could increase as a result of a general economic recovery or other factors, which would reduce the value of our interests in MSRs.\nMoreover, delinquency rates have a significant impact on the value of our investments. When the UPB of mortgage loans cease to be a part of the aggregate UPB of the serviced loan pool (for example, when delinquent loans are foreclosed on or repurchased, or otherwise sold, from a securitized pool), the related cash flows payable to us, as the holder of an interest in the related MSR, cease. An increase in delinquencies will generally result in lower revenue because typically we will only collect on our interests in MSRs from GSEs or mortgage owners for performing loans. An increase in delinquencies with respect to the loans underlying our servicer advances could also result in a higher advance balance and the need to obtain additional financing, which we may not be able to do on favorable terms or at all. Additionally, in the case of residential mortgage loans, consumer loans and RMBS that we own, an increase in foreclosures could result in an acceleration of repayments, resulting in a decrease in interest income. Alternatively, increases in delinquencies and defaults could also adversely affect our investments in RMBS, residential mortgage loans and/or consumer loans if and to the extent that losses are suffered on residential mortgage loans, consumer loans or, in the case of RMBS, the residential mortgage loans underlying such RMBS. Accordingly, if delinquencies are significantly greater than expected, the estimated fair value of these investments could be diminished. As a result, we could suffer a loss, which would have a negative impact on our financial results.\nWe are party to several “recapture agreements” whereby our MSR or Excess MSR is retained if the applicable Servicing Partner originates a new loan the proceeds of which are used to repay a loan underlying an MSR or Excess MSR in our portfolio. We believe that such agreements will mitigate the impact on our returns in the event of a rise in voluntary prepayment rates, with respect to investments where we have such agreements. There are no assurances, however, that counterparties will enter into such arrangements with us in connection with any future investment in MSRs or Excess MSRs. We are not party to any such arrangements with respect to any of our investments other than MSRs and Excess MSRs.\nIf the applicable Servicing Partner does not meet anticipated recapture targets, the servicing cash flow on a given pool could be significantly lower than projected, which could have a material adverse effect on the value of our MSRs or Excess MSRs and consequently on our business, financial condition, results of operations and cash flows. Our recapture target for our current recapture agreements is stated in the table in Note 12 to our Condensed Consolidated Financial Statements.\nServicer advances may not be recoverable or may take longer to recover than we expect, which could cause us to fail to achieve our targeted return on our Servicer Advance Investments or MSRs.\nNRM is generally required to make servicer advances related to the pools of loans for which it is the named servicer. In addition, we have agreed (in the case of Nationstar, together with certain third-party investors) to purchase from certain of the servicers and subservicers that we engage, which we refer to as our “Servicing Partners,” all servicer advances related to certain loan pools, as a result of which we are entitled to amounts representing repayment for such advances. During any period in which a borrower is not making payments, a servicer is generally required under the applicable servicing agreement to advance its own funds to cover the principal and interest remittances due to investors in the loans, pay property taxes and insurance premiums to third parties, and to make payments for legal expenses and other protective advances. The servicer also advances funds to maintain, repair and market real estate properties on behalf of investors in the loans.\nRepayment of servicer advances and payment of deferred servicing fees are generally made from late payments and other collections and recoveries on the related residential mortgage loan (including liquidation, insurance and condemnation proceeds) or, if the related servicing agreement provides for a “general collections backstop,” from collections on other residential mortgage loans\n105\nto which such servicing agreement relates. The rate and timing of payments on servicer advances and deferred servicing fees are unpredictable for several reasons, including the following:\n\n| • | payments on the servicer advances and the deferred servicing fees depend on the source of repayment, and whether and when the related servicer receives such payment (certain servicer advances are reimbursable only out of late payments and other collections and recoveries on the related residential mortgage loan, while others are also reimbursable out of principal and interest collections with respect to all residential mortgage loans serviced under the related servicing agreement, and as a consequence, the timing of such reimbursement is highly uncertain); |\n\n| • | the length of time necessary to obtain liquidation proceeds may be affected by conditions in the real estate market or the financial markets generally, the availability of financing for the acquisition of the real estate and other factors, including, but not limited to, government intervention; |\n\n| • | the length of time necessary to effect a foreclosure may be affected by variations in the laws of the particular jurisdiction in which the related mortgaged property is located, including whether or not foreclosure requires judicial action; |\n\n| • | the requirements for judicial actions for foreclosure (which can result in substantial delays in reimbursement of servicer advances and payment of deferred servicing fees), which vary from time to time as a result of changes in applicable state law; and |\n\n| • | the ability of the related servicer to sell delinquent residential mortgage loans to third parties prior to a sale of the underlying real estate, resulting in the early reimbursement of outstanding unreimbursed servicer advances in respect of such residential mortgage loans. |\n\nAs home values change, the servicer may have to reconsider certain of the assumptions underlying its decisions to make advances. In certain situations, its contractual obligations may require the servicer to make certain advances for which it may not be reimbursed. In addition, when a residential mortgage loan defaults or becomes delinquent, the repayment of the advance may be delayed until the residential mortgage loan is repaid or refinanced, or a liquidation occurs. To the extent that one of our Servicing Partners fails to recover the servicer advances in which we have invested, or takes longer than we expect to recover such advances, the value of our investment could be adversely affected and we could fail to achieve our expected return and suffer losses.\nServicing agreements related to residential mortgage securitization transactions generally require a residential mortgage servicer to make servicer advances in respect of serviced residential mortgage loans unless the servicer determines in good faith that the servicer advance would not be ultimately recoverable from the proceeds of the related residential mortgage loan, mortgaged property or mortgagor. In many cases, if the servicer determines that a servicer advance previously made would not be recoverable from these sources, the servicer is entitled to withdraw funds from the related custodial account in respect of payments on the related pool of serviced mortgages to reimburse the related servicer advance. This is what is often referred to as a “general collections backstop.” The timing of when a servicer may utilize a general collections backstop can vary (some contracts require actual liquidation of the related loan first, while others do not), and contracts vary in terms of the types of servicer advances for which reimbursement from a general collections backstop is available. Accordingly, a servicer may not ultimately be reimbursed if both (i) the payments from related loan, property or mortgagor payments are insufficient for reimbursement, and (ii) a general collections backstop is not available or is insufficient. Also, if a servicer improperly makes a servicer advance, it would not be entitled to reimbursement. While we do not expect recovery rates to vary materially during the term of our investments, there can be no assurance regarding future recovery rates related to our portfolio.\nWe rely heavily on our Servicing Partners to achieve our investment objective and have no direct ability to influence their performance.\nThe value of substantially all of our investments is dependent on the satisfactory performance of servicing obligations by the related mortgage servicer or subservicer, as applicable. The duties and obligations of mortgage servicers are defined through contractual agreements, generally referred to as Servicing Guides in the case of GSEs, the MBS Guide in the case of Ginnie Mae or pooling agreements, securitization servicing agreements, pooling and servicing agreements or other similar agreements (collectively, “PSAs”) in the case of Non-Agency RMBS (collectively, the “Servicing Guidelines”). The duties of the subservicers we engage to service the loans underlying our MSRs are contained in subservicing agreements with our subservicers. The duties of a subservicer under a subservicing agreement may not be identical to the obligations of the servicer under Servicing Guidelines. Our interests in MSRs are subject to all of the terms and conditions of the applicable Servicing Guidelines. Servicing Guidelines generally provide for the possibility of termination of the contractual rights of the servicer in the absolute discretion of the owner of the mortgages being serviced (or the required bondholders in the case of Non-Agency RMBS). Under the Agency Servicing Guidelines, the servicer may be terminated by the applicable Agency for any reason, “with” or “without” cause, for all or any portion of the loans being serviced for such Agency. In the event mortgage owners (or bondholders) terminate the servicer (regardless of whether such servicer is a subsidiary of New Residential or one of its subservicers), the related interests in MSRs would under most circumstances lose all value on a going forward basis. If the servicer is terminated as servicer for any Agency pools, the servicer’s right to service the related mortgage loans will be extinguished and our interests in related MSRs will likely lose all of\n106\ntheir value. Any recovery in such circumstances, in the case of Non-Agency RMBS, will be highly conditioned and may require, among other things, a new servicer willing to pay for the right to service the applicable residential mortgage loans while assuming responsibility for the origination and prior servicing of the residential mortgage loans. In addition, in the case of Agency MSRs, any payment received from a successor servicer will be applied first to pay the applicable Agency for all of its claims and costs, including claims and costs against the servicer that do not relate to the residential mortgage loans for which we own interests in the MSRs. A termination could also result in an event of default under our related financings. It is expected that any termination of a servicer by mortgage owners (or bondholders) would take effect across all mortgages of such mortgage owners (or bondholders) and would not be limited to a particular vintage or other subset of mortgages. Therefore, it is possible that all investments with a given servicer would lose all their value in the event mortgage owners (or bondholders) terminate such servicer. See “—We have significant counterparty concentration risk in certain of our Servicing Partners, and are subject to other counterparty concentration and default risks.” As a result, we could be materially and adversely affected if one of our Servicing Partners is unable to adequately carry out its duties as a result of:\n\n| • | its failure to comply with applicable laws and regulations; |\n\n| • | its failure to comply with contractual and financing obligations and covenants; |\n\n| • | a downgrade in, or failure to maintain, any of its servicer ratings; |\n\n| • | its failure to maintain sufficient liquidity or access to sources of liquidity; |\n\n| • | its failure to perform its loss mitigation obligations; |\n\n| • | its failure to perform adequately in its external audits; |\n\n| • | a failure in or poor performance of its operational systems or infrastructure; |\n\n| • | regulatory or legal scrutiny or regulatory actions regarding any aspect of a servicer’s operations, including, but not limited to, servicing practices and foreclosure processes lengthening foreclosure timelines; |\n\n| • | an Agency’s or a whole-loan owner’s transfer of servicing to another party; or |\n\n| • | any other reason. |\n\nIn the ordinary course of business, our Servicing Partners are subject to numerous legal proceedings, federal, state or local governmental examinations, investigations or enforcement actions which could adversely affect their reputation and their liquidity, financial position and results of operations. Mortgage servicers, including certain of our Servicing Partners, have experienced heightened regulatory scrutiny and enforcement actions, and our Servicing Partners could be adversely affected by the market’s perception that they could experience, or continue to experience, regulatory issues. See “—Certain of our Servicing Partners have been and are subject to federal and state regulatory matters and other litigation, which may adversely impact us.”\nLoss mitigation techniques are intended to reduce the probability that borrowers will default on their loans and to minimize losses when defaults occur, and they may include the modification of mortgage loan rates, principal balances and maturities. If any of our Servicing Partners fail to adequately perform their loss mitigation obligations, we could be required to make or purchase, as applicable, servicer advances in excess of those that we might otherwise have had to make or purchase, and the time period for collecting servicer advances may extend. Any increase in servicer advances or material increase in the time to resolution of a defaulted loan could result in increased capital requirements and financing costs for us and our co-investors and could adversely affect our liquidity and net income. In the event that one of our servicers from which we are obligated to purchase servicer advances is required by the applicable Servicing Guidelines to make advances in excess of amounts that we or, in the case of Nationstar, the co-investors, are willing or able to fund, such servicer may not be able to fund these advance requests, which could result in a termination event under the applicable Servicing Guidelines, an event of default under our advance facilities and a breach of our purchase agreement with such servicer. As a result, we could experience a partial or total loss of the value of our Servicer Advance Investments.\nMSRs and servicer advances are subject to numerous federal, state and local laws and regulations and may be subject to various judicial and administrative decisions. If the Servicing Partner actually or allegedly failed to comply with applicable laws, rules or regulations, it could be terminated as the servicer, and could lead to civil and criminal liability, loss of licensing, damage to our reputation and litigation, which could have a material adverse effect on our business, financial condition, results of operations or cash flows. In addition, servicer advances that are improperly made may not be eligible for financing under our facilities and may not be reimbursable by the related securitization trust or other owner of the residential mortgage loan, which could cause us to suffer losses.\nFavorable servicer ratings from third-party rating agencies, such as S&P Global Ratings (“S&P”), Moody’s Investors Service (“Moody’s”) and Fitch Ratings (“Fitch”), are important to the conduct of a mortgage servicer’s loan servicing business, and a downgrade in a Servicing Partner’s servicer ratings could have an adverse effect on the value of our interests in MSRs and result in an event of default under our financings. Downgrades in a Servicing Partner’s servicer ratings could adversely affect our ability to finance our assets and maintain their status as an approved servicer by Fannie Mae and Freddie Mac. Downgrades in servicer ratings could also lead to the early termination of existing advance facilities and affect the terms and availability of financing that\n107\na Servicing Partner or we may seek in the future. A Servicing Partner’s failure to maintain favorable or specified ratings may cause their termination as a servicer and may impair their ability to consummate future servicing transactions, which could result in an event of default under our financing for servicer advances and have an adverse effect on the value of our investments because we will rely heavily on Servicing Partners to achieve our investment objectives and have no direct ability to influence their performance.\nFor additional information about the ways in which we may be affected by mortgage servicers, see “—The value of our interests in MSRs, servicer advances, residential mortgage loans and RMBS may be adversely affected by deficiencies in servicing and foreclosure practices, as well as related delays in the foreclosure process.”\nA number of lawsuits, including class-actions, have been filed against mortgage servicers alleging improper servicing in connection with residential non-agency mortgage securitizations. Investors in, and counterparties to, such securitizations may commence legal action against us and responding to such claims, and any related losses, could negatively impact our business.\nA number of lawsuits, including class actions, have been filed against mortgage servicers alleging improper servicing in connection with residential non-agency mortgage securitizations. Investors in, and counterparties to, such securitizations may commence legal action against us and responding to such claims, and any related losses, could negatively impact our business. The number of counterparties on behalf of which we service loans significantly increases as the size of our non-agency MSR portfolio increases and we may become subject to claims and legal proceedings, including purported class-actions, in the ordinary course of our business, challenging whether our loan servicing practices and other aspects of our business comply with applicable laws, agreements and regulatory requirements. We are unable to predict whether any such claims will be made, the ultimate outcome of any such claims, the possible loss, if any, associated with the resolution of such claims or the potential impact any such claims may have on us or our business and operations. Regardless of the merit of any such claims or lawsuits, defending any claims or lawsuits may be time consuming and costly and we may be required to expend significant internal resources and incur material expenses, and management time may be diverted from other aspects of our business, in connection therewith. Further, if our efforts to defend any such claims or lawsuits are not successful, our business could be materially and adversely affected. As a result of investor and other counterparty claims, we could also suffer reputational damage and trustees, lenders and other counterparties could cease wanting to do business with us.\nCertain of our Servicing Partners have been and are subject to federal and state regulatory matters and other litigation, which may adversely impact us.\nRegulatory actions or legal proceedings against certain of our Servicing Partners could increase our financing costs or operating expenses, reduce our revenues or otherwise materially adversely affect our business, financial condition, results of operations and liquidity. Such Servicing Partners may be subject to additional federal and state regulatory matters in the future that could materially and adversely affect the value of our investments to the extent we rely on them to achieve our investment objectives because we have no direct ability to influence their performance. Certain of our Servicing Partners have disclosed certain matters in their periodic reports filed with the SEC, and there can be no assurance that such events will not have a material adverse effect on them. We are currently evaluating the impact of such events and cannot assure you what impact these events may have or what actions we may take under our agreements with the servicer. In addition, any of our Servicing Partners could be removed as servicer by the related loan owner or certain other transaction counterparties, which could have a material adverse effect on our interests in the loans and MSRs serviced by such Servicing Partner.\nIn addition, certain of our Servicing Partners have been and continue to be subject to regulatory and governmental examinations, information requests and subpoenas, inquiries, investigations and threatened legal actions and proceedings. In connection with formal and informal inquiries, such Servicing Partners may receive numerous requests, subpoenas and orders for documents, testimony and information in connection with various aspects of their activities, including whether certain of their residential loan servicing and originations practices, bankruptcy practices and other aspects of their business comply with applicable laws and regulatory requirements. Such Servicing Partners cannot provide any assurance as to the outcome of any of the aforementioned actions, proceedings or inquiries, or that such outcomes will not have a material adverse effect on their reputation, business, prospects, results of operations, liquidity or financial condition.\nCompletion of certain pending transactions related to MSRs (the “MSR Transactions”) is subject to various closing conditions, involves significant costs, and we cannot assure you if, when or the terms on which such transactions will close. Failure to complete the pending MSR Transactions could adversely affect our future business and results of operations.\nWe have entered into an agreement for Ocwen to transfer its remaining interests in $110.0 billion of UPB of non-Agency MSRs to NRM (the “Ocwen Subject MSRs”). We currently hold certain interests in the Ocwen Subject MSRs (including all servicer advances) pursuant to existing agreements with Ocwen. The transfer of Ocwen’s interests in the Ocwen Subject MSRs is subject\n108\nto numerous consents of third parties and certain actions by rating agencies. While certain of the Ocwen Subject MSRs have previously transferred to our subsidiaries, there is no assurance that we will be able to obtain such consents in order to transfer Ocwen’s interests in the Ocwen Subject MSRs to our subsidiaries. We have spent considerable time and resources, and incurred substantial costs, in connection with the negotiation of such transaction and we will incur such costs even if the Ocwen Subject MSRs cannot be transferred to our subsidiaries. As of September 30, 2019, MSRs representing approximately $66.7 billion UPB of underlying loans have been transferred pursuant to the Ocwen Transaction. Economics related to the remaining MSRs subject to the Ocwen Transaction were transferred pursuant to the New Ocwen Agreements (Note 5 to our Condensed Consolidated Financial Statements).\nWe may be unable to become the named servicer in respect of certain Non-Agency MSRs. If we are unable to become the named servicer in respect of any of the Ocwen Subject MSRs in accordance with the Ocwen Transaction, Ocwen has the right, in certain circumstances, to purchase from us our interests in the related MSRs. In such a situation, we will be required to sell Ocwen those assets (and will cease to receive income on those investments) and/or may be required to refinance certain indebtedness on terms that are not favorable to us.\nOur ability to acquire MSRs may be subject to the approval of various third parties and such approvals may not be provided on a timely basis or at all, or may be subject to conditions, representations and warranties and indemnities.\nOur ability to acquire MSRs may be subject to the approval of various third parties and such approvals may not be provided on a timely basis or at all, or may be conditioned upon our satisfaction of significant conditions which could require material expenditures and the provision of significant representations, warranties and indemnities. Such third parties may include the Agencies and the Federal Housing Finance Agency (“FHFA”) with respect to agency MSRs, and securitization trustees, master servicers, depositors, rating agencies and insurers, among others, with respect to non-agency MSRs. The process of obtaining any such approvals required for a servicing transfer, especially with respect to non-agency MSRs, may be time consuming and costly and we may be required to expend significant internal resources and incur material expenses in connection with such transactions. Further, the parties from whom approval is necessary may require that we provide significant representations and warranties and broad indemnities as a condition to their consent, which such representations and warranties and indemnities, if given, may expose us to material risks in addition to those arising under the related servicing agreements. Consenting parties may also charge a material consent fee and may require that we reimburse them for the legal expenses they incur in connection with their approval of the servicing transfer, which such expenses may include costs relating to substantial contract due diligence and may be significant. No assurance can be given that we will be able to successfully obtain the consents required to acquire the MSRs that we have agreed to purchase.\nWe have significant counterparty concentration risk in certain of our Servicing Partners and are subject to other counterparty concentration and default risks.\nWe are not restricted from dealing with any particular counterparty or from concentrating any or all of our transactions with a few counterparties. Any loss suffered by us as a result of a counterparty defaulting, refusing to conduct business with us or imposing more onerous terms on us would also negatively affect our business, results of operations, cash flows and financial condition.\nOur interests in MSRs relate to loans serviced or subserviced, as applicable, by our Servicing Partners. As disclosed in Notes 4, 5, and 6 of our Condensed Consolidated Financial Statements, certain of our Servicing Partners service and/or subservice a substantial portion of our interests in MSRs. If any of these Servicing Partners is the named servicer of the related MSR and is terminated, its servicing performance deteriorates, or in the event that any of them files for bankruptcy, our expected returns on these investments could be severely impacted. In addition, a large portion of the loans underlying our Non-Agency RMBS are serviced by certain of our Servicing Partners. We closely monitor our Servicing Partners’ mortgage servicing performance and overall operating performance, financial condition and liquidity, as well as their compliance with applicable regulations and Servicing Guidelines. We have various information, access and inspection rights in our agreements with these Servicing Partners that enable us to monitor aspects of their financial and operating performance and credit quality, which we periodically evaluate and discuss with their management. However, we have no direct ability to influence our Servicing Partners’ performance, and our diligence cannot prevent, and may not even help us anticipate, the termination of any such Servicing Partners’ servicing agreement or a severe deterioration of any of our Servicing Partners’ servicing performance on our portfolio of interests in MSRs.\nFurthermore, certain of our Servicing Partners are subject to numerous legal proceedings, federal, state or local governmental examinations, investigations or enforcement actions, which could adversely affect their operations, reputation and liquidity, financial position and results of operations. See “—Certain of our Servicing Partners have been and are subject to federal and state regulatory matters and other litigation, which may adversely impact us” for more information.\nNone of our Servicing Partners has an obligation to offer us any future co-investment opportunity on the same terms as prior transactions, or at all, and we may not be able to find suitable counterparties from which to acquire interests in MSRs, which could\n109\nimpact our business strategy. See “—We rely heavily on our Servicing Partners to achieve our investment objective and have no direct ability to influence their performance.”\nRepayment of the outstanding amount of servicer advances (including payment with respect to deferred servicing fees) may be subject to delay, reduction or set-off in the event that the related Servicing Partner breaches any of its obligations under the Servicing Guidelines, including, without limitation, any failure of such Servicing Partner to perform its servicing and advancing functions in accordance with the terms of such Servicing Guidelines. If any applicable Servicing Partner is terminated or resigns as servicer and the applicable successor servicer does not purchase all outstanding servicer advances at the time of transfer, collection of the servicer advances will be dependent on the performance of such successor servicer and, if applicable, reliance on such successor servicer’s compliance with the “first-in, first-out” or “FIFO” provisions of the Servicing Guidelines. In addition, such successor servicers may not agree to purchase the outstanding advances on the same terms as our current purchase arrangements and may require, as a condition of their purchase, modification to such FIFO provisions, which could further delay our repayment and adversely affect the returns from our investment.\nWe are subject to substantial other operational risks associated with our Servicing Partners in connection with the financing of servicer advances. In our current financing facilities for servicer advances, the failure of our Servicing Partner to satisfy various covenants and tests can result in an amortization event and/or an event of default. We have no direct ability to control our Servicing Partners’ compliance with those covenants and tests. Failure of our Servicing Partners to satisfy any such covenants or tests could result in a partial or total loss on our investment.\nIn addition, our Servicing Partners are party to our servicer advance financing agreements, with respect to those advances where they service or subservice the loans underlying the related MSRs. Our ability to obtain financing for these assets is dependent on our Servicing Partners’ agreement to be a party to the related financing agreements. If our Servicing Partners do not agree to be a party to these financing agreements for any reason, we may not be able to obtain financing on favorable terms or at all. Our ability to obtain financing on such assets is dependent on our Servicing Partners’ ability to satisfy various tests under such financing arrangements. Breaches and other events with respect to our Servicing Partners (which may include, without limitation, failure of a Servicing Partner to satisfy certain financial tests) could cause certain or all of the relevant servicer advance financing to become due and payable prior to maturity.\nWe are dependent on our Servicing Partners as the servicer or subservicer of the residential mortgage loans with respect to which we hold interests in MSRs, and their servicing practices may impact the value of certain of our assets. We may be adversely impacted:\n| • | By regulatory actions taken against our Servicing Partners; |\n\n| • | By a default by one of our Servicing Partners under their debt agreements; |\n\n| • | By downgrades in our Servicing Partners’ servicer ratings; |\n\n| • | If our Servicing Partners fail to ensure their servicer advances comply with the terms of their Pooling and Servicing Agreements (“PSAs”); |\n\n| • | If our Servicing Partners were terminated as servicer under certain PSAs; |\n\n| • | If our Servicing Partners become subject to a bankruptcy proceeding; or |\n\n| • | If our Servicing Partners fail to meet their obligations or are deemed to be in default under the indenture governing notes issued under any servicer advance facility with respect to which such Servicing Partner is the servicer. |\n\nOur interests in MSRs relate to loans serviced or subserviced, as applicable, by our Servicing Partners. As disclosed in Notes 4, 5, and 6 of our Condensed Consolidated Financial Statements, certain of our Servicing Partners service and/or subservice a substantial portion of our interests in MSRs. In addition, Nationstar is currently the servicer for a significant portion of our loans, and the loans underlying our RMBS. If the servicing performance of one of our subservicers deteriorates, if one of our subservicers files for bankruptcy or if one of our subservicers is otherwise unwilling or unable to continue to subservice MSRs for us, our expected returns on these investments would be severely impacted. In addition, if a subservicer becomes subject to a regulatory consent order or similar enforcement proceeding, that regulatory action could adversely affect us in several ways. For example, the regulatory action could result in delays of transferring servicing from an interim subservicer to our designated successor subservicer or cause the subservicer’s performance to degrade. Any such development would negatively affect our expected returns on these investments, and such effect could be materially adverse to our business and results of operations. We closely monitor each subservicer’s mortgage servicing performance and overall operating performance, financial condition and liquidity, as well as its compliance with applicable regulations and GSE servicing guidelines. We have various information, access and inspection rights in our respective agreements with our subservicers that enable us to monitor their financial and operating performance and credit quality, which we periodically evaluate and discuss with each subservicer’s respective management. However, we have no direct ability to influence each subservicer’s performance, and our diligence cannot prevent, and may not even help us anticipate, a severe deterioration of each subservicer’s respective servicing performance on our MSR portfolio.\n110\nIn addition, a material portion of the consumer loans in which we have invested are serviced by OneMain. If OneMain is terminated as the servicer of some or all of these portfolios, or in the event that it files for bankruptcy or is otherwise unable to continue to service such loans, our expected returns on these investments could be severely impacted.\nMoreover, we are party to repurchase agreements with a limited number of counterparties. If any of our counterparties elected not to renew our repurchase agreements, we may not be able to find a replacement counterparty, which would have a material adverse effect on our financial condition.\nOur risk-management processes may not accurately anticipate the impact of market stress or counterparty financial condition, and as a result, we may not take sufficient action to reduce our risks effectively. Although we will monitor our credit exposures, default risk may arise from events or circumstances that are difficult to detect, foresee or evaluate. In addition, concerns about, or a default by, one large participant could lead to significant liquidity problems for other participants, which may in turn expose us to significant losses.\nIn the event of a counterparty default, particularly a default by a major investment bank or Servicing Partner, we could incur material losses rapidly, and the resulting market impact of a major counterparty default could seriously harm our business, results of operations, cash flows and financial condition. In the event that one of our counterparties becomes insolvent or files for bankruptcy, our ability to eventually recover any losses suffered as a result of that counterparty’s default may be limited by the liquidity of the counterparty or the applicable legal regime governing the bankruptcy proceeding.\nA bankruptcy of any of our Servicing Partners could materially and adversely affect us.\nIf any of our Servicing Partners becomes subject to a bankruptcy proceeding, we could be materially and adversely affected, and you could suffer losses, as discussed below.\nA sale of MSRs or interests in MSRs and servicer advances or other assets, including loans, could be re-characterized as a pledge of such assets in a bankruptcy proceeding.\nWe believe that a mortgage servicer’s transfer to us of MSRs or interests in MSRs and servicer advances or any other asset transferred pursuant to a related purchase agreement, including loans, constitutes a sale of such assets, in which case such assets would not be part of such servicer’s bankruptcy estate. The servicer (as debtor-in-possession in the bankruptcy proceeding), a bankruptcy trustee appointed in such servicer’s bankruptcy proceeding, or any other party in interest, however, might assert in a bankruptcy proceeding MSRs or interests in MSRs and servicer advances or any other assets transferred to us pursuant to the related purchase agreement were not sold to us but were instead pledged to us as security for such servicer’s obligation to repay amounts paid by us to the servicer pursuant to the related purchase agreement. We generally create and perfect security interests with respect to the MSRs that we acquire, though we do not do so in all instances. If such assertion were successful, all or part of the MSRs or interests in MSRs and servicer advances or any other asset transferred to us pursuant to the related purchase agreement would constitute property of the bankruptcy estate of such servicer, and our rights against the servicer could be those of a secured creditor with a lien on such present and future assets. Under such circumstances, cash proceeds generated from our collateral would constitute “cash collateral” under the provisions of the U.S. bankruptcy laws. Under U.S. bankruptcy laws, the servicer could not use our cash collateral without either (a) our consent or (b) approval by the bankruptcy court, subject to providing us with “adequate protection” under the U.S. bankruptcy laws. In addition, under such circumstances, an issue could arise as to whether certain of these assets generated after the commencement of the bankruptcy proceeding would constitute after-acquired property excluded from our entitlement pursuant to the U.S. bankruptcy laws.\nIf such a recharacterization occurs, the validity or priority of our security interest in the MSRs or interests in MSRs and servicer advances or other assets could be challenged in a bankruptcy proceeding of such servicer.\nIf the purchases pursuant to the related purchase agreement are recharacterized as secured financings as set forth above, we nevertheless created and perfected security interests with respect to the MSRs or interests in MSRs and servicer advances and other assets that we may have purchased from such servicer by including a pledge of collateral in the related purchase agreement and filing financing statements in appropriate jurisdictions. Nonetheless, to the extent we have created and perfected a security interest, our security interests may be challenged and ruled unenforceable, ineffective or subordinated by a bankruptcy court, and the amount of our claims may be disputed so as not to include all MSRs or interests in MSRs and servicer advances to be collected. If this were to occur, or if we have not created a security interest, then the servicer’s obligations to us with respect to purchased MSRs or interests in MSRs and servicer advances or other assets would be deemed unsecured obligations, payable from unencumbered assets to be shared among all of such servicer’s unsecured creditors. In addition, even if the security interests are found to be valid and enforceable, if a bankruptcy court determines that the value of the collateral is less than such servicer’s\n111\nunderlying obligations to us, the difference between such value and the total amount of such obligations will be deemed an unsecured “deficiency” claim and the same result will occur with respect to such unsecured claim. In addition, even if the security interest is found to be valid and enforceable, such servicer would have the right to use the proceeds of our collateral subject to either (a) our consent or (b) approval by the bankruptcy court, subject to providing us with “adequate protection” under U.S. bankruptcy laws. Such servicer also would have the ability to confirm a chapter 11 plan over our objections if the plan complied with the “cramdown” requirements under U.S. bankruptcy laws.\nPayments made by a servicer to us could be voided by a court under federal or state preference laws.\nIf one of our Servicing Partners were to file, or to become the subject of, a bankruptcy proceeding under the United States Bankruptcy Code or similar state insolvency laws, and our security interest (if any) is declared unenforceable, ineffective or subordinated, payments previously made by a servicer to us pursuant to the related purchase agreement may be recoverable on behalf of the bankruptcy estate as preferential transfers. Among other reasons, a payment could constitute a preferential transfer if a court were to find that the payment was a transfer of an interest of property of such servicer that:\n| • | Was made to or for the benefit of a creditor; |\n\n| • | Was for or on account of an antecedent debt owed by such servicer before that transfer was made; |\n\n| • | Was made while such servicer was insolvent (a company is presumed to have been insolvent on and during the 90 days preceding the date the company’s bankruptcy petition was filed); |\n\n| • | Was made on or within 90 days (or if we are determined to be a statutory insider, on or within one year) before such servicer’s bankruptcy filing; |\n\n| • | Permitted us to receive more than we would have received in a Chapter 7 liquidation case of such servicer under U.S. bankruptcy laws; and |\n\n| • | Was a payment as to which none of the statutory defenses to a preference action apply. |\n\nIf the court were to determine that any payments were avoidable as preferential transfers, we would be required to return such payments to such servicer’s bankruptcy estate and would have an unsecured claim against such servicer with respect to such returned amounts.\nPayments made to us by such servicer, or obligations incurred by it, could be voided by a court under federal or state fraudulent conveyance laws.\nThe mortgage servicer (as debtor-in-possession in the bankruptcy proceeding), a bankruptcy trustee appointed in such servicer’s bankruptcy proceeding, or another party in interest could also claim that such servicer’s transfer to us of MSRs or interests in MSRs and servicer advances or other assets or such servicer’s agreement to incur obligations to us under the related purchase agreement was a fraudulent conveyance. Under U.S. bankruptcy laws and similar state insolvency laws, transfers made or obligations incurred could be voided if, among other reasons, such servicer, at the time it made such transfers or incurred such obligations: (a) received less than reasonably equivalent value or fair consideration for such transfer or incurrence and (b) either (i) was insolvent at the time of, or was rendered insolvent by reason of, such transfer or incurrence; (ii) was engaged in, or was about to engage in, a business or transaction for which the assets remaining with such servicer were an unreasonably small capital; or (iii) intended to incur, or believed that it would incur, debts beyond its ability to pay such debts as they mature. If any transfer or incurrence is determined to be a fraudulent conveyance, our Servicing Partner, as applicable (as debtor-in-possession in the bankruptcy proceeding), or a bankruptcy trustee on such Servicing Partner’s behalf would be entitled to recover such transfer or to avoid the obligation previously incurred.\nAny purchase agreement pursuant to which we purchase interests in MSRs, servicer advances or other assets, including loans, or any subservicing agreement between us and a subservicer on our behalf could be rejected in a bankruptcy proceeding of one of our Servicing Partners or counterparties.\nA mortgage servicer (as debtor-in-possession in the bankruptcy proceeding) or a bankruptcy trustee appointed in such servicer’s or counterparty’s bankruptcy proceeding could seek to reject the related purchase agreement or subservicing agreement with a counterparty and thereby terminate such servicer’s or counterparty’s obligation to service the MSRs or interests in MSRs and servicer advances or any other asset transferred pursuant to such purchase agreement, and terminate our right to acquire additional assets under such purchase agreement and our right to require such servicer to use commercially reasonable efforts to transfer servicing. If the bankruptcy court approved the rejection, we would have a claim against such servicer or counterparty for any damages from the rejection, and the resulting transfer of our interests in MSRs or servicing of the MSRs relating to our Excess MSRs to another subservicer may result in significant cost and may negatively impact the value of our interests in MSRs.\n112\nA bankruptcy court could stay a transfer of servicing to another servicer.\nOur ability to terminate a subservicer or to require a mortgage servicer to use commercially reasonable efforts to transfer servicing rights to a new servicer would be subject to the automatic stay in such servicer’s bankruptcy proceeding. To enforce this right, we would have to seek relief from the bankruptcy court to lift such stay, and there is no assurance that the bankruptcy court would grant this relief.\nAny Subservicing Agreement could be rejected in a bankruptcy proceeding.\nIf one of our Servicing Partners were to file, or to become the subject of, a bankruptcy proceeding under the United States Bankruptcy Code or similar state insolvency laws, such Servicing Partner (as debtor-in-possession in the bankruptcy proceeding) or the bankruptcy trustee could reject its subservicing agreement with us and terminate such Servicing Partner’s obligation to service the MSRs, servicer advances or loans in which we have an investment. Any claim we have for damages arising from the rejection of a subservicing agreement would be treated as a general unsecured claim for purposes of distributions from such Servicing Partner’s bankruptcy estate.\nOur Servicing Partners could discontinue servicing.\nIf one of our Servicing Partners were to file, or to become the subject of, a bankruptcy proceeding under the United States Bankruptcy Code, such Servicing Partner could be terminated as servicer (with bankruptcy court approval) or could discontinue servicing, in which case there is no assurance that we would be able to continue receiving payments and transfers in respect of the interests in MSRs, servicer advances and other assets purchased under the related purchase agreement or subserviced under the related subservicing agreement. Even if we were able to obtain the servicing rights or terminate the related subservicer, we may need to engage an alternate subservicer (which may not be readily available on acceptable terms or at all) or negotiate a new subservicing agreement with such servicer, which presumably would be on less favorable terms to us. Any engagement of an alternate subservicer by us would require the approval of the related RMBS trustees or the Agencies, as applicable.\nAn automatic stay under the United States Bankruptcy Code may prevent the ongoing receipt of servicing fees or other amounts due.\nEven if we are successful in arguing that we own the interests in MSRs, servicer advances and other assets, including loans, purchased under the related purchase agreement, we may need to seek relief in the bankruptcy court to obtain turnover and payment of amounts relating to such assets, and there may be difficulty in recovering payments in respect of such assets that may have been commingled with other funds of such servicer.\nA bankruptcy of any of our Servicing Partners may default our MSR, Excess MSR and servicer advance financing facilities and negatively impact our ability to continue to purchase interests in MSRs.\nIf any of our Servicing Partners were to file for bankruptcy or become the subject of a bankruptcy proceeding, it could result in an event of default under certain of our financing facilities that would require the immediate paydown of such facilities. In this scenario, we may not be able to comply with our obligations to purchase interests in MSRs and servicer advances under the related purchase agreements. Notwithstanding this inability to purchase, the related seller may try to force us to continue making such purchases. If it is determined that we are in breach of our obligations under our purchase agreements, any claims that we may have against such related seller may be subject to offset against claims such seller may have against us by reason of this breach.\nCertain of our subsidiaries originate and service residential mortgage loans, which subject us to various operational risks that could have a negative impact on our financial results.\nAs a result of our previously disclosed acquisitions of Shellpoint Partners LLC and from Ditech, among others, certain subsidiaries of New Residential perform various mortgage and real estate related services, and have origination and servicing operations, which entail borrower-facing activities and employing personnel. Prior to such acquisitions, neither we nor any of our subsidiaries have previously originated or serviced loans directly, and owning entities that perform these and other operations could expose us to risks similar to those of our Servicing Partners, as well as various other risks, including, but not limited to those pertaining to:\n| • | risks related to compliance with applicable laws, regulations and other requirements; |\n\n| • | significant increases in delinquencies for the loans; |\n\n| • | compliance with the terms of related servicing agreements; |\n\n| • | financing related servicer advances and the origination business; |\n\n| • | expenses related to servicing high risk loans; |\n\n113\n| • | unrecovered or delayed recovery of servicing advances; |\n\n| • | a general risk in foreclosure rates, which may ultimately reduce the number of mortgages that we service (also see-“The residential mortgage loans underlying the securities we invest in and the loans we directly invest in are subject to delinquency, foreclosure and loss, which could result in losses to us.”); |\n\n| • | maintaining the size of the related servicing portfolio and the volume of the origination business; |\n\n| • | compliance with FHA underwriting guidelines; and |\n\n| • | termination of government mortgage refinancing programs. |\n\nAny of the foregoing risks, among others, could have a material adverse effect on our business, financial condition, results of operations and liquidity.\nOur subsidiaries that perform mortgage lending and servicing activities are subject to extensive regulation by federal, state and local governmental and regulatory authorities, and our subsidiaries' business results may be significantly impacted by the existing and future laws and regulations to which they are subject. If our subsidiaries performing mortgage lending and servicing activities fail to operate in compliance with both existing and future statutory, regulatory and other requirements, our business, financial condition, liquidity and/or results of operations could be materially and adversely affected.\nOur subsidiaries that perform mortgage lending and servicing activities are subject to extensive regulation by federal, state and local governmental and regulatory authorities, including the CFPB, the Federal Trade Commission, the U.S. Department of Housing and Urban Development (“HUD”), the U.S. Department of Veterans Affairs (“VA”), the SEC and various state agencies that license, audit, investigate and conduct examinations of such subsidiaries’ mortgage servicing, origination, debt collection, and other activities. In the current regulatory environment, the policies, laws, rules and regulations applicable to our subsidiaries’ mortgage origination and servicing businesses have been rapidly evolving. Federal, state or local governmental authorities may continue to enact laws, rules or regulations that will result in changes in our and our subsidiaries’ business practices and may materially increase the costs of compliance. We are unable to predict whether any such changes will adversely affect our business.\nWe and our subsidiaries must comply with a large number of federal, state and local consumer protection laws including, among others, the Dodd-Frank Act, the Gramm-Leach-Bliley Act, the Fair Debt Collection Practices Act, Real Estate Settlement Procedures Act, the Truth in Lending Act, the Fair Credit Reporting Act, the Servicemembers Civil Relief Act, the Homeowners Protection Act, the Federal Trade Commission Act, the Telephone Consumer Protection Act, the Equal Credit Opportunity Act, as well as individual state licensing and foreclosure laws and federal and local bankruptcy rules. These statutes apply to many facets of our subsidiaries’ businesses, including loan origination, default servicing and collections, use of credit reports, safeguarding of non-public personally identifiable information about customers, foreclosure and claims handling, investment of and interest payments on escrow balances and escrow payment features, and such statutes mandate certain disclosures and notices to borrowers. These requirements can and will change as statutes and regulations are enacted, promulgated, amended, interpreted and enforced.\nIn addition, the GSEs, Ginnie Mae and other business counterparties subject our subsidiaries’ mortgage origination and servicing businesses to periodic examinations, reviews and audits, and we routinely conduct our own internal examinations, reviews and audits. These various examinations, reviews and audits of our subsidiaries’ businesses and related activities may reveal deficiencies in such subsidiaries’ compliance with our policies and other requirements to which they are subject. While we strive to investigate and remediate such deficiencies, there can be no assurance that our internal investigations will reveal any deficiencies or that any remedial measures that we implement, which could involve material expense, will ensure compliance with applicable policies, laws, regulations and other requirements or be deemed sufficient by the GSEs, Ginnie Mae, federal and local governmental authorities or other interested parties.\nWe and our subsidiaries devote substantial resources to regulatory compliance and regulatory inquiries, and we incur, and expect to continue to incur, significant costs in connection therewith. Our business, financial condition, liquidity and/or results of operations could be materially and adversely affected by the substantial resources we devote to, and the significant compliance costs we incur in connection with, regulatory compliance and regulatory inquiries, including any fines, penalties, restitution or similar payments we may be required to make in connection with resolving such matters.\nThe actual or alleged failure of our mortgage origination and servicing subsidiaries to comply with applicable federal, state and local laws and regulations and GSE, Ginnie Mae and other business counterparty requirements, or to implement and adhere to adequate remedial measures designed to address any identified compliance deficiencies, could lead to:\n| • | the loss or suspension of licenses and approvals necessary to operate our or our subsidiaries’ business; |\n\n| • | limitations, restrictions or complete bans on our or our subsidiaries’ business or various segments of our business; |\n\n114\n| • | our or our subsidiaries’ disqualification from participation in governmental programs, including GSE, Ginnie Mae, and VA programs; |\n\n| • | breaches of covenants and representations under our servicing, debt, or other agreements; |\n\n| • | negative publicity and damage to our reputation; |\n\n| • | governmental investigations and enforcement actions; |\n\n| • | administrative fines and financial penalties; |\n\n| • | litigation, including class action lawsuits; |\n\n| • | civil and criminal liability; |\n\n| • | termination of our servicing and subservicing agreements or other contracts; |\n\n| • | demands for us to repurchase loans; |\n\n| • | loss of personnel who are targeted by prosecutions, investigations, enforcement actions or litigation; |\n\n| • | a significant increase in compliance costs; |\n\n| • | a significant increase in the resources we and our subsidiaries devote to regulatory compliance and regulatory inquiries; |\n\n| • | an inability to access new, or a default under or other loss of current, liquidity and funding sources necessary to operate our business; |\n\n| • | restrictions on our or our subsidiaries’ business activities; |\n\n| • | impairment of assets; and |\n\n| • | an inability to execute on our business strategy. |\n\nAny of these outcomes could materially and adversely affect our reputation, business, financial condition, prospects, liquidity and/or results of operations.\nWe cannot guarantee that any such scrutiny and investigations will not materially adversely affect us. Additionally, in recent years, the general trend among federal, state and local lawmakers and regulators has been toward increasing laws, regulations and investigative proceedings with regard to residential mortgage lenders and servicers. The CFPB continues to take an active role in supervising the mortgage industry, and its rule-making and regulatory agenda relating to loan servicing and originations continues to evolve. Individual states have also been increasingly active in supervising non-bank mortgage lenders and servicers such as NewRez, and certain regulators have communicated recommendations, expectations or demands with respect to areas such as corporate governance, safety and soundness, risk and compliance management, and cybersecurity, in addition to their focus on traditional licensing and examination matters.\nFollowing the 2018 Congressional elections, a level of heightened uncertainty exists with respect to the future of regulation of mortgage lending and servicing, including the future of the Dodd-Frank Act and CFPB. We cannot predict the specific legislative or executive actions that may result or what actions federal or state regulators might take in response to potential changes to the Dodd-Frank Act or to the federal regulatory environment generally. Such actions could impact the mortgage industry generally or us specifically, could impact our relationships with other regulators, and could adversely impact our business.\nThe CFPB and certain state regulators have increasingly focused on the use, and adequacy, of technology in the mortgage servicing industry. For example, in 2016, the CFPB issued a special edition supervision report that stressed the need for mortgage servicers to assess and make necessary improvements to their information technology systems in order to ensure compliance with the CFPB’s mortgage servicing requirements. The New York Department of Financial Services (“NY DFS”) also issued Cybersecurity Requirements for Financial Services Companies, effective in 2017, which requires banks, insurance companies, and other financial services institutions regulated by the NY DFS to establish and maintain a cybersecurity program designed to protect consumers and ensure the safety and soundness of New York State’s financial services industry. In addition, in June 2018, the State of California signed into law the California Consumer Privacy Act (“CCPA”), which will become effective in January 2020, will require businesses that maintain personal information of California residents, including certain mortgage lenders and servicers, to notify certain consumers when collecting their data, respond to consumer requests relating to the uses of their data, verify the identities of consumers who make requests, disclose details regarding transactions involving their data, and maintain records of consumer’ requests relating to their data, among various other obligations, and to create procedures designed to comply with CCPA requirements. The CCPA will become effective on January 1, 2020, and its implementing regulations are in the process of becoming finalized. The impact of the CCPA and its implementing regulations on our mortgage origination and servicing businesses remains uncertain, and may result in an increase in legal and compliance costs.\nNew regulatory and legislative measures, or changes in enforcement practices, including those related to the technology we use, could, either individually or in the aggregate, require significant changes to our business practices, impose additional costs on us, limit our product offerings, limit our ability to efficiently pursue business opportunities, negatively impact asset values or reduce our revenues. Accordingly, any of the foregoing could materially and adversely affect our business and our financial condition, liquidity and results of operations.\n115\nA failure to maintain minimum servicer ratings could have an adverse effect on our business, financing activities, financial condition or results of operations.\nS&P, Moody’s and Fitch rates Shellpoint Mortgage Servicing as a residential loan servicer, and a downgrade, or failure to maintain, any of our servicer ratings could:\n| • | adversely affect our ability to maintain our status as an approved servicer by Fannie Mae and Freddie Mac; |\n\n| • | adversely affect our ability to finance servicing advances and certain other assets; |\n\n| • | lead to the early termination of existing advance facilities and affect the terms and availability of advance facilities that we may seek in the future; |\n\n| • | cause our termination as servicer in our servicing agreements that require that we maintain specified servicer ratings; and |\n\n| • | further impair our ability to consummate future servicing transactions. |\n\nAny of the above could adversely affect our business, financial condition and results of operations.\nGSE initiatives and other actions, including changes to the minimum servicing amount for GSE loans, could occur at any time and could impact us in significantly negative ways that we are unable to predict or protect against.\nThe Federal Housing Finance Agency (“FHFA”) and other industry stakeholders or regulators may implement or require changes to current mortgage servicing practices and compensation that could have a material adverse effect on the economics or performance of our investments in MSRs.\nCurrently, when a loan is sold into the secondary market for Fannie Mae or Freddie Mac loans, the servicer is generally required to retain a minimum servicing amount (“MSA”) of 25 basis points of the UPB for fixed rate mortgages. As has been widely publicized, in September 2011, the FHFA announced that a Joint Initiative on Mortgage Servicing Compensation was seeking public comment on two alternative mortgage servicing compensation structures detailed in a discussion paper. Changes to the MSA structure could significantly impact our business in negative ways that we cannot predict or protect against. For example, the elimination of a MSA could radically change the mortgage servicing industry and could severely limit the supply of interests in MSRs available for sale. In addition, a removal of, or reduction in, the MSA could significantly reduce the recapture rate on the affected loan portfolio, which would negatively affect the investment return on our interests in MSRs. We cannot predict whether any changes to current MSA rules will occur or what impact any changes will have on our business, results of operations, liquidity or financial condition.\nOur interests in MSRs may involve complex or novel structures.\nInterests in MSRs may entail new types of transactions and may involve complex or novel structures. Accordingly, the risks associated with the transactions and structures are not fully known to buyers and sellers. In the case of interests in MSRs on Agency pools, Agencies may require that we submit to costly or burdensome conditions as a prerequisite to their consent to an investment in, or our financing of, interests in MSRs on Agency pools. Agency conditions, including capital requirements, may diminish or eliminate the investment potential of interests in MSRs on Agency pools by making such investments too expensive for us or by severely limiting the potential returns available from interests in MSRs on Agency pools.\nIt is possible that an Agency’s views on whether any such acquisition structure is appropriate or acceptable may not be known to us when we make an investment and may change from time to time for any reason or for no reason, even with respect to a completed investment. An Agency’s evolving posture toward an acquisition or disposition structure through which we invest in or dispose of interests in MSRs on Agency pools may cause such Agency to impose new conditions on our existing interests in MSRs on Agency pools, including the owner’s ability to hold such interests in MSRs on Agency pools directly or indirectly through a grantor trust or other means. Such new conditions may be costly or burdensome and may diminish or eliminate the investment potential of the interests in MSRs on Agency pools that are already owned by us. Moreover, obtaining such consent may require us or our co-investment counterparties to agree to material structural or economic changes, as well as agree to indemnification or other terms that expose us to risks to which we have not previously been exposed and that could negatively affect our returns from our investments.\nOur ability to finance the MSRs and servicer advances acquired in the MSR Transactions may depend on the related Servicing Partner’s cooperation with our financing sources and compliance with certain covenants.\nWe have in the past and intend to continue to finance some or all of the MSRs or servicer advances acquired in the MSR Transactions, and as a result, we will be subject to substantial operational risks associated with the related Servicing Partners. In our current financing facilities for interests in MSRs and servicer advances, the failure of the related Servicing Partner to satisfy various\n116\ncovenants and tests can result in an amortization event and/or an event of default. Our financing sources may require us to include similar provisions in any financing we obtain relating to the MSRs and servicer advances acquired in the MSR Transactions. If we decide to finance such assets, we will not have the direct ability to control any party’s compliance with any such covenants and tests and the failure of any party to satisfy any such covenants or tests could result in a partial or total loss on our investment. Some financing sources may be unwilling to finance any assets acquired in the MSR Transactions.\nIn addition, any financing for the MSRs and servicer advances acquired in the MSR Transactions may be subject to regulatory approval and the agreement of the relevant Servicing Partner to be party to such financing agreements. If we cannot get regulatory approval or these parties do not agree to be a party to such financing agreements, we may not be able to obtain financing on favorable terms or at all.\nMortgage servicing is heavily regulated at the U.S. federal, state and local levels, and each transfer of MSRs to our subservicer of such MSRs may not be approved by the requisite regulators.\nMortgage servicers must comply with U.S. federal, state and local laws and regulations. These laws and regulations cover topics such as licensing; allowable fees and loan terms; permissible servicing and debt collection practices; limitations on forced-placed insurance; special consumer protections in connection with default and foreclosure; and protection of confidential, nonpublic consumer information. The volume of new or modified laws and regulations has increased in recent years, and states and individual cities and counties continue to enact laws that either restrict or impose additional obligations in connection with certain loan origination, acquisition and servicing activities in those cities and counties. The laws and regulations are complex and vary greatly among the states and localities, and in some cases, these laws are in conflict with each other or with U.S. federal law. In connection with the MSR Transactions, there is no assurance that each transfer of MSRs to our selected subservicer will be approved by the requisite regulators. If regulatory approval for each such transfer is not obtained, we may incur additional costs and expenses in connection with the approval of another replacement subservicer.\nWe do not have legal title to the MSRs underlying our Excess MSRs or certain of our Servicer Advance Investments.\nWe do not have legal title to the MSRs underlying our Excess MSRs or certain of the MSRs related to the transactions contemplated by the purchase agreements pursuant to which we acquire Servicer Advance Investments or MSR financing receivables from Ocwen, SLS and Nationstar, and are subject to increased risks as a result of the related servicer continuing to own the mortgage servicing rights. The validity or priority of our interest in the underlying mortgage servicing could be challenged in a bankruptcy proceeding of the servicer, and the related purchase agreement could be rejected in such proceeding. Any of the foregoing events might have a material adverse effect on our business, financial condition, results of operations and liquidity. As part of the Ocwen Transaction, we and Ocwen have agreed to cooperate to obtain any third party consents required to transfer Ocwen’s remaining interest in the Ocwen Subject MSRs to us. As noted above, however, there is no assurance that we will be successful in obtaining those consents.\nMany of our investments may be illiquid, and this lack of liquidity could significantly impede our ability to vary our portfolio in response to changes in economic and other conditions or to realize the value at which such investments are carried if we are required to dispose of them.\nMany of our investments are illiquid. Illiquidity may result from the absence of an established market for the investments, as well as legal or contractual restrictions on their resale, refinancing or other disposition. Dispositions of investments may be subject to contractual and other limitations on transfer or other restrictions that would interfere with subsequent sales of such investments or adversely affect the terms that could be obtained upon any disposition thereof.\nInterests in MSRs are highly illiquid and may be subject to numerous restrictions on transfers, including without limitation the receipt of third-party consents. For example, the Servicing Guidelines of a mortgage owner may require that holders of Excess MSRs obtain the mortgage owner’s prior approval of any change of direct ownership of such Excess MSRs. Such approval may be withheld for any reason or no reason in the discretion of the mortgage owner. Moreover, we have not received and do not expect to receive any assurances from any GSEs that their conditions for the sale by us of any interests in MSRs will not change. Therefore, the potential costs, issues or restrictions associated with receiving such GSEs’ consent for any such dispositions by us cannot be determined with any certainty. Additionally, interests in MSRs may entail complex transaction structures and the risks associated with the transactions and structures are not fully known to buyers or sellers. As a result of the foregoing, we may be unable to locate a buyer at the time we wish to sell interests in MSRs. There is some risk that we will be required to dispose of interests in MSRs either through an in-kind distribution or other liquidation vehicle, which will, in either case, provide little or no economic benefit to us, or a sale to a co-investor in the interests in MSRs, which may be an affiliate. Accordingly, we cannot provide any assurance that we will obtain any return or any benefit of any kind from any disposition of interests in MSRs. We may not benefit\n117\nfrom the full term of the assets and for the aforementioned reasons may not receive any benefits from the disposition, if any, of such assets.\nIn addition, some of our real estate and other securities may not be registered under the relevant securities laws, resulting in a prohibition against their transfer, sale, pledge or other disposition except in a transaction that is exempt from the registration requirements of, or is otherwise in accordance with, those laws. There are also no established trading markets for a majority of our intended investments. Moreover, certain of our investments, including our investments in consumer loans and certain of our interests in MSRs, are made indirectly through a vehicle that owns the underlying assets. Our ability to sell our interest may be contractually limited or prohibited. As a result, our ability to vary our portfolio in response to changes in economic and other conditions may be limited.\nOur real estate and other securities have historically been valued based primarily on third-party quotations, which are subject to significant variability based on the liquidity and price transparency created by market trading activity. A disruption in these trading markets could reduce the trading for many real estate and other securities, resulting in less transparent prices for those securities, which would make selling such assets more difficult. Moreover, a decline in market demand for the types of assets that we hold would make it more difficult to sell our assets. If we are required to liquidate all or a portion of our illiquid investments quickly, we may realize significantly less than the amount at which we have previously valued these investments.\nMarket conditions could negatively impact our business, results of operations, cash flows and financial condition.\nThe market in which we operate is affected by a number of factors that are largely beyond our control but can nonetheless have a potentially significant, negative impact on us. These factors include, among other things:\n\n| • | interest rates and credit spreads; |\n\n| • | the availability of credit, including the price, terms and conditions under which it can be obtained; |\n\n| • | the quality, pricing and availability of suitable investments; |\n\n| • | the ability to obtain accurate market-based valuations; |\n\n| • | the ability of securities dealers to make markets in relevant securities and loans; |\n\n| • | loan values relative to the value of the underlying real estate assets; |\n\n| • | default rates on the loans underlying our investments and the amount of the related losses, and credit losses with respect to our investments; |\n\n| • | prepayment and repayment rates, delinquency rates and legislative/regulatory changes with respect to our investments, and the timing and amount of servicer advances; |\n\n| • | the availability and cost of quality Servicing Partners, and advance, recovery and recapture rates; |\n\n| • | competition; |\n\n| • | the actual and perceived state of the real estate markets, bond markets, market for dividend-paying stocks and public capital markets generally; |\n\n| • | unemployment rates; and |\n\n| • | the attractiveness of other types of investments relative to investments in real estate or REITs generally. |\n\nChanges in these factors are difficult to predict, and a change in one factor can affect other factors. For example, at various points in time, increased default rates in the subprime mortgage market played a role in causing credit spreads to widen, reducing availability of credit on favorable terms, reducing liquidity and price transparency of real estate related assets, resulting in difficulty in obtaining accurate mark-to-market valuations, and causing a negative perception of the state of the real estate markets and of REITs generally. Market conditions could be volatile or could deteriorate as a result of a variety of factors beyond our control with adverse effects to our financial condition.\nThe geographic distribution of the loans underlying, and collateral securing, certain of our investments subjects us to geographic real estate market risks, which could adversely affect the performance of our investments, our results of operations and financial condition.\nThe geographic distribution of the loans underlying, and collateral securing, our investments, including our interests in MSRs, servicer advances, Non-Agency RMBS and loans, exposes us to risks associated with the real estate and commercial lending industry in general within the states and regions in which we hold significant investments. These risks include, without limitation: possible declines in the value of real estate; risks related to general and local economic conditions; possible lack of availability of mortgage funds; overbuilding; extended vacancies of properties; increases in competition, property taxes and operating expenses; changes in zoning laws; increased energy costs; unemployment; costs resulting from the clean-up of, and liability to third parties for damages resulting from, environmental problems; casualty or condemnation losses; uninsured damages from floods, hurricanes, earthquakes or other natural disasters; and changes in interest rates.\n118\nAs of September 30, 2019, 24.9% and 23.0% of the total UPB of the residential mortgage loans underlying our Excess MSRs and MSRs, respectively, was secured by properties located in California, which are particularly susceptible to natural disasters such as fires, earthquakes and mudslides. 7.6% and 6.8% of the total UPB of the residential mortgage loans underlying our Excess MSRs and MSRs, respectively, was secured by properties located in Florida, which are particularly susceptible to natural disasters such as hurricanes and floods. As of September 30, 2019, 38.4% of the collateral securing our Non-Agency RMBS was located in the Western U.S., 24.1% was located in the Southeastern U.S., 21.2% was located in the Northeastern U.S., 9.8% was located in the Midwestern U.S. and 6.4% was located in the Southwestern U.S. We were unable to obtain geographical information for 0.1% of the collateral. As a result of this concentration, we may be more susceptible to adverse developments in those markets than if we owned a more geographically diverse portfolio. To the extent any of the foregoing risks arise in states and regions where we hold significant investments, the performance of our investments, our results of operations, cash flows and financial condition could suffer a material adverse effect.\nThe value of our interests in MSRs, servicer advances, residential mortgage loans and RMBS may be adversely affected by deficiencies in servicing and foreclosure practices, as well as related delays in the foreclosure process.\nAllegations of deficiencies in servicing and foreclosure practices among several large sellers and servicers of residential mortgage loans that surfaced in 2010 raised various concerns relating to such practices, including the improper execution of the documents used in foreclosure proceedings (so-called “robo signing”), inadequate documentation of transfers and registrations of mortgages and assignments of loans, improper modifications of loans, violations of representations and warranties at the date of securitization and failure to enforce put-backs.\nAs a result of alleged deficiencies in foreclosure practices, a number of servicers temporarily suspended foreclosure proceedings beginning in the second half of 2010 while they evaluated their foreclosure practices. In late 2010, a group of state attorneys general and state bank and mortgage regulators representing nearly all 50 states and the District of Columbia, along with the U.S. Justice Department and U.S. Department of Housing and Urban Development (“HUD”), began an investigation into foreclosure practices of banks and servicers. The investigations and lawsuits by several state attorneys general led to a settlement agreement in early February 2012 with five of the nation’s largest banks, pursuant to which the banks agreed to pay more than $25.0 billion to settle claims relating to improper foreclosure practices. The settlement does not prohibit the states, the federal government, individuals or investors from pursuing additional actions against the banks and servicers in the future.\nUnder the terms of the agreements governing our Servicer Advance Investments and MSRs, we (in certain cases, together with third-party co-investors) are required to make or purchase from certain of our Servicing Partners, servicer advances on certain loan pools. While a residential mortgage loan is in foreclosure, servicers are generally required to continue to advance delinquent principal and interest and to also make advances for delinquent taxes and insurance and foreclosure costs and the upkeep of vacant property in foreclosure to the extent it determines that such amounts are recoverable. Servicer advances are generally recovered when the delinquency is resolved.\nForeclosure moratoria or other actions that lengthen the foreclosure process increase the amount of servicer advances we or our Servicing Partners are required to make and we are required to purchase, lengthen the time it takes for us to be repaid for such advances and increase the costs incurred during the foreclosure process. In addition, servicer advance financing facilities contain provisions that modify the advance rates for, and limit the eligibility of, servicer advances to be financed based on the length of time that servicer advances are outstanding, and, as a result, an increase in foreclosure timelines could further increase the amount of servicer advances that we need to fund with our own capital. Such increases in foreclosure timelines could increase our need for capital to fund servicer advances (which do not bear interest), which would increase our interest expense, reduce the value of our investment and potentially reduce the cash that we have available to pay our operating expenses or to pay dividends.\nEven in states where servicers have not suspended foreclosure proceedings or have lifted (or will soon lift) any such delayed foreclosures, servicers, including our Servicing Partners, have faced, and may continue to face, increased delays and costs in the foreclosure process. For example, the current legislative and regulatory climate could lead borrowers to contest foreclosures that they would not otherwise have contested under ordinary circumstances, and servicers may incur increased litigation costs if the validity of a foreclosure action is challenged by a borrower. In general, regulatory developments with respect to foreclosure practices could result in increases in the amount of servicer advances and the length of time to recover servicer advances, fines or increases in operating expenses, and decreases in the advance rate and availability of financing for servicer advances. This would lead to increased borrowings, reduced cash and higher interest expense which could negatively impact our liquidity and profitability. Although the terms of our Servicer Advance Investments contain adjustment mechanisms that would reduce the amount of performance fees payable to the related Servicing Partner if servicer advances exceed pre-determined amounts, those fee reductions may not be sufficient to cover the expenses resulting from longer foreclosure timelines.\n119\nThe integrity of the servicing and foreclosure processes is critical to the value of the residential mortgage loans in which we invest and of the portfolios of loans underlying our interests in MSRs and RMBS, and our financial results could be adversely affected by deficiencies in the conduct of those processes. For example, delays in the foreclosure process that have resulted from investigations into improper servicing practices may adversely affect the values of, and result in losses on, these investments. Foreclosure delays may also increase the administrative expenses of the securitization trusts for the RMBS, thereby reducing the amount of funds available for distribution to investors.\nIn addition, the subordinate classes of securities issued by the securitization trusts may continue to receive interest payments while the defaulted loans remain in the trusts, rather than absorbing the default losses. This may reduce the amount of credit support available for senior classes of RMBS that we may own, thus possibly adversely affecting these securities. Additionally, a substantial portion of the $25.0 billion settlement is a “credit” to the banks and servicers for principal write-downs or reductions they may make to certain mortgages underlying RMBS. There remains uncertainty as to how these principal reductions will work and what effect they will have on the value of related RMBS. As a result, there can be no assurance that any such principal reductions will not adversely affect the value of our interests in MSRs and RMBS.\nWhile we believe that the sellers and servicers would be in violation of the applicable Servicing Guidelines to the extent that they have improperly serviced mortgage loans or improperly executed documents in foreclosure or bankruptcy proceedings, or do not comply with the terms of servicing contracts when deciding whether to apply principal reductions, it may be difficult, expensive, time consuming and, ultimately, uneconomic for us to enforce our contractual rights. While we cannot predict exactly how the servicing and foreclosure matters or the resulting litigation or settlement agreements will affect our business, there can be no assurance that these matters will not have an adverse impact on our results of operations, cash flows and financial condition.\nA failure by any or all of the members of Buyer to make capital contributions for amounts required to fund servicer advances could result in an event of default under our advance facilities and a complete loss of our investment.\nNew Residential and third-party co-investors, through a joint venture entity (Advance Purchaser LLC, the “Buyer”) have agreed to purchase all future arising servicer advances from Nationstar under certain residential mortgage servicing agreements. Buyer relies, in part, on its members to make committed capital contributions in order to pay the purchase price for future servicer advances. A failure by any or all of the members to make such capital contributions for amounts required to fund servicer advances could result in an event of default under our advance facilities and a complete loss of our investment.\nThe residential mortgage loans underlying the securities we invest in and the loans we directly invest in are subject to delinquency, foreclosure and loss, which could result in losses to us.\nThe ability of a borrower to repay a loan secured by a residential property is dependent upon the income or assets of the borrower. A number of factors may impair borrowers’ abilities to repay their loans, including, among other things, changes in the borrower’s employment status, changes in national, regional or local economic conditions, changes in interest rates or the availability of credit on favorable terms, changes in regional or local real estate values, changes in regional or local rental rates and changes in real estate taxes.\nOur mortgage backed securities are securities backed by mortgage loans. Many of the RMBS in which we invest are backed by collateral pools of subprime residential mortgage loans. “Subprime” mortgage loans refer to mortgage loans that have been originated using underwriting standards that are less restrictive than the underwriting requirements used as standards for other first and junior lien mortgage loan purchase programs, such as the programs of Fannie Mae and Freddie Mac. These lower standards include mortgage loans made to borrowers having imperfect or impaired credit histories (including outstanding judgments or prior bankruptcies), mortgage loans where the amount of the loan at origination is 80% or more of the value of the mortgage property, mortgage loans made to borrowers with low credit scores, mortgage loans made to borrowers who have other debt that represents a large portion of their income and mortgage loans made to borrowers whose income is not required to be disclosed or verified. Subprime mortgage loans may experience delinquency, foreclosure, bankruptcy and loss rates that are higher, and that may be substantially higher, than those experienced by mortgage loans underwritten in a more traditional manner. To the extent losses are realized on the loans underlying the securities in which we invest, we may not recover the amount invested in, or, in extreme cases, any of our investment in such securities.\nResidential mortgage loans, including manufactured housing loans and subprime mortgage loans are secured by single-family residential property and are also subject to risks of delinquency and foreclosure, and risks of loss. A significant portion of the residential mortgage loans that we acquire are, or may become, sub-performing loans, non-performing loans or REO assets where the borrower has failed to make timely payments of principal and/or interest. As part of the residential mortgage loan portfolios we purchase, we also may acquire performing loans that are or subsequently become sub-performing or non-performing, meaning the borrowers fail to timely pay some or all of the required payments of principal and/or interest. Under current market conditions,\n120\nit is likely that some of these loans will have current loan-to-value ratios in excess of 100%, meaning the amount owed on the loan exceeds the value of the underlying real estate.\nIn the event of default under a residential mortgage loan held directly by us, we will bear a risk of loss of principal to the extent of any deficiency between the value of the collateral and the outstanding principal and accrued but unpaid interest of the loan. Even though we typically pay less than the amount owed on these loans to acquire them, if actual results differ from our assumptions in determining the price we paid to acquire such loans, we may incur significant losses. In addition, we may acquire REO assets directly, which involves the same risks. Any loss we incur may be significant and could materially and adversely affect us.\nOur investments in real estate and other securities are subject to changes in credit spreads as well as available market liquidity, which could adversely affect our ability to realize gains on the sale of such investments.\nReal estate and other securities are subject to changes in credit spreads. Credit spreads measure the yield demanded on securities by the market based on their credit relative to a specific benchmark.\nFixed rate securities are valued based on a market credit spread over the rate payable on fixed rate U.S. Treasuries of like maturity. Floating rate securities are valued based on a market credit spread over LIBOR and are affected similarly by changes in LIBOR spreads. As of September 30, 2019, 68.6% of our Non-Agency RMBS Portfolio consisted of floating rate securities and 31.4% consisted of fixed rate securities, and 100.0% of our Agency RMBS portfolio consisted of fixed rate securities, based on the amortized cost basis of all securities (including the amortized cost basis of interest-only and residual classes). Excessive supply of these securities combined with reduced demand will generally cause the market to require a higher yield on these securities, resulting in the use of a higher, or “wider,” spread over the benchmark rate to value such securities. Under such conditions, the value of our real estate and other securities portfolios would tend to decline. Conversely, if the spread used to value such securities were to decrease, or “tighten,” the value of our real estate and other securities portfolio would tend to increase. Such changes in the market value of our real estate securities portfolios may affect our net equity, net income or cash flow directly through their impact on unrealized gains or losses on available-for-sale securities, and therefore our ability to realize gains on such securities, or indirectly through their impact on our ability to borrow and access capital. Widening credit spreads could cause the net unrealized gains on our securities and derivatives, recorded in accumulated other comprehensive income or retained earnings, and therefore our book value per share, to decrease and result in net losses.\nPrepayment rates on our residential mortgage loans and those underlying our real estate and other securities may adversely affect our profitability.\nIn general, residential mortgage loans may be prepaid at any time without penalty. Prepayments result when homeowners/mortgagors satisfy (i.e., pay off) the mortgage upon selling or refinancing their mortgaged property. When we acquire a particular loan or security, we anticipate that the loan or underlying residential mortgage loans will prepay at a projected rate which, together with expected coupon income, provides us with an expected yield on such investments. If we purchase assets at a premium to par value, and borrowers prepay their mortgage loans faster than expected, the corresponding prepayments on our assets may reduce the expected yield on such assets because we will have to amortize the related premium on an accelerated basis. Conversely, if we purchase assets at a discount to par value, when borrowers prepay their mortgage loans slower than expected, the decrease in corresponding prepayments on our assets may reduce the expected yield on such assets because we will not be able to accrete the related discount as quickly as originally anticipated.\nPrepayment rates on loans are influenced by changes in mortgage and market interest rates and a variety of economic, geographic, political and other factors, all of which are beyond our control. Consequently, such prepayment rates cannot be predicted with certainty and no strategy can completely insulate us from prepayment or other such risks. In periods of declining interest rates, prepayment rates on mortgage loans generally increase. If general interest rates decline at the same time, the proceeds of such prepayments received during such periods are likely to be reinvested by us in assets yielding less than the yields on the assets that were prepaid. In addition, the market value of our loans and real estate and other securities may, because of the risk of prepayment, benefit less than other fixed-income securities from declining interest rates.\nWe may purchase assets that have a higher or lower coupon rate than the prevailing market interest rates. In exchange for a higher coupon rate, we would then pay a premium over par value to acquire these securities. In accordance with GAAP, we would amortize the premiums over the life of the related assets. If the mortgage loans securing these assets prepay at a more rapid rate than anticipated, we would have to amortize our premiums on an accelerated basis which may adversely affect our profitability. As compensation for a lower coupon rate, we would then pay a discount to par value to acquire these assets. In accordance with GAAP, we would accrete any discounts over the life of the related assets. If the mortgage loans securing these assets prepay at a slower rate than anticipated, we would have to accrete our discounts on an extended basis which may adversely affect our\n121\nprofitability. Defaults on the mortgage loans underlying Agency RMBS typically have the same effect as prepayments because of the underlying Agency guarantee.\nPrepayments, which are the primary feature of mortgage backed securities that distinguish them from other types of bonds, are difficult to predict and can vary significantly over time. As the holder of the security, on a monthly basis, we receive a payment equal to a portion of our investment principal in a particular security as the underlying mortgages are prepaid. In general, on the date each month that principal prepayments are announced (i.e., factor day), the value of our real estate related security pledged as collateral under our repurchase agreements is reduced by the amount of the prepaid principal and, as a result, our lenders will typically initiate a margin call requiring the pledge of additional collateral or cash, in an amount equal to such prepaid principal, in order to re-establish the required ratio of borrowing to collateral value under such repurchase agreements. Accordingly, with respect to our Agency RMBS, the announcement on factor day of principal prepayments is in advance of our receipt of the related scheduled payment, thereby creating a short-term receivable for us in the amount of any such principal prepayments. However, under our repurchase agreements, we may receive a margin call relating to the related reduction in value of our Agency RMBS and, prior to receipt of this short-term receivable, be required to post additional collateral or cash in the amount of the principal prepayment on or about factor day, which would reduce our liquidity during the period in which the short-term receivable is outstanding. As a result, in order to meet any such margin calls, we could be forced to sell assets in order to maintain liquidity. Forced sales under adverse market conditions may result in lower sales prices than ordinary market sales made in the normal course of business. If our real estate and other securities were liquidated at prices below our amortized cost (i.e., the cost basis) of such assets, we would incur losses, which could adversely affect our earnings. In addition, in order to continue to earn a return on this prepaid principal, we must reinvest it in additional real estate and other securities or other assets; however, if interest rates decline, we may earn a lower return on our new investments as compared to the real estate and other securities that prepay.\nPrepayments may have a negative impact on our financial results, the effects of which depend on, among other things, the timing and amount of the prepayment delay on our Agency RMBS, the amount of unamortized premium or discount on our loans and real estate and other securities, the rate at which prepayments are made on our Non-Agency RMBS, the reinvestment lag and the availability of suitable reinvestment opportunities.\nOur investments in loans, REO and RMBS may be subject to significant impairment charges, which would adversely affect our results of operations.\nWe are required to periodically evaluate our investments for impairment indicators. The judgment regarding the existence of impairment indicators is based on a variety of factors depending upon the nature of the investment and the manner in which the income related to such investment was calculated for purposes of our financial statements. If we determine that an impairment has occurred, we are required to make an adjustment to the net carrying value of the investment, which would adversely affect our results of operations in the applicable period and thereby adversely affect our ability to pay dividends to our stockholders.\nThe lenders under our financing agreements may elect not to extend financing to us, which could quickly and seriously impair our liquidity.\nWe finance a meaningful portion of our investments with repurchase agreements and other short-term financing arrangements. Under the terms of repurchase agreements, we will sell an asset to the lending counterparty for a specified price and concurrently agree to repurchase the same asset from our counterparty at a later date for a higher specified price. During the term of the repurchase agreement—which can be as short as 30 days—the counterparty will make funds available to us and hold the asset as collateral. Our counterparties can also require us to post additional margin as collateral at any time during the term of the agreement. When the term of a repurchase agreement ends, we will be required to repurchase the asset for the specified repurchase price, with the difference between the sale and repurchase prices serving as the equivalent of paying interest to the counterparty in return for extending financing to us. If we want to continue to finance the asset with a repurchase agreement, we ask the counterparty to extend—or “roll”—the repurchase agreement for another term.\nOur counterparties are not required to roll our repurchase agreements or other financing agreements upon the expiration of their stated terms, which subjects us to a number of risks. Counterparties electing to roll our financing agreements may charge higher spread and impose more onerous terms upon us, including the requirement that we post additional margin as collateral. More significantly, if a financing agreement counterparty elects not to extend our financing, we would be required to pay the counterparty in full on the maturity date and find an alternate source of financing. Alternate sources of financing may be more expensive, contain more onerous terms or simply may not be available. If we were unable to pay the repurchase price for any asset financed with a repurchase agreement, the counterparty has the right to sell the asset being held as collateral and require us to compensate it for any shortfall between the value of our obligation to the counterparty and the amount for which the collateral was sold (which may be a significantly discounted price). Moreover, our financing agreement obligations are currently with a limited number of counterparties. If any of our counterparties elected not to roll our financing agreements, we may not be able to find a replacement\n122\ncounterparty in a timely manner. Finally, some of our financing agreements contain covenants and our failure to comply with such covenants could result in a loss of our investment.\nThe financing sources under our servicer advance financing facilities may elect not to extend financing to us or may have or take positions adverse to us, which could quickly and seriously impair our liquidity.\nWe finance a meaningful portion of our Servicer Advance Investments and servicer advances receivable with structured financing arrangements. These arrangements are commonly of a short-term nature. These arrangements are generally accomplished by having the named servicer, if the named servicer is a subsidiary of the Company, or the purchaser of such Servicer Advance Investments (which is a subsidiary of the Company) transfer our right to repayment for certain servicer advances that we have as servicer under the relevant Servicing Guidelines or that we have acquired from one of our Servicing Partners, as applicable, to one of our wholly owned bankruptcy remote subsidiaries (a “Depositor”). We are generally required to continue to transfer to the related Depositor all of our rights to repayment for any particular pool of servicer advances as they arise (and, if applicable, are transferred from one of our Servicing Partners) until the related financing arrangement is paid in full and is terminated. The related Depositor then transfers such rights to an “Issuer.” The Issuer then issues limited recourse notes to the financing sources backed by such rights to repayment.\nThe outstanding balance of servicer advances securing these arrangements is not likely to be repaid on or before the maturity date of such financing arrangements. Accordingly, we rely heavily on our financing sources to extend or refinance the terms of such financing arrangements. Our financing sources are not required to extend the arrangements upon the expiration of their stated terms, which subjects us to a number of risks. Financing sources electing to extend may charge higher interest rates and impose more onerous terms upon us, including without limitation, lowering the amount of financing that can be extended against any particular pool of servicer advances.\nIf a financing source is unable or unwilling to extend financing, including, but not limited to, due to legal or regulatory matters applicable to us or our Servicing Partners, the related Issuer will be required to repay the outstanding balance of the financing on the related maturity date. Additionally, there may be substantial increases in the interest rates under a financing arrangement if the related notes are not repaid, extended or refinanced prior to the expected repayment dated, which may be before the related maturity date. If an Issuer is unable to pay the outstanding balance of the notes, the financing sources generally have the right to foreclose on the servicer advances pledged as collateral.\nCurrently, certain of the notes issued under our structured servicer advance financing arrangements accrue interest at a floating rate of interest. Servicer advances are non-interest bearing assets. Accordingly, if there is an increase in prevailing interest rates and/or our financing sources increase the interest rate “margins” or “spreads.” the amount of financing that we could obtain against any particular pool of servicer advances may decrease substantially and/or we may be required to obtain interest rate hedging arrangements. There is no assurance that we will be able to obtain any such interest rate hedging arrangements.\nAlternate sources of financing may be more expensive, contain more onerous terms or simply may not be available. Moreover, our structured servicer advance financing arrangements are currently with a limited number of counterparties. If any of our sources are unable to or elected not to extend or refinance such arrangements, we may not be able to find a replacement counterparty in a timely manner.\nMany of our servicer advance financing arrangements are provided by financial institutions with whom we have substantial relationships. Some of our servicer advance financing arrangements entail the issuance of term notes to capital markets investors with whom we have little or no relationships or the identities of which we may not be aware and, therefore, we have no ability to control or monitor the identity of the holders of such term notes. Holders of such term notes may have or may take positions - for example, “short” positions in our stock or the stock of our servicers - that could be benefited by adverse events with respect to us or our Servicing Partners. If any holders of term notes allege or assert noncompliance by us or the related Servicing Partner under our servicer advance financing arrangements in order to realize such benefits, we or our Servicing Partners, or our ability to maintain servicer advance financing on favorable terms, could be materially and adversely affected.\nWe may not be able to finance our investments on attractive terms or at all, and financing for interests in MSRs or servicer advances may be particularly difficult to obtain.\nThe ability to finance investments with securitizations or other long-term non-recourse financing not subject to margin requirements has been challenging as a result of market conditions. These conditions may result in having to use less efficient forms of financing for any new investments, or the refinancing of current investments, which will likely require a larger portion of our cash flows to be put toward making the investment and thereby reduce the amount of cash available for distribution to our stockholders and funds available for operations and investments, and which will also likely require us to assume higher levels of risk when financing\n123\nour investments. In addition, there is a limited market for financing of interests in MSRs, and it is possible that one will not develop for a variety of reasons, such as the challenges with perfecting security interests in the underlying collateral.\nCertain of our advance facilities may mature in the short term, and there can be no assurance that we will be able to renew these facilities on favorable terms or at all. Moreover, an increase in delinquencies with respect to the loans underlying our servicer advances could result in the need for additional financing, which may not be available to us on favorable terms or at all. If we are not able to obtain adequate financing to purchase servicer advances from our Servicing Partners or fund servicer advances under our MSRs in accordance with the applicable Servicing Guidelines, we or any such Servicing Partner, as applicable, could default on its obligation to fund such advances, which could result in its termination of us or any applicable Servicing Partner, as applicable, as servicer under the applicable Servicing Guidelines, and a partial or total loss of our interests in MSRs and servicer advances, as applicable.\nThe non-recourse long-term financing structures we use expose us to risks, which could result in losses to us.\nWe use structured finance and other non-recourse long-term financing for our investments to the extent available and appropriate. In such structures, our financing sources typically have only a claim against the assets included in the securitizations rather than a general claim against us as an entity. Prior to any such financing, we would seek to finance our investments with relatively short-term facilities until a sufficient portfolio is accumulated. As a result, we would be subject to the risk that we would not be able to acquire, during the period that any short-term facilities are available, sufficient eligible assets or securities to maximize the efficiency of a securitization. We also bear the risk that we would not be able to obtain new short-term facilities or would not be able to renew any short-term facilities after they expire should we need more time to seek and acquire sufficient eligible assets or securities for a securitization. In addition, conditions in the capital markets may make the issuance of any such securitization less attractive to us even when we do have sufficient eligible assets or securities. While we would generally intend to retain a portion of the interests issued under such securitizations and, therefore, still have exposure to any investments included in such securitizations, our inability to enter into such securitizations may increase our overall exposure to risks associated with direct ownership of such investments, including the risk of default. Our inability to refinance any short-term facilities would also increase our risk because borrowings thereunder would likely be recourse to us as an entity. If we are unable to obtain and renew short-term facilities or to consummate securitizations to finance our investments on a long-term basis, we may be required to seek other forms of potentially less attractive financing or to liquidate assets at an inopportune time or price.\nThe final Basel FRTB Ruling, which raised capital charges for bank holders of ABS, CMBS and Non-Agency MBS beginning in 2019, could adversely impact available trading liquidity and access to financing.\nIn January 2006, the Basel Committee on Banking Supervision released a finalized framework for calculating minimum capital requirements for market risk, which became effective in January 2019. In the final proposal, capital requirements would overall be meaningfully higher than current requirements, but are less punitive than the previous December 2014 proposal. However, each country’s specific regulator may codify the rules differently. Under the framework, capital charges on a bond are calculated based on three components: default, market and residual risk. Implementation of the final proposal could impose meaningfully higher capital charges on dealers compared with current requirements, and could reduce liquidity in the securitized products market.\nRisks associated with our investment in the consumer loan sector could have a material adverse effect on our business and financial results.\nOur portfolio includes an investment in the consumer loan sector. Although many of the risks applicable to consumer loans are also applicable to residential mortgage loans, and thus the type of risks that we have experience managing, there are nevertheless substantial risks and uncertainties associated with engaging in a different category of investment.\nThe ability of borrowers to repay the consumer loans we invest in may be adversely affected by numerous personal factors, including unemployment, divorce, major medical expenses or personal bankruptcy. General factors, including an economic downturn, high energy costs or acts of God or terrorism, may also affect the financial stability of borrowers and impair their ability or willingness to repay the consumer loans in our investment portfolio. Furthermore, our returns on our consumer loan investments are dependent on the interest we receive exceeding any losses we may incur from defaults or delinquencies. The relatively higher interest rates paid by consumer loan borrowers could lead to increased delinquencies and defaults, or could lead to financially stronger borrowers prepaying their loans, thereby reducing the interest we receive from them, while financially weaker borrowers become delinquent or default, either of which would reduce the return on our investment or could cause losses.\nIn the event of any default under a loan in the consumer loan portfolio in which we have invested, we will bear a risk of loss of principal to the extent of any deficiency between the value of the collateral securing the loan, if any, and the principal and accrued interest of the loan. In addition, our investments in consumer loans may entail greater risk than our investments in residential\n124\nmortgage loans, particularly in the case of consumer loans that are unsecured or secured by assets that depreciate rapidly. In such cases, repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan and the remaining deficiency often does not warrant further substantial collection efforts against the borrower. Further, repossessing personal property securing a consumer loan can present additional challenges, including locating the collateral and taking possession of it. In addition, borrowers under consumer loans may have lower credit scores. There can be no guarantee that we will not suffer unexpected losses on our investments as a result of the factors set out above, which could have a negative impact on our financial results.\nIn addition, a portion of our investment in consumer loans is secured by second and third liens on real estate. When we hold the second or third lien, another creditor or creditors, as applicable, holds the first and/or second, as applicable, lien on the real estate that is the subject of the security. In these situations our second or third lien is subordinate in right of payment to the first and/or second, as applicable, holder’s right to receive payment. Moreover, as the servicer of the loans underlying our consumer loan portfolio is not able to track the default status of a senior lien loan in instances where we do not hold the related first mortgage, the value of the second or third lien loans in our portfolio may be lower than our estimates indicate.\nFinally, one of our consumer loan investments is held through LoanCo, in which we hold a minority, non-controlling interest. We do not control LoanCo and, as a result, LoanCo may make decisions, or take risks, that we would otherwise not make, and LoanCo may not have access to the same management and financing expertise that we have. Failure to successfully manage these risks could have a material adverse effect on our business and financial results.\nThe consumer loan investment sector is subject to various initiatives on the part of advocacy groups and extensive regulation and supervision under federal, state and local laws, ordinances and regulations, which could have a negative impact on our financial results.\nIn recent years consumer advocacy groups and some media reports have advocated governmental action to prohibit or place severe restrictions on the types of short-term consumer loans in which we have invested. Such consumer advocacy groups and media reports generally focus on the annual percentage rate to a consumer for this type of loan, which is compared unfavorably to the interest typically charged by banks to consumers with top-tier credit histories.\nThe fees charged on the consumer loans in the portfolio in which we have invested may be perceived as controversial by those who do not focus on the credit risk and high transaction costs typically associated with this type of investment. If the negative characterization of these types of loans becomes increasingly accepted by consumers, demand for the consumer loan products in which we have invested could significantly decrease. Additionally, if the negative characterization of these types of loans is accepted by legislators and regulators, we could become subject to more restrictive laws and regulations in the area.\nIn addition, we are, or may become, subject to federal, state and local laws, regulations, or regulatory policies and practices, including the Dodd-Frank Act (which, among other things, established the Consumer Financial Protection Bureau (the “CFPB”) with broad authority to regulate and examine financial institutions), which may, amongst other things, limit the amount of interest or fees allowed to be charged on the consumer loans we invest in, or the number of consumer loans that customers may receive or have outstanding. The operation of existing or future laws, ordinances and regulations could interfere with the focus of our investments which could have a negative impact on our financial results.\nCertain jurisdictions require licenses to purchase, hold, enforce or sell residential mortgage loans and/or MSRs, and we may not be able to obtain and/or maintain such licenses.\nCertain jurisdictions require a license to purchase, hold, enforce or sell residential mortgage loans and/or MSRs. In the event that any licensing requirement is applicable to us, and we do not hold such licenses, there can be no assurance that we will obtain such licenses or, if obtained, that we will be able to maintain them. Our failure to obtain or maintain such licenses could restrict our ability to invest in loans in these jurisdictions if such licensing requirements are applicable. With respect to mortgage loans, in lieu of obtaining such licenses, we may contribute our acquired residential mortgage loans to one or more wholly owned trusts whose trustee is a national bank, which may be exempt from state licensing requirements. We have formed one or more subsidiaries to apply for certain state licenses. If these subsidiaries obtain the required licenses, any trust holding loans in the applicable jurisdictions may transfer such loans to such subsidiaries, resulting in these loans being held by a state-licensed entity. There can be no assurance that we will be able to obtain the requisite licenses in a timely manner or at all or in all necessary jurisdictions, or that the use of the trusts will reduce the requirement for licensing. In addition, even if we obtain necessary licenses, we may not be able to maintain them. Any of these circumstances could limit our ability to invest in residential mortgage loans or MSRs in the future and have a material adverse effect on us.\n125\nOur determination of how much leverage to apply to our investments may adversely affect our return on our investments and may reduce cash available for distribution.\nWe leverage certain of our assets through a variety of borrowings. Our investment guidelines do not limit the amount of leverage we may incur with respect to any specific asset or pool of assets. The return we are able to earn on our investments and cash available for distribution to our stockholders may be significantly reduced due to changes in market conditions, which may cause the cost of our financing to increase relative to the income that can be derived from our assets.\nA significant portion of our investments are not match funded, which may increase the risks associated with these investments.\nWhen available, a match funding strategy mitigates the risk of not being able to refinance an investment on favorable terms or at all. However, our Manager may elect for us to bear a level of refinancing risk on a short-term or longer-term basis, as in the case of investments financed with repurchase agreements, when, based on its analysis, our Manager determines that bearing such risk is advisable or unavoidable. In addition, we may be unable, as a result of conditions in the credit markets, to match fund our investments. For example, non-recourse term financing not subject to margin requirements has been more difficult to obtain, which impairs our ability to match fund our investments. Moreover, we may not be able to enter into interest rate swaps. A decision not to, or the inability to, match fund certain investments exposes us to additional risks.\nFurthermore, we anticipate that, in most cases, for any period during which our floating rate assets are not match funded with respect to maturity, the income from such assets may respond more slowly to interest rate fluctuations than the cost of our borrowings. Because of this dynamic, interest income from such investments may rise more slowly than the related interest expense, with a consequent decrease in our net income. Interest rate fluctuations resulting in our interest expense exceeding interest income would result in operating losses for us from these investments.\nAccordingly, to the extent our investments are not match funded with respect to maturities and interest rates, we are exposed to the risk that we may not be able to finance or refinance our investments on economically favorable terms, or at all, or may have to liquidate assets at a loss.\nInterest rate fluctuations and shifts in the yield curve may cause losses.\nInterest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. Our primary interest rate exposures relate to our interests in MSRs, RMBS, loans, derivatives and any floating rate debt obligations that we may incur. Changes in interest rates, including changes in expected interest rates or “yield curves,” affect our business in a number of ways. Changes in the general level of interest rates can affect our net interest income, which is the difference between the interest income earned on our interest-earning assets and the interest expense incurred in connection with our interest-bearing liabilities and hedges. Changes in the level of interest rates also can affect, among other things, our ability to acquire real estate and other securities and loans at attractive prices, the value of our real estate and other securities, loans and derivatives and our ability to realize gains from the sale of such assets. We may wish to use hedging transactions to protect certain positions from interest rate fluctuations, but we may not be able to do so as a result of market conditions, REIT rules or other reasons. In such event, interest rate fluctuations could adversely affect our financial condition, cash flows and results of operations.\nRecently, the Federal Reserve has increased the benchmark interest rate and indicated that there may be further increases in the future. In the event of a significant rising interest rate environment and/or economic downturn, loan and collateral defaults may increase and result in credit losses that would adversely affect our liquidity and operating results.\nOur ability to execute our business strategy, particularly the growth of our investment portfolio, depends to a significant degree on our ability to obtain additional capital. Our financing strategy is dependent on our ability to place the debt we use to finance our investments at rates that provide a positive net spread. If spreads for such liabilities widen or if demand for such liabilities ceases to exist, then our ability to execute future financings will be severely restricted.\nInterest rate changes may also impact our net book value as most of our investments are marked to market each quarter. Debt obligations are not marked to market. Generally, as interest rates increase, the value of our fixed rate securities decreases, which will decrease the book value of our equity.\nFurthermore, shifts in the U.S. Treasury yield curve reflecting an increase in interest rates would also affect the yield required on our investments and therefore their value. For example, increasing interest rates would reduce the value of the fixed rate assets we hold at the time because the higher yields required by increased interest rates result in lower market prices on existing fixed\n126\nrate assets in order to adjust the yield upward to meet the market, and vice versa. This would have similar effects on our real estate and other securities and loan portfolio and our financial position and operations to a change in interest rates generally.\nChanges in banks’ inter-bank lending rate reporting practices or the method pursuant to which LIBOR is determined may adversely affect the value of the financial obligations to be held or issued by us that are linked to LIBOR.\nLIBOR and other indices which are deemed “benchmarks” are the subject of recent national, international, and other regulatory guidance and proposals for reform. Some of these reforms are already effective while others are still to be implemented. These reforms may cause such benchmarks to perform differently than in the past, or have other consequences which cannot be predicted. In particular, regulators and law enforcement agencies in the U.K. and elsewhere conducted criminal and civil investigations into whether the banks that contributed information to the British Bankers’ Association (“BBA”) in connection with the daily calculation of LIBOR may have been under-reporting or otherwise manipulating or attempting to manipulate LIBOR. A number of BBA member banks have entered into settlements with their regulators and law enforcement agencies with respect to this alleged manipulation of LIBOR. LIBOR is calculated by reference to a market for interbank lending that continues to shrink, as its based on increasingly fewer actual transactions. This increases the subjectivity of the LIBOR calculation process and increases the risk of manipulation. Actions by the regulators or law enforcement agencies, as well as ICE Benchmark Administration (the current administrator of LIBOR), may result in changes to the manner in which LIBOR is determined or the establishment of alternative reference rates. For example, on July 27, 2017, the U.K. Financial Conduct Authority announced that it intends to stop persuading or compelling banks to submit LIBOR rates after 2021.\nIt is likely that, over time, U.S. Dollar LIBOR will be replaced by the Secured Overnight Financing Rate (“SOFR”) published by the Federal Reserve Bank of New York. However, the manner and timing of this shift is currently unknown. SOFR is an overnight rate instead of a term rate, making SOFR an inexact replacement for LIBOR. There is currently no perfect way to create robust, forward-looking, SOFR term rates. Market participants are still considering how various types of financial instruments and securitization vehicles should react to a discontinuation of LIBOR. It is possible that not all of our assets and liabilities will transition away from LIBOR at the same time, and it is possible that not all of our assets and liabilities will transition to the same alternative reference rate, in each case increasing the difficulty of hedging. Switching existing financial instruments and hedging transactions from LIBOR to SOFR requires calculations of a spread. Industry organizations are attempting to structure the spread calculation in a manner that minimizes the possibility of value transfer between counterparties, borrowers, and lenders by virtue of the transition, but there is no assurance that the calculated spread will be fair and accurate or that all asset types and all types of securitization vehicles will use the same spread. We and other market participants have less experience understanding and modeling SOFR-based assets and liabilities than LIBOR-based assets and liabilities, increasing the difficulty of investing, hedging, and risk management. The process of transition involves operational risks. It is also possible that no transition will occur for many financial instruments, meaning that those instruments would continue to be subject to the weaknesses of the LIBOR calculation process. At this time, it is not possible to predict the effect of any such changes, any establishment of alternative reference rates or any other reforms to LIBOR that may be implemented. Uncertainty as to the nature of such potential changes, alternative reference rates or other reforms may adversely affect the market for or value of any securities on which the interest or dividend is determined by reference to LIBOR, loans, derivatives and other financial obligations or on our overall financial condition or results of operations. More generally, any of the above changes or any other consequential changes to LIBOR or any other “benchmark” as a result of international, national or other proposals for reform or other initiatives or investigations, or any further uncertainty in relation to the timing and manner of implementation of such changes, could have a material adverse effect on the value of and return on any securities based on or linked to a “benchmark.”\nAny hedging transactions that we enter into may limit our gains or result in losses.\nWe may use, when feasible and appropriate, derivatives to hedge a portion of our interest rate exposure, and this approach has certain risks, including the risk that losses on a hedge position will reduce the cash available for distribution to stockholders and that such losses may exceed the amount invested in such instruments. We have adopted a general policy with respect to the use of derivatives, which generally allows us to use derivatives where appropriate, but does not set forth specific policies and procedures or require that we hedge any specific amount of risk. From time to time, we may use derivative instruments, including forwards, futures, swaps and options, in our risk management strategy to limit the effects of changes in interest rates on our operations. A hedge may not be effective in eliminating all of the risks inherent in any particular position. Our profitability may be adversely affected during any period as a result of the use of derivatives.\nThere are limits to the ability of any hedging strategy to protect us completely against interest rate risks. When rates change, we expect the gain or loss on derivatives to be offset by a related but inverse change in the value of any items that we hedge. We cannot assure you, however, that our use of derivatives will offset the risks related to changes in interest rates. We cannot assure you that our hedging strategy and the derivatives that we use will adequately offset the risk of interest rate volatility or that our hedging transactions will not result in losses. In addition, our hedging strategy may limit our flexibility by causing us to refrain\n127\nfrom taking certain actions that would be potentially profitable but would cause adverse consequences under the terms of our hedging arrangements. The REIT provisions of the Internal Revenue Code limit our ability to hedge. In managing our hedge instruments, we consider the effect of the expected hedging income on the REIT qualification tests that limit the amount of gross income that a REIT may receive from hedging. We need to carefully monitor, and may have to limit, our hedging strategy to assure that we do not realize hedging income, or hold hedges having a value, in excess of the amounts that would cause us to fail the REIT gross income and asset tests. See “—Risks Related to Our Taxation as a REIT—Complying with the REIT requirements may limit our ability to hedge effectively.”\nAccounting for derivatives under GAAP is extremely complicated. Any failure by us to account for our derivatives properly in accordance with GAAP in our financial statements could adversely affect us. In addition, under applicable accounting standards, we may be required to treat some of our investments as derivatives, which could adversely affect our results of operations.\nCybersecurity incidents and technology disruptions or failures could damage our business operations and reputation, increase our costs and subject us to potential liability.\nAs our reliance on rapidly changing technology has increased, so have the risks that threaten the confidentiality, integrity or availability of our information systems, both internal and those provided to us by third-party service providers (including, but not limited to, our Servicing Partners). Cybersecurity incidents may involve gaining authorized or unauthorized access to our information systems for purposes of theft of certain personally identifiable information of consumers, misappropriating assets, stealing confidential information, corrupting data or causing operational disruption. Disruptions and failures of our systems or those of our third-party vendors could result from these incidents or be caused by fire, power outages, natural disasters and other similar events and may interrupt or delay our ability to provide services to our customers, expose us to remedial costs and reputational damage, and otherwise adversely affect our operations.\nDespite our efforts to ensure the integrity of our systems, there can be no assurance that any such cyber incidents will not occur or, if they do occur, that they will be adequately addressed. We also may not be able to anticipate or implement effective preventive measures against all security breaches, especially because the methods and sources of breaches change frequently or may not be immediately detected.\nIn addition, we are subject to various privacy and data protection laws and regulations, and any changes to laws or regulations, including new restrictions or requirements applicable to our business, could impose additional costs and liability on us and could limit our use and disclosure of such information. For example, the New York State Department of Financial Services requires certain financial services companies, such as NRM and NewRez, to establish a detailed cybersecurity program and comply with other requirements, and the California Consumer Privacy Act of 2018 creates new compliance regulations on businesses that collect information from California residents.\nAny of the foregoing events could result in violations of applicable privacy and other laws, financial loss to us or to our customers, loss of confidence in our security measures, customer dissatisfaction, additional regulatory scrutiny, significant litigation exposure and harm to our reputation, any of which could have a material adverse effect on our business, financial condition, liquidity and results of operations.\nWe depend on counterparties and vendors to provide certain services, which subjects us to various risks.\nWe have a number of counterparties and vendors, who provide us with financial, technology and other services that support our businesses. If our current counterparties and vendors were to stop providing services to us on acceptable terms, we may be unable to procure alternative services from other counterparties or vendors in a timely and efficient manner and on similarly acceptable terms, or at all. With respect to vendors engaged to perform certain servicing activities, we are required to assess their compliance with various regulations and establish procedures to provide reasonable assurance that the vendor’s activities comply in all material respects with such regulations. In the event that a vendor’s activities are not in compliance, it could negatively impact our relationships with our regulators, as well as our business and operations. Accordingly, we may incur significant costs to resolve any such disruptions in service which could have a material adverse effect on our business, financial condition, liquidity and results of operations.\nWe are subject to risks related to securitization of any loans originated and/or serviced by our subsidiaries.\nThe securitization of any loans that we originate and/or service subject us to various risks that may increase our compliance costs and adversely impact our financial results, including:\n| • | compliance with the terms of the agreements governing the securitized pools of loans, including any indemnification and repurchase provisions; |\n\n128\n| • | reliance on programs administered by Fannie Mae, Freddie Mac, and Ginnie Mae that facilitate the issuance of mortgage-backed securities in the secondary market and the effect of any changes or modifications thereto (see-“GSE initiatives and other actions, including changes to the minimum servicing amount for GSE loans, could occur at any time and could impact us in significantly negative ways that we are unable to predict or protect against” and -“The federal conservatorship of Fannie Mae and Freddie Mac and related efforts, along with any changes in laws and regulations affecting the relationship between these agencies and the U.S. government, may adversely affect our business”); and |\n\n| • | federal and state legislation in securitizations, such as the risk retention requirements under the Dodd-Frank Act, could result in higher costs of certain lending operations and impose on us additional compliance requirements to meet servicing and originations criteria for securitized mortgage loans. |\n\nMaintenance of our 1940 Act exclusion imposes limits on our operations.\nWe intend to continue to conduct our operations so that neither we nor any of our subsidiaries are required to register as an investment company under the 1940 Act. We believe we will not be considered an investment company under Section 3(a)(1)(A) of the 1940 Act because we will not engage primarily, or hold ourselves out as being engaged primarily, in the business of investing, reinvesting or trading in securities. However, under Section 3(a)(1)(C) of the 1940 Act, because we are a holding company that will conduct its businesses primarily through wholly owned and majority owned subsidiaries, the securities issued by our subsidiaries that are excluded from the definition of “investment company” under Section 3(c)(1) or Section 3(c)(7) of the 1940 Act, together with any other investment securities we may own, may not have a combined value in excess of 40% of the value of our total assets (exclusive of U.S. Government securities and cash items) on an unconsolidated basis, unless another exclusion from the definition of “investment company” is available to us. For purposes of the foregoing, we currently treat our interest in our SLS Servicer Advance Investment and our subsidiaries that hold consumer loans as investment securities because these subsidiaries presently rely on the exclusion provided by Section 3(c)(7) of the 1940 Act. The 40% test under Section 3(a)(1)(C) of the 1940 Act limits the types of businesses in which we may engage through our subsidiaries. In addition, the assets we and our subsidiaries may originate or acquire are limited by the provisions of the 1940 Act and the rules and regulations promulgated under the 1940 Act, which may adversely affect our business.\nIf the value of securities issued by our subsidiaries that are excluded from the definition of “investment company” by Section 3(c)(1) or 3(c)(7) of the 1940 Act, together with any other investment securities we own, exceeds the 40% test under Section 3(a)(1)(C) of the 1940 Act (e.g., the value of our interests in the taxable REIT subsidiaries that hold Servicer Advance Investments and are not excluded from the definition of “investment company” by Section 3(c)(5)(A), (B) or (C) of the 1940 Act increases significantly in proportion to the value of our other assets), or if one or more of such subsidiaries fail to maintain an exclusion or exception from the 1940 Act, we could, among other things, be required either (a) to substantially change the manner in which we conduct our operations to avoid being required to register as an investment company or (b) to register as an investment company under the 1940 Act, either of which could have an adverse effect on us and the market price of our securities. As discussed above, for purposes of the foregoing, we generally treat our interests in our SLS Servicer Advance Investment and our subsidiaries that hold consumer loans as investment securities because these subsidiaries presently rely on the exclusion provided by Section 3(c)(7) of the 1940 Act. If we or any of our subsidiaries were required to register as an investment company under the 1940 Act, the registered entity would become subject to substantial regulation with respect to capital structure (including the ability to use leverage), management, operations, transactions with affiliated persons (as defined in the 1940 Act), portfolio composition, including restrictions with respect to diversification and industry concentration, compliance with reporting, record keeping, voting, proxy disclosure and other rules and regulations that would significantly change our operations.\nFailure to maintain an exclusion would require us to significantly restructure our investment strategy. For example, because affiliate transactions are generally prohibited under the 1940 Act, we would not be able to enter into transactions with any of our affiliates if we are required to register as an investment company, and we might be required to terminate our Management Agreement and any other agreements with affiliates, which could have a material adverse effect on our ability to operate our business and pay distributions. If we were required to register us as an investment company but failed to do so, we would be prohibited from engaging in our business, and criminal and civil actions could be brought against us. In addition, our contracts would be unenforceable unless a court required enforcement, and a court could appoint a receiver to take control of us and liquidate our business.\nFor purposes of the foregoing, we treat our interests in certain of our wholly owned and majority owned subsidiaries, which constitute more than 60% of the value of our adjusted total assets on an unconsolidated basis, as non-investment securities because such subsidiaries qualify for exclusion from the definition of an investment company under the 1940 Act pursuant to Section 3(c)(5)(C) of the 1940 Act. The Section 3(c)(5)(C) exclusion is available for entities “primarily engaged” in the business of “purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” The Section 3(c)(5)(C) exclusion generally requires that at least 55% of these subsidiaries’ assets must comprise qualifying real estate assets and at least 80% of each of their portfolios must comprise qualifying real estate assets and real estate-related assets under the 1940 Act. We expect each of our subsidiaries relying on Section 3(c)(5)(C) to rely on guidance published by the SEC staff or on our analyses of such guidance to\n129\ndetermine which assets are qualifying real estate assets and real estate-related assets. However, the SEC’s guidance was issued in accordance with factual situations that may be substantially different from the factual situations each of our subsidiaries may face, and much of the guidance was issued more than 20 years ago. No assurance can be given that the SEC staff will concur with the classification of each of our subsidiaries’ assets. In addition, the SEC staff may, in the future, issue further guidance that may require us to re-classify some of our subsidiaries’ assets for purposes of qualifying for an exclusion from regulation under the 1940 Act. For example, the SEC and its staff have not published guidance with respect to the treatment of whole pool Non-Agency RMBS for purposes of the Section 3(c)(5)(C) exclusion. Accordingly, based on our own judgment and analysis of the guidance from the SEC and its staff identifying Agency whole pool certificates as qualifying real estate assets under Section 3(c)(5)(C), we treat whole pool Non-Agency RMBS issued with respect to an underlying pool of mortgage loans in which our subsidiary relying on Section 3(c)(5)(C) holds all of the certificates issued by the pool as qualifying real estate assets. Based on our own judgment and analysis of the guidance from the SEC and its staff with respect to analogous assets, we treat Excess MSRs for which we do not own the related servicing rights as real estate-related assets for purposes of satisfying the 80% test under the Section 3(c)(5)(C) exclusion. If we are required to re-classify any of our subsidiaries’ assets, including those subsidiaries holding whole pool Non-Agency RMBS and/or Excess MSRs, such subsidiaries may no longer be in compliance with the exclusion from the definition of an “investment company” provided by Section 3(c)(5)(C) of the 1940 Act, and in turn, we may not satisfy the requirements to avoid falling within the definition of an “investment company” provided by Section 3(a)(1)(C). To the extent that the SEC staff publishes new or different guidance or disagrees with our analysis with respect to any assets of our subsidiaries we have determined to be qualifying real estate assets or real estate-related assets, we may be required to adjust our strategy accordingly. In addition, we may be limited in our ability to make certain investments and these limitations could result in a subsidiary holding assets we might wish to sell or selling assets we might wish to hold.\nIn August 2011, the SEC issued a concept release soliciting public comments on a wide range of issues relating to companies engaged in the business of acquiring mortgages and mortgage-related instruments and that rely on Section 3(c)(5)(C) of the 1940 Act. Therefore, there can be no assurance that the laws and regulations governing the 1940 Act status of REITs, or guidance from the SEC or its staff regarding the Section 3(c)(5)(C) exclusion, will not change in a manner that adversely affects our operations. If we or our subsidiaries fail to maintain an exclusion or exception from the 1940 Act, we could, among other things, be required either to (a) change the manner in which we conduct our operations to avoid being required to register as an investment company, (b) effect sales of our assets in a manner that, or at a time when, we would not otherwise choose to do so, or (c) register as an investment company, any of which could negatively affect the value of our common stock, the sustainability of our business model, and our ability to make distributions. In addition, if we or any of our subsidiaries were required to register as an investment company under the 1940 Act, the registered entity would become subject to substantial regulation with respect to capital structure (including the ability to use leverage), management, operations, transactions with affiliated persons (as defined in the 1940 Act), portfolio composition, including restrictions with respect to diversification and industry concentration, compliance with reporting, record keeping, voting, proxy disclosure and other rules and regulations that would significantly change our operations.\nRapid changes in the values of our assets may make it more difficult for us to maintain our qualification as a REIT or our exclusion from the 1940 Act.\nIf the market value or income potential of qualifying assets for purposes of our qualification as a REIT or our exclusion from registration as an investment company under the 1940 Act declines as a result of increased interest rates, changes in prepayment rates or other factors, or the market value or income from non-qualifying assets increases, we may need to increase our investments in qualifying assets and/or liquidate our non-qualifying assets to maintain our REIT qualification or our exclusion from registration under the 1940 Act. If the change in market values or income occurs quickly, this may be especially difficult to accomplish. This difficulty may be exacerbated by the illiquid nature of any non-qualifying assets we may own. We may have to make investment decisions that we otherwise would not make absent the intent to maintain our qualification as a REIT and exclusion from registration under the 1940 Act.\nWe are subject to significant competition, and we may not compete successfully.\nWe are subject to significant competition in seeking investments. We compete with other companies, including other REITs, insurance companies and other investors, including funds and companies affiliated with our Manager. Some of our competitors have greater resources than we possess or have greater access to capital or various types of financing structures than are available to us, and we may not be able to compete successfully for investments or provide attractive investment returns relative to our competitors. These competitors may be willing to accept lower returns on their investments and, as a result, our profit margins could be adversely affected. Furthermore, competition for investments that are suitable for us, including, but not limited to, interests in MSRs, may lead to decreased availability, higher market prices and decreased returns available from such investments, which may further limit our ability to generate our desired returns. We cannot assure you that other companies will not be formed that compete with us for investments or otherwise pursue investment strategies similar to ours or that we will be able to compete successfully against any such companies.\n130\nOur business could suffer if we fail to attract and retain highly skilled personnel.\nOur future success will depend on our ability to identify, hire, develop, motivate and retain highly qualified personnel for all areas of the Company, in particular skilled managers, loan officers, underwriters, loan servicers, debt default specialists and other personnel specialized in finance, risk and compliance. Trained and experienced personnel are in high demand and may be in short supply in some areas. We may not be able to attract, develop and maintain an adequate skilled workforce necessary to operate our businesses and labor expenses may increase as a result of a shortage in the supply of qualified personnel. If we are unable to attract and retain such personnel, we may not be able to take advantage of acquisitions and other growth opportunities that may be presented to us and this could have a material adverse effect on our business, financial condition, liquidity and results of operations.\nThe valuations of our assets are subject to uncertainty because most of our assets are not traded in an active market.\nThere is not anticipated to be an active market for most of the assets in which we will invest. In the absence of market comparisons, we will use other pricing methodologies, including, for example, models based on assumptions regarding expected trends, historical trends following market conditions believed to be comparable to the then current market conditions and other factors believed at the time to be likely to influence the potential resale price of, or the potential cash flows derived from, an investment. Such methodologies may not prove to be accurate and any inability to accurately price assets may result in adverse consequences for us. A valuation is only an estimate of value and is not a precise measure of realizable value. Ultimate realization of the market value of a private asset depends to a great extent on economic and other conditions beyond our control. Further, valuations do not necessarily represent the price at which a private investment would sell since market prices of private investments can only be determined by negotiation between a willing buyer and seller. If we were to liquidate a particular private investment, the realized value may be more than or less than the valuation of such asset as carried on our books.\nChanges in accounting rules could occur at any time and could impact us in significantly negative ways that we are unable to predict or protect against.\nAs has been widely publicized, the SEC, the Financial Accounting Standards Board (the “FASB”) and other regulatory bodies that establish the accounting rules applicable to us have recently proposed or enacted a wide array of changes to accounting rules. Moreover, in the future these regulators may propose additional changes that we do not currently anticipate. Changes to accounting rules that apply to us could significantly impact our business or our reported financial performance in negative ways that we cannot predict or protect against. We cannot predict whether any changes to current accounting rules will occur or what impact any codified changes will have on our business, results of operations, liquidity or financial condition, directly or through their impact on our Servicing Partners or counterparties.\nA prolonged economic slowdown, a lengthy or severe recession, or declining real estate values could harm our operations.\nWe believe the risks associated with our business are more severe during periods in which an economic slowdown or recession is accompanied by declining real estate values, as was the case in 2008. Declining real estate values generally reduce the level of new mortgage loan originations, since borrowers often use increases in the value of their existing properties to support the purchase of, or investment in, additional properties. Borrowers may also be less able to pay principal and interest on our loans or the loans underlying our securities, interests in MSRs and servicer advances, if the real estate economy weakens. Further, declining real estate values significantly increase the likelihood that we will incur losses on our investments in the event of default because the value of our collateral may be insufficient to cover our basis. Any sustained period of increased payment delinquencies, foreclosures or losses could adversely affect our net interest income from the assets in our portfolio, which would significantly harm our revenues, results of operations, financial condition, liquidity, business prospects and our ability to make distributions to our stockholders.\nCompliance with changing regulation of corporate governance and public disclosure has and will continue to result in increased compliance costs and pose challenges for our management team.\nCertain aspects of the Dodd-Frank Act remain subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on us and, more generally, the financial services and mortgage industries. Additionally, we cannot predict whether there will be additional proposed laws or reforms that would affect us, whether or when such changes may be adopted, how such changes may be interpreted and enforced or how such changes may affect us. However, the costs of complying with any additional laws or regulations could have a material effect on our financial condition and results of operations.\n131\nWe have engaged and may in the future engage in a number of acquisitions and we may be unable to successfully integrate the acquired assets and assumed liabilities in connection with such acquisitions.\nAs part of our business strategy, we regularly evaluate acquisitions of what we believe are complementary assets. Identifying and achieving the anticipated benefits of such acquisitions is subject to a number of uncertainties, including, without limitation, whether we are able to acquire the assets, within our parameters, integrate the acquired assets and manage the assumed liabilities efficiently. It is possible that the integration process could take longer than anticipated and could result in additional and unforeseen expenses, the disruption of our ongoing business, processes and systems, or inconsistencies in standards, controls, procedures, practices and policies, any of which could adversely affect our ability to achieve the anticipated benefits of such acquisitions. There may be increased risk due to integrating the assets into our financial reporting and internal control systems. Difficulties in adding the assets into our business could also result in the loss of contract counterparties or other persons with whom we conduct business and potential disputes or litigation with contract counterparties or other persons with whom we or such counterparties conduct business. We could also be adversely affected by any issues attributable to the related seller’s operations that arise or are based on events or actions that occurred prior to the closing of such acquisitions. Completion of the integration process is subject to a number of uncertainties, and no assurance can be given that the anticipated benefits will be realized in their entirety or at all or, if realized, the timing of their realization. Failure to achieve these anticipated benefits could result in increased costs or decreases in the amount of expected revenues and could adversely affect our future business, financial condition, operating results and cash flows. Due to the costs of engaging in a number of acquisitions, we may also have difficulty completing more acquisitions in the future.\nThere may be difficulties with integrating the loans underlying MSR acquisitions involving servicing transfers into the successor servicer’s servicing platform, which could have a material adverse effect on our results of operations, financial condition and liquidity.\nIn connection with certain MSR acquisitions, servicing is transferred from the seller to a subservicer appointed by us. The ability to integrate and service the assets acquired will depend in large part on the success of our subservicer’s integration of expanded servicing capabilities with its current operations. We may fail to realize some or all of the anticipated benefits of these transactions if the integration process takes longer, or is more costly, than expected. Potential difficulties we may encounter during the integration process with the assets acquired in MSR acquisitions involving servicing transfers include, but are not limited to, the following:\n| • | the integration of the portfolio into our subservicer’s information technology platforms and servicing systems; |\n\n| • | the quality of servicing during any interim servicing period after we purchase the portfolio but before our subservicer assumes servicing obligations from the seller or its agents; |\n\n| • | the disruption to our ongoing businesses and distraction of our management teams from ongoing business concerns; |\n\n| • | incomplete or inaccurate files and records; |\n\n| • | the retention of existing customers; |\n\n| • | the creation of uniform standards, controls, procedures, policies and information systems; |\n\n| • | the occurrence of unanticipated expenses; and |\n\n| • | potential unknown liabilities associated with the transactions, including legal liability related to origination and servicing prior to the acquisition. |\n\nOur failure to meet the challenges involved in successfully integrating the assets acquired in MSR acquisitions involving servicing transfers with our current business could impair our operations. For example, it is possible that the data our subservicer acquires upon assuming the direct servicing obligations for the loans may not transfer from the seller’s platform to its systems properly. This may result in data being lost, key information not being locatable on our subservicer’s systems, or the complete failure of the transfer. If our employees are unable to access customer information easily, or is unable to produce originals or copies of documents or accurate information about the loans, collections could be affected significantly, and our subservicer may not be able to enforce its right to collect in some cases. Similarly, collections could be affected by any changes to our subservicer’s collections practices, the restructuring of any key servicing functions, transfer of files and other changes that occur as a result of the transfer of servicing obligations from the seller to our subservicer.\nWe are responsible for certain of HLSS’s contingent and other corporate liabilities.\nUnder the HLSS acquisition agreement, we have assumed and are responsible for the payment of HLSS’s contingent and other liabilities, including: (i) liabilities for litigation relating to, arising out of or resulting from certain lawsuits in which HLSS is named as the defendant, (ii) HLSS’s tax liabilities, (iii) HLSS’s corporate liabilities, (iv) generally any actions with respect to the HLSS Acquisition brought by any third party and (v) payments under contracts. We currently cannot estimate the amount we may ultimately be responsible for as a result of assuming substantially all of HLSS’s contingent and other corporate liabilities. The amount for which we are ultimately responsible may be material and have a material adverse effect on our business, financial condition, results of operations and liquidity. In addition, certain claims and lawsuits may require significant costs to defend and\n132\nresolve and may divert management’s attention away from other aspects of operating and managing our business, each of which could materially and adversely affect our business, financial condition, results of operations and liquidity.\nWe cannot guarantee that we will not receive further regulatory inquiries or be subject to litigation regarding the subject matter of the subpoenas or matters relating thereto, or that existing inquires, or, should they occur, any future regulatory inquiries or litigation, will not consume internal resources, result in additional legal and consulting costs or negatively impact our stock price.\nWe could be materially and adversely affected by past events, conditions or actions with respect to HLSS or Ocwen.\nHLSS acquired assets and assumed liabilities could be adversely affected as a result of events or conditions that occurred or existed before the closing of the HLSS Acquisition. Adverse changes in the assets or liabilities we have acquired or assumed, respectively, as part of the HLSS Acquisition, could occur or arise as a result of actions by HLSS or Ocwen, legal or regulatory developments, including the emergence or unfavorable resolution of pre-acquisition loss contingencies, deteriorating general business, market, industry or economic conditions, and other factors both within and beyond the control of HLSS or Ocwen. We are subject to a variety of risks as a result of our dependence on Servicing Partners, including, without limitation, the potential loss of all of the value of our Excess MSRs in the event that the servicer of the underlying loans is terminated by the mortgage loan owner or RMBS bondholders. A significant decline in the value of HLSS assets or a significant increase in HLSS liabilities we have acquired could adversely affect our future business, financial condition, cash flows and results of operations. HLSS is subject to a number of other risks and uncertainties, including regulatory investigations and legal proceedings against HLSS, and others with whom HLSS conducted business. Moreover, any insurance proceeds received with respect to such matters may be inadequate to cover the associated losses. Adverse developments at Ocwen, including liquidity issues, ratings downgrades, defaults under debt agreements, servicer rating downgrades, failure to comply with the terms of PSAs, termination under PSAs, Ocwen bankruptcy proceedings and additional regulatory issues and settlements, including those described above, could have a material adverse effect on us. See “—We rely heavily on our Servicing Partners to achieve our investment objective and have no direct ability to influence their performance.”\nOur ability to borrow may be adversely affected by the suspension or delay of the rating of the notes issued under certain of our financing facilities by the credit agency providing the ratings.\nCertain of our financing facilities are rated by one rating agency and we may sponsor financing facilities in the future that are rated by credit agencies. The related agency or rating agencies may suspend rating notes backed by servicer advances, MSRs, Excess MSRs and our other investments at any time. Rating agency delays may result in our inability to obtain timely ratings on new notes, or amend or modify other financing facilities which could adversely impact the availability of borrowings or the interest rates, advance rates or other financing terms and adversely affect our results of operations and liquidity. Further, if we are unable to secure ratings from other agencies, limited investor demand for unrated notes could result in further adverse changes to our liquidity and profitability.\nA downgrade of certain of the notes issued under our financing facilities could cause such notes to become due and payable prior to their expected repayment date/maturity date, which could have a material adverse effect on our business, financial condition, results of operations and liquidity.\nRegulatory scrutiny regarding foreclosure processes could lengthen foreclosure timelines, which could increase advances and materially and adversely affect our business, financial condition, results of operations and liquidity.\nWhen a residential mortgage loan is in foreclosure, the servicer is generally required to continue to advance delinquent principal and interest to the securitization trust and to also make advances for delinquent taxes and insurance and foreclosure costs and the upkeep of vacant property in foreclosure to the extent it determines that such amounts are recoverable. These servicer advances are generally recovered when the delinquency is resolved. Foreclosure moratoria or other actions that lengthen the foreclosure process increase the amount of servicer advances, lengthen the time it takes for reimbursement of such advances and increase the costs incurred during the foreclosure process. In addition, servicer advance financing facilities generally contain provisions that limit the eligibility of servicer advances to be financed based on the length of time that servicer advances are outstanding, and, as a result, an increase in foreclosure timelines could further increase the amount of servicer advances that need to be funded from the related servicer’s own capital. Such increases in foreclosure timelines could increase the need for capital to fund servicer advances, which would increase our interest expense, delay the collection of interest income or servicing revenue until the foreclosure has been resolved and, therefore, reduce the cash that we have available to pay our operating expenses or to pay dividends. For more information, see “—We could be materially and adversely affected by past events, conditions or actions with respect to HLSS or Ocwen” above.\n133\nCertain of our Servicing Partners have triggered termination events or events of default under some PSAs underlying the MSRs with respect to which we are entitled to the basic fee component or Excess MSRs.\nIn certain of these circumstances, the related Servicing Partner may be terminated without any right to compensation for its loss, other than the right to be reimbursed for any outstanding servicer advances as the related loans are brought current, modified, liquidated or charged off. So long as we are in compliance with our obligations under our servicing agreements and purchase agreements, if we or one of our Servicing Partners is terminated as servicer, we may have the right to receive an indemnification payment from the applicable Servicing Partner, even if such termination related to servicer termination events or events of default existing at the time of any transaction with such Servicing Partner. If one of our Servicing Partners is terminated as servicer under a PSA, we will lose any investment related to such Servicing Partner’s MSRs. If we or such Servicing Partner is terminated as servicer with respect to a PSA and we are unable to enforce our contractual rights against such Servicing Partner, or if such Servicing Partner is unable to make any resulting indemnification payments to us, if any such payment is due and payable, it may have a material adverse effect on our financial condition, results of operations, ability to make distributions, liquidity and financing arrangements, including our servicer advance financing facilities, and may make it more difficult for us to acquire additional interests in MSRs in the future.\nRepresentations and warranties made by us in our collateralized borrowings and loan sale agreements may subject us to liability.\nOur financing facilities require us to make certain representations and warranties regarding the assets that collateralize the borrowings. Although we perform due diligence on the assets that we acquire, certain representations and warranties that we make in respect of such assets may ultimately be determined to be inaccurate. In addition, our loan sale agreements require us to make representations and warranties to the purchaser regarding the loans that were sold. Such representations and warranties may include, but are not limited to, issues such as the validity of the lien; the absence of delinquent taxes or other liens; the loans’ compliance with all local, state and federal laws and the delivery of all documents required to perfect title to the lien.\nIn the event of a breach of a representation or warranty, we may be required to repurchase affected loans, make indemnification payments to certain indemnified parties or address any claims associated with such breach. Further, we may have limited or no recourse against the seller from whom we purchased the loans. Such recourse may be limited due to a variety of factors, including the absence of a representation or warranty from the seller corresponding to the representation provided by us or the contractual expiration thereof. A breach of a representation or warranty could adversely affect our results of operations and liquidity.\nOur ability to exercise our cleanup call rights may be limited or delayed if a third party contests our ability to exercise our cleanup call rights, if the related securitization trustee refuses to permit the exercise of such rights, or if a related party is subject to bankruptcy proceedings.\nCertain servicing contracts permit more than one party to exercise a cleanup call-meaning the right of a party to collapse a securitization trust by purchasing all of the remaining loans held by the securitization trust pursuant to the terms set forth in the applicable servicing agreement. While the servicers from which we acquired our cleanup call rights (or other servicers from which these servicers acquired MSRs) may be named as the party entitled to exercise such rights, certain third parties may also be permitted to exercise such rights. If any such third party exercises a cleanup call, we could lose our ability to exercise our cleanup call right and, as a result, lose the ability to generate positive returns with respect to the related securitization transaction. In addition, another party could impair our ability to exercise our cleanup call rights by contesting our rights (for example, by claiming that they hold the exclusive cleanup call right with respect to the applicable securitization trust). Moreover, because the ability to exercise a cleanup call right is governed by the terms of the applicable servicing agreement, any ambiguous or conflicting language regarding the exercise of such rights in the agreement may make it more difficult and costly to exercise a cleanup call right. Furthermore, certain servicing contracts provide cleanup call rights to a servicer currently subject to bankruptcy proceedings from which our servicers have acquired MSRs. While, notwithstanding the related bankruptcy proceedings, it is possible that we will be able to exercise the related cleanup calls within our desired time frame, our ability to exercise such rights may be significantly delayed or impaired by the applicable securitization trustee or bankruptcy estate or any additional steps required because of the bankruptcy process. Finally, many of our call rights are not currently exercisable and may not become exercisable for a period of years. As a result, our ability to realize the benefits from these rights will depend on a number of factors at the time they become exercisable many of which are outside our control, including interest rates, conditions in the capital markets and conditions in the residential mortgage market.\nThe exercise of cleanup calls could negatively impact our interests in MSRs.\nThe exercise of cleanup call rights results in the termination of the MSRs on the loans held within the related securitization trusts. To the extent we own interests in MSRs with respect to loans held within securitization trusts where cleanup call rights are exercised,\n134\nwhether they are exercised by us or a third party, the value of our interests in those MSRs will likely be reduced to zero and we could incur losses and reduced cash flows from any such interests.\nNew Residential’s subsidiary New Residential Mortgage LLC is or may become subject to significant state and federal regulations.\nA subsidiary of New Residential, New Residential Mortgage LLC (“NRM”), has obtained applicable qualifications, licenses and approvals to own Non-Agency and certain Agency MSRs in the United States and certain other jurisdictions. As a result of NRM’s current and expected approvals, NRM is subject to extensive and comprehensive regulation under federal, state and local laws in the United States. These laws and regulations do, and may in the future, significantly affect the way that NRM does business, and subject NRM and New Residential to additional costs and regulatory obligations, which could impact our financial results.\nNRM’s business may become subject to increasing regulatory oversight and scrutiny in the future as it continues seeking and obtaining additional approvals to hold MSRs, which may lead to regulatory investigations or enforcement, including both formal and informal inquiries, from various state and federal agencies as part of those agencies’ oversight of the mortgage servicing business. An adverse result in governmental investigations or examinations or private lawsuits, including purported class action lawsuits, may adversely affect NRM’s and our financial results or result in serious reputational harm. In addition, a number of participants in the mortgage servicing industry have been the subject of purported class action lawsuits and regulatory actions by state or federal regulators, and other industry participants have been the subject of actions by state Attorneys General.\nFailure of New Residential’s subsidiary, NRM, to obtain or maintain certain licenses and approvals required for NRM to purchase and own MSRs could prevent us from purchasing or owning MSRs, which could limit our potential business activities.\nState and federal laws require a business to hold certain state licenses prior to acquiring MSRs. NRM is currently licensed or otherwise eligible to hold MSRs in each applicable state. As a licensee in such states, NRM may become subject to administrative actions in those states for failing to satisfy ongoing license requirements or for other state law violations, the consequences of which could include fines or suspensions or revocations of NRM’s licenses by applicable state regulatory authorities, which could in turn result in NRM becoming ineligible to hold MSRs in the related jurisdictions. We could be delayed or prohibited from conducting certain business activities if we do not maintain necessary licenses in certain jurisdictions. We cannot assure you that we will be able to maintain all of the required state licenses.\nAdditionally, NRM has received approval from FHA to hold MSRs associated with FHA-insured mortgage loans, from Fannie Mae to hold MSRs associated with loans owned by Fannie Mae, and from Freddie Mac to hold MSRs associated with loans owned by Freddie Mac. NRM may seek approval from Ginnie Mae to become an approved Ginnie Mae Issuer, which would make NRM eligible to hold MSRs associated with Ginnie Mae securities. As an approved Fannie Mae Servicer, Freddie Mac Servicer and FHA Lender, NRM is required to conduct aspects of its operations in accordance with applicable policies and guidelines published by FHA, Fannie Mae and Freddie Mac in order to maintain those approvals. Should NRM fail to maintain FHA, Fannie Mae or Freddie Mac approval, or fail to obtain approval from Ginnie Mae, NRM may be unable to purchase certain types of MSRs, which could limit our potential business activities.\nNRM is currently subject to various, and may become subject to additional information reporting and other regulatory requirements, and there is no assurance that we will be able to satisfy those requirements or other ongoing requirements applicable to mortgage loan servicers under applicable state and federal laws. Any failure by NRM to comply with such state or federal regulatory requirements may expose us to administrative or enforcement actions, license or approval suspensions or revocations or other penalties that may restrict our business and investment options, any of which could restrict our business and investment options, adversely impact our business and financial results and damage our reputation.\nWe may become subject to fines or other penalties based on the conduct of mortgage loan originators and brokers that originate residential mortgage loans related to MSRs that we acquire, and the third-party servicers we may engage to subservice the loans underlying MSRs we acquire.\nWe have acquired MSRs and may in the future acquire additional MSRs from third-party mortgage loan originators, brokers or other sellers, and we therefore are or will become dependent on such third parties for the related mortgage loans’ compliance with applicable law, and on third-party mortgage servicers, including our Servicing Partners, to perform the day-to-day servicing on the mortgage loans underlying any such MSRs. Mortgage loan originators and brokers are subject to strict and evolving consumer protection laws and other legal obligations with respect to the origination of residential mortgage loans. These laws and regulations include the residential mortgage servicing standards, “ability-to-repay” and “qualified mortgage” regulations promulgated by the CFPB, which became effective in 2014. In addition, there are various other federal, state, and local laws and regulations that are\n135\nintended to discourage predatory lending practices by residential mortgage loan originators. These laws may be highly subjective and open to interpretation and, as a result, a regulator or court may determine that that there has been a violation where an originator or servicer of mortgage loans reasonably believed that the law or requirement had been satisfied. Failure or alleged failure by originators or servicers to comply with these laws and regulations could subject us to state or CFPB administrative proceedings, which could result in monetary penalties, license suspensions or revocations, or restrictions to our business, all of which could adversely impact our business and financial results and damage our reputation.\nThe final servicing rules promulgated by the CFPB to implement certain sections of the Dodd-Frank Act include provisions relating to, among other things, periodic billing statements and disclosures, responding to borrower inquiries and complaints, force-placed insurance, and adjustable rate mortgage interest rate adjustment notices. Further, the mortgage servicing rules require servicers to, among other things, make good faith early intervention efforts to notify delinquent borrowers of loss mitigation options, to implement specified loss mitigation procedures, and if feasible, exhaust all loss mitigation options before proceeding to foreclosure. Proposed updates to further refine these rules have been published and will likely lead to further changes in requirements applicable to servicing mortgage loans.\nIn addition to NewRez LLC d/b/a Shellpoint Mortgage Servicing, we engage third-party servicers to subservice mortgage loans relating to any MSRs we acquire. It is therefore possible that a third-party servicer’s failure to comply with the new and evolving servicing protocols could adversely affect the value of the MSRs we acquire. Additionally, we may become subject to fines, penalties or civil liability based upon the conduct of any third-party servicer who services mortgage loans related to MSRs that we have acquired or will acquire in the future.\nInvestments in MSRs may expose us to additional risks.\nWe hold investments in MSRs. Our investments in MSRs may subject us to certain additional risks, including the following:\n| • | We have limited experience acquiring MSRs and operating a servicer. Although ownership of MSRs and the operation of a servicer includes many of the same risks as our other target assets and business activities, including risks related to prepayments, borrower credit, defaults, interest rates, hedging, and regulatory changes, there can be no assurance that we will be able to successfully operate a servicer subsidiary and integrate MSR investments into our business operations. |\n\n| • | As of today, we rely on subservicers to subservice the mortgage loans underlying our MSRs on our behalf. We are generally responsible under the applicable Servicing Guidelines for any subservicer’s non-compliance with any such applicable Servicing Guideline. In addition, there is a risk that our current subservicers will be unwilling or unable to continue subservicing on our behalf on terms favorable to us in the future. In such a situation, we may be unable to locate a replacement subservicer on favorable terms. |\n\n| • | NRM’s existing approvals from government-related entities or federal agencies are subject to compliance with their respective servicing guidelines, minimum capital requirements, reporting requirements and other conditions that they may impose from time to time at their discretion. Failure to satisfy such guidelines or conditions could result in the unilateral termination of NRM’s existing approvals or pending applications by one or more entities or agencies. |\n\n| • | NRM is presently licensed or otherwise eligible to hold MSRs in all states within the United States and the District of Columbia. Such state licenses may be suspended or revoked by a state regulatory authority, and we may as a result lose the ability to own MSRs under the regulatory jurisdiction of such state regulatory authority. |\n\n| • | Changes in minimum servicing compensation for Agency loans could occur at any time and could negatively impact the value of the income derived from any MSRs that we hold or may acquire in the future. |\n\n| • | Investments in MSRs are highly illiquid and subject to numerous restrictions on transfer and, as a result, there is risk that we would be unable to locate a willing buyer or get approval to sell any MSRs in the future should we desire to do so. |\n\nOur business, results of operations, financial condition and reputation could be adversely impacted if we are not able to successfully manage these or other risks related to investing and managing MSR investments.\nRisks Related to Our Manager\nWe are dependent on our Manager and may not find a suitable replacement if our Manager terminates the Management Agreement.\nNone of our officers or other senior individuals who perform services for us (other than three part-time employees of NRM), is an employee of New Residential. Instead, these individuals are employees of our Manager. Accordingly, we are completely reliant on our Manager, which has significant discretion as to the implementation of our operating policies and strategies, to conduct our business. We are subject to the risk that our Manager will terminate the Management Agreement and that we will not be able to find a suitable replacement for our Manager in a timely manner, at a reasonable cost or at all. Furthermore, we are dependent on\n136\nthe services of certain key employees of our Manager whose compensation is partially or entirely dependent upon the amount of incentive or management compensation earned by our Manager and whose continued service is not guaranteed, and the loss of such services could adversely affect our operations.\nOn December 27, 2017, SoftBank announced that it completed the SoftBank Merger. In connection with the SoftBank Merger, Fortress operates within SoftBank as an independent business headquartered in New York. There can be no assurance that the SoftBank Merger will not have an impact on us or our relationship with the Manager.\nThere are conflicts of interest in our relationship with our Manager.\nOur Management Agreement with our Manager was not negotiated between unaffiliated parties, and its terms, including fees payable, although approved by the independent directors of New Residential as fair, may not be as favorable to us as if they had been negotiated with an unaffiliated third party.\nThere are conflicts of interest inherent in our relationship with our Manager insofar as our Manager and its affiliates—including investment funds, private investment funds, or businesses managed by our Manager invest in real estate and other securities and loans, consumer loans and interests in MSRs and whose investment objectives overlap with our investment objectives. Certain investments appropriate for us may also be appropriate for one or more of these other investment vehicles. Certain members of our board of directors and employees of our Manager who are our officers also serve as officers and/or directors of these other entities. Although we have the same Manager, we may compete with entities affiliated with our Manager or Fortress for certain target assets. From time to time, affiliates of Fortress focus on investments in assets with a similar profile as our target assets that we may seek to acquire. These affiliates may have meaningful purchasing capacity, which may change over time depending upon a variety of factors, including, but not limited to, available equity capital and debt financing, market conditions and cash on hand. Fortress has two funds primarily focused on investing in Excess MSRs with approximately $0.6 billion in investments in aggregate. We have broad investment guidelines, and we have co-invested and may co-invest with Fortress funds or portfolio companies of private equity funds managed by our Manager (or an affiliate thereof) in a variety of investments. We also may invest in securities that are senior or junior to securities owned by funds managed by our Manager. Fortress funds generally have a fee structure similar to ours, but the fees actually paid will vary depending on the size, terms and performance of each fund.\nOur Management Agreement with our Manager generally does not limit or restrict our Manager or its affiliates from engaging in any business or managing other pooled investment vehicles that invest in investments that meet our investment objectives. Our Manager intends to engage in additional real estate related management and real estate and other investment opportunities in the future, which may compete with us for investments or result in a change in our current investment strategy. In addition, our certificate of incorporation provides that if Fortress or an affiliate or any of their officers, directors or employees acquire knowledge of a potential transaction that could be a corporate opportunity, they have no duty, to the fullest extent permitted by law, to offer such corporate opportunity to us, our stockholders or our affiliates. In the event that any of our directors and officers who is also a director, officer or employee of Fortress or its affiliates acquires knowledge of a corporate opportunity or is offered a corporate opportunity, provided that this knowledge was not acquired solely in such person’s capacity as a director or officer of New Residential and such person acts in good faith, then to the fullest extent permitted by law such person is deemed to have fully satisfied such person’s fiduciary duties owed to us and is not liable to us if Fortress or its affiliates pursues or acquires the corporate opportunity or if such person did not present the corporate opportunity to us.\nThe ability of our Manager and its officers and employees to engage in other business activities, subject to the terms of our Management Agreement with our Manager, may reduce the amount of time our Manager, its officers or other employees spend managing us. In addition, we may engage (subject to our investment guidelines) in material transactions with our Manager or another entity managed by our Manager or one of its affiliates, which may include, but are not limited to, certain financing arrangements, purchases of debt, co-investments in interests in MSRs, consumer loans, and other assets that present an actual, potential or perceived conflict of interest. It is possible that actual, potential or perceived conflicts could give rise to investor dissatisfaction, litigation or regulatory enforcement actions. Appropriately dealing with conflicts of interest is complex and difficult, and our reputation could be damaged if we fail, or appear to fail, to deal appropriately with one or more potential, actual or perceived conflicts of interest. Regulatory scrutiny of, or litigation in connection with, conflicts of interest could have a material adverse effect on our reputation, which could materially adversely affect our business in a number of ways, including causing an inability to raise additional funds, a reluctance of counterparties to do business with us, a decrease in the prices of our equity securities and a resulting increased risk of litigation and regulatory enforcement actions.\nThe management compensation structure that we have agreed to with our Manager, as well as compensation arrangements that we may enter into with our Manager in the future (in connection with new lines of business or other activities), may incentivize our Manager to invest in high risk investments. In addition to its management fee, our Manager is currently entitled to receive incentive compensation. In evaluating investments and other management strategies, the opportunity to earn incentive\n137\ncompensation may lead our Manager to place undue emphasis on the maximization of earnings, including through the use of leverage, at the expense of other criteria, such as preservation of capital, in order to achieve higher incentive compensation. Investments with higher yield potential are generally riskier or more speculative than lower-yielding investments. Moreover, because our Manager receives compensation in the form of options in connection with the completion of our common equity offerings, our Manager may be incentivized to cause us to issue additional common stock, which could be dilutive to existing stockholders. In addition, our Manager’s management fee is not tied to our performance and may not sufficiently incentivize our Manager to generate attractive risk-adjusted returns for us.\nIt would be difficult and costly to terminate our Management Agreement with our Manager.\nIt would be difficult and costly for us to terminate our Management Agreement with our Manager. The Management Agreement may only be terminated annually upon (i) the affirmative vote of at least two-thirds of our independent directors, or by a vote of the holders of a simple majority of the outstanding shares of our common stock, that there has been unsatisfactory performance by our Manager that is materially detrimental to us or (ii) a determination by a simple majority of our independent directors that the management fee payable to our Manager is not fair, subject to our Manager’s right to prevent such a termination by accepting a mutually acceptable reduction of fees. Our Manager will be provided 60 days’ prior notice of any termination and will be paid a termination fee equal to the amount of the management fee earned by the Manager during the 12-month period preceding such termination. In addition, following any termination of the Management Agreement, our Manager may require us to purchase its right to receive incentive compensation at a price determined as if our assets were sold for their fair market value (as determined by an appraisal, taking into account, among other things, the expected future performance of the underlying investments) or otherwise we may continue to pay the incentive compensation to our Manager. These provisions may increase the effective cost to us of terminating the Management Agreement, thereby adversely affecting our ability to terminate our Manager without cause.\nOur directors have approved broad investment guidelines for our Manager and do not approve each investment decision made by our Manager. In addition, we may change our investment strategy without a stockholder vote, which may result in our making investments that are different, riskier or less profitable than our current investments.\nOur Manager is authorized to follow broad investment guidelines. Consequently, our Manager has great latitude in determining the types and categories of assets it may decide are proper investments for us, including the latitude to invest in types and categories of assets that may differ from those in which we currently invest. Our directors will periodically review our investment guidelines and our investment portfolio. However, our board does not review or pre-approve each proposed investment or our related financing arrangements. In addition, in conducting periodic reviews, the directors rely primarily on information provided to them by our Manager. Furthermore, transactions entered into by our Manager may be difficult or impossible to unwind by the time they are reviewed by the directors, even if the transactions contravene the terms of the Management Agreement. In addition, we may change our investment strategy, including our target asset classes, without a stockholder vote.\nOur investment strategy may evolve in light of existing market conditions and investment opportunities, and this evolution may involve additional risks depending upon the nature of the assets in which we invest and our ability to finance such assets on a short or long-term basis. Investment opportunities that present unattractive risk-return profiles relative to other available investment opportunities under particular market conditions may become relatively attractive under changed market conditions, and changes in market conditions may therefore result in changes in the investments we target. Decisions to make investments in new asset categories present risks that may be difficult for us to adequately assess and could therefore reduce our ability to pay dividends on our common stock or have adverse effects on our liquidity, results of operations or financial condition. A change in our investment strategy may also increase our exposure to interest rate, foreign currency, real estate market or credit market fluctuations and expose us to new legal and regulatory risks. In addition, a change in our investment strategy may increase our use of non-match-funded financing, increase the guarantee obligations we agree to incur or increase the number of transactions we enter into with affiliates. Our failure to accurately assess the risks inherent in new asset categories or the financing risks associated with such assets could adversely affect our results of operations, liquidity and financial condition.\nOur Manager will not be liable to us for any acts or omissions performed in accordance with the Management Agreement, including with respect to the performance of our investments.\nPursuant to our Management Agreement, our Manager will not assume any responsibility other than to render the services called for thereunder in good faith and will not be responsible for any action of our board of directors in following or declining to follow its advice or recommendations. Our Manager, its members, managers, officers and employees will not be liable to us or any of our subsidiaries, to our board of directors, or our or any subsidiary’s stockholders or partners for any acts or omissions by our Manager, its members, managers, officers or employees, except by reason of acts constituting bad faith, willful misconduct, gross negligence or reckless disregard of our Manager’s duties under our Management Agreement. We shall, to the full extent lawful, reimburse, indemnify and hold our Manager, its members, managers, officers and employees and each other person, if any,\n138\ncontrolling our Manager harmless of and from any and all expenses, losses, damages, liabilities, demands, charges and claims of any nature whatsoever (including attorneys’ fees) in respect of or arising from any acts or omissions of an indemnified party made in good faith in the performance of our Manager’s duties under our Management Agreement and not constituting such indemnified party’s bad faith, willful misconduct, gross negligence or reckless disregard of our Manager’s duties under our Management Agreement.\nOur Manager’s due diligence of investment opportunities or other transactions may not identify all pertinent risks, which could materially affect our business, financial condition, liquidity and results of operations.\nOur Manager intends to conduct due diligence with respect to each investment opportunity or other transaction it pursues. It is possible, however, that our Manager’s due diligence processes will not uncover all relevant facts, particularly with respect to any assets we acquire from third parties. In these cases, our Manager may be given limited access to information about the investment and will rely on information provided by the target of the investment. In addition, if investment opportunities are scarce, the process for selecting bidders is competitive, or the timeframe in which we are required to complete diligence is short, our ability to conduct a due diligence investigation may be limited, and we would be required to make investment decisions based upon a less thorough diligence process than would otherwise be the case. Accordingly, investments and other transactions that initially appear to be viable may prove not to be over time, due to the limitations of the due diligence process or other factors.\nThe ownership by our executive officers and directors of shares of common stock, options, or other equity awards of entities either owned by Fortress funds managed by affiliates of our Manager or managed by our Manager may create, or may create the appearance of, conflicts of interest.\nSome of our directors, officers and other employees of our Manager hold positions with entities either owned by Fortress funds managed by affiliates of our Manager or managed by our Manager and own such entities’ common stock, options to purchase such entities’ common stock or other equity awards. Such ownership may create, or may create the appearance of, conflicts of interest when these directors, officers and other employees are faced with decisions that could have different implications for such entities than they do for us.\nRisks Related to the Financial Markets\nThe impact of legislative and regulatory changes on our business, as well as the market and industry in which we operate, are uncertain and may adversely affect our business.\nThe Dodd-Frank Act was enacted in July 2010, which affects almost every aspect of the U.S. financial services industry, including certain aspects of the markets in which we operate, and imposes new regulations on us and how we conduct our business. As we describe in more detail below, it affects our business in many ways but it is difficult at this time to know exactly how or what the cumulative impact will be.\nGenerally, the Dodd-Frank Act strengthens the regulatory oversight of securities and capital markets activities by the SEC and established the CFPB to enforce laws and regulations for consumer financial products and services. It requires market participants to undertake additional record-keeping activities and imposes many additional disclosure requirements for public companies.\nMoreover, the Dodd-Frank Act contains a risk retention requirement for all asset-backed securities, which we issue. In October 2014, final rules were promulgated by a consortium of regulators implementing the final credit risk retention requirements of Section 941(b) of the Dodd-Frank Act. Under these “Risk Retention Rules,” sponsors of both public and private securitization transactions or one of their majority owned affiliates are required to retain at least 5% of the credit risk of the assets collateralizing such securitization transactions. These regulations generally prohibit the sponsor or its affiliate from directly or indirectly hedging or otherwise selling or transferring the retained interest for a specified period of time, depending on the type of asset that is securitized. Certain limited exemptions from these rules are available for certain types of assets, which may be of limited use under our current market practices. In any event, compliance with these new Risk Retention Rules has increased and will likely continue to increase the administrative and operational costs of asset securitization.\nFurther, the Dodd-Frank Act imposes mandatory clearing and exchange-trading requirements on many derivatives transactions (including formerly unregulated over-the-counter derivatives) in which we may engage. In addition, the Dodd-Frank Act is expected to increase the margin requirements for derivatives transactions that are not subject to mandatory clearing requirements, which may impact our activities. The Dodd-Frank Act also creates new categories of regulated market participants, such as “swap-dealers,” “security-based swap dealers,” “major swap participants” and “major security-based swap participants,” and subjects or may subject these regulated entities to significant new capital, registration, recordkeeping, reporting, disclosure, business conduct and other regulatory requirements that will give rise to new administrative costs.\n139\nAlso, under the Dodd-Frank Act, financial regulators belonging to the Financial Stability Oversight Council are authorized to designate nonbank financial institutions and financial activities as systemically important to the economy and therefore subject to closer regulatory supervision. Such systemically important financial institutions, or “SIFIs,” may be required to operate with greater safety margins, such as higher levels of capital, and may face further limitations on their activities. The determination of what constitutes a SIFI is evolving, and in time SIFIs may include large investment funds and even asset managers. There can be no assurance that we will not be deemed to be a SIFI or engage in activities later determined to be systemically important and thus subject to further regulation.\nEven new requirements that are not directly applicable to us may still increase our costs of entering into transactions with the parties to whom the requirements are directly applicable. For instance, if the exchange-trading and trade reporting requirements lead to reductions in the liquidity of derivative transactions we may experience higher pricing or reduced availability of derivatives, or the reduction of arbitrage opportunities for us, which could adversely affect the performance of certain of our trading strategies. Importantly, many key aspects of the changes imposed by the Dodd-Frank Act will continue to be established by various regulatory bodies and other groups over the next several years.\nIn addition, there is significant uncertainty regarding the legislative and regulatory outlook for the Dodd-Frank Act and related statutes governing financial services, which may include Dodd-Frank Act amendments, mortgage finance and housing policy in the U.S., and the future structure and responsibilities of regulatory agencies such as the CFPB and the FHFA. For example, in March 2018, the U.S. Senate approved banking reform legislation intended to ease some of the restrictions imposed by the Dodd-Frank Act. Due to this uncertainty, it is not possible for us to predict how future legislative or regulatory proposals by Congress and the Administration will affect us or the market and industry in which we operate, and there can be no assurance that the resulting changes will not have an adverse impact on our business, results of operations, or financial condition. It is possible that such regulatory changes could, among other things, increase our costs of operating as a public company, impose restrictions on our ability to securitize assets and reduce our investment returns on securitized assets.\nThe federal conservatorship of Fannie Mae and Freddie Mac and related efforts, along with any changes in laws and regulations affecting the relationship between these agencies and the U.S. government, may adversely affect our business.\nThe payments we receive on the Agency RMBS in which we invest depend upon a steady stream of payments by borrowers on the underlying mortgages and the fulfillment of guarantees by GSEs. Ginnie Mae is part of a U.S. Government agency and its guarantees are backed by the full faith and credit of the U.S. Fannie Mae and Freddie Mac are GSEs, but their guarantees are not backed by the full faith and credit of the U.S. Government.\nIn response to the deteriorating financial condition of Fannie Mae and Freddie Mac and the credit market disruption beginning in 2007, Congress and the U.S. Treasury undertook a series of actions to stabilize these GSEs and the financial markets, generally. The Housing and Economic Recovery Act of 2008 was signed into law on July 30, 2008, and established the FHFA, with enhanced regulatory authority over, among other things, the business activities of Fannie Mae and Freddie Mac and the size of their portfolio holdings. On September 7, 2008, FHFA placed Fannie Mae and Freddie Mac into federal conservatorship and, together with the U.S. Treasury, established a program designed to boost investor confidence in Fannie Mae’s and Freddie Mac’s debt and Agency RMBS.\nAs the conservator of Fannie Mae and Freddie Mac, the FHFA controls and directs the operations of Fannie Mae and Freddie Mac and may (1) take over the assets of and operate Fannie Mae and Freddie Mac with all the powers of the stockholders, the directors and the officers of Fannie Mae and Freddie Mac and conduct all business of Fannie Mae and Freddie Mac; (2) collect all obligations and money due to Fannie Mae and Freddie Mac; (3) perform all functions of Fannie Mae and Freddie Mac which are consistent with the conservator’s appointment; (4) preserve and conserve the assets and property of Fannie Mae and Freddie Mac; and (5) contract for assistance in fulfilling any function, activity, action or duty of the conservator.\nThose efforts resulted in significant U.S. Government financial support and increased control of the GSEs.\nThe U.S. Federal Reserve (the “Fed”) announced in November 2008 a program of large-scale purchases of Agency RMBS in an attempt to lower longer-term interest rates and contribute to an overall easing of adverse financial conditions. Subject to specified investment guidelines, the portfolios of Agency RMBS purchased through the programs established by the U.S. Treasury and the Fed may be held to maturity and, based on mortgage market conditions, adjustments may be made to these portfolios. This flexibility may adversely affect the pricing and availability of Agency RMBS that we seek to acquire during the remaining term of these portfolios.\n140\nThere can be no assurance that the U.S. Government’s intervention in Fannie Mae and Freddie Mac will be adequate for the longer-term viability of these GSEs. These uncertainties lead to questions about the availability of and trading market for, Agency RMBS. Accordingly, if these government actions are inadequate and the GSEs defaulted on their guaranteed obligations, suffered losses or ceased to exist, the value of our Agency RMBS and our business, operations and financial condition could be materially and adversely affected.\nAdditionally, because of the financial problems faced by Fannie Mae and Freddie Mac that led to their federal conservatorships, the Administration and Congress have been examining reform of the GSEs, including the value of a federal mortgage guarantee and the appropriate role for the U.S. government in providing liquidity for residential mortgage loans. The respective chairmen of the Congressional committees of jurisdiction, as well as the Secretary of the Treasury, has each stated that GSE reform, including a possible wind down of the GSEs, is a priority. However, the final details of any plans, policies or proposals with respect to the housing GSEs are unknown at this time. Other bills have been introduced that change the GSEs’ business charters and eliminate the entities or make other changes to the existing framework. We cannot predict whether or when such legislation may be enacted. If enacted, such legislation could materially and adversely affect the availability of, and trading market for, Agency RMBS and could, therefore, materially and adversely affect the value of our Agency RMBS and our business, operations and financial condition.\nLegislation that permits modifications to the terms of outstanding loans may negatively affect our business, financial condition, liquidity and results of operations.\nThe U.S. government has enacted legislation that enables government agencies to modify the terms of a significant number of residential and other loans to provide relief to borrowers without the applicable investor’s consent. These modifications allow for outstanding principal to be deferred, interest rates to be reduced, the term of the loan to be extended or other terms to be changed in ways that can permanently eliminate the cash flow (principal and interest) associated with a portion of the loan. These modifications are currently reducing, or in the future may reduce, the value of a number of our current or future investments, including investments in mortgage backed securities and interests in MSRs. As a result, such loan modifications are negatively affecting our business, results of operations, liquidity and financial condition. In addition, certain market participants propose reducing the amount of paperwork required by a borrower to modify a loan, which could increase the likelihood of fraudulent modifications and materially harm the U.S. mortgage market and investors that have exposure to this market. Additional legislation intended to provide relief to borrowers may be enacted and could further harm our business, results of operations and financial condition.\nRisks Related to Our Taxation as a REIT\nQualifying as a REIT involves highly technical and complex provisions of the Internal Revenue Code.\nQualification as a REIT involves the application of highly technical and complex Internal Revenue Code provisions for which only limited judicial and administrative authorities exist. Even a technical or inadvertent violation could jeopardize our REIT qualification. Our qualification as a REIT will depend on our satisfaction of certain asset, income, organizational, distribution, stockholder ownership and other requirements on a continuing basis. Compliance with these requirements must be carefully monitored on a continuing basis. Monitoring and managing our REIT compliance has become challenging due to the increased size and complexity of the assets in our portfolio, a meaningful portion of which are not qualifying REIT assets. There can be no assurance that our Manager’s personnel responsible for doing so will be able to successfully monitor our compliance or maintain our REIT status.\nOur failure to qualify as a REIT would result in higher taxes and reduced cash available for distribution to our stockholders.\nWe intend to operate in a manner intended to qualify us as a REIT for U.S. federal income tax purposes. Our ability to satisfy the asset tests depends upon our analysis of the fair market values of our assets, some of which are not susceptible to a precise determination, and for which we do not obtain independent appraisals. See “—Risks Related to our Business—The valuations of our assets are subject to uncertainty because most of our assets are not traded in an active market,” and “—Risks Related to Our Business—Rapid changes in the values of our assets may make it more difficult for us to maintain our qualification as a REIT or our exclusion from the 1940 Act.” Our compliance with the REIT income and quarterly asset requirements also depends upon our ability to successfully manage the composition of our income and assets on an ongoing basis. Moreover, the proper classification of one or more of our investments (such as TBAs) may be uncertain in some circumstances, which could affect the application of the REIT qualification requirements. Accordingly, there can be no assurance that the U.S. Internal Revenue Service (“IRS”) will not contend that our investments violate the REIT requirements.\nIf we were to fail to qualify as a REIT in any taxable year, we would be subject to U.S. federal income tax, including any applicable alternative minimum tax, on our taxable income at regular corporate rates, and distributions to stockholders would not be deductible\n141\nby us in computing our taxable income. Any such corporate tax liability could be substantial and would reduce the amount of cash available for distribution to our stockholders, which in turn could have an adverse impact on the value of, and market price for, our stock. See also “—Our failure to qualify as a REIT would cause our stock to be delisted from the NYSE.”\nUnless entitled to relief under certain provisions of the Internal Revenue Code, we also would be disqualified from taxation as a REIT for the four taxable years following the year during which we initially ceased to qualify as a REIT. The rule against re-electing REIT status following a loss of such status would also apply to us if Drive Shack failed to qualify as a REIT for any taxable year ended on or before December 31, 2014, and we were treated as a successor to Drive Shack for U.S. federal income tax purposes. Although Drive Shack (i) represented in the separation and distribution agreement that it entered into with us on April 26, 2013 (the “Separation and Distribution Agreement”) that it has no knowledge of any fact or circumstance that would cause us to fail to qualify as a REIT and (ii) covenanted in the Separation and Distribution Agreement to use its reasonable best efforts to maintain its REIT status for each of Drive Shack’s taxable years ended on or before December 31, 2014 (unless Drive Shack obtains an opinion from a nationally recognized tax counsel or a private letter ruling from the IRS to the effect that Drive Shack’s failure to maintain its REIT status will not cause us to fail to qualify as a REIT under the successor REIT rule referred to above), no assurance can be given that such representation and covenant would prevent us from failing to qualify as a REIT. Although, in the event of a breach, we may be able to seek damages from Drive Shack, there can be no assurance that such damages, if any, would appropriately compensate us. In addition, if Drive Shack were to fail to qualify as a REIT despite its reasonable best efforts, we would have no claim against Drive Shack.\nOur failure to qualify as a REIT would cause our stock to be delisted from the NYSE.\nThe NYSE requires, as a condition to the listing of our shares, that we maintain our REIT status. Consequently, if we fail to maintain our REIT status, our shares would promptly be delisted from the NYSE, which would decrease the trading activity of such shares. This could make it difficult to sell shares and would likely cause the market volume of the shares trading to decline.\nIf we were delisted as a result of losing our REIT status and desired to relist our shares on the NYSE, we would have to reapply to the NYSE to be listed as a domestic corporation. As the NYSE’s listing standards for REITs are less onerous than its standards for domestic corporations, it would be more difficult for us to become a listed company under these heightened standards. We might not be able to satisfy the NYSE’s listing standards for a domestic corporation. As a result, if we were delisted from the NYSE, we might not be able to relist as a domestic corporation, in which case our shares could not trade on the NYSE.\nThe failure of assets subject to repurchase agreements to qualify as real estate assets could adversely affect our ability to qualify as a REIT.\nWe enter into financing arrangements that are structured as sale and repurchase agreements pursuant to which we nominally sell certain of our assets to a counterparty and simultaneously enter into an agreement to repurchase these assets at a later date in exchange for a purchase price. Economically, these agreements are financings that are secured by the assets sold pursuant thereto. We believe that, for purposes of the REIT asset and income tests, we should be treated as the owner of the assets that are the subject of any such sale and repurchase agreement, notwithstanding that those agreements generally transfer record ownership of the assets to the counterparty during the term of the agreement. It is possible, however, that the IRS could assert that we did not own the assets during the term of the sale and repurchase agreement, in which case we might fail to qualify as a REIT.\nThe failure of our Excess MSRs to qualify as real estate assets or the income from our Excess MSRs to qualify as mortgage interest could adversely affect our ability to qualify as a REIT.\nWe have received from the IRS a private letter ruling substantially to the effect that our Excess MSRs represent interests in mortgages on real property and thus are qualifying “real estate assets” for purposes of the REIT asset test, which generate income that qualifies as interest on obligations secured by mortgages on real property for purposes of the REIT income test. The ruling is based on, among other things, certain assumptions as well as on the accuracy of certain factual representations and statements that we and Drive Shack have made to the IRS. If any of the representations or statements that we have made in connection with the private letter ruling, are, or become, inaccurate or incomplete in any material respect with respect to one or more Excess MSR investments, or if we acquire an Excess MSR investment with terms that are not consistent with the terms of the Excess MSR investments described in the private letter ruling, then we will not be able to rely on the private letter ruling. If we are unable to rely on the private letter ruling with respect to an Excess MSR investment, the IRS could assert that such Excess MSR investments do not qualify under the REIT asset and income tests, and if successful, we might fail to qualify as a REIT.\n142\nDividends payable by REITs do not qualify for the reduced tax rates available for some “qualified dividends.”\nDividends payable to domestic stockholders that are individuals, trusts, and estates are generally taxed at reduced tax rates applicable to “qualified dividends.” Dividends payable by REITs, however, generally are not eligible for those reduced rates. The more favorable rates applicable to regular corporate dividends could cause investors who are individuals, trusts and estates to perceive investments in REITs to be relatively less attractive than investments in the stocks of non-REIT corporations that pay dividends, which could adversely affect the value of the stock of REITs, including our common stock. In addition, the relative attractiveness of real estate in general may be adversely affected by the favorable tax treatment given to non-REIT corporate dividends, which could affect the value of our real estate assets negatively.\nREIT distribution requirements could adversely affect our liquidity and our ability to execute our business plan.\nWe generally must distribute annually at least 90% of our REIT taxable income, excluding any net capital gain, in order for corporate income tax not to apply to earnings that we distribute. We intend to make distributions to our stockholders to comply with the REIT requirements of the Internal Revenue Code. However, differences in timing between the recognition of taxable income and the actual receipt of cash could require us to sell assets or borrow funds on a short-term or long-term basis to meet the 90% distribution requirement of the Internal Revenue Code. Certain of our assets, such as our investment in consumer loans, generate substantial mismatches between taxable income and available cash. As a result, the requirement to distribute a substantial portion of our net taxable income could cause us to: (i) sell assets in adverse market conditions; (ii) borrow on unfavorable terms; (iii) distribute amounts that would otherwise be invested in future acquisitions, capital expenditures or repayment of debt; or (iv) make taxable distributions of our capital stock or debt securities in order to comply with REIT requirements. Further, amounts distributed will not be available to fund investment activities. If we fail to obtain debt or equity capital in the future, it could limit our ability to satisfy our liquidity needs, which could adversely affect the value of our common stock.\nWe may be required to report taxable income for certain investments in excess of the economic income we ultimately realize from them.\nBased on IRS guidance concerning the classification of Excess MSRs, we intend to treat our Excess MSRs as ownership interests in the interest payments made on the underlying residential mortgage loans, akin to an “interest only” strip. Under this treatment, for purposes of determining the amount and timing of taxable income, each Excess MSR is treated as a bond that was issued with original issue discount on the date we acquired such Excess MSR. In general, we will be required to accrue original issue discount based on the constant yield to maturity of each Excess MSR, and to treat such original issue discount as taxable income in accordance with the applicable U.S. federal income tax rules. The constant yield of an Excess MSR will be determined, and we will be taxed, based on a prepayment assumption regarding future payments due on the residential mortgage loans underlying the Excess MSR. If the residential mortgage loans underlying an Excess MSR prepay at a rate different than that under the prepayment assumption, our recognition of original issue discount will be either increased or decreased depending on the circumstances. Thus, in a particular taxable year, we may be required to accrue an amount of income in respect of an Excess MSR that exceeds the amount of cash collected in respect of that Excess MSR. Furthermore, it is possible that, over the life of the investment in an Excess MSR, the total amount we pay for, and accrue with respect to, the Excess MSR may exceed the total amount we collect on such Excess MSR. No assurance can be given that we will be entitled to a deduction for such excess, meaning that we may be required to recognize “phantom income” over the life of an Excess MSR.\nOther debt instruments that we may acquire, including consumer loans, may be issued with, or treated as issued with, original issue discount. Those instruments would be subject to the original issue discount accrual and income computations that are described above with regard to Excess MSRs.\nUnder the Tax Cuts and Jobs Act (“TCJA”) enacted in late 2017, we generally will be required to take certain amounts into income no later than the time such amounts are reflected on certain financial statements. The application of this rule may require the accrual of, among other categories of income, income with respect to certain debt instruments or mortgage-backed securities, such as original issue discount, earlier than would be the case under the general tax rules, although the precise application of this rule is unclear at this time.\nWe may acquire debt instruments in the secondary market for less than their face amount. The discount at which such debt instruments are acquired may reflect doubts about their ultimate collectability rather than current market interest rates. The amount of such discount will nevertheless generally be treated as “market discount” for U.S. federal income tax purposes. Accrued market discount is reported as income when, and to the extent that, any payment of principal of the debt instrument is made. If we collect less on the debt instrument than our purchase price plus the market discount we had previously reported as income, we may not be able to benefit from any offsetting loss deductions.\n143\nIn addition, we may acquire debt instruments that are subsequently modified by agreement with the borrower. If the amendments to the outstanding instrument are “significant modifications” under the applicable U.S. Treasury regulations, the modified instrument will be considered to have been reissued to us in a debt-for-debt exchange with the borrower. In that event, we may be required to recognize taxable gain to the extent the principal amount of the modified instrument exceeds our adjusted tax basis in the unmodified instrument, even if the value of the instrument or the payment expectations have not changed. Following such a taxable modification, we would hold the modified loan with a cost basis equal to its principal amount for U.S. federal tax purposes.\nFinally, in the event that any debt instruments acquired by us are delinquent as to mandatory principal and interest payments, or in the event payments with respect to a particular instrument are not made when due, we may nonetheless be required to continue to recognize the unpaid interest as taxable income as it accrues, despite doubt as to its ultimate collectability. Similarly, we may be required to accrue interest income with respect to debt instruments at the stated rate regardless of whether corresponding cash payments are received or are ultimately collectible. In each case, while we would in general ultimately have an offsetting loss deduction available to us when such interest was determined to be uncollectible, the utility of that deduction could depend on our having taxable income of an appropriate character in that later year or thereafter.\nIn any event, if our investments generate more taxable income than cash in any given year, we may have difficulty satisfying our annual REIT distribution requirement.\nWe may be unable to generate sufficient cash from operations to pay our operating expenses and to pay distributions to our stockholders.\nAs a REIT, we are generally required to distribute at least 90% of our REIT taxable income (determined without regard to the dividends paid deduction and not including net capital gains) each year to our stockholders. To qualify for the tax benefits accorded to REITs, we intend to make distributions to our stockholders in amounts such that we distribute all or substantially all of our net taxable income, subject to certain adjustments, although there can be no assurance that our operations will generate sufficient cash to make such distributions. Moreover, our ability to make distributions may be adversely affected by the risk factors described herein. See also “—Risks Related to our Stock—We have not established a minimum distribution payment level, and we cannot assure you of our ability to pay distributions in the future.”\nThe stock ownership limit imposed by the Internal Revenue Code for REITs and our certificate of incorporation may inhibit market activity in our stock and restrict our business combination opportunities.\nIn order for us to maintain our qualification as a REIT under the Internal Revenue Code, not more than 50% in value of our outstanding stock may be owned, directly or indirectly, by five or fewer individuals (as defined in the Internal Revenue Code to include certain entities) at any time during the last half of each taxable year after our first taxable year. Our certificate of incorporation, with certain exceptions, authorizes our board of directors to take the actions that are necessary and desirable to preserve our qualification as a REIT. Stockholders are generally restricted from owning more than 9.8% by value or number of shares, whichever is more restrictive, of our outstanding shares of common stock, or 9.8% by value or number of shares, whichever is more restrictive, of our outstanding shares of capital stock. Our board may grant an exemption in its sole discretion, subject to such conditions, representations and undertakings as it may determine in its sole discretion. These ownership limits could delay or prevent a transaction or a change in our control that might involve a premium price for our common stock or otherwise be in the best interest of our stockholders.\nEven if we remain qualified as a REIT, we may face other tax liabilities that reduce our cash flow.\nEven if we remain qualified for taxation as a REIT, we may be subject to certain federal, state and local taxes on our income and assets, including taxes on any undistributed income, tax on income from some activities conducted as a result of a foreclosure, and state or local income, property and transfer taxes. Moreover, if a REIT distributes less than 85% of its ordinary income and 95% of its capital gain net income plus any undistributed shortfall from the prior year (the “Required Distribution”) to its stockholders during any calendar year (including any distributions declared by the last day of the calendar year but paid in the subsequent year), then it is required to pay an excise tax on 4% of any shortfall between the Required Distribution and the amount that was actually distributed. Any of these taxes would decrease cash available for distribution to our stockholders. In addition, in order to meet the REIT qualification requirements, or to avert the imposition of a 100% tax that applies to certain gains derived by a REIT from dealer property or inventory, we may hold some of our assets through TRSs. Such subsidiaries generally will be subject to corporate level income tax at regular rates and the payment of such taxes would reduce our return on the applicable investment. Currently, we hold some of our investments in TRSs, including Servicer Advance Investments and MSRs, and we may contribute other non-qualifying investments, such as our investment in consumer loans, to a TRS in the future.\n144\nComplying with the REIT requirements may negatively impact our investment returns or cause us to forgo otherwise attractive opportunities, liquidate assets or contribute assets to a TRS.\nTo qualify as a REIT for U.S. federal income tax purposes, we must continually satisfy tests concerning, among other things, the sources of our income, the nature and diversification of our assets, the amounts we distribute to our stockholders and the ownership of our stock. As a result of these tests, we may be required to make distributions to stockholders at disadvantageous times or when we do not have funds readily available for distribution, forgo otherwise attractive investment opportunities, liquidate assets in adverse market conditions or contribute assets to a TRS that is subject to regular corporate federal income tax. Our ability to acquire and hold MSRs, interests in consumer loans, Servicer Advance Investments and other investments is subject to the applicable REIT qualification tests, and we may have to hold these interests through TRSs, which would negatively impact our returns from these assets. In general, compliance with the REIT requirements may hinder our ability to make and retain certain attractive investments.\nComplying with the REIT requirements may limit our ability to hedge effectively.\nThe existing REIT provisions of the Internal Revenue Code may substantially limit our ability to hedge our operations because a significant amount of the income from those hedging transactions is likely to be treated as non-qualifying income for purposes of both REIT gross income tests. In addition, we must limit our aggregate income from non-qualified hedging transactions, from our provision of services and from other non-qualifying sources, to less than 5% of our annual gross income (determined without regard to gross income from qualified hedging transactions).\nAs a result, we may have to limit our use of certain hedging techniques or implement those hedges through TRSs. This could result in greater risks associated with changes in interest rates than we would otherwise want to incur or could increase the cost of our hedging activities. If we fail to comply with these limitations, we could lose our REIT qualification for U.S. federal income tax purposes, unless our failure was due to reasonable cause, and not due to willful neglect, and we meet certain other technical requirements. Even if our failure were due to reasonable cause, we might incur a penalty tax. See also “—Risks Related to Our Business—Any hedging transactions that we enter into may limit our gains or result in losses.”\nDistributions to tax-exempt investors may be classified as unrelated business taxable income.\nNeither ordinary nor capital gain distributions with respect to our stock nor gain from the sale of stock should generally constitute unrelated business taxable income to a tax-exempt investor. However, there are certain exceptions to this rule. In particular:\n\n| • | part of the income and gain recognized by certain qualified employee pension trusts with respect to our stock may be treated as unrelated business taxable income if shares of our stock are predominantly held by qualified employee pension trusts, and we are required to rely on a special look-through rule for purposes of meeting one of the REIT ownership tests, and we are not operated in a manner to avoid treatment of such income or gain as unrelated business taxable income; |\n\n| • | part of the income and gain recognized by a tax-exempt investor with respect to our stock would constitute unrelated business taxable income if the investor incurs debt in order to acquire the stock; and |\n\n| • | to the extent that we are (or a part of us, or a disregarded subsidiary of ours, is) a “taxable mortgage pool,” or if we hold residual interests in a real estate mortgage investment conduit (“REMIC”), a portion of the distributions paid to a tax exempt stockholder that is allocable to excess inclusion income may be treated as unrelated business taxable income. |\n\nThe “taxable mortgage pool” rules may increase the taxes that we or our stockholders may incur, and may limit the manner in which we effect future securitizations.\nWe may enter into securitization or other financing transactions that result in the creation of taxable mortgage pools for U.S. federal income tax purposes. As a REIT, so long as we own 100% of the equity interests in a taxable mortgage pool, we would generally not be adversely affected by the characterization of a securitization as a taxable mortgage pool. Certain categories of stockholders, however, such as foreign stockholders eligible for treaty or other benefits, stockholders with net operating losses, and certain tax exempt stockholders that are subject to unrelated business income tax, could be subject to increased taxes on a portion of their dividend income from us that is attributable to the taxable mortgage pool. In addition, to the extent that our stock is owned by tax exempt “disqualified organizations,” such as certain government-related entities and charitable remainder trusts that are not subject to tax on unrelated business income, we could incur a corporate level tax on a portion of our income from the taxable mortgage pool. In that case, we might reduce the amount of our distributions to any disqualified organization whose stock ownership gave rise to the tax. Moreover, we may be precluded from selling equity interests in these securitizations to outside investors, or selling any debt securities issued in connection with these securitizations that might be considered to be equity interests for tax purposes. These limitations may prevent us from using certain techniques to maximize our returns from securitization transactions.\n145\nUncertainty exists with respect to the treatment of TBAs for purposes of the REIT asset and income tests, and the failure of TBAs to be qualifying assets or of income/gains from TBAs to be qualifying income could adversely affect our ability to qualify as a REIT.\nWe purchase and sell Agency RMBS through TBAs and recognize income or gains from the disposition of those TBAs, through dollar roll transactions or otherwise. In a dollar roll transaction, we exchange an existing TBA for another TBA with a different settlement date. There is no direct authority with respect to the qualification of TBAs as real estate assets or U.S. Government securities for purposes of the 75% asset test or the qualification of income or gains from dispositions of TBAs as gains from the sale of real property (including interests in real property and interests in mortgages on real property) or other qualifying income for purposes of the 75% gross income test. For a particular taxable year, we would treat such TBAs as qualifying assets for purposes of the REIT asset tests, and income and gains from such TBAs as qualifying income for purposes of the 75% gross income test, to the extent set forth in an opinion from Skadden, Arps, Slate, Meagher & Flom LLP substantially to the effect that (i) for purposes of the REIT asset tests, our ownership of a TBA should be treated as ownership of the underlying Agency RMBS, and (ii) for purposes of the 75% REIT gross income test, any gain recognized by us in connection with the settlement of such TBAs should be treated as gain from the sale or disposition of the underlying Agency RMBS. Opinions of counsel are not binding on the IRS, and no assurance can be given that the IRS would not successfully challenge the conclusions set forth in such opinions. In addition, it must be emphasized that any opinion of Skadden, Arps, Slate, Meagher & Flom LLP would be based on various assumptions relating to any TBAs that we enter into and would be conditioned upon fact-based representations and covenants made by our management regarding such TBAs. No assurance can be given that the IRS would not assert that such assets or income are not qualifying assets or income. If the IRS were to successfully challenge any conclusions of Skadden, Arps, Slate, Meagher & Flom LLP, we could be subject to a penalty tax or we could fail to qualify as a REIT if a sufficient portion of our assets consists of TBAs or a sufficient portion of our income consists of income or gains from the disposition of TBAs.\nThe tax on prohibited transactions will limit our ability to engage in transactions that would be treated as prohibited transactions for U.S. federal income tax purposes.\nNet income that we derive from a “prohibited transaction” is subject to a 100% tax. The term “prohibited transaction” generally includes a sale or other disposition of property (including mortgage loans, but other than foreclosure property, as discussed below) that is held primarily for sale to customers in the ordinary course of our trade or business. We might be subject to this tax if we were to dispose of or securitize loans or Excess MSRs in a manner that was treated as a prohibited transaction for U.S. federal income tax purposes.\nWe intend to conduct our operations so that no asset that we own (or are treated as owning) will be treated as, or as having been, held-for-sale to customers, and that a sale of any such asset will not be treated as having been in the ordinary course of our business. As a result, we may choose not to engage in certain sales of loans or Excess MSRs at the REIT level, and may limit the structures we utilize for our securitization transactions, even though the sales or structures might otherwise be beneficial to us. In addition, whether property is held “primarily for sale to customers in the ordinary course of a trade or business” depends on the particular facts and circumstances. No assurance can be given that any property that we sell will not be treated as property held-for-sale to customers, or that we can comply with certain safe-harbor provisions of the Internal Revenue Code that would prevent such treatment. The 100% prohibited transaction tax does not apply to gains from the sale of property that is held through a TRS or other taxable corporation, although such income will be subject to tax in the hands of the corporation at regular corporate rates. We intend to structure our activities to prevent prohibited transaction characterization.\nLiquidation of assets may jeopardize our REIT qualification or create additional tax liability for us.\nTo qualify as a REIT, we must comply with requirements regarding the composition of our assets and our sources of income. If we are compelled to liquidate our investments to repay obligations to our lenders, we may be unable to comply with these requirements, ultimately jeopardizing our qualification as a REIT, or we may be subject to a 100% tax on any resultant gain if we sell assets that are treated as dealer property or inventory.\nChanges to U.S. federal income tax laws could materially and adversely affect us and our stockholders.\nThe present U.S. federal income tax treatment of REITs and their shareholders may be modified, possibly with retroactive effect, by legislative, judicial or administrative action at any time, which could affect the U.S. federal income tax treatment of an investment in our shares. The U.S. federal income tax rules, including those dealing with REITs, are constantly under review by persons involved in the legislative process, the IRS and the U.S. Treasury Department, which results in statutory changes as well as frequent revisions to regulations and interpretations.\n146\nThe TCJA, which was enacted in 2017, made substantial changes to the Internal Revenue Code. Among those changes are a significant permanent reduction in the generally applicable corporate tax rate, changes in the taxation of individuals and other non-corporate taxpayers that generally but not universally reduce their taxes on a temporary basis subject to “sunset” provisions, the elimination or modification of various currently allowed deductions (including substantial limitations on the deductibility of interest and, in the case of individuals, the deduction for personal state and local taxes), certain additional limitations on the deduction of net operating losses, and preferential rates of taxation on most ordinary REIT dividends and certain business income derived by non-corporate taxpayers in comparison to other ordinary income recognized by such taxpayers. The effect of these, and the many other, changes made in the TCJA remains uncertain, both in terms of their direct effect on the taxation of an investment in our common stock and their indirect effect on the value of our assets or market conditions generally. Furthermore, many of the provisions of the TCJA still require guidance through the issuance of Treasury regulations in order to assess their effect. There may be a substantial delay before such regulations are promulgated, increasing the uncertainty as to the ultimate effect of the statutory amendments on us. There also may be technical corrections legislation proposed with respect to the TCJA, the effect of which cannot be predicted and may be adverse to us or our stockholders.\nRisks Related to our Stock\nThere can be no assurance that the market for our stock will provide you with adequate liquidity.\nOur common stock began trading on the NYSE in May 2013, and our preferred stock began trading on the NYSE in July 2019. There can be no assurance that an active trading market for our common and preferred stock will be sustained in the future, and the market price of our common and preferred stock may fluctuate widely, depending upon many factors, some of which may be beyond our control. These factors include, without limitation:\n\n| • | a shift in our investor base; |\n\n| • | our quarterly or annual earnings and cash flows, or those of other comparable companies; |\n\n| • | actual or anticipated fluctuations in our operating results; |\n\n| • | changes in accounting standards, policies, guidance, interpretations or principles; |\n\n| • | announcements by us or our competitors of significant investments, acquisitions or dispositions; |\n\n| • | the failure of securities analysts to cover our common stock; |\n\n| • | changes in earnings estimates by securities analysts or our ability to meet those estimates; |\n\n| • | market performance of affiliates and other counterparties with whom we conduct business; |\n\n| • | the operating and stock price performance of other comparable companies; |\n\n| • | our failure to qualify as a REIT, maintain our exemption under the 1940 Act or satisfy the NYSE listing requirements; |\n\n| • | negative public perception of us, our competitors or industry; |\n\n| • | overall market fluctuations; and |\n\n| • | general economic conditions. |\n\nStock markets in general have experienced volatility that has often been unrelated to the operating performance of a particular company. These broad market fluctuations may adversely affect the market price of our common and preferred stock.\nSales or issuances of shares of our common stock could adversely affect the market price of our common stock.\nSales or issuances of substantial amounts of shares of our common stock, or the perception that such sales or issuances might occur, could adversely affect the market price of our common stock. The issuance of our common stock in connection with property, portfolio or business acquisitions or the exercise of outstanding options or otherwise could also have an adverse effect on the market price of our common stock. We have an effective registration statement on file to sell common stock or convertible securities in public offerings.\nFailure to maintain effective internal control over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act of 2002 could have a material adverse effect on our business and stock price.\nAs a public company, we are required to maintain effective internal control over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act of 2002. Internal control over financial reporting is complex and may be revised over time to adapt to changes in our business, or changes in applicable accounting rules. We have made investments through joint ventures, such as our investment in consumer loans, and accounting for such investments can increase the complexity of maintaining effective internal control over financial reporting. We cannot assure you that our internal control over financial reporting will be effective in the future or that a material weakness will not be discovered with respect to a prior period for which we had previously believed that our internal control over financial reporting was effective. If we are not able to maintain or document effective internal control over financial reporting, our independent registered public accounting firm will not be able to certify as to the effectiveness of our\n147\ninternal control over financial reporting. Matters impacting our internal control over financial reporting may cause us to be unable to report our financial information on a timely basis, or may cause us to restate previously issued financial information, and thereby subject us to adverse regulatory consequences, including sanctions or investigations by the SEC, or violations of applicable stock exchange listing rules. There could also be a negative reaction in the financial markets due to a loss of investor confidence in us and the reliability of our financial statements. Confidence in the reliability of our financial statements is also likely to suffer if we or our independent registered public accounting firm reports a material weakness in the effectiveness of our internal control over financial reporting. This could materially adversely affect us by, for example, leading to a decline in our stock price and impairing our ability to raise capital.\nYour percentage ownership in us may be diluted in the future.\nYour percentage ownership in us may be diluted in the future because of equity awards that we expect will be granted to our Manager, to the directors, officers and employees of our Manager who perform services for us, and to our directors, officers and employees, as well as other equity instruments such as debt and equity financing. We have adopted a Nonqualified Stock Option and Incentive Award Plan, as amended (the “Plan”), which provides for the grant of equity-based awards, including restricted stock, options, stock appreciation rights, performance awards, tandem awards and other equity-based and non-equity based awards, in each case to our Manager, to the directors, officers, employees, service providers, consultants and advisor of our Manager who perform services for us, and to our directors, officers, employees, service providers, consultants and advisors. We reserved 15 million shares of our common stock for issuance under the Plan. The term of the Plan expires in 2023. On the first day of each fiscal year beginning during the term of the Plan, that number will be increased by a number of shares of our common stock equal to 10% of the number of shares of our common stock newly issued by us during the immediately preceding fiscal year. In connection with any offering of our common or preferred stock, we will issue to our Manager options relating to shares of our common stock, representing 10% of the number of shares being offered. Our board of directors may also determine to issue options to the Manager that are not subject to the Plan, provided that the number of shares relating to any options granted to the Manager in connection with an offering of our common stock would not exceed 10% of the shares sold in such offering and would be subject to NYSE rules.\nWe may incur or issue debt or issue equity, which may negatively affect the market price of our common stock.\nWe may in the future incur or issue debt or issue equity or equity-related securities. In the event of our liquidation, lenders and holders of our debt and holders of our preferred stock (if any) would receive a distribution of our available assets before common stockholders. Any future incurrence or issuance of debt would increase our interest cost and could adversely affect our results of operations and cash flows. We are not required to offer any additional equity securities to existing common stockholders on a preemptive basis. Therefore, additional issuances of common stock, directly or through convertible or exchangeable securities, warrants or options, will dilute the holdings of our existing common stockholders and such issuances, or the perception of such issuances, may reduce the market price of our common stock. Our preferred stock has, and any additional preferred stock issued by us would likely have, a preference on distribution payments, periodically or upon liquidation, which could eliminate or otherwise limit our ability to make distributions to common stockholders. Because our decision to incur or issue debt or issue equity or equity-related securities in the future will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing, nature or success of our future capital raising efforts. Thus, common stockholders bear the risk that our future incurrence or issuance of debt or issuance of equity or equity-related securities will adversely affect the market price of our common stock.\nWe have not established a minimum distribution payment level for our common stock, and we cannot assure you of our ability to pay distributions in the future.\nWe intend to make quarterly distributions of our REIT taxable income to holders of our common stock out of assets legally available therefor. We have not established a minimum distribution payment level and our ability to pay distributions may be adversely affected by a number of factors, including the risk factors described in this report. Any distributions will be authorized by our board of directors and declared by us based upon a number of factors, including our actual and anticipated results of operations, liquidity and financial condition, restrictions under Delaware law or applicable financing covenants, our REIT taxable income, the annual distribution requirements under the REIT provisions of the Internal Revenue Code, our operating expenses and other factors our directors deem relevant.\nOur board of directors approved two increases in our quarterly dividends during 2017, which has resulted in reduced cash flows and we will begin making distributions on our preferred stock issued in July 2019, beginning in November 2019, which will further reduce our cash flows. Although we have other sources of liquidity, such as sales of and repayments from our investments, potential debt financing sources and the issuance of equity securities, there can be no assurance that we will generate sufficient cash or\n148\nachieve investment results that will allow us to make a specified level of cash distributions or year-to-year increases in cash distributions in the future.\nFurthermore, while we are required to make distributions in order to maintain our REIT status (as described above under “—Risks Related to our Taxation as a REIT—We may be unable to generate sufficient cash from operations to pay our operating expenses and to pay distributions to our stockholders”), we may elect not to maintain our REIT status, in which case we would no longer be required to make such distributions. Moreover, even if we do elect to maintain our REIT status, we may elect to comply with the applicable requirements by, after completing various procedural steps, distributing, under certain circumstances, a portion of the required amount in the form of shares of our common stock in lieu of cash. If we elect not to maintain our REIT status or to satisfy any required distributions in shares of common stock in lieu of cash, such action could negatively and materially affect our business, results of operations, liquidity and financial condition as well as the market price of our common stock. No assurance can be given that we will make any distributions on shares of our common stock in the future.\nWe may in the future choose to make distributions in our own stock, in which case you could be required to pay income taxes in excess of any cash distributions you receive.\nWe may in the future make taxable distributions that are payable in cash and shares of our common stock at the election of each stockholder. Taxable stockholders receiving such distributions will be required to include the full amount of the distribution as ordinary income to the extent of our current and accumulated earnings and profits for federal income tax purposes. As a result, stockholders may be required to pay income taxes with respect to such distributions in excess of the cash distributions received. If a U.S. stockholder sells the stock that it receives as a distribution in order to pay this tax, the sale proceeds may be less than the amount included in income with respect to the distribution, depending on the market price of our stock at the time of the sale. Furthermore, with respect to certain non-U.S. stockholders, we may be required to withhold U.S. tax with respect to such distributions, including in respect of all or a portion of such distribution that is payable in stock. In addition, if a significant number of our stockholders determine to sell shares of our common stock in order to pay taxes owed on distributions, it may put downward pressure on the market price of our common stock.\nIn August 2017, the IRS issued guidance authorizing elective cash/stock dividends to be made by public REITs where there is a minimum (of at least 20%) amount of cash that may be paid as part of the dividend, provided that certain requirements are met. It is unclear whether and to what extent we would be able to or choose to pay taxable distributions in cash and stock. In addition, no assurance can be given that the IRS will not impose additional requirements in the future with respect to taxable cash/stock distributions, including on a retroactive basis, or assert that the requirements for such taxable cash/stock distributions have not been met.\nAn increase in market interest rates may have an adverse effect on the market price of our common stock.\nOne of the factors that investors may consider in deciding whether to buy or sell shares of our common stock is our distribution rate as a percentage of our stock price relative to market interest rates. If the market price of our common stock is based primarily on the earnings and return that we derive from our investments and income with respect to our investments and our related distributions to stockholders, and not from the market value of the investments themselves, then interest rate fluctuations and capital market conditions will likely affect the market price of our common stock. For instance, if market interest rates rise without an increase in our distribution rate, the market price of our common stock could decrease, as potential investors may require a higher distribution yield on our common stock or seek other securities paying higher distributions or interest. In addition, rising interest rates would result in increased interest expense on our outstanding and future (variable and fixed) rate debt, thereby adversely affecting cash flow and our ability to service our indebtedness and pay distributions.\nProvisions in our certificate of incorporation and bylaws and of Delaware law may prevent or delay an acquisition of our company, which could decrease the market price of our common stock.\nOur certificate of incorporation, bylaws and Delaware law contain provisions that are intended to deter coercive takeover practices and inadequate takeover bids by making such practices or bids unacceptably expensive to the raider and to encourage prospective acquirers to negotiate with our board of directors rather than to attempt a hostile takeover. These provisions include, among others:\n\n| • | a classified board of directors with staggered three-year terms; |\n\n| • | provisions regarding the election of directors, classes of directors, the term of office of directors, the filling of director vacancies and the resignation and removal of directors for cause only upon the affirmative vote of at least 80% of the then issued and outstanding shares of our capital stock entitled to vote thereon; |\n\n| • | provisions regarding corporate opportunity only upon the affirmative vote of at least 80% of the then issued and outstanding shares of our capital stock entitled to vote thereon; |\n\n149\n| • | removal of directors only for cause and only with the affirmative vote of at least 80% of the then issued and outstanding shares of our capital stock entitled to vote in the election of directors; |\n\n| • | our board of directors to determine the powers, preferences and rights of our preferred stock and to issue such preferred stock without stockholder approval; |\n\n| • | advance notice requirements applicable to stockholders for director nominations and actions to be taken at annual meetings; |\n\n| • | a prohibition, in our certificate of incorporation, stating that no holder of shares of our common stock will have cumulative voting rights in the election of directors, which means that the holders of a majority of the issued and outstanding shares of common stock can elect all the directors standing for election; and |\n\n| • | a requirement in our bylaws specifically denying the ability of our stockholders to consent in writing to take any action in lieu of taking such action at a duly called annual or special meeting of our stockholders. |\n\nPublic stockholders who might desire to participate in these types of transactions may not have an opportunity to do so, even if the transaction is considered favorable to stockholders. These anti-takeover provisions could substantially impede the ability of public stockholders to benefit from a change in control or a change in our management and board of directors and, as a result, may adversely affect the market price of our common stock and your ability to realize any potential change of control premium.\nERISA may restrict investments by plans in our common stock.\nA plan fiduciary considering an investment in our common stock should consider, among other things, whether such an investment is consistent with the fiduciary obligations under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), including whether such investment might constitute or give rise to a prohibited transaction under ERISA, the Internal Revenue Code or any substantially similar federal, state or local law and, if so, whether an exemption from such prohibited transaction rules is available.\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nNone.\nITEM 3. DEFAULTS UPON SENIOR SECURITIES\nNone.\n\nITEM 4. MINE SAFETY DISCLOSURES\nNot Applicable.\n\nITEM 5. OTHER INFORMATION\nMr. David Schneider, the Chief Accounting Officer of the Company, has resigned as an officer of the Company effective as of October 31, 2019. The board of directors of the Company has appointed Mr. Nicola Santoro, Jr. as Chief Accounting Officer effective as of October 31, 2019. Mr. Santoro has been actively involved with New Residential since 2015 and is also the Company’s Chief Financial Officer and Treasurer.\n150\nITEM 6. EXHIBITS\n| Exhibit Number | Exhibit Description |\n| 2.1† | Separation and Distribution Agreement, dated as of April 26, 2013, by and between New Residential Investment Corp. and Newcastle Investment Corp. (incorporated by reference to Exhibit 2.1 to Amendment No. 6 of New Residential Investment Corp.’s Registration Statement on Form 10, filed April 29, 2013) |\n| 2.2† | Purchase Agreement, dated as of March 5, 2013, by and among the Sellers listed therein, HSBC Finance Corporation and SpringCastle Acquisition LLC (incorporated by reference to Exhibit 99.1 to Drive Shack Inc.’s Current Report on Form 8-K, filed March 11, 2013) |\n| 2.3† | Master Servicing Rights Purchase Agreement, dated as of December 17, 2013, by and between Nationstar Mortgage LLC and Advance Purchaser LLC (incorporated by reference to Exhibit 2.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed December 23, 2013) |\n| 2.4† | Sale Supplement (Shuttle 1), dated as of December 17, 2013, by and between Nationstar Mortgage LLC and Advance Purchaser LLC (incorporated by reference to Exhibit 2.2 to New Residential Investment Corp.’s Current Report on Form 8-K, filed December 23, 2013) |\n| 2.5† | Sale Supplement (Shuttle 2), dated as of December 17, 2013, by and between Nationstar Mortgage LLC and Advance Purchaser LLC (incorporated by reference to Exhibit 2.3 to New Residential Investment Corp.’s Current Report on Form 8-K, filed December 23, 2013) |\n| 2.6† | Sale Supplement (First Tennessee), dated as of December 17, 2013, by and between Nationstar Mortgage LLC and Advance Purchaser LLC (incorporated by reference to Exhibit 2.4 to New Residential Investment Corp.’s Current Report on Form 8-K, filed December 23, 2013) |\n| 2.7† | Purchase Agreement, dated as of March 31, 2016, by and among SpringCastle Holdings, LLC, Springleaf Acquisition Corporation, Springleaf Finance, Inc., NRZ Consumer LLC, NRZ SC America LLC, NRZ SC Credit Limited, NRZ SC Finance I LLC, NRZ SC Finance II LLC, NRZ SC Finance III LLC, NRZ SC Finance IV LLC, NRZ SC Finance V LLC, BTO Willow Holdings II, L.P. and Blackstone Family Tactical Opportunities Investment Partnership - NQ - ESC L.P., and solely with respect to Section 11(a) and Section 11(g), NRZ SC America Trust 2015-1, NRZ SC Credit Trust 2015-1, NRZ SC Finance Trust 2015-1, and BTO Willow Holdings, L.P. (incorporated by reference to Exhibit 2.10 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2016, filed on May 4, 2016) |\n| 2.8† | Securities Purchase Agreement, dated as of November 29, 2017, by and among NRM Acquisition LLC, Shellpoint Partners LLC, the Sellers party thereto and Shellpoint Services LLC, as original representative of the Seller (incorporated by reference to Exhibit 2.8 to New Residential Investment Corp.’s Annual Report on Form 10-K for the year ended December 31, 2017, filed on February 15, 2018) |\n| 2.9† | Amendment No. 1 to the Securities Purchase Agreement, dated as of July 3, 2018, by and among NRM Acquisition LLC, Shellpoint Partners LLC, the Sellers party thereto and Shellpoint Representative LLC, as replacement representative of the Sellers (incorporated by reference to Exhibit 2.9 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2018) |\n| 2.10 | Asset Purchase Agreement among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company, dated June 17, 2019 (incorporated by reference to Exhibit 2.10 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2019) |\n| 2.11 | Amendment No. 1 to the Asset Purchase Agreement, dated as of July 9, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\n| 2.12 | Amendment No. 2 to the Asset Purchase Agreement, dated as of August 30, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\n| 2.13 | Amendment No. 3 to the Asset Purchase Agreement, dated as of September 4, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\n| 2.14 | Amendment No. 4 to the Asset Purchase Agreement, dated as of September 5, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\n| 2.15 | Amendment No. 5 to the Asset Purchase Agreement, dated as of September 6, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\n\n151\n| Exhibit Number | Exhibit Description |\n| 2.16 | Amendment No. 6 to the Asset Purchase Agreement, dated as of September 9, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\n| 2.17 | Amendment No. 7 to the Asset Purchase Agreement, dated as of September 17, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\n| 2.18 | Amendment No. 8 to the Asset Purchase Agreement, dated as of September 30, 2019, among New Residential Investment Corp., Ditech Holding Corporation, a Maryland corporation, and Ditech Financial LLC, a Delaware limited liability company |\n| 3.1 | Amended and Restated Certificate of Incorporation of New Residential Investment Corp. (incorporated by reference to Exhibit 3.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed May 3, 2013) |\n| 3.2 | Amended and Restated Bylaws of New Residential Investment Corp. (incorporated by reference to Exhibit 3.2 to New Residential Investment Corp.’s Current Report on Form 8-K, filed May 3, 2013) |\n| 3.3 | Certificate of Amendment to the Amended and Restated Certificate of Incorporation of New Residential Investment Corp. (incorporated by reference to Exhibit 3.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed October 17, 2014) |\n| 3.4 | Certificate of Designations of New Residential Investment Corp., designating the Company’s 7.50% Series A Fixed-to-Floating Rate Cumulative Redeemable Preferred Stock, par value $0.01 per share (incorporated by reference to Exhibit 3.4 to New Residential Investment Corp.’s Form 8-A, filed July 2, 2019) |\n| 3.5 | Certificate of Designations of New Residential Investment Corp., designating the Company’s 7.125% Series B Fixed-to-Floating Rate Cumulative Redeemable Preferred Stock, par value $0.01 per share (incorporated by reference to Exhibit 3.5 to New Residential Investment Corp.’s Form 8-A, filed August 15, 2019) |\n| 4.1 | Specimen Series A Preferred Stock Certificate (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Form 8-A filed July 2, 2019) |\n| 4.2 | Specimen Series B Preferred Stock Certificate of New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Form 8-A, filed August 15, 2019) |\n| 4.3 | Second Amended and Restated Indenture, dated as of September 7, 2018, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, New Residential Mortgage LLC, New Penn Financial, LLC, d/b/a Shellpoint Mortgage Servicing and Credit Suisse AG, New York Branch (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed September 7, 2018) |\n| 4.4 | Omnibus Amendment to Term Note Indenture Supplements, dated as of August 17, 2017, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, New Residential Mortgage LLC, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.2 to New Residential Investment Corp.’s Current Report on Form 8-K, filed August 22, 2017) |\n| 4.5 | Series 2016-T2 Indenture Supplement, dated as of October 25, 2016, to the Indenture, dated as of August 28, 2015, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed October 31, 2016) |\n| 4.6 | Series 2016-T3 Indenture Supplement, dated as of October 25, 2016, to the Indenture, dated as of August 28, 2015, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.2 to New Residential Investment Corp.’s Current Report on Form 8-K, filed October 31, 2016) |\n| 4.7 | Series 2016-T4 Indenture Supplement, dated as of December 15, 2016, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed December 16, 2016) |\n\n152\n| Exhibit Number | Exhibit Description |\n| 4.8 | Series 2016-T5 Indenture Supplement, dated as of December 15, 2016, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.2 to New Residential Investment Corp.’s Current Report on Form 8-K, filed December 16, 2016) |\n| 4.9 | Series 2017-T1 Indenture Supplement, dated as of February 7, 2017, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Current Report on Form 8-K filed February 7, 2017) |\n| 4.10 | Series 2018-VF1 Indenture Supplement, dated as of March 22, 2018, to the Amended and Restated Indenture, dated as of August 17, 2017, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, New Residential Mortgage LLC, JPMorgan Chase Bank, N.A. and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.'s Current Report on Form 8-K, filed March 28, 2018) |\n| 4.11 | Omnibus Amendment to Certain Agreements Relating to the NRZ Advance Receivables Trust 2015-ON1, dated as of September 7, 2018, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, New Residential Mortgage LLC, Credit Suisse AG, New York Branch, New Penn Financial, LLC, d/b/a Shellpoint Mortgage Servicing and New Residential Investment Corp. (incorporated by reference to Exhibit 4.2 to New Residential Investment Corp.’s Current Report on Form 8-K, filed September 7, 2018) |\n| 4.12 | Amendment No. 1 to Series 2018-VF1 Indenture Supplement, dated as of September 7, 2018, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, New Residential Mortgage LLC, New Penn Financial, LLC, d/b/a Shellpoint Mortgage Servicing, JPMorgan Chase Bank, N.A. and New Residential Investment Corp. (incorporated by reference to Exhibit 4.3 to New Residential Investment Corp.’s Current Report on Form 8-K, filed September 7, 2018) |\n| 4.13 | Amendment No. 2 to Series 2018-VF1 Indenture Supplement, dated as of September 28, 2018, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, New Residential Mortgage LLC, New Penn Financial, LLC, d/b/a Shellpoint Mortgage Servicing, JPMorgan Chase Bank, N.A. and New Residential Investment Corp. (incorporated by reference to Exhibit 4.11 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q, filed May 2, 2019) |\n| 4.14 | Amendment No. 3 to Series 2018-VF1 Indenture Supplement, dated as of March 11, 2019, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, New Residential Mortgage LLC, NewRez LLC d/b/a Shellpoint Mortgage Servicing, JPMorgan Chase Bank, N.A. and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed March 15, 2019) |\n| 4.15 | Third Amended and Restated Indenture, dated as of July 25, 2019, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, PHH Mortgage Corporation, HLSS Holdings, LLC, New Residential Mortgage LLC, NewRez LLC, d/b/a Shellpoint Mortgage Servicing and Credit Suisse AG, New York Branch (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Form 8-K, filed July 26, 2019) |\n| 4.16 | Series 2019-T1 Indenture Supplement, dated as of July 25, 2019, to the Third Amended and Restated Indenture, dated as of July 25, 2019, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, PHH Mortgage Corporation, HLSS Holdings, LLC, New Residential Mortgage LLC, NewRez LLC d/b/a Shellpoint Mortgage Servicing, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.2 to New Residential Investment Corp.’s Form 8-K, filed July 26, 2019) |\n| 4.17 | Series 2019-T2 Indenture Supplement, dated as of August 15, 2019, to the Third Amended and Restated Indenture, dated as of July 25, 2019, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, PHH Mortgage Corporation, HLSS Holdings, LLC, New Residential Mortgage LLC, NewRez LLC d/b/a Shellpoint Mortgage Servicing, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Form 8-K, filed August 16, 2019) |\n| 4.18 | Series 2019-T3 Indenture Supplement, dated as of September 20, 2019, to the Third Amended and Restated Indenture, dated as of July 25, 2019, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, PHH Mortgage Corporation, HLSS Holdings, LLC, New Residential Mortgage LLC, NewRez LLC d/b/a Shellpoint Mortgage Servicing, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Form 8-K, filed September 20, 2019) |\n\n153\n| Exhibit Number | Exhibit Description |\n| 4.19 | Series 2019-T4 Indenture Supplement, dated as of October 15, 2019, to the Third Amended and Restated Indenture, dated as of July 25, 2019, by and among NRZ Advance Receivables Trust 2015-ON1, Deutsche Bank National Trust Company, PHH Mortgage Corporation, HLSS Holdings, LLC, New Residential Mortgage LLC, NewRez LLC d/b/a Shellpoint Mortgage Servicing, Credit Suisse AG, New York Branch and New Residential Investment Corp. (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Form 8-K, filed October 18, 2019) |\n| 4.20 | Form of Debt Securities Indenture (including Form of Debt Security) (incorporated by reference to Exhibit 4.1 to New Residential Investment Corp.’s Registration Statement on Form S-3, filed May 16, 2014) |\n| 10.1 | Third Amended and Restated Management and Advisory Agreement, dated as of May 7, 2015, by and between New Residential Investment Corp. and FIG LLC (incorporated by reference to Exhibit 10.4 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2015) |\n| 10.2 | Form of Indemnification Agreement by and between New Residential Investment Corp. and its directors and officers (incorporated by reference to Exhibit 10.2 to Amendment No. 3 to New Residential Investment Corp.’s Registration Statement on Form 10, filed March 27, 2013) |\n| 10.3 | New Residential Investment Corp. Nonqualified Stock Option and Incentive Award Plan, adopted as of April 29, 2013 (incorporated by reference to Exhibit 10.1 to New Residential Investment Corp.’s Current Report on Form 8-K, filed May 3, 2013) |\n| 10.4 | Amended and Restated New Residential Investment Corp. Nonqualified Stock Option and Incentive Plan, adopted as of November 4, 2014 (incorporated by reference to Exhibit 10.6 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2014) |\n| 10.5 | Investment Guidelines (incorporated by reference to Exhibit 10.4 to Amendment No. 4 to New Residential Investment Corp.’s Registration Statement on Form 10, filed April 9, 2013) |\n| 10.6 | Excess Servicing Spread Sale and Assignment Agreement, dated as of December 8, 2011, by and between Nationstar Mortgage LLC and NIC MSR I LLC (incorporated by reference to Exhibit 10.5 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2011) |\n| 10.7 | Excess Spread Refinanced Loan Replacement Agreement, dated as of December 8, 2011, by and between Nationstar Mortgage LLC and NIC MSR I LLC (incorporated by reference to Exhibit 10.6 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2011) |\n| 10.8 | Future Spread Agreement for FHLMC Mortgage Loans, dated as of May 13, 2012, by and between Nationstar Mortgage LLC and NIC MSR IV LLC (incorporated by reference to Exhibit 10.4 to Drive Shack Inc.’s Current Report on Form 8-K, filed May 15, 2012) |\n| 10.9 | Future Spread Agreement for FNMA Mortgage Loans, dated as of May 13, 2012, by and between Nationstar Mortgage LLC and NIC MSR V LLC (incorporated by reference to Exhibit 10.2 to Drive Shack Inc.’s Current Report on Form 8-K, filed May 15, 2012) |\n| 10.10 | Future Spread Agreement for Non-Agency Mortgage Loans, dated as of May 13, 2012, by and between Nationstar Mortgage LLC and NIC MSR VI LLC (incorporated by reference to Exhibit 10.6 to Drive Shack Inc.’s Current Report on Form 8-K, filed May 15, 2012) |\n| 10.11 | Future Spread Agreement for GNMA Mortgage Loans, dated as of May 13, 2012, by and between Nationstar Mortgage LLC and NIC MSR VII, LLC (incorporated by reference to Exhibit 10.8 to Drive Shack Inc.’s Current Report on Form 8-K, filed May 15, 2012) |\n| 10.12 | Current Excess Servicing Spread Acquisition Agreement for FHLMC Mortgage Loans, dated as of May 31, 2012, by and between Nationstar Mortgage LLC and NIC MSR III LLC (incorporated by reference to Exhibit 10.1 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 6, 2012) |\n| 10.13 | Future Spread Agreement for FHLMC Mortgage Loans, dated as of May 31, 2012, by and between Nationstar Mortgage LLC and NIC MSR III LLC (incorporated by reference to Exhibit 10.2 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 6, 2012) |\n| 10.14 | Amended and Restated Current Excess Servicing Spread Acquisition Agreement for FNMA Mortgage Loans, dated as of June 7, 2012, by and between Nationstar Mortgage LLC and NIC MSR II LLC (incorporated by reference to Exhibit 10.1 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 7, 2012) |\n| 10.15 | Amended and Restated Future Spread Agreement for FNMA Mortgage Loans, dated as of June 7, 2012, by and between Nationstar Mortgage LLC and NIC MSR II LLC (incorporated by reference to Exhibit 10.2 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 7, 2012) |\n\n154\n| Exhibit Number | Exhibit Description |\n| 10.16 | Amended and Restated Current Excess Servicing Spread Acquisition Agreement for FHLMC Mortgage Loans, dated as of June 7, 2012, by and between Nationstar Mortgage LLC and NIC MSR II LLC (incorporated by reference to Exhibit 10.3 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 7, 2012) |\n| 10.17 | Amended and Restated Future Spread Agreement for FHLMC Mortgage Loans, dated as of June 7, 2012, by and between Nationstar Mortgage LLC and NIC MSR II LLC (incorporated by reference to Exhibit 10.4 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 7, 2012) |\n| 10.18 | Amended and Restated Current Excess Servicing Spread Acquisition Agreement for Non-Agency Mortgage Loans, dated as of June 7, 2012, by and between Nationstar Mortgage LLC and NIC MSR II LLC (incorporated by reference to Exhibit 10.5 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 7, 2012) |\n| 10.19 | Amended and Restated Future Spread Agreement for Non-Agency Mortgage Loans, dated as of June 7, 2012, by and between Nationstar Mortgage LLC and NIC MSR II LLC (incorporated by reference to Exhibit 10.6 to Drive Shack Inc.’s Current Report on Form 8-K, filed June 7, 2012) |\n| 10.20 | Amended and Restated Current Excess Servicing Spread Acquisition Agreement for FNMA Mortgage Loans, dated as of June 28, 2012, by and between Nationstar Mortgage LLC and NIC MSR V LLC (incorporated by reference to Exhibit 10.1 to Drive Shack Inc.’s Current Report on Form 8-K, filed July 5, 2012) |\n| 10.21 | Amended and Restated Current Excess Servicing Spread Acquisition Agreement for FHLMC Mortgage Loans, dated as of June 28, 2012, by and between Nationstar Mortgage LLC and NIC MSR IV LLC (incorporated by reference to Exhibit 10.2 to Drive Shack Inc.’s Current Report on Form 8-K, filed July 5, 2012) |\n| 10.22 | Amended and Restated Current Excess Servicing Spread Acquisition Agreement for Non-Agency Mortgage Loans, dated as of June 28, 2012, by and between Nationstar Mortgage LLC and NIC MSR VI LLC (incorporated by reference to Exhibit 10.3 to Drive Shack Inc.’s Current Report on Form 8-K, filed July 5, 2012) |\n| 10.23 | Amended and Restated Current Excess Servicing Spread Acquisition Agreement for GNMA Mortgage Loans, dated as of June 28, 2012, by and between Nationstar Mortgage LLC and NIC MSR VII LLC (incorporated by reference to Exhibit 10.4 to Drive Shack Inc.’s Current Report on Form 8-K, filed July 5, 2012) |\n| 10.24 | Current Excess Servicing Spread Acquisition Agreement for GNMA Mortgage Loans, dated as of December 31, 2012, by and between Nationstar Mortgage LLC and MSR VIII LLC (incorporated by reference to Exhibit 10.35 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n| 10.25 | Future Spread Agreement for GNMA Mortgage Loans, dated as of December 31, 2012, by and between Nationstar Mortgage LLC and MSR VIII LLC (incorporated by reference to Exhibit 10.36 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n| 10.26 | Current Excess Servicing Spread Acquisition Agreement for FHLMC Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR IX LLC (incorporated by reference to Exhibit 10.37 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n| 10.27 | Future Spread Agreement for FHLMC Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR IX LLC (incorporated by reference to Exhibit 10.38 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n| 10.28 | Current Excess Servicing Spread Acquisition Agreement for FNMA Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR X LLC (incorporated by reference to Exhibit 10.39 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n| 10.29 | Future Spread Agreement for FNMA Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR X LLC (incorporated by reference to Exhibit 10.40 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n| 10.30 | Current Excess Servicing Spread Acquisition Agreement for GNMA Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR XI LLC (incorporated by reference to Exhibit 10.41 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n| 10.31 | Future Spread Agreement for GNMA Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR XI LLC (incorporated by reference to Exhibit 10.42 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n| 10.32 | Current Excess Servicing Spread Acquisition Agreement for Non-Agency Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR XII LLC (incorporated by reference to Exhibit 10.43 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n\n155\n| Exhibit Number | Exhibit Description |\n| 10.33 | Future Spread Agreement for Non-Agency Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR XII LLC (incorporated by reference to Exhibit 10.44 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n| 10.34 | Current Excess Servicing Spread Acquisition Agreement for Non-Agency Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR XIII LLC (incorporated by reference to Exhibit 10.45 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n| 10.35 | Future Spread Agreement for Non-Agency Mortgage Loans, dated as of January 6, 2013, by and between Nationstar Mortgage LLC and MSR XIII LLC (incorporated by reference to Exhibit 10.46 to Drive Shack Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012) |\n| 10.36 | Interim Servicing Agreement, dated as of April 1, 2013, by and among the Interim Servicers listed therein, HSBC Finance Corporation, as Interim Servicer Representative, HSBC Bank USA, National Association, SpringCastle America, LLC, SpringCastle Credit, LLC, SpringCastle Finance, LLC, Wilmington Trust, National Association, as Loan Trustee, and SpringCastle Finance LLC, as Owner Representative (incorporated by reference to Exhibit 10.35 to Amendment No. 4 to New Residential Investment Corp.’s Registration Statement on Form 10, filed April 9, 2013) |\n| 10.37 | Second Amended and Restated Limited Liability Company Agreement of SpringCastle Acquisition LLC, dated as of March 31, 2016 (incorporated by reference to Exhibit 10.37 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2016) |\n| 10.38 | Services Agreement, dated as of April 6, 2015, by and between HLSS Advances Acquisition Corp. and Home Loan Servicing Solutions, Ltd. (incorporated by reference to Exhibit 2.4 to New Residential Investment Corp.’s Current Report on Form 8-K, filed April 10, 2015) |\n| 10.39 | Receivables Sale Agreement, dated as of August 28, 2015, by and among Ocwen Loan Servicing, LLC, HLSS Holdings, LLC and NRZ Advance Facility Transferor 2015-ON1 LLC (incorporated by reference to Exhibit 10.47 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2015) |\n| 10.40 | Receivables Pooling Agreement, dated as of August 28, 2015, by and between NRZ Advance Facility Transferor 2015-ON1 LLC and NRZ Advance Receivables Trust 2015-ON1 (incorporated by reference to Exhibit 10.48 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2015) |\n| 10.41# | Master Agreement, dated as July 23, 2017, by and among Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, HLSS MSR - EBO Acquisition LLC and New Residential Mortgage LLC (incorporated by reference to Exhibit 10.41 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2017) |\n| 10.42 | Amendment No. 1 to Master Agreement, dated as of October 12, 2017, by and among Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, HLSS MSR - EBO Acquisition LLC and New Residential Mortgage LLC (incorporated by reference to Exhibit 10.42 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2017) |\n| 10.43# | Transfer Agreement, dated as of July 23, 2017, by and among Ocwen Loan Servicing, LLC, New Residential Mortgage LLC, Ocwen Financial Corporation and New Residential Investment Corp. (incorporated by reference to Exhibit 10.43 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2017) |\n| 10.44# | Amendment No. 1 to the Transfer Agreement, dated January 18, 2018, by and among Ocwen Loan Servicing, LLC, New Residential Mortgage LLC, Ocwen Financial Corporation and New Residential Investment Corp. (incorporated by reference to Exhibit 10.44 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2018) |\n| 10.45# | Subservicing Agreement, dated as of July 23, 2017, by and between New Residential Mortgage LLC and Ocwen Loan Servicing, LLC (incorporated by reference to Exhibit 10.44 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2017) |\n| 10.46# | Amendment No. 1 to Subservicing Agreement, dated as of August 17, 2018, by and between New Residential Mortgage LLC and Ocwen Loan Servicing, LLC (incorporated by reference to Exhibit 10.46 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2018) |\n| 10.47# | Cooperative Brokerage Agreement, dated as of August 28, 2017, by and among REALHome Services and Solutions, Inc., REALHome Services and Solutions - CT, Inc. and New Residential Sales Corp. (incorporated by reference to Exhibit 10.45 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2017) |\n\n156\n| Exhibit Number | Exhibit Description |\n| 10.48# | First Amendment to Cooperative Brokerage Agreement, dated as of November 16, 2017, by and among REALHome Services and Solutions, Inc., REALHome Services and Solutions - CT, Inc. and New Residential Sales Corp. (incorporated by reference to Exhibit 10.46 to New Residential Investment Corp.’s Annual Report on Form 10-K for the year ended December 31, 2017, filed on February 14, 2018) |\n| 10.49# | Second Amendment to Cooperative Brokerage Agreement, dated as of January 18, 2018, by and among REALHome Services and Solutions, Inc., REALHome Services and Solutions - CT, Inc. and New Residential Sales Corp. (incorporated by reference to Exhibit 10.47 to New Residential Investment Corp.’s Annual Report on Form 10-K for the year ended December 31, 2017, filed on February 14, 2018) |\n| 10.50 | Third Amendment to Cooperative Brokerage Agreement, dated as of March 23, 2018, by and among REALHome Services and Solutions, Inc., REALHome Services and Solutions - CT, Inc. and New Residential Sales Corp. (incorporated by reference to Exhibit 10.49 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2018) |\n| 10.51 | Fourth Amendment to Cooperative Brokerage Agreement, dated as of September 11, 2018, by and among REALHome Services and Solutions, Inc., REALHome Services and Solutions - CT, Inc. and New Residential Sales Corp. (incorporated by reference to Exhibit 10.51 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2018) |\n| 10.52# | Letter Agreement, dated as of August 28, 2017, by and among New Residential Investment Corp., New Residential Mortgage LLC, REALHome Services and Solutions, Inc., REALHome Services and Solutions - CT, Inc. and Altisource Solutions S.a.r.l. (incorporated by reference to Exhibit 10.46 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2017) |\n| 10.53# | New RMSR Agreement, dated as of January 18, 2018, by and among Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, HLSS MSR - EBO Acquisition LLC, and New Residential Mortgage LLC (incorporated by reference to Exhibit 10.51 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2018) |\n| 10.54# | Amendment No. 1 to New RMSR Agreement, dated as of August 17, 2018, by and among Ocwen Loan Servicing, LLC, HLSS Holdings, LLC, HLSS MSR - EBO Acquisition LLC, and New Residential Mortgage LLC (incorporated by reference to Exhibit 10.54 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2018) |\n| 10.55# | Subservicing Agreement, dated as of August 17, 2018, by and between New Penn Financial, LLC, d/b/a Shellpoint Mortgage Servicing New Residential Mortgage LLC and Ocwen Loan Servicing, LLC (incorporated by reference to Exhibit 10.55 to New Residential Investment Corp.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2018) |\n| 31.1 | Certification of Chief Executive Officer as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2 | Certification of Chief Financial Officer as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101 | The following financial information from the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2019, formatted in iXBRL (Inline Extensible Business Reporting Language): (i) Condensed Consolidated Balance Sheets; (ii) Condensed Consolidated Statements of Comprehensive Income; (iii) Condensed Consolidated Statements of Changes in Stockholders’ Equity; (iv) Condensed Consolidated Statements of Cash Flows; and (v) Notes to Condensed Consolidated Financial Statements |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\n\n| # | Portions of this exhibit have been omitted pursuant to a request for confidential treatment. |\n| * | Portions of this exhibit have been omitted. |\n\n157\nThe following second amended and restated limited liability company agreements of the Consumer Loan Companies are substantially identical in all material respects, except as to the parties thereto and the initial capital contributions required under each agreement, to the Second Amended and Restated Limited Liability Company Agreement of SpringCastle Acquisition LLC that is filed as Exhibit 10.37 hereto and are being omitted in reliance on Instruction 2 to Item 601 of Regulation S-K:\n\n| • | Second Amended and Restated Limited Liability Company Agreement of SpringCastle America, LLC, dated as of March 31, 2016. |\n\n| • | Second Amended and Restated Limited Liability Company Agreement of SpringCastle Credit, LLC, dated as of March 31, 2016. |\n\n| • | Second Amended and Restated Limited Liability Company Agreement of SpringCastle Finance, LLC, dated as of March 31, 2016. |\n\n158\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized:\n\n| NEW RESIDENTIAL INVESTMENT CORP. |\n| By: | /s/ Michael Nierenberg |\n| Michael Nierenberg |\n| Chief Executive Officer and President |\n| (Principal Executive Officer) |\n| October 28, 2019 |\n| By: | /s/ Nicola Santoro, Jr. |\n| Nicola Santoro, Jr. |\n| Chief Financial Officer and Treasurer |\n| (Principal Financial Officer) |\n| October 28, 2019 |\n| By: | /s/ David Schneider |\n| David Schneider |\n| Chief Accounting Officer |\n| (Principal Accounting Officer) |\n| October 28, 2019 |\n\n159\n</text>\n\nWhat is the net income ratio of the Real Estate Securities segment considering the interest income and net income for the three months ended September 30, 2019 in percentages?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 92.24151449443852."
}
|
{
"split": "test",
"index": 67,
"input_length": 176286
}
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docmath_40000_plus
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial Statements\nINDEPENDENT BANK CORP.\nCONSOLIDATED BALANCE SHEETS\n(Unaudited—Dollars in thousands)\n\n| September 302022 | December 312021 |\n| Assets |\n| Cash and due from banks | $ | 172,615 | $ | 141,581 |\n| Interest-earning deposits with banks | 763,681 | 2,099,103 |\n| Securities |\n| Trading | 3,538 | 3,720 |\n| Equity | 20,439 | 23,173 |\n| Available for sale (amortized cost $ 1,605,913 and $ 1,583,736 ) | 1,425,511 | 1,571,148 |\n| Held to maturity (fair value $ 1,509,985 and $ 1,064,133 ) | 1,697,635 | 1,066,818 |\n| Total securities | 3,147,123 | 2,664,859 |\n| Loans held for sale (at fair value) | 5,100 | 24,679 |\n| Loans |\n| Commercial and industrial | 1,548,349 | 1,563,279 |\n| Commercial real estate | 7,677,917 | 7,992,344 |\n| Commercial construction | 1,185,157 | 1,165,457 |\n| Small business | 209,567 | 193,189 |\n| Residential real estate | 1,959,254 | 1,604,686 |\n| Home equity - first position | 578,405 | 589,550 |\n| Home equity - subordinate positions | 508,765 | 450,061 |\n| Other consumer | 32,936 | 28,720 |\n| Total loans | 13,700,350 | 13,587,286 |\n| Less: allowance for credit losses | ( 147,313 ) | ( 146,922 ) |\n| Net loans | 13,553,037 | 13,440,364 |\n| Federal Home Loan Bank stock | 5,218 | 11,407 |\n| Bank premises and equipment, net | 198,408 | 195,590 |\n| Goodwill | 985,072 | 985,072 |\n| Other intangible assets | 26,934 | 32,772 |\n| Cash surrender value of life insurance policies | 293,126 | 289,304 |\n| Other assets | 552,955 | 538,674 |\n| Total assets | $ | 19,703,269 | $ | 20,423,405 |\n| Liabilities and Stockholders' Equity |\n| Deposits |\n| Noninterest-bearing demand deposits | $ | 5,622,260 | $ | 5,479,503 |\n| Savings and interest checking accounts | 6,094,493 | 6,350,016 |\n| Money market | 3,443,622 | 3,556,375 |\n| Time certificates of deposit | 1,178,619 | 1,531,150 |\n| Total deposits | 16,338,994 | 16,917,044 |\n| Borrowings |\n| Federal Home Loan Bank borrowings | 643 | 25,667 |\n| Long-term borrowings | — | 14,063 |\n| Junior subordinated debentures (less unamortized debt issuance costs of $ 33 and $ 35 ) | 62,855 | 62,853 |\n\n5\n| Subordinated debentures (less unamortized debt issuance costs of $ 138 and $ 209 ) | 49,862 | 49,791 |\n| Total borrowings | 113,360 | 152,374 |\n| Other liabilities | 433,714 | 335,538 |\n| Total liabilities | 16,886,068 | 17,404,956 |\n| Commitments and contingencies | — | — |\n| Stockholders' equity |\n| Preferred stock, $ 0.01 par value, authorized: 1,000,000 shares, outstanding: none | — | — |\n| Common stock, $ 0.01 par value, authorized: 75,000,000 shares,issued and outstanding: 45,634,626 shares at September 30, 2022 and 47,349,778 shares at December 31, 2021 (includes 136,904 and 135,273 shares of unvested participating restricted stock awards, respectively) | 454 | 472 |\n| Value of shares held in rabbi trust at cost: 82,617 shares at September 30, 2022 and 82,565 shares at December 31, 2021 | ( 3,239 ) | ( 3,146 ) |\n| Deferred compensation and other retirement benefit obligations | 3,239 | 3,146 |\n| Additional paid in capital | 2,113,313 | 2,249,078 |\n| Retained earnings | 882,503 | 766,716 |\n| Accumulated other comprehensive income (loss), net of tax | ( 179,069 ) | 2,183 |\n| Total stockholders’ equity | 2,817,201 | 3,018,449 |\n| Total liabilities and stockholders' equity | $ | 19,703,269 | $ | 20,423,405 |\n\nThe accompanying notes are an integral part of these unaudited consolidated financial statements.\n6\nINDEPENDENT BANK CORP.\nCONSOLIDATED STATEMENTS OF INCOME\n(Unaudited—Dollars in thousands, except per share data)\n| Three Months Ended | Nine Months Ended |\n| September 30 | September 30 |\n| 2022 | 2021 | 2022 | 2021 |\n| Interest income |\n| Interest and fees on loans | $ | 150,157 | $ | 84,212 | $ | 413,770 | $ | 265,409 |\n| Taxable interest and dividends on securities | 13,243 | 7,792 | 34,567 | 21,603 |\n| Nontaxable interest and dividends on securities | 1 | 4 | 4 | 14 |\n| Interest on loans held for sale | 51 | 193 | 150 | 675 |\n| Interest on federal funds sold and short-term investments | 6,519 | 815 | 10,222 | 1,654 |\n| Total interest and dividend income | 169,971 | 93,016 | 458,713 | 289,355 |\n| Interest expense |\n| Interest on deposits | 6,109 | 1,633 | 10,327 | 6,361 |\n| Interest on borrowings | 1,261 | 1,292 | 3,492 | 3,965 |\n| Total interest expense | 7,370 | 2,925 | 13,819 | 10,326 |\n| Net interest income | 162,601 | 90,091 | 444,894 | 279,029 |\n| Provision for (release of) credit losses | 3,000 | ( 10,000 ) | 1,000 | ( 17,500 ) |\n| Net interest income after provision for credit losses | 159,601 | 100,091 | 443,894 | 296,529 |\n| Noninterest income |\n| Deposit account fees | 6,261 | 4,298 | 17,582 | 11,704 |\n| Interchange and ATM fees | 4,331 | 3,441 | 11,967 | 9,229 |\n| Investment management | 8,436 | 9,174 | 26,438 | 26,350 |\n| Mortgage banking income | 585 | 2,825 | 2,989 | 11,270 |\n| Increase in cash surrender value of life insurance policies | 1,883 | 1,596 | 5,549 | 4,508 |\n| Gain on life insurance benefits | 477 | — | 600 | 258 |\n| Loan level derivative income | 471 | 586 | 1,511 | 875 |\n| Other noninterest income | 5,751 | 4,537 | 15,729 | 12,476 |\n| Total noninterest income | 28,195 | 26,457 | 82,365 | 76,670 |\n| Noninterest expenses |\n| Salaries and employee benefits | 52,708 | 42,235 | 150,957 | 124,759 |\n| Occupancy and equipment expenses | 12,316 | 8,564 | 37,255 | 26,543 |\n| Data processing and facilities management | 2,259 | 1,673 | 6,878 | 5,024 |\n| Consulting expense | 2,547 | 1,560 | 7,057 | 5,443 |\n| Software maintenance | 2,497 | 2,018 | 7,706 | 5,903 |\n| Debit card expense | 1,936 | 1,347 | 5,562 | 3,693 |\n| Amortization of intangible assets | 1,898 | 1,310 | 5,801 | 4,037 |\n| FDIC assessment | 1,677 | 980 | 5,225 | 2,805 |\n| Merger and acquisition expense | — | 1,943 | 7,100 | 3,674 |\n| Other noninterest expenses | 14,890 | 10,789 | 45,249 | 33,522 |\n| Total noninterest expenses | 92,728 | 72,419 | 278,790 | 215,403 |\n| Income before income taxes | 95,068 | 54,129 | 247,469 | 157,796 |\n| Provision for income taxes | 23,171 | 14,122 | 60,699 | 38,506 |\n| Net income | $ | 71,897 | $ | 40,007 | $ | 186,770 | $ | 119,290 |\n| Basic earnings per share | $ | 1.57 | $ | 1.21 | $ | 4.01 | $ | 3.61 |\n| Diluted earnings per share | $ | 1.57 | $ | 1.21 | $ | 4.00 | $ | 3.61 |\n| Weighted average common shares (basic) | 45,839,555 | 33,043,716 | 46,618,209 | 33,024,386 |\n| Common share equivalents | 16,856 | 15,554 | 17,221 | 18,238 |\n| Weighted average common shares (diluted) | 45,856,411 | 33,059,270 | 46,635,430 | 33,042,624 |\n| Cash dividends declared per common share | $ | 0.51 | $ | 0.48 | $ | 1.53 | $ | 1.44 |\n\nThe accompanying notes are an integral part of these unaudited consolidated financial statements.\n7\nINDEPENDENT BANK CORP.\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME\n(Unaudited—Dollars in thousands)\n\n| Three Months Ended | Nine Months Ended |\n| September 30 | September 30 |\n| 2022 | 2021 | 2022 | 2021 |\n| Net income | $ | 71,897 | $ | 40,007 | $ | 186,770 | $ | 119,290 |\n| Other comprehensive income (loss), net of tax |\n| Net change in fair value of securities available for sale | ( 42,582 ) | ( 7,897 ) | ( 128,872 ) | ( 11,878 ) |\n| Net change in fair value of cash flow hedges | ( 27,144 ) | ( 3,383 ) | ( 52,743 ) | ( 11,559 ) |\n| Net change in other comprehensive income for defined benefit postretirement plans | 121 | 280 | 363 | 1,309 |\n| Total other comprehensive loss | ( 69,605 ) | ( 11,000 ) | ( 181,252 ) | ( 22,128 ) |\n| Total comprehensive income | $ | 2,292 | $ | 29,007 | $ | 5,518 | $ | 97,162 |\n\nThe accompanying notes are an integral part of these unaudited consolidated financial statements.\n8\nINDEPENDENT BANK CORP.\nCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\nThree Months Ended September 30, 2022 and 2021\n(Unaudited—Dollars in thousands, except per share data)\n| Common Stock Outstanding | Common Stock | Value of Shares Held in Rabbi Trust at Cost | Deferred Compensation Obligation | Additional Paid in Capital | Retained Earnings | Accumulated OtherComprehensive Income (Loss) | Total |\n| Balance June 30, 2022 | 46,069,761 | $ | 459 | $ | ( 3,196 ) | $ | 3,196 | $ | 2,146,333 | $ | 833,857 | $ | ( 109,464 ) | $ | 2,871,185 |\n| Net income | — | — | — | — | — | 71,897 | — | 71,897 |\n| Other comprehensive loss | — | — | — | — | — | — | ( 69,605 ) | ( 69,605 ) |\n| Common dividend declared ($ 0.51 per share) | — | — | — | — | — | ( 23,251 ) | — | ( 23,251 ) |\n| Stock based compensation | — | — | — | — | 1,017 | — | — | 1,017 |\n| Restricted stock awards issued, net of awards surrendered | 296 | — | — | — | — | — | — | — |\n| Shares issued under direct stock purchase plan | 7,541 | — | — | — | 606 | — | — | 606 |\n| Shares repurchased under share repurchase program | ( 442,972 ) | ( 5 ) | — | — | ( 34,643 ) | — | — | ( 34,648 ) |\n| Deferred compensation and other retirement benefit obligations | — | — | ( 43 ) | 43 | — | — | — | — |\n| Balance September 30, 2022 | 45,634,626 | $ | 454 | $ | ( 3,239 ) | $ | 3,239 | $ | 2,113,313 | $ | 882,503 | $ | ( 179,069 ) | $ | 2,817,201 |\n| Balance June 30, 2021 | 33,037,859 | $ | 329 | $ | ( 3,116 ) | $ | 3,116 | $ | 948,130 | $ | 763,596 | $ | 29,567 | $ | 1,741,622 |\n| Net income | — | — | — | — | — | 40,007 | — | 40,007 |\n| Other comprehensive loss | — | — | — | — | — | — | ( 11,000 ) | ( 11,000 ) |\n| Common dividend declared ($ 0.48 per share) | — | — | — | — | — | ( 15,861 ) | — | ( 15,861 ) |\n| Stock based compensation | — | — | — | — | 707 | — | — | 707 |\n| Restricted stock awards issued, net of awards surrendered | ( 763 ) | — | — | — | ( 3 ) | — | — | ( 3 ) |\n| Shares issued under direct stock purchase plan | 6,716 | — | — | — | 482 | — | — | 482 |\n| Deferred compensation and other retirement benefit obligations | — | — | ( 41 ) | 41 | — | — | — | — |\n| Balance September 30, 2021 | 33,043,812 | $ | 329 | $ | ( 3,157 ) | $ | 3,157 | $ | 949,316 | $ | 787,742 | $ | 18,567 | $ | 1,755,954 |\n\n9\nINDEPENDENT BANK CORP.\nCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\nNine Months Ended September 30, 2022 and 2021\n(Unaudited—Dollars in thousands, except per share data)\n| Common Stock Outstanding | Common Stock | Value of Shares Held in Rabbi Trust at Cost | Deferred Compensation Obligation | Additional Paid in Capital | Retained Earnings | Accumulated OtherComprehensive Income (Loss) | Total |\n| Balance December 31, 2021 | 47,349,778 | $ | 472 | $ | ( 3,146 ) | $ | 3,146 | $ | 2,249,078 | $ | 766,716 | $ | 2,183 | $ | 3,018,449 |\n| Net income | — | — | — | — | — | 186,770 | — | 186,770 |\n| Other comprehensive loss | — | — | — | — | — | — | ( 181,252 ) | ( 181,252 ) |\n| Common dividend declared ($ 1.53 per share) | — | — | — | — | — | ( 70,983 ) | — | ( 70,983 ) |\n| Stock based compensation | — | — | — | — | 3,483 | — | — | 3,483 |\n| Restricted stock awards issued, net of awards surrendered | 50,096 | — | — | — | ( 1,085 ) | — | — | ( 1,085 ) |\n| Shares issued under direct stock purchase plan | 21,717 | — | — | — | 1,765 | — | — | 1,765 |\n| Shares repurchased under share repurchase program | ( 1,786,965 ) | ( 18 ) | — | — | ( 139,928 ) | — | — | ( 139,946 ) |\n| Deferred compensation and other retirement benefit obligations | — | — | ( 93 ) | 93 | — | — | — | — |\n| Balance September 30, 2022 | 45,634,626 | $ | 454 | $ | ( 3,239 ) | $ | 3,239 | $ | 2,113,313 | $ | 882,503 | $ | ( 179,069 ) | $ | 2,817,201 |\n| Balance December 31, 2020 | 32,965,692 | $ | 328 | $ | ( 3,066 ) | $ | 3,066 | $ | 945,638 | $ | 716,024 | $ | 40,695 | $ | 1,702,685 |\n| Net income | — | — | — | — | — | 119,290 | — | 119,290 |\n| Other comprehensive loss | — | — | — | — | — | — | ( 22,128 ) | ( 22,128 ) |\n| Common dividend declared ($ 1.44 per share) | — | — | — | — | — | ( 47,572 ) | — | ( 47,572 ) |\n| Proceeds from exercise of stock options, net of cash paid | 4,744 | — | — | — | ( 57 ) | — | — | ( 57 ) |\n| Stock based compensation | — | — | — | — | 3,467 | — | — | 3,467 |\n| Restricted stock awards issued, net of awards surrendered | 53,795 | 1 | — | — | ( 1,247 ) | — | — | ( 1,246 ) |\n| Shares issued under direct stock purchase plan | 19,581 | — | — | — | 1,515 | — | — | 1,515 |\n| Deferred compensation and other retirement benefit obligations | — | — | ( 91 ) | 91 | — | — | — | — |\n| Balance September 30, 2021 | 33,043,812 | $ | 329 | $ | ( 3,157 ) | $ | 3,157 | $ | 949,316 | $ | 787,742 | $ | 18,567 | $ | 1,755,954 |\n\nThe accompanying notes are an integral part of these unaudited consolidated financial statements.\n10\nINDEPENDENT BANK CORP.\nCONSOLIDATED STATEMENTS OF CASH FLOWS\n(Unaudited—Dollars in thousands)\n\n| Nine Months Ended |\n| September 30 |\n| 2022 | 2021 |\n| Cash flow from operating activities |\n| Net income | $ | 186,770 | $ | 119,290 |\n| Adjustments to reconcile net income to net cash provided by operating activities |\n| Depreciation and amortization | 29,528 | 24,586 |\n| Change in unamortized net loan costs and premiums | ( 6,397 ) | ( 17,217 ) |\n| Accretion of fair value mark of acquired loans | ( 65 ) | ( 5,349 ) |\n| Provision for (release of) credit losses | 1,000 | ( 17,500 ) |\n| Deferred income tax expense | 271 | 271 |\n| Net loss (gain) on equity securities | 2,819 | ( 695 ) |\n| Net loss on bank premises and equipment | 217 | 32 |\n| Realized gain on sale leaseback transaction | ( 433 ) | ( 433 ) |\n| Stock based compensation | 3,483 | 3,467 |\n| Increase in cash surrender value of life insurance policies | ( 5,549 ) | ( 4,508 ) |\n| Gain on life insurance benefits | ( 600 ) | ( 258 ) |\n| Operating lease payments | ( 15,867 ) | ( 8,993 ) |\n| Operating lease termination payments | — | ( 4,750 ) |\n| Change in fair value on loans held for sale | 620 | 1,534 |\n| Net change in: |\n| Trading assets | 182 | ( 666 ) |\n| Loans held for sale | 18,959 | 23,017 |\n| Other assets | 32,252 | 16,700 |\n| Other liabilities | 58,669 | 28,267 |\n| Total adjustments | 119,089 | 37,505 |\n| Net cash provided by operating activities | 305,859 | 156,795 |\n| Cash flows used in investing activities |\n| Proceeds from sales of equity securities | 30 | 1,164 |\n| Purchases of equity securities | ( 471 ) | ( 1,522 ) |\n| Proceeds from maturities and principal repayments of securities available for sale | 100,790 | 75,442 |\n| Purchases of securities available for sale | ( 123,289 ) | ( 1,106,079 ) |\n| Proceeds from maturities and principal repayments of securities held to maturity | 132,997 | 199,304 |\n| Purchases of securities held to maturity | ( 763,987 ) | ( 340,713 ) |\n| Net redemption of Federal Home Loan Bank stock | 6,189 | 1,584 |\n| Investments in low income housing projects | ( 14,896 ) | ( 19,236 ) |\n| Purchases of life insurance policies | ( 115 ) | ( 40,116 ) |\n| Proceeds from life insurance policies | 2,273 | 576 |\n| Net (increase) decrease in loans | ( 107,211 ) | 603,773 |\n| Purchases of bank premises and equipment | ( 18,019 ) | ( 16,114 ) |\n| Proceeds from the sale of bank premises and equipment | 1,228 | 78 |\n| Net cash used in investing activities | ( 784,481 ) | ( 641,859 ) |\n| Cash flows (used in) provided by financing activities |\n| Net decrease in time deposits | ( 351,458 ) | ( 165,052 ) |\n\n11\n| Net (decrease) increase in other deposits | ( 225,519 ) | 1,432,037 |\n| Repayments of short-term Federal Home Loan Bank borrowings | ( 25,000 ) | — |\n| Repayments of long-term Federal Home Loan Bank borrowings | — | ( 10,000 ) |\n| Repayments of long-term debt, net of issuance costs | ( 14,063 ) | ( 14,063 ) |\n| Net payments for exercise of stock options | — | ( 57 ) |\n| Restricted stock awards issued, net of awards surrendered | ( 1,085 ) | ( 1,246 ) |\n| Proceeds from shares issued under direct stock purchase plan | 1,765 | 1,515 |\n| Payments for shares repurchased under share repurchase program | ( 139,946 ) | — |\n| Common dividends paid | ( 70,460 ) | ( 46,875 ) |\n| Net cash (used in) provided by financing activities | ( 825,766 ) | 1,196,259 |\n| Net (decrease) increase in cash and cash equivalents | ( 1,304,388 ) | 711,195 |\n| Cash and cash equivalents at beginning of year | 2,240,684 | 1,296,636 |\n| Cash and cash equivalents at end of period | $ | 936,296 | $ | 2,007,831 |\n| Supplemental schedule of noncash activities |\n| Net increase in capital commitments relating to low income housing project investments | $ | 4,408 | $ | 34,127 |\n| Right-of-use assets obtained in exchange for new lease obligations | $ | 14,124 | $ | 5,888 |\n\nThe accompanying notes are an integral part of these unaudited consolidated financial statements.\n12\nNOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS\nNOTE 1 - BASIS OF PRESENTATION\nIndependent Bank Corp. (the “Company”) is a state chartered, federally registered bank holding company, incorporated in 1985. The Company is the sole stockholder of Rockland Trust Company (“Rockland Trust” or the “Bank”), a Massachusetts trust company chartered in 1907.\nAll material intercompany balances and transactions have been eliminated in consolidation. Certain previously reported amounts have been reclassified to conform to the current year’s presentation.\nThe accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (\"GAAP\") for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation of the financial statements, primarily consisting of normal recurring adjustments, have been included. Results for the nine months ended September 30, 2022 are not necessarily indicative of the results that may be expected for the year ending December 31, 2022 or any other interim period.\nFor further information, refer to the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2021, filed with the Securities and Exchange Commission (the \"2021 Form 10-K\").\nNOTE 2 - RECENT ACCOUNTING STANDARDS UPDATES\nFinancial Accounting Standards Board (\"FASB\") Accounting Standards Codification (\"ASC\") Topic 848 \"Reference Rate Reform\" Update No. 2020-04. Update No. 2020-04 was issued in March 2020 to provide optional expedients and exceptions for applying GAAP to certain contracts, hedging relationships, and other transactions affected by reference rate reform if certain criteria are met. The amendments in this update apply only to contracts, hedging relationships, and other transactions that reference the London Interbank Offered Rate (\"LIBOR\") or another reference rate expected to be discontinued because of reference rate reform. The amendments will not apply to contract modifications made and hedging relationships entered into or evaluated after December 31, 2022, except for hedging relationships existing as of December 31, 2022 for which an entity has elected certain optional expedients that are retained through the end of the hedging relationship. The amendments in this update are effective for all entities as of March 12, 2020 through December 31, 2022 and do not apply to contract modifications made after December 31, 2022. FASB ASC Topic 848 \"Reference Rate Reform\" Update No. 2021-01 was subsequently issued in January 2021 and expanded application of the optional expedients to derivative transactions affected by the discounting transition. The Company has not yet adopted the amendments in these updates, but has established a working group to guide the Company’s transition from LIBOR and has begun efforts to transition off the LIBOR index consistent with industry timelines. The working group has identified its products that utilize LIBOR and has implemented fallback language to facilitate the transition to alternative rates. The Company is also evaluating existing platforms and systems as well as alternative indices in its preparation to offer new products tied to the alternative indices. The Company does not anticipate that the adoption of these updates will have a material impact on the Company's financial statements.\nFASB ASC Topic 260 \"Earnings Per Share\" Update No. 2020-06. In August 2020, the FASB issued update No. 2020-06 (\"ASU 2020-06\"). ASU 2020-06 included amendments to ASC 260 related to the earnings per share calculation, which were designed to simplify and improve consistency of the diluted earnings per share calculation. ASU 2020-06 is effective for public entities for annual periods beginning after December 15, 2021 and interim periods therein. Accordingly, the Company adopted ASU 2020-06 effective January 1, 2022 and the adoption did not have a material impact on the Company's financial statements.\nFASB ASC Topic 815 \"Derivatives and Hedging\" Update No. 2022-01. Update No. 2022-01 was issued in March 2022 and its amendments allow for nonprepayable financial assets to also be included in a closed portfolio hedged using the portfolio layer method. The expanded scope permits an entity to apply the same portfolio hedging method to both prepayable and nonprepayable financial assets resulting in more consistent accounting for similar hedges. All amendments in this update are effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. The Company is currently assessing the impact of the adoption of this standard on the Company's financial statements.\nFASB ASC Topic 326 \"Financial Instruments - Credit Losses\" Update No. 2022-02. Update No. 2022-02 was issued in March 2022 and applies to public entities that have adopted ASU Topic 326. The amendments in this update eliminate the existing accounting guidance for troubled debt restructures (\"TDRs\") by creditors in Subtopic 310-40, Receivables - Troubled Debt Restructurings by Creditors and instead requires that an entity evaluate whether a modification\n13\nrepresents a new loan or a continuation of an existing loan. The amendments also enhance disclosure requirements for certain loan refinancing and restructuring by creditors when a borrower is experiencing financial difficulty. ASU 2022-02 also requires additional disclosure of current period gross write-offs by year of origination for financing receivables to be included in the entity's vintage disclosure, as currently required under Topic 326. All amendments in this update are effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. The Company is currently assessing the impact of the adoption of this standard on the Company's financial statements.\n14\nNOTE 3 - SECURITIES\nTrading Securities\nThe Company had trading securities of $ 3.5 million and $ 3.7 million as of September 30, 2022 and December 31, 2021, respectively. These securities are held in a rabbi trust and will be used for future payments associated with the Company’s non-qualified 401(k) Restoration Plan and Non-qualified Deferred Compensation Plan.\nEquity Securities\nThe Company had equity securities of $ 20.4 million and $ 23.2 million as of September 30, 2022 and December 31, 2021, respectively. These securities consist primarily of mutual funds held in a rabbi trust and will be used for future payments associated with the Company’s supplemental executive retirement plans.\nThe following table represents a summary of the gains and losses recognized within non-interest income and non-interest expense within the consolidated statements of income that relate to equity securities for the periods indicated:\n| Three Months Ended | Nine Months Ended |\n| September 30 | September 30 |\n| 2022 | 2021 | 2022 | 2021 |\n| Dollars in thousands |\n| Net gains (losses) recognized during the period on equity securities | $ | ( 742 ) | $ | ( 169 ) | ( 2,819 ) | 695 |\n| Less: net gains recognized during the period on equity securities sold during the period | — | 50 | 8 | 191 |\n| Unrealized gains (losses) recognized during the reporting period on equity securities still held at the reporting date | $ | ( 742 ) | $ | ( 219 ) | $ | ( 2,827 ) | $ | 504 |\n\nAvailable for Sale Securities\nThe following table summarizes the amortized cost, allowance for credit losses, and fair value of available for sale securities and the corresponding amounts of gross unrealized gains and losses recognized in accumulated other comprehensive income (loss) as of the dates indicated:\n| September 30, 2022 | December 31, 2021 |\n| AmortizedCost | GrossUnrealizedGains | Gross UnrealizedLosses | Allowance for credit losses | FairValue | AmortizedCost | GrossUnrealizedGains | Gross UnrealizedLosses | Allowance for credit losses | FairValue |\n| (Dollars in thousands) |\n| Available for sale securities |\n| U.S. government agency securities | $ | 231,122 | $ | — | $ | ( 31,180 ) | $ | — | $ | 199,942 | $ | 217,393 | $ | 990 | $ | ( 2,901 ) | $ | — | $ | 215,482 |\n| U.S. treasury securities | 873,891 | — | ( 89,433 ) | — | 784,458 | 873,467 | 172 | ( 12,191 ) | — | 861,448 |\n| Agency mortgage-backed securities | 393,296 | 50 | ( 49,193 ) | — | 344,153 | 364,955 | 4,512 | ( 5,534 ) | — | 363,933 |\n| Agency collateralized mortgage obligations | 43,672 | 5 | ( 2,890 ) | — | 40,787 | 78,966 | 1,282 | ( 571 ) | — | 79,677 |\n| State, county, and municipal securities | 193 | — | ( 6 ) | — | 187 | 192 | 11 | — | — | 203 |\n| Single issuer trust preferred securities issued by banks | 489 | — | — | — | 489 | 489 | 2 | — | — | 491 |\n| Pooled trust preferred securities issued by banks and insurers | 1,202 | — | ( 203 ) | — | 999 | 1,199 | — | ( 199 ) | — | 1,000 |\n| Small business administration pooled securities | 62,048 | — | ( 7,552 ) | — | 54,496 | 47,075 | 1,839 | — | — | 48,914 |\n| Total available for sale securities | $ | 1,605,913 | $ | 55 | $ | ( 180,457 ) | $ | — | $ | 1,425,511 | $ | 1,583,736 | $ | 8,808 | $ | ( 21,396 ) | $ | — | $ | 1,571,148 |\n\nExcluded from the table above is accrued interest on available for sale securities of $ 3.3 million and $ 3.0 million as of September 30, 2022 and December 31, 2021, respectively, which is included within other assets on the consolidated balance sheets. Additionally, the Company did not record any write-offs of accrued interest income on available for sale securities during the three and nine months ended September 30, 2022 and 2021. Furthermore, no securities held by the Company were\n15\ndelinquent on contractual payments nor were any securities placed on non-accrual status as of September 30, 2022 and December 31, 2021.\nWhen securities are sold, the adjusted cost of the specific security sold is used to compute the gain or loss on the sale. The Company had no sales of securities available for sale during the three and nine months ended September 30, 2022 and 2021, and therefore no gains or losses were realized during the periods presented.\nThe following tables show the gross unrealized losses and fair value of the Company’s available for sale securities in an unrealized loss position, and for which the Company has not recorded a provision for credit losses, as of the dates indicated. These available for sale securities are aggregated by major security type and length of time that individual securities have been in a continuous unrealized loss position:\n| September 30, 2022 |\n| Less than 12 months | 12 months or longer | Total |\n| # of holdings | FairValue | UnrealizedLosses | FairValue | UnrealizedLosses | FairValue | UnrealizedLosses |\n| (Dollars in thousands) |\n| U.S. government agency securities | 9 | $ | 80,353 | $ | ( 11,483 ) | $ | 119,589 | $ | ( 19,697 ) | $ | 199,942 | $ | ( 31,180 ) |\n| U.S. treasury securities | 18 | 86,592 | ( 12,426 ) | 697,866 | ( 77,007 ) | 784,458 | ( 89,433 ) |\n| Agency mortgage-backed securities | 142 | 263,358 | ( 29,512 ) | 79,167 | ( 19,681 ) | 342,525 | ( 49,193 ) |\n| Agency collateralized mortgage obligations | 11 | 39,291 | ( 2,890 ) | — | — | 39,291 | ( 2,890 ) |\n| State, county, and municipal securities | 1 | 187 | ( 6 ) | — | — | 187 | ( 6 ) |\n| Pooled trust preferred securities issued by banks and insurers | 1 | — | — | 999 | ( 203 ) | 999 | ( 203 ) |\n| Small business administration pooled securities | 8 | 36,885 | ( 3,768 ) | 17,611 | ( 3,784 ) | 54,496 | ( 7,552 ) |\n| Total impaired available for sale securities | 190 | $ | 506,666 | $ | ( 60,085 ) | $ | 915,232 | $ | ( 120,372 ) | $ | 1,421,898 | $ | ( 180,457 ) |\n| December 31, 2021 |\n| Less than 12 months | 12 months or longer | Total |\n| # of holdings | FairValue | UnrealizedLosses | FairValue | UnrealizedLosses | FairValue | UnrealizedLosses |\n| (Dollars in thousands) |\n| U.S. government agency securities | 6 | $ | 160,913 | $ | ( 2,901 ) | $ | — | $ | — | $ | 160,913 | $ | ( 2,901 ) |\n| U.S. treasury securities | 17 | 811,993 | ( 12,191 ) | — | — | 811,993 | ( 12,191 ) |\n| Agency mortgage-backed securities | 12 | 214,678 | ( 5,534 ) | — | — | 214,678 | ( 5,534 ) |\n| Agency collateralized mortgage obligations | 1 | 22,960 | ( 571 ) | — | — | 22,960 | ( 571 ) |\n| Pooled trust preferred securities issued by banks and insurers | 1 | — | — | 1,000 | ( 199 ) | 1,000 | ( 199 ) |\n| Total impaired available for sale securities | 37 | $ | 1,210,544 | $ | ( 21,197 ) | $ | 1,000 | $ | ( 199 ) | $ | 1,211,544 | $ | ( 21,396 ) |\n\nThe Company does not intend to sell these investments and has determined, based upon available evidence, that it is more likely than not that the Company will not be required to sell each security before the recovery of its amortized cost basis. In addition, management does not believe that any of the securities are impaired due to reasons of credit quality. As a result, the Company did not recognize a provision for credit losses on these investments during the three and nine months ended September 30, 2022 and 2021, respectively. The Company made this determination by reviewing various qualitative and quantitative factors regarding each investment category, such as current market conditions, extent and nature of changes in fair value, issuer rating changes and trends, volatility of earnings, and current analysts’ evaluations.\n16\nAs a result of the Company’s review of these qualitative and quantitative factors, the causes of the impairments listed in the table above by category were as follows at September 30, 2022:\n•U.S. Government Agency Securities, U.S. Treasury Securities, Agency Mortgage-Backed Securities, Agency Collateralized Mortgage Obligations and Small Business Administration Pooled Securities: These portfolios have contractual terms that generally do not permit the issuer to settle the securities at a price less than the current par value of the investment. The decline in market value of these securities is attributable to changes in interest rates and not credit quality. Additionally, these securities are implicitly guaranteed by the U.S. Government or one of its agencies.\n•State, County and Municipal Securities: This portfolio has contractual terms that generally do not permit the issuer to settle the securities at a price less than the current par value of the investment. The decline in market value of these securities is attributable to changes in interest rates and not credit quality.\n•Pooled Trust Preferred Securities: This portfolio consists of one below investment grade security which is performing. The unrealized loss on this security is attributable to the illiquid nature of the trust preferred market in the current economic and regulatory environment. Management evaluates collateral credit and instrument structure, including current and expected deferral and default rates and timing. In addition, discount rates are determined by evaluating comparable spreads observed currently in the market for similar instruments.\nHeld to Maturity Securities\nThe following table summarizes the amortized cost, fair value and allowance for credit losses of held to maturity securities and the corresponding amounts of gross unrealized gains and losses recognized in accumulated other comprehensive income (loss) as of the dates indicated:\n| September 30, 2022 | December 31, 2021 |\n| AmortizedCost | GrossUnrealizedGains | Gross UnrealizedLosses | Allowance for credit losses | FairValue | AmortizedCost | GrossUnrealizedGains | Gross UnrealizedLosses | Allowance for credit losses | FairValue |\n| (Dollars in thousands) |\n| U.S. government agency securities | $ | 31,696 | $ | — | $ | ( 2,393 ) | $ | — | $ | 29,303 | $ | 32,987 | $ | — | $ | ( 441 ) | $ | — | $ | 32,546 |\n| U.S. treasury securities | 100,615 | — | ( 12,623 ) | — | 87,992 | 102,560 | 6 | ( 324 ) | — | 102,242 |\n| Agency mortgage-backed securities | 892,102 | 149 | ( 90,158 ) | — | 802,093 | 493,012 | 8,495 | ( 4,271 ) | — | 497,236 |\n| Agency collateralized mortgage obligations | 553,995 | — | ( 77,025 ) | — | 476,970 | 415,736 | 3,232 | ( 10,123 ) | — | 408,845 |\n| Single issuer trust preferred securities issued by banks | 1,500 | 8 | — | — | 1,508 | 1,500 | 8 | — | — | 1,508 |\n| Small business administration pooled securities | 117,727 | 12 | ( 5,620 ) | — | 112,119 | 21,023 | 733 | — | — | 21,756 |\n| Total held to maturity securities | $ | 1,697,635 | $ | 169 | $ | ( 187,819 ) | $ | — | $ | 1,509,985 | $ | 1,066,818 | $ | 12,474 | $ | ( 15,159 ) | $ | — | $ | 1,064,133 |\n\nSubstantially all held to maturity securities held by the Company are guaranteed by the U.S. federal government or other government sponsored agencies and have a long history of no credit losses. As a result, management has determined these securities to have a zero loss expectation and therefore the Company did not record a provision for estimated credit losses on any held to maturity securities during the three and nine months ended September 30, 2022 and 2021, respectively. Excluded from the table above is accrued interest on held to maturity securities of $ 4.3 million and $ 2.0 million as of September 30, 2022 and December 31, 2021, respectively, which is included within other assets on the consolidated balance sheets. Additionally, the Company did not record any write-offs of accrued interest income on held to maturity securities during the three and nine months ended September 30, 2022 and 2021. Furthermore, no securities held by the Company were delinquent on contractual payments nor were any securities placed on non-accrual status as of September 30, 2022 and December 31, 2021.\nWhen securities are sold, the adjusted cost of the specific security sold is used to compute the gain or loss on the sale. The Company had no sales of held to maturity securities during the three and nine months ended September 30, 2022 and 2021, respectively, and therefore no gains or losses were realized during the periods presented.\nThe Company monitors the credit quality of held to maturity securities through the use of credit ratings. Credit ratings are monitored by the Company on at least a quarterly basis. As of September 30, 2022, all held to maturity securities held by the Company were rated investment grade or higher.\n17\nThe actual maturities of certain available for sale or held to maturity securities may differ from the contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. A schedule of the contractual maturities of available for sale and held to maturity securities as of September 30, 2022 is presented below:\n| Due in one year or less | Due after one year to five years | Due after five to ten years | Due after ten years | Total |\n| AmortizedCost | FairValue | AmortizedCost | FairValue | AmortizedCost | FairValue | AmortizedCost | FairValue | AmortizedCost | FairValue |\n| (Dollars in thousands) |\n| Available for sale securities |\n| U.S. government agency securities | $ | — | $ | — | $ | 68,007 | $ | 60,786 | $ | 163,115 | $ | 139,156 | $ | — | $ | — | $ | 231,122 | $ | 199,942 |\n| U.S. treasury securities | — | — | 691,691 | 627,786 | 182,200 | 156,672 | — | — | 873,891 | 784,458 |\n| Agency mortgage-backed securities | 19,658 | 19,617 | 70,984 | 66,817 | 148,475 | 126,625 | 154,179 | 131,094 | 393,296 | 344,153 |\n| Agency collateralized mortgage obligations | — | — | — | — | — | — | 43,672 | 40,787 | 43,672 | 40,787 |\n| State, county, and municipal securities | — | — | 193 | 187 | — | — | — | — | 193 | 187 |\n| Single issuer trust preferred securities issued by banks | — | — | — | — | — | — | 489 | 489 | 489 | 489 |\n| Pooled trust preferred securities issued by banks and insurers | — | — | — | — | — | — | 1,202 | 999 | 1,202 | 999 |\n| Small business administration pooled securities | — | — | — | — | — | — | 62,048 | 54,496 | 62,048 | 54,496 |\n| Total available for sale securities | $ | 19,658 | $ | 19,617 | $ | 830,875 | $ | 755,576 | $ | 493,790 | $ | 422,453 | $ | 261,590 | $ | 227,865 | $ | 1,605,913 | $ | 1,425,511 |\n| Held to maturity securities |\n| U.S. government agency securities | $ | — | $ | — | $ | 31,696 | $ | 29,303 | $ | — | $ | — | $ | — | $ | — | $ | 31,696 | $ | 29,303 |\n| U.S. treasury securities | — | — | 49,766 | 44,047 | 50,849 | 43,945 | — | — | 100,615 | 87,992 |\n| Agency mortgage-backed securities | 228 | 226 | 190,333 | 182,141 | 478,115 | 415,833 | 223,426 | 203,893 | 892,102 | 802,093 |\n| Agency collateralized mortgage obligations | — | — | 29,998 | 28,550 | 36,791 | 31,784 | 487,206 | 416,636 | 553,995 | 476,970 |\n| Single issuer trust preferred securities issued by banks | — | — | — | — | 1,500 | 1,508 | — | — | 1,500 | 1,508 |\n| Small business administration pooled securities | — | — | — | — | — | — | 117,727 | 112,119 | 117,727 | 112,119 |\n| Total held to maturity securities | $ | 228 | $ | 226 | $ | 301,793 | $ | 284,041 | $ | 567,255 | $ | 493,070 | $ | 828,359 | $ | 732,648 | $ | 1,697,635 | $ | 1,509,985 |\n| Total | $ | 19,886 | $ | 19,843 | $ | 1,132,668 | $ | 1,039,617 | $ | 1,061,045 | $ | 915,523 | $ | 1,089,949 | $ | 960,513 | $ | 3,303,548 | $ | 2,935,496 |\n\nIncluded in the table above are $ 24.8 million of callable securities at September 30, 2022.\nThe carrying value of securities pledged to secure public funds, trust deposits, and for other purposes, as required or permitted by law, was $ 963.9 million and $ 740.6 million at September 30, 2022 and December 31, 2021, respectively.\nAt September 30, 2022 and December 31, 2021, the Company had no investments in obligations of individual states, counties, or municipalities which exceeded 10% of consolidated stockholders’ equity.\n18\nNOTE 4 - LOANS, ALLOWANCE FOR CREDIT LOSSES AND CREDIT QUALITY\nLoans Held for Investment and Allowance for Credit Losses\nThe following table summarizes the change in allowance for credit losses by loan category, and bifurcates the amount of loans allocated to each loan category for the period indicated:\n| Three Months Ended September 30, 2022 |\n| (Dollars in thousands) |\n| Commercial andIndustrial | CommercialReal Estate | CommercialConstruction | SmallBusiness | ResidentialReal Estate | Home Equity | Other Consumer | Total |\n| Allowance for credit losses |\n| Beginning balance | $ | 14,107 | $ | 83,456 | $ | 11,710 | $ | 2,784 | $ | 19,750 | $ | 11,740 | $ | 772 | $ | 144,319 |\n| Charge-offs | — | ( 62 ) | — | — | — | — | ( 679 ) | ( 741 ) |\n| Recoveries | 2 | 330 | — | 88 | — | 65 | 251 | 735 |\n| Provision for (release of) credit losses | 6,060 | ( 3,688 ) | ( 291 ) | ( 248 ) | 852 | ( 154 ) | 469 | 3,000 |\n| Ending balance (1) | $ | 20,169 | $ | 80,036 | $ | 11,419 | $ | 2,624 | $ | 20,602 | $ | 11,651 | $ | 812 | $ | 147,313 |\n| Three Months Ended September 30, 2021 |\n| (Dollars in thousands) |\n| Commercial andIndustrial | CommercialReal Estate | CommercialConstruction | SmallBusiness | ResidentialReal Estate | Home Equity | Other Consumer | Total |\n| Allowance for credit losses |\n| Beginning balance | $ | 17,032 | $ | 44,325 | $ | 4,865 | $ | 3,612 | $ | 12,014 | $ | 20,087 | $ | 422 | $ | 102,357 |\n| Charge-offs | ( 1 ) | — | — | ( 83 ) | — | — | ( 248 ) | ( 332 ) |\n| Recoveries | 1 | — | — | 50 | — | 49 | 121 | 221 |\n| Provision for (release of) credit losses | ( 1,018 ) | ( 6,527 ) | ( 397 ) | 88 | ( 967 ) | ( 1,268 ) | 89 | ( 10,000 ) |\n| Ending balance (1) | $ | 16,014 | $ | 37,798 | $ | 4,468 | $ | 3,667 | $ | 11,047 | $ | 18,868 | $ | 384 | $ | 92,246 |\n| Nine Months Ended September 30, 2022 |\n| (Dollars in thousands) |\n| Commercial andIndustrial | CommercialReal Estate | CommercialConstruction | SmallBusiness | ResidentialReal Estate | Home Equity | Other Consumer | Total |\n| Allowance for credit losses |\n| Beginning balance | $ | 14,402 | $ | 83,486 | $ | 12,316 | $ | 3,508 | $ | 14,484 | $ | 17,986 | $ | 740 | $ | 146,922 |\n| Charge-offs | — | ( 62 ) | — | ( 59 ) | — | ( 122 ) | ( 1,749 ) | ( 1,992 ) |\n| Recoveries | 44 | 333 | — | 147 | — | 105 | 754 | 1,383 |\n| Provision for (release of) credit losses | 5,723 | ( 3,721 ) | ( 897 ) | ( 972 ) | 6,118 | ( 6,318 ) | 1,067 | 1,000 |\n| Ending balance (1) | $ | 20,169 | $ | 80,036 | $ | 11,419 | $ | 2,624 | $ | 20,602 | $ | 11,651 | $ | 812 | $ | 147,313 |\n| Nine Months Ended September 30, 2021 |\n| (Dollars in thousands) |\n| Commercial andIndustrial | CommercialReal Estate | CommercialConstruction | SmallBusiness | ResidentialReal Estate | Home Equity | Other Consumer | Total |\n| Allowance for credit losses |\n| Beginning balance | $ | 21,086 | $ | 45,009 | $ | 5,397 | $ | 5,095 | $ | 14,275 | $ | 22,060 | $ | 470 | $ | 113,392 |\n| Charge-offs | ( 3,474 ) | — | — | ( 184 ) | — | ( 69 ) | ( 772 ) | ( 4,499 ) |\n| Recoveries | 100 | 57 | — | 65 | 1 | 107 | 523 | 853 |\n| Provision for (release of) credit losses | ( 1,698 ) | ( 7,268 ) | ( 929 ) | ( 1,309 ) | ( 3,229 ) | ( 3,230 ) | 163 | ( 17,500 ) |\n| Ending balance (1) | $ | 16,014 | $ | 37,798 | $ | 4,468 | $ | 3,667 | $ | 11,047 | $ | 18,868 | $ | 384 | $ | 92,246 |\n\n(1) Balances of accrued interest receivable excluded from amortized cost and the calculation of allowance for credit losses amounted to $ 42.7 million and $ 36.7 million as of September 30, 2022 and September 30, 2021, respectively.\n19\nThe balance of allowance for credit losses of $ 147.3 million as of September 30, 2022 remained relatively flat compared to $ 146.9 million at December 31, 2021. The nominal change in the Company's allowance for credit losses for the nine months ended September 30, 2022 primarily reflects increased reserves attributable to category shifts on nonperforming loans and net loan growth, offset by a stabilized credit environment and continued strong asset quality metrics.\nFor the purpose of estimating the allowance for credit losses, management segregated the loan portfolio into the portfolio segments detailed in the above tables. Each of these loan categories possesses unique risk characteristics that are considered when determining the appropriate level of allowance for each segment. Some of the characteristics unique to each loan category include:\nCommercial Portfolio\n•Commercial and Industrial: Loans in this category consist of revolving and term loan obligations extended to business and corporate enterprises for the purpose of financing working capital and/or capital investment. Collateral generally consists of pledges of business assets including, but not limited to: accounts receivable, inventory, plant and equipment, or real estate, if applicable. Repayment sources consist of primarily, operating cash flow, and secondarily, liquidation of assets.\n•Commercial Real Estate: Loans in this category consist of mortgage loans to finance investment in real property such as multi-family residential, commercial/retail, office, industrial, hotels, educational and healthcare facilities and other specific use properties. Loans are typically written with amortizing payment structures. Collateral values are determined based upon third party appraisals and evaluations. Loan to value ratios at origination are governed by established policy and regulatory guidelines. Repayment sources consist of, primarily, cash flow from operating leases and rents and, secondarily, liquidation of assets.\n•Commercial Construction: Loans in this category consist of short-term construction loans, revolving and nonrevolving credit lines and construction/permanent loans to finance the acquisition, development and construction or rehabilitation of real property. Project types include residential land development, one-to-four family, condominium, and multi-family home construction, commercial/retail, office, industrial, hotels, educational and healthcare facilities and other specific use properties. Loans may be written with nonamortizing or hybrid payment structures depending upon the type of project. Collateral values are determined based upon third party appraisals and evaluations. Loan to value ratios at origination are governed by established policy and regulatory guidelines. Repayment sources vary depending upon the type of project and may consist of sale or lease of units, operating cash flows or liquidation of other assets.\n•Small Business: Loans in this category consist of revolving, term loan and mortgage obligations extended to sole proprietors and small businesses for purposes of financing working capital and/or capital investment. Collateral generally consists of pledges of business assets including, but not limited to, accounts receivable, inventory, plant and equipment, or real estate if applicable. Repayment sources consist primarily of operating cash flows and, secondarily, liquidation of assets.\nFor the commercial portfolio it is the Company’s policy to obtain personal guarantees for payment from individuals holding material ownership interests in the borrowing entities.\nConsumer Portfolio\n•Residential Real Estate: Residential mortgage loans held in the Company’s portfolio are made to borrowers who demonstrate the ability to make scheduled payments with full consideration to underwriting factors such as current and expected income, employment status, current assets, other financial resources, credit history and the value of the collateral. Collateral consists of mortgage liens on one-to-four family residential properties. Residential mortgage loans also include loans to construct owner-occupied one-to-four family residential properties.\n•Home Equity: Home equity loans and credit lines are made to qualified individuals and are primarily secured by senior or junior mortgage liens on owner-occupied one-to-four family homes, condominiums or vacation homes. Each home equity loan has a fixed rate and is billed in equal payments comprised of principal and interest. The majority of home equity lines of credit have a variable rate and are billed in interest-only payments during the draw period. At the end of the draw period, the home equity line of credit is billed as a percentage of the then outstanding principal balance plus all accrued interest over a predetermined repayment period, as set forth in the note. Additionally, the Company has the option of renewing each line of credit for additional draw periods. Borrower qualifications include favorable credit history combined with supportive income requirements and combined loan to value ratios within established policy guidelines.\n•Other Consumer: Other consumer loan products include personal lines of credit and amortizing loans made to qualified individuals for various purposes such as debt consolidation, personal expenses or overdraft protection. Borrower qualifications include favorable credit history combined with supportive income and collateral requirements within established policy guidelines. These loans may be secured or unsecured.\n20\nCredit Quality\nThe Company continually monitors the asset quality of the loan portfolio using all available information. Based on this information, loans demonstrating certain payment issues or other weaknesses may be categorized as adversely risk-rated, delinquent, nonperforming and/or put on nonaccrual status. Additionally, in the course of resolving such loans, the Company may choose to restructure the contractual terms of certain loans to match the borrower’s ability to repay the loan based on their current financial condition.\nThe Company reviews numerous credit quality indicators when assessing the risk in its loan portfolio. For the commercial portfolio, the Company utilizes a 10-point credit risk-rating system, which assigns a risk-grade to each loan obligation based on a number of quantitative and qualitative factors associated with a commercial or small business loan transaction. Factors considered include industry and market conditions, position within the industry, earnings trends, operating cash flow, asset/liability values, debt capacity, guarantor strength, management and controls, financial reporting, collateral, and other considerations. The risk-rating categories for the commercial portfolio are defined as follows:\n•Pass: Risk-rating “1” through “6” comprises of loans ranging from ‘Substantially Risk Free’ which indicates borrowers are of unquestioned credit standing and the pinnacle of credit quality, well established companies with a very strong financial condition, and loans fully secured by cash collateral, through ‘Acceptable Risk’, which indicates borrowers may exhibit declining earnings, strained cash flow, increasing or above average leverage and/or weakening market fundamentals that indicate below average asset quality, margins and market share. Collateral coverage is protective.\n•Potential Weakness: Borrowers exhibit potential credit weaknesses or downward trends deserving management’s close attention. If not checked or corrected, these trends will weaken the Company’s asset and position. While potentially weak, currently these borrowers are marginally acceptable; no loss of principal or interest is envisioned.\n•Definite Weakness Loss Unlikely: Borrowers exhibit well defined weaknesses that jeopardize the orderly liquidation of debt. Loans may be inadequately protected by the current net worth and paying capacity of the obligor or by the collateral pledged, if any. Normal repayment from the borrower is in jeopardy, although no loss of principal is envisioned. However, there is a distinct possibility that a partial loss of interest and/or principal will occur if the deficiencies are not corrected. Collateral coverage may be inadequate to cover the principal obligation.\n•Partial Loss Probable: Borrowers exhibit well defined weaknesses that jeopardize the orderly liquidation of debt with the added provision that the weaknesses make collection of the debt in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Serious problems exist to the point where partial loss of principal is likely.\n•Definite Loss: Borrowers deemed incapable of repayment. Loans to such borrowers are considered uncollectible and of such little value that continuation as active assets of the Company is not warranted.\nThe Company utilizes a comprehensive, continuous strategy for evaluating and monitoring commercial credit quality. Initially, credit quality is determined at loan origination and is re-evaluated when subsequent actions, such as renewals, modifications or reviews, occur. Actively managed commercial borrowers are required to provide updated financial information at least annually which is carefully evaluated for any changes in credit quality. Larger loan relationships are subject to a full annual credit review by experienced credit professionals, while continuous portfolio monitoring techniques are employed to evaluate changes in credit quality for smaller loan relationships. Any changes in credit quality are reflected in risk-rating changes. Additionally, the Company retains an independent loan review firm to evaluate the credit quality of the commercial loan portfolio. The independent loan review process achieves significant penetration into the commercial loan portfolio and reports the results of these reviews to the Audit Committee of the Board of Directors on a quarterly basis. Commercial loan modifications granted by the Company allowing payment deferrals for qualifying borrowers in accordance with the Coronavirus Aid, Relief and Economic Security Act (\"CARES Act\") were assessed for potential downgrades of risk ratings.\nFor the Company’s consumer portfolio, the quality of the loan is best indicated by the repayment performance of an individual borrower. As a result, for this portfolio the Company utilizes a pass/default risk-rating system, based on an age analysis (i.e., days past due) associated with each consumer loan. Under this structure, consumer loans less than 90 days past due are assigned a \"pass\" rating, while any consumer loans 90 days or more past due are assigned a \"default\" rating.\nThe following table details the amortized cost balances of the Company's loan portfolios, presented by credit quality indicator and origination year as of the dates indicated below:\n21\n| September 30, 2022 |\n| 2022 | 2021 | 2020 | 2019 | 2018 | Prior | Revolving Loans | Revolving converted to Term | Total (1) |\n| (Dollars in thousands) |\n| Commercial andindustrial |\n| Pass (2) | $ | 292,601 | $ | 149,588 | $ | 122,752 | $ | 67,591 | $ | 82,911 | $ | 22,943 | $ | 759,390 | $ | 3,362 | $ | 1,501,138 |\n| Potential weakness | 1,540 | 973 | 1,038 | 1,844 | 3,955 | 715 | 6,557 | — | 16,622 |\n| Definite weakness - loss unlikely | 2,485 | 935 | — | 39 | — | 111 | 27,019 | — | 30,589 |\n| Partial loss probable | — | — | — | — | — | — | — | — | — |\n| Definite loss | — | — | — | — | — | — | — | — | — |\n| Total commercial and industrial | $ | 296,626 | $ | 151,496 | $ | 123,790 | $ | 69,474 | $ | 86,866 | $ | 23,769 | $ | 792,966 | $ | 3,362 | $ | 1,548,349 |\n| Commercial real estate |\n| Pass | $ | 922,772 | $ | 1,467,370 | $ | 1,265,711 | $ | 773,102 | $ | 733,621 | $ | 1,976,282 | $ | 47,317 | $ | 1,070 | $ | 7,187,245 |\n| Potential weakness | 32,579 | 53,096 | 41,164 | 14,147 | 68,298 | 205,234 | — | — | 414,518 |\n| Definite weakness - loss unlikely | 26,684 | 2,224 | 4,722 | 2,585 | 17,928 | 21,836 | — | — | 75,979 |\n| Partial loss probable | — | — | — | — | — | 175 | — | — | 175 |\n| Definite loss | — | — | — | — | — | — | — | — | — |\n| Total commercial real estate | $ | 982,035 | $ | 1,522,690 | $ | 1,311,597 | $ | 789,834 | $ | 819,847 | $ | 2,203,527 | $ | 47,317 | $ | 1,070 | $ | 7,677,917 |\n| Commercial construction |\n| Pass | $ | 388,627 | $ | 392,229 | $ | 231,336 | $ | 57,768 | $ | 26,263 | $ | 7,844 | $ | 21,457 | $ | 632 | $ | 1,126,156 |\n| Potential weakness | 40,631 | — | 3,387 | — | — | — | — | — | 44,018 |\n| Definite weakness - loss unlikely | 2,138 | 12,845 | — | — | — | — | — | — | 14,983 |\n| Partial loss probable | — | — | — | — | — | — | — | — | — |\n| Definite loss | — | — | — | — | — | — | — | — | — |\n| Total commercial construction | $ | 431,396 | $ | 405,074 | $ | 234,723 | $ | 57,768 | $ | 26,263 | $ | 7,844 | $ | 21,457 | $ | 632 | $ | 1,185,157 |\n| Small business |\n| Pass | $ | 41,923 | $ | 46,581 | $ | 31,968 | $ | 17,536 | $ | 10,454 | $ | 20,227 | $ | 37,455 | $ | — | $ | 206,144 |\n| Potential weakness | — | 163 | 394 | 369 | 193 | 129 | 697 | — | 1,945 |\n| Definite weakness - loss unlikely | 194 | — | 442 | 7 | 20 | 224 | 591 | — | 1,478 |\n| Partial loss probable | — | — | — | — | — | — | — | — | — |\n| Definite loss | — | — | — | — | — | — | — | — | — |\n| Total small business | $ | 42,117 | $ | 46,744 | $ | 32,804 | $ | 17,912 | $ | 10,667 | $ | 20,580 | $ | 38,743 | $ | — | $ | 209,567 |\n| Residential real estate |\n| Pass | $ | 557,643 | $ | 426,721 | $ | 196,538 | $ | 95,689 | $ | 96,828 | $ | 582,830 | $ | — | $ | — | $ | 1,956,249 |\n| Default | — | — | 676 | 466 | 376 | 1,487 | — | — | 3,005 |\n| Total residential real estate | $ | 557,643 | $ | 426,721 | $ | 197,214 | $ | 96,155 | $ | 97,204 | $ | 584,317 | $ | — | $ | — | $ | 1,959,254 |\n| Home equity |\n| Pass | $ | 37,298 | $ | 61,898 | $ | 56,262 | $ | 32,761 | $ | 27,906 | $ | 124,325 | $ | 741,952 | $ | 3,190 | $ | 1,085,592 |\n| Default | — | — | — | 122 | — | 285 | 1,171 | — | 1,578 |\n| Total home equity | $ | 37,298 | $ | 61,898 | $ | 56,262 | $ | 32,883 | $ | 27,906 | $ | 124,610 | $ | 743,123 | $ | 3,190 | $ | 1,087,170 |\n| Other consumer |\n| Pass | $ | 383 | $ | 2,498 | $ | 1,969 | $ | 1,370 | $ | 380 | $ | 3,630 | $ | 22,680 | $ | — | $ | 32,910 |\n| Default | — | 14 | — | — | — | 11 | 1 | — | 26 |\n| Total other consumer | $ | 383 | $ | 2,512 | $ | 1,969 | $ | 1,370 | $ | 380 | $ | 3,641 | $ | 22,681 | $ | — | $ | 32,936 |\n| Total | $ | 2,347,498 | $ | 2,617,135 | $ | 1,958,359 | $ | 1,065,396 | $ | 1,069,133 | $ | 2,968,288 | $ | 1,666,287 | $ | 8,254 | $ | 13,700,350 |\n\n22\n| September 30, 2021 |\n| 2021 | 2020 | 2019 | 2018 | 2017 | Prior | Revolving Loans | Revolving converted to Term | Total (1) |\n| (Dollars in thousands) |\n| Commercial andindustrial |\n| Pass (2) | $ | 590,532 | $ | 185,706 | $ | 97,095 | $ | 74,381 | $ | 15,175 | $ | 16,731 | $ | 605,718 | $ | 66 | $ | 1,585,404 |\n| Potential weakness | 1,338 | 9,035 | 3,286 | 1,672 | 980 | 1,632 | 10,262 | — | 28,205 |\n| Definite weakness - loss unlikely | 16,597 | 332 | 793 | 1,034 | 2,678 | 214 | 5,452 | — | 27,100 |\n| Partial loss probable | — | — | — | — | — | — | — | — | — |\n| Definite loss | — | — | — | — | — | — | — | — | — |\n| Total commercial and industrial | $ | 608,467 | $ | 195,073 | $ | 101,174 | $ | 77,087 | $ | 18,833 | $ | 18,577 | $ | 621,432 | $ | 66 | $ | 1,640,709 |\n| Commercial real estate |\n| Pass | $ | 699,565 | $ | 1,019,453 | $ | 606,645 | $ | 347,874 | $ | 442,306 | $ | 794,263 | $ | 17,068 | $ | — | $ | 3,927,174 |\n| Potential weakness | 22,106 | 29,091 | 51,976 | 14,628 | 21,350 | 82,655 | 13,615 | — | 235,421 |\n| Definite weakness - loss unlikely | 9,331 | 16,336 | 3,399 | 13,657 | 9,762 | 6,179 | — | — | 58,664 |\n| Partial loss probable | — | — | — | — | — | — | — | — | — |\n| Definite loss | — | — | — | — | — | — | — | — | — |\n| Total commercial real estate | $ | 731,002 | $ | 1,064,880 | $ | 662,020 | $ | 376,159 | $ | 473,418 | $ | 883,097 | $ | 30,683 | $ | — | $ | 4,221,259 |\n| Commercial construction |\n| Pass | $ | 127,945 | $ | 216,573 | $ | 82,559 | $ | 22,851 | $ | 22,873 | $ | 6,505 | $ | 16,424 | $ | 2,134 | $ | 497,864 |\n| Potential weakness | — | 12,991 | — | — | — | — | — | — | 12,991 |\n| Definite weakness - loss unlikely | — | 4,560 | — | — | — | — | — | — | 4,560 |\n| Partial loss probable | — | — | — | — | — | — | — | — | — |\n| Definite loss | — | — | — | — | — | — | — | — | — |\n| Total commercial construction | $ | 127,945 | $ | 234,124 | $ | 82,559 | $ | 22,851 | $ | 22,873 | $ | 6,505 | $ | 16,424 | $ | 2,134 | $ | 515,415 |\n| Small business |\n| Pass | $ | 40,736 | $ | 38,804 | $ | 22,075 | $ | 14,241 | $ | 10,675 | $ | 21,809 | $ | 32,679 | $ | — | $ | 181,019 |\n| Potential weakness | 14 | — | 383 | 200 | 5 | 174 | 627 | — | 1,403 |\n| Definite weakness - loss unlikely | 138 | 637 | 41 | 26 | 10 | 284 | 580 | — | 1,716 |\n| Partial loss probable | — | — | — | — | — | — | — | — | — |\n| Definite loss | — | — | — | — | — | — | — | — | — |\n| Total small business | $ | 40,888 | $ | 39,441 | $ | 22,499 | $ | 14,467 | $ | 10,690 | $ | 22,267 | $ | 33,886 | $ | — | $ | 184,138 |\n| Residential real estate |\n| Pass | $ | 277,949 | $ | 184,974 | $ | 92,723 | $ | 97,915 | $ | 102,581 | $ | 463,397 | $ | — | $ | — | $ | 1,219,539 |\n| Default | — | 123 | — | 1,024 | — | 2,163 | — | — | 3,310 |\n| Total residential real estate | $ | 277,949 | $ | 185,097 | $ | 92,723 | $ | 98,939 | $ | 102,581 | $ | 465,560 | $ | — | $ | — | $ | 1,222,849 |\n| Home equity |\n| Pass | $ | 58,897 | $ | 68,629 | $ | 42,083 | $ | 37,644 | $ | 41,792 | $ | 117,488 | $ | 628,575 | $ | 3,575 | $ | 998,683 |\n| Default | — | — | — | — | — | 33 | 1,717 | 35 | 1,785 |\n| Total home equity | $ | 58,897 | $ | 68,629 | $ | 42,083 | $ | 37,644 | $ | 41,792 | $ | 117,521 | $ | 630,292 | $ | 3,610 | $ | 1,000,468 |\n| Other consumer |\n| Pass | $ | 307 | $ | 347 | $ | 244 | $ | 78 | $ | 500 | $ | 5,338 | $ | 16,359 | $ | — | $ | 23,173 |\n| Default | — | — | — | — | — | — | 2 | — | 2 |\n| Total other consumer | $ | 307 | $ | 347 | $ | 244 | $ | 78 | $ | 500 | $ | 5,338 | $ | 16,361 | $ | — | $ | 23,175 |\n| Total | $ | 1,845,455 | $ | 1,787,591 | $ | 1,003,302 | $ | 627,225 | $ | 670,687 | $ | 1,518,865 | $ | 1,349,078 | $ | 5,810 | $ | 8,808,013 |\n\n23\n(1) Loan origination dates in the tables above reflect the original origination date, or the date of a material modification of a previously originated loan.\n(2) Loans originated as part of the Paycheck Protection Program (\"PPP\") established by the CARES Act are included within commercial and industrial under the 2021 and 2020 vintage year and \"pass\" category as these loans are 100% guaranteed by the U.S. Government. Outstanding PPP loans totaled $ 11.1 million and $ 383.6 million as of September 30, 2022 and 2021, respectively.\nFor the Company’s consumer portfolio, the quality of the loan is best indicated by the repayment performance of an individual borrower. However, the Company does supplement performance data with current Fair Isaac Corporation (“FICO”) scores and Loan to Value (“LTV”) estimates. Current FICO data is purchased and appended to all consumer loans on a regular basis. In addition, automated valuation services and broker opinions of value are used to supplement original value data for the residential real estate and home equity portfolios, periodically. The following table shows the weighted average FICO scores and the weighted average combined LTV ratios at the dates indicated below:\n| September 302022 | December 312021 |\n| Residential real estate portfolio |\n| FICO score (re-scored)(1) | 753 | 749 |\n| LTV (re-valued)(2) | 54.8 | % | 54.4 | % |\n| Home equity portfolio |\n| FICO score (re-scored)(1) | 771 | 772 |\n| LTV (re-valued)(2)(3) | 40.9 | % | 42.4 | % |\n\n(1) The average FICO scores at September 30, 2022 are based upon rescores from June 2022, as available for previously originated loans, or origination score data for loans booked since June 2022. The average FICO scores at December 31, 2021 were based upon rescores available from December 2021, as available for previously originated loans, or origination score data for loans booked in December 2021.\n(2) The combined LTV ratios for September 30, 2022 are based upon updated automated valuations as of August 2022, when available, and/or the most current valuation data available. The combined LTV ratios for December 31, 2021 were based upon updated automated valuations as of November 2021, when available, and/or the most current valuation data available as of such date. The updated automated valuations provide new information on loans that may be available since the previous valuation was obtained. If no new information is available, the valuation will default to the previously obtained data or most recent appraisal.\n(3) For home equity loans and lines in a subordinate lien, the LTV data represents a combined LTV, taking into account the senior lien data for loans and lines.\nUnfunded Commitments\nManagement evaluates the need for a reserve on unfunded lending commitments in a manner consistent with loans held for investment. At September 30, 2022 and December 31, 2021, the Company's estimated reserve for unfunded commitments amounted to $ 1.3 million and $ 1.5 million, respectively.\nAsset Quality\nThe Company’s philosophy toward managing its loan portfolios is predicated upon careful monitoring, which stresses early detection and response to delinquent and default situations. Delinquent loans are managed by a team of collection specialists and the Company seeks to make arrangements to resolve any delinquent or default situation over the shortest possible time frame. As a general rule, loans 90 days or more past due with respect to principal or interest are classified as nonaccrual loans. The Company also may use discretion regarding other loans 90 days or more delinquent if the loan is well secured and/or in process of collection.\nIn response to the COVID-19 pandemic, the Company has granted loan modifications to allow deferral of payments for borrowers negatively impacted by the pandemic. The balance of loans with active deferrals as of September 30, 2022 and December 31, 2021 was $ 193.3 million and $ 383.1 million, respectively. The majority of these loans with active deferrals as of September 30, 2022 continue to be characterized as current loans. In accordance with regulatory guidance, these modifications are not considered to be troubled debt restructures (\"TDRs\") if they were performing as of December 31, 2019. Additionally, a majority of these modified loans are characterized as current and therefore are not impacting nonaccrual or delinquency totals as of September 30, 2022 and December 31, 2021. The Company does, however, consider all active deferrals when estimating loss reserves. As loans reach their deferral maturity date, consideration of TDR and delinquency status will resume in accordance with the Company's accounting policy.\n24\nThe following table shows information regarding nonaccrual loans as of the dates indicated:\n| Nonaccrual Balances |\n| September 30, 2022 | December 31, 2021 |\n| With Allowance for Credit Losses | Without Allowance for Credit Losses | Total | With Allowance for Credit Losses | Without Allowance for Credit Losses | Total |\n| (Dollars in thousands) |\n| Commercial and industrial | $ | 27,374 | $ | 19 | $ | 27,393 | $ | 3,420 | $ | 19 | $ | 3,439 |\n| Commercial real estate | 15,982 | — | 15,982 | 10,870 | — | 10,870 |\n| Small business | 50 | — | 50 | 44 | — | 44 |\n| Residential real estate | 8,891 | — | 8,891 | 8,580 | 602 | 9,182 |\n| Home equity | 3,485 | — | 3,485 | 3,781 | — | 3,781 |\n| Other consumer | 216 | — | 216 | 504 | — | 504 |\n| Total nonaccrual loans (1) | $ | 55,998 | $ | 19 | $ | 56,017 | $ | 27,199 | $ | 621 | $ | 27,820 |\n\n(1) Included in these amounts were $ 1.5 million and $ 2.0 million of nonaccruing TDRs at September 30, 2022 and December 31, 2021, respectively.\nIt is the Company's policy to reverse any accrued interest when a loan is put on nonaccrual status, and, as such, the Company did not record any interest income on nonaccrual loans during the nine months ended September 30, 2022 and 2021.\nThe following table shows information regarding foreclosed residential real estate property at the dates indicated:\n| September 30, 2022 | December 31, 2021 |\n| (Dollars in thousands) |\n| Foreclosed residential real estate property held by the creditor | $ | — | $ | — |\n| Recorded investment in mortgage loans collateralized by residential real estate property that are in the process of foreclosure | $ | 1,871 | $ | 1,426 |\n\nThe following tables show the age analysis of past due financing receivables as of the dates indicated:\n| September 30, 2022 |\n| 30-59 days | 60-89 days | 90 days or more | Total Past Due | TotalFinancingReceivables | Amortized Cost>90 Daysand Accruing |\n| Numberof Loans | PrincipalBalance | Numberof Loans | PrincipalBalance | Numberof Loans | PrincipalBalance | Numberof Loans | PrincipalBalance | Current |\n| (Dollars in thousands) |\n| Loan Portfolio |\n| Commercial and industrial | 10 | $ | 322 | 1 | $ | 182 | 3 | $ | 558 | 14 | $ | 1,062 | $ | 1,547,287 | $ | 1,548,349 | $ | — |\n| Commercial real estate | 9 | 5,419 | 5 | 4,491 | 2 | 208 | 16 | 10,118 | 7,667,799 | 7,677,917 | — |\n| Commercial construction | — | — | 1 | 1,661 | — | — | 1 | 1,661 | 1,183,496 | 1,185,157 | — |\n| Small business | 7 | 233 | 3 | 15 | 6 | 29 | 16 | 277 | 209,290 | 209,567 | — |\n| Residential real estate | 15 | 3,146 | 6 | 1,202 | 19 | 1,804 | 40 | 6,152 | 1,953,102 | 1,959,254 | — |\n| Home equity | 14 | 534 | 8 | 775 | 19 | 1,577 | 41 | 2,886 | 1,084,284 | 1,087,170 | — |\n| Other consumer (1) | 504 | 510 | 36 | 245 | 8 | 26 | 548 | 781 | 32,155 | 32,936 | — |\n| Total | 559 | $ | 10,164 | 60 | $ | 8,571 | 57 | $ | 4,202 | 676 | $ | 22,937 | $ | 13,677,413 | $ | 13,700,350 | $ | — |\n\n25\n| December 31, 2021 |\n| 30-59 days | 60-89 days | 90 days or more | Total Past Due | TotalFinancingReceivables | RecordedInvestment>90 Daysand Accruing |\n| Numberof Loans | PrincipalBalance | Numberof Loans | PrincipalBalance | Numberof Loans | PrincipalBalance | Numberof Loans | PrincipalBalance | Current |\n| (Dollars in thousands) |\n| Loan Portfolio |\n| Commercial and industrial | 7 | $ | 143 | 2 | $ | 252 | 2 | $ | 24 | 11 | $ | 419 | $ | 1,562,860 | $ | 1,563,279 | $ | — |\n| Commercial real estate | 15 | 32,845 | — | — | 4 | 1,339 | 19 | 34,184 | 7,958,160 | 7,992,344 | — |\n| Commercial construction | — | — | — | — | — | — | — | — | 1,165,457 | 1,165,457 | — |\n| Small business | 11 | 136 | 6 | 53 | 4 | 24 | 21 | 213 | 192,976 | 193,189 | — |\n| Residential real estate | 12 | 2,709 | 5 | 714 | 76 | 3,922 | 93 | 7,345 | 1,597,341 | 1,604,686 | — |\n| Home equity | 15 | 1,375 | 6 | 381 | 21 | 1,671 | 42 | 3,427 | 1,036,184 | 1,039,611 | — |\n| Other consumer (1) | 458 | 719 | 41 | 277 | 16 | 112 | 515 | 1,108 | 27,612 | 28,720 | — |\n| Total | 518 | $ | 37,927 | 60 | $ | 1,677 | 123 | $ | 7,092 | 701 | $ | 46,696 | $ | 13,540,590 | $ | 13,587,286 | $ | — |\n\n(1) Other consumer portfolio is inclusive of deposit account overdrafts recorded as loan balances.\nTroubled Debt Restructurings\nIn the course of resolving nonperforming loans, the Bank may choose to restructure the contractual terms of certain loans. The Bank attempts to work out an alternative payment schedule with the borrower in order to avoid foreclosure actions. Exclusive of loans modified under provisions of the CARES Act, any loans that are modified are reviewed by the Bank to identify if a TDR has occurred, which is when, for economic or legal reasons related to a borrower’s financial difficulties, the Bank grants a concession to the borrower that it would not otherwise consider. Terms may be modified to fit the ability of the borrower to repay in line with its current financial status and the restructuring of the loan may include the transfer of assets from the borrower to satisfy the debt, a modification of loan terms, or a combination of the two.\nThe following table shows the Company’s total TDRs and other pertinent information as of the dates indicated:\n| September 30, 2022 | December 31, 2021 |\n| (Dollars in thousands) |\n| TDRs on accrual status | $ | 11,549 | $ | 14,635 |\n| TDRs on nonaccrual | 1,538 | 1,993 |\n| Total TDRs | $ | 13,087 | $ | 16,628 |\n| Additional commitments to lend to a borrower who has been a party to a TDR | $ | 137 | $ | 190 |\n\nThe Company’s policy is to have any restructured loan which is on nonaccrual status prior to being modified remain on nonaccrual status for six months subsequent to being modified before management considers its return to accrual status. If the restructured loan is on accrual status prior to being modified, it is reviewed to determine if the modified loan should remain on accrual status. Additionally, loans classified as TDRs are adjusted to reflect the changes in value of the recorded investment in the loan, if any, resulting from the granting of a concession. For all residential loan modifications, the borrower must perform during a 90 day trial period before the modification is finalized.\n26\nThe following table shows the TDRs which occurred during the periods indicated and the change in the recorded investment subsequent to the modifications occurring:\n| Three Months Ended | Nine Months Ended |\n| September 30, 2022 | September 30, 2022 |\n| Number ofContracts | Pre-ModificationOutstandingRecordedInvestment | Post-ModificationOutstandingRecordedInvestment | Number ofContracts | Pre-ModificationOutstandingRecordedInvestment | Post-ModificationOutstandingRecordedInvestment |\n| (Dollars in thousands) | (Dollars in thousands) |\n| Troubled debt restructurings |\n| Commercial and industrial | 1 | $ | 68 | $ | 67 | 1 | 68 | 67 |\n| Total (1) | 1 | $ | 68 | $ | 67 | 1 | 68 | 67 |\n| Three Months Ended | Nine Months Ended |\n| September 30, 2021 | September 30, 2021 |\n| Number ofContracts | Pre-ModificationOutstandingRecordedInvestment | Post-ModificationOutstandingRecordedInvestment | Number ofContracts | Pre-ModificationOutstandingRecordedInvestment | Post-ModificationOutstandingRecordedInvestment |\n| (Dollars in thousands) |\n| Troubled debt restructurings |\n| Commercial and industrial | — | $ | — | $ | — | 1 | $ | 14,148 | $ | 14,148 |\n| Commercial real estate | — | — | — | 5 | 3,964 | 3,964 |\n| Small business | — | — | — | 2 | 189 | 189 |\n| Total (1) | — | $ | — | $ | — | 8 | $ | 18,301 | $ | 18,301 |\n\n(1) The pre-modification and post-modification balances represent the legal principal balance of the loan. Activity presented in the table above includes $ 14.3 million of modifications on existing TDRs occurring during the nine months ended September 30, 2021.\nThe following table shows the Company’s post-modification balance of TDRs listed by type of modification for the periods indicated:\n| Three Months Ended | Nine Months Ended |\n| September 30 | September 30 |\n| 2022 | 2021 | 2022 | 2021 |\n| (Dollars in thousands) |\n| Combination rate and maturity | — | — | — | 14,148 |\n| Extended maturity | 67 | — | 67 | 4,153 |\n| Total | 67 | — | $ | 67 | $ | 18,301 |\n\nThe Company considers a loan to have defaulted when it reaches 90 days past due. During the nine months ended September 30, 2022 and September 30, 2021, there were no loans modified during the prior twelve months that subsequently defaulted during the respective periods. The Company determines the amount of allowance on TDRs in accordance with CECL methodology using a discounted cash flow approach, or a fair value of collateral approach if the loan is determined to be individually evaluated.\n27\nNOTE 5 - STOCK BASED COMPENSATION\nDuring the nine months ended September 30, 2022, the Company had the following activity related to stock based compensation:\nTime Vested Restricted Stock Awards\nThe Company made the following awards of time vested restricted stock:\n| Date | Shares Granted | Plan | Grant Date Fair Value Per Share | Vesting Period |\n| 2/17/2022 | 52,100 | 2005 Employee Stock Plan | $ | 84.70 | Ratably over 5 years from grant date |\n| 5/24/2022 | 8,099 | 2018 Non-Employee Director Stock Plan | $ | 80.39 | Shares vested immediately |\n| 9/15/2022 | 646 | 2005 Employee Stock Plan | $ | 77.44 | Ratably over 5 years from grant date |\n\nPerformance-Based Restricted Stock Awards\nOn February 17, 2022, the Company granted 20,700 performance-based restricted stock awards, representing the maximum number of shares that may be earned under the awards, to certain executive level employees. These performance-based restricted stock awards were issued from the 2005 Employee Stock Plan and were determined to have a grant date fair value per share of $ 84.70 . The number of shares to be vested are contingent upon the Company's attainment of certain performance criteria to be measured at the end of a three year performance period, ending December 31, 2024. The awards will vest upon the earlier of the date on which it is determined if the performance goal is achieved subsequent to the performance period or March 31, 2025.\nOn March 10, 2022, the performance-based restricted stock awards that were awarded on February 21, 2019 vested at 50 % of the maximum target shares awarded, or 7,450 shares.\n28\nNOTE 6 - DERIVATIVE AND HEDGING ACTIVITIES\nThe Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally to manage the Company’s interest rate risk. Additionally, the Company enters into interest rate derivatives, foreign exchange contracts and risk participation agreements to accommodate the business requirements of its customers (“customer related positions”). The Company minimizes the market and liquidity risks of customer related positions by entering into similar offsetting positions with broker-dealers. Derivative instruments are carried at fair value in the Company's financial statements. The accounting for changes in the fair value of a derivative instrument is dependent upon whether or not it qualifies as a hedge for accounting purposes, and further, by the type of hedging relationship.\nThe Company does not enter into proprietary trading positions for any derivatives.\nThe Company is subject to over-the-counter derivative clearing requirements which require certain derivatives to be cleared through central clearing houses. Accordingly, the Company clears certain derivative transactions through the Chicago Mercantile Exchange Clearing House (\"CME\"). This clearing house requires the Company to post initial and variation margin to mitigate the risk of non-payment, the latter of which is received or paid daily based on the net asset or liability position of the contracts.\nInterest Rate Positions\nThe Company may utilize various interest rate derivatives as hedging instruments against interest rate risk associated with the Company’s borrowings and loan portfolios. An interest rate derivative is an agreement whereby one party agrees to pay a floating rate of interest on a notional principal amount in exchange for receiving a fixed rate of interest on the same notional amount, for a predetermined period of time, from a second party. The amounts relating to the notional principal amount are not actually exchanged.\n29\nThe following tables reflect the Company's derivative positions as of the dates indicated below for interest rate derivatives which qualify as cash flow hedges for accounting purposes:\n| September 30, 2022 |\n| Weighted Average Rate |\n| Notional Amount | Average Maturity | Current Rate Paid | Receive Fixed Swap Rate | Fair Value |\n| (in thousands) | (in years) | (in thousands) |\n| Interest rate swaps on loans | $ | 1,050,000 | 3.23 | 2.72 | % | 2.66 | % | $ | ( 43,365 ) |\n| Current Rate Paid | Receive Fixed Swap Rate Cap - Floor |\n| Interest rate collars on loans | 400,000 | 2.52 | 2.69 | % | 3.09 % - 2.19 % | ( 10,375 ) |\n| Total | $ | 1,450,000 | $ | ( 53,740 ) |\n| December 31, 2021 |\n| Weighted Average Rate |\n| Notional Amount | Average Maturity | CurrentRateReceived | Pay FixedSwap Rate | Fair Value |\n| (in thousands) | (in years) | (in thousands) |\n| Interest rate swaps on borrowings | $ | 25,000 | 0.62 | 0.16 | % | 1.88 | % | $ | ( 294 ) |\n| Current Rate Paid | Receive Fixed Swap Rate |\n| Interest rate swaps on loans | 550,000 | 2.58 | 0.11 | % | 2.16 | % | 11,830 |\n| Current Rate Paid | Receive Fixed Swap Rate Cap - Floor |\n| Interest rate collars on loans | 400,000 | 1.66 | 0.11 | % | 2.73 % - 2.20 % | 9,383 |\n| Total | $ | 975,000 | $ | 20,919 |\n\nThe maximum length of time over which the Company is currently hedging its exposure to the variability in future cash flows for forecasted transactions related to the payment of variable interest on existing financial instruments is 6.5 years.\nFor derivative instruments that are designated and qualify as cash flow hedging instruments, the effective portion of the gains or losses is reported as a component of other comprehensive income (\"OCI\"), and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. The Company expects approximately $ 22.5 million (pre-tax) to be reclassified as an increase to interest expense, from OCI related to the Company’s cash flow hedges in the twelve months following September 30, 2022. This reclassification is due to anticipated payments that will be made and/or received on the swaps based upon the forward curve as of September 30, 2022.\nThe Company had no fair value hedges as of September 30, 2022 or December 31, 2021.\nCustomer Related Positions\nLoan level derivatives, primarily interest rate swaps, offered to commercial borrowers through the Company’s loan level derivative program do not qualify as hedges for accounting purposes. The Company believes that its exposure to commercial customer derivatives is limited because these contracts are simultaneously matched at inception with an offsetting dealer transaction. Derivatives with dealer counterparties are then either cleared through a clearinghouse or settled directly with a single counterparty. The commercial customer derivative program allows the Company to retain variable-rate commercial loans while allowing the customer to synthetically fix the loan rate by entering into a variable-to-fixed interest rate swap. The amounts relating to the notional principal amount are not actually exchanged.\n30\nForeign exchange contracts offered to commercial borrowers through the Company’s derivative program do not qualify as hedges for accounting purposes. The Company acts as a seller and buyer of foreign exchange contracts to accommodate its customers. To mitigate the market and liquidity risk associated with these derivatives, the Company enters into similar offsetting positions. The amounts relating to the notional principal amount are exchanged.\nThe Company has entered into risk participation agreements with other dealer banks in commercial loan agreements. Participating banks guarantee the performance on borrower-related interest rate swap contracts. These derivatives are not designated as hedges and, therefore, changes in fair value are recognized in earnings. Under a risk participation-out agreement, a derivative asset, the Company participates out a portion of the credit risk associated with the interest rate swap position executed with the commercial borrower for a fee paid to the participating bank. Under a risk participation-in agreement, a derivative liability, the Company assumes, or participates in, a portion of the credit risk associated with the interest rate swap position with the commercial borrower for a fee received from the other bank.\n31\nThe following table reflects the Company’s customer related derivative positions as of the dates indicated below for those derivatives not designated as hedging:\n| Notional Amount Maturing |\n| Number of Positions (1) | Less than 1 year | Less than 2 years | Less than 3 years | Less than 4 years | Thereafter | Total | Fair Value |\n| September 30, 2022 |\n| (Dollars in thousands) |\n| Loan level swaps |\n| Receive fixed, pay variable | 285 | $ | 82,932 | $ | 98,409 | $ | 259,419 | $ | 173,197 | $ | 953,915 | $ | 1,567,872 | $ | ( 127,611 ) |\n| Pay fixed, receive variable | 285 | 82,932 | 98,409 | 259,419 | 173,197 | 953,915 | 1,567,872 | 127,609 |\n| Foreign exchange contracts |\n| Buys foreign currency, sells U.S. currency | 62 | 162,094 | 13,013 | — | — | — | 175,107 | ( 15,992 ) |\n| Buys U.S. currency, sells foreign currency | 62 | 162,094 | 13,013 | — | — | — | 175,107 | 16,079 |\n| Risk participation agreements |\n| Participation out | 11 | 2,605 | — | 24,538 | — | 72,045 | 99,188 | 64 |\n| Participation in | 7 | 22,802 | 16,329 | — | — | 25,944 | 65,075 | ( 15 ) |\n| Notional Amount Maturing |\n| Number of Positions (1) | Less than 1 year | Less than 2 years | Less than 3 years | Less than 4 years | Thereafter | Total | Fair Value |\n| December 31, 2021 |\n| (Dollars in thousands) |\n| Loan level swaps |\n| Receive fixed, pay variable | 296 | $ | 37,589 | $ | 139,844 | $ | 123,507 | $ | 260,953 | $ | 1,060,276 | $ | 1,622,169 | $ | 55,984 |\n| Pay fixed, receive variable | 296 | 37,589 | 139,844 | 123,507 | 260,953 | 1,060,276 | 1,622,169 | ( 55,982 ) |\n| Foreign exchange contracts |\n| Buys foreign currency, sells U.S. currency | 52 | 149,588 | 8,784 | — | — | — | 158,372 | 5,734 |\n| Buys U.S. currency, sells foreign currency | 52 | 149,588 | 8,784 | — | — | — | 158,372 | ( 5,734 ) |\n| Risk participation agreements |\n| Participation out | 11 | — | 2,635 | 7,138 | 24,539 | 68,408 | 102,720 | 279 |\n| Participation in | 7 | 29,972 | 28,235 | — | — | 8,339 | 66,546 | ( 55 ) |\n\n(1) The Company may enter into one dealer swap agreement which offsets multiple commercial borrower swap agreements.\n32\nMortgage Derivatives\nThe Company enters into commitments to fund residential mortgage loans at specified rates and times in the future, with the intention that loans may be sold subsequently in the secondary market. Mortgage loan commitments are referred to as derivative loan commitments if the loan that will result from exercise of the commitment will be held for sale upon funding. These commitments are recognized at fair value on the consolidated balance sheet in other assets and other liabilities with changes in their fair values recorded within mortgage banking income. In addition, the Company has elected the fair value option to carry loans held for sale at fair value. The change in fair value of loans held for sale is recorded in current period earnings as a component of mortgage banking income in accordance with the Company's fair value election. The fair value of loans held for sale decreased by $ 194,000 and $ 75,000 for the three months ended September 30, 2022 and 2021, respectively. The fair value of loans held for sale decreased by $ 620,000 and $ 1.5 million for the nine months ended September 30, 2022 and 2021, respectively. These amounts were offset in earnings by the change in the fair value of mortgage derivatives.\nOutstanding loan commitments expose the Company to the risk that the price of the loans arising from exercise of the loan commitment might change from inception of the rate lock to funding of the loan due to changes in mortgage interest rates. If interest rates increase, the value of these loan commitments decreases. Conversely, if interest rates decrease, the value of these loan commitments increases. To protect against the price risk inherent in derivative loan commitments, the Company utilizes both \"mandatory delivery\" and \"best efforts\" forward loan sale commitments to mitigate the risk of potential decreases in the values of loans that would result from the exercise of the derivative loan commitments. Mandatory delivery contracts are accounted for as derivative instruments. Included in the mandatory delivery forward commitments are To Be Announced securities (\"TBAs\"). Certain assumptions, including pull through rates and rate lock periods, are used in managing the existing and future hedges. The accuracy of underlying assumptions will impact the ultimate effectiveness of any hedging strategies.\nWith mandatory delivery contracts, the Company commits to deliver a certain principal amount of mortgage loans to an investor at a specified price on or before a specified date. If the Company fails to deliver the amount of mortgages necessary to fulfill the commitment by the specified date, it is obligated to pay a \"pair-off\" fee, based on then-current market prices, to the investor/counterparty to compensate the investor for the shortfall. Generally, the Company makes this type of commitment once mortgage loans have been funded and are held for sale, in order to minimize the risk of failure to deliver the requisite volume of loans to the investor and paying pair-off fees as a result. The Company also sells TBA securities to offset potential changes in the fair value of derivative loan commitments. Generally, the Company sells TBA securities by entering into derivative loan commitments for settlement in 30 to 90 days. The Company expects that mandatory delivery contracts, including TBA securities, will experience changes in fair value opposite to the changes in the fair value of derivative loan commitments.\nWith best effort contracts, the Company commits to deliver an individual mortgage loan of a specified principal amount and quality to an investor if the loan to the underlying borrower closes. Generally, best efforts cash contracts have no pair off risk regardless of market movement. The price the investor will pay the seller for an individual loan is specified prior to the loan being funded (e.g., on the same day the lender commits to lend funds to a potential borrower). The Company expects that these best efforts forward loan sale commitments will experience a net neutral shift in fair value with related derivative loan commitments.\nThe aggregate amount of net realized gains on sales of such loans included within mortgage banking income was $ 229,000 and $ 4.9 million for the three months ended September 30, 2022 and 2021, respectively, and $ 550,000 and $ 17.2 million for the nine months ended September 30, 2022 and 2021, respectively.\nBalance Sheet Offsetting\nThe Company does not offset fair value amounts recognized for derivative instruments. The Company does net the amount recognized for the right to reclaim cash collateral against the obligation to return cash collateral arising from derivative instruments executed with the same counterparty under a master netting arrangement. Collateral legally required to be maintained at dealer banks by the Company is monitored and adjusted as necessary.\nA daily settlement occurs through the CME for changes in the fair value of centrally cleared derivatives. Not all of the derivatives are required to be cleared through the daily clearing agent. As a result, the total fair values of loan level derivative assets and liabilities recognized on the Company's financial statements are not equal and offsetting.\n33\nThe table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the balance sheet and the potential effect of netting arrangements on its financial position, at the dates indicated:\n| Asset Derivatives (1) | Liability Derivatives (2) |\n| Fair Value at | Fair Value at | Fair Value at | Fair Value at |\n| September 302022 | December 312021 | September 302022 | December 312021 |\n| (Dollars in thousands) |\n| Derivatives designated as hedges |\n| Interest rate derivatives | $ | — | $ | 21,951 | (3) | $ | 53,740 | (4) | $ | 1,032 | (4) |\n| Derivatives not designated as hedges |\n| Customer Related Positions |\n| Loan level derivatives | 127,625 | (3) | 68,726 | (3) | 127,627 | (4) | 68,724 | (4) |\n| Foreign exchange contracts | 16,520 | 6,147 | 16,433 | 6,147 |\n| Risk participation agreements | 64 | 279 | 15 | 55 |\n| Mortgage Derivatives |\n| Interest rate lock commitments | 6 | 753 | 16 | — |\n| Forward sale loan commitments | 86 | 56 | — | — |\n| Forward sale hedge commitments | 73 | — | — | 57 |\n| Total derivatives not designated as hedges | 144,374 | 75,961 | 144,091 | 74,983 |\n| Total | 144,374 | 97,912 | 197,831 | 76,015 |\n| Netting Adjustments (5) | ( 62,614 ) | ( 5,727 ) | 35,293 | 6,769 |\n| Net Derivatives on the Balance Sheet | 81,760 | 92,185 | 162,538 | 69,246 |\n| Financial instruments (6) | 17,744 | 22,378 | 17,744 | 22,378 |\n| Cash collateral pledged (received) | — | — | — | 33,838 |\n| Net Derivative Amounts | $ | 64,016 | $ | 69,807 | $ | 144,794 | $ | 13,030 |\n\n(1) All asset derivatives are reflected in other assets on the balance sheet.\n(2) All liability derivatives are reflected in other liabilities on the balance sheet.\n(3) Approximately $ 660,000 of accrued interest receivable is included in the fair value of the loan level derivative assets at September 30, 2022, in comparison to accrued interest receivable of approximately $ 1.2 million and $ 1.5 million in included in the fair value of interest rate and loan level derivative assets, respectively, at December 31, 2021.\n(4) Approximately $ 36,000 and $ 660,000 of accrued interest payable is included in the fair value of interest rate and loan level derivative liabilities, respectively, at September 30, 2022. Accrued interest payable of approximately $ 5,000 and $ 1.5 million is included in the fair value of the interest rate and loan level derivative liabilities, respectively, at December 31, 2021.\n(5) Netting adjustments represent the amounts recorded to convert derivative assets and liabilities cleared through CME from a gross basis to a net basis, inclusive of the variation margin payments, in accordance with applicable accounting guidance. As displayed in the table above, derivatives that cleared through the CME were either in a net asset position or a net liability position at September 30, 2022.\n(6) Reflects offsetting derivative positions with the same counterparty that are not netted on the balance sheet.\n34\nThe table below presents the effect of the Company’s derivative financial instruments included in OCI and current earnings for the periods indicated:\n| Three Months Ended | Nine Months Ended |\n| September 30 | September 30 |\n| 2022 | 2021 | 2022 | 2021 |\n| (Dollars in thousands) |\n| Derivatives designated as hedges |\n| Loss in OCI on derivatives (effective portion), net of tax | $ | ( 27,144 ) | $ | ( 3,383 ) | $ | ( 52,743 ) | $ | ( 11,559 ) |\n| Gain reclassified from OCI into interest income or interest expense (effective portion) | $ | 407 | $ | 4,791 | $ | 8,427 | $ | 13,869 |\n| Derivatives not designated as hedges |\n| Changes in fair value of customer related positions |\n| Other income | $ | 26 | $ | 54 | $ | 147 | $ | 137 |\n| Other expense | ( 67 ) | ( 80 ) | ( 239 ) | ( 374 ) |\n| Changes in fair value of mortgage derivatives |\n| Mortgage banking income | 41 | ( 213 ) | ( 603 ) | ( 3,840 ) |\n| Total | $ | — | $ | ( 239 ) | $ | ( 695 ) | $ | ( 4,077 ) |\n\nThe Company's derivative agreements with institutional counterparties contain various credit-risk related contingent provisions, such as requiring the Company to maintain a well-capitalized capital position. If the Company fails to meet these conditions, the counterparties could request the Company make immediate payment or demand that the Company provide immediate and ongoing full collateralization on derivative positions in net liability positions. All derivative instruments with credit-risk contingent features were in a net asset position at September 30, 2022. At December 31, 2021, the aggregate fair value of all derivative instruments with credit-risk related contingent features that were in a net liability position was $ 34.8 million. Although none of the contingency provisions have applied as of September 30, 2022 and December 31, 2021, the Company posted collateral to offset the net liability exposure with institutional counterparties at December 31, 2021.\nBy using derivatives, the Company is exposed to credit risk to the extent that counterparties to the derivative contracts do not perform as required. Should a counterparty fail to perform under the terms of a derivative contract, the Company's credit exposure on interest rate swaps is limited to the net positive fair value and accrued interest of all swaps with each counterparty. The Company seeks to minimize counterparty credit risk through credit approvals, limits, monitoring procedures, and obtaining collateral, where appropriate. Institutional counterparties must have an investment grade credit rating and be approved by the Company's Board of Directors. As such, management believes the risk of incurring credit losses on derivative contracts with institutional counterparties is remote. The Company's exposure relating to institutional counterparties was $ 127.6 million and $ 28.3 million at September 30, 2022 and December 31, 2021, respectively. The Company’s exposure relating to customer counterparties was approximately $ 8,000 and $ 62.4 million at September 30, 2022 and December 31, 2021, respectively. Credit exposure may be reduced by the value of collateral pledged by the counterparty.\nNOTE 7 - FAIR VALUE MEASUREMENTS\nFair value is a market-based measure considered from the perspective of a market participant rather than an entity-specific measure. Therefore, even when market assumptions are not readily available, the assumptions applied by the Company when determining fair value reflect those that the Company determines market participants would use to price the asset or liability at the measurement date. If there has been a significant decrease in the volume and level of activity for the asset or liability, regardless of the valuation technique(s) used, the objective of a fair value measurement remains the same. Fair value is the price that would be received if the asset were to be sold or that would be or paid if the liability were to be transferred in an orderly market transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. When determining fair value, the Company considers pricing information and other inputs that are current as of the measurement date. In periods of market dislocation, the observability of prices and other inputs may be reduced for certain instruments, or not available at all. The unavailability or reduced availability of pricing or other input information could cause an instrument to be reclassified from one level to another.\nThe Fair Value Measurements and Disclosures Topic of the FASB ASC defines fair value and establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to\n35\nunobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy under the Fair Value Measurements and Disclosures Topic of the FASB ASC are described below:\nLevel 1 – Inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.\nLevel 2 – Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly.\nLevel 3 – Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable.\nTo the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Accordingly, the degree of judgment exercised by the Company in determining fair value is greatest for instruments categorized in Level 3. A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement.\nValuation Techniques\nThere have been no changes in the valuation techniques used during the nine months ended September 30, 2022.\nSecurities\nTrading and Equity Securities\nThese equity securities are valued based on market quoted prices. These securities are categorized in Level 1 as they are actively traded and no valuation adjustments have been applied.\nU.S. Government Agency and U.S. Treasury Securities\nFair value is estimated using either multi-dimensional spread tables or benchmarks. The inputs used include benchmark yields, reported trades, and broker/dealer quotes. These securities are classified as Level 2.\nAgency Mortgage-Backed Securities\nFair value is estimated using either a matrix or benchmarks. The inputs used include benchmark yields, reported trades, broker/dealer quotes, and issuer spreads. These securities are categorized as Level 2.\nAgency Collateralized Mortgage Obligations and Small Business Administration Pooled Securities\nThe valuation model for these securities is volatility-driven and ratings based, and uses multi-dimensional spread tables. The inputs used include benchmark yields, reported trades, new issue data, broker dealer quotes, and collateral performance. If there is at least one significant model assumption or input that is not observable, these securities are categorized as Level 3 within the fair value hierarchy; otherwise, they are classified as Level 2.\nState, County, and Municipal Securities\nThe fair value is estimated using a valuation matrix with inputs including bond interest rate tables, recent transactions, and yield relationships. These securities are categorized as Level 2.\nSingle and Pooled Issuer Trust Preferred Securities\nThe fair value of trust preferred securities, including pooled and single issuer preferred securities, is estimated using external pricing models, discounted cash flow methodologies or similar techniques. The inputs used in these valuations include benchmark yields, reported trades, new issue data, broker dealer quotes, and collateral performance. If there is at least one significant model assumption or input that is not observable, these securities are classified as Level 3 within the fair value hierarchy; otherwise, they are classified as Level 2.\nLoans Held for Sale\nThe Company has elected the fair value option to account for originated closed loans intended for sale. The fair value is measured on an individual loan basis using quoted market prices and when not available, comparable market value or discounted cash flow analysis may be utilized. These assets are typically classified as Level 2.\n36\nDerivative Instruments\nDerivatives\nThe valuation of these instruments is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilizes. The Company incorporates credit valuation adjustments to appropriately reflect nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral postings. Additionally, in conjunction with fair value measurement guidance, the Company has made an accounting policy election to measure the credit risk of its derivative financial instruments that are subject to master netting agreements on a net basis by counterparty portfolio. Although the Company has determined that the majority of the inputs used to value its interest rate derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its interest rate derivatives and risk participation agreements may also utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by the Company and its counterparties. However, as of September 30, 2022 and December 31, 2021, the Company has assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and has determined that the credit valuation adjustments are not significant to the overall valuation of its derivatives. As a result, the Company has determined that its derivative valuations in their entirety are properly classified as Level 2.\nMortgage Derivatives\nThe fair value of mortgage derivatives is determined based on current market prices for similar assets in the secondary market and, therefore, classified as Level 2 within the fair value hierarchy.\nIndividually Assessed Collateral Dependent Loans\nIn accordance with the CECL standard, expected credit losses on individually assessed loans deemed to be collateral dependent are valued based upon the lower of amortized cost or fair value of the underlying collateral less costs to sell. The inputs used in the appraisals of the collateral are not always observable, and in such cases the loans may be classified as Level 3 within the fair value hierarchy; otherwise, they are classified as Level 2.\nOther Real Estate Owned and Other Foreclosed Assets\nOther Real Estate Owned (\"OREO\") and Other Foreclosed Assets are valued at the lower of cost or fair value of the property, less estimated costs to sell. The fair values are generally estimated based upon recent appraisal values of the property less costs to sell the property. Certain inputs used in appraisals are not always observable, and therefore OREO and Other Foreclosed Assets may be classified as Level 3 within the fair value hierarchy.\nGoodwill and Other Intangible Assets\nGoodwill and other intangible assets are subject to impairment testing. The Company conducts an annual impairment test of goodwill in the third quarter of each year, or more frequently if necessary. Other intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. To estimate the fair value of goodwill and, if necessary, other intangible assets, the Company utilizes both a comparable analysis of relevant price multiples in recent market transactions and a discounted cash flow analysis. Both valuation models require a significant degree of management judgment. In the event the fair value as determined by the valuation model is less than the carrying value, the intangibles may be impaired. If the impairment testing resulted in impairment, the Company would classify the impaired goodwill and other intangible assets subjected to nonrecurring fair value adjustments as Level 3.\n37\nAssets and liabilities measured at fair value on a recurring and nonrecurring basis were as follows at the dates indicated:\n| Fair Value Measurements at Reporting Date Using |\n| Balance | Quoted Pricesin ActiveMarkets forIdenticalAssets(Level 1) | SignificantOtherObservableInputs(Level 2) | SignificantUnobservableInputs(Level 3) |\n| September 30, 2022 |\n| (Dollars in thousands) |\n| Recurring fair value measurements |\n| Assets |\n| Trading securities | $ | 3,538 | $ | 3,538 | $ | — | $ | — |\n| Equity securities | 20,439 | 20,439 | — | — |\n| Securities available for sale |\n| U.S. government agency securities | 199,942 | — | 199,942 | — |\n| U.S. treasury securities | 784,458 | — | 784,458 | — |\n| Agency mortgage-backed securities | 344,153 | — | 344,153 | — |\n| Agency collateralized mortgage obligations | 40,787 | — | 40,787 | — |\n| State, county, and municipal securities | 187 | — | 187 | — |\n| Single issuer trust preferred securities issued by banks and insurers | 489 | — | 489 | — |\n| Pooled trust preferred securities issued by banks and insurers | 999 | — | 999 | — |\n| Small business administration pooled securities | 54,496 | — | 54,496 | — |\n| Loans held for sale | 5,100 | — | 5,100 | — |\n| Derivative instruments | 144,374 | — | 144,374 | — |\n| Liabilities |\n| Derivative instruments | 197,831 | — | 197,831 | — |\n| Total recurring fair value measurements | $ | 1,401,131 | $ | 23,977 | $ | 1,377,154 | $ | — |\n| Nonrecurring fair value measurements |\n| Assets |\n| Individually assessed collateral dependent loans (1) | $ | 13,020 | $ | — | $ | — | $ | 13,020 |\n| Total nonrecurring fair value measurements | $ | 13,020 | $ | — | $ | — | $ | 13,020 |\n\n38\n| Fair Value Measurements at Reporting Date Using |\n| Balance | Quoted Pricesin ActiveMarkets forIdenticalAssets(Level 1) | SignificantOtherObservableInputs(Level 2) | SignificantUnobservableInputs(Level 3) |\n| December 31, 2021 |\n| (Dollars in thousands) |\n| Recurring fair value measurements |\n| Assets |\n| Trading securities | $ | 3,720 | $ | 3,720 | $ | — | $ | — |\n| Equity securities | 23,173 | 23,173 | — | — |\n| Securities available for sale |\n| U.S. government agency securities | 215,482 | — | 215,482 | — |\n| U.S. treasury securities | 861,448 | — | 861,448 | — |\n| Agency mortgage-backed securities | 363,933 | — | 363,933 | — |\n| Agency collateralized mortgage obligations | 79,677 | — | 79,677 | — |\n| State, county, and municipal securities | 203 | — | 203 | — |\n| Single issuer trust preferred securities issued by banks and insurers | 491 | — | 491 | — |\n| Pooled trust preferred securities issued by banks and insurers | 1,000 | — | 1,000 | — |\n| Small business administration pooled securities | 48,914 | — | 48,914 | — |\n| Loans held for sale | 24,679 | — | 24,679 | — |\n| Derivative instruments | 97,912 | — | 97,912 | — |\n| Liabilities |\n| Derivative instruments | 76,015 | — | 76,015 | — |\n| Total recurring fair value measurements | $ | 1,644,617 | $ | 26,893 | $ | 1,617,724 | $ | — |\n| Nonrecurring fair value measurements |\n| Assets |\n| Individually assessed collateral dependent loans (1) | $ | 1,174 | $ | — | $ | — | $ | 1,174 |\n| Total nonrecurring fair value measurements | $ | 1,174 | $ | — | $ | — | $ | 1,174 |\n\n(1) The carrying value of individually assessed collateral dependent loans is based on the lower of amortized cost or fair value of the underlying collateral less costs to sell. The fair value of the underlying collateral is generally determined through independent appraisals, which generally include various Level 3 inputs which are not identifiable. Appraisals may be adjusted by management for qualitative factors such as economic factors and estimated liquidation expenses. The range of these possible adjustments may vary.\n39\nThe estimated fair values and related carrying amounts for assets and liabilities for which fair value is only disclosed are shown below at the dates indicated:\n| Fair Value Measurements at Reporting Date Using |\n| CarryingValue | FairValue | Quoted Pricesin ActiveMarkets forIdenticalAssets(Level 1) | SignificantOtherObservableInputs(Level 2) | SignificantUnobservableInputs(Level 3) |\n| September 30, 2022 |\n| (Dollars in thousands) |\n| Financial assets |\n| Securities held to maturity (a) |\n| U.S. government agency securities | $ | 31,696 | $ | 29,303 | $ | — | $ | 29,303 | $ | — |\n| U.S. treasury securities | 100,615 | 87,992 | — | 87,992 | — |\n| Agency mortgage-backed securities | 892,102 | 802,093 | — | 802,093 | — |\n| Agency collateralized mortgage obligations | 553,995 | 476,970 | — | 476,970 | — |\n| Single issuer trust preferred securities issued by banks | 1,500 | 1,508 | — | 1,508 | — |\n| Small business administration pooled securities | 117,727 | 112,119 | — | 112,119 | — |\n| Loans, net of allowance for credit losses (b) | 13,540,017 | 13,208,966 | — | — | 13,208,966 |\n| Federal Home Loan Bank stock (c) | 5,218 | 5,218 | — | 5,218 | — |\n| Cash surrender value of life insurance policies (d) | 293,126 | 293,126 | — | 293,126 | — |\n| Financial liabilities |\n| Deposit liabilities, other than time deposits (e) | $ | 15,160,375 | $ | 15,160,375 | $ | — | $ | 15,160,375 | $ | — |\n| Time certificates of deposits (f) | 1,178,619 | 1,147,506 | — | 1,147,506 | — |\n| Federal Home Loan Bank borrowings (f) | 643 | 571 | — | 571 | — |\n| Junior subordinated debentures (g) | 62,855 | 59,770 | — | 59,770 | — |\n| Subordinated debentures (f) | 49,862 | 44,066 | — | — | 44,066 |\n\n40\n| Fair Value Measurements at Reporting Date Using |\n| Carrying Value | FairValue | Quoted Pricesin ActiveMarkets forIdenticalAssets(Level 1) | SignificantOtherObservableInputs(Level 2) | SignificantUnobservableInputs(Level 3) |\n| December 31, 2021 |\n| (Dollars in thousands) |\n| Financial assets |\n| Securities held to maturity (a) |\n| U.S. government agency securities | $ | 32,987 | $ | 32,546 | $ | — | $ | 32,546 | $ | — |\n| U.S. treasury securities | 102,560 | 102,242 | — | 102,242 | — |\n| Agency mortgage-backed securities | 493,012 | 497,236 | — | 497,236 | — |\n| Agency collateralized mortgage obligations | 415,736 | 408,845 | — | 408,845 | — |\n| Single issuer trust preferred securities issued by banks | 1,500 | 1,508 | — | 1,508 | — |\n| Small business administration pooled securities | 21,023 | 21,756 | — | 21,756 | — |\n| Loans, net of allowance for credit losses (b) | 13,439,190 | 13,389,515 | — | — | 13,389,515 |\n| Federal Home Loan Bank stock (c) | 11,407 | 11,407 | — | 11,407 | — |\n| Cash surrender value of life insurance policies (d) | 289,304 | 289,304 | — | 289,304 | — |\n| Financial liabilities |\n| Deposit liabilities, other than time deposits (e) | $ | 15,385,894 | $ | 15,385,894 | $ | — | $ | 15,385,894 | $ | — |\n| Time certificates of deposits (f) | 1,531,150 | 1,529,857 | — | 1,529,857 | — |\n| Federal Home Loan Bank borrowings (f) | 25,667 | 25,663 | — | 25,663 | — |\n| Long-term borrowings (f) | 14,063 | 13,989 | — | 13,989 | — |\n| Junior subordinated debentures (g) | 62,853 | 67,019 | — | 67,019 | — |\n| Subordinated debentures (f) | 49,791 | 45,532 | — | — | 45,532 |\n\n(a) The fair values presented are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments and/or discounted cash flow analysis.\n(b) Fair value of loans is measured using the exit price valuation method, determined primarily by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities or cash flows, while incorporating liquidity and credit assumptions. Additionally, this amount excludes individually assessed collateral dependent loans, which are deemed to be marked to fair value on a nonrecurring basis.\n(c) Federal Home Loan Bank stock has no quoted market value and is carried at cost; therefore, the carrying amount approximates fair value.\n(d) Cash surrender value of life insurance policies is recorded at its cash surrender value (or the amount that can be realized upon surrender of the policy), therefore, carrying amount approximates fair value.\n(e) Fair value of demand deposits, savings and interest checking accounts and money market deposits is the amount payable on demand at the reporting date.\n(f) Fair value was determined by discounting anticipated future cash payments using rates currently available for instruments with similar remaining maturities.\n(g) Fair value was determined based upon market prices of securities with similar terms and maturities.\nThis summary excludes certain financial assets and liabilities for which the carrying value approximates fair value. For financial assets, these may include cash and due from banks, federal funds sold and short-term investments. For financial liabilities, these may include federal funds purchased. These instruments would all be considered to be classified as Level 1 within the fair value hierarchy. Also excluded from the summary are financial instruments measured at fair value on a recurring and nonrecurring basis, as previously described.\nThe Company considers its current use of financial instruments to be the highest and best use of the instruments.\n41\nNOTE 8 - REVENUE RECOGNITION\nA portion of the Company's noninterest income is derived from contracts with customers, and as such, the revenue recognized depicts the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The Company considers the terms of the contract and all relevant facts and circumstances when applying this guidance. To ensure its alignment with this core principle, the Company measures revenue and the timing of recognition by applying the following five steps:\n1.Identify the contract(s) with customers\n2.Identify the performance obligations\n3.Determine the transaction price\n4.Allocate the transaction price to the performance obligations\n5.Recognize revenue when (or as) the entity satisfies a performance obligation\nThe Company has disaggregated its revenue from contracts with customers into categories that depict how the nature, amount, timing, and uncertainty of revenue and cash flows are affected by economic factors. The following table presents the revenue streams that the Company has disaggregated as of the periods indicated:\n| Three Months Ended | Nine Months Ended |\n| September 302022 | September 302021 | September 302022 | September 302021 |\n| (Dollars in thousands) |\n| Deposit account fees (inclusive of cash management fees) | $ | 6,261 | $ | 4,298 | $ | 17,582 | $ | 11,704 |\n| Interchange fees | 2,833 | 2,223 | 8,043 | 6,267 |\n| ATM fees | 1,066 | 817 | 2,900 | 2,177 |\n| Investment management - wealth management and advisory services | 7,834 | 8,147 | 23,563 | 23,576 |\n| Investment management - retail investments and insurance revenue | 602 | 1,027 | 2,875 | 2,774 |\n| Merchant processing income | 412 | 365 | 1,140 | 1,024 |\n| Credit card income | 495 | 334 | 1,341 | 883 |\n| Other noninterest income | 1,782 | 1,362 | 4,650 | 3,732 |\n| Total noninterest income in-scope of ASC 606 | 21,285 | 18,573 | 62,094 | 52,137 |\n| Total noninterest income out-of-scope of ASC 606 | 6,910 | 7,884 | 20,271 | 24,533 |\n| Total noninterest income | $ | 28,195 | $ | 26,457 | $ | 82,365 | $ | 76,670 |\n\nIn each of the revenue streams identified above, there were no significant judgments made in determining or allocating the transaction price, as the consideration and service requirements are generally explicitly identified in the associated contracts. Additional information related to each of the revenue streams is further noted below.\nDeposit Account Fees\nThe Company offers various deposit account products to its customers governed by specific deposit agreements applicable to either personal customers or business customers. These agreements identify the general conditions and obligations of both parties, and include standard information regarding deposit account related fees.\nDeposit account services include providing access to deposit accounts as well as access to the various deposit transactional services of the Company. These transactional services are primarily those that are identified in the standard fee schedule, and include, but are not limited to, services such as overdraft protection, wire transfer, and check collection. Revenue is recognized in conjunction with the various services being provided. For example, the Company may assess monthly fixed service fees associated with the customer having access to a deposit account, which can vary depending on the account type and daily account balance. In addition, the Company may also assess separate fixed fees associated with and at the time specific transactions are entered into by the customer. As such, the Company considers its performance obligations to be met concurrently with providing the account access or completing the requested deposit transaction.\n42\nCash Management\nCash management services are a subset of the deposit account fees revenue stream. These services primarily include ACH transaction processing, positive pay and remote deposit services. These services are also governed by separate agreements entered into with the customer. The fee arrangement for these services is structured to assess fees under one of two scenarios, either a per transaction fee arrangement or an earnings credit analysis arrangement. Under the per transaction fee arrangement, fixed fees are assessed concurrently with customers executing the transactions, and as such, the Company considers its performance obligations to be met concurrently with completing the requested transaction. Under the earnings credit analysis arrangement, the Company provides a monthly earnings credit to the customer that is negotiated and determined based on various factors. The credit is then available to absorb the per transaction fees that are assessed on the customer's deposit account activity for the month. Any amount of the transactional fees in excess of the earnings credit is recognized as revenue in that month.\nInterchange Fees\nThe Company earns interchange revenue from its issuance of credit and debit cards granted through its membership in various card payment networks. The Company provides credit cards and debit cards to its customers which are authorized and settled through these payment networks, and in exchange, the Company earns revenue as determined by each payment network's interchange program. The revenue is recognized concurrently with the settlement of card transactions within each network.\nATM Fees\nThe Company deploys automated teller machines (ATMs) as part of its overall branch network. Certain transactions performed at the ATMs require customers to acknowledge and pay a fee for the requested service. Certain ATM fees are disclosed in the deposit account agreement fee schedules, whereas those assessed to non-Rockland Trust deposit holders are solely determined during the transaction at the machine.\nThe ATM fee is a fixed dollar per transaction amount, and as such, is recognized concurrently with the overall daily processing and settlement of the ATM activity.\nInvestment Management - Wealth Management and Advisory Services\nThe Company offers investment management and trust services to individuals, institutions, small businesses and charitable institutions. Each investment management product is governed by its own contract along with a separate identifiable fee schedule unique to that product. The Company also offers additional services, such as estate settlement, financial planning, tax services and other special services quoted at the client's request.\nThe asset management and/or custody fees are based upon a percentage of the monthly valuation of the principal assets in the customer's account, whereas fees for additional or special services are fixed in nature and are charged as services are rendered. As the fees are dependent on assets under management, which are susceptible to market factors outside of the Company's control, this variable consideration is constrained and therefore no revenue is estimated at contract initiation. As such, all revenue is recognized in correlation to the monthly management fee determinations or as transactional services are provided. Due to the fact that payments are primarily made subsequent to the valuation period, the Company records a receivable for revenue earned but not received. The following table provides the amount of investment management revenue earned but not received as of the dates indicated:\n| September 30, 2022 | December 31, 2021 |\n| (Dollars in thousands) |\n| Receivables, included in other assets | $ | 4,401 | $ | 5,385 |\n\nInvestment Management - Retail Investments and Insurance Revenue\nThe Company offers the sale of mutual fund shares, unit investment trust shares, general securities, fixed and variable annuities and life insurance products through registered representatives who are both employed by the Company and licensed and contracted with various broker general agents to offer these products to the Company’s customer base. As such, the Company performs these services as an agent and earns a fixed commission on the sales of these products and services. To a lesser degree, production bonus commissions can also be earned based upon the Company meeting certain volume thresholds.\n43\nIn general, the Company recognizes commission revenue at the point of sale, and for certain insurance products, may also earn and recognize annual residual commissions commensurate with annual premiums being paid.\nMerchant Processing Income\nThe Company refers customers to third party merchant processing partners in exchange for commission and fee income. The income earned is comprised of multiple components, including a fixed referral fee per each referred customer, a rebate amount determined primarily as a percentage of net revenue earned by the third party from services provided to each referred customer, and overall production bonus commissions if certain new account production thresholds are met. Merchant processing income is recognized in conjunction with either completing the referral to earn the fixed fee amount or as the merchant activity is processed to derive the Company's rebate and/or production bonus amounts.\nCredit Card Income\nThe Company provides consumer and business credit card solutions to its customers by soliciting new accounts on behalf of a third party credit card provider in exchange for a fee. The income earned is comprised of new account incentive payments as well as a percentage of interchange income earned by the third party provider offering the consumer and business purpose revolving credit accounts. The credit card income is recognized in conjunction with the establishment of each new credit card member or as the interchange is earned by the third party in connection with net purchase transactions made by the credit card member.\nOther Noninterest Income\nThe Company earns various types of other noninterest income that fall within the scope of the new revenue recognition rules, and have been aggregated into one general revenue stream in the table noted above. This amount includes, but is not limited to, the following types of revenue with customers:\nSafe Deposit Rent\nThe Company rents out the use of safe deposit boxes to its customers, which can be accessed when the bank is open for business. The safe deposit box rental fee is paid upfront and is recognized as revenue ratably over the annual term of the contract.\n1031 Exchange Fee Revenue\nThe Company provides like-kind exchange services pursuant to Section 1031 of the Internal Revenue Code. Fee income is recognized in conjunction with completing the exchange transactions.\nForeign Currency\nThe Company earns fee income associated with various transactions related to foreign currency product offerings, including foreign currency bank notes and drafts and foreign currency wires. The majority of this income is derived from commissions earned related to customers executing the above mentioned foreign currency transactions through arrangements with third party correspondents.\n44\nNOTE 9 - OTHER COMPREHENSIVE INCOME (LOSS)\nThe following tables present a reconciliation of the changes in the components of other comprehensive income (loss) for the periods indicated, including the amount of income tax (expense) benefit allocated to each component of other comprehensive income (loss):\n| Three Months EndedSeptember 30, 2022 | Nine Months EndedSeptember 30, 2022 |\n| Pre-TaxAmount | Tax (Expense)Benefit | After TaxAmount | Pre-TaxAmount | Tax (Expense)Benefit | After TaxAmount |\n| (Dollars in thousands) |\n| Change in fair value of securities available for sale | $ | ( 55,461 ) | $ | 12,879 | $ | ( 42,582 ) | $ | ( 167,814 ) | $ | 38,942 | $ | ( 128,872 ) |\n| Less: net security losses reclassified into other noninterest expense | — | — | — | — | — | — |\n| Net change in fair value of securities available for sale | ( 55,461 ) | 12,879 | ( 42,582 ) | ( 167,814 ) | 38,942 | ( 128,872 ) |\n| Change in fair value of cash flow hedges | ( 37,357 ) | 10,505 | ( 26,852 ) | ( 64,963 ) | 18,277 | ( 46,686 ) |\n| Less: net cash flow hedge gains reclassified into interest income or interest expense | 407 | ( 115 ) | 292 | 8,427 | ( 2,370 ) | 6,057 |\n| Net change in fair value of cash flow hedges | ( 37,764 ) | 10,620 | ( 27,144 ) | ( 73,390 ) | 20,647 | ( 52,743 ) |\n| Amortization of net actuarial losses | 159 | ( 45 ) | 114 | 476 | ( 134 ) | 342 |\n| Amortization of net prior service costs | 10 | ( 3 ) | 7 | 29 | ( 8 ) | 21 |\n| Net change in other comprehensive income for defined benefit postretirement plans (1) | 169 | ( 48 ) | 121 | 505 | ( 142 ) | 363 |\n| Total other comprehensive loss | $ | ( 93,056 ) | $ | 23,451 | $ | ( 69,605 ) | $ | ( 240,699 ) | $ | 59,447 | $ | ( 181,252 ) |\n\n\n| Three Months EndedSeptember 30, 2021 | Nine Months EndedSeptember 30, 2021 |\n| Pre-TaxAmount | Tax (Expense)Benefit | After TaxAmount | Pre-TaxAmount | Tax (Expense)Benefit | After TaxAmount |\n| (Dollars in thousands) |\n| Change in fair value of securities available for sale | $ | ( 10,337 ) | $ | 2,440 | $ | ( 7,897 ) | $ | ( 15,589 ) | $ | 3,711 | $ | ( 11,878 ) |\n| Less: net security losses reclassified into other noninterest expense | — | — | — | — | — | — |\n| Net change in fair value of securities available for sale | ( 10,337 ) | 2,440 | ( 7,897 ) | ( 15,589 ) | 3,711 | ( 11,878 ) |\n| Change in fair value of cash flow hedges | 84 | ( 23 ) | 61 | ( 2,214 ) | 624 | ( 1,590 ) |\n| Less: net cash flow hedge gains reclassified into interest income or interest expense | 4,791 | ( 1,347 ) | 3,444 | 13,869 | ( 3,900 ) | 9,969 |\n| Net change in fair value of cash flow hedges | ( 4,707 ) | 1,324 | ( 3,383 ) | ( 16,083 ) | 4,524 | ( 11,559 ) |\n| Net unamortized gain related to defined benefit pension and other postretirement adjustments arising during the period | — | — | — | 653 | ( 184 ) | 469 |\n| Amortization of net actuarial losses | 346 | ( 97 ) | 249 | 1,037 | ( 291 ) | 746 |\n| Amortization of net prior service costs | 44 | ( 13 ) | 31 | 131 | ( 37 ) | 94 |\n| Net change in other comprehensive income for defined benefit postretirement plans (1) | 390 | ( 110 ) | 280 | 1,821 | ( 512 ) | 1,309 |\n| Total other comprehensive loss | $ | ( 14,654 ) | $ | 3,654 | $ | ( 11,000 ) | $ | ( 29,851 ) | $ | 7,723 | $ | ( 22,128 ) |\n\n(1) The amortization of prior service costs is included in the computation of net periodic pension cost as disclosed in Note 14 \"Employee Benefit Plans\" within the Notes to the Consolidated Financial Statements included in Item 8 of the Company's 2021 Form 10-K.\n45\nInformation on the Company’s accumulated other comprehensive income (loss), net of tax, is comprised of the following components as of the dates indicated:\n| Unrealized Gain (Loss) on Securities | Unrealized Gain (Loss) on Cash Flow Hedge | Defined Benefit Postretirement Plans | Accumulated Other Comprehensive Income (Loss) |\n| (Dollars in thousands) |\n| 2022 |\n| Beginning balance: January 1, 2022 | $ | ( 9,667 ) | $ | 14,137 | $ | ( 2,287 ) | $ | 2,183 |\n| Net change in other comprehensive income (loss) | ( 128,872 ) | ( 52,743 ) | 363 | ( 181,252 ) |\n| Ending balance: September 30, 2022 | $ | ( 138,539 ) | $ | ( 38,606 ) | $ | ( 1,924 ) | $ | ( 179,069 ) |\n| 2021 |\n| Beginning balance: January 1, 2021 | $ | 13,255 | $ | 33,276 | $ | ( 5,836 ) | $ | 40,695 |\n| Net change in other comprehensive income (loss) | ( 11,878 ) | ( 11,559 ) | 1,309 | ( 22,128 ) |\n| Ending balance: September 30, 2021 | $ | 1,377 | $ | 21,717 | $ | ( 4,527 ) | $ | 18,567 |\n\nNOTE 10 - COMMITMENTS AND CONTINGENCIES\nFinancial Instruments with Off-Balance Sheet Risk\nIn the normal course of business, the Company enters into various transactions to meet the financing needs of its customers, which, in accordance with GAAP, are not included in its consolidated balance sheets. These transactions include commitments to extend credit and standby letters of credit, and loan exposures with recourse, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. The Company minimizes its exposure to loss under these commitments by subjecting them to credit approval and monitoring procedures.\nThe Company enters into contractual commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Substantially all of these commitments to extend credit are contingent upon customers maintaining specific credit standards at the time of loan funding.\nThe Company has certain loan exposures for which there is recourse. These loan relationships could require the Company to repurchase or cover certain losses per agreements for certain loans that are either sold or referred to third parties.\nStandby letters of credit are written conditional commitments issued to guarantee the performance of a customer to a third party. In the event the customer does not perform in accordance with the terms of the agreement with the third party, the Company would be required to fund the commitment. The maximum potential amount of future payments the Company could be required to make is represented by the contractual amount of the commitment. If the commitment were funded, the Company would be entitled to seek recovery from the customer. The Company’s policies generally require that standby letter of credit arrangements contain security and debt covenants similar to those contained in loan agreements.\nThe fees collected in connection with the issuance of standby letters of credit are representative of the fair value of the Company's obligation undertaken in issuing the guarantee. In accordance with applicable accounting standards related to guarantees, fees collected in connection with the issuance of standby letters of credit are deferred. The fees are then recognized in income proportionately over the life of the standby letter of credit agreement. The deferred standby letter of credit fees represent the fair value of the Company's potential obligations under the standby letter of credit guarantees.\nThe following table summarizes the above financial instruments at the dates indicated:\n| September 30, 2022 | December 31, 2021 |\n| (Dollars in thousands) |\n| Commitments to extend credit | $ | 4,552,576 | $ | 4,535,895 |\n| Standby letters of credit | 25,565 | 24,412 |\n| Deferred standby letter of credit fees | 187 | 124 |\n| Loan exposures sold with recourse | 171,437 | 202,717 |\n\n46\nLease Commitments\nThe Company leases office space, space for ATM locations, and certain branch locations under noncancellable operating leases. Several of these leases contain renewal options to extend lease terms for a period of 1 to 20 years. During the first quarter of 2022, the Company recognized approximately $ 4.4 million in costs associated with several terminated leased locations acquired from Meridian that were subsequently exited. These costs are reflected within merger and acquisition expense in the Consolidated Statement of Income.\nThere has been no significant change in the future minimum lease payments payable by the Company since December 31, 2021. See the Company's 2021 Form 10-K for information regarding leases and other commitments.\nOther Contingencies\nAt September 30, 2022, the Bank was involved in pending lawsuits that arose in the ordinary course of business. Management has reviewed these pending lawsuits with legal counsel and has taken into consideration the view of counsel as to their outcome. In the opinion of management, the final disposition of pending lawsuits is not expected to have a material adverse effect on the Company’s financial position or results of operations.\n47\nNOTE 11 - LOW INCOME HOUSING PROJECT INVESTMENTS\nThe Company has invested in low income housing projects that generate Low Income Housing Tax Credits which provide the Company with tax credits and operating loss tax benefits over a period of approximately 15 years. None of the original investment is expected to be repaid.\nThe following table presents certain information related to the Company's investments in low income housing projects as of the dates indicated:\n| September 302022 | December 312021 |\n| (Dollars in thousands) |\n| Original investment value | $ | 183,889 | $ | 179,481 |\n| Current recorded investment | 129,875 | 135,497 |\n| Unfunded liability obligation | 63,014 | 73,336 |\n| Tax credits and benefits | 16,679 | (1) | 14,198 |\n| Amortization of investments | 13,375 | (1) | 11,892 |\n| Net income tax benefit | 3,304 | (1) | 2,306 |\n\n(1) Amounts shown represent the estimated full year impact for the year ended December 31 , 2022.\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nThe following discussion should be read in conjunction with the consolidated financial statements, notes and tables included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2021, filed with the Securities and Exchange Commission (the \"2021 Form 10-K\").\nCautionary Statement Regarding Forward-Looking Statements\nThis Quarterly Report on Form 10-Q (this \"Report\"), in Management's Discussion and Analysis of Financial Condition and Results of Operations and elsewhere, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are not historical facts and include expressions about management’s confidence and strategies and management’s expectations about new and existing programs and products, acquisitions, relationships, opportunities, taxation, technology, market conditions and economic expectations. These statements may be identified by forward-looking terminology such as “should,” “could,” “will,” “may,” “expect,” “believe,” “forecast,” “view,” “opportunity,” “allow,” “continues,” “reflects,” “typically,” “usually,” “anticipate,” “estimate,” “intend,” or similar statements or variations of such terms. Such forward-looking statements involve certain risks and uncertainties and our actual results may differ materially from such forward-looking statements. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements, in addition to those risk factors listed under the “Risk Factors” section of the 2021 Form 10-K, include but are not limited to:\n•further weakening in the United States economy in general and the regional and local economies within the New England region and the Company’s market area, including any future weakening caused by the COVID-19 pandemic and any uncertainty regarding the length and extent of economic contraction as a result of the pandemic;\n•the potential effects of inflationary pressures, labor market shortages and supply chain issues;\n•the instability or volatility in financial markets and unfavorable general economic or business conditions, globally, nationally or regionally, caused by geopolitical concerns, including as a result of the conflict between Russia and Ukraine;\n•unanticipated loan delinquencies, loss of collateral, decreased service revenues, and other potential negative effects on our business caused by severe weather, pandemics or other external events;\n•adverse changes or volatility in the local real estate market;\n•adverse changes in asset quality and any unanticipated credit deterioration in our loan portfolio including those related to one or more large commercial relationships;\n•acquisitions may not produce results at levels or within time frames originally anticipated and may result in unforeseen integration issues or impairment of goodwill and/or other intangibles;\n•additional regulatory oversight and related compliance costs;\n•changes in trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System;\n48\n•higher than expected tax expense, resulting from failure to comply with general tax laws and changes in tax laws;\n•changes in market interest rates for interest earning assets and/or interest bearing liabilities and changes related to the phase-out of LIBOR;\n•increased competition in the Company’s market areas;\n•adverse weather, changes in climate, natural disasters, geopolitical concerns, including those arising from the conflict between Russia and Ukraine;\n•the emergence of widespread health emergencies or pandemics, including the magnitude and duration of the COVID-19 pandemic, any further resurgences or variants of the COVID-19 virus, the efficacy and availability of vaccines, boosters or other treatments, actions taken by governmental authorities in response thereto, other public health crises or man-made events, and their impact on the Company's local economies or the Company's operations;\n•a deterioration in the conditions of the securities markets;\n•a deterioration of the credit rating for U.S. long-term sovereign debt;\n•inability to adapt to changes in information technology, including changes to industry accepted delivery models driven by a migration to the internet as a means of service delivery;\n•electronic fraudulent activity within the financial services industry, especially in the commercial banking sector;\n•adverse changes in consumer spending and savings habits;\n•the effect of laws and regulations regarding the financial services industry;\n•changes in laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) generally applicable to the Company’s business;\n•the Company's potential judgments, claims, damages, penalties, fines and reputational damage resulting from pending or future litigation and regulatory and government actions, including as a result of our participation in and execution of government programs related to the COVID-19 pandemic;\n•changes in accounting policies, practices and standards, as may be adopted by the regulatory agencies as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board, and other accounting standard setters including, but not limited to, changes to how the Company accounts for credit losses;\n•cyber security attacks or intrusions that could adversely impact our businesses; and\n•other unexpected material adverse changes in our operations or earnings.\nExcept as required by law, the Company disclaims any intent or obligation to update publicly any such forward-looking statements, whether in response to new information, future events or otherwise. Any public statements or disclosures by the Company following this Report which modify or impact any of the forward-looking statements contained in this Report will be deemed to modify or supersede such statements in this Report.\n49\nSelected Quarterly Financial Data\nThe selected consolidated financial and other data of the Company set forth below does not purport to be complete and should be read in conjunction with, and is qualified in its entirety by, the more detailed information, including the Consolidated Financial Statements and related notes, appearing elsewhere in this Report.\n| Three Months Ended |\n| September 302022 | June 302022 | March 312022 | December 312021 | September 302021 |\n| (Dollars in thousands, except per share data) |\n| Financial condition data |\n| Securities | $ | 3,147,123 | $ | 2,934,956 | $ | 2,861,739 | $ | 2,664,859 | $ | 2,318,757 |\n| Loans | 13,700,350 | 13,675,764 | 13,580,027 | 13,587,286 | 8,808,013 |\n| Allowance for credit losses | (147,313) | (144,319) | (144,518) | (146,922) | (92,246) |\n| Goodwill and other intangible assets | 1,012,006 | 1,013,917 | 1,015,831 | 1,017,844 | 525,261 |\n| Total assets | 19,703,269 | 19,982,450 | 20,159,178 | 20,423,405 | 14,533,311 |\n| Total deposits | 16,338,994 | 16,639,548 | 16,763,392 | 16,917,044 | 12,260,140 |\n| Total borrowings | 113,360 | 138,344 | 138,328 | 152,374 | 157,045 |\n| Stockholders’ equity | 2,817,201 | 2,871,185 | 2,965,439 | 3,018,449 | 1,755,954 |\n| Nonperforming loans | 56,017 | 55,915 | 56,618 | 27,820 | 45,810 |\n| Nonperforming assets | 56,017 | 55,915 | 56,618 | 27,820 | 45,810 |\n| Income statement |\n| Interest income | $ | 169,971 | $ | 148,123 | $ | 140,619 | $ | 125,921 | $ | 93,016 |\n| Interest expense | 7,370 | 3,262 | 3,187 | 3,391 | 2,925 |\n| Net interest income | 162,601 | 144,861 | 137,432 | 122,530 | 90,091 |\n| Provision for (release of) credit losses | 3,000 | — | (2,000) | 35,705 | (10,000) |\n| Noninterest income | 28,195 | 27,898 | 26,272 | 29,180 | 26,457 |\n| Noninterest expenses | 92,728 | 90,562 | 95,500 | 117,126 | 72,419 |\n| Net income | 71,897 | 61,776 | 53,097 | 1,702 | 40,007 |\n| Per share data |\n| Net income—basic | $ | 1.57 | $ | 1.32 | $ | 1.12 | $ | 0.04 | $ | 1.21 |\n| Net income—diluted | 1.57 | 1.32 | 1.12 | 0.04 | 1.21 |\n| Cash dividends declared | 0.51 | 0.51 | 0.51 | 0.48 | 0.48 |\n| Book value per share | 61.73 | 62.32 | 62.59 | 63.75 | 53.14 |\n| Tangible book value per share (1) | 39.56 | 40.31 | 41.15 | 42.25 | 37.24 |\n| Performance ratios |\n| Return on average assets | 1.43 | % | 1.24 | % | 1.06 | % | 0.04 | % | 1.11 | % |\n| Return on average common equity | 9.90 | % | 8.49 | % | 7.16 | % | 0.28 | % | 9.04 | % |\n| Net interest margin (on a fully tax equivalent basis) | 3.64 | % | 3.27 | % | 3.09 | % | 3.05 | % | 2.78 | % |\n| Dividend payout ratio | 32.78 | % | 39.11 | % | 42.80 | % | 931.90 | % | 39.64 | % |\n| Asset Quality Ratios |\n| Nonperforming loans as a percent of gross loans | 0.41 | % | 0.41 | % | 0.42 | % | 0.20 | % | 0.52 | % |\n| Nonperforming assets as a percent of total assets | 0.28 | % | 0.28 | % | 0.28 | % | 0.14 | % | 0.32 | % |\n| Allowance for credit losses as a percent of total loans | 1.08 | % | 1.06 | % | 1.06 | % | 1.08 | % | 1.05 | % |\n| Allowance for credit losses as a percent of nonperforming loans | 262.98 | % | 258.10 | % | 255.25 | % | 528.12 | % | 201.37 | % |\n| Capital ratios |\n\n50\n| Equity to assets | 14.30 | % | 14.37 | % | 14.71 | % | 14.78 | % | 12.08 | % |\n| Tangible equity to tangible assets (1) | 9.66 | % | 9.79 | % | 10.18 | % | 10.31 | % | 8.79 | % |\n| Tier 1 leverage capital ratio | 10.51 | % | 10.42 | % | 10.62 | % | 12.03 | % | 9.36 | % |\n| Common equity tier 1 capital ratio | 13.98 | % | 13.90 | % | 14.45 | % | 14.30 | % | 13.53 | % |\n| Tier 1 risk-based capital ratio | 13.98 | % | 13.90 | % | 14.45 | % | 14.30 | % | 14.21 | % |\n| Total risk-based capital ratio | 15.71 | % | 15.62 | % | 16.18 | % | 16.04 | % | 15.78 | % |\n\n(1) Represents a non-GAAP measure. For reconciliation to GAAP book value per share, see Item 2 \"Management's Discussion and Analysis of Financial Condition and Results of Operations - Executive Level Overview - Non-GAAP Measures\" below.\n51\nExecutive Level Overview\nManagement evaluates the Company's operating results and financial condition using measures that include net income, earnings per share, return on assets and equity, return on tangible common equity, net interest margin, tangible book value per share, asset quality indicators, and many others. These metrics are used by management to make key decisions regarding the Company's balance sheet, liquidity, interest rate sensitivity, and capital resources and assist with identifying opportunities for improving the Company's financial position or operating results. The Company maintains an asset-sensitive profile and, accordingly, has benefited from recent interest rate increases. While asset quality remains very strong, management is closely monitoring the economic environment, including elevated inflationary pressures, supply chain issues, and labor shortages being experienced in the current operating environment across various industries. The Company focuses on organic growth, but will also consider growth through acquisition. Any potential acquisition opportunities are evaluated for the potential to provide a satisfactory financial return as well as other criteria (ease of integration, synergies, geographical location). Recent acquisitions include Meridian Bancorp, Inc. (\"Meridian\") and its subsidiary, East Boston Savings Bank (\"EBSB\"), which closed in the fourth quarter of 2021.\nThird Quarter 2022 Results\nNet income for the three months ended September 30, 2022 was $71.9 million, or $1.57 on a diluted earnings per share basis, as compared to $40.0 million, or $1.21 on a diluted earnings per share basis, for the three months ended September 30, 2021, or an increase of 79.7% and 29.8%, respectively. Net income for the nine months ended September 30, 2022 was $186.8 million, or $4.00 on a diluted earnings per share basis, as compared to $119.3 million, or $3.61 on a diluted earnings per share basis, for the nine months ended September 30, 2021, or an increase of 56.6% and 10.8%, respectively. The nine months ended September 30, 2022 results reflect merger and acquisition-related costs of $7.1 million, pre-tax, associated with the Meridian acquisition, as compared to $3.7 million of merger-related costs during the same prior year period. Excluding these merger and acquisition costs, operating net income was $191.9 million, or $4.11 on a diluted per share basis, for the nine months ended September 30, 2022, as compared to $121.9 million, or $3.69 on a diluted per share basis for the nine months ended September 30, 2021. See \"Non-GAAP Measures\" below for a reconciliation of non-GAAP measures.\nThird quarter 2022 results reflected the following key drivers:\n•Improved net interest margin for the quarter;\n•1.3% annualized net loan growth, excluding Paycheck Protection Program (\"PPP\") runoff;\n•Continued modest cash deployment into the securities portfolio;\n•Strong core deposit account openings and low cost of deposits;\n•Modest provision for credit loss; nonperforming assets remained flat;\n•Strong fee income;\n•49% efficiency ratio for the quarter;\n•443,000 shares repurchased, completing the Company's share repurchase program announced in January 2022.\n52\nInterest-Earning Assets\nThe results depicted in the following table reflect the trend of the Company's interest-earning assets over the past five quarters, inclusive of the Company's acquisition of Meridian during the fourth quarter of 2021. Changes over the five quarter period reflect measured deployment of excess cash balances into the securities portfolio, combined with a longer term overall strategy that typically emphasizes loan growth commensurate with overall economic growth. The following table summarizes the Company's interest-earning assets as of the periods indicated:\nManagement strives to be disciplined about loan pricing and considers interest rate sensitivity when generating loan assets. In addition, management takes a disciplined approach to credit underwriting, seeking to avoid undue credit risk and credit losses.\n53\nFunding and Net Interest Margin\nThe Company's overall sources of funding reflect strong business and retail deposit growth with a management strategy of relying upon core deposit growth to fund loans. The following chart shows sources of funding and percentage of core deposits to total deposits for the trailing five quarters:\nThe following table shows the net interest margin and cost of deposits trends for the trailing five quarters:\n54\nNoninterest Income\nNoninterest income is primarily comprised of deposit account fees, interchange and ATM fees, investment management fees and mortgage banking income. The following chart shows trends in the components of noninterest income over the past five quarters:\nExpense Control\nManagement seeks to take a balanced approach to noninterest expense control by monitoring ongoing operating expenses while making needed capital expenditures and prudently investing in growth initiatives. The Company’s primary expenses arise from Rockland Trust’s employee salaries and benefits, as well as expenses associated with buildings and equipment.\nThe following chart depicts the Company's efficiency ratio on a GAAP basis (calculated by dividing noninterest expense by the sum of noninterest income and net interest income), as well as the Company's efficiency ratio on a non-GAAP operating basis, if applicable (calculated by dividing noninterest expense, excluding certain noncore items, by the sum of noninterest income, excluding certain noncore items, and net interest income), over the past five quarters:\n55\n*See \"Non-GAAP Measures\" below for a reconciliation to GAAP financial measures.\nCapital\nThe Company's approach with respect to revenue and expense is designed to promote long-term earnings growth, which in turn contributes to capital growth. Strong earnings retention has contributed to capital growth, both on an absolute level and per share basis, which has been offset in the last two quarters by share repurchases and other comprehensive losses. The following chart shows the Company's book value and tangible book value per share over the past five quarters:\n*See \"Non-GAAP Measures\" below for a reconciliation to GAAP financial measures.\nThe Company declared a quarterly cash dividend of $0.51 per share for each of the first three quarters of 2022, representing an increase of 6.3% from the 2021 quarterly dividend rate of $0.48 per share. During the third quarter of 2022, the Company repurchased approximately 443,000 shares of common stock under the Company's stock repurchase program announced in January 2022. In total, the Company repurchased 1.8 million shares of its common stock during the nine months ended September 30, 2022 at an average price of $78.32 under the January 2022 program which ended in the third quarter. In consideration of the Company's strong current capital position, on October 20, 2022 the Company announced a new stock repurchase plan, which authorizes repurchases by the Company of up to $120 million in common stock. The new plan will be in effect through October 19, 2023.\n56\nNon-GAAP Measures\nWhen management assesses the Company’s financial performance for purposes of making day-to-day and strategic decisions, it does so based upon the performance of its core banking business, which is derived from the combination of net interest income and noninterest or fee income, reduced by operating expenses, the provision for credit losses, and the impact of income taxes and other noncore items. There are items that impact the Company's results that management believes are unrelated to its core banking business such as gains or losses on the sales of securities, merger and acquisition expenses, provision for credit losses on acquired portfolios, loss on extinguishment of debt, impairment, and other items, such as one-time adjustments as a result of changes in laws and regulations. Management excludes items management considers to be noncore when computing the Company’s non-GAAP operating earnings and operating EPS, noninterest income on an operating basis and efficiency ratio on an operating basis. Management believes excluding these items facilitates greater visibility into the Company’s core banking business and underlying trends.\nManagement also supplements its evaluation of financial performance with analysis of tangible book value per share (which is computed by dividing stockholders' equity less goodwill and identifiable intangible assets, which is referred to as tangible common equity, by common shares outstanding) and tangible common equity ratio (which is computed by dividing tangible common equity by tangible assets), both of which are non-GAAP measures. The Company reports these ratios because management believes that investors may find it useful to have access to the same analytical tools used by management to assess performance and identify trends. The Company has recognized goodwill and other intangible assets in conjunction with merger and acquisition activities. Management believes providing information excluding the impact of goodwill and other intangibles facilitates comparison of the capital adequacy of the Company to other companies in the financial services industry.\nThese non-GAAP measures should not be viewed as a substitute for financial results determined in accordance with GAAP. An item which management deems to be noncore and excludes when computing these non-GAAP measures can be of substantial importance to the Company’s results for any particular period. The Company’s non-GAAP performance measures are not necessarily comparable to similarly named non-GAAP performance measures which may be presented by other companies.\nThe following tables summarize adjustments for noncore items for the periods indicated below and shows the reconciliation of non-GAAP measures:\n57\n| Three Months Ended September 30 |\n| Net Income | DilutedEarnings Per Share |\n| 2022 | 2021 | 2022 | 2021 |\n| (Dollars in thousands, except per share data) |\n| Net income available to common shareholders (GAAP) | $ | 71,897 | $ | 40,007 | $ | 1.57 | $ | 1.21 |\n| Non-GAAP adjustments |\n| Noninterest expense components |\n| Add: merger and acquisition expenses | — | 1,943 | — | 0.06 |\n| Noncore increases to income before taxes | — | 1,943 | — | 0.06 |\n| Net tax benefit associated with noncore items (1) | — | (546) | — | (0.02) |\n| Noncore increases to net income | — | 1,397 | — | 0.04 |\n| Operating net income (Non-GAAP) | $ | 71,897 | $ | 41,404 | $ | 1.57 | $ | 1.25 |\n| Nine Months Ended September 30 |\n| Net Income | DilutedEarnings Per Share |\n| 2022 | 2021 | 2022 | 2021 |\n| (Dollars in thousands, except per share data) |\n| Net income available to common shareholders (GAAP) | $ | 186,770 | $ | 119,290 | $ | 4.00 | $ | 3.61 |\n| Non-GAAP adjustments |\n| Noninterest expense components |\n| Add: merger and acquisition expenses | 7,100 | 3,674 | 0.15 | 0.11 |\n| Noncore increases to income before taxes | 7,100 | 3,674 | 0.15 | 0.11 |\n| Net tax benefit associated with noncore items (1) | (1,995) | (1,033) | (0.04) | (0.03) |\n| Noncore increases to net income | 5,105 | 2,641 | 0.11 | 0.08 |\n| Operating net income (Non-GAAP) | $ | 191,875 | $ | 121,931 | $ | 4.11 | $ | 3.69 |\n\n(1)The net tax benefit associated with noncore items is determined by assessing whether each noncore item is included or excluded from net taxable income and applying the Company's combined marginal tax rate to only those items included in net taxable income.\n58\n\n| Three Months Ended |\n| September 302022 | June 302022 | March 312022 | December 312021 | September 302021 |\n| (Dollars in thousands) |\n| Net interest income (GAAP) | $ | 162,601 | $ | 144,861 | $ | 137,432 | $ | 122,530 | $ | 90,091 | (a) |\n| Noninterest income (GAAP) | $ | 28,195 | $ | 27,898 | $ | 26,272 | $ | 29,180 | $ | 26,457 | (b) |\n| Noninterest expense (GAAP) | $ | 92,728 | $ | 90,562 | $ | 95,500 | $ | 117,126 | $ | 72,419 | (c) |\n| Less: |\n| Merger and acquisition expense | — | — | 7,100 | 37,166 | 1,943 |\n| Noninterest expense on an operating basis (Non-GAAP) | $ | 92,728 | $ | 90,562 | $ | 88,400 | $ | 79,960 | $ | 70,476 | (d) |\n| Total revenue (GAAP) | $ | 190,796 | $ | 172,759 | $ | 163,704 | $ | 151,710 | $ | 116,548 | (a+b) |\n| Ratios |\n| Noninterest income as a % of revenue (GAAP based) | 14.78 | % | 16.15 | % | 16.05 | % | 19.23 | % | 22.70 | % | (b/(a+b)) |\n| Efficiency ratio (GAAP based) | 48.60 | % | 52.42 | % | 58.34 | % | 77.20 | % | 62.14 | % | (c/(a+b)) |\n| Efficiency ratio on an operating basis (Non-GAAP) | 48.60 | % | 52.42 | % | 54.00 | % | 52.71 | % | 60.47 | % | (d/(a+b)) |\n\n59\nThe following table summarizes the calculation of tangible common equity to tangible assets ratio and tangible book value per share and shows the reconciliation of non-GAAP measures:\n| September 302022 | June 302022 | March 312022 | December 312021 | September 302021 |\n| (Dollars in thousands, except per share data) |\n| Tangible common equity |\n| Stockholders' equity (GAAP) | $ | 2,817,201 | $ | 2,871,185 | $ | 2,965,439 | $ | 3,018,449 | $ | 1,755,954 | (a) |\n| Less: Goodwill and other intangibles | 1,012,006 | 1,013,917 | 1,015,831 | 1,017,844 | 525,261 |\n| Tangible common equity (Non-GAAP) | 1,805,195 | 1,857,268 | 1,949,608 | 2,000,605 | 1,230,693 | (b) |\n| Tangible assets |\n| Assets (GAAP) | 19,703,269 | 19,982,450 | 20,159,178 | 20,423,405 | 14,533,311 | (c) |\n| Less: Goodwill and other intangibles | 1,012,006 | 1,013,917 | 1,015,831 | 1,017,844 | 525,261 |\n| Tangible assets (Non-GAAP) | $ | 18,691,263 | $ | 18,968,533 | $ | 19,143,347 | $ | 19,405,561 | $ | 14,008,050 | (d) |\n| Common shares | 45,634,626 | 46,069,761 | 47,377,125 | 47,349,778 | 33,043,812 | (e) |\n| Common equity to assets ratio (GAAP) | 14.30 | % | 14.37 | % | 14.71 | % | 14.78 | % | 12.08 | % | (a/c) |\n| Tangible common equity to tangible assets ratio (Non-GAAP) | 9.66 | % | 9.79 | % | 10.18 | % | 10.31 | % | 8.79 | % | (b/d) |\n| Book value per share (GAAP) | $ | 61.73 | $ | 62.32 | $ | 62.59 | $ | 63.75 | $ | 53.14 | (a/e) |\n| Tangible book value per share (Non-GAAP) | $ | 39.56 | $ | 40.31 | $ | 41.15 | $ | 42.25 | $ | 37.24 | (b/e) |\n\nCritical Accounting Policies\nCritical accounting policies are those that are reflective of significant management judgments and uncertainties, and could potentially result in materially different results under different assumptions and conditions. The Company believes that the most critical accounting policies are those that are both most important to the portrayal of the Company’s financial condition and results and require management's most difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain.\nThere have been no material changes in critical accounting policies during the first nine months of 2022. Refer to \"Critical Accounting Policies and Estimates\" in Item 7. \"Management's Discussion and Analysis of Financial Condition and Results of Operations\" in the Company's 2021 Form 10-K for a complete listing of critical accounting policies.\nFINANCIAL POSITION\nSecurities Portfolio The Company’s securities portfolio consists of trading securities, equity securities, securities available for sale, and securities which management intends to hold until maturity. Securities increased by $482.3 million, or 18.1%, at September 30, 2022 as compared to December 31, 2021, primarily reflecting $887.3 million of purchases, partially offset by unrealized losses of $167.8 million related to the available for sale portfolio, as well as paydowns, calls, and maturities. The ratio of securities to total assets increased to 16.0% at September 30, 2022 compared to 13.0% at December 31, 2021, which reflects the ongoing strategy to deploy excess liquidity into increased investment security purchases. The Company estimates expected credit losses for its available for sale and held to maturity securities in accordance with the current expected credit loss (\"CECL\") methodology. Further details regarding the Company's measurement of expected credit losses on securities can be found in Note 3 “Securities” within the Notes to Consolidated Financial Statements included in Part I. Item 1 of this Report.\n60\nResidential Mortgage Loan Sales The Company’s primary loan sale activity arises from the sale of government sponsored enterprise eligible residential mortgage loans. The Company originates residential loans with the intention of either selling them in the secondary market or holding them in the Company's residential real estate portfolio. When a loan is sold, the Company enters into agreements that contain representations and warranties about the characteristics of the loans sold and their origination. The Company may be required to either repurchase mortgage loans or to indemnify the purchaser from losses if representations and warranties are found to be not accurate in all material respects. The Company incurred no material losses related to residential mortgage repurchases during the three and nine months ended September 30, 2022 and 2021, respectively.\nThe following table shows the total residential real estate loans closed and the breakdown of amounts held in portfolio or sold (or held for sale) in the secondary market during the periods indicated:\nTable 1 - Closed Residential Real Estate Loans\n| Three Months Ended September 30 | Nine Months Ended September 30 |\n| 2022 | 2021 | 2022 | 2021 |\n| (Dollars in thousands) |\n| Held in portfolio | $ | 165,065 | $ | 65,832 | $ | 571,115 | $ | 279,176 |\n| Sold or held for sale in the secondary market | 21,325 | 183,794 | 77,309 | 611,795 |\n| Total closed loans | $ | 186,390 | $ | 249,626 | $ | 648,424 | $ | 890,971 |\n\nThe Company experienced a lower volume of residential real estate loans sales for the three and nine months ended September 30, 2022 compared to the same prior year periods, driven primarily by reduced customer demand in the rising interest rate environment. In addition, the volume of closed residential real estate loans held in portfolio increased during the three and nine months ended September 30, 2022.\nThe table below reflects additional information related to the loans sold during the periods indicated:\nTable 2 - Residential Mortgage Loan Sales\n| Three Months Ended September 30 | Nine Months Ended September 30 |\n| 2022 | 2021 | 2022 | 2021 |\n| (Dollars in thousands) |\n| Sold with servicing rights released | $ | 18,206 | $ | 171,256 | $ | 94,006 | $ | 618,171 |\n| Sold with servicing rights retained (1) | 182 | 3,029 | 863 | 11,116 |\n| Total loans sold | $ | 18,388 | $ | 174,285 | $ | 94,869 | $ | 629,287 |\n\n(1)All loans sold with servicing rights retained during the three and nine months ended September 30, 2022 and 2021, respectively, were sold without recourse.\nWhen a loan is sold, the Company may decide to also sell the servicing of sold loans for a servicing release premium, simultaneously with the sale of the loan, or the Company may opt to sell the loan and retain the servicing. In the event of a sale with servicing rights retained, a mortgage servicing asset is established, which represents the then current estimated fair value based on market prices for comparable mortgage servicing contracts, when available, or alternatively is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses. Servicing rights are recorded in other assets in the Consolidated Balance Sheets, are amortized in proportion to and over the period of estimated net servicing income, and are assessed for impairment based on fair value at each reporting date. Impairment is determined by stratifying the rights based on predominant characteristics, such as interest rate, loan type and investor type. Impairment is recognized through a valuation allowance, to the extent that fair value is less than the capitalized amount. If the Company later determines that all or a portion of the impairment no longer exists, a reduction of the allowance may be recorded as an increase to income. The principal balance of loans serviced by the Bank on behalf of investors was $336.2 million, $382.6 million and $342.3 million at September 30, 2022, December 31, 2021, and September 30, 2021, respectively.\n61\nThe following table shows the adjusted cost of the servicing rights associated with these loans and the changes for the periods indicated:\nTable 3 - Mortgage Servicing Asset\n| Three Months Ended September 30 | Nine Months Ended September 30 |\n| 2022 | 2021 | 2022 | 2021 |\n| (Dollars in thousands) |\n| Balance at beginning of period | $ | 2,993 | $ | 2,295 | $ | 2,627 | $ | 2,365 |\n| Additions | 2 | 30 | 8 | 95 |\n| Amortization | (153) | (244) | (510) | (769) |\n| Change in valuation allowance | 103 | 122 | 820 | 512 |\n| Balance at end of period | $ | 2,945 | $ | 2,203 | $ | 2,945 | $ | 2,203 |\n\nSee Note 6, “Derivative and Hedging Activities” within the Notes to Consolidated Financial Statements included in Part I. Item 1 of this Report for more information on mortgage activity and mortgage related derivatives.\nLoan Portfolio Total loans at September 30, 2022 increased by $113.1 million, or 0.8%, when compared to December 31, 2021. Excluding $205.1 million of net paydowns associated with PPP loans during the nine months ended September 30, 2022, the loan portfolio increased by $318.1 million, or 2.4% (3.2% on an annualized basis), compared to December 31, 2021. Organic loan growth was driven primarily by strong consumer loan activity, as the majority of residential real estate loan closings were retained on the balance sheet, while increased demand and line utilization fueled growth in home equity balances. Excluding the net reduction in PPP loans, the commercial portfolio decreased 0.82% at September 30, 2022 in comparison to December 31, 2021, primarily driven by continued elevated levels of attrition within the commercial real estate portfolio, which were partially offset by increased line utilization and higher closing volumes within the commercial and industrial category, which grew by $190.1 million, or 14.1% (18.9% on an annualized basis), as compared to December 31, 2021.\n62\nThe Company's commercial loan portfolio is comprised primarily of commercial and industrial loans as well as commercial real estate loans. Management considers the Company’s commercial and industrial portfolio to be well-diversified with loans to various types of industries. The following pie chart shows the diversification of the commercial and industrial portfolio as of September 30, 2022:\n\n| (Dollars in thousands) |\n| Average loan size (excluding floor plan tranches) | $ | 388 |\n| Largest individual commercial and industrial loan outstanding | $ | 37,650 |\n| Commercial and industrial nonperforming loans/commercial and industrial loans | 1.77 | % |\n\nThe Company’s commercial real estate loan portfolio, inclusive of commercial construction, is the Company’s largest loan type concentration. The Company believes that this portfolio is also well-diversified with loans secured by a variety of property types, such as owner-occupied and nonowner-occupied commercial, retail, office, industrial, warehouse, and other special purpose properties, such as hotels, motels, nursing homes, restaurants, churches, recreational facilities, marinas, and golf courses. Commercial real estate also includes loans secured by certain residential-related property types, including multi-family apartment buildings, residential development tracts and condominiums. The following pie chart shows the diversification of the commercial real estate loan portfolio as of September 30, 2022:\n63\n| (Dollars in thousands) |\n| Average loan size | $ | 1,573 |\n| Largest individual commercial real estate mortgage outstanding | $ | 63,435 |\n| Commercial real estate nonperforming loans/commercial real estate loans | 0.18 | % |\n| Owner occupied commercial real estate loans/commercial real estate loans | 12.0 | % |\n\n64\nThe Company's consumer portfolio primarily consists of both fixed-rate and adjustable-rate residential real estate loans as well as residential construction lending related to single-home residential development within the Company's market area. The Company also provides home equity loans and lines of credit that may be made as a fixed-rate term loan or under a variable rate revolving line of credit secured by a first or junior mortgage on the borrower's residence or second home. Additionally, the Company makes loans for a wide variety of other personal needs. Other consumer loans primarily consist of installment loans and overdraft protections. The residential real estate, home equity and other consumer portfolios totaled $3.1 billion at September 30, 2022, as noted below:\n| (Dollars in thousands) |\n| Average loan size | $ | 165 |\n| Largest individual consumer loan outstanding | $ | 5,181 |\n| Consumer nonperforming loans/consumer loans | 0.41 | % |\n\nAsset Quality The Company continually monitors the asset quality of the loan portfolio using all available information. Based on this assessment, loans demonstrating certain payment issues or other weaknesses may be categorized as delinquent, nonperforming and/or put on nonaccrual status. In the course of resolving such loans, the Company may choose to restructure the contractual terms of certain loans to match the borrower’s ability to repay the loan based on their current financial condition. If a restructured loan meets certain criteria, it may be categorized as a troubled debt restructuring (\"TDR\"). In addition, the Company has offered need-based payment relief options for commercial and small business loans, residential mortgages, and home equity loans and lines of credit in response to the COVID-19 pandemic. In accordance with the Coronavirus Aid, Relief and Economic Security Act (\"CARES Act\"), these modifications are not accounted for as TDRs or reflected as delinquent or non-accrual loans if the borrower was in compliance with the loan terms as of December 31, 2019.\nDelinquency The Company’s philosophy toward managing its loan portfolios is predicated upon careful monitoring, which stresses early detection and response to delinquent and default situations. The Company seeks to make arrangements to resolve any delinquent or default situation over the shortest possible time frame. Generally, the Company requires that a delinquency notice be mailed to a borrower upon expiration of a grace period (typically no longer than 15 days beyond the due date). Reminder notices may be sent and telephone calls may be made prior to the expiration of the grace period. If the delinquent status is not resolved within a reasonable time frame following the mailing of a delinquency notice, the Bank’s personnel charged with managing its loan portfolios contacts the borrower to ascertain the reasons for delinquency and the prospects for payment. Any subsequent actions taken to resolve the delinquency will depend upon the nature of the loan and\n65\nthe length of time that the loan has been delinquent. The borrower’s needs are considered as much as reasonably possible without jeopardizing the Bank’s position. A late charge is usually assessed on loans upon expiration of the grace period.\nNonaccrual Loans As a general rule, loans 90 days or more past due with respect to principal or interest are classified as nonaccrual loans. However, certain loans that are 90 days or more past due may be kept on an accruing status if the loans are well secured and in the process of collection. Income accruals are suspended on all nonaccrual loans and all previously accrued and uncollected interest is reversed against current income. A loan remains on nonaccrual status until it becomes current with respect to principal and interest (and in certain instances remains current for up to six months), the loan is liquidated, or when the loan is determined to be uncollectible and is charged-off against the allowance for credit losses.\nTroubled Debt Restructurings In the course of resolving problem loans, the Company may choose to restructure the contractual terms of certain loans. The Company attempts to work out an alternative payment schedule with the borrower in order to avoid or cure a default. Loans that are modified are reviewed by the Company to identify if a TDR has occurred, which is when, for economic or legal reasons related to a borrower’s financial difficulties, the Bank grants a concession to the borrower that it would not otherwise consider. Terms may be modified to fit the ability of the borrower to repay in line with its current financial status and the restructuring of the loan may include adjustments to interest rates, extensions of maturity, consumer loans where the borrower's obligations have been effectively discharged through Chapter 7 Bankruptcy and the borrower has not reaffirmed the debt to the Bank, and other actions intended to minimize economic loss and avoid foreclosure or repossession of collateral. If such efforts by the Bank do not result in satisfactory performance, the loan is referred to legal counsel, at which time foreclosure proceedings are initiated. At any time prior to a sale of the property at foreclosure, the Bank may terminate foreclosure proceedings if the borrower is able to work out a satisfactory payment plan.\nIt is the Company’s policy to have any restructured loans which are on nonaccrual status prior to being modified remain on nonaccrual status for six months, subsequent to being modified, before management considers their return to accrual status. If the restructured loan is on accrual status prior to being modified, it is reviewed to determine if the modified loan should remain on accrual status. Loans that are considered TDRs are classified as performing, unless they are on nonaccrual status or are delinquent for 90 days or more. Loans classified as TDRs remain classified as such for the life of the loan, except in limited circumstances, when it may be determined that the borrower is performing under modified terms and the restructuring agreement specified an interest rate greater than or equal to an acceptable market rate for a comparable new loan at the time of the restructuring.\nPurchased Credit Deteriorated Loans Purchased Credit Deteriorated (\"PCD\") loans are acquired loans which have shown a more-than-insignificant deterioration in credit quality since origination. PCD loans are recorded at amortized cost with an allowance for credit losses recorded upon purchase.\nNonperforming Assets Nonperforming assets are typically comprised of nonperforming loans and other real estate owned. Nonperforming loans consist of nonaccrual loans and loans that are 90 days or more past due but still accruing interest.\nThe following table sets forth information regarding nonperforming assets held by the Company at the dates indicated:\nTable 4 - Nonperforming Assets\n| September 302022 | December 312021 | September 302021 |\n| (Dollars in thousands) |\n| Loans accounted for on a nonaccrual basis |\n| Commercial and industrial | $ | 27,393 | $ | 3,439 | $ | 19,275 |\n| Commercial real estate | 15,982 | 10,870 | 11,788 |\n| Small business | 50 | 44 | 46 |\n| Residential real estate | 8,891 | 9,182 | 10,872 |\n| Home equity | 3,485 | 3,781 | 3,746 |\n| Other consumer | 216 | 504 | 83 |\n| Total nonperforming assets (1) | $ | 56,017 | $ | 27,820 | $ | 45,810 |\n| Nonperforming loans as a percent of gross loans | 0.41 | % | 0.20 | % | 0.52 | % |\n| Nonperforming assets as a percent of total assets | 0.28 | % | 0.14 | % | 0.32 | % |\n\n(1)Inclusive of TDRs on nonaccrual status of $1.5 million at September 30, 2022, $2.0 million at December 31, 2021, and $21.1 million at September 30, 2021.\nThe following table summarizes the changes in nonperforming assets for the periods indicated:\nTable 5 - Activity in Nonperforming Assets\n| 2022 | 2021 |\n| Three Months Ended | Nine Months Ended |\n| September 302022 | September 302021 | September 302022 | September 302021 |\n| (Dollars in thousands) |\n| Nonperforming assets beginning balance | $ | 55,915 | $ | 47,818 | $ | 27,820 | $ | 66,861 |\n| New to nonperforming | 30,650 | 4,613 | 67,226 | 9,205 |\n| Loans charged-off | (741) | (332) | (1,992) | (4,499) |\n| Loans paid-off | (29,450) | (3,488) | (33,174) | (17,877) |\n| Loans restored to performing status | (366) | (2,813) | (3,806) | (8,143) |\n| Other | 9 | 12 | (57) | 263 |\n| Nonperforming assets ending balance | $ | 56,017 | $ | 45,810 | $ | 56,017 | $ | 45,810 |\n\n67\nThe following table sets forth information regarding troubled debt restructured loans as of the dates indicated:\nTable 6 - Troubled Debt Restructurings\n| September 302022 | December 312021 | September 302021 |\n| (Dollars in thousands) |\n| Performing troubled debt restructurings | $ | 11,549 | $ | 14,635 | $ | 15,950 |\n| Nonaccrual troubled debt restructurings | 1,538 | 1,993 | 21,104 |\n| Total | $ | 13,087 | $ | 16,628 | $ | 37,054 |\n| Performing troubled debt restructurings as a % of total loans | 0.09 | % | 0.11 | % | 0.18 | % |\n| Nonaccrual troubled debt restructurings as a % of total loans | 0.01 | % | 0.01 | % | 0.24 | % |\n| Total troubled debt restructurings as a % of total loans | 0.10 | % | 0.12 | % | 0.42 | % |\n\nThe following table summarizes changes in TDRs for the periods indicated:\nTable 7 - Activity in Troubled Debt Restructurings\n| Three Months Ended | Nine Months Ended |\n| September 302022 | September 302021 | September 302022 | September 302021 |\n| (Dollars in thousands) |\n| TDRs beginning balance | $ | 13,411 | $ | 39,707 | $ | 16,628 | $ | 39,192 |\n| New to TDR status | 62 | — | 62 | 3,918 |\n| Paydowns | (386) | (2,637) | (3,603) | (6,040) |\n| Charge-offs | — | (16) | — | (16) |\n| TDRs ending balance | $ | 13,087 | $ | 37,054 | $ | 13,087 | $ | 37,054 |\n\nIncome accruals are suspended on all nonaccrual loans and all previously accrued and uncollected interest is reversed against current income. The table below shows interest income that was recognized or collected on all nonaccrual loans and TDRs for the periods indicated:\nTable 8 - Interest Income - Nonaccrual Loans and Troubled Debt Restructurings\n\n| Three Months Ended | Nine Months Ended |\n| September 302022 | September 302021 | September 302022 | September 302021 |\n| (Dollars in thousands) |\n| The amount of incremental gross interest income that would have been recorded if nonaccrual loans had been current in accordance with their original terms | $ | 1,802 | $ | 678 | $ | 4,666 | $ | 2,289 |\n| The amount of interest income on nonaccrual loans and performing TDRs that was included in net income | $ | 1,817 | $ | 257 | $ | 2,443 | $ | 673 |\n\nPotential problem loans are any loans which are not included in nonaccrual or nonperforming loans, where known information about possible credit problems of the borrowers causes management to have concerns as to the ability of such borrowers to comply with present loan repayment terms. At September 30, 2022, there were 51 relationships, with an aggregate balance of $173.5 million, deemed to be potential problem loans. These potential problem loans continued to perform with respect to payments. Management actively monitors these loans and strives to minimize any possible adverse impact to the Company.\n68\nAs previously noted, the Company has offered need-based payment relief options to its customers in response to the COVID-19 pandemic, primarily in the form of payment deferrals, all of which were granted prior to December 31, 2020. Loans that were modified are not accounted for as TDRs or reflected as delinquent or nonaccrual loans if the borrower was in compliance with their loan terms as of December 31, 2019. The Company held $193.3 million of loans with active deferrals at September 30, 2022, of which $137.7 million is scheduled to mature during the fourth quarter of 2022.\nAllowance for Credit Losses The allowance for credit losses is maintained at a level that management considers appropriate to provide for the Company's current estimate of expected lifetime credit losses on loans measured at amortized cost. The allowance is increased by providing for credit losses through a charge to expense and by credits for recoveries of loans previously charged-off and is reduced by loans being charged-off.\nIn accordance with the CECL methodology, the Company estimates credit losses for financial assets on a collective basis for loans sharing similar risk characteristics using a quantitative model combined with an assessment of certain qualitative factors designed to address forecast risk and model risk inherent in the quantitative model output. The model estimates expected credit losses using loan level data over the contractual life of the exposure, considering the effect of prepayments. Economic forecasts are incorporated into the estimate over a reasonable and supportable forecast period of one year, beyond which is a reversion to the Company's historical long-run average for a period of six months. The Company's qualitative assessment is structured based upon nine environmental factors impacting the expected risk of loss within the loan portfolio. Loans that do not share similar risk characteristics with any pools of assets are subject to individual assessment and are removed from the collectively assessed pools to avoid double counting. For the loans that will be individually assessed, the Company uses either a discounted cash flow (“DCF”) approach or a fair value of collateral approach. The latter approach is used for loans deemed to be collateral dependent or when foreclosure is probable.\nThe balance of allowance for credit losses of $147.3 million at September 30, 2022 remained relatively flat compared to $146.9 million at December 31, 2021. The net change in the Company's allowance for credit losses for the nine months ended September 30, 2022 primarily reflects elevated balances of nonperforming loans at September 30, 2022 compared to December 31, 2021, offset by attrition of existing loans and continued strong asset quality metrics. Despite the increase in nonperforming loans, net charge-offs recorded for the three and nine months ended September 30, 2022 were minimal.\nThe aforementioned increase in nonperforming loans contributed to an overall higher quantitative allowance at September 30, 2022 compared to December 31, 2021. Management's forecast anticipates that the federal funds rates will rise in the near term, that supply chain issues will persist, inflation will remain elevated, and the military conflict between Russia and Ukraine will persist for the foreseeable future, potentially impacting global oil supplies and the supply chain more generally. The forecast used by management also anticipates that the U.S. economy will fall into a recession during the fourth quarter of 2022 and that the recession will persist for the short term. Additionally, the allowance for credit losses is qualitatively adjusted on a quarterly basis in order to ensure coverage for relationships that are deemed to be more at risk within certain industries, specific collateral types, or other specific characteristics that may be highly impacted by the current economic environment.\n69\nThe following table summarizes the ratio of net charge-offs to average loans outstanding within each major loan category for the periods presented:\nTable 9 - Summary Net Charge-Offs to Average Loans Outstanding\n| Net Charge-Offs (Recoveries) | Average Loans Outstanding | Ratio of Annualized Net Charge-Offs/(Recoveries) to Average Loans | Net Charge-Offs (Recoveries) | Average Loans Outstanding | Ratio of Annualized Net Charge-Offs/(Recoveries) to Average Loans |\n| (Dollars in thousands) |\n| Three Months Ended September 30, 2022 | Nine Months Ended September 30, 2022 |\n| Commercial and industrial | $ | (2) | $ | 1,520,924 | — | % | $ | (44) | $ | 1,531,421 | — | % |\n| Commercial real estate | (268) | 7,760,470 | (0.01) | % | (271) | 7,832,534 | — | % |\n| Commercial construction | — | 1,157,876 | — | % | — | 1,180,509 | — | % |\n| Small business | (88) | 207,546 | (0.17) | % | (88) | 202,151 | (0.06) | % |\n| Residential real estate | — | 1,909,066 | — | % | — | 1,774,355 | — | % |\n| Home equity | (65) | 1,076,040 | (0.02) | % | 17 | 1,051,921 | — | % |\n| Other consumer | 429 | 31,883 | 5.34 | % | 995 | 31,092 | 4.28 | % |\n| Total | $ | 6 | $ | 13,663,805 | — | % | $ | 609 | $ | 13,603,983 | 0.01 | % |\n| Net Charge-Offs (Recoveries) | Average Loans Outstanding | Ratio of Annualized Net Charge-Offs/(Recoveries) to Average Loans | Net Charge-Offs (Recoveries) | Average Loans Outstanding | Ratio of Annualized Net Charge-Offs/(Recoveries) to Average Loans |\n| (Dollars in thousands) |\n| Three Months Ended September 30, 2021 | Nine Months Ended September 30, 2021 |\n| Commercial and industrial | $ | — | $ | 1,640,422 | — | % | $ | 3,374 | $ | 1,898,100 | 0.24 | % |\n| Commercial real estate | — | 4,232,575 | — | % | (57) | 4,195,200 | — | % |\n| Commercial construction | — | 507,393 | — | % | — | 525,652 | — | % |\n| Small business | 33 | 181,953 | 0.07 | % | 119 | 178,294 | 0.09 | % |\n| Residential real estate | — | 1,231,606 | — | % | (1) | 1,242,991 | — | % |\n| Home equity | (49) | 1,007,371 | (0.02) | % | (38) | 1,027,311 | — | % |\n| Other consumer | 127 | 25,929 | 1.94 | % | 249 | 23,382 | 1.42 | % |\n| Total | $ | 111 | $ | 8,827,249 | — | % | $ | 3,646 | $ | 9,090,930 | 0.05 | % |\n\n70\nFor purposes of the allowance for credit losses, management segregates the loan portfolio into the portfolio segments detailed in the table below. The allocation of the allowance for credit losses is made to each loan category using the analytical techniques and estimation methods described in this Report. While these amounts represent management’s best estimate of credit losses at the evaluation dates, they are not necessarily indicative of either the categories in which actual losses may occur or the extent of such actual losses that may be recognized within each category. Each of these loan categories possess unique risk characteristics that are considered when determining the appropriate level of allowance for each segment. The total allowance is available to absorb losses from any segment of the loan portfolio.\nThe following table sets forth the allocation of the allowance for credit losses by loan category at the dates indicated:\nTable 10 - Summary of Allocation of Allowance for Credit Losses\n\n| September 302022 | December 312021 |\n| AllowanceAmount | Percent ofLoansIn CategoryTo Total Loans | AllowanceAmount | Percent ofLoansIn CategoryTo Total Loans |\n| (Dollars in thousands) |\n| Commercial and industrial (1) | $ | 20,169 | 11.3 | % | $ | 14,402 | 11.5 | % |\n| Commercial real estate | 80,036 | 56.1 | % | 83,486 | 58.8 | % |\n| Commercial construction | 11,419 | 8.7 | % | 12,316 | 8.6 | % |\n| Small business | 2,624 | 1.5 | % | 3,508 | 1.4 | % |\n| Residential real estate | 20,602 | 14.3 | % | 14,484 | 11.8 | % |\n| Home equity | 11,651 | 7.9 | % | 17,986 | 7.7 | % |\n| Other consumer | 812 | 0.2 | % | 740 | 0.2 | % |\n| Total allowance for credit losses | $ | 147,313 | 100.0 | % | $ | 146,922 | 100.0 | % |\n\n(1)Total loans in this category are inclusive of $11.1 million and $216.2 million in loans at September 30, 2022 and December 31, 2021, respectively, which were originated as part of the PPP established by the CARES Act. These loans have been excluded from the credit loss calculations as these loans are 100% guaranteed by the U.S. Government.\nTo determine if a loan should be charged-off, all possible sources of repayment are analyzed. Possible sources of repayment include the potential for future cash flows, the value of the Bank’s collateral, and the strength of co-makers or guarantors. When available information confirms that specific loans or portions thereof are uncollectible, these amounts are promptly charged-off against the allowance for credit losses and any recoveries of such previously charged-off amounts are credited to the allowance.\nRegardless of whether a loan is unsecured or collateralized, the Company charges off the amount of any confirmed loan loss in the period when the loans, or portions of loans, are deemed uncollectible. For troubled, collateral-dependent loans, loss-confirming events may include an appraisal or other valuation that reflects a shortfall between the value of the collateral and the carrying value of the loan or receivable, or a deficiency balance following the sale of the collateral.\nFor additional information regarding the Company’s allowance for credit losses, see Note 4 \"Loans, Allowance for Credit Losses and Credit Quality\" within the Notes to Consolidated Financial Statements included in Part I. Item 1 of this Report.\nFederal Home Loan Bank Stock The FHLB is a cooperative that provides services to its member banking institutions. The primary reason for the FHLB of Boston membership is to gain access to a reliable source of wholesale funding as a tool to manage liquidity and interest rate risk. The purchase of stock in the FHLB is a requirement for a member to gain access to funding. The Company either purchases additional FHLB stock or is subject to redemption of FHLB stock proportional to the volume of funding received. The Company views the holdings as a necessary long-term investment for the purpose of balance sheet liquidity and not for investment return. The Bank held investments in FHLB of Boston stock of $5.2 million and $11.4 million at September 30, 2022 and December 31, 2021, respectively, reflecting redemption activity occurring during 2022.\nGoodwill and Other Intangible Assets Goodwill and other intangible assets were $1.0 billion at both September 30, 2022 and December 31, 2021.\n71\nThe Company typically performs its annual goodwill impairment testing during the third quarter of the year, unless certain indicators suggest earlier testing to be warranted. Accordingly, the Company performed its annual goodwill impairment testing during the third quarter of 2022 and determined that the Company's goodwill was not impaired as of September 30, 2022. Other intangible assets are also reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. There were no events or changes during the third quarter of 2022 that indicated impairment of goodwill and other intangible assets.\nCash Surrender Value of Life Insurance Policies The Bank holds life insurance policies for the purpose of offsetting its future obligations to its employees under its retirement and benefits plans. The cash surrender value of life insurance policies was $293.1 million at September 30, 2022 compared to $289.3 million at December 31, 2021, representing an increase of $3.8 million, or 1.3%, primarily due to income earned on the policies.\nThe Company recorded tax exempt income from life insurance policies of $1.9 million and $1.6 million for the three months ended September 30, 2022 and 2021, respectively, and $5.5 million and $4.5 million for the nine months ended September 30, 2022 and 2021, respectively. The Company recorded gains on life insurance benefits of $477,000 for three months ended September 30, 2022 and no such gains for the three months ended September 30, 2021, respectively, and $600,000 and $258,000 for the nine months ended September 30, 2022 and September 30, 2021, respectively.\nDeposits As of September 30, 2022, total deposits were $16.3 billion, representing a $578.1 million, or 3.4%, decrease from December 31, 2021, primarily attributable to continued runoff in higher-cost time deposits and certain rate sensitive deposits. The total cost of deposits was 0.15% and 0.05% for the three months ended September 30, 2022 and 2021, respectively, and 0.08% and 0.07% for the nine months ended September 30, 2022 and 2021, respectively. Core deposits increased to 87.8% of total deposits as of September 30, 2022 from 84.5% at December 31, 2021.\nThe Company also participates in the IntraFi Network, allowing the Bank to provide easy access to multi-million dollar Federal Deposit Insurance Corporation (\"FDIC\") deposit insurance protection on certificate of deposit and money market investments for consumers, businesses and public entities. This channel allows the Company to seek additional funding in potentially large quantities by attracting deposits from outside the Bank’s core market, and amounted to $751.1 million and $998.1 million at September 30, 2022 and December 31, 2021, respectively. In addition, the Company may occasionally raise funds through the use of brokered deposits outside of the IntraFi Network, which amounted to $102.6 million and $141.6 million at September 30, 2022 and December 31, 2021, respectively.\nBorrowings The Company's borrowings consist of both short-term and long-term borrowings and provide the Bank with one of its primary sources of funding. Maintaining available borrowing capacity provides the Bank with a contingent source of liquidity. Borrowings were $113.4 million at September 30, 2022, a decrease of $39.0 million, or 25.6%, as compared to December 31, 2021, due primarily to the re-payment of a revolving loan credit facility during the first quarter of 2022 and the maturity of a short term Federal Home Loan Bank borrowing during the third quarter of 2022.\nAdditionally, the Bank had $4.3 billion and $4.2 billion of assets pledged as collateral against borrowings at September 30, 2022 and December 31, 2021, respectively. These assets are primarily pledged to the FHLB of Boston and the Federal Reserve Bank of Boston.\n72\nCapital Resources On September 15, 2022 the Company’s Board of Directors declared a cash dividend of $0.51 per share to shareholders of record as of the close of business on September 26, 2022. This dividend was paid on October 7, 2022.\nThe Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company’s and the Bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.\nQuantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of Total, Tier 1 Capital and Common Equity Tier 1 Capital (as defined for regulatory purposes) to risk weighted assets (as defined for regulatory purposes) and Tier 1 Capital to average assets (as defined for regulatory purposes). At September 30, 2022 and December 31, 2021, the Company and the Bank exceeded the minimum requirements for all applicable ratios that were in effect during the respective periods. The Company’s and the Bank’s capital amounts and ratios are presented in the following table, along with the applicable minimum requirements as of each date indicated:\nTable 11 - Company and Bank's Capital Amounts and Ratios\n| Actual | For Capital Adequacy Purposes | To Be Well Capitalized Under PromptCorrective Action Provisions |\n| Amount | Ratio | Amount | Ratio | Amount | Ratio |\n| September 30, 2022 |\n| (Dollars in thousands) |\n| Company (consolidated) |\n| Total capital (to risk weighted assets) | $ | 2,250,741 | 15.71 | % | $ | 1,146,074 | ≥ | 8.0 | % | N/A | N/A |\n| Common equity tier 1 capital (to risk weighted assets) | 2,002,105 | 13.98 | % | 644,666 | ≥ | 4.5 | % | N/A | N/A |\n| Tier 1 capital (to risk weighted assets) | 2,002,105 | 13.98 | % | 859,555 | ≥ | 6.0 | % | N/A | N/A |\n| Tier 1 capital (to average assets) | 2,002,105 | 10.51 | % | 761,820 | ≥ | 4.0 | % | N/A | N/A |\n| Bank |\n| Total capital (to risk weighted assets) | $ | 2,142,284 | 14.95 | % | $ | 1,146,046 | ≥ | 8.0 | % | $ | 1,432,558 | ≥ | 10.0 | % |\n| Common equity tier 1 capital(to risk weighted assets) | 2,004,510 | 13.99 | % | 644,651 | ≥ | 4.5 | % | 931,163 | ≥ | 6.5 | % |\n| Tier 1 capital (to risk weighted assets) | 2,004,510 | 13.99 | % | 859,535 | ≥ | 6.0 | % | 1,146,046 | ≥ | 8.0 | % |\n| Tier 1 capital (to average assets) | 2,004,510 | 10.52 | % | 801,528 | ≥ | 4.0 | % | 1,001,911 | ≥ | 5.0 | % |\n| December 31, 2021 |\n| (Dollars in thousands) |\n| Company (consolidated) |\n| Total capital (to risk weighted assets) | $ | 2,262,740 | 16.04 | % | $ | 1,128,900 | ≥ | 8.0 | % | N/A | N/A |\n| Common equity tier 1 capital (to risk weighted assets) | 2,017,497 | 14.30 | % | 635,006 | ≥ | 4.5 | % | N/A | N/A |\n| Tier 1 capital (to risk weighted assets) | 2,017,497 | 14.30 | % | 846,675 | ≥ | 6.0 | % | N/A | N/A |\n| Tier 1 capital (to average assets) | 2,017,497 | 12.03 | % | 670,659 | ≥ | 4.0 | % | N/A | N/A |\n| Bank |\n| Total capital (to risk weighted assets) | $ | 2,083,689 | 14.77 | % | $ | 1,128,536 | ≥ | 8.0 | % | $ | 1,410,670 | ≥ | 10.0 | % |\n| Common equity tier 1 capital(to risk weighted assets) | 1,949,237 | 13.82 | % | 634,801 | ≥ | 4.5 | % | 916,935 | ≥ | 6.5 | % |\n| Tier 1 capital (to risk weighted assets) | 1,949,237 | 13.82 | % | 846,402 | ≥ | 6.0 | % | 1,128,536 | ≥ | 8.0 | % |\n| Tier 1 capital (to average assets) | 1,949,237 | 11.62 | % | 670,827 | ≥ | 4.0 | % | 838,534 | ≥ | 5.0 | % |\n\n73\nIn addition to the minimum risk-based capital requirements outlined in the table above, the Company is required to maintain a minimum capital conservation buffer, in the form of common equity, in order to avoid restrictions on capital distributions and discretionary bonuses. The required amount of the capital conservation buffer is 2.5%. At September 30, 2022, the Company's capital levels exceeded the buffer.\nDividend Restrictions The Company is subject to capital and dividend requirements administered by federal and state bank regulators, and the Company will not declare a cash dividend that would cause the Company to violate regulatory requirements. The Company is, in the ordinary course of business, dependent upon the receipt of cash dividends from the Bank to pay cash dividends to shareholders and satisfy the Company’s other cash needs. Federal and state law impose limits on capital distributions by the Bank. Massachusetts-chartered banks, such as the Bank, may declare from net profits cash dividends not more frequently than quarterly and non-cash dividends at any time. No dividends may be declared, credited, or paid if the Bank’s capital stock would be impaired. Massachusetts Bank Commissioner approval is required if the total of all dividends declared by the Bank in any calendar year would exceed the total of its net profits for that year combined with its retained net profits of the preceding two years, less any required transfer to surplus or a fund for the retirement of any preferred stock. Dividends paid by the Bank to the Company totaled $64.5 million and $33.9 million for the three months ended September 30, 2022 and 2021, respectively and totaled $142.7 million and $38.9 million for the nine months ended September 30, 2022 and 2021, respectively.\nTrust Preferred Securities In accordance with the applicable accounting standard related to variable interest entities, the common stock of trusts which have issued trust preferred securities has not been included in the consolidated financial statements of the Company. At each of September 30, 2022 and December 31, 2021 there were $61.0 million in trust preferred securities included in the Tier 2 capital of the Company for regulatory reporting purposes pursuant to the Federal Reserve's capital adequacy guidelines.\nInvestment Management The following table presents total assets under administration and number of accounts held by the Rockland Trust Investment Management Group at the following dates:\nTable 12 - Assets Under Administration\n| September 302022 | December 312021 | September 302021 |\n| (Dollars in thousands) |\n| Assets under administration | $ | 5,091,592 | $ | 5,726,368 | $ | 5,434,971 |\n| Number of trust, fiduciary and agency accounts | 6,487 | 6,379 | 6,368 |\n\nDespite strong new asset inflows, assets under administration at September 30, 2022 decreased compared to December 31, 2021, driven primarily by depressed market valuations experienced during the first nine months of 2022. Included in these amounts as of September 30, 2022 and December 31, 2021 are assets under administration of $361.0 million and $447.4 million, respectively, relating to the Company’s registered investment advisor, Bright Rock Capital Management, LLC, which provides institutional quality investment management services to institutional and high net worth clients. Revenue from the Investment Management Group was $7.8 million and $8.1 million for the three months ended September 30, 2022 and 2021, respectively, and $23.6 million for the nine months ended September 30, 2022 and 2021.\nThe administration of trust and fiduciary accounts is monitored by the Trust Committee of the Bank’s Board of Directors. The Trust Committee has delegated administrative responsibilities to three committees, one for investments, one for administration, and one for operations, all of which are comprised of Investment Management Group officers who meet no less than quarterly.\nThe Bank has an agreement with LPL Financial (\"LPL\") and its affiliates and their insurance subsidiary, LPL Insurance Associates, Inc., to offer the sale of mutual fund shares, unit investment trust shares, general securities, fixed and variable annuities and life insurance. Registered representatives who are both employed by the Bank and licensed and contracted with LPL are onsite to offer these products to the Bank’s customer base. These same agents are also approved and appointed with various other Broker General Agents for the purposes of processing insurance solutions for clients. Retail investments and insurance revenue was $601,000 and $1.0 million for the three months ended September 30, 2022 and 2021, respectively, and $2.9 million and $2.8 million for the nine months ended September 30, 2022 and 2021, respectively.\n74\nRESULTS OF OPERATIONS\nThe following table provides a summary of results of operations for the three and nine months ended September 30, 2022 and 2021:\nTable 13 - Summary of Results of Operations\n\n| Three Months Ended September 30 | Nine Months Ended September 30 |\n| 2022 | 2021 | 2022 | 2021 |\n| (Dollars in thousands, except per share data) |\n| Net income | $ | 71,897 | $ | 40,007 | $ | 186,770 | $ | 119,290 |\n| Diluted earnings per share | $ | 1.57 | $ | 1.21 | $ | 4.00 | $ | 3.61 |\n| Return on average assets | 1.43 | % | 1.11 | % | 1.25 | % | 1.15 | % |\n| Return on average equity | 9.90 | % | 9.04 | % | 8.51 | % | 9.20 | % |\n| Net interest margin | 3.64 | % | 2.78 | % | 3.33 | % | 3.00 | % |\n\nNet Interest Income The amount of net interest income is affected by changes in interest rates and by the volume, mix, and interest rate sensitivity of interest-earning assets and interest-bearing liabilities.\nOn a fully tax equivalent basis (\"FTE\"), net interest income for the third quarter of 2022 was $163.6 million, representing an increase of $73.3 million, or 81.2%, when compared to the third quarter of 2021. For the nine months ended September 30, 2022, the net interest income on a FTE basis was $447.9 million, representing an increase of $168.2 million, or 60.1%, when compared to the year ago period. The year-over-year increases in net interest income are primarily attributable to the Meridian acquisition which closed during the fourth quarter of 2021, as well as the positive impact of asset repricing in the rising rate environment and relatively stable funding costs experienced through September 30, 2022, partially offset by reduced PPP fee income.\n75\nThe following tables present the Company’s average balances, net interest income, interest rate spread, and net interest margin for the three and nine months ended September 30, 2022 and 2021. Nontaxable income from loans and securities is presented on a FTE basis by adjusting tax-exempt income upward by an amount equivalent to the prevailing income tax rate that would have been paid if the income had been fully taxable.\nTable 14 - Average Balance, Interest Earned/Paid & Average Yields Quarter-to-Date\n| Three Months Ended September 30 |\n| 2022 | 2021 |\n| AverageBalance | InterestEarned/Paid | Yield/Rate | AverageBalance | InterestEarned/Paid | Yield/Rate |\n| (Dollars in thousands) |\n| Interest-earning assets |\n| Interest-earning deposits with banks, federal funds sold, and short term investments | $ | 1,156,143 | $ | 6,519 | 2.24 | % | $ | 2,135,031 | $ | 815 | 0.15 | % |\n| Securities |\n| Securities - trading | 3,730 | — | — | % | 3,498 | — | — | % |\n| Securities - taxable investments | 3,024,802 | 13,243 | 1.74 | % | 1,880,863 | 7,792 | 1.64 | % |\n| Securities - nontaxable investments (1) | 196 | 1 | 2.02 | % | 468 | 5 | 4.24 | % |\n| Total securities | $ | 3,028,728 | $ | 13,244 | 1.73 | % | $ | 1,884,829 | $ | 7,797 | 1.64 | % |\n| Loans held for sale | 4,263 | 51 | 4.75 | % | 30,143 | 193 | 2.54 | % |\n| Loans (2) |\n| Commercial and industrial (1) | 1,520,924 | 19,289 | 5.03 | % | 1,640,422 | 15,309 | 3.70 | % |\n| Commercial real estate (1) | 7,760,470 | 85,284 | 4.36 | % | 4,232,575 | 41,469 | 3.89 | % |\n| Commercial construction | 1,157,876 | 14,875 | 5.10 | % | 507,393 | 4,916 | 3.84 | % |\n| Small business | 207,546 | 2,819 | 5.39 | % | 181,953 | 2,341 | 5.10 | % |\n| Total commercial | 10,646,816 | 122,267 | 4.56 | % | 6,562,343 | 64,035 | 3.87 | % |\n| Residential real estate | 1,909,066 | 16,533 | 3.44 | % | 1,231,606 | 10,955 | 3.53 | % |\n| Home equity | 1,076,040 | 11,869 | 4.38 | % | 1,007,371 | 9,043 | 3.56 | % |\n| Total consumer real estate | 2,985,106 | 28,402 | 3.77 | % | 2,238,977 | 19,998 | 3.54 | % |\n| Other consumer | 31,883 | 523 | 6.51 | % | 25,929 | 398 | 6.09 | % |\n| Total loans | $ | 13,663,805 | $ | 151,192 | 4.39 | % | $ | 8,827,249 | $ | 84,431 | 3.79 | % |\n| Total interest-earning assets | $ | 17,852,939 | $ | 171,006 | 3.80 | % | $ | 12,877,252 | $ | 93,236 | 2.87 | % |\n| Cash and due from banks | 192,003 | 144,556 |\n| Federal Home Loan Bank stock | 5,745 | 8,904 |\n| Other assets | 1,854,870 | 1,268,199 |\n| Total assets | $ | 19,905,557 | $ | 14,298,911 |\n| Interest-bearing liabilities |\n| Deposits |\n| Savings and interest checking accounts | $ | 6,224,690 | $ | 2,110 | 0.13 | % | $ | 4,426,106 | $ | 338 | 0.03 | % |\n| Money market | 3,459,212 | 3,025 | 0.35 | % | 2,375,492 | 443 | 0.07 | % |\n| Time deposits | 1,246,841 | 974 | 0.31 | % | 795,943 | 852 | 0.42 | % |\n| Total interest-bearing deposits | $ | 10,930,743 | $ | 6,109 | 0.22 | % | $ | 7,597,541 | $ | 1,633 | 0.09 | % |\n| Borrowings |\n| Federal Home Loan Bank borrowings | $ | 12,876 | $ | 55 | 1.69 | % | $ | 31,118 | $ | 165 | 2.10 | % |\n| Long-term borrowings | — | — | — | % | 18,742 | 77 | 1.63 | % |\n| Junior subordinated debentures | 62,854 | 589 | 3.72 | % | 62,852 | 432 | 2.73 | % |\n| Subordinated debentures | 49,847 | 617 | 4.91 | % | 49,753 | 617 | 4.92 | % |\n\n76\n| Total borrowings | $ | 125,577 | $ | 1,261 | 3.98 | % | $ | 162,465 | $ | 1,291 | 3.15 | % |\n| Total interest-bearing liabilities | $ | 11,056,320 | $ | 7,370 | 0.26 | % | $ | 7,760,006 | $ | 2,924 | 0.15 | % |\n| Noninterest bearing demand deposits | 5,641,742 | 4,502,045 |\n| Other liabilities | 325,507 | 280,754 |\n| Total liabilities | $ | 17,023,569 | $ | 12,542,805 |\n| Stockholders' equity | 2,881,988 | 1,756,106 |\n| Total liabilities and stockholders' equity | $ | 19,905,557 | $ | 14,298,911 |\n| Net interest income (1) | $ | 163,636 | $ | 90,312 |\n| Interest rate spread (3) | 3.54 | % | 2.72 | % |\n| Net interest margin (4) | 3.64 | % | 2.78 | % |\n| Supplemental information |\n| Total deposits, including demand deposits | $ | 16,572,485 | $ | 6,109 | $ | 12,099,586 | $ | 1,633 |\n| Cost of total deposits | 0.15 | % | 0.05 | % |\n| Total funding liabilities, including demand deposits | $ | 16,698,062 | $ | 7,370 | $ | 12,262,051 | $ | 2,924 |\n| Cost of total funding liabilities | 0.18 | % | 0.09 | % |\n\n(1)The total amount of adjustment to interest income and yield on a FTE basis was $1.0 million and $220,000 for the three months ended September 30, 2022 and 2021, respectively. The FTE adjustment relates to tax exempt income relating to securities with average balances of $196,000 and $468,000 and tax exempt income relating to loans with average balances of $414.4 million and $61.2 million, for the three months ended September 30, 2022 and 2021, respectively.\n(2)Includes average nonaccruing loans.\n(3)Interest rate spread represents the difference between the weighted average yield on interest-earning assets and the weighted average cost of interest-bearing liabilities.\n(4)Net interest margin represents annualized net interest income as a percentage of average interest-earning assets.\n77\nTable 15 - Average Balance, Interest Earned/Paid & Average Yields Year-to-Date\n| Nine Months Ended September 30 |\n| 2022 | 2021 |\n| AverageBalance | InterestEarned/Paid | Yield/Rate | AverageBalance | InterestEarned/Paid | Yield/Rate |\n| (Dollars in thousands) |\n| Interest-earning assets |\n| Interest-earning deposits with banks, federal funds sold, and short-term investments | $ | 1,477,117 | $ | 10,222 | 0.93 | % | $ | 1,782,463 | $ | 1,654 | 0.12 | % |\n| Securities |\n| Securities - trading | 3,775 | — | — | % | 3,267 | — | — | % |\n| Securities - taxable investments | 2,881,203 | 34,567 | 1.60 | % | 1,550,859 | 21,603 | 1.86 | % |\n| Securities - nontaxable investments (1) | 198 | 5 | 3.38 | % | 555 | 17 | 4.10 | % |\n| Total securities | $ | 2,885,176 | $ | 34,572 | 1.60 | % | $ | 1,554,681 | $ | 21,620 | 1.86 | % |\n| Loans held for sale | 5,841 | 150 | 3.43 | % | 35,953 | 675 | 2.51 | % |\n| Loans (2) |\n| Commercial and industrial (1) | 1,531,421 | 53,816 | 4.70 | % | 1,898,100 | 58,706 | 4.14 | % |\n| Commercial real estate (1) | 7,832,534 | 238,085 | 4.06 | % | 4,195,200 | 123,377 | 3.93 | % |\n| Commercial construction | 1,180,509 | 40,599 | 4.60 | % | 525,652 | 14,976 | 3.81 | % |\n| Small business | 202,151 | 7,891 | 5.22 | % | 178,294 | 6,924 | 5.19 | % |\n| Total commercial | 10,746,615 | 340,391 | 4.23 | % | 6,797,246 | 203,983 | 4.01 | % |\n| Residential real estate | 1,774,355 | 45,109 | 3.40 | % | 1,242,991 | 34,449 | 3.71 | % |\n| Home equity | 1,051,921 | 29,709 | 3.78 | % | 1,027,311 | 26,391 | 3.43 | % |\n| Total consumer real estate | 2,826,276 | 74,818 | 3.54 | % | 2,270,302 | 60,840 | 3.58 | % |\n| Other consumer | 31,092 | 1,519 | 6.53 | % | 23,382 | 1,241 | 7.10 | % |\n| Total loans | $ | 13,603,983 | $ | 416,728 | 4.10 | % | $ | 9,090,930 | $ | 266,064 | 3.91 | % |\n| Total interest-earning assets | $ | 17,972,117 | $ | 461,672 | 3.43 | % | $ | 12,464,027 | $ | 290,013 | 3.11 | % |\n| Cash and due from banks | 184,754 | 147,269 |\n| Federal Home Loan Bank stock | 7,780 | 9,516 |\n| Other assets | 1,853,818 | 1,256,066 |\n| Total assets | $ | 20,018,469 | $ | 13,876,878 |\n| Interest-bearing liabilities |\n| Deposits |\n| Savings and interest checking accounts | $ | 6,224,317 | $ | 3,418 | 0.07 | % | $ | 4,292,992 | $ | 1,145 | 0.04 | % |\n| Money market | 3,517,459 | 4,191 | 0.16 | % | 2,337,445 | 1,393 | 0.08 | % |\n| Time deposits | 1,355,861 | 2,718 | 0.27 | % | 848,143 | 3,823 | 0.60 | % |\n| Total interest-bearing deposits | $ | 11,097,637 | $ | 10,327 | 0.12 | % | $ | 7,478,580 | $ | 6,361 | 0.11 | % |\n| Borrowings |\n| Federal Home Loan Bank borrowings | $ | 21,361 | $ | 311 | 1.95 | % | $ | 34,185 | $ | 544 | 2.13 | % |\n| Long-term borrowings | 2,988 | 31 | 1.39 | % | 23,434 | 282 | 1.61 | % |\n| Junior subordinated debentures | 62,854 | 1,298 | 2.76 | % | 62,852 | 1,287 | 2.74 | % |\n| Subordinated debentures | 49,824 | 1,852 | 4.97 | % | 49,729 | 1,852 | 4.98 | % |\n| Total borrowings | $ | 137,027 | $ | 3,492 | 3.41 | % | $ | 170,200 | $ | 3,965 | 3.11 | % |\n| Total interest-bearing liabilities | $ | 11,234,664 | $ | 13,819 | 0.16 | % | $ | 7,648,780 | $ | 10,326 | 0.18 | % |\n| Noninterest bearing demand deposits | 5,544,476 | 4,213,764 |\n| Other liabilities | 303,308 | 280,002 |\n\n78\n| Total liabilities | $ | 17,082,448 | $ | 12,142,546 |\n| Stockholders' equity | 2,936,021 | 1,734,332 |\n| Total liabilities and stockholders' equity | $ | 20,018,469 | $ | 13,876,878 |\n| Net interest income (1) | $ | 447,853 | $ | 279,687 |\n| Interest rate spread (3) | 3.27 | % | 2.93 | % |\n| Net interest margin (4) | 3.33 | % | 3.00 | % |\n| Supplemental information |\n| Total deposit, including demand deposits | $ | 16,642,113 | $ | 10,327 | $ | 11,692,344 | $ | 6,361 |\n| Cost of total deposits | 0.08 | % | 0.07 | % |\n| Total funding liabilities, including demand deposits | $ | 16,779,140 | $ | 13,819 | $ | 11,862,544 | $ | 10,326 |\n| Cost of total funding liabilities | 0.11 | % | 0.12 | % |\n\n(1)The total amount of adjustment to present interest income and yield on a FTE basis was $3.0 million and $658,000 for the nine months ended September 30, 2022 and 2021, respectively. The FTE adjustment relates to nontaxable investment securities with average balances of $198,000 and $555,000 and tax exempt income relating to loans with average balances of $411.9 million and $63.9 million for the nine months ended September 30, 2022 and 2021, respectively.\n(2)Includes average nonaccruing loans.\n(3)Interest rate spread represents the difference between the weighted average yield on interest-earning assets and the weighted average cost of interest-bearing liabilities.\n(4)Net interest margin represents annualized net interest income as a percentage of average interest-earning assets.\n79\nThe following table presents certain information on a FTE basis regarding changes in the Company’s interest income and interest expense for the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided with respect to changes attributable to: (1) changes in rate (change in rate multiplied by prior period volume), (2) changes in volume (change in volume multiplied by old rate), and (3) changes in volume/rate (change in volume multiplied by change in rate) which is allocated to the change due to rate column:\nTable 16 - Volume Rate Analysis\n| Three Months Ended September 30 | Nine Months Ended September 30 |\n| 2022 Compared To 2021 | 2022 Compared To 2021 |\n| ChangeDue toRate | ChangeDue toVolume | Total Change | ChangeDue toRate | ChangeDue toVolume | Total Change |\n| (Dollars in thousands) |\n| Income on interest-earning assets |\n| Interest earning deposits, federal funds sold and short term investments | $ | 6,078 | $ | (374) | $ | 5,704 | $ | 8,851 | $ | (283) | $ | 8,568 |\n| Securities |\n| Securities - taxable investments | 712 | 4,739 | 5,451 | (5,567) | 18,531 | 12,964 |\n| Securities - nontaxable investments (1) | (1) | (3) | (4) | (1) | (11) | (12) |\n| Total securities | 5,447 | 12,952 |\n| Loans held for sale | 24 | (166) | (142) | 40 | (565) | (525) |\n| Loans |\n| Commercial and industrial (1) | 5,095 | (1,115) | 3,980 | 6,451 | (11,341) | (4,890) |\n| Commercial real estate (1) | 9,250 | 34,565 | 43,815 | 7,737 | 106,971 | 114,708 |\n| Commercial construction | 3,657 | 6,302 | 9,959 | 6,966 | 18,657 | 25,623 |\n| Small business | 149 | 329 | 478 | 41 | 926 | 967 |\n| Total commercial | 58,232 | 136,408 |\n| Residential real estate | (448) | 6,026 | 5,578 | (4,067) | 14,727 | 10,660 |\n| Home equity | 2,210 | 616 | 2,826 | 2,686 | 632 | 3,318 |\n| Total consumer real estate | 8,404 | 13,978 |\n| Other consumer | 34 | 91 | 125 | (131) | 409 | 278 |\n| Total loans (1)(2) | 66,761 | 150,664 |\n| Total income of interest-earning assets | $ | 77,770 | $ | 171,659 |\n| Expense of interest-bearing liabilities |\n| Deposits |\n| Savings and interest checking accounts | $ | 1,635 | $ | 137 | $ | 1,772 | $ | 1,758 | $ | 515 | $ | 2,273 |\n| Money market | 2,380 | 202 | 2,582 | 2,095 | 703 | 2,798 |\n| Time certificates of deposits | (361) | 483 | 122 | (3,394) | 2,289 | (1,105) |\n| Total interest bearing deposits | 4,476 | 3,966 |\n| Borrowings |\n| Federal Home Loan Bank borrowings | (13) | (97) | (110) | (29) | (204) | (233) |\n| Line of Credit | — | — | — | — |\n| Long-term borrowings | — | (77) | (77) | (5) | (246) | (251) |\n| Junior subordinated debentures | 157 | — | 157 | 11 | — | 11 |\n| Subordinated debentures | (1) | 1 | — | (4) | 4 | — |\n| Total borrowings | (30) | (473) |\n| Total expense of interest-bearing liabilities | 4,446 | 3,493 |\n| Change in net interest income | $ | 73,324 | $ | 168,166 |\n\n(1)Reflects income determined on a FTE basis. See footnote (1) to Table 14 and 15 in this Report for the related adjustments.\n(2)Loans include portfolio loans and nonaccrual loans; however, unpaid interest on nonaccrual loans has not been included for purposes of determining interest income.\n80\nProvision For Credit Losses The provision for credit losses represents the charge to expense that is required to maintain an appropriate level of allowance for credit losses. The Company recorded a $3.0 million and a $1.0 million provision for credit losses for the three and nine months ended September 30, 2022, respectively, as compared to releases of provision for credit losses of $10.0 million and $17.5 million for the three and nine months ended September 30, 2021, respectively. The Company’s allowance for credit losses, as a percentage of total loans, was 1.08% at both September 30, 2022 and December 31, 2021, and 1.05% at September 30, 2021. The Company recorded net charge-offs of $6,000 and $609,000 for the three and nine months ended September 30, 2022, respectively, as compared to net charge-offs of $111,000 and $3.6 million for the three and nine months ended September 30, 2021, respectively. Refer to Note 4 \"Loans, Allowance for Credit Losses and Credit Quality\" within the Note to Consolidated Financial Statements included in Part I. Item 1 of this Report, for further details surrounding the primary drivers of the provision for credit losses for the period.\nNoninterest Income The following table sets forth information regarding noninterest income for the periods shown:\nTable 17 - Noninterest Income\n| Three Months Ended |\n| September 30 | Change |\n| 2022 | 2021 | Amount | % |\n| (Dollars in thousands) |\n| Deposit account fees | $ | 6,261 | $ | 4,298 | $ | 1,963 | 45.67 | % |\n| Interchange and ATM fees | 4,331 | 3,441 | 890 | 25.86 | % |\n| Investment management | 8,436 | 9,174 | (738) | (8.04) | % |\n| Mortgage banking income | 585 | 2,825 | (2,240) | (79.29) | % |\n| Gain on life insurance benefits | 477 | — | 477 | 100.00% |\n| Increase in cash surrender value of life insurance policies | 1,883 | 1,596 | 287 | 17.98 | % |\n| Loan level derivative income | 471 | 586 | (115) | (19.62) | % |\n| Other noninterest income | 5,751 | 4,537 | 1,214 | 26.76 | % |\n| Total | $ | 28,195 | $ | 26,457 | $ | 1,738 | 6.57 | % |\n| Nine Months Ended |\n| September 30 | Change |\n| 2022 | 2021 | Amount | % |\n| (Dollars in thousands) |\n| Deposit account fees | $ | 17,582 | $ | 11,704 | $ | 5,878 | 50.22 | % |\n| Interchange and ATM fees | 11,967 | 9,229 | 2,738 | 29.67 | % |\n| Investment management | 26,438 | 26,350 | 88 | 0.33 | % |\n| Mortgage banking income | 2,989 | 11,270 | (8,281) | (73.48) | % |\n| Gain on life insurance benefits | 600 | 258 | 342 | 132.56 | % |\n| Increase in cash surrender value of life insurance policies | 5,549 | 4,508 | 1,041 | 23.09 | % |\n| Loan level derivative income | 1,511 | 875 | 636 | 72.69 | % |\n| Other noninterest income | 15,729 | 12,476 | 3,253 | 26.07 | % |\n| Total | $ | 82,365 | $ | 76,670 | $ | 5,695 | 7.43 | % |\n\nThe primary reasons for the variances in the noninterest income categories for the three and nine months ended September 30, 2022 as compared to the respective prior year periods shown in the preceding table include:\n•Deposit account fees and interchange and ATM fees increased for the three and nine months ended September 30, 2022 in comparison to the same prior year periods driven primarily by increased transaction volume attributable to the larger customer base as a result of the Meridian acquisition.\n81\n•Investment management income decreased for the three months ended September 30, 2022, driven primarily by a decline in overall asset valuations and was consistent for the nine months ended September 30, 2022, as compared to the prior year period, primarily due to a higher volume of new asset inflows, which were offset by depressed market valuations.\n•Mortgage banking income decreased for the three and nine months ended September 30, 2022 in comparison to the prior year periods, due primarily to overall reduced activity resulting from increased interest rates and a greater portion of new originations being retained in the Company's portfolio versus being sold in the secondary market during 2022.\n•The cash surrender value of life insurance policies increased primarily due to the impact of policies acquired from Meridian.\n•The changes in loan level derivative income primarily reflect customer demand during the respective periods.\n•Other noninterest income increased for the three and nine months ended September 30, 2022, primarily attributable to increases in rental income from equipment leases, foreign currency exchange fees, credit card fee income, discounted purchases of Massachusetts historical tax credits, and a gain on the sale of a vacated office space recently acquired during the Meridian acquisition, partially offset by decreases in loan fees and income from like-kind exchanges.\n82\nNoninterest Expense The following table sets forth information regarding non-interest expense for the periods shown:\nTable 18 - Noninterest Expense\n| Three Months Ended |\n| September 30 | Change |\n| 2022 | 2021 | Amount | % |\n| (Dollars in thousands) |\n| Salaries and employee benefits | $ | 52,708 | $ | 42,235 | $ | 10,473 | 24.80 | % |\n| Occupancy and equipment expenses | 12,316 | 8,564 | 3,752 | 43.81 | % |\n| Data processing & facilities management | 2,259 | 1,673 | 586 | 35.03 | % |\n| Consulting expense | 2,547 | 1,560 | 987 | 63.27 | % |\n| Software maintenance | 2,497 | 2,018 | 479 | 23.74 | % |\n| Amortization of intangible assets | 1,898 | 1,310 | 588 | 44.89 | % |\n| Debit card expense | 1,936 | 1,347 | 589 | 43.73 | % |\n| FDIC assessment | 1,677 | 980 | 697 | 71.12 | % |\n| Merger and acquisition expenses | — | 1,943 | (1,943) | (100.00) | % |\n| Other noninterest expenses | 14,890 | 10,789 | 4,101 | 38.01 | % |\n| Total | $ | 92,728 | $ | 72,419 | $ | 20,309 | 28.04 | % |\n| Nine Months Ended |\n| September 30 | Change |\n| 2022 | 2021 | Amount | % |\n| (Dollars in thousands) |\n| Salaries and employee benefits | $ | 150,957 | $ | 124,759 | $ | 26,198 | 21.00 | % |\n| Occupancy and equipment expenses | 37,255 | 26,543 | 10,712 | 40.36 | % |\n| Data processing & facilities management | 6,878 | 5,024 | 1,854 | 36.90 | % |\n| Merger and acquisition expenses | 7,100 | 3,674 | 3,426 | 93.25 | % |\n| Software maintenance | 7,706 | 5,903 | 1,803 | 30.54 | % |\n| Consulting expense | 7,057 | 5,443 | 1,614 | 29.65 | % |\n| Amortization of intangible assets | 5,801 | 4,037 | 1,764 | 43.70 | % |\n| Debit card expense | 5,562 | 3,693 | 1,869 | 50.61 | % |\n| FDIC assessment | 5,225 | 2,805 | 2,420 | 86.27 | % |\n| Other noninterest expenses | 45,249 | 33,522 | 11,727 | 34.98 | % |\n| Total | $ | 278,790 | $ | 215,403 | $ | 63,387 | 29.43 | % |\n\nThe primary reasons for the variances in the noninterest expense categories for the three and nine months ended September 30, 2022 as compared to the respective prior year periods shown in the preceding table include:\n•The increase in salaries and employee benefits was primarily attributable to the Company's increased workforce base following the Meridian acquisition.\n•Occupancy and equipment expenses increased year-over-year, primarily driven by costs associated with the Company's expanded branch network, real estate and other fixed assets resulting from the Meridian acquisition, as well as increased depreciation expense on leased equipment.\n•Data processing and facilities management expenses increased primarily due to the timing of certain initiatives and general increases associated with higher transaction volumes.\n•The Company incurred merger and acquisition costs related to the Meridian acquisition of $7.1 million during the first quarter of 2022, primarily related to lease terminations associated with exited branch locations, along with\n83\nadditional integration costs and professional fees. Meridian related merger and acquisition costs were also incurred, to a lesser extent, during the nine months ended September 30, 2021, leading up to deal close during the fourth quarter of 2021.\n•Software maintenance increased primarily due to the Company's continued investment in its technology infrastructure.\n•FDIC assessment increased primarily due to an increased assessment base resulting from the Meridian acquisition.\n•Consulting expense increased for the three and nine months ended September 30, 2022, primarily due to rollout of strategic initiatives during such periods.\n•Other noninterest expense increased for the three and nine months ended September 30, 2022, primarily due to three full quarters of general increases associated with the Meridian acquisition, elevated unrealized losses on equity securities, and increased marketing and public relations costs.\nIncome Taxes The tax effect of all income and expense transactions is recognized by the Company in each year’s consolidated statements of income, regardless of the year in which the transactions are reported for income tax purposes. The following table sets forth information regarding the Company’s tax provision and applicable tax rates for the periods indicated:\nTable 19 - Tax Provision and Applicable Tax Rates\n| Three Months Ended | Nine Months Ended |\n| September 30 | September 30 |\n| 2022 | 2021 | 2022 | 2021 |\n| (Dollars in thousands) |\n| Combined federal and state income tax provision | $ | 23,171 | $ | 14,122 | $ | 60,699 | $ | 38,506 |\n| Effective income tax rate | 24.37 | % | 26.09 | % | 24.53 | % | 24.40 | % |\n| Blended statutory tax rate | 27.11 | % | 27.92 | % | 27.11 | % | 27.92 | % |\n\nThe Company’s effective tax rate in 2022 thus far is higher as compared to the year ago period primarily due to higher pre-tax income, as well as the impact of discrete items, including tax benefits related to low income housing tax credits and equity compensation. The effective tax rates in the table above are lower than the blended statutory tax rates due to the aforementioned discrete items as well as certain tax preference assets such as life insurance policies, tax exempt bonds, and federal tax credits.\nThe Company invests in various low income housing projects, which are real estate limited partnerships that acquire, develop, own and operate low and moderate-income housing developments. As a limited partner in these operating partnerships, the Company will receive tax credits and tax deductions for losses incurred by the underlying properties. The investments are accounted for using the proportional amortization method and will be amortized over various periods through 2039, which represents the period that the tax credits and other tax benefits will be utilized. The total committed investment in these partnerships is $183.9 million, of which $120.9 million had been funded as of September 30, 2022. It is expected that the limited partnership investments will generate a net tax benefit of approximately $3.3 million for the fiscal year 2022 and a total of $23.7 million over the remaining life of the investments from the combination of the tax credits and operating losses.\nRisk Management\nThe Board of Directors has approved an Enterprise Risk Management Policy and Risk Appetite Statement to state the Company’s goals and objectives in identifying, measuring, and managing the risks associated with the Company’s current and near future anticipated size and complexity. Management is responsible for comprehensive enterprise risk management, and continually strives to adopt and implement practices that strike an appropriate balance between risk and reward and permit the achievement of strategic goals in a controlled environment.\nThe Company has implemented the “three lines of defense” enterprise risk management model. The first line of defense are the executives in charge of business units, operational areas, and corporate functions who, sometimes assisted by management committees, teams, and working groups, own and manage risks. The second line of defense is the Chief Risk Officer and the risk department, who monitor and provide advice with respect to first line risk management. The third line of\n84\ndefense is independent assurance performed by the Chief Internal Auditor, who reports to the Audit Committee of the Company's Board of Directors, and by the Company's internal audit department.\nThe Board of Directors, with the assistance of its Risk Committee, oversees management’s enterprise risk management practices. As risks must be taken to create value, the Board of Directors has defined the acceptable residual risk tolerances for the Company and the eight major risk types identified as having the potential to create significant adverse impacts on the Company, such as financial losses, reputational damage, legal or regulatory actions, nonachievement of strategic objectives, diminished customer experience, and/or cultural erosion. The eight major risk types identified by the Company and addressed in the Risk Appetite Statement are strategic risk, culture risk, credit risk, liquidity risk, interest rate risk, operational risk, technology risk, and reputation risk, each of which is discussed below.\nStrategic Risk Strategic risk is the risk arising from adverse strategic or business decisions, misalignment of strategic direction with the Company’s mission and values, failure to execute strategies or tactics, or an inadequate adaptation or lack of responsiveness to industry and/or operating environment changes. Management seeks to mitigate strategic risk through strategic planning, frequent executive review of strategic plan progress, monitoring of competitors and technology, assessment of new products, new branches, and new business initiatives, customer advocacy, and crisis management planning.\nCulture Risk Culture risk is the risk arising from failed leadership and/or ineffective colleague engagement and workplace management that causes the Company to lose sight of core values and, through acts or omissions, damage the relationship-based culture which has been one of the foundations of the Company’s consistent success. Management mitigates culture risk through effective employee relations, leadership that encourages continuous improvement, cultural development and reinforcement of core values, communication of clear ethical and behavioral standards, consistent enforcement of policies and programs, discipline of misbehavior, alignment of incentives and compensation, and by promoting diversity, equity, and inclusion.\nCredit Risk Credit risk is the risk arising from the failure of a borrower or a counterparty to a contract to make payments as agreed, and includes the risks arising from inadequate collateral and mismanagement of loan concentrations. While the collateral securing loans may be sufficient in some cases to recover the amount due, in other cases the Company may experience significant credit losses which could have an adverse effect on its operating results. The Company makes assumptions and judgments about the collectability of its loan portfolio, including the creditworthiness of its borrowers and counterparties and the value of collateral for the repayment of loans. For further discussion regarding the credit risk and the credit quality of the Company’s loan portfolio, see Note 4, “Loans, Allowance for Credit Losses and Credit Quality” within the Notes to Consolidated Financial Statements included in Part I. Item 1 of this Report.\nLiquidity Risk Liquidity risk is the risk arising from the Company being unable to meet obligations when due. Liquidity risk includes the inability to access funding sources or manage fluctuations in available funding levels. Liquidity risk also results from a failure to recognize or address market condition changes that affect the ability to liquidate assets quickly with minimal value loss.\nThe Company’s primary sources of funds are deposits, borrowings, and the amortization, prepayment, and maturities of loans and securities. The Bank utilizes its extensive branch network to access retail customers who provide a base of in-market core deposits. These funds are principally comprised of demand deposits, interest checking accounts, savings accounts, and money market accounts. Deposit levels are greatly influenced by interest rates, economic conditions, and competitive factors.\nThe Company’s primary measure of short-term liquidity is the Total Basic Surplus/Deficit as a percentage of assets. This ratio, which is an analysis of the relationship between liquid assets plus available Federal Home Loan Bank funding, less short-term liabilities relative to total assets, was within policy limits at September 30, 2022. The Total Basic Surplus/Deficit measure is affected primarily by changes in deposits, securities and short-term investments, loans, and borrowings. An increase in deposits, without a corresponding increase in nonliquid assets, will improve the Total Basic Surplus/Deficit measure, whereas, an increase in loans, with no increase in deposits, will decrease the measure. Other factors affecting the Total Basic Surplus/Deficit include Federal Home Loan Bank collateral requirements, securities portfolio changes, and the mix of deposits.\nThe Company seeks to increase deposits without adversely impacting its weighted average funding cost. The Company also maintains a variety of liquidity sources, including Federal Home Loan Bank advances, Federal Reserve borrowing capacity, and repurchase agreement lines. These funding sources serve as a contingent source of liquidity and, when profitable lending and investment opportunities exist, the Company may access them to provide the liquidity needed to grow the balance sheet. The amount and type of assets that the Company has available to pledge impacts the Company's Federal Home Loan Bank and Federal Reserve borrowing capacity. For example, a prime one-to-four family residential loan may provide 75 cents of borrowing capacity for every $1.00 pledged, whereas a pledged commercial loan may increase borrowing capacity in a lower amount. The Company’s lending decisions, therefore, can also affect its liquidity position.\n85\nThe Company can also raise additional funds through the issuance of equity or unsecured debt privately or publicly and has done so in the past. Additionally, the Company is able to enter into repurchase agreements or acquire brokered deposits at its discretion. The availability and cost of equity or debt on an unsecured basis is dependent on many factors, including the Company’s financial position, the market environment, and the Company’s credit rating. The Company monitors the factors that could impact its ability to raise liquidity through these channels.\nThe following table depicts current and unused liquidity capacity from various sources as of the dates indicated:\nTable 20 - Liquidity Sources\n| September 30, 2022 | December 31, 2021 |\n| Outstanding | AdditionalBorrowingCapacity | Outstanding | AdditionalBorrowing Capacity |\n| (Dollars in thousands) |\n| Federal Home Loan Bank of Boston (1) | $ | 643 | $ | 1,739,262 | $ | 25,667 | $ | 1,622,494 |\n| Federal Reserve Bank of Boston (2) | — | 1,206,651 | — | 1,176,486 |\n| Unpledged Securities | — | 2,159,018 | — | 1,897,148 |\n| Line of Credit | — | 85,000 | — | 85,000 |\n| Long-term borrowing (3) | — | — | 14,063 | — |\n| Junior subordinated debentures (3) | 62,855 | — | 62,853 | — |\n| Subordinated debt (3) | 49,862 | — | 49,791 | — |\n| Reciprocal deposits (3) | 751,133 | — | 998,121 | — |\n| Brokered deposits (3) | 102,610 | — | 141,572 | — |\n| $ | 967,103 | $ | 5,189,931 | $ | 1,292,067 | $ | 4,781,128 |\n\n(1)Loans with a carrying value of $2.6 billion and $2.3 billion at September 30, 2022 and December 31, 2021, respectively, were pledged to the Federal Home Loan Bank of Boston resulting in this additional unused borrowing capacity.\n(2)Loans with a carrying value of $1.7 billion and $1.8 billion at September 30, 2022 and December 31, 2021, respectively, were pledged to the Federal Reserve Bank of Boston resulting in this additional unused borrowing capacity.\n(3)The additional borrowing capacity has not been assessed for these categories.\nIn addition to customary operational liquidity practices, the Board of Directors and management recognize the need to establish reasonable guidelines to manage a heightened liquidity risk environment. Catalysts for elevated liquidity risk can be Company-specific issues and/or systemic industry-wide events. It is therefore the responsibility of management to institute systems and controls designed to provide advanced detection of potentially significant funding shortages, establish methods for assessing and monitoring risk levels, and institute responses that may alleviate or circumvent a potential liquidity crisis. Management has established a Liquidity Contingency Plan to provide a framework to detect potential liquidity problems and appropriately address them in a timely manner. In a period of perceived heightened liquidity risk, the Liquidity Contingency Plan provides for the establishment of a Liquidity Crisis Task Force to monitor the potential for a liquidity crisis and establish and execute an appropriate response.\nInterest Rate Risk Interest rate risk is the risk arising from changes in interest rates and the value of investments due to market conditions or other external factors or events. Interest rate risk includes market risk. The Company’s primary market risk exposure is interest rate risk.\nInterest rate risk is the sensitivity of income to changes in interest rates. Interest rate changes, as well as fluctuations in the level and duration of assets and liabilities, affect net interest income, the Company’s primary source of revenue. Interest rate risk arises directly from the Company’s core banking activities. In addition to directly impacting net interest income, changes in the level of interest rates can also affect the amount of loans originated, the timing of cash flows on loans and securities, and the fair value of securities and derivatives, and have other effects.\nManagement strives to control interest rate risk within limits approved by the Board of Directors that reflect the Company’s tolerance for interest rate risk over short-term and long-term horizons. The Company attempts to manage interest rate risk by identifying, quantifying, and, where appropriate, hedging exposure. If assets and liabilities do not re-price simultaneously and in equal volume, the potential for interest rate exposure exists. It is the Company's objective to maintain stability in the growth of net interest income through the maintenance of an appropriate mix of interest-earning assets and\n86\ninterest-bearing liabilities and, when necessary within limits management deems prudent, through the use of off-balance sheet hedging instruments such as interest rate swaps, floors, and caps.\nThe Company quantifies its interest rate exposures using net interest income simulation models, as well as simpler gap analysis, and an Economic Value of Equity analysis. Key assumptions in these analyses relate to behavior of interest rates and behavior of the Company’s deposit and loan customers. The most material assumptions relate to the prepayment of mortgage assets (including mortgage loans and mortgage-backed securities) and the life and sensitivity of non-maturity deposits (e.g., demand deposit, negotiable order of withdrawal, savings, and money market accounts). In the case of prepayment of mortgage assets, assumptions are derived from published dealer median prepayment estimates for comparable mortgage loans. The risk of prepayment tends to increase when interest rates fall. Since future prepayment behavior of loan customers is uncertain, interest rate sensitivity of loans cannot be determined with precision and actual behavior may differ from assumptions to a significant degree.\nBased upon the net interest income simulation models, the Company currently forecasts that assets are anticipated to re-price faster than liabilities. As a result, net interest income will be positively impacted as market rates increase and negatively impacted if market rates decrease. The Company runs several scenarios to quantify and effectively assist in managing interest rate risk, including instantaneous parallel shifts in market rates as well as gradual (12-24 months) shifts in market rates, and may also include other alternative scenarios as management deems necessary given the interest rate environment. The Company measures the annual income from each scenario and then compares it against the current year base case scenario.\nThe relative results of all scenarios and the impact to net interest income as they compare to the year 1 base scenario are outlined in the table below:\nTable 21 - Interest Rate Sensitivity\n| September 30 |\n| 2022 | 2021 |\n| Year 1 | Year 2 | Year 1 | Year 2 |\n| Parallel rate shocks (basis points) |\n| -300 | (15.2) | % | (21.8) | % | n/a | n/a |\n| -200 | (9.8) | % | (11.3) | % | n/a | n/a |\n| -100 | (3.4) | % | 0.5 | % | (3.4) | % | (9.8) | % |\n| +100 | 2.4 | % | 14.0 | % | 8.4 | % | 9.6 | % |\n| +200 | 4.0 | % | 18.1 | % | 18.0 | % | 22.8 | % |\n| +300 | 6.4 | % | 24.0 | % | 27.9 | % | 36.4 | % |\n| +400 | 8.7 | % | 29.9 | % | 37.5 | % | 49.5 | % |\n| Gradual rate shifts (basis points) |\n| -200 over 12 months | (3.9) | % | (8.2) | % | n/a | n/a |\n| -100 over 12 months | (1.5) | % | 1.6 | % | (1.4) | % | (8.0) | % |\n| +200 over 12 months | 2.3 | % | 17.5 | % | 8.6 | % | 20.3 | % |\n| +400 over 24 months | 2.3 | % | 20.8 | % | 8.6 | % | 31.6 | % |\n| Alternative scenarios |\n| Flat up 200 basis points scenario | n/a | n/a | 8.0 | % | 17.8 | % |\n\nThe results depicted in the table above are dependent on material assumptions. For instance, asymmetrical rate behavior can have a material impact on the simulation results. If competition for deposits prompts the Company to raise rates on those liabilities more quickly than is assumed in the simulation analysis without a corresponding increase in asset yields, net interest income would be negatively impacted. Alternatively, if the Company is able to lag increases in deposit rates as loans re-price upward, net interest income would be positively impacted.\nThe most significant market factors affecting the Company’s net interest income during the nine months ended September 30, 2022 were the shape of the U.S. Government securities and interest rate swap yield curve, the U.S. prime interest\n87\nrate, LIBOR rates, the secured overnight financing rates (\"SOFR\"), and the interest rates being offered on long-term fixed rate loans.\nThe Company manages the interest rate risk inherent in both its loan and borrowing portfolios by using interest rate swap agreements and interest rate caps and floors. An interest rate swap is an agreement in which one party agrees to pay a floating rate of interest on a notional principal amount in exchange for receiving a fixed rate of interest on the same notional amount for a predetermined period of time from the other party. Interest rate caps and floors are agreements where one party agrees to pay a floating rate of interest on a notional principal amount for a predetermined period of time to a second party if certain market interest rate thresholds are realized. While interest is paid or received in swap, cap, and floors agreements, the notional principal amount is not actually exchanged. The Company may also manage the interest rate risk inherent in its mortgage banking operations by entering into forward sales contracts under which the Company agrees to deliver whole mortgage loans to various investors. See Note 6, “Derivative and Hedging Activities” within the Notes to Consolidated Financial Statements included in Part I. Item 1 of this Report for additional information regarding the Company’s derivative financial instruments.\nThe Company’s earnings are not directly or materially impacted by movements in foreign currency rates or commodity prices. Movements in equity prices may have a modest impact on earnings by affecting the volume of activity or the amount of fees from investment-related business lines. See Note 3, “Securities” within the Notes to Consolidated Financial Statements included in Part I. Item 1 of this Report.\nOperational Risk Operational risk is the risk arising from human error or misconduct, transaction errors or delays, inadequate or failed internal systems or processes, data unavailability, loss, or poor quality, or adverse external events. Operational risk includes business resiliency risk, consumer compliance risk, data governance risk, fraud risk, legal risk, model risk, regulatory compliance risk, and third party vendor risk. Potential operational risk exposure exists throughout the Company. The continued effectiveness of colleagues, technical systems, operational infrastructure, and relationships with key third party service providers are integral to mitigating operational risk, and any shortcomings subject the Company to risks that vary in size, scale and scope. Operational risks include operational failures, unlawful tampering, terrorist activities, ineffectiveness or exposure due to interruption in third party support, as well as the loss of key individuals or a failure of key individuals to perform properly.\nTechnology Risk Technology risk is the risk of losses or other impacts arising from the failure of technology systems to function in accordance with expectations and business requirements. Technology risk includes information technology risk, information security risk, and cyber security.\nReputation Risk Reputational risk is the risk arising from negative public opinion of the Company and the Bank. Management seeks to mitigate reputation risk through actions that include a structured process of customer complaint resolution and ongoing reputational monitoring.\nContractual Obligations, Commitments, Contingencies, and Off-Balance Sheet Financial Information\nOff-Balance Sheet Arrangements There were no material changes in off-balance sheet financial instruments during the three months ended September 30, 2022.\nSee Note 6, \"Derivative and Hedging Activities\" and Note 10, \"Commitments and Contingencies\" within the Notes to Consolidated Financial Statements included in Part I. Item 1 of this Report for more information relating to the Company's other off-balance sheet financial instruments.\nContractual Obligations, Commitments, and Contingencies There were no material changes in contractual obligations, commitments, or contingencies during the three months ended September 30, 2022.\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\nInformation required by this Item 3 is included in the \"Risk Management\" section of Part I. Item 2 \"Management's Discussion and Analysis of Financial Condition and Results of Operations\" of this Report and is incorporated herein by reference.\n88\nItem 4. Controls and Procedures\nConclusion Regarding the Effectiveness of Disclosure Controls and Procedures. The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer along with the Company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as such term is defined under Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Based upon that evaluation, the Company’s Chief Executive Officer along with the Company’s Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.\nChanges in Internal Control over Financial Reporting. There were no changes in the Company's internal control over financial reporting that occurred during the third quarter of 2022 that have materially affected or are reasonably likely to materially affect the Company’s internal control over financial reporting.\nPART II. OTHER INFORMATION\nItem 1. Legal Proceedings\nAt September 30, 2022, the Bank was involved in pending lawsuits that arose in the ordinary course of business. Management has reviewed these pending lawsuits with legal counsel and has taken into consideration the view of counsel as to their outcome. In the opinion of management, the final disposition of pending lawsuits is not expected to have a material adverse effect on the Company’s financial position or results of operations.\nItem 1A. Risk Factors\nThe section titled Risk Factors in Part I, Item 1A of the 2021 Form 10-K includes a discussion of the material risks and uncertainties the Company faces, any one or more of which could have a material adverse effect on the Company's business, results of operations, or financial condition (including capital and liquidity). As of the date of this Report, there have been no material changes with regard to the Risk Factors disclosed in Item 1A of the 2021 Form 10-K which are incorporated herein by reference.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\n(a) Not applicable.\n(b) Not applicable.\n(c) The following table sets forth information regarding the Company’s repurchases of its common stock during the three months ended September 30, 2022:\n| Issuer Purchases of Equity Securities |\n| Total Number of Shares Purchased (1) | Average Price Paid Per Share | Total Number ofShares Purchased asPart of PubliclyAnnounced Plan orProgram (2) | Maximum Number of Shares (or Approximate Dollar Value) That May Yet Be Purchased Under the Plan or Program (2) |\n| Period |\n| July 1 to July 31, 2022 | 177,327 | $ | 79.25 | 177,327 | $ | 20,648,057 |\n| August 1 to August 31, 2022 | 111,433 | $ | 78.98 | 111,433 | $ | 11,847,362 |\n| September 1 to September 30, 2022 | 154,212 | $ | 76.48 | 154,212 | $ | — |\n| Total | 442,972 | $ | 78.22 | 442,972 |\n\n(1)Of these shares, none were surrendered in connection with the exercise and/or vesting of equity compensation grants to satisfy related tax withholding obligations.\n(2)On January 20, 2022, the Company announced that its Board of Directors authorized a share repurchase program of up to $140 million in shares of the Company's common stock. The 154,212 shares repurchased under the program in September 2022 represented the balance of the $140 million in shares repurchased, completing the program.\nOn October 20, 2022, the Company announced the commencement of a new stock repurchase plan which authorizes repurchases by the Company of up to $120 million in common stock. Repurchases under the new plan may be made from time to time on the open market and in privately negotiated transactions, including through the use of trading plans intended to qualify under Rule 10b5-1 under the Exchange Act. The extent to which the Company repurchases shares and the size and timing of these repurchases will depend on a variety of factors, including pricing, market and economic conditions, the Company’s capital position and amount of retained earnings and legal and contractual requirements. The\n89\nrepurchase plan is scheduled to expire October 19, 2023 and may be modified, suspended or discontinued without prior notice at any time.\nItem 3. Defaults Upon Senior Securities -\nNone.\nItem 4. Mine Safety Disclosures -\nNot Applicable.\nItem 5. Other Information -\nNone.\nItem 6. Exhibits\nExhibit Index\n\n| No. | Exhibit |\n\n| 31.1 | Section 302 Certification of Sarbanes-Oxley Act of 2002 is attached hereto.* |\n| 31.2 | Section 302 Certification of Sarbanes-Oxley Act of 2002 is attached hereto.* |\n| 32.1 | Section 906 Certification of Sarbanes-Oxley Act of 2002 is attached hereto.+ |\n| 32.2 | Section 906 Certification of Sarbanes-Oxley Act of 2002 is attached hereto.+ |\n| 101 | The instance document does not appear in the interactive data file because its XBRL tags are embedded within the inline XBRL document.* |\n| 104 | Cover page interactive data file (formatted as inline XBRL and contained in Exhibit 101).* |\n\n| * | Filed herewith |\n\n| + | Furnished herewith |\n\n90\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\nINDEPENDENT BANK CORP.\n(registrant)\n\n| November 3, 2022 | /s/ Christopher Oddleifson |\n| Christopher OddleifsonPresident andChief Executive Officer(Principal Executive Officer) |\n\n\n| November 3, 2022 | /s/ Mark J. Ruggiero |\n| Mark J. RuggieroChief Financial Officer (Principal Financial Officer) |\n\n91\n</text>\n\nWhat is the percentage increase of the net income after provision for credit losses for the three months ended September 30, from 2021 to 2022?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nPART I—FINANCIAL INFORMATION\nItem 1. Financial Statements.\nTALKSPACE, INC.\nCONDENSED CONSOLIDATED BALANCE SHEETS\n\n| June 30, 2023 | December 31, 2022 |\n| (U.S. dollars in thousands, except share and per share data) | (Unaudited) |\n| ASSETS | |\n| CURRENT ASSETS: | | |\n| Cash and cash equivalents | $ | 126,104 | $ | 138,545 |\n| Accounts receivable, net | 8,420 | 9,640 |\n| Other current assets | 2,920 | 4,372 |\n| Total current assets | 137,444 | 152,557 |\n| Property and equipment, net | 456 | 677 |\n| Intangible assets, net | 2,157 | 2,529 |\n| Other long-term assets | 464 | 491 |\n| Total assets | $ | 140,521 | $ | 156,254 |\n| LIABILITIES AND STOCKHOLDERS’ EQUITY | | |\n| CURRENT LIABILITIES: | | |\n| Accounts payable | $ | 5,484 | $ | 6,461 |\n| Deferred revenues | 3,683 | 4,355 |\n| Accrued expenses and other current liabilities | 10,444 | 16,502 |\n| Total current liabilities | 19,611 | 27,318 |\n| Warrant liabilities | 820 | 939 |\n| Other long-term liabilities | 295 | 461 |\n| Total liabilities | 20,726 | 28,718 |\n| Commitments and contingencies (Note 5) |\n| STOCKHOLDERS’ EQUITY: | | |\n| Common stock of $ 0.0001 par value — Authorized: 1,000,000,000 shares at June 30, 2023 and December 31, 2022; Issued and outstanding: 166,204,295 and 161,155,030 shares at June 30, 2023 and December 31, 2022, respectively | 16 | 16 |\n| Additional paid-in capital | 384,443 | 378,722 |\n| Accumulated deficit | ( 264,664 | ) | ( 251,202 | ) |\n| Total stockholders’ equity | 119,795 | 127,536 |\n| Total liabilities and stockholders’ equity | $ | 140,521 | $ | 156,254 |\n\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\n3\nTALKSPACE, INC.\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\n(Unaudited)\n\n| Three Months Ended | Six Months Ended |\n| June 30, | June 30, |\n| (U.S. dollars in thousands, except share and per share data) | 2023 | 2022 | 2023 | 2022 |\n| Revenues | $ | 35,645 | $ | 29,844 | $ | 68,981 | $ | 59,994 |\n| Cost of revenues | 17,833 | 15,297 | 34,421 | 30,426 |\n| Gross profit | 17,812 | 14,547 | 34,560 | 29,568 |\n| Operating expenses: |\n| Research and development, net | 4,171 | 5,576 | 9,524 | 10,611 |\n| Clinical operations, net | 1,675 | 2,316 | 3,276 | 4,092 |\n| Sales and marketing | 13,045 | 18,931 | 26,514 | 40,339 |\n| General and administrative | 5,329 | 8,792 | 10,693 | 16,802 |\n| Total operating expenses | 24,220 | 35,615 | 50,007 | 71,844 |\n| Operating loss | ( 6,408 | ) | ( 21,068 | ) | ( 15,447 | ) | ( 42,276 | ) |\n| Financial (income) expense, net | ( 1,712 | ) | 1,865 | ( 2,136 | ) | 996 |\n| Loss before taxes on income | ( 4,696 | ) | ( 22,933 | ) | ( 13,311 | ) | ( 43,272 | ) |\n| Taxes on income | 8 | 89 | 151 | 110 |\n| Net loss | $ | ( 4,704 | ) | $ | ( 23,022 | ) | $ | ( 13,462 | ) | $ | ( 43,382 | ) |\n| Net loss per share: |\n| Basic and Diluted | $ | ( 0.03 | ) | $ | ( 0.15 | ) | $ | ( 0.08 | ) | $ | ( 0.28 | ) |\n| Weighted average number of common shares used in computing basic and diluted net loss per share: |\n| Basic and Diluted | 164,195,697 | 155,709,901 | 163,003,363 | 154,901,165 |\n\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\n4\nTALKSPACE, INC.\nCONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY\n(Unaudited)\n\n| (U.S. dollars in thousands, except share data) | Common Stock |\n| Three and Six Months Ended June 30, 2023 | Number of SharesOutstanding | Amount | Additional paid-incapital | Accumulateddeficit | Total |\n| Balance as of December 31, 2022 | 161,155,030 | $ | 16 | $ | 378,722 | $ | ( 251,202 | ) | $ | 127,536 |\n| Exercise of stock options | 1,739,265 | *) | 621 | — | 621 |\n| Restricted stock units vested, net of tax | 225,050 | *) | ( 65 | ) | — | ( 65 | ) |\n| Stock-based compensation | — | — | 2,303 | — | 2,303 |\n| Net loss | — | — | — | ( 8,758 | ) | ( 8,758 | ) |\n| Balance as of March 31, 2023 (unaudited) | 163,119,345 | $ | 16 | $ | 381,581 | $ | ( 259,960 | ) | $ | 121,637 |\n| Exercise of stock options | 1,837,734 | *) | 869 | — | 869 |\n| Restricted stock units vested, net of tax | 1,247,216 | *) | ( 136 | ) | — | ( 136 | ) |\n| Stock-based compensation | — | — | 2,129 | — | 2,129 |\n| Net loss | — | — | — | ( 4,704 | ) | ( 4,704 | ) |\n| Balance as of June 30, 2023 (unaudited) | 166,204,295 | $ | 16 | $ | 384,443 | $ | ( 264,664 | ) | $ | 119,795 |\n| Common Stock |\n| Three and Six Months Ended June 30, 2022 | Number of SharesOutstanding | Amount | Additional paid-incapital | Accumulateddeficit | Total |\n| Balance as of December 31, 2021 | 152,862,447 | $ | 15 | $ | 363,788 | $ | ( 171,530 | ) | $ | 192,273 |\n| Exercise of stock options | 2,164,870 | *) | 2,063 | — | 2,063 |\n| Restricted stock units vested, net of tax | 77,338 | *) | ( 67 | ) | — | ( 67 | ) |\n| Stock-based compensation | — | — | 2,368 | — | 2,368 |\n| Net loss | — | — | — | ( 20,360 | ) | ( 20,360 | ) |\n| Balance as of March 31, 2022 (unaudited) | 155,104,655 | $ | 15 | $ | 368,152 | $ | ( 191,890 | ) | $ | 176,277 |\n| Exercise of stock options | 1,092,515 | *) | 286 | — | 286 |\n| Restricted stock units vested, net of tax | 1,175,446 | *) | ( 126 | ) | — | ( 126 | ) |\n| Stock-based compensation | — | — | 3,839 | — | 3,839 |\n| Net loss | — | — | — | ( 23,022 | ) | ( 23,022 | ) |\n| Balance as of June 30, 2022 (unaudited) | 157,372,616 | $ | 15 | $ | 372,151 | $ | ( 214,912 | ) | $ | 157,254 |\n\n*) Represents an amount lower than $1\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\n5\nTALKSPACE, INC.\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(Unaudited)\n\n| Six Months EndedJune 30, |\n| (U.S. dollars in thousands) | 2023 | 2022 |\n| Cash flows from operating activities: |\n| Net loss | $ | ( 13,462 | ) | $ | ( 43,382 | ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: |\n| Depreciation and amortization | 608 | 697 |\n| Stock-based compensation | 4,432 | 6,207 |\n| Remeasurement of warrant liabilities | ( 119 | ) | 1,217 |\n| Decrease (increase) in accounts receivable | 1,220 | ( 1,650 | ) |\n| Decrease in other current assets | 1,452 | 5,622 |\n| (Decrease) increase in accounts payable | ( 977 | ) | 381 |\n| Decrease in deferred revenues | ( 672 | ) | ( 1,236 | ) |\n| Decrease in accrued expenses and other current liabilities | ( 6,058 | ) | ( 1,145 | ) |\n| Other | ( 172 | ) | 178 |\n| Net cash used in operating activities | ( 13,748 | ) | ( 33,111 | ) |\n| Cash flows from investing activities: |\n| Purchase of property and equipment | ( 10 | ) | ( 160 | ) |\n| Proceeds from sale of property and equipment | 28 | — |\n| Net cash provided by (used in) investing activities | 18 | ( 160 | ) |\n| Cash flows from financing activities: |\n| Proceeds from exercise of stock options | 1,490 | 2,349 |\n| Payments for employee taxes withheld related to vested stock-based awards | ( 201 | ) | ( 67 | ) |\n| (Payments) proceeds from reverse capitalization, net of transaction costs | — | ( 645 | ) |\n| Net cash provided by financing activities | 1,289 | 1,637 |\n| Net decrease in cash and cash equivalents | ( 12,441 | ) | ( 31,634 | ) |\n| Cash and cash equivalents at the beginning of the period | 138,545 | 198,256 |\n| Cash and cash equivalents at the end of the period | $ | 126,104 | $ | 166,622 |\n| Supplemental cash flow data: |\n| Cash paid during the period for income taxes | $ | 176 | $ | 97 |\n\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\n6\nTALKSPACE, INC.\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(Unaudited)\nNOTE 1. DESCRIPTION OF ORGANIZATION AND BUSINESS OPERATIONS Talkspace, Inc. (together with its consolidated subsidiaries, the “Company” or “Talkspace”) is a leading behavioral healthcare company enabled by a purpose-built technology platform. Talkspace provides individuals and licensed therapists, psychologists and psychiatrists with an online platform for one-on-one therapy delivered via messaging, audio and video. The Company offers convenient and affordable access to a fully credentialed network of highly qualified providers. Since its inception, the Company has connected millions of patients with licensed behavioral health providers across a wide and growing spectrum of care through virtual counseling, psychotherapy, and psychiatry. The Company's principal executive office is located in New York, NY. The Company has three wholly owned subsidiaries, Talkspace LLC, Talkspace Network LLC and Groop Internet Platform LTD. In addition, the Company holds a variable interest in one professional association and six professional corporations, which have been established pursuant to the requirements of their respective domestic jurisdiction governing the corporate practice of medicine. See Note 10, “Variable Interest Entities,” in these notes to the condensed consolidated financial statements for further details.\nNOTE 2. SIGNIFICANT ACCOUNTING POLICIES Basis of presentationThe unaudited condensed consolidated financial statements and accompanying notes have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”). In management’s opinion, the unaudited condensed consolidated financial statements reflect all adjustments of a normal recurring nature that are necessary for a fair presentation of the results for the interim periods presented. The Company’s interim period results do not necessarily indicate the results that may be expected for any other interim period or for the full fiscal year. These condensed consolidated financial statements should be read in conjuction with the consolidated financial statements as of and for the year ended December 31, 2022 included in the Company's Annual Report on Form 10-K for the year ended December 31, 2022. The significant accounting policies applied in the annual consolidated financial statements of the Company as of December 31, 2022, have been applied consistently in these unaudited condensed consolidated financial statements, unless otherwise stated. Intercompany transactions and balances have been eliminated in the preparation of the condensed consolidated financial statements. Use of estimatesThe preparation of financial statements in conformity with U.S. GAAP requires management to make estimates, judgments, and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, together with amounts disclosed in the related notes to the condensed consolidated financial statements. The Company’s significant estimates and assumptions used in these condensed consolidated financial statements include, but are not limited to, the recognition and disclosure of contingent liabilities, revenue recognition, stock-based compensation awards and the fair value of warrant liabilities. The Company bases its estimates on historical factors, current circumstances and the experience and judgment of management. The Company evaluates its assumptions on an ongoing basis. The Company’s management believes that the estimates, judgments, and assumptions used are reasonable based on information available at the time they are made. Estimates, by their nature, are based on judgment and available information, therefore, actual results could be materially different from these estimates. Reclassification Certain prior year amounts have been reclassified to conform to current year presentation . Recently Issued and Adopted Accounting PronouncementsThe Company has reviewed recent accounting pronouncements and concluded that they are either not applicable to its business or that no material effect is expected on the condensed consolidated financial statements as a result of their future adoption.\n7\n| Unaudited | Three Months Ended June 30, | | Six Months Ended June 30, |\n| (in thousands) | 2023 | 2022 | 2023 | 2022 |\n| Revenues from sales to unaffiliated customers: | |\n| Payor revenue | $ | 18,539 | $ | 7,880 | $ | 33,350 | $ | 15,990 |\n| DTE revenue | 8,039 | 6,685 | 16,715 | 12,346 |\n| Total B2B revenue | 26,578 | 14,565 | 50,065 | 28,336 |\n| Consumer revenue | 9,067 | 15,279 | | 18,916 | 31,658 |\n| Total revenue | $ | 35,645 | $ | 29,844 | | $ | 68,981 | $ | 59,994 |\n\n| Level 3 Liabilities (unaudited) |\n| For the Three Months Ended June 30, 2023 |\n| (in thousands) | Beginning Balance | Change in Fair Value | Ending Balance |\n| Private Placement Warrants | $ | 1,128 | $ | ( 308 | ) | $ | 820 |\n| For the Six Months Ended June 30, 2023 |\n| (in thousands) | Beginning Balance | Change in Fair Value | Ending Balance |\n| Private Placement Warrants | $ | 939 | $ | ( 119 | ) | $ | 820 |\n| Level 3 Liabilities (unaudited) |\n| For the Three Months Ended June 30, 2022 |\n| (in thousands) | Beginning Balance | Change in Fair Value | Ending Balance |\n| Private Placement Warrants | $ | 3,195 | $ | 2,092 | $ | 5,287 |\n| For the Six Months Ended June 30, 2022 |\n| (in thousands) | Beginning Balance | Change in Fair Value | Ending Balance |\n| Private Placement Warrants | $ | 4,070 | $ | 1,217 | $ | 5,287 |\n\n9\nNOTE 5. COMMITMENTS AND CONTINGENT LIABILITIES LitigationIn January 2022, the Company and certain of its current and former officers and directors were named as defendants in securities class action complaints filed in the United States District Court for the Southern District of New York under the case headings: (1) Baron v. Talkspace et al., No. 22-cv-00163 (S.D.N.Y.) and (2) Valdez v. Talkspace et al., No. 22-cv-00840 (S.D.N.Y.), which were subsequently consolidated under the caption In re Talkspace, Inc. Securities Litigation, No. 22-cv-00163 (S.D.N.Y) (the “Securities Action”). The Securities Action asserts violations of sections 10(b), 14(a) and 20(a) of the Securities Exchange Act of 1934 and SEC Rules 10b-5 and 14a-9 promulgated thereunder. These actions generally relate to public disclosures and statements by the Company in connection with its merger with Hudson Executive Investment Corp. (“HEIC”). In December 2022, the Company’s subsidiary Tailwind Merger Sub II, LLC, certain of the Company’s current and former directors and officers, and others were named as defendants in a putative class action complaint filed in the Delaware Court of Chancery under the case caption Valdez v. Braunstein, et al., C.A. No. 2022-1148 (Del. Ch.) (the “Delaware Action”). The Delaware Action asserts claims for breach of fiduciary duty and aiding and abetting breach of fiduciary duty relating to the merger with HEIC, among other things, based on many of the same facts at issue in the Securities Action. The complaint seeks, among other things damages on behalf of putative class members who did not redeem their shares in connection with the Company’s merger with HEIC. In February 2023, the Company resolved the Securities Action and the Delaware Action through mediation. The settlement resolves these litigations with respect to all named defendants. The settlement will have to be approved by the court, which the Company expects will occur in the third quarter of 2023. In June and July 2022, two individuals filed stockholder derivative lawsuits on behalf of Talkspace in the United States District Court for the Southern District of New York under the case captions: (1) Odsvall v. Oren Frank et al., No. 22-cv-05016 (S.D.N.Y.) and (2) Nayman v. Berg, et al., No. 22-cv-06258 (S.D.N.Y.), which were subsequently consolidated under the caption In re Talkspace Stockholder Derivative Litigation, No. 22-cv-05016 (S.D.N.Y.) in September 2022 (the “Derivative Action”). The Derivative Action named certain of the Company’s current and former officers and directors as defendants and the Company as a nominal defendant. The Derivative Action asserted claims for violations of federal securities laws, breach of fiduciary duty, and aiding and abetting breaches of fiduciary duty relating to the merger with HEIC, among other things, based on many of the same facts at issue in the Securities Action. In February 2023 the parties reached an agreement in principle to resolve the Derivative Action with respect to all named defendants in exchange for certain changes to the Company’s Corporate Governance environment, including the declassification of the Company’s board of directors, creation of a management-level disclosure committee, enhancements to the responsibilities and duties of the Company’s Audit Committee, the addition of independent directors, enhancements to employee compliance training and retention of an internal controls consultant. In addition, the Company agreed to pay or cause to be paid $ 550,000 in attorney’s fees and expenses. On May 18, 2023, the parties entered into a Stipulation of Settlement and Release Agreement (the “Stipulation”) that sets forth the terms and conditions for the proposed settlement and dismissal with prejudice of the Derivative Action (the “Settlement”). On June 30, 2023, the court entered an order preliminarily approving the Stipulation and proposed Settlement of the Derivative Action and scheduling a hearing for August 16, 2023 to determine whether to give final approval to the Settlement. The defendants have not admitted any liability or wrongdoing in connection with the Settlement and have entered into the Settlement solely to avoid the costs, risks, distraction, and uncertainties of continued litigation of the Derivative Action. In addition to the foregoing, the Company may in the future be involved in various legal proceedings, claims and litigation that arise in the normal course of business. The Company accrues for estimated loss contingencies related to legal matters when available information indicates that it is probable a liability had been incurred and the Company can reasonably estimate the amount of that loss. In many proceedings, however, it is inherently difficult to determine whether any loss is probable or even possible or to estimate the amount of any loss. In addition, even where a loss is possible or an exposure to loss exists in excess of the liability already accrued with respect to a previously recognized loss contingency, it is often not possible to reasonably estimate the size of the possible loss or range of loss or possible additional losses or range of additional losses. 10 Warranties and IndemnificationThe Company’s arrangements generally include certain provisions for indemnifying clients against liabilities if there is a breach of a client’s data or if the Company’s service infringes a third party’s intellectual property rights. To date, the Company has not incurred any material costs as a result of such indemnifications.The Company has also agreed to indemnify its directors and executive officers for costs associated with any fees, expenses, judgments, fines and settlement amounts incurred by any of these persons in any action or proceeding to which any of those persons is, or is threatened to be, made a party by reason of the person’s service as a director or officer, including any action by the Company, arising out of that person’s services as a director or officer or that person’s services provided to any other company or enterprise at the Company’s request. The Company maintains director and officer liability insurance coverage that would generally enable it to recover a portion of any future amounts paid. The Company may also be subject to indemnification obligations by law with respect to the actions of its employees under certain circumstances and in certain jurisdictions.\nNOTE 6. CAPITAL STOCK As of June 30, 2023 and December 31, 2022 there were outstanding 12,780,000 Private Placement Warrants and 21,350,000 Public Warrants to purchase the Company’s common stock at an exercise price of $ 11.50 per share. As of June 30, 2023 and December 31, 2022, no shares of preferred stock were issued or outstanding.\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| Unaudited | 2023 | 2022 | 2023 | 2022 |\n| (in thousands) |\n| Research and development, net | $ | 546 | $ | 662 | $ | 1,220 | $ | 1,208 |\n| Clinical operations, net | 126 | 79 | 246 | 201 |\n| Sales and marketing | 445 | 816 | 836 | 1,593 |\n| General and administrative | 1,012 | 2,282 | 2,130 | 3,205 |\n| Total stock-based compensation expense | $ | 2,129 | $ | 3,839 | $ | 4,432 | $ | 6,207 |\n\n11\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| Unaudited | 2023 | 2022 | 2023 | 2022 |\n| (in thousands, except share and per share data) |\n| Net loss | $ | ( 4,704 | ) | $ | ( 23,022 | ) | $ | ( 13,462 | ) | $ | ( 43,382 | ) |\n| Weighted-average shares used to compute net loss per share: |\n| Basic and Diluted | 164,195,697 | 155,709,901 | 163,003,363 | 154,901,165 |\n| Net loss per share: |\n| Basic and Diluted | $ | ( 0.03 | ) | $ | ( 0.15 | ) | $ | ( 0.08 | ) | $ | ( 0.28 | ) |\n\n| June 30, 2023 | December 31, 2022 |\n| (in thousands) | Unaudited |\n| Employee compensation | $ | 3,821 | $ | 5,290 |\n| User acquisition | 1,913 | 2,256 |\n| Litigation costs | 750 | 5,500 |\n| Professional fees | 576 | 543 |\n| Other | 3,384 | 2,913 |\n| Accrued expenses and other current liabilities | $ | 10,444 | $ | 16,502 |\n\n12\n| (in thousands) | June 30, 2023 | December 31, 2022 |\n| ASSETS | Unaudited |\n| Cash and cash equivalents | $ | 497 | $ | 883 |\n| Accounts receivable | 6,159 | 1,716 |\n| Other assets | — | 4,813 |\n| Total Assets | $ | 6,656 | $ | 7,412 |\n| LIABILITIES |\n| Accrued expenses and other current liabilities | 3,802 | 3,758 |\n| Total Liabilities | $ | 3,802 | $ | 3,758 |\n\n13\nItem 2\n. Management’s Discussion and Analysis of Financial Condition and Results of Operations.\nUnless the context otherwise requires, all references in this section as to “Talkspace,” the “Company,” “we,” “us” or “our” refer to the business of Talkspace, Inc. and its consolidated subsidiaries.\nThe following discussion and analysis of our financial condition and results of operations should be read together with the financial statements and the related notes contained in this Quarterly Report and the financial statements and related notes contained in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2022. This discussion contains forward-looking statements that reflect our plans, estimates, and beliefs that involve risks and uncertainties. As a result of many factors, such as those discussed in Part I, Item 1A, “Risk Factors” of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2022 and “Forward-Looking Statements” sections and elsewhere in this Quarterly Report, our actual results may differ materially from those anticipated in these forward-looking statements.\nThe purpose of this section is to discuss and analyze our consolidated financial condition, liquidity and capital resources and results of operations for the three and six months ended June 30, 2023 and 2022.\nOverview\nTalkspace is a healthcare company offering its members convenient and affordable access to a fully-credentialed network of highly qualified providers. We are a leading virtual behavioral health company and, since Talkspace’s founding in 2012, we have connected millions of patients with licensed mental health providers across a wide and growing spectrum of care through virtual counseling, psychotherapy and psychiatry. We created a purpose-built platform to address the vast, unmet and growing demand for mental health services of our members, serving our business-to-business (“B2B”) channel, comprised of large health plans and employee assistance programs (“Payors”) such as Aetna, Cigna, Premera and Optum and large enterprise clients (“DTE”) such as Google and Expedia (collectively, our “clients”), who offer their insured members and employees access to our platform at in-network reimbursement rates, or while their employer is under an active contract with Talkspace, where applicable, and our business-to-consumer (“Consumer”) channel, comprised of individual consumers who subscribe directly to our platform.\nAs of June 30, 2023, we had approximately 110 million B2B eligible lives and approximately 13,700 consumer active members compared to 77 million B2B eligible lives and 20,100 consumer active members as of June 30, 2022. For the three and six months ended June 30, 2023, our clinicians completed 200,500 and 372,200 B2B sessions, respectively, related to members covered under our health plan clients, as compared to 96,000 and 186,600 completed B2B sessions for the three and six months ended June 30, 2022. Please refer to the “Key Business Metrics” section below for a description of active members and B2B eligible lives.\nOperating Segments\nThe Company operates as a single segment and as one reporting unit, which is how the chief operating decision maker (who is the chief executive officer) reviews financial performance and allocates resources.\nKey Business Metrics\nWe monitor the following key metrics to help us evaluate our business, identify trends affecting our business, formulate business plans and make strategic decisions. We believe the following metrics are useful in evaluating our business:\n\n| Unaudited | Six Months EndedJune 30, |\n| (in thousands except number of health plan and enterprise clients or otherwise indicated) | 2023 | 2022 |\n| Number of B2B eligible lives at period end (in millions) | 110 | 77 |\n| Number of completed B2B sessions during the period | 372.2 | 186.6 |\n| Number of health plan clients at period end | 20 | 16 |\n| Number of enterprise clients at period end | 217 | 205 |\n| Number of Consumer active members at period end | 13.7 | 20.1 |\n\n14\nB2B Eligible Lives: We consider B2B lives “eligible” if such persons are eligible to receive treatment on the Talkspace platform, in the case of our health plan clients, at an agreed upon reimbursement rate through insurance under an employee assistance program or other network behavioral health paid benefit program. There may be instances where a person may be covered through multiple solutions, typically through behavioral health plans and employee assistance programs. In these instances, the person is counted each time they are covered in the B2B eligible lives calculation, which may cause this amount to reflect a higher number of B2B eligible lives than we actually serve.\nActive Members: We consider members “active”, in the case of our Consumer members, commencing on the date such member initiates contact with a provider on our platform until the term of their monthly, quarterly or bi-annual subscription plan expires, unless terminated early.\nComponents of Results of Operations\nRevenues\nWe contract with health insurance plans, employee assistance organizations and enterprises to provide services to individuals who are qualified to receive access to the Company’s services through the Company’s commercial arrangements. We generate revenues from payments from insured members and claims paid by their respective insurance companies and from contracted platform access fees paid to us by our enterprise clients for the delivery of therapy services to their members or employees. We recognize revenues from services provided to insured members at a point in time, as virtual therapy or psychiatry session is rendered. We recognize revenue from our enterprise clients ratably over the contractual term based primarily on a per-member-per month access fee model.\nWe also generate revenues from the sale of monthly, quarterly, bi-annual and annual membership subscriptions to the Company's therapy platform as well as supplementary a la carte offerings directly to individual consumers through a subscription plan. We recognize member subscription revenues ratably over the subscription period, beginning when therapy services commence. We recognize revenues from supplementary a la carte offerings at a point in time, as virtual therapy session is rendered. Members may cancel their subscription at any time and will receive a pro-rata refund for the subscription price.\nRevenue growth is generated from increasing our eligible covered lives through contracting with health plans, increasing utilization within eligible covered lives, expanding enterprise clients, and increasing membership subscriptions.\nCost of Revenues\nCost of revenues is comprised primarily of therapist payments. Cost of revenues is largely driven by number of sessions and the size of our provider network that is required to service the growth of our health plan and enterprise clients, in addition to the growth of our customer base.\nWe designed our business model and our provider network to be scalable and to leverage a hybrid model of both employee providers and independently contracted providers to support multiple growth scenarios. The compensation paid to our independently contracted providers is variable, and the amount paid to a provider is generally based on the amount of time committed by such provider to our members. In addition, our network supervisors have authority to approve the payment of incentive bonuses to providers with certain licenses during periods of higher demand for providers with such licenses. For our employee providers, they receive a fixed-salary and discretionary bonuses, where applicable, all of which is included in cost of revenues.\nWhile we expect to make increased investments to support accelerated growth and the required investment to scale our provider network, we also expect increased efficiencies and economies of scale. Our cost of revenues as a percentage of revenues is expected to fluctuate from period to period depending on the interplay of these factors as well as pricing fluctuations.\n15\nOperating Expenses\nOperating expenses consist of research and development, clinical operations, sales and marketing, and general and administrative expenses.\nResearch and Development Expenses\nResearch and development expenses include personnel and related expenses for software development and engineering, information technology infrastructure, security, privacy compliance and product development (inclusive of stock-based compensation for our research and development employees), third-party services and contractors related to research and development, information technology and software-related costs.\nClinical Operations Expenses\nClinical operations expenses are associated with the management of our network of therapists. This item is comprised of costs related to recruiting, onboarding, credentialing, training and ongoing quality assurance activities (inclusive of stock-based compensation for our clinical operations employees), costs of third-party services and contractors related to recruiting and training and software-related costs.\nSales and Marketing Expenses\nSales expenses consist primarily of employee-related expenses, including salaries, benefits, commissions, travel and stock-based compensation costs for our employees engaged in sales and account management.\nMarketing expenses consist primarily of advertising and marketing expenses for member acquisition and engagement, as well as personnel costs, including salaries, benefits, bonuses, stock-based compensation expense for marketing employees, third-party services and contractors. Marketing expenses also include third-party software subscription services, third-party independent research, participation in trade shows, brand messaging and costs of communications materials that are produced for our clients to generate greater awareness and utilization of our platform among our health plan and enterprise clients.\nGeneral and Administrative Expenses\nGeneral and administrative expenses consist primarily of personnel costs, including salaries, benefits, bonuses and stock-based compensation expense for certain executives, finance, accounting, legal and human resources functions, as well as professional fees, occupancy costs, and other general overhead costs.\nFinancial income, net\nFinancial income, net includes the impact from (i) non-cash changes in the fair value of our warrant liabilities, (ii) interest earned on cash equivalents deposited in our money market accounts and (iii) other financial expenses in connection with bank charges.\nTaxes on income\nOur taxes on income consists primarily of foreign income taxes related to income generated by our subsidiary organized under the laws of Israel.\nWe have a full valuation allowance for our U.S. deferred tax assets, including federal and state NOLs. We expect to maintain this valuation allowance until it becomes more likely than not that the benefit of our federal and state deferred tax assets will be realized through expected future taxable income in the United States.\n16\nResults of Operations\nThe following table presents our results of operations for the three and six months ended June 30, 2023 and 2022 and the dollar and percentage change between the respective periods:\n\n| (in thousands, except percentages) | Three Months EndedJune 30, | Variance | Six Months EndedJune 30, | Variance |\n| Unaudited | 2023 | 2022 | $ | % | 2023 | 2022 | $ | % |\n| Revenue: |\n| Payor revenue | $18,539 | $7,880 | 10,659 | 135.3 | $33,350 | $15,990 | 17,360 | 108.6 |\n| DTE revenue | 8,039 | 6,685 | 1,354 | 20.3 | 16,715 | 12,346 | 4,369 | 35.4 |\n| Total B2B revenue | 26,578 | 14,565 | 12,013 | 82.5 | 50,065 | 28,336 | 21,729 | 76.7 |\n| Consumer revenue | 9,067 | 15,279 | (6,212) | (40.7) | 18,916 | 31,658 | (12,742) | (40.2) |\n| Total revenue | 35,645 | 29,844 | 5,801 | 19.4 | 68,981 | 59,994 | 8,987 | 15.0 |\n| Cost of revenue | 17,833 | 15,297 | 2,536 | 16.6 | 34,421 | 30,426 | 3,995 | 13.1 |\n| Gross profit | 17,812 | 14,547 | 3,265 | 22.4 | 34,560 | 29,568 | 4,992 | 16.9 |\n| Operating expenses: |\n| Research and development, net | 4,171 | 5,576 | (1,405) | (25.2) | 9,524 | 10,611 | (1,087) | (10.2) |\n| Clinical operations, net | 1,675 | 2,316 | (641) | (27.7) | 3,276 | 4,092 | (816) | (19.9) |\n| Sales and marketing | 13,045 | 18,931 | (5,886) | (31.1) | 26,514 | 40,339 | (13,825) | (34.3) |\n| General and administrative | 5,329 | 8,792 | (3,463) | (39.4) | 10,693 | 16,802 | (6,109) | (36.4) |\n| Total operating expenses | 24,220 | 35,615 | (11,395) | (32.0) | 50,007 | 71,844 | (21,837) | (30.4) |\n| Operating loss | (6,408) | (21,068) | 14,660 | 69.6 | (15,447) | (42,276) | 26,829 | 63.5 |\n| Financial (income) expense, net | (1,712) | 1,865 | (3,577) | * | (2,136) | 996 | (3,132) | * |\n| Loss before taxes on income | (4,696) | (22,933) | 18,237 | 79.5 | (13,311) | (43,272) | 29,961 | 69.2 |\n| Taxes on income | 8 | 89 | (81) | (91.0) | 151 | 110 | 41 | 37.3 |\n| Net loss | $(4,704) | $(23,022) | $18,318 | 79.6 | $(13,462) | $(43,382) | $29,920 | 69.0 |\n\n* Percentage not meaningful\nRevenues. Revenues increased by $5.8 million, or 19.4% to $35.6 million for the three months ended June 30, 2023 from $29.8 million for the three months ended June 30, 2022. The increase was principally due to a 82.5% growth in B2B revenue driven by a higher number of completed B2B sessions and an increase in covered lives from health plan clients (\"Payors\") and new enterprise clients (\"DTE\"), partially offset by a 40.7% decline in consumer subscription revenue. Revenue from our health plan clients increased by $10.7 million, or 135.3%, to $18.5 million for the three months ended June 30, 2023 from $7.9 million for the three months ended June 30, 2022. Enterprise client contracts increased by 12 clients, or 5.9%, to 217 clients as of June 30, 2023 from 205 clients as of June 30, 2022. This increase in the number of enterprise clients drove DTE revenue to increase by $1.4 million, or 20.3% to $8.0 million for the three months ended June 30, 2023 from $6.7 million for the three months ended June 30, 2022. Consumer subscriptions revenue decreased by $6.2 million, or 40.7%, to $9.1 million for the three months ended June 30, 2023 from $15.3 million for the three months ended June 30, 2022, due to the Company's intentional and strategic decision to reduce marketing spend related to this service.\nRevenues increased by $9.0 million, or 15.0% to $69.0 million for the six months ended June 30, 2023 from $60.0 million for the six months ended June 30, 2022. The increase was principally due to a 76.7% growth in B2B revenue driven by a higher number of completed B2B sessions and an increase in covered lives from Payors and new DTE clients, partially offset by a 40.2% decline in consumer subscription revenue. Revenue from our health plan clients increased by $17.4 million, or 108.6%, to $33.4 million for the six months ended June 30, 2023 from $16.0 million for the six months ended June 30, 2022. Enterprise client contracts increased by 12 clients, or 5.9%, to 217 clients as of June 30, 2023 from 205 clients as of June 30, 2022. This increase in the number of enterprise clients drove DTE revenue to increase by $4.4 million, or 35.4% to $16.7 million for the six months ended June 30, 2023 from $12.3 million for the six months ended June 30, 2022. Consumer subscriptions revenue decreased by $12.7 million, or 40.2%, to $18.9 million for the six months ended June 30, 2023 from $31.7 million for the six months ended June 30, 2022, due to the Company's intentional and strategic decision to reduce marketing spend related to this service.\nCosts of revenues. Cost of revenues increased by $2.5 million, or 16.6%, to $17.8 million for the three months ended June 30, 2023 from $15.3 million for the three months ended June 30, 2022, and increased by $4.0 million, or 13.1%, to $34.4 million for the six months ended June 30, 2023 from $30.4 million for the six months ended June 30, 2022. The increase in cost of revenues for the three and six months ended June 30, 2023, was primarily due to increased hours worked by therapists to meet strong customer engagement.\n17\nGross profit. Gross profit increased by $3.3 million, or 22.4%, to $17.8 million for the three months ended June 30, 2023 from $14.5 million for the three months ended June 30, 2022. Gross profit increased by $5.0 million, or 16.9%, to $34.6 million for the six months ended June 30, 2023 from $29.6 million for the six months ended June 30, 2022. The increase in gross profit for the three and six months ended June 30, 2023 was primarily driven by higher revenue and provider network productivity.\nGross margin was 50.0% for the three months ended June 30, 2023, compared to 48.7% during the three months ended June 30, 2022. Gross margin was 50.1% for the six months ended June 30, 2023, compared to 49.3% during the six months ended June 30, 2022. The increase in gross margin for the three and six months ended June 30, 2023 was primarily due to higher revenue and provider network productivity, partially offset by the revenue shift mix towards B2B revenue.\nOperating expenses\nOverall, our operating expenses for the three and six months ended June 30, 2023 have decreased due to our efficiency initiatives in order to optimize for profitability.\nResearch and development expenses. Research and development expenses decreased by $1.4 million, or 25.2% to $4.2 million for the three months ended June 30, 2023 from $5.6 million for the three months ended June 30, 2022, and decreased by $1.1 million, or 10.2% to $9.5 million for the six months ended June 30, 2023 from $10.6 million for the six months ended June 30, 2022. The decrease in research and development expenses for the three and six months ended June 30, 2023 was primarily due to a decrease in employee-related costs, inclusive of non-cash stock compensation expense.\nClinical operations expenses. Clinical operations expenses decreased by $0.6 million, or 27.7% to $1.7 million for the three months ended June 30, 2023 from $2.3 million for the three months ended June 30, 2022, and decreased by $0.8 million, or 19.9% to $3.3 million for the six months ended June 30, 2023 from $4.1 million for the six months ended June 30, 2022. The decrease in clinical operations expenses for the three and six months ended June 30, 2023 was primarily due to lower provider recruitment costs.\nSales and marketing expenses. Sales and marketing expenses decreased by $5.9 million, or 31.1%, to $13.0 million for the three months ended June 30, 2023 from $18.9 million for the three months ended June 30, 2022, and decreased by $13.8 million, or 34.3%, to $26.5 million for the six months ended June 30, 2023 from $40.3 million for the six months ended June 30, 2022. The decrease in sales and marketing expenses for the three and six months ended June 30, 2023 was primarily driven by a decrease in direct marketing and promotional costs.\nGeneral and administrative expenses. General and administrative expenses decreased by $3.5 million, or 39.4%, to $5.3 million for the three months ended June 30, 2023 from $8.8 million for the three months ended June 30, 2022, and decreased by $6.1 million, or 36.4%, to $10.7 million for the six months ended June 30, 2023 from $16.8 million for the six months ended June 30, 2022. The decrease in general and administrative expenses for the three and six months ended June 30, 2023 was primarily due to a decrease in professional fees, subcontractor costs and employee-related costs, inclusive of non-cash stock compensation expense.\nFinancial income, net. Financial income, net was $1.7 million for the three months ended June 30, 2023, compared to financial expense, net of $1.9 million for the three months ended June 30, 2022. For the three months ended June 30, 2023 financial income, net was primarily driven by interest income earned on our money market accounts of $1.5 million and $0.3 million in non-cash gains resulting from the remeasurement of warrant liabilities. For the three months ended June 30, 2022 financial expense, net primarily consisted of $2.1 million in non-cash losses resulting from the remeasurement of warrant liabilities.\nFinancial income, net was $2.1 million for the six months ended June 30, 2023, compared to financial expense, net of $1.0 million for the six months ended June 30, 2022. For the six months ended June 30, 2023 financial income, net was primarily driven by interest income earned on our money market accounts of $2.1 million. For the six months ended June 30, 2022 financial expense, net was primarily driven by $1.2 million of non-cash losses resulting from the remeasurement of warrant liabilities.\nTaxes on income. Taxes on income consists primarily of foreign income taxes related to income generated by our subsidiary organized under the laws of Israel.\n18\nNon-GAAP Financial Measures\nIn addition to our financial results determined in accordance with GAAP, we believe adjusted EBITDA, a non-GAAP measure, is useful in evaluating our operating performance and is a key performance measure that our management uses to assess our operating performance. Because adjusted EBITDA facilitates internal comparisons of our historical operating performance on a more consistent basis, we use this measure for business planning purposes and in evaluating acquisition opportunities. We also use adjusted EBITDA to evaluate our ongoing operations and for internal planning and forecasting purposes. We believe that this non-GAAP financial measure, when taken together with the corresponding GAAP financial measures, provides meaningful supplemental information regarding our performance by excluding certain items that may not be indicative of our business, results of operations or outlook. We believe that the use of adjusted EBITDA is helpful to our investors as it is a metric used by management in assessing the health of our business and our operating performance. However, non-GAAP financial information is presented for supplemental informational purposes only, has limitations as an analytical tool and should not be considered in isolation or as a substitute for financial information presented in accordance with GAAP.\nSome of the limitations of adjusted EBITDA include (i) adjusted EBITDA does not necessarily reflect capital commitments to be paid in the future and (ii) although depreciation and amortization are non-cash charges, the underlying assets may need to be replaced and adjusted EBITDA does not reflect these requirements. In evaluating adjusted EBITDA, you should be aware that in the future we will incur expenses similar to the adjustments described herein. Our presentation of adjusted EBITDA should not be construed as an inference that our future results will be unaffected by these expenses or any unusual or non-recurring items. Our adjusted EBITDA may not be comparable to similarly titled measures of other companies because they may not calculate adjusted EBITDA in the same manner as we calculate the measure, limiting its usefulness as a comparative measure. Adjusted EBITDA should not be considered as an alternative to loss before income taxes, net loss, loss per share, or any other performance measures derived in accordance with U.S. GAAP. When evaluating our performance, you should consider adjusted EBITDA alongside other financial performance measures, including our net loss and other GAAP results.\nA reconciliation is provided below for adjusted EBITDA to net loss, the most directly comparable financial measure stated in accordance with GAAP. Investors are encouraged to review our financial statements prepared in accordance with GAAP and the reconciliation of our non-GAAP financial measure to its most directly comparable GAAP financial measure, and not to rely on any single financial measure to evaluate our business.\nWe calculate adjusted EBITDA as net loss income adjusted to exclude (i) depreciation and amortization, (ii) interest and other expenses (income), net, (iii) tax benefit and expense, and (iv) stock-based compensation expense.\nThe following table presents a reconciliation of adjusted EBITDA from the most comparable GAAP measure, net loss for the three and six months ended June 30, 2023 and 2022:\n\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\n| Unaudited | 2023 | 2022 | 2023 | 2022 |\n| (in thousands) |\n| Net loss | $ | (4,704 | ) | $ | (23,022 | ) | $ | (13,462 | ) | $ | (43,382 | ) |\n| Add: |\n| Depreciation and amortization | 302 | 268 | 608 | 697 |\n| Financial (income) expense, net (1) | (1,712 | ) | 1,865 | (2,136 | ) | 996 |\n| Taxes on income | 8 | 89 | 151 | 110 |\n| Stock-based compensation | 2,129 | 3,839 | 4,432 | 6,207 |\n| Adjusted EBITDA | $ | (3,977 | ) | $ | (16,961 | ) | $ | (10,407 | ) | $ | (35,372 | ) |\n\n(1) For the three months ended June 30, 2023, financial (income), net, primarily consisted of $1.5 million of interest income from our money market accounts and $0.3 million in gains resulting from the remeasurement of warrant liabilities. For the six months ended June 30, 2023, financial (income), net, primarily consisted of $2.1 million of interest income from our money market accounts. For the three and six months ended June 30, 2022, financial expense, net primarily consisted of $2.1 million and $1.2 million, respectively, in losses resulting from the remeasurement of warrant liabilities.\n19\nLiquidity and Capital Resources\nAs of June 30, 2023, we had $126.1 million of cash and cash equivalents ($138.5 million as of December 31, 2022), which we use to finance our operations and support a variety of growth initiatives and investments. We had no debt as of June 30, 2023.\nOur primary cash needs are to fund operating activities. Our future capital requirements will depend on many factors including our growth rate, contract renewal activity, the timing and extent of investments to support product development efforts, our expansion of sales and marketing activities, the introduction of new and enhanced service offerings, and the continuing market acceptance of virtual behavioral services. Additionally, we may in the future enter into arrangements to acquire or invest in complementary businesses, services and technologies.\nWe currently anticipate to be able to fund our cash needs for at least the next 12 months and thereafter for the foreseeable future using available cash and cash equivalent balances as of June 30, 2023. However, in the future we may require additional capital to respond to technological advancements, competitive dynamics, customer demands, business and investment opportunities, acquisitions or unforeseen circumstances and we may determine to engage in equity or debt financings for other reasons. We may not be able to timely secure additional debt or equity financing on favorable terms, or at all. If we raise additional funds through the issuance of equity or convertible debt or other equity-linked securities, our existing stockholders could experience significant dilution. Any debt financing obtained by us in the future could involve restrictive covenants relating to our capital raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities, including potential acquisitions. If we cannot raise capital when needed, we may be forced to undertake asset sales or similar measures to ensure adequate liquidity.\nCash Flows from Operating, Investing and Financing Activities\nThe following table presents the summary condensed consolidated cash flow information for the periods presented:\nCash Flows\n\n| Unaudited | Six Months EndedJune 30, |\n| (in thousands) | 2023 | 2022 |\n| Net cash used in operating activities | $ | (13,748 | ) | $ | (33,111 | ) |\n| Net cash provided by (used in) investing activities | 18 | (160 | ) |\n| Net cash provided by financing activities | 1,289 | 1,637 |\n| Net decrease in cash and cash equivalents | $ | (12,441 | ) | $ | (31,634 | ) |\n\nOperating Activities\nThe decrease in net cash used in operating activities was driven primarily by the positive impact of lower operating expenses, favorable timing of collections on receivables and an increase in interest income from our money market accounts offset by unfavorable timing of payments of account payables and accrued expenses.\nInvesting Activities\nThe increase in net cash provided by investing activities was driven primarily by an increase in the proceeds from the sale of computer equipment and a decrease in the purchases of computer equipment and software.\nFinancing Activities\nThe decrease in net cash provided by financing activities was primarily driven by a decrease in the proceeds from the exercise of stock options.\nContractual Obligations, Commitments and Contingencies\nAs of June 30, 2023, we did not have any short-term or long-term debt, or significant long-term liabilities.\nAs of June 30, 2023, we have a non-material long-term operating lease for our office space in New York, NY.\nA settlement was reached in February 2023 for certain class action lawsuits ending an ongoing litigation, see Note 5, “Commitments and Contingent Liabilities” in the notes to the condensed consolidated financial statements for further details.\n20\nIn addition, we may in the future be involved in various legal proceedings, claims and litigation that arise in the normal course of business. We accrue for estimated loss contingencies related to legal matters when available information indicates that it is probable a liability had been incurred and we can reasonably estimate the amount of that loss. In many proceedings, however, it is inherently difficult to determine whether any loss is probable or even possible or to estimate the amount of any loss. In addition, even where a loss is possible or an exposure to loss exists in excess of the liability already accrued with respect to a previously recognized loss contingency, it is often not possible to reasonably estimate the size of the possible loss or range of loss or possible additional losses or range of additional losses. Should any of our estimates and assumptions change or prove to be incorrect, it could have a material impact on our results of operations, financial position, and cash flows. See Note 5, “Commitments and Contingent Liabilities” in the notes to the condensed consolidated financial statements for further details.\nOur commercial contract arrangements generally include certain provisions requiring us to indemnify clients against liabilities if there is a breach of a client’s data or if our service infringes a third party’s intellectual property rights. To date, we have not incurred any material costs as a result of such indemnifications.\nWe have also agreed to indemnify our officers and directors for costs associated with any fees, expenses, judgments, fines and settlement amounts incurred by any of these persons in any action or proceeding to which any of those persons is, or is threatened to be, made a party by reason of the person’s service as a director or officer, including any action by us, arising out of that person’s services as our director or officer or that person’s services provided to any other company or enterprise at our request. We maintain director and officer liability insurance coverage that would generally enable us to recover a portion of any future amounts paid. We may also be subject to indemnification obligations by law with respect to the actions of our employees under certain circumstances and in certain jurisdictions.\nOff-Balance Sheet Arrangements\nWe do not invest in any off-balance sheet vehicles that provide liquidity, capital resources, market or credit risk support, or engage in any activities that expose us to any liability that is not reflected in our condensed consolidated financial statements.\nInflation Risk\nWe do not believe that inflation has had a material effect on our business, financial condition or results of operations. If our costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could harm our business, financial condition or results of operations.\nCritical Accounting Policies and Estimates\nThe Company’s condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. Reference is also made to the Company’s consolidated financial statements and notes thereto found in its Annual Report on Form 10-K for the year ended December 31, 2022.\nThe Company’s accounting policies are essential to understanding and interpreting the financial results reported on the condensed consolidated financial statements. The significant accounting policies used in the preparation of the Company’s consolidated financial statements are summarized in Note 2 to those financial statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2022. Certain of those policies are considered to be particularly important to the presentation of the Company's financial results because they require management to make difficult, complex or subjective judgments, often as a result of matters that are inherently uncertain.\nDuring the six months ended June 30, 2023, there were no material changes to matters discussed under the heading “Critical Accounting Policies and Estimates” in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2022.\nRecent Accounting Pronouncements\nInformation regarding recent accounting developments and their impact on our results can be found in Note 2, “Summary of Significant Accounting Policies and Estimates” in the audited consolidated financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2022 and in Note 2, “Significant Accounting Policies” in the notes to the condensed consolidated financial statements of this Quarterly Report on Form 10-Q.\n21\nFORWARD-LOOKING STATEMENTS\nThis Quarterly Report on Form 10-Q (the “Quarterly Report”) contains forward-looking statements. We intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). All statements other than statements of historical facts contained in this Quarterly Report may be forward-looking statements. In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “could,” “intends,” “targets,” “projects,” “contemplates,” “believes,” “estimates,” “forecasts,” “predicts,” “potential” or “continue” or the negative of these terms or other similar expressions. Forward-looking statements contained in this Quarterly Report include, but are not limited to, statements regarding our future results of operations and financial position, industry and business trends, stock-based compensation, revenue recognition, business strategy, plans and market growth.\nThe forward-looking statements in this Quarterly Report and other such statements we publicly make from time-to-time are only predictions. We base these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our business, financial condition, and results of operations. Forward-looking statements involve known and unknown risks, uncertainties and other important factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements, including, but not limited to, the important factors discussed in Part I, Item 1A, “Risk Factors” of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2022. The forward-looking statements in this Quarterly Report are based upon information available to us as of the date of this Quarterly, and while we believe such information forms a reasonable basis for such statements, such information may be limited or incomplete, and our statements should not be read to indicate that we have conducted an exhaustive inquiry into, or review of, all potentially available relevant information. These statements are inherently uncertain and investors are cautioned not to unduly rely upon these statements.\nYou should read this Quarterly Report and the risk factors discussed in Part I, Item 1A, “Risk Factors” of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2022 with the understanding that our actual future results, levels of activity, performance and achievements may be materially different from what we expect. We qualify all of our forward-looking statements by these cautionary statements. These forward-looking statements speak only as of the date of this Quarterly Report. Except as required by applicable law, we do not plan to publicly update or revise any forward-looking statements contained in this Quarterly Report on Form 10-Q or any forward-looking statements we may publicly make from time-to-time, whether as a result of any new information, future events or otherwise.\nItem 3\n. Quantitative and Qualitative Disclosures About Market Risk.\nDuring the six months ended June 30, 2023, there were no material changes to the information contained in Part II, Item 7A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2022.\n22\n\nItem 4\n. Controls and Procedures.\nIn connection with the preparation of this report, an evaluation was carried out under the supervision, and with the participation of, our management including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act of 1934, as amended (the “Act”)) as of June 30, 2023. Based upon the evaluation and although management has made significant progress in the design and implementation of IT and business process controls, our CEO and CFO concluded our disclosure controls and procedures are not effective as of such date solely due to material weaknesses in internal controls over financial reporting that were disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2022 and are discussed below.\nAs previously described in Part II, Item 9A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2022, we concluded that our internal control over financial reporting was not effective solely due to the existence of the following material weaknesses described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2022:\n1.Management was able to complete the design and establish effective information technology general controls (ITGCs) for the majority of tested ITGCs; however, some ineffective ITGC controls existed at December 31, 2022. As a result, business process controls (automated and IT-dependent manual controls) that are dependent on the ineffective ITGCs, or that use data produced from systems impacted by the ineffective ITGCs were deemed ineffective; and\n2.Management did not have an adequate process in place to monitor and provide oversight over the completion of its testing and assessment of the design and operating effectiveness of internal control over financial reporting in a timely manner.\nThe material weaknesses did not result in any identified misstatements to the financial statements, and there were no changes to previously released financial results.\nRemediation Plan for the Material Weakness\nManagement is committed to the remediation of the material weakness described above, as well as the continued improvement of the Company’s internal control over financial reporting. Management has implemented and continues to implement measures designed to ensure that control deficiencies contributing to the material weakness are remediated, such that these controls are designed, implemented and operating effectively.\nRemediation efforts include but are not limited to, (a) hiring additional personnel with appropriate technical skill sets, (b) developing an execution plan and resources to test controls and providing timely feedback of any deficiencies noted to complete remediation (c) establishing a training program for the entire organization to support ongoing execution of internal controls and adherence to control activities and (d) actively monitoring corrective actions and providing status reporting to leadership on the progress.\nManagement will test and evaluate the implementation of internal controls and revised processes to ascertain whether they are designed and operating effectively to provide reasonable assurance that they will prevent or detect a material error in our financial statements.\nWe believe that once these actions have been completed, it will remediate the material weakness. The material weakness will not be considered remediated, however, until the applicable controls operate for a sufficient period of time and management has concluded, through testing, that controls are operating effectively.\nChanges in Internal Control Over Financial Reporting\nThere have been no changes in the Company’s internal control over financial reporting during the six months ended June 30, 2023 which have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\nIn order to enhance the Company's internal control over financial reporting, management has (a) hired additional personnel with appropriate technical skill sets, (b) developed an execution plan and engaged resources to test controls and provide timely feedback of any deficiencies noted, (c) provided training to the organization to support ongoing execution of internal controls and adherence to control activities, and (d) implemented status reporting to leadership on the progress of the assessment of the design and operating effectiveness of internal control over financial reporting.\n23\nPART II—OTHER INFORMATION\nItem 1\n. Legal Proceedings.\nThe Company reached settlements for certain class action lawsuits in February 2023 ending on going securities and derivatives suits. The settlements for these lawsuits have received preliminary court approval and are expected to receive final court approval in the third quarter of 2023. See Note 5, “Commitments and Contingent Liabilities” in the notes to the condensed consolidated financial statements for further details.\nIn addition to the foregoing, the Company may in the future be involved in various legal proceedings, claims and litigation that arise in the normal course of business. The Company accrues for estimated loss contingencies related to legal matters when available information indicates that it is probable a liability had been incurred and the Company can reasonably estimate the amount of that loss. In many proceedings, however, it is inherently difficult to determine whether any loss is probable or even possible or to estimate the amount of any loss. In addition, even where a loss is possible or an exposure to loss exists in excess of the liability already accrued with respect to a previously recognized loss contingency, it is often not possible to reasonably estimate the size of the possible loss or range of loss or possible additional losses or range of additional losses.\nI\nte\nm\n1a. R\nisk Factors.\nIn addition to the other information set forth in this Quarterly Report, you should carefully consider the factors discussed under Part I, Item 1A. “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2022. These factors could materially adversely affect our business, financial condition, liquidity, results of operations and capital position, and could cause our actual results to differ materially from our historical results or the results contemplated by any forward-looking statements contained in this Quarterly Report. During the six months ended June 30, 2023, there were no material changes to the information contained in Part I, Item 1A of the Company's Annual Report on Form 10-K for the year ended December 31, 2022.\nItem 2\n. Unregistered Sales of Equity Securities and Use of Proceeds.\nNot applicable.\nItem 3\n. Defaults Upon Senior Securities.\nNone.\nItem 4\n. Mine Safety Disclosures.\nNot applicable.\nItem 5\n. Other Information.\nNone.\n24\n\nItem 6\n. Exhibits.\n\n| Filed/ |\n| ExhibitNumber | Exhibit Description | FurnishedHerewith |\n| 31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a). | * |\n| 31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a). | * |\n| 32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350. | ** |\n| 32.2 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350. | ** |\n| 101.INS | Inline XBRL Instance Document - the instance document does not appear in the Interactive Data file because its XBRL tags are embedded within the Inline XBRL document. | * |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document. | * |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document. | * |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document. | * |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document. | * |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document. | * |\n| 104 | Cover Page Interactive Data File (as formatted as Inline XBRL and contained in Exhibit 101). | * |\n\n* Filed herewith.\n** Furnished herewith.\n25\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| Talkspace, Inc. |\n| Date: August 2, 2023 | By: | /s/ Jon Cohen |\n| Jon Cohen |\n| Chief Executive Officer |\n| Date: August 2, 2023 | By: | /s/ Jennifer Fulk |\n| Jennifer Fulk |\n| Chief Financial Officer |\n\n26\n</text>\n\nWhat is the percentage change for Adjusted EBITDA year on year for two consecutive periods ending June 30, 2023 and 2022?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nITEM 1. FINANCIAL STATEMENTS\nLIVENT CORPORATION\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| (in Millions, Except Per Share Data) | (unaudited) |\n| Revenue | $ | 103.6 | $ | 72.6 | $ | 297.5 | $ | 206.0 |\n| Cost of sales | 85.3 | 69.8 | 245.5 | 178.4 |\n| Gross margin | 18.3 | 2.8 | 52.0 | 27.6 |\n| Selling, general and administrative expenses | 11.8 | 10.0 | 34.2 | 31.1 |\n| Research and development expenses | 0.8 | 1.0 | 2.2 | 2.8 |\n| Restructuring and other charges | 1.1 | 4.4 | 3.4 | 10.1 |\n| Separation-related costs | 0.8 | 0.6 | 1.3 | 0.8 |\n| Total costs and expenses | 99.8 | 85.8 | 286.6 | 223.2 |\n| Income/(loss) from operations before loss on debt extinguishment, equity in net loss of unconsolidated affiliates and interest expense, net | 3.8 | ( 13.2 ) | 10.9 | ( 17.2 ) |\n| Loss on debt extinguishment | — | — | — | 0.1 |\n| Equity in net loss of unconsolidated affiliates | 1.0 | 0.1 | 3.7 | 0.4 |\n| Interest expense, net | — | 0.3 | 0.3 | 0.3 |\n| Income/(loss) from operations before income taxes | 2.8 | ( 13.6 ) | 6.9 | ( 18.0 ) |\n| Income tax expense/(benefit) | 15.4 | ( 3.1 ) | 13.8 | ( 5.4 ) |\n| Net loss | $ | ( 12.6 ) | $ | ( 10.5 ) | $ | ( 6.9 ) | $ | ( 12.6 ) |\n| Net loss per weighted average share - basic and diluted | $ | ( 0.08 ) | $ | ( 0.07 ) | $ | ( 0.05 ) | $ | ( 0.09 ) |\n| Weighted average common shares outstanding - basic and diluted | 161.6 | 146.3 | 152.3 | 146.2 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n4\nLIVENT CORPORATION\nCONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| (in Millions) | (unaudited) |\n| Net loss | $ | ( 12.6 ) | $ | ( 10.5 ) | $ | ( 6.9 ) | $ | ( 12.6 ) |\n| Other comprehensive (loss)/income, net of tax: |\n| Foreign currency adjustments: |\n| Foreign currency translation (loss)/gain arising during the period | ( 1.1 ) | 3.0 | ( 0.2 ) | 1.4 |\n| Total foreign currency translation adjustments | ( 1.1 ) | 3.0 | ( 0.2 ) | 1.4 |\n| Derivative instruments: |\n| Unrealized hedging losses, net of tax of less than $ 0.1 | ( 0.1 ) | — | — | ( 0.2 ) |\n| Total derivative instruments loss, net of tax of less than $ 0.1 | ( 0.1 ) | — | — | ( 0.2 ) |\n| Other comprehensive (loss)/income, net of tax | ( 1.2 ) | 3.0 | ( 0.2 ) | 1.2 |\n| Comprehensive loss | $ | ( 13.8 ) | $ | ( 7.5 ) | $ | ( 7.1 ) | $ | ( 11.4 ) |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n5\nLIVENT CORPORATION\nCONDENSED CONSOLIDATED BALANCE SHEETS\n| (in Millions, Except Share and Par Value Data) | September 30, 2021 | December 31, 2020 |\n| ASSETS | (unaudited) |\n| Current assets |\n| Cash and cash equivalents | $ | 195.3 | $ | 11.6 |\n| Trade receivables, net of allowance of $ 0.3 and $ 0.4 , respectively | 83.0 | 76.3 |\n| Inventories, net | 110.2 | 105.6 |\n| Prepaid and other current assets | 43.8 | 56.3 |\n| Total current assets | 432.3 | 249.8 |\n| Investments | 23.2 | 23.8 |\n| Property, plant and equipment, net of accumulated depreciation of $ 238.3 and $ 222.4 , respectively | 605.3 | 545.3 |\n| Deferred income taxes | 2.2 | 13.4 |\n| Right of use assets - operating leases, net | 6.4 | 16.1 |\n| Other assets | 81.6 | 88.4 |\n| Total assets | $ | 1,151.0 | $ | 936.8 |\n| LIABILITIES AND EQUITY |\n| Current liabilities |\n| Accounts payable, trade and other | $ | 49.7 | $ | 43.9 |\n| Accrued customer rebates | — | 0.3 |\n| Accrued and other current liabilities | 35.7 | 36.7 |\n| Operating lease liabilities - current | 1.0 | 1.4 |\n| Income taxes | 2.3 | — |\n| Total current liabilities | 88.7 | 82.3 |\n| Long-term debt | 240.1 | 274.6 |\n| Operating lease liabilities - long-term | 5.5 | 14.8 |\n| Environmental liabilities | 6.2 | 6.1 |\n| Deferred income taxes | 7.8 | 5.6 |\n| Other long-term liabilities | 18.2 | 17.2 |\n| Commitments and contingent liabilities (Note 13) |\n| Total current and long-term liabilities | 366.5 | 400.6 |\n| Equity |\n| Common stock; $ 0.001 par value; 2 billion shares authorized in 2018; 161,676,147 and 146,461,249 shares issued; 161,575,016 and 146,361,981 outstanding at September 30, 2021 and December 31, 2020, respectively | 0.1 | 0.1 |\n| Capital in excess of par value of common stock | 776.4 | 520.9 |\n| Retained earnings | 53.4 | 60.3 |\n| Accumulated other comprehensive loss | ( 44.6 ) | ( 44.4 ) |\n| Treasury stock, common; 101,131 and 99,268 shares at September 30, 2021 and December 31, 2020, respectively | ( 0.8 ) | ( 0.7 ) |\n| Total equity | 784.5 | 536.2 |\n| Total liabilities and equity | $ | 1,151.0 | $ | 936.8 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n6\nLIVENT CORPORATION\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n| Nine Months Ended September 30, |\n| 2021 | 2020 |\n| (in Millions) | (unaudited) |\n| Cash provided by operating activities: |\n| Net loss | $ | ( 6.9 ) | $ | ( 12.6 ) |\n| Adjustments to reconcile net loss to cash provided by operating activities: |\n| Depreciation and amortization | 18.7 | 17.7 |\n| Restructuring and other charges | ( 0.8 ) | 4.3 |\n| Deferred income taxes | 11.2 | ( 5.7 ) |\n| Separation-related costs | — | 0.1 |\n| Share-based compensation | 4.0 | 3.4 |\n| Change in investments in trust fund securities | 0.4 | 0.1 |\n| Loss on debt extinguishment | — | 0.1 |\n| Deferred financing fees amortization | 0.3 | 0.3 |\n| Equity in net loss of unconsolidated affiliates | 3.7 | 0.4 |\n| Changes in operating assets and liabilities: |\n| Trade receivables, net | ( 6.2 ) | 17.5 |\n| Inventories | ( 4.2 ) | ( 0.1 ) |\n| Accounts payable, trade and other | 5.5 | ( 40.9 ) |\n| Change in deferred compensation | 1.2 | 0.4 |\n| Income taxes | 2.3 | ( 0.9 ) |\n| Change in prepaid and other current assets and other assets | 16.6 | ( 5.5 ) |\n| Change in accrued and other current liabilities and other long-term liabilities | ( 4.8 ) | 22.9 |\n| Cash provided by operating activities | 41.0 | 1.5 |\n| Cash used in investing activities: |\n| Capital expenditures(1) | ( 69.4 ) | ( 110.0 ) |\n| Investments in trust fund securities | ( 1.2 ) | ( 0.4 ) |\n| Investment in unconsolidated affiliate | ( 2.5 ) | — |\n| Other investing activities | ( 1.2 ) | ( 1.4 ) |\n| Cash used in investing activities | ( 74.3 ) | ( 111.8 ) |\n| Cash provided by financing activities: |\n| Proceeds from Revolving Credit Facility | 39.5 | 147.0 |\n| Repayments of Revolving Credit Facility | ( 75.1 ) | ( 276.5 ) |\n| Proceeds from 2025 Notes | — | 245.7 |\n| Payments of financing fees | — | ( 8.4 ) |\n| Proceeds from Offering | 261.6 | — |\n| Payments of underwriting fees and expenses - Offering | ( 9.4 ) | — |\n| Proceeds of issuance of common stock - incentive plans | 0.3 | 0.4 |\n| Cash provided by financing activities | 216.9 | 108.2 |\n| Effect of exchange rate changes on cash and cash equivalents | 0.1 | 0.1 |\n| Increase/(decrease) in cash and cash equivalents | 183.7 | ( 2.0 ) |\n| Cash and cash equivalents, beginning of period | 11.6 | 16.8 |\n| Cash and cash equivalents, end of period | $ | 195.3 | $ | 14.8 |\n\n7\nLIVENT CORPORATION\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)\n| Nine Months Ended September 30, |\n| 2021 | 2020 |\n| Supplemental Disclosure for Cash Flow: | (unaudited) |\n| Cash payments for income taxes, net (2) | $ | 0.5 | $ | 2.8 |\n| Cash payments for interest, net (1) | $ | 12.9 | $ | 4.8 |\n| Cash payments for Restructuring and other charges | $ | 4.2 | $ | 5.8 |\n| Cash payments for Separation-related charges | $ | 1.4 | $ | 0.7 |\n| Accrued capital expenditures | $ | 17.8 | $ | 7.8 |\n| Operating lease right-of-use assets and lease liabilities recorded for ASC 842 | $ | 2.1 | $ | 0.8 |\n\n____________________\n1. For the nine months ended September 30, 2021, and 2020 $ 11.5 million and $ 8.1 million of interest expense was capitalized, respectively.\n2.Nine months ended September 30, 2021 includes $ 1.7 million of refunds relating to U.S. state taxes and foreign taxes. Nine months ended September 30, 2020 includes $ 1.9 million refund from FMC related to the Company's 2018 federal income tax return.\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n8\nLIVENT CORPORATION\nCONDENSED CONSOLIDATED STATEMENTS OF EQUITY\n(UNAUDITED)\n| (in Millions Except Per Share Data) | Common Stock, $ 0.001 Per Share Par Value | Capital In Excess of Par | Retained Earnings | Accumulated Other Comprehensive Loss | Treasury Stock | Total |\n| Balance, December 31, 2019 | $ | 0.1 | $ | 516.4 | $ | 76.6 | $ | ( 48.3 ) | $ | ( 0.8 ) | $ | 544.0 |\n| Net loss | — | — | ( 1.9 ) | — | — | ( 1.9 ) |\n| Stock compensation plans | — | 1.2 | — | — | — | 1.2 |\n| Shares withheld for taxes - common stock issuances | — | ( 0.7 ) | — | — | — | ( 0.7 ) |\n| Foreign currency translation adjustments | — | — | — | ( 1.8 ) | — | ( 1.8 ) |\n| Balance, March 31, 2020 | $ | 0.1 | $ | 516.9 | $ | 74.7 | $ | ( 50.1 ) | $ | ( 0.8 ) | $ | 540.8 |\n| Net loss | — | — | ( 0.2 ) | — | — | ( 0.2 ) |\n| Stock compensation plans | — | 1.0 | — | — | — | 1.0 |\n| Net hedging losses, net of income tax | — | — | — | ( 0.2 ) | — | ( 0.2 ) |\n| Foreign currency translation adjustments | — | — | — | 0.2 | — | 0.2 |\n| Exercise of stock options | — | 0.1 | — | — | — | 0.1 |\n| Balance, June 30, 2020 | $ | 0.1 | $ | 518.0 | $ | 74.5 | $ | ( 50.1 ) | $ | ( 0.8 ) | $ | 541.7 |\n| Net loss | — | — | ( 10.5 ) | — | — | ( 10.5 ) |\n| Stock compensation plans | — | 1.2 | — | — | — | 1.2 |\n| Exercise of stock options | — | 0.3 | — | — | — | 0.3 |\n| Foreign currency translation adjustments | — | — | 3.0 | — | 3.0 |\n| Balance, September 30, 2020 | $ | 0.1 | $ | 519.5 | $ | 64.0 | $ | ( 47.1 ) | $ | ( 0.8 ) | $ | 535.7 |\n| Balance, December 31, 2020 | $ | 0.1 | $ | 520.9 | $ | 60.3 | $ | ( 44.4 ) | $ | ( 0.7 ) | $ | 536.2 |\n| Net loss | — | — | ( 0.8 ) | — | — | ( 0.8 ) |\n| Stock compensation plans | — | 1.2 | — | — | — | 1.2 |\n| Exercise of stock options | — | 0.2 | — | — | — | 0.2 |\n| Shares withheld for taxes - common stock issuances | — | ( 0.8 ) | — | — | — | ( 0.8 ) |\n| Net purchases of treasury stock - nonqualified plan | — | — | — | — | ( 0.1 ) | ( 0.1 ) |\n| Foreign currency translation adjustments | — | — | — | ( 0.3 ) | — | ( 0.3 ) |\n| Balance, March 31, 2021 | $ | 0.1 | $ | 521.5 | $ | 59.5 | $ | ( 44.7 ) | $ | ( 0.8 ) | $ | 535.6 |\n| Net income | — | — | 6.5 | — | — | 6.5 |\n| Stock compensation plans | — | 1.4 | — | — | — | 1.4 |\n| Net hedging gains, net of income tax | — | — | — | 0.1 | — | 0.1 |\n| Issuance of common stock - Offering | — | 252.3 | — | — | — | 252.3 |\n| Foreign currency translation adjustments | — | — | — | 1.2 | — | 1.2 |\n| Balance, June 30, 2021 | $ | 0.1 | $ | 775.2 | $ | 66.0 | $ | ( 43.4 ) | $ | ( 0.8 ) | $ | 797.1 |\n| Net loss | — | — | ( 12.6 ) | — | — | ( 12.6 ) |\n| Stock compensation plans | — | 1.4 | — | — | — | 1.4 |\n| Issuance of common stock - Offering | — | ( 0.1 ) | — | — | — | ( 0.1 ) |\n| Shares withheld for taxes - common stock issuances | — | ( 0.2 ) | — | — | — | ( 0.2 ) |\n| Net hedging losses, net of income tax | — | — | — | ( 0.1 ) | — | ( 0.1 ) |\n| Exercise of stock options | — | 0.1 | — | — | — | 0.1 |\n| Foreign currency translation adjustments | — | — | — | ( 1.1 ) | — | ( 1.1 ) |\n| Balance, September 30, 2021 | $ | 0.1 | $ | 776.4 | $ | 53.4 | $ | ( 44.6 ) | $ | ( 0.8 ) | $ | 784.5 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n9\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited)\nNote 1: Description of the Business\nBackground and Nature of Operations\nLivent Corporation (“Livent”, “we”, “us”, \"company\" or “our”) manufactures lithium for use in a wide range of lithium products, which are used primarily in lithium-based batteries, specialty polymers and chemical synthesis applications. We serve a diverse group of markets. Our product offerings generally have few cost-effective substitutes. A major growth driver for lithium in the future will be the rate of adoption of electric vehicles.\nMost markets for lithium chemicals are global with significant growth occurring in Asia, Europe and North America, primarily driven by the development and manufacturing of lithium-ion batteries. We are one of the few leading global producers of performance lithium compounds.\nNote 2: Principal Accounting Policies and Related Financial Information\nThe accompanying condensed consolidated financial statements were prepared in accordance with the requirements of the Securities and Exchange Commission (“SEC”) for interim reporting. As permitted under those rules, certain notes or other financial information that are normally required by U.S. GAAP have been condensed or omitted from these interim financial statements. The financial statements included in this report reflect all normal and recurring adjustments which, in the opinion of management, are necessary for a fair presentation of our condensed consolidated financial position as of September 30, 2021 and December 31, 2020, the condensed consolidated results of operations for the three and nine months ended September 30, 2021 and 2020, and the condensed consolidated cash flows for the nine months ended September 30, 2021 and 2020. The unaudited results of operations for the interim periods reported are not necessarily indicative of results to be expected for the full year. These statements, therefore, should be read in conjunction with the annual consolidated and combined financial statements and related notes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2020 (the \"2020 Annual Report on Form 10-K\").\nEstimates and assumptions\nIn preparing the financial statements in conformity with U.S. GAAP, we are required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period.\nDue to the current coronavirus (\"COVID-19\") pandemic, there has been uncertainty and disruption in the global economy and financial markets. The estimates used for, but not limited to, the collectability of trade receivables, fair value of long-lived assets, income taxes, inventory valuation and fair value of financial instruments could be impacted. We have assessed the impact and are not aware of any specific events or circumstances that required an update to our estimates and assumptions or materially affected the carrying value of our assets or liabilities as of the date of issuance of this Quarterly Report on Form 10-Q. These estimates may change as new events occur and additional information is obtained. Actual results could differ materially from these estimates under different assumptions or conditions.\n4.125 % Convertible Senior Notes due 2025 (the “2025 Notes”)\nWe account for our 2025 Notes under Accounting Standards Update (\"ASU\") No. 2020-06, Debt - Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging - Contracts in Entity's Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity's Own Equity (\"ASU 2020-06\"), which we early adopted January 1, 2021 under the full retrospective method. See Note 3 and Note 9 for details.\nThere were no other significant changes to our accounting policies that are set forth in detail in Note 2 to our annual consolidated and combined financial statements in Part II, Item 8 of our 2020 Annual Report on Form 10-K.\nNote 3: Recently Issued and Adopted Accounting Pronouncements and Regulatory Items\nNew accounting guidance and regulatory items\nIn April 2020, the Financial Accounting Standard Board (\"FASB\") issued ASU No. 2020-04, Reference Rate Reform (Topic 848). The amendments in this ASU provide optional expedients and exceptions for applying U.S. GAAP to contracts, hedging relationships, and other transactions affected by reference rate reform if certain criteria are met. An entity may optionally elect to apply the amendments effective in the first interim period that includes or is subsequent to March 12, 2020 through December 31, 2022. We are evaluating the effect the guidance will have on our condensed consolidated financial statements.\n10\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nRecently adopted accounting guidance\nIn August 2020, FASB issued ASU 2020-06. The ASU reduces the number of accounting models for convertible debt instruments by eliminating the cash conversion model. As compared with current U.S. GAAP, more convertible debt instruments will be reported as a single liability instrument and the interest rate of more convertible debt instruments will be closer to the coupon interest rate. The ASU also aligns the consistency of diluted Earnings Per Share (\"EPS\") calculations for convertible instruments by requiring that (1) an entity use the if-converted method and (2) share settlement be included in the diluted EPS calculation for both convertible instruments and equity contracts when those contracts include an option of cash settlement or share settlement. The ASU is effective for fiscal years beginning after December 15, 2021, including interim periods within those fiscal years. Early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. The FASB has specified that an entity should adopt the guidance as of the beginning of its annual fiscal year. We elected to early adopt ASU 2020-06 on January 1, 2021, using the full retrospective method. Prior to adoption, under Accounting Standards Codification 470-20, Debt with Conversion and Other Options (\"ASC 470-20\"), we had separately accounted for the liability and equity components of our 2025 Notes, which may be settled entirely or partially in cash upon conversion, in a manner that reflected the issuer’s economic interest cost. The effect of ASC 470-20 on the accounting for the 2025 Notes was that the equity component was required to be included in the additional paid-in capital section of stockholders’ equity on our consolidated balance sheet, and the value of the equity component was treated as original issue discount for purposes of accounting for the debt component of the 2025 Notes. As a result, prior to the adoption of ASU 2020-06, we were required to record a greater amount of non-cash interest expense as a result of the amortization of the discounted carrying value of the 2025 Notes to their face amount over the term of the 2025 Notes. Because we intend to settle in cash the principal outstanding under our 2025 Notes, we previously used the treasury stock method when calculating their potential dilutive effect, if any. ASU 2020-06 now requires us to use the if-converted method for EPS. For the full retrospective method of adoption, the accounting change was recognized as an adjustment to the balance of retained earnings, additional paid-in capital, long-term debt and deferred income taxes in our consolidated balance sheet as of December 31, 2020, the year in which the 2025 Notes were issued. See Note 9 and Note 11 for further details.\nIn December 2019, FASB issued ASU No. 2019-12, Simplifying the Accounting for Income Taxes (Topic 740). The amendments in this ASU simplified the accounting for income taxes by removing certain exceptions to the general principle in Topic 740. The amendments also contain improvements and clarifications of certain guidance in Topic 740. The new amendments are effective for fiscal years beginning after December 15, 2020 (i.e. a January 1, 2021 effective date), with early adoption permitted. We adopted the amendments as of January 1, 2021 and the adoption did not have a material impact on our condensed consolidated financial statements.\nNote 4: Revenue Recognition\nDisaggregation of revenue\nWe disaggregate revenue from contracts with customers by geographical areas and by product categories. The following table provides information about disaggregated revenue by major geographical region:\n| (in Millions) | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| North America (1) | $ | 20.0 | $ | 11.0 | $ | 63.4 | $ | 40.5 |\n| Latin America | — | — | — | 0.1 |\n| Europe, Middle East & Africa | 14.2 | 9.8 | 46.0 | 32.3 |\n| Asia Pacific (1) | 69.4 | 51.8 | 188.1 | 133.1 |\n| Total Revenue | $ | 103.6 | $ | 72.6 | $ | 297.5 | $ | 206.0 |\n\n1.During the three months ended September 30, 2021, countries with sales in excess of 10% of combined revenue consisted of Japan, the United States, and China. Sales for the three months ended September 30, 2021 for Japan, the United States, and China totaled $ 24.5 million, $ 19.7 million, $ 36.6 million, respectively. During the nine months ended September 30, 2021, countries with sales in excess of 10% of combined revenue consisted of Japan, the United States, and China. Sales for the nine months ended September 30, 2021 for Japan, the United States, and China totaled $ 65.1 million, $ 62.7 million, $ 89.9 million, respectively. During the three months ended September 30, 2020, countries with sales in excess of 10% of combined revenue consisted of Japan, the United States and China. Sales for the three months ended September 30, 2020 for Japan, the United States and China totaled $ 23.5 million, $ 11.0 million, and $ 19.0 million, respectively. During the nine months ended September 30, 2020, countries with sales in excess of 10% of combined\n11\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nrevenue consisted of Japan, the United States and China. Sales for the nine months ended September 30, 2020 for Japan, the United States and China totaled $ 81.1 million, $ 40.0 million, and $ 29.1 million, respectively.\nFor the three months ended September 30, 2021, one customer accounted for approximately 35 % of total revenue and our 10 largest customers accounted in aggregate for approximately 69 % of total revenue. For the three months ended September 30, 2020, two customers accounted for approximately 34 % and 10 % of total revenue, respectively, and our 10 largest customers accounted in aggregate for approximately 68 % of total revenue. For the nine months ended September 30, 2021, one customer accounted for approximately 36 % of total revenue and our 10 largest customers accounted in aggregate for approximately 68 % of total revenue. For the nine months ended September 30, 2020, one customer accounted for approximately 35 % of total revenue and our 10 largest customers accounted in aggregate for approximately 64 % of total revenue. A loss of any material customer could have a material adverse effect on our business, financial condition and results of operations.\nThe following table provides information about disaggregated revenue by major product category:\n| (in Millions) | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Lithium Hydroxide | $ | 50.7 | $ | 43.9 | $ | 160.5 | $ | 115.4 |\n| Butyllithium | 27.4 | 19.6 | 76.1 | 62.4 |\n| High Purity Lithium Metal and Other Specialty Compounds | 9.8 | 7.1 | 27.6 | 23.0 |\n| Lithium Carbonate and Lithium Chloride | 15.7 | 2.0 | 33.3 | 5.2 |\n| Total Revenue | $ | 103.6 | $ | 72.6 | $ | 297.5 | $ | 206.0 |\n\nContract asset and contract liability balances\nThe following table presents the opening and closing balances of our receivables, net of allowances. As of September 30, 2021 and December 31, 2020, there were no contract liabilities from contracts with customers.\n| (in Millions) | Balance as of September 30, 2021 | Balance as of December 31, 2020 | Increase (Decrease) |\n| Receivables from contracts with customers, net of allowances | $ | 83.0 | $ | 76.3 | $ | 6.7 |\n\nThe balance of receivables from contracts with customers listed in the table above represents the current trade receivables, net of allowance for doubtful accounts. The allowance for receivables represents our best estimate of the probable losses associated with potential customer defaults. We determine the allowance based on historical experience, current collection trends, and external business factors such as economic factors, including regional bankruptcy rates, and political factors.\nPerformance obligations\nOccasionally, we may enter into multi-year take or pay supply agreements with customers. The aggregate amount of revenue expected to be recognized related to these contracts’ performance obligations that are unsatisfied or partially unsatisfied is approximately $ 10 million for the remainder of 2021 and $ 68 million in 2022 and 2023, respectively. T hese approximate revenues do not include amounts of variable consideration attributable to contract renewals or contract contingencies. Based on our past experience with the customers under these arrangements, we expect to continue recognizing revenue in accordance with the contracts as we transfer control of the product to the customer. However, in the case a shortfall of volume purchases occurs, we will recognize the amount payable by the customer over the remaining performance obligations in the contract.\nNote 5: Inventories, Net\nInventories consisted of the following:\n| (in Millions) | September 30, 2021 | December 31, 2020 |\n| Finished goods | $ | 35.0 | $ | 36.1 |\n| Semi-finished goods | 41.3 | 46.2 |\n| Raw materials, supplies and other | 33.9 | 23.3 |\n| Inventory, net | $ | 110.2 | $ | 105.6 |\n\n12\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nNote 6: Investments\nIn 2020, Livent entered into an agreement with The Pallinghurst Group relating to Québec Lithium Partners (\"QLP\"), a joint venture owned equally by The Pallinghurst Group and Livent, and the conduct of certain business operations and oversight, previously conducted solely by Nemaska Lithium Inc. for the development of a fully integrated lithium chemical asset located in Québec, Canada that is not yet in commercial production. QLP owns a 50 % equity interest in the Nemaska Project. The Company accounts for the investment in QLP as an equity method investment on a one-quarter lag basis and is included in Investments in our condensed consolidated balance sheets. For the three and nine months ended September 30, 2021, we recorded a $ 1.0 million and $ 3.7 million loss, respectively, related to our 50 % equity interest in QLP to Equity in net loss of unconsolidated affiliates in our condensed consolidated statement of operations. The carrying amount of our 50 % equity interest in QLP was $ 20.1 million and $ 21.2 million as of September 30, 2021 and December 31, 2020, respectively.\nNote 7: Restructuring and Other Charges\nThe following table shows other charges included in \"Restructuring and other charges\" in the condensed consolidated statements of operations:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (in Millions) | 2021 | 2020 | 2021 | 2020 |\n| Restructuring charges |\n| Severance-related and exit costs (1) | $ | 0.1 | $ | 0.9 | $ | 0.2 | $ | 5.8 |\n| Other charges |\n| Environmental remediation (2) | 0.1 | 0.1 | 0.3 | 0.4 |\n| Other (3) | 0.9 | 3.4 | 2.9 | 3.9 |\n| Total Restructuring and other charges | $ | 1.1 | $ | 4.4 | $ | 3.4 | $ | 10.1 |\n\n___________________\n1.Three and nine months ended September 30, 2020 includes severance costs for management changes at certain operating and administrative facilities and exit costs of $ 1.6 million for the closing of leased office space.\n2.There is one environmental remediation site in Bessemer City, North Carolina.\n3.Three and nine months ended September 30, 2021 consists primarily of transaction-related legal fees and miscellaneous nonrecurring transactions. Three and nine months ended September 30, 2020 consists primarily of legal fees related to IPO securities litigation including a settlement accrual, net of insurance reimbursement, of $ 2.5 million in the third quarter. The IPO litigation settlement was finalized in the second quarter of 2021.\n13\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nNote 8: Income Taxes\nWe determine our interim tax provision using an estimated annual effective tax rate methodology (“EAETR”) in accordance with U.S. GAAP. The EAETR is applied to the year-to-date ordinary income, exclusive of discrete items. The tax effects of discrete items are then included to arrive at the total reported interim tax provision.\nThe determination of the EAETR is based upon a number of estimates, including the estimated annual pretax ordinary income in each tax jurisdiction in which we operate. As our projections of ordinary income change throughout the year, the EAETR will change period-to-period. The tax effects of discrete items are recognized in the tax provision in the period they occur in accordance with U.S. GAAP. Depending on various factors, such as the item’s significance in relation to total income and the rate of tax applicable in the jurisdiction to which it relates, discrete items in any quarter can materially impact the reported effective tax rate. As a global enterprise, our tax expense can be impacted by changes in tax rates or laws, the finalization of tax audits and reviews, as well as other factors. As a result, there can be significant volatility in interim tax provisions.\nProvision for income taxes for the three and nine months ended September 30, 2021 was an expense of $ 15.4 million and $ 13.8 million resulting in an effective tax rate of 540.5 % and 198.7 %, respectively. Provision for income taxes for the three and nine months ended September 30, 2020 was a benefit of $ 3.1 million and $ 5.4 million resulting in an effective tax rate of 22.8 % and 30.0 %, respectively.\nNote 9: Debt\nLong-term debt\nLong-term debt consists of the following:\n| Interest RatePercentage | MaturityDate | September 30, 2021 | December 31, 2020 |\n| (in Millions) | LIBOR borrowings | Base rate borrowings |\n| Revolving Credit Facility (1) | 2.3 % | 4.5 % | 2023 | $ | — | $ | 35.6 |\n| 4.125 % Convertible Senior Notes due 2025 | 4.125 % | 2025 | 245.8 | 245.8 |\n| Transaction costs - 2025 Notes | ( 5.7 ) | ( 6.8 ) |\n| Total long-term debt (2) | $ | 240.1 | $ | 274.6 |\n\n______________________________\n1.As of September 30, 2021 and December 31, 2020, there were $ 14.4 million in letters of credit outstanding under our Revolving Credit Facility and $ 385.6 million and $ 275.0 million available funds as of September 30, 2021 and December 31, 2020, respectively. Fund availability is subject to the Company meeting its debt covenants.\n2. As of September 30, 2021 and December 31, 2020, the Company had no debt maturing within one year.\nOn January 1, 2021, the Company elected to early adopt ASU 2020-06 under the full retrospective method, that is, the accounting change was recognized as an adjustment to the balance of retained earnings, additional paid-in capital, long-term debt and deferred income taxes in our consolidated balance sheet as of December 31, 2020, the year in which the 2025 Notes were issued. The ASU reduces the number of accounting models for convertible debt instruments by eliminating the cash conversion model. Our 2025 Notes are now reported as a single liability instrument net of transaction costs with an interest rate closer to the coupon interest rate.\nThe comparative financial statements of prior years have been adjusted to apply the adopted guidance retrospectively.\n14\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\n| Statement of operations |\n| (in Millions, except per share amounts) |\n| Three months ended September 30, 2021 | As computed under ASC 470-20 | As reported under ASU 2020-06 | Effect of change |\n| Interest expense/(income) | $ | 1.8 | $ | — | $ | ( 1.8 ) |\n| Income from operations before income taxes | 1.0 | 2.8 | 1.8 |\n| Income tax expense | 15.0 | 15.4 | 0.4 |\n| Net (loss)/income | $ | ( 14.0 ) | $ | ( 12.6 ) | $ | 1.4 |\n| Net (loss)/income per weighted average share - basic and diluted | $ | ( 0.09 ) | $ | ( 0.08 ) | $ | 0.01 |\n| Nine months ended September 30, 2021 | As computed under ASC 470-20 | As reported under ASU 2020-06 | Effect of change |\n| Interest expense/(income) | $ | 5.5 | $ | 0.3 | $ | ( 5.2 ) |\n| Income from operations before income taxes | 1.7 | 6.9 | 5.2 |\n| Income tax expense | 12.7 | 13.8 | 1.1 |\n| Net (loss)/income | $ | ( 11.0 ) | $ | ( 6.9 ) | $ | 4.1 |\n| Net (loss)/income per weighted average share - basic and diluted | $ | ( 0.07 ) | $ | ( 0.05 ) | $ | 0.02 |\n| Three months ended September 30, 2020 | As originally reported | As adjusted | Effect of change |\n| Interest expense/(income) | $ | 2.0 | $ | 0.3 | $ | ( 1.7 ) |\n| (Loss)/income from operations before income taxes | ( 15.3 ) | ( 13.6 ) | 1.7 |\n| Income tax (benefit)/expense | ( 3.5 ) | ( 3.1 ) | 0.4 |\n| Net (loss)/income | $ | ( 11.8 ) | $ | ( 10.5 ) | $ | 1.3 |\n| Net (loss)/income per weighted average share - basic and diluted | $ | ( 0.08 ) | $ | ( 0.07 ) | $ | 0.01 |\n| Nine months ended September 30, 2020 | As originally reported | As adjusted | Effect of change |\n| Interest expense/(income) | $ | 2.0 | $ | 0.3 | $ | ( 1.7 ) |\n| (Loss)/Income from operations before income taxes | ( 19.7 ) | ( 18.0 ) | 1.7 |\n| Income tax (benefit)/expense | ( 5.8 ) | ( 5.4 ) | 0.4 |\n| Net (loss)/income | $ | ( 13.9 ) | $ | ( 12.6 ) | $ | 1.3 |\n| Net (loss)/income per weighted average share - basic and diluted | $ | ( 0.10 ) | $ | ( 0.09 ) | $ | 0.01 |\n\n15\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\n| Balance Sheet |\n| (in Millions, except per share amounts) |\n| September 30, 2021 | As computed under ASC 470-20 | As reported under ASU 2020-06 | Effect of change |\n| Deferred income taxes | $ | 15.0 | 7.8 | $ | ( 7.2 ) |\n| Long-term debt | 207.4 | 240.1 | 32.7 |\n| Total liabilities | $ | 222.4 | $ | 247.9 | $ | 25.5 |\n| Common stock, $ 0.001 per share par value | 0.1 | 0.1 | — |\n| Capital in excess of par value of common stock | 808.6 | 776.4 | ( 32.2 ) |\n| Retained earnings | 46.7 | 53.4 | 6.7 |\n| Accumulated other comprehensive loss | ( 44.6 ) | ( 44.6 ) | — |\n| Treasury stock | ( 0.8 ) | ( 0.8 ) | — |\n| Total equity | 810.0 | 784.5 | ( 25.5 ) |\n| Total liabilities and equity | $ | 1,032.4 | $ | 1,032.4 | $ | — |\n| December 31, 2020 | As originally reported | As adjusted | Effect of change |\n| Deferred income taxes | $ | 13.9 | $ | 5.6 | $ | ( 8.3 ) |\n| Long-term debt | 236.7 | 274.6 | 37.9 |\n| Total liabilities | $ | 250.6 | $ | 280.2 | $ | 29.6 |\n| Common stock | 0.1 | 0.1 | — |\n| Capital in excess of par value of common stock | 553.1 | 520.9 | ( 32.2 ) |\n| Retained earnings | 57.7 | 60.3 | 2.6 |\n| Accumulated other comprehensive loss | ( 44.4 ) | ( 44.4 ) | — |\n| Treasury stock, common, at cost | ( 0.7 ) | ( 0.7 ) | — |\n| Total equity | 565.8 | 536.2 | ( 29.6 ) |\n| Total liabilities and equity | $ | 816.4 | $ | 816.4 | $ | — |\n\n| Statement of cash flows |\n| (in Millions) |\n| Nine months ended September 30, 2021 | As computed under ASC 470-20 | As reported under ASU 2020-06 | Effect of change |\n| Net (loss)/income | $ | ( 11.0 ) | $ | ( 6.9 ) | $ | 4.1 |\n| Adjustments to reconcile net (loss)/income to cash provided by operating activities: |\n| Deferred income taxes | 10.1 | 11.2 | 1.1 |\n| Deferred financing fee amortization | 5.5 | 0.3 | ( 5.2 ) |\n| Net cash provided by operating activities | 4.6 | 4.6 | — |\n| Net increase in cash and cash equivalents | 183.7 | 183.7 | — |\n| Cash and cash equivalents, beginning of period | 11.6 | 11.6 | — |\n| Cash and cash equivalents, end of period | $ | 195.3 | $ | 195.3 | $ | — |\n| Nine months ended September 30, 2020 | As originally reported | As adjusted | Effect of change |\n| Net (loss)/income | $ | ( 13.9 ) | $ | ( 12.6 ) | $ | 1.3 |\n| Adjustments to reconcile net (loss)/income to cash required by operating activities: |\n| Deferred income taxes | ( 6.1 ) | ( 5.7 ) | 0.4 |\n| Deferred financing fee amortization | 2.0 | 0.3 | ( 1.7 ) |\n| Net cash required by operating activities | ( 18.0 ) | ( 18.0 ) | — |\n| Net decrease in cash and cash equivalents | ( 2.0 ) | ( 2.0 ) | — |\n| Cash and cash equivalents, beginning of period | 16.8 | 16.8 | — |\n| Cash and cash equivalents, end of period | $ | 14.8 | $ | 14.8 | $ | — |\n\n16\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\n2025 Notes\nIn the fourth quarter of 2021, the holders of the 2025 Notes were notified that the last reported sale price of our common stock for at least 20 trading days (whether or not consecutive) during the period of 30 consecutive trading days ending on, and including, September 30, 2021 was greater than or equal to 130 % of the conversion price on each trading day, and as a result, the holders have the option to convert all or any portion of their 2025 Notes through December 31, 2021. The 2025 Notes are classified as long-term debt.\nThe Company recognized noncash interest related to the amortization of transaction costs of $ 0.4 million and $ 1.1 million for the three and nine months ended September 30, 2021, respectively; $ 0.4 million and $ 0.8 million of which was capitalized for the three and nine months ended September 30, 2021, respectively. The Company recorded $ 2.5 million and $ 7.6 million of accrued interest expense related to the principal amount for the three and nine months ended September 30, 2021, respectively.\nRevolving Credit Facility\nThe carrying value of our deferred financing costs was $ 1.7 million as of September 30, 2021. In June 2021, we used a portion of the net proceeds from the Offering to repay all amounts outstanding under our Revolving Credit Facility.\nCovenants\nThe Credit Agreement contains certain affirmative and negative covenants that are binding on us and our subsidiary, FMC Lithium USA Corp., as borrowers (the \"Borrowers\") and their subsidiaries, including, among others, restrictions (subject to exceptions and qualifications) on the ability of the Borrowers and their subsidiaries to create liens, to undertake fundamental changes, to incur debt, to sell or dispose of assets, to make investments, to make restricted payments such as dividends, distributions or equity repurchases, to change the nature of their businesses, to enter into transactions with affiliates and to enter into certain burdensome agreements. Furthermore, the Borrowers are subject to financial covenants regarding leverage (measured as the ratio of debt to adjusted earnings) and interest coverage (measured as the ratio of adjusted earnings to interest expense). Our maximum allowable first lien leverage ratio is 3.5 as of September 30, 2021. Our minimum allowable interest coverage ratio is 3.5 . We were in compliance with all requirements of the covenants at September 30, 2021.\n17\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nNote 10: Equity\nAs of September 30, 2021 and December 31, 2020, we had 2 billion shares of common stock authorized. The following is a summary of Livent's common stock issued and outstanding:\n| Issued | Treasury | Outstanding |\n| Balance at December 31, 2020 | 146,461,249 | ( 99,268 ) | 146,361,981 |\n| Adjusted FMC RSU awards (1) | 120,986 | — | 120,986 |\n| Livent RSU awards | 102,505 | — | 102,505 |\n| Livent stock option awards | 41,407 | — | 41,407 |\n| Net purchases of treasury stock - deferred compensation plan | — | ( 1,863 ) | ( 1,863 ) |\n| Issuance of common stock | 14,950,000 | — | 14,950,000 |\n| Balance at September 30, 2021 | 161,676,147 | ( 101,131 ) | 161,575,016 |\n\n1.See Note 12 to our consolidated and combined financial statements in Part II, Item 8 of our 2020 Annual Report on Form 10-K for more information on Adjusted FMC RSU awards held by FMC employees.\nI n June 15, 2021, the Company closed on the issuance of 14,950,000 shares of its common stock, par value $ 0.001 per share, at a public offering price of $ 17.50 per share, in an underwritten public offering (the \"Offering\"), including 1,950,000 shares purchased under a 30 -day underwriters' option exercised in full by the underwriters on June 11, 2021. Total net proceeds from the Offering, including from the exercise of the underwriters’ option, were $ 252.2 million, after deducting the underwriters’ fees and offering expenses payable by the Company of $ 9.4 million. The total net proceeds were recorded to paid-in capital in the condensed consolidated balance sheet. In the third quarter of 2021, we purchased $ 140.0 million in limited risk investments with maturities of 90 days or less with a portion of the Offering net proceeds. The investments were recorded to Cash and cash equivalents in our condensed consolidated balance sheet in the third quarter of 2021.\nSummarized below is the roll forward of accumulated other comprehensive loss, net of tax.\n| (in Millions) | Foreign currency adjustments | Derivative Instruments (1) | Total |\n| Accumulated other comprehensive loss, net of tax at December 31, 2020 | $ | ( 44.4 ) | — | $ | ( 44.4 ) |\n| Other comprehensive losses before reclassifications | ( 0.2 ) | — | ( 0.2 ) |\n| Accumulated other comprehensive loss, net of tax at September 30, 2021 | $ | ( 44.6 ) | $ | — | $ | ( 44.6 ) |\n\n| (in Millions) | Foreign currency adjustments | Derivative Instruments (1) | Total |\n| Accumulated other comprehensive loss, net of tax at December 31, 2019 | $ | ( 48.3 ) | $ | — | $ | ( 48.3 ) |\n| Other comprehensive gains/(losses) before reclassifications | 1.4 | ( 0.2 ) | 1.2 |\n| Accumulated other comprehensive loss, net of tax at September 30, 2020 | $ | ( 46.9 ) | $ | ( 0.2 ) | $ | ( 47.1 ) |\n\n1.See Note 12 for more information.\n18\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nReclassifications of accumulated other comprehensive loss\nThe table below provides details about the reclassifications from accumulated other comprehensive loss and the affected line items in the condensed consolidated statements of operations for the period presented. No amounts were reclassified from accumulated other comprehensive loss for the three and nine months ended September 30, 2021.\n| Details about Accumulated Other Comprehensive Loss Components | Amounts Reclassified from Accumulated Other Comprehensive Loss (1) | Affected Line Item in the Condensed Consolidated Statements of Operations |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (in Millions) | 2021 | 2020 | 2021 | 2020 |\n| Derivative instruments |\n| Foreign currency contracts | $ | — | $ | ( 0.2 ) | $ | — | $ | ( 0.2 ) | Costs of sales and services |\n| Total before tax | — | ( 0.2 ) | — | ( 0.2 ) |\n| Amount included in net income (1) | $ | — | $ | ( 0.2 ) | $ | — | $ | ( 0.2 ) |\n\n(1) Provision for income taxes related to the reclassification was less than $ 0.1 million.\nDividends\nFor the three and nine months ended September 30, 2021 and 2020, we paid no dividends. We do not expect to pay any dividends in the foreseeable future.\nNote 11: Loss Per Share\nLoss per common share is computed by dividing net loss by the weighted average number of common shares outstanding during the period on a basic and diluted basis.\nOur potentially dilutive securities include potential common shares related to our stock options and restricted stock units (\"RSU\") granted in connection with the Livent Plan and FMC Plan. See Note 12 to our consolidated and combined financial statements in Part II, Item 8 of our 2020 Annual Report on Form 10-K for more information. Diluted loss per share (“Diluted EPS”) considers the impact of potentially dilutive securities except in periods in which there is a loss because the inclusion of the potential common shares would have an anti-dilutive effect. Diluted EPS excludes the impact of potential common shares related to our stock options in periods in which the option exercise price is greater than the average market price of our common stock for the period. We use the if-converted method when calculating the potential dilutive effect, if any, of our 2025 Notes.\nL oss applicable to common stock and common stock shares used in the calculation of basic and diluted loss per share are as follows:\n| (in Millions, Except Share and Per Share Data) | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Numerator: |\n| Net loss | $ | ( 12.6 ) | $ | ( 10.5 ) | $ | ( 6.9 ) | $ | ( 12.6 ) |\n| Denominator: |\n| Weighted average common shares outstanding - basic and diluted | 161.6 | 146.3 | 152.3 | 146.2 |\n| Basic and diluted loss per common share: |\n| Net loss per weighted average share - basic and diluted | $ | ( 0.08 ) | $ | ( 0.07 ) | $ | ( 0.05 ) | $ | ( 0.09 ) |\n\n19\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nThe following table presents weighted average share equivalents associated with share-based plans and the 2025 Notes that were excluded from the diluted shares outstanding calculation because the result would have been antidilutive. The 2025 Notes are further discussed in Note 9.\n| (in Millions) | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Share equivalents from share-based plans | 1.5 | 0.6 | 1.4 | 0.6 |\n| Share equivalents from 2025 Notes | 45.3 | 28.1 | 44.0 | 10.1 |\n| Total antidilutive weighted average share equivalents | 46.8 | 28.7 | 45.4 | 10.7 |\n\nAnti-dilutive stock options\nFor the three months ended September 30, 2021, none of the outstanding options to purchase shares of our common stock were anti-dilutive. For the nine months ended September 30, 2021, options to purchase 542,760 shares of our common stock at an average exercise price of $ 20.35 per share were anti-dilutive and not included in the computation of diluted loss per share because the exercise price of the options was greater than the average market price of the common stock for the nine months ended September 30, 2021. For the three and nine months ended September 30, 2020, options to purchase 1,835,476 and 1,904,010 shares of our common stock at an average exercise price of $ 12.59 and $ 12.58 per share, respectively, were anti-dilutive and not included in the computation of diluted loss per share because the exercise price of the options was greater than the average market price of the common stock for the three and nine months ended September 30, 2020.\nNote 12: Financial Instruments, Risk Management and Fair Value Measurements\nOur financial instruments include cash and cash equivalents, trade receivables, other current assets, investments held in trust fund, accounts payable, and amounts included in investments and accruals meeting the definition of financial instruments. Investments in the Livent NQSP deferred compensation plan trust fund are considered Level 1 investments based on readily available quoted prices in active markets for identical assets. The carrying value of cash and cash equivalents, trade receivables, other current assets, and accounts payable approximates their fair value and are considered Level 1 investments. Our other financial instruments include the following:\n| Financial Instrument | Valuation Method |\n| Foreign exchange forward contracts | Estimated amounts that would be received or paid to terminate the contracts at the reporting date based on current market prices for applicable currencies. |\n\nThe estimated fair value of our foreign exchange forward contracts have been determined using standard pricing models which take into account the present value of expected future cash flows discounted to the balance sheet date. These standard pricing models utilize inputs derived from, or corroborated by, observable market data such as interest rate yield curves and currency and commodity spot and forward rates. In addition, we test a subset of our valuations against valuations received from the transaction's counterparty to validate the accuracy of our standard pricing models. Accordingly, the estimates presented may not be indicative of the amounts that we would realize in a market exchange at settlement date and do not represent potential gains or losses on these agreements.\nFair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). The inputs used to measure fair value are classified into the following hierarchy:\nLevel 1 - Unadjusted quoted prices in active markets for identical assets or liabilities.\nLevel 2 - Unadjusted quoted prices in active markets for similar assets or liabilities, or unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability.\nLevel 3 - Unobservable inputs for the asset or liability.\n20\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nThe estimated fair value and the carrying amount of debt was $ 292.0 million and $ 240.1 million, respectively, as of September 30, 2021. Our 2025 Notes are classified as Level 2 in the fair value hierarchy. The estimated fair value and carrying amount of debt was $ 267.6 million and $ 274.6 million as of December 31, 2020.\nUse of Derivative Financial Instruments to Manage Risk\nWe mitigate certain financial exposures connected to currency risk through a program of risk management that includes the use of derivative financial instruments. We enter into foreign exchange forward contracts to reduce the effects of fluctuating foreign currency exchange rates.\nWe formally document all relationships between hedging instruments and hedged items, as well as the risk management objective and strategy for undertaking various hedge transactions. This process includes relating derivatives that are designated as fair value or cash flow hedges to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions. We also assess both at the inception of the hedge and on an ongoing basis, whether each derivative is highly effective in offsetting changes in fair values or cash flows of the hedged item. If we determine that a derivative is not highly effective as a hedge, or if a derivative ceases to be a highly effective hedge, we discontinue hedge accounting with respect to that derivative prospectively.\nForeign Currency Exchange Risk Management\nWe conduct business in many foreign countries, exposing earnings, cash flows, and our financial position to foreign currency risks. The majority of these risks arise as a result of foreign currency transactions. The primary currencies for which we have exchange rate exposure are the Euro, the British pound, the Chinese yuan, the Argentine peso, and the Japanese yen. We currently do not hedge foreign currency risks associated with the Argentine peso due to the limited availability and the high cost of suitable derivative instruments. Our policy is to minimize exposure to adverse changes in currency exchange rates. This is accomplished through a controlled program of risk management that could include the use of foreign currency debt and forward foreign exchange contracts. We also use forward foreign exchange contracts to hedge firm and highly anticipated foreign currency cash flows, with an objective of balancing currency risk to provide adequate protection from significant fluctuations in the currency markets.\nConcentration of Credit Risk\nOur counterparties to derivative contracts are primarily major financial institutions. We limit the dollar amount of contracts entered into with any one financial institution and monitor counterparties’ credit ratings. We also enter into master netting agreements with each financial institution, where possible, which helps mitigate the credit risk associated with our financial instruments. While we may be exposed to credit losses due to the nonperformance of counterparties, we consider this risk remote.\nAccounting for Derivative Instruments and Hedging Activities\nCash Flow Hedges\nWe recognize all derivatives on the balance sheet at fair value. On the date we enter into the derivative instrument, we generally designate the derivative as a hedge of the variability of cash flows to be received or paid related to a forecasted transaction (cash flow hedge). We record in accumulated other comprehensive loss (\"AOCL\") changes in the fair value of derivatives that are designated as and meet all the required criteria for, a cash flow hedge. We then reclassify these amounts into earnings as the underlying hedged item affects earnings. In contrast we immediately record in earnings changes in the fair value of derivatives that are not designated as cash flow hedges. As of September 30, 2021, we had open foreign currency forward contracts in AOCL in a net after-tax gain position of less than $ 0.1 million designated as cash flow hedges of underlying forecasted sales and purchases. As of September 30, 2021 we had open forward contracts with various expiration dates to buy, sell or exchange foreign currencies with a U.S. dollar equivalent of approximately $ 5.6 million.\nLess than $ 0.1 million of net after-tax gain, representing open foreign currency exchange contracts, will be realized in earnings during the three months ending December 31, 2021 if spot rates in the future are consistent with market rates as of September 30, 2021. The actual effect on earnings will be dependent on the actual spot rates when the forecasted transactions occur. We recognize derivative gains and losses in the “Costs of sales and services” line in the condensed consolidated statements of operations.\n21\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nDerivatives Not Designated As Cash Flow Hedging Instruments\nWe hold certain forward contracts that have not been designated as cash flow hedging instruments for accounting purposes. Contracts used to hedge the exposure to foreign currency fluctuations associated with certain monetary assets and liabilities are not designated as cash flow hedging instruments and changes in the fair value of these items are recorded in earnings.\nWe had open forward contracts not designated as cash flow hedging instruments for accounting purposes with various expiration dates to buy, sell or exchange foreign currencies with a U.S. dollar equivalent of approximately $ 30.9 million at September 30, 2021.\nFair Value of Derivative Instruments.\nAs of September 30, 2021, we had open derivative cash flow hedge contracts in a net gain fair value position of less than $ 0.1 million. The Company had no open derivative cash flow hedge contracts as of December 31, 2020.\nDerivatives in Cash Flow Hedging Relationships\n| (in Millions) | Total Foreign Exchange Contracts |\n| Accumulated other comprehensive loss, net of tax at March 31, 2021 | $ | — |\n| Unrealized hedging gains, net of tax | 0.1 |\n| Total derivatives instruments impact on comprehensive income, net of tax | 0.1 |\n| Accumulated other comprehensive gain, net of tax at June 30, 2021 | $ | 0.1 |\n| Unrealized hedging losses, net of tax | ( 0.1 ) |\n| Total derivatives instruments impact on comprehensive income, net of tax | ( 0.1 ) |\n| Accumulated other comprehensive gain, net of tax at September 30, 2021 | $ | — |\n\n22\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\n| (in Millions) | Total Foreign Exchange Contracts |\n| Accumulated other comprehensive loss, net of tax at March 31, 2020 | $ | — |\n| Unrealized hedging loses, net of tax | ( 0.2 ) |\n| Total derivatives instruments impact on comprehensive income, net of tax | ( 0.2 ) |\n| Accumulated other comprehensive loss, net of tax at June 30, 2020 | $ | ( 0.2 ) |\n| Unrealized hedging gains, net of tax | 0.2 |\n| Reclassification of deferred hedging gains, net of tax (1) | ( 0.2 ) |\n| Accumulated other comprehensive loss, net of tax at September 30, 2020 | $ | ( 0.2 ) |\n\n1.Amounts are included in \"Cost of sales and services\" on the condensed consolidated statements of operations\nDerivatives Not Designated as Cash Flow Hedging Instruments\n| Location of LossRecognized in Income on Derivatives | Amount of Pre-tax Loss Recognized in Income on Derivatives (1) |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (in Millions) | 2021 | 2020 | 2021 | 2020 |\n| Foreign Exchange contracts | Cost of Sales and Services (2) | $ | ( 0.2 ) | $ | ( 0.8 ) | $ | ( 1.1 ) | $ | ( 1.9 ) |\n| Total | $ | ( 0.2 ) | $ | ( 0.8 ) | $ | ( 1.1 ) | $ | ( 1.9 ) |\n\n____________________\n1.Amounts represent the gain or loss on the derivative instrument offset by the gain or loss on the hedged item.\n2.A loss of $ 0.1 million and $ 0.2 million related to intercompany loan hedges is included in Restructuring and other charges in the consolidated statement of operations for the three and nine months ended September 30, 2021, respectively. A loss of $ 0.1 million related to intercompany loan hedges is included in Restructuring and other charges in the consolidated statement of operations for the three and nine months ended September 30, 2020.\nFair Value Measurements\nFair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Market participants are defined as buyers or sellers in the principle or most advantageous market for the asset or liability that are independent of the reporting entity, knowledgeable and able and willing to transact for the asset or liability.\nFair Value Hierarchy\nWe have categorized our assets and liabilities that are recorded at fair value, based on the priority of the inputs to the valuation technique, into a three-level fair-value hierarchy. The fair-value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure the assets and liabilities fall within different levels of the hierarchy, the categorization is based on the lowest level input that is significant to the fair-value measurement of the instrument.\n23\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nRecurring Fair Value Measurements\nThe following tables present our fair-value hierarchy for those assets and liabilities measured at fair-value on a recurring basis in our condensed consolidated balance sheets.\n| (in Millions) | September 30, 2021 | Quoted Prices in Active Markets for Identical Assets(Level 1) | Significant Other Observable Inputs(Level 2) | Significant Unobservable Inputs(Level 3) |\n| Assets |\n| Investments in deferred compensation plan (1) | $ | 3.1 | $ | 3.1 | $ | — | $ | — |\n| Total Assets | $ | 3.1 | $ | 3.1 | $ | — | $ | — |\n| Liabilities |\n| Deferred compensation plan obligation (2) | $ | 5.5 | $ | 5.5 | $ | — | $ | — |\n| Total Liabilities | $ | 5.5 | $ | 5.5 | $ | — | $ | — |\n\n\n| (in Millions) | December 31, 2020 | Quoted Prices in Active Markets for Identical Assets(Level 1) | Significant Other Observable Inputs(Level 2) | Significant Unobservable Inputs(Level 3) |\n| Assets |\n| Investments in deferred compensation plan (1) | $ | 2.6 | $ | 2.6 | $ | — | $ | — |\n| Total Assets | $ | 2.6 | $ | 2.6 | $ | — | $ | — |\n| Liabilities |\n| Deferred compensation plan obligation (2) | $ | 4.5 | $ | 4.5 | $ | — | $ | — |\n| Total Liabilities | $ | 4.5 | $ | 4.5 | $ | — | $ | — |\n\n____________________\n1.Balance is included in “Investments” in the condensed consolidated balance sheets. Livent NQSP investments in Livent common stock are recorded as \"Treasury stock\" in the condensed consolidated balance sheets and carried at historical cost. A mark-to-market loss of $ 0.4 million was recorded for the three and nine months ended September 30, 2021, related to the Livent common stock. The mark-to-market gains were recorded in \"Selling, general and administrative expense\" in the condensed consolidated statement of operations, with a corresponding offset to the deferred compensation plan obligation in the condensed consolidated balance sheets.\n2.Balance is included in “Other long-term liabilities” in the condensed consolidated balance sheets.\nNote 13: Commitments and Contingencies\nContingencies\nWe are a party to various legal proceedings, including those noted in this section. Livent records reserves for estimated losses from contingencies when information available indicates that a loss is probable and the amount of the loss, or range of loss, can be reasonably estimated. As additional information becomes available, management adjusts its assessments and estimates. Legal costs are expensed as incurred.\nIn addition to the legal proceedings noted below, we have certain contingent liabilities arising in the ordinary course of business. Some of these contingencies are known but are so preliminary that the merits cannot be determined, or if more advanced, are not deemed material based on current knowledge; and some are unknown - for example, claims with respect to which we have no notice or claims which may arise in the future from products sold, guarantees or warranties made, or indemnities provided. Therefore, we are unable to develop a reasonable estimate of our potential exposure of loss for these contingencies, either individually or in the aggregate, at this time. There can be no assurance that the outcome of these contingencies will be favorable, and adverse results in certain of these contingencies could have a material adverse effect on the consolidated financial position, results of operations in any one reporting period, or liquidity.\n24\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nArgentine Customs Authority\nOn July 31, 2020, we received notice from the Argentine Customs Authority that it was conducting an audit of Minera del Altiplano SA, our subsidiary in Argentina (“MdA”). The audit relates to the export of Lithium Carbonate from Argentina for the period January 10, 2015 through December 31, 2017. Although this relates to a period of time when MdA was a subsidiary of FMC, the Company agreed to bear any possible liability for this matter under the terms of the Tax Matters Agreement that it entered into with FMC in connection with the Separation. A range of reasonably possible liabilities, if any, cannot be currently currently estimated by the Company.\nLeases\nAll of our leases are operating leases as of September 30, 2021 and December 31, 2020. We have operating leases for corporate offices, manufacturing facilities, and land. Our leases have remaining lease terms of 1 year to 14 years. Quantitative disclosures about our leases are summarized in the table below.\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (in Millions, except for weighted-average amounts) | 2021 | 2020 | 2021 | 2020 |\n| Lease Cost |\n| Operating lease cost | $ | 0.4 | $ | 0.6 | $ | 1.0 | $ | 1.6 |\n| Short-term lease cost | 0.3 | — | 1.0 | 0.3 |\n| Variable lease cost (1) | — | — | 0.1 | 0.1 |\n| Total lease cost (1) | $ | 0.7 | $ | 0.6 | $ | 2.1 | $ | 2.0 |\n| Other information |\n| Cash paid for amounts included in the measurement of lease liabilities: |\n| Cash paid for operating leases | $ | 0.5 | $ | 0.5 | $ | 1.6 | $ | 1.5 |\n\n__________________________\n1. Short term lease cost for the three months ended September 30, 2020 was less than $ 0.1 million. Variable lease cost for the three months ended September 30, 2020 and 2021 was less than $ 0.1 million. Lease expense is classified as \"Selling, general and administrative expenses\" in our consolidated statements of operations.\nAs of September 30, 2021 and December 31, 2020, our operating leases had a weighted average remaining lease term of 8.6 years and 11.7 years, respectively. As of September 30, 2021 and December 31, 2020, our operating leases had a weighted average discount rate of 4.9 % and 4.4 %, respectively.\nThe table below presents a maturity analysis of our operating lease liabilities for each of the next five years and a total of the amounts for the remaining years.\n| (in Millions) | Undiscounted cash flows |\n| Remainder of 2021 | $ | 0.4 |\n| 2022 | 1.3 |\n| 2023 | 1.1 |\n| 2024 | 1.1 |\n| 2025 | 1.1 |\n| Thereafter | 3.0 |\n| Total future minimum lease payments | 8.0 |\n| Less: Imputed interest | ( 1.5 ) |\n| Total | $ | 6.5 |\n\n25\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nIn the first quarter of 2021, we terminated our existing sublease with FMC for approximately twenty-five thousand square feet of office space used for our corporate headquarters in Philadelphia, Pennsylvania and removed the related right-of-use (\"ROU\") asset and lease liability of approximately $ 10.9 million from our condensed consolidated balance sheets. On April 13, 2021 we executed a new five-year sublease agreement with a different counterparty for approximately thirteen thousand square feet of office space for our corporate headquarters in Philadelphia, Pennsylvania and recorded a $ 2.1 million ROU asset and lease liability in the second quarter of 2021 related thereto.\n26\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\nNote 14: Supplemental Information\nThe following tables present details of prepaid and other current assets, other assets, accrued and other current liabilities, and other long-term liabilities as presented on the condensed consolidated balance sheets:\n| (in Millions) | September 30, 2021 | December 31, 2020 |\n| Prepaid and other current assets |\n| Argentina government receivable (1) | $ | 11.8 | $ | 10.8 |\n| Tax related items | 15.4 | 15.7 |\n| Other receivables | 3.0 | 8.6 |\n| Prepaid expenses | 7.6 | 8.2 |\n| Bank Acceptance Drafts (2) | — | 0.2 |\n| Other current assets (3) | 6.0 | 12.8 |\n| Total | $ | 43.8 | $ | 56.3 |\n\n| (in Millions) | September 30, 2021 | December 31, 2020 |\n| Other assets |\n| Argentina government receivable (1) | $ | 51.0 | $ | 55.8 |\n| Advance to contract manufacturers (4) | 15.6 | 16.3 |\n| Capitalized software, net | 1.5 | 1.8 |\n| Tax related items | 2.5 | 2.7 |\n| Other assets | 11.0 | 11.8 |\n| Total | $ | 81.6 | $ | 88.4 |\n\n_________________\n1.We have various subsidiaries that conduct business in Argentina. As of September 30, 2021 and December 31, 2020, $ 38.3 million and $ 39.5 million, respectively, of outstanding receivables due from the Argentina government, which primarily represent export tax and export rebate receivables, was denominated in U.S. dollars. As with all outstanding receivable balances, we continually review recoverability by analyzing historical experience, current collection trends and regional business and political factors among other factors.\n2.Bank Acceptance Drafts are a common Chinese finance note used to settle trade transactions. Livent accepts these notes from Chinese customers based on criteria intended to ensure collectability and limit working capital usage.\n3.The December 31, 2020 balance includes a $ 5.4 million receivable for insurance reimbursement related to the IPO litigation settlement which was netted with the IPO litigation settlement accrual. The IPO litigation settlement was finalized in the second quarter of 2021. See Note 7 for details.\n4.We record deferred charges for certain contract manufacturing agreements which we amortize over the term of the underlying contract.\n27\nLIVENT CORPORATIONNotes to the Condensed Consolidated Financial Statements (unaudited) — (Continued)\n| (in Millions) | September 30, 2021 | December 31, 2020 |\n| Accrued and other current liabilities |\n| Plant restructuring reserves | $ | 3.2 | $ | 3.2 |\n| Retirement liability - 401K | 0.6 | 2.6 |\n| Accrued payroll | 11.5 | 12.5 |\n| Severance related | 0.2 | 2.5 |\n| Environmental reserves, current | 0.5 | 0.6 |\n| Other accrued and other current liabilities (1) | 19.7 | 15.3 |\n| Total | $ | 35.7 | $ | 36.7 |\n\n| (in Millions) | September 30, 2021 | December 31, 2020 |\n| Other long-term liabilities |\n| Accrued investment in unconsolidated affiliate | $ | 6.2 | $ | 6.2 |\n| Asset retirement obligations | 0.3 | 0.3 |\n| Contingencies related to uncertain tax positions (2) | 3.6 | 3.4 |\n| Deferred compensation plan obligation | 5.5 | 4.5 |\n| Self-insurance reserves | 1.5 | 1.5 |\n| Other long-term liabilities | 1.1 | 1.3 |\n| Total | $ | 18.2 | $ | 17.2 |\n\n____________________\n1.Amounts primarily include accrued capital expenditures related to our expansion projects. December 31, 2020 includes a $ 7.4 million settlement accrual related to IPO litigation recorded in the third quarter of 2020. The IPO litigation settlement was finalized in the second quarter of 2021.\n2.As of September 30, 2021, we have recorded a liability for uncertain tax positions of $ 3.2 million and a $ 0.4 million indemnification liability to FMC for assets held by the Company where the offsetting liability for uncertain tax positions rests with FMC. The Company agreed to bear any possible liability for this matter under the terms of the Tax Matters Agreement that it entered into with FMC in connection with the Separation.\n28\nITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nSPECIAL NOTE REGARDING FORWARD-LOOKING INFORMATION\nStatement under the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995: We and our representatives may from time to time make written or oral statements that are “forward-looking” and provide other than historical information, including statements contained in Item 2 of this Quarterly Report on Form 10-Q, in our other filings with the SEC, or in reports to our stockholders.\nIn some cases, we have identified forward-looking statements by such words or phrases as “will likely result,” “is confident that,” “expect,” “expects,” “should,” “could,” “may,” “will continue to,” “believe,” “believes,” “anticipates,” “predicts,” “forecasts,” “estimates,” “projects,” “potential,” “intends” or similar expressions identifying “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, including the negative of those words and phrases. Such forward-looking statements are based on our current views and assumptions regarding future events, future business conditions and the outlook for the company based on currently available information. These forward-looking statements may include projections of our future financial performance, our anticipated growth strategies and anticipated trends in our business. These statements are only predictions based on our current expectations and projections about future events. These statements involve known and unknown risks, uncertainties and other factors that may cause actual results to be materially different from any results, levels of activity, performance or achievements expressed or implied by any forward-looking statement.\nCurrently, one of the most significant factors is the potential adverse effect of the current COVID-19 pandemic on the financial condition, results of operations, cash flows and performance of the Company, which is substantially influenced by the potential adverse effect of the pandemic on Livent’s customers and suppliers, the global economy and financial markets and costs of implementing COVID-19 safety protocols. The extent to which COVID-19 impacts us will depend on future developments, which are highly uncertain and cannot be predicted with confidence, including the scope, severity and duration of the pandemic, the development of more contagious variants of the virus, such as the Delta variant, the actions taken to contain the pandemic or mitigate its impact, and the direct and indirect economic effects of the pandemic and containment measures, among others.\nAdditional factors include, among other things:\n•a decline in the growth in demand for electric vehicles with high performance lithium compounds;\n•supply chain disruptions in the electric vehicle manufacturing industry, such as shortages, congestion at ports, and rolling electricity blackouts in China, resulting in delays in customer orders for our high performance lithium compounds;\n•reduced customer demand, or delays in growth of customer demand, for higher performance lithium compounds;\n•volatility in the price for performance lithium compounds;\n•adverse global economic and weather conditions that may result in adverse impact on supply chains and customer demand;\n•competition;\n•quarterly and annual fluctuations of our operating results;\n•risks relating to Livent’s capacity expansion efforts and current production;\n•potential development and adoption of battery technologies that do not rely on performance lithium compounds as an input, or that require a lesser amount of performance lithium compounds;\n•difficulty accessing global capital and credit markets;\n•the conditional conversion feature of the 2025 Notes;\n•the lack of sufficient cash flow from our business to pay our debt;\n•the success of Livent’s research and development efforts;\n•future acquisitions that may be difficult to integrate or are otherwise unsuccessful;\n•risks inherent in international operations and sales, including political, financial and operational risks specific to Argentina, China and other countries where Livent has active operations;\n•customer concentration and the possible loss of, or significant reduction in orders from, large customers;\n•failure to satisfy customer qualification processes and customer and government quality standards;\n29\n•fluctuations in the price of energy and certain raw materials;\n•employee attraction and retention, especially in relation to our capacity expansion efforts;\n•union relations;\n•cybersecurity breaches;\n•our ability to protect our intellectual property rights;\n•ESG matters;\n•the lack of proven lithium reserves;\n•legal and regulatory proceedings, including any shareholder lawsuits;\n•compliance with environmental, health and safety laws;\n•changes in tax laws;\n•risks related to our separation from FMC Corporation;\n•potential conflicts of interests among officers and directors who may own equity in, and/or may have otherwise served as employees of, FMC Corporation;\n•risks related to ownership of our common stock, including price fluctuations;\n•provisions under Delaware law and our charter documents that may deter third parties from acquiring us; and\n•the lack of cash dividends at this time.\nMoreover, investors are cautioned to interpret many of these factors as being heightened as a result of the ongoing and numerous adverse impacts of COVID-19. You should carefully consider the risk factors discussed in Part I, Item 1A of our 2020 Annual Report on Form 10-K.\nAlthough we believe the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, level of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of any of these forward-looking statements. We wish to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made. We are under no duty to and specifically decline to undertake any obligation to publicly revise or update any of these forward-looking statements after the date of this Quarterly Report on Form 10-Q to conform our prior statements to actual results, revised expectations or to reflect the occurrence of anticipated or unanticipated events.\nAPPLICATION OF CRITICAL ACCOUNTING POLICIES\nOur condensed consolidated financial statements are prepared in conformity with U.S. GAAP. The preparation of our financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. We have described our accounting policies in Note 2 to our consolidated and combined financial statements included in Part II, Item 8 of our 2020 Annual Report on Form 10-K.\nWe have reviewed these accounting policies, identifying those that we believe to be critical to the preparation and understanding of our condensed consolidated financial statements. We have reviewed these critical accounting policies with the Audit Committee of our Board of Directors. Critical accounting policies are central to our presentation of results of operations and financial condition and require management to make estimates and judgments on certain matters. We base our estimates and judgments on historical experience, current conditions and other reasonable factors.\nThe following is a list of those accounting policies that we have deemed most critical to the presentation and understanding of our results of operations and financial condition. See the \"Critical Accounting Policies\" section included within \"Management's Discussion and Analysis of Financial Condition and Results of Operations\" within Part II, Item 7 of our 2020 Annual Report on Form 10-K for a detailed description of these policies and their potential effects on our results of operations and financial condition.\n•Revenue recognition and trade receivables\n•Impairment and valuation of long-lived assets\n•Income taxes\nDue to the COVID-19 pandemic, there has been uncertainty and disruption in the global economy and financial markets. The estimates used for, but not limited to, revenue recognition and the collectability of trade receivables, impairment and valuation of long-lived assets, and income taxes could be impacted. We have assessed the impact and are not aware of any specific events or circumstances that required an update to our estimates and assumptions or materially affected the carrying value of our assets\n30\nor liabilities as of the date of issuance of this Quarterly Report on Form 10-Q. These estimates may change as new events occur and additional information is obtained. Actual results could differ materially from these estimates under different assumptions or conditions.\nRECENTLY ISSUED AND ADOPTED ACCOUNTING PRONOUNCEMENTS AND REGULATORY ITEMS\nSee Note 3 to these condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for a discussion of recently adopted accounting guidance and other new accounting guidance.\nOVERVIEW\nWe are a pure-play, fully integrated lithium company, with a long, proven history of producing performance lithium compounds. Our primary products, namely battery-grade lithium hydroxide, lithium carbonate, butyllithium and high purity lithium metal are critical inputs used in various performance applications. Our strategy is to focus on supplying high performance lithium compounds to the fast growing Electric Vehicle (“EV”) battery market, while continuing to maintain our position as a leading global producer of butyllithium and high purity lithium metal. With extensive global capabilities, nearly 80 years of continuous production experience, applications and technical expertise, long standing customer relationships, and a favorable sustainability profile, we believe we are well positioned to capitalize on the accelerating trend of vehicle electrification and renewable energy adoption.\nWe produce lithium compounds for use in applications that have specific and constantly changing performance requirements, including battery-grade lithium hydroxide for use in high performance lithium-ion batteries. We believe the demand for our compounds will continue to grow as the electrification of transportation accelerates, and as the use of high nickel content cathode materials increases in the next generation of battery technology products. We also supply butyllithium, which is used in the production of polymers and pharmaceutical products, as well as a range of specialty lithium compounds including high purity lithium metal, which is used in non-rechargeable batteries and in the production of lightweight materials for aerospace applications and non-rechargeable batteries. It is in these applications that we have established a differentiated position in the market through our ability to consistently produce and deliver performance lithium compounds.\nThird Quarter 2021 Highlights\nThe following are the more significant developments in our business during the three months ended September 30, 2021:\n•Revenue of $103.6 million for the three months ended September 30, 2021 increased $31.0 million, or approximately 43%, compared to $72.6 million for the three months ended September 30, 2020, primarily due to higher lithium hydroxide, lithium carbonate and butyllithium sales volumes, driven by an increase in customer demand.\n•Net loss of $(12.6) million for the three months ended September 30, 2021 compared to net loss of $(10.5) million for the three months ended September 30, 2020 was primarily due to an increase in the Argentina tax expense from inflationary tax adjustments, higher logistics, raw material and other operating costs, and $1.0 million Equity in net loss of unconsolidated affiliates partially offset by higher lithium hydroxide, lithium carbonate and butyllithium sales volumes and lower Restructuring and other charges.\n•Adjusted EBITDA of $14.9 million for the three months ended September 30, 2021 increased $14.0 million compared to $0.9 million for the three months ended September 30, 2020, primarily due to higher lithium hydroxide, lithium carbonate and butyllithium sales volumes partially offset by higher logistics, raw material and other operating costs.\nCOVID-19 Impacts\nBusiness and Operations\nDuring the three months ended September 30, 2021, the COVID-19 pandemic continued to negatively impact our business, operations and financial performance. Worldwide government and private sector efforts to contain the spread and mitigate the impact of COVID-19 continued. We still face operational challenges and uncertainties related to the unprecedented global COVID-19 pandemic. The disruptions and duration may be impacted by the actions that governments, businesses and individuals take in relation to the pandemic, the Delta variant and other new variants of the virus, vaccine safety concerns, vaccine resistance, vaccine availability, delays in vaccine distribution and the willingness of individuals to be vaccinated.\nWe have manufacturing operations in the United States, Argentina, China, the United Kingdom, and India, general operations in Singapore, and sales offices in the United States, China, the United Kingdom, India, and Japan. All of these countries have been affected by the COVID-19 pandemic to varying degrees. Each has adopted measures to contain it, and each may adopt different and/or even stricter measures in the future. The government of Argentina, where the Company’s primary lithium brine resource is located, continues to enact new emergency measures to stem the spread of COVID-19 and modify existing ones. While regional curfews and lockdowns are being lifted and businesses and schools are being allowed to reopen, travel and\n31\nimmigration restrictions and workforce retention rules remain in place. In India, regional governments have imposed testing requirements, curfews and travel restrictions. We expect government measures and restrictions globally to continue to have a negative impact on demand for certain of our products and a negative impact on the efficient operation of our facilities, supply chains and logistics. Disruptions and delays within our supply chain and logistics operations included problems and congestion at ports, difficulties with scheduling cargo ships, higher shipment and freight costs, additional warehouse costs due to shipment delays, lack of driver availability and fewer transportation options, and the restriction of movements by trucks within and between countries. The severity of these problems and issues has varied in different geographic locations over the course of the COVID-19 pandemic and continues to remain a challenge in all of the countries where we operate.\nCustomer demand for certain types of our products improved during the third quarter of 2021. However, customers continue to protect their interests by diversifying among multiple suppliers. They continue to actively manage their own inventory levels in the current uncertain market environment. In addition, customers in the fast-growing EV manufacturing industry are currently experiencing their own supply chain constraints, including semiconductors shortages, congestion at ports, and rolling electricity blackouts in China. The semiconductor chip shortage is expected to continue and may adversely impact our business. This, and similar supply chain disruptions experienced by our customers, could cause delays in their demand for our high performance lithium compounds, further adversely impacting our business and growth plans.\nThe continuing spread and effects of COVID-19, including health and safety protocols and supply and logistics disruptions in China and elsewhere, are impacting our expansion work in Argentina and the United States. There can be no assurance that such impacts will not turn into long-term or continuing delays, cause us to decide to suspend our capital expansion work, or otherwise negatively impact our capital expansion. Any significant delay in our capital expansion work in Argentina or the United States could have a material adverse effect on our business, financial condition and results of operations. In addition to delays, there have been increased costs due to slowdown of availability of materials for construction.\nWe have not faced any material issues with employee morale or attrition. Likewise, we have not faced any material issues with our ability to recruit new employees or in talent management of existing employees. However, certain of our employees may resign, and we may be unable to attract certain talent, if we were to impose any vaccine mandate. Broadly, we are observing tightness in the local labor markets where we operate in both the United States and Argentina (e.g., fewer applicants and higher wages). This may impact us and our expansion efforts, our customers and suppliers in the future.\nThe material operational challenges that management and our Board of Directors are monitoring are the health and safety of our employees, vaccine availability and distribution, travel restrictions, COVID-19 mitigation measures, the relaxation of work from home requirements, the restriction of movements within and between countries, and supply chain and logistics issues. Furthermore, our Board of Directors is monitoring the additional expected and unexpected impacts that COVID-19 is having on the economies in the countries where we operate, such as Argentina where inflation remains high and economic instability persists, and China where economic growth has led to shortages of electricity and temporary shutdowns of third party providers to the Company.\nLiquidity and Financial Resources\nThe rapid and global spread of COVID-19 continues to disrupt the businesses of certain customers, contract manufacturers and suppliers. Several of our customers and contract manufacturers have experienced disruptions in their business due to the COVID-19 pandemic. Certain customers have canceled, postponed or delayed orders.\nOur uses of cash were impacted by the effects of COVID-19 during the nine months ended September 30, 2021. We continue to face logistical supply disruptions, such as higher truck, freight and sea shipping costs, along with the need to use air freight from time to time. We expect this to continue. We also continue to use cash to purchase additional COVID-19 testing, personal protective equipment for our employees, such as masks and gloves, and for increased cleaning and disinfectant costs, additional medical personnel at our facilities, and increased personnel transportation costs due to social distancing guidelines.\nCorporate Efforts\nWe have responded to the COVID-19 pandemic in a number of ways. We formed a Global Pandemic Response Team, regional COVID-19 Response Teams, and a Vaccine subcommittee. The Vaccine subcommittee is tasked with monitoring vaccine developments and encouraging our employees to be vaccinated. Our regional COVID-19 Response Teams continue to keep Executive Leadership informed of local matters such as government policies and regulations. Our Enterprise Risk Management processes have worked as designed.\nWe continue to identify potential new suppliers and logistics providers for our operations as supply chain challenges continue. This includes potential new suppliers of chemicals and packaging, and air freight companies when required. We have altered global production schedules to meet changes in customer demand, supply and logistics challenges. Future efforts will continue along these lines and be dictated by the particulars of the COVID-19 pandemic. We continue to plan for a return to more normalized business operations once the COVID-19 pandemic subsides. This may include a relaxation of COVID-19 protocols, more business travel and customer contacts, and hybrid work arrangements.\n32\nHealth & Safety\nWe are working diligently to protect the health and well-being of our employees, customers and other key stakeholders. As an essential business under the rules of the governments in the countries where we operate, our plant personnel continue to remain on the job at their respective facilities. We have instituted numerous safety procedures to protect the health of these plant personnel. Protocols include screening of personnel prior to facility entry, the use of masks and gloves, social distancing measures, and quarantine of close contacts with suspected or confirmed COVID-19 cases. Much of our non-plant personnel continue to work from home, and business travel has been substantially reduced, which has limited our ability to meet with customers, suppliers and fellow employees. Communications relating to all of these policies and COVID-19 preventative measures are regularly distributed to our employees, as there can be significant variation with respect to the COVID-19 pandemic situation in different geographic regions at any one time.\nWe base our health and safety protocols on the advice provided by the White House, the Centers for Disease Control and Prevention, the World Health Organization, and the local government authorities in the countries and regions where we operate.\nIn the United States, we previously implemented the paid sick leave policies that were required under the Families First Coronavirus Response Act and had supplemented them with our own paid sick and other leave policies. Currently, in the United States, we are providing paid sick leave for qualified absences due to COVID-19. In other geographic locations, we are providing our customary local sick leave benefits and any other leave and benefits that may be required by local governmental authorities. We have not experienced any material employee absences as a result of COVID-19. However, social distancing measures and other health and safety protocols have led to reduced workforce numbers in certain locations, such as with our expansion project in Argentina. If a significant number of our employees at any one location were to require leave as a result of COVID-19, this could pose a risk to the continued operation of the particular facility and could potentially disrupt our broader operations.\nGovernment Programs\nWe continue to evaluate government support and tax relief programs in the countries where we operate. This includes support grants, loans, tax deferrals, and tax credits.\nOverall, the impact of the COVID-19 pandemic is fluid and continues to evolve, and therefore, we cannot predict the extent to which our business, results of operations, financial condition or liquidity will ultimately be impacted.\nBusiness Outlook\nWe expect higher volumes across our lithium products and slightly higher average pricing in 2021 versus the prior year. We also expect lower unit costs versus the prior year, driven in part by higher operating rates and the reduced impact of third-party purchased lithium carbonate usage. However, we expect this to be partially offset by cost increases in logistics, solvents and other raw materials.\n33\nRESULTS OF OPERATIONS\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| (in Millions) | (unaudited) |\n| Revenue | $ | 103.6 | $ | 72.6 | $ | 297.5 | $ | 206.0 |\n| Cost of sales | 85.3 | 69.8 | 245.5 | 178.4 |\n| Gross margin | 18.3 | 2.8 | 52.0 | 27.6 |\n| Selling, general and administrative expenses | 11.8 | 10.0 | 34.2 | 31.1 |\n| Research and development expenses | 0.8 | 1.0 | 2.2 | 2.8 |\n| Restructuring and other charges | 1.1 | 4.4 | 3.4 | 10.1 |\n| Separation-related costs | 0.8 | 0.6 | 1.3 | 0.8 |\n| Total costs and expenses | 99.8 | 85.8 | 286.6 | 223.2 |\n| Income/(loss) from operations before loss on debt extinguishment, equity in net loss of unconsolidated affiliates and interest expense, net | 3.8 | (13.2) | 10.9 | (17.2) |\n| Loss on debt extinguishment | — | — | — | 0.1 |\n| Equity in net loss of unconsolidated affiliates | 1.0 | 0.1 | 3.7 | 0.4 |\n| Interest expense, net | — | 0.3 | 0.3 | 0.3 |\n| Income/(loss) from operations before income taxes | 2.8 | (13.6) | 6.9 | (18.0) |\n| Income tax expense/(benefit) | 15.4 | (3.1) | 13.8 | (5.4) |\n| Net loss | $ | (12.6) | $ | (10.5) | $ | (6.9) | $ | (12.6) |\n\nIn addition to net income, as determined in accordance with U.S. GAAP, we evaluate operating performance using certain non-GAAP measures such as EBITDA, which we define as net income plus interest expense, net, income tax expense/(benefit), and depreciation and amortization, and Adjusted EBITDA, which we define as EBITDA adjusted for restructuring and other charges/(income), separation-related costs and certain other losses/(gains). Management believes the use of these non-GAAP measures allows management and investors to compare more easily the financial performance of its underlying business from period to period. The non-GAAP information provided may not be comparable to similar measures disclosed by other companies because of differing methods used by other companies in calculating EBITDA and Adjusted EBITDA. These measures should not be considered as a substitute for net income or other measures of performance or liquidity reported in accordance with U.S. GAAP. The following table reconciles EBITDA and Adjusted EBITDA from net income.\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (in Millions) | 2021 | 2020 | 2021 | 2020 |\n| Net loss (GAAP) | $ | (12.6) | $ | (10.5) | $ | (6.9) | $ | (12.6) |\n| Add back: |\n| Interest expense, net | — | 0.3 | 0.3 | 0.3 |\n| Income tax expense/(benefit) | 15.4 | (3.1) | 13.8 | (5.4) |\n| Depreciation and amortization | 6.2 | 6.1 | 18.7 | 17.7 |\n| EBITDA (Non-GAAP) | 9.0 | (7.2) | 25.9 | — |\n| Add back: |\n| Certain Argentina remeasurement losses (a) | 0.9 | 1.5 | 4.2 | 4.4 |\n| Restructuring and other charges (b) | 1.1 | 4.4 | 3.4 | 10.1 |\n| Separation-related costs (c) | 0.8 | 0.6 | 1.3 | 0.8 |\n| COVID-19 related costs (d) | 1.9 | 1.7 | 4.2 | 1.7 |\n| Loss on debt extinguishment (e) | — | — | — | 0.1 |\n| Other gain/(loss) (f) | 1.2 | (0.1) | 3.0 | (0.4) |\n| Adjusted EBITDA (Non-GAAP) | $ | 14.9 | $ | 0.9 | $ | 42.0 | $ | 16.7 |\n\n___________________\na.Represents impact of currency fluctuations on tax assets and liabilities and on long-term monetary assets associated with our capital expansion as well as significant currency devaluations. The remeasurement gains/(losses) are included within \"Cost of sales\" in our condensed consolidated statement of operations but are excluded from our calculation of Adjusted EBITDA because of: i.) their nature as income tax related; ii.) their association with long-term capital projects which will not be operational until future periods; or iii.) the severity of the devaluations and their immediate impact on our operations in the country.\nb.We continually perform strategic reviews and assess the return on our business. This sometimes results in management changes or in a plan to restructure the operations of our business. As part of these restructuring plans, demolition costs and write-downs of long-lived assets may occur. Also includes transaction related legal fees and miscellaneous nonrecurring transactions. Three and nine months\n34\nended September 30, 2020 consists primarily of legal fees related to IPO securities litigation including a settlement accrual, net of insurance reimbursement, of $2.5 million in the third quarter. The IPO litigation settlement was finalized in the second quarter of 2021.\nc.Represents legal, professional, transaction-related fees and other separation-related activity.\nd.Represents incremental costs associated with COVID-19 recorded in \"Cost of sales\" in the condensed consolidated statement of operations, including but not limited to, incremental quarantine related absenteeism, incremental facility cleaning costs, COVID-19 testing, pandemic-related supplies and personal protective equipment for employees, among other costs; offset by economic relief provided by foreign governments.\ne.Represents the partial write off of deferred financing costs for the temporary reduction in borrowing capacity related to the First Amendment excluded from our calculation of Adjusted EBITDA because the loss is nonrecurring.\nf.Three and nine months ended September 30, 2021 represents our 25% indirect interest in transaction costs incurred for the Nemaska Transaction, certain project-related costs and interest expense, all included in Equity in net loss of unconsolidated affiliates in our condensed consolidated statement of operations. Three and nine months ended September 30, 2020 represents a portion of our nonrefundable prepaid research and development costs advanced to an unconsolidated affiliate in the fourth quarter 2019 and excluded from our calculation of Adjusted EBITDA in the same period because the costs represent research and development activities of the affiliate that had not occurred as of December 31, 2019. These costs were included with our calculation of Adjusted EBITDA for the three and nine months ended September 30, 2020 when the costs were incurred at the unconsolidated affiliate.\nThree Months Ended September 30, 2021 vs. 2020\nRevenue\nRevenue of $103.6 million for the three months ended September 30, 2021 (the \"2021 Quarter\") increased by approximately 43%, or $31 million, compared to $72.6 million for the three months ended September 30, 2020 (the \"2020 Quarter\") primarily due to higher lithium hydroxide, lithium carbonate and butyllithium sales volumes, driven by an increase in customer demand.\nGross margin\nGross margin of $18.3 million for the 2021 Quarter increased by $15.5 million, or approximately 554%, versus $2.8 million for the 2020 Quarter. The increase in gross margin was primarily due to higher lithium hydroxide, lithium carbonate and butyllithium sales volumes, partially offset by higher logistics, raw material and other operating costs.\nRestructuring and other charges\nRestructuring and other charges of $1.1 million for the 2021 Quarter decreased by $3.3 million versus $4.4 million for the 2020 Quarter. Restructuring and other charges for the 2020 Quarter consisted primarily of severance-related costs of $0.9 million, and legal fees related to IPO securities litigation including a settlement accrual, net of insurance reimbursement, of $2.5 million in the 2020 Quarter. The IPO litigation settlement was finalized in the second quarter of 2021. 2021 Quarter Restructuring and other charges consisted primarily of transaction related legal fees and miscellaneous nonrecurring transactions (see Note 7 for details).\nEquity in net loss of unconsolidated affiliates\nEquity in net loss of unconsolidated affiliates of $1.0 million for the 2021 Quarter arises out of our 25% interest in the Nemaska Project.\nInterest expense, net\nInterest expense of $0.3 million for the 2020 Quarter is noncash amortization of transaction costs related to the 2025 Notes which represents the excess interest over the amount of interest capitalized in accordance with U.S. GAAP for the 2020 Quarter. Interest of $3.8 million and $3.4 million for the 2021 Quarter and the 2020 Quarter, respectively was capitalized.\nIncome tax expense/(benefit)\nThe increase in income tax expense to $15.4 million for the 2021 Quarter compared to the income tax benefit of $(3.1) million for the 2020 Quarter, was primarily due to the fluctuations in foreign currency impacts in Argentina of $12.7 million and $(2.6) million for the three months ended September 30, 2021 and 2020, respectively. Within foreign currency impacts, Argentina tax law annually requires an increase to taxable income for inflationary adjustments in the period when the consumer price index fluctuates over a specific threshold, which was met in Q3 of 2021. Additionally, the increase in income tax expense was the result of an increase in income from operations.\nNet loss\nNet loss of $(12.6) million for the 2021 Quarter compared to net loss of $(10.5) million for the 2020 Quarter was primarily due to the an increase in the Argentina tax expense from inflationary tax adjustments, higher logistics, raw material and other\n35\noperating costs, and $1.0 million Equity in net loss of unconsolidated affiliates partially offset by higher lithium hydroxide, lithium carbonate and butyllithium sales volumes and lower Restructuring and other charges.\n36\nNine Months Ended September 30, 2021 vs. 2020\nRevenue\nRevenue of $297.5 million for the nine months ended September 30, 2021 (the \"2021 YTD\") increased by approximately 44%, or $91.5 million, compared to $206.0 million for the nine months ended September 30, 2020 (the \"2020 YTD\") primarily due to higher lithium hydroxide, lithium carbonate and butyllithium sales volumes, driven by an increase in customer demand.\nGross margin\nGross margin of $52.0 million for the 2021 YTD increased by $24.4 million, or approximately 88%, versus $27.6 million for the 2020 YTD. The increase in gross margin was primarily due higher lithium hydroxide, lithium carbonate and butyllithium sales volumes partially offset by COVID-19 costs to implement safety protocols and higher logistics, raw material and other operating costs.\nRestructuring and other charges\nRestructuring and other charges of $3.4 million for the 2021 YTD decreased by $6.7 million versus $10.1 million for the 2020 YTD. Restructuring and other charges for the 2020 YTD consisted of severance-related costs for management changes at certain operating and administrative facilities, exit costs of $1.6 million for the closing of leased office space and legal fees related to IPO securities litigation, including a settlement accrual, net of insurance reimbursement, of $2.5 million in the third quarter of 2020. The IPO litigation settlement was finalized in the second quarter of 2021. 2021 YTD Restructuring and other charges consisted primarily of environmental remediation, transaction related legal fees and miscellaneous nonrecurring costs (see Note 7 for details).\nEquity in net loss of unconsolidated affiliates\nEquity in net loss of unconsolidated affiliates of $3.7 million for the 2021 YTD arises out of our 25% interest in the Nemaska Project and includes $1.6 million of nonrecurring transaction costs incurred for the Nemaska Transaction by an unconsolidated affiliate.\nInterest expense, net\nInterest expense of $0.3 million for the 2021 YTD and 2020 YTD is noncash amortization of transaction costs related to the 2025 Notes which represents the excess interest over the amount of interest capitalized in accordance with U.S. GAAP for the 2021 YTD. Interest expense of $11.5 million and $8.1 million was capitalized in the 2021 YTD and 2020 YTD, respectively.\nIncome tax expense/(benefit)\nThe increase in income tax expense to $13.8 million for the 2021 YTD compared to the income tax benefit of $(5.4) million for the 2020 YTD, was primarily due to the fluctuations in foreign currency impacts in Argentina of $10.8 million and $(7.1) million for the nine months ended September 30, 2021 and 2020, respectively. Within foreign currency impacts, Argentina tax law annually requires an increase to taxable income for inflationary adjustments in the period when the consumer price index fluctuates over a specific threshold, which was met in Q3 of 2021. Additionally, the increase in tax expense was due to an increase in income from operations. The increase in income tax expense was partially offset by an Argentina income tax law, which was amended on June 16, 2021 to introduce new progressive corporate income tax rates from 25% to 35%. This change resulted in a tax benefit of $(2.2) million for the revaluation of Argentina net deferred tax assets for the nine months ended September 30, 2021.\nNet loss\nNet loss of $(6.9) million for the 2021 YTD compared to net loss of $(12.6) million for the 2020 YTD was primarily due to higher lithium hydroxide, lithium carbonate and butyllithium sales volumes and lower Restructuring and other charges, offset by an increase in the Argentina tax expense from inflationary tax adjustments, incremental COVID-19 costs to implement safety protocols, higher logistics, raw material and other operating costs and $3.7 million Equity in net loss of unconsolidated affiliates.\n37\nLIQUIDITY AND CAPITAL RESOURCES\nCash and cash equivalents at September 30, 2021 and December 31, 2020, were $195.3 million and $11.6 million, respectively. Of the cash and cash equivalents balance at September 30, 2021, $12.5 million were held by our foreign subsidiaries. The cash held by foreign subsidiaries for permanent reinvestment is generally used to finance the subsidiaries’ operating activities and future foreign investments. We have not provided additional income taxes for any additional outside basis differences inherent in our investments in subsidiaries because the investments are essentially permanent in duration or we have concluded that no additional tax liability will arise upon disposal. See Note 9, Part II, Item 8 of our 2020 Annual Report on Form 10-K for more information.\nRevolving Credit Facility\nThe Credit Agreement provides for a $400 million senior secured Revolving Credit Facility, $50 million of which is available for the issuance of letters of credit, with an option, subject to certain conditions and limitations, to increase the aggregate amount of the revolving credit commitments to $600 million. The issuance of letters of credit and the proceeds of revolving credit loans made pursuant to the Revolving Credit Facility are available, and will be used, for general corporate purposes, including capital expenditures and permitted acquisitions, See Note 10, Part II, Item 8 of our 2020 Annual Report on Form 10-K for more information.\nWe had $245.8 million and $281.4 million debt outstanding as of September 30, 2021 and December 31, 2020, respectively. Our September 30, 2021 debt outstanding was comprised solely of our 2025 Notes because in June 2021 we used a portion of the net proceeds from the Offering to repay all amounts outstanding under our Revolving Credit Facility. Among other restrictions, our Revolving Credit Facility contains financial covenants applicable to Livent and its consolidated subsidiaries related to leverage (measured as the ratio of debt to adjusted earnings) and interest coverage (measured as the ratio of adjusted earnings to interest expense). Our maximum allowable first lien leverage ratio is 3.5 as of September 30, 2021. Our minimum allowable interest coverage ratio is 3.5. We were in compliance with all covenants at September 30, 2021.\nStatement of Cash Flows\nCash provided by operating activities was $41.0 million and $1.5 million for the nine months ended September 30, 2021 and 2020, respectively.\nThe cash provided by operating activities for the 2021 YTD as compared to the cash provided by operating activities for the 2020 YTD was primarily driven by higher net income in the 2021 YTD and a decrease in payments of accounts payables in the 2021 YTD compared to the 2020 YTD.\nCash used in investing activities was $(74.3) million and $(111.8) million for the nine months ended September 30, 2021 and 2020, respectively.\nThe decrease in cash used in investing activities for the 2021 YTD compared to the 2020 YTD is primarily due to the Company's election to suspend all capital expansion work globally from March 2020 to the second quarter of 2021. The time lag of slowing down and subsequently ramping back up capital spending, resulted in decreased capital expenditures for capacity expansion of lithium carbonate and hydroxide during the nine months ended September 30, 2021.\nCash provided by financing activities was $216.9 million and $108.2 million for the nine months ended September 30, 2021 and 2020, respectively.\nNet cash proceeds for financing activities increased in the 2021 YTD compared to the 2020 YTD and was provided primarily by net proceeds of $252.2 million from the Offering, partially offset by the repayment of the outstanding balance of our Revolving Credit Facility in June 2021.\nOther potential liquidity needs\nWe plan to meet our liquidity needs through available cash, cash generated from operations, borrowings under the committed Revolving Credit Facility, and other potential financing strategies that may be available to us. At September 30, 2021, our remaining borrowing capacity under our Revolving Credit Facility, subject to meeting our debt covenants, is $385.6 million, including letters of credit utilization. Our overall borrowing capacity under the Revolving Credit Facility is $400 million as of September 30, 2021.\nWe expect the COVID-19 pandemic uncertainties, and lithium market challenges to continue in 2021. Our net leverage ratio is determined, in large part, by our ability to manage the timing and amount of our capital expenditures, which is within our\n38\ncontrol. It is also determined by our ability to achieve forecasted operating results and to pursue other working capital financing strategies that may be available to us, which is less certain and outside our control. In the first quarter of 2020, because of the significant practical constraints resulting from actions being taken by authorities around the word in response to the COVID-19 pandemic, the Company elected to suspend all capital expansion work globally. As of the second quarter of 2021, supported by partially reduced COVID-19 related constraints, additional commitments from customers and improved market conditions, Livent resumed its capital expansion work in Argentina and the United States. Based on this resumption, the Company estimates 2021 total capital spending to be $125 million.\nThe company remains focused on maintaining its financial flexibility and will continue to manage its cash flow and capital allocation decisions to navigate through this challenging environment.\nWe believe that our available cash and cash from operations, together with our borrowing availability under the Revolving Credit Facility and other potential financing strategies that may be available to us, will provide adequate liquidity for the next 12 months. Access to capital and the availability of financing on acceptable terms in the future will be affected by many factors, including our credit rating, economic conditions, the COVID-19 pandemic and the overall liquidity of capital markets and cannot be guaranteed.\n39\nCommitments and Contingencies\nSee Note 13 to these condensed consolidated financial statements included in this Quarterly Report on Form 10-Q.\nContractual Commitments\nInformation related to our contractual commitments at December 31, 2020 can be found in a table included within Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations within our 2020 Annual Report on Form 10-K. There have been no significant changes to our contractual commitments during the period ended September 30, 2021.\nClimate Change\nA detailed discussion related to climate change can be found in Part II, Item 7 of our 2020 Annual Report on Form 10-K.\nOff-Balance Sheet Arrangements\nWe do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.\nDERIVATIVE FINANCIAL INSTRUMENTS AND MARKET RISKS\nOur earnings, cash flows and financial position are exposed to market risks relating to fluctuations in commodity prices, interest rates and foreign currency exchange rates. Our policy is to minimize exposure to our cash flow over time caused by changes in interest and currency exchange rates. To accomplish this, we have implemented a controlled program of risk management consisting of appropriate derivative contracts entered into with major financial institutions.\nThe analysis below presents the sensitivity of the market value of our financial instruments to selected changes in market rates and prices. The range of changes chosen reflects our view of changes that are reasonably possible over a one-year period. Market value estimates are based on the present value of projected future cash flows considering the market rates and prices chosen.\nIn the second quarter of 2021, we placed foreign currency hedges for 2021 projected exposure.\nForeign Currency Exchange Rate Risk\nOur worldwide operations expose us to currency risk from sales, purchases, expenses and intercompany loans denominated in currencies other than the U.S. dollar, our functional currency. The primary currencies for which we have exchange rate exposure are the Euro, the British pound, the Chinese yuan, the Argentine peso, and the Japanese yen. Foreign currency debt and foreign exchange forward contracts are used in countries where we do business, thereby reducing our net asset exposure. Foreign exchange forward contracts are also used to hedge firm and highly anticipated foreign currency cash flows. We currently do not hedge foreign currency risks associated with the Argentine peso due to the limited availability and the high cost of suitable derivative instruments.\nTo analyze the effects of changing foreign currency rates, we have performed a sensitivity analysis in which we assume an instantaneous 10% change in the foreign currency exchange rates from their levels at the balance sheet date with all other variables (including interest rates) held constant. As of December 31, 2020, we had no open derivative cash flow hedge contracts.\n| Hedged Currency vs. Functional Currency |\n| (in Millions) | Net asset position on consolidated balance sheets | Net liability position with 10% strengthening | Net asset position with 10% weakening |\n| Net asset/(liability) position as of September 30, 2021 | $ | 0.1 | $ | (0.6) | $ | 0.6 |\n\nInterest Rate Risk\nOne of the strategies that we can use to manage interest rate exposure is to enter into interest rate swap agreements. In these agreements, we agree to exchange, at specified intervals, the difference between fixed and variable interest amounts calculated on an agreed-upon notional principal amount. As of September 30, 2021, we had no interest rate swap agreements.\nOur debt portfolio at September 30, 2021 is composed of fixed-rate and variable-rate debt; consisting of borrowings under our 2025 Notes and Revolving Credit Facility. Changes in interest rates affect different portions of our variable-rate debt portfolio in different ways. Based on the variable-rate debt in our debt portfolio at September 30, 2021, a one percentage point increase or decrease in interest rates would have increased or decreased, respectively, gross interest expense by $0.2 million for the nine months ended September 30, 2021.\n40\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nThe information required by this item is provided in “Derivative Financial Instruments and Market Risks,” under Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations.\nITEM 4. CONTROLS AND PROCEDURES\n(a) Evaluation of disclosure controls and procedures. Based on management’s evaluation (with the participation of the company’s Chief Executive Officer and Chief Financial Officer), the Chief Executive Officer and Chief Financial Officer have concluded that, as of September 30, 2021, the company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) are effective to provide reasonable assurance that information required to be disclosed by the Company in reports filed or submitted under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and is accumulated and communicated to management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.\n(b) Change in Internal Controls. There have been no changes in internal control over financial reporting that occurred during the quarter ended September 30, 2021, that materially affected or are reasonably likely to materially affect, our internal control over financial reporting.\n41\nPART II - OTHER INFORMATION\n\nITEM 1. LEGAL PROCEEDINGS\nWe are involved in legal proceedings from time to time in the ordinary course of our business, including with respect to workers’ compensation matters. Based on information currently available and established reserves, we have no reason to believe that the ultimate resolution of any known legal proceeding will have a material adverse effect on our financial position, liquidity or results of operations. However, there can be no assurance that the outcome of any such legal proceeding will be favorable, and adverse results in certain of these legal proceedings could have a material adverse effect on our financial position, results of operations in any one reporting period, or liquidity. Except as set forth in Note 13 to our financial statements, which is incorporated herein by reference to the extent applicable, there are no material changes from the legal proceedings previously disclosed in our 2020 Annual Report on Form 10-K.\nITEM 1A. RISK FACTORS\nIn addition to the other information set forth in this Quarterly Report on Form 10-Q, you should carefully consider the risk factors discussed in Part I, Item 1A of our 2020 Annual Report on Form 10-K, which is available at www.sec.gov and on our website at www.livent.com. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may adversely affect our business, financial condition or future results.\nForward-Looking Information\nWe wish to caution readers not to place undue reliance on any forward-looking statements contained herein, which speak only as of the date made. We specifically decline to undertake any obligation to publicly revise any forward-looking statements that have been made to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nRepurchases of Common Shares\nA summary of our repurchases of Livent's common stock for the three months ended September 30, 2021 is as follows:\n| ISSUER PURCHASES OF EQUITY SECURITIES |\n| Period | Total Number of Shares Purchased (1) | Average Price Paid Per Share | Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs (2) | Maximum Number of Shares That May Yet Be Purchased Under the Plans or Programs (2) |\n| July 1 through July 31, 2021 | 206 | $ | 19.52 | $ | — | $ | — |\n| August 1 through August 31, 2021 | 187 | $ | 24.22 | — | — |\n| September 1 through September 30, 2021 | 172 | $ | 24.64 | — | — |\n| Total Q3 2021 | 565 | $ | 22.64 | $ | — | $ | — |\n\n(1) The trustee of the Livent NQSP reacquires shares of Livent common stock from time to time through open-market purchases relating to investments by employees in our common stock, one of the investment options available under the Livent NQSP. Such shares are held in a trust fund and recorded to Treasury stock in our condensed consolidated balance sheets.\n(2) We have no publicly announced stock repurchase programs.\n42\nITEM 6. EXHIBITS\n| 31.1 | Certifying Statement of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2 | Certifying Statement of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1 | Certifying Statement of the Chief Executive Officer pursuant to Section 1350 of Title 18 of the United States Code |\n| 32.2 | Certifying Statement of the Chief Financial Officer pursuant to Section 1350 of Title 18 of the United States Code |\n| 101 | Interactive Data File |\n| 104 | The cover page from Livent Corporation’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2021, formatted in Inline XBRL. |\n\n43\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n| LIVENT CORPORATION(Registrant) |\n| By: | /s/ GILBERTO ANTONIAZZI |\n| Gilberto Antoniazzi,Vice President and Chief Financial Officer |\n\nDate: November 4, 2021\n44\n</text>\n\nWhat is the percentage change in operating cash flow to net loss ratio from the year 2020 to 2021?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1.\nFinancial Statements\nUnaudited Condensed Balance Sheets 1\nUnaudited Condensed Statements of Operations 2\nUnaudited Condensed Statements of Changes in Shareholders’ Deficit 3\nUnaudited Condensed Statements of Cash Flows 4\nNotes to Unaudited Condensed Financial Statements 5\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 18\nItem 3. Quantitative and Qualitative Disclosures about Market Risk 22\nItem 4. Control and Procedures 22\nPART II – OTHER INFORMATION\nItem 1. Legal Proceedings 23\nItem 1A. Risk Factors 23\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds 23\nItem 3. Defaults Upon Senior Securities 24\nItem 4. Mine Safety Disclosures 24\nItem 5. Other Information 24\nItem 6. Exhibits 24\nSIGNATURES 25\ni\nPART I – FINANCIAL INFORMATION\nINCEPTION GROWTH ACQUISITION LIMITED\nUNAUDITED CONDENSED BALANCE SHEETS\n(Currency expressed in United States Dollars (“US$”), except for number of shares)\n\n| June 30, 2022 | December 31, 2021 |\n| (Audited) |\n| ASSETS |\n| Current assets: |\n| Cash | $ | 787,449 | $ | 1,365,181 |\n| Prepayments | 313,083 | 404,762 |\n| Total current assets | 1,100,532 | 1,769,943 |\n| Cash and investments held in trust account | 104,710,586 | 104,535,351 |\n| TOTAL ASSETS | $ | 105,811,118 | $ | 106,305,294 |\n| LIABILITIES, TEMPORARY EQUITY AND SHAREHOLDERS’ DEFICIT |\n| Current liabilities: |\n| Accrued liabilities | $ | 97,106 | $ | 475,948 |\n| Advances from a related party | 118,267 | 10,253 |\n| Total current liabilities | 215,373 | 486,201 |\n| Deferred underwriting compensation | 2,587,500 | 2,587,500 |\n| TOTAL LIABILITIES | 2,802,873 | 3,073,701 |\n| Commitments and contingencies |\n| Common stock, subject to possible redemption: 10,350,000 shares (at redemption value of $ 10.12 and $ 10.10 per share) | 104,710,586 | 104,535,000 |\n| Shareholders’ deficit: |\n| Common stock, $ 0.0001 par value; 26,000,000 shares authorized; 2,637,500 shares issued and outstanding (excluding 10,350,000 shares subject to possible redemption) | 264 | 264 |\n| Accumulated other comprehensive income | 158,483 | - |\n| Accumulated deficit | ( 1,861,088 | ) | ( 1,303,671 | ) |\n| Total shareholders’ deficit | ( 1,702,341 | ) | ( 1,303,407 | ) |\n| TOTAL LIABILITIES, TEMPORARY EQUITY AND SHAREHOLDERS’ DEFICIT | $ | 105,811,118 | $ | 106,305,294 |\n\nSee accompanying notes to unaudited condensed financial statements.\n1\nINCEPTION GROWTH ACQUISITION LIMITED\nUNAUDITED CONDENSED STATEMENT OF OPERATIONS\n(Currency expressed in United States Dollars (“US$”), except for number of shares)\n\n| Three months ended June 30, 2022 | Three months ended June 30, 2021 | Six months ended June 30, 2022 | From March 4, 2021 (date of inception) to June 30, 2021 |\n| Formation, general and administrative expenses | $ | ( 170,157 | ) | $ | ( 52,524 | ) | $ | ( 398,583 | ) | $ | ( 52,524 | ) |\n| Other income: |\n| Dividend income | 6,225 | - | 16,752 | - |\n| Total other income, net | 6,225 | - | 16,752 | - |\n| Loss before income taxes | ( 163,932 | ) | ( 52,524 | ) | ( 381,831 | ) | ( 52,524 | ) |\n| Income taxes | - | - | - | - |\n| NET LOSS | $ | ( 163,932 | ) | $ | ( 52,524 | ) | $ | ( 381,831 | ) | $ | ( 52,524 | ) |\n| Other comprehensive income |\n| Unrealized gain on available-for-sale securities | 158,483 | - | 158,483 | - |\n| COMPREHENSIVE LOSS | $ | ( 5,449 | ) | $ | ( 52,524 | ) | $ | ( 223,348 | ) | $ | ( 52,524 | ) |\n| Basic and diluted weighted average shares outstanding, common stock subject to possible redemption | 10,035,000 | - | 10,035,000 | - |\n| Basic and diluted net loss per share, common stock subject to possible redemption | $ | ( 0.01 | ) | $ | - | $ | ( 0.03 | ) | $ | - |\n| Basic and diluted weighted average shares outstanding, common stock attributable to Inception Growth Acquisition Limited | 2,637,500 | 2,250,000 | 2,637,500 | $ | 2,250,000 |\n| Basic and diluted net loss per share, common stock attributable to Inception Growth Acquisition Limited | $ | ( 0.03 | ) | $ | ( 0.02 | ) | $ | ( 0.04 | ) | $ | ( 0.02 | ) |\n\nSee accompanying notes to unaudited condensed financial statements.\n2\nINCEPTION GROWTH ACQUISITION LIMITED\nUNAUDITED CONDENSED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY (DEFICIT)\n(Currency expressed in United States Dollars (“US$”), except for number of shares)\n\n| Ordinary shares | Accumulated other | Total |\n| No. of shares | Amount | comprehensive income | Accumulated deficit | shareholders’ deficit |\n| Balance as of January 1, 2022 | 2,637,500 | $ | 264 | $ | - | $ | ( 1,303,671 | ) | $ | ( 1,303,407 | ) |\n| Accretion of carrying value to redemption value | - | - | - | ( 10,878 | ) | ( 10,878 | ) |\n| Net loss | - | - | - | ( 217,899 | ) | ( 217,899 | ) |\n| Balance as of March 31, 2022 | 2,637,500 | 264 | - | ( 1,532,448 | ) | ( 1,532,184 | ) |\n| Accretion of carrying value to redemption value | - | - | - | ( 164,708 | ) | ( 164,708 | ) |\n| Unrealized gain on available-for-sale securities | - | - | 158,483 | - | 158,483 |\n| Net loss | - | - | - | ( 163,932 | ) | ( 163,932 | ) |\n| Balance as of June 30, 2022 | 2,637,500 | $ | 264 | $ | 158,483 | $ | ( 1,861,088 | ) | $ | ( 1,702,341 | ) |\n\n\n| Ordinary shares | Additional | Total |\n| No. of shares | Amount | paid-in capital | Accumulated deficit | shareholders’ deficit |\n| Balance as of March 4, 2021 (inception) | - | $ | - | $ | - | $ | - | $ | - |\n| Issuance of common stock to founders | 2,587,500 | 259 | 24,741 | - | 25,000 |\n| Balance as of March 31, 2021 | 2,587,500 | 259 | 24,741 | - | 25,000 |\n| Net loss | - | - | - | ( 52,524 | ) | ( 52,524 | ) |\n| Balance as of June 30, 2021 | 2,587,500 | $ | 259 | $ | 24,741 | $ | ( 52,524 | ) | $ | ( 27,524 | ) |\n\nSee accompanying notes to unaudited condensed financial statements.\n3\nINCEPTION GROWTH ACQUISITION LIMITED\nUNAUDITED CONDENSED STATEMENT OF CASH FLOWS\n(Currency expressed in United States Dollars (“US$”))\n\n| Six months ended June 30, 2022 | March 4, 2021 (date of inception) to June 30, 2021 |\n| Cash flows from operating activities |\n| Net loss | $ | ( 381,831 | ) | ( 52,524 | ) |\n| Adjustments to reconcile net loss to net cash used in operating activities |\n| Interest income and dividend income earned in cash and investments income held in trust account | ( 16,752 | ) | - |\n| Change in operating assets and liabilities: |\n| Decrease in prepayment | 91,679 | - |\n| Increase (decrease) in accrued liabilities | ( 378,842 | ) | - |\n| Net cash used in operating activities | ( 685,746 | ) | ( 52,524 | ) |\n| Cash flows from financing activities |\n| Proceed from issuance of common stock | - | 25,000 |\n| Advance from a related party | 108,014 | 27,524 |\n| Net cash provided by financing activities | 108,014 | 52,524 |\n| NET CHANGE IN CASH | ( 577,732 | ) | - |\n| Cash, beginning of period | 1,365,181 | - |\n| Cash, end of period | $ | 787,449 | $ | - |\n| SUPPLEMENTAL DISCLOSURE OF NON-CASH FINANCING ACTIVITIES: |\n| Accretion of carrying value to redemption value | $ | ( 175,586 | ) | $ | - |\n| Deferred offering costs paid by a related party | $ | - | $ | 190,000 |\n\nSee accompanying notes to unaudited condensed financial statements.\n4\nINCEPTION GROWTH ACQUISITION LIMITED\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\n(Currency expressed in United States Dollars (“US$”), except for number of shares)\nNOTE 1 – ORGANIZATION AND BUSINESS BACKGROUND\nInception Growth Acquisition Limited (the “Company”) is a newly organized blank check company incorporated on March 4, 2021, under the laws of the State of Delaware for the purpose of acquiring, engaging in a share exchange, share reconstruction and amalgamation, purchasing all or substantially all of the assets of, entering into contractual arrangements, or engaging in any other similar business combination with one or more businesses or entities (“Business Combination”).\nAlthough the Company is not limited to a particular industry or geographic region for purposes of consummating a Business Combination, the Company intends to focus on businesses that have a connection to the Asian market and shall not undertake an initial business combination with any entity with its principal business operations in China (including Hong Kong and Macau). The Company is an early stage and emerging growth company and, as such, the Company is subject to all of the risks associated with early stage and emerging growth companies. The Company has selected December 31 as its fiscal year end.\nAt June 30, 2022, the Company had not yet commenced any operations. All activities through December 13, 2021 relate to the Company’s formation and the initial public offering (the “Initial Public Offering”). Since the Initial Public Offering, the Company’s activity has been limited to the evaluation of business combination candidates. The Company will not generate any operating revenues until after the completion of a Business Combination, at the earliest. The Company will generate non-operating income in the form of interest income from the proceeds derived from the Initial Public Offering.\nFinancing\nThe registration statement for the Company’s Initial Public Offering became effective on December 8, 2021. On December 13, 2021, the Company consummated the Initial Public Offering of 10,350,000 ordinary units (the “Public Units”), which includes the full exercise by the underwriter of its over-allotment option in the amount of 1,350,000 Public Units, at $ 10.00 per Public Unit, generating gross proceeds of $ 103,500,000 which is described in Note 4.\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the sale of 4,721,250 Warrants (the “Private Warrants”) at a price of $ 1.00 per warrant in a private placement to Soul Venture Partners LLC (the “Sponsor”), generating gross proceeds of $ 4,721,250 , which is described in Note 5.\nTransaction costs amounted to $ 4,832,697 , consisting of $ 1,811,250 of underwriting fees, $ 2,587,500 of deferred underwriting fees and $ 433,947 of other offering costs. In addition, at December 13, 2021, cash of $ 1,498,937 were held outside of the Trust Account (as defined below) and is available for the payment of offering costs and for working capital purposes net with $ 104,535,000 transferred to the Trust Account on December 13, 2021.\nTrust Account\nFollowing the closing of the Initial Public Offering and exercise of the over-allotment option on December 13, 2021, the aggregate amount of 104,535,000 ($ 10.10 per Public Unit) held in Trust Account was invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, with a maturity of 185 days or less, or in any open-ended investment company that holds itself out as a money market fund meeting certain conditions of Rule 2a-7 of the Investment Company Act, as determined by the Company, until the earlier of: (i) the completion of a Business Combination and (ii) the distribution of the funds in the Trust Account to the Company’s stockholders, as described below, except that interest earned on the Trust Account can be released to the Company to pay its tax obligations.\nBusiness Combination\nThe Company’s management has broad discretion with respect to the specific application of the net proceeds of the Initial Public Offering and sale of the Private Warrants, although substantially all of the net proceeds are intended to be applied generally toward consummating a Business Combination. NASDAQ rules provide that the Business Combination must be with one or more target businesses that together have a fair market value equal to at least 80 % of the balance in the Trust Account (as defined below) (less any deferred underwriting commissions and taxes payable on interest earned) at the time of the signing of an agreement to enter into a Business Combination. The Company will only complete a Business Combination if the post-Business Combination company owns or acquires 50 % or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act of 1940, as amended (the “Investment Company Act”). There is no assurance that the Company will be able to successfully effect a Business Combination.\n5\nThe Company will provide its stockholders with the opportunity to redeem all or a portion of their Public Shares upon the completion of a Business Combination either (i) in connection with a stockholder meeting called to approve the Business Combination or (ii) by means of a tender offer. In connection with an Initial Business Combination, the Company may seek stockholder approval of a Business Combination at a meeting called for such purpose at which stockholders may seek to redeem their shares, regardless of whether they vote for or against a Business Combination. The Company will proceed with a Business Combination only if the Company has net tangible assets of at least $ 5,000,001 upon such consummation of a Business Combination and, if the Company seeks stockholder approval, a majority of the outstanding shares voted are voted in favor of the Business Combination.\nNotwithstanding the foregoing, if the Company seeks stockholder approval of a Business Combination and it does not conduct redemptions pursuant to the tender offer rules, the Company’s Amended and Restated Memorandum and Articles of Association provides that a public stockholder, together with any affiliate of such stockholder or any other person with whom such stockholder is acting in concert or as a “group” (as defined under Section 13 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), will be restricted from seeking redemption rights with respect to 15 % or more of the Public Shares without the Company’s prior written consent.\nIf a stockholder vote is not required and the Company does not decide to hold a stockholder vote for business or other legal reasons, the Company will, pursuant to its Amended and Restated Memorandum and Articles of Association, offer such redemption pursuant to the tender offer rules of the Securities and Exchange Commission (“SEC”), and file tender offer documents containing substantially the same information as would be included in a proxy statement with the SEC prior to completing a Business Combination.\nThe stockholders will be entitled to redeem their Public Shares for a pro rata portion of the amount then in the Trust Account (initially $ 10.10 per Public Share, subject to increase of up to an additional $ 0.30 per Public Share in the event that the Sponsor elects to extend the period of time to consummate a Business Combination (see below), plus any pro rata interest earned on the funds held in the Trust Account and not previously released to the Company to pay its tax obligations). The per-share amount to be distributed to stockholders who redeem their Public Shares will not be reduced by the deferred underwriting commissions the Company will pay to the underwriter (as discussed in Note 9). There will be no redemption rights upon the completion of a Business Combination with respect to the Company’s rights or warrants. The common stock will be recorded at redemption value and classified as temporary equity upon the completion of the Initial Public Offering, in accordance with Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity” (“ASC 480”).\nThe Company will proceed with a Business Combination if the Company has net tangible assets of at least $ 5,000,001 upon such consummation of a Business Combination and, if the Company seeks stockholder approval, a majority of the outstanding shares voted are voted in favor of the Business Combination. If a stockholder vote is not required and the Company does not decide to hold a stockholder vote for business or other legal reasons, the Company will, pursuant to its Amended and Restated Certificate of Incorporation, offer such redemption pursuant to the tender offer rules of the Securities and Exchange Commission (“SEC”), and file tender offer documents containing substantially the same information as would be included in a proxy statement with the SEC prior to completing a Business Combination.\nThe Sponsor and any of the Company’s officers or directors that may hold Founder Shares (as defined in Note 7) (the “stockholders”) and the underwriters will agree (a) to vote their Founder Shares, the common stock included in the Private Units (the “Private Shares”) and any Public Shares purchased during or after the Initial Public Offering in favor of a Business Combination, (b) not to propose an amendment to the Company’s Amended and Restated Memorandum and Articles of Association with respect to the Company’s pre-Business Combination activities prior to the consummation of a Business Combination unless the Company provides dissenting public stockholders with the opportunity to redeem their Public Shares in conjunction with any such amendment; (c) not to redeem any shares (including the Founder Shares) and Private Shares into the right to receive cash from the Trust Account in connection with a stockholder vote to approve a Business Combination (or to sell any shares in a tender offer in connection with a Business Combination if the Company does not seek stockholder approval in connection therewith) or a vote to amend the provisions of the Amended and Restated Memorandum and Articles of Association relating to stockholders’ rights of pre-Business Combination activity and (d) that the Founder Shares and Private Shares shall not participate in any liquidating distributions upon winding up if a Business Combination is not consummated. However, the stockholders will be entitled to liquidating distributions from the Trust Account with respect to any Public Shares purchased during or after the Initial Public Offering if the Company fails to complete its Business Combination.\n6\nThe Company will have until March 13, 2023 to consummate a Business Combination. However, if the Company anticipates that it may not be able to consummate a Business Combination within 15 months, the Company may extend the period of time to consummate a Business Combination up to two times, each by an additional three months each time (for a total of 21 months to complete a Business Combination (the “Combination Period”). In order to extend the time available for the Company to consummate a Business Combination, the Sponsor or its affiliate or designees must deposit into the Trust Account $ 1,035,000 (approximately $ 0.1 per Public Share), on or prior to the date of the applicable deadline, for each three months extension. Any funds which may be provided to extend the time frame will be in the form of a loan to us from the sponsor. The terms of any such loan have not been definitely negotiated, provided, however, any loan will be interest free and will be repayable only if we compete a business combination.\nLiquidation\nIf the Company is unable to complete a Business Combination within the Combination Period, the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but no more than ten business days thereafter, redeem 100% of the outstanding Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including interest earned (net of taxes payable and less interest to pay dissolution expenses up to $50,000), divided by the number of then outstanding Public Shares, which redemption will completely extinguish public stockholders’ rights as stockholders (including the right to receive further liquidation distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the remaining stockholders and the Company’s board of directors, proceed to commence a voluntary liquidation and thereby a formal dissolution of the Company, subject in each case to its obligations to provide for claims of creditors and the requirements of applicable law. The underwriter has agreed to waive its rights to the deferred underwriting commission held in the Trust Account in the event the Company does not complete a Business Combination within the Combination Period and, in such event, such amounts will be included with the funds held in the Trust Account that will be available to fund the redemption of the Public Shares. In the event of such distribution, it is possible that the per share value of the assets remaining available for distribution will be less than the Initial Public Offering price per Unit ($ 10.00 ).\nThe Sponsor has agreed that it will be liable to the Company, if and to the extent any claims by a vendor for services rendered or products sold to the Company, or a prospective target business with which the Company has discussed entering into a transaction agreement, reduce the amounts in the Trust Account to below (i) $ 10.10 per share or (ii) such lesser amount per Public Share held in the Trust Account as of the date of the liquidation of the Trust Account due to reductions in the value of the trust assets, except as to any claims by a third party who executed a waiver of any and all rights to seek access to the Trust Account and except as to any claims under the Company’s indemnity of the underwriters of the Initial Public Offering against certain liabilities, including liabilities under the Securities Act of 1933, as amended (the “Securities Act”). In the event that an executed waiver is deemed to be unenforceable against a third party, the Sponsor will not be responsible to the extent of any liability for such third-party claims. The Company will seek to reduce the possibility that the Sponsor will have to indemnify the Trust Account due to claims of creditors by endeavoring to have all vendors, service providers, prospective target businesses or other entities with which the Company does business, execute agreements with the Company waiving any right, title, interest or claim of any kind in or to monies held in the Trust Account.\nLiquidity and capital resources\nFollowing the closing of the Initial Public Offering on December 13, 2021, a total of $ 103,500,000 was placed in the Trust Account, and the Company had $ 1,498,937 of cash held outside of the Trust Account, after payment of costs related to the Initial Public Offering, and available for working capital purposes. As of June 30, 2022, the Company had a working capital equity of $ 885,159 . The Company has incurred and expects to continue to incur significant costs in pursuit of its acquisition plans. Based on the foregoing, the Company believes it will have sufficient cash to meet its needs to execute its intended initial Business Combination in the next twelve months from the date of the issuance of the accompanying unaudited condensed consolidated financial statements.\nIf the Company is unable to raise additional capital, it may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, and reducing overhead expenses. The Company cannot provide any assurance that new financing will be available to it on commercially acceptable terms, if at all. These conditions raise substantial doubt about the Company’s ability to continue as a going concern through one year from the date of these unaudited condensed consolidated financial statements if a Business Combination is not consummated. These unaudited condensed consolidated financial statements do not include any adjustments relating to the recovery of the recorded assets or the classification of the liabilities that might be necessary should the Company be unable to continue as a going concern.\nNOTE 2 – SIGNIFICANT ACCOUNTING POLICIES\n\n| ● | Basis of presentation |\n\nThese accompanying unaudited condensed financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”) and pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). The interim financial information provided is unaudited, but includes all adjustments which management considers necessary for the fair presentation of the results for these periods. Operating results for the interim period ended June 30, 2022 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2022. The information included in this Form 10-Q should be read in conjunction with Management’s Discussion and Analysis, and the audited financial statements and notes thereto included in the Company’s Form 10-K for the fiscal year ended December 31, 2021, filed with the SEC on March 31, 2022.\n7\n\n| ● | Emerging growth company |\n\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the independent registered public accounting firm attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\n\n| ● | Use of estimates |\n\nIn preparing these unaudited condensed financial statements in conformity with U.S. GAAP, management makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited condensed financial statements and the reported expenses during the reporting period.\nMaking estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the unaudited condensed financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. Accordingly, Actual results may differ from these estimates.\n\n| ● | Cash |\n\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did not have any cash equivalents as of June 30, 2022 and December 31, 2021.\n\n| ● | Cash and investment held in trust account |\n\nAt June 30, 2022, the assets held in the Trust Account are held in cash and US Treasury securities. Investment securities in the Company’s Trust Account consisted of $ 104,699,165 in United States Treasury Bills and $ 11,421 in cash. At December 31, 2021, investment securities in the Company’s Trust Account consisted of $ 104,535,263 in United States Treasury Bills and $ 88 in cash.\nThe Company classifies marketable securities as available-for-sale at the time of purchase and reevaluates such classification as of each balance sheet date. All marketable securities are recorded at their estimated fair value. Unrealized gains and losses for available-for-sale securities are recorded in other comprehensive income. The Company evaluates its investments to assess whether those with unrealized loss positions are other than temporarily impaired. Impairments are considered other than temporary if they are related to deterioration in credit risk or if it is likely the Company will sell the securities before the recovery of the cost basis. Realized gains and losses and declines in value determined to be other than temporary are determined based on the specific identification method and are reported in other income (expense), net in the statements of operations.\n8\n\n| ● | Deferred offering costs |\n\nDeferred offering costs consist of underwriting, legal, accounting and other expenses incurred through the balance sheet date that are directly related to the Initial public Offering and that were charged to shareholders’ equity upon the completion of the Initial Public Offering.\n\n| ● | Warrant accounting |\n\nThe Company accounts for warrants as either equity-classified or liability-classified instruments based on an assessment of the warrant’s specific terms and applicable authoritative guidance in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 480, “Distinguishing Liabilities from Equity” (“ASC 480”) and ASC 815, “Derivatives and Hedging” (“ASC 815”). The assessment considers whether the warrants are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and whether the warrants meet all of the requirements for equity classification under ASC 815, including whether the warrants are indexed to the Company’s own common stock and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of the Company’s control, among other conditions for equity classification. This assessment, which requires the use of professional judgment, is conducted at the time of warrant issuance and as of each subsequent quarterly period end date while the warrants are outstanding.\nFor issued or modified warrants that meet all of the criteria for equity classification, the warrants are required to be recorded as a component of equity at the time of issuance. For issued or modified warrants that do not meet all the criteria for equity classification, the warrants are required to be recorded as liabilities at their initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of the warrants are recognized as a non-cash gain or loss on the statements of operations.\nAs the warrants issued upon the IPO and private placements meet the criteria for equity classification under ASC 480, therefore, the warrants are classified as equity.\n\n| ● | Common stock subject to possible redemption |\n\nThe Company accounts for its common stock subject to possible redemption in accordance with the guidance in ASC Topic 480. Common stocks subject to mandatory redemption (if any) are classified as a liability instrument and are measured at fair value. Conditionally redeemable common stocks (including common stocks that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) are classified as temporary equity. At all other times, common stocks are classified as shareholders’ equity. The Company’s common stocks feature certain redemption rights that are subject to the occurrence of uncertain future events and considered to be outside of the Company’s control. Accordingly, at June 30, 2022 and December 31, 2021, 10,350,000 shares of common stock subject to possible redemption, respectively, are presented as temporary equity, outside of the shareholders’ equity section of the Company’s balance sheet.\n\n| ● | Offering costs |\n\nThe Company complies with the requirements of the ASC 340-10-S99-1 and SEC Staff Accounting Bulletin (“SAB”) Topic 5A – “Expenses of Offering”. Offering costs consist principally of professional and registration fees incurred through the balance sheet date that are related to the Public Offering and that were charged to shareholders’ equity upon the completion of the Public Offering.\n\n| ● | Fair value of financial instruments |\n\nASC Topic 820 “Fair Value Measurements and Disclosures” (“ASC 820”) defines fair value, the methods used to measure fair value and the expanded disclosures about fair value measurements. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between the buyer and the seller at the measurement date. In determining fair value, the valuation techniques consistent with the market approach, income approach and cost approach shall be used to measure fair value. ASC 820 establishes a fair value hierarchy for inputs, which represents the assumptions used by the buyer and seller in pricing the asset or liability. These inputs are further defined as observable and unobservable inputs. Observable inputs are those that buyer and seller would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs reflect the Company’s assumptions about the inputs that the buyer and seller would use in pricing the asset or liability developed based on the best information available in the circumstances.\n9\nThe fair value hierarchy is categorized into three levels based on the inputs as follows:\nLevel 1 — Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access. Valuation adjustments and block discounts are not being applied. Since valuations are based on quoted prices that are readily and regularly available in an active market, the valuation of these securities does not entail a significant degree of judgment.\nLevel 2 — Valuations based on (i) quoted prices in active markets for similar assets and liabilities, (ii) quoted prices in markets that are not active for identical or similar assets, (iii) inputs other than quoted prices for the assets or liabilities, or (iv) inputs that are derived principally from or corroborated by the market through correlation or other means.\nLevel 3 — Valuations based on inputs that are unobservable and significant to the overall fair value measurement.\nThe fair value of the Company’s certain assets and liabilities, which qualify as financial instruments under ASC 820, “Fair Value Measurements and Disclosures,” approximates the carrying amounts represented in the balance sheet. The fair values of cash and cash equivalents, and other current assets, accrued expenses, due to the sponsor are estimated to approximate the carrying values as of June 30, 2022 due to the short maturities of such instruments. See Note 8 for the disclosure of the Company’s assets and liabilities that were measured at fair value on a recurring basis.\n\n| ● | Income taxes |\n\nThe Company complies with the accounting and reporting requirements of ASC Topic 740, “Income Taxes” (“ASC 740), which requires an asset and liability approach to financial accounting and reporting for income taxes. Deferred income tax assets and liabilities are computed for differences between the financial statement and tax bases of assets and liabilities that will result in future taxable or deductible amounts, based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.\nASC 740 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of June 30, 2022 and December 31, 2021. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position.\nThe Company may be subject to potential examination by federal, state and city taxing authorities in the areas of income taxes. These potential examinations may include questioning the timing and amount of deductions, the nexus of income among various tax jurisdictions and compliance with federal, state and city tax laws. The Company’s management does not expect that the total amount of unrecognized tax benefits will materially change over the next twelve months.\nThe provision for annual franchise taxes, based on the number of shares of our common stock authorized and outstanding after the completion of the IPO for the six months ended June 30, 2022 and 2021 were $ 48,535 and $ 0 , respectively.\nThe provision for income taxes was deemed to be immaterial for the six months ended June 30, 2022 and 2021.\n10\n\n| ● | Net loss per share |\n\nThe Company calculates net loss per share in accordance with ASC Topic 260, “Earnings per Share.” In order to determine the net income (loss) attributable to both the redeemable shares and non-redeemable shares, the Company first considered the undistributed income (loss) allocable to both the redeemable common stock and non-redeemable common stock and the undistributed income (loss) is calculated using the total net loss less any dividends paid. The Company then allocated the undistributed income (loss) ratably based on the weighted average number of shares outstanding between the redeemable and non-redeemable common stock. Any remeasurement of the accretion to the redemption value of the common stock subject to possible redemption was considered to be dividends paid to the public stockholders. As of June 30, 2022, the Company has not considered the effect of the warrants sold in the Initial Public Offering and private warrants to purchase an aggregate of 9,896,250 shares in the calculation of diluted net loss per share, since the exercise of the warrants is contingent upon the occurrence of future events and the inclusion of such warrants would be anti-dilutive and the Company did not have any other dilutive securities and other contracts that could, potentially, be exercised or converted into common stock and then share in the earnings of the Company. As a result, diluted loss per share is the same as basic loss per share for the period presented.\nThe net income (loss) per share presented in the statement of operations is based on the following:\n\n| For the Three Months Ended | For the Three Months Ended |\n| June 30, 2022 | June 30, 2021 |\n| Net loss | $ | ( 163,932 | ) | $ | ( 52,524 | ) |\n| Accretion of carrying value to redemption value | ( 164,708 | ) | - |\n| Net loss including accretion of carrying value to redemption value | $ | ( 328,640 | ) | $ | ( 52,524 | ) |\n\n\n| For the Six Months Ended | From March 4, 2021 (date of inception) to |\n| June 30, 2022 | June 30, 2021 |\n| Net loss | $ | ( 381,831 | ) | $ | ( 52,524 | ) |\n| Accretion of carrying value to redemption value | ( 175,586 | ) | - |\n| Net loss including accretion of carrying value to redemption value | $ | ( 557,417 | ) | $ | ( 52,524 | ) |\n\n\n| For the six months ended June 30, 2022 | For the six months ended June 30, 2021 |\n| Redeemable ordinary shares | Non- Redeemable ordinary shares | Redeemable ordinary shares | Non-Redeemable ordinary shares |\n| Basic and diluted net loss per share: |\n| Numerators: |\n| Allocation of net loss including carrying value to redemption value | $ | ( 444,217 | ) | $ | ( 113,200 | ) | $ | - | $ | ( 52,524 | ) |\n| Accretion of carrying value to redemption value | 175,586 | - | - | - |\n| Allocation of net loss | $ | ( 268,631 | ) | $ | ( 113,200 | ) | $ | - | $ | ( 52,524 | ) |\n| Denominators: |\n| Weighted-average shares outstanding | 10,350,000 | 2,637,500 | - | 2,250,000 |\n| Basic and diluted net loss per share | $ | ( 0.03 | ) | $ | ( 0.04 | ) | $ | - | $ | ( 0.00 | ) |\n\n11\n\n| For the three months ended June 30, 2022 | For the three months ended June 30, 2021 |\n| Redeemable ordinary shares | Non- Redeemable ordinary shares | Redeemable ordinary shares | Non-Redeemable ordinary shares |\n| Basic and diluted net loss per share: |\n| Numerators: |\n| Allocation of net loss including carrying value to redemption value | $ | ( 261,900 | ) | $ | ( 66,740 | ) | $ | - | $ | ( 52,524 | ) |\n| Accretion of carrying value to redemption value | 164,708 | - | - | - |\n| Allocation of net loss | $ | ( 97,192 | ) | $ | ( 66,740 | ) | $ | - | $ | ( 52,524 | ) |\n| Denominators: |\n| Weighted-average shares outstanding | 10,350,000 | 2,637,500 | - | 2,250,000 |\n| Basic and diluted net loss per share | $ | ( 0.01 | ) | $ | ( 0.03 | ) | $ | - | $ | ( 0.00 | ) |\n\n\n| ● | Related parties |\n\nParties, which can be a corporation or individual, are considered to be related if the Company has the ability, directly or indirectly, to control the other party or exercise significant influence over the other party in making financial and operational decisions. Companies are also considered to be related if they are subject to common control or common significant influence.\n\n| ● | Concentration of credit risk |\n\nFinancial instruments that potentially subject the Company to concentration of credit risk consist of a cash account in a financial institution. The Company has not experienced losses on this account and management believes the Company is not exposed to significant risks on such account.\n\n| ● | Recent accounting pronouncements |\n\nThe Company has considered all new accounting pronouncements and has concluded that there are no new pronouncements that may have a material impact on the results of operations, financial condition, or cash flows, based on the current information.\nNOTE 3 – CASH AND INVESTMENT HELD IN TRUST ACCOUNT\nAs of June 30, 2022, investment securities in the Company’s Trust Account consisted of $ 104,699,165 in United States Treasury Bills and $ 11,421 in cash. The Company classifies its United States Treasury securities as available-for-sale. Available-for-sale marketable securities are recorded at their estimated fair value on the accompanying June 30, 2022 balance sheet. The carrying value, including gross unrealized holding gain as other comprehensive income and fair value of held to marketable securities on June 30, 2022 and December 31, 2021 is as follows:\n\n| Carrying Value as of June 30, 2022 (Unaudited) | Gross Unrealized Holding Gain | Fair Value as of June 30, 2022 (Unaudited) |\n| Available-for-sale marketable securities: |\n| U.S. Treasury Securities | $ | 104,540,682 | $ | 158,483 | $ | 104,699,165 |\n\n\n| Carrying Value as of December 31, 2021 (Audited) | Gross Unrealized Holding Gain | Fair Value as of December 31, 2021 |\n| Available-for-sale marketable securities: |\n| U.S. Treasury Securities | $ | 104,535,263 | $ | - | $ | 104,535,263 |\n\n12\nNOTE 4 – INITIAL PUBLIC OFFERING\nPursuant to the Initial Public Offering, the Company sold 9,000,000 Units, which includes a full exercise by the underwriters of their over-allotment option in the amount of 1,350,000 Public Units, at a purchase price of $ 10.00 per Unit. Each Unit consists of one share of common stock, one-half (1/2) of one redeemable warrant (“Public Warrant”) and one right (“Public Right”) to receive one-tenth (1/10) of one share of common stock. Each Public Warrant will entitle the holder to purchase one share of common stock at an exercise price of $ 11.50 per whole share.\nAll of the 10,350,000 (including over-allotment shares) Public Shares sold as part of the Public Units in the IPO contain a redemption feature which allows for the redemption of such Public Shares if there is a stockholder vote or tender offer in connection with the Business Combination and in connection with certain amendments to the Company’s amended and restated certificate of incorporation, or in connection with the Company’s liquidation. In accordance with the SEC and its staff’s guidance on redeemable equity instruments, which has been codified in ASC 480-10-S99, redemption provisions not solely within the control of the Company require common stocks subject to redemption to be classified outside of permanent equity.\nThe Company’s redeemable common stock is subject to SEC and its staff’s guidance on redeemable equity instruments, which has been codified in ASC 480-10-S99. If it is probable that the equity instrument will become redeemable, the Company has the option to either accrete changes in the redemption value over the period from the date of issuance (or from the date that it becomes probable that the instrument will become redeemable, if later) to the earliest redemption date of the instrument or to recognize changes in the redemption value immediately as they occur and adjust the carrying amount of the instrument to equal the redemption value at the end of each reporting period. The Company has elected to recognize the changes immediately. The accretion or remeasurement is treated as a deemed dividend (i.e., a reduction to retained earnings, or in absence of retained earnings, additional paid-in capital).\nAs of June 30, 2022 and December 31, 2021, the shares of common stock reflected on the balance sheet are reconciled in the following table.\n\n| June 30, | December 31, |\n| 2022 | 2021 |\n| Gross proceeds | $ | 103,500,000 | $ | 103,500,000 |\n| Less: |\n| Proceeds allocated Public Warrants | ( 2,572,990 | ) | ( 2,572,990 | ) |\n| Proceeds allocated Public Rights | ( 7,418,984 | ) | ( 7,418,984 | ) |\n| Offering costs of Public Shares | ( 2,511,906 | ) | ( 2,511,906 | ) |\n| Plus: |\n| Accretion of carrying value to redemption value - 2021 | 13,538,880 | 13,538,880 |\n| Accretion of carrying value to redemption value - 2022 | 175,586 | - |\n| Common stock subject to possible redemption | $ | 104,710,586 | $ | 104,535,000 |\n\nNOTE 5 – PRIVATE PLACEMENT\nSimultaneously with the closing of the Initial Public Offering, the Sponsor and the underwriters purchased an aggregate of 4,721,250 Warrants at a price of $ 1.00 per Warrant, ($ 4,721,250 in the aggregate), in each case, in a private warrant that will occur simultaneously with the closing of the Initial Public Offering (the “Private Warrants”). Each Private Warrant is exercisable to purchase one share of common stock at a price of $ 11.50 per whole share. The Private Warrants may only be exercised for a whole number of shares. The proceeds from the sale of the Private Placement Warrants will be added to the net proceeds from the Initial Public Offering held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the proceeds from the sale of the Private Warrants will be used to fund the redemption of the Public Shares (subject to the requirements of applicable law) and the Private Warrants will expire worthless.\n13\nNOTE 6 – RELATED PARTY TRANSACTIONS\nFounder Shares\nOn March 4, 2021, the Company issued an aggregate of 2,587,500 founder shares to the initial shareholder for an aggregate purchase price of $ 25,000 .\nOn December 13, 2021, the Company issued an aggregate of 50,000 representative shares to the underwriter.\nAs of June 30, 2022 and December 31, 2021, 2,637,500 shares of common stock were issued and outstanding, excluding 10,350,000 shares of common stock are subject to possible conversion.\nAdvance from a Related Party\nOn April 1, 2021, the Company issued an unsecured promissory note to the Sponsor, pursuant to which the Company may borrow up to an aggregate principal amount of $ 1,000,000 (the “Promissory Note”). The Promissory Note is non-interest bearing and payable on the earlier of (i) April 30, 2021 or (ii) the date on which the Company determines not to conduct an initial public offering. As of December 13, 2021, the Company drew $ 134,885 against the promissory note and the entire balance was repaid on December 16, 2021.\nAs of June 30, 2022 and December 31, 2021, the Company had a temporary advance of $ 118,267 and $ 10,253 from the Sponsor, respectively. The balance is unsecured, interest-free and has no fixed terms of repayment.\nAdministrative Services Agreement\nThe Company is obligated, commencing from March 4, 2021, to pay Soul Venture Partners LLC a monthly fee of $ 10,000 for general and administrative services. This agreement will terminate upon completion of the Company’s Business Combination or the liquidation of the trust account to public shareholders.\nNOTE 7 – SHAREHOLDER’S EQUITY\nCommon stocks\nThe Company is authorized to issue 26,000,000 shares of common stock at par value $ 0.0001 . Holders of the Company’s common stocks are entitled to one vote for each share. As of June 30, 2022 and December 31, 2021, 2,637,500 shares of common stocks were issued and outstanding, excluding 10,350,000 shares of common stock subject to possible redemption.\nRights\nEach holder of a right will receive one-tenth (1/10) of one share of common stock upon consummation of a Business Combination, even if the holder of such right redeemed all shares held by it in connection with a Business Combination. No fractional shares will be issued upon exchange of the rights. No additional consideration will be required to be paid by a holder of rights in order to receive its additional shares upon consummation of a Business Combination as the consideration related thereto has been included in the Unit purchase price paid for by investors in the Initial Public Offering. If the Company enters into a definitive agreement for a Business Combination in which the Company will not be the surviving entity, the definitive agreement will provide for the holders of rights to receive the same per share consideration the holders of the common stock will receive in the transaction on an as-converted into common stock basis and each holder of a right will be required to affirmatively convert its rights in order to receive 1/10 share underlying each right (without paying additional consideration). The shares issuable upon exchange of the rights will be freely tradable (except to the extent held by affiliates of the Company).\nIf the Company is unable to complete a Business Combination within the Combination Period and the Company liquidates the funds held in the Trust Account, holders of rights will not receive any of such funds with respect to their rights, nor will they receive any distribution from the Company’s assets held outside of the Trust Account with respect to such rights, and the rights will expire worthless. Further, there are no contractual penalties for failure to deliver securities to the holders of the rights upon consummation of a Business Combination. Additionally, in no event will the Company be required to net cash settle the rights. Accordingly, the rights may expire worthless.\n14\nWarrants\nThe Public Warrants will become exercisable on the later of (a) the completion of a Business Combination or (b) 15 months (or up to 21 months, if we extend the time to complete a business combination) from the closing of this Initial Public Offering. No Public Warrants will be exercisable for cash unless the Company has an effective and current registration statement covering the common stock issuable upon exercise of the Public Warrants and a current prospectus relating to such common stock. Notwithstanding the foregoing, if a registration statement covering the common stock issuable upon the exercise of the Public Warrants is not effective within 52 business days from the consummation of a Business Combination, the holders may, until such time as there is an effective registration statement and during any period when the Company shall have failed to maintain an effective registration statement, exercise the Public Warrants on a cashless basis pursuant to the exemption from registration provided by Section 3(a)(9) of the Securities Act provided that such exemption is available. If an exemption from registration is not available, holders will not be able to exercise their Public Warrants on a cashless basis. The Public Warrants will expire five years after the completion of the Business Combination, at 5:00 p.m., New York City time, or earlier upon redemption or liquidation.\nThe Company may call the warrants for redemption (excluding the Private Warrants), in whole and not in part, at a price of $0.01 per warrant:\n\n| ● | at any time while the Public Warrants are exercisable, |\n\n\n| ● | upon not less than 30 days’ prior written notice of redemption to each Public Warrant holder, |\n\n\n| ● | if, and only if, the reported last sale price of the ordinary shares equals or exceeds $18 per share, for any 30 trading days within a 30 trading day period ending on the third trading day prior to the notice of redemption to Public Warrant holders, and |\n\n\n| ● | if, and only if, there is a current registration statement in effect with respect to the issuance of the ordinary shares underlying such warrants at the time of redemption and for the entire 30-day trading period referred to above and continuing each day thereafter until the date of redemption. |\n\nThe Private Warrants will be identical to the Public Warrants underlying the Units being sold in the Proposed Public Offering, except that the Private Warrants and the common stock issuable upon the exercise of the Private Warrants will not be transferable, assignable or salable until after the completion of a Business Combination, subject to certain limited exceptions. Additionally, the Private Warrants will be exercisable on a cashless basis and will be non-redeemable so long as they are held by the initial purchasers or their permitted transferees. If the Private Warrants are held by someone other than the initial purchasers or their permitted transferees, the Private Warrants will be redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants.\nIf the Company calls the Public Warrants for redemption, management will have the option to require all holders that wish to exercise the Public Warrants to do so on a “cashless basis,” as described in the warrant agreement. The exercise price and number of common stock issuable upon exercise of the warrants may be adjusted in certain circumstances including in the event of a share dividend, extraordinary dividend or recapitalization, reorganization, merger or consolidation. However, the warrants will not be adjusted for issuances of common stock at a price below its exercise price. Additionally, in no event will the Company be required to net cash settle the warrants. If the Company is unable to complete a Business Combination within the Combination Period and the Company liquidates the funds held in the Trust Account, holders of warrants will not receive any of such funds with respect to their warrants, nor will they receive any distribution from the Company’s assets held outside of the Trust Account with respect to such warrants. Accordingly, the warrants may expire worthless.\n15\nNOTE 8 – FAIR VALUE MEASUREMENTS\nThe fair value of the Company’s financial assets and liabilities reflects management’s estimate of amounts that the Company would have received in connection with the sale of the assets or paid in connection with the transfer of the liabilities in an orderly transaction between market participants at the measurement date. In connection with measuring the fair value of its assets and liabilities, the Company seeks to maximize the use of observable inputs (market data obtained from independent sources) and to minimize the use of unobservable inputs (internal assumptions about how market participants would price assets and liabilities). The following fair value hierarchy is used to classify assets and liabilities based on the observable inputs and unobservable inputs used in order to value the assets and liabilities:\nLevel 1: Quoted prices in active markets for identical assets or liabilities. An active market for an asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis.\nLevel 2: Observable inputs other than Level 1 inputs. Examples of Level 2 inputs include quoted prices in active markets for similar assets or liabilities and quoted prices for identical assets or liabilities in markets that are not active.\nLevel 3: Unobservable inputs based on the assessment of the assumptions that market participants would use in pricing the asset or liability.\nThe following table presents information about the Company’s assets and liabilities that were measured at fair value on a recurring basis as of June 30, 2022 and December 31, 2021, and indicates the fair value hierarchy of the valuation techniques the Company utilized to determine such fair value.\n\n| June 30, 2022 | Quoted Prices In Active Markets | Significant Other Observable Inputs | Significant Other Unobservable Inputs |\n| Description | (Unaudited) | (Level 1) | (Level 2) | (Level 3) |\n| Assets: |\n| U.S. Treasury Securities held in Trust Account* | $ | 104,699,165 | $ | 104,699,165 | $ | - | $ | - |\n\n\n| December 31, | Quoted Prices In Active Markets | Significant Other Observable Inputs | Significant Other Unobservable Inputs |\n| Description | 2021 | (Level 1) | (Level 2) | (Level 3) |\n| (Audited) |\n| Assets: |\n| U.S. Treasury Securities held in Trust Account* | $ | 104,535,263 | $ | 104,535,263 | $ | - | $ | - |\n\n\n| * | included in cash and investments held in trust account on the Company’s balance sheets. |\n\nNOTE 9 – COMMITMENTS AND CONTINGENCIES\nRisks and Uncertainties\nManagement is currently evaluating the impact of the COVID-19 pandemic on the industry and has concluded that while it is reasonably possible that the virus could have a negative effect on the Company’s financial position, results of its operations and/or search for a target company, the specific impact is not readily determinable as of the date of these unaudited condensed financial statements. The unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty.\n16\nRegistration Rights\nPursuant to a registration rights agreement entered into on December 13, 2021 the holders of the Founder Shares, Private Warrants (and their underlying securities) and any securities of the Company’s initial stockholders, officers, directors or their affiliates may be issued in payment of working capital loans made to us, will be entitled to registration rights pursuant to an agreement to be signed prior to or on the effective date of this Proposed Public Offering. The holders of the majority of the founder shares can elect to exercise these registration rights at any time commencing three months prior to the date on which these shares of common stock are to be released from escrow. The holders of a majority of the Private Warrants (and underlying securities) and securities issued in payment of working capital loans (or underlying securities) or loans to extend the life can elect to exercise these registration rights at any time after the Company consummates a Business Combination. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the consummation of a Business Combination. The Company will bear the expenses incurred in connection with the filing of any such registration statements.\nUnderwriter Agreement\nThe underwriter is entitled to a cash underwriting discount of 1.75% of the gross proceeds of the Proposed Public Offering, or $1,811,250 until the closing of the Business Combination. In addition, the underwriter will be entitled to a deferred fee ranged between $1,000,000 and $2,250,000. The deferred fee should equal to the greater of 1) $1,000,000; and 2) 2.5% of the cash remaining in the Trust Fund with a maximum amount of $2,250,000. The deferred fee can be paid in cash.\nNOTE 10 – SUBSEQUENT EVENTS\nIn accordance with ASC Topic 855, “Subsequent Events”, which establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before this unaudited condensed financial statements are issued, the Company has evaluated all events or transactions that occurred after the balance sheet date, up through August 12, 2022 was the Company issued the unaudited condensed financial statements. During the period, the Company did not have any material subsequent events other than disclosed above.\n17\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nReferences in this report (the “Quarterly Report”) to “we,” “us” or the “Company” refer to Inception Growth Acquisition Limited. References to our “management” or our “management team” refer to our officers and directors, references to the “Sponsor” refer to Soul Venture Partners LLC. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Quarterly Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\nSpecial Note Regarding Forward-Looking Statements\nThis Quarterly Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Exchange Act that are not historical facts, and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. All statements, other than statements of historical fact included in this Form 10-Q including, without limitation, statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. Words such as “expect,” “believe,” “anticipate,” “intend,” “estimate,” “seek” and variations and similar words and expressions are intended to identify such forward-looking statements. Such forward-looking statements relate to future events or future performance, but reflect management’s current beliefs, based on information currently available. A number of factors could cause actual events, performance or results to differ materially from the events, performance and results discussed in the forward-looking statements. For information identifying important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements, please refer to the Risk Factors section of the Company’s registration statement on Form S-1 filed with the U.S. Securities and Exchange Commission (the “SEC”). The Company’s securities filings can be accessed on the EDGAR section of the SEC’s website at sec.report. Except as expressly required by applicable securities law, the Company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.\nOverview\nWe are a blank check company incorporated as a Delaware corporation on March 4, 2021 and formed for the purpose of entering into a merger, share exchange, asset acquisition, share purchase, recapitalization, reorganization or similar business combination with one or more businesses or entities. We intend to effectuate our initial business combination using cash from the proceeds of the initial public offering and the sale of the Private Warrants, our capital stock, debt or a combination of cash, stock and debt.\nWe presently have no revenue, have had losses since inception from incurring formation costs and have had no operations other than the active solicitation of a target business with which to complete a business combination. We have relied upon the sale of our securities and loans from our officers and directors to fund our operations.\nOn December 13, 2021, we consummated our initial public offering (“IPO”) of 9,000,000 units (the “Units”), each Unit consisting of one share of common stock of the Company, par value $0.0001 per share (the “Common Stock”), one-half of one redeemable warrant (the “Warrant”), each whole Warrant entitling the holder thereof to purchase one share of Common Stock for $11.50 per share, and one right (the “Right”) to receive one-tenth (1/10) of a share of Common Stock upon consummation of an initial business combination. The Units were sold at a price of $10.00 per Unit, generating aggregate gross proceeds to the Company of $90,000,000. On December 9, 2021, the underwriters of the IPO fully exercised their over-allotment option, and the closing and sale of an additional 1,350,000 Units (the “Over-Allotment Units”) occurred on December 13, 2021. The issuance by the Company of the Over-Allotment Units at a price of $10.00 per Unit resulted in total gross proceeds of $13,500,000.\nSimultaneously with the closing of the IPO and the sale of the over-allotment units on December 13, 2021, the Company consummated the private placement (“Private Placement”) with the Sponsor of 4,721,250 warrants (the “Private Warrants”) at a price of $1.00 per Private Warrant, generating total proceeds of $4,721,250. These securities (other than our IPO securities) were issued pursuant to an exemption from registration under the Securities Act of 1933, as amended pursuant to Section 4(2) of the securities Act.\n18\nThe Private Warrants are identical to the warrants sold in the IPO except that the Private Warrants will be non-redeemable and the shares of common stock issuable upon exercise thereof are entitled to registration rights pursuant to the Registration Rights Agreement, in each case so long as they continue to be held by the Sponsor or their permitted transferees. Additionally, our Sponsor has agreed not to transfer, assign, or sell any of the Private Warrants or underlying securities (except in limited circumstances, as described in the Registration Statement) until 30 days after the Company completes its initial business combination.\nOur management has broad discretion with respect to the specific application of the net proceeds of the initial business combination and the Private Placement, although substantially all of the net proceeds are intended to be applied generally towards consummating a business combination.\nResults of Operations\nOur entire activity from inception up to December 13, 2021 was in preparation for the initial public offering. Since the initial public offering, our activity has been limited to the evaluation of business combination candidates, and we will not be generating any operating revenues until the closing and completion of our initial business combination. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. We expect our expenses to increase substantially after this period.\nFor the three and six months ended June 30, 2022 we had a net loss of $163,932 and $381,831, respectively, which was comprised of general and administrative expenses, dividend income and interest income.\nFor the three and six months ended June 30, 2021 we had a net loss of $52,524 and $52,524, respectively, which was comprised of general and administrative expenses.\nFor the six months ended June 30, 2022, cash used in operating activities was $685,746, consisting primarily of a net loss of $381,831 and changes in our operating assets and liabilities used cash of $287,163.\nFor the six months ended June 30, 2021, cash used in operating activities was $52,524, consisting primarily of a net loss of $52,524.\nLiquidity and Capital Resources\nAs of June 30, 2022, we had cash of $787,449. Until the consummation of the initial public offering, the only source of liquidity was an initial purchase of common stock by our Sponsor, monies loaned by the Sponsor under a certain unsecured promissory note and advances from our Sponsor.\nOn December 13, 2021, we consummated the Initial Public Offering of 10,350,000 units (the “Public Units”), which includes the full exercise by the underwriter of its over-allotment option in the amount of 1,350,000 Public Units, at $10.00 per Public Unit, generating gross proceeds of $103,500,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of 4,721,250 Warrants (the “Private Warrants”) at a price of $1.00 per warrant in a private placement to Soul Venture Partners LLC (the “Sponsor”), generating gross proceeds of $4,721,250.\nTransaction costs amounted to $4,832,697, consisting of $1,811,250 of underwriting fees, $2,587,500 of deferred underwriting fees and $433,947 of other offering costs. In addition, at December 13, 2021, cash of $1,498,937 were held outside of the Trust Account and is available for the payment of offering costs and for working capital purposes net with $104,535,000 transferred to the Trust Account on December 13, 2021.\n19\nWe intend to use substantially all of the funds held in the trust account, including any amounts representing interest earned on the trust account to complete our initial business combination (less deferred underwriting commissions). We may withdraw interest to pay taxes. We estimate our annual franchise tax obligations, based on the number of shares of our common stock authorized and outstanding after the completion of this offering, to be $200,000, which is the maximum amount of annual franchise taxes payable by us as a Delaware corporation per annum, which we may pay from funds from this offering held outside of the trust account or from interest earned on the funds held in our trust account and released to us for this purpose. Our annual income tax obligations will depend on the amount of interest and other income earned on the amounts held in the trust account. We expect the interest earned on the amount in the trust account will be sufficient to pay our income and franchise taxes. To the extent that our capital stock or debt is used, in whole or in part, as consideration to complete our initial business combination, the remaining proceeds held in the trust account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies.\nPrior to the completion of our initial business combination, we will have available to us the approximately $1,100,000 (the amount will remain the same if the over-allotment option is exercised in full) of proceeds held outside the trust account. We will use these funds to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, and structure, negotiate and complete an initial business combination.\nWe do not believe we will need to raise additional funds following the offering in order to meet the expenditures required for operating our business. However, if our estimates of the costs of identifying a target business, undertaking in-depth due diligence and negotiating an initial business combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our initial business combination. Moreover, we may need to obtain additional financing either to complete our initial business combination or because we become obligated to redeem a significant number of our public shares upon completion of our initial business combination, in which case we may issue additional securities or incur debt in connection with such business combination. In addition, we intend to target businesses larger than we could acquire with the net proceeds of this offering and the sale of the private warrants, and may as a result be required to seek additional financing to complete such proposed initial business combination. Subject to compliance with applicable securities laws, we would only complete such financing simultaneously with the completion of our initial business combination. If we are unable to complete our initial business combination because we do not have sufficient funds available to us, we will be forced to cease operations and liquidate the trust account. In addition, following our initial business combination, if cash on hand is insufficient, we may need to obtain additional financing in order to meet our obligations.\nOff-balance Sheet Financing Arrangements\nWe have no obligations, assets or liabilities which would be considered off-balance sheet arrangements as of June 30, 2022. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets.\nContractual Obligations\nWe do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities other than an agreement to pay our Sponsor a monthly fee of $10,000 for general and administrative services, including office space, utilities and administrative services to us. We began incurring these fees on March 4, 2021 and will continue to incur these fees monthly until the earlier of the completion of the business combination and our liquidation. Also, we are committed to the below:\nRegistration Rights\nThe holders of the Founder Shares, the Private Placement Warrants (and their underlying securities) and the warrants that may be issued upon conversion of the Working Capital Loans (and their underlying securities) are entitled to registration rights pursuant to a registration rights agreement signed on the effective date of the Public Offering. The holders of a majority of these securities are entitled to make up to two demands that we register such securities. The holders of the majority of the Founder Shares can elect to exercise these registration rights at any time commencing three months prior to the date on which these shares are to be released from escrow. The holders of a majority of the Private Placement Warrants and warrants issued in payment of Working Capital Loans made to us (or underlying securities) can elect to exercise these registration rights at any time after we consummate a Business Combination. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the completion of a Business Combination. We will bear the expenses incurred in connection with the filing of any such registration statements.\nUnderwriting Agreement\nWe are committed to pay the Deferred Fee ranged between $1,000,000 to $2,250,000, which should equal to the greater of 1) $1,000,000 and 2) 2.5% of the cash remaining in the Trust Fund with a maximum amount of $2,250,000. The deferred fee can be paid in cash.\n20\nCritical Accounting Policies\nThe preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have not identified any significant accounting policies.\n\n| ● | Warrant accounting |\n\nWe account for warrants as either equity-classified or liability-classified instruments based on an assessment of the warrant’s specific terms and applicable authoritative guidance in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 480, “Distinguishing Liabilities from Equity” (“ASC 480”) and ASC 815, “Derivatives and Hedging” (“ASC 815”). The assessment considers whether the warrants are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and whether the warrants meet all of the requirements for equity classification under ASC 815, including whether the warrants are indexed to our own common stock and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of our control, among other conditions for equity classification. This assessment, which requires the use of professional judgment, is conducted at the time of warrant issuance and as of each subsequent quarterly period end date while the warrants are outstanding.\nFor issued or modified warrants that meet all of the criteria for equity classification, the warrants are required to be recorded as a component of equity at the time of issuance. For issued or modified warrants that do not meet all the criteria for equity classification, the warrants are required to be recorded as liabilities at their initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of the warrants are recognized as a non-cash gain or loss on the statements of operations.\nAs the warrants issued upon the IPO and private placements meet the criteria for equity classification under ASC 480, therefore, the warrants are classified as equity.\n\n| ● | Common stock subject to possible redemption |\n\nWe account for its common stock subject to possible redemption in accordance with the guidance in ASC Topic 480 “Distinguishing Liabilities from Equity.” Common stocks subject to mandatory redemption (if any) are classified as a liability instrument and are measured at fair value. Conditionally redeemable common stocks (including common stocks that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, common stocks are classified as shareholders’ equity. Our common stocks feature certain redemption rights that are subject to the occurrence of uncertain future events and considered to be outside of our control. Accordingly, at June 30, 2022, 10,350,000 shares of common stock subject to possible redemption, respectively, are presented as temporary equity, outside of the shareholders’ equity section of our balance sheet.\n\n| ● | Offering costs |\n\nWe comply with the requirements of the ASC 340-10-S99-1 and SEC Staff Accounting Bulletin (“SAB”) Topic 5A – “Expenses of Offering”. Offering costs consist principally of professional and registration fees incurred through the balance sheet date that are related to the Public Offering and that were charged to shareholders’ equity upon the completion of the Public Offering.\n\n| ● | Net loss per share |\n\nWe calculate net loss per share in accordance with ASC Topic 260, “Earnings per Share.” In order to determine the net income (loss) attributable to both the redeemable shares and non-redeemable shares, we first considered the undistributed income (loss) allocable to both the redeemable common stock and non-redeemable common stock and the undistributed income (loss) is calculated using the total net loss less any dividends paid. We then allocated the undistributed income (loss) ratably based on the weighted average number of shares outstanding between the redeemable and non-redeemable common stock. Any remeasurement of the accretion to the redemption value of the common stock subject to possible redemption was considered to be dividends paid to the public stockholders. As of June 30, 2022, we have not considered the effect of the warrants sold in the Initial Public Offering and private warrants to purchase an aggregate of 9,896,250 shares in the calculation of diluted net loss per share, since the exercise of the warrants is contingent upon the occurrence of future events and the inclusion of such warrants would be anti-dilutive and we did not have any other dilutive securities and other contracts that could, potentially, be exercised or converted into common stock and then share in our earnings. As a result, diluted loss per share is the same as basic loss per share for the period presented.\n21\n\nItem 3. Quantitative and Qualitative Disclosures about Market Risk\nThe net proceeds of the IPO held in the trust account may be invested in U.S. government treasury bills, notes or bonds with a maturity of 180 days or less or in certain money market funds that invest solely in US treasuries. Due to the short-term nature of these investments, we believe there will be no associated material exposure to interest rate risk.\n\nItem 4. Controls and Procedures\nEvaluation of Disclosure Controls and Procedures\nDisclosure controls and procedures are designed to ensure that information required to be disclosed by us in our Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.\nUnder the supervision and with the participation of our management, including our principal executive officer and principal financial and accounting officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures as of the end of the fiscal quarter ended June 30, 2022, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act. Based on this evaluation, our principal executive officer and principal financial and accounting officer have concluded that during the period covered by this report, our disclosure controls and procedures were effective at a reasonable assurance level and, accordingly, provided reasonable assurance that the information required to be disclosed by us in reports filed under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.\nChanges in Internal Control over Financial Reporting\nThere was no change in our internal control over financial reporting that occurred during the fiscal quarter of June 30, 2022 covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\n22\nPART II - OTHER INFORMATION\n\nItem 1 Legal Proceedings\nThe Company is not party to any legal proceedings as of the filing date of this Form 10-Q.\n\nItem 1A. Risk Factors.\nFactors that could cause our actual results to differ materially from those in this Quarterly Report are any of the risks described in our final prospectus for our Initial Public Offering filed with the SEC on December 8, 2021. Any of these factors could result in a significant or material adverse effect on our results of operations or financial condition. Additional risk factors not presently known to us or that we currently deem immaterial may also impair our business or results of operations. As of the date of this Quarterly Report, there have been no material changes to the risk factors disclosed in our final prospectus dated December 8, 2021 other than as stated below.\n\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\nOn December 13, 2021, we consummated our initial public offering (“IPO”)of 9,000,000 units (the “Units”), each Unit consisting of one share of common stock of the Company, par value $0.0001 per share (the “Common Stock”), one-half of one redeemable warrant (the “Warrant”), each whole Warrant entitling the holder thereof to purchase one share of Common Stock for $11.50 per share, and one right (the “Right”) to receive one-tenth (1/10) of a share of Common Stock upon consummation of an initial business combination. The Units were sold at a price of $10.00 per Unit, generating aggregate gross proceeds to the Company of $90,000,000. On December 9, 2021, the underwriters of the IPO fully exercised their over-allotment option, and the closing and sale of an additional 1,350,000 Units (the “Over-Allotment Units”) occurred on December 13, 2021. The issuance by the Company of the Over-Allotment Units at a price of $10.00 per Unit resulted in total gross proceeds of $13,500,000.\nSimultaneously with the closing of the IPO and the sale of the over-allotment units on December 13, 2021, the Company consummated the private placement (“Private Placement”) with the Sponsor of 4,721,250 warrants (the “Private Warrants”) at a price of $1.00 per Private Warrant, generating total proceeds of $4,721,250. These securities (other than our IPO securities) were issued pursuant to an exemption from registration under the Securities Act of 1933, as amended pursuant to Section 4(2) of the securities Act.\n23\nThe Private Warrants are identical to the warrants sold in the IPO except that the Private Warrants will be non-redeemable and the shares of common stock issuable upon exercise thereof are entitled to registration rights pursuant to the Registration Rights Agreement, in each case so long as they continue to be held by the Sponsor or their permitted transferees. Additionally, our Sponsor has agreed not to transfer, assign, or sell any of the Private Warrants or underlying securities (except in limited circumstances, as described in the Registration Statement) until 30 days after the Company completes its initial business combination.\nAs of December 31, 2021, a total of $104,535,351 was held in a trust account established for the benefit of the Company’s public stockholders, which included $103,500,000 of the net proceeds from the IPO (including the exercise of the over-allotment option) and $4,721,250 of the Private Placements and subsequent interest income.\nWe paid a total of $1,811,250 in underwriting discounts and commissions (not including the deferred underwriting commission payable at the consummation of initial business combination) and approximately $433,947 for other costs and expenses related to our formation and the initial public offering.\n\nItem 3. Defaults Upon Senior Securities.\nNone.\n\nItem 4. Mine Safety Disclosures.\nNot Applicable.\n\nItem 5. Other Information.\nNone.\n\nItem 6. Exhibits\nThe following exhibits are filed as part of, or incorporated by reference into, this Quarterly Report on Form 10-Q.\n\n| 31.1 | Certification of Principal Executive Officer Pursuant to Securities Exchange Act Rules 13a-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2 | Certification of Principal Financial Officer Pursuant to Securities Exchange Act Rules 13a-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1 | Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2 | Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS | Inline XBRL Instance Document. |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document. |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document. |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document. |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document. |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document. |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101). |\n\n24\nSIGNATURES\nIn accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| INCEPTION GROWTH ACQUISITION LIMITED |\n| Date: August 12, 2022 | By: | /s/ Paige E. Craig |\n| Name: | Paige E. Craig |\n| Title: | Chief Executive Officer |\n| (Principal Executive Officer) |\n\n25\n\n</text>\n\nWhat is the growth rate of total liabilities from December 31, 2021, to June 30, 2022?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nITEM 1.\nBUSINESS\nOur Company\nAlign Technology, Inc (“We”, “Our”, “Align”) designs, manufactures and markets a system of clear aligner therapy, intraoral scanners and CAD/CAM (computer-aided design and computer-aided manufacturing) digital services used in dentistry, orthodontics, and dental records storage. Align Technology was founded in March 1997 and incorporated in Delaware in April 1997. Our headquarters is located at 2560 Orchard Parkway, San Jose, California 95131, and our telephone number is 408-470-1000. Our internet address is www.aligntech.com. Our international headquarters is located in Amsterdam, the Netherlands.\nWe have two operating segments: (1) Clear Aligner and (2) Scanners and Services (\"Scanner\"). For the year ended December 31, 2016, Clear Aligner revenues represent approximately 89% of worldwide revenue, while Scanner represent the remaining 11% of worldwide revenues. We distribute the vast majority of our products directly to our customers: orthodontists and general practitioner dentists (\"GPs\"), as well as to restorative dentists, including prosthodontists, periodontists, and oral surgeons. We also supply clear aligners to SmileDirectClub, LLC (\"SDC\") who sells them directly to consumers, with a doctor’s approved prescription.\nWe received 510(k) clearance from the United States Food and Drug Administration (“FDA”) to market the Invisalign System in 1998. The Invisalign System is regulated by the FDA as a Class II medical device. In order to provide Invisalign treatment to their patients, orthodontists and GPs must initially complete an Invisalign training course. The Invisalign System is primarily sold through a direct sales force in the United States (\"U.S.\"), Canada, Europe, certain Asia Pacific countries, Latin America and Middle East and Africa including Australia, New Zealand, China and Japan. We use a distributor model for the sale of our products in non-core country markets in the Asia Pacific (\"APAC\"), Europe, Middle East and Africa (\"EMEA\"), and Latin America regions.\nOur iTero scanner is used by dental professionals and/or labs and services for restorative and orthodontic digital procedures as well as Invisalign digital impression submission. We received 501(k) clearance from the FDA to market iTero software for expanded indications in 2013. Scanners and CAD/CAM Services are primarily sold through our direct sales force in North America, Europe and certain Asia Pacific countries including Taiwan, Singapore, Korea, Australia, New Zealand, and through distribution partners in Thailand, Scandinavia and Russia.\n3\nOur Products and Services\nOur net revenues are generated from the sale of the following product offerings:\n| Fiscal Year |\n| Percentage of Net Revenues by Product | 2016 | 2015 | 2014 |\n| Clear Aligner Segment |\n| Comprehensive Products | 72 | % | 78 | % | 77 | % |\n| Non-Comprehensive Products | 11 | 11 | 11 |\n| Non-Case Products | 6 | 6 | 6 |\n| Total Clear Aligner Segment | 89 | 95 | 94 |\n| Scanners and Services Segment | 11 | 5 | 6 |\n| Total Net Revenues | 100 | % | 100 | % | 100 | % |\n\nClear Aligner Segment\nMalocclusion and Traditional Orthodontic Treatment\nMalocclusion, or the misalignment of teeth, is one of the most prevalent clinical dental conditions, affecting billions of people, or approximately 60% to 75% of the population. Annually, approximately 10 million people in major developed countries elect treatment by orthodontists worldwide, of which approximately 50% or 5 million have mild to moderate malocclusion and are applicable to Invisalign treatment - our served market. In addition, approximately 100 million people with malocclusion want to straighten their teeth; however, they will not seek orthodontic treatment in a doctor's office and would instead elect to receive clear aligner treatment in the convenience of their own home - referred to as the doctor-directed at home market.\nIn the U.S., orthodontists and GPs treat malocclusion primarily with metal arch wires and brackets, referred to as braces, and they may augment braces with elastics, metal expanders, headgear or functional appliances, and other ancillary devices as needed. Available options for improving treatment aesthetics include the use of ceramic, tooth-colored brackets or bonding brackets on the inside, or lingual surface, of the patient’s teeth. The average treatment takes approximately 12 to 24 months to complete and requires several hours of direct dental professional involvement, known in the industry as “chair time,” including the initial diagnosis, creation of an appropriate treatment plan and bonding of the brackets to the patient’s teeth, and attachment of arch wires to the brackets. Subsequent visits involve tightening or otherwise adjusting the braces approximately every six weeks until the final visit when the dental professional removes each bracket and residual bonding agent from the patient’s teeth. Upon completion of the treatment, the dental professional may, at his or her discretion, have the patient use a retainer. GPs, may also combine orthodontic treatment with restorative treatment. Many times the dental professional may need to move certain teeth or roots out of the way to create more space for implant placement, or move teeth to create space for restorations of missing teeth. In addition, GPs may need to move or adjust teeth or spaces to be able to place better restorations. The orthodontic portion of treatment generally comes before the restorative portion.\nThe Invisalign System\nThe Invisalign System is a proprietary method for treating malocclusion based on a series of doctor-prescribed, custom manufactured, clear plastic, removable orthodontic aligners. The Invisalign System offers a range of treatment options, specialized services, and proprietary software for treatment visualization and is comprised of the following phases:\nOrthodontic diagnosis and transmission of treatment data to us. The Invisalign-trained dental professional prepares and sends us a patient’s treatment data package which consists of a prescription form, a polyvinyl-siloxane, (or \"PVS\") impression of the relevant dental arches, photographs of the patient and, at the dental professional’s election, x-rays of the patient’s dentition. The Invisalign-trained dental professional can also submit an intraoral digital scan instead of a physical PVS impression through either Align's iTero scanner or several third-party scanners. See \"Third Party Scanners.\"\nPreparation of computer-simulated treatment plan. Upon receipt, we use the treatment data package to construct digital models of the patient’s dentition. In cases where a PVS impression has been submitted, we use computed tomography, known as CT scanning to develop a digital, three-dimensional computer model of the patient’s current dentition. In cases where the dental professional submits a digital scan, this step in the process is eliminated. We transform this initial digital model into a proposed custom, three-dimensional treatment plan, called a ClinCheck treatment plan. The ClinCheck treatment plan simulates\n4\nappropriate tooth movement broken down into a series of increments and details timing and placement of any attachments that will be used during treatment. Attachments are tooth-colored “buttons” that are sometimes used to increase the biomechanical force on a specific tooth or teeth in order to effect the desired movement.\nReview and approval of the treatment plan by an Invisalign provider. The patient’s ClinCheck treatment plan is then made available to the prescribing dental professional via the Invisalign Doctor Site which enables the dental professional to project tooth movement with a level of accuracy not previously possible with metal arch wires and brackets. By reviewing, modifying as needed and approving the treatment plan, the dental professional retains control over the treatment plan.\nManufacture of custom aligners. Upon the dental professional’s approval of the ClinCheck treatment plan, we use the data underlying the simulation, in conjunction with stereolithography technology (a form of 3D printing technology), to construct a series of molds depicting the future position of the patient’s teeth. Each mold is a replica of the patient’s teeth at each stage of the simulated course of treatment. From these molds, aligners are fabricated by pressure-forming polymeric sheets over each mold. Aligners are thin, clear plastic, removable dental appliances that are custom manufactured in a series to correspond to each stage of the ClinCheck treatment plan.\nShipment to the dental professional and patient aligner wear. All the aligners for a patient are shipped directly to the dental professional, who then dispenses them to the patient at regular check-up intervals throughout the treatment. Aligners are generally worn for consecutive two-week periods or less which correspond to the approved ClinCheck treatment plan. The patient replaces the aligners with the next pair in the series when prescribed, advancing tooth movement with each aligner stage. Throughout treatment, the doctor may place attachments or use other auxiliaries to achieve desired tooth movements, per the doctor’s original prescription and resulting ClinCheck treatment plan. In October 2016, we introduced one-week aligner wear. At the treating doctor’s discretion, we recommend changing from two-week aligner wear to one-week aligner wear for Invisalign treatments with Invisalign Full, Invisalign Teen and Invisalign Assist products, thereby reducing treatment time by up to 50%. Align’s recommendation is based on clinical analysis of more than 200 in-progress Invisalign cases (data on file) and the experiences of numerous Invisalign providers.\nTreatment progress and request for additional aligners. Should the dental professional determine that the treatment is not tracking for various reasons, such as patient compliance, certain teeth not tracking to plan, or they need to extend the treatment a few stages further to achieve their treatment goals, the dental professional can request additional aligners at no charge at any point during the treatment, subject to certain requirements.\nClear Aligner Products\nComprehensive Products:\nInvisalign Full. Used for a wide range of malocclusion, the Invisalign Full treatment consists of the number of aligners necessary to achieve the doctor’s treatment goals. Invisalign Full treatment aligners are manufactured and then delivered to the dental professionals in a single shipment. Invisalign Full is sold in the U.S., Canada and our international regions.\nInvisalign Teen. The Invisalign Teen treatment includes all the features of Invisalign Full treatment, plus additional features that address the orthodontic needs of teenage patients such as compliance indicators, compensation for tooth eruption and six free single arch replacement aligners. This product is predominantly marketed to orthodontists who treat the vast majority of malocclusion in teenage patients. Invisalign Teen treatment aligners (other than the replacement aligners) are manufactured and then delivered to the dental professionals in a single shipment. Invisalign Teen is sold in the U.S., Canada and our international regions.\nInvisalign Assist. Used for anterior alignment and aesthetically-oriented cases, the Invisalign Assist treatment offers added support to our dental practitioners throughout the treatment process, including progress tracking that allows the dental professional to submit new impressions every nine stages. When the progress tracking feature is selected, aligners are shipped to the dental professional after every nine stages thereby helping to achieve successful treatment outcomes. Predominantly marketed to GPs, Invisalign Assist is intended to make it easier to select appropriate cases for their experience level or treatment approach, submit cases more efficiently and manage appointments with suggested tasks. Invisalign Assist is sold in the U.S. and Canada.\n5\nNon-Comprehensive Products:\nInvisalign Express (10 and 5) and Invisalign Lite/i7. Invisalign Express treatments, Invisalign Lite treatment and Invisalign i7 treatment are lower-cost solutions for less complex orthodontic cases, non-comprehensive treatment relapse cases, or straightening prior to restorative or cosmetic treatments such as veneers. Invisalign Express 10 and Invisalign Express 5, which are sold in the U.S. and Canada, use up to 10 and 5 sets of aligners, respectively, and are also available as a single arch option. Invisalign Lite and Invisalign i7, sold in our international regions, use up to 14 and 7 sets of aligners, respectively. For Invisalign Express/Lite/i7, aligners are manufactured and then delivered to the dental professionals in a single shipment.\nInvisalign Go. A simplified and streamlined solution designed for GP dentists to more easily identify and treat patients with mild malocclusion. Invisalign Go combines case assessment support, a simplified ClinCheck treatment plan and a progress assessment feature for case monitoring. Invisalign Go was launched in core European markets in the fourth quarter of 2016 and is expected to launch in North America in the first quarter of 2017.\nSmileDirectClub Aligners. On July 25, 2016, we entered into a supply agreement with SmileDirectClub, LLC (\"SDC\") to manufacture non-Invisalign clear aligners for SDC's doctor-led, at-home program for simple teeth straightening. In October 2016, we became SDC's exclusive third-party supplier and began supplying aligners directly to SDC. SDC aligners include up to 20 stages without attachments or interproximal reduction (\"IPR\"). Align manufactures the aligners per SDC’s specifications for minor tooth movement using EX-30 aligner material.\nNon-Case Products:\nClear Aligner non-case products include retention products, Invisalign training fees and sales of ancillary products, such as cleaning material and adjusting tools used by dental professionals during the course of treatment.\nRetention. We offer two products for post treatment retention. The first is a single set of custom clear aligner retainers. The second is offered as a set of four custom clear aligners called Vivera Retainers made with proprietary material strong enough to maintain tooth position and correct minor relapse if necessary. A shipment of four sets are available to both Invisalign and non-Invisalign patients.\nFeature Enhancements\nWe have consistently introduced enhanced features across the Invisalign System over the past several years, such as Invisalign G3 (launched in October 2010), Invisalign G4 (launched in November 2011), Invisalign G5 (launched in February 2014) and Invisalign G6 (launched in March 2015). In October 2016, we launched Invisalign G7, a set of features designed to deliver greater control of tooth movements and improved treatment outcomes.\nInvisalign G5 innovations for deep bite is engineered to improve clinical outcomes in deep bite treatment with Invisalign treatment. Comprehensive features dedicated to deep bite treatment include new SmartForce® features that are designed to level the curve of spee by improving control of anterior intrusion and premolar extrusion for more predictable deep bite treatments, and precision bite ramps that are designed to disocclude the posterior teeth for improved efficiency in deep bite treatments.\nInvisalign G6 clinical innovations for first premolar extraction is engineered to improve clinical outcomes for orthodontic treatment of severe crowding and bimaxillary protrusion. Feature enhancements include new SmartStage programmed tooth movements that optimize the progression of tooth movements and provide aligner activation, engineered to eliminate unwanted tipping and unwanted anterior extrusion during retraction and new SmartForce features that are designed to deliver the force systems necessary to achieve predictable tooth movements.\nInvisalign G7 builds on earlier Invisalign G-series releases with new features to fine-tune certain tooth movements and deliver treatment outcome quality that Invisalign providers expect, particularly with teenage patients. Powered by Invisalign SmartStage technology that optimizes the staging and sequence of tooth movements and aligner activation for greater predictability, Invisalign G7 delivers better upper lateral control, improved root control, and features to address prevention of posterior open bites.\nSmartTrack™ Aligner Material\nSmartTrack is a proprietary, custom-engineered Invisalign clear aligner material that delivers gentle, more constant force considered ideal for orthodontic tooth movements. Conventional aligner materials relax and lose a substantial percent of energy in the initial days of aligner wear, but SmartTrack maintains more constant force over the period of time the patient wears the\n6\naligners. The flexible SmartTrack material also more precisely conforms to tooth morphology, attachments and interproximal spaces to improve control of tooth movement throughout treatment.\nScanner Segment\nIntraoral scanning is an emerging technology that we believe will have substantial impact on the future of dentistry. By enabling the dental practitioner to create a 3D image of the patient's teeth (digital scan) using a handheld intraoral scanner inside the mouth, digital scanning is more efficient and precise and more comfortable for patients, compared to the mess, discomfort and subjective nature of taking physical impressions. The digitally scanned model is more accurate than a physical impression and substantially reduces the rate of restoration \"remakes\" so patients are recalled less often and the appointment time for the restoration is shorter because of fewer adjustments which results in greater overall patient satisfaction. The digital model file can be used for various procedures and services including fabrication of physical dental models for use by labs to create restorative units such as veneers, inlays, onlays, crowns, bridges and implant abutments; digital records storage; orthodontic diagnosis; orthodontic retainers and appliances; and Invisalign digital impression submission.\niTero Scanner. The iTero scanner is available as a single hardware platform with software options for restorative or orthodontic procedures. In March 2015, we announced our next generation iTero Element Intraoral Scanner which features a more compact footprint, enhanced wand and multi-touch display and is engineered to enable faster scan speeds for more efficient, real-time clinical evaluation. We began shipping the iTero Element Intraoral Scanner in September 2015. We market and sell the iTero Element in North America and in select international markets. The iTero scanner is interoperable with our Invisalign treatment such that a full arch digital scan can be submitted as part of the Invisalign case submission process. In addition, the Invisalign Outcome Simulator and features are exclusive to the iTero scanner.\nRestorative software for iTero. Software designed for GPs, prosthodontists, periodontists, and oral surgeons which includes features for restorative procedures commonly performed in their practices such as veneers, inlays, onlays, crowns, bridges and implants. The iTero restorative software provides the ability to scan quadrants and full arches, and allows simple powder-free capture of digital impressions for single-unit cases as well as more complex restorative and implant treatment plans. The iTero software also contains Invisalign interoperability to support clear aligner orthodontic treatment.\nOrthodontic software for iTero. Software designed for orthodontists for digital records storage, orthodontic diagnosis, Invisalign digital impression submission, and for the fabrication of printed models and retainers. The iTero orthodontic software digitally captures the contours of the dentition and the gingival structures, providing an accurate, powder-free digital orthodontic scan in just minutes. This digital impression procedure ensures a more comfortable patient experience and produces a precise scan that can be seamlessly integrated with Invisalign treatment, OrthoCAD iCast, and OrthoCAD iRecord which allows a doctor to utilize sophisticated measurement and treatment planning tools.\nCAD/CAM Services\niTero Models and Dies. An accurate physical model and dies are manufactured based on the digital scan and sent to the laboratory of the dentist’s choice for completion of the needed restoration. The laboratory also has the option to export the digital file for immediate production of coping and full-contour restorations on their laboratory CAD/CAM systems. The laboratory conducts then completes the ceramic buildup or staining and glazing and delivers the end result - a precisely fitting restoration. iTero prosthetics have a near-zero remake rate.\nOrthoCAD iCast. iCast provides a digital alternative to traditional stone cast models which allows for simplified storage and digital record retrieval. The iCast digital model contains a full American Board of Orthodontics (\"ABO\") base and is available from an iTero scan or from a traditional alginate impression.\nOrthoCAD iRecord. iRecord scans provide a digital alternative to traditional stone cast models which allows for simplified storage and digital record retrieval. iRecord scan data may also be exported to orthodontic laboratories for the fabrication of retainers, orthodontic appliances, and hard model fabrication.\nThird Party Scanners and Digital scans for Invisalign treatment submission. We support an open systems approach to digital scans and other intraoral scanning companies interested in qualifying their scanners to submit a digital impression in place of a traditional PVS impression as part of the Invisalign case submission process. We have qualified several scanners for digital scan submission including 3M™ True Definition scanner (January 2014), the Sirona CEREC Omnicam scanner (March 2015) and certain TRIOS scanners (October 2016).\n7\nChair Side Applications\nInvisalign Outcome Simulator. The Invisalign Outcome Simulator is an exclusive chair-side and cloud-based application for the iTero scanner that allows doctors to help patients visualize how their teeth may look at the end of Invisalign treatment through a dual view layout that shows a prospective patient an image of his/her own current dentition next to his/her simulated final position after Invisalign treatment. Using a full arch digital scan, the Invisalign Outcome Simulator takes a few minutes to run and may be viewed chair-side, on the scanner, or from a computer using MyAlignTech.com. Intuitive tools allow doctors to make real-time adjustments to individual teeth during consultations that increase patient education and the likelihood of patient acceptance. In October 2016, we introduced the following new features in the 4.0 upgrade:\n| • | 3D Progress Tracking - Ability to compare a patient’s new scan with a specific stage of their ClinCheck treatment plan to visually assess and communicate Invisalign treatment progress with an easy to read, color-coded tooth movement report that allows the doctor to know how each tooth is tracking. |\n\n| • | Patient Simulation Sharing - Ability to easily share the patient’s 3D simulated Invisalign treatment outcome through a protected patient portal which can be viewed on smartphones, tablets and computers. |\n\nOur iTero scanner includes orthodontic software and/or restorative software and the Invisalign Outcome Simulator. The orthodontic or restorative software may also be purchased subsequently for an upgrade fee. The Invisalign Outcome Simulator is not available for sale separately.\nOther proprietary software mentioned in this Annual Report on Form 10-K such as ClinCheck and ClinCheck Pro software, the Invisalign Doctor Site, and enhanced feature solutions such as Invisalign G7 are included as part of the Invisalign System and are not sold separately nor do they contribute as individual items of revenue.\nBusiness Strategy\nOur goal is to establish Invisalign clear aligners as the standard method for treating malocclusion and to establish the iTero intraoral scanner as the preferred scanning protocol for 3D digital scans, ultimately driving increased product adoption by dental professionals. We intend to achieve this by continued focus and execution of our strategic growth drivers: International, Orthodontists Utilization, GP Dentists Treat & Refer and Patient Demand & Conversion\n| 1. | International Expansion. We expect to continue to grow and expand our business by investing in resources, infrastructure, and initiatives that will drive Invisalign treatment growth in our current and new international markets. As our core countries within the EMEA and APAC regions continue to grow in both number of new Invisalign providers and utilization, we strive to make sure we can support that growth through investments such as headcount, clinical support, education and advertising. Additionally, we are expanding our presence and entering new markets, such as India and Korea, by establishing a solid base of key opinion leaders and early adopters who can help build clinical confidence in the orthodontic community and create strong brand preference for Invisalign treatment among consumers. We have also transitioned most of our indirect smaller country markets to a direct sales model, and, while we do not expect a material impact from these countries for some time, in the near term, we will leverage our existing infrastructure in adjacent country markets as we build local sales organizations to drive long-term market penetration. |\n\n| 2. | Orthodontist Utilization. We want all of our orthodontist providers to have the confidence and motivation to lead with Invisalign for every patient that walks into their practice. We strive to achieve this by increasing the product applicability and predictability for a wide range of complex cases within adults, teenagers and younger aged patients. As an example, in 2015, we launched Invisalign G6 clinical innovations for first premolar extractions. The nature of malocclusion that requires first premolar tooth extraction is an orthodontic problem that affects more than 50% of people in Asia, 20% in Europe and 12% in North America. In October 2016, we launched Invisalign G7, which builds on earlier Invisalign G-series releases with new features to fine-tune certain tooth movements and deliver treatment outcome quality that Invisalign providers expect, particularly with teenage patients. We also continue to make improvements to our Invisalign treatment software, ClinCheck Pro, designed to deliver an exceptional user experience and increase treatment control to help our doctors achieve their treatment goals. |\n\n| 3. | GP Dentist Treat & Refer. We want to make it easier for GPs to identify the cases that they can treat and refer the cases that are too complex over to orthodontists. Although GPs have a larger pool of potential patients, which can expand the market for Invisalign treatment, overall, we need to provide them with tools to help them quickly identify cases they can treat, monitor patient progress or if needed, help refer them more easily to an orthodontist. The iTero scanner is an important component to that customer experience. In October 2016, we introduced a 3D progress tracking feature in the |\n\n8\nInvisalign Outcome Simulator application that provides our customers with the ability to compare a patient’s new scan with a specific stage of their ClinCheck treatment plan to visually assess and communicate Invisalign treatment progress.\n| 4. | Patient Demand & Conversion. Our goal is to make Invisalign a highly recognized name brand worldwide by creating awareness for Invisalign treatment among consumers and motiving potential patients to seek treatment from an Invisalign provider. In support of this objective, we invest in initiatives designed to strengthen our global brand name recognition, drive patient demand and covert that interest into Invisalign treatment case starts. We accomplish this objective through an integrated consumer marketing strategy that includes television, media, social networking and event marketing as well as educating patients on treatment options and directing them to high volume Invisalign providers. |\n\nSupply Agreement with SmileDirectClub, LLC\nOn July 28, 2016, we announced a supply agreement with SmileDirectClub, LLC (\"SDC\") to manufacture non-Invisalign clear aligners for SDC’s doctor-led, at-home program for affordable, cosmetic teeth straightening. The agreement brings our manufacturing and production expertise to a new and growing segment of the adult treatment market, one that provides new treatment choices to consumers and new business opportunities to Invisalign providers.\nBeginning October 2016, we became SDC’s exclusive third-party supplier for its minor tooth movement aligner program. Specifically, we provide a case setup through SDC’s SmileCheck viewer portal and upon review and approval by a participating licensed orthodontist or general dentist in SDC’s network, we manufacture clear aligners and ship them directly to SDC.\nSDC aligners include up to 20 stages without attachments or interproximal reduction (IPR). We manufacture the aligners per SDC’s specifications for minor tooth movement using EX-30 aligner material. The Invisalign brand and system of clear aligners continue to be available exclusively for in office treatment with Invisalign-trained orthodontists and general dentists.\nIn addition, under the agreement, Align and SDC created a new Invisalign doctor referral program similar to the Invisalign Doc Locator, that systematically refers the approximately 30% of SDC’s SmileCheck case assessments that are too complex for their minor tooth movement product, to Invisalign providers in the patient’s local area. The goal of the agreement is to help expand the market and opportunity for our Invisalign doctors, while supporting SDC’s efforts to provide consumers with access to more choices in treating simple cases from the convenience of their own home.\nManufacturing and Suppliers\nOur manufacturing facilities are located in Juarez, Mexico, where we conduct our aligner fabrication, distribute and repair our scanners and perform our CAD/CAM services, and in Or Yehuda, Israel where we produce our handheld intraoral scanner wand. The final assembly of our iTero scanner is performed by a third party manufacturer located in Israel. Our Invisalign digital treatment planning and interpretation for iTero restorative cases are conducted primarily at our facility located in San Jose, Costa Rica. Information regarding risks associated with our manufacturing process and foreign operations may be found in Item 1A of this Annual Report on Form 10-K under the heading “Risk Factors.”\nOur quality system is required to be in compliance with the Quality System regulations enforced by the FDA, and similar regulations enforced by other worldwide regulatory authorities. We are certified to EN ISO 13485:2003, an internationally recognized standard for medical device manufacturing. We have a formal, documented quality system by which quality objectives are defined, understood and achieved. Systems, processes and procedures are implemented to ensure high levels of product and service quality. We monitor the effectiveness of the quality system based on internal data and direct customer feedback and strive to continually improve our systems and processes, taking corrective action, as needed.\nSince the manufacturing process of our products requires substantial and varied technical expertise, we believe that our manufacturing capabilities are important to our success. In order to produce our highly customized, highly precise, medical quality products in volume, we have developed a number of proprietary processes and technologies. These technologies include complex software algorithms and solutions, CT scanning, stereolithography and automated aligner fabrication. To increase the efficiency of our manufacturing processes, we continue to focus our efforts on software development and the improvement of rate-limiting processes or bottlenecks. We continuously upgrade our proprietary, three-dimensional treatment planning software to enhance computer analysis of treatment data and to reduce time spent on manual and judgmental tasks for each case, thereby increasing the efficiency of our technicians in Costa Rica. In addition, to improve efficiency and increase the scale of our operations, we continue to invest in the development of automated systems for the fabrication and packaging of aligners.\nWe are highly dependent on manufacturers of specialized scanning equipment, rapid prototyping machines, resin and other advanced materials for our aligners, as well as the optics, electronic and other mechanical components of our intraoral scanners. We\n9\nmaintain single supply relationships for many of these machines and materials technologies. In particular, our CT scanning and stereolithography equipment used in our aligner manufacturing and many of the critical components for the optics of our intraoral scanners are provided by single suppliers. We are also committed to purchasing all of our resin and polymer, the primary raw materials used in our manufacturing process for clear aligners, from a single source. The need to replace one of our single source suppliers could cause a disruption in our ability to timely deliver certain of our products or increase costs. See Item 1A Risk Factors — “We maintain single supply relationships for certain of our key machines and materials technologies, and our business and operating results could be harmed if supply is restricted or ends or the price of raw materials used in our manufacturing process increases.”\nSales and Marketing\nOur sales efforts are focused primarily on the Invisalign System and continuing to increase adoption and utilization by orthodontists and GPs worldwide. In North America, Europe and certain Asia Pacific country markets, and more recently in Brazil and certain regions in the Middle East and Africa, we have direct sales and support organizations, which includes quota carrying sales representatives, sales management and sales administration. We also have distribution partners that sell the Invisalign System in smaller non-core country markets outside of North America. We continued to expand in our existing markets through targeted investments in sales coverage, professional marketing and education programs, along with consumer marketing in selected country markets.\nFor the iTero scanner, we have a small team of direct sales representatives in North America. Our intraoral scanner sales team leverages leads generated by our Invisalign sales and marketing resources, including customer events and industry trade-shows. We sell the iTero scanner in select country markets internationally and will expand to additional markets over time to grow the scanner business.\nWe provide training, marketing and clinical support to orthodontists and GPs. In 2016, we had approximately 54,480 active Invisalign providers.\nResearch and Development\nWe are committed to investing in world-class technology development, which we believe is critical to achieving our goal of establishing the Invisalign System as the standard method for treating malocclusion and our intraoral scanning platform as the preferred scanning protocol for digital scans. Our research and development expenses were $75.7 million, $61.2 million and $52.8 million for the year ended December 31, 2016, 2015 and 2014, respectively.\nOur research and development activities are directed toward developing the technology innovations that we believe will deliver our next generation of products and platforms. These activities range from accelerating product and clinical innovation to developing manufacturing process improvements to researching future technologies and products.\nIn an effort to demonstrate Invisalign’s broad treatment capabilities, various clinical case studies and articles have been published that highlight the clinical applicability of Invisalign to malocclusion cases, including those of severe complexity. We undertake pre-commercialization trials and testing of our technological improvements to the product and manufacturing process.\nIntellectual Property\nWe believe our intellectual property position represents a substantial business advantage. As of December 31, 2016, we had issued 425 U.S. patents, 370 foreign issued patents, and 386 pending global patent applications.\nWe continue to pursue further intellectual property protection through U.S. and foreign patent applications and non-disclosure agreements. Our issued U.S. patents expire between 2017 and 2035. In addition, corresponding foreign patents will start to expire in 2018. When patents expire, we lose the protection and competitive advantages they provided to us, which could negatively impact our operating results; however, we continue to pursue further intellectual property protection through U.S. and foreign patent applications and non-disclosure agreements. We also seek to protect our software, documentation and other written materials under trade secret and copyright laws. We cannot be certain that patents will be issued as a result of any patent application or that patents that have been issued to us or that may be issued in the future will be found to be valid and enforceable and sufficient to protect our technology or products. Our intellectual property rights may not be successfully asserted in the future or may be invalidated, circumvented or challenged. In addition, the laws of various foreign countries do not protect our intellectual property rights to the same extent as U.S. laws. Our inability to protect our proprietary information could harm our business. Information regarding risks associated with failing to protect our proprietary technology and our intellectual property rights may be found in Item 1A of this Annual Report on Form 10-K under the heading “Risk Factors.”\n10\nSeasonal Fluctuations\nGeneral economic conditions impact our business and financial results, and we experience seasonal trends related to our two operating segments, customer channels and the geographic locations that we serve. For example, European sales of Invisalign treatment are often weaker in the summer months due to our customers and their patients being on holiday. In North America, summer is typically the busiest season for orthodontists with practices that have a high percentage of adolescent and teenage patients as many parents want to get their teenagers started in treatment before the start of the school year; however, many GPs are on vacation during this time and therefore tend to start fewer cases. For our Scanner segment, capital equipment sales are often stronger in the fourth calendar quarter. Consequently, these seasonal trends have caused and may continue to cause, fluctuations in our quarterly results, including fluctuations in sequential revenue growth rates.\nBacklog\nDue to the individualized nature of an Invisalign treatment which is prescribed by a doctor, no two cases are alike, thus we maintain relatively low levels of backlog. The period from which a treatment data package (or “a case”) is received until the acceptance of the digital ClinCheck treatment plan is dependent on the dental professional’s discretion to modify, accept or cancel the treatment plan. Therefore, we consider the case a firm order to manufacture aligners once the dental professional has approved the ClinCheck treatment plan. Our Invisalign backlog consists of ClinCheck treatment plans that have been accepted but not yet shipped. Because aligners are shipped shortly after the ClinCheck treatment plan has been accepted, we believe that backlog is not a good indicator of future Invisalign sales. Our quarterly Invisalign revenues can be impacted by the timing of the ClinCheck treatment plan acceptances and our ability to ship those cases in the same quarter. We define our intraoral scanner backlog as orders where payment is reasonably assured and credit and financing is approved but the scanner has not yet shipped. Our intraoral scanner backlog as of December 31, 2016 was not material.\nCompetition\nWe operate in a highly competitive market and we encounter a wide variety of competitors, including larger companies or divisions of larger companies with substantial sales, marketing, research and financial capabilities. We also face competition from early stage companies. Although the number of competitors varies by segment, currently our products compete directly against products manufactured and distributed by various companies, both within and outside the U.S., including Danaher Corporation, Sirona Dental Systems, Inc., Dentsply International, Inc., 3M Company and other private competitors. In addition, the expiration of certain of our key patents commencing in 2017, may result in additional competition. Information regarding risks associated with increased competition may be found in Item 1A of this Annual Report on Form 10-K under the heading “Risk Factors.”\nKey competitive factors include:\n| • | effectiveness of treatment; |\n\n| • | price; |\n\n| • | software features; |\n\n| • | aesthetic appeal of the treatment method; |\n\n| • | customer support; |\n\n| • | customer online interface; |\n\n| • | brand awareness; |\n\n| • | innovation; |\n\n| • | distribution network; |\n\n| • | comfort associated with the treatment method; |\n\n| • | oral hygiene; |\n\n| • | ease of use; and |\n\n| • | dental professionals’ chair time. |\n\nWe believe that our products compare favorably with our competitors’ products with respect to each of these factors.\n11\nGovernment Regulation\nIn order for us to market our products, we must obtain regulatory authorization and comply with extensive product and quality system regulations both within and outside the U.S. These regulations, including the requirements for approvals or clearance and the time required for regulatory review, vary from country to country. Failure to obtain regulatory approval and to meet all local requirements including language and specific safety standards in any country in which we currently market or plan to market our products could prevent us from marketing products in such countries or subject us to sanctions and fines. The approval by government authorities is unpredictable and uncertain and may not be granted on a timely basis, if at all. Delays in receipt of, or a failure to receive, such approvals or clearances, or the loss of any previously received approvals or clearances, could have a material adverse effect on our business, financial condition, and results of operations.\nCertain of our products are classified as medical devices under the United States Food, Drug, and Cosmetic Act (the “FD&CA”). The FD&CA requires these products, when sold in the U.S., to be safe and effective for their intended use and to comply with the regulations administered by the United States FDA. Our products may also be regulated by comparable agencies in non-U.S. countries in which they are produced or sold. In the European Union (\"EU\"), our products are subject to the medical devices laws of the various member states, which are based on a Directive of the European Commission. Such laws generally regulate the safety of the products in a similar way to the FDA regulations.\nWe believe we are in compliance with all FDA, federal and state laws and International regulatory requirements that are applicable to our products and manufacturing operations.\nWe are also subject to various laws inside and outside the U.S. concerning our relationships with healthcare professionals and government officials, price reporting and regulation, the promotion, sales and marketing of our products and services, the importation and exportation of our products, the operation of our facilities and distribution of our products. As a global company, we are subject to varying degrees of government regulation in the various countries in which we do business, and the general trend is toward increasingly stringent oversight and enforcement. Initiatives sponsored by government agencies, legislative bodies, and the private sector to limit the growth of healthcare expenses generally are ongoing in markets where we do business. It is not possible to predict at this time the long-term impact of such cost containment measures on our future business.\nOur customers are healthcare providers that may be reimbursed by federally funded programs such as Medicaid or a foreign national healthcare program, each of which may offer some degree of oversight. Many government agencies, both domestic and foreign, have increased their enforcement activities with respect to healthcare providers and companies in recent years. Enforcement actions and associated defense can be expensive, and any resulting findings carry the risk of significant civil and criminal penalties. For example, the U.S. Federal Physician Payment Sunshine Act went into effect in 2014 which requires public transparency of transfers of value to physicians.\nIn addition, we must comply with numerous data protection requirements that span from individual state and national laws in the U.S. to multinational requirements in the EU. In the U.S., final regulations implementing amendments to the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) became effective in the latter part of 2013 with the HIPAA Omnibus Rule. The EU is currently considering a proposal to enact legislation governing data protection which would transform the current mix of European countries’ laws to one overarching multinational law. Meanwhile, the Asia Pacific region has also seen rapid development of privacy laws, including in Singapore, Hong Kong, and Australia. We believe we have designed our product and service offerings to be compliant with the requirements of applicable data protection laws and regulations. Maintaining systems that are compliant with these laws and regulations is costly and could require complex changes in the way we do business or provide services to our customers and their patients. Additionally, our success may be dependent on the success of healthcare providers in managing data protection requirements.\nEmployees\nAs of December 31, 2016, we had approximately 6,060 employees, including 3,970 in manufacturing and operations, 1,270 in sales and marketing which includes customer care, 430 in research and development and 390 in general and administrative functions.\n12\nAvailable Information\nOur website is www.aligntech.com, and our investor relations website is http://investor.aligntech.com. The information on or accessible through our websites is not part of this Annual Report on Form 10-K. Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, our proxy statement on Schedule 14A for our annual stockholders’ meeting and amendments to such reports are available, free of charge, on our investor relations website as soon as reasonably practicable after we electronically file or furnish such material with the SEC. Further, a copy of this Annual Report on Form 10-K is located at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Information on the operation of the Public Reference Room can be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains an internet site that contains reports, proxy and information statements and other information regarding our filings at www.sec.gov.\nExecutive Officers of the Registrant\nThe following table sets forth certain information regarding our executive officers as of February 28, 2017:\n\n| Name | Age | Position |\n| Joseph M. Hogan | 59 | President and Chief Executive Officer |\n| John F. Morici | 50 | Chief Financial Officer |\n| Simon Beard | 50 | Vice President and Managing Director, EMEA |\n| Roger E. George | 51 | Vice President, Corporate and Legal Affairs and General Counsel |\n| Stuart Hockridge | 45 | Vice President, Global Human Resources |\n| Sreelakshmi Kolli | 42 | Vice President, Information Technology |\n| Jennifer Olson | 39 | Vice President and Managing Director, Doctor Directed Consumer Channel |\n| Raphael Pascaud | 45 | Chief Marketing Portfolio and Business Development Officer, and Vice President iTero Scanner and Services |\n| Lynn Pendergrass | 56 | Vice President and Managing Director, Americas |\n| Christopher C. Puco | 56 | Vice President and Managing Director, North America |\n| Zelko Relic | 52 | Vice President, Research & Development |\n| Julie Tay | 50 | Vice President and Managing Director, Asia Pacific |\n| Emory M. Wright | 47 | Vice President, Operations |\n\nJoseph M. Hogan has served as our President and Chief Executive Officer and as a member of our Board of Directors since June 2015. Prior to joining us, Mr. Hogan was Chief Executive Officer of ABB Ltd., a global power and automation technologies company based in Zurich, Switzerland from 2008 to 2013. Prior to working in ABB, Mr. Hogan worked at General Electric Company (GE) in a variety of executive and management roles from 1985 to 2008, including eight years as Chief Executive Officer of GE Healthcare from 2000 to 2008.\nJohn F. Morici has served as our Chief Financial Officer since November 2016. Prior to joining us, Mr. Morici was at NBC Universal from 2007 to 2016 where he held several senior management positions in their Universal Pictures Home Entertainment U.S. and Canadian business, including Chief Financial Officer, Chief Operating Officer, and most recently, Executive Vice President and Managing Director from 2014 to 2016. Prior to NBC Universal, Mr. Morici was in various senior financial management positions at GE Healthcare from 1999 to 2007, including Chief Financial Officer for its Diagnostic Imaging and Global Products units from 2002 to 2003.\nSimon Beard has served as our Vice President and Managing Director, EMEA since October 2015. Prior to joining us, from 2012 to 2014, Mr. Beard was Regional Director for the South East Asia business of Smith & Nephew, a multinational medical equipment manufacturing company. From 2006 to 2012, Mr. Beard was Director & General Manager for UK and Ireland for Smith & Nephew's Advanced Woundcare business. Prior to Smith & Nephew, Mr. Beard held multiple commercial, strategic, and general management positions in companies such as DePuy International (Johnson & Johnson), Sankyo Pharmaceutical and Sanofi Aventis.\nRoger E. George has served as our Vice President, Corporate and Legal Affairs and General Counsel since July 2002. Prior to joining us, Mr. George was the Chief Financial Officer, Vice President of Finance and Legal Affairs and General Counsel of SkyStream Networks, a privately held broadband and broadcast network equipment company. Prior to SkyStream, Mr. George was a partner at Wilson Sonsini Goodrich & Rosati, P.C. in Palo Alto, California.\n13\nStuart Hockridge has served as our Vice President, Global Human Resources since May 2016. Prior to joining us, Mr. Hockridge was Senior Vice President of Talent at Visa Inc. from 2013 to 2016 where he led all aspects of talent delivery for the company including executive development, succession planning, employee engagement, learning and development, and talent acquisition. Prior to Visa, Mr. Hockridge held a number of human resource management positions at GE Healthcare from 2002 to 2012 leading HR processes both globally and for various divisions.\nSreelakshmi Kolli has served as our Vice President, Information Technology since December 2012. Ms. Kolli joined us in June 2003 and has held positions leading business operations and engineering for customer-facing applications. Before joining us, she held technical lead positions with Sword CT Space and Accenture.\nJennifer Olson has served as our Vice President and Managing Director, Doctor-Directed Consumer Channel since August 2016. Ms. Olson joined us in 2002 and has held multiple roles in sales, marketing, and business development. Most recently, she was Area Sales Director for the North America region where she led all sales activities in Western Canada and the Western region of the U.S. Prior to joining Align, Ms. Olson was with technology companies including Extreme Networks and PWI Technologies.\nRaphael Pascaud has served as our Chief Marketing, Portfolio and Business Development Officer, and Vice President, iTero Scanner and Services since July 2015. He joined Align in 2010 as Vice President and Managing Director for the EMEA and was promoted in January 2014 to Vice President, International. Prior to Align, Mr. Pascaud spent 14 years in various management positions within DePuy, a Johnson & Johnson family of companies, including Vice President Orthopedics of EMEA and Vice President Marketing of International.\nLynn Pendergrass has served as our Vice President and Managing Director, Americas since February 2017. Prior to joining us, Ms. Pendergrass was president of Sears Holdings Corporation's hardlines division from 2015 to 2016. Prior to Sears, Ms. Pendergrass served as Worldwide Chairman for Johnson & Johnson Consumer from 2013 to 2014, and as Americas Senior Vice President for Hewlett-Packard's Printing & Personal Systems and its Imaging & Printing Group from 2008 to 2012. Ms. Pendergrass also spent 22 years at General Electric in various operating and commercial roles and held several executive management positions in sales and marketing for its Consumer & Industrial division.\nChristopher C. Puco has served as our Vice President and Managing Director, North America since February 2017. He joined us in 2006 as a sales director and in 2008 became senior director for the U.S. Eastern sales area. He served as Vice President of North America from December 2012 to February 2017. Mr. Puco has more than 20 years of experience in the medical device industry holding sales management positions in both starts-ups and established corporate environments. Prior to joining us, he was with United States Surgical Corporation, General Surgical Innovations, Baxter BioSurgery and Fusion Medical Technologies.\nZelko Relic was appointed Vice President, Research & Development in December 2013. Prior to joining us, Mr. Relic was Vice President, Engineering for Datalogic Automation, a global leader in automatic data capture and industrial automation markets from 2012. Mr. Relic was previously Vice President, Engineering at Danaher Corporation, Accu-Sort Systems business from 2010 to 2012 before it was acquired by Datalogic Automation. From 2005 to 2010, he was at Siemens Medical Solutions USA, most recent as Vice President, and from 2002 to 2004, he held senior management positions in engineering at Kulicke & Soffa Industries, designers and manufactures of semiconductor products. He also held management positions at KLA-Tencor from 1994 to 2000.\nJulie Tay was appointed Vice President and Managing Director, Asia Pacific in March 2013. Prior to joining us, Ms. Tay was regional head of Bayer Healthcare (Diabetes Care) overseeing operations across Asia from 2010 to 2013. From 2006 to 2010, Ms. Tay served as director of marketing and corporate accounts at Sealed Air Corporation (formerly Johnson Diversey), a global provider of food safety and security, facility hygiene and product protection. Prior to that, Ms. Tay spent 15 years with Johnson & Johnson Medical.\nEmory M. Wright has served as our Vice President, Operations since December 2007. He has been with us since March 2000 predominantly in manufacturing and operations roles including Vice President, Manufacturing and was General Manager of New Product Development. Prior to joining Align, Mr. Wright was Senior Manufacturing Manager at Metrika, Inc. a medical device manufacturer from 1999 to 2000. From 1994 to 1999, Mr. Wright served as Manager of Manufacturing and Process Development for Metra Biosystems Inc.\n14\nITEM 1A.\nRISK FACTORS\nWe depend on the sale of the Invisalign system for the vast majority of our net revenues, and any decline in sales of Invisalign treatment for any reason, or a decline in average selling prices would adversely affect net revenues, gross margin and net income.\nWe expect that net revenues from the sale of the Invisalign System, primarily Invisalign Full and Invisalign Teen, will continue to account for the vast majority of our total net revenues for the foreseeable future. Continued and widespread market acceptance of Invisalign by orthodontists, GPs and consumers is critical to our future success. If orthodontists and GPs experience a reduction in consumer demand for orthodontic services, if consumers prove unwilling to adopt Invisalign as rapidly as we anticipate or in the volume that we anticipate, if orthodontists or GPs choose to use a competitive product rather than Invisalign or if the average selling price of our product declines, our operating results would be harmed.\nCompetition in the markets for our products is intense and we expect aggressive competition from existing competitors and other companies that may introduce new technologies in the future.\nCurrently, our products compete directly against products manufactured and distributed by various companies, both within and outside the U.S. Many of these manufacturers, including Danaher Corporation, Sirona Dental Systems, Inc., Dentsply International, Inc. and 3M, have substantially greater financial resources and manufacturing and marketing experience than we do. In addition, as a result of the expiration of certain key patents owned by us, commencing in 2017, we expect that these existing competitors as well as new entrants into the clear aligner market will begin offering an orthodontic system more similar to ours in the near future. Several of these competitors will likely have greater resources as well as the ability to leverage their existing channels in the dental market to compete directly with us, and therefore our share of the clear aligner market could decline which would likely have a material adverse effect on our business, results of operation and financial condition. In addition, corresponding foreign patents will start to expire in 2018 which will likely result in increased competition in some of the markets outside the U.S. large consumer product companies may also enter the orthodontic supply market. Furthermore, we also face competition for companies that now offer clear aligner therapy directly to the consumer eliminating the need for the consumer to visit a dental office. In addition, we may also face competition in the future from new companies that may introduce new technologies. We may be unable to compete with these competitors and one or more of these competitors may render our technology obsolete or economically unattractive. If we are unable to compete effectively with existing products or respond effectively to any products developed by new or existing competitors, our business could be harmed. Increased competition has resulted in the past and may in the future result in volume discounting and price reductions, reduced gross margins, reduced profitability and loss of market share, and reduce dental professionals’ efforts and commitment to expand their use of our products, any of which could have a material adverse effect on our net revenues, volume growth, net income and stock price. We cannot assure that we will be able to compete successfully against our current or future competitors or that competitive pressures will not have a material adverse effect on our business, results of operations and financial condition.\nWe are dependent on our international operations, which exposes us to foreign operational, political and other risks that may harm our business.\nOur key production steps are performed in operations located outside of the U.S. At our facility in San Jose, Costa Rica, technicians use a sophisticated, internally developed computer-modeling program to prepare digital treatment plans, which are then transmitted electronically to Juarez, Mexico. These digital files form the basis of the ClinCheck treatment plan and are used to manufacture aligner molds. Our order acquisition, aligner fabrication and shipping operations are conducted in Juarez, Mexico and starting in July 2016, we transitioned order acquisition for EMEA region to our facility in Amsterdam, the Netherlands. In addition to the research and development efforts conducted in our North America facilities, we also carry out research and development in Moscow, Russia. We also have customer-care, accounts receivable, credit and collections, customer event registration and accounts payable organizations located at our facility in San Jose, Costa Rica. In addition, we have operations in Israel where the design and wand assembly and our intraoral scanner are manufactured. Our reliance on international operations exposes us to risks and uncertainties that may affect our business or results of operation, including:\n| • | difficulties in hiring and retaining employees generally, as well as difficulties in hiring and retaining employees with the necessary skills to perform the more technical aspects of our operations; |\n\n| • | difficulties in managing international operations, including any travel restrictions to or from our facilities located in Russia, Israel and other countries; |\n\n| • | fluctuations in currency exchange rates; |\n\n| • | increased income taxes, and other restrictions and limitations, if we were to decide to repatriate any of our foreign cash balances back to the U.S.; |\n\n15\n| • | import and export license requirements and restrictions; |\n\n| • | controlling production volume and quality of the manufacturing process; |\n\n| • | political, social and economic instability, including as a result of increased levels of violence in Juarez, Mexico or the Middle East. We cannot predict the effect on us of any future armed conflict, political instability or violence in these regions. In addition, some of our employees in Israel are obligated to perform annual reserve duty in the Israeli military and are subject to being called for additional active duty under emergency circumstances. We cannot predict the full impact of these conditions on us in the future, particularly if emergency circumstances or an escalation in the political situation occurs. If many of our employees are called for active duty, our operations in Israel and our business may not be able to function at full capacity; |\n\n| • | acts of terrorism and acts of war; |\n\n| • | general geopolitical instability and the responses to it, such as the possibility of additional sanctions against Russia which continue to bring uncertainty to this region; |\n\n| • | interruptions and limitations in telecommunication services; |\n\n| • | product or material transportation delays or disruption, including as a result of increased levels of violence, acts of terrorism, acts of war or health epidemics restricting travel to and from our international locations or as a result of natural disasters, such as earthquakes or volcanic eruptions; |\n\n| • | burdens of complying with a wide variety of local country and regional laws, including the risks associated with the Foreign Corrupt Practices Act and local anti-bribery compliance; |\n\n| • | trade restrictions and changes in tariffs; and |\n\n| • | potential adverse tax consequences. |\n\nIf any of these risks materialize in the future, we could experience production delays and lost or delayed revenue.\nIn addition, President Donald Trump and his administration have made recent statements regarding the possibility of changing the way in which the international operations of U.S. companies are taxed, including through the implementation of a border tax, tariff or increase in custom duties on products manufactured in countries outside of the U.S., such as Mexico, and imported into the U.S. In the event such taxes, tariffs, increased custom duties or other measures are implemented, they could have a materially adverse effect on our business and or operating results, and we may have to consider relocating some of our international operations.\nWe earn an increasingly larger portion of our total revenues from international sales and face risks attendant to those operations.\nWe earn an increasingly larger portion of our total revenues from international sales generated through our foreign direct and indirect operations. Since our growth strategy depends in part on our ability to further penetrate markets outside the U.S. and increase the localization of our products and services, we expect to continue to increase our sales and presence outside the U.S., particularly in the high-growth markets. Our international operations are subject to risks that are customarily encountered in non-U.S. operations, including:\n| • | local political and economic instability; |\n\n| • | the engagement of activities by our employees, contractors, partners and agents, especially in countries with developing economies, that are prohibited by international and local trade and labor laws and other laws prohibiting corrupt payments to government officials, including the Foreign Corrupt Practices Act, the UK Bribery Act of 2010 and export control laws, in spite of our policies and procedures designed to ensure compliance with these laws; |\n\n| • | although it is our intention to indefinitely reinvest earnings outside the U.S., restrictions on the transfer of funds held by our foreign subsidiaries, including with respect to restrictions on our ability to repatriate foreign cash to the U.S at favorable tax rates; |\n\n| • | fluctuations in currency exchange rates; and |\n\n| • | increased expense of developing, testing and making localized versions of our products. |\n\n16\nAny of these factors, either individually or in combination, could materially impact our international operations and adversely affect our business as a whole.\nWe face risks related to our international sales, including the need to obtain necessary foreign regulatory clearance or approvals.\nOutside of North America, we currently sell our products in Europe, Asia Pacific, Latin America and the Middle East and may expand into other countries from time to time. For sales of our products outside the U.S., we are subject to foreign regulatory requirements that vary widely from country to country. The time required to obtain clearances or approvals required by other countries may be longer than that required for FDA clearance or approval, and requirements for such approvals may differ from FDA requirements. We may be unable to obtain regulatory approvals in one or more of the other countries in which we do business or in which we may do business in the future. We may also incur significant costs in attempting to obtain and maintain foreign regulatory approvals. If we experience delays in receipt of approvals to market our products outside of the U.S., or if we fail to receive these approvals, we may be unable to market our products or enhancements in international markets in a timely manner, if at all, which could materially impact our international operations and adversely affect our business as a whole.\nDemand for our products may not increase as rapidly as we anticipate due to a variety of factors including a weakness in general economic conditions.\nConsumer spending habits are affected by, among other things, prevailing economic conditions, levels of employment, salaries and wage rates, gas prices, consumer confidence and consumer perception of economic conditions. A general slowdown in the U.S. economy and certain international economies or an uncertain economic outlook would adversely affect consumer spending habits which may, among other things, result in a decrease in the number of overall orthodontic case starts, reduced patient traffic in dentists’ offices, reduction in consumer spending on higher value procedures or a reduction in the demand for dental services generally, each of which would have a material adverse effect on our sales and operating results. Weakness in the global economy results in a challenging environment for selling dental technologies and dentists may postpone investments in capital equipment, such as intraoral scanners. In addition, Invisalign treatment, which currently accounts for the vast majority of our net revenues, represents a significant change from traditional orthodontic treatment, and customers and consumers may be reluctant to accept it or may not find it preferable to traditional treatment. We have generally received positive feedback from orthodontists, GPs and consumers regarding Invisalign treatment as both an alternative to braces and as a clinical method for the treatment of malocclusion, but a number of dental professionals believe that the Invisalign treatment is appropriate for only a limited percentage of their patients. Increased market acceptance of all of our products will depend in part upon the recommendations of dental professionals, as well as other factors including effectiveness, safety, ease of use, reliability, aesthetics, and price compared to competing products.\nThe frequency of use of the Invisalign system by orthodontists or GPs may not increase at the rate that we anticipate or at all.\nOne of our key objectives is to continue to increase utilization, or the adoption and frequency of use, of the Invisalign System by new and existing customers. If utilization of the Invisalign System by our existing and newly trained orthodontists or GPs does not occur or does not occur as quickly as we anticipate, our operating results could be harmed.\nWe may experience declines in average selling prices of our products which may decrease our net revenues.\nWe provide volume based discount programs to our doctors. In addition, we sell a number of products at different list prices. If we introduce any price reductions or consumer rebate programs; if we expand our discount programs in the future or participation in these programs increases; or if our product mix shifts to lower priced products or products that have a higher percentage of deferred revenue, our average selling prices would be adversely affected and our net revenues, gross profit, gross margin and net income may be reduced. In July 2015, we launched a new product policy called \"Additional Aligners at No Charge\" that addresses one of our customer's top complaints. With this product policy change, we no longer distinguish between mid-course correction and case refinements and allow doctors to order additional aligners to address either treatment need at no charge, subject to certain requirements. Based on this product policy, beginning in the third quarter of 2015, we deferred more revenue as a result of providing free additional aligners for eligible treatments. Additionally, as we grandfathered over 1 million open cases, we will recognize lower revenues as additional aligners are shipped for at least the following two years until these cases complete.\nWe are exposed to fluctuations in currency exchange rates, which could negatively affect our financial condition and results of operations.\nAlthough the U.S. dollar is our reporting currency, a portion of our net revenues and net income are generated in foreign currencies. Net revenues and net income generated by subsidiaries operating outside of the U.S. are translated into U.S. dollars\n17\nusing exchange rates effective during the respective period and are affected by changes in exchange rates. As a result, negative movements in currency exchange rates against the U.S. dollar will adversely affect our net revenues and net income in our consolidated financial statements. The exchange rate between the U.S. dollar and foreign currencies has fluctuated substantially in recent years and may continue to fluctuate substantially in the future. We have in the past and may in the future enter into currency hedging transactions in an effort to cover some of our exposure to foreign currency exchange fluctuations. These transactions may not operate to fully or effectively hedge our exposure to currency fluctuations, and, under certain circumstances, these transactions could have an adverse effect on our financial condition.\nAs we continue to grow, we are subject to growth related risks, including risks related to excess or constrained capacity at our existing facilities.\nWe are subject to growth related risks, including excess or constrained capacity and pressure on our internal systems and personnel. In order to manage current operations and future growth effectively, we will need to continue to implement and improve our operational, financial and management information systems and to hire, train, motivate, manage and retain employees. We may be unable to manage such growth effectively. Any such failure could have a material adverse impact on our business, operations and prospects. In the near term, we intend to establish additional order acquisition and treatment planning facilities closer to our international customers in order to improve our operational efficiency and provide doctors with a better experience to further improve their confidence in using Invisalign to treat more patients, more often. Our ability to plan, construct and equip additional order acquisition, treatment planning and manufacturing facilities is subject to significant risk and uncertainty, including risks inherent in the establishment of a facility, such as hiring and retaining employees and delays and cost overruns as a result of a number of factors, any of which may be out of our control. If the transition into this additional facility is significantly delayed or demand for our product exceeds our current expectations, we may not be able to fulfill orders timely, which may negatively impact our financial results and overall business. In addition, because we cannot immediately adapt our production capacity and related cost structures to changing market conditions, our facility capacity may at times exceed or fall short of our production requirements. In addition, if product demand decreases or we fail to forecast demand accurately, we could be required to write off inventory or record excess capacity charges, which would lower our gross margin. Production of our intraoral scanners may also be limited by capacity constraints due to a variety of factors, including our dependency on third party vendors for key components in addition to limited production yields. Any or all of these problems could result in the loss of customers, provide an opportunity for competing products to gain market acceptance and otherwise harm our business and financial results.\nIf we fail to sustain or increase profitability or revenue growth in future periods, the market price for our common stock may decline.\nIf we are to sustain or increase profitability in future periods, we will need to continue to increase our net revenues, while controlling our expenses. Because our business is evolving, it is difficult to predict our future operating results or levels of growth, and we have not in the past and may not in the future be able to sustain our historical growth rates. If we do not increase profitability or revenue growth or otherwise meet the expectations of securities analysts or investors, the market price of our common stock will likely decline.\nOur financial results have fluctuated in the past and may fluctuate in the future which may cause volatility in our stock price.\nOur operating results have fluctuated in the past and we expect our future quarterly and annual operating results to fluctuate as we focus on increasing doctor and consumer demand for our products. These fluctuations could cause our stock price to decline or significantly fluctuate. Some of the factors that could cause our operating results to fluctuate include:\n| • | limited visibility into and difficulty predicting the level of activity in our customers’ practices from quarter to quarter; |\n\n| • | weakness in consumer spending as a result of the slowdown in the U.S. economy and global economies; |\n\n| • | changes in relationships with our distributors; |\n\n| • | changes in the timing of receipt of Invisalign case product orders during a given quarter which, given our cycle time and the delay between case receipts and case shipments, could have an impact on which quarter revenue can be recognized; |\n\n| • | fluctuations in currency exchange rates against the U.S. dollar; |\n\n| • | changes in product mix; |\n\n| • | our inability to scale production of our iTero Element scanner to meet customer demand; |\n\n| • | if participation in our customer rebate or discount programs increases our average selling price will be adversely affected; |\n\n18\n| • | seasonal fluctuations in the number of doctors in their offices and their availability to take appointments; |\n\n| • | success of or changes to our marketing programs from quarter to quarter; |\n\n| • | our reliance on our contract manufacturers for the production of sub-assemblies for our intraoral scanners; |\n\n| • | timing of industry tradeshows; |\n\n| • | changes in the timing of when revenue is recognized, including as a result of the introduction of new products or promotions, modifications to our terms and conditions or as a result of changes to critical accounting estimates or new accounting pronouncements; |\n\n| • | changes to our effective tax rate; |\n\n| • | unanticipated delays in production caused by insufficient capacity or availability of raw materials; |\n\n| • | any disruptions in the manufacturing process, including unexpected turnover in the labor force or the introduction of new production processes, power outages or natural or other disasters beyond our control; |\n\n| • | the development and marketing of directly competitive products by existing and new competitors; |\n\n| • | disruptions to our business as a result of our agreement to manufacture clear aligners for SmileDirectClub, LLC (\"SDC\"), including, market acceptance of the SDC business model and product, possible adverse customer reaction and negative publicity about us and our products; |\n\n| • | impairments in the value of our strategic investments in SDC and other privately held companies could be material; |\n\n| • | major changes in available technology or the preferences of customers may cause our current product offerings to become less competitive or obsolete; |\n\n| • | aggressive price competition from competitors; |\n\n| • | costs and expenditures in connection with litigation; |\n\n| • | the timing of new product introductions by us and our competitors, as well as customer order deferrals in anticipation of enhancements or new products; |\n\n| • | unanticipated delays in our receipt of patient records made through an intraoral scanner for any reason; |\n\n| • | disruptions to our business due to political, economic or other social instability, including the impact of an epidemic any of which results in changes in consumer spending habits, consumers unable or unwilling to visit the orthodontist or general practitioners office, as well as any impact on workforce absenteeism; |\n\n| • | inaccurate forecasting of net revenues, production and other operating costs, |\n\n| • | investments in research and development to develop new products and enhancements; |\n\n| • | changes in accounting rules; and |\n\n| • | our ability to successfully hedge against a portion of our foreign currency-denominated assets and liabilities. |\n\nTo respond to these and other factors, we may need to make business decisions that could adversely affect our operating results such as modifications to our pricing policy, business structure or operations. Most of our expenses, such as employee compensation and lease payment obligations, are relatively fixed in the short term. Moreover, our expense levels are based, in part, on our expectations regarding future revenue levels. As a result, if our net revenues for a particular period fall below our expectations, whether caused by changes in consumer spending, consumer preferences, weakness in the U.S. or global economies, changes in customer behavior related to advertising and prescribing our product or other factors, we may be unable to adjust spending quickly enough to offset any shortfall in net revenues. Due to these and other factors, we believe that quarter-to-quarter comparisons of our operating results may not be meaningful. You should not rely on our results for any one quarter as an indication of our future performance.\n19\nOur future success may depend on our ability to develop, successfully introduce and achieve market acceptance of new products.\nOur future success may depend on our ability to develop, manufacture, market and obtain regulatory approval or clearance of new products. There can be no assurance that we will be able to successfully develop, sell and achieve market acceptance of these and other new products and applications and enhanced versions of our existing product or software. The extent of, and rate at which, market acceptance and penetration are achieved by future products is a function of many variables, which include, among other things, our ability to:\n| • | correctly identify customer needs and preferences and predict future needs and preferences; |\n\n| • | include functionality and features that address customer requirements; |\n\n| • | ensure compatibility of our computer operating systems and hardware configurations with those of our customers; |\n\n| • | allocate our research and development funding to products with higher growth prospects; |\n\n| • | anticipate and respond to our competitors’ development of new products and technological innovations; |\n\n| • | differentiate our offerings from our competitors’ offerings; |\n\n| • | innovate and develop new technologies and applications; |\n\n| • | the availability of third-party reimbursement of procedures using our products; |\n\n| • | obtain adequate intellectual property rights; and |\n\n| • | encourage customers to adopt new technologies. |\n\nIf we fail to accurately predict customer needs and preferences or fail to produce viable technologies, we may invest heavily in research and development of products that do not lead to significant revenue. Even if we successfully innovate and develop new products and produce enhancements, we may incur substantial costs in doing so and our profitability may suffer. In addition, even if our new products are successfully introduced, it is unlikely that they will rapidly gain market share and acceptance primarily due to the relatively long period of time it takes to successfully treat a patient with Invisalign. Since it takes approximately 12 to 24 months to treat a patient, our customers may be unwilling to rapidly adopt our new products until they successfully complete at least one case or until more historical clinical results are available.\nOur ability to market and sell new products may also be subject to government regulation, including approval or clearance by the FDA and foreign government agencies. Any failure in our ability to successfully develop and introduce or achieve market acceptance of our new products or enhanced versions of existing products could have a material adverse effect on our operating results and could cause our net revenues to decline.\nA disruption in the operations of our primary freight carrier or higher shipping costs could cause a decline in our net revenues or a reduction in our earnings.\nWe are dependent on commercial freight carriers, primarily UPS, to deliver our products to our customers. If the operations of these carriers are disrupted for any reason, we may be unable to deliver our products to our customers on a timely basis. If we cannot deliver our products in an efficient and timely manner, our customers may reduce their orders from us and our net revenues and operating profits could materially decline. In a rising fuel cost environment, our freight costs will increase. If freight costs materially increase and we are unable to pass that increase along to our customers for any reason or otherwise offset such increases in our cost of net revenues, our gross margin and financial results could be adversely affected.\nIf we are unable to accurately predict our volume growth, and fail to hire a sufficient number of technicians in advance of such demand, the delivery time of our products could be delayed which could adversely affect our results of operations.\nTreatment planning is a key step leading to our manufacturing process which relies on sophisticated computer technology requiring new technicians to undergo a relatively long training process. Training production technicians takes approximately 90 to 120 days. As a result, if we are unable to accurately predict our volume growth, we may not have a sufficient number of trained technicians to deliver our products within the timeframe our customers expect. Such a delay could cause us to lose existing customers or fail to attract new customers. This could cause a decline in our net revenues and net income and could adversely affect our results of operations.\n20\nOur headquarters, digital dental modeling processes, and other manufacturing processes are principally located in regions that are subject to earthquakes and other natural disasters.\nOur digital dental modeling is processed in our facility located in San Jose, Costa Rica. The operations team in Costa Rica creates ClinCheck treatment plans using sophisticated computer software. In addition, our customer facing operations are located in Costa Rica. Our aligner molds and finished aligners are fabricated in Juarez, Mexico. Both locations in Costa Rica and Mexico are in earthquake zones and may be subject to other natural disasters. If there is a major earthquake or any other natural disaster in a region where one of these facilities is located, our ability to create ClinCheck treatment plans, respond to customer inquiries or manufacture and ship our aligners could be compromised which could result in our customers experiencing a significant delay in receiving their completed aligners and a decrease in service levels for a period of time. In addition, our corporate headquarters facility in California is located in the San Francisco Bay Area. An earthquake or other natural disaster in this region could result in a disruption in our operations. Any such business interruption could materially and adversely affect our business, financial condition and results of operations.\nOur information technology systems are critical to our business. System integration and implementation issues and system security risks could disrupt our operations, which could have a material adverse impact on our business and operating results.\nWe rely on the efficient and uninterrupted operation of complex information technology systems. All information technology systems are vulnerable to damage or interruption from a variety of sources. As our business has grown in size and complexity, the growth has placed, and will continue to place, significant demands on our information technology systems. To effectively manage this growth, our information systems and applications require an ongoing commitment of significant resources to maintain, protect and enhance existing systems and develop new systems to keep pace with continuing changes in information processing technology, evolving industry and regulatory standards and changing customer preferences. We are in a multi-year, company-wide program to transform certain business processes or extend established processes which includes the transition to a new enterprise resource planning (\"ERP\") software system. We implemented the first phase of our ERP on July 1, 2016 and, while we believe we are past any potential significant business disruption, we are still monitoring and troubleshooting potential issues. The implementation of additional functionality in the ERP system entails certain risks, including difficulties with changes in business processes that could disrupt our operations, such as our ability to track orders and timely ship products, manage our supply chain and aggregate financial and operational data. Additionally, this implementation may not achieve the anticipated benefits and may divert management's attention from other operational activities, negatively affect employee morale, or have other unintended consequences. Additionally, if we are not able to accurately forecast expenses related to the project, this may have an adverse impact on our financial condition and operating results.\nIf the information we rely upon to run our businesses were to be found to be inaccurate or unreliable, if we fail to properly maintain our information systems and data integrity, or if we fail to develop new capabilities to meet our business needs in a timely manner, we could have operational disruptions, have customer disputes, lose our ability to produce timely and accurate reports, have regulatory or other legal problems, have increases in operating and administrative expenses, lose existing customers, have difficulty in attracting new customers or in implementing our growth strategies, or suffer other adverse consequences. In addition, experienced computer programmers and hackers may be able to penetrate our network security or our cloud-based software servers hosted by third party and misappropriate our confidential information or that of third parties, create system disruptions or cause shutdowns. Furthermore, sophisticated hardware and operating system software and applications that we either internally develop or procure from third parties which we depend upon may contain defects in design and manufacture, including “bugs” and other problems that can unexpectedly interfere with the operation of the system. The costs to eliminate or alleviate security problems, viruses and bugs could be significant, and the efforts to address these problems could result in interruptions that may have a material adverse impact on our operations, net revenues and operating results.\nSystem upgrades and enhancements require significant expenditures and allocation of valuable employee resources. Delays in integration or disruptions to our business from implementation of these new or upgraded systems could have a material adverse impact on our financial condition and operating results.\nAdditionally, we continuously upgrade our customer facing software applications, specifically the ClinCheck and MyAligntech software. Software applications frequently contain errors or defects, especially when they are first introduced or when new versions are released. The discovery of a defect or error or the incompatibility with the computer operating system and hardware configurations of customers in a new upgraded version or the failure of our primary information systems may result in the following consequences, among others: loss of revenue or delay in market acceptance, damage to our reputation or increased service costs, any of which could have a material adverse effect on our business, financial condition or results of operations.\nFurthermore, our business requires the secure transmission of confidential information over public networks. Because of the confidential health information we store and transmit, security breaches could expose us to a risk of regulatory action, litigation,\n21\npossible liability and loss. Our security measures may be inadequate to prevent security breaches, and our business operations and profitability would be adversely affected by, among other things, loss of customers and potential criminal and civil sanctions if they are not prevented.\nThere can be no assurance that our process of improving existing systems, developing new systems to support our expanding operations, integrating new systems, protecting confidential patient information, and improving service levels will not be delayed or that additional systems issues will not arise in the future. Failure to adequately protect and maintain the integrity of our information systems and data may result in a material adverse effect on our financial position, results of operations and cash flows.\nIf the security of our customer and patient information is compromised, patient care could suffer, and we could be liable for related damages, and our reputation could be impaired.\nWe retain confidential customer and patient information in our processing centers. Therefore, it is critical that our facilities and infrastructure remain secure and that our facilities and infrastructure are perceived by the marketplace and our customers to be secure. Despite the implementation of security measures, our infrastructure may be vulnerable to physical break-ins, computer viruses, programming errors, attacks by third parties or similar disruptive problems. If we fail to meet our clients’ expectations regarding the security of healthcare information, we could be liable for damages and our reputation could be impaired. In addition, patient care could suffer, and we could be liable if our systems fail to deliver correct information in a timely manner. Our insurance may not protect us from this risk.\nOur success depends in part on our proprietary technology, and if we are unable to successfully enforce our intellectual property rights, our competitive position may be harmed. Litigating claims of this type is costly and could distract our management and cause a decline in our results of operations and stock price.\nOur success will depend in part on our ability to maintain existing intellectual property and to obtain and maintain further intellectual property protection for our products, both in the U.S. and in other countries. Our inability to do so could harm our competitive position. As of December 31, 2016, we had issued 425 U.S. patents, 370 foreign issued patents, and 386 pending global patent applications.\nWe intend to rely on our portfolio of issued and pending patent applications in the U.S. and in other countries to protect a large part of our intellectual property and our competitive position; however, our currently pending or future patent filings may not result in the issuance of patents. Additionally, any patents issued to us may be challenged, invalidated, held unenforceable, circumvented, or may not be sufficiently broad to prevent third parties from producing competing products similar in design to our products. In addition, any protection afforded by foreign patents may be more limited than that provided under U.S. patents and intellectual property laws. We also rely on protection of our copyrights, trade secrets, know-how and proprietary information. We generally enter into confidentiality agreements with our employees, consultants and our collaborative partners upon commencement of a relationship with us; however, these agreements may not provide meaningful protection against the unauthorized use or disclosure of our trade secrets or other confidential information, and adequate remedies may not exist if unauthorized use or disclosure were to occur. Our inability to maintain the proprietary nature of our technology through patents, copyrights or trade secrets would impair our competitive advantages and could have a material adverse effect on our operating results, financial condition and future growth prospects. In particular, a failure to protect our proprietary rights might allow competitors to copy our technology, which could adversely affect our pricing and market share. In addition, in an effort to protect our intellectual property we have in the past been and may in the future be involved in litigation. The potential effects on our business operations resulting from litigation that we may participate in the future, whether or not ultimately determined in our favor or settled by us, are costly and divert the efforts and attention of our management and technical personnel from normal business operations.\nLitigation, interferences, oppositions, inter partes reviews or other proceedings are, have been and may in the future be necessary in some instances to determine the validity and scope of certain of our proprietary rights, and in other instances to determine the validity, scope or non-infringement of certain patent rights claimed by third parties to be pertinent to the manufacture, use or sale of our products. Litigation, interference, oppositions, inter partes reviews, administrative challenges or other similar types of proceedings are unpredictable and may be protracted, expensive and distracting to management. The outcome of such proceedings could adversely affect the validity and scope of our patent or other proprietary rights, hinder our ability to manufacture and market our products, require us to seek a license for the infringed product or technology or result in the assessment of significant monetary damages. An unfavorable ruling could include monetary damages or, in cases where injunctive relief is sought, an injunction prohibiting us from selling our products. Any of these results from our litigation could adversely affect our results of operations and stock price.\n22\nWhile we believe we currently have adequate internal control over financial reporting, we are required to assess our internal control over financial reporting on an annual basis and any future adverse results from such assessment could result in a loss of investor confidence in our financial reports and have an adverse effect on our stock price.\nPursuant to the Sarbanes-Oxley Act of 2002 and the rules and regulations promulgated by the SEC, we are required to furnish in our Form 10-K a report by our management regarding the effectiveness of our internal control over financial reporting. The report includes, among other things, an assessment of the effectiveness of our internal control over financial reporting as of the end of our fiscal year, including a statement as to whether or not our internal control over financial reporting is effective. This assessment must include disclosure of any material weaknesses in our internal control over financial reporting identified by management. While we believe our internal control over financial reporting is currently effective, the effectiveness of our internal controls in future periods is subject to the risk that our controls may become inadequate because of changes in conditions including our transition to a new ERP software system, and, as a result, the degree of compliance of our internal control over financial reporting with the existing policies or procedures may become ineffective. Establishing, testing and maintaining an effective system of internal control over financial reporting requires significant resources and time commitments on the part of our management and our finance staff, may require additional staffing and infrastructure investments and would increase our costs of doing business. If we are unable to assert that our internal control over financial reporting is effective in any future period (or if our auditors are unable to express an opinion on the effectiveness of our internal controls or conclude that our internal controls are ineffective), we could lose investor confidence in the accuracy and completeness of our financial reports, which could have an adverse effect on our stock price.\nIf we lose our key personnel or are unable to attract and retain key personnel, we may be unable to pursue business opportunities or develop our products.\nWe are highly dependent on the key employees in our clinical engineering, technology development, sales, training and marketing personnel and management teams. The loss of the services provided by those individuals may significantly delay or prevent the achievement of our product development and other business objectives and could harm our business. Our future success will also depend on our ability to identify, recruit, train and retain additional qualified personnel, including orthodontists. Few orthodontists are accustomed to working in a manufacturing environment since they are generally trained to work in private practices, universities and other research institutions. Thus, we may be unable to attract and retain personnel with the advanced qualifications necessary for the further development of our business. Furthermore, we may not be successful in retaining our key personnel or their services. If we are unable to attract and retain key personnel, our business could be materially harmed.\nIf we infringe the patents or proprietary rights of other parties or are subject to a patent infringement claim, our ability to grow our business may be severely limited.\nExtensive litigation over patents and other intellectual property rights is common in the medical device industry. We have been sued for infringement of third party’s patents in the past and we may be the subject of patent or other litigation in the future. From time to time, we have received and may in the future receive letters from third parties drawing our attention to their patent rights. While we do not believe that we infringe upon any valid and enforceable rights that have been brought to our attention, there may be other more pertinent rights of which we are presently unaware. The defense and prosecution of intellectual property suits, interference proceedings and related legal and administrative proceedings could result in substantial expense to us and significant diversion of effort by our technical and management personnel. An adverse determination of any litigation or interference proceeding to which we may become a party could subject us to significant liabilities. An adverse determination of this nature could also put our patents at risk of being invalidated or interpreted narrowly or require us to seek licenses from third parties. Licenses may not be available on commercially reasonable terms or at all, in which event, our business would be materially adversely affected.\n23\nWe maintain single supply relationships for certain of our key machines and materials technologies, and our business and operating results could be harmed if supply is restricted or ends or the price of raw materials used in our manufacturing process increases.\nWe are highly dependent on manufacturers of specialized scanning equipment, rapid prototyping machines, resin and other advanced materials, as well as the optics, electronic and other mechanical components of our intraoral scanners. We maintain single supply relationships for many of these machines and materials technologies. In particular, our CT scanning and stereolithography equipment used in our aligner manufacturing and many of the critical components for the optics of our scanners are provided by single suppliers. We are also committed to purchasing the vast majority of our resin and polymer, the primary raw materials used in our manufacturing process for clear aligners, from a single source. If these or other suppliers encounter financial, operating or other difficulties or if our relationship with them changes, we might not be able to quickly establish or qualify replacement sources of supply and could face production interruptions, delays and inefficiencies. In addition, technology changes by our vendors could disrupt access to required manufacturing capacity or require expensive, time consuming development efforts to adapt and integrate new equipment or processes. Our growth may exceed the capacity of one or more of these manufacturers to produce the needed equipment and materials in sufficient quantities to support our growth. Conversely, in order to secure supplies for production of products, we sometimes enter into non-cancelable purchase commitments with vendors, which could impact our ability to adjust our inventory to reflect declining market demands. If demand for our products is less than we expect, we may experience additional excess and obsolete inventories and be forced to incur additional charges and our profitability may suffer. In the event of technology changes, delivery delays, or shortages of or increases in price for these items, our business and growth prospects may be harmed.\nWe depend on a single contract manufacturer and supplier of parts used in our iTero scanner and any disruption in this relationship may cause us to fail to meet the demands of our customers and damage our customer relationships.\nWe rely on a third party manufacturer to supply key sub-assemblies for our iTero Element scanner. As a result, if this third party manufacturer fails to deliver its components, if we lose its services or if we fail to negotiate acceptable terms, we may be unable to deliver our products in a timely manner and our business may be harmed. Any difficulties encountered by the third party manufacturer with respect to hiring personnel and maintaining acceptable manufacturing standards, controls, procedures and policies could disrupt our ability to deliver our products in a timely manner. Finding a substitute manufacturer may be expensive, time-consuming or impossible and could result in a significant interruption in the supply of our intraoral scanning products. Any failure by our contract manufacturer that results in delays in our fulfillment of customer orders may cause us to lose revenues and suffer damage to our customer relationships.\nWe primarily rely on our direct sales force to sell our products, and any failure to maintain our direct sales force could harm our business.\nOur ability to sell our products and generate revenues primarily depends upon our direct sales force within our North American and international markets. We do not have any long-term employment contracts with the members of our direct sales force. The loss of the services provided by these key personnel may harm our business. If we are unable to retain our direct sales force personnel or replace them with individuals of equivalent technical expertise and qualifications, or if we are unable to successfully instill such technical expertise or if we fail to establish and maintain strong relationships with our customers within a relatively short period of time, our net revenues and our ability to maintain market share could be materially harmed. In addition, due to our large and fragmented customer base, we may not be able to provide all of our customers with product support immediately upon the launch of a new product. As a result, adoption of new products by our customers may be slower than anticipated and our ability to grow market share and increase our net revenues may be harmed.\nIf our distributor relationships are not successful, our ability to market and sell our products would be harmed and our financial performance will be adversely affected.\nWe depend on relationships with distributors for the marketing and sales of our products in various geographic regions, and we have a limited ability to influence their efforts. Relying on distributors for our sales and marketing could harm our business for various reasons, including:\n24\n| • | agreements with distributors may terminate prematurely due to disagreements or may result in litigation between the partners; |\n\n| • | we may not be able to renew existing distributor agreements on acceptable terms; |\n\n| • | our distributors may not devote sufficient resources to the sale of products; |\n\n| • | our distributors may be unsuccessful in marketing our products; |\n\n| • | our existing relationships with distributors may preclude us from entering into additional future arrangements with other distributors; and |\n\n| • | we may not be able to negotiate future distributor agreements on acceptable terms. |\n\nComplying with regulations enforced by the FDA and other regulatory authorities is an expensive and time-consuming process, and any failure to comply could result in substantial penalties.\nOur products are considered medical devices and are subject to extensive regulation in the U.S. and internationally. FDA regulations are wide ranging and govern, among other things:\n| • | product design, development, manufacturing and testing; |\n\n| • | product labeling; |\n\n| • | product storage; |\n\n| • | pre-market clearance or approval; |\n\n| • | complaint handling and corrective actions; |\n\n| • | advertising and promotion; and |\n\n| • | product sales and distribution. |\n\nOur failure to comply with applicable regulatory requirements could result in enforcement action by the FDA or state agencies, which may include any of the following sanctions:\n| • | warning letters, fines, injunctions, consent decrees and civil penalties; |\n\n| • | repair, replacement, refunds, recall or seizure of our products; |\n\n| • | operating restrictions or partial suspension or total shutdown of production; |\n\n| • | refusing our requests for 510(k) clearance or pre-market approval of new products, new intended uses, or modifications to existing products; |\n\n| • | withdrawing clearance or pre-market approvals that have already been granted; and |\n\n| • | criminal prosecution. |\n\nIf any of these events were to occur, they could harm our business. We must comply with facility registration and product listing requirements of the FDA and adhere to applicable Quality System regulations. The FDA enforces its Quality System regulations through periodic unannounced inspections. Our failure to take satisfactory corrective action in response to an adverse inspection or the failure to comply with applicable manufacturing regulations could result in enforcement action, and we may be required to find alternative manufacturers, which could be a long and costly process. Any FDA enforcement action could have a material adverse effect on us.\nBefore we can sell a new medical device in the U.S., or market a new use of or claim for an existing product, we must obtain FDA clearance or approval unless an exemption applies. Obtaining regulatory clearances or approvals can be a lengthy and time-consuming process. Even though the devices we market have obtained the necessary clearances from the FDA, we may be unable to maintain such clearances in the future. Furthermore, we may be unable to obtain the necessary clearances for new devices that\n25\nwe intend to market in the future. Our inability to maintain or obtain regulatory clearances or approvals could materially harm our business.\nIn addition, as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC adopted disclosure requirements regarding the use of certain minerals, known as conflict minerals, which are mined from the Democratic Republic of Congo and adjoining countries, as well as procedures regarding a manufacturer's efforts to identify and discourage the sourcing of such minerals and metals produced from those minerals. Additional reporting obligations are being proposed by the European Union. The U.S. requirements and any additional requirements in Europe could affect the sourcing and availability of metals used in the manufacture of a limited number of parts (if any) contained in our products. For example, the implementation of these disclosure requirements may decrease the number of suppliers capable of supplying our needs for certain metals, thereby negatively affecting our ability to obtain products in sufficient quantities or at competitive prices. Our material sourcing is broad based and multi-tiered, and we may be unable to conclusively verify the origins for all metals used in our products. We may suffer financial and reputational harm if customers require, and we are unable to deliver, certification that our products are conflict free. Regardless, we will incur additional costs associated with compliance with these disclosure requirements, including time-consuming and costly efforts to determine the source of any conflict minerals used in our products.\nIf compliance with healthcare regulations becomes costly and difficult for our customers or for us, we may not be able to grow our business.\nParticipants in the healthcare industry are subject to extensive and frequently changing regulations under numerous laws administered by governmental entities at the federal, state and local levels, some of which are, and others of which may be, applicable to our business. In response to perceived increases in health care costs in recent years, Congress passed health care reform legislation that was signed into law in March 2010. This legislation contains many provisions designed to generate the revenues necessary to fund the coverage expansions. The most relevant of these provisions are those that impose fees or taxes on certain health-related industries, including medical device manufacturers.\nFurthermore, our healthcare provider customers are also subject to a wide variety of laws and regulations that could affect the nature and scope of their relationships with us. The healthcare market itself is highly regulated and subject to changing political, economic and regulatory influences. Regulations implemented pursuant to the Health Insurance Portability and Accountability Act (\"HIPAA\"), including regulations affecting the security and privacy of patient healthcare information held by healthcare providers and their business associates may require us to make significant and unplanned enhancements of software applications or services, result in delays or cancellations of orders, or result in the revocation of endorsement of our products and services by healthcare participants. The effect of HIPAA and newly enforced regulations on our business is difficult to predict, and there can be no assurance that we will adequately address the business risks created by HIPAA and its implementation or that we will be able to take advantage of any resulting business opportunities.\nExtensive and changing government regulation of the healthcare industry may be expensive to comply with and exposes us to the risk of substantial government penalties.\nIn addition to medical device laws and regulations, numerous state and federal healthcare-related laws regulate our business, covering areas such as:\n| • | storage, transmission and disclosure of medical information and healthcare records; |\n\n| • | prohibitions against the offer, payment or receipt of remuneration to induce referrals to entities providing healthcare services or goods or to induce the order, purchase or recommendation of our products; and |\n\n| • | the marketing and advertising of our products. |\n\nComplying with these laws and regulations could be expensive and time-consuming, and could increase our operating costs or reduce or eliminate certain of our sales and marketing activities or our revenues.\nOur business exposes us to potential product liability claims, and we may incur substantial expenses if we are subject to product liability claims or litigation.\nMedical devices involve an inherent risk of product liability claims and associated adverse publicity. We may be held liable if any product we develop or any product that uses or incorporates any of our technologies causes injury or is otherwise found unsuitable. Although we intend to continue to maintain product liability insurance, adequate insurance may not be available on acceptable terms, if at all, and may not provide adequate coverage against potential liabilities. A product liability claim, regardless\n26\nof its merit or eventual outcome, could result in significant legal defense costs. These costs would have the effect of increasing our expenses and diverting management’s attention away from the operation of our business, and could harm our business.\nHistorically, the market price for our common stock has been volatile.\nThe market price of our common stock could be subject to wide price fluctuations in response to various factors, many of which are beyond our control. The factors include:\n| • | quarterly variations in our results of operations and liquidity; |\n\n| • | changes in recommendations by the investment community or in their estimates of our net revenues or operating results; |\n\n| • | speculation in the press or investment community concerning our business and results of operations; |\n\n| • | strategic actions by our competitors, such as product announcements or acquisitions; |\n\n| • | announcements of technological innovations or new products by us, our customers or competitors; and |\n\n| • | general economic market conditions. |\n\nIn addition, the stock market, in general and the market for technology and medical device companies, in particular, have experienced extreme price and volume fluctuations that have often been unrelated to or disproportionate to the operating performance of those companies. These broad market and industry factors may seriously harm the market price of our common stock, regardless of our operating performance. Historically, class action litigation is often brought against an issuing company following periods of volatility in the market price of a company’s securities.\nFuture sales of significant amounts of our common stock may depress our stock price.\nA large percentage of our outstanding common stock is currently owned by a small number of significant stockholders. These stockholders have sold in the past, and may sell in the future, large amounts of common stock over relatively short periods of time. Sales of substantial amounts of our common stock in the public market by our existing stockholders may adversely affect the market price of our common stock. Such sales could create public perception of difficulties or problems with our business and may depress our stock price.\nWe are subject to risks associated with our strategic investments. Impairments in the value of our investments could negatively impact our financial results.\nWe have invested in SmileDirectClub, LLC (\"SDC\") and other privately held companies for strategic reasons and to support key business initiatives, and we may not realize a return on our strategic investments. Many of such companies generate net losses and the market for their products, services or technologies may be slow to develop. Further, valuations of privately held companies are inherently complex due to the lack of readily available market data. If we determine that our investments in SDC or other privately held companies have experienced a decline in value, we may be required to record impairments, which could be material and could have an adverse impact on our financial results.\nIf our goodwill or long-lived assets become impaired, we may be required to record a significant charge to earnings.\nUnder Generally Accepted Accounting Principles in the United States (“U.S. GAAP”), we review our goodwill and long-lived asset group for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. Additionally, goodwill is required to be tested for impairment at least annually. The qualitative and quantitative analysis used to test goodwill are dependent upon various assumptions and reflect management’s best estimates. Changes in certain assumptions including revenue growth rates, discount rates, earnings multiples and future cash flows may cause a change in circumstances indicating that the carrying value of goodwill or the asset group may be impaired. We may be required to record a significant charge to earnings in the financial statements during the period in which any impairment of goodwill or asset group are determined.\nChanges in, or interpretations of, accounting rules and regulations, could result in unfavorable accounting charges.\nWe prepare our consolidated financial statements in conformity with U.S. GAAP. These principles are subject to interpretation by the SEC and various bodies formed to interpret and create appropriate accounting policies. A change in these policies can have a significant effect on our reported results and may even retroactively affect previously reported transactions. Our accounting\n27\npolicies that recently have been, or may be affected by changes in the accounting rules relate to stock-based compensation, revenue recognition and leases.\nIf we fail to manage our exposure to global financial and securities market risk successfully, our operating results and financial statements could be materially impacted.\nThe primary objective of our investment activities is to preserve principal. To achieve this objective, a majority of our marketable investments are investment grade, liquid, fixed-income securities and money market instruments denominated in U.S. dollars. If the carrying value of our investments exceeds the fair value, and the decline in fair value is deemed to be other-than-temporary, we will be required to write down the value of our investments, which could materially harm our results of operations and financial condition. Moreover, the performance of certain securities in our investment portfolio correlates with the credit condition of the U.S. financial sector. In a current unstable credit environment, we might incur significant realized, unrealized or impairment losses associated with these investments.\nOn July 1, 2016, we changed our corporate structure; however, if we are unable to maintain this structure or if it is challenged by U.S. or foreign tax authorities, we may be unable to realize tax savings which could materially and adversely affect our operating results.\nWe implemented a new international corporate structure on July 1, 2016. This corporate structure may reduce our overall effective tax rate over time through changes in the structure of our international procurement and sales operations, as well as realignment of the ownership and use of intellectual property among our wholly-owned subsidiaries.\nThe structure includes legal entities located in jurisdictions with income tax rates lower than the U.S. federal statutory tax rate. Such intercompany arrangements would be designed to result in income earned by such entities in accordance with arm’s-length principles and commensurate with functions performed, risks assumed and ownership of valuable corporate assets. We believe that income taxed in certain foreign jurisdictions at a lower rate relative to the U.S. federal statutory rate will have a beneficial impact on our worldwide effective tax rate over the medium to long term.\nIf the structure is challenged by U.S. or foreign tax authorities, if changes in domestic and international tax laws negatively impact the structure, including proposed legislation to reform U.S. taxation of international business activities, or if we do not operate our business in a manner consistent with the structure and applicable regulatory provisions, we may fail to achieve the financial and operational efficiencies that we anticipate as a result of the structure, and our business, financial condition and operating results may be materially and adversely affected.\nOur effective tax rate may vary significantly from period to period.\nVarious internal and external factors may have favorable or unfavorable effects on our future effective tax rate. These factors include, but are not limited to, changes in tax laws, regulations and/or rates, new or changes to accounting pronouncements, non-deductible goodwill impairments, changing interpretations of existing tax laws or regulations, changes in the relative proportions of revenues and income before taxes in the various jurisdictions in which we operate that have differing statutory tax rates, the future levels of tax benefits of stock-based compensation, settlement of income tax audits, and changes in overall levels of pretax earnings.\nIn addition, our tax rate may be impacted by tax holidays or incentives. In June 2009, the Costa Rica Ministry of Foreign Trade, an agency of the Government of Costa Rica, granted a twelve year extension of certain income tax incentives, which were previously granted in 2002. The incentive tax rates will expire in various years beginning in 2017. We intend to seek a renewal of these income tax incentives before they expire. Under these incentives, all of the income in Costa Rica during these twelve year incentive periods is subject to a reduced tax rate. In order to receive the benefit of these incentives, we must hire specified numbers of employees and maintain certain minimum levels of fixed asset investment in Costa Rica. If we do not fulfill these conditions for any reason, our incentive could lapse, and our income in Costa Rica would be subject to taxation at higher rates, which could have a negative impact on our operating results. The Costa Rica corporate income tax rate that would apply, absent the incentives, is 30% for 2016, 2015 and 2014. As a result of these incentives, income taxes were reduced by $19.1 million, $32.7 million and $32.5 million in the year ended December 31, 2016, 2015 and 2014, respectively. The benefit of the tax holiday on diluted net income per share was $0.23 in the year ended December 31, 2016 and $0.40 in each of the year ended December 31, 2015 and 2014. Our subsidiary in Israel is under audit by the local tax authorities for calendar years 2006 through 2013.\n28\nChanges in tax laws or tax rulings could negatively impact our income tax provision and net income.\nAs a U.S. multinational corporation, we are subject to changing tax laws both within and outside of the U.S. Changes in tax laws or tax rulings, or changes in interpretations of existing tax laws, could affect our income tax provision and net income or require us to change the manner in which we operate our business. Many countries in Europe, as well as a number of other countries and organizations, have recently proposed or recommended changes to existing tax laws or have enacted new laws. For example, the Organization for Economic Cooperation and Development (\"OECD\") has been working on a \"Base Erosion and Profit Shifting Project,\" which is focused on a number of issues, including the shifting of profits between affiliated entities in different tax jurisdictions. The OECD issued in 2015, and is expected to continue to issue, guidelines and proposals that may change various aspects of the existing framework under which our tax obligations are determined in many of the countries in which we do business. In addition, the current U.S. administration and key members of Congress have made public statements indicating that tax reform is a priority. Certain changes to U.S. tax laws, including limitations on the ability to defer U.S. taxation on earnings outside of the United States until those earnings are repatriated to the United States, could affect the tax treatment of our foreign earnings.\nITEM 1B.\nUNRESOLVED STAFF COMMENTS\nNone.\nITEM 2.\nPROPERTIES\nWe occupy several leased and owned facilities with total office and manufacturing area of over 987,000 square feet. At December 31, 2016, the significant facilities were occupied as follows:\n\n| Location | Lease/Own | Primary Use | Expiration of Lease |\n| San Jose, California (1) | Lease | Office for corporate headquarters, research & development and administrative personnel | August 2017 |\n| Juarez, Mexico | Own | Manufacturing and office facilities for manufacturing and administrative personnel | N/A |\n| San Jose, Costa Rica | Lease | Office for administrative personnel, treatment personnel, and customer care | October 2018 |\n| Or Yehuda, Israel | Lease | Manufacturing and office for manufacturing, administrative personnel, and research & development | February 2022 |\n| Amsterdam, The Netherlands | Lease | Office for international headquarters, sales and marketing and administrative personnel | March 2020 |\n| Moscow, Russia | Lease | Office for research & development | July 2023 |\n| Raleigh, North Carolina | Lease | Office for research & development and administrative personnel | October 2024 |\n\n(1) Refer to Note 8 \"Commitments and Contingencies\" of the Notes of Consolidated Financial Statements for information on our corporate headquarters office Purchase Agreement in December 2016.\n29\nITEM 3.\nLEGAL PROCEEDINGS\nSecurities Class Action Lawsuit\nOn November 28, 2012, plaintiff City of Dearborn Heights Act 345 Police & Fire Retirement System filed a lawsuit against Align, Thomas M. Prescott (“Mr. Prescott”), Align’s former President and Chief Executive Officer, and Kenneth B. Arola (“Mr. Arola”), Align’s former Vice President, Finance and Chief Financial Officer, in the United States District Court for the Northern District of California on behalf of a purported class of purchasers of our common stock (the “Securities Action”). On July 11, 2013, an amended complaint was filed, which named the same defendants, on behalf of a purported class of purchasers of our common stock between January 31, 2012 and October 17, 2012. The amended complaint alleged that Align, Mr. Prescott and Mr. Arola violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, and that Mr. Prescott and Mr. Arola violated Section 20(a) of the Securities Exchange Act of 1934. Specifically, the amended complaint alleged that during the purported class period defendants failed to take an appropriate goodwill impairment charge related to the April 29, 2011 acquisition of Cadent Holdings, Inc. in the fourth quarter of 2011, the first quarter of 2012 or the second quarter of 2012, which rendered our financial statements and projections of future earnings materially false and misleading and in violation of U.S. GAAP. The amended complaint sought monetary damages in an unspecified amount, costs and attorneys’ fees. On December 9, 2013, the court granted defendants’ motion to dismiss with leave for plaintiff to file a second amended complaint. Plaintiff filed a second amended complaint on January 8, 2014 on behalf of the same purported class. The second amended complaint states the same claims as the amended complaint. On August 22, 2014, the court granted our motion to dismiss without leave to amend. On September 22, 2014, Plaintiff filed a notice of appeal to the Ninth Circuit Court of Appeals. Briefing for the appeal was completed in May 2015 and the Ninth Circuit held oral arguments in October 2016. Align intends to vigorously defend itself against these allegations. Align is currently unable to predict the outcome of this amended complaint and therefore cannot determine the likelihood of loss nor estimate a range of possible loss, if any.\nShareholder Derivative Lawsuit\nOn February 1, 2013, plaintiff Gary Udis filed a shareholder derivative lawsuit against several of Align’s current and former officers and directors in the Superior Court of California, County of Santa Clara. The complaint alleges that our reported income and earnings were materially overstated because of a failure to timely write down goodwill related to the April 29, 2011 acquisition of Cadent Holdings, Inc., and that defendants made allegedly false statements concerning our forecasts. The complaint asserts various state law causes of action, including claims of breach of fiduciary duty, unjust enrichment, and insider trading, among others. The complaint seeks unspecified damages on behalf of Align, which is named solely as nominal defendant against whom no recovery is sought. The complaint also seeks an order directing Align to reform and improve its corporate governance and internal procedures, and seeks restitution in an unspecified amount, costs, and attorneys’ fees. On July 8, 2013, an Order was entered staying this derivative lawsuit until an initial ruling on our first motion to dismiss the Securities Action. On January 15, 2014, an Order was entered staying this derivative lawsuit until an initial ruling on our second motion to dismiss the Securities Action. On October 14, 2014, an Order was entered staying this derivative lawsuit until a ruling by the Ninth Circuit in the Securities Action discussed above. Align is currently unable to predict the outcome of this complaint and therefore cannot determine the likelihood of loss nor estimate a range of possible losses, if any.\nIn addition, in the course of Align's operations, Align is involved in a variety of claims, suits, investigations, and proceedings, including actions with respect to intellectual property claims, patent infringement claims, government investigations, labor and employment claims, breach of contract claims, tax, and other matters. Regardless of the outcome, these proceedings can have an adverse impact on us because of defense costs, diversion of management resources, and other factors. Although the results of complex legal proceedings are difficult to predict and Align's view of these matters may change in the future as litigation and events related thereto unfold; Align currently does not believe that these matters, individually or in the aggregate, will materially affect Align's financial position, results of operations or cash flows.\nITEM 4.\nMINE SAFETY DISCLOSURES\nNot applicable.\n30\nPART II\n\nITEM 5.\nMARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES\nPrice Range of Common Stock\nOur common stock is quoted on the NASDAQ Global Select Market under the symbol “ALGN.” The following table sets forth the range of high and low per share sales prices as reported for each period indicated:\n| High | Low |\n| Year Ended December 31, 2016: |\n| Fourth quarter | $ | 102.10 | $ | 83.27 |\n| Third quarter | $ | 96.90 | $ | 80.30 |\n| Second quarter | $ | 81.98 | $ | 70.03 |\n| First quarter | $ | 73.55 | $ | 57.31 |\n| Year Ended December 31, 2015: |\n| Fourth quarter | $ | 68.48 | $ | 54.69 |\n| Third quarter | $ | 66.53 | $ | 52.01 |\n| Second quarter | $ | 64.99 | $ | 51.65 |\n| First quarter | $ | 64.75 | $ | 51.77 |\n\nOn February 21, 2017, the closing price of our common stock on the NASDAQ Global Market was $101.86 per share. As of February 21, 2017, there were approximately 96 holders of record of our common stock. Because the majority of our shares of outstanding common stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders.\nWe have never declared or paid any cash dividends on our common stock. We currently intend to retain any future earnings to fund the development and growth of our business and do not anticipate paying any cash dividends in the foreseeable future.\nPerformance Graph\nNotwithstanding any statement to the contrary in any of our previous or future filings with the SEC, the following information relating to the price performance of our common stock shall not be deemed “filed” with the SEC or “Soliciting Material” under the Securities Exchange Act of 1934, as amended, or subject to Regulation 14A or 14C, or to liabilities of Section 18 of the Exchange Act except to the extent we specifically request that such information be treated as soliciting material or to the extent we specifically incorporate this information by reference.\nThe graph below matches our cumulative 5-year total shareholder return on common stock with the cumulative total returns of the NASDAQ Composite index, and the S&P 1500 Composite Health Care Equipment & Supplies index. The graph tracks the performance of a $100 investment in our common stock, in the peer group, and the index (with the reinvestment of all dividends) from December 31, 2011 to December 31, 2016.\n31\nUNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nFollowing is a summary of stock repurchases for the three months ended December 31, 2016:\n| Period | Total Number of Shares Repurchased | Average Price Paid per Share | Total Number of Shares Repurchased as Part of Publicly Announced Program | Approximate Dollar Value of Shares that May Yet Be Repurchased Under the Program (1) |\n| October 1, 2016 through October 31, 2016 | 179,500 | $ | 89.28 | 179,500 | $ | 325,777,042 |\n| November 1, 2016 through November 30, 2016 | 126,000 | $ | 92.36 | 126,000 | $ | 314,139,921 |\n| December 1, 2016 through December 31, 2016 | 106,000 | $ | 97.92 | 106,000 | $ | 303,760,487 |\n\n(1) Stock Repurchase Programs\n| ◦ | April 2014 Repurchase Program. In 2016, we repurchased $50.0 million of our common stock through an accelerated stock repurchase agreement and $46.2 million of stock repurchase in the open market. |\n\n| ◦ | April 2016 Repurchase Program. On April 28, 2016, we announced that our Board of Directors had authorized a plan to repurchase up to $300.0 million of our stock. |\n\n| ◦ | Remaining Available Repurchases. As of December 31, 2016, we have approximately $3.8 million remaining available under the April 2014 Repurchase Program and $300.0 million under the April 2016 Repurchase Plan (Refer to Note 10 \"Common Stock Repurchase Program\" of the Notes to Consolidated Financial Statements for details on common stock repurchase). |\n\n32\nITEM 6.\nSELECTED CONSOLIDATED FINANCIAL DATA\nThe following tables set forth the selected consolidated financial data for each of the years in the five-year period ended December 31, 2016. The selected consolidated financial data should be read in conjunction with the consolidated financial statements and accompanying notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations. We have derived the statements of operations data for the year ended December 31, 2016, 2015 and 2014 and the balance sheet data as of December 31, 2016 and 2015 from the consolidated audited financial statements included elsewhere in this Annual Report on Form 10-K. The statements of operations data for the year ended December 31, 2013 and 2012 and the balance sheet data as of December 31, 2014, 2013 and 2012 were derived from the consolidated audited financial statements that are not included in this Annual Report on Form 10-K.\nSELECTED CONSOLIDATED FINANCIAL DATA\n(in thousands, except per share data)\n\n| Year Ended December 31, |\n| 2016 | 2015 | 2014 | 2013 | 2012 |\n| Consolidated Statements of Operations Data: |\n| Net revenues | $ | 1,079,874 | $ | 845,486 | $ | 761,653 | $ | 660,206 | $ | 560,041 |\n| Gross profit (1) | $ | 815,294 | $ | 640,110 | $ | 578,443 | $ | 498,106 | $ | 416,388 |\n| Income from operations (2) | 248,921 | 188,634 | 193,576 | 94,212 | 85,592 |\n| Interest and other income (expense), net | (6,355 | ) | (2,533 | ) | (3,207 | ) | (1,073 | ) | (1,296 | ) |\n| Net income before provision for income taxes and equity in losses of investee (2) | 242,566 | 186,101 | 190,369 | 93,139 | 84,296 |\n| Provision for income taxes (3) | 51,200 | 42,081 | 44,537 | 28,844 | 25,605 |\n| Equity in losses of investee, net of tax | 1,684 | — | — | — | — |\n| Net income | $ | 189,682 | $ | 144,020 | $ | 145,832 | $ | 64,295 | $ | 58,691 |\n| Net income per share: |\n| Basic | $ | 2.38 | $ | 1.80 | $ | 1.81 | $ | 0.80 | $ | 0.73 |\n| Diluted | $ | 2.33 | $ | 1.77 | $ | 1.77 | $ | 0.78 | $ | 0.71 |\n| Shares used in computing net income per share: |\n| Basic | 79,856 | 79,998 | 80,754 | 80,551 | 80,529 |\n| Diluted | 81,484 | 81,521 | 82,283 | 82,589 | 83,040 |\n| December 31, |\n| 2016 | 2015 | 2014 | 2013 | 2012 |\n| Consolidated Balance Sheet Data: |\n| Working capital (4) | $ | 598,643 | $ | 460,338 | $ | 455,349 | $ | 369,338 | $ | 330,022 |\n| Total assets | 1,396,151 | 1,158,633 | 987,997 | 832,147 | 756,312 |\n| Total long-term liabilities | 46,427 | 39,035 | 33,415 | 22,839 | 19,224 |\n| Stockholders’ equity | $ | 995,389 | $ | 847,926 | $ | 752,771 | $ | 633,970 | $ | 581,317 |\n\n| (1) | Gross profit includes: |\n\n| • | $1.7 million out of period adjustment in 2013 |\n\n| • | $0.2 million acquisition and integration related costs, $0.9 million amortization of intangible assets, and $0.5 million of exit costs in 2012 |\n\n33\n(2) Income from operations and net income before provision for income taxes and equity in losses of investee include:\n| • | $40.7 million and $26.3 million of goodwill and long-lived asset impairment, respectively, in 2013 |\n\n| • | $1.9 million, net of tax, out of period adjustment in 2013 |\n\n| • | $36.6 million of goodwill impairment, $1.3 million acquisition and integration related costs, $4.5 million of amortization of intangible assets, and $0.8 million of exit costs in 2012 |\n\n| (3) | Provision for income taxes includes: |\n\n| • | $1.8 million out of period income tax adjustment in 2014 (Refer to Note 1 \"Summary of Significant Accounting Policies\" of the Notes to Consolidated Financial Statements) |\n\n| (4) | Working capital is calculated as the difference between total current assets and total current liabilities. |\n\n34\nITEM 7.\nMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nThe following discussion and analysis of our financial condition and results of operations should be read together with “Selected Consolidated Financial Data” and our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K.\nOverview\nOur goal is to establish Invisalign clear aligners as the standard method for treating malocclusion and to establish the iTero intraoral scanner as the preferred scanning device for 3D digital scans, ultimately driving increased product adoption by dental professionals. We intend to achieve this by continued focus and execution of our strategic growth drivers set forth in the Business Strategy section in our Annual Report on Form 10-K.\nThe successful execution of our business strategy in 2017 and beyond may be affected by a number of other factors including:\n| • | New Products, Feature Enhancements and Technology Innovation. Product innovation drives greater treatment predictability and clinical applicability and ease of use for our customers which supports adoption of Invisalign in their practices. Increasing applicability and treating more complex cases requires that we move away from individual features to more comprehensive solutions so that Invisalign providers can more predictably treat the whole case, such as with our Invisalign \"G-Series\" of product innovations, including our most recent October 2016 release of Invisalign G7. Invisalign G7 delivers better upper lateral control, improved root control and features to address prevention of posterior open bites. Concurrently, we also announced ClinCheck Pro 5.0, which has new features designed to deliver an improved and user friendly experience and increased control to Invisalign providers. Since the iTero Element began shipping in September 2015, the use of iTero scanners for Invisalign case submissions in place of Polyvinyl-siloxane (\"PVS\") impressions has gradually increased to a record 51.3% of cases from North America and 24.9% of cases from international doctors as of the fourth quarter of 2016. We believe that over the long-term, clinical solutions and treatment tools will increase adoption of Invisalign and increase sales of our intraoral scanners; however, it is difficult to predict the rate of adoption which may vary by region and channel. |\n\n| • | Invisalign Adoption. Our goal is to establish Invisalign as the treatment of choice for treating malocclusion ultimately driving increased product adoption and frequency of use by dental professionals, also known as \"utilization rates.\" Our quarterly utilization rates for the last 9 quarters are as follows: |\n\n* Invisalign Utilization Rates = # of cases shipped divided by # of doctors cases were shipped to\n35\n| ◦ | Total utilization in the fourth quarter of 2016 increased to 5.2 cases per doctor compared to 4.9 in the fourth quarter of 2015. |\n\n| ▪ | North America: Utilization among our North American orthodontist customers reached an all time high of 11.3 cases per doctor in the fourth quarter of 2016 compared to 9.9 in the fourth quarter of 2015. The increase in North America orthodontist utilization reflects improvements in product and technology which continues to strengthen our doctors’ clinical confidence in the use of Invisalign such that they now utilize Invisalign more often and on more complex cases, including their teenage patients. |\n\n| ▪ | International: International doctor utilization of 5.0 cases per doctor in the fourth quarter of 2016 was flat compared with the fourth quarter of 2015. The International utilization reflects growth in both the Europe, Middle East and Africa (\"EMEA\") and Asia Pacific (\"APAC\") regions due to increasing adoption of the product and its ability to treat more complex cases; however, utilization remained flat primarily due to the expansion of our customer base, particularly in APAC. |\n\nWe expect that over the long-term our utilization rates will gradually improve as a result of advancements in product and technology, which continue to strengthen our doctors’ clinical confidence in the use of Invisalign; however, we expect that our utilization rates may fluctuate from period to period due to a variety of factors, including seasonal trends in our business along with adoption rates of new products and features.\n| • | Number of New Invisalign Doctors Trained. We continue to expand our Invisalign customer base through the training of new doctors. In 2016, Invisalign growth was driven primarily by increased utilization across all regions as well as by the continued expansion of our customer base as we trained a total of 11,680 new Invisalign doctors, of which 60% were trained internationally. |\n\n| • | International Invisalign Growth. We will continue to focus our efforts towards increasing Invisalign adoption by dental professionals in our direct international markets. On a year over year basis, international Invisalign volume increased 32.4% driven primarily by strong performance in our APAC and in Europe regions. In 2017, we are continuing to expand in our existing markets through targeted investments in sales coverage and professional marketing and education programs, along with consumer marketing in selected country markets. We expect international Invisalign revenues to continue to grow at a faster rate than North America for the foreseeable future due to our continued investment in international market expansion, the size of the market opportunity, and our relatively low market penetration in this region (Refer to Item 1A Risk Factors - “We are exposed to fluctuations in currency exchange rates, which could negatively affect our financial condition and results of operations.” for information on related risk factors). |\n\n| • | Establish Regional Order Acquisition and Treatment Planning Facilities: We intend to establish additional order acquisition and treatment planning facilities closer to our international customers in order to improve our operational efficiency and provide doctors with a great experience to further improve their confidence in using Invisalign to treat more patients and more often (Refer to Item 1A Risk Factors - “As we continue to grow, we are subject to growth related risks, including risks related to excess or constrained capacity at our existing facilities.” for information on related risk factors). |\n\n| • | Operating Expenses. We expect operating expenses to increase in 2017 due in part to: |\n\n| ◦ | investments in international expansion in new country markets particularly in the APAC region; |\n\n| ◦ | investments in manufacturing to enhance our regional capabilities; |\n\n| ◦ | increases in legal expenses primarily related to the continued protection of our intellectual property rights, including our patents; |\n\n| ◦ | increases in sales and customer support resources; |\n\n| ◦ | increases in expenses related to the purchase of our new corporate headquarters in San Jose, California; and |\n\n| ◦ | product and technology innovation to address such things as treatment times, indications unique to teens and predictability. |\n\nWe believe that these investments will position us to increase our revenue and continue to grow our market share.\n36\n| • | Stock Repurchases: |\n\n| ◦ | April 2014 Repurchase Program. In 2016, we repurchased $50.0 million of our common stock through an accelerated stock repurchase agreement and $46.2 million of stock repurchase in the open market. |\n\n| ◦ | April 2016 Repurchase Program. On April 28, 2016, we announced that our Board of Directors had authorized a plan to repurchase up to $300.0 million of our stock. |\n\n| ◦ | Remaining Available Repurchases. As of December 31, 2016, we have $3.8 million remaining under the April 2014 Repurchase Program and $300.0 million under the April 2016 Repurchase Plan (Refer to Note 10 \"Common Stock Repurchase Program\" of the Notes to Consolidated Financial Statements for details on stock repurchase program). |\n\n| • | SmileDirectClub. On July 25, 2016, we entered into a supply agreement with SmileDirectClub, LLC (\"SDC\") to manufacture clear aligners for SDC's doctor-led, at-home program for simple teeth straightening. In October 2016, we became SDC's exclusive third-party supplier and commercial supplying aligners for its minor tooth movement aligner program. As part of the transaction, we acquired a 17% equity interest in SDC for $46.7 million. We also provided a revolving line of credit to SDC of up to $15.0 million to fund their working capital and general corporate needs (Refer to Note 4 \"Equity Method Investments\" of the Notes to Consolidated Financial Statements for details on accounting treatment). |\n\nWe expect the supply agreement to be incremental to revenue growth in 2017.\n| • | New Corporate Headquarters Office Purchase Agreement. On December 19, 2016, we entered into a Purchase and Sale Agreement (the \"Purchase Agreement\") with LBA RIV-COMPANY XXX, LLC (\"Seller\") to purchase the real property located in San Jose, California (the \"Property\") for the purchase price of $44.1 million. We closed the Purchase Agreement on January 26, 2017 (Refer to Note 8 \"Commitments and Contingencies\" of the Notes of Consolidated Financial Statements for more information on the Purchase Agreement). |\n\nResults of Operations\nNet Revenues by Reportable Segment Comparison for Year Ended December 31, 2016, 2015 and 2014:\nWe group our operations into two reportable segments: Clear Aligner segment and Scanner segment\n| • | Our Clear Aligner segment consists of our Invisalign system which includes Invisalign Full, Teen and Assist (\"Comprehensive Products\"), Express/Lite (\"Non-Comprehensive Products\"), Vivera retainers, along with our training and ancillary products for treating malocclusion (\"Non-Case\"). Clear Aligner segment also include the sale of aligners to SDC under our supply agreement which commenced in the fourth quarter of 2016. SDC revenue is recorded after eliminating outstanding intercompany transactions. |\n\n| • | Our Scanner segment consists of intraoral scanning systems and additional services available with the intraoral scanners that provide digital alternatives to the traditional cast models. This segment includes our iTero scanner and OrthoCAD services. |\n\nNet revenues for our Clear Aligner segment and Scanner segment by region for the year ended December 31, 2016, 2015 and 2014 are as follows (in millions):\n37\n| Year Ended | Year Ended |\n| Net Revenues | December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\n| Clear Aligner Revenues: |\n| North America | $ | 568.7 | $ | 498.7 | $ | 70.0 | 14.0 | % | $ | 498.7 | $ | 446.6 | $ | 52.1 | 11.7 | % |\n| International | 326.6 | 250.1 | 76.5 | 30.6 | % | 250.1 | 219.7 | 30.4 | 13.8 | % |\n| Non-Case | 63.0 | 51.4 | 11.6 | 22.6 | % | 51.4 | 46.2 | 5.2 | 11.3 | % |\n| Total Clear Aligner net revenues | $ | 958.3 | $ | 800.2 | $ | 158.1 | 19.8 | % | $ | 800.2 | $ | 712.5 | $ | 87.7 | 12.3 | % |\n| Scanner net revenues | $ | 121.5 | $ | 45.3 | $ | 76.2 | 168.2 | % | $ | 45.3 | $ | 49.1 | $ | (3.8 | ) | (7.7 | )% |\n| Total net revenues | $ | 1,079.8 | $ | 845.5 | $ | 234.3 | 27.7 | % | $ | 845.5 | $ | 761.6 | $ | 83.9 | 11.0 | % |\n\nChanges and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.\nClear Aligner Case Volume by Region\nCase volume data which represents Clear Aligner case shipments by region, for the year ended December 31, 2016, 2015 and 2014 is as follows (in millions):\n| Year Ended | Year Ended |\n| Region | December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\n| North America | 464.5 | 398.4 | 66.1 | 16.6 | % | 398.4 | 338.5 | 59.9 | 17.7 | % |\n| International | 244.7 | 184.8 | 59.9 | 32.4 | % | 184.8 | 139.5 | 45.3 | 32.5 | % |\n| Total case volume | 709.2 | 583.2 | 126.0 | 21.6 | % | 583.2 | 478.0 | 105.2 | 22.0 | % |\n\nChanges and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.\nFiscal Year 2016 compared to Fiscal Year 2015\nTotal net revenues increased by $234.3 million in 2016 as compared to 2015 primarily as a result of case volume growth across all regions and products as well as increased non-case revenue.\nClear Aligner - North America\nNorth America net revenues increased by $70.0 million in 2016 compared to 2015 primarily due to case volume growth across all channels and products which increased net revenues by $82.7 million. This increase was offset in part by lower average selling price (\"ASP\") which decreased net revenues by $12.7 million. ASP declined in 2016 compared to 2015 as a result of higher promotional discounts of $21.9 million as well as an increase in net deferrals of $7.7 million primarily related to the full year effect of our new additional aligners product policy launched in July 2015. These declines were partially offset by price increases on our Comprehensive Products effective April 1, 2016 which contributed $17.7 million to net revenues.\nClear Aligner - International\nInternational net revenues increased by $76.5 million in 2016 compared to 2015 primarily driven by case volume growth across all channels and products which increased net revenues by $80.9 million. This increase was offset in part by lower ASP which decreased net revenues by $4.4 million. ASP declined in 2016 compared to 2015 as a result of higher promotional discounts of $6.9 million as well as the unfavorable impact of changes in foreign exchange rates of $6.8 million. These declines were partially offset by the price increases on our Comprehensive products effective April 1, 2016 which contributed $5.7 million to net revenues, as well as an increase in additional aligner revenue of $3.5 million.\nClear Aligner - Non-Case\nNon-case net revenues, consisting of training fees and ancillary product revenues, increased by $11.6 million in 2016 compared to 2015 primarily due to increased Vivera volume both in North America and International.\n38\nScanner\nScanner net revenues increased by $76.2 million in 2016 compared to 2015 primarily as a result of an increase in the number of scanners recognized as we began shipping our next generation iTero Element scanner in September 2015, and, to a lesser extent, an increase in ASP.\nFiscal Year 2015 compared to Fiscal Year 2014\nTotal net revenues increased by $83.9 million in 2015 compared to 2014 primarily as a result of case volume growth across all regions and products as well as increased non-case revenue.\nClear Aligner - North America\nNorth America net revenues increased by $52.1 million in 2015 compared to 2014 primarily due to case volume growth across all channels and products which increased net revenues by approximately $79.0 million. These increases were offset in part by lower ASP, which decreased net revenues by $26.9 million. The decrease in ASP was primarily as a result of higher net revenue deferrals of $16.0 million, which includes the impact of our new additional aligner product policy launched in July 2015 of $8.9 million and the impact of higher promotional discounts in 2015 as compared to 2014 of $11.7 million. These decreases in ASP were offset in part by the price increase, effective April 1, 2015 on our Comprehensive Products.\nClear Aligner - International\nInternational net revenues increased by $30.4 million in 2015 compared to 2014 primarily driven by case volume growth across all products of $71.5 million. This was partially offset by lower ASP which decreased net revenues by approximately $41.1 million. The decrease in ASP was primarily as a result of the unfavorable impact from changes in foreign exchange rates primarily due to the weakening of the Euro compared to the U.S. dollar in 2015 compared to 2014 of $34.5 million, and, to a lesser extent, higher net revenue deferrals of $7.8 million which includes the impact of our new additional aligner product policy launched in July 2015 of $4.7 million, as well as higher promotional discounts of $6.3 million in 2015 compared to 2014. These decreases were partially offset by an increase in ASP as we transitioned to direct sales in certain APAC countries and EMEA regions, as well as the price increase on our Comprehensive Products effective July 1, 2015.\nClear Aligner - Non-Case\nNon-case net revenues, consisting of training fees and ancillary product revenues, increased by $5.2 million in 2015 as compared to 2014 primarily due to increased Vivera volume both in North America and International.\nScanner\nScanner net revenues decreased by $3.8 million in 2015 compared to 2014 primarily due to a decrease in scanner revenue, offset in part by a slight increase in services revenue. In March 2015, we announced our next generation scanner and began shipping the iTero Element scanner in September 2015. Scanner revenues declined in 2015 primarily due to fewer scanners recognized and permanent price reductions on our previous generation scanner. The increase in services revenue was primarily due to an increase in the volume of CAD/CAM services resulting from a larger installed base of scanners.\n39\nCost of net revenues and gross profit (in millions):\n\n| Year Ended | Year Ended |\n| December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\n| Clear Aligner |\n| Cost of net revenues | $ | 210.8 | $ | 172.0 | $ | 38.8 | $ | 172.0 | $ | 149.7 | $ | 22.3 |\n| % of net segment revenues | 22.0 | % | 21.5 | % | 21.5 | % | 21.0 | % |\n| Gross profit | $ | 747.5 | $ | 628.2 | $ | 119.3 | $ | 628.2 | $ | 562.9 | $ | 65.3 |\n| Gross margin % | 78.0 | % | 78.5 | % | 78.5 | % | 79.0 | % |\n| Scanner |\n| Cost of net revenues | $ | 53.7 | $ | 33.4 | $ | 20.3 | $ | 33.4 | $ | 33.6 | $ | (0.2 | ) |\n| % of net segment revenues | 44.2 | % | 73.7 | % | 73.7 | % | 68.3 | % |\n| Gross profit | $ | 67.8 | $ | 11.9 | $ | 55.9 | $ | 11.9 | $ | 15.6 | $ | (3.7 | ) |\n| Gross margin % | 55.8 | % | 26.3 | % | 26.3 | % | 31.7 | % |\n| Total cost of net revenues | $ | 264.6 | $ | 205.4 | $ | 59.2 | $ | 205.4 | $ | 183.2 | $ | 22.2 |\n| % of net revenues | 24.5 | % | 24.3 | % | 24.3 | % | 24.1 | % |\n| Gross profit | $ | 815.3 | $ | 640.1 | $ | 175.2 | $ | 640.1 | $ | 578.4 | $ | 61.7 |\n| Gross margin % | 75.5 | % | 75.7 | % | 75.7 | % | 75.9 | % |\n\nChanges and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.\nCost of net revenues for our Clear Aligner and Scanner segments includes salaries for staff involved in the production process, the cost of materials, packaging, shipping costs, depreciation on capital equipment and facilities used in the production process, amortization of acquired intangible assets from training costs and stock-based compensation.\nFiscal Year 2016 compared to Fiscal Year 2015\nClear Aligner\nThe gross margin percentage declined in 2016 compared to 2015 primarily driven by a higher number of aligners per case and lower ASP which was partially offset by higher absorption as a result of increased production volumes.\nScanner\nThe gross margin percentage increased in 2016 compared to 2015 due to a product mix shift to our iTero Element scanner which has a higher ASP along with lower costs per unit.\nFiscal Year 2015 compared to Fiscal Year 2014\nClear Aligner\nThe gross margin percentage declined in 2015 compared to 2014 due to lower ASP which was partially offset by higher absorption as a result of increased production volumes.\nScanner\nThe gross margin percentage decreased in 2015 compared to 2014 due to lower ASP from permanent price reductions on our previous generation scanner, higher manufacturing costs from lower production volumes and higher inventory reserves. This was partially offset by a product mix shift to the lower cost Element scanner which commenced shipping in September 2015.\n40\nSelling, general and administrative (in millions):\n| Year Ended | Year Ended |\n| December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\n| Selling, general and administrative | $ | 490.7 | $ | 390.2 | $ | 100.5 | $ | 390.2 | $ | 332.1 | $ | 58.1 |\n| % of net revenues | 45.4 | % | 46.2 | % | 46.2 | % | 43.6 | % |\n\nChanges and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.\nSelling, general and administrative expense includes personnel-related costs including payroll, commissions and stock-based compensation for our sales force, marketing and administration in addition to media and advertising expenses, clinical education, trade shows and industry events, product marketing, outside consulting services, legal expenses, depreciation and amortization expense, the medical device excise tax (\"MDET\") and allocations of corporate overhead expenses including facilities and IT.\nSelling, general and administrative expense increased in 2016 compared to 2015 primarily due to higher compensation related costs of $47.1 million as a result of increased headcount, resulting in higher salaries expense, incentive bonuses and fringe benefits. We also incurred higher expenses from advertising and marketing of $16.5 million, outside services costs of $12.2 million, equipment and material costs of $6.8 million, travel and related costs of $6.0 million and credit card processing fees of $4.2 million. In addition, during the first quarter of 2015, there was a refund of MDET taxes paid in 2014 of $6.8 million as our aligners are no longer subject to the excise tax.\nSelling, general and administrative expense increased in 2015 compared to 2014 primarily due to higher compensation related costs of $50.1 million as a result of increased headcount, which led to higher salaries, stock based compensation and commissions. In addition, consulting costs increased by $9.7 million primarily due to our enterprise resource planning (\"ERP\") project. Partially offsetting these increases was the MDET refund of $6.8 million received in the first quarter of 2015.\nResearch and development (in millions):\n| Year Ended | Year Ended |\n| December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\n| Research and development | $ | 75.7 | $ | 61.2 | $ | 14.5 | $ | 61.2 | $ | 52.8 | $ | 8.4 |\n| % of net revenues | 7.0 | % | 7.2 | % | 7.2 | % | 6.9 | % |\n\nChanges and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.\nResearch and development expense includes the personnel-related costs including stock-based compensation and outside consulting expenses associated with the research and development of new products and enhancements to existing products and allocations of corporate overhead expenses including facilities and IT.\nResearch and development expense increased in 2016 compared to 2015 due to higher compensation costs as a result of increased headcount along with annual salary increases.\nResearch and development expense increased in 2015 compared to 2014 primarily as a result of our investment in obstructive sleep apnea which was terminated in the third quarter of 2015.\n41\nIncome from operations (in millions):\n| Year Ended | Year Ended |\n| December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\n| Clear Aligner |\n| Income from operations | $ | 411.8 | $ | 371.1 | $ | 40.7 | $ | 371.1 | $ | 341.1 | $ | 30.0 |\n| Operating margin % | 43.0 | % | 46.4 | % | 46.4 | % | 47.9 | % |\n| Scanner |\n| Income (loss) from operations | $ | 37.5 | $ | (12.3 | ) | $ | 49.8 | $ | (12.3 | ) | $ | (8.5 | ) | $ | (3.8 | ) |\n| Operating margin % | 30.9 | % | (27.2 | )% | (27.2 | )% | (17.3 | )% |\n| Total income from operations(1) | $ | 248.9 | $ | 188.6 | $ | 60.3 | $ | 188.6 | $ | 193.6 | $ | (5.0 | ) |\n| Operating margin % | 23.1 | % | 22.3 | % | 22.3 | % | 25.4 | % |\n\nChanges and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.\n(1) Refer to Note 15 \"Segments and Geographical Information\" of the Notes to Consolidated Financial Statements for details on unallocated corporate expenses and the reconciliation to total income from operations.\nFiscal Year 2016 compared to Fiscal Year 2015\nClear Aligner\nOperating margin percentage declined in 2016 compared to 2015 primarily due to higher compensation costs as a result of increased headcount, higher number of aligners manufactured per case and lower ASP.\nScanner\nOperating margin percentage increased in 2016 compared to 2015 due to a product mix shift to our iTero Element scanner resulting in a higher ASP and lower costs per unit. We also incurred lower operating expenses as a percentage of revenues as we leveraged our operating expenses on higher revenues.\nFiscal Year 2015 compared to Fiscal Year 2014\nClear Aligner\nOperating margin percentage declined in 2015 compared to 2014 due to higher compensation costs as a result of increased headcount, higher research and development expenses due to our investment in obstructive sleep apnea and lower ASP.\nScanner\nOperating margin percentage decreased in 2015 compared to 2014 due to lower ASP, higher manufacturing costs, higher inventory reserves and increased compensation related costs.\nInterest and other income (expense), net (in millions):\n| Year Ended | Year Ended |\n| December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\n| Interest and other income (expense), net | $ | (6.4 | ) | $ | (2.5 | ) | $ | (3.9 | ) | $ | (2.5 | ) | $ | (3.2 | ) | $ | 0.7 |\n\nInterest and other income (expense), net, includes foreign currency revaluation gains and losses, interest income earned on cash, cash equivalents and investment balances, gains and losses on foreign currency forward contracts and other miscellaneous charges.\n42\nInterest and other income (expense), net, decreased in 2016 compared to 2015 mainly due to higher foreign exchange losses as a result of weakening of the Euro to the U.S. dollar.\nInterest and other income (expense), net, increased in 2015 compared to 2014 mainly due to higher interest income on higher balances of cash, cash equivalents and investments offset in part by higher foreign exchange losses primarily due to the strengthening of the U.S. dollar to the Euro and Australian dollar.\nEquity in losses of investee, net of tax (in millions):\n| Year Ended | Year Ended |\n| December 31, 2016 | December 31, 2015 | Change | December 31, 2015 | December 31, 2014 | Change |\n| Equity in losses, net of tax | $ | 1.7 | — | $ | 1.7 | — | — | — |\n\nWe invested $46.7 million in SDC on July 25, 2016 and we account for this investment based on the equity method of accounting. In 2016, we recorded a $1.7 million charge representing our share of losses attributable to equity method investments (Refer to Note 4 \"Equity Method Investments\" of the Notes to Consolidated Financial Statements for details on equity method investments).\nProvision for income taxes (in millions):\n| Year Ended | Year Ended |\n| December 31,2016 | December 31,2015 | Change | December 31,2015 | December 31,2014 | Change |\n| Provision for income taxes | $ | 51.2 | $ | 42.1 | $ | 9.1 | $ | 42.1 | $ | 44.5 | $ | (2.4 | ) |\n| Effective tax rates | 21.1 | % | 22.6 | % | 22.6 | % | 23.4 | % |\n\nChanges and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.\nOur provision for income taxes was $51.2 million, $42.1 million and $44.5 million for the year ended December 31, 2016, 2015 and 2014, respectively, representing effective tax rates of 21.1%, 22.6% and 23.4%, respectively. Our effective tax rate differs from the statutory federal income tax rate of 35% due to certain foreign earnings, primarily in Costa Rica and the Netherlands, which are subject to lower tax rates and the impacts from our new international corporate structure in 2016, partially offset by the tax impact of certain stock-based compensation charges and unrecognized tax benefits. The decrease in the effective tax rate in 2016 compared to 2015 was primarily related to our international corporate restructuring as explained below. The decrease in the effective rate for the year ended December 31, 2015 compared to 2014 is mainly due to a $1.8 million tax adjustment recorded in 2014 which related to prior periods.\nOur total gross unrecognized tax benefits, excluding interest and penalties, was $46.4 million and $39.4 million as of December 31, 2016 and 2015, respectively, all of which would impact our effective tax rate if recognized. We have elected to recognize interest and penalties related to unrecognized tax benefits as a component of income taxes. For the year ended December 31, 2016 and 2015, interest and penalties included in tax expense was $1.4 million and $0.7 million, respectively. Our total interest and penalties accrued as of December 31, 2016 was $2.1 million. We do not expect any significant changes to the amount of unrecognized tax benefit within the next twelve months.\nWe file U.S. federal, U.S. state, and non-U.S. income tax returns. Our major tax jurisdictions are U.S. federal and the State of California. For U.S. federal and state tax returns, we are no longer subject to tax examinations for years before 2000. With few exceptions, we are no longer subject to examination by foreign tax authorities for years before 2007. Our subsidiary in Israel is under audit by the local tax authorities for calendar years 2006 through 2013.\nOn July 1, 2016, we implemented a new international corporate structure. This changes the structure of our international procurement and sales operations, as well as realigns the ownership and use of intellectual property among our wholly-owned subsidiaries. We continue to anticipate that an increasing percentage of our consolidated pre-tax income will be derived from, and reinvested in our foreign operations. We believe that income taxed in certain foreign jurisdictions at a lower rate relative to the U.S. federal statutory rate will have a beneficial impact on our worldwide effective tax rate over time. Although the license of intellectual property rights between consolidated entities did not result in any gain in the consolidated financial statements, the Company generated taxable income in certain jurisdictions in 2016 resulting in a tax expense of $34.3 million. Additionally, as a result of the restructuring, we reassessed the need for a valuation allowance against our deferred tax assets considering all available evidence. Given the current earnings and anticipated future earnings of our subsidiary in Israel, we concluded that we have sufficient\n43\npositive evidence to release the valuation allowance against our Israel operating loss carryforwards of $31.4 million, which resulted in an income tax benefit in this period of the same amount.\nAs of December 31, 2016, our remaining valuation allowance was not material.\nIn June 2009, the Costa Rica Ministry of Foreign Trade, an agency of the Government of Costa Rica, granted a twelve year extension of certain income tax incentives, which were previously granted in 2002. The incentive tax rates will expire in various years beginning in 2017. We intend to seek a renewal of these income tax incentives before they expire. Under these incentives, all of the income in Costa Rica during these twelve year incentive periods is subject to a reduced tax rate. In order to receive the benefit of these incentives, we must hire specified numbers of employees and maintain certain minimum levels of fixed asset investment in Costa Rica. If we do not fulfill these conditions for any reason, our incentive could lapse, and our income in Costa Rica would be subject to taxation at higher rates, which could have a negative impact on our operating results. The Costa Rica corporate income tax rate that would apply, absent the incentives, is 30% for 2016, 2015 and 2014. As a result of these incentives, our income taxes were reduced by $19.1 million, $32.7 million and $32.5 million in the year ended December 31, 2016, 2015 and 2014, respectively, representing a benefit to diluted net income per share of $0.23 in the year ended December 31, 2016 and $0.40 for both the year ended December 31, 2015 and 2014.\nAs of December 31, 2016, approximately $438.0 million of undistributed earnings from non-U.S. operations held by our foreign subsidiaries are designated as indefinitely reinvested outside the U.S. We maintain sufficient cash reserves in the U.S. and do not intend to repatriate our foreign earnings. As a result, U.S. income taxes and foreign withholding taxes have not been provided on these foreign earnings. If these earnings were distributed in the form of dividends or otherwise, or if the shares of the relevant foreign subsidiaries were sold or otherwise transferred, we would be subject to additional U.S. income taxes subject to an adjustment for foreign tax credits and foreign withholding taxes. We intend to use the undistributed earnings for local operating expansions and to meet local operating working capital needs. In addition, a significant amount of the cash earned by foreign subsidiaries has been and will continue to be utilized to affect the new international corporate structure described above.\nLiquidity and Capital Resources\nWe fund our operations from product sales. As of December 31, 2016 and 2015, we had the following cash and cash equivalents, and short-term and long-term marketable securities (in thousands):\n| Year Ended December 31, |\n| 2016 | 2015 |\n| Cash and cash equivalents | $ | 389,275 | $ | 167,714 |\n| Short-term marketable securities | 250,981 | 359,581 |\n| Long-term marketable securities | 59,783 | 151,370 |\n| Total | $ | 700,039 | $ | 678,665 |\n\nCash flows (in thousands):\n| Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| Net cash flow provided by (used in): |\n| Operating activities | $ | 247,654 | $ | 237,997 | $ | 226,899 |\n| Investing activities | 72,848 | (166,361 | ) | (201,627 | ) |\n| Financing activities | (95,524 | ) | (100,786 | ) | (66,420 | ) |\n| Effects of exchange rate changes on cash and cash equivalents | (3,417 | ) | (3,007 | ) | (1,934 | ) |\n| Net increase (decrease) in cash and cash equivalents | $ | 221,561 | $ | (32,157 | ) | $ | (43,082 | ) |\n\nAs of December 31, 2016, we had $700.0 million in cash, cash equivalents, and short-term and long-term marketable securities. Cash equivalents and marketable securities are comprised of money market funds and highly liquid debt instruments which primarily include commercial paper, corporate bonds, U.S. dollar denominated foreign corporate bonds, U.S. government agency bonds, U.S. government treasury bonds, municipal securities, asset-backed securities and certificates of deposit.\nAs of December 31, 2016, approximately $459.0 million of cash, cash equivalents and short-term and long-term marketable securities was held by our foreign subsidiaries. Amounts held by foreign subsidiaries are generally subject to U.S. income taxation on repatriation to the U.S. The costs to repatriate our foreign earnings to the U.S. would likely be material; however, our intent is\n44\nto permanently reinvest our earnings from foreign operations, and our current plans do not require us to repatriate them to fund our U.S. operations as we generate sufficient domestic operating cash flow and have access to external funding under our current revolving line of credit.\nOperating Activities\nFor the year ended December 31, 2016, cash flows from operations of $247.7 million resulted primarily from our net income of approximately $189.7 million as well as the following:\nSignificant non-cash activities\n| • | Stock-based compensation was $54.1 million related to equity incentive compensation granted to employees and directors, |\n\n| • | Depreciation and amortization of $24.0 million related to our fixed assets and acquired and purchased intangible assets, |\n\n| • | Excess tax benefits from our share-based compensation arrangements of $16.8 million, |\n\n| • | Net change in deferred tax assets of $16.4 million, and |\n\n| • | Net tax benefits from stock based compensation of $15.9 million. |\n\nSignificant changes in working capital\n| • | Increase of $94.4 million in accounts receivable which is a result of the increase in net revenues, |\n\n| • | Increase of $60.7 million in deferred revenues corresponding to the increases in case shipments and full year effect of our additional aligner product policy effective in July 2015, and |\n\n| • | Increase of $37.6 million in accrued and other long-term liabilities due to timing of payments and activities. |\n\nFor the year ended December 31, 2015, cash flows from operations of $238.0 million resulted primarily from our net income of approximately $144.0 million as well as the following:\nSignificant non-cash activities\n| • | Stock-based compensation was $52.9 million related to our equity incentive compensation granted to employees and directors, |\n\n| • | Depreciation and amortization of $18.0 million related to our fixed assets and acquired intangible assets, and |\n\n| • | Excess tax benefits from our share-based compensation arrangements of $10.4 million. |\n\nSignificant changes in working capital\n| • | Increase of $41.9 million in deferred revenues corresponding to higher product sales along with the increased deferrals as a result of the change to our new additional aligner product policy in July 2015, |\n\n| • | Increase of $40.8 million in accounts receivable which is a result of the increase in net revenues, and |\n\n| • | Increase of $19.5 million in accrued and other long-term liabilities primarily due to an increase in income tax payable along with other accruals due to timing of payment. |\n\nFor the year ended December 31, 2014, cash flows from operations of $226.9 million resulted primarily from our net income of approximately $145.8 million as well as the following:\n45\nSignificant non-cash activities\n| • | Stock-based compensation was $39.8 million related to our equity incentive compensation granted to employees and directors, |\n\n| • | Excess tax benefits from our share-based compensation arrangements of $21.4 million, and |\n\n| • | Depreciation and amortization of $17.9 million related to our fixed assets and acquired intangible assets. |\n\nSignificant changes in working capital\n| • | Increase of $27.2 million in accounts receivable which is a result of the increase in net revenues, |\n\n| • | Increase of $22.7 million in accrued and other long-term liabilities primarily due to an increase in income tax payable along with other accruals due to timing of payment, and |\n\n| • | Increase of $15.8 million in deferred revenues corresponding to the increases in revenues. |\n\nInvesting Activities\nNet cash provided by investing activities was $72.8 million for the year ended December 31, 2016, which primarily consisted of maturities and sales of our marketable securities of $604.0 million. These inflows were partially offset by purchases of marketable securities of $405.6 million, property, plant and equipment purchases of $70.6 million including the implementation of our new ERP system and $46.7 million related to our equity interest investment in SmileDirectClub, LLC (\"SDC\").\nFor 2017, we expect to invest $220.0 million to $250.0 million on capital expenditures primarily for our purchase of a new corporate headquarters office, new order acquisition facility in Singapore and other additional manufacturing and capacity to support our international expansion. Although we believe our current investment portfolio has little risk of impairment, we cannot predict future market conditions or market liquidity and can provide no assurance that our investment portfolio will remain unimpaired.\nNet cash used in investing activities was $166.4 million for the year ended December 31, 2015, which primarily consisted of purchases of marketable securities of $447.1 million and property, plant and equipment purchases of $53.5 million for additional manufacturing capacity and infrastructure including the project to implement a new ERP system which we started in late 2014. These uses were partially offset by $334.1 million of maturities and sales of our marketable securities.\nNet cash used in investing activities was $201.6 million for the year ended December 31, 2014, which primarily consisted of purchases of marketable securities of $437.2 million and property, plant and equipment purchases of $24.1 million. These uses were partially offset by $259.8 million of maturities and sales of our marketable securities.\nFinancing Activities\nNet cash used by financing activities was $95.5 million for the year ended December 31, 2016 primarily resulting from a common stock repurchase of $96.2 million (Refer to Note 10 \"Common Stock Repurchase Program\" of the Notes to Consolidated Financial Statements for details on the stock repurchase program) and $29.9 million of payroll taxes paid for vesting of restricted stock units (\"RSUs\") through share withholdings, partially offset by excess tax benefit from our share-based compensation arrangements of $16.8 million and proceeds from issuance of common stock of $13.8 million.\nNet cash used by financing activities was $100.8 million for the year ended December 31, 2015 resulting from repurchases of our common stock of $101.8 million and $20.7 million of payroll taxes paid for our employees' vesting of RSUs through share withholdings, partially off-set by proceeds from issuance of common stock of $11.3 million and $10.4 million from excess tax benefit from our share-based compensation arrangements.\nNet cash used by financing activities was $66.4 million for the year ended December 31, 2014 resulting from repurchases of our common stock of $98.2 million and $7.6 million of payroll taxes paid for our employees' vesting of RSUs through share withholdings, partially off-set by proceeds from issuance of common stock of $18.0 million and $21.4 million from excess tax benefit from our share-based compensation arrangements.\nAs restricted stock units are taxable to the individuals when they vest, the number of shares we issue to each of our employees will be net of applicable withholding taxes which will be paid by us on their behalf. During 2016, 2015 and 2014, we paid $29.9 million, $20.7 million and $7.6 million, respectively, for taxes related to RSUs that vested during the periods. The cash paid for\n46\ntaxes related to RSUs in 2016 and 2015 increased in comparison to 2014 due to the Company changing its policy in mid 2014 to pay for employees' payroll taxes related to their vesting RSUs instead of requiring employees to sell to cover for their payroll taxes.\nStock Repurchases\nRefer to Note 10 \"Common Stock Repurchase Program\" of the Notes to Consolidated Financial Statements for details on stock repurchase program.\n| ◦ | April 2014 Repurchase Program. In 2016, we repurchased $50.0 million of our common stock through an accelerated stock repurchase agreement and $46.2 million of stock repurchase in the open market. |\n\n| ◦ | April 2016 Repurchase Program. On April 28, 2016, we announced that our Board of Directors had authorized a plan to repurchase up to $300.0 million of our stock. |\n\n| ◦ | Remaining Available Repurchases. As of December 31, 2016, we have $3.8 million remaining under the April 2014 Repurchase Program and $300.0 million under the April 2016 Repurchase Plan. |\n\nWe believe that our current cash and cash equivalents and marketable securities combined with our positive cash flows from operations will be sufficient to fund our operations and stock repurchases for at least the next 12 months. If we are unable to generate adequate operating cash flows, we may need to suspend our stock repurchase program or seek additional sources of capital through equity or debt financing, collaborative or other arrangements with other companies, bank financing and other sources in order to realize our objectives and to continue our operations. There can be no assurance that we will be able to obtain additional debt or equity financing on terms acceptable to us, or at all. If adequate funds are not available, we may need to make business decisions that could adversely affect our operating results such as modifications to our pricing policy, business structure or operations. Accordingly, the failure to obtain sufficient funds on acceptable terms when needed could have a material adverse effect on our business, results of operations and financial condition.\nCredit Facility\nOn March 22, 2013, we entered into a credit facility for a $50.0 million revolving line of credit, with a $10.0 million letter of credit sublimit, and has a maturity date on March 22, 2018 (Refer to Note 7 \"Credit Facility\" of the Notes to Consolidated Financial Statements for details of the credit facility).\nContractual Obligations/Off Balance Sheet Arrangements\nThe impact that our contractual obligations as of December 31, 2016 are expected to have on our liquidity and cash flows in future periods is as follows (in thousands):\n| Payments Due by Period |\n| Total | Less than1 Year | 1-3Years | 3-5Years | More than5 Years |\n| Operating lease obligations | $ | 53,921 | $ | 12,880 | $ | 18,804 | $ | 13,096 | $ | 9,141 |\n| Unconditional purchase obligations | 163,688 | — | — | — | — |\n| Total contractual cash obligations | $ | 217,609 | $ | 12,880 | $ | 18,804 | $ | 13,096 | $ | 9,141 |\n\nOur contractual obligations table above excludes approximately $45.1 million of non-current uncertain tax benefits which are included in other long-term obligations and deferred tax assets on our balance sheet as of December 31, 2016. We have not included this amount because we cannot make a reasonably reliable estimate regarding the timing of settlements with taxing authorities, if any.\nWe had no off-balance sheet arrangements as defined in Regulation S-K Item 303(a) (4) as of December 31, 2016.\n47\nIndemnification Provisions\nIn the normal course of business to facilitate transactions in our services and products, we indemnify customers, vendors, lessors, and other parties with respect to certain matters, including, but not limited to, services to be provided by us and intellectual property infringement claims made by third parties. In addition, we have entered into indemnification agreements with our directors and certain of our officers that will require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors or officers. Several of these agreements limit the time within which an indemnification claim can be made and the amount of the claim.\nIt is not possible to make a reasonable estimate of the maximum potential amount under these indemnification agreements due to the unique facts and circumstances involved in each particular agreement. Additionally, we have a limited history of prior indemnification claims and the payments we have made under such agreements have not had a material adverse effect on our results of operations, cash flows, or financial position. However, to the extent that valid indemnification claims arise in the future, future payments by us could be significant and could have a material adverse effect on our results of operations or cash flows in a particular period. As of December 31, 2016, we did not have any material indemnification claims that were probable or reasonably possible.\nCritical Accounting Policies and Estimates\nManagement’s discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses and disclosures at the date of the financial statements. We evaluate our estimates on an on-going basis, including those related to revenue recognition, stock-based compensation, goodwill and finite-lived assets and related impairment, and income taxes. We use authoritative pronouncements, historical experience and other assumptions as the basis for making estimates. Actual results could differ from those estimates.\nWe believe the following critical accounting policies and estimates affect our more significant judgments used in the preparation of our consolidated financial statements. For further information on all of our significant accounting policies, see Note 1 \"Summary of Significant Accounting Policies\" of the Notes to Consolidated Financial Statements under Item 8.\nRevenue Recognition\nWe enter into sales arrangements that may consist of multiple deliverables of our products and services where certain elements of the sales arrangement are not delivered in one reporting period. We measure and allocate revenue according to the accounting guidance for multiple-deliverable revenue arrangements in Accounting Standards Update (“ASU”) 2009-13, Multiple-Deliverable Revenue Arrangements-a consensus of the Financial Accounting Standard Board (“FASB”) Emerging Issues Task Force.\nEach element within a multiple-element arrangement is accounted for as a separate unit of accounting provided the following criteria are met: the delivered products or services have value to the customer on a standalone basis; and for an arrangement that includes a general right of return relative to the delivered products or services, delivery or performance of the undelivered product or service is considered probable and is substantially controlled by us. We consider a deliverable to have standalone value if the product or service is sold separately by us or another vendor or could be resold by the customer. Further, our revenue arrangements generally do not include a general right of return relative to the delivered products. The arrangement consideration is allocated to each element, delivered or undelivered, based on the relative selling price of each unit of accounting based first on vendor-specific objective evidence (“VSOE”) if it exists, second on third-party evidence (“TPE”) if it exists, or on best estimated selling price (“BESP”) if neither VSOE nor TPE exist (a description as to how we determine VSOE, TPE and BESP is provided below).\n| • | VSOE - In most instances, this applies to products and services that are sold separately in stand-alone arrangements. We determine VSOE based on pricing and discounting practices for the specific product or service when sold separately, considering geographical, customer, and other economic or marketing variables, as well as renewal rates or stand-alone prices for the service element(s). |\n\n| • | TPE - If we cannot establish VSOE of selling price for a specific product or service included in a multiple-element arrangement, we use third-party evidence of selling price. We determine TPE based on sales of comparable amount of similar products or service offered by multiple third parties considering the degree of customization and similarity of product or service sold. |\n\n| • | BESP - The best estimated selling price represents the price at which we would sell a product or service if it were sold on a stand-alone basis. When VSOE or TPE does not exist for all elements, we determine BESP for the arrangement element based on sales, cost and margin analysis, as well as other inputs based on our pricing practices. Adjustments for |\n\n48\nother market and company specific factors are made as deemed necessary in determining BESP. We regularly review our estimates of selling price and maintain internal controls over the establishment and update of these estimates.\nJudgment is required to properly identify the accounting units of the multiple deliverable transactions, to determine the best estimated selling price for each accounting unit, and to determine the manner in which revenue should be allocated among the accounting units. Further, while changes in the allocation of the best estimated selling price between the accounting units will not affect the amount of total revenue recognized for a particular arrangement, any material changes in these allocations could impact the timing of revenue recognition, which could have a material effect on our financial position and results of operations.\nClear Aligner\nWe enter into arrangements (“treatment plans”) that involve multiple future product deliverables. Invisalign Full, Invisalign Teen, and Invisalign Assist products (\"Comprehensive Products\") include optional additional aligners at no charge for a period of up to five years after initial shipment. Invisalign Teen also includes up to six optional replacement aligners in the price of the product and may be ordered by the dental professional any time throughout treatment. Invisalign Lite (\"Non-Comprehensive Products\") includes one optional case refinement in the price of the product. Case refinement is a finishing tool used to adjust a patient's teeth to the desired final position and may be elected by the dental professional at any time during treatment; however, it is generally ordered in the last stages of orthodontic treatment.\nWe determined that our treatment plans, except Invisalign Assist with progress tracking, comprise the following deliverables which also represent separate units of accounting: initial aligners, additional aligners, case refinement, and replacement aligners. We allocate revenue for each treatment plan based on each unit's relative selling price based on BESP and recognize the revenue upon shipment of each unit in the treatment plan.\nFor Invisalign Assist with the progress tracking feature, aligners and services are provided to the dental professional every nine stages (“a batch”). We are able to reliably estimate the number of batches which are expected to be shipped for each case based upon our historical experience. The amounts allocated to this deliverable are recognized on a prorated basis as each batch is shipped.\nScanners and Services\nWe sell intraoral scanners and CAD/CAM services through both our direct sales force and distribution partners. The intraoral scanner sales price includes one year of warranty, and unlimited scanning services. The customer may, for additional fees, also select extended warranty and unlimited scanning services for periods beyond the initial year. When intraoral scanners are sold with an unlimited scanning service agreement and/or extended warranty, we allocate revenue based on each element's relative selling price. We estimate the selling price of each element, as if it is sold on a stand-alone basis, taking into consideration historical prices as well as our discounting strategies.\nStock-Based Compensation Expense\nWe recognize stock-based compensation cost for only those shares ultimately expected to vest on a straight-line basis over the requisite service period of the award. We use the Black-Scholes option pricing model to determine the fair value of stock options and employee stock purchase plan shares. We estimate the fair value of market-performance based restricted stock units using a Monte Carlo simulation model which requires the input of assumptions, including expected term, stock price volatility and the risk-free rate of return. In addition, judgment is required in estimating the number of stock-based awards that are expected to be forfeited. Forfeitures are estimated based on historical experience at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management’s judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future.\nGoodwill and Finite-Lived Acquired Intangible Assets\nGoodwill represents the excess of the purchase price paid over the fair value of tangible and identifiable intangible net assets acquired in business combinations and is allocated to the respective reporting units based on relative synergies generated. For the year ended December 31, 2016 and 2015, all goodwill is attributed to our Clear Aligner reporting unit.\n49\nOur intangible assets primarily consist of intangible assets acquired as part of acquisitions and are amortized using the straight-line method over their estimated useful lives, reflecting the period in which the economic benefits of the assets are expected to be realized.\nImpairment of Goodwill, Finite-Lived Acquired Intangible Assets and Long-Lived assets\nGoodwill\nWe evaluate goodwill for impairment at least annually on November 30th or more frequently if indicators are present, an event occurs or circumstances changes that suggest an impairment may exist and that it would more likely than not reduce the fair value of a reporting unit below its carrying amount. The allocation of goodwill to the respective reporting unit is based on relative synergies generated as a result of an acquisition.\nWe perform an initial assessment of qualitative factors to determine whether the existence of events and circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. In performing the qualitative assessment, we identify and consider the significance of relevant key factors, events, and circumstances that affect the fair value of our reporting units. These factors include external factors such as macroeconomic, industry, and market conditions, as well as entity-specific factors, such as our actual and planned financial performance. We also give consideration to the difference between the reporting unit fair value and carrying value as of the most recent date a fair value measurement was performed. If, after assessing the totality of relevant events and circumstances, we determine that it is more likely than not that the fair value of the reporting unit exceeds its carrying value and there is no indication of impairment, no further testing is performed; however, if we conclude otherwise, the first step of the two-step impairment test is performed by estimating the fair value of the reporting unit and comparing it with its carrying value, including goodwill. Refer to Note 5 \"Goodwill and Intangible Assets\" of Notes to Consolidated Financial Statements for details on intangible long-lived assets.\nFinite-Lived Intangible Assets and Long-Lived Assets\nWe evaluate long-lived assets (including finite-lived intangible assets) for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. An asset or asset group is considered impaired if its carrying amount exceeds the future undiscounted net cash flows the asset or asset group is expected to generate. If an asset or asset group is considered to be impaired, the impairment to be recognized is calculated as the amount by which the carrying amount of the asset or asset group exceeds its fair market value. Our estimates of future cash flows attributable to our long-lived assets require significant judgment based on our historical and anticipated results and are subject to many factors. Factors we consider important which could trigger an impairment review include significant negative industry or economic trends, significant loss of customers and changes in the competitive environment. The estimation of fair value utilizing a discounted cash flow approach includes numerous uncertainties which require our significant judgment when making assumptions of expected growth rates and the selection of discount rates, as well as assumptions regarding general economic and business conditions, and the structure that would yield the highest economic value, among other factors. Refer to Note 5 \"Goodwill and Intangible Assets\" of Notes to Consolidated Financial Statements for details of the impairment analysis.\nAccounting for Income Taxes\nWe make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of certain tax assets and liabilities, which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes.\nAs part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves us estimating our current tax exposure under the applicable tax laws and assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our Consolidated Balance Sheets.\nWe account for uncertainty in income taxes pursuant to authoritative guidance based on a two-step approach to recognize and measure uncertain tax positions taken or expected to be taken in a tax return. The first step is to determine if the weight of available evidence indicates that it is more likely than not that the tax position will be sustained on audit based on its technical merits, including resolution of any related appeals or litigation processes. The second step is to measure the tax benefit as the largest amount that is more than 50% likely to be realized upon ultimate settlement. We adjust reserves for our uncertain tax positions due to changing facts and circumstances, such as the closing of a tax audit, or refinement of estimates due to new\n50\ninformation. To the extent that the final outcome of these matters is different than the amounts recorded, such differences will impact our tax provision in our Consolidated Statements of Operations in the period in which such determination is made.\nWe assess the likelihood that we will be able to realize our deferred tax assets. Should there be a change in our ability to realize our deferred tax assets, our tax provision would increase in the period in which we determine that it is more likely than not that we cannot realize our deferred tax assets. We consider all available evidence, both positive and negative, including historical levels of income, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance. If it is more likely than not that we will not realize our deferred tax assets, we will increase our provision for taxes by recording a valuation allowance against the deferred tax assets that we estimate will not ultimately be realized.\nRecent Accounting Pronouncements\nSee Note 1 “Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements in Item 8 for a full description of recent accounting pronouncements, including the expected dates of adoption and estimated effects on results of operations and financial condition, which is incorporated herein.\n51\nITEM 7A.\nQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nIn the normal course of business, we are exposed to foreign currency exchange rate and interest rate risks that could impact our financial position and results of operations.\nInterest Rate Risk\nChanges in interest rates could impact our anticipated interest income on our cash equivalents and investments in marketable securities. Our cash equivalents and investments are fixed-rate short-term and long-term securities. Fixed-rate securities may have their fair market value adversely impacted due to a rise in interest rates, and as a result, our future investment income may fall short of expectations due to changes in interest rates or we may suffer losses in principal if forced to sell securities which have declined in market value due to changes in interest rates. As of December 31, 2016, we had approximately $310.8 million invested in available-for-sale marketable securities. An immediate 10% change in interest rates would not have a material adverse impact on our future operating results and cash flows.\nWe do not have interest bearing liabilities as of December 31, 2016, and, therefore, we are not subject to risks from immediate interest rate increases.\nCurrency Rate Risk\nAs a result of our international business activities, including the impact of our new international corporate structure in 2016, our financial results could be affected by factors such as changes in foreign currency exchange rates or economic conditions in foreign markets, and there is no assurance that exchange rate fluctuations will not harm our business in the future. We generally sell our products in the local currency of the respective countries. This provides some natural hedging because most of the subsidiaries’ operating expenses are generally denominated in their local currencies as discussed further below. Regardless of this natural hedging, our results of operations may be adversely impacted by exchange rate fluctuations. For the year ended December 31, 2016 and 2015, we had foreign currency net losses of $8.0 million and $4.0 million, respectively.\nIn September 2015, we started to enter into foreign currency forward contracts to minimize the short-term impact of foreign currency exchange rate fluctuations on cash and certain trade and intercompany receivables and payables. These forward contracts are not designated as hedging instruments and do not subject us to material balance sheet risk due to fluctuations in foreign currency exchange rates. The gains and losses on these forward contracts are intended to offset the gains and losses in the underlying foreign currency denominated monetary assets and liabilities being economically hedged. These instruments are marked to market through earnings every period and generally are one month in original maturity. We do not enter into foreign currency forward contracts for trading or speculative purposes. As our international operations grow, we will continue to reassess our approach to managing the risks relating to fluctuations in currency rates. It is difficult to predict the impact hedging activities could have on our results of operations. As of December 31, 2016, we did not have any outstanding foreign exchange forward contracts.\nAlthough we will continue to monitor our exposure to currency fluctuations, and, where appropriate, may use financial hedging techniques in the future to minimize the effect of these fluctuations, the impact of an aggregate change of 10% in foreign currency exchange rates relative to the U.S. dollar on our results of operations and financial position could be material.\n52\nITEM 8.\nCONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA\nQuarterly Results of Operations\n| Three Months Ended |\n| 2016 | 2015 |\n| December 31, 2016 | September 30, 2016 | June 30, 2016 | March 31, 2016 | December 31, 2015 | September 30, 2015 | June 30, 2015 | March 31, 2015 |\n| (in thousands, except per share data)(unaudited ) |\n| Net revenues | $ | 293,203 | $ | 278,589 | $ | 269,362 | $ | 238,720 | $ | 230,276 | $ | 207,636 | $ | 209,488 | $ | 198,086 |\n| Gross profit | 220,249 | 209,202 | 205,216 | 180,627 | 172,810 | 157,576 | 158,634 | 151,090 |\n| Income from operations | 68,372 | 62,079 | 65,136 | 53,334 | 59,339 | 38,046 | 42,325 | 48,924 |\n| Net income | 47,621 | 51,367 | 50,148 | 40,546 | 48,877 | 27,616 | 31,350 | 36,177 |\n| Net income per share: |\n| Basic | $ | 0.60 | $ | 0.64 | $ | 0.63 | $ | 0.51 | $ | 0.61 | $ | 0.35 | $ | 0.39 | $ | 0.45 |\n| Diluted | $ | 0.59 | $ | 0.63 | $ | 0.62 | $ | 0.50 | $ | 0.60 | $ | 0.34 | $ | 0.39 | $ | 0.44 |\n| Shares used in computing net income per share: |\n| Basic | 79,667 | 79,977 | 79,951 | 79,831 | 79,481 | 79,808 | 80,257 | 80,459 |\n| Diluted | 81,248 | 81,466 | 81,281 | 81,320 | 81,051 | 81,092 | 81,394 | 81,824 |\n\n53\nINDEX TO CONSOLIDATED FINANCIAL STATEMENTS\n\n| Page |\n| Report of Management on Internal Control over Financial Reporting | 55 |\n| Report of Independent Registered Public Accounting Firm | 56 |\n| Consolidated Statements of Operations | 57 |\n| Consolidated Statements of Comprehensive Income | 58 |\n| Consolidated Balance Sheets | 59 |\n| Consolidated Statements of Stockholders’ Equity | 60 |\n| Consolidated Statements of Cash Flows | 61 |\n| Notes to Consolidated Financial Statements | 62 |\n\n54\nREPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING\nManagement of Align is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Our internal control over financial reporting is designed by, or under supervision of, our CEO and CFO, and effected by the board of directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that:\n| • | pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of Align; |\n\n| • | provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of Align are being made only in accordance with authorizations of management and directors of Align; and |\n\n| • | provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of Align's assets that could have a material effect on the financial statements. |\n\nBecause of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. In addition, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.\nManagement assessed the effectiveness of our internal control over financial reporting as of December 31, 2016. In making this assessment, management used the criteria set forth in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).\nBased on its assessment, management has concluded that, as of December 31, 2016, our internal control over financial reporting was effective based on criteria in Internal Control - Integrated Framework (2013) issued by the COSO.\nThe effectiveness of our internal control over financial reporting as of December 31, 2016 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which is included herein.\n| /S/ JOSEPH M. HOGAN |\n| Joseph M. Hogan |\n| President and Chief Executive Officer |\n| February 28, 2017 |\n| /S/ JOHN F. MORICI |\n| John F. Morici |\n| Chief Financial Officer |\n| February 28, 2017 |\n\n55\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\nTo the Stockholders and Board of Directors of Align Technology, Inc.:\nIn our opinion, the consolidated financial statements listed in the index appearing under Item 15(a) (1) present fairly, in all material respects, the financial position of Align Technology, Inc. and its subsidiaries at December 31, 2016 and December 31, 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control over Financial Reporting. Our responsibility is to express opinions on these financial statements, on the financial statement schedule, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.\nA company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.\nBecause of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.\n/s/ PricewaterhouseCoopers LLP\nSan Jose, California\nFebruary 28, 2017\n56\nALIGN TECHNOLOGY, INC. AND SUBSIDIARIES\nCONSOLIDATED STATEMENTS OF OPERATIONS\n(in thousands, except per share data)\n\n| Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| Net revenues | $ | 1,079,874 | $ | 845,486 | $ | 761,653 |\n| Cost of net revenues | 264,580 | 205,376 | 183,210 |\n| Gross profit | 815,294 | 640,110 | 578,443 |\n| Operating expenses: |\n| Selling, general and administrative | 490,653 | 390,239 | 332,068 |\n| Research and development | 75,720 | 61,237 | 52,799 |\n| Total operating expenses | 566,373 | 451,476 | 384,867 |\n| Income from operations | 248,921 | 188,634 | 193,576 |\n| Interest and other income (expense), net | (6,355 | ) | (2,533 | ) | (3,207 | ) |\n| Net income before provision for income taxes and equity in losses of investee | 242,566 | 186,101 | 190,369 |\n| Provision for income taxes | 51,200 | 42,081 | 44,537 |\n| Equity in losses of investee, net of tax | 1,684 | — | — |\n| Net income | $ | 189,682 | $ | 144,020 | $ | 145,832 |\n| Net income per share: |\n| Basic | $ | 2.38 | $ | 1.80 | $ | 1.81 |\n| Diluted | $ | 2.33 | $ | 1.77 | $ | 1.77 |\n| Shares used in computing net income per share: |\n| Basic | 79,856 | 79,998 | 80,754 |\n| Diluted | 81,484 | 81,521 | 82,283 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n57\nALIGN TECHNOLOGY, INC. AND SUBSIDIARIES\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME\n(in thousands)\n| Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| Net income | $ | 189,682 | $ | 144,020 | $ | 145,832 |\n| Net change in foreign currency translation adjustment | (670 | ) | (154 | ) | (196 | ) |\n| Change in unrealized gains (losses) on investments, net of tax | 712 | (686 | ) | (238 | ) |\n| Other comprehensive income (loss) | 42 | (840 | ) | (434 | ) |\n| Comprehensive income | $ | 189,724 | $ | 143,180 | $ | 145,398 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n58\nALIGN TECHNOLOGY, INC. AND SUBSIDIARIES\nCONSOLIDATED BALANCE SHEETS\n(in thousands, except per share data)\n\n| December 31, |\n| 2016 | 2015 |\n| ASSETS |\n| Current assets: |\n| Cash and cash equivalents | $ | 389,275 | $ | 167,714 |\n| Marketable securities, short-term | 250,981 | 359,581 |\n| Accounts receivable, net of allowance for doubtful accounts and returns of $4,310 and $2,472, respectively | 247,415 | 158,550 |\n| Inventories | 27,131 | 19,465 |\n| Prepaid expenses and other current assets | 38,176 | 26,700 |\n| Total current assets | 952,978 | 732,010 |\n| Marketable securities, long-term | 59,783 | 151,370 |\n| Property, plant and equipment, net | 175,167 | 136,473 |\n| Equity method investments | 45,061 | — |\n| Goodwill and intangible assets, net | 81,998 | 79,162 |\n| Deferred tax assets | 67,844 | 51,416 |\n| Other assets | 13,320 | 8,202 |\n| Total assets | $ | 1,396,151 | $ | 1,158,633 |\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\n| Current liabilities: |\n| Accounts payable | $ | 28,596 | $ | 34,354 |\n| Accrued liabilities | 134,332 | 107,765 |\n| Deferred revenues | 191,407 | 129,553 |\n| Total current liabilities | 354,335 | 271,672 |\n| Income tax payable | 45,133 | 37,512 |\n| Other long-term liabilities | 1,294 | 1,523 |\n| Total liabilities | 400,762 | 310,707 |\n| Commitments and contingencies (Notes 6 and 8) |\n| Stockholders’ equity: |\n| Preferred stock, $0.0001 par value (5,000 shares authorized; none issued) | — | — |\n| Common stock, $0.0001 par value (200,000 shares authorized; 79,553 and 79,500 issued and outstanding, respectively) | 8 | 8 |\n| Additional paid-in capital | 864,871 | 821,507 |\n| Accumulated other comprehensive income (loss), net | (938 | ) | (980 | ) |\n| Retained earnings | 131,448 | 27,391 |\n| Total stockholders’ equity | 995,389 | 847,926 |\n| Total liabilities and stockholders’ equity | $ | 1,396,151 | $ | 1,158,633 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n59\nALIGN TECHNOLOGY, INC. AND SUBSIDIARIES\nCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\n(in thousands)\n\n| Common Stock | AdditionalPaid-InCapital | AccumulatedOtherComprehensiveIncome (Loss), Net | Retained Earnings (Deficit) | Total |\n| Shares | Amount |\n| Balances at December 31, 2013 | 80,583 | $ | 8 | $ | 729,578 | $ | 294 | $ | (95,910 | ) | $ | 633,970 |\n| Net income | — | — | — | — | 145,832 | 145,832 |\n| Net change in unrealized gains (losses) from investments | — | — | — | (238 | ) | — | (238 | ) |\n| Net change in foreign currency translation adjustment | — | — | — | (196 | ) | — | (196 | ) |\n| Issuance of common stock relating to employee equity compensation plans | 1,536 | — | 18,028 | — | — | 18,028 |\n| Tax withholdings related to net share settlement of restricted stock units | — | — | (7,608 | ) | — | — | (7,608 | ) |\n| Common stock repurchased and retired | (1,914 | ) | — | (17,804 | ) | — | (80,429 | ) | (98,233 | ) |\n| Net tax benefits from stock-based awards | — | — | 21,393 | — | — | 21,393 |\n| Stock-based compensation | — | — | 39,823 | — | — | 39,823 |\n| Balances at December 31, 2014 | 80,205 | 8 | 783,410 | (140 | ) | (30,507 | ) | 752,771 |\n| Net income | — | — | — | — | 144,020 | 144,020 |\n| Net change in unrealized gains (losses) from investments | — | — | — | (686 | ) | — | (686 | ) |\n| Net change in foreign currency translation adjustment | — | — | (10 | ) | (154 | ) | — | (164 | ) |\n| Issuance of common stock relating to employee equity compensation plans | 991 | — | 11,325 | — | — | 11,325 |\n| Tax withholdings related to net share settlements of restricted stock units | — | — | (20,716 | ) | — | — | (20,716 | ) |\n| Common stock repurchased and retired | (1,696 | ) | — | (15,669 | ) | — | (86,122 | ) | (101,791 | ) |\n| Net tax benefits from stock-based awards | — | — | 10,224 | — | — | 10,224 |\n| Stock-based compensation | — | — | 52,943 | — | — | 52,943 |\n| Balances at December 31, 2015 | 79,500 | 8 | 821,507 | (980 | ) | 27,391 | 847,926 |\n| Net income | — | — | — | — | 189,682 | 189,682 |\n| Net change in unrealized gains (losses) from investments | — | — | — | 712 | — | 712 |\n| Net change in foreign currency translation adjustment | — | — | — | (670 | ) | — | (670 | ) |\n| Issuance of common stock relating to employee equity compensation plans | 1,163 | — | 13,778 | — | — | 13,778 |\n| Tax withholdings related to net share settlements of restricted stock units | — | — | (29,857 | ) | — | — | (29,857 | ) |\n| Common stock repurchased and retired | (1,110 | ) | — | (10,593 | ) | — | (85,625 | ) | (96,218 | ) |\n| Net tax benefits from stock-based awards | — | — | 15,888 | — | — | 15,888 |\n| Stock-based compensation | — | — | 54,148 | — | — | 54,148 |\n| Balances at December 31, 2016 | 79,553 | $ | 8 | $ | 864,871 | $ | (938 | ) | $ | 131,448 | $ | 995,389 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n60\nALIGN TECHNOLOGY, INC. AND SUBSIDIARIES\nCONSOLIDATED STATEMENTS OF CASH FLOWS\n(in thousands)\n\n| Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| CASH FLOWS FROM OPERATING ACTIVITIES: |\n| Net income | $ | 189,682 | $ | 144,020 | $ | 145,832 |\n| Adjustments to reconcile net income to net cash provided by operating activities: |\n| Deferred taxes | (16,401 | ) | (11,424 | ) | 4,088 |\n| Depreciation and amortization | 24,002 | 18,004 | 17,856 |\n| Stock-based compensation | 54,148 | 52,943 | 39,823 |\n| Net tax benefits from stock-based awards | 15,888 | 10,224 | 21,393 |\n| Excess tax benefit from share-based payment arrangements | (16,773 | ) | (10,396 | ) | (21,393 | ) |\n| Equity in losses of investee | 1,684 | — | — |\n| Other non-cash operating activities | 12,031 | 13,799 | 10,106 |\n| Changes in assets and liabilities: |\n| Accounts receivable | (94,444 | ) | (40,775 | ) | (27,229 | ) |\n| Inventories | (7,663 | ) | (3,563 | ) | (1,999 | ) |\n| Prepaid expenses and other assets | (9,390 | ) | (3,726 | ) | (2,924 | ) |\n| Accounts payable | (3,395 | ) | 7,575 | 2,887 |\n| Accrued and other long-term liabilities | 37,629 | 19,462 | 22,692 |\n| Deferred revenues | 60,656 | 41,854 | 15,767 |\n| Net cash provided by operating activities | 247,654 | 237,997 | 226,899 |\n| CASH FLOWS FROM INVESTING ACTIVITIES: |\n| Purchase of property, plant and equipment | (70,576 | ) | (53,451 | ) | (24,092 | ) |\n| Purchase of marketable securities | (405,612 | ) | (447,092 | ) | (437,152 | ) |\n| Proceeds from maturities of marketable securities | 387,873 | 304,125 | 176,810 |\n| Purchase of equity method investments | (46,745 | ) | — | — |\n| Proceeds from sales of marketable securities | 216,119 | 30,011 | 82,990 |\n| Other investing activities | (8,211 | ) | 46 | (183 | ) |\n| Net cash provided by (used in) investing activities | 72,848 | (166,361 | ) | (201,627 | ) |\n| CASH FLOWS FROM FINANCING ACTIVITIES: |\n| Proceeds from issuance of common stock | 13,778 | 11,325 | 18,028 |\n| Common stock repurchases | (96,218 | ) | (101,791 | ) | (98,233 | ) |\n| Excess tax benefit from share-based payment arrangements | 16,773 | 10,396 | 21,393 |\n| Employees’ taxes paid upon the vesting of restricted stock units | (29,857 | ) | (20,716 | ) | (7,608 | ) |\n| Net cash used in financing activities | (95,524 | ) | (100,786 | ) | (66,420 | ) |\n| Effect of foreign exchange rate changes on cash and cash equivalents | (3,417 | ) | (3,007 | ) | (1,934 | ) |\n| Net increase (decrease) in cash and cash equivalents | 221,561 | (32,157 | ) | (43,082 | ) |\n| Cash and cash equivalents, beginning of year | 167,714 | 199,871 | 242,953 |\n| Cash and cash equivalents, end of year | $ | 389,275 | $ | 167,714 | $ | 199,871 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n61\nALIGN TECHNOLOGY, INC. AND SUBSIDIARIES\nNOTES TO CONSOLIDATED FINANCIAL STATEMENTS\nNote 1. Summary of Significant Accounting Policies\nBusiness Description\nAlign Technology, Inc. (“We”, “Our”, or “Align”) was incorporated in April 1997 in Delaware and focuses on designing, manufacturing and marketing innovative, technology-rich products to help dental professionals achieve the clinical results they expect and deliver effective, convenient cutting-edge dental treatment options to their patients. We are headquartered in San Jose, California with offices worldwide. Our international headquarters is located in Amsterdam, the Netherlands. We have two operating segments: (1) Clear Aligner, known as the Invisalign System, and (2) Scanners and Services (\"Scanner\"), known as the iTero intraoral scanner and OrthoCAD services.\nBasis of Presentation and Preparation\nThe consolidated financial statements include the accounts of Align and our wholly-owned subsidiaries after elimination of intercompany transactions and balances.\nIn connection with the preparation of the consolidated financial statements, we evaluated events subsequent to the balance sheet date through the financial statement issuance date and determined that all material transactions have been recorded and disclosed properly.\nOut of Period Adjustment\nIn 2014, we recorded an out of period correction that resulted in an increase in the provision for income taxes of $1.8 million. We do not believe the decrease to net income related to the out of period adjustment is material to the consolidated financial statements for the fiscal year ended December 31, 2014 or to any prior years' consolidated financial statements.\nUse of Estimates\nThe preparation of financial statements in conformity with generally accepted accounting principles (\"GAAP\") in the United States of America (“U.S.”) requires our management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates. On an ongoing basis, we evaluate our estimates, including those related to the fair values of financial instruments, long-lived assets and goodwill, equity method investments, useful lives of intangible assets and property and equipment, revenue recognition, stock-based compensation, equity losses of investee, income taxes and contingent liabilities, among others. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities.\nFair Value of Financial Instruments\nWe measure our cash equivalents, marketable securities, Israeli fund and long-term notes receivable at fair value. Fair value is the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is estimated by applying the following hierarchy, which prioritizes the inputs used to measure fair value into three levels and bases the categorization within the hierarchy upon the lowest level of input that is available and significant to the fair value measurement:\nLevel 1 – Quoted (unadjusted) prices in active markets for identical assets or liabilities.\nLevel 2 – Observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the asset or liability.\nLevel 3 – Inputs that are generally unobservable and typically reflect management’s estimate of assumptions that market participants would use in pricing the asset or liability.\n62\nCash and Cash Equivalents\nWe consider currency on hand, demand deposits, time deposits, and all highly liquid investments with an original or remaining maturity of three months or less at the date of purchase to be cash and cash equivalents. Cash and cash equivalents are held in various financial institutions in the U.S. and internationally.\nRestricted Cash\nOur restricted cash balance as of December 31, 2016 was $3.7 million, of which $3.3 million was classified as a long-term asset and $0.4 million as a current asset. Our restricted cash balance as of December 31, 2015 was $3.5 million, of which $3.3 million was classified as a long-term asset and $0.2 million as a current asset. The restricted cash primarily consisted of funds reserved for legal requirements.\nMarketable Securities\nWe invest primarily in money market funds, commercial paper, corporate bonds, U.S. government agency bonds, asset-backed securities, municipal securities, U.S. government treasury bonds and certificates of deposits.\nMarketable securities are classified as available-for-sale and are carried at fair value. Marketable securities classified as current assets have maturities of less than one year. Unrealized gains or losses on such securities are included in accumulated other comprehensive income (loss), net in stockholders’ equity. Realized gains and losses from maturities of all such securities are reported in earnings and computed using the specific identification cost method. Realized gains or losses and charges for other-than-temporary declines in value, if any, on available-for-sale securities are reported in interest and other income (expense), net as incurred. We periodically evaluate these investments for other-than-temporary impairment.\nVariable Interest Entities\nWe have interests in entities determined to be variable interest entity (“VIE”). If we determine we are the primary beneficiary of a VIE, we would consolidate the VIE into our financial statements. In determining if we are the primary beneficiary, we evaluate whether we have the power to direct the activities that most significantly impact the VIE's economic performance and the obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE. Our evaluation includes identification of significant activities and an assessment of our ability to direct those activities based on governance provisions and arrangements to provide or receive product and process technology, product supply, operations services, equity funding, financing, and other applicable agreements and circumstances. Our assessments of whether we are the primary beneficiary of a VIE require significant assumptions and judgments. We have concluded that we are not the primary beneficiary of our VIE investments; therefore, we do not consolidate their results into our consolidated financials.\nInvestments in Privately Held Companies\nInvestments in privately held companies in which we can exercise significant influence but do not own a majority equity interest or otherwise control, are accounted for under the equity method of accounting. Equity method investments are reported on our balance sheet as a single amount, and we record our share of their operating results within equity in losses of investee, net of tax in our Consolidated Statement of Operations.\nDerivative Financial Instruments\nWe may enter into foreign currency forward contracts to minimize the short-term impact of foreign currency exchange rate fluctuations associated with certain assets and liabilities. These forward contracts are not designated as hedging instruments and do not subject us to material balance sheet risk due to fluctuations in foreign currency exchange rates. The gains and losses on these forward contracts are intended to offset the gains and losses in the underlying foreign currency denominated monetary assets and liabilities being economically hedged. We do not enter into foreign currency forward contracts for trading or speculative purposes. The net gain or loss from the settlement of these foreign currency forward contracts is recorded in interest and other income (expense), net in the Consolidated Statement of Operations.\n63\nForeign Currency\nFor our international subsidiaries where the U.S. dollar is the functional currency, we analyze on an annual basis or more often if necessary, if a significant change in facts and circumstances indicate that the primary economic currency has changed. For certain European and Asia Pacific subsidiaries where the local currency is the functional currency, adjustments from translating financial statements from the local currency to the U.S. dollar reporting currency are recorded as a separate component of accumulated other comprehensive income (loss), net in the stockholders’ equity section of the Consolidated Balance Sheet. This foreign currency translation adjustment reflects the translation of the balance sheet at period end exchange rates, and the income statement at an average exchange rate in effect during the period. As of December 31, 2016 and 2015, there were no material amounts in accumulated other comprehensive income (loss), net related to the translation of our foreign subsidiaries’ financial statements. The foreign currency revaluation that are derived from monetary assets and liabilities stated in a currency other than functional currency are included in interest and other income (expense), net. For the year ended December 31, 2016 and 2015, we had foreign currency net losses of $8.0 million and $4.0 million, respectively.\nCertain Risks and Uncertainties\nOur operating results depend to a significant extent on our ability to market and develop our products. The life cycles of our products are difficult to estimate due, in part, to the effect of future product enhancements and competition. Our inability to successfully develop and market our products as a result of competition or other factors would have a material adverse effect on our business, financial condition and results of operations.\nOur cash and investments are held primarily by two financial institutions. Financial instruments which potentially expose us to concentrations of credit risk consist primarily of cash equivalents, marketable securities and accounts receivable. We invest excess cash primarily in money market funds, commercial paper, corporate bonds, U.S. government agency bonds, asset-backed securities, municipal securities, U.S. government treasury bonds and certificates of deposits. If the carrying value of our investments exceeds the fair value, and the decline in fair value is deemed to be other-than-temporary, we will be required to write down the value of our investments, which could adversely affect our results of operations and financial condition. Moreover, the performance of certain securities in our investment portfolio correlates with the credit condition of the U.S. economy. We provide credit to customers in the normal course of business. Collateral is not required for accounts receivable, but ongoing evaluations of customers’ credit worthiness are performed. We maintain reserves for potential credit losses and such losses have been within management’s expectations. No individual customer accounted for 10% or more of our accounts receivable at December 31, 2016 or 2015, or net revenues for the year ended December 31, 2016, 2015 or 2014.\nWe have certain credit risk under our Loan and Security Agreement (\"Loan Agreement\") with SmileDirectClub, LLC (\"SDC\"). We perform ongoing evaluation of credit worthiness of SDC. If the fair value of equity investment is deemed to be other-than temporary impaired, we will be required to write down the value of our investments, which could adversely affect our results of operations and financial condition (Refer to Note 8 \"Commitments and Contingencies\" of the Notes of Consolidated Financial Statements for more information on our Loan Agreement with SDC).\nIn the U.S., the Food and Drug Administration (“FDA”) regulates the design, manufacture, distribution, pre-clinical and clinical study, clearance and approval of medical devices. Products developed by us may require approvals or clearances from the FDA or other international regulatory agencies prior to commercialized sales. There can be no assurance that our products will receive any of the required approvals or clearances. If we were denied approval or clearance or such approval was delayed, it may have a material adverse impact on us.\nWe have manufacturing operations located outside the U.S. We currently rely on our treatment facility in Costa Rica to prepare digital treatment plans using a sophisticated, internally developed computer-modeling program. In addition, we manufacture our clear aligners and distribute our intraoral scanners at our facilities in Juarez, Mexico, and we produce our handheld scanner wand in Or Yehuda, Israel. Our reliance on international operations exposes us to related risks and uncertainties, including difficulties in staffing and managing international operations such as hiring and retaining qualified personnel; controlling production volume and quality of manufacture; political, social and economic instability, particularly as a result of increased levels of violence in Juarez, Mexico and Or Yehuda, Israel; interruptions and limitations in telecommunication services; product and material transportation delays or disruption; trade restrictions and changes in tariffs; import and export license requirements and restrictions; fluctuations in foreign currency exchange rates; and potential adverse tax consequences. If any of these risks materialize, our international manufacturing operations, as well as our operating results, may be harmed.\n64\nWe purchase certain inventory from sole suppliers. Additionally, we rely on a limited number of hardware manufacturers. The inability of any supplier or manufacturer to fulfill our supply requirements could materially and adversely impact our future operating results.\nInventories\nInventories are valued at the lower of cost or market, with cost computed using either standard cost, which approximates actual cost, or average cost on a first-in-first-out basis. Excess and obsolete inventories are determined primarily based on future demand forecasts, and write-downs of excess and obsolete inventories are recorded as a component of cost of revenues.\nProperty, Plant and Equipment\nProperty, plant and equipment are stated at historical cost less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets. Construction in progress (\"CIP\") is related to the construction or development of property (including land) and equipment that have not yet been placed in service for their intended use. Upon sale or retirement, the asset’s cost and related accumulated depreciation are removed from the general ledger and any related gains or losses are reflected in expenses. Maintenance and repairs are expensed as incurred. Refer to Note 3 \"Balance Sheet Components\" of the Notes of Consolidated Financial Statements for details on estimated useful lives.\nGoodwill and Finite-Lived Acquired Intangible Assets\nGoodwill represents the excess of the purchase price paid over the fair value of tangible and identifiable intangible net assets acquired in business combinations and is allocated to the respective reporting units based on relative synergies generated. For the year ended December 31, 2016 and 2015, all goodwill is attributed to our Clear Aligner reporting unit.\nOur intangible assets primarily consist of intangible assets acquired as part of the Cadent acquisition. These assets are amortized using the straight-line method over their estimated useful lives ranging from one to fifteen years, reflecting the period in which the economic benefits of the assets are expected to be realized.\nImpairment of Goodwill and Long-Lived Assets\nGoodwill\nWe evaluate goodwill for impairment at least annually on November 30th or more frequently if indicators are present, an event occurs or circumstances changes that suggest an impairment may exist and that it would more likely than not reduce the fair value of a reporting unit below its carrying amount. The allocation of goodwill to the respective reporting units is based on relative synergies generated as a result of an acquisition.\nWe perform an initial assessment of qualitative factors to determine whether the existence of events and circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. In performing the qualitative assessment, we identify and consider the significance of relevant key factors, events, and circumstances that affect the fair value of our reporting units. These factors include external factors such as macroeconomic, industry, and market conditions, as well as entity-specific factors, such as our actual and planned financial performance. We also give consideration to the difference between the reporting unit fair value and carrying value as of the most recent date a fair value measurement was performed. If, after assessing the totality of relevant events and circumstances, we determine that it is more likely than not that the fair value of the reporting unit exceeds its carrying value and there is no indication of impairment, no further testing is performed; however, if we conclude otherwise, the first step of the two-step impairment test is performed by estimating the fair value of the reporting unit and comparing it with its carrying value, including goodwill.\nStep one of the goodwill impairment test consists of a comparison of the fair value of a reporting unit against its carrying amount, including the goodwill allocated to each reporting unit. We determine the fair value of our reporting units based on the present value of estimated future cash flows under the income approach of the reporting units as well as various price or market multiples applied to the reporting unit's operating results along with the appropriate control premium under the marketing approach, both of which are classified as level 3 within the fair value hierarchy as described in Note 2. If the carrying amount of the reporting\n65\nunit is in excess of its fair value, step two requires the comparison of the implied fair value of the reporting unit’s goodwill against the carrying amount of the reporting unit’s goodwill. Any excess of the carrying value of the reporting unit’s goodwill over the implied fair value of the reporting unit’s goodwill is recorded as an impairment loss.\nFinite-Lived Intangible Assets and Long-Lived Assets\nWe evaluate long-lived assets (including finite-lived intangible assets) for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. An asset or asset group is considered impaired if its carrying amount exceeds the future undiscounted net cash flows the asset or asset group is expected to generate. Factors we consider important which could trigger an impairment review include significant negative industry or economic trends, significant loss of customers and changes in the competitive environment. If an asset or asset group is considered to be impaired, the impairment to be recognized is calculated as the amount by which the carrying amount of the asset or asset group exceeds its fair market value. Our estimates of future cash flows attributable to our long-lived assets require significant judgment based on our historical and anticipated results and are subject to many assumptions. The estimation of fair value utilizing a discounted cashflow approach includes numerous uncertainties which require our significant judgment when making assumptions of expected growth rates and the selection of discount rates, as well as assumptions regarding general economic and business conditions, and the structure that would yield the highest economic value, among other factors. Refer to Note 5 \"Goodwill and Intangible Assets\" of the Notes of Consolidated Financial Statements for details on intangible long-lived assets.\nThere were no triggering events in 2016 that would cause impairments of our goodwill or long-lived assets.\nDevelopment Costs for Internal Use Software\nInternally developed software includes enterprise-level business software that we customized to meet our specific operational needs. Such capitalized costs include external direct costs utilized in developing or obtaining the applications and payroll and payroll-related costs for employees, who are directly associated with the development of the applications. Internally developed software costs capitalized during the year ended December 31, 2016 and 2015 were $13.2 million and $25.4 million, respectively, related to our enterprise resource planning (\"ERP\") project which we placed into production during 2016 and amortize over 10 years.\nThe costs to develop software that is marketed externally have not been capitalized as we believe our current software development process is essentially completed concurrent with the establishment of technological feasibility. As such, all related software development costs are expensed as incurred and included in research and development expense in our Consolidated Statements of Operations.\nProduct Warranty\nClear Aligner\nWe warrant our Invisalign products against material defects until the aligner case is complete. We warrant SmileDirectClub, LLC (“SDC”) products against material defects for one year. We accrue for warranty costs in cost of net revenues upon shipment of products. The amount of accrued estimated warranty costs is primarily based on historical experience as to product failures as well as current information on replacement costs. Actual warranty costs could differ materially from the estimated amounts. We regularly review the accrued balances and update these balances based on historical warranty cost trends.\nScanners and Services\nWe warrant our intraoral scanners for a period of one year, which include materials and labor. We accrue for these warranty costs based on average historical repair costs. An extended warranty may be purchased for additional fees.\nAllowance for Doubtful Accounts and Returns\nWe maintain allowances for doubtful accounts for customers that are not able to make payments and allowances for sales returns. We periodically review these allowances, including an analysis of the customers’ payment history and information regarding the customers’ creditworthiness, as well as historical sales returns as a percentage of revenue. Actual write-offs have not materially differed from the estimated allowances.\n66\nRevenue Recognition\nWe measure and allocate revenue according to the accounting guidance for multiple-deliverable revenue arrangements in Accounting Standards Update (“ASU”) 2009-13, Multiple-Deliverable Revenue Arrangements-a consensus of the Financial Accounting Standard Board (“FASB”) Emerging Issues Task Force.\nMultiple-Element Arrangements (“MEAs”): Arrangements with customers may include multiple deliverables, including any combination of products/equipment and services. The deliverables included in the MEAs are separated into more than one unit of accounting when (i) the delivered product/equipment has value to the customer on a stand-alone basis, and (ii) delivery of the undelivered service element(s) is probable and substantially in our control. Arrangement consideration is then allocated to each unit, delivered or undelivered, based on the relative selling price of each unit of accounting based first on vendor-specific objective evidence (“VSOE”) if it exists, second on third-party evidence (“TPE”) if it exists, or on best estimated selling price (“BESP”) if neither VSOE or TPE exist.\n| • | VSOE - In most instances, this applies to products and services that are sold separately in stand-alone arrangements. We determine VSOE based on pricing and discounting practices for the specific product or service when sold separately, considering geographical, customer, and other economic or marketing variables, as well as renewal rates or stand-alone prices for the service element(s). |\n\n| • | TPE - If we cannot establish VSOE of selling price for a specific product or service included in a multiple-element arrangement, we use third-party evidence of selling price. We determine TPE based on sales of comparable amount of similar products or service offered by multiple third parties considering the degree of customization and similarity of product or service sold. |\n\n| • | BESP - The best estimated selling price represents the price at which we would sell a product or service if it were sold on a stand-alone basis. When VSOE or TPE does not exist for all elements, we determine BESP for the arrangement element based on sales, cost and margin analysis, as well as other inputs based on our pricing practices. Adjustments for other market and company specific factors are made as deemed necessary in determining BESP. We regularly review our estimates of selling price and maintain internal controls over the establishment and update of these estimates. |\n\nRevenue is recognized when persuasive evidence of the arrangement exists, the price is fixed or determinable, collectability is reasonably assured, title and risk of loss have passed to customers based on the shipping terms, and allowances for discounts, returns, and customer incentives can be reliably estimated. Provisions for discounts and rebates to customers are provided for in the same period that the related product sales are recorded.\nClear Aligner\nWe enter into arrangements (“treatment plans”) that involve multiple future product deliverables. Invisalign Full, Invisalign Teen, and Invisalign Assist products (\"Comprehensive Products\") include optional additional aligners at no charge for a period of up to five years after initial shipment. Invisalign Teen also includes up to six optional replacement aligners in the price of the product and may be ordered by the dental professional any time throughout treatment. Invisalign Lite (\"Non-Comprehensive Products\") includes one optional case refinement in the price of the product. Case refinement is a finishing tool used to adjust a patient's teeth to the desired final position and may be elected by the dental professional at any time during treatment; however, it is generally ordered in the last stages of orthodontic treatment.\nWe determined that our treatment plans, except Invisalign Assist with progress tracking, comprise the following deliverables which also represent separate units of accounting: initial aligners, additional aligners, case refinement, and replacement aligners. We allocate revenue for each treatment plan based on each unit's relative selling price based on BESP and recognize the revenue upon shipment of each unit in the treatment plan.\nFor Invisalign Assist with the progress tracking feature, aligners and services are provided to the dental professional every nine stages (“a batch”). We are able to reliably estimate the number of batches which are expected to be shipped for each case based upon our historical experience. The amounts allocated to this deliverable are recognized on a prorated basis as each batch is shipped.\n67\nScanners and Services\nWe recognize revenues from the sales of iTero intraoral scanners and CAD/CAM services. CAD/CAM services include scanning services, extended warranty for the intraoral scanners, a range of iTero restorative services, and OrthoCAD services such as OrthoCAD iRecord. We sell intraoral scanners and services through both our direct sales force and distribution partners. The intraoral scanner sales price includes one year of warranty, and for additional fees, the customer may select an unlimited scanning service agreement over a fixed period of time or extended warranty periods. When intraoral scanners are sold with either an unlimited scanning service agreement and/or extended warranty, we allocate revenue based on each element's relative selling price. We estimate the selling price of each element, as if it is sold on a stand-alone basis, taking into consideration historical prices as well as our discounting strategies.\nScanner revenue, net of related discounts and allowances, is recognized when products or equipment have been shipped and no significant obligations for installation or training remain. For certain distributors who provide installation and training to the customer, we recognize scanner revenue when the intraoral scanner is shipped to the distributor assuming all of the other revenue recognition criteria have been met. Discounts are deducted from revenue at the time of sale. Returns of products, excluding warranty related returns, are infrequent and insignificant.\nService revenue, including iTero restorative and all OrthoCAD services are recognized upon delivery or ratably over the contract term as the specified services are performed. If a customer selects a pay per use basis for scanning service fees, the revenue is recognized as the service is provided.\nWe offer customers an option to purchase extended warranties on certain products. We recognize revenue on these extended warranty contracts ratably over the life of the contract. The costs associated with these extended warranty contracts are recognized when incurred.\nShipping and Handling Costs\nShipping and handling charges to customers are included in net revenues, and the associated costs incurred are recorded in cost of revenues.\nLegal Proceedings and Litigations\nWe are involved in legal proceedings on an ongoing basis. If we believe that a loss arising from such matters is probable and can be reasonably estimated, we accrue the estimated liability in our financial statements. If only a range of estimated losses can be determined, we accrue an amount within the range that, in our judgment, reflect the most likely outcome; if none of the estimates within that range is a better estimate than any other amount, we accrue the low end of the range.\nResearch and Development\nResearch and development expense is expensed as incurred and includes the costs associated with the research and development of new products and enhancements to existing products. These costs primarily include personnel-related costs including stock-based compensation and outside consulting expenses associated with the research and development of new products and enhancements to existing products and allocations of corporate overhead expenses including facilities and IT.\nAdvertising Costs\nThe cost of advertising and media is expensed as incurred. For the year ended December 31, 2016, 2015 and 2014, advertising costs totaled $36.0 million, $23.4 million and $26.9 million, respectively.\nCommon Stock Repurchase\nWe repurchase our own common stock from time to time in the open market when our Board of Directors approve a stock repurchase program. We account for these repurchases under the accounting guidance for equity where we allocate the total\n68\nrepurchase value that are in excess over par between additional paid in capital and retained earnings. All shares repurchased are retired.\nOperating Leases\nWe currently lease office spaces, automobiles and equipment under operating leases with original lease periods of up to 9 years. Certain of these leases have free or escalating rent payment provisions and lease incentives provided by the landlord. We recognize rent expense under such leases on a straight-line basis over the term of the lease as certain leases have adjustments for market provisions.\nIncome Taxes\nWe make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of certain tax assets and liabilities, which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes.\nAs part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves us estimating our current tax exposure under the applicable tax laws and assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our Consolidated Balance Sheet.\nWe account for uncertainty in income taxes pursuant to authoritative guidance based on a two-step approach to recognize and measure uncertain tax positions taken or expected to be taken in a tax return. The first step is to determine if the weight of available evidence indicates that it is more likely than not that the tax position will be sustained on audit based on its technical merits, including resolution of any related appeals or litigation processes. The second step is to measure the tax benefit as the largest amount that is more than 50% likely to be realized upon ultimate settlement. We adjust reserves for our uncertain tax positions due to changing facts and circumstances, such as the closing of a tax audit, or refinement of estimates due to new information. To the extent that the final outcome of these matters is different than the amounts recorded, such differences will impact our tax provision in our Consolidated Statement of Operation in the period in which such determination is made.\nWe assess the likelihood that we will be able to realize our deferred tax assets. Should there be a change in our ability to realize our deferred tax assets, our tax provision would increase in the period in which we determine that it is more likely than not that we cannot realize our deferred tax assets. We consider all available evidence, both positive and negative, including historical levels of income, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance. If it is more likely than not that we will not realize our deferred tax assets, we will increase our provision for taxes by recording a valuation allowance against the deferred tax assets that we estimate will not ultimately be realizable. The available positive evidence at December 31, 2016 included historical operating profits and a projection of future income sufficient to realize most of our remaining deferred tax assets. As of December 31, 2016, it was considered more likely than not that our deferred tax assets would be realized with the exception of certain foreign loss carryovers as we are unable to forecast sufficient future profits to realize the deferred tax assets.\nAs of December 31, 2016, U.S. income taxes and foreign withholding taxes associated with the repatriation of undistributed earnings of foreign subsidiaries on a cumulative total of $438.0 million was not provided as we intend to reinvest these earnings indefinitely in our foreign subsidiaries. If these earnings were distributed in the form of dividends or otherwise, or if the shares of the relevant foreign subsidiaries were sold or otherwise transferred, we would be subject to additional U.S. income taxes subject to an adjustment for foreign tax credit, and foreign withholding taxes. Determination of the amount of unrecognized deferred income tax liability related to these earnings is not practicable.\nAccounting guidance for stock-based compensation prohibits recognition of a deferred income tax asset for excess tax benefits due to stock option exercises that have not yet been realized through a reduction in income taxes payable. We follow the tax law ordering method to determine when excess tax benefits have been realized and consider only the direct impacts of awards when calculating the amount of windfalls or shortfalls.\n69\nStock-Based Compensation\nWe recognize stock-based compensation cost for only those shares ultimately expected to vest on a straight-line basis over the requisite service period of the award. We use the Black-Scholes option pricing model to determine the fair value of employee stock purchase plan shares. We estimate the fair value of market-performance based restricted stock units using a Monte Carlo simulation model which requires the input of assumptions, including expected term, stock price volatility and the risk-free rate of return. In addition, judgment is also required in estimating the number of stock-based awards that are expected to be forfeited. Forfeitures are estimated based on historical experience at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management’s judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future.\nComprehensive Income\nComprehensive income includes all changes in equity during a period from non-owner sources. Comprehensive income, including unrealized gains and losses on investments and foreign currency translation adjustments, are reported net of their related tax effect.\nRecent Accounting Pronouncements\nIn May 2014, the Financial Accounting Standards Board (\"FASB\") released Accounting Standards Update (\"ASU\") 2014-9, \"Revenue from Contracts with Customers,\" (Topic 606) to supersede nearly all existing revenue recognition guidance under GAAP. The core principle of the standard is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration that is expected to be received for the goods or services. The new standard defines a five step process to achieve this core principle and, in doing so, it is possible more judgment and estimates may be required within the revenue recognition process than required under existing GAAP including identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. In addition, the new standard requires that reporting companies disclose the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. We are required to adopt this standard starting in the first quarter of fiscal year 2018 using either of two methods: (i) retrospective to each prior reporting period presented with the option to elect certain practical expedients as defined within the standard; or (ii) retrospective with the cumulative effect of initially applying the standard recognized at the date of initial application and providing certain additional disclosures as defined per the standard. We plan to adopt the standard in the first quarter of fiscal year 2018 by applying the full retrospective method. Our ability to adopt using the full retrospective method is dependent on the completion of our analysis of information necessary to restate prior period financial statements. We are continuing to assess the impact of the adoption of this update on our consolidated financial statements and related disclosures.\nIn April 2016, the FASB released ASU No. 2016-10, \"Revenue from Contracts with Customers,\" to clarify the following two aspects of Topic 606: identifying performance obligations and the licensing implementation guidance, while retaining the principles for those areas of the ASU 2014-9 issued in May 2014. The effective date and the transition requirement of the amendments in this update are the same as the effective date and transition requirements of Topic 606.\nIn May 2016, the FASB released ASU No. 2016-12, \"Revenue from Contracts with Customers,\" to address certain issues in the Topic 606 guidance on assessing the collectability, presentation of sales taxes, non-cash consideration, and completed contracts and contract modifications at transition. The ASU provides narrow-scope improvements and practical expedients to the ASU 2014-9 issued in May 2014. The effective date and the transition requirement of the amendments in this update are the same as the effective date and transition requirements of Topic 606.\nIn December 2016, the FASB released ASU No. 2016-20, \"Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers,\" to clarify certain aspects of guidance in the Topic 606 including its scope, disclosure requirements and contract cost accounting, while retaining the principles for those areas of the ASU 2014-9 issued in May 2014. The effective date and the transition requirement of the amendments in this update are the same as the effective date and transition requirements of Topic 606.\n70\nIn February 2016, the FASB issued ASU No. 2016-02, “Leases” (Topic 842). The FASB issued this update to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The updated guidance is effective for annual periods beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption of the standard is permitted. We plan to adopt the standard in the first quarter of fiscal year 2019 by electing practical expedients available in the standard. While we are currently evaluating the impact of the adoption of this guidance on our consolidated financial statements, we expect the adoption will have a material increase in the assets and liabilities of our consolidated balance sheet.\nIn March 2016, the FASB issued ASU No. 2016-09, \"Improvements to Employee Share-Based Payment Accounting\" (Topic 718). This ASU affects entities that issue share-based payment awards to their employees. The ASU is designed to simplify several aspects of accounting for share-based payment award transactions, which include the income tax consequences, classification of awards as either equity or liabilities, classification on the statements of cash flows and forfeiture rate calculations. This ASU is effective for fiscal years beginning after December 15, 2016 and interim periods within those years. We plan to adopt the standard in the first quarter of fiscal year 2017, and the adoption will have a material impact on our consolidated financial statements.\nIn June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments - Credit Losses” (Topic 326). The FASB issued this update to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. The amendments in this update replace the existing guidance of incurred loss impairment methodology with an approach that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. The updated guidance is effective for annual periods beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption of the update is permitted as of the fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. We are evaluating the impact of the adoption of this update on our consolidated financial statements and related disclosures.\nIn August 2016, the FASB issued ASU 2016-15, \"Classification of Certain Cash Receipts and Cash Payments\" (Topic 230). This FASB clarifies the presentation and classification of certain cash receipts and cash payments in the statements of cash flows. This ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2017. Early adoption is permitted. We are currently evaluating the impact of this guidance on our consolidated financial statements.\nIn October, 2016, the FASB issued ASU 2016-16, \"Intra-Entity Transfers of Assets Other Than Inventory,\" (Topic 740) which requires entities to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs. Prior to the issuance of this ASU, existing guidance prohibited the recognition of current and deferred income taxes for an intra-entity asset transfer until the asset had been sold to an outside party. This ASU is effective for fiscal years beginning after December 15, 2017 and interim periods within those years. Early adoption is permitted. We plan to early adopt the standard in the first quarter of 2017 by applying the modified retrospective approach with a cumulative catch-up adjustment to opening retained earnings at the beginning of the first quarter of 2017. The adoption will impact our consolidated balance sheet but we do not expect the impact to be material.\nIn November 2016, the FASB issued ASU 2016-18, \"Statement of Cash Flows - Restricted Cash,\" which provides guidance to address the classification and presentation of changes in restricted cash in the statements of cash flows. This standard is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period, but any adjustments must be reflected as of the beginning of the fiscal year that includes that interim period. The new standard must be adopted retrospectively. We are currently in the process of evaluating the impact of this new pronouncement on our consolidated statement of cash flows.\n71\nNote 2. Marketable Securities and Fair Value Measurements\nAs of December 31, 2016 and 2015, the estimated fair value of our short-term and long-term marketable securities, classified as available for sale, are as follows (in thousands):\nShort-term\n| December 31, 2016 | AmortizedCost | GrossUnrealizedGains | GrossUnrealizedLosses | Fair Value |\n| Commercial paper | $ | 42,397 | $ | — | $ | (6 | ) | $ | 42,391 |\n| Corporate bonds | 122,788 | 22 | (121 | ) | 122,689 |\n| Municipal securities | 5,852 | — | (5 | ) | 5,847 |\n| U.S. government agency bonds | 28,903 | 9 | (4 | ) | 28,908 |\n| U.S. government treasury bonds | 45,146 | 7 | (7 | ) | 45,146 |\n| Certificates of deposit | 6,000 | — | — | 6,000 |\n| Total Marketable Securities, Short-Term | $ | 251,086 | $ | 38 | $ | (143 | ) | $ | 250,981 |\n\nLong-term\n| December 31, 2016 | AmortizedCost | GrossUnrealizedGains | GrossUnrealizedLosses | Fair Value |\n| U.S. government agency bonds | $ | 6,805 | $ | — | $ | (16 | ) | $ | 6,789 |\n| Corporate bonds | 40,889 | 8 | (85 | ) | 40,812 |\n| U.S. government treasury bonds | 12,016 | 5 | (16 | ) | 12,005 |\n| Asset-backed securities | 177 | — | — | 177 |\n| Total Marketable Securities, Long-Term | $ | 59,887 | $ | 13 | $ | (117 | ) | $ | 59,783 |\n\nShort-term\n| December 31, 2015 | AmortizedCost | GrossUnrealizedGains | GrossUnrealizedLosses | Fair Value |\n| Commercial paper | $ | 38,537 | $ | — | $ | — | $ | 38,537 |\n| Corporate bonds | 179,765 | 6 | (251 | ) | 179,520 |\n| U.S. dollar dominated foreign corporate bonds | 510 | — | (2 | ) | 508 |\n| Municipal securities | 14,209 | 7 | (2 | ) | 14,214 |\n| U.S. government agency bonds | 75,172 | — | (53 | ) | 75,119 |\n| U.S. government treasury bonds | 51,763 | 1 | (81 | ) | 51,683 |\n| Total Marketable Securities, Short-Term | $ | 359,956 | $ | 14 | $ | (389 | ) | $ | 359,581 |\n\nLong-term\n| December 31, 2015 | AmortizedCost | GrossUnrealizedGains | GrossUnrealizedLosses | Fair Value |\n| U.S. government agency bonds | $ | 43,853 | $ | — | $ | (178 | ) | $ | 43,675 |\n| Corporate bonds | 64,012 | 9 | (218 | ) | 63,803 |\n| U.S. government treasury bonds | 37,673 | — | (107 | ) | 37,566 |\n| Municipal securities | 3,993 | — | (2 | ) | 3,991 |\n| Asset-backed securities | 2,338 | — | (3 | ) | 2,335 |\n| Total Marketable Securities, Long-Term | $ | 151,869 | $ | 9 | $ | (508 | ) | $ | 151,370 |\n\n72\nCash and cash equivalents are not included in the table above as the gross unrealized gains and losses are not material. We have no short-term or long-term investments that have been in a continuous material unrealized loss position for greater than twelve months as of December 31, 2016 and 2015. Amounts reclassified to earnings from accumulated other comprehensive income (loss), net related to unrealized gains or losses were not material in 2016 and 2015. For the year ended December 31, 2016 and 2015, realized gains or losses were not material.\nOur fixed-income securities investment portfolio consists of corporate bonds, U.S. dollar denominated foreign corporate bonds, commercial paper, municipal securities, U.S. government agency bonds, U.S. government treasury bonds, certificates of deposit and asset-backed securities that have a maximum effective maturity of 27 months. The securities that we invest in are generally deemed to be low risk based on their credit ratings from the major rating agencies. The longer the duration of these securities, the more susceptible they are to changes in market interest rates and bond yields. As interest rates increase, those securities purchased at a lower yield show a mark-to-market unrealized loss. The unrealized losses are due primarily to changes in credit spreads and interest rates. We expect to realize the full value of all these investments upon maturity or sale. The weighted average remaining duration of these securities was approximately 7 months and 9 months as of December 31, 2016 and 2015, respectively.\nAs the carrying value approximates the fair value for our short-term and long-term marketable securities shown in the tables above, the following table summarizes the fair value of our short-term and long-term marketable securities classified by maturity as of December 31, 2016 and 2015 (in thousands):\n| December 31, |\n| 2016 | 2015 |\n| One year or less | $ | 250,981 | $ | 359,581 |\n| Due in greater than one year | 59,783 | 151,370 |\n| Total available for short-term and long-term marketable securities | $ | 310,764 | $ | 510,951 |\n\nFair Value Measurements\nWe measure the fair value of our cash equivalents and marketable securities as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. We use the GAAP fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. This hierarchy requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The three levels of inputs that may be used to measure fair value:\nLevel 1 — Quoted (unadjusted) prices in active markets for identical assets or liabilities.\nOur Level 1 assets consist of money market funds and U.S. government treasury bonds. We did not hold any Level 1 liabilities as of December 31, 2016 and 2015.\nLevel 2 — Observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the asset or liability.\nOur Level 2 assets consist of commercial paper, corporate bonds, municipal securities, certificates of deposit, U.S. government agency bonds, asset-backed securities and our Israeli funds that are mainly invested in insurance policies. We obtain fair values for our Level 2 investments. Our custody bank and asset managers independently use professional pricing services to gather pricing data which may include quoted market prices for identical or comparable financial instruments, or inputs other than quoted prices that are observable either directly or indirectly, and we are ultimately responsible for these underlying estimates. We did not hold any Level 2 liabilities as of December 31, 2016 and 2015.\nLevel 3 — Unobservable inputs to the valuation methodology that are supported by little or no market activity and that are significant to the measurement of the fair value of the assets or liabilities. Level 3 assets and liabilities include those whose fair value measurements are determined using pricing models, discounted cash flow methodologies or similar valuation techniques, as well as significant management judgment or estimation. Our Level 3 assets consist of long-term notes receivable and are included in other assets on our consolidated balance sheet. In 2016, we entered into a long-term notes receivable for $2.0 million and we\n73\nrecognized $0.05 million in earnings during 2016 as a result of a change in its fair value. As of December 31, 2016, the fair value of long-term notes receivable was approximately $2.05 million. We did not hold any Level 3 liabilities as of December 31, 2016 and 2015.\nThe following tables summarize our financial assets measured at fair value on a recurring basis as of December 31, 2016 and 2015 (in thousands):\n| Description | Balance as ofDecember 31, 2016 | Quoted Prices inActive Markets forIdentical Assets(Level 1) | Significant OtherObservable Inputs(Level 2) | Significant OtherObservable Inputs(Level 3) |\n| Cash equivalents: |\n| Money market funds | $ | 87,179 | $ | 87,179 | $ | — | $ | — |\n| Commercial paper | 2,499 | — | 2,499 | — |\n| Corporate bonds | 750 | — | 750 | — |\n| Short-term investments: |\n| Commercial paper | 42,391 | — | 42,391 | — |\n| Corporate bonds | 122,689 | — | 122,689 | — |\n| Municipal securities | 5,847 | — | 5,847 | — |\n| U.S. government agency bonds | 28,908 | — | 28,908 | — |\n| U.S. government treasury bonds | 45,146 | 45,146 | — | — |\n| Certificates of deposit | 6,000 | — | 6,000 | — |\n| Long-term investments: |\n| U.S. government agency bonds | 6,789 | — | 6,789 | — |\n| Corporate bonds | 40,812 | — | 40,812 | — |\n| U.S. government treasury bonds | 12,005 | 12,005 | — | — |\n| Asset-backed securities | 177 | — | 177 | — |\n| Prepaid expenses and other current assets: |\n| Israeli funds | 2,956 | — | 2,956 | — |\n| Other assets: |\n| Long-term notes receivable | 2,047 | — | — | 2,047 |\n| $ | 406,195 | $ | 144,330 | $ | 259,818 | $ | 2,047 |\n\n74\n| Description | Balance as ofDecember 31, 2015 | Quoted Prices inActive Markets forIdentical Assets(Level 1) | Significant OtherObservable Inputs(Level 2) |\n| Cash equivalents: |\n| Money market funds | $ | 70,148 | $ | 70,148 | $ | — |\n| Commercial paper | 36,887 | — | 36,887 |\n| U.S. government agency bonds | 3,599 | — | 3,599 |\n| Corporate bonds | 625 | — | 625 |\n| Short-term investments: |\n| Commercial paper | 38,537 | — | 38,537 |\n| Corporate bonds | 179,520 | — | 179,520 |\n| U.S. dollar denominated foreign corporate bonds | 508 | — | 508 |\n| Municipal securities | 14,214 | — | 14,214 |\n| U.S. government agency bonds | 75,119 | — | 75,119 |\n| U.S. government treasury bonds | 51,683 | 51,683 | — |\n| Long-term investments: |\n| U.S. government agency bonds | 43,675 | — | 43,675 |\n| Corporate bonds | 63,803 | — | 63,803 |\n| U.S. government treasury bonds | 37,566 | 37,566 | — |\n| Municipal securities | 3,991 | — | 3,991 |\n| Asset-backed securities | 2,335 | — | 2,335 |\n| Prepaid expenses and other assets: |\n| Israeli funds | 2,436 | — | 2,436 |\n| $ | 624,646 | $ | 159,397 | $ | 465,249 |\n\nDerivative Financial Instruments\nWe have in the past and may in the future enter into foreign currency forward contracts to minimize the short-term impact of foreign currency exchange rate fluctuations associated with certain assets and liabilities. The net loss on these forward contracts was not material for the year ended December 31, 2016 and 2015. The net gain or loss from the settlement of these foreign currency forward contracts is recorded in interest and other income (expenses), net in the Consolidated Statements of Operations. We had no material foreign exchange forward contracts outstanding as of December 31, 2016 and 2015. Certain investments in private companies contain embedded derivatives, which do not require bifurcation as we have elected to measure these investments at fair value.\nNote 3. Balance Sheet Components\nInventories\nInventories consist of the following (in thousands):\n| December 31, |\n| 2016 | 2015 |\n| Raw materials | $ | 9,793 | $ | 9,950 |\n| Work in process | 10,773 | 7,067 |\n| Finished goods | 6,565 | 2,448 |\n| Total Inventories | $ | 27,131 | $ | 19,465 |\n\n75\nProperty, Plant and Equipment\nProperty, plant and equipment consist of the following (in thousands):\n| December 31, |\n| Generally Used Estimated Useful Life | 2016 | 2015 |\n| Clinical and manufacturing equipment | Up to 10 years | $ | 153,938 | $ | 128,044 |\n| Computer hardware | 3 years | 27,978 | 25,843 |\n| Computer software | 3 years | 59,997 | 21,451 |\n| Furniture and fixtures | 5 years | 10,306 | 8,855 |\n| Leasehold improvements | Lease term (1) | 22,370 | 20,172 |\n| Building | 20 years | 7,272 | 4,227 |\n| Land | — | 3,072 | 3,072 |\n| CIP | — | 25,948 | 42,846 |\n| Total | 310,881 | 254,510 |\n| Less: Accumulated depreciation and amortization and impairment charges | (135,714 | ) | (118,037 | ) |\n| Total Property, plant and equipment, net | $ | 175,167 | $ | 136,473 |\n\n(1) Shorter of remaining lease term or estimated useful lives of assets.\nDepreciation and amortization was $24.0 million, $18.0 million and $17.9 million, for the year ended December 31, 2016, 2015 and 2014, respectively.\nAccrued Liabilities\nAccrued liabilities consist of the following (in thousands):\n| December 31, |\n| 2016 | 2015 |\n| Accrued payroll and benefits | $ | 79,214 | $ | 55,430 |\n| Accrued sales and marketing expenses | 11,970 | 7,071 |\n| Accrued sales rebate | 10,342 | 8,486 |\n| Accrued sales tax and value added tax | 5,032 | 4,801 |\n| Accrued income taxes | 4,210 | 2,646 |\n| Accrued warranty | 3,841 | 2,638 |\n| Accrued professional fees | 3,604 | 2,775 |\n| Other accrued liabilities | 16,119 | 23,918 |\n| Total Accrued Liabilities | $ | 134,332 | $ | 107,765 |\n\nWarranty\nWe regularly review the accrued balances and update these balances based on historical warranty trends. Actual warranty costs incurred have not materially differed from those accrued; however, future actual warranty costs could differ from the estimated amounts.\nClear Aligner\nWe warrant our Invisalign products against material defects until the aligner case is complete. We warrant SDC products against material defects for one year. We accrue for warranty costs in cost of net revenues upon shipment of products. The amount of accrued estimated warranty costs is primarily based on historical experience as to product failures as well as current information on replacement costs.\n76\nScanners\nWe warrant our scanners for a period of one year from the date of training and installation. We accrue for these warranty costs which includes materials and labor based on estimated historical repair costs. Extended service packages may be purchased for additional fees.\nWarranty accrual as of December 31, 2016 and 2015 consists of the following activity (in thousands):\n| Warranty accrual, December 31, 2014 | $ | 3,148 |\n| Charged to cost of revenues | 1,796 |\n| Actual warranty expenditures | (2,306 | ) |\n| Warranty accrual, December 31, 2015 | 2,638 |\n| Charged to cost of revenues | 4,894 |\n| Actual warranty expenditures | (3,691 | ) |\n| Warranty accrual, December 31, 2016 | $ | 3,841 |\n\nNote 4. Equity Method Investments\nOn July 25, 2016, we acquired a 17% equity interest, on a fully diluted basis, in SmileDirectClub, LLC (“SDC”) for $46.7 million, and account for this as an equity method investment. The investment is reported on our consolidated balance sheet as a single amount under equity method investments, and we record our proportional share of SDC's earnings or losses within equity in losses of investee in our consolidated statement of operations. As of December 31, 2016, the balance of our equity method investments was $45.1 million.\nConcurrently with the investment on July 25, 2016, we also entered into a supply agreement with SDC to manufacture clear aligners for SDC's doctor-led, at-home program for simple teeth straightening. The term of the supply agreement expires on December 31, 2019. We commenced supplying aligners to SDC in October 2016. The sale of aligners to SDC and the income from under the supply agreement are reported in our Clear Aligner business segment after eliminating outstanding intercompany transactions.\nNote 5. Goodwill and Intangible Assets\nGoodwill\n| Total |\n| Balance as of December 31, 2014 | $ | 61,369 |\n| Adjustments (1) | (295 | ) |\n| Balance as of December 31, 2015 | 61,074 |\n| Adjustments (1) | (30 | ) |\n| Balance as of December 31, 2016 | $ | 61,044 |\n\n(1) The adjustments to goodwill were a result of foreign currency translation.\nImpairment of Goodwill\nWe evaluate goodwill for impairment at least annually on November 30th or more frequently if indicators are present, an event occurs or circumstances changes that suggest an impairment may exist and that it would more likely than not reduce the fair value of a reporting unit below its carrying amount. The allocation of goodwill to the respective reporting units is based on relative synergies generated as a result of an acquisition.\n77\nAnnual Impairment Test\nThe remaining goodwill is entirely attributable to our Clear Aligner reporting unit. During the fourth quarter of fiscal 2016, we performed the annual goodwill impairment testing and found no impairment as the fair value of our Clear Aligner reporting unit was significantly in excess of the carrying value.\nIntangible Long-Lived Assets\nWe amortize our intangible assets over their estimated useful lives. We evaluate long-lived assets, which includes property, plant and equipment and intangible assets, for impairment whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. The carrying value is not recoverable if it exceeds the undiscounted cash flows resulting from the use of the asset and its eventual disposition. Our estimates of future cash flows attributable to our long-lived assets require significant judgment based on our historical and anticipated results and are subject to many factors. Factors we consider important which could trigger an impairment review include significant negative industry or economic trends, significant loss of customers and changes in the competitive environment of our intraoral scanning business.\nThere were no triggering events in 2016 that would cause impairments of our long-lived assets.\nAcquired intangible long-lived assets are being amortized as follows (in thousands):\n| Weighted Average Amortization Period (in years) | Gross Carrying Amount as ofDecember 31, 2016 | AccumulatedAmortization | Accumulated Impairment Loss | Net CarryingValue as ofDecember 31, 2016 |\n| Trademarks | 15 | $ | 7,100 | $ | (1,631 | ) | $ | (4,179 | ) | $ | 1,290 |\n| Existing technology | 13 | 12,600 | (4,141 | ) | (4,328 | ) | 4,131 |\n| Customer relationships | 11 | 33,500 | (12,819 | ) | (10,751 | ) | 9,930 |\n| Patents | 8 | 6,316 | (713 | ) | — | 5,603 |\n| Total Intangible Assets | $ | 59,516 | $ | (19,304 | ) | $ | (19,258 | ) | $ | 20,954 |\n\n| Weighted Average Amortization Period (in years) | Gross CarryingAmount as ofDecember 31, 2015 | AccumulatedAmortization | Accumulated Impairment Loss | Net CarryingValue as ofDecember 31, 2015 |\n| Trademarks | 15 | $ | 7,100 | $ | (1,492 | ) | $ | (4,179 | ) | $ | 1,429 |\n| Existing technology | 13 | 12,600 | (3,577 | ) | (4,328 | ) | 4,695 |\n| Customer relationships | 11 | 33,500 | (10,957 | ) | (10,751 | ) | 11,792 |\n| Patents | 8 | 285 | (113 | ) | — | 172 |\n| Total Intangible Assets | $ | 53,485 | $ | (16,139 | ) | $ | (19,258 | ) | $ | 18,088 |\n\nThe total estimated annual future amortization expense for these acquired intangible assets as of December 31, 2016 is as follows (in thousands):\n| Fiscal Year |\n| 2017 | $ | 3,355 |\n| 2018 | 3,353 |\n| 2019 | 3,346 |\n| 2020 | 3,336 |\n| 2021 | 3,334 |\n| Thereafter | 4,230 |\n| Total | $ | 20,954 |\n\n78\nNote 6. Legal Proceedings\nSecurities Class Action Lawsuit\nOn November 28, 2012, plaintiff City of Dearborn Heights Act 345 Police & Fire Retirement System filed a lawsuit against Align, Thomas M. Prescott (“Mr. Prescott”), Align’s former President and Chief Executive Officer, and Kenneth B. Arola (“Mr. Arola”), Align’s former Vice President, Finance and Chief Financial Officer, in the United States District Court for the Northern District of California on behalf of a purported class of purchasers of our common stock (the “Securities Action”). On July 11, 2013, an amended complaint was filed, which named the same defendants, on behalf of a purported class of purchasers of our common stock between January 31, 2012 and October 17, 2012. The amended complaint alleged that Align, Mr. Prescott and Mr. Arola violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, and that Mr. Prescott and Mr. Arola violated Section 20(a) of the Securities Exchange Act of 1934. Specifically, the amended complaint alleged that during the purported class period defendants failed to take an appropriate goodwill impairment charge related to the April 29, 2011 acquisition of Cadent Holdings, Inc. in the fourth quarter of 2011, the first quarter of 2012 or the second quarter of 2012, which rendered our financial statements and projections of future earnings materially false and misleading and in violation of U.S. GAAP. The amended complaint sought monetary damages in an unspecified amount, costs and attorneys’ fees. On December 9, 2013, the court granted defendants’ motion to dismiss with leave for plaintiff to file a second amended complaint. Plaintiff filed a second amended complaint on January 8, 2014 on behalf of the same purported class. The second amended complaint states the same claims as the amended complaint. On August 22, 2014, the court granted our motion to dismiss without leave to amend. On September 22, 2014, Plaintiff filed a notice of appeal to the Ninth Circuit Court of Appeals. Briefing for the appeal was completed in May 2015 and the Ninth Circuit held oral arguments in October 2016. Align intends to vigorously defend itself against these allegations. Align is currently unable to predict the outcome of this amended complaint and therefore cannot determine the likelihood of loss nor estimate a range of possible loss, if any.\nShareholder Derivative Lawsuit\nOn February 1, 2013, plaintiff Gary Udis filed a shareholder derivative lawsuit against several of Align’s current and former officers and directors in the Superior Court of California, County of Santa Clara. The complaint alleges that our reported income and earnings were materially overstated because of a failure to timely write down goodwill related to the April 29, 2011 acquisition of Cadent Holdings, Inc., and that defendants made allegedly false statements concerning our forecasts. The complaint asserts various state law causes of action, including claims of breach of fiduciary duty, unjust enrichment, and insider trading, among others. The complaint seeks unspecified damages on behalf of Align, which is named solely as nominal defendant against whom no recovery is sought. The complaint also seeks an order directing Align to reform and improve its corporate governance and internal procedures, and seeks restitution in an unspecified amount, costs, and attorneys’ fees. On July 8, 2013, an Order was entered staying this derivative lawsuit until an initial ruling on our first motion to dismiss the Securities Action. On January 15, 2014, an Order was entered staying this derivative lawsuit until an initial ruling on our second motion to dismiss the Securities Action. On October 14, 2014, an Order was entered staying this derivative lawsuit until a ruling by the Ninth Circuit in the Securities Action discussed above. Align is currently unable to predict the outcome of this complaint and therefore cannot determine the likelihood of loss nor estimate a range of possible losses, if any.\nIn addition, in the course of Align's operations, Align is involved in a variety of claims, suits, investigations, and proceedings, including actions with respect to intellectual property claims, patent infringement claims, government investigations, labor and employment claims, breach of contract claims, tax, and other matters. Regardless of the outcome, these proceedings can have an adverse impact on us because of defense costs, diversion of management resources, and other factors. Although the results of complex legal proceedings are difficult to predict and Align's view of these matters may change in the future as litigation and events related thereto unfold; Align currently does not believe that these matters, individually or in the aggregate, will materially affect Align's financial position, results of operations or cash flows.\nNote 7. Credit Facility\nThe credit facility provides for a $50.0 million revolving line of credit, with a $10.0 million letter of credit sublimit. The credit facility requires us to comply with specific financial conditions and performance requirements. On December 13, 2016, we amended the credit facility to remove the requirement to maintain a minimum unrestricted cash balance of $50.0 million. On February 10, 2017, we amended the credit facility and extended the maturity date to March 22, 2018. The loans bear interest, at our option, at a fluctuating rate per annum equal to the daily one-month adjusted LIBOR rate plus a spread of 1.75% or an adjusted LIBOR rate (based on one, three, six or twelve-month interest periods) plus a spread of 1.75%. As of December 31, 2016, we had\n79\nno outstanding borrowings under this credit facility and were in compliance with the conditions and performance requirements.\nNote 8. Commitments and Contingencies\nOperating Leases\nWe lease our facilities and certain equipment and automobiles under non-cancelable operating lease arrangements that expire at various dates through 2024 and provide for pre-negotiated fixed rental rates during the terms of the lease. The terms of some of our leases provide for rental payments on a graduated scale. We recognize rent expense on a straight-line basis over the lease period and accrue for any rent expense incurred but not paid. Total rent expense was $9.9 million, $8.2 million and $7.6 million, for the year ended December 31, 2016, 2015 and 2014, respectively.\nMinimum future lease payments for non-cancelable leases as of December 31, 2016, are as follows (in thousands):\n\n| Fiscal Year | Operating Leases |\n| 2017 | $ | 12,880 |\n| 2018 | 10,338 |\n| 2019 | 8,466 |\n| 2020 | 6,849 |\n| 2021 | 6,247 |\n| Thereafter | 9,141 |\n| Total minimum lease payments | $ | 53,921 |\n\nOther Commitments\nOn July 25, 2016, we entered into a Loan and Security Agreement (the \"Loan Agreement\") with SmileDirectClub, LLC (\"SDC\") where we agreed to provide a loan of up to $15.0 million in one or more advances to SDC (the \"Loan Facility\"). Available advances under the Loan Facility are subject to a borrowing base of 80% of SDC's eligible accounts receivable, determined in accordance with the terms of the Loan Agreement, and the satisfaction of other customary conditions. The advances bear interest, paid quarterly, at the rate of 7% per annum. Advances that are repaid or prepaid may be reborrowed. All outstanding principal and accrued and unpaid interest on the advances are due and payable on July 25, 2021. SDC's obligations in respect of the Loan Agreement are collateralized by a security interest in substantially all of SDC's assets. As of December 31, 2016, no advances on the Loan Facility were issued or outstanding (Refer to Note 4 \"Equity Method Investments\" of the Notes of Consolidated Financial Statements for more information on our investments in SDC).\nWe have entered into certain investments with a privately held company where we have committed to purchase up to $5.0 million in convertible promissory notes. The first convertible promissory note for $2.0 million was issued in July 2016 and is outstanding as of December 31, 2016. The remaining $3.0 million is conditioned upon achievement of various business milestones. The notes all mature on December 30, 2018 and accrue interest annually at 2.5%.\nOn December 19, 2016, we entered into a Purchase and Sale Agreement (the \"Purchase Agreement\") with LBA RIV-COMPANY XXX, LLC (\"Seller\") to purchase the real property located in San Jose, California (the \"Property\") for purchase price of $44.1 million. The Property is comprised of land, building and other fixtures as set forth in the Purchase Agreement. As of December 31, 2016, $1.0 million was deposited into escrow and recorded in other current assets in our Consolidated Balance Sheet. We had a right to inspect the Property until January 6, 2017 and if we decided to terminate the Purchase Agreement during the period, the deposit would have been refunded to us. On January 26, 2017, we paid the purchase price of $44.1 million and closed the Purchase Agreement.\nOff-Balance Sheet Arrangements\nAs of December 31, 2016, we had no off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our consolidated financial condition, results of operations, liquidity, capital expenditures or capital resources.\n80\nIndemnification Provisions\nIn the normal course of business to facilitate transactions in our services and products, we indemnify certain parties: customers, vendors, lessors, and other parties with respect to certain matters, including, but not limited to, services to be provided by us and intellectual property infringement claims made by third parties. In addition, we have entered into indemnification agreements with our directors and our executive officers that will require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors or officers. Several of these agreements limit the time within which an indemnification claim can be made and the amount of the claim.\nIt is not possible to make a reasonable estimate of the maximum potential amount under these indemnification agreements due to the unique facts and circumstances involved in each particular agreement. Additionally, we have a limited history of prior indemnification claims and the payments we have made under such agreements have not had a material adverse effect on our results of operations, cash flows or financial position. However, to the extent that valid indemnification claims arise in the future, future payments by us could be significant and could have a material adverse effect on our results of operations or cash flows in a particular period. As of December 31, 2016, we did not have any material indemnification claims that were probable or reasonably possible.\nNote 9. Stockholders’ Equity\nCommon Stock\nThe holders of common stock are entitled to receive dividends whenever funds are legally available and when and if declared by the Board of Directors. We have never declared or paid dividends on our common stock.\nStock-Based Compensation Plans\nOur 2005 Incentive Plan, as amended, provides for the granting of incentive stock options, non-statutory stock options, restricted stock units, market stock units, stock appreciation rights, performance units and performance shares to employees, non-employee directors, and consultants. Shares granted on or after May 16, 2013 as an award of restricted stock, restricted stock unit, market stock units, performance share or performance unit (\"full value awards\") are counted against the authorized share reserve as one and nine-tenths (1 9/10) shares for every one (1) share subject to the award, and any shares canceled that were counted as one and nine-tenths against the plan reserve will be returned at the same ratio. Full value awards granted prior to May 16, 2013 were counted against the authorized share reserve as one and one half (1 1/2) share for every one (1) share subject to the award, and any shares canceled that were counted as one and one half against the plan reserve will be returned at this same ratio.\nAs of December 31, 2016, the 2005 Incentive Plan (as amended) has a total reserve of 27,783,379 shares for issuance of which 8,023,709 shares are available for issuance. In 2016, we added 4,500,000 shares to our pool and no shares were added to the plan in 2015. We issue new shares from our pool of authorized but unissued shares to satisfy the exercise and vesting obligations of our stock-based compensation plans.\nStock-Based Compensation\nStock-based compensation is based on the estimated fair value of awards, net of estimated forfeitures, and recognized over the requisite service period. Estimated forfeitures are based on historical experience at the time of grant and may be revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The stock-based compensation related to all of our stock-based awards and employee stock purchases for the year ended December 31, 2016, 2015 and 2014 is as follows (in thousands):\n| For the Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| Cost of net revenues | $ | 3,966 | $ | 3,938 | $ | 3,616 |\n| Selling, general and administrative | 42,612 | 40,813 | 29,625 |\n| Research and development | 7,570 | 8,192 | 6,582 |\n| Total stock-based compensation | $ | 54,148 | $ | 52,943 | $ | 39,823 |\n\n81\nStock Options\nWe have not granted options since 2011 and all outstanding options were fully vested in 2015. Activity for the year ended December 31, 2016, under the stock option plans are set forth below (in thousands, except years and per share amounts):\n| Stock Options |\n| Number ofSharesUnderlyingStock Options | WeightedAverageExercisePrice per Share | Weighted AverageRemainingContractual Term(in years ) | AggregateIntrinsicValue |\n| Outstanding as of December 31, 2015 | 496 | 15.14 |\n| Granted | — | — |\n| Exercised | (274 | ) | 15.33 |\n| Cancelled or expired | — | — |\n| Outstanding as of December 31, 2016 | 222 | $ | 14.90 | 1.12 | $ | 18,058 |\n| Vested and expected to vest at December 31, 2016 | 222 | $ | 14.90 | 1.12 | $ | 18,058 |\n| Exercisable at December 31, 2016 | 222 | $ | 14.90 | 1.12 | $ | 18,058 |\n\nThe aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between our closing stock price on the last trading day in 2016 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on the last trading day of 2016. This amount will fluctuate based on the fair market value of our stock. The total intrinsic value of stock options exercised for the year ended December 31, 2016, 2015 and 2014 was $18.2 million, $7.4 million and $24.5 million, respectively. The total fair value of the options vested during the year ended December 31, 2016, 2015 and 2014 was not material.\nRestricted Stock Units\nThe fair value of nonvested restricted stock units (“RSUs”) is based on our closing stock price on the date of grant. A summary for the year ended December 31, 2016, is as follows (in thousands, except years and per share amounts):\n\n| SharesUnderlying RSUs | Weighted Average Grant Date Fair Value | WeightedRemainingVesting Period(in years) | AggregateIntrinsicValue |\n| Nonvested as of December 31, 2015 | 2,079 | $ | 49.45 |\n| Granted | 714 | 67.82 |\n| Vested and released | (859 | ) | 45.45 |\n| Forfeited | (145 | ) | 53.36 |\n| Nonvested as of December 31, 2016 | 1,789 | $ | 58.39 | 1.12 | $ | 171,934 |\n\nThe aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (calculated by multiplying our closing stock price on the last trading day of 2016 by the number of nonvested RSUs) that would have been received by the unit holders had all RSUs been vested and released as of the last trading day of 2016. This amount will fluctuate based on the fair market value of our stock. During 2016, of the 859,410 shares vested and released, 300,031 vested shares were withheld for employee minimum statutory tax obligations, resulting in a net issuance of 559,379 shares.\nThe total intrinsic value of RSUs vested and released during 2016, 2015 and 2014 was $59.8 million, $45.9 million and $38.9 million, respectively. The total fair value RSUs vested during the year ended December 31, 2016, 2015 and 2014 was $39.1 million, $30.0 million and $22.0 million, respectively. The weighted average grant date fair value of RSUs granted during 2016, 2015 and 2014 was $67.82, $57.78 and $53.72, respectively. As of December 31, 2016, there was $63.3 million of total unamortized compensation costs, net of estimated forfeitures, related to RSUs and these costs are expected to be recognized over a weighted average period of 2.0 years.\nOn an annual basis, we grant market-performance based restricted stock units (“MSUs”) to our executive officers. Each MSU represents the right to one share of Align’s common stock and will be issued through our amended 2005 Incentive Plan. The actual\n82\nnumber of MSUs which will be eligible to vest will be based on the performance of Align’s stock price relative to the performance of the NASDAQ Composite Index over the vesting period, generally two to three years, up to 150% of the MSUs initially granted.\nThe following table summarizes the MSU performance as of December 31, 2016:\n| Number of SharesUnderlying MSUs(in thousands) | Weighted Average Grant Date Fair Value | Weighted AverageRemainingVesting Period(in years ) | AggregateIntrinsic Value(in thousands) |\n| Nonvested as of December 31, 2015 | 611 | 51.41 |\n| Granted | 218 | 55.77 |\n| Vested and released | (270 | ) | 36.73 |\n| Forfeited | (39 | ) | 56.41 |\n| Nonvested as of December 31, 2016 | 520 | 60.49 | 1.1 | $ | 50,021 |\n\nThe aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (calculated by multiplying our closing stock price on the last trading day of 2016 by the number of non-vested MSUs) that would have been received by the unit holders had all MSUs been vested and released as of the last trading day of 2016. This amount will fluctuate based on the fair market value of our stock. During 2016, of the 270,347 shares vested and released 136,758 shares were withheld for tax payments, resulting in a net issuance of 133,589 shares.\nThe total intrinsic value of MSUs vested and released during 2016, 2015 and 2014 was $17.4 million, $9.2 million and $2.9 million. The total fair value MSUs vested during the year ended December 31, 2016, 2015 and 2014 was $9.9 million, $4.9 million and $1.2 million, respectively. As of December 31, 2016, we expect to recognize $11.1 million of total unamortized compensation cost, net of estimated forfeitures, related to MSUs over a weighted average period of 1.1 years.\nThe fair value of the MSUs is estimated at the grant date using a Monte Carlo simulation that includes factors for market conditions. The following weighted-average assumptions used in the Monte Carlo simulation were as follows:\n| Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| Expected term (in years) | 3 | 3 | 3 |\n| Expected volatility | 34.0 | % | 36.9 | % | 46.0 | % |\n| Risk-free interest rate | 0.9 | % | 1.0 | % | 0.7 | % |\n| Expected dividends | — | — | — |\n| Weighted average fair value per share at grant date | $ | 68.88 | $ | 61.73 | $ | 50.46 |\n\nTotal payments to tax authorities for payroll taxes related to RSUs, including MSUs, that vested during the period were $29.9 million, $20.7 million and $7.6 million during the year ended December 31, 2016, 2015 and 2014, respectively, reflected as a financing activity in the Consolidated Statement of Cash Flows.\nEmployee Stock Purchase Plan\nIn May 2010, our shareholders approved the 2010 Employee Stock Purchase Plan (the “2010 Purchase Plan”), replacing our 2001 Employee Stock Purchase Plan, which consists of consecutive overlapping twenty-four month offering periods with four six-month purchase periods in each offering period. Employees purchase shares at 85% of the fair market value of the common stock at either the beginning of the offering period or the end of the purchase period, whichever is lower. The 2010 Purchase Plan will continue until terminated by either the Board of Directors or its administrator. The maximum number of shares available for issuance under the 2010 Purchase Plan is 2,400,000 shares. During the year ended December 31, 2016, 2015 and 2014, we issued 196,882, 230,078 and 247,343 shares, respectively, at average prices of $48.65, $36.66 and $29.24, respectively. As of December 31, 2016, 936,867 shares remain available for future issuance.\nThe fair value of the option component of the 2010 Purchase Plan shares was estimated at the grant date using the Black-Scholes option pricing model with the following weighted average assumptions:\n83\n| Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| Expected term (in years) | 1.2 | 1.2 | 1.2 |\n| Expected volatility | 30.5 | % | 31.1 | % | 38.8 | % |\n| Risk-free interest rate | 0.7 | % | 0.3 | % | 0.2 | % |\n| Expected dividends | — | — | — |\n| Weighted average fair value at grant date | $ | 22.23 | $ | 16.19 | $ | 17.15 |\n\nWe recognized stock-based compensation expense of $2.7 million, $4.1 million and $2.6 million related to our employee stock purchase plans for the year ended December 31, 2016, 2015 and 2014, respectively. As of December 31, 2016, there was $0.7 million of total unamortized compensation costs related to employee stock purchases which we expect to be recognized over a weighted average period of 0.3 years.\nNote 10. Common Stock Repurchase Program\nApril 2014 Repurchase Program\nOn April 23, 2014, we announced that our Board of Directors had authorized a stock repurchase program (\"April 2014 Repurchase Program\") pursuant to which we may purchase up to $300.0 million of our common stock over a three year period.\nIn 2014, we entered into an accelerated share repurchase agreement (\"2014 ASR\") to repurchase $70.0 million of our common stock. The 2014 ASR was completed in July 2014. We received a total of approximately 1.4 million shares for an average purchase price per share of $51.46. During 2014, we repurchased on the open market approximately 0.6 million shares of our common stock at an average price of $50.93 per share, including commissions, for an aggregate purchase price of approximately $28.2 million.\nIn 2015, we entered into an accelerated share purchase agreement (\"2015 ASR\") to repurchase $70.0 million of our common stock. The 2015 ASR was completed in July 2015. We received a total of approximately 1.2 million shares for an average share price of $60.52. During 2015, we repurchased on the open market approximately 0.5 million shares of our common stock at an average price of $58.89 per share, including commissions, for an aggregate purchase price of approximately $31.8 million.\nIn 2016, we entered into an accelerated share repurchase agreement (\"2016 ASR\") to repurchase $50.0 million of our common stock. The 2016 ASR was completed in September 2016. We received a total of approximately 0.6 million shares for an average share price of $81.89. During 2016, we repurchased on the open market approximately 0.5 million shares of our common stock at an average price of $92.58 per share, including commissions, for an aggregate purchase price of approximately $46.2 million.\nAll shares repurchased in 2016, 2015 and 2014 were retired.\nAs of December 31, 2016, we have $3.8 million remaining under the April 2014 Repurchase Program.\nApril 2016 Repurchase Program\nOn April 28, 2016, we announced that our Board of Directors had authorized an additional plan to repurchase up to $300.0 million of the Company's stock (\"April 2016 Repurchase Plan\"). Any purchases under this stock repurchase program may be made, from time-to-time, pursuant to open market purchases (including pursuant to Rule 10b5-1 plans), privately-negotiated transactions, accelerated stock repurchases, block trades or derivative contracts or otherwise in accordance with applicable federal securities laws, including Rule 10b-18 of the Securities Exchange Act of 1934. As of December 31, 2016, there have not been any repurchases under this plan.\n84\nNote 11. Employee Benefit Plans\n401(k) Plan\nIn January 1999, we adopted a defined contribution retirement plan under Section 401(k) of the Internal Revenue Code for our U.S. employees. This plan covers substantially all U.S. employees who meet minimum age and service requirements and allows participants to defer a portion of their annual compensation on a pre-tax basis. In 2009, our Board of Directors authorized us to match 50% of our employee’s salary deferral contributions up to a 6% of the employee’s eligible compensation effective 2010. We contributed approximately $3.4 million, $2.7 million and $2.2 million to the 401(k) plan during the year ended December 31, 2016, 2015 and 2014, respectively.\nIsraeli Funds\nUnder the Israeli severance fund law, we are required to make payments to dismissed employees and employees leaving employment in certain circumstances. The funding is calculated based on the salary of the employee multiplied by the number of years of employment as of the applicable balance sheet date. Our Israeli employees are entitled to one month’s salary for each year of employment, or a pro-rata portion thereof. We fund the liability through monthly deposits into funds, and the values of these contributions are recorded in other current assets.\nAs of December 31, 2016 and 2015, the accrued funds liability was approximately $3.1 million and $2.7 million, respectively.\nNote 12. Income Taxes\n| Year ended December 31, |\n| 2016 | 2015 | 2014 |\n| Domestic | $ | 118,871 | $ | 87,803 | $ | 94,784 |\n| Foreign | 123,695 | 98,298 | 95,585 |\n| Net income before provision for income taxes and equity in losses of investee | $ | 242,566 | $ | 186,101 | $ | 190,369 |\n\nThe provision for income taxes consists of the following (in thousands):\n| Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| Federal |\n| Current | $ | 40,235 | $ | 28,596 | $ | 1,569 |\n| Deferred | 24,794 | 6,679 | 37,570 |\n| 65,029 | 35,275 | 39,139 |\n| State |\n| Current | 2,603 | 3,271 | 2,162 |\n| Deferred | 2,636 | (703 | ) | 971 |\n| 5,239 | 2,568 | 3,133 |\n| Foreign |\n| Current | 8,964 | 4,305 | 1,596 |\n| Deferred | (28,032 | ) | (67 | ) | 669 |\n| (19,068 | ) | 4,238 | 2,265 |\n| Provision for income taxes | $ | 51,200 | $ | 42,081 | $ | 44,537 |\n\nThe differences between income taxes using the federal statutory income tax rate of 35% and our effective tax rate are as follows:\n85\n| Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| U.S. federal statutory income tax rate | 35.0 | % | 35.0 | % | 35.0 | % |\n| State income taxes, net of federal tax benefit | 2.1 | 1.5 | 1.6 |\n| Impact of differences in foreign tax rates | (6.3 | ) | (16.2 | ) | (16.4 | ) |\n| Valuation allowance release for Israel | (12.9 | ) | — | — |\n| Stock-based compensation | 1.2 | 1.6 | 1.0 |\n| Other items not individually material | 2.0 | 0.7 | 2.2 |\n| 21.1 | % | 22.6 | % | 23.4 | % |\n\nAs of December 31, 2016, approximately $438.0 million of undistributed earnings from non-U.S. operations held by our foreign subsidiaries are designated as indefinitely reinvested outside the U.S. We maintain sufficient cash reserves in the U.S. and do not intend to repatriate our foreign earnings. As a result, U.S. income taxes and foreign withholding taxes have not been provided on these foreign earnings. If these earnings were distributed in the form of dividends or otherwise, or if the shares of the relevant foreign subsidiaries were sold or otherwise transferred, we would be subject to additional U.S. income taxes subject to an adjustment for foreign tax credits and foreign withholding taxes. We intend to use the undistributed earnings for local operating expansions and to meet local operating working capital needs. In addition, a significant amount of the cash earned by foreign subsidiaries has been and will continue to be utilized to affect the new international corporate structure described above.\nOn July 1, 2016, we implemented a new international corporate structure. This changes the structure of our international procurement and sales operations, as well as realigns the ownership and use of intellectual property among our wholly-owned subsidiaries. We continue to anticipate that an increasing percentage of our consolidated pre-tax income will be derived from, and reinvested in our foreign operations. We believe that income taxed in certain foreign jurisdictions at a lower rate relative to the U.S. federal statutory rate will have a beneficial impact on our worldwide effective tax rate over time. Although the license of intellectual property rights between consolidated entities did not result in any gain in the consolidated financial statements, the Company generated taxable income in certain jurisdictions in 2016 resulting in a tax expense of $34.3 million. Additionally, as a result of the restructuring, we reassessed the need for a valuation allowance against our deferred tax assets considering all available evidence. Given the current earnings and anticipated future earnings of our subsidiary in Israel, we concluded that we have sufficient positive evidence to release the valuation allowance against our Israel operating loss carryforwards of $31.4 million, which resulted in an income tax benefit in this period of the same amount.\nIn June 2009, the Costa Rica Ministry of Foreign Trade, an agency of the Government of Costa Rica, granted a twelve year extension of certain tax incentives, which were previously granted in 2002. The incentive tax rates will expire in various years beginning in July 2017. We intend to seek a renewal of these income tax incentives before they expire. Under these incentives, all of the income in Costa Rica during these twelve year incentive periods is subject to a reduced tax rate. In order to receive the benefit of these incentives, we must hire specified numbers of employees and maintain certain minimum levels of fixed asset investment in Costa Rica. If we do not fulfill these conditions for any reason, our incentive could lapse, and our income in Costa Rica would be subject to taxation at higher rates, which could have a negative impact on our operating results. The Costa Rica corporate income tax rate that would apply, absent the incentives, is 30% for 2016, 2015 and 2014. As a result of these incentives, income taxes were reduced by $19.1 million, $32.7 million and $32.5 million in the year ended December 31, 2016, 2015 and 2014, respectively. The benefit of the tax holiday on diluted net income per share was $0.23 in the year ended December 31, 2016 and $0.40 for both the year ended December 31, 2015 and 2014.\n86\n| Year Ended December 31, |\n| 2016 | 2015 |\n| Deferred tax assets: |\n| Net operating loss and capital loss carryforwards | $ | 25,445 | $ | 31,247 |\n| Reserves and accruals | 22,954 | 17,455 |\n| Stock-based compensation | 16,399 | 16,523 |\n| Deferred revenue | 13,975 | 24,432 |\n| Net translation losses | 1,634 | 649 |\n| Credit carryforwards | 679 | 1,932 |\n| 81,086 | 92,238 |\n| Deferred tax liabilities: |\n| Depreciation and amortization | 12,034 | 8,555 |\n| Prepaid expenses | 969 | 601 |\n| 13,003 | 9,156 |\n| Net deferred tax assets before valuation allowance | 68,083 | 83,082 |\n| Valuation allowance | (256 | ) | (31,685 | ) |\n| Net deferred tax assets | $ | 67,827 | $ | 51,397 |\n\nAs of December 31, 2016, the valuation allowance decreased by $31.4 million in comparison to the balance at December 31, 2015. This decrease was due to the release of the valuation allowance against our Israel net deferred tax assets during the year. We determined that these deferred tax assets are more likely than not to be realized based upon our assessment of the available positive and negative evidence. Positive evidence, including expected profitability based upon the implementation of our international corporate restructuring outweighed available negative evidence, which included losses in recent years. The total valuation allowance as of December 31, 2016 was not material.\nAs of December 31, 2016, we have fully utilized California net operating loss carryforwards. As of December 31, 2016, we have California research credit carryforwards of approximately $3.7 million which can be carried forward indefinitely. In addition, we have foreign net operating loss carryforwards of approximately $104.3 million, which, if not utilized will expire beginning in 2025.\nIn the event of a change in ownership, as defined under federal and state tax laws, our tax credit carryforwards may be subject to annual limitations. The annual limitations may result in the expiration of the tax credit carryforwards before utilization.\nThe changes in the balance of gross unrecognized tax benefits, which exclude interest and penalties, for the year ended December 31, 2016, 2015 and 2014, are as follows (in thousands):\n| Unrecognized tax benefit as of December 31, 2013 | $ | 26,668 |\n| Tax positions related to current year: |\n| Additions for uncertain tax positions | 6,659 |\n| Tax positions related to prior year: |\n| Reductions for uncertain tax positions | (260 | ) |\n| Unrecognized tax benefit as of December 31, 2014 | 33,067 |\n| Tax positions related to current year: |\n| Additions for uncertain tax positions | 6,346 |\n| Unrecognized tax benefit as of December 31, 2015 | 39,413 |\n| Tax positions related to current year: |\n| Additions for uncertain tax positions | 6,971 |\n| Unrecognized tax benefit as of December 31, 2016 | $ | 46,384 |\n\n87\nWe account for uncertain tax positions pursuant to authoritative guidance based on a two-step approach to recognize and measure uncertain tax positions taken or expected to be taken in a tax return. We first determine whether it is more likely than not that a tax position will be sustained upon audit based on its technical merits. If a tax position meets the more-likely-than-not recognition threshold it is then measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured as the largest amount of benefit that is more than 50 percent likely to be realized upon ultimate settlement. We adjust our uncertain tax positions due to changing facts and circumstances, such as the closing of a tax audit, or refinement of estimates due to new information. To the extent the final outcome of these matters is different than the amounts recorded, such differences will impact our tax provision in our Consolidated Statements of Operations in the period in which such determination is made.\nDuring fiscal year 2016, the amount of gross unrecognized tax benefits increased by $7.0 million in comparison to fiscal year 2015. The total amount of unrecognized tax benefits, excluding interest and penalties, was $46.4 million and $39.4 million as of December 31, 2016 and 2015, respectively, all of which would impact our effective tax rate if recognized. We have elected to recognize interest and penalties related to unrecognized tax benefits as a component of income taxes. For the year ended December 31, 2016 and 2015, interest and penalties included in tax expense was $1.4 million and $0.7 million, respectively. Our total interest and penalties accrued as of December 31, 2016 and 2015 was $2.1 million and $0.7 million, respectively. We do not expect any significant changes to the amount of unrecognized tax benefit within the next twelve months.\nWe file U.S. federal, U.S. state, and non-U.S. income tax returns. Our major tax jurisdictions are U.S. federal and the State of California. For U.S. federal and state tax returns, we are no longer subject to tax examinations for years before 2000. With few exceptions, we are no longer subject to examination by foreign tax authorities for years before 2007. Our subsidiary in Israel is under audit by the local tax authorities for calendar years 2006 through 2013.\nNote 13. Net Income per Share\nBasic net income per share is computed using the weighted average number of shares of common stock outstanding during the period. Diluted net income per share is computed using the weighted average number of shares of common stock, adjusted for any dilutive effect of potential common stock. Potential common stock, computed using the treasury stock method, includes RSU, MSU, stock options and our ESPP.\nThe following table sets forth the computation of basic and diluted net income per share attributable to common stock (in thousands, except per share amounts):\n| Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| Numerator: |\n| Net income | $ | 189,682 | $ | 144,020 | $ | 145,832 |\n| Denominator: |\n| Weighted-average common shares outstanding, basic | 79,856 | 79,998 | 80,754 |\n| Dilutive effect of potential common stock | 1,628 | 1,523 | 1,529 |\n| Total shares, diluted | 81,484 | 81,521 | 82,283 |\n| Net income per share, basic | $ | 2.38 | $ | 1.80 | $ | 1.81 |\n| Net income per share, diluted | $ | 2.33 | $ | 1.77 | $ | 1.77 |\n\nFor the year ended December 31, 2016, 2015 and 2014, the anti-dilutive effect on net income per share from RSUs, MSUs and ESPP was not material.\n88\nNote 14. Supplemental Cash Flow Information\nThe supplemental cash flow information consists of the following (in thousands):\n| Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| Taxes paid | $ | 47,289 | $ | 40,621 | $ | 5,666 |\n| Non-cash investing activities: |\n| Fixed assets acquired with accounts payable or accrued liabilities | $ | 4,434 | $ | 14,636 | $ | 4,899 |\n\nNote 15. Segments and Geographical Information\nSegment Information\nOperating segments are defined as components of an enterprise for which separate financial information is available that is evaluated regularly by the Chief Operating Decision Maker (“CODM”), or decision-making group, in deciding how to allocate resources and in assessing performance. Our CODM is our Chief Executive Officer. We report segment information based on the management approach. The management approach designates the internal reporting used by CODM for decision making and performance assessment as the basis for determining our reportable segments. The performance measures of our reportable segments include net revenues and gross profit. In the fourth quarter of 2016, management decided to change the way it internally assesses the performance of our reportable segments by including income from operations measure in the performance metrics. Income from operations for each segment includes all geographic revenues, related cost of net revenues and operating expenses directly attributable to the segment. Certain operating expenses are attributable to operating segments and each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. Costs not specifically allocated to segment income from operations include various corporate expenses such as stock-based compensation and costs related to IT, facilities, human resources and accounting and finance, legal and regulatory, and other separately managed general and administrative costs outside the operating segments. We have included the new performance measure in the prior periods presentation to conform to the current year’s presentation.\nWe have grouped our operations into two reportable segments which are also our reporting units: Clear Aligner segment and Scanner segment.\n| • | Our Clear Aligner segment consists of our Invisalign System which includes Invisalign Full, Express/Lite, Teen, Assist, Vivera Retainers, along with our training and ancillary products for treating malocclusion. Clear Aligner segment also include the sale of aligners to SDC under our supply agreement which commenced in the fourth quarter of 2016. SDC revenue is recorded after eliminating outstanding intercompany transactions. |\n\n| • | Our Scanner and Services (\"Scanner\") segment consists of intraoral scanning systems and additional services available with the intraoral scanners that provide digital alternatives to the traditional cast models. This segment includes our iTero scanner and OrthoCAD services. |\n\nThese reportable operating segments are based on how our CODM views and evaluates our operations as well as allocation of resources. The following information relates to these segments (in thousands):\n89\n| For the Year Ended December 31, |\n| Net Revenues | 2016 | 2015 | 2014 |\n| Clear Aligner | $ | 958,327 | $ | 800,186 | $ | 712,549 |\n| Scanner | 121,547 | 45,300 | 49,104 |\n| Total net revenues | $ | 1,079,874 | $ | 845,486 | $ | 761,653 |\n| Gross Profit |\n| Clear Aligner | $ | 747,494 | $ | 628,187 | $ | 562,889 |\n| Scanner | 67,800 | 11,923 | 15,554 |\n| Total gross profit | $ | 815,294 | $ | 640,110 | $ | 578,443 |\n| Income from Operations |\n| Clear Aligner | $ | 411,817 | $ | 371,113 | $ | 341,055 |\n| Scanner | 37,498 | (12,337 | ) | (8,483 | ) |\n| Unallocated corporate expenses | (200,394 | ) | (170,142 | ) | (138,996 | ) |\n| Total income from operations | $ | 248,921 | $ | 188,634 | $ | 193,576 |\n| Depreciation and Amortization |\n| Clear Aligner | $ | 13,742 | $ | 9,842 | $ | 8,706 |\n| Scanner | 3,871 | 3,839 | 4,498 |\n| Unallocated corporate expenses | 6,389 | 4,323 | 4,652 |\n| Total depreciation and amortization | $ | 24,002 | $ | 18,004 | $ | 17,856 |\n\nThe following table reconciles total segment income from operations in the table above to net income before provision for income taxes and equity losses of investee:\n| For the Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| Total segment income from operations | $ | 449,315 | $ | 358,776 | $ | 332,572 |\n| Unallocated corporate expenses | (200,394 | ) | (170,142 | ) | (138,996 | ) |\n| Total income from operations | 248,921 | 188,634 | 193,576 |\n| Interest and other income (expense), net | (6,355 | ) | (2,533 | ) | (3,207 | ) |\n| Net income before provision for income taxes and equity losses of investee | $ | 242,566 | $ | 186,101 | $ | 190,369 |\n\nGeographical Information\nNet revenues are presented below by geographic area (in thousands):\n| For the Year Ended December 31, |\n| 2016 | 2015 | 2014 |\n| Net revenues (1): |\n| United States (2) | $ | 692,254 | $ | 585,874 | $ | 532,569 |\n| The Netherlands (2) | 291,053 | 167,128 | 156,817 |\n| Other International | 96,567 | 92,484 | 72,267 |\n| Total net revenues | $ | 1,079,874 | $ | 845,486 | $ | 761,653 |\n\n| (1) | Net revenues are attributed to countries based on location of where revenue is recognized. |\n\n(2) During 2016, we implemented a new international corporate structure. This changed the structure of our international procurement and sales operations.\n90\nTangible long-lived assets are presented below by geographic area (in thousands):\n| As of December 31, |\n| 2016 | 2015 |\n| Long-lived assets (1): |\n| The Netherlands (2) | $ | 111,515 | $ | 486 |\n| United States (2) | 43,278 | 112,632 |\n| Mexico | 17,918 | 15,422 |\n| Other International | 2,456 | 7,933 |\n| Total long-lived assets | $ | 175,167 | $ | 136,473 |\n\n(1) Long-lived assets are attributed to countries based on entity that owns the assets.\n(2) As a result of the new international corporate structure changes, approximately $92.0 million in long-lived assets were transferred from the U.S. to our Netherlands entity in 2016.\nITEM 9.\nCHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE\nNone\n\nITEM 9A.\nCONTROLS AND PROCEDURES\nEvaluation of disclosure controls and procedures.\nUnder the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective as of December 31, 2016 to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure, and that such information is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms.\nManagement's annual report on internal control over financial reporting.\nSee “Report of Management on Internal Control over Financial Reporting” of this Annual Report on Form 10-K.\nChanges in internal control over financial reporting.\nThere have been no changes in our internal control over financial reporting during the quarter ended December 31, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\nITEM 9B.\nOTHER INFORMATION\nNone.\n91\nPART III\nCertain information required by Part III is omitted from this Form 10-K because we intend to file a definitive Proxy Statement for our 2017 Annual Meeting of Stockholders (the “Proxy Statement”) not later than 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K, and certain information to be included therein is incorporated herein by reference.\n\nITEM 10.\nDIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE\nThe information required by Item 401 of Regulation S-K concerning our directors is incorporated by reference to the Proxy Statement under the section captioned “Election of Directors.” The information required by Item 401 of Regulation S-K concerning our executive officers is set forth in Item 1— “Business” of this Annual Report on Form 10-K. The information required by Item 405 of Regulation S-K is incorporated by reference to the section entitled “Section 16(a) Beneficial Ownership Reporting Compliance” contained in the Proxy Statement. The information required by Item 407(c)(3), 407(d)(4) and 407(d)(5) of Regulation S-K is incorporated by reference to the Proxy Statement under the section entitled “Corporate Governance”.\nCode of Ethics\nWe have a code of ethics that applies to all of our employees, including our principal executive officer, principal financial officer and principal accounting officer. This code of ethics is posted on our Internet website. The Internet address for our website is www.aligntech.com, and the code of ethics may be found on the “Corporate Governance” section of our “Investor Relations” webpage.\nWe intend to satisfy the disclosure requirement under Item 5.05 of Form 8-K regarding an amendment to, or waiver from, a provision of this code of ethics by posting such information on our website, at the address and location specified above, or as otherwise required by the NASDAQ Global Market.\n\nITEM 11.\nEXECUTIVE COMPENSATION\nThe information required by Item 402 of Regulation S-K is incorporated by reference to the Proxy Statement under the section captioned “Executive Compensation.” The information required by Items 407(e)(4) and (e)(5) is incorporated by reference to the Proxy Statement under the section captioned “Corporate Governance—Compensation Committee Interlocks” and “Compensation Committee Report,” respectively.\nITEM 12.\nSECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS\nThe information required by Item 403 of Regulation S-K is incorporated by reference to the Proxy Statement under the section captioned “Security Ownership of Certain Beneficial Owners and Management.”\nEquity Compensation Plan Information\nThe following table provides information as of December 31, 2016 about our common stock that may be issued upon the exercise of options and rights granted to employees, consultants or members of our Board of Directors under all existing equity compensation plans, including the 1997 Equity Incentive Plan, the Employee Stock Purchase Plan (\"ESPP\"), the 2001 Stock Incentive Plan and the 2005 Incentive Plan, each as amended, and certain individual arrangements. Please see Note 9 “Stockholders’ Equity” in the Notes to consolidated financial statements for a description of equity compensation plans.\n\n| Plan Category | Number of securitiesto be issued upon exerciseof outstanding optionsand restricted stockunits(a) | Weighted averageexercise price ofoutstandingoptions(b) | Number of securitiesremaining available forfuture issuance underequity compensation plans(excluding securitiesreflected in column(a)) |\n| Equity compensation plans approved by security holders | 2,531,027 | 1 | $ | 14.90 | 9,454,960 | 2, 3 |\n| Equity compensation plans not approved by security holders | — | — | — |\n| Total | 2,531,027 | $ | 14.90 | 9,454,960 |\n\n92\n\n| 1 | Includes 1,788,372 restricted stock units and 520,350 market-performance based restricted stock units at target, which have an exercise price of zero. |\n\n| 2 | Includes 936,867 shares available for issuance under our ESPP. We are unable to ascertain with specificity the number of securities to be issued upon exercise of outstanding rights or the weighted average exercise price of outstanding rights under the ESPP. |\n\n| 3 | Excludes 494,333 of potentially issuable MSUs if performance targets are achieved at maximum payout. |\n\nITEM 13.\nCERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE\nThe information required by Item 404 and Item 407 of Regulation S-K is incorporated by reference to the Proxy Statement under the sections captioned “Certain Relationships and Related Party Transactions” and “Corporate Governance—Director Independence,” respectively.\n\nITEM 14.\nPRINCIPAL ACCOUNTING FEES AND SERVICES\nThe information required by Item 9(e) of Schedule 14A of the Securities Act of 1934, as amended, is incorporated by reference to the Proxy Statement under the section captioned “Ratification of Appointment of Independent Registered Public Accountants.”\n93\nPART IV\n\nITEM 15.\nEXHIBITS, FINANCIAL STATEMENT SCHEDULES\n| (a) | Financial Statements |\n\n| 1. | Consolidated financial statements |\n\nThe following documents are filed as part of this Annual Report on Form 10-K:\n\n| Report of Independent Registered Public Accounting Firm | 56 |\n| Consolidated Statements of Operations for the year ended December 31, 2016, 2015 and 2014 | 57 |\n| Consolidated Statements of Comprehensive Income for the year ended December 31, 2016, 2015 and 2014 | 58 |\n| Consolidated Balance Sheets as of December 31, 2016 and 2015 | 59 |\n| Consolidated Statements of Stockholders’ Equity for the year ended December 31, 2016, 2015 and 2014 | 60 |\n| Consolidated Statements of Cash Flows for the year ended December 31, 2016, 2015 and 2014 | 61 |\n| Notes to Consolidated Financial Statements | 62 |\n\n\n| 2. | The following financial statement schedule is filed as part of this Annual Report on Form 10-K: |\n\nSchedule II—Valuation and Qualifying Accounts and Reserves\nAll other schedules have been omitted as they are not required, not applicable, or the required information is otherwise included.\nSCHEDULE II: VALUATION AND QUALIFYING ACCOUNTS AND RESERVES\n\n| Balance atBeginningof Period | Additions(Reductions)to CostsandExpenses | WriteOffs | Balance atEnd of Period |\n| (in thousands) |\n| Allowance for doubtful accounts and returns: |\n| Year ended December 31, 2014 | $ | 1,733 | $ | 6,563 | $ | (6,733 | ) | $ | 1,563 |\n| Year ended December 31, 2015 | $ | 1,563 | $ | 8,944 | $ | (8,035 | ) | $ | 2,472 |\n| Year ended December 31, 2016 | $ | 2,472 | $ | 8,585 | $ | (6,747 | ) | $ | 4,310 |\n| Valuation allowance for deferred tax assets: |\n| Year ended December 31, 2014 | $ | 35,108 | $ | (1,793 | ) | $ | (817 | ) | $ | 32,498 |\n| Year ended December 31, 2015 | $ | 32,498 | $ | (813 | ) | $ | — | $ | 31,685 |\n| Year ended December 31, 2016 | $ | 31,685 | $ | (31,429 | ) | $ | — | $ | 256 |\n\n94\n| (b) | The following Exhibits are included in this Annual Report on Form 10-K: |\n\n| ExhibitNumber | Description | Form | Date | ExhibitNumberIncorporatedby Referenceherein | Filedherewith |\n| 3.1 | Amended and Restated Certificate of Incorporation of registrant | Form S-1, as amended (File No. 333-49932) | 12/28/2000 | 3.1 |\n| 3.2 | Amended and Restated Bylaws of registrant | Form 8-K | 2/29/2012 | 3.2 |\n| 3.3 | Certificate of Designations of Rights, Preferences and Privileges of Series A Participating Preferred Stock registrant | Form 8-K | 10/27/2005 | 3.1 |\n| 4.1 | Form of Specimen Common Stock Certificate | Form S-1, as amended (File No. 333-49932) | 1/17/2001 | 4.1 |\n| 10.1† | Registrant's 2005 Incentive Plan (as amended May 2016) | * |\n| 10.2† | Form of RSU agreement under Registrant's 2005 Incentive Plan (Officer Form for officers appointed after September 2016) | * |\n| 10.2A† | Form of RSU agreement under Registrant's 2005 Incentive Plan (Officer Form for officers appointed prior to September 2016) | * |\n| 10.3 | Align’s 2010 Employee Stock Purchase Plan | Form 8-K | 5/25/2010 | 10.2 |\n| 10.4† | Form of Indemnification Agreement by and between registrant and its Board of Directors and its executive officers | Form S-1 as amended (File No. 333-49932) | 1/17/2001 | 10.15 |\n| 10.5† | Form of restricted stock unit award agreement under registrant’s 2005 Incentive Plan (General Form; Director Form) | Form 10-Q | 11/5/2007 | 10.1A,10.1C |\n| 10.6† | Form of option award agreement under registrant’s 2005 Incentive Plan | Form 10-Q | 8/4/2005 | 10.4 |\n| 10.7† | Form of Employment Agreement entered into by and between registrant and each executive officer (other than CEO for executives appointed prior to September 2016) | Form 10-Q | 5/8/2008 | 10.2 |\n| 10.8† | Form of Employment entered into by and between registrant and each executive officer (other than CEO for executives appointed after September 2016) | * |\n| 10.9 | Credit Agreement dated March 22, 2013 between registrant and Wells Fargo National Association | Form 8-K | 3/27/2013 | 10.1 |\n| 10.10† | Summary of 2016 Incentive Awards and Base Salaries | Form 8-K | 2/6/2017 |\n| 10.11† | Form of Market Stock Unit Agreement (officer) | Form 8-K | 2/23/2011 | 10.1 |\n| 10.12† | Form of Market Stock Unit Agreement (CEO) | Form 8-K | 2/23/2011 | 10.2 |\n| 10.13† | Description of Executive Officer Incentive Plan | Form 8-K | 2/23/2011 | Item 5.02 |\n| 10.14 | Fixed Dollar Accelerated Repurchase Transaction Agreement dated May 3, 2016 between Morgan Stanley & Co and registrant | Form 10-Q | 8/4/2016 | 10.1 |\n| 10.15† | Amended and Restated Chief Executive Officer Employment Agreement between Align Technology, Inc. and Joseph Hogan | Form 10-Q | 5/1/2015 | 10.30 |\n\n95\n| ExhibitNumber | Description | Form | Date | ExhibitNumberIncorporatedby Referenceherein | Filedherewith |\n| 10.16† | 2005 Incentive Plan Notice of Grant of Restricted Stock units (Chief Executive Officer) | Form 10-Q | 7/30/2015 | 10.31 |\n| 10.17† | Amended and Restated 2005 Incentive Plan Notice of Grant of Market Stock Units (Chief Executive Officer) | Form 10-Q | 7/30/2015 | 10.34 |\n| 10.18† | Employment Agreement between registrant and John Morici | Form 10-Q | 11/8/2016 | 10.2 |\n| 10.19 | Purchase and Sale Agreement between registrant and LBA RIV-Company XXX, LLC dated December 19, 2016 | Form 8-K | 12/23/2016 | 10.1 |\n| 10.20 | Class C Non-Incentive Unit Purchase Agreement dated July 25, 2016 | Form 8-K | 7/28/2016 | 10.1 |\n| 10.30 | Fifth Amendment to Credit Agreement | Form 8-K | 2/13/2017 | 10.1 |\n| 21.1 | Subsidiaries of Align Technology, Inc. | * |\n| 23.1 | Consent of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm | * |\n| 31.1 | Certifications of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2003 | * |\n| 31.2 | Certifications of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2003 | * |\n| 32 | Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2003 | * |\n| 101.INS | XBRL Instance Document | * |\n| 101.SCH | XBRL Taxonomy Extension Schema Document | * |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document | * |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document | * |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document | * |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document | * |\n\n__________________________________\n| † | Management contract or compensatory plan or arrangement filed as an Exhibit to this form pursuant to Items 14(a) and 14(c) of Form 10-K. |\n| †† | Portions of the exhibit have been omitted pursuant to a request for confidential treatment. The confidential portions have been filed with the SEC. |\n\n96\nSIGNATURES\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on February 28, 2017.\n\n| ALIGN TECHNOLOGY, INC. |\n| By: | /S/ JOSEPH M. HOGAN |\n| Joseph M. Hogan |\n| President and Chief Executive Officer |\n\nEach person whose signature appears below constitutes and appoints Joseph M. Hogan or John F. Morici, his or her attorney-in-fact, with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his or her substitute or substitutes, may do or cause to be done by virtue hereof.\nPursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.\n| Signature | Title | Date |\n| /S/ JOSEPH M. HOGAN | President and Chief Executive Officer (Principal Executive Officer) | February 28, 2017 |\n| Joseph M. Hogan |\n| /S/ JOHN F. MORICI | Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer) | February 28, 2017 |\n| John F. Morici |\n| /S/ JOSEPH LACOB | Director | February 28, 2017 |\n| Joseph Lacob |\n| /S/ C. RAYMOND LARKIN | Director | February 28, 2017 |\n| C. Raymond Larkin |\n| /S/ GEORGE J. MORROW | Director | February 28, 2017 |\n| George J. Morrow |\n| /S/ ANDREA L. SAIA | Director | February 28, 2017 |\n| Andrea L. Saia |\n| /S/ GREG J. SANTORA | Director | February 28, 2017 |\n| Greg J. Santora |\n| /S/ THOMAS M. PRESCOTT | Director | February 28, 2017 |\n| Thomas M. Prescott |\n| /S/ WARREN S. THALER | Director | February 28, 2017 |\n| Warren S. Thaler |\n\n97\nExhibit Index\n| ExhibitNumber | Description | Form | Date | ExhibitNumberIncorporatedby referenceherein | Filedherewith |\n| 3.1 | Amended and Restated Certificate of Incorporation of registrant | Form S-1, as amended (File No. 333-49932) | 12/28/2000 | 3.1 |\n| 3.2 | Amended and Restated Bylaws of registrant | Form 8-K | 2/29/2012 | 3.2 |\n| 3.3 | Certificate of Designations of Rights, Preferences and Privileges of Series A Participating Preferred Stock registrant | Form 8-K | 10/27/2005 | 3.1 |\n| 4.1 | Form of Specimen Common Stock Certificate | Form S-1, as amended (File No. 333-49932) | 1/17/2001 | 4.1 |\n| 10.1† | Registrant's 2005 Incentive Plan (as amended May 2016) | * |\n| 10.2† | Form of RSU agreement under Registrant's 2005 Incentive Plan (Officer Form for officers appointed after September 2016) | * |\n| 10.2A† | Form of RSU agreement under Registrant's 2005 Incentive Plan (Officer Form for officers appointed prior to September 2016) | * |\n| 10.3 | Align’s 2010 Employee Stock Purchase Plan | Form 8-K | 5/25/2010 | 10.2 |\n| 10.4† | Form of Indemnification Agreement by and between registrant and its Board of Directors and its executive officers | Form S-1 as amended (File No. 333-49932) | 1/17/2001 | 10.15 |\n| 10.5† | Form of restricted stock unit award agreement under registrant’s 2005 Incentive Plan (General Form; Director Form) | Form 10-Q | 11/5/2007 | 10.1A,10.1C |\n| 10.6† | Form of option award agreement under registrant’s 2005 Incentive Plan | Form 10-Q | 8/4/2005 | 10.40 |\n| 10.7† | Form of Employment Agreement entered into by and between registrant and each executive officer (other than CEO for executives appointed prior to September 2016) | Form 10-Q | 5/8/2008 | 10.2 |\n| 10.8† | Form of Employment entered into by and between registrant and each executive officer (other than CEO for executives appointed after September 2016) | * |\n| 10.9 | Credit Agreement dated March 22, 2013 between registrant and Wells Fargo National Association | Form 8-K | 3/27/2013 | 10.10 |\n| 10.10† | Summary of 2016 Incentive Awards and Base Salaries | Form 8-K | 2/6/2017 |\n| 10.11† | Form of Market Stock Unit Agreement (officer) | Form 8-K | 2/23/2011 | 10.1 |\n| 10.12† | Form of Market Stock Unit Agreement (CEO) | Form 8-K | 2/23/2011 | 10.2 |\n| 10.13† | Description of Executive Officer Incentive Plan | Form 8-K | 2/23/2011 | Item 5.02 |\n| 10.14 | Fixed Dollar Accelerated Repurchase Transaction Agreement dated May 3, 2016 between Morgan Stanley & Co and registrant | Form 10-Q | 8/4/2016 | 10.1 |\n| 10.15† | Amended and Restated Chief Executive Officer Employment Agreement between Align Technology, Inc. and Joseph Hogan | Form 10-Q | 5/1/2015 | 10.3 |\n| 10.16† | 2005 Incentive Plan Notice of Grant of Restricted Stock units (Chief Executive Officer) | Form 10-Q | 7/30/2015 | 10.3 |\n\n98\n| ExhibitNumber | Description | Form | Date | ExhibitNumberIncorporatedby referenceherein | Filedherewith |\n| 10.17† | Amended and Restated 2005 Incentive Plan Notice of Grant of Market Stock Units (Chief Executive Officer) | Form 10-Q | 7/30/2015 | 10.3 |\n| 10.18† | Employment Agreement between registrant and John Morici | Form 10-Q | 11/8/2016 | 10.2 |\n| 10.19 | Purchase and Sale Agreement between registrant and LBA RIV-Company XXX, LLC dated December 19, 2016 | Form 8-K | 12/23/2016 | 10.1 |\n| 10.20 | Class C Non-Incentive Unit Purchase Agreement dated July 25, 2016 | Form 8-K | 7/28/2016 | 10.1 |\n| 10.30 | Fifth Amendment to Credit Agreement | Form 8-K | 2/13/2017 | 10.1 |\n| 21.1 | Subsidiaries of Align Technology, Inc. | * |\n| 23.1 | Consent of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm | * |\n| 31.1 | Certifications of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2003 | * |\n| 31.2 | Certifications of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2003 | * |\n| 32 | Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2003 | * |\n| 101.INS | XBRL Instance Document | * |\n| 101.SCH | XBRL Taxonomy Extension Schema Document | * |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document | * |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document | * |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document | * |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document | * |\n\n__________________________________\n| † | Management contract or compensatory plan or arrangement filed as an Exhibit to this form pursuant to Items 14(a) and 14(c) of Form 10-K. |\n| †† | Portions of the exhibit have been omitted pursuant to a request for confidential treatment. The confidential portions have been filed with the SEC. |\n\n99\n</text>\n\nWhat is the continuous compounded annual growth rate (CAGR) of net cash used by financing activities from 2014 to 2016? (in millions)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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doc-math
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"style": "rule",
"ground_truth": "Therefore, the answer is 12.878638913766904."
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"index": 72,
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docmath_20000_40000
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nBLACK RIDGE OIL & GAS, INC.\nCONDENSED BALANCE SHEETS\n\n| September 30, | December 31, |\n| 2020 | 2019 |\n| ASSETS | (Unaudited) |\n| Current assets: |\n| Cash | $ | 417,109 | $ | 108,756 |\n| Investment in Allied Esports Entertainment, Inc. securities | 2,242,207 | 6,982,300 |\n| Receivable from Allied Esports Entertainment, Inc. | – | 505 |\n| Prepaid expenses | 25,684 | 47,151 |\n| Total current assets | 2,685,000 | 7,138,712 |\n| Property and equipment: |\n| Property and equipment | – | 134,202 |\n| Less accumulated depreciation | – | (127,803 | ) |\n| Total property and equipment, net | – | 6,399 |\n| Total assets | $ | 2,685,000 | $ | 7,145,111 |\n| LIABILITIES AND STOCKHOLDERS' EQUITY |\n| Current liabilities: |\n| Accounts payable | $ | 110,569 | $ | 35,727 |\n| Accrued expenses | 262,532 | 14,220 |\n| Deferred compensation | – | 1,396,460 |\n| Total current liabilities | 373,101 | 1,446,407 |\n| Notes payable | 262,925 | – |\n| Total liabilities | 636,026 | 1,446,407 |\n| Commitments and contingencies | – | – |\n| Stockholders' equity: |\n| Preferred stock, $0.001 par value, 20,000,000 shares authorized, no shares issued and outstanding | – | – |\n| Common stock, $0.001 par value, 500,000,000 shares authorized, 1,600,424 shares issued and outstanding | 1,600 | 1,600 |\n| Additional paid-in capital | 37,825,774 | 37,054,503 |\n| Accumulated deficit | (35,778,400 | ) | (31,357,399 | ) |\n| Total stockholders' equity | 2,048,974 | 5,698,704 |\n| Total liabilities and stockholders' equity | $ | 2,685,000 | $ | 7,145,111 |\n\nSee accompanying notes to unaudited condensed financial statements.\n\n| 1 |\n\nBLACK RIDGE OIL & GAS, INC.\nCONDENSED STATEMENTS OF OPERATIONS\n(Unaudited)\n\n| For the Three Months | For the Nine Months |\n| Ended September 30, | Ended September 30, |\n| 2020 | 2019 | 2020 | 2019 |\n| Management fee income | $ | – | $ | 153,279 | $ | – | $ | 153,279 |\n| Total revenues | – | 153,279 | – | 153,279 |\n| Operating expenses: |\n| General and administrative expenses: |\n| Salaries and benefits | 483,050 | 279,621 | 936,304 | 910,191 |\n| Stock-based compensation | 322,888 | 2,836,920 | 393,831 | 2,892,738 |\n| Professional services | 130,234 | 40,287 | 327,090 | 79,978 |\n| Other general and administrative expenses | 45,001 | 69,157 | 186,380 | 185,035 |\n| Total general and administrative expenses | 981,173 | 3,225,985 | 1,843,605 | 4,067,942 |\n| Depreciation and amortization | 380 | 131 | 1,030 | 754 |\n| Total operating expenses | 981,553 | 3,226,116 | 1,844,635 | 4,068,696 |\n| Net operating loss | (981,553 | ) | (3,072,837 | ) | (1,844,635 | ) | (3,915,417 | ) |\n| Other income (expense): |\n| Gain on deconsolidation of subsidiary | – | 26,322,687 | – | 26,322,687 |\n| Merger incentive expense | – | (5,874,000 | ) | – | (5,874,000 | ) |\n| Interest expense, including $-0- and $377,440 of warrants issued as a debt discount for the three and nine months ended September 30, 2020, respectively | (1,695 | ) | – | (384,456 | ) | – |\n| Other income | 14 | – | 16 | 51 |\n| Loss on disposal of property and equipment | (5,369 | ) | – | (5,369 | ) | – |\n| Gain (loss) on investment in Allied Esports Entertainment, Inc. securities | (1,503,601 | ) | 2,094,690 | (2,186,557 | ) | 2,094,690 |\n| Total other income (expense) | (1,510,651 | ) | 22,543,377 | (2,576,366 | ) | 22,543,428 |\n| Net income (loss) before provision for income taxes | (2,492,204 | ) | 19,470,540 | (4,421,001 | ) | 18,628,011 |\n| Provision for income taxes | – | – | – | – |\n| Net income (loss) from continuing operations, net of tax | (2,492,204 | ) | 19,470,540 | (4,421,001 | ) | 18,628,011 |\n| Net income from discontinued operations | – | (8,152,165 | ) | – | (7,421,050 | ) |\n| Net income (loss) before non-controlling interest | (2,492,204 | ) | 11,318,375 | (4,421,001 | ) | 11,206,961 |\n| Less net income attributable to redeemable non-controlling interest | – | (142,919 | ) | – | (1,332,529 | ) |\n| Net income (loss) attributable to Black Ridge Oil & Gas, Inc. | $ | (2,492,204 | ) | $ | 11,175,456 | $ | (4,421,001 | ) | $ | 9,874,432 |\n| Weighted average common shares outstanding - basic | 1,600,424 | 1,600,424 | 1,600,424 | 1,600,424 |\n| Weighted average common shares outstanding - fully diluted | 1,600,424 | 1,601,241 | 1,600,424 | 1,601,337 |\n| Net income per common share - basic | $ | (1.56 | ) | $ | 6.98 | $ | (2.76 | ) | $ | 6.17 |\n| Net income per common share - fully diluted | $ | (1.56 | ) | $ | 6.98 | $ | (2.76 | ) | $ | 6.17 |\n\nSee accompanying notes to unaudited condensed financial statements.\n\n| 2 |\n\nBLACK RIDGE OIL & GAS, INC.\nSTATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY\n(Unaudited)\n\n| For the Three Months Ended September 30, 2019 |\n| Additional | Total |\n| Common Stock | Paid-in | Accumulated | Stockholders' |\n| Shares | Amount | Capital | Deficit | Equity |\n| Balance, June 30, 2019 | 1,600,424 | $ | 1,600 | $ | 37,009,795 | $ | (36,788,926 | ) | $ | 222,469 |\n| Common stock options granted for services to employees and directors | – | – | 27,887 | – | 27,887 |\n| Net income attributable to Black Ridge Oil & Gas, Inc. | – | – | – | 11,175,456 | 11,175,456 |\n| Balance, September 30, 2019 | 1,600,424 | $ | 1,600 | $ | 37,037,682 | $ | (25,613,470 | ) | $ | 11,425,812 |\n\n\n| For the Three Months Ended September 30, 2020 |\n| Additional | Total |\n| Common Stock | Paid-in | Accumulated | Stockholders' |\n| Shares | Amount | Capital | Deficit | Equity |\n| Balance, June 30, 2020 | 1,600,424 | $ | 1,600 | $ | 37,502,886 | $ | (33,286,196 | ) | $ | 4,218,290 |\n| Common stock options granted for services to employees and directors | – | – | 322,888 | – | 322,888 |\n| Net loss attributable to Black Ridge Oil & Gas, Inc. | – | – | – | (2,492,204 | ) | (2,492,204 | ) |\n| Balance, September 30, 2020 | 1,600,424 | $ | 1,600 | $ | 37,825,774 | $ | (35,778,400 | ) | $ | 2,048,974 |\n\n\n| For the Nine Months Ended September 30, 2019 |\n| Additional | Total |\n| Common Stock | Paid-in | Accumulated | Stockholders' |\n| Shares | Amount | Capital | Deficit | Equity |\n| Balance, December 31, 2018 | 1,600,424 | $ | 1,600 | $ | 36,953,977 | $ | (35,487,902 | ) | $ | 1,467,675 |\n| Common stock options granted for services to employees and directors | – | – | 83,705 | – | 83,705 |\n| Net income attributable to Black Ridge Oil & Gas, Inc. | – | – | – | 9,874,432 | 9,874,432 |\n| Balance, September 30, 2019 | 1,600,424 | $ | 1,600 | $ | 37,037,682 | $ | (25,613,470 | ) | $ | 11,425,812 |\n\n\n| For the Nine Months Ended September 30, 2020 |\n| Additional | Total |\n| Common Stock | Paid-in | Accumulated | Stockholders' |\n| Shares | Amount | Capital | Deficit | Equity |\n| Balance, December 31, 2019 | 1,600,424 | $ | 1,600 | $ | 37,054,503 | $ | (31,357,399 | ) | $ | 5,698,704 |\n| Common stock options granted for services to employees and directors | – | – | 393,831 | – | 393,831 |\n| Common stock warrants granted to employees and directors for personal guaranty on debt | – | – | 377,440 | – | 377,440 |\n| Net loss attributable to Black Ridge Oil & Gas, Inc. | – | – | – | (4,421,001 | ) | (4,421,001 | ) |\n| Balance, September 30, 2020 | 1,600,424 | $ | 1,600 | $ | 37,825,774 | $ | (35,778,400 | ) | $ | 2,048,974 |\n\nSee accompanying notes to unaudited condensed financial statements.\n\n| 3 |\n\nBLACK RIDGE OIL & GAS, INC.\nCONDENSED STATEMENTS OF CASH FLOWS\n(Unaudited)\n\n| For the Nine Months |\n| Ended September 30, |\n| 2020 | 2019 |\n| CASH FLOWS FROM OPERATING ACTIVITIES |\n| Net income (loss) attributable to Black Ridge Oil & Gas, Inc. | $ | (4,421,001 | ) | $ | 9,874,432 |\n| Net income from discontinued operations | – | 7,421,050 |\n| Net loss attributable to redeemable non-controlling interest | – | 1,332,529 |\n| Adjustments to reconcile net loss attributable to Black Ridge Oil & Gas, Inc. |\n| to net cash used in operating activities: |\n| Gain on deconsolidation of subsidiary | – | (26,322,687 | ) |\n| Merger incentive expense | – | 5,874,000 |\n| Depreciation and amortization | 1,030 | 754 |\n| Loss on disposal of property and equipment | 5,369 | – |\n| (Gain) Loss on investment in Allied Esports Entertainment, Inc. securities, net | 2,186,557 | (2,094,690 | ) |\n| Amortization of stock options | 393,831 | 83,705 |\n| Amortization of stock warrants issued as a debt discount | 377,440 | – |\n| Deferred compensation | – | 2,809,033 |\n| Decrease (increase) in current assets: |\n| Accounts receivable | – | 13 |\n| Accounts receivable, related party | 505 | (181,211 | ) |\n| Prepaid expenses | 21,467 | 17,863 |\n| Increase (decrease) in current liabilities: |\n| Accounts payable | 74,842 | 16,481 |\n| Accrued expenses | 248,312 | 28,136 |\n| Net cash used in operating activities of continuing operations | (1,111,648 | ) | (1,140,592 | ) |\n| Net cash used in operating activities of discontinued operations | – | (8,618,568 | ) |\n| Net cash used in operating activities | (1,111,648 | ) | (9,759,160 | ) |\n| CASH FLOWS FROM INVESTING ACTIVITIES |\n| Cash disposed in deconsolidation | – | (9,991,684 | ) |\n| Purchase of property and equipment | – | (809 | ) |\n| Proceeds received from sale of investment in Allied Esports Entertainment, Inc. securities | 1,157,076 | – |\n| Net cash provided by (used in) investing activities of continuing operations | 1,157,076 | (9,992,493 | ) |\n| Net cash provided by investing activities of discontinued operations | – | 16,880,792 |\n| Net cash provided by investing activities | 1,157,076 | 6,888,299 |\n| CASH FLOWS FROM FINANCING ACTIVITIES |\n| Proceeds received from notes payable | 802,025 | – |\n| Repayments on notes payable | (539,100 | ) | – |\n| Net cash provided by financing activities from continuing operations | 262,925 | – |\n| Net cash provided by financing activities from discontinued operations | – | 1,431,974 |\n| Net cash provided by financing activities | 262,925 | 1,431,974 |\n| NET CHANGE IN CASH AND CASH EQUIVALENTS | 308,353 | (1,438,887 | ) |\n| CASH AT BEGINNING OF PERIOD | 108,756 | 1,503,500 |\n| CASH AT END OF PERIOD | $ | 417,109 | $ | 64,613 |\n| SUPPLEMENTAL INFORMATION: |\n| Interest paid | $ | 4,895 | $ | – |\n| Income taxes paid | $ | – | $ | 751,630 |\n| NON-CASH INVESTING AND FINANCING ACTIVITIES: |\n| Value of debt discounts attributable to warrants | $ | 377,440 | $ | – |\n| Value of investment in securities distributed to board members and employees | $ | 1,133,281 | $ | – |\n| Recognition of subsidiary equity upon deconsolidation | $ | – | $ | 8,498,212 |\n| BRAC Redemptions of redeemable preferred stock from trust account | $ | – | $ | 126,205,985 |\n| BRAC redeemable preferred stock transferred to equity | $ | – | $ | 15,865,798 |\n| BRAC stock issued in merger | $ | – | $ | 51,632,255 |\n| BRAC stock issued to settle intercompany debt | $ | – | $ | 19,300,000 |\n| BRAC loan and accrued interest assumed to settle intercompany debt | $ | – | $ | 10,992,877 |\n| BRAC stock issued to settle liabilities | $ | – | $ | 5,917,500 |\n\nSee accompanying notes to unaudited condensed financial statements.\n\n| 4 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nNote 1 – Organization and Nature of Business\nEffective April 2, 2012, Ante5, Inc. changed its corporate name to Black Ridge Oil & Gas, Inc., and continues to be quoted on the OTCQB under the trading symbol “ANFC”. Black Ridge Oil & Gas, Inc. (formerly Ante5, Inc.) (the “Company” and “BROG”) became an independent company in April 2010. We became a publicly traded company when our shares began trading on July 1, 2010. From October 2010 through August 2019, we had been engaged in the business of acquiring oil and gas leases and participating in the drilling of wells in the Bakken and Three Forks trends in North Dakota and Montana and /or managing similar assets for third parties.\nOn September 26, 2017, the Company finalized an equity raise utilizing a rights offering and backstop agreement, raising net proceeds of $5,051,675 and issuing 1,439,400 shares. The proceeds were used to sponsor a special purpose acquisition company, discussed below, with the remainder for general corporate purposes.\nOn October 10, 2017, the Company’s sponsored special purpose acquisition company, Black Ridge Acquisition Corp. (“BRAC”), completed an IPO raising $138,000,000 of gross proceeds (including proceeds from the exercise of an over-allotment option by the underwriters on October 18, 2017). In addition, the Company purchased 445,000 BRAC units at $10.00 per unit in a private placement transaction for a total contribution of $4,450,000 in order to fulfill its obligations in sponsoring BRAC, a blank check company formed for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities. BRAC’s efforts to identify a prospective target business were not limited to a particular industry or geographic region. Following the IPO and over-allotment, BROG owned 22% of the outstanding common stock of BRAC and managed BRAC’s operations via a management services agreement. On December 19, 2018, BRAC entered into a business combination agreement, which subsequently closed on August 9, 2019.\nOn October 1, 2020 the Company completed its acquisition of S-FDF, LLC pursuant to an Asset Purchase Agreement detailed in Footnote 15, Subsequent Events. In connection with the closing of the Asset Purchase Agreement, the Company acquired $2.5 million in cash and certain assets and agreements related to the Seller’s freeze-dried fruits and vegetables business for human consumption and entered into certain employment and registration rights agreements.\nThe Company currently owns 1,779,529 shares of Allied Esports Entertainment, Inc. (NASDAQ: AESE), the surviving entity after BRAC’s business combination (“Sponsor Shares”), after selling 368,871 shares for total proceeds of $1,282,067, selling warrants to purchase 505,000 shares of AESE (NASDAQ: AESEW) (“Sponsor Warrants”) for total proceeds of $73,668, and distributing 537,100 Sponsor Shares on August 9, 2020 to employees and directors under the 2018 Management Incentive Plan, dated March 6, 2018.\nNote 2 – Basis of Presentation and Significant Accounting Policies\nThe interim condensed financial statements included herein, presented in accordance with United States generally accepted accounting principles and stated in US dollars, have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations, although the Company believes that the disclosures are adequate to not make the information presented misleading.\nThese statements reflect all adjustments, which in the opinion of management, are necessary for fair presentation of the information contained therein. Except as otherwise disclosed, all such adjustments are of a normal recurring nature. It is suggested that these interim condensed financial statements be read in conjunction with the audited financial statements for the year ended December 31, 2019, which were included in our Annual Report on Form 10-K/A. The Company follows the same accounting policies in the preparation of interim reports.\n\n| 5 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nReclassifications\nIn the prior year, the income, expense and cash flows from Black Ridge Acquisition Corp., a wholly-owned subsidiary formed on October 10, 2017, which was consolidated as a variable interest entity through August 9, 2019, the date that BRAC completed a business combination with Allied Esports Entertainment, Inc. (“AESE”), were consolidated and have been retrospectively classified as discontinued operations. In addition, prior period investment in Allied Esports Entertainment, Inc. securities of $6,982,300 were reclassified from long term assets to current assets to conform to current period presentation.\nUse of Estimates\nThe preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates.\nEnvironmental Liabilities\nThe Company was formerly a direct owner of assets in the oil and gas industry. Oil and gas companies are subject, by their nature, to environmental hazard and clean-up costs. At this time, management knows of no substantial losses from environmental accidents or events which would have a material effect on the Company.\nCash in Excess of FDIC Limits\nThe Company maintains its cash in bank deposit accounts which, at times, may exceed federally insured limits. Accounts are guaranteed by the Federal Deposit Insurance Corporation (FDIC) and the Securities Investor Protection Corporation (SIPC) up to $250,000 and $500,000, respectively, under current regulations. The Company didn’t have any cash in excess of SIPC insured limits at September 30, 2020, and has not experienced any losses in such accounts.\nIncome Taxes\nThe Company recognizes deferred tax assets and liabilities based on differences between the financial reporting and tax basis of assets and liabilities using the enacted tax rates and laws that are expected to be in effect when the differences are expected to be recovered. The Company provides a valuation allowance for deferred tax assets for which it does not consider realization of such assets to be more likely than not.\nBasic and Diluted Earnings (Loss) Per Share\nBasic earnings (loss) per share (“EPS”) are computed by dividing net income (the numerator) by the weighted average number of common shares outstanding for the period (the denominator). Diluted EPS is computed by dividing net income by the weighted average number of common shares and potential common shares outstanding (if dilutive) during each period. Potential common shares include stock options, warrants and restricted stock. The number of potential common shares outstanding relating to stock options, warrants and restricted stock is computed using the treasury stock method.\n\n| 6 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nThe reconciliation of the denominators used to calculate basic EPS and diluted EPS for the three and nine months ended September 30, 2020 and 2019 are as follows:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| 2020 | 2019 | 2020 | 2019 |\n| Weighted average common shares outstanding – basic | 1,600,424 | 1,600,424 | 1,600,424 | 1,600,424 |\n| Plus: Potentially dilutive common shares: |\n| Common stock warrants | – | 817 | – | 913 |\n| Weighted average common shares outstanding – diluted | 1,600,424 | 1,601,241 | 1,600,424 | 1,601,337 |\n\nFor the three and nine months ended September 30, 2020, potential dilutive securities had an anti-dilutive effect and were not included in the calculation of diluted net loss per common share. Stock options and warrants excluded from the calculation of diluted EPS because their effect was anti-dilutive were 35,488 three and nine months ended September 30, 2019.\nFair Value of Financial Instruments\nUnder FASB ASC 820-10-05, the Financial Accounting Standards Board establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. This Statement reaffirms that fair value is the relevant measurement attribute. The adoption of this standard did not have a material effect on the Company’s financial statements as reflected herein. The carrying amounts of cash, accounts payable and accrued expenses reported on the balance sheets are estimated by management to approximate fair value primarily due to the short-term nature of the instruments. The Company had no items that required fair value measurement on a recurring basis.\nProperty and Equipment\nProperty and equipment are recorded at cost and depreciated using the straight-line method over their estimated useful lives of three to seven years. Expenditures for replacements, renewals, and betterments are capitalized. Maintenance and repairs are charged to operations as incurred. Long-lived assets are evaluated for impairment to determine if current circumstances and market conditions indicate the carrying amount may not be recoverable. Depreciation expense was $1,030 and $754 for the nine months ended September 30, 2020 and 2019, respectively.\nRevenue Recognition\nThe Company recognizes revenue in accordance with ASC 606 — Revenue from Contracts with Customers. Under ASC 606, the Company recognized revenue from management services through our previously consolidated Special Purpose Acquisition Company (“SPAC”), Black Ridge Acquisition Corp. until December 31, 2019.\nRevenue was primarily generated from BRAC in the form of management services performed within the state of Minnesota on a fixed fee basis. Revenue from the performance of those services was recognized upon completion of the services, at which time the services were delivered to the customer, and collectability of the fee was reasonably assured. We typically required payment within thirty days of the completion of services. Management estimates an allowance for doubtful accounts based on the aging of its receivables.\n\n| 7 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nStock-Based Compensation\nThe Company accounts for equity instruments issued to employees in accordance with the provisions of ASC 718 Stock Compensation (ASC 718) and Equity-Based Payments to Non-employees pursuant to ASC 2018-07 (ASC 2018-07). All transactions in which the consideration provided in exchange for the purchase of goods or services consists of the issuance of equity instruments are accounted for based on the fair value of the consideration received or the fair value of the equity instrument issued, whichever is more reliably measurable. The measurement date of the fair value of the equity instrument issued is the earlier of the date on which the counterparty’s performance is complete or the date at which a commitment for performance by the counterparty to earn the equity instruments is reached because of sufficiently large disincentives for nonperformance. Stock-based compensation was $393,831 and $83,705, consisting entirely of expenses related to common stock options issued for services for the nine months ended September 30, 2020 and 2019, respectively, using the Black-Scholes options pricing model and an effective term of 6 to 6.5 years based on the weighted average of the vesting periods and the stated term of the option grants and the discount rate on 5 to 7 year U.S. Treasury securities at the grant date. In addition, $377,440 of expenses related to the amortization of warrants issued in consideration of personal guarantees provided for debt financing for the nine months ended September 30, 2020, using the Black-Scholes options pricing model and an effective term of 5 years based on the weighted average of the vesting periods and the stated term of the warrant grants and the discount rate on 5 year U.S. Treasury securities at the grant date were recognized as interest expense for the nine months ended September 30, 2020.\nUncertain Tax Positions\nIn accordance with ASC 740, “Income Taxes” (“ASC 740”), the Company recognizes the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be capable of withstanding examination by the taxing authorities based on the technical merits of the position. These standards prescribe a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. These standards also provide guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.\nVarious taxing authorities may periodically audit the Company’s income tax returns. These audits include questions regarding the Company’s tax filing positions, including the timing and amount of deductions and the allocation of income to various tax jurisdictions. In evaluating the exposures connected with these various tax filing positions, including state and local taxes, the Company records allowances for probable exposures. A number of years may elapse before a particular matter, for which an allowance has been established, is audited and fully resolved. Black Ridge Oil & Gas, Inc. has not yet undergone an examination by any taxing authorities.\nThe assessment of the Company’s tax position relies on the judgment of management to estimate the exposures associated with the Company’s various filing positions.\nRecent Accounting Pronouncements\nFrom time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board (“FASB”) that are adopted by the Company as of the specified effective date. If not discussed below, management believes there have been no developments to recently issued accounting standards, including expected dates of adoption and estimated effects on our financial statements, from those disclosed in our Annual Report on Form 10-K/A for the year ended December 31, 2019.\nIn July 2018, the FASB issued ASU No. 2018-10, Codification Improvements to Topic 842, Leases. The amendments in ASU 2018-10 provide additional clarification and implementation guidance on certain aspects of the previously issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”) and have the same effective and transition requirements as ASU 2016-02. Upon the effective date, ASU 2018-10 will supersede the current lease guidance in ASC Topic 840, Leases. Under the new guidance, lessees will be required to recognize for all leases, with the exception of short-term leases, a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis. Concurrently, lessees will be required to recognize a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. ASU 2018-10 is effective for private companies and emerging growth public companies for interim and annual reporting periods beginning after December 15, 2019, with early adoption permitted. The guidance is required to be applied using a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative periods presented in the financial statements. The Company adopted this guidance effective January 1, 2019, and the standard did not have a material impact on the Company’s financial statements and related disclosures until the closing of the asset purchase with S-FDF, LLC on October 1, 2020.\n\n| 8 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nNote 3 – Going Concern\nAs shown in the accompanying financial statements, as of September 30, 2020, the Company has incurred recurring losses from operations resulting in an accumulated deficit of $35,778,400. As of September 30, 2020, the Company’s cash on hand may not be sufficient to sustain operations. These factors raise substantial doubt about the Company’s ability to continue as a going concern. The Company is currently seeking sources of capital to fund the requirements of the Asset Purchase Agreement. The Company intends to sell its AESE shares to continue as a going concern, however, there can be no assurance the share price will be sufficient to sustain operations, therefore the Company may be dependent upon its ability to secure equity and/or debt financing and there are also no assurances that the Company will be successful; therefore, without sufficient financing it would be unlikely for the Company to continue as a going concern.\nThe financial statements do not include any adjustments that might result from the outcome of any uncertainty as to the Company’s ability to continue as a going concern. The financial statements also do not include any adjustments relating to the recoverability and classification of recorded asset amounts, or amounts and classifications of liabilities that might be necessary should the Company be unable to continue as a going concern.\nNote 4 – Related Party\nManagement Incentive Plan\nOn March 1, 2018, the Board of Directors (the “Board”) of the Company approved and adopted the Black Ridge Gas, Inc. 2018 Management Incentive Plan (the “Plan”) and the form of 2018 Management Incentive Plan Award Agreement (the “Award Agreement”).\nIn connection with the approval of the Plan and Award Agreement, the Board approved the issuance of awards (the “Awards”) to certain individuals including officers and directors (the “Grantees”), representing a percentage of the shares of BRAC held by the Company as of the date of closing of a business combination for the acquisition of a target business as described in the BRAC prospectus dated October 4, 2017, as follows:\n\n| Percentage of BRAC Shares Owned by the |\n| Name | Company Granted to the Grantee |\n| Bradley Berman | 1.6% |\n| Lyle Berman | 1.6% |\n| Benjamin Oehler | 1.6% |\n| Joe Lahti | 1.6% |\n| Kenneth DeCubellis | 4.0% |\n| Michael Eisele | 2.8% |\n| James Moe | 2.1% |\n\nFollowing the AESE merger on August 9, 2019, the Company owned 2,685,500 shares of AESE common stock and 505,000 warrants to purchase AESE (NASDAQ: AESEW). During the nine months ending September 30, 2020, the Company sold some of these securities, resulting in gross proceeds of $1,157,076, consisting of 368,870 shares of common stock for total proceeds of $1,083,408, and the sale of warrants to purchase 505,000 shares for total proceeds of $73,668. The Company also distributed 537,101 Sponsor Shares on August 9, 2020 to employees and directors under the 2018 Management Incentive Plan. Employees and directors were required to remain in their positions for a one-year period from the AESE merger, with certain exceptions, to receive the granted shares. The AESE Plan Shares had a fair market value of $1,133,281 on August 10, 2020, when the shares were distributed. The Company recognized $1,396,460 of compensation expense related to the Plan during the year ended December 31, 2019. For the nine months ended September 30, 2020, the Company recognized a gain of $263,179 related to the reduction in the value of the shares to be paid to employees on August 10, 2020, which was offset against the Company’s loss on the investment in AESE shares due to changes in the AESE market price between December 31, 2019 and September 30, 2020.\nLease Agreement\nUpon closing of the Asset Purchase Agreement, the Company assumed the Seller’s obligations under a real property lease for its facility in Irving, Texas under which an entity owned entirely by Ira Goldfarb is the landlord.\n\n| 9 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nNote 5 – Fair Value of Financial Instruments\nUnder FASB ASC 820-10-5, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (an exit price). The standard outlines a valuation framework and creates a fair value hierarchy in order to increase the consistency and comparability of fair value measurements and the related disclosures. Under GAAP, certain assets and liabilities must be measured at fair value, and FASB ASC 820-10-50 details the disclosures that are required for items measured at fair value.\nThe Company has cash and cash equivalents and a revolving credit facility that must be measured under the fair value standard. The Company’s financial assets and liabilities are measured using inputs from the three levels of the fair value hierarchy. The three levels are as follows:\nLevel 1 - Inputs are unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date.\nLevel 2 - Inputs include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates, yield curves, etc.), and inputs that are derived principally from or corroborated by observable market data by correlation or other means (market corroborated inputs).\nLevel 3 - Unobservable inputs that reflect our assumptions about the assumptions that market participants would use in pricing the asset or liability.\nThe following schedule summarizes the valuation of financial instruments at fair value on a recurring basis in the balance sheets as of September 30, 2020 and December 31, 2019:\n\n| Fair Value Measurements at September 30, 2020 |\n| Level 1 | Level 2 | Level 3 |\n| Assets |\n| Cash | $ | 417,109 | $ | – | $ | – |\n| Investment in Allied Esports Entertainment, Inc. securities | 2,242,207 | – | – |\n| Total assets | 2,659,316 | – | – |\n| Liabilities |\n| Notes payable | – | (262,925 | ) | – |\n| Total liabilities | – | (262,925 | ) | – |\n| $ | 2,659,316 | $ | (262,925 | ) | $ | – |\n\n\n| 10 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\n\n| Fair Value Measurements at December 31, 2019 |\n| Level 1 | Level 2 | Level 3 |\n| Assets |\n| Cash | $ | 108,756 | $ | – | $ | – |\n| Investment in Allied Esports Entertainment, Inc. | 6,982,300 | – | – |\n| Total assets | 7,091,056 | – | – |\n| Liabilities |\n| None | – | – | – |\n| Total liabilities | – | – | – |\n| $ | 7,091,056 | $ | – | $ | – |\n\nThere were no transfers of financial assets or liabilities between Level 1 and Level 2 inputs for the nine months ended September 30, 2020.\nNote 6 – Prepaid Expenses\nPrepaid expenses consist of the following:\n\n| September 30, | December 31, |\n| 2020 | 2019 |\n| Prepaid insurance costs | $ | 3,185 | $ | 21,090 |\n| Prepaid employee benefits | 8,082 | 11,587 |\n| Prepaid office and other costs | 14,417 | 14,474 |\n| Total prepaid expenses | $ | 25,684 | $ | 47,151 |\n\nNote 7 – Property and Equipment\nProperty and equipment at September 30, 2020 and December 31, 2019, consisted of the following:\n\n| September 30, | December 31, |\n| 2020 | 2019 |\n| Property and equipment | $ | – | $ | 134,202 |\n| Less: Accumulated depreciation and amortization | – | (127,803 | ) |\n| Total property and equipment, net | $ | – | $ | 6,399 |\n\nOn September 30, 2020, the Company disposed of computer equipment no longer in service. No proceeds were received on the disposal of the equipment, resulting in a loss on disposal of fixed assets of $5,369, which represented the net book value at the time of disposal.\nThe Company recognized depreciation expense of $1,030 and $754 for the nine-month periods ended September 30, 2020 and 2019, respectively.\n\n| 11 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nNote 8 – Investment in Allied Esports Entertainment, Inc.\nFollowing the close of BRAC’s merger, the Company retained 2,685,500 shares of Allied Esports Entertainment Inc. (NASDAQ: AESE) common stock with a value, based on the closing stock of $4.45 on the merger, of $11,950,475, and tradeable warrants to purchase 505,000 shares of AESE (NASDAQ: AESEW) (“Sponsor Warrants”), of which the Company currently owns 1,779,529 shares, after selling 368,870 shares for total proceeds of $1,157,076, selling warrants to purchase 505,000 Sponsor Warrants for total proceeds of $73,668, and distributing 537,101 Sponsor Shares on August 10, 2020 to employees and directors under the 2018 Management Incentive Plan. As noted in Note 4 - Related Party Transactions, 20% or 537,101, of the shares were distributed to employees, officers and directors one year from the date of the merger, or on August 10, 2020. After the distribution and recent sales, the Company still holds 1,799,529 shares of AESE common stock.\nAs of September 30, 2020, the market value of the Company’s investment in AESE’s common stock was $2,242,207, based on the closing stock price of $1.26 per share, resulting in gains and losses on our investment in securities, as follows:\n\n| Net loss on investment in Allied Esports Entertainment, Inc. securities for the nine months ended September 30, 2020 | $ | (2,186,557 | ) |\n| Less: Net gains and losses recognized during 2020 on equity securities sold during the period | (198,012 | ) |\n| Unrealized losses recognized during 2020 on equity securities still held at September 30, 2020 | $ | (2,384,569 | ) |\n\nDuring the third quarter of 2020, the Company sold 51,902 of these shares for total proceeds of $120,596, resulting in a loss on investment of $14,352.\nDuring the second quarter of 2020, the Company sold 316,968 of these shares for total proceeds of $962,812, resulting in a gain on investment of $363,813.\nIn accordance with a brokerage account agreement with RBC Capital Markets, LLC, 500,000 of these shares were used as collateral for a $700,000 promissory note pursuant to a commercial pledge and security agreement, dated March 10, 2020, described below, which was subsequently repaid. Under this standard brokerage agreement, the Company will be able to borrow funds secured by the value of the AESE shares pursuant to a standard margin account arrangement.\n\n| 12 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nNote 9 – Notes Payable\nNotes payable consists of the following at September 30, 2020 and December 31, 2019, respectively:\n\n| September 30, | December 31, |\n| 2020 | 2019 |\n| On June 16, 2020, the Company entered into a loan authorization and loan agreement with the United States Small Business Administration (the “SBA”), as lender, pursuant to the SBA’s Economic Injury Disaster Loan (“EIDL”) assistance program in light of the impact of the COVID-19 pandemic on the Company’s business (the “EIDL Loan Agreement”) encompassing a $150,000 Promissory Note issued to the SBA (the “EIDL Note”)(together with the EIDL Loan Agreement, the “EIDL Loan”), bearing interest at 3.75% per annum. In connection with entering into the EIDL Loan, the Company also executed a security agreement, dated June 16, 2020, between the SBA and the Company (the “EIDL Security Agreement”) pursuant to which the EIDL Loan is secured by a security interest on all of the Company’s assets. Under the EIDL Note, the Company is required to pay principal and interest payments of $731 every month beginning June 16, 2021. All remaining principal and accrued interest is due and payable on June 16, 2050. The EIDL Note may be repaid at any time without penalty. | $ | 150,000 | $ | – |\n| On April 24, 2020, the Company entered into a loan agreement with Kensington Bank (“Kensington”), as lender (the “Loan Agreement”) encompassing a $112,925 Promissory Note issued to Kensington (the “PPP Note”) pursuant to Payroll Protection Program established as part of the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), which provides loans to qualifying businesses and is administered by the U.S. Small Business Administration (the “SBA”). The PPP Note bears interest at 1.00% per annum, with interest payable monthly beginning November 24, 2020, and principal due in full on April 24, 2022. The PPP Note may be repaid at any time without penalty. Under the Payroll Protection Program, the Company will be eligible for loan forgiveness up to the full amount of the PPP Note and any accrued interest. The forgiveness amount will be equal to the amount that the Company spends during the 24-week period beginning April 24, 2020 on payroll costs, payment of rent on any leases in force prior to February 15, 2020 and payment on any utility for which service began before February 15, 2020. The maximum amount of loan forgiveness for non-payroll expenses is 40% of the amount of the PPP Note. No assurance is provided that the Company will obtain forgiveness under the PPP Note in whole or in part. | 112,925 | – |\n| On November 25, 2019, the Company entered into a credit account agreement (“Margin Account”) with RBC Capital Markets, LLC (“RBC”). The Margin Account enables the Company to borrow against the Company’s AESE shares that are held in an account with RBC. The advances received on margin bear interest at rates of between 1.00% and 2.75% over the Base Lending Rate, depending on the average outstanding debit balance. The Base Lending Rate is internally determined by RBC using Broker Call, Prime Rate as determined by commercial banks utilized by RBC CM, Fed Funds, RBC CM’s cost of funds, and other commercially recognized rates of interest. The margin loans are collateralized by the underlying AESE shares. A total of $122,100 was borrowed on the Margin Account over various dates between January 29, 2020 and March 6, 2020. The outstanding balance was repaid in full on, or about, March 12, 2020 out of the proceeds of the loan from Cadence Bank, described below. | – | – |\n\n\n| 13 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\n\n| On March 12, 2020, the Company entered into a business loan agreement with Cadence Bank, N.A. (“Cadence”), as lender encompassing a $700,000 Promissory Note issued to Cadence (the “Note”), a Security Agreement by the Company in favor of Cadence and limited commercial guarantees by the Company’s Chief Executive Officer and Interim Chief Financial Officer, who is one in the same, and members of the Company’s Board of Directors (the “Guarantors”) (collectively, the “Cadence Loan”). The Note carried interest at a rate of 0.50 percentage points over the prime rate, as published in the Wall Street Journal, payable monthly, and was due on March 9, 2021. The Note could be repaid at any time without penalty. The Note was secured by all of the Company’s rights, title and interests in and to 500,000 shares of the common stock of Allied Esports Entertainment Inc. (NASDAQ: AESE) currently owned by the Company and held in the Company’s brokerage account with RBC Capital Markets, LLC. On March 26, 2020, the Company subsequently entered into a separate letter agreement with the Guarantors (the “Letter Agreement”), which provides that if the Company defaults or fails to make any payment due under the Cadence Loan and the Guarantors are required to make payment to Cadence pursuant to the Guarantees, then the Company agrees to issue additional equity interests or rights to Guarantors reflecting ninety-five percent (95%) of the outstanding equity of the Company at the time of such default to participating Guarantors who have made the payments to Cadence. All equity issuances will be subject to any third party or shareholder approvals required at the time of issuance. A total of $417,000 was advanced on the loan and subsequently repaid in full on June 30, 2020. | – | – |\n| Total notes payable | 262,925 | – |\n| Less unamortized derivative discounts: | – | – |\n| Notes payable | 262,925 | – |\n| Less: current maturities | – | – |\n| Notes payable, less current maturities | $ | 262,925 | $ | – |\n\nThe Company recorded total discounts of $377,440, consisting of debt discounts on warrants granted to four officers and directors for warrants issued in consideration of personal guarantees provided for debt financing incurred during the nine months ended September 30, 2020. The discounts were amortized to stock-based compensation expense over the term of the note, until repayment, using the straight-line method, which closely approximated the effective interest method. The Company recorded $377,440 of stock-based compensation expense pursuant to the amortization of note discounts during the nine months ended September 30, 2020.\nThe Company recognized $384,456 of interest expense, consisting of $7,016 of interest and $377,440 of stock-based warrant expense pursuant to the amortization of the debt discount on the business loans during the nine months ended September 30, 2020.\nNote 10 – Changes in Stockholders’ Equity\nReverse Stock Split\nOn February 21, 2020, the Company effected a 1-for-300 reverse stock split (the “Reverse Stock Split”). No fractional shares were issued. Instead, the Company issued the following to any stockholder who otherwise would have received a fractional share as a result of the Reverse Stock Split:\n| · | Stockholders owning 300 or more shares of Common Stock received (1) one share of Common Stock for every 300 shares owned and (2) cash in lieu of fractional shares upon the surrender of such stockholder’s shares; |\n| · | Stockholders owning between 25 and 300 shares of Common Stock had their ownership of shares of Common Stock rounded up to one share; and |\n| · | Stockholders owning fewer than 25 shares of Common Stock received cash in lieu of fractional shares upon the surrender of such stockholders’ shares and no longer own shares of Common Stock. |\n\n\n| 14 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nAny cash payment in lieu of fractional shares were based on the volume weighted average of the closing sales prices of the Company’s Common Stock on the OTCQB operated by OTC Markets Group Inc. (the “OTCQB”) during regular trading hours for the five consecutive trading days immediately preceding the Effective Date, which was $0.018 per share prior to the effects of the reverse stock split.\nThe Company was authorized to issue 500,000,000 shares of common stock prior to the Reverse Stock Split, which remains unaffected. The Reverse Stock Split did not have any effect on the stated par value of the common stock, or the Company’s authorized preferred stock. Unless otherwise stated, all share and per share information in this Interim Report has been retroactively adjusted to reflect the Reverse Stock Split.\nPreferred Stock\nThe Company has 20,000,000 authorized shares of $0.001 par value preferred stock. No shares have been issued to date.\nCommon Stock\nThe Company has 500,000,000 authorized shares of $0.001 par value common stock. As of September 30, 2020, and December 31, 2019, a total of 1,600,424 shares of common stock have been issued.\nNote 11 – Options\nThe 2020 Equity Plan was approved by written consent of a majority of shareholders of record as of November 12, 2019 and adopted by the Board on December 5, 2019, as provided in the definitive information statement filed with Securities and Exchange Commission on January 10, 2020 (the “DEF 14C”). The description of the 2020 Equity Plan is qualified in its entirety by the text of the 2020 Equity Plan, a copy of which was attached as Annex C to the DEF 14C.\nOutstanding Options\nOptions to purchase an aggregate total of 273,871 shares of common stock at a weighted average strike price of $16.32, exercisable over a weighted average life of 8.75 years were outstanding as of September 30, 2020.\nOptions Granted\nOn February 26, 2020, the Company’s Board of Directors granted an aggregate amount of 240,000 stock options pursuant to the 2020 Equity Plan to purchase shares of the Company’s common stock to several officers, directors, and employees at an exercise price of $5.41 per share, which represents the closing price of the Company’s shares on the OTCQB marketplace on February 20, 2020. The officers and directors receiving grants and the amounts of such grants were as follows:\n\n| Stock Option |\n| Name and Title | Shares Granted |\n| Ken DeCubellis, Chief Executive Officer and Interim Chief Financial Officer | 60,377 |\n| Michael Eisele, Chief Operating Officer | 42,264 |\n| Bradley Berman, Chairman of the Board and Director | 24,151 |\n| Joseph Lahti, Director | 24,151 |\n| Benjamin Oehler, Director | 24,151 |\n| Lyle Berman, Director | 24,151 |\n| Total: | 199,245 |\n\nAll of the stock options granted under the 2020 Equity Plan presented in the table above will vest in five equal installments, commencing one year from the date of grant on February 26, 2021, and continuing for the next four anniversaries thereof until fully vested, with the exception of 83,019 options that were awarded to four employees, whose vesting periods were accelerated to be fully vested as of September 30, 2019, pursuant to severance agreements.\nNo options were granted during the nine months ended September 30, 2019.\nThe Company recognized a total of $393,831, and $83,705 of compensation expense during the nine months ended September 30, 2020 and 2019, respectively, related to common stock options issued to Employees and Directors that are being amortized over the implied service term, or vesting period, of the options. The remaining unamortized balance of these options is $517,070 as of September 30, 2020.\n\n| 15 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nOptions Exercised\nNo options were exercised during the nine months ended September 30, 2020 and 2019.\nOptions Forfeited\nA total of 333 options with a weighted average exercise price of $90, and 457 options with a weighted average exercise price of $9.83 expired and were forfeited during the nine months ended September 30, 2020 and 2019, respectively.\nNote 12 – Warrants\nOutstanding Warrants\nWarrants to purchase an aggregate total of 106,300 shares of common stock at a $3.99 strike price, exercisable over a weighted average life of 9.36 years were outstanding as of September 30, 2020.\nWarrants Granted\nIn consideration for four officers and director’s willingness to serve as guarantors of the Cadence Loan, the Company issued warrants to each of the Guarantors (the “Guarantor Warrants”) for the purchase of the Company’s common stock on March 12, 2020. The Guarantor Warrants entitle each Guarantor to purchase 26,250 shares of the Company's common stock (the “Warrant Shares”) at an exercise price of $4.00 per share. The Guarantor Warrants expire on March 12, 2030. No warrants were granted during the comparative nine months ended September 30, 2019. The officers and directors receiving grants and the amounts of such grants were as follows:\n\n| Stock Warrant |\n| Name and Title | Shares Granted |\n| Ken DeCubellis, Chief Executive Officer and Interim Chief Financial Officer | 26,250 |\n| Bradley Berman, Chairman of the Board and Director | 26,250 |\n| Lyle Berman, Director | 26,250 |\n| Benjamin Oehler, Director | 26,250 |\n| Total: | 105,000 |\n\nWarrants Exercised\nNo warrants were exercised during the nine months ended September 30, 2020 and 2019.\n\n| 16 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nNote 13 – Income Taxes\nThe Company accounts for income taxes under ASC Topic 740, Income Taxes, which provides for an asset and liability approach of accounting for income taxes. Under this approach, deferred tax assets and liabilities are recognized based on anticipated future tax consequences, using currently enacted tax laws, attributed to temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts calculated for income tax purposes.\nLosses incurred during the period from April 9, 2011 (inception) to September 30, 2020 could be used to offset future tax liabilities. Accounting standards require the consideration of a valuation allowance for deferred tax assets if it is “more likely than not” that some component or all of the benefits of deferred tax assets will not be realized. As of September 30, 2020, net deferred tax assets were $7,013,057, with no deferred tax liability, primarily related to net operating loss carryforwards. A valuation allowance of approximately $7,013,057 was applied to the net deferred tax assets. Therefore, BROG has no tax expense for 2020 to date.\nIn accordance with FASB ASC 740, the Company has evaluated its tax positions and determined there are no significant uncertain tax positions as of any date on, or before September 30, 2020.\nNote 14 – Commitments\nThe Company from time to time may be involved in various inquiries, administrative proceedings and litigation relating to matters arising in the normal course of business. The Company is not aware of any inquiries or administrative proceedings and is not currently a defendant in any material litigation and is not aware of any threatened litigation that could have a material effect on the Company.\nThe Company periodically maintains cash balances at banks in excess of federally insured amounts. The extent of loss, if any, to be sustained as a result of any future failure of a bank or other financial institution is not subject to estimation at this time.\nNote 15 – Subsequent Events\nThe Company evaluates events that have occurred after the balance sheet date through the date these financial statements were issued.\nAsset Purchase\nOn October 1, 2020, the Company completed its acquisition of S-FDF, LLC, a Texas limited liability company, pursuant to an Asset Purchase Agreement, between the Company and the Seller, dated June 9, 2020, as subsequently amended effective October 1, 2020. In connection with the closing of the Asset Purchase Agreement, the Company acquired $2.5 million in cash and certain assets and agreements related to the Seller’s freeze-dried fruits and vegetables business for human consumption and entered into certain employment and registration rights agreements. The Company did not assume any liabilities of Seller or any liabilities, liens, or encumbrances pertaining to or encumbering the Purchased Assets except for those related to agreements or arrangements specified in the Asset Purchase Agreement. The Seller transferred the Purchased Assets to the Company in exchange for the issuance of 1,120,000 shares of the Company’s common stock to the Seller, representing 41.18% of the Company’s issued and outstanding common stock. The number of Seller Shares to be issued is subject to adjustment, as specified in the Asset Purchase Agreement, based on the extent to which the amount of cash proceeds held by the Company, as derived from the sale of the Company’s holdings of Sponsor Shares, are less than $5 million or greater than $6 million on the date specified in the Asset Purchase Agreement.\nThe Final Determination Date will be the first anniversary of the closing of the Asset Purchase Agreement and the Company has contributed $4 million to the business in the form of proceeds from either the sale of Sponsor Shares after October 1, 2020, proceeds from a financing secured by the AESE Shares after June 9, 2020, proceeds from an equity or convertible debt financing, legal fees paid in connection with the Asset Purchase Agreement, expenses incurred by the Company after August 1, 2020 (except for severance related to change in control payments made to the Company's employees), and the Company's cash as of October 1, 2020 (the “Company Contribution”). If the Company Contribution is less than $4 million on January 1, 2021, then the Final Determination Date will be January 1, 2021.\n\n| 17 |\n\nBLACK RIDGE OIL & GAS, INC.\nNotes to Condensed Financial Statements\n(Unaudited)\nPursuant to its obligations under the Asset Purchase Agreement, on the Closing Date the Company, (a) created three new seats on the Company’s Board of Directors and appointed the Seller’s principals, Ira Goldfarb and Claudia Goldfarb, and a third person designated by the Goldfarbs, Greg Creed, as directors, (b) entered into employment agreements with Ira Goldfarb and Claudia Goldfarb, (c) delivered a registration rights agreement with respect to the Seller Shares and any shares of common stock delivered as part of the employment compensation for Ira Goldfarb or Claudia Goldfarb, and (d) amended the Company’s 2020 Stock Incentive Plan to increase the number of shares of common stock reserved thereunder. At closing, the Company also assumed the Seller’s obligations under a real property lease for its facility in Irving, Texas under which an entity owned entirely by Ira Goldfarb is the landlord.\nAdoption of Non-Employee Director Compensation Plan\nOn October 1, 2020, the Company adopted a Non-Employee Director Compensation Plan. Pursuant to the Plan, each non-employee director will receive annual compensation of $25,000 to be paid in cash or common stock, at the Company’s election, each October 1, beginning with October 1, 2020. On October 1, 2020, the Company issued 4,167 shares to Mr. Bradley Berman, Mr. Lyle Berman, Mr. Joseph Lahti, Mr. Benjamin Oehler, and Mr. Creed under the Non-Employee Director Compensation Plan. In addition, the plan provides for annual compensation of $15,000 to be paid in cash or common stock, at the Company's election, each October 1, beginning with October 1, 2020, to Board committee chairs. On October 1, 2020, the Company issued 2,500 shares to Mr. Benjamin Oehler as its Audit Committee Chair.\nAmendment to 2020 Stock Incentive Plan\nAs a condition to closing on the Asset Purchase Agreement, the Board approved an increase in the number of shares of common stock reserved under the 2020 Stock Incentive Plan adopted in January 2020, from 320,000 shares to a total of 514,150 shares. The increase remains subject to shareholder approval, to be provided, if at all, by October 1, 2021.\nOption Grants\nOn October 1, 2020, Mr. Creed was granted options to purchase 24,151 shares of the Company’s common stock at an exercise price of $6.00 per share, which represented the closing price of the Company’s shares on the OTCQB marketplace on October 1, 2020. These options will vest 60% as of January 1, 2024 and 20% each anniversary thereafter until fully vested.\nOn October 2, 2020, the Company’s Board of Directors also granted an aggregate amount of 115,250 stock options pursuant to the 2020 Equity Plan to purchase shares of the Company’s common stock to several officers, directors, and employees at an exercise price of $5.25 per share, which represents the closing price of the Company’s shares on the OTCQB marketplace on October 2, 2020. The options are exercisable over a ten-year term, and vest 60% on the 3rd anniversary of the grant date and 20% each anniversary thereafter, until fully vested. The officers and directors receiving grants and the amounts of such grants were as follows:\n\n| Stock Option |\n| Name and Title | Shares Granted |\n| Ira Goldfarb, Chairman of the Board and Director | 50,000 |\n| Claudia Goldfarb, Chief Executive Officer | 50,000 |\n| Total: | 100,000 |\n\nManagement Changes\nKen DeCubellis stepped down from his roles as the Company’s Chief Executive Officer and interim Chief Financial Officer on September 30, 2020, and will serve as a transition resource employee and assist with the integration of the Seller’s freeze-dried fruit business into the Company's existing operations through December 15, 2020, or the earlier termination of his employment.\nEffective October 1, 2020, in connection with closing of the Asset Purchase Agreement, Ira Goldfarb was appointed as the Company’s Executive Chairman and Chairman of the Board, and Claudia Goldfarb was appointed as the Company’s Chief Executive Officer.\nEffective October 5, 2020, Brad Burke was appointed and agreed to serve on an interim basis as the Company’s Chief Financial Officer.\n\n| 18 |\n\n\nCautionary Statements\nWe are including the following discussion to inform our existing and potential security holders generally of some of the risks and uncertainties that can affect our company and to take advantage of the “safe harbor” protection for forward-looking statements that applicable federal securities law affords.\nFrom time to time, our management or persons acting on our behalf may make forward-looking statements to inform existing and potential security holders about our company. All statements other than statements of historical facts included in this report regarding our financial position, business strategy, plans and objectives of management for future operations and industry conditions are forward-looking statements. When used in this report, forward-looking statements are generally accompanied by terms or phrases such as “estimate,” “project,” “predict,” “believe,” “expect,” “anticipate,” “target,” “plan,” “intend,” “seek,” “goal,” “will,” “should,” “may” or other words and similar expressions that convey the uncertainty of future events or outcomes. Items making assumptions regarding actual or potential future sales, market size, collaborations, trends or operating results also constitute such forward-looking statements.\nForward-looking statements involve inherent risks and uncertainties, and important factors (many of which are beyond our control) that could cause actual results to differ materially from those set forth in the forward-looking statements include the following:\n\n| · | the effect of the coronavirus (“COVID-19”) pandemic on our ability to obtain funding through various financing transactions or arrangements; |\n\n| · | volatility or decline of our stock price; |\n\n| · | low trading volume and illiquidity of our common stock, and possible application of the SEC’s penny stock rules; |\n\n| · | potential fluctuation in quarterly results; |\n\n| · | low trading volume and price of our investment in AESE Shares; |\n\n| · | inability to maintain adequate liquidity to meet our financial obligations; |\n\n| · | failure to timely launch our freeze-dried fruit product offerings and obtain sufficient sales and distributions; |\n\n| · | litigation, disputes and legal claims involving outside parties; and |\n\n| · | risks related to our ability to be traded on the OTCQB and meeting trading requirements |\n\nWe have based these forward-looking statements on our current expectations and assumptions about future events. While our management considers these expectations and assumptions to be reasonable, they are inherently subject to significant business, economic, competitive, regulatory and other risks and uncertainties, most of which are difficult to predict and many of which are beyond our control. Accordingly, results actually achieved may differ materially from expected results in these statements. Forward-looking statements speak only as of the date they are made.\nReaders are urged not to place undue reliance on these forward-looking statements. We assume no obligation to update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this report, other than as may be required by applicable law or regulation. Readers are urged to carefully review and consider the various disclosures made by us in our reports filed with the United States Securities and Exchange Commission (the “SEC”) which attempt to advise interested parties of the risks and factors that may affect our business, financial condition, results of operation and cash flows. If one or more of these risks or uncertainties materialize, or if the underlying assumptions prove incorrect, our actual results may vary materially from those expected or projected.\n\n| 19 |\n\nOverview and Outlook\nEffective April 2, 2012, we changed our name to Black Ridge Oil & Gas, Inc. Our common stock is still quoted on the OTCQB under the trading symbol “ANFC.”\nAs the sponsor and manager of Black Ridge Acquisition Corp. beginning in May of 2017, the Company was focused on identifying and closing a business combination for BRAC, which closed on August 9, 2019. Upon BRAC (renamed Allied Esports Entertainment, Inc. following the merger or “AESE”, and hereafter named as such following the merger) completing its business combination, we continued to provide additional management services to BRAC until December 31, 2019.\nFollowing the close of the Merger, the Company commenced a strategic review to identify, review and explore alternatives for the Company, including a merger, acquisition, or a business combination. The result of that review is the transaction with S-FDF described below. The Company currently owns 1,779,529 shares of Allied Esports Entertainment, Inc. (NASDAQ: AESE), the surviving entity after BRAC’s business combination, after selling 368,870 shares for total proceeds of $1,083,408, selling warrants to purchase 505,000 shares of AESE (NASDAQ: AESEW) for total proceeds of $73,668, and distributing 537,101 Sponsor Shares on August 10, 2020 to employees and directors under the 2018 Management Incentive Plan.\nOn October 1, 2020, the Company completed its acquisition of S-FDF, LLC, as detailed in Footnote 15, Subsequent Events.\nGoing Concern Uncertainty\nAs of September 30, 2020, the Company has incurred recurring losses from operations resulting in an accumulated deficit of $35,778,400, and as of September 30, 2020, the Company’s cash on hand may not be sufficient to sustain operations. These factors raise substantial doubt about the Company’s ability to continue as a going concern. The Company is currently seeking sources of capital to fund the requirements of the Asset Purchase Agreement including selling its shares of AESE or other sources of capital. The Company intends to sell its AESE shares to continue as a going concern, however, there can be no assurance the share price will be sufficient to sustain operations, therefore the Company may be dependent upon its ability to secure equity and/or debt financing and there are also no assurances that the Company will be successful; therefore, without sufficient financing it would be unlikely for the Company to continue as a going concern.\nWe continue to pursue sources of additional capital through various financing transactions or arrangements, including joint venturing of projects, equity or debt financing or other means. We may not be successful in identifying suitable funding transactions in a sufficient time period or at all, and we may not obtain the capital we require by other means. If we do not succeed in raising additional capital, our resources may not be sufficient to fund our business.\nThe report of the Company’s independent registered public accounting firm that accompanies its audited consolidated financial statements in the Company’s Annual Report on Form 10-K/A contains an explanatory paragraph regarding the substantial doubt about the Company’s ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might result from the outcome of the going concern uncertainty.\n\n| 20 |\n\nResults of Operations for the Three Months Ended September 30, 2020 and 2019.\nThe following table summarizes selected items from the statement of operations for the three months ended September 30, 2020 and 2019, respectively.\n\n| Three Months Ended |\n| September 30, | Increase / |\n| 2020 | 2019 | (Decrease) |\n| Management fee income | $ | – | $ | 153,279 | $ | (153,279 | ) |\n| Total revenues: | – | 153,279 | (153,279 | ) |\n| Operating expenses: |\n| General and administrative expenses: |\n| Salaries and benefits | 483,050 | 279,621 | 203,429 |\n| Stock-based compensation | 322,888 | 2,836,920 | (2,514,032 | ) |\n| Professional services | 130,234 | 40,287 | 89,947 |\n| Other general and administrative expenses | 45,001 | 69,157 | (24,156 | ) |\n| Total general and administrative expenses | 981,173 | 3,225,985 | (2,244,812 | ) |\n| Depreciation and amortization | 380 | 131 | 249 |\n| Total operating expenses | 981,553 | 3,226,116 | (2,244,563 | ) |\n| Net operating loss | (981,553 | ) | (3,072,837 | ) | (2,091,284 | ) |\n| Other income (expense) |\n| Gain on deconsolidation of subsidiary | – | 26,322,687 | (26,322,687 | ) |\n| Merger incentive expense | – | (5,874,000 | ) | (5,874,000 | ) |\n| Interest expense | (1,695 | ) | – | 1,695 |\n| Other income | 14 | – | 14 |\n| Loss on disposal of property and equipment | (5,369 | ) | – | 5,369 |\n| Gain (loss) on investment in Allied Esports Entertainment, Inc. securities | (1,503,601 | ) | 2,094,690 | (3,598,291 | ) |\n| Total other income (expense) | (1,510,651 | ) | 22,543,377 | (24,054,028 | ) |\n| Net income (loss) from continuing operations, net of tax | (2,492,204 | ) | 19,470,540 | (21,962,744 | ) |\n| Provision for income taxes | – | – | – |\n| Net income (loss) from continuing operations, net of tax | (2,492,204 | ) | 19,470,540 | (21,962,744 | ) |\n| Net income from discontinued operations | – | (8,152,165 | ) | (8,142,165 | ) |\n| Net income (loss) before non-controlling interest | (2,492,204 | ) | 11,318,375 | (13,810,579 | ) |\n| Less: Net loss attributable to redeemable non-controlling interest | – | (142,919 | ) | (142,919 | ) |\n| Net income (loss) attributable to Black Ridge Oil & Gas, Inc. | $ | (2,492,204 | ) | $ | 11,175,456 | $ | (13,667,660 | ) |\n\nManagement fee income\nThe Company did not earn any management fees from its management agreement with BRAC during the three months ended September 30, 2020, compared to $153,279 during the three months ended September 30, 2019. The decrease is attributable to the termination of the agreement subsequent to the merger between BRAC and AESE on August 9, 2019.\n\n| 21 |\n\nGeneral and administrative expenses\nSalaries and benefits\nSalaries and benefits for the three months ended September 30, 2020 were $483,050, compared to $279,621 for the three months ended September 30, 2019, an increase of $203,429, or 73%. The increase in salaries and benefits was primarily due to payroll taxes on the distribution of AESE shares to employees in the current period pursuant to the Management Incentive Plan and accrued severance pay to former officers and employees.\nStock-based compensation\nStock-based compensation expense for the three months ended September 30, 2020 was $322,888, compared to $2,836,920 for the three months ended September 30, 2019, a decrease of $2,514,032, or 89%. Stock-based compensation consisted of stock options expense in both periods, and $2,809,033 of expense related to the 2018 Management Incentive Plan (the “2018 Plan”) in the prior period. Amortization of stock options increased as new options were granted toward the end of February 2020, with a five-year vesting period, and the vesting period was accelerated pursuant to separation agreements entered into on September 30, 2020.\nProfessional services\nGeneral and administrative expenses related to professional services were $130,234 for the 2020 period, compared to $40,287 for the 2019 period, an increase of $89,947, or 223%. The increase was primarily due to professional services related to our asset purchase agreement with S-FDF, LLC.\nOther general and administrative expenses\nOther general and administrative expenses for the three months ended September 30, 2020 was $45,001, compared to $69,157 for the three months ended September 30, 2019, a decrease of $24,156, or 35%. The decrease is primarily attributable to decreased administrative activity as we focused on completing the asset purchase with S-FDF, LLC.\nDepreciation\nDepreciation expense for the three months ended September 30, 2020 was $380, compared to $131 for the three months ended September 30, 2019, an increase of $249, or 190%. The increase is attributable to the addition of new computer equipment in 2020.\nOther income (expense)\nIn the three months ended September 30, 2020, other expense was $1,510,651, consisting of $1,695 of interest expense derived from the operating loans the Company received from the PPP and EIDL programs, a loss on the disposal of equipment of $5,369, and a net loss on investments in Allied Esports Entertainment, Inc. securities of $1,503,601, as offset by $14 of interest income. During the comparative three months ended September 30, 2019, other income was $22,543,377, consisting of the gain upon deconsolidation of BRAC of $26,322,687 and an offsetting merger incentive expense of $5,874,000 to recognize the cost related to transferring shares of AESE stock to the former owners of Allied Esports and WPT and other investors as an incentive to participate in the merger, and a gain of $2,094,690 on the investment in Allied Esports Entertainment, Inc. pursuant to the change in fair market value of the AESE shares.\nProvision for income taxes\nThe Company had no income tax expense in the 2020 or 2019 periods, as the Company continues to reserve against any deferred tax assets due to the uncertainty of realization of any benefit.\nNet income from discontinued operations\nNet income from discontinued operations relates to the income and expenses of BRAC during the periods prior to deconsolidation. Net income from discontinued operations for the three months ended September 30, 2019 was $8,152,165.\n\n| 22 |\n\nResults of Operations for the Nine Months Ended September 30, 2020 and 2019.\nThe following table summarizes selected items from the statement of operations for the nine months ended September 30, 2020 and 2019, respectively.\n\n| Nine Months Ended |\n| September 30, | Increase / |\n| 2020 | 2019 | (Decrease) |\n| Management fee income | $ | – | $ | 153,279 | $ | (153,279 | ) |\n| Total revenues: | – | 153,279 | (153,279 | ) |\n| Operating expenses: |\n| General and administrative expenses: |\n| Salaries and benefits | 936,304 | 910,191 | 26,113 |\n| Stock-based compensation | 393,831 | 2,892,738 | (2,498,907 | ) |\n| Professional services | 327,090 | 79,978 | 247,112 |\n| Other general and administrative expenses | 186,380 | 185,035 | 1,345 |\n| Total general and administrative expenses | 1,843,605 | 4,067,942 | (2,224,337 | ) |\n| Depreciation and amortization | 1,030 | 754 | 276 |\n| Total operating expenses | 1,844,635 | 4,068,696 | (2,224,061 | ) |\n| Net operating loss | (1,844,635 | ) | (3,915,417 | ) | (2,070,782 | ) |\n| Other income (expense) |\n| Gain on deconsolidation of subsidiary | – | 26,322,687 | (26,322,687 | ) |\n| Merger incentive expense | – | (5,874,000 | ) | (5,874,000 | ) |\n| Interest expense, including $377,440 of warrants issued as a debt discount | (384,456 | ) | – | 384,456 |\n| Other income | 16 | 51 | (35 | ) |\n| Loss on disposal of property and equipment | (5,369 | ) | – | 5,369 |\n| Gain (loss) on investment in Allied Esports Entertainment, Inc. securities | (2,186,557 | ) | 2,094,690 | (4,281,247 | ) |\n| Total other income (expense) | (2,576,366 | ) | 22,543,428 | (25,119,794 | ) |\n| Net income (loss) from continuing operations, net of tax | (4,421,001 | ) | 18,628,011 | (23,049,012 | ) |\n| Provision for income taxes | – | – | – |\n| Net loss from continuing operations, net of tax | (4,421,001 | ) | 18,628,011 | (23,049,012 | ) |\n| Net income from discontinued operations | – | (7,421,050 | ) | (7,421,050 | ) |\n| Net loss before non-controlling interest | (4,421,001 | ) | 11,206,961 | (15,627,962 | ) |\n| Less: Net loss attributable to redeemable non-controlling interest | – | (1,332,529 | ) | (1,332,529 | ) |\n| Net loss attributable to Black Ridge Oil & Gas, Inc. | (4,421,001 | ) | $ | 9,874,432 | $ | (14,295,433 | ) |\n\n\n| 23 |\n\nManagement fee income\nThe Company did not earn any management fees from its management agreement with BRAC during the nine months ended September 30, 2020, compared to $153,279 during the nine months ended September 30, 2019. The decrease is attributable to the termination of the agreement subsequent to the merger between BRAC and AESE on August 9, 2019.\nGeneral and administrative expenses\nSalaries and benefits\nSalaries and benefits for the nine months ended September 30, 2020 were $936,304, compared to $910,191 for the nine months ended September 30, 2019, an increase of $26,113, or 3%. The increase in salaries and benefits was primarily due to payroll taxes on the distribution of AESE shares to employees in the current period pursuant to the Management Incentive Plan and accrued severance pay to former officers and employees.\nStock-based compensation\nStock-based compensation expense for the nine months ended September 30, 2020 was $393,831, compared to $2,892,738 for the nine months ended September 30, 2019, a decrease of $2,498,907, or 86%. Stock-based compensation consisted of stock options expense in both periods, and $2,809,033 of expense related to the 2018 Management Incentive Plan in the prior period. Amortization of stock options increased as new options were granted toward the end of February 2020, with a five-year vesting period, and the vesting period was accelerated pursuant to separation agreements entered into on September 30, 2020.\nProfessional services\nGeneral and administrative expenses related to professional services were $327,090 for the 2020 period, compared to $79,978 for the 2019 period, an increase of $247,112, or 309%. The increase was primarily due to professional services related to our asset purchase agreement with S-FDF, LLC.\nOther general and administrative expenses\nOther general and administrative expenses for the nine months ended September 30, 2020 was $186,380, compared to $185,035 for the nine months ended September 30, 2019, an increase of $1,345, or 1%.\nDepreciation\nDepreciation expense for the nine months ended September 30, 2020 was $1,030, compared to $754 for the nine months ended September 30, 2019, an increase of $276, or 37%. The increase is attributable to the addition of new computer equipment in 2020.\n\n| 24 |\n\nOther income (expense)\nIn the nine months ended September 30, 2020, other expense was $2,576,366, consisting of $384,456 of interest expense derived from the business loans the Company received from Cadence Bank, N.A, RBC Capital Markets, LLC and additional operating loans from the PPP and EIDL programs, including $377,440 of expense related to the amortization of warrants issued in consideration of personal guarantees provided for debt financing, a loss on the disposal of equipment of $5,369, along with a net loss on investments in Allied Esports Entertainment, Inc. of $2,186,557, as offset by $16 of interest income, compared to other income of $22,543,428 during the nine months ended September 30, 2019, consisting of the $26,322,687 gain upon deconsolidation of BRAC and an offsetting merger incentive expense of $5,874,000 to recognize the cost related to transferring shares of AESE stock to the former owners of Allied Esports and WPT and other investors as incentive to participate in the merger, interest income of $51 and a gain of $2,094,690 on the investment in Allied Esports Entertainment, Inc. pursuant to the change in fair market value the AESE shares.\nProvision for income taxes\nThe Company had no income tax expense in the 2020 or 2019 periods, as the Company continues to reserve against any deferred tax assets due to the uncertainty of realization of any benefit.\nNet income from discontinued operations\nNet income from discontinued operations relates to the income and expenses of BRAC during the periods prior to deconsolidation. Net income from discontinued operations of $7,421,050 during the nine months ended September 30, 2019.\nLiquidity and Capital Resources\nThe following table summarizes our total current assets, liabilities and working capital at September 30, 2020 and December 31, 2019, respectively.\n\n| September 30, | December 31, |\n| 2020 | 2019 |\n| Current Assets | $ | 2,685,000 | $ | 7,138,712 |\n| Current Liabilities | $ | 373,101 | $ | 1,446,407 |\n| Working Capital | $ | 2,311,899 | $ | 5,692,305 |\n\nAs of September 30, 2020, we had working capital of $2,311,899.\n\n| 25 |\n\nThe following table summarizes our cash flows during the nine-month periods ended September 30, 2020 and 2019, respectively.\n\n| Nine Months Ended |\n| September 30, |\n| 2020 | 2019 |\n| Net cash used in operating activities | $ | (1,111,648 | ) | $ | (9,759,160 | ) |\n| Net cash provided by investing activities | 1,157,076 | 6,888,299 |\n| Net cash provided by financing activities | 262,925 | 1,431,974 |\n| Net change in cash and cash equivalents | $ | 308,353 | $ | (1,438,887 | ) |\n\nNet cash used in operating activities was $1,111,648 and $9,759,160 for the nine months ended September 30, 2020 and 2019, respectively, a period over period improvement of $8,647,512. The decrease was primarily due to a decrease of $8,618,568 in net losses in discontinued operations of BRAC. Changes in working capital from continuing operating activities resulted in a decrease in cash of $169,715 in the nine months ended September 30, 2020, as compared to a decrease in cash of $181,718 for the same period in the previous year.\nNet cash provided by investing activities were $1,157,076 and $6,888,299 for the nine months ended September 30, 2020 and 2019, respectively. Cash provided by investing activities were comprised of proceeds of $1,157,076 from the sale of Allied Esports Entertainment, Inc. securities during the nine months ended September 30, 2020. In the comparative period ended September 30, 2019, virtually all the cash was provided from discontinued operations and was the result of transfers and withdrawals from the Trust Account.\nNet cash provided by financing activities was $262,925 and $1,431,974 for the nine months ended September 30, 2020 and 2019, respectively. All of the 2020 activity was the result of $802,025 of net proceeds from notes payable, as offset by $539,100 of repayments, compared to $1,431,974 of cash provided by financing activities from discontinued operations in the comparative nine months ended September 30, 2019.\nSatisfaction of our cash obligations for the next 12 months\nAs of September 30, 2020, our balance of cash was $417,109 and we had total working capital of $2,311,899. We expect to incur significant costs related to the freeze-dried fruit Asset Purchase Agreement which closed on October 1, 2020, which will put a strain on our cash resources. Our plan for satisfying our cash requirements for the next twelve months is through cash on hand and the sale of its AESE shares, however, there can be no assurance the share price will be sufficient to cover our cash obligations for the next 12 months, therefore, additional financing in the form of equity or debt may be needed. The Company realized $1,157,076 of proceeds on the sale of 469,968 shares of AESE stock and 505,000 AESEW warrants, and received proceeds of $112,925 on a PPP loan and $150,000 of proceeds on an EIDL loan to be used as working capital to alleviate economic injury caused by COVID-19 during the second quarter of 2020. Pursuant to the Asset Purchase Agreement we entered into with S-FDF, LLC on June 9, 2020, we will need to contribute $4 million to the business in the form of proceeds from either the sale of Sponsor Shares after October 1, 2020, proceeds from a financing secured by the AESE Shares after June 9, 2020, proceeds from an equity or convertible debt financing, legal fees paid in connection with the Asset Purchase Agreement, expenses incurred by the Company after August 1, 2020 (except for severance related to change in control payments made to the Company's employees), and the Company's cash as of October 1, 2020 (the “Company Contribution”). If the Company Contribution is less than $4 million on January 1, 2021, then the Final Determination Date will be January 1, 2021. The net fair value of the Sponsor Shares is approximately $1.8 million currently, however, there can be no assurance we will be able to realize these proceeds upon the sale of the securities.\n\n| 26 |\n\nOff-Balance Sheet Arrangements\nWe have no off-balance sheet arrangements.\nCritical Accounting Policies and Estimates\nOur management’s discussion and analysis of financial conditions and results of operations is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, or GAAP. The preparation of these financial statements required us to make estimates and judgments that affect the reported amounts of assets, liabilities and expenses. On an ongoing basis, we evaluate these estimates and judgments. We base our estimates on our historical experience and on various other assumptions that we believe to be reasonable under the circumstances. These estimates and assumptions form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results and experiences may differ materially from these estimates.\nOur critical accounting policies are more fully described in Note 2 of the footnotes to our financial statements appearing elsewhere in this Form 10-Q, and Note 2 of the footnotes to the financial statements provided in our Annual Report on Form 10-K/A for the fiscal year ended December 31, 2019.\n\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide the information required by this Item\n\nWe maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed by the Company is recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission.\nOur management, under the direction of our Chief Executive Officer and Interim Chief Financial Officer has evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as such terms are defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of September 30, 2020. As part of such evaluation, management considered the matters discussed below relating to internal control over financial reporting. Based on this evaluation our management, including the Company’s Chief Executive Officer and Interim Chief Financial Officer, has concluded that the Company’s disclosure controls and procedures were effective as of September 30, 2020 to ensure that the information required to be disclosed in our Exchange Act reports was recorded, processed, summarized and reported on a timely basis.\nThere have been no changes in the Company’s internal control over financial reporting during the nine-month period ended September 30, 2020 that materially affected or are reasonably likely to materially affect the Company’s internal control over financial reporting.\n\n| 27 |\n\nPART II - OTHER INFORMATION\n\nITEM 1A.\nRISK FACTORS\n28\n\nNone.\n\nNone.\n\nNot applicable.\n\n| 31 |\n\n\nNone.\n\n\n| Exhibit | Description |\n| 3.1 | Certificate of Incorporation (incorporated by reference to Exhibit 3.1 of the Form 8-K filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on December 12, 2012) |\n| 3.2 | Bylaws (incorporated by reference to Exhibit 3.2 of the Form 8-K filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on December 12, 2012) |\n| 3.3 | Certificate of Amendment to Articles of Incorporation (incorporated by reference to Exhibit 3.1 of the Form 8-K filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on February 21, 2020) |\n| 10.1 | Business Loan Agreement dated March 10, 2020, between Cadence Bank, N.A. and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.1 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on May 15, 2020) |\n| 10.2 | Promissory Note dated March 10, 2020, between Cadence Bank, N.A. and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.2 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on May 15, 2020) |\n| 10.3 | Commercial Pledge and Security Agreement dated March 10, 2020, between Cadence Bank, N.A. and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.3 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on May 15, 2020) |\n| 10.4 | Form of Commercial Guaranty dated March 10, 2020, between Cadence Bank, N.A. and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.4 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on May 15, 2020) |\n| 10.5 | Asset Purchase Agreement dated June 9, 2020, between S-FDF, LLC and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.2 of the Form SC 13D/A filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on June 17, 2020) |\n| 10.6 | Amendment to Asset Purchase Agreement dated October 1, 2020, between S-FDF, LLC and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 2.1 of the Form 8-K filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on October 6, 2020) |\n| 10.7 | Promissory Note dated April 24, 2020, between Kensington Bank and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.6 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on August 11, 2020) |\n| 10.8 | Promissory Note dated June 16, 2020, between the U.S. Small Business Administration and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.7 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on August 11, 2020) |\n| 10.9 | Security Agreement dated June 16, 2020, between the U.S. Small Business Administration and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.8 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on August 11, 2020) |\n| 10.10 | Loan Authorization & Agreement dated June 16, 2020, between the U.S. Small Business Administration and Black Ridge Oil & Gas, Inc. (incorporated by reference to Exhibit 10.9 of the Form 10-Q filed with the Securities and Exchange Commission by Black Ridge Oil & Gas, Inc. on August 11, 2020) |\n| 10.11* | Amended and Restated Employment Agreement dated September 30, 2020, between Kenneth DeCubellis and Black Ridge Oil & Gas, Inc |\n| 10.12* | Separation Agreement and Release dated September 30, 2020, between Michael Eisele and Black Ridge Oil & Gas, Inc. |\n| 31.1* | Section 302 Certification of Chief Executive Officer |\n| 31.2* | Section 302 Certification of Interim Chief Financial Officer |\n| 32.1* | Section 906 Certification of Chief Executive Officer |\n| 32.2* | Section 906 Certification of Interim Chief Financial Officer |\n| 101.INS* | XBRL Instance Document |\n| 101.SCH* | XBRL Schema Document |\n| 101.CAL* | XBRL Calculation Linkbase Document |\n| 101.DEF* | XBRL Definition Linkbase Document |\n| 101.LAB* | XBRL Labels Linkbase Document |\n| 101.PRE* | XBRL Presentation Linkbase Document |\n\n*Filed herewith\n\n| 32 |\n\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| BLACK RIDGE OIL & GAS, INC. |\n| Dated: November 12, 2020 | By: | /s/ Claudia Goldfarb |\n| Claudia Goldfarb, Chief Executive Officer (Principal Executive Officer) |\n| By: | /s/ Brad Burke |\n| Interim Chief Financial Officer (Principal Financial Officer) |\n\n\n| 33 |\n\n</text>\n\nWhat will be the potential dilutive common shares increase (in units) if the company decides to issue common stock options to its CEO Michael Eisele representing 2.8% of shares?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
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doc-math
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"ground_truth": "Therefore, the answer is 44812.0."
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docmath_20000_40000
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"content": "\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial Statements (Unaudited).\nShoals Technologies Group, Inc.\nCondensed Consolidated Balance Sheets (Unaudited)\n(in thousands, except shares)\n| June 30,2021 | December 31, 2020 |\n| Assets |\n| Current Assets |\n| Cash and cash equivalents | $ | 13,171 | $ | 10,073 |\n| Accounts receivable, net | 42,977 | 27,004 |\n| Unbilled receivables | 6,797 | 3,794 |\n| Inventory, net | 21,272 | 15,121 |\n| Other current assets | 7,292 | 155 |\n| Total Current Assets | 91,509 | 56,147 |\n| Property, plant and equipment, net | 13,622 | 12,763 |\n| Goodwill | 50,176 | 50,176 |\n| Other intangible assets, net | 67,996 | 71,988 |\n| Deferred tax asset | 49,573 | — |\n| Other assets | 840 | 4,236 |\n| Total Assets | $ | 273,716 | $ | 195,310 |\n| Liabilities and Stockholders' Deficit / Members’ Deficit |\n| Current Liabilities |\n| Accounts payable | $ | 14,224 | $ | 14,634 |\n| Accrued expenses | 9,499 | 5,967 |\n| Long-term debt—current portion | 3,500 | 3,500 |\n| Total Current Liabilities | 27,223 | 24,101 |\n| Revolving line of credit | 49,000 | 20,000 |\n| Long-term debt, less current portion | 188,859 | 335,332 |\n| Payable Pursuant to the Tax Receivable Agreement | 43,356 | — |\n| Total Liabilities | 308,438 | 379,433 |\n| Commitments and Contingencies (Note 12) |\n| Stockholders’ Deficit / Members’ Deficit |\n| Members’ deficit | — | ( 184,123 ) |\n| Preferred stock, $ 0.00001 par value - 5,000,000 shares authorized; none issued and outstanding as of June 30, 2021 | — | — |\n| Class A common stock, $ 0.00001 par value - 1,000,000,000 shares authorized; 93,545,564 shares issued and outstanding as of June 30, 2021 | 1 | — |\n| Class B common stock, $ 0.00001 par value - 195,000,000 shares authorized; 73,066,607 shares issued and outstanding as of June 30, 2021 | 1 | — |\n| Additional paid-in capital | 78,883 | — |\n| Accumulated deficit | ( 93,782 ) | — |\n| Total stockholders’ deficit attributable to Shoals Technologies Group, Inc. / members' deficit | ( 14,897 ) | ( 184,123 ) |\n| Non-controlling interests | ( 19,825 ) | — |\n| Total stockholders’ deficit / members’ deficit | ( 34,722 ) | ( 184,123 ) |\n| Total Liabilities and Stockholders’ Deficit / Members’ Deficit | $ | 273,716 | $ | 195,310 |\n\nSee accompanying notes to condensed consolidated financial statements.\n1\nShoals Technologies Group, Inc.\nCondensed Consolidated Statements of Operations (Unaudited)\n(in thousands, except per share amounts)\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Revenue | $ | 59,722 | $ | 43,427 | $ | 105,326 | $ | 84,167 |\n| Cost of revenue | 33,543 | 26,598 | 60,373 | 53,152 |\n| Gross profit | 26,179 | 16,829 | 44,953 | 31,015 |\n| Operating Expenses |\n| General and administrative expenses | 10,018 | 9,317 | 16,834 | 11,875 |\n| Depreciation and amortization | 2,062 | 2,064 | 4,130 | 4,125 |\n| Total Operating Expenses | 12,080 | 11,381 | 20,964 | 16,000 |\n| Income from Operations | 14,099 | 5,448 | 23,989 | 15,015 |\n| Interest expense, net | ( 3,620 ) | ( 225 ) | ( 7,329 ) | ( 497 ) |\n| Tax receivable agreement liability adjustment | ( 1,664 ) | — | ( 1,664 ) | — |\n| Loss on debt repayment | — | — | ( 15,990 ) | — |\n| Income (loss) before income taxes | 8,815 | 5,223 | ( 994 ) | 14,518 |\n| Income tax benefit | 339 | — | 1,814 | — |\n| Net income | 9,154 | 5,223 | 820 | 14,518 |\n| Less: net income (loss) attributable to non-controlling interests | 4,596 | — | ( 879 ) | — |\n| Net income attributable to Shoals Technologies Group, Inc. | $ | 4,558 | $ | 5,223 | $ | 1,699 | $ | 14,518 |\n| Three Months EndedJune 30, 2021 | Period from January 27, 2021 to June 30, 2021 |\n| Earnings per share of Class A common stock: |\n| Basic | $ | 0.05 | $ | ( 0.01 ) |\n| Diluted | $ | 0.05 | $ | ( 0.01 ) |\n| Weighted average shares of Class A common stock outstanding: |\n| Basic | 93,544 | 93,542 |\n| Diluted | 166,827 | 93,542 |\n\nSee accompanying notes to condensed consolidated financial statements.\n2\nShoals Technologies Group, Inc.\nCondensed Consolidated Statements of Changes in Members’ / Stockholders’ Equity (Deficit) (Unaudited)\n(in thousands, except shares)\nFor the three and six months ended June 30, 2021\n| Members' Deficit | Class ACommon Stock | Class BCommon Stock | Additional Paid-In Capital | Accumulated Deficit | Non-Controlling Interest | Total Members'/Stockholders Deficit |\n| Shares | Amount | Shares | Amount |\n| Balance atDecember 31, 2020 | $ | ( 184,123 ) | — | $ | — | — | $ | — | $ | — | $ | — | $ | — | $ | ( 184,123 ) |\n| Net income prior to the Organizational Transactions | 2,675 | — | — | — | — | — | — | — | 2,675 |\n| Effect of Organizational Transactions | 181,448 | 81,977,751 | 1 | 78,300,817 | 1 | — | ( 92,806 ) | ( 88,644 ) | — |\n| Issuance of Class A common stock sold in IPO, net of underwriting discounts and commissions and offering costs | — | 11,550,000 | — | ( 5,234,210 ) | — | 70,188 | — | 70,976 | 141,164 |\n| Net loss subsequent to the Organizational Transactions | — | — | — | — | — | — | ( 5,534 ) | ( 5,475 ) | ( 11,009 ) |\n| Equity-based compensation recognized subsequent to the Organizational Transactions | — | — | — | — | — | 1,392 | — | — | 1,392 |\n| Activity under stock compensation plan | — | 11,941 | — | — | — | ( 687 ) | — | 550 | ( 137 ) |\n| Deferred tax adjustment related to Tax Receivable Agreement | — | — | — | — | — | 7,180 | — | — | 7,180 |\n| Balance atMarch 31, 2021 | — | 93,539,692 | 1 | 73,066,607 | 1 | 78,073 | ( 98,340 ) | ( 22,593 ) | ( 42,858 ) |\n| Net income | — | — | — | — | — | — | 4,558 | 4,596 | 9,154 |\n| Equity-based compensation | — | — | — | — | — | 1,955 | — | — | 1,955 |\n| Activity under stock compensation plan | — | 5,872 | — | — | — | ( 857 ) | — | 857 | — |\n| Distributions to Non-controlling interest | — | — | — | — | — | — | — | ( 2,973 ) | ( 2,973 ) |\n| Reallocation of non-controlling interest | — | — | — | — | — | ( 288 ) | — | 288 | — |\n| Balance atJune 30, 2021 | $ | — | 93,545,564 | $ | 1 | 73,066,607 | $ | 1 | $ | 78,883 | $ | ( 93,782 ) | $ | ( 19,825 ) | $ | ( 34,722 ) |\n\n3\nShoals Technologies Group, Inc.\nCondensed Consolidated Statements of Changes in Members’ / Stockholders’ Equity (Deficit) (Unaudited) (continued)\n(in thousands, except shares)\nFor the three and six months ended June 30, 2020\n| Members' Equity |\n| Balance at December 31, 2019 | $ | 149,906 |\n| Member distributions | ( 214 ) |\n| Equity-based compensation | — |\n| Net income | 9,295 |\n| Balance at March 31, 2020 | 158,987 |\n| Member distributions | — |\n| Equity-based compensation | 6,704 |\n| Net income | 5,223 |\n| Balance at June 30, 2020 | $ | 170,914 |\n\nSee accompanying notes to condensed consolidated financial statements.\n4\nShoals Technologies Group, Inc.\nCondensed Consolidated Statements of Cash Flows (Unaudited)\n(in thousands)\n| Six Months Ended June 30, |\n| 2021 | 2020 |\n| Cash Flows from Operating Activities |\n| Net income | $ | 820 | $ | 14,518 |\n| Adjustments to reconcile net income to net cash provided by (used in) operating activities: |\n| Depreciation and amortization | 4,808 | 4,656 |\n| Amortization/write off of deferred financing costs | 5,415 | 21 |\n| Equity-based compensation | 4,172 | 6,704 |\n| Deferred taxes | ( 524 ) | — |\n| Tax receivable agreement liability adjustment | 1,664 | — |\n| Gain on sale of assets | 61 | — |\n| Changes in assets and liabilities: |\n| Accounts receivable | ( 15,973 ) | 21 |\n| Unbilled receivables | ( 3,003 ) | ( 4,970 ) |\n| Inventory | ( 6,151 ) | ( 3,356 ) |\n| Other assets | ( 4,631 ) | 515 |\n| Accounts payable | ( 410 ) | ( 1,494 ) |\n| Accrued expenses | ( 362 ) | 2,313 |\n| Net Cash Provided by (Used in) Operating Activities | ( 14,114 ) | 18,928 |\n| Cash Flows Used In Investing Activities |\n| Purchases of property, plant and equipment | ( 1,736 ) | ( 1,345 ) |\n| Net Cash Used in Investing Activities | ( 1,736 ) | ( 1,345 ) |\n| Cash Flows from Financing Activities |\n| Member / non-controlling interest distributions | ( 2,973 ) | ( 214 ) |\n| Employee withholding taxes related to net settled equity awards | ( 137 ) | — |\n| Deferred financing costs | ( 94 ) | — |\n| Payments on term loan facility | ( 151,750 ) | — |\n| Proceeds from revolving credit facility | 34,000 | — |\n| Repayments of revolving credit facility | ( 5,000 ) | — |\n| Payments on senior debt - term loan | — | ( 1,747 ) |\n| Payments on senior debt - revolving line of credit | — | ( 8,400 ) |\n| Proceeds from issuance of Class A common stock sold in an IPO, net of underwriting discounts and commissions | 154,521 | — |\n| Deferred offering costs | ( 9,619 ) | — |\n| Net Cash Provided by (Used in) Financing Activities | 18,948 | ( 10,361 ) |\n| Net Increase in Cash and Cash Equivalents | 3,098 | 7,222 |\n| Cash and Cash Equivalents—Beginning of Period | 10,073 | 7,082 |\n| Cash and Cash Equivalents—End of Period | $ | 13,171 | $ | 14,304 |\n\n5\nShoals Technologies Group, Inc.\nCondensed Consolidated Statements of Cash Flows (Unaudited) (continued)\n(in thousands)\n| Six Months Ended June 30, |\n| 2021 | 2020 |\n| Supplemental Cash Flows Information: |\n| Cash paid for interest | $ | 5,634 | $ | 476 |\n| Cash paid for taxes | $ | 1,120 | $ | — |\n| Non-cash financing activities: |\n| Reclassification of deferred offering costs to additional paid-in capital | $ | 3,736 | $ | — |\n| Initial establishment of deferred tax assets | $ | 49,049 | $ | — |\n| Initial establishment of amounts payable under tax receivable agreement | $ | 41,692 | $ | — |\n| Capital contribution related to tax receivable agreement | $ | 7,178 | $ | — |\n| Income tax receivable from merger due to former owner | $ | 3,069 | $ | — |\n\nSee accompanying notes to condensed consolidated financial statements.\n6\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\n1. Organization and Business\nShoals Technologies Group, Inc. (the “Company”) was formed as a Delaware corporation on November 4, 2020 for the purpose of facilitating an initial public offering (\"IPO\") and other related organizational transactions to carry on the business of Shoals Parent LLC and its subsidiaries (“Shoals Parent”).\nShoals Parent is a Delaware limited liability company formed on May 9, 2017. The Company is headquartered in Portland, Tennessee and is a manufacturer of electrical balance of systems (“EBOS”) solutions and components related to solar fields selling to customers across the United States and internationally. Shoals Parent, through its wholly-owned subsidiaries, Shoals Intermediate Holdings LLC (“Intermediate”) and Shoals Holdings LLC (“Holdings”) owns four other subsidiaries through which it conducts substantially all operations: Shoals Technologies, LLC, Shoals Technologies Group, LLC, Solon, LLC, and Shoals Structures, LLC (collectively “Shoals”). Shoals Parent acquired Shoals on May 25, 2017.\nInitial Public Offering\nOn January 29, 2021, the Company closed an IPO of 11,550,000 shares of Class A common stock at a public offering price of $ 25.00 per share, including shares issued pursuant to the underwriters' over-allotment option. The Company received $ 278.8 million in proceeds, net of underwriting discounts and commissions of $ 9.9 million, which was used to purchase 6,315,790 newly-issued membership interests (the “LLC Interests”) from Shoals Parent and 5,234,210 LLC Interests from the founder and Class B unit holder in Shoals Parent at a price per interest equal to the IPO price of $ 25.00 per share. Subsequent to the IPO and related organizational transactions that occurred in connection with the IPO, the Company is the sole managing member of, and had a 56.14 % economic interest in, Shoals Parent.\nOrganizational Transactions\nIn connection with the IPO, the Company and Shoals Parent completed a series of transactions (the \"Organizational Transactions\") including the following:\n•the limited liability company agreement of Shoals Parent was amended and restated to, among other things, (i) provide for a new single class of common membership interests or the LLC Interests in Shoals Parent, (ii) exchange all of the then existing membership interests of the holders of Shoals Parent membership interests for LLC Interests and (iii) appoint the Company as the sole managing member of Shoals Parent;\n•the Company's certificate of incorporation was amended and restated to, among other things, (i) provide for Class A common stock with voting and economic rights (ii) provide for Class B common stock with voting rights but no economic rights and (iii) issue 78,300,817 shares of Class B common stock to the former Class B and Class C members of Shoals Parent (the “Continuing Equity Owners”) on a one -to-one basis with the number of LLC Interests they own;\n•the acquisition, by merger, of Shoals Investment CTB or the former Class A member of Shoals Parent (the \"Class A Shoals Equity Owners\"), for which the Company issued 81,977,751 shares Class A common stock as merger consideration (the \"Merger\").\nImmediately following the completion of the IPO and Organizational Transactions, the Company owned 56.14 % of Shoals Parent. The Continuing Equity Owners owned the remaining 43.86 % of Shoals Parent.\n2. Summary of Accounting Policies\n7\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\nBasis of Accounting and Presentation\nThe condensed consolidated financial statements have been prepared on the accrual basis of accounting in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”).\nPrinciples of Consolidation\nThe condensed consolidated financial statements include the accounts of the Company and its subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.\nNon-controlling Interest\nThe non-controlling interest on the condensed consolidated statement of operations represents the portion of earnings or loss attributable to the economic interest in the Company's subsidiary, Shoals Parent, held by the Continuing Equity Owners. Non-controlling interest on the condensed consolidated balance sheet represents the portion of net assets of the Company attributable to the Continuing Equity Owners, based on the portion of the LLC Interests owned by such unit holders. As of June 30, 2021, the non-controlling interest was 43.86 %.\nUnaudited Interim Financial Information\nThe accompanying condensed consolidated balance sheets as of June 30, 2021 and December 31, 2020, the statements of operations, stockholders’ deficit / members’ deficit and cash flows for the periods ended June 30, 2021 and 2020 are unaudited. The unaudited interim financial statements have been prepared on the same basis as the audited annual financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary for the fair statement of the Company’s financial position as of June 30, 2021 and the results of its operations and its cash flows for the periods ended June 30, 2021 and 2020. The financial data and other information disclosed in these notes related to the periods ended June 30, 2021 and 2020 are also unaudited. The results for the three and six months ended June 30, 2021 are not necessarily indicative of results to be expected for the year ending December 31, 2021, any other interim periods, or any future year or period. The balance sheet as of December 31, 2020 included herein was derived from the audited financial statements as of that date. Certain disclosures have been condensed or omitted from the interim financial statements. These financial statements should be read in conjunction with the Company’s consolidated financial statements and related notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2020.\nUse of Estimates\nThe preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates include revenue recognition, allowance for doubtful accounts, useful lives of property, plant and equipment and other intangible assets, impairment of long-lived assets, the reserve for excess and obsolete inventory, the tax receivable agreement, and valuation of deferred tax assets.\nImpact of COVID-19 Pandemic\n8\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\nThe global health crisis caused by the novel coronavirus COVID-19 pandemic and its resurgences has and may continue to negatively impact global economic activity, which, despite progress in vaccination efforts, remains uncertain and cannot be predicted with confidence. In addition, a new Delta variant of COVID-19, which appears to be the most transmissible variant to date, has begun to spread globally.\nTo date, the Company has maintained uninterrupted business operations with normal turnaround times for its delivery of solar EBOS solutions and components. The Company has implemented adjustments to its operations designed to keep employees safe and comply with federal, state and local guidelines, including those regarding social distancing. For the three and six months ended June 30, 2021, the Company incurred $ 0.1 million and $ 0.2 million, respectively, in COVID-19 related costs (disinfecting and reconfiguration of facilities, medical professionals to conduct daily screening of employees and direct legal costs associated with the pandemic) which is included in general and administrative expenses in the accompanying condensed consolidated financial statements.\nThe impact of the Delta variant cannot be predicted at this time, and could depend on numerous factors, including vaccination rates among the population, the effectiveness of the COVID-19 vaccines against the Delta variant and the response by governmental bodies and regulators. Given the ongoing and dynamic nature of the circumstances, it is difficult to predict the impact of the COVID-19 pandemic on our business.\nCustomer Concentrations\nThe Company had the following accounts receivable concentrations as of June 30, 2021 and December 31, 2020 and revenue concentrations for the six months ended June 30, 2021 and 2020:\n| 2021 | 2020 |\n| Revenue % | AccountsReceivable % | Revenue % | AccountsReceivable % |\n| Customer A | 25.5 | % | 41.3 | % | 21.4 | % | 16.7 | % |\n| Customer B | 13.2 | % | 4.2 | % | 23.9 | % | 14.2 | % |\n| Customer C | 3.9 | % | 2.2 | % | 12.1 | % | 12.0 | % |\n| Customer D | 6.5 | % | 8.7 | % | 12.3 | % | 12.5 | % |\n| Customer E | 0.1 | % | 0.3 | % | 10.4 | % | 0.0 | % |\n\nRecent Accounting Pronouncements\nAdopted\nIn December 2019, the FASB issued ASU No. 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes (“ASU No. 2019-12”), which is intended to simplify various aspects of the accounting for income taxes. ASU No. 2019-12 removes certain exceptions to the general principles in Topic 740 and also clarifies and amends existing guidance to improve consistent application. The Company adopted ASU No. 2019-12 as of January 1, 2021 and it did not have a material impact on its consolidated financial statements and related disclosures.\nNot Yet Adopted\nIn February 2016, the FASB issued ASU No. 2016-02 (Topic 842) “Leases” which supersedes the lease recognition requirements in ASC Topic 840, “Leases.” Under ASU No. 2016-02, lessees are required to recognize assets and liabilities on the balance sheet for most leases and provide enhanced disclosures.\n9\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\nLeases will continue to be classified as either finance or operating. For companies that are not emerging growth companies (“EGCs”), the ASU is effective for fiscal years beginning after December 15, 2018. For EGCs, the ASU is effective for fiscal years beginning after December 15, 2021. The Company plans to adopt the new standard using the modified retrospective method, under which the Company will apply Topic 842 to existing and new leases as of January 1, 2022, but prior periods will not be restated and will continue to be reported under Topic 840 guidance in effect during those periods. The Company anticipates that the adoption will not have a material impact on its statements of operations or its statements of cash flows but expects to recognize right-of-use assets and liabilities for lease obligations associated with its operating leases.\nIn June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses, which was subsequently amended by ASU No. 2018-19 and ASU No. 2019-10, and which requires the measurement of expected credit losses for financial instruments carried at amortized cost held at the reporting date based on historical experience, current conditions and reasonable forecasts. The updated guidance also amends the current other-than-temporary impairment model for available-for-sale debt securities by requiring the recognition of impairments relating to credit losses through an allowance account and limits the amount of credit loss to the difference between a security’s amortized cost basis and its fair value. In addition, the length of time a security has been in an unrealized loss position will no longer impact the determination of whether a credit loss exists. The main objective of this ASU is to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. For EGC’s, the standard is effective for fiscal years and interim periods within those fiscal years, beginning after December 15, 2022. The Company will continue to assess the possible impact of this standard, but currently does not expect the adoption of this standard will have a significant impact on its financial statements and its limited history of bad debt expense relating to trade accounts receivable.\n3. Accounts Receivable\nAccounts receivable consists of the following (in thousands):\n| June 30,2021 | December 31, 2020 |\n| Accounts receivable | $ | 43,179 | $ | 27,206 |\n| Less: allowance for doubtful accounts | ( 202 ) | ( 202 ) |\n| Accounts receivable, net | $ | 42,977 | $ | 27,004 |\n\n4. Inventory\n| June 30,2021 | December 31, 2020 |\n| Raw materials | $ | 23,274 | $ | 17,390 |\n| Allowance for slow-moving inventory | ( 2,002 ) | ( 2,269 ) |\n| Inventory, net | $ | 21,272 | $ | 15,121 |\n\n10\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\n5. Property, Plant and Equipment\nProperty, plant, and equipment, net consists of the following (in thousands):\n| Estimated Useful Lives (Years) |\n| June 30,2021 | December 31, 2020 |\n| Land | N/A | $ | 840 | $ | 840 |\n| Building and land improvements | 5 - 40 | 5,992 | 5,621 |\n| Machinery and equipment | 3 - 5 | 10,323 | 9,028 |\n| Furniture and fixtures | 3 - 7 | 1,090 | 1,025 |\n| Vehicles | 5 | 104 | 318 |\n| 18,349 | 16,832 |\n| Less: accumulated depreciation | ( 4,727 ) | ( 4,069 ) |\n| Property, plant and equipment, net | $ | 13,622 | $ | 12,763 |\n\nDepreciation expense for the three months ended June 30, 2021 and 2020 was $ 0.4 million and $ 0.3 million, respectively. During the three months ended June 30, 2021 and 2020, $ 0.3 million and $ 0.2 million, respectively, of depreciation expense was allocated to cost of revenue. During the three months ended June 30, 2021 and 2020, $ 0.1 million and $ 0.1 million, respectively, of depreciation expense was allocated to operating expenses.\nDepreciation expense for the six months ended June 30, 2021 and 2020 was $ 0.8 million and $ 0.7 million, respectively. During the six months ended June 30, 2021 and 2020, $ 0.7 million and $ 0.5 million, respectively, of depreciation expense was allocated to cost of revenue. During the six months ended June 30, 2021 and 2020, $ 0.1 million and $ 0.2 million, respectively, of depreciation expense was allocated to operating expenses.\n6. Goodwill and Other Intangible Assets\nGoodwill\nGoodwill relates to the acquisition of Shoals. As of June 30, 2021 and December 31, 2020, goodwill totaled $ 50.2 million.\nOther Intangible Assets\nOther intangible assets consisted of the following (in thousands):\n11\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\n| Estimated Useful Lives (Years) | June 30,2021 | December 31, 2020 |\n| Amortizable: |\n| Costs: |\n| Customer relationships | 13 | $ | 52,600 | $ | 52,600 |\n| Developed technology | 13 | 34,600 | 34,600 |\n| Trade names | 13 | 11,400 | 11,400 |\n| Noncompete agreements | 5 | 2,000 | 2,000 |\n| Total amortizable intangibles | 100,600 | 100,600 |\n| Accumulated amortization: |\n| Customer relationships | 16,522 | 14,499 |\n| Developed technology | 10,868 | 9,537 |\n| Trade names | 3,581 | 3,142 |\n| Noncompete agreements | 1,633 | 1,434 |\n| Total accumulated amortization | 32,604 | 28,612 |\n| Total amortizable intangibles, net | $ | 67,996 | $ | 71,988 |\n\nAmortization expense related to intangible assets amounted to $ 2.0 million and $ 2.0 million for the three months ended June 30, 2021 and 2020 and $ 4.0 million and $ 4.0 million for the six months ended June 30, 2021 and 2020, respectively.\n7. Long-Term Debt\nLong-term debt consists of the following (in thousands):\n| June 30,2021 | December 31, 2020 |\n| Term Loan Facility | $ | 198,250 | $ | 350,000 |\n| Revolving Credit Facility | 49,000 | 20,000 |\n| Senior Debt—term loan | — | — |\n| Less: deferred financing costs | ( 5,891 ) | ( 11,168 ) |\n| Total debt, net of deferred financing costs | 241,359 | 358,832 |\n| Less: current portion | ( 3,500 ) | ( 3,500 ) |\n| Long-term debt, net current portion | $ | 237,859 | $ | 355,332 |\n\nSenior Secured Credit Agreement\nOn November 25, 2020 Shoals Holdings, entered into that certain credit agreement with the lenders party thereto from time to time and Wilmington Trust, National Association, as administrative agent and collateral agent (the “Senior Secured Credit Agreement”), consisting of (i) a $ 350.0 million senior secured six-year term loan facility (the “Term Loan Facility”), (ii) a $ 30.0 million senior secured delayed draw term loan facility, which matures concurrently with the six-year Term Loan Facility (the “Delayed Draw Term Loan Facility”) and (iii) an uncommitted super senior first out revolving credit facility (the “Revolving Credit Facility”). The proceeds of the Term Loan Facility and a $ 10.0 million draw under the Delayed Draw Term Loan Facility were used to (i) make certain distributions from Shoals Holdings to Shoals Intermediate Holdings and from\n12\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\nthere to certain of the Company’s direct or indirect equity holders, (ii) pay transaction expenses, (iii) repay and terminate all outstanding commitments under the Senior Debt (as defined herein) and (iv) finance working capital and general corporate purposes.\nIn December 2020, Shoals Holdings entered into two amendments to the Senior Secured Credit Agreement in order to obtain a $ 100.0 million increase (the “Revolver Upsize”) to the Revolving Credit Facility and modify the terms of the interest rate and prepayment premium. As part of the first amendment the Company repaid and terminated all outstanding commitments under the Delayed Draw Term Loan Facility.\nOn January 29, 2021, the Company used proceeds from the IPO to repay $ 150.0 million of outstanding borrowings under the Term Loan Facility. The repayment of a portion of the borrowings under the Term Loan Facility resulted in a $ 16.0 million loss on debt repayment as the result of the $ 11.3 million prepayment premium and $ 4.7 million write-off of a portion of the deferred financing costs.\nAs of June 30, 2021, interest rates on the Term Loan facility and the Revolving credit facility were 4.25 % and 3.75 %, respectively and the Company had $ 51.0 million of availability under the Revolving Credit Facility.\nThe Senior Secured Credit Agreement contains affirmative and negative covenants, including covenants that restrict the Company’s incurrence of indebtedness, incurrence of liens, dispositions, investments, acquisitions, restricted payments, and transactions with affiliates. The Senior Secured Credit Agreement also includes customary events of default, including the occurrence of a change of control. As of June 30, 2021, the Company was in compliance with all the required covenants.\nSenior Debt\nIntermediate and subsidiaries were party to a credit agreement (the “Senior Debt Agreement” and obligations thereunder, the “Senior Debt”) under which Holdings and its subsidiaries were borrowers and Intermediate was a guarantor. The Senior Debt was collateralized by all of the assets of the guarantor and borrowers. The amended agreement provided a term loan of $ 35 million and a revolving line of credit of $ 25 million.\nOn October 8, 2020, the Company paid the outstanding amount due on the term loan and settled all obligations with respect to the Senior Debt.\nThe Senior Debt provided for an interest rate to equal the Base Rate plus margin. The Base Rate charged was the highest rate of three defined methods as follows: 1) Federal Funds Rate plus 0.5 %, 2) Fifth Third Bank N.A. Rate or 3) LIBOR Rate plus 1 %. The Base Rate ranged from 1 % to 2.5 % depending on the EBITDA Rate calculation as defined in the Senior Debt Agreement (the “EBITDA Rate calculation”) for the Federal Funds Rate. The Base Rate for the LIBOR Rate ranged from 2 % to 3.5 % depending on the EBITDA Rate calculation.\n8. Earnings (loss) per Share\nBasic earnings (loss) per share of Class A Common Stock is computed by dividing net loss attributable to the Company's losses by the weighted average number of shares of Class A Common Stock outstanding during the period. Diluted net loss per share of Class A Common Stock is computed similarly to basic net loss\n13\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\nper share except the weighted average shares outstanding are increased to include additional shares from the redemption of Class B Common Stock under the if-converted method and the assumed exercise of any common stock equivalents using the treasury stock method, if dilutive. The Company’s restricted stock units are considered common stock equivalents for this purpose.\nAll earnings prior to and up to January 26, 2021, the date of the IPO, were entirely allocable to non-controlling interest and, as a result, earnings (loss) per share information is not applicable for reporting periods prior to this date. Consequently, only the net loss allocable to Shoals Technologies Group, Inc. from the period subsequent to January 26, 2021 is included in the net loss attributable to the stockholders of Class A Common Stock for the periods ended June 30, 2021. Basic and diluted net loss per share of Class A Common Stock from January 27, 2021 to June 30, 2021 have been computed as follows (in thousands, except per share amounts):\n| Three Months Ended June 30, 2021 | Period from January 27, 2021 to June 30, 2021 |\n| Numerator: |\n| Net income (loss) attributable to Shoals Technologies Group, Inc. - basic | $ | 4,558 | $ | ( 976 ) |\n| Reallocation of net income (loss) attributable to non-controlling interests from the assumed conversion of class B common stock | 4,596 | — |\n| Net income (loss) attributable to Shoals Technologies Group, Inc. - diluted | $ | 9,154 | $ | ( 976 ) |\n| Denominator: |\n| Weighted average shares of Class A common stock outstanding - basic | 93,544 | 93,542 |\n| Effect of dilutive securities: |\n| Restricted Stock Units | 216 | — |\n| Class B Common Stock | 73,067 | — |\n| Weighted average shares of Class A common stock outstanding - diluted | 166,827 | 93,542 |\n| Earnings (loss) per share of Class A common stock - basic | $ | 0.05 | $ | ( 0.01 ) |\n| Earnings (loss) per share of Class A common stock - diluted | $ | 0.05 | $ | ( 0.01 ) |\n\nFor the period from January 27, 2021 to June 30, 2021, 1,169,601 restricted stock units and 73,066,607 Class B common stock shares were excluded from the computation of diluted loss per share of Class A common stock because the effect would have been anti-dilutive as we recorded a net loss for the period.\n9. Equity-Based Compensation\nOn January 26, 2021, the Shoals Technologies Group, Inc. 2021 Long-Term incentive Plan (the “2021 Incentive Plan”) became effective. The 2021 Incentive Plan authorized 8,768,124 new shares, subject to adjustment pursuant to the 2021 Incentive Plan.\n14\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\nSince January 26, 2021, the Company has granted 1,196,770 restricted stock units (“RSUs\") to certain employees, officers and directors of the Company. The RSUs were granted at varying prices ranging from $ 25.00 to $ 29.57 per unit and generally vest ratably over 4 years, except for some of the director grants which vest over 1 year.\nThe following table summarizes the restricted stock unit activity for the six months ended June 30, 2021 (in thousands, except per share amounts):\n| RestrictedStock Units | Weighted Average Price |\n| Outstanding at beginning of period | — | $ | — |\n| Granted | 1,196,770 | $ | 26.02 |\n| Forfeited | ( 5,297 ) | $ | 29.57 |\n| Vested | ( 21,872 ) | $ | 27.58 |\n| Outstanding at end of period | 1,169,601 | $ | 25.98 |\n\nFor the three and six months ended June 30, 2021, the Company recognized $ 2.8 million and $ 4.2 million, respectively, in equity-based compensation. As of June 30, 2021, the Company had $ 27.8 million of unrecognized compensation costs which is expected to be recognized over a period of 3.6 years.\n10. Stockholders' Deficit\nAmendment and Restatement of Certificate of Incorporation\nAs discussed in Note 1, on January 26, 2021, the Company's certificate of incorporation was amended and restated to, among other things, provide for the (i) authorization of 1,000,000,000 shares of Class A common stock with a par value of $ 0.00001 per share; (ii) authorization of 195,000,000 shares of Class B common stock with a par value of $ 0.00001 per share; (iii) authorization of 5,000,000 shares of preferred stock that may be issued from time to time by the Company's Board of Directors in one or more series; and (iv) establishment of a classified board of directors, divided into three classes, the members of which will serve for staggered terms.\nHolders of Class A common stock and Class B common stock are entitled to one vote per share and, except as otherwise required, will vote together as a single class on all matters on which stockholders generally are entitled to vote. Holders of Class B common stock are not entitled to receive dividends and will not be entitled to receive any distributions upon the liquidation, dissolution or winding up of the Company. Shares of Class B common stock may only be issued to the extent necessary to maintain the one -to-one ratio between the number of LLC Interests held by the Continuing Equity Owners and the number of shares of Class B common stock held by the Continuing Equity Owners. Shares of Class B common stock are transferable only together with an equal number of LLC Interests. Shares of Class B common stock will be canceled on a one -for-one basis if the Company, at the election of a Continuing Equity Owner, redeem or exchange LLC Interests.\nThe Company must, at all times, maintain a one -to-one ratio between the number of shares of Class A common stock issued by the Company and the number of LLC Interests owned by the Company (subject to certain exceptions for treasury shares and shares underlying certain convertible or exchangeable securities).\nInitial Public Offering\n15\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\nAs discussed in Note 1, on January 29, 2021, the Company closed an IPO of 11,550,000 shares of the Class A common stock at a public offering price of $ 25.00 per share. The Company received $ 278.8 million in proceeds, net of underwriting discounts and commissions, which was used to purchase 6,315,790 LLC Interests from Shoals Parent and 5,234,210 LLC Interests from the founder and Class B unit holder in Shoals Parent at a price per interest equal to the IPO price of the Class A common stock of $ 25.00 .\nShoals Parent Recapitalization\nAs noted above, in connection with the IPO, the limited liability company agreement of Shoals Parent was amended and restated to, among other things, (i) provide for a new single class of common membership interests in Shoals Parent, or the LLC Interests; (ii) exchange all of the then existing membership interests of the Continuing Equity Owners for LLC Interests (iii) exchange all the then existing membership interest of the Class A Shoals Equity Owners for LLC Interests and (iv) appoint the Company as the sole managing member of Shoals Parent. The Company has a majority economic interest in, is the sole managing member of, has the sole voting power in, and controls the management of Shoals Parent.\nThe amendment also requires that Shoals Parent, at all times, maintain (i) a one -to-one ratio between the number of shares of Class A common stock issued by the Company and the number of LLC Interests owned by the Company and (ii) a one -to-one ratio between the number of shares of Class B common stock owned by the Continuing Equity Owners and the number of LLC Interests owned by the Continuing Equity Owners.\nAcquisition of Former Shoals Equity Owners\nOn January 26, 2021, the Company acquired, by merger, an entity that was a member of Shoals Parent, or the Class A Shoals Equity Owners, for which the Company issued 81,977,751 shares of Class A common stock as merger consideration. The only assets held by the Class A Shoals Equity Owners were 81,977,751 LLC Interests. Upon consummation of the Merger, the Company recognized the LLC Interests at carrying value, as the Merger is considered to be a transaction between entities under common control.\n11. Non-Controlling Interests\nOn January 26, 2021, the Company used net proceeds from the IPO to purchase 6,315,790 LLC Interests from Shoals Parent and 5,234,210 LLC Interests from the founder and Class B unit holder in Shoals Parent. In addition, the Company issued 81,977,751 Class A common stock for the same number of LLC Interests as Merger consideration. Following the completion of the Organizational Transactions and as of June 30, 2021, the Company owned 56.14 % of Shoals Parent.\nThe following table summarizes the effects of the changes in ownership in Shoals Parent on equity:\n16\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\n| Three Months EndedJune 30, 2021 | Period from January 27, 2021 to June 30, 2021 |\n| Net income (loss) attributable to non-controlling interest | $ | 4,596 | $ | ( 879 ) |\n| Transfers to non-controlling interests |\n| Increase in accumulated deficit as a result of the Organizational Transactions | — | ( 88,644 ) |\n| Decrease in accumulated deficit as a result of newly issued LLC Interests in IPO | — | 70,976 |\n| Decrease in accumulated deficit as a result of activity under stock compensation plan | 857 | 1,407 |\n| Distributions to non-controlling interest | ( 2,973 ) | ( 2,973 ) |\n| Reallocation of non-controlling interest | 288 | 288 |\n| Change from net income (loss) attributable to non-controlling interest and transfers to non-controlling interest | $ | 2,768 | $ | ( 19,825 ) |\n\nIssuance of Additional LLC Interests\nUnder the first amended and restated limited liability company agreement of Shoals Parent, as amended (the \"LLC Agreement'), the Company is required to cause Shoals Parent to issue additional LLC Interests to the Company when the Company issues additional shares of Class A Common Stock. Other than as it relates to the issuance of Class A Common Stock in connection with an equity incentive program, the Company must contribute to Shoals Parent net proceeds and property, if any, received by the Company with respect to the issuance of such additional shares of Class A Common Stock. The Company must cause Shoals Parent to issue a number of LLC Interests equal to the number of shares of Class A Common Stock issued such that, at all times, the number of LLC Interests held by the Company equals the number of outstanding shares of Class A Common Stock. During the six months ended June 30, 2021, the Company caused Shoals Parent to issue to the Company a total of 6,315,790 LLC Interests in connection with the issuance of Class A common stock in the IPO and 17,813 LLC Interests for the vesting of awards granted under the Shoals Technologies Group, Inc. 2021 Long-Term Incentive Plan.\nDistributions for Taxes\nAs a limited liability company (treated as a partnership for income tax purposes), Shoals Parent does not incur significant federal, state or local income taxes, as these taxes are primarily the obligations of its members. As authorized by the LLC Agreement, Shoals Parent is required to distribute cash, to the extent that Shoals Parent has cash available, on a pro rata basis, to its members to the extent necessary to cover the members’ tax liabilities, if any, with respect to each member’s share of Shoals Parent taxable earnings. Shoals Parent makes such tax distributions to its members quarterly, based on an estimated tax rate and projected year-to-date taxable income, with a final accounting once actual taxable income or loss has been determined. During the six months ended June 30, 2021, tax distributions to non-controlling LLC Interests holders was $ 3.0 million.\n12. Commitments and Contingencies\nLitigation\n17\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\nThe Company is from time to time subject to legal proceedings and claims, which arise in the normal course of its business. In the opinion of management and legal counsel, the amount of losses that may be sustained, if any, would not have a material effect on the financial position, results of operations or cash flows of the Company.\nSurety Bonds\nThe Company provides surety bonds to various parties as required for certain transactions initiated during the ordinary course of business to guarantee the Company’s performance in accordance with contractual or legal obligations. As of June 30, 2021, the maximum potential payment obligation with regard to surety bonds was $ 11.8 million.\n13. Income Taxes\nThe Company is taxed as a subchapter C corporation and is subject to federal and state income taxes. The Company’s sole material asset is Shoals Parent, which is a limited liability company that is taxed as a partnership for US federal and certain state and local income tax purposes. Shoals Parent’s net taxable income and related tax credits, if any, are passed through to its members and included in the member’s tax returns. Shoals Parent is subject to and reports an entity level tax in Tennessee and Texas. The income tax burden on the earnings taxed to the noncontrolling interest holders is not reported by the Company in its consolidated financial statements under U.S. GAAP. As a result, the Company’s effective tax rate differs materially from the statutory rate. The Company’s income tax provision was a benefit of $ 0.3 million and $ 1.8 million for the three and six months ended June 30, 2021, respectively, and the effective tax rate is primarily impacted by the allocation of income taxes to the noncontrolling interest, benefit of the foreign derived intangible income and changes in our valuation allowance. The tax benefit for the three and six months ended June 30, 2021 includes $ 2.0 million of deferred income tax benefit resulting from an increase in the blended state income tax rate.\nAs of June 30, 2021, the Company had recorded a deferred tax asset related to the partnership basis differences in Shoals Parent of $ 49.6 million net of a $ 6.3 million valuation allowance. The Company also recorded an income tax receivable of $ 5.4 million of which the Company estimates $ 3.1 million is owed to the prior owner related to taxes paid prior to the IPO transaction.\nIn calculating the provision for interim income taxes, in accordance with ASC Topic 740, an estimated annual effective tax rate is applied to year-to-date ordinary income. At the end of each interim period, the Company estimates the effective tax rate expected to be applicable for the full fiscal year. This differs from the method utilized at the end of an annual period.\nFor annual periods, the Company accounts for income taxes using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. In assessing the realizability of deferred tax assets, management considers whether it is more-likely-than-not that the deferred tax assets will be realized. Deferred tax assets and liabilities are calculated by applying existing tax laws and the rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in the year of the enacted rate change.\n18\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\nThe Company accounts for uncertainty in income taxes using a recognition and measurement threshold for tax positions taken or expected to be taken in a tax return, which are subject to examination by federal and state taxing authorities. The tax benefit from an uncertain tax position is recognized when it is more likely than not that the position will be sustained upon examination by taxing authorities based on the technical merits of the position. The amount of the tax benefit recognized is the largest amount of the benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. The effective tax rate and the tax basis of assets and liabilities reflect management’s estimates of the ultimate outcome of various tax uncertainties. The Company recognizes penalties and interest related to uncertain tax positions within the provision (benefit) for income taxes line in the accompanying consolidated statements of operations. As of the quarter ended June 30, 2021, no uncertain tax positions have been recorded. The Company will continue to monitor this position each interim period.\nThe Company files U.S. federal and certain state income tax returns. The income tax returns of the Company are subject to examination by U.S. federal and state taxing authorities for various time periods, depending on those jurisdictions’ rules, generally after the income tax returns are filed.\n14. Tax Receivable Agreement\nIn connection with the Organization Transactions and the IPO, the Company entered into a tax receivable agreement (the “TRA”) with the founder and former equity owners of Shoals Investment CTB (the “TRA Owners”). The TRA provides for the payment from time to time by the Company to the TRA Owners of 85 % of the amount of the benefits, if any, that the Company has deemed to realize as a result of (i) increases in tax basis resulting from the purchase or exchange of LLC Interests and other qualifying transactions. These payment obligations are obligations of the Company and not of Shoals Parent. For purposes of the TRA, the benefit deemed realized by the Company will generally be computed by comparing the actual income tax liability of the Company (calculated with certain assumptions) to the amount of such taxes that the Company would have been required to pay had there been no increase to the tax basis of the assets of Shoals Parent as a result of the purchases or exchanges, and had the Company not entered into the TRA.\nThe TRA further provides that, upon certain mergers, asset sales or other forms of business combinations or other changes of control, the Company (or its successor) would owe to the TRA Owners a lump-sum payment equal to the present value of all forecasted future payments that would have otherwise been made under the TRA that would be based on certain assumptions, including a deemed exchange of Shoals Parent LLC Interests and that the Company would have sufficient taxable income to fully utilize the deductions arising from the increased tax basis and other tax benefits related to entering into the TRA. The Company also is entitled to terminate the TRA, which, if terminated, would obligate the Company to make early termination payments to the TRA Owners.\nOn January 26, 2021, the Company acquired 5,234,210 LLC Interests from the founder. This acquisition triggered a tax basis increase subject to the provisions of the TRA. In the first quarter of fiscal year 2021, the Company recognized (i) a deferred tax asset in the amount of $ 32.1 million, (ii) a corresponding liability of $ 27.2 million, representing 85 % of the tax benefits to the TRA Owners and (iii) $ 4.9 million of additional paid-in capital.\nOn January 26, 2021, in connection with the merger with Shoals Investment CTB, the Company distributed 85 % of the value in the tax basis from the original acquisition of Shoals Parent by Shoals investment CTB in 2017 to the holders of the TRA. In the first quarter of fiscal year 2021, the Company\n19\nShoals Technologies Group, Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)\nrecognized (i) a deferred tax asset of $ 16.9 million, (ii) a corresponding liability of $ 14.4 million representing 85 % of the tax benefits to the TRA Owners and (iii) $ 2.5 million of additional paid-in capital.\nDuring the second quarter, the TRA liability was increased by $ 1.7 million resulting from an estimated increase in the Company’s blended state income tax rate. As a result of the adjustment to the Tax Receivable Agreement liability, the Company recorded approximately $ 1.7 million of other expense in the Condensed Consolidated Statement of Operations for the six months ended June 30, 2021. As of June 30, 2021, the amount of Tax Receivable Agreement payments due under the Tax Receivable Agreement was $ 43.4 million.\n15. Revenue by Product\nBased on Topic 606 provisions, the Company disaggregates its revenue from contracts with customers between system solutions and components. System solutions are contracts under which the Company provides multiple products typically in connection with the design and specification of an entire EBOS system. Components represents sales of individual solar components.\nThe following table presents the Company’s revenue disaggregated by system solutions and solar components which are recorded over time as follows (in thousands):\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| System solutions | $ | 51,242 | $ | 31,626 | $ | 84,611 | $ | 54,419 |\n| Solar components | 8,480 | 11,801 | 20,715 | 29,748 |\n| Total revenue | $ | 59,722 | $ | 43,427 | $ | 105,326 | $ | 84,167 |\n\n16. Subsequent Events\nFollow On Offering / Tax Receivable Agreement\nIn July 2021, the Company completed a follow-on offering consisting of 4,989,692 shares of Class A common stock offered by the selling shareholders and 10,402,086 shares of Class A common stock offered by the Company. The Company used the proceeds of the sale of Class A common stock to purchase an equal number of LLC Interests and Class B common stock corresponding to such number of LLC Interests from our founder and management. The Company obtains an increase in its share of the tax basis of the assets of Shoals Parent when LLC Interests and Class B common stock corresponding to such number of LLC Interests are redeemed or exchanged. This increase in tax basis may have the effect of reducing the amounts that the Company would otherwise pay in the future to various tax authorities. The increase in tax basis may also decrease gains (or increase losses) on future dispositions of certain capital assets to the extent tax basis is allocated to those capital assets. The exchange of 10,402,086 LLC Interests and shares of Class B common stock corresponding to such number of LLC Interests triggered a tax basis increase subject to the provisions of the Tax Receivable Agreement. In the third quarter of fiscal year 2021, the Company will recognize a deferred tax asset in the amount of approximately $ 71.8 million, a corresponding increase in the tax receivable agreement liability of $ 61.1 million, representing 85 % of the tax benefits and approximately $ 10.7 million of additional-paid-in capital.\n20\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nThis Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our financial statements and the related notes and other financial information included in our Annual Report on Form 10-K for the year ended December 31, 2020 (“2020 Form 10-K”) and this Quarterly Report on Form 10-Q. In addition to historical financial information, the following discussion and analysis contain forward-looking statements that involve risks, uncertainties and assumptions. For this purpose, any statements contained in this Form 10-Q that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, words such as “may,” “will,” “expect,” “believe,” “anticipate,” “estimate” or “continue” or comparable terminology are intended to identify forward-looking statements. Our actual results and timing of selected events may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those discussed under the sections of our 10-K and this Form 10-Q captioned “Special Note Regarding Forward-Looking Statements” and “Risk Factors”.\nThis Management’s Discussion and Analysis of Financial Condition and Results of Operations contain the presentation of Adjusted EBITDA and Adjusted Net Income, which are not presented in accordance with GAAP. Adjusted EBITDA and Adjusted Net Income are being presented because they provide the Company and readers of this Form 10-Q with additional insight into our operational performance relative to earlier periods and relative to our competitors. We do not intend Adjusted EBITDA and Adjusted Net Income to be substitutes for any GAAP financial information. Readers of this Form 10-Q should use Adjusted EBITDA and Adjusted Net Income only in conjunction with Net Income, the most comparable GAAP financial measure. Reconciliations of Adjusted EBITDA and Adjusted Net Income to Net Income, the most comparable GAAP measure to each, are provided in “—Non-GAAP Financial Measures.”\nOverview\nWe are a leading provider of electrical balance of system or “EBOS” solutions for solar energy projects in the United States. EBOS encompasses all of the components that are necessary to carry the electric current produced by solar panels to an inverter and ultimately to the power grid. EBOS components are mission-critical products that have a high consequence of failure, including lost revenue, equipment damage, fire damage, and even serious injury or death. As a result, we believe customers prioritize reliability and safety over price when selecting EBOS solutions.\nEBOS components that we produce include cable assemblies, inline fuses, combiners, disconnects, recombiners, wireless monitoring systems, junction boxes, transition enclosures and splice boxes. We derive the majority of our revenue from selling “system solutions” which are complete EBOS systems that include several of our products, many of which are customized for the customer’s project. We believe our system solutions are unique in our industry because they integrate design and engineering support, proprietary components and innovative installation methods into a single offering that would otherwise be challenging for a customer to obtain from a single provider or at all.\nWe sell our products principally to engineering, procurement and construction firms (\"EPCs”) that build solar energy projects. However, given the mission critical nature of EBOS, the decision to use our products typically involves input from both the EPC and the owner of the solar energy project. The custom nature of our system solutions and the long development cycle for solar energy projects typically gives us 12 months or more of lead time to quote, engineer, produce and ship each order we receive, and we do not stock large amounts of finished goods.\n21\nWe derived approximately 80% of our revenue from the sale of system solutions for the six months ended June 30, 2021. For the same period, we derived substantially all of our revenue from customers in the U.S. We had $200.5 million of backlog and awarded orders, backlog represents signed purchase orders or contractual minimum purchase commitments with take-or-pay provisions and awarded orders are orders we are in the process of documenting a contract but for which a contract has not yet been signed, as of June 30, 2021, representing a 63% and 11% increase relative to the same date last year and March 31, 2021, respectively.\nWe have maintained focus on our growth strategy throughout the quarter including developments in converting customers to our combine-as-you-go system and developing products for the rapidly growing electric vehicle charging infrastructure market. We believe that eight of the top 10 solar EPCs as reported by Solar Power World Magazine use our combine-as-you-go system on a majority of their projects and we are currently in the process of transitioning an additional 11 EPCs and developers to our system. Additionally, we are currently developing four new product families for the EV charging market: skid solutions that package the key components required for an EV charging station in the factory with the objective of reducing the amount of labor required in the field; raceways that allow wire to be run above ground rather than in underground conduit; EV-Big Lead Assembly (“BLA”) that eliminates homeruns from each dispenser and offers benefits similar to our solar BLA, including a 75% reduction in wire runs; and quad chargers that are prefabricated dispensers with four charge points. We expect to introduce our first offerings for this rapidly growing market in the fourth quarter of 2021.\nInitial Public Offering\nOn January 29, 2021, the Company closed an IPO of 11,550,000 shares of Class A common stock at a public offering price of $25.00 per share, including shares issued pursuant to the underwriters' over-allotment option. The Company received $278.8 million in proceeds, net of underwriting discounts and commissions, which was used to purchase 6,315,790 LLC Interests from Shoals Parent and 5,234,210 LLC Interests from the founder and Class B unit holder in Shoals Parent at a price per interest equal to the IPO price of $25.00 per share. Subsequent to the IPO and related organizational transactions that occurred in connection with the IPO, the Company is the sole managing member of, and had a 56.14% economic interest in, Shoals Parent.\nOrganizational Transactions\nSee Note 1 to the condensed consolidated financial statements of Shoals, included in this Quarterly Report on Form 10-Q for more information about the above-mentioned transactions as well as the other transactions completed in connection with the IPO.\nFollowing the completion of the Organizational Transactions, the Company owned 56.14% of Shoals Parent. The Continuing Equity Owners owned the remaining 43.86% of Shoals Parent.\nAs the Organization Transactions were considered transactions between entities under common control, the condensed consolidated financial statements for the periods prior to the IPO and Organizational Transactions have been adjusted to combine the previously separate entities for presentation purposes.\nImpact of COVID-19\nThe global health crisis caused by the novel coronavirus COVID-19 pandemic and its resurgences has and may continue to negatively impact global economic activity, which, despite progress in vaccination efforts, remains uncertain and cannot be predicted with confidence. In addition, a new Delta variant of COVID-19, which appears to be the most transmissible variant to date, has begun to spread globally. The impact of the Delta variant cannot be predicted at this time, and could depend on numerous factors, including vaccination\n22\nrates among the population, the effectiveness of the COVID-19 vaccines against the Delta variant and the response by governmental bodies and regulators. Given the ongoing and dynamic nature of the circumstances, it is difficult to predict the impact of the COVID-19 pandemic on our business.\nMany countries around the world have continued to impose quarantines and restrictions on travel and mass gatherings to slow the spread of the virus. Accordingly, our ability to continue to operate our business may also be limited. Such events may result in a period of business, supply and manufacturing disruptions, and in reduced operations, any of which could materially affect our business, financial condition and results of operations.\nA continuation or worsening of the levels of market disruption and volatility seen in the recent past could have an adverse effect on our ability to access capital, which could in the future negatively affect our liquidity. In addition, a recession or market correction resulting from the spread of COVID-19 could materially affect our business and the value of our common stock.\nWe continue to monitor the impacts of COVID-19 on the global economy and on our business operations. Although we expect the vaccinations for COVID-19 will continue to improve conditions, the ultimate impact from COVID-19 on our business operations and financial results during 2021 will depend on, among other things, the ultimate severity and scope of the pandemic, including the new variants of the virus, the pace at which governmental and private travel restrictions and public concerns about public gatherings will ease, the rate at which historically large increases in unemployment rates will decrease, if at all, and whether, and the speed with which, the economy recovers. We are not able to fully quantify the impact that these factors will have on our financial results during 2021 and beyond, but developments related to COVID-19 may materially affect us in 2021.\nKey Components of Our Results of Operations\nThe following discussion describes certain line items in our condensed consolidated statements of operations.\nRevenue\nWe generate revenue from the sale of EBOS systems and components for homerun and combine-as-you-go architectures. Our customers include EPCs, utilities, solar developers, independent power producers and solar module manufacturers. We derive the majority of our revenue from selling system solutions. When we sell a system solution, we enter into a contract with our customers covering the price, specifications, delivery dates and warranty for the products being purchased, among other things. Our contractual delivery period for system solutions can vary from one to three months whereas manufacturing typically requires a shorter time frame. Contracts for system solutions can range in value from several hundred thousand to several million dollars.\nOur revenue is affected by changes in the price, volume and mix of products purchased by our customers. The price and volume of our products is driven by the demand for our products, changes in product mix between homerun and combine-as-you-go EBOS, geographic mix of our customers, strength of competitors’ product offerings, and availability of government incentives to the end-users of our products.\nOur revenue growth is dependent on continued growth in the amount of solar energy projects constructed each year and our ability to increase our share of demand in the geographies where we currently compete and plan to compete in the future as well as our ability to continue to develop and commercialize new and innovative products that address the changing technology and performance requirements of our customers.\n23\nCost of Revenue and Gross Profit\nCost of revenue consists primarily of product costs, including purchased materials and components, as well as costs related to shipping, customer support, product warranty, personnel and depreciation of manufacturing and testing equipment. Personnel costs in cost of revenue include both direct labor costs as well as costs attributable to any individuals whose activities relate to the transformation of raw materials or component parts into finished goods or the transportation of materials to the customer. Our product costs are affected by the underlying cost of raw materials, including copper and aluminum; component costs, including fuses, resin, enclosures, and cable; technological innovation; economies of scale resulting in lower component costs; and improvements in production processes and automation. We do not currently hedge against changes in the price of raw materials. Some of these costs, primarily personnel and depreciation of manufacturing and testing equipment, are not directly affected by sales volume. Gross profit may vary from year to year and is primarily affected by our sales volume, product prices, product costs, product mix, customer mix, geographical mix, shipping method, warranty costs and seasonality.\nOperating Expenses\nOperating expenses consist of general and administrative costs as well as depreciation and amortization expense. Personnel-related costs are the most significant component of our operating expenses and include salaries, equity-based compensation, benefits, payroll taxes and commissions. The number of full-time employees in our general and administrative departments increased from 42 to 68 from June 30, 2020 to June 30, 2021, and we expect to hire new employees in the future to support our growth. The timing of these additional hires could materially affect our operating expenses in any particular period, both in absolute dollars and as a percentage of revenue. We expect to invest in additional resources to support our growth which will increase our operating expenses.\nGeneral and Administrative Expenses\nGeneral and administrative expenses consist primarily of salaries, equity-based compensation expense, employee benefits and payroll taxes related to our executives, and our sales, finance, human resources, information technology, engineering and legal organizations, travel expenses, facilities costs, marketing expenses, bad debt expense and fees for professional services. Professional services consist of audit, legal, tax, insurance, information technology and other costs. We expect to increase our sales and marketing personnel as we expand into new geographic markets. Substantially all of our sales in 2020 were in the U.S. We currently have a sales presence in the U.S., Australia and Spain. We intend to expand our sales presence and marketing efforts to additional countries in the future. We also expect that as a result of our recent IPO, we will incur additional audit, tax, accounting, legal and other costs related to compliance with applicable securities and other regulations, as well as additional insurance, investor relations and other costs associated with being a public company.\nDepreciation\nDepreciation in our operating expenses consists of costs associated with property, plant and equipment (“PP&E”) not used in manufacturing our products. We expect that as we increase both our revenue and the number of our general and administrative personnel, we will invest in additional PP&E to support our growth resulting in additional depreciation expense.\nAmortization\nAmortization of intangibles consists of customer relationships, developed technology, trade names and non-compete agreements over their expected period of use.\n24\nNon-operating Expenses\nInterest Expense\nInterest expense consists of interest and other charges paid in connection with our current Senior Secured Credit Agreement (as defined below) and our former Senior Debt which included a revolving line of credit and term loan, which was fully repaid on October 8, 2020.\nTax Receivable Agreement Liability Adjustment\nTax receivable agreement liability adjustment consists of changes to our effective interest rate since the initial recording of the liability related to our tax receivable agreement with our founder and former Class A Shoals Equity Owners of Shoals Parent.\nLoss on Debt Repayment\nLoss on debt repayment consists of prepayment premiums and the write-off off a portion of the deferred financing costs from the prepayment of outstanding borrowings under the Term Loan Facility.\nIncome Tax Expense\nShoals Technologies Group, Inc. is subject to U.S. federal and state income tax in multiple jurisdictions with respect to our allocable share of any net taxable income of Shoals Parent. Shoals Parent is a pass-through entity for federal income tax purposes but incurs income tax in certain state jurisdictions.\n25\nResults of Operations\nThe following table summarizes our results of operations (dollars in thousands):\n| Three Months Ended June 30, | Increase / (Decrease) | Six Months Ended June 30, | Increase / (Decrease) |\n| 2021 | 2020 | 2021 | 2020 |\n| Revenue | $ | 59,722 | $ | 43,427 | $ | 16,295 | 38 | % | $ | 105,326 | $ | 84,167 | $ | 21,159 | 25 | % |\n| Cost of revenue | 33,543 | 26,598 | 6,945 | 26 | % | 60,373 | 53,152 | 7,221 | 14 | % |\n| Gross profit | 26,179 | 16,829 | 9,350 | 56 | % | 44,953 | 31,015 | 13,938 | 45 | % |\n| Operating Expenses |\n| General and administrative expenses | 10,018 | 9,317 | 701 | 8 | % | 16,834 | 11,875 | 4,959 | 42 | % |\n| Depreciation and amortization | 2,062 | 2,064 | (2) | — | % | 4,130 | 4,125 | 5 | — | % |\n| Total Operating Expenses | 12,080 | 11,381 | 699 | 6 | % | 20,964 | 16,000 | 4,964 | 31 | % |\n| Income from Operations | 14,099 | 5,448 | 8,651 | 159 | % | 23,989 | 15,015 | 8,974 | 60 | % |\n| Interest expense, net | (3,620) | (225) | (3,395) | 1509 | % | (7,329) | (497) | (6,832) | 1375 | % |\n| Tax receivable agreement liability adjustment | (1,664) | — | (1,664) | 100 | % | (1,664) | — | (1,664) | 100 | % |\n| Loss on debt repayment | — | — | — | — | % | (15,990) | — | (15,990) | 100 | % |\n| Income (loss) before income taxes | 8,815 | 5,223 | 3,592 | 69 | % | (994) | 14,518 | (15,512) | (107) | % |\n| Income tax benefit | 339 | — | 339 | 100 | % | 1,814 | — | 1,814 | 100 | % |\n| Net income | 9,154 | 5,223 | 3,931 | 75 | % | 820 | 14,518 | (13,698) | (94) | % |\n| Less: net income (loss) attributable to non-controlling interests | 4,596 | — | 4,596 | 100 | % | (879) | — | (879) | 100 | % |\n| Net income attributable to Shoals Technologies Group, Inc. | $ | 4,558 | $ | 5,223 | $ | (665) | (13) | % | $ | 1,699 | $ | 14,518 | $ | (12,819) | (88) | % |\n\nComparison of the Three Months Ended June 30, 2021 and 2020\nRevenue\nRevenue increased by $16.3 million, or 38%, for the three months ended June 30, 2021 as compared to the three months ended June 30, 2020, driven by an increase in demand for solar EBOS generally and our combine-as-you-go system solutions specifically. Our total number of customers increased in 2021 as compared to 2020. We believe customer recognition of the benefits of our combine-as-you-go system is resulting in increased demand for our products.\nCost of Revenue and Gross Profit\nCost of revenue increased by $6.9 million, or 26%, for the three months ended June 30, 2021 as compared to the three months ended June 30, 2020, primarily driven by an increase in production volumes. Gross profit as a percentage of revenue increased from 38.8% in 2020 to 43.8% in 2021 in part due to purchasing efficiencies from increased volumes, improved material planning which reduced logistics costs,\n26\nenhancements to product design that lowered manufacturing costs and other manufacturing efficiencies resulting from higher production volumes. Changes in product mix also contributed to the increase in margin as sales of system solutions for combine-as-you-go EBOS, which have higher margin than our other products, increased as a percentage of our total revenue.\nOperating Expenses\nGeneral and Administrative\nGeneral and administrative expenses increased $0.7 million, or 8%, for the three months ended June 30, 2021 as compared to the three months ended June 30, 2020. The increase in general and administrative expenses was primarily the result of an increase in professional fees of $1.9 million related to preparation for our public offerings, wages and related taxes of $1.6 million related to increased head count and year-end bonuses, and an insurance expense of $0.8 million primarily related to increased costs for our directors and officers policy, offset by a decrease in equity-based compensation of $4.1 million.\nDepreciation and Amortization\nThere was no significant change in depreciation and amortization expense during the three months ended June 30, 2021 as compared to the three months ended June 30, 2020.\nInterest Expense\nInterest expense, net increased by $3.4 million or 1509%, for the three months ended June 30, 2021 as compared to the three months ended June 30, 2020, due to increased borrowings and related deferred financing costs under our Senior Secured Credit Facility entered into on November 25, 2020. We expect interest expense to increase in 2021 as a result of our higher average borrowings under the Senior Secured Credit Facility (see description under “Debt Obligations”).\nTax Receivable Agreement Liability Adjustment\nTax receivable agreement liability adjustment totaled $1.7 million for the three months ended June 30, 2021. The adjustment resulted from an estimated increase in the Company’s blended state income tax rate.\nIncome Tax Benefit\nIncome tax benefit totaled $0.3 million for the three months ended June 30, 2021. The Company did not incur income tax expense prior to the Organizational Transactions, or during the three months ended June 30, 2020.\nComparison of the Six Months Ended June 30, 2021 and 2020\nRevenue\nRevenue increased by $21.2 million, or 25%, for the six months ended June 30, 2021 as compared to the six months ended June 30, 2020, driven by an increase in demand for solar EBOS generally and our combine-as-you-go system solutions specifically. Our total number of customers increased in 2021 as compared to 2020. We believe customer recognition of the benefits of our combine-as-you-go system is resulting in increased demand for our products.\nCost of Revenue and Gross Profit\n27\nCost of revenue increased by $7.2 million, or 14%, for the six months ended June 30, 2021 as compared to the six months ended June 30, 2020, primarily driven by an increase in production volumes. Gross profit as a percentage of revenue increased from 36.8% for the six months ended June 30, 2020 to 42.7% for the six months ended June 30, 2021 in part due to purchasing efficiencies from increased volumes, improved material planning which reduced logistics costs, enhancements to product design that lowered manufacturing costs and other manufacturing efficiencies resulting from higher production volumes. Changes in product mix also contributed to the increase in margin as sales of system solutions for combine-as-you-go EBOS, which have higher margin than our other products, increased as a percentage of our total revenue.\nOperating Expenses\nGeneral and Administrative\nGeneral and administrative expenses increased by $5.0 million, or 42%, for the six months ended June 30, 2021 as compared to the six months ended June 30, 2020. The increase in general and administrative expenses was primarily the result of an increase in professional fees of $2.5 million related to preparation for our public offerings, wages and related taxes of $2.8 million related to increased head count and year-end bonuses, an insurance expense of $1.5 million primarily related to increased costs for our directors and officers policy and franchise and other related taxes of $0.3 million, offset by a decrease in equity-based compensation of $2.8 million and a decrease in travel and trade shows of $0.2 million as a result of COVID-19.\nDepreciation and Amortization\nThere was no significant change in depreciation and amortization expense during the six months ended June 30, 2021 as compared to the six months ended June 30, 2020.\nInterest Expense\nInterest expense, net increased by $6.8 million or 1375%, for the six months ended June 30, 2021 as compared to the six months ended June 30, 2020, due to increased borrowings and related deferred financing costs under our Senior Secured Credit Facility entered into on November 25, 2020. We expect interest expense to increase in 2021 as a result of our higher average borrowings under the Senior Secured Credit Facility (see description under “Debt Obligations”).\nTax Receivable Agreement Liability Adjustment\nTax receivable agreement liability adjustment totaled $1.7 million for the six months ended June 30, 2021. The adjustment resulted from an estimated increase in the Company’s blended state income tax rate.\nLoss on Debt Repayment\nLoss on debt repayment for the six months ended June 30, 2021 consists of $11.3 million of prepayment premium and $4.7 million in write-off off a portion of the deferred financing costs related to a prepayment of $150.0 million of outstanding borrowings under the Term Loan Facility.\nIncome Tax Benefit\nIncome tax benefit totaled $1.8 million for the six months ended June 30, 2021. The Company did not incur income tax expense prior to the Organizational Transactions, or during the six months ended June 30, 2020.\nNon-GAAP Financial Measures\nAdjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS\n28\nWe define Adjusted EBITDA as net income (loss) plus (i) interest expense, (ii) income taxes, (iii) depreciation expense, (iv) amortization of intangibles, (v) tax receivable agreement liability adjustment, (vi) loss on debt repayment, (vii) equity-based compensation, (viii) COVID-19 expenses and (ix) non-recurring and other expenses. We define Adjusted Net Income as net income (loss) plus (i) amortization of intangibles, (ii) tax receivable agreement liability adjustment, (iii) loss on debt repayment, (iv) amortization of deferred financing costs, (v) equity-based compensation, (vi) COVID-19 expenses and (vii) non-recurring and other expenses, all net of applicable income taxes. We define Adjusted Diluted EPS as Adjusted Net Income divided by the diluted weighted average shares of Class A common shares outstanding for the applicable period, which assumes the pro forma exchange of all outstanding Class B common shares for Class A common shares.\nAdjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS are intended as supplemental measures of performance that are neither required by, nor presented in accordance with, GAAP. We present Adjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS because we believe they assist investors and analysts in comparing our performance across reporting periods on a consistent basis by excluding items that we do not believe are indicative of our core operating performance. In addition, we use Adjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS: (i) as factors in evaluating management’s performance when determining incentive compensation; (ii) to evaluate the effectiveness of our business strategies; and (iii) because our credit agreement uses measures similar to Adjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS to measure our compliance with certain covenants.\nAmong other limitations, Adjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS do not reflect our cash expenditures, or future requirements for capital expenditures or contractual commitments; do not reflect the impact of certain cash charges resulting from matters we consider not to be indicative of our ongoing operations; in the case of Adjusted EBITDA, does not reflect income tax expense or benefit for periods prior to the reorganization; and may be calculated by other companies in our industry differently than we do or not at all, which may limit their usefulness as comparative measures.\nBecause of these limitations, Adjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS should not be considered in isolation or as substitutes for performance measures calculated in accordance with GAAP. You should review the reconciliation of net income to Adjusted EBITDA, Adjusted Net Income and Adjusted Diluted EPS below and not rely on any single financial measure to evaluate our business.\nReconciliation of Net Income to Adjusted EBITDA (in thousands):\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Net income | $ | 9,154 | $ | 5,223 | $ | 820 | $ | 14,518 |\n| Interest expense | 3,620 | 225 | 7,329 | 497 |\n| Income tax benefit | (339) | — | (1,814) | — |\n| Depreciation expense | 411 | 338 | 816 | 664 |\n| Amortization of intangibles | 1,996 | 1,996 | 3,992 | 3,992 |\n| Tax receivable agreement liability adjustment(a) | 1,664 | — | 1,664 | — |\n| Loss on debt repayment | — | — | 15,990 | — |\n| Equity-based compensation | 2,780 | 6,704 | 4,172 | 6,704 |\n| COVID-19 expenses(b) | 106 | 806 | 161 | 806 |\n| Non-recurring and other expenses(c) | 1,239 | 112 | 1,578 | 294 |\n| Adjusted EBITDA | $ | 20,631 | $ | 15,404 | $ | 34,708 | $ | 27,475 |\n\n29\n(a) Represents an adjustment to eliminate the remeasurement of the Tax Receivable Agreement.\n(b) Represents costs incurred as a direct impact from the COVID-19 pandemic, disinfecting and reconfiguration of facilities, medical professionals to conduct daily screenings of employees, premium pay during the pandemic to hourly workers in 2020 and direct legal costs associated with the pandemic.\n(c) Represents certain costs associated with non-recurring professional services, Oaktree’s expenses and other costs.\nReconciliation of Net Income Attributable to Shoals Technologies Group, Inc. to Adjusted Net Income (in thousands):\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Net income attributable to Shoals Technologies Group, Inc. | $ | 4,558 | $ | 5,223 | $ | 1,699 | $ | 14,518 |\n| Net income (loss) impact from pro forma conversion of Class B common stock to Class A common stock (a) | 4,596 | — | (879) | — |\n| Adjustment to the provision for income tax (b) | (942) | (1,133) | 192 | (3,150) |\n| Tax effected net income | 8,212 | 4,090 | 1,012 | 11,368 |\n| Amortization of intangibles | 1,996 | 1,996 | 3,992 | 3,992 |\n| Amortization of deferred financing costs | 305 | 12 | 675 | 21 |\n| Tax receivable agreement liability adjustment(c) | 1,664 | — | 1,664 | — |\n| Loss on debt repayment | — | — | 15,990 | — |\n| Equity-based compensation | 2,780 | 6,704 | 4,172 | 6,704 |\n| COVID-19 expenses (d) | 106 | 806 | 161 | 806 |\n| Non-recurring and other expenses (e) | 1,239 | 112 | 1,578 | 294 |\n| Tax impact of adjustments (f) | (1,635) | (635) | (5,806) | (1,110) |\n| Adjusted Net Income | $ | 14,667 | $ | 13,085 | $ | 23,438 | $ | 22,075 |\n\n(a) Reflects net income (loss) to Class A common shares from pro forma exchange of corresponding shares of our Class B common shares held by our founder and management.\n(b) Shoals Technologies Group, Inc. is subject to U.S. Federal income taxes, in addition to state and local taxes with respect to its allocable share of any net taxable income of Shoals Parent LLC. The adjustment to the provision for income tax reflects the effective tax rates below, assuming Shoals Technologies Group, Inc. owns 100% of the units in Shoals Parent LLC.\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Statutory U.S. Federal income tax rate | 21.0 | % | 21.0 | % | 21.0 | % | 21.0 | % |\n| State and local taxes (net of federal benefit) | 2.0 | % | 0.7 | % | 2.0 | % | 0.7 | % |\n| Permanent items, including valuation adjustment | (2.5) | % | — | % | (1.1) | % | — | % |\n| Effective income tax rate for Adjusted Net Income | 20.5 | % | 21.7 | % | 21.9 | % | 21.7 | % |\n\n30\n(c) Represents an adjustment to eliminate the remeasurement of the Tax Receivable Agreement.\n(d) Represents costs incurred as a direct impact from the COVID-19 pandemic, disinfecting and reconfiguration of facilities, medical professionals to conduct daily screenings of employees, premium pay during the pandemic to hourly workers in 2020 and direct legal costs associated with the pandemic.\n(e) Represents certain costs associated with non-recurring professional services, Oaktree’s expenses and other costs.\n(f) Represents the estimated tax impact of all Adjusted Net Income add-backs, excluding those which represent permanent differences between book versus tax.\nReconciliation of Diluted Weighted Average Shares Outstanding to Adjusted Diluted Weighted Average Shares Outstanding (in thousands, except per share):\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Diluted weighted average shares of Class A common shares outstanding, excluding Class B common shares | 93,760 | N/A (b) | 93,650 | N/A (b) |\n| Assumed pro forma conversion of Class B common shares to Class A common shares | 73,067 | N/A (b) | 73,067 | N/A (b) |\n| Adjusted diluted weighted average shares outstanding | 166,827 | N/A (b) | 166,717 | N/A (b) |\n| Adjusted Net Income (a) | $ | 14,667 | N/A (b) | $ | 23,438 | N/A (b) |\n| Adjusted Diluted EPS | $ | 0.09 | N/A (b) | $ | 0.14 | N/A (b) |\n\n(a) Represents Adjusted Net Income for the full period presented.\n(b) This Non-GAAP measure is not applicable for this period, as the reorganization transactions had not yet occurred.\nLiquidity and Capital Resources\n| Six Months Ended June 30, |\n| 2021 | 2020 |\n| Net cash provided by (used in) operating activities | $ | (14,114) | $ | 18,928 |\n| Net cash used in investing activities | (1,736) | (1,345) |\n| Net cash provided by (used in) financing activities | 18,948 | (10,361) |\n| Net increase in cash and cash equivalents | $ | 3,098 | $ | 7,222 |\n\nWe finance our operations primarily with operating cash flows and short and long-term borrowings. Our ability to generate positive cash flow from operations is dependent on the strength of our gross margins as well as our ability to quickly turn our working capital. Based on our past performance and current expectations, we believe that operating cash flows and availability under our Revolving Credit Facility will be sufficient to meet our near term future cash needs.\n31\nWe used cash from operating activities of $14.1 million in the six months ended June 30, 2021 as compared to cash generated from operating activities of $18.9 million for the six months ended June 30, 2020. As of June 30, 2021, our cash and cash equivalents were $13.2 million and we had outstanding borrowings of $247.3 million. We also had $51.0 million available for additional borrowings under our $100.0 million Revolving Credit Facility.\nOperating Activities\nFor the six months ended June 30, 2021, cash used in operating activities was $14.1 million, primarily due to operating results that included $0.8 million of net income which was reduced by $15.6 million, net of non-cash expenses, an increase of $6.2 million in inventory, $19.0 million in receivables, $4.6 million in other current assets and a decrease in accounts payable and accrued expenses of $0.8 million.\nFor the six months ended June 30, 2020, cash provided by operating activities was $18.9 million, primarily due to operating results that included $14.5 million of net income which was reduced by $11.4 million, net of non-cash expenses, an increase of $5.0 million in receivables, an increase of $3.4 million in inventory and an increase of $0.8 million in accounts payable and accrued expenses.\nInvesting Activities\nFor the six months ended June 30, 2021, net cash used in investing activities was $1.7 million, attributable to the purchase of property and equipment.\nFor the six months ended June 30, 2020, net cash used in investing activities was $1.3 million, attributable to the purchase of property and equipment.\nFinancing Activities\nFor the six months ended June 30, 2021, net cash provided by financing activities was $18.9 million, including $144.9 million in net proceeds from the IPO and $29.0 million in borrowings under the Revolving Credit Facility offset by $151.8 million of payments on term loan facility.\nFor the six months ended June 30, 2020, net cash used in financing activities was $10.4 million. We made $8.4 million in payments on our senior debt – revolving credit facility, tax distributions of $0.2 million and payments on our senior debt-term loan of $1.7 million.\nFrom time to time, we may seek to retire or purchase the Company’s outstanding debt or equity securities through cash purchases and/or exchanges for other debt or equity securities in open market purchases, privately negotiated transactions, or otherwise, that may be made pursuant to Rule 10b5-1 or otherwise. Such repurchases or exchanges, if any, will depend on prevailing market conditions, the Company’s liquidity requirements, contractual restrictions and other factors.\nDebt Obligations\nSenior Secured Credit Agreement\nOn November 25, 2020 Shoals Holdings, entered into that certain credit agreement with the lenders party thereto from time to time and Wilmington Trust, National Association, as administrative agent and collateral agent (the “Senior Secured Credit Agreement”), consisting of (i) a $350.0 million senior secured six-year term loan facility (the “Term Loan Facility”), (ii) a $30.0 million senior secured delayed draw term loan facility, which matures concurrently with the six-year Term Loan Facility (the “Delayed Draw Term Loan Facility”) and (iii) an uncommitted super senior first out revolving credit facility (the “Revolving Credit Facility”).\n32\nThe proceeds of the Term Loan Facility and a $10.0 million draw under the Delayed Draw Term Loan Facility were used to (i) make certain distributions from Shoals Holdings to Shoals Intermediate Holdings and from there to certain of our direct or indirect equity holders, (ii) pay transaction expenses, (iii) repay and terminate all outstanding commitments under the Senior Debt (as defined herein) and (iv) finance working capital and general corporate purposes. An additional $10.0 million draw under the Delayed Draw Term Loan Facility funded on December 14, 2020.\nIn December 2020, Shoals Holdings entered into two amendments to the Senior Secured Credit Agreement in order to obtain a $100.0 million increase (the “Revolver Upsize”) to the Revolving Credit Facility and modify the terms of the interest rate and prepayment premium. As part of the first amendment we repaid and terminated all outstanding commitments under the Delayed Draw Term Loan Facility.\nAs of June 30, 2021, interest rates on the Term Loan facility and the Revolving credit facility were 4.25% and 3.75%, respectively and we had $51.0 million of availability under the Revolving Credit Facility.\nThe Senior Secured Credit Agreement contains affirmative and negative covenants, including covenants that restrict our incurrence of indebtedness, incurrence of liens, dispositions, investments, acquisitions, restricted payments, and transactions with affiliates. The Senior Secured Credit Agreement also includes customary events of default, including the occurrence of a change of control. As of June 30, 2021, we were in compliance with all the required covenants.\nSenior Debt\nIntermediate and subsidiaries were party to the Senior Debt Agreement under which Holdings and its subsidiaries were borrowers and Intermediate was a guarantor. The Senior Debt was collateralized by all of the assets of the guarantor and borrowers. The amended agreement provided a term loan of $35 million and a revolving line of credit of $25 million.\nOn October 8, 2020, we paid the outstanding amount due on the term loan and settled all obligations with respect to the Senior Debt.\nThe Senior Debt provided for an interest rate to equal the Base Rate plus margin. The Base Rate charged was the highest rate of three defined methods as follows: 1) Federal Funds Rate plus 0.5%, 2) Fifth Third Bank N.A. Rate or 3) LIBOR Rate plus 1%. The Base Rate ranged from 1% to 2.5% depending on the EBITDA Rate calculation as defined in the Senior Debt (the “EBITDA Rate calculation”) for the Federal Funds Rate. The Base Rate for the LIBOR Rate ranged from 2% to 3.5% depending on the EBITDA Rate calculation.\nSurety Bonds\nWe provide surety bonds to various parties as required for certain transactions initiated during the ordinary course of business to guarantee our performance in accordance with contractual or legal obligations. As of June 30, 2021, the maximum potential payment obligation with regard to surety bonds was $11.8 million.\nCritical Accounting Policies and Significant Management Estimates\nIncome Taxes\nWe record valuation allowances against our deferred tax assets when it is more likely than not that all or a portion of a deferred tax asset will not be realized. In making such determination, we consider all available evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax planning strategies and results of operation. We routinely evaluate the realizability of our deferred tax assets by assessing the likelihood that our deferred tax assets will be recovered based on all available positive and\n33\nnegative evidence. Estimating future taxable income is inherently uncertain and requires judgment. In projecting future taxable income, we consider our historical results and incorporate certain assumptions, including revenue growth and operating margins, among others. As of June 30, 2021, we had $49.6 million of deferred tax assets, net of valuation allowances. We expect to realize future tax benefits related to the utilization of these assets. If we determine in the future that we will not be able to fully utilize all or part of these deferred tax assets, we would record a valuation allowance through earnings in the period the determination was made, which would have an adverse effect on our results of operations and earnings in future periods.\nLiabilities Under Tax Receivable Agreement\nAs described in Note 14 to the condensed consolidated financial statements, we are a party to the TRA under which we are contractually committed to pay the TRA Owners 85% of the amount of any tax benefits that we actually realize, or in some cases are deemed to realize, as a result of certain transactions. Amounts payable under the TRA are contingent upon, among other things, (i) generation of future taxable income over the term of the TRA and (ii) future changes in tax laws. If we do not generate sufficient taxable income in the aggregate over the term of the TRA to utilize the tax benefits, then we generally would not be required to make the related TRA payments. Therefore, we will only recognize a liability for TRA payments if we determine it is probable that we will generate sufficient future taxable income over the term of the TRA to utilize the related tax benefits. Estimating future taxable income is inherently uncertain and requires judgment. In projecting future taxable income, we consider our historical results and incorporate certain assumptions, including revenue growth, and operating margins, among others. As of June 30, 2021, we recognized $43.4 million of liabilities relating to our obligations under the TRA, after concluding that it was probable that we would have sufficient future taxable income to utilize the related tax benefits. There were no transactions subject to the TRA for which we did not recognize the related liability, as we concluded that we would have sufficient future taxable income to utilize all of the related tax benefits generated by all transactions that occurred in connection with the IPO. If we determine in the future that we will not be able to fully utilize all or part of the related tax benefits, we would de-recognize the portion of the liability related the benefits not expected to be utilized.\nAdditionally, we estimate the amount of TRA payments expected to be paid within the next 12 months and classify this amount as current on our condensed consolidated balance sheets. This determination is based on our estimate of taxable income for the next fiscal year. To the extent our estimate differs from actual results, we may be required to reclassify portions of our liabilities under the TRA between current and non-current.\nAs of June 30, 2021, there were no other significant changes in the application of our critical accounting policies or estimation procedures from those presented in our Annual Report on Form 10-K for the year ended December 31, 2020.\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\nThere have been no material changes with respect to our market risk disclosed in our Annual Report on Form 10-K for the year ended December 31, 2020.\nItem 4. Controls and Procedures\nEvaluation of Disclosure Controls and Procedures\nUnder the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on this evaluation, our Chief Executive Officer and Chief\n34\nFinancial Officer concluded that our disclosure controls and procedures were effective as of such date. Our disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.\nChanges in Internal Control Over Financial Reporting\nThere were no changes to our internal control over financial reporting that occurred during the quarter ended June 30, 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\nPART II – OTHER INFORMATION\nItem 1. Legal Proceedings\nFrom time to time, we may be involved in litigation relating to claims that arise out of our operations and businesses and that cover a wide range of matters, including, among others, intellectual property matters, contract and employment claims, personal injury claims, product liability claims and warranty claims. Currently, there are no claims or proceedings against us that we believe will have a material adverse effect on our business, financial condition, results of operations or cash flows. However, the results of any current or future litigation cannot be predicted with certainty, and regardless of the outcome, we may incur significant costs and experience a diversion of management resources as a result of litigation.\nItem 1A. Risk Factors\nThere have been no material changes with respect to our risk factors disclosed in our Annual Report on Form 10-K for the year ended December 31, 2020.\nItem 2. Unregistered Sale of Equity Securities and Use of Proceeds\nRecent Sales of Unregistered Equity Securities\nNone\nItem 3. Defaults Upon Senior Securities\nNone.\nItem 4. Mine Safety Disclosures\nNot applicable.\nItem 5. Other Information\nNone.\nItem 6. Exhibits\n35\n| Incorporated by Reference |\n| Number | Description of Document | Form | Filing Date | Exhibit No. |\n| 3.1 | Amended and Restated Certificate of Incorporation of Shoals Technologies Group, Inc., dated January 28, 2021 | 8-K | 1/29/2021 | 3.1 |\n| 3.2 | Amended and Restated Bylaws of Shoals Technologies Group, Inc., dated January 28, 2021 | 8-K | 1/29/2021 | 3.2 |\n| 31.1* | Certification of the Chief Executive Officer, as required by Section 302 of the Sarbanes- Oxley Act of 2002 (18 U.S.C. 1350) |\n| 31.2* | Certification of the Chief Financial Officer, as required by Section 302 of the Sarbanes- Oxley Act of 2002 (18 U.S.C. 1350) |\n| 32.1* | Certification of the Chief Executive Officer, as required by Section 906 of the Sarbanes-Oxley Act of 2002 ( and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350) |\n| 101.INS | XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document |\n| 101.SCH* | XBRL Taxonomy Extension Schema Document |\n| 101.CAL* | XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF* | XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB* | XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE* | XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104 | Cover Page Interactive Data File - the cover page interactive data file does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document |\n\n________\n* Filed herewith\n† Indicates a management contract or compensatory plan.\n36\nSIGNATURES\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n| Shoals Technologies Group, Inc. |\n| By: | /s/ Jason Whitaker | Date: | August 10, 2021 |\n| Name: | Jason Whitaker |\n| Title: | Chief Executive Officer |\n| By: | /s/ Philip Garton | Date: | August 10, 2021 |\n| Name: | Philip Garton |\n| Title: | Chief Financial Officer |\n\n37\n</text>\n\nWhat would be the Adjusted EBITDA for the six months ended June 30, 2021, if the loss on debt repayment was 20% lower in thousands?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 31510.0."
}
|
{
"split": "test",
"index": 74,
"input_length": 26520
}
|
docmath_0_20000
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n||Years Ended December 31,||\n||2019|2018|\n|Network advertising|$22.7|$28.2|\n|Broadcast station|11.9|10.8|\n|Network distribution|4.9|4.8|\n|Other|2.3|1.6|\n|Total revenue from contracts with customers|41.8|45.4|\n|Other revenue|-|-|\n|Total Broadcasting segment revenue|$ 41.8|$ 45.4|\n Broadcasting Segment Network advertising revenue is generated primarily from the sale of television airtime for programs or advertisements. Network advertising revenue is recognized when the program or advertisement is broadcast. Revenues are reported net of agency commissions, which are calculated as a stated percentage applied to gross billings. The Network advertising contracts are generally short-term in nature. Network distribution revenue consists of payments received from cable, satellite and other multiple video program distribution systems for their retransmission of our network content. Network distribution revenue is recognized as earned over the life of the retransmission consent contract and varies from month to month. Variable fees are usage/sales based, calculated on the average number of subscribers, and recognized as revenue when the usage occurs. Transaction prices are based on the contract terms, with no material judgments or estimates. Broadcast station revenue is generated primarily from the sale of television airtime in return for a fixed fee or a portion of the related ad sales recognized by the third party. In a typical broadcast station revenue agreement, the licensee of a station makes available, for a fee, airtime on its station to a party which supplies content to be broadcast during that airtime and collects revenue from advertising aired during such content. Broadcast station revenue is recognized over the life of the contract, when the program is broadcast. The fees that we charge can be fixed or variable and the contracts that the Company enters into are generally short-term in nature. Variable fees are usage/salesbased and recognized as revenue when the subsequent usage occurs. Transaction prices are based on the contract terms, with no material judgments or estimates. Disaggregation of Revenues The following table disaggregates the Broadcasting segment's revenue by type (in millions):\n\n</text>\n\nIf network advertising revenue in 2019 was 30.0 million, what would be the change from 2018 to 2019? (in million)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 1.8000000000000007."
}
|
{
"split": "test",
"index": 75,
"input_length": 532
}
|
docmath_0_20000
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n||Fiscal year-end||\n||2019|2018|\n|Current portion of Euro Term Loan(1)|$2,748|$3,092|\n|1.3% Term loan due 2024|1,367|1,448|\n|1.0% State of Connecticut term loan due 2023|378|374|\n|Capital lease obligations|370|158|\n|Line of credit borrowings|10,000|—|\n|Total current portion of long-term obligations|$14,863|$5,072|\n Short-term borrowings and current portion of long-term obligations consist of the following (in thousands): (1) Net of debt issuance costs of $4.6 million and $4.7 million at September 28, 2019 and September 29, 2018, respectively.\n\n</text>\n\nWhat would the percentage change in Capital lease obligations from 2018 to 2019 be if the amount in 2019 was $358 thousand instead? (in percent)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 126.58227848101266."
}
|
{
"split": "test",
"index": 76,
"input_length": 289
}
|
docmath_0_20000
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n||FY19|FY18¹|Growth %|Growth %|\n||$m (Reported)|$m (Reported)|(Reported)|(CC)|\n|Revenue by Region:|||||\n|– Americas|253.3|223.6|13.3|13.4|\n|– EMEA|363.6|324.5|12.0|12.7|\n|– APJ|93.7|90.9|3.1|6.2|\n||710.6|639.0|11.2|12.0|\n|Revenue by Product:|||||\n|– Network|328.5|316.5|3.8|4.7|\n|– Enduser|348.4|291.8|19.4|20.2|\n|– Other|33.7|30.7|9.8|10.0|\n||710.6|639.0|11.2|12.0|\n|Revenue by Type:|||||\n|– Subscription|593.9|512.4|15.9|16.7|\n|– Hardware|106.8|115.1|(7.2)|(6.3)|\n|– Other|9.9|11.5|(13.9)|(12.8)|\n||710.6|639.0|11.2|12.0|\n Revenue and deferred revenue The Group adopted IFRS 15 Revenue from Contracts with Customers in the current year and has therefore restated the results for the prior-year on a consistent basis, see note 2 of the Financial Statements for further details. The Group’s revenue increased by $71.6 million, or 11.2 per cent, to $710.6 million in the year-ended 31 March 2019. Subscription revenue was notably strong in the period, with reported growth of 15.9 per cent, or 16.7 per cent on a constant currency basis, because of strong prior-period billings and incremental growth of the MSP channel in the current period. 1 Restated for the adoption of IFRS 15 as explained in note 2 of the Financial Statements Revenue in the period of $710.6 million comprised $394.1 million from the recognition of prior-period deferred revenues and $316.5 million from in-period billings. The majority of the Group’s billings, which are recognised over the life of the contract, relate to subscription products (FY19: 84.8 per cent; FY18: 83.8 per cent), with the benefit from increased billings being spread over a number of years on the subsequent recognition of deferred revenue. The deferred revenue balance at the end of the period of $742.1 million increased $13.5 million year-on-year, an increase of 1.9 per cent. This was mainly due to a net deferral of billings amounting to $49.7 million partially offset by a net currency revaluation of $36.2 million, a consequence of the weakening of the euro and sterling against the US dollar during the year. Deferred revenue due within one year at the balance sheet date of $428.6M increased by 5.1 per cent at actual rates or by 10.7 per cent in constant currency. Revenue in the Americas increased by $29.7 million or 13.3 per cent to $253.3 million in the year-ended 31 March 2019, supported by the recognition of prior-period Enduser billings from the Sophos Central platform and the growth of the MSP channel in the current period. EMEA revenue increased by $39.1 million or 12.0 per cent to $363.6 million in the year-ended 31 March 2019, with growth in Enduser in particular, but also aided by Network sales. APJ revenue increased by $2.8 million, or 3.1 per cent to $93.7 million in the year-ended 31 March 2019, with good growth in Enduser products partially offset by a decline in Network sales following the legacy product transition.\n\n</text>\n\nWhat would the average revenue earned across 2018 and 2019 be if the amount in 2019 was $700.0 million instead? (in million)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 669.5."
}
|
{
"split": "test",
"index": 77,
"input_length": 1042
}
|
docmath_0_20000
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n|FOR THE YEAR ENDED DECEMBER 31|NOTE|WEIGHTED AVERAGE INTEREST RATE AT DECEMBER 31, 2019|2019|2018|\n|Notes payable (1)|26|2.03%|1,994|3,201|\n|Loans secured by trade receivables|26|2.71%|1,050|919|\n|Long-term debt due within one year (2)|22|4.77%|837|525|\n|Total debt due within one year|||3,881|4,645|\n Note 21 Debt due within one year (1) Includes commercial paper of $1,502 million in U.S. dollars ($1,951 million in Canadian dollars) and $2,314 million in U.S. dollars ($3,156 million in Canadian dollars) as at December 31, 2019 and December 31, 2018, respectively, which were issued under our U.S. commercial paper program and have been hedged for foreign currency fluctuations through forward currency contracts. See Note 26, Financial and capital management, for additional details. (2) Included in long-term debt due within one year is the current portion of lease liabilities of $775 million as at December 31, 2019 and the current portion of finance leases of $466 million as at December 31, 2018.\n\n</text>\n\nWhat would the total long-term debt due within one year in 2018 and 2019 be if the amount in 2019 is 875?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 1400.0."
}
|
{
"split": "test",
"index": 78,
"input_length": 430
}
|
docmath_0_20000
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n|All amounts in USD ‘000 |2019|2018|2017|\n|Spot charter revenues*|283,007|259,978|257,495|\n|Time charter revenues |34,213|29,038|39,646|\n|Total Voyage Revenues |317,220|289,016|297,141|\n 3. VOYAGE REVENUES Our voyage revenues consist of time charter revenues and spot charter revenues with the following split: *Spot charter revenues for 2019 and 2018 are presented in accordance we ASC 606 Revenue from Contracts with Customers. The comparative information for 2017 has not been restated.\n\n</text>\n\nWhat would be the value of the 2019 total voyage revenue as a percentage of the 2018 total voyage revenues if the 2018 total voyage revenue is instead $300,000,000? (in percent)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 105.74."
}
|
{
"split": "test",
"index": 79,
"input_length": 283
}
|
docmath_0_20000
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[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n||Number of Options|Weighted average exercise price|Weighted average remaining contractual life (years)|Aggregate intrinsic value $|\n|Outstanding, January 1, 2018|1,368,772|$3.12|||\n|Granted – 2018|401,099|$9.27|||\n|Exercised – 2018|(165,169)|$3.16|||\n|Expired – 2018|(50,002)|$5.48|||\n|Outstanding, December 31, 2018|1,554,700|$4.63|3.0||\n|Granted – 2019|410,134|$12.28|||\n|Exercised – 2019|(251,063)|$3.73|||\n|Expired – 2019|(89,550)|$12.55|||\n|Outstanding, December 31, 2019|1,624,221|$6.27|2.6|$7,925,643|\n|Exercisable, December 31, 2019|1,143,637|$4.39|1.9|$7,197,053|\n NOTE 11 – STOCK COMPENSATION The Company sponsors a stock-based incentive compensation plan known as the 2013 Equity Compensation Plan (the “Plan”), which was established by the Board of Directors of the Company in June 2013. A total of 500,000 shares were initially reserved for issuance under the Plan. The Plan was amended several times since then to eventually increase the authorized shares to 2,500,000 as of December 31, 2019. A total of 1,624,221 shares of common stock underlying options were outstanding at December 31, 2019. The Company had 236,614 remaining shares available to grant under the Plan at December 31, 2019. The Plan allows the Company to grant incentive stock options, non-qualified stock options, stock appreciation rights, or restricted stock. The incentive stock options are exercisable for up to ten years, at an option price per share not less than the fair market value on the date the option is granted. The incentive stock options are limited to persons who are regular full-time employees of the Company at the date of the grant of the option. Non-qualified options may be granted to any person, including, but not limited to, employees, independent agents, consultants and attorneys, who the Company’s Board or Compensation Committee believes have contributed, or will contribute, to the success of the Company. Non-qualified options may be issued at option prices of less than fair market value on the date of grant and may be exercisable for up to ten years from date of grant. The option vesting schedule for options granted is determined by the Compensation Committee of the Board of Directors at the time of the grant. The Plan provides for accelerated vesting of unvested options if there is a change in control, as defined in the Plan. The compensation cost that has been charged against income related to options for the years ended December 31, 2019 and 2018, was $1,687,745 and $1,317,904, respectively. No income tax benefit was recognized in the income statement and no compensation was capitalized in any of the years presented. The Company had the following option activity during the years ended December 31, 2019 and 2018: Of the options outstanding at December 31, 2019, 1,143,637 were exercisable with a weighted average contractual life of 1.9 years.\n\n</text>\n\nWhat would be the total price of exercised or expired options during the fiscal year 2019 if the weighted-average exercise price of exercised options was $4.25?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 2190870.25."
}
|
{
"split": "test",
"index": 80,
"input_length": 950
}
|
docmath_0_20000
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n||2019|2018|\n|Prepaid expenses|$137,927|$90,981|\n|Prepaid income taxes .|47,811|59,319|\n|Indirect tax receivables .|29,908|26,327|\n|Restricted cash|13,697|19,671|\n|Notes receivable (1)|23,873|5,196|\n|Derivative instruments (2) .|1,199|2,364|\n|Other current assets|22,040|39,203|\n|Prepaid expenses and other current assets|$276,455|$243,061|\n Prepaid expenses and other current assets Prepaid expenses and other current assets consisted of the following at December 31, 2019 and 2018 (in thousands): (1) In November 2014 and February 2016, we entered into a term loan agreement and a convertible loan agreement, respectively, with Clean Energy Collective, LLC (“CEC”). Our term loan bears interest at 16% per annum, and our convertible loan bears interest at 10% per annum. In November 2018, we amended the terms of the loan agreements to (i) extend their maturity to June 2020, (ii) waive the conversion features on our convertible loan, and (iii) increase the frequency of interest payments, subject to certain conditions. In January 2019, CEC finalized certain restructuring arrangements, which resulted in a dilution of our ownership interest in CEC and the loss of our representation on the company’s board of managers. As a result of such restructuring, CEC no longer qualified to be accounted for under the equity method. As of December 31, 2019, the aggregate balance outstanding on the loans was $23.9 million and was presented within “Prepaid expenses and other current assets.” As of December 31, 2018, the aggregate balance outstanding on the loans was $22.8 million and was presented within “Notes receivable, affiliate.” (2) See Note 9. “Derivative Financial Instruments” to our consolidated financial statements for discussion of our derivative instruments.\n\n</text>\n\nWhat will be the increase in prepaid expenses from 2018 to 2019 if the amount of prepaid expense in 2019 increased by 20%? (in thousand)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
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{
"style": "rule",
"ground_truth": "Therefore, the answer is 74531.4."
}
|
{
"split": "test",
"index": 81,
"input_length": 596
}
|
docmath_0_20000
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[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n||2019|2018|$ CHANGE|% CHANGE|\n|Operating costs|(6,942)|(6,946)|4|0.1%|\n|Adjusted EBITDA|5,414|5,321|93|1.7%|\n|Adjusted EBITDA margin|43.8%|43.4%||0.4 pts|\n OPERATING COSTS AND ADJUSTED EBITDA Bell Wireline operating costs were essentially stable year over year, decreasing by 0.1% in 2019, compared to 2018, resulting from: • The favourable impact from the adoption of IFRS 16 in 2019 • Continued effective cost containment • Lower pension expenses reflecting reduced DB costs These factors were partly offset by: • Higher cost of goods sold related to the growth in product sales • Increased costs from the acquisition of Axia • Greater payments to other carriers from increased sales of international wholesale long distance minutes Bell Wireline adjusted EBITDA grew by 1.7% in 2019, compared to last year, reflecting the growth in revenues as operating expenses were relatively stable year over year. Adjusted EBITDA margin increased to 43.8% in 2019, compared to the 43.4% achieved last year, resulting from the favourable impact of the adoption of IFRS 16 in 2019 and the flow-through of the service revenue growth, offset in part by higher low-margin product sales in our total revenue base.\n\n</text>\n\nWhat would the sum of the adjusted EBITDA in 2018 and 2019 be if the amount for 2019 is 5,400?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
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{
"style": "rule",
"ground_truth": "Therefore, the answer is 10721.0."
}
|
{
"split": "test",
"index": 82,
"input_length": 415
}
|
docmath_0_20000
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n||Amortized Cost|Unrealized Gains|Unrealized Losses|Fair Value|\n|Current assets:|||||\n|Cash|$67,818|$—|$—|$67,818|\n|Cash equivalents:|||||\n|Money market funds|126,075|—|—|126,075|\n|Corporate bonds|1,000|—|—|1,000|\n|Agency bonds|6,485|1|—|6,486|\n|Commercial paper|9,609|—|(1)|9,608|\n|Certificates of deposit|171|—|—|171|\n|US treasury securities|4,749|—|—|4,749|\n|Total cash equivalents|148,089|1|(1)|148,089|\n|Total cash and cash equivalents|215,907|1|(1)|215,907|\n|Short-term investments:|||||\n|Corporate bonds|103,130|110|(7)|103,233|\n|Agency bonds|3,966|2|—|3,968|\n|US treasury securities|50,703|62|(1)|50,764|\n|Commercial paper|23,827|1|—|23,828|\n|Certificates of deposit|3,936|2|(1)|3,937|\n|Asset-backed securities|15,837|12|—|15,849|\n|Total short-term investments|201,399|189|(9)|201,579|\n|Long-term investments:|||||\n|Corporate bonds|19,407|12|(4)|19,415|\n|US treasury securities|19,300|25|—|19,325|\n|Asset-backed securities|11,693|10|(1)|11,702|\n|Strategic investments|9,750|—|—|9,750|\n|Total long-term investments|$60,150|$47|$(5)|$60,192|\n 5. INVESTMENTS Investments in Marketable Securities The Company’s investments in available-for-sale marketable securities are made pursuant to its investment policy, which has established guidelines relative to the diversification of the Company’s investments and their maturities, with the principal objective of capital preservation and maintaining liquidity sufficient to meet cash flow requirements. The following is a summary of investments, including those that meet the definition of a cash equivalent, as of December 31, 2019 (in thousands):\n\n</text>\n\nWhat percentage of total unrealised gains for short-term investments would consist of US treasury securities if total unrealised gains for short-term investments were 200 thousands instead without change to unrealised gains in US treasury securities? (in percent)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 31.0."
}
|
{
"split": "test",
"index": 83,
"input_length": 716
}
|
docmath_0_20000
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[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n|||Year-ended 31 March 2019|Year-ended 31 March 2018|Year-ended 31 March 2017|\n|||tCO2e|tCO2e|tCO2e|\n|Scope 1|Combustion of natural gas and operation of owned vehicles|220.9|320.0|251.8|\n|Scope 2|Electricity consumption in offices|4,487.2|4,457.3|4,681.9|\n|Scope 3|Business travel (air and car)|3,260.9|5,117.4|4,510.9|\n|Total||7,969.0|9,894.7|9,444.6|\n|Intensity ratio|||||\n|tCO2e per $M of billings||10.5|12.9|14.9|\n Greenhouse gas emissions In line with the Companies Act 2006, Sophos is required to measure and report on its Greenhouse Gas (“GHG”) emissions disclosures. These have been calculated for the year-ending 31 March 2019, in line with the Group’s financial year. The calculation of the disclosures has been performed in accordance with Greenhouse Gas Protocol Corporate Standard and using the UK government’s conversion factor guidance for the year reported. The Group’s operations that primarily release GHG includes usage of electricity and gas of owned and leased offices, business travel and usage of vehicles. The Group keeps its data capture process under review, seeking to extend the availability of direct information wherever possible. Where direct information for certain sites is not available, estimates have been developed that enable reporting for them. These estimates are revised if new or improved data is obtained. The Group will continue to build its GHG reporting capabilities. The Group’s chosen intensity ratio is ‘tonnes of CO2 equivalent per million US dollars of billings’ as it aligns with Sophos’ strategic growth ambitions. Creating an environmentally friendly HQ The Group commissioned a greening study of its global headquarters in Abingdon, Oxfordshire. The purpose of the study was to benchmark the current environmental, health and wellbeing performance of the building against current best practice and against direct and indirect competitors. The findings of the study showed that the building performance was consistent with intermediate good practice and the building management was consistent with standard good practice. The study highlighted areas of future improvement. The findings and recommendations of this report will be a key driver for developing best practice in environmental sustainability to match the growth aspirations and objectives of the Company. The Group is endeavouring to achieve the standards in environmental performance, health and wellbeing that is expected of a global technology organisation at the Group’s headquarters.\n\n</text>\n\nWhat would the percentage change in the intensity ratio in 2019 from 2018 be if the ratio in 2019 was 10.0 instead? (in percent)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is -22.48062015503876."
}
|
{
"split": "test",
"index": 84,
"input_length": 673
}
|
docmath_0_20000
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n|||Years Ended December 31,||\n||2019|2018|2017|\n|Net income|$67,062|$68,921|$5,135|\n|Other comprehensive income (loss):||||\n|Foreign currency translation adjustments|1,034|-15,261|16,744|\n|Total other comprehensive income (loss)|1,034|(15,261 )|16,744|\n|Comprehensive income|$68,096|$53,660|$21,879|\n ACI WORLDWIDE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (in thousands) The accompanying notes are an integral part of the consolidated financial statements.\n\n</text>\n\nWhat would be the change in comprehensive income between 2018 and 2019 if comprehensive income in 2019 was $70,000 thousand instead? (in thousand)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 16340.0."
}
|
{
"split": "test",
"index": 85,
"input_length": 268
}
|
docmath_0_20000
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n||2019|2018|2017|\n|||(in thousands)||\n|Income before income taxes||||\n|U.S|$192,442|$189,691|$76,699|\n|Non-U.S|333,330|278,110|447,713|\n||$525,772|$467,801|$524,412|\n|Provision (benefit) for income taxes||||\n|Current:||||\n|U.S. Federal|$19,297|$(59,122)|$162,679|\n|Non-U.S|52,810|45,083|64,313|\n|State|(4,347)|1,721|2,623|\n||67,760|(12,318)|229,615|\n|Deferred:||||\n|U.S. Federal|(4,522)|29,252|43,687|\n|Non-U.S|(8,007)|(1,243)|(6,476)|\n|State|3,073|331|(106)|\n||(9,456)|28,340|37,105|\n|Total provision for income taxes|$58,304|$16,022|$266,720|\n S. INCOME TAXES The components of income (loss) before income taxes and the provision (benefit) for income taxes as shown in the consolidated statements of operations were as follows: Income tax expense for 2019, 2018 and 2017 totaled $58.3 million, $16.0 million and $266.7 million, respectively. The effective tax rate for 2019, 2018 and 2017 was 11.1%, 3.4% and 50.9%, respectively. On December 22, 2017, the U.S. enacted the Tax Cuts and Jobs Act of 2017 (the “Tax Reform Act”), making significant changes to the Internal Revenue Code. The Tax Reform Act has significant direct and indirect implications for accounting for income taxes under ASC 740, “Accounting for Income Taxes” some of which could not be calculated with precision until further clarification and guidance was made available from tax authorities, regulatory bodies or the FASB. In light of this uncertainty, on December 22, 2017 the SEC issued Staff Accounting Bulletin (“SAB”) No. 118, “Income Tax Accounting Implications of the Tax Cuts and Jobs Act,” to address uncertainty in the application of U.S. GAAP when the registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Tax Reform Act. In accordance with SAB 118, Teradyne recorded $186.0 million of additional income tax expense in the fourth quarter of 2017 which represented Teradyne’s best estimate of the impact of the Tax Reform Act in accordance with Teradyne’s understanding of the Tax Reform Act and available guidance as of that date. The $186.0 million was primarily composed of expense of $161.0 million related to the one-time transition tax on the mandatory deemed repatriation of foreign earnings, $33.6 million of expense related to the remeasurement of certain deferred tax assets and liabilities based on the rates at which they are expected to reverse in the future, and a benefit of $10.3 million associated with the impact of correlative adjustments on uncertain tax positions. In accordance with the requirements of SAB 118, in the fourth quarter of 2018, Teradyne completed its analysis of the effect of the Tax Reform Act based on the application of the most recently available guidance as of December 31, 2018 and recorded $49.5 million of net income tax benefit. The net benefit consisted of $51.7 million of benefit resulting from a reduction in the estimate of the one-time transition tax on the mandatory deemed repatriation of foreign earnings and an expense of $2.2 million associated with the impact of correlative adjustments on uncertain tax positions.\n\n</text>\n\nWhat would the change in U.S. Income before income taxes in 2019 from 2018 if the amount in 2019 was $193,000 thousand instead? (in thousand)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 3309.0."
}
|
{
"split": "test",
"index": 86,
"input_length": 1073
}
|
docmath_0_20000
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n|As at December 31,|2019|2018|\n|Equity securities|||\n|Canada|22.3%|20.8%|\n|United States|19.8%|12.7%|\n|International (other than United States)|14.1%|18.1%|\n|Fixed income instruments|||\n|Canada|41.2%|45.7%|\n|Cash and cash equivalents|||\n|Canada|2.6%|2.7%|\n 30. EMPLOYEE BENEFIT PLANS (cont.) The fair value of the plan assets were allocated as follows between the various types of investments: Plan assets are valued at the measurement date of December 31 each year. The investments are made in accordance with the Statement of Investment Policies and Procedures. The Statement of Investment Policies and Procedures is reviewed on an annual basis by the Management Level Pension Fund Investment Committee with approval of the policy being provided by the Audit Committee.\n\n</text>\n\nWhat would be the percentage change in plan asset fair value allocated in Canada equity securities between 2018 and 2019 if the percentage accorded in 2019 is doubled and then increased by 5%? (in percent)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 28.8."
}
|
{
"split": "test",
"index": 87,
"input_length": 306
}
|
docmath_0_20000
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n||Capped Call|Embedded exchange feature of Notes|Non-marketable investments|\n|||(U.S. $ in thousands)||\n|Balance as of June 30, 2017|$—|$—|$—|\n|Purchases|87,700|(177,907)|—|\n|Gains (losses)||||\n|Recognized in other non-operating (expense) income, net|12,232|(24,646)||\n|Balance as of June 30, 2018|99,932|(202,553)|—|\n|Change in unrealized gains (losses) relating to assets and liabilities held as of June 30, 2018||||\n|Recognized in other non-operating income (expense), net|12,232|(24,646)|—|\n|Balance as of June 30, 2018|$99,932|$(202,553)|$—|\n|Purchases|—|—|23,000|\n|Transfer out|—|—|(20,942)|\n|Gains (losses)||||\n|Recognized in finance income|—|—|270|\n|Recognized in other non-operating (expense) income, net|114,665|(648,573)|—|\n|Recognized in other comprehensive income|—|—|672|\n|Balance as of June 30, 2019|$214,597|$(851,126)|$3,000|\n|Change in unrealized gains (losses) relating to assets and liabilities held as of June 30, 2019||||\n|Recognized in other non-operating income (expense), net|114,665|(648,573)|—|\n Non-marketable investments Non-marketable equity securities are measured at fair value using market data, such as publicly available financing round valuations. Financial information of private companies may not be available and consequently we will estimate the fair value based on the best available information at the measurement date. The following table presents the reconciliations of Level 3 financial instrument fair values: There were transfers out from Level 3 due to initial public offerings of the respective investees during fiscal year 2019. There were no transfers between levels during fiscal year 2018.\n\n</text>\n\nWhat would be the percentage change in the balance of capped call between fiscal year ended June 30, 2018 and 2019 if the value in fiscal year 2018 was $150,000 thousand instead? (in percent)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 43.06466666666667."
}
|
{
"split": "test",
"index": 88,
"input_length": 649
}
|
docmath_0_20000
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n||International|Pinnacle Foods|Corporate|Total|\n|Other cost of goods sold|$—|$3.7|$—|$3.7|\n|Total cost of goods sold .|—|3.7|—|3.7|\n|Severance and related costs|0.7|0.6|110.8|112.1|\n|Accelerated depreciation|—|—|4.7|4.7|\n|Contract/lease termination .|—|0.8|0.3|1.1|\n|Consulting/professional fees .|0.2|—|38.1|38.3|\n|Other selling, general and administrative expenses .|0.1|—|8.2|8.3|\n|Total selling, general and administrative expenses|1.0|1.4|162.1|164.5|\n|Consolidated total|$1.0|$5.1|$162.1|$168.2|\n Notes to Consolidated Financial Statements - (Continued) Fiscal Years Ended May 26, 2019, May 27, 2018, and May 28, 2017 (columnar dollars in millions except per share amounts) During fiscal 2019, we recognized the following pre-tax expenses for the Pinnacle Integration Restructuring Plan: Included in the above results are $163.5 million of charges that have resulted or will result in cash outflows and $4.7 million in non-cash charges.\n\n</text>\n\nWhat would be the proportion of cash charges that have resulted or will result in cash outflows over total consolidated pre-tax expenses if the total consolidated pre-tax expenses were $200 million?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 0.8175."
}
|
{
"split": "test",
"index": 89,
"input_length": 419
}
|
docmath_0_20000
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n|Period|(a) Total Number of Shares (or Units) Purchased|(b) Average Price Paid per Share (or Unit)|(c) Total Number of Shares (or Units) Purchased as Part of Publicly Announced Plans or Programs|(d) Maximum Number (or Approximate Dollar Value) of Shares (or Unites) that May Yet Be Purchased Under the Plans or Programs*|\n|July 1-31, 2019|293|$ 99.35|293|74,706|\n|August 1 - 31, 2019|39,769|107.71|39,769|34,937|\n|September 1 - 30, 2019|91|75.51|91|34,846|\n|Total|40,153|$ 107.58|40,153|34,846|\n REPURCHASE OF COMPANY SHARES The Company repurchased a total of 75,113 and 74,880 shares of its common stock during fiscal 2019 and fiscal 2018, respectively, for cash totaling approximately $7.5 million and $7.7 million, respectively. All repurchased shares were recorded in treasury stock at cost. At September 2019, 34,846 shares of the Company’s common shares remained authorized for repurchase in either the open market or privately negotiated transactions, as previously approved by the Company’s Board of Directors. In October 2019, our Board of Directors renewed the repurchase authorization for up to 75,000 shares of the Company’s common stock. During the fourth quarter of fiscal 2019, the Company repurchased shares of its common stock for cash totaling approximately $4.3 million. The following table summarizes these repurchases made by or on behalf of our Company or certain affiliated purchasers of shares of our common stock for the quarterly period ended September 30, 2019: * In October 2019 and subsequent to the end of fiscal 2019, our Board of Directors authorized purchases of up to\n75,000 shares of our Company’s common stock in open market or negotiated transactions. Management was\ngiven discretion to determine the number and pricing of the shares to be purchased, as well as the timing of any\nsuch purchases.\n\n</text>\n\nWhat would be the percentage change in the shares of common stock repurchased between fiscal 2018 and 2019 if the number of shares repurchased in 2019 is increased by 5,000? (in percent)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 6.988514957264957."
}
|
{
"split": "test",
"index": 90,
"input_length": 635
}
|
docmath_0_20000
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n|||YearEnded||\n||June 30, 2019|June 24, 2018|June 25, 2017|\n|||(in thousands)||\n|United States|$(59,876)|$128,190|$7,553|\n|Foreign|2,506,447|3,023,599|1,804,120|\n||$2,446,571|$3,151,789|$1,811,673|\n Note 7: Income Taxes On December 22, 2017, the “Tax Cuts & Jobs Act” was signed into law and was effective for the Company starting in the quarter ended December 24, 2017. U.S. tax reform reduced the U.S. federal statutory tax rate from 35% to 21%, assessed a one-time transition tax on earnings of certain foreign subsidiaries that were previously tax deferred, and created new taxes on certain foreign sourced earnings. The impact on income taxes due to a change in legislation is required under the authoritative guidance of Accounting Standards Codification (“ASC”) 740, Income Taxes, to be recognized in the period in which the law is enacted. In conjunction, the SEC issued Staff Accounting Bulletin (“SAB”) 118, which allowed for the recording of provisional amounts related to U.S. tax reform and subsequent adjustments related to U.S. tax reform during an up to one-year measurement period that is similar to the measurement period used when accounting for business combinations. The Company recorded what it believed to be reasonable estimates during the SAB 118 measurement period. During the December 2018 quarter, the Company finalized the accounting of the income tax effects of U.S. tax reform. Although the SAB 118 measurement period has ended, there may be some aspects of U.S. tax reform that remain subject to future regulations and/or notices which may further clarify certain provisions of U.S. tax reform. The Company may need to adjust its previously recorded amounts to reflect the recognition and measurement of its tax accounting positions in accordance with ASC 740; such adjustments could be material. The computation of the one-time transition tax on accumulated unrepatriated foreign earnings was recorded on a provisional basis in the amount of $883.0 million in the fiscal year ended June 24, 2018, as permitted under SAB 118. The Company recorded a subsequent provisional adjustment of $36.6 million, as a result of incorporating new information into the estimate, in the Condensed Consolidated Financial Statements in the three months ended September 23, 2018. The Company finalized the computation of the transition tax liability during the December 2018 quarter. The final adjustment resulted in a tax benefit of $51.2 million, which was recorded in the Company’s Condensed Consolidated Financial Statements in the three months ended December 23, 2018. The final balance of total transition tax is $868.4 million. The one-time transition tax is based on the Company’s total post-1986 earnings and profits (“E&P”) that was previously deferred from U.S. income taxes. The Company had previously accrued deferred taxes on a portion of this E&P. The Company has completed the calculation of total post-1986 E&P and related income tax pools for its foreign subsidiaries. The Company elected to pay the one-time transition tax over a period of eight years. Beginning in fiscal year 2019, the Company is subject to the impact of the GILTI provision of U.S. tax reform. The GILTI provision imposes taxes on foreign earnings in excess of a deemed return on tangible assets. The Company has calculated the impact of the GILTI provision on current year earnings and has included the impact in the effective tax rate. The Company made an accounting policy election in the September 2018 quarter to record deferred taxes in relation to the GILTI provision, and recorded a provisional tax benefit of $48.0 million in the Condensed Consolidated Financial Statements in the three months ended September 23, 2018, under SAB 118. The Company finalized the computation of the accounting policy election during the December 2018 quarter. The final adjustment resulted in a tax expense of $0.4 million, which was recorded in the Company’s Condensed Consolidated Financial Statements in the three months ended December 23, 2018. The final tax benefit of the election is $47.6 million. The components of income (loss) before income taxes were as follows:\n\n</text>\n\nWhat would the percentage change in the income before income taxes from Foreign countries from 2018 to 2019 be if the amount in 2019 was 3,000,000 thousand instead? (in percent)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is -0.780493709648667."
}
|
{
"split": "test",
"index": 91,
"input_length": 1105
}
|
docmath_0_20000
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n|||Fiscal Year Ended||\n||December 27, 2019 |December 28, 2018 |December 29, 2017|\n|Net income per share:||||\n|Basic|$0.82|$0.71|$0.55|\n|Diluted|$0.81|$0.70|$0.54|\n|Weighted average common shares:||||\n|Basic|29,532,342|28,703,265|26,118,482|\n|Diluted|30,073,338|29,678,919|27,424,526|\n Note 3 – Net Income per Share The following table sets forth the computation of basic and diluted earnings per share:\n\n</text>\n\nWhat would be the change in net income per diluted share between 2018 and 2019 if the value in 2019 was $0.75 instead?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 0.050000000000000044."
}
|
{
"split": "test",
"index": 92,
"input_length": 273
}
|
docmath_0_20000
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n||||Total Number of|Approximate Dollar|\n||||Shares Purchased as|Value of Shares that|\n||Total Number of|Average Price|Part of Publicly|May Yet Be|\n||Shares|Paid per|Announced|Purchased|\n|(in millions, except per share amounts)|Purchased|Share|Program|Under the Program|\n|March 1, 2019—March 31, 2019|58.0|$52.93|58.0|$8,780.5|\n|April 1, 2019—April 30, 2019|29.1|$54.41|29.1|$7,198.4|\n|May 1, 2019—May 31, 2019|24.9|$54.11|24.9|$5,848.4|\n|Total|112.0|$53.57|112.0||\n Stock Repurchase Program Our Board of Directors has approved a program for us to repurchase shares of our common stock. On September 17, 2018 and February 15, 2019, we announced that our Board of Directors approved expansions of our stock repurchase program totaling $24.0 billion. As of May 31, 2019, approximately $5.8 billion remained available for stock repurchases pursuant to our stock repurchase program. Our stock repurchase authorization does not have an expiration date and the pace of our repurchase activity will depend on factors such as our working capital needs, our cash requirements for acquisitions and dividend payments, our debt repayment obligations or repurchases of our debt, our stock price, and economic and market conditions. Our stock repurchases may be effected from time to time through open market purchases or pursuant to a rule 10b5-1 plan. Our stock repurchase program may be accelerated, suspended, delayed or discontinued at any time. The following table summarizes the stock repurchase activity for the three months ended May 31, 2019 and the approximate dollar value of shares that may yet be purchased pursuant to our stock repurchase program:\n\n</text>\n\nHow much was the Average Price Paid per Share from February 2019 to April 2019 if the total number of shares purchased in February 2019 was the same as that for April 2019 and the Average Price Paid per Share was 88.91?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 62.31111876075732."
}
|
{
"split": "test",
"index": 93,
"input_length": 585
}
|
docmath_0_20000
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n||2019|2018|\n|Advances|500|-|\n|Board compensation|413|413|\n|Other accrued expenses|168|150|\n||$1,081|$563|\n 7. ACCRUED LIABILITIES Other accrued expenses consisted of the following at December 31, 2019 and 2018 (in thousands): Advances are amounts received from litigation counsel as advanced reimbursement of out-of-pocket expenses expected to be incurred by us. Board compensation of $0.4 million at December 31, 2019 and 2018 represents accrued and unpaid board and committee fees from prior periods. In the first quarter of 2020, current and prior board members agreed to waive unpaid cash fees in exchange for share-based compensation awards with an aggregate grant-date fair value of approximately $0.1 million (see Note 18).\n\n</text>\n\nWhat is the total amount of the top 2 categories of accrued liabilities in 2019, if Other accrued expenses made up $1,000 thousand? (in thousand)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 1500.0."
}
|
{
"split": "test",
"index": 94,
"input_length": 282
}
|
docmath_0_20000
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n|||Years Ended December 31,||\n||2019|2018|2017|\n|Average daily utilization|$87,800|$106,189|$268,775|\n|Interest expense (1)|$3,465|$3,817|$6,668|\n|Weighted average interest rate (1)|3.9%|3.6%|2.5%|\n The following table presents information related to our credit agreements (dollars in thousands): (1) Excludes the amortization of deferred loan fees and includes the commitment fee. In January 2018, the Company repaid $175.0 million of long-term debt outstanding under its 2015 Credit Agreement, primarily using funds repatriated from its foreign subsidiaries.\n\n</text>\n\nWhat would the percentage change in Interest expense in 2019 from 2018 be if the amount in 2019 was $3,417 thousand instead? (in percent)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is -10.47943411055803."
}
|
{
"split": "test",
"index": 95,
"input_length": 266
}
|
docmath_0_20000
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n||||Year Ended December 31,|\n|(In thousands, unaudited)|2019|2018|2017|\n|Net income (loss)|$ (19,931)|$ (50,571)|$ 65,299|\n|Add (subtract):||||\n|Interest expense, net of interest income|136,660|134,578|129,786|\n|Income tax benefit|(3,714)|(24,127)|(124,927)|\n|Depreciation and amortization|381,237|432,668|291,873|\n|EBITDA|494,252|492,548|362,031|\n|Adjustments to EBITDA:||||\n|Other, net (1)|(8,847)|549|19,314|\n|Investment distributions (2)|35,809|39,078|29,993|\n|Gain on extinguishment of debt|(4,510)|—|—|\n|Non-cash, stock-based compensation|6,836|5,119|2,766|\n|Adjusted EBITDA|$ 523,540|$ 537,294|$ 414,104|\n Non-GAAP Measures In addition to the results reported in accordance with US GAAP, we also use certain non-GAAP measures such as EBITDA and adjusted EBITDA to evaluate operating performance and to facilitate the comparison of our historical results and trends. These financial measures are not a measure of financial performance under US GAAP and should not be considered in isolation or as a substitute for net income as a measure of performance and net cash provided by operating activities as a measure of liquidity. They are not, on their own, necessarily indicative of cash available to fund cash needs as determined in accordance with GAAP. The calculation of these non-GAAP measures may not be comparable to similarly titled measures used by other companies. Reconciliations of these non-GAAP measures to the most directly comparable financial measures presented in accordance with GAAP are provided below. EBITDA is defined as net earnings before interest expense, income taxes, and depreciation and amortization. Adjusted EBITDA is comprised of EBITDA, adjusted for certain items as permitted or required under our credit facility as described in the reconciliations below. These measures are a common measure of operating performance in the telecommunications industry and are useful, with other data, as a means to evaluate our ability to fund our estimated uses of cash. The following tables are a reconciliation of net income (loss) to adjusted EBITDA for the years ended December 31, 2019, 2018 and 2017: (1) Other, net includes the equity earnings from our investments, dividend income, income attributable to noncontrolling interests in subsidiaries, acquisition and transaction related costs including integration and severance, non-cash pension and post-retirement benefits and certain other miscellaneous items. (2) Includes all cash dividends and other cash distributions received from our investments.\n\n</text>\n\nIf the Net income (loss) in 2019 reduced to (14,047 thousand) what would be the increase/ (decrease) in Net income (loss) from 2018 to 2019? (in thousand)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 36524.0."
}
|
{
"split": "test",
"index": 96,
"input_length": 803
}
|
docmath_0_20000
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n|||Years Ended September 30,||\n||2019|2018|2017|\n|||(in thousands)||\n|Tax expense at U.S. statutory rate|$ 10,992|$ 3,124|$ (3,877)|\n|State income taxes, net of federal tax effect|1,416|(237)|(923)|\n|Nondeductible expenses|1,720|1,186|(185)|\n|Change in reserve for tax contingencies|(1,468)|(1,047)|(4,435)|\n|Change in deferred tax asset valuation allowance|(10,007)|8,784|17,374|\n|Foreign rate differential (1)|2,149|5,684|9,912|\n|Tax credits|(4,767)|(2,656)|(3,459)|\n|Impact of U.S. Tax Reform|—|(7,053)|—|\n|Global Intangible Low-Tax Income|8,182|—|—|\n|Stock Based Compensation|(448)|59|16|\n|Non-controlling interest in equity arrangements|1,802|99|—|\n|Other|1,469|(850)|235|\n|Provision for income taxes|$ 11,040|$ 7,093|$ 14,658|\n The reconciliation of income tax computed at the U.S. federal statutory tax rate to income tax expense is as follows: (1) In 2018, we recorded $3.5 million of tax expense related to foreign earnings which were not permanently reinvested prior to the enactment of the U.S. Tax Act. After enactment, certain foreign earnings are taxed at higher statutory rates than the U.S. which results in $2.1 million of incremental tax expense in 2019. In 2017, we provided for deferred taxes on all cumulative unremitted foreign earnings, as the earnings were no longer considered permanently reinvested resulting in a charge of $9.5 million.\n\n</text>\n\nWhat would the percentage change in nondeductible expenses in 2019 from 2018 be if the amount in 2019 was $1,700 thousand instead? (in percent)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 43.3389544688027."
}
|
{
"split": "test",
"index": 97,
"input_length": 576
}
|
docmath_0_20000
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n||2019|2018|\n||$|$|\n|Short-term employee benefits|12,175,184|14,217,931|\n|Post employment benefits|322,733|297,319|\n|Other long-term benefits|161,569|139,776|\n|Share-based payments|9,177,425|6,594,300|\n||21,836,911|21,249,326|\n This section highlights the Group’s transactions with its related parties, such as its subsidiaries and Key Management Personnel. During the reporting period and previous reporting periods, Woolworths Group Limited advanced loans to, received and repaid loans from, and provided treasury, accounting, legal, taxation, and administrative services to other entities within the Group. Entities within the Group also exchanged goods and services in sale and purchase transactions. All transactions occurred on the basis of normal commercial terms and conditions. Balances and transactions between the Company and its subsidiaries, which are related parties of the Company, have been eliminated on consolidation and are not disclosed in this note. All transactions with directors and Key Management Personnel (including their related parties) were conducted on an arm’s length basis in the ordinary course of business and under normal terms and conditions for customers and employees. Related parties of Key Management Personnel who are employees received normal employee benefits on standard terms and conditions. The total remuneration for Key Management Personnel of the Group is as follows: Details of equity instruments provided as compensation to Key Management Personnel and shares issued on exercise of these instruments, together with the terms and conditions of the instruments, are disclosed in the Remuneration Report.\n\n</text>\n\nWhat is the difference in the total remuneration for Key Management Personnel of the Group between 2018 and 2019 if the total remuneration in 2019 is 22,000,000?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 750674.0."
}
|
{
"split": "test",
"index": 98,
"input_length": 467
}
|
docmath_0_20000
|
[
{
"role": "user",
"content": "\nPlease read the following text and answer the question below.\n\n<text>\n\n|($ in millions)||||\n|For the year ended December 31:|2019|2018|Yr.-to-Yr. Percent Change|\n|Retirement-related plans—cost||||\n|Service cost|$385|$431|(10.7)%|\n|Multi-employer plans|32|38|(16.9)|\n|Cost of defined contribution plans|1,040|1,024|1.5|\n|Total operating costs/ (income)|$1,457|$1,494|(2.5)%|\n|Interest cost|$2,929|$2,726|7.4%|\n|Expected return on plan assets|(4,192)|(4,049)|3.5|\n|Recognized actuarial losses|1,819|2,941|(38.2)|\n|Amortization of prior service costs/(credits)|(9)|(73)|(87.6)|\n|Curtailments/settlements|41|11|262.2|\n|Other costs|28|16|76.2|\n|Total non-operating costs/(income)|$615|$1,572|(60.9)%|\n|Total retirement-related plans—cost|$2,072|$3,066|(32.4)%|\n Retirement-Related Plans The following table provides the total pre-tax cost for all retirement-related plans. Total operating costs/(income) are included in the Consolidated Income Statement within the caption (e.g., Cost, SG&A, RD&E) relating to the job function of the plan participants. Total pre-tax retirement-related plan cost decreased by $994 million compared to 2018, primarily driven by a decrease in recognized actuarial losses ($1,123 million), primarily due to the change in the amortization period in the U.S. Qualified Personal Pension Plan and higher expected return on plan assets ($143 million), partially offset by higher interest costs ($203 million). As discussed in the “Operating (non-GAAP) Earnings” section, we characterize certain retirement-related costs as operating and others as non-operating. Utilizing this characterization, operating retirement-related costs in 2019 were $1,457 million, a decrease of $37 million compared to 2018. Non-operating costs of $615 million in 2019 decreased $957 million year to year, driven primarily by the same factors as above.\n\n</text>\n\nIf interest cost in 2019 increased to 3,000 million, what was the revised average? (in million)\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."
}
] |
doc-math
|
{
"style": "rule",
"ground_truth": "Therefore, the answer is 2863.0."
}
|
{
"split": "test",
"index": 99,
"input_length": 628
}
|
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